This page intentionally left blank U S I N G © IMAGES.COM/CORBIS T H E T H E O R Y Chapter Using the Theory: Are We Saving Lives Efficiently? 47 Chapter 12 Using the Theory: The American Reinvestment and Recovery Act 349 Chapter Using the Theory: The Price of Oil 79 Chapter 13 Using the Theory: The Financial Crisis of 2008 383 Chapter 14 Using the Theory: The Recession, the Financial Crisis, and the Fed 415 Chapter 15 Using the Theory: The Story of Two Recessions 451 Chapter 16 Using the Theory: Should the Fed Prevent (or Pop) Asset Bubbles? 480 Chapter 17 Using the Theory: The U.S Trade Deficit with China 515 Chapter Using the Theory: The Housing Boom and Bust: 1997–2011 110 Chapter Using the Theory: Sudden Disasters and GDP 165 Chapter Using the Theory: The Controversy Over Indexing Social Security Benefits 191 Chapter Using the Theory: Barriers to Catch-Up Growth in the Poorest Countries 260 Chapter 11 317 Using the Theory: 2008 to 2011: The Recession and the Long Slump MAcroeconomics Principles & Applications, 6e © Images.com/Corbis Robert E Hall Department of Economics, Stanford University Marc Lieberman Department of Economics, New York University Australia Brazil Japan Korea Mexico Singapore Spain United Kingdom United States This is an electronic version of the print textbook Due to electronic rights restrictions, some third party content may be suppressed Editorial review has deemed that any suppressed content does not materially affect the overall learning experience The publisher reserves the right to remove content from this title at any time if subsequent rights restrictions require it For valuable information on pricing, previous editions, changes to current editions, and alternate formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for materials in your areas of interest Macroeconomics: Principles & Applications, 6th Edition Robert E Hall and Marc Lieberman Vice President of Editorial, Business: Jack W Calhoun Publisher: Joe Sabatino Executive Editor: Michael Worls Senior Developmental Editor: Susanna C Smart Senior Marketing Manager: John Carey Senior Marketing Communications Manager: Sarah Greber Senior Content Project Manager: Tim Bailey © 2013, 2010 South-Western, Cengage Learning ALL RIGHTS RESERVED No part of this work covered by the copyright herein may be reproduced, transmitted, stored, or used in any form or by any means graphic, electronic, or mechanical, including but not limited to photocopying, recording, scanning, digitizing, taping, web distribution, information networks, or information storage and retrieval systems, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the publisher For product information and technology assistance, contact us at Cengage Learning Customer & Sales Support, 1-800-354-9706 For permission to use material from this text or product, submit all requests online at 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the United States of America 16 15 14 13 12 b r i e f c o n t en t s © Images.com/Corbis   What Is Economics?    Scarcity, Choice, and Economic Systems  24 Part II: Markets and Prices   Supply and Demand  52   Working with Supply and Demand  89 Part III: Macroeconomics: Basic Concepts   What Macroeconomics Tries to Explain  121   Production, Income, and Employment  134   The Price Level and Inflation  172 Part IV: Long-Run Macroeconomics   The Classical Long-Run Model  198   Economic Growth and Rising Living Standards 230 Part V: The Short-Run Model and Fiscal Policy 10 Economic Fluctuations  268 11 The Short-Run Macro Model  285 12 Fiscal Policy  327 Part VI: Expanding the Model: Money, Prices, and the Global Economy 13 Money, Banks, and the Federal Reserve  356 14 The Money Market and Monetary Policy  393 15 Aggregate Demand and Aggregate Supply  423 16 Inflation and Monetary Policy  456 17 Exchange Rates and Macroeconomic Policy  485 Glossary G-1 Index I-1 © Images.com/Corbis Part I: Preliminaries iii c o n t en t s © Images.com/Corbis Part I: Preliminaries Chapter 1: What Is Economics?  Scarcity and Individual Choice  The Concept of Opportunity Cost, Scarcity and Social Choice  The Four Resources, Opportunity Cost and Society’s Trade-offs, The World of Economics  Microeconomics and Macroeconomics, Positive and Normative Economics, Why Study Economics?  10 The Methods of Economics  11 The Art of Building Economic Models, 12 Assumptions and Conclusions, 13 Math, Jargon, and Other Concerns, 13 How to Study Economics  14 Summary 14 Problem Set  14 Appendix: Graphs and Other Useful Tools  16 Chapter 2: Scarcity, Choice, and Economic Systems 24 Society’s Production Choices  24 The Production Possibilities Frontier, 25 Increasing Opportunity Cost, 26 The Search for a Free Lunch  28 Productive Inefficiency, 28 Recessions, 30 Economic Growth, 31 Economic Systems  35 Specialization and Exchange, 35 Comparative Advantage, 36 International Comparative Advantage, 39 Resource Allocation, 41 Understanding the Market  43 The Importance of Prices, 43 Markets, Ownership, and the Invisible Hand, 44 The U.S Market System in Perspective, 45 Using the Theory: Are We Saving Lives Efficiently?  47 Summary 50 Problem Set  51 Part II: Markets and Prices Chapter 3: Supply and Demand  52 Using the Theory: The Price of Oil  79 Markets 52 Characterizing a Market, 53 Summary 84 Demand 56 The Law of Demand, 56 The Demand Schedule and the Demand Curve, 57 Shifts versus Movements Along the Demand Curve, 58 Factors That Shift the Demand Curve, 60 Demand: A Summary, 63 Appendix: Solving for Equilibrium Algebraically  88 © Images.com/Corbis Supply 63 The Law of Supply, 64 The Supply Schedule and the Supply Curve, 64 Shifts versus Movements Along the Supply Curve, 66 Factors That Shift the Supply Curve, 67 Supply—A Summary, 70 Putting Supply and Demand Together  71 Finding the Equilibrium Price and Quantity, 71 What Happens When Things Change?  74 Example: Income Rises, Causing an Increase in Demand, 74 Example: Bad Weather , Supply Decreases, 75 Example: Higher Income and Bad Weather Together, 76 The Three-Step Process  78 iv Problem Set  85 Chapter 4:  Working with Supply and Demand 89 Government Intervention in Markets  89 Fighting the Market: Price Ceilings, 89 Fighting the Market: Price Floors, 92 Manipulating the Market: Taxes, 94 Manipulating the Market: Subsidies, 98 Supply and Demand in Housing Markets  100 What’s Different about Housing Markets, 101 The Supply Curve for Housing, 102 The Demand Curve for Housing, 103 Housing Market Equilibrium, 105 What Happens When Things Change, 106 Using the Theory: The Housing Boom and Bust: 1997–2011  110 Summary 116 Problem Set  116 Appendix: Understanding Leverage  119 Contents v Part III: Macroeconomics: Basic Concepts Chapter 5: What Macroeconomics Tries to Explain  121 Using the Theory: Sudden Disasters and GDP  165 Macroeconomic Goals  121 Economic Growth, 121 High Employment (or Low Unemployment), 124 Stable Prices, 126 Problem Set  169 The Macroeconomic Approach  128 Aggregation in Macroeconomics, 129 Macroeconomic Controversies  129 As You Study Macroeconomics   131 Summary 132 Problem Set  132 Chapter 6: Production, Income, and Employment 134 Production and Gross Domestic Product  134 GDP: A Definition, 135 Tracking and Reporting GDP, 137 The Expenditure Approach to GDP, 139 Other Approaches to GDP, 146 Measuring GDP: A Summary, 149 How GDP Is Used, 149 Problems with GDP, 150 Using GDP Properly, 152 Employment and Unemployment  153 Types of Unemployment, 153 The Costs of Unemployment, 157 How Unemployment Is Measured, 160 Problems in Measuring Unemployment, 161 Alternative Measures of Employment Conditions, 162 Summary 169 Chapter 7:The Price Level and Inflation  172 Measuring the Price Level and Inflation  172 Index Numbers in General, 172 The Consumer Price Index, 173 From Price Index to Inflation Rate, 175 How the CPI Is Used  177 Real Variables and Adjustment for Inflation, 177 Real GDP and the GDP Price Index, 179 The Costs of Inflation  180 The Inflation Myth, 180 The Redistributive Cost of Inflation, 181 The Resource Cost of Inflation, 184 Is the CPI Accurate?  185 Sources of Bias in the CPI, 186 The Overall Bias, 188 Consequences of CPI Bias, 188 The Larger, Conceptual Problem, 189 Using the Theory: The Controversy Over Indexing ­Social Security Benefits  191 Summary 194 Problem Set  194 Appendix: Calculating the Consumer Price Index  196 Part IV: Long-Run Macroeconomics Chapter 8:The Classical Long-Run Model  198 Problem Set  225 Macroeconomic Models: Classical versus Keynesian  199 Why the Classical Model Is Important, 200 Assumptions of the Classical Model, 201 Appendix: The Classical Model in an Open Economy  227 How Much Output Will We Produce?  