CHAPTER 5 Introduction to Macroeconomics Prepared by Fernando

C H A P T E R 17: 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 31

C H A P T E R 17: Introduction to Macroeconomics The classical economist • Classical economists applied microeconomic models, or “market clearing” models, to economywide problems. • Market clearing means: the price at which the level of demand equals the level of supply © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 3 of 31

C H A P T E R 17: Introduction to Macroeconomics The Classical View of the Labor Market • Classical economists believe that the labor market always clears. • If the demand for labor shifts from D 0 to D 1, the equilibrium wage will fall from W 0 to W 1. • Anyone who wants a job at W 1 will have one. • There is always full employment in this sense. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair of 364

C H A P T E R 17: Introduction to Macroeconomics Explaining the Existence of Unemployment © 2004 Prentice Hall Business Publishing • If wages “stick” at W 0 rather than fall to the new equilibrium wage of W* following a shift of demand, the result will be unemployment equal to L 0 – L 1. Principles of Economics, 7/e Karl Case, Ray Fair of 365

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 6 of 31

C H A P T E R 17: Introduction to Macroeconomics Market clearing AS The classical economists assumed that the prices and wages are always in the equilibrium which means the market clearing. prices 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 The Classical Labor Market and the Aggregate Supply Curve • The classical idea that wages adjust to clear the labor market is consistent with the view that wages respond quickly to price changes. This means that the AS curve is vertical. • When the AS curve is vertical, monetary and fiscal policy cannot affect the level of output and employment in the economy. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair of 368

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 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 © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 9 of 31

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 10 of 31

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 will create income and eliminate the unemployment. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 11 of 31

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 12 of 31

C H A P T E R 17: Introduction to Macroeconomics • Macroeconomists often reflect on the microeconomic principles underlying macroeconomic analysis, or the microeconomic foundations of macroeconomics. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 13 of 31

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 1930 s. • The great depression has started by the crashing of stock markets. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 14 of 31

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

C H A P T E R 17: Introduction to Macroeconomics Stock Market Crash

C H A P T E R 17: Introduction to Macroeconomics THE STOCK MARKET • By 1929, many Americans were invested heavily in the Stock Market • The Stock Market had become the most visible sector for investment. © 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 PRICES RISE THROUGH THE 1920 s • Through most of the 1920 s, 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 © 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 stock Market between 1920 - 1928 Stock prices S of Stock b 50 a 5 Ds 1 Q 1 © 2004 Prentice Hall Business Publishing Q 2 Principles of Economics, 7/e Ds 2 Q of stocks Karl Case, Ray Fair

C H A P T E R 17: Introduction to Macroeconomics 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 © 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 stock Market in 1929 – Great Depression Prices of stocks Ss 1 a Ss 2 5. 00 b 1. 00 Ds Q 1 © 2004 Prentice Hall Business Publishing Q 2 Principles of Economics, 7/e Number sold stocks 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 • The factories and business collapsed and closed • Unemployment increased © 2004 Prentice Hall Business Publishing rate 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 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 will create income and eliminate the unemployment. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 26 of 31

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 AD 1 as a curve situation, the economya change in result of would be operating of the any or all at less than capacity, there factors affecting AD would be would increase unemployment and growth, reduce the economy might at unemployment but be growing only a cost of higher slowly. inflation a AD 1 AD Y 1 © 2004 Prentice Hall Business Publishing Y 2 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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 28 of 31

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 1960 s, led to disillusionment ( )ﺧﻴﺒﺔ ﺃﻤﻞ in the 1970 s and early 1980 s where the stagflation has been born in 1970. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 29 of 31

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 © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 30 of 31

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 © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 31 of 31

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 32 of 31

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

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 34 of 31

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 35 of 31

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? © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 36 of 31

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 © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 37 of 31

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 38 of 31

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 39 of 31

C H A P T E R 17: Introduction to Macroeconomics The Components of the Macroeconomy © 2004 Prentice Hall Business Publishing • Everyone’s expenditure is someone else’s receipt. Every transaction must have two sides. Principles of Economics, 7/e Karl Case, Ray Fair 40 of 31

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 41 of 31

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 © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 42 of 31

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 43 of 31

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 44 of 31

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. © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 45 of 31

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 © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 46 of 31

C H A P T E R 17: Introduction to Macroeconomics Aggregate Supply and Aggregate Demand © 2004 Prentice Hall Business Publishing • 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. Principles of Economics, 7/e Karl Case, Ray Fair 47 of 31

C H A P T E R 17: Introduction to Macroeconomics Expansion and Contraction: The Business Cycle © 2004 Prentice Hall Business Publishing • 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. Principles of Economics, 7/e Karl Case, Ray Fair 48 of 31