Finance and Economics Discussion Series: 2011-44 Screen Reader version ^{♣}

Rational Expectations Models

Keywords: Solution algorithms, rational expectations.

Abstract:

This paper describes the E-Newton and E-QNewton algorithms for solving rational expectations (RE) models. Both algorithms treat a model's RE terms as exogenous variables whose values are iteratively updated until they (hopefully) satisfy the RE requirement. In E-Newton, the updates are based on Newton's method; E-QNewton uses an efficient form of Broyden's quasi-Newton method. The paper shows that the algorithms are reliable, fast enough for practical use on a mid-range PC, and simple enough that their implementation does not require highly specialized software. The evaluation of the algorithms is based on experiments with three well-known macro models--the Smets-Wouters (SW) model, EDO, and FRB/US--using code written in EViews, a general-purpose, easy-to-use software package. The models are either linear (SW and EDO) or mildly nonlinear (FRB/US). A test of the robustness of the algorithms in the presence of substantial nonlinearity is based on modified versions of each model that include a smoothed form of the constraint that the short-term interest rate cannot fall below zero. In two single-simulation experiments with the standard and modified versions of the models, E-QNewton is found to be faster than E-Newton, except for solutions of small-to-medium sized linear models. In a multi-simulation experiment using the standard versions of the models, E-Newton dominates E-QNewton.

** JEL Classifications:** C15, C53, C32.

This paper describes the E-Newton and E-QNewton algorithms for solving rational expectations (RE) models. Like the Fair-Taylor (FT) procedure (Fair and Taylor, 1983), both algorithms treat a model's RE terms as exogenous variables whose values are iteratively updated until they (hopefully)
satisfy the RE requirement.^{2} To improve solution speed and reliability, the E-Newton algorithm replaces FT's rudimentary updating mechanism with one based on
Newton's method. In this respect, E-Newton is related to the Newton-based stacked-time procedures that are now more widely used than FT for solving nonlinear RE models.^{3} The expectations updates in the E-QNewton algorithm use a quasi-Newton method. This paper shows that the E-Newton and E-QNewton algorithms are not only practical and reliable, but also that they are relatively simple to program and thus do not require highly specialized
software. For several years, solutions of the RE versions of the Federal Reserve Board's nonlinear FRB/US macroeconomic model have been computed using code for the E-Newton algorithm written in EViews, a general-purpose, easy-to-use software package. The E-QNewton algorithm, which has been
developed more recently, is also written in EViews.

The term rational expectations is used here to describe the condition in which expectations of future values are identical to a model's future solutions in the absence of unexpected shocks. That is, there are no expectations errors. For the algorithms described in this paper, the RE solution of a model with expectations variables for periods involves finding the expectations values that set a like number of expectations errors are zero. The FT algorithm tackles this task with a simple mechanism that is equivalent to updating at each iteration the estimate of each expected future value in isolation, using only its own expectations error. In contrast, E-Newton and E-QNewton update all expectations simultaneously, based on all expectations errors and information on the relationship between the expectations estimates and errors. In E-Newton this information takes the form of the Jacobian matrix of first derivatives of the expectations errors with respect to the expectations estimates. E-QNewton uses an approximate Jacobian that is more easily calculated but less accurate than the Newton Jacobian. The relative speed of the two algorithms in solving a particular RE model depends on the model-specific cost trade-off between the accuracy of the Jacobian and the number of iterations needed to achieve an RE solution.

E-Newton runs a set of impulse-response simulations (dynamic multipliers) to compute the values of the derivatives that enter the Jacobian and then inverts this matrix. These operations can be quite costly if the size of the Jacobian, , is large, especially because the time required to invert a matrix depends on the cube of its size. In fact, when an algorithm similar to E-Newton was developed by Holly and Zarrop (1983) many years ago, these costs were judged to be prohibitive for
most RE models.^{4} Although the vast advances in computation power over the past three decades have greatly diminished the importance of this judgment, the
Jacobian costs in E-Newton can nonetheless be substantial for larger RE models. In such cases, faster solutions may be obtained with a quasi-Newton method, because it does not require the explicit calculation of derivatives and can be set up to run without inverting matrices. The E-QNewton
algorithm uses a version of the quasi-Newton method of Broyden (1965) that is described by Kelley (1995). In E-QNewton, execution time is more sensitive to the number of solution iterations than to the size of the Jacobian.

Newton and quasi-Newton methods are used to solve systems of equations that arise in many scientific disciplines. As this paper will show, the efficiency of these methods when applied to solving RE models can be improved by taking advantage of some characteristics that are common to many models of this type. The cost of computing the E-Newton Jacobian can be greatly reduced for many linear and mildly nonlinear RE models through the use of shortcuts that take account of repetitive patterns in their derivatives. In the E-QNewton algorithm, the accuracy of the approximate Jacobian can be improved for most RE models by choosing a very specific initial approximation that is easily calculated.

Section 2 describes the E-Newton and E-QNewton algorithms. Section 3 briefly discusses the three well-known macro models that are used to evaluate the performance of the algorithms: the Smets-Wouters (SW) model, EDO, and FRB/US. SW and EDO are linear DSGE models; FRB/US is mildly nonlinear. Each model is of medium size or larger. To test the algorithms with models that are substantially nonlinear, an alternative version of each model is created that includes a nonlinear but smooth approximation to the constraint that the short-term interest rate cannot fall below zero.

The evaluation of the algorithms in section 4 is based on three simulation experiments. The first is a one-time shock to each model's interest rate policy rule. The second is a shock that reduces output sufficiently to cause the response of the short-term interest rate to be constrained by the zero bound. The third experiment, which requires the execution of a set of RE simulations, assumes that monetary policy responds to a shock by minimizing a loss function.

The first two experiments suggest several conclusions. First, for single simulations of linear RE models, E-Newton is likely to be faster for models of small-to-medium size ( 2000) and E-QNewton is likely to be faster for larger models. Second, for nonlinear models, E-Newton tends to be penalized relative to E-QNewton to the extent that the nonlinearity eliminates exploitable patterns among the derivatives in the Newton Jacobian. In the specific case of the single-simulation experiment with the zero bound, E-QNewton solves all of the models more rapidly than E-Newton. Third, actual solution times support the claim that the algorithms are sufficiently fast for practical use in many applications. With a mid-range PC, the fastest execution time for each model in each experiment ranges from 0.3 seconds for a stripped-down version of SW in the interest-rate experiment to 13.4 seconds for the version of FRB/US in which all 27 of its expectations variables have RE solutions in the zero-bound experiment.

