Macroeconomics: Meaning, Scope and Importance of macro economics

1] Prof Kenneth E Boulding, “Macroeconomics deals, not with individual quantities as such but
with the aggregates of these quantities, not with individual incomes but with national income, not
with prices but with the price level, not with individual output but with the national output”.

“Macroeconomics theory is that part of the subject which deals with the great aggregates and the
averages of the system rather than with particular items in it and attempts to define these
aggregates in a useful manner and to examine their relationship”.

2] Professor Gardener Ackley, “Macroeconomics concerns itself with such variables as the
aggregate volume of the output of an economy, with the extent to which its resources are
employed, with the size of the national income, with the general price level”.

3] J.L.Hansen, “Macroeconomics is that branch of economics which considers the relationship

between large aggregated such as the volume of employment, total amount of savings,
investment, national income etc”

4] The Economist’s Dictionary of Economics defines Macroeconomics as “The study of whole

economic systems aggregating over the functioning of individual economic units. It is primarily
concerned with variables which follow systematic and predictable paths of behaviour and can be
analysed independently of the decisions of the many agents who determine their level. More
specifically, it is a study of national economies and the determination of national income.”

5] Prof Carl Shapiro, “Macroeconomics deals with the functioning of the economy as a whole.”

6] “Macroeconomics theory is that part of the subject which deals with the great aggregates and
the averages of the system rather than with particular items in it and attempts to define these
aggregates in a useful manner and to examine their relationship”.

It is that part of economic theory which studies the economy in its totality or as a whole.

It studies not individual economic units like a household, a firm or an industry but the whole
economic system. Macroeconomics is the study of aggregates and averages of the entire
economy.

Such aggregates are national income, total employment, aggregate savings and investment,
aggregate demand, aggregate supply general price level, etc.

Here, we study how these aggregates and averages of the economy as a whole are determined
and what causes fluctuations in them. Having understood the determinants, the aim is how to
ensure the maximum level of income and employment in a country.

In short, macroeconomics is the study of national aggregates or economy-wide aggregates. In a

way it is like study of economic forest as distinguished from trees that comprise the forest. Main
tools of its analysis are aggregate demand and aggregate supply.

Since the subject matter of macroeconomics revolves around determination of the level of
income and employment, therefore, it is also known as ‘Theory of Income and
Employment:

These days when the study of lakhs of individual units has become almost impossible and when
government’s participation through monetary and fiscal measures in the economy has increased
very much, use of macro analysis has become indispensable.

Correct economic policies formulated at macro level have made it possible to control business
cycles (inflation and deflation) and as a result violent booms and depressions have become things
of the past.

In a suitably modified form, macroeconomics is the basis of all plans of economic development
of underdeveloped economies. Economists are now confidently exploring the possibilities and
ways of maintaining economic growth and full employment. More than anything else,
macroeconomic thought has enabled us to properly organise, collect and analyse the data about
national income and coordinate international economic policies.

The scope of macroeconomics includes the following parts:

Clearly, the study of the problem of unemployment in India or general price level or problem of
balance of payment is macroeconomic study because these relate to the economy as a whole.

Importance of Macroeconomics:

1. It helps to understand the functioning of a complicated modern economic system. It describes

how the economy as a whole functions and how the level of national income and employment is
determined on the basis of aggregate demand and aggregate supply.

2. It helps to achieve the goal of economic growth, higher level of GDP and higher level of
employment. It analyses the forces which determine economic growth of a country and explains
how to reach the highest state of economic growth and sustain it.

3. It helps to bring stability in price level and analyses fluctuations in business activities. It
suggests policy measures to control Inflation and deflation.

4. It explains factors which determine balance of payment. At the same time, it identifies causes
of deficit in balance of payment and suggests remedial measures.

5. It helps to solve economic problems like poverty, unemployment, business cycles, etc., whose
solution is possible at macro level only, i.e., at the level of whole economy.

6. With detailed knowledge of functioning of an economy at macro level, it has been possible to
formulate correct economic policies and also coordinate international economic policies.

