Question

In the new Keynesian Macroeconomics business cycles are driven by demand shock, while in the new classical macroeconomics they are driven by supply shock. Explain the statement using your knowledge of the AD AS model

Answer 1

Solution: The New classical economists build their macroeconomic theories on the assumption that wages and prices are flexible. They believe that prices “clear” markets—balance supply and demand—by adjusting quickly. New Keynesian economists, however, believe that market-clearing models cannot explain short-run economic fluctuations, and
so they advocate models with “sticky” wages and prices.
The new classical model expalanation of business cycles
The new classical macroeconomics argues that business cycles occur in reaction to specific shocks, including, inter alia, technology shocks and fiscal shock, basically within a traditional market clearing framework.
However, the new classical macroeconomics argues that the monetary shock predicted has no real impact on the actual variables. We also remember that wages and rates are perfectly flexible, ensuring two classic outcomes, that is to say, instant full employment and long-term money neutrality.
Many macroeconomists accept that monetary policy will affect unemployment and production, at least in the short term, the new classical economy developed by Robert Lucas, Thomas Sargent and Robert Barro emphasizes the role of flexible wages and prices, but introduces a new element, called rational expectations, to explain short-term economic volatility or the emergence of market cycles.
New classical macroeconomics holds that I wages and prices are flexible, and (ii) people use all available information in order to make decisions on the basis of which they shape their expectations. The government can't 'fool' the people under the theory, as people are well educated and have access to the same information as government.
The forecasts are objective according to rational expectations and are based on all available information. That means people are making impartial forecasts. The central premise in new classical macroeconomics is that the government can not manipulate people with systemic economic policies because of reasonable expectations.
The theory of rational expectations is focused on three hypotheses:

• individuals and business firms learn from experience to predict the effects of monetary and fiscal policy changes;
• (ii) act immediately to preserve their economic interests;
• (iii) Both resource and commodity markets are strictly competitive; That means all markets are automatically open, even in the absence of government intervention

Imagine the central bank planning to increase the rate of growth in the money supply to stimulate demand and raise employment. The expansionary strategy would be expected according to the principle of rational expectations if the public expects the central bank to allow open market operations in order to minimize unemployment as they have seen it done in the past.

As expectations are realistic, employees and businesses agree that an expansionary strategy would move the AD curve from AD1 to AD2 to the right and expect the aggregate price level to rise to P2. Workers should demand higher wages, so that as the price level increases, their actual earnings remain the same. So there is no extra labour, and no extra production is made.
The AS curve then moves left to AS2 and intersects with AD2 at point 2, a point of equilibrium where aggregate production is at the natural rate level Yn and the price level is increasing to P2.

The new keynesian model explanation of business model

New classical economists build their macroeconomic theories on the assumption that wages and prices are flexible. They believe that prices “clear” markets—balance
supply and demand—by adjusting quickly. New Keynesian economists, however, believe that market-clearing models cannot explain short-run economic fluctuations, and
so they advocate models with “sticky” wages and prices.
The new classical model in business cycles
The new classical macroeconomics argues that business cycles occur in reaction to specific shocks, including, inter alia, technology shocks and fiscal shock, basically within a traditional market clearing framework.
However, the new classical macroeconomics argues that the monetary shock predicted has no real impact on the actual variables. We also remember that wages and rates are perfectly flexible, ensuring two classic outcomes, that is to say, instant full employment and long-term money neutrality.
Many macroeconomists accept that monetary policy will affect unemployment and production, at least in the short term, the new classical economy developed by Robert Lucas, Thomas Sargent and Robert Barro emphasizes the role of flexible wages and prices, but introduces a new element, called rational expectations, to explain short-term economic volatility or the emergence of market cycles.
New classical macroeconomics holds that I wages and prices are flexible, and (ii) people use all available information in order to make decisions on the basis of which they shape their expectations. The government can't 'fool' the people under the theory, as people are well educated and have access to the same information as government.
The forecasts are objective according to rational expectations and are based on all available information. That means people are making impartial forecasts. The central premise in new classical macroeconomics is that the government can not manipulate people with systemic economic policies because of reasonable expectations.
The theory of rational expectations is focused on three hypotheses: I individuals and business firms learn from experience to predict the effects of monetary and fiscal policy changes; (ii) act immediately to preserve their economic interests; (iii) Both resource and commodity markets are strictly competitive; That means all markets are automatically open, even in the absence of government intervention

Imagine the central bank planning to increase the rate of growth in the money supply to stimulate demand and raise employment. The expansionary strategy would be expected according to the principle of rational expectations if the public expects the central bank to allow open market operations in order to minimize unemployment as they have seen it done in the past.

As expectations are realistic, employees and businesses agree that an expansionary strategy would move the AD curve from AD1 to AD2 to the right and expect the aggregate price level to rise to P2. Workers should demand higher wages, so that as the price level increases, their actual earnings remain the same. So there is no extra labour, and no extra production is made.
The AS curve then moves left to AS2 and intersects with AD2 at point 2, a point of equilibrium where aggregate production is at the natural rate level Yn and the price level is increasing to P2.

The new Keynesian theories give different reasons for stickiness in wage prices. Other theories include the principle of productivity compensation, low menu costs and aggregate externality of production, and phased price change, among others.
Short-run fluctuations in production and employment are variations from the natural unemployment rate of the economy — the rate that is compatible with absolute price stability. Deviations from the natural rate occur because of the slow adjustment of wages and prices to rising macroeconomic climate.
This inflexibility (stickiness) is what makes the short run AS curve sloping upwards rather than downwards. Consequently the economy is experiencing volatility in short-run production and employment.
In Keynesian models unemployment is caused by restrictive money wage due to fixed-wage labor contracts and backward-looking price expectations of the workers. As overall product demand decreases, labour-demand also declines. But due to the rigidity of the money wage it is not possible to keep the initial level of employment in the short run.
There are three sources of price and wage rigidities:

1. Imperfection of the product market, that is the nature of unfair competition and oligopoly;

2. Rigidity of quality of the product; and

3. External rigidities — variables that make the actual wage or relative price of a product rigid when dealing with shifts in aggregate demand.
The Southwest quadrant shows a job market. The only deviation from the current classical model is that businesses are imperfectly efficient, such that the marginal labor function product (MPL) is followed by a marginal labor schedule revenue product (MRPL). Companies select a standard of jobs where the MRPL exceeds the real salary (w / p). The quadrant to the southeast
Shows a typical concave manufacturing mechanism connecting jobs and production. The principle of evaluating jobs and production is similar to that of the modern classical model.Households and businesses determine how much labor to trade and generate on the basis of real wage anticipations and understanding that real wages are set in monopolistically competitive conditions. This establishes the real wage and natural level of jobs (N *) and production (y *) of the long-term equilibrium.
The quadrant in the northeast indicates the commodities sector that has a regular AD plan. The AD schedule embodies the interest-rate law of the monetary authority. Unless the monetary authority has a fixed nominal interest rate goal, the nominal interest rate shall remain unchanged over the duration of the AD schedule. If it has a reaction "leaning against the wind," the nominal interest rate rises as
the economy moves down the AD schedule.This also means that in such a system the AD timetable is steeper. There is also a marginal revenue (MR) and marginal costs (MC) schedule, in addition to the AD schedule. Because of the decision on output and work exchange and implied real wages, firms set a price level such that demand expected is equal to production (y *) at which point MR is equal to MC.
Finally, firms are bound by fixed prices for the remainder of the time interval of price change, having set costs. That generates a horizontal short run 28 aggregate supply schedule (SRAS) whereby firms meet all demand for the duration of the price period at the fixed price.