Principles of Economics

Transcription

1 Timothy Taylor s Principles of Economics Economics and the Economy Second Edition Timothy Taylor Journal of Economic Perspectives Macalester College For instructors: Instructor's manual PowerPoint slides Computerized test disk Free to students: e-textbook available as Micro and Macro splits e-study Guide e-lecture Guide e-pamphlet (with video): Using Adobe Reader for the Maximum e-book Experience e-pamphlet (with audio): Study Tips for the College Student

2 When ordering this title, use ISBN To order the Micro version, use ISBN To order the Macro version, use ISBN Cover photos by: Carsten Reisinger Fotolia Pavel Losevsky Fotolia Wimbledon Fotolia Vova Pomortzeff Fotolia Timothy Taylor photo courtesy of Annie Dunnigan Design LLC. Timothy Taylor s Principles of Economics: Economics and the Economy, Edition 2 Copyright 2011, 2008 Timothy Taylor. Published by Textbook Media ISBN All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system without the prior written permission of the author and the publisher. Printed in the United States of America by Freeload Press

3 Part I: The Interconnected Economy 1. The Interconnected Economy 1 2. Choice in a World of Scarcity International Trade 39 Part II: Supply and Demand 4. Demand and Supply Labor and Financial Capital Markets Globalization and Protectionism 103 Part III: The Fundamentals of Microeconomic Theory 7. Elasticity Household Decision Making Cost and Industry Structure Perfect Competition Monopoly Monopolistic Competition and Oligopoly 225 Part IV: Microeconomic Policy Issues Applications 13. Competition and Public Policy Environmental Protection and Negative Externalities Technology, Positive Externalities, and Public Goods Poverty and Economic Inequality Issues in Labor Markets: Unions, Discrimination, Immigration Information, Risk, and Insurance Financial Markets Public Choice 369 Part V: The Macroeconomic Perspective and Goals 21. The Macroeconomic Perspective Economic Growth Unemployment Inflation The Balance of Trade 461 Part VI: A Framework for Macroeconomic Analysis 26. The Aggregate Supply-Aggregate Demand Model The Keynesian Perspective The Neoclassical Perspective 533 Part VII: Monetary and Fiscal Policy 29. Money and Banks Monetary Policy and Bank Regulation Exchange Rates and International Capital Flows Government Budgets and Fiscal Policy Government Borrowing and National Savings Macroeconomic Policy around the World 657 Appendices 675 Glossary 715 Index 727 iii

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5 Preface xv About the Author xvii 1 The Interconnected Economy 1 What Is an Economy? 2 Market-Oriented vs. Command Economies 2 The Interconnectedness of an Economy 2 The Division of Labor 4 Why the Division of Labor Increases Production 4 Trade and Markets 5 The Rise of Globalization 5 Microeconomics and Macroeconomics 7 Microeconomics: The Circular Flow Diagram 7 Macroeconomics: Goals, Frameworks, and Tools 10 Studying Economics Doesn t Mean Worshiping the Economy 10 Key Concepts and Summary 12 Review Questions 13 2 Choice in a World of Scarcity 15 Choosing What to Consume 16 A Consumption Choice Budget Constraint 16 How Changes in Income and Prices Affect the Budget Constraint 16 Personal Preferences Determine Specific Choices 18 From a Model with Two Goods to the Real World of Many Goods 19 Choosing between Labor and Leisure 20 An Example of a Labor-Leisure Budget Constraint 20 How a Change in Wages Affects the Labor-Leisure Budget Constraint 20 Making a Choice Along the Labor-Leisure Budget Constraint 20 Choosing between Present and Future Consumption 22 Interest Rates: The Price of Intertemporal Choice 22 The Power of Compound Interest 24 An Example of Intertemporal Choice 24 Three Implications of Budget Constraints: Opportunity Cost, Marginal Decision-Making, and Sunk Costs 26 Opportunity Cost 26 Marginal Decision-Making and Diminishing Marginal Utility 27 Sunk Costs 28 The Production Possibilities Frontier and Social Choices 29 The Shape of the Production Possibilities Frontier and Diminishing Marginal Returns 30 Productive Efficiency and Allocative Efficiency 32 Why Society Must Choose 33 Confronting Objections to the Economic Approach 33 A First Objection: People, Firms, and Society Don t Act Like This 33 A Second Objection: People, Firms, and Society Shouldn t Do This 34 Facing Scarcity and Making Trade-offs 36 Key Concepts and Summary 36 Review Questions 38 3 International Trade 39 Absolute Advantage 41 A Numerical Example of Absolute Advantage and Trade 41 Trade and Opportunity Cost 44 Limitations of the Numerical Example 45 Comparative Advantage 46 Identifying Comparative Advantage 47 Mutually Beneficial Trade with Comparative Advantage 48 How Opportunity Cost Sets the Boundaries of Trade 50 Comparative Advantage Goes Camping 51 The Power of the Comparative Advantage Example 52 v

