New Classical Model: Videos & Practice Problems

The New Classical Model and the Keynesian Model differ primarily in their views on price and wage flexibility and government intervention. The New Classical Model posits that wages and prices are flexible and can adjust quickly to changes in supply and demand, leading to the economy naturally gravitating towards full employment and potential GDP. In contrast, the Keynesian Model views prices and wages as sticky, meaning they do not adjust quickly, which can result in prolonged periods of unemployment and economic inefficiencies. Additionally, the Keynesian Model advocates for active government intervention to manage economic fluctuations, while the New Classical Model emphasizes minimal government intervention, relying instead on market forces and rational expectations to stabilize the economy.

The New Classical Model of economics was developed in the 1970s by economists Robert Lucas, Thomas Sargent, and Robert Barro. These economists built upon the classical economic theories that existed before the Great Depression, incorporating new ideas such as rational expectations and the flexibility of wages and prices. Their work aimed to provide an alternative to the Keynesian Model, which had dominated economic thought since the Great Depression, by emphasizing the self-correcting nature of markets and the importance of expectations in economic decision-making.

Rational expectations in the New Classical Model refer to the idea that firms and workers make decisions based on their forecasts of future economic variables, such as inflation. These expectations are formed using all available information and are assumed to be accurate on average. If actual inflation deviates from expected inflation, it can lead to economic adjustments, such as shifts in the short-run Phillips curve. The concept underscores the importance of predictable monetary policy, advocating for a steady growth rule in the money supply to help stabilize inflation expectations and reduce economic volatility.

The New Classical Model generally advocates for minimal government intervention in the economy. It emphasizes the self-correcting nature of markets, where flexible wages and prices allow the economy to adjust quickly to changes in supply and demand, naturally gravitating towards full employment and potential GDP. The model suggests that government intervention, such as fiscal and monetary policies, can often lead to inefficiencies and distortions. Instead, it supports a steady growth rule for the money supply to stabilize inflation expectations, aligning with monetarist views on monetary policy.

The steady growth rule in the New Classical Model is significant because it aims to stabilize inflation expectations by ensuring a consistent and predictable increase in the money supply. This rule helps firms and workers form accurate expectations about future inflation, reducing economic uncertainty and volatility. By adhering to a steady growth rule, policymakers can minimize the discrepancies between actual and expected inflation, which can otherwise lead to economic disruptions. This approach aligns with monetarist views, emphasizing the importance of predictable monetary policy in maintaining economic stability.