The U.S. economic dynamics and inflation persistence. A regime-switching perspective

Most comparative analyses explaining the 1970s and 1990s/2000s inflation performance, focusing on good/bad policy versus good/bad luck, assume that price and wage-setting institutions remained constant. While studies acknowledge institutional changes, they typically overlook sources of intrinsic persistence of wage and price inflation. This paper contributes to this ongoing debate by revisiting the U.S. business cycle. We account for time variations in pricing and wage-setting behavior due to institutional changes and for switches in inflation-intrinsic persistence, which we formally represent as changes in the shape of the hazard function. By analyzing how policy and shocks interact within different institutional settings in our model economy, we trace the existing contrasting evidence back to an identification problem that biases regime estimates and leads to misleading interpretations. Once we account for persistence switches, the empirical outcomes strongly support, but refine, the luck interpretation over the policy interpretation. The 1970s were characterized not only by larger shocks but also by more pronounced transmission mechanisms of supply shocks, driven by the price- and wage-setting institutions of the time. Additionally, the data suggest to reinterpret the monetary regimes more in line with the central bankers’ view and show that structural changes in price and wage adjustments play essential and opposite roles in the Great Inflation. Finally, our analysis yields two important general findings. First, it emphasizes the critical role that changes in price and wage-setting institutions play in influencing the propagation of shocks. Second, it validates the use of a generalized time-dependent rule to represent nominal rigidities. (JEL: E24, E31, E32, C11)