The Important Corporate Income Tax and Economic System Articles Main Points Summary

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There are a total of two articles here, please write two short summaries. (two or three paragraphs for each article)1. Snowdon & Vane, ch. 5; 2. Robert Norton, “Corporate Taxation,” Concise Encyclopedia of Economics,
2d edn. (Indianapolis: Liberty Fund, 2008):
http://www.econlib.org/library/Enc/CorporateTaxation.html.

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5. The new classical school
existing Keynesian macroeconometric models are incapable of providing reliable
guidance in formulating monetary, fiscal and other types of policy. This conclusion is based in part on the spectacular recent failure of these models, and in part
on their lack of a sound theoretical or econometric basis … on the latter ground,
there is no hope that minor or even major modification of these models will lead
to significant improvement in their reliability. (Lucas and Sargent, 1978)
5.1
Introduction
During the early 1970s there was a significant renaissance of the belief that a
market economy is capable of achieving macroeconomic stability, providing
that the visible hand of government is prevented from conducting misguided
discretionary fiscal and monetary policies. In particular the ‘Great Inflation’
of the 1970s provided increasing credibility and influence to those economists who had warned that Keynesian activism was both over-ambitious and,
more importantly, predicated on theories that were fundamentally flawed. To
the Keynesian critics the events of the Great Depression together with Keynes’s
theoretical contribution had mistakenly left the world ‘deeply sceptical about
self-organising market systems’ (Sachs, 1999). As we have seen in Chapters 3
and 4, the orthodox Keynesian insistence that relatively low levels of unemployment are achievable via the use of expansionary aggregate demand policies
was vigorously challenged by Milton Friedman, who launched a monetarist
‘counter-revolution’ against policy activism during the 1950s and 1960s.
During the 1970s another group of economists provided a much more damaging critique of Keynesian economics. Their main argument against Keynes
and the Keynesians was that they had failed to explore the full implications of
endogenously formed expectations on the behaviour of economic agents.
Moreover, these critics insisted that the only acceptable way to incorporate
expectations into macroeconomic models was to adopt some variant of John
Muth’s (1961) ‘rational expectations hypothesis’.
Following Thomas Sargent’s (1979) contribution, rational expectationists,
who also adhered to the principle of equilibrium theorizing, became known
collectively as the new classical school. As the label infers, the new classical
school has sought to restore classical modes of equilibrium analysis by assuming continuous market clearing within a framework of competitive markets.
219
220
Modern macroeconomics
The assumption of market clearing, which implies perfectly and instantaneously flexible prices, represents the most controversial aspect of new classical
theorizing. According to Hoover (1992), the incorporation of this assumption
represents the classical element in their thinking, namely a firm conviction
‘that the economy should be modelled as an economic equilibrium’. Thus, to
new classical theorists, ‘the ultimate macroeconomics is a fully specified
general equilibrium microeconomics’. As Hoover notes, this approach implies not only the revival of classical modes of thought but also ‘the euthanasia
of macroeconomics’!
5.2
The Influence of Robert E. Lucas Jr
Professor Robert E. Lucas Jr is widely acknowledged as the originator and
central figure in the development of the new classical approach to macroeconomics and has been described by Michael Parkin (1992) as ‘the leading
macro mountaineer of our generation’. In recognition of Lucas’s seminal
research in macroeconomics, in October 1995 the Royal Swedish Academy
of Sciences announced its decision to award him the Nobel Memorial Prize in
Economics ‘for having developed and applied the hypothesis of rational
expectations, and thereby having transformed macroeconomic analysis and
deepened our understanding of economic policy’. The award of this prestigious prize to Lucas came as no surprise to economists since, without doubt,
his important contributions have made him the most influential macroeconomist
during the last quarter of the twentieth century (see Fischer, 1996a; Hall,
1996; Svensson, 1996; Hoover, 1988, 1992, 1999; Snowdon and Vane, 1998).
