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Micro and Macro: The Economic Divide - Back to Basics: Finance & Development

MicroandMacro:TheEconomicDivide
FINANCE & DEVELOPMENT
G.ChrisRodrigo

Economicsissplitbetweenanalysisofhowtheoveralleconomyworksandhowsinglemarkets
function
Physicistslookatthebigworldofplanets,stars,galaxies,
andgravity.Buttheyalsostudytheminuteworldofatoms
andthetinyparticlesthatcomprisethoseatoms.
Economistsalsolookattworealms.Thereisbigpicture
macroeconomics,whichisconcernedwithhowthe
overalleconomyworks.Itstudiessuchthingsas
employment,grossdomesticproduct,andinflationthe
stuffofnewsstoriesandgovernmentpolicydebates.Little
picturemicroeconomicsisconcernedwithhowsupply
anddemandinteractinindividualmarketsforgoodsand
services.

Aquestionofscale(photo:Zack
Seckler/Corbis)

Inmacroeconomics,thesubjectistypicallyanationhow
allmarketsinteracttogeneratebigphenomenathateconomistscallaggregatevariables.Inthe
realmofmicroeconomics,theobjectofanalysisisasinglemarketforexample,whetherprice
risesintheautomobileoroilindustriesaredrivenbysupplyordemandchanges.The
governmentisamajorobjectofanalysisinmacroeconomicsforexample,studyingtheroleit
playsincontributingtooveralleconomicgrowthorfightinginflation.Macroeconomicsoften
extendstotheinternationalspherebecausedomesticmarketsarelinkedtoforeignmarkets
throughtrade,investment,andcapitalflows.Butmicroeconomicscanhaveaninternational
componentaswell.Singlemarketsoftenarenotconfinedtosinglecountriestheglobalmarket
forpetroleumisanobviousexample.
Themacro/microsplitisinstitutionalizedineconomics,frombeginningcoursesinprinciplesof
economicsthroughtopostgraduatestudies.Economistscommonlyconsiderthemselves
microeconomistsormacroeconomists.TheAmericanEconomicAssociationrecentlyintroduced
severalnewacademicjournals.OneiscalledMicroeconomics.Another,appropriately,istitled
Macroeconomics.

Whythedivide?
Itwasnotalwaysthisway.Infact,fromthelate18thcenturyuntiltheGreatDepressionofthe
1930s,economicswaseconomicsthestudyofhowhumansocietiesorganizetheproduction,
distribution,andconsumptionofgoodsandservices.Thefieldbeganwiththeobservationsofthe
earliesteconomists,suchasAdamSmith,theScottishphilosopherpopularlycreditedwithbeing
thefatherofeconomicsalthoughscholarsweremakingeconomicobservationslongbefore
SmithauthoredTheWealthofNationsin1776.Smithsnotionofaninvisiblehandthatguides
someoneseekingtomaximizehisorherownwellbeingtoprovidethebestoverallresultfor
societyasawholeisoneofthemostcompellingnotionsinthesocialsciences.Smithandother
earlyeconomicthinkerssuchasDavidHumegavebirthtothefieldattheonsetoftheIndustrial
Revolution.
EconomictheorydevelopedconsiderablybetweentheappearanceofSmithsTheWealthof
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NationsandtheGreatDepression,buttherewasnoseparationintomicroeconomicsand
macroeconomics.Economistsimplicitlyassumedthateithermarketswereinequilibriumsuch
thatpriceswouldadjusttoequalizesupplyanddemandorthatintheeventofatransient
shock,suchasafinancialcrisisorafamine,marketswouldquicklyreturntoequilibrium.Inother
words,economistsbelievedthatthestudyofindividualmarketswouldadequatelyexplainthe
behaviorofwhatwenowcallaggregatevariables,suchasunemploymentandoutput.
ThesevereandprolongedglobalcollapseineconomicactivitythatoccurredduringtheGreat
Depressionchangedthat.Itwasnotthateconomistswereunawarethataggregatevariables
couldbeunstable.Theystudiedbusinesscyclesaseconomiesregularlychangedfroma
conditionofrisingoutputandemploymenttoreducedorfallinggrowthandrisingunemployment,
frequentlypunctuatedbyseverechangesoreconomiccrises.Economistsalsostudiedmoneyand
itsroleintheeconomy.ButtheeconomicsofthetimecouldnotexplaintheGreatDepression.
Economistsoperatingwithintheclassicalparadigmofmarketsalwaysbeinginequilibriumhadno
plausibleexplanationfortheextrememarketfailureofthe1930s.
IfAdamSmithisthefatherofeconomics,JohnMaynardKeynesisthefoundingfatherof
macroeconomics.Althoughsomeofthenotionsofmodernmacroeconomicsarerootedinthe
workofscholarssuchasIrvingFisherandKnutWicksellinthelate19thandearly20thcenturies,
macroeconomicsasadistinctdisciplinebeganwithKeynessmasterpiece,TheGeneralTheoryof
Employment,InterestandMoney,in1936.Itsmainconcernistheinstabilityofaggregate
variables.Whereasearlyeconomicsconcentratedonequilibriuminindividualmarkets,Keynes
introducedthesimultaneousconsiderationofequilibriuminthreeinterrelatedsetsofmarkets
forgoods,labor,andfinance.Healsointroduceddisequilibriumeconomics,whichistheexplicit
studyofdeparturesfromgeneralequilibrium.Hisapproachwastakenupbyotherleading
economistsanddevelopedrapidlyintowhatisnowknownasmacroeconomics.

