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New Classical Economics and Rational Versus Adaptive Expectations

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The Power of Macroeconomics: Economic Principles in the Real World

Universidad de California en Irvine

4.6 (1,491 calificaciones) | 160K estudiantes inscritos

In this course, you will learn all of the major principles of macroeconomics normally taught in a quarter or semester course to college undergraduates or MBA students. Perhaps more importantly, you will also learn how to apply these principles to a wide variety of situations in both your personal and professional lives. In this way, the Power of Macroeconomics will help you prosper in an increasingly competitive and globalized environment. This course is also available in Portuguese. To join the fully translated Portuguese version, visit this page: https://www.coursera.org/learn/macroeconomia-pt/

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4.6 (1,491 calificaciones)

5 stars
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3 stars
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PS

Aug 06, 2018

This was an instructive course with lots of examples of the US economy and with a great explanation and tests, nevertheless sometimes I lacked some examples from the other parts of the world.

NT

Sep 07, 2015

The course is so well-organized that helps me to accomplish a systematic understanding about the field. Beyond that, thanks to the Professor, I now feel more keen on learning about this.

De la lección

The Warring Schools of Macroeconomics

A "Mid-Course" Appraisal by Prof Navarro 1:25

New Classical Economics and Rational Versus Adaptive Expectations 7:39

The Great Recession of 2007 and Quantitative Easing 4:44

How to Forecast the Business Cycles and Structural Trade Imbalances7:25

Impartido por:

Dr. Peter Navarro
Professor

Transcripción

[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.

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