Sample Q&As That Help You Take Your Macroeconomics Exams
Struggling to prepare for a macroeconomics exam at college or university? We have your back! Review these sample questions and their answers to get an idea of how to best solve macroeconomics exam questions for a better grade.
What Is the New Classical Macroeconomics?
For about a decade from the mid-1970s, the bulk of theoretical macroeconomic attention was directed towards the work of the New Classical School of economists. What is vitally important is to make a clear distinction between this group and Monetarists, with whom many have confused them. It is certainly true that New Classical ideas evolved out of Monetarism and that many former Monetarists have travelled on. What is not true is that it is safe to subsume one set of ideas within the other set.
The distinguishing feature of New Classical economics is often said to be the rational expectations hypothesis. This is indeed important, but it is clear that three other assumptions also play crucial roles in the typical New Classical analysis. These are the assumption of clearing markets, the natural rate hypothesis and the nature of the aggregate supply curve. Logically, these three are really only two independent assumptions (i.e. about the nature of the supply curve, and whether the economy is on both the demand and supply curves at all times). However, they are stated this way for ease of recognition. The natural rate hypothesis in its stronger version requires both long-run market-clearing and a specific supply structure to the economy.
What Is the Main Drift of New Classical Economics?
For the New Classical economist, the economy is made up of actors who consistently pursue the maximization of some clearly-defined objective function. The actors trade with one another in well-organized markets. Trade takes place at market-clearing prices such that all who wish to trade at the going prices are able to do so. This far, the framework would be recognized by a Classical economist. Novelty arises from the fact that the New Classical economist will not locate these actors in a static world, but rather in a stochastic environment. The world is one in which there are recurrent shocks to the system - bad harvests, earthquakes, sunspots, policy shifts, exogenous taste changes, wars, etc. In other words, while actors are rationally trying to respond to the price signals of the market, these signals are noisy. The fact that they are noisy has important implications. The New Classical world is often characterized as being 'perfect' in the sense of full information and costless adjustment. Some New Classical models are like this, but these are not the most interesting ones. It is central to the New Classical explanations of macroeconomic fluctuations that information is incomplete and that some adjustments are costly - that is, prior commitments are recurrently made.
An individual does not wait to find out the complete set of prices and then make all the supply/demand decisions at those actual prices (as might be the case in the presence of a Walrasian auctioneer). Rather, some decisions have to be made before the price which would affect it has actually been determined. For example, a wage contract may be entered into before work begins and a factory must be built before it can produce. These commitments must be made on the basis of the expectations of what the relevant prices will be, but it is to be emphasized that these expectations can, and will in general, be incorrect because the actual outcome is affected by current disturbances.
The rational expectations hypothesis simply amounts to the assumption that, in forming their expectations of what these prices (and perhaps other variables) will be, actors do the best that they can. This means that, given the information available at the time the forecast is made, no better forecast could be made on the basis of the same information. This does not imply either that the rational forecast will be correct or that some other guess would not be better for specific episodes. What it does imply is that a 'rational' forecast will, on average, be correct and that no other forecasting technique will regularly beat it. If the rational forecast was not correct on average, a such systematic error would imply that information was not being fully utilised. This would contradict the notion of rationality. Equally. there was a way of making forecasts better on average, that information should be included in the rational forecast.
The notion of rational expectations should not be alien to economists Indeed, since the rational forecast is defined as optimal it is hard to support any other. To define the optimal forecast, of course, does not commit us to the view that all actors actually do forecast optimally all the time, any more than to define profit maximisation commits us to the view that all firms maximise profits continuously. What it does do is enable us to examine the logical implications of rational forecasts as well as of deviations from full rationality. The New Classical economics has been mistakenly criticised for its use of rational expectations on the grounds that it requires that actors know too much, or more than they can reasonably be expected to know. It is true that some of the literature requires actors to know all that there is to know. However, much of the New Classical literature achieves its mileage precisely by restricting the information available to actors at the time they make their decisions. Lucas (1973) is a good example of this, where actors are presumed to know current prices in the market in which they sell their product, but only to learn about the general price level with a lag.