While some commentators see Lucas’s contributions to business cycle analysis as ‘part of the natural progress of economics’ (Chari, 1998), or as ‘part of
the steady accumulation of knowledge’ (Blanchard, 2000), others make frequent reference to ‘revolution’ or counter-revolution when discussing the
influence of Lucas’s contributions to macroeconomics (Tobin, 1996; Snowdon and Vane, 1999b; Woodford, 2000).
Although Lucas made explicit use of the rational expectations hypothesis
in analysing optimal investment policy as early as 1965, it was not until he
began to wrestle with aggregate supply issues, within a Walrasian general
equilibrium framework, that the real significance of this hypothesis for macroeconomics became clear (Fischer, 1996a). While the Lucas and Rapping
(1969) paper is perhaps the first ‘new classical’ paper in spirit, because of its
emphasis on the equilibrium (voluntary) nature of unemployment and its
utilization of the intertemporal labour substitution hypothesis (see Hoover,
1988 and Chapter 6), it was the series of papers written by Lucas and
published in the period 1972–8 that established the analytical base of the
rational expectations equilibrium approach to research into aggregate eco-
The new classical school
221
nomic fluctuations (business cycles). Collectively these papers had an immense influence on the direction of macroeconomic research during the last
quarter of the twentieth century. One objective measure or indication of the
impact/influence that certain papers have on the development of macroeconomics is provided by citation counts as recorded by the Social Science
Citations Index. In Table 5.1 citation counts are provided for the three most
heavily cited papers written by Lucas (1972a, 1973, 1976) in the area of
mainstream macroeconomics, together with one example taken from the field
of economic growth (Lucas, 1988). In order to help place the influence of
these papers in context we also provide information on citation counts for
three other well-known and heavily cited papers, namely those by Friedman
(1968a) and Kydland and Prescott (1977, 1982).
Table 5.1
Citation counts: 1966–97
Article
Friedman (1968a)
Kydland and
Prescott (1977)
Kydland and
Prescott (1982)
Lucas (1972a)
Lucas (1973)
Lucas (1976)
Lucas (1988)
1966–70
1971–75
1976–80
1981–97
Total
Average
citations per
year since
publication
30
–
148
–
238
25
508
499
924
524
31
25
–
–
–
443
443
28
–
–
–
–
12
10
–
–
112
122
105
–
503
583
654
568
627
715
759
568
24
29
35
57
Source: Snowdon and Vane (1998).
As Table 5.1 suggests, the influence of Lucas has been tremendously
important for the direction of macroeconomics since 1970. However, other
influential American exponents of new classical macroeconomics during the
1970s included Thomas Sargent, Robert Barro, Edward Prescott and Neil
Wallace. In the UK the new classical approach, in particular the need to
incorporate the rational expectations hypothesis into macroeconomic analysis, was mainly championed by Patrick Minford (see interviews with Professors
Barro and Minford in Snowdon et al., 1994).
