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Model Uncertainty and Endogenous Volatility

  • Wiliam Branch

    (University of Californis - Irvine)

  • George W. Evans

    ()

    (University of Oregon Economics Department)

This paper identifies two channels through which the economy can generate endogenous inflation and output volatility, an empirical regularity, by introducing model uncertainty into a Lucas-type monetary model. The equilibrium path of inflation depends on agents' expectations and a vector of exogenous random variables. Following Branch and Evans (2004) agents are assumed to underparameterize their forecasting models. A Misspecification Equilibrium arises when beliefs are optimal given the misspecification and predictor proportions based on relative forecast performance. We show that there may exist multiple Misspecification Equilibria, a subset of which are stable under least squares learning and dynamic predictor selection. The dual channels of least squares parameter updating and dynamic predictor selection combine to generate regime switching and endogenous volatility.

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File URL: http://economics.uoregon.edu/papers/UO-2005-21_Branch_Volatility.pdf
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Paper provided by University of Oregon Economics Department in its series University of Oregon Economics Department Working Papers with number 2005-21.

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Length: 41
Date of creation: 18 Oct 2005
Date of revision: 26 Oct 2006
Handle: RePEc:ore:uoecwp:2005-21
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Web page: http://economics.uoregon.edu/
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  1. William Poole & Robert H. Rasche, 2002. "Flation," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 1-6.
    • William Poole, 2002. "Flation," Speech 49, Federal Reserve Bank of St. Louis.
  2. Timothy Cogley & Thomas J. Sargent, 2005. "The conquest of US inflation: Learning and robustness to model uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 528-563, April.
  3. George Evans & William Branch, 2003. "Intrinsic Heterogeneity in Expectation Formation," Computing in Economics and Finance 2003 312, Society for Computational Economics.
  4. Giorgio Primiceri & Alejandro Justiniano, 2006. "The Time Varying Volatility of Macroeconomic Fluctuations," 2006 Meeting Papers 353, Society for Economic Dynamics.
  5. Thomas J. Sargent & Noah Williams, 2003. "Impacts of priors on convergence and escapes from Nash inflation," FRB Atlanta Working Paper 2003-14, Federal Reserve Bank of Atlanta.
  6. Philippe BACCHETTA & Eric VAN WINCOOP, 2004. "A Scapegoat Model of Exchange Rate Fluctuations," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 04.01, Université de Lausanne, Faculté des HEC, DEEP.
  7. Kenneth Kasa & In-Koo Cho, 2011. "Learning and Model Validation," 2011 Meeting Papers 1086, Society for Economic Dynamics.
  8. repec:oup:restud:v:74:y:2007:i:4:p:1059-1087 is not listed on IDEAS
  9. Adam, Klaus, 2003. "Learning to Forecast and Cyclical Behavior of Output and Inflation," CFS Working Paper Series 2003/01, Center for Financial Studies (CFS).
  10. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2004. "A Critique of Structural VARs Using Real Business Cycle Theory," Levine's Bibliography 122247000000000518, UCLA Department of Economics.
  11. Cho, In-Koo & Kasa, Kenneth, 2008. "Learning Dynamics And Endogenous Currency Crises," Macroeconomic Dynamics, Cambridge University Press, vol. 12(02), pages 257-285, April.
  12. George W. Evans & Seppo Honkapohja, 1993. "Adaptive forecasts, hysteresis, and endogenous fluctuations," Economic Review, Federal Reserve Bank of San Francisco, pages 3-13.
  13. Brock, W.A. & Hommes, C.H., 1996. "A Rational Route to Randomness," Working papers 9530r, Wisconsin Madison - Social Systems.
  14. Brock, William A. & Hommes, Cars H., 1998. "Heterogeneous beliefs and routes to chaos in a simple asset pricing model," Journal of Economic Dynamics and Control, Elsevier, vol. 22(8-9), pages 1235-1274, August.
  15. Fernández-Villaverde, Jesús & Rubio-Ramírez, Juan Francisco, 2006. "Estimating Macroeconomic Models: A Likelihood Approach," CEPR Discussion Papers 5513, C.E.P.R. Discussion Papers.
  16. Guse, Eran A., 2005. "Stability properties for learning with heterogeneous expectations and multiple equilibria," Journal of Economic Dynamics and Control, Elsevier, vol. 29(10), pages 1623-1642, October.
  17. Christopher A. Sims & Tao Zha, 2004. "Were there regime switches in U.S. monetary policy?," FRB Atlanta Working Paper 2004-14, Federal Reserve Bank of Atlanta.
  18. James B. Bullard & In-Koo Cho, 2003. "Escapist policy rules," Working Papers 2002-002, Federal Reserve Bank of St. Louis.
  19. Klaus Adam, 2007. "Experimental Evidence on the Persistence of Output and Inflation," Economic Journal, Royal Economic Society, vol. 117(520), pages 603-636, 04.
  20. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
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  22. Hommes, Cars & Sorger, Gerhard, 1998. "Consistent Expectations Equilibria," Macroeconomic Dynamics, Cambridge University Press, vol. 2(03), pages 287-321, September.
  23. Bruce McGough, 2006. "Shocking Escapes," Economic Journal, Royal Economic Society, vol. 116(511), pages 507-528, 04.
  24. Branch, William A. & Evans, George W., 2006. "A simple recursive forecasting model," Economics Letters, Elsevier, vol. 91(2), pages 158-166, May.
  25. Chang-Jin Kim & Charles R. Nelson & Jeremy M. Piger, 2003. "The less volatile U.S. economy: a Bayesian investigation of timing, breadth, and potential explanations," Working Papers 2001-016, Federal Reserve Bank of St. Louis.
  26. Cho, In-Koo & Sargent, Thomas J., 2000. "Escaping Nash inflation," Working Paper Series 0023, European Central Bank.
  27. Wiliam Branch & John Carlson & George W. Evans & Bruce McGough, 2004. "Monetary Policy, Endogenous Inattention, and the Volatility Trade-off," University of Oregon Economics Department Working Papers 2004-19, University of Oregon Economics Department, revised 15 May 2007.
  28. N. Williams, 2002. "Stability and Long Run Equilibrium in Stochastic Fictitious Play," Princeton Economic Theory Working Papers cbeeeb49cc8afc83f125df5a8, David K. Levine.
  29. Michael T. Owyang, 2001. "Persistence, excess volatility, and volatility clusters in inflation," Review, Federal Reserve Bank of St. Louis, issue Nov., pages 41-52.
  30. Kenneth Kasa, 2000. "Learning, large deviations, and recurrent currency crises," Working Paper Series 2000-10, Federal Reserve Bank of San Francisco.
  31. James H. Stock & Mark W. Watson, 2003. "Has the business cycle changed?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 9-56.
  32. Evans, George W. & Honkapohja, Seppo & Sargent, Thomas J., 1993. "On the preservation of deterministic cycles when some agents perceive them to be random fluctuations," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 705-721.
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