Chapter 22
Appendix
The New Classical Model
In the new classical model, all wages and prices are completely flexible with
respect to expected changes in the price level. The new classical model was developed in the early to mid-1970s by Robert Lucas of the University of Chicago and
Thomas Sargent, formerly of the University of Minnesota but now at New York
University.1 It departs from the aggregate demand and supply analysis we developed
in Chapter 12 in two important ways.
1. The analysis is based on the assumption that expectations are rational, and thus is
solidly based on microeconomic fundamentals.
2. Wages and prices are completely flexible with respect to changes in expected
inflation; that is, a rise in expected inflation results in an immediate and equal rise
in wage and price inflation because workers and firms try to keep their real wages
and relative prices from falling when they expect inflation to rise.
New Classical Phillips Curve and the Aggregate Supply Curve
Recall our look at the Phillips curve in Chapter 11. The assumption that wages and
prices are flexible with respect to expected inflation implies that the Phillips curve and
hence the short-run aggregate supply curve have inflation rising one-for-one with rises
in expected inflation. Therefore, we can write the new classical short-run aggregate supply curve as follows:
pt = Et - 1pt + g (Yt - YP)
(1)
1See
Robert E. Lucas, “Expectations and the Neutrality of Money,” Journal of Economic Theory 4 (April 1972):
103–24; and Thomas Sargent and Neil Wallace, “Rational Expectations, the Optimal Monetary Instrument,
and the Optimal Money Supply Rule,” Journal of Political Economy 83:2 (April, 1975): 241–54.
1
2
CHAPTER 22 APPENDIX
where,
= Inflation at time t, that is the change in the price level from period
t – 1 to t.
Et – 1p t = Inflation from period t – 1 to t which is expected at time t – 1 using
rational expectations
Yt
= aggregate output at time t
= potential output
YP
= sensitivity of inflation to the output gap
g
pt
The short-run aggregate supply curve based on Equation 1 is shown in Figure 22A1.1.
This aggregate supply curve is similar to the one we derived in Chapter 11 because Et - 1pt is
the same thing as expected inflation pe, but with one subtle difference: the short-run
aggregate supply curve is fixed only for a particular value of expected inflation and will
shift when expected inflation changes. To illustrate, suppose that in Figure 22A1.1
expected inflation is initially at p1. The short-run aggregate supply curve for this level of
expected inflation, AS1, passes through point 1 because at Yt = YP, Equation 1 shows that
actual inflation will be equal to p1. As shown in Figure 22A1.1, if Yt 7 YP, then inflation
FIGURE 22A1.1
Aggregate Supply
in the New
Classical Model
The new classical
model has short-run
aggregate supply
curves that are upward
sloping and specific to
a particular expected
inflation rate, as AS1
and AS2. AS1 is fixed
for Et – 1pt = p1 and this
is why it is marked as
AS1(Et – 1pt = p1) and is
drawn to pass through
point 1, where at an
actual inflation rate at
p1, aggregate output is
at potential (Y = YP)
and so expected inflation is also at p1
(Et – 1pt = p1). Similarly,
AS2 is fixed for Et – 1pt
= p2 and is marked as
AS1(Et – 1pt = p1): it is
drawn to pass through
point 2, where at an
actual inflation rate at
p2, aggregate output is
at potential (Y = YP)
and so expected inflation is also at p2
(Et – 1pt = p2.).
Inflation
Rate, ␲
LRAS
AS2 (Et – 1␲t = ␲2)
AS1 (Et – 1␲t = ␲1)
2
␲2
1
␲1
YP
Aggregate Output, Y
THE NEW CLASSICAL MODEL
3
increases along the AS curve by the amount g(Yt - YP) , as the upward sloping short-run
aggregate supply curve AS indicates. The short-run aggregate supply curve AS1 is thus
specific to an expected inflation rate of p1 and is marked this way in Figure 22A1.1.
