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Chapter 28: Problem 4

During a time when the inflation rate is increasing each year for a number of years, are adaptive expectations or rational expectations likely to give the more accurate forecasts? Briefly explain.

Short Answer

Expert verified
In a state of continuously increasing inflation, the more accurate forecast would generally come from rational expectations, since it takes into account all available information and not just past trends. However, it still largely depends on other factors such as changes in policy and external shocks that could significantly impact future inflation rates.

Step by step solution

01

Understanding Adaptive Expectations Behavior

Think of Adaptive Expectations as being based entirely on past trends. So, if inflation has continuously increased in the past years, someone with adaptive expectations would likely predict that inflation will continue to increase at a similar rate in the future.
02

Understanding Rational Expectations Behavior

The Rational Expectations theory suggests that people will use all accessible information, including government policy changes, global economic trends, and anticipated future events, to forecast the possible future inflation rate. Rational expectations don't just rely on past rates but take into account any available information that could influence future rates.
03

Compare and analyze the two expectation systems

Comparing the two, over a number of years with continuously increasing inflation, adaptive expectations would simply forecast increasing inflation well into the future, based on past trends. However, under rational expectations, if people anticipate a policy or a measure to be taken in the future that might cut down inflation, they would expect less inflation than what has been predicted by adaptive expectations. Therefore, the accuracy of these expectations would depend on changes or anticipated changes in policy, external shocks and other factors besides the past trend of increasing inflation.

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Most popular questions from this chapter

In macroeconomics courses in the \(1960 \mathrm{~s}\) and early \(1970 \mathrm{~s},\) some economists argued that one of the U.S. political parties was willing to have higher unemployment in order to achieve lower inflation and that the other major political party was willing to have higher inflation in order to achieve lower unemployment. Why might such views of the trade-off between inflation and unemployment have existed in the 1960 s? Why are such views rare today?

(Related to the Chapter Opener on page 994) In its 2016 Annual Report, Toll Brothers noted, "If mortgage interest rates increase significantly ... our revenues, gross margins, and net income could be adversely affected." a. Why might an increase in mortgage interest rates reduce revenue and profit for Toll Brothers? b. During this period, was Fed policy attempting to reach a point on the short-run Phillips curve representing higher unemployment and lower inflation or a point representing higher inflation and lower unemployment? Briefly explain. c. What connection is there between Fed policy and Toll Brothers' concern about the effect of rising mortgage interest rates on its profit?

An article in the Economist observed that "a sudden unanticipated spurt of inflation could lead to rapid economic growth." a. Briefly explain the reasoning behind this statement. b. Does it matter whether a spurt of inflation is unanticipated? Might different economists provide different answers to this question? Briefly explain.

An opinion column in the Wall Street Journal noted, "In a democracy, the tradeoff for a central bank's independence is accountability to the nation's elected leadership." a. Why would a country want to grant its central bank more independence than it grants, say, its department of agriculture or department of education? b. In the United States, how is the Fed held accountable to the nation's elected leadership? Source: David Wessel, "Explaining 'Audit the Fed," Wall Street Journal, February 17, 2015 .

What was the "Volcker disinflation"? What happened to the unemployment rate during the period of the Volcker disinflation?
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