Media Illustrations

Curiosity 12.1 What Are New Classicals and New Keynesians?
Several schools of macroeconomic thought have appeared in this book at one stage or another: the Keynesian school, which supplanted the classical school; monetarists, who critiqued the Keynesians; and supply-siders and real business cycle theorists who focused on the supply side of the economy. Two recent schools are the new classical school and the new Keynesian school. Both schools place great emphasis on generating explanations based on individuals acting rationally in their self-interest, which collectively causes macroeconomic phenomena such as excessive unemployment and business cycles. Like the Keynesian school, the new Keynesian School favors government intervention in the economy, whereas the new classicals like the classicals and the monetarists do not.
Oversimplifying somewhat, the difference between them is most sharply drawn on the issue of what gives the short-run aggregate supply curve its upward slope, or, equivalently, what causes the short-run Phillips curve to be downward-sloping. New classicals believe that wages and prices are flexible, that markets always clear, and that it is information problems that cause short-run deviations from the NRU, thereby explaining business cycles.
In contrast, new Keynesians believe that wages and prices m not flexible, that markets do not always clear, and that information problems must be supplemented by the concept of sticky wages and prices. They have devoted their research energies to finding intellectually respectable ways of explaining wage and price rigidities as arising from efficient, rational microeconomic behavior on the part of labor and firms. They would note, for example, that firms find it easier in the short run to meet demand changes by adjusting quantity rather than price. Contractual labor markets and, in particular, implicit contracts play a major role in their explanations, causing some to distinguish between new classicals and new Keynesians on the basis of their belief in the invisible hand versus the invisible handshake.

contracts are renegotiated, bringing the real wage back to its original level and building into new contracts the higher expected inflation. Consequently, the economy's movement toward point B is only temporary. People's expectations of inflation increase; in time, money wages rise to restore the original real wage and thereafter rise at a rate matching the new, higher inflation rate.
In figure 12.2, higher expected inflation shifts the SRPC curve upward. The economy moves along the cured arrowed line from A out toward B, perhaps as far as point C, but eventually back to the NRU at point D, and the SRPC curve ends up eventually at SRPC'. Why does SRPC shift upward with higher inflation expectations? If everyone expects inflation to be two percentage points higher, then regardless of the unemployment rate workers demand and firms grant wage increases two percentage points higher than usual, thus shifting the SRPC up by two percentage points.
A clear implication of this analysis is that, in the long-run, the economy moves along the long-run Phillips curve rather than the traditional downward-sloping, short-run Phillips curve, with no trade-off between inflation and unemployment. Persistent government action to move the economy to a lower level of unemployment only serves to push it to higher

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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