245
See also: Economic man 52–53 ■ Borrowing and debt 76–77 ■ The Keynesian multiplier 164–65 ■ Monetarist policy
196–201 ■ Behavioral economics 266–69 ■ Efficient markets 272 ■ Independent central banks 276–77
Initially, expectations were taken
to be “adaptive.” This assumes
that people form expectations of
the future based solely on what
happened before—if Event A led
to Event B, it will do so again. In
each case individuals adjust for
the gap between what they
expected to happen and the
actual outcome.
The need to allow for
expectations within economic
theory was acknowledged to
weaken the outcome of Keynesian
policies (pp.154–61), where
governments increase spending
to raise demand. These policies
assume that if people’s wages are
increased as a result of a
government boost to the economy,
an increase in their real economic
activity will occur—they will
supply more work. In reality
the increased demand also leads
prices to rise, so in real terms,
their wages have not. People are
temporarily fooled into thinking
that their increased money wages
reflect a raise in real wages
because they take a while to
realize that prices have also
risen—their expectations about
future price increases adjust
slowly. In this way it is possible
for a government to increase
economic output through
monetary or fiscal policy by
(in effect) fooling people.You can’t fool
the people.People are rational
and make predictions using
all the information available
to them.They form
rational expectations
about the future.They will
anticipate the effects
of government attempts
to boost the economy...... and adjust their
behavior, rendering
the government policy
ineffective. However, this only works in
the short term: once people’s
expectations catch up, they realize
that their real wages have not risen,
and the economy reverts to its
original lower level of employment.Rational expectations
This way of modeling
expectations was simple but
flawed. If people only looked at the
past when making their forecasts
about the future, they would be
likely to get their forecasts
persistently wrong. Unexpected
shocks to the economy, pushing
it away (even temporarily) from
its previous path would be
turned into permanent errors in
forecasting. But if people made
persistent forecasting errors,
they would persistently lose out
against the market—and this
did not seem to be a realistic
picture of people’s behavior.
It was dissatisfaction with the
theory of adaptive expectations
that helped lead US economist
John Muth toward a theory of
“rational expectations” in 1961.
At the heart of his theory is a
very simple idea. If buyers in a ❯❯A father passes on his knowledge
of car maintenance to his son. The son
will make future economic decisions,
such as which car to buy, based partly
on this knowledge.POST-WAR ECONOMICS