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2017-24 | September 2017

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Endogenous Regime Switching Near the Zero Lower Bound

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This paper develops a New Keynesian model with a time-varying natural rate of interest (r-star) and a zero lower bound (ZLB) on the nominal interest rate. The representative agent contemplates the possibility of an occasionally binding ZLB that is driven by switching between two local rational expectations equilibria, labeled the "targeted" and "deflation" solutions, respectively. Sustained periods when the real interest rate remains below the central bank's estimate of r-star can induce the agent to place a substantially higher weight on the deflation equilibrium, causing it to occasionally become self-fulfilling. I solve for the time series of stochastic shocks and endogenous forecast rule weights that allow the model to exactly replicate the observed time paths of the U.S. output gap and quarterly inflation since 1988. In model simulations, raising the central bank's inflation target to 4% from 2% can reduce, but not eliminate, the endogenous switches to the deflation equilibrium.

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Article Citation

Lansing, Kevin J. 2017. "Endogenous Regime Switching Near the Zero Lower Bound ," Federal Reserve Bank of San Francisco Working Paper 2017-24. Available at https://doi.org/10.24148/wp2017-24