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

Y

LRAS

Y1

P1

A

AD1

AS1

AD2

Y2

P2

AS3

B

C

Y3=

P3

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

• : subjective (personal) expectation by agent i of variable v for current period, made in previous period

• : true expectation for v, given

1i

E 1i v

E v 1i 1

i

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:

• We have

– where

E 1i v E v 1

i i , E i 1i 0

E 1i v v (E v 1

i v i ) v i

E i 1i 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

• 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

Pe =P-1 <P

N

WP-1.N

S

P-1.ND

P.ND

N*

W*

N1

W1

Two comments:if price has decreased, there would be shift of ND to the left and new employment would be lowerthan original oneif households knew the actual price, they would shift NS properly and the model is classical.

Aggregate supply

• Short run production function:

• Lucas’ aggregate supply:

– is potential (natural) output and– Underestimation of price:– Overestimation of price:– Correct forecast:

• Aggregate supply of output increases with the increase of the ratio of actual and expected price level

Y*=F K,N* , Y1=F K,N1 Y=

P

Pe

P Pe >1 Y

P Pe =1 Y=Y*

Y1)PP( e

Y

P

AS

Y*

P=Pe

XV.6 The model

Anticipated policies• Equilibrium model with rational expectations

– just on ADxAS level• Suppose an exogenous change• 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

M>0

Anticipated monetary change

P

Y

LRAS

Y1

P1

A

AD1

AS1

AD2

Y2

P2

AS3

B

C

Y3=

P3

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

Y

LRAS

Y1

P1

A

AD1

AS1

AD2

Y2

P2 B

Anticipated and un-anticipated 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