Everything about Adaptive Expectations totally explained
In
economics,
adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past. For example, if inflation has been higher than expected in the past, people would revise expectations for the future.
One simple version of adaptive expectations is stated in the following equation, where
is the next year's rate of inflation that's currently expected;
where
equals actual inflation
years in the past. Thus, current expected inflation reflects a weighted average of all past inflation, where the weights get smaller and smaller as we move further in the past.
Once a forecasting error is made by agents, due to a stochastic shock, that'll be unable to correctly forecast the price level again even if the price level experiences no further shocks since they only ever incorporate part of their errors. The backward nature of expectation formulation and the resultant systematic errors made by agents (see
Cobweb model) was unsatisfactory to economists such as
John Muth, who was pivotal in the development of an alternative model of how expectations are formed, called
rational expectations. This has largely replaced adaptive expectations in macroeconomic theory since its assumption of rationality is more consistent with wider economic theory, although not necessarily consistent with economic reality.
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