MACROECONOMICS - BASICS

 

Economics Summary

 Economics is concerned with the optimal distribution of scarce resources within society. For example, economics is concerned with how individual decisions like how firms produce goods and which goods people buy. An important element in economics is concerned with the extent to which governments can intervene in the economy to improve economic welfare. Economics is also concerned with wider issues such as economic growth and unemployment – issues that affect the whole of society.

The most basic model in economics concerns how the price and quantity of goods and services is determined. If there was a shortage of a good – queues of people forming, then there is an incentive for firms to increase price. This increase in price reduces demand and encourages supply. Prices change until markets reach equilibrium.  Adam Smith referred to the ‘invisible hand’ of the market for explaining how prices adjust.

If demand for a good rose, we observe that this usually leads to a higher price. This higher price, in turn, encourages firms to supply more. This simple model helps explain a whole variety of different issues and topics. For example, we can use supply and demand to explain wage differentials. A lawyer can command a high wage because the number of qualified lawyers is very low. Cleaners tend to get lower wages because there are many more people with necessary qualifications.

Behaviour

Economics is concerned with decisions that agents (firms and consumers) make. For example, classical economics generally assumes that people wish to maximise their well-being; i.e. we assume firms wish to maximise profits and consumers wish to maximise their utility (happiness)

However, the real world is more complicated. Not all firms wish to maximise profits; they may seek to maximise market share or pursue other social/environmental objectives. Also, people may not be rational but get caught up in irrational booms and busts (e.g. stock market booms, housing  booms, dot com bubbles). Therefore there is a branch of economics known as behavioural economics. In recent years, this branch of economics has increased (Richard Thaler was awarded the Nobel Prize in Economics (2017) for his work on behavioural economics, which included work on

Dual-system theory – the idea we have two decision making elements. One is impulsive, the other is more rational, cognitive and analytical. Similar to ‘hot-cold’ states.

Mental accounting – how individuals separate their budget into different accounts, limiting spending on particular aspects of expenditure.

Prospect theory – the idea we suffer comparatively more from losses than gains. It also places emphasis on a relative starting point. We judge utility from our loss/gain – rather than our finishing point.

Macro Economics

Macroeconomics is a term relating to nationwide economic problems. For example, the rate of inflation in a country measures the average increase in prices. Higher inflation affects both savers and borrowers and can influence living standards. Economic growth is another key factor that can determine living standards. Higher economic growth can lead to improved living standards and lower rates of unemployment. A recession (negative economic growth) can lead to the opposite. Macroeconomics

Government Intervention in the Economy

A continual debate in economics is the extent to which governments intervene in the economy. On the one hand, free-market economists argue government intervention should be very limited (e.g. the protection of private property, national defence). The argument of free market economics is that governments tend to be inefficient, they don’t have the same incentives to produce what people want and need. If you leave it to markets, the ‘invisible hand’ automatically responds to changes in demand to provide goods that people want.

On the other hand, other economists argue that the free market actually creates many problems. In a free market, we may have monopolies, inequality, under-provision of important public services. Therefore to improve economic welfare, there is a necessity for governments to raise tax and spend on public goods not provided by the free market. Markets vs Government Intervention

Goods with positive externalities (e.g. trains which reduce pollution and congestion) may be under-consumed in a free market. A government can raise taxes and subsidise these positive externalities.

A big issue is to what extent should a government intervene in the economy?

What is the goal of economics?

Classical economic theory assumes the goal of economics is to maximise utility (satisfaction of material wants). This emerged from the philosophy of utilitarianism. It is an assumption firms seek to maximise profits and consumers seek to maximise consumption.

Rational economic man

However, in recent years, more economists have challenged whether economic welfare is the same as maximising production and consumption. For example, with a diminishing marginal utility of wealth, we may get more happiness from increasing leisure time and looking after the environment

DIminishing returns to wealth/income

Happiness economics looks at ways to increase happiness – rather than net welfare.

Economic Systems

To some extent, all major economies have converged on a similar model which may be termed a ‘mixed economy’. This is a combination of free markets (no government intervention) and state provision of goods. The old Soviet Union pursued a ‘command economy’ Communist, where the government decided what to produce, how to produce and for whom.

