New Classical Macroeconomics

New Classical New Classical MacroeconomicMacroeconomic

ssIntermediate MacroeconomicsIntermediate Macroeconomics

ECON-305 Spring 2013ECON-305 Spring 2013Professor DaltonProfessor Dalton

Boise State UniversityBoise State University

New Classical New Classical MacroeconomicsMacroeconomics

““Keynesian orthodoxy or the neoclassical Keynesian orthodoxy or the neoclassical synthesis is in deep trouble, the synthesis is in deep trouble, the deepest kind of trouble in which an deepest kind of trouble in which an applied body of theory can find itself. It applied body of theory can find itself. It appears to be giving seriously wrong appears to be giving seriously wrong answers to the most basic questions of answers to the most basic questions of macroeconomic policy.”macroeconomic policy.”

- Robert E. Lucas, Jr., “Tobin and - Robert E. Lucas, Jr., “Tobin and Monetarism: A Monetarism: A Review Article,” Review Article,” JELJEL (June (June 1981)1981)


Evolved out of monetarist economics of Evolved out of monetarist economics of 1970s1970s

Major proponentsMajor proponents Robert E. Lucas, Jr.Robert E. Lucas, Jr. Thomas SargentThomas Sargent Robert BarroRobert Barro Edward PrescottEdward Prescott Neil WallaceNeil Wallace Patrick MinfordPatrick Minford


Three Central HypothesesThree Central Hypotheses1.1. Rational Expectations HypothesisRational Expectations Hypothesis2.2. Continuous Market-Clearing Continuous Market-Clearing

HypothesisHypothesis3.3. Aggregate Supply HypothesisAggregate Supply Hypothesis

Each can be judged in isolationEach can be judged in isolation New Classicalists accept all threeNew Classicalists accept all three

Rational ExpectationsRational Expectations Rational expectations hypothesis (at Rational expectations hypothesis (at

least in weak form) becomes a central least in weak form) becomes a central modeling assumption of the dominant modeling assumption of the dominant schools in the 1990s and this centuryschools in the 1990s and this century Real Business Cycle SchoolReal Business Cycle School New Keynesian SchoolNew Keynesian School

Rhetorical advantage of Rhetorical advantage of rationalrational expectationsexpectations

Continuous Market-Continuous Market-ClearingClearing

All markets continuously clear in line All markets continuously clear in line with Walrasian viewwith Walrasian view

Agents and Firms are price-takersAgents and Firms are price-takers Observed outcomes result of optimal Observed outcomes result of optimal

responses of agents to price responses of agents to price perceptionsperceptions

New Classical Models are New Classical Models are equilibriumequilibrium modelsmodels


New Classical equilibrium New Classical equilibrium Equilibrium means that agents have Equilibrium means that agents have

optimally responded to price signals based optimally responded to price signals based on existing demands and supplieson existing demands and supplies

Demands and supplies are based on Demands and supplies are based on expectationsexpectations

Lack of complete information can lead to Lack of complete information can lead to expectational errors and equilibria that expectational errors and equilibria that are are notnot identical to the full-information identical to the full-information equilibriaequilibria


New Classical equilibrium New Classical equilibrium Prices always adjust to clear marketsPrices always adjust to clear markets

““instantaneous price adjustment”instantaneous price adjustment” Does not imply that market-clearing Does not imply that market-clearing

prices are prices consistent with full-prices are prices consistent with full-information equilibriuminformation equilibrium

Prices can clear markets but still be Prices can clear markets but still be “wrong”“wrong”


New Classical equilibrium New Classical equilibrium Implies that unemployment is always Implies that unemployment is always

entirely voluntaryentirely voluntary

Most critical and contentious of Most critical and contentious of new classical hypothesesnew classical hypotheses

