HET New+Classical+and+New+Keynesian

New Classical and New
Keynesian
Walter Bazn Fall 2014
Economics Department
Rutgers University
Walter Bazn - Rutgers University
Recall Monetarist
The important of money
The only times that major economic contractions
occurred were when the absolute value of the
money stock fell.
From evidences, changes in money cause changes in
money income.
Monetarists believe that money is a substitute for a
wide range of real and financial assets, but not
single asset could be a close substitute for money.
So interest rate affect money demand.
Recall Monetarist
Monetarists thought that LM is flatter and IS is
steeper than in Keynesians.
Fiscal policy would lead to a large amount of
crowding out of investment and have little impact
on total output.
There is no liquidity trap.
Phillips Curve
The Phillips curve has been a central topic in
Macroeconomics since the 1950s and its
successes and failures have been a major
element in the evolution over time of the
discipline.
The idea that there should be some sort of
positive relationship between inflation and
output has been around almost as long as
economics itself
Phillips Curve
The Phillips Curve provided a menu of tradeoffs
for policy-makers: They could use demand
management policies to increase output and
decrease unemployment, but this could only be
done at the expense of higher inflation.
The Keynesian model implicitly relied on the idea
that low unemployment could be sustained by
allowing high inflation to erode real wages and
thus boost labour demand.
Phillips Curve and Monetarism

The second wave of monetarism deal with Philips
curve.
Philip curve is published in 1958 using UK data. It
shows the inverse relationship between money
wage and the rate of unemployment.
The Keynesians draw the conclusion of this finding
to support their idea of a permanent trade-off
between inflation and unemployment.
Phillips Curve and Monetarism

To justify Keynesian policy, the workers must
have money illusion.
Friedman argued that money illusion occurs
in the short run only. In the long run, there is
no trade-off between unemployment and
inflation and the evidences seem to confirm
this point of view.
PC, Monetarism and Implications

Implications of monetarist
Monetary policy is more effective than fiscal policy.
No long-run trade-off between inflation and unemployment.
The market system was not perfect, the government would
only make things worse.
Fiscal policy could only influence the distribution of income
and the allocation of resources (crowding out effect).
The only way to increase output permanently is to make
market work better.
Adaptive expectation.
New Classical School

Rutgers University
Robert E. Lucas Jr.

1937
University of Chicago
Leading personality of
New
Classical
Revolution
Economist, but originally
studied history
Nobel prize 1995
Thomas J. Sargent
1943
Teacher at several US Universities,
namely
Minnesota,
Chicago,
Stanford and New York (currently),
essential advanced macroeconomic
theory textbooks
Rational expectations
Impact on (namely) monetary
policies, statistical operationality of
RE, models of Phillips curve,
demand
for
money
in
hyperinflations,
intertemporal
coordination of monetary and fiscal
policies, etc.
Nobel prize in 2011 (with
Christopher Sims)

Initiated by
Lucas
Wallace
Sargent
Barro
Initiated because of:
Theoretical : introduce microeconomic foundation in
macroeconomics instead of AD-AS model.
Empirical: inconsistencies between Keynesian and
Monetarist and what actually happened in 1970s from oil
price shocks, Stagflation.
Assumptions
In search of macroeconomic theory, rooted in micro
foundations and Walrasian general equilibrium
approach
All economic agents optimize continuously, i.e.
subject to their constraints, firms maximize profits
and households maximize utility
In taking optimizing decisions, agents take into
account only relative prices (do not suffer from
money illusion)
Agents able to exhaust all profitable opportunities,
wages and prices are flexible and markets
continuously clear

Both Keynesian and monetary framework
insufficient
Consequently - see assumptions above - return to
classical model, i.e. money neutral, AS and LRPC
vertical
But, reality (data) not consistent with classical
assumptions either, namely short-run correlations
positive: price and output (upward sloping AS)
positive: nominal money supply and real GDP (nonneutral money)

negative: inflation and unemployment (downward
sloping PC)
New Classical solution: existence of nonneutralities given by imperfect information, agents
have
A novelty, indeed: classical, pre-WWI model, always
assumed perfect information

Three basics building blocks
Rational expectations
Continuous market learning
New concept of aggregate supply
New Classical School: RE

Rational Expectation
Stagflation is inconsistent with adaptive expectation
(backward-looking).
John Muth developed rational expectation, which is
forward looking expectation.
It features: - people would look to the future.
- people use information wisely.
- people would not make systematic errors.

