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Shocks and Government Beliefs: The Rise and Fall of American Inflation

  • Thomas Sargent
  • Noah Williams
  • Tao Zha

We use a Bayesian Markov Chain Monte Carlo algorithm to estimate the parameters of a ?true? data-generating mechanism and those of a sequence of approximating models that a monetary authority uses to guide its decisions. Gaps between a true expectational Phillips curve and the monetary authority?s approximating nonexpectational Phillips curve models unleash inflation that a monetary authority that knows the true model would avoid. A sequence of dynamic programming problems implies that the monetary authority?s inflation target evolves as its estimated Phillips curve moves. Our estimates attribute the rise and fall of post- WWII inflation in the United States to an intricate interaction between the monetary authority?s beliefs and economic shocks. Shocks in the 1970s made the monetary authority perceive a tradeoff between inflation and unemployment which ignited big inflation. The monetary authority?s beliefs about the Phillips curve changed in ways that account for former Federal Reserve Chairman Paul Volcker?s conquest of U.S. inflation. (JEL E24, E31, E52, N12)

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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 96 (2006)
Issue (Month): 4 (September)
Pages: 1193-1224

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Handle: RePEc:aea:aecrev:v:96:y:2006:i:4:p:1193-1224
Note: DOI: 10.1257/aer.96.4.1193
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  1. Thomas J. Sargent & Noah William, 2005. "Impacts of Priors on Convergence and Escapes from Nash Inflation," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 360-391, April.
  2. Timothy Cogley & Thomas J. Sargent, 2005. "Drift and Volatilities: Monetary Policies and Outcomes in the Post WWII U.S," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 262-302, April.
  3. William Poole & Robert H. Rasche, 2002. "Flation," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 1-6.
    • William Poole, 2002. "Flation," Speech 49, Federal Reserve Bank of St. Louis.
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  5. Peter N. Ireland, 2005. "Changes in the Federal Reserve’s Inflation Target: Causes and Consequences," Boston College Working Papers in Economics 607, Boston College Department of Economics.
  6. Cho, In-Koo & Sargent, Thomas J., 2000. "Escaping Nash inflation," Working Paper Series 0023, European Central Bank.
  7. King, Robert G. & Watson, Mark W., 1994. "The post-war U.S. phillips curve: a revisionist econometric history," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 41(1), pages 157-219, December.
  8. 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.
  9. 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.
  10. Douglas Staiger & James H. Stock & Mark W. Watson, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter.
  11. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, June.
  12. 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.
  13. Henry W. Chappell, Jr. & Rob Roy McGregor & Todd A. Vermilyea, 2005. "Committee Decisions on Monetary Policy: Evidence from Historical Records of the Federal Open Market Committee," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262033305, June.
  14. John Geweke, 1998. "Using simulation methods for Bayesian econometric models: inference, development, and communication," Staff Report 249, Federal Reserve Bank of Minneapolis.
  15. Christopher A. Sims & Tao Zha, 1996. "Bayesian methods for dynamic multivariate models," Working Paper 96-13, Federal Reserve Bank of Atlanta.
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