MODERN PRINCIPLES: MACROECONOMICS Tyler Cowen George Mason University Alex Tabarrok George Mason University Worth Publishers
CONTENTS Preface xv CHAPTER 1 The Big Ideas 1 Big Idea One: Incentives Matter 2 Big Idea Two: Good Institutions Align Self-Interest with the Social Interest 2 Big Idea Three: Trade-offs Are Everywhere 3 Opportunity Cost 4 Big Idea Four: Thinking on the Margin 5 Big Idea Five: Tampering with the Laws of Supply and Demand Has Consequences 6 Big Idea Six: The Importance of Wealth and Economic Growth 6 Big Idea Seven: Institutions Matter 7 Big Idea Eight: Economic Booms and Busts Cannot Be Avoided but Can Be Moderated 8 Big Idea Nine: Prices Rise When the Government Prints Too Much Money 8 Big Idea Ten: Central Banking Is a Hard Job 9 The Biggest Idea of All: Economics Is Fun 9 Chapter Review 10 Part 1: Supply and Demand CHAPTER 2 Supply and Demand 13 The Demand Curve for Oil 13 Consumer Surplus 16 What Shifts the Demand Curve? 17 Important Demand Shifters 17 Income 18 Population 18 Price of Substitutes 18 Price of Complements 18 Expectations 19 Tastes 19 The Supply Curve for Oil 20 Producer Surplus 23 What Shifts the Supply Curve? 23 Important Supply Shifters 23 Technological Innovations and Changes in the Price ot Inputs 24 Taxes and Subsidies 24 Expectations 25 Entry or Exit of Producers 25 Changes in Opportunity Costs 26 Takeaway 27 Chapter Review 28
viii Contents CHAPTER 3 Equilibrium: How Supply and Demand Determine Prices 33 Equilibrium and the Adjustment Process 33 Who Competes with Whom? 35 Gains from Trade Are Maximized at the Equilibrium Price and Quantity 35 Does the Model Work? Evidence from the Laboratory 38 Shifting Demand and Supply Curves 40 Terminology: Demand Compared to Quantity Demanded and Supply Compared to Quantity Supplied 42 Understanding the Price of Oil 44 Takeaway 46 Chapter Review 47 CHAPTER 4 Price Ceilings and Price Floors 51 Price Ceilings 51 Shortages 52 Reductions in Quality 52 Wasteful Lines and Other Search Costs 53 Lost Gains from Trade 55 Misallocation of Resources 56 The End of Price Ceilings 58 Price Floors 59 Surpluses 59 Lost Gains from Trade 60 Wasteful Increases in Quality 62 Misallocation of Resources 63 Takeaway 64 Chapter Review 65 Part 2: Economic Growth CHAPTER 5 GDP and The Measurement of Progress 69 What Is GDP? 70 GDP Is the Market Value... 71... of All Final... 71... Goods and Services... 71... Produced... 72... within a Country... 72... in a Year 72 Growth Rates 73 Nominal vs. Real GDP 73 Real GDP Growth 74 Real GDP Growth per Capita 74 Cyclical and Short-Run Changes in GDP 76 The Many Ways of Splitting GDP 77 The National Spending Approach: Y = C + I + G + NX 78 The Factor Income Approach: The Other Side of the Spending Coin 79 Why Split 80
Contents ix Problems with GDP as a Measure of Output and Welfare 80 GDP Does not Count the Underground Economy 81 GDP Does not Count Nonmarket Production 81 GDP Does not Count Leisure 82 GDP Does not Count Bads: Environmental Costs 82 GDP Does not Measure the Distribution of Income 83 Takeaway 84 Chapter Review 85 CHAPTER 6 The Wealth of Nations and Economic Growth 91 Key Facts about the Wealth of Nations and Economic Growth 92 Fact One: GDP per Capita Today Varies Enormously among Nations 92 Fact Two: Everyone Used to Be Poor 93 Fact Three: There Are Growth Miracles and Growth Disasters 96 Summarizing the Facts: Good and Bad News 97 Understanding the Wealth of Nations 97 The Factors of Production 97 Incentives and Institutions 99 Institutions 101 Institutions of Economic Growth 101 Property Rights 101 Honest Government 102 Political Stability 103 A Dependable Legal System 103 Competitive and Open Markets 104 Institutions and Growth Miracles Revisited 105 Takeaway 106 Chapter Review 106 Appendix: The Magic of Compound Growth: Using a Spreadsheet 111 CHAPTER 7 Growth, Capital Accumulation, and the Economics of Ideas: Catching Up vs. The Cutting Edge 115 The Solow Model and Catch-Up Growth 116 Capital, Production and Diminishing Returns 117 Capital Growth Equals Investment Minus Depreciation 119 Why Capital Alone Cannot Be the Key to Economic Growth 120 Better Ideas Drive Long-Run Economic Growth 122 The Solow Model Details and Further Lessons (Optional section) 124 The Solow Model and an Increase in the Investment Rate 125 The Solow Model and Conditional Convergence 127 From Catching Up to Cutting Edge 128 Solow and the Economics of Ideas in One Diagram 128 Growing on the Cutting Edge: The Economics of Ideas 130 Research and Development Is Investment for Profit 130 Spillovers, and Why There Aren't Enough Good Ideas 132 Government's Role in the Production of New Ideas 132 Market Size and Research and Development 133 The Future of Economic Growth 134 Takeaway 136 Chapter Review 137 Appendix: Excellent Growth 142