202 The Labor Market, 202 From Employment to Output, 205 The Role of Spending  207 Total Spending in a Very Simple Economy, 207 Total Spending in a More Realistic Economy, 209 The Loanable Funds Market  213 The Supply of Loanable Funds, 213 The Demand for Loanable Funds, 214 Equilibrium in the Loanable Funds Market, 216 The Loanable Funds Market and Say’s Law, 217 Fiscal Policy in the Classical Model  219 An Increase in Government Purchases, 219 A Decrease in Net Taxes, 222 The Classical Model: A Summary  223 Summary 224 Chapter 9: Economic Growth and Rising Living Standards 230 The Meaning and Importance of Economic Growth  230 Measuring Living Standards, 231 Small Differences and the Rule of 70, 232 Growth Prospects, 233 What Makes Economies Grow?  235 The Determinants of Real GDP, 235 The Growth Equation, 237 Growth in the Employment-Population Ratio (EPR)  238 Changes in Labor Supply and Labor Demand, 238 Government and the EPR, 240 The Limits to the EPR as a Growth Strategy, 241 Productivity Growth: Increases in the Capital Stock  242 Investment and the Capital Stock, 243 How to Increase Investment, 244 Human Capital and Economic Growth, 248 The Limits to Growth from More Capital, 248 vi Contents Productivity Growth: Technological Change  249 Capital Growth versus Technological Change, 250 Discovery-Based Growth, 251 Catch-Up Growth, 253 Using the Theory: Barriers to Catch-Up Growth in the Poorest Countries  260 Growth Policies: A Summary  255 Problem Set  266 Summary 265 The Costs of Economic Growth  257 Budgetary Costs, 257 Consumption Costs, 258 Sacrifice of Other Social Goals, 259 Part V: The Short-Run Model and Fiscal Policy Chapter 10: Economic Fluctuations  268 Can the Classical Model Explain Economic Fluctuations?  271 Shifts in Labor Supply, 271 Shifts in Labor Demand, 272 Verdict: The Classical Model Cannot Explain Economic Fluctuations, 274 What Triggers Economic Fluctuations?  274 A Very Simple Economy, 275 The Real-World Economy, 276 Why Say’s Law Doesn’t Prevent Recessions, 277 Examples of Recessions and Expansions, 281 Where Do We Go from Here?  282 Summary 283 Other Spending Changes, 310 A Graphical View of the Multiplier, 311 The Multiplier Process and Economic Stability  312 Automatic Stabilizers and the Multiplier, 312 Automatic Destabilizers and the Multiplier, 315 Real-World Multipliers, 316 Using the Theory: 2008 to 2011: The Recession and the Long Slump  317 Summary 323 Problem Set  323 Appendix: Finding Equilibrium GDP Algebraically  326 Problem Set  283 Chapter 12: Fiscal Policy  327 Chapter 11:The Short-Run Macro Model  285 The Short Run: Countercyclical Fiscal Policy  327 The Mechanics of Countercyclical Fiscal Policy, 328 Problems with Countercyclical Fiscal Policy, 332 Consumption Spending  286 Determinants of Consumption Spending, 286 Consumption and Disposable Income, 287 Consumption and Income, 290 The Long Run: Deficits and the National Debt  334 Numbers in Perspective, 334 Outlays, Revenue, and the Deficit, 335 Deficits over Time, 336 The Deficit and the National Debt, 338 Total Spending  294 Other Components of Total Spending, 294 Summing Up: Aggregate Expenditure, 295 Income and Aggregate Expenditure, 296 The National Debt: Myths and Realities  339 A Mythical Concern about the National Debt, 340 The Burden of the National Debt, 341 Genuine Concern #1: A Rising Debt Burden, 343 Genuine Concern #2: A Debt Disaster, 345 The U.S Long-Term Debt Problem, 347 Equilibrium GDP  297 Finding the Equilibrium, 297 Inventories and Equilibrium GDP, 298 Finding Equilibrium GDP with a Graph, 299 Equilibrium GDP and Employment, 303 What Happens When Things Change?  306 A Change in Investment Spending, 306 The Expenditure Multiplier, 307 The Multiplier in Reverse, 309 Using the Theory: The American Reinvestment and Recovery Act  349 Summary 353 Problem Set  354 Part VI: Expanding the Model: Money, Prices, and the Global Economy Chapter 13: Money, Banks, and the Federal Reserve  356 The Federal Reserve System  364 The Structure of the Fed, 365 The Functions of the Fed, 367 Money 356 The Money Supply, 357 Functions of Money, 358 A Brief History of the Dollar, 359 The Fed and the Money Supply  368 How an Open Market Purchase Can Increase the Money Supply, 368 How an Open Market Sale Can Decrease the Money Supply, 372 Some Important Provisos about the Money Multiplier, 373 Other Fed Actions That Change the Money Supply, 374 The Banking System  360 Financial Intermediaries in General, 361 Commercial Banks, 361 A Bank’s Balance Sheet, 362 520  Part VI: Expanding the Model: Money, Prices, and the Global Economy 12 Toward the end of the Using the Theory section, you learned that higher inflation in China than in the U.S has reduced the yuan’s undervaluation in recent years To see how this works, draw a graph similar to that in Figure 12 To keep the problem simple, suppose the price level in the U.S does not change and the price level in China rises, while China continues to fix the exchange rate at $0.15 per yuan a What impact does the rise in China’s price level have on the supply of yuan curve? b What impact does the rise in China’s price level have on the demand for yuan curve? c What is the combined effect of the changes you found in (a) and (b) above on the equilibrium price of the yuan? d After the changes you found above, is the yuan (fixed at $0.15 per yuan) more or less undervalued than initially? Explain briefly G L o s s a ry © Images.com/Corbis Absolute advantage  The ability to produce a good or service, using fewer resources than other ­producers use Aggregate demand (AD) curve  A curve indicating equilibrium GDP at each price level when the money supply is constant Aggregate expenditure (AE)  The sum of spending by households, business firms, the government, and foreigners on final goods and services produced in the United States Aggregate production ­function  The relationship ­showing how much total output can be produced with different quantities of labor, with quantities of all other ­resources and technology held constant Aggregate supply (AS) curve  A curve indicating the price level that is consistent with firms’ unit costs and markups for any level of output over the short run Aggregation  The process of combining different things into a single category Alternate goods  Other goods that firms in a market could produce instead of the good in question Alternate market  A market other than the one being analyzed in which the same good could be sold Appreciation  An increase in the price of a currency in a floating-rate system Automatic destabilizers  A feature of the economy that increases the size of the expenditure multiplier and enlarges the impact of spending changes on real GDP Automatic stabilizer  A feature of the economy that reduces the size of the expenditure multiplier and diminishes the impact of spending changes on real GDP Autonomous consumption spending  The part of consumption spending that is independent of income; also the vertical intercept of the consumption function B Balance sheet  A financial statement showing assets, liabilities, and shareholders’ equity at a point in time Balanced budget multiplier  The multiplier for a change in government purchases that is matched by an equal change in taxes Bank capital  Another name for shareholders’ equity in a bank Banking panic  A situation in which fearful depositors attempt to ­withdraw funds from many banks simultaneously Black market  A market in which goods are sold illegally at a price above the legal ceiling Bond  A promise to pay back borrowed funds, issued by a corporation or government agency Boom  A period of time during which real GDP is above potential GDP Budget deficit  The excess of ­government purchases over net taxes Budget surplus  The excess of net taxes over government purchases Burden of the debt  Interest payments on the national debt as a percentage of GDP Business cycles  Fluctuations in real GDP around its longterm growth trend Business demand for funds curve  Indicates the level of ­investment spending firms plan at various interest rates C Capital  A long-lasting tool that is used to produce other goods Capital gain  The gain to the owner of an asset when it is sold for a price higher than its original purchase price Capital gains tax  A tax on profits earned when a financial asset is sold at more than its acquisition price Capital loss  The loss to the owner of an asset when it is sold for a price lower than its original purchase price Capital per worker  The total ­capital stock divided by total employment Capital ratio  A bank’s capital (shareholders’ equity) as a percentage of its total assets Capital stock  The total amount of capital in a nation that is ­productively useful at a particular point in time Cash in the hands of the public  Currency and coins held by the non-bank public Catch-up growth  Economic growth, primarily in lessadvanced countries, based on increasing capital per worker from low levels, and adopting technologies already used in more advanced countries Central bank  A nation’s principal monetary authority responsible for controlling the money supply G-1 © Images.com/Corbis A G-2 Glossary Ceteris paribus  Latin for “all else remaining the same.” Change in demand  A shift of a demand curve in response to a change in some variable other than price Change in quantity demanded  A movement along a demand curve in response to a change in price Change in quantity supplied  A movement along a supply curve in response to a change in price Change in supply  A shift of a supply curve in response to a change in some variable other than price Circular flow  A simple model that shows how goods, resources, and dollar payments flow between households and firms Classical model  A macroeconomic model