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Appendix
The New Classical Model
In the new classical model, all wages and prices are completely flexible with
respect to expected changes in the price level. The new classical model was developed in the early to mid-1970s by Robert Lucas of the University of Chicago and
Thomas Sargent, formerly of the University of Minnesota but now at New York
University.1 It departs from the aggregate demand and supply analysis we developed
in Chapter 12 in two important ways.
1. The analysis is based on the assumption that expectations are rational, and thus is
solidly based on microeconomic fundamentals.
2. Wages and prices are completely flexible with respect to changes in expected
inflation; that is, a rise in expected inflation results in an immediate and equal rise
in wage and price inflation because workers and firms try to keep their real wages
and relative prices from falling when they expect inflation to rise.
(1)
1See
Robert E. Lucas, Expectations and the Neutrality of Money, Journal of Economic Theory 4 (April 1972):
10324; and Thomas Sargent and Neil Wallace, Rational Expectations, the Optimal Monetary Instrument,
and the Optimal Money Supply Rule, Journal of Political Economy 83:2 (April, 1975): 24154.
CHAPTER 22 APPENDIX
where,
= Inflation at time t, that is the change in the price level from period
t 1 to t.
Et 1p t = Inflation from period t 1 to t which is expected at time t 1 using
rational expectations
Yt
= aggregate output at time t
= potential output
YP
= sensitivity of inflation to the output gap
g
pt
The short-run aggregate supply curve based on Equation 1 is shown in Figure 22A1.1.
This aggregate supply curve is similar to the one we derived in Chapter 11 because Et - 1pt is
the same thing as expected inflation pe, but with one subtle difference: the short-run
aggregate supply curve is fixed only for a particular value of expected inflation and will
shift when expected inflation changes. To illustrate, suppose that in Figure 22A1.1
expected inflation is initially at p1. The short-run aggregate supply curve for this level of
expected inflation, AS1, passes through point 1 because at Yt = YP, Equation 1 shows that
actual inflation will be equal to p1. As shown in Figure 22A1.1, if Yt 7 YP, then inflation
FIGURE 22A1.1
Aggregate Supply
in the New
Classical Model
The new classical
model has short-run
aggregate supply
curves that are upward
sloping and specific to
a particular expected
inflation rate, as AS1
and AS2. AS1 is fixed
for Et 1pt = p1 and this
is why it is marked as
AS1(Et 1pt = p1) and is
drawn to pass through
point 1, where at an
actual inflation rate at
p1, aggregate output is
at potential (Y = YP)
and so expected inflation is also at p1
(Et 1pt = p1). Similarly,
AS2 is fixed for Et 1pt
= p2 and is marked as
AS1(Et 1pt = p1): it is
drawn to pass through
point 2, where at an
actual inflation rate at
p2, aggregate output is
at potential (Y = YP)
and so expected inflation is also at p2
(Et 1pt = p2.).
Inflation
Rate,
LRAS
AS2 (Et 1t = 2)
AS1 (Et 1t = 1)
2
2
1
1
YP
Aggregate Output, Y
increases along the AS curve by the amount g(Yt - YP) , as the upward sloping short-run
aggregate supply curve AS indicates. The short-run aggregate supply curve AS1 is thus
specific to an expected inflation rate of p1 and is marked this way in Figure 22A1.1.
By the same reasoning, if expected inflation is instead at p2, then the short-run
aggregate supply curve will shift up and to the left to AS2, where it passes through
point 2 because as Equation 1 shows, when Yt = YP, inflation in this case will be equal
to p2. The short-run aggregate supply curve AS2 is thus specific to an expected inflation
rate of p2, and is marked this way in Figure 22A1.1. The short-run aggregate supply
curve in the new classical model thus will immediately shift from AS1 to AS2, if
expected inflation rises from p1 to p2.
Misperceptions Theory
We can think of the new classical model as a misperceptions theory because it results
from misperceptions by firms that a general rise in inflation has resulted in higher
relative prices for the goods they sell, so that they supply more.2 To illustrate, we can
rewrite the new classical short-run aggregate supply (Phillips) curve in Equation 1 by subtracting Et - 1pt, from both sides of the equation, dividing by g, and then putting Yt - YP
on the left-hand side. The transformed equation is then as follows:
Yt - YP = (pt - Et - 1pt)/g
(2)
Equation 2 indicates that only when actual inflation is higher than expected inflation
will aggregate output be greater than potential output.
The misperception story behind Equation 2 is as follows. Consider Isaac the ice
cream maker who has to figure out how much ice cream he should make. What you
learned in your principles of economics course is that Isaac will compare the price that
he gets for his ice cream with the prices of other goods and services he wants to buy. If
the price of ice cream rises relative to the price of other goods and services Isaac wants
to buy, he is willing to work harder because he can exchange the ice cream for more
goods and services. If, on the other hand, the price of ice cream falls relative to other
goods and services, Isaac will want to take more time off and enjoy life because there is
less of a payoff to producing ice cream. Therefore, a rise in the relative price of the good
he produces will cause Isaac to increase production, while a fall in the relative price will
lead him to reduce production.
