The Structure of New Classical Models
The new classical school emerged as a distinctive group during the 1970s
and, as we have already noted, the key figure in this development was Robert
E. Lucas Jr. However, the roots of the new classical research tradition are
diverse. For example, the emphasis in early new classical models on information
and expectations provides a link to the Austrian tradition best represented
by the work of Hayek (see Chapter 9). The distinction made by Lucas
between impulse (shocks) and propagation mechanisms when analysing business
cycles has its origins in the pioneering research of Frisch (1933). The
important role given to monetary disturbances in generating aggregate instability
is solidly in the classical and Friedmanite monetarist traditions; indeed,
Tobin (1981) refers to the early new classical contributions as ‘monetarism
mark II’. The work of Phelps et al. (1970) on the Microfoundations of
Employment and Inflation Theory inspired Lucas to utilize the insights gleaned
from Phelps’s use of the ‘island parable’ and search theory to analyse labour
market dynamics. Finally the methodological approach of Lucas is heavily
influenced by the general equilibrium tradition of Walras, Hicks, Arrow and
Debreu (see Zijp, 1993; Beaud and Dostaler, 1997).
The new classical approach as it evolved in the early 1970s exhibited
several important features:
1. a strong emphasis on underpinning macroeconomic theorizing with neoclassical
choice-theoretic microfoundations within a Walrasian general
equilibrium framework;
2. the adoption of the key neoclassical assumption that all economic agents
are rational; that is, agents are continuous optimizers subject to the
constraints that they face, firms maximize profits and labour and households
maximize utility;
3. agents do not suffer from money illusion and therefore only real
magnitudes (relative prices) matter for optimizing decisions;
4. complete and continuous wage and price flexibility ensure that markets
continuously clear as agents exhaust all mutually beneficial gains from
trade, leaving no unexploited profitable opportunities.
Given these assumptions, changes in the quantity of money should be neutral
and real magnitudes will be independent of nominal magnitudes. However,
empirical evidence shows that there are positive correlations (at least in the
short run) between real GDP and the nominal price level (an upward-sloping
aggregate supply curve), between changes in the nominal money supply and
real GDP, and negative correlations between inflation and unemployment (a
Phillips curve); that is, empirically money does not appear to be neutral in the
short run. Solving this puzzle between the neutrality of money predicted by
classical/neoclassical theory and empirical evidence showing non-neutralities
would be a considerable intellectual achievement (Zijp, 1993, refers to this as
the ‘Lucas problem’). Lucas’s (1972a) seminal paper, ‘Expectations and the
Neutrality of Money’, was just such an achievement. Lucas’s key insight was
to change the classical assumption that economic agents have perfect information
to an assumption that agents have imperfect information.
We can sum up the main elements of the early new classical approach to
macroeconomics as the joint acceptance of three main sub-hypotheses involving
(i) the rational expectations hypothesis; (ii) the assumption of
continuous market clearing; and (iii) the Lucas (‘surprise’) aggregate supply
hypothesis. In the discussion of these hypotheses individually in what follows,
the reader should bear in mind that although new classicists accept all
three hypotheses (see Figure 5.1), it is possible for economists of different
persuasions to support the rational expectations hypothesis without necessarily
accepting all three together.
The rational expectations hypothesis
One of the central tenets underlying new classical macroeconomics is the
rational expectations hypothesis (REH) associated with the work of John
Muth (1961) initially in the context of microeconomics. It is, however, interesting
to note that Keuzenkamp (1991) has suggested that Tinbergen was a
precursor to Muth, having presented a model of rational expectations nearly
30 years earlier. We should also note that it was Alan Walters (1971) who first
applied the idea of what he called ‘consistent expectations’ to macroeconomics.
However, it was John Muth’s (1961) seminal paper that proved to be most
influential on the research of the young new classical Turks during the early
1970s. In his seminal article, Muth suggested ‘that expectations since they
are informed predictions of future events are essentially the same as the
predictions of the relevant economic theory’.
Expectations, which are subjective, are fundamental to the behaviour of
economic agents and all economic activities have an informational/expectational
dimension. For example, expectations of the future value of economic variables
will clearly influence demand and supply decisions. As Carter and Maddock
(1984) note, ‘since virtually all economic decisions involve taking actions now
for uncertain rewards in the future, expectations of the future are crucial in
decision making’. An obvious example where expectations of inflation will
influence behaviour concerns wage negotiations between trade unions and
employers. Should a trade union negotiator underestimate the rate of inflation
prevailing over the period of the negotiated wage contract, then workers are
likely to find that they have suffered a nominal wage increase, but a real wage
cut.
An expectation of the future value of some key economic variable need not
be confined to a single predicted value but can more realistically take the
form of a probability distribution of outcomes. Therefore, there are two key
questions facing macroeconomists with respect to incorporating expectations
into macroeconomic models:
1. how do individuals acquire, process and make use of information in
order to form expectations of key variables?
2. what form of expectations hypothesis should we use in macroeconomic
models?
During the 1970s, the rational expectations hypothesis replaced the adaptive
expectations hypothesis as the dominant way of modelling endogenous expectations
(in his General Theory, published in 1936, Keynes had stressed the
importance of expectations for understanding macroeconomic instability, but
in Keynes’s theory expectations were exogenous, being driven by ‘animal
spirits’; see Chapter 8 and Keynes, 1937). One great appeal of the rational
expectations hypothesis is that alternative (non-rational) hypotheses of expectations
formation involve systematic errors, a situation that does not sit
comfortably with the rational calculating agents that populate orthodox neoclassical
models.
The rational expectations hypothesis has over the years been presented in
the literature in a number of different forms and versions (see Redman,
1992). At the outset it is important to note the distinction between weak and
strong versions of the hypothesis. The main idea behind the weak version of
the hypothesis is that, in forming forecasts or expectations about the future
value of a variable, rational economic agents will make the best (most efficient)
use of all publicly available information about the factors which they
believe determine that variable. In other words, expectations are assumed to
be formed ‘rationally’ in line with utility-maximizing behaviour on the part
of individual economic agents. For example, if economic agents believe that
the rate of inflation is determined by the rate of monetary expansion, they
will make the best use of all publicly available information on rates of
monetary expansion in forming their expectations of future rates of inflation.
