New Classical Macroeconomics (NCM) arise from the development of the neoclassical economics principles, such as market clearing and optimization behavior by economic agents, which relate this school to monetarism. Its rise as a doctrine can be traced to the work in the early 1970s of its lead economist Robert Lucas (Chicago School).

Indeed, Lucas developed in 1973 what is known as rational expectations, an improvement on the adaptive expectations hypothesis used by monetarists, which changed the way macroeconomic analysis (and econometric analysis) is undertaken. These rational expectations are still used nowadays in macroeconomics.

Regarding policymaking, the NCM believes that no government intervention concerning demand is beneficial for the economy, not even in the short run. They argue that government can promote growth and stabilize the economy only through supply-side policies.

Economists such as Thomas Sargent, Edward Prescott, Neil Wallace and Robert Barro are amongst the most renowned NCM economists, whose theories are usually opposed to those of the followers of New Keynesian Economics.

New Classical Macroeconomics takes expectations one step further than monetarists did when using adaptive expectations. Rather than supposing that agents will learn to adjust their behaviour based on past experiences, they apply rational expectations, and directly assume that:

• All agents have sufficient working knowledge of the economy and its basic structural relationships to anticipate cause and effect;
• All agents assume that markets naturally reach an equilibrium;
• Information is perfect: market force drivers are ‘common knowledge’.

This all signals a return to the cornerstones of neoclassical economics, and although in practical terms it may be a slight stretch, it means taking the expectations-augmented Phillips curve one step further:

As New Classical Macroeconomics views it, agents are able to anticipate future events without needing to have experienced them previously. This time around, agents will anticipate expansionist monetary policies, and therefore skip point B. Agents have sufficient working knowledge of the economy and monetary policy is transparent enough for agents to directly associate a fall in interest rates with a rise in inflation. Therefore, they waste no time in asking for salary raises (the change on inflation expectations shift the curve directly to point C), and inflation rises before a drop in unemployment is ever reached. Expansionist monetary policy is not even effective in the short term. In the very short term, a small effect might exist, but only as a result of the time needed for expectations to lead to action.

The only way for monetary policy to work under these scenarios is for it to be enough of a surprise and of enough magnitude to pose an economic shock. If agents are not expecting dramatic policy, they have no time to put themselves in order. In this way, economic policy must go beyond expectations, otherwise even an inkling that the government is likely to act will lead to agents immediately counteracting policy, probably before policy is even enacted.

The static theory of labour demand does not specify how, or how long adjustments between production factors take. It is therefore necessary to consider the notion of adjustment costs, such as costs incurred by a company to change the number of factors.

We will follow the lines followed in the model of adjustment costs seen in “Le marché du travail”, 2001, by Pierre Cahuc. These adjustments involve production costs that do not correspond to the activity itself. There are two kinds of adjustment costs:

-Internal adjustment costs: those caused by the loss of efficiency due to reorganization within the company (for example, training for use of new machinery, training of new employees to existing machinery, etc.).

-External adjustment costs: those who can be differentiated from production variations (for example, hiring experts to implement the changes, layoff payments, etc.).

As Cahuc explains, previous studies on the labour markets in the United States and France allow us to compare the situation of two types of markets:

-Recruitment costs are higher than firing costs in the U.S.;

-Firing costs are higher than recruitment costs in France;

-Recruitment costs in the U.S. are higher than in France;

-Firing costs are higher in France than in the U.S.

Furthermore, these studies conclude that these costs increase with the level of wage and/or training.

Employment protection by the public sector is less rigorous in the U.S., Canada or the U.K. than in France, Germany and southern Europe. Furthermore, these studies conclude that much of the higher cost of firing in Europe is due to administrative or regulatory costs (due to the legislation of each country).

LINEAR FORMULATION:

In most jobs, costs are represented by a symmetric convex function (usually quadratic). However, this does not explain asymmetrical adjustments and discontinuous employment. Thus, we see the linear formulation, which is commonly used nowadays.

This representation will show us how companies sometimes hire or fire employees, or remain as they are.

c_h and c_f represent hiring costs (h) and firing costs (f). Adjustment of employment will therefore be asymmetricif c_h ≠ c_f.

EMPLOYMENT ADJUSTMENT:

It is possible to differentiate the effects of c_h and c_f when adopting a linear function. Furthermore, the linearity will see how the adjustment in the levels of labour can be immediate.

