Question

a.What is the difference between adaptive and rational expectations?

2. What is time-inconsistency problem and what role does it play in the debate between supporters of discretion and supporters of rules in policy making?

Answer 1

a)

The adaptive expectations imply that economic agent tends to predict the future by the extrapolating the past information. Here future prediction solely depends on the past information.

While the rational expectation is an improved version of adaptive expectation. Under rational expectations, economic agents tend to predict the future by using the past and present information. and further, economic models are used to predict the future. On average the economic agent predicts the future correctly.

b)

Time inconsistency problem refers to the certain policy planning in advance and later these policies are changed. Here, decisions are taken based on the some potential near by benefits.

in case of discretionary policies, the time inconsistency problem is frequently seen. Here, policymakers profess something else in the advance and later on change the behavior.

Thus, economists argue that rule based policies must be followed as these policies do not suffer from the problem of time incosistencies.