New Classical Economics Theory

The Rise of New Classical Economics, New Classical Economic Theory

In the mid-1970s the term rational expectations first appeared on the macroeconomic horizon. The rational expectations hypothesis was a byproduct of the microeconomic analysis of Charles C. Holt (1921- ), Franco Modigliani (1918- ), John Muth (1930- ), and Herbert Simon (1916- ), who were trying to explain why many people did not seem to optimize in the way that neoclassical economics assumed they would. Their work was meant to explain by means of dynamic models what Simon called "satisficing" behavior; that is, why firms' behavior did not correspond to microeconomic models. John Muth turned that work on its head, writing as follows:

It is sometimes argued that the assumption of rationality in economics leads to theories inconsistent with, or inadequate to explain, observed phenomena, espe­cially changes over time__Our hypothesis is based on exactly the opposite point of view: that dynamic economic models do not assume enough rationality.

Muth maintained that in modeling it is reasonable to assume that because expectations are informed predictors of future events, they would be essentially consistent with the relevant economic theory. As Simon wrote, "[Muth] would cut the Gordian knot. Instead of dealing with uncertainty by elaborating the model of the decision process, he would once and for all—if his hypothesis were correct—make process irrelevant."

With his assumption of a "dynamic rationality," Muth turned disequilibrium into equilibrium. Just as neoclassical writers used rationality to ensure static individual optimality or to ensure that the individual moves to a tangency of his or her budget line and indifference curve, Muth used it to express "dynamic" individual optimality—to set the individual on his or her intertemporal indiffer­ence curve. As long as the private actors in the economy are optimally adjusting to the available information (and there is no good reason to assume the contrary), they will always be on the optimal adjustment path.

Although Muth wrote his article in 1961, the rational expectations assump­tion did not play an important role in economics until it was adopted by Robert Lucas into macroeconomics and combined with the work being done in micro-foundations of macroeconomics. The rational expectations hypothesis struck at the heart of the compromise between microfoundations economists and Keynesi­ans, because it held that people did not adjust their expectations toward equilibrium in stages. They can discover the underlying economic model and adjust immediately, and it would be beneficial for them to do so. Assuming that people have rational expectations, anything that will happen in the long run will happen in the short run. Because in the microfoundations-Keynesian compro­mise the effectiveness of monetary and fiscal policy depended upon incorrect expectations, the rational expectations hypothesis was devastating. In the new view, if Keynesian policy is ineffective in the long run, it is ineffective in the short run.

In the mid-1970s rational expectations caught on in macroeconomics, and there were significant discussions of policy ineffectiveness and the unworkability of Keynesian-type monetary and fiscal policy. This developing work in rational expectations soon came to be known as new classical economics, because its policy conclusions were similar to earlier classical views. By the late 1970s it seemed to many that the future of macroeconomics lay in new classical thinking and that Keynesian economics was dead.

One of the lasting influences of the new classicals on macroeconomics was their contribution to the theory of macroeconomic modeling. As will be discussed in Chapter 16, Keynesians had developed macroeconomic models to a high level of sophistication in the work of economists such as Jan Tinbergen (1903-1994) and Lawrence Klein (1920- ). In the 1960s and 1970s many of these econometric models were not good predictors of future movements in the economy, and many economists were beginning to lose faith in them. Robert Lucas, a leader of the new classicals, specified one reason why these models were poor predictors in an argument that became known as the Lucas critique of econometric models. He argued that individuals' actions depend upon expected policies; therefore, the structure of the model will change as a policy is used. But if the underlying structure of the model changes, the appropriate policy will change, and the model will no longer be appropriate. Thus, it is inappropriate to use econometric models to predict effects of future policy.

The majority response was to change their view of models: models were practical tools that provided insights into particular policy questions; there could be a number of different models that could be used whenever they seemed to apply; there was no need to have a broad consistency of all the models. Thus, modern textbooks present the IS/LM model as a working tool, not as something derived from strict microfoundations. This approach to modeling differed significantly from the neoclassical approach, which saw all models as, in princi­ple, developing from the core assumptions of microeconomics.