What do you Consider the Key Elements of "New Classical" Macroeconomics? What are the Important Policy Implications of this Approach?
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;
. 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) Rational decisions taken by workers and firms reflect optimising behaviour on their part,
ii) The supply of labour/output by workers/firms depends upon relative prices,
It is possible that economists may, however, support one or the other of these hypotheses, without necessarily accepting all three together.
Before Keynes' General Theory many economists were actively engaged in business cycle research (Haberler, 1963). However, one of the important consequences of the Keynesian revolution was the redirection of macroeconomic research towards questions relating to the level of output at a point in time, rather than the dynamic evolution of the economy over time.
The first economist to challenge the orthodoxy of old Keynesian economic theory, which had dominated macroeconomics since the 1930's, was Milton Friedman. Robert E. Lucas, who went on to become the leading developer of new classical macroeconomics, further developed Friedman's earlier work on new classical theory
New classical macroeconomics focuses on trying to explain the existence of business cycles in the economy. New classical theorists suggested two possible explanations for this phenomenon:
i) Equilibrium Business Theory. Decision-makers lack all the information they need to make sufficient economic forecasts.
ii) Real Business Theory. Business cycles are created due to supply or technology shocks.
The first of these ideas was the main focus of the work by Friedman and Lucas. While Edward Prescott developed the second.
Friedman, in his Presidential Address to the American Economic Association, put forward the first new classical theory, the 'fooling model', in 1967. There were two distinct features of this model. Firstly, Friedman suggested that both labour and supply markets always clear, such that workers or firms are never required to operate off the labour demand and supply curves. Secondly, he claimed that the business cycles are due to errors in judgement, mad by workers, who mistakably calculate the projected price level, as a result of the imperfect information to which they are exposed. A graphical representation of Friedman's 'fooling model' can be seen below;
Figure 1
An important element, added by Friedman, which was not present in Keynesian models, was that the labour supply curve is dependent on the expected real wage (W/Pe), which is the nominal wage (W) divided by the price level expected by workers (Pe).
As we can see from the above diagrams, Friedman suggests that an increase in aggregate demand (shift in demand curve from AD to AD1) will result in a rise in the actual price level and therefore, reduce the actual real wage (W/P). Consequently, firms will be encouraged to hire more workers. ...
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Figure 1
An important element, added by Friedman, which was not present in Keynesian models, was that the labour supply curve is dependent on the expected real wage (W/Pe), which is the nominal wage (W) divided by the price level expected by workers (Pe).
As we can see from the above diagrams, Friedman suggests that an increase in aggregate demand (shift in demand curve from AD to AD1) will result in a rise in the actual price level and therefore, reduce the actual real wage (W/P). Consequently, firms will be encouraged to hire more workers. An important aspect here is that only firms are aware of the price change, workers on the other hand, are not. Workers are still anticipating the expected price level. If the firms, now increase the nominal wage rate, workers will assume that their expected real wage rate has increased, and will therefore, work harder. In reality, they are being 'fooled'. The business cycle is now in process, until worker become aware that they are being fooled, and demand a nominal wage increase, hence returning the economy to it's original position once again.
The 'fooling model' is where the notion of 'natural real GDP' originated. Referring back to figure 1, the vertical long run aggregate supply (LAS) line, on the right-hand side diagram, represents accurate expectations. The level of output is always equal to natural real GDP, point Yn, on the diagram. When expectations are accurate. Friedman illustrates that eventually, all expectation errors will be corrected and output will not remain at an 'un-natural' real GDP for long. Therefore, Friedman is suggesting that shifts in aggregate demand have no long-run effects on real GDP. This process is described as the 'natural rate hypothesis'.
There has been much controversy surrounding Friedman's analysis. The claim that firm's have more accurate information than is available to workers, has raised many debates among observers. Critics have observed that workers can predict, almost as accurately as firms, due to the exposure they have to a wide selection of products as they shop, and also to the comprehensive media coverage that is given to economic matters, such as in 'The Financial Times'. Other criticisms involve the notion that workers can be so easily fooled regarding increases in price levels, when they have such easy access to historical evidence that displays trends in such economic developments. For example, these trends would help workers suspect that times of high production and increased job opportunities, are accompanied by an increase in the level of prices.
Major criticism of the 'fooling model' seems to be that Friedman does not appear to give workers much credit. This being the case, with workers not being so easily fooled in reality, an increase in demand that would raise the price level, would bring demands for equal increases in nominal wages from workers. But this would leave the real wage ratio (W/P) unchanged, hence meaning that employment levels remain the same, and so in this case, there would be no business cycle occurring. This demonstrates how the Friedman model isn't entirely applicable as an explanation for business cycles.
There were still many aspects of the Friedman model to be admired. Many economists, including Lucas, who was the most influential, followed up on Friedman's early work.
The 'Lucas model' incorporated Friedman's idea of market clearing and imperfect information, whilst also concentrating on the important aspect of 'rational expectations'. Lucas' theory of rational expectations suggests that people make the best forecasts they can with information available to them, even though it may not initially be correct, they will not make the same error twice, as a result, they learn from their mistakes. This argument contradicts Friedman's view that worker's can be continuously fooled for long periods of time.
