New Classical Economics
New classical economics is a school of macroeconomic thought that emerged in the 1970s and 1980s, emphasising market clearing, rational expectations, and microfoundations. It challenged the Keynesian consensus and reshaped the analysis of macroeconomic policy.
Core Principles
New classical economics holds that markets clear, so that prices and wages adjust to equate supply and demand, and that fluctuations in output and employment reflect real shocks and the choices of optimising agents rather than failures of demand. It emphasises that macroeconomic models should be built on microfoundations, deriving aggregate behaviour from the decisions of individual households and firms.
Rational expectations, the assumption that agents use all available information and understand the structure of the economy, is a central element. Under rational expectations, systematic policy cannot fool agents, and only unanticipated policy changes have real effects.
Policy Ineffectiveness
The policy ineffectiveness proposition, associated with Thomas Sargent and Neil Wallace, holds that anticipated changes in monetary policy have no effect on real output, because agents adjust prices and wages in anticipation. Only unanticipated changes have real effects, and these are, by construction, random.
The proposition implies that systematic demand management cannot stabilise the economy and that the principal contribution of monetary policy is to maintain a predictable environment. It also implies that the credibility of policy is crucial, since agents form expectations based on their beliefs about policy.
Real Business Cycle Theory
Real business cycle theory extends new classical analysis to explain fluctuations as the efficient response of the economy to real shocks, particularly shocks to technology. In these models, recessions are periods of low productivity, and the resulting reduction in output and employment reflects the optimal response of agents to changed conditions.
The theory implies that fluctuations are not failures of the market but efficient outcomes, and that policy intervention is generally unwarranted. It has been criticised for the implausibility of the shocks required to generate observed fluctuations and for the difficulty of reconciling its predictions with the data.
Legacy and Criticisms
New classical economics transformed macroeconomics by insisting on microfoundations and by highlighting the role of expectations and credibility. Its emphasis on rules, on the credibility of central banks, and on the importance of structural reform has influenced policy.
Criticisms include the assumption of market clearing, which is difficult to reconcile with persistent unemployment, and the treatment of expectations, which may be rational in some contexts but not in others. The synthesis of new classical and New Keynesian elements in modern dynamic stochastic general equilibrium models reflects the lasting influence of the new classical challenge.
Equilibrium Business Cycle Analysis
New classical economics analyses fluctuations as equilibrium phenomena, in which output and employment reflect the choices of optimising agents rather than failures of demand. In these models, changes in output arise from changes in productivity, in preferences, or in the constraints that agents face, and markets clear continuously.
This approach contrasts with Keynesian analysis, in which fluctuations reflect changes in aggregate demand and the failure of prices to clear markets. The difference has implications for policy, since equilibrium analysis implies that fluctuations may be efficient and that intervention is generally unwarranted.
Expectations and Credibility
The emphasis on rational expectations and credibility has transformed the analysis of monetary policy. If agents form expectations based on their understanding of policy, then the credibility of the central bank matters, and announcements can affect outcomes even before policies are implemented. This has motivated the development of frameworks that enhance credibility, including central bank independence and inflation targeting.
The analysis also implies that the management of expectations is a central element of policy. Forward guidance, in which the central bank communicates its intentions about future policy, relies on the effects of expectations on current conditions. The effectiveness of such communication depends on its credibility and on the public's understanding of the policy framework.
Criticisms and Developments
Criticisms of new classical economics include the assumption of market clearing, which is difficult to reconcile with the persistence of unemployment, and the difficulty of explaining observed fluctuations with plausible shocks. The empirical performance of some new classical models has been questioned, particularly their ability to match the dynamics of output and employment.
In response, macroeconomics has developed models that combine elements of new classical and New Keynesian analysis, incorporating nominal rigidities and imperfect competition alongside rational expectations and microfoundations. These models, used widely in central banks and policy institutions, represent a synthesis that retains key insights from both traditions.
Policy Legacy
The legacy of new classical economics includes the emphasis on microfoundations, the importance of expectations and credibility, and the recognition of the limits of discretionary policy. These insights have influenced the design of monetary institutions and the conduct of policy, even among economists who do not accept the more extreme conclusions of the school.
The school also contributed to the analysis of policy rules, of the time inconsistency of policy, and of the benefits of commitment. These ideas inform the design of fiscal and monetary frameworks and the assessment of institutional arrangements.