Chapter 9. The Neoclassical Perspective

9.3 The Policy Implications of the Neoclassical Perspective

Learning Objectives

By the end of this section, you will be able to:

  • Discuss why and how economists measure inflation expectations
  • Analyze the impacts of fiscal and monetary policy on aggregate supply and aggregate demand
  • Explain the neoclassical Phillips curve, noting its tradeoff between inflation and unemployment
  • Analyze the Keynesian policy for reducing unemployment and inflation
  • Identify clear distinctions between neoclassical economics and Keynesian economics

To understand the policy recommendations of the neoclassical economists, it helps to start with the Keynesian perspective. Suppose a decrease in aggregate demand causes the economy to go into recession with high unemployment. The Keynesian response would be to use government policy to stimulate aggregate demand and eliminate the recessionary gap. The neoclassical economists believe that the Keynesian response, while perhaps well intentioned, will not have a good outcome for reasons we will discuss shortly. Since the neoclassical economists believe that the economy will correct itself over time, the only advantage of a Keynesian stabilization policy would be to accelerate the process and minimize the time that the unemployed are out of work. Is that the likely outcome?

Keynesian macroeconomic policy requires some optimism about the government’s ability to recognize a situation of too little or too much aggregate demand, and to adjust aggregate demand accordingly with the right level of changes in taxes or spending, all enacted in a timely fashion. After all, neoclassical economists argue, it takes government statisticians months to produce even preliminary estimates of GDP so that politicians know whether a recession is occurring—and those preliminary estimates may be revised substantially later. Moreover, there is the question of timely action. The political process can take more months to enact a tax cut or a spending increase. Political or economic considerations may determine the amount of tax or spending changes. Then the economy will take still more months to put into effect changes in aggregate demand through spending and production. When economists and policy makers consider all of these time lags and political realities, active fiscal policy may fail to address the current problem, and could even make the future economy worse. The average U.S. post-World War II recession has lasted only about a year. By the time government policy activates, the recession will likely be over. As a consequence, the only result of government fine-tuning will be to stimulate the economy when it is already recovering (or to contract the economy when it is already falling). In other words, an active macroeconomic policy is likely to exacerbate the cycles rather than dampen them. Some neoclassical economists believe a large part of the business cycles we observe are due to flawed government policy. To learn about this issue further, read the following Clear It Up feature.

Why and how do economists measure inflation expectations?

People take expectations about inflation into consideration every time they make a major purchase, such as a house or a car. As inflation fluctuates, so too does the nominal interest rate on loans to buy these goods. The nominal interest rate is comprised of the real rate, plus an expected inflation factor. Expected inflation also tells economists about how the public views the economy’s direction. Suppose the public expects inflation to increase. This could be the result of positive demand shock due to an expanding economy and increasing aggregate demand. It could also be the result of a negative supply shock, perhaps from rising energy prices, and decreasing aggregate supply. In either case, the public may expect the central bank to engage in contractionary monetary policy to reduce inflation, and this policy results in higher interest rates. If, however economists expect inflation to decrease, the public may anticipate a recession. In turn, the public may expect expansionary monetary policy, and lower interest rates, in the short run. By monitoring expected inflation, economists garner information about the effectiveness of macroeconomic policies. Additionally, monitoring expected inflation allows for projecting the direction of real interest rates that isolate for the effect of inflation. This information is necessary for making decisions about financing investments.

Expectations about inflation may seem like a highly theoretical concept, but, in fact the Federal Reserve Bank measures, inflation expectations based upon early research conducted by Joseph Livingston, a financial journalist for the Philadelphia Inquirer. In 1946, he started a twice-a-year survey of economists about their expectations of inflation. After Livingston’s death in 1969, the Federal Reserve Bank and other economic research agencies such as the Survey Research Center at the University of Michigan, the American Statistical Association, and the National Bureau of Economic Research continued the survey.

Current Federal Reserve research compares these expectations to actual inflation that has occurred, and the results, so far, are mixed. Economists’ forecasts, however, have become notably more accurate in the last few decades. Economists are actively researching how inflation expectations and other economic variables form and change.

Visit this website to read “The Federal Reserve Bank of Cleveland’s Economic Commentary: A New Approach to Gauging Inflation Expectations” by Joseph G. Haubrich for more information about how economists forecast expected inflation.

