In their article, After Keynesian Macroeconomics, Thomas Sargent and Robert Lucas inquire into and critique the fundamental limitations of the Keynesian approach to Macroeconomics.  The approach to economics that arose from Keynes, was one that necessarily relied on historical data, upon which regression equations could be tested and specified.  Any Keynesian macroeconomic equation can be reduced to a regression equation; but to specify the parameters of the equation from observations of the outputs (Ps, Q, and such) requires a great deal of information about the entire system in the first place.  All estimates of these parameters (like rental rates, factor shares, or marginal products) can only be estimated from the historical data; which means that all Keynesian macro models are founded by ex ante information, and cannot adequately take into account the way that people have rational expectations about the future.  

Indeed, there are a number of related reasons why Keynesian structural macro models are not in fact structural, or theoretical, but rather empirically founded and therefore limited.  Keynes implied some very tight restrictions on macro relationships.  By identifying consumption expenditures as a function of income and current consumption only, or the demand for money as a function of interest rates only, Keynes made radical assumptions about that which money demand, and consumption expenditure was not contingent.  But saying what something is not, requires assumptions, in the same way we assume that some variables are truly exogenous, because they are not influenced by the system, but only influence the system.  This way of estimate ‘structural’ macro models must also exclude the individual from the equation.  When the model is based off of historical data and expectations of future values are based off of the previous values, then the individual acts more as a point of convergence of many historically determined macro variables, rather than an agent that makes rational, profit maximizing decisions.  This retrospective way of estimating models lead to the failure of the Keynesian economics in the face of high inflation and unemployment of the 1970’s.  Equations that always assumed a tradeoff between unemployment and inflation were systematically refuted, as both began to grow at faster and faster rates per year. 

But even more than a simple failure of Keynesian macro economics, the general approach to data and modeling was flawed.  Rather than simply adding or subtracting terms, aggregating or disaggregating, Lucas and Sargent argue that new-classical models are more sound in their assumptions, because by starting at the micro level, they can include the self-referential qualities of human agents—because agents are rational and can refer to the model from which they decide how to behave, the model itself should become part of the model, and change dynamically, rather than linearly through time.  Only at the micro level can we get to this lowest common denominator of all macro behavior; or so argues Lucas and Sargent.  

Lucas, Robert E and Sargent, Thomas J.  “After Keynesian Macroeconomics,” After the Phillips Curve: Persistence of High Inflation and High Unemployment, 1978.    

In this very brief article, Blinder first argues for what should remain within the established tradition of teaching economics. The IS and LM curves should not be included, for several important reason. The IS curve may be fundamentally flawed because the negative relationship between interest rates and investment may only hold good for homebuilding and consumer durable, rather than business investment. Also, the LM curve fails to make a strong distinction between real and nominal, short and long runs. This was also a serious critique of Keynesianism, and so we can see that the old paradigm has not yet given way to the New Classical and New Keynesian synthesis.

Also, by thinking in terms of demand and supply, we tend to assume that aggregate demand and supply are adjusted rapidly to price changes, while wages remain sticky. But in reality, both prices and wages remain sticky—the supply curve should adjust, not just quantity supplied. In doing so, we would then be assuming that wages and prices should be considered to be largely predetermined in the short run, even though in the long run they will be allowed to adjust. These may be agreed to be core principles of economics, however they are not taught to principles students, nor is there any consensus on the reason for wages being so sticky

Given this brief critique, there are four core things to include in the model for understanding economics. 1) Prices and wages are largely predetermined in the short run because of price stickiness. 2) Output is demand determined in the short run—because of this, 3) Monetary and fiscal policy is effective, via demand changes from fiscal, effect interest sensitivity, effected by monetary policy. 4) Okuns law is legitimate—growth and unemployment rate.

And to summarize the problems with the old model, Blinder offers the following points: 1) The term structure of interest rates say that the rate of interest for long term maturities will be equal to the sum of the expected interest rates per year leading up to the long term rate. Although this may be intuitively appealing, it fails all the empirical tests. We must find something better because this is a major cannon of monetary policy, and we need to know more about its limitations. 2.) Modeling expectations: usually relegated to the Phillips curve on the right side of the equation showing expected inflation, but it should be expanded. A major difficulty is when we see that fiscal stimulus can actually encourage a recession. To get to this understanding, we need to see that fiscal policy works more through intertemporal shifting of demand, and that the term structure of interest rates is essentially wrong.

