Everything about Microfoundations totally explained
In economics, the term
microfoundations refers to the
microeconomic analysis of the behavior of individual
agents such as households or firms that underpins a
macroeconomic theory(Barro, 1993, Glossary, p. 594).
Most early macroeconomic models, including early
Keynesian models, were based on hypotheses about relationships between aggregate quantities, such as aggregate
output,
employment,
consumption, and
investment. 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,
allowing economists to test them both with macroeconomic and microeconomic data.
History
Critics of
Keynes' theory of the failures of
laissez faire macroeconomics soon pointed
out that some of Keynes' assumptions were inconsistent with standard
microeconomics. For example,
Milton Friedman's
microeconomic theory of consumption over time (the '
permanent income hypothesis') suggested that the
marginal propensity to consume 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.'s
critique of
traditional macroeconometric forecasting models.
After the apparent shift of the
Phillips curve 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 don't 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 that the microfoundations project has failed.
Further Information
Get more info on 'Microfoundations'.
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