Thus far the discussion may seem to have been unnecessarily abstract. These abstract ideas do, however, have powerful implications for the way we view macroeconomic policy. It is these implications which have attracted so much attention to the New Classical economics. Most famous is the result that systematic aggregate demand policies can have no real effect. Recall that Keynesian economics was invented to show ways in which governments could raise the level of activity in the economy. An argument which says that policy can have no effect will obviously spark considerable controversy. The argument will simply be stated here and discussed further below.
Consider an economy which is at full employment in the sense that the labor market clears at a given real wage. The capital stock is held constant. We know that if all prices and incomes double in nominal terms nothing real will change. Suppose the authorities announce that the money stock is about to double. Rational actors would double their prices and so there would be no real effect. However, if the authorities doubled the money stock without telling anyone they were going to do it, firms and workers may think that there is an increased real demand for their services and so increase their supply. Hence, the short-term effect on the economy will depend crucially upon whether the policy change was anticipated or unanticipated. Only unanticipated aggregate demand policies will have real effects.
A useful way to think of the difference between Keynesian and New Classical perceptions of policy is to notice that a Keynesian would consider the policy-maker to be exogenous to the economy, and so all policies would be unanticipated. In the new view, however, to the extent that the policy-maker responds systematically to the state of the economy, actors learn that this is what they will do and change their own behavior accordingly. More fundamentally, perhaps, it means that the behavior of the economy will differ with each policy regime. Let us now look at this in more detail.
Explain the New Classical Challenge
It has been argued above that Monetarism could be viewed as an evolutionary stage in macroeconomics which started with the simple Keynesian model. While clearly emerging from a Monetarist background, New Classical macroeconomics represents a clean break from the stance of Keynesian economics. The nature of this break is nowhere more clearly evident than in a paper by Robert Lucas and Thomas Sargent (1981a) entitled "After Keynesian Macroeconomics":
For the applied economist, the confident and apparently successful application of Keynesian principles to economic policy which occurred in the United States in the 1960s was an event of incomparable significance and satisfaction. These principles led to a set of simple, quantitative relationships between fiscal policy and economic activity generally, the basic logic of which could be (and was) explained to the general public and which could be applied to yield improvements in economic performance benefiting everyone... We dwell on these halcyon days of Keynesian economics because without conscious effort they are difficult to recall today. In the present decade, the US economy has undergone its first major depression since the 1930s to the accompaniment of inflation rates in excess of 10 per cent per annum. These events have been transmitted (by consent of the governments involved) to other advanced countries and in many cases have been amplified. The events did not arise from a reactionary reversion to outmoded, "classical" principles of tight money and balanced budgets. On the contrary, they were accompanied by massive government budget deficits and high rates of monetary expansion, policies which, although bearing an admitted risk of inflation, promised according to modern Keynesian doctrine rapid real growth and low rates of unemployment.
That these predictions were wildly incorrect and that the doctrine on which they were based is fundamentally flawed are now simple matters of fact, involving no novelties in economic theory. The task now facing contemporary students of the business cycle is to sort through the wreckage, determining which feature of that remarkable intellectual event called the Keynesian Revolution can be salvaged and put to good use and which others must be discarded... Our intention is to establish that the difficulties are fatal, that modern macroeconomic models are of no value in guiding policy and that this condition will not be remedied by modifications along any line which is currently being pursued. (Lucas and Sargent (1981) Pp.295-313)
What is the basis for such strong claims about Keynesian macroeconomics? The argument is now known as the Lucas Critique after the title of the famous paper in which the argument first appeared (Econometric policy evaluation: a critique (Lucas, 1976)). It should be emphasised in advance that these criticisms do not depend in any essential way on the assumption typically used by the New Classical economists themselves. In other words, it is possible to accept the criticisms without in any way accepting the New Classical view of the appropriate solutions. Before explaining the criticisms, of course, it is necessary to have some idea of what Keynesian methodology was supposed to have been.