7. Last but not the least, is that macroeconomic theory has saved us from the dangers of
application of microeconomic theory to the problems of the economy as a whole.
Main differences between Microeconomics and Macroeconomics are as under:

Microeconomics:

1. It is the study of individual economic units of an economy.

2. It deals with Individual Income, Individual prices, Individual output, etc.

3. Its central problem is price determination and allocation of resources.

4. Its main tools are demand and supply of a particular commodity/factor.

5. It helps to solve the central problem of ‘what, how and for whom’ to produce. In the economy

6. It discusses how equilibrium of a consumer, a producer or an Industry Is attained.

7. Price is the main determinant of micro- economic problems.

8. Examples are: Individual Income, Individual savings, price determination of a commodity,

individual firm’s output, consumer’s equilibrium.

Macroeconomics:

1. It is the study of economy as a whole and its aggregates.

2. It deals with aggregates like national Income, general price level, national output, etc.

3. Its central problem is determination of level of Income and employment.

4. Its main tools are aggregate demand and aggregate supply of the economy as a whole.

5. It helps to solve the central problem of full employment of resources in the economy.

6. It is concerned with the determination of equilibrium level of Income and employment of the
economy.

7. Income is the major determinant of macroeconomic problems.

8. Examples are: National Income, national savings, general price level, aggregate demand,
aggregate supply, poverty, unemployment, etc.

transformation from microeconomics to macroeconomics.

It would be of great use to understand that both micro and macroeconomics have been studied by
various economists from time to time.

Mercantilists, Physiocrats and classical economists like Adam Smith, Ricardo and Marx were
concerned with total income in the community and the behaviour of the economic system over a
period of time.

The great Depression (1929-32) and unemployment endangered by it. Second World War and
the desire of the underdeveloped countries to develop quickly attracted the attention of the
economists towards the study of macroeconomics, which led finally to aggregative thinking and
Keynes’ General Theory.

Thus, J.M. Keynes became the chief advocate of macroeconomics in recent times. In fact, his
book ‘General Theory’ may well be described as ‘Aggregative Economics’. The desire to control
business cycles and rapid economic growth of backward economies led economists like L.
Walras, K. Wicksell, I. Fisher to contribute their mite towards the development of
macroeconomic studies. There are certain branches of modern economic theory which could be
classed wholly under macroeconomics, like Public Finance, International Trade, Banking etc.

Three distinct but related developments laid the foundations of the modern macroeconomics:

(i) In the 1920s and 1930s Simon Kuznets (the Nobel Prize winner of 1971) and the U.S.
Department of Commerce laid the conceptual and statistical framework of national income
accounts without which current macroeconomics would have been impossible. They provide the
basic theoretically meaningful variables of macroeconomics, e.g., estimates of saving,
investment, consumption etc., that play a vital role in short run macroeconomics.

(ii) According to Schumpeter, Walras’ work proved the magna charta, for general equilibrium
theory. Similarly, Keynes’ ‘General Theory’ has been the theoretical magna charta for
macroeconomics. He effectively inaugurated explicit macroeconomic model building and
showed how the equilibrium of the economy as a whole could be described. It was as a result of
Keynes’ work that the more elegant mathematization of his theory by Hicks and others became
possible, who unleashed a vast quantity of latest model-building energy. This is the medium in
which macroeconomics has been taught, discussed debated, or advanced ever since.

(iii) Finally, macroeconomics has shared the benefits of accelerated application of mathematical
techniques to economic theory. As a result, both short-run and long-run macroeconomics have
undergone vast mathematical development, so much so that static equilibrium models of Keynes
have given way to dynamic sequential models both of growth and fluctuations.

The pre-Keynesian neglect of macroeconomic theory followed from its views that departures
from full employment were strictly temporary. It argued that automatic forces of competitive
markets will bring employment and output back to full employment level.

The fact that there were relatively few severe or prolonged depressions (at least during the first
half of the nineteenth century) gave support to the above belief. Lapses from full employment
being infrequent and short-lived could be easily explained away as exceptions to the full
employment rule. Keynes was the first economist to present successfully an alternate
macroeconomic theory of the determination of employment and output that explained why the
forces of a free market economy did not assure sufficient aggregate demand that would
automatically generate full employment. His ‘General Theory’ offered an explanation of the
economic disaster of the 1930s that the U.S.A. and many other countries suffered.

