The field of economics is divided into two subfields: macroeconomics and microeconomics. Macroeconomics is the study of the economy as a whole. It examines the cyclical movements and trends in economy-wide phenomena, such as unemployment, inflation, economic growth, money supply, budget deficits, and exchange rates. By contrast, microeconomics focuses on the individual parts of the economy. It studies decision making by households and firms and the interaction among households and firms in the marketplace. It considers households both as suppliers of factors of production (labor, land, capital, entrepreneurship) and as ultimate consumers of final goods and services. It also analyzes firms both as suppliers of goods and services and as demanders of factors of production.
Because the economy-wide events studied in macroeconomics arise from the interaction of many households and firms, macroeconomics is inevitably rooted in microeconomics. When economists study the economy as a whole, they must consider the decisions of individual economic actors. For example, to understand what determines gross savings (a macroeconomic issue), they must think about the intertemporal choices facing an individual—in response to a certain change in interest rates on deposits, whether to increase or decrease saving by decreasing or increasing consumption (a microeconomic issue).
Macroeconomic events and the state of the economy affect all members of society. Businesspeople forecasting the demand for their products and services should anticipate how consumers’ incomes will grow. Pensioners and people living on fixed incomes have concerns about potential price increases that could affect the cost of living. Unemployed persons looking for jobs always hope that the economy will grow fast so that firms will increase their labor force. Even politicians are affected by the state of the economy, which could influence the outcome of presidential or congressional elections. For instance, in purely democratic societies, the popularity of political leaders currently in office could fade in the event of adverse macroeconomic conditions (e.g., high inflation and/or unemployment) because voters are keenly aware of such conditions and their potential impact. It is, therefore, no surprise that economic policy is always a primary issue of debate for candidates during campaigns.
Economists assess the success of an economy’s overall performance by studying how it could achieve high rates of output and consumption growth. For the purpose of such an assessment, three macroeconomic variables are particularly important: gross domestic product (GDP), the unemployment rate, and the inflation rate.
Gross Domestic Product The GDP equals the total value of goods and services produced in a country during a year. Economic growth is, therefore, a sustainable increase in the amount of goods and services produced in an economy over time. However, economic growth is different from economic development. Noneconomists usually make little or no distinction between the two terms, using them interchangeably. Going further than GDP growth, economic development can be defined as “a multi-dimensional process of change focused on the betterment of the community, state, and/or country … and aimed at producing more ‘life sustaining’ necessities such as food, shelter, and health care and broadening their distribution, raising standards of living and individual self esteem, and expanding economic and social choice” (Todaro 2005, p. 4).
Development theories have started to look beyond GDP per capita as a sole measure of development and to consider other measures, such as health-care availability, educational attainment, equality of income distribution, and political freedom. GDP growth, though necessary, is not a sufficient condition for economic development. Modern theories try to explore other requirements for sustainable economic development, including the availability of sound government policies and institutions, infrastructure, lack of trade barriers, and fair judicial systems.
Capital accumulation is an essential factor for economic growth and development, which typically involve large-scale investments in infrastructure, industry, education, health, and financial sectors. Simon Kuznets (1901–1985) argued that levels of economic inequality can change as countries develop and, hence, accumulate more capital. Presumably, countries at early stages of development have relatively equal distributions of income because levels of per capita income and capital are low. As a country develops, more capital is accumulated and income distribution becomes unequal in favor of the owners of capital. Eventually, more-developed countries move back to lower levels of inequality either directly, through social welfare programs and other redistribution mechanisms, or indirectly, through “trickle down” effects.
Macroeconomists usually try to evaluate the economy’s growth and development performance either in comparison to other economies (cross-sectional analysis) or over time (time-series analysis). In other words, macro-economists investigate why the economies of many developing countries in Asia, Africa, Latin America, and eastern Europe tend to grow at a slower rate than those of developed countries, and how the rate of economic growth for a certain country can be improved over time.
