Expectations-Driven Non-Linear Business Cycles

doi:10.1093/oso/9780198288596.003.0019

Chapter

18 Expectations-Driven Non-Linear Business Cycles

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https://doi.org/10.1093/oso/9780198288596.003.0019

Pages

227–255

Published:

December 1994

Abstract

There are two traditional, conflicting views about the workings of a market economy. The so-called classical school stresses the virtues of free markets and their intrinsic internal stability. According to that school, persistent, non-explosive fluctuations should essentially be due to repeated external macroeconomic shocks to the ‘fundamental ‘ characteristics of the system (technology, tastes, resources). Productivity of capital equipment is assumed to vary randomly across the economy by following an exogenously given stationary stochastic process. Demand for goods and services, and supply of labour are, by assumption, subject to exogenous aggregate random shocks. Government agencies and monetary authorities regularly throw dice when tuning up their policy instruments. Models of the ‘classical ‘ vintage typically assume that expectations are self-fulfilling, i.e. every individual ‘s assessment of the future (a probability distribution) is correct at any moment, given his information. According to that view, expectations cannot be an independent source of economic fluctuations. Business cycles are created by aggregate random exogenous shocks to the fundamentals and without them, no persistent economic fluctuations would be observed. There are, from time to time, aggregate macroeconomic shocks to fundamentals that are large enough to generate significant business fluctuations, e.g. the oil shocks of 1973 and 1978, or the 1990-1 Gulf crisis. Policy may be wrongly conceived and ill-timed, and thus may indeed, at times, generate macroeconomic fluctuations rather than dampening them.

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Contents

18 Expectations-Driven Non-Linear Business Cycles

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Abstract

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