The formation of wage expectations in the effort and quit decisions of workers

•Workers form expectations of average wages in decisions about effort and job search.•Workers' wage expectations are likely to be partly adaptive.•Partly adaptive expectations may explain why nominal shocks have real effects.•Results may explain Lucas' (1973) finding about effects of nominal demand shocks.•Microeconomic parameters determine degree to which expectations are adaptive.

This study develops models in which workers form expectations of average wages in choosing levels of effort and on-the-job search. It is assumed that information on lagged average wages is available at a low fixed cost, whilst acquiring other information requires an additional variable cost. Under reasonable conditions, workers' expectations are at least partly adaptive, and may be a mixture of rational and adaptive expectations. Microeconomic parameters determine the degree to which expectations are adaptive and the weights placed on various lags of wages. As a result of partly adaptive expectations, nominal demand shocks may have real effects.