the new classical model - pearson education · 2014. 8. 15. · the new classical model 3 by the...

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Chapter 22 Appendix

The New Classical Model

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

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

2. In the new classical model, wages and prices are completely flexible with respect to changes in expected inflation; that is, a rise in expected inflation results in an imme-diate and equal rise in 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.

New Classical Phillips Curve and the Aggregate Supply Curve

Recall our look at the Phillips curve in Chapter 11. The assumption that wages and prices are flexible with respect to expected inflation implies that the Phillips curve and hence the short-run aggregate supply curve have inflation rising in a one-to-one ratio with rises in expected inflation. Therefore, we can write the new classical short-run aggregate supply curve as follows:

πt = Et- 1πt + γ 1Yt - Y P2 (1)

1See Robert E. Lucas, “Expectations and the Neutrality of Money,” Journal of Economic Theory 4 (April 1972): 103–124; and Thomas Sargent and Neil Wallace, “Rational Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule,” Journal of Political Economy 83:2 (April 1975): 241–254.

Z13_MISH4317_WEB_CH22App_pp001-009.indd 1 14/11/13 12:33 PM

2 chapter 22 appendix

where

πt = Inflation at time t, that is, the change in the price level from period t - 1 to period t

Et- 1 πt = Inflation from period t - 1 to period t, which is expected at time t - 1 using rational expectations

Yt = aggregate output at time t Y P = potential output

γ = sensitivity of inflation to the output gap

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 Et- 1πt is the same thing as expected inflation πe, but with one subtle difference: the short-run aggregate supply curve is fixed only for a particular value of expected inflation and will shift when expected inflation changes. To illustrate, suppose that in Figure 22A1.1, expected inflation is initially at π1. The short-run aggregate supply curve for this level of expected inflation, AS1, passes through point 1 because at Yt = Y P, Equation 1 shows that actual inflation will be equal to π1. As shown in Figure 22A1.1, if Yt 7 Y P, then inflation increases along the AS curve by the amount γ1Yt - Y P2, as the upward sloping short-run aggregate supply curve AS indicates. The short-run aggre-gate supply curve AS1 is thus specific to an expected inflation rate of π1 and is marked this way in Figure 22A1.1.

Figure 22A1.1

Aggregate Supply in the New Classical ModelThe new classical model has short-run aggregate sup-ply curves that are upward-sloping and specific to a particu-lar expected inflation rate, as AS1 and AS2 indicate. AS1 is fixed for Et-1 πt = π1, and this is why it is marked as AS1 1Et-1 πt = π12 and is drawn to pass through point 1, where, at an actual inflation rate of π1, aggregate output is at potential 1Y = Y P2 and so expected inflation is also at π1 1Et-1 πt = π12. Similarly, AS2 is fixed for Et-1 πt = π2 and is marked as AS2 1Et-1 πt = π22: it is drawn to pass through point 2, where, at an actual inflation rate of π2, aggregate output is at potential 1Y = Y P2 and so expected inflation is also at π2 1Et-1 πt = π22.

InflationRate, p

LRAS

p1

p2

AS1 (Et – 1pt = p1)

Aggregate Output, Y

YP

AS2 (Et – 1pt = p2)

1

2


the new classical Model 3

By the same reasoning, if expected inflation is instead at π2, then the short-run aggregate supply curve will shift up and to the left to AS2, where it passes through point 2, because, as Equation 1 shows, when Yt = Y P, inflation will be equal to π2. The short-run aggregate supply curve AS2 is thus specific to an expected inflation rate of π2, and is marked this way in Figure 22A1.1. The short-run aggregate supply curve in the new classical model thus will immediately shift from AS1 to AS2 if expected inflation rises from π1 to π2.

