Principle of Economics Chapter 8 PDF

PRINCIPLE OF ECONOMICS NOOR SA'ADAH SABUDIN SEFB CHAPTER 8 Introduction to Macroeconomics Part I INTHISLECTURE Macroeconomic Concern The Component of the Macroeconomy History of Macroeconomics Macroeconomics Measurements: Prices...

PRINCIPLE OF ECONOMICS NOOR SA'ADAH SABUDIN SEFB CHAPTER 8 Introduction to Macroeconomics Part I INTHISLECTURE Macroeconomic Concern The Component of the Macroeconomy History of Macroeconomics Macroeconomics Measurements: Prices (inflation) and Unemployment After studying this chapter, you will be able: To explain macroeconomic definition, concern and component. To explain the difference between the classical and keynesian economists. To explain the consumer price index and the rate, the type and calculation of inflation. To explain the causes and effects of inflation.. After studying this chapter, you will be able: To explain the definition, the type, the reason and cause of unemployment. To distinguish unemployed, employed, labor force and population terms or definition. To measure unemployment rate. INTRODUCTION: BETWEEN MACROECONOMICS AND MICROECONOMICS 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 price level, which are influenced by the decision-making of all households and firms together in the economy. INTRODUCTION: BETWEEN MACROECONOMICS AND MICROECONOMICS International economics National economy Micro to Macro Markets Firms Consumers  THE HISTORY OF MACROECONOMICS Prior to Keynes, the distinction between Micro & Macro economic issues did not arise at all. The business cycles were considered to be inevitable, and there was no concrete approach to solve these problems. These economists known as Classical economists focused only on the micro aspects of the economy. The Great Depression of 1930s left many of these economists helpless. THE HISTORY OF MACROECONOMICS Free-market economists (Classical) believe the market mechanism is the best way to allocate resources. At the extreme, people can by very passionate about this ‘belief’ and ignore the evidence of market failure. Keynesian economists believe in government intervention to ‘correct’ the economy. WHERE THE DEBATE START? Adam Smith (1723-1790) more or less invented the subject of economics. He developed the idea that the economy worked best when each individual pursued their own self interest. He also recognised the importance of the ‘invisible hand’ of market forces in allocating resources to where they were most needed. Adam Smith’s ideas became the accepted economic orthodoxy for many years. Free- market (or classical) economics grew out of Adam Smith’s work. The government, it was believed, had little role to play in managing the economy. THE GREAT DEPRESSION The Great Depression of the 1930s changed everything. The extent of deprivation, unemployment and poverty was unprecedented in the modern world. The depression became worse rather than getting better, as classical economists argued it would. Economic theory failed to explain what was going on, or how the problems could be solved… THE GREAT DEPRESSION : WHAT HAPPENED?  Stock Markets crashed!  9000 banks filed for bankruptcy  Banks that survived stopped giving loans.  People cut down spending  Large amounts of inventories started piling up  Businesses stopped production….layoffs!( 25% unemployment)  Purchasing power declined  Hawley – Smoot tariff imposed on imports in 1930  Decline in world trade & economic retaliation. THE HISTORY OF MACROECONOMICS The accepted economic theory of the classical model, believed that the economy usually remains at full employment level( full utilization of resources). If there are any departures from this situation, these are purely temporary and for a short period of time. However, these classical models failed to explain the prolonged existence of high unemployment during the Great Depression. This provided the impetus for the development of macroeconomics. THE HISTORY OF MACROECONOMICS In 1936, John Maynard Keynes published The General Theory of Employment, Interest, and Money. Keynes believed governments could intervene in the economy and affect the level of output and employment. During periods of low private demand, the government can stimulate aggregate demand to lift the economy out of recession. THE HISTORY OF MACROECONOMICS Keynes argued that it is possible that high unemployment and underutilization of the capacities may take place and continue in the market economy. He also argued that government can play a bigger role during the economic depressions by effective utilization of monetary and fiscal policies. THE HISTORY OF MACROECONOMICS After the World War II, the focus of economics was just aimed at countering unemployment and inflation, and some economists proposed a fixed money growth rate to address these issues like inflation and unemployment. Hence these economists were called as monetarists as they have given importance to money. In the last few decades, another school of thought has gained prominence among noted economists. These economists opine that people should be given enough incentives for their earnings, rather than imposing taxes on their earnings. This group of economists advocates incentives for savings, known as supply side economists. SUMMARY Adam Smith creates the subject of micro- economics and the free-market orthodoxy which dominates until the 20th century. John Maynard Keynes creates macro- economics in response to the 1930s depression. He advocates government intervention to boost aggregate demand. Milton Friedman leads the free-market counter-revolution as unemployment and inflation soar in the 1970s. He blames excess money supply, trade unions and government failure. A new era of pro-market economic management begins. The financial crisis of 2007 sends the UK in to its deepest recession since the 1930s. Keynes’ policy comes to the rescue. But who is to blame for the crisis; government or the market?  