Learning and Time-Varying Macroeconomic Volatility
AbstractThis paper presents a DSGE model in which agents' learning about the economy can endogenously generate time-varying macroeconomic volatility. Economic agents use simple models to form expectations and need to learn the relevant parameters. Their gain coefficient is endogenous and is adjusted according to past forecast errors. The model is estimated using likelihood-based Bayesian methods. The endogenous gain is jointly estimated with the structural parameters of the system. The estimation results show that private agents appear to have often switched to constant-gain learning, with a high constant gain, during most of the 1970s and until the early 1980s, while reverting to a decreasing gain later on. As a result, the model can generate a pattern of volatility, which is increasing in the 1970s and falling in the second half of the sample, with a decline that can roughly match the magnitude of the Great Moderation. The paper also documents how a failure to incorporate learning into the estimation may lead econometricians to spuriously find time-varying volatility in the exogenous shocks, even when these have constant variance by construction.
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Bibliographic InfoPaper provided by University of California-Irvine, Department of Economics in its series Working Papers with number 070802.
Length: 42 pages
Date of creation: May 2007
Date of revision:
Adaptive learning; Constant gain; Monetary policy; Macroeconomic volatility; Inflation dynamics;
Find related papers by JEL classification:
- C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
- D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
- E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
- E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
- E66 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General Outlook and Conditions
This paper has been announced in the following NEP Reports:
- NEP-ALL-2007-09-30 (All new papers)
- NEP-CBA-2007-09-30 (Central Banking)
- NEP-DGE-2007-09-30 (Dynamic General Equilibrium)
- NEP-MAC-2007-09-30 (Macroeconomics)
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