One of the most relevant questions in economic theory concerns the ability of government to influence the actual state of the economy and the means by which this can be done. The main debate takes place between points of view of an opposing nature: laissez-faire and the need for intervention by the authorities. The question is whether the monetary authorities are capable of managing the economy and what are the best ways to achieve this, whether there is a trade-off between economic variables, for example between inflation rates and real growth as well as employment, as proposed by the Phillips curve. The controversy over which economic policy should be adopted even intensified as expectations theory evolved. Although the notion of expectations applied in economic theories is quite broad and not new, in my essay I will focus on two main hypotheses of expectations, namely adaptive and rational expectations. Having given an overview of the evolution of expectations in economic thought, illustrating the essence of adaptive and rational expectations, I will try to find the explanation of the riddle why, after completely replacing adaptive expectations with expectations rational, the economics profession turned again towards the former after a while. I will also reflect on the issue and express my own views on the question of what type of expectations are most relevant given certain conditions. Say no to plagiarism. Get a tailor-made essay on “Why Violent Video Games Should Not Be Banned”? Get an original essay In the modern economy, expectations have taken center stage. Their importance can be explained by the fact that economic and econometric models strongly depend on the hypotheses on which they are based. Furthermore, expectations about the future are one of the most important factors that influence the decisions and behavior of economic agents. Generally speaking, if certain expectations prevail in society, this will affect how the regulatory actions of monetary authorities will influence the economy. The results of the policies implemented therefore depend to a large extent on this factor. When policy makers try to choose which policy to adopt, they rely on the predictions offered by models. Expectations theory attempts to explain how economic agents form their expectations about the future. The use of expectations to explain economic phenomena is not new, even if the peak is attributable to modern economics. Expectations were first used in economic theory by Emile Cheysson in 1887. Another contribution to the theory was made by Alfred Marshall by introducing the concept of short and long term in classical economics and the hypothesis of static expectations. Mordecai Ezekiel was the first to analyze in depth the influence of expectations on the stability of the economic balance (Ezekiel 1938). Expectations were more frequently used in the 1930s as a relevant tool for constructing macroeconomic models, for example the Fisher hypothesis which explains the inflation rate as the difference between nominal and real interest rates. Another economist of the time, Gunnar Myrdal, was studying the role of expectations in business cycles. However, the greatest influence on expectancy theory of this era was due to John Maynard Keynes and in particular his work The General Theory of Employment, Interest, and Money (1936). InDistinguishing between short-term and long-term expectations, he highlighted the importance of the latter in relation to potential investment returns and asset prices, as the main source of volatility in the economy. Although Keynes attributed a central role to expectations in predetermining the level of production and employment, he did not provide a coherent theory of how agents' expectations are formed. The first expectations models date back to the 1940s. In 1941, Lloyd Appleton Metzler constructed macroeconomic models of inventory cycles including expectations. In the 1950s and 1960s expectations were commonly used in macroeconomics regarding consumption, investment, inflation, and employment. The main period of interest in economic history for this essay begins with the widespread exploitation of adaptive expectations. In his famous book A Theory of Consumption Function (1957), Friedman argues that consumer spending depends on long-term expected income rather than current income. This theory explains the decision-making process of agents in the consumption-savings problem and is also known as the permanent income hypothesis. In 1968, Friedman and Edmund Phelps independently came to the conclusion that inflation expectations affect the current inflation rate. Analyzing the short- and long-run Phillips curve, Milton Friedman formulated the natural rate hypothesis. According to this study, inflation is already anchored in expectations and, therefore, to avoid an acceleration of inflation over time, the unemployment rate must be high enough so that actual inflation equals the expected inflation. Attempts by monetary authorities to set unemployment below its natural rate will result in ever-increasing inflation. The economics profession has adopted the view that the expected rate of inflation is the most important factor affecting actual inflation, more important than, for example, the level of unemployment. In his reasoning, Friedman used the concept of adaptive expectations. This favored the hypothesis of adaptive expectations which became common in the economy of the time. The main idea of ​​this hypothesis is that economic agents form their expectations about the future value of an economic variable (e.g. inflation) based solely on its past values. There are several forms in which the adaptive expectations hypothesis can be formulated. The most common formulation that results in better-fitting equations is the assumption that expected changes are equal to an average of past changes. For example, adaptive price expectation means that the agent revises its future price expectation by taking into account the difference between its former current price expectations and the actual current price. To give an example, according to this theory, if for several previous years the inflation rate was 2% and this year the monetary authorities adopt an expansionary policy and the inflation rate increases to 4%, this creates a brief gap between reality and perception, as in the short term. people expect inflation to be 2% based on their past experience. Aggregate demand will increase temporarily, leading to an increase in the level of GDP. According to adaptive expectations, all this is possible because the increase in inflation was unexpected and therefore there is a trade-off between inflation and the level of output in the short run. However, once people realize what has happened, they will demand higher wages, production costs will rise, and the level of production will return to its potential level.precedent with higher prices and