6 vi Contents Intra-industry Trade between Similar Economies 52 The Prevalence of Intra-industry Trade between Similar Economies 52 Gains from Specialization and Learning 53 Economies of Scale, Competition, Variety 54 Dynamic Comparative Advantage 55 The Size of Benefits from International Trade 56 From Interpersonal to International Trade 57 Key Concepts and Summary 58 Review Questions 58 4 Demand and Supply 59 Demand, Supply, and Equilibrium in Markets for Goods and Services 60 Demand for Goods and Services 60 Supply of Goods and Services 61 Equilibrium: Where Demand and Supply Cross 63 Shifts in Demand and Supply for Goods and Services 64 The Ceteris Paribus Assumption 65 An Example of a Shifting Demand Curve 65 Factors That Shift Demand Curves 66 Summing Up Factors That Change Demand 67 An Example of a Shift in a Supply Curve 67 Factors That Shift Supply Curves 68 Summing Up Factors That Change Supply 70 Shifts in Equilibrium Price and Quantity: The Four-Step Process 71 Good Weather for Salmon Fishing 71 Seal Hunting and New Drugs 72 The Interconnections and Speed of Adjustment in Real Markets 73 Price Ceilings and Price Floors in Markets for Goods and Services 74 Price Ceilings 75 Price Floors 77 Responses to Price Controls: Many Margins for Action 78 Policy Alternatives to Price Ceilings and Price Floors 79 Supply, Demand, and Efficiency 81 Consumer Surplus, Producer Surplus, Social Surplus 81 Inefficiency of Price Floors and Price Ceilings 82 Demand and Supply as a Social Adjustment Mechanism 84 Key Concepts and Summary 84 Review Questions 86 5 Labor and Financial Capital Markets 87 Demand and Supply at Work in Labor Markets 87 Equilibrium in the Labor Market 88 Shifts in Labor Demand 89 Shifts in Labor Supply 90 Technology and Wage Inequality: The Four-Step Process 90 Price Floors in the Labor Market: Living Wages and Minimum Wages 92 The Minimum Wage as an Example of a Price Floor 92 Demand and Supply in Financial Capital Markets 94 Who Demands and Who Supplies in Financial Capital Markets 94 Equilibrium in Financial Capital Markets 95 Shifts in Demand and Supply in Financial Capital Markets 96 The United States as a Global Borrower: The Four-Step Process 97 Price Ceilings in Financial Capital Markets: Usury Laws 98 Don t Kill the Price Messengers 99 Key Concepts and Summary 101 Review Questions Globalization and Protectionism 103 Protectionism: An Indirect Subsidy from Consumers to Producers 104 Demand and Supply Analysis of Protectionism 105 Who Benefits and Who Pays? 106 International Trade and Its Effects on Jobs, Wages, and Working Conditions 108 Fewer Jobs? 108 Trade and Wages 109 Labor Standards 110 The Infant Industry Argument 112 The Dumping Argument 113 The Growth of Anti-Dumping Cases 113 Why Might Dumping Occur? 113 Should Anti-Dumping Cases Be Limited? 114 The Environmental Protection Argument 114 The Race to the Bottom Scenario 115 Pressuring Low-Income Countries for Higher Environmental Standards 116 The Unsafe Consumer Products Argument 117 The National Interest Argument 117 How Trade Policy Is Enacted: Global, Regional, and National 119 The World Trade Organization 119 Regional Trading Agreements 120

