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Model Uncertainty and Endogenous Volatility

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  • Wiliam Branch

    (University of Californis - Irvine)

  • George W. Evans

    ()
    (University of Oregon Economics Department)

Abstract

This paper identifies two channels through which the economy can generate endogenous inflation and output volatility, an empirical regularity, by introducing model uncertainty into a Lucas-type monetary model. The equilibrium path of inflation depends on agents' expectations and a vector of exogenous random variables. Following Branch and Evans (2004) agents are assumed to underparameterize their forecasting models. A Misspecification Equilibrium arises when beliefs are optimal given the misspecification and predictor proportions based on relative forecast performance. We show that there may exist multiple Misspecification Equilibria, a subset of which are stable under least squares learning and dynamic predictor selection. The dual channels of least squares parameter updating and dynamic predictor selection combine to generate regime switching and endogenous volatility.

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Bibliographic Info

Paper provided by University of Oregon Economics Department in its series University of Oregon Economics Department Working Papers with number 2005-21.

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Length: 41
Date of creation: 18 Oct 2005
Date of revision: 26 Oct 2006
Handle: RePEc:ore:uoecwp:2005-21

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Keywords: Lucas model; model uncertainty; adaptive learning; rational expectations; volatility;

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  1. Fernández-Villaverde, Jesús & Rubio-Ramirez, Juan Francisco, 2006. "Estimating Macroeconomic Models: A Likelihood Approach," CEPR Discussion Papers 5513, C.E.P.R. Discussion Papers.
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  3. George Evans & William Branch, 2003. "Intrinsic Heterogeneity in Expectation Formation," Computing in Economics and Finance 2003 312, Society for Computational Economics.
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