New Classicals

New Classical Economist

Largely reliant on the assumptions which extend from Rational Expectations Theory. People behave largely as a result of narrow self interest. This view lends itself most closely to the parody Homo-economicus.

(The following is copied/summarized from Modern Macroeconomics chapter 5) The new classical school emerged as a distinctive group during the 1970s. Lucas was the key figure, but Hayek and others contributed. Tobin referred to the early new classical contributions as “monetarism mark II.” The main features:

1. A strong emphasis on underpinning macroeconomic theorizing with neoclassical choice-theoretic microfoundations within a Walrasian general equilibrium framework;

2. The adoption of the key neoclassical assumption that all economic agents are rational; that is agents are continuous optimizers subject to the constraints that they face, firms maximize profits and labour and households maximize utility;

3. Agents do not suffer from money illusion and therefore e only real magnitudes (relative prices) matter for optimizing decisions;

4. Complete and continuous wage and price flexibility ensure that markets continuously clear as agents exhaust all mutually beneficial gains from trade, leaving no unexploited profitable opportunities. From this changes in the quantity of money should be neutral and real magnitudes will be independent of nominal magnitudes. Yet empirical evidence shows there is at least a short run positive correlation between real GDP and the nominal price level and negative correlation between inflation and unemployment (Philips curve). The discrepancy from the empirical evidence and theory on the neutrality of money was explained by Lucas in “Expectations and the Neutrality of Money” in 1972. The key insight was to change the classical assumption that economic agents have perfect information to an assumption that agents have imperfect information.

The main elements of the early new classical approach to macroeconomics can be summed as the joint acceptance of the three main sub-hypotheses involving i. the rational expectations hypothesis; ii. the assumption of continuous market clearing; and iii. the Lucas (‘surprise’) aggregate supply hypothesis.

As a side note to rational expectation, the word “rational” was an important ‘rhetorical’ weapon in the battle to win the minds of macroeconomists during the 1970s. Barro pointed out that “One of the cleverest features of the rational expectations revolution was the application of the term ‘rational.’ Thereby, the opponents of this approach were forced into the defensive position of either being irrational or of modeling others as irrational, neither of which are comfortable positions for an economist.”

In the Lucas model business cycles are generated by exogenous monetary demand shocks that transmit imperfect price signals to economic agents who, in a world of imperfect information, respond to price increased by increasing supply. The greater is the general price variability (the lower the variation in price attributed to relative price variation), the lower will be the cyclical response of output to a monetary disturbance, and vice versa. A major policy implication of the MEBCT (monetary equilibrium business cycle theory) is that a benign monetary policy would eliminate a large source of aggregate instability. Thus new classical economists come down on the side of rules in the “rules versus discretion’ debate over the conduct of stabilization policy.

In Scholarly works

“Importance of imperfect information for the inferences firms make – say, about the desirability of changing price or quantity. We think the difficulties firms have in inferring whether a shift in the demand curves which they face is due to a real or nominal shock may play a role in explaining ‘why money matters,’ but surely it is not the only reason, nor even perhaps the most important one.” (Greenwald and Stiglitz 1993 p. 40)

New Classicals “Emphasized the importance of expectations …and particularly rational expectations.” (Greenwald and Stiglitz 1993 p. 41)

Sources

• Neoclassical Economics at reference (dot) com
• Greenwald, Bruce and Joseph Stiglitz: “New and Old Keynesians” ‘’The Journal of Economic Perspectives’’ Vol. 7, No. 1. (Winter, 1993), pp. 23-44

Modern Macroeconomics By Brian Snowdon and Howard R. Vane