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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.
Copyright
Robert Schenk
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