Aggregate SupplyAggregate Supply Two main approachesTwo main approaches Both share two orthodox micro Both share two orthodox micro

assumptionsassumptions1.1. Workers’ and Firms’ decisions are Workers’ and Firms’ decisions are

maximizing or optimalmaximizing or optimal2.2. Supply decisions of workers and firms Supply decisions of workers and firms

depend upon relative pricesdepend upon relative prices

Lucas-Rapping ASHLucas-Rapping ASH Lucas, R.E., Jr., and Rapping, L., Lucas, R.E., Jr., and Rapping, L.,

“Real Wages, Employment and “Real Wages, Employment and Inflation,” Inflation,” Journal of Political Journal of Political Economy Economy (Sept./Oct. 1969)(Sept./Oct. 1969)

Essence: during any period, workers Essence: during any period, workers must decide how much time to must decide how much time to allocate between work and leisure.allocate between work and leisure.

Lucas-Rapping ASHLucas-Rapping ASH Workers have notion of “normal” Workers have notion of “normal”

average real wage.average real wage. Workers intertemporally substitute Workers intertemporally substitute

leisure over the course of their leisure over the course of their lifetimes.lifetimes. When w > wWhen w > wee, workers work more and , workers work more and

take less leisuretake less leisure When w < wWhen w < wee, workers work less and , workers work less and

take more leisuretake more leisure

Lucas-Rapping ASHLucas-Rapping ASH Employment is always at the Employment is always at the

voluntary and optimal level.voluntary and optimal level. Changes in employment reflect the Changes in employment reflect the

voluntary choices of labor due to voluntary choices of labor due to changes in relative real wages over changes in relative real wages over time.time.

Lucas ASHLucas ASH Lucas, “Expectations and the Lucas, “Expectations and the

Neutrality of Money,” Neutrality of Money,” Journal of Journal of Economic Theory Economic Theory (April 1972)(April 1972)

Lucas, “Some International Evidence Lucas, “Some International Evidence on Output-Inflation Tradeoffs,” on Output-Inflation Tradeoffs,” AER AER (June 1973)(June 1973)

Spirit: “Signal-Extraction Problem”Spirit: “Signal-Extraction Problem” Problem of information set available to Problem of information set available to

agentsagents

Lucas ASHLucas ASH ““Signal-Extraction Problem”Signal-Extraction Problem”

Firms know current price of own output, but Firms know current price of own output, but price level of other markets known only price level of other markets known only with lag. Agents must form expectations of with lag. Agents must form expectations of prices elsewhere.prices elsewhere.

Firm problem: if PFirm problem: if Pxx increases, does that increases, does that mean Dmean Dxx has increased or AD has has increased or AD has increased?increased?

If DIf Dxx increased, then increase QS increased, then increase QSxx If AD increased, then no change in QSIf AD increased, then no change in QSxx

Lucas “Surprise” AS Lucas “Surprise” AS FunctionFunction

Both Aggregate Supply Hypotheses lead to Both Aggregate Supply Hypotheses lead to notion that Y deviates from Ynotion that Y deviates from YNN due to deviations due to deviations of P from Pof P from Pe e (or deviations of dP from dP(or deviations of dP from dPee))

Y – YY – YNN = = αα ( (PP – – PPee) )

Y – YY – YNN = = αα ( (ddPP – d – dPPee) ) If If PP > > PPee (or P(or P > > PPee), then both workers and ), then both workers and

firms mistake nominal price changes as relative firms mistake nominal price changes as relative price changesprice changes

Equilibrium Business Equilibrium Business CycleCycle

Lucas saw himself asLucas saw himself as Formally incorporating microeconomics Formally incorporating microeconomics

into macroeconomic modelsinto macroeconomic models Taking up the business cycle research Taking up the business cycle research

agenda of Hayek – “incorporating agenda of Hayek – “incorporating cyclical phenomena into system of cyclical phenomena into system of equilibrium theory”equilibrium theory”

Equilibrium Business Equilibrium Business CycleCycle

Central ThesisCentral ThesisUnanticipated AD shocks (resulting mainly Unanticipated AD shocks (resulting mainly form unanticipated ∆Mform unanticipated ∆Mss) cause agents to ) cause agents to make erroneous (rational) expectations, make erroneous (rational) expectations,

that result in Y and L deviations from that result in Y and L deviations from (long-run) full-information equilibrium (long-run) full-information equilibrium

levels. Errors are result of levels. Errors are result of imperfect/incomplete information, so imperfect/incomplete information, so

general price changes are mistaken for general price changes are mistaken for relative price changes.relative price changes.

