The Nature of Macroeconomics

What makes macroeconomics different from microeconomics? The distinguishing feature of macroeconomics is that it focuses on the behavior of the economy as a whole.

Macroeconomic Questions

Table 10-1 lists some typical questions that involve economics. A microeconomic version of the question appears on the left paired with a similar macroeconomic question on the right. By comparing the questions, you can begin to get a sense of the difference between microeconomics and macroeconomics.

Microeconomic Questions Macroeconomic Questions
Should I go to business school or take a job right now? How many people are employed in the economy as a whole this year?
What determines the salary offered by Citibank to Cherie Camajo, a new MBA? What determines the overall salary levels paid to workers in a given year?
What determines the cost to a university or college of offering a new course? What determines the overall level of prices in the economy as a whole?
What government policies should be adopted to make it easier for low-income students to attend college? What government policies should be adopted to promote employment and growth in the economy as a whole?
What determines whether Citibank opens a new office in Shanghai? What determines the overall trade in goods, services, and financial assets between the United States and the rest of the world?
Table : TABLE 10-1 Microeconomic versus Macroeconomic Questions

As these questions illustrate, microeconomics focuses on how decisions are made by individuals and firms and the consequences of those decisions. For example, we use microeconomics to determine how much it would cost a university or college to offer a new course, which includes the instructor’s salary, the cost of class materials, and so on. The school can then decide whether or not to offer the course by weighing the costs and benefits. Macroeconomics, in contrast, examines the overall behavior of the economy—how the actions of all the individuals and firms in the economy interact to produce a particular economy-wide level of economic performance. For example, macroeconomics is concerned with the general level of prices in the economy and how high or how low it is relative to prices last year, rather than with the price of one particular good or service.

You might imagine that macroeconomic questions can be answered simply by adding up microeconomic answers. For example, the model of supply and demand we introduced in Chapter 3 tells us how the equilibrium price of an individual good or service is determined in a competitive market. So you might think that applying supply and demand analysis to every good and service in the economy, then summing the results, is the way to understand the overall level of prices in the economy as a whole.

But that turns out not to be right: although basic concepts such as supply and demand are as essential to macroeconomics as they are to microeconomics, answering macroeconomic questions requires an additional set of tools and an expanded frame of reference.

Macroeconomics: The Whole Is Greater Than the Sum of its Parts

If you occasionally drive on a highway, you probably know what a rubber-necking traffic jam is and why it is so annoying. Someone pulls over to the side of the road for something minor, such as changing a flat tire, and, pretty soon, a long traffic jam occurs as drivers slow down to take a look. What makes it so annoying is that the length of the traffic jam is greatly out of proportion to the minor event that precipitated it. Because some drivers hit their brakes in order to rubber-neck, the drivers behind them must also hit their brakes, those behind them must do the same, and so on. The accumulation of all the individual hitting of brakes eventually leads to a long, wasteful traffic jam as each driver slows down a little bit more than the driver in front of him or her. In other words, each person’s response leads to an amplified response by the next person.

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Understanding a rubber-necking traffic jam gives us some insight into one very important way in which macroeconomics is different from microeconomics: many thousands or millions of individual actions compound upon one another to produce an outcome that isn’t simply the sum of those individual actions.

The behavior of the macroeconomy is greater than the sum of individual actions and market outcomes.
Matthias Clamer/Getty Images

Consider, for example, what macroeconomists call the paradox of thrift: when families and businesses are worried about the possibility of economic hard times, they prepare by cutting their spending. This reduction in spending depresses the economy as consumers spend less and businesses react by laying off workers. As a result, families and businesses may end up worse off than if they hadn’t tried to act responsibly by cutting their spending. This is a paradox because seemingly virtuous behavior—preparing for hard times by saving more—ends up harming everyone. And there is a flip-side to this story: when families and businesses are feeling optimistic about the future, they spend more today. This stimulates the economy, leading businesses to hire more workers, which further expands the economy. Seemingly profligate behavior leads to good times for all.