The strong version of the rational expectations hypothesis is captured in the
above quotation taken from Muth’s (1961) article and it is the Muthian
version that has been taken up by leading exponents of the new classical
school and incorporated into their macroeconomic models. In the Muthian
‘strong’ version, economic agents’ subjective expectations of economic variables
will coincide with the true or objective mathematical conditional
expectations of those variables. Using the example of economic agents’ expectations
of inflation (P˙t ),
e the rational expectations hypothesis may be
expressed algebraically in the following way:
P˙ E(P˙ | ) t
e
= t Ωt−1 (5.1)
where ˙Pt is the actual rate of inflation; E(Pt t ˙ |Ω −1) is the rational expectation
of the rate of inflation subject to the information available up to the previous
period (Ωt−1). It is important to emphasize that rational expectations does not
mean that agents can foresee the future exactly. Rational expectations is not
the same as perfect foresight. In order to form a rational expectation of
inflation, agents will need to take into account what they believe to be the
‘correct’ macroeconomic model of the economy. Agents will make errors in
their forecasts, since available information will be incomplete. Indeed, this is
an essential element of Lucas’s monetary surprise model – see sections 5.3.3
and 5.5.1. However, such forecast errors will be unrelated to the information
set at the time the expectation (for example of inflation) was formed. With
rational expectations, agents’ expectations of economic variables on average
will be correct, that is, will equal their true value. Furthermore, the hypoth
esis implies that agents will not form expectations which are systematically
wrong (biased) over time. If expectations were systematically wrong, agents
would, it is held, learn from their mistakes and change the way they formed
expectations, thereby eliminating systematic errors. More formally, the strong
version of the rational expectations hypothesis implies that:
P˙ P˙ t
e
= t + εt (5.2)
where ˙Pt
e = expected rate of inflation from t to t + 1; ˙Pt = actual rate of
inflation from t to t + 1; and εt = random error term, which (i) has a mean of
zero, and (ii) is uncorrelated with the information set available at the time
when expectations are formed, otherwise economic agents would not be fully
exploiting all available information. In summary, the forecasting errors from
rationally formed expectations will (i) be essentially random with a mean of
zero; (ii) be unrelated to those made in previous periods, revealing no discernible
pattern: that is, they will be serially uncorrelated over time; and (iii)
have the lowest variance compared to any other forecasting method. In other
words, rational expectations is the most accurate and efficient form of expectations
formation.
The rational expectations hypothesis contrasts with the adaptive expectations
hypothesis initially used by orthodox monetarists in their explanation of expectations-
augmented Phillips curve (see Chapter 4, section 4). In the adaptive
expectations hypothesis, economic agents base their expectations of future
values of a variable (such as inflation) only on past values of the variable
concerned. One of the main problems with this ‘backward-looking’ approach to
forming expectations is that, until the variable being predicted is stable for a
considerable period of time, expectations formed of it will be repeatedly wrong.
For example, following the discussion of Chapter 4, section 4.3.2, on the
accelerationist hypothesis, if unemployment is held below the natural rate,
inflation will accelerate and inflation expectations will be biased in a downward
direction. This problem results from (i) the assumption that economic agents
only partially adjust their expectations by a fraction of the last error made; and
(ii) the failure of agents to take into consideration additional information available
to them other than past values of the variable concerned, despite making
repeated errors. In contrast, in the ‘forward-looking’ approach, rational expectations
are based on the use of all publicly available information, with the
crucial implication of the strong version of the hypothesis being that economic
agents will not form expectations which are systematically wrong over time;
that is, such expectations will be unbiased.
A number of criticisms have been raised against the rational expectations
hypothesis and we now consider three common ones. The first of these
concerns the costs (in time, effort and money) of acquiring and processing all
publicly available information in order to forecast the future value of a
variable, such as inflation. It is important to note that the weak version of the
hypothesis does not require, as some critics have suggested, that economic
agents actually use ‘all’ publicly available information. Given the costs involved
in acquiring and processing information, it is unlikely that agents
would ever use all publicly available information. What proponents of the
weak version of the hypothesis suggest is that ‘rational’ economic agents will
have an incentive to make the ‘best’ use of all publicly available information
in forming their expectations. In other words, agents will have an incentive to
use information up to the point where the marginal benefit (in terms of
improved accuracy of the variable being forecast) equals the marginal cost (in
terms of acquiring and processing all publicly available information). In this
case, expectations would be less efficient than they would be if all available
information were used. Furthermore, the weak version of the hypothesis does
not require, as some critics have suggested, that all individual agents directly
acquire and process available information personally. Economic agents can
derive information indirectly from, for example, published forecasts and
commentaries in the news media. Given that forecasts frequently differ, the
problem then arises of discerning which is the ‘correct’ view.
A far more serious objection concerns the problem of how agents actually
acquire knowledge of the ‘correct’ model of the economy, given that economists
themselves display considerable disagreement over this. The issue of
whether individual agents operating in decentralized markets will be able to
‘learn’ the true model of the economy has been the subject of considerable
debate (see, for example, Frydman and Phelps, 1983; Evans and Honkapohja,
1999). With regard to this particular criticism, it is important to note that the
strong version of the hypothesis does not require that economic agents actually
know the correct model of the economy. What the hypothesis implies is
that rational agents will not form expectations which are systematically wrong
over time. In other words, expectations, it is suggested, will resemble those
formed ‘as if’ agents did know the correct model to the extent that they will
be unbiased and randomly distributed over time. Critics of the hypothesis are
not, however, convinced by arguments such as these and suggest that, owing
to such problems as the costs of acquiring and processing all available information,
and uncertainty over which is the correct model, it ‘is’ possible for
agents to form expectations which are systematically wrong. There is some
evidence that agents do make systematic errors in expectations (see, for
example, Lovell, 1986).
A third important criticism, associated in particular with the Post Keynesian
school, relates to the problems of expectations formation in a world of fundamental
uncertainty. To Keynesian fundamentalists, a major achievement of
Keynes was to place the problem of uncertainty at the centre stage of macr
oeconomics. In the Post Keynesian vision, the world is non-ergodic; that is,
each historical event is unique and non-repetitive. In such situations the rules of
probability do not apply. We are in a world of ‘kaleidic’ change and fundamental
discontinuities (Shackle, 1974). Accordingly, Post Keynesians argue that it
is important to follow both Keynes (1921) and Knight (1933) and distinguish
between situations involving risk and situations involving uncertainty. In situations
of risk the probability distribution is known. In contrast, in situations of
uncertainty there is no possibility of formulating any meaningful probability
distribution. Because the rational expectations hypothesis assumes that economic
agents can formulate probability distributions of outcomes of various
economic changes and situations, it belongs to the world of risk. In new
classical models the problem of fundamental uncertainty is ignored since Lucas
(1977) interprets business cycles as repeated instances of essentially similar
events. Hence, in Lucas’s ergodic world, meaningful probability distributions
of outcomes can be gauged by intelligent and rational economic agents. Unfortunately,
according to Post Keynesians, the real world is one characterized by
fundamental uncertainty and this means that conclusions built on models using
the rational expectations hypothesis are useless. Likewise, the Austrian school
are also very critical of the rational expectations hypothesis (see Snowdon et
al., 1994, and Chapters 8 and 9).
