| Summary: | This chapter analyses the Rational Expectations Hypothesis (REH), a pillar of forward-looking macroeconomics that emphasizes expectations. It also develops its implications in terms of ‘market efficiency’ and related concepts. It then reviews New Classical Macroeconomics: its main tenets, the ‘Lucas supply function’ that is crucial for much subsequent theory, and the ‘Lucas island model’ that underpins it. The centrepiece ‘Policy Ineffectiveness Proposition’ (PIP) is developed both intuitively and more formally. Subsequently, the chapter reviews one major line of criticism of PIP, the fact that markets may not clear, based in particular on staggered wage setting. Broader criticisms of the REH, including ‘bounded rationality’, are also reviewed. The chapter concludes with yet another landmark contribution of Robert Lucas, namely the ‘Lucas critique’ of activist stabilization policy.
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