The Conquest of American Inflation: A Summary
📄 Summarized from the full manuscript · Human-reviewed for faithfulness before publication
In brief
Why did U.S. inflation rise through the 1970s and then fall sharply under Volcker? This essay compares two stories from Sargent's book, both about policymakers learning the natural-rate hypothesis. In the "triumph" story the Fed learns the correct model and stops exploiting a trade-off that was never there. In Sargent's own "vindication" story it keeps re-estimating an approximate Phillips curve from recent data, and that coefficient drift lets chance disturbances occasionally convince it the trade-off has vanished, triggering disinflation. Simulations then produce long low-inflation stretches resembling both Arthur Burns and Paul Volcker; but because the true trade-off never disappeared, the same dynamics eventually drift back to high inflation.
What this paper finds — and why it matters
Summarizing Sargent’s “The Conquest of American Inflation,” this essay compares two interpretations of the postwar rise and fall of U.S. inflation, both built around policymakers learning a version of the natural-rate hypothesis but differing in how that learning is modeled. The “triumph of natural-rate theory” story has the government eventually learn the correct rational-expectations version of the theory and simply cease exploiting an illusory long-run Phillips curve trade-off, ushering in the low-inflation “Ramsey outcome.” The essay’s preferred “vindication of econometric policy evaluation” story instead keeps the government using the very Tinbergen-Theil-style econometric procedures Lucas’s Critique condemned – estimating a Phillips curve from recent data and resetting policy accordingly, generating exactly the kind of drifting coefficients Lucas identified as a symptom of policy-dependent behavior but left unexplained. Working through the Kydland-Prescott one-period model, the essay first shows the Nash outcome (positive inflation, unemployment at its natural rate) arises when the government ignores the effect of its rule on expectations, while the Ramsey outcome (zero inflation) arises when it accounts for that effect; it then introduces “self-confirming equilibria,” in which the government’s beliefs about the Phillips curve are validated by the data its own policy generates, reproducing the Nash outcome as a steady state. The essay’s central mechanism is “escape dynamics”: because the government’s learning algorithm discounts older observations (suspecting, incorrectly, that the true relationship is unstable), chance disturbances can occasionally push its estimated Phillips curve toward vertical, triggering a real disinflation whose own resulting data temporarily reinforce that belief – generating, in simulations, long stretches near the efficient Ramsey outcome that “resemble Arthur Burns as well as ones that look like Paul Volcker.” But because the true short-run trade-off never actually disappeared, the same dynamics eventually push the government to rediscover it and drift back toward the high-inflation Nash outcome, so the disinflation is not permanent. The essay closes by stressing this is an exercise in positive, not normative, economics – its simulations do not vindicate the underlying econometric procedures as good policy design – and expresses the explicit hope that the truth is instead the more reassuring “triumph” story, since otherwise “the dynamics governing adaptation threaten eventually to rekindle inflation.”
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Questions & answers
Q1. What two interpretations of U.S. postwar inflation does the essay set out to compare, and what do they share?
“The triumph of natural-rate theory” and “the vindication of econometric policy evaluation” – in both, “the government learns a version of the natural unemployment rate hypothesis: in the first, the correct rational expectations version, in the second, an approximating adaptive expectations version” (Abstract, p. 12). The essay states its verdict up front: “Although the first story is more popular among modern macroeconomists, it suffers from contradictions and loose ends. Therefore the second story is considered. This story… is more successful than the first in explaining the rise and fall of American inflation” (Abstract, p. 12).
Q2. How does the Kydland-Prescott one-period model generate the “Nash” and “Ramsey” outcomes?
If the central bank sets inflation while treating expected inflation as given, it is tempted to create surprise inflation to push unemployment below the natural rate; but rational private agents anticipate this and set their expectations equal to actual inflation, yielding the “Nash outcome,” “characterized by a positive inflation rate, but unemployment equal to the natural rate” (Section “A one-period model,” p. 20). If instead the government internalizes that expected inflation will track actual inflation and that unemployment cannot deviate from the natural rate in the long run, “the optimal rate of inflation is zero, leading to the Ramsey outcome of zero inflation and unemployment equal to the natural rate” (p. 20) – the same unemployment outcome achieved with none of the inflation.
Q3. What is a “self-confirming equilibrium,” and why is it not by itself enough to explain disinflation?
An equilibrium in which “the government’s beliefs about the Phillips curve affect its policy choices, which in turn makes agents act in such a way that the government’s beliefs are confirmed” (Section “Ignoring the Lucas Critique,” p. 17-19). Within such an equilibrium the government is never disappointed and some aspects of the Lucas Critique cease to bite, but the essay is explicit that “these equilibria are not sufficient to generate lower inflation than in the previous rational expectations model” (p. 17) – a self-confirming equilibrium built on the classical Phillips curve simply reproduces the high-inflation Nash outcome as a steady state, since nothing pushes the government’s beliefs away from it on their own.
Q4. What breaks the pull toward the self-confirming (Nash) equilibrium, and why does discounting past data matter?
