ECON 5010 Class Notes Monetary Policy Rules and Macro Stability

1 Introduction From the late 1960s through the early 1980s, the macroeconomy experienced high in‡ation and several recessions. Many attribute this to oil price shocks. Others argue that the persistent high in‡ation may have been due to poorly managed monetary policy. CGG set out to add rigor to this latter argument. CGG estimate a forward-looking interest rate rule before Paul Volker (pre-1979) and after Paul Volker (post-1979). CGG …nd that policymakers pre-1979 did not su¢ ciently raise the Federal Funds in response to expected in‡ation. As a result, real interest rates declined and fueled more in‡ation. Conversely, CGG …nd that policymakers post-1979 were more aggressive toward expected in‡ation. The Federal Funds rate was increased enough to ensure that real interest rates would rise. When embedded in a standard business-cycle model, the pre-Volker rules are shown to generate more instability than the post-Volker rules.