Hume on Microfoundations of Macroeconomics

by Dirk Ehnts, Econoblog101

So-called micro-foundations 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 micro-foundations, 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, never mind 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.

Click to enlarge

As 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 buy 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. After 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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