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New classical economics

What Is New Classical Economics?

New classical economics is a school of thought within macroeconomic theory that emerged in the 1970s, fundamentally emphasizing the importance of rational expectations and the assumption of continuously clearing markets. This approach posits that individuals and firms make decisions optimally, using all available information to form their forecasts about the future. Consequently, it suggests that economies naturally gravitate towards a state of general equilibrium where supply and demand are always in balance, including in labor markets, implying that observed unemployment is primarily voluntary or frictional. A core tenet of new classical economics is the belief that systematic government intervention, particularly through monetary policy, is largely ineffective in influencing real economic variables like output and employment in the long run.

History and Origin

New classical economics rose to prominence in the 1970s as a response to the perceived inability of Keynesian economics to adequately explain the phenomenon of stagflation—simultaneous high inflation and high unemployment. Leading this intellectual shift was economist Robert Lucas Jr., who, along with others like Thomas Sargent, developed and applied the concept of rational expectations to macroeconomic models.
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Lucas's work challenged the traditional view that policymakers could exploit a stable trade-off between inflation and unemployment (as suggested by the Phillips Curve). He argued that if people form rational expectations, they will anticipate policy actions and adjust their behavior accordingly, rendering predictable policies ineffective. 15This idea led to the influential "Lucas Critique," which highlighted that relationships observed in historical economic models might not hold true if policy regimes change and agents adapt their expectations. 14His seminal contributions earned him the Nobel Memorial Prize in Economic Sciences in 1995. 13The new classical framework also gave rise to the real business cycle theory in the 1980s, primarily associated with Finn Kydland and Edward Prescott, which attributes economic fluctuations largely to real shocks, such as technological changes, rather than nominal shocks like changes in the money supply.
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Key Takeaways

  • New classical economics emphasizes that economic agents form rational expectations, meaning they use all available information to make optimal decisions.
  • The theory posits that markets, including labor markets, clear continuously, leading to full employment or a natural rate of unemployment.
  • It suggests that systematic monetary policy and fiscal policy are largely ineffective in influencing real economic variables due to agents' rational anticipation of these policies.
  • New classical models often focus on the role of aggregate supply and real shocks (e.g., technology, productivity) as the primary drivers of business cycles.
  • The school advocates for minimal government intervention, believing that the economy is self-correcting.

Interpreting New Classical Economics

Interpreting new classical economics involves understanding its implications for how economies function and how policy should be conducted. This school of thought suggests that since economic agents are rational and markets clear, deviations from full employment or potential output are primarily due to unexpected shocks or voluntary choices rather than inherent market failures.
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For example, any observed unemployment above a "natural rate" is seen as a temporary phenomenon or a result of individuals choosing not to work at prevailing wages, rather than a failure of the market to provide jobs. This perspective implies that active discretionary policies aimed at stimulating aggregate demand are likely to be ineffective or, at best, have only short-lived impacts, largely because people will anticipate the policy and adjust their behavior in ways that offset its intended effects.
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Hypothetical Example

Consider a scenario where the central bank announces its intention to increase the money supply to stimulate economic growth and reduce unemployment. According to new classical economics, if economic agents have rational expectations, they will anticipate the inflationary consequences of this announced monetary policy.

As a result, workers might immediately demand higher nominal wages, and firms might raise their prices in anticipation of higher costs and demand. This pre-emptive adjustment by individuals and businesses would cause the aggregate supply curve to shift leftward simultaneously with the aggregate demand curve shifting rightward, leaving real output and employment unchanged, but with a higher price level. The policy's intended effect on real economic activity is negated by agents' rational responses.

Practical Applications

The insights from new classical economics have significantly influenced policy debates, particularly concerning the role of government intervention. Its emphasis on rational expectations and market clearing has led to a preference for rules-based policies over discretionary interventions.

For instance, proponents argue that central banks should adhere to pre-announced rules for monetary policy (e.g., fixed money supply growth targets) to foster predictability and anchor inflation expectations, rather than engaging in ad hoc adjustments. 7Similarly, in fiscal policy, the concept of Ricardian equivalence, often associated with new classical thought, suggests that government deficit spending financed by debt will not stimulate demand if people rationally anticipate future tax increases to repay the debt, leading them to save more. 6Furthermore, the focus on aggregate supply has bolstered arguments for supply-side economics, advocating for policies like deregulation, tax cuts, and labor market reforms to enhance productivity and long-term economic potential. 5The Federal Reserve Bank of San Francisco has published economic letters discussing aspects of real business cycle theory, which emerged from the new classical framework, and its implications for understanding economic fluctuations.
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Limitations and Criticisms

Despite its significant influence, new classical economics faces several criticisms, primarily regarding the realism of its underlying assumptions. A major point of contention is the assumption of instantaneous market clearing and perfect information, which critics argue does not reflect the complexities of real-world economies with sticky prices, sticky wages, and information asymmetries.
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Critics also question the empirical validity of the policy ineffectiveness proposition, pointing to instances where monetary policy has appeared to have real short-run effects. The school's inability to fully account for prolonged periods of high unemployment or deep recessions, attributing them mainly to large, albeit efficient, responses to real shocks, has also been a subject of debate. Some analyses suggest that relying solely on technology shocks to explain significant business cycles may be insufficient without strong microeconomic evidence. 2The assumption that unemployment is largely voluntary is another point of frequent critique, as it struggles to explain the involuntary unemployment often observed during economic downturns.
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New Classical Economics vs. New Keynesian Economics

New classical economics and New Keynesian economics represent two dominant, yet contrasting, schools of thought within modern macroeconomics. While both share the foundational assumption of rational expectations and rigorous microeconomics foundations, their differing views on market clearing lead to fundamentally different policy implications.

New classical economists believe that prices and wages are perfectly flexible and adjust instantaneously, ensuring that markets always clear and the economy remains at full employment (or its natural rate). Consequently, they argue that systematic monetary policy and fiscal policy are ineffective in influencing real economic variables, as agents anticipate these policies. In contrast, New Keynesian economists acknowledge that prices and wages can be "sticky" or slow to adjust due to various market imperfections (like menu costs or efficiency wages). This stickiness means that markets may not clear immediately, leading to involuntary unemployment and periods where aggregate demand management policies can be effective in the short run. Therefore, New Keynesians generally advocate for government intervention to stabilize the economy during recessions, whereas new classical economists tend to favor non-interventionist policies.

FAQs

What is the main idea behind new classical economics?

The main idea is that economic agents are rational and markets constantly clear, leading to a self-correcting economy where systematic government policies have little to no effect on real economic outcomes. This relies heavily on the concept of rational expectations.

How does new classical economics view government intervention?

New classical economics generally advocates for minimal government intervention. It argues that active monetary policy and fiscal policy are ineffective because rational individuals will anticipate and offset their intended effects, making the economy self-regulating and efficient in response to shocks.

What is the "policy ineffectiveness proposition"?

The policy ineffectiveness proposition, a key concept in new classical economics, states that predictable changes in monetary policy or fiscal policy will have no effect on real economic variables like output and unemployment, even in the short run, because agents' rational expectations will cause them to adjust their behavior to fully offset the policy's impact.

What is the Lucas Critique?

The Lucas Critique, proposed by Robert Lucas Jr., suggests that traditional macroeconomic models are unreliable for evaluating policy changes because the parameters of these models (like consumption or investment functions) are not stable; they change when the policy regime itself changes, as agents adjust their expectations and behavior. This underscores the importance of fully incorporating rational expectations into macroeconomic analysis.