Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.

The generation of economists that followed Keynes synthesized his theory with neoclassical microeconomics to form the neoclassical synthesis. Although Keynesian theory originally omitted an explanation of price levels and inflation, later Keynesians adopted the Phillips curve to model price-level changes. Some Keynesians opposed the synthesis method of combining Keynes's theory with an equilibrium system and advocated 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 role of money supply in inflation. 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 foundations.

The new classical school culminated in real business cycle theory (RBC). Like early classical economic models, RBC models assumed that markets clear and that business cycles are driven by changes in technology and supply, not demand. New Keynesians tried to address many of the criticisms leveled by Lucas and other new classical economists against Neo-Keynesians. New Keynesians adopted rational expectations and built models with microfoundations of sticky prices that suggested recessions could still be explained by demand factors because 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. The Great Recession led to a retrospective on the state of the field and some popular attention turned toward heterodox economics.

Origins

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

Business cycle theory Beginning with William Stanley Jevons and Clément Juglar in the 1860s, economists attempted to explain the cycles of frequent, violent shifts in economic activity. A key milestone in this endeavor was the foundation of the U.S. National Bureau of Economic Research by Wesley Mitchell in 1920. This marked the beginning of a boom in atheoretical, statistical models of economic fluctuation (models based on cycles and trends instead of economic theory) that led to the discovery of apparently regular economic patterns like the Kuznets wave.

Other economists focused more on theory in their business cycle analysis. Most business cycle theories focused on a single factor, such as monetary policy or the impact of weather on the largely agricultural economies of the time. Although business cycle theory was well established by the 1920s, work by theorists such as Dennis Robertson and Ralph Hawtrey had little impact on public policy. 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. Research in these areas used microeconomic methods to explain employment, price level, and interest rates.

Monetary theory Initially, the relationship between price level and output was explained by the quantity theory of money; David Hume had presented such a theory in his 1752 work Of Money (Essays, Moral, Political, and Literary, Part II, Essay III). Quantity theory viewed the entire economy through Say's law, which stated that whatever is supplied to the market will be sold—in short, that markets always clear. 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. For example, adding more money to an economy would be expected only to raise prices, not to create more goods.

The quantity theory of money dominated macroeconomic theory until the 1930s. 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. 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:

Most classical theories, including Fisher's, held that velocity was stable and independent of economic activity. Cambridge economists, such as John Maynard 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 that money demand and supply were 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. 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.

In 1898, Knut Wicksell proposed a monetary theory centered on interest rates. His analysis used two 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. In Wicksell's theory, 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. 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. This can lead to a cumulative process where inflation increases continuously without an expansion in the monetary base. Wicksell's work influenced Keynes and the Swedish economists of the Stockholm School.

Keynes's General Theory

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. Keynes expanded on the concept of liquidity preferences and built a general theory of how the economy worked. Keynes's theory brought together both monetary and real economic factors for the first time, explained unemployment, and suggested policy achieving economic stability.

Keynes contended that economic output is positively correlated with money velocity. He explained the relationship via changing liquidity preferences: people increase their money holdings during times of economic difficulty by reducing their spending, which further slows 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 slowdown in economic activities means markets might not clear, leaving excess goods to waste and capacity to idle. Turning the quantity theory on its head, Keynes argued that market changes shift quantities rather than prices. Keynes replaced the assumption of stable velocity with one of a fixed price-level. If spending falls and prices do not, the surplus of goods reduces the need for workers and increases unemployment.

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. In Keynes's model, employment and output are driven by aggregate demand, the sum of consumption and investment. Since consumption remains stable, most fluctuations in aggregate demand stem from investment, which is driven by many factors including expectations, "animal spirits", and interest rates. Keynes argued that fiscal policy could compensate for this volatility. During downturns, governments could increase spending to purchase excess goods and employ idle labor. 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 this increase in demand.

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

The exact meaning of Keynes's work has been long debated. Even the interpretation of Keynes's policy prescription for unemployment, one of the more explicit parts of 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.

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" that dominated economics from the 1940s until the early 1970s. Two camps of Keynesians were critical of this synthesis interpretation of Keynes. One group focused on the disequilibrium aspects of Keynes's work, while the other took a fundamentalist stance on Keynes and began the heterodox post-Keynesian tradition.

Neoclassical synthesis