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Economics

Have you ever wondered what the ‘macro’ in macroeconomics stands for? Do you know the difference between macroeconomics and microeconomics? You’re probably thinking: macro - big, micro - small, and you are not wrong. If you’ve heard about macroeconomics before, but are not sure where to start, you are in the right place. This explanation will explain the meaning of macroeconomics and introduce the main foundation for macroeconomics theory.

Macroeconomics is a branch of economics that deals with the structure, performance, behaviour, and decision-making of the whole, or aggregate, economy.

How exactly is macroeconomics different from microeconomics? A question such as ‘What determines the price of milk?’ concerns the price determination mechanism in a single market in the economy. This makes it a micro-scale question.

In contrast, asking ‘What determines the average price level of all goods and services?’ is a macro-scale question. It concerns the big-picture issues affecting the economy in its totality. In other words, microeconomics is the study of one ‘tree’, whereas macroeconomics concerns the whole ‘forest’.

The importance of macroeconomics

Why is it important to study macroeconomics? Macroeconomics helps us expand our capacity to assess the economic well-being from an individual to the whole country, to a global scale. To do that, economists designed models that represent structures, relationships, and behaviours in the economy as a whole.

Those models are frequently mathematical and statistical in nature, providing them with scientific rigour and credibility. They help individuals, firms, and policymakers to understand the past and use their models to forecast the future.

Modern macroeconomics distinguishes between three types of policies: fiscal, monetary, and supply-side. Macroeconomic models help policymakers make informed decisions when applying those policies to regulate the economy.

How does the national economy work?

To understand how the national economy works, economists had to extend the theory of demand and supply to the macroeconomic scale by introducing the concepts of aggregate demand, aggregate supply, and macroeconomic equilibrium. They also simplified and adapted the complicated reality to simpler and easier-to-understand models.

The two fundamental models in macroeconomic theories are:

  • The aggregate demand and aggregate supply (AD-AS model).

  • The circular flow model (Circular flow of income).

Aggregate demand and aggregate supply (AD-AS model)

The aggregate demand and aggregate supply model explains the relationship between the price level and the output in the economy.

You can see this relationship on a diagram. The diagram is very similar to the demand and supply diagram in Microeconomics.

Aggregate demand describes the national income of the economy. There are many ways to define it:

  • A measure of the amount of goods and services demanded in an economy over a time period (usually a year).
  • The total of all demand and expenditures in the economy at any given price level.
  • The term used by economists to denote the total spending on goods and services produced in an economy.

We can break down the total demand and expenditures in the economy into the following components of Aggregate Demand (AD) where:

  • C = Consumption: measures total household spending on consumer goods and services.

  • I = Investment: firms’ expenditure on capital goods. This refers to spending on something that is expected to generate income in the future. For example, building factories or buying machinery. This doesn’t refer to investment in financial instruments such as shares.

  • G = Government spending: spending on state-provided goods and services including public goods and merit goods.

  • X = Exports: sale of domestically produced goods and services abroad.

  • M = Imports: purchase of foreign-produced goods and services.

Modeling the economy’s national income using aggregate demand and its components helps economists comprehend the economy in its entirety. It also allows them to analyse the factors that can influence the well-being of an economy by exploring every component individually. A number of factors can influence all of these components known as the determinants of aggregate demand. You will explore those in more detail in the Aggregate Demand explanation.

We can define aggregate supply as:

  • A measure of the volume of goods and services produced in the economy at a given price level.
  • The total amount that producers in an economy are willing and able to supply at a given price level.

Aggregate supply represents the economy’s ability to deliver goods and services within a specific time frame: either in the short run or in the long run. The short run is typically a period within a year, whereas the long run is a period ranging from more than one year to infinity. However, the time scale varies in different scenarios.

Time is an important factor because producers need it to adjust to changes in the economy: some changes can’t be implemented straight away or take time to come into effect.

Much like the aggregate demand, aggregate supply also has factors that affect it, which are also called the determinants of aggregate supply. You will explore those in more detail in the Aggregate Supply explanation.

Economists use diagrams to portray relationships between different variables. Figure 1 below, for example, demonstrates the changes in the macroeconomic equilibrium as a result of the shifts in the aggregate demand (AD) curve along the long-run aggregate supply (LRAS) curve. It also shows the relationship between the price level and the real output in the economy.

