Monetary Policy in a Markov-Switching VECM: Implications for the Cost of Disinflation and the Price Puzzle

Abstract

Monetary policy VARs typically presume stability of the long-run outcomes.We introduce the possibility of switches in the long-run equilibrium in a cointegrated VAR by allowing both the covariance matrix and weighting matrix in the error-correction term to switch.We find that monetary policy alternates between sustaining long-run growth and disinflationary regimes.Allowing state changes can also help explain the price puzzle and justify the use of commodity prices as a corrective measure.Finally, we show that regime-switching has implications for disinflationary monetary policy and can explain the variety of sacrifice ratio estimates that exist in the literature.

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