Question

What led to the demise of ‘conventional Keynesian wisdom’ in the mid 1970s and why did the theory of rational expectations make the ‘monetarist experiment’ in the early 1980s more attractive to politicians?

Answer 1

theory has its origins in the study of business cycles and monetary theory.[1][2] 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.[3]

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.[4] 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.