Microfoundations of macroeconomic fluctuations and the laws of probability theory: the principle of large numbers versus rational expectations arbitrage

The principle of large numbers shows that the relative deviation for a macro system with N independent elements is of the order of 1/rootN. Lucas' approach to a microfoundations for macroeconomic fluctuations is thus not capable of explaining the magnitude of observed macroeconomic fluctuations. Arbitrage activity would largely eliminate correlations created by rational expectations among economic agents when they face counter movements in relative prices. The complex nature of many-body problems and the statistical feature of aggregate indexes cannot be ignored in a micro-macro modeling. Intermediate structures, such as financial markets and industrial organizations, are more important than households and firms in generating business cycles. (C) 2002 Elsevier Science B.V. All rights reserved.