2017-24 | August 2018
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Endogenous Regime Switching Near the Zero Lower Bound
This paper develops a New Keynesian model in which the representative agent contemplates the possibility of an occasionally binding zero lower bound (ZLB) that is driven by switching between two local equilibria, labeled the "targeted" and "deflation" regimes, respectively. Sustained periods when the equilibrium real interest rate remains below its estimated long-run value can induce the agent to place a substantially higher weight on the deflation forecast rules, causing the deflation equilibrium to occasionally become fully realized. 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, quarterly inflation, and the federal funds rate since 1988. The data since the start of the ZLB episode in 2008.Q4 are best described as a mixture of the two local equilibria. 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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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