How did the Fed slow inflation just by promising to slow inflation?
Background
The rational expectations revolution changed macroeconomics by insisting that agents' beliefs about the future should be consistent with the model's predictions. That discipline killed off many Keynesian policy conclusions that relied on agents being repeatedly fooled by policy.
But survey evidence consistently shows that expectations are heterogeneous, sluggish, and influenced by recent experience in ways that pure rational expectations models miss. Modern macro increasingly works with bounded rationality, learning, and information frictions.
What it covers
Every forward-looking decision -- saving, investing, pricing, wage bargaining -- depends on expectations about the future. A firm setting prices today cares about future demand and costs. A household saving for retirement cares about future returns and inflation. A central bank using forward guidance is betting that its words will shape the expectations that determine today's financial conditions.
The way expectations are modeled has transformed macroeconomics. The rational expectations revolution of the 1970s (Lucas, Sargent) argued that agents use all available information efficiently. Behavioral economics and survey evidence show persistent departures from that benchmark. Modern macro uses a range of expectation assumptions depending on the question.
Open question
Are economic agents forming expectations rationally based on all available information, or do information costs, behavioral biases, and institutional framing produce systematic forecast errors that policy must account for?