New classical macroeconomics

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New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.

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New classical macroeconomics strives to provide neoclassical microeconomic foundations for macroeconomic analysis. This is in contrast with its rival new Keynesian school that uses microfoundations, such as price stickiness and imperfect competition, to generate macroeconomic models similar to earlier, Keynesian ones. [1]

History

Classical economics is the term used for the first modern school of economics. The publication of Adam Smith's The Wealth of Nations in 1776 is considered to be the birth of the school. Perhaps the central idea behind it is on the ability of the market to be self-correcting as well as being the most superior institution in allocating resources. The central assumption implied is that all individuals maximize their utility.

The so-called marginal revolution that occurred in Europe in the late 19th century, led by Carl Menger, William Stanley Jevons, and Léon Walras, gave rise to what is known as neoclassical economics. This neoclassical formulation had also been formalized by Alfred Marshall. However, it was the general equilibrium of Walras that helped solidify the research in economic science as a mathematical and deductive enterprise, the essence of which is still neoclassical and makes up what is currently found in mainstream economics textbooks to this day.

The neoclassical school dominated the field up until the Great Depression of the 1930s. Then, however, with the publication of The General Theory of Employment, Interest and Money by John Maynard Keynes in 1936, [2] certain neoclassical assumptions were rejected. Keynes proposed an aggregated framework to explain macroeconomic behavior, leading thus to the current distinction between micro- and macroeconomics. Of particular importance in Keynes' theories was his explanation of economic behavior as also being led by "animal spirits". In this sense, it limited the role for the so-called rational (maximizing) agent.

The Post-World War II period saw the widespread implementation of Keynesian economic policy in the United States and Western European countries. Its dominance in the field by the 1970s was best reflected by the controversial statement attributed to US President Richard Nixon and economist Milton Friedman: "We are all Keynesians now".

Problems arose during the 1973–75 recession which was largely triggered by the 1973 oil crisis. The nascent classical economists attributed the blame to Keynesian policy responses for the continued unemployment, high inflation and stagnant economic growth—stagflation. Conversely, Keynesians using the Phillips curve or cost-push inflation models of struggled to provide non-ad hoc explanations of stagflation and its different magnitudes across different countries, such as higher inflation in the United States and the United Kingdom than in Germany and Japan.

Emergence in response to stagflation

The New Classical school emerged in the 1970s as a response to what were perceived as failures of Keynesian economics to explain stagflation. New Classical and monetarist criticisms led by Robert Lucas, Jr. and Milton Friedman respectively forced a labored rethinking of Keynesian economics. In particular, Lucas designed the Lucas critique primarily as a means to cast doubt on the Keynesian model. This strengthened the case for macro models to be based on microeconomics.

After the 1970s, the New Classical school for a while became the dominant school in Macroeconomics.

New neoclassical synthesis

Prior to the late 1990s, macroeconomics was split between new Keynesian work on market imperfections demonstrated with small models and new classical work on real business cycle theory that used fully specified general equilibrium models and used changes in technology to explain fluctuations in economic output. [3] The new neoclassical synthesis developed as a consensus on the best way to explain short-run fluctuations in the economy. [4] [5]

The new synthesis took elements from both schools. New classical economics contributed the methodology behind real business cycle theory [6] and new Keynesian economics contributed nominal rigidities (slow moving and periodic, rather than continuous, price changes also called sticky prices). [7] The new synthesis provides the theoretical foundation for much of contemporary mainstream economics. [8] [7] [5]

Analytic method

The new classical perspective takes root in three diagnostic sources of fluctuations in growth: the productivity wedge, the capital wedge, and the labor wedge. Through the neoclassical perspective and business cycle accounting one can look at the diagnostics and find the main ‘culprits’ for fluctuations in the real economy.

Foundation, axioms and assumptions

New classical economics is based on Walrasian assumptions. All agents are assumed to maximize utility on the basis of rational expectations. At any one time, the economy is assumed to have a unique equilibrium at full employment or potential output achieved through price and wage adjustment. In other words, the market clears at all times.

New classical economics has also pioneered the use of representative agent models. Such models have received severe neoclassical criticism, pointing to the disjuncture between microeconomic behavior and macroeconomic results, as indicated by Alan Kirman. [9]

The concept of rational expectations was originally used by John Muth, [10] and was popularized by Lucas. [11] One of the most famous new classical models is the real business cycle model, developed by Edward C. Prescott and Finn E. Kydland.

