Reading the Recent Monetary History of the United States ...Reading the Recent Monetary History of the United States, 1959-2007 Jesús Fernández-Villaverde, Pablo Guerrón-Quintana,

FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JULY/AUGUST 2010 311

Reading the Recent Monetary History of the United States, 1959-2007

Jesús Fernández-Villaverde, Pablo Guerrón-Quintana, and Juan F. Rubio-Ramírez

In this paper the authors report the results of the estimation of a rich dynamic stochastic generalequilibrium (DSGE) model of the U.S. economy with both stochastic volatility and parameter driftingin the Taylor rule. They use the results of this estimation to examine the recent monetary historyof the United States and to interpret, through this lens, the sources of the rise and fall of the GreatInflation from the late 1960s to the early 1980s and of the Great Moderation of business cycle fluc-tuations between 1984 and 2007. Their main findings are that, while there is strong evidence ofchanges in monetary policy during Chairman Paul Volcker’s tenure at the Federal Reserve, thosechanges contributed little to the Great Moderation. Instead, changes in the volatility of structuralshocks account for most of it. Also, although the authors find that monetary policy was differentunder Volcker, they do not find much evidence of a big difference in monetary policy among thetenures of Chairmen Arthur Burns, G. William Miller, and Alan Greenspan. The difference in aggre-gate outcomes across these periods is attributed to the time-varying volatility of shocks. The his-tory for inflation is more nuanced, as a more vigorous stand against it would have reduced inflationin the 1970s, but not completely eliminated it. In addition, they find that volatile shocks (espe-cially those related to aggregate demand) were important contributors to the Great Inflation. (JEL E10, E30, C11)

Federal Reserve Board of St. Louis Review, July/August 2010, 92(4), pp. 311-38.

process. First and foremost, documents are not aperfect photograph of reality. For example, partici-pants at Federal Open Market Committee (FOMC)meetings do not necessarily say or vote what theyreally would like to say or vote, but what theythink is appropriate at the moment given theirobjectives and their assessment of the strategicinteractions among the members of the committee.(The literature on cheap talk and strategic votingis precisely based on those insights.) Also, mem-oirs are often incomplete or faulty and staff memosare the product of negotiations and compromisesamong several actors. Second, even the most com-

1. INTRODUCTION

Uncovering the rationales behind monetarypolicy is hard. While the instruments ofpolicy, such as the federal funds rate or

reserve requirements, are directly observable, theprocess that led to their choice is not. Instead,we have the documentary record of the minutesof different meetings, the memoirs of participantsin the process, and the internal memos circulatedwithin the Federal Reserve System.

Although this paper trail is valuable, it is notand cannot be a complete record of the policy

Jesús Fernández-Villaverde is an associate professor of economics at the University of Pennsylvania, a research associate for the NationalBureau of Economic Research, a research affiliate for the Centre for Economic Policy Research, and a research associate chair for FEDEA(Fundación de Estudios de Economía Aplicada). Pablo Guerrón-Quintana is an economist at the Federal Reserve Bank of Philadelphia. JuanF. Rubio-Ramírez is an associate professor of economics at Duke University and a visiting scholar at the Federal Reserve Bank of Atlanta andFEDEA. The authors thank André Kurmann, Jim Nason, Frank Schorfheide, Tao Zha, and participants at several seminars for useful commentsand Béla Személy for invaluable research assistance. The authors also thank the National Science Foundation for financial support.

© 2010, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect theviews of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. Articles may be reprinted, reproduced,published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Abstracts,synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis.

plete documentary evidence cannot capture thefull richness of a policy decision process in amodern society. Even if it could, it would proba-bly be impossible for any economist or historianto digest the whole archival record.1 Third, evenif we could forget for a minute about the limita-tions of the documents, we would face the factthat actual decisions tell us only about what wasdone, but say little about what would have beendone in other circumstances. And while theabsence of an explicit counterfactual may be aminor problem for historians, it is a deep flawfor economists who are interested in evaluatingpolicy rules and making recommendations regard-ing the response to future events that may be verydifferent from past experiences.

Therefore, in this paper we investigate thehistory of monetary policy in the United Statesfrom 1959 to 2007 from a different perspective.We build and estimate a rich dynamic stochasticgeneral equilibrium (DSGE) model of the U.S.economy with both stochastic volatility andparameter drifting in the Taylor rule that deter-mines monetary policy. Then, we use the resultsof our estimation to examine, through the lensof the model, the recent monetary policy historyof the United States. Our attention is focusedprimarily on understanding two fundamentalobservations: (i) the rise and fall of the GreatInflation from the late 1960s to the early 1980s,the only significant peacetime inflation in U.S.history, and (ii) the Great Moderation of businesscycle fluctuations that the U.S. economy experi-enced between 1984 and 2007, as documentedby Kim and Nelson (1998), McConnell and Pérez-Quirós (2000), and Stock and Watson (2003).

All the different elements in our exercise arenecessary. We need a DSGE model because weare interested in counterfactuals. Thus, we require

a model that is structural in the sense of Hurwicz(1962)—that is, invariant to interventions suchas the ones that we consider. We need a modelwith stochastic volatility because, otherwise, anychanges in the variance of aggregate variableswould be interpreted as the consequence of vari-ations in monetary policy. The evidence in Simsand Zha (2006), Fernández-Villaverde and Rubio-Ramírez (2007), and Justiniano and Primiceri(2008) points out that these changes in volatilityare first-order considerations when we explorethe data. We need a model with parameter drift-ing in the monetary policy rule because we wantto introduce changes in policy that obey a fullyspecified probability distribution, and not a once-and-for-all change around 1979-80, as is oftenpostulated in the literature (for example, inClarida, Galí, and Gertler, 2000, and Lubick andSchorfheide, 2004).

In addition to using our estimation to inter-pret the recent monetary policy history of theUnited States, we follow Sims and Zha’s (2006)call to connect estimated changes to historicalevents. (We are also inspired by Cogley andSargent, 2002 and 2005.) In particular, we discusshow our estimation results relate to both the obser-vations about the economy—for instance, howour model interprets the effects of oil shocks—and the written record.

Our main findings are that, although there isstrong evidence of changes in monetary policyduring Chairman Paul Volcker’s tenure at the Fed,those changes contributed little to the GreatModeration. Instead, changes in the volatilityof structural shocks account for most of it. Also,although we find that monetary policy was differ-ent under Volcker, we do not find much evidenceof a difference in monetary policy among thetenures of Chairmen Arthur Burns, G. WilliamMiller, and Alan Greenspan. The reduction in thevolatility of aggregate variables after 1984 is attrib-uted to the time-varying volatility of shocks. Thehistory for inflation is more subtle. According toour estimated model, a more aggressive stance ofmonetary policy would have reduced inflationin the 1970s, but not completely eliminated it. Inaddition, we find that volatile shocks (especially

Fernández-Villaverde, Guerrón-Quintana, Rubio-Ramírez

312 JULY/AUGUST 2010 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW

1 For instance, Allan Meltzer (2010), in his monumental A Historyof the Federal Reserve, uses the summaries of the minutes of FOMCmeetings compiled by nine research assistants (volume 2, book 1,page X). This shows how even a several-decades-long commitmentto getting acquainted with the archives is not enough to processall the relevant information. Instead, it is necessary to rely on sum-maries, with all the potential biases and distortions that they mightbring. This is, of course, not a criticism of Meltzer: He just proceeded,as many other great historians do, by standing on the shoulders ofothers. Otherwise, modern archival research would be plainlyimpossible.

those related to aggregate demand) were importantcontributors to the Great Inflation.

Most of the material in this paper is basedon a much more extensive and detailed work byFernández-Villaverde, Guerrón-Quintana, andRubio-Ramírez (2010), in which we (i) present theDSGE model in all of its detail, (ii) characterizethe decision rules of the agents, (iii) build thelikelihood function, and (iv) estimate the model.Here, we concentrate instead on understandingrecent U.S. monetary history through the lens ofour theory.

2. A DSGE MODEL OF THE U.S.ECONOMY WITH STOCHASTICVOLATILITY AND PARAMETERDRIFTING

As we argued in the introduction, we need astructural equilibrium model of the economy toevaluate the importance of each of the differentmechanisms behind the evolution of inflation andaggregate volatility in the United States over thepast several decades. However, while the previousstatement is transparent, it is much less clear howto decide which particular elements of the modelto include. On the one hand, we want a modelthat is sufficiently detailed to account for thedynamics of the data reasonably well. But this goalconflicts with the objective of having a parsimo-nious and soundly microfounded description ofthe aggregate economy.

Given our investigation, a default choice fora model is a standard DSGE economy with nomi-nal rigidities, such as the ones in Christiano,Eichenbaum, and Evans (2005) or Smets andWouters (2003). This class of models is currentlybeing used to inform policy in many central banksand is a framework that has proven to be success-ful at capturing the dynamics of the data. How -ever, we do not limit ourselves to a standard DSGEmodel. Instead, we extend it in what we thinkare important and promising directions by incor-porating stochastic volatility into the structuralshocks and parameter drifting in the Taylor rulethat governs monetary policy.

Unfortunately, for our purposes, the modelhas two weak points that we must acknowledgebefore proceeding further: money and Calvo pric-ing. Most DSGE models introduce a demand formoney through money in the utility function (MIA)or cash in advance (CIA). By doing so, we endowmoney with a special function without soundjustification. This hides inconsistencies that aredifficult to reconcile with standard economictheory (Wallace, 2001). Moreover, the relationbetween structures wherein money is essentialand the reduced forms embodied by MIA or CIAis not clear. This means that we do not knowwhether that relation is invariant to changes inmonetary policy or to the stochastic propertiesof the shocks that hit the economy, such as theones we study. This is nothing more than theLucas critique dressed in a different way.

The second weakness of our DSGE model isthe use of Calvo pricing. Probably the best wayto think about Calvo pricing is as a convenientreduced form of a more-complicated pricing mech-anism that is easier to handle, thanks to its mem-oryless properties. However, if we are entertainingthe idea that monetary policy or the volatility ofshocks has changed over time, it is exceedinglydifficult to believe that the parameters that controlCalvo pricing have been invariant over the sameperiod (see the empirical evidence that supportsthis argument in Fernández-Villaverde and Rubio-Ramírez, 2008).

However, getting around these two limitationsseems, at the moment, infeasible. Microfoundedmodels of money are either too difficult to workwith (Kiyotaki and Wright, 1989) or rest in assump-tions nearly as implausible as MIA (Lagos andWright, 2005) or that the data find too stringent(Aruoba and Schorfheide, forthcoming). State-dependent models of pricing are too cumbersomecomputationally for estimation (Dotsey, King, andWolman, 1999).

So, with a certain reluctance, we use a main-stream DSGE model with households; firms (alabor packer, a final-good producer, and a contin-uum of intermediate-good producers); a monetaryauthority, the Federal Reserve, which implementsmonetary policy through open market operationsfollowing a Taylor rule; and nominal rigidities inthe form of Calvo pricing with partial indexation.



2.1 Households

We begin our discussion of the model withhouseholds. We work with a continuum of them,indexed by j. Households are different becauseeach supplies a specific type of labor in the mar-ket: Some households are carpenters and somehouseholds are economists. If, in addition, eachhousehold has some market power over its ownwage and stands ready to supply any amount oflabor at posted prices, it is relatively easy to intro-duce nominal rigidities in wages. Some house-holds are able to change their wages and someare not, and the relative demand for each type oflabor adjusts to compensate for these differencesin input prices.

At the same time, we do not want a compli-cated model with heterogeneous agents that isdaunting to compute. We resort to two tricks toget around that problem. First, we have a utilityfunction that is separable among consumption,cjt, real money balances, mjt/pt, and hours worked,ljt. Second, we have complete markets in Arrowsecurities. Complete markets allow us to equatethe marginal utilities of consumption across allhouseholds in all states of nature. And, since byseparability this marginal utility depends only onconsumption, all households will consume thesame amount of the final good. The result makesaggregation trivial. Of course, it also has theunpleasant feature that those households that donot update their wages will work different num-bers of hours than those that do. If, for example,we have an increase in the average wage, thosehouseholds stuck with the old, lower wages willwork longer hours and have lower total utility.This is the price we need to pay for tractability.

Given our previous choice of a separableutility function and our desire to have a balancedgrowth path for the economy (which requires amarginal rate of substitution between labor andconsumption that is linear in consumption), wepostulate a utility function of the form

(1) E00

1

t

tt

jt jt

jt

tt

d

c hc

m

p

l=

∞−

∑−( )

+

−β

υ ϕ ψ

log

log jjt1

1

+

+

ϑ

ϑ

,

where �0 is the conditional expectation operator,β is the discount factor for one quarter (the timeperiod for our model), h controls habit persistence,and ϑ is the inverse of the Frisch labor supplyelasticity. In addition, we introduce two shiftersto preferences, common to all households: Thefirst is a shifter to intertemporal preference, dt,that makes utility today more or less desirable.This is a simple device to capture shocks to aggre-gate demand. A prototypical example could beincreases in aggregate demand caused by fiscalpolicy, an aspect of reality ignored in our model.Another possibility is to think about dt as the con-sequence of demographic shocks that propagateover time. The second is a shifter to labor supply,ϕt. As emphasized by Hall (1997), this shock iscrucial for capturing the fluctuation of hours inthe data.

A simple way to parameterize the evolutionof the two shifters is to assume AR(1) processes:

where εdt ~ N�0,1�, and

where εϕt ~ N�0,1�. The most interesting featureof these processes is that the standard deviations(SDs), σdt and σϕt, of the innovations, εdt and εϕt,evolve over time. This is the first place where weintroduce time-varying volatility in the model:Sometimes the preference shifters are highlyvolatile; sometimes they are less so. This chang-ing volatility may reflect, for instance, the differ-ent regimes of fiscal policy or the consequencesof demographic forces (Jaimovich and Siu, 2009).

We can specify many different processes forσdt and σϕt. A simple procedure is to assume thatσdt and σϕt follow a Markov chain and take a finitenumber of values. While this specification seemsstraightforward, it is actually quite involved. Thedistribution that it implies for σdt and σϕt is dis-crete and, therefore, perturbation methods (suchas the ones that we use later) are ill designed todeal with it. Such conditions would force us torely on global solution methods that are too slowfor estimation.

log log ,�d dt d t dt dt= +−ρ σ ε1

log log ,�ϕ ρ ϕ σ εϕ ϕ ϕt t t t= +−1



Instead, we can postulate simple AR(1) proc -esses in logs (to ensure the positivity of the SDs):

where udt ~ N�0,1�, and

where uϕt ~ N�0,1�. This specification is bothparsimonious (with only four new parameters,ρσd, ρσϕ

, ηd, and ηϕ) and rather flexible. Becauseof these advantages, we impose the same specifi-cation for the other three time-varying SDs in themodel that appear below (the ones affecting aninvestment-specific technological shock, a neutraltechnology shock, and a monetary policy shock).Hereafter, agents perfectly observe the structuralshocks and the level and innovation to the SDsand have rational expectations about their sto-chastic properties.

Households keep a rich portfolio: They own(physical) capital, kjt; nominal government bonds,bjt, that pay a gross return Rt–1; Arrow securities,ajt+1, which pay one unit of consumption in eventωjt+1,t traded at time t at unitary price qjt+1,t; andcash.

The evolution of capital deserves somedescription. Given a depreciation rate δ, theamount of capital owned by household j at theend of period t is

Investment, xjt, is multiplied by a term thatdepends on a quadratic adjustment cost function,

written in deviations with respect to the balancedgrowth rate of investment, Λx, with adjustmentparameter κ and an investment-specific technol-ogy level µt. This technology level evolves as arandom walk in logs:

log log log ,�σ ρ σ ρ σ ησ σdt d dt d dtd du= −( ) + +−1 1

log log log ,�σ ρ σ ρ σ ηϕ σ ϕ σ ϕ ϕ ϕϕ ϕt t tu= −( ) + +−1 1

k k Vx

xxjt jt t

jt

jtjt= −( ) + −

−

−1 11

1

δ µ ..

Vx

xx

xt

t

t

tx

− −

= −

1 1

2

2κ Λ ,

log log ,�µ µ σ εµ µ µt t t t= + +−Λ 1

where εµt ~ N�0,1�with drift Λµ and innovationεµt, whose SD σµt evolves according to our favoriteautoregressive process:

where uµt ~ N�0,1�.We introduce this shock convinced by the

evidence in Greenwood, Herkowitz, and Krusell(1997) that this is a key mechanism to understand-ing aggregate fluctuations in the United Statesover the past 50 years.

Thus, the jth household’s budget constraint is

where wjt is the real wage, rt is the real rentalprice of capital, ujt > 0 is the rate of use of capital,µt–1Φ[ujt] is the cost of using capital at rate ujt interms of the final good, µt is an investment-specifictechnology level, Tt is a lump-sum transfer, andFt is the profits of the firms in the economy. Wepostulate a simple quadratic form for Φ[.],

and normalize u, the utilization rate in the bal-anced growth path of the economy, to 1. Thisimposes the restriction that the parameter Φ1 mustsatisfy Φ1 = Φ′[1] = r̃, where r̃ is the balancedgrowth path rental price of capital (rescaled bytechnological progress, as we explain later).

Of all the choice variables of the households,the only one that requires special attention ishours. As we explained previously, each house-hold j supplies its own specific type of labor.This labor is aggregated by a labor packer intohomogeneous labor, lt

d, according to a constantelasticity of substitution technology,

log log log ,σ ρ σ ρ σ ηµ σ µ σ µ µ µµ µt t tu= −( ) + +−1 1

c xm

p

b

pq a d

w

jt jtjt

t

jt

tjt t jt jt t

jt

+ + + +

=

++ + +∫1

1 1 1, ,ω

ll r u u k

m

pR

b

p

jt t jt t jt jt

jt

tt

jt

+ − ( )+ +

−−

−−

µ 11

11

Φ

ttjt t ta T+ + + F ,

Φ Φ Φu u u[ ] = −( ) + −( )1

2 212

1 ,

l l djtd

jt=

∫

− −

0

11 1η

η

ηη

.



The labor packer is perfectly competitive andtakes all the individual wages, wjt, and the wagewt for lt

d as given.The household decides, given the demand

function for its type of labor generated by thelabor packer,

which wage maximizes its utility and stands readyto supply any amount of labor at that wage. How -ever, when it chooses the wage, the household issubject to a nominal rigidity: a Calvo pricingmechanism with partial indexation. At the startof every quarter, a fraction 1 – θw of householdsare randomly selected and allowed to reoptimizetheir wages. All other households can only indextheir wages to past inflation with an indexationparameter χw � [0,1].

2.2 Firms

In addition to the labor packer, we have twoother types of firms in this economy. The first, thefinal-good producer, is a perfectly competitivefirm that aggregates a continuum of intermediategoods with the technology:

(2)

This firm takes as given all intermediate-goodprices, pti, and the final-good price, pt, and gen-erates a demand function for each intermediategood:

(3)

Second, we have the intermediate-good pro-ducers, each of which has access to a Cobb-Douglas production function,

where kit–1 is the capital, litd is the packed labor

rented by the firm, and At (our fourth structuralshock) is the neutral productivity level, whichevolves as a random walk in logs:

lw

wl jjt

jt

ttd=

∀−η

,

y y ditd

it= ( )∫− −

0

1 1 1εε

εε

.

ypp

y iitit

ttd=

∀−ε

.

y A k lit t it itd= ( )−

−1

1α α,

where εAt ~ N�0,1�with drift ΛA and innovation εAt.We keep the same specification for the SD of thisinnovation as we did for all previous volatilities:

where uAt ~ N�0,1�.The quantity sold of the good is determined

by the demand function (equation (3)). Givenequation (3), the intermediate-good producersset prices to maximize profits. As was the casefor households, intermediate-good producers aresubject to a nominal rigidity in the form of Calvopricing. In each quarter, a proportion of them,1 – θp, can reoptimize their prices. The remainingfraction θp indexes their prices by a fraction χ � [0,1] of past inflation.

2.3 The Policy Rule of the FederalReserve

In our model, the Federal Reserve implementsmonetary policy through open market operations(that generate lump-sum transfers, Tt, to maintaina balanced budget). In doing so, the Fed followsa modified Taylor rule that targets the ratio ofnominal gross return, Rt, of government bondsover the balanced growth path gross return, R:

This rule depends on (i) the past Rt–1, whichsmooths changes over time; (ii) the “inflation gap,”Πt/Π, where Π is the balanced growth path ofinflation2; (iii) the “growth gap,” which is the ratio

log log ,�A At A t At At= + +−Λ 1 σ ε

log log log ,σ ρ σ ρ σ ησ σAt A At A AtA Au= −( ) + +−1 1

RR

RR

t t t

yy

y

R t t

t=

( )

− −1 1

γ γΠΠ Λ

Π,

exp

−γ γ

ξy t

R

t

,

.

