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MACROECONOMICS
On September 29, 2008, the United States experienced one of the largest economic shocks in its history; the stock market plunged by over 777 points, wiping out over $1 trillion in stock value. The market continued to plummet over the following week, setting off a deep recession. Home prices fell, foreclosures rose, and unemployment soared. Toxic financial products flooded the international marketplace, pushing many of the world’s largest financial companies to the brink of bankruptcy.
Almost immediately, political leaders took action to limit the severity of the recession. They provided government funds to save large banks and connected institutions from default. They created a program to buy up the toxic assets that were dragging down the market. The Federal Reserve expanded the nation’s money supply to cover public debts and loosen credit markets. The president enacted a stimulus plan to get money to consumers in hopes of revitalizing the economy by increasing demand for goods and services.
Today, with the economy functioning but sluggish, U.S. politicians battle over the next course of action. Would another stimulus plan get consumers buying again? Should Congress pass a jobs bill to reduce unemployment? Would printing more money for debts help or cause out-of-control inflation? Could new trade agreements provide an answer to the nation’s economic woes?
Whatever the solution, all of these measures, both implemented and debated, involve macroeconomics. The prefix “macro-,” meaning “big,” in the word “macroeconomics” refers to how economists in this field analyze the structure and function of large-scale economies as a whole, whether regional, national or global. Macroeconomics examines the complex interplay between factors such as national income and savings, gross domestic product, gross national product, consumer and producer price indexes, consumption, unemployment, foreign trade, inflation, investment and international finance. Economists in this field seek to understand fluctuations in business cycles and the elements that contribute to long-term economic growth, which are vital to the creation of sound economic policies by governments and businesses.
The underpinnings of macroeconomic theory emerged in the early 1800s with the work of Swiss writer Jean Charles Léonard de Sismondi. Sismondi proposed that markets experienced natural economic fluctuations apart from those caused by external events, such as war. It was a radical theory at the time, but a major peacetime recession in 1825 proved it valid. Later, in 1860, French economist Clement Juglar took Sismondi’s idea further by identifying specific cycles occurring with fixed investments. These 7-to-11-year cycles became known as Juglar Cycles.
Soon other cycles were observed, such as the lag in feedback on business production (Kitchin Cycle), increased infrastructural investment resulting from demographic expansion (Kuznets wave) and prolonged periods of technological growth (Kondratiev wave). Around 1930, Austrian-American economist Joseph Schumpeter described the four stages of a business cycle: expansion, crisis, recession and recovery.
The concept of business cycles became the basis of macroeconomic theory established by British economist John Maynard Keynes in 1936. Keynes found that classical economics failed to explain prolonged unemployment and recessions, so he proposed examining the economy as a whole to find the answer. What he discovered was that businesses and individuals hoard cash during tough times, restricting the supply of cash available to satisfy demand through consumption. This causes a surplus of goods and labor and slows economic recovery.
Before, economists assumed that markets naturally tended toward satisfying demand, eventually resolving product surpluses and unemployment. Keynes did not only challenge such beliefs, he suggested that government intervention could be used to counteract disruptive economic fluctuations through deficit spending, reduced taxes, expansion of the money supply, lower interest rates and other monetary policies.
Unemployment is a major concern of macroeconomists, as it is detrimental to a country’s productivity and prosperity. While classical economists in Keynes’s day blamed unemployment on high labor costs, Keynes argued that chronic unemployment results from underconsumption – meaning that individuals and businesses are not spending enough to fuel demand for labor.
Keynes proposed that money moves in cycles: the payment for a product goes to pay the wages of an employee. In an economy burdened by underconsumption, businesses simply reduce production instead of lowering prices, giving consumers no incentive to buy, increasing unemployment further and causing recession through decreased national output. If prices remain high during recession, then workers have little incentive to settle for reduced wages since they would still lack the purchasing power needed to jump-start demand. Keynes believed the government could counteract underconsumption, prevent recession and encourage rapid economic growth by getting more money into the hands of consumers when markets failed to adequately redistribute wealth.
Keynes’s theory was revolutionary not just because it offered a more valid explanation of why recessions and unemployment occur, but also because it suggested that such events could be controlled through strategic monetary policy. Economists who supported traditional laissez-faire capitalism found Keynes’s notion of policy-driven economic growth distasteful, to say the least. Nevertheless, Keynesian macroeconomics rose to become the dominant economic theory among capitalist nations for nearly 40 years, especially in the U.S. It was most famously used during World War II to keep unemployment at historically low levels. Macroeconomics also led to the creation of the International Monetary Fund and the World Bank in the 1940s.
In 1956, U.S. economist Milton Friedman modified macroeconomic theory to include an equilibrium approach to regulating the money supply, citing Keynes’s disregard for inflation caused by printing too much money. Then, in the 1970s, Keynesian macroeconomics was largely abandoned when it failed to prevent stagflation. It was replaced by supply-side macroeconomics, which seeks to augment demand by cutting taxes, reducing regulations on businesses and lowering prices through increased production. With the recent global economic crisis, however, Keynesian macroeconomics is experiencing resurgence in popularity.
