Class notes:

Baikuntha Pandey
Asst. Prof. Patan Multiple Campus
baikuntha2027@gmail.com
 Unit -2
New Classical Macroeconomics
• New classical macroeconomics is a school of thought
originated in the early 1970s.
• Robert Lucas was the prominent economist(Nobel Laureate)
–University of Chicago.
• Thomas Sargent, Neil Wallace and Edward Prescott (Nobel
Laureate) were the followers of Rebert Lucas.
• The new classical macroeconomics, however is more fundamental
attack on the Keynesian system than in monetarism.
• Monetarists and Keynes reach different policy conclusions and differ
on a number of empirical questions.
• New classical macroeconomics is an attempt to repudiate and modify
Keynesian view about the role of macroeconomic stabilization policy
in the light of the Classical school of thought.
• The New classical economists hold that monetary and fiscal policy
actions that determine AD will not affect output and employment even
in the short run. This is termed as Policy Ineffectiveness Proposition.
• The new classicists rejected the Keynesian prescription that deficiency
in AD is the main cause of economic crisis.
• Involuntary unemployment rises in the time of recession due to
Keynesian sticky W/P regime.
• But involuntary unemployment would present firms to raise profits
and to optimize themselves.
• The central policy tenet of the new classical economics is that
stabilization of real variables, such as output and employment, can not
be achieved AD management.
Critique to Keynesian Macroeconomics

• Expansionary fiscal policy- consider which increases Ms

• In the short run such policy action would increase AD.
• Price level and level of output would rise.
• This results increase in labour demand schedule which pushes labour
supply schedule which is fixed in the short run.
• The position of both schedules depends on the value of expected
price level.
• The expected price level depends on past prices, not on the current
policy actions.
 Basic Principles
• Rational expectation hypothesis.
• Market clears without posing a systematic error.
• Aggregate supply hypothesis.
In new classical macroeconomics labour supply curve can be stated as

• Ns = f(W/Pe) f' >0

• Ns = Labour supply

• W= money wage

• Pe = Expected price level

• [Expectation are formed on the basis of all available information

Some important Features
• It is an outcome of failure of Keynesian demand
management policy to mitigate economic crisis.
• Based on rational expectation.
• It is forward looking approach widely used as micro
foundation of macroeconomics.
• Its policy measures do not affect real economic variables
even in the short-run.
• In Keynesian analysis current actual price does not affect the current
expected price (Pe) but in new classical does it have.
 Rational Expectations

• Expectations are formed on the basis of all available relevant

information concerning the variable being predicted.
• If expectations are rational, then in forming a prediction of the past
value of the aggregate price level, labour supplier will use all relevant
past information, not just information about past behaviour of prices.
• Labour supplier will take account of any anticipated(expected)policy
actions.
• Furthermore, they are assumed to understand the relationship between
such policies and the price level.
Equilibrium output and employment
• The expected price level depends on the expected level of variables in
the model that actually determine the price level.
• M= money supply, G= government spending, T= tax collection I=
autonomous investment
• ‘e’ denotes expected and ‘o’ denotes actual values.
• The position of labour supply and aggregate supply schedule depend
on the expected value of policy variables.
• We consider figure 2 for further analysis
Shift in Money supply
• The increase in money supply from M0 to M1 will shift the
aggregate demand schedule to Yd (M1).
• If the supply schedule did not shift output would rise from Y0 to
Y1’ and price would increase from P0 to P1’. With the rise in the
price level, the labour demand schedule would shift to the right. If
the labour demand schedule did not also shift, employment would
rise( from N0 to N1’).
• In the New Classical case the position of the labour supply and
aggregate supply schedules are not fixed in the short run as
Keynesian or Monetarists assumed.
• The expansionary action is anticipated. Therefore, the level of expected Ms
will also increases. This increase will rise expected price level.
• As a consequence, the aggregate supply will shift to the left to the position
given by Ns(M1e) and Ys(M1e) . As the decline in the aggregate supply
puts further upward pressure on the price level, the labour demand schedule
shifts to Nd(P1).
• The new equilibrium is where output and employment have returned to their
initial level Y0N0, while price level and money wage are higher at P1 and
W1.
• Such returns to initial levels of output and employment takes place in the
short run when expectations are rational.
• The decline in investment shifts the aggregate demand schedule from

Yd(I0) to

Yd(I1) in 3a causing output to decline from Y0 to Y1.