The various influences on expectations have recently been investigated by
the Bank of England (2003). Reporting the results of a recent ‘inflation
attitudes survey’ the Bank of England finds the following interesting results:
1. disaggregating the data reveals that different people and groups have
different attitudes to inflation;
2. the expectations of ‘professional’ groups cluster around the mean expectation;
3. younger respondents have lower expectations of inflation than older
respondents;
4. mortgage holders have lower inflation expectations than respondents
who rent accommodation;
5. people in the south of Britain have higher expectations of inflation than
those living in the north; and
6. lifetime experience of inflation influences expectations of inflation.
Thus expectations of inflation are influenced by age, geographical location,
education and occupation, and housing status. Clearly those old enough to
have lived through the ‘Great Inflation’ of the 1970s have not been entirely
able to remove that experience from their judgement.
Notwithstanding these criticisms, during the 1970s there was undoubtedly
a ‘rational expectations revolution’ in macroeconomics (Taylor, 1989; Hoo
ver, 1992). However, it should be noted that Muth’s idea was not immediately
taken up by macroeconomists, maybe because during the 1960s the orthodox
Keynesian model was ‘the only game in town’. It took almost ten years
before Lucas, Sargent and other leading new classical economists began to
incorporate the hypothesis into their macroeconomic models.
Evidence of this lag can be gleaned from citation counts for Muth’s (1961)
paper. In an interesting comparison of the relative influence of Muth’s paper
with that of Axel Leijonhufvud’s (1968) famous book, On Keynesian Economics
and the Economics of Keynes (see Chapter 2), Backhouse (1995) has
shown how during the 1970s and 1980s citations of Muth’s paper exploded
while citations of Leijonhufvud’s book declined as interest in Keynesian
economics waned (see Snowdon, 2004a). While Leijonhufvud’s book had an
immediate impact, but ultimately failed to transform macroeconomics in the
direction of coordination failure stressed by Leijonhufvud, in contrast, Muth’s
paper got off to a slow start but ultimately played a key role in transforming
macroeconomics (see Leijonhufvud, 1992, 1993, 1998a, 1998b on the need
for macroeconomics to reconsider, among many other things, the coordination
question in macroeconomics).
One final point is worth making. The use of the word ‘rational’ in the
presentation of the hypothesis proved to be an important ‘rhetorical’ weapon
in the battle to win the minds of macroeconomists during the 1970s. As Barro
(1984) has pointed out:
One of the cleverest features of the rational expectations revolution was the
application of the term ‘rational’. Thereby, the opponents of this approach were
forced into the defensive position of either being irrational or of modelling others
as irrational, neither of which are comfortable positions for an economist.
For a more detailed discussion of the rational expectations hypothesis and its
application in macroeconomics, the reader is referred to Begg (1982); Carter
and Maddock (1984); Shaw (1984); Attfield et al. (1985); Redman (1992);
Sheffrin (1996); and Minford (1997). On the use of rhetoric in new classical
economics, see Backhouse (1997a).
Continuous market clearing
A second key assumption in new classical models is that all markets in the
economy continuously clear, in line with the Walrasian tradition. At each
point of time all observed outcomes are viewed as ‘market-clearing’, and are
the result of the optimal demand and supply responses of economic agents to
their perceptions of prices. As a result the economy is viewed as being in a
continuous state of (short- and long-run) equilibrium. New classical models
are in consequence often referred to as ‘equilibrium’ models, where equilibrium
is interpreted to mean that all economic agents within a market economy
The new classical school 231
have made choices that optimize their objectives subject to the constraints
that they face.
In market-clearing models economic agents (workers, consumers and firms)
are ‘price takers’; that is, they take the market price as given and have no
market power that could be used to influence price. Firms are operating
within a market structure known as ‘perfect competition’. In such a market
structure firms can only decide on their optimal (profit-maximizing) output
(determined where marginal revenue = marginal cost) given the marketdetermined
price. In the absence of externalities the competitive equilibrium,
with market prices determined by the forces of demand and supply, is Paretooptimal
and leads to the maximization of total surplus (the sum of producer
and consumer surplus). In Figure 5.2(a) we can see that a competitive
market-clearing equilibrium (P*, Q*) maximizes the total of consumer and
producer surplus (equal to area BCE) whereas non-market-clearing prices
(output), such as P1(Q1) or P2 (Q2 ), indicated in Figure 5.2(b), result in a
welfare loss indicated by the areas FEI and GEH respectively (see Dixon,
1997).
In Figure 5.2(a) all the mutual gains from trade have been exhausted by
economic agents and there are ‘no dollar bills left on the sidewalk’ (see
Barro, 1979). It is important to note that the position of supply and demand
curves, and hence market-clearing prices and equilibrium output, will be
influenced by the expectations of economic agents. Since even rationally
formed expectations can turn out to be wrong due to incomplete information,
this means that, at least until agents acquire more accurate information, a
currently observed market-clearing equilibrium will differ from a full information
equilibrium. Nevertheless, since agents are doing the best they can
with the information they have acquired, they are seen to be in a state of
equilibrium at all times, as illustrated below.
RATIONALITY ⇒ OPTIMIZATION ⇒ EQUILIBRIUM
The assumption of continuous market clearing is the most critical and controversial
assumption underlying new classical analysis and is highly contentious,
as it implies that prices are free to adjust instantaneously to clear markets (see
Tobin, 1993, 1996). The assumption stands in bold contrast to the approach
adopted in both orthodox Keynesian and monetarist models. As we have
discussed in the two previous chapters, orthodox Keynesians and monetarists
disagree about the time it takes for markets to clear. Keynesian models
incorporate the assumption that markets may fail to clear because of the slow
adjustment of prices, so that the economy is viewed as being in a possible
state of continuous disequilibrium. In contrast, orthodox monetarist models
incorporate the assumption that prices adjust fairly rapidly to clear markets
and, while accepting that the economy may be in disequilibrium in the short
run, monetarists assume that the economy will automatically return to a state
of macroeconomic equilibrium in the long run at the natural rate of output
and employment.
The assumption of continuous market clearing is far more controversial
than the rational expectations hypothesis. As we shall discuss in Chapter 7,
new Keynesians have put forward a number of arguments to explain why
both prices and wages will be slow to adjust to clear markets following a
disturbance. Serious objections can be raised as to the reality of the new
classical assumption, especially with respect to the labour market, where new
classicists hold that anyone wishing to work can find employment at the
market-clearing equilibrium wage; that is, the new classical equilibrium approach
treats unemployment entirely as a voluntary phenomenon (Lucas,
1978a). However, given efficiency wage considerations (see Chapter 7) it can
be argued that it is both profitable and rational for a firm to pay an efficiency
wage above the market-clearing wage. In such a situation equilibrium in the
labour market can occur where supply exceeds demand, with the existence of
involuntary unemployment as an equilibrium phenomenon.
