Macroeconomics

Expectations are crucial in determining the success of government policy on unemployment and inflation. Whatever people expect to happen, their actions will tend to make it happen. At the time that economic agents-households, firms, the government make choices, they are generally uncertain about the future. Assumptions about how these agents form expectations for the future shape the properties of any dynamic economic model. Great debates have gone on among economists and psychologists in recent years over the ways that economic agents actually formulate their expectations about their future and the ways that macroeconomists should assume they do this in their theoretical models. To make economic decisions in an uncertain environment agents must forecast such variables as future rates of inflation, tax rates, government subsidy schemes and regulations.

A business firm contemplating an investment needs to know the future path of income that will result from the investment. However future earnings can be estimated only with considerable uncertainty. If there is a boom in the future, then the future earnings may be high and vice versa. But the actual exact future state of the economy is virtually unknowable. This is why households and firms have to formulate some expectations about the future in order to make choices. Indeed, they must often cope with complex assessments of the relative likelihood of many different possible events- the educated guesses that households have to make about the future value of income for example.

From a macroeconomic perspective expectation may well determine beliefs such as that an expansion of money supply will merely lead to inflation (the monetarist position), then it will. Firms and workers will adjust their prices and wages upwards. Firms will make no plans to expand output and will make no plans to expand output and will not take on any more labour. If, however, people believe that an expansion of demand will lead to higher output and employment (the keynesian position), then, via the accelerator mechanism, it will.

Similarly, just how successful a deflationary policy is in curing inflation depends in large measure on people's expectations. If people believe that a deflationary policy will cause a recession, then firms will stop investing and will cut their workforce. If they believe that it will cure inflation and restore firms' competitiveness abroad, firms may increase investment. To manage the economy successfully, therefore, the government must convince people that its policies will work. This is as much a job of public relations as of pulling the right economic levers.

The importance of expectations has long been appreciated by macroeconomists. When John Maynard Keynes (1883-1946), published his General Theory of Employment, Interest, and Money in 1936, he set off a revolution. Within Keynes's General Theory expectation arose most importantly in the analysis of investment. For example, since building a factory takes time there will be a delay before output is produced. So the entrepreneur has to form expectations about the demand for a product in the future in order to assess the likely profitability of the venture.

However time and uncertainty ...