New Classical Model: Videos & Practice Problems

The new classical model of economics, developed in the 1970s, shares similarities with the classical model, emphasizing potential GDP and full employment. Unlike the Keynesian model, it posits that wages and prices are flexible, allowing for quick adjustments to supply and demand changes. A key concept is rational expectations, where firms and workers base decisions on anticipated inflation, impacting the short-run Phillips curve. The model advocates for a steady growth rule in the money supply to stabilize inflation expectations, aligning with monetarist views on monetary policy.

New Classical Model

So throughout this course, we focus mainly on the Keynesian model of economics. Let's go ahead and see another model, the new classical model of economics. So the new classical model of economics, well, guess what? It has similar views to the classical model of economics that was used prior to the Great Depression. During the Great Depression, the Keynesian model was developed that focused on government intervention to help fight recessions and to help fight inflation as well. So the new classical model was developed by a few people, Robert Lucas, Thomas Sargent, Robert Barro in the 1970s. Likely, you don't have to know those names but that's who developed it. And it has some big similarities to the classical model. That's why it's called the new classical model.

So this model believes that the economy tends to be at potential GDP. So we're at full employment and available resources are in use. So that's a big similarity between the classical model and the new classical model that we tend to be at full employment, potential GDP. They also believe that wages and prices are flexible, that they are able to adjust quickly, to changes in supply and demand. This is one of the main differences from the Keynesian models. Remember that the Keynesian model viewed prices as sticky. They're not able to change as quickly, right? Especially when it comes to wages, a lot of times, your wage isn't able to change or adjust that quickly, right? If you're going through a recession, if the economy is going through a recession and then your employer says: Hey, we're going to cut your pay by 10%. It's not so easy to lower your wage, right? Or if you're in a union and you have a contracted amount of wage, whether prices go up or down, the price level changes, inflation or recession, well, your contracted wage is going to stay the same. So that's one of the main views of the Keynesian model while the new classical model believes that these are more flexible, that they are adjustable, they can adjust quickly, okay?

So one of the big additions that the new classical model brings is the idea of rational expectations and this tends to deal mainly with inflation when we think about this rational expectations in this model. So the idea is that firms and workers have expectations about the future value of economic variables. So they're going to make decisions today based on what they think the future is going to be like, such as what they think inflation is going to be like in the future, okay?

So one of the main things with the rational expectations theory is that if the actual inflation rate is different from the expected inflation rate, if they expect a certain level inflation, we think prices are going to be 2% higher next year, but they end up being 10% higher next year. Well, that's going to have economic repercussions. And we talk about that a lot more when we discuss the short run Phillips curve and we discuss expected inflation. We discuss this idea of rational expectations in that video a lot. But it leads to shifts in the short run Phillips curve. When these expectations are not met, and that has effects on inflation as well as on unemployment as well, okay?

So to try and fight these differences between actual inflation and expected inflation, the new classical theory agrees that there should be some sort of monetary growth rule. So basically, increases in the money supply. So another model we discussed is the monetarist model, and the monetarist model focuses on money supply. So this is an agreement that they have with this model. The new classical theory believes that there should be steady growth, a steady growth rule in the money supply. So when I say steady growth rule for the money supply, which will help firms and workers make expectations about inflation, okay? So they're trying to make expectations about what inflation is going to be like. So if there's this steady constant rule that we're following regarding our money supply, well, we can make better guesses about what the future is going to be like. And that's what the new classical model thinks about. On a high level, you just kind of have to know about this, but we focus mainly on that Keynesian model in this class. That's the main focus of an introductory course like this.

Alright? So that is our new classical model. Let's go ahead and pause, and we'll move on to the next video.

Here’s what students ask on this topic:

What are the main differences between the New Classical Model and the Keynesian Model?

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.

Who developed the New Classical Model of economics?

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.

What is the concept of rational expectations in the New Classical Model?

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.

How does the New Classical Model view the role of government intervention in the economy?

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.

What is the significance of the steady growth rule in the New Classical Model?

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.