Chapter 5

Principles of Macroeconomics

Overview of Macroeconomics

  • When the macroeconomy is doing well:

    • Jobs are easy to find.

    • Incomes are generally rising.

    • Profits of corporations are high.

  • If the macroeconomy is in a slump:

    • New jobs are scarce.

    • Incomes are not growing.

    • Profits are low.

  • Importance of understanding the macroeconomy:

    • Given the significant impact on lives, understanding macroeconomics is crucial.

Chapter Outline and Learning Objectives

5.1 Macroeconomic Concerns

  • Describe the primary three concerns of macroeconomics:

    • Output growth

    • Unemployment

    • Inflation and deflation

5.2 The Components of the Macroeconomy

  • Discuss the interaction between the four components of the macroeconomy:

    1. Households

    2. Firms

    3. The government

    4. The rest of the world

5.3 A Brief History of Macroeconomics

  • Summarize the macroeconomic history of the United States between 1929 and 1970.

5.4 The U.S. Economy since 1970

  • Describe the U.S. economy since 1970.

Introduction to Macroeconomics

5.1 Definitions

  • Microeconomics:

    • Examines the functioning of individual industries and the behavior of individual decision-making units—firms and households.

  • Macroeconomics:

    • Deals with the economy as a whole.

    • Focuses on determinants of total national income.

    • Deals with aggregates such as aggregate consumption and investment.

    • Looks at the overall level of prices instead of individual prices.

5.2 Key Concepts

  • 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.

Macroeconomic Concerns

1. Output Growth

  • 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.

  • Expansion or boom:

    • The period in the business cycle from a trough up to a peak during which output and employment grow.

  • Contraction, recession, or slump:

    • The period from a peak down to a trough during which output and employment fall.

  • Depression:

    • A prolonged and deep recession.

2. Business Cycle Phases

  • Figure 5.1 A Typical Business Cycle:

    • Economy expanding when moving from point A (trough) to peak.

    • Economy in recession moving from point B (peak) to trough.

  • Figure 5.2 U.S. Aggregate Output (Real GDP), 1900–2017:

    • Major fluctuations noted during Great Depression and World Wars I and II.

3. Unemployment

  • Unemployment rate:

    • The percentage of the labor force that is unemployed.

  • Implication of unemployment:

    • Suggests that the aggregate labor market is not in equilibrium.

4. 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.

Components of the Macroeconomy

  • Participants in the economy divided into four broad groups:

    1. Households

    2. Firms

    3. The government

    4. The rest of the world

  • Private Sector:

    • Comprises households and firms.

  • Public Sector:

    • Comprises the government.

  • Foreign Sector:

    • Comprises the rest of the world.

The Circular Flow Diagram

  • Circular Flow:

    • A diagram showing the flows in and out of the sectors in the economy.

  • Transfer payments:

    • Cash payments made by the government to individuals without an exchange for goods or services (e.g., Social Security, veterans' benefits).

Circular Flow Illustration

  • Figure 5.3 The Circular Flow of Payments:

    • Households receive income from firms and the government > purchase goods/services from firms > pay taxes to the government.

    • Firms receive payments from households and the government for goods/services > pay wages, dividends, interest, rents to households > pay taxes to the government.

    • Government receives taxes from firms/households > pays for goods/services to firms/households (including wages to government workers) and pays interest and transfers.

    • Other countries buy domestic goods/services (exports) and/or firms/governments purchase imports.

The Three Market Arenas

Overview

  • Three broad market arenas:

    1. Goods-and-services market

    2. Labor market

    3. Money (financial) market

1. Goods-and-Services Market

  • Households and government purchase goods/services from firms.

  • Firms provide goods/services to each other and supply the goods-and-services market.

  • Households, government, and firms demand from the goods-and-services market.

  • The rest of the world engages in the goods-and-services market by buying/selling.

2. Labor Market

  • In the labor market, households supply labor; firms/government demand labor.

  • Labor is supplied to/demanded from the rest of the world.

3. Money Market

  • Households supply funds expecting income from dividends on stocks and interest on bonds.

  • They also demand (borrow) funds for various purchases.

  • Firms borrow to build new facilities aiming to increase future earnings.

  • Government borrows by issuing bonds.

  • The rest of the world borrows/lends in the money market.

    • Many transactions are coordinated by financial institutions.

Money Market Instruments

  • Treasury bonds, notes, or bills:

    • Promissory notes issued by the federal government when it borrows money.

  • Corporate bonds:

    • Promissory notes issued by corporations when they borrow money.

  • Shares of stock:

    • Financial instruments granting a share of ownership in a firm and thus rights to profits.

  • Dividends:

    • The portion of a firm's profits paid out to shareholders periodically.

The Role of Government in the Macroeconomy

  • Fiscal policy:

    • Government policies concerning taxes and spending.

  • Monetary policy:

    • Tools used by the Federal Reserve to control short-term interest rates.

A Brief History of Macroeconomics

  • Great Depression:

    • Period of severe economic contraction and high unemployment starting 1929, lasting through the 1930s.

  • Fine-tuning:

    • Phrase by Walter Heller referring to the government's role in regulating inflation and unemployment.

  • Stagflation:

    • A situation characterized by both high inflation and high unemployment.

Economics In Practice

Macroeconomics in Literature

  • Novels reflect economic realities:

    • The Great Gatsby:

    • Set in the 1920s, reflecting macroeconomic sentiments.

    • The Grapes of Wrath:

    • Set in the early 1930s, corresponds with macroeconomic struggles.

Critical Thinking Prompts

  • Which of the three macroeconomic concerns is addressed in The Grapes of Wrath?

  • What economics textbook appears in The Great Gatsby?

Figures Illustrating Macroeconomic Trends

  • Figure 5.4 Aggregate Output (Real GDP), 1970 I–2017 IV:

    • Overall growth with five recessionary periods:

    1. 1974 I–1975 I

    2. 1980 II–1982 IV

    3. 1990 III–1991 I

    4. 2001 I–2001 III

    5. 2008 I–2009 II

  • Figure 5.5 Unemployment Rate, 1970 I–2017 IV:

    • Displays wide variations across five recessionary periods indicating spike in unemployment rate.

  • Figure 5.6 Inflation Rate (Percentage Change in the GDP Deflator, Four-Quarter Average), 1970 I–2017 IV:

    • High inflation noted in two significant periods:

    1. 1973 IV–1975 IV

    2. 1979 I–1981 IV

    • Moderate inflation from 1983–1992; relatively low inflation post-1992.

Review Terms and Concepts

  • Aggregate behavior

  • Aggregate output

  • 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

  • Microeconomics

  • Monetary policy

  • Shares of stock

  • Stagflation

  • Sticky prices

  • Transfer payments

  • Treasury bonds, notes, or bills

  • Unemployment rate