This chapter first defines rational expectations, which is an extension to stochastic environments of the idea of perfect foresight. It characterizes the original Muth (1961) model, which exhibits how a number of results on the proliferation of shocks and stability are evaluated. Also, it discusses the efficacy of government policy and reveals that the prominent result attained under the notion of perfect foresight carries through in a stochastic environment. Further, it examines a very famous macroeconomic model, the Cagan (1956) model, which was initially designed to see whether price dynamics could degenerate into hyperinflation. The dynamics of the model are compared under two different expectations schemes: adaptive expectations and rational expectations. The chapter then investigates the set of solutions to a stochastic dynamic equation.
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