I was asked to write a bit about microfoundations, in response to a couple of posts by Tony Yates and Simon Wren-Lewis, so just a quick note before I grade exams.
I've never much liked the word "microfoundations," which comes from the title of the Phelps volume. When the Phelps volume came out in 1970, micro and macro looked like they came from people living on different planets, and you had to convince people that it made sense to take ideas from Mars and use them on Venus. We know better now, of course, and economics is one unified whole. People who call themselves macroeconomists make liberal use of game theory, mechanism design, information theory, optimal growth theory, etc., etc. Solid economists worked all that stuff out for us to use, and it would be wasteful to leave it on the shelf.
So, it's not microfoundations, it's just economics - it's the foundation, the plumbing, the electrical work, the walls, the roof, etc. What people mean when they say: "you need some microfoundations," is really "you need more detail in there, so we can understand better what the mechanism is that is at work." We would like our models to be deep - everything explained nicely - but any modeler knows that a model must be simple to be useful. So, if there is too much detail we're in trouble. The modeler may have trouble understanding the damn thing, and he or she may not be able to explain how it works to anyone else.
So, where do you draw the line? How deep a structure do we need to say something useful? I just had a discussion with Noah Smith about Calvo pricing. For me, this is as case where we would like more detail. Typically, in a New Keynesian model, pricing is the friction that makes monetary policy matter. So, for that particular model, it's the process by which prices are set that we're worried about. That's where we want the detailed explanation of what's going on. But Calvo pricing is pretty crude. There are two technologies for changing prices. Either a firm can change a price at zero cost, or it's infinitely costly. And which technology the firm has is determined at random. Well, that leaves a lot of unanswered questions. Why would it be costly for a firm to change its price? Why can't the firm write contingent pricing rules? If it's costly to change prices, surely it must be costly for a firm to change other things, like employment. Why does the firm just serve all the demand the comes in the door when its price is fixed? Basically, there's a lot of unfinished business. We're concerned about how things might change if we put in more detail. Do all the results about monetary policy change or what?
Every piece of research has unfinished business. I have a working paper where quantitative easing (QE) matters, and it matters because short-maturity government debt is better collateral than long-maturity debt. What's it mean for an asset to be better collateral? There is limited commitment, and a borrower can run away with a fraction of an asset that is posted as collateral. What determines that fraction? It's just exogenous. That's a piece of unfinished business. I can think of reasons why that fraction could be endogenous in a deeper model, but I haven't worked that out yet.
This brings us to the Lucas critique. Lucas's ideas were related to earlier ideas that came out of the Cowles Foundation, including the original work on identification and structure. When I took Art Goldberger's econometrics class, he asked us one day to find a definition of structure and bring that into class the next time we met. We found 20 or 30 different definitions, some wildly different. Apparently structure is in the eye of the beholder. To give you an idea how thorny this is, I once had an argument with Bob Lucas about the money demand function, which he is very fond of. He was trying to tell me how remarkable it was that he had found a money demand specification that was stable for 100 years. My reply was something like: "Big deal, a money demand function is not structurally invariant to whatever policies we might want to think about using it for." He said something like: "Unfortunately I think the Lucas critique is used as a bludgeon to do away with ideas one doesn't like." I think he said that later in a public venue. So, even Lucas isn't sure what he thinks of the Lucas critique.
Ultimately, we know our models are going to be wrong. That is, to be useful, a model has to be simple, and simplicity implies it's wrong. Theory is obviously important. The data does not speak directly to us and, in contrast to what Simon seems to think, neither does the data speak to us when we filter it through a VAR - that's just another way to summarize the data. Theory gives us principles on which to organize how we think about the data, so that we're not totally lost.
It's hard to define what a good policy model is. Maybe we need different models for different situations - with the detail in different places. In any event, we hope a good economist knows a good policy model when he or she sees it. However, in some cases it may be difficult to evaluate a policy model's worth unless we actually experiment by putting it into practice.
the weakest link of the modern macro seems to be the aggregate production function. Franklin Fisher showed this does not exist. How do you see us progressing to a more satisfactory microfounded production theory ? Perhaps the network approach of Acemoglue et al will be a step forwardReplyDelete
Yes, this sometimes comes up in models of money. One person says: You're writing down a model of monetary exchange in which you put money in the utility function? What a stupid idea. Another person says: Well, we're willing to write down models in which there is an aggregate production function. That's a stupid idea too. First person: Yes, they are both stupid ideas.Delete
In general I think it depends on the question you are trying to answer. The details of how production is organized within and among productive units in the economy - the structure of contracts and long-term arrangements - may not be important, for example, to monetary policy. But maybe it is, and people should be working on it.
