Significance and Limitations of Macro Economics

(Lecture 2)

TITLE

Significance and Limitations of Macro Economics

LESSON - 2

COURSE NAME

Principles of Macroeconomics – I

COURSE (as per CBCS)

SEMESTER - III

Introduction

Macroeconomics has gained much popularity among the modern economists since the
publication of Keynes book.' The General Theory of Employment, Interest and Money’ in
1936. Gardner Ackley considers macro economics theory as “a somewhat unattractive and
awkward name for one of the important branches of economic analysis”. Samulson’s view
point of macro economics is sound. "The political, social and military fate of nations depend
greatly on their economic success, and no area of economics is today more vital or more
controversial than macro economics.”

Prof. J.K. Mehta feels that so long as men live in society, the economists cannot afford to
neglect the study of macro-economics.

The importance of macro economics is as follows:

(i) The study of macro economics is indispensable for understanding the

functioning of an economy.
Issues concerning the whole economy cannot be analyzed by the price theory concerned
with the pricing of individual products or specific services. Working of individual markets
or pricing of individual products cannot help us to understand the working of economy as a
whole. Problems of investment; growth and development; prosperity and recession; poverty
and unemployment; inflation, fiscal imbalance and interest rates can be best understood
with the help of macro economics.
(ii) Macro economics is of great help in the formulation of economic policies.
Macroeconomic policies: Monetary and Fiscal Policy are very important in achieving the
objectives of price stability, exchange rate stability, full employment and economic growth.
These policies are subject matter of macro economics. Macro economics explains the tools
of monetary and fiscal policy used in achieving various objectives. Data related to aggregate
income, savings, consumption and investment are needed to formulate economic policies.
Policies of government are concerned with the group of individuals rather than individuals.
(iii) It is helpful in the computation of national income and in the analysis of
problems related to national income.
A study of the national income of a country explains its economic conditions. Countries
can be compared on the basis of their national incomes. Plans are properly made to achieve
different objectives only on the basis of availability of data related to national income of the
economy.
(iv) It helps the policy makers to control trade cycles.
Real GDP does not increase continuously over time. Periods of economic decline
(recession) followed by periods of sustained increases (expansions) are classified as
business cycles. Business cycles are a concern because of the economic hardships
associated with recession. Macro economics can help the policy makers decide what to do
to help avert recession and ensure that recessions are as short and mild as possible when
they occur. Fluctuations have been there for hundreds of years in various countries of the
world and they will undoubtedly continue into the future. Hence, the possibility of another
recession in the economy remains a continual concern to the policy makers. Poverty and
unemployment increase in all recessions. Growth gets retarded during this event.
(v) It is helpful in the study of growth and development of the countries.
Economic growth refers to increase in real GDP over time. With the increase in capital
accumulation and technological changes, a country’s ability to produce increases over time.
Growth of population increases the economy’s labour supply with a time lag. Economic
growth is a major topic in macroeconomics as it directly affects the economic wellbeing.
Macroeconomics provides us with tools to augment the rate of growth of any economy.

(vi) It is helpful in the study of the general level of taxation and expenditure.
Macroeconomics explains how taxes and expenditure of the government can influence the
aggregate demand and supply in the economy which ultimately determine the level of
output, employment and income. Production of harmful goods can be reduced by increasing
tax rates on such goods. If private investment is not coming forward, government can
increase its expenditure on investment projects leading to multiple times rise in income of
the economy due to the working of multiplier. Aggregate demand can be increased by
decreasing the taxes and increasing public expenditure.
(vii) It enables us to study the nature and size of the material welfare of the nations.
Different concepts of national income, sectoral composition of national income and
methods of measuring national income are all studied in macroeconomics. Rising per capita
income implies greater material welfare of the people. Sectoral composition of national
income of India shows that contribution of agriculture to national income has declined
substantially while employment is this sector is quite high. This indicates law productivity
of labour in the agricultural sector. There is a need to improve the productivity in
agricultural sector.
(viii) Macroeconomics helps us to understand and analyse the performance of an
economy.
Performance of an economy can be judged from the macroeconomic indicators like real
GDP, per capita income, level of employment in the economy, level of output, aggregate
consumption, aggregate savings, aggregate investments, fiscal deficit and current account
deficit in the economy. High fiscal deficit and current account deficit are not considered
good for the health of the economy. Low rate of inflation is considered good for the growth
of any economy.
(ix) It is helpful in the study of Micro Economics.
Many theories and principles of micro economics have been constructed on the basis of
macro economics. Law of diminishing marginal utility has been based on the study of
behaviour of group of consumers. This law states that as we go on consuming more and
more units of a product, its marginal utility goes on declining. This law is the basis of law of
demand. In reality, no law of micro economics can be formulated without any reference to
aggregates.
(x) Macro economics helps us to understand and analyse the causes, effects and
control of general price level.
Inflation exists when there is a sustained increase in the price level. The consumer price
index (CPI) and producer price index (PPI) and the GDP deflator are frequently used
measures of price level. The consumer price index measures price changes for goods and
services purchased by urban consumers. The producer price index measures price changes
for goods at the wholesale price level, specifically furnished goods, intermediate goods and
crude materials. The GDP deflator measures changes in price for goods and services
included in GDP. Inflation adversely affects savings, exports, fixed income groups.
Continuously falling prices (deflation) lead to falling incomes and employment in the
economy. Macroeconomics tells us how to control inflation and deflation in the economy. It
can help policy makers in keeping inflation low and stable without making the economy
unstable in the short run.

