An overview
In this chapter, we discuss the stability of the NE in the light of a broadly defined neoclassical macro theory, by reconstructing the most likely scenario or tendencies that can be derived from it. In line with the view that this model is narrow or limited rather than simply false or wrong, we show that it does capture a certain number of intersections on our map, or matrix. In particular, it assigns a lot of weight to those mechanisms we have labelled as ‘positive’. The ‘negative’ mechanisms giving rise to instability, while not necessarily ruled out, are regarded as being weaker or temporary phenomena in the working of a market economy.
In what follows, we shall demonstrate these claims by focusing on the analytical apparatus of NCM, which provides the most refined version of neoclassical theory:
Proponents of this approach maintain that the NE is more stable than the old economy.
Indeed, we can take NCM as the best representation of those interpretations that emphasize the future of the NE as a linear development of current technical potentialities.
In order to analyse this claim, it is convenient to separate it into two parts. This means, according to NCM, that the following two statements are true: (a) the NE does not violate the stability postulate. Thus, it confirms the general laws of economics, that is, those broad qualitative mechanisms that are at play in all market economies. NCM theorists, therefore, concur with those who suggest that despite the occurrence of ‘disturbing’
phenomena, such as network effects and path-dependence, information economics does not really change the basic laws of economics (e.g. Liebowitz and Margolis 1999); (b) the NE provides an additional contribution to stability, because it implies that markets are more efficient. In particular, the NE approaches the perfect competition model as it brings about an improvement in the functioning of the price mechanism, the reduction of the role of the state and an improved monetary policy transmission mechanism in view of the more efficient use of information allowed by ICT (see the Economist 1–4–2000).
Indeed, the advent of ICT is one of the key factors that accounts for the rise of NCM itself. ‘It is, of course, no accident that rational expectations have thrived in the age of information technology. The existence of powerful computers and software has enabled us to simulate models in which the agents are using information efficiently’ (Minford 1997:110).
The NE and the ‘deep’ parameters
Further understanding of the NCM interpretation of the NE can be achieved by relating the distinction just made between the two parts of its overall stability claim to yet another distinction: that between different ‘levels of reality’ that underlies the equilibrium approach to the analysis of economic fluctuations developed by prominent NCM theorists such as Lucas. Indeed, as Vercelli points out, it is important to realize that for Lucas
Economic reality…can be divided into two levels: that of phenomena, characterized by erratic movements (disequilibria, in this particular sense) and by structural instability of parameters; and a deeper and more basic level (one is temped to say an ‘essential’ level)—characterized by the parameters of general economic equilibrium, which are considered structurally stable.
(1991:137–8) On these grounds, the task of Lucas’ equilibrium method becomes clear: it is meant ‘to bring macroeconomic phenomena, with all their apparent disequilibria—erratic movements and episodes of instability—within the scope of the essential level’ (ibid.:
138).
The NCM manages to achieve this result by regarding fluctuations in the levels of potential income, natural rate and inflation as agents’ equilibrium response to shocks.
Fluctuations are inevitable because of information errors or imperfections of some kind.
The NCM approach considers the economy to be in continuous market equilibrium.
However, for the sake of simplicity, we can distinguish between a ‘normal’ state of the economy with no shocks or errors (which we refer to as the systematic part) and another state characterized by the occurrence of some kind of shocks and errors (which we regard as the non-systematic part). This distinction proves relevant for our analysis of the NE. It can be argued that, according to NCM, the NE does not affect the systematic part so much as the non-systematic part of the economy. In particular, it reduces the role of information imperfections which makes the key assumption underlying NCM models—
that of a continuous market clearing equilibrium—even more plausible.
The ‘normal’ working of the economy
Let us start by analysing the ‘normal’ working of the economy implied by NCM, and by neoclassical theory in general. The first point to note is that the macro-economic picture being focused on here (described implicitly or explicitly in many textbooks) can be seen as a simplified representation of a full-blown general equilibrium state, where the
‘essential’ forces of self-interest and competition bring about optimal outcomes. In other words, the so-called deep parameters (i.e. preferences, technology and endowments of productive factors) determine the system of relative prices that will make agents’ plans consistent on all markets.
