Shocks and Government Beliefs: The Rise and Fall of American Inflation

Thomas Sargent, Noah Williams, and Tao Zha
Working Paper 2004-22
September 2004

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The authors use a Bayesian Markov chain Monte Carlo algorithm to estimate a model that allows temporary gaps between a true expectational Phillips curve and the monetary authority’s approximating nonexpectational Phillips curve. A dynamic programming problem implies that the monetary authority’s inflation target evolves as its estimated Phillips curve moves. The authors’ estimates attribute the rise and fall of post-World War II inflation in the United States to an intricate interaction between the monetary authority’s beliefs and economic shocks. Shocks in the 1970s altered the monetary authority’s estimates and made it misperceive the tradeoff between inflation and unemployment. That misperception caused a sharp rise in inflation in the 1970s. The authors’ estimates indicate that policy makers updated their beliefs continuously. By the 1980s, policy makers’ beliefs about the Phillips curve had changed enough to account for Fed chairman Paul Volcker’s conquest of U.S. inflation in the early 1980s.

JEL classification: E3, E5

Key words: updating beliefs, policy evaluation, self-confirming equilibrium, Nash inflation, Ramsey outcomes

The authors thank seminar participants at the NBER Summer Institute—Eric Leeper, James Nason, Ricardo Reis, William Roberds, Frank Schorfheide, Christopher Sims, and Lars Svensson—for helpful discussions and Jordi Mondria for excellent research assistance. Sargent and Williams thank the National Science Foundation for support. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Thomas Sargent, Department of Economics, New York University, 269 Mercer Street, New York, New York 10003, 212-998-3548,; Noah Williams, Department of Economics, Fisher Hall, Princeton, New Jersey 08544-1021, 609-258-4019, 609-258-6419 (fax),; or Tao Zha, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8353, 404-498-8956 (fax),