Monetary Policy and the Great Inflation: A Multi-Country Time-Varying Analysis Using the Taylor Rule

This paper is motivated by the observation that the Great Inflation, i.e., the high and volatile inflation that developed in the mid 1960s and lasted for almost twenty years, was an international phenomenon. Given that observation, we argue that an explanation for the Great Inflation should be consistent with the timing of the events in many developed countries, and not only with the US. We propose an econometric model for studying monetary policy’s responsibility in the developed world, gathering information from the cross section dimension that the international experience offers. Precisely, we examine how the weights in a forward looking Taylor rule change over time for the G7 countries. More interestingly, we explore whether the G7 countries implemented similar changes to their policies during the period of the Great Inflation. To do this, we develop a generalized Bayesian time-varying parameter model to jointly estimate the G7 monetary authorities’ response to inflation. We allow these responses to be correlated across countries, capturing common information, ideas or communication across them. We find that monetary authorities in the G7 countries accommodated inflation until almost the mid 1980s, after which they systematically fought it. Furthermore, we find that the correlation of the policy changes in response to inflation across countries is positive. This commonality among otherwise different economies may be responsible for the common inflation patterns observed during the Great Inflation era. ∗Banque de France †Texas A&M University, Corresponding Author. Email: [email protected]. Address: Texas A&M University, 4228 TAMU, College Station, TX 77843, Website: http://econweb.tamu.edu/azervou. We are very grateful to James Morley for his direction and support. We also thank Athanasios Orphanides, James Bullard, Siddhartha Chib and participants of the Midwest Econometric Group and the 8th Conference on Research on Economic Theory & Econometrics for helpful comments.