The macroeconomic equilibrium diagram is similar to the microeconomic equilibrium. as it has a price level on the y-axis and real output or GDP on the x-axis.

Macroeconomics AD-AS Model StudySmarterFigure 1. AD-AS Model - StudySmarter Originals.

In other StudySmarter explanations, you will learn how to sketch the aggregate demand and aggregate supply curves to depict the macroeconomic equilibrium. You will also find out how the determinants of aggregate demand and aggregate supply affect the curves causing them to shift.

Circular flow of income

The circular flow of income model helps economists understand how money, goods, and services move around the economy through exchange between macroeconomic agents.

The circular flow of income model shows how money travels in the economy through spending and income. It distinguishes between injections and leakages.

Injections are the additions of extra spending into the circular flow of income, such as investment, exports, and government spending. Injections usually increase aggregate demand.

Leakages are withdrawals of possible spending in form of savings, imports, and taxes. Leakages usually decrease aggregate demand.

In the article dedicated to the Circular Flow of Income Model, you will explore the injections and leakages in the economy using a variety of diagrams. You will also learn how the flow links with the macroeconomic equilibrium in the AD-AS model, and the influence of the so-called multiplier effect on the magnitude of changes to the equilibrium. Finally, you will inspect the difference between the flow of money around the open and closed economy.

Macroeconomic policy

The objective of most governments’ macroeconomic policy is to provide an economic environment that promotes sustainable economic growth and that improves the standard of living in the country.

We can divide macroeconomic policy into four main areas:

  • Fiscal policy.

  • Monetary policy.

  • Supply-side policies.

  • Participation in the international economy.

Every government has to look at different areas of the economy to assess if their macroeconomic policy is successful. These areas include economic indicators like economic growth, prices, unemployment levels, and the quality of public services or the environment. Table 1 below shows those areas along with an explanation about their assessment.

Areas within economiesWhat do we assess?
GrowthHow successful has the economy been in achieving economic growth in the short term? Is the economy laying the foundations for expanding its productive capacity in the future?
PricesHow high is inflation? Are price increases under control creating the conditions for price stability?
JobsHow high is unemployment? Are more people finding work in the jobs that they are suited to and which pay a living wage? Is the economy creating enough new jobs for people entering the labour market each year?
TradeIs the economy performing well in trading goods and services with other countries? Is the economy exporting enough to pay for the imported products? Is the economy achieving an equilibrium on its balance of payments?
Public servicesDo the benefits of growth translate into greater and improved provision of key public services such as education, healthcare, and transport? Is the economy in budget deficit or budget surplus?
Economic stabilityIs the economy stable? Is there uncertainty about the future? Have there been economic shocks?
Distribution of income and wealth
Is the distribution of income in the economy fair? What are the levels of poverty?
The environmentWhat is the impact of growth on the environment? Is it sustainable?

Table 1. Assessing macroeconomic performance.

For every area mentioned above, the government designs macroeconomic objectives that are achieved through macroeconomic policies. However, achieving these objectives comes at a cost as there are trade-offs between them. The government needs to balance the attainment of these objectives in the short and long run. To do so, it needs to have a clear idea of how the economy is currently performing.

Economic performance

Economic performance measures how well a country is doing in achieving some of the objectives set out by the government policy.

The key economic performance objectives include:

  • Stable economic growth.
  • Low and stable inflation.
  • High employment.
  • A healthy balance of payments.

You will study these in-depth in the explanation dedicated to Economic Performance.

Typically, economists look at the level of economic growth, inflation, unemployment, and the balance of payments. They measure these using numerical indicators. Here are some examples of the data commonly used to measure the performance of an economy:

  • Real GDP and GDP per capita.

  • Inflation indices such as the Consumer Price Index.

  • Measures of unemployment such as the Claimant Count.

  • The value of the current, capital, and financial accounts on the balance of payments.

You can explore those extensively in the Macroeconomic Performance Indicators explanation.

The government has three key policy types at its disposal to achieve the targets: fiscal, monetary, and supply-side policies. Fiscal and monetary policies are designed to affect aggregate demand, whilst supply-side policies aim to stimulate aggregate supply.

Fiscal policy

Fiscal policy concerns the government’s decisions about its spending, taxation, and borrowing.

Apart from achieving the main performance indicator targets, fiscal policy is also used to carry out the following objectives:

  • To achieve a more desirable distribution of income and wealth. In other words, to reduce inequality through an appropriate tax system and spending on public services.

