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5.1 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’!