## Question from Past Macroeconomics Qualifying Exam (Spring, 2006 - Question one) at George Mason University[]

1) ‘Keynesian macroeconomics, it has been remarked, was not built on consistent individual optimizing foundations’.

a) Explain this statement with reference to standard IS-LM models.

b) Is it possible to re-interpret or reformulate standard IS-LM models so as to provide them with rigorous micro-foundations? If so, how?

c) In what repsects has the introduction of stochastic optimizing models (with rational expectations) resolved the problems that you have noted under (a)? Explain carefully. Do any difficulties remain?

## Answer[]

a) In the standard IS-LM model the analysis is built upon Aggregate Supply and Aggregate Demand only and not on individual optimizing foundations. Starting with an aggregate without a theory of how preferences are aggregated has led to critiques of the Keynesian Macro perspective.

The individual from a classic perspective is absent in the standard IS-LM model for the following reasons:

- The existence of autonomous consumption (Keynesian Cross) in the goods market is empirically only observable for a cross-section. For individuals over time (time-series) autonomous consumption is not observable.
- Labor markets in the IS-LM model do not clear. If the model was founded on individual optimizing principles one would expect changes in real wages in response to unemployment.
- The interest rates are different for the IS and the LM curve. The IS curve is derived from a real interest rate framework, whereas the LM curve is derived with the nominal interest rates.

In the model, the aggregate of agents do not update expectations (i.e. they can be continuously fooled by Fiscal Policy and Monetary Policy) and markets can get “stuck” in disequilibrium for long periods of time (see Macrof05-2). The assumptions behind disequilibrium in the standard IS-LM analysis include effects such as money illusion and nominal wage rigidities, neither of which were developed with any solid optimizing foundation. Missing a microfoundation begs certain questions.

b) The New Keynesian school has tried to reformulate the standard IS-LM model to provide it with rigorous microfoundations. Gregory Mankiw (1983) proposed a model which incorporated nominal rigidities in the form of menu cost into the standard IS-LM analysis. Akerlof and Yellen proposed a theory of efficiency wages in 1986 which explained the possibility of above market clearing level wages.

c) Robert E. Lucas in 1973 initiated the Rational Expectations Revolution with his article 'Some Interntional Evidence on Output Inflation Tradeoffs'. Lucas' model allowed for nominal rigidities in a rational expectations framework with imperfect information in the form of a stochastic error in the inflation expectations of the rational agents.

## References[]

George A. Akerlof and Janet Yellen (1986), 'Efficiency Wage Models of the Labor Market', Cambridge: Cambridge University Press (ISBN 0521312841)

Lucas, Robert E., Jr, Expectations and the Neutrality of Money', Journal of Economic Theory, April 1972, 4, 103-24

Mankiw, Gregory, 'Small Menu Cost and Large Business Cycles: A Macroeconomic Model of Monopoly, QJE 100 (May 1985): 529-537

## Other Questions[]

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