In Sims(2002), the author explains how one solves a linear rational expectations model.

$$\Gamma_0S_t=\Gamma_1S_{t-1}+C+\Psi z_t + \Pi \mu_t$$

The only thing exogenously defined in the $z_t$ variable. Everything else is endogenous.

In the Smets and Wouters (2007) paper, we have the monetary policy rule dependent on the potential output, i.e. the output at flexible prices and wages.

How do we deal with the potential output? Is it assumed to be endogenous, and then included in the $S$ terms? If so, will I have to create $S=(S^f,S^s)'$, where $S^f$ are the state variables for the flexible economy, and $S^s$ are the state variables for the sticky economy?



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