What theory holds that individuals form expectations based on all available information?

Rational expectations theory holds that individuals form expectations using all relevant information available to them.

The theory assumes that people are forward-looking rather than relying mechanically only on past observations. They use current data, knowledge of institutions, policy information, and an understanding—however imperfect—of how the economy works. Their forecasts can still be wrong, but errors should not be systematic when information is properly used.

Economist John F. Muth introduced the phrase in a 1961 paper, and Robert Lucas later made rational expectations central to modern macroeconomics. The approach challenged adaptive expectations, in which people revise forecasts gradually according to past errors. It also influenced the Lucas critique: policy evaluations should account for changes in people’s behavior when policy rules change.

Rational expectations does not mean that every person knows everything or predicts every event correctly. Unexpected shocks can still produce forecast errors. The efficient market hypothesis is related but narrower: it applies mainly to asset prices and market information, whereas rational expectations is a broader modeling assumption about economic agents.