The chapter discusses different models of how people form their expectations reg

Question

The chapter discusses different models of how people form their expectations regarding inflation. Consider the following two investors, who are trying to forecast what inflation will be for next year. Sean reasons as follows: "Inflation was 2.5 percent last year. Therefore, I think it is likely to be 2.5 percent this year." Carlos, on the other hand, thinks this way: "The economy has recovered from recession sufficiently that inflationary pressures are likely to build. Likewise, a weaker dollar means that imports are going to be more expensive. I don't think the Fed will risk slowing the recovery and raising unemployment by raising interest rates to fight inflation. So, in light of all these factors, I expect inflation to increase to 5 percent next year." How would you best describe how each investor is forming his expectations of inflation? Sean is forming his forecast based on the (1) model of inflation and Carlos is forming his forecast based on the (2) model of inflation. What are possible criticisms of the way each investor is forming his expectations? Economists might argue that Sean is not maximally rational, and Carlos can not be as good at understanding how the economy works as he thinks he is. Sean can not be as good at understanding how the economy works as he thinks he is, and Carlos is not maximally rational. Sean is looking back too far, and Carlos is ignoring the past. Sean is not looking back far enough, and Carlos is overconfident in his understanding of how the economy works. expected real interest rate rational expectations quantity theory adaptive expectations seignorage expected real interest rate adaptive expectations quantity theory seignorage rational expectations

Explanation / Answer

1. Adoptive Expectations 2. Rational Expectations

3 D Sean is not looking back far enough , and Carlo is overconfident

As Rational expectations theory defines this kind of expectations as being identical to the best guess of the future (the optimal forecast) that uses all available information. whereas Adoptive expectation people use past information to develop and predict future trend.

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