Modelling Occasionally Binding Constraints Using Regime-Switching
- Andrew Binning and Junior Maih
- Working Paper
Occasionally binding constraints are part of the economic landscape: for instance recent experience with the global financial crisis has highlighted the gravity of the lower bound constraint on interest rates; mortgagors are subject to more stringent borrowing conditions when credit growth has been excessive or there is a downturn in the economy. In this paper we take four common examples of occasionally binding constraints in economics and demonstrate how to use regime-switching to incorporate them into DSGE models. In particular we investigate the zero lower bound constraint on interest rates, occasionally binding collateral constraints, downward nominal wage rigidities and irreversible investment. We compare our approach against some well-known methods for solving occasionally-binding constraints. We demonstrate the versatility of our regime-switching approach by combining multiple occasionally binding constraints to a model solved using higher-order perturbation methods, a feat that is difficult to achieve using alternative methodologies.
Norges Bank’s working papers present research projects and reports that are generally not in their final form. Other analyses by Norges Bank’s economists are also included in the series. The views and conclusions in these documents are those of the authors.
ISSN 1502-8190 (online)