Palgrave Handbook of Econometrics: Applied Econometrics

938 Monetary Policy, Beliefs, Unemployment and Inflation

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

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4.5

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1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 91 96 101

Period

Percent

Figure 18.3 The first solution for inflation

dependence on unemployment of external shocks, but instead assume that the
unemployment effect on inflation is increasing.
Inflation surprises, as shown in Figure 18.4(e), do not play a part in bringing
about the reduction in inflation shown in Figure 18.3, in contrast to the “escapes”
model of Sargent (1999), where unusual realizations of the noise processes are the
sole explanation for switches between high and low inflation.
In keeping with properties of the Beliefs model, the present one also shows that
the authorities’ misspecified Phillips curve does not converge on the “true” Phillips
curve, and the authorities’ estimates of the parameters on the exogenous determi-
nants of unemployment do not converge to their values in the “true” Phillips
curve (as estimated separately). This finding is in line with Sargent’s depiction of
the solution being an SCE.
The next exercise considers what happens to inflation when the authorities are
not aware of the effects of the exogenous variables at all, and the parameters on
these (δ=(δ 1 ,δ 2 ))are set at zero and not updated. The resulting inflation dynamics
are shown in Figure 18.5, which shows a significant increase in inflation. The
interpretation of this solution advanced here is that it represents the effects of an
optimistic view that the natural rate does not worsen in the face of adverse external
shocks. Monetary policy is then set as if these adverse shocks had not happened.
Below we argue that a parallel case to this is where the authorities believe that the
trend rate of productivity growth in the economy has risen when in fact it has not,
and this parallel motivates the comments on the economic events at the end of
the 1980s made in the following section.
As in the previous case, there are substantial changes in the (γ 0 ,γ 1 )parameters
in the authorities’ Phillips curve (see Figures 18.6(a) and (b)). This time, however,
the authorities’ beliefs about the sacrifice ratio (governed by their estimate ofγ 1 ),