The new classical policy conclusions

The new classical view that unanticipated aggregate demand changes affect output and employment
still does not provide a meaningful role for macroeconomic stabilization policy. To see this, consider
the new classical economist view of the propper policy response to a decline in pivate-sector
demand for example, an autonomous decline in investment. We have already analyzed the
Keynesian view of the proper policy response to such a shock (section 10.3). keynesian argue that a
decline in private-sector demand should be offset by an expansionary monetaray or fiscal policy
action to stabilize aggregate demand, output, and empoyment.
The effect of the decline in investment are depicted in Figure 11.3. The decline in investment
demand shifts the aggregate demand schedule from Yd(I0) to Yd(I1) in Figure 11.3a. This shifts causes
output to decline from Y0 to Y1. The price level will fall from P0 to P1 and as result, the labor demand
curve in Figure 11.3b will shift downward from Nd(P0) to Nd(P1). Whether there are additional effect
from the decline in envestment depends, in the new clssical view, on whether the decline was or
was not anticipated. To begin, we assume that it was anticipated.
In that case, labor suppliers will anticipate the decline in the price level that will result from
the decline in aggregate demand. Labor suppliers, now expecting the pricelevel to be lower, will
supply more labor at a given money wage, because with the lower expected price level, a given
money wage corresponds to a higher expected real wage. This fall in the expected price level shifts
the labor supply curve to the right in Figure 11.3b [from NS (Ie0) to NS (Ie1)]. As a consequence, the
aggregate supply schedule shifts.

GAMBAR DI SKIP
Effects of an autonomous decline in investment : a new classical view
an autonomous decline in investment shifts the aggregate demand schedule from Yd(I0) to Yd(I1). This
shifts would reduce output from Y0 to Y1. and lower the price level from P0 to P1. The fall in the price
level shifts the labor demand schedule from Nd(P0) to Nd(P1), and as a result employment falls from
N0 to N1. These are the only effects if the decline in investment was not anticipated. If the decline in
investment was anticipated, the expected level of autonomous investment (Ie ) will also fall (from Ie0
to Ie1). The aggregate supply schedule will shift from YS (Ie0) to YS (Ie1), and the labor supply schedule
will shift from NS (Ie0) to NS (Ie1). Those shifts cause output and employment to return t their initial
levels.
To the right in Figure 11.a from YS (Ie0) to YS (Ie1). There is a further decline in the price level to P1, and
therefore a further downward shift in the labor demand schedule to Nd(P1). At the new short-run
equilibrium, the money wage and price level have fallen sufficiently to restore employment and
output to their initial levels, N0 and Y0.
This analysis is just the reverse of our analysis of an anticipated increase in aggregate
demand resulting from an increase in the money supply. In the new classical system, output and
employment are not affected by anticipated changes in aggregate demand, even in the short run.
Consequently, there is no need for a stabilization policy response to an anticipated demand change
such as adecline in investment. In the new classical view, the economy is self-stabilizing with respect
to such shock.

But what if the decline in investment had not been anticipated? In that case, the labor
supplier would not have foreseen the price decline that resulted from the decline in aggregate
demand. The labor supply curve (Figure 11.3b) and the aggregate supply curve (Figure 11.3a) would
have remained at NS (Ie0) and YS (Ie1), respectively. The decline in investment would have caused
output and employment to decine to the level given by Y1 and N1. Would not an offsetting policy
action to raise aggregate demand back to its initial level be called for?
The answer is that such a policy response would be desirable but not feasible. The decline in
investment was by definition unanticipated. That is, assuming rational expectations, the decline
could not have been predicted by economic agents on the basis of any available information.
Policymakers, like any other economic agent, would have been unable to foresee the investment
decline in advance. They could not have acted to raise aggregate demand to offset the decline. Once
the investment decline has occured and had its effect on output, policymakers could act to raise
aggregate demand if the low investment level was expected to be repeated in future periods. If low
investment was expected to continue, however, there would be no need for a policy response
because private agents would also hold this expectation. At this point, the shift in the labor supply
and aggregate supply schedules would take place. In the words, as long as the shock is
unanticipated, policymakers lack the knowledge needed to offset the shock. Once the shock is
anticipated by policymakers, it is also anticipated by other economic agents, including labor
suppliers, and there is no need to offset the shock.
The foregoing analysis indicates that the new classical view includes no useful role for
aggregate demand policies aimed at stabilizing output and employment. New classical economicts
policy conclusions are strongly noninterventionist, just as were those of classical economists. In the
respect, new classical economists agree with the monetarists. Concerning monetary policy, many
new classical economistsalso arrive at the same position as monetarists, favoring a money growth
rate rule.9 Such as policy rule does away with unanticipated changes in the money supply, which
have no stabilization value and move the economy away from the natural rate of output and
employment by causing economic agents to make price forecast errors. In addition, a stable rate of
growth in the money supply contribute to stability in the inflation rate, and if the money growth rate
was low, to a low inflation rate as well.
In the case of fiscal policy, new classical economists favor stability and the avoidance of
excessive and inflationary stimuli. New classical economists Thomas Sargent and Neil Wallace, for
example, were critical of the large deficits that resulted from the Reagan administrations fiscal
policy of the 1980s.10
Instability in fiscal policy causes uncertainly, making it difficultfor agents forming rational
expectations to correctly anticipate the course of the economy. Moreover Sargent and others
believe that a credible noninflationary monetary policy cannot coexist with a fiscal policy that
generates large dificits. Huge deficits put great presure on the monetary authority to increase
money growth in order to help finance the deficit.11 Sargent and other new classical economists
believe that control of the goverment budget deficit is necessary for a credible, noninflationary
monetary policy.
Read Perspective 11.1
9

