Testing the Expectations Trap Hypothesis: A Time-Varying Parameter Approach

The expectations trap hypothesis is an influential but untested model of monetary policy. The hypothesis conjectures that high inflation during the 1970s was the outcome of a shift in private sector beliefs which were then validated by monetary policy. The subsequent fall in inflation was mainly due to changes in those beliefs. We provide a formal test of the model, using US data from 1948-2008. The flexible least squares approach of Kalaba and Tesfatsion (1988, 1989) is used to evaluate its empirical likelihood. Strong formal support is found for this proposition. Specifically, our results suggest that supply shocks interacting with private sector beliefs about the nature of monetary regime together account for the rise and fall of U.S. inflation.