Or consider what happens when something causes the quantity of cash circulating through the economy to rise. An individual with more cash on hand is richer. But if everyone has more cash, the long-run effect is simply to push the overall level of prices higher, taking the purchasing power of the total amount of cash in circulation right back to where it was before.

A key insight of macroeconomics, then, is that the combined effect of individual decisions can have results that are very different from what any one individual intended, results that are sometimes perverse. The behavior of the macroeconomy is, indeed, greater than the sum of individual actions and market outcomes.

Macroeconomics: Theory and Policy

To a much greater extent than microeconomists, macroeconomists are concerned with questions about policy, about what the government can do to make macroeconomic performance better. This policy focus was strongly shaped by history, in particular by the Great Depression of the 1930s.

In a self-regulating economy, problems such as unemployment are resolved without government intervention, through the working of the invisible hand.

Before the 1930s, economists tended to regard the economy as self-regulating: they believed that problems such as unemployment would be corrected through the working of the invisible hand and that government attempts to improve the economy’s performance would be ineffective at best—and would probably make things worse.

The Great Depression changed all that. The sheer scale of the catastrophe, which left a quarter of the U.S. workforce without jobs and threatened the political stability of many countries—the Depression is widely believed to have been a major factor in the Nazi takeover of Germany—created a demand for action. It also led to a major effort on the part of economists to understand economic slumps and find ways to prevent them.

According to Keynesian economics, economic slumps are caused by inadequate spending, and they can be mitigated by government intervention.

Monetary policy uses changes in the quantity of money to alter interest rates and affect overall spending.

Fiscal policy uses changes in government spending and taxes to affect overall spending.

In 1936 the British economist John Maynard Keynes (pronounced “canes”) published The General Theory of Employment, Interest, and Money, a book that transformed macroeconomics. According to Keynesian economics, a depressed economy is the result of inadequate spending. In addition, Keynes argued that government intervention can help a depressed economy through monetary policy and fiscal policy. Monetary policy uses changes in the quantity of money to alter interest rates, which in turn affect the level of overall spending. Fiscal policy uses changes in taxes and government spending to affect overall spending.

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In general, Keynes established the idea that managing the economy is a government responsibility. Keynesian ideas continue to have a strong influence on both economic theory and public policy: in 2008 and 2009, Congress, the White House, and the Federal Reserve (a quasi-governmental agency that manages U.S. monetary policy) took steps to fend off an economic slump that were clearly Keynesian in spirit, as described in the following Economics in Action.

Fending Off Depression

In 2008 the world economy experienced a severe financial crisis that was all too reminiscent of the early days of the Great Depression. Major banks teetered on the edge of collapse; world trade slumped. In the spring of 2009, the economic historians Barry Eichengreen and Kevin O’Rourke, reviewing the available data, pointed out that “globally we are tracking or even doing worse than the Great Depression.”

But the worst did not, in the end, come to pass. Figure 10-1 shows one of Eichengreen and O’Rourke’s measures of economic activity, world industrial production, during the Great Depression and during “the Great Recession,” the now widely used term for the slump that followed the 2008 financial crisis. During the first year the two crises were indeed comparable. But this time, fortunately, world production leveled off and turned around. Why?

Measures of Economic Activity and World Industrial Production During the Great Depression and the Great Recession
Source: Barry Eichengreen and Kevin O’Rourke (2009), “A Tale of Two Depressions.” © VoxEU.org; CPB Netherlands Bureau for Economic Policy Analysis World Trade Monitor.

At least part of the answer is that policy makers responded very differently. During the Great Depression, it was widely argued that the slump should simply be allowed to run its course. Any attempt to mitigate the ongoing catastrophe, declared Joseph Schumpeter—the Austrian-born Harvard economist now famed for his work on innovation—would “leave the work of depression undone.” In the early 1930s, some countries’ monetary authorities actually raised interest rates in the face of the slump, while governments cut spending and raised taxes—actions that, as we’ll see in later chapters, deepened the recession.

In the aftermath of the 2008 crisis, by contrast, interest rates were slashed, and a number of countries, the United States included, used temporary increases in spending and reductions in taxes in an attempt to sustain spending. Governments also moved to shore up their banks with loans, aid, and guarantees.

