new classical economics

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Chapter 22 Appendix

In the new classical model, all wages and prices are completely flexible withrespect to expected changes in the price level. The new classical model was devoped in the early to mid-1970s by Robert Lucas of the University of Chicago andThomas Sargent, formerly of the University of Minnesota but now at New YorkUniversity. 1 It departs from the aggregate demand and supply analysis we developedin Chapter 12 in two important ways.

1. The analysis is based on the assumption that expectations are rational, and thus issolidly based on microeconomic fundamentals.

2. Wages and prices are completely flexible with respect to changes in expectedinflation; that is, a rise in expected inflation results in an immediate and equal risein wage and price inflation because workers and firms try to keep their real wages

and relative prices from falling when they expect inflation to rise.

The New Classical Model

New Classical Phillips Curve and the Aggregate Supply CurveRecall our look at the Phillips curve in Chapter 11. The assumption that wages andprices are flexible with respect to expected inflation implies that the Phillips curve andhence the short-run aggregate supply curve have inflation rising one-for-one with risesin expected inflation. Therefore, we can write the new classical short-run aggregate sup-ply curve as follows:

p t = Et - 1p t + g (Y t - Y P)

1See Robert E. Lucas, “Expectations and the Neutrality of Money,” Journal of Economic Theory4 (April 1103–24; and Thomas Sargent and Neil Wallace, “Rational Expectations, the Optimal Monetary Instrument,and the Optimal Money Supply Rule,” Journal of Political Economy83:2 (April, 1975): 241–54.


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2 CHAPTER 22 APPENDIX

where,

The short-run aggregate supply curve based on Equation 1 is shown in Figure 22A1.1.This aggregate supply curve is similar to the one we derived in Chapter 11 because isthe same thing as expected inflation , but with one subtle difference: the short-runaggregate supply curve is fixed only for a particular value of expected inflation and willshift when expected inflation changes. To illustrate, suppose that in Figure 22A1.1expected inflation is initially at 1. The short-run aggregate supply curve for this level of expected inflation, AS1, passes through point 1 because at , Equation 1 shows that

actual inflation will be equal to 1. As shown in Figure 22A1.1, if , then inflationY

t 7 Y P

p

Y t = YP

p

p eEt - 1p t

tp = Inflation at time t, that is the change in the price level from periodt – 1 to t.

Et – 1 tp = Inflation from period t – 1 to t which is expected at time t – 1 usingrational expectations

Y t = aggregate output at time tY P = potential outputg = sensitivity of inflation to the output gap

InflationRate,

LRAS

1

2

AS 1 (Et – 1 t = 1 )

Aggregate Output, Y

Y P

AS 2 (Et – 1 t = 2 )

1

2

FIGURE 22A1.1Aggregate Supplyin the NewClassical ModelThe new classicalmodel has short-runaggregate supplycurves that are upwardsloping and specific toa particular expectedinflation rate, as AS1and AS2. AS1 is fixedfor E t – 1 t = 1 and thisis why it is marked as AS1(Et – 1 t = 1) and isdrawn to pass throughpoint 1, where at anactual inflation rate at

1, aggregate output isat potential ( Y = Y P)and so expected infla-tion is also at 1(Et – 1 t = 1). Similarly,

AS2 is fixed for E t – 1 t= 2 and is marked as AS1(Et – 1 t = 1): it isdrawn to pass throughpoint 2, where at anactual inflation rate at

2, aggregate output isat potential ( Y = Y P)and so expected infla-tion is also at 2(Et – 1 t = 2.).pp

p

p

pp

pp

pp

p

p

pp

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THE NEW CLASSICAL MODEL

2The classic references for the misperceptions theory are Milton Friedman, “The Role of Monetary Policy,” American Economic Review(March 1968): 1–17; and Robert E. Lucas, Jr., “Expectations and the Neutrality of Money,” Journal of Economic Theory(April 1972): 103–124.

increases along the AS curve by the amount , as the upward sloping short-runaggregate supply curve AS indicates. The short-run aggregate supply curve AS1 is tspecific to an expected inflation rate of 1 and is marked this way in Figure 22A1.1.

