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Economics: New Classical Macroeconomics


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About this Lesson

  • Type: Video Tutorial
  • Length: 8:32
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 91 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Monetary and Fiscal Policy (17 lessons, $27.72)
Economics: Monetary Policy: Alternative Approaches (3 lessons, $4.95)

This economics video lesson will teach you about new classical macroeconomics. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Can a change in the aggregate price level influence output in the economy? The new classical macroeconomics says yes, and their idea about how prices influence output can be captured in this story that was told by Nobel Laureate Robert Lucas. This is the way new classical macroeconomics works.
People are generalists in their consumption, but specialists in their production. Suppose we have two people, Harry and Louise, and Harry and Louise live on two separate islands and they cannot communicate with one another. Harry and Louise are each specialists in production. Harry produces automobiles. Louise, on her island, produces computers. Now, Harry and Louise each uses the money they earn from their respective production to buy a whole basket of goods. Harry buys some cars, some computers, some food, some movie tickets, some healthcare and so forth, and the same with Louise. Now, what motivates Harry? If the price of automobiles rises relative to the price of all of the stuff he buys, then there has been an increase in Harry's return to labor; that is, his real wage has risen. Working a given number of hours, Harry can afford now to buy more stuff if the price of automobiles is high relative to the price of other goods. On the other hand, if the price of automobiles is low relative to the price of other goods, then Harry's return to labor has fallen. His real wage has fallen and he's going to be less inclined to work, because the reward isn't as big. He's going to be more inclined to take more of his satisfaction in the form of leisure. The same thing is true of Louise. Louise watches the price of calculators relative to the price of all other goods. And when that price is high, she works harder and, when that price is low, she doesn't work as hard.
Now, let's introduce a little wrinkle into this story, and that is suppose Harry is able to tell very quickly if the price of automobiles is changing, but he doesn't see the price of other goods as quickly. He doesn't find out other prices until a little bit later. The same thing is true with Louise. She sees changes in the price of computers, her output, immediately. But it takes her a while to figure out what's happening to the price of other goods. This creates the possibility for some confusion. That is, if Louise sees that the price of computers is rising, she's got to try to figure out is it true that computers are relatively widely demanded and the price of computers is being bid up, because everyone is buying computers? Or is there just inflation in the economy and the price of computers is going up along with the price of cars and everything else? Now, you can see this makes a difference to Louise, because if the price of computers rises relative to the price of everything else, she is going to work harder. But if it's general inflation, so the price of computers is going up along with the price of everything else, then there's no payoff to Louise for working any harder, and she would choose not to. She'd keep working the same number of hours as before. Louise is trying to figure out whether an observed increase in the price of computers means a special opportunity for Louise or whether it's just general economy-wide inflation. And Harry faces the same decision whenever he see the price of trucks go up. Should he work harder or is this just general inflation, so that there's no return for harder work?
Now, since Louise observes only the price of computers and not the general price level, when the price of computers goes up, Louise is going to gamble that, in fact she has a new opportunity to make profit. She's going to gamble by working harder. That is, she's going to split difference. She's not going to work as hard as if she was sure, but she's going to work harder than if there were no change in the price. She's taking a chance and that affects her behavior. The same with Harry. So let's tell this story now with a simple example.
Here's the formula that explains the labor supply of a person in this island model. In this little island economy, the labor supply of Louise or the labor supply of Harry is a function of the difference between the price level they observe and the price level they expected. That is, if their particular price is higher than they expected, then they're going to work harder, because they think they may have an opportunity to get ahead. So let's start this story with an expected price level on Harry's island of 10 and an expected price level on Louise's island also of 10; that is, if they observe a price level of 10, they're going to work just as hard as they planned on working, and let's say that's 8 hours a day for both of our two players. Now, let's get this story rolling.
Let's suppose that the price level winds up being higher than they expected, that Harry sees that the price of car is 11 not 10, and Louise sees that the price of computers is 11 not 10. What are they going to do? Well, Harry things, "Huh, is it just cars that are rising in price? If so, I'm going to work harder to take advantage of this opportunity so I can use the extra money I earn to buy all the other goods that are still at the same low price." However, if it's inflation, he doesn't want to do that, because he's not going to be getting ahead. But, since he's not sure, he splits the difference and works harder. Harry decides to work 12 hours instead of 8. Same with Louise. Louise works 12 hours instead of 8, because she thinks there's a chance to get ahead. Look what just happened; when the price level went up, we got a lot more work out of our two workers and therefore we got more output in the economy. That's the way the Lucas story works. However, in the next period, Harry and Louise are both going to expect higher prices. So if the prices stay at 11, they're going to go back to their old levels of work. That is, the price level adjusts in their expectations, they're now used to 11 as the price, if the price level stays at 11, they're going to go back to where they were to being with. How do we get them to work hard again? Give them an unexpected price increase. And how do you get an unexpected price increase? You can get it by increasing the money supply. Increase the money supply, pump up prices and then people are confused for a while. And, while they're confused, they'll work harder. And, while they're working harder, output is greater.
This is Robert Lucas' story, the new classical macroeconomics story about how prices can influence output. When you confuse people, you make them work harder. But notice, getting people to work harder depends completely on confusion. The moment the confusion clears, there's no harder work. See, if Harry and Louise new what the prices were on each others' islands, they could figure out that, in fact, it's inflation, it's not an increase in demand for cars, it's not an increase in demand for computers, it's just general plain old inflation. And once they figure that out, they're going to go back and work at the same level they planned to work at. It all runs on surprise. So this is how money policy can influence output in a world where people are trying to figure out what's going on. You shock them, you surprise them, and you give them something they didn't expect. And, until they figure out what's going on, they're going to work a little bit harder in the meantime.
Now, this brings us to what some economists call real business cycle theory. When things happen that change the productivity of labor on these two islands, if Harry, for example, gets especially good weather one day, then he's going to work harder, even if prices haven't changed, because other things are influencing his productivity. If a new technological development comes along that lets Louise make computes with less effort today, then she's going to work a little bit harder, because of this nice, fortunate accident that's influenced her opportunities. Real business cycle theory says that increases and decreases in output in the economy, recessions, booms, troughs, all of that is driven at the root by changes in the real economy. Changes in technology, changes in business opportunities, changes in things that are actually part of the tangible production process, not just money, not just government spending. Real business cycle theory is kind of like this story, only instead of looking for changes in prices you look for other changes in the environment that can influence your productivity. And when they change, everyone works harder.
So there you have it, the foundation of new classical macroeconomics. People get confused and, while the confusion persists, they may work harder to take advantage of what they think is an opportunity to better themselves.
Monetary and Fiscal Policy
Monetary Policy: Alternative Approaches
New Classical Macroeconomics Page [2 of 2]

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