Classical macro-economists and stabilisation policies

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Classical macro-economists and stabilisation policies

The "policy inefficacy" principle is probably one of the most famous and controversial assertions of the New Classical School which is often regarded as a (counter)revolution in macroeconomic theory. We shall see, however, that despite the important insights and innovations of the approach, most of its conclusions including the invariance postulate are based on quite restricted and unrealistic assumptions and assertions which may make them of doubtful practical use.

The NC approach is characterised by its "relentless drive for microfoundations" and in particular the desire to base their theories on the assumption of the Rational Economic Man as a reaction perhaps to such Keynesian theories as "animal spirits", money illusion or the liquidity trap which seemed to imply "irrational" individual behaviour. Economic agents are, thus, seen as consistent and successful optimisers to the limits of their information which implies that agents are continuously in equilibrium. This coupled with the assumption of universal perfect competition ensures that markets always clear, unlike most "classical" - and monetarist - economists who considered equilibrium as a limiting case.

NCs therefore work within a Walrasian General Equilibrium unlike Monetarists who often preferred a Marshallian partial equilibrium approach. As required by Walrasian equilibrium the Classical Dichotomy is also re-established and Aggregate Supply (AS) is assumed to depend only on relative prices. As we shall see NCs restated even more strongly than monetarists the neutrality and superneutrality of money.

Another important feature of the NC school is its adoption of Rational Expectations (RE) first developed by Muth. RE assume that people engage in a cost-benefit analysis of whether it is worth searching for certain forms of information and then make efficient use of the information available to them by understanding how the economy works and continually revising expectations to take into account of any new information. NC theory focuses in particular in the efficient use of information aspect of RE, having little to say on how this information is obtained. Lucas and Prescot thus defined RE as the situation where the subjective probability distribution of future economic variables held at any time t coincides with the actual, objective conditional distribution based on the information assumed to be available at that time t.

NC economists accepted and extended Friedman's notion of the natural rate of unemployment which refers to the level of unemployment consistent with stable inflation and labour market equilibrium and is, thus, thought to be "voluntary". For Friedman adaptive expectations meant that though the Long Run Phillips Curve is vertical on the natural unemployment rate - and correspondingly AS is vertical on the level of "permanent" output, the Short Run Phillips Curve and AS are downward and upward sloping respectively. This was so because inflationary expectations were slow to adjust and, therefore, workers and -sometimes- employers suffered from money illusion. Thus Friedman did allow for Demand Management (monetary policy only of course) to affect output in the short run.

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The introduction of RE, however, meant that any systematic govt policy will not be able to affect output because rational agents will - immediately - adjust their inflationary expectations. Keynesians were, thus, accused of overlooking the fact that structural parameters change with government policy. This inability of a feedback money supply rule to affect output was termed by Sargent and Wallace as the "superneutrality" of money. Temporary divergences from the natural rate could only occur if the authorities - or any real shocks - managed to surprise individual agents. Hence, Lucas "surprise" AS function is derived :

Y = Yp ...

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