ESRI Discussion Paper Series No.312
Monetary Policy Regime Shifts Under the Zero Lower Bound:
An Application of a Stochastic Rational Expectations Equilibrium to a Markov Switching DSGE Model

Hirokuni Iiboshi
Professor, Graduate School of Social Sciences, Tokyo Metropolitan University


I extend a simple new Keynesian model with the Markov-switching-type Taylor rule introduced by Davig and Leeper (2007 ) by incorporating the constraint of the zero lower bound (ZLB), using the concept and algorithms of the stochastic rational expectations equilibrium proposed by Billi (2013). According to the calibration, when an economy does not face the ZLB constraint, there is no gap in the fluctuation of output and inflation between stochastic expectations and perfect foresight because of the linear policy functions. In contrast, once negative aggregate demand shocks make the nominal interest rate hit the ZLB under stochastic expectations, unlike perfect foresight, intensifying uncertainty plays an important role in further declines of the output and price level even in response to the same shock, regardless of the monetary policy regime adopted. The calibration also indicates the possibility that the steady states of a model, in the absence of the ZLB, are underestimated in periods of deflation, since the means often used as estimates of the steady states are biased downward from these. The analysis sheds light on an exit strategy from the zero interest rate policy, since a passive policy regime reduces the expected interest rate and induces both the expected output and the inflation to increase under the ZLB.

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  2. page1
  3. page2
    1 Introduction
  4. page4
    2 Motivation
    1. page6
      Figure 1: Perfect foresight vs. Stochastic Rational Expectationsy
    2. page7
      Figure 2: Expected values of Markov-swiching DSGE model under stochastic rational expectations
  5. page8
    3 Model
    1. page8
      3.1 Set-up
    2. page10
      3.2 Stochastic Rational Expectation Equilibrium (SREE)
    3. page15
      3.3 Application of an SREE to an MS-DSGE Model
  6. page17
    4 Calibration
    1. page17
      4.1 Method
    2. page18
      4.2 Calibration Parameters
    3. page19
      Table 1: Parameter Values
  7. page20
    5 Policy Evaluation
    1. page20
      5.1 Analyses of Policy Functions
    2. page20
      5.2 Comparison of the Impulse Response Functions
      1. page21
        Figure 3: Policy functions; non-ZLB vs. ZLB
      2. page22
        Figure 4: Policy functions; Stochastic Expectations vs. Perfect Foresight
      3. page23
        Figure 5: Policy functions; Active Policy Regime vs. Passive Policy Regime
    3. page24
      5.3 Monte Carlo Study of the Model
      1. page24
        Active Regime vs. Passive Regime
        1. page25
          Figure 6: Impulse response of Aggregate Demand Shock conditional on each
        2. page26
          Figure 7: Impulse response of Aggregate Demand Shock under each expectations
        3. page28
          Table 2: Monte Carlo Simulations conditional on Specified Regimes
        4. page29
          Figure 8: Intuitive Interpretation of Calibration Results; Active Policy vs. Passive Policy
        5. page30
          Figure 9: Calibrations; Active Policy vs. Passive Policy
      2. page31
        Regime-Switching Policy vs. Fixed Policy
      3. page31
        The Impact of Mitigating the Uncertainty of Demand Shocks to an Economy
        1. page32
          Table 3: Monte Carlo Simulations under Regime Switching and Fixed Policies
        2. page33
          Figure 10: Calibrations; Regime Switcthing Policy vs. Fixed Policy
        3. page34
          Figure 11: 20% Reduction of St.D of Aggregate Demand Shock
        4. page35
          Table 4: 20% Reduction of Std Dev of Aggregate Demand Shock under Regime Switching and Fixed Policies
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    6 Conclusion
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