According to Lucas, without the 'fooling' of workers, how is it possible for a business cycle to emerge? Lucas answers this, with reference to what he calls 'information barriers'. He claims that both, workers and firms suffer from information barriers that restrict them from making accurate deductions about prices and production of other firms, especially those in other industries. 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). Originally RBC analysis suggested that business cycles originated from real (supply) shocks, rather than monetary (demand) shocks. However, research later confirmed that demand shocks, such as changes in government spending or consumer preferences, as well as supply shocks were responsible for the emergence of business cycles.
The underlying emphasis, still however, remained with supply shocks; examples of which include, new production techniques, new products, bad weather, and changes in prices or availability of raw materials. The major assumption surrounding the RBC analysis is that the economy will always return to equilibrium as a response to these shocks, following on from the new classical assumption of continuous equilibrium. The effect of supply shocks can be seen in the following diagram,
Figure 2
As we can see from the above diagram, an adverse supply shock causes the production curve to shift downward (from a to b). This in turn will have a negative effect on labour and demand.
RBC analysis further demonstrates that workers will reallocate their working time in response to real wages. This is referred to as intertemporal substitution, where workers choose when to work longer or shorter hours, depending on the rate of wages, and having determined this from historical trends in wage fluctuation.
The way in which an economy responds to supply shocks, suggested by RBC, is a result of the choices of workers and firms over when to reduce or raise employment and output, in order to restore the stability of the economy. The notion of 'choice' is imperative to the RBC model. There is no allowance for government intervention, as it would distort employment and output levels from those chosen by the workers and by firms. The lack of a role for stabilisation policy and the assumption of market clearing, are therefore, two distinguishing features of the RBC analysis.
The emphasis that the RBC model put on technological shocks, as the main cause for business cycles, has resulted in it often being considered as a controversial theory. Critics have argued that technology is unique to particular industries and therefore the wide reaching effect of a technological shock in one industry to another unrelated one, is debatable. The theory that promotes demand shocks, such as those associated with government spending, as reasons for business cycles, also further takes away from the uniqueness of the supply shock argument.
Having considered the Friedman, Lucas and RBC models, which together form the basis of new classical macroeconomic theory, it is essential to establish the policy implications of these three models.
The main policy implications of the new classical approach include;
i) The policy ineffectiveness proposition,
ii) The output-employment costs of reducing inflation,
iii) Dynamic time inconsistency, credibility and monetary rules,
iv) The role of microeconomic policies to increase aggregate supply, and
v) The Lucas critique of econometric policy evaluation.
The first of these new classical policy implications, the policy ineffectiveness proposition (PIP); was first presented in two influential papers by Sargent and Wallace (1975, 1976). The PIP can be illustrated using the aggregate demand and supply model, as shown below,
Figure 3
We can see from the model above, that the economy is operating at point A, which is also the point of intersection of AD0, SRAS0, and LRAS. At point A, the price level, P0, is fully anticipated, and output and employment are at their long-run equilibrium (natural) levels. If, for example, authorities decide to increase the money supply, rational economic agents would take this information into account when forming their expectations and fully anticipate the effects of the increase in the money supply on the general price level, so that output and unemployment would remain unchanged at their natural levels. However, if the authorities increase the money supply without announcing their intentions, firms and workers, due to imperfect information, would misperceive the resultant increase in the general price level as an increase in relative prices, and would react by increasing the supply of output and labour. In this case, the AD curve would shift to the right, to AD1, to intersect the positively sloped SRAS0 curve at point B. Output as a result, would also shift to the right, to point Y1. Any change in output or employment levels would, however, be temporary, and would return to natural levels once agents realise that there has been no change in relative prices. To summarise, the new classical analysis suggests that, firstly, an anticipated increase in the money supply will raise the price level and have no effect real output and employment, and secondly, that only anticipated monetary surprises can effect real variables in the short run. The approach therefore, predicts that as rational economic agents will take into account any known monetary rule in forming their expectations, the authorities will be unable to influence output and employment even in the short run by pursuing a systematic monetary policy.
The second policy implication concerns the output-employment costs of reducing inflation. New classical theorist share the monetarist view that inflation is essentially a 'monetary phenomenon' propagated by excessive monetary growth. However, much disagreement exists between economists over the real costs of disinflation. For harmless disinflation to occur, the public must believe that the monetary authority is prepared to carry through its announced monetary contraction. If policy announcements lack credibility, inflationary expectations will not fall sufficiently to prevent the economy from experiencing output-employment costs.
The third policy implication surrounds dynamic time inconsistency, credibility and monetary rules. This case is based on a number of arguments including the informational constraints facing policy makers, problems associated with time-lags and forecasting, uncertainty with respect to the size of fiscal and monetary policy multipliers, the inflationary consequences of reducing employment below the natural rate and a basic distrust of the political process compared to market forces.
The next policy implication of the new classical approach concerns what policies the authorities should pursue if they wish to increase output/reduce unemployment permanently. Changes in output and employment are held to reflect the equilibrium supply decisions of firms and workers, given their perceptions of relative prices. 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.
BIBLIOGRAPHY
. A Modern Guide to Macroeconomics: An Introduction to Competing Schools of Thought, B. Snowden, H. Vane & P. Wynarczyk, Edward Elgar, 1994
2. Macroeconomics, R. J. Gordon, 7th edition, Addison Wesley, 1998
3. Macroeconomics, R. Dornbusch & S. Fischer, 7th edition, McGraw-Hill Inc., 1998
4. Lecture Notes, Intermediate Economic Analysis, 18/02/2002 and 25/02/2002
Intermediate Economic Analysis Tarandeep Baxi
BSc Development Economics 117514