Modern macroeconomic theory has enjoyed some success in the past, though exactly how much remains the subject of much debate. Critics of macroeconomic policies say that government intervention in markets exacerbates, rather than corrects, economic fluctuations through unforeseen consequences. Some point out that Keynesian macroeconomics assumes irrational behavior from economic actors, putting itself in direct conflict with microeconomic theory. Others claim that macroeconomic policies have little effect on market performance.
Of course, macroeconomics is not just employed at the federal level. Banks, industries and local governments look to macroeconomists for data to guide their economic activities. For instance, central bankers, who are responsible for controlling inflation, rely heavily on macroeconomic analyses to determine whether to release more currency into the marketplace or remove some of it. Industries or businesses struggling to find skilled employees likewise turn to macroeconomists to solve the problem.
Macroeconomists perform analyses by constructing models to simulate or predict market behavior. Such models are usually mathematical in nature, but they can also be logical or computational. Generally, models show the relationship between various economic components, such as a country’s exchange rate, interest rate and output, or inflation and unemployment. Economists may draw diagrams based on models to illustrate market dynamics or the flow of money in an economy. Such aids can be useful for those who create and modify monetary policies.
However, macroeconomic models are far from infallible. Models that only examine a few aspects of an economy when testing the potential effects of a new monetary policy may be excluding dozens of mitigating factors. Random, irrational behavior that seems insignificant at the microeconomic stage may be highly magnified at the national or global scene. Though macroeconomics is largely an extension of microeconomic activity, the aggregation of microeconomic forces creates an ‘other-worldly’ level of complexity that’s tough for even brilliant economists to untangle. Inventing a macroeconomic model that takes all economic factors into account would be impossible.
Where macroeconomics fails at predicting future economic outcomes, though, it often does quite well at describing past and current market situations. It has, for example, been particularly useful in helping U.S. leaders and historians understand the factors that contributed to the start and severity of the Great Depression in the 1930s. It has also been used to create strategies to deal with chronic unemployment and increase GDP. Despite the controversy surrounding macroeconomic policies, they likely won’t be abandoned anytime soon.
(http://en.wikipedia.org/wiki/Macroeconomics)
MICROECONOMICS
Meet Employees A, B and C. A year ago, they were hired at the same wage to work for XYZ Electronics. They typically work about 50 hours a week, and all are due for a raise. Employee A receives a 5 percent wage increase and immediately feels energized by the boost in pay. He decides to commit an additional 10 hours a week to the company to increase his income even further. Employee B receives the same raise, but decides her original 50-hour workweek suits her just fine. She’ll make more money for the same work. For Employee C, however, the pay raise means he won’t have to work as many hours to make his starting income, which is adequate to pay his bills. Therefore, he opts to work only 45 hours a week.
How will the decisions of Employees A, B and C affect the company? Cost-wise, who is the most desirable employee for the company? Do the cost savings offered by Employee C’s reduced hours outweigh the potential profit generated by Employee A’s additional work, or vice-versa? Why is Employee A motivated to work more hours, but Employee C is motivated to work fewer? How will this affect their purchasing power as consumers?
Microeconomics seeks to answer questions such as these. The prefix “micro-,” meaning “small,” in the word “microeconomics” refers to the basic, small-scale economic behaviors and decisions that economists in this field study. Microeconomics examines the impact that economic choices made by individuals, businesses and industries have on resource allocation and the supply and demand of goods and services in market economies. Because supply and demand determine the price of goods and services, microeconomics also studies how prices factor into economic decisions, and how those decisions, in turn, affect prices.
Microeconomics emerged as a branch of study when economists began analyzing consumer decision-making processes and their economic outcomes in the early 18th century. The first in-depth explanation of consumer thought came from a Swiss mathematician named Nicholas Bernoulli, who laid the groundwork for microeconomic theory by suggesting that consumer choices are always rational. However, it wasn’t until the late 19th century, when London economist Alfred Marshall proposed examining individual markets and firms as a way to understand the broader economy, that microeconomics became formally established as a field of study.
In the mid 20th century, other economists rose up to modify the theories proposed by Bernoulli and Marshall. Although Marshall first described the concept of utility, or the satisfaction a consumer receives from a purchased product or service, economists John von Neumann and Oskar Morgenstern are credited with introducing modern utility theory, based on Marshall’s work, in 1944.
It’s the concept of market failure, however, that really defined microeconomics in the mid 20th century. Market failure, a term coined in 1958, refers to when markets operate in ways that prevent resources from being allocated in the most efficient manner. Today, micro economists are primarily concerned with analyzing market failure and suggesting ways to correct or prevent it, often through public policy or government intervention.
Monopoly power is one such market failure. Monopolies can form in several ways. A natural monopoly occurs when one business produces a good at a far cheaper cost than its competitors, causing them to go out of business. In an oligopoly, a few businesses that dominate a particular industry may get together and set prices and competition rules for that industry. A strong business may monopolize by buying up industry resources or controlling means of production and shut competitors out of the market by denying them access. Some governments may simply grant monopoly rights to certain businesses.
