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Shocks and Government Beliefs: The Rise and Fall of American Inflation

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Author Info
Thomas Sargent
Noah Williams
Tao Zha

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Abstract

We use a Bayesian Markov Chain Monte Carlo algorithm to estimate the parameters of a “true” data-generating mechanism and those of a sequence of approximating models that a monetary authority uses to guide its decisions. Gaps between a true expectational Phillips curve and the monetary authority’s approximating nonexpectational Phillips curve models unleash inflation that a monetary authority that knows the true model would avoid. A sequence of dynamic programming problems implies that the monetary authority’s inflation target evolves as its estimated Phillips curve moves. Our estimates attribute the rise and fall of post- WWII inflation in the United States to an intricate interaction between the monetary authority’s beliefs and economic shocks. Shocks in the 1970s made the monetary authority perceive a tradeoff between inflation and unemployment which ignited big inflation. The monetary authority’s beliefs about the Phillips curve changed in ways that account for former Federal Reserve Chairman Paul Volcker’s conquest of U.S. inflation. (JEL E24, E31, E52, N12)

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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 96 (2006)
Issue (Month): 4 (September)
Pages: 1193-1224
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Handle: RePEc:aea:aecrev:v:96:y:2006:i:4:p:1193-1224

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Ireland, Peter N., 1999. "Does the time-consistency problem explain the behavior of inflation in the United States?," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 279-291, October. [Downloadable!] (restricted)
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  2. Thomas J. Sargent & Noah Williams, 2003. "Impacts of priors on convergence and escapes from Nash inflation," Working Paper 2003-14, Federal Reserve Bank of Atlanta.
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  3. Staiger, Douglas & Stock, James H & Watson, Mark W, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter. [Downloadable!] (restricted)
  4. Timothy Cogley & Thomas J. Sargent, 2003. "Drifts and volatilities: monetary policies and outcomes in the post WWII U.S," Working Paper 2003-25, Federal Reserve Bank of Atlanta. [Downloadable!]
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  5. Timothy Cogley & Thomas J. Sargent, 2005. "The conquest of US inflation: Learning and robustness to model uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 528-563, April. [Downloadable!] (restricted)
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  6. James D. Hamilton & Daniel F. Waggoner & Tao Zha, 2004. "Normalization in econometrics," Working Paper 2004-13, Federal Reserve Bank of Atlanta. [Downloadable!]
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  7. Cho, In-Koo & Williams, Noah & Sargent, Thomas J, 2002. "Escaping Nash Inflation," Review of Economic Studies, Blackwell Publishing, vol. 69(1), pages 1-40, January.
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  8. Robert G. King & Mark W. Watson, 1994. "The post-war U.S. Phillips curve: a revisionist econometric history," Working Paper Series, Macroeconomic Issues 94-14, Federal Reserve Bank of Chicago.
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  9. John Geweke, 1999. "Using simulation methods for bayesian econometric models: inference, development,and communication," Econometric Reviews, Taylor and Francis Journals, vol. 18(1), pages 1-73. [Downloadable!] (restricted)
  10. Sims, Christopher A & Zha, Tao, 1998. "Bayesian Methods for Dynamic Multivariate Models," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 949-68, November.
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  11. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June. [Downloadable!] (restricted)
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