By the same reasoning, if expected inflation is instead at p2, then the short-run
aggregate supply curve will shift up and to the left to AS2, where it passes through
point 2 because as Equation 1 shows, when Yt = YP, inflation in this case will be equal
to p2. The short-run aggregate supply curve AS2 is thus specific to an expected inflation
rate of p2, and is marked this way in Figure 22A1.1. The short-run aggregate supply
curve in the new classical model thus will immediately shift from AS1 to AS2, if
expected inflation rises from p1 to p2.
Misperceptions Theory
We can think of the new classical model as a misperceptions theory because it results
from misperceptions by firms that a general rise in inflation has resulted in higher
relative prices for the goods they sell, so that they supply more.2 To illustrate, we can
rewrite the new classical short-run aggregate supply (Phillips) curve in Equation 1 by subtracting Et - 1pt, from both sides of the equation, dividing by g, and then putting Yt - YP
on the left-hand side. The transformed equation is then as follows:
Yt - YP = (pt - Et - 1pt)/g
(2)
Equation 2 indicates that only when actual inflation is higher than expected inflation
will aggregate output be greater than potential output.
The misperception story behind Equation 2 is as follows. Consider Isaac the ice
cream maker who has to figure out how much ice cream he should make. What you
learned in your principles of economics course is that Isaac will compare the price that
he gets for his ice cream with the prices of other goods and services he wants to buy. If
the price of ice cream rises relative to the price of other goods and services Isaac wants
to buy, he is willing to work harder because he can exchange the ice cream for more
goods and services. If, on the other hand, the price of ice cream falls relative to other
goods and services, Isaac will want to take more time off and enjoy life because there is
less of a payoff to producing ice cream. Therefore, a rise in the relative price of the good
he produces will cause Isaac to increase production, while a fall in the relative price will
lead him to reduce production.
To figure out what is happening to the relative price of the good he produces, Isaac
could try to find out what is happening to all the other prices of goods and services he
wants to buy, but obviously this would take him too much time. Instead, when he sees
a rise in the price of ice cream he will estimate the relative price by asking himself how
much the price of ice cream has risen relative to what he expects the general rise in the
price level will be, that is, his expectations of inflation. For example, if he sees the price
of ice cream rising by 3% this year, but his expectation of inflation is 2% (that is, he
expects prices in general to rise by 2%), then he will think that the relative price of ice
cream is rising and will produce more. If on the other hand, he expected inflation to be
2The
classic references for the misperceptions theory are Milton Friedman, “The Role of Monetary Policy,”
American Economic Review (March 1968): 1–17; and Robert E. Lucas, Jr., “Expectations and the Neutrality of
Money,” Journal of Economic Theory (April 1972): 103–124.
4
CHAPTER 22 APPENDIX
4%, then the price of ice cream is rising less than prices in general and he will want to
cut production.
If we extend this analysis to other producers besides Isaac, we come to the conclusion that when producers see the prices of the goods they produce rising faster than
what they expect inflation to be, overall production in the economy will rise, and if they
see prices rising by less than what they expect inflation to be, production will fall. This
reasoning tells us that when actual inflation is above expected inflation, firms are fooled
into thinking the relative price of the goods they are producing has risen and so output
in the economy will rise above what firms would produce if they had no misperceptions, which is just potential output YP. On the other hand, if actual inflation is below
expected inflation, firms will produce an amount of output that is less than potential
output. Misperceptions about how fast the general price level is rising then lead to
Equation 2, which indicates that aggregate output exceeds potential output only when
the realized inflation rate is higher than expected inflation.
Effects of Expansionary Policy
The new classical model indicates that the effect of expansionary policy depends on
whether it is anticipated or unanticipated. First, let us look at the short-run response to
an unanticipated (unexpected) expansionary policy coming from a rise in government
spending or an autonomous easing of monetary policy by the Fed.
