## 3. Impulse Reponse Functions Following an Aggregate Demand Shock

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---

### Introduction: context and research question
- Historical background:
  - Late 1960s–1970s: "Great Inflation" — inflation was high, volatile, and persistent; several recessions occurred.
  - Early 1980s onward: "Great Moderation" — lower level, variance, and persistence of inflation; lower output volatility.
- Core puzzle:
  - Why did macroeconomic performance and Federal Reserve (Fed) behavior change since the early 1980s?
  - Existing explanations that rely on Fed "mistakes" or exogenous large shocks face difficulties explaining why Fed behavior itself changed.
- Central hypothesis:
  - A dramatic change in financial markets around 1980 increased widespread participation in asset markets.
  - Limited asset-market participation (market segmentation) can change the sign of the IS-curve slope and rationalize pre-1980 Fed behavior as equilibrium-determinant and welfare-maximizing.
- Empirical strategy:
  - Present institutional evidence on change in U.S. asset market participation in the early 1980s.
  - Estimate a DSGE model with limited-asset market participation using Bayesian methods on two subsamples (pre-Volcker and Volcker–Greenspan).
  - Run counterfactuals to separate the roles of structural change versus changes in shock processes.

### Theoretical framework: limited asset market participation
- Model setup:
  - Augmented "new-synthesis" sticky-price DSGE model with segmented asset markets.
  - Two household types:
    - Asset holders (S): trade state-contingent assets and shares in firms.
    - Non-asset holders (H): do not participate in asset markets; consume wage income only.
  - Shares of agents: asset holders = 1 − ϕ; non-asset holders = ϕ; ϕ is exogenous.
  - Labor supply of non-asset holders is inelastic: n_H,t = 0; their consumption equals the real wage: c_H,t = w_t.
  - Asset-holders' labor supply condition: n_S,t governed by inverse Frisch elasticity ' such that n_S,t = w_t − c_S,t (notation preserved from source).
  - Production function (log-linear): y_t = (1 + μ) n_t, where μ represents steady-state net mark-up and degree of aggregate increasing returns to scale.
- Aggregate consumption and planned expenditure:
  - c_t = ϕ c_H,t + (1 − ϕ) c_S,t = ϕ w_t + (1 − ϕ) c_S,t = ϕ/(1 − ϕ) ' n_t + c_S,t.
  - Planned expenditure / aggregate demand relationship (equation (1), notation preserved):
    - c_t = c̄ y_t + ; rr_t − ρ̄ = ϕ/(1 − ϕ) '/(1 + μ) y_t + c_S,t
  - Marginal propensity to consume out of current income:
    - @c/@y = ϕ/(1 − ϕ) '/(1 + μ) > 0 (partial marginal propensity keeping c_S fixed).
    - This marginal propensity can exceed one when enough agents are non-asset holders and/or labor supply is sufficiently inelastic.
- Threshold for "non-Keynesian" regime (equation (2)):
  - ϕ > ϕ_c = 1/(1 + '/(1 + μ)).
  - If ϕ > ϕ_c then @c/@y > 1 and the economy is "non-Keynesian".
- Consumption of asset holders implication (equation (3)):
  - c_S,t = ε y_t, where ε ≡ 1 − ϕ/(1 − ϕ) '/(1 + μ).
  - ε becomes negative when @c/@y > 1 (i.e., when condition (2) holds): consumption of asset holders can be negatively related to total output because of a negative income effect via falling dividend income when labor supply is inelastic.
  - Mechanism: with many non-asset holders and inelastic labor supply, higher demand increases real wages and marginal cost, possibly reducing profits and dividend income per asset-holder (since each asset-holder holds (1 − ϕ)^(−1) shares).
- Aggregate IS curve (equation (4)):
  - y_t = E_t y_{t+1} − ε^{−1} [r_t − E_t π_{t+1}]
  - Interpretations:
    - Limited asset market participation modifies the elasticity of aggregate demand to real interest rates via ε^{−1} in a nonlinear way.
    - For ϕ < ϕ_c ("Keynesian" region) the standard negative relationship between real rates and demand holds (ε^{−1} > 0).
    - For ϕ > ϕ_c ("non-Keynesian" region) increases in real interest rates can be expansionary (ε^{−1} < 0).
    - As ϕ → 1, ε^{−1} → 0: monetary policy becomes ineffective when nobody holds assets.

### Price dynamics, shocks, and monetary policy rules
- New Phillips curve with cost-push shocks (equation (5)):
  - π_t = β E_t π_{t+1} + κ (y_t + u_t), where κ ≡ ξ̄ and u_t represents "cost-push" shocks (time-varying markups or other wedges).
- Simple interest rate rule considered (equation (6)):
  - r_t = ψ_π E_t π_{t+1}
  - Focus on response to expected inflation; abstract from interest-rate smoothing and response to output for analytic clarity.
- Determinacy and the "Inverted Taylor Principle":
  - Standard full-participation result: when ε^{−1} > 0, the Taylor principle requires ψ_π > 1 to ensure equilibrium determinacy.
  - With limited participation and the possibility that ε^{−1} < 0, the stabilization properties of monetary policy are inverted:
    - When the IS slope changes sign, optimal policy can switch endogenously from passive to active (or vice versa).
    - The necessary condition for determinacy and welfare-maximizing policy becomes an "Inverted Taylor Principle" when enough agents do not participate in asset markets.