We now consider the final main tenet of new classical macroeconomics,
the aggregate supply hypothesis.
The aggregate supply hypothesis
As with the rational expectations hypothesis, various explanations of the
aggregate supply hypothesis can be found in the literature. Having said this,
two main approaches to aggregate supply can be identified. Underlying these
approaches are two orthodox microeconomic assumptions: (i) rational decisions
taken by workers and firms reflect optimizing behaviour on their part;
and (ii) the supply of labour/output by workers/firms depends upon relative
prices.
The first new classical approach to aggregate supply focuses on the supply
of labour and derives from the work of Lucas and Rapping (1969). This
analysis is discussed more fully in Chapter 6 and in what follows we merely
outline the essence of the approach. During any period, workers have to
decide how much time to allocate between work and leisure. Workers, it is
assumed, have some notion of the normal or expected average real wage. If
the current real wage is above the normal real wage, workers will have an
incentive to work more (take less leisure time) in the current period in the
anticipation of taking more leisure (working less) in the future, when the real
wage is expected to be lower. Conversely, if the current real wage is below
the norm, workers will have an incentive to take more leisure (work less) in
the current period in the anticipation of working more (taking less leisure) in
the future, when the real wage is expected to be higher. The supply of labour
is postulated, therefore, to respond to perceived temporary changes in the real
wage. This behavioural response of substituting current leisure for future
leisure and vice versa is referred to as ‘intertemporal substitution’. Within the
intertemporal substitution model, changes in employment are explained in
terms of the ‘voluntary’ choices of workers who change their supply of
labour in response to perceived temporary changes in the real wage.
The second new classical approach to aggregate supply again derives from
the highly influential work of Lucas (1972a, 1973). In what follows we
illustrate the spirit of Lucas’s arguments by focusing on the goods market and
the supply decisions of firms. An important element of Lucas’s analysis
concerns the structure of the information set available to producers. It is
assumed that, while a firm knows the current price of its own goods, the
general price level for other markets only becomes known with a time lag.
When a firm experiences a rise in the current market price of its output it has
to decide whether the change in price reflects (i) a real shift in demand
towards its product, in which case the firm should respond (rationally) to the
increase in the price of its output relative to the price of other goods by
increasing its output, or (ii) merely a nominal increase in demand across all
markets, producing a general increase in prices which would not require a
supply response. Firms are faced by what is referred to as a ‘signal extraction’
problem, in that they have to distinguish between relative and absolute
price changes. Indeed, the greater the variability of the general price level,
the more difficult it will be for a producer to extract a correct signal and the
smaller the supply response is likely to be to any given change in prices (see
Lucas, 1973).
The analysis of the behaviour of individual agents in terms of the supply of
both labour and goods has led to what is referred to as the Lucas ‘surprise’
supply function, the simplest from of which is given by equation (5.3):
t = + α[ − ], α > 0 (5.3)
Since in new classical models expectations are formed rationally, we can
replace (5.3) with (5.4):
Yt YNt Pt E Pt t = + α[ − ( |Ω −1)] (5.4)
Equation (5.4) states that output (Yt) deviates from its natural level (YNt) only
in response to deviations of the actual price level (Pt) from its (rational)
expected value [E(Pt |Ωt−1)], that is, in response to an unexpected (surprise)
increase in the price level. For example, when the actual price level turns out
to be greater than expected, individual agents are ‘surprised’ and mistake the
increase for an increase in the relative price of their own output, resulting in
an increase in the supply of output and employment in the economy. In the
absence of price surprises, output will be at its natural level. For any given
expectation of the price level, the aggregate supply curve will slope upwards
in P–Y space, and the greater the value of α, the more elastic will be the
‘surprise’ aggregate supply curve and the bigger will be the impact on real
variables of an unanticipated rise in the general price level (see Figure 5.3
and section 5.5.1).
An alternative specification of the Lucas surprise function states that output
only deviates from its natural level in response to a deviation of actual
from expected inflation (that is, in response to errors in inflation expectations):
Yt YNt Pt E Pt t t = + α[ ˙ − ( ˙ |Ω −1)]+ ε (5.5)
In equation (5.5) ˙Pt is the actual rate of inflation, E(Pt t ˙ |Ω −1) is the rational
expectation of rate of inflation subject to the information available up to the
previous period, and εt is a random error process. According to Lucas, countries
where inflation has been relatively stable should show greater supply
response to an inflationary impulse and vice versa. In his famous empirical
paper, Lucas (1973) confirmed that:
In a stable price country like the United States … policies which increase nominal
income tend to have a large initial effect on real output, together with a small
positive effect on the rate of inflation … In contrast, in a volatile price county like
Argentina, nominal income changes are associated with equal, contemporaneous
price movements with no discernible effect on real output.
Equation (5.4) can be reformulated to include a lagged output term (Yt–1 –
YNt–1) and this version was used by Lucas (1973) in his empirical work to deal
with the problem of persistence (serial correlation) in the movement of economic
aggregates. The surprise aggregate supply function now takes the form
shown in equation (5.6):
Yt YNt Pt E Pt t Yt YNt t = + − − + − − − + α[ ( |Ω 1)] β( 1 1 ) ε (5.6)
By invoking ‘Okun’s law’ (Okun, 1962), that is, that there is a stable and
predictable negative relationship between unemployment and GDP, the Lucas
surprise aggregate supply equation can be seen as simply an alternative
representation of the rational expectations-augmented Phillips curve shown
in equation (5.7):
P˙ E(P˙ | ) (U U ), t t t t Nt = Ω −1 − ϕ − ϕ > 0 (5.7)
where Ut is the current rate of unemployment, and UNt is the natural rate of
unemployment. Rearranging (5.7), we get equation (5.8):
Ut UNt Pt E Pt t = −1/ϕ[ ˙ − ( ˙ |Ω −1)] (5.8)
In this formulation an inflation surprise leads to a temporary reduction of
unemployment below the natural rate. In equations (5.6) and (5.8) a real
variable is linked to a nominal variable. But, as Lucas demonstrated, the
classical dichotomy only breaks down when a change in the nominal variable
is a ‘surprise’. Indeed, Lucas himself regards the finding that anticipated and
unanticipated changes in monetary growth have very different effects, as the
key idea in post-war macroeconomics (Snowdon and Vane, 1998). Furthermore,
Lucas (1996) notes that this distinction between anticipated and
unanticipated monetary changes is a feature of all rational expectations-style
models developed during the 1970s to explain the monetary non-neutrality
exhibited in short-run trade-offs.
