The Policy Implications of the Neoclassical Perspective

Read this text, which explores how economists measure inflation expectations, the impacts of fiscal and monetary policy on aggregate supply and aggregate demand, and the Neoclassical Phillips Curve. Be sure you can compare Neoclassical and Keynesian economics.

To understand the policy recommendations of the Neoclassical economists, it helps to start with the Keynesian perspective. Suppose a decrease in aggregate demand causes the economy to go into recession with high unemployment. The Keynesian response would be to use government policy to stimulate aggregate demand and eliminate the recessionary gap. The Neoclassical economists believe that the Keynesian response, while perhaps well-intentioned, will not have a good outcome for reasons we will discuss shortly. Since Neoclassical economists believe that the economy will correct itself over time, the only advantage of a Keynesian stabilization policy would be to accelerate the process and minimize the time that the unemployed are out of work. Is that the likely outcome?

Keynesian macroeconomic policy requires some optimism about the government's ability to recognize a situation of too little or too much aggregate demand and to adjust aggregate demand accordingly with the right level of changes in taxes or spending, all enacted in a timely fashion. After all, Neoclassical economists argue, it takes government statisticians months to produce even preliminary estimates of GDP so that politicians know whether a recession is occurring – and those preliminary estimates may be revised substantially later. Moreover, there is the question of timely action.

The political process can take more months to enact a tax cut or a spending increase. Political or economic considerations may determine the amount of tax or spending changes. Then, the economy will take still more months to put into effect changes in aggregate demand through spending and production. When economists and policymakers consider all of these time lags and political realities, active fiscal policy may fail to address the current problem. It could even make the future economy worse. The average U.S. post-World War II recession has lasted only about a year. By the time government policy activates, the recession will likely be over. As a consequence, the only result of government fine-tuning will be to stimulate the economy when it is already recovering (or to contract the economy when it is already falling). In other words, an active macroeconomic policy is likely to exacerbate the cycles rather than dampen them. Some Neoclassical economists believe a large part of the business cycles we observe are due to flawed government policy. To learn about this issue further, read the following Clear It Up feature.

Clear It Up

Why and how do economists measure inflation expectations?

People take expectations about inflation into consideration every time they make a major purchase, such as a house or a car. As inflation fluctuates, so too does the nominal interest rate on loans to buy these goods. The nominal interest rate is comprised of the real rate, plus an expected inflation factor.

Expected inflation also tells economists about how the public views the economy's direction. Suppose the public expects inflation to increase. This could be the result of a positive demand shock due to an expanding economy and increasing aggregate demand. It could also be the result of a negative supply shock, perhaps from rising energy prices, and decreasing aggregate supply. In either case, the public may expect the central bank to engage in contractionary monetary policy to reduce inflation, and this policy results in higher interest rates.

If, however economists expect inflation to decrease, the public may anticipate a recession. In turn, the public may expect expansionary monetary policy, and lower interest rates, in the short run. By monitoring expected inflation, economists garner information about the effectiveness of macroeconomic policies. Additionally, monitoring expected inflation allows for projecting the direction of real interest rates that isolate for the effect of inflation. This information is necessary for making decisions about financing investments.

Expectations about inflation may seem like a highly theoretical concept, but, in fact the Federal Reserve Bank measures, inflation expectations based upon early research conducted by Joseph Livingston, a financial journalist for the Philadelphia Inquirer. In 1946, he started a twice-a-year survey of economists about their expectations of inflation. After Livingston's death in 1969, the Federal Reserve Bank and other economic research agencies such as the Survey Research Center at the University of Michigan, the American Statistical Association, and the National Bureau of Economic Research continued the survey.

Current Federal Reserve research compares these expectations to actual inflation that has occurred, and the results, so far, are mixed. Economists' forecasts, however, have become notably more accurate in the last few decades. Economists are actively researching how inflation expectations and other economic variables form and change.

The Neoclassical Phillips Curve Tradeoff

The Keynesian Perspective introduced the Phillips curve and explained how it is derived from the aggregate supply curve. The short-run upward-sloping aggregate supply curve implies a downward-sloping Phillips curve; thus, there is a tradeoff between inflation and unemployment in the short run. By contrast, a Neoclassical long-run aggregate supply curve will imply a vertical shape for the Phillips curve, indicating no long-run tradeoff between inflation and unemployment. Figure 13.6 (a) shows the vertical AS curve, with three different levels of aggregate demand, resulting in three different equilibria at three different price levels. At every point along that vertical AS curve, the potential GDP and the rate of unemployment remain the same. Assume that for this economy, the natural rate of unemployment is 5%. As a result, the long-run Phillips curve relationship in Figure 13.6 (b) is a vertical line, rising up from 5% unemployment at any level of inflation. Read the following Work It Out feature for additional information on how to interpret inflation and unemployment rates.