### Main theoretical implications emphasized
- Market segmentation (limited asset-market participation) can flip the sign of the IS curve slope; this flip:
  - Makes aggregate demand positively related to real interest rates in the "non-Keynesian" region.
  - Rationalizes why pre-1980 Fed policy that appears "passive" under standard theory might have been consistent with equilibrium determinacy and welfare maximization under limited participation.
- As participation rises (e.g., post-1980 financial liberalization and innovation), the model predicts:
  - A change in the sign of the IS response back toward the standard negative slope.
  - A corresponding endogenous switch in optimal monetary policy conduct from the pre-1980 rule to a more "active" post-1980 rule.
- Model tractability and empirical application:
  - The stripped-down framework abstracts from capital accumulation to obtain analytical results and transparent mechanisms.
  - A more general model (described in the Appendix of the source) is used for Bayesian estimation and counterfactual experiments.

### Institutional evidence for change in U.S. asset-market participation (1965–early 1980s)
- Two major 1970s restrictions constrained small saver access to market rates:
  - Regulation Q (limits on interest paid by commercial banks; no interest on checking accounts) became binding around 1965.
  - Quantitative and denomination restrictions (e.g., T-bills minimum denomination raised to $10,000 in 1970) discouraged small-saver holdings.
- Deregulation and financial innovation beginning around 1980:
  - DIDMCA (Depository Institutions Deregulation and Monetary Control Act, 1980) and Garn-St Germain Act (1982) phased out Regulation Q, approved new instruments, eliminated some usury ceilings, and expanded deposit facility access.
  - Financial innovation produced many new instruments widely used post-1980.
- Magnitudes cited:
  - Total assets of Money Market mutual funds: 4 billion in 1978 → 230 billion in 1982.
  - NOW accounts: 27 billion in 1980 → 101 billion in 1982.
- Survey evidence cited:
  - 1970 → 1983: percentage of families holding certificates of deposit 8 → 20; money market accounts 0 → 14 (Survey of Consumer Finances, 1983).
  - Percentage of families with net worth less than $10,000: 56 percent → 38 percent (Second report, Wolff and Caner, 2002).
  - NYSE: proportion of U.S. families holding shares almost doubled over 1975–1985 (NYSE, 1986).
- Summary: evidence points to a substantial structural change in asset-market participation in early 1980s tied to legislation and financial innovation.

### Empirical strategy: Bayesian structural estimation
- Data and samples:
  - Quarterly U.S. data on real GDP (GDPC1, HP-filtered), annualized quarterly CPI inflation (CPI-U), and average overnight federal funds rate (FYFF), expressed in percent per year.
  - Pre-Volcker sample: 1965:IV – 1979:III.
  - Volcker-Greenspan sample: 1983:I – 2002:I.
  - Excluded the Volcker disinflation period.
- Model extensions for estimation:
  - Habit persistence in consumption (parameter ), price indexation (parameter !), Taylor rule with interest-rate smoothing (parameter _r), AR(1) demand shock g_t and supply shock z_t.
- Key structural reduced-form IS with habit and limited participation (equation (11)):
  - y_t = - [1/(1 + )]  (first-order expression) - ... + (r_t - E_t _{t+1}) + g_t
  - Habit persistence influences the threshold  beyond which IS slope changes sign.
- Phillips curve with indexation (equation (12)):
  - _t = (/(1 + !)) E_t _{t+1} + (!/(1 + !)) _{t-1} + [ (1 - ) (1 - )/ (1 - ) ] y_t - [ ... ] y_{t-1} + z_t
- Monetary policy rule:
  - r_t = _r r_{t-1} + (1 - _r) (_ E_t _{t+1} + _x y_t ) + "r_t

### Priors and fixed calibrations
- Fixed/calibrated:
  - Discount factor  = (1 + r^/100)^{-1/4}
  - Steady-state markup  = 0.2
  - Degree of nominal rigidity  = 0.75
- Priors summary (highlights from Table 1):
  - : Beta; Pre-Volcker mean 0.35 std 0.10; Volcker-Greenspan mean 0.30 std 0.10
  - ' : Gamma mean 3.00 std 0.50 (both samples)
  - , !: Beta mean 0.50 std 0.20 (both)
  - _: Gamma mean 0.50 std 0.50 (pre-Volcker); Gamma mean 2.00 std 0.50 (Volcker-Greenspan)
  - _y: Gamma mean 0.25 std 0.15
  - _r: Beta mean 0.25 std 0.25
  - Shock persistence priors: _g and _z Beta mean 0.70 std 0.10
  - Innovation std priors: _"g Inverse Gamma mean 0.38 std 0.20; _"z Inverse Gamma mean 1.00 std 0.52; _"r Inverse Gamma mean 0.31 std 0.16
  - Correlation _{gz} prior truncated normal mean 0.0 std 0.10
- Estimation via Kalman filter and Metropolis-Hastings to obtain posterior distributions.

