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31/10/2015
1
ECON 313: MACROECONOMICS I
W/C 9th November 2015
MACROECONOMIC THEORY AFTER KEYNES
New Classical Economics
Ebo Turkson , PhD
The New Classical
EconomicsFROYEN CHAPTER 11
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Sections
The New Classical Position
Introduction : The Policy Ineffectiveness Proposition
A Review of the Keynesian Position
The Rational Expectations
Concept and Its Implications
New Classical Policy Conclusions
The Keynesian Counter critique
The Question of Persistence
The Extreme Informational Assumption
Auction Market Versus Views of the Labour Market
Introduction
This theoretical system was developed against the
background of the high rates of inflation and
unemployment of the 1970s.
Keynesian economics had failed to predict high rates of
inflation and unemployment because high rates of inflation
was expected to coincide with low unemployment.
Robert Lucas, the central figure under the New Classical
economics was at the forefront of the dissatisfaction and
scathing criticism of Keynesian economics
New Classical Economist believed that the Keynesian
structure is fundamentally flawed, internally inconsistent
and not useful for understanding economic events.
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The Policy Ineffectiveness Proposition
The proposition asserts that systematic monetary and
fiscal policy actions that change AD will not affect output
and employment even in the short run.
The central policy tenet of the new classical economics is
that stabilisation of real variables such as output and
employment cannot be achieved by aggregate demand
management policies
A Review of the Keynesian Position
Keynes analysis of the relationship between AD, output
and employment showed that demand management
policies influence real output and employment.
For instance the effect of an expansionary monetary
policy in the short run
Shifts AD to the right along an upward sloping AS curve leading to
an increase in real output and price
Increase in price simultaneously shifts the labour demand curve
and with the labour SS given leads to an increase in employment
needed to produce the increase in real output
In all of this the AS and Labour SS curves were assumed
to be fixed in the SR because they depended on Pe
which Keynes assumed depend primarily on past prices.
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Output Market
Expansionary Monetary Policy
Real GDP
P0
AS
P1
Y0Y1
AD0
AD1
E0
YC
E1
Labour Market
Expansionary Monetary Policy
Employment
W0
NS (Pe0)
W1
N0 N1
MPN. P0
MPN. P1
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A Review of the Keynesian Position
The implication is that in the SR there is a trade-off
between inflation and unemployment
Higher growth in AD correspond to higher prices (higher rates of
inflation) and higher output and employment (lower
Unemployment)
In the LR the expected price level converges with the
actual price level
This shifts the AS and labour SS curve to the left sending real
output and employment back to initial equilibrium.
Here both prices and money wages are left permanently higher as
a result of the expansionary monetary policy
Thus in the LR output and employment are unaffected
(this was similar to what the monetarist believed in)
Rational Expectations: Concept and Implications
The new classicals do not agree with the Keynesian (and
monetarists) analysis of demand management policies
At the heart of their disagreement is the Keynesian and
monetarist assumption concerning price expectations
To the new classicals price expectations are not formed
adaptively but rather rationally
They criticise the adaptive expectations as naïve in the
extreme.
The NC ask “why would rational economic agents form
an expectation of the price level relying on only past
values when systematically they find that the actual
prices depend on current policy?”
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Rational Expectations: Concept and Implications
Rather than being naïve , the NCs propose that
economic agents will form rational expectations of the
price level and therefore will not make systematic errors
According to the rational expectations hypothesis;
Expectations are formed on the basis of all available
relevant information concerning the variable being
predicted. Moreover economic agents are assumed to use
the available information intelligently because they
understand the relationship between the variables they
observe and the variables they are trying to predict.
Rational Expectations: Concept and Implications
Thus labour will not only base their expectations on past
values of the price level but also information about
current policies that influence the price level
If labour suppliers are forward-looking in their formation
of Pe, then the conclusion from the Keynesian and
monetarist analysis wont suffice even in the SR.
In all of this, what is important in forming the rational
expectations is whether the policy changes are
anticipated or unanticipated
anticipated or unanticipated policy changes have
different effects under rational expectations
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Rational Expectations: Concept and Implications
If we assume that the policy changes are anticipated
what will be the conclusion when expectations are
rational?