Contents CHAPTER 8 Saving, Investment, and the Financial System 147 The Supply of Savings 148 Individuals Want to Smooth Consumption 148 Individuals Are Impatient 149 Marketing and Psychological Factors 150 The Interest Rate 150 The Demand to Borrow 151 Individuals Want to Smooth Consumption 151 Borrowing Is Necessary to Finance Large Investments 152 The Interest Rate 153 Equilibrium in the Market for Loanable Funds 153 Shifts in Supply and Demand 154 The Role of Intermediaries: Banks, Bonds, and Stock Markets 156 Banks 157 The Bond Market 158 Bond Prices and Interest Rates 160 The Stock Market 161 What Happens When Intermediation Fails? 162 Insecure Property Rights 162 Controls on Interest Rates and Inflation 163 Politicized Lending and Government-Owned Banks 165 Bank Failures and Panics 165 Takeaway 167 Chapter Review 167 Appendix: Bond Pricing and Arbitrage 172 CHAPTER 9 Stock Markets and Personal Finance 177 Passive vs. Active Investing 177 Why Is It Hard to Beat the Market? 179 How to Really Pick Stocks, Seriously 181 Diversify 181 Avoid High Fees 183 Compound Returns Build Wealth 184 The No Free Lunch Principle or No Return Without Risk 185 Other Benefits and Costs of Stock Markets 187 Bubble, Bubble, Toil, and Trouble 188 Takeaway 189 Chapter Review 190 Part 3: Business Fluctuations CHAPTER 10 Unemployment and Labor Force Participation 193 Defining Unemployment 195 How Good an Indicator Is the Unemployment Rate? 195 Frictional Unemployment 196 Structural Unemployment 197 Labor Regulations and Structural Unemployment 198 Unemployment Benefits 199 Minimum Wages and Unions 200
Contents xi Employment Protection Laws 201 A Tale of Two Riots 202 Labor Regulations to Reduce Structural Unemployment 203 Factors That Affect Structural Unemployment 204 Cyclical Unemployment 204 The Natural Unemployment Rate 206 Labor Force Participation 207 Lifecycle Effects and Demographics 207 Incentives 208 Incentives and the Increase in Female Labor Force Participation 209 How the Pill Increased Female Labor Force Participation 211 Takeaway 212 Chapter Review 213 CHAPTER 11 Inflation and the Quantity Theory of Money 217 Defining and Measuring Inflation 218 Price Indexes 218 Inflation in the United States and Around the World 219 The Quantity Theory of Money 222 The Cause of Inflation 223 An Inflation Parable 225 The Costs of Inflation 226 Price Confusion and Money Illusion 227 Inflation Redistributes Wealth 227 Hyperinflation and the Breakdown of Financial Intermediation 231 Inflation Interacts with Other Taxes 231 Inflation Is Painful to Stop 232 Takeaway 232 Chapter Review 233 Appendix: Get Real! An Excellent Adventure 236 CHAPTER 12 Business Fluctuations and the Dynamic Aggregate Demand-Aggregate Supply Model 241 A Skeleton Model 243 The Solow Growth Curve 243 Shifts in the Solow Growth Curve 244 The Dynamic Aggregate Demand Curve 244 Shifts in the Dynamic Aggregate Demand Curve 246 The Real Business Cycle Model: Real Shocks and the Solow Growth Curve 247 Shocks to Aggregate Demand in the Real Business Cycle Model 249 The New Keynesian Model 250 The Short-Run Aggregate Supply Curve 250 Sticky Wages 251 Shifting the SRAS Curve 251 The Parable of the Angry Professor 252 Sticky Prices 254 Shocks to Aggregate Demand in the New Keynesian Model 255 An Increase in M the New Keynesian Model 255 Shocks to the Components of Aggregate Demand 256 A Decrease in C the New Keynesian Model 256 Why Changes in V Tend to Be Temporary 257 Other Factors That Shift the AD Curve 257
