What Is Macroeconomics? Why Study It?

Paraphrasing Macroeconomics: Understanding the Wealth of Nations. By David Miles, Imperial College, and Andrew Scott, London Business School. Chichester, UK: John Wiley & Sons, 2005


Soft start:

- [M]acroeconomics is far more than just an intellectual toolkit for understanding current events. It is also about understanding the long-term forces that drive the economy and shape the business environment

- [M]acroeconomics is about the economy as a whole ... how the whole economy evolves over time rather than on any one sector, region, or firm. Yet macroeconomics also considers the important issues from the perspective of the firm and/or the individual consumer. It is the overall, or aggregate, implications of tens of thousands of individual decisions that companies and households make that generates the macroeconomic outcomes.

- Economics is the study of the allocation of scarce resources ... Not all these needs can be satisfied, but economics should be able to help you (and society) meet as many of them as possible.

- Market economies allocate resources through prices. Prices tell producers what the demand for a particular product is—if prices are high, then producers know the good is in demand, and they can increase production. If prices are low, producers know that demand for the product is weak, and they should cut back production. Thus the market ensures that society produces more of the goods that people want and less of those that they do not.

- Broadly speaking, economics has two components: microeconomics and macroeconomics. ... microeconomics essentially examines how individual units, whether they be consumers or
firms, decide how to allocate resources and whether those decisions are desirable.

- Macroeconomics studies the economy as a whole; it looks at the aggregate outcomes of
all the decisions that consumers, firms, and the government make in an economy. Macroeconomics is about aggregate variables such as the overall levels of output, consumption, employment, and prices—and how they move over time and between countries.

- In terms of prices, microeconomics focuses on, for instance, the price of a particular firm’s product, whereas macroeconomics focuses on the exchange rate (the price of one country’s money in terms of that of another country) or the interest rate (the price of spending today rather than tomorrow).


The Difference between Macro and Microeconomics

[A] gray area exists between micro and macroeconomics that relates to aggregation—at what point do the actions of a number of firms cease to be a microeconomic issue and become a macroeconomic issue?

- another way of outlining the differences ... In microeconomics the focus is on a small group of agents, say a group of consumers or two firms battling over a particular market. ... economists pay a great deal of attention to the behavior of the agents the model is focusing on ... make assumptions about what consumers want or how much they have to spend, or about whether the two firms are competing over prices or market share, and whether one firm is playing an aggressive strategy, and so on. The result is a detailed analysis of the way particular firms or consumers should behave in a given situation.

- [T]his microeconomic analysis does not explain what is happening in the wider economic environment. Think about consumers’ choice of what goods to consume. In addition to consumers’ own income and the price of the goods they wish to purchase, their decisions depend on an enormous amount of other information. How high is unemployment? Is the government going to increase taxes? Is the exchange rate about to collapse, requiring a sharp increase in interest rates? ... [I]f imported materials are important for the firm’s production process, then a depreciating currency will lead to higher import costs, reducing profit margins even before the firm engages in a price war.

- While none of these background influences—shifts in interest rates or movements in the exchange rate—are under the control of the firm or consumer, they still influence their decisions.
Macroeconomics analyzes the backdrop of economic conditions against which firms and consumers make decisions.

- The economy, as a whole, represents the outcome of decisions that millions of individual
firms and consumers make ... The inflation rate reflects the number of firms that are increasing prices and the amount by which each firm is raising prices ... all of the individual pricing decisions that millions of firms make determine the macroeconomic environment.

- While microeconomics is mainly concerned with studying in detail the decisions of a few agents, taking as given the basic economic backdrop, macroeconomics is about studying how the decisions of all the agents who make up the economy create this backdrop.

- Consider, for instance, the issue of whether a firm should adopt the latest developments in information technology (IT), which promise to increase labor productivity by, say, 20%. A microeconomic analysis of this topic would focus mainly on the costs the firm faces in adopting this technology and the likely productivity and profit gains that it would create. Macroeconomics would consider this IT innovation in the context of the whole economy. In particular, it would examine how, if many firms were to adopt this technology, costs in the whole economy would fall and the demand for skilled labor would rise... this would lead to an increase in wages and the firm’s payroll costs... [could] also shift demand away from unskilled towards skilled workers, causing the composition of unemployment and relative wages to change.

- The microeconomic analysis is one where the firm alone is contemplating adopting a new technology, and the emphasis is on the firm’s pricing and employment decisions, probably holding wages fixed... the analysis assumes the firm’s decisions do not influence the background economic environment. [T]he macroeconomic analysis examines the consequences when many firms implement the new technology and investigates how this affects economy-wide output, wages, and unemployment. [W]hich [form of analysis] is more appropriate depends on the issue to be analyzed and the question that needs to be answered.


Why to study macroeconomics - limitations, relevance

- Understanding macroeconomics is not simply a useful aspect of the public relations role of the business person; nor is it solely related to better understanding government policy.

