Crash course in neoclassical economics

 
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This is the way the world ends. Not with a bang but a whimper.
The term "neoclassical" is heavily politicised and usually thrown around synonymously with neoliberal, but this really does a disservice to the school. Neoclassical micro served as the underpinning of Keynesian macro, but what I'm interested in today in neoclassical macro. It's something of a specific interest of mine, and I consider my view of the economy to be (very) broadly neoclassical.

Now, neoclassical usually refers to a "school" of thought in microeconomics; when it comes to macro people tend to use the phrase New Classical, which tried to depose the neoclassical-Keynesian synthesis as the dominant macro position. However, I'm going to be using neoclassical to discuss the "non-Keynesian" macro school in general, since it'll be easier for my to differentiate the various strands.

New Classical macro made a lot of assumptions for its models. It assumed that money was super-neutral, and thus could have no effect on the business cycle and not cause recessions; it made a number of other assumptions like homo economicus, the profit-maximising firm, rational expectations and incomplete information. However, it turned out that models based on such assumptions had very low explanatory power.

The New Classical school was originally rather novel, as it provided some of the best empirical analysis and combined a model of market-clearing equilibrium with rational expectations. However, the New Keynesians rolled up, using microfoundations to demonstrate that the market doesn't clear as the New Classicals suggested, and incorporated rational expectations into their models.

Neoclassical macro then developed Real Business Cycle Theory, which like New Classical macro claims that recessions are actually efficient market responses given the structure of the market. This essentially means that things like taxation and regulation are the drivers of the business cycle, which monetary policy having little-to-no effect. The real innovation that RBCT made over NCM was to change certain the assumption of incomplete information to full information, and add a function for productivity shocks.

Now, of course, the idea that monetary policy is neutral always and everywhere is a bit of a non-starter. If you ask what would happen if the money supply suddenly dropped by 90pc tomorrow, I don't think even the most ardent RBC theorist would claim that the market could clear in such a situation, simply because the physical denominations of money would make the payment of debt/wages impossible.

Which is where we reach the most important part. The New Neoclassical Synthesis. Now, to me, this offers the greatest explanation of the economy we see today. The evidence would suggest that RBCT can account for fluctuations in myriad economic variables over the medium-run, but it falls down during the short-run. It is fairly clear that nominal wage and price stickiness (where each have trouble falling in nominal value, thus leading to unemployment and other issues) is an issue, and dominates the business cycle in the short-run.

So, essentially, we have a model which states that in the short-run the business cycle is dominating by monetarist/New Keynesian claims of aggregate demand deficits due to monetary disequilibria (or some other hypothesis, although I find the monetary explanations the most satisfying) whereas the medium run is dominated by a Real Business Cycle (which sometimes has influence over the short-run, but not to the same extent as monetarist/NK explanations).

And essentially what this illuminates is that the job of the central bank is to make sure neoclassical macro is true, since it becomes true once complete nominal stability is obtained.


 
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Screw you, this is interesting.


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Yeah