Economics, New Classical

BIBLIOGRAPHY

New classical economics takes the view that short-run fluctuations in the aggregate economy—the business cycle—can be understood within an equilibrium framework of rational, forward-looking agents, without relying on the presumption that market rigidities or imperfections (such as sticky prices ), and the consequent disequilibrium adjustment as articulated in John Maynard Keynes’s (1883-1946) General Theory of Employment, Interest, and Money (1936), are necessary to explain the cyclical behavior of the macroeconomy. New classical economics assumes universal market clearing, rational expectations, an equilibrium or “natural” rate of employment and output, and labor suppliers who respond rationally to intertemporal relative prices. At the same time, it assumes that information about relative prices is costly to obtain and therefore imperfect, which can provide a means for aggregate demand to act as a determinant of real economic activity.

This school of thought is known as the new classical economics because it builds on the general equilibrium principles of classical economics to give aggregate demand a causal role in explaining observed correlations among prices, income, employment, and money. Such a role is difficult to find in the writings of the pre-Keynesian classical economists, who tended to view the overall market economy as self-adjusting and aggregate demand as being neutral in its effects on the economy.

New classical economics has its genesis in the work of Nobel laureate Robert E. Lucas Jr. Lucas summarizes the new classical approach and justifies its insistence on explaining business cycles using equilibrium models of economic behavior, that is, models that “account for the observed movements in quantities … as an optimizing response to observed movements in prices” (1977, p. 14). Elsewhere, Lucas (1980) discusses the new classical view in the historical context of business cycle theory.

Lucas and Leonard Rapping (1969) made the first attempt to explain aggregate employment and wage behavior based on a dynamic theory of competitive labor market equilibrium. The Lucas-Rapping model relies on a precise formulation of households’ optimal choices of labor and leisure over time. This approach has since become the foundation for dynamic macroeconomic models.

Because the Lucas-Rapping model rules out disequilibrium adjustment in the labor market, it must account for short-run fluctuations in employment owing to real wage changes, while remaining consistent with the accepted fact that employment is independent of real wages in the long-run. It does so through appeal to the intertemporal substitution of labor and leisure —the response of workers to incentives to alter their supply of labor across different periods of time. Suppose that labor suppliers face wages temporarily below their expected normal or long-run levels. Dynamic utility maximization implies that these workers will respond by reducing hours of work today (that is, by increasing the consumption of leisure today), and increasing work in the future, at the expense of future leisure. The response of rational, forward-looking agents to changes in intertemporal relative prices is a cornerstone of new classical economics, and indeed of modern macroeconomics.

Drawing further inspiration from Edmund Phelps et al. (1970), Lucas (1972, 1973) goes on to develop a general equilibrium extension to the Lucas-Rapping partial equilibrium model of the labor market. His primary motivation is to explain the positive empirical correlation of money and output while retaining the “classical” assumptions that consumers and producers respond rationally to relative prices, that all markets clear, and that expectations are rational —agents’ forecasts of unknown variables relevant for decisions are, on average, unbiased conditional on available information. Taken alone, the classical assumptions suggest a world in which money and nominal aggregate demand are neutral, affecting all nominal prices proportionately and therefore leaving relative prices and real activity unaltered. The challenge Lucas faced is therefore one of accounting for monetary nonneutralities while avoiding appeal to nonclassical (Keynesian) frictions.

Lucas meets this challenge by assuming, as suggested by Phelps, that information does not flow freely across markets, so that rational (Lucas-Rapping) producers mistake common money supply shocks with market-specific supply and demand shocks. Ideally, producers base supply decisions on their going market price relative to prices in all other markets (as summarized by the price level). However, a lack of current information concerning other prices prevents local producers from knowing with certainty what the overall price level is. An unperceived economy-wide increase in the money stock, which tends to raise demand and prices in all markets, will therefore be perceived by the individual producer as an increase in his or her product’s relative price. The producer’s rational response in this case is to increase production. Because all producers are similarly confused, the nominal money shock will increase overall output, which would not be the case if information flowed freely.

Lucas’s “imperfect-information” model further implies that the extent of producers’ confusion regarding the sources of movements in market prices depends on the volatility of economy-wide shocks relative to market-specific shocks. In particular, in economies with high aggregate demand variance, producers are reasonably sure that a change in their market price is caused by an aggregate shock (thus leading the price level, not relative prices, to change) since these shocks are typically large relative to market-specific shocks. In this case, producers will have little incentive to respond to any given aggregate shock by altering production, because they are less likely to be “fooled.” Lucas (1973) explicitly tests this implication using cross-country data and finds that countries with relatively high aggregate demand variability respond less to aggregate demand shocks than countries with relatively low aggregate demand variability, a finding consistent with his theory.

The so-called Lucas supply curve, which makes explicit the dependence of output on the difference between the realized and expected price level, is the new classical reformulation of the expectations-augmented Phillips curve of Milton Friedman (1968) and Phelps (1968). The new classical approach is consistent with the natural rate hypothesis of Friedman and Phelps—that deviations in output from its natural or full-employment level cannot be sustained without a sustained deviation of actual from expected inflation.