1



2 Here we are being careful with our words: Π is inflation in thebalanced growth path, not the target of inflation in the stochasticsteady state. As we will see later, we solve the model using a second-order approximation. The second-order terms move the mean ofthe ergodic distribution of inflation, which corresponds in our viewto the usual view of the inflation target, away from the balancedgrowth path level. We could have expressed the policy rule in termsof this mean of the ergodic distribution, but it would amount tosolving a complicated fixed-point problem (for every inflation level,we would need to solve the model and check that indeed this isthe mean of the ergodic distribution), which is too complicated atask for the potential benefits we can derive from it.

between the growth rate of the economy, yt/yt–1,and Λy, the balanced path gross growth rate of yt,dictated by the drifts of neutral and investment-specific technological change; and (iv) a monetarypolicy shock, ξt = exp

σm,tεmt, with an innova tionεmt ~ N�0,1� and SD of the innovation, σm,t, thatevolves as

Note that, since we are dealing with a generalequilibrium model, once the Fed has chosen avalue of Π, R is not a free target, as it is determinedby technology, preferences, and Π.

We introduce monetary policy changesthrough a parameter drift over the responses ofRt to inflation, γ Π,t, and growth gaps, γy,t:

where επt ~ N�0,1� and

where εyt ~ N�0,1�.In preliminary estimations, we discovered

that, while other parameters such as γR could alsobe changing, the likelihood function of the modeldid not react much to that possibility and, thus,we eliminated those channels.

Our parameter-drifting specification tries tocapture mainly two different phenomena. First,changes in the composition of the voting membersof the FOMC (through changes in governors andin the rotating votes of presidents of regionalReserve Banks) may affect how strongly the FOMCresponds to inflation and output growth becauseof variations in the political-economic equilibriumin the committee.3 Similarly, changes in staff mayhave effects as long as their views have an impacton the voting members through briefings andother, less-structured interactions. This may have

log log log .,σ ρ σ ρ σ ησ σmt m mt m m tm mu= −( ) + +−1 1

log log log ,γ ρ γ ρ γ η εγ γ π πΠ Π ΠΠ Πt t t= −( ) + +−1 1

log log log ,�γ ρ γ ρ γ η εγ γyt y yt y yty y= −( ) + +−1 1

been particularly true in the late 1960s, when amajority of staff economists embraced Keynesianpolicies and the MIT-Penn-Federal Reserve System(MPS) model was built.4 The second phenomenonis the observation that, even if we keep constantthe members of the FOMC, their reading of thepriorities and capabilities of monetary policy mayevolve (or be more or less influenced by the gen-eral political climate of the nation). We arguebelow that this is a good description of Martin,who changed his beliefs about how strongly theFed could fight inflation in the late 1960s, or ofGreenspan’s growing conviction in the mid-1990sthat the long-run growth rate of the U.S. economyhad risen.

While this second channel seems welldescribed by a continuous drift in the parameters(beliefs plausibly evolving slowly), changes inthe voting members, in particular the Chairman,might potentially be better understood as discretejumps in γ Π,t and γy,t. In fact, our smoothed pathof γ Π,t, which we estimate from the data, givessome support to this view. But in addition to ourpragmatic consideration that computing modelswith discrete jumps is hard, we argue in Section 6that, historically, changes have occurred moreslowly and even new Chairmen have requiredsome time before taking a decisive lead on theFOMC (Goodfriend and King, 2005).

In Section 7, we discuss other objections toour form of parameter drifting—in particular theobjection to the assumption that agents observethe changes in parameters without problem, itsexogeneity, or its avoidance of open economyconsiderations.

2.4 Aggregation and Equilibrium

The model is closed by finding an expressionfor aggregate demand,

and another for aggregate supply,

y c x u ktd

t t t t t= + + −

−µ 11Φ ,



3 According to Walter Heller, President Kennedy clearly stated,“About the only power I have over the Federal Reserve is the powerof appointment, and I want to use it” (cited by Bremner, 2004, p. 160). The slowly changing composition of the Board of Governorsmay lead to situations, such as the one in February 1986 (dis-cussed later in the text), when Volcker was outvoted by RonaldReagan’s appointees on the Board.

4 The MPS model is the high-water mark of traditional Keynesianmacroeconometric models in the Cowles tradition. The MPS modelwas used operationally by staff economists at the Fed from theearly 1970s to the mid-1990s (see Brayton et al., 1997).

where

is demanded labor,

is the aggregate loss of labor input induced bywage dispersion, and

is the aggregate loss of efficiency induced by pricedispersion of the intermediate goods. By marketclearing, yt = yt

d = yts.

The definition of “equilibrium” for this modelis rather standard: It is just the path of aggregatequantities and prices that maximize the problemsof households and firms, the government followsits Taylor rule, and markets clear. But while thedefinition of equilibrium is straightforward, itscomputation is not.

3. SOLUTION AND LIKELIHOODEVALUATION

The solution of our model is challenging. Wehave 19 state variables, 5 innovations to the struc-tural shocks (εdt, εϕt, εAt, εµt, εmt), 2 innovations tothe parameter drifts (επt, εyt), and 5 innovations tothe volatility shocks (udt, uϕt, uµt, uAt, umt), for atotal of 31 variables that we must consider.

A vector of 19 states makes it impossible touse value-function iteration or projection methods(finite elements or Chebyshev polynomials). Thecurse of dimensionality is too acute even for themost powerful of existing computers. Standardlinearization techniques do not work either:Stochastic volatility is inherently a nonlinearprocess. If we solved the model by linearization,all terms associated with stochastic volatilitywould disappear because of certainty equivalence

yv

A u k lts

tp t t t t

d= ( ) ( )−−1

1

1α α,

lv

l djtd

tw jt= ∫1

0

1

vw

wdjt

w jt

t

=

∫

−

0

1η

vpp

ditp it

t

=

∫

−

0

1ε

and our investigation would be essentiallyworthless.

Nearly by default, then, using perturbationto obtain a higher-order approximation to theequilibrium dynamics of our model is the onlyoption. A second-order approximation includesterms that depend on the level of volatility. Thus,these terms capture the responses of agents (house-holds and firms) to changes in volatility. At thesame time, a second-order approximation can befound sufficiently fast, which is of the utmostimportance since we want to estimate the modeland that forces us to solve it repeatedly for manydifferent parameter values. Thus, a second-orderapproximation is an interesting compromisebetween accuracy and speed.

The idea of perturbation is simple. Instead ofthe exact decision rule of the agents in the model,we use a second-order Taylor expansion to therule around the steady state. That Taylor expan-sion depends on the state variables and on theinnovations. However, we do not know the coef-ficients multiplying each term of the expansion.Fortunately, we can find them by an applicationof the implicit function theorem as follows (seealso Judd, 1998, and Schmitt-Grohé and Uribe,2006).

First, we write all the equations describing theequilibrium of the model (optimality conditionsfor the agents, budget and resource constraints,the Taylor rule, and the laws of motion for thedifferent stochastic processes). Second, we rescaleall the variables to remove the balanced growthpath induced by the presence of the drifts in theevolution of neutral and investment-specific tech-nology. Third, we find the steady state implied bythe rescaled variables. Fourth, we linearize theequilibrium conditions around the steady statefound in the previous step. Then, we solve for theunknown coefficients in this linearization, whichhappen to be, by the implicit function theorem,the coefficients of the first-order terms of the deci-sion rules in the rescaled variables that we arelooking for (which can be easily rearranged todeliver the decision rules in the original variables).The next step is to take a second-order approxi-mation of the equilibrium conditions, pluggingin the terms found before, and solve for the coef-



ficients of the second-order terms of the decisionrules.

While we could keep iterating in this proce-dure for as long as we want, Aruoba, Fernández-Villaverde, and Rubio-Ramírez (2006) show that,for the basic stochastic neoclassical growth model(the backbone of our model) calibrated to the U.S.data, a second-order approximation delivers excel-lent accuracy at great computational speed. In ouractual computation, we undertake the symbolicderivatives of the equilibrium conditions usingMathematica 6.0. The code generates all of therelevant expressions and exports them automat-ically into Fortran files. Then, Fortran sendsparticular parameter values in each step of theestimation, evaluates those expressions, anddetermines the terms of the Taylor expansionsthat we need.

Once we have the approximated solution tothe model, given some parameter values, we useit to build a state-space representation of thedynamics of states and observables. This repre-sentation is, as we argued before, nonlinear andhence standard techniques such as the Kalmanfilter cannot be applied to evaluate the associatedlikelihood function. Instead, we resort to a simu-lation method known as the particle filter, asapplied to DSGE models by Fernández-Villaverdeand Rubio-Ramírez (2007). The particle filter gen-erates a simulation of different states of the modeland evaluates the probability of the innovationsthat make these simulated states explain theobservables. These probabilities are also calledweights. A simple application of a law of largenumbers tells us that the mean of the weights isan evaluation of the likelihood. The secret of thesuccess of the procedure is that, instead of per-forming the simulation over the whole sample,we perform it only period by period, resamplingfrom the set of simulated state variables accord-ing to the weights we just found. This sequentialstructure, which makes the particle filter a case ofa more general class of algorithms called sequen-tial Monte Carlo methods, ensures that the simu-lation of the state variables remains centered onthe true but unknown value of the state variables.This dramatically limits the numerical varianceof the procedure.

Now that we have an evaluation of the likeli-hood of the model given observables, we onlyneed to search over different parameter valuesaccording to our favorite estimation algorithm.This can be done in two ways. One is with a reg-ular maximum likelihood algorithm: We look fora global maximum of the likelihood. This proce-dure is complicated by the fact that the evaluationof the likelihood function that we obtain from theparticle filter is nondifferentiable with respect tothe parameters because of the inherent discrete-ness of the resampling step. An easier alternative,and one that allows the introduction of presampleinformation, is to follow a Bayesian approach. Inthis route, we specify a prior over the parameters,multiply the likelihood by it, and sample from theresulting posterior by means of a random-walkMetropolis-Hastings algorithm. In this paper, wechoose this second route. In our estimation, how -ever, we do not take full advantage of presampleinformation since we impose flat priors to facili-tate the communication of the results to otherresearchers: The shape of our posterior distribu-tions will be proportional to the likelihood. Wemust note, however, that relying on flat priorsforces us to calibrate some parameters to valuestypically used in the literature (see Fernández-Villaverde, Guerrón-Quintana, and Rubio-Ramírez,2010 [FGR hereafter], for the values and justifica-tion of the calibrated values).

