i) Adaptive Expectations and Rational Expectations:
Adaptive Expectations: Adaptive expectations is an economic theory that suggests individuals form their expectations about future variables, such as inflation or economic growth, based on past observations and experiences. In other words, people adjust their expectations incrementally over time, often by assuming that future outcomes will be similar to recent trends. Adaptive expectations can lead to lagged adjustments and may not always accurately predict future outcomes, especially in the face of unexpected events or changes.
Rational Expectations: Rational expectations theory posits that individuals form their expectations based on all available information, including their understanding of economic theory and the expectations of others. It assumes that people are forward-looking and make predictions that are unbiased and efficient given the information at hand. Rational expectations incorporate both current and future information, leading to more accurate forecasts of economic variables. This theory suggests that individuals’ expectations are optimal in the sense that they minimize forecasting errors on average.
Key Difference: The key difference between adaptive expectations and rational expectations lies in how individuals form their expectations. Adaptive expectations rely on past observations and tend to lag behind changes in economic variables, while rational expectations incorporate all available information and are forward-looking. Rational expectations theory implies that economic agents are sophisticated and capable of making the best possible predictions, considering the information they have.
ii) Absolute and Relative Purchasing Power Parity (PPP):
Absolute Purchasing Power Parity (PPP): Absolute PPP is an economic theory that suggests that in the absence of transportation costs and trade barriers, identical goods should have the same price when expressed in a common currency across different countries. This theory is based on the idea that exchange rates should adjust to equalize the purchasing power of different currencies for the same goods. However, in reality, factors such as transaction costs, taxes, and market imperfections can prevent perfect equalization of prices.
Relative Purchasing Power Parity (PPP): Relative PPP is a refined version of the PPP theory that takes into account changes in exchange rates over time. It states that the percentage change in the exchange rate between two currencies should be approximately equal to the difference in their inflation rates. In other words, if one country has a higher inflation rate than another, its currency should depreciate in value relative to the other country’s currency to maintain purchasing power parity.
Key Difference: The key difference between absolute and relative PPP lies in their focus on price levels and changes in price levels over time. Absolute PPP is concerned with the direct relationship between prices of identical goods, while relative PPP considers the effect of inflation differentials on exchange rates. Relative PPP takes into account the changes in purchasing power parity that can occur due to differences in inflation rates between countries.