• The price level will fall from P0 to P1’ as a result, the labour demand

schedule schedule(3b) will shift downwards from Nd(P0 ) to Nd(P1’ ).

• Let’s take Anticipated Assumption:
• Labour supplier will supply more labour expecting price level to be
decreased. As a result, labour supply schedule shifts to the right from
Ns(I0e ) to Ns (I1).
• Now, the aggregate supply schedule shift from Ys(I0) to Ys(I1). There
is further decline in price level to P1 therefore further downward shift
in labour demand schedule to Nd (P1).
• Money wage and price level have fallen significantly to restore N0 and
Y0.
 Let’s take Unanticipated Assumption:
• In this case labour supply would not have foreseen the price decline
that resulted from the decline in aggregate demand.
• The labour supply schedule and aggregate supply curve would have
remained at Ns(I0e ) and Ys(I0e ). This will cause output and
employment to decline ie. Y1’ and N1’.
• In such case there would not an offsetting policy action to raise aggregate
demand back to its initial level.
• Any changes in real output and employment from the unanticipated money
supply changes can be termed as " Monetary Surprise" in new- classical
Macroeconomics
Real Business Cycle Theory
• Real Business Cycle Theory has been evolved out of the American
New classical School in 1980s.
• Main contributors are Kydland and Prescott, Barro and King, Long
and Plosser, Mankiw, Summers and others.
• Main ideas: Technological shocks, labour market, interest rate, role of
money, fiscal policy, prices and wages in business cycles.
• They hold the view that aggregate economic variables are the
outcome of decision made by many economic agents acting to
maximize their utility subject to production possibility and resource
constraints.
• Real Business cycle theorists agree with new classical that (i) agents
optimize and (ii) market clear. But the difference is that they focus on
micro foundation of optimizing decisions.
• Economic fluctuations can be explained by adding random
disturbances to the neoclassical framework with optimizing agents,
rational expectations, and market clearing under perfect
competition.
• Aggregate economic variables are the outcome of the decisions made
by many economic agents acting to maximize their utility subject to
production possibility constraints.
• The RBC theory is explained by considering the following variables:
technological shocks, labour market, interest rates, role of money,
fiscal policy, prices and wage rates.
 Assumptions

• Single commodity in the market,

• Wage price flexibility,
• Output and employment are unaffected by MS and P,
• Rational economic agents in the economy,
• Agents optimise decisions,
• There is supply side shock in the economy,
• Technological shocks affecting the economy,
• Constant returns to scale production technology


Simple Real Business Cycle Model

• Aggregate economic variables are outcome of the decision of millions of

individual agents. Individual agents optimize.
Description of the model
•Utility function Ut= F(Ct , Let) ………… (1)
•Production function Yt= zt F(Kt, Nt) ……………..(2)
•Equilibrium condition Yt= Ct+ St……………. (3)
•Capital accumulation Kt+1 = St+ (1-𝛿)𝐾𝑡 … … … (4)
Role of Technological Shocks

• An initial shock in the form of technological advance shifts the

production function upwards.
• This leads to increase in available resources, investment, consumption
and output.
• With the increase in investment, the capital stock increases which
further increases real output, consumption and investment.
• Production function of the economy is:
Yt= zt F(Kt, Nt)
• Output depends on technology and capital stock which is determined
by ,Yt= zt F(Kt, Nt).
• The K depreciates at the rate 𝛿, so that the undepreciated K evolves as
(1-𝛿)K which turns as input for production in the next periods.
• The total resources available in the economy in the current period:
Yt + (1-𝛿)𝐾𝑡 𝑜𝑟 zt F(Kt)+ (1-𝛿)𝐾𝑡 .
• These resources can either be consumed or accumulated as capital to
be used as investment for the next period.
• When there is initial K ,output increases from OY to OY1 if the
production function shifts to z1 F(Kt) thereby increasing resource to
zF(Kt)+ (1-𝛿)𝐾𝑡 .
• With the increase in total resource, both current consumption and
capital accumulation also increase which leads to increase in K.
• Increase in K to K1 in the next periods leads to a further rise in output
OY2 and the increase in total resource to R2 .
• In this way economy expands when consumption, investment and
output increase gradually leading to a new steady state equilibrium.
• But the increase in output and resources is smaller than in the initial
periods as shown in the given figure ie. R1R2 <RR1 Y1Y2 < YY1 .
• In the long run there is a gradual decline in investment and
consumption even when output continues to increase at a decreasing
rate till the economy reaches the new steady state equilibrium. The
path is illustrated in the figure below:
• In the period 1, there is a permanent technological shock which
pushes Z from a to b. This causes increase in I from c to d and output
from e to f.
• When the technology Z is parallel to X- axis in the subsequent
periods, the I curve also falling subsequently but Y continues to
increase at a decreasing rate till the economy reaches the new steady
state equilibrium.
• Labour Market: The real business cycle theory emphasizes that there
is inter-temporal substitution of labour in the labour market. When a
technology advance leads to a boom, the marginal product of labour
increases. There is increase in employment and real wage.
• In response to a high real wage, workers reduce leisure
• On the contrary, when technology is unfavourable and declines, the
marginal product of labour, employment and real wage rate are low.
In response to a low real wage, workers increase leisure. Thus an
important implication of real business theory is that the real wage is
pro-cyclical.
• Interest rest: The real business cycle theory also takes into account
the role of real interest rate in response to a technological shock. The
real interest is equal to the marginal product of capital. When a
favourable technological change leads to a boom, the marginal
product of capital and the real interest rate rise.
• On the contrary, an unfavourable technical change leading to a
recession reduces the marginal product of capital and the real
interest rate. When the economy reaches the new steady state, the
real interest rate eventually returns to its initial level.
Role of Monetary policy

