One of the most relevant questions in economic theory concerns the government's ability to influence the real state of the economy and by what means this can be done. The main debate takes place between opposing visions: laissez-faire and the need for intervention by the authorities. The question is whether monetary authorities are capable of managing the economy and what are the best ways to do so, whether there is a trade-off between economic variables, for example between inflation rates and real growth together with employment as proposed by the Phillips. The controversy over the question of which economic policy should be adopted even intensified with the evolution of the theory of expectations. Although the notion of expectations applied in economic theories is quite broad and not new, in my essay I will focus on two main hypotheses of expectations, namely adaptive and rational expectations. After providing an overview of the evolution of expectations in economic thought, illustrating the essence of adaptive and rational expectations, I will try to find the explanation of the enigma whereby, after completely replacing adaptive expectations with rational ones, the economics profession is returned after some time to the first ones. I will also reflect on the issue and express my point of view on the question which type of expectations is more relevant depending on certain conditions. Say no to plagiarism. Get a tailor-made essay on "Why Violent Video Games Shouldn't Be Banned"? Get an original essay In the modern economy, expectations have taken a central place. Their importance can be explained by the fact that economic and econometric models strongly depend on the assumptions on which they are based. Furthermore, expectations regarding the future are one of the most significant factors influencing the decisions and behavior of economic agents. In general, if certain expectations prevail in society, this will influence how the regulatory actions of monetary authorities will affect the economy. Therefore the outcomes of the policies introduced depend to a large extent on this factor. When policy makers try to choose which policy to adopt, they rely on the predictions proposed by the models. Expectancy theory tries to explain how economic agents form their expectations about the future. Using expectations to explain economic phenomena is nothing new, although the peak represents modern economics. Expectations were first used in economic theory by Emile Cheysson in 1887. A further contribution to the theory was made by Alfred Marshall when he introduced the concept of short and long runs into classical economics and the static expectations hypothesis. Mordecai Ezekiel was the first to analyze in depth the influence of expectations on the stability of economic equilibrium (Ezekiel 1938). Expectations were used more frequently in the 1930s as a relevant tool for building macroeconomic models, for example the Fisher hypothesis explaining the inflation rate as the difference between nominal and real interest rates. Another economist of the time, Gunnar Myrdal, studied the role of expectations in business cycles. However, the greatest influence on the expectations theory of that time was John Maynard Keynes and in particular his work The General Theory of Employment, Interest, and Money (1936). Distinguishing between short-term and long-term expectations, he underlined the importance of the latter regarding future investment returns and asset prices as the main source of volatility in the economy. Although Keynes assigns a central role toexpectations in predetermining the level of production and employment, does not provide a coherent theory of how agents' anticipations are formed. The first models of expectations date back to the 1940s. In 1941 Lloyd Appleton Metzler constructed macroeconomic models of inventory cycles that included expectations. In the 1950s and 1960s expectations were commonly used in macroeconomics regarding consumption, investment, inflation and employment. The period of primary interest in economic history for this essay begins with the widespread exploitation of adaptive expectations. In his famous book A Theory of Consumption Function (1957) Friedman states that consumer spending depends on long-term expected income rather than current income. This theory explains the decision-making process of agents in the consumption saving problem and is also known as the permanent income hypothesis. In 1968, Friedman and Edmund Phelps independently concluded that inflation expectations influence the actual inflation rate. By analyzing the short-run and long-run Phillips curve, Milton Friedman formulated the natural rate hypothesis. According to it, inflation is already built into expectations and therefore, to avoid an acceleration of inflation over time, the unemployment rate must be high enough so that actual inflation equals expected inflation. Attempts by monetary authorities to keep unemployment below the natural rate will lead to ever-increasing inflation. The economics profession has adopted the view that the expected inflation rate is the most important factor influencing actual inflation, more important, for example, than the level of unemployment. In his reasoning, Friedman used the concept of adaptive expectations. This promoted the adaptive expectations hypothesis which became mainstream in economics at the time. The main idea of ​​this hypothesis is that economic agents form their expectations about the future value of some economic variable (e.g. inflation) based solely on its past values. There are several forms in which the adaptive expectations hypothesis could be formulated. The most popular formulation that provides best-fitting equations is the assumption that expected changes are equal to an average of past changes. For example, adaptive price expectation means that the agent revises his expectation of the future price by taking into account the difference between his previous expectations of the current price and the actual current price. To give an example, according to this theory if in previous years the inflation rate was 2% and this year the monetary authorities adopt an expansionary policy and the inflation rate increases to 4%, this creates a short gap between reality and perception how in the short run people expect inflation to be 2% based on their previous experience. Aggregate demand will temporarily increase, which in turn will increase the level of GDP. According to adaptive expectations, all this is possible because the increase in inflation was unexpected and therefore there is a trade-off between inflation and the level of output in the short run. However, once people realize what has happened, they will demand higher wages, production costs will rise, and the level of production will return to its previous potential level with higher prices and unemployment at its natural level. Therefore, it is possible to temporarily delude the agents, as they look at the past values ​​of the variable and then try to adapt if there is an error in their expectations about those values. Agents with adaptive expectations cannot react immediately to current events and must wait untilthey realize their mistake to adjust their expectations. They are just passive participants