 Figure 13.6 From a Long-Run AS Curve to a Long-Run Phillips Curve (a) With a vertical LRAS curve, shifts in aggregate demand

Figure 13.6 From a Long-Run AS Curve to a Long-Run Phillips Curve (a) With a vertical LRAS curve, shifts in aggregate demand do not alter the level of output but do lead to changes in the price level. Because output is unchanged between the equilibria E0, E1, and E2, all unemployment in this economy will be due to the natural rate of unemployment. (b) If the natural rate of unemployment is 5%, then the Phillips curve will be vertical. That is, regardless of changes in the price level, the unemployment rate remains at 5%.

Work It Out

Tracking Inflation and Unemployment Rates

Suppose that you have collected data for years on inflation and unemployment rates and recorded them in a table, such as Table 13.1. How do you interpret that information?

Year Inflation Rate Unemployment Rate
1970 2% 4%
1975 3% 3%
1980 2% 4%
1985 1% 6%
1990 1% 4%
1995 4% 2%
2000 5% 4%

Table 13.1

Step 1. Plot the data points in a graph with inflation rate on the vertical axis and unemployment rate on the horizontal axis. Your graph will appear similar to Figure 13.7.

 Figure 13.7 Inflation Rates

Figure 13.7 Inflation Rates

Step 2. What patterns do you see in the data? You should notice that there are years when unemployment falls but inflation rises, and other years where unemployment rises and inflation falls.

Step 3. Can you determine the natural rate of unemployment from the data or from the graph? As you analyze the graph, it appears that the natural rate of unemployment lies at 4%. This is the rate that the economy appears to adjust back to after an apparent change in the economy. For example, in 1975 the economy appeared to have an increase in aggregate demand.

The unemployment rate fell to 3% but inflation increased from 2% to 3%. By 1980, the economy had adjusted back to 4% unemployment and the inflation rate had returned to 2%. In 1985, the economy looks to have suffered a recession as unemployment rose to 6% and inflation fell to 1%. This would be consistent with a decrease in aggregate demand. By 1990, the economy recovered back to 4% unemployment, but at a lower inflation rate of 1%. In 1995 the economy again rebounded and unemployment fell to 2%, but inflation increased to 4%, which is consistent with a large increase in aggregate demand. The economy adjusted back to 4% unemployment but at a higher rate of inflation of 5%. Then in 2000, both unemployment and inflation increased to 5% and 4%, respectively.

Step 4. Do you see the Phillips curve(s) in the data? If we trace the downward sloping trend of data points, we could see a short-run Phillips curve that exhibits the inverse tradeoff between higher unemployment and lower inflation rates. If we trace the vertical line of data points, we can see a long-run Phillips curve at the 4% natural rate of unemployment.

The unemployment rate on the long-run Phillips curve will be the natural rate of unemployment. A small inflationary increase in the price level from AD0 to AD1 will have the same natural rate of unemployment as a larger inflationary increase in the price level from AD0 to AD2. The macroeconomic equilibrium along the vertical aggregate supply curve can occur at a variety of different price levels, and the natural rate of unemployment can be consistent with all different rates of inflation. The great economist Milton Friedman (1912–2006) summed up the Neoclassical view of the long-term Phillips curve tradeoff in a 1967 speech: "[T]here is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off."

In the Keynesian perspective, the primary focus is on getting the level of aggregate demand right in relationship to an upward-sloping aggregate supply curve. That is, the government should adjust AD so that the economy produces at its potential GDP, not so low that cyclical unemployment results and not so high that inflation results. In the Neoclassical perspective, aggregate supply will determine output at potential GDP, the natural rate of unemployment determines unemployment, and shifts in aggregate demand are the primary determinants of changes in the price level.

Fighting Unemployment or Inflation?

As we explained in Unemployment, economists divide unemployment into two categories: cyclical unemployment and the natural rate of unemployment, which is the sum of frictional and structural unemployment. Cyclical unemployment results from fluctuations in the business cycle and is created when the economy is producing below potential GDP – giving potential employers less incentive to hire. When the economy is producing at potential GDP, cyclical unemployment will be zero. Because of labor market dynamics, in which people are always entering or exiting the labor force, the unemployment rate never falls to 0%, not even when the economy is producing at or even slightly above potential GDP. Probably the best we can hope for is for the number of job vacancies to equal the number of job seekers.

We know that it takes time for job seekers and employers to find each other, and this time is the cause of frictional unemployment. Most economists do not consider frictional unemployment to be a "bad" thing. After all, there will always be workers who are unemployed while looking for a job that is a better match for their skills. There will always be employers that have an open position while looking for a worker who is a better match for the job. Ideally, these matches happen quickly, but even when the economy is very strong, there will be some natural unemployment, and this is what the natural rate of unemployment measures.

The Neoclassical view of unemployment tends to focus attention away from the cyclical unemployment problem – that is, unemployment caused by the recession – while putting more attention on the unemployment rate issue that prevails even when the economy is operating at potential GDP. To put it another way, the Neoclassical view of unemployment tends to focus on how the government can adjust public policy to reduce the natural rate of unemployment. Such policy changes might involve redesigning unemployment and welfare programs so that they support those in need but also offer greater encouragement for job-hunting. It might involve redesigning business rules with an eye to whether they are unintentionally discouraging businesses from taking on new employees. It might involve building institutions to improve the flow of information about jobs and the mobility of workers to help bring workers and employers together more quickly. For those workers who find that their skills are permanently no longer in demand (for example, the structurally unemployed), economists can design policies to provide opportunities for retraining so that these workers can reenter the labor force and seek employment.

Neoclassical economists will not tend to see aggregate demand as a useful tool for reducing unemployment; after all, with a vertical aggregate supply curve determining economic output, aggregate demand has no long-run effect on unemployment. Instead, Neoclassical economists believe that aggregate demand should be allowed to expand only to match the gradual shifts of aggregate supply to the right – keeping the price level much the same and inflationary pressures low.

If aggregate demand rises rapidly in the Neoclassical model, in the long run, it leads only to inflationary pressures. Figure 13.8 shows a vertical LRAS curve and three different levels of aggregate demand, rising from AD0 to AD1 to AD2. As the macroeconomic equilibrium rises from E0 to E1 to E2, the price level rises, but real GDP does not budge, nor does the rate of unemployment, which adjusts to its natural rate. Conversely, reducing inflation has no long-term costs, either. Think about Figure 13.8 in reverse, as the aggregate demand curve shifts from AD2 to AD1 to AD0, and the equilibrium moves from E2 to E1 to E0. During this process, the price level falls, but in the long run, neither the real GDP nor the natural unemployment rate changes.

 Figure 13.8 How Aggregate Demand Determines the Price Level in the Long Run As aggregate demand shifts to the right, from AD

Figure 13.8 How Aggregate Demand Determines the Price Level in the Long Run As aggregate demand shifts to the right, from AD0 to AD1 to AD2, real GDP in this economy and the level of unemployment do not change. However, there is inflationary pressure for a higher price level as the equilibrium changes from E0 to E1 to E2.

Fighting Recession or Encouraging Long-Term Growth?

Neoclassical economists believe that the economy will rebound out of a recession or eventually contract during an expansion because prices and wage rates are flexible and will adjust either upward or downward to restore the economy to its potential GDP. Thus, the key policy question for Neoclassical is how to promote growth of potential GDP. We know that economic growth ultimately depends on the growth rate of long-term productivity. Productivity measures how effective inputs are at producing outputs.

We know that U.S. productivity has grown on average about 2% per year. That means that the same amount of inputs produce 2% more output than the year before. We also know that productivity growth varies a great deal in the short term due to cyclical factors. It also varies somewhat in the long term. From 1953–1972, U.S. labor productivity (as measured by output per hour in the business sector) grew at 3.2% per year. From 1973–1992, productivity growth declined significantly to 1.8% per year. Then, from 1993–2010, productivity growth increased to around 2% per year. In recent years, it has grown less than 2% per year, although it did pick up in 2019 and 2020 to over 2% again. The Neoclassical economists believe the underpinnings of long-run productivity growth to be an economy's investments in human capital, physical capital, and technology, operating together in a market-oriented environment that rewards innovation. Government policy should focus on promoting these factors.

Summary of Neoclassical Macroeconomic Policy Recommendations

Let's summarize what Neoclassical economists recommend for macroeconomic policy. Neoclassical economists do not believe in "fine-tuning" the economy. They believe that a stable economic environment with a low rate of inflation fosters economic growth. Similarly, tax rates should be low and unchanging. In this environment, private economic agents can make the best possible investment decisions, which will lead to optimal investment in physical and human capital as well as research and development to promote improvements in technology.

Summary of Neoclassical Economics versus Keynesian Economics

Table 13.2 summarizes the key differences between the two schools of thought.

Summary Neoclassical Economics Keynesian Economics
Focus: long-term or short term Long-term Short-term
Prices and wages: sticky or flexible? Flexible Sticky
Economic output: Primarily determined by aggregate demand or aggregate supply? Aggregate supply Aggregate demand
Aggregate supply: vertical or upward-sloping? Vertical Upward-sloping
Phillips curve vertical or downward-sloping Vertical Downward sloping
Is aggregate demand a useful tool for controlling inflation? Yes Yes
What should be the primary area of policy emphasis for reducing unemployment? Reform labor market institutions to reduce the natural rate of unemployment Increase aggregate demand to eliminate cyclical unemployment
Is aggregate demand a useful tool for ending a recession? At best, only in the short-run temporary sense, but it may just increase inflation instead. Yes

Table 13.2 Neoclassical versus Keynesian Economics

Source: Rice University,
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Last modified: Thursday, September 21, 2023, 10:22 AM