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    MACROECONOMICS read more..

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    MACROECONOMICS SEVENTH EDITION N . GREGORY MANKIW Harvard University Worth Publishers read more..

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    Senior Publishers: Catherine Woods and Craig Bleyer Senior Acquisitions Editor: Sarah Dorger Senior Marketing Manager: Scott Guile Consulting Editor: Paul Shensa Senior Development Editor: Marie McHale Development Editor: Jane Tufts Assistant Editor, Media and Supplements: Tom Acox Associate Managing Editor: Tracey Kuehn Project Editor: Dana Kasowitz Art Director: Babs Reingold Cover read more..

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    v about the author N. Gregory Mankiw is Professor of Economics at Harvard University. He began his study of economics at Princeton University, where he received an A.B. in 1980. After earning a Ph.D. in economics from MIT, he began teaching at Harvard in 1985 and was promoted to full professor in 1987. Today, he regularly teaches both undergraduate and graduate read more..

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    To Deborah read more..

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    Those branches of politics, or of the laws of social life, on which there exists a collection of facts sufficiently sifted and methodized to form the beginning of a science should be taught ex professo. Among the chief of these is Political Economy, the sources and conditions of wealth and material prosperity for aggregate bodies of human beings. . . . The same read more..

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    viii | Preface xxiii Supplements and Media xxxii part I Introduction 1 Chapter 1 The Science of Macroeconomics 3 Chapter 2 The Data of Macroeconomics 17 part II Classical Theory: The Economy in the Long Run 43 Chapter 3 National Income: Where It Comes From and Where It Goes 45 Chapter 4 Money and Inflation 79 Chapter 5 The Open Economy 119 read more..

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    | ix Preface xxiii Supplements and Media xxxii part I Introduction 1 Chapter 1 The Science of Macroeconomics 3 1-1 What Macroeconomists Study 3 CASE STUDY The Historical Performance of the U.S. Economy 4 1-2 How Economists Think 7 Theory as Model Building 7 FYI Using Functions to Express Relationships Among Variables 11 The Use of Multiple Models 12 read more..

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    x | Contents CASE STUDY Trends in Labor-Force Participation 38 The Establishment Survey 39 2-4 Conclusion: From Economic Statistics to Economic Models 40 part II Classical Theory: The Economy in the Long Run 43 Chapter 3 National Income: Where It Comes From and Where It Goes 45 3-1 What Determines the Total Production of Goods and Services? 47 The Factors of read more..

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    Contents | xi Chapter 4 Money and Inflation 79 4-1 What Is Money? 80 The Functions of Money 80 The Types of Money 81 CASE STUDY Money in a POW Camp 82 The Development of Fiat Money 82 CASE STUDY Money and Social Conventions on the Island of Yap 83 How the Quantity of Money Is Controlled 83 How the Quantity of Money Is Measured 84 FYI read more..

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    4-8 Conclusion: The Classical Dichotomy 112 Appendix: The Cagan Model: How Current and Future Money Affect the Price Level 116 Chapter 5 The Open Economy 119 5-1 The International Flows of Capital and Goods 120 The Role of Net Exports 120 International Capital Flows and the Trade Balance 122 International Flows of Goods and Capital: An Example 124 FYI The read more..

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    CASE STUDY The Characteristics of Minimum-Wage Workers 171 Unions and Collective Bargaining 172 Efficiency Wages 174 CASE STUDY Henry Ford’s $5 Workday 175 6-4 Labor-Market Experience: The United States 176 The Duration of Unemployment 176 Variation in the Unemployment Rate Across Demographic Groups 177 Trends in Unemployment 178 Transitions Into and Out of the read more..

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    Chapter 8 Economic Growth II: Technology, Empirics, and Policy 221 8-1 Technological Progress in the Solow Model 222 The Efficiency of Labor 222 The Steady State With Technological Progress 223 The Effects of Technological Progress 224 8-2 From Growth Theory to Growth Empirics 225 Balanced Growth 225 Convergence 226 Factor Accumulation Versus Production Efficiency 227 read more..

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    9-2 Time Horizons in Macroeconomics 265 How the Short Run and Long Run Differ 265 CASE STUDY If You Want to Know Why Firms Have Sticky Prices, Ask Them 266 The Model of Aggregate Supply and Aggregate Demand 268 9-3 Aggregate Demand 269 The Quantity Equation as Aggregate Demand 269 Why the Aggregate Demand Curve Slopes Downward 270 Shifts in the Aggregate read more..

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    The Intersection Between Monetary and Fiscal Policy 315 CASE STUDY Policy Analysis With Macroeconomic Models 317 Shocks in the IS–LM Model 318 CASE STUDY The U.S. Recession of 2001 319 What Is the Fed’s Policy Instrument—The Money Supply or the Interest Rate? 320 11-2 IS–LM as a Theory of Aggregate Demand 321 From the IS–LM Model to the Aggregate read more..

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    12-5 Should Exchange Rates Be Floating or Fixed? 361 Pros and Cons of Different Exchange-Rate Systems 361 CASE STUDY Monetary Union in the United States and Europe 362 Speculative Attacks, Currency Boards, and Dollarization 363 The Impossible Trinity 364 CASE STUDY The Chinese Currency Controversy 365 12-6 From the Short Run to the Long Run: The Mundell–Fleming read more..

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    The Nominal Interest Rate: The Monetary-Policy Rule 414 CASE STUDY The Taylor Rule 415 14-2 Solving the Model 417 The Long-Run Equilibrium 418 The Dynamic Aggregate Supply Curve 418 The Dynamic Aggregate Demand Curve 420 The Short-Run Equilibrium 422 14-3 Using the Model 423 Long-Run Growth 423 A Shock to Aggregate Supply 424 FYI The Numerical Calibration read more..

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    Chapter 16 Government Debt and Budget Deficits 467 16-1 The Size of the Government Debt 468 CASE STUDY The Troubling Long-Term Outlook for Fiscal Policy 470 16-2 Problems in Measurement 472 Measurement Problem 1: Inflation 472 Measurement Problem 2: Capital Assets 473 Measurement Problem 3: Uncounted Liabilities 474 CASE STUDY Accounting for TARP 474 Measurement read more..

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    Optimization 504 How Changes in Income Affect Consumption 505 How Changes in the Real Interest Rate Affect Consumption 506 Constraints on Borrowing 507 17-3 Franco Modigliani and the Life-Cycle Hypothesis 509 The Hypothesis 510 Implications 511 CASE STUDY The Consumption and Saving of the Elderly 512 17-4 Milton Friedman and the Permanent-Income Hypothesis 514 The read more..

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    Chapter 19 Money Supply, Money Demand, and the Banking System 547 19-1 Money Supply 547 100-Percent-Reserve Banking 548 Fractional-Reserve Banking 549 A Model of the Money Supply 550 The Three Instruments of Monetary Policy 552 CASE STUDY Bank Failures and the Money Supply in the 1930s 553 Bank Capital, Leverage, and Capital Requirements 555 19-2 Money Demand read more..

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    xxiii preface An economist must be “mathematician, historian, statesman, philosopher, in some degree . . . as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.” So remarked John Maynard Keynes, the great British economist who, as much as anyone, could be called the father of macroeconomics. No single statement summarizes read more..

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    time, I recognize that many of the ideas of Keynes and the new Keynesians are necessary for understanding economic fluctuations. Substantial coverage is given also to the IS–LM model of aggregate demand, the short-run tradeoff between inflation and unemployment, and modern models of business cycle dynamics. Third, I present macroeconomics using a variety of simple models. read more..

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    ➤ Chapter 9 includes a new FYI box on the monetary theory of David Hume. ➤ Chapter 10 has a new Case Study on the economic stimulus plan proposed and signed by President Barack Obama. ➤ Chapter 11 includes a new Case Study called “The Financial Crisis and Economic Downturn of 2008 and 2009.” ➤ Chapter 13’s appendix includes a new schematic diagram illustrating read more..

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    Part Two, Classical Theory: The Economy in the Long Run Part Two examines the long run over which prices are flexible. Chapter 3 pre- sents the basic classical model of national income. In this model, the factors of production and the production technology determine the level of income, and the marginal products of the factors determine its distribution to households. read more..

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    uses the IS–LM model to explain economic fluctuations and the aggregate demand curve. It concludes with an extended case study of the Great Depression. The study of short-run fluctuations continues in Chapter 12, which focuses on aggregate demand in an open economy. This chapter presents the Mundell–Fleming model and shows how monetary and fiscal policies affect the economy read more..

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    Epilogue The book ends with a brief epilogue that reviews the broad lessons about which most macroeconomists agree and discusses some of the most important open questions. Regardless of which chapters an instructor chooses to cover, this cap- stone chapter can be used to remind students how the many models and themes of macroeconomics relate to one another. Here and read more..

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    FYI Boxes These boxes present ancillary material “for your information.” I use these boxes to clarify difficult concepts, to provide additional information about the tools of economics, and to show how economics relates to our daily lives. Several are new or revised in this edition. Graphs Understanding graphical analysis is a key part of learning macroeconomics, and I have read more..

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    Glossary To help students become familiar with the language of macroeconomics, a glos- sary of more than 250 terms is provided at the back of the book. Translations The English-language version of this book has been used in dozens of coun- tries. To make the book more accessible for students around the world, edi- tions are (or will soon be) available in 15 other read more..

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    In addition, I am grateful to Stacy Carlson, a student at Harvard, who helped me update the data, refine my prose, and proofread the entire book. The people at Worth Publishers have continued to be congenial and dedi- cated. I would like to thank Catherine Woods, Senior Publisher; Craig Bleyer, Senior Publisher; Sarah Dorger, Acquisitions Editor; Scott Guile, read more..

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    Supplements and Media Worth Publishers has worked closely with Greg Mankiw and a team of talented economics instructors to put together a variety of supple- ments to aid instructors and students. We have been delighted at the positive feedback we have received on these supplements. Here is a summary of the resources available. For Instructors Instructor’s Resources read more..

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    explanations and additional case studies, data, and helpful notes to the instruc- tor. Designed to be customized or used “as is,” they include easy instructions for those who have little experience with PowerPoint. They are available on the companion Web site. For Students Student Guide and Workbook Roger Kaufman (Smith College) has revised his superb study guide for read more..

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    Companion Web Site for Students and Instructors ( The companion site is a virtual study guide for students and an excellent resource for instructors. Joydeep Bhattacharya (Iowa State University) has updated the innovative software package for students. For each chapter in the textbook, the tools on the companion Web site include the following: ➤ read more..

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    ➤ Images From the Textbook. Instructors have access to a complete set of figures and tables from the textbook in high-resolution and low- resolution JPEG formats. The textbook art has been processed for “high- resolution” (150 dpi). These figures and photographs have been especially formatted for maximum readability in large lecture halls and follow stan- dards that were read more..

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    BlackBoard The Mankiw BlackBoard course cartridge makes it possible to combine Black- Board’s popular tools and easy-to-use interface with the text’s Web content, including preprogrammed quizzes and tests. The result is an interactive, compre- hensive online course that allows for effortless implementation, management, and use. The files are organized and prebuilt to work within read more..

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    15-week subscription when 10 or more students purchase a subscription. Students get 15 issues of The Economist for just $15. That’s a savings of 85 percent off the cover price. Inside and outside the classroom, The Economist provides a global perspective that helps students keep abreast of what’s going on in the world and provides insight into how the world views the read more..

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    Introduction PA R T I read more..

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    3 The Science of Macroeconomics The whole of science is nothing more than the refinement of everyday thinking. —Albert Einstein 1 CHAPTER What Macroeconomists Study Why have some countries experienced rapid growth in incomes over the past century while others stay mired in poverty? Why do some countries have high rates of inflation while others maintain stable prices? Why do all read more..

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    Although the job of making economic policy belongs to world leaders, the job of explaining the workings of the economy as a whole falls to macroecono- mists. Toward this end, macroeconomists collect data on incomes, prices, unem- ployment, and many other variables from different time periods and different countries. They then attempt to formulate general theories to read more..

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    CHAPTER 1 The Science of Macroeconomics | 5 measures the total income of everyone in the economy (adjusted for the level of prices). The inflation rate measures how fast prices are rising. The unem- ployment rate measures the fraction of the labor force that is out of work. Macroeconomists study how these variables are determined, why they change over time, and how they read more..

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    Figure 1-2 shows the U.S. inflation rate. You can see that inflation varies substan- tially over time. In the first half of the twentieth century, the inflation rate averaged only slightly above zero. Periods of falling prices, called deflation, were almost as common as periods of rising prices. By contrast, inflation has been the norm dur- ing the past half read more..

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    How Economists Think Economists often study politically charged issues, but they try to address these issues with a scientist’s objectivity. Like any science, economics has its own set of tools—terminology, data, and a way of thinking—that can seem foreign and arcane to the layman. The best way to become familiar with these tools is to prac- tice using them, read more..

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    learns a lot from them nonetheless. The model illustrates the essence of the real object it is designed to resemble. (In addition, for many children, building models is fun.) Economists also use models to understand the world, but an economist’s model is more likely to be made of symbols and equations than plastic and glue. Economists build their “toy economies” read more..

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    and on the price of materials Pm, such as cheese, tomatoes, flour, and anchovies. This relationship is expressed as Q s = S(P, Pm), where S( ) represents the supply function. Finally, the economist assumes that the price of pizza adjusts to bring the quantity supplied and quantity demanded into balance: Q s = Q d. These three equations compose a model of the market read more..

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    materials. The model does not attempt to explain them but instead takes them as given (perhaps to be explained by another model). The endogenous variables are the price of pizza and the quantity of pizza exchanged. These are the variables that the model attempts to explain. The model can be used to show how a change in one of the exogenous vari- ables affects both read more..

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    equilibrium price of pizza rises and the equilibrium quantity of pizza falls. Thus, the model shows how changes either in aggregate income or in the price of materials affect price and quantity in the market for pizza. Like all models, this model of the pizza market makes simplifying assumptions. The model does not take into account, for example, that every pizzeria is read more..

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    The art in economics is in judging when a simplifying assumption (such as assuming a single price of pizza) clarifies our thinking and when it misleads us. Simplification is a necessary part of building a useful model: any model con- structed to be completely realistic would be too complicated for anyone to understand. Yet models lead to incorrect conclusions if they assume read more..

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    their newsstand prices only every three or four years. Although market-clearing models assume that all wages and prices are flexible, in the real world some wages and prices are sticky. The apparent stickiness of prices does not make market-clearing models use- less. After all, prices are not stuck forever; eventually, they adjust to changes in supply and demand. read more..

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    14 | PA R T I Introduction FYI The winner of the Nobel Prize in economics is announced every October. Many winners have been macroeconomists whose work we study in this book. Here are a few of them, along with some of their own words about how they chose their field of study: Milton Friedman (Nobel 1976): “I graduated from college in 1932, when the United States was read more..

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    How This Book Proceeds This book has six parts. This chapter and the next make up Part One, the Intro- duction. Chapter 2 discusses how economists measure economic variables, such as aggregate income, the inflation rate, and the unemployment rate. Part Two, “Classical Theory: The Economy in the Long Run,” presents the classical model of how the economy works. read more..

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    1. Explain the difference between macroeconomics and microeconomics. How are these two fields related? 2. Why do economists build models? KEY C ONCEPT S Macroeconomics Real GDP Inflation and deflation Unemployment QUES TIONS F O R REVIEW Recession Depression Models Endogenous variables Exogenous variables Market clearing Flexible and sticky prices Microeconomics 3. What is a market-clearing model? read more..

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    17 The Data of Macroeconomics It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to fit facts. —Sherlock Holmes 2 CHAPTER Scientists, economists, and detectives have much in common: they all want to figure out what’s going on in the world around them. To do this, they rely on read more..

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    income and the total expenditure on its output of goods and services. The con- sumer price index, or CPI, measures the level of prices. The unemployment rate tells us the fraction of workers who are unemployed. In the following pages, we see how these statistics are computed and what they tell us about the economy. 2-1 Measuring the Value of Economic Activity: Gross read more..

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    to produce bread, which the firms in turn sell to the households. Hence, labor flows from households to firms, and bread flows from firms to households. The outer loop in Figure 2-1 represents the corresponding flow of dollars. The households buy bread from the firms. The firms use some of the revenue from these sales to pay the wages of their workers, and the read more..

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    on total income. If the firm produces the extra loaf without hiring any more labor (such as by making the production process more efficient), then profit increases. If the firm produces the extra loaf by hiring more labor, then wages increase. In both cases, expenditure and income increase equally. Rules for Computing GDP In an economy that produces only bread, we read more..

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    Gross domestic product (GDP) is the market value of all final goods and services pro- duced within an economy in a given period of time. To see how this definition is applied, let’s discuss some of the rules that economists follow in constructing this statistic. Adding Apples and Oranges The U.S. economy produces many different goods and services—hamburgers, haircuts, read more..

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    Now suppose, instead, that the bread is put into inventory to be sold later. In this case, the transaction is treated differently. The owners of the firm are assumed to have “purchased’’ the bread for the firm’s inventory, and the firm’s profit is not reduced by the additional wages it has paid. Because the higher wages raise total income, and read more..

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    Imputations are especially important for determining the value of housing. A person who rents a house is buying housing services and providing income for the landlord; the rent is part of GDP, both as expenditure by the renter and as income for the landlord. Many people, however, live in their own homes. Although they do not pay rent to a landlord, they are read more..

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    and oranges. In this economy GDP is the sum of the value of all the apples pro- duced and the value of all the oranges produced. That is, Economists call the value of goods and services measured at current prices nom- inal GDP. Notice that nominal GDP can increase either because prices rise or because quantities rise. It is easy to see that GDP computed this way read more..

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    The GDP Deflator From nominal GDP and real GDP we can compute a third statistic: the GDP deflator. The GDP deflator, also called the implicit price deflator for GDP, is the ratio of nominal GDP to real GDP: GDP Deflator = . The GDP deflator reflects what’s happening to the overall level of prices in the economy. To better understand this, consider again an economy read more..

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    26 | PA R T I Introduction FYI For manipulating many relationships in econom- ics, there is an arithmetic trick that is useful to know: the percentage change of a product of two vari- ables is approximately the sum of the percentage changes in each of the variables. To see how this trick works, consider an example. Let P denote the GDP deflator and Y denote real GDP. read more..

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    correlated with each other. As a practical matter, both measures of real GDP reflect the same thing: economy-wide changes in the production of goods and services. The Components of Expenditure Economists and policymakers care not only about the economy’s total output of goods and services but also about the allocation of this output among alternative uses. The national income read more..

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    28 | PA R T I Introduction FYI Newcomers to macroeconomics are sometimes confused by how macroeconomists use familiar words in new and specific ways. One example is the term “investment.” The confusion arises because what looks like investment for an individual may not be investment for the economy as a whole. The gen- eral rule is that the economy’s investment does not read more..

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    ers than he spent on foreign goods, he must have financed the difference by tak- ing out loans from foreigners (or, equivalently, by selling them some of his assets). Thus, the average American borrowed $2,343 from abroad in 2007. ■ Other Measures of Income The national income accounts include other measures of income that differ slightly in definition from GDP. read more..

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    because this rental income is a factor payment to abroad, it is not part of U.S. GNP. In the United States, factor payments from abroad and factor payments to abroad are similar in size—each representing about 3 percent of GDP—so GDP and GNP are quite close. To obtain net national product (NNP), we subtract the depreciation of capital— the amount of the read more..

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    CHAPTER 2 The Data of Macroeconomics | 31 transfers to individuals minus social insurance contributions paid to the govern- ment. Fourth, we adjust national income to include the interest that households earn rather than the interest that businesses pay. This adjustment is made by adding personal interest income and subtracting net interest. (The difference between personal interest read more..

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    When economists study fluctuations in real GDP and other economic vari- ables, they often want to eliminate the portion of fluctuations due to predictable seasonal changes. You will find that most of the economic statistics reported in the newspaper are seasonally adjusted. This means that the data have been adjusted to remove the regular seasonal fluctuations. (The precise read more..

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    The consumer price index is the most closely watched index of prices, but it is not the only such index. Another is the producer price index, which measures the price of a typical basket of goods bought by firms rather than consumers. In addition to these overall price indexes, the Bureau of Labor Statistics computes price indexes for specific types of goods, read more..

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    of living. Although it accounts for the substitution of alternative goods, it does not reflect the reduction in consumers’ welfare that may result from such substitutions. The example of the destroyed orange crop shows the problems with Laspeyres and Paasche price indexes. Because the CPI is a Laspeyres index, it overstates the impact of the increase in orange prices read more..

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    4 For further discussion of these issues, see Matthew Shapiro and David Wilcox, “Mismeasurement in the Consumer Price Index: An Evaluation,” NBER Macroeconomics Annual, 1996, and the sym- posium on “Measuring the CPI” in the Winter 1998 issue of The Journal of Economic Perspectives. CHAPTER 2 The Data of Macroeconomics | 35 Does the CPI Overstate Inflation? The read more..

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    36 | PA R T I Introduction 2-3 Measuring Joblessness: The Unemployment Rate One aspect of economic performance is how well an economy uses its resources. Because an economy’s workers are its chief resource, keeping workers employed is a paramount concern of economic policymakers. The unemployment rate is the statistic that measures the percentage of those people wanting to work read more..

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    CHAPTER 2 The Data of Macroeconomics | 37 and Unemployment Rate =× 100. A related statistic is the labor-force participation rate, the percentage of the adult population that is in the labor force: Labor-Force Participation Rate =× 100. The Bureau of Labor Statistics computes these statistics for the overall popula- tion and for groups within the population: men and women, whites read more..

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    38 | PA R T I Introduction Labor-Force Participation Over the past several decades, the labor-force participation rate for women has risen, while the rate for men has declined. Source: U.S. Department of Labor. Labor force participation rates Year 100 90 80 70 60 50 40 30 20 10 0 Men Women 1960 1970 1955 1950 1980 1965 1975 1985 1990 1995 2000 2005 FIGURE 2-5 Trends in read more..

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    CHAPTER 2 The Data of Macroeconomics | 39 is due to changing political and social attitudes. Together these developments have had a profound impact, as demonstrated by these data. Although the increase in women’s labor-force participation is easily explained, the fall in men’s participation may seem puzzling. There are several developments at work. First, young men now read more..

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    40 | PA R T I Introduction are included in the establishment survey. The BLS tries to estimate employment at start-ups, but the model it uses to produce these estimates is one possible source of error. A different problem arises from how the household survey extrapolates employment among the surveyed household to the entire population. If the BLS uses incorrect estimates read more..

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    which is the ratio of nominal GDP to real GDP, the CPI measures the overall level of prices. 5. The labor-force participation rate shows the fraction of adults who are working or want to work. The unemployment rate shows what fraction of those who would like to work do not have a job. CHAPTER 2 The Data of Macroeconomics | 41 1. List the two things that GDP read more..

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    42 | PA R T I Introduction e. National defense purchases f. State and local purchases g. Imports Do you see any stable relationships in the data? Do you see any trends? (Hint: A good place to look for data is the statistical appendices of the Economic Report of the President, which is written each year by the Council of Economic Advisers. Alternative- ly, you can go read more..

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    Classical Theory: The Economy in the Long Run PA R T I I read more..

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    45 National Income: Where It Comes From and Where It Goes A large income is the best recipe for happiness I ever heard of. —Jane Austen 3 CHAPTER The most important macroeconomic variable is gross domestic product (GDP). As we have seen, GDP measures both a nation’s total output of goods and services and its total income. To appreciate the signifi- cance of GDP, read more..

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    real economies function. It shows the linkages among the economic actors— households, firms, and the government—and how dollars flow among them through the various markets in the economy. Let’s look at the flow of dollars from the viewpoints of these economic actors. Households receive income and use it to pay taxes to the government, to con- sume goods and services, read more..