The new classical school emerged as a distinctive group during the 1970s
and, as we have already noted, the key figure in this development was Robert
E. Lucas Jr. However, the roots of the new classical research tradition are
diverse. For example, the emphasis in early new classical models on information
and expectations provides a link to the Austrian tradition best represented
by the work of Hayek (see Chapter 9). The distinction made by Lucas
between impulse (shocks) and propagation mechanisms when analysing business
cycles has its origins in the pioneering research of Frisch (1933). The
important role given to monetary disturbances in generating aggregate instability
is solidly in the classical and Friedmanite monetarist traditions; indeed,
Tobin (1981) refers to the early new classical contributions as ‘monetarism
mark II’. The work of Phelps et al. (1970) on the Microfoundations of
Employment and Inflation Theory inspired Lucas to utilize the insights gleaned
from Phelps’s use of the ‘island parable’ and search theory to analyse labour
market dynamics. Finally the methodological approach of Lucas is heavily
influenced by the general equilibrium tradition of Walras, Hicks, Arrow and
Debreu (see Zijp, 1993; Beaud and Dostaler, 1997).
The new classical approach as it evolved in the early 1970s exhibited
several important features:
1. a strong emphasis on underpinning macroeconomic theorizing with neoclassical
choice-theoretic microfoundations within a Walrasian general
equilibrium framework;
2. the adoption of the key neoclassical assumption that all economic agents
are rational; that is, agents are continuous optimizers subject to the
constraints that they face, firms maximize profits and labour and households
maximize utility;
3. agents do not suffer from money illusion and therefore only real
magnitudes (relative prices) matter for optimizing decisions;
4. complete and continuous wage and price flexibility ensure that markets
continuously clear as agents exhaust all mutually beneficial gains from
trade, leaving no unexploited profitable opportunities.
Given these assumptions, changes in the quantity of money should be neutral
and real magnitudes will be independent of nominal magnitudes. However,
empirical evidence shows that there are positive correlations (at least in the
short run) between real GDP and the nominal price level (an upward-sloping
aggregate supply curve), between changes in the nominal money supply and
real GDP, and negative correlations between inflation and unemployment (a
Phillips curve); that is, empirically money does not appear to be neutral in the
short run. Solving this puzzle between the neutrality of money predicted by
classical/neoclassical theory and empirical evidence showing non-neutralities
would be a considerable intellectual achievement (Zijp, 1993, refers to this as
the ‘Lucas problem’). Lucas’s (1972a) seminal paper, ‘Expectations and the
Neutrality of Money’, was just such an achievement. Lucas’s key insight was
to change the classical assumption that economic agents have perfect information
to an assumption that agents have imperfect information.
We can sum up the main elements of the early new classical approach to
macroeconomics as the joint acceptance of three main sub-hypotheses involving
(i) the rational expectations hypothesis; (ii) the assumption of
continuous market clearing; and (iii) the Lucas (‘surprise’) aggregate supply
hypothesis. In the discussion of these hypotheses individually in what follows,
the reader should bear in mind that although new classicists accept all
three hypotheses (see Figure 5.1), it is possible for economists of different
persuasions to support the rational expectations hypothesis without necessarily
accepting all three together.
The rational expectations hypothesis
One of the central tenets underlying new classical macroeconomics is the
rational expectations hypothesis (REH) associated with the work of John
Muth (1961) initially in the context of microeconomics. It is, however, interesting
to note that Keuzenkamp (1991) has suggested that Tinbergen was a
precursor to Muth, having presented a model of rational expectations nearly
30 years earlier. We should also note that it was Alan Walters (1971) who first
applied the idea of what he called ‘consistent expectations’ to macroeconomics.
However, it was John Muth’s (1961) seminal paper that proved to be most
influential on the research of the young new classical Turks during the early
1970s. In his seminal article, Muth suggested ‘that expectations since they
are informed predictions of future events are essentially the same as the
predictions of the relevant economic theory’.
Expectations, which are subjective, are fundamental to the behaviour of
economic agents and all economic activities have an informational/expectational
dimension. For example, expectations of the future value of economic variables
will clearly influence demand and supply decisions. As Carter and Maddock
(1984) note, ‘since virtually all economic decisions involve taking actions now
for uncertain rewards in the future, expectations of the future are crucial in
decision making’. An obvious example where expectations of inflation will
influence behaviour concerns wage negotiations between trade unions and
employers. Should a trade union negotiator underestimate the rate of inflation
prevailing over the period of the negotiated wage contract, then workers are
likely to find that they have suffered a nominal wage increase, but a real wage
cut.
An expectation of the future value of some key economic variable need not
be confined to a single predicted value but can more realistically take the
form of a probability distribution of outcomes. Therefore, there are two key
questions facing macroeconomists with respect to incorporating expectations
into macroeconomic models:
1. how do individuals acquire, process and make use of information in
order to form expectations of key variables?
2. what form of expectations hypothesis should we use in macroeconomic
models?
During the 1970s, the rational expectations hypothesis replaced the adaptive
expectations hypothesis as the dominant way of modelling endogenous expectations
(in his General Theory, published in 1936, Keynes had stressed the
importance of expectations for understanding macroeconomic instability, but
in Keynes’s theory expectations were exogenous, being driven by ‘animal
spirits’; see Chapter 8 and Keynes, 1937). One great appeal of the rational
expectations hypothesis is that alternative (non-rational) hypotheses of expectations
formation involve systematic errors, a situation that does not sit
comfortably with the rational calculating agents that populate orthodox neoclassical
models.
The rational expectations hypothesis has over the years been presented in
the literature in a number of different forms and versions (see Redman,
1992). At the outset it is important to note the distinction between weak and
strong versions of the hypothesis. The main idea behind the weak version of
the hypothesis is that, in forming forecasts or expectations about the future
value of a variable, rational economic agents will make the best (most efficient)
use of all publicly available information about the factors which they
believe determine that variable. In other words, expectations are assumed to
be formed ‘rationally’ in line with utility-maximizing behaviour on the part
of individual economic agents. For example, if economic agents believe that
the rate of inflation is determined by the rate of monetary expansion, they
will make the best use of all publicly available information on rates of
monetary expansion in forming their expectations of future rates of inflation.
