Regime Switches, AgentsBeliefs, and Post-World War II U.S. Macroeconomic Dynamics

The evolution of in‡ation and output over the last 50 years is examined through the lens of a micro-founded model that allows for changes in the behavior of the Federal Reserve and in the volatility of structural shocks. Agents are aware of the possibility of regime changes and their beliefs have an impact on the law of motion underlying the macroeconomy. The results support the view that there were regime switches in the conduct of monetary policy. However, behavior of the Federal Reserve is identi…ed by repeated ‡uctuations between a Hawk and aDoveregime, instead of by the traditional preand postVolcker structure. Counterfactual simulations show that if agents had anticipated the appointment of an extremely conservative Chairman, in‡ation would not have reached the peaks of the late ‘70s and the in‡ation-output trade-o¤ would have been less severe. These "beliefs counterfactuals" are new in the literature. Finally, the paper provides a Bayesian algorithm to handle the technical di¢ culties that arise in rational expectations model with Markov-switching regimes. I am grateful to Chris Sims, Mark Watson, Efrem Castelnuovo, Nobuhiro Kiyotaki, David Lucca, Esteban Rossi-Hansberg, Barbara Rossi, Tom Sargent, and all seminar participants at Princeton University, the Board of Governors, the Federal Reserve Bank of Chicago, the New York Area Workshop on Monetary Policy, University of Pennsylvania, University of Virginia, Northwestern University, Duke University, UCLA, New York University, Philadelphia Fed, Penn State, CREI-Pompeu Fabra, University of Bern, NBER Summer Institute, Society for Economic Dynamics Annual Meeting for useful suggestions and comments. Part of this paper was completed while the author was visiting the Board of Governors, whose hospitality is gratefully acknowledged. Correspondence: Duke University, 213 Social Sciences Building, Box 90097, Durham, NC 27708-0097. E-mail: [email protected].