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The new classical policy conclusions

The new classical view that unanticipated aggregate demand changes affect output and employment
still does not provide a meaningful role for macroeconomic stabilization policy. To see this, consider
the new classical economist’ view of the propper policy response to a decline in pivate-sector
demand –for example, an autonomous decline in investment. We have already analyzed the
Keynesian view of the proper policy response to such a shock (section 10.3). keynesian argue that a
decline in private-sector demand should be offset by an expansionary monetaray or fiscal policy
action to stabilize aggregate demand, output, and empoyment.
The effect of the decline in investment are depicted in Figure 11.3. The decline in investment
demand shifts the aggregate demand schedule from Yd(I0) to Yd(I1) in Figure 11.3a. This shifts causes
output to decline from Y0 to Y’1. The price level will fall from P0 to P’1 and as result, the labor demand
curve in Figure 11.3b will shift downward from Nd(P0) to Nd(P’1). Whether there are additional effect
from the decline in envestment depends, in the new clssical view, on whether the decline was or
was not anticipated. To begin, we assume that it was anticipated.
In that case, labor suppliers will anticipate the decline in the price level that will result from
the decline in aggregate demand. Labor suppliers, now expecting the pricelevel to be lower, will
supply more labor at a given money wage, because with the lower expected price level, a given
money wage corresponds to a higher expected real wage. This fall in the expected price level shifts
the labor supply curve to the right in Figure 11.3b [from NS (Ie0) to NS (Ie1)]. As a consequence, the
aggregate supply schedule shifts.

GAMBAR DI SKIP
Effects of an autonomous decline in investment : a new classical view
an autonomous decline in investment shifts the aggregate demand schedule from Yd(I0) to Yd(I1). This
shifts would reduce output from Y0 to Y’1. and lower the price level from P0 to P’1. The fall in the price
level shifts the labor demand schedule from Nd(P0) to Nd(P’1), and as a result employment falls from
N0 to N’1. These are the only effects if the decline in investment was not anticipated. If the decline in
investment was anticipated, the expected level of autonomous investment (Ie ) will also fall (from Ie0
to Ie1). The aggregate supply schedule will shift from YS (Ie0) to YS (Ie1), and the labor supply schedule
will shift from NS (Ie0) to NS (Ie1). Those shifts cause output and employment to return t their initial
levels.
To the right in Figure 11.a from YS (Ie0) to YS (Ie1). There is a further decline in the price level to P1, and
therefore a further downward shift in the labor demand schedule to Nd(P1). At the new short-run
equilibrium, the money wage and price level have fallen sufficiently to restore employment and
output to their initial levels, N0 and Y0.
This analysis is just the reverse of our analysis of an anticipated increase in aggregate
demand resulting from an increase in the money supply. In the new classical system, output and
employment are not affected by anticipated changes in aggregate demand, even in the short run.
Consequently, there is no need for a stabilization policy response to an anticipated demand change
such as adecline in investment. In the new classical view, the economy is self-stabilizing with respect
to such shock.

