Walk on the Wild Side: Temporarily Unstable Paths and Multiplicative Sunspots
Hedibert F. Lopes
- American Economic Review (Forthcoming)
We propose a generalization of the rational expectations framework to allow for temporarily unstable paths. Our approach introduces multiplicative sunspot shocks and it yields drifting parameters and stochastic volatility. Then, we provide an econometric strategy to estimate this generalized model on the data. The methodology allows the data to choose between different possible alternatives: determinacy, indeterminacy and temporary instability. We apply our methodology to US inflation dynamics in the '70s through the lens of a simple New Keynesian model. When temporarily unstable paths are allowed, the data unambiguously select them to explain the stagnation period in the '70s.
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