Robert Hall and Michael Woodford’s work modelling the macroeconomy based on individual agents’ decisions has significant implications for monetary policy. Despite being hailed as providing a rigorous foundation for stabilisation policies, focusing on the individual blinds us to the way the macroeconomy actually works. It may seem paradoxical; John Maynard Keynes’s insight was that the aggregate economy cannot be understood simply as the sum of individual actions. Heterodox economics, by focusing on the structure of the broader economy rather than its individual components, provides a much better framework for understanding the economy.

Investment and interest rates

The work of Keynes in the wake of the Great Depression led to the development of the study of the aggregate economy, as opposed to studying demand and supply of individual commodities.

Microeconomics focuses on the optimising behaviour of the individual, while macroeconomics focuses on statistical relationships to characterise aggregate behaviour.

Hall and Woodford provided rigorous models that rooted the study of macroeconomic aggregates, such as consumption, investment and employment, in the behaviour of individual agents. A key contribution was linking consumption to interest rates and the future. Individuals chose to smooth consumption over their lifetimes rather than base it solely on their current needs.

When interest rates were high, savings yielded greater returns. Individuals therefore had an incentive to defer some consumption to earn more and consume more in the future. Higher interest rates could reduce current consumption and hence lower current demand, and vice versa. Macroeconomic dynamics could consequently be derived from rigorous formulations of how individuals responded to market signals and policy variables such as interest rates.

This provided a framework within which Central Bankers could target an interest rate that was ‘neutral’ to the real economy — one that neither excessively stimulated nor depressed aggregate demand — greatly aiding the development of sophisticated stabilisation paradigms for monetary policy.

However, this approach collapsed the distinction between consumption, savings and investment. By viewing consumption inter-temporally, and by making it the main component of demand, the microfoundations methodology relegated the importance of volatile investment expectations to the background. Whatever was not consumed currently was saved, and automatically translated into future consumption demand. This was the framework followed by classical economics, which Keynes contested. He cautioned that not all saving is necessarily undertaken for future consumption.

In contrast, investment is fuelled by expectations of business owners as to prospects of profit. There is no necessity for the savings behaviour of individuals to always imply a demand for future consumption, and hence investment, by businesses. How can businesses determine whether an act of individual savings is to spend on a house for the future, or to ward against a future health emergency that may or may not occur? In such a situation, the interest rate cannot serve as an indicator of the extent of future consumption.

Keynes further suggested a radical intervention. It was not the interest rate that equated savings and investment, but income. Investment raised income, and generated an equal amount of savings.

This is not merely a technical insight, but an important way in which to view policy. It is not savings or inter-temporal consumption demand that affects output growth and employment, but business investment. To understand why economies are prone to instability, one must examine the investment behaviour of companies rather than the consumption demands of individuals.

Class and macroeconomic policy

According to Keynes, investment being done for profit in an environment of uncertainty is the chief source of economic instability. In uncertain situations, it is rational for investors to follow the herd, investing during a boom for fear of missing out on speculative returns, and withdrawing investment in a recession for fear of loss. This is the reason why booms and recessions get amplified. The work of Keynesians such as Hyman Minsky and Jan Kregel offers great insight into how the financial behaviour of firms brought about the boom in housing construction and finance, as well as the recession in 2008. Much of the current stock market gains in the U.S. economy are being driven by AI hyperscalers, giving rise to concerns of a new bubble that might eventually burst. Such outcomes can be clearly discerned when viewed from a Keynesian lens.

Some might argue that it does not matter how one views the economy, if the framework designed to bring about stability is effective. Moreover, in centering the actions of individuals, so the argument goes, this framework takes into account the reality of a complex economy being driven by individual choices.

Keynes’ genius was in going beyond what appeared at first glance. In a capitalist economy, it is not individuals that drive the economy, but the decision of businesses to expand the stock of productive machinery. The point stressed by Keynes is that individual welfare is harmed by an economic system driven by subjective expectations of the future made by businesses focused on profits rather than societal welfare.

The mainstream focus on individual-level microfoundations implicitly assumes that every individual is similarly placed in the hierarchy of the economy, differing only in the values of a few key parameters determining economic action.

In dividing the economy into two classes, heterodox economics does not reduce complexity or resort to ad hoc explanations. Instead, it provides a better analysis of why the individual is often ill-served by prevailing models of unregulated capitalism where the holding of capital, and the ability to make decisions regarding its investment, is restricted to members of a certain class. The structure of the economy determines its dynamics, and these nuances are lost in a framework that begins and ends with the individual.

(Rahul Menon is associate professor at O.P. Jindal Global University)

Published – October 23, 2026 08:30 am IST