Adaptive expectations is the economic principle of forecasting future performance based on past results. This includes interest and inflation and their margin of error. The principle takes into account the errors revealed in past forecasts and makes adjustments according to real results. For this reason, the principle is also known as the error-learning hypothesis. Adaptive expectations are used to forecast figures which are then typically replaced with actual values as they unfold.
A typical equation used to calculate adaptive expectations will use a weighted average of past figures. The gap between what was forecasted in the past and what actually happened will also be included. Using this information to adjust forecasts for the future is known as partial adjustment. An equation can be continually adjusted in order to accommodate new actual figures and thus improve the chances of making an accurate forecast.
The principle of adaptive expectations came to popularity in the 1950s. After a couple of decades of widespread use, it fell out of favor in the early 1970s. This was primarily because of the limitations inherent in making projections based only on past performance and not including current trends. While the past was an effective gauge in many aspects, it could not account for the development of unforeseen trends and events in the present day that were changing the economic climate.
A new principle known as rational expectations became popular as adaptive expectations fell out of fashion. Economist John Muth was one of the primary figures involved in creating this theory in the early 1960s. It is based around the belief that if all information available, including past and current trends, is used properly, then the only factor that could make the figures dramatically inaccurate is an unanticipated event or trend.
Rational expectations are somewhat similar to adaptive expectations in that they rely primarily on what people expect. The primary difference is that it takes into consideration not only the expected behavior of people based on past events, but on what appears to be unfolding in the present. Rational expectations assume that people will generally not make errors in their forecasts, while adaptive expectations are centered on the way errors affect a forecast.
Yale economist Irving Fischer created the principle of adaptive expectations. He died in 1947, before his theory came into wide use. Fischer contributed to the economics field in several other ways, including his influential debt-deflation theory, the Phillips Curve, and the many books he wrote about the theory of investment and capital.