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5.6 An Assessment

The contributions made by leading new classicists such as Lucas, Barro,

Sargent and Wallace dominated macroeconomics discussion throughout the

1970s, particularly in the USA. In particular the business cycle research of

Lucas during the 1970s had an enormous methodological impact on how

macroeconomists conducted research and looked at the world (Lucas, 1980a,

1981a; Hoover, 1992, 1999; Chapter 6). For example, although the idea that

all unemployment should be viewed as voluntary remains controversial, economists

after the ‘Lucasian revolution’ have been much less willing to accept

uncritically Keynes’s idea of ‘involuntary unemployment’ (see Solow, 1980;

Blinder, 1988a; Snowdon and Vane, 1999b).

However, by the close of the 1970s, several weaknesses of the new classical

equilibrium approach were becoming apparent. These deficiencies were

mainly the consequence of utilizing the twin assumptions of continuous

market clearing and imperfect information. By 1982 the monetary version of

new classical equilibrium models had reached both a theoretical and empirical

impasse. For example, on the theoretical front the implausibility of the

assumption relating to information confusion was widely recognized (Okun,

1980; Tobin, 1980b). With sticky prices ruled out on methodological grounds,

new classical models were left without an acceptable explanation of business

cycles involving money-to-output causality. Furthermore, the doubts cast by

Sims (1980) on the causal role of money in money–output correlations raised

questions with respect to monetary explanations of the business cycle. On the

empirical front, despite some early success, the evidence in support of the

proposition that anticipated money was neutral did not prove to be robust (see

Barro, 1977a, 1978, 1989a). According to Gordon (1989) the influence of the

first phase of new classical theorizing peaked in the period 1976–8. Gordon

also dates the downfall of this phase ‘precisely at 8.59 a.m. EDT on Friday

13th October, 1978, at Bald Peak, New Hampshire’ for it was here that

Robert Barro and Mark Rush (1980) began their presentation ‘of an empirical

test of the policy-ineffectiveness proposition on quarterly US post-war data

that was not only severely criticised by three discussants, but also contained

dubious results that seemed questionable even to the authors’ (see Hoover,

1992, Vol. 1). Thus the early 1980s witnessed the demise of the mark I

(monetary surprise) version of the new classical approach in large part due to

the implausibility of supposed information gaps relating to aggregate price

level and money supply data, and the failure of empirical tests to provide

strong support for the policy ineffectiveness proposition (Barro, 1989a). The

depth of the recessions in both the USA and the UK in the 1980–82 period

following the Reagan and Thatcher deflations provided the critics with further

ammunition. As a consequence of these difficulties the monetary surprise

model has come to be widely regarded as inappropriate for modern information-

rich industrial economies.

Meanwhile Stanley Fischer (1977) and Edmund Phelps and John Taylor

(1977) had already shown that nominal disturbances were capable of producing

real effects in models incorporating rational expectations providing the

assumption of continuously clearing markets was abandoned. While accepting

the rational expectations hypothesis was a necessary condition of being a

new classicist, it was certainly not sufficient. Following the embryonic new

Keynesian contributions it was quickly realized that the rational expectations

hypothesis was also not a sufficient condition for policy ineffectiveness. As a

result the policy-ineffectiveness proposition was left ‘to die neglected and

unmourned’ and ‘Into this vacuum stepped Edward Prescott from Minnesota,

who has picked up the frayed new classical banner with his real business

cycle theory’ (Gordon, 1989). Thus Lucas’s MEBCT has been replaced since

the early 1980s by new classical real business cycle models emphasizing

technological shocks (Stadler, 1994), new Keynesian models emphasizing

Figure 5.7 The evolution of new classical macroeconomics





Sargent & Wallace (1975, 1976)




Fellner (1976, 1979)



Kydland & Prescott (1977);

Barro & Gordon (1983a and b)



e.g. tax and regulatory policies




Lucas (1975, 1977)


Barro (1977a, 1978);

Mishkin (1982);

Gordon (1982a)



Lucas (1976)






monetary disturbances (Gordon, 1990), and new neoclassical synthesis models

combining insights from both approaches (see Lucas, 1987; Goodfriend

and King, 1997; Blanchard, 2000).

Economists sympathetic to the new classical approach (such as Finn Kydland

and Edward Prescott) have developed a mark II version of the new classical

model, known as real equilibrium business cycle theory (REBCT, see Figure

5.7). While proponents of the REBCT approach have abandoned the monetary

surprise approach to explaining business cycles, they have retained

components of the equilibrium approach and the propagation mechanisms

(such as adjustment costs) used in mark I versions. Responding to the Lucas

critique was also a major driving force behind the development of REBCT

(see Ryan and Mullineux, 1997).

