Expectations and Macroeconomics

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Expectations and Macroeconomics

• In the long run
• workers experience no money illusion which means,
• actual and natural unemployment rates are one and
  the same. VERTICAL PC.

2
Expectations and Macroeconomics

• In the short run
• in order to decide how much labor to supply,
  workers must determine real wage rate. This
  necessitates forecasting price level and
  inflation, Pe .

3
Expectations and Macroeconomics

• In the short run
• in order to decide how much labor to supply,
  workers must determine real wage rate. This
  necessitates forecasting price level and
  inflation.
• If price expectations and actual prices are the
  same, then, actual and natural unemployment rates
  will be the same.
• Pe P Ut Un

4
Expectations and Macroeconomics

• In the short run
• in order to decide how much labor to supply,
  workers must determine real wage rate. This
  necessitates forecasting price level and
  inflation.
• Pe P Ut Un
• Actual and natural unemployment rates will be the
  same.
• If price expectations and actual prices are
  different, then, actual and natural unemployment
  rates will not be the same. That is, business
  cycles will occur.
• If Pe ? P Ut ? Un

5
Expectations and Macroeconomics

• In the short run
• in order to decide how much labor to supply,
  workers must determine real wage rate. This
  necessitates forecasting price level and
  inflation.
• Pe P Ut Un
• If price expectations and actual prices are the
  same, then, actual and natural unemployment rates
  will be the same.
• If Pe ? P Ut ? Un
• If price expectations and actual prices are not
  the same, then, actual and natural unemployment
  rate will not be the same. That is, business
  cycles will occur. Therefore, how expectations
  are formed and how they influence decisions
  dictate macroeconomic models and outcomes.

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Adaptive Expectations

• Decisions
• decisions
• decisions
• decisions
• decisions

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Adaptive Expectations

• Decisionsdecisionsdecisionsdecisionsdecisions
• We need to make decisions about buying, selling,
  hiring, firing, coming, going, etc. without full
  information this includes information about
  prices, wages, technical know-how about the
  future. How then people forecast the future?
  Guesstimate based on the information is available.

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Adaptive Expectations

• Process
• next years inflation rate is equal to this
  years inflation rate

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Adaptive Expectations

• Process
• next years inflation rate is equal to this
  years inflation rate
• next years inflation rate is equal to the
  average of the last three years inflation rates

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Adaptive Expectations

• Process
• next years inflation rate is equal to this
  years inflation rate
• next years inflation rate is equal to the
  average of the last three years inflation rates
• fit a trend line (regression analysis) to the
  last 20-30 years and find the next periods
  inflation on the trend line

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Adaptive Expectations

• Process
• next years inflation rate is equal to this
  years inflation rate
• next years inflation rate is equal to the
  average of the last three years inflation rates
• fit a trend line to the last 20-30 years and
  find the next periods inflation on the trend
  line
• estimate an equation (regression analysis)
  according to a model

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Adaptive Expectations Implications

• Workers adjust their expectations only when new
  data about price level and inflation come in.
  Before any new data on the past values of the
  variable becomes available, there is no reason to
  change their expectations and forecast.

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Adaptive Expectations Implications

• Workers adjust their expectations only when new
  data about price level and inflation come in.
  Before any new data on the past values of the
  variable becomes available available, there is no
  reason to change their expectations and forecast.
  As a result, they consider nominal wage raises
  beyond their Guesstimate as real raises and
  supply more labor which leads to higher output.
  Positively sloped AS and negatively sloped PC.
  MONEY ILLUSION.

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Adaptive Expectations Implications

• Workers adjust their expectations only when new
  data about price level and inflation come in.
  Before any new data on the past values of the
  variable becomes available available, there is no
  reason to change their expectations and forecast.
  As a result, they consider nominal wage raises
  beyond their Guesstimate as real and supply more
  labor which leads to higher output. Positively
  sloped AS and negatively sloped PC. MONEY
  ILLUSION. In this case, the theory suggests that,
  workers consciously ignore other information such
  as changes in the monetary or fiscal policies.

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Rational Expectations Hypothesis

• John Muth, 1969
• Robert Lucas
• Thomas Sargent
• Neil Wallace
• Robert Barro
• are the formulator of the rational expectations
  hypothesis.

