Here we reply to Robert Solow’s comment (forthcoming) on our work (Chari and Kehoe (2007)).Macroeconomics

Patrick J. Kehoe

V. V. Chari

English

Research Papers in Economics

Federal Reserve Bank of Minneapolis
Research Department
Reply to Solow∗
V .V .C h a r ia n dP a t r i c kJ .K e h o e
Working Paper 654
September 2007
ABSTRACT
Here we reply to Robert Solow’s comment (forthcoming) on our work (Chari and Kehoe (2007)).
∗Chari, University of Minnesota and Federal Reserve Bank of Minneapolis; Kehoe, Federal Reserve Bank of Minneapolis
and University of Minnesota. The views expressed herein are those of the authors and not necessarily those of the
Federal Reserve Bank of Minneapolis or the Federal Reserve System.We welcome this opportunity to respond to Robert Solow, whose seminal contributions set the
stage for how we now construct models and how we conduct quantitative analyses. In writing down
a one-sector production function in his growth model, he sacriﬁced realism for an abstraction that
has proved invaluable. In this growth accounting, he showed us how we should use this abstraction
to provide a quantitative answer to an important economic question.
In his comment, Solow eloquently voices the commonly heard complaint that too much of
modern macroeconomics starts with a model with a single type of agent. In our response we clarify
that modern macroeconomics does not end there–and may in fact not end too far from where Solow
prefers.
Solow also argues that improvements can be made in how macroeconomists use data to
discipline their models and, in that context, approvingly cites the work of Hansen and Heckman
(1996). We agree with much of the constructive research program that Hansen and Heckman oﬀer
and elaborate on this agreement below.
Finally, Solow wonders why bright young economists are attracted to modern macroeco-
nomics. We present one answer below.
The Trade-Oﬀ between Transparency and Detail in Model Building
Professor Solow’s comments beautifully illustrate a struggle that academic macroeconomists
engage in every day. On the one hand Solow says, “My general preference is for small, transparent,
tailored models, often partial equilibrium, usually aimed at understanding some little piece of the
(macro-) economic mechanism.” On the other hand he also says that
a modern economy is populated by consumers, workers, pensioners, owners, managers,
investors, entrepreneurs, bankers and others, with diﬀerent and sometimes conﬂicting
desires, information, expectations, capacities, beliefs and rules of behavior. Their inter-
actions in markets and elsewhere are studied in other branches of economics; mechanisms
based on those interactions have been plausibly implicated in macroeconomic ﬂuctua-
tions. To ignore all this in principle does not seem to qualify as mere abstraction–that
is setting aside inessential details. It seems more like the arbitrary suppression of clues
merely because they are inconvenient for cherished preconceptions.
Clearly, it is impossible to have a small model that incorporates all the richness that Solow
sees in a modern economy.
From our perspective, models are designed to answer speciﬁc questions. Understanding the
answers from the model requires understanding the economic mechanism–which is easier to do when
the model is a simple one. In this sense, we entirely share Solow’s preference for small, transparent,
tailored models, although the kind of macroeconomic questions we ask typically require general
equilibrium models.Solow seems to think that, in principle, modern macroeconomics ignores all the rich detail that
he sees in the modern economy. In this belief, we think he is wrong. Most of modern macroeconomics
is about examining mechanisms based on the kinds of interactions that Solow seems to have in mind.
For example, Ríos-Rull (1996) develops a life-cycle model with consumers, workers, and pensioners
and uses it to ask questions about the quantitative sources of business cycle ﬂuctuations. Krusell
and Smith (1998) develop an incomplete markets model with heterogeneous consumers possessing
conﬂicting desires and use it to ask questions about business cycle ﬂuctuations. Rogerson and
Wallenius (2007) use a life cycle in which agents have diﬀerent capacities for supplying labor and
use it to ask questions about tax rates and average employment rates across countries. Bernanke,
Gertler, and Gilchrist (1999) and Cooley, Marimon, and Quadrini (2004) develop models with
investors, entrepreneurs, and bankers who have conﬂicting desires and use these models to study
t h er o l eo fﬁnancial constraints over the business cycle.
Solow’s principal complaint seems to be that the style in modern macroeconomics is to start