7 Contents vii Trade Policy at the National Level 121 Long-Term Trends in Barriers to Trade 121 The Trade-offs of Trade Policy 123 Key Concepts and Summary 124 Review Questions Elasticity 127 Price Elasticity of Demand 128 Calculating the Elasticity of Demand 129 A Possible Confusion, a Clarification, and a Warning 131 Price Elasticity of Supply 132 Calculating the Elasticity of Supply 132 Elastic, Inelastic, and Unitary Elasticity 134 Applications of Elasticity 137 Does Raising Price Bring in More Revenue? 137 Passing on Costs to Consumers? 138 Long-Run vs. Short-Run Impact 141 Elasticity as a Gener al Concept 142 Income Elasticity of Demand 142 Cross-Price Elasticity of Demand 143 Elasticity in Labor and Financial Capital Markets 143 Stretching the Concept of Elasticity 144 Conclusion 145 Key Concepts and Summary 145 Review Questions Household Decision Making 149 Consumption Choices 149 Total Utility and Diminishing Marginal Utility 150 Choosing with Marginal Utility 152 A Rule for Maximizing Utility 152 Measuring Utility with Numbers 153 How Changes in Income and Prices Affect Consumption Choices 154 How Changes in Income Affect Consumer Choices 154 How Price Changes Affect Consumer Choices 155 The Foundations of Demand Curves 156 Applications in Business and Government 157 Labor-Leisure Choices 159 The Labor-Leisure Budget Constraint 160 Applications of Utility Maximizing with the Labor- Leisure Budget Constraint 161 Intertemporal Choices in Financial Capital Markets 163 Using Marginal Utility to Make Intertemporal Choices 163 Applications of the Model of Intertemporal Choice 166 The Unifying Power of the Utility-Maximizing Budget Set Framework 167 Key Concepts and Summary 167 Review Questions Cost and Industry Structure 169 The Structure of Costs in the Short Run 170 Fixed and Variable Costs 170 Average Costs, Average Variable Costs, Marginal Costs 173 Lessons Taught by Alternative Measures of Costs 174 A Variety of Cost Patterns 175 The Structure of Costs in the Long Run 176 Choice of Production Technology 176 Economies of Scale 178 Shapes of Long-Run Average Cost Curves 179 The Size and Number of Firms in an Industry 181 Shifting Patterns of Long-Run Average Cost 183 Conclusion 184 Key Concepts and Summary 185 Review Questions Perfect Competition 187 Quantity Produced by a Perfectly Competitive Firm 188 Comparing Total Revenue and Total Cost 188 Comparing Marginal Revenue and Marginal Costs 190 Marginal Cost and the Supply Curve 191 Profits and Losses with the Average Cost Curve 192 The Shutdown Point 192 Short-Run Outcomes for Perfectly Competitive Firms 194 Entry and Exit in the Long Run Output 196 How Entry and Exit Lead to Zero Profits 196 Economic Profit vs. Accounting Profit 197 The Economic Function of Profits 198 Factors of Production in Perfectly Competitive Markets 199 The Derived Demand for Labor 199 The Marginal Revenue Product of Labor 200 Are Workers Paid as Much as They Deserve? 201 Physical Capital Investment and the Hurdle Rate 202 Physical Capital Investment and Long-Run Average Cost 203 Efficiency in Perfectly Competitive Markets 204 Conclusion 205 Key Concepts and Summary 205 Review Questions 207

8 viii Contents 11 Monopoly 209 Barriers to Entry 210 Legal Restrictions 210 Control of a Physical Resource 211 Technological Superiority 211 Natural Monopoly 212 Intimidating Potential Competition 213 Summing Up Barriers to Entry 214 How a Profit-Maximizing Monopoly Chooses Output and Price 214 Demand Curves Perceived by a Perfectly Competitive Firm and by a Monopoly 214 Total and Marginal Revenue for a Monopolist 216 Marginal Revenue and Marginal Cost for a Monopolist 216 Illustrating Monopoly Profits 219 The Inefficiency of Monopoly 220 Conclusion 221 Key Concepts and Summary 222 Review Questions Monopolistic Competition and Oligopoly 225 Monopolistic Competition 226 Differentiated Products 226 Perceived Demand for a Monopolistic Competitor 227 How a Monopolistic Competitor Chooses Price and Quantity 227 Monopolistic Competitors and Entry 230 Monopolistic Competition and Efficiency 231 The Benefits of Variety and Product Differentiation 232 Oligopoly 233 Why Do Oligopolies Exist? 233 Collusion or Competition? 234 The Prisoner s Dilemma 234 The Oligopoly Version of the Prisoner s Dilemma 235 How to Enforce Cooperation 236 Trade-offs of Imperfect Competition 238 Key Concepts and Summary 239 Review Questions Competition and Public Policy 241 Corporate Mergers 242 Regulations for Approving Mergers 242 The Four-Firm Concentration Ratio 244 The Herfindahl-Hirshman Index 245 New Directions for Antitrust 246 Regulating Anticompetitive Behavior 247 Restrictive Practices 247 The Microsoft Case 248 An Evolving Set of Standards 249 When Breaking Up Is Hard to Do: Regulating Natural Monopolies 249 The Choices in Regulating a Natural Monopoly 250 Cost-Plus versus Price Cap Regulation 251 The Great Deregulation Experiment 252 Doubts about Regulation of Prices and Quantities 252 The Effects of Deregulation 253 Frontiers of Deregulation 254 Around the World: From Nationalization to Privatization 255 Key Concepts and Summary 256 Review Questions Environmental Protection and Negative Externalities 259 Externalities 261 Pollution as a Negative Externality 261 Command-and-Control Regulation 263 Market-Oriented Environmental Tools 264 Market-Friendly Environmental Tool #1: Pollution Charges 264 Market-Friendly Environmental Tool #2: Marketable Permits 265 Market-Friendly Environmental Tool #3: Better-Defined Property Rights 267 Applying Market-Oriented Environmental Tools 268 The Benefits and Costs of U.S. Environmental Laws 268 Benefits and Costs of Clean Air and Clean Water 268 Marginal Benefits and Marginal Costs 269 The Unrealistic Goal of Zero Pollution 271 International Environmental Issues 271 The Trade-off between Economic Output and Environmental Protection 272 Key Concepts and Summary 273 Review Questions Technology, Positive Externalities, and Public Goods 275 The Incentives for Developing New Technology 277 Some Grumpy Inventors 278 The Positive Externalities of New Technology 278 Contrasting Positive Externalities and Negative Externalities 280 How to Raise the Rate of Return for Innovators 281 Intellectual Property Rights 281 Government Spending on Research and Development 282

