Expectations theory

economic-dictionary

The theory of expectations is any hypothesis that tries to explain how agents formulate their estimates with respect to certain economic variables.

That is, this type of theory seeks to understand how investors, consumers or companies make their future projections.

Thus, a theory of expectations can take as a reference different decision variables such as, for example, historical data or current financial and political information.

It should be noted that expectations are the ideas that individuals have built regarding the future value of different economic variables such as inflation, unemployment or income.

Main theories of expectations

There are mainly two types of theories of expectations:

  • Adaptive Expectations Theory: Assumes that agents formulate their projections based on historical data. This theory was introduced by Philip Cagan in 1956 who postulated that consumers estimate future inflation based on data from the past. The contribution of this hypothesis is that agents learn from their mistakes.
  • Theory of rational expectations: Individuals formulate their estimates taking as a reference all the available information.That is, it is not only based on the historical data of the variable to be estimated, but on the behavior of other variables, and even news or announcements that may impact the economic or financial sphere. These ideas were initially put forward by John Muth in the early 1960s.

It should be noted that, before the theory of adaptive expectations, there was the theory of exogenous expectations. According to this postulate, agents formulate their projections only based on external variables, unrelated to the personal experiences of each user. Therefore, the fact that individuals learn from their mistakes had not been considered.

Another model considered unsatisfactory was that of static expectations. This theory stated that individuals only used the current value of the variable to predict the future. This approach was used by Nicolás Kaldor in the 1930s in the cobweb model that assumed that farmers decided how much to sow (whose harvest will be sold in the future) based on the current price.

Importance of expectations theory

All theories of expectations are important because they give us a different contribution to understanding how agents formulate their forecasts.

In practice, it can be useful for economic policy planning to know how consumers, for example, project inflation. Thus, if you consider that part of your forecasts are based on the past, it is not advisable to let prices rise rapidly today because people will start to buy more than necessary, thinking that in the future everything will be more expensive.

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