Working Paper

Monetary Policy and Macroeconomic Stability Revisited

Abstract: A large literature has established that the Fed? change from a passive to an active policy response to inflation led to US macroeconomic stability after the Great Inflation of the 1970s. This paper revisits the literature?s view by estimating a generalized New Keynesian model using a full-information Bayesian method that allows for equilibrium indeterminacy and adopts a sequential Monte Carlo algorithm. The model empirically outperforms canonical New Keynesian models that confirm the literature?s view. Our estimated model shows an active policy response to inflation even during the Great Inflation. More importantly, a more active policy response to inflation alone does not suffice for explaining the US macroeconomic stability, unless it is accompanied by a change in either trend inflation or policy responses to the output gap and output growth. This extends the literature by emphasizing the importance of the changes in other aspects of monetary policy in addition to its response to inflation.

Keywords: Great Inflation; Trend inflation; Monetary policy; Sequential Monte Carlo; Indeterminacy;

JEL Classification: C11; C52; C62; E31; E52;

https://doi.org/10.26509/frbc-wp-201914

Bibliographic Information

Provider: Federal Reserve Bank of Cleveland

Part of Series: Working Papers

Publication Date: 2019-06-27

Number: 19-14