Download Introduction to Macroeconomics

CHAPTER
5
Introduction to
Macroeconomics
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Introduction to Macroeconomics
• Microeconomics examines the behavior of individual
decision-making units—business firms and households.
• Macroeconomics deals with the economy as a whole; it
examines the behavior of economic aggregates such as
aggregate income, consumption, investment, and the
overall level of prices.
– Aggregate behavior refers to the behavior of all households
and firms together.
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C H A P T E R 17: Introduction to Macroeconomics
The classical economist
 Classical economists applied microeconomic models, or
“market clearing” models, to economy-wide problems.
 Market clearing means: the price at which the level of
demand equals the level of supply
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C H A P T E R 17: Introduction to Macroeconomics
Market clearing
AS
prices
The classical economists
assumed that the prices and
wages are always in the
equilibrium which means the
market clearing
P*
AD
Aq
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Principles of Economics, 7/e
Quantity of goods
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Market clearing – labour market
Wages
LS
Excess L Supply
unemployment
a
W1
W2
Example: when the wages are (w1) there is
an
excess
supply
of
labours
(unemployment) and smaller demand on
labour. so, the wages will be decreased
instantly to reach the equilibrium . (full
employment)
b
E
W*
The classical economists assumed that
the wages adjust instantly to market
clearing (equilibrium point)
c
d
And also when the wages are (w2) there is
an excess demand on labour. So, the
wages will be increased directly to reach the
equilibrium wage.
Excess L demand
LD
Ld1
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Lf
Ld2
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Quantity of Labours
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
The Roots of Macroeconomics
• Under the classical model, the economists assumed that
during the recession period there is unemployment and
excess supply of labors, so, the wages will be decreased, so
this encourages the firms to increase the demand of labors
under these new wages. So, the unemployment rate will be
decreased.
unemployment
wages
Quantity of Labour Demand directly
unemployment
• During the great depression this theory has fallen to explain
this case which creates the macroeconomic theory.
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Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
The Great Depression
and the Keynesian View
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Macroeconomics
Prior to the Great Depression
• Prior to the Great Depression of the 1930s, economists (now
called classical economists) stressed the importance of
production and
paid little heed to aggregate demand.
• Say’s Law (named for a nineteenth-century French economist J.
B. Say) was central to their analysis.
• Say’s Law:
The production (supply) of goods creates the purchasing
power (demand) required to purchase the goods. Hence,
deficient total demand could never be a problem as the
production of goods always generates demand sufficient
to purchase the goods produced; put another way,
“supply creates its own demand.”
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Macroeconomics
Prior to the Great Depression
• Classical economists believed that markets would
adjust quickly and direct the economy toward full
employment. The huge decline in output, prolonged
unemployment, and lengthy duration of the Great
Depression undermined the classical view and
provided the foundation for Keynesian economics.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Keynesian Explanation
of the Great Depression
• Keynesian economics was developed during the
Great Depression (1930s).
• Keynesian theory provided an explanation for the
severe and prolonged unemployment of the 1930s.
• Keynes argued that wages and prices were highly
inflexible, particularly in a downward direction.
Thus, he did not think changes in prices and interest
rates would direct the economy back to full
employment.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Keynesian Explanation
of the Great Depression
• Keynesian View of spending and output:
• Keynes argued that spending induced
business firms to supply goods & services.
• Hence, if total spending fell, then firms
would respond by cutting back production.
Less spending would lead to less output.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Supply creates Demand
• In the classical view the economists said that the supply creates
demand and this happened when the factories produced goods
and services they sell it in the market and they will gain income
where this income will be used to purchase all other goods
which means:
Supply Creates Demand
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C H A P T E R 17: Introduction to Macroeconomics
The Roots of Macroeconomics
• However, simple classical models failed to
explain the prolonged existence of high
unemployment during the Great Depression.
This provided the impetus for the development
of macroeconomics.
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The Roots of Macroeconomics
•
•
According to the John Keynz this theory is wrong and he
said that the demand creates supply,
The increasing of the AD will increase the labor demand
and will create income and eliminate the unemployment.
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Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Sticky price
• Sticky prices are prices that do not always
adjust rapidly to maintain the equality between
quantity supplied and quantity demanded.
