Introduction To Macroeconomics: Prepared By: Fernando Quijano and Yvonn Quijano

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
Introduction to Macroeconomics
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
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
Market clearing
AS
prices
The classical economists
assumed that the prices and
wages are always in the
equilibrium which means the
P* market clearing
AD
Aq Quantity of goods
Market clearing – labour market
Wages Excess L Supply LS

The classical economists assumed that the wages ad
unemployment instantly to market clearing (equilibrium point)
a b Example: when the wages are (w1) there is an excess sup

of labours (unemployment) and smaller demand on lab
W1 so, the wages will be decreased instantly to reach
equilibrium . (full employment)
W* E And also when the wages are (w2) there is an exc
demand on labour. So, the wages will be increased dire
to reach the equilibrium wage.
c d
W2
Excess L demand
LD
Lf
Ld1 Ld2 Quantity of Labours
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.
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
• 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.
• 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.
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.
Introduction to Macroeconomics
• Macroeconomists often reflect on the

microeconomic principles underlying
macroeconomic analysis, or the microeconomic
foundations 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.
How Great was the Great Depression?
• Real output (GDP)
• Unemployment
•Prices
•Some 7000 banks failed.
Unemployment
Stock Market Crash
THE STOCK MARKET
• By 1929, many Americans were

invested in the Stock Market
• The Stock Market had become

the most visible sector for
investment.
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
The stock Market between 1920 - 1928
Stock prices
S of Stock
b
50
a
5
Ds1 Ds2
Q1 Q2 Q of stocks
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
The stock Market in 1929 – Great Depression
Prices of stocks
Ss1
a Ss2
5.00
b
1.00
Ds
Q1 Q2
Number sold stocks
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
CONSUMER SPENDING DOWN
• Most people did not have

the money to buy the
flood of goods factories
produced
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.
Stimulation of AD
A shift in the AD
AS In thisto
situation,
AD1 as athe
Inflation curve
economy
result of awould
changebein
operating
any or all ofat the
less
than
factorscapacity,
affectingthere
AD
would be
would increase
unemployment
growth, reduce and
the economy might
unemployment but at
b be growing only
a cost of higher
slowly.
inflation
2.5%
a
2.0%
AD 1
AD
Y1 Y2 Real National Income
• 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.
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 أمل‬in the 1970s and early 1980s where the
stagflation has been born in 1970.
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
Macroeconomic Concerns
• Three of the major concerns of

macroeconomics are:
• Inflation
• Output growth
• Unemployment
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.
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 ?
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.
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.
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?
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
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.
The Components of
the Macroeconomy
• The circular flow diagram shows

the income received and payments
made by each sector of the
economy.
The Components of
the Macroeconomy
• Everyone’s
expenditure is
someone else’s
receipt. Every
transaction must
have two sides.
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.
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
• 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.
• 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.
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.
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
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.
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.
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.

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CHAPTER 5

Prepared by: Fernando Quijano

• Microeconomics examines the behavior of

• Classical economists applied microeconomic models, or “market clearing” models,

Wages Excess L Supply LS

a b Example: when the wages are (w1) there is an excess sup

• Under the classical model, the economists assumed that

unemployment wages Quantity of Labour Demand directly

• During the great depression this theory has fallen to explain

• In the classical view the economists said that the supply

Supply Creates Demand

• However, simple classical models failed to

• According to the John Keynz this theory is wrong and he said

• The increasing of the AD will increase the labor demand and

• Sticky prices are prices that do not always

• Macroeconomists often reflect on the

• The Great Depression was a period of severe

• The great depression has started by the

• Real output (GDP)

•Some 7000 banks failed.

• By 1929, many Americans were

• The Stock Market had become

• Through most of the 1920s, stock prices rose

• The prices of bonds and stocks started to decreased

• High percentage of Americans sold their bonds and

• After the crash, many

• Banks had invested in

Bank run 1929, Los Angeles

• Most people did not have

• According to the Keynesian theory , the level of employment is not

• Keynes believes that the government has to stimulate the aggregate

Y1 Y2 Real National Income

• In 1936, John Maynard Keynes published

• During periods of low private demand, the

• Fine-tuning in 1960 was the phrase used by

• The use of Keynesian policy to fine-tune the

• Stagflation occurs when the overall

• Stagflation : Increasing of inflation

• Three of the major concerns of

• Inflation is an increase in the overall price level.

• Hyperinflation is a period of very rapid increases in the

• Hyperinflation is a situation in which prices and wages

• Deflation is a decrease in the overall price level.

• 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 ?

• The business cycle is the cycle of short-term

• The main measure of how an economy is doing

• Aggregate output is the total quantity of goods

• A recession is a period during which aggregate output

• A prolonged and deep recession becomes a depression.

• The unemployment rate is the percentage of the

• There are three kinds of policy

3. Growth or supply-side policies

• Fiscal policy refers to government policies concerning

• Monetary policy consists of tools used by the Federal

• Growth policies are government policies that focus on

• The circular flow diagram shows

• Transfer payments are payments made by the

• Households, firms, the government,

3. Money (financial) market