Answer to Question #144922 in Macroeconomics for Anonymous

Question

Explain how rational expectations are best expectations. Also explain the disadvantages of adaptive expectations.

Answer 1

The theory of rational expectations is that people's current expectations about the economy can themselves influence what the future state of economies will be.  The theory posits that individuals base their decisions on three primary factors: their human rationality, the information available to them, and their past experiences. By including rational expectations in forecast modeling, future economic processes can be determined more reliably. Therefore rational expectations are best expectations

The disadvantages of adaptive expectations:

• based only on past trends
• they show only one factor influencing future trends

These limitations led to the development of rational expectations which incorporated many factors into the decision making process.