Subject Business Economics Paper No and Title 5

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BUSINESS ECONOMICS

PAPER NO. : 5, MACROECONOMICS ANALYSIS AND POLICY

MODULE NO. : 29, EXPECTATIONS THEORY AND FINANCIAL MARKETS

Subject Business Economics

Paper No and Title 5, Macroeconomics Analysis and Policy

Module No and Title 29, Expectations Theory and Financial Markets

Module Tag BSE_P5_M29

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TABLE OF CONTENTS

1. Learning Outcomes

2. Introduction

3. Theories of Expectations Formation

3.1 Markov Expectations

3.2 Adaptive Expectations

3.3 Rational Expectations

4. Movements in Stock Prices

4.1 Stock Prices

4.2 Monetary Policy and Stock Market

4.3 Consumer Spending and Stock Market

5. Efficient Market Hypothesis

5.1 Versions of the Efficient Market Hypothesis

6. Bubbles in Stock Market

7. Summary

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1. Learning Outcomes

After studying this module, you shall be able to

Learn how participants in financial markets form expectations.

Analyze the reasons that might cause expectations in financial markets to change over

time.

Identify the reasons behind movements in stock prices.

Evaluate the impact of unexpected expansion in consumption on stock prices.

Analyze the impact of monetary and fiscal policies on stock prices.

Identify the bubbles in stock market.

Understand efficient market hypothesis.

2.Introduction

Expectations play a central role in money, banking and financial markets. Hence, in this module

we look at methods people use to form expectations. We look at three ways to form expectations:

the Markov expectations, adaptive expectations and rational expectations hypotheses, we focus

on the formation of inflationary expectations to compare and contrast expectation formation

under each theory. However, similar methods may be used to form expectations about the

variables as well.

Firms raise funds in two ways; either by issuing debt instrument like bonds or by issuing equity

instrument like stocks. Bond holder gets a fixed payment independent of the firm’s performance

while shareholders receive dividends that are dependent on firm’s performance. As a result,

firm’s performance plays a crucial role in determining the stock price of that firm. In this

module, we will also look at the role of expectations in stock market and how stock prices

respond to changes in economic environment and macroeconomic policy.

3.Theories of Expectations Formation:-

3.1 Markov Expectation

The Markov expectations hypothesis asserts that economic agents expect the future to be like the

most recent past. Hence, individuals expect tomorrow to be exactly like today. Hence, under

Markov expectations, the expected value of y, based on information available at time t, is simply

yt.

𝑬𝒕 (𝒚𝒕+𝟏

) = 𝒚𝒕

Thus, investor simply uses the most recent known value of y to forecast future values of y.

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A shortcoming of Markov expectations is that they do not take into account available information

that might change the future environment. For example, if the inflation rate is rising, according to

Markov expectation, investors will expect the inflation rate to remain at its previous level, but

each year they will under estimate the inflation rate. Thus, investor simply uses the most recent

known value of y to forecast future values of y.

3.2 Adaptive Expectations

Adaptive expectations allow previous forecast errors to affect future expectations as individuals

slowly learn from past mistakes. Hence, expectations evolve overtime in light of past experience.

Like Markov expectations, adaptive expectations are based on past experience, however, adaptive

expectations adjust current expectations based on information about error in previous forecasts.

Symbolically, the current adaptive expectation about y in period t (𝒚𝒕𝒆) given what is known in

period t-1 is given by

𝑬𝒕(𝒚𝒕+𝟏) = 𝑬𝒕−𝟏(𝒚𝒕) + 𝜽[𝒚𝒕 − 𝑬𝒕−𝟏(𝒚𝒕)], 0≤ θ ≤ 1

This formula states that the current expectation of y, 𝑬𝒕(𝒚𝒕+𝟏), equals last periods expectation,

𝑬𝒕−𝟏(𝒚𝒕), plus an adjustment term that adjust this period’s expectation in light of past

error 𝜽[𝒚𝒕 − 𝑬𝒕−𝟏(𝒚𝒕)], where the expression in parentheses is last period’s expectation error and

θ (taking value between 0 and 1) is called the coefficient of expectation.

