Policy evaluation and design in the light of rational expectations

Abstract

This thesis examines certain key problems that the existence of forward rational expectations poses for policy analysis. The separate stages of estimating, testing and solving an econometric model are dealt with in turn. The main body of original work is in chapters four and six. In chapter four the problem of the existence of a continuum of solutions to a rational expectations model is addressed. We show that the existing practice of imposing terminal conditions is arbitrary and a procedure is advanced which in principle at least, can be used to estimate the solution jointly with the parameters. In chapter six analytical closed forms for the first order conditions of the likelihood function of the endogenous variables of a general rational expectations model are derived. We believe this is a major contribution to the literature because it opens the door to computationally efficient and cheap likelihood estimation, something not previously available. The first order conditions for a class of models with no predetermined variables has been programmed in Fortran IV and this has been used in chapter seven to estimate a model of financial asset demands. A likelihood ratio test of restrictions implied by rational expectations is comfortably passed so establishing empirical support for the hypothesis. Other original work in the thesis is contained in chapter five. Here we scrutinise the validity of a simulation technique advanced by Fair and Anderson which it is claimed solves a standard non rational model to yield an approximate rational expectations solution. The results of the chapter suggest the method is better in certain circumstances than in others and these circumstances pertain to the make up of the model in question. Finally, chapters two and three cast a critical eye over the policy analysis literature to which a minor contribution is made