 Systematic economic theories or analyses in which

expectations play a major role began as early as

Henry Thornton’s treatment of paper credit,
published in 1802, and Émile Cheysson’s 1887
formulation of a framework which had features of
the “cobweb” cycle.

 There is also some discussion of the role of

expectations by the Classical Economists, but while
they were interested in dynamic issues such as
capital accumulation and growth, their method of
analysis was essentially static. The economy was
thought to be in a stationary state which can be
seen as a sequence of static equilibria. A part of
this interpretation was the notion of perfect
foresight, so that expectations were equated with
actual outcomes. This downplayed the significance
of expectations.
 Alfred Marshall also extended the classical
approach to incorporate the distinction between
the short and the long run. He did not have a full
dynamic theory, but he is credited with the notion
of “static expectations” of prices.
 The first explicit analysis of stability in the
cobweb model was made by Ezekiel (1938).
 Hicks (1939) is considered to be the key systematic
exposition of the temporary equilibrium approach,
initiated by the Stockholm school, in which
expectations of future prices influence demands
and supplies in a general equilibrium context.
 Finally, Muth (1961) was the first to formulate
explicitly the notion of rational expectations and
did so in the context of the cobweb model.
 In macroeconomic contexts the importance of the
state of long-term expectations of prospective yields
for investment and asset prices was emphasized by
Keynes in his General Theory.
 Keynes emphasized the central role of expectations
for the determination of investment, output, and
employment. However, he often stressed the
subjective basis for the state of confidence and did
not provide an explicit model of how expectations
are formed.
 In the 1950s and 1960s expectations were introduced
into almost every area of macroeconomics, including
consumption, investment, money demand, and
inflation.
 Typically, expectations were mechanically
incorporated in macroeconomic modeling using
adaptive expectations or related lag schemes.
Rational expectations then made the decisive
appearance in macroeconomics in the papers of Lucas
(1972) and Sargent (1973).[8]
 Keynesian and Monetarists believe that there is a
difference between the short-run and long-run views.
This is deeply rooted to the view that expectations
about price level by employees are fixed in the short-
run. This means that labour supply schedule does not
change with government policies, hence policies
affect employment and output.
 In the long-run, expectations adjust to the effects of
policy actions, it is in the short run that they differ.
 In the Orthodox Keynesian that expectations are
effectively static, that is they never changes.
 Expectations are adaptive (backward looking) in the
Keynesian and monetarist world, and so they change
slowly with people making systematic predictable
mistakes.
 In early 1960s, John Muth developed a model where
agents had forward looking expectations.
 It quickly turned out that these large models led to
unreliable predictions. ... The diagnosis of this
failure was given by Robert Lucas, Nobel Prize
winner in economics. The old models considered
individual agents (consumers and producers) as
passive... Prof Lucas stressed that these agents are
human beings endowed with intelligence and a
desire to look for the best possible outcome. In
such an environment, he argued, the [agents]
should be modelled as active ... trying to
anticipate what the central bank would do.
 This criticism led to the rational expectations
revolution in economics. New models were built in
which a new assumption was introduced. Individual
agents now were assumed to understand the
complexity of the world in which they live and to
continuously compute the implications of central
bank actions for their present and future welfare.
 There are three different types of
expectations :
 Static expectation
 Adaptive expectation
 Rational expectation
 Static expectation deals with what would be
happened in the future is the same to what
was in the past. No addition information, no
updates.
 However the other two types treat future
economic performance in different ways.
 In economics, adaptive expectations means that people base
their expectations of what will happen in the future based on
what has happened in the past. For example, if inflation has
been high in the past, people would expect it to be high in
the future.
 In the theory of inflation, demand pull inflation and cost push
inflation are usually short-lived shocks. However, a series of
such shocks may lead people to assume that inflation is a
permanent feature of the economy (especially if the shocks
are large).
 In that case they will modify their economic behaviour
accordingly, based on their heightened expectation of future
inflation rates.
 For instance, they may begin demanding larger (nominal) pay
raises. This in itself acts as a cost push, leading firms to push
their prices higher, especially since the firms themselves have
similar expectations of inflation. This encourages another
round of pay-raises. This merges with the "price/wage spiral"
to build some inflation directly into the economy.
 The combination of the price/wage spiral and inflationary
expectations reflecting the recent past's experience with
inflation gives an economy built-in inflation.
 The theory of adaptive expectations can be stated using the
following equation, where pe is the next year's rate of
inflation that is currently expected; pe-1 is this year's rate
of inflation that was expected last year; p is this year's
actual rate of inflation,

pe = pe-1 + ?*(p – pe-1)