We define the adjustment cost function as:

The producer’s problem is choosing the level of labour that maximises its profits: 

(r=is the rate at which future profits are actualised to present value)

The employment level is given by the equation:

which translates into the following conditions:

In all other cases, the producer maintains its level of staff. As we assume w, r, c_h and c_f constant, we can define employment levels L_h and L_f  as:

The company adjusts its level of workers L_h (respectively L_f) if this is higher (respectively lower) than the initial level of employment L₀. If not, it means that L₀ is maintained between L_h and L_f, its optimal level:

GRAPHICAL ANALYSIS:

The curves in the lower half of the adjacent figure represent the relationship between initial employment and final employment levels. The conclusions we can derive from this model are:

-↑c_f: An increase in firing costs (U.S. spending levels to levels of FR.) Prevents staff adjustment downwards, and no incentive to hire;

-↑c_h: Increased recruitment costs (FR. spending levels to U.S. levels) prevents new hires;

-↓c_h: A lower recruitment cost always has positive effects on employment because it increases the optimal level of employment L_h;

Therefore, this model explains:

· higher unemployment in France (for little flexibility when firing);

· when wages are equal in both economies, U.S. production levels will be higher;

· in recessions, the situation is worse in France because it’s hard to fire employees;

· in times of expansion, the situation is worse in the U.S. because it’s hard to hire.

The main conclusion that can be derived from this model is that proper management of the costs of hiring and firing ensures greater stability in the demand for labour.

The New Keynesian Economics seeks to provide Keynesianism with microeconomic foundation support. This contemporary economic doctrine comes as a response to the critiques that Keynesianism received from the New Classical Macroeconomics (NCM) advocates.

New Keynesian Economics can be traced back to late 70s when the first foundations were built by economists such as Stanley Fischer, Edmund Phelps and John Taylor. One of the best economists to characterize the New Keynesian Economics is Gregory Mankiw, as he has made many contributions to this doctrine.

The main issue of this economic doctrine is to explain why changes in the aggregate price level are “sticky”. While in NCM competitive price-taking firms make choices on how much output to produce, and not at what price, in New Keynesian Economics monopolistically competitive firms set their own individual prices and accept the level of sales as a constraint. From a New Keynesian Economics point of view, two main arguments try to answer why aggregate prices fail to imitate the nominal GNP evolution. One of them is used both by NKE and NCM approach to macroeconomics, this is the assumption that economic agents, households and firms have rational expectations. However New Keynesian Economics considers that rational expectations become distorted as market failure arises from asymmetric information and imperfect competition. As economic agents can’t have a full scope of the economic reality their information will be limited, and there will be no reasons to believe that other agents will change their prices, and therefore maintain their expectations unchanged. Expectations are a crucial part for price determination, as they remain unaltered, so will the price, what leads to price rigidity. For firms, price rigidity may also come from what’s known as menu costs, this is, costs that result from price changes.

As a result of this price stickiness, which implies a slow adjustment of the economy and can lead to undesired levels of unemployment, government intervention is justified to stabilize the economy, by using both fiscal and monetary policies. However, this intervention ought to be minimal, much lower than New Keynesian Economics’s predecessors, the Neoclassical Synthesis, would argue for.

The term NAIRU (non-accelerating inflation rate of unemployment) is a term first used by James Tobin in 1980, in his article “Stabilization Policy Ten Years After”. It refers to the level of unemployment at which the economy settles if monetary policy is held stable. In these terms, it can be associated to Friedman’s natural rate of unemployment.

The NAIRU is based on empirical evidence regarding inflation and unemployment. Indeed, in most countries, inflation rises when unemployment is low because of the higher demand this implies; correspondingly, inflation falls when unemployment is high. This relation explains how unemployment may be above or below the NAIRU level not only because of the effects of monetary policy, but also because other factors such as production costs or trade unions negotiation processes. The Layard-Nickell NAIRU model explains it quite simply.

Even though the term NAIRU is usually merged in the economic literature with the term natural rate of unemployment, there are a few differences between the two. These differences are summarized in the following grid:

The Layard-Nickell NAIRU model emerged as a reply from New Keynesian Economics to the natural rate of unemployment, devised by Milton Friedman as a criticism of the Neoclassical Synthesis’ Phillips curve. This NAIRU model comes from an article entitled “Unemployment in Britain”, 1986, by Richard Layard and Stephen Nickell.

