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Three great American disinflations

  • Michael Bordo
  • Christopher Erceg
  • Andrew Levin
  • Ryan Michaels

This paper analyzes the role of transparency and credibility in accounting for the widely divergent macroeconomic effects of three episodes of deliberate monetary contraction: the post-Civil War deflation, the post-WWI deflation, and the Volcker disinflation. Using a dynamic general equilibrium model in which private agents use optimal filtering to infer the central bank's nominal anchor, we demonstrate that the salient features of these three historical episodes can be explained by differences in the design and transparency of monetary policy, even without any time variation in economic structure or model parameters. For a policy regime with relatively high credibility, our analysis highlights the benefits of a gradualist approach (as in the 1870s) rather than a sudden change in policy (as in 1920-21). In contrast, for a policy institution with relatively low credibility (such as the Federal Reserve in late 1980), an aggressive policy stance can play an important signalling role by making the policy shift more evident to private agents.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 898.

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Date of creation: 2007
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Handle: RePEc:fip:fedgif:898
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  1. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," NBER Working Papers 8403, National Bureau of Economic Research, Inc.
  2. Olivier J. Blanchard, 1984. "The Lucas Critique and the Volcker Deflation," NBER Working Papers 1326, National Bureau of Economic Research, Inc.
  3. Christopher Erceg & Luca Guerrieri & Christopher Gust, 2004. "Can long-run restrictions identify technology shocks?," International Finance Discussion Papers 792, Board of Governors of the Federal Reserve System (U.S.).
  4. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
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  8. Lars E.O. Svensson, 2002. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Working Papers 118, Princeton University, Department of Economics, Center for Economic Policy Studies..
  9. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
  10. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1998. "Monetary Policy Shocks: What Have We Learned and to What End?," NBER Working Papers 6400, National Bureau of Economic Research, Inc.
  11. Thomas J. Sargent, 1981. "The ends of four big inflations," Working Papers 158, Federal Reserve Bank of Minneapolis.
  12. Thomas M. Humphrey, 2004. "Classical deflation theory," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 11-32.
  13. Robert J. Gordon, 1982. "Why Stopping Inflation May Be Costly: Evidence from Fourteen Historical Episodes," NBER Chapters, in: Inflation: Causes and Effects, pages 11-40 National Bureau of Economic Research, Inc.
  14. Laurence Ball, 1990. "Credible Disinflation with Staggered Price Setting," NBER Working Papers 3555, National Bureau of Economic Research, Inc.
  15. John M. Firestone, 1960. "Federal Receipts and Expenditures During Business Cycles, 1879-1958," NBER Books, National Bureau of Economic Research, Inc, number fire60-1.
  16. Frank Smets & Raf Wouters, 2002. "An estimated dynamic stochastic general equilibrium model of the euro area," Working Paper Research 35, National Bank of Belgium.
  17. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
  18. Christopher J. Erceg and Andrew T. Levin, 2001. "Imperfect Credibility and Inflation Persistence," Computing in Economics and Finance 2001 19, Society for Computational Economics.
  19. Anderson, Gary & Moore, George, 1985. "A linear algebraic procedure for solving linear perfect foresight models," Economics Letters, Elsevier, vol. 17(3), pages 247-252.
  20. Taylor, John B, 1983. "Union Wage Settlements during a Disinflation," American Economic Review, American Economic Association, vol. 73(5), pages 981-93, December.
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  32. Robert J. Gordon, 1986. "Front matter, The American Business Cycle. Continuity and Change," NBER Chapters, in: The American Business Cycle: Continuity and Change, pages -15 National Bureau of Economic Research, Inc.
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