As we have seen, one key difference between classical economics and Keynesian economics is that classical economists believed that the short-run aggregate supply curve is vertical, but Keynes emphasized the idea that the aggregate supply curve slopes upward in the short run. As a result, Keynes argued that demand shocks—shifts in the aggregate demand curve—can cause fluctuations in aggregate output.

The challenges to Keynesian economics that arose in the 1950s and 1960s—the renewed emphasis on monetary policy and the natural rate hypothesis—didn’t question the view that an increase in aggregate demand leads to a rise in aggregate output in the short run nor that a decrease in aggregate demand leads to a fall in aggregate output in the short run. In the 1970s and 1980s, however, some economists developed an approach to the business cycle known as new classical macroeconomics, which returned to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not aggregate output. The new approach evolved in two steps. First, some economists challenged traditional arguments about the slope of the short-run aggregate supply curve based on the concept of rational expectations. Second, some economists suggested that changes in productivity caused economic fluctuations, a view known as real business cycle theory.

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In the 1970s, a concept known as rational expectations had a powerful impact on macroeconomics. Rational expectations, a theory originally introduced by John Muth in 1961, is the view that individuals and firms make decisions optimally, using all available information.

For example, workers and employers bargaining over long-term wage contracts need to estimate the inflation rate they expect over the life of that contract. Rational expectations says that in making estimates of future inflation, they won’t just look at past rates of inflation; they will also take into account available information about monetary and fiscal policy. Suppose that prices didn’t rise last year, but that the monetary and fiscal policies announced by policy makers made it clear to economic analysts that there would be substantial inflation over the next few years. According to rational expectations, long-term wage contracts will be adjusted today to reflect this future inflation, even though prices didn’t rise in the past.

Rational expectations can make a major difference to the effects of government policy. According to the original version of the natural rate hypothesis, a government attempt to trade off higher inflation for lower unemployment would work in the short run but would eventually fail because higher inflation would get built into expectations. According to rational expectations, we should remove the word eventually: if it’s clear that the government intends to trade off higher inflation for lower unemployment, the public will understand this, and expected inflation will immediately rise.

In the 1970s, Robert Lucas of the University of Chicago, in a series of highly influential papers, used this logic to argue that monetary policy can change the level of unemployment only if it comes as a surprise to the public. If his analysis was right, monetary policy isn’t useful in stabilizing the economy after all. In 1995 Lucas won the Nobel Prize in economics for this work, which remains widely admired. However, many—perhaps most—macroeconomists, especially those advising policy makers, now believe that his conclusions were overstated. The Federal Reserve certainly thinks that it can play a useful role in economic stabilization.

Why, in the view of many macroeconomists, doesn’t the rational expectations hypothesis accurately describe how the economy behaves? New Keynesian economics, a set of ideas that became influential in the 1990s, provides an explanation. It argues that market imperfections interact to make many prices in the economy temporarily sticky. For example, one new Keynesian argument points out that monopolists don’t have to be too careful about setting prices exactly “right”: if they set a price a bit too high, they’ll lose some sales but make more profit on each sale; if they set the price too low, they’ll reduce the profit per sale but sell more. As a result, even small costs to changing prices can lead to substantial price stickiness and make the economy as a whole behave in a Keynesian fashion.

Over time, new Keynesian ideas combined with actual experience have reduced the practical influence of the rational expectations concept. Nonetheless, the idea of rational expectations served as a useful caution for macroeconomists who had become excessively optimistic about their ability to manage the economy.

Earlier we introduced the concept of total factor productivity, the amount of output that can be generated with a given level of factor inputs. Total factor productivity grows over time, but that growth isn’t smooth. In the 1980s, a number of economists argued that slowdowns in productivity growth, which they attributed to pauses in technological progress, are the main cause of recessions. Real business cycle theory claims that fluctuations in the rate of growth of total factor productivity cause the business cycle. Believing that the aggregate supply curve is vertical, real business cycle theorists attribute the source of business cycles to shifts of the aggregate supply curve: a recession occurs when a slowdown in productivity growth shifts the aggregate supply curve leftward, and a recovery occurs when a pickup in productivity growth shifts the aggregate supply curve rightward. In the early days of real business cycle theory, the theory’s proponents denied that changes in aggregate demand had any effect on aggregate output.

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This theory was strongly influential, as shown by the fact that two of the founders of real business cycle theory, Finn Kydland of Carnegie Mellon University and Edward Prescott of the Federal Reserve Bank of Minneapolis, won the 2004 Nobel Prize in economics. The current status of real business cycle theory, however, is somewhat similar to that of rational expectations. The theory is widely recognized as having made valuable contributions to our understanding of the economy, and it serves as a useful caution against too much emphasis on aggregate demand. But many of the real business cycle theorists themselves now acknowledge that their models need an upward-sloping aggregate supply curve to fit the economic data—and that this gives aggregate demand a potential role in determining aggregate output. And as we have seen, policy makers strongly believe that aggregate demand policy has an important role to play in fighting recessions.