XV. New Classical
Macroeconomics
XV.1 Introduction
• Before WWI: “classical”
macroeconomics, market clearing,
full employment and full employment
product, vertical AS
• Great Depression and birth of
Keynesian economics, horizontal AS
• After WWII: neoclassical synthesis,
in the long run, the economy tends
towards full employment and to
vertical AS
Monetarist’s contribution
• Since 1950: continuous criticism of Keynesian
propositions
• Alternative policy proposals
• Natural rate of unemployment and
expectations augment Phillips curve
• Since the end of 1960’s: major monetarist
proposition were adopted by the Keynesians
– Natural rate of unemployment and expectations
augmented Phillips curve fit into neoclassical
synthesis
– Keynesians accepted the importance of monetary
policies ( along Friedman’s recommendations)
Reality of 1970’s
• Continuous high inflation and high
unemployment
• External oil shocks (1973 and 1979)
• Failure of Keynesian economic policies
• But also monetarist recommendation
seemed to be sterile when facing a new
reality
XV.2 Basic framework
Robert E. Lucas Jr.
• 1937 –
• University of Chicago
• Leading personality of
“New Classical
Revolution”
• Economist, but
originally studied
history
• Nobel prize 1995
Thomas J. Sargent
• 1943 –
• Teacher at several US
Universities, namely Minnesota,
Chicago, Stanford and New York
(currently), essential advanced
macroeconomic theory textbooks
• Rational expectations
• Impact on (namely) monetary
policies, statistical operationality
of RE, models of Phillips curve,
demand for money in
hyperinflations, intertemporal
coordination of monetary and
fiscal policies, etc.
• Nobel prize in 2011 (with
Christopher Sims)
Assumptions/features
• In search of macroeconomic theory, rooted
in micro foundations and Walrasian general
equilibrium approach
• All economic agents optimize continuously,
i.e. subject to their constraints, firms
maximize profits and households maximize
utility
• In taking optimizing decisions, agents take
into account only relative prices (do not
suffer from money illusion)
• Agents able to exhaust all profitable
opportunities, wages and prices are flexible
and markets continuously clear
Facing the challenge of reality
• Both Keynesian and monetary framework insufficient
• Consequently - see assumptions above - return to
classical model, i.e. money neutral, AS and LRPC
vertical
• But, reality (data) not consistent with classical
assumptions either, namely short-run correlations
– positive: price and output (upward sloping AS)
– positive: nominal money supply and real GDP (non-neutral
money)
– negative: inflation and unemployment (downward sloping
PC)
• New Classical solution: existence of non-neutralities
given by imperfect information, agents have
– A novelty, indeed: classical, pre-WWI model, always assumed
perfect information
Three basic building blocks
• Rational expectations
• Continuous market learning
• New concept of aggregate supply
XV.3 Rational expectations (REH)
The importance of
expectations
• Economic decisions: action today to receive
uncertain return in the future
– Quality of expectations crucial, most famous
example: expected inflation in wage negotiations
• Expectation: not only one predicted value,
but a probability distribution of all possible
outcomes
• Two crucial issues
– How people get, process and use information to
form expectations?
– What type of expectations hypothesis is most
suitable for application in macroeconomics?
Medium term adjustment
P
LRAS
AS3
AS1
P3
P2
C
A
B
AD2
P1
AD1
Y3 = Y1
Y2
Y
Rationale
• All previous models, be it neoclassical synthesis,
monetarism - either explicitly or implicitly used
expectations
• So far, PFH or AEH and - in the long run - return to
potential output and other natural values
• Even when adjustment to past errors takes place
(AEH), the errors are all the time systematically
biased
Pe-P
Origins
• John Muth (1961):
– “Economists should be more careful about their
informational assumption, in particular about the
ways, the expectations are formed.”
– “ … expectations since they are informed
predictions of future events are essentially the
same as predictions of the relevant economic
theory.”
Econometrica (1961): Rational Expectations and the
Theory of Price Movements
• Before, expectations either neglected,
considered strictly exogenous (Keynes) or
modeled in a way that allowed for a systematic
errors (monetarists, AEH)
Definitions
•  : information set, available to agent i
at the beginning of period
i
• E1v : subjective (personal) expectation
by agent i of variable v for current period,
made in previous period
i
i