unemployment will return to its natural level. Therefore, it is possible to temporarily mislead agents, as they examine past values ​​of the variable and then attempt to adapt if there is an error in their expectations of those values. Agents with adaptive expectations cannot react immediately to current events and must wait until they see their mistake before adjusting their expectations. They are just passive participants who do not expect future changes in the economy. This was one of the main points of criticism of this theory. Rational agents should be able to adapt their expectations and therefore their decisions and behaviors not only based on past events but also by observing current changes. Individuals form their expectations not only by looking over their shoulder at past values, but also by actively participating in the economy, monitoring current events and announcements and building anticipations on this basis as well. For example, simply by knowing what policy the government will introduce (e.g. it is an expansionary policy will result in a higher level of inflation), rational individuals can update their expectations for the future. Another drawback of adaptive expectations is that, according to this hypothesis, agents make systematic errors. This is completely in contradiction with the concept of rationality. Some authors even argue that the adaptive formalization of expectations contradicts the very purpose of constructing a theory of expectations because, according to this attitude, what influences the future is affected only by history, and not by expectations; the prospective attitude of the agents is completely lost (Gertchev 2007). The understanding and role of expectations has evolved over time. Monetarist theory gave rise to a new classical school of macroeconomic thought in the 1970s. The new classical economists disagreed with Friedman and, relying on the weaknesses of the adaptive expectations hypothesis, they developed the concept of rational expectations. In 1973, the oil crisis broke out and the American economy experienced stagflation. This was a test of existing theories and whether economic approaches to forecasting could exist. To the great surprise of supporters of monetarist theories, these methods failed. In response to this, Lucas introduced the rational expectation hypothesis based on the empirical research of Jan Tinbergen and the theoretical elaborations of John Muth (1961). He announced that existing economic models could not predict the crisis because they were based on misleading and unrealistic assumptions of adaptive expectations. Lucas argued that rational agents are active participants capable of anticipating and adjusting their expectations based on changes in the real economy. They do not react passively to the government's actions post factum, but in turn attempt to predict them. Another important development of this theory, contrary to adaptive expectations, is that agents do not make systematic errors when forming their expectations. As in the previous example, if the monetary authorities announce that they are about to introduce an expansionary policy, individuals who act in accordance with the rational expectations hypothesis may understand that this means a lower level of inflation. high during the following period and will therefore adjust their expectations without delay. If inflation actually increases, they will anticipate it in advance. Therefore, if the authorities want to increase the massmonetary, there will be no trade-off between inflation and output, even temporarily, aggregate demand will not increase and the economy will immediately end up with the same level of GDP at higher prices. The adaptive and rational expectations hypotheses, despite their differences, are still quite similar in this regard and lead to the same overall conclusions about the type of policies the government should pursue. According to both theories, the government should not intervene in the economy by adopting expansionary policies, as this would only lead to higher prices in the long run. The two theories are similar and yet ultimately different in their essence. There is, however, a large ongoing debate as to which assumption is most realistic and should be used in economic models. This discussion is also prompted by the importance of the assumptions underlying the final results and predictions provided by economic models. And these, in turn, are widely used by policymakers to predict what impact this or that movement of monetary authorities will have on the real economy and to what extent. Based on the above-mentioned considerations about the process of evolution of these theories and the ideas behind them, it seems reasonable that the rational expectations hypothesis is more advanced and realistic than the advanced expectations. In light of current technological advances, this seems even more plausible. Information is becoming more and more easily accessible; the speed of information diffusion increases, the information space transforms in such a way that the information available to the agents converges towards a perfect information concept. However, over time after rational expectations were adopted as the better alternative, they came under heavy criticism. The main puzzle is why, after a while, the economics profession began to deny rational expectations designed to eliminate erroneous assumptions that were commonly used before. There are two versions of rational expectations: “weak” and “strong”. The “strong” version assumes that individuals have access to all information and only make rational decisions based on all available knowledge. Errors can occur only due to unforeseen events. Subjective expectations are almost identical to the objective. It's as if people have a "correct model" in mind that gives unbiased predictions. The “weak” version assumes that economic agents have a limited field of information on the basis of which they form their expectations and make decisions. This is more realistic since very often people use the rule of thumb to undertake certain routine activities like grocery shopping. The majority of criticism was aimed at the “strong” version. Rational expectations have been attacked primarily because of the ambiguity regarding how individuals receive information that allows them to act unequivocally, as the “strong” version assumes. For this to become a reality, a static world with typical transactions and predictable actions of other market participants based on perfect information is needed (Garbicz 2008). However, the real world is very dynamic and obtaining information is expensive. This raises the question of whether agents can make correct predictions, in the same way. All individuals differ in their backgrounds, personal characteristics, circumstances, and access to information. Therefore, the formation of their expectations also differs. Another one..