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nomy with monetary policy he generally favored a policy of steady growth in the money supply rather than frequent intervention 8 528 friedman also challenged the original simple phillips curve relationship between inflation and unemployment friedman and edmund phelps who was not a monetarist proposed an augmented version of the phillips curve that excluded the possibility of a stable long run tradeoff between inflation and unemployment 30 when the oil shocks of the 1970s created a high unemployment and high inflation friedman and phelps were vindicated monetarism was particularly influential in the early 1980s but fell out of favor when central banks found the results disappointing when trying to target money supply instead of interest rates as monetarists recommended concluding that the relationships between money growth inflation and real gdp growth are too unstable to be useful in practical monetary policy making 31 new classical economics edit new classical macroeconomics further challenged the keynesian school a central development in new classical thought came with robert lucas s introduction of rational expectations into macroeconomics before lucas economists had generally used adaptive expectations in which agents were assumed to look at the recent past to form expectations about the future under rational expectations agents are assumed to be more sophisticated 8 530 consumers will not simply assume a 2 inflation rate just because that has been the average the past few years they will look at current monetary policy and economic conditions to make an informed forecast in the new classical models with rational expectations monetary policy only had a limited impact lucas also made an influential critique of keynesian empirical models he argued that forecasting models based on empirical relationships would continue to produce the same predictions even as the underlying data generating model changed he advocated models based on fundamental economic theory i e having an explicit microeconomic foundation that would in principle be structurally accurate as economies changed 8 530 following lucas s critique new classical economists led by edward c prescott and finn e kydland developed real business cycle rbc models of the macroeconomy rbc models were created by combining fundamental equations from neo classical microeconomics to make quantitative models to generate macroeconomic fluctuations rbc models explained recessions and unemployment as changes in technology rather than in the markets for goods or money critics of rbc models argue that technological changes which typically diffuse slowly throughout the economy could hardly generate the large short run output fluctuations that we observe in addition there is strong empirical evidence that monetary policy does affect real economic activity and the idea that technological regress can explain recent recessions seems implausible 8 533 9 195 despite criticism of the realism in the rbc models they have been very influential in economic methodology by providing the first examples of general equilibrium models based on microeconomic foundations and a specification of underlying shocks that aim to explain the main features of macroeconomic fluctuations not only qualitatively but also quantitatively in this way they were forerunners of the later dsge models 9 194 new keynesian response edit new keynesian economists responded to the new classical school by adopting rational expectations and focusing on developing microfounded models immune to the lucas critique like classical models new classical models assumed that prices would adjust perfectly and that monetary policy would only lead to price changes new keynesian models investigated sources of sticky prices and wages due to imperfect competition 32 which would not adjust allowing monetary policy to impact quantities instead of prices stanley fischer and john b taylor produced early work in this area by showing that monetary policy could be effective even in rational expectations models when contracts locked in workers wages other new keynesian economists including olivier blanchard janet yellen julio rotemberg greg mankiw david romer and michael woodford expanded on this work and demonstrated other cases where various market imperfections caused inflexible prices and wages leading in turn to monetary and fiscal policy having real effects other researchers focused on imperfections in labor markets developing models of efficiency wages or search and matching sam models or imperfections in credit markets like ben bernanke 8 532 36 by the late 1990s economists had reached a rough consensus 33 the market imperfections and nominal rigidities of new keynesian theory were combined with rational expectations and the rbc methodology to produce a new and popular type of models called dynamic stochastic general equilibrium dsge models the fusion of elements from different schools of thought has been dubbed the new neoclassical synthesis 34 35 these models are now used by many central banks and are a core part of contemporary macroeconomics 8 535 36 2008 financial crisis edit the 2008 financial crisis and the subsequent great recession were the first events to lead to a major reassessment of macroeconomics this field had generally neglected the specific role of financial institutions in the economy after the crisis macroeconomic researchers have turned their attention to several new directions the financial system and the nature of macro financial linkages and frictions studying leverage liquidity and complexity problems in the financial sector the use of macroprudential tools and the dangers of an unsustainable public debt 8 537 36 increased emphasis on empirical work as part of the so called credibility revolution in economics using improved methods to distinguish between correlation and causality to improve future policy discussions 37 interest in understanding the importance of heterogeneity among the economic agents leading among other examples to the construction of heterogeneous agent new keynesian models hank models which may potentially also improve understanding of the impact of macroeconomics on the income distribution 38 understanding the implications of integrating the findings of the increasingly useful behavioral economics literature into macroeconomics 39 and behavioral finance growth models edit research in the economics of the determinants behind long run economic growth has followed its own course 40 the harrod domar model from the 1940s attempted to build a long run growth model inspired by keynesian demand driven considerations 41 the solow swan model worked out by robert solow and independently trevor swan in the 1950s achieved more long lasting success however and is still today a common textbook model for explaining economic growth in the long run 42 the model operates with a production function where national output is the product of two inputs capital and labor the solow model assumes that labor and capital are used at constant rates without the fluctuations in unemployment and capital utilization commonly seen in business cycles 43 in this model increases in output i e economic growth can only occur because of an increase in the capital stock a larger population or technological advancements that lead to higher productivity total factor productivity an increase in the savings rate leads to a temporary increase in output as the economy