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Federal Reserve Bank of Richmond
Working Paper
Indeterminacy and Learning: An Analysis of Monetary Policy in the Great Inflation
Thomas A. Lubik
Christian Matthes
Abstract

We argue in this paper that the Great Inflation of the 1970s can be understood as the result of equilibrium indeterminacy in which loose monetary policy engendered excess volatility in macroeconomic aggregates and prices. We show, however, that the Federal Reserve inadvertently pursued policies that were not anti-inflationary enough because it did not fully understand the economic environment it was operating in. Specifically, it had imperfect knowledge about the structure of the U.S. economy and it was subject to data misperceptions. The real-time data flow at that time did not capture the true state of the economy, as large subsequent revisions showed. It is the combination of learning about the economy and, more importantly, the use of data riddled with measurement error that resulted in policies, which the Federal Reserve believed to be optimal, but when implemented led to equilibrium indeterminacy in the economy.


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Thomas A. Lubik & Christian Matthes, Indeterminacy and Learning: An Analysis of Monetary Policy in the Great Inflation, Federal Reserve Bank of Richmond, Working Paper 14-2, 31 Jan 2014.
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Keywords: Federal Reserve; Great Moderation; Bayesian Estimation; Least Squares Learning
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