We propose a generalization of the rational expectations framework to allow for multiplicative sunspot shocks and temporarily unstable paths. Then, we provide an econometric strategy to estimate this generalized model on the data. Our approach yields drifting parameters and stochastic volatility. The methodology allows the data to choose between different possible alternatives: determinacy, indeterminacy and temporary instability. We apply our methodology to US inflation dynamics in the ˜70s through the lens of a simple New Keynesian model. When temporarily unstable paths are allowed, the data unambiguously select them to explain the stagflation period in the ˜70s.
Keywords: Rational Expectations, Sunspots, Instability, Indeterminacy, Inflation, Monetary Policy.
JEL classifications: E31, E52.
Working paper no. 597