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    what determines their level of production (and, thus, the level of national income). Then we examine how the markets for the factors of production distribute this income to households. Next, we consider how much of this income households consume and how much they save. In addition to dis- cussing the demand for goods and services arising from the consumption of read more..

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    48 | PA R T I I Classical Theory: The Economy in the Long Run The Production Function The available production technology determines how much output is produced from given amounts of capital and labor. Economists express this relationship using a production function. Letting Y denote the amount of output, we write the production function as Y = F(K, L). This equation states read more..

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    CHAPTER 3 National Income: Where It Comes From and Where It Goes | 49 we discuss economic growth in Chapters 7 and 8, we will examine how increas- es in capital and labor and advances in technology lead to growth in the econo- my’s output. 3-2 How Is National Income Distributed to the Factors of Production? As we discussed in Chapter 2, the total output of read more..

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    To understand factor prices and the distribution of income, we must examine the demand for the factors of production. Because factor demand arises from the thousands of firms that use capital and labor, we start by examining the decisions a typical firm makes about how much of these factors to employ. The Decisions Facing the Competitive Firm The simplest assumption read more..

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    CHAPTER 3 National Income: Where It Comes From and Where It Goes | 51 The firm sells its output at a price P, hires workers at a wage W, and rents cap- ital at a rate R. Notice that when we speak of firms renting capital, we are assum- ing that households own the economy’s stock of capital. In this analysis, households rent out their capital, just as read more..

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    that the marginal product of labor is the difference between the amount of out- put produced with L + 1 units of labor and the amount produced with only L units of labor. Most production functions have the property of diminishing marginal product: holding the amount of capital fixed, the marginal product of labor decreases as the amount of labor increases. To see why, read more..

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    compares the extra revenue from increased production with the extra cost of higher spending on wages. The increase in revenue from an additional unit of labor depends on two variables: the marginal product of labor and the price of the output. Because an extra unit of labor produces MPL units of output and each unit of output sells for P dollars, the extra revenue read more..

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    Like labor, capital is subject to diminishing marginal product. Once again con- sider the production of bread at a bakery. The first several ovens installed in the kitchen will be very productive. However, if the bakery installs more and more ovens, while holding its labor force constant, it will eventually contain more ovens than its employees can effectively operate. read more..

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    maximizing, then each factor of production is paid its marginal contribution to the production process. The real wage paid to each worker equals the MPL, and the real rental price paid to each owner of capital equals the MPK. The total real wages paid to labor are therefore MPL × L, and the total real return paid to capital owners is MPK × K. The income that read more..

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    56 | PA R T I I Classical Theory: The Economy in the Long Run Under our assumptions—constant returns to scale, profit maximization, and competition—economic profit is zero. If these assumptions approximately describe the world, then the “profit” in the national income accounts must be mostly the return to capital. We can now answer the question posed at the read more..

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    Paul Douglas was a U.S. senator from Illinois from 1949 to 1966. In 1927, however, when he was still a professor of economics, he noticed a surprising fact: the division of national income between capital and labor had been roughly con- stant over a long period. In other words, as the economy grew more prosperous over time, the total income of workers and the read more..

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    58 | PA R T I I Classical Theory: The Economy in the Long Run Next, consider the marginal products for the Cobb–Douglas production func- tion. The marginal product of labor is 5 MPL = (1 − ) A K L− , and the marginal product of capital is MPK = A K α−1L1−α. From these equations, recalling that is between zero and one, we can see what caus- es the read more..

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    The Cobb–Douglas production function is not the last word in explaining the economy’s production of goods and services or the distribution of national income between capital and labor. It is, however, a good place to start. CHAPTER 3 National Income: Where It Comes From and Where It Goes | 59 The Ratio of Labor Income to Total Income Labor income has remained about read more..

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    60 | PA R T I I Classical Theory: The Economy in the Long Run of work grew about 2.1 percent per year. Real wages grew at 2.0 percent—almost exactly the same rate. With a growth rate of 2 percent per year, productivity and real wages double about every 35 years. Productivity growth varies over time. The table shows the data for three short- er periods read more..

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    In Chapter 2 we identified the four components of GDP: ■ Consumption (C ) ■ Investment (I ) ■ Government purchases (G) ■ Net exports (NX ). The circular flow diagram contains only the first three components. For now, to simplify the analysis, we assume our economy is a closed economy—a country that does not trade with other countries. Thus, net exports are read more..

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    The marginal propensity to consume (MPC) is the amount by which consumption changes when disposable income increases by one dollar. The MPC is between zero and one: an extra dollar of income increases consumption, but by less than one dollar. Thus, if households obtain an extra dollar of income, they save a portion of it. For example, if the MPC is 0.7, read more..

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    and makes the investment. If the interest rate is above 10 percent, the firm forgoes the investment opportunity and does not build the factory. The firm makes the same investment decision even if it does not have to bor- row the $1 million but rather uses its own funds. The firm can always deposit this money in a bank or a money market fund and earn interest read more..

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    Government Purchases Government purchases are the third component of the demand for goods and services. The federal government buys guns, missiles, and the services of government employees. Local governments buy library books, build schools, and hire teachers. Governments at all levels build roads and other public works. All these transactions make up government purchases of read more..

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    Transfer payments do affect the demand for goods and services indirectly. Transfer payments are the opposite of taxes: they increase households’ disposable income, just as taxes reduce disposable income. Thus, an increase in transfer pay- ments financed by an increase in taxes leaves disposable income unchanged. We can now revise our definition of T to equal taxes minus read more..

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    Equilibrium in the Market for Goods and Services: The Supply and Demand for the Economy’s Output The following equations summarize the discussion of the demand for goods and services in Section 3-3: Y = C + I + G. C = C(Y − T ). I = I(r). G = G – . T = T – . The demand for the economy’s output comes from consumption, investment, and government purchases. read more..

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    Equilibrium in the Financial Markets: The Supply and Demand for Loanable Funds Because the interest rate is the cost of borrowing and the return to lending in financial markets, we can better understand the role of the interest rate in the economy by thinking about the financial markets. To do this, rewrite the nation- al income accounts identity as Y − C − G = read more..

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    “price” is the interest rate. Saving is the supply of loanable funds—households lend their saving to investors or deposit their saving in a bank that then loans the funds out. Investment is the demand for loanable funds—investors borrow from the pub- lic directly by selling bonds or indirectly by borrowing from banks. Because invest- ment depends on the interest read more..

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    is unchanged, so consumption C is unchanged as well. Therefore, the increase in government purchases must be met by an equal decrease in investment. To induce investment to fall, the interest rate must rise. Hence, the increase in government purchases causes the interest rate to increase and investment to decrease. Government purchases are said to crowd out investment. read more..

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    70 | PA R T I I Classical Theory: The Economy in the Long Run FIGURE 3-9 Real interest rate, r I(r) Investment, Saving, I, S r 2 r 1 S 2 S 1 1. A fall in saving ... 2. ... raises the interest rate. A Reduction in Saving A reduction in saving, possi- bly the result of a change in fiscal policy, shifts the sav- ing schedule to the left. The new equilibrium is the read more..

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    this figure. These data support the model’s prediction: interest rates do tend to rise when government purchases increase. 7 One problem with using wars to test theories is that many economic changes may be occurring at the same time. For example, in World War II, while gov- ernment purchases increased dramatically, rationing also restricted consumption of many goods. read more..

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    however, many exogenous variables may change at once. Unlike controlled lab- oratory experiments, the natural experiments on which economists must rely are not always easy to interpret. ■ A Decrease in Taxes Now consider a reduction in taxes of ΔT. The imme- diate impact of the tax cut is to raise disposable income and thus to raise con- sumption. Disposable income read more..

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    We would reach a different conclusion, however, if we modified our simple consumption function and allowed consumption (and its flip side, saving) to depend on the interest rate. Because the interest rate is the return to saving (as well as the cost of borrowing), a higher interest rate might reduce consumption and increase saving. If so, the saving schedule would read more..

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    74 | PA R T I I Classical Theory: The Economy in the Long Run 3-5 Conclusion In this chapter we have developed a model that explains the production, distri- bution, and allocation of the economy’s output of goods and services. The model relies on the classical assumption that prices adjust to equilibrate supply and demand. In this model, factor prices equilibrate read more..

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    Summary 1. The factors of production and the production technology determine the economy’s output of goods and services. An increase in one of the factors of production or a technological advance raises output. 2. Competitive, profit-maximizing firms hire labor until the marginal product of labor equals the real wage. Similarly, these firms rent capital until the marginal product read more..

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    76 | PA R T I I Classical Theory: The Economy in the Long Run 1. What determines the amount of output an economy produces? 2. Explain how a competitive, profit-maximizing firm decides how much of each factor of production to demand. 3. What is the role of constant returns to scale in the distribution of income? 4. Write down a Cobb–Douglas production function for which read more..

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    CHAPTER 3 National Income: Where It Comes From and Where It Goes | 77 f. What do your previous answers imply for the price of haircuts relative to the price of food? g. Who benefits from technological progress in farming—farmers or barbers? 6. (This problem requires the use of calculus.) Consider a Cobb–Douglas production function with three inputs. K is capital (the read more..

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    78 | PA R T I I Classical Theory: The Economy in the Long Run c. Compare the old and the new equilibria. How does this policy affect the total quantity of investment? The quantity of business investment? The quantity of residential investment? 12. If consumption depended on the interest rate, how would that affect the conclusions reached in this chapter about the effects of read more..

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    79 Money and Inflation Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. . . . Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, read more..

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    The “hidden forces of economic law” that lead to inflation are not as mysteri- ous as Keynes claims in the quotation that opens this chapter. Inflation is simply an increase in the average level of prices, and a price is the rate at which money is exchanged for a good or a service. To understand inflation, therefore, we must understand money—what it is, read more..

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    ed according to relative prices—the prices of goods relative to other goods—yet stores post their prices in dollars and cents. A car dealer tells you that a car costs $20,000, not 400 shirts (even though it may amount to the same thing). Similar- ly, most debts require the debtor to deliver a specified number of dollars in the future, not a specified amount read more..

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    82 | PA R T I I Classical Theory: The Economy in the Long Run Money in a POW Camp An unusual form of commodity money developed in some Nazi prisoner of war (POW) camps during World War II. The Red Cross supplied the prisoners with various goods—food, clothing, cigarettes, and so on. Yet these rations were allo- cated without close attention to personal read more..

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    tain quantity of gold. If people believe the government’s promise to redeem the paper bills for gold, the bills are just as valuable as the gold itself. In addition, because the bills are lighter than gold (and gold coins), they are easier to use in transactions. Eventually, no one carries gold around at all, and these gold-backed government bills become the read more..

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    In the United States and many other countries, monetary policy is delegated to a partially independent institution called the central bank. The central bank of the United States is the Federal Reserve —often called the Fed. If you look at a U.S. dollar bill, you will see that it is called a Federal Reserve Note. Decisions over monetary policy are made by the read more..

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    CHAPTER 4 Money and Inflation | 85 allow investors to write checks against their accounts, although restrictions sometimes apply with regard to the size of the check or the number of checks written. Because these assets can be easily used for transactions, they should arguably be included in the quantity of money. Because it is hard to judge which assets should be included read more..

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    of the money stock that the Federal Reserve calculates for the U.S. economy, together with a list of which assets are included in each measure. From the small- est to the largest, they are designated C, M1, and M 2. The Fed used to calculate another, even more extensive measure called M 3 but discontinued it in March 2006. The most common measures for read more..

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    For example, suppose that 60 loaves of bread are sold in a given year at $0.50 per loaf. Then T equals 60 loaves per year, and P equals $0.50 per loaf. The total number of dollars exchanged is PT = $0.50/loaf × 60 loaves/year = $30/year. The right-hand side of the quantity equation equals $30 per year, which is the dollar value of all transactions. Suppose read more..

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    Because Y is also total income, V in this version of the quantity equation is called the income velocity of money. The income velocity of money tells us the number of times a dollar bill enters someone’s income in a given period of time. This version of the quantity equation is the most common, and it is the one we use from now on. The Money Demand Function and read more..

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    infrequently (V is small). Conversely, when people want to hold only a little money (k is small), money changes hands frequently (V is large). In other words, the money demand parameter k and the velocity of money V are opposite sides of the same coin. The Assumption of Constant Velocity The quantity equation can be viewed as a definition: it defines velocity V as read more..

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    90 | PA R T I I Classical Theory: The Economy in the Long Run This theory explains what happens when the central bank changes the supply of money. Because velocity is fixed, any change in the money supply leads to a proportionate change in nominal GDP. Because the factors of production and the production function have already determined real GDP, nominal GDP can read more..

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    the United States over each decade since the 1870s. The data verify the link between inflation and growth in the quantity of money. Decades with high money growth (such as the 1970s) tend to have high inflation, and decades with low money growth (such as the 1930s) tend to have low inflation. Figure 4-2 examines the same question using international data. It shows read more..

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    not in the short run. We examine the short-run impact of changes in the quantity of money when we turn to economic fluctuations in Part Four of this book. ■ 4-3 Seigniorage: The Revenue from Printing Money So far, we have seen how growth in the money supply causes inflation. With inflation as a consequence, what would ever induce a central bank to read more..

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    CHAPTER 4 Money and Inflation | 93 taxes, such as personal and corporate income taxes. Second, it can borrow from the public by selling government bonds. Third, it can print money. The revenue raised by the printing of money is called seigniorage. The term comes from seigneur, the French word for “feudal lord.” In the Middle Ages, the lord had the exclusive read more..

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    94 | PA R T I I Classical Theory: The Economy in the Long Run 5 Mathematical note: This equation relating the real interest rate, nominal interest rate, and inflation rate is only an approximation. The exact formula is (1 + r) = (1 + i )/(1 + p). The approximation in the text is reasonably accurate as long as r, i, and p are relatively small (say, less read more..

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    Once we separate the nominal interest rate into these two parts, we can use this equation to develop a theory that explains the nominal interest rate. Chap- ter 3 showed that the real interest rate adjusts to equilibrate saving and invest- ment. The quantity theory of money shows that the rate of money growth determines the rate of inflation. The Fisher equation then read more..

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    96 | PA R T I I Classical Theory: The Economy in the Long Run 50 years. When inflation is high, nominal interest rates are typically high, and when inflation is low, nominal interest rates are typically low as well. Similar support for the Fisher effect comes from examining the variation across countries. As Figure 4-4 shows, a nation’s inflation rate and its read more..

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    interest rate, and the real interest rate that is actually realized, called the ex post real interest rate. Although borrowers and lenders cannot predict future inflation with certainty, they do have some expectation about what the inflation rate will be. Let p denote actual future inflation and E p the expectation of future inflation. The ex ante real interest rate is i read more..

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    4-5 The Nominal Interest Rate and the Demand for Money The quantity theory is based on a simple money demand function: it assumes that the demand for real money balances is proportional to income. Although the quantity theory is a good place to start when analyzing the effects of money on the economy, it is not the whole story. Here we add another determinant of read more..

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    Consider how the introduction of this last link affects our theory of the price level. First, equate the supply of real money balances M/P to the demand L(i, Y): M/P = L(i, Y ). Next, use the Fisher equation to write the nominal interest rate as the sum of the real interest rate and expected inflation: M/P = L(r + E p, Y ). This equation states that the level read more..

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    This announcement causes people to expect higher money growth and high- er inflation. Through the Fisher effect, this increase in expected inflation rais- es the nominal interest rate. The higher nominal interest rate increases the cost of holding money and therefore reduces the demand for real money bal- ances. Because the Fed has not changed the quantity of money available read more..

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    CHAPTER 4 Money and Inflation | 101 Why, then, is a persistent increase in the price level a social problem? It turns out that the costs of inflation are subtle. Indeed, economists disagree about the size of the social costs. To the surprise of many laymen, some economists argue that the costs of inflation are small—at least for the moderate rates of inflation read more..

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    The Costs of Expected Inflation Consider first the case of expected inflation. Suppose that every month the price level rose by 1 percent. What would be the social costs of such a steady and pre- dictable 12 percent annual inflation? One cost is the distortion of the inflation tax on the amount of money peo- ple hold. As we have already discussed, a higher read more..

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    the analogy, suppose that Congress passed a law specifying that a yard would equal 36 inches in 2010, 35 inches in 2011, 34 inches in 2012, and so on. Although the law would result in no ambiguity, it would be highly inconvenient. When someone measured a distance in yards, it would be necessary to specify whether the measurement was in 2010 yards or 2011 read more..

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    104 | PA R T I I Classical Theory: The Economy in the Long Run These situations provide a clear argument against variable inflation. The more variable the rate of inflation, the greater the uncertainty that both debtors and creditors face. Because most people are risk averse—they dislike uncertainty—the unpredictability caused by highly variable inflation hurts almost read more..

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    This debate over silver found its most memorable expression in a children’s book, The Wizard of Oz. Written by a midwestern journalist, L. Frank Baum, just after the 1896 election, it tells the story of Dorothy, a girl lost in a strange land far from her home in Kansas. Dorothy (representing traditional American values) makes three friends: a scarecrow (the read more..

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    inflation, the real wage will be stuck above the equilibrium level, resulting in higher unemployment. For this reason, some economists argue that inflation “greases the wheels” of labor markets. Only a little inflation is needed: an inflation rate of 2 percent lets real wages fall by 2 percent per year, or 20 percent per decade, without cuts in nominal wages. read more..

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    CHAPTER 4 Money and Inflation | 107 warm over time, it would lose value less rapidly than the money left sitting in the patron’s wallet. Tax systems are also distorted by hyperinflation—but in ways that are differ- ent from the distortions of moderate inflation. In most tax systems there is a delay between the time a tax is levied and the time it is actually read more..

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    “We think only about today and converting every peso into dollars,’’ says Ronald MacLean, the manager of a gold-mining firm. “We have become myopic.’’ And intent on survival. Civil servants won’t hand out a form without a bribe. Lawyers, accountants, hairdressers, even prostitutes have almost given up working to become money-changers in the streets. Workers read more..

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    only mechanism at its disposal—the printing press. The result is rapid money growth and hyperinflation. Once the hyperinflation is under way, the fiscal problems become even more severe. Because of the delay in collecting tax payments, real tax revenue falls as inflation rises. Thus, the government’s need to rely on seigniorage is self-reinforcing. Rapid money creation read more..

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    110 | PA R T I I Classical Theory: The Economy in the Long Run Money and Prices in Interwar Germany Panel (a) shows the money supply and the price level in Germany from January 1922 to December 1924. The immense increases in the money supply and the price level provide a dramatic illustration of the effects of print- ing large amounts of money. Panel (b) shows read more..

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    CHAPTER 4 Money and Inflation | 111 did fall as inflation increased and then increased again as inflation fell. Yet the increase in real money balances was not immediate. Perhaps the adjustment of real money balances to the cost of holding money is a gradual process. Or per- haps it took time for people in Germany to believe that the inflation had ended, so that read more..

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    112 | PA R T I I Classical Theory: The Economy in the Long Run buy what we can. Our pension was destroyed ages ago. None of us have any sav- ings left.” The Zimbabwe hyperinflation finally ended in March 2009, when the government abandoned its own money. The U.S. dollar became the nation’s official currency. ■ 4-7 Conclusion: The Classical Dichotomy We read more..

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    Summary 1. Money is the stock of assets used for transactions. It serves as a store of value, a unit of account, and a medium of exchange. Different sorts of assets are used as money: commodity money systems use an asset with intrinsic value, whereas fiat money systems use an asset whose sole function is to serve as money. In modern economies, a central read more..

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    114 | PA R T I I Classical Theory: The Economy in the Long Run KEY C ONCEPT S Inflation Hyperinflation Money Store of value Unit of account Medium of exchange Fiat money Commodity money Gold standard Money supply Monetary policy Central bank Federal Reserve Open-market operations Currency Demand deposits Quantity equation Transactions velocity of money Income velocity of money Real money read more..

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    CHAPTER 4 Money and Inflation | 115 The money supply grows by 12 per year, and real income grows by 4 percent per year. a. What is the average inflation rate? b. How would inflation be different if real income growth were higher? Explain. c. Suppose, instead of a constant money demand function, the velocity of money in this econ- omy was growing steadily because read more..

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    APPENDIX 116 The Cagan Model: How Current and Future Money Affect the Price Level In this chapter we showed that if the quantity of real money balances demand- ed depends on the cost of holding money, the price level depends on both the current money supply and the future money supply. This appendix develops the Cagan model to show more explicitly how this relationship read more..

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    Now substitute Equation A3 for pt+1 in Equation A2 to obtain pt = mt + mt+1 + pt+2. (A4) Equation A4 states that the current price level is a weighted average of the cur- rent money supply, the next period’s money supply, and the following period’s price level. Once again, the price level in period t + 2 is determined as in Equa- tion A2: pt+2 = () mt+2 + () read more..

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    where Ept+1 is the expected price level. Equation A8 states that real money bal- ances depend on expected inflation. By following steps similar to those above, we can show that pt = () [mt + () Emt+1 + () 2 Emt+2 + () 3 Emt+3 + … ]. (A9) Equation A9 states that the price level depends on the current money supply and expected future money supplies. Some economists use read more..

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    119 The Open Economy 5 CHAPTER Even if you never leave your hometown, you are an active participant in the global economy. When you go to the grocery store, for instance, you might choose between apples grown locally and grapes grown in Chile. When you make a deposit into your local bank, the bank might lend those funds to your next-door neighbor or to a read more..

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    rate at which the domestic currency trades for foreign currencies. Our model shows how protectionist trade policies—policies designed to protect domestic industries from foreign competition—influence the amount of international trade and the exchange rate. 5-1 The International Flows of Capital and Goods The key macroeconomic difference between open and closed economies is that, in an read more..

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    open economy, some output is sold domestically and some is exported to be sold abroad. We can divide expenditure on an open economy’s output Y into four components: ■ C d, consumption of domestic goods and services, ■ I d, investment in domestic goods and services, ■ G d, government purchases of domestic goods and services, ■ X, exports of domestic goods and read more..

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    This equation states that expenditure on domestic output is the sum of con- sumption, investment, government purchases, and net exports. This is the most common form of the national income accounts identity; it should be familiar from Chapter 2. The national income accounts identity shows how domestic output, domes- tic spending, and net exports are related. In particular, read more..

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    investment, and it is lending the excess to foreigners. If the net capital outflow is negative, the economy is experiencing a capital inflow: investment exceeds sav- ing, and the economy is financing this extra investment by borrowing from abroad. Thus, net capital outflow reflects the international flow of funds to finance capital accumulation. The national income accounts read more..

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    124 | PA R T I I Classical Theory: The Economy in the Long Run Whether foreigners buy domestically issued debt or domestically owned assets, they obtain a claim to the future returns to domestic capital. In both cases, for- eigners end up owning some of the domestic capital stock. International Flows of Goods and Capital: An Example The equality of net exports and read more..

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    economy (in the form of the Japanese currency) rather than to an investment in the U.S. economy. Thus, U.S. saving exceeds U.S. investment. The rise in U.S. net exports is matched by a rise in the U.S. net capital outflow. If Mr. Gates wants to invest in Japan, however, he is unlikely to make curren- cy his asset of choice. He might use the 5,000 read more..

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    126 | PA R T I I Classical Theory: The Economy in the Long Run in contrast to the Chapter 3 model, we do not assume that the real interest rate equilibrates saving and investment. Instead, we allow the economy to run a trade deficit and borrow from other countries or to run a trade surplus and lend to other countries. If the real interest rate does not read more..

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    open economies. Remember from Chapter 1 that economic models are built with simplifying assumptions. An assumption need not be realistic to be useful. Assuming a small open economy simplifies the analysis greatly and, therefore, will help clarify our thinking. Q: Can we relax this assumption and make the model more realistic? A: Yes, we can, and we will. The read more..