  • To correct market failure at the microeconomic level. In other words, to encourage the provision of merit and public goods and discourage the consumption of demerit goods.

You will find out more about the types of fiscal policy, its features, and the nature of the government budget in the Fiscal Policy explanation. With it, you will evaluate the extent to which fiscal policy is effective in achieving performance targets.

Monetary policy

Monetary policy concerns the government’s manipulation of monetary variables like the rate of interest, the money supply, and the exchange rate.

Here are a few brief examples of its possible impact on the economy:

  • The government can stimulate exports and regulate imports by manipulating its currency, which improves the balance of payments.
  • If the Bank of England aims to reduce the inflation rate, it could restrict the growth of money supply by reducing the number of notes it prints. It could also discourage commercial banks lending by raising the interest rate.

In the Monetary Policy explanation, you will find more details about the policy, its objectives, instruments, and types. You will also explore the role of the central banks and the financial markets in the economy’s working. Finally, you will discuss the effectiveness of monetary policy in achieving government performance objectives.

Supply-side policy

Supply-side policies stem from the revival of free-market ideology in the late twentieth century. Arthur Laffer, the founding father of supply-side economics, wrote in 1983:

Supply-side economics provides a framework of analysis, which relies on personal and private incentives. When incentives change, people’s behavior changes in response. People are attracted towards positive incentives and repelled by the negative. The role of government in such a framework is carried out by the ability of the government to alter incentives and thereby affect societys’ behavior.

Supply-side policy aims at increasing aggregate supply in the long run by boosting the economy’s efficiency and productivity.

In times of rapid technological changes, underskilled workers are likely to lose their jobs due to the shifts in the way the economy works. For example, when there is a shift from an industrial to a knowledge-based economy. However, if the government improves education opportunities by providing upskilling courses, it incentivises more workers to come back into employment.

If successful, supply-side policy increases the economy’s productive potential, thereby reducing inflation, curtailing structural unemployment, and improving the country’s trade position. It could also indirectly lower firms’ costs of production by increasing the efficiency of labour and product markets.

Fiscal, monetary, and supply-side policies help the government to regulate domestic economic performance. However, participation in the international economy on a global scale also helps move the domestic economy forward.

Participation in the international economy

Except for a few exceptions, economies do not exist in isolation. They participate in the international economy through the exchange of goods and services. Participation in the global market can be beneficial for a country’s economy and therefore it is an important part of a government’s macroeconomic policy. The key concept to understand why and how economies interact with each other is specialisation.

Specialisation occurs when a country focuses on producing a narrow range of goods or services to increase its efficiency.

Specialisation allows producing goods and services at a lower opportunity cost, which leads to an advantage over trading partners. This advantage is called comparative advantage and is usually explained together with absolute advantage. It allows countries to produce more or better products thanks to access to natural resources, lower labour costs, or highly developed skilled workers.

From the perspective of macroeconomic policy, governments can either support the free exchange of goods (free trade) or decide to control it through barriers to trade. They can impose high taxes (tariffs) or limit an imported good’s quantity (quotas). This kind of policy is called protectionism because it aims to protect domestic producers from competition from abroad. Protectionism doesn’t always work as you can see in the example below.

During the Great Depression, the US Government decided to raise the already high tariffs on imported goods through the Smoot-Hawley Tariff Act from 40% to 50%. The intention was to protect US farmers from cheaper goods imported from Europe. Unfortunately, the Act had the opposite effect. It increased the food prices in the US and the retaliation of other countries led to a decrease in the global trade of 65%. The consequences of this Act are still discussed today and some economists, controversially, blame it for contributing to the start of the Second World War.

Since the Second World War, politicians have favoured the free trade approach. Since then, several international institutions have been founded to lower trade barriers between countries. The most prominent example is the Agreement on Tariffs (GATT), later replaced by the World Trade Organisation (WTO). This trend in international economics led to speeding up the process of globalisation.

Globalisation is the process of increased integration between people, companies, and governments worldwide. It can be attributed to the spread of cultural exchanges, the growth of the Internet, travel, and most importantly, economic exchange.

Some countries choose to cooperate even closer and they sign intergovernmental agreements that reduce to a minimum or eliminate barriers of trade entirely. These agreements are called trading blocs. Currently, the biggest trading bloc is called Regional Comprehensive Economic Partnership (RCEP) and was signed in 2020 by 15 countries in the Asia-Pacific region. It accounts for around 30% of the global GDP and topped the previous biggest trading blocs: the European Union (EU) and North American Free Trade Agreement (NAFTA).

