Core Economic Definitions & Theoretical Mechanisms
The New Classical school introduced rational expectations and Real Business Cycle (RBC) theory, asserting that markets clear instantly and policy is ineffective. The New Keynesian school accepted rational expectations and micro-foundations but introduced imperfect competition and nominal rigidities (menu costs, sticky prices). This formed the New Neoclassical Synthesis, the basis for modern DSGE models.
Underlying Mathematical Formulas & Equations
New Keynesian Phillips Curve (NKPC): pi_t = beta * E_t(pi_{t+1}) + kappa * x_t. Inflation depends on expected future inflation and the output gap (x_t).
Concrete Worked Numerical Example
Menu Costs: A restaurant faces a $500 cost to reprint menus if it raises prices. If raw ingredient costs increase marginally, optimal pricing might suggest raising menu prices by 1%. However, if the increased profit is less than the $500 menu cost, prices remain ‘sticky’, transmitting the shock to output rather than prices.
Real-World Empirical Application: Historical Case Study
Central bank inflation targeting regimes rely on New Keynesian models. By clearly communicating a 2% inflation target, central banks aim to anchor rational expectations (E_t(pi_{t+1}) in the NKPC). This successfully reduced inflation volatility during the Great Moderation (1985-2007).
Limitations, Criticisms, and Competing Schools of Thought
DSGE models failed spectacularly to predict the 2008 financial crisis because they largely ignored the financial sector, debt, and the possibility of severe rational irrationality. Critics argue the models prioritize mathematical elegance over real-world relevance.
Comprehensive FAQ Section
What are rational expectations?
The assumption that economic agents make forward-looking decisions optimally using all available information, meaning they cannot be systematically fooled by policymakers.
Academic References & Primary Source Citations
- Lucas, R. E. (1976). Econometric Policy Evaluation: A Critique.
- Woodford, M. (2003). Interest and Prices: Foundations of a Theory of Monetary Policy.