Modern economic theory realized that the most crucial difference between natural science and economics is the presence of forward-looking decisions in economics. Expectation play significant role in all aspects of microeconomics. Expectations are highly valued in modern macroeconomics. Expectations have a great influence on the time path of the economy and the time flow in turn influences the economy. The currently accepted procedure for modeling expectations is to consider rational expectations.
In the previously used dynamic stochastic models, rational expectations were explained as the mathematical conditional expectation of the crucial variables. The decision makers prepare the expectations based on the statistics available to them. Rational expectations thus constitute strong assumptions based on the available knowledge and the analyzing and predicting skill of the decision makers. Expectations and their roles are highly emphasized by rational expectations which are the most modern step in the big list of dynamic theories.
The history of economic expectations can be traced back to the ancient Greek Period where Aristotle used the principles of economic expectations. We can also see the importance of economic expectations in the story of Joseph (in Old Testament) where he stored up food expecting a famine in the land. Classical economists also gave much importance to expectations as they dealt with capital accumulation and growth. Their expectations were based on nothing but prevailing statistics and trends. Economy was mostly considered following from the static equilibria.
This economic interpretation was also based on flawless foresight which made the expectations were almost equal to the real outcomes. Alfred Marshall used classical approach to distinguish between short and long run. He came out with the concept of ‘static expectations’ in prices. Ezekiel (1938) analyzed the ‘stability’ according to the cobweb model. Hicks expanded the temporary equilibrium approach according to which future prices have influence on demands and supplies in a general equilibrium set up. Muth (1961) later came up with the concept of rational expectations and explained it in the context of the cobweb model.
In the macroeconomic theory, the significance of long-term expectations of prospective yields for asset prices and investments were highlighted by the General theory of Keynes. According to Keynes, expectation plays a major role in deciding output, investment and employment. Expectations were applied in all aspects of macroeconomics by the middle of the twentieth century. For example, investment, inflation, demand and consumption were few areas where the concepts of expectations were used. Expectations are applied in macroeconomic modeling with the help of related lag or adaptive expectation schemes.
The theories of expectations also appeared in the papers of Sargent (1973) and Lucas (1972) which confirms the importance of expectations in macroeconomics. The importance of expectations can be explained with the help of the well-known model, the cobweb model. These models would explain the new view of expectations formation and its inferences on macroeconomic theory. Consider the Cobweb model. The Cobweb Model explains how the achieving of supply and demand equilibrium would be so mechanical. The suppliers determine the price and the consumers react with the quantity they need, the demand.
For certain slopes of the demand and supply curves, the equilibrium may be quite unstable. The model explains the fact that dynamic behavior by economic agents may not lead to a constant equilibrium with supply equaling the demand. The Cobweb Model The Cobweb model or Cobweb theory explains why prices undergo periodic fluctuations in certain markets. This is a typical economic model of cyclical supply and demand where there happens a lag between producer’s responses to the price change. In the Cobweb model, the price elasticity of demand is less than the price elasticity of supply.
Moreover the fluctuations would increase in magnitude per cycle. Apart from this, in Cobweb model, if the price elasticity of demand is more than the mean price elasticity of supply, fluctuations decrease in magnitude per cycle. These trends are the unstable and stable cobweb model respectively. Moreover, in Cobweb model the Fluctuations may also stand at a constant magnitude. Expectations play a major role according to this model. Expectations play a significant role in the economic theories that support majority of the macroeconomic models. As far as economic life is concerned, planning for the future is too crucial.
The decisions like how much to spend, how much to save, the type of furniture to buy, the real place to invest, all these force people to take decisions to make the most sense for today as well as the future. Not only family, companies, business firms, factories, trusts and all organizations take decisions that matters for their future. They decide where to locate their production areas, what kind of employees to be employed, what all machines to be used, which all products to be produced and what all services need to be given. All these decision are based on their expected consequences in the future.
These decisions may have their consequences lasting for years, and may play a great role in the overall performance and sustainability of the company. People make informed guesses about the possible events of the years ahead and plan accordingly. All these decisions are based on expectations. Expectations play a major role in economic fluctuations and the efficacy of monetary policy. Assumptions and beliefs also have a central role in economic fluctuations and the efficacy of monetary policy. Economic fluctuations mainly depend upon the changing demands, and not on the change in supplies.
The economy repeats the observed record of fluctuations in US (Considering US as an example) (using a specific model with flexible prices where economic agents maintain a rational belief). Under the monetary rules monetary policy show a strong stabilization effect. The anti-inflationary policy is also able to bring the inflation volatility to zero. Moreover the statistical Phillips Curve varies considerably with policy instruments and activist policy rules make it vertical. It has been proved that even though the prices are flexible, the money shocks bring about less proportional variations in inflation.
As a result of this, the total price level appears sticky with respect to the money shocks. The fluctuations thus absolute depend upon demands or the demand expectations. Economists have accepted the fact that expectations play a prominent role in economic decision-making. Expectations are proved to be the most significant factors of macroeconomic models. Expectations are found to be playing a major role in formulating monetary policy. Expectations are found to overpower the influence of monetary policy. Even if there happens a sudden change in the monetary policy there will not be any real effect on the economy.
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