Expectations, Static

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Expectations, Static

In economics, the concept of static expectations describes an assumption that economists make about the way people form their predictions regarding the future values of economic variables. Specifically, the static expectations assumption states that people expect the value of an economic variable next period to be equal to the current value of this variable.

The concept of static expectations has been widely used in the early economics literature, such as in the cobweb model of price determinations. In the cobweb model, the static expectations assumption states that sellers expect the price of a good next period to be the same as it is today and adjust their production accordingly. The early literature did not focus much on unexpected shocks.

The concept of static expectations and its more advanced variation, the concept of adaptive expectations, play an important role in the monetary economics, the branch of economics that addresses the design and the impact of monetary policy. This concept was formalized in 1968 simultaneously by Milton Friedman (1912–2006) in his article “The Role of Monetary Policy” and by Edmund Phelps (b. 1933) in his article “Money–Wage Dynamics and Labor Market Equilibrium.” Because only unexpected inflation, or inflation rate in excess of the expected inflation rate, can increase the aggregate output of the economy, it is important for policymakers to know what inflation rate economic agents expect in the future. For economists this means that they have to make an assumption about how economic agents form their predictions of future inflation.

The most simple–minded assumption about expectations one can make is that of static, or naïve, expectations: Agents are assumed to expect the inflation rate next year to be the same as it was this year. Adaptive expectations assumption merely extrapolates the concept of static expectations—it suggests that economic agents expect the inflation rate to be equal to the weighted average of the inflation rate in the past few periods. Economists used the assumptions of static and adaptive expectations until the concept of rational expectations was developed.

The main criticism of the concept of static expectations is that it assumes that people ignore the information about possible shifts in policy variables. In case of monetary policy, if policymakers announce credibly that they will adopt an anti–inflationary stance, it would not be rational for economic agents to believe that the inflation rate will remain the same. Thus, rational expectations assumption incorporates all possible information available at the time the expectations are formulated, not just the past values of the variable being forecasted, as is the case with static or with adaptive expectations.

In modern economic theory most models that incorporate uncertainty about the future assume rational expectations, not static expectations. Nevertheless, some economic variables and many financial variables follow a specific stochastic process, called martingale, for which the best prediction of the future value is today’s value. For these variables static expectations turn out to be rational expectations.

SEE ALSO Expectations; Expectations, Implicit