The E-Newton algorithm has a substantial advantage over E-QNewton on experiments that involve a large number of RE solutions, as long as the same Jacobian can be used for each E-Newton solution. This Jacobian condition is satisfied by each of the models in the third experiment, which is designed so that the zero bound is not an issue. This optimal-policy simulation, which entails 42 RE solutions for the linear models (SW and EDO) and 131 RE solutions for FRB/US, executes between 2.2 and 18 times faster with E-Newton than with E-QNewton, depending on the model.

For purposes of comparison, solutions of SW and EDO for the first two experiments were also executed with the stacked-time algorithm in Dynare, a specialized software language for RE models. The Octave-based Dynare solution times are similar to the best of each model's E-Newton and E-QNewton runs. Had they been run in Matlab, the Dynare solutions would likely have been somewhat faster than the E-Newton and E-QNewton runs but not dramatically so. This suggests that many users may find the added solution time of using the algorithms described here in a software language like EViews to be more than offset by the many features available in such a general-purpose environment that facilitate its use.

This section of the paper, which may be skipped by the reader who is less interested in technical details, has four parts. The first part summarizes the algorithms. The second part examines in more detail the E-Newton Jacobian and the shortcuts that can be used to speed up its construction. The third part describes the E-QNewton approximate Jacobian and a pair of transformations that enable it to be efficiently used. The last part discusses convergence properties. Additional information on the algorithms is provided in the Appendix.

**2a. Overview**

Consider a model of equations in which is a vector-valued function of endogenous variables, .

For expositional simplicity, the model contains only a single lag and single lead of and exogenous variables are not shown. The lead term captures the model's RE expectations variables. The E-Newton and E-QNewton algorithms (and FT, as well) replace with an exogenous estimate of expectations, denoted by ,

The algorithms execute one or more iterations, each of which starts with a solution of (2) for a given set of expectations estimates. The resulting values of the RE expectations errors, ,

are then computed, taking as given the value of obtained in solving (2). Depending on the size of the errors, the solution of equations 2-3 may be repeated with a different step length, in which the expectations estimates are moved either back toward or farther from their values in the previous iteration. Lastly, a set of revised expectations estimates is constructed for use in the next
iteration.

Some additional notation is needed to describe how the expectations estimates are revised in the last step of each iteration. Assume a solution for , and stack the vectors of the expectations estimates and expectations errors for all time periods in and , respectively. If there are distinct expectations variables, and are vectors of length . The relationship between these two stacked vectors can be written in general terms as

where the function is a compact representation of the model's structure, also in stacked form.^{5} Using this representation, the condition that expectations are rational,

is the solution of a system of (possibly) nonlinear equations. Each evaluation of requires a simulation of the model given by equations 2-3.

The field of numerical analysis contains many algorithms for solving systems of nonlinear equations. Some of these algorithms characterize the adjustment of at iteration as the product of a step length, , and a direction, ,

where the direction in turn depends on the product of an updating matrix and the value of in the previous iteration,

The iterations of E-Newton and E-QNewton can be expressed in the form of equations 6-7, differing only in how is defined. The FT algorithm is the
special case in which is the identity matrix.

When Newton's method is used to solve a system of equations, the updating matrix is the inverse of the Jacobian matrix of first derivatives (
). In E-Newton specifically, is the matrix of
derivatives of the expectations errors with respect to the expectations estimates.^{6}

When quasi-Newton methods are used to solve systems of equations, the updating matrix is the inverse of an approximate Jacobian () whose elements are based only on the implicit derivative
information observed each iteration in the movements of and . Quasi-Newton
methods do not calculate derivatives explicitly. Rather, starting from some initial estimate (), they revise the approximate Jacobian each iteration so that it matches the slope of
revealed in the previous iteration in the particular direction that was
adjusted. Many matrix updating formulas satisfy this condition. The E-QNewton algorithm is based on the widely used method of Broyden (1965), whose updating formula is the one that makes the smallest possible change to the approximate Jacobian each iteration.^{7}

**2b. The E-Newton Jacobian**

The most important and costly part of the E-Newton algorithm is the computation and inversion of the Jacobian (). The algorithm executes impulse-response simulations (dynamic multipliers) of the model formed by equations 2-3 to compute . Although impulse-response simulations may be needed for this purpose at each iteration (one for each expectations variable in each simulation period), models that are linear or mildly nonlinear require many fewer simulations.

The Jacobian of a linear RE model has a repetitive structure. This is illustrated with a single-equation RE model in which the variable depends only on its first lead and first lag,

Define the operational model using to represent the expectations estimate and the expectations error.

Repeated substitution of (9) into (10) yields the following equation,

from which the stacked Jacobian is easily obtained.

Element () of is the derivative of with respect to . Each northwest-southeast diagonal contains a single repeated value, except in the bottom row. For the
nonzero diagonals, this pattern is a consequence of the property of a linear model that the effect on an endogenous variable at period of an exogenous shock at period depends only on number of intervening periods, . The zero diagonals correspond to
expectations errors that are dated too far in the future to be affected by the particular expectations estimate. The zeros in most elements of the bottom row appear because the expectations error associated with that row, , depends on the unchanging terminal value . Given these patterns, all of the elements of this Jacobian can be determined from the values in the first
and last columns and the bottom row. These values in turn can be generated by two impulse-response simulations, one that perturbs and one that perturbs , and priori knowledge of the bottom row.

A simple generalization of this single-equation Jacobian holds for all linear RE models in which expectations are formed at time for outcomes at . The Jacobians of such models, which consist of blocks, each of which is similar to (12), can be
calculated with only 2 impulse response simulations and priori knowledge of the bottom row of each Jacobian block. For qualifying models, this shortcut greatly speeds up the computation of the
Jacobian.^{8}

The cost of computing the Jacobian can also be reduced for models that are mildly nonlinear. Although the Jacobian blocks of such models do not have constant diagonals, the values along each diagonal may shift relatively smoothly. Useful approximations to these Jacobian can usually be constructed by calculating a subset of the columns with impulse-response simulations and estimating the values in the other columns by linear interpolation along the diagonals.

