Model Answer
0 min readIntroduction
Modern macroeconomic thought is largely shaped by the debates between New Classical and New Keynesian economics. Emerging in the 1970s as responses to the failures of earlier Keynesian models to explain stagflation, these schools offer contrasting perspectives on how individuals and markets operate. The New Classical school, rooted in rational expectations and market clearing, advocates for minimal government intervention. Conversely, the New Keynesian school acknowledges market imperfections and justifies a more active role for stabilization policies. Understanding their differing assumptions is crucial for evaluating macroeconomic policies.
New Classical Economics
The New Classical school, spearheaded by economists like Robert Lucas and Thomas Sargent, builds upon neoclassical principles. Its core assumptions are:
- Rational Expectations: Individuals form expectations about the future based on all available information and use these expectations optimally. They do not make systematic errors.
- Market Clearing: Prices and wages are perfectly flexible and adjust rapidly to equate supply and demand in all markets.
- Methodological Individualism: Macroeconomic phenomena are ultimately explained by the behavior of individual agents maximizing their utility or profits.
- Neutrality of Money: Changes in the money supply only affect nominal variables (like prices) and have no real effects on output or employment in the long run.
Consequently, New Classical economists argue that government intervention, such as discretionary fiscal or monetary policy, is largely ineffective. Attempts to ‘fine-tune’ the economy are likely to be destabilizing because individuals will anticipate the policy changes and adjust their behavior accordingly, negating the intended effects – the ‘policy ineffectiveness proposition.’
New Keynesian Economics
The New Keynesian school, developed by economists like Gregory Mankiw and David Romer, accepts the rational expectations assumption but challenges the assumption of perfectly flexible prices and wages. Key assumptions include:
- Sticky Prices and Wages: Prices and wages are slow to adjust due to menu costs (the costs of changing prices) and long-term contracts.
- Imperfect Competition: Markets are not perfectly competitive, leading to firms having some market power.
- Coordination Failures: Even if individuals are rational, they may face coordination problems that prevent them from achieving optimal outcomes.
- Externalities: Economic activities can generate externalities (positive or negative) that are not fully reflected in market prices.
These assumptions imply that aggregate demand can influence output and employment, especially in the short run. New Keynesian economists advocate for active stabilization policies, such as monetary and fiscal policy, to mitigate business cycle fluctuations. They believe that government intervention can help to correct market failures and improve economic outcomes.
Comparative Analysis
| Feature | New Classical | New Keynesian |
|---|---|---|
| Expectations | Rational Expectations | Rational Expectations |
| Price/Wage Flexibility | Perfectly Flexible | Sticky |
| Market Clearing | Markets Clear | Markets May Not Clear |
| Role of Government | Minimal Intervention | Active Stabilization |
| Policy Effectiveness | Policy Ineffectiveness Proposition | Policy Can Be Effective |
The 2008 financial crisis saw a resurgence of New Keynesian ideas, as the crisis highlighted the importance of aggregate demand and the limitations of relying solely on market forces to restore economic stability. However, the debate continues, with New Classical economists arguing that the crisis was exacerbated by government interventions.
Conclusion
In conclusion, the New Classical and New Keynesian approaches differ fundamentally in their assumptions about how individuals and markets behave. While both schools embrace rational expectations, their contrasting views on price flexibility and market clearing lead to divergent policy recommendations. The New Classical school favors limited government intervention, while the New Keynesian school advocates for active stabilization policies. The relative merits of each approach remain a subject of ongoing debate in macroeconomic research and policy-making.
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.