As you can see, macroeconomics is a very interesting subject that will help you understand and explain many of the existing world’s problems: from unemployment in the domestic economy to global income inequality. And maybe, one day, you will become a leader that will shape the world for the better!

Macroeconomics - Key takeaways

  • Macroeconomics is a branch of economics that deals with the structure, performance, behaviour, and decision-making of the whole, or aggregate, economy.
  • It is important to study macroeconomics because it helps us expand our capacity to assess the economic well-being from an individual to the whole country, to a global scale.
  • To understand how the national economy works, economists had to extend the theory of demand and supply to the macroeconomic scale by introducing the concepts of aggregate demand, aggregate supply, and macroeconomic equilibrium.
  • The circular flow of income model helps economists understand how money, goods, and services move around the economy through exchange between various macroeconomic agents.
  • The objective of most governments’ macroeconomic policy is to provide an economic environment that promotes sustainable economic growth and improves the country’s standard of living.
  • Economic performance measures how well a country is doing in achieving some of the objectives set out by the government policy.
  • Participation in the global market can be beneficial for a country’s economy and therefore it is an important part of a government’s macroeconomic policy.

Frequently Asked Questions about Macroeconomics

Macroeconomics is a branch of economics that deals with the structure, performance, behaviour, and decision-making of the whole, or aggregate, economy. 

The five macroeconomic objectives of the UK government are:

    • Stable economic growth

    • Low and stable inflation

    • High employment or low unemployment

    • Healthy balance of payments

    • Reduction of inequality

Arguably, the three major concerns of macroeconomics are the design of policies to:

    • Eradicate poverty

    • Achieve a uniform standard of living

    • Reduce income inequality

Macroeconomic aims or objectives are government set goals designed to achieve optimal economic performance. Some examples of the UK government objectives include stable growth, low and stable inflation, and low unemployment.

Final Macroeconomics Quiz

Question

What is macroeconomics?

Show answer

Answer

Macroeconomics is a branch of economics that deals with the structure, performance, behaviour, and decision-making of the whole, or aggregate, economy.

Show question

Question

Why is it important to study macroeconomics?

Show answer

Answer

It is important to study macroeconomics because it helps us expand our capacity to assess the economic well-being from an individual to the whole country, to a global scale.

Show question

Question

What does the aggregate demand and aggregate supply model explain?


Show answer

Answer

The aggregate demand and aggregate supply model explains the relationship between the price level and output in the economy.

Show question

Question

What is the circular flow of income model?


Show answer

Answer

The circular flow of income model helps economists understand how money, goods, and services move around the economy through exchange between various macroeconomic agents. 

Show question

Question

What is the general objective of macroeconomic policy?


Show answer

Answer

The general objective of most governments' macroeconomic policy is to provide an economic environment that promotes sustainable economic growth and improves the country’s standard of living.

Show question

Question

What is economic performance?


Show answer

Answer

Economic performance imeasures how well a country is doing in achieving some of the objectives set out by the government policy.

Show question

Question

Name two areas of macroeconomic policy.


Show answer

Answer

You can mention any of these four main areas:

    • Fiscal policy.

    • Monetary policy.

    • Supply-side policies.

    • Participation in international economy.

Show question

Question

What is fiscal policy?


Show answer

Answer

Fiscal policy concerns the decisions of the government about its spending, taxation, and borrowing. 

Show question

Question

What is monetary policy?


Show answer

Answer

Monetary policy is a type of policy used to achieve government objectives by manipulating the following monetary variables: the rate of interest, the money supply, and the exchange rate. 

Show question

Question

What is supply-side policy?

Show answer

Answer

Supply-side policy is aimed at increasing aggregate supply in the long-run by boosting economy's efficiency and productivity.

Show question

Question

What is specialisation?


Show answer

Answer

Specialisation occurs when a country focuses on the production of a narrow range of goods or services to increase its efficiency.

Show question

Question

What is globalisation?

Show answer

Answer

Globalisation is the process of increased integration between people, companies, and governments worldwide. It can be attributed to the spread of cultural exchange, the growth of the Internet, travel, and most importantly - economic exchange.

Show question

Question

Define net capital flow. 

Show answer

Answer

Net capital flow is the difference between the inward and outward flow of capital. 

Show question

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