# History of macroeconomic thought

1st row: Quantity theorist Irving Fisher, John Maynard Keynes, Neo-Keynesian Franco Modigliani
2nd row: Neo-Keynesian Robert Solow, monetarist Milton Friedman, monetarist Anna Schwartz
3rd row: New classical Thomas J. Sargent, new Keynesian Stanley Fischer, real business cycle theorist Edward C. Prescott

Macroeconomic theory has its origins in the study of business cycles and monetary theory.123 John Maynard Keynes attacked some of these earlier theories and produced a general theory of the economy that described the whole economy in terms of aggregates instead of looking at individual, microeconomic parts. Keynes attempted to explain unemployment and recessions. He argued that the tendency for people and businesses to hoard cash and avoid investment during a recession invalidated the assumptions of earlier, "classical" economists who thought markets always clear, leaving no surplus of goods and no willing labor left idle.4

A generation of economists following Keynes synthesized his theory with neoclassical microeconomics to form the neoclassical synthesis. Keynesian theory originally omitted a theory of price levels and inflation. Later Keynesians adopted the Phillips curve to model price level changes. Some Keynesian economists opposed the synthesis method of combining Keynes's theory with an equilibrium system and advocated using disequilibrium models instead. Monetarists, led by Milton Friedman, adopted some Keynesian ideas, such as the importance of the demand for money, but argued that Keynesians ignored the money supply's role in inflation.5 Robert Lucas and other new classical macroeconomists criticized Keynesian models that did not work under rational expectations. Lucas also argued that Keynesian empirical models would not be as stable as models based on microeconomic theories.

The new classical school culminated in real business cycle theory (RBC). Like classical economic models, RBC models assumed that markets clear and business cycles are driven by changes in technology and supply, not demand. New Keynesians tried to address many of the criticisms. They built models with microfoundations of sticky prices that suggested recessions could still be explained by demand factors because price rigidities stop prices from falling to a market clearing level, leaving a surplus of goods and labor. The new neoclassical synthesis combined elements of both new classical and new Keynesian macroeconomics into a consensus. Other economists avoided the new classical and new Keynesian debate on short-term dynamics and developed the new growth theories of long-run economic growth.6

## Origins

Early monetary theorists Alfred Marshall, Arthur Cecil Pigou, and Keynes were based at University of Cambridge.7 Pigou and Keynes were associated with the constituent King's College (chapel shown above).8

Macroeconomics descends from two areas of research: Business cycle theory and monetary theory.12 Monetary theory dates back to the 16th century and the work of Martín de Azpilcueta, while business cycle analysis dates from the mid 19th.2

Beginning with William Jevons and Clément Juglar in the 1860s,9 economists attempted to describe the cyclical activity of frequent, violent shifts in economic activity.10 The foundation of the National Bureau of Economic Research by Wesley Mitchell in 1920 marked the beginning of a boom in atheoretical statistical models of economic fluctuation that led to the discovery of apparently regular economic patterns like the Kuznets wave.11

Other economists focused more on theory in their business cycle analysis. Most business cycle theories focused on a single factor,10 such as monetary policy or the impact of weather on the largely agricultural economies of the time.9 Business cycle theory was well established by the 1920s. However, work by business cycle theorists such as Dennis Robertson and Ralph Hawtrey had little impact on public policy.12 Their partial equilibrium theories could not capture general equilibrium, where markets interact with each other; in particular, early business cycle theories treated goods markets and financial markets separately.10 Research in these areas used microeconomic methods to explain employment, price level, and interest rates.13

### Monetary theory

Initially, the relationship between price level and output was explained by the quantity theory of money.14 David Hume presented a quantity theory in his 1752 work Of Money.14 The quantity theory viewed the entire economy through Say's law, which stated that whatever is supplied to the market will be sold: that markets always clear.4 In this view, money is neutral and cannot impact the real factors in an economy like output levels. This was consistent with the classical dichotomy view that real aspects of the economy and nominal factors, such as price levels and money supply, can be considered independent from one another.15 For example, adding more money to an economy would be expected only to raise prices, not to create more goods.16

The quantity theory of money dominated macroeconomic theory until the 1930s.14 Two versions were particularly influential, one developed by Irving Fisher in works that included his 1911 The Purchasing Power of Money and another by Cambridge economists over the course of the early 20th century.14 Fisher's version of the quantity theory can be expressed by holding money velocity (the frequency with which a given piece of currency is used in transactions) (V) and real income (Q) constant and allowing money supply (M) and the price level (P) to vary in the equation of exchange:17

$M\cdot V = P\cdot Q$

Most classical theories, including Fisher's, held that velocity was stable and independent of economic activity.18 Cambridge economists, including Keynes, began to challenge this assumption. They developed the Cambridge cash balance theory, which looked at money demand and how it impacted the economy. The Cambridge theory did not assume money demand and supply are always at equilibrium, and it accounted for people holding more cash when the economy sagged. By factoring in the value of holding cash, the Cambridge economists took significant steps toward the concept of liquidity preference that Keynes would later develop.19 Cambridge theory argued that people hold money for two reasons: to facilitate transactions and to maintain liquidity. In later work, Keynes added a third motive, speculation, to his liquidity preference theory and built on it to create his general theory.20

Knut Wicksell proposed a monetary theory centered on interest rates. His analysis used two interest rates: the market interest rate, determined by the banking system, and the real or "natural" interest rate, determined by the rate of return on capital.21 In Wicksell's theory, first published in 1898, cumulative inflation will occur when technical innovation causes the natural rate to rise or when the banking system allows the market rate to fall. Cumulative deflation occurs under the opposite conditions causing the market rate to rise above the natural.2 Wicksell's theory did not produce a direct relationship between the quantity of money and price level. According to Wicksell, money would be created endogenously, without an increase in quantity of hard currency, as long as the natural exceeded the market interest rate . In these conditions, borrowers turn a profit and deposit cash into bank reserves, which expands money supply.22 This can lead to a cumulative process where inflation increases continuously without an expansion in the monetary base.22 Wicksell's work influenced Keynes and the Swedish economists of the Stockholm School.22

## Keynes's General Theory

Keynes (right) with Harry Dexter White, assistant secretary of the U.S. Treasury, at a 1946 International Monetary Fund meeting

Modern macroeconomics can be said to have begun with Keynes and the publication of his book The General Theory of Employment, Interest and Money in 1936.23 Keynes expanded on the concept of liquidity preferences and built a general theory of how the economy worked. Keynes's theory was the first to bring together both monetary and real economic factors,10 explain unemployment and recessions, and provide a potential model for achieving economic stability.