The strong version of the rational expectations hypothesis is captured in the
above quotation taken from Muth’s (1961) article and it is the Muthian
version that has been taken up by leading exponents of the new classical
school and incorporated into their macroeconomic models. In the Muthian
‘strong’ version, economic agents’ subjective expectations of economic variables
will coincide with the true or objective mathematical conditional
expectations of those variables. Using the example of economic agents’ expectations
of inflation (P˙t ),
e the rational expectations hypothesis may be
expressed algebraically in the following way:
P˙ E(P˙ | ) t
e
= t Ωt−1 (5.1)
where ˙Pt is the actual rate of inflation; E(Pt t ˙ |Ω −1) is the rational expectation
of the rate of inflation subject to the information available up to the previous
period (Ωt−1). It is important to emphasize that rational expectations does not
mean that agents can foresee the future exactly. Rational expectations is not
the same as perfect foresight. In order to form a rational expectation of
inflation, agents will need to take into account what they believe to be the
‘correct’ macroeconomic model of the economy. Agents will make errors in
their forecasts, since available information will be incomplete. Indeed, this is
an essential element of Lucas’s monetary surprise model – see sections 5.3.3
and 5.5.1. However, such forecast errors will be unrelated to the information
set at the time the expectation (for example of inflation) was formed. With
rational expectations, agents’ expectations of economic variables on average
will be correct, that is, will equal their true value. Furthermore, the hypoth
esis implies that agents will not form expectations which are systematically
wrong (biased) over time. If expectations were systematically wrong, agents
would, it is held, learn from their mistakes and change the way they formed
expectations, thereby eliminating systematic errors. More formally, the strong
version of the rational expectations hypothesis implies that:
P˙ P˙ t
e
= t + εt (5.2)
where ˙Pt
e = expected rate of inflation from t to t + 1; ˙Pt = actual rate of
inflation from t to t + 1; and εt = random error term, which (i) has a mean of
zero, and (ii) is uncorrelated with the information set available at the time
when expectations are formed, otherwise economic agents would not be fully
exploiting all available information. In summary, the forecasting errors from
rationally formed expectations will (i) be essentially random with a mean of
zero; (ii) be unrelated to those made in previous periods, revealing no discernible
pattern: that is, they will be serially uncorrelated over time; and (iii)
have the lowest variance compared to any other forecasting method. In other
words, rational expectations is the most accurate and efficient form of expectations
formation.
The rational expectations hypothesis contrasts with the adaptive expectations
hypothesis initially used by orthodox monetarists in their explanation of expectations-
augmented Phillips curve (see Chapter 4, section 4). In the adaptive
expectations hypothesis, economic agents base their expectations of future
values of a variable (such as inflation) only on past values of the variable
concerned. One of the main problems with this ‘backward-looking’ approach to
forming expectations is that, until the variable being predicted is stable for a
considerable period of time, expectations formed of it will be repeatedly wrong.
For example, following the discussion of Chapter 4, section 4.3.2, on the
accelerationist hypothesis, if unemployment is held below the natural rate,
inflation will accelerate and inflation expectations will be biased in a downward
direction. This problem results from (i) the assumption that economic agents
only partially adjust their expectations by a fraction of the last error made; and
(ii) the failure of agents to take into consideration additional information available
to them other than past values of the variable concerned, despite making
repeated errors. In contrast, in the ‘forward-looking’ approach, rational expectations
are based on the use of all publicly available information, with the
crucial implication of the strong version of the hypothesis being that economic
agents will not form expectations which are systematically wrong over time;
that is, such expectations will be unbiased.
A number of criticisms have been raised against the rational expectations
hypothesis and we now consider three common ones. The first of these
concerns the costs (in time, effort and money) of acquiring and processing all
publicly available information in order to forecast the future value of a
variable, such as inflation. It is important to note that the weak version of the
hypothesis does not require, as some critics have suggested, that economic
agents actually use ‘all’ publicly available information. Given the costs involved
in acquiring and processing information, it is unlikely that agents
would ever use all publicly available information. What proponents of the
weak version of the hypothesis suggest is that ‘rational’ economic agents will
have an incentive to make the ‘best’ use of all publicly available information
in forming their expectations. In other words, agents will have an incentive to
use information up to the point where the marginal benefit (in terms of
improved accuracy of the variable being forecast) equals the marginal cost (in
terms of acquiring and processing all publicly available information). In this
case, expectations would be less efficient than they would be if all available
information were used. Furthermore, the weak version of the hypothesis does
not require, as some critics have suggested, that all individual agents directly
acquire and process available information personally. Economic agents can
derive information indirectly from, for example, published forecasts and
commentaries in the news media. Given that forecasts frequently differ, the
problem then arises of discerning which is the ‘correct’ view.
A far more serious objection concerns the problem of how agents actually
acquire knowledge of the ‘correct’ model of the economy, given that economists
themselves display considerable disagreement over this. The issue of
whether individual agents operating in decentralized markets will be able to
‘learn’ the true model of the economy has been the subject of considerable
debate (see, for example, Frydman and Phelps, 1983; Evans and Honkapohja,
1999). With regard to this particular criticism, it is important to note that the
strong version of the hypothesis does not require that economic agents actually
know the correct model of the economy. What the hypothesis implies is
that rational agents will not form expectations which are systematically wrong
over time. In other words, expectations, it is suggested, will resemble those
formed ‘as if’ agents did know the correct model to the extent that they will
be unbiased and randomly distributed over time. Critics of the hypothesis are
not, however, convinced by arguments such as these and suggest that, owing
to such problems as the costs of acquiring and processing all available information,
and uncertainty over which is the correct model, it ‘is’ possible for
agents to form expectations which are systematically wrong. There is some
evidence that agents do make systematic errors in expectations (see, for
example, Lovell, 1986).
A third important criticism, associated in particular with the Post Keynesian
school, relates to the problems of expectations formation in a world of fundamental
uncertainty. To Keynesian fundamentalists, a major achievement of
Keynes was to place the problem of uncertainty at the centre stage of macr
oeconomics. In the Post Keynesian vision, the world is non-ergodic; that is,
each historical event is unique and non-repetitive. In such situations the rules of
probability do not apply. We are in a world of ‘kaleidic’ change and fundamental
discontinuities (Shackle, 1974). Accordingly, Post Keynesians argue that it
is important to follow both Keynes (1921) and Knight (1933) and distinguish
between situations involving risk and situations involving uncertainty. In situations
of risk the probability distribution is known. In contrast, in situations of
uncertainty there is no possibility of formulating any meaningful probability
distribution. Because the rational expectations hypothesis assumes that economic
agents can formulate probability distributions of outcomes of various
economic changes and situations, it belongs to the world of risk. In new
classical models the problem of fundamental uncertainty is ignored since Lucas
(1977) interprets business cycles as repeated instances of essentially similar
events. Hence, in Lucas’s ergodic world, meaningful probability distributions
of outcomes can be gauged by intelligent and rational economic agents. Unfortunately,
according to Post Keynesians, the real world is one characterized by
fundamental uncertainty and this means that conclusions built on models using
the rational expectations hypothesis are useless. Likewise, the Austrian school
are also very critical of the rational expectations hypothesis (see Snowdon et
al., 1994, and Chapters 8 and 9).