**2c. The E-QNewton approximate Jacobian**

Define the step as the change from the previous iteration of and as the resulting change of . In the RE context, is the change in the expectations estimates and is the change in the expectations errors. With these definitions, the revision to the approximate Jacobian in Broyden's method can be expressed as,

Some intuition about this formula is obtained by noting that the revision to depends on the vector
, which measures how much the change in differs from what
would have occurred if had in fact been the true Jacobian.

Although it avoids the cost of computing explicit derivatives, the Broyden formula given by (13) has practical drawbacks in applications whose approximate Jacobians are large and that require many iterations to solve: To compute the adjustment direction each iteration, needs to be inverted and then multiplied by . However, two transformations lead to a formula that executes much more quickly in these cases. The first transformation uses the Sherman-Morrison formula to convert (13) into an expression for directly updating the inverse of the approximate Jacobian.

The second transformation recognizes that the expression
can be expressed as a function of the product of the inverse of the initial approximate Jacobian and
, and the iteration histories of revisions to the expectations estimates and step lengths.

As long as is not too large relative to and has a simple form, it can be considerably faster to compute the adjustment direction using (15) than by the two-step process of forming from (14) and multiplying the result by
.^{9}

Before it starts, the E-QNewton algorithm requires an initial approximate Jacobian, . The conventional recommendation is to use the identity matrix, a choice that, because it has the effect of eliminating all matrices from (15), causes each iteration to execute very quickly. As a general matter, the choice of has to balance two considerations: A simpler estimate speeds up each iteration, while a more accurate estimate reduces the number of iterations required for convergence. For most of the models examined here, a simplified, block-diagonal estimate of the Jacobian, calculated from impulse response simulations (one per RE variable), is usually a better choice than the identity matrix. Because this matrix, , has an inverse that can be easily computed and stored compactly in matrices, its use increases computation time per iteration only modestly relative to that for . At the same time, the improvement in the accuracy of the initial approximate Jacobian is such that the benefit of fewer iterations greatly outweighs the higher cost per iteration in most cases.

**2d. Convergence and the step length**

The adjustment of the expectations estimates each iteration is the product of the step direction () and the step length (). Thus far, the detailed discussion of the two algorithms has concentrated on the E-Newton Jacobian and the E-QNewton approximate Jacobian, matrices that enter the computation of the direction. With regard to the step length, algorithms that use
the Newton or quasi-Newton directions always converge to the solutions of linear models when =1.0.^{10} With this step length, E-Newton solutions require a single iteration, as long as the Jacobian is exactly computed, and E-QNewton solutions require at most iterations.^{11}

A step length of 1.0 does not guarantee the convergence of E-Newton or E-QNewton to the solution of a nonlinear RE model, unless the starting point is close to the solution. For nonlinear models, the convergence properties of the pair of algorithms is improved if line-search procedures are used
to examine alternative step lengths, whenever the default length (, typically) yields an insufficient movement toward the RE solution. The ratio of the sum of squared expectations
errors in successive iterations,

provides a scalar measure of the iteration-by-iteration progress.

E-Newton uses the relatively simple Armijo line-search procedure in which the step length starts at 1.0 and then is repeatedly shortened, if necessary, until either
or the maximum number of step-length iterations is reached.^{12} In E-Newton, = .01, the step length shortening parameter is 0.5, and the maximum number of line-search iterations
is ten.

For quasi-Newton methods, the decision of how intensively to search for the best step length each iteration is more complex than in the Newton case, because even an iteration that fails to make much or any progress toward the RE solution is still likely to improve the accuracy of the approximate Jacobian to be used in the next iteration. In particular, it may be more efficient to move on to the next iteration than to try to refine the step length in the current iteration, when the direction in which is being adjusted is likely to make little progress. For this reason, E-QNewton uses the non-monotone step-length procedure of La Cruz, Martinez, and Raydan (LMR, 2005). This procedure tolerates temporary, limited increases in the sum of squared expectations errors, , without searching for a better step length, especially in the initial solution iterations, when the accuracy of the approximate Jacobian and the adjustment direction is likely to be worst. In addition, the LMR procedure tests both positive and negative step lengths, a feature that is useful when the direction is so poor that no positive step length reduces the sum of squared expectations errors.

Both E-Newton and E-QNewton have much better convergence properties than FT. All of models considered here converge to their RE solutions in all of the experiments for at least one of the E-Newton Jacobian options and for at least one of the E-QNewton options for initializing the approximate
Jacobian, using the line-search algorithms just discussed when appropriate. In contrast, the FT algorithm does not have a high rate of successful convergence for these specific models, a result which can be shown using a simple condition provided by this paper's RE solution framework.^{13}

For a linear model, the evolution of the expectations errors depends on the Jacobian and the expectations estimates.

The derivation of (18) uses the version of (7) that holds under FT to substitute for the change in the expectations estimates. FT convergence of to zero thus requires that the eigenvalues of
lie inside the unit circle. Related to this is a second condition that requires all of the eigenvalues of to be less than 1.0 for there to exist some that satisfies the first condition.^{14} Of the linear models used in this paper, EDO satisfies the second FT convergence condition but SW does not. For nonlinear models, FT convergence requires that the second condition hold in some neighborhood
of the solution. This is satisfied by the simpler version of FRB/US but not by the one in which all 27 of its expectations variables have RE solutions.

