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16-September-2008 16:15:15 - expectations 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 pe is the next year's rate of inflation that is currently expected; p^e_-1 is this year's rate of inflation that was expected last year; and p is this year's actual rate of inflation: p^e = p^e_-1 + \lambda p_-1 - p^e_-1 With λ is between 0 and 1, this says that current expectations of future inflation reflect past expectations and an error-adjustment term, in which current expectations are raised or lowered according to the gap between actual inflation and previous expectations. This error-adjustment is also called partial adjustment. The theory of adaptive expectations can be applied to all previous periods so that current inflationary expectations equal: p^e = 1 - \lambda \sum_j = 0^\infty \lambda^j p_j where pj equals actual inflation j 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, they will 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. References George W. Evans and Seppo Honkapohja 2001, Learning and Expectations in Macroeconomics. Princeton University Press, ISBN 0-691-04921. See also Rational Expectations Policy Ineffectiveness Proposition Self-fulfilling prophecy Problem of induction Retrieved from http://en..org/wiki/Adaptive_expectations Categories: Macroeconomics Views Article Discussion this page History Personal tools Log in / create account Navigation Main page Contents Featured content Current events Random article Search Go Search Interaction Community portal Recent changes Contact Donate to Help Toolbox What links here Related changes Upload file Special pages Printable version Permanent link Cite this page Languages Deutsch Español ລາວ Polski 中文 This page was last modified on 27 June 2008, at 02:12
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