A generalized approach to indeterminacy in linear rational expectations models

Abstract

We propose a novel approach to deal with the problem of indeterminacy in linear rational expectations models. The method consists of augmenting the original state space with a set of auxiliary exogenous equations to provide the adequate number of explosive roots in presence of indeterminacy. The solution in this expanded state space, if it exists, is always determinate, and is identical to the indeterminate solution of the original model. The proposed approach accommodates determinacy and any degree of indeterminacy, and it can be implemented even when the boundaries of the determinacy region are unknown. Thus, the researcher can estimate the model using standard software packages without restricting the estimates to the determinacy region. We combine our solution method with a novel hybrid Metropolis–Hastings algorithm to estimate the New–Keynesian model with rational bubbles by Galí (2021) over the period 1982:Q4–2007:Q3. We find that the data support the presence of two degrees of indeterminacy, implying that the central bank was not reacting strongly enough to the bubble component.