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Glossary of Financial & Economic Terms |
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Adaptive expections T
In economics, adaptive expectations means that people base their expectations of what will happen in the future based on what has happened in the past. For example, if inflation has been high in the past, people would expect it to be high in the future. In the theory of inflation, demand pull inflation and cost push inflation are usually short-lived shocks. However, a series of such shocks may lead people to assume that inflation is a permanent feature of the economy (especially if the shocks are large). In that case they will modify their economic behaviour accordingly, based on their heightened expectation of future inflation rates. For instance, they may begin demanding larger (nominal) pay raises. This in itself acts as a cost push, leading firms to push their prices higher, especially since the firms themselves have similar expectations of inflation. This encourages another round of pay-raises. This merges with the "price/wage spiral" to build some inflation directly into the economy! The combination of the price/wage spiral and inflationary expectations reflecting the recent past's experience with inflation gives an economy built-in inflation. The theory of adaptive expectations was popular in the 1980s, as an explanation of some aspects of the economic crisis that the West went through after the 1970s oil shock. The fact that some countries, particularly the UK, took until the 1990s to achieve stable low inflation rates again suggests there may well be something in the idea. The theory of adaptive expectations can be stated using the following equation, where pe is the next year's rate of inflation that is currently expected; pe-1 is this year's rate of inflation that was expected last year; p is this year's actual rate of inflation,
pe = pe-1 + λ*(p – pe-1)
With λ is between 1 and 0, this says that current expectations of future inflation reflect past expectations and an "error-adjustment" term, in which current expectations are raised (or lowered) according to the gap between actual inflation and previous expectations. This error-adjustment is also called "partial adjustment." Rather than reflecting changing expectations of inflation, it may reflect the slow change in people's ability to act on changes in their expectations. Alternatively, the theory of adaptive expectations implies that current inflationary expectations equal:
pe = (1 – λ)*Σ (λj*p–j)
where the summation (Σ) is over all j from 0 to infinity and p–j equals actual inflation j years in the past. Thus, current expected inflation reflects a weighted average all past inflation, where the weights get smaller and smaller as we move further in the past. An alternative theory of how expectations are formed is rational expectations. Though many macroeconomists saw the theory of rational expectations as a revolutionary improvement during the 1970s and 1980s, criticisms of that theory have encouraged a return to the adaptive expectations model.
source: http://en.wikipedia.org/wiki/Adaptive_expectations
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