new classical macroeconomics theory, rational expectations, Lucas critique , economics optional

new classical macroeconomics theory, rational expectations, Lucas critique, economics optional • In 1930 unemployment was the major problem in the world Keynes suggest to increase public expenditure to reduce unemployment. • During Second World War 1939 -1945 inflation was the major problem. • Post-war late 1960 again unemployment was a major problem. • From the late 1960 to-70, a new problem arises called stagflation in which both inflation and unemployment are high. • According to Keynesians or monetarists Changes in aggregate demand due to expansionary monetary policy or expansionary fiscal policy cause a temporary increase in employment and output but in the long-run output and employment return to their natural rate. • According to a new classical economist systematic monetary and fiscal policy actions that change aggregate demand will not affect output and employment, even in the short run. This has been termed the new classical policy ineffectiveness proposition. The new classical economics developed against the background of the high inflation and unemployment of the 1970s and the accompanying dissatisfaction with the prevailing Keynesian orthodoxy. THE RATIONAL EXPECTATIONS CONCEPT AND ITS IMPLICATIONS The theory posits that individuals base their decisions on three primary factors: 1. Their human rationality, 2. The information available to them, 3. Their past experiences. • Keynesians and monetarists have assumed that price expectations adjust slowly and can be fixed for the analysis of policy effects over short periods. In the Keynesian model, expectations are backwards-looking. The expectation of a variable such as a price level adjusts (slowly) to the past behaviour of the variable. • New classical economists criticize such formulations. New classical economists propose that economic agents are rational and do not make systematic errors. According to the rational expectations hypothesis, expectations are formed based on all available relevant information concerning the variable being predicted. rational expectations are forward-looking so labour supply will charge according to future expectations. • Anticipated and unanticipated policy changes have very different effects when expectations are assumed to be rational. Anticipated policy changes and rational expectation • In the new classical model, with the assumption of rational expectations, the expected price level depends on money supply (M), government spending (G) and tax collections (T'), • The increase in the money supply will shift the aggregate demand schedule to the right If the supply schedule did not shift, the output would rise from Yo to Y1 and the price level would increase from Po to P1. With the rise in the price level, the labour demand schedule shifts to the right. If the labour supply schedule did not also shift, employment would rise (from No to N1). As money supply changes are anticipated by labour suppliers labour supply schedule will shift to the left this shift will lead due to a reduction in unemployment and output switch back to their initial level N0, Y0.