Cagan's Model of Hyperinflation under Rational Expectations

This paper studies P. Cagan's model of the German hyperinflation under the hypothesis that adaptive expectations are rational. It shows that inference about the key money demand elasticity parameter, a, is very senstitive to the specification of the dynamic interaction of the unobserved money demand shock with prices and money. In particular, if T. J. Sargent's 1977 specification is modified, then his basic conclusions are overturned: identification of a does not require prior knowledge about the covariance of unobserved shock terms; and d ata on the German hyperinflation imply a sharp, not loose estimate of a, which is of plausible magnitude. Finally, informal tests indicate that modifying Sargent's specification gives rise to improved model fit.