Building on the insights developed by Milton Friedman (1968a) and Edmund
Phelps (1968) concerning the neglect of endogenous expectations in Keynesian
macro models, the work of Lucas (1972a, 1972b, 1973, 1975, 1976) was
crucial in introducing macroeconomists to Muth’s (1961) rational expecta-
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Modern macroeconomics
tions hypothesis, together with its enormous implications for theoretical and
empirical work (Lucas, 1981a). In particular, with the introduction of rational
expectations the standard Keynesian models seemed unable to deliver their
traditional policy conclusions. It soon became apparent that what Alan Blinder
refers to as the ‘Lucasian revolution’ represented a much more powerful and
potentially damaging challenge to the Keynesian mainstream than the monetarist critique, which was of longer standing (see Snowdon, 2001a). Lucas
recalls that he was ‘raised as a monetarist in the 1960s’ and that Friedman
‘has been an enormous influence’. Indeed, during the 1990s, Lucas still
thought of himself as a ‘monetarist’ (Lucas, 1994b; Snowdon and Vane,
1998). But while orthodox monetarism presented itself as an alternative to
the standard Keynesian model, it did not constitute a radical theoretical
challenge to it (see Laidler, 1986). Thus while the mark I 1970s version of
new classical macroeconomics initially evolved out of monetarist macroeconomics, and incorporates certain elements of that approach (such as the
monetarist explanation of inflation), it is clear that new classical economics
should be regarded as a separate school of thought from orthodox monetarism. While the new classical school during the 1970s was undoubtedly
‘monetarist’ in terms of its policy prescriptions, according to Hoover (1984)
the more radical tone to new classical conclusions stems from key theoretical
differences between Lucas and Friedman, and the roots of this theoretical
divide are methodological: while Friedman is a Marshallian, Lucas is a
Walrasian. Despite their methodological differences, De Vroey (2001) is
undoubtedly correct in arguing that ‘Friedman and Lucas have probably been
the most influential economists of the second half of the twentieth century:
between them they were able to throw the Keynesian paradigm off its pedestal’. In his review of Tobin’s (1980a) book, Asset Accumulation and Economic
Activity: Reflections on Contemporary Macroeconomic Theory, Lucas (1981b)
declared that:
Keynesian orthodoxy or the neoclassical synthesis is in deep trouble, the deepest
kind of trouble in which an applied body of theory can find itself. It appears to be
giving seriously wrong answers to the most basic questions of macroeconomic
policy.
Why and how Lucas and other new classical economists came to this negative view of Keynesian economics during the 1970s is the main theme of this
chapter.
In the remainder of this chapter we have four main objectives. First, to
discuss the central theoretical propositions which underlie new classical models
(section 5.3). Second, in the light of this discussion, to consider the new
classical theory of the business cycle (section 5.4). Third, to examine the
main policy implications that derive from the new classical approach to
The new classical school
223
macroeconomics (section 5.5). Finally (section 5.6) we assess the impact that
the new classical school has had on the development of macroeconomics.
5.3
The Structure of New Classical Models
The new classical school emerged as a distinctive group during the 1970s
and, as we have already noted, the key figure in this development was Robert
E. Lucas Jr. However, the roots of the new classical research tradition are
diverse. For example, the emphasis in early new classical models on information and expectations provides a link to the Austrian tradition best represented
by the work of Hayek (see Chapter 9). The distinction made by Lucas
between impulse (shocks) and propagation mechanisms when analysing business cycles has its origins in the pioneering research of Frisch (1933). The
important role given to monetary disturbances in generating aggregate instability is solidly in the classical and Friedmanite monetarist traditions; indeed,
Tobin (1981) refers to the early new classical contributions as ‘monetarism
mark II’. The work of Phelps et al. (1970) on the Microfoundations of
Employment and Inflation Theory inspired Lucas to utilize the insights gleaned
from Phelps’s use of the ‘island parable’ and search theory to analyse labour
market dynamics. Finally the methodological approach of Lucas is heavily
influenced by the general equilibrium tradition of Walras, Hicks, Arrow and
Debreu (see Zijp, 1993; Beaud and Dostaler, 1997).
The new classical approach as it evolved in the early 1970s exhibited
several important features:
1.
2.
3.
4.
a strong emphasis on underpinning macroeconomic theorizing with neoclassical choice-theoretic microfoundations within a Walrasian general
equilibrium framework;
the adoption of the key neoclassical assumption that all economic agents
are rational; that is, agents are continuous optimizers subject to the
constraints that they face, firms maximize profits and labour and households maximize utility;
agents do not suffer from money illusion and therefore only real
magnitudes (relative prices) matter for optimizing decisions;
complete and continuous wage and price flexibility ensure that markets
continuously clear as agents exhaust all mutually beneficial gains from
trade, leaving no unexploited profitable opportunities.