As a result, during the decade following the appearance of the ‘General Theory’ economists
engaged themselves to refining, building, analyzing and upholding the pioneer work of Keynes.
Keynesian macro- economic theory was successfully applied during and after World War II to
the problems of tackling inflation. From this macro theory flowed policy measures designed to
lift the economy to the level of full employment to which automatic forces of free market
economy failed to carry it. For these reasons macro-economic rose to prominence through the
1940s and 1950s from its earlier relative obscurity.

This large scale acceptance of the major parts of Keynesian macroeconomics over the past
quarter century meant widespread rejection of large parts of classical macroeconomics. The self
satisfaction that the economists felt in Keynesian macroeconomic theory proved to be short-lived
; because the various policy measures adopted during 1960s in U.S.A. and other countries failed
to check ‘inflation’ or ‘stagflation’. In view of the experience during the 1960s to early 1970s,
economists who believed that Keynesian macroeconomic know-how was sufficient to cope with
the problems were greatly disillusioned.

Apparently, final solutions for the basic macroeconomic problems mentioned above had not been
found. As such, Keynesian macroeconomic theory which started as a revolution against the
classical orthodoxy and ended up with such success that by the beginning of 1960s it had itself
become a new orthodoxy. Keynesian macroeconomics or revolution has in recent years been
confronted with what has been called the monetarist counter revolution.

It seems safe to say that Keynesian orthodoxy is in the midst of facing a challenge that began in
the early 1960s and as a result has been forced to recognize and correct its intellectual short-
comings. It is not right to conclude that the Keynesian macroeconomics which has risen to such
great prominence has been dislodged by the challenge of monetarism. It will, in other words, be
granted that the monetarist attack led to some substantial qualifications, rethinking and
amendments to Keynesian macroeconomics but no more than that.

Interdependence between Micro and Macroeconomics

Actually micro and macroeconomics are interdependent. The theories regarding the behaviour of
some macroeconomic aggregates (but not all) are derived from theories of individual behaviour.

For instance, the theory of investment, which is a part and parcel of the microeconomic theory, is
derived from the behaviour of individual entrepreneur.

According to this theory, an individual entrepreneur in his investment activity is governed by the
expected rate of profit on the one hand and rate of interest on the other. And so is the aggregate
investment function. Similarly, the theory of aggregate consumption function is based upon the
behaviour patterns of individual consumers.

It may be noted that we are able to draw aggregate investment function and aggregate
consumption function because in this respect the behaviour of the aggregate is in no way
different from the behaviour patterns of individual components. Moreover, we can derive the
behaviour of these aggregates only if either the composition of aggregates is constant or the
composition changes in some regular way as the size of aggregates changes.

From this it should not be understood that behaviour of all macroeconomic relationship is in
conformity with behaviour patterns of individuals composing them. As we saw above, saving-
investment relationship and wage-employment relationship for the economic system as a whole
are quite different from the corresponding relationships in case of individual parts.
Microeconomic theory contributes to macroeconomic theory in another way also. The theory of
relative prices of products and factors is essential in the explanation of the determination of
general price level. Even Keynes used microeconomic theory to explain the rise in the general
price level as a result of the increase in the cost of production in the economy. According to
Keynes, when as a result of the increase in money supply and consequently the aggregate
demand, more output is produced, the cost of production rises. With the rise in the cost of
production, the prices rise.

According to Keynes, cost of production rises because of:

(1) The law of diminishing returns operates and

(2) Wages and prices of raw materials may rise as the economy approaches full- employment
level.

Now, the influences of cost of production, diminishing returns, etc., on the determination of
prices are the parts of microeconomics. Not only does macroeconomics depend upon to some
extent on microeconomics, the latter also depends upon to some extent on macroeconomics. The
determination of the rate of profit and the rate of interest are well-known microeconomic topics,
but they greatly depend upon the macroeconomic aggregates.

