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Minimal state variable solutions to Markov-switching rational expectations models

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  • Roger E.A. Farmer
  • Daniel F. Waggoner
  • Tao Zha

Abstract

We develop a new method for computing minimal state variable solutions (MSV) to Markov-switching rational expectations models. We provide an algorithm to compute an MSV solution and show how to test a given solution for uniqueness and boundedness. We construct an example that is calibrated to U.S. data and show that the MSV solution in our example is unique. This solution can potentially explain in three different ways the observed reduction in the variance of inflation and the interest rate after 1980: The policy rule might have changed, the variance of the fundamental shocks might have fallen, or the private sector equations might have been different across regimes. We compare these three explanations for the change in variance and show that any one of them can potentially account for the facts. Our paper provides the necessary tools for a future empirical study of this issue.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 2008-23.

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Date of creation: 2008
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Handle: RePEc:fip:fedawp:2008-23

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Keywords: Econometric models;

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  1. McCallum, Bennett T., 1983. "On non-uniqueness in rational expectations models : An attempt at perspective," Journal of Monetary Economics, Elsevier, vol. 11(2), pages 139-168.
  2. Farmer, Roger E A & Waggoner, Daniel F & Zha, Tao, 2006. "Indeterminacy in a Forward Looking Regime Switching Model," CEPR Discussion Papers 5919, C.E.P.R. Discussion Papers.
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  13. Christopher Sims & Tao Zha, 2002. "Macroeconomic switching," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
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  15. Troy Davig & Eric M. Leeper, 2006. "Generalizing the Taylor Principle," Caepr Working Papers 2006-001, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
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  17. Christiano, Lawrence & Rostagno, Massimo & Motto, Roberto, 2010. "Financial factors in economic fluctuations," Working Paper Series 1192, European Central Bank.
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  20. Beyer, Andreas & Farmer, Roger E. A., 2003. "Identifying the monetary transmission mechanism using structural breaks," Working Paper Series 0275, European Central Bank.
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