Answer to Question #145281 in Macroeconomics for Divya Bhalla

Question

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

Answer 1

The problem of expectations is very multifaceted and quite contradictory. Economic actors not only monitor information, not only receive it. They process it, evaluate it, learn from the information received.

Acquaintance with the mechanism of formation of expectations allows one to more accurately represent the influence of economic policy on the development of the economic process. There are two theories, or two approaches to assessing expectations:

• theory of adaptive expectations

• theory of rational expectations.

Adaptive expectations theory assumes that firms adjust their expectations (and actions) based on past events, trends, and confirmations or errors in past forecasts. In a similar way, the probable situation in the markets of individual goods, price dynamics, and changes in market conditions are assessed. Adaptive expectations are thus based on a somewhat narrowed down, limited estimate; firms rely mainly on past experience, past "trajectories" in the movement of variables.

The theory of rational expectations is based on more complete and wider information based on the analysis, assessments of upcoming (future) events.

Rational expectations are based on forecasts. This is nothing more than "predicting economic events."

The theory of rational expectations assumes that firms in their forecasts proceed from the following estimates: how the existing economic model functions; what was the past dynamics of prices, costs, interest rate levels, etc .; what are the likely consequences of government decisions; how the main indicators of macroeconomics (the size of the national product, rates, employment, demand, exchange rate) may change in this regard. On the basis of assessments, the "rational" behavior of participants in economic activity is formed.

The theory of rational expectations leads to the conclusion that the government's ability to influence the economy has significantly narrowed.

Short-term demand management policies are increasingly proving to be ineffective. In the long term, the level of employment and production indicators are determined by structural shifts.