Although sustainable growth is always desired by economic policymakers, economies do not always grow steadily and sometimes undergo periods of slowdown or expansion. Slowdowns in economic growth are called recessions. Severe economic slowdowns are called depressions (e.g., the Great Depression). During recessions, aggregate incomes decrease, as does the demand for goods and services. As a result, firms realize less profit, more firms go out of business, and, therefore, job opportunities become scarce.
On the other hand, economies can sometimes grow unusually fast. These periods of rapid economic growth are called expansions, and particularly strong expansions are called booms. During an expansion, businesses witness increasing growth and, hence, profits; incomes are higher because more people get raises and promotions; and, as a result, the demand for goods and services increases, which causes firms to realize even more profits, and more job opportunities become available. Given their importance, macroeconomists have a keen interest in analyzing economic fluctuations and whether policymakers can (or should) do anything about them.
Unemployment Rate The second most important macro-economic concept is the unemployment rate, which is a key indicator of the condition of the labor market. The unemployment rate is defined as the percentage of people willing to be employed at the prevailing wage rate, yet unable to find job opportunities. When the unemployment rate is high, work is not only hard to find, but also less rewarding as people already holding jobs might find it difficult to get wage increases or promotions. A low unemployment rate is an indication of good economic performance. Thus, keeping workers employed is always a chief concern of economic policymakers.
Inflation The third most important macroeconomic concept is inflation, which is an increase in the overall level of prices measured by the consumer price index. This index shows how the value of money changes over time. Inflation is one of the primary concerns of economists and policymakers because it imposes a variety of costs on the economy. When the inflation rate is high, the real value of money erodes. People on fixed incomes, such as pensioners who receive a fixed dollar payment each month, cannot keep up with the rising cost of living. Inflation also redistributes wealth among the population in a way that has nothing to do with merit. When there is a sustained period of inflationary pressure, lenders and workers lose while borrowers and employers benefit because many work and loan contracts in the economy are specified in terms of money. Another cost of inflation is that it discourages saving. The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. This reduces the after-tax real interest rate, and hence makes saving less attractive.
International Trade Another major macroeconomic topic is international trade, which is the exchange of goods and services across international borders. Because modern economies are highly interdependent, macroeconomists often study the impact and desirability of free trade agreements. They also study the causes and effects of trade imbalances, which occur when the quantity of goods and services that a country sells abroad (its exports) differs significantly from the quantity of goods and services its citizens buy from abroad (its imports).
Until the 1930s, most economic analysis did not separate microeconomic behavior from macroeconomic behavior. The 1776 publication of The Wealth of Nations by the Scottish economist Adam Smith (1723–1790) marked the birth of classical economics. Along with Smith, the major representatives of this school of economic thought include David Ricardo (1772–1823), Thomas Robert Malthus (1766–1834), and John Stuart Mill (1806–1873).
Classical economists emphasized the optimization of private economic agents, the adjustment of relative prices to equate supply and demand, and the efficiency of free markets. The classical theory dominated economic analysis till the late 1920s. Its main presumption is that the economy works better when government intervention is kept at a minimum because the behavior of different economic agents tends to achieve self-interests that are consistent with the overall well-being of the economy. Classical economists believed that the market itself would correct for any economic imbalance or turbulence without the need for government intervention. Any disequilibrium in a single market would eventually result in an automatic correction via the interaction between the two sides of the market, supply and demand, with the help of price flexibility. This flexibility would always ensure that macroeconomic equilibria in the national economy are a result of automatic equilibria (clearance) in single markets. Classical economists also believed that the utilization of more inputs of production can be translated into higher levels of national output and income.
The Great Depression that began in 1929 in the United States was the worst economic catastrophe in the country’s history. During the depression, the United States experienced massive unemployment and greatly reduced incomes. This devastating period caused many economists to question the validity of classical economic theory, which seemed incapable of explaining the Great Depression. Classical economists believed that factor supplies and available technology determined the level of national income. However, real income in the United States decreased by 30 percent between 1929 and 1933 even though factors of production and technology remained unchanged. Therefore, many economists believed that a new theory was needed to explain such a large and sudden economic downturn and to identify government policies that might reduce the economic hardship so many people faced.
