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A Response to Hoover’s The New Classical Macroeconomics

Tuesday, February 19th, 2008

In Kevin Hoover’s introduction, he discusses as to why Keynesian economics began to fade away by the 1970s.  The “Keynesian dominance of macroeconomics” ended because of the “absence of microfoundations for macroeconomics.”  Hoover cites two prime examples where microfoundations are incorporated into aggregate economic relationships–the life-cycle model and permanent-income hypothesis.  Don Patinkin sought to prove these two theories using the value theory of money and rational expectations and decided that Keynesian economics was the “economics of disequilibrium” because when labor markets are in equilibrium, there is no involuntary unemployment.  In continuing reading, I couldn’t quite understand the microfoundations that Keynes had left out of his model nor why his models dealing with the labor market were considered in disequilibrium.  Hoover continues the macroeconomic story by mentioning the fact that both Milton Friedman and Edmund Phelps recognized that there is no long-run trade off between unemployment and inflation.  Only in the short run, however, can the two be traded off so as long as people mistake absolute prices (nominal) for higher relative prices (real).  Thus, it is important to note that both Friedman and Phelps recognized that expectations plays a large role in determining how high inflation can be to lower the unemployment rate because once people don’t confuse the real and nominal prices, the two rates will both increase and there will no longer be a trade off.  It was at this point that John Muth’s idea of rational expectations started to confound policymakers and thus macroeconomic policy was proven to be ineffective during the 1970s when the country faced both high inflation rates and high unemployment rates.  This idea of stagflation and incorporation of rational expectations is what Kevin Hoover cites as the second factor that led to the downfall of Keynesian economics.

The birth of new classical macroeconomics became prominent in the 1980s when economists used rational expectations in their models because they believed that “macroeconomic models are legitimate only if they possess market-clearing microfoundations grounded in individual rationality.”  The first question that needs to be addressed is the difference between classicals and Keynesians.  In class, we did look at this comparison, but I will reiterate it in the blog once more.  Classicals view the aggregate supply curve as vertical.  As the price rises, the real wage will fall and employers will want to hire more labor, but workers won’t work for lower real wages and therefore, the labor supply market is no longer in equilibrium (demand > supply) and the only way to return to equilibrium is to raise nominal wages by as much as the increase in the price level.  At this point, the old real wage is reached again and full employment is at the same level as before the rise in prices.  Therefore, inflation doesn’t affect GDP potential.  According to Hoover, the Keynesians viewed the aggregate supply curve as a J-curve because Keynes couldn’t explain it, but still made the assumption that there was some involuntary unemployment in the labor market.  As a result, employers could hire those individuals at lower real wages, which would put the employment level at a level greater than what it previously was, and consequently, push GDP potential to the right.  However, even Keynes recognized that the real wage couldn’t drop below it’s market-clearing level (where supply = demand) because workers wouldn’t accept those low real wages.  In this section of Chapter 1, Hoover makes one last comparison between classicals and Keynesians in that he said that classicals believed that the monetary side (i.e. changes in the money supply) only affected nominal output whereas Keynesians believed that the monetary side could have real effects on GDP.  Afterwards, he comments that the neoclassical synthesis between classicals and Keynesians was in describing the vertical section of Keynes’ J-curve because at that point, the economy is in equilibrium.  (It is here where Hoover makes it known that their biggest accomplishment was in developing the Phillips curve.)

 The quantity theory of money was “kept alive” by the monetarists who also believed that long-run markets cleared, which is modeled by a vertical aggregate supply curve.  The biggest distinction for defining a monetarist is someone who ascribes to the notion that inflation is a monetary phenomenon–that is, if the money supply is increased by x percent, then the price level will increase by x percent and be returned to the GDP potential.  (In the short run, however, Hoover notes that an increase in aggregate demand will increase actual GDP, but at a higher price.  When people’s expectations come in to focus with the higher prices, the aggregate supply curve will shift up and GDP will return to potential, but at even higher prices than before.

As new classical economics came into being, it was first considered “radical monetarism” because it built in expectations into the Phillips curve model.  Essentially, the model of aggregate demand-aggregate supply (long- and short-run) looks identical except for the fact that the aggregate supply curves have been replaced by “virtual aggregate supply” curves that reflect “money illusion” (i.e. real prices rather than absolute prices should matter to them) that is, once people’s expectations account for the random errors, they will move off of the curve.  Thus, if the shift in aggregate demand is expected, the price level will increase but the GDP potential will remain unchanged.  However, if the change is unanticipated, then GDP actual will move past GDP potential at a higher price, but when people realize the higher prices, GDP actual will move back to GDP potential at the cost of even higher prices.  Essentially, new classicals view the aggregate curves as nothing more than “crude devices that do not reveal the underlying behavior of optimizing individuals.”  According to the classicals, these graphical relationships shouldn’t be the basis for any economic analysis.

Hoover lists three tenets for new classicals–(1) savings, consumption, or investment are based on real, not nominal factors; (2) agents seek to maximize but are constrained by the limits of their information; and (3) agents make decisions with rational expectations.  The author also stresses the role of rational expectations.  As in class, the book, too, discusses two forms of rational expectations.  Either people do the best they can with the information they have (weak form of rational expectations) or people construct a model of the world and use that model to form their expectations (strong version of rational expectations).  Hoover extends the idea of rational expectations to Milton Friedman’s natural rate of unemployment hypothesis (1968).  Here, Hoover validates Friedman’s hypothesis by stating that there will be short-run deviations from the natural rate only because people mistake changes in their nominal wages for changes in their real wages.

Lucas and Rapping (1969) modified Friedman’s natural rate hypothesis and can probably be the first paper to deserve the title of “new classical.”  The two suggest that Friedman assumed labor supply to be elastic–that is, as wage rates increased, the labor supply would increase indefinitely.  However, this is not fully true because labor supply is dependent on population constraints and demographic changes and as a result, the long-run labor supply is inelastic with respect to the real wage.  Friedman generated an unemployment model based on people’s adaptive expectations of wages in time period t-1 and t, but Lucas and Rapping didn’t think adaptive expectations explained the fluctuations in unemployment.  The two felt that people’s expectations always lagged behind the real wage in time t because of unanticipated increases in the level of inflation, and consequently, the laborers would consistently think that their real wage was higher than normal, but eventually there would be decreases back to the original levels of employment.  This lagged expectation is why they didn’t think that expectations fit into the model of the natural rate.  Nevertheless, the one point that Lucas stresses is that agents act rationally, but will still make mistakes (random) that can be large or small.  The key to rational expectations, though, is to develop a rational expectation model that minimizes those mistakes so he can discern what was due to real price changes versus inflationary pressures.

Source: Hoover, Kevin D.  1988.  The new classical macroeconomics.  Cambridge, Massachusetts: Basil Blackwell.