xii o Contents Understanding the Great Depression: Aggregate Demand Shocks and Real Shocks 259 Aggregate Demand Shocks and the Great Depression 259 Real Shocks and the Great Depression 260 Takeaway 262 Chapter Review 263 CHAPTER 13 The Real Business Cycle Model: Shocks and Transmission Mechanisms 269 Shocks 269 Oil Shocks 270 Shocks, Shocks, Shocks 273 How Transmission Mechanisms Amplify and Spread Shocks 273 Intertemporal Substitution 274 Uncertainty and Irreversible Investments 276 Labor Adjustment Costs 277 Time Bunching 278 Sticky Wages and Prices 280 Transmission Mechanisms: Summary 281 Takeaway 282 Chapter Review 283 ox: Business Fluctuations and the Solow Model 286 CHAPTER 14 The Federal Reserve System and Open Market Operations 289 What Is the Federal Reserve System? 289 The U.S. Money Supplies 290 Fractional Reserve Banking, the Reserve Ratio, and the Money Multiplier 293 How the Fed Controls the Money Supply 295 Open Market Operations 295 The Fed Controls a Real Rate Only in the Short Run 297 Discount Rate Lending and the Term Auction Facility 297 The Term Auction Facility 299 Required Reserves and Payment of Interest on Reserves 300 The Federal Reserve and Systemic Risk 300 Revisiting Aggregate Demand and Monetary Policy 301 Who Controls the Fed? 303 Takeaway 304 Chapter Review 305 Appendix: The Money Multiplier Process in Detail 309 CHAPTER 15 Monetary Policy 313 Monetary Policy: The Best Case 314 Rules vs. Discretion 316 Reversing Course and Engineering a Decrease in AD 317 The Fed as Manager of Market Confidence 318
Contents xiii The Negative Real Shock Dilemma 319 The Problem with Positive Shocks: The 1997-2006 Housing Boom and Bust 322 Takeaway 324 Chapter Review 324 CHAPTER 16 The Federal Budget: Taxes and Spending 335 Tax Revenues 335 The Individual Income Tax 336 Taxes on Capital Gains and Interest and Dividends 338 The Alternative Minimum Tax (AMT) 339 Social Security and Medicare Taxes 339 The Corporate Income Tax 340 The Bottom Line on the Distribution of Federal Taxes 340 Spending 342 Social Security 342 Defense 344 Medicare and Medicaid 345 Unemployment Insurance and Welfare Spending 345 Everything Else 345 The National Debt, Interest on the National Debt, and Deficits 347 Will the U.S. Government Go Bankrupt? 349 The Future Is Hard to Predict 350 Revenues and Spending Undercount the Role of Government in the Economy 352 Takeaway 352 Chapter Review 353 CHAPTER 17 Fiscal Policy 359 Fiscal Policy: The Best Case 360 The Multiplier 361 The Limits to Fiscal Policy 362 Crowding Out 363 A Special Case of Crowding Out: Ricardian Equivalence 365 A Drop in the Bucket: Can Government Spend Enough to Stimulate Aggregate Demand? 367 A Matter of Timing 367 Automatic Stabilizers 369 Government Spending versus Tax Cuts as Expansionary Fiscal Policy 369 Fiscal Policy Does Not Work Well to Combat Real Shocks 370 When Fiscal Policy Might Make Matters Worse 372 So When Is Fiscal Policy a Good Idea? 373 Takeaway 374 Chapter Review 375 Part 5: International Economics.CHAPTER 18 International Trade 381 Why Trade? 381 The Division of Knowledge 381
xiv Contents Economies of Scale and Creating Competition 383 Comparative Advantage 383 Adam Smith on Trade 387 Analyzing Trade with Supply and Demand 387 Analyzing Tariffs with Demand and Supply 388 The Costs of Protectionism 390 Winners and Losers from Trade 392 Arguments against International Trade 393 Trade and Jobs 393 Child Labor 394 Trade and National Security 396 Key Industries 396 Strategic Trade Protectionism 397 Trade and Globalization 397 Takeaway 398 Chapter Review 398 CHAPTER 19 International Finance 407 The U.S. Trade Deficit and Your Trade Deficit 408 The Balance of Payments 409 The Current Account 410 The Capital Account, Sometimes Called the Financial Account 410 The Official Reserves Account 411 How the Pieces Fit Together 411 Two Sides, One Coin 411 The Bottom Line on the Trade Deficit 413 What Are Exchange Rates? 413 Exchange Rate Determination in the Short Run 414 Exchange Rate Determination in the Long Run 417 How Monetary and Fiscal Policy Affect Exchange Rates and How Exchange Rates Affect Aggregate Demand 420 Monetary Policy 420 Fiscal Policy 422 Fixed vs. Floating Exchange Rates 422 The Problem with Pegs 423 What Are the IMF and the World Bank? 424 Takeaway 426 Chapter Review 426 Appendix A Reading Graphs and Making Graphs A-1 Appendix B Answers to Check Yourself Questions B-1 Glossary G-1 References R-1 Index I-O