Output, Interest and Prices: Part I
Building up the neoclassical consensus
Before Macroeconomics: The Old Classicals
Before macroeconomics was a field unto itself, its precursors were the fields of political economy, monetary theory and business cycle theory as expounded upon by the Old Classical economists. Adam Smith and Jean-Baptiste Say were two of the leading political economists. In his 1776 The Wealth of Nations, Smith famously said that “it is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own interest”. In doing so, the father of economics set up the notion that markets are able to align private incentives with the public interest. His most well-known analogy was that of the invisible hand, and noting that a producer is “led by an invisible hand to promote an end which was no part of his intention … By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it”.
Smith went on to argue that “the quantity of every commodity brought to market naturally suits itself to the effectual demand … The natural price, therefore is, as it were, the central price to which the prices of all commodities are continually gravitating. Different accidents may sometimes keep them suspended a good deal above it, and sometimes force them even somewhat below it. But whatever may be the obstacles which hinder them from settling in this center of repose and continuance, they are constantly tending towards it”. In saying this, Smith described the central tenet of Old Classical economics - that via the price mechanism, the market equilibrium would naturally equilibrate towards an efficient level.
This was summed up by Say’s Law of Markets in his 1803 Traité d’économie politique: “When the producer has put the finishing hand to his product, he is most anxious to sell it immediately, lest its value should diminish in his hands. Nor is he less anxious to dispose of the money he may get for it, for the value of money is also perishable. But the only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of creation of one product immediately opens a vent for other products”. Put more succinctly, supply creates its own demand. It is worth being clear that the common caricature of Say’s Law as suggesting there can never be a demand shortfall is mistaken. Indeed, Say went on to say that “a glut can take place only when there are too many means of production applied to one kind of product and not enough to another”. So a misallocation of resources between markets could cause problems, but Say did reject the idea of a general glut.
As for the determination of real output, The Wealth of Nationsdescribed it as coming from “the annual produce of the land and labour”. In the long run, this could only be “increased in value by no other means, but by increasing either the number of its productive labourers, or the productive powers of those labourers”. That is, real output was seen by Smith as a function of land and labour, with increases in productivitydriving long-run growth of output per capita.
Meanwhile, Old Classical monetary theory had its three paragons in David Hume, Irving Fisher and Knut Wicksell. Hume’s “Of Money” in 1752 gave one of the first accounts of the uses of money, arguing that “money is … only the instrument which men have agreed upon to facilitate the exchange of one commodity for another”, establishing its role as the medium of exchange. Hume went on to say that “if we consider any one kingdom by itself, it is evident that the greater or less plenty of money is of no consequence, since the prices of commodities are always proportioned to the plenty of money”. And he was also able to identify that ““if the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated” - that is, the demand for money matters too, alongside its supply. He repeats this in his 1752 “Of the Balance of Trade”, noting that there is a fallacy of composition when it comes to an increase in the money supply: “we fancy, because an individual would be much richer were his stock of money doubled, that the same good effect would follow were the money of every one increased, not considering that this would raise as much the price of every commodity and reduce every man, in time, to the same condition as before”.
In doing so, he set out the two key ideas in long-run monetary theory: the neutrality of money and the quantity theory of money. The former says that the nominal and real parts of the economy are separate in the long run i.e. you can’t print yourself rich, because the productive potential of the economy is determined by the aforementioned factors of production, not the quantity of money. The latter says that the long-run effect of increasing the money supply is to raise the general level of prices by the same amount. These claims were corroborated by the writing of other classical economists, with Smith noting in The Wealth of Nations that for any good “its real price may be said to consist in the quantity of the necessaries and conveniences of life which are given for it; its nominal price, in the quantity of money”. And in the vein of the quantity theory, David Ricardo described in his 1810 The High Price of Bullion the effects of an increase in the money supply as one where “the circulating medium would be lowered in value and goods would experience a proportionate rise”.