Micro economists see monopolies and other market failures as undesirable and highly inefficient ways to allocate resources in an economy. For instance, a monopoly can choose to charge a higher-than-market-value price for its product because no competition exists that can force it to do otherwise. Consumers who are charged an unfair price are unable to maximize their utility and satisfy demand, either because the product is too expensive for most to afford, or consumers must forgo purchasing other products. If the monopoly’s product is a necessary one, like water or gasoline, consumers may be forced to negatively alter their spending habits to buy it, putting strain on other areas of the economy. Furthermore, a business that has a monopoly on a limited resource may misuse or deplete the resource, damaging both the environment and the economy. Other kinds of market failure include information asymmetry, missing markets and externalities.
Micro economists believe supply and demand can only be balanced through perfect competition, where no one individual or entity possesses the power to influence the price of a particular good or service. In a perfectly competitive economy, the complete cost of a product is factored into its price, and the product is sold for maximum profit based on its demand. In theory, perfect competition maximizes both consumer utility and company profits while ensuring resources are used in the most efficient manner. Since micro economists generally aren’t concerned with promoting any sort of political philosophy, they tend to recommend whatever they think will most likely achieve perfect competition. Suggestions may range from anti-trust and right-to-know laws to government-created markets and social welfare expansion.
Unfortunately, such recommendations are rarely foolproof. Because economics involves many complex interactions between various market forces, accurately predicting the outcome of an economic policy is tricky at best, impossible at worst. For example, expanding social welfare may create a safety net that protects workers from economic hard times and promotes upward mobility. The result is a wealthier population that will drive economic growth. However, the same welfare expansion may give some workers an incentive to stop working, which will reduce the government’s income tax revenue and slow economic growth.
Of course, the outcome may not be simply either/or. When offered welfare benefits, some people find incentive to work harder, while others find incentive to work less. The micro economist’s task is to propose solutions to market failures that will result in the best possible outcomes despite unintended consequences.
To determine the best policies, micro economists attempt to predict how people will respond to the incentives, or disincentives, such policies will create. For example, an economist sees that a paper company has been clear-cutting too many trees in one area to make paper. For the company, cutting a large number of trees makes sense because it can produce its product quickly at a cheap price that consumers love. However, the economist estimates that if the unrestrained cutting continues, the trees will disappear and the company will go out of business within five years, leaving hundreds of workers unemployed. Construction prices in the area will also skyrocket due to lumber scarcity, and tourism will decline from the destruction of the land’s natural beauty. To prevent these outcomes, the economist suggests the local government should regulate the number of trees that can be harvested at one time.
However, the new regulation means the company won’t be able to produce paper as quickly or cheaply as before, causing its product price to rise. The rise in price means some consumers may not be able to afford the product, or they may choose to buy from another supplier, shrinking the company’s profits. If the company finds the regulation too punitive, it may choose to relocate to another state, resulting in the local unemployment the economist was trying to avoid. The economist can prevent such an outcome by recommending the government provide the company with an incentive to support the regulation, like a tax break.
Of course, such an incentive may not even be necessary. Consumers may happily pay the higher prices and even increase their patronage because they see the company treating the environment responsibly. The company may discover that sticking to cutting quotas protects it from fluctuations in resource availability, leading to greater price stability and steadier profits over time. These outcomes may not become obvious until after the regulation is implemented.
Micro economists also examine opportunity cost when evaluating consumer and corporate behavior. Opportunity cost refers to the next best alternative a consumer or company passes up to purchase or produces a product. In other words, buying or producing one thing is done at the expense of buying or producing something else. A consumer who chooses to rent an apartment over buying a house, for instance, misses out on building equity and taking advantage of the homeowners’ tax credit provided by the government. Likewise, a homeowner must provide maintenance for his property’s upkeep, while a renter usually does not.
Examining opportunity costs reveals much about what people value, which guides micro economists in making policy recommendations. The tricky part comes when such costs involve items whose monetary value is unclear. For instance, some people value preserving the integrity of an Alaskan wildlife refuge over drilling for oil that could be used to lower gasoline prices. Economists must work to establish the refuge’s value so it can be accurately compared to the cost benefit of drilling for oil. Cost-benefit analyses play a major role in microeconomics.
For micro economists, however, economic behavior always comes back to one concept: utility. Consumers purchase products to increase their satisfaction, and businesses produce to maximize their profits. It’s utility that drives demand and keeps prices reasonable through market competition. Utility can be used to explain why a consumer chooses to take a tropical vacation over enrolling in college, or why a business chooses to make children’s toys instead of rifle ammunition. The benefit of such a theory is that it’s simple to understand and apply. Indeed, microeconomics provides the foundation for nearly all economic theory and has applications in the fields of health, law, psychology, history, urban development, politics and sociology.
(http://en.wikipedia.org/wiki/Microeconomics)