Other new classical economists favor rules that target the inflation rate directly or target the grow
rate in nominal income. Such rules are discussed in Chapter 17.

10

Thomas Sargent and Neil Wallace. Some Unpleasant Monetarist Arithmetic, Federal Reserve
Bank of Minneapolis Review (Fall 1981),
11

Recall that form the goverments budget constraint it follows that dficits must be financed by
either the sale of bonds or the creation of new money. Even if, at present, the dificit is financed only
by bond sales, the new classical economists argue that the resulting upward pressure on the interest
rate will eventually lead the monetary authority to deviate from a stable money growth rule Rational
economics agents will predict this action and therefore will not believe that the monetary authority
will stick to announced targets for money growth.

11.2 A BROADER VIEW OF THE NEW CLASSICAL POSITION

New classical position economists are critical of Keynesian economics as a whole. New classical
economists Robert Lucas and Thomas Sargent use terms such as fundamentally flawed,
wreckage, failure on a grand scale, and of no value to describe major aspect of the Keynesian
theoritical and policy analysis.12 The title of their paper, After Keynesian Macroeconomics, suggest
their view that a total restructuring of macroeconomics is required.
Lucas, Sargent, and other new classical economists are critical of the theoretical foundations
of the Keynesian system. They argue that Keynesian rules of thumb such as the consumption
function and Keynesian money demand function replaced classical functions based on individual
optimizing behavior. The Keynesian model is, in their view, made up of ad hoc elements, which were
failed attemps at explaining the observed behavior of the economy in aggregate. A good example of
this failing of the Keynesian system is the handling of expectations. The Keynesian system uses a rule
of thumb whereby the expected current price is expressed as a function of the past behavior of
prices. Such as assumption is not based on individuals making optimal use of information and
implies, in general, that economic agents choose to ignore useful information in making their price
forecast. New classical economists make the alternative assumption that expectation are rational,
which they argue to be consist with optimal use of information by the economic agents in the
model.
New classical economists are also critical of keynes assumption that wages are sticky,
meaning, as they interpret this assumption, that wages are set a level or by a process that could be
taken as uninfluenced by the macroeconomic forces he proposed to analyze. We have already
considered the arguments that Keynesians advanced to support the assumption of wage rigidity.
New classical economists do not find these arguments convincing. They favor the classical view that
markets, including the labor market, clear; that is, prices, including the money wage rate, move to
equate supply and demand.
New classical economists argue that fruitful macroeconomic models should rectify the
failures of Keynesian economics by consistently adhering to the following assumptions:
1. Agents optimize: that is, they act in their own self-interest
2. Markets clear
Why, then, did Keynes dispense with those assumptions? In the new classical view.
Keynesian economics was a response to the supposed failure of classical economics to
explain the problem of unemployment and relattionship between unemployment and
aggregate demand. Recall that the classical aggregate supply shedule was vertical. With such

a vertical supply schedule, aggregate output was totally dependent on supply factors. The
classical model was abandoned by Keynes.