Misperceptions TheoryWe can think of the new classical model as a misperceptions theory because it results from misperceptions by firms that a general rise in inflation will result in higher rela-tive prices for the goods they sell, so that they will supply more.2 To illustrate, we can rewrite the new classical short-run aggregate supply (Phillips) curve in Equation 1 by subtracting Et- 1πt from both sides of the equation, dividing by γ, and then putting Yt - Y P on the left-hand side. The transformed equation is then as follows:

Yt - Y P = 1πt - Et- 1πt2>γ (2)

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

The misperception story behind Equation 2 is as follows. Consider Isaac the Ice Cream Maker, who has to figure out how much ice cream he should make. What you learned 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 prices of other goods and services Isaac wants to buy, he is willing to work harder because he can exchange the ice cream for more goods and services. If, on the other hand, the price of ice cream falls relative to the prices of other goods and services, Isaac will want to take more time off and enjoy life because there is less of a payoff to producing ice cream. Therefore, a rise in the relative price of the good he produces will cause Isaac to increase produc-tion, while a fall in the relative price will lead him to reduce production.

To figure out what is happening to the relative price of the good he produces, Isaac could try to find out what is happening to the prices of all the other goods and services he wants to buy, but obviously this would take too much time. Instead, when he sees a rise in the price of ice cream, he will estimate the relative price by asking himself how much the price of ice cream has risen relative to what he expects the general rise in the price level will be, that is, his expectations of inflation. For example, if he sees the price of ice cream rising by 3% this year, but his expectation of inflation is 2% (that is, he expects prices in general to rise by 2%), then he will think that the relative price of ice cream is rising and will produce more. If, on the other hand, he expects inflation to be 4%, then the price of ice cream is rising less than prices in gen-eral, and he will want to cut production.

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

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.



they see 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 fooled into thinking that the relative prices of the goods they are producing are rising, and so output in the economy will rise above what firms would produce if they had no misperceptions, which is just potential output, Y P. On the other hand, if actual inflation is below expected inflation, firms will produce an amount of output that is less than potential output. Misperceptions about how fast the general price level is rising then lead to Equation 2, which indicates that aggregate output exceeds potential output only when the realized inflation rate is higher than expected inflation.

Effects of Expansionary PolicyThe new classical model indicates that the effect of expansionary policy depends on whether it is anticipated or unanticipated. First, let us look at the short-run response to an unanticipated (unexpected) expansionary policy coming from a rise in government spending 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, where actual and expected inflation are at π1 and the short-run aggregate supply curve is at AS1. The initial aggregate demand curve intersects AS1 at point 1, where the realized inflation rate is equal to the

Figure 22A1.2

response to expansionary Policy in the New Classical ModelInitially, the economy is at point 1 at the intersection of AD1 and AS1 1Et-1πt = π12, where aggregate output is at Y P and inflation is at π1. An expansionary policy shifts the aggre-gate demand curve from AD1 to AD2, but if the policy is unan-ticipated, the short-run aggregate supply curve remains at AS1. Equilibrium now occurs at point 2′—aggregate output has increased to Y2′, and inflation has increased to π2′. If the expansionary policy is anticipated, then the short-run aggregate supply curve shifts up to AS2 1Et-1πt = π22. The economy then moves to point 2, where aggregate output does not change from Y P, but inflation rises by even more to π2.

InflationRate, p

LRAS

p1

p2

p2'

AS1 (Et – 1pt = p1)

1

2

Aggregate Output, Y

YP

AS2 (Et – 1pt = p2)

AD2

AD1

2'

Y2'

Step 1. Positivedemand shockshifts AD tothe right.

Step 2. If the policy is unanticipated,AS doesn’t shift and the economymoves to point 2', and inflationand output rise.

Step 3. If the policy is anticipated, AS shiftsup and the economy moves to point 2, andinflation rises by more, but output does not rise.



expected inflation rate π1 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 the aggregate sup-ply curve to shift. The economy remains in long-run equilibrium.

