[MUSIC] The so-called new classical school is rooted in the Classical Economic tradition. It is important not just because of the strong influence it has had on recent macroeconomic theory. But also because New Classical economists played a pivotol role in the 1992 defeat of George Bush by Bill Clinton. New Classical economics is based on the controversial theory of rational expectations. This theory was developed by Nobel laureate Robert Lucas of The University of Chicago along with Thomas Sargent of Stanford and Robert Barrow of Harvard. It provides a sharp contrast to the notion of adaptive expectations we previously introduced in our lesson on inflation and unemployment. You may recall from that lesson with Adaptive Expectations people tend to assume that inflation will continue to be what it already is. For example, if inflation was 3% last year Adaptive Expectations will lead you to predict that inflation will be 3% next year. In contrast, if you form your expectations rationally you will take into account all available information including the future effects of activist fiscal and monetary policies. The idea behind rational expectations is that such activist policies might be able to fool people for a while. However, after a while, people will learn from their experiences, and then you can't fool them at all. The central policy implication of this idea is, of course, profound. Rational expectations render activist fiscal and monetary policies completely ineffective. So, they should be abandoned. And let me show you waht I mean. Suppose the federal reserve undertakes expansionary monetary policy to close a recessionary gap. Repeated experiences with such activist policy have taught people that increases in the money supply fuel inflation. To protect themselves in a world of rational expectations, businesses will immediately respond to the Fed's expansion by raising prices. Workers will demand higher wages and the attempted stimulus will be completely offset by the contractionary effects of inflation. Alternatively, suppose the government undertakes expansionary fiscal policy to stimulate the economy. People with rational expectations will respond by increasing their savings and reducing consumption, and thereby, likewise offset any expansionary effect. They will do this because they know that a larger budget deficit now means higher taxes later. So, they prepare for this future burden by saving more. Or, so the new classical argument goes. To illustrate this Rational Expectations dynamic, let's look at the aggregate supply, aggregate demand framework in this figure, and let's contrast the adjustment process of the economy with Adaptive versus Rational Expectations. In the figure, the general price level is on the vertical axis. Real output is on the horizontal access. The vertical line represents the long run aggregate supply curve at that natural rate of unemployment and the economy is in both the short and long run equilibrium at full employment output Y sub one and price piece of one. This is where the short-run aggregate supply and aggregate demand curves cross at point A. Suppose, then, we first assume adaptive expectations, and the government undertakes expansionary policy to increase output above the full employment rate. This expansion shifts the aggregate demand curve out to AD sub one and the economy temporarily reaches a new equilibrium output at point B. Here, output is Y sub two, at a new price level of P sub two. Note however, that once businesses and workers realise that inflation is higher, they add these inflationary expectations into their calculations of prices and wages. This shifts the aggregate supply curve inwards to AS two and the economy falls back to point C. The end result is a short run spurt of growth above full employment output, followed by a return to the natural rate, albeit at a higher price level of p sub three. Now, what the new classical school says is that rather than travel from point A to point B and back to point C. The economy will enjoy no short run growth spurt at point B. Instead, the economy will move instantaneously from point A to point C. And the only result of the government's activist policy will be higher inflation. This is because, as we explained above, people with rational expectations anticipate the future impacts of current government policy decisions and react immediately. Now there are several things to say about Rational Expectations Theory, from both and economic and political perspective. Economically, critics of Rational Expectation say that most people are not as sophisticated in their economic thinking As the theory requires. And therefore, adjustments will not take place with anywhere near the speed they're supposed to. However, this criticism should not detract from the central point of rational expectations, namely that people's behavior may partially, or perhaps, completely counteract goals of activist fiscal monetary policy. Politically however, as George Bush painfully learned, relying on new classical economic thinking can be hazardous to one's health. Indeed, Presidents Bush's new classical advisers flatly rejected any Keynesian quick fix to Bush's deepening recession. Instead, in their economic report to the President, they called for more stable and systematic policies based on long term goals, rather than a continued reliance on short sighted discretionary reactions. Well, Bush took the new classical advice. The economy limped into the 1992 presidential election and like Richard Nixon in 1960, Bush lost to a Democrat promising to get the economy moving agian. What is prheaps most intersting about this transistion of power, is that Bill Clinton actually did very little to stimulate the economy. The mere fact, however, that Clinton promised a more activist approach helped restore business and consumer confidence. At the same time, congressional passage of Clinton's deficit reduction legislation in 1993, sent Wall Street a clear signal that his administration was serious about budget balance. Together, these factors helped accelerate a recovery that had already begun by the end of Bush's term and set the stage for Clinton's remarkably easy reelection in 1996.
