PART II CONCEPTS AND PROBLEMS IN MACROECONOMICS Chapter

PART II CONCEPTS AND PROBLEMS IN MACROECONOMICS Chapter 5 Introduction to Macroeconomics Prepared by: Fernando & Yvonn Quijano © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair

CHAPTER 5: Introduction to Macroeconomics PART II CONCEPTS AND PROBLEMS IN MACROECONOMICS Introduction to Macroeconomics 5 Chapter Outline The Roots of Macroeconomics The Great Depression Recent Macroeconomic History Macroeconomic Concerns Inflation and Deflation Output Growth: Short Run and Long Run Unemployment Government In the Macroeconomy Fiscal Policy Monetary Policy Growth Policies The Components of the Macroeconomy The Circular Flow Diagram The Three Market Arenas The Methodology of Macroeconomics Connections to Microeconomics Aggregate Demand Aggregate Supply The U. S. Economy Since 1900: Trends and Cycles Expansion and Contraction: The Business Cycle The U. S. Economy Since 1970 © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 2

CHAPTER 5: Introduction to Macroeconomics INTRODUCTION TO MACROECONOMICS microeconomics Examines the functioning of individual industries and the behavior of individual decisionmaking units—business firms and households. macroeconomics Deals with the economy as a whole. Macroeconomics focuses on the determinants of total national income, deals with aggregates such as aggregate consumption and investment, and looks at the overall level of prices instead of individual prices. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 3

CHAPTER 5: Introduction to Macroeconomics Which of the following statements is correct? a. Macroeconomics examines the behavior of individual industries. b. Both macroeconomics and microeconomics are concerned with the decisions of households and firms. c. Microeconomists look for macroeconomic foundations to explain why most markets arrive at equilibrium. d. All of the above. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 4

CHAPTER 5: Introduction to Macroeconomics Which of the following statements is correct? a. Macroeconomics examines the behavior of individual industries. b. Both macroeconomics and microeconomics are concerned with the decisions of households and firms. c. Microeconomists look for macroeconomic foundations to explain why most markets arrive at equilibrium. d. All of the above. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 5

CHAPTER 5: Introduction to Macroeconomics INTRODUCTION TO MACROECONOMICS aggregate behavior The behavior of all households and firms together. sticky prices Prices that do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded. microeconomic foundations of macroeconomics The microeconomic principles underlying macroeconomic analysis. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 6

CHAPTER 5: Introduction to Macroeconomics THE ROOTS OF MACROECONOMICS THE GREAT DEPRESSION Great Depression The period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930 s. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 7

CHAPTER 5: Introduction to Macroeconomics THE ROOTS OF MACROECONOMICS Classical Models Classical economists applied microeconomic models, or “market clearing” models, to economy-wide problems. 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. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 8

CHAPTER 5: Introduction to Macroeconomics THE ROOTS OF MACROECONOMICS The Keynesian Revolution In 1936, John Maynard Keynes published The General Theory of Employment, Interest, and Money. Much of macroeconomics has roots in Keynes’s work. According to Keynes, it is not prices and wages that determine the level of employment, as classical models had suggested, but instead the level of aggregate demand for goods and services. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 9

CHAPTER 5: Introduction to Macroeconomics THE ROOTS OF MACROECONOMICS RECENT MACROECONOMIC HISTORY Fine-Tuning in the 1960 s fine-tuning The phrase used by Walter Heller to refer to the government’s role in regulating inflation and unemployment. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 10

CHAPTER 5: Introduction to Macroeconomics Which of the following ideas was central in Keynesian theory? a. The invisible hand. The forces of supply and demand ensure that a market will quickly adjust to deviations from equilibrium. b. Self-correcting prices and wages determine the level of output and employment in the economy. c. Government intervention can be used to affect the level of output and employment in the economy. d. Monetary policy can bring the economy out of a recession, or a depression. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 11

