Overhead 1 New Classical Economics

New Classical Macroeconomics

  • Developed from the 1970s

  • Key assertions:

    • Flexible Prices: Prices adjust instantly to all available information; output is at its natural level.

    • Imperfect Information: Random shocks are unforeseen by individuals.

    • Rational Expectations: Decisions made using all available information.

Rational Expectations

  • Notation:

    • 𝑃𝑑 = actual price level

    • 𝑃𝑑𝑒 = expected price level by agents

    • Ξ¦π‘‘βˆ’1 = all information available at time π‘‘βˆ’1

  • Expected value formula under rational expectations:

    • πΈπ‘‘βˆ’1 𝑃𝑑𝑒 = 𝐸 𝑃𝑑 Ξ¦π‘‘βˆ’1

  • Implications:

    • Expectations based on relevant economic model.

    • No systematic mistakes in expectations; average accuracy.

    • Forecasting errors (πœ€ = 𝑃𝑑 βˆ’ 𝑃𝑑𝑒) are uncorrelated with mean zero.

    • Random shocks lead to unsystematic mistakes.

Policy Ineffectiveness Proposition

  • Context: Rational expectations + flexible prices.

  • Proposition: Change in economic policy is ineffective if agents anticipate it, applicable in both short and long run.

  • Contrast with previous models: Those had adaptive expectations or rigid prices.

AD-AS Model with New Classical Assumptions

  • Key equations:

    • Aggregate demand (AD): 𝑦𝑑 = 𝛽0 + 𝛽1 π‘šπ‘‘ βˆ’ 𝑝𝑑 + 𝛽2𝑔𝑑 + πœˆπ‘‘

    • Aggregate supply (AS): 𝑦𝑑 = 𝑦̅ + 𝛼 (𝑝𝑑 βˆ’ 𝑝𝑑𝑒) + πœ‡π‘‘

  • πœˆπ‘‘ and πœ‡π‘‘ represent uncorrelated shocks with a mean of zero.

Government Expenditures and Money Supply

  • Government expenditures: 𝑔𝑑 = 𝑔̅ + πœƒπ‘‘

  • Money supply: π‘šπ‘‘ = π‘šΜ… + πœ™π‘‘

  • 𝑔̅ and π‘šΜ… are known systematic parts; πœƒπ‘‘ and πœ™π‘‘ are stochastic elements (mean zero).

Equilibrium Conditions

  • Equilibrium (AD=AS) leads to:

    • 𝑝𝑑 determined from solving AD and AS equations, expressing interdependencies among variables.

  • Further equations lead to articulated expressions of output (𝑦𝑑) based on parameterized expectations and shocks.

Endogenous Variables

  • Endogenous variables:

    • 𝑦𝑑 and 𝑝𝑑 are affected by demand (πœˆπ‘‘) and supply shocks (πœ‡π‘‘).

    • Policy systematic parts (𝑔̅, π‘šΜ…) lose significance in affecting real output, reinforcing the Policy Ineffectiveness Proposition.

Sargent and Wallace (1975) - Policy Ineffectiveness Proposition

  • Systematic policies ineffective in determining equilibrium output.

  • Output equilibrium fluctuates around its natural level, dependent solely on stochastic elements.

AD-AS: Anticipated Policy Effects

  • Case of anticipated policy changes (like money supply increase): agents adjust expectations accordingly; output is unaffected because agents foresee the implications.

AD-AS: Unanticipated Policy Effects

  • Unexpected increase in money supply leads to temporary increase in output before returning to original output with higher prices in the long run.

Painless Disinflation

  • Example: Central bank reduces money growth (10% to 0%) resulting in no output loss; credibility of the central bank crucial for belief shift in agents.

The Lucas Critique

  • Developed by Robert Lucas (1976).

  • Any policy change should consider altered expectations and behavior of agents; observed economic relationships may shift due to policy changes.

  • Importance for policymakers: strategic interactions that affect results.