New Classical Macroeconomics

New classical macroeconomics, sometimes simply called new classical economics, is a school of
thought in macroeconomics that builds its analysis entirely on a neoclassical framework.
Specifically, it emphasizes the importance of rigorous foundations based on microeconomics,
especially rational expectations.
New classical macroeconomics strives to provide neoclassical microeconomic foundations for
macroeconomic analysis. This is in contrast with its rival new Keynesian school that uses micro-
foundations, such as price stickiness and imperfect competition, to generate macroeconomic
models similar to earlier, Keynesian ones.

History
Classical economics, originating with Adam Smith’s “The Wealth of Nations” in 1776, focuses
on the market’s self-correcting nature and its efficiency in resource allocation. It assumes
individuals seek to maximize their utility. Neoclassical economics, influenced by figures like
Carl Menger, William Stanley Jevons, and Léon Walras, built upon these ideas. Alfred Marshall
and Walras formalized this school, emphasizing mathematical and deductive methods. However,
the Great Depression led to a shift with John Maynard Keynes introducing macroeconomics,
distinguishing it from microeconomics. Keynes’ ideas incorporated “animal spirits,” challenging
the rational agent concept. Post-World War II, Keynesian policies dominated until the 1970s
when stagflation and global market changes raised doubts about their effectiveness.

The New Classical school emerged in the 1970s as a response to what were perceived as failures
of Keynesian economics to explain stagflation. New Classical and monetarist criticisms led by
Robert Lucas, Jr. And Milton Friedman respectively forced a labored rethinking of Keynesian
economics. In particular, Lucas designed the Lucas critique primarily as a means to cast doubt on
the Keynesian model. This strengthened the case for macro models to be based on
microeconomics.

After the 1970s, the New Classical school for a while became the dominant school in
Macroeconomics.

The New Classical Synthesis

Prior to the late 1990s, macroeconomics was divided between new Keynesian models focusing
on market imperfections in small-scale models and new classical theories that used detailed
general equilibrium models, explaining economic fluctuations through technology changes. The
new neoclassical synthesis emerged as a consensus, combining elements from both approaches.
It incorporated the methodology of real business cycle theory from new classical economics and
the concept of nominal rigidities (slow, periodic price changes) from new Keynesian economics.
This synthesis forms the theoretical basis for a significant portion of modern mainstream
economics.
Analytical Methods

The new classical perspective identifies three key factors contributing to fluctuations in
economic growth: the productivity wedge, the capital wedge, and the labor wedge. These
diagnostic tools help pinpoint the primary factors responsible for economic fluctuations.

1. Productivity Wedge: This measures the overall efficiency of aggregate production. A

2. Capital Wedge: The capital wedge represents the gap between the intertemporal marginal
rate of substitution in consumption and the marginal product of capital. It creates a
“deadweight” loss that affects capital accumulation and savings decisions, acting as a
distortionary tax on capital (savings).

3. Labor Wedge: The labor wedge is the ratio between the marginal rate of substitution of
consumption for leisure and the marginal product of labor. It acts as a distortionary tax on
labor, making it less profitable to hire workers, often due to labor market frictions.

These wedges provide insights into the causes of fluctuations in the real economy from a
neoclassical perspective and business cycle accounting.

Foundation, axioms and assumptions

New classical economics is grounded in Walrasian assumptions, where all agents are presumed
to act rationally with the aim of maximizing their utility through the lens of rational expectations.
The theory posits that the economy always maintains a unique equilibrium with full employment
or potential output, achieved through price and wage adjustments. In essence, the market is seen
as constantly clearing.

This school of thought is known for introducing representative agent models, although they have
faced criticism from neoclassical perspectives for the gap between microeconomic behavior and
macroeconomic outcomes, as noted by Alan Kirman.

The concept of rational expectations, initially formulated by John Muth and popularized by
Lucas, is a key component of new classical economics. One of its most famous models is the real
business cycle model, developed by Edward C. Prescott and Finn E. Kydland.

Legacy

Pure new classical models had limited explanatory and predictive power as they couldn’t
simultaneously account for both the duration and magnitude of actual economic cycles.
Furthermore, their key idea that only unexpected changes in money supply could influence the
business cycle and unemployment didn’t hold up in empirical tests.
In response, the mainstream economic thought shifted toward the new neoclassical synthesis,
which integrates elements from new classical and new Keynesian economics. Most economists,
including many new classical proponents, acknowledged that wages and prices do not adjust
quickly to achieve long-term equilibrium. Therefore, they accepted that monetary policy could
have a significant short-term impact.

New classical macroeconomics contributed the rational expectations hypothesis and the concept
of intertemporal optimization to new Keynesian economics and the new neoclassical synthesis.

Critics, such as Peter Galbács, argue that understanding new classical macroeconomics requires
considering the conditional nature of its doctrines. If specific conditions are met, such as
completely flexible prices, rational expectations, and white noise economic shocks, monetary
policy may not affect unemployment or production. However, if any of these conditions are not
met, countercyclical fiscal policy can be effective. New classical macroeconomics highlights the
conditions under which economic policy can be effective rather than asserting its inherent
inefficiency. Countercyclical efforts can still be valuable, but the scope of their effectiveness is
narrower in the new classical framework.