Learning with unobserved regimes

This paper introduces new economic dynamics induced by learning. Under monetary policy with regime switches, private sector agents learn about output and inflation, which are functions of their beliefs about those variables. The learners’ models are misspecified because they do not observe the regimes. The novel dynamics occur if the regime switches are slow relative to the learning speed: Learners’ beliefs do not converge to the single process that usually describes their asymptotic beliefs, but to a Markov switching process. Checking for this possibility is crucial: When it occurs, the standard analysis gives incorrect results about the equilibria to which beliefs and other endogenous variables will converge. In an extension in which the learners choose their learning speed optimally, the result is strengthened.