DP4696 Monetary Magic? How the Fed Improved the Flexibility of the Economy

Author(s): Tamim Bayoumi, Silvia Sgherri
Publication Date: October 2004
Keyword(s): inflation dynamics, Kalman filter, monetary policy
JEL(s): C51, E31, E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4696

Extending recent theoretical contributions on sources of inflation inertia, we argue that monetary policy uncertainty helps determine the sluggish adjustment of expectations to nominal disturbances. Estimating a model in which rational individuals learn over time about shifts in US monetary policy and the Phillips curve, we find strong evidence that this link exists. These results question the standard approach for evaluating monetary rules by assuming unchanged private sector responses, help clarify the role of monetary stability in reducing output variability in the US and elsewhere, and tell a subtle and dynamic story of the interaction between monetary policy and the supply-side of the economy.