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  Adaptive Expectations and Static Expectations

Adaptive Expectations:

If expectations are as well as remain adaptive then the economy approaches the long run equilibrium, however slowly. An expansionary preliminary shock that shifts the aggregate demand relation inward on the Phillips curve diagram generates a fall in unemployment, a raise in real GDP, and an increase in inflation. Call this stage 1. Stage 1 takes place prior to anyone has had any chance to adjust their expectations of inflation.

Then arrives stage 2 managers, workers, investors and others look at what inflation was in stage 1 and increase their expectations of inflation. The Phillips curve shifts up by the difference among actual and expected inflation in stage 1. If the aggregate demand relation doesn’t shift when plotted on the Phillips curve diagram between stage 1 as well as stage 2 unemployment rises real GDP falls and inflation rises.

Then arrives stage 3 managers, workers, investors and others look at what inflation was in stage 1 and raise their expectations of inflation. The Phillips curve shifts up by the difference among actual and expected inflation in stage 2. If the aggregate demand relation doesn’t shift when plotted on the Phillips curve diagram, between stage 2 as well as stage 3 unemployment rises, real GDP falls and inflation rises. As time passes the gaps between actual as well as expected inflation between real GDP and potential output and between unemployment and its natural rate shrink toward zero.

Convergence to the Long Run under Adaptive Expectations:

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Legend: Under adaptive expectations shifts in policy have strong preliminary effects on unemployment and production however those effects on unemployment and production slowly die off over time.

Under adaptive expectations people's forecasts turns into closer and closer to being accurate as more and more time passes. Therefore the ‘long run’ arrives gradually. Every year the portion of the change in demand that isn’t implicitly incorporated in people's adaptive forecasts becomes smaller and smaller. Therefore a larger and larger proportion of the shift is ‘long run’, and a smaller and smaller proportion is ‘short run’.

Static Expectations:

Under static expectations the long run by no means arrives: the analysis of chapters 6 through 8 never becomes related. Under static expectations the gap among expected inflation and actual inflation can grow arbitrarily large as different shocks affect the economy. And if the gap among expected inflation and actual inflation becomes managers, workers, large, investors and consumers will not remain so foolish as to retain static expectations.

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