Adaptive expectations
Encyclopedia
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
is the next year's rate of inflation that is currently expected; 
is this year's rate of inflation that was expected last year; and 
is this year's actual rate of inflation:
where
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:
where
equals actual inflation 
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.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, 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
is the next year's rate of inflation that is currently expected; is this year's rate of inflation that was expected last year; and is this year's actual rate of inflation:
where
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:
where
equals actual inflation 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
Cobweb model
The cobweb model or cobweb theory is an economic model that explains why prices might be subject to periodic fluctuations in certain types of markets. It describes cyclical supply and demand in a market where the amount produced must be chosen before prices are observed. Producers' expectations...
) was unsatisfactory to economists such as John Muth
John Muth
-Legacy:It has hard to point to one substantial area of economic research into dynamic problems which has not changed as a result of the publication of Muth's works at GSIA. Almost paradoxically, the only viable alternative to Muth's hypothesis is the research agenda put forward by Herb Simon and...
, who was pivotal in the development of an alternative model of how expectations are formed, called rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...
. This has largely replaced adaptive expectations in macroeconomic theory since its assumption of optimality of expectations is consistent with economic theory.
See also
- Rational ExpectationsRational expectationsRational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...
- Policy Ineffectiveness PropositionPolicy Ineffectiveness PropositionThe Policy Ineffectiveness Proposition is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations...
- Self-fulfilling prophecySelf-fulfilling prophecyA self-fulfilling prophecy is a prediction that directly or indirectly causes itself to become true, by the very terms of the prophecy itself, due to positive feedback between belief and behavior. Although examples of such prophecies can be found in literature as far back as ancient Greece and...
- Problem of inductionProblem of inductionThe problem of induction is the philosophical question of whether inductive reasoning leads to knowledge. That is, what is the justification for either:...