The new classical school

Introduction
During the early 1970s there was a significant renaissance of the belief that a
market economy is capable of achieving macroeconomic stability, providing
that the visible hand of government is prevented from conducting misguided
discretionary fiscal and monetary policies. In particular the ‘Great Inflation’
of the 1970s provided increasing credibility and influence to those economists
who had warned that Keynesian activism was both over-ambitious and,
more importantly, predicated on theories that were fundamentally flawed. To
the Keynesian critics the events of the Great Depression together with Keynes’s
theoretical contribution had mistakenly left the world ‘deeply sceptical about
self-organising market systems’ (Sachs, 1999). As we have seen in Chapters 3
and 4, the orthodox Keynesian insistence that relatively low levels of unemployment
are achievable via the use of expansionary aggregate demand policies
was vigorously challenged by Milton Friedman, who launched a monetarist
‘counter-revolution’ against policy activism during the 1950s and 1960s.
During the 1970s another group of economists provided a much more damaging
critique of Keynesian economics. Their main argument against Keynes
and the Keynesians was that they had failed to explore the full implications of
endogenously formed expectations on the behaviour of economic agents.
Moreover, these critics insisted that the only acceptable way to incorporate
expectations into macroeconomic models was to adopt some variant of John
Muth’s (1961) ‘rational expectations hypothesis’.
Following Thomas Sargent’s (1979) contribution, rational expectationists,
who also adhered to the principle of equilibrium theorizing, became known
collectively as the new classical school. As the label infers, the new classical
school has sought to restore classical modes of equilibrium analysis by assuming
continuous market clearing within a framework of competitive markets.
The assumption of market clearing, which implies perfectly and instantaneously
flexible prices, represents the most controversial aspect of new classical
theorizing. According to Hoover (1992), the incorporation of this assumption
represents the classical element in their thinking, namely a firm conviction
‘that the economy should be modelled as an economic equilibrium’. Thus, to
new classical theorists, ‘the ultimate macroeconomics is a fully specified
general equilibrium microeconomics’. As Hoover notes, this approach implies
not only the revival of classical modes of thought but also ‘the euthanasia
of macroeconomics’!