Question

What is the new classic macroeconomics model and what effect does government policy have on real Balance of Payments, real Inflation, real economic growth and real Unemployment?

Answer 1

New Classical macroeconomic models are developed to reformulate the Keynesian and monetarist theories. New classical economics were mainly based on classical microeconomics. Robert Lucas, Thomas Sargent, Patrick Minford and Robert Barro were the famous economists in this school. Markets clearing continuously, rational expectations and aggregate supply hypothesis are the major principle of this school. All the markets were continuously cleared in the economy and the price and wages were adjusted for this clearing. The economy is in equilibrium at both short run and long run. The prices and wages were adjusted so the level of unemployment is equilibrium unemployment. All the unemployment levels in the economy are natural rate of unemployment. If the natural rate of unemployment raises workers will not accept to do their works at low incentives. Ls Wage rate W* M Ld N* Nt Quantity of labour Point E is the equilibrium point and it determines the market clearing wage rate and price level. This point is the full employment point. There are several workers who are voluntarily unemployed in the market is shows in figure, the line EM. This voluntarily unemployed workers wish for higher wage than the equilibrium point. In new classical model, the markets are free from government intervention. So the government policies and its effect only have a small impact in the economy. If there is government intervention through expansionary fiscal policy, the balance of payment become surplus. The real wage rate may increase to attract the voluntarily unemployed workers. This may increase the productivity and also leads to economic development. Most of the theories are based on rational expectations. So most of the workers believed that the government intervention will acquire higher level of employment and wage rates. Based on the market conditions the economy tried to remain in the stable equilibrium point. Most of the new classical economists argued that the unemployment will fall down with expansion of aggregate demand. Higher market process was imposed on the basis of the higher real returns. Increased output and lowering unemployment will give temporary rise in the returns and purchasing power. This will leads to higher inflation rate.