Monetary Policy, Self-Fulfilling Expectations and the U.S. Business Cycle

Abstract

I estimate a medium-scale New-Keynesian model and relax the conventional assumption that the central bank adopted an active monetary policy by pursuing inflation and output stability over the entire post-war period. Even after accounting for a rich structure, I find that monetary policy was passive prior to the Volcker disinflation. However, sunspot shocks did not represent quantitatively relevant sources of volatility. By contrast, such passive interest rate policy accommodated fundamental productivity and cost shocks that de-anchored inflation expectations, propagated via self-fulfilling inflation expectations and constituted the primary sources of the run-up in inflation from the 1960s through the late 1970s.

Does the Centrual Economic Work Conference (CEWC) affect the stock market?

“…Via the expectation of audiences and individual behavior, the CBC affects the financial market by exerting an impact on the expectation of the individual investors’ behavior, which is dependent on the information obtained from the text of CBC (Belke and Beckmann, 2015; Guo et al. , 2021; Nicolò, 2020).…”

“…For example, the exchange rate changes (Conrad and Lamla, 2010; Mirkov et al. , 2019), inflation (Nicolò, 2020) and interest rate (Brubakk et al. , 2021) and bonds (Zhang and Shen, 2021).…”

The (Ir)Relevance of Rule‐of‐Thumb Consumers for U.S. Business Cycle Fluctuations

“…Bianchi and Nicolò (2019) propose a new method for solving and estimating linear rational expectations (LRE) models under indeterminacy that can handle more complex medium‐scale models and can be implemented even when the boundaries of the determinacy region are unknown. Building on this, Nicolò (2020) estimates the medium‐scale model of Smets and Wouters (2007) for different subsamples while allowing for indeterminacy.…”

“…In contrast, for high enough values of the degree of ROT share, IADL might be in place as in Bilbiie (2008), resulting in either indeterminacy due to active monetary policy or determinacy if monetary policy is passive, as found by Bilbiie and Straub (2013). Our paper is also related to Nicolò (2020), who estimates the model of Smets and Wouters (2007) for different subsamples while allowing for indeterminacy and employing the methodology proposed by Bianchi and Nicolò (2019). He shows that monetary policy was passive in the Great Inflation period and active afterward.…”

“…The reason is that the estimated fraction of ROT consumers is so low that it is not affecting the dynamics of the model compared to a standard representative agent model. First, the estimations of both a model with ROT and one without (RANK) point to an indeterminate equilibrium in the pre‐Volcker period, due to passive monetary policy, and to a determinate equilibrium in the post‐Volcker period with active monetary policy, as in Lubik and Schorfheide (2004) and Nicolò (2020). Second, in the pre‐Volcker period, the log‐likelihoods of the two models are very close, while in the latter period, the RANK model is preferred by the data.…”