New Classical Macroeconomics

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Table of Contents

About New Classical Macroeconomics
Rational Expectation
Policy implication of the New Classical Macroeconomics
Conclusion
Reference List

About New Classical Macroeconomics

The new classical macroeconomics school of thought was based on the neoclassical background. This school of thought which originated in the 1970s was formulated by key economists such as by Robert Lucas, Thomas Sargent, Neil Wallace, and Edward Prescott. The New Classical Macroeconomics school of thought attempts to analyse macroeconomic models using the microeconomic models.

Specifically, this school of though has the primary building blocks borrowed from classical economics that was originally formulated by Adam Smith. The school of thought contradicts with the new Keynesian school of thought since the latter makes use of the microeconomic foundations to produce macroeconomic models.

The New Classical Macroeconomics school of thought pays attention to the role of rational economic agents and the theory of rational expectations in making decisions. Based on the rational expectations, the school of thought assumes that agents aims at maximising utility.

The model opines that the government intervention in demand management is not effective in the short run (Bade and Parkin 2009, p. 43). Thus, this analytical treatise attempts to explicitly discuss the main propositions of the New Classical Macroeconomics and its policy implications in understanding macroeconomics models.

Propositions of the New Classical Macroeconomics

Specifically, the three main propositions that will be extrapolated include flexible prices, imperfect information and rational expectation. The treatise explicitly explores the concept of rational expectation in addressing the propositions of the new classical macroeconomic school of thought.

Rational Expectation

About the rational expectation theory

The rational expectation hypothesis argues that expectations are formed on the basis of available information. Reflectively, the information should be relevant and based on the variables being predicted. The hypothesis states that agents should comprehend the fundamental economic associations in the economy and assumes that expectation errors are not systematic but are random.

Random expectation is different from adaptive expectation since adaptive expectations have no random errors. The lack of randomness of the adaptive expectations makes adaptive expectations not satisfactory when dealing with agents (Barber 2010, p. 32).

Accordingly, rational expectations require the agents to be coherent and optimising. This implies that agents make use of all available information in an efficient way to make informed decisions on their expectations about economic variables. The hypothesis argues that for the agents to form rational expectations, then they must be aware of the true economical model that connects all the relevant economic variables.

For instance, assume that a true economic model that estimates the price level is given by the quantity theory of money. The information to be provided in the economic model that would help agents make rational decisions should comprise of variables such as money supply, speed of money, and nominal and real income. Besides, the agents must be well informed and where possible be educated in order to be in a postion to make decisions based on the relevant economic theory.

Additionally, the hypothesis assumes that the agents are aware and well educated of the relevant economic model, and that they use the model to make decisions. For the model to work, then the errors should not be serially correlated and the errors should have a zero mean and should have the features of a random variable, that is, identically, and independently distributed. Interestingly, the errors in time (t) are not correlated with errors in time (t-1) (Henderson 2004, p. 51).

Explanation of rational hypothesis above is unrealistic in the sense that there is no possibility of having perfect information. As a matter of fact, it is not possible to have a scenario where all players in the market have perfect information. Further, it is based on Walrasian assumptions that may not be practical in the market. Also, error terms in different periods are often related to the market dynamics and not static.

Shortcomings of the rational expectation hypothesis

In as much as the rational expectation hypothesis forms the major proposition of the New Classical Macroeconomics, it has a number of shortcomings. First, the hypothesis is unrealistic since it ignores the influence of fiscal and monetary policies in the economy. Reflectively, it is not possible for such a scenario to occur since most economies have set up various institutions that work towards maintaining the stability of the economy.

Examples of such institution are the central bank and financial institutions (Saada 2009, p. 63). Secondly, the hypothesis assumes that all agents in the economy have perfect information about the expected behavior of the economy. This is not feasible in any economy since it is not possible in any economy. Rather, it is an idealised assumption that only exists in a perfectly competitive economy.

Thirdly, the model assumes that all agents are well informed of the actions they should take when the economy changes. This is not feasible since not all players in an economy have the perfect information. Thus, the assumptions of the rational expectation hypothesis casts doubt on the effectiveness of the New Classical Macroeconomics (Parkin 2007, p. 33).

Flexibility of prices

The New Classical Macroeconomics school of thought assumes that prices are flexible. This implies that the market operates without intervention or impediments so as to allow complete flexibility. Consequently, the forces of demand and supply sets the equilibrium price and quantity.

This also implies that the economy will be operating at the natural rate of output. Flexibility of prices requires that the prices of goods and services and wages in the economy to befully determined by the forces of demand and supply. This ignores the existence of labor unions and government intervention such as minimum wage principles (Chrystal and Price 1994, p. 27) which are vital in price determination.

Imperfect information

The second key proposition of this school of thought is imperfect information. The proposition asserts that the economic agents in the economy do not have perfect information concerning the economy. This is because they live in a random environment and more than often, there are swings in the economy and having a perfect information on how the economy will work is not feasible.

This proposition contradicts with the rational expectations theory which assumes that all agents in the economy have adequate information and that they will make use of all available information to make informed decisions (Snowdon and Vane 2005, p. 29).

