Tourists crowd the scenic banks of Venice Water City in Dalian, Liaoning Province, on Aug. 18th. Photo: Fang Ke/CSST

China’s economy has recently shown a positive trend of recovery and development. However, there is a long road ahead and advancing China’s high-quality development requires sustained and persistent efforts. Sound macroeconomic policies that are conducive to keeping expectations, economic growth, and employment stable should be adopted. Stability is of overall importance, as it is the basis for everything we do. The upcoming economic developments should pursue progress while ensuring stability, promoting stability through progress, and establishing the new before abolishing the old. Policies that contribute to stabilizing expectations, growth, and employment are much needed. Among these, policies that stabilize expectations at the micro level in the market are key to achieving macro-level goals such as expanding effective demand and stabilizing growth.

Role of market expectations in macroeconomics

In the framework of modern macroeconomics, discussions about the expectation formation mechanism are generally abstracted as the Rational Expectations Hypothesis (REH). Its core argument is that decision-makers in the market can use all available historical information to form unbiased predictions about future market variables, without any systematic forecasting errors. This implies that all individuals can comprehend the world’s complex structure, meaning that for everyone, there is only one understanding of the objective world, and all people understand this reality. Consequently, in this theoretical model, everyone has the same expectations. When all participants in economic activities hold such rational expectations, a competitive market will automatically converge to an efficient equilibrium. This means that when a competitive market faces exogenous shocks, the decision-makers involved in transactions can quickly make optimal adjustments to their expectations, thereby enabling the market to correct its own errors. Therefore, if the market deviates from an efficient equilibrium, it can only be due to issues like imperfect competition, distorted incentive mechanisms, or information asymmetry.

However, in reality, decision-makers do not form the expectations which REH suggests. They do not possess a complete knowledge of economic laws nor do they have advanced computing abilities, thus people are unable to fully understand the complexity of their economic reality. This means that the real world is an uncertain environment, where the probabilities are difficult to calculate, rather than a risk environment with known probabilities. As a result, decision-makers do not have a reliable ability to make unbiased predictions about the future, which makes the assumptions required for REH too fragile. Therefore, a key research focus for expectation theory is how to expand beyond REH to explore participants’ actual expectation patterns in real trading scenarios.

Once the assumption of rational expectations is abandoned, researchers immediately face a reality where different decision-makers hold different expectation patterns. This is because decision-makers in the real world have varying cognitive abilities, and even if they face the same scenario their perspectives and rules for interpretation will differ. This leads to the question of whether we can observe, classify, and summarize expectation patterns in the real world.

British economist John Maynard Keynes’ theory of three modes of expectation formation posits that heterogeneous expectation patterns are common, and individuals adjust or change their expectation patterns based on market feedback, thereby improving the accuracy of their expectations.

However, improved accuracy of decision-maker’s expectations might not lead the market to an efficient equilibrium. If the expectations held by each decision-maker aligns, on average, with the direction of rational expectations, then the market may converge upon an efficient outcome. Numerous experimental studies have shown that when decision-makers trade in experimental markets, various levels of interaction occur between them, easily leading to mutual imitation, learning, and coordination, which in turn causes their expectation patterns to converge.

The direction of expectation convergence may not necessarily align with rational expectations, meaning that the resulting market outcomes could systematically deviate from an efficient equilibrium. This suggests that in real economic activities, when markets encounter exogenous shocks, it is difficult to perfectly “filter” or “digest” these shocks. In fact, these “shocks” can be intensified and amplified in a particular direction, causing the market to persistently deviate from equilibrium, leading to economic overheating or a prolonged recession.

Expectation feedback mechanisms and insufficient effective demand

The above analysis indicates that market expectations and their formation mechanisms are crucial to the stable operation of the macroeconomy. Further research reveals that this is also related to how the market responds to people’s expectations. As mentioned earlier, the macroeconomy can be seen as a “self-regenerating” expectation feedback system, where people make choices based on their formed expectations, and the market outcomes which result from these choices serve as the basis for forming a new round of expectations.

In this process, if individuals find that the market results confirm the choices they made based on their expectations, meaning that their expectations are self-fulfilling, they will become more confident in their expectation patterns. This, in turn, will attract more people to imitate and learn from them, quickly leading to a coordination of similar expectations among people. If the newly formed market expectations are again confirmed by new market outcomes, this process will repeat itself, ultimately causing market expectations to converge and mutually reinforce the actual market outcomes. This can be viewed as a positive feedback mechanism for expectations.

