DEPARTMENT OF ECONOMICS

ASSIGNMENT
MACROECONOMICS

SUBMITTED TO;
MISS TAYYABA RIZWI

Submitted By;
ASIA BUTT
SANA MUBASHIR
HUMA ARSHAD
SADIA ABBAS
KIRAN ANSARI

LAHORE COLLEGE FOR WOMEN UNIVERSITY,

JAIL ROAD , LAHORE,
PAKISTAN
www.lcwu.edu.pk
DATED 12-12-2014

SCHOOL OF THOUGHT IN ECONOMICS

History of intellectual series has been generated incredible School of Thought in
Economics. They played crucial role in their time.

CLASSICAL SCHOOL

The Classical school, which is regarded as the first school of economic thought, is
associated with the 18th Century Scottish economist Adam Smith, and those British
economists that followed, such as Robert Malthus and David Ricardo.
KEYNESIAN SCHOOL
British economist John Maynard Keynes believed that classical economic theory did
not provide a way to end Depressions. He argued that uncertainty caused individuals
and businesses to stop spending and investing, and government must step in and
spend money to get the economy back on track. His ideas led to a revolution in
economic thought.
NEW CLASSICAL SCHOOL
New classical macro-economics dates from the 1970s, and is an attempt to explain
macro-economic problems and issues using micro-economic concepts like rational
behavior, and rational expectations. New classical economics is associated with the
work of Chicago economist, Robert Lucas.
NEW KEYNESIAN SCHOOL
Keynesian economists broadly follow the main macro-economic ideas of British
economist John Maynard Keynes. Keynes is widely regarded as the most important
economist of the 20th Century, despite falling out of favor during the 1970s and
1980s following the rise of new classical economics. In essence, Keynesian
economists are skeptical that, if left alone, free markets will inevitably move towards
full employment equilibrium.

KEY WORDS

OPEC;

ORGANISATION OF PETROLEUM EXPORTING

COUNTRIES.

GDP;
MEBCT;
PIP;
RBC;

GROSS DOMESTIC PRODUCT.

MONETARY EQUILIBRIUM BUSINESS CYCLE
THEORY.
POLICY INEFFECTIVENESS PROPOSITION
Real business cycle

ASSIGNMENT TOPIC
QUESTION;
TO EXPLAIN ECONOMIC FLUCTUTATIONS, DIFFERENT SCHOOL OF
THOUGHT HAVE MADE SUBSTANTIAL ADVANCES WITHIN THEIR OWN
PARADIGM. EXPLAIN THOSE ADVANCES IN ECONOMIC FLUCTUATIONS
WITH REFERENCE TO MANKIW 1990.

NEW CLASSICAL SCHOOL OF THOUGHT

INTRODUCTION
In 1970, ORGANIZATION OF PETROLEUM EXPORTING COUNTRIES (OPEC)
increased the oil prices four-fold following Arab-Israel war and STAGFLATION in
Capitalist Countries. The New Classical School of Thought emerged as a distinctive
group to explain STAGFLATION because Keynesian Economics had failed then, on the
basis, of theoretical and empirical flaws.
New Classical Macroeconomists wanted to provide neo-classical microeconomic
foundation for macroeconomic analysis. Lucas was initiated in Macroeconomic analysis
and contributed by Barro (1977,1981), Sergent and Wallace (1975).
DEVELOPMENT OF NEW CLASSICAL MACROECONOMISTS
On the theoretical level, New Classical macroeconomists argue that traditional models
have assumed that expectations are formed in naive ways. Naive expectations are
inconsistent with the assumption of macroeconomics. If people are out to maximize
utility and profit, they should form their expectations in a smarter way.
RATIONA L EXPECTATIONS
If firms have rational expectations and if they set prices and wages, on this basis, then on
average, prices and wages will be set at levels that ensure equilibrium in the product and
labor market.

RELATIVE PRICES MATTER FOR OPTIMIZING DECISION

The main feature of New Classical model is that economic agents do not suffer from
money illusion and therefore, only relative prices matter for optimizing decisions.
Wage and price flexibility ensure that markets continuously clear as agents exhaust all
mutually beneficial gains from trade, leaving no exploited profitable opportunities. Hence
changes in the quantity of money should be neutral and real magnitudes will be
independent of nominal magnitudes. Yet empirical evidence shows that there is at least a
short run positive correlation between real GDP and nominal price level and negative
correlation between inflation and unemployment(Phillips Curve).This discrepancy from
the empirical evidence and theory on the neutrality of money was explained by Lucas in
Expectation and Neutrality of money in 1972.