The rational expectations hypothesis, conceived by John Muth (1961) and formalized by Lucas and Edward Prescott (1971), is an essential (though not unique) feature of new classical economics and an important innovation in the study of macroeconomics. It applies the basic principles of rational, economic behavior to forecasting, requiring economic agents to equate their “subjective” probabilities with those “objective” probabilities implied by the model itself. Lucas justifies rational expectations based on the implausibility of systematic forecast errors in the face of the “recurrent character of the [business] cycle” (1977, p. 15). Indeed, rational expectations are now assumed in most macroeconomic models, including ones that do not take market-clearing prices for granted and therefore fall outside the boundaries of new classical economics.

Lucas’s work and the new classical economics it has fostered have had a lasting influence on our understanding of the effects of aggregate demand policies, in particular monetary policy, on the economy. One of the most important implications, further developed by Thomas Sargent and Neil Wallace (1975), is the policy ineffectiveness proposition. Lucas’s canonical new classical model implies that only unanticipated shocks to money or aggregate demand can alter incentives; anticipated shocks will be quickly incorporated into all nominal magnitudes, so that relative prices will remain unaltered. Therefore, systematic monetary policies—those manipulations of money and interest rates by the central bank that are anticipated by market participants—can have no hope of influencing income or employment. This implication provides theoretical backbone to Friedman’s earlier proposal for a constant money growth rule, while condemning the “fine-tuning” polices of the 1960s and 1970s.

A corollary to the ineffectiveness proposition is that credible changes in policy rules can have immediate effects on inflation without much effect on output. Sargent (1982) shows convincingly that some historical episodes of “big inflations” ended quickly without severe recessions when people fully understood and anticipated permanent anti-inflation reforms.

The consensus view of macroeconomists today is that the imperfect-information theory of new classical economics is not satisfactorily borne out by the data, and is therefore inadequate for understanding business cycles or providing a framework for policy analysis (see, for example, Woodford 2003, p. 6). Nonetheless, its influence continues beyond the now common use of the assumption of rational expectations. Real business cycle theories, first formulated by Finn Kydland and Prescott (1982), take up the mantle of equilibrium economics from the new classical paradigm, but emphasize the role of “real” shocks— shocks to preferences and technology—as the sources of aggregate fluctuations as opposed to nominal or monetary shocks. On the other hand, and somewhat ironically, the new classical critique of Keynesian models that they lack theoretical foundations for market and price rigidities has led to a resurgence of such models. The reaction to this critique, new Keynesian economics, attempts to explain such rigidities as the outcome of optimizing behavior on the part of rational agents. The papers in N. Gregory Mankiw and David Romer (1991) provide a good summary of some of the early work in this vein.

SEE ALSO Economics, Classical

BIBLIOGRAPHY

Friedman, Milton. 1968. The Role of Monetary Policy. American Economic Review 58: 1-17.

Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money. London: Macmillan.

Kydland, Finn E., and Edward C. Prescott. 1982. Time to Build and Aggregate Fluctuations. Econometrica 50: 1345–1370.

Lucas, Robert E., Jr. 1972. Expectations and the Neutrality of Money. Journal of Economic Theory 4: 103–124.

Lucas, Robert E., Jr. 1973. Some International Evidence of Output/Inflation Tradeoffs. American Economic Review 63: 326–334.

Lucas, Robert E., Jr. 1977. Understanding Business Cycles. In Carnegie-Rochester Conference Series on Public Policy, Vol. 5, eds. Karl Brunner and Allan H. Meltzer, 7–29. Amsterdam, NY: North-Holland.

Lucas, Robert E., Jr. 1980. Methods and Problems in Business Cycle Theory. Journal of Money, Credit, and Banking 12: 696–715.

Lucas, Robert E., Jr., and Edward C. Prescott. 1971. Investment Under Uncertainty. Econometrica 39: 659–681.

Lucas, Robert E., Jr., and Leonard Rapping. 1969. Real Wages, Employment, and Inflation. Journal of Political Economy 77: 721–754.

Mankiw, N. Gregory, and David Romer, eds. 1991. New Keynesian Economics. 2 vols. Cambridge, MA: MIT Press.

Muth, John F. 1961. Rational Expectations and the Theory of Price Movements. Econometrica 29: 315–335.

Phelps, Edmund S. 1968. Money-Wage Dynamics and Labor Market Equilibrium. Journal of Political Economy 76: 678–711.

Phelps, Edmund S., et al. 1970. Microeconomic Foundations of Employment and Inflation Theory. New York: Norton.

Sargent, Thomas J. 1982. The Ends of Four Big Inflations. In Inflation: Causes and Effects, ed. Robert E. Hall, 41–98. Chicago: University of Chicago Press.

Sargent, Thomas J., and Neil Wallace. 1975. “Rational Expectations,” the Optimal Monetary Instrument, and the Optimal Money Supply Rule. Journal of Political Economy 83: 241–254.

Woodford, Michael. 2003. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton, NJ: Princeton University Press.

William D. Lastrapes