Econ2035_Ch7

They cannot be predicted ahead of 7me 14 ra7onal

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: •  AdapMve ExpectaMons –  Tradi7onal view of expecta7on forma7on –  Only based on past experience –  Adjustment takes place slowly •  RaMonal ExpectaMons –  Modern view of expecta7on forma7on and widely used –  Expecta7ons will be iden7cal to op7mal forecasts (The best guess of the future) using all available informa7on 12 Ra7onal Expecta7ons •  It equals the best possible forecast, given all available informaMon –  If there is a change in the way a variable moves, the way in which expecta7ons of this variables are formed will change as well •  It does not mean that predic7ons are always accurate –  If errors are predictable, then they are a part of available informa7on 13 Ra7onal Expecta7ons •  However, the expecta7ons must be correct on average –  The forecast errors of expecta7ons will, on average, be zero (posi7ve errors offset nega7ve ones in the long run) –  They cannot be predicted ahead of 7me 14 Ra7onal Expecta7ons •  Two reasons why an expecta7on may fail to be ra7onal a)  Aware of all available informa7on but find that it is too costly to make their expecta7on the best b)  People might be unaware of some available relevant informa7on, so their best guess of the future will not be accurate •  Even when an addi7onal factor is important, an expecta7on is s7ll ra7onal if the informa7on is not available 15 The Efficient Market Hypothesis •  An applica7on of the ra7onal expecta7on in finance •  Assump7on: Prices of securi7es in financial markets fully reflect all available informa7on •  Recall how to calculate the rate of return: Unknown at 7me t = + + Expected price at 7me t+1 available at 7me t − = Expected return + + − 16 The Efficie...
View Full Document

Ask a homework question - tutors are online