Meanwhile, Hume went on to “trace the money in its progress through the commonwealth … it must first quicken the diligence of every individual, before it increases the price of labour”. In doing so, he outlined the important short-run idea in monetary theory i.e. the short-run non-neutrality of money, where changes in the supply of money temporarily affect the level of real output. Consequently, he argued for creeping inflation: that “the good policy of the magistrate consists only in keeping the quantity of money, if possible, still increasing; because, by that means, he keeps alive a spirit of industry”.
The breadth of Hume’s work extended beyond just discussing money and prices - he also produced “Of Interest” in 1752, where he argued that high interest rates arose from “a great demand for borrowing and little riches to supply that demand”. In doing so, he established the loanable funds model of interest rate determination - that is, the interest rate rr is the price at which the demand for loanable funds i.e. investment is equal to the supply of loanable funds i.e. savings. He also clarified that “though both these effects, plenty of money and low interest, naturally arise from commerce and industry, they are altogether independent of each other” - that is, the quantity of money does not determine the interest rate.
Questions regarding money and interest rates continued to be pursued by Fisher and Wicksell. Fisher’s defining work was his 1930 The Theory of Interest. In this book, he set up three concepts that still live on till this day. Firstly, he defined capital as an asset that would produce a flow of income - as such, the value of such an asset would be the net present value of the future income stream. Secondly, he saw interest rates rr as “an index of a community’s preference for a dollar of present over a dollar of future income”. This time preference theory of interest rate determination is reflected by the fact that the full title of his book was The Theory of Interest as Determined by Impatience to Spend Income and Opportunity to Invest - that is, the interest rate was set by how impatient people were to spend right now versus how much return people would get on the capital they saved and invested in. Thirdly, he produced the Fisher equation, which says that the nominal interest rate equals the real interest rate plus the inflation rate.
Beyond interest rates, Fisher also elucidated two broader relationships. The first was the equation of exchange, where nominal spending equals the money supply multiplied by the velocity of money i.e. number of times which a piece of money was used. Nominal spending also equals the price level multiplied by the real value of transactions. This equation of exchange would be echoed in a different form by the Cambridge economists Alfred Marshall and Arthur Pigou, who thought that the demand for money was equal to some fraction of nominal output, since people held money to spend it. If nominal output were higher, people would want to hold more money. Equally, if the nominal interest rate were higher, people would want to hold less money due to the higher opportunity cost of holding cash in lieu of interest-bearing assets - hence why was that fraction was a decreasing function of the nominal interest rate.
And the second of Fisher’s relationships was in a 1926 paper titled “A Statistical Relation between Unemployment and Price Changes”, where he noted a “close correspondence between unemployment and changes in the purchasing power of money”. In particular, he described the negative relationship between inflation and unemployment in the US. Importantly, he made clear the distinction between “the price level and changes in the price level” - while the former had little to do with whether full employment was achieved, the latter did have such an effect. One reason for this non-neutrality was outlined in his 1928 The Money Illusion, where he noted that people often faced a “failure to perceive that the dollar, or any other unit of money, expands or shrinks in value”. As such, changes in nominal quantities e.g. inflation, could affect real magnitudes via this monetary confusion.
As for Wicksell, his approach was put forward in his 1898 Interest and Prices. He claimed that the quantity theory held true in the long run, with changes in the price level originating “outside the commodity market”. Rather, “the total volume of money instruments … in relation to the quantity of commodities exchanged, was the regulator of commodity prices”, and “the conditions of production and consumption … affect only exchange values or relative prices”. However, he posited that in the period where prices were still adjusting, it failed to explain how money demand and supply were equilibrated - as such, he incorporated interest rates as the adjusting variable to equalise the two while prices were adjusting. Thus “the quantity theory is correct, insofar as it is true that an increase or relative diminution in the stock of money must always tend to raise or lower prices - by its opposite effect in the first place on rates of interest”.