to a low inflation rate as well. In addition. The foregoing analysis indicates that the new classical view includes no useful role for aggregate demand policies aimed at stabilizing output and employment. the decline could not have been predicted by economic agents on the basis of any available information.1 9 Other new classical economists favor rules that target the inflation rate directly or target the grow rate in nominal income. respectively. If low investment was expected to continue. policymakers lack the knowledge needed to offset the shock. new classical economists favor stability and the avoidance of excessive and inflationary stimuli.9 Such as policy rule does away with unanticipated changes in the money supply. Would not an offsetting policy action to raise aggregate demand back to it’s initial level be called for? The answer is that such a policy response would be desirable but not feasible. Once the shock is anticipated by policymakers. noninflationary monetary policy. favoring a money growth rate rule. there would be no need for a policy response because private agents would also hold this expectation. assuming rational expectations. Concerning monetary policy. Policymakers. many new classical economistsalso arrive at the same position as monetarists. and if the money growth rate was low. The decline in investment would have caused output and employment to decine to the level given by Y’1 and N’1. . like any other economic agent. New classical economicts’ policy conclusions are strongly noninterventionist. At this point. Huge deficits put great presure on the monetary authority to increase money growth in order to help finance the deficit. it is also anticipated by other economic agents. The decline in investment was by definition unanticipated. which have no stabilization value and move the economy away from the natural rate of output and employment by causing economic agents to make price forecast errors.But what if the decline in investment had not been anticipated? In that case. the labor supplier would not have foreseen the price decline that resulted from the decline in aggregate demand. policymakers could act to raise aggregate demand if the low investment level was expected to be repeated in future periods. The labor supply curve (Figure 11. for example. were critical of the large deficits that resulted from the Reagan administration’s fiscal policy of the 1980s. however. Such rules are discussed in Chapter 17. as long as the shock is unanticipated. Read Perspective 11. New classical economists Thomas Sargent and Neil Wallace. including labor suppliers. new classical economists agree with the monetarists. Once the investment decline has occured and had it’s effect on output. just as were those of classical economists. making it difficultfor agents forming rational expectations to correctly anticipate the course of the economy. a stable rate of growth in the money supply contribute to stability in the inflation rate. In the words.11 Sargent and other new classical economists believe that control of the goverment budget deficit is necessary for a credible. In the case of fiscal policy. They could not have acted to raise aggregate demand to offset the decline.3b) and the aggregate supply curve (Figure 11. would have been unable to foresee the investment decline in advance.10 Instability in fiscal policy causes uncertainly. That is.3a) would have remained at NS (Ie0) and YS (Ie1). the shift in the labor supply and aggregate supply schedules would take place. In the respect. Moreover Sargent and others believe that a credible noninflationary monetary policy cannot coexist with a fiscal policy that generates large dificits. and there is no need to offset the shock.

including the labor market. 11 Recall that form the goverment’s budget constraint it follows that dficits must be financed by either the sale of bonds or the creation of new money. “Some Unpleasant Monetarist Arithmetic. New classical economists do not find these arguments convincing. that wages “are set a level or by a process that could be taken as uninfluenced by the macroeconomic forces he proposed to analyze. move to equate supply and demand. the new classical economists argue that the resulting upward pressure on the interest rate will eventually lead the monetary authority to deviate from a stable money growth rule Rational economics agents will predict this action and therefore will not believe that the monetary authority will stick to announced targets for money growth. did Keynes dispense with those assumptions? In the new classical view. They favor the classical view that markets. made up of ad hoc elements. Recall that the classical aggregate supply shedule was vertical. that economic agents choose to ignore useful information in making their price forecast.” suggest their view that a total restructuring of macroeconomics is required.” and “of no value” to describe major aspect of the Keynesian theoritical and policy analysis. With such . which were failed attemps at explaining the observed behavior of the economy in aggregate. at present. Markets clear Why. The Keynesian system uses a rule of thumb whereby the expected current price is expressed as a function of the past behavior of prices. “ We have already considered the arguments that Keynesians advanced to support the assumption of wage rigidity.2 A BROADER VIEW OF THE NEW CLASSICAL POSITION New classical position economists are critical of Keynesian economics as a whole. which they argue to be consist with optimal use of information by the economic agents in the model. The Keynesian model is.10 Thomas Sargent and Neil Wallace. they act in their own self-interest 2.” “failure on a grand scale. in general. New classical economists argue that fruitful macroeconomic models should rectify the failures of Keynesian economics by consistently adhering to the following assumptions: 1. They argue that Keynesian rules of thumb such as the consumption function and Keynesian money demand function replaced classical functions based on individual optimizing behavior.” Federal Reserve Bank of Minneapolis Review (Fall 1981). prices. Even if. including the money wage rate. “clear”. “After Keynesian Macroeconomics. in their view.12 The title of their paper. New classical economists are also critical of keyne’s assumption that wages are “sticky. Agents optimize: that is.” “wreckage. Such as assumption is not based on individuals’ making optimal use of information and implies. Sargent. A good example of this failing of the Keynesian system is the handling of expectations. New classical economists Robert Lucas and Thomas Sargent use terms such as “fundamentally flawed. New classical economists make the alternative assumption that expectation are rational. then. as they interpret this assumption. and other new classical economists are critical of the theoretical foundations of the Keynesian system. Lucas. Keynesian economics was a response to the supposed failure of classical economics to explain the problem of unemployment and relattionship between unemployment and aggregate demand.” meaning. that is. the dificit is financed only by bond sales. 11.

