No Such Thing as a Free Lunch: Principles of Economics (Part 96)

“The General Theory (The General Theory of Employment, Interest and Money by John Maynard Keynes) was not truly revolutionary at all but merely old and oft-refuted mercantilist and inflationist fallacies dressed up in shiny new garb, replete with newly constructed and largely incomprehensible jargon.”

― Murray N. Rothbard, Keynes The Man

Introduction to Macroeconomics (Part E)

by

Charles Lamson

The Methodology of Macroeconomics

Macroeconomists build models based on theories, and they test their models using data. In this sense, the methodology of macroeconomics is similar to the methodology of microeconomics.

The Connection to Microeconomics

How do macroeconomists try to explain aggregate behavior? One way assumes that the same factors that affect individual behavior also affect aggregate behavior. For example, we know from microeconomics that an individual's wage rate should affect her consumption habits and the amount of labor she is willing to supply. If we were to apply this microeconomic hypothesis to the aggregate data, we would say that the average wage rate in the economy should affect total consumption and total labor supply (which seems to be true).

The reason for looking to microeconomics for help in explaining macroeconomic events is simple:

Consider unemployment. The unemployment rate is the number of people unemployed as a fraction of the labor force. To be classified as "in the labor force," a person must either have a job or be seeking one actively. To understand aggregate unemployment, we need to understand individual household behavior in the labor market. Why do people choose to enter the labor force? Under what circumstances will they drop out?  Why does unemployment exist even when the economy seems to be doing very well? A knowledge of microeconomic behavior is the logical starting point for macroeconomic analysis.

Aggregate Demand and Aggregate Supply

A major concern of the next several posts is the behavior of aggregate demand and aggregate supply. Aggregate demand is the total demand for goods and services. Aggregate supply is the total supply of goods and services.

Figure 2 shows aggregate demand and aggregate supply curves. Measured on the horizontal axis is the overall price level, not the price of a particular good or service. The economy is in equilibrium at the point at which these curves intersect.

We will see that aggregate demand and supply curves are much more complicated than the simple demand and supply curves we described in part 19 of this analysis. The simple logic of supply, demand, and equilibrium in individual markets does not explain what is depicted in Figure 2. It will take several more upcoming posts for us to describe what is meant by "aggregate output" and the "overall price level." Furthermore, although we will look at the behavior of households and firms in individual markets for clues about how to analyze aggregate behavior, there are important differences when we move from the individual to the aggregate level.

Consider, for example, demand, one of the most important concepts in economics. When the price of a specific good increases, perhaps the most important determinant of consumer response is the availability of other goods that can be substituted for the good whose price has increased. Part of the reason that an increase in the price of airline tickets causes a decline in the quantity of airline tickets demanded is that a higher price relative to other goods means that the opportunity cost (the loss of potential gain from other alternatives when one alternative is chosen) of buying a ticket is higher: The sacrifice required in terms of other goods and services has increased. However, when the overall price level changes, there may be no changes in the opportunity cost of goods. For example, a higher-priced airline ticket when compared to higher-priced other goods may involve the same trade-offs as before all prices increased.

Microeconomics teaches us that, ceteris paribus (all else equal), the quantity demanded of a good falls when its price rises and rises when its price falls. (This is the microeconomic law of demand.) In other words, individual demand curves and market demand curves slope downward to the right. The reason the aggregate demand curve in Figure 2 slopes downward to the right is complex. As we will see you later, the downward slope of the aggregate demand curve is related to what goes on in the money (financial) market.

The aggregate supply curve is very different from the supply curve of an individual firm or market. A firm's supply curve is derived under the assumption that all its input prices are fixed. In other words, the firm's input prices are assumed to remain unchanged as the price of the firm's output changes. When we derived Clarence Brown's soybean supply schedule in part 13 of this analysis, we took his input prices as fixed. A change in an input price leads to a shift in Brown's supply curve, not a movement along it. If we are examining changes in the overall price level, however, all prices are changing (including input prices), so the aggregate supply curve cannot be based on the assumption of fixed input prices. We will see that the aggregate supply curve is another source of controversy in macroeconomics. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 384-385*

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