DP5919 Indeterminacy in a Forward Looking Regime Switching Model

Author(s): Roger E A Farmer, Daniel F Waggoner, Tao Zha
Publication Date: October 2006
Keyword(s): indeterminacy, regime switching, Taylor Principle
JEL(s): C3, E4, E5
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5919

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.