Understanding Expectations in Economics

Question 1

What does the adaptive expectations hypothesis suggest?

Answer 1

Individuals form their expectations of future inflation based on past trends.

Question 2

How do individuals expect future inflation if it has been consistently high?

Answer 2

They expect it to remain high.

Question 3

How do individuals expect future inflation if it has been low?

Answer 3

They anticipate it will stay low.

Question 4

What type of approach does the adaptive expectations hypothesis represent?

Answer 4

A backward-looking approach.

Question 5

What economic concept was widely used before the development of rational expectations?

Answer 5

Adaptive expectations.

Question 6

What significant economic event in the 1970s is associated with the breakdown of the Phillips Curve?

Answer 6

Stagflation.

Question 7

What policy mistake did governments make during the 1970s regarding inflation and unemployment?

Answer 7

They believed that increasing inflation could reduce unemployment.

Question 8

What was the consequence of workers and firms adapting their expectations to persistently high inflation?

Answer 8

They demanded higher wages, leading to a wage-price spiral.

Question 9

What is a wage-price spiral?

Answer 9

A situation where rising wages lead to higher prices, which in turn leads to further wage demands.

Question 10

Fill in the blank: The adaptive expectations hypothesis was used before the development of _______.

Answer 10

[rational expectations].

Question 11

True or False: The adaptive expectations hypothesis is a forward-looking approach to inflation.

Answer 11

False.

Question 12

What is a strength of Adaptive Expectations?

Answer 12

Simplicity → Useful for explaining short-term behavior.

Adaptive Expectations provide a straightforward framework for understanding immediate responses in economic behavior.

Question 13

What is a limitation of Adaptive Expectations in volatile economies?

Answer 13

Fails in volatile economies → Does not account for sudden shifts in economic policy or external shocks.

This limitation indicates that Adaptive Expectations may not accurately predict behavior during times of economic instability.

Question 14

In what type of environments is Adaptive Expectations considered empirically weak?

Answer 14

Empirically weak in high-information environments → Agents do not always rely on past trends when they have access to better data.

High-information environments allow agents to make more informed decisions, reducing reliance on historical data.

Question 15

What is the rational expectations hypothesis?

Answer 15

Individuals use all available information to make optimal predictions about the future.

Developed by Robert Lucas and John Muth.

Question 16

According to the rational expectations hypothesis, how are expectations generally formed?

Answer 16

On average, expectations are correct, though individual errors may occur.

Question 17

Who was the Chair of the Federal Reserve during the 1980s Volcker Shock?

Answer 17

Paul Volcker.

Question 18

What action did Paul Volcker take to combat high inflation in the early 1980s?

Answer 18

Aggressively raised interest rates.

Question 19

What was a consequence of the aggressive interest rate hikes during the 1981-1982 period?

Answer 19

A severe recession.

Question 20

What occurred once economic agents were convinced that the Fed was committed to reducing inflation?

Answer 20

Expectations adjusted, and inflation fell sharply.

Question 21

Fill in the blank: The rational expectations hypothesis suggests that economic agents use _______ to make predictions.

Answer 21

[all available information].

Question 22

True or False: The rational expectations hypothesis states that individual expectations are always correct.

Answer 22

False.

Question 23

What does the example of the 1980s Volcker Shock illustrate about rational expectations?

Answer 23

Rational expectations can make disinflation faster and less costly than previously believed.

Question 24

What is the main theoretical implication of rational expectations?

Answer 24

Explains why anticipated policies often have limited effects

For example, monetary policy is less effective if it is expected.

Question 25

What empirical support is provided for rational expectations?

Answer 25

Volcker’s shock illustrates how rational expectations can anchor inflation ## Footnote This refers to the events during Paul Volcker's tenure as Federal Reserve Chairman.

Question 26

True or False: Rational expectations assumes individuals have perfect information.

Answer 26

False ## Footnote In reality, individuals do not always have access to all economic data.

Question 27

What aspect of human behavior does rational expectations ignore?

Answer 27

Cognitive biases ## Footnote People may misinterpret signals due to uncertainty or herd behavior.

Question 28

What does the Permanent Income Hypothesis suggest about consumer spending?

Answer 28

Consumers base their spending on expected lifetime income rather than short-term fluctuations. ## Footnote This theory was proposed by Milton Friedman.

Question 29

How do consumers react to expected inflation according to the Permanent Income Hypothesis?

Answer 29

They may increase spending today to avoid future price increases. ## Footnote This behavior reflects a proactive approach to anticipated economic changes.

Question 30

What is the consumer behavior during expected deflation?

Answer 30

They delay purchases, which can worsen economic downturns. ## Footnote This was notably observed during Japan’s ‘Lost Decade’ of the 1990s.

Question 31

Fill in the blank: Under the Permanent Income Hypothesis, consumers base their spending on _______.

Answer 31

[expected lifetime income]

Question 32

What was the consumer behavior in the UK from 2016 to 2019 following Brexit uncertainty?

