9.0 Introduction

The expectation of consumers, banks and other businesses have pronounced effects on supply and demand in financial markets. If inflationary expectations increase, the supply of and demand for loanable funds shift, and higher interest rates result. Also bank’s portfolio of assets and liabilities depends in part on the expected return to various assets and the expected cost of various liabilities. For example, a bank’s amount of excess reserves is determined partly by the expected return on alternative assets such as loans and bonds and partly expectation of the rate of deposit withdrawals. Price of a corporate bond will depend on investor’s expectations about the bond’s default risk.

8.1 Three theories of expectation formation

Suppose you want to forecast the inflation rate for the current year to determine the expected real rate of interest on your saving deposits. By the fisher equation, your expected real interest rate (R) is the difference between the nominal interest rate (i) paid by the bank and your inflationary

If your bank pays 3 percent on saving deposits and you expect inflation to be 2 percent over the next year, you expected real interest rate is only 1 percent. Obviously your incentives to deposit money in a saving account depend not only on the rate the bank offers but on your inflationary expectations as well. The same is true or other savers, including large investors like mutual funds, insurance companies and traders. Furthermore, there is cost of making errors in your inflationary expectations. If your inflationary expectations are too low on average during the course of your life, your errors may lead you to make investment decisions that yield a negative
real return.

How, then, do you go about forming expectations of inflation?
There are several ways to form expectations. These include the Markov expectations, Adaptive expectations and rational expectation hypotheses. Each approach requires a different level of sophistication on the part of those firming expectations.

The simplest way to form expectations about future events is to form Markov expectation. The Markov expectations hypothesis asserts that individuals expect the future to be like the most recent past. For instance, if the inflation rate last year was 3.5%, you can simply presume the future rate will be the same as last year’s 3.5%. With Markov expectations, individuals expect tomorrow to be exactly like today.

An obvious shortcoming of Markov expectations is that they do not take into account knowable events that might change the future environment. For instance, if the inflation rate is rising, Markov expectations will continually miss the mark. Each year you will expect the inflation rate to remain at its previous level, but each year you will be surprised to find it higher than expected.

This hypothesis ignores other information that might be useful in predicting the future. Markov expectations are based solely on the most recent value of the variable being forecast.

The adaptive expectations approach assumes expectation evolve over time in light of past experience. It allows past trends in variables as well as previous forecast errors to affect future expectation as people slowly learn from past mistakes. For instance, a person may notice that her expectation of inflation was too high previous period and thus revise downward her expectation of the future inflation rate. Since adaptive expectations look backward, they take into account the past history of a variable and of forecasts of that variable.

A potential problem with adaptive expectations is that when the future is continually changing, past history is not always a good forecast of the future. Another problem is that adaptive expectations do not use all the information that is useful in forecasting the future.

The main criticism of Markov and adaptive expectations is that they may not be based on variables economic theory suggests are useful in forming more accurate expectations. This has led to the idea of rational expectations, which is the most sophisticated of the three methods of forming expectation.

The rational expectations hypotheses asserts that when people form expectations, the use all knowable information, including variables economic theory suggests are relevant for making predictions. Since rational expectations incorporate all relevant information, any deviations from what is expected are purely random in nature; any forecast errors that arise are just as likely to
positive as negative.

People will use all available information to formulate expectations of economic variables such as inflation, interest rate and money supply. Individuals have strong incentives to make rational forecasts and will act accordingly. If their expectations are consistently wrong, they will reformulate the expectations model to include other variables. Therefore, increasing inflation would lead to a rational conclusion that the monetary authorities like central bank will engage in restrictive monetary policy to reduce inflationary pressure.
Such expectations would be considered rational because they include information that is relevant for properly forecasting inflation.

In forming a rational expectation about interest rates, bond prices, or exchange rates an individual would list all the determinants of demand and supply. All available information about this determinant would be used to help predict the location of demand and supply curve to form an expectation of the equilibrium interest rate, bond prices, or exchange rate. In this way rational expectations are based on the known variables economic theory various as relevant, thus there are no systematic forecasting errors.

8.2 Rational Expectation and the Efficient Market Hypothesis

The efficient market hypothesis states that the current price of an asset such as a share of stock reflects all available information about the value of the asset. More generally, according to the efficient markets hypothesis, the risk adjusted expected return on all investments will be equal; that is, the return you should expect to earn you could earn on this stock exactly equals the return
you could earn on any other asset with similar risk characteristics. The reason is that if one asset earns a higher risk-adjusted expected rate of return than other asset, investors will quickly attempt to purchase that asset, driving up its price and thus lowering its expected return.

The efficient markets hypothesis is closely related to the rational expectations. In fact, for a market to be efficient, expectations must be based on all known relevant information, which rational expectations require. Thus rational expectations are necessary for efficient markets.

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