While our description of the solution andestimation method has been necessarily brief,the reader is invited to check FGR for additionaldetails. In particular, FGR characterize the struc-ture of the higher-order approximations, showingthat many of the relevant terms are zero andexploiting this result to quickly solve for the inno-vations that explain the observables given somestates. This result, proved for a general class ofDSGE models with stochastic volatility, is bound tohave wide application in all cases where stochas-tic volatility is an important aspect of the problem.

4. ESTIMATIONTo estimate our model, we use five time series

for the U.S. economy: (i) the relative price of



investment goods with respect to the price ofconsumption goods, (ii) the federal funds rate,(iii) real per capita output growth, (iv) the con-sumer price index, and (v) real wages per capita.Our sample covers 1959:Q1 to 2007:Q1.

Figure 1 plots three of the five series: inflation,(per capita) output growth, and the federal fundsrate—the three series most commonly discussedwhen commentators talk about monetary policy.By refreshing our memory about their evolutionin the sample, we can frame the rest of our dis-cussion. For ease of reading, each vertical barcorresponds to the tenure of one Fed Chairman:Martin, Burns-Miller (we merge these two becauseof Miller’s short tenure), Volcker, Greenspan, andBernanke.

The top panel shows the history of the GreatInflation: From the late 1960s to the mid-1980s,the U.S. experienced its only significant inflationin peace time, with peaks of around 12 to 14 per-cent during the 1973 and 1979 oil shocks. Themiddle panel shows the Great Moderation: A sim-ple inspection of the series after 1984 reveals amuch smaller amplitude of fluctuations (espe-cially between 1993 and 2000) than before thatdate. The Great Inflation and the Great Moderationare the two main empirical facts to keep in mindfor the rest of the paper. The bottom panel showsthe federal funds rate, which follows a pattern

similar to inflation: It rises in the 1970s (althoughless than inflation during the earlier years of thedecade and more during the last years) and staysmuch lower in the 1990s, reaching historicalminima by the end of the sample.

The point estimates we get from our posteriordistribution agree with other estimates in the lit-erature. For example, we document a fair amountof nominal rigidities in the economy. In any case,we refer the reader to FGR to avoid a lengthy dis-cussion. Here, we report only the modes and SDsof the posterior distributions associated with theparameters governing stochastic volatility (Table 1)and policy (Table 2). In our view, those parame-ters are the most relevant for our reading of therecent history of monetary policy in the UnitedStates.

The main lesson from Table 1 is that the scaleparameters, ηi, are clearly positive and boundedaway from zero, confirming the presence of time-variant volatility in the data. Shocks to the volatil-ity of the intertemporal preference shifter, σd, arethe most persistent (also, the SDs are tight enoughto suggest that we are not suffering from seriousidentification problems). The innovations to thevolatility of the intratemporal labor shock, ηϕ ,are large in magnitude, which suggests that laborsupply shocks may have played an important roleduring the Great Inflation by moving the marginal



Table 1Posterior Distributions: Parameters of the Stochastic Processes for Volatility Shocks

Parameter

logσd logσϕ logσµ logσA logσm

–1.9834 –2.4983 –6.0283 –3.9013 –6.000(0.0726) (0.0917) (0.1278) (0.0745) (0.1471)

ρσdρσϕ

ρσµρσA

ρσm

0.9506 0.1275 0.7508 0.2411 0.8550(0.0298) (0.0032) (0.035) (0.005) (0.0231)

ηd ηϕ ηµ ηA ηm

0.3246 2.8549 0.4716 0.7955 1.1034(0.0083) (0.0669) (0.006) (0.013) (0.0185)

NOTE: Numbers in parentheses indicate standard deviations.



1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

0

2

4

6

8

10

12

14

Inflation

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

−15

−10

−5

0

5

10Output

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

2

4

6

8

10

12

14

16

18

Interest Rate

Annualized Rate

Annualized Rate

Annualized Rate

Burns-Miller

VolckerGreenspan

Bernanke

Martin

Figure 1

Time Series for Inflation, Output Growth, and the Federal Funds Rate

cost of intermediate-good producers. Finally, theestimates for the volatility process governinginvestment-specific productivity suggest thatsuch shocks are important in accounting forbusiness cycles fluctuations in the United States(Fisher, 2006).

The results from Table 2 indicate that thecentral bank smooths interest rates (γR > 0). Theparameter γ Π is the average magnitude of theresponse to inflation in the Taylor rule. Its esti-mated value (1.045 in levels) is just enough toguarantee determinacy in the model (Woodford,2003).5 The size of the innovations to the drift-ing inflation parameter, ηπ , reaffirms our view ofa time-dependent response to inflation in mone-tary policy. The estimates for γy,t (the responseto output deviations in the Taylor rule) are notreported because preliminary attempts at estima-tion convinced us that ηy was nil. Hence, in ournext exercises, we set ργy and ηy to zero.

5. TWO FIGURESIn this section, we present two figures that

show us much about the evolution and effects ofmonetary policy: (i) the estimated smoothed pathof γ Πt over our sample and (ii) the evolution dur-ing the same years of a measure of the real interestrate. In the next section, we map these figures intothe historical record.

Figure 2, perhaps the most important figurein this paper, plots the smoothed estimate of theevolution of the response of monetary policy to

inflation plus or minus a 2-SD interval given ourpoint estimates of the structural parameters. Themessage of Figure 2 is straightforward. Accordingto our model, at the arrival of the Kennedy admin-istration, the response of monetary policy toinflation was around its estimated mean, slightlyover 1.6 It grew more or less steadily during the1960s, until reaching a peak at the end of 1967and beginning of 1968. Subsequently, γ Πt fell soquickly that it was below 1 by 1971. For nearlyall of the 1970s, γ Πt stayed below 1 and picked uponly with the arrival of Volcker. Interestingly, thetwo oil shocks did not have an impact on the esti-mated γ Πt. The parameter stayed high throughoutthe Volcker years and fell after a few quarters intoGreenspan’s tenure, when it returned to levelseven lower than during the Burns and Miller years.The likelihood function favors an evolving mone-tary policy even after introducing stochasticvolatility in the model. In FGR, we assess thisstatement more carefully with several measuresof model fit, including the construction of Bayesfactors and the computation of Bayesian infor-mation criteria between different specificationsof the model.

The reader could argue, with some justifica-tion, that we have estimated a large DSGE modeland that it is not clear what is driving the resultsand what variation in the data is identifying themovements in monetary policy. While a fullyworked-out identification analysis is beyond thescope of this paper, as a simple reality check, weplot in Figure 3 a measure of the (short-term)

5 In this model, local determinacy depends only on the mean of γΠ.



Table 2Posterior Distribution: Policy Parameters

Parameter

γR logγy Π logγΠ ηπ

0.7855 –1.4034 1.0005 0.0441 0.1479(0.0162) (0.0498) (0.0043) (0.0005) (0.002)

NOTE: Numbers in parentheses indicate standard deviations.

6 This number nearly coincides with the estimate of Romer andRomer (2002a) of the coefficient using data from the 1950s.



1960 1965 1970 1975 1980 1985 1990 1995 2000 2005–1

0

1

2

3

4

5

Level of Parameter

Burns-Miller

VolckerGreenspan

Bernanke

Martin

Figure 2

Smoothed Path for the Taylor Rule Parameter on Inflation ±2 SDs

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

0

2

4

6

8

10

12

Annualized Rate

–2

Burns-Miller

VolckerGreenspan

Bernanke

Martin

Figure 3

Real Interest Rate (Federal Funds Rate Minus Inflation)

real interest rate defined as the federal funds rateminus current inflation.7

This figure shows that Martin kept the realinterest rate at positive values around 2 percentduring the 1960s (with a peak by the end, whichcorresponds with the peak of our estimated γ Πt).However, during the 1970s, the real interest ratewas often negative and only rarely above 2 percent,a rather conservative lower bound on the balancedgrowth real interest rate given our point estimates.The likelihood function can interpret those obser-vations only as a very low γ Πt (remember that theTaylor principle calls for increases in the realinterest rate when inflation rises; that is, nominalinterest rates must grow more than inflation). Realinterest rates skyrocketed with the arrival ofVolcker, reaching a historic record of 13 percentby 1981:Q2. After that date, they were never evenclose to zero, and only in two quarters were theybelow 3 percent. Again, the likelihood functioncan interpret that observation only as a high γ Πt.The Greenspan era is more complicated becausereal interest rates were not particularly low in the1990s. However, output growth was very positive,which pushed the interest rates up in the Taylorrule. Since the federal funds rate was not as highas the policy rule would have predicted with ahigh γ Πt, the smoothed estimate of the parameteris lowered. During the 2000s, real interest ratesclose to zero were enough, by themselves, to keepγ Πt low.

6. READING MONETARY HISTORYTHROUGH THE LENS OF OURMODEL

Now that we have our model and our esti-mates of the structural parameters, we smooththe structural and volatility shocks implied bythe data and use them to read the recent monetaryhistory of the United States. Somewhat conven-tionally, we organize our discussion around thedifferent Chairmen of the Fed from Martin to

Greenspan—except for Miller, whom we groupwith Burns because of his short tenure.

One fundamental lesson from this exercise isthat Figure 2 can successfully guide our interpre-tation of policy from 1959 to 2007. We documenthow both Martin and Volcker believed that infla-tion was dangerous and that the Fed had both theresponsibility and the power to fight it, althoughgrowing doubts about that power overcame Martinduring his last term as Chairman. Burns, on theother hand, thought the costs of inflation werelower than the cost of a recession triggered bydisinflation. In any case, he was rather skepticalabout the Fed’s ability to successfully disinflate.Greenspan, despite his constant warnings aboutinflation, had in practice a much more nuancedattitude. According to our estimated model, goodpositive shocks to the economy gave him theprivilege of skipping a daunting test of his resolve.