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Rational Expectations Hypothesis

• REH states that
• an individual makes the best possible forecast of
  a macroeconomic variable such as the price level
  and inflation rate using all available past and
  present information and drawing on an
  understanding of what factors affect the
  macroeconomic variable.

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Rational Expectations Hypothesis

• REH states that
• an individual makes the best possible forecast of
  a macroeconomic variable such as the price level
  and inflation rate using all available past and
  present information and drawing on an
  understanding of what factors affect the
  macroeconomic variable. REH is a forward looking
  process.
• Uses past and current information
• Uses an understanding (model) of the economy

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Advantages of Rational Expectations

• REH
• imposes no constraint on how people use and
  forecast macro variables

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Advantages of Rational Expectations

• REH
• imposes no constraint on how people use and
  forecast macro variables
• more general

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Advantages of Rational Expectations

• REH
• imposes no constraint on how people use and
  forecast macro variables
• more general
• if people could use any information to improve
  their forecast, they would do so

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Advantages of Rational Expectations

• REH
• imposes no constraint on how people use and
  forecast macro variables
• more general
• if people could use any information to improve
  their forecast, they would do so
• if there is no information or foresight about a
  variable other than its own past values, REH and
  adaptive expectations are the same.

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Limitations of Rational Expectations

• Many individuals

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Limitations of Rational Expectations

• Many individuals
• Many forecasts

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Limitations of Rational Expectations

• Many individuals
• Many forecasts
• Understanding the macroeconomy

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Limitations of Rational Expectations

• Many individuals
• Many forecasts
• Understanding the macroeconomy
• Knowing how to model the economy

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Limitations of Rational Expectations

• Each individuals economic model is different
  from another. This means different REH model.
  This creates a difficulty in macroeconomic
  modeling.

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Limitations of Rational Expectations

• Each individuals economic model is different
  from another. This means different REH model.
  This creates a difficulty in macroeconomic
  modeling.
• Individuals expectations affect the economy.
  Does this mean that individuals should
  incorporate other peoples expectations in their
  expectation model (cross pollination)?

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Limitations of Rational Expectations

• Each individuals economic model is different
  from another. This means different REH model.
  This creates a difficulty in macroeconomic
  modeling.
• Individuals expectations affect the economy.
  Does this mean that individuals should
  incorporate other peoples expectations in their
  expectation model?
• Representative agent assumption?
• This will take care of the problem of many models
  and many forecasts.

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New Classical Hypothesis

• Assumptions
• Pure competition

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New Classical Hypothesis

• Assumptions
• Pure competition
• Wage and Price Flexibility (no minimum wage laws
  or labor contracts that fix nominal wages)

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New Classical Hypothesis

• Assumptions
• Pure competition
• Wage and Price Flexibility (no minimum wage laws
  or labor contracts that fix nominal wages)
• Self interest

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New Classical Hypothesis

• Assumptions
• Pure competition
• Wage and Price Flexibility (no minimum wage laws
  or labor contracts that fix nominal wages)
• Self interest
• All individuals form rational expectations
  despite the fact that they do not have complete
  information

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New Classical Hypothesis
Ys(Pe1 , Me1, ge1 ,te1)
E
P1
Yd( M 1, g1 ,t1)
y1
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New Classical Hypothesis

• Unanticipated expansionary policy

Ys(Pe1 , Me1, ge1 ,te1)
P2
E
E
P1
Yd( M 2, g2 ,t2)
Yd( M 1, g1 ,t1)
y1
y2
35
New Classical Hypothesis

• Unanticipated expansionary policy

Ys(Pe2 , Me2, ge2 ,te2)
Ys(Pe1 , Me1, ge1 ,te1)
E
P2
E
E
P1
Yd( M 2, g2 ,t2)
Yd( M 1, g1 ,t1)
y1
y2
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New Classical Hypothesis

• Policy ineffectiveness Proposition
• Systematic, or predictable, macroeconomic policy
  should have no short run effects on the real
  variables such as output, employment or
  unemployment. Only unanticipated policies have
  short run effects.