The theory of Rational Expectations was first developed by (Muth, 1961). While describing different economic scenarios, the term was used to describe the likelihood of that particular outcome which people have come to believe. For example, the price of an agricultural product depends on the acres being farmed by the farmer which is dependent on the price famers expect at the time of reaping and selling the crops. Similarly, the rate at which any currency would be depreciated depend on the rate of depreciation that is expected. This is partly because people rush to sell the currency which they believe is going to go down in the future thereby contributing to the loss in its value.
Likewise, the price of the bond and stock would be what is being expected by buyers and sellers going forward (Reddick, 2004).The use of economic theory is not new at all in the economics. (Keynes, 1924) referred to this as waves of optimism and pessimism that would define the level of economic activity. While making their mind, people predict as to what would happen in the future.
Investors have a strong incentive to use forecasting rules as being seen in the case of stock market. Higher profits are generated by those who act on the basis of better understanding about the stock market. When you are asked to forecast the price of the stock again and again, its human tendency to adjust their price level according to the market scenario. Thus, there is a continual feedback from past events for the future likelihood of occurrences of various events. The concept of rational expectation assumes that outcomes do not differ in a predicted pattern from what people expect them to be. Abraham Lincoln (Lincoln & Willey, 2014) stated the similar fact long ago when he said that ‘anyone could fool some of the people all the time and all the people at different events but it would be difficult to repeat the pattern and fool all the people all the time.
Analysts who believe in the Rational Expectations Theory base their opinion on the fact that people are guided to behave in the best interest in order to maximize their benefit (Reddick, 2004).