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Chapter 16: Problem 12

Explain both the short- and long-run movements of the new classical theory, assuming that expectations are formed rationally and policy is unanticipated.

Short Answer

Expert verified
In the new classical theory, unexpected policy changes may temporarily influence the economic behavior in the short-run by altering the aggregate demand. However, in the long-run, people adjust their expectations, and the economy returns to its natural rate of output and unemployment, regardless of the inflation rate, reflecting the notion of policy-ineffectiveness proposition in new classical economics.

Step by step solution

01

Understanding the New Classical Theory

The New Classical Theory is an economic concept that emphasizes the understanding of customer behavior by incorporating the concept of rational expectations. It assumes individuals always make optimal decisions by using all available information and making expectations about future economic conditions. In this case, any unanticipated change in policy would therefore have an effective impact on economic behavior.
02

Short-Run Impact of New Classical Theory

In the short-run, the new classical theory implies that unexpected policy changes may influence rational expectations, altering an individual's behavior and thereby disturbing aggregate demand. For instance, an unanticipated monetary policy expansion could temporarily increase output and reduce unemployment, shifting the short run Phillips curve to the right. This happens because people rationally expect the price level to remain unchanged, and only adjust their expectations after realizing the policy change.
03

Long-Run Impact of New Classical Theory

In the long-run, individuals adjust their expectations to account the unanticipated policy change. Output and unemployment will return to their natural rates, regardless of the rate of inflation. This reflects the vertical long-run Phillips curve in the new classical theory, where the economy self-adjusts back to its natural level of output. The realized inflation rate equals the expected rate, leaving no room for policymakers to exploit the trade-off between inflation and unemployment.

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Most popular questions from this chapter

New Keynesian theory holds that wages are not completely flexible because of such things as long-term labor contracts. New classical economists often respond that experience teaches labor leaders to develop and bargain for contracts that allow for wage adjustments. Do you think that the new classical economists have a good point? Why or why not?

Assume a current short-run trade-off between inflation and unemployment, as well as a change in technology that permits the wider dispersion of economic policy news. How would the change affect the trade-off? Explain your answer.

Explain both the short- and long-run movements of Friedman natural rate theory, assuming that expectations are formed adaptively.

"The policy ineffectiveness proposition (connected with new classical theory) does not eliminate policy makers' ability to reduce unemployment through aggregate demand-increasing policies, because they can always increase aggregate demand by more than the public expects." What might be the weak point in this argument?

In real business cycle theory, why can't the change in the money supply prompted by a series of events catalyzed by an adverse supply shock be considered the cause of the business cycle?
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