CHAPTER 5: Introduction to Macroeconomics Which of the following ideas was central in Keynesian theory? a. The invisible hand. The forces of supply and demand ensure that a market will quickly adjust to deviations from equilibrium. b. Self-correcting prices and wages determine the level of output and employment in the economy. c. Government intervention can be used to affect the level of output and employment in the economy. d. Monetary policy can bring the economy out of a recession, or a depression. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 12

CHAPTER 5: Introduction to Macroeconomics THE ROOTS OF MACROECONOMICS Disillusionment in the 1970 s and Early 1980 s stagflation Occurs when the overall price level rises rapidly (inflation) during periods of recession or high and persistent unemployment (stagnation). © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 13

CHAPTER 5: Introduction to Macroeconomics THE ROOTS OF MACROECONOMICS Good Times in the 1990 s, Pause in 2000– 2001, and Recovery in 2002– 2005 The strong economy in the 1990 s and recovery in 2002– 2005 did not lead to a convergence of views of macroeconomists about how the macroeconomy works. The discipline of macroeconomics is still in flux, and many important issues have yet to be resolved. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 14

CHAPTER 5: Introduction to Macroeconomics MACROECONOMIC CONCERNS Three of the major concerns of macroeconomics are: ■ Inflation ■ Output growth ■ Unemployment © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 15

CHAPTER 5: Introduction to Macroeconomics For economists, the main measure of how an economy is doing is: a. Aggregate output. b. Aggregate employment. c. The aggregate price level. d. The growth rate of the population. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 16

CHAPTER 5: Introduction to Macroeconomics For economists, the main measure of how an economy is doing is: a. Aggregate output. b. Aggregate employment. c. The aggregate price level. d. The growth rate of the population. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 17

CHAPTER 5: Introduction to Macroeconomics MACROECONOMIC CONCERNS INFLATION AND DEFLATION inflation An increase in the overall price level. hyperinflation A period of very rapid increases in the overall price level. deflation A decrease in the overall price level. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 18

CHAPTER 5: Introduction to Macroeconomics MACROECONOMIC CONCERNS OUTPUT GROWTH: SHORT RUN AND LONG RUN business cycle The cycle of shortterm ups and downs in the economy. aggregate output The total quantity of goods and services produced in an economy in a given period. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 19

CHAPTER 5: Introduction to Macroeconomics MACROECONOMIC CONCERNS recession A period during which aggregate output declines. Conventionally, a period in which aggregate output declines for two consecutive quarters. depression A prolonged and deep recession. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 20

CHAPTER 5: Introduction to Macroeconomics MACROECONOMIC CONCERNS UNEMPLOYMENT unemployment rate The percentage of the labor force that is unemployed. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 21

CHAPTER 5: Introduction to Macroeconomics In microeconomic theory, which of the following happens as the labor market eliminates unemployment and restores its equilibrium? a. The equilibrium wage rises above the wage that prevailed when there was unemployment. b. As it moves toward equilibrium, the market experiences an increase in the quantity of labor demanded and a decrease in the quantity supplied. c. The market will turn a shortage into a surplus. d. Supply and demand will shift, but equilibrium price remain the same in the end. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 22

CHAPTER 5: Introduction to Macroeconomics In microeconomic theory, which of the following happens as the labor market eliminates unemployment and restores its equilibrium? a. The equilibrium wage rises above the wage that prevailed when there was unemployment. b. As it moves toward equilibrium, the market experiences an increase in the quantity of labor demanded and a decrease in the quantity supplied. c. The market will turn a shortage into a surplus. d. Supply and demand will shift, but equilibrium price remain the same in the end. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 23

CHAPTER 5: 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 © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 24

CHAPTER 5: Introduction to Macroeconomics GOVERNMENT IN THE MACROECONOMY FISCAL POLICY fiscal policy Government policies concerning taxes and expenditures (spending). © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 25

CHAPTER 5: Introduction to Macroeconomics GOVERNMENT IN THE MACROECONOMY MONETARY POLICY monetary policy The tools used by the Federal Reserve to control the quantity of money in the economy. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 26

