Question

2. Some macroeconomists consider the adaptive-expectations hypothesis to be unsatisfactory or

"unappealing". What is it about adaptive-expectations that some macroeconomists find

"unappealing"? Explain

Answer 1

Adaptive expectations is a process by which 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.

It assumes that investors will adjust their expectations of future behavior based on recent past behaviour

If the market is downward it will continue that way since it’s the same historically as well.

A classic example of Adaptive Expectations is the 2008 crises, where based on the appreciation value of the houses people were expecting that it would only keep increasing, which was not the case after the housing bubble burst.

One of the most important reasons why Macro Economist don’t find this approach satisfactory is because It only assumes that people base their decisions on past experiences and data. However, in the real world, past data is one of the few factors that influence future behaviour. Expectations are especially limited if inflation is on an upward or downward trend. Economists prefer Rational Expectations that take into consideration many factors in the decision making process. Humans now and in the recent past have lived in environments very different from those in which human cognitive capacities evolved, thus only basing decision on the past would not be of real value.