Other considerations reinforced a move in the same direction. In the late
1960s, Friedman (1968) and Phelps (1968) saw, by thinking through the
issue at a general equilibrium level, that there could be no long run Phillips
curve tradeoff between inflation and real output. But such long run tradeoffs
were implicit in all of the macroeconometric models of the day, and the
econometric methods that were in standard use at that time seemed to reject
the Friedman-Phelps natural rate hypothesis. This conflict led to a re-thinking
of the theoretical basis of these statistical tests, and the discovery of
serious difficulties with them. Sargent (1971) and Lucas (1972), (1976)
showed that the conventional rejections of the natural rate hypothesis
depended critically on irrational expectations, or to put the same point backward,
that if one assumed rational expectations these tests settled nothing.
It seemed clear that it was necessary to put macroeconomics on a general
equilibrium basis that incorporated rational expectations.