We propose a generalization of the rational expectations framework to allow for temporarily unstable paths. Our approach introduces multiplicative sunspot shocks and it yields drifting parameters and stochastic volatility. Then, we provide an econometric strategy to estimate this generalized model on the data. The methodology allows the data to choose between different possible alternatives: determinacy, indeterminacy, and temporary instability. We apply our methodology to US in?ation dynamics in the 1970s through the lens of a simple New Keynesian model. When temporarily unstable paths are allowed, the data unambiguously select them to explain the stag?ation period in the 1970s.
ASJC Scopus subject areas
- Economics and Econometrics