ABSTRACT
The reasoning suggests that low credibility on the part of the Federal Reserve may help to explain the severity of the recession induced by the Volcker disinflation. The true parameters are assumed to be unobservable due to the presence of exogenous stochastic shocks that enter the reaction function. The policy shocks, together with stochastic disturbances to other parts of the economy, give rise to a distribution of observed inflation rates around any given inflation target. The behavior of the long-term nominal interest rate in the model is governed by the pure expectations hypothesis, that is, the long-term rate is a weighted average of current and expected future short-term rates. Consequently, agents’ expectations of future inflation are revised upward, and the long-term nominal interest rate experiences a sudden increase.
