Regime Switching, Learning, and the Great Moderation

James Murray ()
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James Murray: Indiana University Bloomington

No 2008-011, CAEPR Working Papers from Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington

Abstract: This paper examines the "bad luck" explanation for changing volatility in U.S. inflation and output when agents do not have rational expectations, but instead form expectations through least squares learning with an endogenously changing learning gain. It has been suggested that this type of endogenously changing learning mechanism can create periods of excess volatility without the need for changes in the variance of the underlying shocks. Bad luck is modeled into a standard New Keynesian model by augmenting it with two states that evolve according to a Markov chain, where one state is characterized by large variances for structural shocks, and the other state has relatively smaller variances. To assess whether learning can explain the Great Moderation, the New Keynesian model with volatility regime switching and dynamic gain learning is estimated by maximum likelihood. The results show that learning does lead to lower variances for the shocks in the volatile regime, but changes in regime is still significant in differences in volatility from the 1970s and after the 1980s.

Keywords: Learning; regime switching; great moderation; New Keynesian model; maximum likelihood (search for similar items in EconPapers)
JEL-codes: C13 E31 E50 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2008-04
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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