Because by using a DSGE model we have acomplete set of structural and volatility shocks,in FGR, we complete this analysis with the con-struction of counterfactual exercises. In those exer-cises, we build artificial histories of economiesin which some source of variation has been elimi-nated or modified in an illustrative manner. Forexample, we can evaluate how the economywould have behaved in the absence of changesin the volatility of the structural shocks or if theaverage monetary policy of one period had beenapplied in another. By interpreting those counter-factual histories, we attribute most of the defeatof the Great Inflation to monetary policy underVolcker and most of the Great Moderation after1984 to good shocks. We incorporate informationfrom those counterfactuals as we move along.

Our exercise in this section is closely relatedto the work of Christina and David Romer (1989;2002a,b; 2004), except that we attack the problemfrom exactly the opposite perspective. While theylet their narrative approach guide their empiricalspecification and like to keep a flexible relationwith equilibrium models, we start from a tightlyparameterized DSGE model of the U.S. economyand use the results of our estimation to read thenarrative told by the documents. We see bothstrategies as complementary since each can teachus much of interest. Quite remarkably, given the



7 Since inflation is nearly a random walk (Stock and Watson,2007), its current value is an excellent proxy for its expected value.In any case, our argument is fully robust to slightly different defi-nitions of the real interest rate.

different research designs, many of our conclu-sions are similar to the views expressed by Romerand Romer.

6.1 The Martin Era: Resistance andSurrender

William McChesney Martin, the Chairman ofthe Fed between April 2, 1951, and January 31,1970, knew how to say no. On December 3, 1965,he dared to raise the discount rate for the first timein more than five years, despite warnings fromthe Treasury secretary, Henry Fowler, and thechairman of the Council of Economic Advisors,Gardner Ackley, that President Lyndon Johnsondisapproved of such a move. Johnson, a man notused to seeing his orders ignored, was angeredby Martin’s unwelcome display of independenceand summoned him to a meeting at his Texasranch. There, for over an hour, he tried to cornerthe Chairman of the Fed with the infamous bul-lying tactics that had made him a master of theSenate in years past. Martin, however, held hisground and carried the day: The raise would stand.Robert Bremner starts his biography of Martinwith this story.8 The choice is most appropriate.The history of this confrontation illustrates betterthan any other event our econometric results.

The early 1960s were the high years ofMartin’s tenure. The era of the “New Economics”combined robust economic growth, in excess of5 percent, and low inflation, below 3 percent.According to our estimated model, this moderateinflation was, in part, a reflection of Martin’s viewsabout economic policy. Bremner (2004, p. 122)summarizes Martin’s guiding principles this way:Stable prices were crucial for the correct workingof a market economy and the Fed’s main task wasto maintain that stability. In Martin’s own words,“the Fed has a responsibility to use the powersit possesses over economic events to dampenexcesses in economic activity [by] keeping the

use of credit in line with resources available forproduction of goods and services.”9 Martin wasalso opposed to the idea (popular at the time)that the U.S. economy had a built-in bias towardinflation, a bias the Fed had to accommodatethrough monetary policy. Sumner Slichter, aninfluential professor of economics at Harvard,was perhaps the most vocal proponent of thebuilt-in bias hypothesis. In Martin’s own words,“I refuse to raise the flag of defeatism in the battleof inflation” and “there is no validity whateverin the idea that any inflation, once accepted, canbe confined to moderate proportions.”10 As wewill see in the next subsection, this oppositionstands in stark contrast to Burns’s pessimisticview of inflation, which had many points of con-tact with Slichter’s.

Our estimates of γ Π,t, above 1 and growingduring the period, clearly tell us that Martin wasdoing precisely that: working to keep inflation low.Our result also agrees with Romer and Romer’s(2002a) narrative and statistical evidence regard-ing the behavior of the Fed during the late 1950s.We must not forget, however, that our estimatesin FGR suggest as well that the good performanceof the economy from 1961 to 1965 was also theconsequence of good positive shocks.

The stand against inflation started to be testedaround 1966. Intellectually, more and more voiceshad been raised since the late 1950s defendingthe notion that an excessive concern with infla-tion was keeping the economy from working atfull capacity. Bremner (2004, p. 138) cites WalterHeller and Paul Samuelson’s statements beforethe Joint Economic Committee in February 1959as examples of an attitude that would soon gainstrength. The following year, Samuelson andRobert Solow’s (1960) classic paper about thePhillips curve was taken by many as providing



8 Bremner (2004, pp. 1-2). This was not the only clash of Martin witha president of the United States. In late 1952, Martin bumped intoHarry Truman leaving the Waldorf Astoria Hotel in New York City.To Martin’s “Good afternoon,” Truman wryly replied, “Traitor!”Truman was deeply displeased by how the Fed had implementedthe accord of March 3, 1951, between the Fed and the Treasury thatended the interest rate peg in place since 1942 (Bremner, 2004, p. 91).

9 Martin’s testimony to the Joint Economic Committee, February 5,1957 (cited by Bremner 2004, p. 123).

10 The first quotation is from the New York Times, March 16, 1957,where Martin was expressing dismay for having reached a 2 percentrate of inflation. The second quotation is from the Wall StreetJournal, August 19, 1957. Martin also thought that Keynes himselfhad changed his views on inflation after the war (they had talkedprivately on several occasions) and that, consequently, Keynesianeconomists were overemphasizing the benefits of inflation. SeeBremner (2004, pp. 128 and 229).

an apparently sound empirical justification fora much more sanguine position with respect toinflation: “In order to achieve the nonperfec-tionist’s goal of high enough output to give usno more than 3 percent unemployment, the priceindex might have to rise by as much as 4 to 5 per-cent per year. That much price rise would seemto be the necessary cost of high employment andproduction in the years immediately ahead”(Samuelson and Solow, 1960, p. 192).11 Heller’sand Tobin’s arrival on the Council of EconomicAdvisors transformed the critics into the insiders.

The pressures on monetary policy were con-tained during Kennedy’s administration, in goodpart because C. Douglas Dillon, the secretary ofthe Treasury and a Rockefeller Republican, sidedon many occasions with Martin against Heller.12

But the changing composition of the Board ofGovernors and the arrival of Johnson, with hisexpansionary fiscal programs, the escalation ofthe Vietnam War, and the departure of Dillon fromthe Treasury Department, changed the weights ofpower.

While the effects of the expansion of federalspending in the second half of the 1960s oftenplay a central role in the narrative of the start ofthe Great Inflation, the evolution of the Board ofGovernors has received less attention. Hellerrealized that, by carefully selecting the governors,he could shape monetary policy without theneed to ease Martin out. This was an inspiredobservation, since up to that moment, the gover-nors who served under the Chairman had playedan extremely small role in monetary policy andthe previous administrations had, consequently,shown little interest in their selection. The strat-

egy worked. Heller’s first choice, George W.Mitchell, would become a leader of those prefer-ring a more expansionary monetary policy onthe FOMC.

By 1964, Martin was considerably worriedabout inflation. He told Johnson: “I think we’reheading toward an inflationary mess that we won’tbe able to pull ourselves out of.”13 In 1965, heran into serious problems with the president, asdiscussed at the beginning of this section. Theproblems appeared again in 1966 with the appoint-ment of Brimmer as a governor against Martin’srecommendation. During all this time, Martinstuck to his guns, trying to control inflation evenif it meant erring on the side of overtightening theeconomy. Our estimated γ Π,t captures this attitudewith an increase from around 1965 to around 1968.

But by the summer of 1968, Martin gave into an easing of monetary policy after the tax sur-charge was passed by Congress. As reported byHetzel (2008), at the time, the FOMC was dividedinto two camps: members more concerned aboutinflation (such as Al Hayes, the president of theFederal Reserve Bank of New York) and membersmore concerned about output growth (Brimmer,14

Maisel,15 and Mitchell, all three appointees ofKennedy and Johnson). Martin, always a seekerof consensus, was growlingly incapable of carry-ing the day.16 Perhaps Martin felt that the politi-cal climate had moved away from a commitment

11 The message of the paper is, however, much more subtle thanlaying down a simple textbook Phillips curve. As Samuelson andSolow (1960) also say in the next page of their article (p. 193), “Allof our discussion has been phrased in short-run terms, dealingwith what might happen in the next few years. It would be wrong,though, to think that our Figure 2 menu that relates obtainable priceand unemployment behavior will maintain its shape in the longerrun. What we do in a policy way during the next few years mightcause it to shift in a definite way.”

12 In particular, Dillon’s support for Martin’s reappointment for anew term in 1963 was pivotal. Hetzel (2008, p. 69) suggests thatPresident Kennedy often sided with Dillon and Martin over Hellerto avoid a gold crisis on top of the problems with the Soviet Unionover Cuba and Berlin.



13 Oral history interview with Martin, Lyndon B. Johnson Library(quoted by Bremner, 2004, p. 191).

14 Brimmer is also the first African American to have served as agovernor and was, for a while, a faculty member at the Universityof Pennsylvania.

15 Sherman Maisel was a member of the Board of Governors between1965 and 1972. Maisel, a professor at the Haas School of Businessat the University of California–Berkeley, has the honor of being thefirst academic economist appointed as a governor after AdolphMiller, one of the original governors in 1914. As he explained inhis book, Managing the Dollar (one of the first inside looks at theFed and still a fascinating read today), Maisel was also a strongbeliever in the Phillips curve: “There is a trade-off between idlemen and a more stable value of the dollar. A conscious decisionmust be made as to how much unemployment and loss of outputis acceptable in order to get smaller price rises” (Maisel, 1973, p. 285). Maisel’s academic and Keynesian background merged inhis sponsoring of the MPS model mentioned in Section 2.

16 On one occasion, Maisel felt strongly enough to call a press con-ference to explain his dissenting vote in favor of more expansion.

to fight inflation.17 Or perhaps he was justexhausted after many years running the Fed (atthe last meeting of the FOMC in which he partici-pated, he expressed feelings of failure for nothaving controlled inflation). No matter what theexact reason was, monetary policy eased drasti-cally in comparison with what was being calledfor by the Taylor rule with a γ Π,t above 1. Thus,our estimated γ Π,t starts to plunge in the springof 1968, reflecting that the increases in the federalfunds rate passed at the end of 1968 and in 1969were, according to our estimated Taylor rule, notaggressive enough given the state of the economy.The genie of the Great Inflation was out of thebottle.

