Click through the slides in this presentation to review the distinction between adaptive and rational expectations.

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New Classical Economists ask why people don’t learn that they consistently underestimate inflation? Shouldn’t they learn from their mistakes? If individuals are rational, shouldn’t they use all available information to improve their predictions of inflation, not just past values of it? Moreover, if inflation is determined through some systematic process, shouldn’t finding out the process and using it to forecast improve one’s predictions? These questions led to the theory of rational expectations.

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Rational expectations says that economic agents should use all the information they have about how the economy operates to make predictions about economic variables in the future. The predictions may not always be right, but people should learn over time and improve their predictions.