Dawn of expectation theories

Most of the contemprorary economic models involving the interference of individuals’ perception towards decision making were first derived from the adaptive expectation principle which holds that the future value of economic variables like economic growth, interest rates or inflation can be projected based on past figures inclusive of their margin of error. This simply means that past figures have crucial bearing over future figures unless new set of figures prove otherwise. However, adaptive expectation principle has not been able to account for the ever changing variables and concentrates only on past trends to such an extent that the proposition was abandoned in the early study of hyper inflation.

Let’s us explain this fact in light of the dividend growth model,

Po = [Do x (1 + g)] over (r -g )

Po denotes as the share price at period 0

Do denotes as dividend payout at period 0
g denotes as growth rate
r denotes as interest rate

The proposition suggests that share price is determinant of its dividend payout (Do) growing at a factor of g discounted by the real interest rate (r – g) which is also known as the interest rate adjusted for inflation.

In real life, the dividend growth is pretty much affected by the GDP growth of the economy where dividend growth [D0 x (1 + g)] is a function of GDP growth. On the other hand, the interest rate has an inverse relationship with dividend earnings that implies a higher interest rate erodes profits and hence dividend earnings distribution in terms of having a higher borrowing cost serviced. The interest rate variable is primarily determined by the current state of inflation so to speak; a higher interest rate is needed to curb a higher state of inflation. Empirical evidence also shows that a higher growth rate correlates with a higher level of inflation and thus interest rate might be rise to keep inflation at bay. All these factors are intertwinely fluctuating or even at times evolving on their accord. Hence, the adaptive expectation principle fails to explain the complexity of these economics indicators as progress over time.