Lecture: The Role of Expectations in Economics

Introduction

Expectations play a critical role in economics, influencing various sectors including asset pricing.
Focus on how expectations impact the IS-LM model taught in chapters 15 and 16 of the course material.
Traditional IS-LM model overemphasizes the present, neglecting future conditions.

Expectations affect decisions of economic actors: investors, consumers, firms, governments, and foreign investors.
Political events, like elections, can change expectations and thus have significant economic impacts.

Traditional view: Consumption depends only on current disposable income.
More accurate view: Permanent Income Hypothesis (Milton Friedman) - Consumption depends on expected lifetime income.
Life Cycle Hypothesis (Franco Modigliani) - Consumption and saving behaviors change throughout an individual's life cycle.

Financial Wealth: Assets (and their expected returns) minus debts. Important for current and future consumption decisions.
Human Wealth: Expected future income based on human capital. More significant in early life stages but harder to borrow against.
Total Wealth = Financial Wealth + Human Wealth.
Consumption should ideally relate more to wealth than to current disposable income alone.
Realistic consumption function considers both current income and wealth due to practical constraints (e.g., lack of savings).

Investment decisions are made based on expectations of future profits and interest rates.
Decision to invest incorporates expected present discounted value of cash flows from the investment.
A better investment function includes the role of future economic conditions and interest rates, not just current parameters.
Financial frictions can cause firms to rely more on current cash flows, similarly to consumers.

Aggregate demand should factor in expected future variables, not just current ones.
Future output, taxes, interest rates, and government expenditure all play roles in shifting the IS curve.
Current changes in economic conditions have a muted effect compared to expected future changes.

Monetary Policy: Effective only if it persuades people that changes (e.g., interest rate cuts) will be long-lasting. Central banks manage expectations rather than just controlling current interest rates.
Fiscal Policy: Also depends on expectations. Fiscal contractions can be less contractionary if they lead to expectations of future monetary easing or improved fiscal stability.

Ireland in the late 1980s: Fiscal consolidation improved future expectations and led to an economic boost despite short-term unemployment rise.
Greenspan Conundrum: Even successive interest rate hikes failed to cool the economy as long-term rates did not respond accordingly due to external factors like capital inflows from China.

Expectations influence both aggregate demand and supply, as well as asset prices, playing a critical role in economic modeling and policy effectiveness.
Understanding the role of expectations is crucial for interpreting unexpected policy outcomes.