9 Contents ix Tax Breaks for Research and Development 283 Cooperative Research and Development 284 A Balancing Act 284 Public Goods 284 The Definition of a Public Good 285 The Free Rider Problem 286 The Role of Government in Paying for Public Goods 288 Positive Externalities and Public Goods 288 Key Concepts and Summary 289 Review Questions Poverty and Economic Inequality 291 Drawing the Poverty Line 292 The Poverty Trap 294 The Safety Net 297 Temporary Assistance for Needy Families 297 Earned Income Credit (EIC) 297 Food Stamps 298 Medicaid 299 Other Safety Net Programs 299 Measuring Income Inequality 299 Income Distribution by Quintiles 300 Lorenz Curve 301 Causes of Growing Income Inequality 302 The Changing Composition of American Households 302 A Shift in the Distribution of Wages 303 Government Policies to Reduce Income Inequality 304 Redistribution 305 The Ladder of Opportunity 306 Inheritance Taxes 307 The Trade-off between Incentives and Income Equality 308 Key Concepts and Summary 309 Review Questions Issues in Labor Markets: Unions, Discrimination, Immigration 311 Labor Unions 312 Facts about Union Membership and Pay 313 Higher Wages for Union Workers 314 The Decline in U.S. Union Membership 317 Concluding Thoughts about the Economics of Unions 319 Employment Discrimination 320 Earnings Gaps by Race and Gender 320 Investigating the Female/Male Earnings Gap 321 Investigating the Black/White Earnings Gap 322 Competitive Markets and Discrimination 323 Public Policies to Reduce Discrimination 324 An Increasingly Diverse Workforce 325 Immigration 326 Historical Patterns of Immigration 3261 Economic Effects of Immigration 326 Proposals for Immigration Reform 327 Conclusion 328 Key Concepts and Summary 328 Review Questions Information, Risk, and Insurance 331 The Problem of Imperfect Information 332 Lemons and Other Examples of Imperfect Information 332 How Imperfect Information Can Affect Equilibrium Price and Quantity 333 When Price Mixes with Imperfect Information about Quality 334 Mechanisms to Reduce the Risk of Imperfect Information 334 Insurance and Imperfect Information 336 How Insurance Works 337 Risk Groups and Actuarial Fairness 339 The Moral Hazard Problem 339 The Adverse Selection Problem 341 Government Regulation of Insurance 342 Conclusion 344 Key Concepts and Summary 344 Review Questions Financial Markets 347 How Businesses Raise Financial Capital 348 Early Stage Financial Capital 348 Profits as a Source of Financial Capital 349 Borrowing: Banks and Bonds 349 Corporate Stock and Public Firms 350 How Firms Choose between Sources of Financial Capital 351 How Households Supply Financial Capital 353 Bank Accounts 353 Bonds 355 Stocks 357 Mutual Funds 361 Housing and Other Tangible Assets 361 The Trade-offs between Return and Risk 363 How to Become Rich 364 Why It s Hard to Get Rich Quick: The Random Walk Theory 364 Getting Rich the Slow, Boring Way 365 How Capital Markets Transform Financial Flows 366 Key Concepts and Summary 366 Review Questions 368

