A theme that dominates modern discussions of macro policy is the importance of expectations, and economists have devoted a great deal of thought to expectations and the economy. Change in expectations can shift the aggregate demand (AD) curve; expectations of inflation can cause inflation. For this reason expectations are central to all policy discussions, and what people believe policy will be significantly influences the effectiveness of the policy.
Expectations complicate models and policymaking enormously; they change the focus of discussions from a response that can be captured by simple models to much more complicated discussions.
The adaptive expectations theory assumes people form their expectations on future inflation on the basis of previous and present inflation rates and only gradually change their expectations as experience unfolds. In this theory, there is a short-run tradeoff between inflation and unemployment which does not exist in the long-run. Any attempt to reduce the unemployment rate blow the natural rate sets in motion forces which destabilize the Phillips Curve and shift it rightward.
The Rational expectations model was developed by Robert Lucas,rational economic agents are assumed to make the best of all possible use of all publicly available information. Before reaching a conclusion, people are assumed to consider all available information before them, then make informed, rational judgments on what the future holds. This does not mean that every individual’s expectations or predictions about the future will be correct. Those errors that do occur will be randomly distributed, such that the expectations of large numbers of people will average out to be correct.
Expectations of inflation
Some workers may feel cheated by inflation. They might believe that without it, they would experience real-wage increases because their nominal wages are rising 5% a year. Unfortunately, they are wrong. They suffer what some economists call money illusion, a confusion of real and nominal magnitudes. The source of the illusion is as thus; since real wages are constant, the only reason their nominal wages rise by 5% is the general 5% inflation. If there was no inflation, their nominal wages would not increase at all.
After a time, everyone in the economy will begin to expect that the 5% annual inflation that it had occurred in the past would continue in the future. Economists call this expectations of inflation. People’s expectations of inflation affect all aspects of economic life. For example, in the steady-state economy I just described, textile producers will expect to increase the price of their products by 5% every year. They will also expect their costs of labour and steel, for example, to increase the same way. Workers will begin to believe that the increase in their wages will be matched by the same increase in the prices of goods they buy.
Also, wages are influenced by expectations. Suppose, for example, that...