Paper 3: Taylor Rule and The Great Inflation

Aside from the Great Depression of the 1930s, the Great Inflation of
the 1970s is considered to be one of the greatest macroeconomic failures in
the United States since the founding of the Federal Reserve. Throughout the
1970s and through the early 1980s, the United States experienced a severe
inflationary period. It wasnt until the early 1980s, around when Paul Volcker
was appointed Chairman of the Federal Reserve, that inflation returned to
low and relatively stable levels. Many economists argue that the Great
Inflation was driven, predominantly, by oil price shocks. In the paper, I will
discuss the oil price shock theory as well as alternative explanations for the
Great Inflation. In particular, I will focus on how violations of the Taylor rule
principle could justify the Great Inflation. I will also discuss other leading
hypotheses regarding monetary policy mistakes that may have caused or
strengthened the Great Inflation.
Most economists originally hypothesized that the Great Inflation was
the result of two major oil shocks (1973 and 1979). The idea was that these
oil shocks were the driving forces behind the inflationary period. Hamilton
(1983) argued that oil shocks are a central driving force in business
cycles. But can oil shocks, without other macroeconomic imbalances, force
a shift in macroeconomic volatility? Clarida, Gali, and Gertler, in a 2000
paper, confront this question. They argue that monetary policy decisions
are critical to understanding the Great Inflation for two reasons. First,
Clarida, Gali, and Gertler, using Bernanke, Gertler, and Watsons 1997

paper as an example, emphasized that the theory that oil shocks can
account for the volatile behavior in output in the 1970s is up for debate.
Even though there was a shock to the real price of oil before both
inflationary induced recessions (1974-1975 and 1980-1982), there was also
tightening of monetary policy preceding these economic stints (Clarida et al
2000). Hamiltons original analysis (1983) does not take into account
monetary policy changes. Clarida, Gali, and Gertler pointed to this
identification problem between the relative importance of the oil shocks
and monetary policy during the Great Inflation as a reason to doubt the
magnitude oil shocks can have on volatile macroeconomic behavior.
Second, Clarida, Gali, and Gertler investigated the timing of the oil shocks.
They found inconsistency between the timing of the oil price shocks and the
inflation shocks. This further raises doubt that oil shocks are the leading
explanation for high inflation throughout the 1970s.
Real Oil Price and Inflation

Figure 1

As can be seen in Figure 1, the initial increase in inflation, in the late 1960s,
far precedes the first oil shock. Even more noteworthy, the inflation rate is
steadily increasing from the late 1960s through the first oil shock in 1974
(while the real price of oil is decreasing). In 1977, during the second major
inflationary spike of the period, the real oil price is relatively constant.
These inconsistencies have led economists to research alternative
explanations, regarding monetary policy, to explain the plague of constant
high inflation rates throughout the 1970s.
Building on the 1990s consensus that interest rates are to be used as
operating targets and that inflation should be targeted by central banks,
Taylor (1993) proposed the following rule to model US monetary policy:

In this model i is the nominal interest rate, r* is the target real interest rate,
pi* is the target inflation rate, y is the actual output, y* is the potential
output, and pi is the actual inflation. Essentially, this equation says that the
federal funds rate is equal to an equilibrium federal funds rate plus .5 times
the output gap plus 1.5 times inflation minus inflations target. Taylor found
that this rule generates an extremely high R-squared when testing with US
data from 1987 Q1 1992 Q2. In other words, Taylors rule was quite
accurate at measuring the variance in monetary policy in the US from 1987
Q1 1992 Q2 (Bowdler 2015). Taylor made no claim that this model is
optimal, but based off modeling tests it provided a good baseline for
measuring the effectiveness of monetary policy. One of the key features of

