Distinguish between adaptive expectation and rational expectation

Rational expectations

Table of Contents

List of abbreviations

List of tables

1. Introduction (Peter Franken)

2. Basics of expectation formation (Peter Franken)
2.1 Difference between nominal and real interest
2.2 The expected present value
2.3 IS-LM model
2.4 Fisher hypothesis and its evidence
2.5 Relationship between expectations and consumption

3. Expectations (Nils Johann Schneider)
3.1 Regressive Expectations
3.2 Stationary expectations
3.3 Extrapolative Expectations
3.4 Adaptive Expectations
3.5 Rational Expectations
3.6 Criticism Rational Expectations

4. The Phillips curve and the labor market (Nils Johann Schneider)

5. Conclusion (Peter Franken)


List of abbreviations

Figure not included in this excerpt

List of figures and tables

Figure 1: IS-LM model, page 5: Blanchard, Olivier; Illing, Gerhard, p.424, (2004).

Figure 2: IS-LM model short term p.5: Blanchard, Olivier; Illing, Gerhard, p.425, (2004).

Figure 3: The Phillips Curve in Neoclassicism. P. 11: Volkmann, R., p. 145, (2006)


Anderegg Prof. Dr. Ralph (2006): Fundamentals of monetary theory and policy, script A-Vwl WS 06/07, University of Cologne.

Blanchard, Olivier; Illing, Gerhard (2004): Macroeconomics, a.o. Munich. Cape. 14, pp 461-471.

Brockhaus - The Encyclopedia: 20th revised and updated edition,
6th volume, F.A. Brockhaus, Leipzig / Mannheim.

Felderer, B .; Homburg, S. (1994): Macroeconomics and New Macroeconomics, 6th Edition, Berlin / Heidelberg / New York, pp.263-268.

Funk, Prof. Dr. Peter (2002/2003): Fundamentals of Macroeconomic Theory, Script Vwl-B, WS 02/03, University of Cologne.

Hielscher, T. (1999): Uncertainty, Expectations and the Hypothesis of Rational Expectation Formation, Contributions to the Discussion of the Department of Economics at the Free University of Berlin, Berlin

Krugman, Paul; Obstfeld, Maurice (2006): International Economics, Pearson Studies, Munich.

Schilling, G. (1986): Rational Expectations in Macroeconomic Models, Wiesbaden.

Volksmann, R. (2006): Simply learn! Macroeconomics, student support

http://de.wikipedia.org/wiki/Rationale_Erwartung accessed on May 8, 2007

http://www.wiwi.uni-frankfurt.de/Professoren/eisen/Tut9Loesung.pdf WS 2005 \ 2006 accessed on June 14, 2007

http://www.wiwi.uni-bielefeld.de/~dawid/Lehre/Downloads/VWL1_15.pdf accessed on June 29, 2007

1 Introduction

The seminar paper on the topic of "Rational Expectations" was created as part of the introductory seminar Introduction to Economics in the 2007 summer semester. Rational expectation is a macroeconomic theory originally developed by Muth (1961) and later by Lucas. In 1995 he received the Nobel Prize for Economics for this theory. The theory itself is used to model how agents predict future economic events. It is particularly used in classical neo-Keynesian theories and financial market theories.[1] Economic decisions depend not only on what is happening today, but also on expectations about the future, because many decisions have little to do with what is happening today. Why would an increase in sales affect investment plans today if one does not expect that demand will remain high in the future? New machines, for example, shouldn't be ready for use until demand has long since flattened out again. So far, the role of expectations has been neglected. In the following, this paper will examine and contrast the influence of expectations in detail.

2 Basics of expectation formation

According to Özga (1965, in Schilling 1986), we understand an expectation to be a statement about a future event that is based on subjective, personal attitudes and on objective, realized observations. Expectations are uncertain predictions of future events that cannot be controlled by individuals.[2] In the literature, a distinction is made between extrapolative, regressive and adaptive expectations and various combinations of these hypotheses. A characteristic of these approaches is the restriction to one's own past development of the estimated size. For the prognosis they only use historical data of the variables to be estimated and are therefore summarized under the general name of autoregressive expectation formation, as we will explain in more detail later.[3]

2.1 Difference between nominal and real interest

First of all, for the further consideration of rational expectations, it makes sense to differentiate between real and nominal interest rates, since for economic subjects, for example when borrowing, it is important how many goods one will have to do without in the future if more goods are consumed today. On the other hand, it is of interest how many goods we can consume in the future if we do without a certain number of them today.

Nominal interest it refers to interest that is expressed in a specific currency unit (e.g. dollars or euros). In contrast, real interest rt is understood to mean interest that is expressed in units of a basket of goods or interest that takes changes in the value of money into account[4]. Using the consumer price index, the real interest rate shows us how much consumption we will have to forego tomorrow if we consume one more unit today.[5]

This results in a real interest rate in the next period of (1 + rt). Using the nominal interest rate, it is possible to determine the real interest rate with the help of the expected inflation rate. An exact derivation of the exact relationship is not given at this point, since the approximation also leads to good results. In an approximate form, this equation corresponds to the following relationship: rt ≈ it- πet.

This equation provides important insights:

- If the expected inflation is zero, then the real interest rate corresponds to the nominal interest rate.
- As the expected inflation is usually positive, the nominal interest rate is higher than the real interest rate.
- Given the nominal interest rate, the higher the expected inflation, the lower the real interest rate.

2.2 The expected present value

The issue of the discounted expected present value is important because investment considerations that enable production increases and higher profits also incur costs. In the case of positive interest rates, future profits must be discounted at the interest rate, i.e. we calculate the discounted expected present value in order to decide whether an investment is profitable.


[1] Wikipedia accessed on May 8, 2007

[2] Schilling, p.8, (1986).

[3] Schilling, p.23, (1986).

[4] Anderegg, p.89, (2006).

[5] Blanchard, Olivier; Illing, Gerhard, p.413, (2004).