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Monetary Policy Mistakes and the Evolution of Inflation Expectations

Athanasios Orphanides () and John Williams ()

No 2010-2, Working Papers from Central Bank of Cyprus

Abstract: What monetary policy framework, if adopted by the Federal Reserve, would have avoided the Great Inflation of the 1960s and 1970s? We use counterfactual simulations of an estimated model of the U.S. economy to evaluate alternative monetary policy strategies. We show that policies constructed using modern optimal control techniques aimed at stabilizing inflation, economic activity, and interest rates would have succeeded in achieving a high degree of economic stability as well as price stability only if the Federal Reserve had possessed excellent information regarding the structure of the economy or if it had acted as if it placed relatively low weight on stabilizing the real economy. Neither condition held true. We document that policymakers at the time both had an overly optimistic view of the natural rate of unemployment and put a high priority on achieving full employment. We show that in the presence of realistic informational imperfections and with an emphasis on stabilizing economic activity, an optimal control approach would have failed to keep inflation expectations well anchored, resulting in highly volatile inflation during the 1970s. Finally, we show that a strategy of following a robust first-difference policy rule would have been highly successful in the presence of informational imperfections. This robust monetary policy rule yields simulated outcomes that are close to those seen during the period of the Great Moderation starting in the mid-1980s.

Keywords: Great Inflation; rational expectations; robust control; model uncertainty; natural rate of unemployment (search for similar items in EconPapers)
JEL-codes: E52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2010-05
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Related works:
Chapter: Monetary Policy Mistakes and the Evolution of Inflation Expectations (2013) Downloads
Working Paper: Monetary Policy Mistakes and the Evolution of Inflation Expectations (2011) Downloads
Working Paper: Monetary Policy Mistakes and the Evolution of Inflation Expectations (2010) Downloads
Working Paper: Monetary policy mistakes and the evolution of inflation expectations (2010) Downloads
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