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Macroeconomics and its Limitations

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 Abstract

Macroeconomics is the basis of the fundamental analysis of investors who analyse how an economy is, what are its most prosperous sectors and how is its regulation to make sure that their investment will be profitable. Although macroeconomics includes many models, it still has shortcomings that do not make it entirely reliable. Even with these restrictions, it’s a necessary tool when making decisions to invest.

There are many unknown variables in current economies, and there are questions like why some countries grow more than others, why inflation varies from year to year, why all countries suffer from crises and recessions, which measures can be taken by local governments to reduce the frequency and the magnitude of these events. Macroeconomics is the branch of the economy that tries to solve all these questions that are related to the economy of a country.

To appreciate the importance of macroeconomics, it is best to read newspapers daily or listen to the news.  Every day we see headlines related to the economy, central bank measures, trade agreements with other countries, the unemployment rate, and many others. Although many people are not interested in these issues, it is important to be updated as all these variables affect the lives of all people. For workers and independent people, the Central Banks decisions are significant, as they influence their consumption. Also, these measures determine the levels of investment in industries and commerce.

As the state of the economy affects all people, macroeconomics is a subject that plays a central role in political debates. In the elections of president, governors, and senators it is important that people give the necessary importance to choose who would be a good governor depending on their economic proposals. Other proposals of social and political reforms also matter, but economics is not a minor issue when choosing the right candidate.

It is normal that the popularity of a president would grow when the economy performs satisfactorily, and fall in the polls when crises occur and the unemployment rate increases. But macroeconomic issues are not only an important issue at a local level. There are meetings between leaders and world politicians to carry out joint policies among several countries so that the benefit is mutual, and development is equitable.

Although the world leaders have the job of devising and executing the measures that concern the economy, the work of developing models and explaining what the effects of those policies are is the work of the macroeconomists. To examine the models, macroeconomists must collect information on production, prices, unemployment and other variables from different time periods and several countries. The theoretical models, although they are not fully accurate, are a good tool to determine the effects of monetary policies, fiscal policies, international trade, among other measures, that the authorities can take.

The truth is that macroeconomics is an imperfect and young science. Since historical data is used to test the models, predictions about the future can often be wrong, economic conditions are never the same in two different periods of time. But with the development of several models in the last 50 years, the effect of some measures is clear such as increased public spending or tax reduction. What is often not well known is its magnitude.

Each era has its economic problems. In certain years between 1970 and 1980, some countries had problems with their inflation rates that were extremely high, while the opposite is happening in recent years, experiencing extremely weak inflation rates that do not allow central banks to execute policies that could stimulate higher growth in the economy. In 2007, there was a global financial crisis that lasted for several years. A financial juncture from which some countries still did not have recovered. There have been collapses in the stock markets, as well as the one that happened in the year 2000, when stock values went well above their fair value, especially in the technology sector.

As each epoch has its problems and different political and social conjunctures, it is difficult for macroeconomics to make accurate predictions about the variables in the future because contingencies will always arise. The historical facts of macroeconomics provide incentives to new models to explain past events and predict what may happen in the future. But the basic principles of macroeconomics do not vary in years or decades; there are specific rules that must be followed to model according to the data to which the analysts have to get accustomed.

While the models are far from reality, they are made in a simple way to be more understandable, and often a simple model that explains historical facts is better because a complicated model that takes more time to elaborate, ends up explaining the same thing as the simple model. The models have two kinds of variables, endogenous and exogenous. The endogenous variables are the variables that the model tries to explain, and the exogenous variables come as assumptions to the model, which are taken as true and do not need explanation. The purpose of the model is to show how the exogenous variables affect and determine the endogenous variables.

With the various existing models, macroeconomists analyse all the variables of interest from the savings rate and its impact on long-term growth to the impact of the minimum wage on unemployment. It is important to mention that not only one model explains all or most of the variables, but it is also a set of models from which conclusions can be drawn for fiscal or monetary policies or other types of policies that are implemented in the economy. To know how good a model is, we must analyse how realistic the assumptions and their exogenous variables are, because if they are far from reality, then the conclusions reached will be erroneous.

Another important branch of the economy is microeconomics which studies how households and companies make decisions and how these decisions affect the market which is the place of interaction between agents. A principle of microeconomics is to assume that companies and households have budget constraints, but always try to maximise their benefit.

Given this analysis of companies and people, microeconomics and macroeconomics are related, since microeconomics starts with the most specific aspects of households and their relationship with companies, and macroeconomics is more general, studying not only this relationship but also studying other components that may affect this relationship and factors beyond these two agents such as international trade, the interest rate, public spending of the government, the rate of investment in an economy, etc. The following graph summarizes the difference between macroeconomics and microeconomics.

macroeconomics and microeconomics

Graph 40. Microeconomics and Macroeconomics. Retrieved 10th December 2017. From https://byjus.com/commerce/microeconomics-and-macroeconomics-study-material/

After decades and decades of studies and new models, there are some lessons that macroeconomists have learned about how the economy works and what its limitations are. One of the most important facts that have been learned is that in the long term the capacity of a country to produce more goods and services will determine the quality of life of its inhabitants. To measure this productive capacity, we have the indicator of real gross domestic product (GDP), which does not consider equality metrics in the distribution of that production, but it serves as an approximation of the quality of life.

