Expectations of Macroeconomic Cycles

03rd July, 2019

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Introduction

Goal of economic policy : Diminishing the impact of recessions

Traditional theory : The active members in shaping the course of the
macroeconomy are governments and businesses and the passive member is the
consumer. There is no channel by wich changes in consumer demand can cause
economic-wide recessions.
Q : Is it true that the onset of each recession takes consumers by surprise ?
A : There is no reason to believe that rational consumers would not asume that a
series of recessions would likely occur during their lifetime.

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Introduction

All of the major actors int the economy look for conditions as early warning signs
of a potential downturs. However, consumers expectations are assumed to be
unwilling to predict the future downturns, after all they are just unprepared
members of the economy.
Purpose of this chapter : Explore how the role of expectations provides new
foundation for understanding macroeconomic cycles.

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Consumers shift from subsistence to discretion

Since the time of Keynes, consumers are taken as a sector which have no
independent role in determining the course of the macroeconomy, basically
because of the so called fundamental psychological law (current income is the
main determinant of consumption) as a consequence consumer expectations of
future income were simply viewed as outputs of the economic system.
Other theories relied on the assumption of certainty equivalence which exclude
the impact of uncertainty in consumers.
This may be true before the Industrial Revolution, where the main purpose of
consumers were subsistence (rising incomes and savings were unthinkable as a
result also discretionary investments)

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Expectations of Macroeconomic Cycles

One of the principles of modern economic theory is that people use information
about their permanent income to make optimal decisitions each period i.e. people
expectations are formed rationally, where only permanent changes in income
has an efect on consumption.
Q : How do people manage to diminishing the risk associated with economic
cycles ?
A : For few of them people can purchase insurance, however most of the
economic risks associated with business cycles are uninsurable (such as job and
wage prospects, return on assets, tax obligations, etc).

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Expectations of Macroeconomic Cycles

There are few theories about how a recession might impact at people’s
consumption some of them argue that it has no impact due to their association
with a transitory change in income.
However as recessions differ in length and depth, rational consumers should be
prepare for an economy down turn, basically because it should cut some
expenses on “investment” goods that are tipically financed by debt.

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Consumer Expectations as a leading indicator

How can we expect that the average consumer would know the direction of
change in the macroeconomy ?
The University of Michigan has estimated a correlation between change in
consumers sentiment and GDP growth, the overall patterns of change indicate
that consumers expected economy-wide downturns in advance of the decline in
GDP, due to consumers use informal information about potential direction of the
economy and do not use formal information such as GDP, inflation or interest
rates. In fact, a Granger causality test has shown that quearterly changes in the
Index of Consumer sentiment significantly predicts changes in quarterly GDP, and
not otherwise.

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New micro foundations for macroeconomics

Consumer spending is a primary force behind economic cycles and that forming
expectations about future business cycles is an essential task for them.
Consumers directly account for almost two-thirds of the GDP.
Common theories need to be changed due to the change of consumers roles as
their only objective is no longer subsistence.
The biggest mistake is the denial that consumers can have an independent effect
on the course of the macroeconomy. New theories must recognize that economic
recessions (as well as recoveries) can be driven by expectations from all the
members of the economy (businesses, government and consumer).

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