New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in
macroeconomics
Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study topics such as output (econ ...
that builds its analysis entirely on a
neoclassical framework. Specifically, it emphasizes the importance of foundations based on
microeconomics
Microeconomics is a branch of economics that studies the behavior of individuals and Theory of the firm, firms in making decisions regarding the allocation of scarcity, scarce resources and the interactions among these individuals and firms. M ...
, especially
rational expectations
Rational expectations is an economic theory that seeks to infer the macroeconomic consequences of individuals' decisions based on all available knowledge. It assumes that individuals' actions are based on the best available economic theory and info ...
.
New classical macroeconomics strives to provide neoclassical microeconomic foundations for macroeconomic analysis. This is in contrast with its rival
new Keynesian
New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroe ...
school that uses
microfoundations
Microfoundations are an effort to understand macroeconomic phenomena in terms of individual agents' economic behavior and interactions.Maarten Janssen (2008),Microfoundations, in ''The New Palgrave Dictionary of Economics'', 2nd ed. Research in mi ...
, such as
price stickiness and
imperfect competition
In economics, imperfect competition refers to a situation where the characteristics of an economic market do not fulfil all the necessary conditions of a perfectly competitive market. Imperfect competition causes market inefficiencies, resulting in ...
, to generate macroeconomic models similar to earlier, Keynesian ones.
History
Classical economics
Classical economics, also known as the classical school of economics, or classical political economy, is a school of thought in political economy that flourished, primarily in Britain, in the late 18th and early-to-mid 19th century. It includ ...
is the term used for the first modern school of economics. The publication of
Adam Smith
Adam Smith (baptised 1723 – 17 July 1790) was a Scottish economist and philosopher who was a pioneer in the field of political economy and key figure during the Scottish Enlightenment. Seen by some as the "father of economics"——— or ...
's ''
The Wealth of Nations
''An Inquiry into the Nature and Causes of the Wealth of Nations'', usually referred to by its shortened title ''The Wealth of Nations'', is a book by the Scottish people, Scottish economist and moral philosophy, moral philosopher Adam Smith; ...
'' in 1776 is considered to be the birth of the school. Perhaps the central idea behind it is on the ability of the market to be self-correcting as well as being the most superior institution in allocating resources. The central assumption implied is that all individuals maximize their utility.
The so-called "
marginal revolution" that occurred in Europe in the late 19th century, led by
Carl Menger
Carl Menger von Wolfensgrün (; ; 28 February 1840 – 26 February 1921) was an Austrian economist who contributed to the marginal theory of value. Menger is considered the founder of the Austrian school of economics.
In building his margi ...
,
William Stanley Jevons
William Stanley Jevons (; 1 September 1835 – 13 August 1882) was an English economist and logician.
Irving Fisher described Jevons's book ''A General Mathematical Theory of Political Economy'' (1862) as the start of the mathematical method i ...
, and
Léon Walras
Marie-Esprit-Léon Walras (; 16 December 1834 – 5 January 1910) was a French mathematical economics, mathematical economist and Georgist. He formulated the Marginalism, marginal theory of value (independently of William Stanley Jevons and Carl ...
, gave rise to what is known as
neoclassical economics
Neoclassical economics is an approach to economics in which the production, consumption, and valuation (pricing) of goods and services are observed as driven by the supply and demand model. According to this line of thought, the value of a go ...
. This neoclassical formulation had also been formalized by
Alfred Marshall
Alfred Marshall (26 July 1842 – 13 July 1924) was an English economist and one of the most influential economists of his time. His book ''Principles of Economics (Marshall), Principles of Economics'' (1890) was the dominant economic textboo ...
. However, it was the
general equilibrium
In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an ov ...
of Walras that helped solidify the research in economic science as a mathematical and deductive enterprise, the essence of which is still neoclassical and makes up what is currently found in mainstream economics textbooks to this day.
The neoclassical school dominated the field up until the
Great Depression
The Great Depression was a severe global economic downturn from 1929 to 1939. The period was characterized by high rates of unemployment and poverty, drastic reductions in industrial production and international trade, and widespread bank and ...
of the 1930s. Then, however, with the publication of ''
The General Theory of Employment, Interest and Money
''The General Theory of Employment, Interest and Money'' is a book by English economist John Maynard Keynes published in February 1936. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory and ...
'' by
John Maynard Keynes
John Maynard Keynes, 1st Baron Keynes ( ; 5 June 1883 – 21 April 1946), was an English economist and philosopher whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originall ...
in 1936, certain neoclassical assumptions were rejected. Keynes proposed an aggregated framework to explain macroeconomic behavior, leading thus to the current distinction between micro- and
macroeconomics
Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study topics such as output (econ ...
. Of particular importance in Keynes' theories was his explanation of economic behavior as also being led by "animal spirits". In this sense, it limited the role for the so-called rational (maximizing) agent.
