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31/10/2015 1 ECON 313: MACROECONOMICS I W/C 9 th November 2015 MACROECONOMIC THEORY AFTER KEYNES New Classical Economics Ebo Turkson , PhD The New Classical Economics FROYEN CHAPTER 11

ECON 313: MACROECONOMICS I W/C 9th MACROECONOMIC THEORY AFTER KEYNES New … · 2015-10-31 · ECON 313: MACROECONOMICS I W/C 9th November 2015 MACROECONOMIC THEORY AFTER KEYNES New

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Page 1: ECON 313: MACROECONOMICS I W/C 9th MACROECONOMIC THEORY AFTER KEYNES New … · 2015-10-31 · ECON 313: MACROECONOMICS I W/C 9th November 2015 MACROECONOMIC THEORY AFTER KEYNES New

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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.