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, while Keynesian economics claims that the aggregate supply curve slopes upward in the short run. A consequence of the upward-sloping demand curve is that demand shocks—shifts in the aggregate demand curve—cause fluctuations in aggregate output.

However, the challenges to Keynesian economics that arose in the 1950s and 1960s from monetarists and from natural rate theorists didn’t rely on classical economics ideas. The challengers accepted an upward-sloping aggregate supply curve—that an increase in aggregate demand leads to a rise in aggregate output in the short run and that a decrease in aggregate demand leads to a fall in aggregate output in the short run. Instead, they argued that the policy medicine advocated by traditional Keynesians, activist macroeconomic policy, would worsen the very disease they were trying to cure—economic fluctuations.

In the 1970s and 1980s, the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not aggregate output, was revived in an approach known as new classical macroeconomics. It evolved in two stages. 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 cause economic fluctuations, a view known as real business cycle theory.

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

For example, workers and employers bargaining over long-term wage contracts need to take account of the expected inflation rate 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 currently 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 have made it clear that there will 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 haven’t yet risen.

Adopting the premise of rational expectations can significantly alter beliefs about the effectiveness of activist macroeconomic policy. According to the original version of the natural rate hypothesis, a government attempt to persistently push the unemployment rate below the natural rate would work in the short run but will eventually fail because higher inflation will get built into expectations. According to rational expectations, we should remove the word eventually and replace it with immediately: if the government tries to lower unemployment today at the cost of higher inflation in the future, inflation will shoot up immediately without even a temporary fall in unemployment. So, under rational expectations, government intervention fails in the short run and the long run.

In the 1970s Robert Lucas of the University of Chicago, in a series of highly influential papers, used the logic of rational expectations to argue that monetary policy can change the level of output and unemployment only if it comes as a surprise to the public. Otherwise, attempts to lower unemployment will simply result in higher prices. According to Lucas’s rational expectations model of the economy, 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 Lucas’s rational expectations model of macroeconomics accurately describe how the economy actually 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. And with sticky prices, expected inflation can’t rise quickly enough to offset activist macroeconomic policy.

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.

In Chapter 24 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 because a slowdown in productivity growth shifts the aggregate supply curve leftward, and a recovery occurs because 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—and, likewise, macroeconomic policy activism—had any effect on aggregate output.

This theory was strongly influential, reflected 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 the actual economic data indicate that their models need an upward-sloping aggregate supply curve—and that this gives aggregate demand a potential role in determining aggregate output. And as we have seen, policy makers continue to strongly believe that aggregate demand policy has an important role to play in fighting recessions.