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The Role of Expectations in a Macroeconomic Model with Inventories

  • Luca Colombo

    (Catholic University of Milan)

  • Gerd Weinrich

    ()

    (Catholic University of Milan)

In this paper we use a non-tâtonnement dynamic macroeconomic model with overlapping generations of consumers to study the role of expectations and inventories in the business cycle. Prices are fixed at the beginning of each period but adjusted between periods, taking into account possible market imbalances that have occurred within the period in an equilibrium with stochastic rationing. Producers hold inventories if they do not succeed to sell all their supply in the current period. Consumers too may store the consumption good so as to transfer it to the second period of their life. Whether they do this depends on their price expectations: only if they expect the price to rise will they desire to buy the planned consumption for both periods in the first period. Therefore price expectations are decisive for the type of dynamics that comes forth. In particular there are multiple equilibria in the sense that, for otherwise the same parameters but with different types of expectations, there are sequences of inflationary as well as deflationary equilibria with self-confirming expectations. In addition, and consistent with expectations, there may be endogenous expectations-switching along a trajectory. The above framework is applied to policy evaluations regarding the effectiveness of measures to overcome a quasi-stationary state of deflationary recession with underemployment, as is currently occurring in Japan. Such a state may have been provoked by a restrictive monetary shock and exasperated by over-investment and inventory holding, the latter by amplifying the spill-over effect from the goods to the labour market. If the recession is not to deep, creating inflationary expectations succeeds in exiting from the recession. Otherwise there may be a temporary effect of reducing unemployment but then the economy falls back into recession. Thus in that case other policy measures have to be taken, too. Among these, and contrary to conventional wisdom, balanced-budget cuts in taxes and government spending combined with downward rigidity of nominal wages seem to be the most effective ones.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2006 with number 65.

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Date of creation: 04 Jul 2006
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Handle: RePEc:sce:scecfa:65
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