DP8101 US Post-war Monetary Policy: What Caused the Great Moderation?
Using indirect inference based on a VAR we confront US data from 1972 to 2007 with a standard New Keynesian model in which an optimal timeless policy is substituted for a Taylor rule. We find the model explains the data both for the Great Acceleration and the Great Moderation. The implication is that changing variances of shocks caused the reduction of volatility. Smaller Fed policy errors accounted for the fall in inflation volatility. Smaller supply shocks accounted for the fall in output volatility and smaller demand shocks for lower interest rate volatility. The same model with differing Taylor rules of the standard sorts cannot explain the data of either episode. But the model with timeless optimal policy could have generated data in which Taylor rule regressions could have been found, creating an illusion that monetary policy was following such rules.