but unanticipated changes in aggregate demand will. Such as we considered previously (Figure 11. 12 Robert Lucas and Thomas Satgent.3 THE KEYNESIAN COUNTERCRITIQUE The theme that runs through the Keynesian response to the new classical criticisms is that. Unanticipated declines in aggregate demand would move output and employment below the full employment levels. An unanticipated decline in investment. By the next year. and these have no effect on output and employment in the new classical view.3). changes in aggregate demand will not affect output and employment. New classical economists substitute the assumption that labor suppliers make a rational forecast of the aggregate price level. The Question of Persistence In the preceding section. could explain deviations from full employment. 1978). “After Keynesian Macroeconomics. It is not adequate to explain the persistent and substantial deviations from full employment that we have actually experienced. Recall that the classical theory of the labor market. implying that labor suppliers had perfect information about the value that the aggregate price level would take on over the short run. meaningful aggregate demand management policies involve systematic variations in aggregate demand.” in After the Phillips Curve: Persistence of High Inflation and High Unemployment (Boston: Federal Reserve Bank of Boston. Keynesians argue that although such an explanation might be plausible for brief departures from full employment. for as we saw earlier in this chapter. New classical economists argue that a model in cassical tradition can explain the deviations from full employment if the assumption of rational expectation is incorporated into the classical system.a vertical supply schedule. systematic. although they raise valid points. especially concerning the weakness of the Keynesian threatment of expectations information.”13 Keynesian continue to believe that Keynes provided the basis fo a useful framework in which to analyze the determinants of output and employment. we saw that the new classical model. Such unanticipated changes in aggregate demand can explain deviations from full employment. with the concept of rational expectations. however. as the Keynesian Robert Solow puts it. as we have seen. which was the basis for the classical vertical aggregate supply function. “much too early to tear up the IS-LM chapters in the textbooks of your possibly misspent youth. This substitution the assumtion of rational expectations for the classical assumtion of perfect information does not require substantive changes in the noninterventionist classical policy conclusions. aggregate output was totally dependent on supply factors. 11. . and hence anticipated. The major areas in which the Keynesians have raised objections to the new classical view are as follows. In this case. it is still. this decline in aggregate. Let us say one year. assumed that labor supplier knew the real wage. The classical model was abandoned by Keynes. Because it did not explain prolonged deviations of output and employment from full-employment levels. They continue to believe in the usefulness of activist policies to stabilize output and employment. might well cause output and employment to decline over a short period.

Moreover. workers who have become unemployed will not find it optimal to take the first job offer that comes along but will search for the best job opportunity. the response to an unanticiated decline in aggregate demand.13 Robert Solow. has tentatively explained the severity of the U. Consequently. On the labor supply side. the effect of the shock will persist. the shifts to the right in the labor supply curve and the aggregate supply curve discussed previously (see Figure 11. such as the United States experienced during the mid-1970s and early 1980s. then. so the changes is no longer unanticipated.) would restore employment and output to their initial level. Robert Barro. the unanticipated change in aggregate demand. everyone recorgnizes that demand has fallen.” The Canadian Journal of Economics (August 1979). when the unemployment rate exceeded 14 percent for 10 consecutive years? In the more ecent past. It will take time to run off such stock.”15 The extreme informational Assumptions of Rational Expectations . in the meantime. New classical economists argue that. Demand would be seen to have taken place. when the money supply fell by one-third.2 The new classical economists respond that although the source of the unempoyment. On this question of persistance. for example.14 Other new classical economists. If markets clear and there is no involuntary unemployment. Keynesian remain unconvinced that adjustment lags sufficiently explain prolonged and severe unemployment. can be explained even though the schocks that cause such deviations are short-lived. such as Sargent and Lucas. to the classical or new classical economists “what happened to the United States in the 1930s was a severe attack of contagious laziness. Declines in output and employment will have occured. Consider. This being the case. but do not find the Keynesian explanation convincing. will be of short duration. They believe that accepting the classical or new classical framework can explain episodes such as the Great Depression only as a result of factors on the supply side. as Modigliani puts it. Labor suppliers would recognize that the aggregate price level had declined. agree with Keynesians that the Great Depression is not well explained by their theory. it would no longer be unanticipated. production and therefore employment will remain depressed. New classical economists argue that it wall take time before such decline are reversed. firms will have accumulated excess inventory stocks over the period during which output was in decline. “Alternative Approaches to Macroeconomic Theory: A Partial View.S experience by the extent of the largely unanticipated monetary collapse during the early years of the Depression. how can such longed recession of the mid-1970s and early 1980s? Read Perspective 11. Assume that after one years or so. The slow recovery is viewed as a result of the massive goverment intervention during the new deal period that subverted the normal adjustment mechanisms of the private sector. What about the depresion in Great Britain and the United States in the 1930s? One proponent of the new classical position. as a consequence of such adjustment lags. lengthy deviations from full employment. how can the new classical model explain unemployment rates of 10 percent or more in Great Britain for the entire period 1923-39 or during the Great Depression of the 1930s in the United States. which in their view are the only factors in these models that could cause prolonged unemployment. Firms that have already cut output will not find it optimal to restore production immediately to preshock levels because of the cost adjusting output levels.