Indeed, the Layard-Nickell NAIRU model was able to explain the paradigm shift by moving away from assumptions of a perfectly competitive labour market into a model based on wage determination by means of trade union bargaining. In a perfectly competitive market, salaries and the prices of goods are traditionally determined by considering that the price of a product is fixed via its marginal cost (and, in the case of imperfect competition, a mark-up).

Trade unions will bargain with employers in order to get higher real wages for the workers. In the adjacent figure, it can be seen how the more people is employed and represented by trade unions, the higher real wages will be, thus marking the upward sloping BRW curve (Bargained Real Wages). The explanation is quite simple: from the workers point of view, higher employment rates mean lower opportunity costs derived from job seeking; on the other hand, employers are more likely to pay higher real wages when the economy is in expansion, since they don’t want to lower production (which would happen if workers went on strike.

Once trade unions have bargained an adequate real wages, the employer will fix prices (P) considering both costs of production and mark-ups (μ). If we assume real wages (W) as the only production cost (which is a reasonable assumption, since wages usually make up for a large portion of production costs), and we take into consideration also marginal productivity (MP_L), we can find out what would be the price chosen by the employer:

and assuming the following:

we come up with the real wage: 

This real wage (called Price-determined Real Wage, PRW) can be represented graphically as shown in the adjacent figure. Note that it’s a horizontal line, since for any given BRW, and at any employment level, the mark-up would be the same as well as the marginal productivity.

The reciprocal relation between wages and inflation is determined. The distance from the level of employment at equilibrium (L*) and the total labour force (L^T), is the NAIRU. When, for example, the level of employment increases, trade unions will be able to negotiate higher real wages (A). Since the employer won’t be willing to accept a decrease in its profits, the mark-up will be maintained, which will raise prices. Therefore, an increase on employment, which will take the employment level higher than the NAIRU, will end-up increasing aggregate price-levels.

Anything that affects wage formation or unemployment rates is likely to affect inflation. Thus, fixing salaries above what they would be in a competitive labour market leads to higher prices, which increases inflation and reduces real wages. In a similar fashion, an increase in unemployment benefits drives salaries above what would naturally be determined, with similar effects. In this “battle of the mark-ups” between employers and employees, the NAIRU rises. This aims to explain the structural factors between some countries having a higher or lower “natural” unemployment rate than others. Empirically, it is interesting for example to note that only 15% of salaries in the US are fixed by trade unions, whereas in some countries of Europe, such as France, Italy or Spain, famed for having a naturally high NAIRU, almost 75% of employees are covered by a collective agreement.

Menu costs are costs that result from price changes. An easy way to understand menu costs is by means of a typical example: restaurants. When a restaurant manager wants to change prices, the cost of changing the menus (in order to show the new prices) must be taken into consideration. Therefore, the manager will need to assess whether the increase in prices will cover for the cost of printing new menus.

As Gregory Makiw demonstrates in his article “Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly”, 1985, this menu costs may lead to a non-socially optimal situation. Indeed, Mankiw’s menu costs model shows how higher menu costs may lead to a situation where prices remain unchanged, thus provoking so called price stickiness.

Contrary to what economists from the New Classical Macroeconomics think, which is that business cycles are originated by shifts in supply (which originate mainly from technological shocks), New Keynesian economists believe that business cycles are originated by price stickiness.  This price stickiness might be explained by menu costs, since the slow adjustment of the economy may explain business cycles.

There is a great debate over the following question: are these menu costs really large enough to cause business cycles? An article from Daniel Levy et al., “The Magnitude of Menu Costs: Direct Evidence from Large U.S. Supermarket Chains”, 1997, demonstrates, using empirical evidence, that these menu costs are indeed large enough to cause business cycles. The authors use store-level data from five multistore supermarket chains to directly measure menu costs. They find that the menu costs per store at those chains average more than 35% of net profit margins, which may be forming a barrier to price changes. When applying these findings to theoretical models of menu costs, the authors conclude that these menu costs are large enough to be capable of having macroeconomic significance. Furthermore, they believe that these menu costs may cause considerable nominal rigidity in other industries or markets, thus amplifying the effects on business cycles. These menu costs, they say, vary largely due to local and regional legislation, which may require, for instance, a separate price tag on each item, thus increasing menu costs.

