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MICRO versus MACRO Economics

Economics is defined as the study of how humans work together to convert limited resources
into goods and services to satisfy their wants (unlimited) and how they distribute the same
among themselves. In economics, the major assumption is that resources are limited but
demands or needs are unlimited. The challenge lies in distributing limited resources in a way
that maximizes satisfaction and needs of everyone.

BASIS MICRO ECONOMICS MACRO ECONOMICS

Meaning The branch of The branch of
economics economics
that studies the behavior of that studies the behavior of
an individual consumer, firm, the whole economy, (both
family is known as national and international) is
Microeconomics known as Macroeconomics

Scope Covers various issues Covers various issues

like like,
demand, supply, product national income, general
pricing, factor pricing, price level, distribution,
production, consumption, employment, money etc
economic welfare, etc

Importance Helpful in determining the Maintains stability in the

prices of a product along general price level and
with the prices of factors resolves the major

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of production (land, problems of the economy like

labor, capital, inflation, deflation, reflation,
entrepreneur etc.) unemployment and poverty as
within the economy a whole

Equilibrium Microeconomics works In Macroeconomics, the

on
the principle that economy may be in a state
markets
soon create Equilibrium. Of equilibrium/
For a long time, it was disequilibrium for a longer
Assumed that Period (boom or
Macroeconomics also recession)
performed similarly and
Always returned to
equilibrium. Before
1930s,
there was no separate
Branch of
Macroeconomics.

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Macroeconomics as a separate branch:

Macroeconomics, as a separate branch of economics, emerged after the John Maynard

Keynes published his celebrated book “The general theory of employment, interest and
money” in 1936.

Before Keynes, it was assumed that all laborers willing to work would find work and all
factories would run at full capacity. This thought was called as “classical thought”.

Following The Great Depression in 1929, countries in the west faced huge unemployment
and fall in output. There was fall in demand for goods and services, which led to fall in
output and resulting unemployment due to idle factories. J M Keynes studied this
phenomenon by analyzing the economy as a whole for the first time and thus
macroeconomics as a field of study was born. (EXPLAINED IN THE VIDEO)

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Contribution of Keynes:

Prior to Keynesian economics, classical economic thinking held that cyclical swings in
employment and economic output would be modest and self-adjusting. According to this
classical theory, if aggregate demand in the economy fell, the resulting weakness in
production and jobs would precipitate a decline in prices and wages. A lower level of
inflation and wages would induce employers to make capital investments and employ more
people, stimulating employment and restoring economic growth.

The depth and severity of the Great Depression, however, severely tested this hypothesis.
Keynes brought out that structural rigidities and certain characteristics of market economies
would increase economic weakness and cause aggregate demand to plunge further.

For example, Keynesian economics refutes the notion held by some economists that lower

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wages can restore full employment, by arguing that employers will not add employees to
produce goods that cannot be sold because demand is weak. Similarly, poor business
conditions may cause companies to reduce capital investment, rather than take advantage of
lower prices to invest in new plant and equipment; this would also have the effect of reducing
overall expenditures and employment.

Keynes thus advocated increased government expenditures and lower taxes to stimulate
demand and pull the global economy out of the Depression. Subsequently, the term
“Keynesian economics” was used to refer to the concept that optimal economic performance
could be achieved – and economic slumps prevented – by influencing aggregate
demand through activist stabilization and economic intervention policies by the government.
Keynesian economics is considered to be a “demand-side” theory that focuses on changes in
the economy over the short run by government intervention in stimulating demand.

Causes/ Reasons for The Great Depression: (EXPLAINED THOROUGHLY IN THE VIDEO)

Current theories may be broadly classified into two main points of view:

First, there are demand-driven theories, from Keynesian and institutional economists who
argue that the depression was caused by a widespread loss of confidence that led to under
consumption.

The demand-driven theories argue that the financial crisis following the 1929 crash led to a
sudden and persistent reduction in consumption and investment spending. Once panic and
deflation set in, many people believed they could avoid further losses by keeping clear of the
markets. Holding money therefore became profitable as prices dropped lower and a given
amount of money bought ever more goods, exacerbating the drop in demand.

Second, there are the monetarists, who believe that the Great Depression started as an
ordinary recession, but that significant policy mistakes by monetary authorities (especially the
Federal Reserve) caused a shrinking of the money supply which greatly exacerbated the
economic situation, causing a recession to descend into the Great Depression. Related to

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this explanation are those who point to debt deflation “causing those who borrow to owe
ever more in real terms”.