The opposite to a Command economy is a pure free market, where there is no government intervention. Within the two are mixed economies. The extent of government intervention in an economy varies significantly from 17% of GDP (Hong Kong) to over 50% in Scandinavian countries like Norway and Sweden.

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Difference between microeconomics and macroeconomics

 

• Microeconomics is the study of particular markets, and segments of the economy. It looks at issues such as consumer behaviour, individual labour markets, and the theory of firms.
• Macro economics is the study of the whole economy. It looks at ‘aggregate’ variables, such as aggregate demand, national output and inflation.

Micro economics involves

• Supply and demand in individual markets.
• Individual consumer behaviour. e.g. Consumer choice theory
• Individual labour markets – e.g. demand for labour, wage determination.
• Externalities arising from production and consumption. e.g. Externalities

Macro economics involves

• Monetary / fiscal policy. e.g. what effect does interest rates have on the whole economy?
• Reasons for inflation and unemployment.
• Economic growth
• International trade and globalisation
• Reasons for differences in living standards and economic growth between countries.
• Government borrowing

Moving from micro to macro

If we look at a simple supply and demand diagram for motor cars. Microeconomics is concerned with issues such as the impact of an increase in demand for cars.

This micro economic analysis shows that the increased demand leads to higher price and higher quantity.

Macro economic analysis

This looks at all goods and services produced in the economy.

• The macro diagram is looking at real GDP (which is the total amount of output produced in the economy) instead of quantity.
• Instead of the price of a good, we are looking at the overall price level (PL) for the economy. Inflation measures the annual % change in the aggregate price level.
• Instead of just looking at individual demand for cars, we are looking at aggregate demand (AD) – total demand in the economy.
• Macro diagrams are based on the same principles as micro diagrams; we just look at Real GDP rather than quantity and Inflation rather than Price Level (PL)

The main differences between micro and macro economics

1. Small segment of economy vs whole aggregate economy.
2. Microeconomics works on the principle that markets soon create equilibrium. In macro economics, the economy may be in a state of disequilibrium (boom or recession) for a longer period.
3. There is little debate about the basic principles of micro-economics. Macro economics is more contentious. There are different schools of macro economics offering different explanations (e.g. Keynesian, Monetarist, Austrian, Real Business cycle e.t.c).
4. Macro economics places greater emphasis on empirical data and trying to explain it. Micro economics tends to work from theory first – though this is not always the case.

Differences between microeconomics and macroeconomics

The main difference is that micro looks at small segments and macro looks at the whole economy. But, there are other differences.

Equilibrium – Disequilibrium

Classical economic analysis assumes that markets return to equilibrium (S=D). If demand increases faster than supply, this causes price to rise, and firms respond by increasing supply. For a long time, it was assumed that the macro economy behaved in the same way as micro economic analysis. Before, the 1930s, there wasn’t really a separate branch of economics called macroeconomics.

Great Depression and birth of Macroeconomics

In the 1930s, economies were clearly not in equilibrium. There was high unemployment, output was below capacity, and there was a state of disequilibrium. Classical economics didn’t really have an explanation for this dis-equilibrium, which from a micro perspective, shouldn’t occur.

In 1936, J.M.Keynes produced his The General Theory of Employment, Interest and Money; this examined why the depression was lasting so long. It examined why we can be in a state of disequilibrium in the macro economy. Keynes observed that we could have a negative output gap (disequilibrium in the macro-economy) for a prolonged time. In other words, microeconomic principles of markets clearing, didn’t necessarily apply to macro economics. Keynes wasn’t the only economist to investigate this new branch of economics. For example, Irving Fisher examined the role of debt deflation in explaining the great depression. But, Keynes’ theory was the most wide-ranging explanation and played a large role in creating the new branch of macro-economics.

Since 1936, macroeconomics developed as a separate strand within economics. There have been competing explanations for issues such as inflation, recessions and economic growth.

Similarities between microeconomics and macroeconomics

Although it is convenient to split up economics into two branches – microeconomics and macroeconomics, it is to some extent an artificial divide.