10 x Contents 20 Public Choice 369 When Voters Don t Participate 370 Special-Interest Politics 372 Identifiable Winners, Anonymous Losers 373 Pork Barrels and Logrolling 374 Voting Cycles 375 Where Is Government s Self-Correcting Mechanism? 376 A Balanced View of Markets and Government 377 Key Concepts and Summary 378 Review Questions The Macroeconomic Perspective 381 Measuring the Size of the Economy: Gross Domestic Product 383 GDP Measured by Components of Demand 383 GDP Measured by What Is Produced 386 The Problem of Double Counting 387 Comparing GDP among Countries 388 Converting Currencies with Exchange Rates 388 Converting to Per Capita GDP 390 The Pattern of GDP over Time 391 How Well Does GDP Measure the Well-Being of Society? 393 Some Differences between GDP and Standard of Living 393 Does a Rise in GDP Overstate or Understate the Rise in the Standard of Living? 395 GDP Is Rough, but Useful 396 Conclusion 396 Key Concepts and Summary 396 Review Questions Economic Growth 399 The Relatively Recent Arrival of Economic Growth 400 Worker Productivity and Economic Growth 401 The Power of Sustained Economic Growth 403 The Aggregate Production Function 404 Components of the Aggregate Production Function 405 Growth Accounting Studies 407 A Healthy Climate for Economic Growth 408 Future Economic Convergence? 409 Arguments Favoring Convergence 410 Arguments That Convergence Is Neither Inevitable Nor Likely 412 The Slowness of Convergence 413 Key Concepts and Summary 414 Review Questions Unemployment 417 Unemployment and the Labor Force 418 In or Out of the Labor Force? 418 Calculating the Unemployment Rate 419 Controversies over Measuring Unemployment 419 Patterns of Unemployment 420 The Historical U.S. Unemployment Rate 420 Unemployment Rates by Group 421 International Unemployment Comparisons 423 Why Unemployment Is a Puzzle for Economists 424 Looking for Unemployment with Flexible Wages 424 Why Wages Might Be Sticky Downward 425 The Short Run: Cyclical Unemployment 426 The Long Run: The Natural Rate of Unemployment 427 Frictional Unemployment 428 Productivity Shifts and the Natural Rate of Unemployment 429 Public Policy and the Natural Rate of Unemployment 430 The Natural Rate of Unemployment in Recent Years 432 The Natural Rate of Unemployment in Europe 432 A Preview of Policies to Fight Unemployment 433 Key Concepts and Summary 434 Review Questions Inflation 437 Combining Prices to Measure the Inflation Rate 438 The Changing Price of a Basket of Goods 438 Index Numbers 440 Measuring Changes in the Cost of Living 442 Practical Solutions for the Substitution and the Quality/New Goods Biases 444 Alternative Price Indexes: PPI, GDP Deflator, and More 445 Inflation Experiences 446 Historical Inflation in the U.S. Economy 446 Inflation around the World 447 Adjusting Nominal Values to Real Values 448 Nominal to Real GDP 448 Nominal to Real Interest Rates 450 The Dislocations of Inflation 451 The Land of Funny Money 451 Unintended Redistributions of Purchasing Power 452 Blurred Price Signals 454 Problems of Long-Term Planning 454 Some Benefits of Inflation? 455

11 Contents xi Indexing and Its Limitations 455 Indexing in Private Markets 456 Indexing in Government Programs 456 Might Indexing Reduce Concern Over Inflation? 457 A Preview of Policy Discussions of Inflation 457 Key Concepts and Summary 458 Review Questions The Balance of Trade 461 Measuring Trade Balances 462 Components of the U.S. Current Account Balance 462 Trade Balances in Historical and International Context 464 The Intimate Connection between Trade Balances and Flows of Financial Capital 465 The Parable of Robinson Crusoe and Friday 466 The Balance of Trade as the Balance of Payments 467 The National Saving and Investment Identity 468 The National Saving and Investment Identity 468 Domestic Saving and Investment Determine the Trade Balance 469 Exploring Trade Balances One Factor at a Time 470 How Short-Term Movements in the Business Cycle Can Affect the Trade Balance 471 When Are Trade Deficits and Surpluses Beneficial or Harmful? 472 The Difference between Level of Trade and the Trade Balance 473 Final Thoughts about Trade Balances 475 Key Concepts and Summary 476 Review Questions The Aggregate Supply-Aggregate Demand Model 479 Macroeconomic Perspectives on Demand and Supply 480 Say s Law and the Macroeconomics of Supply 480 Keynes Law and the Macroeconomics of Demand 481 Combining Supply and Demand in Macroeconomics 482 Building a Model of Aggregate Supply and Aggregate Demand 482 The Aggregate Supply Curve and Potential GDP 482 The Aggregate Demand Curve 484 Equilibrium in the Aggregate Supply-Aggregate Demand Model 485 AS and AD Are Macro, not Micro 485 Shifts in Aggregate Supply 487 How Productivity Growth Shifts the AS Curve 487 How Changes in Input Prices Shift the AS Curve 488 Shifts in Aggregate Demand 488 How Changes by Consumers and Firms Can Affect AD 489 How Government Macroeconomic Policy Choices Can Shift AD 491 How the AS-AD Model Combines Growth, Unemployment, Inflation, and the Balance of Trade 492 Growth and Recession in the AS-AD Diagram 493 Unemployment in the AS-AD Diagram 493 Inflationary Pressures in the AS-AD Diagram 493 The Balance of Trade and the AS-AD Diagram 495 Keynes Law and Say s Law in the AS-AD Model 496 Key Concepts and Summary 498 Review Questions The Keynesian Perspective 501 The Building Blocks of Keynesian Analysis 502 The Importance of Aggregate Demand in Recessions 502 Wage and Price Stickiness 503 The Two Keynesian Assumptions in the AS-AD Model 504 The Components of Aggregate Demand 505 What Causes Consumption to Shift? 505 What Causes Investment to Shift? 506 What Causes Government Demand to Shift? 507 What Causes Exports and Imports to Shift? 507 The Phillips Curve 509 The Discovery of the Phillips Curve 509 The Instability of the Phillips Curve 510 Keynesian Policy for Fighting Unemployment and Inflation 512 The Expenditure-Output Model 513 The Axes of the Expenditure-Output Diagram 513 The Potential GDP Line and the 45-degree Line 513 The Aggregate Expenditure Schedule 514 Building the Aggregate Expenditure Schedule 514 Consumption as a Function of National Income 515 Investment as a Function of National Income 516 Government Spending and Taxes as a Function of National Income 517 Exports and Imports as a Function of National Income 518 Building the Combined Aggregate Expenditure Function 519 Equilibrium in the Keynesian Cross Model 520 Where Equilibrium Occurs 520 Recessionary and Inflationary Gaps 521

