Question

What is the difference between old classical and new classical economics?

Short answer

Short Answer: Old classical economics, championed by economists like Adam Smith and David Ricardo, emphasizes the role of the market, free trade, and the "invisible hand" in driving economic growth and prosperity, with an assumption of flexible wages and prices. New classical economics, developed by economists like Robert Lucas Jr. and Thomas Sargent, incorporates microeconomic foundations, rational expectations, and the idea that market fluctuations are primarily due to exogenous shocks. Key differences between the two include assumptions about flexibility, microeconomic foundations, rational expectations, the role of market fluctuations, and policy implications.

Step-by-step solution

Define Old Classical Economics

Old classical economics, also known as classical economics, refers to the set of economic ideas that were widely accepted and taught before the Great Depression in the 1930s. The key features of classical economics include the theories of Adam Smith, David Ricardo, and John Stuart Mill, among others. Emphasis is placed on the role of the market, free trade, and the "invisible hand" in driving economic growth and prosperity. Classical economists believed that markets would self-regulate and tend to full employment in the long run, given flexible wages and prices.

Define New Classical Economics

New classical economics, also known as neoclassical economics or modern classical economics, emerged in the late 20th century as an evolution and the refinement of classical economics. It includes the works of economists such as Robert Lucas Jr., Thomas Sargent, and Edward Prescott. New classical economists have integrated microeconomic foundations and rational expectations into their models. They argue that market fluctuations and business cycles are mainly due to exogenous shocks, rather than inherent market failures. According to new classical economists, economic agents are rational and have perfect information, thus markets are assumed to clear quickly and efficiently.

Highlight The Key Differences

Now that we have briefly described each of the two economic theories, we can highlight the key differences between them: 1. Assumptions about flexibility: Old classical economics assume that wages and prices are flexible, while new classical economics recognize that real-world markets may have rigidities and frictions that prevent perfect flexibility. 2. Microeconomic foundations: New classical economics has a stronger focus on microeconomic foundations and the behavior of economic agents, while old classical economics relies more heavily on macroeconomic concepts and themes. 3. Rational expectations: New classical models incorporate rational expectations, meaning that economic agents form their expectations about the future based on the optimal use of available information. This contrasts with the old classical models, where agents do not necessarily have rational expectations. 4. Role of market fluctuations: New classical economists argue that market fluctuations and business cycles are primarily due to exogenous shocks, whereas old classical economists believe that market fluctuations can result from inherent market failures. 5. Policy implications: Given their different assumptions and conclusions about the behavior of markets, old classical and new classical economics have different policy implications. For example, new classical economists generally advocate for limited government intervention in the economy, whereas old classical economists may support certain government measures to address market failures. By following these steps, we have differentiated between old classical and new classical economics, examining their key features and highlighting the main differences that set them apart.

Key concepts

Economic Theories and Models

Understanding the underlying principles of economic thought is essential in grasping the contrast between classical and new classical economics.

Classic economic theories, foundational to economics as a discipline, stem from the works of Adam Smith and his compatriots who introduced concepts like the invisible hand and the notion of free markets leading to economic equilibrium.

Main Components of Classical Economics

• Market-driven growth and free trade as catalysts for prosperity.
• The belief in markets' self-regulation and tendency towards full employment with flexible wages and prices.

In contrast, new classical economics evolved with advanced mathematical modeling and incorporated nuanced understandings of microeconomic behaviors into the macroeconomic narrative. This branch of economics is equipped with sophisticated models to explain economic phenomena, taking into account the rational expectations of individuals and market efficiencies.

Distinct Features of New Classical Economics

• Integration of microeconomic behaviors with macroeconomic theories.
• The assumption that individuals have rational expectations and access to complete information.
• Emphasis on exogenous shocks as primary instigators of economic fluctuations.

This shift in thought has led to the development of dynamic stochastic general equilibrium (DSGE) models that combine time, randomness, and microeconomic foundations to explain how economies operate over time.

Market Efficiency and Rational Expectations

A key concept distinguishing new classical from classical economics is the rational expectations theory. This theory posits that individuals make decisions based on all available information and in anticipation of future events.

This entails not simply reactionary behavior to present circumstances but a proactive forecasting of future market conditions and economic policies.

Implications of Rational Expectations

• Markets are seen to be efficient as individuals will adjust their behavior to optimize outcomes.
• It challenges the effectiveness of governmental intervention in the market because people are expected to respond in ways that can counteract policy changes.

Rational expectations are critical in new classical economic models, which assumes that because agents act strategically, markets will clear quickly without necessitating significant governmental interference. This theory often leads to the conclusion that markets are generally capable of self-correction.

Macroeconomics and Microeconomic Foundations

The melding of macroeconomics with microeconomic foundations is a hallmark of new classical economics. New classical economists stress that to truly understand the economy as a whole, one must start with the individual components that comprise it.

This approach takes into account how individual choices, driven by preferences and constraints, shape aggregate outcomes like GDP, unemployment rates, and inflation.

Benefits of Integrating Micro and Macro

• Provides a more comprehensive view of economic activities.
• Facilitates the creation of more granular and accurate economic models.
• Allows for the analysis of policy effects on individual behavior and vice versa.

By focusing on the decision-making processes of households and firms, and not just aggregated data, economists can better understand and predict the mechanisms of the market on a granular level while simultaneously observing macroeconomic trends.

Economic Policy Implications

The diverging viewpoints of classical and new classical economics have profound implications for economic policy. Classical economists might advocate for governmental measures to correct market failures, such as public goods provision or addressing externalities.

New classical economists, however, favor minimal government intervention, believing that policies are often ineffective as rational individuals anticipate and neutralize their effects.

Policy Stances

• New classical advocates suggest that adaptive market expectations reduce the impact of fiscal and monetary policy.
• Classical economists may support interventionist policies during periods of downturn and imbalance.

Overall, these economic schools provide policymakers with frameworks for understanding how economic agents might respond to regulation, taxation, and spending, effectively shaping the debate on the appropriate role of government in managing the economy.