 
 With ? is between 1 and 0, this says that current
expectations of future inflation reflect past expectations
and an "error-adjustment" term, in which current
expectations are raised (or lowered) according to the gap
between actual inflation and previous expectations.
 This error-adjustment is also called "partial adjustment."
Rather than reflecting changing expectations of inflation, it
may reflect the slow change in people's ability to act on
changes in their expectations.
 Alternatively, the theory of adaptive expectations implies
that current inflationary expectations reflect a weighted
average all past inflation, where the weights get smaller and
smaller as we move further in the past.
 Under AEH, there are temporary effects on real
output. Therefore, the policy makers may be
tempted to use a monetary expansion to combat
unemployment.
 However, policy makers not very good at timing
monetary policy due to lag structures and its
effect on effectiveness on monetary policy.
 As a result, monetary policy can accentuate
business cycle fluctuations in economy. That is
why Friedman suggests the Central bank should
follow a constant growth rule for some monetary
aggregates and not tinker with monetary policy
in order to try to influence aggregate demand
and employment.

 John Muth argued that:
1. People would look to the future: they do not look to the
past, but would also look to the future. I doing so, they
would use piece of information they had available to
predict what was going to happen in the future.
2. People would use information intelligently: people form
expectations using relevant economic theory. They
understand the way in which economic variables they
observe affect the variable they are forming expectation
is about.
3. People would not make systematic errors: When forming
expectations, people would not keep getting it wrong.
This is in contrast to Keynesian theory that states people
make systematic errors.
4. He argued that expectations are formed rationally.
Rational expectations are forecasts that use all the
relevant information available about past and present
events, and that have the least errors.
 People who form rational expectations do
make mistakes, but they do not make
systematic mistakes. People expectations are
correct on average. This development had
obvious difference compared to the previous
school of thought.
1. Different from Classical Economics who
believed that except in the very short-run
that people had perfect information.
2. Keynesian and Monetarist argue that
expectations are not formed rationally. Due
to factors like costly information,
asymmetric information, people are not
machines and are not perfect in both
schools.
 Contemporary macroeconomics gives due weight to
the role of expectations. A central aspect is that
expectations influence the time path of the economy,
and one might reasonably hypothesize that the time
path of the economy influences expectations.
 The current standard methodology for modeling
expectations is to assume rational expectations (RE).
 Formally, in dynamic stochastic models, RE is usually
defined as the mathematical conditional expectation
of the relevant variables.
 The expectations are conditioned on all of the
information available to the decision makers. For
reasons that are well known, and which we will later
explain, RE implicitly makes some rather strong
assumptions.
 Rational expectations modeling has been the latest
step in a very long line of dynamic theories which
have emphasized the role of expectations.
 We have seen that with adaptive expectations,
agents may incur in systematic errors over time.
 This is not very satisfactory if we deal with
rational and optimizing agents.
 Rational expectations mean that agents in
forming their expectations about economic
variables use all the available information in an
efficient way.
 Therefore, in order for the idea of rational
expectations to work we need to assume that:
a) Agents know the relevant economic model
that describes the economy;
b) Agents use this model to create their
expectations;
 According to the idea of rational expectations,
agents do not make systematic errors and
expectations are in average correct. This implies
that the forecasting error should be zero
 The second wave of monetarism dealt with the split
of the effect of change In the rate of monetary
expansion between nominal and real magnitude.
 This had to do with the Phillips curve which was
discovered in 1958 by A. Phillips.
 There seemed to be have a systematic relationship
between the rate of change in money wages and the
rate of unemployment for the UK and other
countries with key characteristics of:
1. Inverse relationship
2. non-linear relationship
 Findings: Increase in demand for output :
1. would increase money wages or incomes because of
increase in labour demand.
2. would decrease the rate of unemployment because
labour demand would increase so as to produce
output.
 Typically, the Phillips curve is given as a relationship
between inflation rate and unemployment rate. This
can be justified on two grounds:
1. If prices are just markups from wages then the two
will move together
2. Empirically, the evidence shows that movements in
prices and wages are vey similar.