12 xii Contents The Multiplier Effect 523 How Does the Multiplier Work? 523 Calculating the Multiplier 525 Calculating Keynesian Policy Interventions 526 Multiplier Trade-offs: Stability vs. the Power of Macroeconomic Policy 527 Is Keynesian Economics Pro-Market or Anti-Market? 528 Key Concepts and Summary 529 Review Questions The Neoclassical Perspective 533 The Building Blocks of Neoclassical Analysis 534 The Importance of Potential GDP in the Long Run 534 The Role of Flexible Prices 535 How Fast Is the Speed of Macroeconomic Adjustment? 538 Policy Implications of the Neoclassical Perspective 539 Fighting Recession or Encouraging Long-Term Growth? 540 Fighting Unemployment or Inflation? 541 The Neoclassical Phillips Curve Trade-off 542 Macroeconomists Riding Two Horses 543 Key Concepts and Summary 545 Review Questions Money and Banks 547 Defining Money by Its Functions 548 Barter and the Double Coincidence of Wants 548 Three Functions for Money 549 Measuring Money: Currency, M1, and M2 550 How Banks Work 552 Banks as Financial Intermediaries 552 A Bank s Balance Sheet 554 How Banks Go Bankrupt 555 How Banks Create Money 557 The Story of System Bank 557 The Money Multiplier 558 Cautions about the Money Multiplier 559 Conclusions 560 Key Concepts and Summary 561 Review Questions Monetary Policy and Bank Regulation 563 Monetary Policy and the Central Bank 564 The Federal Reserve 564 Other Tasks and Funding of Central Banks 564 How a Central Bank Affects the Money Supply 566 Open Market Operations 566 Reserve Requirements 568 The Discount Rate 569 Quantitative Easing 569 Monetary Policy and Economic Outcomes 570 The Effect of Monetary Policy on Interest Rates 570 The Effect of Monetary Policy on Aggregate Demand 571 What the Federal Reserve Has Done 572 Pitfalls for Monetary Policy 574 Long and Variable Time Lags 575 Excess Reserves 575 Unpredictable Movements of Velocity 576 Is Unemployment or Inflation More Important? 578 Should the Central Bank Tackle Asset Bubbles and Leverage Cycles? 579 Bank Regulation 581 Bank Runs 581 A Weakened Banking Sector 582 Deposit Insurance 582 Bank Supervision 583 Lender of Last Resort 583 Summary 584 Conclusion 585 Key Concepts and Summary 585 Review Questions Exchange Rates and International Capital Flows 589 How the Foreign Exchange Market Works 590 The Extraordinary Size of the Foreign Exchange Markets 590 Demanders and Suppliers of Currency in Foreign Exchange Markets 590 Participants in the Exchange Rate Market 593 Strengthening and Weakening Currency 594 Demand and Supply Shifts in Foreign Exchange Markets 597 Expectations about Future Exchange Rates 598 Differences across Countries in Rates of Return 599 Relative Inflation 599 Purchasing Power Parity 600 Macroeconomic Effects of Exchange Rates 601 Exchange Rates, Aggregate Demand, and Aggregate Supply 601 Fluctuations in Exchange Rates 603 Exchange Rates, Trade Balances, and International Capital Flows 605 Summing Up Public Policy and Exchange Rates 607 Exchange Rate Policies 608 Floating Exchange Rates 608 Using Soft Pegs and Hard Pegs 609 Trade-offs of Soft Pegs and Hard Pegs 611 A Single Currency 612