By the same reasoning, if expected inflation is instead at 2, then the short-ruaggregate supply curve will shift up and to the left to AS2, where it passes througpoint 2 because as Equation 1 shows, when , inflation in this case will be equalto 2. The short-run aggregate supply curve AS2 is thus specific to an expected inflatiorate of 2, and is marked this way in Figure 22A1.1. The short-run aggregate supplycurve in the new classical model thus will immediately shift from AS1 to ASexpected inflation rises from 1 to 2.

Misperceptions TheoryWe can think of the new classical model as a misperceptions theory because it resufrom misperceptions by firms that a general rise in inflation has resulted in higherrelative prices for the goods they sell, so that they supply more. 2 To illustrate, we c

rewrite the new classical short-run aggregate supply (Phillips) curve in Equation 1 by sub-tracting , from both sides of the equation, dividing by , and then puttingon the left-hand side. The transformed equation is then as follows:

Equation 2 indicates that only when actual inflation is higher than expected inflationwill aggregate output be greater than potential output.

The misperception story behind Equation 2 is as follows. Consider Isaac the icecream maker who has to figure out how much ice cream he should make. What youlearned in your principles of economics course is that Isaac will compare the price that

he gets for his ice cream with the prices of other goods and services he wants to buy. If the price of ice cream rises relative to the price of other goods and services Isaac wantsto buy, he is willing to work harder because he can exchange the ice cream for moregoods and services. If, on the other hand, the price of ice cream falls relative to othergoods and services, Isaac will want to take more time off and enjoy life because there isless of a payoff to producing ice cream. Therefore, a rise in the relative price of the goodhe produces will cause Isaac to increase production, while a fall in the relative price willlead him to reduce production.

To figure out what is happening to the relative price of the good he produces, Isaaccould try to find out what is happening to all the other prices of goods and services hewants to buy, but obviously this would take him too much time. Instead, when he sees

a rise in the price of ice cream he will estimate the relative price by asking himself howmuch the price of ice cream has risen relative to what he expects the general rise in price level will be, that is, his expectations of inflation. For example, if he sees the priceof ice cream rising by 3% this year, but his expectation of inflation is 2% (that is, heexpects prices in general to rise by 2%), then he will think that the relative price of icecream is rising and will produce more. If on the other hand, he expected inflation to be

Y t - YP = (p t - Et - 1p t)/ g

Y t -gEt - 1p t

pp

p

p

Y t = YP

p

p

g (Y t - Y P)


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4%, then the price of ice cream is rising less than prices in general and he will want tocut production.

If we extend this analysis to other producers besides Isaac, we come to the conclu-sion that when producers see the prices of the goods they produce rising faster thanwhat they expect inflation to be, overall production in the economy will rise, and if theysee prices rising by less than what they expect inflation to be, production will fall. This

reasoning tells us that when actual inflation is above expected inflation, firms are fooledinto thinking the relative price of the goods they are producing has risen and so outputin the economy will rise above what firms would produce if they had no mispercep-tions, which is just potential output Y P. On the other hand, if actual inflation is belowexpected inflation, firms will produce an amount of output that is less than potentialoutput. Misperceptions about how fast the general price level is rising then lead toEquation 2, which indicates that aggregate output exceeds potential output only whenthe realized inflation rate is higher than expected inflation.

Effects of Expansionary PolicyThe new classical model indicates that the effect of expansionary policy depends onwhether it is anticipated or unanticipated. First, let us look at the short-run response toan unanticipated (unexpected) expansionary policy coming from a rise in governmentspending or an autonomous easing of monetary policy by the Fed.