Keynes contended that economic output is positively correlated with money velocity.24 He explained the relationship via changing liquidity preferences:25 people increase their money holdings in bad economic times, by reducing their spending, further slowing the economy. This paradox of thrift claimed that individual attempts to survive a downturn only worsen it. When the demand for money increases, money velocity slows. A slow down in economic activities means markets might not clear, leaving excess goods to waste and capacity to idle.26

Turning the quantity theory on its head, Keynes argued that market changes shift quantities rather than prices.27 Keynes replaced the assumption of stable velocity with one of a fixed price-level. If spending falls and prices do not, the excess goods reduce the need for workers, increasing unemployment.28 Classical economists had difficulty explaining involuntary unemployment and recessions because they applied Say's Law to the labor market and expected that all those willing to work at the prevailing wage would be employed.29 In Keynes's model, employment and output are driven by aggregate demand, the sum of consumption and investment.30 Investment fluctuates more than consumption, depending on changes in factors including expectations, "animal spirits", and interest rates.30 Keynes argued that fiscal policy could compensate for this volatility. During downturns, government could increase spending to purchase excess and goods and employ idle labor.31 Moreover, a multiplier effect increases the effect of this direct spending since newly employed workers would spend their income, which would percolate through the economy, while firms would invest to respond to the increase in demand.25

Keynes's prescription for strong public investment had ties to his interest in uncertainty.32 Keynes had given a unique perspective on the statistical inference in A Treatise on Probability, written in 1921, years before his major economic works.33 Keynes thought strong public investment and fiscal policy would counter the negative impacts the uncertainty of economic fluctuations can have on the economy.32 While Keynes's successors paid little attention to the probabilistic aspects of his work, uncertainty may have played a central part in the investment and liquidity preference aspects of the General Theory.32

The exact meaning of Keynes's work has been long debated.34 Even the interpretation of Keynes's policy prescription for unemployment, one of the more explicit parts of The General Theory, has been the subject of debates. Economists and scholars debate whether Keynes intended his advice to be a major policy shift to address a serious problem or a moderately conservative solution to deal with a minor issue.34

## Keynes's successors

Keynes's successors debated the exact formulations, mechanisms, and consequences of the Keynesian model. One group emerged representing the "orthodox" interpretation of Keynes; They combined classical microeconomics with Keynesian thought to produce the "neoclassical synthesis."35 Two camps of Keynesians were critical of the synthesis interpretation of Keynes. Some of these Keynesian economists focused on the disequilibrium aspects of Keynes's work while the other group took a fundamentalist stance on Keynes and began the heterodox Post Keynesian tradition.36

### Neoclassical synthesis

The generation of economists following Keynes, Neo-Keynesians, created the "neoclassical synthesis" by combining Keynes's macroeconomics with neoclassical microeconomics.37 Neo-Keynesians dealt with two microeconomic issues: First, providing foundations for aspects of Keynesian theory such as consumption and investment, and, second, combining Keynesian macroeconomics with general equilibrium theory.38 (In general equilibrium theory, individual markets interact with one another and an equilibrium price exists if there is perfect competition, no externalities, and perfect information.)3539 Paul Samuelson's Foundations of Economic Analysis (1947) provided much of the microeconomic basis for the synthesis.37 Samuelson's work set the pattern for the methodology used by Neo-Keynesians: economic theories expressed in formal, mathematical models.40 While Keynes's theories prevailed in this period, his successors largely abandoned his informal methodology in favor of Samuelson's.41

The neoclassical synthesis dominated economics from the 1940s until the early 1970s.42 By the mid-1950s, the vast majority of economists had ceased debating Keynesianism and accepted the synthesis view;43 however, room for disagreement remained.44 The synthesis attributed problems with market clearing to sticky prices that failed to adjust to changes in supply and demand.45 Another group of Keynesian economists focused on disequilibrium economics and tried to reconcile the concept of equilibrium with the absence of market clearing.46

### Neo-Keynesian models

IS/LM chart with an upward shift in the IS curve. The chart illustrates how a shift in the IS curve, caused by factors like increased government spending or private investment, will lead to higher output (Y) and increased interest rates (i).

