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Expectations are crucial in determining the success of government policy on unemployment and inflation. Whatever people expect to happen, their actions will tend to make it happen. At the time that economic agents-households, firms, the government make choices, they are generally uncertain about the future. Assumptions about how these agents form expectations for the future shape the properties of any dynamic economic model. Great debates have gone on among economists and psychologists in recent years over the ways that economic agents actually formulate their expectations about their future and the ways that macroeconomist's should assume they do this in their theoretical models. To make economic decisions in an uncertain environment agents must forecast such variables as future rates of inflation, tax rates, government subsidy schemes and regulations.
A business firm contemplating an investment needs to know the future path of income that will result from the investment. However future earnings can be estimated only with considerable uncertainty. If there is a boom in the future, then the future earnings may be high and vice versa. But the actual exact future state of the economy is virtually unknowable. This is why households and firms have to formulate some expectations about the future in order to make choices.
Indeed, they must often cope with complex assessments of the relative likelihood of many different possible events- the educated guesses that households have to make about the future value of income for example. >From a macroeconomic perspective expectation may well determine beliefs such as that an expansion of money supply will merely lead to inflation (the monetarist position), then it will. Firms and workers will adjust their prices and wages upwards. Firms will make no plans to expand output and will make no plans to expand output and will not take on any more labor. If, however, people believe that an expansion of demand will lead to higher output and employment (the Keynesian position), then, via the accelerator mechanism, it will. Similarly, just how successful a deflationary policy is in curing inflation depends in large measure on peoples expectations.
If people believe that a deflationary policy will cause a recession, then firms will stop investing and will cut their workforce. If they believe that it will cure inflation and restore firms competitiveness abroad, firms may increase investment. To manage the economy successfully, therefore, the government must convince people that its policies will work. This is as much a job of public relations as of pulling the right economic levers. The importance of expectations has long been appreciated by macroeconomist's. When John Maynard Keynes (1883 - 1946), published his General Theory of Employment, Interest, and Money in 1936, he set off a revolution.
Within Keynes General Theory expectation arose most importantly in the analysis of investment. For example, since building a factory takes time there will be a delay before output is produced. So the entrepreneur has to form expectations about the demand for a product in the future in order to assess the likely profitability of the venture. However time and uncertainty are inextricably linked in post-Keynesian thinking, as evident in the writings of Robinson and Shackle. They stress that economies must be analyzed as a sequential process through time and not in an essentially timeless state Keynes seemed to pose.
The present is seen as the link between a known past and a highly uncertain future. Money and financial assets play a key role in connecting the past, the present and the future. Because the future is so uncertain, the way expectations are formed, in particular the influence of the present upon such expectations becomes extremely important. It is in the light of these considerations that investment plays a key role in the interpretation of the General Theory.
For investment to occur the demand price of capital (that is, the present value of future expected net cash flows from investment) must exceed the supply price (the cost of the capital inputs). The demand price is determined by two sets of forces. The first set consists of those factors which determine the expected future net cash flow, and the second set consists of the determinants of the cost of financial capital which is used to discount the net cash flow stream. The first set of factors is subject to a lot of uncertainty and is not amenable to quantitative probabilistic calculations: There is instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation. (The General Theory, p. 161) The entrepreneurs expectations are attributed largely to inexplicable waves of optimism or pessimism called animal spirit: Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirit of spontaneous urge to action, rather than inaction. (The General Theory, p. 161) Fundamentally Keynes theory of expectation called upon the animal spirit of business men, which is continually changing, therefore investment will follow suit due to this animal spirit. Keynes referred to this as Gut Instinct.
The problem posed by the presence of expectation takes the same form whenever it arises in the explicit formulation of testable models. When the expected value of some variable appears in an equation something has to be done about it because that variable is unobservable. A common method of solving this problem has been to extrapolate the past behavior of the variable itself. In other words, take the past trend in the variable and assume that the trend will continue. A specific form of extrapolation is provided by the error learning mechanism or adaptive expectation. Prior to the mid- 1970 s the standard assumption for the way in which households form their expectations about the price level was down to adaptive expectation.
