RDP 9611: A Markov-Switching Model of Inflation in Australia 5. Conclusion

By focusing on relatively simple equations in a framework that allows regimes to change, Markov-switching models would appear to provide a useful supplement to conventional modelling strategies for inflation. The results suggest that, within this framework, inflation in Australia since the early 1960s is reasonably well modelled by a two-regime specification, with regime changes occurring in the early 1970s and early 1990s. Within each regime, inflation in the preferred model is characterised by a simple autoregressive process supplemented by information about the output gap. The analysis may provide some insight into the behaviour of expectations, suggesting that within this limited-information framework it may be rational for imperfectly informed observers to change the forecasting rule only infrequently.