[An updated version of this article can be found at New Classical Macroeconomics in the 2nd edition.]
"New classical macroeconomics" (NCM) uses the standard principles of economic analysis to understand how a nation's total output (gross domestic product, or GDP) is determined. In the NCM view supply and demand result from the actions of economically rational households and firms. Macroeconomic quantities like GDP are the result of the general equilibrium of the markets in an economy. It is surprising that this perspective is considered revolutionary in macroeconomics when we see the current nature of economic analysis in other fields, such as public finance, international trade, and labor economics. All use standard economic principles to analyze a wide range of issues. Macroeconomics has lagged behind because Keynesian macroeconomics was dominant when these principles were systematically applied in these other fields in the forties through the sixties.
From its inception with John Maynard Keynes's General Theory of Employment, Interest, and Money in 1936, Keynesian macroeconomics held a leading position for three main reasons. First, its basic analytical models were simple, flexible, and easy to use and seemed broadly consistent with observed patterns of economic activity. Second, Keynes and his disciples made a strong and effective critique of the alternative school, which they called classical macroeconomics, portraying it as complicated, inflexible, and empirically irrelevant. Third, these analytical Keynesian models provided a base for detailed statistical models of macroeconomic activity, which could be used for economic forecasting and for evaluating alternative policies.
In contrast to classical macroeconomics, new and old, Keynesian macroeconomics did not begin with the assumption that an economy is made up of individually rational economic suppliers and demanders. Instead of deriving demand from individual choices that are made within specified constraints, for example, the Keynesian procedure was to directly specify a behavioral rule. Keynes claimed that aggregate spending on consumption was governed by a "consumption function" in which consumption depended solely on current income. More generally, Keynesian macroeconomics posited that people followed fixed rules of thumb, with no presumption that firms and households made rational choices. Partly, this grew out of a suspicion on the part of Keynesian modelers that people did not typically act rationally. Partly, it was a pragmatic modeling decision: if people's economic behavior is purposeful, the task of specifying how they will act in various situations is more complicated and, therefore, more difficult to model.
The Keynesians were right that the classical macroeconomics of the thirties could not answer important public policy questions. Classical macroeconomics at that time, like most other fields of economics, was just beginning to build formal mathematical and statistical models of economic behavior. Over the last decade an intense amount of research has largely overcome these challenges, and this body of research is now called the new classical macroeconomics. The NCM approach has become increasingly important in discussions of macroeconomic policy in the United States and other countries around the world in recent years.
The superiority of new classical or Keynesian macroeconomics will depend on which appears to provide a better understanding of macroeconomic activity. It is important to decide between these contending views because they typically imply very different consequences for public policies.
The General Differences in Perspective
Some central, repeated differences of opinion in macroeconomic policy are traceable to basic differences in Keynesian and new classical macroeconomics.
Three ideas are central to the Keynesian view. The first is that there is little presumption that market outcomes are desirable. This leaves a great deal of scope for government intervention. The second is that changes in the supply side of markets are important mainly in the long run, which is taken to be very far away in most policy situations. The third Keynesian view is that the fiscal and monetary authorities can control demand conditions for specific products and for the economy as a whole.
By contrast, three diametrically opposed ideas are central to new classical macroeconomics. First, because market supply and demand decisions are assumed to be made by economically rational agents, these decisions are presumed to be efficient for those who make them. That individual rationality in markets will generally lead to socially desirable outcomes is, of course, the message that is at the core of economic analysis from Adam Smith's Wealth of Nations to modern welfare economics. Thus, the case for government intervention, in the NCM view, requires two key steps: (1) identifying a "market failure" and (2) demonstrating that the government can actually follow policies that will lead to social improvements.
Second, the NCM view systematically stresses the importance of supply behavior to market outcomes even in the very short run. Third, the NCM view questions whether typical policy instruments can be manipulated to accomplish specific policy objectives.
Current Policy Discussions
Keynesian and new classical macroeconomics lead to very different conclusions about three economic policies that were often suggested, for example, during the election campaign of 1992:
2. a temporary revival of the investment tax credit
3. expansionary policies by the Federal Reserve (i.e., increases in the rate of growth of the money supply and reductions in the discount rate)
Investigating the first two topics requires an understanding of how consumer spending and investment spending are determined, so we begin by discussing how Keynesian and new classical macroeconomics view each of these.
