The files submitted are the codes and data for the Journal of Applied Econometrics article “Inflation Expectations and Nonlinearities in the Phillips Curve” by Alexander Doser, Ricardo Nunes, Nikhil Rao, and Viacheslav Sheremirov.

Please see "readme.dnrs.pdf" in the files submitted. Please note that the structure of folders must be preserved. Folders "figures" and "tables" are initially empty but will be populated when the codes are run.

The Volcker Shock was a period of historically high interest rates precipitated by Federal Reserve Chairperson Paul Volcker's decision to raise the central bank's key interest rate, the Fed funds effective rate, during the first three years of his term. Volcker was appointed chairperson of the Fed in August 1979 by President Jimmy Carter, as replacement for William Miller, who Carter had made his treasury secretary. Volcker was one of the most hawkish (supportive of tighter monetary policy to stem inflation) members of the Federal Reserve's committee, and quickly set about changing the course of monetary policy in the U.S. in order to quell inflation. The Volcker Shock is remembered for bringing an end to over a decade of high inflation in the United States, prompting a deep recession and high unemployment, and for spurring on debt defaults among developing countries in Latin America who had borrowed in U.S. dollars.

Monetary tightening and the recessions of the early '80s

Beginning in October 1979, Volcker's Fed tightened monetary policy by raising interest rates. This decision had the effect of depressing demand and slowing down the U.S. economy, as credit became more expensive for households and businesses. The Fed funds rate, the key overnight rate at which banks lend their excess reserves to each other, rose as high as 17.6 percent in early 1980. The rate was allowed to fall back below 10 percent following this first peak, however, due to worries that inflation was not falling fast enough, a second cycle of monetary tightening was embarked upon starting in August of 1980. The rate would reach its all-time peak in June of 1981, at 19.1 percent. The second recession sparked by these hikes was far deeper than the 1980 recession, with unemployment peaking at 10.8 percent in December 1980, the highest level since The Great Depression. This recession would drive inflation to a low point during Volcker's terms of 2.5 percent in August 1983.

The legacy of the Volcker Shock

By the end of Volcker's terms as Fed Chair, inflation was at a manageable rate of around four percent, while unemployment had fallen under six percent, as the economy grew and business confidence returned. While supporters of Volcker's actions point to these numbers as proof of the efficacy of his actions, critics have claimed that there were less harmful ways that inflation could have been brought under control. The recessions of the early 1980s are cited as accelerating deindustrialization in the U.S., as manufacturing jobs lost in 'rust belt' states such as Michigan, Ohio, and Pennsylvania never returned during the years of recovery. The Volcker Shock was also a driving factor behind the Latin American debt crises of the 1980s, as governments in the region defaulted on debts which they had incurred in U.S. dollars. Debates about the validity of using interest rate hikes to get inflation under control have recently re-emerged due to the inflationary pressures facing the U.S. following the Coronavirus pandemic and the Federal Reserve's subsequent decision to embark on a course of monetary tightening.

We propose a novel theory of intrinsic inflation persistence by introducing trend inflation and variable elasticity of demand in a model with staggered price and wage setting. Under nonzero trend inflation, the variable elasticity generates intrinsic persistence in inflation through a measure of price dispersion stemming from staggered price setting. It also introduces intrinsic persistence in wage inflation under staggered wage setting, which affects price inflation. With the theory we show that inflation exhibits a persistent, hump-shaped response to a monetary policy shock. We also show that a credible disinflation leads to a gradual decline in inflation and a fall in output, and lower trend inflation reduces inflation persistence, as observed around the time of the Volcker disinflation.

Empirical studies document a decline in inflation persistence in the 1980s, around the time of the Volcker disinflation. The most common explanation for this decline is a more aggressive response of monetary policy to inflation. We propose an alternative explanation: inflation persistence fell due to the lower trend inflation rate the Volcker disinflation produced. Our explanation suggests higher inflation persistence could be an important consideration in the debate about the costs and benefits of a higher inflation target.

Empirical studies have documented that the persistence of the gap between inflation and its trend declined after the Volcker disinflation. Previous research into the source of the decline has offered competing views while sidestepping the possibility of equilibrium indeterminacy. This paper examines the source by estimating a medium-scale DSGE model using a Bayesian method that allows for indeterminacy. The estimated model shows 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 dynamics of the economy.

In this paper, we develop solutions for linearized models with forward-looking expectations and structural changes under a variety of assumptions regarding agents' beliefs about those structural changes. For each solution, we show how its associated likelihood function can be constructed by using a backward-forward algorithm. We illustrate the techniques with two examples. The first considers an inflationary program in which beliefs about the inflation target evolve differently from the inflation target itself, and the second applies the techniques to estimate a new Keynesian model through the Volcker disinflation. We compare our methodology with the alternative in which structural change is captured by switching between regimes via a Markov switching process. We show that our method can produce accurate results much faster than the Markov switching method as well as being easily adapted to handle beliefs departing from reality.