Macroeconomics Definition, History, and Schools of Thought

What Is Macroeconomics?

Macroeconomics is a branch of economics that studies the behavior of an overall economy, which encompasses markets, businesses, consumers, and governments. Macroeconomics examines economy-wide phenomena such as inflation, price levels, rate of economic growth, national income, gross domestic product (GDP), and changes in unemployment.

Some of the key questions addressed by macroeconomics include: What causes unemployment? What causes inflation? What creates or stimulates economic growth? Macroeconomics attempts to measure how well an economy is performing, understand what forces drive it, and project how performance can improve.

Understanding Macroeconomics

As the term implies, macroeconomics is a field of study that analyzes an economy through a wide lens. This includes looking at variables like unemployment, GDP, and inflation. In addition, macroeconomists develop models explaining the relationships between these factors.

These models, and the forecasts they produce, are used by government entities to aid in constructing and evaluating economic, monetary, and fiscal policy. Businesses use the models to set strategies in domestic and global markets, and investors use them to predict and plan for movements in various asset classes.

Properly applied, economic theories can illuminate how economies function and the long-term consequences of particular policies and decisions. Macroeconomic theory can also help individual businesses and investors make better decisions through a more thorough understanding of the effects of broad economic trends and policies on their own industries.

History of Macroeconomics

While the term "macroeconomics" dates back to the 1940s, many of the field's core concepts have been subjects of study for much longer. Topics like unemployment, prices, growth, and trade have concerned economists since the beginning of the discipline in the 1700s. Elements of earlier work from Adam Smith and John Stuart Mill addressed issues that would now be recognized as the domain of macroeconomics.

In its modern form, macroeconomics is often defined as starting with John Maynard Keynes and his book The General Theory of Employment, Interest, and Money in 1936. In it, Keynes explained the fallout from the Great Depression, when goods went unsold and workers were unemployed.

Before the popularization of Keynes' theories, economists generally did not differentiate between microeconomics and macroeconomics. The same microeconomic laws of supply and demand that operate in individual goods markets were understood to interact between individual markets to bring the economy into a general equilibrium, as described by Leon Walras.

The link between goods markets and large-scale financial variables such as price levels and interest rates was explained through the unique role that money plays in the economy as a medium of exchange by economists such as Knut Wicksell, Irving Fisher, and Ludwig von Mises.

Macroeconomics vs. Microeconomics

Macroeconomics differs from microeconomics, which focuses on smaller factors that affect choices made by individuals. Individuals are typically classified into subgroups, such as buyers, sellers, and business owners. These actors interact with each other according to the laws of supply and demand for resources, using money and interest rates as pricing mechanisms for coordination. Factors studied in both microeconomics and macroeconomics typically influence one another.

A key distinction between microeconomics and macroeconomics is that macroeconomic aggregates can sometimes behave in very different ways or even the opposite of similar microeconomic variables. For example, Keynes referenced the so-called Paradox of Thrift, which argues that individuals save money to build wealth on a microeconomic level. However, when everyone tries to increase their savings at once, it can contribute to a slowdown in the economy and less wealth in the aggregate, macroeconomic level. This is because there would be a reduction in spending, affecting business revenues, and lowering worker pay.

Limits of Macroeconomics

It is also important to understand the limitations of economic theory. Theories are often created in a vacuum and lack specific real-world details like taxation, regulation, and transaction costs. The real world is also decidedly complicated and includes matters of social preference and conscience that do not lend themselves to mathematical analysis.

Even with the limits of economic theory, it is important and worthwhile to follow significant macroeconomic indicators like GDP, inflation, and unemployment. This is because the performance of companies, and by extension their stocks, is significantly influenced by the economic conditions in which the companies operate.

Likewise, it can be invaluable to understand which theories are currently in favor, and how they may be influencing a particular government administration. Such economic theories can say much about how a government will approach taxation, regulation, government spending, and similar policies. By better understanding economics and the ramifications of economic decisions, investors can get at least a glimpse of the probable future and act accordingly with confidence.

Macroeconomic Schools of Thought

The field of macroeconomics is organized into many different schools of thought, with differing views on how the markets and their participants operate.

Classical

Classical economists held that prices, wages, and rates are flexible and markets tend to clear unless prevented from doing so by government policy; these ideas build on Adam Smith's original theories. The term “classical economists” is not actually a school of macroeconomic thought but a label applied first by Karl Marx and later by Keynes to denote previous economic thinkers with whom they disagreed.

Keynesian

Keynesian economics was founded mainly based on the works of John Maynard Keynes and was the beginning of macroeconomics as a separate area of study from microeconomics. Keynesians focus on aggregate demand as the principal factor in issues like unemployment and the business cycle.

Keynesian economists believe that the business cycle can be managed by active government intervention through fiscal policy, where governments spend more in recessions to stimulate demand or spend less in expansions to decrease it. They also believe in monetary policy, where a central bank stimulates lending with lower rates or restricts it with higher ones.

Keynesian economists also believe that certain rigidities in the system, particularly sticky prices, prevent the proper clearing of supply and demand.

Monetarist

The Monetarist school is a branch of Keynesian economics credited mainly to the works of Milton Friedman. Working within and extending Keynesian models, Monetarists argue that monetary policy is generally a more effective and desirable policy tool to manage aggregate demand than fiscal policy. However, monetarists also acknowledge limits to monetary policy that make fine-tuning the economy ill-advised and instead tend to prefer adherence to policy rules that promote stable inflation rates.

