Suppose Mt = α + β1 Y*t + β2 R*t + ut
where M = demand for real cash balances, Y* = expected real income, and R* = expected interest rate. Assume that expectations are formu- lated as follows:
Y*t = γ1 Yt + (1 - γ1 )Yt-1
R*t = γ2 Rt + (1 - γ2 ) Rt-1
where γ1 and γ2 are coef?cients of expectation, both lying between 0 and 1.
a. How would you express Mt in terms of the observable quantities?
b. What estimation problems do you foresee?