• Example: Suppose there is an inflation occurred in Gaza Strip,
and the labor of PALTEL company asked the administration of
the company to increase their wages. The administration
decided to delay this decision in order to see if the inflation will
continue for the long period or not. So, in the short run the
wages will be sticky, but in the long run it might be increased.
So, the response comes late not rapidly.
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Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Introduction to Macroeconomics
• Macroeconomists
often reflect on the
microeconomic
principles
underlying
macroeconomic analysis, or the microeconomic
foundations of macroeconomics.
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Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
The Roots of Macroeconomics
• The Great Depression was a period of severe
economic
contraction
and
high
unemployment that began in 1929 and
continued throughout the 1930s.
• The great depression has started by the
crashing of stock markets.
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C H A P T E R 17: Introduction to Macroeconomics
How Great was the Great Depression?
• Real output (GDP)
• Unemployment
•Prices
•Some 7000 banks failed.
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Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Unemployment
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Principles of Economics, 7/e
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C H A P T E R 17: Introduction to Macroeconomics
Stock Market Crash
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C H A P T E R 17: Introduction to Macroeconomics
FINANCIAL COLLAPSE
• After the crash, many
Americans withdrew their
money from banks
• Banks had invested in the
Stock Market and lost money
• Banks collapsed
Bank run 1929, Los Angeles
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
CONSUMER SPENDING DOWN
• Most people did not have the
money to buy the flood of
goods factories produced
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Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
The Keynesian Revolution
 According to the Keynesian theory , the level of employment is not
determined by the wages and prices but it determined by the
aggregate demands for goods and services
 Keynes believes that the government has to stimulate the
aggregate demand to affect the levels of employment and outputs
and solve recession
 The increasing of the AD will increase the labor demand and will
create income and eliminate the unemployment.
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C H A P T E R 17: Introduction to Macroeconomics
Stimulation of AD
AS
Inflation
b
2.5%
2.0%
A shift in the AD
In
thisto
situation,
curve
AD1 as athe
economy
bein
result of awould
change
operating
at th...e
less
any or all of
than
capacity,
there
factors
affecting
AD
would
be
would increase
unemployment
growth, reduce and
the
economy might
unemployment
but at
be
growing
only
a cost of higher
slowly.
inflation
a
AD 1
AD
Y1
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Principles of Economics, 7/e
Real National Income
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
The Roots of Macroeconomics
• In 1936, John Maynard Keynes published The
General Theory of Employment, Interest, and
Money.
• During periods of low private demand, the
government can stimulate aggregate demand
to lift the economy out of recession.
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Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Recent Macroeconomic History
• Fine-tuning in 1960 was the phrase used by
Walter Heller to refer to the government’s role
in regulating inflation and unemployment.
• The use of Keynesian policy to fine-tune the
economy in the 1960s, led to disillusionment in
the 1970s and early 1980s where the stagflation
has been born in 1970.
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C H A P T E R 17: Introduction to Macroeconomics
Recent Macroeconomic History
• Stagflation occurs when the
overall price level rises rapidly
(inflation) during periods of
recession or high and persistent
unemployment (stagnation).
• Stagflation : Increasing of inflation
rapidly when unemployment
increased in the same period
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Principles of Economics, 7/e
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C H A P T E R 17: Introduction to Macroeconomics
Macroeconomic Concerns
• Three of the major concerns of
macroeconomics are:
– Inflation
– Output growth
– Unemployment
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Principles of Economics, 7/e
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C H A P T E R 17: Introduction to Macroeconomics
Inflation and Deflation
• Inflation is an increase in the overall price level.
• Hyperinflation is a period of very rapid increases in the overall
price level. Hyperinflations are rare, but have been used to
study the costs and consequences of even moderate inflation.
• Hyperinflation is a situation in which prices and wages rise very
fast, causing damage to a country’s economy:
• Deflation is a decrease in the overall price level. Prolonged
periods of deflation can be just as damaging for the economy as
sustained inflation.
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C H A P T E R 17: Introduction to Macroeconomics
Output Growth:
Short Run and Long Run
• The business cycle is the cycle of short-term
ups and downs in the economy.
• The main measure of how an economy is
doing is aggregate output:
• Aggregate output is the total quantity of
goods and services produced in an economy
in a given period.