The Post-World War II period saw the widespread implementation of Keynesian economic policy in the United States and Western European countries. Its dominance in the field by the 1970s was best reflected by the controversial statement attributed to US President
Richard Nixon
Richard Milhous Nixon (January 9, 1913April 22, 1994) was the 37th president of the United States, serving from 1969 until Resignation of Richard Nixon, his resignation in 1974. A member of the Republican Party (United States), Republican ...
and economist
Milton Friedman
Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and ...
: "
We are all Keynesians now
"We are all Keynesians now" is a famous phrase attributed to Milton Friedman and later rephrased by U.S. president Richard Nixon. It is popularly associated with the reluctant embrace in a time of financial crisis of Keynesian economics, for exampl ...
".
Problems arose during the
1973–75 recession which was largely triggered by the
1973 oil crisis
In October 1973, the Organization of Arab Petroleum Exporting Countries (OAPEC) announced that it was implementing a total oil embargo against countries that had supported Israel at any point during the 1973 Yom Kippur War, which began after Eg ...
. The nascent classical economists attributed the blame to Keynesian policy responses for the continued
unemployment
Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is the proportion of people above a specified age (usually 15) not being in paid employment or self-employment but currently available for work du ...
, high inflation and stagnant economic growth—
stagflation
Stagflation is the combination of high inflation, stagnant economic growth, and elevated unemployment. The term ''stagflation'', a portmanteau of "stagnation" and "inflation," was popularized, and probably coined, by British politician Iain Mac ...
. Conversely, Keynesians using the
Phillips curve
The Phillips curve is an economic model, named after Bill Phillips, that correlates reduced unemployment with increasing wages in an economy. While Phillips did not directly link employment and inflation, this was a trivial deduction from his ...
or
cost-push inflation
Cost-push inflation is a purported type of inflation caused by increases in the cost of important goods or services where no suitable alternative is available. Cause
As businesses face higher prices for underlying inputs, they are forced to incre ...
models of struggled to provide non-ad hoc explanations of stagflation and its different magnitudes across different countries, such as higher inflation in the United States and the United Kingdom than in Germany and Japan.
Emergence in response to stagflation
The New Classical school emerged in the 1970s as a response to what were perceived as failures of Keynesian economics to explain stagflation. New Classical and monetarist criticisms led by
Robert Lucas, Jr.
Robert Emerson Lucas Jr. (September 15, 1937 – May 15, 2023) was an American economist at the University of Chicago. Widely regarded as the central figure in the development of the new classical approach to macroeconomics, he received the N ...
and
Milton Friedman
Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and ...
respectively forced a labored rethinking of Keynesian economics. In particular, Lucas designed the
Lucas critique
The Lucas critique argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. More formally, it states t ...
primarily as a means to cast doubt on the Keynesian model. This strengthened the case for macro models to be based on microeconomics.
After the 1970s, the New Classical school for a while became the dominant school in Macroeconomics.
New neoclassical synthesis
Prior to the late 1990s, macroeconomics was split between new Keynesian work on market imperfections demonstrated with small models and new classical work on
real business cycle theory that used fully specified
general equilibrium
In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an ov ...
models and used
changes in technology to explain fluctuations in economic output. The new neoclassical synthesis developed as a consensus on the best way to explain
short-run
In economics, the long-run is a theoretical concept in which all markets are in economic equilibrium, equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long-run contrasts with the short-run, in which there a ...
fluctuations in the economy.
[Goodfriend, Marvin and King, Robert G. ''The New Neoclassical Synthesis and The Role of Monetary Policy''. Federal Reserve Bank of Richmond. Working papers. June 1997. No. 98–5. http://www.richmondfed.org/publications/research/working_papers/1998/pdf/wp98-5.pdf.]
The new synthesis took elements from both schools. New classical economics contributed the methodology behind real business cycle theory and new Keynesian economics contributed nominal rigidities (slow moving and periodic, rather than continuous, price changes also called
sticky prices
In economics, nominal rigidity, also known as price-stickiness or wage-stickiness, is a situation in which a nominal price is resistant to change. Complete nominal rigidity occurs when a price is fixed in nominal terms for a relevant period of tim ...
).
The new synthesis provides the theoretical foundation for much of contemporary mainstream economics.
[Woodford, Michael. ''Convergence in Macroeconomics: Elements of the New Synthesis''. January 2008. http://www.columbia.edu/~mw2230/Convergence_AEJ.pdf.]
Analytic method
The new classical perspective takes root in three diagnostic sources of fluctuations in growth: the productivity wedge, the capital wedge, and the labor wedge. Through the neoclassical perspective and business cycle accounting one can look at the diagnostics and find the main ‘culprits’ for fluctuations in the real economy.
* 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
Capital accumulation is the dynamic that motivates the pursuit of profit, involving the investment of money or any financial asset with the goal of increasing the initial monetary value of said asset as a financial return whether in the form ...
