Economics studies how individuals, businesses and government make choices in face of scarcity. Microeconomics focuses on small-scale economic activity, whereas macroeconomics examines the entire economy. In this post, we’ll look at what macroeconomics is, how it differs from microeconomics, and why it’s important for understanding the world we live in.
By the end of this post, you will learn:
- What macroeconomics is
- The differences and interactions between micro and macroeconomics
- Why macroeconomics is studied as a separate discipline
- Its scope, importance, and limitations
Ragnar Frisch coined the terms microeconomics and macroeconomics in 1933. The term ‘micro’ is derived from the Greek word ‘Mikros,’ meaning ‘small’ or ‘individual.’ The term ‘macro’ is also derived from the Greek word ‘Makros,’ meaning ‘large’ or ‘aggregate’.
Microeconomics vs Macroeconomics
Microeconomics deals with the behavior of small individual units of an economy such as individual consumers, individual firms, individual industries and markets. It explains how products prices and factors prices are determined and explains how resources are allocated among various products and how income distribution among factors is determined.
Macroeconomics on the other hand deals with the behavior and performance of the economy as a whole. It studies aggregate economic activities such as aggregate output, aggregate demand, national income, aggregate price level, employment level, savings, investment, international trade, business cycles etc.
According to Kenneth E. Boulding “Microeconomics is the study of particular firms, particular households, individual prices, wages, incomes, individual industries, particular commodities.” While “Macroeconomics deals not with individual quantities but with aggregates of these quantities; not with individual incomes but with national income; not with individual prices but with price levels; not with individual outputs but with the national output.”
The subject matter of microeconomics is to explain how product prices and factor prices are determined and how the resources are allocated efficiently based on these prices. Therefore, it is also called Price Theory. The subject matter of macroeconomic is to explain how the level of national income and employment are determined, and what causes fluctuations in the level of national income, output and employment. Therefore, it is also called Income Theory.
Interaction b/w Microeconomics & Macroeconomics
Micro and macroeconomics are interdependent. Micro eventually, generates macro. The total output and employment in the economy depends on the production and employment of all individual firms. If many of the individual firms cut down production and reduce hiring labor the entire economy experiences higher unemployment and slower growth.
Similarly, the aggregate consumption function depends on the behaviour of consumption of all individual consumers. If individual consumers reduce their spending, it leads to fall in aggregate demand which slows down production, reduces output, and increases unemployment. Thus, we see that micro behavior shapes macroeconomic performance.
On the other side, macroeconomic policies influence microeconomic behavior. For example, if the central bank increases interest rates to control inflation, borrowing becomes expensive. This macro decision directly affects micro behavior: households reduce borrowing for cars or homes, and firms postpone investment in new projects. As a result, economic activity slows down.
A clear example of this two-way relationship is found in the housing market. At the micro level, households decide to buy homes based on personal income and interest rates. If interest rates fall, many families take home loans, increasing demand for houses. This increased demand stimulates construction, generates jobs, and raises national income which is a macroeconomic outcome produced by micro decisions.
Why Macroeconomics a separate discipline
Fallacy of composition is an incorrect belief that what is true for the individual, or part, must necessarily be true for the group or whole. For example, at micro level if an individual firm decreases its price, then he can raise his sales but at macro level if all firms in the economy do the same i.e. decrease their prices, this will create deflation in the whole economy. The producers will be discouraged and reduce investment which decrease national income. So, what is true for individual firm is not true for all firms as a whole.
Wage-Employment Paradox: Similarly, at micro level if an individual firm decreases its money wages, then it can employ more labor, at macro level if all firms do the same and reduces money wages it will reduce purchasing power of all laborers which decreases the aggregate demand for goods and services which remain unsold. This lowers the demand for labor which lead to increase unemployment.
Paradox of Thrift: At micro level every individual think to save money at present to enjoy better living standard in the future or save for old age or for their children. But at macro level if all individuals start saving today, the demand for goods and services goes down which lead to over-production or unsold goods and services which lead to deflation and unemployment.
