New neoclassical synthesis

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The new neoclassical synthesis (NNS) or new synthesis is the fusion of the major, modern macroeconomic schools of thought, new classical and New-Keynesianism, into a consensus on the best way to explain short-run fluctuations in the economy. [1] This new synthesis is analogous to the neoclassical synthesis that combined neoclassical economics with Keynesian macroeconomics. [2] The new synthesis provides the theoretical foundation for much of contemporary mainstream economics. It is an important part of the theoretical foundation for the work done by the Federal Reserve and many other central banks. [3] [ page needed ]

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.

The neoclassical synthesis, or the neoclassical–Keynesian synthesis was a post-World War II academic movement in economics that worked towards absorbing the macroeconomic thought of John Maynard Keynes into neoclassical economics. The resultant macroeconomic theories and models are termed neo-Keynesian economics. Mainstream economics is largely dominated by the synthesis, being largely Keynesian in macroeconomics and neoclassical in microeconomics.

Neoclassical economics is an approach to economics focusing on the determination of goods, outputs, and income distributions in markets through supply and demand. This determination is often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by firms facing production costs and employing available information and factors of production, in accordance with rational choice theory, a theory that has come under considerable question in recent years.

Contents

Prior to the synthesis 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. [4] The new synthesis has taken 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). [2]

Technology shock

Technology shocks are sudden changes in technology that significantly effect economic, social, political or other outcomes. In economics, the term technology shock usually refers to events in a macroeconomic model, that change the production function. Usually this is modeled with an aggregate production function that has a scaling factor.

Four elements

Goodfriend and King proposed a list of four elements that are central to the new synthesis: [6] [ page needed ] intertemporal optimization, rational expectations, imperfect competition, and costly price adjustment (menu costs). [7] Goodfriend and King also find that the consensus models produce certain policy implications. [6] [ page needed ] In contradiction with some new classical thought, monetary policy can affect real output in the short-run, but there is no long-run trade-off: money is not neutral in the short-run but it is in the long-run. Inflation has negative welfare effects. It is important for central banks to maintain credibility through rules based policy like inflation targeting.

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.

Five principles

More recently, Michael Woodford attempted to describe the new synthesis with five elements. First, he stated that there is now agreement on intertemporal general equilibrium foundations. These allow both short-run and long-run impacts of changes in the economy to be examined in a single framework and microeconomic and macroeconomic concerns are no longer separated. This element of the synthesis is partly a victory for the new classical, but it also includes the Keynesian desire for modeling short-run aggregate dynamics. [8]

Second, the modern synthesis recognizes the importance of using observed data, but economists now focus on models built out of theory instead of looking at more generic correlations. [9]

Third, the new synthesis addresses the Lucas critique and uses rational expectations. However, based on sticky prices and other rigidities, the synthesis does not embrace the complete neutrality of money proposed by earlier new classical economists. [10]

The Lucas critique, named for Robert Lucas's work on macroeconomic policymaking, argues that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. More formally, it states that the decision rules of Keynesian models—such as the consumption function—cannot be considered as structural in the sense of being invariant with respect to changes in government policy variables. The Lucas critique is significant in the history of economic thought as a representative of the paradigm shift that occurred in macroeconomic theory in the 1970s towards attempts at establishing micro-foundations.

Fourth, the new synthesis accepts that shocks of varying types can cause economic output to fluctuate. This view goes beyond the monetarist view that monetary variables cause fluctuations and the Keynesian view that supply is stable while demand fluctuates. [11] Older Keynesian models measured output gaps as the difference between measured output and an ever-growing trend of output capacity. [5] Real business cycle theory did not consider the possibility of gaps and used changes in efficient output, caused by shocks to the economy, to explain fluctuations in output. Keynesians rejected this theory and argued that changes in efficient output were not large enough to explain wider swings in the economy. [12]

The new synthesis combines elements from both schools on this issue. In the new synthesis, output gaps exist, but they are the difference between actual output and efficient output. The use of efficient output recognizes that potential output does not grow continuously, but can move upward or downward in response to shocks. [5] [11]

Fifth, it is accepted that central banks can control inflation through the use of monetary policy. This is partly a victory for monetarists, but new synthesis models also include an updated version of the Philips curve that draws from Keynesianism. [13]

See also

General

Notes

  1. Mankiw 2006, p. 38.
  2. 1 2 Mankiw 2006, p. 39.
  3. Mankiw 2006.
  4. Blanchard 2000, p. 1404.
  5. 1 2 3 Kocherlakota 2010, p. 12.
  6. 1 2 Goodfriend & King 1997.
  7. Snowdon & Vane 2005, p. 411.
  8. Woodford 2009, p. 269.
  9. Woodford 2009, pp. 270–71.
  10. Woodford 2009, p. 272.
  11. 1 2 Woodford 2009, pp. 272–73.
  12. Kocherlakota 2010, p. 10.
  13. Woodford 2009, pp. 273–74.

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