The New Classical Economics FROYEN CHAPTER 11

Transcription

1 ECON 313: MACROECONOMICS I W/C 9 th November 2015 MACROECONOMIC THEORY AFTER KEYNES New Classical Economics Ebo Turkson, PhD The New Classical Economics FROYEN CHAPTER 11 1

2 Sections The New Classical Position Introduction : The Policy Ineffectiveness Proposition A Review of the Keynesian Position The Rational Expectations Concept and Its Implications New Classical Policy Conclusions The Keynesian Counter critique The Question of Persistence The Extreme Informational Assumption Auction Market Versus Views of the Labour Market Introduction This theoretical system was developed against the background of the high rates of inflation and unemployment of the 1970s. Keynesian economics had failed to predict high rates of inflation and unemployment because high rates of inflation was expected to coincide with low unemployment. Robert Lucas, the central figure under the New Classical economics was at the forefront of the dissatisfaction and scathing criticism of Keynesian economics New Classical Economist believed that the Keynesian structure is fundamentally flawed, internally inconsistent and not useful for understanding economic events. 2

3 The Policy Ineffectiveness Proposition The proposition asserts that systematic monetary and fiscal policy actions that change AD will not affect output and employment even in the short run. The central policy tenet of the new classical economics is that stabilisation of real variables such as output and employment cannot be achieved by aggregate demand management policies A Review of the Keynesian Position Keynes analysis of the relationship between AD, output and employment showed that demand management policies influence real output and employment. For instance the effect of an expansionary monetary policy in the short run Shifts AD to the right along an upward sloping AS curve leading to an increase in real output and price Increase in price simultaneously shifts the labour demand curve and with the labour SS given leads to an increase in employment needed to produce the increase in real output In all of this the AS and Labour SS curves were assumed to be fixed in the SR because they depended on P e which Keynes assumed depend primarily on past prices. 3

4 Output Market Expansionary Monetary Policy AS P 1 E 1 P 0 E 0 AD 1 AD 0 Y 0 Y 1 Y C Real GDP Labour Market Expansionary Monetary Policy NS (P e 0) W 1 W 0 MPN. P 1 MPN. P 0 N 0 N 1 Employment 4

5 A Review of the Keynesian Position The implication is that in the SR there is a trade-off between inflation and unemployment Higher growth in AD correspond to higher prices (higher rates of inflation) and higher output and employment (lower Unemployment) In the LR the expected price level converges with the actual price level This shifts the AS and labour SS curve to the left sending real output and employment back to initial equilibrium. Here both prices and money wages are left permanently higher as a result of the expansionary monetary policy Thus in the LR output and employment are unaffected (this was similar to what the monetarist believed in) Rational Expectations: Concept and Implications The new classicals do not agree with the Keynesian (and monetarists) analysis of demand management policies At the heart of their disagreement is the Keynesian and monetarist assumption concerning price expectations To the new classicals price expectations are not formed adaptively but rather rationally They criticise the adaptive expectations as naïve in the extreme. The NC ask why would rational economic agents form an expectation of the price level relying on only past values when systematically they find that the actual prices depend on current policy? 5

6 Rational Expectations: Concept and Implications Rather than being naïve, the NCs propose that economic agents will form rational expectations of the price level and therefore will not make systematic errors According to the rational expectations hypothesis; Expectations are formed on the basis of all available relevant information concerning the variable being predicted. Moreover economic agents are assumed to use the available information intelligently because they understand the relationship between the variables they observe and the variables they are trying to predict. Rational Expectations: Concept and Implications Thus labour will not only base their expectations on past values of the price level but also information about current policies that influence the price level If labour suppliers are forward-looking in their formation of P e, then the conclusion from the Keynesian and monetarist analysis wont suffice even in the SR. In all of this, what is important in forming the rational expectations is whether the policy changes are anticipated or unanticipated anticipated or unanticipated policy changes have different effects under rational expectations 6

7 Rational Expectations: Concept and Implications If we assume that the policy changes are anticipated what will be the conclusion when expectations are rational? Anticipated policy changes because the policy is announced or alternatively the public will anticipate the change because the policy maker is known to act in certain ways Recall under Keynesian economics that labour SS depends on the real wage which itself depends on P e, this is exactly what the NCs also assume It is what informs the P e that is the point of digression According to the NCs, P e depends on the expected levels of all the variables that determine the price level Rational Expectations: Concept and Implications These include Expected level of money supply (M e ) Expected level of Government Spending (G e ) Expected level of taxation (T e ) Expected level of autonomous Investment (I e ) And other variables Thus if the AS and labour SS depends on P e and as assumed under rational expectations P e depends on M e G e,t e, I e etc., then; AS=f(M e 0 G e 0,T e 0, I e 0 ) NS=f(M e 0 G e 0,T e 0, I e 0 ) 7

