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Does

Macroeconomics
Need
Microfoundations?
Kevin D. Hoover

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Topics to be covered
From “Political Economy” to Microeconomics
Reductionism: Taking Science to Economics
Methodological Individualism
The Illusion of Aggregation
“Representative” Agent Models
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From “Political Economy” to
Microeconomics
 Lucas’s Longing – Sound economics vs Bad Economics
 Economics: Management of the household
 Political Economics: Management of the state

 Early (17th & 18th century) Economics
 Hierarchy > Individual
 Determining and enhancing military capabilities

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From “Political Economy” to
Microeconomics
 Seeds of Individualism – Adam Smith
 Classical Economists with a love for markets
 Limited Individualism

 19th Century marginalism
 Individual highlighted by the French
 Individualism vs Super Individual categories

 Methodological Individualism

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but  No systematic aggregation technique  1936  Criticism of General Theory and IS-LM Models  Birth of representative agent models 5 .From “Political Economy” to Microeconomics  Alfred Marshall  Removed the Political in Political Economy  Representative Firm and agent  Mid 1930’s. Keynes and General Theory  Distinguished macro from micro  Heterogeneity of individuals.

Reductionism: Taking Science to Economics   Scientific explanation: Parsimony  18th Century gas laws: Boyles-Charles law  Reduced macro-physical gas into microphysical Newtonian mechanics  Restrictive assumptions  Temperature  Mean energy  Pressure  Mean momentum 6 .

Reductionism: Taking Science to Economics  “the only way to reduce biology to chemistry is through death”  The philosophical mind/body problem  Mental state (macro) and brain-state (micro)  Supervenience:  No one-to-one mapping between micro and macro phenomena 7 .

Methodological Individualism  Defining Economics  Plutology: Study of wealth  Mill and Marshall – Study of wealth + Study of man  Lionel Robbinson – The science of choice  Cournot Problem  Heterogeneous individuals with unique tastes and constraints  Reclaiming teleology in economics  Contrast with biology 8 .

Methodological Individualism  Lucas’s Critique  People are not stupid!  Securing against Lucas’s Critique  Birth of Methodological Individualism  Methodological or Ontological Individualism? 9 .

Methodological Individualism  Lucas’s Critique  People are not stupid!  Securing against Lucas’s Critique  Birth of Methodological Individualism Ontological Individualism 10 .

Methodological Individualism  Supervience of Macroeconomics to Microeconomics  Intentionality at micro – Cournot Problem  Microeconomics necessarily uses Macroeconomics models as input 11 .

technique and mathematics  Economists part ways with physicists  Economics is about heterogeneous things  In search of a common denominator  Coal and Oil  H2O 12 .The Illusion of Aggregation  Microeconomics or Macroeconomics?  Same language.

The Illusion of Aggregation  Composite Commodity Theorem  Constant Relative prices  Assumptions  Constant tastes and technology (Identical Utility Functions)  Utility function is homothetic  Renders Income distribution unimportant  Same ratio of consumption and relative prices  Composite Commodity theorem holds 13 .

The Illusion of Aggregation  These conditions do not hold  Distributional Variations – Aggregate functions are unrestricted  Altering fundamental categories after aggregation 14 .

“Representative” Agent Models  Assuming the problem away is not actually a solution!  Aggregates that belong to no one!  Frank Ramsey’s optimal savings problem and the wise men at Cambridge  Two theorems of welfare economics  Top down rather than Bottom up  Ignores redistribution  “He who comes into equity shall come with clean hands”  Avoid the category mistake 15 .

Kirman 16 .Whom or what does the representative individual represent? Alan P.

Whom or what does the representative individual represent?  Theoretical in nature  Published in Journal of Economic Perspectives  By Alan P. Florence. Italy)  The year 1992  Volume no 6  Pg 117-136 17 . Kirman (professor at European Universtiy Institute.

What is the article about?  HOW THE MODEL OF REPRESENTATIVE AGENT IS  NOT NEEDED  CREATES PROBLEMS IN THE ANALYSIS  WHAT SHOULD BE FOLLOWED INSTEAD OF THE REPRESENTATIVE AGENT MODEL  ALLOW HETROGENIETY 18 .

Apprach of the article  TO TEAR APART THE ARGUMENT OF THE OPPOSING PARTY(REPRESENTATIVE INDIVIDUAL ARGUMENT) ONE DIMENTION AT A TIME 19 .

Need for Representative individual  Due to microfoundations  Why microfoundations are called for?  Because they believe that an adequate model of agent behavior has been found  Because they need unique and stable equilibrium  Need to use comparative statics in order to analyze policy changes.  Need to create appropriate shape of the aggregate demand curve 20 .

 Why cant we find conditions for unique and stable equilibrium Need for representative individual might not arise If there conditions can be found which give a unique and stable equilibrium  There are none  Sonnenschein (1972)  Debreu (1974) 21 .

that the value of total excess demand must equal zero at all positive prices  the budget constraint for the economy as a whole be satisfied (Walras' law).Restrictuve conitions  Attempting to create unique and stable equilibrium via assumptions: via applying 3 assumptions  continuity.  Even this solution suffers from weak axiom of revealed preferences 22 .  Excess demand is homogeneous of degree zero (only relative prices count).