who do not expect future changes in the economy. This has been one of the main points of criticism of this theory. Rational agents should be able to adapt their expectations and therefore their decisions and behaviors not only based on past events but also by observing current changes. Individuals do not form their expectations only by looking back at past values, but also by actively participating in the economy, monitoring current events and announcements, and building anticipations based on them as well. For example, only by knowing what policy the government will introduce (e.g., it is a common understanding that expansionary policy will lead to a higher level of inflation) can rational individuals update their expectations for the future. A further disadvantage of adaptive expectations is that according to this hypothesis agents make systematic errors. This is completely at odds with the concept of rationality. Some authors even argue that the adaptive formalization of expectations contradicts the very purpose of building a theory of expectations because according to this attitude what influences the future is influenced only by history, not by expectations; the forward-looking attitude of the agents is completely lost (Gertchev 2007). The understanding and role of expectations have evolved over time. Monetarist theory gave rise to a new classical school of macroeconomic thought in the 1970s. The new classical economists disagreed with Friedman and, based on the weaknesses of the adaptive expectations hypothesis, developed the concept of rational expectations. In 1973, the oil crisis occurred and the American economy suffered stagflation. This was a test of existing theories and the ability of economic approaches to make predictions. To the surprise of supporters of monetarist theories, these methods failed. In response to this, Lucas introduced the rational expectation hypothesis based on the empirical research of Jan Tinbergen and the theoretical elaborations of John Muth (1961). He announced that existing economic models could not predict the crisis because they were based on misleading and unrealistic assumptions of adaptive expectations. Lucas argues that rational agents are active participants capable of anticipating and adapting their anticipations based on changes in the real economy. They do not passively react to government actions post factum, but in turn try to predict them. A more important elaboration of this counter-adaptive expectations theory is that agents do not make systematic errors while forming their expectations. Following the previous example, if the monetary authorities announce that they are willing to introduce an expansionary policy, individuals who act accordingly based on the rational expectations hypothesis can understand that this means a higher level of inflation in the following period and therefore they will adjust their expectations without waiting for inflation to actually increase, they will anticipate it in advance. Consequently, if the authorities want to increase the money supply, there will be no trade-off between inflation and output, even temporarily, aggregate demand will not increase, and the economy will immediately find itself with the same level of GDP at higher prices. Both the adaptive expectations hypothesis and the rational expectations hypothesis, despite their differences, are still quite similar in this respect and lead to the same general conclusions regarding the types of policies the government should pursue. According to both theories, the government should not intervene in the economy by implementing an expansionary policy becausein the long run this will only lead to higher prices. Both theories are similar and yet, ultimately, they are different in their essence. However, there is extensive debate about which assumption is more realistic and should be used in economic models. This discussion is also triggered by the importance of underlying assumptions for the final results and predictions provided by economic models. And these, in turn, are widely used by policy makers to predict what impact this or that movement of the monetary authorities will have on the real economy and to what extent. Based on the above-mentioned considerations about the process of evolution of these theories and the ideas that underlie them, it seems reasonable that the rational expectations hypothesis is more advanced and realistic than advanced expectations. In light of current technological advances, this seems even more plausible. Information is becoming more and more easily accessible; the speed of diffusion of information increases, the information space is transformed in such a way that the information available to the agents converges to the concept of perfect information. However, as time passed from the adoption of rational expectations as the better alternative, they were heavily criticized. The main puzzle is why after some time the economics profession began to deny rational expectations designed to eliminate previously commonly used incorrect assumptions. There are two versions of rational expectations: “weak” and “strong”. The “strong” version assumes that individuals have access to all information and make only rational decisions based on the full scope of available knowledge. Any errors could only occur due to unexpected events. Subjective expectations are almost identical to objective expectations. It is as if people have a “correct model” in their heads that provides unbiased predictions. The “weak” version assumes that economic agents have a limited scope of information on the basis of which they form their expectations and make decisions. This is more realistic since very often people use the rule of thumb to carry out some routine tasks such as buying groceries. Most of the criticism was aimed at the “strong” version. Rational expectations have been attacked above all for the ambiguity relating to the way in which individuals receive information that allows them to act unambiguously, as the “strong” version assumes. For this to become reality a static world with typical transactions and predictable actions of other market participants based on perfect information is needed (Garbicz 2008). However, the real world is very dynamic and obtaining information is expensive. This raises the question of whether agents can make correct predictions, all in the same way. All individuals differ in their backgrounds, personal characteristics, circumstances, and access to information. Therefore, the formation of their expectations also differs. Another criticism concerns the fact that the rational expectations hypothesis does not take into account the costs of acquiring the information used to form expectations (Mucha 2009). Besides the fact that in principle all agents cannot be informed in the same way, as discussed above, it is also necessary to keep in mind that, although the way in which information can be accessed has been simplified by virtue of technological advances, it requires still some costs. As already mentioned, in reality people do not remember a perfectly educated homo oeconomicus and on the contrary tend to simplify the decision-making process regarding routine tasks. Furthermore, rational expectations presuppose not only that all.