Anticipated policy changes because the policy is announced or
alternatively the public will anticipate the change because the
policy maker is known to act in certain ways
Recall under Keynesian economics that labour SS
depends on the real wage which itself depends on Pe,
this is exactly what the NCs also assume
It is what informs the Pe that is the point of digression
According to the NCs, Pe depends on the expected levels
of all the variables that determine the price level
Rational Expectations: Concept and Implications
These include
Expected level of money supply (Me)
Expected level of Government Spending (Ge)
Expected level of taxation (Te)
Expected level of autonomous Investment (Ie)
And other variables
Thus if the AS and labour SS depends on Pe and as
assumed under rational expectations Pe depends on Me
Ge ,Te , Ie etc., then;
AS=f(Me0 Ge
0 ,Te0 , Ie0 )
NS=f(Me0 Ge
0 ,Te0 , Ie0 )
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Rational Expectations: Concept and Implications
So what will be the impact of an expansionary
monetary policy under rational expectations?
Under Keynesian
M ( 𝑴 𝑷) ESM EDB PB r (LM shifts
downwards to left to LM1 and AD shifts rightward) Y
and P (since upward sloping AS is fixed)
P (MPN.P) shifts Labour DD curve upwards
W and N (employment) since the Labour SS remains
fixed
Thus M Y , P and N and W
Rational Expectations: Concept and Implications
Under New Classicals –Rational Expectations
(anticipated Policy Changes)
M ( 𝑴 𝑷) ESM EDB PB r (LM shifts
downwards to left to LM1 and AD shifts rightward) Y
and P (MPN.P) shifts Labour DD curve upwards
W and N (employment).
Because rational expectations are being held AS and
Labour SS are not fixed.
Suppliers of labour will anticipate the inflationary impact of
the M and so will revise their Pe upwards left shift of the
AS Y until output returns to initial Y and P further
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Rational Expectations: Concept and Implications
Under New Classicals – Rational Expectations
(anticipated Policy Changes)
Revision of Pe upwards will also shift NS to the left at the
same time the higher P (MPN.P) shifts Labour DD
curve upwards again until N returns to intial.
Even in the SR
M P and W but NO CHANGE in Y and N
This far the New Classicals differ from the prediction
of the Keynesians and monetarists.
Output Market: RE and Anticipated Change
Expansionary Monetary Policy
Real GDP
P0
AS(Me0 Ge
0 ,Te0 , Ie
0 )
P1
Y0 Y1
AD0
AD1
E1
E2
E0
P2
AS(Me1 Ge
0 ,Te0 , Ie
0 )
M
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Labour Market RE and Anticipated Change
Expansionary Monetary Policy
Employment
W0
NS(Me0 Ge
0 ,Te0 , Ie
0 )
W1
N0 N1
ND0= MPN. P0
ND1= MPN. P1
W2
ND2= MPN. P2
E2
E0
E1
NS(Me1 Ge
0 ,Te0 , Ie
0 )
Rational Expectations: Concept and Implications
Under New Classicals –Rational Expectations
(unanticipated Policy Changes)
M ( 𝑴 𝑷) ESM EDB PB r (LM shifts
downwards to left to LM1 and AD shifts rightward) Y
and P (MPN.P) shifts Labour DD curve upwards
W and N (employment).
although rational expectations are being held AS and
Labour SS will not shift because the policy changes are not
anticipated by suppliers of labour.
Thus in the SR M Y , P and N and W
This conclusion does not differ from Keynesians and
monetarists
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Output Market: RE and Unanticipated Change
Expansionary Monetary Policy
Real GDP
P0
AS(Me0 Ge
0 ,Te0 , Ie
0 )
P1
Y0 Y1
AD0
AD1
E1
E0
M
Labour Market RE and Unanticipated Change
Expansionary Monetary Policy
Employment
W0
NS(Me0 Ge
0 ,Te0 , Ie
0 )
W1
N0 N1
ND0= MPN. P0
ND1= MPN. P1
E0
E1
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RE and Unanticipated Change
The case of unanticipated policy changes shows a very
important difference between the new classicals and the
classical theory
Under classical theory economic agents are assumed to
have perfect information and that there are no monetary
surprises therefore no policy change will have an impact on
the supply determined real output level and employment
Under the new classical theory, in the case of monetary
surprises (i.e. unanticipated policy changes), although
economic agents form rational expectations, they do not
have prefect information and therefore aggregate demand
policies could impact on real output level and employment.
New Classicals Policy Conclusions
In spite of their acceptance that unanticipated AD policy
changes have an impact on output and employment, the
NCs still object to the role of stabilisation policies
For instance they argue that any stabilization policy to
correct any imbalance is needless and at best desirable
but not feasible.
For instance suppose there is an autonomous decline in
investment, should a stabilisation policy be pursued to
get the economy on track?
Keynes answer would be an emphatic Yes
The new classicals NO if anticipated and desirable if
unanticipated, but not feasible irrespective.
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New Classicals Policy Conclusions
Why NO if anticipated and desirable if unanticipated,
but not feasible irrespective.
