Irrational Expectations

by Elaine Schwartz    •    Jun 13, 2011    •    790 Views

Let’s say that you purchased the house in which you now live during 1997 for the average national price, $171,900. With housing prices steadily rising, by 2006, a neighbor’s house would have sold for as much as $317,000.

In the NY Times, Nobel laureate Robert Schiller, explains the impact of rising home prices. Calling it a “contagion of optimism,” he says skyrocketing home prices fueled the stock market, the housing market, consumer spending and consumer expectations. Expecting our wealth to increase, we spent more.

But, trees do not grow to the sky.

After housing prices hit their high during the beginning of 2008, they plunged. The house that was worth $317,000 now would get $268,000 if it could be sold at all. This reversal of prices meant a reversal of expectations.

Dr. Schiller believes that economists were unable to understand the housing bubble because prevailing economic theory inadequately explained the impact of our expectations.

The Economic Lesson

Economists study our expectations because they relate to current decisions, future outcomes and government policy.

University of Chicago economist, Robert Lucas (1937- ) won the 1995 Nobel Prize in economics for his theory of rational expectations. Rational expectations theorists tell us that:

For example, if people think housing prices will rise by 10%, those selling a house will price it 10% higher. The result? Prices are up by 10%. How should government respond? You can look here.

An Economic Question: Thinking about wages, how might expectations about inflation create inflation?


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