Unanticipated Expansionary PolicySuppose that the economy is initially at point 1 in Figure 22A1.2, in which actual andexpected inflation is at 1 so that the short-run aggregate supply curve is at AS1. The ini-tial aggregate demand curve intersects AS1 at point 1, where the realized inflation rate isequal to the expected inflation rate 1 and aggregate output is at potential at Y P. Because

point 1 is also on the long-run aggregate supply curve at Y P, there is no tendency for theaggregate supply curve to shift. The economy remains in long-run equilibrium.

Suppose the government or the Fed suddenly decides the unemployment rate is toohigh and so pursues expansionary policy that shifts the aggregate demand curve to theright to AD 2. If this expansionary policy is unexpected, the expected inflation rateremains at 1 and the short-run aggregate supply curve remains at AS1. Equilibrium isnow at point 2', the intersection of AD 2 and AS1. Aggregate output increases abovepotential output to Y 2' and the realized inflation rate increases to 2'.

Anticipated Expansionary PolicySuppose, by contrast, that the expansionary policy is fully anticipated by the public.

Again referring to Figure 22A1.2, because expectations are rational, workers and firmsrecognize that an expansionary policy will shift the aggregate demand curve to theright from AD1 to AD2 and inflation will rise to 2. With expected inflation at 2, theshort-run aggregate supply curve then shifts up from AS1 to AS2 and intersects AD2 atpoint 2, an equilibrium point where aggregate output is at potential output Y P and theinflation rate has risen to 2.

The new classical model demonstrates that aggregate output does not increase as aresult of anticipated monetary or fiscal policy and that the economy immediately moves

p

pp

p

p

p

p


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InflationRate,

LRAS

1

2

2 '

AS 1 (Et – 1 t = 1 )

1

2

Aggregate Output, Y

Y P

AS 2 (Et – 1 t = 2 )

AD 2

AD 1

2 '

Y 2 '

Step 1 . Po s itivedemand s hoc ks hifts AD tothe right.

Step 2 . If the policy i s unanticipated, AS doe s n ’t s hift and the economymove s to point 2 ' , and inflationand output ri s e.

Step 3 . If the policy i s anticipated, AS s hiftsup and the economy move s to point 2, andinflation ri s e s by more, but output doe s not ri s e.

FIGURE 22A1.2Response toExpansionaryPolicy in the NewClassical ModelInitially, the economyis at point 1 at the inter-section of AD1 and AS1(Et – 1 t = 1) whereaggregate output is at

and inflation is at1. An expansionary

policy shifts the aggre-gate demand curvefrom AD1 to AD2, but if the policy is unantici-pated, the short-runaggregate supply curveremains at AS1.Equilibrium nowoccurs at point 2'—aggregate output hasincreased to Y 2' , andinflation has increasedto 2'. If the expansion-ary policy is antici-pated, then theshort-run aggregatesupply curve shifts upto AS2 (Et – 1 t = 2).The economy thenmoves to point 2,where aggregate outputdoes not change from

, but inflation rises by even more to 2.pY P

pp

p

p

Y P

pp

to a point of long-run equilibrium (point 2) where aggregate output is at potential out-put. Although Figure 22A1.2 suggests why this occurs, we have not yet proved why ananticipated expansionary policy shifts the short-run aggregate supply curve to exactly

AS2 (corresponding to an expected inflation rate of 2) and hence why aggregate outpunecessarily remains at the level of potential output. The somewhat complex proof is thesubject of the box entitled, “Proof of the Policy Ineffectiveness Proposition.”

Policy Ineffectiveness PropositionWe can now understand why the new classical model has the word classical associawith it. When policy is anticipated, the new classical model has a property that is associ-ated with the classical economists of the nineteenth and early twentieth centuries:Aggregate output remains at the level of potential output. Yet the new classical modelallows aggregate output to fluctuate away from potential output as a result of unanticipshifts in the aggregate demand curve. The policy ineffectiveness proposition

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striking conclusion to the new classical model: anticipated policy has no effect on thebusiness cycle, only unanticipated policy matters. It implies that one anticipated pol-icy is just like any other: it has no effect on output fluctuations. Recognize that thisproposition does not rule out output effects from policy changes. If the policy is a sur-prise (unanticipated) it will have an effect on output.