### Bayesian estimation results (posterior means and 90% intervals)
- Share of non-asset holders :
  - Pre-Volcker mean 0.44 [0:38–0:51]
  - Volcker-Greenspan mean 0.24 [0:17–0:31]
  - 90 percent intervals do not overlap.
- Inverse labor supply elasticity ':
  - Pre-Volcker 2.98 [2:27–3:63]
  - Volcker-Greenspan 2.62 [1:90–3:36]
- Habit persistence :
  - Pre-Volcker 0.43 [0:24–0:64]
  - Volcker-Greenspan 0.36 [0:27–0:45]
- Price indexation !:
  - Pre-Volcker 0.54 [0:34–0:74]
  - Volcker-Greenspan 0.07 [0:01–0:13]
- IS-slope (calculated from estimated structural parameters):
  - Pre-Volcker: 1.25
  - Volcker-Greenspan: -0.65
- Inflation response coefficient _:
  - Pre-Volcker 0.52 [0:42–0:62]
  - Volcker-Greenspan 2.39 [2:09–2:70]
- Interest-rate smoothing _r:
  - Pre-Volcker 0.01 [0:00–0:02]
  - Volcker-Greenspan 0.66 [0:57–0:75]
- Steady-state inflation ^ and real rate r^:
  - Pre-Volcker ^ = 4.54 [3:11–6:02]; r^ = 1.21 [0:43–2:03]
  - Volcker-Greenspan ^ = 3.26 [2:48–4:10]; r^ = 2.73 [1:98–3:47]
- Shock persistence:
  - _g: Pre-Volcker 0.71 [0:60–0:83]; Volcker-Greenspan 0.91 [0:87–0:96]
  - _z: Pre-Volcker 0.76 [0:67–0:87]; Volcker-Greenspan 0.68 [0:55–0:80]
- Innovation standard deviations (reduced-form):
  - _"g: Pre-Volcker 0.29 [0:18–0:40]; Volcker-Greenspan 0.16 [0:11–0:22]
  - _"z: Pre-Volcker 0.72 [0:57–0:87]; Volcker-Greenspan 0.83 [0:67–0:98]
  - _"r: Pre-Volcker 0.34 [0:28–0:40]; Volcker-Greenspan 0.15 [0:12–0:18]
- Correlation _{gz}:
  - Pre-Volcker 0.05 [(−0:11)–0:21]
  - Volcker-Greenspan 0.31 [0:15–0:45]

### Key empirical findings and interpretations
- Strong evidence that share of non-asset holders  fell from 0.44 (pre-Volcker) to 0.24 (Volcker-Greenspan); 90% posterior intervals do not overlap.
- IS curve sign reversal: IS-slope estimated positive (1.25) in pre-Volcker and negative (−0.65) thereafter, consistent with theory linking  to IS slope sign.
- Monetary policy rule:
  - Pre-Volcker: inflation response _ < 1 and near-zero interest-rate smoothing (_r ≈ 0.01) — implied passive rule.
  - Volcker-Greenspan: _ > 1 and substantial interest-rate smoothing (_r ≈ 0.66) — implied active rule.
- Price indexation and inflation persistence higher in pre-Volcker period (! = 0.54 vs 0.07).
- Stochastic environment changed:
  - Demand shock persistence higher in Volcker-Greenspan (_g 0.91 vs 0.71).
  - Supply shock persistence lower in Volcker-Greenspan (_z 0.68 vs 0.76).
  - Standard deviations of demand and monetary shocks fell in Volcker-Greenspan; cost-push shock standard deviation roughly stable (computed e_z: 0.72 pre-Volcker; 0.78 Volcker-Greenspan).

### Stochastic simulations and counterfactuals
- Data moments confirm higher mean and persistence of inflation and higher volatility of inflation and output in pre-Volcker era.
- Simulated model using posterior means reproduces key stylized facts:
  - Pre-Volcker model: higher average inflation (model 4.46) vs Volcker-Greenspan model (3.17).
  - Simulated standard deviations:
    - Inflation std: Pre-Volcker model 4.66; Volcker-Greenspan model 1.54.
    - Output std: Pre-Volcker model 1.25; Volcker-Greenspan model 0.97.
- Counterfactual scenarios:
  - "Structure scenario" (pre-Volcker shocks but Volcker-Greenspan structure) produces outcomes closer to actual Volcker-Greenspan data for mean and persistence of inflation and for volatility of inflation and interest rates.
  - "Shocks scenario" (Volcker-Greenspan shocks but pre-Volcker structure) better explains the fall in output volatility ("Great Moderation") and increase in interest-rate persistence.
- Impulse responses (cost-push and aggregate demand shocks):
  - Cost-push shock: Pre-Volcker responses show higher and more persistent inflation, deeper recessions, persistently negative real rates (policy passive).
  - Counterfactual where pre-Volcker structure is given Volcker-Greenspan policy and  produces dynamics similar to Volcker-Greenspan — joint changes in asset-market participation and monetary rule explain bulk of change in shock transmission.
  - Aggregate demand shock responses show analogous patterns.

### Conclusions and policy implications
- Evidence supports hypothesis that U.S. asset-market participation increased substantially in early 1980s ( fell from 0.44 → 0.24), driven by deregulation and financial innovation.
- The change in participation induced a sign change in the IS-curve slope, moving economy from a regime where passive monetary rules were required for determinacy and optimality to one where active rules became optimal.
- Pre-Volcker monetary policy, when evaluated in the structural context with limited participation, was consistent with welfare maximization and equilibrium determinacy.
- Both structural changes (asset-market participation, policy rule) and changes in shock distributions matter for the Great Inflation and Great Moderation:
  - Structural change explains many features (inflation mean, persistence, volatility; interest-rate moves).
  - Changes in shock distributions are crucial for explaining the fall in output volatility.
- Overall interpretation: change in macro dynamics across samples chiefly reflects changes in economic structure combined with changes in shocks, rather than solely "better policy" that simply eliminated sunspot-driven indeterminacy.

*Source: _wp06200 — extracted content from the provided PDF chapter/section.*

### References..............................................................................................................

