Posted: January 10th, 2023

Lucas Critique and Micro-founded models – New Classical macro economical theory

Lucas Critique and Micro-founded models – New Classical macro economical theory 

Introduction

The economic activities carried out by individuals or corporations within a nation are determined by the decision making by the state in terms of adopting a guiding economic theory. The economic decision making determines the economic environment from which a country’s residents operate within. At any given point, despite deferring opinions being held by leading economists, there is always a prevailing economic theory. Since the 1970s, the prevailing economic theory has been the new classical macro economical theory (Yang and Ng, 2015: 33). This research essay will analyze the evolution of economical theory and the principles and arguments that are held by New Classical macro economical theory.
Historical Development of New Classical Macroeconomics

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The first accepted formal theory of economics is referred to as the classical theory. The hallmarks of classical theory were firmly rooted in the staunch belief in a self regulating economy and the opposition to any governmental intervention. British Economist, Adam Smith, is largely credited with being the ‘father’ of the classical theory of economics when in 1776 he published his seminal book, wealth of a nation (Negishi, 2014: 16). In the book, smith called for a shift towards basing an economy on trade rather than its gold reserves. He also stated that the general national economic well being directly derives from the business activities, and wealth transfer of its private individuals. The people’s own self interest can be depended upon to fuel the national economy. However, smith recognized that people’s self interest cannot be depended upon in certain areas, such as education. As concerns education, and a small number of social amenities, the government’s involvement is required to ensure all citizens (even those that cannot afford it) are provided with the basic necessities.

Other notable economists such as David Ricardo, Say, Malthus and Stuart Mill built upon the theory while generally retaining the core principles identified by Smith’s theory. The guiding principles upon which classical theory is founded upon include the belief in a self regulating (free) economy. Every market has its natural equilibrium in terms of supply, demand, and commodity pricing. The existing market forces are adequate in terms of enabling the market achieve this natural state of equilibrium without any external intervention; this is termed as the ‘invisible hand’ (North, 2016: 74) of the market. Say’s law further builds upon this theory by stating that the supply made available in a market is sufficient to fuel the demand of the commodities on offer. The production phase creates enough wealth within a market to sustain the purchase of the commodities produced. Interest rates and interest rates should also be determined by the market forces without any government intervention. The same principles also govern the labour market which should be governed by market forces without any state involvement.

The classical theory was largely accepted in the period following the industrial revolution and preceding the great depression as it was a period that featured immense economic growth and general prosperity. The great depression was the single most significant reason that prompted the classical theory to be viewed critically and alternate guiding principles to be developed.

British economist, John Maynard Keynes, in the aftermath of the great depression, led the efforts to supplant classical theory as the prevailing economic theory. According to Keynes, the great depression was evidence that a self-regulating (free) market was not equipped to come up with solutions that can resolve the economy after a cataclysmic economic event (Moggridge, 2013: 29). Concerning employment, Keynes insisted that under the guidance of classical theories, employment was not available to all that needed it despite classical theory tenets stating that it was. Keynesian theory argued that government involvement is needed to achieve both price stability as well as full employment.

Keynes largely agrees with Say’s law that stated that ultimately, the supply will create its own demand (Amsden, 2010: 61). However, the great depression showed that a weakened economy sees a sharp reduction in the overall demand. The reduced demand forces suppliers to reduce their output and lay off their employees due to reduced revenue. These layoffs add to the overall unemployment and further reduce the demand. This vicious cycle of reduced demand and increasing unemployment can only be checked and corrected by government intervention. The principle foundation of Keynesian theories is government intervention. During the troughs of a business cycle, a government can ‘jump start’ an economy by increasing its spending to support production. Likewise, the reduction of the interest rate could provide the economy with affordable credit thus boosting the economy. During the peaks of the business cycle, Keynesian theories propose increased government regulation, especially concerning corporate financial behaviour and employment.

Keynesian theories were popular in the post-depression economy as they oversaw the rebuilding of the global economy. However, towards the 1970, the economy globally was faced with an extended period of economic stagnation (Kaldor, 2015: 43). This period of stagnation saw the Keynesian theories being critically questioned and the development of other economic theories. The theory that was widely accepted in this pot Keynesian period was the new classical macro economical theory that is the subject matter for this research essay.

