The problem of modelling expectations in macroeconomics : a framework for replacing expectations with confidence

Expectations are firmly embedded in the field of modern mainstream macroeconomics; however they hold a troubled place in economic theory. We review the history of expectations and the development of adaptive, rational and heuristic forms of expectations. We find all of these to be problematic. Following lines of thinking originating with Keynes but never formalized within economics, we propose the replacemant of the expectations concept by the concept of animal spirits (or confidence). We further review attempts to formalize animal spirits and note their shortcomings, leading to the proposal of a new framework for spirits which embodies Keynes’ original insights. Examples of such models of spirits are presented and the way in which they replace expectations and drive the evolution of an economy is illustrated by inserting them in a previously developed dynamic macroeconomic model. We discuss the potential for a model of animal spirits to replace expectations and thereby avoid both the lack of reality of rational expectations and the unbounded possibilities of heuristics.