Rational Sunspots

Guido Ascari, Paolo Bonomolo and Hedibert F. Lopes

No 226, Business and Economics Working Papers from Unidade de Negocios e Economia, Insper

Abstract: The instability of macroeconomic variables is usually ruled out by rational expectations. We propose a generalization of the rational expectations framework to estimate possible temporary unstable paths. Our approach yields drifting parameters and stochastic volatility. The methodology allows the data to choose between diferent possible alternatives: determinacy, indeterminacy and instability. We apply our methodology to US inflation dynamics in the '70s through the lens of a simple New Keynesian model. When unstable RE paths are allowed, the data unambiguously select them to explain the stagflation period in the '70s. Thus, our methodology suggests that US inflation dynamics in the '70s is better described by unstable rational equilibrium paths.

Pages: 52 pages
Date: 2016
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