Discussion
People quickly form and revise their expectations using all available information and intelligently predict the changes in prices and form their expectations on that basis. This statement relates to ................ .
Answer: D
This describes the Rational Expectations Approach.
The rational expectations hypothesis (Muth, later Lucas and Sargent) holds that people use all available information, including what they know about policy and how the economy works, to form expectations, so their forecasts are not systematically wrong.
Under adaptive expectations, people form expectations from past values only and correct them gradually after errors, so they lag behind events. The classical and Keynesian theories as such are not theories of how expectations are formed.
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