Expectations Theory

9 Key excerpts on "Expectations Theory"

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  The Theory of Interest

  • Friedrich A. Lutz, Friedrich Lutz(Authors)
  • 2017(Publication Date)
  • Routledge

    (Publisher)

  This point was made most forcefully by Luckett: “We are thus treated to the spectacle of an individual standing on the eve of World War II, atomic bombs, the cold war, the postwar inflations, the Employment Act of 1946, et hoc genus omne, trying to decide what short-term rates will be fifteen to twenty years in the future.” 13 Such an assumption would obviously be absurd. However, most adherents of the expectation theory cannot be reproached on this score, as they have worked in one form or another with the assumption that the market participants use short periods as the basis for their calculations. 14 To be sure, we can then no longer work with the expected short rates alone, but must introduce the bond prices expected by the participants in the market for the end of their (short) time horizon. To object to this procedure on the ground that these prices are themselves determined by the short rates expected for still later periods would be quite unrealistic, as no one takes these distant short rates into consideration at the present. A further point is even more important. Let us begin with the observation that “an investor’s personal expectations about the future course of short rates do not necessarily commit him as to his expectations about the long rate, since the latter depends, not on what he thinks about the future short rates, but what the ‘market’, i.e. other people, think about them. The individual investor, therefore, may quite reasonably form an opinion about the future long rate which is inconsistent with his opinion about future short rates”. 15 Luckett has quite properly shown that if we follow this reasoning we must give up the expectation theory. He takes a case in which a large majority or even all of the participants in the market expect that the long rate will rise but that the short rate will stay unchanged

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  Big Players and the Economic Theory of Expectations

  • R. Koppl(Author)
  • 2002(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Part I Introduction 1 Introduction and Summary 1 Expectations and economic theory The need for a theory The problem of expectations is one of the central issues of economic theory. Every human action aims at a more or less distant future. Thus, expectations guide all action. For this reason, expectations matter in any economic argument. John Maynard Keynes (1936) helped to make expectations a separate and vital problem of economic theory. He explained unemployment as a product of deficient foresight. No one knows the future. F. A. Hayek (1937) argued that a tendency toward equilibrium exists only if “the expectations of the people and parti- cularly of the entrepreneurs … become more and more correct” over time. (1937, p. 45). “The only trouble,” Hayek lamented, “is that we are still pretty much in the dark about (a) the conditions under which this tendency is supposed to exist and (b) the nature of the process by which individual knowledge is changed” (1937, p. 45). Much has been written about expectations since Hayek’s lament. And yet we are still pretty much in the dark. Keynes (1936, 1937) out- lined a theory of expectations. Shackle (1949, 1972) and others have developed Keynes’ theory. It is rich in useful insights. I will draw on them in later chapters. But I will also argue that the fundamentals of the theory are deficient. The orthodox treatment takes a view exactly opposite to that of Keynes. With rational expectations, everyone knows the future. There is widespread dissatisfaction with the rational expectations hypothesis. Fundamental criticisms of it are widely accepted. But no clear replacement has yet come along. Fundamental work on learning and expectations has been done by a variety of very different authors. (A few of the more prominent examples are Arthur 3

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  Inflation

  A Theoretical Survey and Synthesis

  • John Hudson(Author)
  • 2016(Publication Date)
  • Routledge

    (Publisher)

  Chapter 3 Expectations of Inflation

  Expectations as a concept seem to be growing increasingly important, and much of economic theory is now being rewritten to take explicit account of them. Indeed in future years when economists look back at this era, it may well prove to be that this is seen as the thread that links together much of the work being done, as in a similar manner the rejection of the assumption of perfect knowledge characterises much of the work done in the interwar period. However, this awareness of the importance of expectations is not a new phenomenon. Marshall (1920), for example, was aware of the importance of the concept, although as Shackle (1967) comments, this was not a trumpet he chose to blow too hard. But it was really in Sweden that the importance of expectations in economic theory was first fully appreciated, with the work of Myrdal (1939), amongst others, while in England at about this time Keynes’ General Theory had just appeared, in which expectations are of prime importance.

  Most of this early work was connected with the effects of expectations, rather than with how they were formed. Keynes, at least, thought that some expectations were closely akin to a random variable, and hence unexplainable, that is, unless a theory of animal spirits can be provided. Since then, and particularly since 1960, a substantial volume of literature has appeared concerned with how expectations are formed. This can be divided into two fairly distinct parts, that dealing with theoretical considerations, and that which is mainly empirical in nature. There has, of course, been some interchange between these two avenues of research, but unfortunately this has not been common, and they have by and large remained separate areas. It is hoped in this survey not only to summarise these two approaches, but to forge closer links between them.

