The first chapter of Sargent’s book, “Rational Expectations and Inflation,” discusses the reconstruction of macroeconomics in order to incorporate people’s changing expectations into the picture. He starts by illustrating how under the same set of rules, it is relatively simple to extrapolate a past behavior pattern into the future. He shows how the Houston Oilers would punt nearly 100% of the time on fourth down within their own territory during a given season. From this it would be fairly simple to assume that if they were in their own territory on fourth down, they would punt no matter what stadium they were in or what team they were playing. He then assumes that the rules were changed to allow for six downs in the NFL. If this were the case, the Oilers would never punt on fourth down. This explains his idea that people’s expectations and behaviors change when the rules of the game they are playing also change.
He asserts that models should be dynamic with regards to people’s behavior and allow it to change as the rules change. He says that models tend to do a good job of predicting future behavior as long as the rules remain constant. However, once the rules of the game change, models lose their forecasting ability. His first example is the investment decision. It shows how government imposed taxes affect the amount invested on capital. He shows that the demand for capital responds negatively to current and future tax rates. However, how much people will invest depends on their expectations about the future. If they believe it is a short term tax increase, they will stop investing in the short term and wait until the tax has been relaxed to make more investments. If they believe it is the first of a series of tax increases, they might investment more in the short term before the taxes grow even further.
His next point is the inflationary effect of government deficits. He shows that the effects on inflation are due mostly to how the government plans to service the debt that it issues. First he assumes that all deficits will be offset by a future surplus and therefore there would be no inflation. He contrasts this with the more applicable model illustrated by Friedman in which the government funds their deficit by issuing additional base money. This shows that issuing interest-bearing government debt has an inflationary effect if for no other reason that it signals a possible increase in base money.
These examples show how the behavior patterns change when the constraints people face are changed. He says new models and econometric methods are needed in which this principle is adhered to in order to make more accurate predicitions about future actions. Sargent claims that if dynamic econometric models were formulated explicitly in terms of the parameters of preferences, technologies, and constraints, in principle they could be used to predict the effects on observed behavior of changes in policy rules. He talks about the new research efforts taking place to develop theoretical and econometric methods capable of isolating parameters that are invariant under government interventions in the form of changes in the rules of the game. New methods and models such as h=T(f), where h is a collection of decision rules of private agents, f is a collection of elements that form the “environment” facing private agents, and T is a “cross-equation restriction” since each element of h and f is itself a decision rule or eqution determining the choice of some variable under an agent’s control, utilize time series observations on an economy that was operating for some period under the a single set of government rules or strategies. The crux of these new equations is the concept of cross-equation restrictions which allow the dependence of the private agents’ strategies on the government strategies to be viewed. However, these methods and models are still in the developmental stages and need much refining.
Cross-country analysis has also been used in an attempt to see how policies have affected the private agents’ decisions over time. It allows economists to have distinct pairs of obvervations h1, f1: h2,f2:……. and so on however, these data points are often fragmented and therefore incapable of formal time-series econometric analysis that is typically used.
He goes on to discuss some on the implications for policy makers. He discusses how the shift of the policy makers view can go to how they are setting up the rules of the game. They must think about how they are doing such things as setting the tax rate and the different approaches they can take. Sargent also says that the peoples’ views on the law of motion is necessary to make relatively accurate decisions about how they will react to certain changes in the rules. He preaches that the government should attempt to look at the bigger picture and think about how they will continually adjust the tax rate in response to the state of the economy and not isolate on how it will move the tax rate in response to a single recession.
I thought this was a very good read for expectations. The mathematical formulas and notation is fairly difficult however, Sargent does a good job of explaining what is actually meant by the symbols. I tend to agree with the fact that how people react to a certain action has a great deal to do with their thoughts on how that action has affected things in the past and what it will do in the future. I also feel like Sargent was correct in saying that in order to have more accurate and dependable models, there must be some measure of what people feel like will happen in the future. Without some measure of peoples expectations, it is nearly impossible to forecast what they will do in response to a tax increase or interest rate cut.