Rational Expectations, Market Clearing, and Real Business Cycles
The University of Chicago, where much of New Classical Economics was built by Robert Lucas, Jr.
Photo Credit: Wikimedia Commons
In my last post I began an examination of what is at present the only viable alternative to New Keynesian economics: New Classical economics. There may be many who are perplexed that socialism would not be considered a candidate for our economic organization, but socialism has given ample historical reasons for being rejected. If you are not convinced,  please read my posts Why Socialism Does Not Work, Bending History, Meanings of the Word Socialism, and Chaotic Economies and Adam Smith’s Invisible Hand.
In what follows, I am relating what I have learned from the textbook Macroeconomics by Robert J. Barro, an eminent New Classical economist and a professor of economics at Harvard University ( reference [E13]). I am also using information from a number of websites, including Wikipedia’s entry on New Classical Macroeconomics and the entry for New Classical Macroeconomics by Kevin Hoover on the Library of Economics and Liberty website.
The Pieces of a New Classical Model of the Economy
What are the major pieces of a New Classical  description of an economy’s behavior? Going from the micro level to the macro requires describing how average human behavior, under the influence of the neoclassical economic laws, determines price, consumption, and output levels; and savings and investment rates. Also, eventually the theory would have to explain the non-ideal effects introduced by government and incomplete information possessed by economic agents. By an economic agent I mean individuals or groups of individuals, such as companies, that buy or sell goods and services. The non-ideal effects created by government include inflation (or deflation), and tax and regulatory burdens. To make these explanations, a New Classical model of the economy generally has the following major parts:
- A market clearing model: This is the original piece that connects the model to the laws of supply and demand and of marginal utility. It is an idealization that will be partially lifted later with the addition of realistic phenomena such as inflation, and effects of incomplete information.
- Rational expectations: A model of people’s rational expectations about non-ideal phenomena is added to explain their effects. For example, the effects of the so-called “nominal shock” of inflation or deflation is handled in this piece of the theory.
- Assumption of a natural rate of unemployment: This assumption, originally due to Milton Friedman and Edmund Phelps, is a replacement for the Keynesians’ Phillips Curve.
- Real Business Cycle (RBC) Theory: This is a class of New Classical macroeconomic models in which business cycles (the alterations of growth and recession, or of faster and slower growth) are explained in terms of “real” changes to the economy, usually called shocks, A distinction is made between real shocks, such as a change in technology or in the supply of a commodity, and nominal shocks such as inflation caused by a change in the value of money (i.e. the price level).
Market Clearing
The building of a New Classical model always begins with a market clearing model. Markets are said to clear when
- all goods offered for sale are bought by consumers,
- when all bonds offered for sale are bought (i.e. borrowing by all bond issuers equals the money lent by all bond holders), and
- the total of money demanded in transactions (taking into account the velocity of money) is equal to the total money stock.
New Classical economists call each of these three conditions aggregate-consistency conditions. A more precise statement of market clearing is that in a free-market, neglecting non-ideal effects, prices and interest rates (the price for borrowing money) will always adjust until markets clear.
These are clearly ideal conditions only achievable in perfect free-markets. For example, when all goods offered for sale are bought, each good has had its point in its quantity-price plane driven to the intersection of Alfred Marshall’s supply and demand curves. The second condition is substantially the same as the first when you consider that an interest rate is the price for the service of being lent money.
Rational Expectations
The assumption of rational expectations by economic agents does not imply that all agents are rational, but that on average all economic agents use available information to optimize their economic outcomes. The expectations of some or even most of the economic agents at any one time might be wrong, but averaged over time their expectations are correct.
This assumption in modeling was first made by John Muth in 1961 in the context of microeconomics. However, later on it was adapted by Robert Lucas, Finn Kydland, Edward Prescott, and others for New Classical macroeconomics. Where this form of modeling becomes crucial is when all the non-ideal effects of a less-than-perfect free-market are taken into account. This includes many of the effects of the central bank’s monetary policies, as well as those of government regulations and taxes.
Natural Rate of Unemployment
The assumption that there exists a natural rate of unemployment for every economy is a replacement for the Keynesians’ Phillips curve. In this assumption, if the unemployment rate deviates from the natural rate, say by being decreased with an expansionary monetary policy by the Fed, market forces will tend to bring unemployment back to its natural rate. The difference between this picture and that from the Phillips curve is the Keynesians viewed an unemployment decrease in exchange for more inflation to be a stable state. The natural rate point of view on the other hand declared the decreased unemployment to be a disequilibrium that could only be maintained against market forces by even more inflation. This natural rate hypothesis is clearly consistent with the stagflation of the late 1970s, while the Phillips curve is not,
There are transient forces other than Federal Reserve monetary policy that can cause an unemployment deviation from the natural rate. For example, increases in government regulations such as minimum wage laws or mandates for more employer paid-for healthcare can increase the cost of employment for some beyond the value of what they produce, requiring the loss of their jobs. Milton Friedman believed the main causes of such deviations were expectations errors that would cause employers to either hire more workers than conditions could justify, or to layoff more than they should.
Real Business Cycle Theory
Real Business Cycle (RBC) theory sees the fluctuations of the business cycle as an efficient reaction to real condition changes in the economy. A fall into recession is not a market failure to clear as Keynesian theory would have it, but an efficient response to changed conditions within the economy. Rather than adopting an ad hoc policy of stimulating the economy through arbitrary fiscal or monetary policies, the government would be more useful investigating what structural economic changes caused the recession. Then if government policies caused the problem, which in the modern world is more often the case than not, eliminating those government causes would eliminate, or at least ameliorate, the causes of the recession.
An Amazingly Intricate Economic Model
As you can both see and imagine, an attempt to describe a modern economy starting at the level of the ‘atoms’ – the economic agents – of that system is a very complicated and intricate endeavor. The model has a huge number of complex moving parts, and in this post I have given only a very superficial summary of those parts. This was only to be expected from what I wrote in Chaotic Economies and Adam Smith’s Invisible Hand. Yet the understanding of these various pieces will offer us a greater chance of effectively eliminating economic problems than any of the various incarnations of Keynes ever could. In future posts I hope to expand in much greater detail on each of those parts.
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