The New Classical Model

The New Classical Model Chapter 22 Appendix 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 aggregate 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 immediate 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: π t = E t-1 π t + γ 1Y t - Y P 2 (1 1 See 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. 1

2 chapter 22 appendix where π t = Inflation at time t, that is, the change in the price level from period t - 1 to period t E t-1 π t = Inflation from period t - 1 to period t, which is expected at time t - 1 using rational expectations Y t = 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 E t-1 π t is the same thing as expected inflation π e, 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 π 1. The short-run aggregate supply curve for this level of expected inflation, AS 1, passes through point 1 because at Y t = Y P, Equation 1 shows that actual inflation will be equal to π 1. As shown in Figure 22A1.1, if Y t 7 Y P, then inflation increases along the AS curve by the amount γ1y t - Y P 2, as the upward sloping short-run aggregate supply curve AS indicates. The short-run aggregate supply curve AS 1 is thus specific to an expected inflation rate of π 1 and is marked this way in Figure 22A1.1. Figure 22A1.1 Aggregate Supply in the New Classical Model The new classical model has shortrun aggregate supply curves that are upward-sloping and specific to a particular expected inflation rate, as AS 1 and AS 2 indicate. AS 1 is fixed for E t - 1 π t = π 1, and this is why it is marked as AS 1 1E t - 1 π t = π 1 2 and is drawn to pass through point 1, where, at an actual inflation rate of π 1, aggregate output is at potential 1Y = Y P 2 and so expected inflation is also at Inflation Rate, p p 2 p 1 π 1 1E t - 1 π t = π 1 2. Similarly, AS 2 is fixed for E t - 1 π t = π 2 and is marked as AS 2 1E t - 1 π t = π 2 2: it is drawn to pass through point 2, where, at an actual inflation rate of π 2, aggregate output is at potential 1Y = Y P 2 and so expected inflation is also at π 2 1E t - 1 π t = π 2 2. LRAS Y P 2 1 AS 2 = p 2 AS 1 = p 1 Aggregate Output, Y

The New Classical Model 3 By the same reasoning, if expected inflation is instead at π 2, then the short-run aggregate supply curve will shift up and to the left to AS 2, where it passes through point 2, because, as Equation 1 shows, when Y t = Y P, inflation will be equal to π 2. The short-run aggregate supply curve AS 2 is thus specific to an expected inflation rate of π 2, 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 AS 1 to AS 2 if expected inflation rises from π 1 to π 2. Misperceptions Theory We 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 relative 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 E t-1 π t from both sides of the equation, dividing by γ, and then putting Y t - Y P on the left-hand side. The transformed equation is then as follows: Y t - Y P = 1π t - E t-1 π t 2>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 production, 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 general, and he will want to cut production. If we extend this analysis to other producers besides Isaac, we come to the conclusion 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 2 The 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.

4 chapter 22 appendix 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 Policy The 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 Policy Suppose that the economy is initially at point 1 in Figure 22A1.2, where actual and expected inflation are at π 1 and the short-run aggregate supply curve is at AS 1. The initial aggregate demand curve intersects AS 1 at point 1, where the realized inflation rate is equal to the Figure 22A1.2 Response to expansionary Policy in the New Classical Model Initially, the economy is at point 1 at the intersection of AD 1 and AS 1 1E t - 1 π t = π 1 2, where aggregate output is at Y P and inflation is at π 1. An expansionary policy shifts the aggregate demand curve from AD 1 to AD 2, but if the policy is unanticipated, the shortrun aggregate supply curve remains at AS 1. Equilibrium now occurs at point 2 aggregate output has increased to Y 2, and inflation has increased to π 2. If the expansionary policy is Inflation Rate, p p 2 p 2' p 1 anticipated, then the short-run aggregate supply curve shifts uo AS 2 1E t - 1 π t = π 2 2. The economy then moves to point 2, where aggregate output does not change from Y P, but inflation rises by even more to π 2. LRAS Y P 2 1 Y 2' Step 3. If the policy is anticipated, AS shifts up and the economy moves to point 2, and inflation rises by more, but output does not rise. 2' AS 2 = p 2 AS 1 = p 1 Step 2. If the policy is unanticipated, AS doesn t shift and the economy moves to point 2', and inflation and output rise. AD 2 AD 1 Step 1. Positive demand shock shifts AD to the right. Aggregate Output, Y

