Model Answer
0 min readIntroduction
Macroeconomic thought has evolved significantly over the 20th and 21st centuries. Initially, Keynesian economics, emphasizing the role of aggregate demand and government intervention, dominated policy-making. This was later challenged by Monetarism, which focused on the money supply as the primary driver of economic activity. The 1970s witnessed the emergence of New Classical Macroeconomics, a school of thought that fundamentally questioned the foundations of both Keynesianism and, to a lesser extent, Monetarism. This school, built on rational expectations and market clearing, posited that government intervention was largely ineffective and even counterproductive. The question asks us to assess the extent to which New Classical Macroeconomics has indeed “upset the apple-cart” of these established schools.
Keynesianism and Monetarism: A Brief Overview
Keynesian economics, developed by John Maynard Keynes in the wake of the Great Depression, advocated for active government intervention to stabilize the economy. It argued that aggregate demand could be insufficient to achieve full employment, necessitating fiscal policy (government spending and taxation) to boost demand. The Multiplier effect was central to this theory.
Monetarism, championed by Milton Friedman, emerged as a critique of Keynesianism. Monetarists believed that changes in the money supply were the primary determinant of nominal income. They advocated for a stable monetary policy rule, such as a fixed growth rate of the money supply, to control inflation and promote economic stability. They argued that discretionary fiscal policy was often ineffective due to lags and political considerations.
The Rise of New Classical Macroeconomics
New Classical Macroeconomics, spearheaded by economists like Robert Lucas, Thomas Sargent, and Robert Barro, represented a radical departure from both Keynesian and Monetarist thought. Its core tenets include:
- Rational Expectations: Individuals form expectations about the future based on all available information, and these expectations are, on average, correct. This implies that policymakers cannot systematically “fool” economic agents.
- Market Clearing: Markets are assumed to clear continuously, meaning that prices adjust rapidly to equate supply and demand. This eliminates the possibility of prolonged periods of unemployment due to sticky prices, a key assumption in Keynesian models.
- Real Business Cycle Theory: Fluctuations in economic activity are primarily driven by real shocks – changes in technology, preferences, or resource availability – rather than aggregate demand shocks.
- Policy Ineffectiveness Proposition: Anticipated monetary and fiscal policy changes have no real effects on the economy because individuals will adjust their behavior to offset the policy’s impact.
How New Classical Economics Challenged Existing Paradigms
Challenging Keynesianism
New Classical economics directly challenged the core assumptions of Keynesianism. The assumption of sticky prices was rejected in favor of market clearing. The policy ineffectiveness proposition undermined the Keynesian belief in the power of discretionary fiscal and monetary policy to stabilize the economy. For example, the Lucas Critique (1976) argued that traditional econometric models based on past relationships between variables would break down when policy rules changed, as individuals would alter their behavior in response to the new policy regime. This rendered many Keynesian policy prescriptions unreliable.
Impact on Monetarism
While New Classical economics didn’t entirely dismiss Monetarism, it refined and complicated the relationship between money and the economy. New Classical economists argued that the demand for money was not stable, and that the effects of monetary policy depended on whether it was anticipated or unanticipated. Unanticipated monetary policy could have short-run real effects, but these effects were temporary and unpredictable. This challenged the simple quantity theory of money underpinning much of Monetarist thought.
Evidence and Limitations
The New Classical revolution had a significant impact on macroeconomic research and policy. Central banks began to focus more on maintaining price stability and adopting transparent policy rules. However, the New Classical model faced criticism, particularly after the 2008 financial crisis. The crisis demonstrated that financial market imperfections and behavioral biases could lead to prolonged periods of economic instability, contradicting the assumption of perfectly rational agents and continuously clearing markets. Furthermore, the zero lower bound on nominal interest rates limited the effectiveness of monetary policy in stimulating demand during the crisis, highlighting the potential role for fiscal policy – a Keynesian insight.
| Feature | Keynesianism | Monetarism | New Classical |
|---|---|---|---|
| Role of Government | Active intervention | Limited intervention; stable money supply | Minimal intervention; focus on stable rules |
| Price Flexibility | Sticky prices | Flexible prices | Perfectly flexible prices |
| Expectations | Adaptive expectations | Adaptive expectations | Rational expectations |
| Primary Driver of Fluctuations | Aggregate demand | Money supply | Real shocks |
Conclusion
The advent of New Classical Macroeconomics undeniably “upset the apple-cart” of Keynesianism, fundamentally altering the way economists thought about macroeconomic policy. While it didn’t entirely displace Monetarism, it refined and complicated its core tenets. Although the New Classical model has faced challenges, particularly in explaining the aftermath of the 2008 crisis, its emphasis on rational expectations, market clearing, and the limitations of government intervention continues to influence macroeconomic research and policy debates. Modern macroeconomic models often incorporate elements from all three schools of thought, recognizing the complexities of the real world and the need for a nuanced approach to economic policy.
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.