Evolution of macroeconomic thought II

1. Classical vs. Keynesian Theory

 Classical theory: Advocates minimal government intervention.

 Keynesian theory: Prescribes active government intervention, especially via fiscal policy.

 Paul A. Samuelson (1955) introduced the Neoclassical Synthesis, combining Keynesian and classical ideas —
promoted a mixed economy.

2. Dominance of Keynesian Economics (1940s–1960s)

 Influenced policies during and after WWII to combat the Great Depression.

 Government spending was used to stimulate aggregate demand.

 Resulted in high growth in developed capitalist countries during 1950s–60s.

3. Crisis in Keynesian Economics (1970s)

 Stagflation: Simultaneous unemployment and inflation in the 1970s challenged Keynesian theory.

 Oil shock of 1973 (OPEC embargo) worsened economic conditions.

 High government expenditure led to fiscal crises.

 Keynesian tools failed to explain or fix the situation.

 Shift toward market liberalization and reducing state stimulus.

4. Rise of Monetarism

 Milton Friedman’s Monetarism gained popularity.

 Emphasis on controlling inflation and allowing wage flexibility.

 Marked a return to classical ideas, focusing on monetary policy and market efficiency.

 Price expectations began to be integrated into macroeconomic theory.

5. New Classical vs. New Keynesian Schools

 New Classical Economics:

o Emerged post-1970s.

o Advocates rational individuals and micro-foundations.

o Believes government intervention is ineffective.

o Explains business cycles through technological shocks (e.g., Real Business Cycle model).

 New Keynesian Economics:

o Built on Samuelson’s tradition.

o Recognizes imperfections in markets (e.g., wage/price rigidity).

o Despite rational behavior, market failures occur.

o Supports government intervention to correct sub-optimal outcomes.

6. Modern Synthesis: DSGE Models

 Dynamic Stochastic General Equilibrium (DSGE) models:

 o Combine features of new classical and new Keynesian theories.

o Currently used in modern macroeconomic analysis and policy modeling.

Neoclassical synthesis
1. Neoclassical Synthesis (Paul A. Samuelson, 1955)

 A blend of Classical and Keynesian ideas.

 Keynesian view for the short run, Classical results for the long run.

 Tools like IS-LM Model and Phillips Curve were developed to support this synthesis.

2. Role of Expectations (Friedman & Phelps)

 Introduced adaptive expectations in the 1960s.

 In the short run, expectations about prices (Pᵉ) remain fixed, leading to sticky wages.

 Labour demand ↓ as real wages ↑; labour supply ↑ with higher expected real wages.

 Causes less than full wage flexibility in the short run.

3. Short-Run vs. Long-Run Aggregate Supply

 Short-Run Aggregate Supply (SRAS): Upward sloping due to wage stickiness.

 Long-Run Aggregate Supply (LRAS): Vertical, because expectations adjust and nominal wages are revised.

 In the long run, expected prices = actual prices, and full employment output is achieved (Yₙ).

4. Expectations-Augmented Phillips Curve

 In the short run (SRPC): Trade-off between inflation and unemployment exists due to unanticipated
inflation.

 In the long run (LRPC): Vertical at the natural rate of unemployment (uₙ).

 No trade-off between inflation and unemployment in the long run.

 Concept of natural rate of unemployment introduced by Friedman and Phelps.

5. Summary of Adjustment Mechanism

 Short run: Keynesian outcome with sticky wages and misaligned expectations.

 Long run: Classical outcome with price/wage adjustment and full employment.

 Demand shocks affect output only in the short run.

 Supply-side factors influence long-run output.

📊 Short Run vs Long Run: Keynesian vs Classical Outcomes

Aspect Short Run (Keynesian View) Long Run (Classical View)

Vertical LRAS curve at full employment

Aggregate Supply (AS) Upward sloping SRAS curve
output (Yₙ)

Sticky wages (due to contracts or rigidities); Flexible wages and prices; adjust fully over
Wages & Prices
prices adjust slowly time
Aspect Short Run (Keynesian View) Long Run (Classical View)

Expectations (Pᵉ) Fixed or slow to adjust (adaptive expectations) Adjusted to actual price level (Pᵉ = P)

Output and employment can change due to Output returns to natural level; only supply
Employment & Output
demand fluctuations factors matter

Fiscal/monetary policy effective in changing

Policy Effectiveness Policy ineffective in changing real variables
output and employment

