Neoclassical economics

1. Neoclassical economics Cornel Ban

2. Classical economics • 1770s-1870s • Adam Smith, David Ricardo, Say

3. Neoclassical economics • 1870-1939 • Marshall, Walras, Jevons • “The allocation of scarce resources among alternative ends” (Lord Robbins) • Marginal tradeoffs based on calculus • Assumes farsighted rationality • Individual rationality aggregates into social rationality • Markets tends towards equilibrium • Say’s Law:supply always equals demand, namely that where there is seller there must be a buyer. 

4. Neoclassical synthesis • 1939-1976 • Hicks, Samuelson, Solow • Synthesis of neoclassical and Keynesian worlds: THE neoclassical modelwas assumed to hold in the long-run while the Keynesian one was applicable in the short run and for situations when the economic situation was marked by sticky wages, liquidity traps and interest-insensitive investment • Modeling with time series econometrics • There is apermanent trade-off between inflation and unemployment; there is only a temporary trade-off • Expansionary fiscal and monetary policies in times of crisis

5. Monetarism • 1960- • Milton Friendman • An excessive supply in the quantity of money by the central bank is the most important cause of inflation, and that the vagaries of monetary policy are responsible for the cyclical fluctuations of the economy. • Governments may not know in advance what the real effects of monetary policy will be in the long term. • Hence: monetary targets, , budgetary spending cuts, quantitative controls of the increase in bank credit, strong central bank, all with a view to reduce the effective demand for goods and services. • The government’s attempts to lower it are doomed to generate either inflationary spirals if unemployment is set below the natural rate, or deflation if it is set above this rate. The most important implication of this argument is that there is no permanent trade-off between inflation and unemployment; there is only a temporary trade-off.

6. Supply-side economics • 1970s • Arthur Laffer • Reduce costs on the supply-side of the economy • Pumping up demand would simply lead to higher inflation, if it were not done in conjunction with the improvement of markets through deregulation, liberalization, privatization or free trade. • Regulation created perverse incentives and distorted resource allocation as much as it cured other problems. So, deregulate and privatize. • Reductions in welfare benefits: not based on the monetarist idea that welfare spending can be inflationary, but on the supply-side discovery that the labor supply decreases when the unemployed are offered benefits that give them incentives not to work

7. New Classical economics • 1975-1985 • Robert Lucas, Thomas Sargent • Booms and busts are created by supply-side shocks, such as technological revolutions, raw materials price spikes and radical changes in the organization of production. • Employment, like output, would rise with favorable shocks and fall with unfavorable shocks • If private agents were completely rational and if markets were competitive, it would be impossible for the government to stabilize the economy, simply because agents would adjust their inflationary expectations and “outsmart” the government. Consequently, the government’s only policy option was to credibly commit itself to anti-inflationary policies, whose costs in terms of higher unemployment could be addressed by boosting the supply-side of the economy through tax cuts and labor market deregulation.

8. New Keynesians • Late 1980s on • Blanchard, Wooford • Monetary policy activism • DGSE: They had equilibrium because they started from the premise that supply would equal demand ideally; they were dynamic because the models incorporated changing behaviour by individuals or firms (agents); and they were stochastic as ‘shocks’ to the system (trade union wage push, government spending action) were considered as random with a range of outcomes, unless confirmed otherwise). • There is a total absence of investment or profit as ‘shocks’ in these models.  Everything starts with consumer preferences • General equilibrium not lack of effective demand • No regulatory and prudential controls

9. New keynesianism • Price stability is the primary objective of monetary policy; • Monetary policy works through interest rate policy, not money supply rules (abandoned in the 80s). Price stability can be achieved through monetary policy since inflation is a monetary phenomenon; as such it can only be controlled through changes in the rate of interest. • This policy is undertaken through inflation targeting (IT). • Fiscal policy is downgraded. It should only be concerned with possibly broadly balancing government expenditure and taxation, effectively downgrading its importance as an active instrument of economic policy. This is an assumption based on the usual arguments of crowding out of government deficits and, thus, the ineffectiveness of fiscal policy; • What’s Keynesian in it? Temporary nominal rigidities in the form of sticky wages, prices, and information, or some combination of these frictions, so that the central bank, by manipulating the nominal rate of interest, is able to influence real interest rates and, hence, real spending in the short run

10. ON DGSE • :” a modern economy is populated by consumers, workers, pensioners, owners, managers, investors, entrepreneurs, bankers, and others, with different and sometimes conflicting desires, information, expectations, capacities, beliefs, and rules of behavior … To ignore all this in principle does not seem to qualify as mere abstraction – that is setting aside inessential details. “(Robert Solow) • “In four years of reflection and rather intense involvement with this financial crisis, not a single aspect of dynamic stochastic general equilibrium has seemed worth even a passing thought.” (Larry Summers)

11. New neoclassical synthesis • When monetary policy became relatively impotent at the zero bound, synthesis models clearly show fiscal policy can be highly effective at stimulating output The ‘demand denial’ is indefensible. • The Keynesian/Anti-Keynesian division is always going to be with us, because it reflects an ideological divide about state intervention