Given these assumptions, changes in the quantity of money should be neutral
and real magnitudes will be independent of nominal magnitudes. However,
empirical evidence shows that there are positive correlations (at least in the
short run) between real GDP and the nominal price level (an upward-sloping
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Modern macroeconomics
aggregate supply curve), between changes in the nominal money supply and
real GDP, and negative correlations between inflation and unemployment (a
Phillips curve); that is, empirically money does not appear to be neutral in the
short run. Solving this puzzle between the neutrality of money predicted by
classical/neoclassical theory and empirical evidence showing non-neutralities
would be a considerable intellectual achievement (Zijp, 1993, refers to this as
the ‘Lucas problem’). Lucas’s (1972a) seminal paper, ‘Expectations and the
Neutrality of Money’, was just such an achievement. Lucas’s key insight was
to change the classical assumption that economic agents have perfect information to an assumption that agents have imperfect information.
We can sum up the main elements of the early new classical approach to
macroeconomics as the joint acceptance of three main sub-hypotheses involving (i) the rational expectations hypothesis; (ii) the assumption of
continuous market clearing; and (iii) the Lucas (‘surprise’) aggregate supply
hypothesis. In the discussion of these hypotheses individually in what follows, the reader should bear in mind that although new classicists accept all
three hypotheses (see Figure 5.1), it is possible for economists of different
persuasions to support the rational expectations hypothesis without necessarily accepting all three together (see Chapter 7).
Figure 5.1
The structure of new classical models
The new classical school
225
5.3.1 The rational expectations hypothesis
One of the central tenets underlying new classical macroeconomics is the
rational expectations hypothesis (REH) associated with the work of John
Muth (1961) initially in the context of microeconomics. It is, however, interesting to note that Keuzenkamp (1991) has suggested that Tinbergen was a
precursor to Muth, having presented a model of rational expectations nearly
30 years earlier. We should also note that it was Alan Walters (1971) who first
applied the idea of what he called ‘consistent expectations’ to macroeconomics. However, it was John Muth’s (1961) seminal paper that proved to be most
influential on the research of the young new classical Turks during the early
1970s. In his seminal article, Muth suggested ‘that expectations since they
are informed predictions of future events are essentially the same as the
predictions of the relevant economic theory’.
Expectations, which are subjective, are fundamental to the behaviour of
economic agents and all economic activities have an informational/expectational
dimension. For example, expectations of the future value of economic variables
will clearly influence demand and supply decisions. As Carter and Maddock
(1984) note, ‘since virtually all economic decisions involve taking actions now
for uncertain rewards in the future, expectations of the future are crucial in
decision making’. An obvious example where expectations of inflation will
influence behaviour concerns wage negotiations between trade unions and
employers. Should a trade union negotiator underestimate the rate of inflation
prevailing over the period of the negotiated wage contract, then workers are
likely to find that they have suffered a nominal wage increase, but a real wage
cut.
An expectation of the future value of some key economic variable need not
be confined to a single predicted value but can more realistically take the
form of a probability distribution of outcomes. Therefore, there are two key
questions facing macroeconomists with respect to incorporating expectations
into macroeconomic models:
1.
2.
how do individuals acquire, process and make use of information in
order to form expectations of key variables?
what form of expectations hypothesis should we use in macroeconomic
models?
During the 1970s, the rational expectations hypothesis replaced the adaptive
expectations hypothesis as the dominant way of modelling endogenous expectations (in his General Theory, published in 1936, Keynes had stressed the
importance of expectations for understanding macroeconomic instability, but
in Keynes’s theory expectations were exogenous, being driven by ‘animal
spirits’; see Chapter 8 and Keynes, 1937). One great appeal of the rational
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Modern macroeconomics
expectations hypothesis is that alternative (non-rational) hypotheses of expectations formation involve systematic errors, a situation that does not sit
comfortably with the rational calculating agents that populate orthodox neoclassical models.