Short-Run Phillips Curve (SRPC): inverse

Long-Run Phillips Curve (LRPC): vertical at
Phillips Curve relationship between inflation &
natural rate of unemployment (uₙ)
unemployment

Inflation- No trade off – attempts to lower

Exists – policy can reduce unemployment
Unemployment unemployment below uₙ cause only higher
temporarily at the cost of inflation
Tradeoff inflation

Cause of Output Changes in Aggregate Supply (AS) or

Changes in Aggregate Demand (AD)
Changes productivity

Economic Adjustments Incomplete price and wage adjustments Full adjustment of all prices and wages

Keynesian vs Monetarist (Monetarism)

📊 Comparison: Keynesian Theory vs Monetarism vs New Schools

Monetarism (Milton New Classical New Keynesian

Aspect Keynesian Theory
Friedman) Economics Economics

Robert Lucas, Thomas Gregory Mankiw, David

Main Proponent John Maynard Keynes Milton Friedman
Sargent Romer

Fiscal policy to boost Monetary policy to

Micro-foundations, Micro-foundations +
Core Focus demand and reduce control inflation and
rational expectations price/wage rigidities
unemployment stabilize output

Minimal – focus on Intervention justified

Role of Active role via fiscal Minimal – markets
steady money supply due to market
Government spending adjust efficiently
growth imperfections

Inflation- No long-run trade-off;

Exists in short run No long-run trade-off; Short-run trade-off
Unemployment economy returns to
(Phillips Curve) LRPC is vertical exists due to rigidities
Trade-off natural output

Direct influence on Emphasis on Affects output if

View on Money Affects output via
output; money supply expectations; policy prices/wages are
Supply interest rate (indirect)
is key ineffective sticky

Explanation of Demand shocks, lack of Fluctuations in money Real shocks (e.g., Sticky prices/wages
Business Cycles aggregate demand supply technology changes) and nominal frictions

Fiscal > Monetary Both ineffective in

Fiscal/monetary can
Policy Effectiveness (especially during Monetary > Fiscal short run due to
work in short run
recession) rational expectations
 Monetarism (Milton New Classical New Keynesian
Aspect Keynesian Theory
Friedman) Economics Economics

Worsened due to Emphasizes

View on Great Caused by collapse in May attribute to real
failure of monetary coordination failures
Depression investment demand shocks or policy errors
expansion and rigid wages

Adaptive Rational expectations,

Expectations Implicit or adaptive Rational expectations
expectations but with rigidities

📘 Comparative Table: New Classical Economics (vs Keynesian & Monetarist Thought)

Aspect Keynesian Theory Monetarist Theory New Classical Theory

Key Proponent(s) John Maynard Keynes Milton Friedman Robert Lucas, Thomas Sargent

View on Policy Fiscal policy effective in Monetary policy more Policy ineffective if expected; only
Effectiveness short run effective than fiscal surprises work

Expectations Adaptive or static Adaptive Rational expectations

Strong microfoundations (utility,

Micro foundations Largely absent Limited
production, intertemporal choice)

Lucas Critique Not applicable Partly considered Central: Aggregative models unreliable

Markets always clear; prices/wages

Market Behavior Prices/wages are sticky Prices adjust slowly
flexible

Inflation–
Exists in short run No long-run trade-off No trade-off at all; LRPC vertical even in
Unemployment Trade-
(Phillips Curve) (vertical LRPC) short run
off

Upward sloping due to Upward sloping due to labor-leisure

Short-Run AS Curve Upward sloping
price rigidity trade-off

Vertical (full
Long-Run AS Curve Vertical Vertical (determined by real factors)
employment)

Business Cycles Demand shocks, Monetary policy Real shocks (e.g., tech changes, info
Explained by instability fluctuations shocks)

Active intervention
Government Role Passive monetary role Minimal; markets self-adjust
recommended

✅ Key Takeaways of New Classical Theory:

 Focuses on individual decision-making under constraints (micro-foundations).

 Rejects systematic policy effectiveness — if people expect a policy, it gets neutralized.

 Introduces rational expectations — people use all available information efficiently.

 Market-clearing assumption implies that any unemployment is voluntary or frictional.

