New Classical Economics Chapter 12 Prof. Steve Cunningham Intermediate Macroeconomics ECON 219

2 Rational Expectations Hypothesis (REH) Expectations are formed on the basis of all available relevant information concerning the variable being predicted. Agents understand the underlying economic relationships. Expectational errors are NOT systematic.

3 Rational Expectations Subjective Objective

4 Adaptive vs. Rational Expectations Adaptive Expectations Rational Expectations Actual x x x x x x x x x x x x x x x x x

5 New Classical Economics Essentially classical economics with rational expectations, hence new classical. Theoretical attack on Keynesian Economics Monetarism II

6 Policy Ineffectiveness Proposition Real output and employment are uneffected by systematic or predictable changes in aggregate demand policy. If policy changes are systematic, therefore predictable, then agents will not make systematic mistakes in their forecasts. – Agents recognize that mistakes are costly, and will seek out all available information to avoid such mistakes. They will only make mistakes when they are “surprised”. Unanticipated policy changes will have a short- run impact.

7 Phillips Curve under REH inflation Unemployment SRPC(  0 ) SRPC(  1 ) SRPC(  2 ) LRPC U*U1U1 11 22

8 More on PIP If a shock to the economy could be anticipated, and if it were to persist, then unanticipated aggregate demand policy could be used to offset its effects. – But if the shock could be anticipated by policymakers, then it could also be anticipated by all agents, and the policy response would also be anticipated and would therefore be ineffective. – Shocks don’t persist (aren’t guaranteed to persist). Hence there is no role for stabilization policy. Systematic money supply policy would avoid expectational errors that would likely move the economy temporarily away from full employment. – Therefore, adopt a constant growth rate rule for the money supply.

9 Fiscal Policy Deficit spending? – People would anticipate the long-run costs of debt, and would act so as to offset deficit spending. – They would increase saving to prepare for future tax increases. – Fiscal policy would have little effect. – This is the Ricardian Equivalence Theorem, and was restated by Robert Barro in the 1970s.

10 Lucas Critique Argues that econometric models cannot be used to predict the effects of proposed policy. Because of expectations, relationships between economic variables (equations) change with policy changes. Can we predict the economy at all? If we cannot predict, how can we employ activist countercyclical policies?

11 Time Inconsistency Another thread of new classical thought is due to Kydland and Prescott. They present the time inconsistency problem. The policymaker analyzes the economy and implements an optimal policy. But once the policy is implemented, if the policymaker re-analyzes the economy, it appears that the policy is no longer optimal. In fact, what appears to be optimal policy never becomes optimal policy once it is implemented.

12 New Classical View of Keynesian Economics “Failure on a grand scale.” Made up of ad hoc assumptions, not built on a strong foundation of rational agents. Must assume rational, optimizing agents. Must assume that markets clear. Keynesians do not explicitly handle expectations, and expectations have been shown to be critically important. Have not given explicit structural explanations of wage stickiness. How can you explain persistence in business cycles?

13 New Keynesian Response (1) Persistence: – There have been and are persistent and substantial deviations from full employment. There is nothing to the persistence question. Unemployment in Great Britain was greater than or equal to 10% from U.S. Great Depression, unemployment was greater than or equal to 14% for 10 years.

14 New Keynesian Response (2) Extreme Informational Assumptions – NK’s accept that adaptive expectations are ad hoc and unrealistic, but… – Unconstrained REH implies unrealistically sophisticated agents – Bounded rationality – Structural impediments

15 New Keynesian Response (3) Justify wage stickiness by using a contractual view of the labor market – Okun: an “invisible handshake” rules the labor market, not an “invisible hand” – Agents choose to contract because it minimizes costs and stabilizes nominal cash flows. – Agents may contract in overlapping contracts, and firms may make offers while looking at wages set by other firms.