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C H A P T E R 17: Introduction to Macroeconomics
Output Growth:
Short Run and Long Run
• A recession is a period during which aggregate
output declines. Two consecutive quarters of
decrease in output signal a recession.
• A prolonged and deep recession becomes a
depression.
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C H A P T E R 17: Introduction to Macroeconomics
Unemployment
• The unemployment rate is the percentage of
the labor force that is unemployed.
• The unemployment rate is a key indicator of
the economy’s health.
• The existence of unemployment seems to
imply that the aggregate labor market is not in
equilibrium. Why do labor markets not clear
when other markets do?
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Principles of Economics, 7/e
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C H A P T E R 17: Introduction to Macroeconomics
Government in the Macroeconomy
• There are three kinds of policy that
the government has used to
influence the macroeconomy:
1. Fiscal policy
2. Monetary policy
3. Growth or supply-side policies
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C H A P T E R 17: Introduction to Macroeconomics
Government in the Macroeconomy
• Fiscal policy refers to government policies concerning taxes
and spending.
• Monetary policy consists of tools used by the Federal Reserve
to control the quantity of money in the economy.
• Growth policies are government policies that focus on
stimulating aggregate supply instead of aggregate demand.
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C H A P T E R 17: Introduction to Macroeconomics
The Components of
the Macroeconomy
• The circular flow diagram shows the
income received and payments made
by each sector of the economy.
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C H A P T E R 17: Introduction to Macroeconomics
The Components of
the Macroeconomy
• Everyone’s
expenditure is
someone else’s
receipt. Every
transaction must
have two sides.
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C H A P T E R 17: Introduction to Macroeconomics
The Components of
the Macroeconomy
• Transfer payments are payments made by the government to
people who do not supply goods, services, or labor in
exchange for these payments.
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C H A P T E R 17: Introduction to Macroeconomics
The Three Market Arenas
• Households, firms, the
government, and the rest of the
world all interact in three
different market arenas:
1. Goods-and-services market
2. Labor market
3. Money (financial) market
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C H A P T E R 17: Introduction to Macroeconomics
The Three Market Arenas
• Households and the government purchase goods and services
(demand) from firms in the goods-and services market, and
firms supply to the goods and services market.
• In the labor market, firms and government purchase
(demand) labor from households (supply).
– The total supply of labor in the economy depends on the sum of
decisions made by households.
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C H A P T E R 17: Introduction to Macroeconomics
The Three Market Arenas
• In the money market—sometimes called the financial
market—households purchase stocks and bonds from
firms.
– Households supply funds to this market in the expectation of
earning income, and also demand (borrow) funds from this
market.
– Firms, government, and the rest of the world also engage in
borrowing and lending, coordinated by financial institutions.
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C H A P T E R 17: Introduction to Macroeconomics
Financial Instruments
• Treasury bonds, notes, and bills are promissory
notes issued by the federal government when it
borrows money for a long period of time, it
pays interest
• Corporate bonds are promissory notes issued
by corporations when they borrow money.
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C H A P T E R 17: Introduction to Macroeconomics
Financial Instruments
• Shares of stock are financial instruments
that give to the holder a share in the firm’s
ownership and therefore the right to share
in the firm’s profits.
– Dividends are an amount of the profits that a
company pays to shareholders each period
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C H A P T E R 17: Introduction to Macroeconomics
The Methodology of Macroeconomics
• Connections to microeconomics:
– Macroeconomic behavior is the sum of all the
microeconomic decisions made by individual
households and firms. We cannot understand
the former without some knowledge of the
factors that influence the latter.
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Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Aggregate Supply and
Aggregate Demand
• Aggregate demand is the
total demand for goods and
services in an economy.
• Aggregate supply is the
total supply of goods and
services in an economy.
• Aggregate supply and
demand curves are more
complex than simple
market supply and demand
curves.
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Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 17: Introduction to Macroeconomics
Expansion and Contraction:
The Business Cycle
• An expansion, or boom, is the
period in the business cycle
from a trough up to a peak,
during which output and
employment rise.
• A contraction, recession,
or slump is the period in
the business cycle from a
peak down to a trough,
during which output and
employment fall.
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