New Classical v. New Classical v. Orthodox MonetarismOrthodox Monetarism

OM: Workers fooled by inflation, firms aren’tOM: Workers fooled by inflation, firms aren’t Adaptive expectations mean workers can be Adaptive expectations mean workers can be

continuously fooledcontinuously fooled NC: Both workers and firms can be fooled by NC: Both workers and firms can be fooled by

inflationinflation Rational expectations mean agents can only be Rational expectations mean agents can only be

fooled by surprisesfooled by surprises Both: Once agents realize errors, Y and L Both: Once agents realize errors, Y and L

return to long-run (or full-information) return to long-run (or full-information) equilibriumequilibrium

New Classical Business New Classical Business CycleCycle

In New Classical Approach, deviations In New Classical Approach, deviations from long-run equilibrium are due to from long-run equilibrium are due to random shocks which cause errors in random shocks which cause errors in price expectations.price expectations. Why are shocks necessarily random?Why are shocks necessarily random?

Ratex implies expectational errors are Ratex implies expectational errors are random.random.

Ratex and ASH imply Y and L fluctuate Ratex and ASH imply Y and L fluctuate randomly around Yrandomly around YNN and L and LNN..


Unemployment and output deviate Unemployment and output deviate from natural levels due to:from natural levels due to:

1.1. Demand shocksDemand shocks2.2. Supply shocksSupply shocks3.3. Monetary surpriseMonetary surprise


Further assumptions required to explain Further assumptions required to explain persistence of deviations of Y and L persistence of deviations of Y and L from trend values during business from trend values during business cycles.cycles. Lagged output and durability of Lagged output and durability of

capital goods.capital goods. Labor contracts inhibiting immediate Labor contracts inhibiting immediate

adjustment.adjustment. Adjustment costs.Adjustment costs.

Policy ImplicationsPolicy Implications1.1. Policy Ineffectiveness PropositionPolicy Ineffectiveness Proposition2.2. Output-Employment Costs of Reducing Output-Employment Costs of Reducing

InflationInflation3.3. Dynamic Time Inconsistency, Credibility Dynamic Time Inconsistency, Credibility

and Monetary Rulesand Monetary Rules4.4. Central Bank IndependenceCentral Bank Independence5.5. Role of Micro Policies to Increase ASRole of Micro Policies to Increase AS6.6. The “Lucas Critique” of Econometric The “Lucas Critique” of Econometric

Policy EvaluationPolicy Evaluation

Policy IneffectivenessPolicy Ineffectiveness

““Monetary authorities are Monetary authorities are unable to influence output unable to influence output and employment, even in and employment, even in the short-run, by pursuing the short-run, by pursuing systematic monetary systematic monetary policy.”policy.”

Policy IneffectivenessPolicy Ineffectiveness Agents form rational expectations.Agents form rational expectations. If monetary authorities are following a If monetary authorities are following a

systematic policy, agents will come to know systematic policy, agents will come to know the policy and its effects.the policy and its effects.

Agents will on average correctly anticipate Agents will on average correctly anticipate the actions and effects of monetary policy.the actions and effects of monetary policy.

Deviations from full employment output are Deviations from full employment output are result of surprise.result of surprise.

Therefore, systematic policy can not affect Therefore, systematic policy can not affect output and employment.output and employment.