Keynesian Policy for Fighting Unemployment and Inflation

Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right. For example, if aggregate demand was originally at ADr in Figure 9.12, so that the economy was in recession, the appropriate policy would be for government to shift aggregate demand to the right from ADr to ADf, where the economy would be at potential GDP and full employment.

Keynes noted that while it would be nice if the government could spend additional money on housing, roads, and other amenities, he also argued that if the government could not agree on how to spend money in practical ways, then it could spend in impractical ways. For example, Keynes suggested building monuments, like a modern equivalent of the Egyptian pyramids. He proposed that the government could bury money underground, and let mining companies start digging up the money again. These suggestions were slightly tongue-in-cheek, but their purpose was to emphasize that a Great Depression is no time to quibble over the specifics of government spending programs and tax cuts when the goal should be to pump up aggregate demand by enough to lift the economy to potential GDP.

The graph shows three possible downward-sloping AD curves, an upward-sloping AS curve, and a vertical, straight potential GDP line.
Figure 9.12 Fighting Recession and Inflation with Keynesian Policy If an economy is in recession, with an equilibrium at Er, then the Keynesian response would be to enact a policy to shift aggregate demand to the right from ADr toward ADf. If an economy is experiencing inflationary pressures with an equilibrium at Ei, then the Keynesian response would be to enact a policy response to shift aggregate demand to the left, from ADi toward ADf.

The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment. If aggregate demand was originally at ADi in Figure 9.12, so that the economy was experiencing inflationary rises in the price level, the appropriate policy would be for government to shift aggregate demand to the left, from ADi toward ADf, which reduces the pressure for a higher price level while the economy remains at full employment.

In the Keynesian economic model, too little aggregate demand brings unemployment and too much brings inflation. Thus, you can think of Keynesian economics as pursuing a “Goldilocks” level of aggregate demand: not too much, not too little, but looking for what is just right.

Visit this website to read about the effects of economic intervention.

Fighting Unemployment or Inflation?

As we explained in Unemployment, economists divide unemployment into two categories: cyclical unemployment and the natural rate of unemployment, which is the sum of frictional and structural unemployment. Cyclical unemployment results from fluctuations in the business cycle and is created when the economy is producing below potential GDP—giving potential employers less incentive to hire. When the economy is producing at potential GDP, cyclical unemployment will be zero. Because of labor market dynamics, in which people are always entering or exiting the labor force, the unemployment rate never falls to 0%, not even when the economy is producing at or even slightly above potential GDP. Probably the best we can hope for is for the number of job vacancies to equal the number of job seekers. We know that it takes time for job seekers and employers to find each other, and this time is the cause of frictional unemployment. Most economists do not consider frictional unemployment to be a “bad” thing. After all, there will always be workers who are unemployed while looking for a job that is a better match for their skills. There will always be employers that have an open position, while looking for a worker that is a better match for the job. Ideally, these matches happen quickly, but even when the economy is very strong there will be some natural unemployment and this is what the natural rate of unemployment measures.

The neoclassical view of unemployment tends to focus attention away from the cyclical unemployment problem—that is, unemployment caused by recession—while putting more attention on the unemployment rate issue that prevails even when the economy is operating at potential GDP. To put it another way, the neoclassical view of unemployment tends to focus on how the government can adjust public policy to reduce the natural rate of unemployment. Such policy changes might involve redesigning unemployment and welfare programs so that they support those in need, but also offer greater encouragement for job-hunting. It might involve redesigning business rules with an eye to whether they are unintentionally discouraging businesses from taking on new employees. It might involve building institutions to improve the flow of information about jobs and the mobility of workers, to help bring workers and employers together more quickly. For those workers who find that their skills are permanently no longer in demand (for example, the structurally unemployed), economists can design policy to provide opportunities for retraining so that these workers can reenter the labor force and seek employment.

Neoclassical economists will not tend to see aggregate demand as a useful tool for reducing unemployment; after all, with a vertical aggregate supply curve determining economic output, then aggregate demand has no long-run effect on unemployment. Instead, neoclassical economists believe that aggregate demand should be allowed to expand only to match the gradual shifts of aggregate supply to the right—keeping the price level much the same and inflationary pressures low.

