Working Paper No. 677
By Katerina Petrova, George Kapetanios, Riccardo M Masolo and Matthew Waldron
We estimate a time varying parameter structural macroeconomic model of the UK economy, using a Bayesian local likelihood methodology. This enables us to estimate a large open-economy DSGE model over a sample that comprises several different regimes and an incomplete set of data. Our estimation identifies a gradual shift to a monetary policy regime characterised by a marked increase in the responsiveness of monetary policy to inflation alongside a decrease in the level of trend inflation down to the 2% target level. The time varying model also performs remarkably well in forecasting and delivers statistically significant accuracy improvements for most variables and horizons in both point and density forecast performance compared to the standard fixed parameter version.