1. Micro principles are used in macroeconomics. If you study the impact of devaluation, you are likely to use same economic principles, such as the elasticity of demand to changes in price.
2. Micro effects macroeconomics and vice versa. If we see a rise in oil prices, this will have a significant impact on cost-push inflation. If technology reduces costs, this enables faster economic growth.
3. Blurring of distinction. If house prices rise, this is a micro economic effect for the housing market. But, the housing market is so influential that it could also be considered a macro-economic variable, and will influence monetary policy.
4. There have been efforts to use computer models of household behaviour to predict the impact on the macro economy.

by Tejvan Pettinger

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Micro and Macro: The Economic Divide

FINANCE & DEVELOPMENT

G. Chris Rodrigo

Economics is split between analysis of how the overall economy works and how single markets function

A question of scale (photo: Zack Seckler/Corbis)

Physicists look at the big world of planets, stars, galaxies, and gravity. But they also study the minute world of atoms and the tiny particles that comprise those atoms.

Economists also look at two realms. There is big-picture macroeconomics, which is concerned with how the overall economy works. It studies such things as employment, gross domestic product, and inflation—the stuff of news stories and government policy debates. Little-picture microeconomics is concerned with how supply and demand interact in individual markets for goods and services.

In macroeconomics, the subject is typically a nation—how all markets interact to generate big phenomena that economists call aggregate variables. In the realm of microeconomics, the object of analysis is a single market—for example, whether price rises in the automobile or oil industries are driven by supply or demand changes. The government is a major object of analysis in macroeconomics—for example, studying the role it plays in contributing to overall economic growth or fighting inflation. Macroeconomics often extends to the international sphere because domestic markets are linked to foreign markets through trade, investment, and capital flows. But microeconomics can have an international component as well. Single markets often are not confined to single countries; the global market for petroleum is an obvious example.

The macro/micro split is institutionalized in economics, from beginning courses in “principles of economics” through to postgraduate studies. Economists commonly consider themselves microeconomists or macroeconomists. The American Economic Association recently introduced several new academic journals. One is called Microeconomics. Another, appropriately, is titled Macroeconomics.

Why the divide?

It was not always this way. In fact, from the late 18th century until the Great Depression of the 1930s, economics was economics—the study of how human societies organize the production, distribution, and consumption of goods and services. The field began with the observations of the earliest economists, such as Adam Smith, the Scottish philosopher popularly credited with being the father of economics—although scholars were making economic observations long before Smith authored The Wealth of Nations in 1776. Smith’s notion of an invisible hand that guides someone seeking to maximize his or her own well-being to provide the best overall result for society as a whole is one of the most compelling notions in the social sciences. Smith and other early economic thinkers such as David Hume gave birth to the field at the onset of the Industrial Revolution.

Economic theory developed considerably between the appearance of Smith’s The Wealth of Nations and the Great Depression, but there was no separation into microeconomics and macroeconomics. Economists implicitly assumed that either markets were in equilibrium—such that prices would adjust to equalize supply and demand—or that in the event of a transient shock, such as a financial crisis or a famine, markets would quickly return to equilibrium. In other words, economists believed that the study of individual markets would adequately explain the behavior of what we now call aggregate variables, such as unemployment and output.

The severe and prolonged global collapse in economic activity that occurred during the Great Depression changed that. It was not that economists were unaware that aggregate variables could be unstable. They studied business cycles—as economies regularly changed from a condition of rising output and employment to reduced or falling growth and rising unemployment, frequently punctuated by severe changes or economic crises. Economists also studied money and its role in the economy. But the economics of the time could not explain the Great Depression. Economists operating within the classical paradigm of markets always being in equilibrium had no plausible explanation for the extreme “market failure” of the 1930s.

If Adam Smith is the father of economics, John Maynard Keynes is the founding father of macroeconomics. Although some of the notions of modern macroeconomics are rooted in the work of scholars such as Irving Fisher and Knut Wicksell in the late 19th and early 20th centuries, macroeconomics as a distinct discipline began with Keynes’s masterpiece, The General Theory of Employment, Interest and Money, in 1936. Its main concern is the instability of aggregate variables. Whereas early economics concentrated on equilibrium in individual markets, Keynes introduced the simultaneous consideration of equilibrium in three interrelated sets of markets—for goods, labor, and finance. He also introduced “disequilibrium economics,” which is the explicit study of departures from general equilibrium. His approach was taken up by other leading economists and developed rapidly into what is now known as macroeconomics.

