New Classical Economics and Efficient Markets
1.
The Distinction between Adaptive and Rational Expectations: An expectation that is formed adaptively is based
only on past information. A rational
expectation is based on all available past and current information and relies
on an understanding of how the economy works.
2.
The Key Assumptions Underlying New Classical Macroeconomics: The new classical model is based on the assumption
of imperfect information in the short run, but efficient “market clearing” outcomes
as information is fully known.
3.
Policy Anticipations Determine the Actual Effects of Policy
Actions: If decision makers adjust to
price level and inflation rate expectations rapidly, then policy actions will
have no real effect on output or employment.
However, if not fully anticipated in the short-run, then policy can
affect real output and employment.
4.
Implication for Public Policy to Have a Real Effect: If monetary or fiscal policymakers wish to change
real output and employment, they must find ways to enact policies that are
unsystematic, or unpredictable.
5.
Implications of efficient markets:
Most
applicable in competitive financial markets where bond prices and real interest
rates reflect market equilibrium.
Adjustment lags will be more apparent in product and labor markets.
1.
The Modern Theory of Wage Stickiness:
The
modern Keynesian theory hypothesizes that workers and firms may desire to use
wage contracts to avoid the transaction costs entailed in continual wage
bargaining, to reduce risks associated with wage variability, or to deal with
problems arising from asymmetric information.
2.
The Role of Rational Expectations:
Firms
and workers make rational forecasts of the price level to set the appropriate
wage for the interval that the contract will be in force. During the contract term, unanticipated
fluctuations in the price level can induce changes in employment and real
output, resulting in an upward sloping aggregate supply curve.
3.
Several Factors Determine the Duration of Wage Contracts with
Macroeconomic Implications: The optimal duration of a
wage contract falls as the contract negotiation costs decline and as the
volatility in the price level resulting from aggregate demand and supply
variation rises. Contract negotiation
costs differ across firms and industries, so contract bargaining and ending
dates are staggered. The overlapping of
contracts causes aggregate demand fluctuations to have persistent effects on
employment and real output.
4.
The Modern Keynesian Theory is Observably Equivalent to the New
Classical Model: The essential predictions of
basic versions of both theories are the same.
Both approaches indicate that unexpected policy actions are more likely
to have effects on employment and real output, even though they are based on
different views about the functioning of the labor market.
1.
The Ultimate Goals of Macroeconomic Policy: Stable
price level, high levels of employment, growth in real output over time.
2.
Effectiveness of Monetary and Fiscal Policy: The New Classical School
and New Keynesian School agree that monetary and fiscal policy can do little to
affect real output over a long-run time horizon.
3.
Monetary Policy: Monetary policy may affect the
price level and real output in the short run, but only the price level in the
long-run.
4.
Fiscal Policy: Fiscal policy also primarily
affects price and output in the short-run, but it may affect the allocation of
resources between private and public goods that could influence economic
growth.
1. Finding an Intermediate
Target for Monetary Policy: An intermediate target between policy actions and
ultimate goals is chosen by the Fed based on theoretical as well as practical
issues.
2. Characteristics of
Intermediate Targets: Four key attributes are (i)
they can be frequently observed with up-to-date information, (ii) they are
consistent with the central bank’s ultimate objectives, (iii) they are
definable and measurable, and (iv) they are controllable.
3. The Menu of Intermediate
Target Variables: Three alternative targets are (i) monetary or credit aggregates, (ii)
interest rates, and (iii) nominal GDP.
4.
Interest-Rate Targeting: The indirect effects of interest rates on financial
markets are expected to ultimately affect aggregate spending. It is clearly the best target for
stabilization in the face of variation in money demand.
5.
Monetary Aggregate Targeting: Monetary aggregate targeting
is the best policy in the face of autonomous changes in aggregate demand
because the interest rate serves as an automatic stabilizer.
6.
Targeting Nominal GDP: The advantage of nominal GDP
targeting is that it potentially can reduce the inflationary consequences of
aggregate supply variability. In this
respect, it is superior to monetary aggregate or interest rate targeting that
focus on aggregate demand.
1.
The Indirect channel: Changes in the money supply
affect AD through changes in the interest rate due to adjustment in the bond
market and the foreign exchange market.
2.
The Direct channel: Changes in the money supply
directly affect how much people want to spend on real goods and services. Financial markets adjust to maintain a
stable proportion of money versus other financial assets and real assets.
3.
The Effectiveness of the Indirect Channel: A
change in the money supply will cause a change in the market rate of interest due to the substitution
between money and bonds or foreign exchange.
(A “liquidity trap” may result in no change in interest rates as all new
money is held and monetary policy is ineffective). A change in the market rate of interest changes desired spending
or aggregate demand. (Interest
inelastic investment or other desired spending makes monetary policy
ineffective.)
4.
The Effectiveness of Direct Channel:
In
this view, people hold their money in financial assets and REAL ASSETS
(real estate, cars, etc…). The demand for money is a stable proportion
of total assets, so that the velocity of money is constant. (The equation of exchange holds after asset
adjustment.)
5.
How Much Money is Needed: If the
velocity of money changes with interest rates, then the velocity of money will
change in the opposite direction of the money supply. Then money must change more than proportional to output. If the velocity of money is constant a
simple proportional rule can be applied based on potential growth in real
output.
6.
What Determines the Velocity of Money: (i) Customs and Conventions
of Commerce. The velocity of money has
increased over time as a variety of commercial innovations (charge accounts,
credit cards, ATMs, debit cards) have facilitated exchange. (ii) The frequency with which workers get
paid. (More frequent pay period lower
the average amount of money held, increasing velocity.
In
the right-hand margin click on “Key Speeches” and then on Wim Duisenberg: Testimony before the Committee on
Economic and Monetary Affairs of the European Parliament, Brussels,
23 January 2002.
3. What similarities exist between Duisenberg’s testimony and the Greenspan’s Humphrey-Hawkins testimony?