New Keynesian Economics argue that menu costs are the reason for price stickiness. Price stickiness, the suboptimal adjustment of prices in response to demand shocks, can result in business cycles. Gregory Mankiw proved in 1985 in his article “Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly” that sticky prices can be both privately efficient and socially inefficient. In fact, as Mankiw points out, even small menu costs can cause large welfare losses.

Mankiw uses a static model of a monopoly firm’s pricing decision, which starts by setting its price in advance and changes it ex post, but incurring in a small menu cost. The monopoly faces a constant cost function and an inverse demand function:

C = kqN

where

C: total nominal cost of production

q: quantity produced

k: constant

P = f(q)N

where

P: nominal price

N is a nominal scale variable, which denotes the exogenous level of aggregate demand. It can be regarded, for instance, as the overall price level. C and P increase proportionally to the level of nominal demand N.

Now, let c = C/N and p = P/N, which will turn the firm’s problem independent of aggregate demand:

c = kq

p = f(q)

In the figure below, we see the producer surplus (profits earned by the firm), equal to the rectangle between k and p_m. On the other hand, the excess value over the price paid represents consumer surplus, the triangle above profits. Total surplus, which represents welfare, is the sum of consumer and producer surplus.

The firm needs to set its price one period ahead based on expectations about future aggregate demand, being this price p_mN^e. If expectations are correct ex post, the observed price p₀ is p_m. If not, the observed price is p_m(N^e/N).

First scenario

The first case Mankiw examines is when aggregate demand N is lower than expected, and therefore p₀ is higher than p_m, as shown in the figure below. The producer surplus is lowered by B-A (since profits as seen before were equal to rectangle B plus the rectangle to its left), which is positive because p_m is by definition the profit-maximising price. Social welfare (or total surplus) is reduced by B+C, and therefore the reduction in welfare due to the contraction in aggregate demand is larger than the loss in the surplus of the firm.

Now, let’s suppose that the firm is capable of changing its price ex post, at a menu cost of z. The firm can then reduce its price from p₀ to p_m and obtain additional profits of B-A, which the firm will do if B-A > z. However, from the point of view of a social planner, the firm should lower its prize if and only if B+C > z. Let’s see Mankiw’s propositions on different outcomes:

-Proposition 1. Following a contraction in demand, if the firm cuts its price, then doing so is socially optimal (if it cuts it, is because B-A > z and therefore B+C > z+A+C > z).

-Proposition 2. Following a contraction in demand, if B+C > z > B-A, then the firm does not cut its price to p_m, even if it would be socially optimal (the inefficiency results because printing new menus result in an external benefit of C+A).

-Proposition 3. A contraction in aggregate demand reduces social welfare unambiguously, as shown by the sum of producer and consumer surplus. If the producer reduces its price, then the contraction only has the menu cost z. If the firm does not cut its price, then the contraction has the cost of B+C (probably much larger than z).

Second scenario

The second case Mankiw analyses is an expansion in aggregate demand (N > N^e), and therefore p₀ <p_m. Firstly, let’s see what happens when p₀ > k (N/N^e < p_m/k), as shown in our third figure. In this case, producer surplus is reduced by D-F, which is positive (p_m maximises the firm’s profits) and social welfare increases by E+F. The firm will reset its price if the increase in profits beats the menu cost. In other words, the firm will change its price if D-F > z.

-Proposition 4. If there is an expansion in demand and if the firm resets its price, social welfare decreases by the menu cost. If it doesn’t, total surplus increases by E+F.

Third scenario

Now, let’s see what happens if N/N^e > p_m/k, and therefore p₀ < k. Then, social welfare decreases by a positive or negative amount of I-J, which makes for an uncertain welfare effect. The firm’s profits, which are now negative, have been reduced by G+H+I. If G+H+I > z, then the firm will reset its price to p_m. Doing so would be socially optimal if I-J > z.

-Proposition 5. If the firm resets its price following the expansion in demand mentioned, social welfare (total surplus) will decrease by the menu cost z. If it doesn’t, total surplus does not decrease by more than the menu cost (if the firm doesn’t reset its price is because G+H+I < z, which implies that I-J < z-J-G-H < z and therefore the social welfare reduction I-J < z).

