Introduction

The principal choices that people make in a market economy – choices between present and future consumption, between labor and leisure, between real and monetary assets – depend on their beliefs about the future. In forming their beliefs, individuals attempt to separate transitory and ephemeral changes from permanent and persistent changes. Even individuals who are fully informed about past and current variables cannot be certain about their future values. A basic inference problem that individuals face is to distinguish permanent values of variables like income, wages, and prices from current values. Implicitly or explicitly, each of us makes judgments about the persistence of current developments before making major decisions.

For example, if the relative wage of a particular kind of labor goes up, the reactions of individual workers to this change will depend on whether they believe this change to be permanent or temporary. If the wage increase is perceived as permanent, there may be some increase in the supply of labor. (This will be the case if the substitution effect is larger than the income effect over the life cycle.) If the wage increase is perceived as temporary, however, the increase in the labor supply will be greater as individuals try to work more today because they believe the wage currently offered is unusually high.