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Optimal policy in Markov-switching rational expectations models

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  • Blake, Andrew P.
  • Zampolli, Fabrizio

Abstract

In this paper we consider the optimal quadratic control problem of Markov-switching linear rational expectation models. These models are general and flexible tools for modelling not only regime but also model or parameter uncertainty. We show, first, how to find the solution of a Markov-switching linear rational expectation model. Based on this solution we then show how to apply dynamic programming to find the optimal time-consistent policy and the resulting Nash-Stackelberg equilibrium. Suitable modifications of the algorithm allow to deal with the (non-RE) case in which the policymaker and the private sector hold different beliefs or probabilities over regime change. We also show how the optimisation procedure can be employed to obtain the optimal policy under commitment. As an illustration we compute the optimal policy in a small open economy subject to stochastic structural breaks in some of its key parameters.

Suggested Citation

  • Blake, Andrew P. & Zampolli, Fabrizio, 2011. "Optimal policy in Markov-switching rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 35(10), pages 1626-1651, October.
  • Handle: RePEc:eee:dyncon:v:35:y:2011:i:10:p:1626-1651
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    References listed on IDEAS

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    Cited by:

    1. Kostas Mavromatis, 2017. "US monetary regimes and optimal monetary policy in the Euro Area," DNB Working Papers 570, Netherlands Central Bank, Research Department.
    2. Chen, Xiaoshan & Kirsanova, Tatiana & Leith, Campbell, 2017. "How optimal is US monetary policy?," Journal of Monetary Economics, Elsevier, vol. 92(C), pages 96-111.
    3. Garreth Rule, 2012. "Collateral management in central bank policy operations," Handbooks, Centre for Central Banking Studies, Bank of England, edition 1, number 31.
    4. Garreth Rule, 2011. "Issuing central bank securities," Handbooks, Centre for Central Banking Studies, Bank of England, edition 1, number 30.
    5. Barthélemy, Jean & Marx, Magali, 2017. "Solving endogenous regime switching models," Journal of Economic Dynamics and Control, Elsevier, vol. 77(C), pages 1-25.

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