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This paper investigates empirically the degree of substitutability between debt and equity securities in the United States during 1960-1980. The analysis first applies fundamental relationships connecting portfolio choices with expected asset returns to infer key asset substitutabilities directly from the observed U.S. asset return experience. It then compares these implied substitutabilities with the observed portfolio behavior of U.S. households. The resulting evidence provides little ground for any conclusion about even the sign, much less the magnitude, of the substitutability of short-term debt and equity. Although the implied optimal behavior indicates that these two assets are substitutes, the observed behavior indicates that households have treated them as complements. By contrast, the evidence consistently indicates that long-term debt and equity are substitutes. Moreover, with a few exceptions the empirical estimates of the associated substitution elasticity are quite closely clustered around the value -.035. The conclusion that long-term debt and equity are substitutes with elasticity -.035 bears mixed implications for broader economic and financial questions. At one level, the finding that the two assets are indeed substitutes validates the standard assumption underlying a variety of familiar models in monetary economics and finance. At the same time, if the elasticity is only -.035, then many of these models' more important substantive conclusions do not follow.

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The experience of costly disinflation in the early 1980s has contradicted the central policy promise of the new classical macroeconomics just as sharply as the experience of accelerating inflation in the l970s contradicted the chief promise of earlier thinking. Much of the attractive appeal of each approach rested on its holding out the prospect of successfully dealing with the foremost macroeconomic policy issue of its time -unemployment in the earlier case, and inflation more recently -without incurring the costs that previous thinking associated with effective solutions. Inflation did accelerate in the 1970s, however, and now the real economic costs of disinflation have proved remarkably in line with conventional estimates antedating the new classical macroeconomics. The implication of this unfortunate outcome is not, of course, simply to return to earlier approaches,but to retain what is theoretically appealing about the methodology of the new classical macroeconomics i a form that does not lead to falsified policy conclusions.