12

Robert Lucas and Thomas Satgent. After Keynesian Macroeconomics, in After the Phillips Curve:
Persistence of High Inflation and High Unemployment (Boston: Federal Reserve Bank of Boston,
1978).
Because it did not explain prolonged deviations of output and employment from full-employment
levels.
New classical economists argue that a model in cassical tradition can explain the deviations
from full employment if the assumption of rational expectation is incorporated into the classical
system. Recall that the classical theory of the labor market, which was the basis for the classical
vertical aggregate supply function, assumed that labor supplier knew the real wage, implying that
labor suppliers had perfect information about the value that the aggregate price level would take on
over the short run. New classical economists substitute the assumption that labor suppliers make a
rational forecast of the aggregate price level. In this case, as we have seen, systematic, and hence
anticipated, changes in aggregate demand will not affect output and employment, but unanticipated
changes in aggregate demand will. Such unanticipated changes in aggregate demand can explain
deviations from full employment.
This substitution the assumtion of rational expectations for the classical assumtion of perfect
information does not require substantive changes in the noninterventionist classical policy
conclusions, for as we saw earlier in this chapter, meaningful aggregate demand management
policies involve systematic variations in aggregate demand, and these have no effect on output and
employment in the new classical view.
11.3 THE KEYNESIAN COUNTERCRITIQUE
The theme that runs through the Keynesian response to the new classical criticisms is that, although
they raise valid points, especially concerning the weakness of the Keynesian threatment of
expectations information, it is still, as the Keynesian Robert Solow puts it, much too early to tear up
the IS-LM chapters in the textbooks of your possibly misspent youth.13 Keynesian continue to
believe that Keynes provided the basis fo a useful framework in which to analyze the determinants
of output and employment. They continue to believe in the usefulness of activist policies to stabilize
output and employment. The major areas in which the Keynesians have raised objections to the new
classical view are as follows.
The Question of Persistence
In the preceding section, we saw that the new classical model, with the concept of rational
expectations, could explain deviations from full employment. Unanticipated declines in aggregate
demand would move output and employment below the full employment levels. Keynesians argue
that although such an explanation might be plausible for brief departures from full employment. It
is not adequate to explain the persistent and substantial deviations from full employment that we
have actually experienced. An unanticipated decline in investment. Such as we considered previously
(Figure 11.3), might well cause output and employment to decline over a short period. Let us say one
year. By the next year, however, this decline in aggregate.

13

Robert Solow, Alternative Approaches to Macroeconomic Theory: A Partial View. The Canadian
Journal of Economics (August 1979).
Demand would be seen to have taken place; it would no longer be unanticipated. Labor suppliers
would recognize that the aggregate price level had declined. Consequently, the shifts to the right in
the labor supply curve and the aggregate supply curve discussed previously (see Figure 11.) would
restore employment and output to their initial level.
This being the case, how can the new classical model explain unemployment rates of 10
percent or more in Great Britain for the entire period 1923-39 or during the Great Depression of the
1930s in the United States, when the unemployment rate exceeded 14 percent for 10 consecutive
years? In the more ecent past, how can such longed recession of the mid-1970s and early 1980s?
Read Perspective 11.2
The new classical economists respond that although the source of the unempoyment, the
unanticipated change in aggregate demand, will be of short duration, the effect of the shock will
persist. Consider, for example, the response to an unanticiated decline in aggregate demand.
Assume that after one years or so, everyone recorgnizes that demand has fallen, so the changes is
no longer unanticipated. Declines in output and employment will have occured. New classical
economists argue that it wall take time before such decline are reversed. Firms that have already cut
output will not find it optimal to restore production immediately to preshock levels because of the
cost adjusting output levels. Moreover, firms will have accumulated excess inventory stocks over the
period during which output was in decline. It will take time to run off such stock; in the meantime,
production and therefore employment will remain depressed. On the labor supply side, workers who
have become unemployed will not find it optimal to take the first job offer that comes along but will
search for the best job opportunity. New classical economists argue that, as a consequence of such
adjustment lags, lengthy deviations from full employment, such as the United States experienced
during the mid-1970s and early 1980s, can be explained even though the schocks that cause such
deviations are short-lived.
What about the depresion in Great Britain and the United States in the 1930s? One
proponent of the new classical position, Robert Barro, has tentatively explained the severity of the
U.S experience by the extent of the largely unanticipated monetary collapse during the early years of
the Depression, when the money supply fell by one-third. The slow recovery is viewed as a result of
the massive goverment intervention during the new deal period that subverted the normal
adjustment mechanisms of the private sector.14 Other new classical economists, such as Sargent and
Lucas, agree with Keynesians that the Great Depression is not well explained by their theory, but do
not find the Keynesian explanation convincing.
On this question of persistance, Keynesian remain unconvinced that adjustment lags
sufficiently explain prolonged and severe unemployment. They believe that accepting the classical or
new classical framework can explain episodes such as the Great Depression only as a result of factors
on the supply side, which in their view are the only factors in these models that could cause
prolonged unemployment. If markets clear and there is no involuntary unemployment, then, as
Modigliani puts it, to the classical or new classical economists what happened to the United States
in the 1930s was a severe attack of contagious laziness.15