Hence, in each period economic agents adjust their expectation by some fraction of the error in

expectations of the previous period. The error that is realized in period t is given by

𝜺𝒕 = 𝒚𝒕 − 𝑬𝒕−𝟏(𝒚𝒕)

Thus, agents revise their previous expectations in each period in proportion to the difference

between actual observation and what was previously expected. The error adjustment mechanism

can be applied to all previous periods so that current expectations equal1:

𝐸𝑡(𝑦𝑡+1) = 𝜃 ∑(1 − 𝜃)𝑘𝑦𝑡−𝑘

𝑡

𝑘=0

]

Thus, adaptive expectations make current period’s forecasts a weighted average of past

observations. The coefficient of expectations θ, determines the responsiveness to past errors. If θ

is 1, 𝑬𝒕(𝒚𝒕+𝟏) = 𝒚𝒕. Hence, Markov expectations is a special case of adaptive expectations when

θ= 1.

1𝑬𝒕(𝒚𝒕+𝟏) = 𝜽𝒚𝒕 + (𝟏 − 𝜽)𝑬𝒕−𝟏(𝒚𝒕) Substituting𝑬𝒕−𝟏(𝒚𝒕) = 𝜽𝒚𝒕−𝟏 + (𝟏 − 𝜽)𝑬𝒕−𝟐(𝒚𝒕−𝟏) And repeating the process𝑬𝒕(𝒚𝒕+𝟏) = 𝜽𝒚𝒕 + 𝜽(𝟏 − 𝜽)𝒚𝒕−𝟏 + 𝜽(𝟏 − 𝜽)𝟐𝒚𝒕−𝟐 + ⋯

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A serious problem with adaptive expectations is that the expected future value depends on past

values and nothing else. But rational economic agents typically use all available information, and

not past values only in making forecasts. This has led to the idea of rational expectations, which

is the most sophisticated of the three methods of forming expectations.

3.3 Rational Expectations

According to rational expectations hypothesis, people use all knowable information, including

variables that economic theory suggests are relevant for making predictions. Rational

expectations do not imply that forecasts are always right; it only implies that there is no

systematic error in forecasts. Any deviation from what is forecasted is purely random and is just

as likely to be positive as negative. For example, informing a rational expectation about bond

prices, an investor would list all the determinants of demand and supply of bonds. In order to

form an expectation of the equilibrium bond price all available information about the

determinants of demand and supply would be used.

Sometimes, rational expectations is criticized based on the argument that economists themselves

do not always agree on the relevant economic theory, so how can non economists be expected to

both know the relevant economic theory and gather and process the needed information.

4. Movements in Stock Prices

4.1 Stock Prices

Stock promises a sequence of dividends in future. Hence, stock price must equal the present

value of future expected dividends. Let Pt be the price of the stock. Let 𝒅𝒕denote the dividend

this year, 𝒅𝒕+𝟏𝒆 the expected dividend next year, 𝒅𝒕+𝟐

𝒆 the expected dividend two years from now,

and so on. The price of the stock in the current period is then given by:-

𝑷𝒕 = 𝒅𝒕 +𝒅𝒕+𝟏

𝒆

𝟏+𝒊𝟏𝒕+

𝒅𝒕+𝟐𝒆

(𝟏+𝒊𝟐𝒕)(𝟏+𝒊𝟐𝒕𝒆 )

… … … … … (1)

where𝒊𝟏𝒕 is current 1-year interest rate and 𝒊𝟐𝒕𝒆 is next year’s expected 1-year interest rate.

Equation (1) gives the stock price as the present value of expected dividends. This is defined as

‘the fundamental value’ of the stock.

Equation 1 has two important implications:-

Higher expected future dividends lead to a higher stock price.

Higher current and expected future 1-year interest rates lead to a lower stock price.

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Stock prices are very volatile and often said to be unpredictable. It is also recognized that

expectation of a high stock price next year leads to a high stock price today as people start

demanding more of stocks in comparison to other assets in expectation of high future stock price.

