A "Nearly Ideal" Solution To Linear Time-Varying Rational Expectations Models

For a well-identified class of forward-looking models under rational expectations and time-varying parameters, it is shown that there exists always a solu- tion having the property of being the closest, in mean square, to the state motion of the autoregressive dynamic equation governing the "ideal" behavior of the eco- nomic system. A recursive algorithm--based upon Kalman filtering--providing the exact expression for the conditional expectations (hence, the solution) and the optimal filtering estimate, is also presented.