Expectations Are Fundamental

Over the weekend I received a comment on my post about Clark Johnson’s new paper from someone who disputed Johnson’s assertion that it is a myth that the Fed has been following an expansionary monetary policy since the 2008 financial crisis. Here is the relevant part of the comment:

The Fed cannot fix the economy by changing “expectations” because they have no tools to follow through. Just saying that they should “change expectations” is not enough. I cannot change expectations of the whole economy, because I have no tools to follow through, the same applies to the Fed.

Even though I disagree with the commenter that the Fed cannot affect expectations, I understand and sympathize with the commenter’s skepticism that Fed could actually do so. As I have written here before, I don’t think that our current theory of fiat money explains very well how the value of a fiat money (i.e., the inverse of a comprehensively defined price level) is determined. Without such a theory, it is hard to specify the exact mechanism or channel by which a central bank can control the price level. Nevertheless, it seems clear that an essential element in that mechanism is control, though perhaps limited and imperfect, over the price-level expectations of economic agents.

Then I read this morning on Scott Sumner’s blog the following quotation from a news item in the New York Times:

WASHINGTON — The Federal Reserve made a rare promise on Tuesday to hold short-term interest rates near zero through at least the middle of 2013, in a sign that it has all but written off the chances of an expansion strong enough to drive up wages and prices. . . .

By its action, the Fed is declaring that it, too, sees little prospect of rapid growth and little risk of inflation. Its hope is that the showman’s gesture will spur investment and risk-taking by convincing markets that the cost of borrowing will not rise for at least two years.

The Fed’s statement, with its mix of grim tidings and welcome aid, contributed to wild market oscillations as investors struggled to make sense of the economy and the path ahead.

The juxtaposition of my commenter’s skepticism about the ability of the Fed to affect expectations with the news item quoted by Scott suggests to me (or, to be more precise, reinforces for me) the following observations about expectations:

  1. Expectations are partly autonomous, partly induced by policy rules or by policy announcements made by policy makers;
  2. Expectations sometimes affect outcomes;
  3. Expectations can therefore be self-fulfilling (referred to by Karl Popper as the Oedipus effect);
  4. Expectations are often contagious;
  5. Expectations can be cyclical (even exhibiting bubble-like characteristics);
  6. Expectations sometimes are, and sometimes are not, consistent with equilibrium
  7. There may be multiple equilibria corresponding to various sets of expectations;
  8. Keynes’s famous characterization (General Theory, chapter 12) of the stock market as a beauty contest has an important kernel of truth to it and does not presume that traders act irrationally;
  9. There is no clear distinction between expectations and fundamentals, because expectations are fundamentals.

If these observations about expectations are right, then conventional rational expectations (DSGE) models, which assume a unique equilibrium determined by fundamentals, are flawed at the most basic level, because they exclude a priori the existence of multiple potential equilibria. If there are many possible equilibria, each corresponding to a particular set of expectations, economic policy can affect outcomes by altering expectations, leading to the realization of a different equilibrium from the one that would have been realized under the old set of expectations. What real business cycle theorists identify as productivity shocks could just as easily be regarded as expectational shocks, possibly induced by policy choices. Put another way, by affecting expectations, monetary policy can affect not only the expected rate of inflation, it can affect the real rate of interest, so that the standard interpretation of the Fisher equation, in which expected inflation is added to an unvarying real rate of interest, is valid only on the assumption that there is a unique real equilibrium independent of the expected rate of inflation. But if there are multiple possible equilibria, whose realizations depend on what rate of inflation is expected, the observed nominal rate is not simply the sum of expected inflation and a uniform real rate, because the real rate is not uniform with respect to the expected rate of inflation.

This is what Keynes meant when (General Theory, p. 219) he rejected the concept of a unique natural rate (which in his terminology corresponded to the Fisherian real rate), because there is a different real rate corresponding to each level of employment. In fact, it is even more complicated than that because in Keynesian terminology, the real marginal efficiency of capital may shift as the expected rate of inflation changes. But we can save that complication for another time.

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14 Responses to “Expectations Are Fundamental”


  1. 1 Benjamin Cole October 31, 2011 at 7:47 pm

    I certainly support transparent, rules-based NGDP targeting.

    That said, I wonder about “expectations.”

    I suspect most business people expand to meet demand. I always have (and contracted likewise). You get the orders, you fill ‘em.

    Sure, I advertise—but there any number of imponderables. Competition, new salespeople, the economy. You have the wrong style for sale.

    Everything is always a crapshoot. The Fed could say a Niagara of money is coming, except I do not know if I will get my share. Only when my sales go up do I know I am getting my share.

    That’s why I think the Fed has to firehose money into the GDP now, through sustained and heavy QE, and also cut IOR.

    If I could, I would dump grocery bags of cash in low-income neighborhoods (only because they would spend it, not save it). A national lottery that pays out more than it takes in–and is only sold in smaller ticket amounts (so it is not worth the time of the wealthy to buy).

