Bad Luck, Bad Policy, and Learning? A Markov-Switching Approach to Understanding Postwar U.S. Macroeconomic Dynamics
45 Pages Posted: 3 Jul 2016 Last revised: 15 Mar 2019
Date Written: June 30, 2017
Abstract
In this paper we analyze changes in the Federal Reserve behavior and objectives since the
1960s justified by potentially evolving beliefs—through a real-time learning process—about
the structure of the economy and shifts in policymakers’ preferences in the late 1970s. In addition, we allow for changes in the volatility of the structural shocks in a Markov-switching
DSGE model. We evaluate the relative contribution of each narrative to the explanation of
the Great Inflation and the Great Moderation. We argue that the interplay between central
bank learning and a shift in policy makers’ preferences explains movements in the monetary
instrument. In addition, the model captures non-policy related high volatility periods clustered
around the mid-to-late 1970s, specifically supply side shocks that behaved as destabilizing
forces driving macroeconomic fluctuations. We also find that the monetary policy shift toward
inflation stabilization (in the late 1970s) changed the composition of output making the
marginal efficiency of investment shock the most important contributor to the business cycle.
To conclude, we observe that a change in monetary policy objectives, assumptions about policymakers’ learning process, and Markov-switching volatility are key to fit the model to U.S.
post-war data.
Keywords: Great Inflation, Policy Preferences, Policymakers' Beliefs, Constant Gain Learning, Markov-switching DSGE Models
JEL Classification: C11, D83, E31, E50, E52, E58, E32, E44
Suggested Citation: Suggested Citation