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Realised and Optimal Monetary Policy Rules in an Estimated Markov-Switching DSGE Model of the United Kingdom

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Listed author(s):
  • Xiaoshan Chen
  • Ronald MacDonald

Abstract

This paper conducts a systematic investigation of parameter instability in a small open economy DSGE model of the UK economy over the past thirty-five years. Using Bayesian analysis, we find a number of Markov-switching versions of the model provide a better fit for the UK data than a model with time-invariant parameters. The Markov-switching DSGE model that has two independent Markov-chains - one governing the shifts in UK monetary policy and nominal price rigidity and one governing the standard deviations of shocks - is selected as the best fitting model. The preferred model is then used to evaluate and design monetary policy. For the latter, we use the Markov-Jump-Linear-Quadratic (MJLQ) model, as it incorporates abrupt changes in structural parameters into derivations of the optimal and arbitrary policy rules. It also reveals the entire forecasting distribution of the targeted variables. To our knowledge, this is the first paper that attempts to evaluate and design UK monetary policy based on an estimated open economy Markov-switching DSGE model.

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Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2011_04.

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Date of creation: Jan 2011
Handle: RePEc:gla:glaewp:2011_04
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Keywords: DSGE models; Markov-switching; Bayesian analysis;

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Find related papers by JEL classification:
  • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
  • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
  • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
  • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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Cited by:

  1. Boris Blagov, 2013. "Financial crises and time- varying risk premia in a small open economy: a Markov-Switching DSGE model for Estonia," Bank of Estonia Working Papers wp2013-8, Bank of Estonia, revised 09 Dec 2013.
  2. Chen, Xiaoshan & Kirsanova, Tatiana & Leith, Campbell, 2013. "How Optimal is US Monetary Policy?," Stirling Economics Discussion Papers 2013-05, University of Stirling, Division of Economics.
  3. Marian Vavra, 2013. "Testing for linear and Markov switching DSGE models," Working and Discussion Papers WP 3/2013, Research Department, National Bank of Slovakia.
  4. Afonso, António & Toffano, Priscilla, 2013. "Fiscal regimes in the EU," Working Paper Series 1529, European Central Bank.
  5. Mustafa Caglayan & Zainab Jehan & Kostas Mouratidis, 2016. "Asymmetric Monetary Policy Rules for an Open Economy: Evidence from Canada and the Uk," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 21(3), pages 279-293, 07.
  6. LI, XI HAO & Gallegati, Mauro, 2015. "Stock-Flow Dynamic Projection," MPRA Paper 62047, University Library of Munich, Germany.
  7. Caglayan, Mustafa & Jehan, Zainab & Mouratidis, Kostas, 2012. "Asymmetric monetary policy rules for open economies: Evidence from four countries," MPRA Paper 37401, University Library of Munich, Germany.
  8. Ma, Yong, 2016. "Nonlinear monetary policy and macroeconomic stabilization in emerging market economies: Evidence from China," Economic Systems, Elsevier, vol. 40(3), pages 461-480.
  9. Andrej Drygalla, 2015. "Switching to Exchange Rate Flexibility? The Case of Central and Eastern European Inflation Targeters," FIW Working Paper series 139, FIW.

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