V -** -.!&Z oremacroeconorracs 1 Gerald W. Stone Metropolitan State College of Denver Worth Publishers
BRIEF CONTENTS CHAPTER 1 Exploring Economics 1 CHAPTEFL2 j Production, Economic Growth, and Trade 27 CHAPIER-3L., Supply and Demand 51 CHAPTER_4_, Market Efficiency, Market Failure, and Government Intervention 81 CHAPTER JL-, Introduction to Macroeconomics 111 CHAPTER 6 Measuring Inflation and Unemployment 139 CHAPTER Z.., Economic Growth 165 CHAPTER 8, Keynesian Macroeconomics 185 CHAPTER J-L, Aggregate Demand and Supply 211 CHAPTER : 1O :I Fiscal Policy 235 CHAPTER It The Monetary System 257 CHAPTER-1Z Monetary Policy 279 CHAPTER 13 Federal Deficits and Public Debt 309 CHAPTER 14, Macroeconomic Policy Challenges 331 CHAPTER 15, International Trade 355 CHARTER 16, Open Economy Macroeconomics 379 xvii
CONTENTS Exploring Economics WHAT IS ECONOMICS ABOUT? Microeconomics Versus Macroeconomics 4 Economic Theories and Reality 6 Model Building 6 Ceteris Paribus: All Else Held Constant Equity Versus Efficiency 7 Checkpoint: What Is Economics About? 7 KEY IDEAS OF ECONOMICS 8 Choice and Scarcity Force Tradeoffs 8 Opportunity Costs Dominate Our Lives 10 Rational Behavior Requires Thinking at the Margin 10 People Follow Incentives 10 Markets Are Efficient 11 Government Must Deal with Market Failure 11 Information Is Important 11 Specialization and Trade Improve Our Lives 12 Productivity Determines Our Standard of Living 12 Government Can Smooth the Fluctuations in the Overall Economy 12 Checkpoint: Key Ideas of Economics 13 KEY CONCEPTS 13 CHAPTER SUMMARY 13 QUESTIONS AND PROBLEMS 15 ANSWERS TO CHECKPOINT QUESTIONS 16 APPENDIX: WORKING WITH GRAPHS AND FORMULAS 17 Graphs and Data 18 Graphs and Models 21 Linear Relationships 21 Nonlinear Relationships 23 Ceteris Paribus, Simple Equations, and Shifting Curves 24 Correlation Is Not Causation 26 ADAM SMITH (1723-1790) 5 NOBEL PRIZE PAUL A. SAMUELSON 9 xix
XX Contents If '")) A. Production, Economic Growth, and Trade // ; BASIC ECONOMIC QUESTIONS AND PRODUCTION 29 Basic Economic Questions 29 Resources, Production, and Efficiency 31 Land '31 Labor 31 Capital 31 Entrepreneurial Ability 32 Production and Efficiency 32 Checkpoint: Basic Economic Questions and Production 32 PRODUCTION POSSIBILITIES AND ECONOMIC GROWTH 33 Production Possibilities 33 Full Employment 34 Opportunity Cost 34 Increasing Opportunity Costs 35 Economic Growth 36 Expanding Resources 37 Technological Change 38 Estimating the Sources of Economic Growth 39 Checkpoint: Production Possibilities and Economic Growth 40 SPECIALIZATION, COMPARATIVE ADVANTAGE, AND TRADE 41 Absolute and Comparative Advantage 42 The Gains from Trade 43 Ancient Humans and Trade 44 Limits on Trade and Globalization 45 Is There a Moral Dimension to Economic Growth? 46 Checkpoint: Specialization, Comparative Advantage, and Trade 47 KEY CONCEPTS 47 CHAPTER SUMMARY 47 QUESTIONS AND PROBLEMS 48 NOBEL PRIZE FRIEDRICH VON HAYEK AND GUNNAR MYRDAL 30 DAVID RICARDO (1772-1823) 41 ANSWERS TO CHECKPOINT QUESTIONS 50 f" Supply and Demand p cr^ MARKETS 52 The Price System 52 Checkpoint: Markets 53 DEMAND ~ 53 The Relationship between Quantity Demanded and Price 53 The Law of Demand 54
