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What do you Consider the Key Elements of "New Classical" Macroeconomics? What are the Important Policy Implications of this Approach?

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Introduction

WHAT DO YOU CONSIDER THE KEY ELEMENTS OF "NEW CLASSICAL" MACROECONOMICS? WHAT ARE THE IMPORTANT POLICY IMPLICATIONS OF THIS APPROACH? While new classical macroeconomics evolved out of monetarist macroeconomics, during the 1970's and incorporates certain elements of that approach, such as the monetarist explanation of inflation. However, it should be seen as a separate school of thought from orthodox monetarism. The new classical approach is often taken to be synonymous with the works of Robert Lucas Jr. (university of Chicago). Other new classical macroeconomists include Thomas Sargent, Robert Barro, Edward Prescott and Neil Wallace. Underlying the new classical approach to macroeconomics is the joint acceptance of 3 main sub-hypotheses, involving; 1. The rational expectations hypotheses, John Muth (1961) suggested 'that expectations since they are informed predictions of future events are essentially the same as the predictions of the relevant economic theory'. It took approximately 10 years before either Lucas or Sargent incorporated this hypothesis into their models. 2. The assumption of continuous market clearing, The key assumption in the new classical models is that all markets are continuously clearing in line with the Walrasian tradition. At each point of time, all observed outcomes are viewed as 'market-clearing', and are the result of the optimal demand and supply responses of economic agents to their perceptions of prices. As a result the economy is viewed being as being in continuous state of (long run and short run) equilibrium. As a result, new classical models are often referred to as equilibrium models. 3. The aggregate supply hypotheses, There are two main approaches to aggregate supply that can be identified; i) ...read more.

Middle

Therefore, irregularities will occur and firms may misjudge price levels in other markets and as a result, charge relatively inaccurate prices in their own. This causes misrepresentation in market equilibrium and therefore, also in the business cycles. Lucas suggests that, in this case, firms must use rational expectations, in order to overcome these information barriers. Lucas' rational expectation analysis has led many to observe, what has become known as 'supply responses' of certain economies. According to Lucas, an economy that has historically experienced unique price movements will naturally have a high supply response, whereas an economy that has historically had stable prices movements will have a low supply response. Using this frame of thought, Lucas illustrates that in countries where inflation is relatively stable, such as the USA, and where unique movements in prices would therefore be more significant, the supply response will be high, and vice versa in countries where the inflation levels fluctuate greatly, such as Brazil and Argentina. This underlines the fact that developing countries such as Brazil and Argentina, will have much steeper supply curves, (as there are no great movements in supply), than developed countries such as the USA. This proved that the work of earlier economists, who had suggested that all countries would have similar supply slopes, was incorrect. This idea was a major breakthrough for Lucas, as well as the new classical theorists. Prescott followed the works of Friedman and Lucas, and suggested that rather than being a result of imperfect information; business cycles were caused by 'technology or supply shocks'. This has become commonly known as 'The Real Business Cycle' model (RBC). ...read more.

Conclusion

The labour market continuously clears so that anyone wanting to work at the current real wage can do so. Those who are unemployed voluntarily choose not to work at the current real wage rate. It follows from this that the appropriate policy measures to increase output/reduce unemployment are those that increase the microeconomic incentives for firms and workers to supply more output and labour. The final implication of the new classical approach concerns what is commonly known as the 'Lucas critique'. Since policy makers cannot predict the effects of new and different economic policies on the parameters of their models, replications using existing models cannot be used to predict the consequences of alternative policy regimes. In Lucas' view, the invariability of parameters in a model to policy changes cannot be guaranteed in Keynesian-type disequilibrium models. It is evident that new classical macroeconomic theory has had an important impact on the history of progressive economic thought, despite its limitations. The rational expectations theory has it foundations in the classical microeconomic assumptions of profit and utility maximisation, with both workers and firms wanting to make the best possible decisions, which will deliver the greatest rewards. This helped bring new classical macroeconomics in line with traditional microeconomics. The theory of market clearing has proved to be correct, as a result of the empirical evidence available in markets, such as the stock market and the foreign exchange market. The idea that people have rational expectations has improved our understanding of economic policy, as well as the distinction between anticipated policy changes and policy surprises. This shows that even when it is not theoretically foolproof, the policy implications of new classical theory will mean that we have a clearer economic understanding today. ...read more.

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