Chapter 16: Problem 13

"Even if some people do not form their expectations rationally, the new classical theory is not necessarily of no value." Discuss this statement.

Short Answer

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Though the New Classical Theory assumes rational expectations, its value does not diminish even when some individuals do not act rationally. The theory still provides useful insight into aggregate economic behavior and responses to policy changes. However, its limitations should also be acknowledged and the worth of other economic theories and models that capture non-rational behavior shouldn't be dismissed.

Step by step solution

Definition of New Classical Theory

The New Classical Theory (NCT) in Economics suggests that all agents in an economy have rational expectations and make optimal decisions based on all available information. Changes in output and employment in the short run are mainly driven by unexpected policy changes rather than systematic ones. In the long run, however, the economy is always driven to a state of equilibrium.

Rational vs Non-Rational Expectations

While NCT is based on the assumption of rational expectations, real world observations show that not everyone forms their expectations rationally. This means they may not make use of all available information or may have personal biases.

Applicability of the Theory

Despite these inconsistencies with the real world, NCT is still of value. This is because macroeconomic models provide insights about the general direction of the economy and its likely reactions to policy changes. The models are not to predict individual behavior, but to capture broader macroeconomic trends that become apparent when the actions of many individuals are aggregated.

Limitations and Criticisms

However, the value of NCT should not mean dismissal of its limitations and criticisms. There are other schools of thought (like behavioral economics or the Keynesian school) that emphasize on non-rational behavior and have also contributed valuable insight into economic decision-making and policy outcomes. Thus, NCT is a tool among many other tools within the field of economics.

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