Origins of Monetary Policy Shifts: A New Approach to Regime Switching in DSGE Models
CAEPR Working Paper Series 2018-011
41 Pages Posted: 16 Dec 2018 Last revised: 4 Mar 2021
Date Written: February 17, 2021
We examine monetary policy shifts by taking a new approach to regime switching in a small scale monetary DSGE model with threshold-type switching in the monetary policy rule. The policy response to inﬂation is allowed to switch endogenously between two regimes, hawkish and dovish, depending on whether a latent regime factor crosses a threshold level. Endogeneity stems from the historical impacts of structural shocks driving the economy on the regime factor. We quantify the endogenous feedback from each structural shock to the regime factor to understand the sources of the observed policy shifts. This new channel sheds new light on the interaction between policy changes and measured economic behavior. We develop a computationally eﬃcient ﬁltering algorithm for state-space models with time-varying transition probabilities that handles classical regression models as a special case. We apply this ﬁlter to estimate our DSGE model using the U.S. data and ﬁnd strong evidence of endogeneity in the monetary policy shifts.
Keywords: Monetary policy, DSGE model, regime switching, latent autoregressive regime factor, endogenous feedback, expectation formation eﬀects
JEL Classification: E52, C13, C32
Suggested Citation: Suggested Citation