In reality, it was a combination of above reasons that resulted in the great depression of
1929. In simple terms, the causes were:

1. High Income Inequality- Companies made record profits in 1920s. markets expanded
fast and widely. While profits soared, wages or workers increased only incrementally.
This widened the distribution of wealth. The richest 1 percent of americans owned
one-third of total wealth. The result of income inequality was that large volume of
money was saved by the rich rather than investing back into the economy. Fair
distribution to the middle class would have made the economy more sustainable and
stronger.

2. Stretched debt capacities of the middle class- In 1920s, consumption soared with high
economic growth in America. However, this consumption was based on high debt
levels of middle class rather than higher income levels. The middle class bought more
without having enough money to buy consumables by taking high debt. With stock
market crash and panic in the economy, consumption levels fell further resulting in a
fall in aggregate demand for goods and services in the economy.

3. Fundamental reasons- there was no guarantee on bank deposits. In tough times,

people started taking out their money from banks due to lack of trust.

4. Lack of money supply- As the recession set in, the federal bank decided not to supply
money to the economy. This worsened the situation as lack of money supply increased
value of money and people started hoarding cash rather than investing money
(deflation causes an increase in value of money in the future). This caused a
contraction in production and employment, resulting into a depression. Due to Fed’s
policy, there were widespread bank runs and bank failures in US economy.

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Basics of national income accounting

In order to understand level of production, investment and growth of a country and the
world as a whole, we need to understand basic terms of macroeconomics:

1. Final goods and Intermediate goods- Every good passes through various levels to
arrive at the final level of consumption. For example, wheat is planted by a farmer and
sold to bread maker who makes bread out of it. The bread maker then sells the bread
to a distributor who packs and transports the bread to the market for final
consumption by the consumer. The bread at different stages will be called an
intermediate good but when the consumer consumes this bread finally, it becomes a
final good and the economic value of bread at that level is important for an economy.
If the bread is purchased by a restaurant for making food for customers, the final
economic value of bread changes to what is being paid by the customer in the
restaurant. In the process of calculating GDP, the value of only final economic good is
to be considered for calculation.

2. Consumption and capital goods- goods like food, clothing, private transport and
services like recreation that are consumed when purchased by the ultimate
consumers are called consumption goods or consumer goods. Consumption goods
that last longer (a car, a bike, a TV) are called consumer durables. On the other hand,
goods or services that are purchased for further production like machines purchased
by an entrepreneur for making textiles or computers purchased by an IT company for
creating softwares are called capital goods. Capital goods form an important backbone
of production processes in an economy and they result in value addition and money
multiplication because they are not just consumed but help in further production. The
importance of consumption versus capital goods will be highlighted when we talk
about “History of Indian Planning”.

3. Gross and net investment- we have just talked about “capital goods”. Final output of
capital goods in an economy in a year is called gross investment because these goods
are used as investments to produce further (intermediate or final) goods. For example,
machines purchased to produce cars in a factory are capital goods meant for
producing Cars (which can be intermediate or final goods). These machines are
investments by the owner/ entrepreneur in his enterprise. Therefore, they are also
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called as gross investments. Capital goods last multiple accounting years and require
regular maintenance for satisfactory performance. The part of capital goods
production that is meant for maintenance of existing capital goods is deducted from
gross investments to arrive at net investments. The deduction is termed as
“depreciation”.

Net Investment = Gross Investment – Depreciation

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Circular flow of income

Four kinds of contributions can be made during production of goods and services by factors
of production. Four kinds of remunerations are received by these factors: (EXPLAINED IN
THE VIDEOS)

• Land- remuneration received in terms of rent

• Labor- remuneration received in terms of wage

• Capital- remuneration received in terms of Interest

• Entrepreneurship- remuneration received in terms of profit

In a simple economy, after a good or service is produced, it is assumed that it is consumed

entirely by households. There are no savings, no taxation and no purchase of imported goods.

Similarly, the amount of remuneration paid to 4 factors of production by businesses is equal

to consumption expenditure by households that industries receive as sales revenue.

In circular flow of income, there are a total of 4 flows, out of which 3 become important in
our future understanding of calculating national income.