In microeconomic theory, the profits are regarded as reward for uncertainty bearing but
microeconomic theory fails to show the economic forces which determine the magnitude of
profits earned by the entrepreneur and why there are fluctuations in them. The magnitude of
profits depends upon the level of aggregate demand, national income, and the general price level
in the country.

We know that at times of depression when the levels of aggregate demand, national income and
price level are low, the entrepreneurs in the various fields of the economy suffer losses. On the
other hand, when aggregate demands, incomes of the people, the general price level go up and
conditions of boom prevail, the entrepreneurs earn huge profits.

Now, take the case of the rate of interest. Strictly speaking theory of the rate of interest has now
become a subject of macroeconomic theory. Partial equilibrium theory of interest which belongs
to microeconomic theory would not reveal all the forces which take part in the determination of
the rate of interest. Keynes showed that the rate of interest is determined by the liquidity
preference function and the stock (or supply) of money in the economy.

The liquidity preference function and the stock of money in the economy are macroeconomic
concepts. No doubt, the Keynesian theory has also been shown to be indeterminate, but in the
modern theory of interest Keynesian aggregative concepts of liquidity preference and stock of
money play an important role in the determination of the rate of interest.

Moreover, in the modern interest theory (i.e., determination of interest rate through intersection
of LM and IS curves) along with liquidity preference and the supply of money, the other two
forces which are used to explain the determination of interest are saving and investment
functions which are also conceived in aggregative or macro terms.
It is thus clear from above that the determination of profits and rate of interest cannot be
explained without the tools and concepts of macroeconomics. It follows that though
microeconomics and macroeconomics deal with different subjects, but there is a good deal of
interdependence between them. In the explanation of many economic phenomena, both micro
and macro-economic tools and concepts have to be applied. About interdependence between
microeconomics and macroeconomics. Professor Ackley’s remarks are worth quoting.

He says, “The relationship between macroeconomics and theory of individual behaviour is a

two-way street. On the one hand, microeconomic theory should provide the building blocks for
our aggregate theories. But macroeconomics may also contribute to microeconomic
understanding. If we discover, for example, empirically stable macroeconomic generalisations
which appear inconsistent with microeconomic theories, or which relate to aspects of behaviour
which microeconomics has neglected, macroeconomics may permit us to improve our
understanding of individual behaviour.”

Why Should We Study Macroeconomics Separately?

Now, an important question which arises is why a separate study of the economic system as a
whole or its large aggregates is necessary.

Can’t we generalise about the behaviour of the economic system as a whole or about the
behaviour of large aggregates such as aggregate consumption, aggregate saving, aggregate
investment from the economic laws governing the behaviour patterns of the individual units
found by microeconomics.

In other words, can’t we obtain the laws governing the macroeconomic variables such as total
national product, total employment and total income, general price level etc. by simply adding
up, multiplying or averaging the results obtained from the behaviour of the individual firms and
industries.

The answer to this question is that the behaviour of the economic system as a whole or the
macroeconomic aggregates is not merely a matter of addition or multiplication or averaging of
what happens in the various individual parts of the whole. As a matter of fact, in the economic
system what is true of parts is not necessarily true of the whole.

Therefore, the application of micro-approach to generalise about the behaviour of the economic
system as a whole or macroeconomic aggregate is incorrect and may lead to misleading
conclusions. Therefore, a separate macro-analysis is needed to study the behaviour of the
economic system as a whole as well as in respect of various macroeconomic aggregates.

When laws or generalisations are true of constituent individual parts but untrue and invalid in
case of the whole economy, paradoxes seem to exist. K.E. Boulding has called these paradoxes
as macroeconomic paradoxes. It is because of the existence of these macroeconomic paradoxes
that there is a justification for making macro-analysis of the behaviour of the whole economic
system or its large economic aggregates.

Thus, Professor Boulding rightly remarks, “It is these paradoxes more than any other factor,
which justify the separate study of the system as whole, not merely as an inventory or list of
particular items, but as a complex of aggregates.”
Professor Boulding further elaborates his point by comparing the economic system with a forest
and the individual firms or industries with the trees in the forest. Forest, he says, is the
aggregation of trees but it does not reveal the same properties and behaviour patterns as the
individual trees. It will be misleading to apply the rules governing the individual trees to
generalise about the behaviour of the forest.

