The quest for prosperity without inflation

In recent years, activist monetary policy rules responding to inflation and the level of economic activity have been advanced as a means of achieving effective output stabilization without inflation. Advocates of such policies suggest that their flexibility may yield substantial stabilization benefits while avoiding the excesses of overzealous discretionary fine-tuning such as is thought to characterize the experience of the 1960s and 1970s. In this study I present evidence suggesting that these conclusions are misguided. Using an estimated model, I show that when informational limitations are properly accounted for, activist policies would not have averted the Great Inflation but instead would have resulted in worse macroeconomic performance than the actual historical experience. The problem can be attributed, in large part, to the counterproductive reliance of these policies on the output gap. The analysis suggests that the dismal economic outcomes of the Great Inflation may have resulted from an unfortunate pursuit of activist policies in the face of bad measurement, specifically, overoptimistic assessments of the output gap associated with the productivity slowdown of the late 1960s and early 1970s.