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Chapter 13 Review Question 4 What are expectations, and why are they important, in macroeconomic models? What would you think about a macroeconomic model that assumed that peoples expectations of inflation were constant, even though the inflation rate changed over time?
In dynamic models expectations are ways people view the future economic variables. Rational expectations utilize all available information. This is the idea that people make choices based on their rational outlook, available information and past experiences. Expectations are best modeled as endogenous variables If inflation has been stable for decades, never changing very much from some level, then people may be safe in assuming that such a trend will continue. If monetary policy has changed from one that stabilizes the inflation rate to one that results in higher inflation rates over time, then households will adjust their expectations. If peoples expectations about inflation depend on their expectations about future monetary policy, people wish to understand the incentives facing monetary policymakers. If a household can figure out why policymakers make the decisions they do, it is able to form better expectations about future inflation. A paper published by the Federal Reserve Bank of San Francisco, Expectations…

and Economic Fluctuations: An Analysis Using Survey Data suggests that the idea that changes in expectations of future activity can be important drivers of economic fluctuations has received increased attention with the unfolding of boom-bust cycles around the world over the past 20 years”. It also mentions the experiences of Japan (1980s), East Asia (1990s) and the U.S. (2001 and 2007) suggesting that optimism about the prospects for future growth helped fuel the booms and then downward revisions in expectations helped lead to busts. (Leduc, S. & Sill, K. (2010). The Federal Reserve Bank of San Francisco. Retrieved from www.frb



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