CONSISTENT EXPECTATIONS EQUILIBRIA IN MARKOV REGIME SWITCHING MODELS AND INFLATION DYNAMICS

Marco Airaudo and Ina Hajdini

International Economic Review, 2021, vol. 62, issue 4, 1401-1430

Abstract: We study the existence of Stochastic Consistent Expectations Equilibria (SCEE) in linear Markov regime switching models. An SCEE exists when the model‐implied mean and first‐order autocorrelation coincide with those predicted by the agents via misspecified forecasting rules. For a simple regime‐switching monetary policy model, the parametric space where at least one SCEE exists is rather wide, and may extend well beyond the rational expectations equilibrium determinacy frontier. Misspecified expectations combined with regime switching yield a strong endogenous amplification mechanism that help generate the near unit root dynamics for inflation observed in the United States before the Great Moderation.

Date: 2021
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