I received the following email the other day:
Given your past criticisms of this issue in your posts, I do not think you will like my co-authored paper, “Microfoundations of the Business Cycle and Monetary Shocks” . . .
Given this lead-in, of course I had to take a look. The paper is by James Holmes, John Holmes, and Patricia Hutton, it’s called “Microfoundations of the Business Cycle and Monetary Shocks,” and they say:
Non-rational expectations can produce larger expected real income for some or all agents than rational expectations. . . . Hence, “rational expectations” are not rational, and “money illusion” can be optimal and satisfy the “Lucas Critique.” . . . Nominal wage rigidity or stickiness can be the rational response of firms or workers and need not be evidence of money illusion.
I asked Holmes why he thought I would not like the paper, as I am not opposed to microfoundations when they are of interest. My opposition is to the attitude that microfoundations are necessary for macro understanding. Holmes replied that his point was that his article was an example of how a simple micro model can yield new and unconventional insights which would not have been obtained simply by studying macro patterns in a statistical, model-free way. (Here I’m using the term “model” in the economic sense of a mathematical formulation of individual decisions, rather than in the statistical sense of a joint probability distribution.)
To get to the details of the paper . . . hmmm, I’ll leave that to others. (Paging Rajiv Sethi . . .) I am sympathetic to the sorts of arguments presented in this paper but I don’t have the energy to go through what the authors are actually saying. I have no training in studying this sort of model (my last econ class was in 11th grade!) and I can’t bring myself right now to put in the effort required to follow it all. But I’m setting it out there in case any of you are interested.