Determinants of Consumption and Investment
In the Keynesian view, consumption (consumer spending) is determined primarily by changes in current disposable income (i.e., national income minus taxes). The new classical perspective is quite different. In the NCM view a household's consumption in a specific time period depends on its current income and on the income it expects in the future, as well as on the interest rates at which it can borrow or lend.
The Keynesian and new classical perspectives regarding investment also differ. Keynesian macroeconomists typically stress current cash flows to a firm and its current cost of capital as the main determinants of investment spending. NCM agrees that these matter, but stresses the role of expected future cash flows and expected future costs of capital as well.
For both consumption and investment, then, a key difference between the Keynesian and new classical views is the importance each puts on expectations about future economic conditions. While many Keynesian macroeconomists might accept some role for expectations, they do not think expectations are important. Further, many Keynesian macroeconomists view expectations about the future as having little systematic relationship to actual future outcomes. Therefore, in the Keynesian view, expectations change only gradually or are governed by what Keynes called "animal spirits." By contrast, NCM sees individuals as regularly trying to determine what will actually happen in the future and using new information efficiently in gauging the relative likelihood of different economic outcomes.
Temporary Tax Cuts for the Middle Class
The traditional Keynesian analysis of tax reductions is very simple and direct. Because tax cuts leave households with more funds, households increase their spending as a result. With higher demand for products, there is an increase in the output of domestic business. Thus tax cuts stimulate the economy, leading to more income and more jobs.
In this view there are only two problems. First, consumers may save their tax cut instead of spending it. Second, consumers may spend their tax cut on imported goods rather than domestic ones. Either way, demand would not rise by the full amount of the tax cut, and the tax cut would be less effective than otherwise at raising domestic production and creating jobs.
But Keynesian macroeconometric models suggest that these two problems are not very important. Following Keynes, economists describe the coefficient linking consumption changes to income changes as "the marginal propensity to consume [MPC] out of income." In a typical Keynesian econometric model the MPC is about .6, which means that 60 percent of a tax cut is spent. Further, standard Keynesian econometric models suggest that only a very small portion of changes in income is spent on imports. So the Keynesian policy of stimulating the economy looks pretty effective on these grounds.
NCM challenges this logic directly and concludes that a one-time tax cut would have a minimal effect on consumption. From the NCM perspective the key point is that the tax change is temporary and thus will add little to the household's ability to finance consumption expenditures on a sustained basis. Therefore, the NCM view is that about 95 percent of the tax reduction will be saved. In other words, the marginal propensity to consume out of this type of income is only .05.
But isn't this NCM view inconsistent with the estimates of Keynesian models, which have found that changes in income brought about sizable changes in consumption? The surprising answer is no. As Milton Friedman first explained and Robert Lucas subsequently emphasized, Keynesian macroeconomic models confuse the response of private consumption to permanent changes in income—such as those that often happen when someone changes jobs—with other, more transitory variations. Consumption responds a lot to permanent changes, which are the dominant influence, and little to temporary ones. By failing to distinguish between these different types of income changes, NCM followers believe, Keynesian modelers overestimate the effect of a temporary tax cut on consumption spending.
Moreover, when there is a tax cut now, the government must raise its borrowing and, ultimately, raise taxes in the future. The recognition that more taxes will come later can actually cause current overall demand to decrease. Thus, the NCM view questions the idea that a temporary tax cut will stimulate the total demand for products.
On-Again-Off-Again Investment Tax Credits
The investment tax credit (ITC), which was abolished in the 1986 tax reform, permitted a company to deduct a fraction of the purchase price of a new investment good from its corporate income tax payments. For this reason it provided a powerful incentive for investment. Most Keynesian macroeconomic models predict that a restoration of the tax credit would cause large, immediate increases in investment spending. The reasoning is that reducing a tax on any activity increases the amount of that activity.
But Keynesian models typically miss a key feature of the investment tax credit—its on-again-off-again nature. An ITC that is temporarily high in one year makes it desirable for firms to delay investment they had scheduled for the prior year and move forward investment that would otherwise have been made in later years. Therefore, a temporary ITC, unlike a temporary income tax cut, can have very powerful effects on demand precisely because it is temporary. But the effects are likely to be perverse.
