Introduction to Expectations

Abstract

This book is concerned with expectations in economics—that is, with anticipations or views about the future. Since 1930, when Irving Fisher introduced the ‘anticipated rate of inflation’ as the difference between the nominal and real interest rates, expectations have played an important role in economic theory. This is because economics is generally concerned with the implications of current actions for the future. The importance of expectations in money markets, stock markets and foreign exchange markets is quite obvious. Views about the future dominate the actions of traders. In mainstream macro- economic theory, the consumption function (via permanent income), the investment function (via expected demand), and the Phillips curve all require expectations to perform an important role. The development over the past thirty years of macroeconometric models has forced economists to recognise that expectations are not something to be treated as exogenous—which can be ignored at will—but instead are central to our understanding of how the economy works. Attention has switched from more or less mechanical forms of expectations generation which are essentially ad hoc to the theoretically attractive approach of the ‘rational expectations’ hypothesis. This states that agents use economic theory to form their expectations, and should not make systematic errors in their forecasts of the future.