The purpose of this research is to examine and assess the concept of expectations in economic theory. Comparisons are made between the views on expectations of Alfred Marshall, John Maynard Keynes, and contemporary economists.
Expectations, in economic theory, are “attitudes, beliefs, or states of mind about the nature of future events.” Expectations affect economic behavior, and are, thus, a part of the psychology of economic behavior. Expectations pose difficulties for economists, because they cannot be directly observed. In economics, expectations may apply to virtually anything–prices, interest rates, demand, profits, and so forth. Expectations are held by both producers and consumers, and they affect economic decisions.
Alfred Marshall was active in the development of economic theory from the 1870s until well past his retirement, which occurred in 1908. Marshall was in “the long tradition of the English classical school of economics, which was founded by Adam Smith and David Ricardo.” Among his greatest works was The Principles of Economics, which was published in 1890. His theory of value, which incorporates the concept of utility, is possibly his greatest contribution to economic theory.
John Maynard Keynes
John Maynard Keynes studied economics under Alfred Marshall. He was active in the development of economic theory from the early-1900s until his death in 1946. The best known of his economic works is The General Theory of Employment, Interest and Money, which was published in 1936. Keynes challenged many of the theories of classical economics, and a separate branch of economic thought eventually developed around his ideas. In the mid-1980s, Keynes is probably most often thought of as a proponent of an active role for government in the management of the economy. Keynes, however, cemented the role of psychology in economic behavior. Expectations play a major role in many of his theories.
EXPECTATIONS: MARSHALL AND KEYNES
The classical economic theory of money-stimulates-trade had two major deficiencies. The first of these deficiencies was that it ignored the effects of money on the price level. This deficiency was corrected by Alfred Marshall. The second deficiency was that it overlooked the role of expectations in the economic decision-making process. This deficiency was corrected by John Maynard Keynes.
Keynes recognized that exectations played a major role in consumption decisions, and he also recognized that expectations were important in the reaching of decisions related to investment. Expectations play a major role in Keynes’ concept of the marginal efficiency of capital. Keynes believed, while Marshall did not, that “aggregate investment is conditioned largely by price and profit expectations.” Marshall tended to associate prices, costs, and economic decisions with events, as opposed to expectations.
EXPECTATIONS: MARSHALL, KEYNES,
AND CONTEMPORARY ECONOMISTS
The rational expectations hypothesis holds that people make guesses about the future on the basis of the best available information at the time decisions are made. People are further assumed to have enough information concerning the causes of future events to insure that only genuinely new information will affect their expectations about the future.
The rational expectations hypothesis has been extended by neoclassical economists to a variety of macroeconomic events, including the trade, or business, cycle. The rational expectations hypothesis is expected, by its proponents, to provide reliable forecasts of future events. The hypothesis has not always performed as its proponents anticipated, however, and, as a result, many theoretical and empirical criticisms have been leveled at it.
Robert Lucas attempted “to understand and clarify the nature and origins of some recent developments in business cycle theory,” and, in so doing, defended the rational expectations hypothesis. Lucas also has made a strong case for the use of mathematical models for the explanation of economic phenomena and in the application of economic theory. Certainly, few contemporary economists object to the use of quantitative models. This point, however, was important to Lucas, because he wished to distance contemporary economic thought from that of Marshall, because rational expectations theory has something new to offer–something that is not “in Marshall.”
Lucas also attempts to justify the use of quantitative models which have little relation to real world events. He argues strongly that it is only through the exclusion of realism from quantitative models that economists are able to construct analog systems which are imitations of the real economy, within which the relationships in the real economy may be investigated without distortion. The use of unrealistic quantitative models is not universally accepted in the economic community. Thus, Lucas makes an extra effort to justify their use, because models based on the rational expectations hypothesis tend to be unrealistic.
Lucas also made a case for the importance of technical advances in the shaping of economic theory. By this contention, he meant that improvements in mathematical methods, statistical procedure, and computational capacity (which, in themselves, are unrelated to economic theory) affect the way in which economists think. They, in turn, affect the development of economic thought. This assertion is significant to the development and application of rational expectations theory, Lucas contends, because prior to the occurrence of these technical developments, economists did not possess the capacity to investigate “in detail market interactions” and could, thus, “only conjecture” as to just what the actual relationships and interactions between macroeconomic variables were. 
