Microeconomic Thinking and Macroeconomic Models

Microeconomics is the study of how households and firms make decisions and
how these decisionmakers interact in the marketplace.A central principle of microeconomics
is that households and firms optimize—they do the best they can
for themselves given their objectives and the constraints they face. In microeconomic
models, households choose their purchases to maximize their level of satisfaction,
which economists call utility, and firms make production decisions to
maximize their profits.
Because economy-wide events arise from the interaction of many households
and many firms, macroeconomics and microeconomics are inextricably linked.
When we study the economy as a whole,we must consider the decisions of individual
economic actors. For example, to understand what determines total consumer
spending, we must think about a family deciding how much to spend
today and how much to save for the future.To understand what determines total
investment spending, we must think about a firm deciding whether to build a
new factory. Because aggregate variables are the sum of the variables describing
many individual decisions, macroeconomic theory rests on a microeconomic
foundation.
Although microeconomic decisions always underlie economic models, in
many models the optimizing behavior of households and firms is implicit rather
than explicit.The model of the pizza market we discussed earlier is an example.
Households’ decisions about how much pizza to buy underlie the demand for
pizza, and pizzerias’ decisions about how much pizza to produce underlie the
supply of pizza. Presumably, households make their decisions to maximize utility,
and pizzerias make their decisions to maximize profit.Yet the model did not
focus on these microeconomic decisions; it left them in the background. Similarly,
in much of macroeconomics, the optimizing behavior of households and
firms is left implicit.

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What Macroeconomists Study

Why have some countries experienced rapid growth in incomes over the past century while others stay mired in poverty? Why do some countries have high rates of inflation while others maintain stable prices? Why do all countries experience recessions and depressions—recurrent periods of falling incomes and rising unemployment—and how can government policy reduce the frequency and severity of these episodes? Macroeconomics, the study of the economy as a whole, attempts to answer these and many related questions.
To appreciate the importance of macroeconomics, you need only read the newspaper or listen to the news. Every day you can see headlines such as INCOME GROWTH SLOWS, FED MOVES TO COMBAT INFLATION, or
STOCKS FALL AMID RECESSION FEARS.Although these macroeconomic
events may seem abstract, they touch all of our lives. Business executives forecasting
the demand for their products must guess how fast consumers’ incomes will
grow. Senior citizens living on fixed incomes wonder how fast prices will rise.
Recent college graduates looking for jobs hope that the economy will boom and
that firms will be hiring.
Because the state of the economy affects everyone,macroeconomic issues play
a central role in political debate.Voters are aware of how the economy is doing,
and they know that government policy can affect the economy in powerful
ways.As a result, the popularity of the incumbent president rises when the economy
is doing well and falls when it is doing poorly.
Macroeconomic issues are also at the center of world politics. In recent years,
Europe has moved toward a common currency, many Asian countries have experienced
financial turmoil and capital flight, and the United States has financed
large trade deficits by borrowing from abroad.When world leaders meet, these
topics are often high on their agendas.


Although the job of making economic policy falls to world leaders, the job of
explaining how the economy as a whole works falls to macroeconomists.Toward
this end, macroeconomists collect data on incomes, prices, unemployment, and
many other variables from different time periods and different countries. They
then attempt to formulate general theories that help to explain these data. Like
astronomers studying the evolution of stars or biologists studying the evolution
of species, macroeconomists cannot conduct controlled experiments. Instead,
they must make use of the data that history gives them. Macroeconomists observe
that economies differ from one another and that they change over time.
These observations provide both the motivation for developing macroeconomic
theories and the data for testing them.
To be sure, macroeconomics is a young and imperfect science. The macroeconomist’s
ability to predict the future course of economic events is no better
than the meteorologist’s ability to predict next month’s weather. But, as you will
see, macroeconomists do know quite a lot about how the economy works.This
knowledge is useful both for explaining economic events and for formulating
economic policy.
Every era has its own economic problems. In the 1970s, Presidents Richard
Nixon, Gerald Ford, and Jimmy Carter all wrestled in vain with a rising rate of
inflation. In the 1980s, inflation subsided, but Presidents Ronald Reagan and
George Bush presided over large federal budget deficits. In the 1990s, with President
Bill Clinton in the Oval Office, the budget deficit shrank and even turned
into a budget surplus, but federal taxes as a share of national income reached a
historic high. So it was no surprise that when President George W. Bush moved
into the White House in 2001, he put a tax cut high on his agenda. The basic
principles of macroeconomics do not change from decade to decade, but the
macroeconomist must apply these principles with flexibility and creativity to
meet changing circumstances.

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