Variable parameter estimation of consumer price expectations for the South African economy

Abstract

Individuals frequently form expectation about the future level of prices e.g. when making consumption expenditure decisions and during wage bargaining. Expectations are formed conditional on economic agents' perceptions of the current economic environment or regime as well as possible time-related changes in that environment. Expectations, i.e. anticipations or views of the future, have featured prominently in macroeconomic literature from the inception of the concept. Since 1930, when Irving Fisher introduced the 'anticipated rate of inflation' as the difference between the nominal and real interest rates, expectations have played an important role in economic theory. Formal analytical treatment of expectations formation, however, only emerged over the last quarter of this century. As a result, important advances in this area occurred. The development over the past thirty years of macroeconomic models has forced economists to recognise that expectations are not to be treated as exogenous — or to be ignored at will — but instead are central to our understanding of the functioning of the economy (Holden et al. 1985:1). Historically, there have been two distinct methods of dealing with expectations in economic analysis — one is the direct measuring of expectations by conducting surveys to determine expectations, the other is to provide a simple model of expectations formation. Direct measures are, for obvious reasons, not a very plausible method of obtaining expected values for future outcomes of economic variables. Although undoubtedly useful in preparing economic forecasts, gathering direct measures of expectations are costly and time consuming; in addition the data becomes outdated rather quickly. Furthermore, and perhaps more importantly, direct measures of agents' expectations provide little insight into how expectations would change as policy changes. The breakthrough that led to a more general approach to expectations modelling came with the realisation that expectations could be treated as an unobservable component. In this study, the latter method is adopted: a simple model of expectations formation is specified and the coefficient vector of the expectations rule is treated as an unobservable component.