Three models are used to evaluate the E-Newton and E-QNewton algorithms. One model is the well-known New-Keynesian DSGE of Smets and Wouters (2007). The other two models are ones developed and used at the Federal Reserve Board: EDO and FRB/US. EDO is a New-Keynesian DSGE that is considerably
larger than Smets-Wouters (SW).^{15}FRB/US, which is an even larger model, also has New-Keynesian characteristics, but its structure is estimated with fewer
constraints than a DSGE framework would impose.^{16}

Several versions of each model are employed. A small version of SW (SW-small) eliminates the flexible-price concept of potential output, a change that permits several equations to be dropped but requires that the interest-rate equation be modified to depend on the log level of output rather than
on the output gap. One version of FRB/US assumes that all of its expectations variables have RE solutions (FRB/US-all); in a second version, only those expectations that appear in asset-pricing equations have RE solutions (FRB/US-mcap).^{17}

Model | Equations | |||

SW-small | 22 | 7 | 100 | 700 |

SW-full | 33 | 12 | 100 | 1200 |

EDO | 70 | 33 | 160 | 5280 |

FRB/US-mcap | 393 | 7 | 160 | 1120 |

FRB/US-all | 393 | 28 | 160 | 4480 |

For each model version described thus far, table 1 presents two measures of size: the number of equations and the product of the number of distinct RE variables () and the number of simulation periods (). The number of equations varies from 22 (SW-small) to 393 (FRB/US). The second measure of size () is especially important in the E-Newton algorithm, because it equals the dimension of the Jacobian, whose computation and inversion takes the largest component of that algorithm's execution time. The Jacobian dimension varies from 700 (SW-small) to 5280 (EDO). Because the time required to invert a matrix depends on the cube of its size, inversion of the EDO Jacobian takes about 430 times longer than inversion of the SW-small Jacobian. The number of simulation periods is set separately for each model so that the simulated outcomes in the first part of each experiment are little affected if the simulation length is increased.

SW and EDO are linear; FRB/US is mildly nonlinear. In order to expand the set of models to include ones that are more nonlinear than FRB/US, a modified form of each model version is created in which a very nonlinear but continuously differentiable equation is added to constrain the short-term interest rate () from falling below zero.

In (19) is the unconstrained rate of interest. The dashed line in figure 1 plots the constrained rate of interest for values of the unconstrained rate of interest between -0.5 and 0.5.

Unlike the other models, the design of FRB/US permits each of its expectations terms to have either a backward-looking VAR-based solution, which is based on a fixed formula, or an RE solution.^{18} In FRB/US-mcap, the seven expectations that appear in the equations for asset prices have RE solutions and the other 21 have VAR solutions. The VAR formulas themselves are a type of RE expectation, but one that is based on a
smaller information set than the one embodied in the full FRB/US model. Each VAR formula is derived as part of the sector-by-sector estimation of FRB/US, which relies on small models that combine one or a few structural equations with several VAR relationships.^{19}

One of the purposes of this paper is to show that the E-Newton and E-QNewton algorithms are fast enough to be of practical use for solving a variety RE models. The evidence is based on a set of simulation experiments that are run on a mid-range PC, one whose characteristics are more likely to
represent the computing resources available to a broad range of people who solve, or would like to solve, RE macro models, than would the characteristics of a state-of-the-art PC. ^{20} All simulations were run in EViews 7.2.^{21}

In the simulations, convergence to an RE solution occurs when the absolute value of every expectations error is less than 1e-05. In the E-Newton runs that require more than one iteration, the Jacobian is computed initially and then recomputed only after those iterations in which the sum of squared expectations errors falls by less than 50 percent. In all runs that permit the step length to be adjusted from its default value (1.0, typically), alternative step lengths are evaluated only during those iterations in which the sum of squared expectations errors falls by less than 10 percent at the default step length. Reported execution times do not include the time needed to load each model and its data.

The first simulation experiment (table 2) is a one-time, 100-basis-point shock to the equation for the short-term rate of interest. Execution times are reported for three E-Newton options and two E-QNewton options.

In the E-Newton solutions, all derivatives are directly computed in constructing the Jacobian under the "every" option; every 12 derivative is directly computed and the others are
interpolated under the "interp(12)" shortcut; and only two derivatives are directly computed for each RE variable under the "linear" shortcut. For the three RE model versions that are linear, the "linear" and "every" options both compute the same (exact) Jacobian. The "interp(12)"
Jacobian is always an approximation, even for linear models.^{22} The advantage of the "linear" shortcut for these models is substantial. A comparison of
columns 1 and 3 reveals reductions in execution time that range from 56 percent in EDO to 91 percent in SW-full. To a large extent, the variation in these percentages reflects variation in the share of execution time devoted to inverting the Jacobian, an operation that is not affected by any
of the options. A model whose is high (EDO) devotes proportionally more execution time to matrix inversion than does a model whose is low (SW). In the interest-rate simulations of the two FRB/US versions, the nonlinearity of the model, while mild, is nonetheless substantial enough that the resulting inaccuracy of the "linear" Jacobian causes E-Newton to fail to
converge. For this model, the "interp(12)" option is a powerful shortcut, one that reduces execution time in this experiment by at least 85 percent.

Model | E-Newton linear | E-Newton interp(12) | E-Newton every | E-QNewton | E-QNewton |

SW-small | .3 | .5 | 2.2 | .5 | 2.3 |

SW-small number of interations | (1,1) | (4,1) | (1,1) | (61) | (251) |

SW-full | .3 | .6 | 3.4 | .7 | 2.7 |

SW-full number of interations | (1,1) | (4,1) | (1,1) | (61) | (251) |

EDO | 34.2 | 42.7 | 79.4 | 5.4 | 23.0 |

EDO number of interations | (1,1) | (11,1) | (1,1) | (101) | (409) |

FRB/US-mcap | nc | 10.9 | 99.7 | 2.9 | 2.1 |

FRB/US-mcap number of interations | (4,1) | (3,1) | (17) | (18) | |

FRB/US-all | nc | 65.5 | 432.4 | 9.0 | 27.7 |

FRB/US-all number of interations | (5,1) | (3,1) | (41) | (217) |

Notes: nc: No convergence. The second number in parentheses in the E-Newton columns is the number of iterations in which the Jacobian is computed. Both E-Newton and E-QNewton use a fixed step length (=1).

The interest-rate simulations that use the E-QNewton algorithm reveal the advantage of setting the initial approximate Jacobian to the block-diagonal matrix, , rather than to the identity matrix, . For four of the five model versions, the block-diagonal initial approximation reduces the number of iterations by at least 75 percent and the solution time by nearly as much. The only exception is FRB/US-mcap which, unlike the other model versions, expresses all of its RE variables in a way that makes the true Jacobian close enough to an identity matrix that the benefit of using from fewer solution iterations is minor and does not outweigh the cost of the added computations per iteration.

