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Asset market participation, monetary policy rules and the great inflation

  • Bilbiie, Florin O.
  • 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. In an otherwise conventional sticky-price model, standard aggregate demand logic is inverted at low enough asset market participation: interest rate increases become expansionary; passive monetary policy ensures equilibrium determinacy and maximizes welfare. This suggests that Federal Reserve policy in the pre-Volcker era was better than conventional wisdom implies. 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. JEL Classification: E310, E320, E440, E520

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Paper provided by European Central Bank in its series Working Paper Series with number 1438.

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Date of creation: May 2012
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Handle: RePEc:ecb:ecbwps:20121438
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