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Keywords:

  • Regime switch;
  • depreciation shock;
  • financial shock;
  • Müeller method;
  • volatility changes;
  • inflation target
  • C11;
  • C51;
  • E32;
  • E42;
  • E52

We examine the sources of macroeconomic fluctuations by estimating a variety of richly parameterized DSGE models within a unified framework that incorporates regime switching both in shock variances and in the inflation target. We propose an efficient methodology for estimating regime-switching DSGE models. Our counterfactual exercises show that changes in the inflation target are not the main driving force of high inflation in the 1970s. The model that best fits the U.S. time-series data is the one with synchronized shifts in shock variances across two regimes, and the fit does not rely on strong nominal rigidities. We provide evidence that a shock to the capital depreciation rate, which resembles a financial shock, plays a crucial role in accounting for macroeconomic fluctuations.