Understanding Expectations in Economics Flashcards
What does the adaptive expectations hypothesis suggest?
Individuals form their expectations of future inflation based on past trends.
How do individuals expect future inflation if it has been consistently high?
They expect it to remain high.
How do individuals expect future inflation if it has been low?
They anticipate it will stay low.
What type of approach does the adaptive expectations hypothesis represent?
A backward-looking approach.
What economic concept was widely used before the development of rational expectations?
Adaptive expectations.
What significant economic event in the 1970s is associated with the breakdown of the Phillips Curve?
Stagflation.
What policy mistake did governments make during the 1970s regarding inflation and unemployment?
They believed that increasing inflation could reduce unemployment.
What was the consequence of workers and firms adapting their expectations to persistently high inflation?
They demanded higher wages, leading to a wage-price spiral.
What is a wage-price spiral?
A situation where rising wages lead to higher prices, which in turn leads to further wage demands.
Fill in the blank: The adaptive expectations hypothesis was used before the development of _______.
[rational expectations].
True or False: The adaptive expectations hypothesis is a forward-looking approach to inflation.
False.
What is a strength of Adaptive Expectations?
Simplicity → Useful for explaining short-term behavior.
Adaptive Expectations provide a straightforward framework for understanding immediate responses in economic behavior.
What is a limitation of Adaptive Expectations in volatile economies?
Fails in volatile economies → Does not account for sudden shifts in economic policy or external shocks.
This limitation indicates that Adaptive Expectations may not accurately predict behavior during times of economic instability.
In what type of environments is Adaptive Expectations considered empirically weak?
Empirically weak in high-information environments → Agents do not always rely on past trends when they have access to better data.
High-information environments allow agents to make more informed decisions, reducing reliance on historical data.
What is the rational expectations hypothesis?
Individuals use all available information to make optimal predictions about the future.
Developed by Robert Lucas and John Muth.
According to the rational expectations hypothesis, how are expectations generally formed?
On average, expectations are correct, though individual errors may occur.
Who was the Chair of the Federal Reserve during the 1980s Volcker Shock?
Paul Volcker.
What action did Paul Volcker take to combat high inflation in the early 1980s?
Aggressively raised interest rates.
What was a consequence of the aggressive interest rate hikes during the 1981-1982 period?
A severe recession.
What occurred once economic agents were convinced that the Fed was committed to reducing inflation?
Expectations adjusted, and inflation fell sharply.
Fill in the blank: The rational expectations hypothesis suggests that economic agents use _______ to make predictions.
[all available information].
True or False: The rational expectations hypothesis states that individual expectations are always correct.
False.
What does the example of the 1980s Volcker Shock illustrate about rational expectations?
Rational expectations can make disinflation faster and less costly than previously believed.
What is the main theoretical implication of rational expectations?
Explains why anticipated policies often have limited effects
For example, monetary policy is less effective if it is expected.
What empirical support is provided for rational expectations?
Volcker’s shock illustrates how rational expectations can anchor inflation
This refers to the events during Paul Volcker’s tenure as Federal Reserve Chairman.
True or False: Rational expectations assumes individuals have perfect information.
False
In reality, individuals do not always have access to all economic data.
What aspect of human behavior does rational expectations ignore?
Cognitive biases
People may misinterpret signals due to uncertainty or herd behavior.
What does the Permanent Income Hypothesis suggest about consumer spending?
Consumers base their spending on expected lifetime income rather than short-term fluctuations.
This theory was proposed by Milton Friedman.
How do consumers react to expected inflation according to the Permanent Income Hypothesis?
They may increase spending today to avoid future price increases.
This behavior reflects a proactive approach to anticipated economic changes.
What is the consumer behavior during expected deflation?
They delay purchases, which can worsen economic downturns.
This was notably observed during Japan’s ‘Lost Decade’ of the 1990s.
Fill in the blank: Under the Permanent Income Hypothesis, consumers base their spending on _______.