6.2 The Burns-Miller Era: MonetaryPolicy in the Time of Turbulence

Arthur F. Burns started his term as Chairmanof the Fed on February 1, 1970. A professor ofeconomics at Columbia University and the presi-dent of the National Bureau of Economic Researchbetween 1957 and 1967, Burns was the first aca-demic economist to hold the chairmanship. Allthe previous nine Chairmen had been bankers orlawyers. However, any hope that his economicseducation would make him take an aggressivestand against the inflation brewing during thelast years of Martin’s tenure quickly disappeared.The federal funds rate fell from an average of8.02 percent during 1970:Q1 to 4.12 percent by1970:Q4. The justification for those reductionswas the need to jump-start the economy, whichwas stacked in the middle of the first recessionin nearly a decade, since December 1969. Butsince inflation stayed at 4.55 percent by the endof 1970, the reduction in the nominal rate meantthat real interest rates sank into the negativeregion.

Our smoothed estimate of γ Π,t in Figure 2responds to this behavior of the Fed by quicklydropping during the same period. This indicatesthat the actual reduction in the federal funds ratewas much more aggressive than the reductionsuggested by the (important) fall in output growthand the (moderate) fall in inflation. Furthermore,the likelihood function accounts for the persistentfall in the real interest rate with a persistent fallin γ Π,t.

Burns did little over the next few years toreturn γ Π,t to higher values. Even if the federalfunds rate had started to grow by the end of 1971(after the 90-day price controls announced onAugust 15 of that year as part of Nixon’s NewEconomic Policy) and reached new highs in 1973and 1974, it barely kept up with inflation. Thereal interest rate was not above our benchmarkvalue of 2 percent until the second quarter of 1976.Later, in 1977, the federal funds rate was onlyraised cautiously, despite the evidence of strongoutput growth after the 1973-75 recession andthat inflation remained relatively high.

Our econometric results come about becausethe Taylor rule does not care about the level ofthe interest rate in itself, but by how much infla-tion deviates from Π. If γ Π,t > 1, the increases inthe federal funds rate are bigger than theincreases in inflation. This is not what happenedduring Burns’s tenure: The real interest rate wasabove the cutoff of 2 percent that we proposedbefore only in three quarters: his first two quar-ters as Chairman (1970:Q2 and 1970:Q3) and in1976:Q2. This observation, by itself, should besufficient proof of the stand of monetary policyduring the period.18

Burns’s successor, William Miller, did nothave time to retract these policies in the briefinterlude of his tenure, from March 8, 1978, toAugust 6, 1979. But he also did not have eitherthe capability, since his only experience in theconduct of monetary policy was serving as a



17 Meltzer (2010, p. 549) points out that Martin and the other Boardmembers might have been worried by Johnson’s appointment, atthe suggestion of Arthur Okun (the chairman of the Council ofEconomic Advisors at the time), of a task force to review changesin the Federal Reserve System. That message only became rein-forced with the arrival of a new administration in 1969, givenRichard Nixon’s obsession with keeping unemployment as low aspossible. (Nixon was convinced that he had lost the 1960 presiden-tial election to a combination of vote fraud and tight monetarypolicy.)

18 A memorandum prepared at the end of December 1997 by two ofCarter’s advisers reveals the climate of the time, proposing not toreappoint Chairman Burns for a third term because he was moreconcerned with inflation than unemployment (memo for the presi-dent on the role of the Federal Reserve, Box 16, R.K. Lipshitz Files,Carter Library, December 10, 1977, pp. 1-2; cited by Meltzer, 2010,p. 922).

director of the Federal Reserve Bank of Boston,or the desire, since he had little faith in restrictivemonetary policy’s ability to lower inflation.19

Thus, our estimated γ Π,t remains low during thattime.20

Burns was subject to strong pressure fromNixon.21 His margin of maneuver was also limitedby the views among many leading economiststhat overestimated the costs of disinflation andwho were in any case skeptical of monetary pol-icy.22 But his own convictions leaned in the samedirection. According to the recollections ofStephen H. Axilrod, a senior staff member at the

Board back then, Burns did not believe any theoryof the economy—whether Keynesian or mone-tarist—could account for the business cycle; hedismissed the relation between the stock of moneyand the price level; and he was unwilling orunable to make a persuasive case against inflationto the nation and to the FOMC.23

In addition, Burns had a sympathetic attitudetoward price and wage controls. For instance, hetestified to Congress on February 7, 1973:

[T]here is a need for legislation permitting somedirect controls over wages and prices...Thestructure of our economy—in particular, thepower of many corporations and trade unionsto exact rewards that exceed what could beachieved under conditions of active competi-tion—does expose us to upward pressure oncosts and prices that may be cumulative andself-reinforcing (cited by Hetzel, 2008, p. 79).

He reiterated that view in a letter to the presi-dent on June 1, 1973, in which he proposed toreintroduce mandatory price controls for largefirms.24 In his view, controls could break the cost-push spiral of the economy and the inflationarypressures triggered by the social unrest of the late1960s and be a more effective instrument thanopen market operations, which could be quitecostly in terms of employment and financial dis-turbances.25 In fact, many members of the FOMCbelieved that the introduction of price and wagecontrols in different phases between 1971 and1973 had not only eased the need for monetarytightening, but also positively suggested that mone-tary policy should not impose further restrainton the economy.26 More interestingly, if price andwage controls were an argument for loose mone-tary policy, their easing was also an argumentfor expansionary policy, or as Governor CharlesPartee put it during the FOMC meeting ofJanuary 11, 1973, the lifting of controls “mightnecessitate a somewhat faster rate of monetary

19 Miller stated, “Our attempts to restrain inflation by using conven-tional stabilization techniques have been less than satisfactory.Three years of high unemployment and underutilized capital stockhave been costly in terms both of lost production and of the denialto many of the dignity that comes from holding a productive job.Yet, despite this period of substantial slack in the economy, westill have a serious inflation problem” (Board of Governors, 1978,p. 193; quoted by Romer and Romer, 2004, p. 140).

20 The situation with Miller reached the surrealistic point when, asnarrated by Kettl (1986), Charles Schultze, the chairman of theCouncil of Economic Advisors, and Michael Blumenthal, theTreasury secretary, were leaking information to the press to pressureMiller to tighten monetary policy.

21 Perhaps the clearest documented moment is the meeting betweenNixon and Burns on October 23, 1969, right after Burns’s nomina-tion, as narrated by John Ehrlichman (1982, pp. 248-49): “I knowthere’s the myth of the autonomous Fed...Nixon barked a quicklaugh…and when you go up for confirmation some Senator mayask you about your friendship with the President. Appearancesare going to be important, so you can call Ehrlichman to get mes-sages to me, and he’ll call you.” The White House continued itspressure on Burns by many different methods, from constant con-versations to leaks to the press (falsely) accusing Burns of request-ing a large wage increase. These, and many other histories, arecollected in a fascinating article by Abrams (2006).

22 Three examples. First, Franco Modigliani testified before the U.S.Congress on July 20, 1971: “[Y]ou have to recognize that prices arepresently rising, and no measure we can take short of creating mas-sive unemployment is going to make the rate of change of pricessubstantially below 4 percent.” Second, Otto Eckstein, the builderof one of the large macroeconometric models at the time, the DRIU.S. model, argued that it was not the Fed’s job to solve structuralinflation. Third, James Tobin (1974): “For the rest of us, the torment-ing difficulty is that the economy shows inflationary bias evenwhen there is significant involuntary unemployment. The bias isin some sense a structural defect of the economy and society…Chronic and accelerating inflation is then a symptom of a deepersocial disorder, of which involuntary unemployment is an alter-native symptom. Political economists may differ about whetherit is better to face the social conflicts squarely or to let inflationobscure them and muddle through. I can understand why anyonewho prefers the first alternative would be working for structuralreform, for a new social contract. I cannot understand why hewould believe that the job can be done by monetary policy. Withinlimits, the Federal Reserve can shift from one symptom to the other.But it cannot cure the disease.” The examples are quoted by Hetzel(2008, pp. 86, 89, and 128).



24 Burns papers, B_N1, June 1, 1973, as cited by Meltzer (2010, p. 787).

25 At the time, many financial institutions were subject to ceilingrates on deposits, which could have made them bankrupt in thecase of a fast tightening of monetary policy.

26 Maisel’s diary entry for August 25, 1971; cited by Meltzer, 2010,p. 790.

growth to finance the desired growth in real out-put under conditions of greater cost-push inflationthan would have prevailed with tighter controls”(cited by Meltzer, 2010, p. 815).

Burns’s 1979 Per Jacobsson lecture is a reveal-ing summary of Burns’s own views on the originsand development of inflation. He blamed thegrowing demands of different social groups duringthe late 1960s and early 1970s and the federalgovernment’s willingness to concede to them asthe real culprit behind inflation. Moreover, hefelt that the Fed could not really stop the inflation-ary wave: If the Federal Reserve then sought tocreate a monetary environment that fell seriouslyshort of accommodating the upward pressureson prices that were being released or reinforcedby governmental action, severe difficulties couldbe quickly produced in the economy. Not onlythat, the Federal Reserve would be frustratingthe will of Congress to which it was responsible.

But beyond Burns’s own defeatist attitudetoward inflation, he was a most unfortunate Chair -man. He was in charge during a period of highturbulence and negative shocks, not only the 1973oil shock, but also poor crops in the United Statesand the Soviet Union. Our model estimates largeand volatile intertemporal shocks, dt, and laborsupply shocks, ϕt, during his tenure (see FGR fora plot of these shocks). Examples of intertemporalshocks include the final breakdown of the BrettonWoods Agreement, fiscal policy during the 1973-75 recession (with a temporary tax cut signed inMarch 1975 and increases in discretionary spend-ing), and Nixon’s price and wage controls (whichmost likely distorted intratemporal allocations).Examples of labor supply shocks include the his-torically high level of strikes in American indus-try during the early 1970s. (A major issue in theRepublican primary of 1976 between Ford andReagan was picketing rules for striking workers,a policy issue most unlikely to grab many voters’attention nowadays.)

Both types of shocks complicated monetarypolicy. Large positive intertemporal shocksincrease aggregate demand. In our model, thistranslates partly into higher output and partlyinto higher inflation. Positive labor supply shocks

increase wages, which pushes up the marginalcost and, therefore, inflation. Moreover, FGR showthat, if volatility had stayed at historical levels,even with negative innovations, inflation wouldhave been much lower and the big peak of 1973avoided.