In 1937 John Hicksa published an article that incorporated Keynes's thought into a general equilibrium framework47 where the markets for goods and money met in an overall equilibrium.48 Hick's IS/LM (Investment-Savings/Liquidity preference-Money supply) model became the basis for decades of theorizing and policy analysis into the 1960s.49 The model represents the goods market with the IS curve, a set of points representing equilibrium in investment and savings. The money market equilibrium is represented with the LM curve, a set of points representing the equilibrium in supply and demand for money. The intersection of the curves identifies an aggregate equilibrium in the economy50 where there are unique equilibrium values for interest rates and economic output.51 Other economists built on the IS/LM framework. Notably, in 1944, Franco Modiglianib added a labor market. Modigliani's model represented the economy as a system with general equilibrium across the interconnected markets for labor, finance, and goods,47 and it explained unemployment with rigid nominal wages.52

Growth had been of interest to classical economists like Adam Smith, but work tapered off during the 19th and early 20th century marginalist revolution when researched focused on microeconomics.53 The study of growth revived when Neo-Keynesian economists Roy Harrod and Evsey Domar independently developed the Harrod-Domar model,54 an extension of Keynes's theory to the long-run, an area Keynes had not looked at himself.55 Their models combined Keynes's multiplier with an accelerator model of investment,56 and produced the simple result that growth equaled the savings rate divided by the capital output ratio (the amount of capital divided by the amount of output).57 The Harrod-Domar model dominated growth theory until Robert Solowc and Trevor Swand independently developed neoclassical growth models in 1956.54 The Harrod-Domar model faced a major weakness since it suggested an unstable, "knife's edge" growth equilibrium. For the model to stay at equilibrium, both capital and labor would have to grow at the same rate; otherwise, the economy could spiral downward with lower output and increasing unemployment. This model did not match empirical data where observed swings in output were much less dramatic than those predicted.58 Solow and Swan produced a more empirically appealing model with "balanced growth" based on the substitution of labor and capital in production.59 The Solow and Swan suggested that increased savings could only temporarily increase growth and only technological improvements could increase growth in the long-run.60 After Solow and Swan, growth research tapered off with little or no research on growth from 1970 until 1985.54

Economists incorporated the theoretical work from the synthesis into large-scale macroeconometric models that combined individual equations for factors such as consumption, investment, and money demand61 with empirically observed data.62 This line of research reached its height with the MIT-Penn-Social Science Research Council (MPS) model developed by Modigliani and his collaborators.61 MPS combined IS/LM with other aspects of the synthesis including Robert Solow's growth model63 and the Phillips curve relation between inflation and output.64 Both large-scale models and the Phillips curve became targets for critics of the synthesis.

### Phillips curve

The US economy in the 1960s followed the Phillips curve, a correlation between inflation and unemployment.

Keynes did not lay out an explicit theory of price level.65 Early Keynesian models assumed wage and other price levels were fixed.66 These assumptions caused little concern in the 1950s when inflation was stable, but by the mid-1960s inflation increased and became an issue for macroeconomic models.67 In 1958 A.W. Phillipse set the basis for a price level theory when he made the empirical observation that inflation and unemployment seemed to be inversely related. In 1960 Richard Lipseyf provided the first theoretical explanation of this correlation. Generally Keynesian explanations of the curve held that excess demand drove high inflation and low unemployment while an output gap raised unemployment and depressed prices.68 In the late 1960s and early 1970s, the Phillips curve faced attacks on both empirical and theoretical fronts. The presumed trade-off between output and inflation represented by the curve was the weakest part of the Keynesian system.69

### Disequilibrium macroeconomics

Some Keynesians placed less importance on price rigidities and continued to emphasize uncertainty, imperfect competition, and other possible sources of business cycles and unemployment. This line of research led to the development of disequilibrium models. In the neoclassical synthesis, equilibrium models were the rule. In these models, rigid wages modeled unemployment at equilibria. These models were challenged by Don Patinkin,70 Robert W. Clower (1965)g and Axel Leijonhufvud (1968)h focused on the role of disequilibrium.71 Clower and Leijonhufvud argued that disequilibrium formed a fundamental part of Keynes's theory and deserved greater attention.72 Robert Barro and Herschel Grossman formulated general disequilibrium modelsi in which individual markets were locked into prices before there was a general equilibrium. These markets produced "false prices" resulting in disequilibrium.73 Soon after the work of Barro and Grossman, disequilibrium models fell out of favor in the United States,747576 and Barro abandoned Keynesianism and adopted new classical, market-clearing hypotheses.77

Diagram based on Malinvaud's typology of unemployment shows curves for equilibrium in the goods and labor markets given wage and price levels. Walrasian equilibrium is achieved when both markets are at equilibrium. According to Malinvaud the economy is usually in a state of either Keynesian unemployment, with excess supply of goods and labor, or classical unemployment, with excess supply of labor and excess demand for goods.78

In France, Jean-Pascal Bénassy (1975)j and Yves Younès (1975)k studied macroeconomic models with fixed prices. Disequilibrium economics received greater research as mass unemployment returned to Western Europe in the 1970s. European economists such as Edmond Malinvaud and Jacques Drèze expanded on the disequilibrium tradition and worked to explain price rigidity instead of simply assuming it.79

Malinvaud (1977)l used disequilibrium analysis to develop a theory of unemployment.80 He argued that disequilibrium in the labor and goods markets could lead to rationing of goods and labor, leading to unemployment.81 Malinvaud adopted a fixprice framework and argued that pricing would be rigid in modern, industrial prices compared to the relatively flexible pricing systems of raw goods that dominate agricultural economies.81 Prices are fixed and only quantities adjust.82 Malinvaud considers an equilibrium state in classical and Keynesian unemployment as most likely.83 Work in the neoclassical tradition is confined as a special case of Malinvaud's typology, the Walrasian equilibrium. In Malinvaud's theory, reaching the Walrasian equilibrium case is almost impossible to achieve given the nature of industrial pricing.84

## Monetarism

Milton Friedman developed an alternative to Keynesian macroeconomics eventually labeled monetarism. Generally monetarism is the idea that the supply of money matters for the macroeconomy.85 When monetarism emerged in the 1950s and 1960s, Keynesians neglected the role money played in inflation and the business cycle, and monetarism directly challenged those points.5

