The possibility of regime shifts in monetary policy can have important effects on rational agents' expectation formation and equilibrium dynamics. In a dynamic stochastic general equilibrium model where the monetary policy rule switches between a dovish regime that accommodates inflation and a hawkish regime that stabilizes inflation, the expectation effect is asymmetric across regimes. Such an asymmetric effect makes it difficult but still possible to generate substantial reductions in the volatilities of inflation and output as the monetary policy switches from the dovish regime to the hawkish one.
JEL classification: E32, E42, E52
Key words: structural breaks, expectations formation, monetary policy regime, macroeconomic volatility, Lucas critique
The authors thank Jean Boivin, Jeff Campbell, V.V. Chari, Roger Farmer, Marc Giannoni, Marvin Goodfriend, Alejandro Justiniano, Nobu Kiyotaki, and especially Michael Golosov and Richard Rogerson for helpful suggestions and discussions. Jean Boivin and Marc Giannoni kindly provided us with their Matlab code for computing minimum state variable solutions. The authors also thank Joan Gieseke for editorial assistance. Liu thanks the Federal Reserve Banks of Atlanta and Minneapolis for their hospitality. The views expressed here are the authors' and not necessarily those of the Federal Reserve Banks of Atlanta and Minneapolis or the Federal Reserve System. Any remaining errors are the authors' responsibility.
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