CHAPTER II New Classical Economics against the background of the high inflation and unemployment of the 1970s and the accompanying dissatisfaction with the prevailing Keynesian orthodoxy, Both monetarism and the new classical economies have their origins in classical eco- nomics, and the two schools of economists reach similar noninterventionist poliey con- clusions, Robert Lucas, the central igure in the development of the new classical economies, basically agrees with Milton Friedman's proposal for noninterventionist policy rules.! Much in the spirit of Friedman, Lucas says, “As an advice giving profes sion we are in way over our heads.” In fact, new classical economists are even more skeptical than Friedman about the usefulness of activist stabilization policies, “The new classical economies, however, is a more fundamental attack on the Key- nesian theoretical system than is monetarism. Monetarists and Keynesians reach differ- ent policy conclusions and differ on a number of empirical questions, but in Chapter 9 we presented no distinet monetarist theoretical model. New classical economists have been motivated by a belief that the Keynesian structure is fundamentally flawed, They have attacked not just the usefulness of Keynesian analysis for understanding eco- nomic events and desigaing useful policies but also its internal consistency, The alter- native way new classical economisls propose to address macroeconomic questions is important not only to their own theory, as set out in this chapter, but also to the real business eyele theory and to the new Keynesian analysis we consider in Chapter 12 This chapter first presents the new classical economists’ critique of Keynesian macroeconomics, focusing especially on the differences inthe policy conclusions of the two groups (Section 11.1). Next, we take a broader look atthe new classical economies (Section 11.2). We then consider the Keynesian response to the new classical econom- ies (Section 11.3). The final section (11.4) contains concluding comments on the cur- rent slat of the controversy between Keynesian and new classical economists Tz next theoretical system we consider, the new classical economics, developed 11.1 The New Classical Position new classical policy ineffectiveness proposition asserts that sys- tematic monetary and fiscal policy actions that change aggregate demand will nor affect output and employment even, in the short run 228 ‘We have already quoted Franco Modigliani’s Keynesian view that a private-enterprise economy needs to be, can be, and should be stabilized by active government aggregate demand management. The central policy tenet of the new classical economics is that stabilization of real variables, such as output and employment, cannot be achieved by aggregate demand management. The values of such variables in both the short run and the long run are insensitive to systematic aggregate demand management policies. In other words, in the new classical view, systematic monetary and fiscal policy actions that change aggregate demand will not affect output and employment, even in the short run. This has been termed the new classical policy ineffectiveness proposition, ‘Rober Lucas, “Rules, Discretion, and the Role ofthe Economic Advisor." in Stanley Fischer, ed, Rational Expectations and Economie Policy (Chicago: University of Chicago Press, 1980), p. 259 id, p. 259.rational expectations expectations formed on the basis ofall availa ble relevant infor- ‘mation concerning the variable being predicted. Moreo- ‘agents are assumed. to use available information inte: ligently; that is, they understand the relationships between the vari- ables they observe ‘and the variables they are trying to predict CHAPTER I1 New Classical Economics 229 A REVIEW OF THE KEYNESIAN Position To see the basis for this new classical position, we first consider the new classical econ- ‘mists’ critique of Keynesian macroeconomics. A good starting place is a review of the Keynesian analysis of the relationships among output, employment, and aggregate demand, as discussed in Section 10.3. Consider the effects in the Keynesian model of an expansionary policy action—for example, an increase in the money supply. In the short run, such a policy action would increase aggregate demand. The aggregate demand schedule would shift to the right along the upward-sloping ageregate supply schedule (as illustrated, for example, in Figure 10-Sa). The price level and level of out- put would rise. Parallel to the increase in output is a rise in employment as labor demand increases, with the rise in prices shifting the labor demand schedule to the right along the upward-sloping (drawn against the money wage) labor supply schedule (as illustrated, for example, in Figure 10-56). Crucial to these results is the fact that the positions of both the aggregate supply schedule and labor supply schedule are fixed in the short run. The position of both of these schedules depends on the value of the expected price level (P*), which is assumed to depend primarily on past prices and not to change with current policy actions, In the long run, the expected price level converges to the actual price level, and oth the aggregate supply schedule and the labor supply schedule shift fo the left. ‘The initial levels of employment and output are restored, with only the price level and the money wage left permanently higher as a result of the increase in the money supply (see Figure 10-7). Output and employment remain above their long-run equi- librium levels only as long as it takes labor suppliers to perceive correctly the change in