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CHAPTER 12 NEW CLASSICAL. RATIONAL EXPECTATIONS. Keynesian economics by John Maynard Keynes (1883-1946) believe that the macro-economy tends towards extended business cycles, with high levels of unemployed factors

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chapter 12 new classical



classical vs keynesian http www economyprofessor com

Keynesian economics

  • by John Maynard Keynes (1883-1946)
  • believe that the macro-economy tends towards extended business cycles, with high levels of unemployed factors
  • high unemployment can be solved through government management or stimulation of the economy in influencing demand (through monetary or fiscal policy)
  • monetary and fiscal policies thus stimulate the economy in times of slump by generating employment, and slow the economy down in times of inflation.
  • classical macroeconomic model (18th-19th century)
  • first developed by French economist Jean-Baptiste Say (1767-1832)
  • assumes factor and product price flexibility to reach full employment equilibrium
  • the absence of regulations which prevent the market adjustment of demand and supply

Classical vs Keynesian

new classical http www economyprofessor com

new classical macroeconomics (1970s)

  • by American economists Robert Lucas (1937- ) and THOMAS SARGENT (1943- ), and British economists PATRICK MINFORD (1943- ) and MICHAEL BEENSTOCK (1946- ).
  • the economy will settle at a natural rate of unemployment and attempts to alter this equilibrium state will be counteracted by economic agents.
  • 3 main facets to the new classical macroceconomics:
  • (1) the real economic decisions of agents (i.e. saving, consumption, or investment) are based on real not nominal or monetary factors;(2) agents are held to be continuously in equilibrium;(3) agents hold on to their rational expectations.
  • The rational expectations theory and the NAIRU (non-accelerating inflation rate of unemployment) are important propositions.

New Classical

ineffectiveness proposition

New Classical Policy Ineffectiveness Proposition:

  • “systematic monetary and fiscal policy actions that change aggregate demand will not affect output and employment even in the short run”
  • Wikipedia:
  • “The Policy Ineffectiveness Proposition (PIP) is a new classical theory proposed in 1976 by Thomas J. Sargent and Neil Wallace based upon the theory of rational expectations. It demonstrated that governments are powerless in the management of output and employment in an economy.”

Ineffectiveness Proposition

keynesian expansionary policy
Keynesian Expansionary Policy

SRun Goods market: Ms ↑, aggregate demand ↑, Y* ↑, P*↑.

Labor market: labor demand ↑, wage↑.

LRun Labor market: expected real wage (W/Pe)↓, labor supply ↓

Goods market: aggregate supply ↓, Y* ↓, P* ↑

keynesian vs new classical

Keynesian: backward-looking

- assumes labor supply is slow to adjust to price changes

- only reacts in the long-run based on affected new price

New classical: forward-looking

- rational expectation: understanding the relationship between variables

- labor supply make predictions based on available information = anticipated changes in M, G, T, I, …

Keynesian vs New Classical

new classical expansionary policy


  • policy changes are fully anticipated
  • labor supply and aggregate supply not fixed in SR
  • Ls and AS adjusts equilibrium back to Y0

New Classical Expansionary Policy

new classical monetary surprise


  • unanticipated increase in money supply
  • labor demand shifts to Nd(P’1)
  • may affect output and employment = Keynesian

New Classical Monetary Surprise

new classical change in investment

Autonomous change in investment = aggregate demand ↓, Y* ↓, P* ↓ If unanticipated, then Nd (P0)  Nd (P’) = P1, Y1

If anticipated, then Nd (P1) + Ns (Ie1) = P0, Y0.

(Based on rational expectation, autonomous changes in investment is unanticipated. If low I is expected to continue, then the supply side will also adjust to restore equilibrium.)

New Classical: Change in Investment

anticipated vs unanticipated

Anticipated policy changes

- will not affect output and unemployment

- even in the short-run, labor supply and aggregate supply adjusts quickly to expected price changes

- i.e. expansionary policy shifts aggregate demand and labor demand  followed by counter-shifts by labor supply and aggregate supply

Unanticipated policy changes

- may affect output and unemployment

- labor supply and aggregate supply fail to adjust to price changes especially in the short-run

- only aggregate demand and labor demand shifts - results in disequilibrium

Anticipated vs Unanticipated

new classical policy conclusion

Output and employment are not affected by anticipated changes in aggregate demand, even in the short-run

  • Stabilization policy is not effective due to rational expectations
  • Monetary policy that targets money supply or inflation will reduce unanticipated changes in money supply resulting in price forecast errors.
  • Fiscal policy that stimulates inflation causes uncertainty, makes rational expectations difficult.
  • Government should control budget deficit for non-inflationary monetary policy to work effectively.

New Classical Policy Conclusion