HARRIS DELLAS

A Dialogue between Micro- and Macroeconomics:

Introduction

“. . . The most recent developments in macroeconomic theory seem to me describable asthe reincorporation of aggregate problems such as inflation and the business cycle withinthe general framework of ‘microeconomic’ theory. If these developments succeed, theterm ‘macroeconomic’ will simply disappear from use and the modifier ‘micro’ willbecome superfluous. We will simply speak, as did Smith, Ricardo, Marshall and Walras,of economic theory. . . .” (Lucas, Models of Business Cycles, 1987, pp. 107–8)

THERE IS LITTLE doubt that, during the two decades that haveelapsed since Lucas’ comment, the process of reincorporation of aggregate problemsinto the framework of micro-economic theory has more or less been completed.Macroeconomics, nowadays, involves the study of the equilibrium in an economywith rational, optimizing agents who are endowed with well-specified preferencesand face explicit constraints (budget, informational, etc.). The practice of studyingrelationships among aggregate variables without deriving them first from an explicitly“micro-founded” model has become more or less extinct. Nevertheless, notwithstand-ing the marriage between micro and macro, the two fields seem to have remaineddistinct. Some of their most prominent differences concern the types of questionspursued and the types of models and empirical methods used. A natural question iswhether there is still room for further integration and how it can be accomplished.

The purpose of the JMCB-SNB-UniBern conference was to bring together leadingrepresentatives of the micro and macro approach in various fields of economics(namely, labor, public, industrial organization, and behavioral) and to explore whetheranything constructive could be learned from the interaction of the two sides. Inparticular, are the two sides in each subfield interconnected research wise? Is the flowof ideas and methods a one- or a two-way street? Are the differences reconcilable?

The contributed papers fell in two categories. They were either reflective pieces orsurveys of the interaction (or its lack therefore) between micro and macro. Or, they

Received April 25, 2011; and accepted in revised form April 25, 2011.

Journal of Money, Credit and Banking, Supplement to Vol. 43, No. 5 (August 2011)C© 2011 The Ohio State University

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represented a good example of how business is done on ones side (micro or macro)and the lessons for the other side.

In labor economics, Richard Rogerson represented the macro and Cunha the mi-cro side, respectively. Rogerson’s earlier seminal contribution on indivisible laborallowed the Real Business Cycles model to include an extensive margin in labordecisions, making the model both more realistic and more relevant for understandingemployment fluctuations. In his conference paper, Rogerson goes one step further andexamines how the source of labor indivisibility matters for the relationship betweenindividual and aggregate labor supply. He shows that uncovering the microfoun-dations of indivisibility is important for determining the aggregate properties of themodel (the elasticity of the aggregate labor supply). He presents two different founda-tions for “indivisible labor” in a life-cycle setting and shows that not only do they havevery different implications for the response of aggregate hours worked to changes intax and transfer programs, but they also differ with regard to their implications aboutthe kind of data (micro vs. aggregate data) that are appropriate for estimating keyindividual preference parameters.

The returns to skill and, in particular, their contribution to the observed collegepremium have been the subject of a large body of literature. Several nonmutuallyexclusive theories exist, but it has proved difficult to discriminate among them dueto the lack of suitable data on skills and income. In their paper, Cunha, Karahan, andSoares develop an econometric framework that allows them to pool disparate databases, maximizing the information available for estimating the contribution of skillsto the premium. They then examine how the returns to cognitive and noncognitiveskills have evolved over time and how such movements in the returns to ability haveaffected the college. Their main findings are that the dynamics of the returns tocognitive skills in the college sector are quite similar to those of the college premium.The shifts in the relative supply of and demand for college versus high school laborare behind the movements in the college premium. And that much of the more recentincrease in the college premium has been due to an increase in the returns to cognitiveskills.

In the Industrial Organization session, John Leahy represented the macro andHugo Hopenhayn the micro side. Leahy started by identifying the four essen-tial modeling elements of macro-economic theory: uncertainty, dynamics, gen-eral equilibrium, and microfoundations. These elements induce such a degree ofcomplexity that makes it impracticable to include in macro models the kind ofmicroscopic detail present in Industrial Organization (IO) models. Together withthe fact that realistic microdetails are often irrelevant for understanding the aggre-gate phenomena under consideration, they justify the adoption of the stark, simpleassumptions often made in macroeconomics.