I0 AE Y (at initial Price level and AD shifts
leftward) P (MPN.P) shifts Labour DD
curve downwards W and N (employment).
Whether this will subsequently trigger a reaction from
labour suppliers or not will depend on whether the
decline in autonomous Investment was anticipated or
not.
New Classicals Policy Conclusions
If I0 is anticipated
I0 AE Y (at initial Price level and AD shifts
leftward) P (MPN.P) shifts Labour DD
curve downwards W and N (employment).
because labour supplier expects prices to fall and real
wages increase they will supply more labour at the
current money wage leading to a rightward shift in
Labour SS
NS curve shifts right AS curve shifts right P
further down and Y back to initial equilibrium
level.
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New Classicals Policy Conclusions
If I0 is anticipated
P further down(MPN.P) shifts Labour DD
curve further downwards W and N back to
initial level.
I0 P and W but NO CHANGE in Y and N
Output Market: RE and Anticipated Change
Decline in autonomous Investment
Real GDP
P0
AS1(Me0 Ge
0 ,Te0 , Ie
1 )
P1
Y0Y1
AD0
AD1
E1
E2
E0
P2
AS0(Me0 Ge
0 ,Te0 , Ie
0 )
I0
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Labour Market RE and Anticipated Change
Decline in autonomous Investment
Employment
W0
NS1(Me0 Ge
0 ,Te0 , Ie
1 )
W1
N0N1
ND0= MPN. P0
ND1= MPN. P1
W2
ND2= MPN. P2
E2
E0
E1
NS0(Me0 Ge
0 ,Te0 , Ie
0 )
New Classicals Policy Conclusions
If I0 is unanticipated
I0 AE Y (at initial Price level and AD shifts
leftward) P (MPN.P) shifts Labour DD
curve downwards W and N (employment).
because labour suppliers do not expect prices to fall
(because they did not anticipate I0 ) Labour SS and AS
will remain unchanged
I0 P and W as well as Y and N
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Output Market: RE and Unanticipated Change
Decline in autonomous Investment
Real GDP
P0
P1
Y0Y1
AD0
AD1
E1
E2
E0
AS0(Me0 Ge
0 ,Te0 , Ie
0 )
I0
Labour Market RE and Unanticipated Change
Decline in autonomous Investment
Employment
W0
W1
N0N1
ND0= MPN. P0
ND1= MPN. P1
W2
ND2= MPN. P2
E0
E1
NS0(Me0 Ge
0 ,Te0 , Ie
0 )
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New Classicals Policy Conclusions
If I0 is unanticipated
The question is wont an offsetting policy action reverse this
undesirable outcome.
I0 AE Y (at initial Price level and AD shifts leftward)
P (MPN.P) shifts Labour DD curve downwards
W and N (employment).
I0 P and W as well as Y and N
For instance an expansionary monetary policy
M AD shifts rightward back to origin Y and P back
to initial (MPN.P) shifts Labour DD curve upwards
back to initial W and N (employment) back to initial.
New Classicals Policy Conclusions
If I0 is unanticipated
The NC argue that an offsetting policy action is desirable
only temporary. Why?
because over time suppliers of labour will become aware
of the I0 especially if it persists and so will make
adjustment in the next period to Labour SS and AS so that
in the final analysis there will be no change in Y and N (as
in the anticipated policy change case)
Conclusion
There is no useful role for AD policies aimed at
stabilizing output and employment
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Keynesian Counter Critique
The Keynesian accept the criticisms of the new classical
as valid especially concerning the adaptive expectations
assumption
They however point out that in spite of this weakness,
Keynes analysis provided a basic useful framework in
which to analyse the determinants of output and
employment.
They believe that activists policies to stabilise output and
employment are very important and should not be
ignored.
They raise three major objections to the new classical
analysis.
Keynesian Counter Critique
1. The Question of Persistence
1. Why the persistent high unemployment rates in Gt.
Britain between 1923-39 or during the Great depression
in the US when unemployment was over 14% for 10
consecutive years.
2. Auction market versus Contractual Views of
the Labour market
1. Perfectly flexible money wage and price assumption is
unrealistic
2. Long term contracts make money wage rigid especially
downwards
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Keynesian Counter Critique
3. The Extreme Informational Assumptions of
Rational Expectations
Adaptive expectations during the 1950s to 60s and
possibly rational expectations during post 1970.
But even then assumption of sophisticated economic
agents is unrealistic especially in the SR. Yes maybe they
could be knowledgeable in the LR after going through a
learning process
New Classicals accept that the rational expectations
assumption is unrealistic and indicate that so are all other
theories because theories extremely simplify reality.