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Expectations Affect Behavior

We have discussed a number of cases in which people's behavior has depended on expectations: people's consumption depends on expected income; businesses make investment decisions based on what they expect the future demand for their products to be; workers and employers make decisions on wage rates based on what they expect the rate of inflation to be. In addition to these examples, expectations played special roles in the Great Depression and the Great Inflation.

A major reason money stock declined as much as it did between 1929 and 1933 was that the public's faith in the banking system was shaken, and there were three periods in which there were runs on the banks, in October 1930, March 1931, and January 1933. When a run on a bank occurs, people try to withdraw their deposits, asking the bank for currency. Expectations about banks closing tend to be self-fulfilling. A bank holds only a small part of its assets in currency and other liquid forms, and can pay off on short notice only a small part of its liabilities. If enough people fear that a bank will close, it will close, whether or not it is sound. Once one bank closes, people become concerned about other banks. Hence, the failure of an unsound bank can trigger runs on sound banks, causing them to close (which may be only temporary), thereby causing runs on still more banks.

When people lose faith in the soundness of banks and withdraw currency, their actions, unless offset by actions of the central bank, reduce money stock. In the early 1930s the Federal Reserve did not act to offset the effects of the currency drain on the banks, and much of the decline in money stock resulted from the public's substitution of currency for bank deposits. The process illustrates an important amplifying feedback relationship. The withdrawal of deposits from banks reduced money stock, which caused income to drop, the drop in income caused bankruptcies and made people question whether or not their banks were still sound. In their concern they withdrew more money from banks, which tended to cause a further reduction in money, etc.

Expectations--and luck--played an important role in stopping Germany's hyperinflation. Hjalmar Schacht, became Currency Commissioner in November of 1923. He immediately introduced a new currency, the rentenmark. A strike of Berlin printers made rentenmarks scarce. People waited in line to convert their old marks into rentenmarks--they desired to get out of marks into anything that might retain value. Because people thought rentenmarks were scarce and expected them to keep their value, people hoarded them, which gave rentenmarks a much lower velocity of circulation than the old marks had. The government was able to issue them at a fairly rapid rate without a renewal of inflation, giving it time to get its fiscal house in order. (The government had relied heavily on borrowing to finance World War I, believing that the war would be short and that Germany would win and be able to force its opponents to pay for the war. It did not raise taxes, and continued to rely on borrowing after the war. In fiscal year 1920-21, only about 40% of government expenditures were raised through taxes.) Germans were ready and eager for a stable money, and wanted to believe that the rentenmark would be such a money. If they had not believed that it would retain value, the Great Inflation would have continued.

Though all economists believe that expectations matter, how they matter and which expectations matter remain subject to controversy. For example, the Keynesian emphasis on the role of autonomous investment as a cause of fluctuations in business activity is based on expectations. Keynes thought expectations were sometimes erratic and not always explainable. He referred to the "animal spirits" of businessmen, and believed that speculative binges were important not only in the stock market but in investment decisions. Thus, if for unexplainable reasons businessmen become optimistic, investment will rise, and pull business activity with it.

Other economists see less importance in autonomous shifts in investment because they see businessmen not as speculative investors moved by erratic expectations, but as cold-hearted and clear-headed evaluators of available evidence who are searching for profit opportunities. In this world of rational expectations, investment does not play an active role in business fluctuations, but a passive one. Investment changes when conditions, such as demand for products or the availability of funds, changes.

If expectations do not instantly reflect the state of the world but are formed as learn about our economic environment, adjustment of the entire economy to an autonomous change will take time. We have looked at a number of places in which lags occur in adjustment because it takes time to distinguish permanent changes from temporary changes. In a world of perfect expectations and perfect mobility, a world of no lags, there should be no recessions. Prices should adjust to any level of total demand to insure full output. This clearly does not happen in the real world. In the case of the Great Depression, real GNP did exceed its level of 1929 until 1939 (though it would have passed it in 1937 had not the recession of 1937-38 occurred). On the other hand, the dislocations caused by the sudden end of German hyperinflation in 1923 were remarkably small.

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Copyright Robert Schenk