Monetary Policy Regime Switches and Macroeconomic Dynamics

Abstract

This paper investigates how different monetary policy regime switching types impact macroeconomic dynamics. Policy switches that either affect the inflation target or the response to inflation deviations from target lead to different determinacy regions and different output, inflation, and interest rate distributions. With regime switching, the standard Taylor Principle breaks down in multiple ways; satisfying the Principle period-by-period is neither necessary nor sufficient for determinacy. Switching inflation targets primarily affects the economy’'s level, whereas switching inflation responses affects the variance. Even in periods with a fixed monetary policy rule, expectations of future policy switches produce different outcomes depending upon the switching type. Monetary authorities with given inflation objectives need to adjust their policy parameters to counteract expectations of future policy switches.

Keywords: regime switching, Taylor Rule, infl‡ation targeting, determinacy

JEL Classification: C63, E31, E52