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Economics of Expectations

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Economics of Expectations Existential Social Theory liberation. Reading Heidegger in relation to Hegel Friedrich (1844–1900); Sociology, History of; Weber, he produced in Being and Nothingness (1956 [1943]) Max (1864–1920); Weberian Social Thought, History an impressive restatement of the entire project of Of modernityasthediscoveryofhumanautonomy.Herethe commitment to freedom as the fundamental pre- requisite for any valuedform of human beingis restated with unsurpassed determination. The result is less a Bibliography secular version of a Christian notion of existence Camus A 1954 The Rebel [English translation by Bower A]. (Kierkegaard) than the consecration of a particular Knopf, New York kind of Romanticism (Fichte). This is characteristic Heidegger M 1962 [1927] Being and Time [English translation by also of Albert Camus (1913–60), whose The Rebel Macquarrie J, Robinson E]. Harper, New York (1954) returned to nineteenth-century Russian lit- Jaspers K 1933 Man in the Modern Age [English translation by erature for an understanding of nihilism as the most Paul E, Paul C]. Routledge, London consistent and fearless of existential views of the Jaspers K 1963 General Psychopathology [English translation human world. Only the free act could be considered by Hoening J, Hamilton M]. University of Chicago Press, authentically human, and as conformity to any exist- Chicago, IL Kierkegaard S 1978 [1845] Two Ages [English translation by ing convention was tainted with coercion, acts of Hong H V, Hong E H (eds.)]. Princeton University Press, rebellion bore the only indubitable sign of freedom Princeton, NJ and, therefore, of authenticity. Kierkegaard S 1980 [1844] The Concept of Anxiety [English Sartre increasingly sought for his existentialism a translation by Hong H V, Hong E H (eds.)]. Princeton larger and more dramatic stage; history and the University Press, Princeton, NJ collective subject, rather than the small individual acts Kierkegaard S 1987 [1843] Either\Or [English translation by of everyday life, supplied the setting for the working Hong H V, Hong E H (eds.)]. Princeton University Press, out of the great refusal; the negation of everything Princeton, NJ intolerable in modern life. The attempted synthesis of Langiulli N 1997 European Existentialism. Transaction, New existentialist and Marxist traditions resulted, in Crit- Brunswick, Canada and London Nietzsche F 1986 Human, All Too Human [English translation by ique of Dialectical Reason (1976 [1960]), in a social Hollingdale R J]. Cambridge University Press, Cambridge, theory paradoxically ‘founded’ on ‘anti-foundational’ UK existential insights. Through this Sartre sought to Sartre J-P 1956 [1943] Being and Nothingness [English translation establish praxis relevant to contemporary life rather by Barnes H]. Philosophical Library, New York than an explanation of its various features. Sartre J-P 1976 [1960] Critique of Dialectical Reason [English His views, thus, remain rooted in existential insight; translation by Sheridan-Smith A]. New Left Books, London ‘The only concrete basis for the historical dialectic is Weber M 1948 From Max Weber: Essays in Sociology [English the dialectical structure of individual acts.’ The radical translation by Gerth H H, Wright Mills C (eds.)]. Routledge freedom central to Being and Nothingness is somewhat and Kegan Paul, London muted here—reciprocity and otherness, mediated H. Ferguson through a series of ‘objective’ forms (dyad, triad, serial group, fused group, statutory group, organization, class), are conceived as pre-given and as essential aspects of, and constraints upon, every human project. However the subversive genius of its empty form is also invoked: ‘For freedom is nothing other than a Expectations, Economics of choice which creates for itself its own possibilities.’ The human remains the being for whom ‘The upsurge of freedom is immediate and concrete.’ ‘Expectations’ in economics refers to the forecasts or Existential social theory seeks to realize two distinct views that decision makers hold about future prices, and seemingly incompatible values; the absolute and sales, incomes, taxes, or other key variables. The untrammeled freedom of the subject; and the actualiz- importance of expectations is due to their often ation of authentic selfhood. Much of the development substantial impact on the current choices of firms and of existentialism is an attempt to reconcile these two households, and hence on current prices and the values and to imagine a social world in which they overall level of economic activity. could be harmonically interrelated. The urgency and difficulty of such a task is the source of the pathos, which distinguishes all serious existential social theory. 