The 1920s were roaring. Industrial production was climbing, and the stock market seemed to have no ceiling. To the classical economist, the market was a self-correcting machine.
Then came 1929. The machine seized up. GDP collapsed by nearly 30%, and unemployment skyrocketed to 25%. This wasn't a correction; it was a catastrophe.
Classical theory said wages would fall and employment would return. But the lines on the chart stayed flat. The world needed a new manual for the machine.
Enter John Maynard Keynes.
Keynes argued that the economy wasn't limited by supply, but by demand. In this diagram—the "Keynesian Cross"—equilibrium is where total spending meets total output.
When investors panic, Investment (I) drops. The aggregate demand curve shifts down. The economy settles at a new equilibrium—stuck far below full employment.
The solution? If the private sector won't spend, the government must. Increasing Government Spending (G) pushes the curve back up, restoring full employment through the multiplier effect.
Economists turned Keynes's words into a schematic: the IS-LM Model. The IS curve represents the "real" economy: lower interest rates encourage investment, boosting output.
The LM curve represents the money market. Where they cross, both markets are in balance. This was the cockpit from which economists believed they could steer the economy.
Pull the fiscal lever (spend more), and the IS curve shifts right. Output rises, but so do interest rates as demand for money increases.
Pull the monetary lever (print money), and the LM curve shifts down. Interest rates fall, stimulating investment and output. The machine seemed perfectly controllable.
Money flows in, output flows out. For decades, this "hydraulic" view dominated. It was an era of confidence—until the long run arrived.
Keynes focused on the short run. But Robert Solow asked: what drives wealth over decades? He modeled capital accumulation. An economy grows until investment equals depreciation: the Steady State.
If a nation saves more, it invests more. The curve shifts up, driving capital accumulation to a higher level. But eventually, growth levels off again.
Capital isn't enough. Solow found that the bulk of growth comes from Technology (A)—the "Solow Residual." Better ideas allow us to produce more with the same machines.
The model predicted that poor countries (with less capital) should grow faster than rich ones, eventually catching up. The data, however, told a messier story.
In the 1960s, policymakers relied on a simple trade-off: accept a little inflation to get lower unemployment. It seemed like a stable menu of choices.
Governments tried to "ride" the curve, pumping demand to keep unemployment historically low. For a while, it worked.
Then, the machine broke again. In the 1970s, inflation soared, but unemployment didn't fall. It rose. The curve had shifted. We had Stagflation.
Milton Friedman argued that you can't fool the market forever. Inflation, he said, is "always and everywhere a monetary phenomenon." The hydraulic levers had failed.
Robert Lucas delivered the final blow. He argued that the big macro models were flawed because they assumed people were robots who wouldn't react to policy changes.
If the government changes the rules (like printing more money), people change their expectations. They anticipate inflation, neutralizing the policy.
Macroeconomics had to be rebuilt from the ground up, based on rational agents making optimizing choices. The era of the simple hydraulic machine was over.
By 1980, the dashboard looked very different. The simple correlations were gone. The economy was no longer a machine to be steered, but a complex game to be understood.
As the 20th century closed, new questions arose. Information wasn't perfect. Markets weren't always rational. And a new digital revolution was about to rewrite the rules of value once again.