The gamma1-isoform of protein phosphatase-1 expressed in Escherichia coli (PP1gamma) and the native PP1 catalytic subunit (PP1C) isolated from skeletal muscle dephosphorylated Ser-14 of glycogen phosphorylase at comparable rates. In contrast, PP1gamma dephosphorylated several tyrosine-phosphorylated proteins at similar rates to authentic protein tyrosine phosphatases (PTPases), but native PP1C was almost inactive towards these substrates. The phosphorylase phosphatase (PhP) and PTPase activities of PP1gamma were inhibited by vanadate with IC50 values (30-100 microM) comparable to authentic PTPases, whereas the PhP activity of native PP1C was insensitive to vanadate. PP1gamma lost its PTPase activity, and its PhP activity became insensitive to vanadate, after interaction with inhibitor-2, followed by the reversible phosphorylation of inhibitor-2 at Thr-72. These findings support and extend the hypothesis that inhibitor-2 functions like a chaperone to fold PP1 into its native conformation, and suggest that the correct folding of PP1 may be critical to prevent the uncontrolled dephosphorylation of cellular phosphotyrosine residues.