New classical macroeconomics

New classical macroeconomics

Overview
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

 that builds its analysis entirely on a neoclassical
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...

 framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

. Macroeconomic model is built in analogy to the actions of individual agents, whose behavior is modeled in microeconomics.

New classical macroeconomics strives to provide neoclassical microeconomic foundations for macroeconomic analysis.
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Encyclopedia
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

 that builds its analysis entirely on a neoclassical
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...

 framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

. Macroeconomic model is built in analogy to the actions of individual agents, whose behavior is modeled in microeconomics.

New classical macroeconomics strives to provide neoclassical microeconomic foundations for macroeconomic analysis. This is in contrast with its rival new Keynesian
New Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...

 school that uses microfoundations
Microfoundations
In economics, the term microfoundations refers to the microeconomic analysis of the behavior of individual agents such as households or firms that underpins a macroeconomic theory....

 such as price stickiness
Sticky (economics)
Sticky, in the social sciences and particularly economics, describes a situation in which a variable is resistant to change. Sticky prices are an important part of macroeconomic theory since they may be used to explain why markets might not reach equilibrium right away. Nominal wages are often said...

 and imperfect competition
Imperfect competition
In economic theory, imperfect competition is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied...

 to generate macroeconomic models similar to earlier, Keynesian ones.

History


Classical economics is the term used for the first modern school of economics. The publication of Adam Smith
Adam Smith
Adam Smith was a Scottish social philosopher and a pioneer of political economy. One of the key figures of the Scottish Enlightenment, Smith is the author of The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations...

'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
Marginal Revolution
Marginal Revolution is a blog focused on economics run by economists Tyler Cowen and Alex Tabarrok, both of whom teach at George Mason University. The blog's slogan is "Small steps toward a much better world." The site is updated daily and focuses on current events and newly released reports or books...

 that occurred in Europe, led by Carl Menger
Carl Menger
Carl Menger was the founder of the Austrian School of economics, famous for contributing to the development of the theory of marginal utility, which contested the cost-of-production theories of value, developed by the classical economists such as Adam Smith and David Ricardo.- Biography :Menger...

, William Stanley Jevons
William Stanley Jevons
William Stanley Jevons was a British economist and logician.Irving Fisher described his book The Theory of Political Economy as beginning the mathematical method in economics. It made the case that economics as a science concerned with quantities is necessarily mathematical...

, and Leon Walras
Léon Walras
Marie-Esprit-Léon Walras was a French mathematical economist associated with the creation of the general equilibrium theory.-Life and career:...

, gave rise to what is known as the neo-classical synthesis. This neo-classical formulation had also been formalized by Alfred Marshall
Alfred Marshall
Alfred Marshall was an Englishman and one of the most influential economists of his time. His book, Principles of Economics , was the dominant economic textbook in England for many years...

. However, it was the general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...

 of Walras that helped solidify the research in economic science as a mathematical and deductive enterprise, the essence of which is still neo-classical and makes up what is currently found in mainstream economics textbooks to this day.

The neo-classical school dominated the field up until the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

. Then, however, with the publication of The General Theory of Employment, Interest and Money by John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

 in 1936, certain neo-classical assumptions were rejected. Keynes proposed an aggregated framework to explain macroeconomic behavior, leading thus to the current distinction between micro- and macroeconomics
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

. 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
Richard Nixon
Richard Milhous Nixon was the 37th President of the United States, serving from 1969 to 1974. The only president to resign the office, Nixon had previously served as a US representative and senator from California and as the 36th Vice President of the United States from 1953 to 1961 under...

 and economist Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

: "We are all Keynesians now
We are all Keynesians now
"We are all Keynesians now" is a now-famous phrase coined by Milton Friedman and attributed to U.S. president Richard Nixon. It is popularly associated with the reluctant embrace in a time of financial crisis of Keynesian economics by individuals such as Nixon who had formerly favored monetarist...

".