• Money has proportional relationship with price. But it does not

change in real output and employments.
• Desirable monetary policy would result slow, steady growth in money
supply and stable prices or at least a low rate of inflation.
• There is no role of activists' monetary stabilization policy.
 Role of Fiscal policy

• Fiscal policy affects output and employments but through supply side
that is change in tax rate which affects trade-off between leisure and
work, return from capital.
• Task of fiscal policy is to minimize the distortion from tax rate.
 New Keynesian Macroeconomics
• N Gregory Mankiw and David Romer are the prominent pillar of New Keynesian
model.
• They published two volume of collection of articles.
• Book named, New Keynesian Economics(1991),MIT Press.
• Various surveys are made on the New Keynesian economics:
➢ What is New Keynesian Economics?-Robert J. Gordon(1990),Journal of
Economic Literature.
➢The New Keynesian Synthesis-David Romer(1993),Journal of economic
perspective.
➢Staggered Price and Wage Setting in Macroeconomics- John B. Taylor(1998),
Handbook of Macroeconomics.
• Economists working within the Keynesian tradition have pursued
additional explanations of involuntary unemployment. Wage-price
rigidity is the central to the Keynesian system which arise from the
behaviour of optimizing agents.
• The new researches is response to the new classical critique of the
older Keynesian models.
• The new classical economists argued that the Keynesian economics
was theoretically inadequate, that macroeconomics must be built on a
firm microeconomic foundation.
• The new Keynesian literature is characterized by dizzying diversity
approach which have the following elements:
i) Imperfect competition is assumed for the product market instead of
perfect competition.
ii) Product price rigidity instead of nominal rigidity in the money wage.
iii) Real rigidity instead of money wage rigidity.
Richard T. Froyen( Macroeconomics, 10 th edition, 2019) has
elaborated three types of new Keynesian models that go ………
 New Keynesian Models

1. Menu cost models

• The menu cost models is also known as sticky price models.
• The costs of adjusting prices are called the menu costs. Changing
prices requires the use of resources by a firm. It has to print new price
lists (menus), catalogues, and other printed material. A super market
has to reliable all products and shelves with the new prices. A hotel
and a restaurant have to reprint its menu with new prices. Meetings,
phone calls, and trips by representatives of a firm to renegotiate with
suppliers, all fall under the category of menu costs.
• If these perceived costs of price changes are high enough, price
stickiness will exist. Such cost of price changes are called menu costs.
• Decline in AD will result in falls in output and employment, not price
reduction.
• In the menu costs approach to sticky prices, it is profitable for firms to
react to small changes in demand by keeping prices constant over a
short period and responding with changes in output.
• If the perceived cost to changing prices that overweighted the benefit
of the price cut, the firms would hold the prices constant even as
demand fell.
• A crucial element in new Keynesian sticky price models is that the
firm must not be a perfect competitor.
• Monopolistic competitors and oligopolies have some control over the
price of their products. If all firms hold to the initial price no
individual firm will loose sales to its competitors.
• Profit maximizing price of the firms in imperfect competition may
decline in the face of a fall in demand but there will be a small gain.
• Sticky price models suggest a role for monetary and fiscal policies to
offset shifts in aggregate demand.
• The equilibrium level of output will be below the optimal level, thus
offsetting declines in demand will be more important than offsetting
increases.
• In the presence of menu costs when firms make pricing decisions they
will recognize that they may be stuck with the price for some time
and therefore be forward looking and try to predict future costs and
demand.
 2. Sticky Real Wages:
• The new Keynesian theories focus on the real wage rigidity where
workers are not paid market-clearing wage and involuntary
unemployment exists even in the long run.
There are four main approaches to real wage rigidities. They are:
(a) asymmetric information model,
(b) implicit contract theory,
(c) insider-outsider theory, and
(d) efficiency wage theory.
 Asymmetric Information Model

