Adam Smith had developed two chief lines of analysis. One centered on economic growth and its relationship to the distribution of income. This theme was taken up by David Ricardo and Thomas Malthus, and later by Karl Marx. Smith's second theme was the competitive marketplace, in which the interaction of demand and supply determined the "natural" price of commodities.
This second theme was developed further by the neoclassical economists. One group, led by Leon Walras, expanded Smith's analysis of individual markets into a theory of general equilibrium in all markets. These theorists concentrated on the conditions necessary for the existence of a general market equilibrium but paid little attention to how it could be achieved. They gave even less attention to problems of economic growth.
A second group of neoclassical economists headed by Alfred Marshall, sought to extend the analysis of demand and supply in individual markets in greater detail by developing a partial equilibrium theory that could be applied to specific economic problems, rather than the more general equilibrium of the followers of Walras. This was the situation, greatly simplified, that prevailed in conventional or mainstream economics at the time Keynes loosed his macroeconomic bombshell on the profession.
Economic theory is never isolated from politics and ideology, however. We have already seen how proponents of the neoclassical synthesis of the 1960s argued that competitive markets driven by consumer demand could continue to allocate resources and produce what the public wanted as long as Keynesian budget and monetary policies provided a stable economy at or near full employment. This, it was argued, would enable the U.S. economy to prosper while the inefficient authoritarian planning of the Soviet Union would slowly lead to economic stagnation there. Keynesian macroeconomic management plus free markets would lead to victory in the Cold War.
The limits of this approach became apparent with the ending of the long postwar boom in the late 1960s and the Great Inflation of the 1970s. Keynesian management of aggregate demand seemed to have little impact on the relative stagnation and the worsened recessions in the new era of slow economic growth. Unemployment increased and tended to last longer despite the best efforts of Keynesian-oriented policies. Worse yet, severe inflation, fueled by
increased energy costs, monetary expansion, and military spending, seemed completely out of control. Once again, events brought a change in economic thought. High theory in economics provided a new rationale for the desirability of private-enterprise capitalism in the form of general equilibrium theory, a new neoclassical macroeconomics, and a theory of real business cycles.