Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

Chapter 4

Expectations – Answers

4.1 Checklist questions

1. What role do expectations play in the IS curve that underpins the 3-
equation model? Provide an example of a situation where a change in
expectations of the future can influence households’ behaviour in the cur-
rent period and shift the IS curve.
ANSWER:
Expectations about the future influence the spending decisions of house-
holds and firms. Tobin’s q theory is a very clear example of a model of
investment in which there is an institutional mechanism – the stock mar-
ket – that aggregates information about the views of those outside the
firm about the firm’s expected future profits. When Tobin’s Q is greater
than one, the model predicts positive investment. More optimistic expec-
tations about future profitability, for instance, will shift the IS curve to
the right. Similarly, the permanent income hypothesis encapsulates the
idea that consumption decisions today reflect all the available information
about expected future income. A change in pension entitlement is an ex-
ample of a change in expectations of the future that would be expected to
affect consumption in the current period.
2. Describe the difference between risk and uncertainty. Provide an example
of each case.
ANSWER:
Risk exists when individuals make decisions about the future based on
known probabilities. In such conditions agents can work out an expected
outcome. A typical example could be one where two opponents bet £10
each on picking a card out of a pack of 40 cards. Each player will face
the same ex-ante probability 1/40 of winning, which gives an expected
outcome of £0.25. Uncertainty differs from risk in two important ways:
first, uncertainty exists where it is impossible to assign probabilities to

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

2 CHAPTER 4. EXPECTATIONS – ANSWERS

known outcomes and, second, where there are some outcomes which may
be unknown. Some future events may be so uncertain that we are not able
to attach any meaningful probabilities to them. An example could be the
prospect of the development of nuclear fusion as a commercial source of
energy.

3. This question focuses on the discussion of Chevalier and Goolsbee (2009)

in Section 4.2.2. Make sure you re-read this discussion before answering
the following questions. Chevalier and Goolsbee (2009) suggests that the
market for textbooks in the United States is rational and students are
forward looking. If expectations were not rational and forward looking,
how would you expect the example to differ? Would publishers be able to
raise revenue by speeding up revision cycles?
ANSWER:
The reason students are not willing to buy books with a short projected life
is because they are forward-looking and they incorporate the information
that shorter revision cycles imply a sooner release of a new edition and
the inability to re-sell older editions. If students were not forward-looking,
then they would not take this piece of information into account. In other
words, they would violate the rational expectations hypothesis and would
make systematic errors. For instance, they would buy a book with a
short projected life. Publishers, in turn, would be able to raise revenue by
speeding up revision cycles.

4. Assess the following statements S1 and S2. Are they both true, both false
or is only one true? Justify your answer.
S1. Rational expectations means agents do not to make systematic errors
S2. Rational, forward-looking central banks’ forecasts are often wrong.
ANSWER:
Statement S1 is true, by definition of REH. Statement S2 is also true.
Central banks build, test and refine their models of the economy. Their
models and forecasts are subject to extensive external scrutiny and it is
unlikely that the central bank would make systematic mistakes without
being forced to reconsider its methods. Therefore, central banks can be
deemed to be rational, forward-looking agents. Nevertheless, not making
systematic errors does not preclude the possibility of delivering wrong
forecasts.

5. When we add rational expectations to the 3-equation model, how does

that change the predictions of the model?
ANSWER:
Assuming that all the agents in the 3-equation model have rational ex-
pectations implies three main changes. Firstly, the dynamic behaviour
of the economy when adjusting to random shocks disappears. In other

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

4.1. CHECKLIST QUESTIONS 3

words, inflation does not get ‘built into the system’ and, therefore, there
is no costly process of disinflation to return the economy to target inflation
and equilibrium output. Second, in contrast to the 3-equation model with
adaptive expectations, there is no role for a stabilizing central bank whose
role it is to guide the economy along the MR curve to equilibrium. Finally,
since wage and price setters are forward looking, the central bank can in-
fluence expectations directly. Differently from adaptive expectations, we
do not need to wait for actual inflation to fall before it influences expected
inflation.
6. Explain what is meant by the following statement: "disinflation can be
costless if the central bank is perfectly credible". Draw the impulse re-
sponse functions for output, inflation and the real interest rate following
an inflation shock and interpret your results, when:

(a) inflation expectations are fully backward looking

(b) inflation expectations are firmly anchored to the inflation target.

