Model Answer
0 min readIntroduction
The aggregate supply of output in an economy is fundamentally linked to the labor market and the real wage rate workers expect to receive. Unlike Keynesian models that emphasize sticky wages, the New Classical school posits that wages are flexible and adjust rapidly to market conditions. This implies that the aggregate supply curve is largely determined by workers’ expectations about future real wages. When aggregate demand falls short of the economy’s potential, leading to output below the natural rate of employment, the policy prescriptions differ significantly depending on the economic school of thought. New Classical economists, known for their emphasis on rational expectations and market efficiency, generally advocate a limited role for government intervention in such scenarios.
Aggregate Supply and Expected Real Wages
The aggregate supply (AS) curve represents the total quantity of goods and services firms are willing to produce at a given price level. In the New Classical framework, AS is determined by the labor market. Workers supply labor based on their expected real wage – the nominal wage adjusted for anticipated inflation. If workers expect inflation to be high, they will demand higher nominal wages to maintain their purchasing power. Firms, in turn, will adjust prices accordingly. This implies that the short-run AS curve is relatively vertical, meaning that changes in aggregate demand have a limited impact on output.
Determining Aggregate Supply
The aggregate supply can be derived from the microeconomic foundations of firm behavior and labor supply. Firms maximize profits by hiring labor until the marginal revenue product of labor (MRPL) equals the real wage (W/P). Workers, on the other hand, choose their labor supply based on their utility maximization, considering the expected real wage. The intersection of labor demand (derived from MRPL) and labor supply (based on expected real wage) determines the equilibrium employment level. This employment level, combined with the production function, determines the aggregate supply of output.
Scenario: Aggregate Demand Below Natural Rate
When aggregate demand (AD) is below the level consistent with the natural rate of employment (and potential output), the economy experiences a recessionary gap. This means there is excess capacity and unemployment. In a traditional Keynesian framework, this situation calls for expansionary fiscal or monetary policy to boost AD and close the gap. However, New Classical economists view this situation differently.
New Classical Response: Laissez-Faire
New Classical economists argue that any attempt by the government to stimulate AD will be ineffective or even counterproductive. Their reasoning is based on the following:
- Rational Expectations: Workers and firms are rational and form expectations about future economic conditions based on all available information. If the government attempts to stimulate AD, they will anticipate the resulting inflation and adjust their behavior accordingly.
- Wage Flexibility: Wages are flexible and adjust quickly to changes in AD. Any increase in AD will primarily lead to higher prices (inflation) rather than increased output.
- Crowding Out: Expansionary fiscal policy may lead to higher interest rates, crowding out private investment and offsetting the stimulative effect of government spending.
Therefore, New Classical economists advocate a laissez-faire approach – minimal government intervention. They believe that the economy is self-correcting and will eventually return to the natural rate of employment through wage and price adjustments. They argue that the best policy is to maintain a stable monetary policy focused on controlling inflation and avoid discretionary interventions that can distort market signals.
Policy Implications & Limitations
The New Classical prescription has significant policy implications. It suggests that governments should focus on creating a stable macroeconomic environment rather than attempting to fine-tune the economy. However, this approach has been criticized for its assumptions about perfect information, instantaneous wage and price adjustments, and the absence of market imperfections. Real-world economies often exhibit wage stickiness, imperfect information, and other frictions that can prevent rapid self-correction. Furthermore, the assumption of rational expectations is not always realistic, as behavioral economics demonstrates that individuals often exhibit cognitive biases and make irrational decisions.
The 2008 financial crisis highlighted the limitations of the New Classical approach. The crisis demonstrated that even with flexible wages, a severe shock to aggregate demand can lead to prolonged periods of unemployment and economic stagnation. Many economists argue that government intervention, such as fiscal stimulus and quantitative easing, was crucial in mitigating the effects of the crisis.
Conclusion
In conclusion, the New Classical view of aggregate supply, based on expected real wages and rational expectations, leads to a strong preference for limited government intervention in the face of aggregate demand shocks. While their emphasis on long-run stability and the dangers of discretionary policy is valuable, the strict laissez-faire approach may not be optimal in all circumstances, particularly when faced with significant market imperfections or severe economic crises. A pragmatic approach that combines elements of both New Classical and Keynesian thought is often necessary to navigate the complexities of the modern economy.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.