Now suppose the government or the Fed suddenly decides the unemployment rate is too high and so pursues expansionary policy that shifts the aggregate demand curve to the right to AD2. If this expansionary policy is unexpected, the expected inflation rate remains at π1 and the short-run aggregate supply curve remains at AS1. Equilibrium is now at point 2′, at the intersection of AD2 and AS1. Aggregate output increases above potential output to Y2′ and the realized inflation rate increases to π2′.

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 firms recognize that an expansionary policy will shift the aggregate demand curve to the right from AD1 to AD2, and inflation will rise to π2. With expected inflation at π2, the short-run aggregate supply curve then shifts up from AS1 to AS2 and intersects AD2 at point 2, the equilibrium point at which aggregate output is at potential output Y P and the inflation rate has risen to π2.

The new classical model demonstrates that aggregate output does not increase as a result of anticipated monetary or fiscal policy and that the economy immediately moves to a point of long-run equilibrium (point 2) at which aggregate output is at potential out-put. Although Figure 22A1.2 suggests why this occurs, we have not yet proved why an anticipated expansionary policy shifts the short-run aggregate supply curve to exactly AS2 (corresponding to an expected inflation rate of π2) and hence why aggregate output necessarily remains at the level of potential output. The somewhat complex proof is the subject 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 associated with it. When policy is anticipated, the new classical model has a property that is associ-ated with the theories of the classical economists of the nineteenth and early twentieth centuries: Aggregate output remains at the level of potential output. Yet the new classi-cal model allows aggregate output to fluctuate away from potential output as a result of unanticipated shifts in the aggregate demand curve. The policy ineffectiveness propo-sition is a striking conclusion to the new classical model: anticipated policy has no effect on the business cycle; only unanticipated policy matters. This result implies that one anticipated policy is just like any other: it has no effect on output fluctuations. Recognize that this proposition does not rule out output effects from policy changes. If the policy is a surprise (unanticipated), then 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 uncertainty about whether policy that is intended to be expansionary will actually have that effect in the short run. Indeed, in the new classical model, an expansionary policy, such as a



cut in income taxes or interest rates, can lead to a decline in aggregate output if the pub-lic expects an even more expansionary policy than the one actually implemented. There will be a surprise in policy, but it will be negative and will drive output down. Policy makers 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 the short 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 at Y P and the infla-tion rate is at π1. Now suppose that the public expects the government to cut taxes to shift the aggregate demand curve from AD1 to AD2. As we see in Figure 22A1.3, the short-run aggregate supply curve shifts leftward from AS1 to AS2 because the inflation rate is expected to rise to π2. Suppose the expansionary policy actually falls short of what was expected, so that the aggregate demand curve shifts only to AD2′. The result of the mistaken expectation is that output falls to Y2′ in the short run, while the inflation rate rises to π2′ rather than to π2. An expansionary policy that is less expansionary than anticipated leads initially to an output movement directly opposite to that intended.

Implications for Policy MakersThe new classical model, with its policy ineffectiveness proposition, has two important lessons 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? It seems that once they figure out the public’s expectations, they will know what effect their policies will have.

The proof that in the new classical macroeco-nomic model aggregate output necessarily remains at potential output when there is antici-pated expansionary policy is as follows. In the new classical model, the expected inflation rate for the short-run aggregate supply curve occurs at its intersection with the long-run aggregate supply curve (see Figure 22A1.2). The opti-mal forecast of inflation is given by the inter-section of the aggregate supply curve with the anticipated aggregate demand curve AD2. If the short-run aggregate supply curve is below AS2 in Figure 22A1.2, it will intersect AD2 at an inflation rate that is lower than the expected level, which is the intersection of this aggregate

supply curve and the long-run aggregate supply curve. The optimal forecast of inflation then will not equal expected inflation, thereby violating the rationality of expectations. We can make a similar argument to show that when the short-run aggregate supply curve is above AS2, the assumption of rational expectations is violated. Only when the short-run aggregate supply curve is at AS2 (corresponding to an expected inflation rate of π2) are expectations rational, because at that point the optimal forecast of inflation equals expected inflation. As we see in Figure 22A1.2, the AS2 curve implies that aggregate output remains at potential output as a result of the anticipated expansionary policy.