### References..........................................................................................................................30

### Tables
- 1. Prior Distribution for DSGE Model Parameters .......................................................18
- 2. Bayesian Estimation Results.....................................................................................20
- 3.      Stochastic      Simulations ..............................................................................................23
- 4. General Model Summary. .........................................................................................27

### Figures
- 1. Keynesian and Non-Keynesian Crosses .....................................................................8
- 2. Impulse Reponse Functions Following a Cost-Push Shock .....................................28

*Source: _wp06200 - References..............................................................................................................*

### 3. Impulse Reponse Functions Following an Aggregate Demand Shock.....................29

### 3. Impulse Reponse Functions Following an Aggregate Demand Shock

### Introduction: context and research question
- Historical background:
  - Late 1960s–1970s: "Great Inflation" — inflation was high, volatile, and persistent; several recessions occurred.
  - Early 1980s onward: "Great Moderation" — lower level, variance, and persistence of inflation; lower output volatility.
- Core puzzle:
  - Why did macroeconomic performance and Federal Reserve (Fed) behavior change since the early 1980s?
  - Existing explanations that rely on Fed "mistakes" or exogenous large shocks face difficulties explaining why Fed behavior itself changed.
- Central hypothesis of the paper:
  - A dramatic change in financial markets around 1980 increased widespread participation in asset markets.
  - Limited asset-market participation (market segmentation) can change the sign of the IS-curve slope and rationalize pre-1980 Fed behavior as equilibrium-determinant and welfare-maximizing.
- Empirical strategy:
  - Present institutional evidence on change in U.S. asset market participation in the early 1980s.
  - Estimate a DSGE model with limited-asset market participation using Bayesian methods on two subsamples (pre-Volcker and Volcker–Greenspan).
  - Run counterfactuals to separate the roles of structural change versus changes in shock processes.

### Theoretical framework: limited asset market participation
- Model setup:
  - Augmented "new-synthesis" sticky-price DSGE model with segmented asset markets.
  - Two household types:
    - Asset holders (S): trade state-contingent assets and shares in firms.
    - Non-asset holders (H): do not participate in asset markets; consume wage income only.
  - Shares of agents: asset holders = 1 − ϕ; non-asset holders = ϕ; ϕ is exogenous.
  - Labor supply of non-asset holders is inelastic: n_H,t = 0; their consumption equals the real wage: c_H,t = w_t.
  - Asset-holders' labor supply condition: ' n_S,t = w_t − c_S,t, where ' is inverse Frisch elasticity.
  - Production function (log-linear): y_t = (1 + μ) n_t, where μ represents steady-state net mark-up and degree of aggregate increasing returns to scale.
- Aggregate consumption (log deviations):
  - c_t = ϕ c_H,t + (1 − ϕ) c_S,t = ϕ w_t + (1 − ϕ) c_S,t = ϕ/(1 − ϕ) ' n_t + c_S,t.
  - Planned expenditure / aggregate demand relationship (equation (1)):
    - c_t = c̄ y_t + ; rr_t − ρ̄ = ϕ/(1 − ϕ) '/(1 + μ) y_t + c_S,t
    - Interpretations: aggregate demand depends positively on current income and negatively on the real interest rate via the asset-holders Euler equation.
- Marginal propensity to consume out of current income:
  - @c/@y = ϕ/(1 − ϕ) '/(1 + μ) > 0 (partial marginal propensity keeping c_S fixed).
  - This marginal propensity can exceed one when enough agents are non-asset holders and/or labor supply is sufficiently inelastic.
- Threshold for "non-Keynesian" regime (equation (2)):
  - ϕ > ϕ_c = 1/(1 + '/(1 + μ)).
  - If ϕ > ϕ_c then @c/@y > 1 and the economy is "non-Keynesian".
- Implication for consumption of asset holders (equation (3)):
  - c_S,t = ε y_t, where ε ≡ 1 − ϕ/(1 − ϕ) '/(1 + μ).
  - ε becomes negative when @c/@y > 1 (i.e., when condition (2) holds): consumption of asset holders can be negatively related to total output because of a negative income effect via falling dividend income when labor supply is inelastic.
  - The mechanism: with many non-asset holders and inelastic labor supply, higher demand increases real wages and marginal cost, possibly reducing profits and dividend income per asset-holder (since each asset-holder holds (1 − ϕ)^(−1) shares).
- Aggregate IS curve (equation (4)):
  - y_t = E_t y_{t+1} − ε^{−1} [r_t − E_t π_{t+1}]
  - Interpretation:
    - Limited asset market participation modifies the elasticity of aggregate demand to real interest rates via ε^{−1} in a nonlinear way.
    - For ϕ < ϕ_c ("Keynesian" region) the standard negative relationship between real rates and demand holds (ε^{−1} > 0).
    - For ϕ > ϕ_c ("non-Keynesian" region) increases in real interest rates can be expansionary (ε^{−1} < 0).
    - As ϕ → 1, ε^{−1} → 0: monetary policy becomes ineffective when nobody holds assets.

### Price dynamics, shocks, and monetary policy rules
- New Phillips curve with cost-push shocks (equation (5)):
  - π_t = β E_t π_{t+1} + κ (y_t + u_t), where κ ≡ ξ̄ and u_t represents "cost-push" shocks (time-varying markups or other wedges).
- Simple interest rate rule considered (equation (6)):
  - r_t = ψ_π E_t π_{t+1}
  - Focus on response to expected inflation; abstract from interest-rate smoothing and response to output for analytic clarity.
- Determinacy and the "Inverted Taylor Principle":
  - Standard full-participation result: when ε^{−1} > 0, the Taylor principle requires ψ_π > 1 (nominal rates increase more than one-for-one with inflation) to ensure equilibrium determinacy.
  - With limited participation and the possibility that ε^{−1} < 0, the stabilization properties of monetary policy are inverted:
    - When the IS slope changes sign, optimal policy can switch endogenously from passive to active (or vice versa).
    - The necessary condition for determinacy and welfare-maximizing policy becomes an "Inverted Taylor Principle" when enough agents do not participate in asset markets.

