New Classical economists take a fundamentally different view of short-run dynamics. They assert that markets are self-correcting, even in the short term, due to the presence of rational expectations and fully flexible wages and prices. Under this framework, firms and workers anticipate economic changes and adjust their behaviour accordingly. This preemptive adjustment means that monetary or demand shocks have little to no effect on real variables like output or employment. Instead, only real changes such as improvements in technology or shifts in the labour force that can influence output and employment. The New Classical model assumes that markets clear continuously, so any unemployment is either frictional or voluntary. Consequently, short-run economic fluctuations are viewed as temporary and largely irrelevant in terms of real outcomes. In addition, they do acknowledge that if there is a surprising and unexpected monetary policy which increases the money supply, it may cause a temporary deviation in output and employment. However, this effect does not last long because people will quickly realize and adjust the expectations. From a long-run perspective, New Classical economists argue that employment and output are determined exclusively by supply-side factors. Increases in productivity, capital accumulation, and labour force participation enhance the economy’s capacity to produce goods and services. They also believe that policies which incentivize work, saving, and investment can raise long-term economic performance. Crucially, they uphold the concept of monetary neutrality, asserting that neither fiscal nor monetary policy can affect real output or employment in the long run. The long-run aggregate supply curve is considered vertical, reflecting the idea that output is fixed at its natural level, determined by resource availability and technology. Any policy that solely influences demand will only affect the price level, not the real economy. Thus, growth is determined by changes in real factors, and not nominal ones. draw the SR and LR graph for goods and labour market
Interpretation: An unexpected monetary expansion shifts AD right. In the short run (SRAS upward-sloping due to surprises), output and employment can rise temporarily (E2). In the long run, expectations adjust and output returns to the natural level Y_n while only the price level rises (LRAS vertical).
Interpretation: An unexpected demand for labour (e.g., from higher production) can raise employment and real wages in the short run. Because markets clear and expectations/wages adjust, employment returns to its natural level L_n in the long run (vertical LR supply).
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