The New Classical Economics : Rational Expectations Model

INTRODUCTION

• An important post-Keynesian development in macroeconomics is the rational expectations model, propounded in the 1970s by Robert Lucas, which re-established several classical ideas and is therefore known as New Classical Economics.

• This model emerged against the background of simultaneous high inflation and high unemployment in the United States during the 1970s, a situation that appeared to contradict Keynesian theory and generated widespread dissatisfaction with Keynesian explanations and policies.

• The rational expectations approach is closely related to monetarism associated with Milton Friedman, as both draw from classical economics and advocate non-intervention by the government, but new classical economists are even more sceptical than monetarists about the effectiveness of activist fiscal and monetary policies.

• New classical economists regard the Keynesian framework as fundamentally flawed and offer a more basic and far-reaching critique than monetarists, arguing that demand-management policies do not influence real variables such as output and employment.

• A central conclusion of the new classical approach is the policy ineffectiveness postulate, which states that systematic monetary and fiscal policies cannot achieve macroeconomic stabilisation through aggregate demand management, either in the short run or the long run.

• While monetarists believe discretionary fiscal policy is ineffective in the long run but accept that systematic monetary policy can affect output and employment in the short run, new classical economists reject the usefulness of activist fiscal and monetary policies altogether, making their challenge to Keynesian economics more fundamental.

RATIONAL EXPECTATIONS: MEANING

• New Classical Economics, developed by Robert Lucas of the University of Chicago, is founded on the rational expectations hypothesis, which states that economic agents such as workers and firms form expectations about the future by using all available information and making the best possible forecasts, even though the future is uncertain.

• Earlier Phillips Curve analysis assumed that workers and firms made systematic errors, repeatedly mistaking higher money wages caused by inflation for higher real wages, and therefore supplied more labour when inflation rose, which created a stable trade-off between inflation and unemployment.

• Lucas rejected this assumption, arguing that individuals do not make systematic mistakes; although they may be temporarily misled by unexpected policy changes, especially monetary surprises, they quickly adjust once they recognise the true situation.

• As explained by Robert J. Barro, an unanticipated increase in money supply may temporarily fool workers into believing their real wages have risen, and producers into thinking relative prices of their goods have improved, leading to a short-lived boom; however, once expectations adjust, output and employment return to their natural levels.

• A key feature of the rational expectations model is the belief in continuous market-clearing equilibrium, rejecting wage and price stickiness; with rational expectations, wages and prices are set at levels that ensure labour and product markets clear on average, leaving little scope for systematic government intervention to influence real variables.