However, these negative shocks should notmake us forget that, according to our model, ifmonetary policy had engineered higher realinterest rates during those years, the history ofinflation could have been different. In FGR wecalculate that, had monetary policy behavedunder Burns and Miller as it did under Volcker,inflation would have been 4.36 percent on average,instead of the observed 6.23 percent. The experi-ence of Germany or Switzerland, which had muchlower inflation than the United States during thesame time, suggests that this was possible. Afterall, the peak of inflation in Germany was in 1971,well before any of the oil shocks. And in neitherof these two European countries do we observestatements such as that by Governor Sheehan onthe January 22, 1974, FOMC meeting: “[T]heCommittee had no choice but to validate the risein prices if it wished to avoid compounding therecession” (Hetzel, 2008, p. 93).

Thus, our reading of monetary policy duringthe Burns years through the lens of our modelemphasizes the confluence of two phenomena:an accommodating position with respect to infla-tion and large and volatile shocks that compli-cated the implementation of policy. There is ampleevidence in the historical record to support thisview. This was, indeed, monetary policy in thetime of turbulence.

6.3 The Volcker Era: High Noon

In his 1979 Per Jacobsson lecture cited earlier,Burns had concluded: “It is illusory to expectcentral banks to put an end to the inflation thatnow afflicts the industrial democracies.” PaulVolcker begged to differ. He had been presidentof the Federal Reserve Bank of New York sinceAugust 1975 and, from that position, a vocal foeof inflation. In particular, during his years as amember of the FOMC, Volcker expressed concernthat the Fed was consistently underpredicting



inflation and that, therefore, monetary policywas more expansionary than conventionallyunderstood (Meltzer, 2010, p. 942).27

In the summer of 1979, Jimmy Carter movedMiller to the Treasury Department. Then, heoffered Volcker the chairmanship of the Board ofGovernors. Volcker did not hesitate to take it, butnot before warning the president “of the needfor tighter money—tighter than Bill Miller hadwanted” (Volcker and Gyothen, 1992, p. 164)and the Senate in his confirmation hearings that“the only sound foundation for the continuinggrowth and prosperity of the American economyis much greater price stability” (U.S. Senate, 1979,p. 16; quoted by Romer and Romer, 2004, p. 156).Deep changes were coming and the main decision-makers were aware of them.

We should be careful not to attribute all ofthe sharp break in monetary policy to Volcker’sappointment. In 1975, the House passed Concur -rent Resolution 133, the brainchild of Karl Brunner(Weintraub, 1977). This resolution, which askedthe Fed to report to the House Banking Committeeon objectives and plans with respect to the rangesof growth or diminution of monetary and creditaggregates in the upcoming twelve months, wasa first victory for monetarism. Although the reso-lution probably did little by itself, it was a signthat times were changing. Congress acted againwith the Full Employment and Balanced GrowthAct of 1978, which required the Fed to reportmonetary aggregates in its reports to Congress. InApril 1978, the federal funds rate started growingquickly, from a monthly average of 6.9 percent to10 percent by the end of the year. This reflecteda growing consensus on the FOMC (still withmany dissenting voices) regarding the need forlower inflation. Figure 2 shows the start of anincrease in γ Π,t around that time. At the same time,the new procedures for monetary policy that tar-geted money growth rates and reserves insteadof the federal funds rate were not announced

until October 6, 1979. Additionally, Goodfriendand King (2005) have argued that Volcker requiredsome time before asserting his control over theFOMC. For instance, in the Board meeting ofSeptember 18, 1979, Volcker did obtain a rise inthe discount rate, but only with three dissentingvotes. As we argued in Section 2, all of theseobservations suggest that modeling the evolutionof monetary policy as a smooth change may bemore appropriate than assuming a pure break.

Regardless of the exact timing of changes inmonetary policy, the evidence in Figure 2 is over-whelming: On or about August 1979, the characterof monetary policy changed. The federal fundsrate jumped to new levels, with the first signifi-cant long-lasting increase in the real interest ratein many years. Real interest rates would remainhigh for the remainder of the decade of the 1980s,partly reflecting high federal fund rates and partlyreflecting the deeply rooted expectations of infla-tion among the agents. In any case, the responseof monetary policy to inflation, γ Π,t, was consis-tently high during the whole of Volcker’s years.

An important question is the extent to whichthe formalism of the Taylor rule can capture theway in which monetary policy was conductedat the time, when money growth targeting andreserve management were explicitly tried (whatVolcker called “practical monetarism”). We arenot overly concerned about this aspect of the databecause, in our DSGE model, there is a mappingbetween money targeting and the Taylor rule(Woodford, 2003). Thus, as long as we are carefulto interpret the monetary policy shocks during theperiod (which we estimate were, indeed, largerthan in other parts of the sample), our exerciseshould be relatively robust to this consideration.28

A much more challenging task could be to builda DSGE model with a richer set of monetary pol-

27 This position links to an important point made by Orphanides(2002): Monetary policy decisions are implemented using real-time data, a point that our model blissfully ignores. In turbulenttimes such as the 1970s, this makes steering the ship of policy tar-gets exceedingly difficult.



28 This begets the question of why Volcker spent so much effort onswitching the operating procedure of the Fed between 1979 and1982. Volcker himself ventures that it was easier to sell a restrictivemonetary policy in terms of money growth rates than in terms ofinterest rates: “More focus on the money supply also would be away of telling the public that we meant business. People don’t needan advanced course in economics to understand that inflation hassomething to do with too much money” (Volcker and Gyohten,1992, pp. 167-68).

icy rules and switches between them. However,at the moment, this goal seems infeasible.29

The impressions of participants in the mone-tary policy process reinforced the message ofFigure 2. For instance, Axilrod (2009, p. 91) states:

During Paul Volcker’s eight-year tenure aschairman of the Fed...policy changed dramati-cally. He was responsible for a major transfor-mation—akin to a paradigm shift—that wasintended to greatly reduce inflation, keep itunder control, and thereby restore the Fed’sbadly damaged reputation. Furthermore, it wasalmost solely because of Volcker that this par-ticular innovation was put in place—one of thefew instances in my opinion where a dramaticshift in policy approach could be attributedto a particular person’s presence rather thanmainly or just to circumstances.

Volcker himself was very explicit about hisviews30:

[M]y basic philosophy is over time we have nochoice but to deal with the inflationary situa-tions because over time inflation and unem-ployment go together...Isn’t that the lesson ofthe 1970s? We sat around [for] years thinkingwe could play off a choice between one or theother...It had some reality when everybodythought processes were going to be stable...Soin a very fundamental sense, I don’t think wehave the choice.

In fact, Volcker’s views put him in the ratherunusual position of being outvoted on February 24,1986. In that meeting, a majority of four membersof the Board voted against Volcker and two otherdissenting members to lower the discount rate50 basis points.

At the same time, and according to our model,Volcker was also an unlucky Chairman. The econ-omy still suffered from large and negative shocksduring his tenure, since the level and volatility

of the intratemporal preference shifter did notfall until later in his term. In FGR, we build acounterfactual in which Volcker is faced withthe same structural shocks he faced in real life,but with the historical average volatility. In thiscounterfactual history, inflation falls to negativevalues by the end of 1983, instead of still hover-ing around 3 to 4 percent. It was a tough policyin a difficult time. However, despite these misfor-tunes and heavy inheritance from the past, ourmodel tells us that monetary policy conqueredthe Great Inflation. The Great Moderation wouldhave to wait for better shocks.

We started this subsection with Burns’s ownwords in the 1979 Per Jacobsson lecture. In 1989,Volcker was invited to give the same lecture. Whata difference a decade can make! While Burnswas sad and pessimistic (his lecture was entitled“The Anguish of Central Banking”), Volcker washappy and confident (his lecture was entitled“The Triumph of Central Banking?”). Inflationhad been defeated and he warned that “our collec-tive experience strongly emphasizes the impor-tance of dealing with inflation at an early stage”(Volcker, 1990, p. 14).

6.4 The Greenspan Era: Speaking Likea Hawk and Walking Like a Dove

These are the colorful words with whichLaurence Meyer (2004, p. 83) summarizesGreenspan’s behavior during Meyer’s time as agovernor (June 1996 to January 2002). Once andagain,

[Greenspan] seemed to fall into a pattern: TheChairman would ask for no change in the fundsrate, suggest that the time was approachingfor action, and indicate that there was a highprobability of a move at the next meeting. Thenat the next meeting, he would explain that thedata did not yet provide a credible basis fortightening, and in any case, that the marketsdidn’t expect a move. However, he would con-clude that he expected the Committee wouldbe forced to move at the next meeting.

Meyer means these words in a positive way. Inhis opinion, Greenspan discovered before he did



29 The impact of the credit controls imposed by the Carter adminis-tration starting on March 14, 1980, is more difficult to gauge. Inter -estingly, we estimate a large negative innovation to the intratemporalpreference shifter at that point in time, a likely reflection of thedistortions of the controls in the intertemporal choices of house-holds (see the historical description in Shreft, 1990).

30 Volcker papers, Federal Reserve Bank of New York, speech at theNational Press Club, Box 97657, January 2, 1980; quoted by Meltzer,2010, p. 1034.

that the economy was being hit during the secondhalf of the 1990s by an unusual sequence of posi-tive shocks and directed monetary policy to takeadvantage of them.

We quote Meyer because it illustrates thatGreenspan showed from the start that he knewhow to respond to changing circumstances. Hewas appointed on August 11, 1987. In his confir-mation hearings, he clearly reaffirmed the need tofight inflation.31 But after just a couple of months,on October 19, 1987, he reacted to the big crashof the stock market by declaring the Fed’s dispo-sition to serve as a source of liquidity, even if, inthe short run, this could complicate the controlof inflation.

Later, in early 1989, the federal funds ratestarted to fall, despite the fact that inflationremained at around 6 percent until the end of1990. As shown in Figure 2, our estimate of γ Π,tpicks up this fall by dropping itself. Moreover, itdropped fast. We estimate that γ Π,t was soon below1, back to the levels of Burns-Miller (although, fora while, there is quite a bit of uncertainty in ourestimate). The parameter stayed there for the restof Greenspan’s tenure. The reason for this esti-mated low level of γ Π,t is that the real interest ratealso started to fall rather quickly. At the same time,a remarkable sequence of good shocks deliveredrapid output growth and low inflation.

