If the Representative Agent is Used, Should He Be Believed? Aggregation, Welfare and the Role of Microfoundations in Quantitative Economic Policy

Abstract

One of the most pervasive trends in modern macroeconomics is the use of microeconomic theory to derive the behavioural equations of a macroeconomic model. This is frequently accomplished by the invocation of a single “representative agent”, whose own optimising decisions are then scaled up to represent the aggregate behaviour of all consumers in the economy. On the positive side, these strong assumptions permit the marriage of micro and macroeconomic analysis, with the behaviour of the economy at aggregate level directly explicable in terms of individual optimising behaviour. In addition, the preferences of the representative agent are often used to rank different policy outcomes. In the words of Woodford (2001):

“An important advantage of using a model founded on private-sector optimisation to analyze the consequences of alternative policy rules is that there is a natural welfare criterion in the context of such a model, provided by the preferences of private agents that are displayed in the structural relations that determine the effects of alternative policies.” This usage of microfounded models to provide a welfare-metric evaluation marks an important new step in quantitative economic policy. Previously, the task of economic theory was typically confined to the positive role of quantifying the likely effects of various policies. The normative task of ranking policy outcomes, or of specifying the “optimal policy”, was left to the policymaker, who would simply choose according to his own volition from the menu of possible outcomes given by the positive economic analysis.