Model Uncertainty and Endogenous Volatility

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

No 33, Computing in Economics and Finance 2005 from Society for Computational Economics

Abstract: This paper introduces model uncertainty into a simple Lucas-type monetary model. 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 are 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. Using this as a basis, we identify two channels through which the economy can generate endogenous inflation and output volatility, an empirical regularity. The dual channels of least squares parameter updating and dynamic predictor selection combine to generate regime switching and endogenous volatility

JEL-codes: C53 C62 D83 (search for similar items in EconPapers)
Date: Written
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Working Paper: Model Uncertainty and Endogenous Volatility (2006)
Journal Article: Model Uncertainty and Endogenous Volatility (2007)
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