Uncertainty, Expectations, and Shocks

The fact that the future is uncertain makes investment projects sometimes produce disappointing results or even fail totally. As a result, firms spend considerable time trying to predict future trends so that they can, hopefully, invest only in projects that are likely to succeed. This implies that macroeconomics has to take into account expectations about the future.
Expectations are hugely important for two reasons.
The more obvious reason involves the effect that changing expectations have on current behavior. If firms grow more pessimistic about the future returns that are likely to come from current investments, they are going to invest less today than they would if they were more optimistic. Expectations therefore have a large effect on economic growth since increased pessimism will lead to less current investment and, subsequently, less future consumption. The less-obvious reason that expectations are so important has to do with what happens when expectations are unmet. Firms are often forced to cope with s hocks — situations in which they were expecting one thing to happen but then something else happened. For instance, consider a situation in which a firm decides to build a highspeed railroad that will shuttle passengers between Washington, D.C., and New York. They do so expecting it to be very popular and make a handsome profit. But if it unexpectedly turns out to be unpopular and loses money, the railroad must figure out how to respond. Should the railroad go out of business completely? Should it attempt to see if it can turn a profit by hauling cargo instead of passengers? Is there a possibility that the venture might succeed if the firm borrows $30 million from a bank to pay for a massive advertising campaign? These sorts of decisions are necessitated by the shock and surprise of having to deal with an unexpected situation.
Economies are exposed to both demand shocks and supply shocks. Demand shocks are unexpected changes in the demand for goods and services. Supply shocks are unexpected changes in the supply of goods and services.
Please note that the word shock only tells us that something unexpected has happened. It does not tell us whether what has happened is unexpectedly good or unexpectedly bad. To make things more clear, economists use more specific terms. For instance, a positive demand shock refers to a situation in which demand turns out to be higher than expected, while a negative demand shock refers to a situation in which demand turns out to be lower than expected.
Economists believe that most short-run fluctuations are the result of demand shocks. Supply shocks do happen in some cases and are very important when they do occur. But we will focus most of our attention in this chapter and subsequent chapters on demand shocks, how they affect the economy, and how government policy may be able to help the economy adjust to them. But why are demand shocks such a big problem? Why would we have to consider calling in the government to help deal with them? And why can’t firms deal with demand shocks on their own?
The answer to these questions is that the prices of many goods and services are inflexible (slow to change, or “sticky”) in the short run. As we will explain, this implies that price changes do not quickly equalize the quantities demanded of such goods and services with their respective quantities supplied. Instead, because prices are inflexible, the economy is forced to respond in the short run to demand shocks primarily through changes in output and employment rather than through changes in prices.