In order to understand the core of neoclassical macroeconomics, a convenient starting point is the following equation:
This reflects the view that supply (production or income, ) creates its own demand (C+I), in line with Say’s Law. In other words, the equilibrium level of income is
determined by the supply conditions. The standard model implies that certain economic mechanisms, such as price flexibility in all markets, guarantee that actual income always equals potential income, that is, that which can be produced by employing all available productive factors. Therefore, these supply factors pose a constraint on actual income growth because they determine potential income.
Neoclassical theorists thus place the emphasis on long-period analysis, on the determinants of capital accumulation and labour force growth. As shown by most macroeconomics textbooks, the standard production functions can be used to summarize the main factors at work (see e.g. Mankiw 2001, 2003; Blanchard 2003).
where A=state of technology. This can be defined in a narrow sense as the blueprint of techniques and goods that could be produced or in a broad sense as encompassing other factors, such as the degree of market competition and ‘perfection’, norms and the political climate.1 L=labour; K=physical capital; H=human capital; N=natural resources, which can also be stated in productivity terms by assuming constant returns to scale:
p=Af(1, K/L, H/L, N/L) where p=productivity and K, H, N, per worker.
In the flow chart below we have indicated the main features of this analytical framework, assuming a constant labour supply and lack of technological change.2 One of the key points this diagram highlights is the interaction between production, capital and savings (S). In particular, the diagram shows that potential income is determined by supply factors. It can be calculated as the product of three factors: productivity (p), number of workers (L) and the price level (P). Productivity depends on a number of factors, such as the state of technology and the size of resources, which are taken as exogenous, that is, unaccounted for by the model. L is determined on the labour market, where the forces of demand and supply (Ld, Ls) are equilibrated by the real wage (W/P). P is determined by the money supply (M), in line with the quantity theory of money, according to which money is neutral and does not modify real variables.
Potential income is then either consumed or saved, and savings (S) is simply reinvested (I). In turn, this implies other key assumptions, such as that capital markets are efficient—with the rate of interest (r) equilibrating savings and investment—and that, in view of the scarcity of resources, increasing the production of capital goods (investment) requires growth in savings and a reduction in the production of consumer goods.
Figure 16.1 also reveals that this analytical apparatus implies a very high level of aggregation; in principle, there is no problem of singling out or specifying other components of aggregate demand beyond consumption and investment.
New classical macroeconomics and the new economy 181
Figure 16.1 The neoclassical macro model.
The point is that relative prices (including exchange rates) will automatically generate the right amounts of it. In the case where relative prices are not enough, absolute price changes will stimulate demand through, for example, the Pigou effect or the Keynes effect. This analytical apparatus implies, therefore, that competitiveness issues, distribution effects and structural unbalances are not relevant at the macroeconomic level.
On the one hand, price flexibility and competition will favour the appearance of new sectors and the disappearance of mature ones; more in general, they will rule out quantity adjustments and spillover effects. On the other hand, neoclassical analysis rests on the assumption of the representative agent, ruling out any distinction between different types of agents.
Economic fluctuations
In NCM, Figure 16.1 described in the previous section also forms the basis for studying the dynamic behaviour of the economy, both in the short run (i.e. analysis of fluctuations) and the long run (i.e. analysis of accumulation and growth). Before dealing with these issues, two aspects of the kind of ‘dynamic’ analysis allowed by the NCM must be clarified. First, from this perspective—where the equilibrium described by the model coincides with the ‘objective’ equilibrium in the real world—the exact procedure by which equilibrium is reached has no scientific importance. Any other equilibrium would only be transitory, as it would imply the existence of overlooked opportunities that would eventually be discovered and exploited by agents (see e.g. Dow 2002:94). Second, the analysis of change is conducted on the grounds of something like standard comparative statics analysis. As we shall see in the next section, the NCM somehow departs from the latter as it adopts a different notion of equilibrium; in essence, however, the meaning is the same. If we suppose, for example, that changes in the parameters occur, the NCM