Question

Why is the new classical theory associated with the word "classical?" Why has it been said that classical theory failed where new classical theory succeeds- because the former could not explain the business cycle (the ups and downs of the economy), but the latter can?

Short answer

The 'classical' in New Classical theory refers to the fundamental belief that free markets can regulate themselves. While both theories share this belief, New Classical theory introduced the concept of rational expectations and suggested that markets, including the labor market, clear themselves, thereby providing a more comprehensive explanation of the business cycle. The original classical theory, which assumed the economy always operates at full employment, failed to explain the business cycle's ups and downs, a shortcoming addressed by the New Classical theory.

Step-by-step solution

Deciphering the 'Classical' Aspect

Both 'Classical' and 'New Classical' theories follow the fundamental economic view that free markets can regulate themselves when left alone, thus the word 'classical'. Classical theory, developed in the 18th and 19th century, assumes that the economy is always at the state of full employment. New classical theory, developed in late 20th century, varies from the classical view by including the advanced concept of rational expectations into its analysis. It maintains the classical view in a more modernized and pragmatic manner.

Where Classical Theory Fell Short - Business Cycle

Classical theory assumed that the economy always operates at full employment due to flexible prices, and did not consider the possibility of fluctuations or variations in employment and production levels. As a result, it was unable to explain occurrences of underemployment and oscillation between economic growth and decline, a phenomenon known as the business cycle. This was a significant shortcoming of the classical theory.

How New Classical Theory Succeeds

New Classical theory introduced the concept of rational expectations, suggesting individuals and firms make decisions based on the best information available and learn from past mistakes. This theory suggests that market clearing happens not only in the goods market but also in the labour market, leading to a better understanding of the business cycle. This assertion allows the theory to explain how economies may not always be operating at full employment and thus, is better equipped to explain changes in the business cycle. It succeeds where classical theory failed by offering a more comprehensive and realistic interpretation of economic conditions and shifts.

Key concepts

Classical Theory

The classical theory of economics is a concept with roots in the 18th and 19th centuries, emerging from the ideas of renowned economists like Adam Smith. It is predicated on the belief that free markets are capable of regulating themselves without the need for significant government intervention.

Key to this theory is the principle of 'laissez-faire'—a hands-off approach advocating minimal government involvement in economic matters. The classical model assumes that prices for goods and services are flexible and so are wages. This flexibility promotes self-correcting mechanisms within an economy, leading to what is known as full employment. Full employment, in classical economics, implies that anyone who wants to work at the going wage rate can find employment.

However, this school of thought did not account for economic downturns and persistent unemployment, making it inadequate in addressing the real-world phenomena of economic cycles.

Business Cycle

The term 'business cycle' refers to the fluctuations that an economy experiences over time, represented by periods of expansion (growth) or contraction (recession) in economic activity. Throughout history, economies have naturally undergone these cycles, which are characterized by varying levels of GDP, employment, and other economic indicators.

Classical theorists had difficulty explaining the business cycle because their models hinged on the notion that an economy would naturally return to a state of full employment due to price and wage flexibility. Contrary to their predictions, economies would often experience prolonged periods of unemployment and output levels beneath full capacity, defying the classical paradigm.

Rational Expectations

Introduced by new classical economists in the late 20th century, the concept of rational expectations emerged as a game-changing hypothesis. It states that individuals and firms make decisions based on the best available information and that they learn from past trends and mistakes, thereby forming expectations about economic variables (like inflation, interest rates) in a rational manner.

This concept is a cornerstone of new classical macroeconomics because it implies that people are not easily fooled by policies that aim to exploit short-term economic relationships, which can otherwise result in unintended long-term effects. The ability of individuals to anticipate the consequences of economic policy can neutralize the intended stimulus and thus questions the efficacy of government intervention.

Full Employment

In economic terms, full employment doesn't imply zero unemployment, rather it represents a condition where all available labor resources are being utilized in the most efficient manner. It's commonly associated with the 'natural rate of unemployment,' which accounts for frictional and structural unemployment that exist even in a healthy economy.

New classical economics modifies the classical concept of full employment by incorporating the idea that even with fully flexible prices and wages, the labor market could be in equilibrium without offering a job to everyone who wants one. The implications of rational expectations add another layer of depth to the understanding of why full employment does not necessarily mean every individual in the labor force is employed.

Market Clearing

Market clearing is an economic concept denoting a state where the quantity supplied is equal to the quantity demanded—meaning there is no surplus or shortage in the market. Classical theory posited that markets always clear via adjustments in prices.

The introduction of market clearing in the labor market was a significant new classical revision to the earlier classical model. In the new classical view, the labor market clears at the natural rate of unemployment, taking into account vacancies, job search time, and the matching process between employers and job seekers. This perspective allows for a better understanding of the complexities involved in the employment market and the reasons why an economy might deviate from a state of full employment.