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Asset Market Participation, Monetary Policy Rules and the Great Inflation

  • Bilbiie, Florin Ovidiu
  • Straub, Roland

This paper argues that limited asset market participation is crucial in explaining U.S. macroeconomic performance and monetary policy before the 1980s, and their changes thereafter. We develop an otherwise standard sticky-price DSGE model, whereby at low enough asset market participation, standard aggregate demand logic is inverted: interest rate increases become expansionary. Thereby, a passive monetary policy rule ensures equilibrium determinacy and maximizes welfare, suggesting that Federal Reserve policy in the pre-Volcker era was better than conventional wisdom suggests. We provide empirical evidence consistent with this hypothesis, and study the relative merits of changes in structure and shocks for reproducing the conquest of the Great Inflation and the Great Moderation.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8555.

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Date of creation: Sep 2011
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Handle: RePEc:cpr:ceprdp:8555
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