Question

Discuss how expectations affect the economy at the macro and micro levels. Give examples.

Answer 1

(A) In the micro level, expectations can affect the economy as follows.

(i) When consumers expect an increase (decrease) in income, they increase (decrease) consumption, thus increasing (decreasing) demand for the good in question. Its demand curve shifts right (left), increasing (decreasing) both price and quantity of the good.

(ii) When consumers expect an increase (decrease) in price of the good in future, they increase (decrease) current consumption, thus increasing (decreasing) demand for the good in question. Its demand curve shifts right (left), increasing (decreasing) both price and quantity of the good.

(iii) When producers expect the state of economy to improve (deteriorate) in future, the expect to sell more (less) and increase (decrease) production. Supply of the good rises (falls), shifting its supply curve rightward (leftward), which leads to a decrease (increase) in price and increase (decrease) in quantity.

(iv) When producers expect the price of the good to decrease (increase) in future, the expect to sell more (less) and increase (decrease) production. Supply of the good rises (falls), shifting its supply curve rightward (leftward), which leads to a decrease (increase) in price and increase (decrease) in quantity.

(B) In the macro level, expectations can affect the economy as follows.

(i) When firms expect interest rates to decrease (increase), they increase (decrease) investment. Aggregate demand increases (decreases), shifting AD curve rightward (leftward), which increases (decreases) both price level (inflation) and real GDP.

(ii) When consumers expect the state of economy to improve (deteriorate) in future, consumer confidence rises (falls), so consumption demand increases (decreases). When firms expect the state of economy to improve (deteriorate) in future, investor confidence rises (falls), so investment demand increases (decreases). Aggregate demand increases (decreases), shifting AD curve rightward (leftward), which increases (decreases) both price level (inflation) and real GDP.

(iii) When consumers expect inflation rate to increase (decrease) in future, current consumption demand increases (decreases). Aggregate demand increases (decreases), shifting AD curve rightward (leftward), which increases (decreases) both price level (inflation) and real GDP.

(iv) When producers expect inflation rate to decrease (increase) in future, current production increases (decreases). Aggregate supply increases (decreases), shifting AS curve rightward (leftward), which decreases (increases) price level (inflation) and increases (decreases) real GDP.