Where Macroeconomics Meets Microeconomics - dummies

Where Macroeconomics Meets Microeconomics

By Daniel Richards, Manzur Rashid, Peter Antonioni

Economics is often split into microeconomics and macroeconomics. Microeconomics is the study of individual and firm behavior, and macroeconomics is the study of the economy as a whole. Decades ago they were very different fields with different ways of doing things:

  • Microeconomics stressed the importance of modeling individuals and firms as optimizing agents. This means that when people and companies make choices, they consider all possible options and then choose the one they prefer most. Economists say that individuals maximize their utility and firms maximize their profits.
  • Macroeconomics often uses models that are less rooted in strict optimizing behavior. The reason, in part, is that the outcome of an aggregate variable such as aggregate consumer spending across all households or aggregate investment spending across all firms is not the outcome of one optimizing consumer or business person, but many. Unless all households and businesses are the same — what macroeconomists call a representative agent — the aggregate behavior may be hard to derive as the result of a strict optimization exercise. So, macroeconomists have often used models that seemed reasonable if not formally optimal and that seemed to capture the basic features of the economy.

This modeling approach, though, runs the danger that one will just adjust the model in a “reasonable” way every time the model mispredicts. As a result, this approach can seem a bit ad hoc. Not happy with this situation, many economists felt that because the economy is made up of millions of interactions between individuals and firms, macroeconomic models should have as their building blocks microeconomic foundations — so macroeconomic models (explicitly or implicitly) should have optimizing agents within them. In short, most economists now feel that good macroeconomics should be based on sound so-called microfoundations.