• They assumed that managers know more about the interests of the firm
than do the workers. Given this better knowledge, it is possible and
profitable for managers to deceive the workers about the real position
of the firm.
• They enter into contracts with workers for employment commitments
whereby the firm pays them rigid real wages. However, there is an
employment commitment in this model that tends to increase the
amount of employment in the firm.
 Implicit Contract Theory

• Usually employment contracts between workers and firms are explicit

agreements. But often there are other dimensions that are not written
in the actual contracts.
• These dimensions are called implicit contracts. Workers and firms
enter into implicit contracts concerning job insurance and income
because workers are risk-averse with respect to income. Workers
dislike the risk arising from income and fluctuations of employment
more than the firms.
 Insiders and Outsiders theory

• Insiders are those workers who already have jobs and outsiders are
those who are unemployed in the labour market. Insiders are
represented by unions who have more say in wage bargaining than the
outsiders. Unions negotiate the real wage with firms and set it higher
than the market-clearing level so that the outsiders are excluded from
jobs leading to involuntary unemployment in the presence of fall in
aggregate demand.
• Unions use their bargaining power to negotiate wages through
turnover costs. Turnover costs relate to the costs of firing, hiring and
retaining of new workers. These costs prevent the firms to employ
outsiders in place of insiders.
• Unions can also prevent the entry of outsiders for jobs threatening
strikes and work-to-rule. Insiders can also use these costs against
outsiders to achieve a higher negotiated wage than the wage at which
the outsiders are prepared to work.
 Efficiency Wage Theory

• In new Keynesian economics, payment of efficiency wages leads to

real wage rigidity and the failure of market-clearing mechanism. High
wages increase efficiency and productivity of workers.
• In 1974, Henry Ford instituted the five dollar per day for his worker as
against 2 -3 dollar of going rates.
• He found it improved workers absenteeism, morale and productivity.
• Hence, the efficiency of workers depends positively on the real wage
they are paid.
• Efficiency wage model implies that forms will set the real wage above
the market clearing level.
• The efficiency wage idea can be formalized by defining an index of
worker efficiency, or productivity, such that
e=e( W/P)………………….(1),where e implies productivity
of workers, W/P implies real wage.
Worker’s efficiency is a positive function of the real wage. Now
aggregate production function be

Y =F [𝐾,eN]………………………..(2)
As per (2), the goals of the firms is to set the real wage so that the cost
of an efficiency unit of labour is minimized.
• This goal is accomplished by increasing the real wage to the point
where the elasticity of the efficiency index [e(W/P)] w.r. to real wage
is equal to 1.
• So, condition that determines the optimal level of the real wage,
which is called efficiency wage,(W/P)* is

𝑊
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑒( 𝑃 )
𝑊 =1……………….(3)
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 ( 𝑃 )
• Notice that the real wage is fixed on the efficiency ground (3).
• Efficiency wage models explain a real rigidity.
• If there was a fall in nominal aggregate demand resulting from a
decline in the money supply, firms could lower their prices sufficiently
to keep output unchanged and lower the money wage by the same
amount to keep the real wage at the efficiency wage,(W/P)* .
• If firms do not lower the price because of the menu costs, then to keep
the real wage at the efficiency wage requires the money wage also to
be fixed.
 3. conclusion

• New Keynesian economics is an attempt to improve the

microeconomic foundations of the traditional Keynesian models, not
to challenge their major premises.
• Applicable in imperfect market structure.
• Sticky price premise rather that wage-price rigidity.
• Menu cost is determining factor to remain at the current price even in
the economic slow down.
• Efficiency in labour boosts up the productivity. So firms would be
ready to pay for wage bill for the shake of increased out put resulted
from improved productivity.
This Photo by Unknown Author is licensed under CC BY