Model Uncertainty and Endogenous Volatility
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Date
2005-10-18
Authors
Branch, William A.
Evans, George W., 1949-
Journal Title
Journal ISSN
Volume Title
Publisher
University of Oregon, Dept of Economics
Abstract
This paper identifies two channels through which the economy can generate endogenous inflation and output volatility, an empirical regularity, by introducing model uncertainty into a Lucas-type monetary model. The equilibrium path of inflation depends on agents' expectations and a vector of exogenous random variables. Following Branch and Evans (2004) agents are assumed to underparameterize their forecasting models. A Misspecification Equilibrium arises when beliefs are optimal given the misspecification and predictor proportions based on relative forecast performance. We show that there may exist multiple Misspecification Equilibria, a subset of which are stable under least squares learning and dynamic predictor selection. The dual channels of least squares parameter updating and dynamic predictor selection combine to generate regime switching and endogenous volatility.
Description
41 p.
Keywords
Lucas model, Model uncertainty, Adaptive learning, Rational expectations (Economic theory), Volatility