Expectations, Credibility, and Disinflation in a Small Macroeconomic Model

We use a version of the Fuhrer-Moore model to study the effects of expectations and central bank credibility on the economy’s dynamic transition path during a disinflation. Simulations are compared under four different specifications of the model that vary according to the way that expectations are formed (rational versus adaptive) and the degree of central bank credibility (full versus partial). In general, the various specifications exhibit qualitatively similar behavior and can reasonably approximate the trend movements in U.S. macro variables during the Volcker disinflation of the early 1980s. However, the specification with adaptive expectations and partial credibility is the only one to capture the temporary rise in the long-term nominal interest rate observed in U.S. data at the start of the disinflation. Our simulations also show that incremental reductions in the sacrifice ratio are largest at the low end of the credibility range, suggesting that a central bank may face diminishing returns in its efforts to enhance credibility.