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Rational expectations and M2 demand.

Article Excerpt
Abstract

This essay expands on existing studies of M2 money demand. It differs in that it applies a rational expectations approach to an adaptive expectation model. Unlike the adaptive expectations models, the author includes an explanatory variable for expectations of future inflation. The expectation variables used are: the actual inflation rate (t + 1) and the Livingston Survey from the Philadelphia Fed. By using the different measures of expectations the author is able to compare several adaptive expectations models that appear in the literature and the rational expectations models for fit and forecast ability. The empirical results are such that the importance of including the rational expectations variable is evident even though the overall fit of the equation is comparable to one of the existing adaptive expectations models. (JEL E4)

Introduction

Past empirical studies of M2 money demand typically limit the explanatory variables to GDP, the opportunity cost of M2, and lagged values of those variables. Such studies include Mehra [1993], Hetzel and Mebra [1989], and Hetzel [1989]. These adaptive expectations models are very useful and tend to explain money demand well. However, assuming that economic agents are rational, theoretically modeling this behavior is necessary. This paper extends the adaptive expectations error correction...

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