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First, following the rational expectations literature in economics, a large sample of countries over a long time period permits tests of the unbiasedness implication of the rational expectations hypotheses REH , revealing much variation in the accuracy of expectations and the nature of the biases in expectations. Secondly, a theory of expectation formation encompassing the unbiasedness prediction of the REH and setting out the conditions under which economic expectations should be too optimistic or too pessimistic is elucidated.

Finally, the theoretical argument that political context impacts the accuracy of average expectations is tested. While this may distract some political scientists unfamiliar with the somewhat technical econometric debates that animate much of this literature, we think this approach is essential if our contextual analysis of economic expectations is to have more impact in the economics literature than has previous work on economic expectations in political science.

It should be pointed out that an important difference between the measurement of subjective economic evaluations in political science versus economic research is the content of the survey instruments. One of the major factors contributing to endogeneity of economic perceptions in the political science realm is the fact that questions regarding economic evaluations are typically asked in survey instruments that include a battery of political partisanship and preference questions which might principally cause the bias Palmer , Harvey D. Instruments designed by economists to measure subject economic assessments are not likely to include these political items.

The American Electorate and the U.

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As such, it is unclear exactly what correspondence one would expect between this summary measure and specific economic indicators. Rather, such deviations may simply reflect the weight the average voter places on that indicator in her overall assessment of the economy. There are exceptions, though. In the s, Conover, Feldman and Knight examined unemployment expectations per se. However, since most of the arguments that have been made concerning REH and the arguments we will make about political and economic differences in context can be applied to both perceptions and expectations with little adjustment the formal conditions for rational economic perceptions would be very similar to those provided below, with the exception that the only relevant piece of information in the citizens information set would be the real value of the economy itself , we will focus on, and use the language of, expectations as all other analyses in economics do.

Finally, there are other methods of transformation that do not rely on having both kinds of series, but these both require the evaluations data to be disaggregated at a level that is not available to us, and have been shown to be less accurate for expectations than the method we use. The use of reported data here is not substantively important. Hakkio , Craig S.

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In general, such tests will come down in favour of REH if outcomes and expectations are both integrated and also cointegrated. If this is true, then the series is in a long-run equilibrium and they can never wander too far apart. However, any persistence of out-of-equilibrium shocks violates the usual requirements of REH.

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Further, since our principal interest is not in tracing out the long-term dynamics in expectations, but rather in testing some comparative hypotheses about how political and economic institutions accentuate biases in expectations, we find that equations like Equations 1 and 2 are adequate for our substantive purposes. That said, we did perform a whole set of integration based tests of REH, which are available from the authors, www.

In general, these tests showed that both the inflation and expectations series were integrated in each country and that they were also cointegrated. However, different ECM or, equivalently, lagged-DV specifications, estimated in different ways, told different stories about the dynamics of the processes and were not stable to relatively minor changes in estimation strategy and specification.

Thus, we could come to no firm conclusions about the nature of the biases if any revealed in these kinds of estimates. Thus, we chose to stick with the well-understood and often-used methods reported in the text. Estimating dynamic regressions requires a choice of lag length for the lags and leads of differences that are included in the model.

Ng and P. Specifically, we start out with a large lag length we chose 11, given the overlapping data problem discussed above , and then estimate models sequentially for decreasing lag lengths, stopping when the longest lag in a given specification is significant. This approach was applied country by country. Perry and James Tobin Eds. Reprinted in the Hoover Digest , No. Taylor ed. Taylor and Michael Woodford Eds. Condensed version in Hoover Digest , No. Reducing Inflation , University of Chicago Press, pdf. Reifscheider, David J. Growth and Development: The Economics of the 21st Century , pdf.

Greg Mankiw ed. Monetary Policy , University of Chicago Press, pdf. Price Stabilization in the s , University of Tokyo Press, pdf. Reprinted in N. Gregory Mankiw and David Romer Eds. Gagnon , Economic Modeling , 7, July , pp. Helliwell, J.

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SS pdf. Currie, J. Frenkel, P. Masson, and R. Portes Eds.

Fischer ed. Macroeconomics Annual , 3, pdf. Burger ed. The U. Eatwell, M. Milgate, and P. Newman Eds. Bryant et al. Barnett and K. Singleton Eds. Nalbantian ed. Hafer ed. Gordon ed. As my colleague Rick Mishkin recently discussed, the extent to which inflation expectations are anchored has first-order implications for the performance of inflation and of the economy more generally Mishkin, Mishkin illustrated this point by considering the implications of the fact that inflation expectations have become much better anchored over the past thirty years for the estimated coefficients of the conventional Phillips curve, which I define here to encompass specifications that use lagged values of inflation to proxy for expectations or other sources of inflation inertia.

