The New Classical Macroeconomics: Policy
Ineffectiveness Proposition
Tehseen Iqbal
AERC, UoK
[Link]@[Link]
June 4, 2025
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 1 / 22
New Classical Macroeconomics
“Any systematic economic policy is totally ineffective in determin-
ing the equilibrium value of real output. With rational expecta-
tions and price flexibility the equilibrium level of output fluctuates
around its natural level and those fluctuations depend only on
stochastic (and so unpredictable) elements”
Sargent and Wallace (1975)
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 2 / 22
New Classical Macroeconomics
The New Classical Macroeconomics begins with the work of R.E locus
and T.J Sargent.
The assumptions of the new classical macroeconomics are:
Flexible prices; the economy is always close to the natural level of
output
Imperfect informations; Economy is continuously subject to the random
shocks (Stochastic environment)
Rational expectation.
New classical macroeconomic models are based on micro-foundation
(optimizing behaviour agents) and it is known as micro-foundation of
macroeconomics.
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 3 / 22
Policy Ineffective Proposition
Consider the following AD-AS model
AD : yt = β0 + β1 (mt − pt ) + β2 gt + νt (1)
where, β0 can include all the autonomous spending elements. νt is
the random shock to aggregate demand.
The Lucas aggregate supply curve is given as following.
AS : yt = ȳ + α(pt − pte ) + µt (2)
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 4 / 22
Policy Ineffective Proposition
We assume the following:
gt = γg g¯t + θt
(3)
mt = γm m̄t + ϑt
The equation (3) shows the monetary and fiscal policy rules used by
the authorities. γg g¯t and γm m̄t are systematic part of the rules which
are known by all the agents in the economy. θt and ϑ are the
stochastic elements of the policy rules.
Expectation of the policy rule:
E (gt ) = E (γg g¯t ) + E (θ)
E (mt ) = E (γm m̄t ) + E (ϑ)
The expected value of a value known with certainty is the value itself
E (γg g¯t ) = γg g¯t and E (γm m̄t ) = γm m̄t
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 5 / 22
Policy Ineffective Proposition
The expected value of stochastic (random) variable is zero
E (θt ) = 0
E (ϑ) = 0
In average the agents expect the policy rules to be equal to their
systematic parts.
gte = E (γg g¯t ) + E (θt ) = γg g¯t
(4)
mte = E (γm m̄t ) + E (ϑ) = γm m̄t
From equations (3) and (4) we get the forecasting error which is
given as:
gt − gte = θ
mt − mte = ϑ
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 6 / 22
Policy Ineffective Proposition
Consider the equilibrium implied by our AD-AS model (where
AD=AS):
β0 + β1 (mt − pt ) + β2 gt + νt = ȳ + α(pt − pte ) + µt (5)
β0 + β1 mt − β1 pt + β2 gt + νt = ȳ + αpt − αpte + µt
(α + β1 )pt = β0 + β1 mt + β2 gt − ȳ + νt − µt + αpte
The equilibrium price level is given as following:
β0 β1 mt β2 gt ȳ νt − µt pte
pt = + + − + + α
(α + β1 ) (α + β1 ) (α + β1 ) (α + β1 ) (α + β1 ) (α + β1 )
(6)
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 7 / 22
Policy Ineffective Proposition
Equilibrium value of yt is found by substituting the equilibrium price
into aggregate demand function.
h β0 β1 mt β2 gt
yt = β0 + β1 mt − β1 + +
(α + β1 ) (α + β1 ) (α + β1 )
ȳ νt − µt pte i
− + + α + β2 gt + νt
(α + β1 ) (α + β1 ) (α + β1 )
β1 β0 β12 mt β1 β2 gt
yt = β0 + β1 mt − − −
(α + β1 ) (α + β1 ) (α + β1 )
β1 ȳ β1 (νt − µt ) β1 pte i
+ − − α + β2 gt + νt
(α + β1 ) (α + β1 ) (α + β1 )
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 8 / 22
Policy Ineffective Proposition
αβ0 β0 β1 αβ1 mt β12 mt β0 β1
yt = + + + −
(α + β1 ) (α + β1 ) (α + β1 ) (α + β1 ) (α + β1 )
β 2 mt β1 β2 gt β1 ȳ β1 (νt − µt ) αβ1 pte
− 1 − + − −
(α + β1 ) (α + β1 ) (α + β1 ) (α + β1 ) (α + β1 )
αβ2 gt β1 β2 gt ανt β1 νt
+ + + +
(α + β1 ) (α + β1 ) (α + β1 ) (α + β1 )
αβ0 β0 β1 αβ1 mt β 2 m
t
β0 β1
yt = + + + − 1 −
(α + β1 ) (α + β1 ) (α + β1 ) (α + β1 )
(α + β1 )
2
β m β1 β2 g β1 ȳ β1 (νt − µt ) αβ1 pte
t t
− 1 − + − −
(α+ β1 ) (α + β1 ) (α + β1 ) (α + β1 ) (α + β1 )
αβ2 gt β1 β2 g
t
ανt β1 νt
+ + + +
(α + β1 ) (α + β1 ) (α + β1 ) (α + β1 )
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 9 / 22
Policy Ineffective Proposition
αβ0 αβ1 mt β1 ȳ β1 (νt − µt )
yt = + + −
(α + β1 ) (α + β1 ) (α + β1 ) (α + β1 )
αβ1 pte αβ2 gt ανt β1 νt
− + + +
(α + β1 ) (α + β1 ) (α + β1 ) (α + β1 )
Equilibrium level of income is obtained as following:
αβ0 + αβ1 mt + αβ2 gt + β1 ȳ − αβ1 pte
yt = + ϕt (7)
(α + β1 )
ανt −β1 (νt −µt )+β1 νt
where ϕt = (α+β1 )
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 10 / 22
Policy Ineffective Proposition
Agents use this model to form the expectation. The expected price
level is given as:
"
β0 β1 mt β 2 gt ȳ