4.2 Monetary Policy and Stock market

Suppose the economy is in a recession and the central bank adopts on expansionary monetary

policy. This leads to shift of LM curve downwards. New equilibrium output moves from E to E.

How will the stock market react? The answer depends on what participants in the stock market

had expected about the stance of monetary policy.

Figure 1: Expansionary Monetary Policy

If stock market participants had fully anticipated the expansionary monetary policy, then the

stock market will not react. Neither its expectations of future interest rates nor its expectations of

future dividends are affected by a move it had already expected. Thus nothing in equation (1)

changes and stock prices remain the same.

Suppose instead that the central bank’s move is partly unexpected. In that case, stock price will

increase. Due to expansionary monetary policy interest rates fall and output rises leading to

higher dividends (Figure 1). Both lower interest rates and higher dividends – current and

expected – leads to an increase in stock prices, as equation (1) tells us.

4.3 Consumer Spending and Stock Market

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Due to autonomous increase in consumption spending (caused possibly by a cut in personal

income tax or a boost in consumer confidence about the economy's future) shifting the IS Curve

to the right, output increases from E to E in figure 2. Hence, we might be tempted to conclude

that stock prices will go up as higher output means higher profits and higher dividends. But this

answer is incomplete. What happens to the stock market depends on the slope of the LM curve

and central bank’s behavior. The movement along the LM curve also implies an increase in

interest rates. Higher interest rates lead to lower stock prices. The final impact on stock prices

depends on which of the two effects, higher profits/output or higher interest rates, dominate.

Figure 2: Increase in Consumer Spending

Hence, the final impact depends on the slope of the LM curve. In case of flat LM curve, as

shown in figure 3, rise in interest rate is low and rise in output is high leading to rise in stock

prices, whereas, in case of steep LM curve, rise in interest rate is high and that in output is low

and therefore a decrease in stock prices is likely to result.

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Figure 3: Steep and Flat LM Curve

4.3.1 Monetary Policy Response

The above discussion ignores the effect of increase in consumer spending on central authority’s

behavior. This effect is something that most financial investors care about – after an unexpected

surge in economic activity, what would be the response of central authority. Central bank may

respond in three ways:

1. Accommodative monetary policy: If central bank increase the money supply to meet

the higher money demand due to upsurge in economic activity, shifting the LM curve

downwards from LM to LM’ in figure 4,stock prices will increase as output is expected

to be higher and interest rates are not expected to rise.

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Figure 4: Accommodative Monetary Policy

2. Unchanged monetary policy: In this situation LM curve will remain unchanged and

impact on stock prices is ambiguous as discussed above. Profits will be higher, but so

will interest rates.

3. Contractionary Monetary Policy: Central authority may follow a contractionary

monetary policy if the economy is already close to the natural level of output. In this

case, a further increase in output will lead to increase in inflation. Due to contractionary

monetary policy, LM Curve shifts backwards and output does not change (figure5). As a

result, interest rate is expected to go up with no change in expected output and profits.

Hence, stock prices will go down.

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Figure 5: Contractionary Monetary Policy

5. Efficient Markets Hypothesis

The efficient markets hypothesis states that the current price of an asset, such as a share of stock,

reflects all available information about the value of the asset. More generally, according to the

efficient markets hypothesis, the risk-adjusted expected return on all investments will be equal;

that is, the return one expects to earn on a stock exactly equals to return that could be earned on

any other asset with similar risk characteristics. This is because, if one asset earns a higher risk-

adjusted expected rate of return than another asset, investors will quickly attempt to purchase that

asset, driving up its price and thus lowering its expected return. Hence, all information that is

relevant for forecasting the future returns on the stock are already reflected in its price.

5.1 Versions of the Efficient Markets Hypothesis

The idea of efficient markets is that asset prices tend to change very quickly in response to new

information. There are three versions of the efficient markets hypothesis: the weak form, the

semi-strong form and the strong form. As their names imply, these three statements of market

efficiency make increasingly strong assumptions about asset market pricing.