that explains the ­long-run behavior of the economy Command or centrally planned economy  An economic system in which resources are allocated according to explicit instructions from a central authority Comparative advantage  The ability to produce a good or service at a lower opportunity cost than other producers Complement  A good that is used together with some other good Complete crowding out  A ­dollar-for-dollar decline in one sector’s spending caused by an increase in some other sector’s spending Consumer Price Index  An index of the cost, through time, of a ­market basket of goods purchased by a typical household Consumption (C)  The part of GDP purchased by households as final users Consumption function  A ­positively sloped relationship between real consumption spending and real disposable income Consumption tax  A tax on the part of their income that households spend Consumption–income line  A line showing aggregate consumption spending at each level of income or GDP Corporate profits tax  A tax on the profits earned by corporations Critical assumption  Any assumption that affects the conclusions of a model in an important way Crowding out  A decline in one sector’s spending caused by an increase in some other sector’s spending Cyclical unemployment  Joblessness arising from changes in production over the business cycle D Debt ratio  Publicly held national debt as a percentage of GDP Deflation  A decrease in the price level from one period to the next Demand curve  A graph of a demand schedule; a curve showing the quantity of a good or service demanded at various prices, with all other variables held constant Demand curve for foreign currency  A curve indicating the quantity of a specific foreign currency that Americans will want to buy, during a given period, at each different exchange rate Demand curve for housing  A curve showing, at each price, the total number of homes that everyone in the market would like to own, given the constraints that they face Demand schedule  A list showing the quantities of a good that consumers would choose to purchase at different prices, with all other variables held constant Demand shock  Any event that causes the AD curve to shift Demand-side effects  Macroeconomic policy effects on total output that work through changes in total spending Depreciation  A decrease in the price of a currency in a floating-rate system Depression  An unusually severe recession Devaluation  A change in the exchange rate from a higher fixed rate to a lower fixed rate Discount rate  The interest rate the Fed charges on loans to banks Discouraged workers  Individuals who would like a job, but have given up searching for one Discovery-based growth  Economic growth, primarily in advanced countries, based on technological change from new discoveries Disposable income  Household income minus net taxes, which is either spent or saved E Economic growth  The increase in our production of goods and services that occurs over long periods of time Economics  The study of choice under conditions of scarcity Entrepreneurship  The ability and willingness to combine the other resources—labor, capital, and land—into a productive enterprise Equilibrium GDP  In the short run, the level of output at which output and aggregate expenditure are equal Equilibrium price  The market price that, once achieved, remains constant until either the demand curve or supply curve shifts Equilibrium quantity  The market quantity bought and sold per period that, once achieved, remains constant until either the demand curve or supply curve shifts Excess demand  At a given price, the amount by which quantity demanded exceeds quantity supplied Excess demand for bonds  The amount of bonds demanded exceeds the amount supplied at a particular interest rate Excess reserves  Reserves in excess of required reserves Excess supply  At a given price, the amount by which quantity supplied exceeds quantity demanded Excess supply of money  The amount of money supplied exceeds the amount demanded at a ­particular interest rate Exchange  The act of trading with others to obtain what we desire Exchange rate  The amount of one country’s currency that is traded for one unit of another country’s currency Glossary G-3 Excise tax  A tax on a specific good or service Expansion  A period of increasing real GDP Expenditure approach  Measuring GDP by adding the value of goods and services purchased by each type of final user Expenditure multiplier  The amount by which equilibrium real GDP changes as a result of a ­one-dollar change in autonomous consumption, investment spending, government purchases, or net exports Explicit cost  The dollars sacrificed—and actually paid out— for a choice F Factor payments  Payments to the owners of resources that are used in production Factor payments approach  Measuring GDP by summing the factor payments earned by all ­households in the economy Federal funds rate  The interest rate charged for loans of reserves among banks Federal Open Market Committee (FOMC)  A committee of Federal Reserve officials that establishes U.S monetary policy Federal Reserve System  The monetary authority of the United States, charged with creating and regulating the nation’s supply of money Fiat money  Something that serves as a means of payment by government declaration Final good  A good sold to its final user Financial intermediary  A business firm that specializes in brokering between savers and borrowers Fiscal policy  A change in ­government purchases or net taxes ­designed to change total output Fixed exchange rate  A government-declared exchange rate maintained by central bank intervention in the foreign exchange market Floating exchange rate  An exchange rate that is freely determined by the forces of supply and demand Flow variable  A variable representing a process that takes place over some time period Foreign currency crisis  A loss of faith that a country can prevent a drop in its exchange rate, leading to a rapid depletion of its foreign currency (e.g., dollar) reserves Foreign exchange market  The market in which one country’s currency is traded for another country’s Frictional unemployment  Joblessness experienced by people who are between jobs or who are just entering or reentering the labor market Full employment  A situation in which there is no cyclical unemployment G GDP price index  An index of the price level for all final goods and ­services included in GDP Government demand for funds curve  Indicates the amount of government borrowing at various interest rates Government outlays  Total disbursements by the government for purchases, transfer payments, and interest on the debt Government purchases (G )  Spending by federal, state, and local governments on goods and services Gross domestic product (GDP)  The total value of all final goods and services produced for the marketplace during a given year, within the nation’s borders Growth equation  An equation showing the percentage growth rate of real GDP per capita as the sum of the growth rates of productivity, average hours, and the employment-population ratio H (Household) saving  The portion of after-tax income that households not spend on consumption Human capital  The skills and training of the labor force I Implicit cost  The value of something sacrificed when no direct payment is made Income  The amount that a person or firm earns over a particular period Index  A series of numbers used to track a variable’s rise or fall over time Indexed payment  A payment that is periodically adjusted in proportion with a price index Inferior good  A good that people demand less of as their income rises Inflation rate  The percentage change in the price level from one period to the next Injections  Spending on a country’s output from sources other than its households Input  Anything (including a ­resource) used to produce a good or service Insolvent  Condition of a firm (e.g., a bank) when total assets are less than total liabilities Intermediate goods  Goods used up in producing final goods Investment tax credit  A ­reduction in taxes for firms that invest in new capital Involuntary part-time workers  Individuals who would like a full-time job, but who are working only part time L Labor  The time human beings spend producing goods and services Labor demand curve  Indicates how many workers firms will want to hire at various real wage rates Labor force  Those people who have a job or who are looking for one Labor productivity  The output produced by the average worker in an hour G-4 Glossary Labor supply curve  Indicates how many people will want to work at various real wage rates Land  The physical space on which production takes place, as well as the natural resources that come with it Law of demand  As the price of a good increases, the quantity demanded decreases Law of supply  As the price of a good increases, the quantity supplied increases Leakages  Income earned by households that they not spend on the country’s output during a given year Loan  An agreement to pay back borrowed funds, signed by a household or noncorporate business Loanable funds market  The ­market in which savers make their funds available to borrowers Long-run aggregate supply