Derivation of the Aggregate Model

Abstract

Microeconomic behavioral assumptions are usually converted into aggregate relationships by invoking the concept of the ‘representative’ firm. Although rather unsatisfactory, such side-stepping of the aggregation problem is often the only procedure that leads to tractable macro models. It is basically also the way we pursue here. However, the assumption that the aggregate economy consists of identical firms in the sense that the micro model of eqs. (1) to (4) can directly be transposed to the macro level (identifying y^d with aggregate demand, etc.) would have quite unrealistic implications: The model would produce discrete switches of regimes for the economy as a whole, i.e. imply that aggregate output and employment are either purely demand-determined or purely supply-determined. Considering the actual heterogeneity of goods and labor markets, it seems much more likely that situations of excess demand and excess supply coexist and that transitions between regimes are gradual. This view is endorsed for example by business survey data, which, on the one hand, convey the existence of an overall business cycle but, on the other hand, clearly show that this ‘common factor’ is superimposed in the cross section of firms by ‘firm-specific factors’. Sensible aggregate relationships should account for this micro level dispersion and exhibit a certain degree of ‘continuity’ or ‘smoothness’ in relation to the underlying discrete micro relationships.