Take the slowdown in the U.S. economy that started in the summer of 1990 and developed gradually through the subsequent year. By summer 1991 there was intense speculation in the financial press that the ITC would be restored. Such speculation was reasonable because the ITC was raised during many other post-World War II recessions. But subsequent to each recession, Congress typically reduced the ITC. Consider a company thinking of upgrading a photocopying machine during the summer of 1991. Suppose that the company would have to pay thirty thousand dollars for this machine. If there was a temporary ITC of 10 percent during 1992, then the company could save three thousand dollars just by delaying its purchase until the beginning of 1992. This is very likely a desirable strategy for the company. But for the economy it is perverse: lower investment occurs just when the economy needs high demand for investment goods.
Note the irony. In 1991 the administration considers an ITC for 1992 partly because of low investment in 1991. But part of the reason for low investment is that firms anticipate an ITC for 1992. Thus, the on-again—off-again ITC destabilizes the economy during 1991.
Investment and the Middle-Class Tax Cut
In considering the temporary income tax cut, we focused entirely on the implications for consumption and ignored investment. Did we miss something? It depends critically on how the government plans to pay for the tax cut. If it plans to increase taxes on business, then there could well be effects like those for the investment tax credit. A personal income tax cut for the middle class could signal higher future taxes on capital income and lower rewards to the current investments that are necessary to generate those incomes. The link is an indirect one, but one that could easily overwhelm the small positive effect on consumption.
Monetary Policy and Macroeconomic Activity
In the fifties and sixties the orthodox Keynesian view was that permanently high inflation—brought about by expansionary monetary and fiscal policy—would lead to permanent increases in GDP. Correspondingly, monetary policies that reduced the long-run rate of inflation would cause a long-run reduction in GDP. In the United Kingdom such a trade-off was suggested by the empirical work of A. W. Phillips, who was careful to avoid indicating whether the trade-off was short run or long run. But other economists in the United States and United Kingdom were less cautious. The importance of this trade-off in the United States was stressed by leading theoretical macroeconomists such as Paul Samuelson and Robert Solow of MIT and built into most major econometric models, such as the Data Resources model developed by Otto Eckstein and his colleagues.
But few economists now believe that higher inflation has any important long-run benefits. The shift in thinking has occurred because of two related events. First, work in the classical tradition by Milton Friedman, Edmund Phelps, and Robert Lucas suggested that little or no long-run trade-off should exist, even if macroeconometric models predicted their existence. Second, the coexistence of high inflation and low growth in the United States during the seventies led to a questioning of this trade-off. Economists devoted increased attention to other episodes of high inflation, like those in Latin America in recent decades and in Europe between the wars. In those episodes very high inflation rates proved unambiguously bad for real GDP.
Thus, if a U.S. recession is due in part to real factors—such as a decline in U.S. competitiveness in world markets—monetary policy has limited ability to make things better. Although expansionary monetary policy may work to increase real activity over one or two years, it cannot deal with the systematic long-run challenges that the United States faces. And the expansionary monetary policy risks igniting higher inflation.
New classical macroeconomics applies standard principles of economics to the behavior of the economy as a whole. Thus, it means that macroeconomists and other economists—such as public finance economists—can use broadly similar models to discuss what public policies are best for the United States and for other countries. As a result NCM has begun to refocus the debate about the appropriate choice of macroeconomic policies. In particular, since NCM now enjoys an increasingly wide following among economists, there is less discussion of policies that seek to "fine-tune" the economy in the short run—like the temporary middle-class tax cut or the countercyclical manipulation of the ITC—which were stressed by Keynesian macroeconomics. More attention is being given to developing macroeconomic policies that promote the long-run health of the economy.
Robert King is a professor of economics at Boston University. He is also the editor of the Journal of Monetary Economics and a consultant to the Research Department at the Federal Reserve Bank of Richmond.
Barro, Robert J. Macroeconomics. 1985.
King, Robert G. "Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?" Journal of Economic Perspectives 7, no. 1 (Winter 1993): 67-82.
Lucas, Robert E., Jr. "Econometric Policy Evaluation: A Critique." In The Carnegie-Rochester Conference Series on Public Policy. Vol. 1, The Phillips Curve and Labor Markets, edited by Karl Brunner and Alan Meltzer. 1976. (A classic article articulating the NCM view that central failures of Keynesian econometric models could be traced to the fact that these models did not build on standard principles of economics.)
McCallum, Bennett T. Monetary Economics: Theory and Policy. 1989.