How does the new classical macroeconomic model differ from the
standard, pre-Lucas AS-AD model?
What does the new classical macroeconomic model suggest
regarding the efficacy of activist monetary policy? Why?
Rational expectations is an economic theory that postulates that
market participants input all available relevant information into
the best forecasting model available to them. Although individual
forecasts can be very wide of the mark, actual economic outcomes do
not vary in a predictable way from participants’ aggregate
predictions or expectations. Perhaps Abraham Lincoln summed it up
best when he asserted that “you can fool some of the people all of
the time, and all of the people some of the time, but you cannot
fool all of the people all of the time.”www.econlib.org/library/Enc/RationalExpectations.html
That might sound like a trite insight, but the theory of
rational expectations has important implications for monetary
policy. In a quest to understand why policymakers had such a poor
record, especially during the 1970s, Len Mirman (University of
Virginia),www.virginia.edu/economics/mirman.htm Robert Lucas
(University of Chicago),home.uchicago.edu/~sogrodow Thomas
Sargent (New York University),homepages.nyu.edu/~ts43
Bennett McCallum
(Carnegie-Mellon),public.tepper.cmu.edu/facultydirectory/FacultyDirectoryProfile.aspx?ID=96
Edward Prescott (Arizona
State),www.minneapolisfed.org/research/prescott and other
economists of the so-called expectations revolution discovered
that expansionary monetary policies cannot be effective if economic
agents expect them to be implemented. Conversely, to thwart
inflation as quickly and painlessly as possible, the central bank
must be able to make a credible commitment to stop it. In other
words, it must convince people that it can and will stop prices
from rising.
Stop and Think Box
During the American Revolution, the
Continental Congress announced that it would stop printing bills of
credit, the major form of money in the economy since 1775–1776,
when rebel governments (the Continental Congress and state
governments) began financing their little revolution by printing
money. The Continental Congress implemented no other policy
changes, so everyone knew that its large budget deficits would
continue. Prices continued upward. Why?
The Continental Congress did not make a
credible commitment to end inflation because its announcement did
nothing to end its large and chronic budget deficit. It also did
nothing to prevent the states from issuing more bills of
credit.
Lucas was among the first to highlight the importance of public
expectations in macroeconomic forecasting and policymaking. What
matters, he argued, was not what policymakers’ models said would
happen but what economic agents (people, firms, governments)
believed would occur. So in one instance, a rise in the fed funds
rate might cause long-term interest rates to barely budge, but in
another it might cause them to soar. In short, policymakers
can’t be certain of the effects of their policies before
implementing them.
Because Keynesian cross diagrams and the IS-LM and AS-AD models
did not explicitly take rational expectations into account, Lucas,
Sargent, and others had to recast them in what is generally called
the new classical macroeconomic model. That new model uses the
AS, ASL, and AD curves but reduces the short run of aggregate
demand shocks to zero if the policy is expected. So, for
example, an anticipated EMP shifts AD right but immediately shifts
AS left as workers spontaneously push for higher wages. The price
level rises, but output doesn’t budge. An unanticipated EMP, by
contrast, has the same effect as described in earlier chapters—a
temporary (but who knows how long?) increase in output(and a rise in P followed by another when the AS curve
eventually shifts left).
Now get this: Y* can actually decline if an EMP is not as
expansionary as expected! If economic actors expect a big
shift in AD, the AS curve will shift hard left to keep Y* at
Ynrl, as in Figure 26.1 . If the AD curve does not shift
as far right as expected, or indeed if it stays put, prices will
rise and output will fall, as in the following graph. This
helps to explain why financial markets sometimes react badly to
small decreases in the Fed’s fed funds target. They expected
more!
What this means for policymakers is that they have to know not
only how the economy works, which is difficult enough, they also
have to know the expectations of economic agents. Figuring out
what those expectations are is quite difficult because economic
agents are numerous and often have conflicting expectations, and
weighting them by their importance is super-duper-tough. And that
is at T1. At T2, nanoseconds from now, expectations
may be very different.
key takeaways
The new classical macroeconomic model takes the theory of
rational expectations into account, essentially driving the short
run to zero when economic actors successfully predict policy
implementation.
The new classical macroeconomic model draws the efficacy of EMP
or expansionary fiscal policy (EFP) into serious doubt because if
market participants anticipate it, the AS curve will immediately
shift left (workers will demand higher wages and suppliers will
demand higher prices in anticipation of inflation), keeping output
at Ynrl but moving prices significantly higher.
Stabilization (limiting fluctuations in Y*) is also difficult
because policymakers cannot know with certainty what the public’s
expectations are at every given moment.
The good news is that the model suggests that inflation can be
ended immediately without putting the economy into recession
(decreasing Y*) if policymakers (central bankers and those in
charge of the government’s budget) can credibly commit to
squelching it.
That is because workers and others will stop pushing the AS
curve to the left as soon as they believe that prices will stay
put.