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  Organizations, Individualism and Economic Theory

  • Maria Brouwer(Author)
  • 2012(Publication Date)
  • Routledge

    (Publisher)

  Profits and losses appear sequentially in markets that are driven by collective opinion. Markets that are steered by individual judgments, however, will show profits and losses simultaneously. Profits outweigh losses in dynamic economies featuring productivity growth. Net investment is sustained as long as average profits match investor expectations. Capital and labor shares can remain constant, if a constant fraction of national income is invested and expected returns on investment are realized on average. Rates of return will, however, either exceed or fall short of expectations in individual cases. Markets with a sufficient number of uncorrelated investment decisions will be more stable than an economy that is driven by collective opinion. The economy is no longer steered by a force heading in one direction, but stays on course by a multitude of forces going in different directions. Stock and real estate booms would be absent, whereas stock and real estate prices show a wave like pattern, if they are driven by collective opinion, erring both on the up and the downside.

  Expectations in economic theory

  Before Keynes

  It was mentioned above that expectations are central to investment decisions. However, economics has only a short history modeling expectations. Expectations entered economic theory with the publication of Keynes’ General Theory in 1936. English classical theory assumed that investment opportunities were equally obvious to all. Investors were looking forward, but expectations were always realized; the future being related to the present in unmistakable ways. The only brake on investment was a lack of savings.

  Neoclassical theory that was developed in the late nineteenth century differed from classical economic theory. Neoclassical theory introduced the concepts of marginal costs and benefits. Neoclassical economists argued that producers and consumers decided by weighing marginal costs and benefits. Producers would expand output until a point was reached where the last unit produced did not contribute to producer surplus. Consumers weighed the utility they derived from consuming an extra hotdog while standing at the stand against its costs. Marginal analysis is located in present time. Capital would flow into and out of an industry in response to exogenous demand and supply shocks until profits were restored to ‘normal’ levels. Neoclassical theory depicts investors as myopic. This differed from classical economics, where investors appraised investment projects based on long term effects. But investors did not need to individually appraise investment projects in classical theory, since good projects were known to all. Scarcity of savings allowed firms to reap profits. Both theories, therefore, assumed that scarcity rents were the source of profits. Some production factors were more scarce than others; capital and land being the pivotal examples. Both theories also did not distinguish between plan and realization. Classical economists assumed that the quality of investment plans was known beforehand, while plans did not figure at all in neoclassical theory.

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  Reformulation Of Keynesian Economics, A

  • Jagdish Handa(Author)
  • 2015(Publication Date)
  • WSPC

    (Publisher)

  It argues that, by the nature of how human beings think, economic agents always hold a “view” or “views” (whether vague or precise) on how the future values of the variable in question will evolve. Economists believe that the expected values should be based on a theory of the structure of the market in question or the economy. Since different theories are likely to yield different expected future values of the variable in question, these expected values may be designated as “theory-specific” or “model-specific.” Section 7.3 considers the variety of model-specific EH in macroeconomics. Section 7.4 discusses the time dimension relevant to the formation of expectations. Sections 7.5 and 7.6 consider the imperfection of knowledge and its implications for EH. Section 7.7 focuses on the classical (strong) REH, with Sec. 7.8 illustrating the use of this hypothesis in the context of a compact classical macroeconomic model based on Lucas (1972, 1973). Section 7.9 lays out what we consider to be the essential aspects of the Keynesian EH and our proposal for an EH. It argues that such hypotheses need to include an autonomous component and an endogenous one. 7.1  The Stylized Facts on Expectations in Economics Economic agents form expectations on the future values of many variables. It would be useful to start by listing a set of stylized facts about these expectations. On these, we offer the following list, though, obviously, without expecting a consensus on some of the following items. i. Expectations of the future values play a very significant role in the determination — in addition to their other determinants such as technology and preferences, etc. — of the current and future values of several macroeconomic variables. ii. The impact of expectations over short periods ahead is well established. This impact is especially evident in the prices of some types of assets. iii

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  A Concise Guide to Macroeconomics, Second Edition

  What Managers, Executives, and Students Need to Know

  • David Moss(Author)
  • 2014(Publication Date)
  • Harvard Business Review Press

    (Publisher)

  67 C H A P T E R T H R E E Expectations A final topic of great importance in macroeconomics is expecta- tions. Expectations about the future play a pivotal role in every market economy, influencing in one way or another nearly every economic transaction and decision. As we have seen, expecta- tions can drive an entire economy in one direction or another and can even become self-fulfilling. If depositors expect a bank to fail, it very well might if fearful depositors begin pulling their money out en masse. Similarly, for the economy as a whole, expectations of inflation can produce the real thing; and an econ- omy can fall into recession if enough people expect it to falter. These sorts of expectations are of particular interest to macro- economists. The good news is that expectations can push economic reality not only in a negative direction, but in a positive one as well. Understanding the Macro Economy 68 Sometimes these favorable expectations emerge on their own. At other times, many macroeconomists believe, the government has to help cultivate them. In fact, managing expectations may well be the most important function of macroeconomic policy, both monetary and fiscal. Expectations and Inflation Naturally, neither firms nor individuals want to come out on the losing side of inflation. If workers expect consumer prices to rise in the months and years ahead, they will likely demand higher wages to ensure that their real incomes—that is, their incomes after adjusting for inflation—don’t fall. By the same token, if firms expect wages and other input prices to rise, they are likely to try to raise their prices to ensure that their earnings don’t fall. Prices and wages will therefore rise in reality as individuals and firms try to protect themselves against expected price increases. In this way, expectations of inflation can powerfully drive reality.