8 Rational Expectations: Concept and Implications So what will be the impact of an expansionary monetary policy under rational expectations? Under Keynesian M ( M P ) ESM EDB P B r (LM shifts downwards to left to LM 1 and AD shifts rightward) Y and P (since upward sloping AS is fixed) P (MPN.P) shifts Labour DD curve upwards W and N (employment) since the Labour SS remains fixed Thus M Y, P and N and W Rational Expectations: Concept and Implications Under New Classicals Rational Expectations (anticipated Policy Changes) M ( M P ) ESM EDB P B r (LM shifts downwards to left to LM 1 and AD shifts rightward) Y and P (MPN.P) shifts Labour DD curve upwards W and N (employment). Because rational expectations are being held AS and Labour SS are not fixed. Suppliers of labour will anticipate the inflationary impact of the M and so will revise their P e upwards left shift of the AS Y until output returns to initial Y and P further 8

9 Rational Expectations: Concept and Implications Under New Classicals Rational Expectations (anticipated Policy Changes) Revision of P e upwards will also shift NS to the left at the same time the higher P (MPN.P) shifts Labour DD curve upwards again until N returns to intial. Even in the SR M P and W but NO CHANGE in Y and N This far the New Classicals differ from the prediction of the Keynesians and monetarists. Output Market: RE and Anticipated Change Expansionary Monetary Policy AS(M e 1 G e 0,T e 0, I e 0 ) AS(M e 0 G e 0,T e 0, I e 0 ) P 2 E 2 P 1 E 1 P 0 E 0 M AD 1 AD 0 Y 0 Y 1 Real GDP 9

10 Labour Market RE and Anticipated Change Expansionary Monetary Policy NS(M e 1 G e 0,T e 0, I e 0 ) NS(M e 0 G e 0,T e 0, I e 0 ) W 2 E 2 W 1 E 1 W 0 E 0 N D 2= MPN. P 2 N D 1= MPN. P 1 N D 0= MPN. P 0 N 0 N 1 Employment Rational Expectations: Concept and Implications Under New Classicals Rational Expectations (unanticipated Policy Changes) M ( M P ) ESM EDB P B r (LM shifts downwards to left to LM 1 and AD shifts rightward) Y and P (MPN.P) shifts Labour DD curve upwards W and N (employment). although rational expectations are being held AS and Labour SS will not shift because the policy changes are not anticipated by suppliers of labour. Thus in the SR M Y, P and N and W This conclusion does not differ from Keynesians and monetarists 10

11 Output Market: RE and Unanticipated Change Expansionary Monetary Policy AS(M e 0 G e 0,T e 0, I e 0 ) P 1 E 1 P 0 E 0 M AD 1 AD 0 Y 0 Y 1 Real GDP Labour Market RE and Unanticipated Change Expansionary Monetary Policy NS(M e 0 G e 0,T e 0, I e 0 ) W 1 E 1 W 0 E 0 N D 1= MPN. P 1 N D 0= MPN. P 0 N 0 N 1 Employment 11

12 RE and Unanticipated Change The case of unanticipated policy changes shows a very important difference between the new classicals and the classical theory Under classical theory economic agents are assumed to have perfect information and that there are no monetary surprises therefore no policy change will have an impact on the supply determined real output level and employment Under the new classical theory, in the case of monetary surprises (i.e. unanticipated policy changes), although economic agents form rational expectations, they do not have prefect information and therefore aggregate demand policies could impact on real output level and employment. New Classicals Policy Conclusions In spite of their acceptance that unanticipated AD policy changes have an impact on output and employment, the NCs still object to the role of stabilisation policies For instance they argue that any stabilization policy to correct any imbalance is needless and at best desirable but not feasible. For instance suppose there is an autonomous decline in investment, should a stabilisation policy be pursued to get the economy on track? Keynes answer would be an emphatic Yes The new classicals NO if anticipated and desirable if unanticipated, but not feasible irrespective. 12

