TY - JOUR AU - Orphanides, Athanasios AU - Williams, John TI - Monetary Policy Mistakes and the Evolution of Inflation Expectations JF - National Bureau of Economic Research Working Paper Series VL - No. 17080 PY - 2011 Y2 - May 2011 DO - 10.3386/w17080 UR - http://www.nber.org/papers/w17080 L1 - http://www.nber.org/papers/w17080.pdf N1 - Author contact info: Athanasios Orphanides Sloan School of Management Massachusetts Institute of Technology 77 Massachusetts Avenue Cambridge, MA 02139 E-Mail: athanasios.orphanides@gmail.com John Williams Federal Reserve Bank of San Francisco Executive Offices 101 Market St. San Francisco, CA 94105 Tel: (415) 974-2121 E-Mail: john.c.williams@sf.frb.org M1 - published as Athanasios Orphanides, John C. Williams. "Monetary Policy Mistakes and the Evolution of Inflation Expectations," in Michael D. Bordo and Athanasios Orphanides, editors, "The Great Inflation: The Rebirth of Modern Central Banking" University of Chicago Press (2013) M3 - presented at "The Great Inflation Conference", September 25-27, 2008 AB - What monetary policy framework, if adopted by the Federal Reserve, would have avoided the Great Inflation of the 1960s and 1970s? We use counterfactual simulations of an estimated model of the U.S. economy to evaluate alternative monetary policy strategies. We show that policies constructed using modern optimal control techniques aimed at stabilizing inflation, economic activity, and interest rates would have succeeded in achieving a high degree of economic stability as well as price stability only if the Federal Reserve had possessed excellent information regarding the structure of the economy or if it had acted as if it placed relatively low weight on stabilizing the real economy. Neither condition held true. We document that policymakers at the time both had an overly optimistic view of the natural rate of unemployment and put a high priority on achieving full employment. We show that in the presence of realistic informational imperfections and with an emphasis on stabilizing economic activity, an optimal control approach would have failed to keep inflation expectations well anchored, resulting in high and highly volatile inflation during the 1970s. Finally, we show that a strategy of following a robust first-difference policy rule would have been highly effective at stabilizing inflation and unemployment in the presence of informational imperfections. This robust monetary policy rule yields simulated outcomes that are close to those seen during the period of the Great Moderation starting in the mid-1980s. ER -