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

Listed author(s):
  • Yuriy Gorodnichenko

    (UC Berkeley)

  • Olivier Coibion

    (College of William & Mary)

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 satisfied the Taylor principle in the pre-Volcker era, the US economy was still subject to self-fulfilling fluctuations in the 1970s, 2) while the Fed’s response to inflation is not statistically different before and after the Volcker disinflation, the US economy nonetheless moved from indeterminacy to determinacy in this time period, 3) since the 1970s, the Fed has largely switched from responding to the output gap to responding to output growth, and 4) the change from indeterminacy to determinacy is due to the simultaneous decrease in the response to the output gap, increases in the response to inflation and output growth and the decline in steady-state inflation from the Volcker disinflation.

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Paper provided by Society for Economic Dynamics in its series 2009 Meeting Papers with number 21.

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Date of creation: 2009
Handle: RePEc:red:sed009:21
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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