E
v


•
 1  : true expectation for v, given  1
i
1
Weak version - basic idea (1)
• People, when forming subjective
expectations, do make errors (no perfect
foresight)
• BUT: they do make NO systemic errors
• Weak version of REH:
i
E1
v  E  vi1    i , E   ii1   0
• We have
– where
i
E1
v  v  (E  vi1   v   i )  v   i
E  ii1   0
Weak version - basic idea (2)
• Interpretation: subjective expectation for a
variable v, made by particular agent i at
previous period, is equal to the true value
of v plus an error term with zero mean
• The objective, true conditional expectation
E[.] exists, i.e. the information set Ω is
sufficient to allow agent to determine E[.]
• Agents’ expectations are always
consistent with their information
What makes it rational?
• See assumptions above - all agents are
optimizers  they are also using all available
information in an optimal way (best use of info)
• Weak version: in forming the expectations,
agents perform cost-benefit analysis regarding
how much information to obtain
• Compared to AEH, agents use all available info
– AEH: learning from the past mistakes in predicting
only the same variable
– REH: taking into account all information, about all
other variables and about all other relevant facts
Strong version
• Weak version plus assumption that all relevant
information is available to the agent, namely:
– A complete, true economic model of the economy
and all the rules that govern the decisions of all
other agents
– The values of all exogenous variables till present
moment (including all probability distributions, if
some of the exogenous are stochastic)
– Realized values of all endogenous variables (and
eventual stochastic exogenous) till the present
moment
• … in another words: “one should know
everything”
• However, it is this strong version that is usually
assumed in the model with rational
expectations
What does it exactly mean?
• People DO make errors in forecast
– It is NOT perfect foresight
• The errors are due to the incomplete
information
• The errors are independent on the
information set Ω-1
• On average, agent’s expectations are
correct, i.e. equal to the true values
– Expectations are NOT systematically
wrong over time (are not biased)
XV.4 Continuous market
clearing
Rationality  optimization 
equilibrium
• Agents
– either perform an optimal search for all
available information (weak version)
– or just have all information from period -1
(strong version)
• In both cases they are (a) rational, (b)
optimizing their behavior  the
resulting prices and quantities are
consistent with general equilibrium
outcomes
• Consequently: all markets clear
Back to Walras
• Market outcomes – optimal demand
and supply responses of economic
agents to their perception of prices
• Equilibrium approach
• The most controversial assumption
of New Classical Macroeconomics
XV.5 Lucas’ Aggregate Supply
• If both firms and households have
complete information, than – assuming
rational expectations – the forecast is
always perfect
– Rational expectations with PFH, i.e. with
classical model
• Reality
– Firms: usually have complete information,
including the price
– Households: do not have complete information
Labor market
• Start with the classical case, i.e. full
employment N* (and Y *).
• In next period actual price P>P-1, known to
firms, but unknown to households
• They can make only expectations, assume
P e =P-1 <P
• Firms: know that real wage is lower at any
nominal wage → shift of ND
• Households: don’t know that real wage is for
any nominal wage lower → do not shift NS
• Increase in equilibrium employment
W
P-1.NS
W1
P.N D
W*
P-1.ND
N*
N1
N
Two comments:
if price has decreased, there would be shift of ND to the left and new employment would be lower
than original one
if households knew the actual price, they would shift NS properly and the model is classical.
Aggregate supply
• Short run production function:
Y* =F K,N* , Y1 =F K,N1
• Lucas’ aggregate supply:
P
Y= e
P




–  is potential (natural) output and
e
P
P
>1  Y 
– Underestimation of price:
e
(
P
P
) 1 Y 
– Overestimation of price:
– Correct forecast:
P P e =1  Y=Y*




• Aggregate supply of output increases with the
increase of the ratio of actual and expected
price level
P
AS
P=Pe
Y*
Y
XV.6 The model
Anticipated policies
• Equilibrium model with rational expectations
– just on ADxAS level
• Suppose an exogenous change M>0
• People form expectations of price changes as
a consequence of change in M
• Rational expectation: if people anticipate the
monetary policy and there is no other random
shock, than they will make a proper forecast
of price, because
– They have full information
– They don’t make systematic errors
• In this case, given the price changes, both AD
and AS shift
Anticipated monetary
change
P
LRAS
AS3
AS1
P3
P2
C
A
B
AD2
P1
AD1
Y3 = Y1
Y2
Y
Un-anticipated policies
• Suppose, that the change in monetary
policy is not anticipated by the
households and/or some random
shocks appear
• Then households will not properly
forecast the price level, but firms will →
only AD shifts, but AS does not
• There is a new equilibrium level of
employment and output as a
consequence of change in the monetary
policy
Un-anticipated monetary
change
P
LRAS
AS1
P2
P1
B
A
AD2
AD1
Y1
Y2
Y
Anticipated and unanticipated policies
• Anticipated: households immediately adjust
expectations (and behavior)
– Market clearing
– Vertical, classical AS
• Un-anticipated: households make mistake
from the shock
– Equilibrium moves along the positively sloped
Lucas’ AS
– New equilibrium output (and employment)
• However, given the rational expectation
proposition, this is not the end of the story –
in the next period, households learn their
mistake and will adjust → return to Y* anyway
Do economic policies
matter?
• New Classical Macroeconomics
– Allows for short term fluctuations from natural
values
– Based on completely different theory than the
Keynesian one
– Consistent with microeconomic assumptions
– Limited effects of governmental policies:
• If policies anticipated, than quick adjustment and no
effect on output (and other variables)
• If un-anticipated policy (or some random, exogenous
shock), than after some short term fluctuations
adjustment to natural values anyway
• Policy impotence proposition – PIP
XV.7 Conclusions
Critical assessment
• New Classical Economics - a “great leap
forward”, but a lot of criticism
• Rational expectations:
– Costs to obtain information
– What is the correct model of the economy?
– Risk vs. uncertainty
• Continuous clearing:
– Sluggish adjustment of prices and wages
– Involuntary unemployment
• Empirical studies
– There is an empirical support for non-neutrality of
the money (anticipated nominal money change
has an impact on real output)
A permanent legacy
• Rational expectations (as opposed to
AEH)
– Adopted by all subsequent
macroeconomic schools (see next
Lectures)
• Anticipated vs. un-anticipated
policies
• Equilibrium approach
• The real business cycle school
Literature to Ch. XV
• Snowdon, Vane, A Modern Guide to
Macroeconomics, Edvard Elgar,
2005, Ch.5 verbal, relatively easy and instructive
explanation
• Heijdra, Modern Macroeconomics,
Oxford, 2009, Ch.4 slightly more formal, need to
study previous three chapters as well, but very good examples
• See the references in both textbooks
above