methodological contribution is to illustrate how one goes about constructing dynamic, stochastic general equilibrium models to shed light on questions of substantive economic interest. In order to test the proposition that where nominal aggregate demand shocks are highly volatile the effect of any particular nominal aggregate demand shock is less, Lucas got data on nominal and real output/ expenditure covering the years 1951-1967 for 18 countries. He then assumed that, for each country, the mean value of the growth in their nominal expenditure over the whole period was a reasonable estimate of what people were expecting nominal spending growth to be in any particular year. The difference between the actual growth in nominal spending and this mean in any year was used by
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'η ' is the systematic part of monetary policy. Solving the system, Sargent and Wallace assume that markets clear, and by equating the money demand and supply, mtD =mtS, the interest rate can be determined as a function of prices and output, since pt + yt - Rt = η(yt-1 –y*) +t ----------------------------------------------- (2.16)
Hence, Rt =1/ {η (yt-1 –y*) +t –pt – yt} ------------------------------- (2.17)
Equating the aggregate demand and aggregate supply, ytS =ytD,
'η ' is the systematic part of monetary policy. Solving the system, Sargent and Wallace assume that markets clear, and by equating the money demand and supply, mtD =mtS, the interest rate can be determined as a function of prices and output, since pt + yt - Rt = η(yt-1 –y*) +t ----------------------------------------------- (2.16)
Hence, Rt =1/ {η (yt-1 –y*) +t –pt – yt} ------------------------------- (2.17)
Equating the aggregate demand and aggregate supply, ytS =ytD,