Incorporating rational expectations in the AS-AD
model
1. Imperfect information : Household may not know
the price level at the time they make decision.
2. Parameterization of AS, Ls and Ld curve: The

curves are parameterized by expectations of the
values of the exogenous variable.

Implications of new classical economics
Expectations are formed normally. They may form wrong
expectations, but once they have learnt their mistake, they
will no longer make mistakes.
Only unanticipated policies have an effect on the output
and employment.
SR AS is upward sloping from imperfect information.
LR AS is vertical.
Self-correcting economy.

Economic decisions: action today to receive
uncertain return in the future
Quality of expectations crucial, most famous example:
expected inflation in wage negotiations
Expectation: not only one predicted value, but a

probability distribution of all possible outcomes
Two crucial issues
How people get, process and use information to form
expectations?
What type of expectations hypothesis is most suitable
for application in macroeconomics?

P
LRAS
AS3
AS1
P3
P2
C
B
AD2
P1
AD1
Y3 = Y1
Y2

All previous models, be it neoclassical synthesis,
monetarism - either explicitly or implicitly used
expectations
So far, PFH or AEH and - in the long run - return
to potential output and other natural values
Even when adjustment to past errors takes place
(AEH), the errors are all the time systematically
biased

Why Rational?
See assumptions above - all agents are optimizers
they are also using all available information in an
optimal way (best use of info)
Weak version: in forming the expectations, agents
perform cost-benefit analysis regarding how much
information to obtain
Compared to AEH, agents use all available info
AEH: learning from the past mistakes in predicting only the
same variable
REH: taking into account all information, about all other
variables and about all other relevant facts

People DO make errors in forecast
It is NOT perfect foresight
The errors are due to the incomplete information
The errors are independent on the information
set -1
On average, agents expectations are correct,
i.e. equal to the true values
Expectations are NOT systematically wrong
over time (are not biased)
New Classical School: CCM

Continuous Clearing Market
Agents
either perform an optimal search for all available
information (weak version)
or just have all information from period -1 (strong
version)
In both cases they are (a) rational, (b)

optimizing their behavior the resulting
prices and quantities are consistent with
general equilibrium outcomes
Consequently: all markets clear
New Classical School: CCM

Lucas Aggregate Supply
If both firms and households have complete
information, than assuming rational expectations
the forecast is always perfect
Rational expectations with PFH, i.e. with classical
model
Reality
Firms: usually have complete information,
including the price
Households: do not have complete information
New Classical School: CCM -Labor

Start with the classical case, i.e. full employment N*
(and Y *).
In next period actual price P>P-1, known to firms, but
unknown to households
They can make only expectations, assume
P e =P-1 <P
Firms: know that real wage is lower at any nominal
wage shift of ND
Households: dont know that real wage is for any
nominal wage lower do not shift NS
Increase in equilibrium employment
New
Classical
School:
CCM
-Labor
W
P-1 .NS
W1
P.N D
W*
P-1.N D
N*
N1
N
Two comments:
if price has decreased, there would be shift of ND to the left and new employment would
be lower than original one. If households knew the actual price, they would shift NS
properly and the model is classical. Walter Bazn - Rutgers University
New Classical School: Aggregate

P
Supply
AS
P=Pe
Y*
New Classical School: Anticipated

Equilibrium model with rational expectations
just on ADxAS level
Suppose an exogenous change

M>0
People form expectations of price changes as a
consequence of change in M
Rational expectation: if people anticipate the
monetary policy and there is no other random
shock, than they will make a proper forecast of
price, because
They have full information
They dont make systematic errors
In this case, given the price changes, both AD

and AS shift
Anticipated monetary change

P
LRAS
AS3
AS1
P3
P2
C
B
AD2
P1
AD1
Y3 = Y1
Y2
New Classical School: Un-Anticipated

Suppose, that the change in monetary policy is
not anticipated by the households and/or some
random shocks appear
Then households will not properly forecast the
price level, but firms will only AD shifts, but AS
P e =P-1 <P
does not
There is a new equilibrium level of employment
and output as a consequence of change in the
monetary policy
Un-anticipated monetary change