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    In Chapter 3 we graphed saving and investment as in Figure 5-2. In the closed economy studied in that chapter, the real interest rate adjusts to equilibrate sav- ing and investment—that is, the real interest rate is found where the saving and investment curves cross. In the small open economy, however, the real interest rate equals the world real interest rate. read more..

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    The same logic applies to a decrease in taxes. A tax cut lowers T, raises dispos- able income Y − T, stimulates consumption, and reduces national saving. (Even though some of the tax cut finds its way into private saving, public saving falls by the full amount of the tax cut; in total, saving falls.) Because NX = S − I, the reduction in national saving read more..

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    saving exceeds investment at r 2 *, there is a trade surplus. Hence, starting from bal- anced trade, an increase in the world interest rate due to a fiscal expansion abroad leads to a trade surplus. Shifts in Investment Demand Consider what happens to our small open economy if its investment schedule shifts outward—that is, if the demand for investment goods at every read more..

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    CHAPTER 5 The Open Economy | 131 investment schedule. At a given world interest rate, investment is now higher. Because saving is unchanged, some investment must now be financed by bor- rowing from abroad. Because capital flows into the economy to finance the increased investment, the net capital outflow is negative. Put differently, because NX = S − I, the increase read more..

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    132 | PA R T I I Classical Theory: The Economy in the Long Run The Trade Balance, Saving, and Investment: The U.S. Experience Panel (a) shows the trade balance as a percentage of GDP. Positive numbers represent a surplus, and negative numbers represent a deficit. Panel (b) shows national saving and investment as a percentage of GDP since 1960. The trade balance equals read more..

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    CHAPTER 5 The Open Economy | 133 it was large throughout these three decades. In 2007, the trade deficit was $708 billion, or 5.1 percent of GDP. As accounting identities require, this trade deficit had to be financed by borrowing from abroad (or, equivalently, by selling U.S. assets abroad). During this period, the United States went from being the world’s read more..

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    134 | PA R T I I Classical Theory: The Economy in the Long Run The history of the U.S. trade deficit shows that this statistic, by itself, does not tell us much about what is happening in the economy. We have to look deeper at saving, investment, and the policies and events that cause them (and thus the trade balance) to change over time. 1 ■ 1 read more..

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    resented by the variable A). For example, compared to rich nations, poor nations may have less access to advanced technologies, lower levels of education (or human capital ), or less efficient economic policies. Such differences could mean less output for given inputs of capital and labor; in the Cobb–Douglas produc- tion function, this is translated into a lower read more..

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    136 | PA R T I I Classical Theory: The Economy in the Long Run exchange one dollar for 120 yen in world markets for foreign currency. A Japan- ese who wants to obtain dollars would pay 120 yen for each dollar he bought. An American who wants to obtain yen would get 120 yen for each dollar he paid. When people refer to “the exchange rate’’ between two read more..

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    CHAPTER 5 The Open Economy | 137 This calculation of the real exchange rate for a single good suggests how we should define the real exchange rate for a broader basket of goods. Let e be the nominal exchange rate (the number of yen per dollar), P be the price level in the United States (measured in dollars), and P * be the price level in Japan (measured in read more..

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    The Determinants of the Real Exchange Rate We now have all the pieces needed to construct a model that explains what fac- tors determine the real exchange rate. In particular, we combine the relationship between net exports and the real exchange rate we just discussed with the model of the trade balance we developed earlier in the chapter. We can summarize the read more..

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    foreigners who want dollars to buy our goods. At the equilibrium real exchange rate, the supply of dollars available from the net capital outflow balances the demand for dollars by foreigners buying our net exports. How Policies Influence the Real Exchange Rate We can use this model to show how the changes in economic policy we dis- cussed earlier affect the real exchange read more..

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    raises S − I and thus NX. That is, the increase in the world interest rate causes a trade surplus. Figure 5-10 shows that this change in policy shifts the vertical S − I line to the right, raising the supply of dollars to be invested abroad. The equilibrium real 140 | PA R T I I Classical Theory: The Economy in the Long Run FIGURE 5-10 Real exchange rate, read more..

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    exchange rate falls. That is, the dollar becomes less valuable, and domestic goods become less expensive relative to foreign goods. Shifts in Investment Demand What happens to the real exchange rate if investment demand at home increases, perhaps because Congress passes an investment tax credit? At the given world interest rate, the increase in investment demand leads to read more..

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    amount of goods and services exported or imported. Most often, trade policies take the form of protecting domestic industries from foreign competition— either by placing a tax on foreign imports (a tariff) or restricting the amount of goods and services that can be imported (a quota). As an example of a protectionist trade policy, consider what would happen if the read more..

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    appreciation offsets the increase in net exports that is directly attributable to the trade restriction. Although protectionist trade policies do not alter the trade balance, they do affect the amount of trade. As we have seen, because the real exchange rate appreciates, the goods and services we produce become more expensive rela- tive to foreign goods and services. read more..

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    144 | PA R T I I Classical Theory: The Economy in the Long Run Inflation and Nominal Exchange Rates If we look at data on exchange rates and price levels of different countries, we quickly see the importance of inflation for explaining changes in the nominal exchange rate. The most dramatic examples come from periods of very high infla- tion. For example, the read more..

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    CHAPTER 5 The Open Economy | 145 Inflation Differentials and the Exchange Rate This scatterplot shows the relationship between inflation and the nominal exchange rate. The horizontal axis shows the country’s average inflation rate minus the U.S. average inflation rate over the period 1972–2007. The vertical axis is the average percentage change in the country’s exchange rate read more..

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    146 | PA R T I I Classical Theory: The Economy in the Long Run FIGURE 5-14 Real exchange rate, e Net exports, NX NX( e) S − I Purchasing-Power Parity The law of one price applied to the international marketplace sug- gests that net exports are highly sensitive to small movements in the real exchange rate. This high sensitivity is reflected here with a very flat net-exports read more..

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    CHAPTER 5 The Open Economy | 147 3 To learn more about purchasing-power parity, see Kenneth A. Froot and Kenneth Rogoff, “Per- spectives on PPP and Long-Run Real Exchange Rates,” in Gene M. Grossman and Kenneth Rogoff, eds., Handbook of International Economics, vol. 3 (Amsterdam: North-Holland, 1995). The Big Mac Around the World The doctrine of purchasing-power read more..

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    instance, that a U.S. dollar should buy the greatest number of Indonesian rupiahs and fewest British pounds, and this turns out to be true. In the case of Mexico, the predicted exchange rate of 8.96 pesos per dollar is close to the actual 148 | PA R T I I Classical Theory: The Economy in the Long Run Exchange Rate (per US dollar) Price of a Country Currency read more..

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    CHAPTER 5 The Open Economy | 149 exchange rate of 10.2. Yet the theory’s predictions are far from exact and, in many cases, are off by 30 percent or more. Hence, although the theory of pur- chasing-power parity provides a rough guide to the level of exchange rates, it does not explain exchange rates completely. ■ 5-3 Conclusion: The United States as a read more..

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    Consider, for example, a reduction in national saving due to a fiscal expansion. As in the closed economy, this policy raises the real interest rate and crowds out domestic investment. As in the small open economy, it also reduces the net cap- ital outflow, leading to a trade deficit and an appreciation of the exchange rate. Hence, although the model of the small read more..

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    CHAPTER 5 The Open Economy | 151 1. What are the net capital outflow and the trade balance? Explain how they are related. 2. Define the nominal exchange rate and the real exchange rate. 3. If a small open economy cuts defense spending, what happens to saving, investment, the trade balance, the interest rate, and the exchange rate? QUES TIONS F O R REVIEW 4. If a small read more..

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    152 | PA R T I I Classical Theory: The Economy in the Long Run 6. A case study in this chapter concludes that if poor nations offered better production efficiency and legal protections, the trade balance in rich nations such as the United States would move toward surplus. Let’s consider why this might be the case. a. If the world’s poor nations offer better read more..

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    When analyzing policy for a country such as the United States, we need to com- bine the closed-economy logic of Chapter 3 and the small-open-economy logic of this chapter. This appendix presents a model of an economy between these two extremes, called the large open economy. Net Capital Outflow The key difference between the small and large open economies is the behavior read more..

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    The closed economy is the special case shown in panel (a) of Figure 5-16. In the closed economy, there is no international borrowing or lending, and the interest rate adjusts to equilibrate domestic saving and investment. This means that CF = 0 at all interest rates. This situation would arise if investors here and abroad were unwilling to hold foreign assets, read more..

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    too small to affect the world interest rate. The economy’s interest rate would be fixed at the interest rate prevailing in world financial markets. Why isn’t the interest rate of a large open economy such as the United States fixed by the world interest rate? There are two reasons. The first is that the Unit- ed States is large enough to influence world financial read more..

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    Figure 5-17 shows the market for loanable funds. The supply of loanable funds is national saving. The demand for loanable funds is the sum of the demand for domestic investment and the demand for foreign investment (net capital out- flow). The interest rate adjusts to equilibrate supply and demand. The Market for Foreign Exchange Next, consider the relationship between the read more..

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    The real exchange rate is determined as in Figure 5-18, and the price levels are determined by monetary policies here and abroad, as we discussed in Chapter 4. Forces that move the real exchange rate or the price levels also move the nom- inal exchange rate. Policies in the Large Open Economy We can now consider how economic policies influence the large open read more..

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    Note that the impact of fiscal policy in this model combines its impact in the closed economy and its impact in the small open economy. As in the closed economy, a fiscal expansion in a large open economy raises the interest rate and crowds out investment. As in the small open economy, a fiscal expansion causes a trade deficit and an appreciation in the exchange read more..

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    Shifts in Investment Demand Suppose that the investment demand sched- ule shifts outward, perhaps because Congress passes an investment tax credit. Fig- ure 5-21 shows the effect. The demand for loanable funds rises, raising the equilibrium interest rate. The higher interest rate reduces the net capital outflow: Americans make fewer loans abroad, and foreigners make more read more..

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    Shifts in Net Capital Outflow There are various reasons that the CF sched- ule might shift. One reason is fiscal policy abroad. For example, suppose that Germany pursues a fiscal policy that raises German saving. This policy reduces the German interest rate. The lower German interest rate discourages Ameri- can investors from lending in Germany and encourages German read more..

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    mitigates the shift in the CF schedule, CF still falls. The reduced level of net cap- ital outflow reduces the supply of dollars in the market for foreign exchange. The exchange rate appreciates, and net exports fall. Conclusion How different are large and small open economies? Certainly, policies affect the interest rate in a large open economy, unlike in a small read more..

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    162 | PA R T I I Classical Theory: The Economy in the Long Run MORE PROBLEMS AND APPLICA TIONS 1. If a war broke out abroad, it would affect the U.S. economy in many ways. Use the model of the large open economy to examine each of the following effects of such a war. What happens in the United States to saving, investment, the trade balance, the read more..

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    163 Unemployment A man willing to work, and unable to find work, is perhaps the saddest sight that fortune’s inequality exhibits under the sun. —Thomas Carlyle 6 CHAPTER Unemployment is the macroeconomic problem that affects people most directly and severely. For most people, the loss of a job means a reduced living standard and psychological distress. It is no surprise read more..

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    economy fluctuates. The natural rate is the rate of unemployment toward which the economy gravitates in the long run, given all the labor-market imperfections that impede workers from instantly finding jobs. 6-1 Job Loss, Job Finding, and the Natural Rate of Unemployment Every day some workers lose or quit their jobs, and some unemployed workers are hired. This perpetual ebb read more..

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    We start with some notation. Let L denote the labor force, E the number of employed workers, and U the number of unemployed workers. Because every worker is either employed or unemployed, the labor force is the sum of the employed and the unemployed: L = E + U. In this notation, the rate of unemployment is U/L. To see what factors determine the unemployment read more..

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    166 | PA R T I I Classical Theory: The Economy in the Long Run Next, we divide both sides of this equation by L to obtain f = s(1 − ). Now we can solve for U/L to find = . This can also be written as = . This equation shows that the steady-state rate of unemployment U/L depends on the rates of job separation s and job finding f. The higher the rate read more..

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    CHAPTER 6 Unemployment | 167 are equally well suited for all jobs. If this were true and the labor market were in equilibrium, then a job loss would not cause unemployment: a laid-off worker would immediately find a new job at the market wage. In fact, workers have different preferences and abilities, and jobs have different attributes. Furthermore, the flow of read more..

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    168 | PA R T I I Classical Theory: The Economy in the Long Run program, unemployed workers can collect a fraction of their wages for a cer- tain period after losing their jobs. Although the precise terms of the program differ from year to year and from state to state, a typical worker covered by unemployment insurance in the United States receives 50 percent of read more..

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    workers become ineligible for benefits, they are more likely to find jobs. In par- ticular, the probability of a person finding a job more than doubles when his or her benefits run out. One possible explanation is that an absence of benefits increases the search effort of unemployed workers. Another possibility is that workers without benefits are more likely to accept read more..

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    To understand wage rigidity and structural unemployment, we must examine why the labor market does not clear. When the real wage exceeds the equilibri- um level and the supply of workers exceeds the demand, we might expect firms to lower the wages they pay. Structural unemployment arises because firms fail to reduce wages despite an excess supply of labor. We now read more..

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    the supply of teenage workers equals the demand is low. The minimum wage is therefore more often binding for teenagers than for others in the labor force. Many economists have studied the impact of the minimum wage on teenage employment. These researchers compare the variation in the minimum wage over time with the variation in the number of teenagers with jobs. These read more..

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    172 | PA R T I I Classical Theory: The Economy in the Long Run released a report describing the workers who earned at or below the minimum wage in 2007, when, in July, the minimum wage was raised from $5.15 to $5.85 per hour. Here is a summary: ■ About 76 million American workers are paid hourly, representing 59 per- cent of all wage and salary workers. read more..

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    CHAPTER 6 Unemployment | 173 The wages of unionized workers are determined not by the equilibrium of supply and demand but by bargaining between union leaders and firm manage- ment. Often, the final agreement raises the wage above the equilibrium level and allows the firm to decide how many workers to employ. The result is a reduc- tion in the number of workers read more..

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    bargaining takes place at the national level—with the government often playing a key role. Despite a highly unionized labor force, Sweden has not experienced extraordinarily high unemployment throughout its history. One possible expla- nation is that the centralization of wage bargaining and the role of the govern- ment in the bargaining process give more influence to the read more..

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    CHAPTER 6 Unemployment | 175 is imperfectly monitored. The firm can reduce the problem of moral hazard by paying a high wage. The higher the wage, the greater the cost to the worker of getting fired. By paying a higher wage, a firm induces more of its employees not to shirk and thus increases their productivity. Although these four efficiency-wage theories differ in read more..

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    176 | PA R T I I Classical Theory: The Economy in the Long Run 6-4 Labor-Market Experience: The United States So far we have developed the theory behind the natural rate of unemployment. We began by showing that the economy’s steady-state unemployment rate depends on the rates of job separation and job finding. Then we discussed two reasons why job finding is read more..

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    CHAPTER 6 Unemployment | 177 we look at spells of unemployment or months of unemployment, most unem- ployment can appear to be either short-term or long-term. This evidence on the duration of unemployment has an important implica- tion for public policy. If the goal is to lower substantially the natural rate of unemployment, policies must aim at the long-term unemployed, read more..

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    the higher unemployment rates for blacks, especially for black teenagers, arise because of both higher rates of job separation and lower rates of job finding. Pos- sible reasons for the lower rates of job finding include less access to informal job-finding networks and discrimination by employers. Trends in Unemployment Over the past half century, the natural rate of read more..

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    unemployment. Perhaps slowing productivity during the 1970s raised the natural rate of unemployment, and accelerating productivity during the 1990s lowered it. Why such an effect would occur, however, is not obvious. In standard theories of the labor market, higher productivity means greater labor demand and thus higher real wages, but unemployment is unchanged. This read more..

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    180 | PA R T I I Classical Theory: The Economy in the Long Run Variable Description Rate U-1 Persons unemployed 15 weeks or longer, as a percent of the civilian labor 2.6% force (includes only very long-term unemployed) U-2 Job losers and persons who have completed temporary jobs, as a percent of 3.9 the civilian labor force (excludes job leavers) U-3 Total unemployed, as a read more..

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    What is the cause of rising European unemployment? No one knows for sure, but there is a leading theory. Many economists believe that the problem can be traced to the interaction between a long-standing policy and a more recent shock. The long-standing policy is generous benefits for unemployed workers. The recent shock is a technologically driven fall in the demand for read more..

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    182 | PA R T I I Classical Theory: The Economy in the Long Run the welfare state provides unskilled workers with an alternative to working for low wages. As the wages of unskilled workers fall, more workers view the dole as their best available option. The result is higher unemployment. This diagnosis of high European unemployment does not suggest an easy remedy. read more..

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    The role of unions also varies from country to country, as we saw in Table 6-1. This fact also helps explain differences in labor-market outcomes. National unem- ployment rates are positively correlated with the percentage of the labor force whose wages are set by collective bargaining with unions. The adverse impact of unions on unemployment is smaller, however, in read more..

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    184 | PA R T I I Classical Theory: The Economy in the Long Run about as much as a 1-percentage-point increase in unemployment. The com- monly cited “misery index,” which is the sum of the inflation and unemploy- ment rates, apparently gives too much weight to inflation relative to unemployment. 11 ■ The Rise of European Leisure Higher unemployment rates in Europe read more..

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    The difference in hours worked reflects two facts. First, the average employed per- son in the United States works more hours per year than the average employed person in Europe. Europeans typically enjoy shorter workweeks and more fre- quent holidays. Second, more potential workers are employed in the United States. That is, the employment-to-population ratio is higher in read more..

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    186 | PA R T I I Classical Theory: The Economy in the Long Run 12 To read more about this topic, see Edward C. Prescott, “Why Do Americans Work So Much More Than Europeans?” Federal Reserve Bank of Minneapolis Quarterly Review 28/1 ( July 2004): 2–13; Alberto Alesina, Edward Glaeser, and Bruce Sacerdote, “Work and Leisure in the U.S. and Europe: read more..

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    5. The unemployment rates among demographic groups differ substantially. In particular, the unemployment rates for younger workers are much higher than for older workers. This results from a difference in the rate of job sep- aration rather than from a difference in the rate of job finding. 6. The natural rate of unemployment in the United States has exhibited long- term read more..

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    188 | PA R T I I Classical Theory: The Economy in the Long Run requiring firms to pay workers a real wage of 1 unit of output. How does this wage compare to the equilibrium wage? d. Congress cannot dictate how many workers firms hire at the mandated wage. Given this fact, what are the effects of this law? Specifi- cally, what happens to employment, output, and read more..

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    P A R T III Growth Theory: The Economy in the Very Long Run read more..

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    191 Economic Growth I: Capital Accumulation and Population Growth The question of growth is nothing new but a new disguise for an age-old issue, one which has always intrigued and preoccupied economics: the present versus the future. —James Tobin 7 CHAPTER If you have ever spoken with your grandparents about what their lives were like when they were young, most likely you read more..

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    192 | P A RT III Growth Theory: The Economy in the Very Long Run movie than a photograph. The Solow growth model shows how saving, popula- tion growth, and technological progress affect the level of an economy’s output and its growth over time. In this chapter we analyze the roles of saving and pop- ulation growth. In the next chapter we introduce read more..

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    much output is produced at any given time and how this output is allocated among alternative uses. The Supply of Goods and the Production Function The supply of goods in the Solow model is based on the production function, which states that output depends on the capital stock and the labor force: Y = F(K, L). The Solow growth model assumes that the production function read more..

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    194 | P A RT III Growth Theory: The Economy in the Very Long Run The Demand for Goods and the Consumption Function The demand for goods in the Solow model comes from consumption and investment. In other words, output per worker y is divided between consumption per worker c and investment per worker i: y = c + i. This equation is the per-worker version of the read more..

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    This equation shows that investment equals saving, as we first saw in Chapter 3. Thus, the rate of saving s is also the fraction of output devoted to investment. We have now introduced the two main ingredients of the Solow model— the production function and the consumption function—which describe the economy at any moment in time. For any given capital stock k, read more..

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    and the allocation of that output between consumption and saving is determined by the saving rate s. To incorporate depreciation into the model, we assume that a certain fraction d of the capital stock wears out each year. Here d (the lowercase Greek letter delta) is called the depreciation rate. For example, if capital lasts an average of 25 years, then the read more..

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    an economy not at the steady state will go there. That is, regardless of the level of capital with which the economy begins, it ends up with the steady-state level of capital. In this sense, the steady state represents the long-run equilibrium of the economy. To see why an economy always ends up at the steady state, suppose that the economy starts with less read more..

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    production function f(k), divide both sides of the production function by the labor force L: = . Rearrange to obtain = () 1/2 . Because y = Y/L and k = K/L, this equation becomes y = k 1/2, which can also be written as y = k. This form of the production function states that output per worker equals the square root of the amount of capital per worker. To complete the read more..

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    or, equivalently, = . This equation provides a way of finding the steady-state level of capital per worker, k*. Substituting in the numbers and production function from our example, we obtain = . Now square both sides of this equation to find k* = 9. The steady-state capital stock is 9 units per worker. This result confirms the cal- culation of the steady state in read more..

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    200 | P A RT III Growth Theory: The Economy in the Very Long Run The Miracle of Japanese and German Growth Japan and Germany are two success stories of economic growth. Although today they are economic superpowers, in 1945 the economies of both countries were in shambles. World War II had destroyed much of their capital stocks. In the decades after the war, read more..

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    omy will have a small capital stock and a low level of output in the steady state. This conclusion sheds light on many discussions of fiscal policy. As we saw in Chap- ter 3, a government budget deficit can reduce national saving and crowd out investment. Now we can see that the long-run consequences of a reduced sav- ing rate are a lower capital stock and read more..

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    202 | P A RT III Growth Theory: The Economy in the Very Long Run Saving and Investment Around the World We started this chapter with an important question: Why are some countries so rich while others are mired in poverty? Our analysis has taken us a step closer to the answer. According to the Solow model, if a nation devotes a large fraction of its income to read more..

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    cial circumstances.) The data show a positive relationship between the fraction of output devoted to investment and the level of income per person. That is, countries with high rates of investment, such as the United States and Japan, usu- ally have high incomes, whereas countries with low rates of investment, such as Ethiopia and Burundi, have low incomes. Thus, read more..

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    204 | P A RT III Growth Theory: The Economy in the Very Long Run Comparing Steady States To keep our analysis simple, let’s assume that a policymaker can set the economy’s saving rate at any level. By setting the saving rate, the policymaker determines the economy’s steady state. What steady state should the policymaker choose? The policymaker’s goal is to read more..

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    Golden Rule level, an increase in the capital stock raises output more than depreciation, so consumption rises. In this case, the production function is steeper than the dk* line, so the gap between these two curves—which equals consumption—grows as k* rises. By contrast, if the capital stock is above the Golden Rule level, an increase in the capital stock read more..

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    206 | P A RT III Growth Theory: The Economy in the Very Long Run the depreciation rate d. Thus, the net effect of this extra unit of capital on con- sumption is MPK – d. If MPK – d > 0, then increases in capital increase con- sumption, so k* must be below the Golden Rule level. If MPK – d < 0, then increases in capital decrease consumption, read more..

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    steady-state capital stock will be too high. If the saving rate is lower, the steady- state capital stock will be too low. In either case, steady-state consumption will be lower than it is at the Golden Rule steady state. Finding the Golden Rule Steady State: A Numerical Example Consider the decision of a policymaker choosing a steady state in the following economy. read more..