### Criticizing and augmenting the Phillips curve

The Phillips curve appeared to reflect a clear, inverse relationship between inflation and output. The curve broke down in the 1970s as economies suffered simultaneous economic stagnation and inflation known as stagflation. The empirical implosion of the Phillips curve followed attacks mounted on theoretical grounds by Friedman and Edmund Phelps. Phelps, although not a monetarist, argued that only unexpected inflation or deflation impacted employment. Variations of Phelps's "expectations-augmented Phillips curve" became standard tools. Friedman and Phelps used models with no long-run trade-off between inflation and unemployment. Instead of the Phillips curve they used models based on the natural rate of unemployment where expansionary monetary policy can only temporarily shift unemployment below the natural rate. Eventually, firms will adjust their prices and wages for inflation based on real factors, ignoring nominal changes from monetary policy. The expansionary boost will be wiped out.86

### Importance of money

Anna Schwartz collaborated with Friedman to produce one of monetarism's major works: A Monetary History of the United States (1963) that linked money supply to the business cycle.87 The Keynesians of the 1950s and 60s had adopted the view that monetary policy does not impact aggregate output or the business cycle. They based this belief on evidence that, during the Great Depression, interest rates had been extremely low but output remained depressed.88 Friedman and Schwartz argued that Keynesians missed the relationship by only looking at nominal rates and neglecting the role inflation plays in real interest rates, which had been high during much of the Depression and monetary policy had effectively been contractionary.89

Friedman developed his own quantity theory of money that referred to Irving Fisher's but inherited much from Keynes.90 Friedman's 1956 "The Quantity Theory of Money: A Restatement"m incorporated Keynes's demand for money and liquidity preference into an equation similar to the classical equation of exchange.91 Friedman's updated quantity theory also allowed for the possibility of using monetary or fiscal policy to remedy a major downturn.92 Friedman broke with Keynes by arguing that money demand is relatively stable—even during a downturn.91 Friedman and other monetarists argued that "fine-tuning" through fiscal and monetary policy is counterproductive. They found money demand to be stable even during fiscal policy shifts,93 and that both fiscal and monetary policies suffer from lags that made them too slow to prevent mild downturns.94

### Prominence and decline

Money velocity had been stable and grew consistently until around 1980 (green). After 1980 (blue), money velocity became erratic and the monetarist assumption of stable money velocity was called into question.95

Monetarism attracted the attention of policy makers in the late 1970s and 1980s. Friedman and Phelps's version of the Phillips curve performed better during stagflation and gave monetarism a boost in credibility.96 By the mid-1970s monetarism had become the new orthodoxy in macroeconomics,97 and by the late–1970s central banks in the United Kingdom and United States had largely adopted a monetarist policy of targeting money supply instead of interest rates when setting policy.98 However, targeting monetary aggregates proved difficult for central banks because of measurement difficulties.99 Monetarism faced a major test when Paul Volcker took over the Federal Reserve Chairmanship in 1979. Volcker tightened the money supply and brought inflation down, creating a severe recession in the process. The recession lessened monetarism's popularity, but clearly demonstrated the importance of money supply in the economy.5 Monetarism became less credible when once-stable money velocity defied monetarist predictions and began to move erratically in the United States during the early 1980s.95 Monetarist methods of single-equation models and non-statistical analysis of plotted data also lost out to the simultaneous-equation modeling favored by Keynesians.100 Monetarism's policies and method of analysis lost influence among central bankers and academics, but its core tenets of the long-run neutrality of money (increases in money supply cannot have long-term effects on real variables, such as output) and use of monetary policy for stabilization became a part of the macroeconomic mainstream even among Keynesians.599

## New classical economics

Much of new classical research was conducted at the University of Chicago.

Following monetarism, a further challenge to the Keynesian paradigm came in the mid-1970s from the closely related school of "new classical economics." New classical economics and monetarism share a basis in classical economics,101 and monetarism has been labeled as the "first wave" of new classical economics.102 However, the schools had clear differences. New classical economists did not share the monetarist belief that monetary policy could systematically impact the economy.103 They also broke with Keynesian economic theory completely while the monetarists built on Keynesian ideas.104 While ignoring Keynesian theory, new classical economists did share the Keynesian focus on explaining short-run fluctuations. New classical economists replaced monetarists as Keynes's primary opponents and changed the primary debate in macroeconomics from whether to look at short-run fluctuations to whether macroeconomic models should be grounded in microeconomic theories.105 Like monetarism, new classical economics was rooted at the University of Chicago, principally with Robert Lucas. Other leaders in the development of new classical economics include Finn Kydland at Carnegie Mellon, Edward Prescott at University of Minnesota, and Robert Barro at Harvard.

New classical economists wrote that earlier macroeconomic theory was based only tenuously on microeconomic theory and described its efforts as providing "microeconomic foundations for macroeconomics." New classical economists also introduced rational expectations, and they argued that governments had little ability to stabilize the economy given the rational expectations of economic agents. Most controversially,106 new classical economists revived the market-clearing assumption, assuming both that prices be flexible and that the market should be modeled at equilibrium.106

### Rational expectations and policy irrelevance

John Muth first proposed rational expectations when he criticized the cobweb model (example above) of agricultural prices. Muth showed that agents making based on rational expectations would be more successful than those who made their estimates based on adaptive expectations, which could lead to the cobweb situation above where decisions about producing quantities (Q) lead to prices (P) spiraling out of control away from the equilibrium of supply (S) and demand (D).107108

Keynesians and monetarists recognized that people based their economic decisions on expectations about the future. However, until the 1970s, most models relied on adaptive expectations, which assumed that expectations were based on an average of past trends.109 For example, if inflation averaged 4% over a period, economic agents were assumed to expect 4% inflation the following year.109 In 1972 Lucas,n influenced by a 1961 agricultural economics paper by John Muth,o introduced rational expectations to macroeconomics.110 Essentially, adaptive expectations modeled behavior as if it were backward-looking while rational expectations modeled economic agents (consumers, producers and investors) who were forward-looking.111 New classical economists also claimed that an economic model would be internally inconsistent if it assumed that the agents it models behave as if they were unaware of the model.112 Under the assumption of rational expectations, models assume agents make predictions based on the optimal forecasts of the model itself.109 This did not imply that people have perfect foresight,113 but that they act with an informed understanding of economic theory and policy.114

