Expectations are one of the most important factors in macroeconomics. When central banks make decisions like increasing the interest rate or starting a QE program, those changes do have an impact on the economy, but the effects of those decisions trigger a lot of expectations. Economic agents have to work with the current indicators and their expectations for the future… And so should you!
This is NOT another article on Macro (check the Macroeconomics Series here). In today’s article, I want to explain the basics of expectations and how all of us can use this concept to our advantage in everyday decisions and habits.
As I said in the first paragraph, expectations drive the economy, and they are even more powerful than actual decisions or moves sometimes. They play a very important role in modern macroeconomic models, and they are used by central banks as a measure in itself (“forward guidance” is the term).
The most basic example of expectations in macroeconomics is the Phillips curve (which we’ll talk about in future articles) and its interpretation by Milton Friedman. The Phillips curve is, basically, a correlation between inflation and unemployment. William Phillips discovered that there was a correlation between a rise in inflation and a decrease in the unemployment rate. That trade-off meant that, if the economy struggled with unemployment, some inflation (money supply ↑) could help solve that problem. Things were not that easy (sadly) because of expectations. When the central bank decided to increase the money supply, the economic agents (at least some of them) knew that said increase would have an impact on the price level.
Friedman said that, because the economic agents had this knowledge, their reaction to monetary policy would not be to increase consumption and investment. They knew that having more money in their pockets didn’t necessarily mean they were richer than before, so neither consumption nor investment would get affected by that change in the money supply in the long run.
Rational expectations are a purely theoretical concept, related to equilibrium and other concepts that rely heavily on each other for the “basic” models to work. However, there is nothing keeping us from making them work in our everyday decisions!
Let’s start from an equilibrium in life. You have a 9-5 job, low energy, some hobbies you would like to work on and a few things to take care of like fitness, household chores and a good, balanced diet. You get back home from work, get in your pyjamas and lay down to watch some Netflix and call it a day. That is your routine and, since you’ve done those things today, your brain knows what to expect for tomorrow. In a way, habits are the result of expectations.
It only takes one good action every day to start changing your own expectations. Expectations and outcome reinforce each other, so one day of positive outcome will help your expectations for the next day be more positive. Positive expectations are more likely to lead to a positive outcome than negative expectations, so your outcome for the next day will probably be better (at least equal) than your outcome for today.
Some days will be better than others, and the upward trend will probably slow down with time, but the underlying concept still stands: positive expectations today make positive outcome easier to achieve tomorrow, and vice versa. Why not give economics a chance and let it help you build good habits? J
Read more on expectations and monetary policy here! ↓
HOMMES, C. et al.: Monetary policy under behavioral expectations: Theory and experiment (2019)
Communication, expectations and monetary policy: Intervention by Luis de Guindos, Vice-President of the ECB, at the ECB policy panel of the Annual Congress of the European Economic Association, Manchester, 27 August 2019