Persisting Problems on the link between Macroeconomics and Microeconomics

Permanent link: http://bit.ly/microfoundations
As a requirement for our macroeconomics class, Dr. Dante Canlas asked us to submit a survey paper on a macroeconomic issue of our choice. I especially took interest on the approach of modern macroeconomics based on so-called "microfoundations" - microeconomic assumptions used to explain aggregate phenomenon. New classical economists see this as the final bridging of macroeconomics and microeconomics, spurring hopes of a single economic theory that would explain both the individual and aggregate economic phenomena. (note how this parallels physicists' dream of uniting large-scale relativistic physics with quantum mechanics). This spurred an orientation in economic research and pedagogy characterized by complex mathematical models capturing "deep" parameters in taste, technology, and expectations.

Recently, the microfoundations approach came under attack after models with "deep" microeconomic parameters supposedly failed to predict and recommend effective policy recommendations to mitigate the current global economic crisis. Even recent Nobel Laureate Thomas Sargent - one of the pioneers of modern macro - is under fire. Why this is so - as well as earlier, almost forgotten challenges to the microfoundations approach - is the subject of the survey paper I submitted. Read the abstract and full text below:

Abstract

The history of economics, for the most part, has been bifurcated between the study of individual economic decisions (microeconomics) and the aggregate economic phenomena (macroeconomics). The attempt to marry the two, via incorporating “microeconomic foundations” or “microfoundations” to explanations for macroeconomic observations and predictions, has so far taken sway a majority of mainstream economists with the failure of Keynesian models to accurately predict aggregate behavior in the presence of government policy. Robert Lucas Jr. posited that people form “rational expectations” of government policy and act so as to render forecasts unstable.

However, there are some persisting theoretical and empirical challenges on this research direction – the empirical instability of macro-models which incorporated microfoundations, the Sonnenschein–Mantel–Debreu result which may spell the theoretical dead end to economic aggregation, the still unresolved Cambridge capital controversies started by the reswitching argument by Italian economist Pierro Sraffa and American economist Joan Robinson in the 1960s, and the missing “representative consumer or firm” that can take into account the behavior of the aggregate. These challenges give the idea that aggregate economic behavior is almost impossible to deduce from microeconomic behavior of agents. Post-Keynesianism – which asserts that long-term expectations are largely determined by non-economic, psychological processes exogenous to the model – is posited as a possible way forward.

To read full text, click:
Persisting Problems on the link between Macroeconomics and Microeconomics


Some notes:

• There are other interesting discourses that the paper has not covered. For one, recent advances in behavioral and "neuroeconomics" may in fact convince us that it is not macroeconomics, but rather microeconomics, which lacks and needs foundations. The rationalizing agent which neoclassical microeconomics thought to be the analytic primitive may prove to be non-existent at all, which means that explaining macro phenomenon through rational representative agent is the wrong way to continue.
• Post-Keynesianism is not the sole counter-framework to microfoundations. Evolutionary economics, which relies on technological explanations more than information on actual aggregate demand, may also prove to be a good starting point. At this point though, evolutionary economics retains the agentic approach in many of its models, which may prove to be limiting.
• Advances in "crowd psychology" and sociology may be helpful. The debate between "contagion theory", which states that crowd acts on the individual, and "convergence theory", which holds that crowd behavior is a product of certain individuals carried into the crowd, is a good starting point. Thus, the question is best dealt through a multidisciplinary approach rather than a purely economic one.

Related articles

• Using Microeconomics to Understand Macroeconomic Problems (coordinationproblem.org)
• Non-Self-Averaging in Macroeconomic Models: A Criticism of Modern Micro-founded Macroeconomics (thejournalofeconomic.wordpress.com)
• Microfoundations --- what parts of this narrative would you contest? (coordinationproblem.org)
• After Keynesian Macroeconomics (gregmankiw.blogspot.com)
• Why Isn't There More Discussion of Micro-Macro Linkages Amongst Economists? (thesociologicalimagination.com) - There are interesting comments in this short blog post.