Adaptive expectations

Economics
A supply and demand diagram, illustrating the effects of an increase in demand.
Index Outline Category
History Types Classification
History of economics Economic history (academic study) Schools of economics Microeconomics Macroeconomics Methodology Heterodox economics JEL classification codes
Concepts Theory Techniques
Econometrics Economic growth Economic system Experimental economics Mathematical economics Game theory Post-scarcity Market National accounting
By application
Agricultural Behavioral Business Computational Cultural Demographic Development Digitization Ecological Education Environmental Evolutionary Expeditionary Geography Health Industrial organization Information International Knowledge Labour Law Managerial Monetary / Financial Natural resource Organizational Personnel Public / Welfare economics Regional Rural Service Urban Welfare
Lists
Economists Publications (journals)
Business and economics portal

In economics, adaptive expectations is a hypothesized process by which 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 $p^{e}$ is the next year's rate of inflation that is currently expected; $p_{-1}^{e}$ 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_{-1}^{e}+\lambda (p-p_{-1}^{e})

where $\lambda$ 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}=\lambda \sum _{j=0}^{\infty }((1-\lambda )^{j}p_{j})

where $p_{j}$ 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 optimality of expectations is consistent with economic theory. However, it must be stressed that confronting adaptivity and rationality is not necessarily justified, in other words, there are situations in which following the adaptive scheme is a rational response.

Adaptive expectations were instrumental in the Phillips curve outlined by Milton Friedman. For Friedman, workers form adaptive expectations, so the government can easily surprise them through unexpected monetary policy changes. As agents are trapped by the money illusion, they are unable to correctly perceive price and wage dynamics, so, for Friedman, unemployment can always be reduced through monetary expansions. The result is an increasing level of inflation if the government chooses to fix unemployment at a low rate for an extended period of time. However, in this framework it is clear why and how adaptive expectations are problematic. Agents are arbitrarily supposed to ignore sources of information which, otherwise, would affect their expectations. For example, government announcements are such sources: agents are expected to modify their expectations and break with the former trends when changes in economic policy necessitate it. This is the reason why the theory of adaptive expectations is often regarded as a deviation from the rational tradition of economics.^[1]

References

↑ Galbács, Peter (2015). The Theory of New Classical Macroeconomics. A Positive Critique. Heidelberg/New York/Dordrecht/London: Springer. ISBN 978-3-319-17578-2. doi:10.1007/978-3-319-17578-2.

George W. Evans and Seppo Honkapohja (2001), Learning and Expectations in Macroeconomics. Princeton University Press, ISBN 978-0-691-04921-2.

Economics
Economic theory Econometrics Applied economics
Macroeconomics	Adaptive expectations Aggregate demand Balance of payments Business cycle Capacity utilization Capital flight Central bank Consumer confidence Currency Demand shock Depression (Great Depression) DSGE Economic growth Economic indicator Economic rent Effective demand General Theory of Keynes Hyperinflation Inflation Interest Interest rate Investment IS–LM model Microfoundations Monetary policy Money NAIRU National accounts PPP Rate of profit Rational expectations Recession Saving Shrinkflation Stagflation Supply shock Unemployment Macroeconomics publications
Microeconomics	Aggregation problem Budget set Consumer choice Convexity Cost–benefit analysis Deadweight loss Distribution Duopoly Economic equilibrium Economic shortage Economic surplus Economies of scale Economies of scope Elasticity Expected utility hypothesis Externality General equilibrium theory Indifference curve Intertemporal choice Marginal cost Market failure Market structure Monopoly Monopsony Non-convexity Oligopoly Opportunity cost Preference Production set Profit Public good Returns to scale Risk aversion Scarcity Social choice theory Sunk costs Supply and demand Theory of the firm Trade Transaction cost Value Uncertainty Utility Microeconomics publications
Applied fields	Agricultural Business Demographic Development Economic history Education Environmental Financial Health Industrial organization International Knowledge Labour Law and economics Monetary Natural resource Public Service Urban Welfare
Methodology	Behavioral economics Computational economics Econometrics Economic systems Experimental economics Mathematical economics Methodological publications
Economic thought	Ancient economic thought Austrian school of economics Chicago school of economics Classical economics Feminist economics Heterodox economics Institutional economics Keynesian economics Mainstream economics Marxian economics Neoclassical economics Post-Keynesian economics Schools overview
Notable economists and thinkers within economics	Kenneth Arrow Gary Becker Francis Ysidro Edgeworth Milton Friedman Ragnar Frisch Friedrich Hayek Harold Hotelling John Maynard Keynes Tjalling Koopmans Paul Krugman Robert Lucas Jr. Jacob Marschak Alfred Marshall Karl Marx John von Neumann Vilfredo Pareto David Ricardo Paul Samuelson Joseph Schumpeter Amartya Sen Herbert A. Simon Adam Smith Robert Solow Léon Walras more
International organizations	Asia-Pacific Economic Cooperation Economic Cooperation Organization European Free Trade Association International Monetary Fund Organisation for Economic Co-operation and Development World Bank World Trade Organization
Category Index Lists Outline Publications Business and economics portal

This article is issued from Wikipedia. The text is licensed under Creative Commons - Attribution - Sharealike. Additional terms may apply for the media files.

Adaptive expectations

See also

References