How about locally unique  We could use locally unique and stable equilibriums. 23 .  This argument is weak because of  Inconsistencies  Not actually used by macroeconomists.

Typical assumptions on representative agent (NOT ALL)  Homothetic utility functions  relative income distribution should be fixed and independent of prices. 24 .

Where would the representative individual be useful Stoker(1986) individuals take their decisions only on the basis of aggregate variables all individuals have the same marginal reaction 25 .

Why we cant skip representative individual  If we do either  Preferences vary  Income distribution would vary.  Prefernce vary  Degrees of freedom would be too high  Multiple equilibria  Income distribution vary  Multiple equilibria 26 .

Representative individual  Representative individual is one "representative" standard utility maximizing individual whose choices coincide with the aggregate choices of the heterogeneous individuals  Will discuss the issues that come by one by one.  Where repetitive we would mention the concept again without giving full details 27 .

 Hakansson et al.  Such models are particularly ill-suited to studying macroeconomic problems like unemployment. which should be viewed as coordination failures  Economists show this through models of no trade such as  Rubenstein. 1982.  Milgrom and Stokey.1. 1982 28 . No coordination  Identical agents don’t need to coordinate as there is nothing to coordinate about.. 1975.

”  The failure of the above argument is due to four reasons  Aggregate behavior is not equal to individual behavior  Economy might be rational on the aggregate but it does not mean that the individual is rational  Using such a model to analyze the consequences of policy changes may not be valid  Because actions preferred by the representative individual may not be preferred by the actual individuals 29 . questions of coordination but are designed to examine some central macroeconomic phenomena.Counter points  Argument for representative agent says that “Such models are not intended to study those problems which involve. in an essential way.

it is not clear whether one is really rejecting the hypothesis in question. The preferences of the representative individual cannot legitimately be used to decide whether one economic situation is "better" than another because  it may well be the case that in two situations of which the representative prefers the first to the second. every individual prefers the second to the first  Empirical testing of the representative agent might be falsified because  Individual possessing unnatural characteristics. or rejecting the additional hypothesis that there is only one individual 30 .  if one rejects a particular behavioural hypothesis.

 i. No trade (counter argument)  Counter point is that economy is always in equilibrium. the representative agent eats what he produces. 31 .  Hence the actions of the representative agents are movements around the equilibrium which show the evolution of the economy.e.2.

No trade counter point weakness  The argument requires some adjustment mechanism e. tatonment.  these adjustment process are found to hold 32 .g.

 His equilibrium and not his choices coincide with the society.3.  Geweke (1985)  Kupiec and Sharpe (1991) 33 . Representative agent before and after the policy  If the representative agent that represents the aggregate choice might represent the aggregate change after the policy change.  Proven in the papers.

4.  For technical details refer to the paper 34 . whilst all the individuals that are "represented" strictly prefer b to a. Problem of preference of the individual  It is possible that the representative individual prefers situation a to situation b. Jerison (1984).

 Summers (1991) says that in Hansen and Singleton (1982. 35 . Joint hypothesis problem: testing the change or the compatibility of the change with the representative individual  Whenever we are testing a behavioral hypothesis we are testing two things:  the behavioral hypothesis itself  if the choices of the aggregate can indeed be described as the choices of a single utility- maximizing agent.5. 1983) the rejection of the asset pricing and consumption relationship was more a rejection of the relationship between consumption and asset pricing of the representative individual rather than the asset pricing of the aggregate.

e. Clarida (1991) constructed a model that allowed for heterogeneity but does not contain excess smoothing. 36 .Another example: excess consumption smoothing  The very existence of the Deaton paradox might be due to the representative agent i.

1984).  erratic individual demand behaviour may give very smooth aggregate demand behaviour(Cournot)  Individual jumps will occour at diferent prices and hence cause the Demand cuve to be more continuous. Hildenbrand (1983) 37 .STUDIES INVOLVING HETROGENIETY ARE THE ANSWER  Increasing dispersion of income and preferences would be a positive development because  It would more stable outputs Hildenbrand (1983) and Grandmont (1987. 1991). (Trockel.  if the income distribution is decreasing -that is if each successively higher income class contains a smaller proportion of agents-then the law of demand holds.

then aggregate excess demand will have the well known "gross substitutability" property and equilibria will be unique and stable. Grandmont (1991)  Don’t even require maximization as long as the budget constraints are satisfied. 38 .STUDIES INVOLVING HETROGENIETY ARE THE ANSWER  Increasing dispersion of income and preferences would be a positive development because  if agents have very spread out preferences.

INTRODUCTION OF THE HETROGENIETY IS NOT ENOUGH  Need to change the way economic agents interact with each other  Change from unconscious to direct and conscious. which include  Trading  Passing of information  Reputations  Groups for purposes of bargaing  New tools could be introduced  Game theory 39 .

40 .Game theory  Single agent models are being replaced by multiple agent models  Individuals operate in sub-pockets of economy.  local but interacting activity emerges some sort of self organization which provides regularity at the macroeconomic level. Lesourne (1991)  Models for interaction of agents and how the changes are propogated throughout the economy are also investigated.

41 .Conclusion  We should take the right way out. not the easy way out.

THANK YOU .