The rational expectations hypothesis has over the years been presented in
the literature in a number of different forms and versions (see Redman,
1992). At the outset it is important to note the distinction between weak and
strong versions of the hypothesis. The main idea behind the weak version of
the hypothesis is that, in forming forecasts or expectations about the future
value of a variable, rational economic agents will make the best (most efficient) use of all publicly available information about the factors which they
believe determine that variable. In other words, expectations are assumed to
be formed ‘rationally’ in line with utility-maximizing behaviour on the part
of individual economic agents. For example, if economic agents believe that
the rate of inflation is determined by the rate of monetary expansion, they
will make the best use of all publicly available information on rates of
monetary expansion in forming their expectations of future rates of inflation.
The strong version of the rational expectations hypothesis is captured in the
above quotation taken from Muth’s (1961) article and it is the Muthian
version that has been taken up by leading exponents of the new classical
school and incorporated into their macroeconomic models. In the Muthian
‘strong’ version, economic agents’ subjective expectations of economic variables will coincide with the true or objective mathematical conditional
expectations of those variables. Using the example of economic agents’ expectations of inflation ( P?t e ), the rational expectations hypothesis may be
expressed algebraically in the following way:
P?t e = E( P?t | ? t ?1 )
(5.1)
where P?t is the actual rate of inflation; E( P?t | ? t ?1 ) is the rational expectation
of the rate of inflation subject to the information available up to the previous
period (? t?1 ). It is important to emphasize that rational expectations does not
mean that agents can foresee the future exactly. Rational expectations is not
the same as perfect foresight. In order to form a rational expectation of
inflation, agents will need to take into account what they believe to be the
‘correct’ macroeconomic model of the economy. Agents will make errors in
their forecasts, since available information will be incomplete. Indeed, this is
an essential element of Lucas’s monetary surprise model – see sections 5.3.3
and 5.5.1. However, such forecast errors will be unrelated to the information
set at the time the expectation (for example of inflation) was formed. With
rational expectations, agents’ expectations of economic variables on average
will be correct, that is, will equal their true value. Furthermore, the hypoth-
The new classical school
227
esis implies that agents will not form expectations which are systematically
wrong (biased) over time. If expectations were systematically wrong, agents
would, it is held, learn from their mistakes and change the way they formed
expectations, thereby eliminating systematic errors. More formally, the strong
version of the rational expectations hypothesis implies that:
P?t e = P?t + ? t
(5.2)
where P?t e = expected rate of inflation from t to t + 1; P?t = actual rate of
inflation from t to t + 1; and ?t = random error term, which (i) has a mean of
zero, and (ii) is uncorrelated with the information set available at the time
when expectations are formed, otherwise economic agents would not be fully
exploiting all available information. In summary, the forecasting errors from
rationally formed expectations will (i) be essentially random with a mean of
zero; (ii) be unrelated to those made in previous periods, revealing no discernible pattern: that is, they will be serially uncorrelated over time; and (iii)
have the lowest variance compared to any other forecasting method. In other
words, rational expectations is the most accurate and efficient form of expectations formation.
The rational expectations hypothesis contrasts with the adaptive expectations
hypothesis initially used by orthodox monetarists in their explanation of expectations-augmented Phillips curve (see Chapter 4, section 4). In the adaptive
expectations hypothesis, economic agents base their expectations of future
values of a variable (such as inflation) only on past values of the variable
concerned. One of the main problems with this ‘backward-looking’ approach to
forming expectations is that, until the variable being predicted is stable for a
considerable period of time, expectations formed of it will be repeatedly wrong.
For example, following the discussion of Chapter 4, section 4.3.2, on the
accelerationist hypothesis, if unemployment is held below the natural rate,
inflation will accelerate and inflation expectations will be biased in a downward
direction. This problem results from (i) the assumption that economic agents
only partially adjust their expectations by a fraction of the last error made; and
(ii) the failure of agents to take into consideration additional information available to them other than past values of the variable concerned, despite making
repeated errors. In contrast, in the ‘forward-looking’ approach, rational expectations are based on the use of all publicly available information, with the
crucial implication of the strong version of the hypothesis being that economic
agents will not form expectations which are systematically wrong over time;
that is, such expectations will be unbiased.