ANSWER:
If expectations are firmly anchored to the inflation target, then in the
absence of shocks, the Phillips curve does not move, unless the inflation
target changes. A perfectly credible central bank achieves firmly anchored
expectations. Therefore, if it announces a new, lower inflation target and
this is perfectly credible, the economy will jump to the new equilibrium
without requiring a fall in output. In other words, disinflation is cost-
less and the impulse response functions will show no change in output or
unemployment; there will be a purely transitory effect on inflation. In con-
trast, with backward-looking expectations, there is the need for a painful
increase in unemployment to bring inflation back to target.
7. Assess the following statements S1 and S2. Are they both true, both false
or is only one true? Justify your answer.
S1. Better communication by central banks can influence the path the
economy takes after an economic shock
S2. Better communication by central banks does not affect how economic
agents react to interest rate changes (which is the main tool used by
monetary policy makers to achieve their inflation target). Hint: which of
the curves IS-PC-MR is affected by communication?
ANSWER:
Both statements are true. Communication affects the extent to which
inflation expectations are anchored to target, which affects the Phillips
curve. While affecting the supply side of the economy, it has no impact
on the demand side, leaving the IS unchanged. Therefore, the reaction
of agents to a given change in interest rates will be unaffected by com-
munication. The effect of anchored expectations on the P C means the

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

4 CHAPTER 4. EXPECTATIONS – ANSWERS

central bank’s best response output gap is reduced and hence, a smaller
change in the interest rate is required for the central bank to bring the
economy back to the M R curve. [Extra points for the observation that
anchored expectations effectively make the Phillips curve steeper (i.e. the
constraint faced by the central bank is steeper – join points B and C in
Fig. 4.6 in the chapter), which will have the additional effect of making
the M R curve flatter.]

8. Provide a definition of the Lucas critique. What is the relevance of the

critique to the stagflation of the 1970s?
ANSWER:
The Lucas Critique highlights the dangers of forecasting by using models
that rely on the relationships found in historical data. Such forecasting
methods will be unreliable if those relationships are conditional on the
policy regime that was in place during the historical period being analysed.
If the policy regime is different in the future, then the relationships found
in historical data could well break down. This is particularly relevant if
we argue that agents will adjust their behaviour in response to the new
policy regime.
The Lucas critique was directed at the use of the large econometric mod-
els that had been developed for forecasting. Such models dominated gov-
ernments and central banks from the 1950s to the mid-1970s and failed
to capture the change in inflation expectations formation. The associ-
ated policy mistakes in the stagflation of the 1970s coincided with the
development of New Classical Macroeconomics, aimed at developing new
models to address the Lucas critique. The underlying principle of New
Classical Economics is that macroeconomic models should be based on
well-specified microeconomic foundations, and in particular, on forward-
looking optimizing agents with model-consistent expectations.

9. Imagine the government is able to exert control over monetary policy.

What happens under adaptive expectations when the government targets
a level of output above equilibrium? Is there a short-run trade-off between
inflation and unemployment? How about under rational expectations?
ANSWER:
Under adaptive expectations, if a government uses monetary policy to
target a level of output above equilibrium, this will result in so-called in-
flation bias. This means that targeting above-equilibrium output implies
a gradual rise in inflation, which eventually leads the economy back to
equilibrium output but with higher inflation. In the medium-run, output
needs to be at equilibrium. In the short-run, there is a trade-off: ex-
pansion in aggregate demand given by the higher output target boosts
inflation through the standard bargaining channel in wage-price setting.
When wage and price setters have rational expectations, inflation bias will

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

4.2. PROBLEMS AND QUESTIONS FOR DISCUSSION 5

arise too. The only difference is in the adjustment process, which will be
instantaneous with no short-run trade-off.
10. Can a government with an overly ambitious output target credibly commit
to targeting equilibrium output? If not, then how can they solve the
inflation bias problem?
ANSWER:
The inflation bias result suggests that a government cannot commit to a
credible output target of ye if it has a preference for output above equilib-
rium. Indeed, the government will always have an incentive to use mon-
etary policy in order to boost output above equilibrium in the short-run.
The problem of inflation bias can be solved by the government delegating
monetary policy to an independent central bank that can credibly commit
to target output at the equilibrium level.

