Microfoundation is the grounding of an aggregate economic claim in the optimising behaviour of individual agents — households, firms, wage-setters. In macro policy, it is the underlying mechanism that lets a central bank argue an observed outcome reflects durable structural change rather than a transient statistical artefact.
How it works
A microfounded argument derives macro outcomes from explicit decision rules of agents — utility-maximising households, profit-maximising firms, forward-looking price- and wage-setters — rather than asserting an aggregate relationship by fiat. A central bank claiming inflation is "self-sustaining" needs a microfoundation: evidence that wage- and price-setting behaviour has actually shifted, so the result holds beyond the current cycle.
Why it matters now
In 2025-2026 the Bank of Japan must show its 2% target is becoming self-sustaining via a wage-price microfoundation — durable shunto wage gains feeding services inflation — not just imported cost-push. The microfoundation is what distinguishes a regime change from a temporary overshoot, and conditions the pace of normalisation.
Example
For the Bank of Japan, the microfoundation of "self-sustaining 2% inflation" is the spring shunto wage round: 2024 delivered roughly 5.1% headline negotiated wage growth and 2025 a similar print, the strongest in three decades. The BoJ's claim rests on firms passing labour costs into services prices and workers expecting continued raises — a behavioural mechanism, not just a CPI number, justifying its exit from negative rates in March 2024.
Frequently asked
- What is a microfoundation in economics?
- A microfoundation is the grounding of an aggregate macroeconomic relationship in the optimising behaviour of individual agents — households, firms, and wage-setters. Rather than asserting that, say, inflation persists, a microfounded argument derives that persistence from explicit decision rules, such as forward-looking
Glossary · ex ante
Ex ante means "before the event" — an assessment, expectation, or probability formed in advance, using only information available at the time, before outcomes are realized. It contrasts with ex post, which evaluates the same quantity after the fact, with hindsight and realized data.
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- Why do microfoundations matter for central bank credibility?
- Microfoundations matter because they let a central bank argue an outcome is structural rather than transient. A bank claiming inflation is self-sustaining must point to changed behaviour — firms routinely passing costs through, workers expecting raises — not just a string of high CPI prints. Without a behavioural mechanism, the claim is statistical extrapolation and the regime shift unproven.
- Why does the Bank of Japan need a microfoundation for its 2% target?
- The Bank of Japan needs a wage-price microfoundation to argue its 2% inflation target is becoming self-sustaining rather than imported cost-push. The mechanism is the shunto spring wage round feeding into services inflation: 2024 and 2025 each delivered roughly 5% negotiated wage growth. This behavioural channel, not the headline number, justifies normalising policy after decades of deflation.
- How does a microfoundation differ from a DSGE model?
- A microfoundation is the principle that aggregate relationships should derive from individual optimisation; a DSGE model
Glossary · DSGE model
A Dynamic Stochastic General Equilibrium model is a macroeconomic forecasting framework built from optimizing households and firms, nominal rigidities, and stochastic shocks, estimated to project output, inflation, and policy rates — and the probabilities of outcomes like recession — under internally consistent equilibrium dynamics.
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- Did the Lucas critique drive the shift to microfoundations?
- The Lucas critique, published by Robert Lucas in 1976, drove the shift to microfoundations in macroeconomics. It argued that aggregate relationships estimated from historical data break down when policy changes, because agents' expectations and behaviour adjust. Only models grounded in stable structural parameters — preferences and technology — survive policy shifts, making microfoundations the methodological standard thereafter.