Compare and contrast the new classical and the mainstream view of self-correction in the economy.

What will be an ideal response?

The new classical view of economics, held by monetarists and rational expectation economists, is that the economy may deviate from the full-employment level of output, but it eventually returns to this output level because there are self-corrective mechanisms in the economy. Graphically, if aggregate demand increases, it temporarily raises real output and the price level. Then, nominal wages rise and productivity falls, so short-run aggregate supply decreases, thus bringing the economy back to its long-run output level. There is disagreement about the speed of adjustment. The monetarists adopt the adaptive expectations view that there will be a slower, temporary change in output, but in the long-run it will return to its natural level.
Other new classical economists adopt the rational expectations theory (RET) that there will be a rapid adjustment with little or no change in output. RET is based on two assumptions: people understand how the economy works so that they quickly anticipate the effect on the economy of an economic event; all markets in the economy are so competitive that equilibrium prices and quantities quickly adjust to changes in policy. In RET, unanticipated price-level changes, called price-level surprises, cause short-run changes in real output because it causes misperceptions about the economy among workers and firms. In RET, fully anticipated price-level changes do not change real output even in the short-run because workers and firms anticipate and counteract the effects of the changes.
The mainstream view of self-correction suggests that price and wages may be inflexible downward in the economy. Graphically, a decrease in aggregate demand will decrease real output, but not the price level because nominal wages will not decline and cause the short-run aggregate supply curve to shift right. The economy can get stuck in a recession for a long time period.
Downward wage inflexibility primarily arises because of wage contracts and the legal minimum wage, but they may also occur from efficiency wages and insider-outsider relationships according to mainstream economics. An efficiency wage minimizes the firm’s labor cost per unit of output, but may be higher than the market wage. This higher wage may result in greater efficiency because it stimulates greater work effort, requires less supervision costs, and reduces job turnover. Insider-outsider relationships may also produce downward wage inflexibility. During a recession, outsiders (who are less essential to the firm) may try to bid down wages to try to keep their jobs, but the firm may not lower wages because it does not want to alienate insiders (who are more essential to the firm) and disrupt the cooperative environment in the firm that is needed for production.