Because a self-confirming equilibrium “does not admit regime changes and drifting coefficients, but we observe these in practice, convergence to such an equilibrium must be resisted through some mechanism” – specifically, “assuming that the government suspects that the environment is unstable (although in fact it is not), and therefore uses a learning rule that discounts past observations, weakens the tendency of the economy to converge to a self-confirming equilibrium” (Section “Ignoring the Lucas Critique,” p. 19). The essay notes that with an equal-weighted least-squares learning rule the model “always converges to the inferior self-confirming Nash equilibrium,” but discounting past data lets chance disturbances have an outsized effect on the government’s current estimates, opening the door to escape (Section on simulations, p. 33).
Q5. What do the simulations of the “classical” adaptive model show about the path of inflation?
Inflation starts near the self-confirming Nash value (about 5 percent in the classical calibration), then “drops almost to zero and stays there for a long time,” before slowly heading back toward the self-confirming value and being “propelled back toward zero again” (Figure 6, p. 31). The mechanism: during a stabilization episode the sum of coefficients on inflation in the government’s estimated Phillips curve “jumps from its self-confirming value of −1 to nearly zero,” activating what the essay calls the “induction hypothesis” (belief in a vertical, non-exploitable Phillips curve) and prompting the government to cut inflation; “the stabilization generates observations that temporarily add credibility to the induction hypothesis that prompted it” even though this is not technically self-confirming (p. 31-32).
Q6. Why do disinflations in this model eventually reverse rather than persist?
Because the true data-generating process still has a genuine short-run trade-off that the government has not permanently forgotten how to detect: “since the true model has a short-run trade-off in the Phillips curve, the government soon identifies it, after a sufficient number of new observations have arrived. It then wants to exploit the trade-off… [and] the economy moves toward the Nash outcome again” (Section on simulations, p. 32-33). The essay calls the resulting cycle an “experimentation trap”: at the Nash outcome inflation expectations are constant because the government sets a constant rate, so escaping again requires fresh shocks to reawaken the learning dynamics – meaning the system oscillates between the two outcomes rather than settling permanently at either.
Q7. What is the essay’s overall verdict on whether this “vindication” story should be read as good news about the underlying econometric procedures?
Explicitly not: “the vindication of econometric policy evaluation is an exercise in positive economics, not normative economics,” and although the simulations “produce near Ramsey outcomes for long periods,” the essay warns against inferring the underlying procedures are good policy design, since “the simulations contain episodes that resemble Arthur Burns as well as ones that look like Paul Volcker” (Concluding remarks, p. 38-39). It notes theoretical work since Kydland and Prescott has instead sought commitment mechanisms that remove the temptation to inflate altogether, which “rejects the idea suggested here that chance will lead policy makers armed with an approximate model eventually to learn to do approximately the right thing” (p. 39).
Q8. What final hope does the essay express, and why?
That the “vindication” story is actually the wrong one – “we hope instead that policy makers somehow have learned a correct rational expectations version of the natural rate hypothesis and found devices to commit themselves to low inflation. Otherwise, the dynamics governing adaptation threaten eventually to rekindle inflation” (Concluding remarks, p. 39). This closing line underscores that the essay’s own preferred, better-fitting model is also the more pessimistic one about the durability of low inflation, since it implies the current low-inflation regime is a temporary phase in a recurring cycle rather than a settled, credible equilibrium.
Key terms in this paper
Definitions below follow the paper's own usage.
- The "triumph of natural-rate theory" story
- The account built on Kydland and Prescott (1977) and Barro and Gordon (1983) in which policymakers eventually learn "the correct rational expectations version" of the natural-rate hypothesis and therefore "should ignore any temporary Phillips curve trade-off and strive only for low inflation," so that "these ideas spread among academics, then influenced policy makers, and ultimately promoted the lower inflation rates of the 1980's and 1990's."
- The "vindication of econometric policy evaluation" story
- Sargent and Söderström's preferred account, in which the government "ignores the Lucas Critique," recurrently re-estimating an adaptive Phillips curve from recent data using Tinbergen-Theil-style procedures that generate drifting coefficients; despite Lucas's warning that such procedures are unreliable because they ignore agents' responses to policy, "the procedures that violate the Lucas Critique yield better outcomes than ones that respect it," since coefficient drift is precisely what lets the government's beliefs -- and hence its policy -- evolve away from a high-inflation trap.
- Self-confirming equilibrium
- A steady state in which "the government's beliefs about the Phillips curve affect its policy choices, which in turn makes agents act in such a way that the government's beliefs are confirmed"; in the Kydland-Prescott model this reproduces the Nash outcome (positive inflation, natural-rate unemployment), but because the true model has an exploitable short-run trade-off the government does not see in equilibrium, the essay notes "these equilibria are not sufficient to generate lower inflation" on their own -- escape requires the adaptive dynamics described next.
- Escape dynamics and the "induction hypothesis"
- The essay's account of how the model escapes a high-inflation self-confirming equilibrium: because the government's learning algorithm discounts past data (suspecting, incorrectly, that the environment is unstable), chance shocks can occasionally push its estimated Phillips curve toward vertical (the "induction hypothesis"), prompting a real disinflation whose own resulting data reinforce that belief for a time -- but "since the true model has a short-run trade-off in the Phillips curve, the government soon identifies it... [and] the economy moves toward the Nash outcome again," so escapes to low inflation are temporary, not permanent.