Markov Switching Monetary Policy in a two-country DSGE model

Using real-time data for the US and the Eurozone I find evidence in favor of 1) regime changes in US monetary policy since 1999 and 2) the fact that the responses inflation and output in the Eurozone are sensitive to the regime of US monetary policy. I examine this case theoretically through the lens of a New Keynesian two-country model. Foreign monetary policy changes regimes over time and agents in both countries are aware of the possibility of those. This affects home inflation and output volatility and their responses to shocks, substantially, as long as the home central bank commits to a time invariant interest rate rule. Optimal policy in the home country instead reacts to the regime of foreign monetary policy and so implies a time-varying interest rate rule. In this case, the effect of foreign regime shifts on home agents expectations is offset, leaving home inflation and output completely
unaffected.