Controversies in Macro economics: (5) New Classical Economics

New Classical Economics:

An alternative to Keynesian macroeconomics is new classical economics. The new Classical economics is taken very seriously in academic circles but has less impact in policy planning. It was the creation of Robert Lucas. The key idea unifying the new classical school is the importance of expectations of the future in macroeconomics and in particular expectations about future government policies. The new classical economists argue that rational individuals, in forming their expectations of the future will use all available information without making systematic errors rendering government policy both unnecessary and futile. In other words individuals are rational in forming their expectations. This innocent sounding idea has some very revolutionary implication in macroeconomics that provide fundamental challenges to Keynesian views on the economy works and the way policy should be conducted.

The new classical economics grew out of monetarism during the 1970s. It focuses on the way in which economic agents form their expectations for the future. As per rational expectations model the Ad curve will intersect As curve at natural output unless there is some unanticipated changes in As or Ad. According to the new classical economics the anticipated change in the monetary and fiscal policy that shift the AD curve will lead to an immediate and equal shift in AS curve with no effect on real GNP. The policy implications of this model are that government policy should be predictable and that government can eliminate inflation without cost by following a publicly announced policy of keeping money growth stable and low. Robert Lucas argues that Keynesians have failed to account for the way individual expectations about future policy change when policy changes. This criticism of Keynesians’ is known as ‘Lucas Critique’ in the macroeconomic theory and represents a challenge to Keynesian analysis.