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New Classical Economics

New Classical Economics is a school of macroeconomic thought that builds analysis on neoclassical foundations and emphasizes rational expectations. It aims to provide microeconomic foundations for macroeconomics, unlike Keynesian economics. The school emerged in response to stagflation in the 1970s and criticisms of Keynesian economics. New Classical Economics assumes agents maximize utility with rational expectations and the economy instantly clears markets through price and wage adjustments.

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247 views1 page

New Classical Economics

New Classical Economics is a school of macroeconomic thought that builds analysis on neoclassical foundations and emphasizes rational expectations. It aims to provide microeconomic foundations for macroeconomics, unlike Keynesian economics. The school emerged in response to stagflation in the 1970s and criticisms of Keynesian economics. New Classical Economics assumes agents maximize utility with rational expectations and the economy instantly clears markets through price and wage adjustments.

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Fetsum Lakew
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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NEW CLASSICAL ECONOMICS:

New Classical Economics, is a school of thought in macroeconomics that builds its analysis entirely on a
neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on
microeconomics, especially rational expectations.

New classical macroeconomics strives to provide neoclassical microeconomic foundations for


macroeconomic analysis. This is in contrast with its rival new Keynesian school that uses micro
foundations such as price stickiness and imperfect competition to generate macroeconomic models
similar to earlier, Keynesian ones.

The New Classical school emerged in the 1970s as a response to the failure of Keynesian economics to
explain stagflation.

New classical economics is based on Walrasian assumptions. All agents are assumed to maximize utility
on the basis of rational expectations. At any one time, the economy is assumed to have a unique
equilibrium at full employment or potential output achieved through price and wage adjustment.

New Classical and monetarist criticisms led by Robert Lucas, Jr. and Milton Friedman respectively forced
the rethinking of Keynesian economics. In particular, Lucas made the Lucas critique that cast doubt on
the Keynesian model. This strengthened the case for macro models to be based on microeconomics.

After the 1970s and the apparent failure of Keynesian economics, the New Classical school for a while
became the dominant school in Macroeconomics.

The new classical perspective takes root in three diagnostic sources of fluctuations in growth: the
productivity wedge, the capital wedge, and the labor wedge.

. A productivity/efficiency wedge is a simple measure of aggregate production efficiency. In relation to


the Great Depression, a productivity wedge means the economy is less productive given the capital and
labor resources available in the economy.  A capital wedge is a gap between the intertemporal
marginal rate of substitution in consumption and the marginal product of capital. In this wedge, there’s
a “deadweight” loss that affects capital accumulation and savings decisions acting as a distortionary
capital (savings) tax.  A labor wedge is the ratio between the marginal rate of substitution of
consumption for leisure and the marginal product of labor and acts as a distortionary labor tax, making
hiring workers less profitable (i.e. labor market frictions).

New classical economics is based on Walrasian assumptions. All agents are assumed to maximize utility
on the basis of rational expectations. At any one time, the economy is assumed to have a unique
equilibrium at full employment or potential output achieved through price and wage adjustment. In
other words, the market clears at all times.

New classical economics has also pioneered the use of representative agent models. Such models have
received severe neoclassical criticism, pointing to the disjuncture between microeconomic behavior and
macroeconomic results, as indicated by Alan Kirman.

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