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Optimal monetary policy in Markov-switching models with rational expectations agents

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  • Andrew P Blake
  • Fabrizio Zampolli

Abstract

In this paper we consider the optimal control problem of models with Markov regime shifts and forward-looking agents. These models are very general and flexible tools for modelling model uncertainty. An algorithm is devised to compute the solution of a linear rational expectations model with random parameters or regime shifts. This algorithm can also be applied in the optimisation of any arbitrary instrument rule. A second algorithm computes the time-consistent policy and the resulting Nash-Stackelberg equilibrium. Similar methods can be easily employed to compute the optimal policy under commitment. Furthermore, the algorithms can also handle the case in which the policymaker and the private sector hold different beliefs. We apply these methods to compute the optimal (non-linear) monetary policy in a small open economy subject to random structural breaks in some of its key parameters.

Suggested Citation

  • Andrew P Blake & Fabrizio Zampolli, 2006. "Optimal monetary policy in Markov-switching models with rational expectations agents," Bank of England working papers 298, Bank of England.
    • Handle: RePEc:boe:boeewp:298
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    References listed on IDEAS

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    Cited by:

    1. Tao Zha & Juan F. Rubio-Ramirez & Daniel F. Waggoner & Andrew T. Foerster, 2010. "Perturbation Methods for Markov-Switching Models," 2010 Meeting Papers 239, Society for Economic Dynamics.
    2. Barthélemy, Jean & Marx, Magali, 2017. "Solving endogenous regime switching models," Journal of Economic Dynamics and Control, Elsevier, vol. 77(C), pages 1-25.
    3. Andrew Foerster & Juan F. Rubio‐Ramírez & Daniel F. Waggoner & Tao Zha, 2016. "Perturbation methods for Markov‐switching dynamic stochastic general equilibrium models," Quantitative Economics, Econometric Society, vol. 7(2), pages 637-669, July.
    4. Xiaoshan Chen & Ronald Macdonald, 2012. "Realized and Optimal Monetary Policy Rules in an Estimated Markov-Switching DSGE Model of the United Kingdom," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(6), pages 1091-1116, September.
    5. Richhild Moessner, 2006. "Optimal discretionary policy in rational expectations models with regime switching," Bank of England working papers 299, Bank of England.
    6. repec:hal:spmain:info:hdl:2441/644vfdaim38frrvbit4u0bh0ha is not listed on IDEAS
    7. Barthélemy, J. & Marx, M., 2011. "State-Dependent Probability Distributions in Non Linear Rational Expectations Models," Working papers 347, Banque de France.
    8. Jean Barthélemy & Magali Marx, 2016. "Solving Endogenous Regime Switching Models," SciencePo Working papers hal-03393181, HAL.
    9. repec:spo:wpmain:info:hdl:2441/644vfdaim38frrvbit4u0bh0ha is not listed on IDEAS
    10. Troy Davig, 2016. "Phillips Curve Instability and Optimal Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 48(1), pages 233-246, February.
    11. Pardo, S. & Rautureau, N. & Vallée, T., 2011. "Optimal versus realized policy rules in a regime-switching framework," Economic Modelling, Elsevier, vol. 28(6), pages 2761-2775.
    12. Farmer, Roger E.A. & Waggoner, Daniel F. & Zha, Tao, 2009. "Understanding Markov-switching rational expectations models," Journal of Economic Theory, Elsevier, vol. 144(5), pages 1849-1867, September.
    13. repec:hal:spmain:info:hdl:2441/7l23tbn4rd9539sljmp8of2hcb is not listed on IDEAS
    14. repec:spo:wpmain:info:hdl:2441/7l23tbn4rd9539sljmp8of2hcb is not listed on IDEAS
    15. André P. Calmon & Thomas Vallée & João B. R. Do Val, 2009. "Monetary policy as a source of uncertainty," Working Papers hal-00422454, HAL.
    16. Doğan, İbrahim & Bilgili, Faik, 2014. "The non-linear impact of high and growing government external debt on economic growth: A Markov Regime-switching approach," Economic Modelling, Elsevier, vol. 39(C), pages 213-220.

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