Macroeconomics Does Not Need

Microeconomic Foundations
Abstract
The desire for sound foundation for macroeconomics is justified, but the attempt to derive
macroeconomics from microeconomics commits the fallacy of constructionism. Macroeconomics
can instead be derived directly from macroeconomic definitions itself. The resulting foundational
models are detailed in this paper. Even with simple linear behavioural assumptions, these models fit
the Great Moderation-Great Recession period far better than far more complicated, but inherently
non-complex, Neoclassical macroeconomic models derived from microfoundations.

Introduction
Since the development of Real Business Cycle theory (Finn and Edward, 1982), a guiding principle in
the development of macroeconomics has been the desire to make consistent with microeconomics.
As Lucas put it, “Nobody was satisfied with IS-LM as the end of macroeconomic theorizing. The idea
was we were going to tie it together with microeconomics and that was the job of our generation”
(Lucas, 2004, p. 20). This principle has persisted even after the failure of RBC and DSGE models to
anticipate the Great Recession: as Blanchard put it, “Starting from explicit microfoundations is
clearly essential; where else to start from?” (Blanchard, 2018, p. 47).

From the perspective of complex systems analysis, this is the fallacy of “constructionism”. As Physics
Nobel Laureate Philip Anderson observed, though reductionism has been and remains a critical facet
of science,

the reductionist hypothesis does not by any means imply a "constructionist" one:
The ability to reduce everything to simple fundamental laws does not imply the
ability to start from those laws and reconstruct the universe… The constructionist
hypothesis breaks down when confronted with the twin difficulties of scale and
complexity… Instead, at each level of complexity entirely new properties appear,
and the understanding of the new behaviors requires research which I think is as
fundamental in its nature as any other. (Anderson, 1972, p. 393)

The key reason that Blanchard gave for microfoundations was the justified opposition of economics
to “ad-hoc” modelling: “Ad hoc equations will not do for that purpose” of giving macroeconomics
sound foundations (Blanchard, 2018, p. 47). However, though simplifying assumptions are still
needed, neither microfoundations nor “ad-hocery” are required for a well-founded
macroeconomics. Instead, macroeconomics can be derived from sound macroeconomic
foundations—though what results is very different to Neoclassical macroeconomics.

Take two uncontentious macroeconomic definitions: the employment rate  as employment L

divided by population N and the wages share of GDP  as the wage bill W divided by GDP Y :

L

N
(1.1)
W

Y
These can be turned into dynamic definitions by differentiating with respect to time. Using the
1 dx
notation x =  this yields the dynamic definitions that (1) the employment rate will rise if
x dt
employment grows faster than population, and (2) the wages share of GDP will rise if wages rise
faster than GDP:

  L−N
(1.2)
  W −Y
Introduce two more definitions, the GDP to employment ratio a and the capital K to output ratio
v:
Y
a
L
(1.3)
K
v
Y
This yields:

  K −v−a− N
(1.4)
 W − K −v
Investment I is by definition K so that

I
 −v−a− N
K
(1.5)
I
 W − −v
K
Having proceeded as far as we can with strict definitions, simplifying assumptions are needed to turn
this into a model. We make the realistic “first-pass” simplifying assumptions that the capital to
output ratio is constant, while the output to employment ratio and population rise at the
exogenously given constant rates  and  respectively, and we assume a uniform real wage rate
wR :

v=0
a =
(1.6)
N =
W = wR + L

Lastly we add two first-pass behavioural assumptions. We assume that all profits   Y − W are
invested so that gross investment equals profit I G =  , and that depreciation  K is linear. Net
investment is therefore

I =  − K  K (1.7)

This lets us define the rate of growth g r as a function of the wages share of GDP :
 1− 
g r ( ) = −K (1.8)
v
In general, given Equation (1.3), the growth rate is the gross investment to capital ratio, minus
depreciation:

IG
gr = −K (1.9)
v Y
We assume that the rate of change of the real wage is an increasing function of the level of
employment (Phillips, 1958). Though Phillips argued strongly for a highly nonlinear function, for
simplicity in a first-pass model, we commence with a linear function with a slope S  and a zero
intercept Z  :

wR = wFn (  ) = S  (  −  ) (1.10)

Feeding these assumptions into (1.5) yields the fundamental non-monetary macroeconomic model
that can be derived from sound macrofoundations:

 = g r (  ) − ( +  )
(1.11)
 = w Fn ( ) −
This allows us to flesh out the earlier definitional dynamic statement: (1) the employment rate will
rise if the rate of economic growth exceeds the sum of growth in the output to labour ratio plus
population growth; (2) the wages share of GDP will rise if the change in wages exceeds the change in
the output to labour ratio.

Figure 1 shows a simulation of this model, using parameter values derived for the USA by Grasselli
and Maheshwari (Grasselli and Maheshwari, 2017) in their correction of Harvie (Harvie, 2000) on the
empirical validity of Goodwin’s growth cycle model (Goodwin, 1967).
Table 1: Parameter values and initial conditions for the simulation shown in Figure 1

Parameter Definition Value

 Rate of growth of the output to labor ratio 0.01
 Rate of population growth 0.02
v Capital to output ratio 1.78
K Depreciation rate 0.06
S Slope of wage change function 10
Z Zero of wage change function 0.6
This model is structurally equivalent to Goodwin’s model,1 and generates a system with a neutral
equilibrium and sustained cycles.