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).
Foundation, axioms and assumptions
New classical economics is based on
Walrasian assumptions. All agents are assumed to maximize
utility
In economics, utility is a measure of a certain person's satisfaction from a certain state of the world. Over time, the term has been used with at least two meanings.
* In a normative context, utility refers to a goal or objective that we wish ...
on the basis of
rational expectations
Rational expectations is an economic theory that seeks to infer the macroeconomic consequences of individuals' decisions based on all available knowledge. It assumes that individuals' actions are based on the best available economic theory and info ...
. At any one time, the economy is assumed to have a unique
equilibrium
Equilibrium may refer to:
Film and television
* ''Equilibrium'' (film), a 2002 science fiction film
* '' The Story of Three Loves'', also known as ''Equilibrium'', a 1953 romantic anthology film
* "Equilibrium" (''seaQuest 2032'')
* ''Equilibr ...
at
full employment
Full employment is an economic situation in which there is no cyclical or deficient-demand unemployment. Full employment does not entail the disappearance of all unemployment, as other kinds of unemployment, namely structural and frictional, may ...
or
potential output
In economics, potential output (also referred to as "natural gross domestic product") refers to the highest level of real gross domestic product (potential output) that can be sustained over the long term. Actual output happens in real life while ...
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
Economists use the term representative agent to refer to the typical decision-maker of a certain type (for example, the typical consumer, or the typical firm).
More technically, an economic model is said to have a representative agent if all agen ...
models. Such models have received severe neoclassical criticism, pointing to the disjuncture between microeconomic behavior and macroeconomic results, as indicated by
Alan Kirman.
The concept of
rational expectations
Rational expectations is an economic theory that seeks to infer the macroeconomic consequences of individuals' decisions based on all available knowledge. It assumes that individuals' actions are based on the best available economic theory and info ...
was originally used by
John Muth
John Fraser Muth (; September 27, 1930 – October 23, 2005) was an American economist. He is "the father of the rational expectations revolution in economics", primarily due to his article "Rational Expectations and the Theory of Price Movemen ...
, and was popularized by Lucas. One of the most famous new classical models is the
real business cycle
Real business-cycle theory (RBC theory) is a class of new classical macroeconomics models in which business-cycle fluctuations are accounted for by real, in contrast to nominal, shocks. RBC theory sees business cycle fluctuations as the effic ...
model, developed by
Edward C. Prescott
Edward Christian Prescott (December 26, 1940 – November 6, 2022) was an American economist. He received the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, Nobel Memorial Prize in Economics in 2004, sharing the award with ...
and
Finn E. Kydland.
Legacy
It turned out that pure new classical models had low explanatory and predictive power. The models could not simultaneously explain both the duration and magnitude of actual cycles. Additionally, the model's key result that only unexpected changes in money can affect the business cycle and unemployment did not stand empirical tests.
The mainstream turned to the
new neoclassical synthesis
The new neoclassical synthesis (NNS), which is occasionally referred as the New Consensus, is the fusion of the major, modern macroeconomic schools of thought – new classical macroeconomics/ real business cycle theory and early New Keynesian e ...
.
[Mankiw, N. Greg. ''The Macroeconomist as Scientist and Engineer''. May 2006. p. 14–15. http://scholar.harvard.edu/files/mankiw/files/macroeconomist_as_scientist.pdf?m=1360042085.] Most economists, even most new classical economists, accepted the
new Keynesian
New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroe ...
notion that for several reasons wages and prices do not move quickly and smoothly to the values needed for
long-run equilibrium
In economics, the long-run is a theoretical concept in which all markets are in equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long-run contrasts with the short-run, in which there are some constraints a ...
between quantities supplied and demanded. Therefore, they also accept the
monetarist
Monetarism is a school of thought in monetary economics that emphasizes the role of policy-makers in controlling the amount of money in circulation. It gained prominence in the 1970s, but was mostly abandoned as a direct guidance to monetary ...
and new Keynesian view that monetary policy can have a considerable effect in the
short run
In economics, the long-run is a theoretical concept in which all markets are in equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long-run contrasts with the short-run, in which there are some constraints a ...
.
[ Kevin Hoover (2008)]
"New Classical Macroeconomics"
econlib.org The new classical macroeconomics contributed the
rational expectations hypothesis and the idea of
intertemporal optimisation to new Keynesian economics and the new neoclassical synthesis.
See also
*
Neoclassical synthesis
The neoclassical synthesis (NCS), or neoclassical–Keynesian synthesis Mankiw, N. Gregory. "The Macroeconomist as Scientist and Engineer". '' The Journal of Economic Perspectives''. Vol. 20, No. 4 (Fall, 2006), p. 35. is an academic movement a ...
References
Further reading
*
*
*
External links
*
{{Macroeconomics
Schools of economic thought