Economics: Macroeconomics and Microeconomics

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I know what you're thinking. You're wondering what the difference is between micro and macro and you want to know which one's easier. Well, let's start with this explanation. Microeconomics is about the decision-making process of individuals--households deciding whether they're going to buy apples or oranges, a firm deciding whether it's going to install a computer or hire another worker. Macroeconomics is about the aggregate. Whenever you lump together all of these households and business and the government and foreign trade, what kind of organism do you get? In fact, that's a good way of thinking about it. Let's use a biological metaphor.
Microeconomics is like the study of a cell, the mitochondria and the nucleus and the way energy is created and the way the cell works. We put the microscope in on this particular cell and we look at its chemical processes. Macroeconomics is stepping back and letting these cells merge until they become a body, something that doesn't look like a cell at all, but in fact, has arms and legs and does different things. Cells metabolize energy; bodies reach over and pick up an apple and eat it. Macroeconomics is about the study of the economy as an organism. It's an organism that has its own vital signs, like inflation and unemployment, and the interest rate, and the money supply. Macroeconomics is a look at the overall economy as an organism. Microeconomics is looking at how the cell works.
So, apart from this metaphor, how does this work in economics? Well, in microeconomics we're going to be answering questions about the way individuals respond to changes in relative prices. For instance, in microeconomics we ask the question, if the wage rate goes up, will a household supply more labor or less? You can argue it either way. A higher wage causes you to substitute your energy away from leisure towards labor so that you can afford to buy more toys. On the other hand, the higher wage increases your wealth, which inclines you then to want to take more vacations and to work less. Microeconomics is the study about the way a particular household would respond to a change in its incentives created by movement in the wage.
Macroeconomics, on the other hand, steps back and looks at all of these households together and asks a question like, what happens when productivity increases in our economy? Will the overall employment rate, that is, the percentage of people who are actually able to work, working in jobs - will that increase or decrease? Do computers increase employment in the economy or do they reduce it? Macroeconomics asks questions about the money supply. Now, I know I told you before probably that economics isn't about money. Well, that's only partly true, because once you're talking about economics as the study of the economy as an organism, money is the life blood of that organism, and whenever the Federal Reserve creates and prints and puts into circulation more money, well, people have more in their bank accounts and they can compete more aggressively for goods and services in the market, and that will probably, in fact, most definitely, have an influence on the price level, as well as the ease of getting credit and a loan if you are a business that wants to expand.
Macroeconomics does study money, and it looks at how the Federal Reserve's activity in the economy, the creation and circulation of money, influences the price level, which in turn, may influence businesses' investment decisions and household purchases.
Microeconomics, on the other hand, pretty much ignores money. We treat the world as if it's one big barter system where you trade apples for cups of coffee without having to use bills or change. In microeconomics we look at the relative prices. Everything is expressed as maybe two apples equals a cup of coffee without thinking about how things are paid for. Whenever relative prices change, people change their purchasing decisions; they change their spending patterns. But in macroeconomics money is studied much the way that blood is studied in biology. It carries things through the system. It carries nutrition. When the blood supply increases, that changes the health of the organism. Too much or too little blood within a body can create problems. The same thing is true of money in the economy.
So one important difference between macro and microeconomics is that micro is the study of individual decision-making, macroeconomics is the study of the economy as an organism. Another important distinction is that while microeconomics doesn't really pay much attention to money as a phenomenon, macroeconomics takes money very seriously, and the money supply is an important determinant of the health of the economy.
Now, in micro and macroeconomics both there are actors; that is, people who are making decisions. Let's look at who we're going to be studying in macroeconomics and talk about how our perspective on them differs from the way we thought about them in microeconomics. The important players in the macro economy are households, businesses, the government, and the rest of the world, which is linked to a particular economy by foreign trade. In macroeconomics, the spending of households is called consumption. Whenever households spend money they are said to engage in consumption. The alternative to consumption is savings. And another thing a household can do is it can use its income to pay taxes.
