Both adaptive expectations and rational expectations are prone to error (a discrepancy between the expectation and the actual experience). In each case, how does error affect the formation of new expectations?
What will be an ideal response?
With adaptive expectations, the newest information is considered neither more nor less significant than the oldest available data. Rational expectations augment data with one or more hypotheses regarding the underlying mechanisms. Each new discrepancy is an opportunity to assess the accuracy of the presumed mechanisms. Given all available, relevant information, the latest discrepancy might be dismissed as an anomaly to be ignored when forming subsequent expectations. Or, the discrepancy might prompt a revision of hypotheses, such that new expectations are affected profoundly.
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The ceteris paribus assumption is important to use when building economic models
Indicate whether the statement is true or false
Which of the following leads to a fundamental difficulty for stabilization policy?
A. Time lags in policy decisions B. Presence of shock absorbers in the economy C. Absence of data on the effectiveness of policy measures D. Existence of self-correcting mechanism