5: Expectation as Determining Output and Employment

This chapter is about not just expectations, but the nature of time: in particular that it’s irreversible, that we don’t know exactly what’s going to happen but have to predict it nonetheless, and we can’t go back and change earlier decisions. These points are obvious but (neo)classical economics has always had trouble dealing with them. I’m interested to hear from anyone who knows, to what extent was this really news to economics in the 1930s?

The difficulty economics has had in dealing with it is still apparent and always good for a laugh: ‘rational expectations’ was a key player in the 1970s neoclassical counter-revolution,  holding (as Wikipedia puts it) that “people do not make systematic errors when predicting the future, and deviations from perfect foresight are only random” and modelling this “by assuming that the expected value of a variable is equal to the value predicted by the model, plus a random error term representing the role of ignorance and mistakes”.

Keynes distinguishes between short-term expectation – determining current output/employment – and long-term expectation – determining investment. At a macro-level these are inter-related, since investment decisions involve buying the short-term output of some entrepreneurs.

Thus the behaviour of each individual firm in deciding its [short-term] output will be determined by its short-term expectations – expectations as to the cost of output on various possible scales and expectations as to the sale-proceeds of this output; though, in the case of additions to capital equipment and even of sales to distributors, these short-term expectations will largely depend on the long-term (or medium-term) expectations of other parties. [p. 47]

So this chapter has implications not just about time and expectations in the abstract, but about the interrelation of different sectors of the economy – Marx’s Department I and Department II. This is interesting in light of Keynes’ discussion of the transition from one set of expectations to another anticipating higher employment.

For the process of building up capital to satisfy the new state of expectation may lead to more employment and also to more current consumption than will occur when the long-period position has been reached. Thus the change in expectation may lead to a gradual crescendo in the level of employment, rising to a peak and then declining to the new long-period level. [p. 49]

A dynamic conception of the economy seems to be at war with a conception of transition between two equilibria (comparative statics). Keynes recognises that movement to a new set of expectations might not be stable: “Thus a mere change in expectation is capable of producing an oscillation of the same kind of shape as a cyclical movement, in the course of working itself out.” [p. 49] But this is not merely to do with expectations, it also involves the balance between the sector producing consumer goods and the sector producing investment goods, right? In a footnote [p. 48] Keynes suggests that the analysis could be adapted to a more realistic situation where entrepreneurs anticipate the rate of economic growth, rather than a stationary state. This would make things even more complicated, as Marx knew.

This is a side-issue, though. Here Keynes is trying to give a sense of the additional destabilisation that comes from continual changes in expectations, rather than dwelling on the conditions of balanced growth. We should recognise this but not exaggerate it. Keynes establishes expectations as a relatively independent variable, not entirely independent. Expectations and unfolding reality are mutually determining; for example: “… it is sensible for producers to base their expectations on the assumption that the most recently realised results will continue, except in so far as there are definite reasons for expecting a change.” [p. 51]

While rational expectations is absurd as a hypothesis, expectations in reality are not a wild stab in the dark. In normal times economic expectations are not too far off – it’s pesky turning points that are hard to predict. A turn in expectations may develop into a self-fulfilling prophecy, but it is also possible for a turn to come unexpectedly; expectations are not the only destabiliser.

The last section stresses the irreversibility of time – that the present economy is stuck with capital equipment it produced in previous periods due to expectations about the future prevailing at that time. So the activity of the present depends both on the legacy of history and prophecy about the future.

Published in: on 10 October, 2007 at 9:25 am  Comments (1)  

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  1. […] [pp. 143-44] But let’s not forget that when Keynes discussed expectations in Chapter 5, it was tied up with the intersectoral relationship between producers of consumer goods and producers…, i.e., dynamic problems of balanced growth. Come to think of it, this was also at stake in Chapter […]

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