Differentiate between rational expectation and adaptive expectation using suitable examples
The theory of rational expectations holds that people form the most accurate possible expectations about the future using all information available to them. For example, Google operates a shuttle for its employees living in San Francisco. An interesting thing happens when Google creates a shuttle stop for its buses: in each location that Google has placed a shuttle stop, home prices in the surrounding neighborhoods quickly increase. Presumably, when a Google shuttle stop appears in a neighborhood, property owners can rationally expect that well-paid Google employees will begin buying houses in that neighborhood. As a result, housing prices increase almost immediately based upon these expectations. The theory of rational expectations points out that even though none of the changes will happen immediately, home prices in the neighborhood will rise immediately because the expectation that homes will be worth more in the future leads buyers to be willing to pay more for homes in the present.
The theory of adaptive expectations holds that people look at past experience and gradually adapt their beliefs and behavior as circumstances change, but are not perfect synthesizers of information or accurate predictors of the future, as rational expectations theory assumes them to be. If most people and businesses have some form of adaptive expectations, then the adjustment from the short run to the long run will be traced out in incremental steps that occur over time.
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