Problems arose in the 1970s and the 1980s when stagflation occurred. The decade saw rising oil prices caused by OPEC embargo on the United States. This caused both high inflation and steep economic downturn that in turned caused unemployment. Keynesians were puzzled by the outbreak of stagflation because the original Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

 ruled it out.

The new classical school emerged in the 1970s as a response to the failure of Keynesian economics to explain stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...

. New classical and monetarist criticisms led by Robert Lucas, Jr.
Robert Lucas, Jr.
Robert Emerson Lucas, Jr. is an American economist at the University of Chicago. He received the Nobel Prize in Economics in 1995 and is consistently indexed among the top 10 economists in the Research Papers in Economics rankings. He is married to economist Nancy Stokey.He received his B.A. in...

 and Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

 respectively forced the rethinking of Keynesian economics. In particular, Lucas made the Lucas critique
Lucas critique
The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.The basic idea...

 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
NAIRU
In monetarist economics, particularly the work of Milton Friedman, on which also worked Lucas Papademos and Franco Modigliani in 1975,NAIRU is an acronym for Non-Accelerating Inflation Rate of Unemployment, and refers to a level of unemployment below which inflation rises.It is widely used in...

 that contradicts the then accepted relationship between inflation and unemployment rate. The stagflation of the 1970s proved him right.

After the 1970's 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
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...

 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.

Foundation and assumptions


New classical economics is based on Walrasian assumptions
Walras' law
Walras’ Law is a principle in general equilibrium theory asserting that when considering any particular market, if all other markets in an economy are in equilibrium, then that specific market must also be in equilibrium. Walras’ Law hinges on the mathematical notion that excess market demands ...

. All agents are assumed to maximize utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....

 on the basis of rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...

. At any one time, the economy is assumed to have a unique equilibrium
Economic equilibrium
In economics, economic equilibrium is a state of the world where economic forces are balanced and in the absence of external influences the values of economic variables will not change. It is the point at which quantity demanded and quantity supplied are equal...

 at full employment
Full employment
In macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so....

 or potential output
Potential output
In economics, potential output refers to the highest level of real Gross Domestic Product output that can be sustained over the long term. The existence of a limit is due to natural and institutional constraints...

 achieved through price and wage adjustment. In other words, the market clears
Market clearing
In economics, market clearing refers to either# a simplifying assumption made by the new classical school that markets always go to where the quantity supplied equals the quantity demanded; or# the process of getting there via price adjustment....

 at all times.

New classical economics has also pioneered the use of representative agent
Representative agent
Economists use the term representative agent to refer to the typical decision-maker of a certain type ....

 models. Such models have recently received severe neoclassical criticism, pointing to the clear disjuncture between microeconomic behavior and macroeconomic results, as indicated by Kirman (1992), and the fallacy of composition
Fallacy of composition
The fallacy of composition arises when one infers that something is true of the whole from the fact that it is true of some part of the whole...

. In some ways, this critique is akin to the Cambridge capital controversy
Cambridge capital controversy
The Cambridge capital controversy – sometimes simply called "the capital controversy" – refers to a theoretical and mathematical debate during the 1960s among economists concerning the nature and role of capital goods and the critique of the dominant neoclassical vision of aggregate...

.

The concept of rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...

 was originally used by John Muth
John Muth
-Legacy:It has hard to point to one substantial area of economic research into dynamic problems which has not changed as a result of the publication of Muth's works at GSIA. Almost paradoxically, the only viable alternative to Muth's hypothesis is the research agenda put forward by Herb Simon and...

, and was popularized by Lucas. One of the most famous new classical models is the real business cycle model, developed by Edward C. Prescott
Edward C. Prescott
Edward Christian Prescott is an American economist. He received the Nobel Memorial Prize in Economics in 2004, sharing the award with Finn E. Kydland, "for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles"...

 and Finn E. Kydland
Finn E. Kydland
Finn Erling Kydland is a Norwegian economist. He is currently the Henley Professor of Economics at the University of California, Santa Barbara. He also holds the Richard P...

.

External links