The quest for microfoundations

There has been recent debate in the blogosphere about what we learn from demanding microfoundations for macro results. I am a firm believer in microfoundations, while recognizing the abuses to which the concept has been put.

Via Mark Thoma, enter Robert Hall and his latest paper (pdf), here is the abstract:

The financial crisis of late 2008 shifted household expenditure downward, as financial institutions tightened lending standards and required repayment of outstanding consumer loans. The crisis also raised financial frictions by depleting the equity capital of financial institutions. The result was a severe reduction in business and residential investment expenditure. The zero bound on the interest rate worsened the adverse effects of these developments by limiting the corrective response of monetary policy. In a straightforward and comprehensible macro model, I measure the two financial driving forces by matching the actual and forecasted movements of two key variables, the unemployment rate and the investment/GDP ratio. I then use the model to describe a counterfactual economy over the period 2009 through 2020 in which the same increase in financial frictions occurred but no household deleveraging took place. The comparison of the counterfactual and actual economies reveals the separate effects of the two financial driving forces. Deleveraging had an important but transitory role immediately after the crisis, while high financial frictions account for the long period of high unemployment, depressed GDP, and subnormal investment.

Maybe you don’t agree with Hall (I am of mixed mind), but he gives us a systematic framework for analyzing the depth and length of the recent recession, noting that it is microfoundations but not strict DSGE because he wishes to create more space for changes in basic structural parameters.

I have three observations: a) such a paper would not have been possible without a microfoundations approach, b) Hall finds a strong role for intermediation, which is a favorite topic of the microfoundations advocates and a feature lacking in IS-LM models, and c) his methods suggest some weaknesses in the recent stress on deleveraging as the continuing plague, again noting this is a framework for discussion rather than the final answer.

The microfoundations approach proves its value virtually every day.


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