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Does Inflation Walk on Unstable Paths? Rational Sunspots and Drifting Parameters

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  • Paolo Bonomolo

    (University of Pavia)

  • Guido Ascari

    (Universita degli Studi di Pavia)

Abstract

We propose a generalization of the rational expectations (RE) hypothesis: as in the original approach by Muth (1961), the case of multiple solutions is the natural case, and expectations are formed by randomizing across the infinite RE solutions. We call our approach: "rational sunspots". The infinite solutions differ in the way agents form their expectations, or more precisely in the way agents weight past data to make forecasts. It follows that our approach naturally yields drifting parameters and stochastic volatility. It also allows for the possibility of temporary explosive paths. Moreover, a simple method to distinguish between determinacy and indeterminacy is based on the Normality of the likelihood.

Suggested Citation

  • Paolo Bonomolo & Guido Ascari, 2012. "Does Inflation Walk on Unstable Paths? Rational Sunspots and Drifting Parameters," 2012 Meeting Papers 743, Society for Economic Dynamics.
  • Handle: RePEc:red:sed012:743
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    File URL: https://economicdynamics.org/meetpapers/2012/paper_743.pdf
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    References listed on IDEAS

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    1. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," The Quarterly Journal of Economics, Oxford University Press, vol. 115(1), pages 147-180.
    2. John H. Cochrane, 2011. "Determinacy and Identification with Taylor Rules," Journal of Political Economy, University of Chicago Press, vol. 119(3), pages 565-615.
    3. Bullard, James & Mitra, Kaushik, 2002. "Learning about monetary policy rules," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1105-1129, September.
    4. Thomas A. Lubik & Frank Schorfheide, 2004. "Testing for Indeterminacy: An Application to U.S. Monetary Policy," American Economic Review, American Economic Association, vol. 94(1), pages 190-217, March.
    5. Blanchard, Olivier J, 1979. "Backward and Forward Solutions for Economies with Rational Expectations," American Economic Review, American Economic Association, vol. 69(2), pages 114-118, May.
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