Table Of ContentExpectations: Theory and Evidence
Expectations:
Theory and Evidence
K. Holden, D. A. Peel
and J. L. Thompson
St. Martin's Press New York
© K. Holden, D. A. Peel and J. L. Thompson 1985
Softcover reprint of the hardcover 1st edition 1985 978-0-333-35084-3
All rights reserved. For information, write:
St. Martin's Press, Inc., 175 Fifth Avenue, New York, NY 10010
Published in the United Kingdom by Macmillan Publishers Ltd.
First published in the United States of America in 1985
ISBN 978-0-333-35085-0 ISBN 978-1-349-17862-9 (eBook)
DOI 10.1007/978-1-349-17862-9
Library of Congress Cataloging in Publication Data
Holden, K.
Expectations: theory and evidence.
Bibliography: p.
Includes index.
1. Rational expectations (Economic theory)
I. Peel, D. II. Thompson, John L. III. Title.
HB172.5.H65 1985 339'.0724 84-24762
To our parents
Contents
Preface X
1 Introduction to Expectations 1
1.1 Introduction 1
1.2 Surveys of expectations 2
1.3 Literature on expectations surveys 7
1.4 Adaptive expectations mechanisms 11
1.5 Concept of rational expectations 18
1.6 Time-series modelling 20
2 The Theory of Rational Expectations 24
2.1 Introduction 24
2.2 Solution of rational expectations models 30
2.3 Incomplete current information 38
2.4 Rational expectations and stabilisation policy 40
2.5 Lucas critique of policy evaluation 44
2.6 Criticism of the rational expectations hypothesis 46
2.7 Conclusions 50
2.8 Appendix 1: illustration of Wold's decomposition theorem 51
2.9 Appendix 2: rationality of adaptive and regressive
expectations 52
2.10 Appendix 3: further example of the Muthian and Lucas
solution methods 53
Vll
viii Contents
2.11 Appendix 4: model with incomplete current information 55
2.12 Appendix 5: solution of equation (2.78) 60
2.13 Appendix 6: effects of a change in policy regime on time-
series forecasts 62
2.14 Appendix 7: learning and the convergence to rational
expectations 64
3 Survey Evidence on Expectations Formation 66
3.1 Test procedures 66
3.2 The Livingston series 74
3.3 Consumer's expectations data 77
3.4 Business expectations data 82
3.5 Econometric forecasts as expectations 87
3.6 Wage, interest rate and money supply expectations 89
3.7 Conclusions 92
4 The Efficient Markets Hypothesis 94
4.1 Econometric implications of expectations 94
4.2 Efficient markets hypothesis 98
4.3 Short-term rates of interest and expected inflation 99
4.4 Term structure of interest rates 106
4.5 Foreign exchange market 112
4.6 Conclusions 119
5 Other Single-equation Studies 120
5.1 Introduction 120
5.2 Expectations and the consumption function 120
5.3 The wage equation 130
5.4 Expected capital gains 139
5.5 Conclusions 141
6 Expectations in Econometric Models 143
6.1 Introduction 143
6.2 Models of the UK economy 143
6.3 Expectations in UK models 147
6.4 Conclusions on UK macroeconometric models 152
6.5 Expectations in other macroeconometric models 154
6.6 Conclusions 161
Contents IX
7 Aggregate Expectations Formation 163
7.1 Methods of combining forecasts 163
7.2 Empirical evidence 166
7.3 Combined forecasts as expectations 168
7.4 Aggregation of forecasts in asset markets 170
7.5 Implications of weighted public forecasts 171
7.6 Conclusions 172
8 Conclusions 174
References 177
Author Index 189
Subject Index 193
Preface
The explanation of how economic agents form their expectations
about the future is currently a matter of controversy in macro
economics. This book is intended as an introduction both to theories
of expectation formation and to the empirical evidence concerning
those theories. It is intended for advanced undergraduates and
postgraduates taking courses in macroeconomics and monetary
economics. Some prior knowledge of intermediate economics is
assumed, as is a familiarity with algebra and introductory statistics.
Much of the material should be accessible to students with little
quantitative background; for others, detailed derivations and
explanations are included in the appendices to chapter 2.
A list of references is included at the end of the text. Equations are
numbered sequentially in each chapter. We acknowledge financial
assistance from the Economic and Social Research Council (Grant
HR6305) in the preliminary stages of preparing the manuscript. Our
thanks are also due to Vivienne Oakes for her accurate and efficient
typing of several drafts of the text. As always, any errors and
omissions are the responsibility of the authors.
K. Holden
D. A. Peel
J. L. Thompson
X
1
Introduction to
Expectations
1.1 Introduction
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 develop
ment 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 theo
retically attractive approach of the 'rational expectations' hypothesis.
This states that agents use economic theory to form their expecta
tions, and should not make systematic errors in their forecasts of the
future.
1