A number of criticisms have been raised against the rational expectations
hypothesis and we now consider three common ones. The first of these
concerns the costs (in time, effort and money) of acquiring and processing all
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Modern macroeconomics
publicly available information in order to forecast the future value of a
variable, such as inflation. It is important to note that the weak version of the
hypothesis does not require, as some critics have suggested, that economic
agents actually use ‘all’ publicly available information. Given the costs involved in acquiring and processing information, it is unlikely that agents
would ever use all publicly available information. What proponents of the
weak version of the hypothesis suggest is that ‘rational’ economic agents will
have an incentive to make the ‘best’ use of all publicly available information
in forming their expectations. In other words, agents will have an incentive to
use information up to the point where the marginal benefit (in terms of
improved accuracy of the variable being forecast) equals the marginal cost (in
terms of acquiring and processing all publicly available information). In this
case, expectations would be less efficient than they would be if all available
information were used. Furthermore, the weak version of the hypothesis does
not require, as some critics have suggested, that all individual agents directly
acquire and process available information personally. Economic agents can
derive information indirectly from, for example, published forecasts and
commentaries in the news media. Given that forecasts frequently differ, the
problem then arises of discerning which is the ‘correct’ view.
A far more serious objection concerns the problem of how agents actually
acquire knowledge of the ‘correct’ model of the economy, given that economists themselves display considerable disagreement over this. The issue of
whether individual agents operating in decentralized markets will be able to
‘learn’ the true model of the economy has been the subject of considerable
debate (see, for example, Frydman and Phelps, 1983; Evans and Honkapohja,
1999). With regard to this particular criticism, it is important to note that the
strong version of the hypothesis does not require that economic agents actually know the correct model of the economy. What the hypothesis implies is
that rational agents will not form expectations which are systematically wrong
over time. In other words, expectations, it is suggested, will resemble those
formed ‘as if’ agents did know the correct model to the extent that they will
be unbiased and randomly distributed over time. Critics of the hypothesis are
not, however, convinced by arguments such as these and suggest that, owing
to such problems as the costs of acquiring and processing all available information, and uncertainty over which is the correct model, it ‘is’ possible for
agents to form expectations which are systematically wrong. There is some
evidence that agents do make systematic errors in expectations (see, for
example, Lovell, 1986).
A third important criticism, associated in particular with the Post Keynesian
school, relates to the problems of expectations formation in a world of fundamental uncertainty. To Keynesian fundamentalists, a major achievement of
Keynes was to place the problem of uncertainty at the centre stage of macr-
The new classical school
229
oeconomics. In the Post Keynesian vision, the world is non-ergodic; that is,
each historical event is unique and non-repetitive. In such situations the rules of
probability do not apply. We are in a world of ‘kaleidic’ change and fundamental discontinuities (Shackle, 1974). Accordingly, Post Keynesians argue that it
is important to follow both Keynes (1921) and Knight (1933) and distinguish
between situations involving risk and situations involving uncertainty. In situations of risk the probability distribution is known. In contrast, in situations of
uncertainty there is no possibility of formulating any meaningful probability
distribution. Because the rational expectations hypothesis assumes that economic agents can formulate probability distributions of outcomes of various
economic changes and situations, it belongs to the world of risk. In new
classical models the problem of fundamental uncertainty is ignored since Lucas
(1977) interprets business cycles as repeated instances of essentially similar
events. Hence, in Lucas’s ergodic world, meaningful probability distributions
of outcomes can be gauged by intelligent and rational economic agents. Unfortunately, according to Post Keynesians, the real world is one characterized by
fundamental uncertainty and this means that conclusions built on models using
the rational expectations hypothesis are useless. Likewise, the Austrian school
are also very critical of the rational expectations hypothesis (see Snowdon et
al., 1994, and Chapters 8 and 9).
