Systems Simulation. Expectation formation in behavioral simulation models

The nature and rationality of expectations are hotly debated in economics and management science. Expectations are usually portrayed in behavioral simulation models and system dynamics as adaptive learning processes. This paper presents a behavioral model of trend expectation formation. The model assumes expectations about the growth rate of a quantity are formed adaptively from the recent growth rate of the input variable itself. The model is then tested directly against actual forecasts in two quite different domains: short-term expectations of inflation and long-term energy demand forecasts. In both cases the model replicates the evolution of the expectations quite well over extended time periods. The results support the use of adaptive expectations and trend extrapolation. The results also suggest the presence of additional judgmental heuristics which can have dynamic and policy significance. In particular, there seem to be substantial conservatisms in both inflation expectations and energy demand forecasts: forecasters systematically underestimate the growth rate of the input. Such conservatisms are consistent with the empirical literature on judgment and decision making. The results show it is possible to test the expectation formation processes assumed in behavioral simulation models; implications for use of adaptive expectations in behavioral models when empirical data are unavailable are also discussed.