Internal Consistency, Nominal Inertia and the Microfoundation of Macroeconomics.

Working paper

Microfounded macromodels (SDGE models) represent the dominant approach in academic macroeconomics, and their influence now extends to the forecasting models of central banks. These models appear to adopt a clear methodological approach, which promotes internal consistency above external consistency as a necessary condition of admissibility. This paper develops two arguments. The first notes that internal consistency means that the development of microfounded macromodels depends on the pace of theoretical innovation. The delay in the acceptance of nominal inertia as part of microfounded modelling illustrates the importance of this constraint, and similar delays are already apparent in other areas. This had led to an internal debate between ‘pragmatists’ who argue for limited departures from internal consistency, and ‘purists’ who claim that this would fatally compromise the methodological integrity of microfounded macroeconomics. The second argument is directly relevant to this debate. It is that the inclusion of nominal inertia into these models via short-cuts like Calvo contracts has required a key modification of the microfoundations methodology, such that internal consistency can only be claimed indirectly by appeal to theory developed elsewhere. This modification is significant because these indirect internal consistency claims cannot be demonstrated formally, and instead depend on judgement. It seems implausible that this judgement is not influenced by external consistency. As a result, the methodological integrity of the microfoundations project is not as unblemished as the ‘purists’ imagine.

Authors: Wren-Lewis, S

• Publisher: Department of Economics (University of Oxford)
• Series: Discussion paper series
• Publication date: 2009-01-01
• Language: English