Uncertainty About Policy OutcomesAnother important feature of the new classical model is that there is a lot of uncertaintyabout whether policy that is intended to be expansionary will actually have that effectin the short run. Indeed, in the new classical model, an expansionary policy, such as acut in income taxes or interest rates, can lead to a declinein aggregate output if the pub-lic expects an even more expansionary policy than the one actually implemented. Therewill be a surprise in policy, but it will be negative and drive output down. Policy mak-ers cannot be sure if their policies will work in the intended direction.

To see how an expansionary policy can lead to a decline in aggregate output in theshort run, let us turn to the aggregate demand and supply analysis in Figure 22A1.3.Initially we are at point 1, the intersection of AD1 and AS1: output is Y P and the inflationrate is 1. Now suppose that the public expects the government to cut taxes to shift theaggregate demand curve from AD1 to AD2. As we saw in Figure 22A1.3, the short-runaggregate supply curve shifts leftward from AS1 to AS2 because the inflation rate isexpected to rise to 2. Suppose the expansionary policy actually falls short of what wasexpected so that the aggregate demand curve shifts only to AD2'. The result of the mis-taken expectation is that output falls to Y 2' in the short run, while the inflation rate risesto 2' rather than to 2. An expansionary policy that is less expansionary than antici-pated leads initially to an output movement directly opposite to that intended.

pp

p

p

The proof that in the new classical macro-economic model aggregate output necessarilyremains at potential output when there is antici-pated expansionary policy is as follows. In thenew classical model, the expected inflation ratefor the short-run aggregate supply curve occursat its intersection with the long-run aggregatesupply curve (see Figure 22A1.2). The optimalforecast of inflation is given by the intersectionof the aggregate supply curve with the antici-pated aggregate demand curve AD2. If the short-run aggregate supply curve is below AS2 inFigure 22A1.2, it will intersect AD 2 at an infla-tion rate lower than the expected level, which isthe intersection of this aggregate supply curve

and the long-run aggregate supply curve. Theoptimal forecast of inflation will then not equalexpected inflation, thereby violating the ration-ality of expectations. We can make a similarargument to show that when the short-runaggregate supply curve is above AS2, theassumption of rational expectations is violated.Only when the short-run aggregate supplycurve is at AS2 (corresponding to an expectedinflation rate of 2) are expectations rational because the optimal forecast of inflation equalsexpected inflation. As we see in Figure 22A1.2,the AS2 curve implies that aggregate outputremains at potential output as a result of theanticipated expansionary policy.

p

Proof of the Policy Ineffectiveness Proposition


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Implications for Policy MakersThe new classical model, with its policy ineffectiveness proposition, has two importantlessons for policy makers.

1. It illuminates the distinction between the effects of anticipated versus

unanticipated policy actions.2. It demonstrates that policy makers cannot know the outcome of their deci-sions without knowing the public’s expectations regarding them.

Can policy makers still use policy to stabilize the economy? Once they figure out thepublic’s expectations, they can know what effect their policies will have. There are twocatches to such a conclusion. First, it may be nearly impossible to find out what the pub-lic’s expectations are, given that the public consists of over 300 million U.S. citizens.Second, even if it were possible, policy makers would run into further difficulties becausethe public has rational expectations and will try to guess what policy makers plan to do.Public expectations do not remain fixed while policy makers are plotting a surprise—thepublic will revise its expectations, and policies will have no predictable effect on output.

Where does this insight lead us? According to the new classical model, should theFed and other policy making agencies pack up, lock their doors, and go home? In asense, the answer is yes. The new classical model implies that discretionary stabilizationpolicy cannot be effective and might have undesirable effects on the economy. Policymakers’ attempts to use discretionary policy may create a fluctuating policy stance thatleads to unpredictable policy surprises, which in turn cause undesirable fluctuationsaround potential output. To eliminate these undesirable fluctuations, the Fed and otherpolicy making agencies should abandon discretionary policy and generate as few policysurprises as possible.