### Main theoretical implications emphasized
- Market segmentation (limited asset-market participation) can flip the sign of the IS curve slope; this flip:
  - Makes aggregate demand positively related to real interest rates in the "non-Keynesian" region.
  - Rationalizes why pre-1980 Fed policy that appears "passive" under standard theory might have been consistent with equilibrium determinacy and welfare maximization under limited participation.
- As participation rises (e.g., post-1980 financial liberalization and innovation), the model predicts:
  - A change in the sign of the IS response back toward the standard negative slope.
  - A corresponding endogenous switch in optimal monetary policy conduct from the pre-1980 rule to a more "active" post-1980 rule.
- Model tractability and empirical application:
  - The stripped-down framework abstracts from capital accumulation to obtain analytical results and transparent mechanisms.
  - A more general model (described in the Appendix of the source) is used for Bayesian estimation and counterfactual experiments.

*Source: _wp06200 - 3. Impulse Reponse Functions Following an Aggregate Demand Shock — extracted content from the provided PDF chapter/section.*

### Chapter 6) for details.

### _wp06200 - Chapter 6) for details.

### Theoretical framework: limited asset-market participation and IS/AS dynamics
- Model incorporates two types of agents (asset holders and non-asset holders) with limited asset-market participation parameter .
- New Keynesian Phillips curve and IS curve modified by ; when  rises, relative weight on output stabilization increases ( = 1 + ' 1).
- Non-Keynesian regime: if  < 0 the IS curve can have "wrong" sign; an "Inverted Taylor principle" holds and monetary policy must be passive to ensure determinacy ( < 1).
- Mechanisms described:
  - A non-fundamental increase in expected inflation can raise the output gap today if policy rule is active ( > 1).
  - Passive policy response leads to falling real rate, partial increases in consumption of asset holders, complex labor-market interactions, and ultimately prevents inflationary self-fulfillment when asset market participation is limited "enough" as made explicit by equation (2).
- Welfare objective (quadratic approximation around efficient flexible-price equilibrium):
  - Ut = -1/2 E_t Σ_{i=t}^∞ [  y_{t+i}^2 + _{t+i}^2 ] where  = 1 + ' 1 - /(1 + ').
  - Weight on output stabilization increases in the share of non-asset holders; as  → 1, weight on output stabilization → infinity.
- Discretionary optimal policy under IS-AS constraints yields:
  - y_t = - (/) _t  (equation (9))
  - Under AR(1) cost-push shocks E_t u_{t+1} = _u u_t, reduced-form:
    - _t =   u_t; y_t = -   u_t where  = [^2 + (1 -  _u)]^{-1}
  - Implicit optimal instrument rule:
    - r^o_t = ^o_ E_t _{t+1} with ^o_ =  [1 +   / ( (1 - _u) _u  )]
  - Optimal response to inflation decreases with : @^o_ / @ < 0.
- Three policy implications:
  1. Limited asset-market participation → optimal policy yields greater inflation volatility and lower output gap volatility than full participation ( > 0), i.e., more output stabilization at cost of accommodating inflationary pressures.
  2. In non-Keynesian economy ( < 0), optimal instrument rule is passive (^o_ < 1).
  3. Optimal response to inflation switches from passive to active when  changes sign (e.g., increase in asset-market participation).

### Institutional evidence for change in U.S. asset-market participation (1965–early 1980s)
- Two major 1970s restrictions constrained small saver access to market rates:
  - Regulation Q (limits on interest paid by commercial banks; no interest on checking accounts) became binding around 1965.
  - Quantitative and denomination restrictions (e.g., T-bills minimum denomination raised to $10,000 in 1970) discouraged small-saver holdings.
- Deregulation and financial innovation beginning around 1980:
  - DIDMCA (Depository Institutions Deregulation and Monetary Control Act, 1980) and Garn-St Germain Act (1982) phased out Regulation Q, approved new instruments, eliminated some usury ceilings, and expanded deposit facility access.
  - Financial innovation produced many new instruments widely used post-1980 (examples cited from Wenninger (1984) and Silber (1983)).
- Magnitudes cited:
  - Total assets of Money Market mutual funds: 4 billion in 1978 → 230 billion in 1982.
  - NOW accounts: 27 billion in 1980 → 101 billion in 1982.
- Survey evidence cited:
  - 1970 → 1983: percentage of families holding certificates of deposit 8 → 20; money market accounts 0 → 14 (Survey of Consumer Finances, 1983).
  - Percentage of families with net worth less than $10,000: 56 percent → 38 percent (Second report, Wolff and Caner, 2002).
  - NYSE: proportion of U.S. families holding shares almost doubled over 1975–1985 (NYSE, 1986).
- Summary evidence points to a substantial structural change in asset-market participation in early 1980s tied to legislation and financial innovation.