Thomas Sargent and Neil Wallace (1975)p applied rational expectations to models with Phillips curve trade-offs between inflation and output and found that monetary policy could not be used to systematically stabilize the economy. Sargent and Wallace's policy ineffectiveness proposition found that economic agents would anticipate inflation and adjust to higher price levels before the influx of monetary stimulus could boost employment and output.115 Only unanticipated monetary policy could increase employment, and no central bank could systematically use monetary policy for expansion without economic agents catching on and anticipating price changes before they could have a stimulative impact.116

Robert E. Hallq applied rational expectations to Friedman's permanent income hypothesis that people base the level of their current spending on their wealth and lifetime income rather than current income.117 Hall found that people will smooth their consumption over time and only alter their consumption patterns when their expectations about future income change.118 Both forms of the permanent income hypothesis challenged the Keynesian view that short-term stabilization policies like tax cuts can stimulate the economy.117 The permanent income view suggests that consumers base their spending on wealth and not income, so a temporary boost in income would only produce a moderate increase in consumption.117 Empirical tests of Hall's hypothesis suggest it may understate boosts in consumption due to income increases;119 however, Hall's work helped to popularize Euler equation models of consumption.119

### The Lucas critique and microfoundations

In 1976 Lucas wrote a paperr criticizing large-scale Keynesian models used for forecasting and policy evaluation. Lucas argued that economic models based on empirical relationships between variables are unstable as policies change: a relationship under one policy regime may be invalid after the regime changes.112 The Lucas's critique went further and argued that a policy's impact is determined by how the policy alters the expectations of economic agents. No model is stable unless it accounts for expectations and how expectations relate to policy.120 New classical economists argued that abandoning the disequilibrium models of Keynesianism and focusing on structure- and behavior-based equilibrium models would remedy these faults.121 Keynesian economists responded by building models with microfoundations grounded in stable theoretical relationships.122

### Lucas supply theory and business cycle models

Lucas and Leonard Rappings laid out the first new classical approach to aggregate supply in 1969. Under their model, changes in employment are based on worker preferences for leisure time. Lucas and Rapping modeled decreases in employment as voluntary choices of workers to reduce their work effort in response to the prevailing wage.123

Lucas (1973)t proposed a business cycle theory based on rational expectations, imperfect information, and market clearing. While building this model, Lucas attempted to incorporate the empirical fact that there had been a trade-off between inflation and output without ceding that money was non-neutral in the short-run.124 This model included the idea of money surprise: monetary policy only matters when it causes people to be surprised or confused by the price of goods changing relative to one another.125 Lucas hypothesized that producers become aware of changes in their own industries before they recognize changes in other industries. Given this assumption, a producer might perceive an increase in general price level as an increase in the demand for his goods. The producer responds by increasing production only to find the "surprise" that prices had increased across the economy generally rather than specifically for his goods.126 This "Lucas supply curve" models output as a function of the "price" or "money surprise," the difference between expected and actual inflation.126 Lucas's "surprise" business cycle theory fell out of favor after the 1970s when empirical evidence failed to support this model.127128

George W. Bush meets Kydland (left) and Prescott (center) at an Oval Office ceremony in 2004 honoring the year's Nobel Laureates.

While "money surprise" models floundered, efforts continued to develop a new classical model of the business cycle. A 1982 paper by Kydland and Prescottu introduced real business cycle theory (RBC).129 Under this theory business cycles could be explained entirely by the supply side and represented the economy with systems at constant equilibrium.130 RBC dismissed the need to explain business cycles with price surprise, market failure, price stickiness, uncertainty, and instability.131 Instead, Kydland and Prescott built parsimonious models that explained business cycles with changes in technology and productivity.127 Employment levels changed because these technological and productivity changes altered the desire of people to work.127 RBC rejected the idea of high involuntary unemployment in recessions127 and not only dismissed the idea that money could stabilize the economy but also the monetarist idea that money could destabilize it.132

Real business cycle modelers sought to build macroeconomic models based on microfoundations of Arrow–Debreu133 general equilibrium.134135136137 RBC models were one of the inspirations for dynamic stochastic general equilibrium (DSGE) models. DSGE models have become a common methodological tool for macroeconomists—even those who disagree with new classical theory.129

## New Keynesian economics

New classical economics had pointed out the inherent contradiction of the neoclassical synthesis: Walrasian microeconomics with market-clearing and general equilibrium could not lead to Keynesian macroeconomics where markets failed to clear. New Keynesians recognized this paradox, but, while the new classicals abandoned Keynes, new Keynesians abandoned Walras and market-clearing.138 During the late 1970s and 1980s, new Keynesian researchers investigated how market imperfections like monopolistic competition, nominal frictions like sticky prices, and other frictions made microeconomics consistent with Keynesian macroeconomics.138 New Keynesians often formulated models with rational expectations, which had been proposed by Lucas and adopted by new classical economists.139

### Nominal and real rigidities

Stanley Fischer (1977)v responded to Thomas J. Sargent and Neil Wallace's monetary ineffectiveness proposition and showed how monetary policy could stabilize an economy even with rational expectations.139 Fischer's model showed how monetary policy could have an impact in a model with long-term nominal wage contracts.140 John B. Taylor expanded on Fischer's work and found that monetary policy could have long lasting effects—even after wages and prices had adjusted. Taylor arrived at this result by building on Fischer's model with the assumptions of staggered contract negotiations and contracts that fixed nominal prices and wage rates for extended periods.140 These early new Keynesian theories were based on the basic idea that, given fixed nominal wages, a monetary authority (central bank) can control the employment rate.141 Since wages are fixed at a nominal rate, the monetary authority can control the real wage (wage values adjusted for inflation) by changing the money supply and thus impact the employment rate.141

