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What’s it? New Classical economics is an evolution of the classical schools of economics. It uses a neoclassical microeconomic approach to explain macroeconomic phenomena. It emphasizes the maximization of utility and the rational expectations of economic agents. We also call this the new classical macroeconomics.
The new classical economists are proponents of the free market. They encourage privatization, reduction of trade union power, and labor market reform. They are the successors of classical economists but differ slightly in several ways.
For example, classical economists viewed a product’s price as derived from materials and labor costs. Meanwhile, the new classical economists saw that price depends on consumer perceptions of a product’s value. If consumers perceive a product has high value and satisfies them, they are willing to buy it at a high price. Otherwise, the product is worthless.
New classical economics emerged in the early 1970s through the work of Robert Lucas. It flourishes at the University of Chicago and Minnesota. Some of the names of the new classical economists are:
- Thomas Sargent
- Neil Wallace
- Edward Prescott
- Finn E. Kydland
The latter two then develop the real business cycle (RBC). This theory explains the business cycle occurs because of a fundamental problem on the side of aggregate supply. External shocks such as technological innovation are responsible for random fluctuations in productivity levels and shifting constant growth trends up or down.
A Reaction to Keynesianism
The New Classical economists are proponents of the free market. They advised the government not to interfere in the economy. They believe the economy will equilibrate itself and are likely to survive in the long run. The internal mechanisms in the economy will automatically bring the equilibrium back to potential output. It goes through wage and price adjustments.
Policymakers should ensure automatic corrections take place rather than engage in active fiscal and monetary policies. Among the new classical economists’ policy suggestions are to reform the labor market, spur innovation through entrepreneurship, and ensure the economy operates under a free market. These are all important for influencing aggregate supply.
Preferably, Keynesian views the government needs to intervene. When an economic recession or depression occurs, the economy will not come to equilibrium and recover by itself. The private sector, households, and businesses are not strong enough to drive the economy. They are rational. When the economy falls, income and profits fall. The household and business sectors will not be willing to increase consumption and investment during this period.
Furthermore, the new Keynesian economists also criticized several new classical economic assumptions. Prices and wages tend to be sticky. Both may be easy to raise but not to lower due to factors such as the employment contract. Moreover, most markets also operate under imperfect competition rather than perfect competition, as the new classical economists assumed.
Core assumptions of new classical economics
New classical economics rests on two main assumptions about how economic agents and markets behave.
Rational expectations
New classical economists believe that people in the economy, whether consumers, firms, or workers, are all rational actors. This means they make decisions with the goal of maximizing their own well-being, such as maximizing utility for consumers or profit for firms. They also assume these actors have access to all relevant information and use it to make accurate predictions about the future, including what government policies might be implemented.
This perfect foresight leads to a lack of systematic errors in their decisions. Economic agents can even analyze historical data to predict future trends, based on the idea that history repeats itself (ergodicity).
As a consequence of this rational expectation, any anticipated government policies are already factored into economic calculations, potentially rendering many government interventions ineffective. However, unexpected policy changes, or “shock policies”, could have an impact.
Perfect competition and flexible prices
New classical economics assumes that all markets, both for goods and labor, function under perfect competition. This means there are many buyers and sellers with full information and no individual control over prices.
Prices and wages are completely flexible and can adjust immediately to reach equilibrium. In the labor market, this would lead to an automatic equilibrium at the natural rate of unemployment (NRU), where there is no unemployment due to insufficient demand.
This differs from Keynesian economics, which argues that involuntary unemployment can occur due to a lack of aggregate demand. Because of these assumptions about perfect competition and flexible prices, new classical economics believe that Say’s Law (supply creates its own demand) and the neutrality of money (money growth only affects prices, not real variables) hold true immediately. This differs from monetarism, which sees these effects playing out only in the long run.
These core assumptions lead new classical economists to be more skeptical of government intervention than Keynesians or Monetarists. Since they believe the economy is self-correcting and reaches equilibrium quickly, they view many government policies as ineffective.
New Classical Economics: A Market-Centric View
New classical economics emerged in response to the perceived shortcomings of Keynesian economics. Keynesian theory focused on government intervention to manage economic fluctuations, but new classical economists argued for a market-centric approach. They believed the economy is self-regulating and reaches equilibrium through adjustments in wages and prices.
Free market
New classical economics ardently promotes a free market system, believing it to be the most efficient and productive economic model. They advocate for minimal government intervention through fiscal or monetary policy.
According to this economic thought, the government’s role should be limited to ensuring a legal framework that upholds property rights and facilitates free competition. Unlike Keynesian economics, which emphasizes government intervention to manage economic fluctuations, new classical economics believes the economy is a self-regulating system.
Prices and wages act as crucial signals, constantly adjusting to reflect supply and demand. If there’s a surplus of labor, for instance, wages will naturally fall, incentivizing businesses to hire more workers.
Conversely, if there’s a shortage of labor, wages will rise, encouraging more people to enter the workforce. This organic process of price and wage adjustments, free from government interference, is believed to lead to an optimal allocation of resources and promote long-term economic growth.
New classical economists posit that government intervention, through policies like price controls or artificial wage hikes, can disrupt these natural adjustments, leading to inefficiencies and potentially worsening economic conditions.
Business cycle
New classical economists view the business cycle occurs because of problems in aggregate supply. Shocks from external factors cause long-run shifts in aggregate supply and changes in economic productivity.
The business cycle is a long-term phenomenon. New classical economists assumed the economy was at or near its potential output potential. The economy’s ups and downs occur not because of aggregate demand changes but because of long-run aggregate supply changes. A shock to the price of raw materials (such as a surge in oil prices) or technological innovation may affect potential output.
For this reason, fiscal and monetary policies are ineffective because they both affect aggregate demand, not aggregate supply. New classical economists argue the economy will go to full employment and its new equilibrium through price and wage adjustments.
Prices and wages
New classical economists assumed they were both flexible. Thus, monetary variables (such as inflation) have no impact on gross domestic product (GDP) and unemployment.
The labor market and the product market operate under perfect competition. Economic actors have sufficient economic information to anticipate future economic conditions. Such expectations influence their current behavior, including saving, investing, and spending. So, even if we assume the government intervenes, it will only be useless because they already know what will happen. That is the reason monetary policy and fiscal policy are ineffective.
Unemployment
Unemployment is a short-term phenomenon, according to new classical economics. They argue that when the unemployment rate is high, wages will naturally adjust downward. This downward pressure comes from unemployed workers who become more willing to accept lower wages (reservation wage falls) in order to secure employment.
This flexibility in wages, combined with the assumed rationality of economic actors, leads new classical economists to believe that unemployed workers can quickly find employers who are willing to hire them at the new wage level. The market itself, without government intervention, will correct unemployment imbalances through this process of wage adjustment.