Coexistence and complementarity

Microeconomics is based on models of consumers or firms (which economists call agents) that make decisions about what to buy, sell, or produce—with the assumption that those decisions result in perfect market clearing (demand equals supply) and other ideal conditions. Macroeconomics, on the other hand, began from observed divergences from what would have been anticipated results under the classical tradition.

Today the two fields coexist and complement each other.

Microeconomics, in its examination of the behavior of individual consumers and firms, is divided into consumer demand theory, production theory (also called the theory of the firm), and related topics such as the nature of market competition, economic welfare, the role of imperfect information in economic outcomes, and at the most abstract, general equilibrium, which deals simultaneously with many markets. Much economic analysis is microeconomic in nature. It concerns such issues as the effects of minimum wages, taxes, price supports, or monopoly on individual markets and is filled with concepts that are recognizable in the real world. It has applications in trade, industrial organization and market structure, labor economics, public finance, and welfare economics. Microeconomic analysis offers insights into such disparate efforts as making business decisions or formulating public policies.

Macroeconomics is more abstruse. It describes relationships among aggregates so big as to be hard to apprehend—such as national income, savings, and the overall price level. The field is conventionally divided into the study of national economic growth in the long run, the analysis of short-run departures from equilibrium, and the formulation of policies to stabilize the national economy—that is, to minimize fluctuations in growth and prices. Those policies can include spending and taxing actions by the government or monetary policy actions by the central bank.

Bridging the micro/macro divide

Like physical scientists, economists develop theory to organize and simplify knowledge about a field and to develop a conceptual framework for adding new knowledge. Science begins with the accretion of informal insights, particularly with observed regular relationships between variables that are so stable they can be codified into “laws.” Theory is developed by pinning down those invariant relationships through both experimentation and formal logical deductions—called models.

Since the Keynesian revolution, the economics profession has had essentially two theoretical systems, one to explain the small picture, the other to explain the big picture (micro and macro are the Greek words, respectively, for “small” and “big”). Following the approach of physics, for the past quarter century or so, a number of economists have made sustained efforts to merge microeconomics and macroeconomics. They have tried to develop microeconomic foundations for macroeconomic models on the grounds that valid economic analysis must begin with the behavior of the elements of microeconomic analysis: individual households and firms that seek to optimize their conditions.

There have also been attempts to use very fast computers to simulate the behavior of economic aggregates by summing the behavior of large numbers of households and firms. It is too early to say anything about the likely outcome of this effort. But within the field of macroeconomics there is continuing progress in improving models, whose deficiencies were exposed by the instabilities that occurred in world markets during the global financial crisis that began in 2008.

How they differ

Contemporary microeconomic theory evolved steadily without fanfare from the earliest theories of how prices are determined. Macroeconomics, on the other hand, is rooted in empirical observations that existing theory could not explain. How to interpret those anomalies has always been controversial. There are no competing schools of thought in microeconomics—which is unified and has a common core among all economists. The same cannot be said of macroeconomics—where there are, and have been, competing schools of thought about how to explain the behavior of economic aggregates. Those schools go by such names as New Keynesian or New Classical. But these divisions have been narrowing over the past few decades (Blanchard, Dell’Ariccia, and Mauro, 2010).

Microeconomics and macroeconomics are not the only distinct subfields in economics. Econometrics, which seeks to apply statistical and mathematical methods to economic analysis, is widely considered the third core area of economics. Without the major advances in econometrics made over the past century or so, much of the sophisticated analysis achieved in microeconomics and macroeconomics would not have been possible.

Reference

Blanchard, Olivier, Giovanni Dell’Ariccia, and Paolo Mauro, 2010, “Rethinking Macroeconomic Policy,” IMF Staff Position Note 10/03 (Washington: International Monetary Fund).

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