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Realised and Optimal Monetary Policy Rules in an Estimated Markov-Switching DSGE Model of the United Kingdom

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Author Info

  • Xiaoshan Chen
  • Ronald MacDonald

Abstract

This paper conducts a systematic investigation of parameter instability in a small open economy DSGE model of the UK economy over the past thirty-five years. Using Bayesian analysis, we find a number of Markov-switching versions of the model provide a better fit for the UK data than a model with time-invariant parameters. The Markov-switching DSGE model that has two independent Markov-chains - one governing the shifts in UK monetary policy and nominal price rigidity and one governing the standard deviations of shocks - is selected as the best fitting model. The preferred model is then used to evaluate and design monetary policy. For the latter, we use the Markov-Jump-Linear-Quadratic (MJLQ) model, as it incorporates abrupt changes in structural parameters into derivations of the optimal and arbitrary policy rules. It also reveals the entire forecasting distribution of the targeted variables. To our knowledge, this is the first paper that attempts to evaluate and design UK monetary policy based on an estimated open economy Markov-switching DSGE model.

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Bibliographic Info

Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2011_04.

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Date of creation: Jan 2011
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Handle: RePEc:gla:glaewp:2011_04

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Keywords: DSGE models; Markov-switching; Bayesian analysis;

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Cited by:
  1. Kirsanova, Tatiana & Leith, Campbell & Chen, Xiaoshan, 2013. "How Optimal is US Monetary Policy?," SIRE Discussion Papers 2013-53, Scottish Institute for Research in Economics (SIRE).
  2. Marian Vavra, 2013. "Testing for linear and Markov switching DSGE models," Working and Discussion Papers WP 3/2013, Research Department, National Bank of Slovakia.
  3. Caglayan, Mustafa & Jehan, Zainab & Mouratidis, Kostas, 2012. "Asymmetric monetary policy rules for open economies: Evidence from four countries," MPRA Paper 37401, University Library of Munich, Germany.
  4. António Afonso & Priscilla Toffano, 2013. "Fiscal regimes in the EU," Working Papers Department of Economics 2013/10, ISEG - School of Economics and Management, Department of Economics, University of Lisbon.
  5. Boris Blagov, 2013. "Financial crises and time- varying risk premia in a small open economy: a Markov-Switching DSGE model for Estonia," Bank of Estonia Working Papers wp2013-8, Bank of Estonia, revised 09 Dec 2013.

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