    But for now, forceful susatined QE and lower IOR would probably do the trick.

  2. 2 Lorenzo from Oz November 1, 2011 at 3:52 am

    The link to your previous post on the value of fiat money does not work (it wants you to login).

    The Australian monetary policy experience is that anchoring expectations is fundamental to macroeconomic stability, as is pointed out by this op ed.

  3. 3 David Glasner November 1, 2011 at 5:48 am

    Lorenzo, I tried to fix the link, let me know if it works now. On anchoring expectations, we agree that it’s important to anchor expectations, but I don’t think we have discovered the best way to do the anchoring yet.

  4. 4 Becky Hargrove November 1, 2011 at 7:41 am

    The ongoing skeptical view of expectations is all the more frustrating for me, in that I took on economic studies in a search for real tools and real action. Sitting in a corner and not really doing anything, no matter the ideological leaning, makes me nuts. Admittedly I thought the conditions of expectation were more direct than they apparently are, as I had an idea of economic activity as a flow from the most concentrated sources to the least concentrated sources, i.e. ultimately the small town banker. In that view I had imagined local areas as being capable of maximizing economic flow by opening economic access to those who were trying to stay economically connected. Silly me. (don’t worry I’ll feel better about expectations tomorrow, tomorrow.)

  5. 5 JP Koning November 1, 2011 at 11:49 am

    This is very good post. I much enjoyed reading points 1-9.

    “Put another way, by affecting expectations, monetary policy can affect not only the expected rate of inflation, it can affect the real rate of interest, so that the standard interpretation of the Fisher equation, in which expected inflation is added to an unvarying real rate of interest, is valid only on the assumption that there is a unique real equilibrium independent of the expected rate of inflation.”

    I had not thought about things this way.

    A few general thoughts.

    When you write that expectations are partly autonomous, partly induced by policy rules, I think it’s important to point out that policy rules should not be confined to those set by government. For instance, rules set by private bodies like the Chicago Mercantile Exchange are very influential and changes to them can have very dramatic effects on expectations, and outcomes. As another example of privately created rules that affect expectations and outcomes, I’d include option pricing theory and formulas, which were derived in academia and quickly adopted by the markets. Theories operate much like rules.

    I hadn’t realized that Karl Popper thought about self-fulfilling prophecies. So did his pupil, George Soros; he uses the term reflexivity. The earliest academic I’ve found to abstract on this topic was Oskar Morgenstern. He called his idea Wirtschaftsprognose. A while ago I suggested you read Donald Mackenzie, who talks about performativity, a very similiar concept. Here is his paper:

    http://bscw.cs.ncl.ac.uk/pub/bscw.cgi/d61382/MacKenzie,%20D.%20&%20Millo,%20Y.%20Constructing%20a%20Market,%20Performing%20Theory:%20The%20Historical%20Sociology%20of%20a%20Financial%20Derivatives%20Exchange.pdf

  6. 6 Lorenzo from Oz November 1, 2011 at 11:32 pm

    Yes. There are two parts to the argument over the Fed.

    (1) The need for the Fed to have an explicit monetary regime.
    (2) The argument over which such monetary regime would be optimal.

    Having an explicit monetary regime would be an improvement, because (assuming it was credible) people could frame expectations on the basis of it.

  7. 7 Lorenzo from Oz November 1, 2011 at 11:32 pm

    Yes, the link now works :)

  8. 8 David Glasner November 2, 2011 at 5:59 pm

    Lorenzo, But the problem is that if the regime is less than perfect, following the rules will sometimes get you into trouble. People go around saying, “oh no, you can’t violate the rule people will be confused and expectations will become unanchored and then the sky will fall.” Well, what if the sky is already falling?

    Becky, I guess all I can say is “it’s complicated.”

    JP, For some reason, Soros who likes to give Popper credit for a lot of things, completely ignores the Oedipus effect, and claims that he (Soros) invented the theory of reflexivity. Actually, the Oedipus effect is stronger than reflexivity, because the Oedipus effect changes the long-run equilibrium while reflexivity only cause a deviation from equilibrium that is eventually reversed


  1. 1 Money Is Always* and Everywhere* Non-Neutral « Uneasy Money Trackback on June 19, 2012 at 8:43 pm
  2. 2 There’s a Whole Lot of Bubbling Going On « Uneasy Money Trackback on October 22, 2012 at 8:54 pm
  3. 3 Why Are Real Interest Rates So Low, and Will They Ever Bounce Back? « Uneasy Money Trackback on January 9, 2013 at 8:07 pm
  4. 4 Keynes on the Fisher Equation and Real Interest Rates | Uneasy Money Trackback on September 2, 2013 at 7:41 pm
  5. 5 Paul Krugman and Roger Farmer on Sticky Wages | Uneasy Money Trackback on February 10, 2014 at 8:19 pm

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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