By the 1980s new Keynesian economists became dissatisfied with these early nominal wage contract models.142 These models predicted that real wages would be countercyclical (real wages would rise when the economy fell), but empirical evidence showed that real wages tended to be independent of economic cycles or even slightly procyclical.143 These contract models also did not make sense from a microeconomic standpoint since it was unclear why firms would use long-term contracts if they led to inefficiencies.141 Instead of looking for rigidities in the labor market, new Keynesians shifted their attention to the goods market and the sticky prices that resulted from "menu cost" models of price change.142 The term refers to the literal cost to a restaurant of printing new menus when it wants to change prices; however, economists also use it to refer to more general costs associated with changing prices, including the expense of evaluating whether to make the change.142 Since firms must spend money to change prices, they do not always adjust them to the point where markets clear, and this lack of price adjustments can explain why the economy may be in disequilibrium.144 Studies using data from the United States Consumer Price Index confirmed that prices do tend to be sticky. A good's price typically changes about every four to six months or, if sales are excluded, every eight to eleven months.145

While some studies suggested that menu costs are too small to have much of an aggregate impact, Laurence Ball and David Romer (1990)w showed that real rigidities could interact with nominal rigidities to create significant disequilibrium. Real rigidities occur whenever a firm is slow to adjust its real prices in response to a changing economic environment. For example, a firm can face real rigidities if it has market power or if its costs for inputs and wages are locked-in by a contract.146147 Ball and Romer argued that real rigidities in the labor market keep a firm's costs high, which makes firms hesitant to cut prices and lose revenue. The expense created by real rigidities combined with the menu cost of changing prices makes it less likely that firm will cut prices to a market clearing level.144

### Coordination failure

In this model of coordination failure, a representative firm ei makes its output decisions based on the average output of all firms (ē). When the representative firm produces as much as the average firm (ei=ē), the economy is at an equilibrium represented by the 45 degree line. The curve represents the output for the individual firm given the output of other firms, and it intersects with the equilibrium line at three equilibrium points. The firms could coordinate and produce at the optimal level of point B, but, without coordination, firms might produce at a less efficient equilibrium.148149

Coordination failure is another potential explanation for recessions and unemployment.150 In recessions a factory can go idle even though there are people willing to work in it, and people willing to buy its production if they had jobs. In such a scenario, economic downturns appear to be the result of coordination failure: The invisible hand fails to coordinate the usual, optimal, flow of production and consumption.151 Russell Cooper and Andrew John (1988)x expressed a general form of coordination as models with multiple equilibria where agents could coordinate to improve (or at least not harm) each of their respective situations.152 Cooper and John based their work on earlier models including Peter Diamond's (1982)y coconut model,153 which demonstrated a case of coordination failure involving search and matching theory.154 In Diamond's model producers are more likely to produce if they see others producing. The increase in possible trading partners increases the likelihood of a given producer finding someone to trade with. As in other cases of coordination failure, Diamond's model has multiple equilibria, and the welfare of one agent is dependent on the decisions of others.155 Diamond's model is an example of a "thick-market externality" that causes markets to function better when more people and firms participate in them.156 Other potential sources of coordination failure include self-fulfilling prophecies. If a firm anticipates a fall in demand, they might cut back on hiring. A lack of job vacancies might worry workers who then cut back on their consumption. This fall in demand meets the firm's expectations, but it is entirely due to the firm's own actions.152

### Labor market failures

New Keynesians offered explanations for the failure of the labor market to clear. In a Walrasian market, unemployed workers bid down wages until the demand for workers meets the supply.157 If markets are Walrasian, the ranks of the unemployed would be limited to workers transitioning between jobs and workers who choose not to work because wages are too low to attract them.158 They developed several theories explaining why markets might leave willing workers unemployed.159 Of these theories, new Keynesians were especially associated with efficiency wages and the insider-outsider model used to explain long-term effects of previous unemployment,160 where short-term increases in unemployment become permanent and lead to higher levels of unemployment in the long-run.161

#### Efficiency wages

In the Shapiro-Stiglitz model workers are paid at a level where they do not shirk. This prevents wages from dropping to market clearing levels. Full employment cannot be achieved because workers would slack off if they were not threatened with the possibility of unemployment. The curve for the no-shirking condition (labeled NSC) goes to infinity at full employment.

In efficiency wage models, workers are paid at levels that maximize productivity instead of clearing the market.162 For example, in developing countries, firms might pay more than a market rate to ensure their workers can afford enough nutrition to be productive.163 Firms might also pay higher wages to increase loyalty and morale, possibly leading to better productivity.164 Firms can also pay higher than market wages to forestall shirking.164 Shirking models were particularly influential.165 Carl Shapiro and Joseph Stiglitz (1984)z created a model where employees tend to avoid work unless firms can monitor worker effort and threaten slacking employees with unemployment.166 If the economy is at full employment, a fired shirker simply moves to a new job.167 Individual firms pay their workers a premium over the market rate to ensure their workers would rather work and keep their current job instead of shirking and risk having to move to a new job. Since each firm pays more than market clearing wages, the aggregated labor market fails to clear. This creates a pool of unemployed laborers and adds to the expense of getting fired. Workers not only risk a lower wage, they risk being stuck in the pool of unemployed. Keeping wages above market clearing levels creates a serious disincentive to shirk that makes workers more efficient even though it leaves some willing workers unemployed.166

