Asymmetric expectation effects of regime shifts and the Great Moderation

Zheng Liu, Daniel Waggoner and Tao Zha

No 653, Working Papers from Federal Reserve Bank of Minneapolis

Abstract: We assess the quantitative importance of the expectation effects of regime shifts in monetary policy in a DSGE model that allows the monetary policy rule to switch between a ?bad? regime and a ?good? regime. When agents take into account such regime shifts in forming expectations, the expectation effect is asymmetric across regimes. In the good regime, the expectation effect is small despite agents? disbelief that the regime will last forever. In the bad regime, however, the expectation effect on equilibrium dynamics of inflation and output is quantitatively important, even if agents put a small probability that monetary policy will switch to the good regime. Although the expectation effect dampens aggregate fluctuations in the bad regime, a switch from the bad regime to the good regime can still substantially reduce the volatility of both inflation and output, provided that we allow some ?reduced-form? parameters in the private sector to change with monetary policy regime. Much of the volatility reduction is attributed to a structural break in the persistence of equilibrium dynamics of macroeconomic variables.

Keywords: Monetary policy; Inflation (Finance) (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Related works:
Working Paper: Asymmetric expectation effects of regime shifts and the Great Moderation (2007)
Working Paper: Asymmetric Expectation Effects of Regime Shifts and the Great Moderation (2007)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmwp:653

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