13 New Classicals Policy Conclusions Why NO if anticipated and desirable if unanticipated, but not feasible irrespective. I 0 AE Y (at initial Price level and AD shifts leftward) P (MPN.P) shifts Labour DD curve downwards W and N (employment). Whether this will subsequently trigger a reaction from labour suppliers or not will depend on whether the decline in autonomous Investment was anticipated or not. New Classicals Policy Conclusions If I 0 is anticipated I 0 AE Y (at initial Price level and AD shifts leftward) P (MPN.P) shifts Labour DD curve downwards W and N (employment). because labour supplier expects prices to fall and real wages increase they will supply more labour at the current money wage leading to a rightward shift in Labour SS NS curve shifts right AS curve shifts right P further down and Y back to initial equilibrium level. 13

14 New Classicals Policy Conclusions If I 0 is anticipated P further down(mpn.p) shifts Labour DD curve further downwards W and N back to initial level. I 0 P and W but NO CHANGE in Y and N Output Market: RE and Anticipated Change Decline in autonomous Investment AS 0 (M e 0 G e 0,T e 0, I e 0 ) AS 1 (M e 0 G e 0,T e 0, I e 1 ) P 0 E 0 P 1 E 1 P 2 E 2 I 0 AD 0 AD 1 Y 1 Y 0 Real GDP 14

15 Labour Market RE and Anticipated Change Decline in autonomous Investment NS NS 1 (M e 0 G e 0,T e 0, I e 0 (M e 1 ) 0 G e 0,T e 0, I e 0 ) W 0 E 0 W 1 E 1 W 2 E 2 N D 0= MPN. P 0 N D 1= MPN. P 1 N D 2= MPN. P 2 N 1 N 0 Employment New Classicals Policy Conclusions If I 0 is unanticipated I 0 AE Y (at initial Price level and AD shifts leftward) P (MPN.P) shifts Labour DD curve downwards W and N (employment). because labour suppliers do not expect prices to fall (because they did not anticipate I 0 ) Labour SS and AS will remain unchanged I 0 P and W as well as Y and N 15

16 Output Market: RE and Unanticipated Change Decline in autonomous Investment AS 0 (M e 0 G e 0,T e 0, I e 0 ) P 0 E 0 P 1 E 1 E 2 I 0 AD 0 AD 1 Y 1 Y 0 Real GDP Labour Market RE and Unanticipated Change Decline in autonomous Investment NS 0 (M e 0 G e 0,T e 0, I e 0 ) W 0 E 0 W 1 E 1 W 2 N D 0= MPN. P 0 N D 1= MPN. P 1 N D 2= MPN. P 2 N 1 N 0 Employment 16

17 New Classicals Policy Conclusions If I 0 is unanticipated The question is wont an offsetting policy action reverse this undesirable outcome. I 0 AE Y (at initial Price level and AD shifts leftward) P (MPN.P) shifts Labour DD curve downwards W and N (employment). I 0 P and W as well as Y and N For instance an expansionary monetary policy M AD shifts rightward back to origin Y and P back to initial (MPN.P) shifts Labour DD curve upwards back to initial W and N (employment) back to initial. New Classicals Policy Conclusions If I 0 is unanticipated The NC argue that an offsetting policy action is desirable only temporary. Why? because over time suppliers of labour will become aware of the I 0 especially if it persists and so will make adjustment in the next period to Labour SS and AS so that in the final analysis there will be no change in Y and N (as in the anticipated policy change case) Conclusion There is no useful role for AD policies aimed at stabilizing output and employment 17

18 Keynesian Counter Critique The Keynesian accept the criticisms of the new classical as valid especially concerning the adaptive expectations assumption They however point out that in spite of this weakness, Keynes analysis provided a basic useful framework in which to analyse the determinants of output and employment. They believe that activists policies to stabilise output and employment are very important and should not be ignored. They raise three major objections to the new classical analysis. Keynesian Counter Critique 1. The Question of Persistence 1. Why the persistent high unemployment rates in Gt. Britain between or during the Great depression in the US when unemployment was over 14% for 10 consecutive years. 2. Auction market versus Contractual Views of the Labour market 1. Perfectly flexible money wage and price assumption is unrealistic 2. Long term contracts make money wage rigid especially downwards 18

19 Keynesian Counter Critique 3. The Extreme Informational Assumptions of Rational Expectations Adaptive expectations during the 1950s to 60s and possibly rational expectations during post But even then assumption of sophisticated economic agents is unrealistic especially in the SR. Yes maybe they could be knowledgeable in the LR after going through a learning process New Classicals accept that the rational expectations assumption is unrealistic and indicate that so are all other theories because theories extremely simplify reality. 19