curve  A vertical line indicating all possible output and price-level combinations at which the economy could end up in the long run Long-run Phillips curve  A vertical line indicating that in the long run, unemployment must equal its natural rate, regardless of the rate of inflation M Macroeconomics  The study of the behavior of the overall economy Managed float  A policy of ­frequent central bank intervention to move the exchange rate Marginal propensity to ­consume  The amount by which consumption spending rises when disposable income rises by one ­dollar Market  A group of buyers and ­sellers with the potential to trade with each other Market clearing  Adjustment of prices until quantities supplied and demanded are equal Market economy  An economic system in which resources are ­allocated through individual decision making Means of payment  Anything acceptable as payment for goods and services Microeconomics  The study of the behavior of individual households, firms, and governments; the choices they make; and their interaction in specific markets Mixed economy  A market economy in which the government also plays an important role in allocating resources Model  An abstract representation of reality Monetary policy  Control or manipulation of interest rates by the Federal Reserve designed to achieve a macroeconomic goal Money  An asset widely accepted as a means of payment Money demand curve  A curve indicating how much money will be demanded at each nominal interest rate Money multiplier  The multiple by which the money supply changes after a change in reserves Money supply  The total amount of money (cash, checking deposits, and traveler’s checks) held by the public Money supply curve  A line ­showing the total quantity of money in the economy at each interest rate Mortgage  A loan given to a home-buyer for part of the purchase price of the home N National debt  The total amount the federal government still owes to the general public from past borrowing Natural rate of unemployment  The unemployment rate when there is no cyclical unemployment Net exports (NX)  Total exports minus total imports Net financial inflow  An inflow of funds equal to a nation’s trade deficit Net investment  Investment minus depreciation Net taxes  Government tax ­revenues minus transfer payments Nominal interest rate  The ­annual percent increase in a lender’s dollars from making a loan Nominal variable  A variable measured without adjustment for the dollar’s changing value Non-bank  A financial intermediary less strictly regulated than a bank, and with no government-guaranteed deposits Nonmarket production  Goods and services that are produced but not sold in a market Normal good  A good that people demand more of as their income rises Normative economics  The ­practice of recommending policies to solve economic problems O Open market operations  Purchases or sales of government bonds by the Federal Reserve System Opportunity cost  What is given up when taking an action or making a choice P Perfectly competitive market  (informal definition) A market in which no buyer or seller has the power to influence the price Phillips curve  A curve indicating the Fed’s choices between inflation and unemployment in the short run Physical capital  The part of the capital stock consisting of physical goods, such as machinery, equipment, and factories Planned investment ­spending  Business purchases of plant and equipment Positive economics  The study of how the economy works Potential output  The level of ­output the economy could produce if operating at full employment Glossary G-5 Price  The amount of money that must be paid to a seller to obtain a good or service Price ceiling  A government-imposed maximum price in a market Price floor  A government-imposed minimum price in a market Price level  The average level of prices in the economy Product markets  Markets in which firms sell goods and services to households Production possibilities frontier (PPF)  A curve showing all combinations of two goods that can be produced with the resources and technology currently available Productively inefficient  A ­situation in which more of at least one good can be produced without sacrificing the production of any other good Purchasing power parity (PPP) theory  The idea that the exchange rate will adjust in the long run so that the average price of goods in two countries will be roughly the same Q Quantity demanded  The quantity of a good that all buyers in a market would choose to buy during a period of time, given their constraints Quantity supplied  The specific amount of a good that all sellers in a market would choose to sell over some time period, given their constraints R Real interest rate  The annual ­percent increase in a lender’s ­purchasing power from making a loan Real variable  A variable adjusted for changes in the dollar’s value Recession  A period of significant decline in real GDP Rent controls  Government-imposed maximum rents on apartments and homes Required reserve ratio  The minimum fraction of checking account balances that banks must hold as reserves Required reserves  The minimum amount of reserves a bank must hold, depending on the amount of its deposit liabilities Reserves  Vault cash plus balances held at the Fed Resource markets  Markets in which households that own resources sell them to firms Resources  The labor, capital, land (including natural resources), and entrepreneurship that are used to produce goods and services Run on the bank  An attempt by many of a bank’s depositors to ­withdraw their funds S Say’s law  The idea that total ­spending will be sufficient to ­purchase the total output produced Scarcity  A situation in which the amount of something available is insufficient to satisfy the desire for it Seasonal adjustment  Adjusting an economic variable to remove the effects of changes predicted to occur at that time of year Seasonal unemployment  Joblessness related to changes in weather, tourist patterns, or other seasonal factors Self-correcting mechanism  The adjustment process through which price and wage changes return the economy to fullemployment output in the long run Shadow banking system  The entire collection of non-bank financial intermediaries Shareholders’ equity  The difference between total assets and total liabilities Short side of the market  The smaller of quantity supplied and quantity demanded at a particular price Short-run macro model  A macroeconomic model that explains how changes in spending can affect real GDP in the short run Short-run macroeconomic equilibrium  A combination of price level and GDP consistent with both the AD and AS curves Shortage  An excess demand not eliminated by a rise in price, so that quantity demanded continues to exceed quantity supplied Simplifying assumption  Any assumption that makes a model ­simpler without affecting any of its important conclusions Slump  A period during which real GDP is below potential and/or the employment rate is below normal Specialization  A method of ­production in which each person concentrates on a limited number of activities Spread  The difference between an interest rate and some other, benchmark interest rate Stagflation  The combination of falling output and rising prices Stock variable  A variable representing a quantity at a moment in time Store of value  A form in which wealth can be held Structural unemployment  Joblessness arising from mismatches between workers’ skills and employers’ requirements or ­between workers’ locations and ­employers’ locations Subsidy  A government payment to buyers or sellers on each unit purchased or sold Substitute  A good that can be used in place of some other good and that fulfills more or less the same purpose Supply curve  A graph of a supply schedule, showing the quantity of a good or service supplied at various prices, with all other variables held constant G-6 Glossary Supply curve for foreign currency  A curve indicating the quantity of a specific foreign currency that will be supplied, during a given period, at each different exchange rate Supply curve for housing  A vertical line showing the total number of homes in a market that are available for ownership Supply of funds curve  Indicates the level of household saving at ­various interest rates Supply schedule  A list showing the quantities of a good or service that firms would choose to produce and sell at different prices, with all other variables held constant Supply shock  Any event that causes the AS curve to shift Supply-side effects  Macroeconomic policy effects on total output that work by changing the quantities of resources available Surplus  An excess supply not eliminated by a fall in price, so that quantity supplied continues to exceed quantity demanded T Tax incidence  The division of a tax payment between buyers and sellers, determined by comparing the new (after tax) and old (pretax) market equilibriums Tax multiplier  The amount by which real GDP changes for each one-dollar change in net taxes Taylor rule  A proposed rule that would require the Fed to change the interest rate by a specified amount whenever real GDP or inflation deviates from its pre-announced target Technological change  The ­invention or discovery of new inputs, new outputs, or new ­production ­methods Total demand for funds curve  Indicates the total amount of borrowing at various interest rates Trade deficit  The excess of a nation’s imports over its exports during a given period Trade surplus  The excess of a nation’s exports over its imports during a given period Traditional economy  An econ­omy in which resources are allocated according to long-lived practices from the past Transfer payment  Any payment that is not compensation for supplying goods, services, or resources U Unemployment rate  The fraction of the labor force that is without a job Unit of account  A common unit for measuring how much something is worth V Value added  The revenue a firm receives minus the cost of the ­intermediate goods it buys Value-added approach  Measuring GDP by summing the values added by all firms in the economy W Wealth  The total value of everything a person or firm owns, at a point in time, minus the total amount owed Wealth constraint  At any point in time, total wealth is fixed Z Zero lower bound  The lowest possible value (zero) for any nominal interest rate (such as the federal funds rate) Index A absolute advantage defined, 37 adjustable rate mortgage (ARM), 112 aggregate demand (AD), 423 and aggregate supply, 439–440 aggregate demand curves, 423–431 defined, 427 deriving, 426–427 and the equilibrium GDP, 427–428 misconceptions about, 428 movements along, 428, 431 recessions, 451–453 shifts of, 428–431 understanding, 427–428 aggregate expenditures, 295–296, 297–298 monetary policy and, 405 aggregate production function, 205, 304 aggregate supply (AS) and aggregate demand, 439–440 output levels, 433 aggregate supply curves, 423, 431–439 and the classical model, 448 defined, 435 deriving, 435–436 long-run, 447–448 movements along, 436 recessions, 451–453 shifts of, 436–439 technological changes, 439 aggregation, defined, 53, 129 Agricultural Adjustment Act of 1933, 93 alternate goods, defined, 68 alternate markets, defined, 68 alternative fiscal scenario, 348 American Airlines, 29 American Recovery and Reinvestment Act (ARRA) of 2009, 198, 349–353, 453 appreciation in currency price, 493 approximation rule, 182 Archer Daniels Midland (ADM), 117 assets See also Money balance sheets and, 362–364 of banks, 363–364 assumptions, 13 automatic destabilizers, 315–316 automatic stabilizers, 312–315 autonomous consumption spending, 288, 290, 293–294, 315 B baht, 500–501, 502–503 balanced budget multiplier, 331–332 balanced trade, 227 balance sheet, 362–364 bank capital, 380 banking panics, 375–381 defined, 377 banking system, 360–364 See also Money supply balance sheets and, 362–364 commercial banks, 361–364 financial crisis of 2008, 383–388 regulation of, 380–381 versus shadow banking system, 381–383 base period, 173 Bernanke, Ben, 366, 415, 482 black markets, defined, 91 Boeing, 361 bonds, 372 defined, 362 excess demand for, 400 prices, 400–401 treasury securities, 338 booms, 268 See also Expansions British pounds demand for, 487–489 supply of, 490–492 bubbles and the Federal Reserve System, 480–483 housing, 110, 114 budget deficits, 214 and economic growth, 246–248, 338 historic, 336–337 and national debt, 334–339 and recessions, 338 budgets, federal, 334–335 budget surplus, 214 building restrictions, 107–108 burden of the debt, 341–343 increasing, 343–345 Bureau of Economic Analysis (BEA), 139–140, 179 Bush, President George W., 336, 366, 387 tax cuts and, 255–256 business cycles, 125–126 defined, 125 business demand for funds curve, 215–216 C capital defined, and economic growth, 31 technological changes, 250–251 physical, capital formation, 144 capital gains, 394 defined, 108 taxes on, 246 capitalism, 44–45 capital losses, defined, 108 capital per worker, 242 capital ratio, 380 capital requirements, 380–381 capital stock defined, and gross domestic product, 143–144 productivity growth and, 242–249 careers, preparing for, 11 cash, 356, 357 See also Money catch-up growth, 253–255 barriers to, 260–265 causal relationships, 16 cell phones in India, 253 central bank, 364 centrally planned economy, defined, 42–43 ceteris paribus, 221 defined, 57 in demand, 57 in supply, 64 chained consumer price index, 188, 189 change in demand, 59 change in quantity demanded, 59 change in quantity supplied, 67 change in supply, 67 checkable deposits, 357 check clearing, 368 China economic growth in, 254–255 trade deficit with U.S., 515–517 choice individual, and scarcity, 2–6 social, and scarcity, 6–8 circular flow, defined, 53 circular flow model, 53–54 classical economics, 129 classical economics model, 198–202 aggregate supply curves, 448 and economic fluctuations, 271–274, 282–283 fiscal policy and, 219–223 loanable funds market, 213–219 in an open economy, 227–229 output production, 202–207 production function, 205–206 spending, 207–212 summary of, 223–224 worker productivity, 242–243 Clinton, President William, 336 colleges benefits of, 5–6 opportunity cost of, 3–5 command economy, defined, 42–43 commercial banks, 361–364 commodity money, 360 comparative advantages defined, 37 gains from, 38–39 international, 39–41 I-1 © Images.com/Corbis © Images.com/Corbis I-2 Index comparative advantages (Continued) of specialization and exchange, 36–39 competition in markets, 54–55 and the supply curve, 69 competitive markets, 55 complement, defined, 61 complete crowding out, 221–222, 464 constraints on demand, 56 governmental, 46 consumer durables, 144 consumer goods, 34 consumer price index (CPI), 173–175 accuracy of, 185–191, 475 calculating, 196–197 discount prices, 188 historic, 176 and inflation, 175–176, 179 quality changes, 187 and standard of living, 190 substitution bias, 186 technological changes, 186–187 uses for, 177–180 weight of items, 174, 175 consumer price index - elderly (CPI-E), 193 consumer price index - research series (CPI-RS), 188, 189, 190 consumption defined, 141 versus growth, 33–35 consumption function, 288, 289, 290 consumption-income line, 291–294 consumption spending and the classical model, 211 decrease in, 221 disposable income, 286, 287–290 in gross domestic product, 141 and income, 286–287, 290–294 short-run macro model, 286–294, 310 consumption taxes, 246 contraction, 125 conventional monetary policy, 410 corporate profits taxes, 245 costs of economic growth, 257–260 and prices, 432 of unemployment, 157–160 countercyclical fiscal policy, 327–334 defined, 328 problems with, 332–334 counterfactual, 350 CPI See Consumer price index (CPI) CPI market basket, 174, 196 credit limits, 340 creeping inflation, 185 critical assumptions, defined, 13 crowding out, 221–222 in an open economy, 229 demand shocks, 442–443 from tax cut, 223 curved line graphs, 18 demand curves, 58–60 movements along, 21–22 cyclical unemployment, 155–157, 457–458 D debt ratio, 339 defaults governmental, 345 in housing market, 112 deficits See Budget deficits; Trade deficits deflation, 128, 475 avoiding, 479–480 defined, 176 and monetary policy, 456 deleveraging assets, 391–392 demand See also Supply and demand aggregate, 423 and availability, 63 change in, 59 curves See Demand curves demand schedule, 57–58 excess, 71–72 for labor classical model for, 203–204 economic fluctuations, 272–274 increases in, 241 law of, 56–57 loanable funds, 214–216 for money, 393–397 demand curve, 396–397 economy-wide, 395–396 household, 393–395 demand curves, 57–58 aggregate, 423 defined, 58 for foreign currency, 487–489 for housing, 103–105 equilibrium, 105–106 labor, 239–240 for money, 396–397 movement along, 58–60, 105 shifts in, 58–63, 76 for housing, 105 for money, 396–397 summary of, 62 demand deposits, 357 demand for funds curve, 215–216 demand schedule, 57–58 demand shocks, 440–447 crowding out, 442–443 and exchange rates, 504 Federal Reserve System, 460–465 fiscal policy, 442–443 government purchases and, 441–442 and the Great Depression, 443–444 long-run, 444–447 and the classical model, 448 money supply, 443, 461–462 and recessions, 452–453 short-run, 440–444 demand-side effects, 219–223 dependent variables, graphs of, 16 depository institutions, 361 depreciation in currency price, 494 and gross domestic product, 144 depressions, 10, 30–31, 125 See also Great Depression devaluation, 502 diminishing returns to labor, 204, 205 dirty float, 499–500 discount prices, 188 discount rates changes in, 374–375 defined, 367 discouraged workers, 162 discovery-based growth, 251–253 disposable income, 211 consumption spending, 286, 287–290 forward-looking behavior, 314–315 Dodd-Frank Wall Street Reform and Consumer Protection Act, 387–388 dollar history of, 359–360 value of, 135 downtime, minimizing, 36 downward wage rigidity, 273 duel mandate of the Fed, 456 E earnings, 177, 178–179 earthquakes and GDP, 169 economic fluctuations, 268–283, 423 causes of, 274–282 and the classical model, 271–274, 282–283 demand for labor, 272–274 and productivity of labor, 273 supply of funds, 278–280 supply of labor, 271–272 and total spending, 274 economic growth, 31–35, 230–235 and budget deficits, 246–248 catch-up growth, 253–255 causes of, 235–238 costs of, 257–260 budgetary, 257 consumption, 258–259 for social goals, 259–260 defined, 122 discovery-based, 251–253 employment-population