Contents XXi The Demand Curve 54 Market Demand Curves 55 Determinants of Demand 56 Tastes and Preferences 56 Income 57 Prices of Related Goods 57 The Number of Buyers 57 Expectations about Future Prices, Incomes, and Product Availability 57 Changes in Demand Versus Changes in Quantity Demanded 58 Changes in Demand 58 ^ Changes in Quantity Demanded 59 Checkpoint: Demand 59 SUPPLY 60 The Relationship between Quantity Supplied and Price 60 The Law of Supply 60 The Supply Curve 61 Market Supply Curves 61 Determinants of Supply 61 Production Technology 61 Costs of Resources 62 Prices of Other Commodities 62 Expectations 62 Number of Sellers 62 Taxes and Subsidies 62 Changes in Supply Versus Changes in Quantity Supplied 63 Checkpoint: Supply 63 MARKET EQUILIBRIUM 64 Moving to a New Equilibrium: Changes in Supply and Demand 68 Predicting the New Equilibrium When One Curve Shifts 68 Predicting the New Equilibrium When Both Curves Shift 69 Summarizing Shifts and Equilibrium 71 Checkpoint: Market Equilibrium 73 PUTTING SUPPLY AND DEMAND TO WORK 73 Excess Grape Supply and Two-Buck Chuck 73 Trek Bicycles and Lance Armstrong 74 KEY CONCEPTS 75 CHAPTER SUMMARY 75 QUESTIONS AND PROBLEMS 77 ALFRED MARSHALL (1842-1924) 67 ANSWERS TO CHECKPOINT QUESTIONS 80 Market Efficiency, Market Failure, and Government Intervention MARKETS AND EFFICIENCY 82 Efficient Market Requirements 83 Accurate Information Is Widely Available 83 Property Rights Are Protected 83
XXII Contents Contract Obligations Are Enforced 84 There Are No External Costs or Benefits 84 Competitive Markets Prevail 84 The Discipline of Markets 85 Consumer and Producer Surplus: A Tool for Measuring Economic Efficiency 86 Checkpoint: Markets and Efficiency 87 MARKET FAILURES Accurate Information Is Not Widely Available: Asymmetric Information Adverse; Selection 91 Moral Hazard 92 Problems with Property Rights 93 Public Goods 94 Common Property Resources 95 Contract Enforcement Is Problematical 96 There Are Significant External Costs or Benefits: Externalities 96 Competitive Markets Do Not Prevail: Monopoly Power 98 Checkpoint: Market Failures 98 GOVERNMENT-CONTROLLED PRICES 99 Price Ceilings 99 Price Floors 101 Taxes and Deadweight Loss 102 Checkpoint: Government-Controlled Prices 103 Who Is Watching Your Money? Bank Regulation and Information Problems 103 KEY CONCEPTS 105 CHAPTER SUMMARY 105 QUESTIONS AND PROBLEMS 107 NOBEL PRIZE GEORGE AKERLOF, A. MICHAEL SPENCE, AND JOSEPH STIGLITZ 90 ANSWERS TO CHECKPOINT QUESTIONS 109 Introduction to Macroeconomics THE SCOPE OF MACROECONOMICS 112 Major Events that Shaped Macroeconomic Ideas 112 The Great Depression 113 Episodes of Hyperinflation 113 Budget Deficits 113 Macroeconomic Goals 114 Business Cycles 115 Defining Business Cycles 116 Dating Business Cycles 117 Is the New Economy Producing Micro Recessions? 118 Checkpoint: The Scope of Macroeconomics 120 NATIONAL INCOME ACCOUNTING 120 The Core of NIPA 122 The Circular Flow Diagram 122 Spending and Income: Looking at GDP in Two Ways 123
Contents XXI11 Gross Domestic Product 123 The Expenditures Approach to Calculating GDP 124 Personal Consumption Expenditures 124 Gross Private Domestic Investment 125 Government Purchases 126 Net Exports of Goods and Services 126 Summing Aggregate Expenditures 126 The Income Approach to Calculating GDP 126 Compensation of Employees 127 Proprietors' Income 127 Rental Income 128 i Corporate Profits 128 Net Interest 128 Taxes, Foreign Income, and Miscellaneous Adjustments 128 National Income - 128 From National Income to GDP 128 Net Domestic Product 128 Personal Income and Disposable Personal Income 129 GDP and Our Standard of Living 129 Checkpoint: National Income Accounting 130 Technology and Schumpeter's Creative Destruction 131 KEY CONCEPTS 133 CHAPTER SUMMARY 133 QUESTIONS AND PROBLEMS 135 NOBEL PRIZE SIMON KUZNETS AND RICHARD STONE 121 JOSEPH SCHUMPETER (1883-1950) 132 ANSWERS TO CHECKPOINT QUESTIONS 137 Measuring Inflation and Unemployment INFLATION 140 Defining Inflation Terms 140 ^ Measuring Inflation 141 The Consumer Price Index (CPI) 142 Problems in Measuring Consumer Prices 143 Personal Consumption Expenditures (PCE) Index 144 The Producer Price Index (PPI) 144 The GDP Deflator 145 Adjusting for Inflation: Escalation and Deflation 146 Escalator Clauses 146 Deflating Series: Nominal Versus Real Values 147 The Consequences of Inflation 147 Hyperinflation 148 Checkpoint: Inflation 148 UNEMPLOYMENT 149 The Historical Record 149 The Household Survey 152 Defining and Measuring Unemployment 152
