Regime Switches, Agents' Beliefs, and Post-World War II U.S. Macroeconomic Dynamics

Abstract

The evolution of the U.S. economy over the past 55 years is examined through the lens of a micro-founded model that allows for changes in the behaviour of the Federal Reserve and in the volatility of structural shocks. Agents are aware of the possibility of regime changes and their beliefs matter for the law of motion underlying the macroeconomy. Monetary policy is identified by repeated fluctuations between a Hawk and a Dove regime, with the latter prevailing in the 1970s and during the recent crisis. To explore the role of agents' beliefs I introduce a new class of counterfactual simulations: beliefs counterfactuals. If, in the 1970s, agents had anticipated the appointment of an extremely conservative Chairman, inflation would have been lower and the inflation-output trade-off more favourable. The large drop in inflation and output at the end of 2008 would have been mitigated if agents had expected the Federal Reserve to be exceptionally active in the near future.