The various influences on expectations have recently been investigated by
the Bank of England (2003). Reporting the results of a recent ‘inflation
attitudes survey’ the Bank of England finds the following interesting results:
1.
2.
3.
4.
5.
6.
disaggregating the data reveals that different people and groups have
different attitudes to inflation;
the expectations of ‘professional’ groups cluster around the mean expectation;
younger respondents have lower expectations of inflation than older
respondents;
mortgage holders have lower inflation expectations than respondents
who rent accommodation;
people in the south of Britain have higher expectations of inflation than
those living in the north; and
lifetime experience of inflation influences expectations of inflation.
Thus expectations of inflation are influenced by age, geographical location,
education and occupation, and housing status. Clearly those old enough to
have lived through the ‘Great Inflation’ of the 1970s have not been entirely
able to remove that experience from their judgement.
Notwithstanding these criticisms, during the 1970s there was undoubtedly
a ‘rational expectations revolution’ in macroeconomics (Taylor, 1989; Hoo-
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Modern macroeconomics
ver, 1992). However, it should be noted that Muth’s idea was not immediately
taken up by macroeconomists, maybe because during the 1960s the orthodox
Keynesian model was ‘the only game in town’. It took almost ten years
before Lucas, Sargent and other leading new classical economists began to
incorporate the hypothesis into their macroeconomic models.
Evidence of this lag can be gleaned from citation counts for Muth’s (1961)
paper. In an interesting comparison of the relative influence of Muth’s paper
with that of Axel Leijonhufvud’s (1968) famous book, On Keynesian Economics and the Economics of Keynes (see Chapter 2), Backhouse (1995) has
shown how during the 1970s and 1980s citations of Muth’s paper exploded
while citations of Leijonhufvud’s book declined as interest in Keynesian
economics waned (see Snowdon, 2004a). While Leijonhufvud’s book had an
immediate impact, but ultimately failed to transform macroeconomics in the
direction of coordination failure stressed by Leijonhufvud, in contrast, Muth’s
paper got off to a slow start but ultimately played a key role in transforming
macroeconomics (see Leijonhufvud, 1992, 1993, 1998a, 1998b on the need
for macroeconomics to reconsider, among many other things, the coordination question in macroeconomics).
One final point is worth making. The use of the word ‘rational’ in the
presentation of the hypothesis proved to be an important ‘rhetorical’ weapon
in the battle to win the minds of macroeconomists during the 1970s. As Barro
(1984) has pointed out:
One of the cleverest features of the rational expectations revolution was the
application of the term ‘rational’. Thereby, the opponents of this approach were
forced into the defensive position of either being irrational or of modelling others
as irrational, neither of which are comfortable positions for an economist.
For a more detailed discussion of the rational expectations hypothesis and its
application in macroeconomics, the reader is referred to Begg (1982); Carter
and Maddock (1984); Shaw (1984); Attfield et al. (1985); Redman (1992);
Sheffrin (1996); and Minford (1997). On the use of rhetoric in new classical
economics, see Backhouse (1997a).
5.3.2 Continuous market clearing
A second key assumption in new classical models is that all markets in the
economy continuously clear, in line with the Walrasian tradition. At each
point of time all observed outcomes are viewed as ‘market-clearing’, and are
the result of the optimal demand and supply responses of economic agents to
their perceptions of prices. As a result the economy is viewed as being in a
continuous state of (short- and long-run) equilibrium. New classical models
are in consequence often referred to as ‘equilibrium’ models, where equilibrium is interpreted to mean that all economic agents within a market economy
The new classical school
231
have made choices that optimize their objectives subject to the constraints
that they face.
In market-clearing models economic agents (workers, consumers and firms)
are ‘price takers’; that is, they take the m