Econ 102: Neoclassical Economic Perspectives and Implications

Neoclassical Economic School

• Historical Context

  • Emerged after the Classical school of thought, which dominated the 19th to early 20th century.

  • Classical economics emphasized market-clearing principles: prices adjust quickly according to supply and demand.

  • Foundation: Economic systems must be framed within a legal structure for resource allocation.

• Key Developments

  • Adam Smith (1776): Authored The Wealth of Nations, introducing significant microeconomic perspectives.

  • Observational methods showcased efficiencies (e.g., the pin factory and car assembly line).

  • 1929 Stock Crash: Led to the Great Depression and prompted a Keynesian reaction advocating government intervention to stimulate demand.

Building Blocks of Neoclassical Economics

1. Potential Real GDP

   • Defined by labor, capital, and technology.

   • Necessary to understand deviations of real GDP from potential GDP.

2. Flexible Wages and Prices

   • More flexible than previously suggested by Keynesian perspectives.

3. Expectations

   • Rational expectation theory: agents use all available information to make economic predictions, influencing prices and outcomes.

Economic Shocks

• Positive Demand Shock

  • Caused by an external factor affecting GDP, resulting in a rightward shift of the Aggregate Demand (AD) curve.

  • Nominal Wages: Must rise to maintain real wages, impacting firms' costs and shifting the Short-Run Aggregate Supply (SRAS) left.

• Graphical Analysis

  • Neoclassical Explanation (Dotted Line): Wages/prices quickly adjust leading to short-lived economic benefits.

  • Keynesian Explanation (Solid Line): Slower adjustments lead to prolonged dis-equilibrium and extended impacts on output.

Policy Implications of Positive Demand Shocks

• Households prefer immediate wage adjustments to mitigate rising prices due to inflation.

• Fully Anticipated Demand Shock: Results in higher prices without increased output, signifying a shift from point A to point C on the AD curve without deviation from the Long-Run Aggregate Supply (LRAS) curve.

• Rational Expectations: If households expect inflation due to increased aggregate demand, they may demand higher nominal wages, keeping real GDP stable.

Relationship Between Money Supply and Inflation

• An increase in money supply often leads to higher prices but no meaningful change in output.

• Hyperinflation Phenomenon: Results from simultaneous rightward shift of the AD and leftward shift of the SRAS due to expected inflation and increased nominal wages.

• Phillips Curve Insights: Neoclassical perspectives predict multiple inflation levels can exist at the same unemployment, represented by a vertical long-run Phillips curve.

Adjustment Mechanisms in Neoclassical Perspectives

• Wages and prices adjust rapidly under neoclassical thought, effectively managing the effects of anticipated demand shocks.

• Fiscal vs. Monetary Policy: Fiscal policy has limits, whereas monetary policy can continuously increase the money supply practically without immediate output change.

Phillips Curve Dynamics

• The neoclassical relationship is a vertical line, indicating no long-term trade-off between inflation and unemployment.

• Key Shifts:

  1. Inflation Expectations: Change can shift the Short-Run Phillips Curve (SRPC) to meet a new long-term equilibrium.

  2. Natural Unemployment Rate Changes: Affected shifts in the Long-Run Phillips Curve (LRPC) impact both curves.

Complementarity of Economic Schools

• Modern macroeconomic models integrate both neoclassical and Keynesian principles, informed by microeconomic foundations focusing on maximizing behavior of households and firms.

Current Challenges in Economics

• Policy Landscape Uncertainty: Trade wars influencing household consumption and business investment.

• Mixed Economic Pressures: AD weakening against upward inflation pressure creates complex dynamics in pricing and output predictions.

Conclusion

• The synergy between neoclassical and Keynesian economics helps contextualize modern economic challenges through both long-term and short-term analytical lenses.

Neoclassical Economic School - Historical Context - Emerged after the Classical school of thought that dominated the 19th to early 20th century, emphasizing market-clearing principles. - Foundation: Economic systems must function within a legal framework. - Key Developments - Adam Smith (1776): His book The Wealth of Nations introduced microeconomic perspectives, demonstrating efficiencies. - 1929 Stock Crash led to the Great Depression, prompting Keynesian intervention.

Building Blocks of Neoclassical Economics 1. Potential Real GDP - Defined by labor, capital, and technology. 2. Flexible Wages and Prices - More responsive than earlier Keynesian views. 3. Expectations - Rational expectation theory argues agents use all information available.

Economic Shocks - Positive Demand Shock - Results in a rightward shift of GDP; raises nominal wages to keep real wages stable. - Neoclassical view: Quick adjustments lead to short-term benefits. - Keynesian view: Slower adjustments cause prolonged effects on output.

Policy Implications - Households prefer immediate wage adjustments to combat inflation. - Fully anticipated shocks lead to higher prices with stable real GDP as wages adjust.

Money Supply and Inflation - Increased money supply often results in higher prices, not output. - Hyperinflation occurs with simultaneous shifts in AD and SRAS. - Multiple inflation levels can coexist at the same unemployment in neoclassical theory.

Adjustment Mechanisms - Rapid adjustments of wages and prices in response to demand shocks. - Fiscal policy has limits; monetary policy can increase money supply continuously.

Phillips Curve Dynamics - The long-run Phillips Curve is vertical, indicating no trade-off between inflation and unemployment. - Shifts can occur due to inflation expectations or natural unemployment rate changes.

Economic Schools' Integration - Modern models blend neoclassical and Keynesian principles, focusing on behavior of households and firms.

Current Economic Challenges - Policy uncertainties like trade wars affect consumption and investment. - Mixed pressures of weak AD against inflation complicate pricing and output predictions.

Conclusion - The integration of neoclassical and Keynesian economics provides a comprehensive lens for understanding modern economic issues.