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Do not underestimate the power of microfoundations

Author(s): Simon Wren-Lewis

"Why are microfounded models so dominant? From my perspective this is a methodological question, about the relative importance of ‘internal’ (theoretical) versus ‘external’ (empirical) consistency."


From mainly macro:

Brad DeLong asks why the New Keynesian (NK) model, which was originally put forth as simply a means of demonstrating how sticky prices within an RBC framework could produce Keynesian effects, has managed to become the workhorse of modern macro, despite its many empirical deficiencies. (Recently Stephen Williamson asked the same question, but I suspect from a different perspective!) Brad says his question is closely related to the “question of why models that are microfounded in ways we know to be wrong are preferable in the discourse to models that try to get the aggregate emergent properties right.”

I would guess the two questions are in fact exactly the same. The NK model is the microfounded way of doing Keynesian economics, and microfounded (DSGE) models are de rigueur in academic macro, so any mainstream academic wanting to analyse business cycle issues from a Keynesian perspective will use a variant of the NK model. Why are microfounded models so dominant? From my perspective this is a methodological question, about the relative importance of ‘internal’ (theoretical) versus ‘external’ (empirical) consistency.

As macro 50 years ago was very different, it is an interesting methodological question to ask why things changed, even if you think the change has greatly improved how macro is done (as I do). I would argue that the New Classical (counter) revolution was essentially a methodological revolution. However there are two problems with having such a discussion. First, economists are usually not comfortable talking about methodology. Second, it will be a struggle to get macroeconomists below a certain age to admit this is a methodological issue. Instead they view microfoundations as just putting right inadequacies with what went before.

So, for example, you will be told that internal consistency is clearly an essential feature of any model, even if it is achieved by abandoning external consistency. You will hear how the Lucas critique proved that any non-microfounded model is inadequate for doing policy analysis, rather than it simply being one aspect of a complex trade-off between internal and external consistency. In essence, many macroeconomists today are blind to the fact that adopting microfoundations is a methodological choice, rather than simply a means of correcting the errors of the past.


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