Unanticipated Expansionary Policy
Suppose that the economy is initially at point 1 in Figure 22A1.2, in which actual and
expected inflation is at p1 so that the short-run aggregate supply curve is at AS1. The initial aggregate demand curve intersects AS1 at point 1, where the realized inflation rate is
equal to the expected inflation rate p1 and aggregate output is at potential at YP. Because
point 1 is also on the long-run aggregate supply curve at YP, there is no tendency for the
aggregate supply curve to shift. The economy remains in long-run equilibrium.
Suppose the government or the Fed suddenly decides the unemployment rate is too
high and so pursues expansionary policy that shifts the aggregate demand curve to the
right to AD2. If this expansionary policy is unexpected, the expected inflation rate
remains at p1 and the short-run aggregate supply curve remains at AS1. Equilibrium is
now at point 2', the intersection of AD2 and AS1. Aggregate output increases above
potential output to Y2' and the realized inflation rate increases to p2'.
Anticipated Expansionary Policy
Suppose, by contrast, that the expansionary policy is fully anticipated by the public.
Again referring to Figure 22A1.2, because expectations are rational, workers and firms
recognize that an expansionary policy will shift the aggregate demand curve to the
right from AD1 to AD2 and inflation will rise to p2. With expected inflation at p2, the
short-run aggregate supply curve then shifts up from AS1 to AS2 and intersects AD2 at
point 2, an equilibrium point where aggregate output is at potential output YP and the
inflation rate has risen to p2.
The new classical model demonstrates that aggregate output does not increase as a
result of anticipated monetary or fiscal policy and that the economy immediately moves
THE NEW CLASSICAL MODEL
5
FIGURE 22A1.2
Response to
Expansionary
Policy in the New
Classical Model
Initially, the economy
is at point 1 at the intersection of AD1 and AS1
(Et – 1pt = p1) where
aggregate output is at
YP and inflation is at
p1. An expansionary
policy shifts the aggregate demand curve
from AD1 to AD2, but if
the policy is unanticipated, the short-run
aggregate supply curve
remains at AS1.
Equilibrium now
occurs at point 2'—
aggregate output has
increased to Y2' , and
inflation has increased
to p2'. If the expansionary policy is anticipated, then the
short-run aggregate
supply curve shifts up
to AS2 (Et – 1pt = p2).
The economy then
moves to point 2,
where aggregate output
does not change from
YP, but inflation rises
by even more to p2.
Inflation
Rate, ␲
LRAS
Step 3. If the policy is anticipated, AS shifts
up and the economy moves to point 2, and
inflation rises by more, but output does not rise.
AS2 (Et – 1␲t = ␲2)
AS1 (Et – 1␲t = ␲1)
␲2
2
␲2'
2'
␲1
1
Step 2. If the policy is unanticipated,
AS doesn’t shift and the economy
moves to point 2', and inflation
and output rise.
AD2
AD1
YP
Step 1. Positive
demand shock
shifts AD to
the right.
Y 2'
Aggregate Output, Y
to a point of long-run equilibrium (point 2) where aggregate output is at potential output. Although Figure 22A1.2 suggests why this occurs, we have not yet proved why an
anticipated expansionary policy shifts the short-run aggregate supply curve to exactly
AS2 (corresponding to an expected inflation rate of p2) and hence why aggregate output
necessarily remains at the level of potential output. The somewhat complex proof is the
subject of the box entitled, “Proof of the Policy Ineffectiveness Proposition.”
Policy Ineffectiveness Proposition
We can now understand why the new classical model has the word classical associated
with it. When policy is anticipated, the new classical model has a property that is associated with the classical economists of the nineteenth and early twentieth centuries:
Aggregate output remains at the level of potential output. Yet the new classical model
allows aggregate output to fluctuate away from potential output as a result of unanticipated
shifts in the aggregate demand curve. The policy ineffectiveness proposition is a
6
CHAPTER 22 APPENDIX
Proof of the Policy Ineffectiveness Proposition
The proof that in the new classical macroeconomic model aggregate output necessarily
remains at potential output when there is anticipated expansionary policy is as follows. In the
new classical model, the expected inflation rate
for the short-run aggregate supply curve occurs
at its intersection with the long-run aggregate
supply curve (see Figure 22A1.2). The optimal
forecast of inflation is given by the intersection
of the aggregate supply curve with the anticipated aggregate demand curve AD2. If the shortrun aggregate supply curve is below AS2 in
Figure 22A1.2, it will intersect AD2 at an inflation rate lower than the expected level, which is
the intersection of this aggregate supply curve
and the long-run aggregate supply curve. The
optimal forecast of inflation will then not equal
expected inflation, thereby violating the rationality of expectations. We can make a similar
argument to show that when the short-run
aggregate supply curve is above AS2, the
assumption of rational expectations is violated.
