1. LECTURE NOTES ON MACROECONOMICS ECO306 SPRING 2014 GHASSAN DIBEH

2. Chapter 7: New Classical Macroeconomics and Economic Fluctuations  Rational Expectations became the springboard for new ideas on how to reconcile the classical doctrine that the capitalist economy is stable and at full employment with the empirical facts of economic fluctuations.  The new business cycle theory initiated by Nobel laureate Robert Lucas (1975) attempted to revive the age old project of embedding the business cycle into equilibrium theory and making economic fluctuations compatible with competitive equilibrium; a project that was largely abandoned with the triumph of Keynesian economics.

3.  Lucas and Sargent (1978) said that, "increased attention and respect are accorded to the theoretical casualties of the Keynesian revolution, to the ideas of Keynes's contemporaries and of earlier economists whose thinking for years has been regarded as outmoded" (p. 57).  The New Classical Macroeconomics revived albeit in rigorous formulation the old Classical school of macroeconomics.  The two main tenets of the new theory are: 1- Markets always clear: The flexibility of prices and rational expectations ensure that the economy is always at full employment equilibrium (the natural rate) 2- Policy is ineffective: Only monetary surprises will have an effect on output albeit transitory.

4.  The main task that confronted the New Classical School was the explanation of economic fluctuations and unemployment that Keynesian theory well explained.  If Keynesian theory is to be discarded, how can market clearing and rational expectations be reconciled with the empirical facts of fluctuating output and employment in capitalist economies?  Two main market clearing approaches were developed to provide an alternative to the Keynesian explanation of the business cycle: the Lucas equilibrium business cycle and the Real Business Cycle model (RBC).

5. The equilibrium business cycle  The building blocks of the basic Lucas (1975) model consist of rational optimizing agents that are geographically separated in an island-type economy. These individuals lack the ability to obtain perfect information on prices.  If a certain general price increase (inflation) is perceived by the agents as an increase in the relative price of the commodity they are producing, then their immediate rational reaction would be to increase the production and supply of the commodity.  Once the agents discover their error--the error being that they confused a general price level for a relative price increase--which should have no effects on their production plans, they scale back production.

6. The equilibrium business cycle

10. Real business Cycles [Robinson Crusoe + max U)  Plosser (1989b) motivates the Real Business Cycle models by providing a methodological introduction to RBC modeling which criticizes Keynesian economics on two grounds: (1) the absence of a consistent foundation based on a choice theoretic framework of economics (2) the static nature of the Keynesian model that contains none of the dynamic elements found in the earlier business cycle research of Mitchell and Von Hayek.  According to Plosser, the introduction of dynamics into the Keynesian system was at best done in an ad hoc fashion such as the accelerator mechanism and the wage and price adjustment equations (the Phillips curve).

11. Real business Cycles [Robinson Crusoe + max U)

13. Figure 19. Capital stock and output fluctuations in RBC model

14. Real business Cycles [Robinson Crusoe + max U)