Learning, monetary policy rules, and macroeconomic stability

Several papers have documented a regime switch in US monetary policy from ‘passive’ and destabilizing in the pre-1979 period to ‘active’ and stabilizing afterwards. These studies typically work with DSGE models with rational expectations. This paper relaxes the assumption of rational expectations and allows for learning instead. Economic agents form expectations from simple models and update the parameters through constant-gain learning. In this setting, the paper aims to test whether monetary policy may have been a source of macroeconomic instability in the 1970s by inducing unstable learning dynamics. The model is estimated by Bayesian methods. The constant-gain coefficient is jointly estimated with the structural and policy parameters in the system. The results show that monetary policy was respecting the Taylor principle also in the pre-1979 period and, therefore, did not trigger macroeconomic instability. r 2008 Elsevier B.V. All rights reserved. JEL classification: C11; D84; E30; E50; E52; E58