Great Expectations: The Role of Beliefs in Economics and Monetary Policy: Based on a Speech Given by President Santomero at the Penn Humanities Forum, University of Pennsylvania, Philadelphia, PA, November 5, 2003
Santomero, Anthony M., Business Review (Federal Reserve Bank of Philadelphia)
Whether one looks at consumers or businesses, expectations--people's beliefs--are driving forces of every economy. The economic outcomes one can expect from public policy are affected by the way beliefs are formed and how they vary over time. In this message, President Santomero gives his perspective on the important role beliefs play in economic decisions and policymaking. He also offers some observations on the important role the policymaker's credibility plays in determining the outcome of any monetary policy action.
Beliefs play an important role in economic decisions and economic policymaking. The beliefs held by both consumers and businesses lead to physical results in terms of the amount a nation produces, the opportunity for employment, and the formation of both personal and national wealth. The connection is the effect that beliefs have on people's demand for goods and services and on businesses' willingness to invest in new equipment and the construction of new facilities.
Beliefs are important to the decisions people make. Whether one looks at consumers or businesses, expectations--people's beliefs--are driving forces of every economy. The economic outcomes one can expect from public policy are affected by the way beliefs are formed and how they vary over time. It matters whether people form their beliefs by looking at the past or by looking forward, by either trusting economic policymakers' promises or forecasting economic conditions.
Beliefs also play a central role in one current debate within monetary policy circles: the importance of the credibility of the policymaker in determining the outcome of any monetary policy action.
BELIEFS IN AN ECONOMIC CONTEXT--ECONOMIC EXPECTATIONS
You will not see the word "beliefs" very much in the field of economics. Rather, you will find the phrase "economic expectations." This is because economists generally talk about people's "beliefs" in the context of their expectations about the future. Yet, these expectations are at the heart of virtually every economic decision people make today.
For example, when consumers make decisions to spend or save, expectations play an important role. When making these decisions, people base their actions on both their current income and future prospects. This implies that actions today are predicated upon people's belief in the future and their future expected earnings. This plays out on college campuses every day. Even during their graduate school days, MBA, law, and medical school students generally spend more than doctoral students. Unfortunately, the life of a scholar tends to be less remunerative than a career in business, law, or medicine. Since students know this, their spending habits begin to emerge early, and these patterns develop not because of current stipends but because of earnings expected well into the future. Likewise, as each of us saves for retirement, we base our decisions on how long we expect to be employed, our expected future annual income, and what we expect to obtain from our accumulated wealth over the intervening years until retirement. Again, expectations about the future matter in an important way, as our beliefs dictate the steps we take today and the plans we make for tomorrow, aimed at achieving our economic and personal goals.
Business decisions are similarly affected by managers' view of the future. In fact, their behavior is perhaps even more dependent on an assessment of the years ahead. Businesses routinely try to project future gains that can be derived from current investments. When making a decision to invest in a specific project today, businesses compare the project's expected future flow of revenues to its current cost. This is fundamental to capital budgeting. These cash flows are only expectations because they are not contracted, nor are they guaranteed. They are derived from management's belief in the firm's value proposition, the marketing studies that support the project, and the firm's assessment of its own capability. …