The British economist John Maynard Keynes (1883–1946) revolutionized the way economists think with his book, The General Theory of Employment, Interest, and Money (1936). It was pathbreaking in several ways. The two most important are, first, that it introduced the notion of aggregate demand as the sum of consumption, investment, and government spending. Second, it showed that full employment could be maintained only with the help of government spending.
Keynes proposed that low aggregate demand is responsible for the low income and high unemployment that characterize economic downturns. He criticized the classical theory for assuming that factor supply alone determines national income and that prices are flexible. In contrast to the classical theory, Keynes asserted that, in the short run, changes in aggregate demand rather than aggregate supply influence national income. Moreover, automatic economic equilibria are not necessarily ensured in the Keynesian world. In fact, economic balance can only occur by chance. Consequently, government intervention is sometimes sought in order to correct for economic instability.
The work of Keynes remains a central point of reference even today because all economic schools of thought label themselves in relation to the ideas initially developed by Keynes in his General Theory. Since the breakdown of the Keynesian consensus in the early 1970s, macroeconomics witnessed the emergence of a number of competing schools of thought consisting of economists who share a broad vision of how the economy as a whole works. Two “new” schools in particular have been highly influential: the new classical and the new Keynesian. These new schools share the view that macroeconomic theories should be based on solid microeconomic foundations.
Most economists use the term new classical broadly to describe the many challenges to Keynesian orthodoxy that prevailed in the 1960s. New classical economists advocate models in which wages and prices adjust quickly to clear markets. More recently, many new classical economists have turned their attention to real business cycle theory, which uses the assumptions of the classical theory—especially flexible prices—to explain short-run economic fluctuations.
New Keynesian economists, on the other hand, believe that market-clearing models cannot explain short-run economic fluctuations, and so they advocate models with sticky wages and prices. New Keynesian research is aimed at explaining how wages and prices behave in the short run by identifying more precisely the market imperfections that make wages and prices sticky.
Even though they sometimes reach differing conclusions, the various schools of thought are not always in direct competition with one another. It is unlikely that one of the current schools of economic thought perfectly captures the workings of the economy. Rather, each theory contributes a small piece of the overall puzzle.
Like all scientists, economists rely on both theory and observation. Macroeconomists usually try to explain the economic world as it is and consider what it could be. For this purpose, they use many types of data to measure the performance of an economy. They collect data on incomes, prices, unemployment, and many other economic variables from different periods and different countries. They then attempt to formulate theories that could help explain these data. They try to answer such questions as: Why do incomes increase over time? Why do some countries have high rates of inflation while others maintain stable prices? What causes recessions and how can economic policy be used to reduce their incidence and scale?
The goal of studying macroeconomics, however, is not just to explain economic events but also to improve economic policy. Macroeconomic policies are government actions designed to influence the performance of the economy as a whole. By understanding how government policies affect the economy, economists can help policymakers do a better job and avoid serious mistakes.
The policy goals that macroeconomists typically associate with the discipline include economic growth, price stability, and full employment. Policymakers always face three fundamental macroeconomic questions: (1) How can the rate of economic growth be increased and sustained? (2) How can unemployment be reduced? (3) How can inflation be kept under control? To find answers to these questions, policymakers can implement the tools of three major types of macroeconomic policy: monetary policy, fiscal policy, and structural policy.
The term monetary policy refers to the management of the nation’s money supply (cash and coins, although modern economies have other forms of money such as savings and time deposits and money market mutual funds). Most economists agree that changes in the money supply affect important macroeconomic variables, including national output, employment, interest rates, inflation, stock prices, and the exchange rate. In almost all countries, monetary policy is implemented by a government institution called the central bank.
Fiscal policy refers to decisions that determine the government’s budget, including the amount and composition of government expenditures and government revenues. The balance between government spending and taxes is a particularly important aspect of fiscal policy. When the government spends more than it collects in taxes, it runs a deficit, and when it spends less, the government’s budget is in surplus. There is a consensus among economists that fiscal policy can have an important impact on the overall performance of the economy.
