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This paper examines the interactions between monetary policy and the formation of expectations to explain U.S. business cycle fluctuations in the post-war period. I estimate a conventional medium-scale New-Keynesian model, in which I relax the assumption
that the central bank pursued an ‘active' monetary policy — i.e. that stabilizes inflation and output growth — over this entire period. I find that between 1955 and 1979 monetary policy was ‘passive', and structural shocks de-anchored inflation expectations
from the central bank's long-run target. Fundamental productivity and cost shocks were the primary cause of volatility and propagated via persistent self-fulfilling inflationary expectations. By contrast, non-fundamental ‘sunspot' shocks, caused by unexpected changes in inflation expectations, were insignificant sources of uncertainty.
