Revisiting the Great Moderation using the Method of Indirect Inference

We estimate a VAR for each period and we then ask what candidate DSGE models could
have generated each VAR. Having established which model comes closest to doing so, we
then examine how the dierence between them accounts for the Great Moderation. Since
these models embrace the ones put forward by the authors who argue that policy regime
change accounts for it, we are also able to evaluate these authors' claims statistically.
Thus we bring evaluative statistics to bear on the authors who claim policy regime change,
while we bring identication to bear on the authors who use SVARs.
We describe our methods in detail below. But rst we discuss the empirical evidence
from single equation estimates for the Taylor Rule.
3 Taylor Rules, Estimation and Identication
Taylor (1993) suggested that a good rule for monetary policy would set the Federal funds
rate according to the following equation:
i A t = A t + 0:5x t + 0:5( A t ) + g (1)
where x t is the percentage deviation of real GDP from trend, A t
is the annual rate of
ination averaged over the past four quarters, with ination target and real GDP
growth rate g both set at 2 percent.
Known as the original `Taylor Rule', equation (1) was found to have predicted the
movement of actual Fed rates well for much of the period from 1987 until the early 1990s.
This success convinced many economists that the Fed's policy at the time could be
conveniently described by this equation. A number of variants have also been proposed;
for example, one with policy inertia as in Clarida, Gali and Gertler (1999):
i A t = (1 )[ + ( A t ) + x x t ] + i A t 1 (2)
with showing the degree of `interest rate smoothing'. Others have introduced backward-
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