Federal Reserve Bank of San Francisco Working Paper Series Asymmetric Expectation Effects of Regime Shifts in Monetary Policy Asymmetric Expectation Effects of Regime Shifts in Monetary Policy Asymmetric Expectation Effects of Regime Shifts 2

The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System. Abstract. This paper addresses two substantive issues: (1) Does the magnitude of the expectation effect of regime switching in monetary policy depend on a particular policy regime? (2) Under which regime is the expectation effect quantitatively im-portant? Using two canonical DSGE models, we show that there exists asymmetry in the expectation effect across regimes. The expectation effect under the dovish policy regime is quantitatively more important than that under the hawkish regime. These results suggest that the possibility of regime shifts in monetary policy can have important effects on rational agents' expectation formation and on equilibrium dynamics. They offer a theoretical explanation for the empirical possibility that a policy shift from the dovish regime to the hawkish regime may not be the main source of substantial reductions in the volatilities of inflation and output. an anonymous referee, and especially Michael Golosov and Richard Rogerson for helpful suggestions and discussions. Jean Boivin and Marc Giannoni kindly provided us with their Matlab code for computing MSV solutions. We are grateful to Joan Gieseke for editorial assistance. Liu wishes to thank the Federal Reserve Banks of Atlanta and Minneapolis for their hospitality. The views expressed herein are those of the authors and do not necessarily reflect the views of the Federal Reserve Banks of Atlanta and San Francisco or the Federal Reserve System. [Lucas (1976)] has expressed the view that it makes no sense to think of the government as conducting one of several possible policies while at the same time assuming that agents remain certain about the policy rule in effect. Explicit modelling of the connection of expectation-formation mechanisms to policy [regime] in an accurately identified model would allow better use of the data.