Working Paper 653

Asymmetric Expectation Effects of Regime Shifts and the Great Moderation

Zheng Liu
Daniel F. Waggoner
Tao Zha

Revised October 1, 2007

The possibility of regime shifts in monetary policy can have important effects on rational agents’ expectation formation and equilibrium dynamics. In a DSGE 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 regime.

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