Question

What is a major difference between adaptive and rational expectations? Give an example of each.

Short answer

Adaptive expectations are when individuals form their expectations about the future based on recent past experiences and events, like expecting price levels to continue as they've been based on past trends. Rational expectations, on the other hand, are when individuals make predictions about the future based on all relevant information, like anticipating and planning for inflation upon hearing that the government will print more money.

Step-by-step solution

Definition of Adaptive and Rational Expectations

Adaptive expectations refer to an economic theory that states that individuals adjust their expectations about the future based on recent past experiences and events. On the other hand, rational expectations is an economic theory that states individuals make choices based on their rational outlook, available information and past experiences. They do not only adapt but also anticipate changes and behave accordingly.

Example of Adaptive Expectations

Consider price levels in the economy. If in the past, price levels have steadily increased, people would expect this trend to continue in the future, hence, they adapt their expectation based on past data. This is an example of adaptive expectations.

Example of Rational Expectations

Again consider price levels. Under rational expectations, if people know that the government is going to print more money (a piece of information), they anticipate that there will be inflation in the future. Hence, they take steps like securing wages that will keep up with the anticipated inflation. This is an example of rational expectations.