ECON 1110 Lecture Notes 12

ECON 1110 Lecture Notes 12 - ECON 1110 Lecture Notes 12...

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ECON 1110 Lecture Notes 12 ECON 1110 Intermediate Macroeconomics James R. Maloy Spring 2011 Lecture Notes for Topic 12: New Classical Macroeconomics Readings: Froyen Chapter 11 (8 th Ed. Ch. 12) I. Introduction to the New Classical Position New classical economics emerged in the 1970s as a radical challenge to the fundamental assumptions of the Keynesian and monetarist theories. Recall that we saw that Keynesians believe that government policies that shift aggregate demand will be effective in changing output in the short run, since labour supply and therefore aggregate supply do not immediately adjust to the resulting change in prices. Keynesians believe that workers use backwards looking expectations in determining the expected price, and that only in the long run will workers realise that prices have changed and thus only in the long run will aggregate supply shift and return the output to the original level. Policy is effective in the short run. Monetarists would agree with this analysis for the most part. Recall that monetarists believe that only monetary policy is effective and argue that the private sector is stable and hence there is not need for active policymaking, but the monetarist model basically uses the Keynesian framework. Most of the differences between monetarists and Keynesians are centred on empirical issues, such as arguments over the stability of money demand and the private sector. The monetarist theory does not challenge the fundamentals of the Keynesian AS-AD; it just argues that the data and theory should be interpreted in a different way. The new classical economists, led by Robert Lucas, challenge the fundamentals of Keynesian and monetarist theory. As the name suggests, new classical economics is firmly rooted in the classical tradition, which Keynes thoroughly rejected in forming his model. The remainder of this topic will discuss what the new classical economists see as fundamental flaws in the Keynesian system and the alternative theories Lucas and his followers propose. The role of government policy in the new classical model will also be covered. The Keynesian response to the new classical theories will also be discussed. 1
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ECON 1110 Lecture Notes 12 II. The Rational Expectations Hypothesis The rational expectations hypothesis is fundamental to the new classical criticism of Keynesian and monetarist theory. New classical economists argue that the backwards looking formation of price expectations in the earlier models is “naïve in the extreme.” Backwards looking expectations imply that workers are systematically fooled; that they never learn, for example, that an increase in the money supply will cause price increases until much later. The rational expectations hypothesis states that workers will use all available information in forming expectations . There is no reason why workers would ignore current information and intentionally form incorrect price expectations. Furthermore, rational expectations theorists expect agents to interpret the information intelligently. Participants in
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This note was uploaded on 03/10/2012 for the course ECON 1110 taught by Professor Tedloch-temzelides during the Spring '08 term at Pittsburgh.

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ECON 1110 Lecture Notes 12 - ECON 1110 Lecture Notes 12...

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