The extreme informational Assumptions of Rational Expectations

Keynesians accept the new classical economists critism of price expectations formulations based
only on information about past prices. Such rules are naive because they assume that economic
agents neglect other available and potentially useful information in making their forecasts. Such
naive assumption about expectations came into use in 1950s and early 1960s when the inflation rate
was both low and stable. In these circumtances, such rules might have been rasonable
approximations of the way people made forecasts, because good forecasts could, in fact, have been
based on the past behaviour of prices. With the volatile and, at times, high inflation of the post 1970
period, it is harder to believe that economic agents did not find it worthwhile to make more
sophisticated forecasts.
Still, many Keynesians argue that the rational expectations assumption errs in assuming that
economic agents are unrealistically sophisticated forecasters, especially when rational expectations
are assumed for individual suppliers of labor. Keynesians criticize the assumption that individuals use
all available relevant information in making their forecast. Such an assumption ignores the cost
gathering information.
14

See Robert Barro, Second Thoughts on Keynesian Economics, American Economic Review; 69
(May 1979), p. 57. Examples of such New Deal interventions include NRA codes to fix prices and
wages, agricurtural policies to restrict output and raise prices, and increased regulation of the
banking and security industry, which might have hindered the raising of funds for investment. (See
Perspective 11.3)
15

Franco Modigliani, The Monetarist Controversy, or Should We Forsake Stabilization Policies?

American Economic Reviw, 67 (March 1977), p. 6.
The rational expectations theory also presumes that individuals use available information
intelligently. They know the relationships that link observed variables with the variabes they are
trying to predict. They are also able to estimate the systematic response pattern of policymakers.
For example, if the monetary policymaker typically responds to rising unemployment by increasing
the money supply, the public will come to anticipate such policy actions. They will also be able to
predict the price effects of such anticipated monetary policy actions. Many Keynesian deny that
individual labor suppliers prssess knowledge of both the working of the economy and the behavior
patterns of policymakers.
If the economy, including the behavior of policymakers, had been stable and subject to little
change for a long period of time, it is perhaps reasonable to believe that economic agents would
come to know the underlying relationships that govern policy variables and economic aggregates.
The rational expectations assumption might be realistic in a long-run equilibrium model, but
Keynesian argue that it is not realistic in the short run. In the short run, the cost of gathering and
processing information may be high enough that labor suppliers making forecast of the aggregate
price level or inflation rate do not find it worthwhile to use much information over and above the
past behavior of prices.
If expectation are not rational, there is a role for aggregate demand management aimed at
stabilizing output and employment. Even systematic changes in aggregate demand will affect output
and employment because they will not be predicted by economic agents. If private sector aggregate
demand is unstable, as Keynesians believe it is, a stabilization policy is needed. Further, the
monetary and fiscal policy making authorities should be able to forecast systematic changes in
private-sector aggregate demand. These policymaking authorities do gather what they consider to
be all the available and important information on variables they wish to forecast and control. They

also invest considerable resources in trying to estimate the relationship that characterize the
economy. Keynesians regard the rational expectations assumption as reasonaby correct when
applied to the policymakers. The policymakers can design policy changes to offset what to the public
are unanticipated changes in private-sector economic agents are not rational, the actions of the
policymakers will not be anticipated. In essence, this role for stabilization policy sterm from an
information advantage on the part of the policymaker.
Keynesian conclude :
Macroeconomic models based on the assumptions of the rational expectations hypothesis
do not demonstrate the short-run ineffectiveness of policy, therefore, because they are not
really short-run models. The information availability assumption of the rational expectations
hypothesis implicity places such models in a long-run equilibrium context in which their
classical properties... are not surprising.16

16

Benjamin Friedman. Optimal Expectations and the Extreme Information Assumption of Rational
Expectation Macromodels, Journal of Monetary Economics (January 1979), pp. 39-40.