This involves the adjustment of expectations according to observed past error. Thus, for example, the expectation of the price level at a certain date t could be written as the expectation at t- 1 plus some fraction of the observed error at date t- 1. There are, however, two main objections to this assumption. The first is that in an inflationary world, i. e. one in which the growth rate of prices is consistently positive, agents will continuously under predict the price level.
Even under a very basic assumption of common sense we would expect them to notice their mistakes all in the same direction and adjust their expectation-formation mechanism accordingly. A second related objection to the adaptive expectations model is that it unnecessarily, and severely, restricts the information set which agents are assumed to use in forming expectations. It is implicitly assumed that only past observed prices are deemed relevant in predicting current and future prices. This again seems counter to common sense. There are numerous factors which go to determine the overall price level and which agents can readily observe. Why should we therefore adopt a theory of expectation which prohibits agents from taking any of these factors into consideration?
During the mid- 1970 s the objections outlined in the above paragraph led the New Classical economists to abandon the assumption of adaptive expectation and to replace it with that of rational expectations. Rational expectations is a good example of Friedman's methodology: a simple assumption which is obviously not strictly realistic, but generates powerful testable predictions. Economics is founded on the model of homo economics who efficiently maximizes his or her utility subject to constraints of prices and resources. Rational expectations extends this model to information he or she now uses information efficiently as well, in forming expectations about these constraints. Previously all sorts of arbitrary assumptions were made about how these expectations might be formed. Since this extended model is being applied to average behavior, its lack of individual realism need not matter.
Keynesian's still see aggregate demand as playing the crucial role in determining then level of inflation, output and employment. Nevertheless the Keynesian position has undergone three major modifications in recent years. This has been in response to the problem of stagflation and the inability of the traditional Keynesian model to explain it. The three modification are as follows: An increased importance attached to cost push factors. An increased importance attached to equilibrium unemployment. The incorporation of the theory of expectations: either adaptive or rational.
Some Keynesian's incorporate adaptive expectations into their models. Others incorporate rational expectations. Either way their models differ from monetarists models in two important respects: Prices and wages are not perfectly flexible. Markets are characterised by various rigidities. Expectations influence output and employment decisions, not just pricing decisions. Price and wage rigidities are likely to be greater downwards than upward.
It is thus necessary to separate the analysis of a decrease in aggregate demand from that of an increase. To summarise, with the development of 'rational expectations' theory in the 1970 s a reaction against Keynesian thought which formalised the idea that people learn from their mistakes economics became dominated by 'New Classicists'. They inhabited a highly formalised mathematical world of perfect competition, perfect information and perfect rationality, a world their techniques explained to them with great clarity. Since this world did not exist outside the economists' models, though, the discipline seemed in danger of becoming irrelevant. This danger was seen off in the mid- 1980 s, largely thanks to an extraordinarily talented group of young economists most of whom were at Harvard University or the Massachusetts Institute of Technology. This group applied the sophisticated analytical tools of the rational expectations revolution to the real world, a world where people had imperfect information and where markets sometimes failed.
They were the first generation both to be steeped in rational expectations and to care deeply about economic policy, and the combination was fruitful. More recently, an important role for expectation has arisen in the context of wage and price setting behaviour. This is because in negotiating wage contracts, for example, agents need to have some view about future changes in the value of money in order to assess the real value of any settlement. Over the last 20 years a new more extreme version of monetarism has gained a considerable following.
This is the new classical school. Leading exponents of new classical macroeconomics include Robert Lucas and Thomas Sargent in the USA and Patrick Minor in the UK. This school of economists believe that markets clear virtually instantaneously and that expectations are formed rationally. Bibliography: Dornbusch, Fischer, and Start, Macroeconomics. New York: McGraw-Hill, 1998 Baumol and Blinder. Economics - Principles and Policy.
Boston: Allyn and Bacon, 1999 A. G. Anderton. Economics: A New Approach. New York: Macmillan, 1997
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