ECON 304 Lecture Notes - Lecture 2: Rational Expectations, Phillips Curve, Adaptive Expectations
1 Jan 2018
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Document Summary
As we saw in the previous lectures, adaptive expectations have many drawbacks and are therefore an unappealing way of modeling expectations. An alternative expectations formation mechanism proposed by muth (1961) and popularized by lucas and sargent in the 1970s is rational expecta- tions. Under rational expectations, agents who make forecasts, do so in an efficient manner. They not only use all past information to form expectations but also all other information, including information about future events to form their expectations. The rational expectations hypothesis (reh) overcome the basic problems inherent in the adaptive expectations model, that is agents making systematic mistakes. Under rational expectations, agents do not make systematic errors and expectations are formed using all available information. It is important to note that under rational expectations, agents ac- tually make forecast errors; however these forecast errors have no serial correlation or no systematic component. In other words, agents do not make mistakes on average.