New Classical

The New Classical school, along with the New Keynesians, is mainly built on integrating microeconomic foundations into macroeconomics to resolve the glaring theoretical contradictions between the two subjects.

The New Classical school emphasizes the importance of microeconomics and models based on that behavior. New Classical economists assume that all agents try to maximize their utility and have rational expectations, which they incorporate into macroeconomic models. New Classical economists believe that unemployment is largely voluntary and that discretionary fiscal policy destabilizes, while inflation can be controlled with monetary policy.

New Keynesian

The New Keynesian school also attempts to add microeconomic foundations to traditional Keynesian economic theories. While New Keynesians accept that households and firms operate based on rational expectations, they still maintain that there are a variety of market failures, including sticky prices and wages. Because of this "stickiness," the government can improve macroeconomic conditions through fiscal and monetary policy.

Austrian

The Austrian School is an older school of economics that is seeing some resurgence in popularity. Austrian economic theories mainly apply to microeconomic phenomena. However, like the so-called classical economists, they never strictly separated microeconomics and macroeconomics.

Austrian theories also have important implications for what are otherwise considered macroeconomic subjects. In particular, the Austrian business cycle theory explains broadly synchronized (macroeconomic) swings in economic activity across markets due to monetary policy and the role that money and banking play in linking (microeconomic) markets to each other and across time. 

Macroeconomic Indicators

Macroeconomics is a rather broad field, but two specific research areas dominate the discipline. The first area looks at the factors that determine long-term economic growth. The other looks at the causes and consequences of short-term fluctuations in national income and employment, also known as the business cycle.

Economic Growth

Economic growth refers to an increase in aggregate production in an economy. Macroeconomists try to understand the factors that either promote or retard economic growth to support economic policies that will support development, progress, and rising living standards.

Economists can use many indicators to measure economic performance. These indicators fall into 10 categories:

• Gross Domestic Product indicators: Measure how much the economy produces
• Consumer Spending indicators: Measure how much capital consumers feed back into the economy
• Income and Savings indicators: Measure how much consumers make and save
• Industry Performance indicators: Measure GDP by industry
• International Trade and Investment indicators: Indicate the balance of payments between trade partners, how much is traded, and how much is invested internationally
• Prices and Inflation indicators: Indicate fluctuations in prices paid for goods and services and changes in currency purchasing power
• Investment in Fixed Assets indicators: Indicate how much capital is tied up in fixed assets
• Employment indicators: Show employment by industry, state, county, and other areas
• Government indicators: Show how much the government spends and receives
• Special indicators: Include all other economic indicators, such as distribution of personal income, global value chains, healthcare spending, small business well-being, and more

The Business Cycle

Superimposed over long-term macroeconomic growth trends, the levels and rates of change of significant macroeconomic variables such as employment and national output go through fluctuations. These fluctuations are called expansions, peaks, recessions, and troughs—they also occur in that order. When charted on a graph, these fluctuations show that businesses perform in cycles; thus, it is called the business cycle.

The National Bureau of Economic Research (NBER) measures the business cycle, which uses GDP and Gross National Income to date the cycle. The NBER is also the agency that declares the beginning and end of recessions and expansions.

How to Influence Macroeconomics

Because macroeconomics is such a broad area, positively influencing the economy is challenging and takes much longer than changing the individual behaviors within microeconomics. Therefore, economies need to have an entity dedicated to researching and identifying techniques that can influence large-scale changes.

In the U.S., the Federal Reserve is the central bank with a mandate of promoting maximum employment and price stability. These two factors have been identified as essential to positively influencing change at the macroeconomic level.

To influence change, the Fed implements monetary policy through tools it has developed over the years, which work to affect its dual mandates. It has the following tools it can use:

• Federal Funds Rate Range: A target range set by the Fed that guides interest rates on overnight lending between depository institutions to boost short-term borrowing
• Open Market Operations: Purchase and sell securities on the open market to change the supply of reserves
• Discount Window and Rate: Lending to depository institutions to help banks manage liquidity
• Reserve Requirements: Maintaining a reserve to help banks maintain liquidity
• Interest on Reserve Balances: Encourages banks to hold reserves for liquidity and pays them interest for doing so
• Overnight Repurchase Agreement Facility: A supplementary tool used to help control the federal funds rate by selling securities and repurchasing them the next day at a more favorable rate
• Term Deposit Facility: Reserve deposits with a term, used to drain reserves from the banking system
• Central Bank Liquidity Swaps: Established swap lines for central banks from select countries to improve liquidity conditions in the U.S. and participating countries' central banks
• Foreign and International Monetary Authorities Repo Facility: A facility for institutions to enter repurchase agreements with the Fed to act as a backstop for liquidity
• Standing Overnight Repurchase Agreement Facility: A facility to encourage or discourage borrowing above a set rate, which helps to control the effective federal funds rate

The Fed continuously updates the tools it uses to influence the economy, so it has a list of many other previously used tools it can implement again if needed.

The Bottom Line

Macroeconomics is a field of study used to evaluate overall economic performance and develop actions that can positively affect an economy. Economists work to understand how specific factors and actions affect output, input, spending, consumption, inflation, and employment.

The study of economics began long ago, but the field didn't start evolving into its current form until the 1700s. Macroeconomics now plays a large part in government and business decision-making.