E (pt ) = E + + −
(α + β1 ) (α + β1 ) (α + β1 ) (α + β1 )
# (8)
νt − µt pte
+ + α
(α + β1 ) (α + β1 )
β0 β1 β2
E (pt ) = + E (mt ) + E (gt )
(α + β1 ) (α + β1 ) (α + β1 )
(9)
ȳ 1 α
− + E (νt − µt ) + E (pte )
(α + β1 ) (α + β1 ) (α + β1 )
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 11 / 22
As we know that:
E (pte ) = pte
E (pt ) = pte
E (mt ) = mte
E (gt ) = gte
E (νt ) − E (µt )
=0
(α + β1 )
Therefore
β0 β1 β2 ȳ α
pte = + mte + gte − + pe
(α + β1 ) (α + β1 ) (α + β1 ) (α + β1 ) (α + β1 ) t
(10)
β1 β0 β1 β2 ȳ
pte = + mte + gte −
(α + β1 ) (α + β1 ) (α + β1 ) (α + β1 ) (α + β1 )
(11)
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 12 / 22
Policy Ineffective Proposition
The expected price level (pte ) is obtained as following:
β0 β2 ȳ
pte = + mte + gte − (12)
β1 β1 β1
Equilibrium level of income form equation (7)
αβ0 + αβ1 mt + αβ2 gt + β1 ȳ αβ1 pte
yt = + ϕt − (13)
(α + β1 ) (α + β1 )
Substitute the value of expected price level from equation (12) into
the equation of equilibrium level of income (13)
αβ0 + αβ1 mt + αβ2 gt + β1 ȳ
yt = + ϕt
(α + β1 )
! (14)
αβ1 β0 e β2 e ȳ
− + m t + gt −
(α + β1 ) β1 β1 β1
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 13 / 22
Policy Ineffective Proposition
αβ0 + αβ1 mt + αβ2 gt + β1 ȳ
yt = + ϕt
(α + β1 )
(15)
αβ0 − αβ1 mte − αβ2 gte + αȳ
−
(α + β1 )
αβ1 mt − αβ1 mte + αβ2 gt − αβ2 gte + β1 ȳ + αȳ
yt = + ϕt (16)
(α + β1 )
The equilibrium level of income is
αβ1 (mt − mte ) αβ2 (gt − gte )
yt = ȳ + + + ξt (17)
α + β1 α + β1
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 14 / 22
Policy Ineffective Proposition
We know that gt − gte = θt and mt − mte = ϑt
Therefore, under rational expectation we have that
αβ1 αβ2
yt = ȳ + ϑt + θt + ξt (18)
α + β1 α + β1
where ξt is a shock that depends on demand and supply shocks
We can write the above equation as:
yt = ȳ + ηt (19)
where
αβ1 αβ2
ηt = ϕt + θt + ξt
α + β1 α + β1
and
E (ηt ) = 0
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 15 / 22
Policy Ineffective Proposition
In equilibrium, with rational expectations and flexible prices, the level
of aggregate income fluctuates around the natural level
The two levels of income do not coincide only because of stochastic
terms that depend on
Shocks on the aggregate supply and the aggregate demand (µt , νt )
Shocks on the policy rules (θt , ϑ)
The systematic parts of the policy functions do not appear into
equation of equilibrium level of output.
This result is knowns as Policy Ineffective Proposition
Policy may have short-run effects only when it is not correctly
anticipated by the [Link] when economic agents are fooled by the
policy authorities that deviate from the systematic parts of their
policy rules.
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 16 / 22
Policy ineffectiveness Proposition and AD-AS
model(Anticipated change in Monetary Policy)
Suppose that the Central Bank announces that the money supply will
increase
Agents believe that the announcement of the central bank is credible.
Agents have rational expectations
An increase in money supply that is systematic should increase the
price level without affecting the real variables of the economy.
Agents correctly anticipate the effects of the policy by correcting their
expectations about future prices
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 17 / 22
Figure 1: Effect of anticipated change in monetary policy
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 18 / 22
Policy ineffectiveness Proposition and AD-AS
model(Unanticipated change in Monetary Policy)
In case of unanticipated increase in money supply p differs from p e
Unanticipated increase in money supply increases p unexpectedly.
When p > p e real output increase in short run
Real Output comeback to full employment level of output after
expectation adjusts accordingly.
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 19 / 22
Figure 2: Short and long run effects of unanticipated change in monetary policy
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 20 / 22
Painless Disinflation
The introduction of rational expectations can have the effect that a
government can reduce inflation without increasing unemployment.
Suppose that the growth rate of money supply is 10% today and the
central bank announces that in 6 months the growth rate money
supply will be reduced to 0%
Suppose that agents believe that the announcement of the central
bank is credible
Agents will adjust their expectations and so the short-run Phillips
curve will shift down to the curve associated with an expected
inflation of 0%.
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 21 / 22
Painless Disinflation
Figure 3: Phillips Curve and Painless disinflation
Tehseen Iqbal (AERC) Advanced Macroeconomics June 4, 2025 22 / 22