XXIV Contents Employed 152 Unemployed 152 Labor Force 153 Problems with Unemployment Statistics 153 Underemployment and Discouraged Workers 153 Checkpoint: Unemployment 154 UNEMPLOYMENT AND THE ECONOMY 154 Types of Unemployment 155 Frictional Unemployment 155 Structural Unemployment 155 Cyclical Unemployment 155 Defining Full Employment 156 The Natural Rate of Unemployment 156 Checkpoint: Unemployment and the Economy 156 Job Gains and Losses: Establishment (or Payroll) Survey Versus Household Survey 157 KEY CONCEPTS 160 CHAPTER SUMMARY 160 QUESTIONS AND PROBLEMS 162 ANSWERS TO CHECKPOINT QUESTIONS 163 Economic Growth /.i L THE CLASSICAL MODEL 167 Aggregate Production Function 167 Product Markets 168 Labor Markets 169 Capital Markets: Saving and Investment 170 Implications for Economic Growth 172 Checkpoint: The Classical Model 172 SOURCES OF LONG-RUN ECONOMIC GROWTH 172 Growth in the Labor Force 173 Productivity Is Important 173 Sources of Productivity Growth 174 Increasing the Capital-to-Labor Ratio 174 Increasing the Quality of the Labor Force 174 Improvements in Technology 174 Modern Growth Theory 175 Checkpoint: Sources of Long-Run Economic Growth 177 INFRASTRUCTURE AND ECONOMIC GROWTH 177 Public Capital 177 Protection of Property Rights 177 Enforcement of Contracts 178
Contents XXV Stable Financial System 178 Economic Freedom Index 178 Checkpoint: Infrastructure and Economic Growth 180 The Changing Face of Innovation Waves 180 KEY CONCEPTS 182 CHAPTER SUMMARY 182 QUESTIONS AND PROBLEMS 183 THOMAS MALTHUS (1766-1834) 171 NOBEL PRIZE ROBERT SOLOW 176 ANSWERS TO CHECKPOINT QUESTIONS 184 Keynesian Macroeconomics AGGREGATE EXPENDITURES 186 Some Simplifying Assumptions 186 Consumption and Saving 187 Average Propensities to Consume and Save 189 Marginal Propensities to Consume and Save 190 Other Determinants of Consumption and Saving 191 Investment 192 Investment Demand 193 Other Determinants of Investment Demand 193 Aggregate Investment Schedule 194 Checkpoint: Aggregate Expenditures 195 THE SIMPLE KEYNESIAN MODEL 195 Macroeconomic Equilibrium in the Simple Model 196 The Multiplier Effect 197 The Multiplier 198 The Multiplier Works in Both Directions 199 Checkpoint: The Simple Keynesian Model 200 THE FULL KEYNESIAN MODEL 200 Adding Government Spending and Taxes 200 Tax Changes and Equilibrium 201 The Balanced Budget Multiplier 202 Adding Net Exports 202 Recessionary and Inflationary Gaps 203 Recessionary Gap 203 Inflationary Gap 204 Checkpoint: The Full Keynesian Model 205 The Great Depression and Keynesian Analysis 205 KEY CONCEPTS 206 CHAPTER SUMMARY 206 QUESTIONS AND PROBLEMS 208 JOHN MAYNARD KEYNES (1883-1946) 188 ANSWERS TO CHECKPOINT QUESTIONS 210
