4 - Expectations & Time Inconsistency Flashcards
What role do expectations play in the IS curve?
Expectations about the future influence the spending decisions of firms and households.
Tobin’s q theory
- uses stock market to aggregate information about the firm’s expected future profits
- > 1, model predicts positive investment
Permanent Income Hypothesis (PIH)
-consumption decisions today reflect all the available information about expected future income.
What is the difference between risk and uncertainty?
Risk exists when we make decisions based on known probabilities.
-eg dice, pack of cards
Uncertainty differed from risk in two ways:
- Uncertainty exists where is is impossible to assign prob. to known outcomes.
- There are some outcomes which may be unknown.
Risk
Risk exists when we make decisions based on known probabilities.
Uncertainty
- Uncertainty exists where is is impossible to assign probabilities to known outcomes.
- There are son outcomes which may be unknown.
Disinflation can be cost less if the CB is perfectly credible.
A perfectly credible CB achieved firmly anchored expectations.
If it announced a lower inflation target and this is perfectly credible, the economy will jump to the new equilibrium without requiring a fall in output.
-disinflation is costless, purely transitory effect on inflation
Communication by CBs
Communication affects the extent to which inflation expectations are anchored to target, which affects the PC.
- IS is unchanged
- anchored expectations on the PC means the CB’s best response output gap is reduced, so a smaller change in the interest rate is required to get back on MR curve.
- anchored expectations make the PC steeper, causing the MR to be flatter.
Lucas critique
The Lucas critique highlights the dangers of forecasting by using models that rely on the relationships found in historical data
-depends on policy regimes in the past (unreliable) and the future (relationships break down).
Imagine the government is able to exert control over monetary policy.
Under adaptive expectations, if a government uses monetary policy to target a level of output above equilibrium, this will result in INFLATION BIAS (with no long run output gain).
-targeting above equilibrium output implies a gradual rise in inflation, which eventually leads the economy back to equilibrium output but with higher inflation.
Inflation bias
Targeting above equilibrium output implies a gradual rise in inflation, which eventually leads the economy back to equilibrium output but with higher inflation.
There is a short-run trade off between inflation and unemployment:
Expansion in aggregate demand given by the higher output target boosts inflation throughly the standard bargaining channel in wage-price setting.
The inflation bias suggests:
A government cannot commit to a credible output target of equilibrium if it has a preference for output above equilibrium.
-the government will always have an incentive to use monetary policy to boost output above equilibrium in the short-run (lower interest rates to boost aggregate demand)
How can governments solve the inflation bias problem?
It can be solved by the government delegating monetary policy to an independent CB that can credibly commit to target output at the equilibrium level.
Keynes
Keynes believed that some things were inherently uncertain and that we could not attach any meaning probability to them.
Adaptive expectations
Agents use actual current inflation as their best guess for further inflation.
Rational expectations
Agents use the true model of the economy and all available information to form their forecasts.
