Expectations, Economics of

Abstract

The role of expectations in economics has long been recognized. However, explicit models of expectation formation are relatively recent. In contemporary macroeconomics, expectations of future variables play a key role in the determination of inflation, consumer expenditures, investment, asset prices, and the business cycle. In the 1950s and 1960s, the adaptive expectations hypothesis was employed widely in both empirical and theoretical work. In the 1970s and 1980s the ‘rational expectations (RE) revolution’ led to a fundamental reformulation. Expectations were modeled as optimal forecasts, given the stochastic process followed by the variables being predicted. Important topics in RE modeling include techniques to compute RE, econometric testing of expectations for ‘rationality’ and the ‘Lucas critique’ of traditional policy evaluation. Some economic models exhibit multiple RE equilibria. Manifestations include coordination failures, asset price bubbles, sunspots and endogenous fluctuations. These ideas formalize an independent role for expectations in economic dynamics. Recent developments in modeling of expectations have raised two related issues. How can agents coordinate on RE? If agents have some more bounded form of rationality, can they ‘learn’ to have RE? An RE equilibrium may or may not be stable under econometric learning. Furthermore, learning behavior can also lead to new economic phenomena.