Before you read on: a central bank has created extra money each time unemployment rose, and people have learned the pattern. What did new classical economists expect the next boost to do?
Thomas Sargent and Neil Wallace argued that people expecting the extra money push up wages and prices in advance, so no jobs follow.
- Emerged
- Early 1970s, centred on Chicago and Minnesota universities; Lucas was then at Carnegie Mellon
- Key figures
- Robert Lucas (1937 to 2023), Thomas Sargent, Neil Wallace, Robert Barro, Finn Kydland and Edward Prescott
- Key works
- Lucas, Econometric Policy Evaluation: A Critique (1976); Barro, Are Government Bonds Net Wealth? (1974); Kydland and Prescott, Rules Rather than Discretion (1977)
- Nobel prizes
- Lucas (1995), Kydland and Prescott (2004), Sargent (2011, with Christopher Sims)
- Where it shaped policy
- The case for credible, independent central banks
- Main rivals
- Keynesians; new Keynesians from the 1980s
What it was reacting to
1960s Keynesian models assumed a stable trade-off between inflation and unemployment. Thomas Sargent notes that the main US models of around 1970 implied policy could cut unemployment to 4 per cent at the cost of 4 per cent inflation. By the mid-1970s the US had about 9 per cent of each. This was stagflation, amid oil-price shocks.
Robert Lucas and his colleagues argued that the models failed because they treated past patterns as fixed, though those rested on people's expectations.
The key ideas
Can you name the four key ideas of new classical economics?
People use all they know, including how policy is run, and so avoid repeating the same mistake. Lucas applied John Muth's 1961 idea to the whole economy. Sargent and Wallace concluded that foreseen monetary policy cannot change output or jobs.
Can you think of an example?
A government has boosted money growth before the last three elections. Firms and workers now expect it, so the next boost adds no jobs.
Lucas argued in 1976 that relationships in past data, such as the Phillips curve, depend on the policy in force. When policy changes, behaviour changes, so the old relationship misleads.
Can you think of an example?
A model built on years of 8 per cent inflation links extra inflation to lower unemployment. A 2 per cent target changes expectations, and the link breaks.
Robert Barro argued in 1974 that, under strict assumptions, households spend the same whether the government taxes now or borrows. People see that borrowing today means higher taxes later, and save to meet them.
Can you think of an example?
A government cuts taxes by £500 a household, borrowing to cover it. Expecting future taxes of equal value, plus interest, households save the money.
Kydland and Prescott argued in 1982 that booms and slumps can come from changes in productivity, with no change in total spending. The swings are the economy's efficient response to these shocks, so policy should not try to smooth them.
Can you think of an example?
New technology makes each hour of work more productive, so firms invest and people choose to work longer.