4.2 Problems and questions for discussion

1. Use this chapter and your own knowledge and further research to answer
the following questions:

(a) Is Keynes’ treatment of expectations consistent with the rational ex-

pectations hypothesis?
(b) What is meant by agents making ‘systematic errors’ under adaptive
expectations?

ANSWER:
(a) Keynes believed some things were inherently uncertain and that we
could not attach any meaningful probabilities to them. To quote his words:
"We are merely reminding ourselves that human decisions affecting the fu-
ture, whether personal or political or economic, cannot depend on strict
mathematical expectation, since the basis for making such calculations
does not exist; and that it is our innate urge to activity which makes the
wheels go round, our rational selves choosing between the alternatives as
best we are able, calculating where we can, but often falling back for our
motive on whim or sentiment or chance." As Hoover (1997) points out,
"Keynes understood the essential message of the rational expectations hy-
pothesis long before it was formulated by Muth. He would nevertheless not
have been a ‘rational expectationist’. The most important reason is that
rational expectations cannot accommodate Keynes’s fundamental distinc-
tion between short-term and long-term expectations." For Keynes, the
presence of uncertainty is central to understanding economic behaviour,
which is at odds with the view that the rational expectations hypothesis
is an adequate way of characterizing expectations formation.
(b) The adaptive expectations hypothesis states that wage setters respond
to their forecasting errors but they do this in a purely mechanical way.

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

6 CHAPTER 4. EXPECTATIONS – ANSWERS

Let’s consider a positive output gap: as long as y > ye , the real wage
outcome is below what had been expected since the inflation outturn is
higher than expected. As a result, agents are systematically wrong and
thus make systematic errors in forecasting future inflation.

2. Collect data on inflation and unemployment for the UK and the US dur-
ing the 1970s and 1980s using OECD.Stat. The 1980s was a period of
significant disinflation for the two economies. Use the data gathered and
the content of this chapter to answer the following questions:

(a) Was the disinflation costly (in terms of rising unemployment)?

(b) Does the data provide evidence that inflation expectations were being
formed rationally during this period?
(c) How can the concept of anchored expectations be used to suggest
what the UK and US governments could have done to reduce the
costs associated with disinflation.

ANSWER:
(a) Yes, but it was costly especially for UK, which saw unemployment
rising until 1986.
(b) No. Typically, as seen in the model, adaptive expectations imply
some periods of high unemployment in order to push inflation down. If
expectations were rational, inflation would have jumped to the inflation
target without the need of high and persistent unemployment.
(c) The central bank can enhance its credibility, for instance through com-
munication and independence, in order to shift agents’ expectations from
adaptive to expectations anchored on the inflation target. The extent
to which they succeed in anchoring inflation expectations to the central
bank’s target reduces the costs of disinflation, both in terms of unemploy-
ment spikes and persistence.

3. Assume that inflation expectations are formed rationally. Use the 3-

equation model to show the adjustment of the economy to a permanent
demand and a permanent supply shock. Provide a period by period ex-
planation of the adjustment process (as done in Chapter 3). How does
the central bank reaction differ from the cases where we assumed adaptive
inflation expectations (as shown in the last chapter)?
ANSWER:
Fig. 4.1 depicts the case when inflation expectations are formed rationally
and are fully anchored to the target. In the case of a positive permanent
aggregate demand shock, output is pushed above equilibrium to point B.
The Phillips curve does not shift since inflation expectations are rational:
the central bank understands this and therefore sets the interest rates to
the new stabilising rate, in order to be back on the M R curve at point Z.