He elaborated on what this meant by clarifying two interest rates. The natural rate of interest is the interest rate determined in the production sphere i.e. the loanable funds market, where the interest rate equals the marginal product of capital. After all, suppliers of loanable funds shouldn’t be willing to lend at a lower rate than that which they can get from buying capital, while demanders of loanable funds shouldn’t be willing to borrow for more than the returns on capital they would be receiving. Meanwhile, the market rate of interest is the interest rate determined in the financial sphere i.e. whatever banks and other financial institutions lent and borrowed at. When the market rate is different from the natural rate, there is a Wicksellian “cumulative process” - for example, Wicksell noted that if the market rate is less than the real rate, people would borrow to spend, causing a rise in output and prices. As such, “the demand for money loans is consequently increased, and as a result of a greater need for cash holdings, the supply is diminished. The consequence is that the rate of interest is soon restored to its normal level, so that it again coincides with the natural rate”. Thus Wicksell provided a way of reconciling the loanable funds and financial theories of interest rate determination.
This distinction between the natural and market interest rate was sufficiently important that in his 1906 Lectures on Political Economy, Wicksell warned against reasoning from a change in interest rates - while “a fall in loan rates caused by increased supplies of real capital should thus in itself cause neither a rise nor a fall in the average price level”, a fall in the market rate due to “artificial capital created by credit” would caused a rise in the price level. That is, the market rate could fall due to a secular fall in the natural rate, or because it was deviating from the natural rate due to a monetary injection. Wicksell also recognised that the Humean notion of creeping inflation, noting in the lectures that “sometimes, it is true, we hear it said that … a progressive rise in commodity prices might be preferred” because it “would act as a stimulus to enterprise”. However he argued that this was “evidently naïve … if this fall in the value of money is the result of our own deliberate policy, or indeed can be anticipated and foreseen, then these supposed beneficial effects will never occur, since the approaching rise in prices will be taken into account … What is contemplated is, therefore, unforeseen rises in price”.
The logical implication of all of this for central bank policy was Wicksell’s rule: “so long as prices remain unaltered, the bank’s rate of interest is to remain unaltered. If prices rise, the rate of interest is to be raised; and if prices fall, the rate of interest is to be lowered”. The need for price stability was further elaborated upon by John Maynard Keynes in his 1923 A Tract on Monetary Reform, where he said that “inflation is unjust and deflation inexpedient”. This was because rising prices would redistribute away from people earning nominally fixed incomes, while falling prices would reduce expectations of earnings and increase real debt burdens, hurting economic growth. Crucially, this was best done by an independent central bank, because “the impecuniosity of governments and the superior political influence of the debtor class” would incentivise seigniorage i.e. “taxation by currency depreciation”.
Finally, the field of business cycle theory was still rather nascent. Compendiums of the field were focused on measuring business cycles and hypotheses about potential causes, as exemplified by NBER founder Wesley Mitchell’s 1913 Business Cycles as well as Gottfried Haberler’s 1937 Prosperity and Depression. Some suggested explanations included the unstable provision of money and credit, the possibility of overinvestment causing a misallocation of real resources, the redistributive effects of deflation towards creditors reducing consumption, the process of output growing too fast and leading to underconsumption as well as the unstable expectations regarding future prosperity.
So on the eve of the Keynesian revolution, the still nebulous field of macroeconomics had begun coalescing. In the long run, output depended on the factors of production i.e. technology, capital (subsuming land) and labour. The natural rate of interest was the marginal product of capital and the price level was given by the equation of exchange.
In the short run, the Wicksellian framework allowed the integration of goods and financial markets. The Wicksellian difference determined the deviation of output from its long-run potential. Monetary theory explained how the market interest rate deviated from its natural rate. Inflation was a function of output as per Fisher or a function of the Wicksellian difference - these two are consistent, because the Wicksellian difference determines output fluctuations. But it was also a function of expected inflation, since Wicksell noted that only unanticipated inflation would affect output. And with inflation determined, the nominal interest rate was set by the Fisher equation.
