Introduction to Macroeconomic Schools of Thought
The Keynesian school of thought, which dominated the field of economics for many years, faced two major challenges. The first challenge came from the monetarist school, but it was the second challenge, led by Robert E. Lucas, Jr., that introduced the New Classical school of thought, which had a significant impact on the field of macroeconomics.
The New Classical School and Rational Expectations
The New Classical school, led by Robert E. Lucas, Jr., introduced the concept of rational expectations. According to this idea, decision makers in the economy do not just look at current and past data when making decisions. Instead, they also form expectations about the future based on all the information available to them. This means that if a change in monetary policy is predicted, it will have no effect on real variables such as output and the unemployment rate, because decision makers will have already taken the implications of that policy into account. As a result, predictable changes in monetary policy will only affect nominal variables such as prices and wages.
Real-Business-Cycle Models
Following Lucas’s work, economists such as Finn E. Kydland and Edward C. Prescott developed real-business-cycle (RBC) models. These models used strong mathematical foundations and the concept of rational expectations to explain the fluctuations of the business cycle. RBC models argued that macroeconomic fluctuations are the result of external and internal shocks, such as changes in technology. However, these models were criticized for overemphasizing the role of technology and underemphasizing the role of monetary and fiscal policy.
The New Keynesian Response
In response to the RBC models, a new Keynesian school of thought emerged in the 1980s. New Keynesians, such as John B. Taylor and Stanley Fischer, adopted the rigorous modeling approach of the RBC models but modified some of the underlying assumptions. They introduced the concept of "stickiness" in nominal variables such as prices and wages, which are often locked in by contractual agreements. This stickiness means that economic decision makers may react to macroeconomic events by altering other variables, such as employment.
The Impact of Market Imperfections
The introduction of market imperfections, such as wage and price stickiness, helped to build more accurate macroeconomic models. These models showed that in a world with market imperfections, monetary policy can have a direct impact on output and employment in the short run. This is because wages and prices are slow to adjust, giving central banks the ability to influence the business cycle. However, in the long run, the imperfections become less binding, and monetary policy can only influence prices.
Conclusion
The development of new Keynesian models has led to a consensus that monetary policy is effective in the short run and can be used to tame business cycles. The financial crisis of 2007-08 and the Great Recession that followed have revived interest in the new Keynesian approach, which is likely to lead to improved theories and better macroeconomic models in the future. Overall, the evolution of macroeconomic thought has highlighted the importance of understanding the complexities of the economy and the role of monetary policy in shaping economic outcomes.
