Aiming Low or Reacting Strongly? Investigating the Source of the Time Variation in U.S. Monetary Policy

Abstract

Through the lens of the Taylor rule, New Keynesian models suggest that a central bank can enhance the macroeconomic stability by aiming for a low inflation target and by strengthening the response to changes in inflation, but these two strategies are difficult to be identified empirically.Using the Bayesian model comparison, I find that the evidence for the Markov-switching response to inflation vanishes when the time variations of the inflation target in the past four decades are taken account for. This paper provides empirical supports for the hypothesis that the low-inflation-target policy conducted by Volcker stabilized inflation expectation and contributed to the Great Moderation.