It has been established that in countries with higher GDP per capita, the population have higher purchasing power, better social indicators, better health system and even better media coverage.

In the long term, the gross domestic product depends on factors of production such as physical capital, human capital, the technological level of the country and the work required to produce goods and services. Domestic production increases when these factors improve or increase. For example, if more technology is used in production, it will be more efficient, it will require fewer working hours and capital, and therefore companies will be able to produce more. Or when a government encourages and gives access to better education for its population, workers will be capable of performing duties that were previously not capable.

As already mentioned in the previous paragraph, there are several policies a government could adopt to increase the production of goods and services. One of them could be incentives to increase the savings rate,  which serve as an investment source in the future, higher efficiency in production, improve existing standards and institutions that allow the market to have no frictions or information asymmetries among others. That is, there are many ways in which the government can intervene in the trend in which the economy has, but it must act based on studies to know what could be the possible effects of the intervention.

Another important lesson is that in the short-term aggregate demand directly influences the number of goods and services produced within a country. That is a result of the behaviour of prices since in the short term they are almost fixed and do not vary much. Therefore, the factors that affect aggregate demand in the short term will end up affecting domestic production. Fiscal and monetary policies and possible shocks to the goods and services market are directly responsible for the behaviour of the economy in the short term, thus determining production and the unemployment rate.

The third important lesson that macroeconomists have learned is that in the long term the rate of growth of money determines the rate of inflation, but has no influence on real variables such as the growth of production or the rate of employment. When a central bank prints more money, in the long term it will not encourage production or employment, it will only cause a devaluation of the currency due to higher inflation rates. In addition, these higher inflation rates will cause increases in the nominal interest rate. But the fact is that being a nominal variable, the growth of money will not affect real variables in the long term such as employment because the variables that determine that is the rate of layoffs and hiring.

The last significant lesson is that, in the short term, those in charge of monetary and fiscal policies face a tradeoff between inflation and unemployment. Although inflation and unemployment are not related in the long term, in the short term they are. Therefore, often authorities must choose which variable to manage. In the short term, the authorities can use fiscal and monetary policies to expand aggregate demand, which will reduce unemployment, but increase the rate of inflation or in an opposite case, they can use contractionary policies in demand which will control inflation, but will affect jobs. In the long term, they stop being correlated because the expectations of the agents are involved.

Now we will show the factors that macroeconomists have not been able to solve. One of the biggest criticisms to macroeconomics is that alternative theories are not considered, that the whole theory is based on neoclassical models, with assumptions about certain behaviours of the agents and the market that other theories debate.  So the possible errors that the models may produce are widespread because there is no debate on the theoretical principles.

The classical theory assumes a natural rate of unemployment and a potential rate of production. But some economists suggest that these levels are not fixed, they change over time depending on the institutions established and the policies implemented by governments, so it is a mistake to talk about these key levels of the economy.

Another important problem is that many times in those models, which are based on historical facts, they attain results not applicable at present. That is, the growth of countries in the past can be explained, but when lagging countries try to implement the policies that allowed that growth, they cannot achieve the same results. But this is not only a criticism of macroeconomics. It is a crisis in general on economic studies because they manage to explain why the crises happened, but fail to prevent them.

Another problem of macroeconomics is that some economists suggest that it is better not to intervene in the economy due to the lack of precision of the models, and therefore, it is not entirely known whether a policy will have the desired effects on the variables analysed. Also, authorities might pursue political goals such as obtaining popularity or votes, so they would use models and studies that favour them, that might not always be the best for the population.

A neoclassical theory emerged in the late 60s and 70s due to several years of economic weakness and with several recessions in between. The main authorities of countries such as the United Kingdom and the United States tried to encourage the accumulation of physical capital over labour as the predominant factor in retaking corporate and economic profit rates. With these reforms aimed at higher profit margins of companies, the world economy seemed to enter a new stage of bonanza, for which they began to reject alternative theories and its predecessor, the Keynesian theory seemed obsolete.

But the volatility experienced in the last two decades, and mainly the 2007 crisis, is the evidence that the theory aims to understand the economic crises, but fails to prevent highly significant events such as that one that started 10 years ago:  A huge financial breakdown from which many countries have struggled to recover, and the well-being achieved in decades disappeared in a matter of years. This lack of foresight about that episode is evidence of the lack of communication of the neoclassical theory with other theories that perhaps might contribute to the appearance of new concepts that might lead to a better general welfare.

In conclusion, macroeconomics is a branch of the economy that studies the big variables such as unemployment, production, investment and savings among others. It has provided many concepts, and clarity about how the general behaviour of the economy is, and how its different components are related. But being dominated by a mainstream theoretical background that does not admit debates about its principles is a science with limitations.  Macroeconomics still does not achieve its purpose of avoiding major crises, and countries who apply policies based on macroeconomic theory do not develop at the same rates as the reference country. Despite its limitations, it is a valuable tool that allows for better overall well-being than decades prior to the world wars.

 ©Forex.Economy

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