THE COMPONENT OF MACROECONOMICS We divide the participants in the economy into four broad groups: Households (C) Firms (I) The government (G) The rest of the world (X-M) Households and firms make up the private sector, the government is the public sector, and the rest of the world is the foreign sector. THE COMPONENT OF MACROECONOMICS The Circular Flow Diagram  THE COMPONENT OF MACROECONOMICS The Circular Flow Diagram  A diagram showing the income received and payments made by each sector of the economy.  In the circular flow diagram, everyone’s expenditure is someone else’s receipt. Every transaction must have two sides.  What starts from one variable comes back to it after one round e.g (money paid by households for Goods &Services comes back to it in form of factor incomes)  THE COMPONENT OF MACROECONOMICS The Circular Flow Diagram  Households receive income from firms and the government, purchase goods and services from firms, and pay taxes to the government.  They also purchase foreign-made goods and services (imports).  THE COMPONENT OF MACROECONOMICS The Circular Flow Diagram  Firms receive payments from households and the government for goods and services; they pay wages, dividends, interest, and rents to households and taxes to the government.  THE COMPONENT OF MACROECONOMICS The Circular Flow Diagram  The government receives taxes from firms and households, pays firms and households for goods and services—including wages to government workers—and pays interest and transfers to households. Note: 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.  THE COMPONENT OF MACROECONOMICS The Circular Flow Diagram  Finally, people in other countries purchase goods and services produced domestically (exports). Note: Although not shown in this diagram, firms and governments also purchase imports.  THE COMPONENT OF MACROECONOMICS The Circular Flow Diagram All four sectors in the economy interact in three different market arenas which are the : (i) goods and services market (goods market) (AD-AS) (ii) labour market (Ld-Ls) (iii) financial market (Md-Ms) MACROECONOMIC CONCERN In macroeconomics, there are three important or major concerns, which are:  Output growth  Unemployment  Inflation and deflation OUTPUT GROWTH  Output growth is referred as an increase in the aggregate output (total quantity of goods and services produced) in an economy throughout a given period (usually one year).  The common measure for aggregate output is Gross Domestic Product (GDP). GDP in fixed prices (adjusted for price changes through years) is referred as real GDP.  Output Growth or Growth Rate = [(real GDP Year 2 – real GDP Year 1)/real GDP Year 1] X 100 OUTPUT GROWTH  There are two general areas of concern of output growth: (i) The short-run fluctuations in economic performance. The short-run fluctuations are referring to the short-term ups (increases) and downs (decreases) of aggregate output in the economy. (ii) The long-run economics growth.  Technically, these are known as “expansion” (output growth) and “recession” (output decrease) in the economy. OUTPUT GROWTH The Business Cycle Repeating period of expansion and recession makes up a “business cycle.” Recession = economic downturn or technically known as declines in aggregate output for at least two consecutive quarters. Depression = A prolonged and deep recession  OUTPUT GROWTH The Business Cycle  FIGURE 8.1 A Typical Business Cycle In this business cycle, the economy is expanding as it moves through point A from the trough to the peak. The economy is in recession when it moves through point B from a peak down to a trough. OUTPUT GROWTH Malaysia Growth Rate of GDP OUTPUT GROWTH Malaysia Growth Rate of GDP EMPLOYMENT AND UNEMPLOYMENT Each month, we chart the course of unemployment and inflation as measures of the health of the Malaysian economy. How do we measure the unemployment rate? How do we measure the inflation rate? Are they reliable vital signs for the economy? EMPLOYMENT AND UNEMPLOYMENT What kind of job market will you enter when you graduate? The class of 2012 in US had a tough time: In July 2012, 25 million Americans wanted a job but couldn’t find one. On a typical day, fewer than half that number of Americans are unemployed. The U.S. economy creates lots of jobs: 139 million people had jobs during the recession of 2009. But in recent years, the population has grown faster than the number of jobs, so unemployment is a serious problem.  