Rational Sunspots

Mar 2016 | 787

Authors: Guido Ascari Paolo Bonomolo Hedibert F. Lopes


The instability of macroeconomic variables is usually ruled out by rational expectations. We propose a generalization of the rational expectations framework to estimate possible temporary unstable paths. Our approach yields drifting parameters and stochastic volatility. The methodology allows the data to choose between different possible alternatives: determinacy, indeterminacy and instability. We apply our methodology to US inflation dynamics in the ‘70s through the lens of a simple New Keynesian model. When unstable RE paths are allowed, the data unambiguously select them to explain the stagflation period in the ‘70s.Thus, our methodology suggests that US inflation dynamics in the ‘70s is better described by unstable rational equilibrium paths.

JEL Codes: E31, E52

Keywords: Rational Expectations, Sunspots, Instability, Indeterminacy, Inflation, Monetary Policy.

View All Working Papers