Turning to the question of which algorithm is faster given that its most efficient option is chosen, E-Newton outperforms E-QNewton in the interest-rate simulations when is not too large (2000) and the model is linear; E-QNewton is faster otherwise. In general, the E-Newton simulations exhibit much more variation in solution time than do the the E-QNewton simulations. This is clearest in the results for the three linear model versions. In the simulations with the E-Newton "linear" option, the ratio of the longest solution time to the shortest solution time is 114; the corresponding ratio in the simulations with the E-QNewton option is only 11. This difference is explained by time required to invert the E-Newton Jacobian, which varies with the cube of . The E-QNewton solution times appear to be not far from proportional to .

The second simulation experiment (table 3) focuses on how well the two algorithms solve RE models that are substantially nonlinear. For this purpose, a smooth approximation to the constraint that the short-term interest rate cannot fall below zero is added to each model, and shocks are introduced that reduce output by an amount sufficient to cause this nonlinearity to have a large impact on the solution. The magnitude of the shocks is chosen so that in each model the cumulative loss of output over the first 20 periods is roughly twice as large as the increase in output that would occur if the signs of the shocks were reversed. In the simulations, the number of periods that the rate of interest, if unconstrained, would be less than zero ranges from seven periods (SW-small and SW-full) to 25 periods (FRB/US-mcap).

Model | E-Newton linear | E-Newton interp(12) | E-Newton every | E-QNewton | E-QNewton |

SW-small | nc | nc | 6.2 | 1.1 | 7.6 |

SW-small number of interations | (16,2) | (88) | (392) | ||

SW-full | nc | nc | 8.5 | 1.3 | 9.1 |

SW-full number of interations | (16,2) | (88) | (392) | ||

EDO | 44.2 | 51.9 | 97.7 | 9.0 | 34.7 |

EDO number of interations | (35,1) | (38,1) | (36,1) | (121) | (500) |

FRB/US-mcap | nc | 15.2 | 130.7 | 3.9 | 2.8 |

FRB/US-mcap number of interations | (11,1) | (12,1) | (19) | (20) | |

FRB/US-all | nc | 75.8 | 524.1 | 13.4 | nc |

FRB/US-all number of interations | (10,1) | (6,1) | (57) |

Notes: nc: No convergence. The second number in parentheses in the E-Newton columns is the number of iterations in which the Jacobian is computed. E-Newton uses the Armijo step-length procedure. E-QNewton uses the LMR step-length procedure. Convergence of the FRB/US-all simulation requires 0.5.

The E-QNewton algorithm completes all of the zero-bound simulations much more rapidly than does E-Newton. For each model version, the best E-QNewton solution takes only about 20 percent as long as the best E-Newton solution. Even though the shocks are not the same, a rough gauge of the effects on each algorithm of the substantial nonlinearity introduced in this experiment can be made by comparing the execution times in table 3 with those in table 2. On this basis, the zero-bound nonlinearity tends to increase the E-QNewton execution times modestly and relatively uniformly for each model version. The effects in the E-Newton runs are more variable and depend on whether each model's best Jacobian shortcut in table 2 continues to work. For EDO and the two versions of FRB/US, the best shortcuts remain effective and solution times in the zero-bound experiment are modestly longer than those in the interest-rate experiment. In contrast, neither shortcut now converges for either version of SW, and the best E-Newton solution times are more than 20 times longer in the zero-bound simulation than in the interest-rate simulation.

Before turning to the third, more complex simulation experiment, it is useful to address the claim made at the start of this section concerning the practicality of the E-Newton and E-QNewton algorithms. Taking the best result for each model version in each of the first two experiments, the execution times range from as little as 0.3 seconds for SW-small and SW-full in the interest-rate experiment to as long as 13.4 seconds for FRB/US-all in the zero-bound experiment. These times are clearly fast enough for practical use.

Note: Best N/QN: Fastest E-Newton or E-QNewton time.

Although the focus of this section is on the absolute amount of time that E-Newton and E-QNewton take to solve various RE models, the speed of the two algorithms relative to other RE algorithms is obviously of some interest. Table 4 addresses this issue in a limited way.
For purposes of comparison, the SW and EDO simulations of the first two experiments were repeated using the stacked-time algorithm in Dynare.^{23} Compared
with the best of each model's E-Newton and E-QNewton runs, Dynare solution times are moderately slower for the two SW versions but somewhat faster for EDO. The Dynare solutions were computed in Octave.^{24} Even taking account of the fact that the Dynare solutions would run more rapidly in Matlab, the results indicate that any loss of solution efficiency from using a general-purpose software platform to run the algorithms described
here, rather than using specialized software designed for RE models, is not that large, and suggest that for many users this cost may be more than offset by the features available in the general-purpose environment that facilitate its use.

The final experiment assumes that each model's monetary policymaker, rather than following a simple policy rule, sets the short-term rate of interest to minimize a loss function. For illustrative purposes, the loss function is a weighted, discounted sum of squared differences of output and inflation from their baseline values and of the rate of interest from its value in the previous period. The loss function is minimized over the first 40 simulation periods. The solution of this experiment requires a sequence of "outer" iterations, each of which consists of 40 RE derivative solutions that compute the effects on the arguments of the loss function of perturbations to the policy instrument in each optimization period, followed by one or more RE solutions in which the policy variable is set according to these derivatives and the values of the loss function arguments.

The experiment repeats the output shocks of the second experiment, but reverses their signs so that output expands initially and the zero bound is not an issue. Because the Jacobian of a linear model is invariant to where it is calculated, a single "linear" Jacobian is clearly sufficient to run all of the necessary E-Newton RE simulations for the linear model versions. In addition, the optimal-policy solution for these models requires a single outer iteration. Although FRB/US is nonlinear, the nonlinearity is mild enough that a single "interp(12)" Jacobian proves to be accurate enough to complete all of the needed E-Newton RE simulations. The nonlinearity does, however, increase to three the number of outer iterations needed for convergence to the optimal-policy solution. That is, the derivatives of the arguments of the loss function with respect to the policy instrument in each period have to be computed three times.