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Many of these measures were controversial, to say the least. But most economists believe that by responding actively to the Great Recession—and doing so using the knowledge gained from the study of macroeconomics—governments helped avoid a global economic catastrophe.

Quick Review

  • Microeconomics focuses on decision making by individuals and firms and the consequences of the decisions made. Macroeconomics focuses on the overall behavior of the economy.
  • The combined effect of individual actions can have unintended consequences and lead to worse or better macroeconomic outcomes for everyone.
  • Before the 1930s, economists tended to regard the economy as self-regulating. After the Great Depression, Keynesian economics provided the rationale for government intervention through monetary policy and fiscal policy to help a depressed economy.

Check Your Understanding 10-1

    • Question

      WDk1JqwUACKXZm6XQHDOy/iYm+2TaR9UAFJ0MN7KsqR/lP6iPIF960iMbn7oB+l/Gw0aaI6DWu7MdjO5/Ddv89HAP4oFw4kO9jqsPNb9cWWA+MjXESQ7+vTPWmcqU/KPukY1TOZTZwuT1leAkEhNxricaBp+osPHZW7EW4Hjs2zCR6KfTyTLUxFXwZpLXLRJT6dY/pI3Nsowft0t5+Zr4zGN4Nr+oyP/Q9Rj2Msh4lUEs/eFk1m79qrXvy7CCXFI
      This is a microeconomic question because it addresses decisions made by individual consumers about a particular product.

    • Question

      /Sfim5ffrNUYAiezYBwULqSeT/G96wHPaYFataX6upAq5KvBbsjQvnXtRjGoZmFvSdqPuuUR2oCfZxS2MSe1+pIf2cyefaDpXRgjLdp2+gOkvXRut8rM24ImmTPdIKnRFg1NsIP+E6pmLmweu3wUuO+TYbyURSkbVBneFbfnvXDIAADowq8X4ruEZ1CzgHrNSvkVpsohRvAzzUkffPNbFf+g5itIW+630OK1NUZavE8OsvoHgscTInMjDxlIND+vSYYzMg==
      This is a macroeconomic question because it addresses consumer spending in the overall economy.

    • Question

      UrF9IMxsel7T9s/zh5EcW7ao4Meuip6f42QP9/Ep7kMspyfq35PtXbiR7UvNwU2g4IIuy0hejPpJVOUSx4xGyvG6t7XfG1N7N90qHETs0QEs5V0PwFvocvugjHSoi7Du8UnAM/u9GJvO0RwMpWe+SAndlWZghejSDGP7xJH1TSJjtELM0N1dOjekTNbR5Wa9SPsLo5LpwJoX0amDzaH+8DK5Q2WWep+uRMZhZUyug+8RzeVZ+EDTvaHwwRvXM3u4Ar/mw9huADb3DvlYBERj+mSYhxhJkFJLJM8Zlln1uRNNiuARl0c9kFmNBCjnoMUsZZ4p+EnAjbgYwk4Z
      This is a macroeconomic question because it addresses changes in the overall economy.

    • Question

      bjiLMYJIgdVwKj5aCgNVYdh2b7DY3ukiZkOeVJfjDTpIFw/ToQLkXNOoa34bfcMhmnfmqv7tkZiDSqXlA/sL/IEx0Tu+cVavyw/cQccMcE0vOkT6CG/eu8dRXEuJP10e+Bo97hL/WxPcxXnv36CP51OMf0jbG0dgH0T72zQuQBAHwJ5RytVA4b8yvecmYYWi2Fr9NH91F56tUJaJuuGdO/SrAZuDr31Tw8H8rGC7et8bktxzA7yhcCHryWMIBMhyPX7+MXI15OXt0dspUb+GiM0njVkmjTHnkl9eRuLjeIM=
      This is a microeconomic question because it addresses changes in a particular market, in this case the market for geologists.

