DEPARTMENT OF ECONOMICS WORKING PAPER SERIES Targets and Lags in a Two-Equation Model of US Stabilization

A simple model of activist macroeconomic policy derives a reaction function by assuming that rational governments have performance objectives, but are constrained by the Phillips curve. Although not formally modeled, governments apply a variety of instruments to influence inflation and output, in addition to monetary policy these including fiscal policy, bailouts and exchange rates. Our econometric results are generally consistent with US economic history. One qualification is that governments appear more likely to target growth rates than output gaps. Another inference is that inflation expectations are more likely to be backward than forward looking; a variety of rational expectations models fit the data less well than do simple inertial expectations. We also find that annual data series are more appropriate than quarterly ones for studying these issues. JEL codes: E3, E6