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I can no longer avoid the question of what exactly is meant by the term
'expectations'. The discussion turns on what we mean by uncertainty. Consider
first a stylized example. A fair coin is to be tossed and all agree that the
probability of a head is one half. Statisticians might approach this definition of
probability either from the ex-ante standpoint that the event of tossing a fair
coin can be decomposed into two possible outcomes, each of which is equally
likely; or from the ex post standpoint that half the outcomes would be heads if
the coin were tossed sufficiently often. Suppose we assign the value zero to the
outcome of a head and the value one to the outcome of a tail. The expected
value of the outcome of a single toss-is then 6ne half. By this mathematical
expectation, or mean, we denote the result of taking each conceivable
outcome, here zero and unity, multiplying each outcome by the associated
probability, and summing over all possible outcomes. Suppose next that we
toss the coin ten times, adding the score for each outcome to obtain a total
score. Since the different tosses are independent experiments, we can deduce
that the mean total score is ten times one half. We may also define measures
of the dispersion around this mean of five, indicating the probability that the
total score will depart from five by various amounts. For example, the outcome
of ten consecutive heads is very unlikely, but possible.
We wish to model individual behaviour in an uncertain world. Consider an
individual faced with two alternative bets, each with the same mean but having
different dispersions or degrees of riskiness of deviating, from the mean value.
If individuals reveal that they are indifferent between the two bets, we say that
they are risk neutral their preferences may be entirely described in terms of the
mean or mathematical expectation of the uncertain event. If, for two bets
having the same mean, individuals prefer the bet with the lower dispersion, we
say that individuals exhibit risk aversion. Since individuals then assess
uncertain events both by the mean and the dispersion, it will be necessary to
model each of these influences on individual behaviour. Nevertheless, if the
degree of dispersion or riskiness remains approximately constant over time, we
may be able to capture the most important determinants of changes in
behaviour merely by modeling changes in the mathematical expectation.
In such a world we might interpret the rather loose phrase expectations of the
future to mean the strict mathematical expectation of future variables, given
the assessment of riskiness at the d. Ate expectations are to be formed. Of
course, individuals may not make a correct assessment of the true
probabilities, but then a slightly weaker concept will suffice. We could say that
individuals make subjective assessments of the probabilities and use these to
construct the relevant weighted average in the manner discussed above. We
then say that individuals act on the basis of subjective expectations. By
modelling the manner in which individuals arrive at assessments of these
subjective expectations, it is then possible to construct a theory of expectations
formation which relies on available information at the date expectations are to
be formed.
This interpretation has one great merit. The conventional interpretation of The
General Theory views the work as a collection of ad hoc relations, each of
which has subsequently been 'improved' by Post-Keynesian macroeconomics.
The simple consumption function has been supplanted by a version of the
Permanent Income-Lifecycle model, the' marginal efficiency of investment
schedule has been replaced by a version of the Flexible Accelerator model,
liquidity preference by more explicit analysis of the transactions cost and risk
motives for money demand, and so on. In constrast, the above interpretation
not only places individual relations within a modem intertemporal framework,
but emphasizes that they represent a coherent and internally consistent
approach.
Adaptive Expectations
(2.3.1)
Having some forecast t-2x_t based on information available at the end of time
t-2, individuals examine ex post how well that forecast predicted the actual
value xt-1 and revise their forecast for x one period later at time t by some
fraction of the forecasting error at time t-1. Rearranging equation (2. 3.1)
(2.3.2)
All terms except the final term are observable. Since is a positive fraction, (1-
)^n+1 gets steadily smaller as n is increased. Provided only that the value of
this final expectation is finite, we can shrink its influence on current
expectations to an infinitesimal level by considering a sufficiently large value of
n. The appeal of the Adaptive Expectations hypothesis is that it allows us to
model unobservable expectations purely in terms of past observations on the
relevant variable x, without the need to specify the process by which the initial
level of expectations is determined.
Equation (2.3.3) also emphasises that the behavioural rule (2. 3. 1) is really an
assertion that current expectations t-1x$ are based on an extrapolation or
weighted average of past actual values of x in which the weights have the
simple property of geometric decline: the coefficient on xt-k in equation (2. 3.
3) is (1-) times the coefficient on xt-(k-1). For this reason, the Adaptive
Expectations rule is sometimes known as the geometric distributed lag on past
values of x.
If the economy has been in static equilibrium for a sufficient time, individuals
forming Adaptive Expectations will eventually come to anticipate correctly the
value which x takes on. This seems a minimal requirement for a plausible rule
for modelling expectations formation. However, if the economy is not in static
equilibrium, the hypothesis of Adaptive Expectations allows individuals to learn
from previous forecasting errors.
Subtracting equation (2.3.5) from equation (2.3.4) and using equation (2.3.1)
we obtain
Fitting this equation to the data to obtain coefficient estimates, the value of
could be inferred from the coefficient on yt-1, hence allowing the value of to
be inferred from the coefficient on, xt-1, while the value of P could be inferred
from the coefficient on zt. Although equation (2.3.3) makes clear that Adaptive
Expectations is implicitly an extrapolation of an infinite number of previous
observable x values, the trick of transforming the original equation by
subtraction of the relevant multiple of yt-1 leads to the simple formulation
(2.3.6) which is easy to implement empirically.
The hypothesis thus offered a simple solution to the needs of both theoretical
and empirical macroeconomists seeking to model expectations formation;
indeed, the apparently plausible behavioural assumption (2.3.1) seemed to
provide a theoretical justification for the empirical practice of implicit
extrapolation which was first adopted by Fisher (1930) in studying the effect of
expected inflation on nominal interest rates. Nor was it necessary to confine
attention to extrapolative Schemes imposing a geometric decline on the
weights attached to past values of the relevant variable; Almon (1965) devised
an econometric technique allowing empirical economists conveniently to
estimate more flexible lag shapes, the particular weights being chosen so that
the implied expectations best fitted the data for the model in question.
While the hypothesis of Adaptive Expectations, and its subsequent
generalizations, represented a considerable advance, several problems
remained. First, the hypothesis is entirely backward looking as equation (2. 3.
3) makes clear. Suppose that OPEC is meeting next week but that the outcome
of their deliberations is a formality; everyone knows that they will announce a
doubling of oil prices. Surely economists will be predicting higher inflation from
the moment at which news of the prospective oil price increase first becomes
available? Yet the hypothesis of Adaptive Expectations asserts that individuals
raise inflation expectations only after higher inflation has gradually fed into the
past data from which they extrapolate. Adjustment of expectations is very
sluggish. Using such a rule, individuals would make systematic mistakes,
underpredicting the actual inflation rate for many periods after tine oil price
rise. It is not plausible that individuals would take no action to amend the basis
of their forecasting rule under such circumstances.
Rational Expectations theorists would still raise the following objections. First,
it is still imagined that the only variables which need to be considered are past
values of the variable about which expectations are to be formed. Such partial
equilibrium analysis does not fit comfortably within the tradition of
macroeconomics in which the general equilibrium or system-wide effects are of
great importance. For example, data about past rates of money growth may
usefully supplement data on past inflation rates in predicting future inflation.
Secondly, all mechanistic backward looking extrapolative rules allow the
possibility of systematic forecasting errors for many periods in succession. The
suboptimal use of available information is hard to reconcile with the idea of
optimization which is the foundation of most microeconomic analysis.
Begg (1982) discusses the relation between Keynes and Rational Expectations,
but the reader is advised to wait until the material in Chapter 6 has been
considered.