The New Classical Macro-economical Theory

After the stagnation experienced b the global economy in the 1970s, the new classical theory was adopted to supplant the prevailing Keynesian theories. Work on the neo classical theories of macroeconomics was particularly robust in the 1960s as many mainstream economics started having opposing views to Keynesian theories. The economics credited with the development of new classical macro economical theory include Robert Lucas, Neil Wallace, Edward Prescott and Thomas Sargant (Berg and Gigerenzer, 2010: 141). While other economists were involved in the development of the theory, these four are recognized as the neo classical theory pioneers.

The theory highlighted the shortcomings in Keynesian theories and opposed the economic models developed under Keynesianism as being ineffective. The new classical theories are largely concerned with the futility of state intervention as a tool for correcting the unpredictable ‘shocks’ to the economy.

1. Principles

While there are many economists that identify as being neo-classist, they often have different viewpoints on certain issues. However, the following principles are the guiding principles on which the new classical theories are based on. Support on these guiding principles is almost universal with all neo classic economists.

1. The assumption of rational expectation

Keynesian theories largely fail to account for the expectations that people have. One of the pioneering new classical theory pioneers, Milton Friedman, sated that people have a certain expectations concerning the outcome of an economic policy. Ultimately, the outcomes should not differ greatly from the people’s expectations. An economic policy that fails to match the expectations is considered to be flawed by the new classical school of thought (Mertens and Ravn, 2014: 08).

Most economical models are concerned with the forecasting of future economic situations and the manner with which the market will react to them. For example, the forecast information of future inflation rates is important in terms of the decision making involving investment, employment and the public’s consumption. Keynesian theories based their model creation on adaptive expectations which stated that future events can be predicted based on past events.

The assumption of rational expectation states that people will always make decisions to further their self interest; and these decisions are based on the information that they have. Information received serves to shape their expectations of the future and influence their economical decision making.

1.  The assumption of natural rate

There is a natural equilibrium for all products that is determined by the unique factors that constitute a market. This is especially true concerning the labour market. The natural rate of unemployment was a theoretical concept that was developed by Edward Phelps and Milton Friedman in the 1960s/ full employment, as hypothesized by Keynesianism is impossible to achieve. The theory sates that each market has a production capacity, and when this peak output is achieved, there is no unemployment that is caused by the lack of labour demand. When a market achieves peak output, the unemployment rate observed is the market’s natural unemployment rate (Daly et al., 2011: 13).

While Keynesian theories showed that, to some extent, government intervention could reduce unemployment, it is impossible to reduce the unemployment rate past the market’s natural unemployment rate without a resultant increase in inflation. Lucas Critique and Micro-founded models – New Classical macro economical theory Economists have recognized, for a long time, that there is an inverse relationship between the inflation rate and the unemployment rate. A rise in inflation is accompanied by a reduction of the unemployment rate; similarly, a drop in inflation is accompanied by an increase in the unemployment rate. Keynesian theories believe that a government can exploit this trade-off to impact the unemployment rate. Policies aimed at increasing inflation could be used to reduce the unemployment rate as per the Keynesian school of thought. However, adopting expansionist policies, to reduce the unemployment rate past the natural rate is extremely counterproductive.  Initially, such a move may show nominal results in the short-term, however, in the long run, the market will see an inflation increase that reduces the overall spending power that the residents have. This sees them demand for increased wages to remedy this situation, and over time, the unemployment rate will increase until it goes back to its natural rate. Meanwhile, the inflation rate will remain high without any payoffs in terms of reduced unemployment

1. Theory of continuous market clearing

This theoretical concept is concerned with the matter of pricing within a market. New classical macroeconomic theory believes in the market’s ability to settle on a general equilibrium price. The general equilibrium price is the price whereby the supply produced equals to the amount demanded. As per the theory of continuous market clearing, the market forces of supply and demand will eventually set the equilibrium price.

This is the price at which the commodities supplied equal to the demand. When the market price is more than the equilibrium price, the demand would reduce leading to an inventory surplus on the supply side. When the market price is below the equilibrium price, the demand would exceed the supply, leading to commodity shortage as suppliers’ output fails to meet the demand rate. Any factors that change within the market to make the market price different from the equilibrium price will be rectified by the market as its either adapts to the new change by coming up with a new equilibrium price or by forcing the market price to naturally tend towards the natural equilibrium price Lucas Critique and Micro-founded models – New Classical macro economical theory.

