Chapter 10
THE CLASSICAL SCHOOL.
Introduction.
§ Different schools of thought in economics give different solutions (or different answers) to the same economic problems (or questions.)
§ There are mainly two approaches to macroeconomics:
- Keynesian: supporters of demand-side policies, pro government intervention.
- Classical: supporters of supply-side policies, anti government intervention.
§ Both schools agree on basic economic principles (e.g.: what factors affect consumption) but disagree on how the whole economy interacts (e.g.: how effective monetary policy is.)
- Classical economists argue that markets clear instantly, that is, that prices and wages adjust rapidly so as to clear any shortage or surplus.
- Keynesian economists argue that prices are sticky (non-flexible) in the short-run and so markets may not clear -so requiring government intervention.
§ If we put these schools in their historical context we can get a better understanding of why their arguments differ:
- Keynesian macroeconomics was developed during Great Depression, when it was obvious that countries could not automatically recover from some recessions without government help.
- Demand side economics (mainly G) were very successful after WWII and brought strong economic growth to many countries.
- Classical macroeconomics was "revived" in the 60s and 70s when the shortcomings of demand-side economics were made evident by high inflation and crowding out of private investment.
- Monetary policy (excessive M) was strongly criticized and the application of many classical arguments helped stabilize and “clean up” economies, allowing them to grow faster.
§ Again, this is not a case of one school being wrong and the other being right, it is a question of what part of the picture they consider more important:
- Keynesian economists will look at the economy mostly through the IS-LM model (where prices are not an issue)
- Classical economists will look at the economy mostly through the AS-AD model (where output levels and inflation are connected.
§ Nowadays we are somewhere in-between:
- There is a general consensus about the benefits of government intervention in some specific areas of the economy (e.g.: education, financial regulation.)
- The most dramatic predictions of the classical school have not materialized (e.g.: we can enjoy simultaneously high economic growth and low inflation.)
10.1 Classical Business Cycle Theory.
§ An important difference between the classical and keynesian schools is how they analyze the business cycle:
- Keynesians consider fiscal and monetary policies useful tools to shorten recessions or promote expansions, while classical economists see them as useless or even disruptive.
- The classical school considers money as being neutral (no real effects, no effects on real GDP, unemployment...) while keynesians defend the short-run effect of monetary shocks.
- Classical economists consider that markets clear rapidly because prices and wages adjust almost instantly, while keynesians propose that prices and wages can be sticky.
§ Under the Real Business Cycle theory (RBC), real shocks are the only causes of business cycles. In other words, the business cycle is driven by changes in supply.
§ Productivity shocks affect the demand / supply of labor and capital, and so produce shifts in the SRAS and FE (LRAS) curves.
- Expansions will be the result of improvements in technology.
- Contractions will be the result of reductions in productivity.
§ Do we observe this type of trends in the historical record of business cycles? Indeed the RBC theory is very accurate when explaining some of the stylized facts of business cycles:
- Employment is pro-cyclical (A ® Y ® ¯u)
- Productivity is pro-cyclical (A ® MPN) (this is critical to explain how u keeps on falling)
- Wages are pro-cyclical (A ® MPN ® wages)
§ A weak point of the RBC theory is to expect prices higher prices during a recession and to expect them to fall while the economy expands.
- The historical record shows inflation as being strongly pro-cyclical but a point of contention has been raised with regards to how that conclusion is reached by empirical studies.
Points of Criticism.
§ The RBC theory relies heavily on the occurrence of almost continuous productivity shocks (changes in A), some positive and some negative, to explain business cycles.
- There is consistent evidence of those shocks, as recorded through the Solow residual.
§ Recently, strong doubts have been raised about the validity of employing such a tool to capture changes in productivity. In particular,
- The intensity of factor use (e.g.: overtime work put in by employees, electricity consumption) varies during the business cycle and the Solow residual does not reflect that.
- For example, during economic downturns firms will avoid laying off many workers (they will hoard labor) so they don't lose the workers’ expertise. Similarly, firms will invest in machinery upgrades and maintenance, rather than in new equipment, during a downturn.
- This distorts the change in productivity measured through the growth accounting equation.
§ The RBC school argues that the use of fiscal policy to recover from a recession will be mostly inflationary and largely ineffective (demand policies are useless to counter a supply shock)
- Nonetheless, including fiscal policy factors as determinants of business cycles improves the fit of the theory with the stylized facts.
- As we have discussed, RBC theorists generally reject government intervention in the economy and claim that “markets” will correct any existing imbalances on their own.
- If a recession were to be caused by a drop in consumer confidence (¯C ® ¯AD), RBC theory would expect lower prices to be regarded by firms as lower production costs and so shift the SRAS right –closing the recessionary gap.
