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June 29, 2014

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Posted: 29 Jun 2014 12:06 AM PDT

The Rise and Fall of the New Classical Model

Posted: 28 Jun 2014 10:27 AM PDT

Simon Wren-Lewis (my comments are at the end):

Understanding the New Classical revolution: In the account of the history of macroeconomic thought I gave here, the New Classical counter revolution was both methodological and ideological in nature. It was successful, I suggested, because too many economists were unhappy with the gulf between the methodology used in much of microeconomics, and the methodology of macroeconomics at the time.
There is a much simpler reading. Just as the original Keynesian revolution was caused by massive empirical failure (the Great Depression), the New Classical revolution was caused by the Keynesian failure of the 1970s: stagflation. An example of this reading is in this piece by the philosopher Alex Rosenberg (HT Diane Coyle). He writes: "Back then it was the New Classical macrotheory that gave the right answers and explained what the matter with the Keynesian models was."
I just do not think that is right. Stagflation is very easily explained: you just need an 'accelerationist' Phillips curve (i.e. where the coefficient on expected inflation is one), plus a period in which monetary policymakers systematically underestimate the natural rate of unemployment. You do not need rational expectations, or any of the other innovations introduced by New Classical economists.
No doubt the inflation of the 1970s made the macroeconomic status quo unattractive. But I do not think the basic appeal of New Classical ideas lay in their better predictive ability. The attraction of rational expectations was not that it explained actual expectations data better than some form of adaptive scheme. Instead it just seemed more consistent with the general idea of rationality that economists used all the time. Ricardian Equivalence was not successful because the data revealed that tax cuts had no impact on consumption - in fact study after study have shown that tax cuts do have a significant impact on consumption.
Stagflation did not kill IS-LM. In fact, because empirical validity was so central to the methodology of macroeconomics at the time, it adapted to stagflation very quickly. This gave a boost to the policy of monetarism, but this used the same IS-LM framework. If you want to find the decisive event that led to New Classical economists winning their counterrevolution, it was the theoretical realisation that if expectations were rational, but inflation was described by an accelerationist Phillips curve with expectations about current inflation on the right hand side, then deviations from the natural rate had to be random. The fatal flaw in the Keynesian/Monetarist theory of the 1970s was theoretical rather than empirical.

I agree with this, so let me add to it by talking about what led to the end of the New Classical revolution (see here for a discussion of the properties of New Classical, New Keynesian, and Real Business Cycle Models). The biggest factor was empirical validity. Although some versions of the New Classical model allowed monetary non-neutrality (e.g. King 1982, JPE), when three factors are present, continuous market clearing, rational expectations, and the natural rate hypothesis, monetary neutrality is generally present in these models. Initially work from people like Barrow found strong support for the prediction of these models that only unanticipated changes in monetary policy can affect real variables like output, but subsequent work and eventually the weight of the evidence pointed in the other direction. Both expected and unexpected changes in the money supply appeared to matter in contrast to a key prediction of the New Classical framework.

A second factor that worked against New Classical models is that they had difficulty explaining both the duration and magnitude of actual business cycles. If the reaction to an unexpected policy shock was focused in a single period, the magnitude could be matched, but not the duration. If the shock was spread over 3-5 years to match the duration, the magnitude of cycles could not be matched. Movements in macroeconomic variables arising from informational errors (unexpected policy shocks) did not have enough "power" to capture both aspects of actual business cycles.

The other factor that worked against these models was that information problems were a key factor in generating swings in GDP and employment, and these variations were costly in aggregate. Yet no markets for information appeared to resolve this problem. For those who believe in the power of markets, and many proponents of New Classical models were also market fundamentalists, the lack of markets for information was a problem.

The New Classical model had displaced the Keynesian model for the reasons highlighted above, but the failure of the New Classical model left the door open for the New Keynesian model to emerge (it appeared to be more consistent with the empirical evidence on the effects of changes in the money supply, and in other areas as well, e.g. the correlation between productivity and economic activity).

But while the New Classical revolution was relatively short-lived as macro models go, it left two important legacies, rational expectations and microfoundations (as well as better knowledge about how non-neutralities might arise, in essence the New Keynesian model drops continuous market clearing through the assumption of short-run price rigidities, and about how to model information sets). Rightly or wrongly, all subsequent models had to have these two elements present within them (RE and microfoundaions), or they would be dismissed.

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