The previous installment was here. This installment discusses expectations.

[UPDATE: This installment happens to contain what I would say is my answer to the question posed today by Tyler Cowen.|Expectations

When people make economic decisions, how do they form expectations about the future? In my view, there are two types of markets to consider. First, there are centralized, national financial markets. Second, there are decentralized local markets.

Centralized, national markets include the stock market, the bond market, commodities markets, and derivatives markets. They are centralized in that you know where you need to go to trade in those markets. If I want to buy wheat futures, I go to Chicago. If I want to buy stocks, I go to New York. These markets are national in that what people buy and sell is the same no matter where they live. IBM stock is IBM stock, whether you are in Peoria or Topeka.

Decentralized, local markets include markets for labor, haircuts, and property. In fact, most nonfinancial markets are decentralized and local. The prices and characteristics of goods and services that are exchanged can differ from place to place. When I need a haircut, I do not think in terms of Chicago (say) as the place to go to get it. I do not expect the style and price to be identical regardless of where I live. If I work in marketing communications, I do not expect that the salary and work requirements will be identical working for a cattle feed company in Wyoming and working for a social media startup in Silicon Valley.

Next, let me posit two ways that people can form expectations. These two ways are habit-based and model-based, respectively.

Habit-based expectations involve simple extrapolations of the recent past. If I saw that orange juice sold for $3 a gallon at the grocery yesterday, then I expect it to sell for $3 a gallon next week. If college tuition has been going up about 5 percent every year, then I expect it to go up 5 percent again next year. Among economists, the term “adaptive expectations” is commonly used where I am using habit-based expectations.

Model-based expectations involve coming up with a theory of the determinants of long-run equilibrium and of the process for getting to that equilibrium. For example, I might have a theory of the exchange rate that in the long run the exchange rate will be one at which there is a trade balance, with a process of adjustment that is gradual. If the dollar is overvalued by 15 percent, then I might expect it to depreciate at 3 percent for five years.

What I call model-based expectations is closer to what economists mean by rational expectations. Rational expectations means that the model that market participants are using is in fact an accurate representation of the true processes that determine long-term equilibrium and the path of adjustment. If expectations are rational and there are no surprises, then going forward the price path expected by market participants should coincide with the true path. I use the term model-based expectations to include the case where individuals are forward-looking (not habit-based or adaptive) but might be using the wrong model.

The local-national distinction and the habit-model distinction can be put into a matrix that yields four combinations, as shown below..

Local Markets National Markets
Habit-based expectations Policy has discretion Bubbles
Model-based expectations Game-theoretic Policy Efficient markets

Inside the matrix, I have put what I see are the most important characteristics of each configuration. For example, when there are local markets with habit-based expectations, policy has discretion. To put it simply, when workers and firms set wages based on local conditions and habits, then policy makers have the discretion to affect real wage rates. In the textbook model, when the money supply expands, prices rise and real wages fall.

When even local markets have model-based expectations, policy has a more difficult time. We are in a game-theoretic environment, in which market agents choose their strategies on the basis of how they think policy makers are going to behave. This means that workers will take steps to ensure that their real wages are insulated from monetary policy changes. That means trying to anticipate such changes and factoring anticipated monetary policy changes into wage bargains. This line of theory takes us down the road of “rational expectations” macroeconomics, about which we will say more in subsequent chapters. As we will see, this path was considered promising to an entire generation or more of economists, and yet I see little or no value in it.

Turning to national markets in which financial assets are traded, if expectations are habit-based then it is easy to see how bubbles could form. People expect prices to go up because they have been going up, without regard to long-term fundamental economic factors that should determine those prices.

On the other hand, suppose that many investors actually do try to determine the fundamental values for asset prices. If their model is objectively correct, then markets will be strongly efficient. That is, any information that affects the long-term value of the asset will be reflected in its current price.

I believe in a weaker form of market efficiency, as reflected in the phrase There Ain’t No Such Thing As A Free Lunch for speculators, meaning that there is no way to easily beat the market using known information. I believe that there are enough investors who are trying to use models to assess fundamental long-term values. However, they do not necessarily know the correct model. If you have a different model, your model may turn out to be correct, in which case you can make a huge profit by betting on your model. But you never know. TANSTAAFL.

Today, we speak of the housing bubble that took place from approximately 2003 through 2006. However, housing falls closer to my definition of local markets than national markets. Because of that, I think it would be more precise to speak of multiple housing bubbles taking place simultaneously.

In general, I think it is most useful to think of expectation formation in local markets as habit-based. I think it is most useful to think of expectation formation in national markets as model-based. This has the following relationship to my views of macroeconomics.

1.I think that the asset markets in which the central bank operates, including the foreign exchange market and the bond market, are model-based. Accordingly, I am skeptical about the ability of central banks to make discretionary changes in these markets. Instead, markets will be measuring central bank targets against feasible long-run equilibrium values. Think of the exchange rate, for example. If the central bank has an exchange rate target that conforms to the feasible value, then speculators will help the central bank hit the target. On the other hand, if the central bank has an exchange rate target that is out of line with the feasible value, then at some point speculators will start betting against the central bank, and if they are correct, then the central bank will lose.
2.I think that habit-based expectations prevail in local markets. However, I do not subscribe to the textbook model of the transmission mechanism for macroeconomic policy, in which policy affects demand, demand affects real wage rates, and real wage rates affect employment and the supply of output. Thus, for me, it is of little or no consequence whether labor market expectations are habit-based or model-based.