w i t ham o d e lw i t has i n g l et y p eo fa g e n ta n dt h e ne n r i c hi tw i t he n o u g hn e c e s s a r yd e t a i lt oa n s w e r
the question at hand. Instead, he seems to prefer starting with a model with eight types of agents
and then trimming the unnecessary details to end up with the small model he prefers. Does it really
matter whether we start with a single type of agent and then boost it to three types to answer the
question at hand, or that he starts with eight types of agents and then reduces the number to three
to answer the same question? Analogies about school colors and carrots aside, there does not seem
to be much of substance here to argue about.
Implications of the Sonnenschein-Mantel-Debreu Result
The Sonnenschein-Mantel-Debreu result implies that if we have only aggregate data, theory
imposes little discipline on the modeling of aggregates. Some may despair at this lack of discipline.
Fortunately (the Sonnenschein-Mantel-Debreu result notwithstanding), if we have micro data on
how individual households and ﬁrms behave, then theory imposes many restrictions on the behav-
ior of aggregates. The whole point of modern macroeconomics is to build models at the level of
individual households and ﬁrms, disciplined by microeconomic evidence, and use these models to
answer aggregate questions.
This disciplining method is still a work in progress. Professor Solow approvingly cites Hansen
and Heckman (1996), who suggest ways to improve the process of using microeconomic evidence in
building macroeconomic models. Interestingly, Hansen and Heckman argue that for this process to
succeed, microeconomists need to change the way they do business. Indeed, Hansen and Heckman
(1996, p. 100) write,
A more productive research program would provide clearly formulated theories that will
stimulate more focused microeconomic empirical research. Much recent micro research
2is atheoretical in character and does not link up well with macro general equilibrium
t h e o r y ....A r e d i r e c t i o n o f m i c r o e m p i r i c a l w o r k t o w a r d p r o v i d i n g i n p u t i n t o w e l l -
deﬁned general equilibrium models would move discussions of micro evidence beyond
discussions of whether wage or price eﬀects exist, to the intellectually more important
questions of what the micro estimates mean and how they can be used to illuminate
well-posed economic questions.
We wholeheartedly agree, and we look forward to seeing this new strain of microeconomic
empirical research.
Winning Young Minds with Economic Theory
Solow wonders why bright young economists are attracted to modern macroeconomics. We
think it is for the same reason that, along with many other contributions, Robert Solow developed
the growth model, James Tobin developed portfolio theory, and Paul Samuelson developed the
overlapping generations model. These economists were, like the generations that followed, attracted
to using what was then the frontier of economic theory to shed light on macroeconomic questions.
References
Bernanke, Ben S., Mark Gertler, and Simon Gilchrist (1999), “The Financial Accelerator in
a Quantitative Business Cycle Framework,” in Handbook of Macroeconomics, Vol. 1C, ed. John B.
Taylor and Michael Woodford (Amsterdam: North-Holland).
Chari, V. V., and Patrick J. Kehoe (2006), “Modern Macroeconomics in Practice: How
Theory is Shaping Policy,” Journal of Economic Perspectives 20 (4) (Fall): 3—28.
Cooley, Thomas, Ramon Marimon, and Vincenzo Quadrini (2004), “Aggregate Consequences
of Limited Contract Enforceability,” Journal of Political Economy 112 (August): 817—47.
Hansen, Lars Peter, and James J. Heckman (1996), “The Empirical Foundations of Calibra-
tion,” Journal of Economic Perspectives 10 (Winter): 87—104.
Krusell, Per, and Anthony A. Smith, Jr. (1998), “Income and Wealth Heterogeneity in the
Macroeconomy,” Journal of Political Economy 106 (October): 867—96.
Ríos-Rull, José-Víctor (1996), “Life-Cycle Economies and Aggregate Fluctuations,” Review
of Economic Studies 63 (July): 465—89.
Rogerson, Richard, and Johanna Wallenius (2007), “Micro and Macro Elasticities in a Life
Cycle Model With Taxes.”
Solow, Robert (forthcoming), “The State of Macroeconomics,” Journal of Economic Perspec-
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3

Life-Cycle Economies and Aggregate Fluctuations,”

Micro and Macro Elasticities in a Life Cycle Model With Taxes.” Solow, Robert (forthcoming),

Modern Macroeconomics in Practice: How Theory is Shaping Policy,”

The Financial Accelerator in a Quantitative Business Cycle Framework,”

Reply to Solow

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