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.

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 .

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

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

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.

Adaptive Expectations

• Decisions

• decisions

• decisions

• decisions

• decisions

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.

Adaptive Expectations

Process:

• next year’s inflation rate is equal to this year’s inflation rate

Adaptive Expectations

Process:• next year’s inflation rate is equal to this year’s inflation rate

• next year’s inflation rate is equal to the average of the last three year’s inflation rates

Adaptive Expectations

Process:• next year’s inflation rate is equal to this year’s inflation rate

• next year’s inflation rate is equal to the average of the last three year’s inflation rates

• fit a trend line (regression analysis) to the last 20-30 years and find the next period’s inflation on the trend line

Adaptive Expectations

Process:• next year’s inflation rate is equal to this year’s inflation rate

• next year’s inflation rate is equal to the average of the last three year’s inflation rates

• fit a trend line to the last 20-30 years and find the next period’s inflation on the trend line

• estimate an equation (regression analysis) according to a model

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.

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.

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.

Rational Expectations Hypothesis

• John Muth, 1969

• Robert Lucas

• Thomas Sargent

• Neil Wallace

• Robert Barro

are the formulator of the rational expectations hypothesis.

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.

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

Advantages of Rational Expectations

REH

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

Advantages of Rational Expectations

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

• more general

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

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.

Limitations of Rational Expectations

• Many individuals

Limitations of Rational Expectations

• Many individuals

• Many forecasts

Limitations of Rational Expectations

• Many individuals

• Many forecasts

• Understanding the macroeconomy

Limitations of Rational Expectations

• Many individuals

• Many forecasts

• Understanding the macroeconomy

• Knowing how to model the economy

Limitations of Rational Expectations

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

Limitations of Rational Expectations

• Each individual’s 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)?

Limitations of Rational Expectations

• Each individual’s 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.

New Classical Hypothesis

Assumptions

• Pure competition

New Classical Hypothesis

Assumptions• Pure competition

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

New Classical Hypothesis

Assumptions• Pure competition

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

• Self interest

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

New Classical Hypothesis

Yd( M 1, g1 ,t1)

Ys(Pe1 , Me

1, ge1 ,te

1)

EP1

y1

New Classical Hypothesis

Unanticipated expansionary policy

Yd( M 1, g1 ,t1)

Ys(Pe1 , Me

1, ge1 ,te

1)

EP1

y1 y2

P2 E’

Yd( M 2, g2 ,t2)

New Classical HypothesisUnanticipated expansionary policy

Yd( M 1, g1 ,t1)

Ys(Pe1 , Me

1, ge1 ,te

1)

EP1

y1 y2

P2 E’

Yd( M 2, g2 ,t2)

Ys(Pe2 , Me

2, ge2 ,te

2)

E’’

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.