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Optimal monetary policy in Markov-switching models with rational expectations agents

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  • Andrew P Blake
  • Fabrizio Zampolli

Abstract

In this paper we consider the optimal control problem of models with Markov regime shifts and forward-looking agents. These models are very general and flexible tools for modelling model uncertainty. An algorithm is devised to compute the solution of a linear rational expectations model with random parameters or regime shifts. This algorithm can also be applied in the optimisation of any arbitrary instrument rule. A second algorithm computes the time-consistent policy and the resulting Nash-Stackelberg equilibrium. Similar methods can be easily employed to compute the optimal policy under commitment. Furthermore, the algorithms can also handle the case in which the policymaker and the private sector hold different beliefs. We apply these methods to compute the optimal (non-linear) monetary policy in a small open economy subject to random structural breaks in some of its key parameters.

Suggested Citation

  • Andrew P Blake & Fabrizio Zampolli, 2006. "Optimal monetary policy in Markov-switching models with rational expectations agents," Bank of England working papers 298, Bank of England.
  • Handle: RePEc:boe:boeewp:298
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    File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2006/WP298.pdf
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    References listed on IDEAS

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    Cited by:

    1. Xiaoshan Chen & Ronald Macdonald, 2012. "Realized and Optimal Monetary Policy Rules in an Estimated Markov‐Switching DSGE Model of the United Kingdom," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(6), pages 1091-1116, September.
    2. Andrew Foerster & Juan F. Rubio‐Ramírez & Daniel F. Waggoner & Tao Zha, 2016. "Perturbation methods for Markov‐switching dynamic stochastic general equilibrium models," Quantitative Economics, Econometric Society, vol. 7(2), pages 637-669, July.
    3. Troy Davig, 2016. "Phillips Curve Instability and Optimal Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 48(1), pages 233-246, February.
    4. Richhild Moessner, 2006. "Optimal discretionary policy in rational expectations models with regime switching," Bank of England working papers 299, Bank of England.
    5. Doğan, İbrahim & Bilgili, Faik, 2014. "The non-linear impact of high and growing government external debt on economic growth: A Markov Regime-switching approach," Economic Modelling, Elsevier, vol. 39(C), pages 213-220.
    6. Jean Barthélemy & Magali Marx, 2011. "State-Dependent Probability Distributions in Non Linear Rational Expectations Models," Sciences Po publications 347, Sciences Po.
    7. Pardo, S. & Rautureau, N. & Vallée, T., 2011. "Optimal versus realized policy rules in a regime-switching framework," Economic Modelling, Elsevier, vol. 28(6), pages 2761-2775.
    8. Farmer, Roger E.A. & Waggoner, Daniel F. & Zha, Tao, 2009. "Understanding Markov-switching rational expectations models," Journal of Economic Theory, Elsevier, vol. 144(5), pages 1849-1867, September.
    9. André P. Calmon & Thomas Vallée & João B. R. Do Val, 2009. "Monetary policy as a source of uncertainty," Working Papers hal-00422454, HAL.

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