CHAPTER 5: Introduction to Macroeconomics GOVERNMENT IN THE MACROECONOMY GROWTH POLICIES supply-side policies Government policies that focus on stimulating aggregate supply instead of aggregate demand. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 27

CHAPTER 5: Introduction to Macroeconomics THE COMPONENTS OF THE MACROECONOMY Macroeconomics focuses on four groups: (1) households and (2) firms, which together compose the private sector, (3) the government (the public sector), and (4) the rest of the world (the international sector). © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 28

CHAPTER 5: Introduction to Macroeconomics THE COMPONENTS OF THE MACROECONOMY THE CIRCULAR FLOW DIAGRAM circular flow A diagram showing the income received and payments made by each sector of the economy. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 29

CHAPTER 5: Introduction to Macroeconomics THE COMPONENTS OF THE MACROECONOMY FIGURE 5. 1 The Circular Flow of Payments © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 30

CHAPTER 5: Introduction to Macroeconomics THE COMPONENTS OF THE MACROECONOMY transfer payments Cash payments made by the government to people who do not supply goods, services, or labor in exchange for these payments. They include Social Security benefits, veterans’ benefits, and welfare payments. Everyone’s expenditures go somewhere. It is impossible to sell something without there being a buyer, and it is impossible to make a payment without there being a recipient. Every transaction must have two sides. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 31

CHAPTER 5: Introduction to Macroeconomics THE COMPONENTS OF THE MACROECONOMY THE THREE MARKET ARENAS Another way of looking at the ways households, firms, the government, and the rest of the world relate to each other is to consider the markets in which they interact. The three market arenas are: 1. Goods-and-services market 2. Labor market 3. Money (financial) market © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 32

CHAPTER 5: Introduction to Macroeconomics THE COMPONENTS OF THE MACROECONOMY Goods-and-Services Market Firms supply to the goods-and-services market. Households, the government, and firms demand from this market. Labor Market In this market, households supply labor, and firms and the government demand labor. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 33

CHAPTER 5: Introduction to Macroeconomics THE COMPONENTS OF THE MACROECONOMY Money Market 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. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 34

CHAPTER 5: Introduction to Macroeconomics THE COMPONENTS OF THE MACROECONOMY Treasury bonds, notes, and bills Promissory notes issued by the federal government when it borrows money. corporate bonds Promissory notes issued by corporations when they borrow money. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 35

CHAPTER 5: Introduction to Macroeconomics All of the following are debt instruments, or promissory notes issued by a borrower, except one. Which one? a. Treasury bonds. b. Treasury notes. c. Treasury bills. d. Corporate Stocks. e. Corporate bonds. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 36

CHAPTER 5: Introduction to Macroeconomics All of the following are debt instruments, or promissory notes issued by a borrower, except one. Which one? a. Treasury bonds. b. Treasury notes. c. Treasury bills. d. Corporate Stocks. e. Corporate bonds. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 37

CHAPTER 5: Introduction to Macroeconomics THE COMPONENTS OF THE MACROECONOMY shares of stock 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 The portion of a corporation’s profits that the firm pays out each period to its shareholders. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 38

CHAPTER 5: Introduction to Macroeconomics THE METHODOLOGY OF MACROECONOMICS CONNECTIONS TO MICROECONOMICS The reason for looking to microeconomics for help in explaining macroeconomic events is simple: Macroeconomic behavior is the sum of all the microeconomic decisions made by individual households and firms. If the movements of macroeconomic aggregates, such as total output or total employment, reflect decisions made by individual firms and households, we cannot understand the former without some knowledge of the factors that influence the latter. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 39

CHAPTER 5: Introduction to Macroeconomics THE METHODOLOGY OF MACROECONOMICS AGGREGATE DEMAND AGGREGATE SUPPLY aggregate demand The total demand for goods and services in an economy. aggregate supply The total supply of goods and services in an economy. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 40

CHAPTER 5: Introduction to Macroeconomics The logic behind the aggregate supply and aggregate demand curves is: a. Identical to the market supply and market demand curves. b. More abstract than the logic of individual supply and demand curves. c. More complex than the logic of market supply and demand. d. Less abstract and complex than the logic of market supply and demand. e. Irrational because it is impossible to sum all microeconomic decisions. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 41

