Do people really design their forms using pure XAML (manually creating XAML code)?
Yes, many people do. Designers are getting more popular, but understanding the generated XAML is very useful. The trick here isn't to think in Windows Forms terms - if you look at Windows Forms generated code, it's a lot of code to do something very simple - look at how many lines of code is required to place and wire up a button, for example. In WPF, you can do this with a single XAML element, and have a lot more flexibility in the process as you go.
The only thing I can think of that might be more tedious than this approach is writing forms in assembler.
I actually disagree. XAML takes some getting used to, but it's highly descriptive, so you can make a very usable UI in very little time.
Are tools like Expression Blend designed to allow you to develop WPF forms the traditional drag/drop way and then create the XAML for you?
Yes. The Visual Studio 2010 designer does a good job for simple cases - Blend is much more feature rich, however. It especially shines when it comes to doing more elaborate styling - once up to speed in it, you'll find you can customize a UI in Blend in ways you never imagined in Windows Forms, very quickly and easily.