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Monetary Policy Mistakes and the Evolution of Inflation Expectations

In: The Great Inflation: The Rebirth of Modern Central Banking

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  • Athanasios Orphanides
  • John C. Williams

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.

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This chapter was published in:

  • Michael D. Bordo & Athanasios Orphanides, 2013. "The Great Inflation: The Rebirth of Modern Central Banking," NBER Books, National Bureau of Economic Research, Inc, number bord08-1.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 9176.

    Handle: RePEc:nbr:nberch:9176

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Athanasios Orphanides, 2002. "Monetary policy rules and the Great Inflation," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2002-8, Board of Governors of the Federal Reserve System (U.S.).
    2. Orphanides, Athanasios, 2003. "The quest for prosperity without inflation," Journal of Monetary Economics, Elsevier, Elsevier, vol. 50(3), pages 633-663, April.
    3. Orphanides, Athanasios & Williams, John C, 2006. "Inflation Targeting under Imperfect Knowledge," CEPR Discussion Papers, C.E.P.R. Discussion Papers 5664, C.E.P.R. Discussion Papers.
    4. Athanasios Orphanides & John C. Williams, 2008. "Imperfect knowledge and the pitfalls of optimal control monetary policy," Working Paper Series, Federal Reserve Bank of San Francisco 2008-09, Federal Reserve Bank of San Francisco.
    5. Fabio Milani, 2005. "Expectations, Learning and Macroeconomic Persistence," Macroeconomics, EconWPA 0510022, EconWPA.
    6. Robert J. Tetlow, 2010. "Real-time model uncertainty in the United States: 'Robust' policies put to the test," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2010-15, Board of Governors of the Federal Reserve System (U.S.).
    7. Orphanides, Athanasios & Williams, John C., 2004. "The decline of activist stabilization policy: natural rate misperceptions, learning, and expectations," Working Paper Series, European Central Bank 0337, European Central Bank.
    8. Athanasios Orphanides & John Williams, 2004. "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," NBER Chapters, in: The Inflation-Targeting Debate, pages 201-246 National Bureau of Economic Research, Inc.
    9. Athanasios Orphanides & John C. Williams, 2002. "Robust monetary policy rules with unknown natural rates," Working Paper Series, Federal Reserve Bank of San Francisco 2003-01, Federal Reserve Bank of San Francisco.
    10. Andrew T. Levin & John C. Williams, 2003. "Robust monetary policy with competing reference models," Working Paper Series, Federal Reserve Bank of San Francisco 2003-10, Federal Reserve Bank of San Francisco.
    11. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
    12. Lindsay, David E. & Orphanides, Athanasios & Rasche, Robert H., 2004. "The reform of October 1979: How it happened and why," CFS Working Paper Series 2005/01, Center for Financial Studies (CFS).
    13. Herbert Stein, 1996. "A Successful Accident: Recollections and Speculations about the CEA," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 10(3), pages 3-21, Summer.
    14. Schmidt-Hebbel, Klaus & Tapia, Matias, 2002. "Inflation targeting in Chile," The North American Journal of Economics and Finance, Elsevier, Elsevier, vol. 13(2), pages 125-146, August.
    15. Marvin Goodfriend & Robert King, 2005. "The Incredible Volcker Disinflation," NBER Working Papers 11562, National Bureau of Economic Research, Inc.
    16. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Inflation Targeting Rules," NBER Working Papers 9939, National Bureau of Economic Research, Inc.
    17. Franco Modigliani & Lucas Papademos, 1975. "Targets for Monetary Policy in the Coming Year," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 6(1), pages 141-166.
    18. Wiliam Branch & George W. Evans, 2005. "A Simple Recursive Forecasting Model," University of Oregon Economics Department Working Papers, University of Oregon Economics Department 2005-3, University of Oregon Economics Department, revised 01 Feb 2005.
    19. Kalchbrenner, J H & Tinsley, Peter A, 1976. "On the Use of Feedback Control in the Design of Aggregate Monetary Policy," American Economic Review, American Economic Association, American Economic Association, vol. 66(2), pages 349-55, May.
    20. Dean Croushore & Tom Stark, 1999. "A real-time data set for macroeconomists," Working Papers 99-4, Federal Reserve Bank of Philadelphia.
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    Cited by:
    1. Athanasios Orphanides, 2010. "Monetary Policy Lessons from the Crisis," Working Papers, Central Bank of Cyprus 2010-1, Central Bank of Cyprus.
    2. M. Hashem Pesaran & Ron P. Smith, 2012. "Counterfactual Analysis in Macroeconometrics: An Empirical Investigation into the Effects of Quantitative Easing," CESifo Working Paper Series 3879, CESifo Group Munich.
    3. Athanasios Orphanides, 2011. "New Paradigms in Central Banking?," Working Papers, Central Bank of Cyprus 2011-6, Central Bank of Cyprus.

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