This set up the hodgepodge of business cycle theories to explain how various factors affected the natural rate or the market rate, and thereby caused changes in output, interest and prices. It meant that the government had a role in improving the productive potential of the economy and there was a role for an independent central bank to stabilise prices and the business cycle. But although the degree of formal modelling was limited and this was by no means a complete and consistent explanation of growth, money or business cycles, many important ideas had been set out. And as we will see, these ideas have stood the test of time.
Explaining The Great Depression: The Keynesian Revolution
The Great Depression would shake this Old Classical approach to its core, catalysing the Keynesian revolution and heralding the beginnings of macroeconomics as a unified and coherent field. Although the Old Classicals were well-aware of the potential for business cycle fluctuations, the underlying philosophy remained one of equilibration. The depth and persistence of the Great Depression meant that many felt this process of seeing economies as naturally returning to its efficient equilibrium as unsatisfying, especially because so much of it came from ad hoc suggestions as opposed to a unified framework. Indeed, Keynes had declared in his 1923 Tract that “in the long run, we are all dead. Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again”.
So when the Depression arrived, Keynes produced his magnum opus in 1936: The General Theory of Employment, Interest and Money, which represented a dramatic turn from the writings of Old Classicals (including his own previous works in that tradition). In this book, he expounded upon how involuntary unemployment could occur and persist as was happening during the Depression. In particular, he argued that investment was especially volatile, because most investment decisions “can only be taken as a result of animal spirits - of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantified benefits … Thus if the animal spirits are dimmed and spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die”. This rather behavioural economics-esque explanation meant that “the level of employment at any time depends … not merely on the existing state of expectation but on the states of expectation which have existed over a certain past period … embodied in today’s capital equipment”. Consequently, there was a role for government intervention when such an adverse shock occurred.
Unfortunately, Keynes’s text is verbose and it is consequently difficult to parse what this means in a model - the canonical interpretation is by John Hicks in his 1937 “Mr. Keynes and the”Classics”. In this paper, Hicks defined the Keynesian story in terms of the IS-LM model. The IS curve relates to the equalisation of investment and savings, while the LM curve relates to the equalisation of liquidity preference and the money supply.
Savings are an increasing function of output, since people tend to save more their incomes are larger. “The amount of investment … depends on the rate of interest” according to Hicks, since a lower real interest rate makes it cheaper to borrow to invest. The preference for liquidity (or money) is increasing in nominal output and decreasing in the interest rate (for the same reasons as in the Cambridge equation of exchange), while the money supply is just that. Many of these ideas are not new - indeed, the disagreements between Old Classical monetary theorists were precisely about how to reconcile the fact that the interest rate was determined both in the goods and the money market. Hume had focused on the goods market in terms of loanable funds, Fisher had directed his attention to the time preference explanation in the money market, while Wicksell had argued for two interest rates. In this respect, the key Keynesian insight was the notion of simultaneous determination in a system of two equations. That is to say, because both real output and real interest rates were involved in the two equations, both would adjust simultaneously in this system of two equations to equilibrate investment to be equal to savings and liquidity preference to be equal to the money supply.
Suppose there were an adverse shock to investment as in a recession, due to pessimistic expectations of the future. Keynes, rightly or wrongly, characterised the Old Classical position as one where the real interest rate would fall to equilibrate and ensure real output stayed at its original level. By contrast, he argued that because the interest rate was equilibrating the money market, real output would be the variable that adjusts and falls. One response to this would be to increase the money supply. This would mean that given the preference for the liquidity stays the same, people would put this money into interest-bearing assets, lowering the real interest rate. As such, there would be a rise in investment and real output, counteracting the effects of the recession. But if interest rates were at 0 or if investment wasn’t very interest-elastic, one might struggle to induce a rise in investment via monetary expansion. It is in those circumstances that Keynes pushed for fiscal policy, raising net government spending directly to prevent real output from falling. In particular, he posited in The General Theory that he expected “the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organising investment”.
