CHAPTER 11: NEW CLASSICAL ECONOMICS
Additional Questions
Essay Questions and/or Problems:
1. Define the concept of “rational expectations”. Do rational expectations mean that
individuals do not make mistakes when forming their expectations?
2. Explain the new classical proposition of “policy ineffectiveness”.
3. The Federal Reserve has increasingly become more open in their sharing of information
about monetary policy. According to new classical theory, what impact should this
openness have on their ability to stabilize output? Explain.
4. Explain the new classical theory explanation of the Great Depression. What is the
Keynesian critique of this explanation?
5. Discuss the new classical critique of Keynesian stabilization policy.
6. Explain what is meant by an auction market. Is an auction market perfectly competitive?
7. True or False. In the Keynesian model, individuals explicitly maximize their utility and
firms maximize their profits.
8. Suppose that the Federal Reserve makes an announcement that it is going to permanently
reduce the inflation rate to zero. Will inflation expectations immediately adjust? What will
determine the extent to which they adjust?
9. If policy irrelevance holds in the new classical model, does that mean that monetary and
fiscal policy can never impact output? Under what conditions could it impact output?
Explain.
Additional Essay Questions and/or Problems:
10. How does the contract theory of the labor market in the Keynesian model differ from the
auction market of the new classical model. Explain how this difference between the models
explains the different policy conclusions regarding the effectiveness of stabilization policy.
11. Use the IS-LM curve framework from previous chapters, together with the aggregate
demand and supply curve for the new classical case, to analyze the effects on the interest
rate as a result of an increase in the money supply. Consider both the case where the
increase in the money stock is anticipated and the case where it is unanticipated.
12. Analyze the effects of tax cut within the new classical model. Consider both the case where
the increase is anticipated and the case where it is unanticipated. In each case, include in
your answer the effects of this policy shift on the levels of output, employment, the price
level, and the level of the money wage.
13. How long is the long run? What determines how long the long-run is? Do you think that
Keynesians, Monetarists, and new classical economists would have different opinions about
how long the long run is? Why?
14. During the early 1980s, the U.S. economy experienced a sharp reduction in the rate of
inflation, which was widely believed to be due to a more restrictive monetary policy. The
reduction in inflation was accompanied, however, by a deep and reasonably long recession
(16 months from business cycle peak to trough). Explain these events within a Keynesian
and then a new classical framework.
15. Suppose that the Federal Reserve thinks that the natural rate of unemployment is 5%, when
in fact the natural rate of unemployment is 6%. If expectations are rational, what will be the
impact of a discretionary monetary policy that attempts to sustain 5% unemployment?
Explain.
16. Assume that the fraction of firms that negotiate fixed wage contracts declines over time.
Use the new classical model to analyze the impact of this change. Will monetary and fiscal
policy become more effective or less effective over time? Explain.
17. a. Suppose that an economy begins at the natural rate of unemployment and that the
expected inflation rate is equal to the actual price level in the preceding period. If the
central bank makes a permanent reduction in the money supply, draw a graph illustrating
the path of inflation and unemployment over time. Illustrate your AD/AS and Phillips curve
graphs.
b. How would your answer be different to part (a) under rational expectations versus
adaptive expectations? Explain.
18. Consider the impact of the internet on the slope of the AS curve. Can you make an
argument that the internet is making the AS curve steeper over time? Can you make an
argument that the internet is having not effect or even making the AS curve flatter over
time? Explain.
Multiple-Choice Questions:
1. According to the new classical model,
2. In the view of the new classical economists, an increase in the money stock will affect real
output and employment only if the increase in the money stock
3. The concept of “rational expectations” is consistent with the notion of
4. New classical economists
5. In the new classical model, an anticipated increase in the money stock would cause
6. New classical macroeconomists believe that
7. A difference between the classical and new classical models is that
8. An unanticipated decline in investment demand within the new classical model will cause
9. Aggregate supply in the new classical aggregate supply
10. Which of the following statements about the history of inflation in the U.S. is true?
11. A difference between the new classical and monetarist models is that expectations in the
new classical model are _____ while they are _____ in the monetarist model
12. If the stock market behaves according to the efficient market hypothesis, then
13. In the new classical view, an anticipated decrease in government spending would be
expected to
14. From the new classical perspective, the disinflation in the early 1980s resulted in a
significant recession because
15. New classical economics
16. In the new classical model, an unanticipated increase in the money stock would cause
17. According to new classical model, real wages
18. A change in expectations in the new classical model
19. If rational expectations hold, aggregate demand policy actions only affect output if
20. According to which of the following models are economic agents assumed to have perfect
information?
21. In an economy with higher and more variable inflation, the new classical model would
predict that the short run aggregate supply curve would
22. When expectations are rational,
23. Like the monetarists, new classical economists favor
24. Regarding fiscal policy, the new classical economists
25. Rational expectations imply
26. One similarity between the policy recommendations of the new classical and monetarist
models is that
27. Assume that a central bank with a history of inflation announces that it is going to reduce
money growth and inflation. According to the rational expectations model, the public will
28. New classical economists like Robert Lucas argue that the Great Depression was primarily
caused by
29. According to the new classical model, the output cost of reducing inflation
30. Which of the following would be evidence against rational expectations?
31. Keynesians disagree with the new classical model because
32. In a move to increase its openness, the Fed has consistently increased the amount of
information available to the public. According to the new classical model, the Phillips curve
the Fed faces should become more:
33. According to the new classical theory, a monetary surprise will
34. New classical economists believe that the classical model
35. Monetarists and Keynesians agree that expectations are
36. In the new classical model, stabilization policies
37. The theory of rational expectations states that
38. If government policy makers become more secretive, then the short run aggregate supply
curve should get
39. Which of the following statements is (are) correct? Keynesians criticize the new classical
theory because
40. “All available information” in the definition of rational expectations means that
41. According to Thomas Sargent and other new classical economists,
42. According to new classical economists,
43. In the rational expectations model
44. In the early 1980s, the disinflation in the United States
45. According to the new classical view, if the money supply and prices fall but output remains
46. Which of the following statements is (are) correct?
47. Which of the following statements is correct?
48. One criticism of the new classical model is that it does not have an adequate explanation for
49. Which of the following statements is (are) correct? The new classical economics
50. “Policy ineffectiveness” refers to the hypothesis that monetary and fiscal policy actions that
change aggregate demand will
51. According the Lucas’ misperception model, when prices unexpectedly rise, suppliers infer
that their relative prices have _____, which induces them to _____ output.
52. Keynesians would argue that:
53. The more limited information, the _____ the new classical AS curve.
54. According to Lucas’ misperception theory, countries with higher rates of inflation should
have a _____new classical AS curve.
55. Compared to adaptive expectations, rational expectations would imply that the transition
between the short-run and the long-run will take: