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Regime Switches, Agents’ Beliefs, and Post-World War II U.S. Macroeconomic Dynamics

  • Francesco Bianchi

    (Princeton University)

This paper is focused on the evolution of inflation and output dynamics over the last 50 years, the changes in the behavior of the Federal Reserve, and the role of agents' beliefs. I consider a new Keynesian dynamic stochastic general equilibrium model with Markov-switching structural parameters and heteroskedastic shocks. Agents are aware of the possibility of regime changes and they form expectations accordingly. The results support the view that there were regime switches in the conduct of monetary policy. However, the idea that US monetary policy can be described in terms of pre- and post- Volcker proves to be misleading. The behavior of the Federal Reserve has instead repeatedly fluctuated between a Hawk- and a Dove- regime. Counterfactual simulations show that if agents had anticipated the appointment of an extremely conservative Chairman, inflation would not have reached the peaks of the late `70s and the inflation-output trade-off would have been less severe. This result suggests that in the `70s the Federal Reserve was facing a serious problem of credibility and that there are potentially important gains from committing to a regime of inflation targeting. Finally, I show that in the last year the Fed has systematically deviated from standard monetary practice. As a technical contribution, the paper provides a Bayesian algorithm to estimate a Markov-switching DSGE model.

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Paper provided by Society for Economic Dynamics in its series 2009 Meeting Papers with number 198.

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Date of creation: 2009
Date of revision:
Handle: RePEc:red:sed009:198
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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