Professors Robert E. Hall and Michael Woodford have been awarded the Nobel Prize in Economics this year “for microeconomic foundations of macroeconomic stabilisation”. In this piece, we take a longue durée view of macroeconomics to situate their work within the context of political economy. In many ways, the field has come full circle from the days of John Maynard Keynes and Michal Kalecki (henceforth KK)
Economists are products of their times. While KK wrote against the backdrop of the Great Depression, the deepest and longest economic crisis faced by capitalism (Chart 1a), this year’s Nobel laureates wrote in the aftermath of the unprecedented inflation of the 1970s (see Chart 1b).
These are two watershed moments in both the history of capitalism and the field of macroeconomics. The former brought the Keynesian revolution (though a misnomer, as Kalecki had an equal part in it), while the latter are part of a counterrevolution to reestablish pre-Keynesian orthodoxy in many ways.
Ideas matter a great deal. The arguments and policy flowing out of the KK framework led to what is considered the golden age of capitalism (1945-1973), a period that recorded the highest sustained growth rates (compare the average growth rates across time in chart 2).
What creates a business cycle?
What is a business cycle? Like a ship navigating the ocean, a capitalist economy moves through ebbs and flows in economic activity. Just as a ship cruises smoothly when the waters are calm, an economy has an underlying long-term trend rate of growth. Both the cycle and the underlying trend rate of growth have been the subject of intense debates in economics. There are two broad poles in this debate — with some variations within each: heterodox and orthodox approaches.
Heterodox approaches hold that demand influences both the cycle and the trend, while orthodox approaches believe demand plays a role in the cycle but not the trend, albeit for different reasons. The Nobel laureates work within the latter tradition, while KK did within the former. Why should the readers bother about these esoteric questions? Because our livelihoods, jobs, cost of living, and much else depend on which side is steering the ship.
Consider the orthodox approach. Before KK, it was believed that in the long run, economies move along full-employment paths with cycles arising from external shocks, which did not require policy interventions from the State. These arguments, however, were built on ad hoc assumptions. In the 1980s, a newer version of this orthodox approach sought to build the framework from the bottom up, moving from micro-foundations to a macroeconomic model. This led to the development of real business cycle (RBC) theory, associated with economists Finn Kydland and Edward Prescott, who won the 2004 Nobel Prize in Economics. The economy functions along the full-employment path, with the trend determined by the growth of the labour force and its productivity (Graph 1(a)). For them, output and labour markets clear in the short run, so even the cyclical movements were caused by the supply side, thereby precluding the possibility of any State intervention.
Economists such as Hall and Woodford, while keeping the RBC framework intact, argued that economies can fall off the full-employment path if prices do not adjust fast enough to clear the markets. The argument they made was that not all firms change their prices at the same time; some do so in one period, while others in another. As a result, prices do not fully adjust between these periods. If household demand for goods is less than what firms collectively wish to supply (Graph 1(b)), prices may not fall enough to restore equilibrium. The economy then operates at lower levels of demand (recession). The opposite happens if demand is greater than supply (boom with signs of overheating).
If you consider a time period long enough (over a business cycle), on average, the prices would have adjusted fully, in which case demand also adjusts fully to what the firms would like to supply. Demand creates supply in the short run while supply determines the demand in the long run. It is obvious, therefore, that policy is required only for the short run and not the long run.
Demand and long-term growth
The KK tradition is markedly different from this. They argued that demand matters not just in determining the cyclical component of growth but also the underlying trend. Kalecki had famously said, “the long-run trend is but a slowly changing component of a chain of short-period situations; it has no independent entity”. If the economy is underemployed through the short run, it remains so in the long run as well (see graph 2 (a)). And if policy changes the short-run equilibrium, it affects the trend rate of growth too.
But even more importantly, their analysis of the short term differs as well. Economies are stuck at below-capacity output or with unemployed workers not because prices and wages are rigid but because capital investment by the capitalists is not enough to employ all those who seek employment. Rigidity of investment, not prices, causes unemployment. In Keynes, prices are not even rigid, let alone being the cause of the business cycle. In Kalecki, they are, but that is not the cause of the shortage of demand. Unless the fall in prices could affect investment, it would have no impact on demand. Demand is vertical in prices (Graph 2(b)).
A fall in prices may in fact have a negative impact on investment through debt defaults, etc. All of this had a profound impact on both understanding the workings of a capitalist economy as well as policy prescriptions.
Non-neutrality of money
Having looked at their understanding of how capitalism functions, consider their take on policy, particularly monetary policy.
Before Keynes, it was believed that money could not affect the ‘real’ economy, i.e., it was neutral in its impact on output. It was believed that a larger pool of money would chase the same amount of goods, which simply leads to a rise in their prices. The role of monetary policy, therefore, was to stabilise prices. The New Keynesian Model (NKM) agrees that this is indeed the case in the long run; however, in the short run, since prices are sticky, a rise in the money supply increases real balances in the hands of households, who increase their consumption, thereby making money non-neutral. But this holds only in the short run. While money is non-neutral in the short run, the primary role of monetary policy nevertheless is to stabilise inflation. No wonder that this policy approach is called inflation targeting. The KK framework, on the other hand, did not believe that money leads to inflation. Given that the ebbs in activity were caused by a lack of adequate private investment, their policy recommendations foregrounded policies which increased the level of activity directly, i.e., through fiscal intervention by the State. If private investment is not coming through, public investment fills the gap.
As for monetary policy, it mostly played a second fiddle to fiscal policy in their framework. Monetary policy on its own may not work because it is an indirect route of increasing private investment by decreasing the cost of loans. KK believed that low investment is because the demand for the products the factories produce is low, so a mere fall in the cost of loans will not reverse the ‘animal spirits’ of the capitalists.
Class politics of inflation
All of this is not just a theoretical debate. While the Keynesian revolution improved the lot of the workers on the whole, the monetarist counter-revolution has made them the scapegoats in this fight against inflation, which we have written about in these columns earlier. It is not surprising that the wage shares were rising during the KK years and a reversal has taken place since the RBC counterrevolution took hold over the discipline (Chart 3). Economic frameworks and policy prescriptions, therefore, are not, and can never be, class agnostic.
(The authors are a part of the DevMac (Development Macroeconomics) network, which seeks pluralism in Economics)
Published – October 15, 2026 08:30 am IST
