Hostname: page-component-5d59c44645-dknvm Total loading time: 0 Render date: 2024-03-02T01:09:26.129Z Has data issue: false hasContentIssue false


Published online by Cambridge University Press:  24 May 2016

Gabriela Best*
California State University, Fullerton
Address correspondence to: Gabriela Best, Department of Economics, Steven G. Mihaylo College of Business and Economics, California State University, Fullerton, Fullerton, CA 92834-6848, USA; e-mail:


The literature has proposed two potential channels through which monetary policy played a role in the Great Inflation in the United States. One approach posits that the Federal Reserve held misperceptions of the economy. An alternative explanation contends that policy makers shifted preferences from an output gap stabilization goal toward inflation stabilization after 1979. This paper develops a medium-scale macroeconomic model that incorporates real-time learning by policy makers as well as a (potential) shift in policy makers' preferences. The empirical results show that combining both views—distorted policy makers' beliefs about the persistence of inflation and the inflation-output gap trade-off, accompanied by a stronger preference for inflation stabilization after 1979—illuminates the role played by monetary policy in propagating and ending the Great Inflation.

Copyright © Cambridge University Press 2016 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)


I especially thank Fabio Milani for his advice and help in many aspects of this project. I also thank Bill Branch, Edward Nelson, Michelle Garfinkel, Michael Owyang, Dale Poirier, Giorgio Primiceri, Davide Debortoli, Char Weise, Ricardo Reis, Judy Ahlers, Sherif Khalifa, Pavel Kapinos, Patrick Best, anonymous referees, and all seminar participants at the 2011 Midwest Macro Meetings at Vanderbilt University, Federal Reserve Bank of St. Louis, University of California, Irvine, for important input into this paper. I also thank the Federal Reserve Bank of St. Louis for hosting me during part of this project and the Department of Economics and School of Social Sciences at the University of California, Irvine, for financial support.



