Indeterminacy in a Forward Looking Regime Switching Model

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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.

Published: Roger E. A. Farmer & Daniel F. Waggoner & Tao Zha, 2009. "Indeterminacy in a forward-looking regime switching model," International Journal of Economic Theory, The International Society for Economic Theory, vol. 5(1), pages 69-84.

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