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IAI Actuarial Core Principles · Business Economics · Main economic schools and their key features

According to New Classical economists, why is a systematic and fully anticipated increase in the money supply unlikely to raise real output even in the short run?

Under New Classical theory agents have rational expectations and markets clear, so they foresee an anticipated money increase and raise wages and prices at once. Output stays at its natural level and only the price level rises, making systematic monetary policy ineffective for real output.

  1. AWorkers and firms form rational expectations and build the expected price rise into wages and prices, so only the price level changesCorrect
  2. BPrices and wages are permanently fixed by long-term contracts, so money has no effect
  3. CBanks automatically hold back the extra money as idle reserves
  4. DAggregate demand is always perfectly elastic in the short run
  5. Government spending crowds out all private investment one for one

Explanation

New Classical theory combines rational expectations with market clearing. If a policy is systematic and anticipated, agents adjust wages and prices immediately, so real output stays at its natural level and only prices rise. The contract-fixity option describes a New Keynesian idea, which is the opposite approach.

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