Various examples of macroeconomic paradoxes (that is, what is true of parts is not true of the
whole) can be given from the economic field. We shall give two such examples which are
concerned with savings and wages, on the basis of which Keynes laid stress on using and
applying macroeconomic analysis as a separate and distinct approach from microeconomic
analysis.

Take savings first. Savings are always good for an individual since they save with some purpose
in view, for old age, for education of their children, for purchasing durable things like houses and
cars etc. in the future, accumulation of money to start or expand business, for lending money to
others including banks to earn interest.

But savings are not always good for the society as a whole. If an economy is in the grip of
depression and unemployment caused by the deficiency of aggregate effective demand, the
increase in savings by individuals will lead to a fall in aggregate consumption demand of the
society which will cause aggregate demand to fall.

As a result, national income will decline. Given the propensity to save, at the lower level of
national income, the aggregate saving will fall to the original level of aggregate saving. The
paradox of thrift arises because the act of all the people to save more does not actually lead to the
increase in national saving. Besides, as their decision to save more causes fall in national income,
consumption of the people is less than before which implies they will become worse off than
before. Therefore, this has been called a paradox of thrift.

Another common example to prove that what is true for the individual may not be true for the
society as a whole is the wage-employment relationship. As pointed out above, classical and neo-
classical economists, especially A. C. Pigou, contended that the cut in money wages at times of
depression and unemployment would lead to the increase in employment and thereby eliminate
unemployment and depression.

Now, whereas it is true that a cut in money wages in an individual industry will lead to more
employment in that industry but it is not a valid proposition for the economy as a whole. It is
quite common-place conclusion of microeconomic theory that, given the demand curve for
labour, at a lower wage rate more men will be employed. But for the society or economy as a
whole this is highly misleading.

If the wages are cut all round in the economy, as was suggested by Pigou and others on the basis
of wage-employment relationship in an individual industry, the aggregate demand for goods and
services in the society will decline, since wages are incomes of the workers which constitute
majority in the society.

The decline in aggregate demand will mean the decrease in demand for goods of many
industries. Because the demand for labour is a derived demand, i.e. derived from the demand for
goods, the fall in aggregate demand of goods will result in the decline in demand for labour
which will create more unemployment rather than reduce it.

We thus see that the laws or generalisations which hold good for the behaviour of an individual
consumer, firm or industry may be quite invalid and misleading when applied to the behaviour of
the economic system as a whole. There is thus a fallacy of composition. This is so because what
is true of individual components is not true of their collective whole.As mentioned these are
called macroeconomic paradoxes and it is because of these paradoxes that a separate study of the
economic system as a whole is essential. above,

Macroeconomic analysis takes account of many relationships which are not applicable to
individual parts at all. For instance, an individual may save more than that he invests or he may
invest more than he saves, but for the economy as a whole it is one of the important principles of
Keynesian macroeconomics that actual savings are always equal to actual investment.

Likewise, for an individual, expenditure may be more or less than his income but the national
expenditure of the economy must be equal to the national income. In fact, the national
expenditure and national income are two identical things.

Similarly, in the case of full employment, an individual industry may increase its output and
employment by bidding away the workers from other industries, but the economy cannot
increase its output and employment in this way. Thus, what applies to an individual industry
does not do so in case of the economic system as a whole.

We therefore conclude that a separate and distinct macroeconomic analysis is essential if we

want to understand the true working of the economic system as a whole. From this it should not
be understood that microeconomic theory is worthless and should be abandoned. As a matter of
fact, microeconomics and macroeconomics are complementary to each other rather than being
competitive.

The two types of theories deal with different subjects, one deals mainly with the explanation of
relative prices of goods and factors and the other with the short-run determination of income and
employment of the society as well as its long- run growth. The study of both micro and
macroeconomics is therefore necessary. Professor Samuelson rightly says, “There is really no
opposition between micro and macroeconomics. Both are absolutely vital. And you are only
half-educated if you understand the one while being ignorant of the other.