DP8555 Asset Market Participation, Monetary Policy Rules and the Great Inflation

Author(s): Florin Ovidiu Bilbiie, Roland Straub
Publication Date: September 2011
Keyword(s): aggregate demand, Bayesian estimation, Great Inflation, Great Moderation, limited asset markets participation, passive monetary policy rules, real (in)determinacy
JEL(s): E31, E32, E44, E52, E58, E65, N12, N22
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8555

This paper argues that limited asset market participation is crucial in explaining U.S. macroeconomic performance and monetary policy before the 1980s, and their changes thereafter. We develop an otherwise standard sticky-price DSGE model, whereby at low enough asset market participation, standard aggregate demand logic is inverted: interest rate increases become expansionary. Thereby, a passive monetary policy rule ensures equilibrium determinacy and maximizes welfare, suggesting that Federal Reserve policy in the pre-Volcker era was better than conventional wisdom suggests. We provide empirical evidence consistent with this hypothesis, and study the relative merits of changes in structure and shocks for reproducing the conquest of the Great Inflation and the Great Moderation.