Inflation Sensitivity To Monetary Policy: What Has Changed since the Early 1980s?
| DOI | http://doi.org/10.1111/obes.12272 |
| Published date | 01 April 2019 |
| Date | 01 April 2019 |
| Author | Roberto Pancrazi,Marija Vukotić |
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©2018 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 81, 2 (2019) 0305–9049
doi: 10.1111/obes.12272
Inflation Sensitivity To Monetary Policy:What Has
Changed since the Early 1980s?*
Roberto Pancrazi† and Marija Vukoti ´
c†
†University of Warwick, Economics Department, Coventry, CV4 7AL, UK
(e-mail: r.pancrazi@warwick.ac.uk; m.vukotic@warwick.ac.uk)
Abstract
Have conventional monetary policy instruments maintained the same ability to accom-
modate undesirable effects of shocks throughout the postwar period? Or has the changed
economic environmentcharacterizing the last 30 years diminished the sensitivityof macroe-
conomic volatility to systematic changes in the conduct of monetary policy? The answer
is no to the first question and, consequently, yes to the second question. We estimate a
medium-scale New-Keynesian model in two subsamples, 1955–79 and 1984–2012, and
find that the sensitivity of inflation variance to changes in conventionalmonetary policy has
declined. We document that the changed properties of the labour market largely contributed
to this decline.
I. Introduction
The U.S.economy experienced some fundamental changes around the early 1980s; whereas
for a long time researchers havefocused on understanding the sources behind the evident re-
duction in macroeconomic volatility,a phenomenon referred to as the ‘Great Moderation’1,
more recently several authors have argued that the changes after early 1980s have been
even more profound. Forexample, Gal´
i´ı and Gambetti (2009), Barnichon (2010) document
an altered pattern of comovements among output, hours, and labour productivity after the
early 1980s, attributing part of this changed dynamics to a shift in the composition of exoge-
nous shocks; Nucci and Riggi (2013), Gal´ı andVan Rens (2014) document similar patterns
JEL Classification numbers: E52, E32.
*We thank the editor and twoanonymous referees who made valuable suggestions for improving the paper.
1Broadly speaking, one strand of this literature attributes most of this reduction to smaller macroeconomic shocks,
another strand of the literature attributes it mainly to the more systematic response of monetary policy to fluc-
tuations in economic conditions. This first explanation of the Great Moderation is known as the ‘good luck’ hy-
pothesis. See, for example, Kim and Nelson (1999), Stock and Watson (2002, 2003), Ahmed, Levin and Wilson
(2004), Primiceri (2005), Liu, Waggoner and Zha (2009). The second explanation is known as the ‘good policy’
hypothesis. See, for example, Clarida, Gal´ı and Gertler (2000), Cogley and Sargent (2001, 2005), Blanchard and
Simon (2001), Benati and Surico (2009), Boivin (2006). Other explanations have also been proposed in the liter-
ature; for example, a change in inventories management, proposed by McConnell and Perez-Quiros (2000), Kahn,
McConnell and Perez-Quiros (2002), and financial innovation, proposed by Dynan and Elmendorf (2006), among
others.
Inflation sensitivity to monetary policy 413
and relate them to structural shifts on the labour market; Foroni, Furlanetto and Lepetit
(2015) find that labour market shocks became more important drivers of macroeconomic
fluctuations in the post-1980.
Motivated by this evidence, our paper asks the following question: how have these
changes after the early 1980s affected the ability of monetary policy to smooth out aggre-
gate fluctuations? With the purpose of clarifying this economic question, consider a fairy
simple three-equation New Keynesian model, composed of the New Keynesian Phillips
curve, an aggregate demand curve, and a monetary policy schedule, for example, a Tay-
lor rule. In this context, it is well known that by increasing the systematic response of
interest rate to inflation, the monetary policy is able to reduce fluctuations in nominal
and real macroeconomic variables. Hence, using this conventional monetary policy tool,
monetary policy is effective in reducing macroeconomic fluctuations. This consideration
squares with the findings of Clarida et al. (2000), Cogley and Sargent (2001), Romer and
Romer (2002), Boivin and Giannoni (2006), among others, who conclude that an increase
in monetary policy’s response to inflation during Volcker era indeed played a dominant
role in the reduction of macroeconomic volatility. But, how sensitive is the reduction of
macroeconomic volatility to changes in this type of conventional monetary policy tools?
And how has this sensitivity evolved over time?
To answer these questions, we start from the simple observation that the ability of
monetary policy to reduce macroeconomic volatility can be affected by various factors,
such as the structure of the economy, the relative importance of exogenous shocks, as well
as their persistence. We then consider a fairly standard medium-scale dynamic stochastic
general equilibrium (DSGE) model as in Smets and Wouters (2007) and, as standard in the
Great Moderation literature, estimate it in two subsamples: the pre-1980 and post-1980
sample period. This approach allows us to consider all of the above factors, while being
agnostic about their relative importance in driving changes between the two subsamples.
Finally, we propose a measure of the sensitivity of macroeconomic volatility to changes
in conventional monetary policy tools. This measure captures by how much the variance
of a macroeconomic variable, such as inflation or output gap, varies as a consequence of a
small change in the systematic response of a monetary authority to inflation.
We find that the sensitivity of inflation volatility has declined drastically.2Howdowe
interpret this result? We argue that the economic environment at the end of the 1970s
was particularly favourable for a relatively small increase in the systematic response to
inflation to have a large effect on inflation volatility. In fact, because in this period the
economic environment was such that the sensitivity of inflation volatility to changes in
conventional policy tools was quite high, the monetary policy was very effective in re-
ducing inflation volatility by increasing the Taylor-rule parameter, as pointed out in the
literature. However, in the last three decades, the economic environment, characterized by
structural changes and the estimated changes in the exogenous shocks, brought about a
large decline in the sensitivity. Therefore, should a policymaker nowadays need to achieve
a large reduction in inflation variance, it would need to respond to inflation much more
aggressively. Importantly, in this paper we focus only on conventional monetary policy
2Wealso analyse the sensitivity of output gap volatility and document that it is low and roughly unchanged across
the two subsamples. Therefore, we focus most of our attention on explaining changes in the sensitivity of inflation
volatility.
©2018 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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