EMPLOYMENT AND UNEMPLOYMENT What is Unemployment Unemployment refers to a situation in which the workers who are capable of working and willing to work do not get employment. A person who is :- Physically Fit Mentally sound Well qualified Willing to work at prevailing wage rate but does not get job, this situation is called unemployment. EMPLOYMENT AND UNEMPLOYMENT Why Unemployment Is a Problem Unemployment results in  Lost incomes and production  Lost human capital The loss of income is devastating for those who bear it. Employment benefits create a safety net but don’t fully replace lost wages, and not everyone receives benefits. Prolonged unemployment permanently damages a person’s job prospects by destroying human capital. EMPLOYMENT AND UNEMPLOYMENT Current Population Survey The U.S. Census Bureau/Malaysia’s Department of Statistic conducts a monthly population survey to determine the status of the U.S./Malaysian labor force. The population is divided into two groups: 1. The working-age population—the number of people aged 16 years and older who are not in jail, hospital, or some other institution 2. People too young to work (under 16 years of age) or in institutional care EMPLOYMENT AND UNEMPLOYMENT The working-age population is divided into two groups: 1. People in the labor force 2. People not in the labor force The labor force is the sum of employed and unemployed workers. EMPLOYMENT AND UNEMPLOYMENT Outside the Labor Force:  People with disabilities or mental  Pensions  People who study  People who are not interested in seeking or accepting jobs  People involved with their own work, like housewives  People who are not actively looking for work (discourage worker) EMPLOYMENT AND UNEMPLOYMENT Figure 8.2 shows the labor force categories in US. In June 2012: Population: 314 million Working-age population: 243.4 million Labor force: 155.0 million Employed: 142.2 million Unemployed: 12.8 million EMPLOYMENT AND UNEMPLOYMENT Measurement The unemployment rate is the percentage of the labor force that is unemployed. The unemployment rate is expressed as a percentage, and is calculated as follows: Number of people unemployed  100. labor force In June 2012, the labor force was 155 million and 12.8 million were unemployed, so the unemployment rate was 8.2 percent. The unemployment rate increases in a recession and reaches its peak value after the recession ends.  EMPLOYMENT AND UNEMPLOYMENT Figure 8.2 shows the unemployment rate in US : 1980–2012. The unemployment rate increases in a recession. EMPLOYMENT AND UNEMPLOYMENT Figure shows the unemployment rate in Malaysia : 1982–2023. The unemployment rate increases in a recession. EMPLOYMENT AND UNEMPLOYMENT Malaysia’s Unemployment rate 2021-2024 TYPES OF UNEMPLOYMENT Unemployment can be classified into three types:  Frictional unemployment  Structural unemployment  Cyclical unemployment  Seasonal unemployment TYPES OF UNEMPLOYMENT Frictional Unemployment Frictional unemployment is unemployment that arises from normal labor market turnover. Transitional unemployment due to people moving between jobs: Includes people experiencing short spells of unemployment Includes new and returning entrants into the labor market. Frictional unemployment is a permanent and healthy phenomenon of a growing economy. TYPES OF UNEMPLOYMENT Frictional Unemployment As we know, frictional unemployment occurs when a worker moves from one job to another. It is a result of imperfect information in the labor market, because if job seekers knew that they would be employed for a particular job vacancy, almost no time would be lost in getting a new job, eliminating this form of unemployment. Imperfect information about available job opportunities can lengthen the period of someone’s job search. Example: When you make up your mind and set off looking for a better job and abandoning the current one, you are in the frictional unemployment labor force. TYPES OF UNEMPLOYMENT Structural Unemployment Structural unemployment is unemployment created by changes in technology and foreign competition that change the skills needed to perform jobs or the locations of jobs. Structural unemployment arises when the qualification of a person is not enough to meet his job responsibilities. Under structural unemployment, a person either goes out of the job or remains unemployed for prolonged period of time till he acquires new skills. Structural unemployment lasts longer than frictional unemployment. TYPES OF UNEMPLOYMENT Structural Unemployment This types of unemployment also arises due to structural change in dynamic economy leads to change in the pattern of labor demand in the economy. Example: Heavy Manufacture (mining) - Manufacture now involves machines so humans are no longer needed for the harder work. Structural unemployment poses more of a problem because workers must seek jobs elsewhere or must develop the skills demanded. The process is full of pain and frustration, and may lead to negative impacts on society.  TYPES OF UNEMPLOYMENT Cyclical Unemployment (Keynesian) Cyclical unemployment, occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work. Demand for goods and services fall, less production is needed and less workers too. TYPES OF UNEMPLOYMENT Cyclical Unemployment (Keynesian) When business cycles are at their peak, cyclical unemployment will be low because total economic output is being maximized. When economic output falls, the business cycle is low and cyclical unemployment will rise. A worker who is laid off because the economy is in a recession and is then rehired when the expansion begins experiences cyclical unemployment. TYPES OF UNEMPLOYMENT Cyclical Unemployment (Keynesian) There is a cyclical relationship between demand, output, employment and unemployment. Caused by a fall in aggregate demand leading to a loss of real national output and employment. A slowdown can lead to businesses