The Difference Between Micro- and Macro-economics

What is the difference between microeconomics and macroeconomics? A typical textbook would say something like this: “Microeconomics is the study of how firms and households make decisions; macroeconomics is the study of the economy as a whole.” There is a good reason for this bifurcation. If we want to avoid the fallacy of composition, we must recognize that a whole may exhibit properties that are not present in its parts. “Cells are invisible with the naked eye; Alex is made up of cells; therefore Alex is invisible to the naked eye” is clearly bad logic. So it makes sense to suppose the whole of the economy is more than the simple sum of its parts.

Problems come in, however, when the method of study for the economy as a whole looks radically different from that used for its parts. In the heyday of hydraulic Keynesianism, macroeconomics held that there existed relatively simple relationships between statistical aggregates such as national income, consumption spending, and government spending. This viewpoint, because it eschewed the complexities of individual decision-making and how those decisions mapped onto economy-wide outcomes, fell into the trap of thinking the observed relationships between aggregates were stable and predictable; thus, macroeconomic stabilization policy to tame the business cycle should be straightforward. Milton Friedman (monetarism) and Robert Lucas Jr. (New Classical economics) eventually showed this conception of macroeconomics was essentially flawed. But it took more than three painful decades following the end of World War II for macroeconomics to leave behind its dark age.

But now it seems that macroeconomics has veered too far in the opposite direction. The rise of representative-agent modeling and the accompanying microfoundations revolution put macroeconomics, exemplified by the now-infamous dynamic stochastic general equilibrium (DSGE) models, back on sound microeconomic footing. But lost in transition was an appreciation for what motivated keeping macroeconomics as a distinct field in the first place: the idea that the whole is more complex than the sum of its parts, and so reducing the whole to the sum of its parts is also wrongheaded. An argument can be made that macroeconomists, including monetary and financial economists, missed the signs of the 2007-8 financial crisis in part because they lost sight of the difference between their models and reality; they mistook the map for the territory.

Good macroeconomics is very hard to do. It simultaneously has to do two things: rest on a secure foundation of individual decision-making (microfoundations) while also being open to the possibility that millions of actors’ aggregated choices may result in much richer patterns of complexity than are evident from any particular choice or group of choices. Various schools of thought have all contributed to this project, many of them productively, but none of them definitively.

We cannot abandon the economic way of thinking when doing macroeconomics. Social phenomena still should be explicable in terms of the choices of individual decision-makers and their institutional environment. But explicable does not mean reducible. Macroeconomics has to find a way to navigate these tensions without sacrificing parsimony to explanatory power, and vice versa.

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Alexander W. Salter

Alexander W. Salter is an Assistant Professor of Economics in the Rawls College of Business and the Comparative Economics Research Fellow with the Free Market Institute at Texas Tech University. His research interests include the political economy of central banking, NGDP targeting, and free (laissez-faire) banking. He has published articles in leading scholarly journals, including the Journal of Money, Credit and Banking, Journal of Economic Dynamics and Control, Journal of Financial Services Research, and Quarterly Review of Economics and Finance. His popular work have appeared in RealClearPolitics and U.S. News and World Report.

Salter earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Occidental College. He was an AIER Summer Fellowship Program participant in 2011.