Question

The New Classical Macroeconomics sought to revolutionise macroeconomic theory. Discuss its distinguishing features and tease out TWO policy implications.

Answer 1

The new classical macroeconomics is an attempt to repudiate and modify Keynesian and monetarist views about the role of macroeconomic stabilisation policy in the light of the classical school of thought. The Keynesians advocate demand management policies both fiscal and monetary to stabilise the economy. They favour active interventionist fiscal and monetary policies.

During the late 1970s when the debate between Keynesians and monetarists stalemated, the new classical macroeconomics emerged based on classical microeconomics. It was developed by Robert Lucas, Thomas Sargent, Robert Barro and Neil Wallace in America and Patrick Minford in England.

The features that constitute the New Classical Macroeconomics are discussed below

1. Markets Continuously Clear:

The new classical economists assume that all markets continuously clear in the economy. Prices and wages adjust instantaneously to clear markets. The economy is in a state of continuous equilibrium both in the short-run and long-run where all markets clear.

The new classical differ from Keynesians and monetarists over market clearing. According to Keynesians, markets may not clear due to slow price adjustments. So the economy may remain in a state of disequilibrium. Monetarists assume that markets have a tendency to clear. Prices and wages are fairly flexible. Therefore, the economy may be in disequilibrium temporarily in the short run and attain equilibrium in the long run.

The new classical assume that markets clear instantaneously and there is no disequilibrium even in the short run. Since price and wage adjustments are almost instantaneous, all unemployment is equilibrium unemployment.

2. Rational Expectations:

One of the most important principles of the new classical macroeconomics is the rational expectations hypothesis. The Ratex hypothesis, as it is called, holds that economic agents (individuals, firms, etc.) form expectations of the future values of economic variables like prices, incomes, etc. by using all the economic information available to them.

The new classical economists use Ratex to explain the Phillips curve in the inflation theory. According to them, rational expectations are not based on past rates of inflation but on the current state of the economy and policies being followed by the government.

Workers and firms base their information on various forecasts made by specialists and agencies, and government announcements and reports. On the basis of such current information, they predict the rate of information.

3. Aggregate Supply Hypothesis:

The new classical macroeconomics incorporates the Lucas aggregate supply hypothesis based on two assumptions:

(1) Rational decisions taken by workers and firms reflect their optimising behaviour, and (2) the supply of labour by workers and output by firms depend upon relative prices. Thus the aggregate supply hypothesis is derived from optimising behaviour of workers and firms about supply of labour and goods which depend on relative prices only.

The new classical macroeconomics has a number of policy implications which are explained as under:

1. Policy Ineffectiveness Proposition:

The new classical macroeconomic analysis holds that with rational expectations and flexible prices and wages, monetary policy, if anticipated in advance, will have no effect on output and employment in the short run. This is the policy ineffectiveness proposition. It is only an unanticipated increase in the money supply that will affect output and employment.

2. Impotency of Systematic Monetary Policy:

According to the new classical analysis, anticipated changes in aggregate demand will have no effect on output and employment even in the short run by pursuing a systematic monetary policy. A systematic monetary policy is one which takes into account any known “rule”.

Such a policy can be fully predicted by the private sector before the monetary authority actually acts upon it. So private buyers and sellers who anticipate increase in the money supply adjust their purchases and sales through flexible wages and prices. Further, the new classicists argue that non- systematic (or discretionary or unanticipated) monetary policy will only bring changes in output and employment around their natural levels.

Therefore, to prevent unanticipated changes in aggregate demand and unemployment deviating from its natural level, the new classical advocate clear monetary rules and avoidance of any discretionary monetary policy.

3. Policy Credibility:

The new classical approach is based on the presumption that rational economic agents have expectations about what the monetary authority is going to announce and this influences their behaviour. But it is on the credibility of policy announcements of monetary authority that agents form expectations.

Thus the new classical policy implies that announced (or anticipated) changes in monetary policy will have no effect on output and employment even in the short run provided the policy is credible. Suppose there is an announced and credible reduction in the money supply. This will immediately lead to a downward revision of inflation expectations of rational economic agents. This will, in turn, enable the monetary authority to have disinflation without output and employment costs.