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• Individuals provide factor services/ labor for which they get income/ factor payments
from businesses.

• Individuals spend this income by purchasing goods and services produced by the
businesses. So goods are provided to individuals in return for expenditure by these
households.

Since the same amount of money, representing aggregate value of goods and services is
moving in a circular way, if we want to estimate the aggregate value of goods and services
produced during a year, we can measure it by 3 methods-

1. Aggregate value of expenditure by households (CALLED EXPENDITURE METHOD)

2. Aggregate value of goods and services provided by businesses and (CALLED PRODUCT
METHOD/ VALUE ADDED METHOD)

3. Aggregate value of factor payments/ income to households (CALLED INCOME

METHOD)

Now, let us calculate national income/ aggregate value of goods and services through these
3 methods:

1. Value Added Method/ Product Method:

In value added method, we calculate the aggregate annual value of goods and services
produced. It is called value added method because only the additional value of a product is
added to find its final value in total production in the economy. For example, there is a farmer
producing wheat. He makes wheat worth Rs 100, out of which wheat worth Rs 50 is provided
to a bread maker who produces bread out of wheat. The rest Rs 50 wheat is consumed directly
by the consumer. The bread maker sells bread worth Rs 200.

According to value added method, total product value of wheat and bread combined will be:

Farmer Baker

Total production 100 200

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Intermediate goods used 0 50

Value added 100 150

Total value added will be 100 + 150 = Rs. 250

The value added in an economy is measured/ calculated using the same fundamental
method as used above.

As we saw, to calculate value added, we reduce value of intermediate goods from final goods
so that there is no double counting. If this method is not followed, the total value of product
would be 100 + 200 = 300. The value of wheat worth Rs 50 is calculated twice in such a
scenario. In order to avoid such double counting, we rely on value added method to find out
gross value added in an economy.

Therefore, we can write-

Gross value added of a firm = gross value of output produced by the firm – value of
intermediate goods used by the firm

Net value added of the firm = gross value added – depreciation of the firm/ consumption of
fixed capital

To calculate Gross Domestic Product (GDP), we make sum total of gross value added of all
the firms in the economy.

So, GDP = GVA1 + GVA2 + GVA3.....+ GVAn

2. Expenditure Method:

An alternative way to calculate GDP is by looking at the demand side of the products. This
method is referred to as expenditure method.

In expenditure method, we calculate the final expenditure made by households to purchase

different products. We do not consider intermediate expenditure by businesses to produce
further products. For example, according to previous example, expenditure of 50 by baker

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on purchasing wheat from the farmer will not be considered because it is not final
expenditure by the baker.

In expenditure method, the following expenditures are included to calculate final GDP.

a) Consumption expenditure for final consumption

b) Investment expenditure on capital goods for producing further goods or services

c) Expenditure made by government on final goods and services

d) Export revenues by selling goods abroad

Therefore, total value of revenues of a firm according to expenditure method (RV) = C + I +

G+X

As we are taking exports in this case, we will also consider imports by households,
government and businesses (Investment)

Therefore, RV = C – Cimport + I – Iimport + G – Gimport + X

RV = C + I + G + (Exports – Imports)

RV = C + I + G + (X - M)

GDP = sum of revenues of all firms in the economy = expenditures by households, firms and
government in the economy

3. Income Method:

Income method uses aggregate income of all households in an economy to find out GDP.
Aggregate income of households includes income from wages, rent, entrepreneurship
(profits) and interest from capital investment.

GDP = W + P + In + R

Considering expenditure and income method together, we get

GDP = C + I + G + X-M = W + P + In + R

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There are only three major ways in which households can spend their Incomes i.e.
consumption, savings and taxes

Since total spending is supposed to be equal to total income,

GDP = C + S + T

Now if we compare expenditure method with income method again, we will get

GDP = C + I + G + X-M = C + S + T

Rewriting it, we get

(I – S) + (G – T) = M – X

The above equation means that

I – S is excess of investment over saving in an economy,

G – T is excess of government expenditure over tax revenues. This can also be stated as
budget deficit

M – X is excess of imports over exports. This can also be stated as Trade Deficit

Further, we had assumed in the starting of this chapter of circular flow of income that
there is no government, no foreign trade. We assumed that there is only households and
businesses. Keeping that in mind now, we get

G=T=M=X=0

Therefore, S = I

This means that savings will be equal to investments in a simple economy.

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