1. Main Argument

One of the central tenets of neo-classic theories is the ineffectiveness of government interventionist policies to influence the market. This is known as the theory of policy ineffectiveness as is the central argument posed by new classical macroeconomic theories. The issue of unemployment offers the best insight into policy ineffectiveness.

The Philips curve visually represented the aforementioned relationship between unemployment and inflation (Gallegati et al., 2011: 491). The relationship, as previously explained, is inverse in nature. Keynesian intervention policies believe that expansionist policies and strategies result in reduced unemployment despite the trade-off in terms of increased inflation. Figure 1 below shows the short term benefits of government intervention. As the figure shows, at point A on the curve, unemployment is at 5% while inflation is at 2%. The introduction of expansionist policies sees the market experience the situation represented by point B on the curve, with unemployment being at 3% while inflation rising to 6% Lucas Critique and Micro-founded models – New Classical macro economical theory

 

Figure 1: Short Term Philips curve. Source:http://www.econlib.org/library/Enc/NewClassicalMacroeconomics.html

Work on policy ineffectiveness was pioneered by Friedman, who introduced the concept of permanent income. Permanent income refers to all the income that an individual expects to receive in their lifetime. Consumption decisions are based on this permanent income rather than on present ‘actual’ income. Government intervention believes that expansionist strategies, which raise ‘actual’ income, will spur consumption. However, new classical theories show that this is not the case, as without a change in the permanent income, there is no significant change in the public’s consumption behaviours. This introduces the concept of the long run Philips curve, as shown by figure 2 below.

Figure 2: Long Term Philips Curve. Source: http://www.econlib.org/library/Enc/NewClassicalMacroeconomics.html

 

The first curve (SRPC1) shows how unemployment is reduced by government intervention on a short term basis, from 5% to 3%. However, over time, the effects of inflation, and having reduced spending power, will force the Philips curve to shift to the right and becomes SRPC2. At this point, the economic situation is at point C on SRPC2 where the unemployment rate has reverted to 5% while the inflation increases to 5% (from 2%). Therefore, government intervention is not only ineffective but actually counterproductive as the resultant situation is worse than the situation at the beginning of the scenario. Further intervention will see the curve shift to SRPC3 without positively affecting the unemployment rate. The red perpendicular line (LRPC) represents the long term Philips curve.

The famed Lucas critique (Lubik and Surico, 2010: 179) builds on the theory of policy ineffectiveness by using the theory of rational expectation. Human beings will always work towards serving their self interests. They base their decision making on the information that they have, either from education or from past experience. Once a government makes an expansionist intervention, the people expect to benefit financially. They may experience some benefit in the short term that is in line with their expectations and therefore adjust their spending habits. However, as time goes by and they realize that their spending power has diminished, they will revert back into their ‘normal’ spending pattern.

When the same government tries to make a similar intervention at a later date, the people are now armed with the knowledge that the seemingly improved situation is only superficial and the economic situation has both improved for the better. Therefore, they will not change their spending habits due to a change in their expectation. This is why Friedman sated that when the population’s expectations are different from the expected outcome, the policy cannot be effective.

Conclusion

Government policy making in economic matters has a profound effect on the ordinary citizens, and business decision makers, as it determines the nature of the economic environment in the country. Economic theory has invested a significant amount of theoretical work and academic literature towards determining the most efficient theoretical methods to use to achieve positive economic growth and prosperity. The first ‘formal’ theory, the classical theory was largely discarded after its self-governing principles failed to improve the economy after the great depression. Keynesian theories were adopted, which were later discarded after they resulted in economic stagnation in the 1970s. New classical theories were adopted and are the dominant theory used globally. Neo classical theorists adopt much of the characteristics used by traditional post-Keynesian classical theorists but the theory has been much improved by new theory making n the 1960s and 1970s.

Neo classical macro economical theories believe in the market’s self-clearing ability but are more focused towards understanding the expectations that the people have, and the information that they posses. The main foundations of the theory include the theory of rational expectation, the theory of natural rate and the aforementioned theory of continuous market clearing. The main argument of the theory is the ‘policy ineffectiveness’ that state that any expansionist policies will to achieve any long term effect Lucas Critique and Micro-founded models – New Classical macro economical theory.