Model | E-Newton option | E-Newton time | E-QNewton option | E-QNewton time | Number of RE sims | Number of instr.derivs. |

SW-small | linear | .8 | 14.0 | 42 | 1 | |

SW-full | linear | 1.0 | 17.8 | 42 | 1 | |

EDO | linear | 48.5 | 153.6 | 42 | 1 | |

FRB/US-mcap | interp(12) | 84.9 | 202.4 | 131 | 3 | |

FRB/US-all | interp(12) | 241.0 | 521.8 | 131 | 3 |

The E-Newton algorithm has a substantial advantage in this experiment, because the Jacobian is a pure fixed cost for each model version. The fixed costs associated with E-QNewton are relatively minor. The E-Newton solutions are from 2.2 to 18 times faster than the corresponding E-QNewton solutions (table 5). The E-Newton execution times themselves range from about a second (the two SW versions) to four minutes (FRB/US-all). The latter execution time does not seem excessive, given that the solution requires 131 RE simulations of a large (mildly) nonlinear model.

More than 30 years ago, Holly and Zarrop (1983) developed an algorithm for solving RE models that used Newton's method in an iterative framework that, although expressed as an optimal control problem, is broadly similar to the E-Newton algorithm presented here.^{25} They demonstrated their "penalty-function" algorithm with a model containing two RE variables. Use of the Holly-Zarrop approach seems to have ceased after a few years. S.G. Hall
(1985, pp. 157-158) noted:

The real drawback of [the Holly-Zarrop] technique is that it severely limits the number of expectations terms that can appear in the model. Optimal control problems quickly become intractable as the number of control variables rises and it would be impossible to use this technique to solve a model with 20 or more expectations variables.

Later, Fisher (1992, p. 56) concluded:

it is clear that [Holly-Zarrop] methods are not efficient

These observations reflect the limited capabilities of the computer hardware that was available at the time.

Computer hardware is now cheap by the standards of the past, a development that greatly extends the range of RE models for which Newton algorithms like Holly-Zarrop and E-Newton are feasible and practical. Nonetheless, if execution speed were the only criteria for comparing solution procedures,
neither E-Newton nor E-QNewton would come out on top. Relative to faster procedures, an important advantage of E-Newton and E-QNewton lies in their simplicity, which enables them to be coded in software that is easy to use. This advantage would not have been very important 20 or 30 years ago, when
the time penalty for choosing a user-friendly software product might have translated into many extra minutes or even hours of execution time.^{26} Today, the
availability of much faster hardware means that the added execution time is likely to be measured in seconds and thus less important.

This paper demonstrates the ability of a Newton algorithm that iterates on a set of expectations estimates to solve several well-known RE models. Compared with the Newton procedure developed by Holly and Zarrop, the E-Newton algorithm presented here contains options that accelerate the computation of the Jacobians of linear and mildly nonlinear RE models.

This paper also develops an RE solution algorithm based on the quasi-Newton method of Broyden, an approach that appears not to have been used before on this type of problem. The E-QNewton algorithm combines a block-diagonal initial estimate of the approximate Jacobian, an economical approach to updating the approximate Jacobian, and the option to use the LMR step-length procedure with nonlinear models. E-QNewton solves the reported single-simulation experiments more rapidly than E-Newton, except when the model is linear and of small-to-medium size. E-Newton outperforms E-QNewton on the experiment that involves a set of RE solutions in which the Newton Jacobian is a one-time fixed cost.

**Appendix**

**A.1 Setting up the RE problem**

The rational expectations model is split into two models, one that has no leads of endogenous variables and one that has no lags of endogenous variables. The former can be easily solved forward in time and the latter can be easily solved backward in time.

The model without leads takes the original model and replaces the vector with a vector of expectations estimates, , that is based on information available at and has two components: the function of the model's endogenous variables and the exogenous vector .

The model without lags contains the RE formulas for the expectations estimates, whose solutions in the second model are denoted by , and the expectations errors, .

Note that is endogenous in (A1) but exogenous in (A2). The pair of models simplifies to equations 2-3
when the equation for in the first model does not have an endogenous component and the equation for in the second model simplifies to
.

The more general form of A1-A2 is necessary to accomodate two characteristics of the expectations structure of FRB/US that are absent in the other models. First, the VAR-based expectations framework in FRB/US, although designed as an alternative to rational expectations, has proved to be a good starting point for the RE expectations estimates. The VAR-based formulas are the endogenous expectations component in the RE versions of FRB/US. Second, many FRB/US equations are written in such a way that their expectations terms correspond to infinite weighted sums of future values of endogenous variables, not to a single future value. This form appears in the model's present value relationships for financial variables and in its decision-rule representations of some nonfinancial equations. The latter, which are derived from Euler equations, substitute for one or a few future values of the dependent variable with infinite future sums of the other variables that appear in the equation. Because the coefficients of the infinite sums decline either geometrically or based on a mixture of several geometric parameters, the sums collapse to the form shown in the lower line of A2. For financial expectations, the upper summation limits, and , are one and zero, respectively. For nonfinancial expectations, the limits are typically greater than one but never larger than three.

The RE solution of equations A1-A2, which obtains when is chosen such that for , is written compactly as

The stacked vector of expectations constants, , has elements, where
is the number of RE variables and the number of simulation periods. Convergence to
the RE solution occurs at iteration if the maximum absolute expectations error, , is less than .

The ratio of the sum of squared expectations errors in the current and previous iterations,

provides a scalar measure of the progress made toward the RE solution each iteration.

**A.2 The E-Newton algorithm**

The organization of the E-Newton algorithm is sketched out below. is the Jacobian of at , is the step length, and is the step direction. Parameter values are =0.5, =0.9, and =1e-05.

1. Initialize:

(a) set ; choose

(b) compute

(c)

2. For

(a) + 1

(b)

(c) exit if

(d) for nonlinear models, invoke Armijo line search if

(1) search for satisfactory

(2)

(3) exit if

(e) compute if ; else

(f)

**A.2a The E-Newton Jacobian**

The E-Newton RE Jacobian (), which is an matrix, is composed of submatrices.

Submatrix contains all of the derivatives that involve expectations constant and expectations error .

The term
denotes the derivative of expectations error in period with respect to expectations constant in period
.

Impulse-response (IR) simulations are used to calculate the Jacobian. Each IR simulation, which perturbs a particular , provides the information needed to fill a single column of . The number of IR simulations executed each time the Jacobian is calculated depends on the setting of the "jmeth" option. When "jmeth=every", all IR simulations are run. The setting "jmeth=linear" runs the IR simulations needed to construct the Jacobian of a standard, linear RE model. For use with mildly nonlinear models, the setting "jmeth=interp(r)" computes an approximate Jacobian from IR simulations, where is the integer part of .