ratio, 238–242 versus expansion, 126 fiscal policy and, 255 goal of macroeconomics, 121–123, 125 and human capital, 248 and social goals, 259–260 and standard of living See Standard of living technological changes, 250–251 economics defined, macroeconomics See Macroeconomics methods of, 11–13 microeconomics, 8–9 normative, 9–10 positive, 9–10 as social science, study of, 10–11, 14 economic systems, 35–43 economic well being, 151–152 economists becoming, 11 policy differences between, 9–10 employment, 124–126 See also Labor markets; Unemployment and the business cycle, 125–126 equilibrium GDP, 303–306 false benefits from, 30 full, 156, 204–205 Index I-3 monetary policy for, 457–460 in the U.S., 161, 269, 270 Employment Act of 1946, 125 employment-population ratio (EPR), 164, 236 growth in, 238–242 entrepreneurship defined, and factor payments, 147 equilibrium exchange rates, 492–493 loanable funds market, 216–217 money market, 399–402 total employment, 204–205 equilibrium GDP, 297–306 and the aggregate demand curve, 427–428 algebraic solution for, 326 automatic destabilizers, 315–316 automatic stabilizers, 312–315 and employment, 303–306 expenditure multiplier, 307–309, 311–312 automatic destabilizers, 315–316 automatic stabilizers, 312–315 and economic stability, 312 real life, 316 and fiscal policies, 328 graphing, 299–303 inventories and, 298–299 investment spending, 306–307 spending changes, 309–311 equilibrium interest rate, 399 equilibrium price algebraic calculation of, 88 defined, 71 in housing, 105–106 and price increase, 74–75 supply and demand, 71–74 equilibrium quantity algebraic calculation of, 88 defined, 71 and price increase, 74–75 supply and demand, 71–74 equity in an asset, 119 erroneus logic loop, 75 European Central Bank (ECB), 505, 506 crisis of 2011, 507–508 euro zone, 505–508 excess demand, 71–72 for bonds, 400 defined, 71 and price ceilings, 90 excess reserves, 363 excess supply, 72–73 defined, 72 excess supply of money, 400 exchange defined, 36 and specialization, 35–36 exchange rates changes in, 493–499 long-run, 497–499 short-run, 496–497 very short-run, 495–496 defined, 486 and demand shocks, 504 equilibrium, 492–493 and the euro zone, 505–508 expected changes in, 489, 492 fixed, 500–502 floating, 492 and foreign exchange markets, 485–493 and monetary policy, 504–505 and trade deficits, 508–514 excise taxes, 94–98 on buyers, 96–98 defined, 95 on sellers, 95–96 expansions and budget deficits, 338 defined, 125 economic fluctuations, 268 versus economic growth, 126 examples of, 281–282 and interest rates, 280–281 and labor supply, 272 expected prices, 61–62, 69 expenditure multiplier, 307–309, 311–312 automatic destabilizers, 315–316 automatic stabilizers, 312–315 and economic stability, 312 real life, 316 expertise, development of, 36 explicit costs defined, and opportunity costs, 5, exports in gross domestic product, 145–146 short-run macro model, 314 F factor payments, 147 factor payments approach, 147–149 defined, 148 failure of banks, 376–377 farm prices, floors on, 92–94 Federal Deposit Insurance Corporation (FDIC), 379, 383 federal funds market, 409 federal funds rates, 409, 410 Federal Open Market Committee (FOMC), 367, 409–410 Federal Reserve and bank reserves, 363 and fiscal stimulus, 350 interest rates, 111 Federal Reserve Banking Act, 456 Federal Reserve System (the Fed), 364–368 bank panics, 378–379 bubbles, 480–483 defined, 359 and demand shocks, 460–465 neutralization of, 463–465 economic fluctuations, 280, 281 Federal Open Market Committee (FOMC), 367 financial crises, 414–415 financial crisis of 2008, 386–387, 415–420, 482–483 fiscal policy, 333 functions of, 367–368 historic performance, 459–460 inflation and, 413, 468–475 interest rate changes, 402–403, 406 losses of, 412 monetary policy See Monetary policy and the money supply, 368–375, 398, 402–403 structure of, 365–367 and supply shocks, 465–467 fiat money, 360 final goods, 136 final users, 135–136 financial collapse, 414 financial crisis of 2008, 317–323 banks, effect on, 383–388 demand shock and, 452–453 and the Federal Reserve System, 415–420, 482–483 and fiscal policies, 327 financial crisis of 2011, 507–508 financial intermediaries, 279, 361 Financial Stability Oversight Council, 387 fiscal austerity, 345 fiscal policy, 327–353 balanced budget multiplier, 331–332 in the classical model, 219–223 countercyclical, 327–334 problems with, 332–334 demand shocks, 442–443 economic growth, 255 government purchases, 329 long-run, 334–339 net taxes, 329–331 short-run, 327–334 fiscal stimulus, 350 controversies of, 130 fixed exchange rates, 500–502 floating exchange rates, 492 flow variables, 101–102 housing market, 103 fluctuations See Economic fluctuations foreclosures in housing market, 112–113 forgone income, foreign currency crises, 502–503 foreign exchange markets British pounds demand for, 487–489 supply of, 490–492 currency crises, foreign, 502–503 defined, 485 and exchange rates See Exchange rates government intervention in, 499–503 managed float, 499–500 fractional reserve system, 376 “free lunch,” search for, 28–35 frictional unemployment, 153 Friedman, Milton, 28 full employment, 156 and the classical model, 204–205 monetary policy and, 457–460 Full Employment and Balanced Growth Act, 125 futures market for oil, 79 G GDP See Gross domestic product (GDP) General Accounting Office (GAO), 94 General Theory of Employment, Interest, and Money, The by John Maynard Keynes, 129 global markets, 43 goods, final, 136 goods and services, 136, 137 government consumption and investment purchases, 144 government demand for funds curve, 215–216 I-4 Index government intervention in markets See also Fiscal policy building restrictions, 107–108 catch-up growth, 254–255 employment-population ratio, 240–242 foreign exchange See Foreign exchange markets infrastructure, institutional, 252–253 laissez-faire policies, 129 price ceilings, 89–92 price floors, 92–94 productivity growth, 252–253 subsidies, 98–100 taxes, 94–98 government investment, 144 government outlays, 335–336 government policies for economic growth, 255–256 Great Depression, 423 housing markets, 111–112 government purchases and the aggregate demand curve, 429–431 and the classical model, 219–221 defined, 144 and demand shocks, 441–442 and fiscal policy, 329 and gross domestic product, 144–145 short-run macro model, 295 graphs, 16–19 Great Depression bank panics and, 379 and the classical model, 199–200 deflation and, 479 and demand shocks, 443–444 the Federal Reserve System and, 414–415 and government policies, 10, 423 and national income accounts, 134 unemployment during, 124, 125, 270, 303 and World War II, 30–31 greater opportunity cost, 26 Greece’s debt disaster, 346–347 Greenspan, Alan, 467, 482 gross domestic product (GDP) aggregate expenditure, 296 annualization, 137–139 consumption spending, 141 defined, 135–137 economic well being, 151–152 equilibrium GDP See Equilibrium GDP expenditure approach to, 139–146, 149 defined, 140 factor payments approach to, 147–149 government purchases, 144–145 growth rates, 139, 150 Hurricanes Katrina and Rita, 165–168 net exports, 145–146 nominal vs real, 138–139 private investments, 141–144 and production, 134–152 real, 122–123 actual and potential, 159, 269 determinants of, 235–236 equilibrium, 206–207 and the GDP price index, 179–180 growth equation, 237–238 growth rates, 150 versus nominal, 138–139 and standard of living, 231–233 short-run macro model See Short-run macro model and standard of living, 231–233 sudden disasters and, 165–169 tracking and reporting, 137–139 growth rates, 139 and unit costs, 433 use of, 149–150, 152 value-added approach to, 146–147, 149 growth equation, 237–238 growth rates, 139 growth vs consumption, 33–35 H Hall, Robert E., 158 hard-landing scenario, 514 hawk and dove inflation policies, 467 horizontal axis, 16 hot money, 495–496 household savings, 211, 245–246 and economic fluctuations, 278–279, 280 housing markets boom and bust of 1997-2011, 110–116 bubbles, 110, 114 changes in, 106–109 demand curve for, 103–105 and demand decrease, 114 and economic growth, 111 equilibrium of, 105–106 financial innovations, 112 government policy, 111–112 interest rates, 111 lending standards, 112–113 speculation, 113 supply and demand, 100–109 supply curve for, 102–103 human capital defined, and economic growth, 248 and gross domestic product, 144 Hurricanes Katrina and Rita, 165–168 I imperfectly competitive markets, defined, 55 implicit costs defined, and opportunity costs, imported consumption goods, 141 imports, 314 imputed items, 141 income aggregate expenditure and, 296–270 consumption spending, 286–287, 290–294 defined, 60 and the demand curve, 60, 74–75 taxes and transfers, 313–314 and wealth, 61 independent variables, 16 indexed payments, 189 Social Security, 177, 191–193 index numbers, 172–173 consumer price index, 173–175 inferior goods, 60 inflation alternative measures of, 189 built-in, 469–471 consumer price index and, 175–176, 179 expectations of, 469 expected, 182–183 and the Federal Reserve System, 413, 468–475 historic rates of, 176, 185 measures, alternative, 189 monetary policy for, 456, 457 built-in, 469–471 ongoing, 468–469, 475 the Phillips Curve, 471–473 and the national