New Classical Macroeconomics

1. New Classical Macroeconomics Intermediate Macroeconomics ECON-305 Spring 2013 Professor Dalton Boise State University

2. New Classical Macroeconomics “Keynesian orthodoxy or the neoclassical synthesis is in deep trouble, the deepest kind of trouble in which an applied body of theory can find itself. It appears to be giving seriously wrong answers to the most basic questions of macroeconomic policy.” - Robert E. Lucas, Jr., “Tobin and Monetarism: A Review Article,” JEL (June 1981)

3. New Classical Macroeconomics • Evolved out of monetarist economics of 1970s • Major proponents • Robert E. Lucas, Jr. • Thomas Sargent • Robert Barro • Edward Prescott • Neil Wallace • Patrick Minford

4. New Classical Macroeconomics • Three Central Hypotheses • Rational Expectations Hypothesis • Continuous Market-Clearing Hypothesis • Aggregate Supply Hypothesis • Each can be judged in isolation • New Classicalists accept all three

5. Rational Expectations • Rational expectations hypothesis (at least in weak form) becomes a central modeling assumption of the dominant schools in the 1990s and this century • Real Business Cycle School • New Keynesian School • Rhetorical advantage of rational expectations

6. Continuous Market-Clearing All markets continuously clear in line with Walrasian view Agents and Firms are price-takers Observed outcomes result of optimal responses of agents to price perceptions New Classical Models are equilibrium models

7. Continuous Market-Clearing • New Classical equilibrium • Equilibrium means that agents have optimally responded to price signals based on existing demands and supplies • Demands and supplies are based on expectations • Lack of complete information can lead to expectational errors and equilibria that are not identical to the full-information equilibria

8. Continuous Market-Clearing • New Classical equilibrium • Prices always adjust to clear markets • “instantaneous price adjustment” • Does not imply that market-clearing prices are prices consistent with full-information equilibrium • Prices can clear markets but still be “wrong”

9. Continuous Market-Clearing • New Classical equilibrium • Implies that unemployment is always entirely voluntary Most critical and contentious of new classical hypotheses

10. Aggregate Supply • Two main approaches • Both share two orthodox micro assumptions • Workers’ and Firms’ decisions are maximizing or optimal • Supply decisions of workers and firms depend upon relative prices

11. Lucas-Rapping ASH Lucas, R.E., Jr., and Rapping, L., “Real Wages, Employment and Inflation,” Journal of Political Economy (Sept./Oct. 1969) Essence: during any period, workers must decide how much time to allocate between work and leisure.

12. Lucas-Rapping ASH • Workers have notion of “normal” average real wage. • Workers intertemporally substitute leisure over the course of their lifetimes. • When w > we, workers work more and take less leisure • When w < we, workers work less and take more leisure

13. Lucas-Rapping ASH Employment is always at the voluntary and optimal level. Changes in employment reflect the voluntary choices of labor due to changes in relative real wages over time.

14. Lucas ASH • Lucas, “Expectations and the Neutrality of Money,” Journal of Economic Theory (April 1972) • Lucas, “Some International Evidence on Output-Inflation Tradeoffs,” AER (June 1973) • Spirit: “Signal-Extraction Problem” • Problem of information set available to agents

15. Lucas ASH • “Signal-Extraction Problem” • Firms know current price of own output, but price level of other markets known only with lag. Agents must form expectations of prices elsewhere. • Firm problem: if Px increases, does that mean Dx has increased or AD has increased? • If Dx increased, then increase QSx • If AD increased, then no change in QSx

16. Lucas “Surprise” AS Function Both Aggregate Supply Hypotheses lead to notion that Y deviates from YN due to deviations of P from Pe(or deviations of dP from dPe) Y – YN = α (P – Pe) Y – YN = α (dP – dPe) If P > Pe(or P > Pe), then both workers and firms mistake nominal price changes as relative price changes

17. Equilibrium Business Cycle • Lucas saw himself as • Formally incorporating microeconomics into macroeconomic models • Taking up the business cycle research agenda of Hayek – “incorporating cyclical phenomena into system of equilibrium theory”

18. Equilibrium Business Cycle Central Thesis Unanticipated AD shocks (resulting mainly form unanticipated ∆Ms) cause agents to make erroneous (rational) expectations, that result in Y and L deviations from (long-run) full-information equilibrium levels. Errors are result of imperfect/incomplete information, so general price changes are mistaken for relative price changes.

