A Critique of Adaptive and Rational Expectations

Abstract

In contemporary economic theory, and especially in macroeconomics, expectations are being given a central place. There is virtually no economic model that does not examine how, within a dynamic perspective, the explicit account of individuals' expectations qualifies the conclusions of the static analysis. To a certain extent this prominent place is well founded, for expectations of future events do motivate present actions and thereby influence social phenomena as they occur in reality. However, contemporary macroeconomists go a step further. They also maintain that a specific model of the formation of expectations is necessary in order to assess the role played by expectations, and ultimately to build economic theory itself. The goal of this paper is not to study the foundation of this point of view, or the proper way for economists to fathom the importance of expectations. Its more limited scope is to examine to what extent the two most common models of expectations formation attain their end. This end is to convey and exemplify the role expectations play in the manifestation of even the most basic economic phenomena, such as the determination of quantities produced and the formation of prices. Expectations are the unobservable opinions about the future that individuals form in their minds. In the absence of a clear-cut conclusion from cognitive sciences as to the objective, observable, determinants of human thoughts, economic models of expectations formation can be but arbitrary assumptions. From this standpoint, these