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Model Uncertainty and Endogenous Volatility

Author

Listed:
  • Wiliam Branch

    (University of Californis - Irvine)

  • George W. Evans

    (University of Oregon Economics Department)

Abstract

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.

Suggested Citation

  • Wiliam Branch & George W. Evans, 2005. "Model Uncertainty and Endogenous Volatility," University of Oregon Economics Department Working Papers 2005-21, University of Oregon Economics Department, revised 26 Oct 2006.
    • Handle: RePEc:ore:uoecwp:2005-21
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    JEL classification:

    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • C62 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Existence and Stability Conditions of Equilibrium
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General

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