The various influences on expectations have recently been investigated by
the Bank of England (2003). Reporting the results of a recent ‘inflation
attitudes survey’ the Bank of England finds the following interesting results:
1. disaggregating the data reveals that different people and groups have
different attitudes to inflation;
2. the expectations of ‘professional’ groups cluster around the mean expectation;
3. younger respondents have lower expectations of inflation than older
respondents;
4. mortgage holders have lower inflation expectations than respondents
who rent accommodation;
5. people in the south of Britain have higher expectations of inflation than
those living in the north; and
6. lifetime experience of inflation influences expectations of inflation.
Thus expectations of inflation are influenced by age, geographical location,
education and occupation, and housing status. Clearly those old enough to
have lived through the ‘Great Inflation’ of the 1970s have not been entirely
able to remove that experience from their judgement.
Notwithstanding these criticisms, during the 1970s there was undoubtedly
a ‘rational expectations revolution’ in macroeconomics (Taylor, 1989; Hoo
ver, 1992). However, it should be noted that Muth’s idea was not immediately
taken up by macroeconomists, maybe because during the 1960s the orthodox
Keynesian model was ‘the only game in town’. It took almost ten years
before Lucas, Sargent and other leading new classical economists began to
incorporate the hypothesis into their macroeconomic models.
Evidence of this lag can be gleaned from citation counts for Muth’s (1961)
paper. In an interesting comparison of the relative influence of Muth’s paper
with that of Axel Leijonhufvud’s (1968) famous book, On Keynesian Economics
and the Economics of Keynes (see Chapter 2), Backhouse (1995) has
shown how during the 1970s and 1980s citations of Muth’s paper exploded
while citations of Leijonhufvud’s book declined as interest in Keynesian
economics waned (see Snowdon, 2004a). While Leijonhufvud’s book had an
immediate impact, but ultimately failed to transform macroeconomics in the
direction of coordination failure stressed by Leijonhufvud, in contrast, Muth’s
paper got off to a slow start but ultimately played a key role in transforming
macroeconomics (see Leijonhufvud, 1992, 1993, 1998a, 1998b on the need
for macroeconomics to reconsider, among many other things, the coordination
question in macroeconomics).
One final point is worth making. The use of the word ‘rational’ in the
presentation of the hypothesis proved to be an important ‘rhetorical’ weapon
in the battle to win the minds of macroeconomists during the 1970s. As Barro
(1984) has pointed out:
One of the cleverest features of the rational expectations revolution was the
application of the term ‘rational’. Thereby, the opponents of this approach were
forced into the defensive position of either being irrational or of modelling others
as irrational, neither of which are comfortable positions for an economist.
For a more detailed discussion of the rational expectations hypothesis and its
application in macroeconomics, the reader is referred to Begg (1982); Carter
and Maddock (1984); Shaw (1984); Attfield et al. (1985); Redman (1992);
Sheffrin (1996); and Minford (1997). On the use of rhetoric in new classical
economics, see Backhouse (1997a).
Continuous market clearing
A second key assumption in new classical models is that all markets in the
economy continuously clear, in line with the Walrasian tradition. At each
point of time all observed outcomes are viewed as ‘market-clearing’, and are
the result of the optimal demand and supply responses of economic agents to
their perceptions of prices. As a result the economy is viewed as being in a
continuous state of (short- and long-run) equilibrium. New classical models
are in consequence often referred to as ‘equilibrium’ models, where equilibrium
is interpreted to mean that all economic agents within a market economy
The new classical school 231
have made choices that optimize their objectives subject to the constraints
that they face.
In market-clearing models economic agents (workers, consumers and firms)
are ‘price takers’; that is, they take the market price as given and have no
market power that could be used to influence price. Firms are operating
within a market structure known as ‘perfect competition’. In such a market
structure firms can only decide on their optimal (profit-maximizing) output
(determined where marginal revenue = marginal cost) given the marketdetermined
price. In the absence of externalities the competitive equilibrium,
with market prices determined by the forces of demand and supply, is Paretooptimal
and leads to the maximization of total surplus (the sum of producer
and consumer surplus). In Figure 5.2(a) we can see that a competitive
market-clearing equilibrium (P*, Q*) maximizes the total of consumer and
producer surplus (equal to area BCE) whereas non-market-clearing prices
(output), such as P1(Q1) or P2 (Q2 ), indicated in Figure 5.2(b), result in a
welfare loss indicated by the areas FEI and GEH respectively (see Dixon,
1997).
In Figure 5.2(a) all the mutual gains from trade have been exhausted by
economic agents and there are ‘no dollar bills left on the sidewalk’ (see
Barro, 1979). It is important to note that the position of supply and demand
curves, and hence market-clearing prices and equilibrium output, will be
influenced by the expectations of economic agents. Since even rationally
formed expectations can turn out to be wrong due to incomplete information,
this means that, at least until agents acquire more accurate information, a
currently observed market-clearing equilibrium will differ from a full information
equilibrium. Nevertheless, since agents are doing the best they can
with the information they have acquired, they are seen to be in a state of
equilibrium at all times, as illustrated below.
RATIONALITY ⇒ OPTIMIZATION ⇒ EQUILIBRIUM
The assumption of continuous market clearing is the most critical and controversial
assumption underlying new classical analysis and is highly contentious,
as it implies that prices are free to adjust instantaneously to clear markets (see
Tobin, 1993, 1996). The assumption stands in bold contrast to the approach
adopted in both orthodox Keynesian and monetarist models. As we have
discussed in the two previous chapters, orthodox Keynesians and monetarists
disagree about the time it takes for markets to clear. Keynesian models
incorporate the assumption that markets may fail to clear because of the slow
adjustment of prices, so that the economy is viewed as being in a possible
state of continuous disequilibrium. In contrast, orthodox monetarist models
incorporate the assumption that prices adjust fairly rapidly to clear markets
and, while accepting that the economy may be in disequilibrium in the short
run, monetarists assume that the economy will automatically return to a state
of macroeconomic equilibrium in the long run at the natural rate of output
and employment.
The assumption of continuous market clearing is far more controversial
than the rational expectations hypothesis. As we shall discuss in Chapter 7,
new Keynesians have put forward a number of arguments to explain why
both prices and wages will be slow to adjust to clear markets following a
disturbance. Serious objections can be raised as to the reality of the new
classical assumption, especially with respect to the labour market, where new
classicists hold that anyone wishing to work can find employment at the
market-clearing equilibrium wage; that is, the new classical equilibrium approach
treats unemployment entirely as a voluntary phenomenon (Lucas,
1978a). However, given efficiency wage considerations (see Chapter 7) it can
be argued that it is both profitable and rational for a firm to pay an efficiency
wage above the market-clearing wage. In such a situation equilibrium in the
labour market can occur where supply exceeds demand, with the existence of
involuntary unemployment as an equilibrium phenomenon.
