Quantitative Economics: Jul, 2011, Volume 2, Issue 2

Sources of macroeconomic fluctuations: A regime-switching DSGE approach

Zheng Liu, Daniel F. Waggoner, Tao Zha

We examine the sources of macroeconomic fluctuations by estimating a variety
of richly parameterized DSGE models within a unified framework that incorpo-
rates regime switching both in shock variances and in the inflation target. We
propose an efficient methodology for estimating regime-switching DSGE mod-
els. Our counterfactual exercises show that changes in the inflation target are not
the main driving force of high inflation in the 1970s. The model that best fits the
U.S. time-series data is the one with synchronized shifts in shock variances across
two regimes, and the fit does not rely on strong nominal rigidities. We provide ev-
idence that a shock to the capital depreciation rate, which resembles a financial
shock, plays a crucial role in accounting for macroeconomic fluctuations.
Keywords. Regime switch, depreciation shock, financial shock, Müeller method,
volatility changes, inflation target.
JEL classification. C11, C51, E32, E42, E52.

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