New Classical EconomicsNew Classical EconomicsNew Classical Economics (2)Two Types of MonetarismKevin Hoover, JEL (March 1984)The Twilight of the Monetarist Debate (1)Thomas Mayer, 1984 (Working Paper)The Twilight of the Monetarist Debate (2)Thomas Mayer, 1984 (Working Paper)Lucas Islands ModelLucas Islands Model (2)Lucas Islands Model (3)Sargent and Wallace (1976)Sargent and Wallace (2)Sargent and Wallace (3)Policy Ineffectiveness PropositionPhillips Curve under REHMore on PIPLucas Critique (1)Lucas Critique (2)Fiscal PolicyMonetary Misperceptions Theory of Business Cycles (1)Monetary Misperceptions Theory of Business Cycles (2)Monetary Misperceptions Theory of Business Cycles (3)Time InconsistencyNew Classical View of Keynesian EconomicsNew Classical EconomicsNew Classical EconomicsGraduate Macroeconomics IECON 309 – Cunningham2New Classical EconomicsNew Classical Economics1. Accepts model of GE with no imperfections.2. Prices are perfectly flexible, and all markets are permanently cleared (S=D). All markets are self-correcting.3. Individuals do not leave prices at “false” levels since this would result in disadvantages. Equilibrium is optimal.4. Because present actions entail future consequences, all agents deliberately form rational expectationsrational expectations. That is, they exploit all available information at all times since it is in their best interests to do so.3New Classical Economics (2)New Classical Economics (2)5. Agents adjust their decisions and actions so that their plans will be fulfilled optimally when their expectations are correct.6. Therefore, expectationsexpectations (and informationinformation) play the dominant role in determining the state of the economy at any point in time.7. They replace the deterministic setting with a stochastic stochastic one. People habitually suffer from expectational errors. It is the errors that explain economic fluctuations.8. Fluctuations and unemployment can be traced to voluntaryvoluntary deviations of supply and demand.9. Thus the business cycle is an equilibrium phenomenonequilibrium phenomenon, and is therefore optimal.4Two Types of MonetarismTwo Types of MonetarismKevin Hoover, JEL (March 1984)Kevin Hoover, JEL (March 1984)z Monetarism (Friedman)– Marshallian: • Small (partial equilibrium) models• Aggregate Prices– Money can “fool” agents on the short-run– Mistakes can cause agents to act in ways apparently inconsistent with optimization– Transient behavior occurs as agents “learn” (adaptive expectations)z New Classicals (Lucas, Sargent-Wallace, Barro)– Walrasian: • Large (general equilibrium) models• Relative Prices– Decisions made entirely on real factors– Agents (to the limits of their information) act in ways consistent with successful optimization– Continuously at equilibrium– Agents make no systematic errors (REH)5The Twilight of the Monetarist Debate (1)The Twilight of the Monetarist Debate (1)Thomas Mayer, 1984 (Working Paper)Thomas Mayer, 1984 (Working Paper)z Monetarism– Positivist– Policy Orientation– Pragmatic– Based on Empirical Macroeconomicsz New Classical/New Keynesian– More Interested in Elegance than Forecasts– Theoretical Rigor– Based on Theoretical Microfoundations6The Twilight of the Monetarist Debate (2)The Twilight of the Monetarist Debate (2)Thomas Mayer, 1984 (Working Paper)Thomas Mayer, 1984 (Working Paper)z What happened to Monetarism? Is it Dead? – Shift in Methodological Preferences– Absorption into Neo- and New Keynesian theories– Weakness of the Monetarist Theoretical Case– Errors in Presentation– Failures:• Velocity Change of 1980s• Causality issues (endogeneity?)• Research Agenda7Lucas Islands ModelLucas Islands Modelz Lucas, R.E., Jr. “Some International Evidence on Output-Inflation Tradeoffs,” AER Vol. 63 No. 3 (1973).z Assumptions:– Economy with single good traded.– Suppliers are scattered across a large number of geographically separated markets (islands).– Demand is unevenly distributed across the islands. Hence, prices vary across islands.– No arbitrage across islands.– Agents know the current price in their own market, but not current prices in other markets. – Agents form expectations rationally.8Lucas Islands Model (2)Lucas Islands Model (2)P1P2P3P4P5P6P7P8• Agents attempt to discern the general price level by observing the prices in markets.• They must attempt to discriminate between relative price changes and general price level changes (brought about by policy changes).• This is the so-called “signal extraction problem”.“signal extraction problem”.9Lucas Islands Model (3)Lucas Islands Model (3)z Yields the “Lucas Supply Function”:z The β depends upon the variance in prices across markets.z The greater the variance across markets, the more difficult the signal extraction problem, and the greater the error.z Greater error means greater short-run Phillips Curve tradeoff.tetttstuppyy +−β+δ=−)(110Sargent Sargent and Wallace (1976)and Wallace (1976)z “Rational Expectations and the Theory of Economic Policy,” Journal of Monetary Economics 2 (1976), 169-183.zz“There is no longer any serious debate “There is no longer any serious debate about whether monetary policy should be about whether monetary policy should be conducted according to rules or conducted according to rules or discretion. Quite appropriately, it is widely discretion. Quite appropriately, it is widely agreed that monetary policy should obey a agreed that monetary policy should obey a rule.”rule.”11SargentSargentand Wallace (2)and Wallace (2)21var,0][,)()1(utttetttstuuEuppyy σ==+−β+δ=−2var,0][,)()2(vtttttdtvvEvpmy σ==+−θ=dtsttyyy ==)3(1*)4(−γ+=ttymmnsExpectatioStaticpet0)5( =[]nsExpectatioRationalpEpttet 1)6(−=PickOne:12Sargent Sargent and Wallace (3)and Wallace (3)θβ+⎟⎠⎞⎜⎝⎛θβ++⎟⎟⎟⎠⎞⎜⎜⎜⎝⎛θβ+β+⎟⎟⎟⎠⎞⎜⎜⎜⎝⎛θβ+βγ+δ=−1*111ttttvumyySolution with Static ExpectationsStatic ExpectationsSolution with Rational ExpectationsRational Expectationsβθ++⎟⎠⎞⎜⎝⎛βθ+δ=−11ttttvuyy13Policy Ineffectiveness PropositionPolicy Ineffectiveness Propositionz How expectations are treated in macro models fundamentally affects the results!!!!z Under rational expectationsrational expectations (endogenous expectations), real output and employment are uneffected by systematic or predictable changes in aggregate demand policy.z If