Although counterfactual history of thought is a highly speculative business, one can plausibly argue that without extensive work on the rational expectations hypothesis by macroeconomic theorists, John Muth's ideas would not be anywhere near as popular as they are today. Robert E. Lucas's several seminal papers in the early seventies took Muth's concept and pushed it to the forefront of current economic thought. The background for these papers was the growing professional interest in the formation and effects of inflationary expectations, a topic that was brought forcefully to the attention of the profession by Phelps (1970) and Friedman (1968). Any discussion of the rational expectations hypothesis in macroeconomics must therefore begin with the Phelps-Friedman “natural-rate” revolution.

Until the work of Phelps and Friedman, the Phillips curve was the established doctrine linking unemployment and inflation. Over two decades ago, A. W. Phillips (1958) noticed a striking inverse relationship between the British unemployment and inflation rates. This empirical observation became known as the Phillips curve and gave rise to both an extensive body of empirical studies that attempted to replicate this finding for other periods and countries, and the notion that there was an exploitable “trade-off” between inflation and unemployment. Policy makers could achieve a lower unemployment rate but only at the expense of a higher inflation rate or could achieve a lower inflation rate but only by incurring higher unemployment.

The theoretical justification for the Phillips curve was, on the surface, quite straightforward.