In rebuttal, new classical economics have defended the rational expectations assumptions.
They admit that the rational expectations hypothesis is unrealistics, but as Bennett McCallum
argues, All theories o models are unrealistic in the sense of being extremely simplified descriptions
of reality..... So the true issue is: of all the simple expectational assumptions conceiveable, which one
should be embodied in a macroeconomic model to be used for stabilization analysis?17 New
classical economists favor the rational expectations assumption over the assumption that individuals
form price expectations based on the past history of prices because the rational expectations
hypothesis is consistent with individual optimizing behavior.
Auction Market Versus Contractual Views of the Labor Market
In the new classical view, as in the original classical theory, the money wage is assumed to adjust
quickly to clear the labor market to equate labor supply and demand. This is an auction market
characterization. In contrast, in the Keynesian contractual view of the labor market, wages are not
set to clear markets in the short run, but rather are strongly conditioned by longer-term
considerations involving... employer-worker relations.18 The money wage is sticky in the downward
direction. In arthur Okuns phase, the labor market functions more by the invisible handshake than
by the invisible hand of a competitive market merchanism. Most of the response to a decline in
aggregate demand and, consquently, the demand for labor comes in the form of a reduction in
employment rather than a fall in the money wage.
Keynesian view the labor market as one in which long term arrangements are made
between buyers and sellers. In general, such relationships fix the money wage while leaving the
employer free to adjust hours worked over the course of the explicit or implicit contract. Layoffs or
reduced hours are considered an acceptable response on the part of the employer to a fall in
demand. Appliying pressure for wage cuts or replacing current workers with unemployed workers
who will work for lower wages is not acceptable. This contactual keynesian view explains wage
stickiness on the basis of the institutional mechanisms that characterize the labor market. Much
work is currently under way to investigate the theoretical reasons such labor market intitutions have
developed. Even without such theoritical foundations, the Keynesians argue that institutional

mechanisms of this nature do exist, and they critize new classical economists for ignoring these
elements of relity that their model cannot explain.
17

Benneth McCallum, The Significant of Rational Expectations Theory, Challenge Magazine

(January-February 1980). P. 39.
18

Arthur Okun, Price and Quantitive (Washington D.C.: The Brookings Institution, 1981), extends this
contractual view to product markets, with resulting price stickness, New Keynesian models this type
are examined in Chapter 12.

New classical economists agree that labor market is, at least i part, characterized by long-term
contracts. They deny, however, that the existence of such contracts has, of itself, any implication for
whether the labor market will clearthat is, for whether there will be involuntary unemployment.
They deny that the terms of labor contracts are so rigid that employers and employees cannot effect
changes desirable to both parties. For example, if the money wage specified is too high to maintain
the contract, increase the work done per hour, or in extreme cases allow revision of the wage in
some fashion. New classical economists do not deny that labor contracts cause some deviation of
employment from the market-clearing levels, but they do not believe this deviation is significant.
Read Perspective 11.3

11.4 CONCLUSION
The new classical economics presents a fundamental challenge to Keynesian orthodoxy. On the
theoretical level, new classical economists question the soundness of the Keynesian model, arguing
that many of its relationships are not firmly based on individual optimizing behavior. New classical
economists point to the naive thretment of price expectations in the Keynesian model as an
example. Further, they criticize what they consider Keynesians arbitary assumptions concerning
wage stickness and consequent involuntary unemployment.
On policy questions, new classical economists maintain that output and employment are
independent of systematic and therefore, anticipated changes in aggregate demand. This is the new
classical policy ineffectiveness postulate. Because maningful aggregate demand management
policies to stabilize output and employment consist of systematic changes in aggregate demand,
new classical economists see no role for these polices. They arrive at noninterventionist policy
concusions similiar to those of the original classical economists.
Keynesians criticize the new classical theory on several grounds. They argue that the new
classical model cannot explain the prolonged and severe unemployment experienced by the United
States and other industrialized countries. They claim that the rational expectation assumption
ascribes an extreme and unrealistic availability of information to market participant. Finally, and
most important, they criticize the auction market characterization of the labor market is much more
a contractual market and that the nature of these contractual arrangements leads to wage rigidities
and consequent involuntary unemployment.
The new classical critique has, however, stimulated new avenues of Keynesian research on
the causes of unemployment. The new Keynesian models emerging from this research are
considered in Chapter 12, in which we also examine the development of a second generation of new
classical medols the so-called real business cycle models.