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New classical macroeconomics is a school of thought inmacroeconomics based on aneoclassical framework. It emphasizes the importance of foundations based onmicroeconomics, especiallyrational expectations.
New classical macroeconomics uses neoclassical microeconomic foundations for macroeconomic analysis. This is in contrast with thenew Keynesian school that usesmicrofoundations, such asprice stickiness andimperfect competition, to generate macroeconomic models similar to earlier, Keynesian ones.[1]
Classical economics is the term used for the first modern school of economics. The publication ofAdam Smith'sThe Wealth of Nations in 1776 is considered to be the birth of the school. 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 "marginal revolution" that occurred in Europe in the late 19th century, led byCarl Menger,William Stanley Jevons, andLéon Walras, gave rise to what is known asneoclassical economics. This neoclassical formulation had also been formalized byAlfred Marshall. However, it was thegeneral equilibrium of Walras which made economic science a mathematical and deductive endeavor, the essence of which is still neoclassical.
The neoclassical school was the main school in the field, until theGreat Depression of the 1930s. Then, with the publication ofThe General Theory of Employment, Interest and Money byJohn Maynard Keynes in 1936,[2] certain neoclassical assumptions were rejected. Keynes proposed an aggregated framework to explain macroeconomic behavior, leading to the current distinction between micro- andmacroeconomics. 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 PresidentRichard Nixon and economistMilton Friedman: "We are all Keynesians now".
Criticism for the Keynesian theories arose during the1973–75 recession, which was largely triggered by the1973 oil crisis. The nascent classical economists attributed the blame to Keynesian policy responses for the continuedunemployment, high inflation and stagnant economic growth—stagflation. Conversely, Keynesians using thePhillips curve orcost-push inflation models struggled to provide explanations of stagflation and its different magnitudes across different countries, such as higher inflation in the United States and the United Kingdom than in Germany and Japan.
The New Classical school emerged in the 1970s as a response to what were perceived as failures of Keynesian economics to explain stagflation. New Classical and monetarist criticisms led byRobert Lucas, Jr. andMilton Friedman respectively forced a labored rethinking of Keynesian economics. In particular, Lucas designed theLucas critique primarily as a means to cast doubt on the Keynesian model. This strengthened the case for macro models to be based on microeconomics.
Prior to the late 1990s, macroeconomics was split between new Keynesian work on market imperfections demonstrated with small models and new classical work onreal business cycle theory that used fully specifiedgeneral equilibrium models and usedchanges in technology to explain fluctuations in economic output.[3] The new neoclassical synthesis developed as a consensus on the best way to explainshort-run fluctuations in the economy.[4][5]
The new synthesis took elements from both schools. New classical economics contributed the methodology behind real business cycle theory[6] and new Keynesian economics contributed nominal rigidities (slow moving and periodic, rather than continuous, price changes also calledsticky prices).[7] The new synthesis provides the theoretical foundation for much of contemporary mainstream economics.[8][7][5]
The new classical perspective takes root in three diagnostic sources of fluctuations in growth: the productivity wedge, the capital wedge, and the labor wedge. Through the neoclassical perspective and business cycle accounting one can look at the diagnostics and find the main 'culprits' for fluctuations in the real economy.
New classical economics is based onWalrasian assumptions. All agents are assumed to maximizeutility on the basis ofrational expectations. At any one time, the economy is assumed to have a uniqueequilibrium atfull employment orpotential output achieved through price and wage adjustment. In other words, themarket clears at all times.
New classical economics has also pioneered the use ofrepresentative agent models. Such models have received severe neoclassical criticism, pointing to the disjuncture between microeconomic behavior and macroeconomic results, as indicated byAlan Kirman.[9]
The concept ofrational expectations was originally used byJohn Muth,[10] and was popularized by Lucas.[11] One of the most famous new classical models is thereal business cycle model, developed byEdward C. Prescott andFinn E. Kydland.
New classical models had low explanatory and predictive power. The models could not simultaneously explain both the duration and magnitude of actual cycles. Additionally, the model's key result that only unexpected changes in money can affect the business cycle and unemployment did not stand empirical tests.[12][13][14][15][16]
The mainstream turned to thenew neoclassical synthesis.[8][17][5] Most economists, even most new classical economists, accepted thenew Keynesian notion that for several reasons wages and prices do not move quickly and smoothly to the values needed forlong-run equilibrium between quantities supplied and demanded. Therefore, they also accept themonetarist and new Keynesian view that monetary policy can have a considerable effect in theshort run.[18] The new classical macroeconomics contributed therational expectations hypothesis and the idea ofintertemporal optimisation to new Keynesian economics and the new neoclassical synthesis.[12]
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