CHAPTER 5: Introduction to Macroeconomics The logic behind the aggregate supply and aggregate demand curves is: a. Identical to the market supply and market demand curves. b. More abstract than the logic of individual supply and demand curves. c. More complex than the logic of market supply and demand. d. Less abstract and complex than the logic of market supply and demand. e. Irrational because it is impossible to sum all microeconomic decisions. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 42

CHAPTER 5: Introduction to Macroeconomics THE METHODOLOGY OF MACROECONOMICS FIGURE 5. 2 The Aggregate Demand Aggregate Supply Curves © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 43

CHAPTER 5: Introduction to Macroeconomics THE U. S. ECONOMY SINCE 1900: TRENDS AND CYCLES EXPANSION AND CONTRACTION: THE BUSINESS CYCLE FIGURE 5. 3 A Typical Business Cycle © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 44

CHAPTER 5: Introduction to Macroeconomics Which of the following terms applies to the characteristics of the typical business cycle? a. Regular, recurrent, symmetric. b. Irregular, recurrent, symmetric. c. Irregular, recurrent, asymmetric. d. Periods of expansion that are equal in length to the periods of contraction. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 45

CHAPTER 5: Introduction to Macroeconomics Which of the following terms applies to the characteristics of the typical business cycle? a. Regular, recurrent, symmetric. b. Irregular, recurrent, symmetric. c. Irregular, recurrent, asymmetric. d. Periods of expansion that are equal in length to the periods of contraction. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 46

CHAPTER 5: Introduction to Macroeconomics THE U. S. ECONOMY SINCE 1900: TRENDS AND CYCLES expansion or boom The period in the business cycle from a trough up to a peak, during which output and employment rise. contraction, recession, or slump The period in the business cycle from a peak down to a trough, during which output and employment fall. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 47

CHAPTER 5: Introduction to Macroeconomics THE U. S. ECONOMY SINCE 1900: TRENDS AND CYCLES FIGURE 5. 4 Real GDP, 1900– 2004 © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 48

CHAPTER 5: Introduction to Macroeconomics THE U. S. ECONOMY SINCE 1900: TRENDS AND CYCLES THE U. S. ECONOMY SINCE 1970 FIGURE 5. 5 Real GDP, 1970 I– 2005 II © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 49

CHAPTER 5: Introduction to Macroeconomics THE U. S. ECONOMY SINCE 1900: TRENDS AND CYCLES FIGURE 5. 6 Unemployment Rate, 1970 I– 2005 II © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 50

CHAPTER 5: Introduction to Macroeconomics THE U. S. ECONOMY SINCE 1900: TRENDS AND CYCLES FIGURE 5. 7 Percentage Change in the GDP Deflator (Four-Quarter Average), 1970 I– 2005 II © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 51

CHAPTER 5: Introduction to Macroeconomics Since 1983, which of the following rates has been low relative to the standards of the 1970 s? a. The unemployment rate. b. The inflation rate. c. The rate of interest. d. The exchange rate. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 52

CHAPTER 5: Introduction to Macroeconomics Since 1983, which of the following rates has been low relative to the standards of the 1970 s? a. The unemployment rate. b. The inflation rate. c. The rate of interest. d. The exchange rate. © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 53

CHAPTER 5: Introduction to Macroeconomics REVIEW TERMS AND CONCEPTS aggregate behavior aggregate demand aggregate output aggregate supply business cycle circular flow contraction, recession, or slump corporate bonds deflation depression dividends expansion or boom fine-tuning fiscal policy Great Depression hyperinflation macroeconomics microeconomic foundations of macroeconomics microeconomics monetary policy recession shares of stock stagflation sticky prices supply-side policies transfer payments Treasury bonds, notes, bills unemployment rate © 2007 Prentice Hall Business Publishing Principles of Economics 8 e by Case and Fair 54