debt, 344, 345 ongoing, 468–469, 475 the Phillips Curve, 471–473 opportunity costs of, 184–185 and the Phillips Curve, 471–473 and price levels, 172–176 rising and falling, 178 and purchasing power, 180–181 shifting, 182–184 rates, historic, 459 rates of, 126–128, 175–176 historic, 176, 185 and real income calculating, 189 purchasing power of, 180–181 redistribution of, 181 and recessions, 470, 475 redistributive cost of, 181–184 resource cost of, 184–185 rising and falling, 178 unexpected, 183–184 infrastructure, governmental, 252–253 injections, 212, 217–219 in an open economy, 227 innovators, inputs defined, negatively related, 57 versus resources, insolvency, 376–377 intercept, 19, 33 interest on loanable funds, 213 interest on reserves (IOR), 410 interest rates and bond prices, 400–401 consumption spending, 286–287 demand shocks, 462–463 economic fluctuations, 280–281 and the economy, 404 and the Federal Reserve System, 402–403, 406 housing markets, 111 and money held, 395 on reserves, 375 spreads, 411–412 targeting, 406–409 theories of, 402 intermediate goods, defined, 136 international trade, 145–146 inventories and the classical model, 210 and equilibrium GDP, 298–299 Index I-5 gross domestic product and, 142–143 total spending and, 295 inverse relationships, graphs of, 16 investments and gross domestic product, 141–144 increasing incentives, 244–246 investment spending equilibrium GDP, 306–307 marginal propensity to consume, 306, 308–309 short-run macro model, 294–295, 315–316 investment tax credits, 245 “invisible hand” of Adam Smith, 45 involuntary part-time workers, 162 It’s a Wonderful Life, 375, 377 J Japan, 69, 165, 168 K Keynes, John Meynard, 129, 200, 285 Keynesian model, 200 L labor, defined, labor demand curve, 203 labor force, 161 labor markets See also Employment; Unemployment classical model for, 202–205 demand for labor classical model for, 203–204 economic fluctuations, 272–274 increasing, 241 economic fluctuations demand for labor, 272–274 supply of labor, 271–272 international unemployment, 155 productivity of, 235–236 classical economics model, 242–243 classical model for, 242–243 planned investment spending, 243–244 standard of living, 238–240 supply of labor classical model for, 203 economic fluctuations, 271–272 increasing, 240–241 labor supply curve classical model and, 203 and economic fluctuations, 271–272 laissez-faire policies, 129 land, defined, law of demand, 56–57 defined, 57 law of increasing opportunity cost, 26 law of supply, defined, 64 leakages, 211–212, 217–219 in an open economy, 227 lender of last resort, 368, 456 leveraged assets financial crisis of 2008, 385 at financial institutions, 391–392 housing market, 108–109, 114, 119–120 lifesaving, 47–50 linear equations, 19 solving, 22–23 liquidity trap, 412 loanable funds market, 213–219, 402 economic fluctuations, 279–280 equilibrium in, 216–217 loans, 362 long-run aggregate supply curve, 447–448 long-run costs and short-run costs, 433–435 long-run Phillips Curve, 473–475 M M1 and M2, 358 macroeconomics, 8–9 aggregation in, 129 approach of, 128–129 the classical model, 198–202 in an open economy, 227–229 fiscal policy and, 219–223 loanable funds market, 213–219 output production, 202–207 spending, 207–212 summary of, 223–224 controversies of, 129–131 defined, economic growth goal, 121–123 employment goal, 124–126 fiscal policy and, 219–223 loanable funds market, 213–219 market, defined, 53 versus microeconomics, 129 output production, 202–207 short-run model See Shortrun macro model stable prices goal, 126–128 study of, 131–132 Making Home Affordable Program, 115 Malthus, Thomas, 230 managed float, 499–500 marginally attached to the labor force, 162 marginal propensity to consume (MPC), 290, 292 forward-looking behavior, 314–315 investment spending and, 306, 308–309 market basket for the CPI, 174, 196 market capitalism, 44–45 market clearing, 201, 219 and recessions, 273 market demand curves See Demand curves market economy, 45–46 defined, 43 marketplace, 137 markets, 52–56 competition in, 54–55 defined, 43, 52–53 demand, 56–63 government intervention in, 89–100 price ceilings, 89–92, 93 price floors, 92–94 subsidies, 98–100 taxes, 94–98 prices, 43–44 product markets, 53–54 resource markets, 53–54 supply, 63–70 supply and demand, 55–56 markups, 432 means of payment, 356, 358 money, 394 microeconomics defined, versus macroeconomics, 129 market, defined, 53 mixed economy defined, 46 models assumptions, 13 building, 12 conclusions, 13 defined, 11 mathematical concepts, 13 monetary policy, 404–410 challenges for, 476–480 information problems, 476–477 deflation, 456, 479–480 and exchange rates, 504–505 Federal Reserve System, 368 and full employment, 457–460 and Greece’s debt disaster, 347 hawk and dove policies, 467 inflation and, 456, 457 built-in, 469–471 ongoing, 468–469, 475 the Phillips Curve, 471–473 interest rate spreads, 411–412 with many interest rates, 409–410 and the money market, 393 objectives of, 456–460 employment, full, 457–460 and the Phillips Curve, 471–473 unconventional, 410–415, 416–417 zero lower bound, 412–414 money, 356–360 defined, 356 demand for, 393–397 dollar, history of, 359–360 economy-wide demand, 395–396 functions of, 358–359 household demand for, 393–395 supply of, 398 excess, 400 money demand curve, 396–397 money market equilibrium in, 399–402 and monetary policy, 393 and the price level, 424–426 money multiplier, 371–372, 373–374 money supply, 357–358 and the aggregate demand curve, 431 defined, 358 demand shocks, 443, 461–462 Federal Reserve System, 368–375, 398, 402–403 M1 and M2, 358 open market operations and, 368–372 and open market sales, 372–373 money supply curve, 398 mortgage-backed securities, 112, 384 I-6 Index mortgages defined, 104 tax deductibility of interest, 111 MPC See Marginal propensity to consume (MPC) N National Bureau of Economic Research, 158 national debt, 334 burden of, 341–343 increasing, 343–345 deficits and, 334–339 disaster of, 345–347 myths about, 339–341 U.S problem of, 347–349 national debt clock, 339–340 national income accounts, 134 natural rate of unemployment, 458–460, 474 uncertainty about, 477 natural resources, negatively related inputs, 57 negative relationships, graphs of, 16 net exports, 146 in gross domestic product, 145–146 short-run macro model, 295 net financial inflow, 509, 510–513 net investment, defined, 144 net taxes, 210 decrease in, 222–223 fiscal policy, 329–331 revenues, 210–211 net tax multiplier, 330 new home construction, 141, 143 nominal interest rates, 182 and money held, 395 nominal variables, 139, 177 nominal wages, 177, 178–179 and the aggregate supply curve, 433, 434–435, 439 non-banks, 382–383 nonmarket production, 151 normal goods defined, 60 and the demand curve, 60 normative economics, 9–10 defined, and a fiscal stimulus, 130 O Obama, President Barak, 31, 256, 366 and fiscal stimulus, 327, 349, 350, 387 health care reform, 24 housing policies, 115–116 oil, price of and the aggregate supply curve, 437 in the consumer price index, 186 modeling supply and demand, 79–84 and stagflation, 450 and supply shocks, 449, 451, 467 OPEC (Organization of Petroleum Exporting Countries), 79 open economy, 227–229 open market operations, 368 money supply, 368–372 open market sales, 372–373 opportunity costs, 2–6 See also Costs and comparative advantage, 37–38 defined, increasing, 26–28 of inflation, 184–185 price ceilings, 91 and quantity demanded, 56 society’s tradeoffs, 7–8 of unemployment, 157, 458 Organization of Petroleum Exporting Countries (OPEC), 79 origin of a graph, 16 output levels and aggregate supply, 433 short-run macro model, 315–316 output production, 202–207 ownership costs of housing, 103–105 P Patient Protection and Affordable Care Act, 24, 46 perfectly competitive markets, defined, 55 Phillips, A W., 471 Phillips Curve defined, 471 downward shift in, 472 inflation and, 471–473 long-run, 473–475 upward shift in, 472–473 physical capital, defined, planned investment spending, 210 decrease in, 220 and worker productivity, 243–244 plants, 141–143 policies See also Government intervention in markets differences of, 9–10 for economic growth, 255–256 fiscal See Fiscal policy housing markets, 111–112 monetary See Monetary policy poor countries, economic growth of barriers to, 260–265 cell phones in India, 253 policies for, 256 population and the demand curve, 61 growth prediction, 230 positive economics, 9–10 defined, positive relationships, graphs of, 16 positive statements, potential output, 157 pounds, British, demand for, 487–489 price ceilings, 89–92 defined, 89 rent controls, 92 setting, 93 price floors, 92–94 defined, 92 and surpluses, 93–94 price index, 179–180 See also Consumer price index (CPI) price levels defined, 172 and inflation, 172–176 rising and falling, 178 and money held, 394 and the money market, 424–426 tracking and reporting, 174–175 price of oil modeling supply and demand, 79–84 prices ceilings on, 89–92 and costs, 432 defined, 43 and the demand curve, 61–62 expected, 61–62, 69 floors on, 92–94 and quantity demanded, 56 and quantity supplied, 64 of related goods, 61 short-run macro model, 303 and the supply curve, 68 price support programs, 92 private investments, 141–144 production, 