The different economic theories have exhibited success due to being appropriate for the economic environment from which they were created. The neo classic theory captures this by acknowledging that there is no way to really predict the unpredictability of economical ‘shocks’. Classical theory worked well as it was suitable for the post industrial revolution economic climate; likewise, the theories associated with Keynesianism were appropriate to pull the global economy from the effects of the great depression. Similarly, new classical theories were appropriate to jump start the economy from its lull n the 1970s. It is my belief that economical theory should be flexible to be able to handle the unique situation that the economy is facing presently.

 

References

Amsden, A.H., 2010. Say’s Law, poverty persistence, and employment neglect. Journal of Human Development and Capabilities, 11(1), pp.57-66.

Berg, N. and Gigerenzer, G., 2010. As-if behavioral economics: Neoclassical economics in disguise?. History of Economic Ideas, pp.133-165.

Daly, M.C., Hobijn, B. and Valletta, R.G., 2011. The recent evolution of the natural rate of unemployment.

Gallegati, M., Gallegati, M., Ramsey, J.B. and Semmler, W., 2011. The US wage Phillips curve across frequencies and over time. Oxford Bulletin of Economics and Statistics, 73(4), pp.489-508.

Kaldor, N., 2015. Keynesian economics after fifty years. In Essays on Keynesian and Kaldorian Economics (pp. 27-74). Palgrave Macmillan UK.

Lubik, T.A. and Surico, P., 2010. The Lucas critique and the stability of empirical models. Journal of Applied Econometrics, 25(1), pp.177-194.

Mertens, K.R. and Ravn, M.O., 2014. Fiscal policy in an expectations-driven liquidity trap. The Review of Economic Studies, p.rdu016.

Moggridge, D.E. ed., 2013. [The collected writings]; The collected writings of John Maynard Keynes. 29. The general theory and after: a supplement. Cambridge University Press.

Negishi, T., 2014. History of economic theory (Vol. 26). Elsevier.

North, D.C., 2016. Institutions and Economic Theory. The American Economist, 61(1), pp.72-76.

Yang, X. and Ng, Y.K., 2015. Specialization and economic organization: A new classical microeconomic framework (Vol. 215). Elsevier.

ECONOMICS ASSIGNMENT

TASK

Outline and critically discuss the principal ideas, tenets and arguments of New Classical Macroeconomics, paying particular reference (but without limiting your attention) to

          (i) The Lucas Critique, and

          (ii) Micro-founded models.

In addition, discuss the extent to which this school of macroeconomics has influenced macroeconomic thinking in general during the last four decades. Lucas Critique and Micro-founded models – New Classical macro economical theory

Guidance Notes

(i) The relative amount of attention given to the aspects specifically mentioned in the above question could conceivably vary significantly from one high-scoring answer to another, and it is not essential that an equal amount of discussion be assigned to each. However, an excellent answer would provide at least some incisive and well-informed coverage of each of those aspects, as well as providing an outline / discussion of other aspects of New Classical modelling approaches and policy conclusions.

(ii) In addition to the recommended texts referred to in this handbook, students are encouraged to search online for relevant academic articles on this topic area. It is

worthwhile consulting the original article by RE Lucas (1976), entitled “Econometric Policy Evaluation: A Critique”. However, to earn a high mark it is not essential that an

intimate acquaintance with this article (as opposed to a sound understanding of its line of argument) be demonstrated.

(iii) Discussion of applications of the Lucas critique to phenomena other than the Phillips curve will potentially attract higher marks.

(iv) To earn a high mark, it is not essential that a specific micro-founded model be presented or analyzed, although some insightful discussion of this concept is expected.

(v) Students are required to submit a word-processed assignment answer. Students who fail to do so will lose 10% of their assignment mark (i.e. a mark of 70% will be reduced

to 63% if this penalty is applied). Please note that it is not acceptable for any aspect of the assignment (including equations and other mathematical expressions, as well as any diagrams) to consist of a digital scan of a hand-written passage or expression or of a hand-drawn diagram.

Key Marking criteria will include:

 Correctness, validity and appropriateness of economics-related verbal statements and mathematical expressions

 Coherence, validity and completeness of the presented arguments and exposition

 Accuracy, correctness and relevance of diagrams (if included)

 Soundness of discussion of diagrams (if included)

 Overall quality of the assignment Lucas Critique and Micro-founded models – New Classical macro economical theory