Economic Forecasting Using Linear Rational Expectation Model

Abstract

Economic forecasting is an activity to predict the future using economic theory to provide a systematic explanation of the past, which is assumed to occur in the future. One of the models used in economic forecasting is rational expectation. Rational expectation essentially attempts to predict future economic variables to make the right policy. The model discussed in this work is linear. In this study, the macroeconomic dynamics are described into four structural equations, including the output gap, output, inflation and nominal interest rates. This model also involves four variables as sources of exogenous shocks on several economic indicators. Structural equations are then formulated in the form of linear rational expectation model and solved simultaneously by using the undetermined coefficient method. By transforming the solution of this model into state space form, the impulse responses of each endogenous variable due to shocks are given.