Optimal Discretionary Policy in Rational Expectations Models with Regime Switching

The existence of and uncertainty about structural change in the economy are important features facing policymakers. This paper considers the implications for policy design of uncertainty about structural change, modelling the time variation in parameters of forward-looking models as Markov processes. We extend an algorithm of Backus and Driffill for optimal discretionary policy in rational expectations models to the case with Markov switching in model parameters. As an illustration, we apply our method to determine the optimal monetary policy solution in the presence of structural changes in intrinsic output persistence, within a hybrid New Keynesian model estimated for the euro area. We find that the coefficients of the optimal policy rule are state-dependent, and depend non-linearly on the transition probabilities between states with different values of intrinsic output persistence