A new perspective on microfoundations

3 July, 2017 at 11:40 | Posted in Economics | 1 Comment

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Defenders of microfoundations and its rational expectations equipped representative agent’s intertemporal optimization often argue as if sticking with simple representative agent macroeconomic models doesn’t impart a bias to the analysis. I unequivocally reject that unsubstantiated view, and have given the reasons why here.

These defenders often also maintain that there are no methodologically coherent alternatives to microfoundations modeling. That allegation is of course difficult to evaluate, substantially hinging on how coherence is defined. But one thing I do know, is that the kind of microfoundationalist macroeconomics that New Classical economists and “New Keynesian” economists are pursuing, are not methodologically coherent according to the standard coherence definition (see e. g. here). And that ought to be rather embarrassing for those ilks of macroeconomists to whom axiomatics and deductivity is the hallmark of science tout court.

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The fact that Lucas introduced rational expectations as a consistency axiom is not really an argument to why we should accept it as an acceptable assumption in a theory or model purporting to explain real macroeconomic processes (see e. g. here). And although virtually any macroeconomic empirical claim is contestable, so is any claim in micro (see e. g. here).

On this issue I think Paul Krugman comes closer to truth than his “New Keynesian” buddies with his remark that

what we call “microfoundations” are not like physical laws. Heck, they’re not even true.

Using formal mathematical modeling, mainstream economists sure can guarantee that the conclusions hold given the assumptions. However, the validity we get in abstract model worlds does not warrantly transfer to real world economies. Validity may be good, but it isn’t enough. From a realist perspective both relevance and soundness are sine qua non.

broken-linkIn their search for validity, rigour and precision, mainstream macro modellers of various ilks construct microfounded DSGE models that standardly assume rational expectations, Walrasian market clearing, unique equilibria, time invariance, linear separability and homogeneity of both inputs/outputs and technology, infinitely lived intertemporally optimizing representative household/ consumer/producer agents with homothetic and identical preferences, etc., etc. At the same time the models standardly ignore complexity, diversity, uncertainty, coordination problems, non-market clearing prices, real aggregation problems, emergence, expectations formation, etc., etc.

Oscar Reutersvärd’s impossible ‘Penrose triangle’ certainly looks possible when you look at one corner at a time. The problem — paradox — appears first when you view the triangle as a whole …

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1 Comment

  1. They say a difference of opinion makes a horse race. A naïve analyst might imagine that a similar principle must apply to drive market exchange, especially financial market exchange, but use of representative agents and rational expectations puts this seeming precondition out of view before the analysis begins. It is nothing against the practice of theoretical analysis or deductive reasoning to say that, despite claims of rigor, this is doing it wrong.


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