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Woon Gyu Choi is a Senior Economist at the IMF Institute of the International Monetary Fund. Yi Wen is an Assistant Vice President at the Federal Reserve Bank of St. Louis. We thank Enrica Detragiache, Ling Hui Tan, and Nicoletta Batini for useful comments and suggestions and Tack Yun for helpful conversations.
In the theoretical literature on optimal monetary policy using dynamic stochastic general-equilibrium models, optimal monetary policy is designed with respect to specific shocks instead of to endogenous variables such as output or inflation (for example, Khan, King, and Wolman, 2003; Schmitt-Grohe and Uribe, 2004; and Benigno and Woodford, 2005). Considering the implementability condition, however, a number of studies have focused on a policy rule whereby policy variables are set as a function of a small number of easily observable macroeconomic indicators (Schmitt-Grohe and Uribe, 2007).
The more traditional monetary policy literature suggests that, in response to a positive demand shock, optimal policy is characterized as monetary tightening (Poole, 1970); and conversely in response to a positive productivity shock, monetary easing for output stability counteracts monetary tightening for price stability (Dotsey and King, 1983; and Canzoneri and others, 1983). More recently, Dotsey and Hornstein (2002) show that optimal interest rate policy requires lower interest rates in response to output increases driven by productivity shocks.
The conventional interpretation of the Taylor rule suggests that a higher output gap should call for monetary tightening. However, the optimal monetary policy literature would not necessarily recommend an equal amount of monetary contraction if the increased output gap is caused by an adverse supply shock to the trend component of output (for example, a natural disaster) rather than by a positive demand shock to the cyclical component of output.
Many studies have stressed that monetary policymakers in the 1960s and 1970s were not as successful as those of the last two decades—the “policy mistakes” view. This view is compared with the “bad luck” view (the volatility of exogenous, non-policy shocks was higher) and the “lack of commitment” view (policymakers did not have incentives to keep inflation low) in explaining the high inflation in the 1960s and 1970s.
There is a strand of the literature that focuses on policymakers’ learning dynamics. For example, Primiceri (2006) suggests that the “Great Inflation” in the 1960s and 1970s was attributable to policymakers’ bias on both the natural rate of unemployment and the persistence of inflation in the Phillips curve.
The exogenous aspect of monetary policy is not the focus of our paper since it has been widely studied in the literature (for example, Sims, 1982; Christiano and Eichenbaum, 1992; Galí, 1992; Leeper, Sims, and Zha, 1996; and Clarida, Galí, and Gertler, 2000).
We use output growth instead of a measure of the output gap because we want to identify a permanent component in the output level from the SVAR analysis. This permanent component represents a stochastic long-run growth trend and can be viewed as the potential output.
This by no means suggests that market forces do not play a role in moving the funds rate. However, the Fed has the absolute power to change the funds rate if it wants to intervene.
For a robustness check, we find qualitatively the same results from an alternative model where inflation and the nominal interest rate are first-differenced.
Another definition of the output gap characterizes potential output as a deterministic linear trend, y*=γt, where γ is the mean growth rate of the economy. It is also straightforward in this case to uncover the Taylor rule coefficients with respect to the output gap from our estimated impulse response functions.
We used the following data series, obtained from the website of the Federal Reserve Bank of St. Louis (FRED): GDP (nominal GDP), GDPC1 (real GDP), FEDFUNDS (effective federal funds rate, %), and CPIAUCSL (consumer price index: all items).
Giordani (2004) shows that introducing the output gap and capacity utilization in VARs reduces the price puzzle but does not eliminate it for periods including pre-1979 samples.
The contribution of supply shocks to output growth and inflation is substantially lower for the 1980s and 1990s, which may be attributable partly to the reduced variance of supply shocks (Favero and Rovelli, 2003; and Cecchetti and others, 2004).
Semi-annual forecast data for real GDP growth and CPI inflation from the Livingston Survey are converted into quarterly data. Pre-1979 regressions use the industrial production forecast as a proxy for the output forecast available only from 1971 (correlation between the two variables is 0.93 for 1971:Q1–2009:Q1).
Our finding is consistent with Chowdhury and Schabert’s (2008) finding from the “money supply lens” approach—which looks at that money supply responses to inflation and the output gap—that the Fed policy was sufficiently reactive to inflation so as to ensure equilibrium determinacy during the pre-1979 period.
In contrast, the Sims and Zha (1998) experiment is to shut down “indefinitely” the policy response that would otherwise be implied by the VAR estimates. In this case, people are “repeatedly surprised” by the failure of the policy response to non-policy shocks, as Bernanke, Gertler, and Watson (1997) point out.
Leeper and Zha (2003) show that a modest policy change has a small impact on agents’ beliefs about policy regime and thus induces no change in the behavior of agents.
In the counterfactual scenario, the demand shock can have a permanent effect on output because imposing zero contemporaneous coefficients invalidates restriction R1 when those coefficients are non-zero in the historical rule.