XXVi Contents Aggregate Demand and Supply AGGREGATE DEMAND 213 Why Is the Aggregate Demand Curve Negatively Sloped? 213 The Wealth Effect 214 Impact on Exports 214 Interest Rate Effects 214 Determinants of Aggregate Demand 214 Consumer Spending 215 Investment 215 Government Spending and Net Exports 216 Checkpiont: Aggregate Demand 217 AGGREGATE SUPPLY 217 Depression Period (Horizontal) 217 Short Run (Upward Sloping) 218 Long Run (Vertical) 218 Determinants of Aggregate Supply 219 Input Prices 219 Productivity 219 Taxes 220 Market Power of Firms 220 Expectations 220 Checkpoint: Aggregate Supply 221 MACROECONOMIC EQUILIBRIUM 221 The Spending Multiplier 222 Using AD/AS: The Great Depression 223 Using AD/AS:.Demand-Pull Inflation 224 Using AD/AS: Cost-Push Inflation 226 Checkpoint: Macroeconomic Equilibrium 227 KEY CONCEPTS 228 CHAPTER SUMMARY 228 QUESTIONS AND PROBLEMS 229 ANSWERS TO CHECKPOINT QUESTIONS 232 APPENDIX: DERIVING THE AGGREGATE DEMAND CURVE 233 Fiscal Policy \\\ FISCAL POLICY AND AGGREGATE DEMAND 238 Discretionary Fiscal Policy 238 Government Spending 238 Taxes 239 Transfers 240
Contents XXVII Expansionary and Contractionary Fiscal Policy 240 Checkpoint: Fiscal Policy and Aggregate Demand 243 FISCAL POLICY AND AGGREGATE SUPPLY 243 Modern Growth Theory 244 Reducing Tax Rates 244 The Laffer Curve 245 High Marginal Income Tax Rates and the Labor Supply of Women 246 Expanding Investment and Reducing Regulations 246 Checkpoint: Fiscal Policy and Aggregate Supply v 247 IMPLEMENTING FISCAL POLICY 248 Automatic Stabilizers 248 Fiscal Policy Timing Lags 248 Crowding-Out Effect 249 The Size of Government Debate 249 Checkpoint: Implementing Fiscal Policy 251 KEY CONCEPTS 252 CHAPTER SUMMARY 252 QUESTIONS AND PROBLEMS 254 ANSWERS TO CHECKPOJNT QUESTIONS 255 The Monetary System WHAT IS MONEY? 258 The Functions of Money 258 Medium of Exchange 258 Unit of Account 259 Store of Value 259 Defining the Money Supply 260 Narrowly Defined Money: Ml 260 A Broader Definition: M2 261 Where Did All the One-Dollar Coins Go? 261 Checkpoint: What Is Money? 262 MONEY: DEMAND AND SUPPLY 262 The Market for Money and Bonds 262 The Demand for Money 262 Equilibrium in the Money Market 263 Bond Prices and Interest Rates 264 How Banks Create Money 265 Functions of Financial Institutions 265 Fractional Reserve System 265 The Money Creation Process 266 The Money Multiplier 267 Checkpoint: Money: Demand and Supply 268
XXViii Contents THE FEDERAL RESERVE SYSTEM 268 The Structure of the Federal Reserve 269 The Board of Governors 269 Federal Reserve Banks 271 Federal Open Market Committee (FOMC) 271 The Tools of the Federal Reserve 272 Reserve Requirements 272 Discount Rate 273 Open Market Operations 273 Checkpoint: The Federal Reserve System 274 KEY CONCEPTS 274 CHAPTER SUMMARY 275 QUESTIONS AND PROBLEMS 277 ALAN GREENSPAN 270 ANSWERS TO CHECKPOINT QUESTIONS 278 Monetary Policy L, MONETARY THEORIES 280 The Long Run: Quantity Theory 281 The Equation of Exchange 281 Classical Money Transmission Mechanism 282 The Short Run: Interest Rate Channels 285 Keynesian Monetary Analysis 285 Monetarist Model 287 Checkpoint: Monetary Theories 290 MONETARY POLICY LAGS 291 Information Lags 291 Recognition Lags 291 Decision Lags 292 Implementation Lags 292 Checkpoint: Monetary Policy Lags 292 IMPLEMENTING MONETARY POLICY 293 Monetary Policy Targets 293 Long Run: Price Stability 293 Short Run: Price Level and Income 293 Rules or Discretion? 296 Simple Rules (Targets) to Guide Monetary Policy 297 Monetary Targeting 297 Inflation Targeting 299 The Fed's Performance 299 Checkpoint: Implementing Monetary Policy 301 Transparency and the Federal Reserve 301 KEY CONCEPTS 303 CHAPTER SUMMARY 303 QUESTIONS AND PROBLEMS 305 IRVING FISHER (1867-1947) 283 NOBEL PRIZE MILTON FRIEDMAN 288 ANSWERS TO CHECKPOINT QUESTIONS 307
