Transcript Intermediate Macroeconomics - College Of Business and Economics

New Classical
Macroeconomics
Intermediate Macroeconomics
ECON-305 Spring 2013
Professor Dalton
Boise State University
New Classical Macroeconomics
“Keynesian orthodoxy or the neoclassical
synthesis is in deep trouble, the deepest
kind of trouble in which an applied body
of theory can find itself. It appears to be
giving seriously wrong answers to the
most basic questions of macroeconomic
policy.”
- Robert E. Lucas, Jr., “Tobin and Monetarism: A
Review Article,” JEL (June 1981)
New Classical Macroeconomics


Evolved out of monetarist economics of
1970s
Major proponents
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Robert E. Lucas, Jr.
Thomas Sargent
Robert Barro
Edward Prescott
Neil Wallace
Patrick Minford
New Classical Macroeconomics

Three Central Hypotheses
1.
2.
3.
Rational Expectations Hypothesis
Continuous Market-Clearing
Hypothesis
Aggregate Supply Hypothesis


Each can be judged in isolation
New Classicalists accept all three
Rational Expectations

Rational expectations hypothesis (at
least in weak form) becomes a central
modeling assumption of the dominant
schools in the 1990s and this century
Real Business Cycle School
 New Keynesian School


Rhetorical advantage of rational
expectations
Continuous Market-Clearing




All markets continuously clear in line
with Walrasian view
Agents and Firms are price-takers
Observed outcomes result of optimal
responses of agents to price
perceptions
New Classical Models are equilibrium
models
Continuous Market-Clearing

New Classical equilibrium
Equilibrium means that agents have
optimally responded to price signals
based on existing demands and supplies
 Demands and supplies are based on
expectations
 Lack of complete information can lead to
expectational errors and equilibria that
are not identical to the full-information
equilibria

Continuous Market-Clearing

New Classical equilibrium

Prices always adjust to clear markets

“instantaneous price adjustment”
Does not imply that market-clearing
prices are prices consistent with fullinformation equilibrium
 Prices can clear markets but still be
“wrong”

Continuous Market-Clearing

New Classical equilibrium

Implies that unemployment is always
entirely voluntary
Most critical and contentious of
new classical hypotheses
Aggregate Supply


Two main approaches
Both share two orthodox micro
assumptions
1.
2.
Workers’ and Firms’ decisions are
maximizing or optimal
Supply decisions of workers and firms
depend upon relative prices
Lucas-Rapping ASH
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Lucas, R.E., Jr., and Rapping, L., “Real
Wages, Employment and Inflation,”
Journal of Political Economy
(Sept./Oct. 1969)
Essence: during any period, workers
must decide how much time to
allocate between work and leisure.
Lucas-Rapping ASH


Workers have notion of “normal”
average real wage.
Workers intertemporally substitute
leisure over the course of their
lifetimes.
When w > we, workers work more and
take less leisure
 When w < we, workers work less and take
more leisure

Lucas-Rapping ASH


Employment is always at the voluntary
and optimal level.
Changes in employment reflect the
voluntary choices of labor due to
changes in relative real wages over
time.
Lucas ASH

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Lucas, “Expectations and the
Neutrality of Money,” Journal of
Economic Theory (April 1972)
Lucas, “Some International Evidence
on Output-Inflation Tradeoffs,” AER
(June 1973)
Spirit: “Signal-Extraction Problem”

Problem of information set available to
agents
Lucas ASH

“Signal-Extraction Problem”
Firms know current price of own output,
but price level of other markets known
only with lag. Agents must form
expectations of prices elsewhere.
 Firm problem: if Px increases, does that
mean Dx has increased or AD has
increased?

If Dx increased, then increase QSx
 If AD increased, then no change in QSx

Lucas “Surprise” AS Function

Both Aggregate Supply Hypotheses lead to
notion that Y deviates from YN due to
deviations of P from Pe (or deviations of dP
from dPe)
Y – YN = α (P – Pe)
Y – YN = α (dP – dPe)

If P > Pe (or P > Pe), then both workers and
firms mistake nominal price changes as
relative price changes
Equilibrium Business Cycle

Lucas saw himself as
Formally incorporating microeconomics
into macroeconomic models
 Taking up the business cycle research
agenda of Hayek – “incorporating cyclical
phenomena into system of equilibrium
theory”