13 Contents xiii Conclusion 613 Key Concepts and Summary 614 Review Questions Government Budgets and Fiscal Policy 617 An Overview of Government Spending 618 Total U.S. Government Spending 618 Keeping Federal Budget Numbers in Perspective 620 State and Local Government Spending 621 An Overview of Taxation 621 State and Local Taxes 624 Federal Deficits and Debt 625 Debt/GDP Ratio 626 The Path from Deficits to Surpluses to Deficits 626 Using Fiscal Policy to Affect Recession, Unemployment, and Inflation 628 Expansionary Fiscal Policy 629 Contractionary Fiscal Policy 630 Automatic Stabilizers 631 Counterbalancing Recession and Boom 631 The Standardized Employment Deficit or Surplus 632 Practical Problems with Discretionary Fiscal Policy 633 Fiscal Policy and Interest Rates 634 Long and Variable Time Lags 634 Temporary and Permanent Fiscal Policy 635 Structural Economic Change Takes Time 636 The Limitations of Potential GDP and the Natural Rate of Unemployment 636 Educating Politicians 636 Summing Up Discretionary Fiscal Policy 637 Requiring a Balanced Budget? 637 Conclusion 638 Key Concepts and Summary 638 Review Questions Government Borrowing and National Savings 641 How Government Borrowing Affects Investment and the Trade Balance 641 The National Saving and Investment Identity 642 What about Budget Surpluses and Trade Surpluses? 642 Fiscal Policy, Investment, and Economic Growth 643 Crowding Out Physical Capital Investment 644 The Interest Rate Connection 644 Public Investment in Physical Capital 646 Public Investment in Human Capital 647 How Fiscal Policy Can Improve Technology 649 Summary of Fiscal Policy, Investment, and Economic Growth 649 Will Private Saving Offset Government Borrowing? 650 Fiscal Policy and the Trade Balance 651 Twin Deficits? 651 Fiscal Policy and Exchange Rates 652 From Budget Deficits to International Economic Crisis 653 Using Fiscal Policy to Address Trade Imbalances 654 Conclusion 655 Key Concepts and Summary 655 Review Questions Macroeconomic Policy around the World 657 The Diversity of Countries and Economies across the World 658 Economic Growth 659 Growth Policies for the Technological Leaders 660 Growth Policies for the Converging Economies 660 Growth Policies for the Technologically Disconnected 661 Lower Unemployment 663 Unemployment from a Recession 663 The Natural Rate of Unemployment 664 Undeveloped Labor Markets 665 Policies for Lower Inflation 666 Policies for a Sustainable Balance of Trade 667 Concerns over International Trade in Goods and Services 668 Concerns over International Flows of Capital 668 Final Thoughts on Economics and Market Institutions 670 Key Concepts and Summary 672 Review Questions 673 Chapter Appendices 1 Interpreting Graphics Indifference Curves Present Discounted Value An Algebraic Approach to the Expenditure-Output Model 709 Glossary 715 Index 727