builds more capital however eventually the depreciation rate will limit capital expansion savings will be used to replace depreciated capital leaving none to pay for additional expansion solow s model suggests that economic growth measured by output per capita depends solely on technological advances that enhance productivity 44 the solow model can be interpreted as a special case of the more general ramsey growth model where households savings rates are not constant as in the solow model but derived from an explicit intertemporal utility function in the 1980s and 1990s endogenous growth theory arose to challenge the neoclassical growth theory of ramsey and solow this group of models explains economic growth through factors such as increasing returns to scale in capital and learning by doing that are endogenously determined rather than the exogenous technological improvement used to explain growth in solow s model 45 another type of endogenous growth model endogenizes technological progress by explicitly modelling research and development activities of profit maximizing firms 10 280 308 climate change in macroeconomics edit natural resources flow through the economy and end up as waste and pollution since the 1970s various environmental problems have been integrated into macroeconomic models particularly growth models to study the implications of resource scarcity and global climate change for aggregate economic outcomes the earliest work tackling the former question of scarcity was presented in william jevons s 1865 book the coal question in which he postulates a paradox whereby productivity improvements may accelerate scarcity in a growing economy during the oil crises of the 1970s when scarcity problems of natural resources were high on the public agenda economists like joseph stiglitz and robert solow introduced non renewable resources into neoclassical growth models to study the possibilities of maintaining growth in living standards under these conditions 10 201 39 in 2006 economist nicholas stern published the first comprehensive analysis of the global damages to the economy as a result of projected climate change scenarios in the stern review 46 this paper was the first to develop a model to assess the impact of slow on set climate change on gdp more recently the issue of climate change and the possibilities of a sustainable development are examined in so called integrated assessment models iams pioneered by william nordhaus 47 the use of iams is now widespread in climate economics and is used to get both disaggregated regional assessment of damages or global damages under different policy scenarios more theoretically macroeconomic models in environmental economics model a system in which production takes natural resources such as land water or energy as inputs in this case one example of an integrated model would replace the circular flow of income diagram may be replaced by a more complex flow diagram reflecting the input of solar energy which sustains natural inputs and environmental services which are then used as units of production such as the early work of herman daly 48 once consumed natural inputs pass out of the economy as pollution and waste the potential of an environment to provide services and materials is referred to as an environment s source function and this function is depleted as resources are consumed or pollution contaminates the resources the sink function describes an environment s ability to absorb and render harmless waste and pollution when waste output exceeds the sink s capacity long term damage occurs 49 8 many methods for national accounting that include environmental goods and services as components of economic output remain under discussion 50 heterodox macroeconomics edit other branches of macroeconomics that resist mainstream macroeconomic theories are broadly classified as heterodox macroeconomics this discipline includes the aforementioned ecological economics modern monetary theory marxian economics and other schools of thought that build on theoretical traditions beyond neoclassical or keynesian works for example heterodox economists see the driver of economic instability as price flexibility rather than price stickiness and therefore develop models with different assumptions and structures 51 austrian school macroeconomics edit the austrian school approaches macroeconomics from a distinct methodological standpoint following ludwig von mises human action austrians generally adopt praxeology a deductive method that treats economics as a science of purposeful individual action rather than human design 52 on this basis austrian economists have objected to the core tools of mainstream economics arguing that aggregate variables such as national output or general price levels mask the structural composition of an economy obscuring the underlying heterogenous capital structure subjective values prices and individual preferences that microeconomic decisions are based on citation needed the best known substantive contribution of the school is the austrian business cycle theory abct developed by mises and elaborated by hayek a contemporary of keynes macroeconomic policy edit the division into various time frames of macroeconomic research leads to a parallel division of macroeconomic policies into short run policies aimed at mitigating the harmful consequences of business cycles known as stabilization policy and medium and long run policies targeted at improving the structural levels of macroeconomic variables 10 18 stabilization policy is usually implemented through two sets of tools fiscal and monetary policy both forms of policy are used to stabilize the economy i e limiting the effects of the business cycle by conducting expansive policy when the economy is in a recession or contractive policy in the case of overheating 8 53 structural policies may include labour market policies that aim to change the structural unemployment rate or policies that affect long run propensities to save invest or engage in education research and development 10 19 monetary policy edit further information monetary policy central banks conduct monetary policy mainly by adjusting short term interest rates 54 the actual method through which the interest rate is changed differs from central bank to central bank but typically the implementation happens either directly via administratively changing the central bank s own offered interest rates or indirectly via open market operations 55 via the monetary transmission mechanism interest rate changes affect investment consumption asset prices like listed companies shares prices and house prices and through exchange rate reactions export and import in this way aggregate demand employment and ultimately inflation are affected 56 expansionary monetary policy lowers interest rates increasing economic activity whereas contractionary monetary policy raises interest rates in a fixed exchange rate system interest rate decisions together with direct intervention by central banks in exchange rate dynamics are major tools for controlling the exchange rate 57 in developed countries most central banks follow inflation targeting focusing on keeping medium term inflation close to an explicit target say 2 or within an explicit range this includes the federal reserve and the european central bank which are generally considered to follow a strategy very close to inflation targeting even though they do not 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