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addition the data becomes outdated rather quickly.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.
