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.