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    Using this formula, the last two columns of Table 7-3 present the values of MPK and MPK – d in the different steady states. Note that the net marginal product of capital is exactly zero when the saving rate is at its Golden Rule value of 0.5. Because of diminishing marginal product, the net marginal product of capital is greater than zero whenever the economy read more..

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    happens to consumption, investment, and capital when the economy makes the transition between steady states? Might the impact of the transition deter the policymaker from trying to achieve the Golden Rule? We must consider two cases: the economy might begin with more capital than in the Golden Rule steady state, or with less. It turns out that the two cases offer read more..

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    210 | P A RT III Growth Theory: The Economy in the Very Long Run Note that, compared to the old steady state, consumption is higher not only in the new steady state but also along the entire path to it. When the capital stock exceeds the Golden Rule level, reducing saving is clearly a good policy, for it increases consumption at every point in time. Starting read more..

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    CHAPTER 7 Economic Growth I: Capital Accumulation and Population Growth | 211 the economy is initially below the Golden Rule, reaching the Golden Rule requires raising investment and thus lowering the consumption of current gen- erations. Thus, when choosing whether to increase capital accumulation, the policymaker faces a tradeoff among the welfare of different generations. A read more..

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    212 | P A RT III Growth Theory: The Economy in the Very Long Run This equation shows how investment, depreciation, and population growth influ- ence the per-worker capital stock. Investment increases k, whereas depreciation and population growth decrease k. We saw this equation earlier in this chapter for the special case of a constant population (n = 0). We can think read more..

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    ulation growth. An economy is in a steady state if capital per worker k is unchanging. As before, we designate the steady-state value of k as k*. If k is less than k*, investment is greater than break-even investment, so k rises. If k is greater than k*, investment is less than break-even investment, so k falls. In the steady state, the positive read more..

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    214 | P A RT III Growth Theory: The Economy in the Very Long Run growth from n1 to n2 reduces the steady-state level of capital per worker from k*1 to k*2. Because k* is lower and because y* = f(k*), the level of output per worker y* is also lower. Thus, the Solow model predicts that countries with higher population growth will have lower levels of GDP read more..

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    nations by the World Bank, often advocate reducing fertility by increasing education about birth-control methods and expanding women’s job opportu- nities. Toward the same end, China has followed the totalitarian policy of allowing only one child per couple. These policies to reduce population growth should, if the Solow model is right, raise income per person in the read more..

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    Alternative Perspectives on Population Growth The Solow growth model highlights the interaction between population growth and capital accumulation. In this model, high population growth reduces output per worker because rapid growth in the number of workers forces the capital stock to be spread more thinly, so in the steady state, each worker is equipped with less capital. The read more..

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    CHAPTER 7 Economic Growth I: Capital Accumulation and Population Growth | 217 likely than rapidly expanding ones. There is now little reason to think that an ever expanding population will overwhelm food production and doom mankind to poverty. 6 The Kremerian Model While Malthus saw population growth as a threat to rising living standards, economist Michael Kremer has suggested read more..

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    218 | P A RT III Growth Theory: The Economy in the Very Long Run 7-4 Conclusion This chapter has started the process of building the Solow growth model. The model as developed so far shows how saving and population growth determine the economy’s steady-state capital stock and its steady-state level of income per person. As we have seen, it sheds light on many read more..

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    CHAPTER 7 Economic Growth I: Capital Accumulation and Population Growth | 219 PROBLEMS AND APPLICA TIONS worker and consumption per worker. How many years will it be before the consumption in country B is higher than the consumption in country A? 2. In the discussion of German and Japanese postwar growth, the text describes what happens when part of the capital stock is read more..

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    220 | P A RT III Growth Theory: The Economy in the Very Long Run c. Assume that the depreciation rate is 10 percent per year. Make a table showing steady-state capital per worker, output per worker, and consumption per worker for sav- ing rates of 0 percent, 10 percent, 20 percent, 30 percent, and so on. (You will need a calcu- lator with an exponent key read more..

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    221 Economic Growth II: Technology, Empirics, and Policy Is there some action a government of India could take that would lead the Indian economy to grow like Indonesia’s or Egypt’s? If so, what, exactly? If not, what is it about the “nature of India” that makes it so? The consequences for human welfare involved in questions like these are simply staggering: read more..

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    Solow growth model provides the theoretical framework within which we con- sider these policy issues. Our fourth and final task is to consider what the Solow model leaves out. As we have discussed previously, models help us understand the world by simplify- ing it. After completing an analysis of a model, therefore, it is important to con- sider whether we have read more..

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    CHAPTER 8 Economic Growth II: Technology, Empirics, and Policy | 223 force L. Suppose, for example, that an advance in production methods makes the efficiency of labor E double between 1980 and 2010. This means that a single worker in 2010 is, in effect, as productive as two workers were in 1980. That is, even if the actual number of workers (L) stays the same read more..

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    As shown in Figure 8-1, the inclusion of technological progress does not substantially alter our analysis of the steady state. There is one level of k, denoted k*, at which capital per effective worker and output per effective worker are constant. As before, this steady state represents the long-run equi- librium of the economy. The Effects of Technological Progress Table read more..

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    CHAPTER 8 Economic Growth II: Technology, Empirics, and Policy | 225 The introduction of technological progress also modifies the criterion for the Golden Rule. The Golden Rule level of capital is now defined as the steady state that maximizes consumption per effective worker. Following the same arguments that we have used before, we can show that steady-state consumption read more..

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    Consider first output per worker Y/L and the capital stock per worker K/L. According to the Solow model, in the steady state, both of these variables grow at g, the rate of technological progress. U.S. data for the past half century show that output per worker and the capital stock per worker have in fact grown at approximately the same rate—about 2 percent per read more..

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    CHAPTER 8 Economic Growth II: Technology, Empirics, and Policy | 227 Experience is consistent with this analysis. In samples of economies with sim- ilar cultures and policies, studies find that economies converge to one another at a rate of about 2 percent per year. That is, the gap between rich and poor economies closes by about 2 percent each year. An example is read more..

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    228 | P A RT III Growth Theory: The Economy in the Very Long Run person in a well-functioning economy may have greater resources and incentive to stay in school and accumulate human capital. Another hypothesis is that cap- ital accumulation may induce greater efficiency. If there are positive externalities to physical and human capital, then countries that save and read more..

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    CHAPTER 8 Economic Growth II: Technology, Empirics, and Policy | 229 percent per year, while the closed economies again grew at 0.7 percent per year. These findings are consistent with Smith’s view that trade enhances prosperity, but they are not conclusive. Correlation does not prove causation. Perhaps being closed to trade is correlated with various other restrictive read more..

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    Evaluating the Rate of Saving According to the Solow growth model, how much a nation saves and invests is a key determinant of its citizens’ standard of living. So let’s begin our policy dis- cussion with a natural question: is the rate of saving in the U.S. economy too low, too high, or about right? As we have seen, the saving rate determines the read more..

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    CHAPTER 8 Economic Growth II: Technology, Empirics, and Policy | 231 Thus, about 4 percent of the capital stock depreciates each year, and the marginal product of capital is about 12 percent per year. The net marginal product of cap- ital, MPK − d, is about 8 percent per year. We can now see that the return to capital (MPK − d = 8 percent per year) is well read more..

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    232 | P A RT III Growth Theory: The Economy in the Very Long Run giving preferential treatment to income saved in these accounts. Some econo- mists have proposed increasing the incentive to save by replacing the current system of income taxation with a system of consumption taxation. Many disagreements over public policy are rooted in different views about how much read more..

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    CHAPTER 8 Economic Growth II: Technology, Empirics, and Policy | 233 naturally be most willing to borrow at market interest rates to finance new investment. Many economists advocate that the government should merely cre- ate a “level playing field” for different types of capital—for example, by ensuring that the tax system treats all forms of capital equally. The read more..

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    234 | P A RT III Growth Theory: The Economy in the Very Long Run Establishing the Right Institutions As we discussed earlier, economists who study international differences in the stan- dard of living attribute some of these differences to the inputs of physical and human capital and some to the productivity with which these inputs are used. One reason nations may have read more..

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    What explains the correlation? Some economists have suggested that the trop- ical climates near the equator have a direct negative impact on productivity. In the heat of the tropics, agriculture is more difficult, and disease is more prevalent. This makes the production of goods and services more difficult. Although the direct impact of geography is one reason tropical read more..

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    236 | P A RT III Growth Theory: The Economy in the Very Long Run Despite this limited understanding, many public policies are designed to stim- ulate technological progress. Most of these policies encourage the private sector to devote resources to technological innovation. For example, the patent system gives a temporary monopoly to inventors of new products; the tax read more..

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    CHAPTER 8 Economic Growth II: Technology, Empirics, and Policy | 237 is easy to measure. But if technological advance leads to faster computers being built, then output and productivity have increased, but that increase is more sub- tle and harder to measure. Government statisticians try to correct for changes in quality, but despite their best efforts, the resulting data read more..

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    238 | P A RT III Growth Theory: The Economy in the Very Long Run 11 For various views on the growth slowdown, see “Symposium: The Slowdown in Productivity Growth’’ in the Fall 1988 issue of The Journal of Economic Perspectives. For a discussion of the sub- sequent growth acceleration and the role of information technology, see “Symposium: Computers and read more..

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    This old joke takes aim at how economists use assumptions to simplify—and sometimes oversimplify—the problems they face. It is particularly apt when eval- uating the theory of economic growth. One goal of growth theory is to explain the persistent rise in living standards that we observe in most parts of the world. The Solow growth model shows that such persistent read more..

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    This equation shows what determines the growth rate of output ΔY/Y. Notice that, as long as sA > d, the economy’s income grows forever, even without the assumption of exogenous technological progress. Thus, a simple change in the production function can alter dramatically the predictions about economic growth. In the Solow model, saving leads to growth temporarily, but read more..

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    CHAPTER 8 Economic Growth II: Technology, Empirics, and Policy | 241 where u is the fraction of the labor force in universities (and 1 – u is the fraction in manufacturing), E is the stock of knowledge (which in turn determines the effi- ciency of labor), and g is a function that shows how the growth in knowledge depends on the fraction of the labor force in read more..

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    Some endogenous growth models try to incorporate these facts about research and development. Doing this requires modeling both the decisions that firms face as they engage in research and the interactions among firms that have some degree of monopoly power over their innovations. Going into more detail about these models is beyond the scope of this book, but it should be read more..

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    bad for incumbent producers, who may find it hard to compete with the entrant. If the new product is sufficiently better than old ones, the incumbents may even be driven out of business. Over time, the process keeps renewing itself. The entre- preneur’s firm becomes an incumbent, enjoying high profitability until its product is displaced by another entrepreneur with read more..

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    8-5 Conclusion Long-run economic growth is the single most important determinant of the economic well-being of a nation’s citizens. Everything else that macroeconomists study—unemployment, inflation, trade deficits, and so on—pales in comparison. Fortunately, economists know quite a lot about the forces that govern eco- nomic growth. The Solow growth model and the more recent read more..

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    6. Modern theories of endogenous growth attempt to explain the rate of technological progress, which the Solow model takes as exogenous. These models try to explain the decisions that determine the creation of knowledge through research and development. CHAPTER 8 Economic Growth II: Technology, Empirics, and Policy | 245 KEY C ONCEPT S Efficiency of labor Labor-augmenting technological read more..

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    246 | P A RT III Growth Theory: The Economy in the Very Long Run e. What must the saving rate be to reach the Golden Rule steady state? 3. Prove each of the following statements about the steady state of the Solow model with population growth and technological progress. a. The capital–output ratio is constant. b. Capital and labor each earn a constant share of an read more..

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    Real GDP in the United States has grown an average of about 3 percent per year over the past 50 years. What explains this growth? In Chapter 3 we linked the output of the economy to the factors of production—capital and labor—and to the production technology. Here we develop a technique called growth accounting that divides the growth in output into three different read more..

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    of a unit. If we increase the amount of capital by 10 units, we can compute the amount of additional output as follows: DY = MPK × DK = 1/5 × 10 units of capital = 2 units of output. By increasing capital by 10 units, we obtain 2 more units of output. Thus, we use the marginal product of capital to convert changes in capital into changes in read more..

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    CHAPTER 8 Economic Growth II: Technology, Empirics, and Policy | 249 We now want to convert this last equation into a form that is easier to inter- pret and apply to the available data. First, with some algebraic rearrangement, the equation becomes 17 = () + () . This form of the equation relates the growth rate of output, ΔY/Y, to the growth rate of capital, read more..

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    250 | P A RT III Growth Theory: The Economy in the Very Long Run where A is a measure of the current level of technology called total factor produc- tivity. Output now increases not only because of increases in capital and labor but also because of increases in total factor productivity. If total factor productivity increases by 1 percent and if the inputs are read more..

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    The Sources of Growth in the United States Having learned how to measure the sources of economic growth, we now look at the data. Table 8-3 uses U.S. data to measure the contributions of the three sources of growth between 1948 and 2007. This table shows that output in the non-farm business sector grew an average of 3.6 percent per year during this time. Of read more..

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    252 | P A RT III Growth Theory: The Economy in the Very Long Run come close to reversing the spectacular long-run growth that the Asian Tigers have experienced.) What accounts for these growth miracles? Some commentators have argued that the success of these four countries is hard to reconcile with basic growth theory, such as the Solow growth model, which takes read more..

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    driving force behind short-run economic fluctuations, and the complementary hypothesis that monetary policy has no role in explaining these fluctuations, is the foundation for an approach called real-business-cycle theory. Prescott’s interpretation of these data is controversial, however. Many econo- mists believe that the Solow residual does not accurately represent changes in read more..

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    254 | P A RT III Growth Theory: The Economy in the Very Long Run get some training, and do other useful tasks that standard measures of output fail to include. If so, then output is underestimated in recessions, which would also make the measured Solow residual cyclical for reasons other than technology. Thus, economists can interpret the cyclical behavior of the read more..

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    Business Cycle Theory: The Economy in the Short Run PA R T I V read more..

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    257 Introduction to Economic Fluctuations The modern world regards business cycles much as the ancient Egyptians regarded the overflowing of the Nile. The phenomenon recurs at intervals, it is of great importance to everyone, and natural causes of it are not in sight. —John Bates Clark, 1898 9 CHAPTER Economic fluctuations present a recurring problem for economists and pol- read more..

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    These historical events raise a variety of related questions: What causes short- run fluctuations? What model should we use to explain them? Can policymak- ers avoid recessions? If so, what policy levers should they use? In Parts Two and Three of this book, we developed theories to explain how the economy behaves in the long run. Here, in Part Four, we see read more..

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    growth, but those quarters were not consecutive. In fact, the NBER’s Business Cycle Dating Committee does not follow any fixed rule but, instead, looks at a variety of economic time series and uses its judgment when picking the starting and ending dates of recessions. As this book was going to press, the economy was in the midst of the recession of 2008–2009, read more..

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    Unemployment and Okun’s Law The business cycle is apparent not only in data from the national income accounts but also in data that describe conditions in the labor market. Figure 9-3 shows the unemployment rate from 1970 to early 2009, again with the shaded areas representing periods of recession. You can see that unemployment rises in each recession. Other labor-market read more..

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    CHAPTER 9 Introduction to Economic Fluctuations | 261 Unemployment The unemployment rate rises significantly during periods of recession, shown here by the shaded areas. Source: U.S. Department of Labor. FIGURE 9-3 1970 1975 1980 1985 1990 1995 2000 2005 Year 12 10 8 6 4 2 0 Percentage of labor force Unemployment rate newspapers, decline during recessions. Put simply, during an economic down- read more..

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    262 | PA R T I V Business Cycle Theory: The Economy in the Short Run If the unemployment rate remains the same, real GDP grows by about 3 percent; this normal growth in the production of goods and services is due to growth in the labor force, capital accumulation, and technological progress. In addition, for every percentage point the unemployment rate rises, read more..

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    CHAPTER 9 Introduction to Economic Fluctuations | 263 correlated with the utilization of the economy’s labor force. The declines in the production of goods and services that occur during recessions are always associ- ated with increases in joblessness. Leading Economic Indicators Many economists, particularly those working in business and government, are engaged in the task of read more..

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    ■ New orders for nondefense capital goods. This series is the counterpart to the previous one, but for investment goods rather than consumer goods. ■ Index of supplier deliveries. This variable, sometimes called vendor perfor- mance, is a measure of the number of companies receiving slower deliv- eries from suppliers. Vendor performance is a leading indicator because deliveries read more..

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    CHAPTER 9 Introduction to Economic Fluctuations | 265 9-2 Time Horizons in Macroeconomics Now that we have some sense about the facts that describe short-run econom- ic fluctuations, we can turn to our basic task in this part of the book: building a theory to explain these fluctuations. That job, it turns out, is not a simple one. It will take us not only read more..

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    in economic conditions) means that, in the short run, real variables such as out- put and employment must do some of the adjusting instead. In other words, during the time horizon over which prices are sticky, the classical dichotomy no longer holds: nominal variables can influence real variables, and the economy can deviate from the equilibrium predicted by the read more..

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    firms’ pricing decisions. Notice that each of the theories was endorsed by some of the managers, but each was rejected by a large number as well. One interpre- tation is that different theories apply to different firms, depending on industry characteristics, and that price stickiness is a macroeconomic phenomenon with- out a single microeconomic explanation. Among the read more..

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    268 | PA R T I V Business Cycle Theory: The Economy in the Short Run more coordinated wage and price setting—somehow achieved—could improve welfare. But if this proves difficult or impossible, the door is opened to activist monetary policy to cure recessions.” 3 ■ The Model of Aggregate Supply and Aggregate Demand How does the introduction of sticky prices change read more..

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    a large economy. By contrast, as we will see in the coming chapters, the model of aggregate supply and aggregate demand is a sophisticated model that incor- porates the interactions among many markets. In the remainder of this chapter we get a first glimpse at those interactions by examining the model in its most simplified form. Our goal here is not to read more..

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    Why the Aggregate Demand Curve Slopes Downward As a strictly mathematical matter, the quantity equation explains the downward slope of the aggregate demand curve very simply. The money supply M and the velocity of money V determine the nominal value of output PY. Once PY is fixed, if P goes up, Y must go down. What is the economic intuition that lies behind this read more..

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    For example, consider what happens if the Fed reduces the money supply. The quantity equation, MV = PY, tells us that the reduction in the money supply leads to a proportionate reduction in the nominal value of output PY. For any given price level, the amount of output is lower, and for any given amount of output, the price level is lower. As in Figure 9-6(a), read more..

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    need another relationship between P and Y that crosses the aggregate demand curve—an aggregate supply curve. The aggregate demand and aggregate supply curves together pin down the economy’s price level and quantity of output. Aggregate supply (AS ) is the relationship between the quantity of goods and services supplied and the price level. Because the firms that supply goods read more..

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    the aggregate demand curve with this vertical aggregate supply curve determines the price level. If the aggregate supply curve is vertical, then changes in aggregate demand affect prices but not output. For example, if the money supply falls, the aggregate demand curve shifts downward, as in Figure 9-8. The economy moves from the old intersection of aggregate supply read more..

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    they hire just enough labor to produce the amount demanded. Because the price level is fixed, we represent this situation in Figure 9-9 with a horizontal aggregate supply curve. The short-run equilibrium of the economy is the intersection of the aggre- gate demand curve and this horizontal short-run aggregate supply curve. In this case, changes in aggregate demand do read more..

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    aggregate demand and aggregate supply, point A, to the new intersection, point B. The movement from point A to point B represents a decline in output at a fixed price level. Thus, a fall in aggregate demand reduces output in the short run because prices do not adjust instantly. After the sudden fall in aggregate demand, firms are stuck with prices that are too read more..

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    figure, there are three curves: the aggregate demand curve, the long-run aggre- gate supply curve, and the short-run aggregate supply curve. The long-run equi- librium is the point at which aggregate demand crosses the long-run aggregate supply curve. Prices have adjusted to reach this equilibrium. Therefore, when the economy is in its long-run equilibrium, the short-run read more..

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    and they usually do their best to prevent that from happening. Fortunately, history often fills in the gap when recent experience fails to produce the right experiment. A vivid example of the effects of monetary contraction occurred in eighteenth-century France. François V elde, an economist at the Federal Reserve Bank of Chicago, recently studied this episode in French read more..

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    9-5 Stabilization Policy Fluctuations in the economy as a whole come from changes in aggregate supply or aggregate demand. Economists call exogenous events that shift these curves shocks to the economy. A shock that shifts the aggregate demand curve is called a demand shock, and a shock that shifts the aggregate supply curve is called a supply shock. These shocks disrupt the read more..

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    stabilization policy using our simplified version of the model of aggregate demand and aggregate supply. In particular, we examine how monetary policy might respond to shocks. Monetary policy is an important component of stabi- lization policy because, as we have seen, the money supply has a powerful impact on aggregate demand. Shocks to Aggregate Demand Consider an read more..

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    What can the Fed do to dampen this boom and keep output closer to the nat- ural level? The Fed might reduce the money supply to offset the increase in velocity. Offsetting the change in velocity would stabilize aggregate demand. Thus, the Fed can reduce or even eliminate the impact of demand shocks on output and employment if it can skillfully control the money supply. read more..

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    supply, the economy goes immediately from point A to point C. In this case, the Fed is said to accommodate the supply shock. The drawback of this option, of course, is that the price level is permanently higher. There is no way to adjust aggregate demand to maintain full employment and keep the price level stable. CHAPTER 9 Introduction to Economic Fluctuations | read more..

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    282 | PA R T I V Business Cycle Theory: The Economy in the Short Run How OPEC Helped Cause Stagflation in the 1970s and Euphoria in the 1980s The most disruptive supply shocks in recent history were caused by OPEC, the Organization of Petroleum Exporting Countries. OPEC is a cartel, which is an organization of suppliers that coordinate production levels and read more..

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    CHAPTER 9 Introduction to Economic Fluctuations | 283 Change in Inflation Unemployment Year Oil Prices Rate (CPI) Rate 1983 –7.1% 3.2% 9.5% 1984 –1.7 4.3 7.4 1985 –7.5 3.6 7.1 1986 –44.5 1.9 6.9 1987 l8.3 3.6 6.1 In 1986 oil prices fell by nearly half. This favorable supply shock led to one of the lowest inflation rates experienced in recent U.S. history and to falling read more..

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    In the chapters that follow, we refine our understanding of this model and our analysis of stabilization policy. Chapters 10 through 12 go beyond the quantity equation to refine our theory of aggregate demand. Chapter 13 examines aggre- gate supply in more detail. Chapter 14 brings these elements together in a dynamic model of aggregate demand and aggregate supply. read more..

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    CHAPTER 9 Introduction to Economic Fluctuations | 285 KEY C ONCEPT S Okun’s law Leading indicators Aggregate demand Aggregate supply Shocks Demand shocks Supply shocks Stabilization policy 1. When real GDP declines during a recession, what typically happens to consumption, invest- ment, and the unemployment rate? 2. Give an example of a price that is sticky in the short run but read more..

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    286 | PA R T I V Business Cycle Theory: The Economy in the Short Run a. An exogenous decrease in the velocity of money. b. An exogenous increase in the price of oil. 4. The official arbiter of when recessions begin and end is the National Bureau of Economic Research, a nonprofit economics research group. Go to the NBER’s Web site ( and find the latest read more..

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    287 Aggregate Demand I: Building the IS–LM Model I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case. . . . Moreover, the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its read more..

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    288 | PA R T I V Business Cycle Theory: The Economy in the Short Run these two views with the model of aggregate demand and aggregate supply introduced in Chapter 9. In the long run, prices are flexible, and aggregate sup- ply determines income. But in the short run, prices are sticky, so changes in aggregate demand influence income. In 2008 and 2009, as read more..