Legacy

It turned out that pure new classical models had low explanatory and predictive power. The models could not simultaneously explain both the duration and magnitude of actual cycles. Additionally, the model's key result that only unexpected changes in money can affect the business cycle and unemployment did not stand empirical tests. [12] [13] [14] [15] [16]

The mainstream turned to the new neoclassical synthesis. [8] [17] [5] Most economists, even most new classical economists, accepted the new Keynesian notion that for several reasons wages and prices do not move quickly and smoothly to the values needed for long-run equilibrium between quantities supplied and demanded. Therefore, they also accept the monetarist and new Keynesian view that monetary policy can have a considerable effect in the short run. [18] The new classical macroeconomics contributed the rational expectations hypothesis and the idea of intertemporal optimisation to new Keynesian economics and the new neoclassical synthesis. [12]

See also

Related Research Articles

Keynesian economics are the various macroeconomic theories and models of how aggregate demand strongly influences economic output and inflation. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy. It is influenced by a host of factors that sometimes behave erratically and impact production, employment, and inflation.

<span class="mw-page-title-main">Macroeconomics</span> Study of an economy as a whole

Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study topics such as output/GDP and national income, unemployment, price indices and inflation, consumption, saving, investment, energy, international trade, and international finance.

<span class="mw-page-title-main">Neoclassical economics</span> Approach to economics

Neoclassical economics is an approach to economics in which the production, consumption, and valuation (pricing) of goods and services are observed as driven by the supply and demand model. According to this line of thought, the value of a good or service is determined through a hypothetical maximization of utility by income-constrained individuals and of profits by firms facing production costs and employing available information and factors of production. This approach has often been justified by appealing to rational choice theory.

New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.

<span class="mw-page-title-main">Index of economics articles</span>

This aims to be a complete article list of economics topics:

<span class="mw-page-title-main">Robert Lucas Jr.</span> American economist (1937–2023)

Robert Emerson Lucas Jr. was an American economist at the University of Chicago. Widely regarded as the central figure in the development of the new classical approach to macroeconomics, he received the Nobel Memorial Prize in Economic Sciences in 1995 "for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy". N. Gregory Mankiw characterized him as "the most influential macroeconomist of the last quarter of the 20th century". In 2020, he ranked as the 10th most cited economist in the world.

Constantine Christos "Costas" Azariadis is a macroeconomist born in Athens, Greece. He has worked on numerous topics, such as labor markets, business cycles, and economic growth and development. Azariadis originated and developed implicit contract theory.

The policy-ineffectiveness proposition (PIP) is a new classical theory proposed in 1975 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations, which posits that monetary policy cannot systematically manage the levels of output and employment in the economy.

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<span class="mw-page-title-main">Permanent income hypothesis</span> Economic model explaining consumption pattern formation

The permanent income hypothesis (PIH) is a model in the field of economics to explain the formation of consumption patterns. It suggests consumption patterns are formed from future expectations and consumption smoothing. The theory was developed by Milton Friedman and published in his A Theory of the Consumption Function, published in 1957 and subsequently formalized by Robert Hall in a rational expectations model. Originally applied to consumption and income, the process of future expectations is thought to influence other phenomena. In its simplest form, the hypothesis states changes in permanent income, rather than changes in temporary income, are what drive changes in consumption.

<span class="mw-page-title-main">Mainstream economics</span> Generally accepted economic schools of thought

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<span class="mw-page-title-main">Schools of economic thought</span> Group of economic thinkers who share or shared a common perspective on the way economies work

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In economics, the freshwater school comprises US-based macroeconomists who, in the early 1970s, challenged the prevailing consensus in macroeconomics research. A key element of their approach was the argument that macroeconomics had to be dynamic and based on how individuals and institutions interact in markets and make decisions under uncertainty.

<span class="mw-page-title-main">History of macroeconomic thought</span>

Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.

In macroeconomic theory, general disequilibrium is a situation in which some or all of the aggregated markets, such as the money market, the goods market, and the labor market, fail to clear because of price rigidities. In the 1960s and 1970s, economists such as Edmond Malinvaud, Robert Barro and Herschel Grossman, Axel Leijonhufvud, Robert Clower, and Jean-Pascal Benassy investigated how economic policy would impact an economy where prices did not adjust quickly to changes in supply and demand. The most notable case occurs when some external factor causes high levels of unemployment in an economy, leading to households consuming less and firms providing less employment, leading to a rationing of both goods and work hours. Studies of general disequilibrium have been considered the "height of the neoclassical synthesis" and an immediate precursor to the new Keynesian economics that followed the decline of the synthesis.