InflationRate,

LRAS

1

2

2 '

AS 1 (Et – 1 t = 1 )

1

2

Aggregate Output, Y

Y P

AS 2 (Et – 1 t = 2 )

AD 2 AD 2 ' AD 1

2 '

Y 2 '

Step 2 .Expan s ionary policys hifts AD to AD 2 ' ,which i s le ss thanthe expected AD 2.

Step 1 . AS s hifts up to AS 2becau s e the public expect s

AD to s hift to AD 2.

Step 3 . The economymove s to point 2 ' ,where output fall s .

FIGURE 22A1.3Uncertainty AboutPolicy OutcomesBecause the publicexpects the aggregatedemand curve to shift

to AD 2, the short-runaggregate supplycurve shifts to AS2(Et – 1 t = 2). Whenthe actual expansion-ary policy falls short of the public’s expectation(the aggregate demandcurve merely shifts to AD2'), the economyends up at point 2', atthe intersection of AD2'and AS2. Despite theexpansionary policy,

aggregate outputfalls to Y 2'.

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As we have seen in Figure 22A1.2, even though anticipated policy has no effect onaggregate output in the new classical model, it doeshave an effect on inflation. The newclassical macroeconomists care about anticipated policy and suggest that policy rules bedesigned so that the inflation rate will remain stable.

Objections to the New Classical ModelAlthough the new classical model was a major advance in business cycle modeling, par-ticularly in bringing rational expectations to the forefront in macroeconomic research,there are some serious objections to the theory behind this model. The strongest objec-tion is that firms could easily get information about movements in the general pricelevel and so would not be fooled for very long. Thus when the inflation rate rises, firmswould not increase the amount of goods and services they supply by very much, mak-ing it hard to understand why unanticipated inflation would explain deviations of aggregate output from potential. Even more importantly, the new classical model wasunable to address the persistence of business cycle movements. As Figure 22A1.2 indi-

cates, unanticipated expansionary policy would only lead to an increase in output rela-tive to potential for one period. However, as we noted in Chapter 8, business cyclespersist for long periods of time, with cycles lasting for a number of years. In addition,empirical evidence casts doubt on the policy ineffectiveness proposition, an importantimplication of the new classical model. 3

The objections to the new classical model led economists to go in two directions indeveloping new theories of the business cycle, which are discussed in Chapter 22. Onewas the real business cycle model, which kept the assumption of market-clearing and flex-ible prices, while the other, the new Keynesian model, sought to provide better microfoun-dations for sticky prices and placed price stickiness at the core of their models.

3For empirical evidence on the policy ineffectiveness proposition, see Robert J. Barro, “Unanticipated MoneyGrowth and Unemployment in the United States,” American Economic Review 67 (March 1977): 101–15;Frederic S. Mishkin, “Does Anticipated Monetary Policy Matter? An Econometric Investigation,” Journal of Political Economy 90 (February1982): 22–51; Frederic S. Mishkin, “Does Anticipated Aggregate Demand PolicyMatter? Further Econometric Results,” American Economic Review 72 (September 1982): 788–802; and FredericS. Mishkin, A Rational Expectations Approach to Macroeconometrics: Testing Policy Ineffectiveness and Efficient

Markets Models (Chicago: University of Chicago Press, 1983).

SUMMARY 1. The new classical macroeconomic model assumes

that expectations are rational and that wages andprices are completely flexible with respect to the

expected price level. It leads to the policy ineffec-tiveness proposition that anticipated policy has noeffect on output; only unanticipated policy matters.


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KEY TERMSmisperceptions theory, p. 3 new classical model, p. 1 policy ineffectiveness

proposition, p. 5

REVIEW QUESTIONS AND PROBLEMS1. Why is the new classical model described as a

misperceptions theory?2. Why does it matter in the new classical model

whether a policy change is anticipated orunanticipated by the public?

3. What implications does the policy ineffective-ness proposition have for policy makers?

4. What objections to the new classical modelhave been raised?

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