Real New Classical Models

📊 Comparative Summary Table: New Classical Models of Business Cycles

Key Policy
Model Core Idea Expectations Business Cycle Cause Criticisms
Economists Effectiveness

Workers are
Temporary effect; Asymmetric:
fooled by price
Friedman Milton Misperception of price only assumes only
signals due to Adaptive
Model Friedman level by workers unanticipated workers are
adaptive
policies work fooled
expectations

Both workers
Unclear why
and firms are
Phelps Edmund Both sides misread Short-term both parties are
fooled by Adaptive
Model Phelps relative price changes effectiveness equally fooled in
aggregate price
real world
level

Agents learn
Rational agents Signal extraction
Anticipated quickly; short
Lucas Robert E. can be fooled Rational problem (mistaking
policies are information lags
Model Lucas once, but not expectations nominal shocks for
ineffective weaken the
repeatedly real ones)
"fooling" logic

Ignores demand
Real (supply)
Real No role for shocks; can't
Kydland & shocks cause Tech/weather/raw
Business Rational fiscal/monetary explain
Prescott changes in material shocks
Cycle policy recessions
potential output
without inflation

🔍 Key Insights:

 All fooling models explain business cycles through misinformation or misperception, but differ in who is
fooled and how.

 Lucas improved upon Friedman and Phelps by introducing rational expectations, making policy prediction
more realistic.

 RBC models shift away from misinformation — they explain output changes as rational responses to real
supply shocks, assuming full information and flexible markets.

New Keynesian Economics

🌐 New Keynesian Economics – Key Highlights

🔹 Background and Basis

 Emerged as a response to New Classical theories.

 Builds on Keynesian ideas using micro-foundations and rational expectations.

 Rejects perfect competition assumption; focuses on market imperfections.

 Believes in price and wage rigidities due to asymmetric information.

🔹 Key Features

 Based on rational, utility-maximizing agents, like New Classical models.

 Non-market clearing models: prices and wages adjust slowly, causing output fluctuations.

 Demand shocks can lead to changes in output and employment due to rigid prices/wages.

🔹 Sources of Rigidity

1. Menu Costs:

o Cost of changing prices (e.g., printing menus) leads firms to avoid frequent price changes.

o Small individually, but significant at the macro level.

2. Sticky Marginal Cost:

o Even without menu costs, marginal cost may not fall with marginal revenue.

o Reasons:

 Labour contracts fix wages over long durations.

 Input prices may not adjust uniformly.

 Geographic/local demand changes don’t align with cost structures.

3. Staggered Prices:

o Firms adjust prices at different times → slow aggregate price adjustment.

4. Coordination Failure:

o Firms fail to coordinate decisions, leading to low-level equilibrium.

o Results in unemployment and unused inventories, even when goods and labor are available.

🔹 Criticism

 Too many different explanations for wage/price rigidity.

 Business cycles occur even in flexible labor markets without unions or contracts.

📊 Dynamic Stochastic General Equilibrium (DSGE) Models – Key Highlights

🔹 Definition and Characteristics

 General Equilibrium: Models the entire economy, not just individual markets.

 Dynamic: Considers inter-temporal decision-making and optimisation over time.

 Stochastic: Includes random shocks (e.g., demand, supply, policy).

🔹 Origins and Evolution

 Developed from convergence of New Classical and New Keynesian ideas.

 New Classicals assume perfect competition and price/wage flexibility.

 New Keynesians include market imperfections and sticky prices/wages.

🔹 Structure of DSGE Models

Three core components:

 1. Demand Block

2. Supply Block

3. Monetary Policy Equation (often based on Taylor Rule)

All are derived from micro-foundations (i.e., behaviour of individual agents).

🔹 Key Features

 Based on rational expectations and optimising behaviour.

 Simple DSGE includes:

o IS Curve: from rational expectations theory of consumption.

o SP Curve: inflation depends on expected inflation and output gap (Phillips Curve version).

o Taylor Rule: central bank sets interest rate in response to inflation and output gap.

🔹 Purpose and Use

 Helps explain and predict business cycles caused by various shocks.

 Widely used in macroeconomic policy analysis.

🔹 Policy Applications

1. Currency Depreciation:

o Positive: boosts exports.

o Negative: raises debt servicing burden and import costs (esp. inelastic goods like oil).

2. Interest Rate Hike:

o Positive: controls inflation via reduced demand.

o Negative: raises borrowing costs and may raise prices.

o DSGE helps weigh trade-offs and assess net impact.