Proposal No. 0720839 Markov-Switching Rational Expectations Models Roger Farmer UCLA
U.S. macroeconomic history since WWII can be divided into two periods. Before 1979 the economy experienced volatile growth in gross domestic product (GDP), inflation and interest rates and a persistent buildup of inflation that peaked in 1979 at 18%. In the third quarter of 1979 Paul Volcker took over as Chairman of the Board of Governors of the Federal Reserve (Fed) and immediately initiated a period of disinflation. Under Volcker's predecessors, the Fed followed a policy of controlling the interest rate. Under Volcker, the Fed began a new policy of targeting the rate of growth of the money supply. This policy lasted until mid 1982 when the Fed reverted to interest rate control. The period from 1979 through 1982 was one of highly volatile fluctuations in interest rates, inflation and GDP but it succeeded in bringing inflation under control. The period since 1982 has been one of relative calm with low inflation, low interest rates, stable growth of GDP and low volatility in all three variables. This change of affairs is referred to in the literature as the Great Moderation.
Although the Fed targeted the interest rate both before 1979 and after 1982, implementation had changed. Before 1979 the Fed did not respond aggressively to signs of inflation; in contrast, since 1982 the Fed has tended to raise interest rates by more than one for one whenever inflation appears to be re-emerging. Simple theoretical models of the economy predict that the Fed is doing the right thing and they ascribe the reduction of volatility in GDP to good policy. But in the data, it is hard to disentangle good policy from good luck and a number of recent papers have suggested that the Great Moderation is an accident. Part of the difficulty in separating these hypotheses comes from the fact that existing empirical work has estimated 'reduced form' models in which it is difficult or impossible to identify policy changes. Economists do not try to estimate the contemporaneous links between variables and, more importantly, they do not estimate the links between private sector actions and private sector beliefs about the future. This project proposes a method that allows one to estimate these links and thereby to answer the question: Was it good policy, or good luck?
Previous work in this area has been hindered by the difficulty of modeling beliefs about future actions when policy regimes may change. Individuals in the economy in the 1970's must have been aware that the buildup of inflation would not be permitted to persist indefinitely and that a change of regime was likely, at some point, to occur. We propose methods for accounting for these beliefs in structural models of the U.S. economy and we intend to use our methods to estimate a model that disentangles the effect of policy changes from possible reductions in the variances of the shocks. Our research has the potential to inform policy makers about whether their actions have indeed been effective or whether they have just been lucky.