Consider the simple expenditure system given by equations (1.1) to (1.6) in Chapter 1. A real model used for policy analysis would be more complicated than this, but the point can be made just as well in this stripped-down version. Let us just take the 'multiplier' equation (1.7):
The Keynesian strategy would be straightforward. First, estimate the parameters x, ß and d from available historical data. For some view of the likely values of the exogenous variables I and X. Forecast the value of Yon on the basis of the estimated parameters and the predicted values of the exogenous variables, assuming the policy instruments G and T are unchanged. Then see what would happen to Y under different assumptions about the values of the policy instruments. Choose values of the policy instruments which generate the most desirable outcome by some criterion.
The Lucas criticism is that, while it may produce reasonable short-term forecasts, it is not an appropriate tool for the analysis of alternative policy scenarios. The short-term forecasts are reasonable because actual forecast- ing models incorporate lots of lagged variables. So forecasting just amounts to an extrapolation of what is going on already. Policy analysis, however, is worthless because the estimated parameters a, ß, d, etc. will not be invariant to the policies chosen. Even the assumed values of the 'exogenous' variables may vary with the policy if the assumption of exogeneity is not actually justified. It is a complete waste of time for the authorities to predict what will be the result of a change in policy when that prediction relies on the assumption of stability of parameters which will, in fact, change as a result of the policy change.
It may seem to the student that this problem is of minor significance. However, there are several episodes in recent British economic history where it has to be taken seriously, namely the failure to anticipate the inflationary effect of the 1967 devaluation; the misunderstanding of the impact of the 1971 Competition and Credit Control reforms on the monetary system; the Barber 'dash for growth' which had no visible impact on manufacturing investment; the change in the price-output dynamics of the economy which resulted from the adoption of floating exchange rates; the over-appreciation of sterling in 1979-80 which was associated with a 17 per cent decline in manufacturing output in one year; the aftermath of financial deregulation and the asset price boom of the mid-to-late 1980s. It is more than bad luck that just about every macroeconomic relationship broke down in the 1970s. Such breakdowns should be expected whenever there is a major change in the policy environment as actors adjust their behaviour to the new environment.
According to the New Classical School, the search should be for 'policy invariant models; i.e., models which are based upon the optimizing behavior of actors in such a way that the reaction of behavior to policy changes can be explicitly accounted for. This is one of the reasons for the insistence on rationality as a characteristic of the decision-making of the typical actor. If the behavior was sub-optimal, then presumably reactions to policy changes would be arbitrary and unpredictable.
Once these important lessons were learned, academic and government forecasters did indeed begin to try to model relationships in a way that was immune to the Lucas Critique. To some extent, as Hendry (1988) observed, the proof of the econometric pudding was in the breakdown of relationships, and improvements in modelling technology have led to improvements in this respect. However, it is now routine for estimated macro-economic relationships to be separated into their expectational and 'structural components, instead of bundling them together, as was done by default in the past. Price (1992a) is just such an example, where the explicit account is taken of forward-looking expectations in a model of UK price-setting. There is now a lot of evidence to support the idea that this approach, desirable on theoretical grounds, is also a practical methodology. The foremost UK forecasting model maintained by the National Institute - is largely constructed on this basis.
How Do Expectations Play Out in The New Classical Macroeconomics?
The importance of expectations has long been appreciated by macro-economists. In early Keynesian macroeconomics, they arose most importantly in the analysis of the investment. For example, since building a factory takes time there will be a delay before the output is produced. So the entrepreneur has to form expectations about the demand for the product in the future in order to assess the likely profitability of the venture. More recently, an important role for expectations has arisen in the context of wage and price-setting behaviour. This is because in negotiating wage contracts, for example, agents need to have some view about future changes in the value of money in order to assess the real value of any settlement. This issue will be discussed more fully in Chapter 7 below.
