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

Michael L. Mussa

NBER Working Paper No. 1398
Issued in July 1984
NBER Program(s):International Trade and Investment Program, International Finance and Macroeconomics Program

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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Document Object Identifier (DOI): 10.3386/w1398

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