Regime Switching, Learning, and the Great Moderation
AbstractThis paper examines the "bad luck" explanation for changing volatility in U.S. inflation and output when agents do not have rational expectations, but instead form expectations through least squares learning with an endogenously changing learning gain. It has been suggested that this type of endogenously changing learning mechanism can create periods of excess volatility without the need for changes in the variance of the underlying shocks. Bad luck is modeled into a standard New Keynesian model by augmenting it with two states that evolve according to a Markov chain, where one state is characterized by large variances for structural shocks, and the other state has relatively smaller variances. To assess whether learning can explain the Great Moderation, the New Keynesian model with volatility regime switching and dynamic gain learning is estimated by maximum likelihood. The results show that learning does lead to lower variances for the shocks in the volatile regime, but changes in regime is still significant in differences in volatility from the 1970s and after the 1980s.
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Bibliographic InfoPaper provided by Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington in its series Caepr Working Papers with number 2008-011.
Length: 36 pages
Date of creation: Apr 2008
Date of revision:
Learning; regime switching; great moderation; New Keynesian model; maximum likelihood;
Find related papers by JEL classification:
- C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
- E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
- E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-05-10 (All new papers)
- NEP-CBA-2008-05-10 (Central Banking)
- NEP-MAC-2008-05-10 (Macroeconomics)
- NEP-OPM-2008-05-10 (Open Economy Macroeconomics)
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