The problem posed by the presence of expectations takes the same form wherever it arises in the explicit formulation of testable models. When the expected value of some variable appears in an equation something has to be done about it because that variable is unobservable. A common method of solving this problem has been to extrapolate the past behaviour of the variable itself. In other words, take the past trend in the variable and assume that the trend will continue. A specific form of extrapolation is provided by the 'error learning mechanism' or 'adaptive expectations". This says that the forecast currently being made of the next period's value of the variable in question is a revision of the forecast made last period for the current period. The size of this revision is proportional to the error made last time and is in the same direction. If the expectation was, for example, of the price level, we would write:
Pet-Pet-1= μ (Pt-1Pet-1) 0< μ<1 (4.1)
The difference between the expectation of the price level in period t and the expectation in period t-1 depends on the difference between the actual outturn, Pt- 1 in t-1 and the expectation of what that would be. The time subscripts refer to the period of the outcome. The expectation is formed immediately prior to that.
This may not look very helpful as a way of replacing an unobservable variable with observables. Since
Pet= μ Pt-1+ (1- μ) Pet-1 (4.2)
We would be replacing one unobservable with an expression which contains another. However, it is also true that:
Pet-1= μPt-2+ (1- μ) Pet-2 (4.3)
By continued substitutions, we can obtain
Pet= μ Pt-1+ (1- μ) Pt-2+ (1- μ)2 Pt-3+…+(1- μ)n Pt-n-1+(1- μ)n+1 Pet-n-1 (4.4)
The right-hand side of this expression only contains observables, except for the last term (1- μ) n+1 Pet-n-1. Since μ is less than unity, (1- μ)n+1 will become very small as n gets larger. So if a large enough number of lagged values is used this last term can be ignored. The expectation of the variable is then replaced by a weighted average of past observations, the weights being geometrically declining.
One thing to notice immediately about adaptive expectations is that the only information used in forming them is the past observations on the variable in question. No other information is presumed to be of assistance. It would not be permissible, for example, for actors to expect higher prices just because OPEC (Organisation of Petroleum Exporting Countries) announces a substantial rise in the price of oil today. They would have to wait until this had worked through to prices in the shops. The second thing to notice is that until prices have been stable for a considerable time expectations formed adaptively will be consistently incorrect. This is because there is only a partial adjustment in response to the error in forecasting. Hence, there will be no error in the steady state only when the variable to be forecast is constant for some time.
The rational expectation (Muth, 1961) of a variable is defined in such a way that it cannot be systematically incorrect. Formally, the rational expectation is the mathematical expectation given the information available at the time the expectation is formed:
Pet = E (pt|It-1)
where E is the expectations operator, Pet is the typical actor's subjective expectation of the price level in period 1, formed on the basis of all information available up to and including period t-1, It-1. In other words, the actors' expectations will be the same as the best forecast that could be made with the information available when the forecast is made. This is what was meant by the statement that actors do 'the best they can'. It does not follow that the rational expectation will typically be correct, but it does follow that over-predictions and under-predictions will average out to zero, unless the information set is changing.
Pet = Pt+ εt
E (εt) =0, E (εt εt-1) =0 for all i>0 (4.6)
The expectation will be equal to the actual value plus a random (‘expectational) error with a mean zero. If this error were not random, the actor could improve the forecast by incorporating that information; i.e. they would learn from their mistakes.
It is sometimes argued in criticism of rational expectations that it is unreasonable to expect actors to be able to forecast as well as the best professional. Criticisms of this kind miss the point. Rationality implies no more than that the expectation is formed as the outcome of an optimisation exercise. In this respect, it is no more extreme than the assumption of profit maximisation or utility maximisation. If information is freely available people will use it optimally. If information is not freely available they will acquire only just as much as it is worth their while to acquire. It is only in specific applications of the idea that it is possible to say if the information required is in excess of that which it is reasonable to believe actors have.