SOLVING STOCHASTIC SADDLEPOINT SYSTEMS: A QUALITATIVE TREATMENT WITH ECONOMIC APPLICATIONS

We examine the effect of introducing stochastic shocks into a linear rational expectations model with saddlepoint dynamics generated by a forward-looking asset price. We derive the fundamental differential equation governing the path of the asset price as a function of the "sluggish" variable. The equation does not admit of closed form solutions in general, but we provide a complete qualitative characterization of the solution paths which are symmetric about equilibrium. These are the relevant solutions to consider in the presence of symmetric boundary conditions. We present two applications. The first analyzes how financial markets might react to the implementation of fiscal stabilization policy where public expenditures are only adjusted when GNP moves outside a threshold around a target level. Bond prices are perfectly flexible and move to satisfy an arbitrage condition. The second examines exchange rate behavior in the presence of a currency subject to a known realignment rule requiring an adjustment to monetary policy.


Issue Date:
Oct 10 1988
Publication Type:
Working or Discussion Paper
Record Identifier:
http://ageconsearch.umn.edu/record/268343
Language:
English
Total Pages:
34




 Record created 2018-02-14, last modified 2018-02-15

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