DP6250 Learning and the Great Inflation

Author(s): Giacomo Carboni, Martin Ellison
Publication Date: April 2007
Keyword(s): Great Inflation, learning, monetary policy, uncertainty
JEL(s): E52, E58, E65
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6250

We respond to the challenge of explaining the Great Inflation by building a coherent framework in which both learning and uncertainty play a central role. At the heart of our story is a Federal Reserve that learns and then disregards the Phillips curve as in Sargent's Conquest of American Inflation, but at all times takes into account that its view of the world is subject to considerable uncertainties. Allowing Federal Reserve policy to react to these perceived uncertainties improves our ability to explain the Great Inflation with a learning model. Bayesian MCMC estimation results are encouraging and favour a model where policy reacts to uncertainty over a model where uncertainty is ignored. The posterior likelihood is higher and the internal Federal Reserve forecasts implied by the model are closer to those reported in the Greenbook.