There are inherent limitations in the IS-LM framework because thinking in terms of aggregate non-dynamic relationships will always, at least implicitly, ignore the way individuals react in accordance with rational, inter-temporal expectations. When Keynes developed his general theory, it was never in anyway general because it failed to incorporate expectations, and the time dimension beyond a single period. The IS LM framework developed by Keynes, however, cannot be made to incorporate rational expectations because the assumptions and foundations are inherently incompatible. The author explains that old economists were asking the wrong questions: it should not be what explains cycles, but rather, what explains differences in cycles—in assuming that cycles are not uniform in time, this latter form of the questions gets at the time dimension of cyclical behavior, and therefore opens up more questions about what are the determinants of this time dimension—indeed, this article deals with the journey to formulating this as a question, and the answers to this question.

Looking closely into the Keynesian system we see that he was generally short run oriented. We need to take his time period into account before we judge him too harshly; he was oriented mostly towards policy prescriptions and short run corrections for shocks for which he could not provide an explanation. By neatly dividing up all the interaction in the economy into three major relationships, Keynes was then able to develop his general theory with a few characteristics that King identifies as trouble spots. 1) liquidity preference responding to nominal prices as largely predetermined 2) expectations were largely exogenous, and onlyn effect to be reckoned with by the model, and not from within the model 3) behavioral rules were essentially fixed, and so public policy had the responsibility of seeing the variability in the exogenous shock; therefore, public policy should be developed on a case by case basis.

Milton Friedman criticized the Phillips curve which is consistent with Keynesian theory, for showing changes between the inflation and unemployment rates, rather than a series of events. The relationship was therefore oversimplified into a tradeoff that appeared static rather than dynamic. Even though Friedman criticized the static nature of the Phillips curve, his own formulation of the curve that incorporates expectations seems to be a static theory in other respects. It implicitly assumed that real wage increases would encourage the same increase of labor supply in the short and long run. The new-classical framework assumes, rather that labor supply is exogenous (population growth rate), so that in the long run labor is fixed and much more inelastic with respect to real wage changes. Also, by incorporating micro-foundations and the permanent income hypothesis, the neoclassical approach was able to account for the dynamic relationship between inflation and unemployment, by looking into the individual consumption function.

Indeed, behind this critique however there is a long literature of economists who have built upon the ISLM framework, curve by curve. On the income side of the IS curve, Friedman and his life cycle theory, Modigliani, and Brumberg, all imply the sensitive relationship between the patterns of income, savings and consumption over the lifetime of a rational agent that implicitly hold a stock of wealth. These variables, assumed to be largely independent of each other in ISLM analysis, are intimately related from the perspective of the individual in time. “The marginal propensity to consume depends in an essential way on the nature of the income profile under consideration: it is low for changes in income that are temporary; high for those that are permanent; and depends in a delicate way on the details of the stochastic process for situations in between.”(pg 76) Therefore, as the neoclassical research and theory continued, it became clear that econometric models should also include some variables that control for expectations about the future conditions of income, production, and cost levels.

The demand for money in the LM portion of the graph, is also complicated by expectations. It was deficient because it boiled down to static models—expectations of future inflation, could only influence cash holdings because inflation effects the nominal interest rate in the future. The choice is not simply between money and bonds, but also between different time-maturity bonds, which requires some inclusion of expectations. For these reasons, we see that Friedman implicitly includes wealth in his permanent income theory, and other economist investigate the influences of inflation directly on money demand by looking into “partial adjustment” phenomena in the money demand market.

These models confirm and build upon the rational expectations augmented neoclassical models that came into the picture around the same time. Rational expectations link the short and long run; money and savings-investment markets that were assumed in the IS LM framework to be mutually exclusive, now became essentially linked by individual agents. The permanent income hypothesis is also derived from the rational expectations framework, and gives a very sensitive account of consumer behavior—empirically its predictions are sounds, and theoretically, it demonstrates that IS curve should be dependent on everything—this is just evidence of how much as Keynes model overlooked. In the end, the author wants to change the direction teaching, policy analysis, and econometrics. Because this framework never even addresses, or recognizes the existence of the long run, asking questions and formulation questions from within this framework is could only tell half the story; which never makes for a good story.

Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?
Robert G. King The Journal of Economic Perspectives, Vol. 7, No. 1. (Winter, 1993), pp. 67-82.

By looking deeply into the differences that exist between Keynes and the New Classical, Shaw contends price flexibility is a major point of divergence.  The new classical assumed that markets would always clear and achieve a Walrasian equilibrium condition, in which there existed a single price vector for all markets that satisfied equilibrium in all markets.  In Walrasian theory, there is an auction type environment where all perfect information prevails, products are homogenous and transaction costs are zero.  This is what Hicks refers to as flexprice markets; because whatever market follows these conditions will likely have flexible prices. 

The characteristics of financial markets most closely resemble these requirements of flexprice markets.  There is extreme competition, well informed specialized traders act as auctioneers, information is equally available amongst all market participants, and there is a large quantity of homogeneous products (from the perspective of the buyer) being sold in near cost-loss conditions.  And indeed, these markets do have extremely flexible prices and wages.   However, not all markets have these pleasant conditions .  Most markets in the world are not financial, but rather have trading in goods and services.  Shaw runs through at least seven different sources of price inflexibility that can arise under conditions where information is not perfect, products are not homogenous, and transaction costs are relatively high.  Hicks refers to these as fixprice market.

The first source Shaw mentioned arises when there is no auctioneer as there was in the Walrasian auction system, such that there would be tremendous costs for all the market participants to have to congregate in one place to bid on prices.  The price tag is cheaper to use from the perspective of the buyer and seller, because fixing a price for a time period would also reduce search costs for buyers (the price wont change by the second, so they wont have to keep checking on it), and this allows time for the buyers to become aware of the price and respond accordingly.  Adjustment are never instantaneous, so it is infact a good thing that prices are fixed because it allows the market time to adjust. Also, this lowers the associated costs of changing price tags, up until it becomes profitable to do so.  Because the cost of a price change will be the same regardless of the extent of a price change, a firm will wait until the benefits of changing the price exceed the cost of the price change; until that point all adjustment will be output adjustments.

Also, in the case of Walrasian equilibrium, perfect information exists because the auctioneer acts to coordinate all market clearing price adjustments.  We see an example for this in the game theory dilemma of private firms in the face of an aggregate money demand shock.  When the supply of money decreases, a firm will experience a drop in the nominal demand for its products.  But at the same time, the cost of its inputs should decrease as well; if the firm decreases its output prices, and input prices fall, then profits should remain unaffected.  But to lower prices means that they will be earning less profit than competitors, so who will be the first one to make the move?  This lack of coordination will delay the impact of nominal changes in demand, and result in price stickiness and changes in real variables.  And of course, these effects are magnified because there is often a lag between intermediate and final goods markets.  The input cost price adjustment will respond more slowly than the nominal demand change, so the firm is not likely to decrease prices because profits would decrease in the short run.

This is a summary of Chapter 7 from Rational Expectations by G. K. Shaw.

New Classical Macroeconomics

The classical foundations of the Monetarist school provide a first point of departure for the New Classical approach to macroeconomics. There are a few important characteristics of monetarism that should be clarified in order to show more clearly the unique qualities of the New Classical tradition. In general, the monetarist critique of Keynesian economics arose out of the period of stagflation during the 1970’s and 80’s. The Phillips curve, adapted into the Keynesian framework, was unable to explain or account for the co-existence of two seemingly inconsistent phenomena; inflation and unemployment should be tradeoff consequences of demand management. In 1968, a few years before stagflation ever became an insue, the monetarist Milton Friedman portended a few serious limitations with the Keynesian framwork and specifically the Phillips curve. Rather than showing a simple inverse relationship between inflation and unemployment, the curve should relate unemployment to real wages rather than nominal prices. Also, in showing changes between the inflation and unmployment rates, the relationship was implicitly oversimplified into a tradoff that appeared static rather than dynamic. Also among his contributions was the natural rate hypothesis, which proposed a stable equilibrium rate of unemployment to which “the stable private economy tends to return once disruptive influences” are removed (Hoover 25).

