Adaptive and Rational Expectations Hypotheses: Reviewing the Critiques

Abstract

The pervasiveness of expectations in economic analysis has created significant discussion on the merits and demerits of the two main expectations formation hypotheses, adaptive and rational expectations. This paper gives concise outlines of the two hypotheses and reviews their respective critiques to assess their validity. We outline that the two hypotheses have essentially been regarded as antitheses of each other in economic discourse. In this discourse, exaggerated theoretical intents and criticisms are evident. Inconsistencies among the advocates of rational expectations are also evident, with many of these inconsistencies manifesting themselves in spirited attempts to defend the hypothesis. In the end rational expectations and adaptive expectations are both based on some historical data and learning from experience. While evidence on the usefulness of the models is mixed, it is concluded that both models are beneficial. The adaptive expectations hypothesis may be considered an ad hoc approach, more appropriate for short-term expedient analysis when data and information are scanty. Rational expectations, being based on broader and longer learning experience and data, may be considered appropriate for more comprehensive and longer-term planning. It remains that the rational expectations hypothesis is not per se a model of expectations formation, but a concept pointing to the need for more systematic modeling. 

Keywords: Adaptive expectations, rational expectations, forecasting, belief, uncertainty