Model Uncertainty and Endogenous Volatility

William A. Branch () and George William Evans ()

University of Oregon Economics Department Working Papers from 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.

Keywords: Lucas model; model uncertainty; adaptive learning; rational expectations; volatility (search for similar items in EconPapers)
JEL-codes: C53 C62 D83 D84 E40 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac and nep-sea
Date: 2005-10-18
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Related works:
Working Paper: Model Uncertainty and Endogenous Volatility (2005)
Journal Article: Model Uncertainty and Endogenous Volatility (2007)
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