Download the neoclassical tradition

NEOCLASSICAL ECONOMICS
Cornel Ban
CLASSICAL ECONOMICS
1770s-1870s
Adam Smith, David Ricardo, Say
NEOCLASSICAL ECONOMICS
1870-1939
Marshall, Walras, Jevons
“The allocation of scarce resources among alternative ends” (Lord Robbins)
Marginal tradeoffs based on calculus
Assumes farsighted rationality
Individual rationality aggregates into social rationality
Markets tends towards equilibrium
Say’s Law: supply always equals demand, namely that where there is seller
there must be a buyer.
NEOCLASSICAL SYNTHESIS
1939-1976
Hicks, Samuelson, Solow
Synthesis of neoclassical and Keynesian worlds: THE neoclassical model was
assumed to hold in the long-run while the Keynesian one was applicable in the
short run and for situations when the economic situation was marked by sticky
wages, liquidity traps and interest-insensitive investment
Modeling with time series econometrics
There is a permanent trade-off between inflation and unemployment; there is only
a temporary trade-off
Expansionary fiscal and monetary policies in times of crisis
MONETARISM
1960Milton Friendman
An excessive supply in the quantity of money by the central bank is the most important cause of
inflation, and that the vagaries of monetary policy are responsible for the cyclical fluctuations of
the economy.
Governments may not know in advance what the real effects of monetary policy will be in the
long term.
Hence: monetary
targets, , budgetary spending cuts, quantitative controls of the increase in bank
credit, strong central bank, all with a view to reduce the effective demand for goods and services.
The government’s attempts to lower it are doomed to generate either inflationary spirals if
unemployment is set below the natural rate, or deflation if it is set above this rate. The most
important implication of this argument is that there is no permanent trade-off between inflation
and unemployment; there is only a temporary trade-off.
SUPPLY-SIDE ECONOMICS
1970s
Arthur Laffer
Reduce costs on the supply-side of the economy
Pumping up demand would simply lead to higher inflation, if it were not done in
conjunction with the improvement of markets through deregulation, liberalization,
privatization or free trade.
Regulation created perverse incentives and distorted resource allocation as much
as it cured other problems. So, deregulate and privatize.
Reductions in welfare benefits: not based on the monetarist idea that welfare
spending can be inflationary, but on the supply-side discovery that the labor
supply decreases when the unemployed are offered benefits that give them
incentives not to work
NEW CLASSICAL ECONOMICS
1975-1985
Robert Lucas, Thomas Sargent
Booms and busts are created by supply-side shocks, such as technological revolutions, raw
materials price spikes and radical changes in the organization of production.
Employment, like output, would rise with favorable shocks and fall with unfavorable shocks
If private agents were completely rational and if markets were competitive, it would be impossible
for the government to stabilize the economy, simply because agents would adjust their
inflationary expectations and “outsmart” the government. Consequently, the government’s only
policy option was to credibly commit itself to anti-inflationary policies, whose costs in terms of
higher unemployment could be addressed by boosting the supply-side of the economy through
tax cuts and labor market deregulation.
NEW KEYNESIANS
Late 1980s on
Blanchard, Wooford
Monetary policy activism
DGSE: They had equilibrium because they started from the premise that supply
would equal demand ideally; they were dynamic because the models incorporated
changing behaviour by individuals or firms (agents); and they were stochastic as
‘shocks’ to the system (trade union wage push, government spending action) were
considered as random with a range of outcomes, unless confirmed otherwise).
There is a total absence of investment or profit as ‘shocks’ in these
models. Everything starts with consumer preferences
General equilibrium not lack of effective demand
No regulatory and prudential controls
NEW KEYNESIANISM
Price stability is the primary objective of monetary policy;
Monetary policy works through interest rate policy, not money supply rules
(abandoned in the 80s). Price stability can be achieved through monetary policy
since inflation is a monetary phenomenon; as such it can only be controlled
through changes in the rate of interest.
This policy is undertaken through inflation targeting (IT).
Fiscal policy is downgraded. It should only be concerned with possibly broadly
balancing government expenditure and taxation, effectively downgrading its
importance as an active instrument of economic policy. This is an assumption
based on the usual arguments of crowding out of government deficits and, thus,
the ineffectiveness of fiscal policy;
What’s Keynesian in it? Temporary nominal rigidities in the form of sticky wages,
prices, and information, or some combination of these frictions, so that the
central bank, by manipulating the nominal rate of interest, is able to influence real
interest rates and, hence, real spending in the short run
ON DGSE
:” a modern economy is populated by consumers, workers, pensioners, owners, managers,
investors, entrepreneurs, bankers, and others, with different and sometimes conflicting
desires, information, expectations, capacities, beliefs, and rules of behavior … To ignore all
this in principle does not seem to qualify as mere abstraction – that is setting aside
inessential details. “(Robert Solow)
“In four years of reflection and rather intense involvement with this financial crisis, not a
single aspect of dynamic stochastic general equilibrium has seemed worth even a passing
thought.” (Larry Summers)
NEW NEOCLASSICAL SYNTHESIS
When monetary policy became relatively impotent at the zero bound,
synthesis models clearly show fiscal policy can be highly effective at
stimulating output The ‘demand denial’ is indefensible.
The Keynesian/Anti-Keynesian division is always going to be with us, because
it reflects an ideological divide about state intervention