In justifying the rational expectations hypothesis and its application to the business cycle, Lucas made a concerted effort to demonstrate that all other explanations of the business cycle were invalid, as a result of misspecification and faulty methodology. The theory of rational expectations was developed as a means of explaining price fluctuations in securities and commodities markets. Lucas and others, however, extend the application of the hypothesis to other economic relationships.
To apply a theory designed to explain price movement in securities and commodities markets to the explanation of macroeconomic phenomena is, in itself, somewhat presumptuous. To do so in the face of controversy surrounding its original applications requires a great deal of daring–and a great deal of justification. Lucas provides justifications for his contentions. The justifications are accepted by some economists, and rejected by others.
Rational expectations theory is based upon assumptions that:
1. All individuals make guesses concerning the future on the basis of the best available information at the time such guesses are made.
2. All individuals have sufficient information concerning the causes of future events upon which to base their guesses.
3. All individuals have access to the same information, and have this access at approximately the same point in time.
Assumptions such as those above discount the impacts of past behavioral patterns which may be a significant part of the makeups of individuals, and they ignore the potential for psychological influences in decisions made by individuals. Rational expectations theory assumes that all individuals will react in exactly the same manner, if they have access to the same set of data, which is also assumed by the rational expectations hypothesis.
To make such assumptions in relation to securities and commodities markets is one thing. To make such assumptions in relation to the entire economy is quite another. In the securities and commodities markets, a great majority (but, certainly not all) of the players can be assumed to have access to roughly the same information and thus have such access at roughly the same time. The essential assumption in rational expectations theory that all players in the securities and commodities markets will act on this information in the same way, however, requires that rational expectations models consider only mean expectations and ignore the fact that probability distributions are also involved. Thus, it is, at once, obvious that rational expectations models work only with central tendencies, and the unity in expectaitons assumed by the rational expectations theory simply does not exist in the real world.
When one moves away from rational expectations applications in the securities and commodities markets to rational expectations to macroeconomic phenomena, the assumptions that all players will have access to roughly the same information at roughly the same time are enough to stretch the credulity of rational individuals to the breaking point. If one could consider only the expectations of those engaged in large-scale business activities, the assumptions would not be quite so absurd. However, one cannot restrict consideration of expectations to large-scale business activities when macroeconomic phenomena are involved, because ordinary consumers are major players in macroeconomic activities. Further, there is no empirical data (which Lucas holds very important in the application of rational expectations models) to support the assumption that all consumers will act in the same manner, even if they have access to the same information and have such access at the same time.
One of the major contentions of the proponents of a rational expectations explanation of the business cycle is that government should not intervene in the economy, in an attempt to guide the economy, to “fine-tune” the economy, or to counter major shocks to the economy. Alternative explanations of the business cycle, such as the Phillips Curve, hold that trade-offs exist between economic phenomena–such as that between the rate of price inflation and the rate of unemployment. In the 1970s, it became obvious to all economists that the most widely applied theoretical models did not satisfactorily explain the relationships between economic phenomena in the contemporary economic environment. The rational expectations theory was applied to business cycle theory as one means of attempting to provide a satisfactory explanation.
In general, rational expectations theory, when applied to explaining the business cycle, holds that trade-offs between economic phenomena do not exist, and more significantly, that the economy never enters into a state of disequilibrium. If, indeed, there is no trade-off between economic phenomena and if the economy never enters into a state of disequilibrium, then there is no reason for government to intervene in the economy, because such intervention would simply be to no avail.
The rational expectations model of the business cycle holds that excess supply does not exist. Thus, unemployment never exceeds the natural rate of employment, because whatever the unemployment rate is at a given point in time is the natural rate of unemployment, and disequilibrium does not occur, because those conditions which occur are those which are to be expected. The proponents of the rational expectations explanation of the business cycle hold that the only way in which changes occur in the economy is for changes in the expectations of the players to occur. Thus, the only appropriate action for a government or for a central monetary agency to take is to announce that a non-inflationary money supply policy will be followed (regardless of what actually occurs in the economy) and that government will follow only a conservative, non-interventionist fiscal policy (balanced budget, etc.) By following such policies, central monetary agencies and governments will cause all players in the economy to develop rational expectations which will, eventually, result in the development of some sort of economic Shangri-la.
