Indeterminacy and learning: An analysis of monetary policy in the Great Inflation

• Great Inflation is explained as an indeterminate equilibrium due to loose policy.
• The Fed has imperfect knowledge about the economy and observes data with error.
• Measurement error affects Fed׳s assessment of current state of economy.
• Policy can be optimal from Fed׳s perspective but imply indeterminacy in the economy.
• Crucial break in Fed policy occurred in 1974 and not during Volcker disinflation.

The Great Inflation of the 1970s can be understood as the result of equilibrium indeterminacy in which loose monetary policy engendered excess volatility in macroeconomic aggregates and prices. The Federal Reserve inadvertently pursued policies that were not anti-inflationary enough because it did not fully understand the economic environment it was operating in. Specifically, it had imperfect knowledge about the structure of the economy and was subject to data misperceptions. The combination of learning about the economy and the use of mis-measured data resulted in policies, which the Federal Reserve believed to be optimal, but when implemented led to equilibrium indeterminacy.