Chapter Objectives - Chapter 1

HOW T H E S O C I E T Y C A N A L L O C AT E I T S L I M I T E D R E S O U R C E S
M O S T E F F I C I E N T LY ?

DIVIDEDI N T O D I S T I N C T A R E A S O F S T U D Y, M I C R O E C O N O M I C S
AND MACROECONOMICS.

 ADVENT OF KEYNES ’ B OOK, ‘TH E GEN ER AL THEORY OF

E M P L O Y M E N T, I N T E R E S T A N D M O N E Y ” I N T H E Y E A R 1 9 3 6 .

EXERCISE:
 Macroeconomics is important for all: Individual, consumer, firm or
government.

 L E A R N I N G T H AT T H E VA R I A B L E S I N A N Y E C O N O M I C M O D E L C A N
B E A S T O C K O R A F L O W.

 S TAT I C R E L AT I O N S H I P ( W H E N A L L VA R I A B L E S R E L AT E T O T H E
SAME TIME PERIOD)
 D Y N A M I C R E L AT I O N S H I P ( W H E N A L L T H E VA R I A B L E S R E L AT E
TO DIFFERENT TIME PERIODS).

 G I V E N S E T O F R E L AT I O N S H I P S B E T W E E N T H E VA R I A B L E S M AY
LEAD TO EQUILIBRIUM OR A DISEQUILIBRIUM SOLUTION.
 Macroeconomics and Microeconomics

• ECONOMIC PROBLEMS
• of limited resources and unlimited wants.

• of scarcity

• DIVISION: MICROECONOMICS AND MACROECONOMICS

• Microeconomics
• Which analyzes market behavior and decision making process of the individual consumers
and firms.
• Macroeconomics
• How the national economy as a whole grows and the changes which occur over time.

• EXERCISE:

• “While foundation of microeconomics lies in macroeconomics,2

foundation of macroeconomics lies in microeconomic”
2.Keynesian Economics provided an alternative theory to
explain the determination of employment and output.
What causes unemployment and downturns?
• How the consumption and investment levels are determined?
• How a central bank manages the money and interest rates?
• Why some nations prosper and why others stagnate?
• 1936 that Keynes book, “The General Theory of Employment, Interest
and Money” .

• Criticism:
• Too much restrictive policy measures led to 1970 recession, not successful
in checking recession.
• Tools focused too much on controlling the aggregate demand and
neglected the supply side.
3. Post Keynesian Economics, monetarism.

Role of money as a major factor for whatever

happens in an economy!

• In the 1970’s the classical theory took a new turn with the introduction
of the concept of rational expectations.

 Economic concept
 People make choices based on their rational outlook, available
information and past experiences.

 Current expectations in an economy are equivalent to what people

think the future state of the economy will become.

 This contrasts with the idea that government policy influences people's
decisions
CASE: Great Recession 1929
 Great Depression was a worldwide economic depression that lasted 10
years. Its kickoff was “Black Thursday," October 24, 1929. That's when
traders sold 12.9 million shares of stock in one day, triple the usual amount.
Over the next four days, stock prices fell 23 percent in the stock market
crash of 1929. The Great Depression had already started in August when
the economy contracted.

 Unemployment Reached 25 Percent

 The Great Depression affected all aspects of society. By its height in
1933, unemployment had risen from 3 percent to 25 percent of the nation’s
workforce. Wages for those who still had jobs fell 42 percent. U.S. gross
domestic product was cut in half, from $103 billion to $55 billion. That was
partly because of deflation. Prices fell 10 percent each year. Panicked
government leaders passed the Smoot-Hawley tariff to protect domestic
industries and jobs. As a result, world trade plummeted 65 percent as
measured in U.S. dollars.
 It fell 25 percent in the total number of units.

CASE: Great Recession 1929

 CASE: Great Recession 1929

Life During The Depression

 Depression caused many farmers to lose their farms. At the

same time, years of over-cultivation and drought created the
“Dust Bowl” in the Midwest. It ended agriculture in a previously
fertile region. Thousands of these farmers and other
unemployed workers looked for work in California. Many ended
up living as homeless “hobos.” Others moved to shantytowns
called “Hoovervilles," named after then-President Herbert
Hoover.
 What Caused It
 According to Ben Bernanke, past chairman of the Federal Reserve, the central
bank helped create the Depression. It used tight monetary policies when it
should have done the opposite. Bernanke highlighted the Fed's five critical
mistakes.
 (i) The Fed began raising the fed funds rate in the spring of 1928. It kept
increasing it through a recession that started in August 1929. When the stock
market crashed, investors turned to the currency markets. At that time,
the gold standard supported the value of the dollars held by the U.S.
government. Speculators began trading in their dollars for gold in September
1931. That created a run on the dollar. The Fed raised interest rates again to
preserve the dollar's value. That further restricted the availability of money for
businesses. More bankruptcies followed.
 The Fed did not increase the supply of money to combat deflation. Investors
withdrew all their deposits from banks. The failure of the banks created more
panic. The Fed ignored the banks' plight. This situation destroyed any of
consumers’ remaining confidence in financial institutions. Most people
withdrew their cash and put it under their mattresses. That further decreased
the money supply. The Fed did not put enough money in circulation to get the
economy going again. Instead, the Fed allowed the total supply of U.S. dollars
to fall 30 percent
What Ended the Great Depression

