New classical macroeconomics

Last updated

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.

Contents

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 triggered by the 1973 oil crisis. Keynesian policy responses did not reduce unemployment, instead leading to a period of high inflation and stagnant economic growth—stagflation. Keynesians were puzzled by the outbreak of stagflation because the original Phillips curve ruled out concurrent high inflation and high unemployment.

Emergence in response to stagflation

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

After the 1970s and the apparent failure of Keynesian economics, 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]

The new synthesis took elements from both schools. New classical economics contributed the methodology behind real business cycle theory [5] and new Keynesian economics contributed nominal rigidities (slow moving and periodic, rather than continuous, price changes also called sticky prices). [6] The new synthesis provides the theoretical foundation for much of contemporary mainstream economics. [7] [8] [9]

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 Kirkman. [10]

The concept of rational expectations was originally used by John Muth, [11] and was popularized by Lucas. [12] 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. [13] [14] [15] [16] [17]

The mainstream turned to the new neoclassical synthesis. [7] [8] [9] 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. [13]

Peter Galbács [19] thinks that critics have a superficial and incomplete understanding of the new classical macroeconomics. He argues that one should not forget the conditional character of the new classical doctrines. If prices are completely flexible and if public expectations are completely rational and if real economic shocks are white noises, monetary policy cannot affect unemployment or production and any intention to control the real economy ends up only in a change in the rate of inflation. However, and this is the point, if any of these conditions does not hold, monetary policy can be effective again. So, if any of the conditions necessary for the equivalence does not hold, countercyclical fiscal policy can be effective. Controlling the real economy is possible perhaps in a Keynesian style if government regains its potential to exert this control. Therefore, actually, new classical macroeconomics highlights the conditions under which economic policy can be effective and not the predestined inefficiency of economic policy. Countercyclical aspirations need not to be abandoned, only the playing-field of economic policy got narrowed by new classicals. While Keynes urged active countercyclical efforts of fiscal policy, these efforts are not predestined to fail not even in the new classical theory, only the conditions necessary for the efficiency of countercyclical efforts were specified by new classicals.

See also

Related Research Articles

Keynesian economics Group of macroeconomic theories

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. Instead, it is influenced by a host of factors – sometimes behaving erratically – affecting production, employment, and inflation.

Macroeconomics Study of an economy as a whole

Macroeconomics is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and government spending to regulate an economy’s growth and stability. This includes regional, national, and global economies. According to a 2018 assessment by economists Emi Nakamura and Jón Steinsson, economic "evidence regarding the consequences of different macroeconomic policies is still highly imperfect and open to serious criticism."

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, a theory that has come under considerable question in recent years.

Stagflation Both high inflation and high unemployment

In economics, stagflation or recession-inflation is a situation in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high. It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment.

New Keynesian economics

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.

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

Robert Lucas Jr. American economist

Robert Emerson Lucas Jr. is an American economist at the University of Chicago, where he is currently the John Dewey Distinguished Service Professor Emeritus in Economics and the College. Widely regarded as the central figure in the development of the new classical approach to macroeconomics, he received the Nobel Prize in Economics 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". He has been characterized by N. Gregory Mankiw as "the most influential macroeconomist of the last quarter of the 20th century." As of 2020, he ranks as the 11th most cited economist in the world.

Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption. Neutrality of money is an important idea in classical economics and is related to the classical dichotomy. It implies that the central bank does not affect the real economy by creating money. Instead, any increase in the supply of money would be offset by a proportional rise in prices and wages. This assumption underlies some mainstream macroeconomic models. Others like monetarism view money as being neutral only in the long run.

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.

In macroeconomics, the classical dichotomy is the idea, attributed to classical and pre-Keynesian economics, that real and nominal variables can be analyzed separately. To be precise, an economy exhibits the classical dichotomy if real variables such as output and real interest rates can be completely analyzed without considering what is happening to their nominal counterparts, the money value of output and the interest rate. In particular, this means that real GDP and other real variables can be determined without knowing the level of the nominal money supply or the rate of inflation. An economy exhibits the classical dichotomy if money is neutral, affecting only the price level, not real variables. As such, if the classical dichotomy holds, money only affects absolute rather than the relative prices between goods.

Permanent income hypothesis 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 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.

Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Also known as orthodox economics, it can be contrasted to heterodox economics, which encompasses various schools or approaches that are only accepted by a minority of economists.

In the history of economic thought, a school of economic thought is a group of economic thinkers who share or shared a common perspective on the way economies work. While economists do not always fit into particular schools, particularly in modern times, classifying economists into schools of thought is common. Economic thought may be roughly divided into three phases: premodern, early modern and modern. Systematic economic theory has been developed mainly since the beginning of what is termed the modern era.

Dynamic stochastic general equilibrium modeling is a macroeconomic method which is often employed by monetary and fiscal authorities for policy analysis, explaining historical time-series data, as well as future forecasting purposes. DSGE econometric modeling applies general equilibrium theory and microeconomic principles in a tractable manner to postulate economic phenomena, such as economic growth and business cycles, as well as policy effects and market shocks.

Microfoundations

Microfoundations are an effort to understand macroeconomic phenomena in terms of economic agents' behaviors and their interactions. Research in microfoundations explores the link between macroeconomic and microeconomic principles in order to explore the aggregate relationships in macroeconomic models.

The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a neoclassical economics academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936). It was formulated most notably by John Hicks (1937), Franco Modigliani (1944), and Paul Samuelson (1948) dominated economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s 1960s, and 1970s.

Saltwater and freshwater economics

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.

Outline of economics Overview of and topical guide to economics

The following outline is provided as an overview of and topical guide to economics:

History of macroeconomic thought Aspect of history

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.

New neoclassical synthesis

The new neoclassical synthesis (NNS), which is now generally referred to as New Keynesian economics, and occasionally 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.

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 2006, p. 38.
  5. Kocherlakota 2010, p. 12.
  6. Mankiw 2006, p. 39.
  7. 1 2 Woodford, Michael. Convergence in Macroeconomics: Elements of the New Synthesis. January 2008. http://www.columbia.edu/~mw2230/Convergence_AEJ.pdf.
  8. 1 2 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.
  9. 1 2 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.
  10. 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.
  11. Muth, John F. (1961). "Rational Expectations and the Theory of Price Movements". Econometrica . 29 (3): 315–335. doi:10.2307/1909635. JSTOR   1909635.
  12. 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.
  13. 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.
  14. 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.
  15. 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.
  16. Mark Thoma, New Classical, New Keynesian, and Real Business Cycle Models, Economist's View
  17. 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.
  18. Kevin Hoover (2008). "New Classical Macroeconomics", econlib.org
  19. Galbács, Peter (2015). The Theory of New Classical Macroeconomics. A Positive Critique. Contributions to Economics. Heidelberg/New York/Dordrecht/London: Springer. doi:10.1007/978-3-319-17578-2. ISBN   978-3-319-17578-2.

Further reading