The Winds of Change
As the decade of the eighties began, there was controversy and debate about the nature of the macroeconomic world. Among academic economists, new ideas had been surfacing throughout the seventies, especially the rational-expectations notions of Robert Lucas, Thomas Sargent, Robert Barro, and others. 1 Their basic premise, that participants in market processes accurately anticipate future market developments, especially price movements, put expectations at the forefront of economic analysis. Within the context of the macroeconomic conditions of the 1970s, it provided a much more appealing explanation for events than the negatively sloped Phillips curve of the sixties. It can be argued that the almost vertical Phillips curve of the seventies reflected anticipation by markets of the effect of the traditional tools of demand management—monetary and fiscal policy—on price levels and the like. If anticipated inflation is approximately equal to actual inflation, the impact of policies of demand management are effectively discounted by markets and it becomes impossible to drive the unemployment rate below its natural or equilibrium level, even temporarily. In short, it is not possible in a rational-expectations world to create the money illusion in labor markets that characterized the 1960s.
At the other extreme from the rational-expectations view were the Keynesians who, in the Eckstein mode, maintained their faith in the notion that the unemployment rate can be manipulated at will, even though the cost, in terms of price inflation, may be substantial. For the confirmed Keynesian or neo-Keynesian, there was still no equilibrium constraint on the unemployment side.