Overhead 1 New Classical Economics

New Classical Macroeconomics

Introduction

  • New school of macroeconomics established since the 1970s.

  • Focuses on macroeconomic theories that embrace the efficiency of markets and the rational behavior of agents.

Key Assumptions

  1. Flexible Prices

    • Prices adjust immediately to reflect all available information.

    • Output is always at its natural level.

  2. Imperfect Information

    • Recognizes a stochastic environment where individuals do not foresee future random shocks.

  3. Rational Expectations

    • Individuals base their decisions on all the information accessible.

Rational Expectations

  • Let 𝑃𝑡 be the actual price level and 𝑃𝑡 𝑒 be agents’ expectations of price at time 𝑡.

  • Denote Φ𝑡−1 as available information at time 𝑡−1.

  • Under rational expectations,[ E_{t-1} [P_t^e] = E[P_t | Φ_{t−1}] ]

    • Expected price level is determined using all available information.

    • Agents understand the relevant economic model characterizing the economy.

    • They utilize this model to frame their expectations.

Characteristics

  • Agents avoid systematic mistakes.

  • Average expectations are correct, leading to uncorrelated forecasting errors 𝜖 = 𝑃𝑡 − 𝑃𝑡 𝑒 with a mean of zero.

  • Random shocks introduce unsystematic errors.

Policy Ineffectiveness Proposition

  • Proposes that with rational expectations and flexible prices,

    • "A change in economic policy is completely ineffective, both long-term and short-term, if agents anticipate the change."

  • Contrasts sharply with previous models that relied on adaptive expectations or rigid prices.

AD-AS Model with New Classical Assumptions

Components

  • Aggregate Demand (AD): [ y_t = β_0 + β_1 m_t - p_t + β_2 g_t + ν_t ]

    • Where ν_t represents uncorrelated demand shocks.

  • Aggregate Supply (AS): [ y_t = \bar{y} + α(p_t - p_t^e) + μ_t ]

    • Where μ_t signifies uncorrelated supply shocks.

Government and Money Supply

  • Government expenditures: [ g_t = \bar{g} + θ_t ]

  • Money supply: [ m_t = \bar{m} + φ_t ]

    • Here, the systematic policy parts are known to agents, while stochastic elements θ_t and φ_t have mean zero but with known distributions.

Equilibrium and Adjustments

  • Equilibrium Condition (AD=AS):[ β_0 + β_1 m_t - p_t + β_2 g_t + ν_t = \bar{y} + α(p_t - p_t^e) + μ_t ]

  • Solving yields expressions for price level and output based on rational expectations and adjustments.

Reduced Form Equilibrium

  • The model demonstrates how endogenous variables for output 𝑦𝑡 and price level 𝑝𝑡 depend on shocks.

  • Price levels positively correlate with demand shocks but negatively with supply shocks.

  • Highlights the dominance of stochastic elements in explaining fluctuations around natural output levels.

The Policy Ineffectiveness Proposition (PIP)

  • Sargent and Wallace (1975):

    • Any systematic economic policy fails to determine equilibrium output levels, which only fluctuate around their natural levels due to unpredictable elements.

Effects of Anticipated Policies

  • If a central bank or government announces changes like increasing the money supply or public spending,

    • Agents anticipate these changes correctly, leading to no impact on actual output as expectations adjust accordingly.

Effects of Unanticipated Policies

  • If a policy change occurs without prior announcement (e.g., a surprise increase in money supply),

    • Short-run supply adjustments result in increased output temporarily, but long-term adjustments normalize prices with original output levels returning.

Painless Disinflation

  • When a central bank announces a reduction in money growth,

    • Agents adjust their expectations downward, minimizing output reductions, crucially depend on the bank's credibility.

The Lucas Critique

  • Developed in 1976 by Robert Lucas, emphasizing that

    • Policy changes should account for shifts in agents' expectations and behaviors in response to new policies.

    • Changes in observed economic relationships can arise due to policy alterations, stressing the importance of strategic interactions in economic planning.