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POLICY SWITCH AND THE GREAT MODERATION: THE ROLE OF EQUILIBRIUM SELECTION

Published online by Cambridge University Press:  30 December 2011

Efrem Castelnuovo
Efrem Castelnuovo*
Affiliation:
University of Padua and Bank of Finland
*
Address correspondence to: Efrem Castelnuovo, Department of Economics, University of Padua, Via del Santo 33, I-35123 Paduva (PD), Italy; e-mail: efrem.castelnuovo@unipd.it.
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Abstract

“Good policy” and “good luck” have been identified as two of the possible drivers of the “Great Moderation,” but their relative importance is still widely debated. This paper investigates the role played by equilibrium selection under indeterminacy in the assessment of their relative merits. We contrast the outcomes of counterfactual simulations conditional on the “continuity” selection strategy–largely exploited by the literature–with those obtained with a novel “sign restriction” based strategy. Our results suggest that conclusions achieved under “continuity” are not necessarily robust to the selection of different–still economically sensible–equilibria. According to our simulations, the switch to a hawkish systematic monetary policy may very well induce an increase in output volatility. Hence, our sign restriction–selection strategy “resurrects” the inflation–output policy tradeoff.

Keywords

Great ModerationIndeterminacyGood PolicyGood LuckEquilibrium Selection
Type
Articles
Information
Macroeconomic Dynamics , Volume 16 , Issue 3 , June 2012 , pp. 449 - 471
Copyright
Copyright © Cambridge University Press 2011

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