New classical macroeconomics
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.
New classical macroeconomics strives to provide neoclassical microeconomic foundations for macroeconomic analysis. This is in contrast with its rival new Keynesian school that uses microfoundations such as price stickiness and imperfect competition to generate macroeconomic models similar to earlier, Keynesian ones.
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 economic activity.
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. Then, however, with the publication of The General Theory of Employment, Interest and Money by John Maynard Keynes in 1936, 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 ex-President Richard Nixon and economist Milton Friedman: "We are all Keynesians now".
Problems arose in the 1970s and early 1980s when stagflation occurred. Stagflation occurs when unemployment and inflation are both high at the same time. The decade of the 1970s saw rising oil prices caused by an OPEC oil embargo on the United States. This oil embargo caused both high inflation and steep economic downturn that in turned caused high unemployment. 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 Keynesian model. This strengthened the case for macro models to be based on microeconomics.
Meanwhile, Friedman before the stagflation proposed that the Phillips curve did not exist and would fail. He theorized of an existence of a natural rate of unemployment that contradicts the then accepted relationship between inflation and unemployment rate. The stagflation of the 1970s seemed to proved him right.
After the 1970s and the apparent failure of Keynesian economics, the New Classical school became the dominant school in Macroeconomics. This was captured by the fact that the new concepts and ideas which emerged from New Classical economics such as rational expectations were accepted by the opposing new Keynesian school except for the fact that the latter still maintained the effectiveness of fiscal and monetary policy. Both the New Classical and the New Keynesian schools now form the basis of mainstream macroeconomics.
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.
- A productivity/efficiency wedge is a simple measure of aggregate production efficiency. In relation to the Great Depression, a productivity wedge means the economy is less productive given the capital and labor resources available in the economy.
- A capital wedge is a gap between the intertemporal marginal rate of substitution in consumption and the marginal product of capital. In this wedge, there’s a “deadweight” loss that affects capital accumulation and savings decisions acting as a distortionary capital (savings) tax.
- A Labor wedge is the ratio between the marginal rate of substitution of consumption for leisure and the marginal product of labor and acts as a distortionary labor tax, making hiring workers less profitable (i.e. labor market frictions).
Foundation and assumptions
New classical economics is based on Walrasian assumptions. All agents are assumed to maximize utility on the basis of rational expectations. At any one time, the economy is assumed to have a unique equilibrium at full employment or potential output achieved through price and wage adjustment. In other words, the market clears at all times.
New classical economics has also pioneered the use of representative agent models. Such models have recently received severe neoclassical criticism, pointing to the disjuncture between microeconomic behavior and macroeconomic results, as indicated by Kirman (1992), and the fallacy of composition. In some ways, this critique is akin to the Cambridge capital controversy.
The concept of rational expectations was originally used by John Muth, and was popularized by Lucas. One of the most famous new classical models is the real business cycle model, developed by Edward C. Prescott and Finn E. Kydland.
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