Abstract
The common practice in monetary economics is to linearize a model around its deterministic equilibrium. In this paper, we show analytically that when central banks stabilize both output and inflation, a standard dynamic New Keynesian model has three deterministic equilibria under a realistic parameterization. One is associated with targeted inflation as is commonly found in the literature; the other two are associated with deflation and high inflation. Our findings suggest that empirical research should allow for multiple equilibria or regimes, including both the one with high inflation and the one with deflation, in modeling inflation dynamics.
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Notes
In this paper, we use deterministic steady states and deterministic equilibria interchangeably.
Another approach is to let data speak out the number of regimes directly. For example, Bianchi and Melosi (2017) estimate a MS-VAR model to determine that the number of regimes in a DSGE model should be three. Isakin and Ngo (2019) use the bootstrap method to identify three as the number of regimes in an unobserved component stochastic volatility model.
Another branch of the regime switching DSGE literature is associated with a single deterministic steady state. Bianchi (2012) models structural changes in monetary and fiscal policies and estimates a model in which the monetary/fiscal policy mix follows a six-regime Markov chain. Liu et al. (2009) study the expectation effect of regime switches using a model where monetary policy switches between dovish and hawkish regimes. Baele et al. (2015) estimate a DNK model with regime switches in monetary policy and macro-shocks using survey-based expectations for inflation and output. In these papers, there is only one deterministic steady state because the switching in monetary and fiscal policies is relevant at steady state.
We also analyzed the role of deterministic technology on inflation in different regimes. However, we found that permanent technology shock does not affect relative inflation in the regimes. To save space, we do not report that result.
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We are grateful to the financial support from the Faculty Scholarship Initiative (FSI) Program of the Cleveland State University. We thank an anonymous referee and the editor George S. Tavlas for helpful discussions and comments.
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Isakin, M., Ngo, P.V. Multiplicity in New Keynesian Models. Open Econ Rev 33, 505–521 (2022). https://doi.org/10.1007/s11079-021-09643-5
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DOI: https://doi.org/10.1007/s11079-021-09643-5