An Analysis of a Macro-Econometric Model with Rational Expectations in the Bond and Stock Markets

The difficulty of accounting for expectational effects in macro-economic models is well known. The standard procedure in dealing with this problem in the construction of large-scale macro-econometric models is to use current and lagged values as “proxies” for expected future values. An alternative procedure is to assume that expectations are rational. Although the assumption of rational expectations has received increased attention lately in work with theoretical and small-scale empirical models,’ it has not yet been applied to large-scale macro-econometric models. In thii paper the assumption that expectations are rational in the bond and stock markets will be applied to a large-scale macro-econometric model. The quantitative effects of monetary and fiscal policies in this model will be compared to those in a similar model without rational expectations. The quantitative sensitivity of monetary and fiscal policy effects to alternative expectational assumptions is clearly an important question in macroeconomics, and the primary purpose of this paper is to provide an estimate of this sensitivity for the assumption of rational expectations in the bond and stock markets. The econometric model that is used in this study is the one in my 1976 book. Three ‘versions” of this model are analyzed: the original version and two modified versions.