Interdependence between Micro and Macroeconomics

Actually micro and macroeconomics are interdependent. The theories regarding the behaviour of some macroeconomic aggregates (but not all) are derived from theories of individual behaviour.

For instance, the theory of investment, which is a part and parcel of the microeconomic theory, is derived from the behaviour of individual entrepreneur.

According to this theory, an individual entrepreneur in his investment activity is governed by the expected rate of profit on the one hand and rate of interest on the other. And so is the aggregate investment function. Similarly, the theory of aggregate consumption function is based upon the behaviour patterns of individual consumers.

It may be noted that we are able to draw aggregate investment function and aggregate consumption function because in this respect the behaviour of the aggregate is in no way different from the behaviour patterns of individual components. Moreover, we can derive the behaviour of these aggregates only if either the composition of aggregates is constant or the composition changes in some regular way as the size of aggregates changes.

From this it should not be understood that behaviour of all macroeconomic relationship is in conformity with behaviour patterns of individuals composing them. As we saw above, saving-investment relationship and wage-employment relationship for the economic system as a whole are quite different from the corresponding relationships in case of individual parts.

Microeconomic theory contributes to macroeconomic theory in another way also. The theory of relative prices of products and factors is essential in the explanation of the determination of general price level. Even Keynes used microeconomic theory to explain the rise in the general price level as a result of the increase in the cost of production in the economy. According to Keynes, when as a result of the increase in money supply and consequently the aggregate demand, more output is produced, the cost of production rises. With the rise in the cost of production, the prices rise.

According to Keynes, cost of production rises because of:

(1) The law of diminishing returns operates and

(2) Wages and prices of raw materials may rise as the economy approaches full- employment level.

Now, the influences of cost of production, diminishing returns, etc., on the determination of prices are the parts of microeconomics. Not only does macroeconomics depend upon to some extent on microeconomics, the latter also depends upon to some extent on macroeconomics. The determination of the rate of profit and the rate of interest are well-known microeconomic topics, but they greatly depend upon the macroeconomic aggregates.

In microeconomic theory, the profits are regarded as reward for uncertainty bearing but microeconomic theory fails to show the economic forces which determine the magnitude of profits earned by the entrepreneur and why there are fluctuations in them. The magnitude of profits depends upon the level of aggregate demand, national income, and the general price level in the country.

We know that at times of depression when the levels of aggregate demand, national income and price level are low, the entrepreneurs in the various fields of the economy suffer losses. On the other hand, when aggregate demands, incomes of the people, the general price level go up and conditions of boom prevail, the entrepreneurs earn huge profits.

Now, take the case of the rate of interest. Strictly speaking theory of the rate of interest has now become a subject of macroeconomic theory. Partial equilibrium theory of interest which belongs to microeconomic theory would not reveal all the forces which take part in the determination of the rate of interest. Keynes showed that the rate of interest is determined by the liquidity preference function and the stock (or supply) of money in the economy.

The liquidity preference function and the stock of money in the economy are macroeconomic concepts. No doubt, the Keynesian theory has also been shown to be indeterminate, but in the modern theory of interest Keynesian aggregative concepts of liquidity preference and stock of money play an important role in the determination of the rate of interest.

Moreover, in the modern interest theory (i.e., determination of interest rate through intersection of LM and IS curves) along with liquidity preference and the supply of money, the other two forces which are used to explain the determination of interest are saving and investment functions which are also conceived in aggregative or macro terms.

It is thus clear from above that the determination of profits and rate of interest cannot be explained without the tools and concepts of macroeconomics. It follows that though microeconomics and macroeconomics deal with different subjects, but there is a good deal of interdependence between them. In the explanation of many economic phenomena, both micro and macro-economic tools and concepts have to be applied. About interdependence between microeconomics and macroeconomics. Professor Ackley’s remarks are worth quoting.

He says, “The relationship between macroeconomics and theory of individual behaviour is a two-way street. On the one hand, microeconomic theory should provide the building blocks for our aggregate theories. But macroeconomics may also contribute to microeconomic understanding. If we discover, for example, empirically stable macroeconomic generalisations which appear inconsistent with microeconomic theories, or which relate to aspects of behaviour which microeconomics has neglected, macroeconomics may permit us to improve our understanding of individual behaviour.”