No 93. The Quest for Prosperity Without Inflation

Abstract

In recent years, activist monetary policy rules responding to in ation and the level of economic activity have been advanced as a means of achieving effective output stabiliza- tion without inflation. Advocates of such policies suggest that their exibility may yield substantial stabilization benefits while avoiding the excesses of overzealous discretionary fine-tuning such as is thought to characterize the experience of the 1960s and 1970s. In this paper, I demonstrate that these conclusions are misguided. To illustrate this fact, I construct a database with data available to policymakers in real time from 1965 to 1993 and, using an estimated model, I perform counterfactual simulations under alternative informational assumptions regarding the knowledge policymakers can reasonably have had about the state of the economy when policy decisions were made. Using realistic informa- tional assumptions overturns findings favoring activist policies in favor of prudent policies that ignore short-run stabilization concerns altogether. The evidence points to mispercep tions of the economy's productive capacity as the primary underlying cause of the 1970s in ation and suggests that apparent di_erences in the framework governing monetary policy decisions during the 1970s compared to the more recent past have been greatly exaggerated.