To figure out what is happening to the relative price of the good he produces, Isaac
could try to find out what is happening to all the other prices of goods and services he
wants to buy, but obviously this would take him too much time. Instead, when he sees
a rise in the price of ice cream he will estimate the relative price by asking himself how
much the price of ice cream has risen relative to what he expects the general rise in the
price level will be, that is, his expectations of inflation. For example, if he sees the price
of ice cream rising by 3% this year, but his expectation of inflation is 2% (that is, he
expects prices in general to rise by 2%), then he will think that the relative price of ice
cream is rising and will produce more. If on the other hand, he expected inflation to be
2The
classic references for the misperceptions theory are Milton Friedman, The Role of Monetary Policy,
American Economic Review (March 1968): 117; and Robert E. Lucas, Jr., Expectations and the Neutrality of
Money, Journal of Economic Theory (April 1972): 103124.
CHAPTER 22 APPENDIX
4%, then the price of ice cream is rising less than prices in general and he will want to
cut production.
If we extend this analysis to other producers besides Isaac, we come to the conclusion that when producers see the prices of the goods they produce rising faster than
what they expect inflation to be, overall production in the economy will rise, and if they
see prices rising by less than what they expect inflation to be, production will fall. This
reasoning tells us that when actual inflation is above expected inflation, firms are fooled
into thinking the relative price of the goods they are producing has risen and so output
in the economy will rise above what firms would produce if they had no misperceptions, which is just potential output YP. On the other hand, if actual inflation is below
expected inflation, firms will produce an amount of output that is less than potential
output. Misperceptions about how fast the general price level is rising then lead to
Equation 2, which indicates that aggregate output exceeds potential output only when
the realized inflation rate is higher than expected inflation.
FIGURE 22A1.2
Response to
Expansionary
Policy in the New
Classical Model
Initially, the economy
is at point 1 at the intersection of AD1 and AS1
(Et 1pt = p1) where
aggregate output is at
YP and inflation is at
p1. An expansionary
policy shifts the aggregate demand curve
from AD1 to AD2, but if
the policy is unanticipated, the short-run
aggregate supply curve
remains at AS1.
Equilibrium now
occurs at point 2'
aggregate output has
increased to Y2' , and
inflation has increased
to p2'. If the expansionary policy is anticipated, then the
short-run aggregate
supply curve shifts up
to AS2 (Et 1pt = p2).
The economy then
moves to point 2,
where aggregate output
does not change from
YP, but inflation rises
by even more to p2.
Inflation
Rate,
LRAS
AS1 (Et 1t = 1)
2
2'
2'
AD2
AD1
YP
Step 1. Positive
demand shock
shifts AD to
the right.
Y 2'
Aggregate Output, Y
to a point of long-run equilibrium (point 2) where aggregate output is at potential output. Although Figure 22A1.2 suggests why this occurs, we have not yet proved why an
anticipated expansionary policy shifts the short-run aggregate supply curve to exactly
AS2 (corresponding to an expected inflation rate of p2) and hence why aggregate output
necessarily remains at the level of potential output. The somewhat complex proof is the
subject of the box entitled, Proof of the Policy Ineffectiveness Proposition.
CHAPTER 22 APPENDIX
striking conclusion to the new classical model: anticipated policy has no effect on the
business cycle, only unanticipated policy matters. It implies that one anticipated policy is just like any other: it has no effect on output fluctuations. Recognize that this
proposition does not rule out output effects from policy changes. If the policy is a surprise (unanticipated) it will have an effect on output.
FIGURE 22A1.3
Uncertainty About
Policy Outcomes
Because the public
expects the aggregate
demand curve to shift
to AD2, the short-run
aggregate supply
curve shifts to AS2
(Et 1p t = p 2). When
the actual expansionary policy falls short of
the publics expectation
(the aggregate demand
curve merely shifts to
AD2'), the economy
ends up at point 2', at
the intersection of AD2'
and AS2. Despite the
expansionary policy,
aggregate output
falls to Y2'.
Inflation
Rate,
LRAS
AS2 (Et 1t = 2)
AS1 (Et 1t = 1)
2
2'
1
2
2'
AD2
AD2'
AD1
Step 2.
Expansionary policy
shifts AD to AD2',
which is less than
the expected AD2.
Y 2' YP
Aggregate Output, Y
CHAPTER 22 APPENDIX
As we have seen in Figure 22A1.2, even though anticipated policy has no effect on
aggregate output in the new classical model, it does have an effect on inflation. The new
classical macroeconomists care about anticipated policy and suggest that policy rules be
designed so that the inflation rate will remain stable.
SUMMARY
1. The new classical macroeconomic model assumes
that expectations are rational and that wages and
prices are completely flexible with respect to the
3For
expected price level. It leads to the policy ineffectiveness proposition that anticipated policy has no
effect on output; only unanticipated policy matters.
empirical evidence on the policy ineffectiveness proposition, see Robert J. Barro, Unanticipated Money
Growth and Unemployment in the United States, American Economic Review 67 (March 1977): 10115;
Frederic S. Mishkin, Does Anticipated Monetary Policy Matter? An Econometric Investigation, Journal of
Political Economy 90 (February1982): 2251; Frederic S. Mishkin, Does Anticipated Aggregate Demand Policy
Matter? Further Econometric Results, American Economic Review 72 (September 1982): 788802; and Frederic
S. Mishkin, A Rational Expectations Approach to Macroeconometrics: Testing Policy Ineffectiveness and Efficient
Markets Models (Chicago: University of Chicago Press, 1983).
KEY TERMS
misperceptions theory, p. 3
policy ineffectiveness
proposition, p. 5
3. What implications does the policy ineffectiveness proposition have for policy makers?
4. What objections to the new classical model
have been raised?