Question

a. Define Rational Expectations and Adaptive Expectations.

b. Discuss the impact of an expansionary monetary policy on economy in the following scenarios

1. If consumers and producers form expectations based on Rational expectations.

2. If consumers and producers form expectations based on Adaptive expectaions.

Answer 1

a) adaptive expectation hypothesis is a theory that assumes that people form there expectation about the future depending on there experience about the past. on the other hand rational expectation hypothesis states that people always use all the available information and form there expectation about the future rationally, taking into consideration all the information available about the past and present. so there are less chances of error in forcasting.

b) 1- if the cenytral bank is adopting expansionary monetary policy and the consumers are supposed to form there expectations based on rational expectation then the central bank will fail to increase the employment rate. only inflation will increase in the economy as people will rightly predict the policy change and its impact in the shortrun.

2- if the cenytral bank is adopting expansionary monetary policy and the consumers are supposed to form there expectations based on adaptive expectations then both inflation and employmnent will increase in the shortrun as consumers will not be able to predict the effect of policy change. so in the short run governmet will be able to fool them but after some time the economy will return back to its full employment level.