Now, in microeconomics we answered questions like what happens when this household goes to the grocery store? Do they buy apples or do they buy oranges. In macroeconomics, on the other hand, we're going to ask about what determines the amount of consumption spending overall that this household will do in a year, and we'll look at variables like income, taxes, and age, as influential on the consumption decisions of this household.
What about businesses? In microeconomics we answered questions like, will this business choose to hire an extra worker or an extra machine at this point? That is, in what ratio will this business employ capital and labor, and if the wage rate increases, we've found that businesses were inclined to hire less labor because it was more expensive, and substitute and hire more capital instead. That's a microeconomic analysis. On the macro side what we do is we look at the big picture. When interest rates go up, or interest rates go down, are businesses inclined to do more investment spending or less. That is, what influences the overall amount of spending that businesses are inclined to do? Rather than looking at individual decisions within the firm, we consider businesses as part of this overall organism, and we ask what determines the amount of spending that they plan to do.
Next, we look at the government. From the point of view of microeconomics, we didn't talk that much about the government because the government seems to mainly be a policy player. In microeconomics the government set the tax rates, which influence people's purchasing decisions. In macroeconomics, on the other hand, we usually think about government spending as a stimulus to the economy, or government debt as creating bonds, which create a financial market, which has other benefits for the economy. Government plays a big role in macroeconomics as a policy player, not in the sense of influencing individual decisions as they did by setting tax rates in micro, but because the government can choose to pump up the economy by spending more money, or to slow it down by spending less. Also, the Federal Reserve, although not technically part of the federal government, really seems like a government entity. That is, the Central Bank is kind of part of the government, and it's the Central Bank that determines the amount of money that's in circulation, which influences the price level and other factors and variables in the economy.
Finally, have foreigners, and we didn't talk about foreigners in microeconomics at all, but now the foreign sector becomes very important, because the demand for our goods overseas determines the amount that we can export, and that's going to determine how much factories are going to be inclined to produce. Factories tend not to produce goods they can't sell, and foreign demand becomes an important component in the macro economy.
So these are the players in the macro economy. These are the players, and the way that we think about them in macroeconomics is broadly. Consumers spend money, pay taxes, and save. Businesses spend on investment goods. The government increases spending, maybe runs a deficit, maybe pays off its debt. And foreigners, depending on the exchange rate, they buy more of our goods or less.
Now, there's one more thing that we're going to want to consider whenever we think about macroeconomics. I've already mentioned the importance of money in macroeconomics, and that raises the question of being careful whenever we're discussing a particular economic story of being clear about whether we're talking about a real variable or a nominal variable. Anything measured in terms of money is considered nominal. So, for instance, if I hold up this cup of coffee and you can see the price tag on it, if I want to talk in real terms, it's one cup of coffee. When we talk about real goods and services we're talking about physical, tangible, actual goods and services that people enjoy - cups of coffee, apples, haircuts, vacations, medical care.
However, this is also $1.25 worth of coffee. That is, I can represent this coffee in nominal terms, like talking about how much money I would have to pay to get it in the market. Things measured in terms of money are called "nominal variables." So here is one dollar, a nominal measure, and here is $1.25 worth of coffee, another nominal measure. The neat thing about nominal measures is they're very easy to add up. If an apple is 0.50 and a cup of coffee is $1.25, 0.50 and $1.25 is $1.75, that's nominal spending. That's how much money I've paid out today to get the things I enjoy for breakfast. However, real goods and services are actual things that are harder to add up, because they're in some respects non-conformable. I mean, how do you add apples and oranges and coffee and medical care? What we tend to do economics is we add up the dollar amounts that are paid for these goods and services and we divide by something that reduces them to a common denominator.
I'm going to be discussing that later, but right now I want you to be clear on the distinction between real and nominal variables, things that are measured in terms of money are nominal; things that are measured in terms of physical goods and services are real.
Introduction to Economics
The Basics of Economics
Macroeconomics and Microeconomics Page [3 of 3]