Finally, the term structural policy includes government policies aimed at changing the underlying structure, or institutions, of the economy. The move away from government control of the economy and toward a more market-oriented approach in many formerly communist countries, such as Poland, the Czech Republic, and Hungary, is a large-scale example of structural policy. Many developing countries have tried similar structural reforms. Supporters of structural policy hope that by changing the basic characteristics of the economy or by restructuring its institutions they can stimulate economic growth and improve living standards.
Different analytical approaches lead to different policy conclusions. For example, a Keynesian approach would have governments run a surplus during the boom period of business cycles and a deficit during a recession. On the other hand, classical economists would prefer that the government not intervene to correct for short-term economic fluctuations; they believe this will distort the way free markets function. Others argue that using taxation as a macroeconomic policy tool has no effect on the economy; rational individuals tend to save when they receive tax cuts because they expect the government to raise taxes in the future to pay off its deficit.
As articulated in Mankiw (2004), there are three unresolved questions pertaining to monetary and fiscal policies, each of which is central to political debates: First, should policymakers try to stabilize the economy? Second, should monetary policy be made by rule rather than by discretion? Third, should the government balance its budget?
With regard to the first debate on whether monetary and fiscal policymakers should try to stabilize the economy, proponents argue that policymakers should take an active role in leading the economy to stability. When aggregate demand is inadequate to ensure full employment, policymakers should act to boost spending in the economy. When aggregate demand is excessive and there is a risk of inflation, policymakers should act to lower spending. Such policy actions put macroeconomic theory to its best use by leading to a more stable economy. Opponents argue that there are substantial difficulties associated with running fiscal and monetary policies. One of the most important problems is the time lag that often occurs with policy. Economic conditions change over time. Thus, policy effects that occur with a lag may hit the economy at the wrong time, leading to a more unstable economy. Therefore, policymakers should refrain from intervening in order to avoid doing any harm to the economy.
As for the controversy on whether monetary policy should be made by rule rather than by discretion, advocates assert that discretionary monetary policy does not limit incompetence and abuse of power. For example, a central banker may choose to create a political business cycle to help a particular candidate. One way to avoid such a problem is to force the central bank to follow a monetary rule that is flexible enough to allow for some unforeseen circumstances that could affect the economy. Critics of this view argue that discretionary monetary policy allows flexibility, which gives the central bank the ability to react to unforeseen situations quickly.
Finally, macroeconomists have long debated whether the government should balance its budget or run a deficit. Advocates of a balanced budget argue that future generations of taxpayers will be burdened by public debt if the government accumulates annual deficits in the present. Opponents of the balanced budget approach argue that the problems caused by government debt are overstated and that the future generation’s burden of debt is relatively small when compared with their lifetime incomes. If public spending on education and health is reduced, for example, this could lead to lower economic growth in the future, which would certainly not make future generations better off.
SEE ALSO Inflation; Involuntary Unemployment; Microeconomics; Natural Rate of Unemployment
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Khaled I. Abdel-Kader
Economics is a broad subject that can be divided into two areas: macroeconomics and microeconomics. To differentiate between the two, the analogy of the forest and the individual trees can be helpful. Macroeconomics is the study of the behaviors and activities of the economy as a whole; hence, the forest. Microeconomics looks at the behaviors and activities of individual households and firms, the individual components that make up the whole economy; hence, the individual trees.
The Federal Reserve System was created by the Federal Reserve Act of 1913, which divided the United States into twelve districts with a Federal Reserve Bank located in each. Each of these banks is owned by the member banks located within that district. The Federal Reserve System's most important function is to control the supply of money in circulation. Monetary policies made by the Federal Reserve System's Board of Governors have a tremendous impact on the total economy. These policies influence such factors as the amount of money member banks have available to loan, interest rates, and the overall price level of the economy. Three ways in which the Federal Reserve Board regulates the economy are by changing reserve requirements, changing the discount rate, and buying and selling government securities.
Macroeconomists also study unemployment, which simply defined is a very large work force and a small job market, to determine methods to control this serious economic problem. The U.S. Department of Labor estimates the level of unemployment in the economy by using results from monthly surveys conducted by the Bureau of the Census.
