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Some people from the more extreme microfoundations/internal consistency camp keep bashing the Neo Keynesian model for the Calvo pricing being not micro founded and hence the whole model not being immune to the Lucas critique.

However, one could argue that we don't observe inflation rates far away from the steady state in the US, and, as long as this was true, the lack of micro foundations was minor.

Which argument dominates here? Are there other arguments to be made around NK and the Lucas critique? What is the literature's conclusion?

FooBar
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  • Surely we sometimes observe inflation rates far, far away from long run values. Forget about the Wiemar-era hyper-inflation, what about the 1970's in the USA? – BKay Feb 05 '15 at 16:55
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    Are there any macro models immune to the Lucas critique? – serakfalcon Feb 16 '15 at 10:24
  • @BKay: Some people argue that there was a discontinuity since the great moderation - and that the models are also not fit for discussing supply-side inflation. – FooBar Feb 16 '15 at 10:52
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    @serakfalcon I guess the standard RBC model is immune to the Lucas critique - if you take all its parameters, be it production, preferences or else to be "deep parameters". – FooBar Feb 16 '15 at 10:53
  • For the shake of brevity, could we summarize the essence of "Calvo's pricing" as "firms don't change their prices every day?" – Alecos Papadopoulos Sep 14 '15 at 12:03
  • @AlecosPapadopoulos "Firms cannot change their prices every day" – FooBar Sep 14 '15 at 12:51

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Before gravity was conceived as a physical phenomenon and studied by Isaac Newton, gravity was not microfounded. So before Newton, modelling the real world should assume away gravity, because it was not microfounded. We should instead create models into which humans could walk on air.

When a phenomenon appears stable, while attempting to understand and decipher it (to micro-found it), we should be wise enough to accept its existence and include it in our models, of course in an "ad hoc" manner since we haven't decipher it yet.

Whether firms "cannot" or "choose optimally not to" change their prices everyday, makes little difference, as long as we haven't settled on the optimization framework into which such an optimal choice could come about. It makes little difference because in the absence of knowledge it can be seen as a semantic issue: I can re-interpret "cannot" as "an optimizing agent cannot do what is suboptimal -it goes against every inch of its existence".

Nevertheless, bashing for micro-foundations of an observed regularity (and it is a prevailing observed regularity across time, space, cultures and economic systems that firms don't changes their prices continually), is a good thing, in that it keeps up the pressure to finally find those microfoundations.
I just hope the bashers don't argue in addition, that in the meantime, we should only be modelling people as walking also on air -sorry, be modelling firms only as being able to change their prices continually.

And to send the ball back, I have never seen in my life any convincing "micro-foundation argument" for the assumption that prices are perfectly elastic.

Alecos Papadopoulos
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  • As someone whose macro knowledge is lacking I am interested in this question and was very happy to see that it finally received an answer. Unfortunatelly after reading the answer I am none the wiser. This may easily be because I don't even know the fundamental issues. Another possible reason is that the answer is very heavy on irony and strawmen arguments and any real reasoning is lost in between. – Giskard Dec 05 '15 at 20:53
  • @denesp I don't see any irony here. The issue is epistemological: should we incorporate in our models things we observe, can describe but don't understand adequately why they happen, or we should not? – Alecos Papadopoulos Dec 05 '15 at 22:11
  • Really? You find no trace of irony (or is it sarcasm? I am always unsure) in your answer? I guess I am reading in it wrong. – Giskard Dec 05 '15 at 23:36
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    @denesp I can understand why it can pass as sarcasm or irony, but the issue remains. In a humorous tone, the French, to express the high level of abstract and theoretical thinking in their top Universities, have a saying, something like "this looks pretty good in practice, but it will never work in theory". This is exactly the kind of criticism against "Calvo's pricing" that FooBar mentioned. Calvo's pricing expresses an undeniable widespread regularity but it is lacking in its theoretical foundation. Should we then banish it from our theoretical models? – Alecos Papadopoulos Dec 06 '15 at 00:33