Question

1. What is meant by adaptive expectations? Write an equation that expresses the adaptive-

expectations hypothesis? Explain, with reference to this equation, why the adaptive-expectations

hypothesis is often called the error-learning hypot

Answer 1

Adaptive expectations is a theory or a process which refers to the expectations formed of future based on the experience of the past.

The equation of adaptive expectations is given by

E[π_t] = E[π_t-1] + {π_t-1-Eπ_t-1}

The term in the bracket refers to the forecast error which was used to determine inflation since it is the difference between actual and expected inflation.

This hypothesis is called the error learning hypothesis because the present expected inflation is based on the expected inflation of past and the error term. So we tend to learn from the error which was made in the forecast to determine and adapt the changes , so that our future exoecexp inflation is more precise and a better forecast than the previous one.

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