[expected lifetime income]
What was the consumer behavior in the UK from 2016 to 2019 following Brexit uncertainty?
Households increased precautionary savings, slowing consumption growth despite low unemployment.
This demonstrates the impact of expectations on spending decisions.
True or False: According to the Permanent Income Hypothesis, actual income changes are the primary driver of consumer spending.
False
The hypothesis emphasizes expected lifetime income over actual income changes.
What do firms base investment decisions on?
Expected future conditions
If firms expect high inflation, what action might they take regarding investments?
Front-load investments to avoid rising costs
What might firms do if they expect deflation?
Cut investments, leading to slower growth
What event is used as an example of weak capital investment despite low interest rates?
2008 Financial Crisis
What did firms anticipate following the Global Financial Crisis that affected their investment decisions?
Prolonged economic stagnation
What was the response of businesses to the Bank of England and the Federal Reserve cutting rates aggressively post-crisis?
Businesses did not respond as expected due to anticipating weak demand
Fill in the blank: Firms may _______ investments to avoid rising costs during high inflation.
front-load
True or False: Firms are more likely to increase investments during expected deflation.
False
What was a significant factor influencing firms’ investment behavior during the 2008 Financial Crisis?
Weak capital investment despite record-low interest rates
What do workers and firms negotiate based on?
Expected inflation
What happens if workers expect high inflation?
They demand higher wages, contributing to cost-push inflation
What do firms do if they expect deflation?
They resist wage increases or reduce salaries
What was a significant example of wage negotiation in the 1970s?
UK Trade Unions negotiating wage increases above productivity growth
What was the consequence of the UK Trade Unions’ actions in the 1970s?
Exacerbation of inflation and industrial unrest
What did the government fail to do in the 1970s that contributed to inflation?
Anchor expectations
Fill in the blank: If firms expect ________, they resist wage increases.
deflation
True or False: Strong trade unions in the 1970s negotiated wage increases below productivity growth.
False
What is the primary focus of central banks in managing monetary policy?
Managing expectations to maintain price stability
What is inflation targeting?
A strategy used by central banks to anchor inflation expectations and stabilize actual inflation
Which central banks utilize inflation targeting?
- Bank of England
- European Central Bank (ECB)
- Federal Reserve (Fed)
When did the Bank of England gain independence to target inflation?
1997
What inflation target has the Bank of England set since 1997?
2% inflation
What methods does the Bank of England use to shape expectations?
- Forward guidance
- Credibility
True or False: The Bank of England’s inflation targeting has helped maintain stable inflation rates in the UK over the long run.
True
What do expectation-based models explain about policy effectiveness?
If expectations are well-anchored, monetary and fiscal policy have predictable outcomes.
How are expectation-based models crucial for inflation control?
Central banks use expectations management to prevent inflationary or deflationary spirals.
What is one benefit of expectation-based models in economic forecasting?
Helps predict economic trends more effectively than models that assume static behavior.
What is a limitation of expectation-based models regarding rationality?
Over-reliance on rationality; behavioral economics shows consumers and firms are prone to irrationality.
What challenge exists in measuring expectations in expectation-based models?
Surveys and market-based indicators (e.g., bond yields) are imperfect proxies.
What can happen if expectations become self-fulfilling?
If firms expect a recession, they cut investment, causing the downturn they feared.
What are central to modern macroeconomic theory?
Expectations
Expectations influence various economic behaviors including consumption and investment.
What aspects does the shift from adaptive to rational expectations improve?
Policy effectiveness
Rational expectations provide a more accurate framework for understanding economic behavior.
List three real-world deviations that highlight the need for refinement of expectation-based models.
- Uncertainty
- Misinformation
- Cognitive biases
These factors can impact the accuracy of expectations in economic models.
What remains one of the most important challenges for economists and policymakers?
Understanding and managing expectations
Proper management of expectations can significantly influence economic stability and growth.
True or False: The shift to rational expectations completely eliminates the need for refining economic models.
False
Real-world complexities necessitate ongoing adjustments to expectation-based models.
