Discuss one important policy implication.
It is assumed that the Great Depression gave birth to modern macroeconomics, after which Keynes put forward a new and revolutionary theory “General Theory of Employment, Interest and Money” (1936) to explain and provide a remedy for the challenges associated with this phenomena of severe unemployment and low economic activity. Although Keynes was successful in introducting the concept of demand – driven responses to correct problems associated with economic crisis undertaken by a more active role of Government to tackle the excesses of the free market, Keynesianism failed in explaining the periods of stagflation experienced in the Industrialised economies of the world, such as the US and UK and as a result New Classical Economics emerged in 1970.
The first phase of NCE can be traced back to the early workings of Robert Lucas, Thomas Sargent and Robert Barro – Producing an influencial paper titled “After Keynesian Macro Economics” debating reasons why the Keynesian Model had failed. They outlined the lack of microeconomic foundations in Keynes’s analysis incorporating this a mistaken expectations hypothesis to explain the theoretical failings of 1960, they also identified econometric flaws in Keynesian Macroeconomic Models to explain the grand-scale failures evident in economic history during the 1970’s.
Therefore central to the beliefs of NCE’s was a belief in building macroeconomic models based on firm microeconomic foundations, whilst incorporating traditionally classical ideas of the continuous clearing of perfectly competitive markets demonstrated through the flexibility of prices, However it should be noted that NCE is distinguished from Classicalists and Monetarists in their explanation of economic fluctuations through random shocks (Hillier 1991).
Most distinguishing of NCE thinking in 1970 was argueably the “Rational Expectations Revolution” (Taylor 1989) highlighting the importance of the behavior of individual economic agents and their assumptions and expectations, incorporating John Muths “Rational Expectations Hypothesis (1961) within their analysis of macroeconomic study. As expressed by Luca and Sargent who advocated “Equilibrium” Classical Models in which Markets always clear and ‘rational’ agents optimize (Snowdon and Vane 1997).
Leading on the formation of The ‘Surprise’ Aggregate Supply Function by Robert Lucas drawing on criticisms initially proposed by Friedman in his analysis of the Philips curve through his Natural Rate hypothesis (1968).
The inclusion of Rational Expecations, Continuous Market clearing and Aggregate Supply hypothesizes within new classical models produced five highly controversial policy implications. In this essay I will be debating The Policy Ineffectiveness Proposistion.
The Rational Expectations Hypothesis:
The REH is crucial to NCE thinking and is associated with the workings of John Muth (birth – death). The hypothesis can be explained as such, economic agents are known to form subjective expectations of economic variables (eg: anticipated Inflation), it is argued that this will coincide with the “true” or “objective” mathematical conditional expectations of those variables, John Muth (1961) argues that expectations since they are informed predicitions of future events are essentially the same predictions of the relevant economic theory” The understanding agents have of the workings of the economy is what he argues distinguishes how accurate and efficient their assumptions are.
NCE aim to give macro economics, micro foundations and this can be identified with there adaptation of the REH – As…