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Microfoundations

Microfoundations

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In economics, the term microfoundations refers to the microeconomic
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

 analysis of the behavior of individual agents
Agent (economics)
In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....

 such as households or firms that underpins a macroeconomic
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

 theory
(Barro, 1993, Glossary, p. 594).

Most early macroeconomic models, including early Keynesian
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 models, were based on hypotheses about relationships between aggregate quantities, such as aggregate output, employment
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...

, consumption
Consumption (economics)
Consumption is a common concept in economics, and gives rise to derived concepts such as consumer debt. Generally, consumption is defined in part by comparison to production. But the precise definition can vary because different schools of economists define production quite differently...

, and investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...

. Critics and proponents of these models disagreed as to whether these aggregate relationships were consistent with the principles of microeconomics. Therefore, in recent decades macroeconomists have attempted to combine microeconomic models of household and firm behavior to derive the relationships between macroeconomic variables. Today, many macroeconomic models, representing different theoretical points of view, are derived by aggregating microeconomic models
Dynamic stochastic general equilibrium
Dynamic stochastic general equilibrium modeling is a branch of applied general equilibrium theory that is influential in contemporary macroeconomics...

,
allowing economists to test them both with macroeconomic and microeconomic data.

History


Critics of the Keynesian
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 approach to macroeconomics soon pointed out that some of Keynes' assumptions were inconsistent with standard microeconomics
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

. For example, Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

's
microeconomic theory of consumption over time (the 'permanent income hypothesis
Permanent income hypothesis
The permanent income hypothesis is a theory of consumption that was developed by the American economist Milton Friedman. In its simplest form, the hypothesis states that the choices made by consumers regarding their consumption patterns are determined not by current income but by their longer-term...

') suggested that the
marginal propensity to consume
Marginal propensity to consume
In economics, the marginal propensity to consume is an empirical metric that quantifies induced consumption, the concept that the increase in personal consumer spending occurs with an increase in disposable income...

 out of temporary income, which is crucial for the Keynesian multiplier, was likely to be much smaller than Keynesians assumed. For this reason, many empirical studies
have attempted to measure the marginal propensity to consume (Barro, 1993, Ch. 3, p. 87), and macroeconomists
have also studied alternative microeconomic models (such as models of credit market imperfections and precautionary saving)
that might imply a higher marginal propensity to consume.

One particularly influential call for microfoundations was Robert Lucas, Jr.
Robert Lucas, Jr.
Robert Emerson Lucas, Jr. is an American economist at the University of Chicago. He received the Nobel Prize in Economics in 1995 and is consistently indexed among the top 10 economists in the Research Papers in Economics rankings. He is married to economist Nancy Stokey.He received his B.A. in...

's critique
Lucas critique
The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.The basic idea...

 of
traditional macroeconometric forecasting models.
After the apparent shift of the Phillips curve
Phillips curve
In economics, the Phillips curve is a historical inverse relationship between the rate of unemployment and the rate of inflation in an economy. Stated simply, the lower the unemployment in an economy, the higher the rate of inflation...

 relationship in the 1970s, Lucas argued that the correlations between
aggregate variables observed in macroeconomic data would tend to change whenever macroeconomic policy changed.
This implied that microfounded models are more appropriate for predicting the impact of policy changes, under the assumption that changes in macroeconomic policy do not alter the underlying microeconomic structure of the macroeconomy.

Controversy


Some, such as Alan Kirman and S. Abu Turab Rizvi, argue on the basis of the Sonnenschein-Mantel-Debreu Theorem
Sonnenschein-Mantel-Debreu Theorem
The Sonnenschein–Mantel–Debreu theorem is a result in general equilibrium economics. It states that the excess demand function for an economy is not restricted by the usual rationality restrictions on individual demands in the economy...

 that the microfoundations project has failed.

See also

  • Macroeconomics
    Macroeconomics
    Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

  • Microeconomics
    Microeconomics
    Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

  • Macroeconomic model
  • Lucas critique
    Lucas critique
    The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.The basic idea...

  • Dynamic stochastic general equilibrium
    Dynamic stochastic general equilibrium
    Dynamic stochastic general equilibrium modeling is a branch of applied general equilibrium theory that is influential in contemporary macroeconomics...

  • Methodological individualism
    Methodological individualism
    Methodological individualism is the theory that social phenomena can only be accurately explained by showing how they result from the intentional states that motivate the individual actors. The idea has been used to criticize historicism, structural functionalism, and the roles of social class,...