Taylors Model is the Taylor Principle. Taylor argued that the coefficient on
inflation deviation must be bigger than one in order to avoid inflation
shocks. If inflation goes up by 1%, to keep real interest rates stable, policy
makers need to increase nominal interest rates by at least 1%. If the
inflation reaction coefficient was less than one, an economy would
experience explosive inflation (Bowdler 2015). In literature, the Taylor
Principle has been used as a benchmark for testing the rationality of
monetary policy decisions If the inflation deviation coefficient is at least
one then monetary policy is considered rational.
Clarida, Gali, and Gertler (2000) used the Taylor Principal to develop
an alternative hypothesis for the cause of the Great Inflation. They break
down their analysis to pre- and post-1979 (the year Paul Volcker was
appointed Chairman of the Federal Reserve). Clarida et al. used a forwardlooking modification on Taylors equation - If either lagged inflation or a
combination of lagged inflation and the output gap is a sufficient statistic
for forecasting future inflation, then the equation Clarida et al. used
collapses to the Taylor Rule (Clarida et al. 2000). A forward-looking
modification to Taylors Rule allows the central bank to consider a broad
range of information in order to make policy decisions. Gertler et al. found
this to be very realistic. To examine the conduct of monetary policy pre- and
post-1979, Clarida et al. estimated monetary policy rules using their
forward looking Taylor Rule. They found the following:

The beta is the inflation reaction coefficient, and the gamma is the output
gap reaction coefficient. In this discussion, I will focus on the beta. PreVolcker the inflation reaction coefficient is estimated to be .83 (more than
two standard errors from one significant evidence Taylors Principle is
being violated). For every 1% rise in inflation above the target inflation rate,
the Federal Reserve raised the nominal interest rate by .83%. Therefore,
real interest rates were going down. During the Volcker-Greenspan era
(post-1979), the inflation reaction coefficient is estimated to be 2.15. Post1979, for every 1% rise in inflation above the target rate, the Federal
Reserve raised the federal funds rate by 2.15%. Thus, real interest rates
were going up (1.15% rise). This will bring down demand and inflation In
the 1980s that is exactly what happened. Inflation decreased back to
target levels and the Great Inflation ended. Clarida et al. main thesis is the
argument that the Great Inflation can be understood through the lens of
Taylors Rule. Pre-Volcker, the Taylor Principle was failing. Post-1979,
Volckers Federal Reserve brought inflation under control by following
Taylors Principle.
Orphanides (2001, 2002, 2003) questioned and built upon Clarida et
al. (CGG) findings. Orphanides found that there are informational issues

with the CGG hypothesis. CGG used ex-post revised data when conducting
their research. Orphanides discovered this to be problematic for a couple of
reasons. First, ex-post revised data was obviously not available to policy
makers when making decisions to fluctuate the Federal Funds rate. Second,
Orphanides found that, using Taylors rule, the real-time policy
recommendations are significantly different than those obtained from expost revised data. CGG used what was known in 2000 about the output and
inflation gap to ask how strong the response of monetary policy in the
1970s was. Orphanides argues that this doesnt provide any insight to the
actual behavior of monetary policy because policy makers did not have
revised inflation and output figures to conduct policy. Instead, Orphanides
argues that in order to properly assess monetary policy one needs to
examine how policy makers in the 70s reacted to what was known at the
time about US output and inflation using data other than what was
available to policy makers, in real time, during the Great Inflation is difficult
to interpret. The biggest discretion between real-time and ex-post data was
in the output gap. In 1974 the perceived output gap in the US was 15% there was a seemingly large recession. With ex-post data we now know that
two-thirds of the apparent recession was really due to a decline in
equilibrium output. The measurement errors between real-time and ex-post
data, in regards to inflation, are much smaller. Armed with real-time data,
Orphanides (2002) ran two particularly significant analyses. First, he took
Taylors original rule (.5 output gap coefficient and 1.5 inflation deviation

coefficient) and calculated the federal funds rate using real-time data.
Second, he re-estimated the CGG regressions using real-time data rather
than the ex-post data that CGG used. Orphanides found that the difference
between what the Federal Reserve did, and what they should have done
(adhering to Taylors principle and using real time data) is minimal. Further,
using real time data, the inflation deviation coefficient on the CGG
regressions was higher than 1 both pre- and post-1979. Based off of
Orphanides findings, it is hard to argue that the Federal Reserves policy
decisions pre-1979 were bad. Thus it is hard to find merit in the CGG
hypothesis.
Orphanides (2003) proposed an alternative to the CGG hypothesis. He
argues that the main cause of the Great Inflation can be pinned down on
the output gap mismeasurement I described above. Orphanides argues that
the dismal economic outcomes of the Great Inflation may have resulted
from an unfortunate pursuit of activist policies in the face of bad
measurement, specifically, overoptimistic assessments of the output gap
associated with the productivity slowdown of the late 1960s and early
1970s. Policy makers were overconfident in believing that they could
ascertain in real-time the current state of the economy relative to its
potential (Orphanides 2003). Orphanides cited two main reasons why
policy makers were misguided in their estimates of potential output: First,
the natural rate of unemployment was misjudged. In 1961, 4% was
considered a reasonable estimate. In reality, unemployment averaged 6.3%