MONETARY BUSINESS CYCLE

The important point of New Classical Model was to change the Classical assumption that
economic agents have perfect information to an assumption that agents have imperfect
information.
In Lucas model, business cycles are generated by exogenous monetary demand shocks
that transmit imperfect price signals to economic agents who in a world of imperfect
information respond to a price increased by increasing supply. The greater is the general
price variability, the lower will be the cyclical response of output to a monetary
disturbance and vice versa.
A major policy implication of the MEBCT is that a benign monetary policy would
eliminate a large source of aggregate instability. Thus New Classical Economists come
down on the side of rules in the RULE VERSUS DISCRETION debate over the
conduct of Stabilizing Policy.
POLICY INEFFECTIVENESS PROPOSITION
The PIP is a striking feature of New Classical model. Anticipated Policy has no effect on
the business cycle; only unanticipated Policy matters. It implies that one anticipated
policy is just like any other: It has no effects on output fluctuations. This proposition does
not rule out output effects from policy changes. If policy is surprise, it will have an effect
on output.

LUCAS SUPPLY FUNCTION

The supply function embodies the idea that output (y )
Depends on the difference between actual price level and the expected price level.
Y = f(p-pe)
Price surprise = Actual Price Level minus Expected Price Level
MANKIW ANALYSIS
According to Nicholas Gregory Mankiw :
Although this theory of business cycle has gained much attention during 1970, but it
declined its importance in recent times.
REAL BUSINESS CYCLE;

Beyond doubt, there is a relationship of continuity between real business cycle models
and Lucass work. They are based on the same conceptual ingredients: a perfectly
competitive economy, the equilibrium discipline, rational expectations, a stochastic
dynamic environment, and inter-temporal substitution. The three main departures
Kydland and Prescott (1982) made from Lucass approach were: abandoning his view of
a money-driven cycle, an important move, which also meant a departure from the
Friedmanian vision; replacing imperfect perfect
information: engaging in applied work. This second change deserves further attention.
Business cycles pose a special challenge for new classical economists. The economy, they
believe, is often buffeted by unexpected shocks. Shocks to aggregate demand are
typically unanticipated changes in monetary or fiscal policy. Shocks to aggregate supply
are typically changes in productivity that may result, for example, from transient changes
to technology, price of raw materials, or the organization of production. Ideally, firms
would choose to produce more and to pay their workers more when the economy has
been hit by favorable shocks and less when hit by unfavorable shocks. Similarly, workers
would be willing to work more when productivity and wage rates are higher and to take
more leisure when their rewards are lower. For both, the rule is make hay while the sun
shines.
The fact that the economy experiences good and bad shocks is not enough to explain
business cycles. An adequate theory must account for persistence, the fact that business
cycles typically display long rums good times followed by shorter, but still significant,
runs of bad times. Those new classical who regard demand shocks as dominant argue that
the shocks are propagated slowly. It is always costly to adjust production levels quickly.
Similarly, when higher production requires new capital, it takes time to build it up. And
when lower production renders existing capital redundant, it takes time to wear it out or
use it up. New classicals of the real business cycle school (led by Edward Presscott and
Finn Kydland, co- recipients of the 2004 Nobel Prize) regards to changes in productivity
as driving forces in business cycles. Because changes in technology may also come in
waves, run of favorable of unfavorable productivity(or technology) shocks may account
for some of persistence characteristic of business cycles.
Mankiw And three assumptions of RBC;
First, real business cycle theory assumes that the economy expriences large and sudden
changes in the available production technology. Many real business cycle models explain
recessions as periods of technological ability. Critics argue that large changes in
technology regress, are implausible (Summers 1986; Mankiw 1989). It is more common
presumption that technological progress occurs gradually.
Second, real business cycle theory assumes that fluctuations in employment reflect
changes in the amount, people want to work. This assumption conflicts with many
econometrics studies of labor supply using data on individuals, which typically find small

in tertemproal elasticitys of substitution (Joseph Altonji 1986).

Third, real business cycle theory assumes and this is the assumption from which the
theory derives its name, that monetary policy is irrelevant for economic fluctuation.
Before real business cycle theory entered the debated in the early 1980s, almost all
macroeconomists agreed on one proposition; money matters.
Real business cycle theorists have challenged that view using the old Keynesian argument
that any correlation of money with output arises because the money supply is endogenous
(King and Plosser 1984).

