Classical macroeconomic model

The new classical macroeconomics model was originated in the early 1970’s by the economists working in the University of Chicago and the University of Minnesota. Robert Lucas, Thomas sergeant, Edward Prescott and Neil Wallace are the economists who were behind the formulation of this macroeconomic model. New classical Macroeconomics model opposes John Maynard Keynes - Keynesian macroeconomics and it develops its analysis on a completely neoclassical framework. It focuses on rigorous foundations, where macro economic model is built in a similarity to the actions of individual agents, behaviors of whom are modeled by micro economics.

New classical models have several assumptions such as:

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• All agents are assumed to possess rational expectations and also are perceived to infinitely lived
• The macro economy is perceived to have unique equilibrium at potential output or full employment at any one time and the equilibrium is assumed to come into existence every time via wage adjustment or price. New classical economics has developed the use of representative agent models that has recently faced tremendous neoclassical criticism. Real Business cycles is the most famous new classical model which has been created by Robert Lucas, Edward C. Prescott and Finn E. Kydland.

Considering the Keynes’s approach, the classics analyzed the price system as efficiently and effectively enabling the mutual adjustment of supply and demand in a free economy in all markets including the labor market as well. Only market imperfection could lead to unemployment – the action of the labor unions or the intercession of the government – elimination could be possible by removing the imperfection. Keynes analysis focused on the whole economy rather than the individual markets and argued that aggregate demand might fall short of aggregate productive capacity of its capital and labor even without imperfections of the market.

Such a situation makes unemployment involuntary which means that workers stay unemployed even though they are ready to work on lower rates of wages then that offered by the firm to their current workers. Later Keynesian economists achieved or we can say developed a measure to accept the classics a bit. Neoclassical Synthesis was developed in which classical economics was considered as a ruling resource allocation when full employment was assumed in the economy through judicious government policy.

Consumption investment, money demand and other important elements of the Keynesian model were explained by other Keynesian economists assuming that individuals behave optimally. This was regarded as the “micro foundations” for macroeconomics. Origins of the New Classical Macroeconomics The name if we consider shows the revival of classical economics and rejection of Keynesian economics. The basis of New Classical Macro economics started with the Leonard Rapping’s and Luca’s attempt to provide micro foundations for labor market of Keynesian.

The rule applied by them was that the equilibrium in market occurs when quantity demanded and quantity supplied equals whereas involuntary unemployment is when the amount of labor supplied exceeds the amount demanded in actual, therefore their analysis proved not to be appropriate for involuntary unemployment at all. Keyne’s view of recession was that it occurs when the aggregate demand falls due to the result of decrease in private investments which eventually results in firms producing below their capacity. Hence due to producing less, employment falls as now firm needs only few workers.

Firms due to this reason fail to reduce wages to a lower level such as a job seeker will accept and this is from where the involuntary unemployment starts. The New Classical rejects and approves this step to be regarded as irrational. Firms get an opportunity to raise profits in the case of involuntary unemployment by employing a worker on a lower level of wage. Firms would not be optimizing if they are not able to benefit from the opportunity. Since unemployed labor is even ready to get employed on lower wages, the employed workers are not able to resist such wage cuts effectively.

Keynesian economics would not hold true then as it would either approve on irrationality or market imperfections and both Keynes denied (Moss, 2007). Two Fundamental factors of New Classical macroeconomics are illustrated by these criticisms of Keynesian:

• Individuals are considered as optimizers as they always choose the best options for themselves let it be prices such as wage rates or any other asset they possess even including their training and education.
• People maximize utility and firms maximize profits
• The choices made by the individuals also changes to align quantity demanded and supplied with the change in the adjustment in prices and therefore changing the incentives to the individuals.

New Classical macroeconomics model states that unemployment rate rises in slumps and falls in boom. When a worker is unemployed, he tends to seek a new job. He then compares the value of adjusting to a lower paid job that he might find easily against that of a better paid job which is almost impossible for him to find in that particular time.

The New Classical don’t say that the job searcher is content and happy with his decision rather it says that the worker still chooses what he feels is the best option available, even when the options he has chosen is actually poor. If he chooses to remain unemployed it’s based on the judgment that costs are outweighed by the benefits of the search, but this is again not an exception to the rule that amount demanded and supplied equals.

References

1. Moss, D. A. (2007). Concise Guide to Macroeconomics: What Managers, Executives and Students Need to Know: Harvard Business School Press.

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