Term 2 Week 4: Expectations Flashcards
What are expectations, and who forms them (1,4)
-Expectations are the forecasts/views decision makers hold about the future
-Firms form expectations of future profits (Tobin’s Q, with a forward looking stock market valuation and future expected profit)
-Households form expectations over their future incomes (PIH and the desire to smooth consumption with expected future income)
-Wage setters form inflation expectations
-Policy makers forecast inflation in the next periods (monetary policy)
What is the difference between risk and uncertainty (1,2)
-Forming expectations is a vital part of economic life due to risk and uncertainty
-Risk is the known probabilities which can be attached to future outcomes, which can be measured, controlled, minimised etc
-Uncertainty is when it is impossible to assign probabilities to known/unknown outcomes, cannot be measured, controlled, minimised
How did the world economy develop from the 1950s-1980s (2,3)
-There was stable but positive inflation in the 1950s/1960s due to governments pursuing activist demand management policies, and were happy to achieve low unemployment even if there was some positive inflation
-This is due to the depression, and policymakers fear of deflation
-However, towards the end of the 1960s, inflation began to rise, one expectation being supply side developments leading to a rise in equilibrium unemployment
-In many developed countries, the 1970s were characterised by stagflation, high unemployment and inflation
-This disagreed with the notion there was a long run trade off between inflation and output
How can we graphically represent the 1970s stagflation (4)
-There was a shift in bargaining power towards workers, and a series of commodity price shocks
-This led to an upward shift in the WS curve, and a downwards shift of the PS curve
-This thus decreased equilibrium output from ye to ye’
-Whilst the government keeps ye > ye’, inflation will rise continually, as inflation expectations will adjust upwards and this causes the cyclical upwards shifts of the PC curve and vertical movements in the economies position
What are adaptive expectations (4)
-Adaptive expectations involve having backwards-looking behaviour, as agents expect inflation to be what it was previously
-Adaptive agents make systematic errors, as long as y > ye, the real wage outcome is below what is expected as inflation is higher than expected
-Wage setters respond to their forecasting errors, but in a purely mechanical way
-Adaptive expectations do not allow agents to learn from their mistakes, and they played an important role in the 1950s and 60s
How can we modify the standard Phillips curve to get the adaptive expectations curve (1,3)
-The Adaptive Expectations Hypothesis is that πet = πt-1
-πt = πE + a(yt - ye)
-πt = πt-1 + a(yt - ye)
-Hence, Δπt = a(yt-ye)
What are Rational Expectations (3)
-Rational expectations involve forward-looking behaviour, where all available information is used and systematic errors avoided
-Expectation formation model is ‘model consistent’ (agents in the model know the model, and take the prediction as valid)
-In the RE framework, it is only unanticipated shocks to inflation/OG that result in inflation differing from expected
How can we apply rational expectations to the Phillips curve (1,2,3,1)
-The Rational Expectations Hypothesis is that π^Et = πt (inflation = expected)
-πt = π^ET + a(yt-ye) + εt (an error term)
-yt = ye - εt/a
-In this model, expectations are correct apart from the shock term
-It is crucial the error process is the ‘mean zero white noise’ kind, in order to rule out systematic errors.
-This error term is sometimes +ive, sometimes -ive, but on average it is 0
-Applying rational expectations to the standard Philips curve means there is no longer a tradeoff between inflation and the output gap
