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Arnold has posted below on Matt Ygelesias's criticism of the view that macroeconomics requires a microeconomic foundation. There's more to say.

First, check out comment #21 by one, Matt Rognlie, on Yglesias's site. It's quite good. I was surprised when I went to his own blog and found that he's 20 years old. Yikes!

Second, the demand for microfoundations, or at least the supply of them, goes back more than 10 years before the date Arnold claims. It goes back at least to Milton Friedman's A Theory of the Consumption Function, in which he introduced the idea that consumption depends, not as Keynes believed, on current income but on "permanent income," a theoretical construct that represented what people think the average of their income over a few years will be.

Third, interestingly, Milton Friedman himself would probably agree with Yglesias about the idea that there's not necessarily a need for micro foundations for macro. In a 1996 interview published in Brian Snowdon and Howard R. Vane, Modern Macroeconomics, Edward Elgar, 2005, Friedman said:

It is less important for macroeconomic models to have choice-theoretic microfoundations than it is for them to have empirical implications that can be subjected to refutation.

In saying this, Friedman was going back to his positivist roots, which he laid out at length in his classic 1953 essay, "The Methodology of Positive Economics," published in Essays in Positive Economics. There was always an interesting tension in Friedman's work, which he never resolved, between reasoning as a clear-headed economist about people acting based on incentives and constraints and "positivistly" black-boxing it and trying to come up with predictions.

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CATEGORIES: Macroeconomics

COMMENTS (13 to date)
ThomasL writes:

This seems to be the week for bringing up Milton Friedman and permanent income vs. temporary income.

Keith Hennessey talked about it as well in an interesting post about the stimulus, particularly the context of efficiency (http://keithhennessey.com/2009/06/03/will-the-stimulus-come-too-late/).

(FWIW, I don't understand the application as advocacy for cash-like stimulus, as one gets in a position of trying to say that people respond hesitantly to a temporary income change (eg, save large portions) but businesses respond instantly to the small portion the people spend -- and with positive feedback transforming that small portion into some greater overall effect. IE, that businesses will always treat all income as permanent stream, while individuals differentiate between temporary and permanent. It seems just as likely to go ill if that were right...)

Mattyoung writes:

The economy requires increasing economies of scale when outlook is uncertain. It solves the problem using coherency between consumer and producer, they agree on time and production scales for essential goods.

For example. If consumers plan their housing on ten year cycles, then how often should they buy a car? I want my car purchase uncorrelated with my house purchase, I am looking for distinct budget items.

Maximum economies of scale mean the essential goods are uncorrelated. So, the economy is forced to select the auto planning cycle such that it is observable less than the house planning cycle. That means if I change housing every ten years, then my next distinct period for car purchase is going to be about four years.

This works for two reasons: 1) The consumer has a macro model built in to his micro transactions. and 2) When economies of scale are met, the term structure has a specific shape.

Craig writes:

Surely, the bigger question is why are you taking the ramblings of an ill-informed, partisan political blogger seriously?

Pareto writes:

Matt Rognile's post is very lucid (which is great), but is it really that surprising for a 20-year-old to know about the Lucas critique?

johnleemk writes:


Judging by the quality of what passes for intelligent economics discussion online, it is pretty surprising. Most people who hold forth on the economy don't seem to have even taken an introductory economics class, let alone an introductory macroeconomics class, where the Lucas critique might be briefly touched on.

David R. Henderson writes:

What Johnleemk said. Plus, as you said, it's so lucid. It's the combination of explaining a somewhat complex point and doing it well.

Greg Ransom writes:

Matt Rognlie is an undergraduate at Duke ....

What a little history of economic though can do.

Greg Ransom writes:

This demand / supply of microfoundations goes back to Friedrich Hayek's landmark paper "Economics and Knowledge" (1937), his equally important book _The Pure Theory of Capital_, and his series of essay's titled "Scientism and the Study of Society" (1941-1944).

Hayek replayed these same themes in his 1974 Nobel Prize Lecture "The Pretense of Knowledge" -- a Nobel Prize Hayek was awarded for his work on trade cycle theory, capital theory, and the intimately related knowledge problem.

David writes:

"the demand for microfoundations, or at least the supply of them, goes back more than 10 years before the date Arnold"

Matt Simpson writes:

I don't think there is a tension in Friedman's thinking at all. We want our models to predict, otherwise, what are they good for? If a model doesn't have microfoundations and predicts well, so what? Microeconomic models, as Yglesias notes, don't have "microfoundations" in psychology. Yet they still do a pretty good job under a variety of circumstances.

The reason microfoundations are necessary is instrumental to predictive power. It turns out that models with microfoundations predict better than models without them, in all fields. This is why chemists tend to build their models up from physics and why biologists to the same with chemistry. It also turns out that microeconomics can be quite successful without microfoundations, while macroeconomics is far less successful.

The Lucas critique tells us many of the reasons why macroeconomics needs microfoundations. The main reason microeconomics does not is that it is built from pretty solid intuitions about how individuals act. They aren't perfect, of course, but as a first approximation (instrumental) rationality does a pretty good job of describing human behavior in many cases. And the only way we really do know this is by going out and testing our models which, behavioral economics notwithstanding, have done well.

There's a trade off between accuracy and analytical tractability while modeling. More microfoundations will tend to increase accuracy, but imagine if we started with physics for every single scientific problem. The computations would be insane, so instead we simplify things and ignore some of the microfoundations. It is called a model for a reason, after all.

Friedman is right: if microfoundations do end up being important, models without them will do poorly relative models that use them (and thus the relevant trade off will manifest itself). Note that this is precisely what happened in the history of macro, and kudos to Friedman for realizing that microfoundations were important before the rest of the field. I suspect that macro models do well in an absolute sense though, but that is another matter entirely.

Matt Simpson writes:

Oops, that last sentence should read:
I suspect that macro models _don't_ do well in an absolute sense though, but that is another matter entirely.

Lee Kelly writes:

Macroeconomics doesn't need a microeconomic foundation, but it does need to be consistent with microeconomics, otherwise you have something wrong with you.

Mattyoung writes:

A macro model assumes that the statistics of a price remain the same statistics over the period of observation, the stationary or partial stationary premise. However, stationary must imply a micro-foundation, the agent must be subject to some corrective incentive..

In other words, Macro always had a micro foundation, just weakly described.

Bill Woolsey writes:

I think Friedman's macro black box held up badly--that the conglomerate of bank liabilities called M2 would have a "velocity" (or really, a ratio to) nominal income that is subject only to zero mean random shocks.

What are microfoundations? Do they have to be formal? A complete formal GE model of the economy? How sucessful are those in microeconomics?

I don't think so. As long as there is a plausible story that connects the macro relationships to sensible individual actions, it is "good enough." I beleive that orthodox Keynesian economics is good enough on those grounds. And, it has gotten better.

I think the failing of Keynesian macro was that the monetary disequilibrium that is the source of the macro difficulties is hidden in the background. And their is this constant grasp at finding a long run equilibrium that involves persistent changes in real output and employment due to a failure of prices to adjust in optimal ways. But it seemed to me that new Keynesian macro had accepted that these are disequilibrium processes being studied (using quasi-equilibrium tools.)

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