### Empirical strategy: Bayesian structural estimation
- Data and samples:
  - Quarterly U.S. data on real GDP (GDPC1, HP-filtered), annualized quarterly CPI inflation (CPI-U), and average overnight federal funds rate (FYFF), expressed in percent per year.
  - Pre-Volcker sample: 1965:IV – 1979:III.
  - Volcker-Greenspan sample: 1983:I – 2002:I.
  - Excluded the Volcker disinflation period.
- Model extensions for estimation:
  - Habit persistence in consumption (parameter ), price indexation (parameter !), Taylor rule with interest-rate smoothing (parameter _r), AR(1) demand shock g_t and supply shock z_t.
- Key structural reduced-form IS with habit and limited participation (equation (11)):
  - y_t = - [1/(1 + )]  (first-order expression) - ... + (r_t - E_t _{t+1}) + g_t
  - Definitions of coefficients involve , ' ,  and ; habit persistence 
 influences the threshold  beyond which IS slope changes sign.
- Phillips curve with indexation (equation (12)):
  - _t = (/(1 + !)) E_t _{t+1} + (!/(1 + !)) _{t-1} + [ (1 - ) (1 - )/ (1 - ) ] y_t - [ ... ] y_{t-1} + z_t
- Monetary policy rule:
  - r_t = _r r_{t-1} + (1 - _r) (_ E_t _{t+1} + _x y_t ) + "r_t

### Priors and fixed calibrations
- Fixed/calibrated:
  - Discount factor  = (1 + r^/100)^{-1/4}
  - Steady-state markup  = 0.2
  - Degree of nominal rigidity  = 0.75
- Priors summary (Table 1 highlights):
  - : Beta; Pre-Volcker mean 0.35 std 0.10; Volcker-Greenspan mean 0.30 std 0.10
  - ' : Gamma mean 3.00 std 0.50 (both samples)
  - , !: Beta mean 0.50 std 0.20 (both)
  - _: Gamma mean 0.50 std 0.50 (pre-Volcker); Gamma mean 2.00 std 0.50 (Volcker-Greenspan)
  - _y: Gamma mean 0.25 std 0.15
  - _r: Beta mean 0.25 std 0.25
  - Shock persistence priors: _g and _z Beta mean 0.70 std 0.10
  - Innovation std priors: _"g Inverse Gamma mean 0.38 std 0.20; _"z Inverse Gamma mean 1.00 std 0.52; _"r Inverse Gamma mean 0.31 std 0.16
  - Correlation _{gz} prior truncated normal mean 0.0 std 0.10
- Estimation via Kalman filter and Metropolis-Hastings to obtain posterior distributions.

### Bayesian estimation results (Table 2: posterior means and 90% intervals)
- Share of non-asset holders :
  - Pre-Volcker mean 0.44 [0:38–0:51]
  - Volcker-Greenspan mean 0.24 [0:17–0:31]
  - 90 percent intervals do not overlap.
- Inverse labor supply elasticity ':
  - Pre-Volcker 2.98 [2:27–3:63]
  - Volcker-Greenspan 2.62 [1:90–3:36]
- Habit persistence :
  - Pre-Volcker 0.43 [0:24–0:64]
  - Volcker-Greenspan 0.36 [0:27–0:45]
- Price indexation !:
  - Pre-Volcker 0.54 [0:34–0:74]
  - Volcker-Greenspan 0.07 [0:01–0:13]
- IS-slope (calculated from estimated structural parameters):
  - Pre-Volcker: 1.25
  - Volcker-Greenspan: -0.65
- Inflation response coefficient _:
  - Pre-Volcker 0.52 [0:42–0:62] (below 1)
  - Volcker-Greenspan 2.39 [2:09–2:70] (above 1)
- Interest-rate smoothing _r:
  - Pre-Volcker 0.01 [0:00–0:02]
  - Volcker-Greenspan 0.66 [0:57–0:75]
- Steady-state inflation ^ and real rate r^:
  - Pre-Volcker ^ = 4.54 [3:11–6:02]; r^ = 1.21 [0:43–2:03]
  - Volcker-Greenspan ^ = 3.26 [2:48–4:10]; r^ = 2.73 [1:98–3:47]
- Shock persistence:
  - _g: Pre-Volcker 0.71 [0:60–0:83]; Volcker-Greenspan 0.91 [0:87–0:96]
  - _z: Pre-Volcker 0.76 [0:67–0:87]; Volcker-Greenspan 0.68 [0:55–0:80]
- Innovation standard deviations (reduced-form):
  - _"g: Pre-Volcker 0.29 [0:18–0:40]; Volcker-Greenspan 0.16 [0:11–0:22]
  - _"z: Pre-Volcker 0.72 [0:57–0:87]; Volcker-Greenspan 0.83 [0:67–0:98]
  - _"r: Pre-Volcker 0.34 [0:28–0:40]; Volcker-Greenspan 0.15 [0:12–0:18]
- Correlation _{gz}:
  - Pre-Volcker 0.05 [(−0:11)–0:21]
  - Volcker-Greenspan 0.31 [0:15–0:45]

### Key empirical findings and interpretations
- Strong evidence that share of non-asset holders  fell from 0.44 (pre-Volcker) to 0.24 (Volcker-Greenspan); 90% posterior intervals do not overlap.
- IS curve sign reversal: IS-slope estimated positive (1.25) in pre-Volcker and negative (−0.65) thereafter, consistent with theory linking  to IS slope sign.
- Monetary policy rule:
  - Pre-Volcker: inflation response _ < 1 and near-zero interest-rate smoothing (_r ≈ 0.01) — implied passive rule.
  - Volcker-Greenspan: _ > 1 and substantial interest-rate smoothing (_r ≈ 0.66) — implied active rule.
- Price indexation and inflation persistence higher in pre-Volcker period ( ! = 0.54 vs 0.07).
- Stochastic environment changed:
  - Demand shock persistence higher in Volcker-Greenspan (_g 0.91 vs 0.71).
  - Supply shock persistence lower in Volcker-Greenspan (_z 0.68 vs 0.76).
  - Standard deviations of demand and monetary shocks fell in Volcker-Greenspan; cost-push shock standard deviation roughly stable (computed e_z: 0.72 pre-Volcker; 0.78 Volcker-Greenspan).