It is worth noting that there are many interpretations of Keynes, especially with respect to the question of why within nominal output, it is real output that falls as opposed to prices. The hydraulic Keynesianism of IS-LM assumes that the price level is fixed, perhaps due to sticky wages where workers refuse to accept nominal wage cuts - this was most persuasively put forward by Franco Modigliani in his 1944 “Liquidity Preference and the Theory of Interest and Money”. But there are other stories too.
For example, the post-Keynesian school has focused more on animal spirits, arguing that the stickiness of prices and wages is not essential to Keynes’s story. Rather, it is inconsistent expectations about the future that prevent the economy from reaching its full productive potential - this is best exemplified in Roger Farmer’s work, but a simple story of why flexible prices do not guarantee full output goes as follows.
Consider a world with perfect competition and flexible prices. It is still possible to have unemployed resources, because price rigidity or frictions in market structures aren’t the only things to cause suboptimal resource allocation. If we think of our macroeconomic model as made up of various supply and demand models in different markets, the expectations of producers and consumers feed into their supply and demand curves. If they have inconsistent expectations, this will shift the two curves by different amounts, causing the intersection at a lower level of output than is optimal. So in that sense, it is not prices that are stopping from market clearing, but that the market clears at a point where there are mutually beneficial trades foregone due to inconsistent expectations.
The focus of Keynes’s 1937 “The General Theory of Employment” in which he replied to comments regarding his 1936 magnus opus lends credence to this line of argument, since it overwhelmingly focused on expectations and did not mention stickiness or rigidity. Indeed, Keynes argued that the Old Classical theories were “incapable of dealing with the general case where employment is liable to fluctuate”, with the implication being that full output was a special case, and that the economy may remain under potential even in the long run when prices have fully adjusted due to inconsistent expectations.
Another avenue of interpreting Keynes is the disequilibrium approach explored by the likes of Don Patinkin, Robert Clower and Axel Leijonhufvud. They focused on the idea that recessions and falls in real output were a disequilibrium phenomena - that is, the fact that markets do not clear continuously via some centralised Walrasian auctioneer means there is room for difficulties of coordination within a decentralised economy. In particular, the speed of adjustment was one where prices were sluggish and quantity was rapid, rather than the usual idea of prices adjusting quickly. Although this has not caught on much within mainstream economics nowadays (bar a brief revival from Robert Barro and Herschel Grossman), the ideas of search theory are in many ways in a similar vein of rejecting the Walrasian auctioneer. But regardless of one’s personal choice of exegesis and whether one saw Hicks as having bastardised Keynes, the next few decades of macroeconomics would be dominated by the IS-LM approach, where short-run output and interest rates were described by the two aforementioned equations.
Although it is true that macroeconomics as a field is borne out of the Great Depression and Keynes, I am quite skeptical of the extent to he was revolutionary. Methodologically, the main shift was away from more hand-waving discussions of business cycles over time towards the simultaneous determination of macroeconomic variables within a system of equations. That was certainly a change, and Pigou in his 1950 Keynes’s General Theory: A Retrospective View argued that “nobody before Keynes, as far as I know, had brought all the relevant factors, real and monetary at once, together in a single formal scheme, through which their interplay could be coherently investigated”.
But in terms of the substantive content, Hicks concedes in his 1937 paper that the Keynesian description was only “completely out of touch with the classical world” in the special case of a liquidity trap i.e. where interest rates were at 0 and fiscal policy was required. So I think Keynes actually oversold his contributions by caricaturing the Old Classicals as more faithful adherents to Say’s Law than they actually were.
Unifying Macroeconomics: The Neoclassical Synthesis
The reason why IS-LM dominated was because of a convergence in macroeconomics that was beginning to take shape. While business cycle theory was perhaps the most prominent strand of macroeconomics in the aftermath of the Great Depression, economists behind the scenes had continued to work on issues of long-run growth as well as microeconomic foundations. And by the 1950s, these had been brought together into one coherent story that would be the cornerstone of the research agenda for the next few decades.