Bigio and La'O seem to find that the production structure is important for understanding financial frictions.ReplyDelete
Do you like their approach in their paper financial frictions in production networks)
I've seen the paper (Saki presenting), not that I remember all the details. I think this is more like thinking about an exogenous input/output structure and the consequences for aggregate credit frictions and misallocation. There are other papers, for example this one, that are related:Delete
"However, in some cases it may be difficult to evaluate a policy model's worth unless we actually experiment by putting it into practice."ReplyDelete
Economic models are rarely directly put into practice and contrary to your claims empirical evidence does not have to be filtered through theory. The facts are that fiscal policy is quite effective in a liquidity trap (at least in one direction) and that QE has modest to nonexisting effects upon output.
How to interpret these facts is a totally different matter and here theory comes in. For the first fact I stick with Keynes, the boom and not the slump is the time for austerity. No need for fancy-pants New Keynesian models, the EMPIRICAL fiscal multipliers are large right now.
About the second fact, here I would stick with guys like yourself ... if you had not been so totally wrong about your inflation predictions. QE is basically just a giant asset swap and the stuff you do views money as asset. But Keynes already figured out that monetary policy becomes ineffective during a liquidity trap more than 70 years ago and as he was also right about the first fact I roll with the theory that is able to explain both facts.
"Economic models are rarely directly put into practice and contrary to your claims empirical evidence does not have to be filtered through theory. The facts are that fiscal policy is quite effective in a liquidity trap (at least in one direction) and that QE has modest to nonexisting effects upon output."Delete
You'll have to explain that. How did you come to the conclusions in the second sentence?
"The facts are that fiscal policy is quite effective in a liquidity trap (at least in one direction) and that QE has modest to nonexisting effects upon output."Delete
Then how do you explain recent U.S growth? The market monetarist "monetary offset" was just put to the test against the supposed ravages of austerity. By some measures the U.S did more austerity than Europe. The big difference was monetary policy. We can also add the UK as another example.
Yes, whether monetary policy is doing much at all, if we listened to the fiscal policy enthusisasts, we would think that we'd be looking at a disaster. Why isn't that happening?Delete
That's another possible interpretation. Why do you think we are seeing these divergent outcomes in what Beckwith & Evans-Pritchard call the "QE bloc vs EMU bloc"?Delete
About microfoundations, methodological individualism is incredibly important for us, it is hard to imagine economics without it. But we might wanna keep in mind that methodological individualism is an important but not the only tool available to us.ReplyDelete
If you understand how subatomic physics work you do not automatically understand how the larger system, chemics, works. And understanding organic chemistry doesn't make you a biologist yet. Being good at biology doesn't mean you know much about human medicine. A physician can treat cancer but not depression. The psychologist might be able to help you with your depression but only the sociologist can explain why depression becomes more or less widespread.
There are ample of aggregation problems in macro. Sometimes it is useful to look onto the microlevel. But sometimes it is not and the economist who claim that economics HAS to be microfounded are as monoistic (albeit not always as evil) as the eye of Sauron.
Question: Why do you use the word "wanna" instead of "want to?"Delete
Question: Where is the runaway inflation you have predicted for years?Delete
You wanna read this. It good readin.Delete
"In order to increase the inflation rate over the medium term, the policy rate has to rise." Sure, and the sun revolts around the earth.ReplyDelete
Any other nonsense you wanna put out there to deflect from your inflation predictions from a few years ago which turned out to be wrong (compared to those of your fellow economist whom you cannot stand and who turned out to be wright, Paul Krugman)? Proper economics is an empirical discipline, if your theory is wrong you put it in the trash bin. Ignoring a mistake like you did is not an option ... unless you do not care about scientific economics in the first place.