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5.1.1 Weak-form Market Efficiency: According to weak-form market efficiency, the best

predictor of next period’s asset price is this period’s price. Hence, historical data on asset price

cannot improve on this prediction. However, there exists evidence of minor departures from weak

form market efficiency in stock market. For example, there may exist ‘day of the week’ effects if

stock prices tend to rise on some day of the week (say Monday) or fall on some day of the week

(say Friday).

5.1.2 Semi-strong form Market Efficiency: asserts that no publicly available information

will help predict future asset prices better than the current value of the asset. This includes not

only historical data of the asset in question but also publicly available information on interest

rates, tax rates, profits, business opportunities, other asset prices etc. Thus, any useful publicly

available information will be quickly reflected in the market price. Thus, the current price is the

best predictor of future prices.

5.1.3 Strong-form Market Efficiency: makes a very strong statement, that no current

information, either publicly available or not (inside information), can better predict the asset price

than using the most recently known value of an asset price.

Although, there is evidence that the stock market may not meet the strict conditions of strong-

form market efficiency. The weak and semi strong forms of market efficiency, in contrast, are

largely consistent with the observations in financial markets.

6. Bubbles in Stock Market

Sometimes stock price changes are so enormous that these movements do not seem to be

explained by any news about future dividends and interest rates. Hence, many economists argue

that stock prices are not always equal to their fundamental value defined in equation (1).

Sometimes stocks are underpriced and sometimes overpriced eventually ending with a crash.

Such mispricing can occur even when investors are rational. For example, investors may expect

that they will be able to sell the stock, that has zero fundamental value, at a higher price in future

and stock price may increase just because investors expect them to.

Often financial investors become excessively optimistic by the performance of past short span of

time. Hence, they may not behave in a rational way and extrapolate from past returns to predict

future returns and due to which there is increase in demand for stock and stock becomes high

priced for no reason other than its price had increased in the past and so is expected to rise in the

near future. Hence, price of stock keeps on rising fueled by expectations of further rise and

deviating more and more from its fundamental value.

The two most famous bubbles of the twentieth century, the bubble in American stocks in the

1920s just before the Great Depression and the Dot-com bubble of the late 1990s were based on

speculative activity surrounding the development of new technologies. The 1920s saw the

http://en.wikipedia.org/wiki/Great_Depression

http://en.wikipedia.org/wiki/Dot-com_bubble

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widespread introduction of an amazing range of technological innovations

including radio, automobiles, aviation and the deployment of electrical power grids. The 1990s

was the decade when Internet and e-commerce technologies emerged.

Stock market bubbles frequently produce hot markets in initial public offerings, since investment

bankers and their clients see opportunities to float new stock issues at inflated prices. These hot

IPO markets misallocate investment funds to areas dictated by speculative trends, rather than to

enterprises generating longstanding economic value. Typically when there is an overabundance of

IPOs in a bubble market, a large portion of the IPO companies fails completely, never achieve

what is promised to the investors, or can even be vehicles for fraud.

7. Summary

1. We looked at Markov expectations, adaptive expectations and rational expectations

approach of forming expectations and noted the pros and cons of each.

2. Properly formed rational expectations contain no systematic errors but they usually

require more information than Markov or adaptive expectations do.

3. The fundamental value of a stock is the present value of expected future real dividends,

discounted using current and future expected 1-year interest rates.

4. An increase in current and expected 1 year interest rates (and a decrease in expected

dividends) leads to a decrease in their fundamental value.

5. Output and stock prices may change in same direction or different direction depending on

what the market had expected, what is the source of the stock and what the market

expects the central bank to react to output change.

6. The efficient markets hypothesis states that the current price of an asset, such as a share

of stock, reflects all available information about the value of the asset.

7. Stocks prices are subject to bubbles causing a stock price differ from its fundamental

value. Blanchard (2010) describes bubbles as episodes where financial investors buy a

stock for a price higher than its fundamental value, anticipating reselling it at an even

higher price.

http://en.wikipedia.org/wiki/Radio

http://en.wikipedia.org/wiki/Automobiles

http://en.wikipedia.org/wiki/Aviation

http://en.wikipedia.org/wiki/Electrical_power_grid

http://en.wikipedia.org/wiki/Initial_public_offering

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Subject Business Economics Paper No and Title 5