Chapter 17

New Classical
Macro
Confronts New
Keynesian
Macro

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 The Development of
Macroeconomics

• The development of new theories and the abandonment of

old theories often occur in response to major
macroeconomic development.
– In the 1930s, the Great Depression spurred the Keynesian
revolution.
– Keynesian thought dominated macroeconomics until significant
inflation emerged in the late 1960s and brought about the
monetarist “counterrevolution.”
• Since the early 1970s, macroeconomics has been split
between two basic explanations of business cycles.
– New Classical Macroeconomics
– New Keynesian Economics

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 The “Fooling Model”

• In 1967, Milton Friedman developed a model of the economy where all

markets clear continuously, but there is imperfect information.
– Firms always know the current value of the price level, but workers only
learn the actual price level with a time lag.
• Suppose there is an increase in AD
– Higher AD boosts prices encouraging firms to increase output.
– Nominal wages also rise, but not as quickly as the price level.
– Because workers do not realized that their real wage has fallen, they are
willing to work more in response to AD.
– When workers realize that their nominal wages did not keep up with the
price level (i.e. that they were “fooled”), they demand higher wages shifting
back AS.
• Implication: Business cycles happen only because workers are fooled.

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 Figure 17-1 Effect of an Adverse Supply
Shock on Output and Employment in the
Real Business Cycle Model

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 Other Versions of the Fooling
Model

• The Fooling Model obeys the Natural Rate

Hypothesis, which states that shifts in AD have
no long-run effect on real GDP.
• Edmund Phelps developed a similar model to
Friedman’s where both firms and workers were
fooled by a general rise in the price level.
• In another model, turnover unemployment is
reduced (thus boosting output) when workers stay
with their own firms when receiving wage
increases not realizing that all wages have risen.
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 The Lucas Model

• The Lucas Model (named after Robert Lucas) has three basic assumptions:
– Markets clear.
– There is imperfect information.
– There are Rational Expectations, which are expectations that need not be correct, but must
make the best use of available information, avoiding errors that could have been foreseen by
knowledge of history.
• Suppose there is a “price surprise.”
– Firms cannot distinguish between an increase in their own price vs. an increase in the general
price level.
– Firms respond to a higher price by increasing output and employment (and thus, wages).
– If firms discover that the “price surprise” was a general increase in the price level, they reduce
their output and wages back to their original levels.
• Implication: Anticipated monetary policy cannot change real GDP in a regular
and predictable way. This is the Policy Ineffectiveness Proposition.

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 Figure 17-2 The Price-Setting Decision of a
Monopolist

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 The Real Business Cycle Model

• The problem with the Fooling Model and the

Lucas model is the easily available
aggregate price information that makes it
unlikely that imperfect information is the only
source of business cycles.
• The Real Business Cycle (RBC) model
explains business cycles in output and
employment as being caused by technology
or supply shocks.
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 Figure 17-3 The Price-Setting Choice
of a Monopolist Facing a Decline in
Demand

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 Criticisms of RBC models

• Although technology may advance at an irregular

pace, there is no retreat in technological progress
to explain recessions.
– Big recessions require big supply shocks.
• RBC models imply that prices should fluctuate
positively with output, but sometimes prices rise
during recessions.
• RBC models imply that real wages are procyclical;
however, the statistical evidence suggests there is
no systematic movement of real wages.
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 International Perspective:
Productivity Fluctuations in the
United States and Japan (1 of 2)

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 International Perspective:
Productivity Fluctuations in the
United States and Japan (2 of 2)

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 Contributions of New Classical
Macro

• What are the attractions of new classical theory to

economists?
– The assumption of rational expectations requires that people do not
repeat mistakes.
• It also provides microeconomic foundations to macroeconomic theory.
– Many of the ideas developed by new classical economists have
been applied successfully to financial markets where continuous
market clearing is a reasonable assumption.
– Greater understanding of economic policy.
– New techniques of analysis developed have had a pervasive effect
on economic research.

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 The New Keynesian Economics

• New and old Keynesian models are Non-Market Clearing

models, meaning that workers and firms are not
continuously on their respective demand and supply
schedules.
• The New Keynesian Economics explains rigidity in prices
and wages as consistent with the self-interest of firms and
works, all of whom are assumed to have rational
expectations.
• The difference between new and old Keynesian models is
that the new approach attempts to explain the
microeconomic foundations of slow adjustment of both
wages and prices.
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 Figure 17-4 The Relationship
Between the Relative Wage Rate
and Worker Efficiency

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 The Effect of Small Rigidities

• A Menu Cost is any expense associated with

changing prices, including the cost of printing new
menus or distributing new catalogs.
• A Macroeconomic Externality is a cost incurred
by society as a result of a decision by an individual
worker or firm.
• A Coordination Failure occurs when there is no
private incentive for firms to act together to avoid
actions that impose social costs on society.
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 The Efficiency Wage Model

• The efficiency wage model explains real

rigidities by arguing that firms do not want to
cut wages relative to the wage paid by other
firms.
– A higher relative wage encourages greater effort
by workers.
• Suppose demand falls.
– Firms respond by cutting employment while
maintaining the “efficiency wage.”
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 Criticisms of the New
Keynesian Approach

• The new Keynesian approach solves the main dilemma of

earlier business cycle models studied. That is, it explains
observed business cycles without:
– Assuming away output fluctuations.
– Assuming complete wage rigidity.
– Requiring imperfect information.
– Assuming procyclical wages.
• Criticisms of the new Keynesian approach:
– It provide too many reasons why wages and prices are sticky.
– Empirical testing of this approach is still in its infancy.

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