This theory implies that there is no real tradeoff between unemployment and inflation, but rather any short run tradeoff reflects that economic agents have made a mistake in their expectations of future inflation. In doing so, workers have succumbed to a ‘money illusion’ because they have confused absolute and relative price changes. In the short run the aggregate supply curve is upward sloping because workers have not yet adjusted to real changes in wages. Over time, the incorrect expectations of the workers gradually adapts to coincide with the actual level of prices; the short run aggregate supply curve shifts upward until the wage increase translates entirely into a proportional increase in the price level. We have again reached the classical formula: every increase in spending or wages will translate into an equivalent change in the price level. Even amongst the monetarists there is no clear consensus about how long this corrective period lasts. For monetarists in general, however, we can see that the problem of ‘money illusion’ arises from limited information about relative wages, and expectations that are always retrospective, or ‘adaptive.’

Although involuntary unemployment is something that comes about in disequilibrium, Friedmans theory of unemployment was an equilibrium approach. How is this when unemployment is a disequilibrium phenomenon? The money illusion can only have an impact on unemployment, insofar as workers have been mistaken in their expectations about the future rate of inflation. When there is an unexpected fall in aggregated demand, the price level and price of output will also fall. Employers will higher more workers as the marginal cost per worker increases, and as the real wage is perceived to decrease, so will the aggregate supply of labor. In the end, unemployment falls. Frictional unemployment comes about as workers move between jobs and adjust to nominal price changes. Therefore, unemployment happens in the economy when workers have mistaken expectations even while they are struggling to maximize their utility. This is not an ideal situation because under different circumstances the aggregate income could be higher—but it is the best situation given the set of constraints.

In what Kevin Hoover calls the “first paper to deserve to be called ‘new classical,’” Lucas and Rapping manage to unite this “equilibrium” approach to unemployment with a labor supply curve that is elastic in the short run but inelastic in the long run. Although Friedman critisized the static nature of the Phillips curve, his own formulation of the curve that incoroporates expectaions, seems to be a static theory in other respects. It implicitly assumed that real wage increases would encourage the same increase of labor supply in the short and long run. The new-classical framework assumes rather that labor supply is exogenous (population growth rate), so that in the long run labor is fixed and much more inelastic with respect to real wage changes. As a note to the reader, be careful not to confuse nominal and real price changes; Friedman and the new classicals agree that the Phillips curve is vertical in the long run only when graphed against nominal price changes. Lucas and Rapping integrate this distinction into the their model as they begin from an individual agent’s consumption function in which future and current leisure are close substitutes. When real wage rises temporarily above its ‘normal’ level, more labor is supplied because the relative cost of leisure has increased. When the real wage rises permanently, there should be no long run change in the level of employment. The relative prices of working and leisure would remain constant, such that an agent would not substitute future for current leisure. This model is representative of the new classical approach in several ways. 1) It begins from microfoundation and a consumers utility function. 2) From within this micro-framework, the profit/utility maximizing agents behave in a way that is consistent with a general equilibrium. 3) The intertemporal substitution of leisure is the most relevant factor that determines fluctuations in output and employment.

But how can rational maximizers continue with adaptive expectations when their expectations are consistently wrong? To do so would be irrational, and therefore inconsistent with equilibrium. In this critique we are able to introduce “rational expectations” as an important element of new-classical thought. Friedman and Lucas noted that adaptive expectations are not compatible with natural rate hypothesis, because expectations would never fully adapt to real prices. If an exogenous supply shock increases the real wage rate, maximizing agents would always have expectations that lagged behind the real wage and price level. As relative prices and wages corrected over the short run from lower values in the past, workers would continue to perceive incorrectly that their real wage was higher than ‘normal.’ Labor supply would never adjust to its initial level, and a natural rate of unemployment would be unreachable. (29 Hoover) Adaptive expectations are systematically wrong. The new-classical economists therefore adopted the “rational expectations hypothesis” developed by John Muth. There are at least three defining features of rational expectations. 1) Information is always a limited resource that is never wasted. 2) There is no “inside” information because all information is public. As long as it remains public, no one is able to profit more than anyone else is. (15 Hoover) 3) Expectations are always developed from within a ‘relevant system’ that explains the economy, that is, people act as if they know the predictions of the model for the economy that incorporates all the relevant variables.