Altig, David, Christiano, Lawrence, Eichenbaum, Martin, and Linde, Jesper (2011) Firm-specific capital, nominal rigidities and the business cycle. Review of Economic Dynamics 14 (2), 225247.CrossRefGoogle Scholar
An, Sungbae and Schorfheide, Frank (2007) Bayesian analysis of DSGE models. Econometric Reviews 26 (2–4), 113172.CrossRefGoogle Scholar
Ang, Andrew, Boivin, Jean, Dong, Sen, and Loo-Kung, Rudy (2011) Monetary policy shifts and the term structure. Review of Economic Studies 78 (2), 429457.CrossRefGoogle Scholar
Bernanke, Ben S. (2004) The Great Moderation. Remarks by Governor Ben S. Bernanke at the meetings of the Eastern Economic Association, Washington, DC, February 20, 2004.Google Scholar
Best, Gabriela (2015) A New Keynesian model with staggered price and wage setting under learning. Journal of Economic Dynamics and Control 57, 96111.CrossRefGoogle Scholar
Bianchi, Francesco and Melosi, Leonardo (2012) Inflationary Sentiments and Monetary Policy Communication. Mimeo, Duke University.Google Scholar
Boivin, Jean (2006) Has U.S. monetary policy changed? Evidence from drifting coefficients and real-time data. Journal of Money, Credit and Banking 38 (5), 11491173.CrossRefGoogle Scholar
Brainard, William (1967) Uncertainty and the effectiveness of policy. American Economic Review 57, 411425.Google Scholar
Branch, William, Davig, Troy, and McGough, Bruce (2013) Adaptive learning in regime-switching models. Macroeconomic Dynamics 17 (5), 9981022.CrossRefGoogle Scholar
Carboni, Giacomo and Ellison, Martin (2009) The Great Inflation and the Greenbook. Journal of Monetary Economics 56 (6), 831841.CrossRefGoogle Scholar
Cecchetti, Stephen G., Hooper, Peter, Kasman, Bruce, Schoenholtz, Kermit L., and Watson, Mark W. (2007) Understanding the Evolving Inflation Process. U.S. Monetary Policy Forum 2007, February.Google Scholar
Chib, Siddhartha and Greenberg, Edward (1995) Understanding the Metropolis–Hastings algorithm. American Statistician 49 (4), 327335.Google Scholar
Christiano, Larry, Eichenbaum, Martin S., and Evans, Charles (1999) Monetary policy shocks: What have we learned and to what end? In Taylor, John and Woodford, Michael (eds.), Handbook of Macroeconomics, vol. 1A., pp. 65148. Amsterdam: North-Holland Elsevier.CrossRefGoogle Scholar
Christiano, Larry, Eichenbaum, Martin S., and Evans, Charles (2005) Nominal rigidities and the dynamic effects of a shock to monetary policy. Journal of Political Economy 113, 145.CrossRefGoogle Scholar
Cogley, Timothy, Primiceri, Giorgio E., and Sargent, Thomas J. (2010) Inflation-gap persistence in the US. American Economic Journal: Macroeconomics 2 (1), 4369.Google Scholar
Cogley, Timothy and Sargent, Thomas (2005) Drifts and volatilities: Monetary policies and outcomes in the post WWII U.S. Review of Economic Dynamics 8, 262302.CrossRefGoogle Scholar
Cukierman, Alex (1989) Why does the Fed smooth interest rates? In Belgonia, M. (ed.), Monetary Policy on the 75th Anniversary of the Federal Reserve System, pp. 111147. Boston, MA: Kluwer Academica Press.Google Scholar
Debortoli, Davide and Nunes, Ricardo (2014) Monetary regime switches and central bank preferences. Journal of Money, Credit and Banking 46 (8), 15911626.CrossRefGoogle Scholar
De Long, Brad (1997) America's only peacetime inflation: The 1970s. In Romer, C. and Romer, D. (eds.), Reducing Inflation, pp. 247280. Chicago: University of Chicago Press.Google Scholar
Dennis, Richard (2006) The policy preferences of the US Federal Reserve. Journal of Applied Econometrics 21, 5577.CrossRefGoogle Scholar
Duffy, John and Engle-Warnick, Jim (2006) Multiple regimes in U.S. monetary policy? A nonparametric approach. Journal of Money, Credit and Banking 38 (5), 13631377.CrossRefGoogle Scholar
Erceg, Christopher, Henderson, Dale W., and Levin, Andrew T. (2000) Optimal monetary policy with staggered wage and price contracts. Journal of Monetary Economics 46, 281313.CrossRefGoogle Scholar
Fernandez-Villaverde, Jesus and Rubio-Ramirez, Juan (2007) Estimating macroeconomic models: A likelihood approach. Review of Economic Studies 74 (4), 10591087.CrossRefGoogle Scholar
Giannoni, Marc and Woodford, Michael (2003) Optimal inflation-targeting rules. In Bernanke, Ben S. and Woodford, Michael (eds.), Inflation Targeting, pp. 93172. Chicago: University of Chicago Press.Google Scholar
Justiniano, Alejandro and Primiceri, Giorgio E. (2008) The time-varying volatility of macroeconomic fluctuations. American Economic Review 98 (3), 604641.CrossRefGoogle Scholar
Kim, Chang-Jin and Nelson, Charles R. (1999) Has the U.S. economy become more stable? A Bayesian approach based on a Markov-switching model of the business cycle. Review of Economics and Statistics 81 (4), 608616.CrossRefGoogle Scholar
Kim, Chang-Jin and Nelson, Charles R. (2006) Estimation of a forward-looking monetary policy rule: A time-varying parameter model using ex post data. Journal of Monetary Economics 53 (8), 19491966.CrossRefGoogle Scholar