Impact of the propositions

Based on the propositions, the New Classical Macroeconomics holds that the market will clear by itself at all times. In addition, the economy will be operating at full employment and at a natural level of output all the time. However, there are adjustments on the prices and wages so as to achieve the natural level of output.

Therefore, the New Classical Macroeconomics argue that there should be no interference in the market since the market clears all the times. They auxiliary argue that, in times of crisis such as during a recession, the market should be allowed to clear without making adjustments in the market.

The arguments of the New Classical Macroeconomics are consistent with how the perfect market operates on the assumption that prices are flexible. The perfect markets also assume that all players in the market aim at maximising their utility. For instance, buyers aim at maximising their utility, workers aim at maximising their welfare, and sellers aims at maximising revenue and profits.

Finally, there are no transaction costs in the market. The efficiency theory of the New Classical Macroeconomics school of thought is consistent with the Say’s law (in Classical economics) which states that in an economy, the aggregate supply must be equal to the aggregate demand so as to ensure stability.

Based on the comparison with the perfect market, it implies that the New Classical Macroeconomics school of thought ensures that there is a Pareto efficient market. Thus, one person cannot gain without making another person lose in the market because the resources are allocated using equilibrium forces. Further, firms only earn normal profits from business operations since competition would reduce any abnormal profits earned (Moon 2013, p. 22).

Policy implication of the New Classical Macroeconomics

Self adjusting economy

As mentioned above, the New Classical Macroeconomics school of thought assumes that the economy is self correcting all the time. This implies that there is no need for intervention to correct imbalances in the economy. This is as a result of the efficiency of the economy.

The model asserts that the economy has several mechanisms that ensure that all imbalances are restored to the equilibrium state at all times. From this school of thought, it can be deduced that since the economy operates at close to full employment and natural level of output, then there is no need to aggressively interfere with the economy since intervention may cause disequilibrium or inflation.

Thus, the school of thought ensures that an economy has free markets that do not have failures and is achieved using the supply side policies. The supply side policies are used to increase aggregate supply without increasing the price level in the economy.

An example of the supply side policy would be to reduce the amount of benefits at work so as to increase the upturn of people to work in addition to reducing the influence of trade unions so as to make wages in the economy more flexible. Generally, the policy aims at minimising regulations so as to make the markets open to the forces of demand and supply (Wessels 2006).

Secondly, the New Classical Macroeconomics school of thought ensures that the quantity of money supply in the economy is under control so as to keep the inflation rates at low levels. Examples of the policies that can be put in place to control money supply is introducing controls on interest rates and monetary base. As a result, the amount of money demanded and money supplied in the economy will be controlled by the forces of demand and supply (Mankiw 2011, p. 48).

Conclusion

The New Classical Macroeconomics school of thought is built on the assumption that all agents in the economy use the information available to make rational decisions. As a consequence, the behavior of all agents in the economy is consistent with the rational expectation hypothesis.

However, this hypothesis is based on unrealistic assumptions that casts doubt on the efficiency of the New Classical Macroeconomics school of thought. The school of thought ensures efficiency since the economy is self correcting and thus, there is no need of any kind of intervention. The efficiency assumption is similar to the characteristics of a perfect market. It is also built based on some quite unrealistic assumptions (Arnold 2008, p. 29).

The policy implication of the New Classical Macroeconomics of a self adjusting economy has been criticised in a number of areas. The policy does not give an account of unemployment in an economy because, based on the school of thought, it is expected that the forces of labor supply and labor demand will create equilibrium in the economy.

This equilibrium in the labor market should yield full employment implying that there should be zero unemployment rate. However, this is contrary to most economies since soaring unemployment rates has discredited the underlying assumptions of this school of thought (Adil 2006, p. 31). Secondly, the school of thought fails to explain the existence of a business cycle in an economy caharacterised by the cycles of boom, depression, recession, and recovery.

Based on the New Classical Macroeconomics school of thought, an economy should not experience the business cycle. This is because the economy should be in a position to self correct before moving to another point in the cycle.

This school of thought cannot give explanations for the recession that was experienced between 2009 and 2010 (Mankiw 2011, p. 38). In as much as the New Classical Macroeconomics school of thought is based on unrealistic assumptions and it has failed in certain areas, it gives directions on how to influence the supply side so as to achieve stability in the economy.

Reference List

Adil, J 2006, Supply and demand, Capstone Press, USA.

Arnold, R 2008, Economics, Cengage learning, USA.

Bade, R & Parkin, M 2009, Essential foundations of economics, Pearson Education, United States of America.

Barber, R 2010, Elasticity, University of Michigan, New York.

Chrystal, A & Price, S 1994, Controversies in Macroeconomics, Harvester Wheatsheaf, Hertfordshire.

Henderson, D 2004, Supply and demand, Kessinger Publishing, USA.

Mankiw, G 2011, Principles of economics, Cengage Learning, USA.

Moon, M 2013, Demand and supply integration: The key to world-class demand forecasting, Pearson Education Inc., USA.

Parkin, M 2007, Economics, University of Michigan, USA.

Saada, S 2009, Elasticity: theory and application, Ross Publishing, USA.

Snowdon, B & Vane, H 2005, Modern Macroeconomics: Its Origins, Development and Current State, Edward Elgar, Cheltenham.

Wessels, W 2006, Economics, Barron’s Educational Series, USA.

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