### Stochastic simulations and counterfactuals (Table 3 and impulse responses)
- Data moments (columns 1 and 3) confirm higher mean and persistence of inflation and higher volatility of inflation and output in pre-Volcker era.
- Simulated model using posterior means reproduces key stylized facts:
  - Pre-Volcker model: higher average inflation (model 4.46) vs Volcker-Greenspan model (3.17).
  - Simulated standard deviations:
    - Inflation std: Pre-Volcker model 4.66; Volcker-Greenspan model 1.54.
    - Output std: Pre-Volcker model 1.25; Volcker-Greenspan model 0.97.
- Counterfactual scenarios:
  - "Structure scenario" (pre-Volcker shocks but Volcker-Greenspan structure) produces outcomes closer to actual Volcker-Greenspan data for mean and persistence of inflation and for volatility of inflation and interest rates.
  - "Shocks scenario" (Volcker-Greenspan shocks but pre-Volcker structure) better explains the fall in output volatility ("Great Moderation") and increase in interest-rate persistence.
- Impulse responses (Figures 2 and 3):
  - Cost-push shock: Pre-Volcker responses show higher and more persistent inflation, deeper recessions, persistently negative real rates (policy passive).
  - Counterfactual where pre-Volcker structure is given Volcker-Greenspan policy and  produces dynamics similar to Volcker-Greenspan — joint changes in asset-market participation and monetary rule explain bulk of change in shock transmission.
  - Aggregate demand shock responses show analogous patterns.

### Conclusions and policy implications
- Evidence supports hypothesis that U.S. asset-market participation increased substantially in early 1980s ( fell from 0.44 → 0.24), driven by deregulation and financial innovation.
- The change in participation induced a sign change in the IS-curve slope, moving economy from a regime where passive monetary rules were required for determinacy and optimality to one where active rules became optimal.
- Pre-Volcker monetary policy, when evaluated in the structural context with limited participation, was consistent with welfare maximization and equilibrium determinacy — i.e., "better than is usually thought."
- Both structural changes (asset-market participation, policy rule) and changes in shock distributions matter for the Great Inflation and Great Moderation:
  - Structural change explains many features (inflation mean, persistence, volatility; interest-rate moves).
  - Changes in shock distributions are crucial for explaining the fall in output volatility.
- Overall interpretation: change in macro dynamics across samples chiefly reflects changes in economic structure combined with changes in shocks, rather than solely "better policy" that simply eliminated sunspot-driven indeterminacy.

*Source: _wp06200 - Chapter 6) for details.*

### References

### References

### Journal Articles
- Alvarez F., R. Lucas Jr., and  W. Weber, 2001, "Interest Rates and Inflation," American Economic Review, Vol. 91, No. 2, pp. 219–25.
- Blinder, A. S., 1982, "The Anatomy of Double Digit Inflation in the 1970’s," in Inflation: Causes and Effects, ed. by Robert E. Hall, 261–82 (Chicago: University of Chicago Press).
- Calvo, G., 1983, "Staggered Prices in a Utility-Maximizing Framework," Journal of Monetary Economics, Vol. 12, pp. 383–98.
- Campbell, J. Y. and G. Mankiw, 1989, "Consumption, Income, and Interest Rates: Reinterpreting the Time Series Evidence," in NBER Macro Annual pp. 185–216 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Chari, V., L. Christiano, and M. Eichenbaum, 1999, "Expectation Traps and Discretion," Journal of Economic Theory, Vol. 81, No. 2, pp. 462–92.
- Clarida, R., J. Galí, and M. Gertler, 1999, "The Science of Monetary Policy: a New Keynesian Perspective," Journal of Economic Literature, Vol. 37, pp. 1661–707.
- Clarida, R., 2000, "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," Quarterly Journal of Economics, Vol. 115, pp. 147–80.
- Cogley, T., and  T. Sargent, 2002, "Drifts and Volatilities: Monetary Policies and Outcomes in the Post WWII U.S.," Review of Economic Dynamic, Vol. 8, No. 2, pp. 262–302.
- Galí, J., D. Lopez–Salido., and J. Valles, 2003a, "Technology Shocks and Monetary Policy: Assessing the Fed's Performance," Journal of Monetary Economics, Vol. 50, pp. 723–43.
- Galí, J., D. Lopez–Salido., and J. Valles, 2003b, "Rule–of–Thumb Consumers and the Design of Interest Rate Rules," Journal of Money, Credit and Banking, forthcoming.
- Hetzel, R., 1999, "Arthur Burns and Inflation," Economic Quarterly, Vol. 1999, No.II, Federal Reserve Bank of Richmond, Richmond.
- Ireland, P., 2004, "Technology Shocks in the New Keynesian model," forthcoming in the Review of Economics and Statistics.
- Lubik, T., and F. Schorfheide , 2003, "Computing Sunspot Equilibria in Linear Rational Expectations Models" Journal of Economic Dynamics and Control, Vol. 28(2), pp. 273–85.
- Lubik, T., and F. Schorfheide , 2004, "Testing for Indeterminacy: An Application to U.S. Monetary Policy" American Economic Review, Vol.. 94(1), 190–217.
- Mankiw, G., 2000, "The Savers–Spenders Theory of Fiscal Policy," American Economic Review, Vol. 90 (2), pp. 120–125.
- Meulendyke, A., 1989, "U.S. Monetary Policy and Financial Markets", Federal Reserve Bank of New York, New York.
- Mishkin, F. S., 1991, "Financial Innovation and Current Trends in U.S. Financial Markets," NBER Working Paper Series, No. 3323 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Orphanides, A., 2002, "Monetary Policy Rules and the Great Inflation," American Economic Review, Papers and Proceedings, Vol. 92, No. 2, pp.115–120.
- Sargent, T., 1999, "The Conquest of American Inflation,"Princeton, (New Jersey: Princeton University Press).
- Sargent, T., 2002, "Reactions to the 'Berkeley Story'," mimeo, Hoover Institution, Stanford.
- Sargent, T., N. Williams, and T. Zha, 2006, “Shocks and Government Beliefs: The Rise and Fall of American Inflation”, American Economic Review, forthcoming.
- Sims, C., and T. Zha, 2006, “Were there regime switches in U.S. monetary policy?”, American Economic Review, forthcoming.
- Silber, W., 1983, "The Process of Financial Innovation," American Economic Review, Vol. 73, No. 2, pp. 89–95.
- Stock, J., and M. Watson, 2002, "Has the Business Cycle Changed and Why?" NBER Macroeconomics Annual, (Cambridge, Massachusetts: National Bureau of Economic Research).
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- Woodford, M., 2001, "The Taylor Rule and Optimal Monetary Policy," American Economic Review, Vol. 91, No. 2, pp. 232–37.

