Microfoundation Research Programs

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A cornerstone of the GEM Project is macro model coherence. Optimizing price-mediated exchange among agents with rational expectations is organized around continuous general decision-rule equilibrium. Prior to the 1975 invitation-only International Economic Association conference on “The Microeconomics of Macroeconomics” (initiated by John Hicks), research programs on microfoundations were loosely organized. That quickly changed.

The New Classical Project (NCP), associated with Robert Lucas and his colleagues, was first out the gate. It required that representative agents with rational expectations operate in continuous market-centric decision-rule equilibrium. Unemployment fluctuates as a result of imperfect market information on prices and wages, manifest as money illusion: the money-supply surprise model. Lucas (1987, p.234) described his business-cycle research as “simply an attempt to understand and make more explicit the implicit model underlying the policy proposals of Henry Simons, Milton Friedman, and other critics of activist aggregative policy.” NCP papers became prominent in the early 1970s.

The Real-Business-Cycle Project (RBCP) came later and was constructed on, first, the premise of general market-clearing and, second, rational market exchange conducted by continuously optimizing representative agents with rational expectations. The action occurs when everybody gets buffeted about by technology shocks. Ramsey’s model of optimal saving in a socialist economy and Solow’s neoclassical growth model provided analytic roadmaps. RBCP papers began to appear around the early 1980s. The New Keynesian Project (NKP) also used the representative household, rational expectations, and optimizing exchange, both coherently organized by continuous general equilibrium and restricted to the marketplace. The school differed from the RBCP approach in that NK theorists emphasized the identification of powerful, model-coherent market frictions that would deliver their models from market-clearing. In particular, they wanted to go beyond Lucas by finding a super friction that would microfound the causal link from nominal demand disturbances to involuntary job loss and unemployment. The NKP-RBCP battle for dominance in the academy has always been about the classical dichotomy. NKP papers also began appearing in the early 1980s.

By the middle 1990s, the NCP research project had withered under the weight of money illusion. More significantly, NKP gatekeepers concluded that their methodological differences with RBC thinking were insufficient to continue the 30-year macro war. Goodfriend and King (1997) announced the peace treaty. From Woodford (2009, p.268): “there has been considerable convergence of opinion among macroeconomists over the past 10 or 15 years…. The cessation of methodological struggle within macroeconomics is due largely to the development of a new synthesis by Marvin Goodfriend and Robert G. King, called ‘the New Neoclassical Synthesis,’ that incorporates important elements of each of the apparently irreconcilable traditions of macroeconomic thought.”  In the NNS, New Keynesians accept the necessity of coherent market-centric dynamic stochastic general equilibrium (DSGE) model framework, while RBC theorists accept the use of model-consistent market frictions. NK theorists particularly agreed to eschew the early-Keynesian reliance on free parameters.

Two characteristics of the periods leading up to and after the NNS merger are noteworthy. First, NK and RBC schools have always problematically accepted the presumption of market-clearing beyond the short-run. Everybody pays homage to the neoclassical growth model. Second, after investing hugely in a multi-pronged effort to identify a coherent super friction capable of rationally suppressing wage recontracting, it finally dawned on many NK theorists that the quest was futile. The model-consistent market friction needed to motivate the causal link from nominal demand disturbances to involuntary job loss simply does not exist. Many leading NK thinkers grudgingly accepted that, if their market-exchange models are to be coherent, they will only generate the mildest of business cycles. That acquiescence ushered in the final piece of the puzzle, i.e., the ubiquitous use of the Search/Match/Bargain framework with its inherently voluntary joblessness in NKP instability research.

Dashed aspirations with respect to the will-o’-the-wisp super friction has trapped NKP gatekeepers, as they adhere to model coherence, into muting their objections to market clearing, the presumption of which this website has named the Ptolemaic Convention. NKP theorists are in a tough spot. They must choose between withdrawing from the NNS consensus and its admirable coherence, perhaps reviving some stabilization relevance via free-parameter guesswork, or accepting (perhaps with a wink) the Ptolemaic Convention and its situational approach to available evidence. The former strategy is illustrated by Christiano, Eichenbaum, and Evans (2005); the latter by Woodford (2003, 2009).

Enter the GEM Project. Generalized-exchange theory is at the core of the fourth microfoundations research program. Unlike the NC, RBC and NK projects, the GEM macro model class is simultaneously coherent and stabilization-relevant. (Whether or not that claim catches your attention is a test of how Ptolemaic your macro thinking has become.) That the Project is successful where NC, RBC and NK theorists have failed results from its shift in focus from rational expectations, representative agents, or market competition to the nonintuitive, deeply restrictive assumption that all rational exchange must occur in the marketplace. Once optimizing price-mediated exchange organized by rational expectations and coherent continuous equilibrium is generalized from the marketplace to the workplace, most of the problems that have plagued mainstream macro theorists throughout the difficult NC-RBC-NK saga are easily resolved. Most notably, GEM uniquely microfounds the causal link from nominal demand disturbances to involuntary job loss, justifying the activist management of total spending and pushing the stabilization policies of Simons, Friedman, Lucas, Prescott, and Woodford aside. (Chapters 2, 10) Moreover, the two-venue theory powerfully informs an intermediate-run featuring, on the one hand, expectations of trend profit that motivate investment and growth, described in the Solow model or, on the other, downsizing and restructuring, along the lines of the Thatcherite revolution in Britain or the 1980s wave of labor-cost bankruptcies in basic industries in the United States.  (Chapters 3, 10) The GEM Project explains a lot of macro behavior, easily more than its three predecessors combined.

Blog Type: New Keynesian Saint Joseph, Michigan



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