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

4.2. PROBLEMS AND QUESTIONS FOR DISCUSSION 7

Z
rS′

A B
rS
IS IS ′
y
π
π0 PC(π 0E = π T )
B

πT A, Z

MR
ye y0 y

Figure 4.1: Permanent demand shock - rational expectations

Differently from the case under adaptive expectations, there is no need for
some periods of output below equilibrium in order to squeeze out inflation.
In the case of a permanent supply shock, as in Fig. 4.2, the Phillips curve
shifts because the equilibrium output has changed; for the same reason,
the M R curve shifts too. Rational agents understand that the inflation
target has not changed and thus the economy jumps to the new MRE at
point Z. Differently from the case with adaptive expectations, the slow
adjustment of the economy is missing, and so output is not required to go
above the equilibrium level with interest rates below the new stabilising
rate to get inflation back up to the target rate.
4. This question uses the Macroeconomic Simulator available from the Car-
lin and Soskice website to show how central bank credibility affects the
adjustment of the economy following an inflation shock. Start by open-
ing the simulator and choosing the closed economy version. Then reset all
shocks by clicking the appropriate button on the left hand side of the main
page. Use the simulator and the content of this chapter to work through
the following questions:

(a) Apply a 2% positive inflation shock. Save your data.

(b) Adjust the degree of inflation inertia/credibility of the central bank

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

8 CHAPTER 4. EXPECTATIONS – ANSWERS

r
rS A

rS′ Z

IS
y
π
PC(π 0E = π T , ye )
PC(π E = π T , ye′ )
A Z
πT

B
π0
MR′
MR
ye ye′ y

Figure 4.2: Permanent supply shock - rational expectations

to zero (i.e. full credibility, which is equivalent to setting χ = 1 in

Equation 4.5). Save your data.
(c) Use the impulse response function and Section 4.4.3 to compare the
adjustment path of the economy following the shock in each case. Use
the 3-equation model to explain any differences in the adjustment
paths.
(d) Set the degree of inflation inertia/credibility of the central bank to
0.5 (i.e. partial credibility). Save your data.
(e) What do our answers to parts a. to d. tell us about the benefit to a
central bank of increasing their credibility?
(f) How might a central bank go about increasing their credibility?

ANSWER:
(c) Fig. 4.3 shows the impulse response functions for the 2 cases. Under
full credibility, an inflation shock is just a one-period shock to inflation.
Inflation expectations are firmly anchored to target, therefore the P C will
not shift. As a result, there is no need for unemployment to rise in order
to push down inflation. Similarly, the central bank does not need to raise
interest rates. In the standard setup labelled as case 1, instead, inflation
expectations are backward-looking. After the inflation shock, the central

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

4.2. PROBLEMS AND QUESTIONS FOR DISCUSSION 9

Figure 4.3: Impulse responses to an inflation shock - different degrees of credi-

bility

bank forecasts that the agents will expect inflation next period to be equal
to the current period inflation. Hence, it works out the negative output
gap required to be back on the MR curve and implements the associated
increase in interest rates. Interest rates are then gradually decreased whilst
the economy converges back to equilibrium output.
(e) Fig. 4.4 shows the response under the three different levels of credibil-
ity. As expected, partial credibility implies a weighted average response
in terms of inflation, output and interest rates. Having higher credibil-
ity implies a quicker recovery of inflation and output towards equilibrium
with respect to fully backward-looking inflation expectations. Neverthe-
less, this is not as quick as a one-period shock to inflation with perfect
credibility, and output needs to fall. Similarly, the required increase in
interest rates under partial credibility is milder than with fully backward-
looking expectations.
(f) First of all, credibility is generally assessed on the grounds of the ability
of the central bank to stick to its policy objective. Moreover, the ability
of the central bank to shape inflation expectations is crucial too. The
communications strategies of central banks appear to address both. This
is particularly relevant with respect to the ability of the central bank to

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Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

10 CHAPTER 4. EXPECTATIONS – ANSWERS

Figure 4.4: Impulse responses to an inflation shock - different degrees of credi-

bility

communicate the independence of monetary policy decisions from political

pressure. Independence is not the only driver of central bank credibility,
transparency also plays a role. A transparent central bank is one that
lets the public and financial markets into their decision-making process.
The more the central bank communicates what they are doing and why,
and their view of the future path of the economy and interest rates, the
more easily the general public and the private sector can form inflation
expectations.

© Wendy Carlin and David Soskice 2015. All rights reserved.