P
LRAS
AS1
P2
P1
AD2
AD1
Y1
Y2
New Classical School: Policy

Anticipated: households immediately
expectations (and behavior)
adjust
Market clearing
Vertical, classical AS
Un-anticipated: households make mistake from

the shock
Equilibrium moves along the positively sloped Lucas
AS
New equilibrium output (and employment)
However, given the rational expectation

proposition, this is not the end of the story in
the next period, households learn their mistake
and will adjust return to Y* anyway
New Classical School: Policy

New Classical Macroeconomics
Allows for short term fluctuations from natural values
Based on completely different theory than the
Keynesian one
Consistent with microeconomic assumptions
Limited effects of governmental policies:
If policies anticipated, than quick adjustment and no effect on
output (and other variables)
If un-anticipated policy (or some random, exogenous shock),
than after some short term fluctuations adjustment to natural
values anyway
Policy impotence proposition PIP

New Classical School: Critics

New Classical Economics - a great leap forward,
but a lot of criticism
Rational expectations:
Costs to obtain information
What is the correct model of the economy?
Risk vs. uncertainty
Continuous clearing:
Sluggish adjustment of prices and wages
Involuntary unemployment
Empirical studies
There is an empirical support for non-neutrality of
the money (anticipated nominal money change
Walterreal
Bazn - Rutgers
University
has an impact on
output)
Lucas: A Positive Program for Business Cycles

Continuous market-clearing, dynamic equilibrium
against Keyness involuntary unemployment
involuntary unemployment is not a fact or a phenomenon
which it is the task of the theorist to explain. It is, on the
contrary, a theoretical construct which Keynes . . . hope[d] would
be helpful in discovering a correct explanation for a genuine
phenomenon: large-scale fluctuations in measured, total
unemployment. Is it the task of modern theoretical economics
to explain the theoretical constructs of our predecessors,
whether or not they have proved fruitful?
Business cycle phenomena:

not objects, but patterns of covariation
picked up by Kydland and Prescott
surprising respect for Burns and Mitchell
The Transition to the Real Business Cycle

Model
Lucass 1975 Business Cycle Model
growth, capital, and the propagation mechanism
the last gasp of the monetary surprises
alternative rationales for money
Kydland and Prescott, Time to Build and

Aggregate Fluctuations
technology shocks
the absence of monetary shocks
the irrelevance of time-to-build
Real Business cycle

New classical fails to explain the important
empirical fact, deviations from capacity output
tended to be prolonged and correlated.
Real Business cycle

Important summary
1. Random walks : shocks to US output is random
walk so it did not revert back to its trend.
2. Intertemporal substition : Instead of AS-AD
model, RBC tried to use intertemporal substitution
to explain how shocks are transmitted into the
economy.
3. RBC still uses rational expectation.
Real Business cycle

Important summary (cont)
4. Market are always clearing.
5. Money is neutral.
6. Economic fluctuations are due to supply side
such as technological changes, natural disaster, tax,
input prices, etc.
New Keynesian School

Rutgers University
New Keynesian Economics: Basics

The name New Keynesian Theory was
introduced by Michael Parkin (1982).
One of the earliest uses of the term newKeynesian Economics was in an article by Ball,
Mankiw, and Romer (1988).
New is used instead of neo to distinguish
from
Neoclassical
Synthesis
Keynesian
Economics (a term used by Samuelson and
others), and also to show it is the counterargument to the New Classical Economics.
New Keynesian Economics: Basics

According to Gordon, sticky prices implies that
real GDP is a residual, and is not determined
by agents in the economy.
If this is the case, then firms optimize by
setting prices, and accept quantities
(production levels) as given.
In the neoclassical and new classical theories,
the firms are price takers and optimize by
setting quantities (production levels).
New Keynesian Economics

There are 4 main problems with new classical
1. Unhappy / involuntary workers.
2. 1982 US recession.
3. Intertemporal substitution of labor does not seem
to be as large as RBC suggested.
4. Hysteresis of unemployment.

New Keynesian uses the new classical model
but introduces:
Union models
Contracts and staggering of price and wage
changes
Menu cost and imperfect competition

Implications of New Keynesian Economics
Market may not adjust quickly even with rational
expectation.
Strong recession warrants government
intervention.
Government should ensure that market works
smoothly as possible via microeconomic policies.

