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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. 2 of 31 © 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 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 3 of 31 © 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 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 © 2004 Prentice Hall Business Publishing 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 © 2004 Prentice Hall Business Publishing Lf Ld2 Principles of Economics, 7/e 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. 6 of 31 © 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 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 12 of 31 © 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 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. 13 of 31 © 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 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. 14 of 31 © 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 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. 15 of 31 © 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 • Macroeconomists often reflect on the microeconomic principles underlying macroeconomic analysis, or the microeconomic foundations of macroeconomics. 16 of 31 © 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 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. 17 of 31 © 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 How Great was the Great Depression? • Real output (GDP) • Unemployment •Prices •Some 7000 banks failed. © 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 Unemployment © 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 Stock Market Crash © 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 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 © 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 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. 23 of 31 © 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 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 © 2004 Prentice Hall Business Publishing Y2 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. 25 of 31 © 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 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. 26 of 31 © 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 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 27 of 31 © 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 Macroeconomic Concerns • Three of the major concerns of macroeconomics are: – Inflation – Output growth – Unemployment 28 of 31 © 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 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. 29 of 31 © 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 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. 30 of 31 © 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 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. 31 of 31 © 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 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? 32 of 31 © 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 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 33 of 31 © 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 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. 34 of 31 © 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 The Components of the Macroeconomy • The circular flow diagram shows the income received and payments made by each sector of the economy. 35 of 31 © 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 The Components of the Macroeconomy • Everyone’s expenditure is someone else’s receipt. Every transaction must have two sides. 36 of 31 © 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 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. 37 of 31 © 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 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 38 of 31 © 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 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. 39 of 31 © 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 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. 40 of 31 © 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 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. 41 of 31 © 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 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 42 of 31 © 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 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. 43 of 31 © 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 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. 44 of 31 © 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 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. 45 of 31 © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair