26.2 The Policy Implications of the Neoclassical Perspective

The neoclassical perspective on macroeconomic policy focuses on long-term economic stability. It emphasizes the natural rate of unemployment and the flexibility of wages and prices, suggesting that government intervention can't permanently lower unemployment without causing inflation.

This view contrasts with Keynesian economics, which argues for more active government involvement. Neoclassical economists believe fiscal and monetary policies only affect aggregate demand in the short run, with limited long-term impact on economic output.

Neoclassical Perspective on Macroeconomic Policy

Neoclassical Phillips Curve

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• Vertical line at the natural rate of unemployment assumes wages and prices are flexible in the long run implying no long-run tradeoff between inflation and unemployment
• Downward sloping short-run Phillips curve assumes wages and prices are sticky in the short run implying a short-run tradeoff between inflation and unemployment (lower unemployment leads to higher inflation)
• Policymakers cannot permanently reduce unemployment below the natural rate without causing accelerating inflation attempts will only lead to higher inflation in the long run (hyperinflation in extreme cases)

Fiscal and Monetary Policy Impact

• Aggregate supply primary determinant of economic output in the long run according to neoclassical economists fiscal and monetary policies can only affect aggregate demand
• Expansionary fiscal policy (increased government spending or tax cuts) shifts aggregate demand to the right leading to higher output and employment in the short run but only higher prices in the long run (crowding out effect)
• Contractionary fiscal policy (decreased government spending or tax increases) shifts aggregate demand to the left leading to lower output and employment in the short run but only lower prices in the long run (austerity measures)
• Expansionary monetary policy (increased money supply) shifts aggregate demand to the right leading to higher output and employment in the short run but only higher prices in the long run (inflation targeting)
• Contractionary monetary policy (decreased money supply) shifts aggregate demand to the left leading to lower output and employment in the short run but only lower prices in the long run (deflationary spiral risk)

Neoclassical vs Keynesian Economics

• Neoclassical emphasizes aggregate supply in determining output believes prices and wages are flexible in the long run allowing economy to return to natural output level argues for limited government intervention to avoid distorting market incentives (laissez-faire approach)
• Keynesian emphasizes aggregate demand in determining output believes prices and wages are sticky in the short run leading to prolonged economic disequilibrium argues for government intervention (fiscal and monetary policies) to stabilize economy and reduce severity of recessions (countercyclical policies)
• Neoclassical assumes markets are inherently stable and will return to equilibrium on their own (invisible hand) while Keynesian assumes markets can remain in disequilibrium for extended periods and may require government intervention (animal spirits)