DP4865 | The Decline of Activist Stabilization Policy: Natural Rate Misperceptions, Learning and Expectations

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We develop an estimated model of the US economy in which agents form expectations by continually updating their beliefs regarding the behaviour of the economy and monetary policy. We explore the effects of policy-makers' misperceptions of the natural rate of unemployment during the late 1960s and 1970s on the formation of expectations and macroeconomic outcomes. We find that the combination of monetary policy directed at tight stabilization of unemployment near its perceived natural rate and large real-time errors in estimates of the natural rate uprooted here-to-fore quiescent inflation expectations and contributed to poor macroeconomic performance. Had monetary policy reacted less aggressively to perceived unemployment gaps, inflation expectations would have remained anchored and the stagflation of the 1970s would have been avoided. Indeed, we find that less activist policies would have been more effective at stabilizing both inflation and unemployment. We argue that policy-makers, learning from the experience of the 1970s, eschewed activist policies in favour of policies that concentrated on the achievement of price stability, contributing to the subsequent improvements in macroeconomic performance of the US economy.