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Monetary Policy Mistakes and the Evolution of Inflation Expectations

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  • Athanasios Orphanides

    ()
    (Central Bank of Cyprus)

  • John C. Williams

    ()
    (Federal Reserve Bank of San Francisco)

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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Bibliographic Info

Paper provided by Central Bank of Cyprus in its series Working Papers with number 2010-2.

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Length: 47 pages
Date of creation: May 2010
Date of revision:
Handle: RePEc:cyb:wpaper:2010-2

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Web page: http://www.centralbank.gov.cy/nqcontent.cfm?a_id=1
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Keywords: Great Inflation; rational expectations; robust control; model uncertainty; natural rate of unemployment;

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References

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  1. Athanasios Orphanides & John C. Williams, 2007. "Inflation targeting under imperfect knowledge," Economic Review, Federal Reserve Bank of San Francisco, pages 1-23.
  2. Orphanides, Athanasios & Williams, John C., 2004. "The decline of activist stabilization policy: natural rate misperceptions, learning, and expectations," Working Paper Series 0337, European Central Bank.
  3. Athanasios Orphanides & John C. Williams, 2008. "Imperfect knowledge and the pitfalls of optimal control monetary policy," Working Paper Series 2008-09, Federal Reserve Bank of San Francisco.
  4. Milani, Fabio, 2007. "Expectations, learning and macroeconomic persistence," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 2065-2082, October.
  5. Goodfriend, Marvin & King, Robert G., 2005. "The incredible Volcker disinflation," Journal of Monetary Economics, Elsevier, vol. 52(5), pages 981-1015, July.
  6. Athanasios Orphanides, 2002. "Monetary-Policy Rules and the Great Inflation," American Economic Review, American Economic Association, vol. 92(2), pages 115-120, May.
  7. Athanasios Orphanides & John C. Williams, 2003. "Robust monetary policy rules with unknown natural rates," Finance and Economics Discussion Series 2003-11, Board of Governors of the Federal Reserve System (U.S.).
  8. Orphanides, Athanasios, 2000. "The quest for prosperity without inflation," Working Paper Series 0015, European Central Bank.
  9. David E. Lindsey & Athanasios Orphanides & Robert H. Rasche, 2005. "The reform of October 1979: how it happened and why," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 187-236.
  10. 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, vol. 66(2), pages 349-55, May.
  11. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Inflation Targeting Rules," NBER Working Papers 9939, National Bureau of Economic Research, Inc.
  12. Athanasios Orphanides & John C. Williams, 2002. "Imperfect knowledge, inflation expectations, and monetary policy," Working Paper Series 2002-04, Federal Reserve Bank of San Francisco.
  13. Schmidt-Hebbel, Klaus & Tapia, Matias, 2002. "Inflation targeting in Chile," The North American Journal of Economics and Finance, Elsevier, vol. 13(2), pages 125-146, August.
  14. Dean Croushore & Tom Stark, 1999. "A real-time data set for macroeconomists," Working Papers 99-4, Federal Reserve Bank of Philadelphia.
  15. Robert J. Tetlow, 2010. "Real-time model uncertainty in the United States: 'Robust' policies put to the test," Finance and Economics Discussion Series 2010-15, Board of Governors of the Federal Reserve System (U.S.).
  16. Wiliam Branch & George W. Evans, 2005. "A Simple Recursive Forecasting Model," University of Oregon Economics Department Working Papers 2005-3, University of Oregon Economics Department, revised 01 Feb 2005.
  17. Herbert Stein, 1996. "A Successful Accident: Recollections and Speculations about the CEA," Journal of Economic Perspectives, American Economic Association, vol. 10(3), pages 3-21, Summer.
  18. 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.
  19. John C. Williams & Andrew T. Levin, 2003. "Robust Monetary Policy with Competing Reference Models," Computing in Economics and Finance 2003 291, Society for Computational Economics.
  20. Dean Croushore, 1993. "Introducing: the survey of professional forecasters," Business Review, Federal Reserve Bank of Philadelphia, issue Nov, pages 3-15.
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Cited by:
  1. Pesaran, M. Hashem & Smith, Ron P., 2012. "Counterfactual Analysis in Macroeconometrics: An Empirical Investigation into the Effects of Quantitative Easing," IZA Discussion Papers 6618, Institute for the Study of Labor (IZA).
  2. Athanasios Orphanides, 2010. "Monetary Policy Lessons from the Crisis," Working Papers 2010-1, Central Bank of Cyprus.
  3. Athanasios Orphanides, 2011. "New Paradigms in Central Banking?," Working Papers 2011-6, Central Bank of Cyprus.

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