The second of these characteristics poses the biggest challenge for Keynesian and Monetarist theory. Agents with rational expectations do not suffer from the money illusion, but rather from incorrect expectations. When workers confuse a nominal increase with a real increase, they will work more because their rewards for working have seemingly increased. An agent with rational expectations, however, will always have perceptions that are consistent with the actual values of the variable in question, differing only by an amount that averages out to a serially uncorrelated random event. In any given situation “expectations may be incorrect,” but never “systematically incorrect” or else the expectations should grow to integrate whatever information is missing. All errors are random and not the result of any missing information, even though perfect information is never required. (347 Laidler) Using this random component, new classical economists were able to develop upon the supply side monetarist approach, without assuming adaptive expectations or perfect information into their models.

Allowing for imperfect or a non-zero cost of information; the new classicals were indeed new and something other than older classical economists. In the classical framework, as we have seen, all agents are blessed with perfect information, price flexibility, and clearing markets. While the last two conditions still hold true for new classicals, non-perfect information means that while the economy will always be in equilibrium, that growth path will not necessarily be constant. What brings the new classical in line with classical thought, also separates the new classicals from monetarist theory. Of course, we have already seen many differences, 1) Monetarists are more comfortable with high levels of aggregation, while New classicals always begin from micro-foundations. 2) Rational expectations are an integral element in all new classical models, while this is not the case for monetarists. And to assume perfect price and wage flexibility is to go even further. 3) As we have said, among the monetarists the aggregate supply curve is upward sloping because workers have not yet adjusted to real changes in wages. Over time the incorrect expectations of the workers gradually adapts to coincide with the actual level of prices; the short run aggregate supply curve gradually shifts upward until the wage increase translates entirely into a proportional increase in the price level. This process is always temporary, however in the new classical approach, it is almost instantaneous. Prices and wages are assumed to be perfectly flexible, so any increase in the money supply translates immediately into a price increase that is perceived and anticipated. What matters most for the aggregate labor supply, is rather real wages and expected real wages in the future.

So then, in summary, what are the major characteristics of new classical economics? There are at least three necessary concitions. 1) Real factors determine the economic decisions of rational agents. Consumption saving, and investment decisions are not based on nominal or monetary factors. 2) In accordance with the microfoundations of new classical, economic agents will always optimize and are always in equilibrium. 3) There can be no systematic errors in they ways they observe and behave in their economic environment; that is, they must have rational expectations. Of course, while a new-classical economist necessarily believes in rational expectations, all of those whom subscribe to rational expectations are not new-classical economist

There are a number of theoretical and empirical weaknesses within the new-classical approach. First of all, with respect to New Classical models, Laidler points out that the “truthfulness” of a model should not be contingent upon whether or not it can explain the data on which it was designed; “this is just testing the logical ability of the economist.” Rather a model should be able to anticipate those events that the economist did not know about first, or define the model to address beforehand. The desperate attachment to maximization, deduceability, and the apriori non-empirical model, has hobbled the predictive abilities of neo-classical thought. Empirically and historically, there are some demonstrations of these weaknesses. Because the neo-classicals propose that the Phillips curve reflects the elasticity of the supply of labor with respect to real wages, we are able to test the hypothesis. Aggregate employment fluctuates too strongly relative to inflation; changes in employment are only supposed to be the result of real wage changes. Secondly, in accordance with new classical theory, output follows changes in the real price; prices should always move prior to output changes. The data show, however, that quantity changes seem to precede associated changes in price.

Works Cited

Hoover, Kevin D. The New Classical Macroeconomics: A Skeptical Inquiry. New York, NY, Basil Blackwell: 1988

Laidler, David. 1986. The New Classical Contribution to Macroeconomics. Banca Nazionale Del Lavoro Quarterly Review, (March), pp 27-55. In A Macroeconomics Reader. Ed. Brian Snowdon and Howard R. Vane. London, Routledge Press: 1997.

Shaw, G K. Rational Expectations: An Elementary Exposition. New York, NY. St. Martin’s Press.