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Monetary Policy, Trend Inflation and the Great Moderation:An Alternative Interpretation

  • Olivier Coibion

    ()

    (Department of Economics, College of William and Mary)

  • Yuriy Gorodnichenko

    ()

    (Department of Economics, University of California, Berkeley)

With positive trend inflation, the Taylor principle is not enough to guarantee a determinate equilibrium. We provide new theoretical results on restoring determinacy in New Keynesian models with positive trend inflation and combine these with new empirical findings on the Federal Reserve’s reaction function before and after the Volcker disinflation to find that 1) while the Fed likely satisfied the Taylor principle in the pre-Volcker era, the US economy was still subject to self-fulfilling fluctuations in the 1970s, 2) the US economy moved from indeterminacy to determinacy during the Volcker disinflation, and 3) the switch from indeterminacy to determinacy was due to the changes in the Fed’s response to macroeconomic variables and the decline in trend inflation during the Volcker disinflation.

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Paper provided by Department of Economics, College of William and Mary in its series Working Papers with number 94.

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Length: 59 pages
Date of creation: 15 Sep 2010
Handle: RePEc:cwm:wpaper:94
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