19. New Classical v. Orthodox Monetarism • OM: Workers fooled by inflation, firms aren’t • Adaptive expectations mean workers can be continuously fooled • NC: Both workers and firms can be fooled by inflation • Rational expectations mean agents can only be fooled by surprises • Both: Once agents realize errors, Y and L return to long-run (or full-information) equilibrium

20. New Classical Business Cycle • In New Classical Approach, deviations from long-run equilibrium are due to random shocks which cause errors in price expectations. • Why are shocks necessarily random? • Ratex implies expectational errors are random. • Ratex and ASH imply Y and L fluctuate randomly around YN and LN.

21. New Classical Business Cycle • Unemployment and output deviate from natural levels due to: • Demand shocks • Supply shocks • Monetary surprise

22. New Classical Business Cycle • Further assumptions required to explain persistence of deviations of Y and L from trend values during business cycles. • Lagged output and durability of capital goods. • Labor contracts inhibiting immediate adjustment. • Adjustment costs.

23. Policy Implications Policy Ineffectiveness Proposition Output-Employment Costs of Reducing Inflation Dynamic Time Inconsistency, Credibility and Monetary Rules Central Bank Independence Role of Micro Policies to Increase AS The “Lucas Critique” of Econometric Policy Evaluation

24. Policy Ineffectiveness “Monetary authorities are unable to influence output and employment, even in the short-run, by pursuing systematic monetary policy.”

25. Policy Ineffectiveness Agents form rational expectations. If monetary authorities are following a systematic policy, agents will come to know the policy and its effects. Agents will on average correctly anticipate the actions and effects of monetary policy. Deviations from full employment output are result of surprise. Therefore, systematic policy can not affect output and employment.

26. Policy Ineffectiveness LRAS P SRAS1 SRAS0 P2 P1 P0 AD1 AD0 YN Y* Y Expansionary monetary policy shifts AD to right. If unexpected, workers and firms act as if increase in P is increase in relative prices and output increase beyond YN to Y*. As agents realize their mistakes, output returns to YN as prices adjust to full-information levels.

27. Policy Ineffectiveness LRAS P SRAS1 SRAS0 P2 P0 AD1 AD0 YN Y Expansionary monetary policy shifts AD to right. If unexpected, workers and firms act as if increase in P is increase in relative prices and output increase beyond YN to Y*. As agents realize their mistakes, output returns to YN as prices adjust to full-information levels. If policy is expected, agents realize prices will rise to full-information level, P2, and therefore no real changes occur.

28. Corollary “Attempts to affect output and employment by random monetary policy only increases the variation of output and employment around the natural levels.”

29. Policy Ineffectiveness • Empirical Tests • Early work of Barro supportive of New Classical Theory and the policy ineffectiveness proposition • Subsequent studies by Mishkin and Gordon find counter evidence

30. Output-Employment Costs of Reducing Inflation Sacrifice ratio = amount of lost output per percentage point reduction in inflation Orthodox Keynesians: sacrifice ratio large owing to sluggish response of prices and wages to reduced AD

31. Output-Employment Costs of Reducing Inflation • Orthodox Monetarists: sacrifice ratio dependent upon (1) degree of monetary contraction (2) extent of institutional adaptations (3) rate of expectations adjustment • Rate of expectations adjustment depends upon credibility of monetary authority

32. Output-Employment Costs of Reducing Inflation New Classical: an announced credible monetary contraction leads to immediate reduction of inflationary expectations and sacrifice ratio is 0! Only monetary surprises have effect on real output and employment.

