Microfoundations

In economics, the term microfoundations refers to the microeconomic analysis of the behavior of individual agents such as households or firms that underpins a macroeconomic theory (Barro, 1993, Glossary, p. 594).^[1][2]

Most early macroeconomic models, including early Keynesian models, were based on hypotheses about relationships between aggregate quantities, such as aggregate output, employment, consumption, and investment. Critics and proponents of these models disagreed as to whether these aggregate relationships were consistent with the principles of microeconomics. Therefore, in recent decades macroeconomists have attempted to combine microeconomic models of household and firm behavior to derive the relationships between macroeconomic variables. Today, many macroeconomic models, representing different theoretical points of view,^[3][4] are derived by aggregating microeconomic models, allowing economists to test them both with macroeconomic and microeconomic data.

History

Critics of the Keynesian approach to macroeconomics soon pointed out that some of Keynes' assumptions were inconsistent with standard microeconomics. For example, Milton Friedman's microeconomic theory of consumption over time (the 'permanent income hypothesis') suggested that the marginal propensity to consume out of temporary income, which is crucial for the Keynesian multiplier, was likely to be much smaller than Keynesians assumed. For this reason, many empirical studies have attempted to measure the marginal propensity to consume (Barro, 1993, Ch. 3, p. 87), and macroeconomists have also studied alternative microeconomic models (such as models of credit market imperfections and precautionary saving) that might imply a higher marginal propensity to consume.^[5]

One particularly influential call for microfoundations was Robert Lucas, Jr.'s critique of traditional macroeconometric forecasting models. After the apparent shift of the Phillips curve relationship in the 1970s, Lucas argued that the correlations between aggregate variables observed in macroeconomic data would tend to change whenever macroeconomic policy changed. This implied that microfounded models are more appropriate for predicting the impact of policy changes, under the assumption that changes in macroeconomic policy do not alter the underlying microeconomic structure of the macroeconomy.^[6]

Controversy

Some, such as Alan Kirman^[7] and S. Abu Turab Rizvi,^[8] argue on the basis of the Sonnenschein-Mantel-Debreu Theorem that the microfoundations project has failed.^{[clarification needed]}

See also

• Macroeconomics
• Microeconomics
• Macroeconomic model
• Lucas critique
• Dynamic stochastic general equilibrium
• Methodological individualism

References

1. ^ Robert J. Barro (1993), Macroeconomics, 4th ed. ISBN 0-471-57543-7.
2. ^ Maarten Janssen (2008), 'Microfoundations', in The New Palgrave Dictionary of Economics, 2nd ed.
3. ^ Thomas Cooley, ed., (1995), Frontiers of Business Cycle Research. Princeton University Press, ISBN 069104323X.
4. ^ Michael Woodford (2003), Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University Press, ISBN 0691010498.
5. ^ Angus Deaton (1992), Understanding Consumption. Oxford University Press, ISBN 0-19-828824-7.
6. ^ 'The Smets-Wouters model': ECB webpage with discussion of advantages of microfounded macroeconomic models
7. ^ Kirman, Alan P. (1992), "Whom or What Does the Representative Individual Represent?", Journal of Economic Perspectives 6 (2): 117–136, JSTOR 2138411 
8. ^ Rizvi, S. Abu Turab (1994), "The Microfoundations Project in General Equilibrium Theory", Cambridge Journal of Economics 18: 357–377, http://cje.oxfordjournals.org/content/18/4/357.full.pdf+html