1. © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 5 Chapter PART II CONCEPTS AND PROBLEMS IN MACROECONOMICS Introduction to Macroeconomics

2. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 54 Chapter Outline 5 Introduction to Macroeconomics PART II CONCEPTS AND PROBLEMS IN MACROECONOMICS 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 and Aggregate Supply The U.S. Economy Since 1900: Trends and Cycles Expansion and Contraction: The Business Cycle The U.S. Economy Since 1970

3. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 54 INTRODUCTION TO MACROECONOMICS microeconomics Examines the functioning of individual industries and the behavior of individual decision- making 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.

4. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 54 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.

5. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 54 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.

6. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 54 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.

7. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 54 THE ROOTS OF MACROECONOMICS Great Depression The period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s. THE GREAT DEPRESSION

8. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 54 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.

9. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 54 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.

10. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 54 THE ROOTS OF MACROECONOMICS Fine-Tuning in the 1960s RECENT MACROECONOMIC HISTORY fine-tuning The phrase used by Walter Heller to refer to the government’s role in regulating inflation and unemployment.

11. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 54 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.

12. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 54 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.

13. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 54 THE ROOTS OF MACROECONOMICS Disillusionment in the 1970s and Early 1980s stagflation Occurs when the overall price level rises rapidly (inflation) during periods of recession or high and persistent unemployment (stagnation).

14. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 54 THE ROOTS OF MACROECONOMICS Good Times in the 1990s, Pause in 2000–2001, and Recovery in 2002–2005 The strong economy in the 1990s 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.

15. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 54 MACROECONOMIC CONCERNS Three of the major concerns of macroeconomics are: ■Inflation ■Output growth ■Unemployment

16. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 54 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.

17. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 54 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.

18. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 54 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.

19. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 54 MACROECONOMIC CONCERNS OUTPUT GROWTH: SHORT RUN AND LONG RUN business cycle The cycle of short- term ups and downs in the economy. aggregate output The total quantity of goods and services produced in an economy in a given period.

20. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 54 MACROECONOMIC CONCERNS depression A prolonged and deep recession. recession A period during which aggregate output declines. Conventionally, a period in which aggregate output declines for two consecutive quarters.

21. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 54 MACROECONOMIC CONCERNS unemployment rate The percentage of the labor force that is unemployed. UNEMPLOYMENT

22. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 54 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.

23. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 54 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.

24. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 54 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

25. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 54 GOVERNMENT IN THE MACROECONOMY fiscal policy Government policies concerning taxes and expenditures (spending). FISCAL POLICY

26. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 54 GOVERNMENT IN THE MACROECONOMY monetary policy The tools used by the Federal Reserve to control the quantity of money in the economy. MONETARY POLICY

27. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 54 GOVERNMENT IN THE MACROECONOMY supply-side policies Government policies that focus on stimulating aggregate supply instead of aggregate demand. GROWTH POLICIES

28. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 54 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).

29. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 54 THE COMPONENTS OF THE MACROECONOMY circular flow A diagram showing the income received and payments made by each sector of the economy. THE CIRCULAR FLOW DIAGRAM

30. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 54 THE COMPONENTS OF THE MACROECONOMY FIGURE 5.1The Circular Flow of Payments

31. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 54 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.

32. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 32 of 54 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

33. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 33 of 54 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.

34. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 34 of 54 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.

35. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 35 of 54 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.

36. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 36 of 54 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.

37. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 37 of 54 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.

38. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 38 of 54 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.

39. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 39 of 54 THE METHODOLOGY OF MACROECONOMICS CONNECTIONS TO MICROECONOMICS 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. The reason for looking to microeconomics for help in explaining macroeconomic events is simple:

40. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 40 of 54 THE METHODOLOGY OF MACROECONOMICS AGGREGATE DEMAND AND 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.

41. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 41 of 54 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.

42. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 42 of 54 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.

43. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 43 of 54 THE METHODOLOGY OF MACROECONOMICS FIGURE 5.2The Aggregate Demand and Aggregate Supply Curves

44. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 44 of 54 THE U.S. ECONOMY SINCE 1900: TRENDS AND CYCLES FIGURE 5.3A Typical Business Cycle EXPANSION AND CONTRACTION: THE BUSINESS CYCLE

45. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 45 of 54 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.

46. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 46 of 54 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.

47. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 47 of 54 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.

48. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 48 of 54 THE U.S. ECONOMY SINCE 1900: TRENDS AND CYCLES FIGURE 5.4Real GDP, 1900–2004

49. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 49 of 54 THE U.S. ECONOMY SINCE 1900: TRENDS AND CYCLES FIGURE 5.5Real GDP, 1970 I–2005 II THE U.S. ECONOMY SINCE 1970

50. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 50 of 54 THE U.S. ECONOMY SINCE 1900: TRENDS AND CYCLES FIGURE 5.6Unemployment Rate, 1970 I–2005 II

51. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 51 of 54 THE U.S. ECONOMY SINCE 1900: TRENDS AND CYCLES FIGURE 5.7Percentage Change in the GDP Deflator (Four-Quarter Average), 1970 I–2005 II

52. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 52 of 54 Since 1983, which of the following rates has been low relative to the standards of the 1970s? a.The unemployment rate. b.The inflation rate. c.The rate of interest. d.The exchange rate.

53. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 53 of 54 Since 1983, which of the following rates has been low relative to the standards of the 1970s? a.The unemployment rate. b.The inflation rate. c.The rate of interest. d.The exchange rate.

54. CHAPTER 5: Introduction to Macroeconomics © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 54 of 54 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 inflation 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 REVIEW TERMS AND CONCEPTS