A Model of Stochastic Process Switching

Abstract

Often, a policy authority such as a central bank operates by establishing a policy rule to set the variables under its control. Such a rule is allowed to operate freely as long as certain endogenous variables of interest to the authority remain within particular bounds; however, then those endogenous variables cross their bounds, the authority switches toa new policy rule which it had prepared to meet this contingency. Since variable such as prices are determined partly by agents' beliefs about future events, agents' behavior injects the probabilities that policy switches will occur at particular future times into current price determination.

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