If aggregate demand rises rapidly in the neoclassical model, in the long run it leads only to inflationary pressures. Figure 9.13 shows a vertical LRAS curve and three different levels of aggregate demand, rising from AD0 to AD1 to AD2. As the macroeconomic equilibrium rises from E0 to E1 to E2, the price level rises, but real GDP does not budge; nor does the rate of unemployment, which adjusts to its natural rate. Conversely, reducing inflation has no long-term costs, either. Think about Figure 9.13 in reverse, as the aggregate demand curve shifts from AD2 to AD1 to AD0, and the equilibrium moves from E2 to E1 to E0. During this process, the price level falls, but, in the long run, neither real GDP nor the natural unemployment rate changes.

The graph shows three aggregate demand curves that all intersect with the vertical potential GDP line at around 62 on the x-axis, but at different price levels.
Figure 9.13. How Aggregate Demand Determines the Price Level in the Long Run As aggregate demand shifts to the right, from AD0 to AD1 to AD2, real GDP in this economy and the level of unemployment do not change. However, there is inflationary pressure for a higher price level as the equilibrium changes from E0 to E1 to E2.

Visit this website to read about how inflation and unemployment are related.

Fighting Recession or Encouraging Long-Term Growth?

Neoclassical economists believe that the economy will rebound out of a recession or eventually contract during an expansion because prices and wage rates are flexible and will adjust either upward or downward to restore the economy to its potential GDP. Thus, the key policy question for neoclassicals is how to promote growth of potential GDP. We know that economic growth ultimately depends on the growth rate of long-term productivity. Productivity measures how effective inputs are at producing outputs. We know that U.S. productivity has grown on average about 2% per year. That means that the same amount of inputs produce 2% more output than the year before. We also know that productivity growth varies a great deal in the short term due to cyclical factors. It also varies somewhat in the long term. From 1953–1972, U.S. labor productivity (as measured by output per hour in the business sector) grew at 3.2% per year. From 1973–1992, productivity growth declined significantly to 1.8% per year. Then, from 1993–2014, productivity growth increased slightly to 2% per year. The neoclassical economists believe the underpinnings of long-run productivity growth to be an economy’s investments in human capital, physical capital, and technology, operating together in a market-oriented environment that rewards innovation. Government policy should focus on promoting these factors.

Summary of Neoclassical Macroeconomic Policy Recommendations

Let’s summarize what neoclassical economists recommend for macroeconomic policy. Neoclassical economists do not believe in “fine-tuning” the economy. They believe that a stable economic environment with a low rate of inflation fosters economic growth. Similarly, tax rates should be low and unchanging. In this environment, private economic agents can make the best possible investment decisions, which will lead to optimal investment in physical and human capital as well as research and development to promote improvements in technology.

Summary of Neoclassical Economics versus Keynesian Economics

The table below summarizes the key differences between the two schools of thought.

Table 9.3 Neoclassical versus Keynesian Economics
Summary Neoclassical Economics Keynesian Economics
Focus: long-term or short term Long-term Short-term
Prices and wages: sticky or flexible? Flexible Sticky
Economic output: Primarily determined by aggregate demand or aggregate supply? Aggregate supply Aggregate demand
Aggregate supply: vertical or upward-sloping? Vertical Upward-sloping
Phillips curve vertical or downward-sloping Vertical Downward sloping
Is aggregate demand a useful tool for controlling inflation? Yes Yes
What should be the primary area of policy emphasis for reducing unemployment? Reform labor market institutions to reduce natural rate of unemployment Increase aggregate demand to eliminate cyclical unemployment
Is aggregate demand a useful tool for ending recession? At best, only in the short-run temporary sense, but may just increase inflation instead Yes

Self-Check Questions – answers available at end of chapter

  1. Legislation proposes that the government should use macroeconomic policy to achieve an unemployment rate of zero percent, by increasing aggregate demand for as much and as long as necessary to accomplish this goal. From a neoclassical perspective, how will this policy affect output and the price level in the short run and in the long run? Sketch an aggregate demand/aggregate supply diagram to illustrate your answer. Hint: revisit [link].
  2. Would it make sense to argue that rational expectations economics is an extreme version of neoclassical economics? Explain.


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