Coexistenceandcomplementarity
Microeconomicsisbasedonmodelsofconsumersorfirms(whicheconomistscallagents)that
makedecisionsaboutwhattobuy,sell,orproducewiththeassumptionthatthosedecisions
resultinperfectmarketclearing(demandequalssupply)andotheridealconditions.
Macroeconomics,ontheotherhand,beganfromobserveddivergencesfromwhatwouldhave
beenanticipatedresultsundertheclassicaltradition.
Todaythetwofieldscoexistandcomplementeachother.
Microeconomics,initsexaminationofthebehaviorofindividualconsumersandfirms,isdivided
intoconsumerdemandtheory,productiontheory(alsocalledthetheoryofthefirm),andrelated
topicssuchasthenatureofmarketcompetition,economicwelfare,theroleofimperfect
informationineconomicoutcomes,andatthemostabstract,generalequilibrium,whichdeals
simultaneouslywithmanymarkets.Mucheconomicanalysisismicroeconomicinnature.It
concernssuchissuesastheeffectsofminimumwages,taxes,pricesupports,ormonopolyon
individualmarketsandisfilledwithconceptsthatarerecognizableintherealworld.Ithas
applicationsintrade,industrialorganizationandmarketstructure,laboreconomics,public
finance,andwelfareeconomics.Microeconomicanalysisoffersinsightsintosuchdisparateefforts
asmakingbusinessdecisionsorformulatingpublicpolicies.
Macroeconomicsismoreabstruse.Itdescribesrelationshipsamongaggregatessobigastobe
hardtoapprehendsuchasnationalincome,savings,andtheoverallpricelevel.Thefieldis
conventionallydividedintothestudyofnationaleconomicgrowthinthelongrun,theanalysisof
shortrundeparturesfromequilibrium,andtheformulationofpoliciestostabilizethenational
economythatis,tominimizefluctuationsingrowthandprices.Thosepoliciescaninclude
spendingandtaxingactionsbythegovernmentormonetarypolicyactionsbythecentralbank.

Bridgingthemicro/macrodivide
Likephysicalscientists,economistsdeveloptheorytoorganizeandsimplifyknowledgeabouta
fieldandtodevelopaconceptualframeworkforaddingnewknowledge.Sciencebeginswiththe
accretionofinformalinsights,particularlywithobservedregularrelationshipsbetweenvariables
thataresostabletheycanbecodifiedintolaws.Theoryisdevelopedbypinningdownthose
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invariantrelationshipsthroughbothexperimentationandformallogicaldeductionscalled
models.
SincetheKeynesianrevolution,theeconomicsprofessionhashadessentiallytwotheoretical
systems,onetoexplainthesmallpicture,theothertoexplainthebigpicture(microandmacro
aretheGreekwords,respectively,forsmallandbig).Followingtheapproachofphysics,for
thepastquartercenturyorso,anumberofeconomistshavemadesustainedeffortstomerge
microeconomicsandmacroeconomics.Theyhavetriedtodevelopmicroeconomicfoundationsfor
macroeconomicmodelsonthegroundsthatvalideconomicanalysismustbeginwiththebehavior
oftheelementsofmicroeconomicanalysis:individualhouseholdsandfirmsthatseektooptimize
theirconditions.
Therehavealsobeenattemptstouseveryfastcomputerstosimulatethebehaviorofeconomic
aggregatesbysummingthebehavioroflargenumbersofhouseholdsandfirms.Itistooearlyto
sayanythingaboutthelikelyoutcomeofthiseffort.Butwithinthefieldofmacroeconomicsthere
iscontinuingprogressinimprovingmodels,whosedeficiencieswereexposedbytheinstabilities
thatoccurredinworldmarketsduringtheglobalfinancialcrisisthatbeganin2008.

Howtheydiffer
Contemporarymicroeconomictheoryevolvedsteadilywithoutfanfarefromtheearliesttheories
ofhowpricesaredetermined.Macroeconomics,ontheotherhand,isrootedinempirical
observationsthatexistingtheorycouldnotexplain.Howtointerpretthoseanomalieshasalways
beencontroversial.Therearenocompetingschoolsofthoughtinmicroeconomicswhichis
unifiedandhasacommoncoreamongalleconomists.Thesamecannotbesaidof
macroeconomicswherethereare,andhavebeen,competingschoolsofthoughtabouthowto
explainthebehaviorofeconomicaggregates.ThoseschoolsgobysuchnamesasNewKeynesian
orNewClassical.Butthesedivisionshavebeennarrowingoverthepastfewdecades(Blanchard,
DellAriccia,andMauro,2010).
Microeconomicsandmacroeconomicsarenottheonlydistinctsubfieldsineconomics.
Econometrics,whichseekstoapplystatisticalandmathematicalmethodstoeconomicanalysis,is
widelyconsideredthethirdcoreareaofeconomics.Withoutthemajoradvancesineconometrics
madeoverthepastcenturyorso,muchofthesophisticatedanalysisachievedinmicroeconomics
andmacroeconomicswouldnothavebeenpossible.
G.ChrisRodrigoisaVisitingScholarintheIMFsResearchDepartment.

Reference

Blanchard,Olivier,GiovanniDellAriccia,andPaoloMauro,2010,RethinkingMacroeconomicPolicy,
IMFStaffPositionNote10/03(Washington:InternationalMonetaryFund).
Updated:March28,2012

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