The New Classical Model 5 expected inflation rate π 1 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 supply 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 AD 2. If this expansionary policy is unexpected, the expected inflation rate remains at π 1 and the short-run aggregate supply curve remains at AS 1. Equilibrium is now at point 2, at the intersection of AD 2 and AS 1. Aggregate output increases above potential output to Y 2 and the realized inflation rate increases to π 2. Anticipated Expansionary Policy Suppose, 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 AD 1 to AD 2, and inflation will rise to π 2. With expected inflation at π 2, the short-run aggregate supply curve then shifts up from AS 1 to AS 2 and intersects AD 2 at point 2, the equilibrium point at which aggregate output is at potential output Y P and the inflation rate has risen to π 2. 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 output. 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 AS 2 (corresponding to an expected inflation rate of π 2 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 Proposition We 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 associated 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 classical model allows aggregate output to fluctuate away from potential output as a result of unanticipated shifts in the aggregate demand curve. The policy ineffectiveness proposition 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 Outcomes Another 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

6 chapter 22 appendix Proof of the Policy Ineffectiveness Proposition The proof that in the new classical macroeconomic model aggregate output necessarily remains at potential output when there is anticipated 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 optimal forecast of inflation is given by the intersection of the aggregate supply curve with the anticipated aggregate demand curve AD 2. If the short-run aggregate supply curve is below AS 2 in Figure 22A1.2, it will intersect AD 2 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 shortrun aggregate supply curve is above AS 2, the assumption of rational expectations is violated. Only when the short-run aggregate supply curve is at AS 2 (corresponding to an expected inflation rate of π 2 are expectations rational, because at that point the optimal forecast of inflation equals expected inflation. As we see in Figure 22A1.2, the AS 2 curve implies that aggregate output remains at potential output as a result of the anticipated expansionary policy. cut in income taxes or interest rates, can lead to a decline in aggregate output if the public 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 AD 1 and AS 1 : output is at Y P and the inflation rate is at π 1. Now suppose that the public expects the government to cut taxes to shift the aggregate demand curve from AD 1 to AD 2. As we see in Figure 22A1.3, the short-run aggregate supply curve shifts leftward from AS 1 to AS 2 because the inflation rate is expected to rise to π 2. Suppose the expansionary policy actually falls short of what was expected, so that the aggregate demand curve shifts only to AD 2. The result of the mistaken expectation is that output falls to Y 2 in the short run, while the inflation rate rises to π 2 rather than to π 2. An expansionary policy that is less expansionary than anticipated leads initially to an output movement directly opposite to that intended. Implications for Policy Makers The 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 decisions 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 New Classical Model 7 Figure 22A1.3 Uncertainty About Policy Outcomes Because the public expects the aggregate demand curve to shift to AD 2, the shortrun aggregate supply curve shifts to AS 2 1E t - 1 π t = π 2 2. When the actual expansionary policy falls short of the public s expectation (the aggregate demand curve merely shifts to AD 2, the economy ends up at point 2, at the intersection of AD 2 and AS 2. Despite the expansionary policy, aggregate output falls to Y 2. Inflation Rate, p p 2 p 2' p 1 Step 3. The economy moves to point 2', where output falls. LRAS 2 2' 1 Y Y P 2' AS 2 = p 2 AS 1 = p 1 Step 1. AS shifts uo AS 2 because the public expects AD to shift to AD 2. AD 2 AD 2' AD 1 Step 2. Expansionary policy shifts AD to AD 2', which is less than the expected AD 2. Aggregate Output, Y 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 difficulties because the public has rational expectations and will try to guess what policy makers 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 Model Although the new classical model was a major advance in business cycle modeling, particularly 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

8 chapter 22 appendix 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 business 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 number of years. In addition, empirical evidence casts doubt on the policy ineffectiveness proposition, 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 marketclearing and flexible prices. The other, the new Keynesian model, sought to provide better microfoundations for sticky prices and placed price stickiness at its core. 3 For empirical evidence on the policy ineffectiveness proposition, see Robert J. Barro, Unanticipated Money Growth 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 of Political 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 Frederic S. Mishkin, A Rational Expectations Approach to Macroeconometrics: Testing Policy Ineffectiveness and Efficient Markets Models (Chicago: University of Chicago Press, 1983.

The New Classical Model 9 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 Terms misperceptions theory, p. 3 new classical model, p. 1 policy 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 ineffectiveness proposition have for policy makers? 4. What objections to the new classical model have been raised?