### Books, Chapters, and Edited Volumes
- Blinder, A. S., 1982, "The Anatomy of Double Digit Inflation in the 1970’s," in Inflation: Causes and Effects, ed. by Robert E. Hall, 261–82 (Chicago: University of Chicago Press).
- DeLong, B., 1997, "America's Only Peacetime Inflation: the '70s" ed. by C. Romer and D. Romer in “Reducing Inflation: Motivation and Strategy,” (Chicago: University of Chicago Press).
- Keynes, J.M., 1935, "The General Theory of Employment, Interest and Money," (Cambridge: MacMillan).
- Mayer, T., 1999, “Monetary Policy and the Great Inflation in the United States: The Federal Reserve and the Failure of Macroeconomic Policy, 1965–79,” Edward Elgar Publishing.
- Sargent, T., 1999, "The Conquest of American Inflation,"Princeton, (New Jersey: Princeton University Press).
- Taylor, J. B., 1999, "A Historical Analysis of Monetary Policy Rules," edited by Taylor, John: “Monetary Policy Rules”, (Chicago: University of Chicago Press).
- Woodford, M., 2003, “Interest and Prices: Foundations of a Theory of Monetary Policy,” Princeton, (Princeton, New Jersey: Princeton University Press).

### Working Papers, Discussion Papers, Unpublished, and Mimeo
- Bilbiie, F.O., 2003, "Limited Asset Markets Participation, Monetary Policy and (Inverted) Keynesian Logic" (unpublished, Nuffield College, University of Oxford).
- Bilbiie, F.O., and R. Straub, 2005, "Saving the Output Euler Equation" (unpublished, Nuffield College, University of Oxford and International Monetary Fund, Washington).
- Christiano, L., and C. Gust, 1999, "The Great Inflation of the 1970s" (unpublished, Chicago Northwestern University).
- Collard, F., and H. Dellas, H. 2004, "The Great Inflation of the 1970s," International Finance Discussion Papers, No. 799, Boards of Governor of the Federal Reserve System, Washington.
- Domeij, D., and M. Floden, 2004, "The labor supply elasticity and borrowing constraints: Why estimates are biased," forthcoming in the Review of Economic Dynamics.
- Duca, J., 2001, "The Democratization of America's Capital markets," Economic and Financial Review, Vol. April 2001, Federal Reserve Bank of Dallas, Dallas.
- Jones, C., 2002, "A Century of Stock Market Liquidity and Trading Costs," unpublished, Columbia Business School, New York.
- Lubik, T., and F. Schorfheide , 2003, "Computing Sunspot Equilibria in Linear Rational Expectations Models" Journal of Economic Dynamics and Control, Vol. 28(2), pp. 273–85.
- Lubik, T., and F. Schorfheide , 2004, "Testing for Indeterminacy: An Application to U.S. Monetary Policy" American Economic Review, Vol.. 94(1), 190–217.
- New York Stock Exchange, 1986, "Shareownership 1985", unpublished, New York.
- Wenninger, J., 1984, "Financial Innovation in the United States," pp. 232–258 in 'Financial Innovations and Monetary Policy”, Bank of International Settlements.
- Wolff, E., 2000, "Recent Trends in Wealth Ownership," a paper for the Conference on Benefits and Mechanisms for Spreading Asset Ownership in the United States, New York University, December 10–12, 1998.
- Wolff, E., and A. Caner 2002, "Asset Poverty in the United States, 1984–1999: Evidence from the Panel Study of Income Dynamics," Working Paper No. 356 (Blithewood, New York: The Levy Institute).

*References list as provided in the source PDF.*

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