#### Insider-outsider model

Economists became interested in hysteresis when unemployment levels spiked with the 1979 oil shock and early 1980s recessions but did not return to the lower levels that had been considered the natural rate.168 Olivier Blanchard and Lawrence Summers (1986)aa explained hysteresis in unemployment with insider-outsider models, which were also proposed by of Assar Lindbeck and Dennis Snower in a series of papers and then a book.ab Insiders, employees already working at a firm, are only concerned about their own welfare. They would rather keep their wages high than cut pay and expand employment. The unemployed, outsiders, do not have any voice in the wage bargaining process, so their interests are not represented. When unemployment increases, the number of outsiders increases as well. Even after the economy has recovered, outsiders continue to be disenfranchised from the bargaining process.169 The larger pool of outsiders created by periods of economic retraction can lead to persistently higher levels of unemployment.169 The presence of hysteresis in the labor market also raises the importance of monetary and fiscal policy. If temporary downturns in the economy can create long term increases in unemployment, stabilization policies do more than provide temporary relief; they prevent short term shocks from becoming long term increases in unemployment.170

## New growth theory

Empirical evidence showed that growth rates of low income countries varied widely instead of converging to a uniform income level.171

Following research on the neoclassical growth model in the 1950s and 1960s, little work on economic growth occurred until 1985.54 Papers by Paul Romeracad were particularly influential in igniting the revival of growth research.172 Beginning in the mid-1980s and booming in the early 1990s many macroeconomists shifted their focus to the long-run and started "new growth" theories, including endogenous growth.173172 Growth economists sought to explain empirical facts including the failure of sub-Saharan Africa to catch up in growth, the booming East Asian Tigers, and the slowdown in productivity growth in the United States prior to the technology boom of the 1990s.174

Three families of new growth models challenged neo-classical models.175 The first challenged the assumption of previous models that the economic benefits of capital would decrease over time. These early new growth models incorporated positive externalities to capital accumulation where one firm's investment in technology generates spillover benefits to other firms because knowledge spreads.176 The second focused on the role of innovation in growth. These models focused on the need to encourage innovation through patents and other incentives.177 A third set, referred to as the "neoclassical revival", expanded the definition of capital in exogenous growth theory to include human capital.178 This strain of research began with Mankiw, Romer, and Weil (1992),ae which showed that 78% of the cross-country variance in growth could be explained by a Solow model augmented with human capital.179

Endogenous growth theories implied that countries could experience rapid "catch-up" growth through an open society that encouraged the inflow of technology and ideas from other nations.180 Endogenous growth theory also suggested that governments should intervene to encourage investment in research and development because the private sector might not invest at optimal levels.180

## New synthesis

Based on the DSGE model in Christiano, Eichenbaum, and Evans (2005),af impulse response functions show the effects of a one standard deviation monetary policy shock on other economic variables over 20 quarters.

A new synthesis, called the "new neoclassical synthesis" or simply the "new synthesis," emerged in the 1990s. This synthesis used ideas from both the new Keynesian and new classical schools.181 From the new classical school, it adapted RBC hypotheses, including rational expectations, and methods;182 from the new Keynesian school, it took nominal rigidities (price stickiness)150 and other market imperfections.183 New synthesis theory has developed RBC models called dynamic stochastic general equilibrium (DSGE) models.184 DSGE models formulate hypotheses about the behaviors and preferences of firms and households; numerical solutions of the resulting DSGE models are computed.185 These models also included a "stochastic" element created by shocks to the economy. In the original RBC models these shocks were limited to technological change, but more recent models have incorporated other real changes.186 DSGE models have another theoretical advantage, avoiding the Lucas critique.187 The new synthesis was adopted by academic economists and soon by policy makers, such as central bankers.150

Econometric analysis of DSGE models suggested that real factors sometimes affect the economy. A paper by Frank Smets and Rafael Woulters (2007)ag stated that monetary policy explained only a small part of the fluctuations in economic output.188 In new synthesis models, shocks can affect both demand and supply.189 The new synthesis also implies that monetary policy can have a stabilizing effect on the economy, contrary to new classical theory.189190

Under the synthesis, debates have become less ideological and more methodological.191 Business cycle modelers can be broken into two camps: those in favor of calibration and those in favor of estimation.191 When models are calibrated, the modeler selects parameter values based on other studies or casual empirical observation.192 Instead of using statistical diagnostics to evaluate models, the model's operating characteristics to determine the quality of the model.193 Kydland and Prescott (1982) offered no formal evaluation of their model, but noted how variables like hours worked did not match real data well while the variances of other elements of the model did.194 When estimation methods are used, models are evaluated based on standard statistical goodness of fit criteria.195 Calibration is generally associated with real business cycle modelers of the new classical school; however, while Lucas, Prescott, and Kydland are calibration advocates, Sargent favors estimation.195

## Financial crisis and the breakdown of consensus

The 2007–2008 financial crisis and subsequent Great Recession challenged macroeconomic theory. Few economists predicted the crisis, and, even afterwards, there was great disagreement on how to address it.196 The new synthesis consensus broke down as economists debated policy responses to deal with the deep recession. The new synthesis formed during the Great Moderation and had not been tested in a severe economic environment.197 Many economists agree that the crisis stemmed from an economic bubble, but neither of the major macroeconomic schools had paid much attention to finance or a theory of asset bubbles:196 how they form, how they can be recognized, and how they can be prevented. The failures of current economic theory to deal with the crisis spurred economists to reevaluate their thinking.198 Commentary ridiculed the mainstream and proposed a major reassessment.199

