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The Adaptive Expectations Hypothesis

Instructor: Brianna Whiting

Brianna has a masters of education in educational leadership, a DBA business management, and a BS in animal science.

In this lesson, we'll learn about the adaptive expectations hypothesis, including its definition and how it compares to rational expectations. At the end of the lesson, you'll have the chance to test your understanding of the topic with a short quiz.

Adaptive Expectations in Real Life

If you're a hobbyist or a home sewer, you may know somebody like Karen. Karen owns her own fabric business. Each day, she walks her store to see which fabrics she's running low on and needs to reorder. At the end of the month, Karen reviews her order and tries to identify which fabrics are selling out the fastest. For example, are her customers craving plaids, or are they buying more animal prints? If Karen can figure out which fabrics are the most popular, her customer's purchasing history can help her decide what to order in the future.

In making her purchasing decisions, Karen is using her past sales to predict future decisions. When this same principle is applied to investment decisions, we call it the adaptive expectations hypothesis.

Adaptive Expectations Hypothesis: Definition

In business and finance, the adaptive expectations hypothesis is an economic theory that looks at past activity to predict future outcomes. The theory is especially concerned with inflation rates, or the relationship between increases in prices and decreases in purchasing power. For example, if the last few years show a steady increase in inflation rates, investors could safely expect them to rise in the future and make their investment decisions accordingly. Keep in mind that extreme changes in inflation can occur, which might cause investors to overestimate or underestimate the change in inflation rates.

Adaptive Expectations and Rational Expectations

Adaptive expectations differ from rational expectations, which form a more thorough approach to predicting an economical or financial future. Rational expectations take into consideration not only past activities, but also current activities, as well as what sensible investors believe will happen next. As a result, what economic stakeholders and investors expect to happen can affect what will happen to the economy, markets and prices in the future.

For example, Karen's wholesale fabric supplier expects prices of animal print fabrics to go up in the future. Although the prints are among her fastest-moving lines, the wholesaler may ship her less or slow down the shipments until prices go up. By decreasing Karen's supply of a high-demand product, the wholesaler himself causes the price of animal prints to go up.

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