 Algebraically,
* *
U t  U t 1   ( Pt  Pt 1 )
 Where U represents unemployment rate, and
represents inflation rate. <0 Also represents
governs how much a one percentage point increase in
inflation will decrease the unemployment rate,
 Short run: Money Illusion
1. The Phillips curve result gave a strong justification
for Keynesian stabilization policies and also showed
what government needed to do stabilize the
economy.
2. The curve was not stable over longer time frame, it
changes position. In particular, higher inflation rates
seemed to be associated with lower levels of
unemployment initially, but then the unemployment
rate seemed to return to its value before inflation
had increased. Both Keynesian and Friedman were in
puzzle why this phenomenon occurred and tried to
figure out what was going one.
3. The trade-off required that workers suffered from
money illusion. Workers consider nominal wage, not
real wage , in their decision. As both Friedman and
Phelps argued, this is because firms and workers set
nominal wage when then entered into contracts, but
real wage and unemployment ay change over period.
So, the trade-off is in short run.
 Long run: No money illusion
1. Both Friedman and Phelps argues that in the long
run, this trade-off is untenable since such
contracts tended to be for a finite period.
2. Workers then try and catch up, then real wage
would return to its initial higher level.
3. Therefore, entering in such contract, workers
and forms bargain on the basis of their
expectation of the price level, and hence the real
wage.
 In short, there can be a short-run trade-off, there
is no long-run trade-off. The long –run curve is
vertical at natural rate of unemployment.
 Noting that wage contracts are usually staggered
so there will be some changes in wage over
period.
 Algebraically, the expectation adjusted
Phillips curve is given as:

 New Classical economics was initiated by

Robert Lucas and arose for two reasons:
1. Theoretical: Introspection and a dislike
for the monetarist and Keynesian
modelling.
2. empirical: inconsistencies between
Keynesian and Monetarist models and
what actually happened in the late 1970s
resulting from oil price shocks.

 Stagflation and aggregate supply:
1. The Phillips curve found in 1958 and more elaborated
in the 1960s seemed to promise to have stable trade-
off between unemployment and inflation rate.
2. However, the experience of the late 1960s and 1970s
blew this relationship apart. During this period most
economies experienced both high inflation and high
unemployment-stagflation. The magnitude of the
change in unemployment seemed very large as
compared to the size of change in inflation.
3. A single short-run Phillips curve would have trouble in
explaining these movement, hence expectations
augmented Phillips curve.
4. Some economists argued that the size of these
changes seemed inconsistent with adaptive
expectations, which implied that people would adjust
their expectations slowly over time. This means that
larger changes will cause larger errors and therefore
larger adjustment in expectations.
 The introduction of rational expectation in a model
with flexible prices has the result that an anticipated
economic policy is totally ineffective (in affecting the
level of real output) also in the short-run.
 Rational expectations are not sufficient for this result
to hold, there is the need of price flexibility as well.
 This result is known as Policy Ineffectiveness
Proposition (PIP) and is due to Sargent and Wallace
(1975): “any systematic economic policy is totally
ineffective in determining the equilibrium value of
real output. With rational expectations and price
flexibility the equilibrium level of output fluctuates
around its natural level and those fluctuations
depend only on stochastic (and so unpredictable)
elements”
 Policy may have short-run effects only when it is not
correctly anticipated by the agents. Or in other
words: when economic agents are fooled by the
policy authorities that deviate from the systematic
parts of their policy rules.
 Is the PIP confirmed by the data? We should expect
that according to this theory, only unanticipated
monetary or fiscal policy can have effect on real
income. Evidence suggests that both anticipated and
unanticipated policies affect the level of output.
 Does this mean that the PIP is just a theoretical
result with applications in the real world? Probably
yes, however, the evidence depends on how we
distinguish between an anticipated and an
unanticipated policy. Furthermore, what is really
important from this theory is to show us how the
introduction of expectations (in this case rational
expectation) may affect the role of economic
policies.
 The Lucas’ critique (R.E. Lucas, 1976) referred
to a critique to the way macro econometric
models were used to analyze and forecast the
effects of economic policies. Now it is referred
more generally to a critique to economic policy
in general.
 The idea is the following: according to new
classical macroeconomists, when a government
changes a policy or implements a new policy it
should take into account that also the behaviour
of the agents will change.
 When we have analysed the effects of fiscal
policy in the IS-LM model, we have done that by
assuming that all the other parameters of the
model would remain constant. According to new
macroeconomists this is not realistic and can
bring the analysis to a wrong result.
 For example, if there is a change in fiscal policy
and the behaviour of agents will change
according to this change, then the marginal
propensity to consume may change as well.
 This in turn will change the result of the
analysis. In terms of macro econometric models,
the estimated coefficients cannot be used to
analyze a change in a given policy.
 Indeed those coefficients may change with the
change in the policy. Assuming them to remain
constant to get some forecasts of the effects of
the policy can be misleading.
 Governments should be aware that there is a sort
of strategic interaction going on with economic
agents when deciding a particular policy.