topic 4 - expectations

Question 1

what do the rational expectations of the 1970s believe were the traits of the agents>

Answer 1

Agents (households, firms etc.)
* are forward looking;
* Exploit the best information that is available to them at the time(which includes the best available economic model of the relevant variable such as the ones used by policy makers);
* Do not make systematic errors. This means that on average they are correct in their predictions. Individually they may be wrong in any number of ways, but the errors average out over time and over space.

Question 2

what is weak form rational expectations?

Answer 2

in forming forecasts or expectations about the future value of a variable, rational economic agents will make the best(most efficient) use of all publicly available information about the factors which they believe determine that variable.

Question 3

what is the strong form of rational expectations?

Answer 3

The Strong Form of the rational expectations hypothesis is that economic agents’ subjective expectations of economic variables will coincide with the true or objective mathematical conditional expectations of those variables.

Question 4

what form of rational expectatiosn is the economic agents expectations of inflation ?

Answer 4

Using the example of economic agents’ expectations of inflation, therational expectations hypothesis in strong form as it is subject to information available up to the previous period

Question 5

how can rational expectations be formed from weighted averages?

Answer 5

Rational Expectations implies taking a weighted average of all the possible values the variable can take, each weighted by its respective probability of actually occurring. Probabilities are obtained from the full information set that is available to all agents. Individuals will undoubtedly get things wrong but overtime and space subjective expectations converge to the true weighted average with probability. the probabilities can be represented by a normal distribution

Question 6

why are rational expectations useful?

Answer 6

• They are a very stringent context to examine solutions to particular problems. If a solution works under the assumption of RE it is likely to work even if its stringent assumptions are not all met;
• It is a way of ensuring consistency so that no ad-hoc assumptions of informational asymmetry are invoked to obtain any specific result.
• They may be considered preferable to the adaptive expectations mechanism seen as too mechanical a backward looking rigid rule. But such a criticism of adaptive expectations does not –in and of itself- imply that rational expectations are necessarily better.

Question 7

why are rational expectations wrong?

Answer 7

• They assume a level of perfect information that is deeply implausible.
• They ignore the cost in terms of time and other factors that is implied by acquiring that high level of information. Most people would often use rules of thumb and conventions because acquiring the full information set is prohibitively expensive and unlikely to be sufficiently rewarding even if it were possible to do so.
• Proponents of RE have tried to retreat behind an “as if” assumption(Friedman 1953) whereby it is not postulated that the strong form actually applies in reality but just that the economy behaves as if it did, generating expectations that are never wrong on average. But as the “correct” model may never be known and agents may be forming expectations on the wrong one this sounds very implausible.
• The most devastating critique of RE is given by Davidson (1982)and can be summarized by saying that for RE to be applicable, the economic variables being examined must display the statistical property of ‘ergodicity’ and they very rarely do.

Question 8

what is ergodicity?

Answer 8

Ergodicity’ is a statistical property whereby a given variable displays averages that converge to a constant over time and over space. It is typical of natural sciences phenomena (e.g. gravity) where the timing and location of the experiment make no difference

Question 9

how can ergodicity be used to make future predictions?

Answer 9

If a variable is ergodic past observations can provide the probability distribution, and the future can be expected by treating past observations as if they were a sample drawn from the future

Question 10

what is the issues with assuming economic variables as being ergodic?

Answer 10

Some economic variables may be ergodic (e.g. routine consumption decisions) but most are not and the most important ones definitely aren’t. Typically investment decisions with prohibitive sunk costs are irreversible and ‘crucial’ in the Shackle sense so that the past is no guidance for the future.

Question 11

when is a condition of risk said to arise?

Answer 11

A condition of risk is said to arise when the precise future outcome of a process cannot be known, but when the range of its possible outcomes is known fully, and to each individual outcome a probability can be assigned on the basis of observed past realisations.

Question 12

when is a condition of uncertaintity said to arise?

Answer 12

A condition of uncertainty arises instead when none of the above is possible and the full range of possible outcomes is not and cannot be known, and no meaningful probability can be assigned to any or some of the outcomes.

Question 13

does rational expectations mean perfect foresight, explain?

Answer 13

rational expectations does not mean perfect foresight. in order to make rational expectations, agents need to take into account what they believe is the correct macroeconomic model of the economy. there will be errors in these forecasts as models are simplifications and the information will not be complete however these errors are not related to the information at the time.

Question 14

what is the equation for rational expectation of today’s inflation and what does it mean?

Answer 14

it can be said that todays inflation is equal to the expected today’s inflation plus the error term. as the mean of the error term is equal to zero and is uncorrelateed with the information at the time, economic agents are fully exploiting all available information