Sectoral Shifts;
Another new classical approach to the business cycle is the sectoral shift theory, which
emphasizes the costly adjustment of labor among sectors. Recent work by David Lilien
(1982) has argued that the positive correlation between the dispersion of employment
growth rates across sectors and the unemployment rate implies that sectoral shifts in labor
demand are responsible for a substantial fraction of cyclical variation in unemployment.
The business-cycle literature typically assumes that aggregate disturbances, and in
particular aggregate demand movements, are the primary cause of cyclical swings in
unemployment. The aggregate models utilized by macroeconomists usually fail to take
into account the possibility that shifts in the sectoral composition of demand can have
adverse macro consequences in an economy in which resources are not instantaneously
mobile across sectors. Lilien argues that shifts in demand from some sectors to others,
rather than movements in the level of aggregate demand, are in fact responsible for half
or more of all cyclical variation in unemployment in the postwar periods. Lillians
evidence on this point appears to have been rather widely accepted. The aggregate
demand and sectoral shift explanation for cyclical unemployment have potentially quite
different policy implication. A pure sectoral shift explanation seems to rule out a useful

role for aggregate demand policies in moderating unemployment fluctuations. Thus the
degree to which each of these two possible sources contributes to cyclical unemployment
is a matter of considerable importance.
Walrasian paradigm by assuming that when a worker moves form one sector to another,
a period of unemployment is required, perhaps for jobs search .According to the sector
shift theory, recessions are periods during which there are more sectoral shocks and thus a
greater need for sectoral adjustment.
Although there is still much empirical work being done, the weight of the available
evidence appears not to support the sectoral shift theory.

Employment, like output, would clearly rise with favorable shocks and fall with
unfavorable shocks. But having rejected the very notion of involuntary unemployment.
When a worker is laid off, he must seek a new job. He weighs the value of taking a
lower-paid job that might be easily available (a machinist might become a day laborer)
against the value of a better-paid, more suitable job that is harder to find. The new
classicals do not argue that the Unemployment job searcher is happy with his choice:
being laid off was a bad draw , and , like everyone, he prefers good luck to bad. Rather,
they argue that the works chooses what he regards as the best available option, even when
the option are poor. To remain unemployed (and to show up in the unemployment
statistics) is something that he chooses based on his judgment that the benfits of the
search outweigh the costs; this is not an exception to the rule that amount supplied equals
amount demanded.
High unemployment rates coincide with low levels of help wanted advertising
(Katharine Abraham and Lawrence Katz 1986).

Procyclical movement of workers;

The sectoral shift theory suggests that workers are moving between sectors during
recessions, the opposite appears to be the case; The measured movement of workers is
strongly Procyclical (Kevin Murphy and Robert Topel 1987).

Mankiw Analysis;
These finding suggest that the sectoral shift theory is unlikely to be plausibly reconciled
with observed economic fluctuations.
Advocates of the sectoral shifts theory argue that evidence of this sort is not persuasive. It
is possible that because the process of sectoral adjustment requires a period of high
unemployment and low income, it lowers the demand for the products of all sectors.
Thus,
we might observe low vacancies and low movement during recession, even if recessions
are initially caused by the need to reallocate labor among sectors. In this form, it is not
clearly how to distinguish empirically the sectoral shift theory from real business cycle
theories that emphasize economy-wide fluctuations in technology or Keynesian theories
that emphasize fluctuations in aggregate demand.

CONCLUSION:
New Classical Macroeconomists are also known freshwater economics (Chicago School

of Economics) in neoclassical tradition. They illuminate the distinction between the

effects of anticipated versus unanticipated policy actions. They explained that
policymakers cannot know the outcome of their decision without known the publics
expectations regarding them. New Classical macroeconomic models will be emphasized
as Benchmark model led to the development of modern macro theory. The new
classicals have made substantial advances within their own paradigms. To explain
economic fluctuations, new classicals theorists now emphasized technological
disturbances, intertemporal substitution of leisure, and real business cycle. It is so
difficult to explain that macroeconomics has found the task of controlling, predicting or
even explaining economic fluctuations. Improvement in the track record of
macroeconomics will require the development of theories that can explain why exchange
sometimes works well and other times breaks down.

REFERENCES:
Mankiw Gregory.N A Quick Refresher Course in Macroeconomics Journal of
Economic Literature, December 1990, pp.1645-1660.
Abraham, Katharine G. and Kats, Lawrence F. Cyclical Unemployment; Sectoral Shifts
or Aggregate Disturbances? J. Polit. Econ, June 1986,94(3), pp. 507-22.
www.google.com/search.