Kreps, David (1998) Anticipated utility and dynamic choice. In Jacobs, Donald P., Kalai, Ehud, and Kamien, Morton I. (eds.), Frontiers of Research in Economic Theory, pp. 242274. Cambridge, UK: Cambridge University Press.CrossRefGoogle Scholar
Lubik, Thomas and Schorfheide, Frank (2004) Testing for indeterminacy: An application to U.S. monetary policy. American Economic Review 94 (1), 190219.CrossRefGoogle Scholar
Marcet, Albert and Nicolini, Juan P. (2003) Recurrent hyperinflations and learning. American Economic Review 93 (5), 14761498.CrossRefGoogle Scholar
Milani, Fabio (2007) Expectations, learning and macroeconomic persistence. Journal of Monetary Economics 54, 20652082.CrossRefGoogle Scholar
Milani, Fabio (2011) Expectations shocks and learning as drivers of the business cycle. Economic Journal 121, 379401.CrossRefGoogle Scholar
Milani, Fabio (2012) Has globalization transformed U.S. macroeconomic dynamics? Macroeconomic Dynamics 16 (2), 204229.CrossRefGoogle Scholar
Milani, Fabio (2014) Learning and time-varying macroeconomic volatility. Journal of Economic Dynamics and Control 47, 94114.CrossRefGoogle Scholar
Nelson, Edward (2005) The Great Inflation of the seventies: What really happened? Advances in Macroeconomics 5 (1), Article 3.Google Scholar
Okun, Arthur M. (1978) Efficient disinflationary policies. American Economic Review 68, 348352.Google Scholar
Orphanides, Athanasios (2001) Monetary policy rules, macroeconomic stability and inflation: A view from the trenches. Journal of Money, Credit and Banking 36 (2), 151175.CrossRefGoogle Scholar
Orphanides, Athanasios and Williams, John (2005) The decline of activist stabilization policy: Natural rate misperceptions, learning and expectations. Journal of Economic Dynamics and Control 29, 19271950.CrossRefGoogle Scholar
Owyang, Michael and Ramey, Garey (2004) Regime switching and monetary policy measurement. Journal of Monetary Economics 51, 15771597.CrossRefGoogle Scholar
Primiceri, Giorgio (2006) Why inflation rose and fell: Policymakers beliefs and US postwar stabilization policy. Quarterly Journal of Economics 121, 867890.CrossRefGoogle Scholar
Pruitt, Seth (2010) Uncertainty over models and data: The rise and fall of American inflation. Journal of Money, Credit and Banking 44 (2-3), 341365 CrossRefGoogle Scholar
Romer, Christina D. and Romer, David H. (1989) Does monetary policy matter? A new test in the spirit of Friedman and Schwartz. In NBER Chapters. NBER Macroeconomics Annual 4, 121184.Google Scholar
Romer, Christina D. and Romer, David H. (1994) What ends recessions? In NBER Chapters. NBER Macroeconomics Annual 9, 1380.Google Scholar
Romer, Christina D. and Romer, David (2002) The evolution of economics understanding and postwar stabilization policy. In Federal Reserve Bank of Kansas City, Proceedings, Economic Policy Symposium, Jackson Hole, pp. 11–78.CrossRefGoogle Scholar
Salemi, Michael K. (1995) Revealed preferences of the Federal Reserve: Using inverse control theory to interpret the policy equation of a vector autoregression. Journal of Business and Economics Statistics 13, 419433.Google Scholar
Sargent, Thomas (1987) Dynamic Macroeconomic Theory. Cambridge, MA: Harvard University Press.Google Scholar
Sargent, Thomas (1999) The Conquest of American Inflation. Princeton, NJ: Princeton University Press.CrossRefGoogle Scholar
Sargent, Thomas, Williams, Noah, and Zha, Tao (2006) Shocks and government beliefs: The rise and fall of American inflation. American Economic Review, 6 (4), 11931224.CrossRefGoogle Scholar
Sims, Christopher (2002) Solving Linear Rational Expectations Models. Mimeo, Princeton University.Google Scholar
Slobodyan, Sergey and Wouters, Raf (2012a) Learning in a medium-scale DSGE Model with expectations based on small forecasting models. American Economic Journal: Macroeconomics 4 (2), 65101.Google Scholar
Slobodyan, Sergey and Wouters, Raf (2012b) Learning in an estimated medium-scale DSGE model. Journal of Economic Dynamics and Control 36 (1), 2646.CrossRefGoogle Scholar
Smets, Frank and Wouters, Raf (2003) An estimated dynamic stochastic general equilibrium model of the Euro Area. Journal of the European Economic Association 1 (5), 11231175.CrossRefGoogle Scholar
Smets, Frank and Wouters, Raf (2007) Shocks and frictions in US business cycles: A Bayesian DSGE approach. American Economic Review 97, 586606.CrossRefGoogle Scholar
Stock, H. James and Watson, Mark W. (2003) Has the business cycle changed and why? In NBER Chapters. NBER Macroeconomics Annual 17, 159230.Google Scholar
Taylor, John (1993) Discretion versus policy rules in practice. Carnegie–Rochester Conference Series on Public Policy 39, 195214.CrossRefGoogle Scholar
Woodford, Michael (2003) Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton, NJ: Princeton University Press.Google Scholar