ECON 364 – Topic Seven

New Classical Economics

Most Taken From: "New Classical Economics" by Robert King, The Fortune Encyclopedia of Economics, ed. by David R. Henderson

 

In the New Classical Macroeconomics, supply and demand result form the actions of economically rational households and firms.

Keynes dominated when these principles were developed in micro theory -- therefore they weren't incorporated into macroeconomics.

 

Fixed Rules of Thumb (Keynes) vs. Rational Behavior (New Classical):

 

Instead of deriving demand from individual choices that are made within specified constraints, for example, the Keynesian procedure was to directly specify a behavior rule.

 

For example, C = f (Y) -- there was no presumption that households or firms acted rationally.

 

People didn't act purposefully, simply followed some rule of thumb.

 

If people's economic behavior is purposeful, the task of specifying how they will act in various situations is more complicated and, therefore, more difficult to model.  It becomes more "individual" in nature, less "macro."

 

The General Differences in Perspective:  Keynes vs. New Classical Economics

 

Remember with Keynes:

1.  market outcomes not desirable, need government

2.  short run, supply side changes happen in the long run, which are too far away

3.  fiscal and monetary policy can control demand conditions for specific products and for the economy as a whole

 

In contrast, the New Classical School:

1.  because of economically rational agents, efficiency takes place and markets clear -- leading to more socially desirable outcomes

2.  systematic importance of supply-side factors (Say's law) in both short run and long run

3.  questions whether typical short run policy instruments can be manipulated to accomplish specific policy objectives

 

Current Policy Discussions

1.  a temporary tax cut for the middle class

2.  a temporary revival of the investment tax credit

3.  expansionary policies by the FED

 

To look at these different policies, must look at the differences between the two schools with respect to consumption and investment.

 

Determinants of Consumption and Investment

Keynes:

C = primarily f (current disposable income)

New Classical:

C in a specific time period = f (current income and on the income it expects in the future, as well as the interest rates at which it can borrow or lend)

Keynes:

I = f (current cash flows to a firm and current cost of capital)

New Classical:

I = f (agree with above, but stress the role of expected future cash flows and expected future costs of capital as well)

 

Main Difference:  the importance of expectations about future economic conditions.

 

Keynesians:  don't think expectations are that important.  Expectations change gradually based upon "animal spirits", not rationality.

 

New Classical:  individuals are constantly trying to determine what will actually happen in the future and using new information efficiently in gauging the relative likelihood of different economic outcomes.

 

Policies:

 

1.  Temporary Tax Cuts for the Middle Class

 

Keynes:  Tax cuts leave households with more funds, so they spend more, increasing AD, increasing income and employment.

    Two possible problems (not very important):  people save or they spend their tax cut on imported goods instead of domestic goods.  Standard MPC = .6.

 

New Classical:  a one time tax cut will have a minimum effect on consumption.  The tax cut is temporary and people know it.  So people can't finance consumption on a sustained basis.  So the MPC is only .05 -- as people save about 95% thinking their taxes will go up again.  Note the look into the future and people acting rationally to deal with it.

 

Permanent income changes (job loss, for example) vs. temporary, transitory variations.  According to the NCS, consumption changes little with transitory variations, but a lot with permanent income changes.

 

So the NCS say Keynesians over-estimate the effect of a temporary tax cut.

Also, when there is a tax cut now, government borrows more and taxes will be raised in the future.  So overall demand will decrease in order to save for the future.

 

2.  On Again Off Again Investment Tax Credit (ITC)

 

ITC allows companies to deduct a fraction of the purchase price of a new investment good from its corporate income tax.

So, incentives to invest increases.

 

Keynes:  a tax credit will create large, immediate increases in investment spending.

 

New Classical:  but if it is temporary, then a firm will try to work its investment around the years in which there is an investment tax credit.  So investment demand may be very high one year to take advantage of the credit, but decline considerably in the future.

 

For example:  If there's a restoration of the tax credit in year 2004 that takes effect in Jan. 2005, the effect will not happen until 2005 -- not now, when the "stimulus" is needed.

 

3.  Monetary Policy and Macroeconomic Activity

 

Orthodox Keynes:  in the 50s and 60s -- permanent increases in the money supply would lead to permanent increases in GDP and vice versa.

 

Phillips Curve Again:

 

 

 

But now, few economists believe that high inflation has any important long-run benefits, but instead costs.

Why?

1.  work of Milton Friedman and others shows that little or no long run trade-off exists.

2.  the coexistence of high inflation and low growth (high unemployment) in the U.S. in the 70s

 

Thus, if a U.S. recession is due in part to real factors, such as a decline in the U.S. competitiveness in world markets -- monetary policy has limited ability to make things better.

Basically, should we focus on short-run "fine-tuning" (Keynes) or on the long-run growth of the economy (more New Classical)?

 

Keynes:  short run tuning

New Classical:  long run growth

 

Study Questions to consider:

 

  1. What is the difference between how the New Classical Macroeconomists (NCE) and the Keynesians model the behavior of economic actors?

  1. What are the three general differences between Keynesian and NCE perspectives?

  1. What are the differences between Keynesians and NCE with respect to consumption?

  1. What are the differences between Keynesians and NCE with respect to investment?

  1. What role do expectations play in the answers to 3 and 4?

  1. How would Keynesians and NCE differ with respect to the effects of a temporary tax cut on the middle class?

  1. How would Keynesians and NCE differ with respect to the effects of a temporary investment tax credit?

  1. How would Keynesians and NCE differ with respect to the effects of monetary policy – i.e., permanent increases in the money supply?  Relate your answer to the Phillips Curve. 

  1. Why did the Phillips curve theory break down – two reasons?

  1. How would Keynesians and NCE differ with respect to what economists should be focusing on (regarding policy)?