xi) Essential for economic planning

Plans are very essential for the development of an economy. In India we are having 5 year
plans. Objectives and targets of plans can be set only if one know the macro-economic
variables like national income, composition of national income, level of unemployment,
level and nature of poverty, mutual dependence of various sectors. Planning is not possible
without the knowledge of these aggregates.

xii) It explains inter-relationship among different sectors.

Macroeconomics explains how different sectors like primary sector, secondary sector,
service sector, public and private sector, internal and external sector are related to each
other. If one sector is neglected it will adversely affect the growth of other sectors. Overall
growth of the economy depends upon the growth of each sector. Macroeconomics tells us
how internal and external balance can be achieved by the use of monetary and fiscal policy.

xiii) Macroeconomics also explains macro-economic paradoxes.

Macroeconomic paradoxes refer to those concepts which hold good for a single individual
but when they are applied to all the people, their validity becomes doubtful. For example:
(i) if a farmer produces more wheat in his farm, he can become rich by selling more
wheat in the market. But if all the farmers increase the production of wheat, overproduction
of wheat will result in falling prices of wheat leading to fall in incomes of the farmers.
(ii) If one person starts saving more, he can be rich. But if all the people start saving
more, this will result in poverty. Study of macroeconomics helps in understanding these
paradoxes.

Thus we see that macro-economics is of great significance in explaining the important

problems of an economy like unemployment, inflation, unbalanced budget, poverty,
economic growth, economic planning and role of the government in the economy.

Limitations of Macro-Economics

1. Firstly, there is danger of excessive generalisation of individual experience to a

system as a whole.
Several conclusions of macroeconomics are based on the sum total of individual units. In
fact, it is not correct because what is good for the individual may not be good for the group.
For example as a person saves more, he can accumulate wealth but if all start saving more,
this will lead to fall in aggregate demand resulting in decline in output ,employment and
income in the economy. This is called “Fallacy of Composition.”

2. Under macroeconomics, heterogeneous units are studied.

It is not possible to express these units in uniform numbers. According to Prof. Boulding it
is possible to add or subtract oranges to apples, but it is not possible to add or subtract
apples and sky scrapers. Therefore, it is not possible to derive aggregates of individual
goods.
3. Composition of structure of the aggregate is more important than the aggregate
itself.
Price index of the two years may be the same while it is possible that price of some goods
may have increased and the price of some goods may have fallen. National Income may be
increased but there may be inequitable distribution of income. So composition of the
aggregates is also very essential to have a true picture of the economy.
4. Different effect of aggregates
Effect of aggregates is not the same on all the sectors. During inflation, traders and
industrialists gain from the rise in price while wage earners are the losers.
5. Conceptual and practical difficulties in the formulation of macro-economic
variables.
There are various problems in the measurement of national income, general price level,
unemployment etc.
6. Limited Application
Some economists are of the view that most of the macro-economic models have only
theoretical significance. In practical life they are not of much use. According to Prof. Hicks
“macro-economic variables like GNP, fixed capital, investment, BOP and so on are subject
to errors and to ambiguities.”
7. An indiscriminate and uncritical use of macro-economics in analysing the
problems of real world can often be misleading.

In spite of these limitations, macro-economics is very important. It really helps in

understanding the working of a complex economic system and the formulation of
appropriate macro-economic policies to achieve macro-economic goals.

Summary

This lesson has described how Macro Economics is essential for understanding the
functioning of the economy as a whole. It has discussed the role of macro economics in
explaining the determinants of national income, output, employment, general price
level and economic growth. It has mentioned the role of monetary and fiscal policies in
achieving the goals of price stability and economic growth through aggregate demand
and aggregate supply. Performance of different economies can be judged on the basis
of macroeconomic variables .It enables us to know the relationship between various
sectors of the economy. Without the knowledge of this subject we cannot understand
the economic paradoxes. But Macro Economics is not without limitations. Sometimes
we do not get a true picture of the whole economy on the basis of economic
aggregates.