As he noted, many studies of the conventional Phillips curve find that the sensitivity of inflation to activity indicators is lower today than in the past that is, the Phillips curve appears to have become flatter ; 1 and that the long-run effect on inflation of "supply shocks," such as changes in the price of oil, also appears to be lower than in the past Hooker, These findings are of much more than academic interest. To the extent that the Phillips curve may have flattened, inflation will now tend to be more stable than in the past in the face of variations in aggregate demand.

Of course, this can be a good thing or a bad thing, depending on whether inflation expectations are anchored in the vicinity of price stability. Likewise, a lower sensitivity of long-run inflation to supply shocks would imply that such shocks are much less likely to generate economic instability today than they would have been several decades ago. Notably, the sharp increases in energy prices over the past few years have not led either to persistent inflation or to a recession, in contrast for example to the U.

Various factors might account for these changes in the Phillips curve, but, as Mishkin pointed out, better-anchored inflation expectations--themselves, of course, the product of monetary policies that brought inflation down and have kept it relatively stable--certainly play some role. If people set prices and wages with reference to the rate of inflation they expect in the long run and if inflation expectations respond less than previously to variations in economic activity, then inflation itself will become relatively more insensitive to the level of activity--that is, the conventional Phillips curve will be flatter.

Similar logic explains the finding that inflation is less responsive than it used to be to changes in oil prices and other supply shocks. Certainly, increases in energy prices affect overall inflation in the short run because energy products such as gasoline are part of the consumer's basket and because energy costs loom large in the production of some goods and services.

However, a one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent "wage-price spiral. A related implication is that, if inflation expectations are well anchored, changes in energy and food prices should have relatively little influence on "core" inflation, that is, inflation excluding the prices of food and energy.

Although inflation expectations seem much better anchored today than they were a few decades ago, they appear to remain imperfectly anchored.

Rational expectations hypothesis (ECO)

A number of studies confirm that observation. Levin, Natalucci, and Piger have shown that some survey measures of inflation expectations in the United States respond to recent changes in the actual rate of inflation, which would not be the case if expectations were perfectly anchored. Models of the term structure of interest rates better fit the data under the assumption that both inflation expectations and beliefs about the central bank's reaction function are evolving Kozicki and Tinsley, ; Rudebusch and Wu, ; Cogley, An indirect but elegant way to make the point that inflation expectations remain imperfectly anchored comes from a statistical analysis of inflation by Stock and Watson Stock and Watson model inflation as having two components, which may be interpreted as the trend and the cycle. Changes in the trend component are highly persistent whereas shocks to the cyclical component are temporary. That is, unexpected changes in inflation are today much more likely to be transitory than they were before the early s. Because it seems quite unlikely that changes in inflation could persist indefinitely unless long-run expectations of inflation also changed, I interpret the Stock-Watson finding as consistent with the view that inflation expectations have become much more anchored since the early s.

At the same time, that the variability of the trend component of inflation, though modest, remains positive, implies that long-run expectations of inflation are not perfectly anchored today. The policy implications of the much-improved but still imperfect anchoring of inflation expectations are not at all straightforward.

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To evaluate these implications, we must understand better the historical variation in inflation expectations, the effect of this variation on actual inflation and economic activity, and the relationship between policy actions and the formation of inflation expectations. With the hope of promoting progress on these broad topics, I pose three questions to researchers, the answer to any of which would be quite useful for practical policymaking.

First, how should the central bank best monitor the public's inflation expectations? Theoretical treatments tend to neglect the fact that in practice many measures of inflation expectations exist, including the forecasts of professional economists, results from surveys of consumers, information extracted from financial markets such as the market for inflation-indexed debt, and limited information on firms' pricing plans. In a very interesting paper, Mankiw, Reis, and Wolfers compared the available measures, emphasizing in particular that median measures of inflation expectations often obscure substantial cross-sectional dispersion of expectations.

Do we need new measures of expectations or new surveys? Information on the price expectations of businesses--who are, after all, the price setters in the first instance--as well as information on nominal wage expectations is particularly scarce. Second, how do changes in various measures of inflation expectations feed through to actual pricing behavior? Promising recent research has looked at price changes at very disaggregated levels for insight into the pricing decision Bils and Klenow, ; Nakamura and Steinsson, But this research has not yet linked pricing decisions at the microeconomic level to inflation expectations; undertaking that next step would no doubt be difficult but also very valuable.

Third, what factors affect the level of inflation expectations and the degree to which they are anchored? Answering this question essentially involves estimating the learning rule followed by the public or various components of the public, although one could consider alternative frameworks like Carroll's epidemiological model of the propagation of information among private agents. A fuller understanding of the public's learning rules would improve the central bank's capacity to assess its own credibility, to evaluate the implications of its policy decisions and communications strategy, and perhaps to forecast inflation.