What’s it: New classical economics is an evolution of the classical schools of economics and 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 at a high price. Otherwise, if not, the product is worthless to buy.
Main contributors to new classical economics
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.
Difference between the new classical economics and 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.
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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, is not strong enough to drive the economy. They are rational. When the economy falls, income and profits fall. The household and business sector 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.
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New classical economic theory
Here are some thoughts from the new classical economists.
Free market. Governments should not interfere in the economy through fiscal or monetary policy. The economy regulates itself through adjustments in wages and prices.
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 is at or near its potential output potential. The ups and downs of the economy occur not because of aggregate demand changes but because of long-run aggregate supply changes. It may be due to a shock to the price of raw materials (such as a surge in oil prices) or technological innovation, affecting 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. When the unemployment rate is high, wages will adjust downward. Unemployed workers reduce the reservation wage (the lowest level of wages they are willing to accept a job). They can immediately find employers who are willing to employ them.
Rationality. Economic actors make decisions based on rational expectations. They try to maximize their respective utility. Households will maximize satisfaction in consuming goods and services. Meanwhile, the company will maximize profits.
All economic agents will motivate and behave in the same way in the face of economic fluctuations. For example, when the economy is sluggish, firms will rationally lower prices to attract demand. Likewise, during this period, unemployed workers will be willing to lower the reservation wage to find employers. Finally, the economy is gradually heading for recovery.