Working Paper: NBER ID: w1398
Authors: Michael Mussa
Abstract: 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.
Keywords: rational expectations; dynamic processes; economic sensibility
JEL Codes: E30; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| number of stable roots (C62) | economic sensibility (A13) |
| number of stable roots (C62) | number of independent backward looking processes (C69) |
| number of stable roots (C62) | multiple nonexplosive solutions (L72) |
| multiple nonexplosive solutions (L72) | economic sensibility (A13) |
| model parameters (C51) | economic interpretations (D46) |
| stable roots (C62) | economic outcomes (F61) |