New Classical School (Rational Expectation Theory)

New classical school (Rational expectation theory)

                 -      Rational expectation theory on quantity theory of money

                 -      Rational version on quantity theory of money

                 -      Radicalist version on quantity theory of money

                 -      Radicalist version on quantity theory of money

                 -      Lucas version on quantity theory of money

The term rational expectation is used in economics only since 1961 by John Muth (American economist) by publishing an article “Rational expectation and price movement”. So, he is also considered as the father of rational expectation revolution.

But, the concept and term “Rational expectation” is widely used, highly developed and made more popular by an American economist Robert Lucas in 1972 by publishing an article called “Expectation and neutrality of money” and award Nobel prize in 1995.
Lucas is also known as the lender of new classical school of economic thought.

The theory says that people are rational and always looking forward for better future. So, the current economic behavior of people is also based on their rational expectations that depends on rational outlook, past experiences, availability of reliable and adequate data and information, (quantitative and qualitative) about the economic variables.

Hence, the theory basically deals with the current role and current effects of rational expectations on the real macro-economic variables in the future. However, the theory is based on given few assumptions:

a) Price and wage rate is perfectly flexible as said by classical school of economic thought

b) All economic agents (consumers, producers, business firm, government, etc) try to maximize utility on the basis of rational expectation

c) There is a unique equilibrium at full employment economy or potential output achieved through the price and wage rate flexibility.

On the basis of given assumptions, the theory says that,

a) Money is neutral at all the time so that the change in money supply affects only on general price level and nominal income but money supply both in short run and long run does not effects on the real output and employments.

b) There is no effect of other policies in an economy i.e. policy in ineffectiveness.

c) There is a tradeoff between price level and nominal income but no tradeoff between inflation and unemployment as in Phillips Curve.

d) Growth of economy is related to the real forces of technological progress, increase in productively of labour, increase in skilled population etc. but not money supply.

e) Market itself adjusts the equilibrium prices.

f) Although the government can help to reduce the rate of unemployment that will also lead to increase price level. So, that the government should not intervene in labour market.

According to the new classical economists, when money supply increases under the expansionary monetary policy, there is only increase in general price level and nominal income but no change in real income, output, employment and real wage rate due to rational expectation. That can be shown with the help of given figures:

Where, the first figure indicates labour market equilibrium, similarly second figure indicates equilibrium position of the economy.

If money supply increases, there is also increase in price level from P5 to P6 with increase in AD1 to AD2. So, the trade union starts decreasing supply of labour for high wage rate by shifting SL1 to SL0.

The result is only increase in price level from P5 to P7 and thereby increase in nominal income i.e. OP7 ×OY5. So, the increase in price level from P5 to P6 is known as demand pull or Keynesian inflation.

And the increase in price level from P6 to P7 is known as cost push inflation.

Again, the movement of equilibrium points of the economy from e1 to e2 and e2 to e3 is known as the cyclical inflation (inflationary cycle).

Hence, according to the rationalists, there is only increase in general price level and nominal income due to increase in money supply but no exchange in real income, output, employment and real wage rate.

However, Radicalists criticizes between Keynesianism and Monetarism but more closer to the views of monetarism so that Radicalists are known as “Keynsman”.

The similarities between Radicalists and Monetarists are like:

a) Both theories developed more or less at the same period about 1971 after the fall down of Keynesianism.

b) Both theories are based on the assumption of classical economists like wage-price flexibility.

c) Both theories concluded that “Money does not matter” in the long run

d) Both theories rejected “Phillip curve” in the long run which is perfectly inelastic or vertical (In long run Phillips curve is dead.)


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