laying off workers because they lack confidence that demand will recover. Keynes argued that an economy can become stuck with a low rate of AD and an economy operating persistently below its potential. TYPES OF UNEMPLOYMENT Seasonal Unemployment Seasonal unemployment occurs at certain seasons of the year. It refers to a situation where a number of persons are not able to find jobs during some months of the year. EXAMPLE-: Agriculture is a seasonal activity. There is an increased demand for labor at the time of sowing, harvesting, weeding and threshing. In between there is little or no demand for labor. Agricultural labor finds himself unemployed during this period. This is called seasonal unemployment. TYPES OF UNEMPLOYMENT “Natural” Unemployment Natural unemployment is the unemployment that arises from frictions and structural change when there is no cyclical unemployment. Natural unemployment is all frictional and structural unemployment. The natural unemployment rate is natural unemployment as a percentage of the labor force. UNEMPLOYMENT AND FULL EMPLOYMENT Full employment is defined as the situation in which the unemployment rate equals the natural unemployment rate. When the economy is at full employment, there is no cyclical unemployment or, equivalently, all unemployment is frictional and structural. UNEMPLOYMENT AND FULL EMPLOYMENT The natural unemployment rate changes over time and is influenced by many factors. Key factors are  The age distribution of the population  The scale of structural change  The real wage rate  Unemployment benefits UNEMPLOYMENT AND FULL EMPLOYMENT The age distribution of the population An economy with young population has a large number of new job seekers every year and has a high level of frictional unemployment. An economy with aging population has fewer new job seekers and low level of frictional unemployment. UNEMPLOYMENT AND FULL EMPLOYMENT The scale of structural change The amount of structural unemployment fluctuates with the pace and volume of technological change and the change driven by fierce international competition, especially from fast changing Asian economics. UNEMPLOYMENT AND FULL EMPLOYMENT The real wage rate Real wage rate that bring unemployment are minimum wage and efficiency wage. Minimum wage set above equilibrium wage rate, thus Ls > Ld and create unemployment. An efficiency wage is a wage set above the going market wage to enables firms to attract the most productive workers, get them to work hard, and discourage them from quitting. UNEMPLOYMENT AND FULL EMPLOYMENT Unemployment benefits Unemployment benefits increase the natural unemployment rate by lowering the opportunity cost of job search. UNEMPLOYMENT AND FULL EMPLOYMENT Real GDP and Unemployment Over the Cycle Potential GDP is the quantity of real GDP produced at full employment. Potential GDP corresponds to the capacity of the economy to produce output on a sustained basis. Real GDP minus potential GDP is the output gap. Over the business cycle, the output gap fluctuates and the unemployment rate fluctuates around the natural unemployment rate. UNEMPLOYMENT AND FULL EMPLOYMENT Figure 8.5 shows the output gap and … the fluctuations of unemployment around the natural rate. When the output gap is negative,... the unemployment rate exceeds the natural unemployment rate. THE EFFECT OF UNEMPLOYMENT Effect of Unemployment on the Economy  Wastage of human resources  Low income/GDP  Low saving  Low capital formation  Low living standard  Low labour productivity  Higher welfare-budget deficit UNEMPLOYMENT AND FULL EMPLOYMENT Effect of Unemployment on the Society  Tension over taxes rise  Insecurity among employees  Crime and violence  Extra demand on health related services-stress related illness PRICE LEVEL, INFLATION AND DEFLATION The price level is the average level of prices and the value of money. A persistently rising price level is called inflation. A persistently falling price level is called deflation. We are interested in the price level because we want to 1. Measure the inflation rate or the deflation rate 2. Distinguish between money values and real values of economic variables. PRICE LEVEL, INFLATION AND DEFLATION Why Inflation and Deflation Are Problems Low, steady, and anticipated inflation or deflation is not a problem. Unpredictable inflation or deflation is a problem because it  Redistributes income and wealth  Lowers real GDP and employment  Diverts resources from production  PRICE LEVEL, INFLATION AND DEFLATION Why Inflation and Deflation Are Problems Affect the distribution of income and wealth : Wage contracts between workers and employers has resulted in losses to the employee if inflation is not expected to be too high, while wages will not rise immediately. Loan contract with agreed interest rate will result in a loss to the lender in the event that unexpected inflation is too high. Borrowers will gain much more from lender because the money paid by the borrower is less than the actual value of the loan. Interest rate paid by the borrower is unable to pay compensation incurred by the lender due to the loss of money lent.  PRICE LEVEL, INFLATION AND DEFLATION Why Inflation and Deflation Are Problems Lowers real GDP and employment : Unexpected inflation is increase the profitability of the firm, thereby increasing the firm's investment, production and employment, real GDP> potential GDP, the current unemployment rate