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The success of the Volcker disinflation led to a new era known as the Great Moderation (mid-1980s to 2007). This period was characterized by low and stable inflation, reduced volatility in output, and a near-flattening of the Phillips Curve. Many economists attributed this success to improved monetary policy frameworks, particularly . Adopted by the Reserve Bank of New Zealand in 1990 and later by many other central banks, this approach involved publicly announcing an inflation target (e.g., 2%) and adjusting interest rates preemptively to achieve it.
The 1970s delivered a devastating empirical refutation of the simple Phillips Curve. Following the OPEC oil embargo of 1973 and subsequent supply shocks, the U.S. and other developed economies experienced simultaneous rises in both unemployment and inflation—stagflation. This was theoretically impossible according to the original Phillips Curve, which had posited that one could only move along the curve, not shift it outward. Macroeconomia
The most dramatic application of this theory came during the of 1979–1982. When newly appointed Federal Reserve Chair Paul Volcker announced a determined policy to crush double-digit inflation by restricting money supply growth, rational expectations theory predicted that if the policy was credible , inflation expectations would fall quickly, and the recession would be shorter and shallower than under adaptive expectations. In reality, the policy lacked immediate credibility. Businesses and workers doubted the Fed’s resolve, leading to a deep, painful recession with unemployment peaking at nearly 11%. Only after the Fed proved its commitment through sustained contraction did expectations finally adjust, and inflation fell dramatically. This episode taught central bankers that credibility is the most valuable asset they possess. To manage expectations, they needed a clear, transparent, and consistent policy framework. The success of the Volcker disinflation led to