Policy IneffectivenessPolicy Ineffectiveness Expansionary monetary policy Expansionary monetary policy

shifts AD to right.shifts AD to right. If unexpected, workers and If unexpected, workers and

firms act as if increase in P is firms act as if increase in P is increase in relative prices and increase in relative prices and output increase beyond Youtput increase beyond YNN to to Y*.Y*.

As agents realize their As agents realize their mistakes, output returns to Ymistakes, output returns to YNN as prices adjust to full-as prices adjust to full-information levels. information levels.

P

Y

LRAS

SRAS0

AD1

AD0

SRAS1

Y*YN

P0

P1

P2

Policy IneffectivenessPolicy Ineffectiveness Expansionary monetary policy Expansionary monetary policy

shifts AD to right.shifts AD to right. If unexpected, workers and If unexpected, workers and

firms act as if increase in P is firms act as if increase in P is increase in relative prices and increase in relative prices and output increase beyond Youtput increase beyond YNN to Y*. to Y*.

As agents realize their mistakes, As agents realize their mistakes, output returns to Youtput returns to YNN as prices as prices adjust to full-information levels. adjust to full-information levels.

If policy is expected, agents If policy is expected, agents realize prices will rise to full-realize prices will rise to full-information level, Pinformation level, P22, and , and therefore no real changes occur.therefore no real changes occur.

P

Y

LRAS

SRAS0

AD1

AD0

SRAS1

YN

P0

P2

CorollaryCorollary

““Attempts to affect output Attempts to affect output and employment by and employment by random monetary policy random monetary policy only increases the variation only increases the variation of output and employment of output and employment around the natural levels.”around the natural levels.”

Policy IneffectivenessPolicy Ineffectiveness Empirical TestsEmpirical Tests

Early work of Barro supportive of Early work of Barro supportive of New Classical Theory and the New Classical Theory and the policy ineffectiveness propositionpolicy ineffectiveness proposition

Subsequent studies by Mishkin Subsequent studies by Mishkin and Gordon find counter evidenceand Gordon find counter evidence

Output-Employment Output-Employment Costs of Reducing Costs of Reducing

InflationInflation Sacrifice ratio = amount of lost Sacrifice ratio = amount of lost

output per percentage point output per percentage point reduction in inflationreduction in inflation

Orthodox KeynesiansOrthodox Keynesians: sacrifice : sacrifice ratio large owing to sluggish ratio large owing to sluggish response of prices and wages to response of prices and wages to reduced ADreduced AD


InflationInflation Orthodox MonetaristsOrthodox Monetarists: sacrifice : sacrifice

ratio dependent uponratio dependent upon(1) degree of monetary contraction(1) degree of monetary contraction(2) extent of institutional adaptations(2) extent of institutional adaptations(3) rate of expectations adjustment(3) rate of expectations adjustment

Rate of expectations adjustment Rate of expectations adjustment depends upon credibility of monetary depends upon credibility of monetary authorityauthority


InflationInflation New ClassicalNew Classical: an announced : an announced

crediblecredible monetary contraction monetary contraction leads to immediate reduction of leads to immediate reduction of inflationary expectations and inflationary expectations and sacrifice ratio is 0!sacrifice ratio is 0!

Only monetary surprises have effect on Only monetary surprises have effect on real output and employment.real output and employment.

Monetary Growth RulesMonetary Growth Rules Friedman’s Case for Monetary Friedman’s Case for Monetary

Growth RuleGrowth Rule Informational constraints facing Informational constraints facing

policymakerspolicymakers Lag and forecasting problemsLag and forecasting problems Uncertainty of size of fiscal and Uncertainty of size of fiscal and

monetary multipliersmonetary multipliers Accelerationist hypothesisAccelerationist hypothesis Distrust of political processDistrust of political process

