Kiel Working Papers, Kiel Institute for World Economics
No 1357:
Expectation Effects of Regimes Shifts in Monetary Policy
Zheng Liu, Daniel F. Waggoner and Tao Zha
Abstract: We assess the quantitative importance of 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. 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.
42 pages, June 2007
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