Endogenous Forecast Switching Near the Zero Lower Bound

Abstract

A representative agent contemplates the possibility of an occasionally binding zero lower bound (ZLB) on the nominal interest rate that is driven by switching between two local equilibria, labeled the "targeted" and "deflation" solutions, respectively. This view turns out to be true in simulations, thus validating the agent's beliefs. I solve for the time series of stochastic shocks and endogenous forecast weights that allow the model to exactly replicate the observed time paths of U.S. data since 1988. The data since the start of the ZLB episode in 2008.Q4 are best described as a time-varying mixture of the two local equilibria. Note: The first version of this paper was September 28, 2017, and was published originally as "Endogenous Regime Switching Near the Zero Lower Bound." A subsequent revision was titled "Endogenous Regime Shifts in a New Keynesian Model with a Time-Varying Natural Rate of Interest."

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