Proof of the Policy Ineffectiveness Proposition



There are two catches to such a conclusion. First, it may be nearly impossible to find out what the public’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 difficul-ties because the public has rational expectations and will try to guess what policy mak-ers plan to do. Public expectations do not remain fixed while policy makers are plotting a surprise—the public 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 the Fed and other policy-making agencies pack up, lock their doors, and go home? In a sense, the answer is yes. The new classical model implies that discretionary stabilization policy cannot be effective and might have undesirable effects on the economy. Policy makers’ attempts to use discretionary policy may create a fluctuating policy stance that leads to unpredictable policy surprises, which in turn cause undesirable fluctuations around potential output. To eliminate these undesirable fluctuations, the Fed and other policy-making agencies should abandon discretionary policy and generate as few policy surprises as possible.

As we have seen in Figure 22A1.2, even though anticipated policy has no effect on aggregate output in the new classical model, it does have an effect on inflation. The new classical macroeconomists care about anticipated policy and suggest that policy rules be designed 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 objection is that

InflationRate, p

LRAS

p1

p2

p2'

AS1 (Et – 1pt = p1)

1

2

Aggregate Output, Y

YP

AS2 (Et – 1pt = p2)

AD2

AD2'

AD1

2'

Y2'

Step 2.Expansionary policyshifts AD to AD2',which is less thanthe expected AD2.

Step 1. AS shifts up to AS2because the public expectsAD to shift to AD2.

Step 3. The economymoves to point 2',where output falls.

Figure 22A1.3

uncertainty About Policy OutcomesBecause the public expects the aggregate demand curve to shift to AD2, the short-run aggregate supply curve shifts to AS2 1Et-1 πt = π22. When the actual expansionary policy falls short of the public’s expectation (the aggregate demand curve merely shifts to AD2′), the economy ends up at point 2′, at the intersec-tion of AD2′ and AS2. Despite the expansionary policy, aggregate output falls to Y2′.



firms could easily get information about movements in the general price level and so would not be fooled for very long. Thus, when the inflation rate rises, firms will not increase the amount of goods and services they supply by very much, making it hard to understand why unanticipated inflation would explain deviations of aggregate output from potential. Even more importantly, the new classical model is unable to address the persistence of busi-ness cycle movements. As Figure 22A1.2 indicates, unanticipated expansionary policy will lead to an increase in output relative to potential for only one period. However, as we noted in Chapter 8, business cycles persist for long periods of time, with cycles lasting for a num-ber of years. In addition, empirical evidence casts doubt on the policy ineffectiveness propo-sition, an important implication of the new classical model.3

The objections to the new classical model led economists to go in two different directions in developing new theories of the business cycle, which are discussed in Chapter 22. One was the real business cycle model, which kept the assumption of market-clearing and flexible prices. The other, the new Keynesian model, sought to provide better microfoundations for sticky prices and placed price stickiness at its core.

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): 101–115;Frederic S. Mishkin, “Does Anticipated Monetary Policy Matter? An Econometric Investigation,” Journal ofPolitical Economy 90 (February 1982): 22–51; Frederic S. Mishkin, “Does Anticipated Aggregate Demand Policy Matter? 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 and prices are completely flexible with respect to the expected price level. It leads

to the policy ineffectiveness proposition that anticipated policy has no effect on output; only unanticipated policy matters.

KEy TErMSmisperceptions theory, p. 3new classical model, p. 1policy ineffectiveness proposition, p. 5

rEvIEw QUESTIONS ANd PrOblEMS 1. 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 or unanticipated by the public?

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

4. What objections to the new classical model have been raised?



the new classical model - pearson education · 2014. 8. 15. · the new classical model 3 by the...

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