The Role of Liquid Government Bonds in the Great Transformation of American Monetary Policy* by Matthew Canzoneri + , Robert Cumby + , Behzad Diba + and David López-Salido ++ e-mail: canzonem@georgetown.edu cumbyr@georgetown.edu dibab@georgetown.edu david.j.lopez-salido@frb.gov April 23, 2010 ABSTRACT A fundamental shift in monetary policy occurred around 1980: the Fed went from a “passive” policy to an “active” policy. The passive policy was sharply criticized because conventional models predicted that it would allow sunspot equilibria. The FTPL explained away the sunspot equilibria, but its explanation required that fiscal policy also changed in a fundamental way in 1980; there is no documentation for this in the literature. Here, we study a model in which government bonds provide trans- actions services, providing a new link between debt dynamics inflation dynamics. We present two calibrations of our model: using pre and post-1980 data. We show that typical estimates of pre and post 1980 policy rules, and conventional estimates of the fiscal response to debt, all lie within our determinacy regions; so with our interpretation, there is no shift in fiscal policy that needs to be documented. The pre- 1980 policy was still very bad monetary policy, even if it avoided sunspot. Model simulations suggest that household welfare would have increased by 3.3 percent of permanent consumption in this period under an active policy. This welfare gain is an order of magnitude higher than the welfare differences between good and bad active policies. ________________ * The opinions expressed here are solely those of the authors and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System or of anyone else associated with the Federal Reserve System. + Georgetown University ++Federal Reserve Board