Transcript Chapter 12: New Classical Economics

New Classical Economics
Chapter 12
Prof. Steve Cunningham
Intermediate Macroeconomics
ECON 219
Rational Expectations Hypothesis (REH)
Expectations are formed on the basis
of all available relevant information
concerning the variable being
predicted.
 Agents understand the underlying
economic relationships.
 Expectational errors are NOT
systematic.

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Rational Expectations
Inflation Survey
600
Subjective
Objective
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400
Tally 300
200
100
0
0
1
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Predicted Inflation Rate
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Adaptive vs. Rational Expectations
x
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x x
Actual
Actual
x x
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x
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Adaptive Expectations
x
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x
x
Rational Expectations
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New Classical Economics
Essentially classical economics
with rational expectations, hence
new classical.
 Theoretical attack on Keynesian
Economics
 Monetarism II
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Policy Ineffectiveness Proposition
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Real output and employment are uneffected by
systematic or predictable changes in aggregate
demand policy.
If policy changes are systematic, therefore
predictable, then agents will not make systematic
mistakes in their forecasts.
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
Agents recognize that mistakes are costly, and will seek
out all available information to avoid such mistakes.
They will only make mistakes when they are
“surprised”.
Unanticipated policy changes will have a shortrun impact.
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Phillips Curve under REH
inflation
LRPC
2
5
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SRPC(2)
1
3
2
SRPC(1)
1
U1
U*
Unemployment
SRPC(0)
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More on PIP
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If a shock to the economy could be anticipated, and if it
were to persist, then unanticipated aggregate demand
policy could be used to offset its effects.
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But if the shock could be anticipated by policymakers, then it
could also be anticipated by all agents, and the policy
response would also be anticipated and would therefore be
ineffective.
Shocks don’t persist (aren’t guaranteed to persist).
Hence there is no role for stabilization policy.
Systematic money supply policy would avoid expectational
errors that would likely move the economy temporarily
away from full employment.
–
Therefore, adopt a constant growth rate rule for the money
supply.
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Fiscal Policy

Deficit spending?
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People would anticipate the long-run costs of
debt, and would act so as to offset deficit
spending.
They would increase saving to prepare for
future tax increases.
Fiscal policy would have little effect.
This is the Ricardian Equivalence Theorem,
and was restated by Robert Barro in the 1970s.
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Lucas Critique
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Argues that econometric models cannot
be used to predict the effects of proposed
policy.
Because of expectations, relationships
between economic variables (equations)
change with policy changes.
Can we predict the economy at all?
If we cannot predict, how can we employ
activist countercyclical policies?
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Time Inconsistency
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Another thread of new classical thought is due to
Kydland and Prescott. They present the time
inconsistency problem.
The policymaker analyzes the economy and
implements an optimal policy.
But once the policy is implemented, if the
policymaker re-analyzes the economy, it appears
that the policy is no longer optimal.
In fact, what appears to be optimal policy never
becomes optimal policy once it is implemented.
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New Classical View
of Keynesian Economics
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“Failure on a grand scale.”
Made up of ad hoc assumptions, not built on a
strong foundation of rational agents.
Must assume rational, optimizing agents.
Must assume that markets clear.
Keynesians do not explicitly handle expectations,
and expectations have been shown to be critically
important.
Have not given explicit structural explanations of
wage stickiness.
How can you explain persistence in business
cycles?
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New Keynesian Response (1)

Persistence:
–
There have been and are persistent and
substantial deviations from full
employment. There is nothing to the
persistence question.
•
•
Unemployment in Great Britain was greater
than or equal to 10% from 1923-1939.
U.S. Great Depression, unemployment was
greater than or equal to 14% for 10 years.
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New Keynesian Response (2)

Extreme Informational Assumptions
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NK’s accept that adaptive expectations
are ad hoc and unrealistic, but…
Unconstrained REH implies
unrealistically sophisticated agents
Bounded rationality
Structural impediments
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New Keynesian Response (3)

Justify wage stickiness by using a
contractual view of the labor market
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Okun: an “invisible handshake” rules the labor
market, not an “invisible hand”
Agents choose to contract because it
minimizes costs and stabilizes nominal cash
flows.
Agents may contract in overlapping contracts,
and firms may make offers while looking at
wages set by other firms.
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