- Economists distinguish between two types of uncertainty: aggregate and idiosyncratic. Aggregate uncertainty affects all firms and sectors in the economy; idiosyncratic uncertainty affects only a few individuals, firms, or industries. Macroeconomics is essentially about the aggregate sources of uncertainty that affect firms, workers, and consumers.

- [W]hich source of uncertainty is more important for individual health ... ? Evidence (covering firms and consumers) shows that the biggest source of uncertainty in the short term for most firms is the idiosyncratic component. All firms should worry about loss through illness of key personnel, major clients canceling contracts, litigation, fire and theft, and so forth.

- For households, or individuals, idiosyncratic risk is also generally more important than systematic (or aggregate) uncertainty. Whether you pass an exam; how well you get along with your first boss; whether you avoid serious illness in your forties and fifties—for [most these] are likely to be more important for their standard of living over their lifetime than ... aggregate output or ... inflation.

- Consider ... unemployment. In recessions unemployment rises, but not everyone becomes unemployed. Most people carry on with their regular job even through the worst recessions. ...
Therefore, the aggregate measure of unemployment, while important, gives an incomplete
picture of what is happening to individuals in the labor market. Idiosyncratic factors are significant—even during the worst recession some firms ... will be doing well and hiring workers; it is just that more firms are doing badly.

- This does not mean macroeconomics is unimportant to business. Netherlands case in
the early 1980s, and ... the early 1990s, p. 9

- Aggregate uncertainty is also important because it generates a type of risk that, by definition, all firms and consumers share ... the only source of uncertainty that is fully portable between jobs in different industries is aggregate uncertainty.

- [O]nly a small part of corporate uncertainty in any one year is due to aggregate or macroeconomic uncertainty. However, the further ahead one looks, the more important aggregate uncertainty becomes.



C O N C E P T U A L Q U E S T I O N S

1. (Section 1.1) What factors do you think explain why the United States is so rich and Bangladesh is so poor? What do you think accounts for the growth that most economies have shown?

Answer: Despite ideological disputes, proposals to tax the rich more in some Swiss cantons or NY State, and calling big business owners locusts (some SPD candidate), etc., there is a consensus that (see Obama's inauguration, 2009), a relatively free market economy and the rule of law are essential for prosperity. We can summarize Bangladesh plight saying that the country have neither of those essentials, nor many other factors for growth. They even had a mutiny in the Army this year - that is not precisely what investors need to have confidence.

2. (1.3) Figure 1.5 shows the pattern of bankruptcies and interest rates in the Netherlands. What do you think might account for this pattern? What can firms do to try to minimize this cyclical risk of bankruptcy?

A.: It is a good explanation that those pikes in interest rates were costly for many companies. As to try to minimize that risk and the real effect of that risk, I cannot think of anything of value: if rates go from 7 to 12 pct, or from 3 to 6 pct, what can you do? It is a tragedy.

3. (1.3) Figure 1.6 shows the real price of oil since 1913. What other industries besides automobile manufacturers are affected by fluctuations in oil prices, and how are they affected? What are the effects on individual consumers? How do you suppose that national economies of oil-producing nations are affected by changes in oil prices? What about the economies of countries that use a lot of imported oil?

A.: Transportation of all goods, food producers, almost anyone, including individuals and countries that import oil, will see their monthly bills go up for the same or less productive work, less customers and less spending of those customers. Exporting oil countries, to some extent, get more for less, so they can pay debt (to foreign investors) and debts (pending pensions, civil servants' paychecks, etc.).

4. (1.4) Consider the differing impact of microeconomic and macroeconomic factors in the near term prospects of

(a) a graduating student
(b) a restaurant in a village
(c) a restaurant in an airport
(d) a manufacturer of low-price cars
(e) a manufacturer of luxury sports cars


A N A L Y T I C A L Q U E S T I O N S

1. (Section 1.1) Consider the data in Figure 1.2. What growth rate will Bangladesh have to
show to catch up with the 2002 U.K. and U.S. per capita income level within 10 years? 20
years? 30 years? How would population growth affect your calculations?


2. (1.3) Consider an economy made up of 5 equal sized firms (labeled A to E). Under one scenario the output of each firm alternates between

Firm A B C D E
Output 1 2 3 4 5

And

Firm A B C D E
Output 5 4 3 2 1

What is the balance between idiosyncratic and aggregate risk in this economy?

A.: aggregate risk is flat, since final output, number of employees, etc., is the same after the change than before it. But idiosyncratic damage is big for company E, and gains for company A are enormous too.

How does your answer change if each firm oscillates between

Firm A B C D E
Output 3 3 3 3 3

And

Firm A B C D E
Output 4 4 4 4 4


A.: aggregate risk is lower if output is not eaten by price changes, and the country is richer than it was. Also, idiosyncratic risk is lower, since all companies earn more, but also the employees probably will get a bigger chunk of the pie, so in the end there will be a pressure on costs that will transmit to the consumer.