Working Paper: NBER ID: w4342
Authors: Matthew D. Shapiro
Abstract: Romer and Romer (1989,1990,1992) identify dates where the Federal Reserve appears to have shifted its policy towards reducing the rate of inflation. This paper examines the economic context that drives this decision. It finds that the Fed appears to weigh the outlook for unemployment as well as that for inflation in making its decision about disinflation. Previous work has not examined the course of inflation over the disinflations. This paper finds responses of the inflation rate to the "disinflations" only in a specification where the effects of the policy are presumed to be permanent Moreover, the Volcker disinflation is found to be the only "disinflation" to reduce inflation permanently. The disinflation after the 1973 OPEC price increases was effective, but only temporarily. Other disinflations had negligible impacts on the rate of inflation over all horizons. Variables measuring the expected present discounted values of unemployment and inflation are constructed. These variables are used in a discrete-choice model to explain the Fed's decision to disinflate. This model does a fairly good job of explaining the Fed's decisions. Both inflation and unemployment drive the Fed's decision. For some episodes, notably in the 1970's, inflation is the main variable driving the decision. In the 1969 and 1988 episodes, unemployment matters more.
Keywords: Federal Reserve; disinflation; inflation; unemployment
JEL Codes: E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Federal Reserve's decisions to reduce inflation (E52) | inflation rate (E31) |
| disinflationary policy (E31) | inflation rate (E31) |
| Volcker disinflation (E31) | inflation rate (E31) |
| disinflation (E31) | costs and benefits of disinflation (E31) |
| Federal Reserve's decisions to reduce inflation (E52) | unemployment rate (J64) |
| inflation (E31) | Federal Reserve's decisions to reduce inflation (E52) |
| unemployment (J64) | Federal Reserve's decisions to reduce inflation (E52) |