Inflation gap persistence, indeterminacy, and monetary policy

Abstract

Empirical literature has documented that the persistence of the gap between inflation and its trend declined after the Volcker disinflation. Previous studies into the source of the decline in inflation gap persistence have offered competing views while sidestepping the possibility of equilibrium indeterminacy. We examine the source of the decline by estimating a medium-scale dynamic stochastic general equilibrium model using Bayesian methods that allow for indeterminacy. We show that the Fed's change from a passive to an active policy response to the inflation gap or a decrease in firms' probability of price change can fully account for the decline in inflation gap persistence by ruling out indeterminacy that induces persistent economic dynamics.