3) 15 Franco Modigliani. high inflation of the post 1970 period. If expectation are not rational. Keynesians criticize the assumption that individuals use all available relevant information in making their forecast.” American Economic Review. the monetary and fiscal policy making authorities should be able to forecast systematic changes in private-sector aggregate demand. it is perhaps reasonable to believe that economic agents would come to know the underlying relationships that govern policy variables and economic aggregates. They will also be able to predict the price effects of such anticipated monetary policy actions. at times. agricurtural policies to restrict output and raise prices. there is a role for aggregate demand management aimed at stabilizing output and employment. 69 (May 1979). which might have hindered the raising of funds for investment. In the short run. and increased regulation of the banking and security industry. as Keynesians believe it is. “Second Thoughts on Keynesian Economics. in fact. 57. the public will come to anticipate such policy actions. p. such rules might have been rasonable approximations of the way people made forecasts. 14 See Robert Barro. had been stable and subject to little change for a long period of time. In these circumtances. Such naive assumption about expectations came into use in 1950s and early 1960s when the inflation rate was both low and stable. or Should We Forsake Stabilization Policies?” American Economic Reviw.Keynesians accept the new classical economists’ critism of price expectations formulations based only on information about past prices. Still. If private sector aggregate demand is unstable. but Keynesian argue that it is not realistic in the short run. The rational expectations theory also presumes that individuals use available information intelligently. Further. They know the relationships that link observed variables with the variabes they are trying to predict. Many Keynesian deny that individual labor suppliers prssess knowledge of both the working of the economy and the behavior patterns of policymakers. p. have been based on the past behaviour of prices. With the volatile and. If the economy. many Keynesians argue that the rational expectations assumption errs in assuming that economic agents are unrealistically sophisticated forecasters. Examples of such New Deal interventions include NRA codes to fix prices and wages. These policymaking authorities do gather what they consider to be all the available and important information on variables they wish to forecast and control. 67 (March 1977). especially when rational expectations are assumed for individual suppliers of labor. They . it is harder to believe that economic agents did not find it worthwhile to make more sophisticated forecasts. (See Perspective 11. Even systematic changes in aggregate demand will affect output and employment because they will not be predicted by economic agents. including the behavior of policymakers. “The Monetarist Controversy. the cost of gathering and processing information may be high enough that labor suppliers making forecast of the aggregate price level or inflation rate do not find it worthwhile to use much information over and above the past behavior of prices. Such rules are naive because they assume that economic agents neglect other available and potentially useful information in making their forecasts. a stabilization policy is needed. The rational expectations assumption might be realistic in a long-run equilibrium model. 6. Such an assumption ignores the cost gathering information. if the monetary policymaker typically responds to rising unemployment by increasing the money supply. They are also able to estimate the systematic response pattern of policymakers. because good forecasts could. For example.

