Since the 1930’s expectations (anticipation’s or views about the future) have played an important role in economic theory. This is because economics is generally concerned with the implications of current actions for the future. In recent times attention has switched from more or less mechanical forms of expectations generation (extrapolative or adaptive) which has become essentially ad-hoc to the theoretically attractive approach of the rational expectations hypothesis. This states that agents use economic theory to form their expectations, and should not make systematic errors in their forecast of the future.
The reason for this switching however, is not hard to find. It derives partly from the sad state in which macroeconomic theory found itself in the early 1970’s, with the phenomenon of stagflationconfounding earlier Keynesian optimism and with the Philips curve apparently experiencing increasing instability and collapse. It also relates to the fact that the adaptive expectations model associated closely with the name, Cagan (1956) became increasingly untenable as a model of expectations formation under conditions of accelerating inflation which typified the 1970’s.
THE NEW CLASSICAL APPROACH
The new Classical approach to explaining business cycles in relation to the role of expectations has something in common with monetarist, in that the shock sets off the cycle is a change in the money supply.
New Classical economists assume that the actors in the private sector of the economy have rational expectations. This assumes that agents form expectations based upon all available information about the future at the time they take the decision. Therefore, agents make only random errors in forecasting the future course of economic variables. This means that the expectational errors that trigger cycles cannot be systematic. If they were systematic, agents could learn from the pattern of mistakes and improve their forecasts.
According to the New Classical approach, only unanticipated policy changes lead to changes in real national income. Systematic policy changes will be predictable and will have no real effects. Most economists do not accept the proposition that only unexpected policy changes will have real effects. One reason is that there a lot of fluctuations in price and wage setting behaviour that very few contracts can be renegotiated as soon as a policy change in relation to interest rates is announced. Hence the policy –makers certainly have some leverage over real activity, even when making policy changes that are predictable.
Another reason is that the massive complexity of the economy makes it impossible for individual agents to know how some change in policy will affect all the relevant prices and quantities that matter to them over any specified period of time. This is where the presumption that private agents have expectations of what policy makers are going to do, and that this influences private behaviour, is the subject matter here. Without, assuming randomly, just reasonable approximate expectations, private anticipation of government action can affect the outcome of policies.
Monetarism is closely allied with the Classical school of thought. It is essentially an extension of Classical theory which was developed in the 1960s and 1970s to try to explain a new economic phenomenon, stagflation.
This sees expectations as determined by essentially une