What is the importance of expectations in the economy? To start with, Tom Sargent's quote matters: "What's going to happen is going to depend partly on what you think is going to happen."
In the modern world, the introduction of expectations set a new problem to economy. Uncertainty, hopes, doubts and fears towards general ecnomic issues influence the ultimate decisions of people. The general expectation or fear of inflation is enough to spark an inflationary period. Consumers who think that the price of one good will increase in the future may spend more of their money in order to buy that good and therefore save less. This process results in demand-pull inflation. When a lot of individuals are trying to buy the same good, the price will inevitably increase. When this happens across the whole economy for all goods, it is called as demand-pull inflation.
In 2011, tax revenue of US has increased, in result, comsumption increased but investment did not. They are just sitting on their money and waiting because "expectations" are unstable. For many Americans, the common question of "what will happen?" matters. Unless expectations change and are managed effectively, crisis will not come to end.
Even if economy is improving, expectations may be worse. In this case, the role of central bank and the government is highly important. People should know that policy changes as well as structural changes in a country, and going to a new stage in the economy affect prices of goods and production costs. So, 'rational' expectations are the main issue that we have to consider. Expectations may change faster than the CB responds. The tricky issue is forecasting whether inflation expectations might change or not. If inflations are steady , it is the success of Central Bank's credibility.
The main idea is that if we all expect inflation, we'll seek higher prices, rents, and wages as a result we will produce the inflation we expect. Again same thing, if we all believe the Central Bank won't permit inflation to take off, it won't. Therefore, according to our expectations (pessimistic or optimistic) we shape our mentality toward consumption, investment, demand and so on. This of course was an improvement in economic thinking. In the past, some economists assume that people match their expected inflation only the recent past, but now they are smarter.
As an economist said, life is about managing inflation, and so managing the economy. Managers must be careful about what they say because the fear of inflation is enough to create it. Hence, policymakers should act like a psychologist to the economy.
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