Post-Keynesian and New Classical Economics

The economic debates between Post-Keynesian and New Classical economists reflect differing approaches to macroeconomic theory. Post-Keynesian economics emerged as a critique of mainstream neoclassical economics, particularly in the interpretation and extension of Keynes’ ideas. In contrast, New Classical economics, with a focus on rational expectations and market-clearing models, represented a revival of classical approaches to economics with modern mathematical tools.

1. Post-Keynesian Critiques of Mainstream Economics

Post-Keynesian economics is rooted in the ideas of John Maynard Keynes but seeks to address gaps and oversimplifications in both traditional Keynesian and neoclassical models. Post-Keynesians argue that mainstream economics, particularly neoclassical economics, fails to capture the realities of how economies function, particularly regarding uncertainty, market imperfections, and income distribution.

Key critiques include:

Rejection of Equilibrium: Post-Keynesians argue that economies rarely operate at full employment or equilibrium, as assumed by mainstream models. They emphasize disequilibrium, where markets are subject to volatility and shocks that prevent smooth adjustments.
Importance of Historical Time: Instead of static models that assume perfect foresight, Post-Keynesians emphasize the passage of real (historical) time, where past events shape future decisions, leading to path dependency.
Endogenous Money: Post-Keynesian economists argue that money supply is determined by the demand for credit, not by central banks, making money supply endogenous to the economy.
Focus on Income Distribution: They critique mainstream economics for ignoring how the distribution of income and wealth affects consumption, investment, and overall economic stability.

Post-Keynesians emphasize the importance of government intervention and fiscal policy in managing demand and addressing the inherent instability of capitalist economies.

2. The Role of Uncertainty in Economic Decision-Making

One of the central themes in Post-Keynesian economics is the role of uncertainty in shaping economic behavior. Unlike the quantifiable risks used in mainstream models, Post-Keynesians distinguish between risk (which can be measured) and uncertainty (which cannot be measured or predicted with confidence).

Fundamental Uncertainty: Economic actors face uncertainty that cannot be easily predicted or reduced to probabilities. For example, firms and consumers must make decisions about investment or spending without knowing how future markets, technology, or policy changes will unfold.
Expectations Formation: Because of this uncertainty, economic decisions are often based on conventions or heuristics, rather than rational optimization models. Firms may invest based on past experiences or social norms rather than detailed forecasts.
Impact on Markets: This uncertainty leads to volatility and financial instability, as investment and spending decisions may fluctuate with changing expectations, often resulting in crises or boom-bust cycles.

The Post-Keynesian view suggests that governments should actively manage economies to mitigate the impact of uncertainty, through fiscal policy, monetary intervention, and regulation of financial markets.

3. Rational Expectations and the Lucas Critique

In contrast to the Post-Keynesian focus on uncertainty, New Classical Economics—led by figures such as Robert Lucas—advocates for the importance of rational expectations. This approach assumes that individuals and firms form expectations about the future based on all available information and that, on average, they are correct.

Rational Expectations Hypothesis (REH): Economic agents are presumed to have the ability to make predictions about future economic conditions that are consistent with actual outcomes. This implies that policy changes, such as shifts in monetary or fiscal policy, will be anticipated and incorporated into decision-making processes.
The Lucas Critique: Lucas challenged traditional Keynesian models by arguing that they are not reliable for predicting the effects of policy changes. His critique states that any policy that changes the economic environment will also change the expectations and behavior of economic agents, making previous empirical relationships invalid. For instance, if people anticipate inflation, they will adjust wages and prices accordingly, nullifying the effect of expansionary policies.

The Lucas Critique emphasizes the need for models that incorporate rational expectations and dynamic optimization to properly understand the impact of economic policies.

4. Real Business Cycle Theory

Real Business Cycle (RBC) Theory is another cornerstone of New Classical economics. It challenges the idea that business cycles—periods of boom and bust—are caused by market failures or demand-side shocks. Instead, RBC theorists argue that cycles are the result of real, exogenous shocks to the economy, such as changes in technology or productivity.

Key elements of RBC Theory include:

Productivity Shocks: Business cycles are seen as natural responses to changes in productivity. For example, a technological breakthrough could lead to a boom, while a natural disaster or other productivity-reducing event could cause a recession.
Market Clearing: Unlike Keynesian models, which assume that markets may not always clear (i.e., supply may not equal demand), RBC theory assumes that markets clear in the long run, with prices and wages adjusting to ensure this.
No Need for Policy Intervention: Since business cycles are viewed as efficient responses to real shocks, RBC theorists argue that government intervention is unnecessary and may even be harmful. The economy will naturally return to equilibrium after a shock, making active fiscal or monetary policy redundant.

RBC models focus on supply-side factors, emphasizing labor and capital as the primary drivers of economic fluctuations, rather than demand-side interventions as in Keynesian frameworks.

Conclusion

The debate between Post-Keynesian and New Classical economics highlights different approaches to understanding economic stability, uncertainty, and policy intervention. Post-Keynesians emphasize the importance of managing uncertainty, income distribution, and the instability inherent in capitalist economies, while New Classical economists advocate for rational expectations, the limited role of government intervention, and supply-side explanations for economic fluctuations. Understanding these contrasting views helps clarify the ongoing discourse in macroeconomic theory and policy.