Question

Intermediate Macroeconomics Question

Q: Compare and contrast the perfect foresight, adaptive expectation and rational expectation approaches to forming expectations.  

Answer 1

Perfect foresight is an important assumption in an economic model which asserts that people make perfect predictions about the future without systematic errors. It is based on the assumption that the expected value of an observation is equal to the expected value predicted by the model. It means that the model is correct for prediction and would give reliable results.

Adaptive expectations is another assumption used in economic models where predictions about the future are based on past experiences. For example, if inflation in the current period is higher than in past years and shows an increasing trend then consumers would form higher expectations of a price hike in the future. In some cases, it is about recent past and in other, it requires for a lag of two or more years.

Rational expectations assume that in an economic model consumers make future predictions based on their rationality, information available currently and past experience. Based on such assumptions it is implied that agents know all about the model and make correct decisions regarding future outcomes.