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

Florin Bilbiie and Roland Straub

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From the late 60s until the early 80s, the United States experienced a period of high and changing inflation, punctuated by crises (“the Great Inflation”). A moderate period then occurred, with a contained inflation and low market volatility (“the Great Moderation”). Did the Fed commit strategic errors in the 60s, negatively impacting key indicators and economic activity?
Florin Bilbiie and Roland Straub suggest another explanation: at the turn of the 80s, financial deregulation increased the proportion of agents participating in financial markets. Until then, this participation was limited by a high degree of regulation, and - according to a theory initiated by F. Bilbiie in a previous study - a positive relationship existed between the Central Bank interest rates and aggregate demand. Passive monetary policy ensures equilibrium determinacy and maximizes welfare: this suggests that Fed policy in the pre-Volcker era was better than conventional wisdom implies. This paper provides empirical evidence consistent with this hypothesis, and studies the relative merits of changes in structure and shocks for reproducing the conquest of the Great Inflation and the Great Moderation.
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Original title of the article: Asset Market Participation, Monetary Policy Rules, and the Great Inflation
Published in : Review of Economics and Statistics, May 2013, Vol. 95, Issue 2, p 377-392
Download : http://www.mitpressjournals.org/doi/abs/10.1162/REST_a_00254#.Uzk3z_l_s-U
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