Unemployment means lost production for the economy and loss of income for the individual. One type of unemployment is frictional unemployment, which includes those people who are not employed because they have been fired or have quit their job. Cyclical unemployment follows the cycles of the economy. For example, during a recession, spending is low and workers are laid off because production needs are reduced. Structural unemployment occurs when a job is left vacant because a worker does not have the necessary skills needed or a worker does not live where there are available jobs. Some unemployment is due to seasonal factors; that is, employees are hired only during certain times of the year. To help lessen the problem of unemployment, the government can use its powers to increase levels of spending by consumers, businesses, and the government itself and by lowering taxes or giving tax incentives, which makes available more money with which to purchase goods and services. This in turn puts more laid-off workers back to work. The Federal Reserve System can also increase spending by lowering interest rates.
Total economic spending, which includes consumer, business, and government spending, determines the level of the gross domestic product (GDP), which is the market value of all final products produced in a year's time. GDP is one of the most commonly used measures of economic performance. An increasing GDP from year to year shows that the economy is growing. The nation's policy makers look at past and present GDPs to formulate policies that will contribute to economic growth, which would result in a steady increase in the production of goods and services. If GDP is too high or growing too rapidly, inflation occurs. If GDP is too low or decreasing, an increase in unemployment occurs.
Fluctuations in total economic activity are known as business cycles, and macroeconomists are concerned with understanding why these cycles occur. Most unemployment and inflation are caused by these fluctuations. There are four phases of the business cycle: prosperity (peak), recession, trough, and recovery. The length and duration of each cycle varies. From its highest point, prosperity, to its lowest point, trough, these phases are marked by increases and decreases in GDP, unemployment, demand for goods and services, and spending.
Microeconomics looks at the individual components of the economy, such as costs of production, maximizing profits, and the different market structures.
Business firms are the suppliers of goods and services, and most firms want to make a profit; in fact, they want to maximize their profits. Firms must determine the level of output that will result in the greatest profits. Costs of production play a major role in determining this level of output. Costs of production include fixed costs and variable costs. Fixed costs are costs that do not vary with the level of output, such as rent and insurance premiums. Variable costs are costs that change with the level of output, such as wages and raw materials. Therefore, total cost equals total fixed costs plus total variable costs (TC = TFC + TVC ). Marginal cost, which is the cost of producing one more unit of output, helps determine the level at which profits will be maximized. Marginal cost (MC ) measures the change (Δ) in total cost when there is a change in quantity (Q ) produced (MC = ΔTC /ΔQ ). Firms must then decide whether they should produce additional quantities.
Revenue, the money a firm receives for the product it sells, is also a part of the profit equation because total revenue minus total costs equal profit (TR − TC = profit). Marginal revenue, which is the additional revenue that results from producing and selling one more unit of output, is also very important. As long as marginal revenue exceeds marginal cost, a firm can continue to maximize profits.
There are four basic categories of market structures in which firms sell their products. Pure competition includes many sellers, a homogeneous product, easy entry and exit, and no artificial restrictions such as price controls. A monopoly is the opposite of pure competition and is characterized by a single firm with a unique product and barriers to entry. An oligopoly has few sellers, a homogeneous or a differentiated product, and barriers to entry such as high start-up costs. Where products are differentiated, nonprice competition occurs; that is, consumers are persuaded to buy products without consideration of price. The fourth market structure is monopolistic competition. It includes many sellers, differentiated products, easy entry and exit, and nonprice competition.
see also Economic Analysis ; Economics
Gottheil, Fred M. (2005). Principles of Economics (4th ed.). Mason, OH: Thomson.
Lisa S. Huddlestun
mac·ro·ec·o·nom·ics / ˈmakrōˌekəˈnämiks; -ˌēkə-/ • pl. n. [treated as sing.] the part of economics concerned with large-scale or general economic factors, such as interest rates and national productivity.DERIVATIVES: mac·ro·ec·o·nom·ic adj.mac·ro·e·con·o·mist / -iˈkänəmist/ n.