Dynamic Time Dynamic Time InconsistencyInconsistency

Kydland and Prescott, “Rules Rather Kydland and Prescott, “Rules Rather than Discretion: The Inconsistency of than Discretion: The Inconsistency of Optimal Plans,” Optimal Plans,” Journal of Political Journal of Political EconomyEconomy (June 1977) (June 1977) Rigorous New Classical model where Rigorous New Classical model where

policymakers are engaged in strategic policymakers are engaged in strategic dynamic game with rational private dynamic game with rational private sector agentssector agents


Time-inconsistencyTime-inconsistency: the divergence : the divergence between between ex ante ex ante and and ex post ex post optimality optimality of government fiscal/monetary policyof government fiscal/monetary policy

Time-inconsistency weakens credibility Time-inconsistency weakens credibility of announced policies;of announced policies;

Time-inconsistency leads to an Time-inconsistency leads to an inflationary-bias in discretionary policyinflationary-bias in discretionary policy


The ModelThe ModelPolicymakersPolicymakers

(1) specify targets(1) specify targets(2) identify SWF w/ targets as arguments(2) identify SWF w/ targets as arguments(3) choose policy s.t. SWF is maximized(3) choose policy s.t. SWF is maximized

Private AgentsPrivate AgentsAnticipate and adjust to policyAnticipate and adjust to policy

Social Welfare FunctionSocial Welfare FunctionSStt = f(U = f(Utt, dP, dPtt) with SRPC constraint) with SRPC constraint


A time-consistent policy A time-consistent policy is one that maximizes S is one that maximizes S s.t. constraint and is s.t. constraint and is consistent with agent consistent with agent full-information full-information adjustmentadjustment

Points on vertical axis Points on vertical axis (LRPC) are potential (LRPC) are potential equilibriaequilibria

C is a time-consistent C is a time-consistent equilibriaequilibria

A is a time-inconsisent A is a time-inconsisent equilibria (why?)equilibria (why?)

UN

Ut

dPt

dPe = c

dPe = 0

0

CA


Suppose at C (inferior or Suppose at C (inferior or sub-optimal) Why?sub-optimal) Why?

Reduction of monetary Reduction of monetary growth from dM=C to dM growth from dM=C to dM = 0 will move economy = 0 will move economy directly to 0 directly to 0 if credibleif credible

Once at 0, superior Once at 0, superior position can be achieved position can be achieved through inflationary through inflationary surprise to move to Asurprise to move to A

But such a policy is time-But such a policy is time-inconsistent (why?)inconsistent (why?)

UN

Ut

dPt

dPe = c

dPe = 0

0

CA


Policy ImplicationsPolicy Implications If monetary authorities have If monetary authorities have

discretionary powers, they have an discretionary powers, they have an incentive to cheatincentive to cheat

Since agents know this, announced Since agents know this, announced policies that are time-inconsistent are policies that are time-inconsistent are not crediblenot credible

Discretionary policy produces sub-Discretionary policy produces sub-optimal outcomes with an inflationary optimal outcomes with an inflationary biasbias

Central Bank Central Bank IndependenceIndependence

If time-inconsistency argument is accepted, If time-inconsistency argument is accepted, some constraint to discretion must be foundsome constraint to discretion must be found

Does central bank independence provide this?Does central bank independence provide this? Empirical evidenceEmpirical evidence

greater independence reduces average inflation greater independence reduces average inflation rate while having no effect on real performancerate while having no effect on real performance

CounterargumentsCounterarguments Free banking and history of FedFree banking and history of Fed Macroeconomic coordinationMacroeconomic coordination

Micro Policies and ASMicro Policies and AS Unemployment is equilibrium Unemployment is equilibrium

outcome of optimal decisionsoutcome of optimal decisions Appropriate policy to reduce Appropriate policy to reduce

unemployment is to increase unemployment is to increase incentives for employmentincentives for employment Examples?Examples?

