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Chapter 16: Problem 3

What is a major difference between adaptive and rational expectations? Give an example of each.

Short Answer

Expert verified
Adaptive expectations are when individuals form their expectations about the future based on recent past experiences and events, like expecting price levels to continue as they've been based on past trends. Rational expectations, on the other hand, are when individuals make predictions about the future based on all relevant information, like anticipating and planning for inflation upon hearing that the government will print more money.

Step by step solution

01

Definition of Adaptive and Rational Expectations

Adaptive expectations refer to an economic theory that states that individuals adjust their expectations about the future based on recent past experiences and events. On the other hand, rational expectations is an economic theory that states individuals make choices based on their rational outlook, available information and past experiences. They do not only adapt but also anticipate changes and behave accordingly.
02

Example of Adaptive Expectations

Consider price levels in the economy. If in the past, price levels have steadily increased, people would expect this trend to continue in the future, hence, they adapt their expectation based on past data. This is an example of adaptive expectations.
03

Example of Rational Expectations

Again consider price levels. Under rational expectations, if people know that the government is going to print more money (a piece of information), they anticipate that there will be inflation in the future. Hence, they take steps like securing wages that will keep up with the anticipated inflation. This is an example of rational expectations.

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Most popular questions from this chapter

Explain both the short- and long-run movements of the new classical theory, assuming that expectations are formed rationally and policy is unanticipated.

In real business cycle theory, why can't the change in the money supply prompted by a series of events catalyzed by an adverse supply shock be considered the cause of the business cycle?

Assume a current short-run trade-off between inflation and unemployment, as well as a change in technology that permits the wider dispersion of economic policy news. How would the change affect the trade-off? Explain your answer.

According to Friedman, how do we know when the economy is in long-run equilibrium?

"Even if some people do not form their expectations rationally, the new classical theory is not necessarily of no value." Discuss this statement.
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