In contrast, if the market outcomes resulting from people’s choices contradict their expectations, it amplifies divergence. People will reflect on and adjust their expectation patterns, but this leads to greater differentiation in their expectations. If decision-makers find that the new expectations again conflict with new market outcomes, the adjustment process will continue. This process is understood to be a negative feedback mechanism for expectations.

Positive feedback mechanisms for expectations encourage people to strengthen mutual imitation, learning, and coordination, thereby accelerating the convergence of expectations and making it easier to produce market outcomes that systematically deviate from rational expectations. On the other hand, the negative feedback mechanism for expectations prompts people to initiate self-reflection, which weakens the convergence of expectations, leading to greater differentiation. This differentiation is more likely to align with rational expectations on average, thus promoting the market’s convergence toward an efficient equilibrium.

China’s economy currently faces the challenge of insufficient effective demand. We can deepen our understanding of this issue from the perspective of expectation feedback mechanisms. For investment activities, profit expectations are an important determinant of their investment decisions; for consumption activities, consumers’ income expectations are a crucial factor influencing their consumption behavior. Due to the inherent connection between investment and consumption, profit expectations and income expectations are causally related.

If profit expectations strengthen, investment activities will become more active, leading to more employment and income, thereby enhancing residents’ income expectations and increasing their willingness to spend. Furthermore, once the willingness to consume increases, expanded consumption will allow enterprises to gain more profits, further strengthening their profit expectations and willingness to invest. In this upward spiral, investors’ and consumers’ expectations influence and reinforce each other, leading to expanded investment and consumption and increased effective demand. However, when this increase surpasses the capacity of effective supply, the economy may overheat. Conversely, if either investment or consumption expectations weaken, the entire process will spiral downward, leading to a decline in effective demand. If this downward trend results in excess capacity and idleness, it indicates insufficient effective demand.

The circular relationship between investors’ and consumers’ expectations discussed here is similar to the positive feedback mechanism for expectations described earlier, which can easily lead to the market persistently deviating from the equilibrium of rational expectations, making it difficult to achieve optimal resource allocation. When this positive feedback mechanism causes a simultaneous weakening of investors’ and consumers’ expectations, the resulting inefficient market outcomes will impede the virtuous cycle of mutual reinforcement between consumption and investment, leading to insufficient effective demand. Therefore, to expand insufficient effective demand, we must first stabilize both profit expectations and income expectations.

Optimizing expectation feedback mechanisms

In summary, market expectations, as an important psychological characteristic of microeconomics, influence market performance and even the operation of the macroeconomy. The formation process for these expectations depends on feedback from the market. Therefore, stabilizing market expectations can start with improving and optimizing feedback mechanisms. Accordingly, we can consider optimizing market feedback mechanisms in two key areas, to stabilize expectations and boost effective demand.

First, on the investment side, improving firms’ profit expectations can enhance their willingness to invest. Profits generally depend on a firm’s production costs and the revenue from product sales. Comparatively, the risks associated with product sales are difficult to estimate accurately, making them more likely to affect profit expectations. Therefore, improving market feedback on firms’ profit expectations can start with actively expanding consumption, thereby enlarging profit margins and countering the current weak trend in profit expectations.

It is essential to “seek progress while maintaining stability” by stabilizing and expanding traditional consumption. This can be accomplished by cultivating and expanding new types of consumption such as digital, green, and health-related consumption. Such an expansion would enhance profit expectations in related industries, thereby driving investment in these consumption scenarios. On the other hand, it is also important to “promote stability through progress” by enhancing standards in technology, environmental protection, and other key areas to drive the upgrade and renewal of traditional consumer goods, thereby stabilizing profit expectations in traditional industries and spurring fixed-asset investment in related sectors.

Second, on the consumption side, improving consumers’ income expectations can enhance their willingness to spend. This relies on improving residents’ assessments of income risks and employment prospects, which are closely related to companies’ investment activities and business operations. Therefore, improving market feedback on consumers’ income expectations, and reversing weak trends in these expectations, can also be achieved by actively expanding corporate investment. In this way, government investment plays a leading and amplifying role in driving private investment. Key areas to support include breakthroughs in critical core technologies, the development of new infrastructure, the advancement of energy-saving and carbon-reduction technologies, and the cultivation of new growth drivers.

On this basis, it is also necessary to clear out industries that have redundant layouts and are excessively competitive to address overcapacity. By doing so, the positive impact of investment will expand and optimize employment. This will effectively increase the incomes of urban and rural residents, enhance consumers’ income expectations, and boost their willingness to consume.

Na Yi is an associate professor from the School of Economics at Nankai University.