DEFINITION of 'Adaptive Expectations Hypothesis'

A hypothesis stating that individuals make investment decisions based on the direction of recent historical data, such as past inflation rates, and adjust the data (based on their expectations) to predict future rates.

BREAKING DOWN 'Adaptive Expectations Hypothesis'

For example, if inflation over the last 10 years has been running in the 2-3% range, investors would use an inflation expectation of that range when making investment decisions. Consequently, if a temporary extreme fluctuation in inflation occurred recently, such as a cost-push inflation phenomenon, investors will overestimate the movement of inflation rates in the future. The opposite would occur in a demand-pull inflationary environment.

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