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    The two parts of the IS –LM model are, not surprisingly, the IS curve and the LM curve. IS stands for “investment’’ and “saving,’’ and the IS curve represents what’s going on in the market for goods and services (which we first discussed in Chapter 3). LM stands for “liquidity’’ and “money,’’ and the LM curve repre- sents what’s read more..

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    firms sell more than planned, their stock of inventories falls. Because these unplanned changes in inventory are counted as investment spending by firms, actual expenditure can be either above or below planned expenditure. Now consider the determinants of planned expenditure. Assuming that the economy is closed, so that net exports are zero, we write planned expenditure PE read more..

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    thus higher planned expenditure. The slope of this line is the marginal propen- sity to consume, MPC: it shows how much planned expenditure increases when income rises by $1. This planned-expenditure function is the first piece of the model called the Keynesian cross. The Economy in Equilibrium The next piece of the Keynesian cross is the assumption that the economy is in read more..

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    292 | PA R T I V Business Cycle Theory: The Economy in the Short Run they are producing. Firms add the unsold goods to their stock of inventories. This unplanned rise in inventories induces firms to lay off workers and reduce production; these actions in turn reduce GDP. This process of unintended inven- tory accumulation and falling income continues until income Y read more..

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    Why does fiscal policy have a multiplied effect on income? The reason is that, according to the consumption function C = C(Y − T ), higher income causes higher consumption. When an increase in government purchases raises income, it also raises consumption, which further raises income, which further raises con- sumption, and so on. Therefore, in this model, an read more..

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    294 | PA R T I V Business Cycle Theory: The Economy in the Short Run The government-purchases multiplier is DY/DG = 1 + MPC + MPC 2 + MPC 3 + . . . This expression for the multiplier is an example of an infinite geometric series. A result from algebra allows us to write the multiplier as 2 DY/DG = 1/(1 − MPC ). For example, if the marginal propensity to read more..

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    Just as an increase in government purchases has a multiplied effect on income, so does a decrease in taxes. As before, the initial change in expenditure, now MPC ×ΔT, is multiplied by 1/(1 − MPC ). The overall effect on income of the change in taxes is ΔY/ΔT =−MPC/(1 − MPC ). This expression is the tax multiplier, the amount income changes in response to read more..

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    296 | PA R T I V Business Cycle Theory: The Economy in the Short Run Cutting Taxes to Stimulate the Economy: The Kennedy and Bush Tax Cuts When John F. Kennedy became president of the United States in 1961, he brought to Washington some of the brightest young economists of the day to work on his Council of Economic Advisers. These economists, who had been read more..

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    CHAPTER 10 Aggregate Demand I: Building the IS–LM Model | 297 Increasing Government Purchases to Stimulate the Economy: The Obama Spending Plan When President Barack Obama took office in January 2009, the economy was suffering from a significant recession. (The causes of this recession are discussed in a Case Study in the next chapter.) Even before he was inaugurated, the read more..

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    areas are also declining because they have been producing goods and services that are not in great demand, and will not be in demand in the future. Therefore, the overall value added by improving their roads and other infrastructure is likely to be a lot less than if the new infrastructure were located in growing areas that might have relatively little read more..

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    trates how the equilibrium level of income depends on the interest rate. Because an increase in the interest rate causes planned investment to fall, which in turn causes equilibrium income to fall, the IS curve slopes downward. How Fiscal Policy Shifts the IS Curve The IS curve shows us, for any given interest rate, the level of income that brings the goods market read more..

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    and thus for a given level of planned investment. The Keynesian cross in panel (a) shows that this change in fiscal policy raises planned expenditure and there- by increases equilibrium income from Y1 to Y2. Therefore, in panel (b), the increase in government purchases shifts the IS curve outward. We can use the Keynesian cross to see how other changes in fiscal read more..

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    In summary, the IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for goods and services. The IS curve is drawn for a given fiscal policy. Changes in fiscal policy that raise the demand for goods and services shift the IS curve to the right. Changes in fiscal policy that reduce the read more..

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    where the function L( ) shows that the quantity of money demanded depends on the interest rate. The demand curve in Figure 10-9 slopes downward because higher interest rates reduce the quantity of real money balances demanded. 5 According to the theory of liquidity preference, the supply and demand for real money balances determine what interest rate prevails in the economy. read more..

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    the interest rate reaches the equilibrium level, at which people are content with their portfolios of monetary and nonmonetary assets. Now that we have seen how the interest rate is determined, we can use the theory of liquidity preference to show how the interest rate responds to changes in the supply of money. Suppose, for instance, that the Fed suddenly read more..

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    Here’s the background: By the late 1970s, inflation in the U.S. economy had reached the double-digit range and was a major national problem. In 1979 con- sumer prices were rising at a rate of 11.3 percent per year. In October of that year, only two months after becoming the chairman of the Federal Reserve, Paul Vol- cker decided that it was time to change read more..

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    the equilibrium interest rate depends on the level of income. The higher the level of income, the higher the demand for real money balances, and the higher the equilibrium interest rate. For this reason, the LM curve slopes upward. How Monetary Policy Shifts the LM Curve The LM curve tells us the interest rate that equilibrates the money market at any level of read more..

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    10-3 Conclusion: The Short-Run Equilibrium We now have all the pieces of the IS –LM model. The two equations of this model are Y = C(Y − T ) + I(r) + GIS, M/P = L(r, Y ) LM. The model takes fiscal policy G and T, monetary policy M, and the price level P as exogenous. Given these exogenous variables, the IS curve provides the combinations of r and Y read more..

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    In this chapter we developed the Keynesian cross and the theory of liquidity preference as building blocks for the IS –LM model. As we see more fully in the next chapter, the IS –LM model helps explain the position and slope of CHAPTER 10 Aggregate Demand I: Building the IS–LM Model | 307 FIGURE 10-13 Equilibrium in the IS–LM Model The intersection of the IS read more..

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    the aggregate demand curve. The aggregate demand curve, in turn, is a piece of the model of aggregate supply and aggregate demand, which economists use to explain the short-run effects of policy changes and other events on national income. Summary 1. The Keynesian cross is a basic model of income determination. It takes fiscal policy and planned investment as exogenous and read more..

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    CHAPTER 10 Aggregate Demand I: Building the IS–LM Model | 309 PROBLEMS AND APPLICA TIONS where T − and t are parameters of the tax code. The parameter t is the marginal tax rate: if income rises by $1, taxes rise by t × $1. a. How does this tax system change the way consumption responds to changes in GDP? b. In the Keynesian cross, how does this tax read more..

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    310 | PA R T I V Business Cycle Theory: The Economy in the Short Run 5. Suppose that the money demand function is (M/P) d = 1,000 – 100r, where r is the interest rate in percent. The money supply M is 1,000 and the price level P is 2. a. Graph the supply and demand for real money balances. b. What is the equilibrium interest rate? c. Assume that the price read more..

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    311 Aggregate Demand II: Applying the IS–LM Model Science is a parasite: the greater the patient population the better the advance in physiology and pathology; and out of pathology arises therapy. The year 1932 was the trough of the great depression, and from its rotten soil was belatedly begot a new subject that today we call macroeconomics. —Paul Samuelson 11 CHAPTER In read more..

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    of this traumatic economic downturn. And, as we will see throughout this chap- ter, the model can also be used to shed light on more recent recessions, such as those that began in 2001 and 2008. 11-1 Explaining Fluctuations With the IS–LM Model The intersection of the IS curve and the LM curve determines the level of nation- al income. When one of these curves read more..

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    by this amount. The equilibrium of the economy moves from point A to point B. The increase in government purchases raises both income and the interest rate. To understand fully what’s happening in Figure 11-1, it helps to keep in mind the building blocks for the IS –LM model from the preceding chapter—the Key- nesian cross and the theory of liquidity preference. read more..

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    income, an increase in real money balances leads to a lower interest rate. There- fore, the LM curve shifts downward, as in Figure 11-3. The equilibrium moves from point A to point B. The increase in the money supply lowers the interest rate and raises the level of income. Once again, to tell the story that explains the economy’s adjustment from point A to read more..

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    Reserve increases the supply of money, people have more money than they want to hold at the prevailing interest rate. As a result, they start depositing this extra money in banks or using it to buy bonds. The interest rate r then falls until peo- ple are willing to hold all the extra money that the Fed has created; this brings the money market to a new read more..

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    FIGURE 11-4 Interest rate, r Interest rate, r Interest rate, r Income, output, Y Income, output, Y Income, output, Y LM 2 IS 1 IS 2 LM 1 2. ... but because the Fed holds the money supply constant, the LM curve stays the same. 2. ... and to hold the interest rate constant, the Fed contracts the money supply. LM IS 1 IS 2 1. A tax increase shifts the IS curve . . . 1. A read more..

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    higher taxes depress consumption, while the lower interest rate stimulates investment. Income is not affected because these two effects exactly balance. From this example we can see that the impact of a change in fiscal policy depends on the policy the Fed pursues—that is, on whether it holds the money supply, the interest rate, or the level of income constant. read more..

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    That is, a $100 billion increase in government purchases raises GDP by $60 bil- lion, and a $100 billion increase in taxes lowers GDP by $26 billion. Table 11-1 shows that the fiscal-policy multipliers are very different under the two assumptions about monetary policy. The impact of any change in fiscal pol- icy depends crucially on how the Fed responds to that read more..

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    of liquidity preference, when money demand rises, the interest rate necessary to equilibrate the money market is higher (for any given level of income and money supply). Hence, an increase in money demand shifts the LM curve upward, which tends to raise the interest rate and depress income. In summary, several kinds of events can cause economic fluctuations by shift- read more..

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    The third shock was a series of accounting scandals at some of the nation’s most prominent corporations, including Enron and WorldCom. The result of these scan- dals was the bankruptcy of some companies that had fraudulently represented them- selves as more profitable than they truly were, criminal convictions for the executives who had been responsible for the fraud, and read more..

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    interest rates are the necessary changes in the money supply. A newspaper might report, for instance, that “the Fed has lowered interest rates.” To be more precise, we can translate this statement as meaning “the Federal Open Market Commit- tee has instructed the Fed bond traders to buy bonds in open-market operations so as to increase the money supply, shift read more..

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    To explain why the aggregate demand curve slopes downward, we examine what happens in the IS–LM model when the price level changes. This is done in Figure 11-5. For any given money supply M, a higher price level P reduces the supply of real money balances M/P. A lower supply of real money balances shifts the LM curve upward, which raises the equilibrium read more..

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    in the aggregate demand curve. The factors shifting aggregate demand include not only monetary and fiscal policy but also shocks to the goods market (the IS curve) and shocks to the money market (the LM curve). We can summarize these results as follows: A change in income in the IS–LM model resulting from a change in the price level represents a movement along the read more..

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    The IS–LM Model in the Short Run and Long Run The IS –LM model is designed to explain the economy in the short run when the price level is fixed. Yet, now that we have seen how a change in the price level influences the equilibrium in the IS –LM model, we can also use the model to describe the economy in the long run when the price level read more..

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    economy gravitates. Point K describes the short-run equilibrium, because it assumes that the price level is stuck at P1. Eventually, the low demand for goods and services causes prices to fall, and the economy moves back toward its natural rate. When the price level reaches P2, the economy is at point C, the long-run equilibrium. The diagram of aggregate supply and read more..

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    11-3 The Great Depression Now that we have developed the model of aggregate demand, let’s use it to address the question that originally motivated Keynes: what caused the Great Depression? Even today, more than half a century after the event, economists continue to debate the cause of this major economic downturn. The Great Depression provides an extended case study to read more..

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    The Spending Hypothesis: Shocks to the IS Curve Table 11-2 shows that the decline in income in the early 1930s coincided with falling interest rates. This fact has led some economists to suggest that the cause of the decline may have been a contractionary shift in the IS curve. This view is sometimes called the spending hypothesis, because it places primary blame for read more..

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    328 | PA R T I V Business Cycle Theory: The Economy in the Short Run inadequate bank regulation, and these bank failures may have exacerbated the fall in investment spending. Banks play the crucial role of getting the funds available for investment to those households and firms that can best use them. The clos- ing of many banks in the early 1930s may have read more..

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    money supply was accompanied by an even greater fall in the price level. Although the monetary contraction may be responsible for the rise in unem- ployment from 1931 to 1933, when real money balances did fall, it cannot easi- ly explain the initial downturn from 1929 to 1931. The second problem for the money hypothesis is the behavior of interest rates. If a read more..

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    The debt-deflation theory begins with an observation from Chapter 4: unan- ticipated changes in the price level redistribute wealth between debtors and creditors. If a debtor owes a creditor $1,000, then the real amount of this debt is $1,000/P, where P is the price level. A fall in the price level raises the real amount of this debt—the amount of purchasing power read more..

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    investment depresses planned expenditure, which in turn depresses income. The fall in income reduces the demand for money, and this reduces the nominal interest rate that equilibrates the money market. The nominal interest rate falls by less than the expected deflation, so the real interest rate rises. Note that there is a common thread in these two stories of read more..

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    332 | PA R T I V Business Cycle Theory: The Economy in the Short Run The fiscal-policy mistakes of the Depression are also unlikely to be repeated. Fiscal policy in the 1930s not only failed to help but actually further depressed aggregate demand. Few economists today would advocate such a rigid adherence to a balanced budget in the face of massive unemployment. In read more..

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    how markets equilibrate supply and demand. Moreover, the price of housing in 2008 was merely a return to the level that had prevailed in 2004. But, in this case, the price decline led to a series of problematic repercussions. The first of these repercussions was a substantial rise in mortgage defaults and home foreclosures. During the housing boom, many homeowners had read more..

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    As this book was going to press, the outcome of the story was not clear. These policy actions would not prove to be enough to prevent a significant downturn in economic activity. But would they be sufficient to prevent the downturn from evolv- ing into another depression? Policymakers were certainly hoping for that to be the case. By the time you are reading this, read more..

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    11-4 Conclusion The purpose of this chapter and the previous one has been to deepen our under- standing of aggregate demand. We now have the tools to analyze the effects of monetary and fiscal policy in the long run and in the short run. In the long run, prices are flexible, and we use the classical analysis of Parts Two and Three of this book. In the read more..

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    336 | PA R T I V Business Cycle Theory: The Economy in the Short Run PROBLEMS AND APPLICA TIONS each case, explain what the Fed should do to keep income at its initial level. a. After the invention of a new high-speed computer chip, many firms decide to upgrade their computer systems. b. A wave of credit-card fraud increases the fre- quency with which people make read more..

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    CHAPTER 11 Aggregate Demand II: Applying the IS-LM Model | 337 The investment function is I = 200 − 25r. Government purchases and taxes are both 100. For this economy, graph the IS curve for r ranging from 0 to 8. b. The money demand function in Hicksonia is (M/P) d = Y − 100r. The money supply M is 1,000 and the price level P is 2. For this economy, graph read more..

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    338 | PA R T I V Business Cycle Theory: The Economy in the Short Run b. How does the slope of the IS curve depend on the parameter d, the interest rate sensitivi- ty of investment? Refer to your answer to part (a), and explain the intuition. c. Which will cause a bigger horizontal shift in the IS curve, a $100 tax cut or a $100 increase in government read more..

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    339 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime The world is still a closed economy, but its regions and countries are becoming increasingly open. . . . The international economic climate has changed in the direction of financial integration, and this has important implications for economic policy. —Robert Mundell, 1963 12 CHAPTER When read more..

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    340 | PA R T I V Business Cycle Theory: The Economy in the Short Run Mundell–Fleming model assumes an open economy. The Mundell–Fleming model extends the short-run model of national income from Chapters 10 and 11 by includ- ing the effects of international trade and finance discussed in Chapter 5. The Mundell–Fleming model makes one important and extreme assumption: it read more..

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    The Key Assumption: Small Open Economy With Perfect Capital Mobility Let’s begin with the assumption of a small open economy with perfect capital mobility. As we saw in Chapter 5, this assumption means that the interest rate in this economy r is determined by the world interest rate r*. Mathematically, we can write this assumption as r = r *. This world interest read more..

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    become cheaper compared to domestic goods, and this causes exports to fall and imports to rise. The goods-market equilibrium condition above has two financial variables affecting expenditure on goods and services (the interest rate and the exchange rate), but the situation can be simplified using the assumption of perfect capital mobility, so r = r*. We obtain Y = C(Y − read more..

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    The IS* curve slopes downward because a higher exchange rate reduces net exports, which in turn lowers aggregate income. To show how this works, the other panels of Figure 12-1 combine the net-exports schedule and the Keyne- sian cross to derive the IS* curve. In panel (a), an increase in the exchange rate from e1 to e2 lowers net exports from NX(e1) to read more..

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    fiscal policy G and T, monetary policy M, the price level P, and the world interest rate r *. The endogenous variables are income Y and the exchange rate e. Figure 12-3 illustrates these two relationships. The equilibrium for the econ- omy is found where the IS* curve and the LM * curve intersect. This intersec- tion shows the exchange rate and the level of read more..

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    12-2 The Small Open Economy Under Floating Exchange Rates Before analyzing the impact of policies in an open economy, we must specify the international monetary system in which the country has chosen to operate. That is, we must consider how people engaged in international trade and finance can convert the currency of one country into the currency of another. We start read more..

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    346 | PA R T I V Business Cycle Theory: The Economy in the Short Run Notice that fiscal policy has very different effects in a small open economy than it does in a closed economy. In the closed-economy IS–LM model, a fiscal expan- sion raises income, whereas in a small open economy with a floating exchange rate, a fiscal expansion leaves income at the same read more..

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    In both closed and open economies, the quantity of real money balances sup- plied M/P is fixed by the central bank (which sets M ) and the assumption of sticky prices (which fixes P ). The quantity demanded (determined by r and Y) must equal this fixed supply. In a closed economy, a fiscal expansion causes the equilibrium interest rate to rise. This increase read more..

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    influence spending? To answer this question, we once again need to think about the international flow of capital and its implications for the domestic economy. The interest rate and the exchange rate are again the key variables. As soon as an increase in the money supply starts putting downward pressure on the domes- tic interest rate, capital flows out of the economy, read more..

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    12-3 The Small Open Economy Under Fixed Exchange Rates We now turn to the second type of exchange-rate system: fixed exchange rates. Under a fixed exchange rate, the central bank announces a value for the exchange rate and stands ready to buy and sell the domestic currency to keep the exchange rate at its announced level. In the 1950s and 1960s, most of the read more..

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    the Bretton Woods system—an international monetary system under which most governments agreed to fix exchange rates. The world abandoned this sys- tem in the early 1970s, and most exchange rates were allowed to float. Yet fixed exchange rates are not merely of historical interest. More recently, China fixed the value of its currency against the U.S. dollar—a policy read more..

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    It is important to understand that this exchange-rate system fixes the nominal exchange rate. Whether it also fixes the real exchange rate depends on the time horizon under consideration. If prices are flexible, as they are in the long run, then the real exchange rate can change even while the nominal exchange rate is fixed. Therefore, in the long run described in read more..

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    352 | PA R T I V Business Cycle Theory: The Economy in the Short Run To see how an international gold standard fixes exchange rates, suppose that the U.S. Treasury stands ready to buy or sell 1 ounce of gold for $100, and the Bank of England stands ready to buy or sell 1 ounce of gold for 100 pounds. Together, these policies fix the rate of exchange read more..

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    currency to the central bank, causing the money supply and the LM* curve to return to their initial positions. Hence, monetary policy as usually conducted is ineffectual under a fixed exchange rate. By agreeing to fix the exchange rate, the central bank gives up its control over the money supply. CHAPTER 12 The Open Economy Revisited: The Mundell-Fleming Model and the read more..

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    354 | PA R T I V Business Cycle Theory: The Economy in the Short Run A country with a fixed exchange rate can, however, conduct a type of mon- etary policy: it can decide to change the level at which the exchange rate is fixed. A reduction in the official value of the currency is called a devaluation, and an increase in its official value is called a read more..

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    the net-exports schedule to the right, but only under a fixed exchange rate does a trade restriction increase net exports NX. The reason is that a trade restriction under a fixed exchange rate induces monetary expansion rather than an appre- ciation of the currency. The monetary expansion, in turn, raises aggregate income. Recall the accounting identity NX = S − I. When read more..

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    356 | PA R T I V Business Cycle Theory: The Economy in the Short Run 12-4 Interest Rate Differentials So far, our analysis has assumed that the interest rate in a small open economy is equal to the world interest rate: r = r*. To some extent, however, interest rates differ around the world. We now extend our analysis by considering the causes and read more..

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    less valuable currency than loans made in dollars. To compensate for this expect- ed fall in the Mexican currency, the interest rate in Mexico will be higher than the interest rate in the United States. Thus, because of both country risk and expectations of future exchange-rate changes, the interest rate of a small open economy can differ from interest rates in other read more..

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    358 | PA R T I V Business Cycle Theory: The Economy in the Short Run FIGURE 12-11 Exchange rate, e Income, output, Y 3. ... resulting in a depreciation. 1. When an increase in the risk premium drives up the interest rate, the IS* curve shifts to the left ... 2. ... and the LM* curve shifts to the right, ... IS* 2 IS* 1 LM* 2 LM* 1 An Increase in the Risk Premium An read more..

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    At the beginning of 1994, Mexico was a country on the rise. The recent passage of the North American Free Trade Agreement (NAFTA), which reduced trade barriers among the United States, Canada, and Mexico, made many people confident about the future of the Mexican economy. Investors around the world were eager to make loans to the Mexican government and to Mexican read more..

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    360 | PA R T I V Business Cycle Theory: The Economy in the Short Run currency lose much of its value, but Mexico also went through a deep recession. Fortunately, by the late 1990s, the worst was over, and aggregate income was growing again. But the lesson from this experience is clear and could well apply again in the future: changes in perceived country read more..

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    5. Reduced collateral increased default rates on bank loans. 6. Greater defaults exacerbated problems in the banking system. Now return to step 1 to complete and continue the circle. Some economists have used this vicious-circle argument to suggest that the Asian crisis was a self-fulfilling prophecy: bad things happened merely because people expected bad things to happen. Most read more..

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    362 | PA R T I V Business Cycle Theory: The Economy in the Short Run excessive growth in the money supply. Yet there are many other policy rules to which the central bank could be committed. In Chapter 15, for instance, we discuss policy rules such as targets for nominal GDP or the inflation rate. Fixing the exchange rate has the advantage of being simpler read more..

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    formed a monetary union that uses a common currency called the euro. As a result, the exchange rate between France and Germany is now as fixed as the exchange rate between New York and California. The introduction of a common currency has its costs. The most important is that the nations of Europe are no longer able to conduct their own monetary policies. Instead, the read more..

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    364 | PA R T I V Business Cycle Theory: The Economy in the Short Run to zero. In this case, the central bank has no choice but to abandon the fixed exchange rate and let the peso depreciate. This fact raises the possibility of a speculative attack—a change in investors’ per- ceptions that makes the fixed exchange rate untenable. Suppose that, for no good read more..

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    exchange rate at its predetermined level. In a sense, when a nation fixes its curren- cy to that of another nation, it is adopting that other nation’s monetary policy. The third option is to restrict the international flow of capital in and out of the country, as China has done in recent years. In this case, the interest rate is no longer fixed by world read more..

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    366 | PA R T I V Business Cycle Theory: The Economy in the Short Run the fixed exchange rate. That is, the Chinese central bank had to supply yuan and demand dollars in foreign-exchange markets to keep the yuan at the pegged level. If this intervention in the currency market ceased, the yuan would rise in value compared to the dollar. The pegged yuan became a read more..

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    These equations should be familiar by now. The first equation describes the IS* curve; and the second describes the LM* curve. Note that net exports depend on the real exchange rate. Figure 12-13 shows what happens when the price level falls. Because a lower price level raises the level of real money balances, the LM* curve shifts to the right, as in panel read more..