Despite the controversy that surrounds the approach, new classical economics

has had a significant impact on the development of macroeconomics

over the last decade and a half. This impact can be seen in a number of areas.

First, it has led to much greater attention being paid to the way that expectations

are modelled, resulting in a so-called ‘rational expectations revolution’

in macroeconomics (Taylor, 1989). For example, the rational expectations

hypothesis has been widely adopted by new Keynesians and researchers in

the area of the ‘new political macroeconomics (see Chapters 7 and 10). It also

formed a crucial input to Dornbusch’s (1976) exchange rate overshooting

model (see Chapter 7). Second, the insight of rational expectations that a

change in policy will almost certainly influence expectations (which in turn is

likely to influence the behaviour of economic agents) is now fairly widely

accepted. This in turn has led economists to reconsider the role and conduct

of macroeconomic stabilization policy. In particular, the modern emphasis on

‘policy rules’ when discussing the stabilizing role of monetary policy has

been heavily influenced by the idea of rational expectations.

Much of the controversy that surrounds new classical macroeconomics is

directed, not at the rational expectations hypothesis per se, but at the policy

implications that derive from the structure of new classical models. In this

context it is interesting to note that Keynesian-like disequilibrium models

(where markets do not clear continuously) but which allow agents to have

rational expectations, as well as incorporating the natural rate hypothesis,

still predict a role for demand management policies to stabilize the economy.

If, in the face of random shocks to aggregate demand, the government is able

to adjust its policies more quickly than the private sector can renegotiate

money wages, then there is still a role for aggregate demand management to

stabilize the economy and offset fluctuations in output and employment around

their natural levels. As Buiter (1980) summed it up, ‘in virtually all economically

interesting models there will be real consequences of monetary and

fiscal policy–anticipated or unanticipated. This makes the cost–benefit analysis

of feasible policy intervention the focus of the practical economist’s

concern.’ There should therefore be no presumption that ‘a government that

sits on its hands and determines the behaviour of its instruments by the

simplest possible fixed rules is guaranteed to bring about the best of all

possible worlds’. Furthermore, given the gradual adjustment of prices and

wages in new Keynesian models, any policy of monetary disinflation, even if

credible and anticipated by rational agents, will lead to a substantial recession

in terms of output and employment, with hysteresis effects raising the

natural rate of unemployment (see Chapter 7).

Finally, in trying to come to an overall assessment of the impact of new

classical macroeconomics on the debate concerning the role and conduct of

macroeconomic stabilization policy, three conclusions seem to suggest themselves.

First, it is fairly widely agreed that the conditions necessary to render

macroeconomic stabilization policy completely powerless to influence output

and employment in the short run are unlikely to hold. Having said this, the

possibility that economic agents will anticipate the effects of changes in

economic policy does imply that the authorities’ scope to stabilize the economy

is reduced. Second, new classical macroeconomics has strengthened the case

for using aggregate supply policies to stimulate output and employment.

Lastly, new Keynesians have been forced to respond to the challenge of new

classical macroeconomics and in doing so, in particular explaining why wages

and prices tend to adjust only gradually, have provided a more sound microtheoretical

base to justify interventionist policies (both demand and supply

management policies) to stabilize the economy.

Before discussing new Keynesian economics we first examine in the next

chapter the evolution of the Mark II version of new classical economics, that

is, real business cycle theory.

Robert Lucas was born in 1937 in Yakima, Washington and obtained his BA

(History) and PhD from the University of Chicago in 1959 and 1964 respectively.

He was a lecturer at the University of Chicago (1962–3), Assistant

Professor (1963–7), Associate Professor (1967–70) and Professor of Economics

(1970–74) at Carnegie-Mellon University, Ford Foundation Visiting

Research Professor (1974–5) and Professor (1975–80) at the University of

Chicago. Since 1980 he has been John Dewey Distinguished Service Professor

of Economics at the University of Chicago.

Best known for his equilibrium approach to macroeconomic analysis, and

his application of rational expectations to the analysis of macroeconomic

policy, Robert Lucas is widely acknowledged as being the leading figure in

the development of new classical macroeconomics. In addition to his highly

influential work on macroeconomic modelling and policy evaluation, he has

made a number of important contributions to other research fields including,

more recently, economic growth. In 1995 he was awarded the Nobel Memorial

Prize in Economics: ‘For having developed and applied the hypothesis of

rational expectations, and thereby having transformed macroeconomic analysis

and deepened our understanding of economic policy’.

Among his best-known books are: Studies in Business Cycle Theory (Basil

Blackwell, 1981); Rational Expectations and Econometric Practice (University

of Minnesota Press, 1981), co-edited with Thomas Sargent; Models of

Permission to reprint from the University of


Credit: Lloyd De Grane