The “Lucas Critique”The “Lucas Critique”Lucas, “Econometric Policy Evaluation: Lucas, “Econometric Policy Evaluation:

A Critique,” in Brunner and Meltzer, A Critique,” in Brunner and Meltzer, ed., ed., The Phillips Curve and Labor The Phillips Curve and Labor Markets Markets (1976)(1976)

Attacks practice of using large scale Attacks practice of using large scale macro models to evaluate macro models to evaluate consequences of alternative policy consequences of alternative policy scenariosscenarios

The “Lucas Critique”The “Lucas Critique” Such models are based on assumption Such models are based on assumption

coefficients don’t change with change coefficients don’t change with change in policyin policy

Economic agents will adjust behavior Economic agents will adjust behavior to new policyto new policy

EmpiricsEmpirics Models under-predicted dP in late 1960s Models under-predicted dP in late 1960s

and early 1970sand early 1970s Direct tests: no strong supportDirect tests: no strong support

Whose Critique?Whose Critique?““There is first of all the central question of methodology, - There is first of all the central question of methodology, - the logic of applying the method of multiple correlation to the logic of applying the method of multiple correlation to unanalysed economic material, which we know to be non-unanalysed economic material, which we know to be non-homogeneous through time. If we were dealing with the homogeneous through time. If we were dealing with the action of numerically measurable, independent forces, action of numerically measurable, independent forces, adequately analysed so that we were dealing with adequately analysed so that we were dealing with independent atomic factors and between them completely independent atomic factors and between them completely comprehensive, acting with fluctuating relative strength on comprehensive, acting with fluctuating relative strength on material constant and homogeneous through time, we might material constant and homogeneous through time, we might be able to use the method of multiple correlation with some be able to use the method of multiple correlation with some confidence for disentangling the laws of their action… In fact confidence for disentangling the laws of their action… In fact we know that every one of these conditions is far from being we know that every one of these conditions is far from being satisfied by the economic material under investigation… ”satisfied by the economic material under investigation… ”

- Keynes, “Professor Tinbergen’s Method,” - Keynes, “Professor Tinbergen’s Method,” Economic JournalEconomic Journal (1937) (1937)

Distinguishing BeliefsDistinguishing Beliefs(1) Economy inherently stable and (1) Economy inherently stable and

erratic monetary growth is primary erratic monetary growth is primary source of instabilitysource of instability

(2) No long-run tradeoff between (2) No long-run tradeoff between inflation and unemployment; no inflation and unemployment; no short-run tradeoff from systematic short-run tradeoff from systematic monetary policymonetary policy

Distinguishing BeliefsDistinguishing Beliefs(3) Credibility of monetary authority (3) Credibility of monetary authority

primary determinant of fluctuations in primary determinant of fluctuations in output and employmentoutput and employment

(4) Discretionary monetary policy has (4) Discretionary monetary policy has time-inconsistent inflationary bias; time-inconsistent inflationary bias; rules are preferablerules are preferable

(5) Fiscal policy has no effect on the (5) Fiscal policy has no effect on the economy, except to alter the natural economy, except to alter the natural levels of output and employmentlevels of output and employment

Evaluation: WeaknessesEvaluation: WeaknessesNew Classical macroeconomics argues New Classical macroeconomics argues

that the Business Cycle is ultimately that the Business Cycle is ultimately caused by caused by information gapsinformation gaps

Given low cost availability of price and Given low cost availability of price and monetary data, magnitude and duration of monetary data, magnitude and duration of actual business cycles seem too big to actual business cycles seem too big to reconcilereconcile

Empirics cast doubt that only unanticipated Empirics cast doubt that only unanticipated changes in monetary policy have real changes in monetary policy have real output effectsoutput effects

Evaluation: Lasting Evaluation: Lasting ImpactsImpacts

(1) Attention to modeling (1) Attention to modeling expectationsexpectations

(2) Focus on building macro models (2) Focus on building macro models upon microeconomic foundationsupon microeconomic foundations

(3) Understanding that policy less (3) Understanding that policy less robust than intimated by robust than intimated by macroeconometric modelsmacroeconometric models

Documents

New Classical Macroeconomics