5 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Introduction to Macroeconomics

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 31 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

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Market clearing prices Quantity of goods AD AS Aq The classical economists assumed that the prices and wages are always in the equilibrium which means the market clearing P*

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Market clearing – labour market Wages Quantity of Labours LD LS Lf The classical economists assumed that the wages adjust instantly to market clearing (equilibrium point) 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) 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. W1 Ld1Ld2 W2 unemployment Excess L Supply Excess L demand W* ab E c d

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 31 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. During the great depression this theory has fallen to explain this case which creates the macroeconomic theory. wages Quantity of Labour Demand directly unemployment

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 31 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

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 31 Introduction to Macroeconomics Macroeconomists often reflect on the microeconomic principles underlying macroeconomic analysis, or the microeconomic foundations of macroeconomics.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Real output (GDP) Unemployment Prices Some 7000 banks failed. How Great was the Great Depression?

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Unemployment

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Stock Market Crash

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair THE STOCK MARKET By 1929, many Americans were invested in the Stock Market The Stock Market had become the most visible sector for investment.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair STOCK PRICES RISE THROUGH THE 1920s Through most of the 1920s, stock prices rose steadily Speculation: Too many Americans were engaged in speculation – buying stocks & bonds hoping for a quick profit High demands on stocks and bonds before 1929

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair The stock Market between Stock prices Q of stocks D s1 5 D s2 Q2 S of Stock 50 Q1 b a

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair STOCK PRICES DECREASED DURING 1929 The prices of bonds and stocks started to decreased High percentage of Americans sold their bonds and stocks The stock market crashed The prices of stocks decreased The profits of speculators decreased

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair The stock Market in 1929 – Great Depression Prices of stocks Number sold stocks Ds S s Q1Q2 S s b a

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 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

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair CONSUMER SPENDING DOWN Most people did not have the money to buy the flood of goods factories produced

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Stimulation of AD Inflation Real National Income AS AD 2.0% Y1 In this situation, the economy would be operating at less than capacity, there would be unemployment and the economy might be growing only slowly. AD 1 Y2 2.5% A shift in the AD curve to AD1 as a result of a change in any or all of the factors affecting AD would increase growth, reduce unemployment but at a cost of higher inflation b a

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 31 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 (خيبة أمل) in the 1970s and early 1980s where the stagflation has been born in 1970.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 31 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

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 31 Macroeconomic Concerns Three of the major concerns of macroeconomics are: Inflation Output growth Unemployment

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 31 Questions related to inflation Who will gain from inflation ? How could we solve inflation ? What cost does inflation impose on the society ? What causes of inflation? What are the types of inflation ?

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 33 of 31 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?

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 34 of 31 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

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 35 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 36 of 31 The Components of the Macroeconomy The circular flow diagram shows the income received and payments made by each sector of the economy.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 37 of 31 The Components of the Macroeconomy Everyone’s expenditure is someone else’s receipt. Every transaction must have two sides.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 38 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 39 of 31 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

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 40 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 41 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 42 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 43 of 31 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

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 44 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 45 of 31 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.

C H A P T E R 17: Introduction to Macroeconomics © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 46 of 31 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.