Distinguish among Marcov, adaptive and rational expectations, providing an intuitive explanation of each.
Ans. (i) Marcov Expectations:
Marcov expectations claim that immediate past will repeat in future. In other words, we can say that most recent value of a variable is used to predict its future value.
If price of an asset is Rs. 100 in period t, we can expect its price for period t+1 to be Rs. 100. To put it symbolically
,P e t+1 = Pt It is suitable in a stable environment. For example, when there is no inflation, no fluctuations otherwise, it can be used.
(ii) Adaptive Expectations: It claims that people keep on revising their expectations i.e. keep on adapting expectations as per the latest information or in the light of forecast errors. It can formally be written as follows:
X e t+1 – X e t = (Xt –Xe t )
A is speed of adjustment. It means how fast investors change their expectations on the basis of past experience. Therefore, above equation can be rewritten as:
X e t+1 – X e t = (Xt –Xe t )
The value of lies between 0 and 1. 0 indicates that adjustment never takes place and 1 indicates that adjustment is instantaneous. It means more is the value of , faster is the adaptation in expectations.
(iii) Rational Expectations:
It was introduced by John Muth in 1961. It is very complicated method offorming expectations. It claims that the subjective expectations formed by anyone say an investor about returns on an investment, will be exactly equal to the mathematical conditional expectation suggested by economic theory. It says that economic agents are not illiterate and are well aware of probability methods and quantitative techniques. They may not know actual values of the variables but they do know their probability values.
It states that a person takes into account all available information in the process of forming expectations. It will involve all relevant variables in the context.
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