controls--so that movements in quantity depend only on shocks to supply. If this situation holds for the majority of markets, one again gets prescriptions for the government's macro policies, but they are basically opposite to the ose from the K odel. The serious alternative to either of these two polar cases is a framework where demand and supply are somehow balanced or equilibrated on the various markets. Although I regard this equilibrium approach as the logical way to think about macroeconomics, this approach - pursued by new clas macroeconomists-- turns out to be inconsistent with basic Keynesian themes assia Approach The new classical macroeconomics, sometimes referred to as rationa expectations macroeconomics or as the equilibrium approach to macroeconomics, egan with Bob Lucas's research(Lucas, 1972, 1976) in the early 1970s. A guiding discipline of this work was that economic agents acted rationally in the context of their environment; notably that people assembled and used nformation in an efficient manner. Although the approach stressed fully worked out equilibrium theories, the analysis was directed at explaining eal-world business fluctuations. The basic viewpoint implied that it would be unsatisfactory to explain"these fluctuations by easily correctable market failures, such as those present in Keynesian models. Hence fluctuations had to reflect real or monetary disturbances, whose dynamic economic effects depended on costs of obtaining information, costs of ad justment, and so on The biggest challenge to the new classical approach was to explain why money was non-neutral, and, in particular, why monetary disturbances played a
major role in business cycles. This area was a significant challenge because first, it seemed to be empirically important, and second, the equilibriu framework with flexible prices tends to generate a close approximation to monetary neutrality Initially, the approach seemed to achieve notable successes. On theoretical level, short-term real effects of monetary disturbances could arise from imperfect information about money and the general price level Monetary shocks, which affected the general price level in the same direction, could be temporarily misperceived as shifts in relative prices which led to ad justments in the supply of labor and other quantities. These real effects vanished in the long run, but could persist for awhile because of information lags and costs of adjusting the quantities of factor inputs On the other hand, anticipated monetary changes--which include systematic monetary policies--would not matter because they did not lead to informational confusions(Sargent and Wallace, 1975) On an empirical level, there was also evidence that appeared to support the approach. Monetary disturbances seemed to be important sources of business fluctuations, and there was some indication that it was mainly the unanticipated or surprise part of monetary movements that mattered for real variables(Barro,1981).Some cross-country evidence supported the theoretical predictions concerning the relation between the volatility of money and the slopes of estimated Phillips curves( Kormendi and Meguire The theory was al sistent with the observed absence of a substantial long-term relationship between real economic performance and the growth rates of money and prices; that is, with the absence of a long-run Phillips curve
Further investigations cast doubt on these successes. First, the informational lag in observing money and the general price level did not seem to be very important. If incomplete information about money and the general price level mattered a lot for economic decisions, people could expend relatively little effort to find out quickly about these variables. Second the theory did not do so well in terms of its predictions about monetary effects on real interest rates, real wage rates, and consumption. Third, the predicted Phillips curve-type relation between price surprises and real economic activity basically disappeared after the early 1970s. Fourth, the sitive relation between monetary shocks and output shows up most clearly with broad monetary aggregates. The relation with narrow aggregates, such as the monetary base, is much weaker The upshot of these arguments is that the new classical approach does not do very well in accounting for an important role of money in business fluctuations. However, this failing may not be so serious because the empirical evidence on the causal role of money for real variables seems also to have been overstated. In other words, the accounting for major short-run non-neutralities of money was a misplaced priority for the new classical approach. Some empirical evidence supports this conclusion; for example, the observation that the correlation of real economic activity with broad monetary aggregates is greater than that with the monetary base or the price level, or the finding that real effects from the quantity of money are weak once the behavior of nominal interest rates is held constant. These results suggest that endogenous responses of money--partly from the behavior of policymakers and partly from the workings of the financial system--may