In 1932, the country elected Franklin D. Roosevelt as president. He promised to create

federal government programs to end the Great Depression. Within 100 days, he signed
the New Deal into law. It created 42 new agencies. They were designed to create jobs,
allow unionization, and provide unemployment insurance. Many of these programs still
exist. They include Social Security, the Securities and Exchange Commission, and
the Federal Deposit Insurance Corporation. These programs help safeguard the
economy and prevent another depression. Many argue that World War II, not the New
Deal, ended the Depression. But if FDR had spent as much on the New Deal as he did
during the War, it would have ended the Depression. In the nine years between the
launch of the New Deal and the attack on Pearl Harbor, FDR increased the debt by $3
billion. In 1942, defense spending added $23 billion to the debt. In 1943, it added
another $64 billion. In fact, WWII had its roots in the Depression. Financial stress made
Germans desperate enough to elect Adolf Hitler's Nazi party to a majority in 1933.
If FDR had spent enough on the New Deal to end the Depression before Hitler rose to
power, World War II might never have happened.

CASE: Great Recession 1929

Reasons a Great Depression Could Not Happen Again
A depression on the same scale could not happen the
same way. Central banks around the world, including the
Federal Reserve, have learned from the past. They know
how to use monetary policy to manage the economy.
But monetary policy can't offset fiscal policy. The sizes of
the U.S. national debt and the current account deficit could
trigger an economic crisis. That would be difficult for
monetary policy to fix. No one can be certain what will
happen since the current U.S. debt level is unprecedented.

CASE: Great Recession 1929

 Need to Study Macroeconomics…different view points!

VIEWPOINT OF AN INDIVIDUAL:
W H O I S M A N A G I N G H I S O W N A S S E T P O R T F O L I O ; I T M AY B E O F C O N S I D E R A B L E
I M P O R T A N C E T O B E A W A R E O F T H E C U R R E N T F I S C A L P O L I C Y ; G O V T M AY B U Y B A C K
OR RE-ISSUE BONDS

VIEWPOINT OF THE CONSUMERS;

CONSUMER ’ S INTEREST LIES IN WANTIN G TO KNOW ABOUT THE PRICE OF THE
GOODS AND SERVICE AND ALSO AS TO H O W M U C H M AY B E T H E C O S T O F
BORROWING.

VIEWPOINT OF BUSINESS:
L I E S I N WAN T I N G T O K N O W W H E T H E R O R N O T T O E X PAN D P R O D U C T I O N

VIEWPOINT OF GOVERNMENT;
T U R N S TO M AC R O - E C O N O M Y W H E N P L AN N I N G I T S B U D G E T AN D TAX E S , D E C I D I N G O N
T H E I N T E R E S T R AT E S A N D M A K I N G I T S O T H E R P O L I C Y D E C I S I O N S .

V I E W P O I N T O F AN E C O N O M Y:
I T S P E R F O R M A N C E I S E V A L U A T E D B Y T H E N A T I O N A L O U T P U T, T H E R AT E OF
U N E M P L O Y M E N T, T H E I N F L A T I O N R A T E A N D T H E T R A D E P E R F O R M A N C E . 11

E C O N O M Y ’ S S TAB I L I T Y AN D G R O W T H ,
V I E W P O I N T O F A N M A C R O E C O N O M I S T S A R E I N V O LV E D I N T R Y I N G T O A N A LY S E T H E
S H O R T - R U N F L U C T U AT I O N S I N T H E N AT I O N A L I N C O M E W H I C H L E A D T O T H E
 Concepts in Macroeconomics
• STOCK
• Quantity which is measured at a point in time.

• W H I L E A C H A N G E I N S T O C K O C C U R S D U E T O A C H A N G E I N T H E F L O W, A
C H A N G E I N F L O W M AY A L S O B E I N F L U E N C E D B Y A C H A N G E I N S T O C K .

• E Q U I L I B R I U M I S A S T AT E O F B A L A N C E O R A S T AT E W H E R E T H E R E I S N O
C H A N G E . D I S E Q U I L I B R I U M I S A S T AT E O F I M B A L A N C E .

• FLOW E Q U I L I B R I U M C A N B E TA K E N A S S H O R T R U N E Q U I L I B R I U M .
S T O C K E Q U I L I B R I U M C A N B E TA K E N A S L O N G R U N E Q U I L I B R I U M .

• TWO METHODS EMPLOYED IN THE CONSTRUCTION OF THESE ECONOMIC

M O D E L S A R E S T AT I C S A N D D Y N A M I C S .
• I N S T AT I C M O D E L S
• Relations between the different variables relate to the same period in time. Static models are unable to explain
the process of change.

• DYNAMIC MODELS 12
• Trace the changes that occur in the values of the different variables over time.
 Partial Equilibrium and General Equilibrium

• PA R T I A L E Q U I L I B R I U M A N A LY S I S ( M A R S H A L L ’ S )

• Based on the assumption of ceteris paribus.

• Relevant for the learners as well as the noninterventionist
professors.

• G E N E R A L E Q U I L I B R I U M A N A LY S I S ( L E O N W A L R A S … )

• Involves a state where all the markets and the decision making
units in the economy are in a simultaneous equilibrium.

• Real economists are more interested in Walras ’ s general

equilibrium analysis.
13