New Classical Macroeconomics

Abstract

Over the past two decades or so a new radical alternative to Keynesian macroeconomics has been developed, principally by Lucas and a number of other authors (see, e.g., Friedman, 1968; Phelps, 1970; Lucas, 1972, 1975, 1976; Kydland and Prescott, 1977; Sargent and Wallace, 1975). This approach is now commonly referred to as the new classical macroeconomics. The bedrock postulates of the approach are, first, that observed outcomes in an economy are the result of the equilibration of demand and supplies and are, consequently, market-clearing outcomes. Second, the demand and supply functions in the economy are the result of intertemporal optimising decision of rational maximising firms and individuals. Third, that in many circumstances, agents will not have perfect information and accordingly will have to form expectations of current and future outcomes. These expectations are assumed to be formed rationally, which means that expectations are correct on average, forecast errors are not serially correlated when allowance is made for the forecast horizon, and forecast errors are uncorrelated with information available at the time expectations were formed (see Chapter 2 and Holden, Peel and Thompson, 1985). Since the first postulate is common to the old classical macroeconomics, it is the assumption of the absence of perfect information and its replacement with rational expectations, as well as the derivation of the aggregate behaviour of the economy as the result of the dynamic optimising behaviour of firms and individuals, which adds the new flavour to the new classical economics.