Contemporary economic thought

Macroeconomics since the Bretton Woods era

From the 1970s onwards Friedman's monetarist critique of Keynesian macroeconomics formed the starting point for a number of trends in macroeconomic theory opposed to the idea that government intervention can or should stabilise the economy. Robert Lucas criticized Keynesian thought for its inconsistency with microeconomic theory. Lucas's critique set the stage for a neoclassical school of macroeconomics, New Classical economics based the foundation of classical economics. Lucas also popularized the idea of rational expectations, which was used as the basis for several new classical theories including the Policy Ineffectiveness Proposition.

The standard model for new classical economics is the real business cycle theory, which sought to explain observed fluctuations in output and employment in terms of real variables such as changes in technology and tastes. Assuming competitive markets, real business cycle theory implied that cyclical fluctuations are optimal responses to variability in technology and tastes, and that macroeconomic stabilisation policies must reduce welfare.

Keynesian economic made a comeback among mainstream economists with the advent of New Keynesian macroeconomics. The central theme of new Keynesianism was the provision of a microeconomic foundation for Keynesian macroeconomics, obtained by identifying minimal deviations from the standard microeconomic assumptions which yield Keynesian macroeconomic conclusions, such as the possibility of significant welfare benefits from macroeconomic stabilization. Akerlof’s ‘menu costs’ arguments, showing that, under imperfect competition, small deviations from rationality generate significant (in welfare terms) price stickiness, are good example of this kind of work.

Developments in microeconomics

From the 1970s onwards, microeconomics saw a resurgence of interest in the ideas of game theory, first developed by von Neumann and Morgenstern in 1944. One focus was on exploring and refining the concept of Nash equilibrium.

Financial economics

The efficient-market hypothesis (EMH) formed the core of financial economics for most of the later 20th century. The theory, associated with Eugene Fama, held that the current price of an asset, such as a stock, fully represented all information about the asset. This theory implied that it would be difficult, if not impossible, to consistently beat the typical market return on assets. The theory also dismissed technical analysis, and argued that an asset price followed a random walk—meaning an asset's future price movements were independent of its past movements. Economists used neoclassical rational expectations to support the theory. Instead of trying to pick winning investments, adherents of the EMH focused on modern portfolio theory, which showed how to diversify risks to maximize likely profits. The persistence of financial bubbles has cast doubt on the empirical validity of the EMH, as the market often appears to be driven by irrational exuberance. Recent research in behavioral finance and other fields have disputed the EMH on theoretical grounds, offering alternative models for financiers' behavior.

Behavioral economics

Behavioral economics and behavioral finance are closely related fields that have evolved to be a separate branch of economic and financial analysis, which applies scientific research on human and social, cognitive and emotional factors to better understand economic decisions by consumers, borrowers, investors, and how they affect market prices, returns and the allocation of resources.

Environmental and ecological economics

By the 20th century, the industrial revolution had led to an exponential increase in the human consumption of resources. The increase in health, wealth and population was perceived as a simple path of progress. However, in the 1930s economists began developing models of non-renewable resource management (see Hotelling's Rule) and the sustainability of welfare in an economy that uses non-renewable resources (Hartwick's Rule).

The work of economists Nicholas Georgescu-Roegen and Herman Daly was important in the development of ecological economics. In the Entropy law and the Economic Process (1971), Roegan attempted to demonstrate that the mathematical analysis of production in neoclassical economics is badly flawed because it fails to incorporate the laws of thermodynamics. In his view, an economy must be viewed in thermodynamic terms as a unidirectional flow in which inputs of low entropy matter and energy are used to produce two kinds of outputs, goods and services and high entropy waste and degraded matter.^[81] Since neoclassical economic theory in that view, assigns value only to the first output and completely ignores the costs associated with the second, Georgescu-Roegen attempted to refashion this theory to include these costs.^[82] Biophysical economics attempts to factor in aspects of energy and environment.^[83]Energy economics which relates to biophysical economics also attempts to factor in thermodynamic aspects of energy and environment.^[84] One technique for evaluating energy systems is net energy analysis, which seeks to compare the amount of energy delivered to society by a technology to the total energy required to find, extract, process, deliver, and otherwise upgrade that energy to a socially useful form. Energy return on investment (EROEI) is the ratio of energy delivered to energy costs. Biophysical and ecological economists argue that net energy analysis has several advantages over standard economic analysis.