Model uncertainty and endogenous volatility

This paper identifies two channels through which the economy can generate endogenous inflation and output volatility, an empirical regularity, by introducing model uncertainty into a Lucas-type monetary model. The equilibrium path of inflation depends on agents' expectations and a vector of exogenous random variables. Following Branch and Evans agents are assumed to underparameterize their forecasting models [Branch, W., Evans, G.W., 2006a. Intrinsic heterogeneity in expectation formation. Journal of Economic Theory 127, 264-295]. A Misspecification Equilibrium arises when beliefs are optimal, given the misspecification, and predictor proportions are based on relative forecast performance. We show that there may exist multiple Misspecification Equilibria, a subset of which is stable under least squares learning and dynamic predictor selection. The dual channels of least squares parameter updating and dynamic predictor selection combine to generate regime switching and endogenous volatility. (c) 2006 Elsevier Inc. All rights reserved.