The "jmeth=linear" option takes into account the repetitive structure of the Jacobian of a standard linear RE model. When RE expectations are based on information at time for variables at , each Jacobian submatrix has the following simple form.

is a matrix in which every element along each diagonal has the same value, 0 is
vector of zeros, and equals 1.0 if and zero otherwise. The Jacobian shown
in equation 12 is a concrete example of this simple form. Only two perturbation simulations are needed per RE variable to construct all the Jacobian submatrices. To see this, recall that each simulation fills a matrix column. Thus, a pair of simulations in which an expectations
constant is separately shocked in periods 1 and is sufficient to determine all elements of .

The "jmeth=interp(r)" option takes advantage of the property of mildly nonlinear RE models that their Jacobian submatrices have diagonals whose elements tend to move relatively smoothly across time from northwest to southeast. This permits an approximate Jacobian to be constructed by interpolating many of its elements. Let the columns of the submatrix be denoted by . The "interp(r)" option runs impulse-response simulations to calculate , and calculates the other columns by linear interpolation along the diagonals. Because the interpolation direction is diagonal, there are triangles of elements at the top and bottom of the interpolated columns for which only one adjacent impulse-response column is available. For these triangular regions, the single available impulse-response value is repeated along the diagonal.

**A.3 The E-QNewton algorithm**

Broyden's quasi-Newton method uses an approximation of the Jacobian, , which is updated along with the tentative solution each iteration.

In (A10),
denotes the change to the tentative solution for and
the resulting change in .
The revision to depends on the "surprise" to as given by (
), a term that would be zero if were the true Jacobian in the
neighborhood of
. It is easily verified that replacing with the updated
Jacobian approximation, , would have set the "surprise" to zero.

**A.3a Derivation of The E-QNewton formulas**

The E-QNewton algorithm reduces computational costs through two modifications to (A9) and (A10). First, given that the solution for in (A9) depends on the inverse of the approximate Jacobian, each iteration can be made more efficient by applying the Sherman-Morrison formula to rewrite (A10) in terms of this inverse.

Vectors , , and are defined as follows.

The step norm is defined as
.

The second modification, which is taken from Kelley (1995, chapters 7-8), expresses the product as a sequence of vector operations applied to . The derivation of this modification starts by (tediously) transforming the expression for in (A14) into one in which depends only on the step and step length and not on the approximate Jacobian.

Now, take the definition of the Broyden direction (A16), substitute for using (A11) to get (A17), and substitute for
using (A15), substitute for using (A13), and rearrange terms to get (A18).

The vector in (A18) is defined as follows:

Finally, simplify the matrix operations in (A20) by computing with the following loop, after inserting the definitions of and .

The key E-QNewton formulas are given by (A18) and (A21). Their use requires only the inverse of the initial approximate Jacobian () and the sequence of steps and step lengths from prior iterations. The decrease in simulation time obtained when solutions are based on these formulas, rather than on (A11) and (A16), can be substantial. The E-QNewton simulation times in table A1 are taken from the columns of tables 2 and 3, except for FRB/US-mcap, whose times are from the columns. The simulation times in the "Broyden" columns are from comparable experiments in which the solutions are based on code that uses (A11) and (A16).

Model | Experiment 1 E-QNewton | Experiment 1 Broyden | Experiment 2 E-QNewton | Experiment 2 Broyden |

SW-small | .5 | 1.9 | 1.1 | 3.1 |

SW-full | .7 | 2.1 | 1.3 | 3.3 |

EDO | 5.4 | 179.3 | 9.0 | 211.4 |

FRB/US-mcap | 2.1 | 3.4 | 2.8 | 4.1 |

FRB/US-all | 9.0 | 68.9 | 13.4 | 95.8 |

**A.3b The E-QNewton estimate of **

The standard recommendation is to use the identity matrix as the initial approximate Jacobian, , as this further simplifies the loop of commands (A21) that computes . For most of the models studied here, however, a better choice is a block-diagonal matrix, , that adds modestly to the cost of computing each iteration but speeds up convergence by substantially reducing the number of solution iterations.

Each () diagonal block, , in turn contains only two non-zero values,
which are repeated along the main diagonal and first super-diagonal. These are the elements of the RE Jacobian that are usually largest in absolute value.

The estimates of
and
are taken from an impulse-response simulation that perturbs the expectations constant at the date closest to the midpoint of the simulation period (, if is an even number, and otherwise). Construction of the
block-diagonal matrix requires impulse response simulations (one per MC
variable). Its inverse can be easily computed and stored in () matrices.

**A.3c The E-QNewton step length**

The non-monotone line-search procedure of La Cruz, Martinez, and Raydan (LMR, 2005) is used to choose the step length when the E-QNewton algorithm is used to solve nonlinear RE models.^{27} Define
as the sum of squared expectations errors and recall that
is the ratio of this sum of squares in two successive iterations. In the LMR procedure, line search is not started, or terminates if already started, when
is less than the sum of three terms.

The two parameter in this expression are set as follows: =4, =1e-04.
The first term on the right hand side of (A24), which is always less than 1.0 at the selected value of , by itself leads the procedure to try to find a step
length that reduces the sum of squared expectations errors from one iteration to the next. The remaining terms act to moderate this requirement. The second term allows the
sequence to be locally increasing without invoking line search. The third term, whose value goes to zero in the limit, prevents rising values of
from starting line search in the initial iterations of a solution.

The E-QNewton algorithm starts each iteration with and . The expression for is given in (A18). If condition (A24) fails to hold, the LMR procedure starts and computes a smaller positive step length ().

where

When appears on the right hand side of either (A25) or (A26), it denotes the value that was assigned to that parameter prior to the
current step-length iteration, which is 1.0 initially. If condition (A24) is satisfied at the new value of , line search terminates. If the condition is not
satisfied, a negative step length () is computed using a set of analogous formulas. In this case, the value of that appears on the right hand side of the formulas is initially set to -1.0. If condition (A24) is satisfied at the new value of , line search terminates. If the condition is not satisfied, line search continues with ever smaller values of and until the condition is satisfied or the maximum number of line-search iterations is reached. The simulation experiments set =.5 and =.1.