Only when the short-run aggregate supply
curve is at AS2 (corresponding to an expected
inflation rate of p 2) are expectations rational
because the optimal forecast of inflation equals
expected inflation. As we see in Figure 22A1.2,
the AS2 curve implies that aggregate output
remains at potential output as a result of the
anticipated expansionary policy.
striking conclusion to the new classical model: anticipated policy has no effect on the
business cycle, only unanticipated policy matters. It implies that one anticipated policy is just like any other: it has no effect on output fluctuations. Recognize that this
proposition does not rule out output effects from policy changes. If the policy is a surprise (unanticipated) it will have an effect on output.
Uncertainty About Policy Outcomes
Another important feature of the new classical model is that there is a lot of uncertainty
about whether policy that is intended to be expansionary will actually have that effect
in the short run. Indeed, in the new classical model, an expansionary policy, such as a
cut in income taxes or interest rates, can lead to a decline in aggregate output if the public expects an even more expansionary policy than the one actually implemented. There
will be a surprise in policy, but it will be negative and drive output down. Policy makers cannot be sure if their policies will work in the intended direction.
To see how an expansionary policy can lead to a decline in aggregate output in the
short run, let us turn to the aggregate demand and supply analysis in Figure 22A1.3.
Initially we are at point 1, the intersection of AD1 and AS1: output is YP and the inflation
rate is p1. Now suppose that the public expects the government to cut taxes to shift the
aggregate demand curve from AD1 to AD2. As we saw in Figure 22A1.3, the short-run
aggregate supply curve shifts leftward from AS1 to AS2 because the inflation rate is
expected to rise to p2. Suppose the expansionary policy actually falls short of what was
expected so that the aggregate demand curve shifts only to AD2'. The result of the mistaken expectation is that output falls to Y2' in the short run, while the inflation rate rises
to p2' rather than to p2. An expansionary policy that is less expansionary than anticipated leads initially to an output movement directly opposite to that intended.
THE NEW CLASSICAL MODEL
7
FIGURE 22A1.3
Uncertainty About
Policy Outcomes
Because the public
expects the aggregate
demand curve to shift
to AD2, the short-run
aggregate supply
curve shifts to AS2
(Et – 1p t = p 2). When
the actual expansionary policy falls short of
the public’s expectation
(the aggregate demand
curve merely shifts to
AD2'), the economy
ends up at point 2', at
the intersection of AD2'
and AS2. Despite the
expansionary policy,
aggregate output
falls to Y2'.
Inflation
Rate, ␲
Step 3. The economy
moves to point 2',
where output falls.
LRAS
AS2 (Et – 1␲t = ␲2)
AS1 (Et – 1␲t = ␲1)
␲2
␲2'
␲1
2
2'
Step 1. AS shifts up to AS2
because the public expects
AD to shift to AD2.
1
AD2
AD2'
AD1
Step 2.
Expansionary policy
shifts AD to AD2',
which is less than
the expected AD2.
Y 2' YP
Aggregate Output, Y
Implications for Policy Makers
The new classical model, with its policy ineffectiveness proposition, has two important
lessons for policy makers.
1. It illuminates the distinction between the effects of anticipated versus
unanticipated policy actions.
2. It demonstrates that policy makers cannot know the outcome of their decisions without knowing the public’s expectations regarding them.
