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Shocks and government beliefs: the rise and fall of American inflation

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Author Info
Thomas Sargent
Noah Williams
Tao Zha

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Abstract

The authors use a Bayesian Markov chain Monte Carlo algorithm to estimate a model that allows temporary gaps between a true expectational Phillips curve and the monetary authority’s approximating nonexpectational Phillips curve. A dynamic programming problem implies that the monetary authority’s inflation target evolves as its estimated Phillips curve moves. The authors’ estimates attribute the rise and fall of post-World War II inflation in the United States to an intricate interaction between the monetary authority’s beliefs and economic shocks. Shocks in the 1970s altered the monetary authority’s estimates and made it misperceive the tradeoff between inflation and unemployment. That misperception caused a sharp rise in inflation in the 1970s. The authors’ estimates indicate that policy makers updated their beliefs continuously. By the 1980s, policy makers’ beliefs about the Phillips curve had changed enough to account for Fed chairman Paul Volcker’s conquest of U.S. inflation in the early 1980s.

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Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 2004-22.

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Date of creation: 2004
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Handle: RePEc:fip:fedawp:2004-22

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  1. John Geweke, 1998. "Using simulation methods for Bayesian econometric models: inference, development, and communication," Staff Report 249, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  2. Ireland, Peter N., 1999. "Does the time-consistency problem explain the behavior of inflation in the United States?," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 279-291, October. [Downloadable!] (restricted)
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  3. Thomas J. Sargent & Noah Williams, 2003. "Impacts of priors on convergence and escapes from Nash inflation," Working Paper 2003-14, Federal Reserve Bank of Atlanta.
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  4. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, January.
  5. Staiger, Douglas & Stock, James H & Watson, Mark W, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter. [Downloadable!] (restricted)
  6. Timothy Cogley & Thomas J. Sargent, 2003. "Drifts and volatilities: monetary policies and outcomes in the post WWII U.S," Working Paper 2003-25, Federal Reserve Bank of Atlanta. [Downloadable!]
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  7. Timothy Cogley & Thomas J. Sargent, 2005. "The conquest of US inflation: Learning and robustness to model uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 528-563, April. [Downloadable!] (restricted)
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  8. Peter N. Ireland, 2007. "Changes in the Federal Reserve's Inflation Target: Causes and Consequences," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(8), pages 1851-1882, December. [Downloadable!] (restricted)
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  9. James D. Hamilton & Daniel F. Waggoner & Tao Zha, 2004. "Normalization in econometrics," Working Paper 2004-13, Federal Reserve Bank of Atlanta. [Downloadable!]
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  10. Cho, In-Koo & Williams, Noah & Sargent, Thomas J, 2002. "Escaping Nash Inflation," Review of Economic Studies, Blackwell Publishing, vol. 69(1), pages 1-40, January.
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  11. Robert G. King & Mark W. Watson, 1994. "The post-war U.S. Phillips curve: a revisionist econometric history," Working Paper Series, Macroeconomic Issues 94-14, Federal Reserve Bank of Chicago.
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  12. Sims, Christopher A & Zha, Tao, 1998. "Bayesian Methods for Dynamic Multivariate Models," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 949-68, November.
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  13. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June. [Downloadable!] (restricted)
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