Equilibrium Business Cycle
Central Thesis
Unanticipated AD shocks (resulting
mainly form unanticipated ∆Ms) cause
agents to make erroneous (rational)
expectations, that result in Y and L
deviations from (long-run) fullinformation equilibrium levels. Errors are
result of imperfect/incomplete
information, so general price changes
are mistaken for relative price changes.
New Classical v. Orthodox
Monetarism

OM: Workers fooled by inflation, firms
aren’t
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NC: Both workers and firms can be fooled
by inflation
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Adaptive expectations mean workers can be
continuously fooled
Rational expectations mean agents can only be
fooled by surprises
Both: Once agents realize errors, Y and L
return to long-run (or full-information)
equilibrium
New Classical Business Cycle

In New Classical Approach, deviations
from long-run equilibrium are due to
random shocks which cause errors in
price expectations.



Why are shocks necessarily random?
Ratex implies expectational errors are
random.
Ratex and ASH imply Y and L fluctuate
randomly around YN and LN.
New Classical Business Cycle

Unemployment and output deviate
from natural levels due to:
1.
2.
3.
Demand shocks
Supply shocks
Monetary surprise
New Classical Business Cycle

Further assumptions required to
explain persistence of deviations of Y
and L from trend values during
business cycles.
 Lagged output and durability of
capital goods.
 Labor contracts inhibiting immediate
adjustment.
 Adjustment costs.
Policy Implications
1.
2.
3.
4.
5.
6.
Policy Ineffectiveness Proposition
Output-Employment Costs of
Reducing Inflation
Dynamic Time Inconsistency,
Credibility and Monetary Rules
Central Bank Independence
Role of Micro Policies to Increase AS
The “Lucas Critique” of Econometric
Policy Evaluation
Policy Ineffectiveness
“Monetary authorities are
unable to influence output
and employment, even in
the short-run, by pursuing
systematic monetary
policy.”
Policy Ineffectiveness
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Agents form rational expectations.
If monetary authorities are following a
systematic policy, agents will come to
know the policy and its effects.
Agents will on average correctly anticipate
the actions and effects of monetary policy.
Deviations from full employment output
are result of surprise.
Therefore, systematic policy can not affect
output and employment.
Policy Ineffectiveness
P
LRAS
SRAS1
SRAS0


P2
P1

P0
AD1
AD0
YN Y*
Y
Expansionary monetary policy
shifts AD to right.
If unexpected, workers and
firms act as if increase in P is
increase in relative prices and
output increase beyond YN to
Y*.
As agents realize their
mistakes, output returns to YN
as prices adjust to fullinformation levels.
Policy Ineffectiveness
LRAS
P
SRAS1
SRAS0


P2

P0
AD1
AD0
YN

Y
Expansionary monetary policy
shifts AD to right.
If unexpected, workers and
firms act as if increase in P is
increase in relative prices and
output increase beyond YN to
Y*.
As agents realize their
mistakes, output returns to YN
as prices adjust to fullinformation levels.
If policy is expected, agents
realize prices will rise to fullinformation level, P2, and
therefore no real changes
occur.
Corollary
“Attempts to affect output
and employment by
random monetary policy
only increases the variation
of output and employment
around the natural levels.”
Policy Ineffectiveness

Empirical Tests

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Early work of Barro supportive of
New Classical Theory and the policy
ineffectiveness proposition
Subsequent studies by Mishkin and
Gordon find counter evidence
Output-Employment Costs
of Reducing Inflation
Sacrifice ratio = amount of lost
output per percentage point
reduction in inflation
 Orthodox Keynesians: sacrifice
ratio large owing to sluggish
response of prices and wages to
reduced AD

Output-Employment Costs
of Reducing Inflation

Orthodox Monetarists: sacrifice
ratio dependent upon
(1) degree of monetary contraction
(2) extent of institutional adaptations
(3) rate of expectations adjustment

Rate of expectations adjustment
depends upon credibility of monetary
authority
Output-Employment Costs
of Reducing Inflation
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New Classical: an announced
credible monetary contraction
leads to immediate reduction of
inflationary expectations and
sacrifice ratio is 0!
Only monetary surprises have effect on
real output and employment.
Monetary Growth Rules

Friedman’s Case for Monetary Growth
Rule
Informational constraints facing
policymakers
 Lag and forecasting problems
 Uncertainty of size of fiscal and monetary
multipliers
 Accelerationist hypothesis
 Distrust of political process

