output = β(Yt“1 “ YNt“1); and

a random component = µt.

4.

242 Modern macroeconomics

Thus, in the Lucas model business cycles are generated by exogenous mon-

etary demand shocks that transmit imperfect price signals to economic agents

who, in a world of imperfect information, respond to price increases by

increasing supply. The greater is the general price variability (the lower the

variation in price attributed to relative price variation), the lower will be the

cyclical response of output to a monetary disturbance, and vice versa. A

major policy implication of the MEBCT is that a benign monetary policy

would eliminate a large source of aggregate instability. Thus new classical

economists come down on the side of rules in the ˜rules versus discretion™

debate over the conduct of stabilization policy.

We now turn to consider the main policy implications of the new classical

approach to macroeconomics in more detail.

5.5 The Policy Implications of the New Classical Approach

The combination of the rational expectations, continuous market-clearing

and aggregate supply hypotheses produces a number of important policy

conclusions. In what follows we discuss the main policy implications of the

new classical approach, namely (i) the policy ineffectiveness proposition; (ii)

the output“employment costs of reducing in¬‚ation; (iii) dynamic time incon-

sistency, credibility and monetary rules; (iv) central bank independence; (v)

the role of microeconomic policies to increase aggregate supply; and (vi) the

Lucas critique of econometric policy evaluation.

We begin with a discussion of the strong policy conclusion that fully

anticipated changes in monetary policy will be ineffective in in¬‚uencing the

level of output and employment even in the short run, that is, the super-

neutrality of money.

5.5.1 The policy ineffectiveness proposition

The new classical policy ineffectiveness proposition was ¬rst presented in

two in¬‚uential papers by Sargent and Wallace (1975, 1976). The proposition

can best be illustrated using the aggregate demand/supply model shown in

Figure 5.3. Those readers unfamiliar with the derivation of this model should

refer to any standard macroeconomics text, such as Mankiw (2003). In Figure

5.3, the economy is initially operating at point A, the triple intersection of

AD0, SRAS0 and LRAS. At point A, in line with equation (5.3), the price level

(P0) is fully anticipated (that is, the actual and expected price levels coincide)

and output and employment are at their long-run (full information) equilib-

rium (natural) levels. Suppose the authorities announce that they intend to

increase the money supply. Rational economic agents would take this infor-

mation into account in forming their expectations and fully anticipate the

effects of the increase in the money supply on the general price level, so that

The new classical school 243

Figure 5.3 The effects of anticipated and unanticipated changes in the

money supply on the level of output and the price level

output and employment would remain unchanged at their natural levels. The

rightward shift of the aggregate demand curve from AD0 to AD1 would be

offset by an upward shift to the left of the positively sloped aggregate supply

curve from SRAS0 to SRAS1, as money wages were increased following an

immediate upward revision of price expectations. In this case the economy

would move straight from point A to C, remaining on the vertical long-run

aggregate supply curve with no change in output and employment even in the

short run; that is, money is super-neutral.

In contrast, suppose the authorities surprise economic agents by increasing

the money supply without announcing their intentions. In this situation ¬rms

and workers with incomplete information would misperceive the resultant

increase in the general price level as an increase in relative prices and react

by increasing the supply of output and labour. In other words, workers and

¬rms would mistakenly perceive this as a real (as opposed to a nominal)

increase in the demand for their services/goods and respond by increasing the

supply of labour/output. In terms of Figure 5.3, the aggregate demand curve

would shift to the right from AD0 to AD1 to intersect the positively sloped

aggregate supply curve SRAS0 at point B. In line with equation (5.3), output

(Y1) would deviate from its natural level (YN) as a consequence of deviations

of the price level (P1) from its expected level (P0), that is, as the result of

244 Modern macroeconomics

expectational errors by agents. Any increase/decrease in output/unemploy-

ment would, it is argued, only be temporary. Once agents realized that there

had been no change in relative prices, output and employment would return

to their long-run equilibrium (natural) levels. In terms of Figure 5.3, as agents

fully adjusted their price expectations the positively sloped aggregate supply

curve would shift upwards to the left, from SRAS0 to SRAS1, to intersect AD1

at point C. It is interesting to note that the former new classical adjustment

process discussed above (from A to C) corresponds to the orthodox monetar-

ist case in the long run, while the latter adjustment process (from A to B to C)

corresponds to the orthodox monetarist case in the short run, regardless of

whether the increase in the money supply is anticipated or unanticipated. To

summarize, the new classical analysis suggests that (i) an anticipated increase

in the money supply will raise the price level and have no effect on real

output and employment, and (ii) only unanticipated monetary surprises can

affect real variables in the short run.

This strong policy ineffectiveness proposition has major implications for

the controversy over the role and conduct of macroeconomic stabilization

policy. If the money supply is determined by the authorities according to

some ˜known™ rule, then the authorities will be unable to in¬‚uence output and

employment even in the short run by pursuing a systematic monetary policy

as it can be anticipated by agents. For example, the authorities might adopt a

monetary rule which allows for a given ¬xed rate of monetary growth of 6 per

cent per annum. In forming their expectations of in¬‚ation, rational economic

agents would include the anticipated effects of the 6 per cent expansion of the

money supply. Consequently the systematic component (that is, 6 per cent) of

the monetary rule would have no effect on real variables. If, in practice, the

money supply grew at a rate of 8 per cent per annum, the non-systematic

(unanticipated) component of monetary expansion (that is, 2 per cent per

annum) would cause output and employment to rise temporarily above their

long-run equilibrium (natural) levels, owing to errors in in¬‚ation expecta-

tions. Alternatively the authorities might allow the money supply to be

determined by a feedback rule (for example, in response to changes in unem-

ployment and output). Again changes in the rate of monetary growth which

arise from a known feedback rule will be anticipated by agents, making the

feedback policy rule ineffective. Only departures from a known monetary

rule (such as policy errors made by the monetary authorities or unforeseen

changes in policy) which are unanticipated will in¬‚uence output.

The policy ineffectiveness proposition can be expressed algebraically in

the following way (see Gordon, 1976). We begin by rewriting the Friedman“

Phelps equation in modi¬ed linear form as:

Pt = Pt e ’ φ(Ut ’ U Nt ) + φθSt

™™ (5.14)

The new classical school 245

where θSt represents an ˜exogenous™ supply shock (with zero mean) and Ut “

UNt represents the deviation of unemployment from its natural rate. Equation

(5.14) can be rewritten as:

Ut = U Nt ’ 1/φ( Pt ’ Pt e ) + θSt

™™ (5.15)

™

The structural relationship between in¬‚ation Pt and the rate of monetary

™

growth Mt is given by:

Pt = Mt + θDt

™ ™ (5.16)

where θDt represents ˜unpredictable™ demand shocks (such as shocks from

™

the private sector) which also have a zero mean. If Mte is the expected rate of

growth of the money supply, the rational expectation of in¬‚ation will be:

Pt e = Mte

™ ™ (5.17)

Suppose a Keynesian-inspired monetary authority attempts to control mon-

etary growth so that it grows at some constant rate (»0) plus some proportion

(»1) of the previous period™s deviation of unemployment from its natural rate.

In this case the actual rate of monetary growth will be: