Unemployment and Inflation Regimes
In this paper we study 2-state Markov switching VAR models of monthly unemployment and inflation for three countries: Sweden, United Kingdom, and the United States. We find that such models seem to provide a better description of the data than single regime VARs and need fewer lags to account for serial correlation. To interpret the regimes the empirical results are compared with the predictions from a version of Rogoff's (1985) model of monetary policy. We find that both the theoretical and the empirical results suggest that an increase in central bank "conservativeness" can be associated with either a higher or a lower variance in unemployment. In the U.S. case we find that the variance of unemployment is lower in the low inflation regime than in the high inflation regime, while the Swedish case suggests that unemployment variability is higher in the low inflation regime. According to the theoretical model this may be explained by a higher labor supply elasticity in the U.S. than in Sweden.
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