Adaptive vs Rational Expectations - 1453 Words

Differentiate between Rational and Adaptive Expectations and clearly explain their role in focusing on future macro-economic variables 1. Rational Expectations The theory of rational expectations was first proposed by John F. Muth of Indiana University in the early 1960s. He used the term to describe the many economic situations in which the outcome depends partly on what people expect to happen. Rational expectations theory is an assumption in a model that the agent under study uses a forecasting mechanism that is as good as is possible given the stochastic (random) processes and information available to the agent. Rational expectations is thus a theory used to model the determination of expectations of future events by economic agents†¦show more content†¦This 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. III. Role of Rational and Adaptive Expectations in focusing on future macro economic variables. Economist today use the adaptive expectations model but then complement it with ideas based on the rational expectations to understand a variety of situations in which specialisation about the future is a crucial factor in determining current action. This theory is a building block for the â€Å"random walk† or â€Å"efficient markets† and design of economic stabilization policies among others. †¢ The Efficient Markets Theory of Stock Prices A sequence of observations on a variable (such as daily stock prices) is said to follow a random walk if the current value gives the best possible prediction of future values. When properly adjusted for discounting and dividends, stock price changes follow a random walk. In their efforts to forecast such prices, investors comb all sources of information including patterns that they can spot in past price movements. They buy stocks they expect to have a higher than average returns and sell those they expect to have lower returns. When they do so, they bid up prices of stocks expected to have higher than average returns and drive down the prices of those expected to have a lower than average returns. The prices of stocks adjust until the expected returnsShow MoreRelatedThe Marine Corps And Amphibious Warfare1708 Words   |  7 Pageseconomic thought concerning market predictions where disagreeing parties argue the merits of adaptive vs. rational expectations. 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