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    events that raise income for a given price level shift the aggregate demand curve to the right; policies and events that lower income for a given price level shift the aggregate demand curve to the left. We can use this diagram to show how the short-run model in this chapter is related to the long-run model in Chapter 5. Figure 12-14 shows the short-run and read more..

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    price level raises real money balances, shifting the LM* curve to the right. The real exchange rate depreciates, so net exports rise. Eventually, the economy reaches point C, the long-run equilibrium. The speed of transition between the short-run and long-run equilibria depends on how quickly the price level adjusts to restore the economy to the natural level of read more..

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    Summary 1. The Mundell–Fleming model is the IS–LM model for a small open econo- my. It takes the price level as given and then shows what causes fluctuations in income and the exchange rate. 2. The Mundell–Fleming model shows that fiscal policy does not influence aggregate income under floating exchange rates. A fiscal expansion causes the currency to appreciate, reducing read more..

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    CHAPTER 12 The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime | 371 PROBLEMS AND APPLICA TIONS a. How would a change in the nominal exchange rate affect competitiveness in the short run when prices are sticky? b. Suppose you wanted to make domestic indus- tries more competitive but did not want to alter aggregate income. According to the read more..

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    372 | PA R T I V Business Cycle Theory: The Economy in the Short Run domestic goods Pd and the price of foreign goods measured in foreign currency Pf are fixed. a. Suppose that we graph the LM* curve for given values of Pd and Pf (instead of the usual P). Is this LM* curve still vertical? Explain. b. What is the effect of expansionary fiscal poli- cy under read more..

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    When analyzing policies in an economy such as that of the United States, we need to combine the closed-economy logic of the IS–LM model and the small- open-economy logic of the Mundell–Fleming model. This appendix presents a model for the intermediate case of a large open economy. As we discussed in the appendix to Chapter 5, a large open economy dif- fers from a read more..

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    axis. The IS and LM curves together determine the equilibrium level of income and the equilibrium interest rate. The new net-capital-outflow term in the IS equation, CF(r), makes this IS curve flatter than it would be in a closed economy. The more responsive inter- national capital flows are to the interest rate, the flatter the IS curve is. You might recall read more..

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    Fiscal Policy Figure 12-16 examines the impact of a fiscal expansion. An increase in govern- ment purchases or a cut in taxes shifts the IS curve to the right. As panel (a) illus- trates, this shift in the IS curve leads to an increase in the level of income and an increase in the interest rate. These two effects are similar to those in a closed economy. Yet, read more..

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    the fiscal-policy multipliers. In a large open economy, there is yet another off- setting factor: as the interest rate rises, the net capital outflow falls, the currency appreciates in the foreign-exchange market, and net exports fall. Together these effects are not large enough to make fiscal policy powerless, as it is in a small open economy, but they do reduce read more..

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    We can now see that the monetary transmission mechanism works through two channels in a large open economy. As in a closed economy, a monetary expansion lowers the interest rate, which stimulates investment. As in a small open economy, a monetary expansion causes the currency to depreciate in the market for foreign exchange, which stimulates net exports. Both effects read more..

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    378 | PA R T I V Business Cycle Theory: The Economy in the Short Run b. If the CF function changes in this way, what happens to the slope of the IS curve? c. How does this change in the IS curve affect the Fed’s ability to control the interest rate? d. How does this change in the IS curve affect the Fed’s ability to control national income? 3. Suppose read more..

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    379 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment Probably the single most important macroeconomic relationship is the Phillips curve. —George Akerlof There is always a temporary tradeoff between inflation and unemployment; there is no permanent tradeoff. The temporary tradeoff comes not from inflation per se, but from unanticipated inflation, which read more..

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    380 | PA R T I V Business Cycle Theory: The Economy in the Short Run understanding of short-run aggregate supply to better reflect the real world in which some prices are sticky and others are not. After examining the basic theory of the short-run aggregate supply curve, we establish a key implication. We show that this curve implies a tradeoff between two measures read more..

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    CHAPTER 13 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment | 381 The Sticky-Price Model The most widely accepted explanation for the upward-sloping short-run aggre- gate supply curve is called the sticky-price model. This model emphasizes that firms do not instantly adjust the prices they charge in response to changes in demand. Sometimes prices are set read more..

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    Now assume that there are two types of firms. Some have flexible prices: they always set their prices according to this equation. Others have sticky prices: they announce their prices in advance based on what they expect economic condi- tions to be. Firms with sticky prices set prices according to p = EP + a(EY − EY − ), where, as before, E represents the read more..

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    CHAPTER 13 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment | 383 where a = s/[(1 – s)a]. The sticky-price model says that the deviation of output from the natural level is positively associated with the deviation of the price level from the expected price level. 2 An Alternative Theory: The Imperfect-Information Model Another explanation for the read more..

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    384 | PA R T I V Business Cycle Theory: The Economy in the Short Run The other possibility is that the farmer did not expect the price level to increase (or to increase by this much). When she observes the increase in the price of asparagus, she is not sure whether other prices have risen (in which case asparagus’s relative price is unchanged) or whether read more..

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    CHAPTER 13 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment | 385 International Differences in the Aggregate Supply Curve Although all countries experience economic fluctuations, these fluctuations are not exactly the same everywhere. International differences are intriguing puzzles in themselves, and they often provide a way to test alternative economic read more..

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    Note that the sticky-price model can also explain Lucas’s finding that coun- tries with variable aggregate demand have steep aggregate supply curves. If the price level is highly variable, few firms will commit to prices in advance (s will be small). Hence, the aggregate supply curve will be steep ( a will be small). ■ Implications We have seen two models of read more..

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    Now that we have a better understanding of aggregate supply, let’s put aggregate supply and aggregate demand back together. Figure 13-2 uses our aggregate supply equation to show how the economy responds to an unex- pected increase in aggregate demand attributable, say, to an unexpected mon- etary expansion. In the short run, the equilibrium moves from point A to read more..

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    13-2 Inflation, Unemployment, and the Phillips Curve Two goals of economic policymakers are low inflation and low unemployment, but often these goals conflict. Suppose, for instance, that policymakers were to use monetary or fiscal policy to expand aggregate demand. This policy would move the economy along the short-run aggregate supply curve to a point of higher output and read more..

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    CHAPTER 13 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment | 389 With one addition, one subtraction, and one substitution, we can transform this equation into the Phillips curve relationship between inflation and unemployment. Here are the three steps. First, add to the right-hand side of the equation a supply shock v to represent exogenous read more..

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    when we are studying unemployment and inflation. But we should not lose sight of the fact that the Phillips curve and the aggregate supply curve are two sides of the same coin. Adaptive Expectations and Inflation Inertia To make the Phillips curve useful for analyzing the choices facing policymakers, we need to specify what determines expected inflation. A simple read more..

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    CHAPTER 13 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment | 391 there are no supply shocks, the continued rise in price level neither speeds up nor slows down. This inertia arises because past inflation influences expectations of future inflation and because these expectations influence the wages and prices that people set. Robert Solow captured the read more..

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    unemployment in the United States from 1960 to 2008. This data, spanning almost half a century, illustrates some of the causes of rising or falling inflation. The 1960s showed how policymakers can, in the short run, lower unemploy- ment at the cost of higher inflation. The tax cut of 1964, together with expan- sionary monetary policy, expanded aggregate demand and read more..

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    first raised oil prices in the mid-1970s, pushing the inflation rate up to about 10 percent. This adverse supply shock, together with temporarily tight monetary policy, led to a recession in 1975. High unemployment during the recession reduced inflation somewhat, but further OPEC price hikes pushed inflation up again in the late 1970s. The 1980s began with high inflation read more..

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    and unemployment. In the short run, for a given level of expected inflation, pol- icymakers can manipulate aggregate demand to choose any combination of infla- tion and unemployment on this curve, called the short-run Phillips curve. Notice that the position of the short-run Phillips curve depends on the expected rate of inflation. If expected inflation rises, the curve read more..

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    CHAPTER 13 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment | 395 policymaker cannot keep inflation above expected inflation (and thus unem- ployment below its natural rate) forever. Eventually, expectations adapt to whatever inflation rate the policymaker has chosen. In the long run, the clas- sical dichotomy holds, unemployment returns to its natural read more..

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    396 | PA R T I V Business Cycle Theory: The Economy in the Short Run natural rate? Before deciding whether to reduce inflation, policymakers must know how much output would be lost during the transition to lower inflation. This cost can then be compared with the benefits of lower inflation. Much research has used the available data to examine the Phillips curve quan- read more..

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    change expectations, and an evaluation of any policy change must incorporate this effect on expectations. If people do form their expectations rationally, then inflation may have less inertia than it first appears. Here is how Thomas Sargent, a prominent advocate of rational expectations, describes its implications for the Phillips curve: An alternative “rational read more..

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    398 | PA R T I V Business Cycle Theory: The Economy in the Short Run and unemployment downward, permitting a lower rate of inflation without higher unemployment. Although the rational-expectations approach remains controversial, almost all economists agree that expectations of inflation influence the short-run tradeoff between inflation and unemployment. The credibility of a policy read more..

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    at a smaller cost than many economists had predicted. One explanation is that Volcker’s tough stand was credible enough to influence expectations of inflation directly. Yet the change in expectations was not large enough to make the dis- inflation painless: in 1982 unemployment reached its highest level since the Great Depression. Although the Volcker disinflation is only one read more..

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    400 | PA R T I V Business Cycle Theory: The Economy in the Short Run The natural-rate hypothesis allows macroeconomists to study separately short-run and long-run developments in the economy. It is one expression of the classical dichotomy. Some economists, however, have challenged the natural-rate hypothesis by suggesting that aggregate demand may affect output and employment read more..

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    13-3 Conclusion We began this chapter by discussing two models of aggregate supply, each of which focuses on a different reason why, in the short run, output rises above its natural level when the price level rises above the level that people had expect- ed. Both models explain why the short-run aggregate supply curve is upward sloping, and both yield a read more..

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    402 | PA R T I V Business Cycle Theory: The Economy in the Short Run 1. Explain the two theories of aggregate supply. On what market imperfection does each theo- ry rely? What do the theories have in common? 2. How is the Phillips curve related to aggregate supply? 3. Why might inflation be inertial? QUES TIONS F O R REVIEW 4. Explain the differences between read more..

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    CHAPTER 13 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment | 403 diagrams: one for the IS–LM model, one for the AD–AS model, and one for the Phillips curve. 5. Assume that people have rational expectations and that the economy is described by the sticky-price model. Explain why each of the fol- lowing propositions is true. a. Only read more..

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    404 | PA R T I V Business Cycle Theory: The Economy in the Short Run What do you think Blinder meant by this? What are the policy implications of the viewpoint Blinder is advocating? Do you agree? Why or why not? 9. Go to the Web site of the Bureau of Labor Sta- tistics ( For each of the past five years, find the inflation rate as measured by read more..

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    APPENDIX The Mother of All Models In the previous chapters, we have seen many models of how the economy works. When learning these models, it can be hard to see how they are related. Now that we have finished developing the model of aggregate demand and aggregate supply, this is a good time to look back at what we have learned. This appendix sketches a read more..

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    related to one another. In particular, many of the models we have been studying are special cases of this large model. Let’s consider six special cases in particular. (A prob- lem at the end of this section examines a few more.) Special Case 1: The Classical Closed Economy Suppose that EP = P, L(i, Y ) = (1/V )Y, and CF(r − r*) = 0. In words, these read more..

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    CHAPTER 13 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment | 407 You should now see the value in this big model. Even though the model is too large to be useful in developing an intuitive understanding of how the econ- omy works, it shows that the different models we have been studying are close- ly related. In each chapter, we read more..

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    Keynesian special case (which occurs when a equals infinity, so the price level is completely fixed). 2. Closed or Open? You decide whether you want a closed economy (which occurs when the capital flow CF always equals zero) or an open economy (which allows CF to differ from zero). 3. Small or Large? If you want an open economy, you decide whether you want a small read more..

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    409 A Dynamic Model of Aggregate Demand and Aggregate Supply The important thing in science is not so much to obtain new facts as to discover new ways of thinking about them. William Bragg 14 CHAPTER This chapter continues our analysis of short-run economic fluctuations. It presents a model that we will call the dynamic model of aggregate demand and aggregate supply. This read more..

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    410 | PA R T I V Business Cycle Theory: The Economy in the Short Run create a surprisingly original meal. In this case, we will mix familiar econom- ic relationships in a new way to produce deeper insights into the nature of short-run economic fluctuations. Compared to the models in preceding chapters, the dynamic AD –AS model is closer to those studied by read more..

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    The first term on the right-hand side of the equation, Y − t, implies that the demand for goods and services rises with the economy’s natural level of output. In most cases, we can simplify matters by taking this variable to be constant; that is, Y − t will be assumed to be the same for every time period t. We will, however, examine how this model read more..

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    412 | PA R T I V Business Cycle Theory: The Economy in the Short Run level between periods t − 1 and t. Similarly, pt+1 is the percentage change in the price level that will occur between periods t and t + 1. As of time period t, pt+1 represents a future inflation rate and therefore is not yet known. Note that the subscript on a variable tells us when read more..

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    CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply | 413 to the state of economic activity and how quickly firms adjust prices in response to changes in cost. In this model, the state of the business cycle is measured by the deviation of output from its natural level (Yt − Y − t ). The Phillips curves in Chapter 13 sometimes emphasized the read more..

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    414 | PA R T I V Business Cycle Theory: The Economy in the Short Run The Nominal Interest Rate: The Monetary-Policy Rule The last piece of the model is the equation for monetary policy. We assume that the central bank sets a target for the nominal interest rate it based on inflation and output using this rule: it = pt + r + vp(pt − pt*) + vY(Yt − Y − read more..

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    CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply | 415 1 John B. Taylor, “Discretion Versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy 39 (1993): 195–214. hitting that target requires adjustments in the money supply. For this model, we do not need to specify the equilibrium condition for the money market, but we read more..

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    416 | PA R T I V Business Cycle Theory: The Economy in the Short Run the real federal funds rate equals 2 percent when inflation is 2 percent and GDP is at its natural level. The first constant of 2 percent in this equation can be inter- preted as an estimate of the natural rate of interest r, and the second constant of 2 percent subtracted from inflation read more..

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    1 4-2 Solving the Model We have now looked at each of the pieces of the dynamic AD –AS model. To summarize, here are the five equations that make up the model: Yt = Y − t − a (rt − r) + et The Demand for Goods and Services rt = it − Et pt+1 The Fisher Equation pt = Et−1 pt + f(Yt − Y − t ) + ut The Phillips Curve Et pt+1 = pt Adaptive read more..

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    the equations as well as the previous period’s inflation rate. Lagged inflation pt−1 is called a predetermined variable. That is, it is a variable that was endogenous in the past but, because it is fixed by the time when we arrive in period t, is essentially exogenous for the purposes of finding the current equilibrium. We are almost ready to put these pieces read more..

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    are the variables of central interest. As in the conventional AD–AS model, output will be on the horizontal axis. But because the price level has now faded into the background, the vertical axis in our graphs will now represent the inflation rate. To generate this graph, we need two equations that summarize the relation- ships between output Yt and inflation pt. read more..

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    420 | PA R T I V Business Cycle Theory: The Economy in the Short Run The Dynamic Aggregate Demand Curve The dynamic aggregate supply curve is one of the two relationships between output and inflation that determine the economy’s short-run equilibrium. The other relationship is (no surprise) the dynamic aggregate demand curve. We derive it by combining four equations read more..

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    CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply | 421 interest rate based on macroeconomic conditions, and it allows the money sup- ply to adjust accordingly. The dynamic aggregate demand curve is downward sloping because of the following mechanism. When inflation rises, the central bank follows its rule and responds by increasing the nominal interest rate. read more..

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    422 | PA R T I V Business Cycle Theory: The Economy in the Short Run The Short-Run Equilibrium The economy’s short-run equilibrium is determined by the intersection of the dynamic aggregate demand curve and the dynamic aggregate supply curve. The economy can be represented algebraically using the two equations we have just derived: Yt = Y − t – [ avp/(1 + avY)](pt read more..

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    aggregate supply curve in that period, which in turn affects output and inflation in period t + 1, which then affects expected inflation in period t + 2, and so on. These linkages of economic outcomes across time periods will become clear as we work through a series of examples. 14-3 Using the Model Let’s now use the dynamic AD –AS model to analyze how the read more..

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    424 | PA R T I V Business Cycle Theory: The Economy in the Short Run The shifts in these curves move the economy’s equilibrium in the figure from point A to point B. Output Yt increases by exactly as much as the natural level Y − t. Inflation is unchanged. The story behind these conclusions is as follows: When the natural level of output increases, the read more..

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    CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply | 425 curve shifts upward by exactly the size of the shock, which we assumed to be 1 percentage point. Because the supply shock ut is not a variable in the dynamic aggregate demand equation, the DAD curve is unchanged. Therefore, the econ- omy moves along the dynamic aggregate demand curve read more..

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    426 | PA R T I V Business Cycle Theory: The Economy in the Short Run In the periods after the shock occurs, expected inflation is higher because expectations depend on past inflation. In period t + 1, for instance, the economy is at point C. Even though the shock variable ut returns to its normal value of zero, the dynamic aggregate supply curve does not read more..

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    nearby FYI box for their description.) As panel (a) shows, the shock ut spikes upward by 1 percentage point in period t and then returns to zero in subsequent periods. Inflation, shown in panel (d), rises by 0.9 percentage point and gradual- ly returns to its target of 2 percent over a long period of time. Output, shown in panel (b), falls in response to read more..

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    428 | PA R T I V Business Cycle Theory: The Economy in the Short Run economy does not immediately return to its initial equilibrium, point A. The peri- od of high demand has increased inflation and thereby expected inflation. High expected inflation keeps the dynamic aggregate supply curve higher than it was ini- tially. As a result, when demand falls off, the read more..

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    CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply | 429 A Shift in Monetary Policy Suppose that the central bank decides to reduce its target for the inflation rate. Specifically, imagine that, in period t, pt* falls from 2 percent to 1 percent and thereafter remains at that lower level. Let’s consider how the economy will react to this change in read more..

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    curve shifts to the left, as shown in Figure 14-10. (To be precise, it shifts down- ward by exactly 1 percentage point.) Because target inflation does not enter the dynamic aggregate supply equation, the DAS curve does not shift initially. The economy moves from its initial equilibrium, point A, to a new equilibrium, point B. Output and inflation both fall. read more..

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    CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply | 431 toward DASfinal, the economy approaches a new long-run equilibrium at point Z, where output is back at its natural level (Yfinal = Y − all) and inflation is at its new lower target ( pt*,t+1, . . . = 1 percent). Figure 14-11 shows the response of the variables over time to a reduction in read more..

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    to 4.2 percent. Over time, however, the nominal interest rate falls as inflation and expected inflation fall toward the new target rate; eventually, it approaches its new long-run value of 3.0 percent. Thus, a shift toward a lower inflation target increas- es the nominal interest rate in the short run but decreases it in the long run. We close with a caveat: read more..

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    This phenomenon is illustrated in Figure 14-12. In the two panels of this fig- ure, the economy experiences the same supply shock. In panel (a), the dynamic aggregate demand curve is nearly flat, so the shock has a small effect on inflation but a large effect on output. In panel (b), the dynamic aggregate demand curve is steep, so the shock has a large read more..

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    Two key parameters here are vp and vY, which govern how much the central bank’s interest rate target responds to changes in inflation and output. When the central bank chooses these policy parameters, it determines the slope of the DAD curve and thus the economy’s short-run response to supply shocks. On the one hand, suppose that, when setting the interest rate, read more..

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    CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply | 435 The Fed Versus the European Central Bank According to the dynamic AD –AS model, a key policy choice facing any cen- tral bank concerns the parameters of its policy rule. The monetary parameters vp and vY determine how much the interest rate responds to macroeconomic con- ditions. As we have just read more..

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    The Taylor Principle How much should the nominal interest rate set by the central bank respond to changes in inflation? The dynamic AD –AS model does not give a definitive answer, but it does offer an important guideline. Recall the equation for monetary policy: it = pt + r + vp(pt − pt*) + vY(Yt − Y − t). According to this equation, a 1-percentage-point read more..

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    Taylor principle, after economist John Taylor, who emphasized its impor- tance in the design of monetary policy. Most of our analysis in this chapter assumed that the Taylor principle holds (that is, we assumed that vp > 0). We can see now that there is good reason for a central bank to adhere to this guideline. CHAPTER 14 A Dynamic Model of Aggregate Demand read more..

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    announced a change in monetary policy that eventually brought inflation back under control. Volcker and his successor, Alan Greenspan, then presided over low and stable inflation for the next quarter century. The dynamic AD –AS model offers a new perspective on these events. According to research by monetary economists Richard Clarida, Jordi Gali, and Mark Gertler, the read more..

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    CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply | 439 1 4-5 Conclusion: Toward DSGE Models If you go on to take more advanced courses in macroeconomics, you will likely learn about a class of models called dynamic, stochastic, general equilibrium models, often abbreviated as DSGE models. These models are dynamic because they trace the path of variables read more..

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    440 | PA R T I V Business Cycle Theory: The Economy in the Short Run PROBLEMS AND APPLICA TIONS the five equations to derive the value of each variable in the model. Be sure to show each step you follow. 1. On a carefully labeled graph, draw the dynamic aggregate supply curve. Explain why it has the slope it has. 2. On a carefully labeled graph, draw the read more..

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    CHAPTER 14 A Dynamic Model of Aggregate Demand and Aggregate Supply | 441 2. Suppose the monetary-policy rule has the wrong natural rate of interest. That is, the central bank follows this rule: it = pt + r' + vp(pt − pt*) + vY(Yt − Y − t) where r' does not equal r, the natural rate of interest in the equation for goods demand. The rest of the dynamic AD read more..

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    c. Suppose the central bank does not respond to changes in inflation but only to changes in output, so that vp = 0. How, if at all, would this fact change your answer to part (a)? d. Suppose the central bank does not follow the Taylor principle but instead raises the nominal interest rate only 0.8 percentage point for each percentage-point increase in inflation. In read more..

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    PA R T V Macroeconomic Policy Debates read more..

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    445 Stabilization Policy The Federal Reserve’s job is to take away the punch bowl just as the party gets going. —William McChesney Martin What we need is not a skilled monetary driver of the economic vehicle continuously turning the steering wheel to adjust to the unexpected irregularities of the route, but some means of keeping the monetary passenger who is in the back read more..

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    446 | PA R T V Macroeconomic Policy Debates policymakers should use the theory of short-run economic fluctuations devel- oped in the preceding chapters. In this chapter we ask two questions that arise in this debate. First, should monetary and fiscal policy take an active role in trying to stabilize the economy, or should policy remain passive? Second, should policymakers read more..

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    Lags in the Implementation and Effects of Policies Economic stabilization would be easy if the effects of policy were immediate. Making policy would be like driving a car: policymakers would simply adjust their instruments to keep the economy on the desired path. Making economic policy, however, is less like driving a car than it is like pilot- ing a large ship. A car read more..

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    end up stimulating the economy when it is heating up or depressing the econ- omy when it is cooling off. Advocates of active policy admit that such lags do require policymakers to be cautious. But, they argue, these lags do not neces- sarily mean that policy should be completely passive, especially in the face of a severe and protracted economic downturn, such read more..

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    CHAPTER 15 Stabilization Policy | 449 Mistakes in Forecasting “Light showers, bright intervals, and moderate winds.” This was the forecast offered by the renowned British national weather service on October 14, 1987. The next day Britain was hit by its worst storm in more than two centuries. Like weather forecasts, economic forecasts are a crucial input to private and read more..

