Can Financial Frictions Help Explain the Performance of the U.S. Fed?

This paper analyzes the decreased volatility of U.S. macroeconomic variables starting in the 1980's in a model where monetary policy is affected by financial frictions. The model is estimated for postwar U.S. data with a break in 1981:3, allowing for changes in the policy rule, shock processes and financial frictions across subsamples. There is some evidence that changed monetary policy is more important to explain inflation stabilization, while "good luck" helps explain the increased stability in output. However, the results are most consistent with a decline in shock variances which was reinforced by a decrease in financial frictions, making the economy less vulnerable to shocks.