They use the micro foundations approach as used by
the New Classical school.
They argue that the Keynesian conclusions about the
effectiveness of fiscal and monetary policy are still
valid because goods and labour market do not clear
quickly because of imperfections in these markets.
Prices and wages are sticky.
Market fails and prices and wages are

sticky
menu cost
long period sales and purchase agreements and
imperfect competitions in goods markets and
wage contracts between unions and employers,

insider-outsider behaviour of unions,
efficiency wage behaviour in the labour market.

Old Question:Why is the AS Curve Upward Sloping?

New answer: Mark Ups in Wage Rate and Prices
Why is the aggregate demand upward sloping? Why increasing demand can increase
output in the short run?
Price
Classical Supply
New Classical Supply
p1
Keynesian supply
p0
AD1
AD
yn
Output
Write equations for each of these supply lines
Menu Cost and Impact of an Increase in

Aggregate Demand
Profit maximising price and output of a monopolist
Impact of an increase in aggregate demand (Ne >N)
Price
And cost
P0
?
A
pm
pm
?
B
k
q1

If the expected aggregate demand in
greater than the actual N e N then p0 pm
and if N e N then p0 pm .
Firms should change their price whenever
demand changes.
But there is a menu cost z of changing the
prices because menus have to be printed
again and sent to the customers.
New Keynesian Economics: Final Issues

The authors claim that Keynesians, new and old, can be
identified viz a viz members of other schools by their belief in
three propositions:
An excess supply of labor may exist, sometimes for prolonged periods,
at the prevailing level of real wages.
The aggregate level of economic activity fluctuates widelymore
widely than can be explained by short-run changes in technology,
tastes, or demographics.
Money matters, at least most of the time, although monetary policy
may be ineffective at times.
A lot of this boils down to the proposition that at times

quantities adjust rather than prices to bring about cash-flow
equilibria.

1.
Nominal price rigidities are the fundamental ways in which

real-world economies differ from Walrasian Arrow-Debreu
economies. Most of the work here focuses on explaining
sources of rigidity.
- Because of these rigidities, the classical dichotomy breaks down,
and policy can be effective.
2.
Even if prices and wages were perfectly flexible, output

would still be volatile. This flexibility is not the central
problem. In fact, more flexibility might make things worse.
This approach focuses on market failures.
- Thus monetary policy has real effects even when prices and wages
are perfectly flexible.

The flex-price NK school argues that:
Natural economic forces can magnify shocks that seems
small, and
Sticky prices and wages may actually reduce the
magnitude of the fluctuations (as Keynes argued).
This makes this group less interested in the source of

the shocks (unlike the RBC theorists), and more
interested in the mechanisms by which they
propagate, are magnified or diminished.

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New Classical and New

Walter Bazn - Rutgers University

Phillips Curve and Monetarism

Walter Bazn - Rutgers University

Phillips Curve and Monetarism

Walter Bazn - Rutgers University

PC, Monetarism and Implications

New Classical School

Robert E. Lucas Jr.

Walter Bazn - Rutgers University

New Classical School

New Classical School

Walter Bazn - Rutgers University

New Classical School

Walter Bazn - Rutgers University

New Classical School

New concept of aggregate supply

Walter Bazn - Rutgers University

New Classical School: RE

Walter Bazn - Rutgers University

New Classical School: RE

2. Parameterization of AS, Ls and Ld curve: The

Walter Bazn - Rutgers University

New Classical School: RE

Walter Bazn - Rutgers University

New Classical School: RE

Expectation: not only one predicted value, but a

New Classical School: RE

Walter Bazn - Rutgers University

New Classical School: RE

Walter Bazn - Rutgers University

New Classical School: RE

New Classical School: RE

Walter Bazn - Rutgers University

New Classical School: CCM

In both cases they are (a) rational, (b)

New Classical School: CCM

New Classical School: CCM -Labor

New Classical School: Aggregate

New Classical School: Anticipated

Suppose an exogenous change

In this case, given the price changes, both AD

Anticipated monetary change

Walter Bazn - Rutgers University

New Classical School: Un-Anticipated

Walter Bazn - Rutgers University

Un-anticipated monetary change

Walter Bazn - Rutgers University

New Classical School: Policy

Un-anticipated: households make mistake from

However, given the rational expectation

New Classical School: Policy

Policy impotence proposition PIP

New Classical School: Critics

Lucas: A Positive Program for Business Cycles

Business cycle phenomena:

The Transition to the Real Business Cycle

Kydland and Prescott, Time to Build and