In business cycle theory, the final piece of the puzzle was the addition of a supply-side relationship between output and prices to the IS-LM model. This was provided by William Phillips, who published “The Relationship Between Unemployment and the Rate of Change of the Money Wage Rates in the United Kingdom” in 1958. In doing so, he reminded the profession of the forgotten finding by Fisher back in 1926: the negative relationship between unemployment and wage inflation. He suggested that since “when the demand is low relative to the supply we expect the price to fall … it seems plausible that this principle should operate as one of the factors determining the rate of change of money wage rates. With Paul Samuelson and Robert Solow going on to provide the theoretical explanation behind”the menu of choice between different degrees of unemployment and price stability” in their 1960 “Analytical Aspects of Anti-Inflation Policy”, they had closed out a model of output, interest rate and price determination. And since the model was dependent upon the idea of sluggish price adjustment, it could be relegated to being a short-run story only.
Meanwhile, the Smithian invisible hand had been formalised in microeconomics by Léon Walras’s 1874 Éléments d’économie politique pure, Kenneth Arrow and Gérard Debreu’s 1954 “Existence of an Equilibrium for a Competitive Economy” as well as Lionel McKenzie’s 1954 “On Equilibrium in Graham’s Model of World Trade and Other Competitive Systems”. These set up the foundations of microeconomic theory, which would be used to combine macroeconomics with general equilibrium theory as well as to formalise the microeconomic foundations of macroeconomics. This was best exemplified by the 1956 book Money, Interest and Prices by Don Patinkin, which brought together the three equations with microeconomic theory. Crucially, the combination of microfoundations and the explicitly short-run nature of the IS-LM-PC model allowed Samuelson to coin one of the most famous phrases regarding economic methodology in his canonical undergraduate textbook Economics: “I have set forth what I call a grand neoclassical synthesis … Its basic tenet is this: solving the vital problems of monetary and fiscal policy … will validate and bring back into relevance the classical verities. This neoclassical synthesis … heals the breach between aggregative macroeconomics and traditional microeconomics and brings them into complementing unity”.
So what was happening in growth theory during all of this? Although the Old Classicals had already set up an explanation of how the factors of production fed into the long-run productive potential of an economy, they did not have a clear model of the dynamics of economic growth over time. The Keynesian theory of growth was put forward by Roy Harrod in his 1939 “An Essay in Dynamic Theory” as well as Evsey Domar in his 1946 “Capital Expansion, Rate of Growth and Employment”. The Harrod-Domar model assumed a production function that only includes capital and has the marginal product of capital as constant - as such, capital is fixed proportion of real output. The capital stock depends upon new investment and what is left of the capital stock after depreciation. Investment is equal to savings, which is taken as a fixed proportion of income.
What they found was that this implied the growth rate of output was given by the savings rate, the marginal product of capital and the depreciation rate. Although this offered plausible policy prescriptions for increasing the growth rate, it also had a deeply Keynesian insight regarding the long run. If the population grew at a fixed rate nn, the possibility of full employment would be an entirely knife-edge situation, since n>gn>g would imply that the population is growing faster than real output, meaning that there was no tendency for reverting to full employment.
And so in 1956, Robert Solow and Trevor Swan wrote “A Contribution to the Theory of Economic Growth” and “Economic Growth and Capital Accumulation” respectively. Their Solow-Swan model of growth relaxed a range of assumptions that the Harrod-Domar model had depended upon: it included labour and technology as factors of production, it set the factors of production as having decreasing rather than constant marginal products and it did not force the capital-ouput ratio to be fixed. It kept the process of capital accumulation, while also incorporating the growth of the population and technology over time. The Cobb-Douglas functional form of this model is given below.