If an individual firm installs a chemical plant in a populus area then it can increase firm profit and employ labor, but at, macro level if all firms do the same then it led to large scale pollution. Thus, what is good for individual it may not be good for the whole.
Scope of Macroeconomics
The scope of macroeconomics refers to the areas covered by it. These areas include various theories such as:
Theory of National Income
Macroeconomics is concerned with the various concepts of national income, methods to measure national income, difficulties in measuring the national income and its different components.
Theory of Income and Employment
This part of macroeconomics studies equilibrium level of national income with the help of AD/AS model and IS/LM model, determination of employment level, causes and effects of unemployment. Two major theories in this regard are Classical and the Keynesian theory of income and employment.
Theory of Business Cycles
In macroeconomics we study the causes and theories of business cycles which are short run fluctuation in economic activities. The major theories in this regard are Keynesian theory, Hicks theory, Schumpeter theory, Samuelson`s theory.
Theory of Consumption and Investment
A major part of the economy’s output is spent on consumption. In macroeconomics we study major theories of consumption such as Keynesian theory of consumption, Friedman Permanent Income hypothesis, Dusenbery Relative Income hypothesis and Modigliani Life Cycle hypothesis. Investment is the most volatile component of AD, we study the relationship and interest rate and investment, determinants of investment.
Theory of Money and Banking
Macroeconomics studies the effect of money supply on economy, determination of interest rate, the relationship between money supply and price level like quantity theory of money, causes and effects of inflation, determinants of money demand, relationship between inflation and unemployment, the role and functions of banks in the economy.
Theory of Economic Stabilization
Inflation, unemployment, unequal income distribution, misallocation of resources, deficit in BOP and budget deficit are regarded as major macroeconomic problems in this regard the role monetary and fiscal policy is examined to stabilize the economy.
Theory of Economic Growth
Economic growth and development are major concerns of all economies whether developed or underdeveloped. In macroeconomics we study the major growth models such as Harrod-Domar model, Solow growth model, Kaldor model and many more to study the growth path of the economy.
Theory of International Trade
We study the causes and theories of international trade, determination of exchange rate, causes and effects of deficit of balance of payments and balance of trade etc. Important theories in this regard are: Absolute advantage, Comparative advantage, Hecksher-Ohlin model etc.
Importance of Macroeconomics
- Working of an Economy: Macroeconomics helps us understand how an economy functions at the national and global level. It explains the behavior of total output, total income, total employment, and the general price level and their interrelationships.
- Performance of an Economy: Macroeconomics helps us to understand and analyse the performance of an economy. GNP and National Income (NI) estimates are used to measure the performance of an economy over time and across countries.
- Formulation of Economic Policies: Macroeconomics acts as a guide for governments and central banks in economic policy-making such as fiscal policy and monetary policy to control inflation, reducing unemployment, removing deficits, stabilizing economy and promoting economic growth.
- Economic Stability and Business Cycle Analysis: Macroeconomics helps identify the causes of economic fluctuations such as booms, recessions, and depressions. By understanding business cycles, governments can take preventive measures to control economic instability.
- Forecast Macro Events: Policymakers and economists use macroeconomic models to forecast the impact of fiscal or monetary policy changes, predict economic cycles, and assess the potential effects of external shocks.
- Helpful for Businesses and Investors: Businesses and investors use macroeconomic variables (like interest rates, inflation, GDP growth) to make strategic decisions. Knowledge of macroeconomics helps firms plan production, investment, pricing, and expansion.
Limitations of Macroeconomics
- Fallacy of composition: It means that what is true for an individual may not be true for the whole. For example, if an individual saves it is a virtue but if all people save it may lead to recession.
- Aggregates as homogeneous: Macroeconomics assumes that all individual units such as consumers and firms are homogenous. In reality, individuals and firms differ greatly.
- Aggregate variables may not be important necessarily: National income of a country is the sum of all individual incomes. A rise in national income does not mean that individual incomes have risen. National income can also rise as a result of increase in incomes of few rich people.
