Should Macroeconomic Models Be Based on Sound Microeconomic Foundations?

Over the last two decades, there has been a growing acceptance that macroeconomic theory and macroeconomic models should be explicitly derived from microeconomic analysis and it should be based on assumptions of rational expectations and inter-temporal utility maximization (C.J.M van den Bergh and J.M. Cowdy, 2003). However, there are advantages as well as disadvantages of insisting on building macroeconomic models based on sound microfoundations. The advantages that will be discussed in this essay are those associated with Neo-classical view of general economic theory. Their belief is that all economic phenomena, including levels of output and employment, should be derived from the first principles of inter-temporal optimization of consumption and leisure of an individual. Furthermore, they are of the opinion that macroeconomics is the result of aggregation of microeconomics (A. Zouache, 2008). The disadvantages that this essay will try to address are in contrast contradictions by economists to the fact that such aggregation is possible and as a result microfoundations may not be a good basis of macroeconomic models (R.E Backhouse and A. Salanti, 2000).

Let us consider a consumer agent, who rationally maximizes his/her utility, which depends on consumption each period and labour supply each period. This agent will face an inter-temporal budget constraint. The maximization of the agent’s utility function will give us his/her consumption function, where consumption depends on total wealth and the real interest rate. S.Wren-Lewis argues that this type of consumption function is supported by current academic literature on macroeconomics (S.Wren-Lewis, 2006). In other words, macroeconomic models use consumption functions that have been derived from the individual consumer theory.

There are two perfect examples of microfoundations that have been used as a basis in macroeconomic modeling. According to S.Wren-Lewis, the first was provided by Michiel Woodford...