This paper examines the role played by oil price shocks and monetary policy with a particular focus on the Great Inflation. Using Bayesian estimation techniques with a Sequential Monte Carlo algorithm while allowing for indeterminacy, we estimate a sticky price model with trend inflation and oil entering in both consumption and production. We .nd that the US economy during the pre-Volcker period is best described by a determinate version of the model that features a high degree of real wage rigidity. In this environment, the oil price shocks of the 1970s created an acute trade-o¤ between inflation and output-gap stabilization. Faced with this dilemma, the Federal Reserve chose to react forcefully both to inflation and output growth, but not to the output gap, thereby preventing the appearance of multiple equilibria and sunspot shocks. We further document that oil price shocks are no longer as stagflationary as they used to be owing to lower real wage rigidity, thereby explaining the resilience of the U.S. economy to the sustained oil price increases in the 2000s.

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Colin Clark Building (#39)
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629