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  Selected Papers Of Lawrence R Klein: Theoretical Reflections And Econometric Applications

  • Kanta Marwah(Author)
  • 1997(Publication Date)
  • World Scientific

    (Publisher)

  15 THE TREATMENT OF EXPECTATIONS IN ECONOMETRICS* 1. Specification of Econometric Models To a large extent, econometric analysis builds on an economic theory base. This is particularly true in the specification of econometric models; whether micro or macro, whether partial or complete. The prominent role assigned to expectations in economic theory must surely carry over, then, to econometric analysis. Theo-reticians like Professor Shackle have made the point in a telling way that economic units use expectations when making optimal economic decisions. In some versions of theory, economic units are assumed to optimize expected profits or expected satisfactions. These optimization schemes are planned in terms of expected mar-ket variables, such as expected output price, expected interest rate, expected wage rate or even expected tax rate. Expected income levels, expected activity levels, expected factor inputs are also highly relevant in model building. This is all clear enough and rightfully enriches theoretical reasoning in eco-nomics, but what of econometrics, where it is not appropriate to reduce a problem to various contingencies about the outcome of expectations? In econometrics, we need definite measurement and fully testable model formulations. The trouble with expectations variables is that they are subjective, personal, and not easily measured for numerical statistical analysis. For as long as most living econometricians can remember, an attempt has been made to introduce lags in econometric model specifications as surrogates for expectations. In my first model building venture, for the Cowles Commission in the middle 1940s, I specified the equations of the models being constructed in terms of anticipated values and used recently realized values of a variable as indi-cators of anticipated values. 1 I wrote, ... the immediate past level, rate of change, acceleration, etc., of prices would be a likely set of data on which to form ex-pectations of future prices.

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  Exchange Rate Forecasting: Techniques and Applications

  • I. Moosa(Author)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  This excludes two pieces of information that can be useful in forming expecta- tions. The first is the past history of the other factors that affect the exchange rate such as interest rates and inflation rates. The second is expectations concerning these variables. For example, if the Bank of England is expected to run an expansionary monetary policy in the future, then we should expect the pound to depreciate. The adaptive expectations hypothesis does not allow for this consideration, but the rational expecta- tions hypothesis does. In fact, the rational expectations hypothesis implies that agents are rational in the sense that they utilise all available information to form expectations. The rational expectations hypothesis does not imply that the forecast is necessarily correct. However, it implies that the expectations error is random. Hence, the specification may be written as E(s t+ i\Q t ) = s,+i + £ t+1 (1.12) where £ (+1 is a white-noise error term realised at t + 1. Rational expecta- tions thus implies the following: on the basis of the information set available at time t, Vt t , the expected value of the exchange rate at time t +\ will be equal to the actual value plus a random error term (which may be positive or negative). It also tells us that the expected value of the exchange rate should converge on the mathematical expectation or the value generated by the true 19 Exchange Rate Forecasting: Techniques and Applications model. The mathematical expectation or simply the expected value of a random variable is a weighted average of all possible outcomes where the weight assigned to an outcome is equal to its probability. The concept of rational expectations brings us to the issue of the rationality of forecasting or forecasts. This concept is best illustrated with this example. Suppose that, as part of a survey, you asked two people, an academic economist and a professional economist, to forecast the exchange rate over the next year.

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  The Influence of Uncertainty in a Changing Financial Environment

  An Inquiry into the Root Causes of the Great Recession of 2007-2008

  • Ricardo A. Halperin(Author)
  • 2017(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The fact that so many smaller firms fail soon after they are established 6 does suggest that the analysis leading to the decision to set them up was not as thorough as theory would lead us to expect. Rationality in the development of expectations seems like a logical cor- ollary to the assumption of rational behavior. It implies that consumers develop their expectations about the future by drawing on all the available information from the past, learning by doing how to translate this infor- mation into their expectations which, on average, tend to be validated by results. The concept of rational expectations asserts that outcomes do not differ system- atically (i.e., regularly or predictably) from what people expected them to be. 7 What holds for consumers presumably would hold even more strongly for business firms, which have more resources to examine past records in order to develop their expectations for the future, and take their decisions accordingly. This is not to argue that everyone makes rational decisions every time, or holds rational expectations about everything, as the periodic failures R.A. HALPERIN 171 of those forecasting the end of the world by specific dates have repeat- edly shown. It is enough to argue that rationality is the dominant force in economic decision making and in formulating expectations, so that the discrepancy between expected and actual outcomes becomes an unpre- dictable variable, which will err as much on the optimist as on the pessi- mist side. Rational Expectations Theory builds upon these simple concepts and examines their implications in real life.

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