In fact, in FGR we find that all of the shockswent right for monetary policy during the 1990s.A large string of positive and stable investment-specific technological shocks delivered fast pro-ductivity growth, a falling intertemporal shifterlowered demand pressures, and labor supplyshocks pressured wages downward—and, withthem, marginal costs. This fantastic concatenationof shocks accounted for the bulk of the GreatModeration. In FGR, we calculate that withoutchanges in volatility, the Great Moderation wouldhave been much smaller. The SD of inflation

would have fallen by only 13 percent (instead of60 percent in the data), the SD of output growthwould have fallen by 16 percent (instead of 46percent in the data), and the SD of the federal fundsrate would have fallen by 35 percent (instead of39 percent in the data). That is, the moderationin inflation fluctuations would have been onlyone-fifth as large as in the data (and the counter-factual mean would have actually been higherthan in the data) and the moderation for outputgrowth’s SD only one-third.

We can push the argument even further. InFGR we build the counterfactual in which theaverage γ Π,t during the Greenspan years is pluggedinto the model at the time of Burns’s appointment.Then, we keep γ Π,t at that level and hit the modelwith exactly the same shocks that we backed outfrom our estimation. This exercise is logicallycoherent, since we are working with a DSGEmodel and, therefore, the structural and volatilityshocks are invariant to this class of interventions.We compute that the average monetary policyduring Greenspan’s years would not have mademuch of a difference in the 1970s. If anything,inflation would have been even slightly higher(6.83 percent in the counterfactual instead of 6.23percent in the data). This finding contrasts withour counterfactual in which Volcker is moved tothe Burns-Miller era. In this counterfactual, infla-tion would have been only 4.36 percent. To sum-marize, our reading of monetary policy during theGreenspan years is that it was not too differentfrom the policy in the Burns-Miller era; it justfaced much better shocks.

Is this result credible? First, it is clear that itis not a pure artifact of our model. A similarresult is found in Sims and Zha (2006). Theseauthors, using structural vector autoregressionswith Markov switching, which imposes manyfewer cross-equation restrictions than our analy-sis, do not find much evidence of differences inmonetary policy across time (actually, Sims andZha’s position is even stronger than ours, sincethey do find that monetary policy was differenteven under Volcker). Second, there are hints inthe data that lead us to believe that the resultsmake sense. At the start of the 1994 inflation scare,

31 Greenspan stated in his confirmation hearings: “[W]e allowed oursystem to take on inflationary biases which threw us into such astructural imbalance that, in order to preserve the integrity of thesystem, the Federal Reserve had to do what it did. Had it not actedin the way which it did at that time, the consequences would havebeen far worse than what subsequently happened” (U.S. Senate,1987, p. 35; quoted by Romer and Romer, 2004, p. 158).



when there were no signs of the “new economy”anywhere to be seen, Greenspan argued32:

You know, I rarely feel strongly about an issue,and I very rarely sort of press this Committee.But let me tell you something about what’sgnawing at me here. I am very sympatheticwith the view that we’ve got to move and thatwe’re going to have an extended period ofmoves, assuming the changes that are going onnow continue in the direction of strength. It isvery unlikely that the recent rate of economicgrowth will not simmer down largely becausesome developments involved in this particularperiod are clearly one-shot factors—namely,the very dramatic increase in residential con-struction and the big increase in motor vehiclesales. Essentially the two of those have addedone-shot elements to growth. In the context ofa saving rate that is not high, the probability isin the direction of this expansion slowing fromits recent pace, which at the moment is wellover 4 percent and, adjusting for weathereffects, may be running over 5 percent. This isnot sustainable growth, and it has nothing todo with monetary policy. In other words, it willcome down. And the way a 3 percent growthfeels, if I may put it that way, is a lot differentfrom the way the expansion feels now.

I would be very concerned if this Committeewent 50 basis points now because I don’t thinkthe markets expect it...I’ve been in the economicforecasting business since 1948, and I’ve beenon Wall Street since 1948, and I am telling youI have a pain in the pit of my stomach, whichin the past I’ve been very successful in alludingto. I am telling you—and I’ve seen these mar-kets—this is not the time to do this. I think therewill be a time; and if the staff’s forecast is right,we can get to 150 basis points pretty easily.We can do it with a couple of 1/2 point jumpslater when the markets are in the position toknow what we’re doing and there’s continuity.I really request that we not do this. I do requestthat we be willing to move again fairly soon,and maybe in larger increments; that dependson how things are evolving.

We construe this statement as revealing a lowγ Πt. We could present similar evidence regarding

the behavior of policy in the aftermath of the LongTerm Capital Management fiasco or in the exitfrom the 2001 recession. But we feel the pointhas been made. We believe that our estimates areright: Monetary policy in the Greenspan yearswas similar to monetary policy under Burns andMiller. Instead, time-varying structural shockswere the mechanism that played a key role inthe Great Moderation and the low inflation of1987-2007.

7. WHAT ARE WE MISSING?What is our model missing that is really impor-

tant? The answer will tell us much about wherewe want to go in terms of research and where weneed to be careful in our reading of monetary his-tory. Of all the potential problems of our specifi-cation, we are particularly concerned about thefollowing.

First, households and firms in the modelobserve the changes in the coefficients γ Πt and γ ytwhen they occur. A more plausible scenario wouldinvolve filtering in real time by the agents whoneed to learn the stand of the monetary authorityfrom observed decisions.33 A similar argumentcan be made for the values of the SDs of all theother shocks in the economy. Unfortunately,introducing learning suffers from two practicaldifficulties: It is not obvious what is the best wayto model learning about monetary policy, espe-cially in a nonlinear environment such as ourswhere least-square rules may not work properly.And it would make the computation of the modelnearly infeasible.

Second, we assume that monetary policychanges are independent of the events in theeconomy. However, many channels make thisassumption untenable. For instance, each admin-istration searches for governors of the Board whoconform with its views on the economy (after all,



32 Board of Governors FOMC Transcripts, February 3-4, 1994, p. 55.

33 The difficulties in observing monetary policy changes can beillustrated by Axilrod’s description of a lunch with Arthur Burnsshortly after the announcement of Volcker’s new policy. Accordingto Axilrod (2009, p. 100), Burns stated: “You are not really goingto be doing anything different from what we were doing. If aninsider like Burns had difficulties in filtering Volcker’s behavior,it is hard to conclude anything but that the average agents in theeconomy had difficulties as well.”

this is what a democracy is supposed to be about).We saw how Heller discovered that an adminis-tration could select governors to twist the FOMCtoward its policy priorities. This is a traditionthat has continued. Meyer (2004, p. 17) describesthe process for his own appointment as one clearlyguided by the desire of the Clinton administrationto make monetary policy more accommodativeand growth-oriented. As long as the party in poweris a function of the state of the economy, the com-position of the FOMC will clearly be endogenous.Similarly, changes in public perception of thedangers of inflation certainly weighed heavilyon Carter when he appointed Volcker to lead theFed in 1979.

Third, and related to our two previous points,evolving beliefs about monetary policy might beendogenous to the developments of events andlead to self-confirming equilibria. This is a pointemphasized by Cho, Williams, and Sargent (2002)and Sargent (2008).

Fourth, our technological drifts are constantover time. The literature on long-run risk has high-lighted the importance of slow-moving compo-nents in growth trends (Bansal and Yaron, 2004).It may be relevant to judge monetary policy to esti-mate a model in which we have these slow-movingcomponents, since the productivity slowdownof the 1970s and the productivity acceleration ofthe late 1990s are bound to be reflected in ourassessment of the stance of monetary policy dur-ing those years. This links us back to some of theconcerns expressed by Orphanides (2002). At thesame time and nearly by definition, there is verylittle information in the data about this component.

Fifth, our model is a closed economy. How -ever, the considerations regarding exchange rateshave often played an important role in monetarypolicymaking. For instance, during the late 1960s,the United States fought an increasingly desperatebattle to keep the Bretton Woods Agreementalive, which included the Fed administering aprogram to voluntarily reduce the amount offunds that American banks could lend abroad(Meltzer, 2010, p. 695) and purchasing long-termTreasury bonds to help the British pound stabilizeafter its 1967 devaluation. The end of BrettonWoods also deeply influenced policymakers in

the early 1970s. Later, Volcker’s last years at theFed were colored by the Plaza and Louvre Accordsand the attempts to manage the exchange ratebetween the U.S. dollar and the Japanese yen.

Finally, our model ignores fiscal policy. Theexperience of the 1960s, in which there was anexplicit attempt at coordinating fiscal and mone-tary policies, and the changes in long-run interestrates possibly triggered by the fiscal consolida-tions of the 1990s indicate that the interactionbetween fiscal and monetary policies deservesmuch more attention, a point repeatedly madeby Chris Sims (for example in Sims, 2009).

8. CONCLUDING REMARKSThe title of this paper is not only a tribute to

Friedman and Schwartz’s (1971) opus magnum,but also a statement of the limitations of our inves-tigation. Neither the space allocated to us34 norour own abilities allow us to get even close toFriedman and Schwartz’s achievements. We havetried to demonstrate, only, that the use of modernequilibrium theory and econometric methodsallows us to read the monetary policy history ofthe United States since 1959 in ways that we findfruitful. We proposed and estimated a DSGE modelwith stochastic volatility and parameter drifting.The model gave us a clear punch line: First, thereis ample evidence of both strong changes in thevolatility of the structural shocks that hit the econ-omy and changes in monetary policy. The changesin volatility accounted for most of the GreatModeration. The changes in monetary policymattered for the rise and conquest of the GreatInflation. Inflation stayed low during the nextdecades in large part due to good shocks. Whenwe go to the historical record and use the resultsof our estimation to read and assess the documen-tary evidence, we find ample confirmation, in ouropinion, that the model, despite all its limitations,is teaching us important lessons.

34 For an only slightly longer period than ours, Meltzer (2010) requires1,300 pages to cover the details of the history of monetary policyin the United States, including the evolution of operational pro-cedures that we have not even mentioned.



As we argued in the previous section, weleave much unsaid. Hopefully, the results in thispaper will be enticing enough for other researchersto continue a close exploration of recent monetarypolicy history with the tools of modern dynamicmacroeconomics.



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Documents

Reading the Recent Monetary History of the United States ...Reading the Recent Monetary History of the United States, 1959-2007 Jesús Fernández-Villaverde, Pablo Guerrón-Quintana,