Regime-switching monetary policy and real business cycle fluctuations

This paper investigates the implications of a regime switching monetary policy on real business cycle fluctuations. In a Cash-in-Advance model, a regime switching monetary policy with the typical observed business cycle durations could cause sizable fluctuations in real variables such as consumption, and to a lesser extent, investment. The correlations of these real variables with output matched those in the data very well. It is also found that the expected durations of the monetary policy in each regime have a significant effect on the fluctuation of real variables such as consumption and investment. In the longer duration case, the agents would supply more hours and invest less (thus consume more) in the low inflation regime than in the high inflation regime. However, if the monetary policy has a very short expected duration in each regime and switches a lot between the states, the agents' decision rules in different regimes will be close, and contrary to the long duration case, hours are a little lower and investment a little higher in the lower money growth regime than in the higher growth regime. The findings are consistent with the agents' behavior with rational expectations. Adding monetary shock in real business cycle models helps to explain the fluctuations not only in monetary and price variables, but also in real variables. Compared to a non-monetary model, the variations in the model economy are closer to what we see in the data. The implication is that, if there are different policy regimes and people are uncertain about the timing of policy changes, then the expected duration of monetary policy could affect the size of business cycle fluctuations even in a world where agents are assumed to behave rationally and there are no \\"confusions\\" or \\"rigidities.\\"