It’s time to get rid of the ”representative agent” in monetary theory

“Tis vain to talk of adding quantities which after the addition will continue to be as distinct as they were before; one man’s happiness will never be another man’s happiness: a gain to one man is no gain to another: you might as well pretend to add 20 apples to 20 pears.”

Jeremy Bentham, 1789

I have often felt that modern-day Austrian economists are fighting yesterday’s battles. They often seem to think that mainstream economists think as if they were the “market socialists” of the 1920s and that the “socialist-calculation-debate” is still on-going. I feel like screaming “wake up people! We won. No economist endorses central planning anymore!”

However, I am wrong. The Austrians are right. Many economists still knowingly or out of ignorance today endorse some of the worst failures of early-day welfare theory. Economists have known since the time of Jeremy Bentham that one man’s happiness can not be compared to another man’s happiness. Interpersonal utility comparison is a fundamental no-no in welfare theory. We cannot and shall not compare one person’s utility with another man’s utility. But this is exactly what “modern” monetary theorists do all the time.

Take any New Keynesian model of the style made famous by theorists like Michael Woodford. In these models the central banks is assumed to be independent (and benevolent). The central banker sets interest rates to minimize the “loss function” of a “representative agent”. Based on this kind of rationalisation economists like Woodford find theoretical justification for Taylor rule style monetary policy functions.

Nobody seems to find this problematic and it is often argued that Woodford even has provided the microeconomic foundation for these loss functions. Pardon my French, but that is bullsh*t. Woodford assumes that there is a representative agent. What is that? Imagine we introduced this character in other areas of economic research? Most economists would find that highly problematic.

There is no such thing as a representative agent. Let me illustrate it. The economy is hit by a negative shock to nominal GDP. With Woodford’s representative agent all agents in the economy is hit in the same way and the loss (or gain) is the same for all agents in the economy. No surprise – all agents are assumed to be the same. As a result there is no conflict between the objectives of different agents (there is basically only one agent).

But what if there are two agents in the economy. One borrower and one saver. The borrower is borrowing from the other agent at a fixed nominal interest rate. If nominal GDP drops then that will effectively be a transfer of wealth from the borrower to the saver.

This might of course of course make the Calvinist ideologue happy, but what would the modern day welfare theorist say?

The modern welfare theorist would of course apply a Pareto criterion to the situation and argue that only a monetary policy rule that ensures Pareto efficiency is a good monetary policy rule: An allocation is Pareto efficient if there is no other feasible allocation that makes at least one party better off without making anyone worse off. Hence, if the nominal GDP drops and lead to a transfer of wealth from one agent to another then a monetary policy that allows this does not ensure Pareto efficiency and is hence not an optimal monetary policy.

David Eagle has shown in a number of papers that only one monetary policy rule can ensure Pareto efficiency and that is NGDP level targeting (See David’s guest posts here, here and here). All other policy rules, inflation targeting, Price level targeting and NGDP growth targeting are all Pareto inefficient. Price level targeting, however, also ensures Pareto efficiency if there are no supply shocks in the economy.

This result is significantly more important than any result of New Keynesian analysis of monetary policy rules with a representative agent. Analysis based on the assumption of the representative agent completely fails to tell us anything about the present economic situation and the appropriate response to the crisis. Just think whether a model with a “representative country” in the euro zone or one with Greece (borrower) and Germany (saver) make more sense.

It is time to finally acknowledge that Bentham’s words also apply to monetary policy rules and finally get rid of the representative agent.


For a much more insightful and clever discussion of this topic see David Eagle’s paper “Pareto Efficiency vs. the Ad Hoc Standard Monetary Objective – An Analysis of Inflation Targeting” from 2005.

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