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5.3 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 (see Chapter 7).

Figure 5.1 The structure of new classical models