Contents XXIX Federal Deficits and Public Debt II r ~% FINANCING THE FEDERAL GOVERNMENT 310 Defining Deficits and the National Debt 310 Public Choice Analysis 313 Approaches to Federal Finance 313 i s Annually Balanced Budget 314 Cyclically Balanced Budget 314 Functional Finance 315 Checkpoint: Financing the Federal Government 315 FINANCING DEBT AND DEFICITS 316 The Government Budget Constraint 316 The Role of the Federal Reserve 316 Budget and Trade Deficits 316 Implications of Deficit Financing in an Open Economy 317 Checkpoint: Financing Debt and Deficits 317 THE BURDEN OF THE PUBLIC DEBT 318 Internally Versus Externally Held Debt 318 Interest Payments 319 Crowding-Out Effect 320 Public Investment and Crowding Out 321 Intergenerational Burdens of Fiscal Policy 322 Fiscal Sustainability of the Federal Budget 322 Checkpoint: The Burden of the Public Debt 324 How Much Debt Can We Carry? 324 KEY CONCEPTS 326 CHAPTER SUMMARY 326 QUESTIONS AND PROBLEMS 329 ANSWERS TO CHECKPOINT QUESTIONS 330 Macroeconomic Policy Challenges UNEMPLOYMENT AND INFLATION: PHILLIPS CURVES 333 Productivity, Prices, and Wages 333 The Importance of Inflationary Expectations 335 Natural Rate of Unemployment 336 The Long-Run Phillips Curve 337 Accelerating Inflation 337 Phillips Curves and Disinflation 338 Checkpoint: Unemployment and Inflation: Phillips Curves 341 RATIONAL EXPECTATIONS AND POLICY FORMATION 341 Defining Rational Expectations 342 Policy Implications of Rational Expectations 342
XXX Contents A Critique of Rational Expectations 345 Checkpoint: Rational Expectations and Policy Formation 346 Are Recoveries Becoming "Jobless Recoveries"? 347 KEY CONCEPTS 350 CHAPTER SUMMARY 350 QUESTIONS AND PROBLEMS 352 NOBEL PRIZE ROBERT LUCAS 343 ANSWERS TO CHECKPOINT QUESTIONS 353 International Trade"! ; ; \\ THE GAINS FROM TRADE 357 Absolute and Comparative Advantage 357 Gains from Trade 358 Practical Constraints on Trade 360 Checkpoint: The Gains from Trade 360 THE TERMS OF TRADE 361 Determining the Terms of Trade 361 The Impact of Trade 362 How Trade Is Restricted 363 Effects of Tariffs and Quotas 363 Checkpoint: The Terms of Trade 366 ARGUMENTS AGAINST FREE TRADE 366 Traditional Economic Arguments 366 Infant Industry Argument 367 Antidumping 367 Low Foreign Wages 368 National Defense Argument 368 Globalization Concerns 368 Trade and Domestic Employment 368 Trade and the Environment 369 Trade and Its Effect on Working Conditions in Developing Nations 370 Checkpoint: Arguments Against Free Trade 371 The Dynamics of Trade: Cashmere 371 KEY CONCEPTS 373 CHAPTER SUMMARY 373 QUESTIONS AND PROBLEMS 375. ANSWERS TO CHECKPOINT QUESTIONS 378 Open Economy Macroeconomics THE BALANCE OF PAYMENTS 380 The Current Account 380 Imports and Exports 380
Contents XXXI Income 381 Transfers 381 The Capital Account 381 Checkpoint: The Balance of Payments 383 EXCHANGE RATES 383 Defining Exchange Rates 383 Nominal Exchange Rates 384 Real Exchange Rates 386 Purchasing Power Parity 386 V Exchange Rate Determination 387 A Market for Foreign Exchange 387 Flexible Exchange Rates 388 Currency Appreciation and Depreciation 389 Determinants of Exchange Rates 390 Exchange Rates and the Current Account 390 Changes in Inflation Rates 390 Changes in Domestic Disposable Income 390 Exchange Rates and the Capital Account 391 Interest Rate Changes 391 Exchange Rate Changes 391 Exchange Rates and Aggregate Supply and Demand 392 Checkpoint: Exchange Rates 393 MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY 393 Fixed and Flexible Exchange Rate Systems 394 Policies Under Fixed Exchange Rates 394 Policies Under Flexible Exchange Rates 395 Checkpoint: Monetary and Fiscal Policy in an Open Economy 396 KEY CONCEPTS 397 CHAPTER SUMMARY 397 QUESTIONS AND PROBLEMS 399 NOBEL PRIZE ROBERT MUNDELL 385 ANSWERS TO CHECKPOINT QUESTIONS 400 GLOSSARY G-1 INDEX 1-0