    • Question

      Qbu7jgZ9Pxm0pDj4XsrzIsZC72lUBRhjeLpGcgt2qOsfGixTQwGS0Orwr8G9ZFd9ROeka6DDeuiyDokTWiiSKKINZ16oxu1mpU2s/gUGMF/3RtHxBDvQcyYvDJ1Gbxjz0a3w2YKkI3PqGnwWGSHKpTlwsWiQqbgedpUqDO1L/apPbZENdge5rGDL0YT++ApUvB8GpGtahVsOgiuTnzxWxhJKeb9rBJBXZ9ov1n3jN6KZ3cZhNYnzoREiNqCFMwk7xpEGlfHI9U089ru+rACghA==
      This is a microeconomic question because it addresses choices made by individual consumers and producers about which mode of transportation to use.

    • Question

      HrSJdM4A/uDYFXdC35gUvM9KYIJNLqnwCdVoEsAEJHQo+P1yR+0w+n/+dMy0Y+zhxcuNZkPhTGU30vMUaWZEcXyPk9x9777zHcddKbMLF4jxFWMI6uiuvdftNMCpcEh9guvAZEoNGVuGwnet213AoKXoDayTfwjl6v20qZVAxpt03ZNBa17+Tu821Mub6AQ6FbRk76qAPjWgIwXQdekGTtz02v0m/WezPxXJ+cSFhlriGNo9BC7kLQwwh5BHat8InBUVPA==
      This is a microeconomic question because it addresses changes in a particular market.

    • Question

      r+vPNFS9lZbZnQqwpOyNQpVQXYGcXVe1GVC32prSQ+6dSd/9jVDglv5oJQmio/vUCSXESn/2moJs+om0UEm0SWZdC82a10W0Zp+QGDsTNbN/6x8V0CL05LMIJaCsNUn9pUxu+mnkhTpOhXt48/Cggs/evoDt0Nc1PwrT2CNqkkNYpcc3c9lvsMHc6TMUbyTrlaBQUV0S62AmkDhs2Of6MpY9PwB+LTM4ZqdOdXZFu3d3Auyr
      This is a macroeconomic question because it addresses changes in a measure of the economy's overall price level.

    • Question

      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
      When people can't get credit to finance their purchases, they will be unable to spend money. This will weaken the economy, and as others see the economy weaken, they will also cut back on their spending in order to save for future bad times. As a result, the credit shortfall will spark a compounding effect through the economy as people cut back their spending, making the economy worse, leading to more cutbacks in spending, and so on.

    • Question

      iXfzQKXcGtj82cGU8cyOz0LLR0J2Jy/+Q/e0RXWZO5rq3wZxFYTFuyPqJTUwsb71ZR8AKMstaSkaK3stwAhSMAls2c+TXOm2we8wwPWOhLBGjCfChiqQweBl44T8yjflSEV44bvWHjjYJnVoaHWNy78xM/aObNZ4u0pLljrKq3AcSywwQOEJkatsVKOYl63rycK7+cx2NbKmca5TumYLW9ZaOYUwSg/Q9vjbcZ5rOMpXA4u6JQ2V9r7Wtu1by2prJ2WgGJ7+pE03KZKAh+KVGt6J6k0IUoHTc/+9gtP5jOeDCKBVLOfBfciWWlOkAWO3/L1T8FknQY0SSxFd6BDb6sDYTcly3qCeQgH1K8sGaszwlBryS4TTL9Lcrs/PTBtNce0l6Rdrl+lLMzxlENu0wqTTa2S3qfLQIX/NsuxBPigpBjh16muxKJD5TGBi/CXncr7PhxLWg6oHR+CDAm+dBztBNY3afnniCK5+l919kCjooXzl2iE33ZhmEsfkoabHlMgc0kPI6CuOFHRihfJTdZVITiuKfK2hLZCZTIgacb1VFCOU55Xx6wkOLSMzaNsMXwVa44HDMBBXmhF/O7afZHfUq1BS2jsWyeqUObNTudA/teJp
      If you believe the economy is selfregulating, then you would advocate doing nothing in response to the slump.

    • Question

      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
      If you believe in Keynesian economics, you would advocate that policy makers undertake monetary and fiscal policies to stimulate spending in the economy.

Solutions appear at back of book.