New classical macroeconomics

• 1. Introduction

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  New classical macroeconomics arrived in the 1970s as a direct challenge to the economic orthodoxy that had governed Western policy for three decades. At its core was one bold claim: that governments, by trying to manage the economy, had made things far worse. How did a handful of academic economists manage to overturn the dominant framework of their era? And what happens when the theory that replaces it turns out to have its own limits? Those are the questions this documentary will explore.

• 2. From Smith to Keynes

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  Adam Smith's The Wealth of Nations, published in 1776, is counted as the founding document of what we now call classical economics. Its central conviction was that markets are self-correcting and represent the best available mechanism for allocating resources. Every individual, acting in their own interest, drives the whole system toward efficient outcomes.

  The marginal revolution of the late 19th century, led by Carl Menger, William Stanley Jevons, and Leon Walras, refined that tradition into what became known as neoclassical economics. Alfred Marshall contributed to formalizing it further. Walras, though, left the deepest structural mark: his general equilibrium framework transformed economics into a mathematical and deductive discipline.

  That neoclassical consensus held until the Great Depression of the 1930s. John Maynard Keynes published The General Theory of Employment, Interest and Money in 1936, directly challenging core neoclassical assumptions. Keynes argued that economic behavior is also driven by what he called animal spirits, not purely rational calculation. That single move limited the role of the self-maximizing agent that neoclassical theory depended on, and it drew a new line between the study of individual markets and the study of the economy as a whole.

• 3. Stagflation and the Opening

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  Richard Nixon, a Republican president, and Milton Friedman, a fierce critic of government intervention, were both described as having affirmed the phrase "We are all Keynesians now" by the early 1970s. That statement captures just how thoroughly Keynesian thinking had colonized economic policymaking in the United States and across Western Europe in the post-war decades.

  The 1973 oil crisis broke that consensus open. The recession of 1973-75 produced stagflation, a combination of high unemployment, high inflation, and stagnant growth that Keynesian tools struggled to explain. The Phillips curve, which Keynesian economists had used to track the trade-off between inflation and unemployment, could not account for both rising at once. Cost-push inflation models fared no better. The divergence across countries made things worse: inflation ran higher in the United States and the United Kingdom than in Germany and Japan, and Keynesian frameworks offered no clean explanation for why.

  Those gaps were the opening that critics needed. Robert Lucas Jr. and Milton Friedman led the charge. Lucas developed what became known as the Lucas critique, aimed specifically at casting doubt on the reliability of Keynesian econometric models as guides to policy. His argument strengthened the case that macro models had to be built from microeconomic foundations, not assumed from aggregate relationships.

• 4. Rational Expectations and the Core Toolkit

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  John Muth had introduced the concept of rational expectations before the new classical school adopted it as a cornerstone. Lucas popularized it and made it central to the new program. The idea is that people form expectations about the future using all available information as efficiently as possible. They are not systematically fooled by predictable patterns.

  New classical economics built its framework on Walrasian foundations. All agents are assumed to maximize utility on the basis of rational expectations. The economy is assumed to reach a unique equilibrium at full employment or potential output through continuous price and wage adjustment. The market, in other words, clears at all times.

  Edward C. Prescott and Finn E. Kydland developed the real business cycle model, one of the most prominent outputs of the new classical program. New classical economists also pioneered the use of representative agent models, which treat the whole economy as if it were a single decision-making household. That approach drew serious criticism, with Alan Kirman among those pointing out the disconnect between individual behavior and aggregate results.

  The school's diagnostic framework identified three sources of economic fluctuations: a productivity wedge measuring aggregate production efficiency, a capital wedge capturing the gap between the return on savings and the marginal product of capital, and a labor wedge reflecting frictions in the labor market that act like a tax on hiring.

• 5. Empirical Limits

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  New classical models performed poorly when measured against actual economic data. They could not simultaneously explain both how long and how severe real business cycles tended to be. The models' central claim, that only unexpected changes in the money supply can affect unemployment and the business cycle, did not hold up under empirical testing.

  The representative agent framework received sustained criticism for assuming that what is true of an individual household is also true of the economy as a whole. Alan Kirman was among the economists who pointed to the disjuncture between microeconomic behavior and macroeconomic results as a fundamental flaw in that approach.

  Even many economists who had started in the new classical tradition came to accept the new Keynesian point that wages and prices do not move quickly or smoothly to their long-run equilibrium values. That acceptance implied, in turn, that monetary policy can have a real effect on the economy in the short run, which is precisely what the new classical models had denied. Greg Mankiw's account of this transition, published in 2006, treated the shift as essentially complete.

• 6. The New Neoclassical Synthesis

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  By the late 1990s, macroeconomics had split into two camps that were talking past each other. New Keynesian economists worked with small models focused on market imperfections like sticky prices and imperfect competition. New classical economists worked with fully specified general equilibrium models and attributed output fluctuations to changes in technology. Marvin Goodfriend and Robert G. King described the emerging consensus in a Federal Reserve Bank of Richmond working paper in 1997, which they called the new neoclassical synthesis.

  The synthesis borrowed from both sides. From the new classical tradition, it took the methodology behind real business cycle theory and the commitment to fully specified general equilibrium models. From new Keynesian economics, it took nominal rigidities, the recognition that prices move slowly and periodically rather than continuously. Michael Woodford's January 2008 paper on convergence in macroeconomics treated this synthesis as the foundation of contemporary mainstream economics.

  What the new classical school contributed to that synthesis was specific and durable: the rational expectations hypothesis and the concept of intertemporal optimization, the idea that households and firms make decisions by weighing present choices against their future consequences. Both of those tools remain active ingredients in how mainstream economists model the economy today.