Dynamic Time Inconsistency
Kydland and Prescott, “Rules Rather
than Discretion: The Inconsistency of
Optimal Plans,” Journal of Political
Economy (June 1977)

Rigorous New Classical model where
policymakers are engaged in strategic
dynamic game with rational private sector
agents
Dynamic Time Inconsistency
 Time-inconsistency:
the divergence
between ex ante and ex post
optimality of government
fiscal/monetary policy
Time-inconsistency weakens credibility
of announced policies;
Time-inconsistency leads to an
inflationary-bias in discretionary policy
Dynamic Time Inconsistency
The Model
Policymakers
(1) specify targets
(2) identify SWF w/ targets as arguments
(3) choose policy s.t. SWF is maximized
Private Agents
Anticipate and adjust to policy
Social Welfare Function
St = f(Ut, dPt) with SRPC constraint
Dynamic Time Inconsistency
dPt

C
A

0
Ut
dPe = c 
dPe = 0
UN

A time-consistent policy
is one that maximizes S
s.t. constraint and is
consistent with agent
full-information
adjustment
Points on vertical axis
(LRPC) are potential
equilibria
C is a time-consistent
equilibria
A is a time-inconsisent
equilibria (why?)
Dynamic Time Inconsistency
dPt


C
A
0
Ut

dPe = c
dPe = 0
UN

Suppose at C (inferior or
sub-optimal) Why?
Reduction of monetary
growth from dM=C to
dM = 0 will move
economy directly to 0 if
credible
Once at 0, superior
position can be achieved
through inflationary
surprise to move to A
But such a policy is
time-inconsistent (why?)
Dynamic Time Inconsistency
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Policy Implications
If monetary authorities have
discretionary powers, they have an
incentive to cheat
Since agents know this, announced
policies that are time-inconsistent are
not credible
Discretionary policy produces suboptimal outcomes with an inflationary
bias
Central Bank Independence
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
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If time-inconsistency argument is accepted,
some constraint to discretion must be
found
Does central bank independence provide
this?
Empirical evidence


greater independence reduces average inflation
rate while having no effect on real performance
Counterarguments


Free banking and history of Fed
Macroeconomic coordination
Micro Policies and AS
Unemployment is equilibrium
outcome of optimal decisions
 Appropriate policy to reduce
unemployment is to increase
incentives for employment


Examples?
The “Lucas Critique”
Lucas, “Econometric Policy Evaluation: A
Critique,” in Brunner and Meltzer, ed.,
The Phillips Curve and Labor Markets
(1976)
 Attacks practice of using large scale
macro models to evaluate
consequences of alternative policy
scenarios
The “Lucas Critique”


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Such models are based on assumption
coefficients don’t change with change
in policy
Economic agents will adjust behavior
to new policy
Empirics
Models under-predicted dP in late 1960s
and early 1970s
 Direct tests: no strong support

Whose Critique?
“There is first of all the central question of methodology, - the
logic of applying the method of multiple correlation to
unanalysed economic material, which we know to be nonhomogeneous through time. If we were dealing with the
action of numerically measurable, independent forces,
adequately analysed so that we were dealing with
independent atomic factors and between them completely
comprehensive, acting with fluctuating relative strength on
material constant and homogeneous through time, we might
be able to use the method of multiple correlation with some
confidence for disentangling the laws of their action… In fact
we know that every one of these conditions is far from being
satisfied by the economic material under investigation… ”
- Keynes, “Professor Tinbergen’s Method,”
Economic Journal (1937)
Distinguishing Beliefs
(1) Economy inherently stable and
erratic monetary growth is primary
source of instability
(2) No long-run tradeoff between
inflation and unemployment; no
short-run tradeoff from systematic
monetary policy
Distinguishing Beliefs
(3) Credibility of monetary authority
primary determinant of fluctuations
in output and employment
(4) Discretionary monetary policy has
time-inconsistent inflationary bias;
rules are preferable
(5) Fiscal policy has no effect on the
economy, except to alter the natural
levels of output and employment
Evaluation: Weaknesses
New Classical macroeconomics argues
that the Business Cycle is ultimately
caused by information gaps


Given low cost availability of price and
monetary data, magnitude and duration of
actual business cycles seem too big to
reconcile
Empirics cast doubt that only unanticipated
changes in monetary policy have real
output effects
Evaluation: Lasting Impacts
(1) Attention to modeling
expectations
(2) Focus on building macro models
upon microeconomic foundations
(3) Understanding that policy less
robust than intimated by
macroeconometric models