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Over the past five years, you have recorded the inflation rate to be 3 percent, 4...

Over the past five years, you have recorded the inflation rate to be 3 percent, 4 percent, 3 percent, 4 percent, and 3 percent, respectively. According to rational expectations theory, what would market participants expect inflation to be next year, and why?

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Answer #1

Answer: expected inflation is 4%.

The theory indicates a model as below:

No.1) Available information – there are information of inflation rates of last 5 years.

No.2) Past experiences – (a) if a year has decreasing inflation rate, the following year would have increasing inflation rate. (b) The rates of inflation are just between two numbers 3% and 4%.

No.3) Rational judgment: Based on the past experiences (a) the last inflation (3%) is lower than earlier (4%), therefore the next year’s inflation would be higher, (b) since it ends up with 3%, the next rate would be 4%.

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