the price level that results from the expansionary policy action. As long as our attention is confined to monetary policy actions, monetarists would agree with the foregoing analysis. ‘Tre RATIONAL EXPECTATIONS CONCEPT AND Its IMPLICATIONS New classical economists do not agree. In particular, they do not accept the difference between the short-run and long-run results in the Keynesian or monetatist analysis of the effects of aggregate demand on output and employment. The focal point of their criticism is the Keynesian (and monetarist) assumption concerning price expectations, This formulation assumes that labor suppliers form an expectation of the current aggregate price level (or inflation rate) on the basis of the past behavior of prices, In practice, Keynesians and monetatists have assumed that such price expectations adjust slowly and can be fixed for the analysis of policy effects over short periods. New classical economists criticize such formulations of expectations as naive in the extreme. Why, they ask, would rational economic agents forming an expectation of the price levei rely only on past values of the price level? Why especially would they do so when in general such behavior results in their being systematically wrong when aggregate demand shifts? We have been assuming that after changes in aggre- gate demand—for example, the increase in the money supply considered in the pre- ceding subsection—labor suppliers fail to perceive that the demand shift will affect price. New classical economists propose that economic agents will form rational expecta- tions, rational in that they will not make systematic errors. According to the hypothesis of rational expectations, expectations are formed on the basis of all available relevant information concerning the variable being predicted. Furthermore, the hypothesis main- tains that individuals use available information intelligently; that is, they understand the230 Par Il MACROECONOMIC THEORY AFTER KEYNES ‘way in which the variables they observe will affect the variable they are trying to predict, Thus, according to the rational expectations hypothesis, expectations are, as the origi nator of the concept, John Muth, suggested, “essentially the same as the predictions of the relevant economic theory,”” based on available information. If expectations are rational, then in forming a prediction of the value of the aggregate price level, labor suppliers will use all relevant past information, not just information about the past behavior of prices. In addition, they will use any infor- mation they have about the current values of variables that play a role in determin- ing the price level. Most important from the standpoint of aggregate demand ‘management policy, labor suppliers will take account of any anticipated (expected) policy actions, Further, they are assumed to understand the relationship between such policies and the price level. ‘A useful contrast can be made between the backward-looking nature of expecta- tions in the Keynesian model and the forward-looking nature of rational expectations. In the Keynesian model, expectations are backward looking. The expectation of a var- iable such as the price level adjusts (Slowly) to the past behavior of the variable. According to the rational expectations hypothesis, economic agents instead use all available relevant information and intelligently assess the implication of that informa- tion for the future behavior of a variable. If labor suppliers make forward-looking rational forecasts of the price level, then the preceding analysis must be modified. To see this modification, we analyze the effects of an expansionary policy action previously considered: a one-time increase in the money supply. To analyze this change with the assumption that expectations are rational, we must begin by specifying whether the policy change was anticipated. Anticipated and unanticipated policy changes have very different effects when expec- tations are assumed to be rational. First, we assume that the policy change is antici- pated, perhaps because the policy maker announced the policy change. Alternatively, the public may anticipate the change because the policy maker is known to act in eer- tain ways. For example, if the policy maker systematically responds to an increase in unemployment in one period by increasing the money supply in the next period (to counteract unemployment), the public will come to anticipate an increase in the ‘money supply for period ¢ when they observe an increase in the unemployment rate of period HL ‘To begin, consider the characterization of equilibrium output and employment in the new classical analysis, as illustrated in Figure 11-1, The crucial difference between the new classical case and the Keynesian case concerns the variables that determine the positions of the labor supply and aggregate supply schedules. As in the Keynesian theory, we assume here that labor supply depends on the expected real wage, the known money wage divided by the expected price level: fw N () ay Consequently, the position ofthe labor supply schedule, and therefore that of the aggregate supply schedule, depends on the expected price level. Increases in the expected price level will shift both schedules to the left. John Muth, “Rational Expectations and the Theory of Price Movements," Econometrica, 29 (uly 1961), p36, ‘he terms expected and anticipated or unexpected and unanticipated are used interchangeably here. Policy shift ate referred to as either anscpated or unanticipated, whereas we refer to expected levels of variables, Including poliy variables