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Economically Sensible Solutions for Linear Rational Expectations Models with Forward and Backward Looking Dynamic Processes

  • Michael L. Mussa
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    Using variants of a modified version of Dornbusch's model of price level and exchange rate dynamics, it is demonstrated that satisfaction of the formal condition for existence of a unigue non-explosive solution of a linear rational expectations model with forward and backward looking dynamic processes (equality of the number of stable roots with the number of independent backward looking processes) does not guarantee the economic sensibility of this solution, even if one accepts the usual arguments for excluding "speculative babbles" from the solutions of such models. Moreover, satisfaction of the formal condition for existence of an infinity of non-explosive solutions for such rational expectations models (more stable roots than independent backward looking processes) does not assure that any of these solutions is economically sensible.

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    File URL: http://www.nber.org/papers/w1398.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1398.

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    Date of creation: Jul 1984
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    Handle: RePEc:nbr:nberwo:1398
    Note: ITI IFM
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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    1. A. S. Blinder & S. Fischer, 1978. "Inventories, Rational Expectations, and the Business Cycle," Working papers 220, Massachusetts Institute of Technology (MIT), Department of Economics.
    2. repec:nbr:nberre:0126 is not listed on IDEAS
    3. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
    4. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
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