The new neoclassical synthesis (NNS), which is occasionally referred as the New Consensus, is the fusion of the major, modern macroeconomic schools of thought – new classical macroeconomics/real business cycle theory and early New Keynesian economics – into a consensus view on the best way to explain short-run fluctuations in the economy. This new synthesis is analogous to the neoclassical synthesis that combined neoclassical economics with Keynesian macroeconomics. The new synthesis provides the theoretical foundation for much of contemporary mainstream macroeconomics. It is an important part of the theoretical foundation for the work done by the Federal Reserve and many other central banks.

<span class="mw-page-title-main">Inframarginal analysis</span>

Inframarginal analysis is an analytical method in the study of classical economics. Xiaokai Yang created the super marginal analysis method and revived the important thought of division of labour of Adam Smith. The new classical economics reconstructs several independent economic theories with the core of neoclassical economics from the perspective of endogenous individual choice specialization level by means of inframarginal analysis, which is the frontier subject of economics development.

References

  1. ↑ Chapter 1. Snowdon, Brian and Vane, Howard R., (2005). Modern Macroeconomics: Its Origin, Development and Current State. Edward Elgar Publishing, ISBN   1-84542-208-2
  2. ↑ Skidelsky, Robert (1996). "The Influence of the Great Depression on Keynes's General Theory" (PDF). History of Economics Review . 25 (1): 78–87. doi:10.1080/10370196.1996.11733219.
  3. ↑ Blanchard 2000, p. 1404.
  4. ↑ Mankiw, N. Gregory (May 2006). "The Macroeconomist as Scientist and Engineer" (PDF). pp. 14–15.
  5. 1 2 3 Goodfriend, Marvin and King, Robert G. The New Neoclassical Synthesis and The Role of Monetary Policy. Federal Reserve Bank of Richmond. Working papers. June 1997. No. 98–5. http://www.richmondfed.org/publications/research/working_papers/1998/pdf/wp98-5.pdf.
  6. ↑ Kocherlakota 2010, p. 12.
  7. 1 2 Mankiw, N. Gregory (May 2006). "The Macroeconomist as Scientist and Engineer" (PDF).
  8. 1 2 Woodford, Michael. Convergence in Macroeconomics: Elements of the New Synthesis. January 2008. http://www.columbia.edu/~mw2230/Convergence_AEJ.pdf.
  9. ↑ Kirkman, Alan P. (1992). "Whom or What does the Representative Individual Represent?". Journal of Economic Perspectives. 6 (2): 117–136. doi:10.1257/jep.6.2.117. JSTOR   2138411.
  10. ↑ Muth, John F. (1961). "Rational Expectations and the Theory of Price Movements". Econometrica . 29 (3): 315–335. doi:10.2307/1909635. JSTOR   1909635.
  11. ↑ Lucas, Robert E. (1972). "Expectations and the Neutrality of Money". Journal of Economic Theory . 4 (2): 103–124. CiteSeerX   10.1.1.592.6178 . doi:10.1016/0022-0531(72)90142-1.
  12. 1 2 Snowdon, Brian (Fall 2007). "The New Classical Counter-Revolution: False Path or Illuminating Complement?" (PDF). Eastern Economic Journal. 33 (4): 541–562. doi:10.1057/eej.2007.40. JSTOR   20642377. S2CID   154761891.
  13. ↑ Gilbert, Evan; Michie, Jonathan (1997). "New Classical Macroeconomic Theory and Fiscal Rules: Some Methodological Problems". Contributions to Political Economy. 16 (1): 1–21. doi:10.1093/oxfordjournals.cpe.a014051.
  14. ↑ Greenwald, Bruce C.; Stiglitz, Joseph E. (1987). "Keynesian, New Keynesian, and New Classical Economics". Oxford Economic Papers. 39 (1): 119–133. CiteSeerX   10.1.1.692.8775 . doi:10.1093/oxfordjournals.oep.a041773.
  15. ↑ Mark Thoma, New Classical, New Keynesian, and Real Business Cycle Models, Economist's View
  16. ↑ Seidman, Laurence (Fall 2007). "Reply to: "The New Classical Counter-Revolution: False Path or Illuminating Complement?"" (PDF). Eastern Economic Journal. 33 (4): 563–565. doi:10.1057/eej.2007.41. JSTOR   20642378. S2CID   153260374.
  17. ↑ Mankiw, N. Greg. The Macroeconomist as Scientist and Engineer. May 2006. p. 14–15. http://scholar.harvard.edu/files/mankiw/files/macroeconomist_as_scientist.pdf?m=1360042085.
  18. ↑ Kevin Hoover (2008). "New Classical Macroeconomics", econlib.org

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