- Although the argument is attractive, it is not clear that prices will adjust so rapidly and that markets for goods and labor will clear instantly.
- On RBC theory’s support, even if ¯T or G were to be appropriate economic measures, the slow political process involved in their implementation will make them be out of sync (lagged) with the business cycle. Also, their fine tuning is pure guesswork.
§ Unemployment persistence is unexplained by RBC theory. Even during expansions the unemployment rate can remain fairly constant.
- This can happen if the wage does not match the quantity supplied and the quantity demanded of labor. For example, workers will not perform certain jobs for low wages. Labor markets are segmented because not all workers are the same.
- There is a voluntary component of unemployment. Workers may choose to remain unemployed rather than to take an available job that does not match their salary and professional expectations.
- In many cases there is a mismatch between labor supply and labor demand. Sometimes it is due to the sharply different speeds of job creation (new positions available) and job destruction (positions that are eliminated) within industrial sectors. (See Figure 10.5)
- The idea of the natural rate of unemployment itself is a classical conception, and although basically indisputable, it can be stretched to fit almost any level of unemployment (is the natural rate of unemployment 5 percent or 9 percent?)
- Classical economists will argue that in order for the labor market to clear faster and more efficiently the government should eliminate some of its regulations (e.g.: minimum wages, excessive lay-off compensations, mandatory maternity leaves…)
10.2 Money in the Classical Model.
§ The classical school considers money neutral because prices adjust immediately to an increase in the money supply. This is a central point of monetarist (neoclassical) economics.
§ Money neutrality means that nominal variables (e.g.: the price level, the money supply...) do not have any effect on real variables (e.g.: real GDP, unemployment.)
§ Monetary policy is thus ineffective to promote economic activity and at worst simply drives inflation up:
- If M to ¯r and soC, I and AD
- But when M, P (recall M. v = P. Y)
- Therefore: M ® ¯r but M ® P and so i = r + P remains the same.
- Besides, as P, Md (because now transactions require more cash) so eventually r.
§ In clear contrast, the Keynesian school doesn't consider that prices are so flexible and therefore there is room for a monetary policy with real effects.
Points of Criticism.
§ The expected neutrality of money is contradicted by the empirical fact that monetary expansions precede increases in economic activity.
- Classical economists argue that there is a difference between preceding and causing (e.g.: we take our umbrellas when it is cloudy but the umbrellas themselves do not cause the rain.)
- According to the RBC theorists, the money supply increases before an economic expansion simply because the Fed observes an incipient raise in money demand (from Y) and decides to match it to facilitate the expansion of activity.
- This process of reverse causation is contradicted by extensive and rigorous historical studies that found that changes in monetary policy actually preceded (and so motivated) changes in real activity.
The Misperceptions Theory.
§ The non-neutrality of money can also be explained with classical arguments. It may be that although prices adjust quickly imperfect information affects output decisions.
§ These theories were developed by Milton Friedman and subsequently formalized by Robert Lucas, both Nobel Prize laureates from the University of Chicago.
§ Even though prices may adjust quickly in different markets, producers of goods and services may not have complete information about the relative price of their goods:
- If the price of the good I produce increases faster than the price of my raw materials or my competitors’ prices (i.e.: general price level) I will produce more of my good –in order to increase revenues and profits.
- If producers misinterpret an increase in the general price level for an increase in the relative price of their goods (i.e.: my final price grows faster than my raw materials,) production will increase as the price level rises.
- This theory will allow for an upward sloping SRAS curve, instead of the vertical one.
§ Monetary policy will then be effective in the short-run if it is unanticipated by consumers and producers. This unanticipated inflation will “trick” producers into increasing output.
- M to ¯r, C, I and AD
- P will be misread by producers as a rise in the relative price level, and so as a sign to Y
- Eventually, as Y grows above full employment Y*, the increased costs of production will catch up with firms and shift left the SRAS.
§ Monetary policy will then be ineffective in the short-run if anticipated by consumers and producers:
- M to ¯r, C, I and AD
- P will be recognized as a rise in the general price level, an increase in relative prices, but also an increase in production costs, so there will be no Y.
§ Either being anticipated or not, monetary expansions are neutral in the long-run. Even under the misperceptions theory producers eventually learn about their relative prices.
§ But does this theory imply that the only policies that the Fed can apply are "surprise" expansions or contractions of the money supply?
- We will talk about monetary theory in more detail later on but for the time being we will say that economic agents develop rational expectations.
- This means that by combining a significant amount of the information available about the economy, firms and consumers can accurately predict what is going to happen next.
- In that case, monetary policy will be taken as a powerful indicator of future economic developments and trends.