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The Decline of Activist Stabilization Policy: Natural Rate Misperceptions, Learning, and Expectations

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Author Info
Athanasios Orphanides () (Federal Reserve Board, Washington, D.C. 20551)
John C. Williams () (Federal Reserve Bank of San Francisco, 101 Market Street, San Francisco, CA 94105)

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Abstract

We develop an estimated model of the U.S. economy in which agents form expectations by continually updating their beliefs regarding the behavior of the economy and monetary policy. We explore the effects of policymakers' misperceptions of the natural rate of unemployment during the late 1960s and 1970s on the formation of expectations and macroeconomic outcomes. We find that the combination of monetary policy directed at tight stabilization of unemployment near its perceived natural rate and large real-time errors in estimates of the natural rate uprooted heretofore quiescent in inflation expectations and destabilized the economy. Had monetary policy reacted less aggressively to perceived unemployment gaps, in inflation expectations would have remained anchored and the stag inflation of the 1970s would have been avoided. Indeed, we find that less activist policies would have been more effective at stabilizing both in inflation and unemployment. We argue that policymakers, learning from the experience of the 1970s, eschewed activist policies in favor of policies that concentrated on the achievement of price stability, contributing to the subsequent improvements in macroeconomic performance of the U.S. economy.

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Paper provided by Center for Financial Studies in its series CFS Working Paper Series with number 2004/24.

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Length: 36 pages
Date of creation: 24 Jan 2004
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Handle: RePEc:cfs:cfswop:wp200424

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Related research
Keywords: Monetary Policy; Stagnation; Rational Expectations; Learning;

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Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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