Expectation in Macro Economics, Essays (university) of Macroeconomics

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EXPECTATION IN

MACROECONOMICS

The importance of

expectations

• (^) Economic decisions : action today to receive

uncertain return in the future

• (^) Quality of expectations crucial, most famous

example: expected inflation in wage

negotiations

• Expectation : not only one predicted value, but a

probability distribution of all possible outcomes

• Two crucial issues - How people get, process and use information

to form expectations?

• What type of expectations hypothesis is most

suitable for application in macroeconomics?

Conditional expectation

The objective, E[.] exists, i.e. the

information set Ω is sufficient to

allow agent to determine E[.]

Agents’ expectations are always

consistent with their information

What does it exactly mean?

People DO make errors in forecast

• It is NOT perfect foresight

The errors are due to the incomplete

information

• (^) The errors are independent on the

information set Ω

• (^) On average, agent’s expectations are

correct, i.e. equal to the true values

• (^) Expectations are NOT systematically

wrong over time (are not biased)

Expectations

The two most common expectations

models are

 adaptive expectations and

 rational expectations

 with the latter being the standard in

mainstream economics.

The adaptive expectations

The adaptive expectations hypothesis

states that the expected value of an

economic variable Yp (for permanent

or expected income introduced by

Friedman (1957)) is formed adaptively

by the following equation, with t

denoting time and the time for the

current period subpressed:

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Adaptive Expectation

Hypothesis

Thus, under adaptive expectations

the expected value can be viewed as

a sum of the immediate past

expectation and the weighted

expectational error (equation 1).

Adaptive expectations

• (^) Assumes that inflation in the future is an

extrapolation(genuine guess) of recent

price trends

• Thus, if inflation has been on the

increase, this suggests that people expect

inflation to continue to go up

• This ignores any possible

countercyclical policy response by the

government(National bank of Federal

Reserve)

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Rational Expectations

Hypothesis (REH)

All agents are optimizers  they are

also using all available information in

an optimal way (best use of info)

An attempt to define would be, the

expectation formation process in

which optimal (rational and efficient)

use is made of all available and

relevant information that eventually

eliminates systematic forecasting

errors.

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Rational Expectations

Hypothesis (REH)

• (^) Assuming that, besides the variable of

interest (say, Y), other relevant (related)

variables X and Z. A mathematical outline

of this hypothesis would be

• (^) where U

t

is a random variable. The

values of all the lagged variables are

known at the time of forecasting , which is

at the end of period t-1, while the value of

the random variable is only known at the

end of period t.

t t t t t

Y   Y  X  Z  U

0 1  1 2  1 3  1

   

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Rational Expectations

Hypothesis (REH)

Justification of the rational

expectation hypothesis is an extension

of human rationality that systematic

expectational errors are eliminated

over time because rationality

embodies individuals purposeful

behaviour or intentionality.

• That is, “ if the same errors repeat over

time, the individual could not be

considered fully rational

When are Expectations Rational?

(Cont.)

• (^) Rational expectations
  • (^) People will use all available information to

formulate expectations of economic

variables—inflation, interest, money supply

• Individuals have strong incentives to make

rational forecasts and will act accordingly

• (^) If their expectations are consistently wrong ,

they will re-formulate the expectations

model to include other variables

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Adaptive vs. Rational

Expectations

Adaptive ExpectationsRational Expectations

Actual

Actual

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

x

AEH Vs REH

• They both assume some high level of

analytical abilities on the part of economic

agents

• They both make use of historical data and

learning from experience.

• Compared to AEH, agents use all available

info

• (^) AEH: learning from the past mistakes in

predicting only the same variable

• (^) REH: taking into account all information, about all

other variables and about all other relevant facts