Day 3: Wednesday

Linear systems and Rational Expectations

CURRENT YEAR LECTURE OUTLINES

Lecture 5: Linear systems and rational expectations models: structure and uses (PDF  of handwritten notes)

Lecture 6: Solving linear RE models: an overview of the theory behind DYNARE (PDF of printed notes)

Michael Siemer’s presentation for Wednesday evening (PDF)

 

Lecture 5A: Linear systems

 

* LS Chapter 2, "Time Series", sections 2.4 and afterwards PDF

Paul Samuelson, Interactions between the multiplier and the principle of acceleration," Review of Economics and Statistics, 1939 PDF

 

Lecture 5B. Introduction to Rational Expectations 

* John F. Muth, “Rational Expectations and the Theory of Price Movements,” Econometrica, vol. 29, no. 3 (July 1961), pages 313-335. PDF 

Robert E. Lucas, Jr., “Econometric Policy Evaluation: A Critique,” in The Phillips Curve and Labor Markets. PDF

 

Lecture 6: Rational Expectations and the Structure of Dynamic Models

* O.J. Blanchard and C. Kahn, “The Solution of Linear Difference Models Under Rational Expectations,” Econometrica, 45, July 1980, 1305-1311. PDF

R.G. King and M.W. Watson, “The Solution of Singular Linear Difference Models Under Rational Expectations”, International Economic Review, 1998. PDF

 

Presentation Materials from prior years

Lecture 5A (PDF)

Lecture 5B (PDF)

Lecture 6   (PDF)

 

Study Problems

There are three areas where rational expectations has had major effects on macroeconomic modeling. Problem 1 illustrates applications to pricing dynamics, along New Keynesian lines, as will be extensively discussed in week 4 of the class. Problem 2 illustrates applications to the term term structure of interest rates.

A virtue of the model solution approach exposited in Lecture 6 is that the underlying economic model can move from one type of behavior to another without the structural equations of the model being altered (only parameters changed) or the solution method being altered. Problem 3 illustrates this idea in the context of a classic area, labor demand, in which the behavior changes from static to dynamic as a result of a change in a parameter.  The connection to singularities in model solution methods is explored. Problem 3 illustrates one manner in which dynamics (forward, backward) are introduced into major macroeconomic policy models.

Problems (PDF) and solutions (PDF). Note: solution to problem 3 not yet provided

A worked example.

It is reassuring to know that there is general theory like that explored in lecture 6, but it is sometimes helpful to work through a detailed example. The attached notes work through the lecture 6 concepts in detail, using a basic model from lecture 5(PDF)