The result was that, because the factors of production had diminishing marginal products, there was a steady state level of output per capita which the economy would converge to. In the long run, the growth rate of real output would be solely determined by the growth rate of technology gg, which is also known was Total Factor Productivity. This was a powerful rejoinder against the Harrod-Domar model - not only did it better track the six stylised facts about growth which Nicholas Kaldor had proposed in his 1957 “A Model of Economic Growth”, it did not have weird knife edge conditions and it did not imply the absurd claim that it was possible to perpetually achieve economic growth by raising the savings rate. Later on, the combination of Frank Ramsey’s 1928 “A Mathematical Theory of Saving”, David Cass’s 1965 “Optimum Growth in an Aggregative Model of Capital Accumulation” and Tjalling Koopmans’s 1965 “On the Concept of Optimal Economic Growth” would provided a microfounded version of the Solow model by explaining how the savings rate was determined as opposed to assuming it was a fixed exogenous value. In any case, the Solow model and its microfounded cousin of the Ramsey-Cass-Koopmans model would become the mainstays of neoclassical growth theory.
The combination of all of this meant that up till the 1970s, the neoclassical synthesis reigned supreme in macroeconomics. Long-run potential output was still determined by the factors of production as per the Old Classicals, but we now had a formal model for how it grew over time i.e. at the rate of Total Factor Productivity improvements. The natural rate of interest and price level were consistent with Old Classical explanations.
The short run was described by a combination of the IS-LM model and the Phillips curve. The main change from the Old Classicals is the fact that we had a clearer sense of the actual equations and of how everything was determined together. But we also lost some insights: the role of expectations in the Phillips curve was de-emphasised, as was the idea of the Wicksellian difference. Although to be clear, Samuelson and Solow did make clear in their 1960 paper that “it would be wrong, though, to think that our menu … will maintain its same shape in the longer run. What we do in a policy way during the next few years might cause it to shift in a definite way”.
Regardless, this spurred on the next decade or so of research.
Macroeconomists mostly focused on understanding the various functions implicit in the IS-LM-PC model. In particular, the literature focused on the consumption function, the investment function, the money demand function and the price-setting function. The most important contribution to the consumption function was the permanent income hypothesis, which argued that people’s consumption depended on their expected path of income across their entire lifetime, rather than just their current income. This notion that people smooth their consumption across their lifetime was independently proposed by Milton Friedman in his 1957 A Theory of the Consumption Function as well as Franco Modigliani and Richard Brumberg’s 1954 “Utility Analysis and the Consumption Function”. On the question of the investment function, Jorgenson’s 1963 “Capital Theory and Investment Behaviour” as well as James Tobin’s 1969 “A General Equilibrium Approach to Monetary Theory” were two defining papers in that field. Jorgenson focused on the idea that in a frictionless world, firms invest to maximise the net present value of their profits. By contrast, Tobin looked at Tobin’s q i.e. the market value of the firm’s assets divided by the replacement cost of the firm’s assets, with a higher q suggesting that the firm’s market value is greater than the value of its capital and thus incentivising more investment. With respect to money demand, the 1952 “The Transactions Demand for Cash” by William Baumol and the 1956 “The Interest Elasticity of Transactions Demand For Cash” by Tobin formalised the ideas of liquidity preference that were already present in the IS-LM model.
At the same time, the rising computational power of computers meant that large scale macroeconometric models were being developed. By taking these functions and estimating them mathematically, economists were developing models aimed at predicting the effects of various policies on the economy. One of the first examples was Lawrence Klein and Arthur Goldberger’s 1955 An Econometric Model for the United States, with 20 simultaneous equations to describe the US economy. Augmented by work from the Cowles Commission, the Brookings Institution and others, this approach reached its apex with the Federal-Reserve-Board-MIT-Penn (FMP) model, which combined the IS-LM-PC model with the neoclassical growth theories in the background to produce a model with hundreds of equations.
But in spite of this seeming united research program, not all was well with macroeconomics, and this neoclassical synthesis didn’t go unchallenged. In fact, it was facing a challenge from Monetarists in the 1960s, and this would be followed up in the 1970s and 1980s by critiques from the New Classicals and Real Business Cycle theorists.