New Classical Economics: Principles, Rational Expectations, and Critiques
The New Classical Economics
The new classical economics emerged during the 1970s, a period of high inflation and unemployment, and growing dissatisfaction with Keynesian orthodoxy.
It critiques Keynesian theory, building upon monetarism. New classical economists argue that Keynesian models are flawed and advocate for a return to classical economics principles to construct robust macroeconomic models.
In the new classical view, systematic monetary and fiscal policies aimed at changing aggregate demand do not affect production or employment, even in the short term. This is known as the ineffectiveness theorem of new classical economic policy.
The central tenet is that stabilizing real variables like output and employment cannot be achieved through aggregate demand management. These variables are insensitive to systematic economic policies, both short and long term.
New classical economists criticize the Keynesian assumption of backward-looking price expectations. They argue that economic agents do not make systematic errors. Instead, they form rational expectations.
Rational expectations are formed based on all available relevant information. Individuals understand how observed variables affect the variable they are trying to predict.
New classical economists question why rational agents would make systematic errors when aggregate demand shifts, proposing that they must form rational expectations. This means expectations are based on all available information, and individuals understand how variables interact.
This contrasts with the retrospective nature of expectations in Keynesian models, where expectations are based on past behavior. If a policy change is expected, the public can anticipate it.
A key difference between new classical and Keynesian economics lies in the determinants of labor supply and aggregate supply curves.
New classical analysis incorporates rational expectations, assuming that suppliers understand price increases as consequences of increased money stock and demand higher wages proportionally.
If expectations are rational, suppliers cannot be systematically deceived by anticipated changes in aggregate demand policy. These policies will not affect production or employment, even short term.
Lucas, Sargent, and others argue that the classical system is more rigorously built on rational individual decisions by households and businesses. They criticize Keynes’ assumption of rigid wages, arguing that markets, including labor markets, clear, with prices (including wages) adjusting to match supply and demand. Their core assumptions are:
- Agents optimize, acting in their self-interest.
- Markets clear.
Keynesians raise several objections to new classical economics:
The Problem of Persistence: While rational expectations can explain short-term deviations from full employment, they struggle to explain persistent and significant deviations. New classical economists attribute this to short-term, unexpected aggregate demand shocks, but Keynesians find this insufficient to explain prolonged unemployment.
Extreme Assumptions about Rational Expectations: Keynesians accept the critique of backward-looking expectations but argue that assuming economic agents are perfect forecasters is unrealistic, especially for individual labor suppliers. They criticize the assumption that individuals use all relevant information, ignoring the costs of information gathering.
In conclusion, rational expectations theory assumes individuals use available information intelligently. Keynesians deny that individual labor suppliers possess such extensive knowledge about the economy and policy makers’ behavior. While rational expectations may be plausible in long-run equilibrium models, Keynesians argue it’s unrealistic in the short term. If expectations are not fully rational, economic policy can play a role in stabilizing output and employment through aggregate demand management. However, Keynesians also acknowledge that rational expectations can apply to policy makers who can design policies to counteract unanticipated changes in aggregate demand.