Rational Expectations Hypothesis During 1930s, unemployment was the major problem and during the II world war,

Inflation emerged as the main economic problem. In the post-war years till the late 1960s again unemployment was major problem. During 1960s 1970s a strange phenomenon i.e., Stagflation appeared but not solution for that on behalf of either Keynes or any other economists and policy makers. Therefore to come out of this crisis emerged a new macroeconomic policy which is called the RATIONAL EXPECTATIONS HYPOTHESIS.

The concept of RE s was first put forwarded by Muth (1961) and Lucas (1972) Sargent (1973) who translated it into the field of macro economics in general and inflation in particular.

Definitions:

RE s is the application of the principle of rational behavior to the acquisition and processing of information and to the formation of expectations. RE s approach implies that expectations are formed on the basis of all currently available information.
Adoptive Expectations:

Expectations are framework or predictions by an Economic Agents regarding the uncertain economic variables which are relevant to economic decisions. They are based on past trends as well as current information and experience.

In recent years economists have mostly used the adoptive expectations hypothesis in model building. The pioneering work was done by Cagan in 1956 and Nerlove in 1957.

According to adoptive expectations hypotheses, economic agents expect the future to be essentially a continuation of the past.

They expect the future values of economic variables like prices, incomes etc., to be an average of past values and to change very slowly.
They revise their expectations in accordance with the last forecasting error. Errors resulting from past behavior represent an important source of information for forming expectations. Milton Friedmans analysis of the long run Philips curve is based on the adoptive expectations hypotheses.

Rational Expectations & Philips Curve: John Muth model mainly dealt with Modeling Price Movements in markets. He was able to construct a theory of Rational Expectations in which consumers and producers responses to expected price changes depended on their responses to actual price changes.

In the Friedman-Phelps acceleration hypothesis of the Philips curve, there is a short-run trade-off between unemployment and inflation but no longrun tradeoff exists.
The Rational Expectationists idea is explained diagrammatically. Suppose the UE rate is 3% and the Inflation rate is 2%. We start at point A on the SPC1 curve. In order to reduce UE, the Govt increases Money supply so price start rising.

It implies that monetary policy is unable to change the difference between the actual and NRU. This means that the economy can only be to the left or right of point N of the LR Philips curve in a random manner. Thus stabilization policy is ineffective. Thus, RATEX hypothesis stated that expansion fiscal monetary policy will have a temporary impact on UE and if continued may cause more inflation and unemployment. For such policies to be successful, they must be unanticipated by people. But it is unlikely happen all the time. So according to advocates of RATEX hypothesis, inflation can be controlled without causing widespread unemployment, if the Govt announces fiscal & MP measures and convinces the people about it and do not take them surprise.