134–152 comparative advantages in, 38 and economic growth, 34 in GDP definition, 137 production possibilities frontier See Production possibilities frontier (PPF) and resources, society’s choices, 24–28 production function, 205–206 production possibilities frontier (PPF), 25–26 economic growth, 31–35 lifesaving and, 47–50 productive inefficiency, 28–30 productive inefficiency, 28–30 in lifesaving, 48–50 productively efficient, 45 productively inefficient, defined, 29 productivity of labor, 235–236 growth in, 242–249 and recessions, 273 product markets, defined, 53 purchasing power parity (PPP) theory, 497–499 Q quality changes consumer price index, 187 and gross domestic product, 151 quantitative easing, 417–418 quantity demanded defined, 56 of money, 396 and the short side of the market, 90 quantity supplied, 63–64 defined, 63 and the short side of the market, 90 R rate of return, 120 Reagan, President Ronald, 336 real GDP per capita, 122–123 real gross domestic product (real GDP), 122–123 actual and potential, 159, 269 determinants of, 235–236 equilibrium, 206–207 and the GDP price index, 179–180 growth equation, 237–238 growth rates, 150 versus nominal GDP, 138–139 and standard of living, 231–233 Index I-7 real income inflation calculating, 189 purchasing power of, 180–181 redistribution of, 181 and money held, 395 real interest rates, 182 and money held, 395 real variables defined, 139 inflation adjustment of, 177–179 real wages, 177, 178–179 recessions, 29, 125–126, 451–453 and budget deficits, 338 defined, 125, 158 demand shock, 452–453 economic fluctuations, 268 examples of, 281–282 and inflation, 470, 475 interest rates, 280–281 labor demand and, 272–274 labor supply and, 271–272 and market clearing, 273 and productivity of labor, 273 supply shock, 451–452 of 2008 to 2011, 317–323 regulation of banks, 380–381 related goods, 61 rent controls, 92 required reserve ratio, 363, 371–372 changes in, 374 required reserves, 363 research and development spending, 252 reserves, 363 resource markets, 53–54 resources, 6–7 allocation of, 41–43 defined, versus inputs, and production, risk, in interest rate spreads, 411 risk takers, Romer, Paul, 251 rule of 70, 233 run on the bank, 378 S Sarducci, Father Guido, 52 Say, Jean Baptiste, 208 Say’s Law, 208–209 in an open economy, 227–228 loanable funds markets, 217–219 and recessions, 277–281 scarcity and individual choice, 2–6 and social choice, 6–8 in spending power, seasonal adjustment, 154 seasonal unemployment, 153–154 securitization of mortgages, 112 self-correcting mechanism, 425, 445 services, 303 shadow banking system, 381–383, 385–386 defined, 382 shareholders’ equity, 364, 380 Shaw, George Bernard, 129 shifting graphs, 19–22 demand curve, 58–60, 76–78 for housing, 105 supply curve, 66–70, 76–78 for housing, 103 shortages, defined, 90 short-run costs, 433–435 short-run macroeconomic equilibrium, 439 short-run macro model, 285–362 aggregate expenditures, 295–297 consumption spending, 286–294, 310 equilibrium GDP See Equilibrium GDP government purchases, 295 investment spending, 294–295 net exports, 295 prices, 303 total spending, 294–297 short side of the market, defined, 90 simple leverage ratio, 119–120, 391 simplifying assumptions, defined, 13 slope of a line, 17–18 slumps, 157–158, 270 See also Recessions Smith, Adam, 45 social change through economics, 11 socialism and market capitalism, 44–45 social safety nets, 46, 259–260 social science, Social Security indexed payments, 177, 191–193 and national debt, 347 soft-landing scenario, 513–514 specialization comparative advantage, 36–39 international, 39–41 defined, 35 and exchange, 35–36 spending power classical model and, 207–212 and scarcity, spot market, 79 spreads, 411 interest rates, 411–412 stable prices goal, 126–128 stagflation, 449–450, 466 Stalin, Joseph, 263 standard of living, 149, 230–235 and the consumer price index, 190 and economic growth, 231–235 growth prospects, 233–235 increasing, 232–235 labor markets, 238–240 measuring, 231–232 productivity of labor, growth in, 242–249 Starbucks, 30 Stewart, James, 375 stickiness of wage rates, 434–435 sticky wages, 273 Stiglitz, Joseph, 130 stock variables, 101–102 defined, 101 housing market, 103 store of value, 359 straight line graphs, 17–18 consumption function, 288, 289, 290 shifting, 19–22 structural unemployment, 154–155, 457 subprime loans, 113 subsidies to buyers, 98–100 governmental, 98–100 to sellers, 100 substitutes, defined, 61 substitution bias, 186, 197 sudden disasters and GDP, 165–169 supply, 63–70 See also Supply and demand change in, 67 excess, 72–73 of money, 400 law of, 64 loanable funds, 213–214 of money, 398 excess, 400 supply curve, 65–66 movement along, 66–67 shifts of, 66–70, 76–78 supply schedule, 64–66 supply and demand changes in, 74–78 erroneous logic loop, 75 in housing markets, 100–109 changes in, 106–109 demand curve for, 103–105 supply curve for, 102–103 market clearing, 201 markets, 55–56, 71–74 modeling, 78 price of oil, 79–84 supply curve, 65–66 aggregate, 423 defined, 66 for foreign currency, 490 of funds, 213–214 for housing markets, 102–103 labor, 238–239 movement along, 66–67 shifts of, 66–70, 76–78 for housing, 103 summary of, 70 supply of funds curve, 213–214 economic fluctuations, 278–280 supply schedule, 64–66 defined, 64 supply shocks, 440 and the Federal Reserve System, 465–467 long-run effects of, 450 in recessions, 451–452 short-run effects of, 449–450 supply-side effects, defined, 255 surpluses, 93–94 budget, 214 defined, 93 T tables and graphs, 16–19 tangent line, 18 tastes and the demand curve, 61–62 taxes and crowding out, 223 excise, 94–98 and income transfers, 313–314 and markets, 94–98 and national debt, 341 net See Net taxes short-run macro model, 313–314 tax incidence, 95–96, 98 defined, 95 and tax collection, 98 Taylor, John, 130, 478 Taylor rule, 478–479 I-8 Index technological changes and the aggregate supply curve, 439 and the consumer price index, 186–187 defined, 249 economic growth and, 31, 250–251 productivity growth and, 249–255 and the supply curve, 68 terrorist attack of September 11, 2001, 165 Thailand’s foreign exchange rate, 500–501, 502–503 time is money, scarcity of, total demand for funds curve, 215–216 total employment, 204–205, 238 total spending, 207–212 in an open economy, 227 and economic fluctuations, 274 short-run macro model, 294–297 total value, 135 trade, 45 international, 145–146 trade deficits, 228, 508–514 China’s, with the U.S., 515–517 hard-landing scenario, 514 and net financial inflows, 510–513 soft-landing scenario, 513–514 of the U.S., 508–510 with China, 515–517 concerns about, 513–514 trade surpluses, 508 traditional economy, defined, 42 transfer payments, 145, 313–314 traveler’s checks, 357 treasury securities, 338, 372 Troubled Asset Relief Program (TARP), 387, 417 tuition assistance, 98–100 U underground economy, 151 unemployment, 30, 31, 153–164 See also Employment costs of, 157–160 cyclical, 155–157, 457–458 employment-population ratio, 164 establishment survey, 164 frictional, 153 during Great Depression, 124, 125, 270, 303 historic rates of, 459 international rates of, 155 measuring, 160–164 alternatives for, 162–163 employment-population ratio, 164 establishment survey, 164 natural rate of, 458–460, 474 uncertainty about, 477 opportunity costs of, 157, 458 rates defined, 161 historic, 459 international, 155 six “U”s, 163 in the U.S., 124–125, 159–160 seasonal, 153–154 structural, 154–155 U.S rates of, 124–125, 159–160 unit costs, 433 United States debt ratio, 339, 347–348 United States Department of Agriculture (USDA), 93 unit of account, 359 upward bias of CPI, 185–188 consequences of, 188–189 U.S Bureau of Labor Statistics consumer price index (CPI), 173, 174, 185, 186, 475 calculating, 196 unemployment rates, 160–161, 162, 163–164 U.S Census Bureau, 160–161 U.S Congressional Budget Office (CBO), 156, 166, 348, 350–352 U.S Department of Commerce, 139–140 U.S Department of the Treasury, 417 U.S Federal Reserve interest rates, See Federal Reserve V value added, defined, 146 value-added approach, 146–147 defined, 147 vertical axis, 16 W wage rates, 434–435 wages, nominal, 177 and the aggregate supply curve, 433, 434–435, 439 wealth consumption spending, 286–287, 290–294 defined, 60 and the demand curve, 60–61 and income, 61 resource costs of inflation, 185 short run macro model, 315 wealth constraint, 394 weather and the supply curve, 69, 75–78 aggregate, 438 workers See Labor markets world, understanding through economics, 10–11 World War II, inflation rates and, 127 Z zero lower bound, 412–414, 479 Zimbabwe inflation, 127, 185, 499 ... Images.com/Corbis Macroeconomics: Principles and Applications is about ­economic principles and how economists use them to understand the world It was conceived, written, and for the sixth edition, substantially... Summary 84 Demand 56 The Law of Demand, 56 The Demand Schedule and the Demand Curve, 57 Shifts versus Movements Along the Demand Curve, 58 Factors That Shift the Demand Curve, 60 Demand: A Summary,... Scarcity, Choice, and Economic Systems  24 Part II: Markets and Prices   Supply and Demand  52   Working with Supply and Demand  89 Part III: Macroeconomics: Basic Concepts   What Macroeconomics