Rational Expectations Theory contains the underlying assumption that economic outcomes depend greatly on what people expect to happen. The price of a stock, for example, "depends partly on what prospective buyers and sellers believe it will be in the future." According to an article on Rational Expectations by Thomas J. Sargent in "The Fortune Encyclopedia of Economics, the use of rational expectations in economics , though first officially proposed by economist, John F. Muth in the 1960's, has been a staple of economics for much longer: The influences between expectations and outcomes flow both ways. In forming their expectations, people try to forecast what will actually occur. They have strong incentives to use forecasting rules that work well because higher "profits" accrue to someone who acts on the basis of better forecasts, whether that someone be a trader in the stock market or someone considering the purchase of a new car. And when people have to forecast a particular price over and over again, they tend to adjust their forecasting rules to eliminate avoidable errors. Thus, there is a continual feedback from past outcomes to current expectations.
"The use of expectations in economic theory is not new. Many earlier economists, including A. C. Pigou, John Maynard Keynes, and John R. Hicks, assigned a central role in the determination of the business cycle to people's expectations about the future. Keynes referred to this as "waves of optimism and pessimism" that helped determine the level of economic activity. But proponents of the rational expectations theory are more thorough in the analysis of--and assign a more important role to-- expectations.
...The concept of rational expectations asserts that outcomes do not differ systematically (i.e., regularly or predictably) from what people expected them to be." Proponents of Rational Expectations assume that "people behave in ways that maximise their utility (their enjoyment of life) or profits."
According to Sargent, "Rational expectations undermines the idea that poilicymakes can manipulate the economy by systematically making the public have false expectations. Robert Lucas showed that if expectations are rational, it simply is not possible for the government to manipulate those forecast errors in a predictable and reliable way for the very reason that the errors made by a rational forecaster are inherently unpredictable. Lucas's work led to what has sometimes been called the "policy inneffectiveness proposition". If people have rational expectations, policies that try to manipulate the economy by inducing people into having false expectations may introduce more "noise" into the economy but cannot, on average, improve the economy's performance."
It should also be noted that, during the 1950's, economist Franco Modigliani and Emile Grumburg wrote an article called, "The Predictability of Social Events, which "pointed out that people may inticipate certain government policies and act accordingly. Modigliani strenuously objects, though, to how far the rational expectations school has run with this basic insight."
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