1. Expectations in the History of Thought Modern economic theory recognizes that the central See also: Marxist Social Thought, History of; Mod- difference between economics and natural sciences lies ernity; Modernity: History of the Concept; Modern- in the forward-looking decisions made by economic ization and Modernity in History; Nietzsche, agents. Therefore expectations are a basic building 5060 Expectations, Economics of block of economic theories. For example, in con- and it is currently the benchmark paradigm in both sumption theory the paradigm life cycle and per- micro- and macroeconomics. Some recent research manent income approaches stress the role of expected has gone beyond RE by developing models of learning future incomes. In investment decisions present value behaior with explicit theories of data collection and calculations are conditional on expected future prices forecasting. and sales. Equity prices, interest rates, and exchange In this article we review developments in the rates all clearly depend on expected future prices. modeling of expectations formation, with an emphasis A central aspect of economic theories is that on rational expectations and learning behavior. RE expectations influence the time path of the economy, modeling is the subject of many books, e.g., Sargent and conversely one might reasonably hypothesize that (1987) and Farmer (1999). Evans and Honkapohja the time path influences expectations. The current (2001) is a treatise on the learning approach. standard methodology for modeling expectations is to assume rational expectations (RE), which is in fact an equilibrium in this two-sided relationship. 2. Traditional Models RE modeling is a recent key step in a long line of dynamic theories which have emphasized the role of We will illustrate the modeling of expectations with expectations. The earliest references to economic some well-known simple models. The first example is expectations or forecasts date to the ancient Greek the cobweb model. Consider a single competitive philosophers and the Bible. Systematic economic market in which there is a time lag in production. analyses in which expectations play a major role began Demand is assumed to depend negatively on the as early as Henry Thornton’s treatment of paper prevailing market price: credit, published in 1802, and E; mile Cheysson’s 1887 l k j formulation of a framework which had features of the dt mI mp pt "t (1) ‘cobweb’ cycle. The role of expectations was given some attention by the classical economists, but their while supply depends positively on the expected price: method of analysis was based on the stationary state in l j ej which perfect foresight prevails. Expectations were st rI rp pt #t (2) equated with actual outcomes, which downplayed " their significance. where mp, rp 0 and mI and rI denote the intercepts. Alfred Marshall is credited with the notion of ‘static We have introduced shocks to both demand and expectations’ of prices. The ‘cobweb’ model of a market supply. "t, #t are exogenous iid (identically and with a production lag was one of the first formal independently distributed) random variables with models with expectations in the 1930s. In the same mean zero and constant variance. decade, the temporary equilibrium approach, initiated The interpretation of the supply function is that by the Stockholm school, explicitly introduced expec- there is a one-period production lag, so that supply tations of future prices influencing current demands decisions for period t must be based on information and supplies. John Muth (1961) was the first to available at time tk1. For simplicity we make the formulate the notion of rational expectations and did representative agent assumption that all agents have so in the context of the cobweb model. the same expectation. Extensions to heterogeneous In macroeconomic contexts the importance of the expectations have been analyzed in the literature. state of long-term expectations of prospective yields We assume that markets clear. The observed price is for investment and asset prices was emphasized by then obtained by equating st and dt, which leads to John Maynard Keynes (1936) in his General Theory. l µjα ejη Keynes stressed the central role of expectations for the pt pt t (3) determination of output and employment, but did not have an explicit model of how expectations are formed. where µ l (m kr )\m and α lkr \m ! 0. η l k \ I I p η "p p σ# t η He even sometimes suggested that attempting to ( "t #t) mp so that we can write t iid(0, η), i.e., t forecast very distant future events can virtually over- is an iid random variable with mean zero and variance # whelm rational calculation. In the 1950s and 1960s ση. expectations were introduced into almost every area of Equation (3) is an example of a temporary equi- macroeconomics, including consumption, investment, librium relationship. It illustrates the central role of money demand and inflation using adaptie expec- expectations by showing how the current market- tations or related schemes. clearing price depends on expected prices. Develop- Rational expectations made the decisive appearance ments since the Stockholm School and Keynes can be in macroeconomics in the work of Robert E. Lucas Jr. seen as different theories of expectations formation, and Thomas J. Sargent in the beginning of 1970s. i.e., how to close the model so that it constitutes a fully Many of the key contributions are collected in Lucas specified dynamic theory.
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