The policymakers can design policy changes to offset what to the public are unanticipated changes in private-sector economic agents are not rational. Much work is currently under way to investigate the theoretical reasons such labor market intitutions have developed. “ Journal of Monetary Economics (January 1979). This contactual keynesian view explains wage stickiness on the basis of the institutional mechanisms that characterize the labor market. new classical economics have defended the rational expectations assumptions. Appliying pressure for wage cuts or replacing current workers with unemployed workers who will work for lower wages is not acceptable. They admit that the rational expectations hypothesis is “unrealistics..16 16 Benjamin Friedman. “All theories o models are ‘unrealistic’ in the sense of being extremely simplified descriptions of reality.”18 The money wage is sticky in the downward direction.. Keynesians regard the rational expectations assumption as reasonaby correct when applied to the policymakers.. as in the original classical theory.. Keynesian conclude : Macroeconomic models based on the assumptions of the rational expectations hypothesis do not demonstrate the short-run ineffectiveness of policy. pp. because they are not really short-run models. In essence. this role for stabilization policy sterm from an information advantage on the part of the policymaker. the demand for labor comes in the form of a reduction in employment rather than a fall in the money wage. the labor market functions more by the invisible handshake than by the invisible hand of a competitive market merchanism. In general.. So the true issue is: of all the simple expectational assumptions conceiveable. In rebuttal.. Auction Market Versus Contractual Views of the Labor Market In the new classical view. Layoffs or reduced hours are considered an “acceptable” response on the part of the employer to a fall in demand. in the Keynesian contractual view of the labor market. “wages are not set to clear markets in the short run. 39-40.. In arthur Okun’s phase. consquently. Most of the response to a decline in aggregate demand and. such relationships fix the money wage while leaving the employer free to adjust hours worked over the course of the explicit or implicit contract. the actions of the policymakers will not be anticipated. are not surprising. the Keynesians argue that institutional .also invest considerable resources in trying to estimate the relationship that characterize the economy. but rather are strongly conditioned by longer-term considerations involving. In contrast.” but as Bennett McCallum argues. The information availability assumption of the rational expectations hypothesis implicity places such models in a long-run equilibrium context in which their classical properties. employer-worker relations. “Optimal Expectations and the Extreme Information Assumption of Rational Expectation” Macromodels. the money wage is assumed to adjust quickly to clear the labor market to equate labor supply and demand.. Even without such theoritical foundations. Keynesian view the labor market as one in which long term arrangements are made between buyers and sellers. which one should be embodied in a macroeconomic model to be used for stabilization analysis?”17 New classical economists favor the rational expectations assumption over the assumption that individuals form price expectations based on the past history of prices because the rational expectations hypothesis is consistent with individual optimizing behavior. This is an auction market characterization. therefore.

for whether there will be involuntary unemployment. New classical economists point to the naive thretment of price expectations in the Keynesian model as an example. at least i part. Price and Quantitive (Washington D. On the theoretical level. On policy questions. anticipated changes in aggregate demand. New classical economists agree that labor market is. This is the new classical policy ineffectiveness postulate. The new Keynesian models emerging from this research are considered in Chapter 12. new classical economists maintain that output and employment are independent of systematic and therefore. extends this contractual view to product markets. . Finally. new classical economists see no role for these polices. arguing that many of it’s relationships are not firmly based on individual optimizing behavior. “The Significant of Rational Expectations Theory. stimulated new avenues of Keynesian research on the causes of unemployment. if the money wage specified is too high to maintain the contract. or in extreme cases allow revision of the wage in some fashion. Read Perspective 11.mechanisms of this nature do exist.: The Brookings Institution. but they do not believe this deviation is significant. and most important. 17 Benneth McCallum. with resulting price stickness.3 11. characterized by long-term contracts. 18 Arthur Okun. They claim that the rational expectation assumption ascribes an extreme and unrealistic availability of information to market participant.C. any implication for whether the labor market will clear—that is.4 CONCLUSION The new classical economics presents a fundamental challenge to Keynesian orthodoxy. that the existence of such contracts has.” Challenge Magazine (January-February 1980). They argue that the new classical model cannot explain the prolonged and severe unemployment experienced by the United States and other industrialized countries. They arrive at noninterventionist policy concusions similiar to those of the original classical economists. New classical economists do not deny that labor contracts cause some deviation of employment from the market-clearing levels. Further. They deny that the terms of labor contracts are so rigid that employers and employees cannot effect changes desirable to both parties. P. The new classical critique has. For example. increase the work done per hour. in which we also examine the development of a second generation of new classical medols – the so-called real business cycle models. new classical economists question the soundness of the Keynesian model. Because maningful aggregate demand management policies to stabilize output and employment consist of systematic changes in aggregate demand. New Keynesian models this type are examined in Chapter 12. They deny. 1981). 39. they criticize the auction market characterization of the labor market is much more a contractual market and that the nature of these contractual arrangements leads to wage rigidities and consequent involuntary unemployment. however. of itself. they criticize what they consider Keynesian’s arbitary assumptions concerning wage stickness and consequent involuntary unemployment. however. and they critize new classical economists for ignoring these elements of relity that their model cannot explain. Keynesians criticize the new classical theory on several grounds.