Answer 32

Households increased precautionary savings, slowing consumption growth despite low unemployment. ## Footnote This demonstrates the impact of expectations on spending decisions.

Question 33

True or False: According to the Permanent Income Hypothesis, actual income changes are the primary driver of consumer spending.

Answer 33

False ## Footnote The hypothesis emphasizes expected lifetime income over actual income changes.

Question 34

What do firms base investment decisions on?

Answer 34

Expected future conditions

Question 35

If firms expect high inflation, what action might they take regarding investments?

Answer 35

Front-load investments to avoid rising costs

Question 36

What might firms do if they expect deflation?

Answer 36

Cut investments, leading to slower growth

Question 37

What event is used as an example of weak capital investment despite low interest rates?

Answer 37

2008 Financial Crisis

Question 38

What did firms anticipate following the Global Financial Crisis that affected their investment decisions?

Answer 38

Prolonged economic stagnation

Question 39

What was the response of businesses to the Bank of England and the Federal Reserve cutting rates aggressively post-crisis?

Answer 39

Businesses did not respond as expected due to anticipating weak demand

Question 40

Fill in the blank: Firms may _______ investments to avoid rising costs during high inflation.

Answer 40

front-load

Question 41

True or False: Firms are more likely to increase investments during expected deflation.

Answer 41

False

Question 42

What was a significant factor influencing firms' investment behavior during the 2008 Financial Crisis?

Answer 42

Weak capital investment despite record-low interest rates

Question 43

What do workers and firms negotiate based on?

Answer 43

Expected inflation

Question 44

What happens if workers expect high inflation?

Answer 44

They demand higher wages, contributing to cost-push inflation

Question 45

What do firms do if they expect deflation?

Answer 45

They resist wage increases or reduce salaries

Question 46

What was a significant example of wage negotiation in the 1970s?

Answer 46

UK Trade Unions negotiating wage increases above productivity growth

Question 47

What was the consequence of the UK Trade Unions' actions in the 1970s?

Answer 47

Exacerbation of inflation and industrial unrest

Question 48

What did the government fail to do in the 1970s that contributed to inflation?

Answer 48

Anchor expectations

Question 49

Fill in the blank: If firms expect ________, they resist wage increases.

Answer 49

deflation

Question 50

True or False: Strong trade unions in the 1970s negotiated wage increases below productivity growth.

Answer 50

False

Question 51

What is the primary focus of central banks in managing monetary policy?

Answer 51

Managing expectations to maintain price stability

Question 52

What is inflation targeting?

Answer 52

A strategy used by central banks to anchor inflation expectations and stabilize actual inflation

Question 53

Which central banks utilize inflation targeting?

Answer 53

* Bank of England * European Central Bank (ECB) * Federal Reserve (Fed)

Question 54

When did the Bank of England gain independence to target inflation?

Answer 54

1997

Question 55

What inflation target has the Bank of England set since 1997?

Answer 55

2% inflation

Question 56

What methods does the Bank of England use to shape expectations?

Answer 56

* Forward guidance * Credibility

Question 57

True or False: The Bank of England's inflation targeting has helped maintain stable inflation rates in the UK over the long run.

Answer 57

True

Question 58

What do expectation-based models explain about policy effectiveness?

Answer 58

If expectations are well-anchored, monetary and fiscal policy have predictable outcomes.

Question 59

How are expectation-based models crucial for inflation control?

Answer 59

Central banks use expectations management to prevent inflationary or deflationary spirals.

Question 60

What is one benefit of expectation-based models in economic forecasting?

Answer 60

Helps predict economic trends more effectively than models that assume static behavior.

Question 61

What is a limitation of expectation-based models regarding rationality?

Answer 61

Over-reliance on rationality; behavioral economics shows consumers and firms are prone to irrationality.

Question 62

What challenge exists in measuring expectations in expectation-based models?

Answer 62

Surveys and market-based indicators (e.g., bond yields) are imperfect proxies.

Question 63

What can happen if expectations become self-fulfilling?

Answer 63

If firms expect a recession, they cut investment, causing the downturn they feared.

Question 64

What are central to modern macroeconomic theory?

Answer 64

Expectations ## Footnote Expectations influence various economic behaviors including consumption and investment.

Question 65

What aspects does the shift from adaptive to rational expectations improve?

Answer 65

Policy effectiveness ## Footnote Rational expectations provide a more accurate framework for understanding economic behavior.

Question 66

List three real-world deviations that highlight the need for refinement of expectation-based models.

Answer 66

* Uncertainty * Misinformation * Cognitive biases ## Footnote These factors can impact the accuracy of expectations in economic models.

Question 67

What remains one of the most important challenges for economists and policymakers?

Answer 67

Understanding and managing expectations ## Footnote Proper management of expectations can significantly influence economic stability and growth.

Question 68

True or False: The shift to rational expectations completely eliminates the need for refining economic models.

Answer 68

False ## Footnote Real-world complexities necessitate ongoing adjustments to expectation-based models.