33. Monetary Growth Rules • Friedman’s Case for Monetary Growth Rule • Informational constraints facing policymakers • Lag and forecasting problems • Uncertainty of size of fiscal and monetary multipliers • Accelerationist hypothesis • Distrust of political process

34. Dynamic Time Inconsistency Kydland and Prescott, “Rules Rather than Discretion: The Inconsistency of Optimal Plans,” Journal of Political Economy (June 1977) • Rigorous New Classical model where policymakers are engaged in strategic dynamic game with rational private sector agents

35. Dynamic Time Inconsistency • Time-inconsistency: the divergence between ex ante and ex post optimality of government fiscal/monetary policy Time-inconsistency weakens credibility of announced policies; Time-inconsistency leads to an inflationary-bias in discretionary policy

36. Dynamic Time Inconsistency The Model Policymakers (1) specify targets (2) identify SWF w/ targets as arguments (3) choose policy s.t. SWF is maximized Private Agents Anticipate and adjust to policy Social Welfare Function St = f(Ut, dPt) with SRPC constraint

37. Dynamic Time Inconsistency dPt C A 0 Ut dPe = c dPe = 0 UN A time-consistent policy is one that maximizes S s.t. constraint and is consistent with agent full-information adjustment Points on vertical axis (LRPC) are potential equilibria C is a time-consistent equilibria A is a time-inconsisentequilibria (why?)

38. Dynamic Time Inconsistency dPt C A 0 Ut dPe = c dPe = 0 UN Suppose at C (inferior or sub-optimal) Why? Reduction of monetary growth from dM=C to dM = 0 will move economy directly to 0 if credible Once at 0, superior position can be achieved through inflationary surprise to move to A But such a policy is time-inconsistent (why?)

39. Dynamic Time Inconsistency Policy Implications If monetary authorities have discretionary powers, they have an incentive to cheat Since agents know this, announced policies that are time-inconsistent are not credible Discretionary policy produces sub-optimal outcomes with an inflationary bias

40. Central Bank Independence • If time-inconsistency argument is accepted, some constraint to discretion must be found • Does central bank independence provide this? • Empirical evidence • greater independence reduces average inflation rate while having no effect on real performance • Counterarguments • Free banking and history of Fed • Macroeconomic coordination

41. Micro Policies and AS • Unemployment is equilibrium outcome of optimal decisions • Appropriate policy to reduce unemployment is to increase incentives for employment • Examples?

42. The “Lucas Critique” Lucas, “Econometric Policy Evaluation: A Critique,” in Brunner and Meltzer, ed., The Phillips Curve and Labor Markets (1976) Attacks practice of using large scale macro models to evaluate consequences of alternative policy scenarios

43. The “Lucas Critique” • Such models are based on assumption coefficients don’t change with change in policy • Economic agents will adjust behavior to new policy • Empirics • Models under-predicted dP in late 1960s and early 1970s • Direct tests: no strong support

44. Whose Critique? “There is first of all the central question of methodology, - the logic of applying the method of multiple correlation to unanalysed economic material, which we know to be non-homogeneous through time. If we were dealing with the action of numerically measurable, independent forces, adequately analysed so that we were dealing with independent atomic factors and between them completely comprehensive, acting with fluctuating relative strength on material constant and homogeneous through time, we might be able to use the method of multiple correlation with some confidence for disentangling the laws of their action… In fact we know that every one of these conditions is far from being satisfied by the economic material under investigation… ” - Keynes, “Professor Tinbergen’s Method,” Economic Journal (1937)

45. Distinguishing Beliefs (1) Economy inherently stable and erratic monetary growth is primary source of instability (2) No long-run tradeoff between inflation and unemployment; no short-run tradeoff from systematic monetary policy

46. Distinguishing Beliefs (3) Credibility of monetary authority primary determinant of fluctuations in output and employment (4) Discretionary monetary policy has time-inconsistent inflationary bias; rules are preferable (5) Fiscal policy has no effect on the economy, except to alter the natural levels of output and employment

47. Evaluation: Weaknesses New Classical macroeconomics argues that the Business Cycle is ultimately caused by information gaps Given low cost availability of price and monetary data, magnitude and duration of actual business cycles seem too big to reconcile Empirics cast doubt that only unanticipated changes in monetary policy have real output effects

48. Evaluation: Lasting Impacts (1) Attention to modeling expectations (2) Focus on building macro models upon microeconomic foundations (3) Understanding that policy less robust than intimated by macroeconometric models