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    These episodes—the Great Depression, the recession and recovery of 1982, and the recent economic downturn—show that many of the most dramatic eco- nomic events are unpredictable. Although private and public decisionmakers have little choice but to rely on economic forecasts, they must always keep in mind that these forecasts come with a large margin of error. ■ read more..

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    there is still much that we do not know. Economists cannot be completely con- fident when they assess the effects of alternative policies. This ignorance suggests that economists should be cautious when offering policy advice. In his writings on macroeconomic policymaking, Lucas has emphasized that economists need to pay more attention to the issue of how people form read more..

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    452 | PA R T V Macroeconomic Policy Debates policy has successfully insulated the economy from these shocks, then the case for active policy should be clear. Conversely, if the economy has experienced few large shocks, and if the fluctuations we have observed can be traced to inept eco- nomic policy, then the case for passive policy should be clear. In other read more..

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    period appears almost as volatile as the early period, suggesting that the volatility of the early period may be largely an artifact of how the data were assembled. Romer’s work is part of the continuing debate over whether macroeconom- ic policy has improved the performance of the economy. Although her work remains controversial, most economists now believe that the read more..

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    454 | PA R T V Macroeconomic Policy Debates are incompetent or opportunistic, then we may not want to give them the dis- cretion to use the powerful tools of monetary and fiscal policy. Incompetence in economic policy arises for several reasons. Some econo- mists view the political process as erratic, perhaps because it reflects the shift- ing power of special interest read more..

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    Time inconsistency is illustrated most simply with a political rather than an economic example—specifically, public policy about negotiating with terrorists over the release of hostages. The announced policy of many nations is that they will not negotiate over hostages. Such an announcement is intended to deter terrorists: if there is nothing to be gained from kidnapping read more..

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    456 | PA R T V Macroeconomic Policy Debates has been discovered, the government is tempted to revoke the patent or to regulate the price to make the drug more affordable. ■ To encourage good behavior, a parent announces that he or she will pun- ish a child whenever the child breaks a rule. But after the child has mis- behaved, the parent is tempted to forgive read more..

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    Rules for Monetary Policy Even if we are convinced that policy rules are superior to discretion, the debate over macroeconomic policy is not over. If the Fed were to commit to a rule for monetary policy, what rule should it choose? Let’s discuss briefly three policy rules that various economists advocate. Some economists, called monetarists, advocate that the Fed keep read more..

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    458 | PA R T V Macroeconomic Policy Debates Inflation Targeting: Rule or Constrained Discretion? Since the late 1980s, many of the world’s central banks—including those of Aus- tralia, Canada, Finland, Israel, New Zealand, Spain, Sweden, and the United King- dom—have adopted some form of inflation targeting. Sometimes inflation targeting takes the form of a central read more..

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    CHAPTER 15 Stabilization Policy | 459 Central-Bank Independence Suppose you were put in charge of writing the constitution and laws for a country. Would you give the president of the country authority over the poli- cies of the central bank? Or would you allow the central bank to make deci- sions free from such political influence? In other words, assuming that monetary read more..

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    460 | PA R T V Macroeconomic Policy Debates 15-3 Conclusion: Making Policy in an Uncertain World In this chapter we have examined whether policy should take an active or passive role in responding to economic fluctuations and whether policy should be con- ducted by rule or by discretion. There are many arguments on both sides of these questions. Perhaps the only read more..

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    [T]he ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices read more..

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    462 | PA R T V Macroeconomic Policy Debates 3. Describe the Lucas critique. 4. How does a person’s interpretation of macroeconomic history affect his view of macroeconomic policy? 5. What is meant by the “time inconsistency’’ of economic policy? Why might policymakers be tempted to renege on an announcement they made earlier? In this situation, what is the advantage of a read more..

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    In this appendix, we examine more formally the time-inconsistency argument for rules rather than discretion. This analysis is relegated to an appendix because it requires some calculus. 7 Suppose that the Phillips curve describes the relationship between inflation and unemployment. Letting u denote the unemployment rate, u n the natural rate of unemployment, p the rate of read more..

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    What is the optimal rule? Because unemployment is at its natural rate regard- less of the level of inflation legislated by the rule, there is no benefit to having any inflation at all. Therefore, the optimal fixed rule requires that the Fed pro- duce zero inflation. Now let’s consider discretionary monetary policy. Under discretion, the econ- omy works as follows: 1. read more..

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    game against private decisionmakers who have rational expectations. Unless it is committed to a fixed rule of zero inflation, the Fed cannot get private agents to expect zero inflation. Suppose, for example, that the Fed simply announces that it will follow a zero- inflation policy. Such an announcement by itself cannot be credible. After private agents have formed read more..

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    read more..

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    467 Government Debt and Budget Deficits Blessed are the young, for they shall inherit the national debt. —Herbert Hoover I think we ought to just go ahead and make “zillion” a real number. “Gazillion,” too. A zillion could be ten million trillions, and a gazillion could be a trillion zillions. It seems to me it’s time to do this. —George Carlin 16 CHAPTER read more..

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    468 | PA R T V Macroeconomic Policy Debates economists. According to the Ricardian view, government debt does not influ- ence national saving and capital accumulation. As we will see, the debate between the traditional and Ricardian views of government debt arises from disagree- ments over how consumers respond to the government’s debt policy. Section 16-5 then looks at read more..

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    amount of government debt for 28 major countries expressed as a percentage of each country’s GDP. At the top of the list are the heavily indebted countries of Japan and Italy, which have accumulated a debt that exceeds annual GDP. At the bottom are Luxembourg and Australia, which have accumulated relatively small debts. The United States is not far from the read more..

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    One instance of a large increase in government debt in peacetime began in the early 1980s. When Ronald Reagan was elected president in 1980, he was committed to reducing taxes and increasing military spending. These policies, coupled with a deep recession attributable to tight monetary policy, began a long period of substantial budget deficits. The government debt expressed read more..

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    economists in the Congressional Budget Office (CBO) and other government agencies are always trying to look ahead to see what problems and opportu- nities are likely to develop. When these economists conduct long-term pro- jections of U.S. fiscal policy, they paint a troubling picture. One reason is demographic. Advances in medical technology have been increasing life expectancy, read more..

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    472 | PA R T V Macroeconomic Policy Debates age, while giving people more incentive to save during their working years as preparation for assuming their own retirement and health costs. Resolving this debate will likely be one of the great policy challenges in the decades ahead. ■ 16-2 Problems in Measurement The government budget deficit equals government spending minus read more..

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    federal government reported a budget deficit of $28 billion. Inflation was 8.6 percent, and the government debt held at the beginning of the year by the public (excluding the Federal Reserve) was $495 billion. The deficit was there- fore overstated by pD = 0.086 × $495 billion = $43 billion. Corrected for inflation, the reported budget deficit of $28 billion turns into read more..

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    474 | PA R T V Macroeconomic Policy Debates Measurement Problem 3: Uncounted Liabilities Some economists argue that the measured budget deficit is misleading because it excludes some important government liabilities. For example, consider the pen- sions of government workers. These workers provide labor services to the gov- ernment today, but part of their compensation is deferred read more..

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    CHAPTER 16 Government Debt and Budget Deficits | 475 future, the banks were expected to pay the Treasury a preferred dividend (similar to interest) and eventually to repay the initial investment as well. When that repay- ment occurred, the Treasury would relinquish its ownership share in the banks. The question then arose: how should the government’s accounting statements read more..

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    These automatic changes in the deficit are not errors in measurement, because the government truly borrows more when a recession depresses tax rev- enue and boosts government spending. But these changes do make it more dif- ficult to use the deficit to monitor changes in fiscal policy. That is, the deficit can rise or fall either because the government has changed policy read more..

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    CHAPTER 16 Government Debt and Budget Deficits | 477 Before responding to the senator, you open your favorite economics textbook—this one, of course—to see what the models predict for such a change in fiscal policy. To analyze the long-run effects of this policy change, you turn to the models in Chapters 3 through 8. The model in Chapter 3 shows that a tax cut read more..

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    employment, although inflation would likely be higher as well. Future genera- tions would bear much of the burden of today’s budget deficits: they would be born into a nation with a smaller capital stock and a larger foreign debt. Your faithful servant, CBO Economist 478 | PA R T V Macroeconomic Policy Debates FYI Throughout this book we have summarized the tax system read more..

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    The senator replies: Dear CBO Economist: Thank you for your letter. It made sense to me. But yesterday my commit- tee heard testimony from a prominent economist who called herself a “Ricar- dian’’ and who reached quite a different conclusion. She said that a tax cut by itself would not stimulate consumer spending. She concluded that the budget deficit would therefore read more..

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    480 | PA R T V Macroeconomic Policy Debates One can view this argument another way. Suppose that the government bor- rows $1,000 from the typical citizen to give that citizen a $1,000 tax cut. In essence, this policy is the same as giving the citizen a $1,000 government bond as a gift. One side of the bond says, “The government owes you, the bondhold- er, read more..

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    current spending, rational consumers look ahead to the future taxes required to support this debt. Thus, the Ricardian view presumes that people have substan- tial knowledge and foresight. One possible argument for the traditional view of tax cuts is that people are shortsighted, perhaps because they do not fully comprehend the implications of government budget deficits. It read more..

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    consumers would spend the extra income, thereby stimulating aggregate demand and helping the economy recover from the recession. Bush seemed to be assum- ing that consumers were shortsighted or faced binding borrowing constraints. Gauging the actual effects of this policy is difficult with aggregate data, because many other things were happening at the same time. Yet some read more..

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    According to Barro’s analysis, the relevant decisionmaking unit is not the indi- vidual, whose life is finite, but the family, which continues forever. In other words, an individual decides how much to consume based not only on his own income but also on the income of future members of his family. A debt-financed tax cut may raise the income an individual read more..

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    Making a Choice Having seen the traditional and Ricardian views of government debt, you should ask yourself two sets of questions. First, with which view do you agree? If the government cuts taxes today, runs a budget deficit, and raises taxes in the future, how will the policy affect the econ- omy? Will it stimulate consumption, as the traditional view holds? Or read more..

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    have the foresight to see that government borrowing today will result in future taxes levied on them or their descendants? Do you believe that consumers will save the extra income to offset that future tax liability? We might hope that the evidence could help us decide between these two views of government debt. Yet when economists examine historical episodes of large read more..

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    Stabilization A budget deficit or surplus can help stabilize the economy. In essence, a balanced-budget rule would revoke the automatic stabilizing powers of the system of taxes and transfers. When the economy goes into a recession, taxes automatically fall, and transfers automatically rise. Although these automat- ic responses help stabilize the economy, they push the budget read more..

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    CHAPTER 16 Government Debt and Budget Deficits | 487 fiscal reforms that include large cuts in government spending and therefore a reduced need for seigniorage. In addition to this link between the budget deficit and inflation, some econ- omists have suggested that a high level of debt might also encourage the gov- ernment to create inflation. Because most government debt is read more..

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    to balance the budget” can force politicians to judge whether spending’s “benefits really justify its costs.” These arguments have led some economists to favor a constitutional amend- ment requiring Congress to pass a balanced budget. Often these proposals have escape clauses for times of national emergency, such as wars and depressions, when a budget deficit is a read more..

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    CHAPTER 16 Government Debt and Budget Deficits | 489 The Benefits of Indexed Bonds In 1997, the U.S. Treasury Department started to issue bonds that pay a return based on the consumer price index. These bonds typically pay a low interest rate of about 2 percent, so a $1,000 bond pays only $20 per year in interest. But that interest payment grows with the overall read more..

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    490 | PA R T V Macroeconomic Policy Debates The Treasury’s new indexed bonds, therefore, produced many benefits: less inflation risk, more financial innovation, better government incentives, more informed monetary policy, and easier lives for students and teachers of macroeconomics. 6 ■ 16-6 Conclusion Fiscal policy and government debt are central in the U.S. political read more..

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    to the future. The debate between the traditional and Ricardian views of government debt is ultimately a debate over how consumers behave. Are consumers rational or shortsighted? Do they face binding borrowing constraints? Are they economically linked to future generations through altruistic bequests? Economists’ views of government debt hinge on their answers to these questions. 5. read more..

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    492 | PA R T V Macroeconomic Policy Debates the country’s debt.” Would such actions by U.S. corporations actually reduce the national debt as it is now measured? How would your answer change if the U.S. government adopted capital budgeting? Do you think these actions represent a true reduction in the government’s indebted- ness? Do you think Taco Bell was serious about read more..

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    More on the Microeconomics Behind Macroeconomics PA R T V I read more..

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    495 Consumption Consumption is the sole end and purpose of all production. —Adam Smith 17 CHAPTER How do households decide how much of their income to consume today and how much to save for the future? This is a microeconomic question because it addresses the behavior of individual decisionmakers. Yet its answer has important macroeconomic consequences. As we have seen in read more..

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    17-1 John Maynard Keynes and the Consumption Function We begin our study of consumption with John Maynard Keynes’s General Theo- ry, which was published in 1936. Keynes made the consumption function cen- tral to his theory of economic fluctuations, and it has played a key role in macroeconomic analysis ever since. Let’s consider what Keynes thought about the consumption read more..

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    On the basis of these three conjectures, the Keynesian consumption function is often written as C = C − + cY, C − > 0, 0 < c < 1, where C is consumption, Y is disposable income, C − is a constant, and c is the marginal propensity to consume. This consumption function, shown in Figure 17-1, is graphed as a straight line. C − determines the read more..

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    498 | PA R T V I More on the Microeconomics Behind Macroeconomics consumed more, which confirms that the marginal propensity to consume is greater than zero. They also found that households with higher income saved more, which confirms that the marginal propensity to consume is less than one. In addition, these researchers found that higher-income households saved a larg- read more..

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    CHAPTER 17 Consumption | 499 work. He discovered that the ratio of consumption to income was remarkably stable from decade to decade, despite large increases in income over the period he studied. Again, Keynes’s conjecture that the average propensity to consume would fall as income rose appeared not to hold. The failure of the secular-stagnation hypothesis and the findings read more..

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    how Modigliani and Friedman tried to solve the consumption puzzle, we must discuss Irving Fisher’s contribution to consumption theory. Both Modigliani’s life-cycle hypothesis and Friedman’s permanent-income hypothesis rely on the theory of consumer behavior proposed much earlier by Irving Fisher. 17-2 Irving Fisher and Intertemporal Choice The consumption function introduced by read more..

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    where S is saving. In the second period, consumption equals the accumulated saving, including the interest earned on that saving, plus second-period income. That is, C2 = (1 + r)S + Y2, where r is the real interest rate. For example, if the real interest rate is 5 percent, then for every $1 of saving in period one, the consumer enjoys an extra $1.05 of read more..

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    the two periods. At point B, the consumer consumes nothing in the first period (C1 = 0) and saves all income, so second-period consumption C2 is (1 + r)Y1 + Y2. At point C, the consumer plans to consume nothing in the second period (C2 = 0) and borrows as much as possible against second-period income, so 502 | PA R T V I More on the Microeconomics Behind read more..

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    first-period consumption C1 is Y1 + Y2/(1 + r). These are only three of the many combinations of first- and second-period consumption that the consumer can afford: all the points on the line from B to C are available to the consumer. Consumer Preferences The consumer’s preferences regarding consumption in the two periods can be rep- resented by indifference curves. An read more..

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    1 unit of first-period consumption. When first-period consumption is low and second-period consumption is high, as at point Y, the marginal rate of substitu- tion is high: the consumer requires much additional second-period consump- tion to give up 1 unit of first-period consumption. The consumer is equally happy at all points on a given indifference curve, but he prefers read more..

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    CHAPTER 17 Consumption | 505 budget constraint is the indifference curve that just barely touches the budget line, which is curve IC3 in the figure. The point at which the curve and line touch—point O, for “optimum”—is the best combination of consumption in the two periods that the consumer can afford. Notice that, at the optimum, the slope of the indifference read more..

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    that consumption in period one and consumption in period two are both nor- mal goods. The key conclusion from Figure 17-6 is that regardless of whether the increase in income occurs in the first period or the second period, the consumer spreads it over consumption in both periods. This behavior is sometimes called consumption smoothing. Because the consumer can borrow and read more..

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    consumption in period two becomes less expensive relative to consumption in period one when the interest rate rises. That is, because the real interest rate earned on saving is higher, the consumer must now give up less first-period con- sumption to obtain an extra unit of second-period consumption. This substitu- tion effect tends to make the consumer choose more read more..

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    508 | PA R T V I More on the Microeconomics Behind Macroeconomics The inability to borrow prevents current con- sumption from exceeding current income. A con- straint on borrowing can therefore be expressed as C1 ≤ Y1. This inequality states that consumption in period one must be less than or equal to income in period one. This additional constraint on the consumer is read more..

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    binding, and consumption in both periods depends on the present value of life- time income, Y1 + [Y2/(1 + r)]. For other consumers, the borrowing constraint binds, and the consumption function is C1 = Y1 and C2 = Y2. Hence, for those con- sumers who would like to borrow but cannot, consumption depends only on current income. 17-3 Franco Modigliani and the Life-Cycle read more..

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    510 | PA R T V I More on the Microeconomics Behind Macroeconomics income from those times in life when income is high to those times when it is low. This interpretation of consumer behavior formed the basis for his life-cycle hypothesis. 1 The Hypothesis One important reason that income varies over a person’s life is retirement. Most people plan to stop working at about read more..

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    particular, aggregate consumption depends on both wealth and income. That is, the economy’s consumption function is C = aW + bY, where the parameter a is the marginal propensity to consume out of wealth, and the parameter b is the marginal propensity to consume out of income. Implications Figure 17-10 graphs the relationship between consumption and income predict- ed by read more..

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    512 | PA R T V I More on the Microeconomics Behind Macroeconomics To make the same point somewhat differently, consider how the consumption function changes over time. As Figure 17-10 shows, for any given level of wealth, the life-cycle consumption function looks like the one Keynes suggested. But this func- tion holds only in the short run when wealth is constant. read more..

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    The first explanation is that the elderly are concerned about unpredictable expenses. Additional saving that arises from uncertainty is called precautionary saving. One reason for precautionary saving by the elderly is the possibility of living longer than expected and thus having to provide for a longer than average span of retirement. Another reason is the possibility of illness read more..

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    17-4 Milton Friedman and the Permanent-Income Hypothesis In a book published in 1957, Milton Friedman proposed the permanent-income hypothesis to explain consumer behavior. Friedman’s permanent-income hypothesis complements Modigliani’s life-cycle hypothesis: both use Irving Fisher’s theory of the consumer to argue that consumption should not depend on current income alone. But unlike read more..

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    CHAPTER 17 Consumption | 515 in response to transitory changes in income. For example, if a person received a permanent raise of $10,000 per year, his consumption would rise by about as much. Yet if a person won $10,000 in a lottery, he would not consume it all in one year. Instead, he would spread the extra consumption over the rest of his life. Assuming read more..

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    516 | PA R T V I More on the Microeconomics Behind Macroeconomics variation in income comes from the permanent component. Hence, in long time-series, one should observe a constant average propensity to consume, as in fact Kuznets found. CASE STUDY The 1964 Tax Cut and the 1968 Tax Surcharge The permanent-income hypothesis can help us interpret how the economy responds to read more..

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    they expect to receive in the future. Thus, the permanent-income hypothesis highlights that consumption depends on people’s expectations. Recent research on consumption has combined this view of the consumer with the assumption of rational expectations. The rational-expectations assump- tion states that people use all available information to make optimal forecasts about the future. read more..

  • Page - 557

    518 | PA R T V I More on the Microeconomics Behind Macroeconomics Hence, if consumers have rational expectations, policymakers influence the economy not only through their actions but also through the public’s expectation of their actions. Expectations, however, cannot be observed directly. Therefore, it is often hard to know how and when changes in fiscal policy alter read more..

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    17-6 David Laibson and the Pull of Instant Gratification Keynes called the consumption function a “fundamental psychological law.” Yet, as we have seen, psychology has played little role in the subsequent study of consumption. Most economists assume that consumers are rational maxi- mizers of utility who are always evaluating their opportunities and plans in order to obtain read more..

  • Page - 559

    520 | PA R T V I More on the Microeconomics Behind Macroeconomics consumer behavior? Will it offer new and better prescriptions regarding, for instance, tax policy toward saving? It is too early to give a full evaluation, but without a doubt, these questions are on the forefront of the research agenda. 6 CASE STUDY How to Get People to Save More Many read more..

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    be required to automatically enroll workers in direct-deposit retirement accounts. Employees would then be able to opt out of the system if they wished. Whether this proposal would become law was still unclear as this book was going to press. A second approach to increasing saving is to give people the opportunity to control their desires for instant gratification. One read more..

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    522 | PA R T V I More on the Microeconomics Behind Macroeconomics Economists continue to debate the importance of these determinants of consumption. There remains disagreement about, for example, the influence of interest rates on consumer spending, the prevalence of borrowing con- straints, and the importance of psychological effects. Economists sometimes disagree about economic read more..

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    CHAPTER 17 Consumption | 523 PROBLEMS AND APPLICA TIONS c. What will happen to Jill’s consumption in the first period when the interest rate increases? Is Jill better off or worse off than before the interest rate increase? 3. The chapter analyzes Fisher’s model for the case in which the consumer can save or borrow at an interest rate of r and for the case in which read more..

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    524 | PA R T V I More on the Microeconomics Behind Macroeconomics c. Graph the two budget constraints and shade the area that represents the combination of first-period and second-period consumption the consumer can choose. d. Now add to your graph the consumer’s indif- ference curves. Show three possible outcomes: one in which the consumer saves, one in which he borrows, read more..

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    525 Investment The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelope our future. —John Maynard Keynes 18 CHAPTER While spending on consumption goods provides utility to households today, spending on investment goods is aimed at providing a higher standard of living at a later date. Investment is the component of GDP that read more..

  • Page - 565

    In this chapter we build models of each type of investment to explain these fluctuations. The models will shed light on the following questions: ■ Why is investment negatively related to the interest rate? ■ What causes the investment function to shift? ■ Why does investment rise during booms and fall during recessions? At the end of the chapter, we return to these read more..

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    opposed to inventory investment, which will be used or sold within a short time. Business fixed investment includes everything from office furniture to factories, computers to company cars. The standard model of business fixed investment is called the neoclassical model of investment. The neoclassical model examines the benefits and costs to firms of owning capital goods. The model read more..

  • Page - 567

    Because the real rental price R/P equals the marginal product of capital in equi- librium, we can write R/P = aA(L/K) 1 −a. This expression identifies the variables that determine the real rental price. It shows the following: ■ The lower the stock of capital, the higher the real rental price of capital. ■ The greater the amount of labor employed, the higher the read more..

  • Page - 568

    The cost of owning capital is more complex. For each period of time that it rents out a unit of capital, the rental firm bears three costs: 1. When a rental firm borrows to buy a unit of capital, it must pay interest on the loan. If PK is the purchase price of a unit of capital and i is the nominal interest rate, then iPK is the interest cost. Notice read more..

  • Page - 569

    This equation states that the cost of capital depends on the price of capital, the real interest rate, and the depreciation rate. Finally, we want to express the cost of capital relative to other goods in the economy. The real cost of capital —the cost of buying and renting out a unit of capital measured in units of the economy’s output—is Real Cost of read more..

  • Page - 570

    We can now derive the investment function. Total spending on business fixed investment is the sum of net investment and the replacement of depreciated cap- ital. The investment function is I = In [MPK − (PK/P)(r + d)] + dK. Business fixed investment depends on the marginal product of capital, the cost of capital, and the amount of depreciation. This model shows why read more..

  • Page - 571

    532 | PA R T V I More on the Microeconomics Behind Macroeconomics product will rise. Eventually, as the capital stock adjusts, the marginal product of capital approaches the cost of capital. When the capital stock reaches a steady-state level, we can write MPK = (PK/P)(r + d). Thus, in the long run, the marginal product of capital equals the real cost of cap- read more..