Elements of modern macroeconomic consensus were criticized following the financial crisis. Robert Solow testified before the U.S. Congress that DSGE models had "nothing useful to say about antirecession policy" because the conclusion that macroeconomic policy is impotent is built into the "essentially implausible assumptions" behind the model.200 Solow also criticized DSGE models for frequently assuming that a single, "representative agent" can represent the complex interaction of the many diverse agents that make up the real world.201 Robert Gordon criticized much of macroeconomics after 1978. Gordon called for a renewal of disequilibrium theorizing and disequilibrium modeling. He disparaged both new classical and new Keynesian economists who assumed that markets clear; he called for a renewal of economic models that could included both market-clearing and sticky-priced goods, such as oil and housing respectively.202 While criticizing DSGE models, Ricardo J. Caballero argues that recent work in finance shows progress and suggests that modern macroeconomics needed to be re-centered but not scrapped.203

## Heterodox theories

Heterodox economists adhere to theories sufficiently outside the mainstream to be marginalized204 and treated as irrelevant by the establishment.205 Initially, heterodox economists including Joan Robinson, worked alongside mainstream economists, but heterodox groups isolated themselves and created insular groups in the late 1960s and 1970s.206 Present day heterodox economists often publish in their own journals rather than those of the mainstream204 and eschew formal modelling in favor of more abstract theoretical work.204

The 2008 financial crisis and subsequent recession highlighted limitations of existing macroeconomic theories, models, and econometrics. The popular press discussed Post Keynesian economics207 and Austrian economics, two heterodox traditions that have little influence on mainstream economics.208209

### Post Keynesian economics

While Neo-Keynesians integrated Keynes's ideas with Neoclassical theory, Post Keynesians went in other directions. Post Keynesians opposed the neoclassical synthesis and shared a fundamentalist interpretation of Keynes that sought to develop economic theories without classical elements.210 The core of Post Keynesian belief is the rejection of three axioms that are central to classical and mainstream Keynesian views: the neutrality of money, gross substitution, and the ergodic axiom.211212 Post Keynesians not only reject the neutrality of money in the short-run, they also see money as an important factor in the long-run,211 a view other Keynesians dropped in the 1970s. Gross substitution implies that goods are interchangeable. Relative price changes cause people to shift their consumption in proportion to the change.213 The ergodic axiom asserts that the future of the economy can be predicted based on the past and present market conditions. Without the ergodic assumption, agents are unable to form rational expectations, undermining new classical theory.213 In a non-ergodic economy, predictions are very hard to make and decision-making is hampered by uncertainty. Partly because of uncertainty, Post Keynesians take a different stance on sticky prices and wages than new Keynesians. They do not see nominal rigidities as an explanation for the failure of markets to clear. They instead think sticky prices and long-term contracts anchor expectations and alleviate uncertainty that hinders efficient markets.214 Post Keynesian economic policies emphasize the need to reduce uncertainty in the economy including safety nets and price stability.215212 Hyman Minsky applied Post Keynesian notions of uncertainty and instability to a theory of financial crisis where investors increasingly take on debt until their returns can no longer pay the interest on leveraged assets, resulting in a financial crisis.212 The financial crisis of 2007–2008 brought mainstream attention to Minsky's work.207

Friedrich Hayek, founder of Austrian business cycle theory

Austrian economics began with Carl Menger's 1871 Principles of Economics. Menger's followers formed a distinct group of economists until around the Second World War when the distinction between Austrian economics and other schools of thought had largely broken down. The Austrian tradition survived as a distinct school, however, through the works of Ludwig von Mises and Friedrich Hayek. Present day Austrians are distinguished by their interest in earlier Austrian works and abstention from standard empirical methodology including econometrics. Austrians also focus on market processes instead of equilibrium.216 Mainstream economists are generally critical of its methodology.217218

Hayek created the Austrian business cycle theory, which synthesizes Menger's capital theory and Mises's theory of money and credit.219 The theory proposes a model of inter-temporal investment in which production plans precede the manufacture of the finished product. The producers revise production plans to adapt to changes in consumer preferences.220 Producers respond to "derived demand," which is estimated demand for the future, instead of current demand. If consumers reduce their spending, producers believe that consumers are saving for additional spending later, so that production remains constant.221 Combined with a market of loanable funds (which relates savings and investment through the interest rate), this theory of capital production leads to a model of the macroeconomy where markets reflect inter-temporal preferences.222 Hayek's model suggests that an economic bubble begins when cheap credit initiates a boom where resources are misallocated, so that early stages of production receive more resources than they should and overproduction begins; the later stages of capital are not funded for maintenance to prevent depreciation.223 Overproduction in the early stages cannot be processed by poorly maintained later stage capital. The boom becomes a bust when a lack of finished goods leads to "forced saving" since fewer finished goods can be produced for sale.223

## Notes

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18. ^ Lucas, Robert (1976). "Econometric Policy Evaluation: A Critique". In Brunner, K.; Meltzer, A. The Phillips Curve and Labor Markets. Carnegie-Rochester Conference Series on Public Policy 1. New York: American Elsevier. pp. 19–46. ISBN 978-0-444-11007-7
19. ^ Lucas, R.E.; Rapping, L.A. (1969). "Real Wages, Employment and Inflation". Journal of Political Economy 77 (5): 721–754. doi:10.1086/259559. JSTOR 1829964.
20. ^ Lucas, R. E. (1973). "Some International Evidence on Output-Inflation Tradeoffs". The American Economic Review 63 (3): 326–334. doi:10.2307/1914364.
21. ^ Kydland, F. E.; Prescott, E. C. (1982). "Time to Build and Aggregate Fluctuations". Econometrica 50 (6): 1345–1370. doi:10.2307/1913386.
22. ^ Fischer, S. (1977). "Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule". The Journal of Political Economy 85 (1): 191–205. doi:10.1086/260551.
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## References

### Books

Friedman, Benjamin M., and Frank H. Hahn, ed. , 1990. v. 1 links for description & contents and chapter-outline previews
_____, 1990. v. 2 links for description & contents and chapter-outline previews.
Friedman, Benjamin, and Michael Woodford, 2010. v. 3A & 3B links for description & and chapter abstracts.

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