That this rational expectations explanation of economic phenomena does not satisfactorily explain past developments in the economy does not bother the proponents of the rational expectations theory. Of the depression of the 1930s, which defies explanation by the rational expectations model, Lucas says, simply, that it was a one-time historical occurrence that need not concern contemporary applications of the rational expectations theory to macroeconomic phenomena.
The success of Keynesian theories in the 1930s was due to the fact that recognition was made that the economic theories applied at that time did not explain what was occurring in the economy, and that the untenable conditions would not likely change, unless different theoretical approaches were applied. As it turned out, the Keynesian approaches were correct for the conditions existing in the 1930s. The war in the 1940s distorted economic relationships, and the failure of Keynesian theories in the 1950s and the 1960s was due to the fact that recognition was not made that the economic theories applied at that time did not explain what was occurring in the economy, and that, unless different economic theories were applied, significant disequilibrium in the economy would, again, occur. Eventually, severe disequilibrium did occur in the economy–in great part, due to distortions resulting from the spending on the war in Viet Nam, the failure to fund the cost of the war from current economic activity, spending for the “war on poverty,” without transferring the funding for this war from current economic activity, and the shocks to the economy of the significant and rapid changes in both energy prices and in the recipients of energy spending.
The rational expectations proponents attempted to provide answers to the presence of disequilibrium in the contemporary economy, by stating that no disequilibrium existed; rather, that the conditions which developed were those to be expected. No model based upon rational expectations theory, however, would have predicted the occurrences of the three major shocks which hit the American economy in the 1960s and 1970s, and no significant number of the players in the economy had access to the type of information related to these shocks which would have permitted the making of decisions based upon rational expectations, and few had the background necessary to interpret such information had it been available.
Expectations are incorporated into most economic theory. The role of expectations in economic decision-making, however, was given added weight by Keynes. A major problem with the incorporation of expectations into economic theory, however, is that they cannot be directly observed, in spite of such efforts to do so through such hypotheses as rational expectations.
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R. E. Baxter, Economics, Third Edition (Harmondsworth,
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F. S. Mackenzie, Economics (Vancouver, British Columbia: North Coast Publishers, 1987), p. 143. ↑
Baxter, p. 272. ↑
Baxter, p. 99. ↑
Ibid., p. 100. ↑
Ibid., p. 165. ↑
Mackenzie, p. 151. ↑
R. B. Ekelund, Jr., and R. F. Hebert, A History of Economic Theory and Method, Second Edition (New York: McGraw-Hill, 1983), p. 116. ↑
Ekelund, and Hebert, pp. 437-439. ↑
Ibid., p. 439. ↑
Ibid., pp. 444-445. ↑
Ibid., p. 499. ↑
T. Sargent, and N. Wallace, “Rational Expectations and the Theory of Economic Policy,” Journal of Monetary Economics II (1976): 103-113. ↑
R. Maddock, and M. Carter, “A Child’s Guide to Rational Expectations,” Journal of Economic Literature XX (March 1982): 39-51. ↑
R. E. Lucas, Jr., “Methods and Problems in Business Cycle Theory,” Journal of Money, Credit, and Banking XII, 4 (November 1980): 713. ↑
R. E. Lucas, Jr. Studies in Business Cycle Theory (New York: McGraw-Hill, 1982), pp. 68-69. ↑
Lucas, 1980, p. 697. ↑
R. Bausor, “The Rational-Expectations Hypothesis and the Epistemics of Time,” Cambridge Journal of Economics VII (1983): 1-10. ↑
Lucas, 1980, p. 697. ↑
Sargent, and Wallace, pp. 103-113; S. Fischer, “Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule,” JPE LXXXV (1977): 263-275. ↑
Bausor, p. 9. ↑