Can policy makers still use policy to stabilize the economy? Once they figure out the
public’s expectations, they can know what effect their policies will have. There are two
catches to such a conclusion. First, it may be nearly impossible to find out what the public’s expectations are, given that the public consists of over 300 million U.S. citizens.
Second, even if it were possible, policy makers would run into further difficulties because
the public has rational expectations and will try to guess what policy makers plan to do.
Public expectations do not remain fixed while policy makers are plotting a surprise—the
public will revise its expectations, and policies will have no predictable effect on output.
Where does this insight lead us? According to the new classical model, should the
Fed and other policy making agencies pack up, lock their doors, and go home? In a
sense, the answer is yes. The new classical model implies that discretionary stabilization
policy cannot be effective and might have undesirable effects on the economy. Policy
makers’ attempts to use discretionary policy may create a fluctuating policy stance that
leads to unpredictable policy surprises, which in turn cause undesirable fluctuations
around potential output. To eliminate these undesirable fluctuations, the Fed and other
policy making agencies should abandon discretionary policy and generate as few policy
surprises as possible.
8
CHAPTER 22 APPENDIX
As we have seen in Figure 22A1.2, even though anticipated policy has no effect on
aggregate output in the new classical model, it does have an effect on inflation. The new
classical macroeconomists care about anticipated policy and suggest that policy rules be
designed so that the inflation rate will remain stable.
Objections to the New Classical Model
Although the new classical model was a major advance in business cycle modeling, particularly in bringing rational expectations to the forefront in macroeconomic research,
there are some serious objections to the theory behind this model. The strongest objection is that firms could easily get information about movements in the general price
level and so would not be fooled for very long. Thus when the inflation rate rises, firms
would not increase the amount of goods and services they supply by very much, making it hard to understand why unanticipated inflation would explain deviations of
aggregate output from potential. Even more importantly, the new classical model was
unable to address the persistence of business cycle movements. As Figure 22A1.2 indicates, unanticipated expansionary policy would only lead to an increase in output relative to potential for one period. However, as we noted in Chapter 8, business cycles
persist for long periods of time, with cycles lasting for a number of years. In addition,
empirical evidence casts doubt on the policy ineffectiveness proposition, an important
implication of the new classical model.3
The objections to the new classical model led economists to go in two directions in
developing new theories of the business cycle, which are discussed in Chapter 22. One
was the real business cycle model, which kept the assumption of market-clearing and flexible prices, while the other, the new Keynesian model, sought to provide better microfoundations for sticky prices and placed price stickiness at the core of their models.
SUMMARY
1. The new classical macroeconomic model assumes
that expectations are rational and that wages and
prices are completely flexible with respect to the
3For
expected price level. It leads to the policy ineffectiveness proposition that anticipated policy has no
effect on output; only unanticipated policy matters.
empirical evidence on the policy ineffectiveness proposition, see Robert J. Barro, “Unanticipated Money
Growth and Unemployment in the United States,” American Economic Review 67 (March 1977): 101–15;
Frederic S. Mishkin, “Does Anticipated Monetary Policy Matter? An Econometric Investigation,” Journal of
Political Economy 90 (February1982): 22–51; Frederic S. Mishkin, “Does Anticipated Aggregate Demand Policy
Matter? Further Econometric Results,” American Economic Review 72 (September 1982): 788–802; and Frederic
S. Mishkin, A Rational Expectations Approach to Macroeconometrics: Testing Policy Ineffectiveness and Efficient
Markets Models (Chicago: University of Chicago Press, 1983).
THE NEW CLASSICAL MODEL
9
KEY TERMS
misperceptions theory, p. 3
new classical model, p. 1
policy ineffectiveness
proposition, p. 5
REVIEW QUESTIONS AND PROBLEMS
1. Why is the new classical model described as a
misperceptions theory?
2. Why does it matter in the new classical model
whether a policy change is anticipated or
unanticipated by the public?
3. What implications does the policy ineffectiveness proposition have for policy makers?
4. What objections to the new classical model
have been raised?