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    provides. One example is the investment tax credit, a tax provision that reduces a firm’s taxes by a certain amount for each dollar spent on capital goods. Because a firm recoups part of its expenditure on new capital in lower taxes, the credit reduces the effective purchase price of a unit of capital PK. Thus, the investment tax credit reduces the cost of capital read more..

  • Page - 573

    534 | PA R T V I More on the Microeconomics Behind Macroeconomics The numerator of Tobin’s q is the value of the economy’s capital as determined by the stock market. The denominator is the price of that capital if it were pur- chased today. Tobin reasoned that net investment should depend on whether q is greater or less than 1. If q is greater than 1, read more..

  • Page - 574

    and aggregate supply. Suppose, for instance, that you observe a fall in stock prices. Because the replacement cost of capital is fairly stable, a fall in the stock market is usually associated with a fall in Tobin’s q. A fall in q reflects investors’ pessimism about the current or future profitability of capital. This means that the invest- ment function has read more..

  • Page - 575

    watched economic indicator. A case in point is the deep economic downturn in 2008 and 2009: the substantial declines in production and employment were pre- ceded by a steep decline in stock prices. ■ Alternative Views of the Stock Market: The Efficient Markets Hypothesis Versus Keynes’s Beauty Contest One continuing source of debate among economists is whether stock market read more..

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    CHAPTER 18 Investment | 537 Although the efficient markets hypothesis has many proponents, some econo- mists are less convinced that the stock market is so rational. These economists point out that many movements in stock prices are hard to attribute to news. They sug- gest that when buying and selling, stock investors are less focused on companies’ fun- damental values read more..

  • Page - 577

    538 | PA R T V I More on the Microeconomics Behind Macroeconomics undertaking profitable investments. When a firm is unable to raise funds in finan- cial markets, the amount it can spend on new capital goods is limited to the amount it is currently earning. Financing constraints influence the investment behavior of firms just as borrowing constraints influence the read more..

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    potentially profitable investment projects. Such an increase in financing con- straints is sometimes called a credit crunch. We can use the IS–LM model to interpret the short-run effects of a credit crunch. When some would-be investors are denied credit, the demand for invest- ment goods falls at every interest rate. The result is a contractionary shift in the IS curve. read more..

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    540 | PA R T V I More on the Microeconomics Behind Macroeconomics Panel (b) of Figure 18-5 shows how the relative price of housing determines the supply of new houses. Construction firms buy materials and hire labor to build houses and then sell the houses at the market price. Their costs depend on the overall price level P (which reflects the cost of wood, read more..

  • Page - 580

    price. Panel (b) shows that the increase in the housing price increases residen- tial investment. One important determinant of housing demand is the real interest rate. Many people take out loans—mortgages—to buy their homes; the interest rate is the cost of the loan. Even the few people who do not have to borrow to purchase a home will respond to the interest rate, read more..

  • Page - 581

    542 | PA R T V I More on the Microeconomics Behind Macroeconomics The Housing Market from 2000 to 2008 The first decade of the 2000s began with a boom in the housing market, followed by a bust. Panel (a) shows an index of housing prices. Panel (b) shows housing starts—the number of new houses on which builders begin construction. Source: House prices are the seasonally read more..

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    CHAPTER 18 Investment | 543 18-3 Inventory Investment Inventory investment—the goods that businesses put aside in storage—is at the same time negligible and of great significance. It is one of the smallest components of spending, averaging about 1 percent of GDP. Yet its remark- able volatility makes it central to the study of economic fluctuations. In recessions, firms read more..

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    544 | PA R T V I More on the Microeconomics Behind Macroeconomics tomorrow rather than selling it today, it gives up the interest it could have earned between today and tomorrow. Thus, the real interest rate measures the opportu- nity cost of holding inventories. When the real interest rate rises, holding inventories becomes more costly, so rational firms try to read more..

  • Page - 584

    Summary 1. The marginal product of capital determines the real rental price of capital. The real interest rate, the depreciation rate, and the relative price of capital goods determine the cost of capital. According to the neoclassical model, firms invest if the rental price is greater than the cost of capital, and they disinvest if the rental price is less than read more..

  • Page - 585

    546 | PA R T V I More on the Microeconomics Behind Macroeconomics PROBLEMS AND APPLICA TIONS greater than zero that measures the influence of the interest rate on investment. Use the IS–LM model to consider the short-run impact of an increase in government purchas- es on national income Y, the interest rate r, consumption C, and investment I. How might this investment read more..

  • Page - 586

    547 Money Supply, Money Demand, and the Banking System There have been three great inventions since the beginning of time: fire, the wheel, and central banking. —Will Rogers 19 CHAPTER The supply and demand for money are crucial to many issues in macroeco- nomics. In Chapter 4, we discussed how economists use the term “money,” how the central bank controls the quantity read more..

  • Page - 587

    In this section we see that the money supply is determined not only by Fed policy but also by the behavior of households (which hold money) and banks (in which money is held). We begin by recalling that the money supply includes both currency in the hands of the public and deposits at banks that households can use on demand for transactions, such as checking read more..

  • Page - 588

    Fractional-Reserve Banking Now imagine that banks start to use some of their deposits to make loans— for example, to families who are buying houses or to firms that are investing in new plants and equipment. The advantage to banks is that they can charge interest on the loans. The banks must keep some reserves on hand so that reserves are available whenever depositors read more..

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    550 | PA R T V I More on the Microeconomics Behind Macroeconomics Although this process of money creation can continue forever, it does not cre- ate an infinite amount of money. Letting rr denote the reserve–deposit ratio, the amount of money that the original $1,000 creates is Original Deposit = $1,000 Firstbank Lending = (1 − rr) × $1,000 Secondbank Lending = (1 read more..

  • Page - 590

    CHAPTER 19 Money Supply, Money Demand, and the Banking System | 551 ■ The monetary base B is the total number of dollars held by the public as currency C and by the banks as reserves R. It is directly controlled by the Federal Reserve. ■ The reserve–deposit ratio rr is the fraction of deposits that banks hold in reserve. It is determined by the business read more..

  • Page - 591

    Here’s a numerical example. Suppose that the monetary base B is $800 billion, the reserve–deposit ratio rr is 0.1, and the currency–deposit ratio cr is 0.8. In this case, the money multiplier is m == 2.0, and the money supply is M = 2.0 × $800 billion = $1,600 billion. Each dollar of the monetary base generates two dollars of money, so the total money supply read more..

  • Page - 592

    The discount rate is the interest rate that the Fed charges when it makes loans to banks. Banks borrow from the Fed when they find themselves with too few reserves to meet reserve requirements. The lower the discount rate, the cheaper are borrowed reserves, and the more banks borrow at the Fed’s discount window. Hence, a reduction in the discount rate raises the read more..

  • Page - 593

    increased their holdings of reserves to well above the legal minimum. Just as households responded to the banking crisis by holding more currency relative to deposits, bankers responded by holding more reserves relative to loans. Together these changes caused a large fall in the money multiplier. Although it is easy to explain why the money supply fell, it is more read more..

  • Page - 594

    Bank Capital, Leverage, and Capital Requirements The model of the banking system presented in this chapter is simplified. That is not necessarily a problem: after all, all models are simplified. But it is worth draw- ing attention to one particular simplifying assumption. In the bank balance sheets presented so far, a bank takes in deposits and uses those deposits to make read more..

  • Page - 595

    that banks will be able to pay off their depositors. The amount of capital required depends on the kind of assets a bank holds. If the bank holds safe assets such as government bonds, regulators require less capital than if the bank holds risky assets such as loans to borrowers whose credit is of dubious quality. In 2008 and 2009 many banks found themselves with read more..

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    CHAPTER 19 Money Supply, Money Demand, and the Banking System | 557 Portfolio Theories of Money Demand Theories of money demand that emphasize the role of money as a store of value are called portfolio theories. According to these theories, people hold money as part of their portfolio of assets. The key insight is that money offers a differ- ent combination of risk and read more..

  • Page - 597

    558 | PA R T V I More on the Microeconomics Behind Macroeconomics dominate currency and checking accounts. M2, for example, includes savings accounts and money market mutual funds. When we examine why people hold assets in the form of M2, rather than bonds or stock, the portfolio considerations of risk and return may be paramount. Hence, although the portfolio read more..

  • Page - 598

    To see how transactions theories explain the money demand function, let’s develop one prominent model of this type. The Baumol–Tobin model was developed in the 1950s by economists William Baumol and James Tobin, and it remains a leading theory of money demand. 4 The Baumol–Tobin Model of Cash Management The Baumol–Tobin model analyzes the costs and benefits of holding read more..

  • Page - 599

    560 | PA R T V I More on the Microeconomics Behind Macroeconomics money holdings over the course of the year under this plan. His money holdings begin the year at Y and end the year at zero, averaging Y/2 over the year. A second possible plan is to make two trips to the bank. In this case, he withdraws Y/2 dollars at the beginning of the year, gradually read more..

  • Page - 600

    Average money holding is Average Money Holding = Y/(2N *) = √ . This expression shows that the individual holds more money if the fixed cost of going to the bank F is higher, if expenditure Y is higher, or if the interest rate i is lower. So far, we have been interpreting the Baumol–Tobin model as a model of the demand for currency. That is, we have read more..

  • Page - 601

    changes the quantity of money demanded for any given interest rate and income. It is easy to imagine events that might influence this fixed cost. The spread of automatic teller machines, for instance, reduces F by reducing the time it takes to withdraw money. Similarly, the introduction of Internet banking reduces F by making it easier to transfer funds among accounts. read more..

  • Page - 602

    CHAPTER 19 Money Supply, Money Demand, and the Banking System | 563 weighted average of the demands of the two groups. The income elasticity will be between 1/2 and 1, and the interest elasticity will be between 1/2 and zero, as the empirical studies find. 6 ■ Financial Innovation, Near Money, and the Demise of the Monetary Aggregates Traditional macroeconomic analysis read more..

  • Page - 603

    564 | PA R T V I More on the Microeconomics Behind Macroeconomics 12 months, M1 had grown at an extremely high 12-percent rate, while M2 had grown at an extremely low 0.5-percent rate. Depending on how much weight was given to each of these two measures, monetary policy was either very loose, very tight, or somewhere in between. Since then, the Fed has read more..

  • Page - 604

    5. Portfolio theories of money demand stress the role of money as a store of value. They predict that the demand for money depends on the risk and return on money and alternative assets. 6. Transactions theories of money demand, such as the Baumol–Tobin model, stress the role of money as a medium of exchange. They predict that the demand for money depends positively read more..

  • Page - 605

    566 | PA R T V I More on the Microeconomics Behind Macroeconomics b. What would have happened to the money supply if the reserve–deposit ratio had risen but the currency–deposit ratio had remained the same? c. Which of the two changes was more respon- sible for the fall in the money supply? 2. To increase tax revenue, the U.S. government in 1932 imposed a two-cent read more..

  • Page - 606

    567 What We Know, What We Don’t If all economists were laid end to end, they would not reach a conclusion. —George Bernard Shaw The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, which helps its possessor to draw correct conclusions. —John read more..

  • Page - 607

    Lesson 1: In the long run, a country’s capacity to produce goods and services determines the standard of living of its citizens. Of all the measures of economic performance introduced in Chapter 2 and used throughout this book, the one that best measures economic well-being is GDP. Real GDP measures the economy’s total output of goods and services and, there- fore, a read more..

  • Page - 608

    Lesson 3: In the long run, the rate of money growth determines the rate of inflation, but it does not affect the rate of unemployment. In addition to GDP, inflation and unemployment are among the most closely watched measures of economic performance. Chapter 2 discussed how these two variables are measured, and subsequent chapters developed models to explain how they are read more..

  • Page - 609

    unemployment and raises inflation. Or they can use these policies to contract aggregate demand, which raises unemployment and lowers inflation. Policymakers face a fixed tradeoff between inflation and unemployment only in the short run. Over time, the short-run Phillips curve shifts for two reasons. First, supply shocks, such as changes in the price of oil, change the read more..

  • Page - 610

    the large differences in unemployment that we observe across countries, and the large changes in unemployment we observe over time within countries, suggest that the natural rate is not an immutable constant but depends on a nation’s policies and institutions. Yet reducing unemployment is a task fraught with per- ils. The natural rate of unemployment could likely be read more..

  • Page - 611

    is a passive one. In addition, many economists believe that policymakers are all too often opportunistic or follow time-inconsistent policies. They conclude that policymakers should not have discretion over monetary and fiscal policy but should be committed to following a fixed policy rule. Or, at the very least, their discretion should be somewhat constrained, as is read more..

  • Page - 612

    in real wages. Yet it is also possible that economists are mistaken: perhaps infla- tion is in fact very costly, and we have yet to figure out why. The cost of reducing inflation is a topic on which economists often disagree among themselves. As we discussed in Chapter 13, the standard view—as described by the short-run Phillips curve—is that reducing read more..

  • Page - 613

    Chapter 17 assume, they will save today to meet their or their children’s future tax liability. These economists believe that government debt has only a minor effect on the economy. Still other economists believe that standard measures of fiscal policy are too flawed to be of much use. Although the government’s choices regarding taxes and spending have great influence read more..

  • Page - 614

    575 example, an income tax system that automatically reduces taxes when income falls. Average propensity to consume (APC): The ratio of consumption to income (C/Y ). Balance sheet: An accounting statement that shows assets and liabilities. Balanced budget: A budget in which receipts equal expenditures. Balanced growth: The condition under which many economic variables, such as income per read more..

  • Page - 615

    Capital budgeting: An accounting procedure that measures both assets and liabilities. Capital requirement: A minimum amount of bank capital mandated by regulators. Central bank: The institution responsible for the conduct of monetary policy, such as the Federal Re- serve in the United States. Classical dichotomy: The theoretical separation of real and nominal variables in the classical read more..

  • Page - 616

    Demand-pull inflation: Inflation resulting from shocks to aggregate demand. (Cf. cost-push inflation.) Demand shocks: Exogenous events that shift the aggregate demand curve. Depreciation: 1. The reduction in the capital stock that occurs over time because of aging and use. 2. A fall in the value of a currency relative to other currencies in the market for foreign exchange. read more..

  • Page - 617

    Federal funds rate: The overnight interest rate at which banks lend to one another. Federal Reserve (the Fed): The central bank of the United States. Fiat money: Money that is not intrinsically useful and is valued only because it is used as money. (Cf. commodity money, money.) Financial intermediation: The process by which resources are allocated from those individuals who wish read more..

  • Page - 618

    Income effect: The change in consumption of a good resulting from a movement to a higher or lower indifference curve, holding the relative price constant. (Cf. substitution effect.) Index of leading indicators : See leading indicators. Indifference curves: A graphical representation of preferences that shows different combinations of goods producing the same level of satisfaction. read more..

  • Page - 619

    LM curve: The positive relationship between the interest rate and the level of income (while holding the price level fixed) that arises in the market for real money balances. (Cf. IS–LM model, IS curve.) Loanable funds: The flow of resources available to finance capital accumulation. Lucas critique: The argument that traditional policy analysis does not adequately take into ac- read more..

  • Page - 620

    Natural-rate hypothesis: The premise that fluctu- ations in aggregate demand influence output, em- ployment, and unemployment only in the short run, and that in the long run these variables return to the levels implied by the classical model. Near money: Assets that are almost as useful as money for engaging in transactions and, therefore, are close substitutes for money. read more..

  • Page - 621

    Procyclical: Moving in the same direction as out- put, incomes, and employment over the business cycle; falling during recessions and rising during re- coveries. (Cf. acyclical, countercyclical.) Production function: The mathematical relation- ship showing how the quantities of the factors of production determine the quantity of goods and services produced; for example, Y F(K, L). read more..

  • Page - 622

    Seigniorage: The revenue raised by the govern- ment through the creation of money; also called the inflation tax. Shock: An exogenous change in an economic rela- tionship, such as the aggregate demand or aggregate supply curve. Shoeleather cost: The cost of inflation from reduc- ing real money balances, such as the inconvenience of needing to make more frequent trips to the read more..

  • Page - 623

    Transitory income: Income that people do not expect to persist into the future; current income minus normal income. (Cf. permanent income.) Underground economy: Economic transactions that are hidden in order to evade taxes or conceal illegal activity. Unemployment insurance: A government program under which unemployed workers can collect benefits for a certain period of time after losing read more..

  • Page - 624

    585 index Note: Page numbers followed by f indi- cate figures; those followed by n indi- cate notes; those followed by t indicate tables. Abel, Andrew B., 231n Account, money as unit of, 80–81 Accounting profit, 55 Accounting scandals, 320 Acemoglu, Daron, 235 AD. See Aggregate demand (AD) Adaptive expectations, 390–391 AD-AS model and, 413 AD-AS model, read more..

  • Page - 625

    Brazil (continued) population growth and income per person in, 215f standard of living in, 192t Break-even investment, 212 Breit, William, 14n Bretton Woods system, 349–350, 361 Britain. See England; United Kingdom Brown, Charles, 171n Brown, E. Cary, 328n Brumberg, Richard, 509 Bryan, William Jennings, 104–105 Bubonic plague, factor prices and, 56 Buchanan, read more..

  • Page - 626

    for investment. See Investment demand for money. See Money demand Demand deposits, 84 Demand-pull inflation, 391 Demand shocks, 278, 279f, 279–280 AD-AS model and, 427–428, 428f, 429f Democracy in Deficit (Buchanan and Wagner), 487 Denmark Big Mac price and exchange rate in, 148t devaluation by, 354 government debt of, 468t inflation in, 145f population growth and income read more..

  • Page - 627

    East Asian Tigers, economic growth in, 251–252 ECB. See European Central Bank (ECB) Economic fluctuations, 257–284. See also Business cycle(s); Depressions; Great Depression; Real-business- cycle theory; Recessions aggregate demand and, 269–271 aggregate supply and, 271–277 banking crises and, 538–539 stabilization policy and, 278–283 time horizons and, 265–269 Economic read more..

  • Page - 628

    Federal Open Market Committee (FOMC), 320 federal funds rate targets of, 415 Federal Reserve (Fed), 84, 446. See also Monetary policy European Central Bank versus, 435 inflation targeting and, 457–458 as lender of last resort, 554 money supply and. See Monetary policy monitoring of CPI by, 35 recapitalization of banking system and, 556 supply shocks and, 281, 282 read more..

  • Page - 629

    Goods and services (continued) production of, aggregate demand and, 568 supply of, 48–49, 65–73 used goods, 21 valuing government services, 23 Goods market, IS* curve and, 341–343, 342f Gordon, David, 463n Gordon, Robert J., 35, 243n, 396n Gourinchas, Pierre-Olivier, 510n Government bonds, in United Kingdom, 70 Government debt, 467–490. See also Budget read more..

  • Page - 630

    India investment rate in, 202f legal tradition in, 234 population growth and income per person in, 215f standard of living in, 192t Indifference curves, 503f, 503–504 Indonesia Big Mac price and exchange rate in, 148t financial crisis of 1997-1998 and, 360–361 financial crisis of 1997-1998 in, 538 inflation and money growth in, 92f standard of living in, 192t Industrial read more..

  • Page - 631

    Japan (continued) economic growth in, 200, 201, 229 economic slump of 1990s in, 538 government debt of, 468t, 469 inflation in, 145f investment rate in, 202f, 203 real GDP in, 237t standard of living in, 192t Johnson, Lyndon B., tax surcharge under, 516 Johnson, Simon, 235 Jones, Charles I., 227n, 239n Jordan, population growth and income per person in, read more..

  • Page - 632

    Martin, William McChesney, 445 Marx, Karl, 49, 226 Mauro, Paul, 234n Mayan civilization, 217 McCallum, Bennett T., 254n McDonald’s, Big Mac prices and, 147–149, 148t McKinley, William, 104–105 Medicaid, 471 Medicare, 471 Medium of exchange, money as, 81 Menu cost of inflation, 102 Metrick, Andrew, 521n Mexico Big Mac price and exchange rate in, 148t read more..

  • Page - 633

    Net capital outflow, 122–123 Net exports, 27. See also Trade balances international flows of capital and goods and, 120–122 real exchange rate and, 138–139, 139f Net foreign investment, 122–123 Netherlands collective bargaining in, 173t exchange rate of, 354 government debt of, 468t Net investment, 530 Net national product (NNP), 30 Neumark, David, 171n Nevins, read more..

  • Page - 634

    of Big Macs, 147–149, 148t current, future money and, 98–100, 99f of factors of production, 49–50, 50f, 56 falling, money hypothesis and, 329–331 flexible versus sticky, 12–13 law of one price and, 145–146 rental, of capital, 54 sticky, 266t, 266–268, 267t Price levels, 89 changing, Mundell-Fleming model with, 366–369, 367f, 368f current and future read more..

  • Page - 635

    Seasonal adjustment, 31–32 Sectoral shifts, 167 Secular stagnation, 498 Securitization, 332 Seigniorage, 92–94 Services. See Goods and services Shapiro, Matthew D., 35n, 449n, 482n, 533 Shiller, Robert J., 101, 490n, 537n Shimer, Robert, 179n Shleifer, Andrei, 483n Shocks, 278 demand, 278, 279f, 279–280 in IS–LM model, 318–320 supply. See Supply shocks read more..

  • Page - 636

    Big Mac price and exchange rate in, 148t collective bargaining in, 173t government debt of, 468t inflation and money growth in, 92f inflation and nominal interest rate in, 96f inflation in, 144–145, 145f investment rate in, 202f Taiwan Big Mac price and exchange rate in, 148t economic growth in, 251–252 TARP. See Troubled Assets Relief Program (TARP) Tax(es) decrease in, read more..

  • Page - 637

    United States (continued) financial crisis of 2008-2009 in, 69, 332–334, 393, 474–475, 538, 541 GDP of, 28–29, 29t government debt of. See Government debt historical performance of economy in, 4–6, 5f–7f indexation in, 104 inflation and money growth in, 92f inflation and nominal interest rate in, 96f inflation in, 4, 79, 144–145, 145f, 391–393, 392f, read more..

  • Page - 638

    Real GDP Growth –4 –2 0 2 4 6 8 Percent 1970 1975 1980 1985 1990 1995 2000 2005 Year Unemployment Rate 3 4 5 6 7 8 9 10 Percent 1970 1975 1980 1985 1990 1995 2000 2005 Year Source: U.S. Department of Commerce Source: U.S. Department of Labor read more..

  • Page - 639

    Inflation Rate (GDP Deflator) 0 2 4 6 8 10 Percent 1970 1975 1980 1985 1990 1995 2000 2005 Year Nominal Interest Rate (Three-Month Treasury Bills) 0 5 10 15 Percent 1970 1975 1980 1985 1990 1995 2000 2005 Year Source: U.S. Department of Commerce Source: U.S. Federal Reserve read more..

  • Page - 640

    U.S. Federal Government Budget Deficit (Adjusted for Inflation) 4 3 2 1 0 –1 –2 –3 –4 –5 –6 Percent of GDP Sur plus Def icit 1970 1975 1980 1985 1990 1995 2000 2005 Year Money Growth (M 2) Percent 1970 1975 1980 1985 1990 1995 2000 2005 Year 0 2 4 6 8 10 12 14 Source: U.S. Federal Reserve Source: U.S. Congressional Budget Office, U.S. Department of Commerce, and author's read more..

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    U.S. Net Exports of Goods and Services –6 –5 –4 –3 –2 –1 0 1 Percent of GDP 1970 1975 1980 1985 1990 1995 2000 2005 Year U.S. Trade- weighted Real Exchange Rate 80 90 100 110 120 130 Index 1970 1975 1980 1985 1990 1995 2000 2005 Year Source: U.S. Federal Reserve Source: U.S. Department of Commerce read more..

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