Why are expectations so important in macroeconomic theory? Explain the different approaches to expectation adopted by economists from Keynes onward.
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
However time and uncertainty are inextricably linked in post-Keynesian thinking, as evident in the writings of Robinson and Shackle. They stress that economies must be analysed as a sequential process through time and not in an essentially timeless state Keynes seemed to pose. The present is seen as the link between a known past and a highly uncertain future. Money and financial assets play a key role in connecting the past, the present and the future. Because the future is so uncertain, the way expectations are formed, in particular the influence of the present upon such expectations, becomes extremely important. · The incorporation of the theory of expectations: either adaptive or rational. The problem posed by the presence of expectation takes the same form whenever it arises in the explicit formulation of testable models. When the expected value of some variable appears in an equation something has to be done about it because that variable is unobservable. A common method of solving this problem has been to extrapolate the past behaviour of the variable itself. In other words, take the past trend in the variable and assume that the trend will continue. A specific form of extrapolation is provided by the ‘error learning mechanism’ or ‘adaptive expectation’.
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Approximate Word count = 1749
Approximate Pages = 7 (250 words per page double spaced)
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