Working Paper: CEPR ID: DP5919
Authors: Roger E. A. Farmer; Daniel F. Waggoner; Tao Zha
Abstract: This paper is about the properties of Markov switching rational expectations (MSRE) models. We present a simple monetary policy model that switches between two regimes with known transition probabilities. The first regime, treated in isolation, has a unique determinate rational expectations equilibrium and the second contains a set of indeterminate sunspot equilibria. We show that the Markov switching model, which randomizes between these two regimes, may contain a continuum of indeterminate equilibria. We provide examples of stationary sunspot equilibria and bounded sunspot equilibria which exist even when the MSRE model satisfies a 'generalized Taylor principle'. Our result suggests that it may be more difficult to rule out non-fundamental equilibria in MRSE models than in the single regime case where the Taylor principle is known to guarantee local uniqueness.
Keywords: indeterminacy; regime switching; Taylor principle
JEL Codes: C3; E4; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| First regime (P30) | unique determinate rational expectations equilibrium (C62) |
| Second regime (P30) | set of indeterminate sunspot equilibria (C62) |
| MSRE model randomizes between regimes (C32) | continuum of indeterminate equilibria (D50) |
| Actions of policymakers in single regime (D78) | cannot rule out stationary sunspot equilibria in MSRE models (C62) |
| Generalized Taylor principle (C61) | does not guarantee local uniqueness in presence of regime switching (C32) |