Posted by: Dirk | April 16, 2013

Hume on microfoundations of macroeconomics

So-called microfoundations of macroeconomic models means that agents in the model always use some sort of optimization given the state of variables in the economy. A case in point is the consumption function. Keynesian normally say that consumption depends on income, maybe on wealth, but this dependence is expressed through a fixed constant. So, maybe consumption is 0.8 times income. No optimization happens as agents use rules of thumb. In a model with microfoundations, agents with higher income might decide to work less or save more, which changes other parts of the model.

David Hume, a Scottish philosopher of the 18th century, wrote this paragraph:

As this is a question of fact, not of abstract science, we can only expect success, by following the experimental method, and deducing general maxims from a comparison of particular instances. The other scientific method, where a general abstract principle is first established, and is afterwards branched out into a variety of inferences and conclusions, may be more perfect in itself, but suits less the imperfection of human nature, and is a common source of illusion and mistake in this as well as in other subjects. Men are now cured of their passion for hypotheses and systems in natural philosophy, and will hearken to no arguments but those which are derived from experience. It is full time they should attempt a like reformation in all moral disquisitions; and reject every system of ethics, however subtle or ingenious, which is not founded on fact and observation.

So, empirical evidence needs to be explained. The red line in the following graph is real disposable personal income, the blue line real personal consumption expenditures. It looks like the relationship between the two is quite stable in the sense that expenditures are a (quite high) share of income. It does seem like a good idea to use this sort of explanation, nevermind that this means people are not optimizing by spending more if interest rates are low or working more (less?) when hourly real wages are rising.

fredgraph_cyAs Hume said: we should “reject every system of ethics, however subtle or ingenious, which is not founded on fact and observation.” Let me add that if we don’t, we’ll get strange policy results, like a depression in the European periphery because apparently some policy makers believe that falling incomes will not lead to a fall in consumption. If people do not consume, than who is supposed to by the production? Foreigners would, but since these countries have no control over the euro exchange rate this is a hard case to make. And putting wages down in order to let prices fall might increase exports, but not incomes. Afer all, export earnings are quantity times price. The fall in price hence would have to be overcompensated by the rise in quantity. The complications of these issue were discussed by Ohlin and Keynes back in the days, and it seems to have been so confusing that nobody attempted yet to write a Wikipedia article on the transfer problem.

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Responses

  1. It is more then obvious that fixig the pegg, or accepting foreign currency is also fixing the standard levels of countries over the business cycle, fixing it to the relation of the leading countries.
    Inside business cycle, temporary capital flows can trick the fix of standard also temporarily and get the higher standards in low living standard countries. But in time, that standard get to be lowered when capital flows reverses.

    There is no other way to equalize living standards but to implement permanent fiscal transfers within the single currency area using unified retirement, health, military, education and welfare systems. This issue comes from the natural tendency that surplus country will hoard more and more money and deficit country will have less and less due to the fact that surplus on allready have an advantage and will keep it on its own without any effort. It is the system. Just as rich (surplus) people will always keep getting more and more while poor (deficit) will have less and less.

    At the present, there is no way for a confederation as EU is to be sustained without producing tribal antagonisms and possibly war. EU have to federalize or loose the euro. This parallels to USA Civil War process.

  2. Dirk,

    Let me ask quick question. In a recent posting in your blog you presented a chart depicting income and consumption. In macroeconomic sense as Keynes defined consumption has a different meaning. Consumption means the value of sale proceeds that are not sold to another entrepreneurs; (that is A2= A-A1 where as A is total proceeds, A1 is sales to another entrepreneurs and A2 is the consumption.) If you did the computation based on this definition will the line of consumption in chart will shift upward above the line of income (disposable income + tax)? Thanks.

    Hema/NY.

    • I can’t recall presenting that chart of income and consumption that you mentioned. Perhaps you could copy&paste your comment into that blog post when you find it?

      Dirk

      • The chart I am referring is in the blog post titled ” Hume on microfoundations of macroeconomics.”
        Thank you for your attention on my question.
        Hema/NY

  3. Sorry, I was on my phone and did not see the graph. I did no computation here, it is all done by FRED. If you really want to know you find the data source in the graph.

    Dirk

    • My question was not about data or computation but about definitions of Consumption and Income. I said the chart uses microeconomic basis in the computation (foundations) to show the macro picture but I asked you what would possibly happen if consumption and income are computed based on macro-definitions of both variables. And do you know the macroeconomic definitions of both terms? Thanks.
      Hema/NY


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