Expectations in Macroeconomics

Abstract

Virtually all important macroeconomic decisions involve expectations concerning uncertain future outcomes. The decision to invest in a capital asset, for example, involves making a financial outlay today in the expectation of generating future income streams which, when adequately discounted, justify the original act of investment. Likewise, an unemployed worker who turns down the offer of a job because he considers the rate of remuneration inadequate entertains the expectation that there are preferable employment opportunities available elsewhere and thus he is encouraged to enter into search activity in the hope of locating them. The decision to buy government bonds in the hope of realising capital gains involves an expectation as to the course of future interest rates. Numerous other examples could be cited. The point, however, is a simple one, namely that utility-maximising agents form expectations in their decisionmaking processes and if economic theory is to be able to explain the behaviour of economic agents it must be capable of taking expectations formation — and more importantly changes in the pattern of expectations formation — fully into account. The purpose of the present chapter is to examine the manner in which economic theory has attempted to deal with expectations formation in macroeconomic models and to derive the implications for policy which then follow.