New classical macroeconomics (1970S)

Developed by American economists Robert Lucas (1937- ) and THOMAS SARGENT (1943- ), and British economists PATRICK MINFORD (1943- ) and MICHAEL BEENSTOCK (1946- ).

New classical macroeconomists argue that the economy will settle at a natural rate of unemployment and attempts to alter this equilibrium state will be counteracted by economic agents.

When the Keynesian dominance of macroeconomics ended in the early 1970s, several new schools of economic thought arose.

There are three main facets to the new classical macroceconomics:

(1) the real economic decisions of agents (for example, saving, consumption, or investment) are based on real not nominal or monetary factors;
(2) agents are held to be continuously in equilibrium;
(3) agents hold on to their rational expectations.

The rational expectations theory and the NAIRU (non-accelerating inflation rate of unemployment) are important propositions.

Also see: keynesian economics, laissez-faire

Source:
K D Hoover, The New Classical Macroeconomics (Oxford, 1988)

History

Classical economics is the term used for the first modern school of economics. The publication of Adam Smith’s The Wealth of Nations in 1776 is considered to be the birth of the school. Perhaps the central idea behind it is on the ability of the market to be self-correcting as well as being the most superior institution in allocating resources. The central assumption implied is that all individuals maximize their utility.

The so-called marginal revolution that occurred in Europe in the late 19th century, led by Carl Menger, William Stanley Jevons, and Léon Walras, gave rise to what is known as neoclassical economics. This neoclassical formulation had also been formalized by Alfred Marshall. However, it was the general equilibrium of Walras that helped solidify the research in economic science as a mathematical and deductive enterprise, the essence of which is still neoclassical and makes up what is currently found in mainstream economics textbooks to this day.

The neoclassical school dominated the field up until the Great Depression of the 1930s. Then, however, with the publication of The General Theory of Employment, Interest and Money by John Maynard Keynes in 1936,[2] certain neoclassical assumptions were rejected. Keynes proposed an aggregated framework to explain macroeconomic behavior, leading thus to the current distinction between micro- and macroeconomics. Of particular importance in Keynes’ theories was his explanation of economic behavior as also being led by “animal spirits”. In this sense, it limited the role for the so-called rational (maximizing) agent.

The Post-World War II period saw the widespread implementation of Keynesian economic policy in the United States and Western European countries. Its dominance in the field by the 1970s was best reflected by the controversial statement attributed to US President Richard Nixon and economist Milton Friedman: “We are all Keynesians now”.

Problems arose during the 1973–75 recession triggered by the 1973 oil crisis. Keynesian policy responses did not reduce unemployment, instead leading to a period of high inflation and stagnant economic growth—stagflation. Keynesians were puzzled by the outbreak of stagflation because the original Phillips curve ruled out concurrent high inflation and high unemployment.

Emergence in response to stagflation

The New Classical school emerged in the 1970s as a response to the failure of Keynesian economics to explain stagflation. New Classical and monetarist criticisms led by Robert Lucas, Jr. and Milton Friedman respectively forced the rethinking of Keynesian economics. In particular, Lucas made the Lucas critique that cast doubt on the Keynesian model. This strengthened the case for macro models to be based on microeconomics.

After the 1970s and the apparent failure of Keynesian economics, the New Classical school for a while became the dominant school in Macroeconomics.

New neoclassical synthesis

Prior to the late 1990s, macroeconomics was split between new Keynesian work on market imperfections demonstrated with small models and new classical work on real business cycle theory that used fully specified general equilibrium models and used changes in technology to explain fluctuations in economic output.[3] The new neoclassical synthesis developed as a consensus on the best way to explain short-run fluctuations in the economy.[4]

The new synthesis took elements from both schools. New classical economics contributed the methodology behind real business cycle theory[5] and new Keynesian economics contributed nominal rigidities (slow moving and periodic, rather than continuous, price changes also called sticky prices).[6] The new synthesis provides the theoretical foundation for much of contemporary mainstream economics

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