Overview: Macroeconomics

What It Means

The field of economics is divided into two main branches: microeconomics and macroeconomics. Microeconomics deals with the choices of individual people or groups (consumers, business firms, government agencies) and involves attempts to understand particular economic sectors. For instance, in microeconomics we might analyze the behavior of consumers and producers of chocolate candy during a period of time when chocolate prices were rising. Macroeconomics, by contrast, examines the overall health and growth of the economy. It focuses on the economy as a whole, concerning itself with the aggregate behavior (the total result of individual actions) of consumers and producers in various parts of the economy. In macroeconomics we would not pay attention to individuals or specific groups in the chocolate-candy market or even to the chocolate-candy market as a whole. Instead, we might consider such variables as aggregate demand (the collective demand in the entire economy) and inflation (the degree to which prices are rising) in the nondurable goods sector, a portion of the economy that includes all goods that cannot be reused or will not retain their value for more than a year.

Economists examine various large-scale factors to determine the health of an economy. Six of the most important are national income, prices, employment, fiscal and monetary policy, consumption and investment, and balance of payments.

National income is the total value of all goods and services produced in a country. There are different ways of measuring national income. In the United States the most common measurement is gross domestic product, or GDP.

When studying prices, economists analyze pricing trends among different categories of goods and services, and they ask questions such as “How much do goods and services cost, relative to incomes and other economic indicators?” and “How fast are prices rising?” Inflation (the general rising of prices) is perhaps the single greatest danger to any economy, outside of extraordinary conditions such as war and global upheaval.

Employment is another chief factor affecting the economy on a large scale. Economists attempt to determine how many people are out of work at a given moment and what this means for the economy. An economy’s health is strongly tied to the proportion of the population that both wants to find work and can find work.

The government’s approach to spending and taxation is called its fiscal policy, while its approach to the money supply (the amount of money in circulation) is called its monetary policy. Both types of policy have the ability to affect the overall economy in dramatic fashion.

Consumption is the purchase of goods and services by individuals and households; investment is the purchase of goods and services by businesses to buy things that will allow the production of other goods and services. These two forms of spending drive much of economic activity and together account for nearly 80 percent of GDP.

Balance of payments refers to the relationship between a country’s imports and exports (the amount of money paid to foreign countries or institutions for their goods and services and the amount of money accepted as payment from foreign countries or institutions for our goods and services) in a given time period. The degree to which a country is in debt and the amount of money owed to it by other countries have an influence on overall economic health.

Macroeconomics revolves around these six topics. Economists pay close attention to these indicators, tracking their past and current fluctuations; they use the information they gather to help guide government policy. They also analyze such fluctuations in the context of national and global affairs in order to refine old theories and develop new ones. Macroeconomics as a field has been shaped by varying philosophical approaches to these six and other large-scale economic phenomena.

When Did It Begin

Modern economic theory dates from the book An Inquiry into the Nature and Causes of the Wealth of Nations (1776) by the Scottish philosopher Adam Smith (1723–90). Smith argued (among other things) that the market system (a market is any place where buyers and sellers come together) ensured the most efficient distribution of money, resources, and well-being. Applied on a national and international scale and refined by succeeding theorists, this view of a world kept in balance by the individual actions of buyers and sellers dominated economic thought for much of the following century and came to be known as the classical school of economics. There was no distinction between microeconomics and macroeconomics until well into the twentieth century.

But the Great Depression (a worldwide economic decline that started in 1929 and lasted through most of the 1930s) upset classical notions such as the idea that the balancing desires of buyers (demand) and sellers (supply) kept prices in line and ultimately ensured that, in a free market, healthy levels of employment would be maintained. Enormous numbers of people lost their jobs, and business activity ground to a halt across the developed world, but classical theory could not explain why this had happened.

In 1936 the British economist John Maynard Keynes (1883–1946) published The General Theory of Employment, Interest, and Money, a book that satisfactorily explained the causes of the Great Depression and offered what came to be known as macroeconomic solutions to the crisis. Keynes argued that an imbalance between savings and investment (the portion of income that households were saving was not getting back into the economy through business investment) had led to economic instability and the eventual collapse of the economy. In the vacuum created by that collapse, Keynes proposed, government should step in to make up for the lack of private investment. Governments could do so by changing their approach to fiscal and monetary policy, most notably by engaging in what is called deficit spending (spending using borrowed money that a nation does not have the means to pay back in the short term).

