Blog o’ Burns

Hoover, Kevin D. “Is Macroeconomics for Real?” (June 1999)

How sad would it be if the big punchline to this course was the fact that macroeconomics wasn’t real? I’d ask for a refund. Thankfully, that was not the conclusion of this article and hasn’t necessarily been the conclusion of most economists. In general, economists don’t doubt that stable and observable relationships exist at the aggregate level; however, can these relationships be explained in the context of an individual’s rational microeconomic behavior? I won’t pretend to completely (or even mostly… or even partly…) understand Hoover’s argument against the necessity of microfoundations, but I believe he is saying that macroeconomics is not just a construct of measurement or of theory– economic aggregates aren’t just derived from micro behavior; they also affect behavior in ways that alter economic “reality.”

The quest to base macro theory on microfoundations is founded in methodological individualism, which argues that explanations of social, political, and economic phenomena can only be adequate if they are based on the beliefs, attitudes, and decisions of individuals. Lucas and his fellow new classicals have tried to achieve this by using representative-agent models in which a single individual takes on national income as his/her budget constraint and makes microeconomic optimal choices which are supposed to represent the choices of the aggregate economy. However, few macro phenomena have been successfully reduced to their microfoundations.

Hoover distinguishes between two types of economic aggregates: natural aggregates are simple sums or averages, while synthetic aggregates are derived from their components in a way that makes them “dimensionally distinct” from those components. For example, changes in the general price level entail more than just looking at the price of one good or even just averaging the prices of many goods. Everyone has the sense that inflation exists and recognizes that a dollar doesn’t buy as much as it used to, but looking at prices alone won’t tell you much about changes in purchasing power. Economists have multiple ways of measuring inflation, but none will perfectly capture what the everyday person experiences– this just shows how aggregates can exist independent of how they are measured and how they affect the behavior of economic agents.

Though I’m typically the kind of person who likes tearing apart an argument, I have to say that I applaud Hoover’s questioning of the need for microfoundations. To me, new classical pretensions of finding economic truth by incorporating microfoundations seems like just a veneer covering up an over-simplified theory that assumes away any of the messiness that characterizes a real economy. Besides that, I never saw any evidence that these models were truly based on micro behavior. As far as I could tell, microfoundations were just used to explain why the economy is always operating at potential– since people/firms attempt to maximize utility/profits, they always react rationally to shocks in the economy, and thus output is always at its optimal level given people’s preferences for leisure and consumption. Such conclusions seem terribly convenient and don’t take into account possibilities for externalities, prisoner dilemma situations, and any number of occasions for market failure. Of course, all of these issues occur at the micro level, but I don’t feel like it’s necessary (or even possible) to model such problems at the aggregate level.

The point is that details matter. I consider myself a rational person, but my utility function probably changes on a daily basis based on my mood. If I’m having a bad day, I might buy some ice cream even though I wouldn’t consider it worthwhile on any other day. Let’s say that I’m a representative human being, and every person on earth increases his/her marginal propensity to consume ice cream on a bad day. Now imagine that there’s a shock to the economy, and suddenly everyone on earth is having an incredibly terrible day. A new classical would say: “And then all of the rational Stephanie’s went out to buy ice cream instead of doing homework, and ice cream prices rose due to higher demand, causing some of the Stephanie’s to drop out of line and equilibrating supply and demand.” However in the real world, it goes something more like this: “And then all of the Stephanie’s lined up at all of the Carl’s in the world and got way annoyed that the line was so long. The line was so long that the opportunity cost of getting ice cream (better grades from doing homework) exceeded the pleasure of eating it. However, if the line got shorter because other Stephanie’s dropped out, the net benefit of sticking around would make it worthwhile. As such, all of the Stephanie’s waited for each other to drop out of line. Meanwhile, the employees at Carl’s didn’t want to raise their prices, because they were afraid that all of their business would go to Coldstone instead. Besides, they knew that tomorrow would be a good day, so it didn’t make sense to change their prices for just one day. In the end, a suboptimal amount of homework got done and Carl’s didn’t make as much profit as it could have.” As you can see, all of these decisions were made at the micro level, but they were all based on perceptions of the larger economy. I hope that’s at least part of what Hoover is talking about.