from 1966 to 1993 (Orphanides 2003). Second, the Federal Reserve was
overly optimistic about the rate of labor productivity improvement and how
that would translate to the natural growth rate of output. Given the issues
with accurately measuring the output gap, Orphanides proposed that
alternative strategies that do not rely on the output gap might be more
effective and provide more robust benchmarks for policy analysis.
In response to Orphanides, Nelson (2005) argues that the monetary
policy neglect hypothesis, which claims that policymakers took a
nonmonetary view of the inflation process, is a more likely explanation of
the Great Inflation. Nelson and Nikolov (2002) describe the hypothesis as
follows:
Policymakers viewed monetary policy as disconnected from inflation, for two reasons. First,
inflation was perceived as largely driven by factors other than the output gap; secondly,
policymakers were highly skeptical about the ability of monetary policy to affect aggregate
demand or the output gap appreciably... Monetary policy was not seen as essential for
inflation control; the latter, instead, was largely delegated to incomes policy (wage and
price controls). Such views, we argue, led to a combination of easy monetary policy and
attempts to control inflation through other devices, and contributed heavily to the breakout
of inflation in the 1960s and 1970s.

Nelson (2005) provided examples of how the Great Inflation conformed to

the monetary policy neglect hypothesis, which I wont get into detail about
in this paper. Lastly, Nelson argues that the circuit breaker of the persistent
inflation of the 1970s was the exchange rate depreciation in 1978 that
legitimized monetary tightening as an appropriate response to inflation
even from a cost-push perspective. It is important to note that Nelson
(2005) does not discount Orphanides hypothesis. Instead he argues that

while the output gap played a role, its mismeasurement was not the
principal cause of the 1970s policy mistakes.
Economists still argue over the true cause of the Great Inflation. For
example, in 2008, Blinder and Rudd found strong evidence to support the
supply-shock explanation of the Great Inflation. In the future, it will be
important to understand why and how policy makers made certain
decisions. In doing this type of analysis future decision makers can
understand what went wrong, why it went wrong, and what can be changed
to prevent such a problem from occurring again. In the case of the Great
Inflation, I think it makes more sense to view it as an outcome of monetary
policy mistakes. By examining the decisions that led policy makers astray,
further policy will only benefit.

References
i. Slides From Money and Banking Lecture 4, Oxford University, October
2015.
ii. Clarida, R., J. Gali and M. Gertler (2000). Monetary Policy Rules and
Macroeconomic Stability: Evidence and Some Theory Quarterly Journal of
Economics, 115, no. 1, pp.147-80.
iii. Orphanides, A. (2001). Monetary Policy Rules Based on Real Time Data.
American
Economic Review, 91, no. 4, pp. 964-85.
iv. Orphanides, O. (2003). The quest for prosperity without inflation.
Journal of
Monetary Economics, 50, pp. 633-663.
v. Nelson, E. (2005). The Great Inflation of the Seventies: What Really
Happened?
Advances in Macroeconomic, article 3.
vi. Orphanides, A. (2002). `Monetary Policy Rules and the Great Inflation.
American
Economic Review, Papers and Proceedings, 92, no. 2, pp. 115-20.
vii. Blinder, A. and J. Rudd (2008). 'The Supply-Shock Explanation of the
Great
Stagflation Revisited.' NBER working paper number 14563.
viii. Chowdhury, I. and A. Schabert (2008). 'Federal Reserve policy viewed
through a
money supply lens' Journal of Monetary Economics, pages 825-34.