In the succeeding decades Keynes’s ideas had an enormous influence on governments and revolutionized the study of economics. He was largely responsible for pointing out that large-scale factors (such as those listed in his book’s title) should be studied as indicators of economic health without focusing on the individual behavior of economic decision makers. That is, theories about supply, demand, and prices as they applied to individual businesses and consumers (today these theories form the basis of what we call microeconomics) might not always tell the whole story about an economy. It was necessary, according to Keynes, to study an economy from the top down as well, using aggregate factors like those that are studied in macroeconomics today. Thus, it is largely because of Keynes that macroeconomics was established as a discipline and the field of economics split in two.

More Detailed Information

Whereas microeconomic theory is based on simple, long-established ideas such as the laws of supply and demand, the basic principles of macroeconomic theory have been subject to debate and refinement in the years since Keynes outlined his views on the topics that would define the discipline.

Before Keynes had convincingly demonstrated his theories in The General Theory of Employment, Interest, and Money, most economists and political leaders believed that the government should stay largely on the margins of a national economy. They argued that, when governments involved themselves in public-works projects (such as dams and roads), they took business away from private companies and were less efficient at the projects than private companies were. Moreover, it was widely believed that a balanced national budget was a firm requirement: a government, like a household, should not spend more than it takes in; debt was irresponsible and dangerous.

While Keynes agreed with many principles of classical economics, he also argued that governments could apply their power directly to the macroeconomic factors that affected an economy. Governments, in Keynes’s view, could at times regulate the balance between savings and investment (too much savings and too little investment had been a major cause of the Great Depression, in his view) through monetary policy (adjusting the money supply). In a deep recession or depression, however, monetary policy would have little effect; in those cases governments could borrow money to be used on spending programs. This would allow them to funnel money into the national economy without taking it out of citizens’ pockets through higher taxes, which would in turn allow for the favorable macroeconomic effects of increased employment and increased purchasing power.

These ideas drove what was known as the Keynesian revolution in economics, and Keynesian economics became the successor to the classical economics school. In the 1930s government intervention such as President Franklin D. Roosevelt’s large-scale public-works projects (including the Works Progress Administration, which provided jobs for the unemployed, mostly in construction) steered U.S. and European recovery from the Depression. The soundness of these policies reinforced Keynes’s theories. Keynesian economics and its offshoots, neo-Keynesianism and neoclassical economics, dominated macroeconomics until the 1960s, both in academia and in the realm of government policy.

In the 1960s, however, the American economist Milton Friedman (1912–2006) began challenging Keynesian economics. Friedman believed, first, that Adam Smith had been right to suggest that the market was by far the most effective means of promoting efficiency and well-being, and second, that government spending did indeed crowd out private businesses. His knowledge of macroeconomic forces, however, allowed him to go beyond the classical theory that Smith had used. Friedman argued that government could, in fact, contribute to the well-being of the economy, but only in one way: by controlling the money supply. This would allow the government to guard against inflation. In all other respects, government should refrain from interfering with the economy. Friedman’s way of thinking about the economy was called monetarism because of his belief that inflation was tied strictly to the money supply.

Just as classical theory could not explain the Great Depression, Keynesian theory could not explain economic conditions in the United States in the 1970s, when something unprecedented happened: unemployment rose at the same time as inflation (a phenomenon that was dubbed “stagflation”). Friedman had been predicting that Keynesian economic policy would create just such a result, and his theories accordingly began to hold sway in macroeconomics.

Recent Trends

Friedman’s views had a great deal of influence in the 1980s, especially with U.S. president Ronald Reagan and British prime minister Margaret Thatcher. Economists in academia were split between those who roughly agreed with Friedman and gravitated around the university where he had both studied and taught (the University of Chicago) and those who opposed many of his views about strict monetarism and government nonintervention and who were often associated with the Massachusetts Institute of Technology and Harvard University. Changing economic conditions in the mid-1980s seemed to contradict some of Friedman’s predictions, however, and monetarism fell out of fashion. Although Friedman’s approach to macroeconomic issues remained a major influence on conservative thought in the United States, monetarism was supplanted by the doctrines of what came to be known as “new classical economics.”

New classical economics is similar to monetarism in that it represents a revival of classical economics, especially in its view that government intervention should be avoided. A key difference between new classical economics and monetarism is that the theoretical structure of the former is based on microeconomic theory. It uses the highly logical framework of microeconomics to derive macroeconomic theories and policies.