2. Unemployment in the Macroeconomic Framework
2.5 The new classical view of economic fluctuations
effect on the natural rate of unemployment since this rate is determined merely by real supply-side factors.8
The natural rate concept has significant implication for economic policies.
Since the economy will return to its equilibrium with the natural rate of unemployment, aggregate-demand policies can only affect the level of output and employment in the short run and they are in the long run powerless. Governments wishing to achieve higher output and employment permanently should manage to reduce the natural rate of unemployment. Supply-management policies should be pursued which are constructed to improve the structure and functioning of the labor market: (a) to increase the incentive to work, for example through reductions in marginal income tax rates, and reductions in unemployment and social security benefits; (b) to increase the flexibility of wages and working practices, for example by curtailing trade union power; (c) to increase the occupational and geographical mobility of labor, for example through greater provision of government retraining systems in the former case; (d) to increase the efficiency of markets for goods and service, for example by privatization.
Originated from the influential work of L.M. Friedman, monetary economists attacked the orthodox Keynesianism successfully. Monetarists’ ideas were rapidly propagated in the early 1970s. But soon the prominence of monetarism was undertaken by a powerful wave of new classical contributions.
monetary disturbances) cause errors in price expectations by rational agents and result in output and employment deviating from their natural levels (which are also long-run equilibrium levels).
In the next section, the aggregate supply hypothesis and the assumption of continuous market clearing as the central theoretical propositions underlying new classical models will be elaborated.9 Political implications and an assessment are subsequently discussed.
2.5.1 The central propositions of new classical models
2.5.1.1 The aggregate supply hypothesis
Among the various explanations of the new classical aggregate supply hypothesis, two main approaches can be identified which are based on two orthodox microeconomic assumptions: (a) rational decisions taken by workers and firms reflect optimizing behavior on their part and (b) the supply of labor/output by workers/firms depends on relative prices.
Originated from the work of Lucas and Rapping (1969), the first approach focuses on labor supply. It is concerned with the intertemporal labor substitution hypothesis and explains changes in employment as the ‘voluntary’ choices of workers who change their supply of labor in response to perceived temporary changes in the real wage. This hypothesis will be elaborated later in real business cycle theory.10
The second approach to aggregate supply is also derived from the influential work of Lucas (1972, 1973). It implies that a firm has to decide whether a rise in the current market price of its output reflects a real shift in demand towards its product or not. Only in the case of the price of its output increasing relative to the price of other goods, should the rational firm increase its output. Note that this analysis also conforms to the expectations-augmented Phillips Curve.11
9 The rational expectations hypothesis is another central theoretical proposition of the new classical macroeconomics.
10 See section 2.6.1.2.
11 The relationship Y-YN=α(P-PPe), also the so-called Lucas ‘surprise’ function, can be expressed as Y-Y =α(π-πN e) which turns out to be a restatement of the expectations-augmented Phillips Curve.
2.5.1.2 The hypothesis of continuous market clearing
The assumption of continuous market clearing states that all markets continuously clear in line with the Walrasian tradition. The economy is thought of as being in a continuous state of equilibrium, both in the short-run and long-run.
This assumption implies that prices are free to adjust instantaneously to clear markets and contrasts the assumption in both orthodox Keynesian and monetarist models. Based on the assumption of slow prices adjustment, Keynesian models predict the economy to be probably in a state of continuous disequilibrium.
Orthodox monetarists believe instead that prices adjust rather rapidly. With the admission of possible short-run disequilibrium, they argue that the economy will automatically return to macroeconomic equilibrium at the natural rate of output and employment in the long run.
The assumption of continuous market clearing is, however, often objected to due to its deficiency of reality, especially with respect to the labor market. New classical economists insist that anyone wishing to work can find employment at the market-clearing equilibrium wage. In other words, in the new classical models unemployment is entirely a voluntary phenomenon.
2.5.2 Policy implications
The new classical approach has a number of important policy conclusions..Those concerning unemployment and econometric models will be elaborated here.
With regard to reducing unemployment permanently, new classical economists have brought the possibility of using aggregate supply policies much more to the forefront. As illustrated earlier, in new classical models changes in output and employment are considered to reflect the equilibrium decisions of firms and workers, based on their perceptions of relative prices. The labor market continuously clears. Unemployment is viewed as an equilibrium outcome reflecting the optimal decisions of workers in response to movements in current and expected future real wages and involuntary unemployment does not exist. If the authorities wish to increase output and reduce unemployment in the long run, they should pursue those policy measures that increase the microeconomic incentives for firms and workers to supply more output and labor.
Another influential contribution of the new classical economics is the Lucas critique which attacks the standard approach of using large-scale macroeconometric models for policy evaluations. Lucas denies the underlying assumption of Keynesian disequilibrium models that the model’s parameters remain constant when there is a policy change. Identifying the treatment of expectations as a major defect in the micro foundation of Keynesian-type models, he insists that economic agents with rational expectations may adjust their behavior to the new environment quickly so that the parameters of large-scale macroeconometric models may not remain unchanged in the face of policy changes. By focusing on individuals’ objectives and constraints, equilibrium theorizing instead is much more likely to result in models containing structural relations which are invariant to policy changes.
2.5.3 An assessment
The 1970s saw the dominance of new classical equilibrium approach in the macroeconomics discussion. Besides the policy ineffectiveness proposition stating that anticipated monetary policy will be ineffective, the insight of rational expectations and its integration into the macroeconometric models brought about the so-called ‘rational expectations revolution’. This has furthermore led economists to reconsider the role and conduct of macroeconomic stabilization policy.
However, models based on the new classical theory had reached both a theoretical and an empirical impasse by the early 1980s. Theoretically, the deficiencies mainly lay in the utilization of both the assumption of continuous market clearing and that of imperfect information. On the empirical front, the proposition that only unanticipated monetary surprises have real output effects did not prove to be robust. A macroeconometric model with rational expectations still brings about Keynesian result: Monetary and fiscal policies are effective with respect to real variables. In response to these criticisms, some economists have developed equilibrium real business cycle theory since the mid-1980s.