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15 When authors describe their reasons for writing an economics textbook, it seems customary to proclaim lofty goals, like teaching students to think like economists so that they can become more informed voters and citizens. Paul Samuelson, the author of the most famous introductory economics textbook for the second half of the twentieth century, famously said: I don t care who writes a nation s laws--or crafts its advanced treaties--if I can write its economics textbooks. On my best days, I have sufficient time and energy to lift my eyes to the horizon, strike a statuesque pose, and proclaim exalted goals. But most of the time, I m just a workaday teacher and my goals are more limited and concrete. The pedagogical approach of this textbook is rooted in helping students master the tools that they need to solve problems for a course in introductory economics. Indeed, one of the great pleasures of writing the book is having the opportunity to open up and to share my teaching toolkit of step-by-step explanations, practical examples, and metaphors that stick in the mind. On quizzes and exams, I do not ask broad or open-ended questions about informed citizenship and thinking like an economist. At the most basic level, my goal for an economics class is that students should feel well-prepared for quizzes and exams. The preparation that students need to perform well in an introductory economics class can be divided into three parts. First, an introductory economics class involves mastering a specialized vocabulary. I sometimes tell students that learning economics is akin to learning a foreign language with the added difficulty that terms in economics like demand or supply or money sound like standard English, and thus learning economics often requires that students to drop their preconceptions about what certain words mean. Second, students need to acquire some basic analytical tools. There are four central analytical models in an introductory economics course: budget constraints, supply and demand, cost curves, and aggregate demand/aggregate supply. These four models are used for a very wide variety of applications; still, there are only four of them. There are also a few key formulas and equations to learn with regard to topics like growth rates over time and elasticity. Third, students must learn to recognize when these terms and tools apply and to practice using them. I often tell students not to bother memorizing particular questions and answers from the textbook or homework, because my quiz and exam questions will ask them to apply what they have learned in contexts they have not seen before. To provide a variety of contexts, this book describes many economic issues and events, drawn from recent times and past history, and also drawn both from U.S. and international experiences. When students see a concept or analytical skill applied in a number of ways, they learn to focus on the underlying and unifying idea. I ve also found that students do take away knowledge of many economic events and episodes although different students seem to focus on an unpredictable (to me) array of examples, which is perhaps as it should be in an introductory course. As a workaday teacher, the goal of helping students master the material so that they can perform well on my quizzes and exams is lofty enough and tough enough for me. There s an old joke that economics is the science of taking what is obvious about human behavior and making it incomprehensible. Actually, in my experience, the process works in the other direction. Many students spend the opening weeks of an introductory economics course feeling as if the material is difficult, even impossible, but by the middle and the end of the class, what seemed so difficult early in the term has become obvious and straightforward. As a course in introductory economics focuses on one lesson after another and one chapter after another, it s easy to get tunnel vision. But when raise your eyes at the end of class, it can be quite astonishing to look back and see how far you have come. As students apply xv

16 xvi Preface the terms and models they have learned to a series of real and hypothetical examples, they often find to their surprise that they have also imbibed a considerable amount about economic thinking and the real-world economy. Learning always has an aspect of the miraculous. As always, my family makes a significant contribution to the existence of this book. In the three years since the first edition, the U.S. and world economy has been convulsed by a Great Recession. The task of updating figures and examples for this second edition is inevitably large, but thinking about how to building connections from the concepts in the text to the economic events of the last few years made it larger. During the process of preparing this second edition, my wife has dealt lovingly with a distracted husband; my children, with a father who was sleep-deprived or at the office. In a very real sense, then, this book is from my dear ones to the students and instructors who use it. I hope that it serves you well. Timothy Taylor St. Paul, Minnesota October 6, 2010

17 Timothy T. Taylor Journal of Economic Perspectives Macalester College St. Paul, MN For 20 years the Managing Editor, Journal of Economic Perspectives, Saint Paul, MN. Published quarterly by the American Economic Association. Circulation: 22,000. Education September 1982-May 1984 September 1978-May 1982 Selected Papers M.A. Stanford University, Stanford, CA. Studied economics, focusing on public finance, industrial organization, and economic history. B.A. Haverford College, Haverford, PA. Majored in economics and political science. Graduated magna cum laude and Phi Beta Kappa. Recommendations for Further Reading, Journal of Economic Perspectives. A regular column, eight pages in length and containing recommended articles, reports, or interviews that Tim Taylor has been writing for this quarterly journal since the Spring 2005 issue. Medicare: Apocalypse Later, Milken Institute Review, Third Quarter 2005, pp Available at In Defense of Outsourcing, Cato Journal, Spring/Summer 2005, 25:2, pp Available at Shortfalls in the Long Run: Predictions about the Social Security Trust Fund, co authored with James R. Hines Jr., Journal of Economic Perspectives, Spring 2005, 19:2, pp The Economy in Perspective, The Public Interest, Fall 2004, pp Dumping the Lump: A Century of Misunderstanding, Milken Institute Review, Third Quarter 2004, pp Available at xvii

18 xviii About the Author The Truth about Globalization, The Public Interest, Spring 2002, pp Available at Reprinted in Harf, James E. and Mark Owen Lombardi Taking Sides: Clashing Views on Controversial Global Issues. McGraw-Hill/Dushkin, Dubuque, Iowa. pp Teaching Awards Lecturer for Economics 5010, Economic Immersion, at the Hubert H. Humphrey Institute of Public Affairs at the University of Minnesota during Fall In 1997, voted by students as Teacher of the Year for the Humphrey Institute. Lecturer for Economics 1101 and 1102, courses in principles of micro- and macroeconomics, at the University of Minnesota during Fall 1995 and Winter 1996, respectively. Based on student and departmental evaluations, named a Distinguished Instructor by the Department of Economics. Lecturer for Economics 1 at Stanford University, at least one quarter each year from 1989 to Enrollment ranged from students. In 1992, winner of the award for excellent teaching in a large class (more than 30 students) from Associated Students of Stanford University.