-Proposition 6 (as a summary of previous propositions). An expansion in aggregate demand may either increase welfare or reduce it, but never more than the menu cost. On the other hand, a contraction in aggregate demand will reduce welfare, possibly in an amount much larger than the menu cost.

Conclusion

To sum up, Mankiw demonstrates that private incentives ensures a high price adjustment when aggregate demand expands, but a small adjustment following a contraction in aggregate demand. From a social planner’s point of view, prices may be stuck too high, but never too low, which translates into downward price stickiness, although not into an upward rigidity. Mankiw also points out that a more complete model (general equilibrium) will probably show higher degrees of price stickiness, since interfirm purchases will exacerbate price rigidity. Therefore, the main conclusion of this paper (that small menu costs can translate into large inefficiency effects) would certainly remain in a general equilibrium model.

Regarding economic policies required to alleviate these problems, Mankiw explains how an active monetary policy is required. More particularly, he mentions policies that aim at the pricing mechanism, such as tax-based incomes policy and other supply-side policies.

Business cycle, as Joseph Schumpeter saw it, is the economic activity fluctuation that occurs over time, and that comes from the succession of expansionary and contracting seasons. It is analysed comparing real GDP to potential GDP (Y*). There are a few common characteristics, which help differentiate cycles, such as its phases, the way it oscillates, the periodicity and a few stylized facts:

1. Phases:

Four phases can be distinguished, following Richard Lipsey’s classification:

-Trough or depression (A), characterized by a high rate of unemployment and low consumption levels in relation to its real capacity;

-Expansion or recovery (B) of previous employment, income and consumption levels, that usually comes together with a rising in prices;

-Peak (C), distinguished by factors full use, high investment and shortage of labour, particularly for high-skilled jobs;

-Recession (D), demands fall causing unemployment and decreasing production levels.

2. Oscillations:

3. Periodicity:

Economic cycles have been classified depending in their periodicity. The most common are:

-Very short cycles, with duration of 30-40 months; also known as Kitchin cycles, whose studies saw in stock rotation the origin of these cycles;

-Short cycles, with duration of 7-11 years; also known as Juglar cycles, which origin is based on subsequent inventions;

-Long cycles with duration of 15-25 years; commonly known as Kuznets cycles, whose analysis placed the origin of cycles in demographic factors such as birth rates or migrations;

-Very long or Kondratiev cycle with duration of 50-60 years. This cycles originate with breakthroughs in capital goods, such as the steam engine or the Internet.

4. Stylized facts:

Both over time and between countries (a few of numerous reviewed by Robert Lucas in his article “Understanding Business Cycles”, 1977):

-There is positive correlation between variables, which helps smooth fluctuations;

-Co-movement between some variables:

·output fluctuates in the same direction in different sectors (although different amplitudes may apply);

·investment and consumption are clearly pro-cyclical: investment leads and is more volatile, consumption lags and is rather stable;

·income: real wages and profits are pro-cyclical;

·employment and labour force are also pro-cyclical.

-Expansions are usually longer than recessions.

Many papers and works have been written on business cycles and different points of view have taken form. Keynesian economics tries to deal with the economic fluctuation to minimize their impact. Business cycles are seen as a proof of market failure, and justify government intervention in order to assure the correct level of economic activity. Until the optimum level of employment has not been reached, the economy will not be readjusted. Depending on the cycle phase, expansionary or contractionary economic policies may be used.

New Classical Macroeconomics supporters have also dealt with economic cycles, and as a result the Real business cycle theory arises as an alternative view to Keynesian´s. Kydland and Prescott, and in general the Chicago School, are mostly related with the development of this theory. For them, cycles are explained by technological shocks. The fluctuations in the economy are seen to be produced by shifts in the supply curve, as a result of changes in productivity levels. These shocks can be caused by different factors: technology innovation, unusual weather conditions, changes in raw material prices, new policies and regulatory measures, etc. What is basic for these shocks to occur is an alteration in the effectiveness of either capital or labour factors, and therefore changing productivity. As a result in changes in the production quantity, the supply curve shifts, implying a new equilibrium point in the supply and demand model.  Thus they believe that economy will reach its new equilibrium point, through the forces of demand and supply in itself, without the need for a government intervention. In fact from their view, government intervention will only worsen the situation.