Leahy’s paper provides a valuable discussion of the key IO ingredients of theNew Keynesian Phillips curve. These ingredients are price frictions (the degree,frequency and characteristics of price rigidity, its relation to strategic complementar-ities/substitutabilities), markups (their size and cyclicality), and marginal costs (theirsensitivity to idiosyncratic and aggregate variables). His discussion of the alternative

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ways for getting a flat Phillips curve represents a masterful synthesis of the literatureand is very valuable for understanding the properties and implications of diversemodeling choices made in the extant literature. Having defined the IO issues thatare important in the analysis of the Phillips curve, Leahy invites IO economists tocontribute by carrying out studies that could be relevant from an aggregate perspectiverather than focusing on studies of particular, and possibly idiosyncratic, industries orfirms.

Hopenhayn’s paper provides a concise and critical survey of the evolution of IOtheory during the last half century as well as a review of its contribution to macro-economic questions. He argues that IO has more or less followed two parallel lines ofresearch. The micro one has been preoccupied with market structure, firm conduct,and performance. It has relied heavily on game theory and—lately—on “ultra-micro”econometric work. The main weakness of the game theory based IO is that it producedan endless series of special cases that lack robustness and generality (a theoreticalchaos in the words of Pelzman). Similarly, the “ultra-micro” work has turned out torepresent a set of exercises in structural estimation in highly specific environmentsrather than a search for robust empirical regularities that hold across industries andcould, thus, have relevance for understanding aggregate phenomena.

The macro line, on the other hand, has focused on broader questions and hasproved more influential. It has established a number of stylized facts regarding firmheterogeneity and dynamics. It has developed models that, by being capable ofmatching those facts, they are suitable for addressing important macro questionssuch as the determination and evolution of aggregate Total Factor Productivity.

The efficient redistribution of resources across individuals and also the provisionof social insurance are among the key themes in public finance. Two fairly distinctapproaches, a micro and a macro have been developed in dealing with these issues.In their paper, Golosov, Troshkin, and Tsyvinski offer a survey of these two lit-eratures and also provide suggestions of how the two approaches can be merged.The micro approach has typically employed static, deterministic models with a greatdeal of heterogeneity. It has been able to produce concrete and empirically relevantcharacterizations of optimal taxes. But it has neglected the stochastic and dynamicdimensions and is, thus, silent on issues of capital taxation and social insurance. Themacro literature, on the other hand, has studied optimal (and in particular, capital)taxation and social insurance in stochastic, dynamic environments. But it has notbeen able so far to produce characterizations of taxes that are empirically recogniz-able or implementable. The Golosov, Troshkin, and Tsyvinski contribution makesan important step in amending this deficiency by introducing a consolidated laborincome account and integrating the tax and social security system.

In his contribution, Judd discusses optimal taxes and the gains from tax reform(moving from income to consumption taxation in dynamic economies that enrichthe standard model by adding imperfect competition, risky assets, and human capitalformation). He argues that the presence of imperfect competition strengthens the casefor consumption taxation. That elimination of the debt–equity distinction in the taxcode is of substantial value. And that adding human capital also increases the benefits

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from tax reform. Furthermore, Judd makes two additional important points. First, thedifferential treatment of different types of capital creates substantial efficiency losses.And second, existing tax policies are so complex as to render the concept of a single,effective tax rate unreliable.

Most of the macro-economic literature assumes rationally behaving, self-interestedeconomic agents. Recently, however, other forms of behavior are being contemplated.For instance, there is a small but growing literature that studies the consequences ofnonselfish preferences (such as preferences for fairness and reciprocity) for macro-economic outcomes. In his contribution on behavioral economics, Schmidt, reviewsand qualifies the role of social preferences in competitive markets. He argues thatsocial preferences do not matter under perfect competition as long as the followingconditions are satisfied: the selfish and social component of utility are separable;either there is no uncertainty, or in the presence of uncertainty, complete contingentcontracts are traded. An important challenge for future research remains to writedown standard macro-economic models with social preferences and to identify theirquantitative contribution to important macro-economic outcomes.

Chauvin, Laibson, and Mollerstrom’s work represents an attempt to measure thesize of welfare losses associated with—presumably preventable—asset-price bub-bles. They study an economy in which agents heterogeneous in terms of asset holdingsare born in a period in which a bubble starts. The bubble generates a distribution ofconsumption volatilities in the population both because of changes in perceptions ofpermanent income due to the boom/busts in asset prices and also because of the assettrades that take place during the bubble period. Chauvin, Laibson, and Mollerstromestimate the costs arising from “excessive” (relative to the no bubble equilibrium)consumption volatility to be a large multiple of the number obtained by Lucas in hisfamous paper on the cost of economic fluctuations.