We now consider the final main tenet of new classical macroeconomics,
the aggregate supply hypothesis.
The aggregate supply hypothesis
As with the rational expectations hypothesis, various explanations of the
aggregate supply hypothesis can be found in the literature. Having said this,
two main approaches to aggregate supply can be identified. Underlying these
approaches are two orthodox microeconomic assumptions: (i) rational decisions
taken by workers and firms reflect optimizing behaviour on their part;
and (ii) the supply of labour/output by workers/firms depends upon relative
prices.
The first new classical approach to aggregate supply focuses on the supply
of labour and derives from the work of Lucas and Rapping (1969). This
analysis is discussed more fully in Chapter 6 and in what follows we merely
outline the essence of the approach. During any period, workers have to
decide how much time to allocate between work and leisure. Workers, it is
assumed, have some notion of the normal or expected average real wage. If
the current real wage is above the normal real wage, workers will have an
incentive to work more (take less leisure time) in the current period in the
anticipation of taking more leisure (working less) in the future, when the real
wage is expected to be lower. Conversely, if the current real wage is below
the norm, workers will have an incentive to take more leisure (work less) in
the current period in the anticipation of working more (taking less leisure) in
the future, when the real wage is expected to be higher. The supply of labour
is postulated, therefore, to respond to perceived temporary changes in the real
wage. This behavioural response of substituting current leisure for future
leisure and vice versa is referred to as ‘intertemporal substitution’. Within the
intertemporal substitution model, changes in employment are explained in
terms of the ‘voluntary’ choices of workers who change their supply of
labour in response to perceived temporary changes in the real wage.
The second new classical approach to aggregate supply again derives from
the highly influential work of Lucas (1972a, 1973). In what follows we
illustrate the spirit of Lucas’s arguments by focusing on the goods market and
the supply decisions of firms. An important element of Lucas’s analysis
concerns the structure of the information set available to producers. It is
assumed that, while a firm knows the current price of its own goods, the
general price level for other markets only becomes known with a time lag.
When a firm experiences a rise in the current market price of its output it has
to decide whether the change in price reflects (i) a real shift in demand
towards its product, in which case the firm should respond (rationally) to the
increase in the price of its output relative to the price of other goods by
increasing its output, or (ii) merely a nominal increase in demand across all
markets, producing a general increase in prices which would not require a
supply response. Firms are faced by what is referred to as a ‘signal extraction’
problem, in that they have to distinguish between relative and absolute
price changes. Indeed, the greater the variability of the general price level,
the more difficult it will be for a producer to extract a correct signal and the
smaller the supply response is likely to be to any given change in prices (see
Lucas, 1973).
The analysis of the behaviour of individual agents in terms of the supply of
both labour and goods has led to what is referred to as the Lucas ‘surprise’
supply function, the simplest from of which is given by equation (5.3):
t = + α[ − ], α > 0 (5.3)
Since in new classical models expectations are formed rationally, we can
replace (5.3) with (5.4):
Yt YNt Pt E Pt t = + α[ − ( |Ω −1)] (5.4)
Equation (5.4) states that output (Yt) deviates from its natural level (YNt) only
in response to deviations of the actual price level (Pt) from its (rational)
expected value [E(Pt |Ωt−1)], that is, in response to an unexpected (surprise)
increase in the price level. For example, when the actual price level turns out
to be greater than expected, individual agents are ‘surprised’ and mistake the
increase for an increase in the relative price of their own output, resulting in
an increase in the supply of output and employment in the economy. In the
absence of price surprises, output will be at its natural level. For any given
expectation of the price level, the aggregate supply curve will slope upwards
in P–Y space, and the greater the value of α, the more elastic will be the
‘surprise’ aggregate supply curve and the bigger will be the impact on real
variables of an unanticipated rise in the general price level (see Figure 5.3
and section 5.5.1).
An alternative specification of the Lucas surprise function states that output
only deviates from its natural level in response to a deviation of actual
from expected inflation (that is, in response to errors in inflation expectations):
Yt YNt Pt E Pt t t = + α[ ˙ − ( ˙ |Ω −1)]+ ε (5.5)
In equation (5.5) ˙Pt is the actual rate of inflation, E(Pt t ˙ |Ω −1) is the rational
expectation of rate of inflation subject to the information available up to the
previous period, and εt is a random error process. According to Lucas, countries
where inflation has been relatively stable should show greater supply
response to an inflationary impulse and vice versa. In his famous empirical
paper, Lucas (1973) confirmed that:
In a stable price country like the United States … policies which increase nominal
income tend to have a large initial effect on real output, together with a small
positive effect on the rate of inflation … In contrast, in a volatile price county like
Argentina, nominal income changes are associated with equal, contemporaneous
price movements with no discernible effect on real output.
Equation (5.4) can be reformulated to include a lagged output term (Yt–1 –
YNt–1) and this version was used by Lucas (1973) in his empirical work to deal
with the problem of persistence (serial correlation) in the movement of economic
aggregates. The surprise aggregate supply function now takes the form
shown in equation (5.6):
Yt YNt Pt E Pt t Yt YNt t = + − − + − − − + α[ ( |Ω 1)] β( 1 1 ) ε (5.6)
By invoking ‘Okun’s law’ (Okun, 1962), that is, that there is a stable and
predictable negative relationship between unemployment and GDP, the Lucas
surprise aggregate supply equation can be seen as simply an alternative
representation of the rational expectations-augmented Phillips curve shown
in equation (5.7):
P˙ E(P˙ | ) (U U ), t t t t Nt = Ω −1 − ϕ − ϕ > 0 (5.7)
where Ut is the current rate of unemployment, and UNt is the natural rate of
unemployment. Rearranging (5.7), we get equation (5.8):
Ut UNt Pt E Pt t = −1/ϕ[ ˙ − ( ˙ |Ω −1)] (5.8)
In this formulation an inflation surprise leads to a temporary reduction of
unemployment below the natural rate. In equations (5.6) and (5.8) a real
variable is linked to a nominal variable. But, as Lucas demonstrated, the
classical dichotomy only breaks down when a change in the nominal variable
is a ‘surprise’. Indeed, Lucas himself regards the finding that anticipated and
unanticipated changes in monetary growth have very different effects, as the
key idea in post-war macroeconomics (Snowdon and Vane, 1998). Furthermore,
Lucas (1996) notes that this distinction between anticipated and
unanticipated monetary changes is a feature of all rational expectations-style
models developed during the 1970s to explain the monetary non-neutrality
exhibited in short-run trade-offs.
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