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IAI Actuarial Core Principles · Economic Modelling · Rational expectations theory and the efficient markets hypothesis

Expected inflation is formed adaptively: E(t+1) = E(t) + 0.5 x (actual(t) - E(t)). Currently E(t) = 6%, and actual inflation in period t is 10%. Agents, however, are actually rational and know inflation follows a steady policy-determined path of 10% every period, so their forecast for t+1 is 10%. What is the difference between the rational forecast and the adaptive forecast for t+1?

The difference is 2 percentage points. The adaptive forecast is 6% plus half of the 4% error, which gives 8%. The rational forecast uses knowledge of the policy path and equals 10%. The gap of 2% shows that adaptive expectations lag behind rational ones.

  1. A0%
  2. B1%
  3. C2%Correct
  4. D4%
  5. 5%

Explanation

Adaptive forecast = 6 + 0.5 x (10 - 6) = 8%. The rational forecast is 10%, since agents know the policy path. The difference is 10 - 8 = 2%. A value of 4% would arise from ignoring the 0.5 adjustment weight.

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