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* I thank Rosalind Bennett, Marc Escrihuela, David Jones, Edward Kane and seminar participants at the Central Bank of Brazil, EESP/FGV, Ibmec-Rio, IPEA-Rio, PUC-Rio, the University of SPaulo, the 2010 International Industrial Organization Conference and Finlawmetrics 2010 for comments. The views expressed herein are my own and do not necessarily reflect those of the Board of Governors or the staff of the Federal Reserve System. The author can be contacted through email at marcelo.rezende@frb.gov or phone: (202) 452-3264/ fax: (202) 728-5890 Return to Text

2. The "E-" prefix attached to the names of the algorithms signifies the central role of the expectations estimates in the iteration process. Return to Text

3. Stacked-time algorithms, which impose the RE requirement by solving all time periods in a simulation simultaneously, iterate on the values of all endogenous variables. Newton versions of stacked time are described in Hollinger (1996) and Juillard (1996).
Return to Text

4. Hall (1985) and Fisher (1992) discuss the efficiency and practicality of the Holly-Zarrop "penalty function" algorithm. Return to Text

5. also depends on the initial and terminal values of . Return to Text

6. Note the distinction between the *RE* Jacobian, , which is associated with equation 5, and the *structural* Jacobian
of the original RE model in equation 1. The iterations of the Newton-based stacked-time algorithm make use of a stacked form of the structural Jacobian. Return to Text

7. The change in the approximate Jacobian is defined in terms of its norm:
. Return to Text

8. Some linear RE models contain expectations of outcomes dated more than one period in the future or form expectations only on the basis of lagged information. These modifications alter the repetitive structure of the Jacobian blocks in specific ways. With
the first modification, more than one diagonal above the main diagonal contains non-zero entries, and more than one row at the bottom has entries that differ from the pattern in the rows above. The assumption of lagged expectations modifies the right-hand columns of the Jacobian blocks. Return to Text

9. The transformation embodied in (15) is taken from Kelley (1995, chapters 7-8). The specific form of the function is presented
in the Appendix. As shown in Appendix table A1, the second transformation reduces solution time between 32 and 97 percent, depending on the model and the simulation experiment. Return to Text

10. This statement requires several qualifications. The Newton Jacobian or the quasi-Newton approximate Jacobian must be non-singular. The statement does not apply to the E-Newton algorithm when it uses an inexact Jacobian. For an RE model that does not
satisfy the Blanchard-Kahn conditions, the solution obtained may not be economically meaningful. Return to Text

11. The E-QNewton convergence results are based on Gay (1979), who proves that Broyden's method always converges to the solution of a linear system of equations when the step length is 1.0, and that the required number of iterations never exceeds twice the
number of equations. Return to Text

12. Kelley (1995, pp. 138-141) describes the conditions under which the Armijo procedure is globally convergent. Return to Text

13. For a summary of convergence problems that have been encountered when using FT to solve other RE macro models, see Juillard *et. al.* (1999), who report that nine of 13 macro modelers surveyed had difficulties with FT and similar algorithms in cases
where the stacked-time algorithm worked. Because they are both Newton methods, the convergence properties of E-Newton and stacked-time should be similar. Return to Text

14. For other representations of the first FT convergence condition, see Fisher and Hughes Hallett (1988) and Armstrong, *et. al.* (1998). The relationship between convergence conditions of the first and second type is described in Fisher and Hughes
Hallett (1988). Return to Text

15. EDO is described in Chung, (2010) and Edge, (2008). Return to Text

16. FRB/US is described in Brayton and Tinsley (1996) and Brayton, (1997a). Return to Text

17. MCAP: Model-Consistent Asset Pricing. Return to Text

18. The expectations structure of FRB/US is described in Brayton *et. al.* (1997b) Return to Text

19. Several aspects of expectations structure of FRB/US, including the VAR expectations option, require an RE solution approach that is more general than the one presented in equations 2-3. In this more general
approach, the expectations estimates have separate endogenous and exogenous components, and the iterative updating procedure operates on the latter, not on the expectations estimates themselves. This and related technical issues are discussed in section A1 of the Appendix. Return to Text

20. The PC used for all simulation experiments contains an Intel Core 2 Duo E6750 2.67 GHz chip and 4 GB of RAM. Some of the experiments were also executed on a PC with a newer Intel I7-2600 3.40 GHz chip. The experiments run about twice as fast on this
second machine than on the first. Return to Text

21. Because the matrix inversion code in EViews 7 is able to distribute this task to multiple processing threads, the E-Newton algorithm runs substantially faster on PCs, like the one used in these simulations, that can run more than one process
simultaneously, especially when the Jacobian is large. The advantage of having more than two processing threads does not seem to be significant, however. Return to Text

22. Unlike the "linear" shortcut, the "interp(12)" option does not take account of the irregular derivative patterns in the bottom row of each Jacobian block. Return to Text

23. Dynare versions of SW and EDO are either available or easily created. This is not the case for FRB/US, due to its large size and complex structure. Return to Text

24. The Dynare solutions wre executed on the same PC as the other experiments, using Dynare 4.2.1 and Octave 3.2.4. The standard linear versions of SW and EDO could also be solved using any of the eigenvalue-splitting methods that originated with Blanchard
and Kahn (1980), including AIM (Anderson and Moore, 1985) and Gensys (Sims, 2001). The software that is available for these methods typically is not designed for ease of use. Return to Text

25. The E-Newton algorithm imposes RE by solving a system of equations. When there are as many instruments as objectives, as is the case for RE solutions, the optimal control approach used by Holly and Zarrop is identical to solving a system of equations.
Return to Text

26. Hollinger (1996) reports solution times using the stacked-time algorithm in Troll for several macro models, of which the 466-equation Multimod is closest in size to FRB/US. A 150-period solution of Multimod required 21 minutes on a relatively fast
computer. Return to Text

27. The LMR procedure is a key part of the DF-SANE equation-solving algorithm, an approach that is not based on Newton or quasi-Newton methods and does not start with a step length of one. For use with the E-QNewton algorithm, the LMR formulas are modified to
incorporate an initial step length of one. Return to Text