1
Though with the addition of a rate of depreciation, which Goodwin overlooked.
Figure 1: Closed cycles of foundational Goodwin model

P
We now add a contentious macroeconomic definition: the private debt ratio d r as private debt
DP divided by GDP Y :

DP
dr P  (1.12)
Y
Adding this definition is contentious because, in Neoclassical economics, private debt plays no
significant macroeconomic role. As Bernanke put it, from a Neoclassical perspective, “Absent
implausibly large differences in marginal spending propensities among the groups, it was suggested,
pure redistributions should have no significant macroeconomic effects” (Bernanke, 2000, p. 24).
However, this perspective is based on the Loanable Funds model of banking, which The Bank of
England and Bundesbank (McLeay et al., 2014, Deutsche Bundesbank, 2017) have repudiated in
favour of the Post-Keynesian “Endogenous Money” model (Moore, 1979), in which credit—the
change in private debt—has significant macroeconomic effects (Keen, 2020). Fama and French’s
empirical findings (Fama and French, 1999a, Fama and French, 1999b, Fama and French, 2002) show
that a major role of credit is to finance investment when it exceeds retained earnings:

The source of financing most correlated with investment is long-term debt… debt
plays a key role in accommodating year-by-year variation in investment (Fama
and French, 1999a, p. 1954).

We make the simplifying assumption, following Fama and French (1999a) that credit is used to
finance the gap between gross investment and profits

d
DP = I G − 
dt
(1.13)
I −
DP = G
DP

This yields the dynamic definition that the debt ratio will rise if debt grows faster than GDP:

dr P  DP − Y (1.14)
The definition of aggregate profit has to be extended to include interest payments at the rate rP on
outstanding debt:

 = Y − wR  L − rP  DP (1.15)

Gross investment is assumed to be a function of the rate of profit  r , which itself can be expressed
as a function of the profit share  s = 1 −  − rP  d r :
P

Y − wR  L − rP  DP
r =
K
1 −  − rP  d r P
r = (1.16)
v
s
r =
v
For simplicity, the investment function is assumed to be of the same form as the wage change
function, with Z representing the rate of profit at which all profit is invested. Above this level,
firms finance additional investment via borrowing:

IG = I Fn  Y
(1.17)
I Fn ( r ) = S  ( r − Z )

Algebraic manipulation reveals that the debt ratio will rise if the rate of growth of the debt ratio
exceeds the rate of economic growth:

I Fn  Y − 
dr P = −Y
DP
Y I Fn  Y − 
= − g r ( r )
Y DP
(1.18)
Y I Fn  Y − 
= − g r ( r )
DP Y
1
= ( I Fn −  s ) − gr ( r )
dr P

This foundational model is now three-dimensional, the minimum number of dimensions needed to
display chaotic behaviour (Li and Yorke, 1975):

 = g r (  r ) − ( +  )
 = w Fn ( ) −  (1.19)
I Fn −  s
dr P = − g r ( r )
dr P

The particular form of chaotic behaviour this model displays is known as intermittent route to chaos
(Pomeau and Manneville, 1980): a long period of diminishing volatility precedes a period of rising
volatility—see Figure 2.
Figure 2: The model simulated in the Open-Source system dynamics program Minsky

In stark contrast to mainstream Neoclassical models, it provides an integrated explanation for both
the “Great Moderation” and the “Great Recession”: the reduction in economic volatility prior to the
crisis, and the crisis itself, were not independent events, but part of the same complex systems
process (Keen, 2020, Keen, 2017, pp. 18-20).
Figure 3: USA Inflation, Unemployment & Growth from the "Great Moderation" till 2016

15
GreatRecession
14 Inflation
13
Unemployment
Growth Rate
12
11
10
9
8
7
6
5
4
3
2
1
0 0
−1
−2
−3
−4
−5
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016

Another emergent property of this model is a redistribution of income from workers to banks as the
level of debt rises relative to GDP (Keen, 2017, pp. 18-20). This, as well as the “Great Moderation”
followed by the “Great Recession”, is also evident in the US data—see Figure 4.
Figure 4: Time trend of private debt versus wage income 1970-2010

USA Private Debt and Wages Share of GDP 1970-2010

54
Data
53
Trend

52
Wages Share Percent of GDP

51

50

49

48

47

46

45

44
80 90 100 110 120 130 140 150 160 170 180

Private Debt Ratio Percent of GDP

Building on this foundation

Akin to Lorenz’s simple model of deterministic nonperiodic flow (Lorenz, 1963), this is a deliberately
stylized and parsimonious model, and it can readily be extended as Lorenz’s has in applied
meteorology. An obvious extension is to include price dynamics, which can be introduced by the
same definitional method by which this model was derived. We redefine Y as nominal output, and
introduce real output YR and the price level P :

Y = P  YR (1.20)

This adds price dynamics to two of the three system state equations:

(
ˆ = YR − a + N )
ˆ = W − YR − P (1.21)2

dr P = Dˆ − YR − P

2
This alters the wage setting equation to one in the money wage wM rather than real wage. Price dynamics
can also be derived in a definitional manner. It is easily shown that P = wM −  −  .
In practice, nonlinear behavioural functions should replace the simple linear forms used here, in line
with Phillips on wage formation (Phillips, 1954, Phillips, 1958) and Minsky on “euphoric
expectations” affecting the level of investment (Minsky, 1982, pp. 124, 151, 280). These functions
will constrain the extreme swings in wages and investment manifest in the simple model detailed
here.

Conclusion
There is a macroeconomics after microfoundations. It is far richer in its capacity to explain the
economy’s recent behaviour, far easier to derive than the “long slog from the competitive model to
a reasonably plausible description of the economy” anticipated by Blanchard (Blanchard, 2018, p.
47), and it does not require abandoning the search for incontrovertible foundations. Instead, like the
drunkard who never found his keys because he looked only near the lamppost, economists will only
find the true keys to macroeconomics if they abandon the lamppost of microeconomics.

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