Neo-Wicksellian macroeconomics

Modern macro has more to do with Wicksell's Interest and Prices than with Keynes' General Theory. For one, the idea of a natural rate of unemployment derives directly from Wicksell's natural rate of interest, as Friedman noted. So here is a brief explanation of Wicksell's main argument in that book.

Wicksell distinguished between the natural rate of interest (R*) and the monetary or bank rate of interest (R). The former was determined by the marginal productivity of capital (I) and the intertemporal decisions of consumption (leading to savings S), along the lines of what became known as the loanable funds theory. The monetary rate was determined by bank decisions. That is, banks supplied credit (Ms) at the chosen rate of interest (R), according to money demand (Md). Monetary equilibrium occurred when the two rates coincided (see figure below). The natural rate is the gravitational center around which the bank rate fluctuates. Real and monetary shocks could cause deviations of the bank rate from equilibrium.

Wicksell assumes that a positive productivity shock raises the natural rate of interest, and that banks maintain the initial monetary rate. Thus, with a low bank rate, investment exceeds savings and once the system reaches full employment prices would go up. However, continuous lending would reduce bank reserves, and as a result banks would be forced to increase the monetary bank until a new equilibrium was reached. Inflation resulted from a bank rate that was too low, as much as deflation (and temporary unemployment) from a bank rate that was too high.

The low bank rate implies overinvestment, and the need for additional savings. The inflationary process by reducing the ability of consumers to spend provides the additional 'forced savings.' Inflation acts as a tax that provides the additional resources needed to finance investment. The business cycle can be explained by exogenous shocks to productivity (the I curve), changes in consumers preferences (shocks to S), or by the misconduct of the banking sector (shocks to Ms). Wicksell, as much as the modern Real Business Cycle (RBC) School, favored the former.