Differentiate between Rational and Adaptive Expectations and clearly explain their role in focusing on future macro-economic variables
1. Rational Expectations
The theory of rational expectations was first proposed by John F. Muth of Indiana University in the early 1960s. He used the term to describe the many economic situations in which the outcome depends partly on what people expect to happen.
Rational expectations theory is an assumption in a model that the agent under study uses a forecasting mechanism that is as good as is possible given the stochastic (random) processes and information available to the agent. Rational expectations is thus a theory used to model the determination of expectations of future events by economic agents
• Inflationary Expectations and Phillip’s Curve
The doctrine of rational expectations has been applied to deny that there exists any trade-off between inflation and unemployment, even in the short run. Economists argue that if workers can see inflation coming and if they receive compensation for it in advance, that is, if their money wages specified in a contract are adjusted for inflation so that inflation does not erode real wages, then the economy’s aggregate supply curve will not slope upwards but it will be a vertical line at the level of output corresponding to potential GNP. This is from the fact that firms have no incentive to raise production as prices rise because they compensate the workers who after learning from experience and with increasing access to relevant information, are able to anticipate future price rises accurately and demand higher money wages to compensate for the rise in cost of living. Since we derive short run Philip’s curve from the aggregate supply curve, the short run Phillip’s curve will also be vertical.

From the above graphs, if expectations are rational inflation rate can be reduced without the need for a period of high unemployment because the short run Phillips curve is vertical.

Rational expectations theorists argue that the government’s ability to manipulate aggregate demand gives it ability