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Macroeconomics, seventh edition is organized around two central parts: A core and a set of two major extensions. The text’s flexible organization emphasizes an integrated view of macroeconomics, while enabling professors to focus on the theories, models, and applications that they deem central to their particular course.

The flowchart below quickly illustrates how the chapters are organized and fit within the book’s overall structure. For a more detailed explanation of the Organization, and for an extensive list of Alternative Course Outlines, see pages xiv–xv in the preface.

Flexible Organization

The Short Run The Goods Market Chapter 3 Financial Markets I Chapter 4

Goods and Financial Markets: The IS-LM Model Financial Markets II: The Extended IS-LM Model Chapter 6

Chapter 5

The Medium Run The Labor Market Chapter 7

The Phillips Curve, the Natural Rate of Unemployment, and Inflation Chapter 8

From the Short to the Medium Run: The IS-LM PC Model Chapter 9

The Long Run The Facts of Growth Chapter 10

Saving, Capital Accumulation, and Output Chapter 11 Technological Progress and Growth Chapter 12

Technological Progress: The Short, the Medium, and the Long Run Chapter 13

THE CORE

INTRODUCTION A Tour of the World Chapter 1 A Tour of the Book Chapter 2

EXTENSIONS

BACK TO POLICY Should Policy Makers Be Restrained? Chapter 21

Fiscal Policy: A Summing Up Chapter 22 Monetary Policy: A Summing Up Chapter 23

EPILOGUE The Story of Macroeconomics Chapter 24

EXPECTATIONS Financial Markets and Expectations Chapter 14

Expectations, Consumption, and Investment Chapter 15 Expectations, Output, and Policy Chapter 16

THE OPEN ECONOMY Openness in Goods and Financial Markets Chapter 17

The Goods Market in an Open Economy Chapter 18 Output, the Interest Rate, and the Exchange Rate Chapter 19

Exchange Rate Regimes Chapter 20

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Olivier Blanchard

MacroeconoMics Seventh Edition

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Library of Congress Cataloging-in-Publication Data

Names: Blanchard, Olivier (Olivier J.), author.|Johnson, David R., Title: Macroeconomics/Olivier Blanchard, International Monetary Fund, Massachusetts Institute of Technology, David R. Johnson, Wilfrid Laurier University. Description: Seventh edition.|Boston: Pearson, [2017] Identifiers: LCCN 2016001144|ISBN 9780133780581 (casebound) Subjects: LCSH: Macroeconomics. Classification: LCC HB172.5 .B573 2017|DDC 339—dc23 LC record available at http://lccn.loc.gov/2016001144

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To Noelle

A citizen of France, Olivier Blanchard has spent most of his professional life in Cambridge, U.S.A. After obtaining his Ph.D. in economics at the Massachusetts Institute of Technology in 1977, he taught at Harvard University, returning to MIT in 1982. He was chair of the economics department from 1998 to 2003. In 2008, he took a leave of absence to be the Economic Counsellor and Director of the Research Department of the International Monetary Fund. Since October 2015, he is the Fred Bergsten Senior Fellow at the Peterson Institute for International Economics, in Washington. He also remains Robert M. Solow Professor of Economics emeritus at MIT.

He has worked on a wide set of macroeconomic issues, from the role of monetary policy, to the nature of speculative bubbles, to the nature of the labor market and the determinants of unemployment, to transition in former communist countries, and to forces behind the recent global crisis. In the process, he has worked with numerous countries and international or- ganizations. He is the author of many books and articles, including a graduate level textbook with Stanley Fischer.

He is a past editor of the Quarterly Journal of Economics, of the NBER Macroeconom- ics Annual, and founding editor of the AEJ Macroeconomics. He is a fellow and past council member of the Econometric Society, a past vice president of the American Economic Associa- tion, and a member of the American Academy of Sciences.

About the Authors

iv

The Core

Introduction 1 Chapter 1 A Tour of the World 3 Chapter 2 A Tour of the Book 21

The Short Run 45 Chapter 3 The Goods Market 47 Chapter 4 Financial Markets I 67 Chapter 5 Goods and Financial Markets;

The IS-LM Model 89 Chapter 6 Financial Markets II: The Extended

IS-LM Model 111

The Medium Run 135 Chapter 7 The Labor Market 137 Chapter 8 The Phillips Curve, the Natural Rate

of Unemployment, and Inflation 157

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 177

The Long Run 197 Chapter 10 The Facts of Growth 199 Chapter 11 Saving, Capital Accumulation,

and Output 217 Chapter 12 Technological Progress and

Growth 241 Chapter 13 Technological Progress:

The Short, the Medium, and the Long Run 263

exTensions

Expectations 283 Chapter 14 Financial Markets and

Expectations 285 Chapter 15 Expectations, Consumption, and

Investment 311 Chapter 16 Expectations, Output, and

Policy 331

The Open Economy 347 Chapter 17 Openness in Goods and Financial

Markets 349 Chapter 18 The Goods Market in an Open

Economy 369 Chapter 19 Output, the Interest Rate, and

the Exchange Rate 391 Chapter 20 Exchange Rate Regimes 411

Back to Policy 433 Chapter 21 Should Policy Makers Be

Restrained? 435 Chapter 22 Fiscal Policy:

A Summing Up 453 Chapter 23 Monetary Policy:

A Summing Up 477 Chapter 24 Epilogue: The Story

of Macroeconomics 497

Brief Contents

v

vi

Preface xiii

The Core

Introduction 1 Chapter 1 A Tour of the World 3

1-1 The Crisis 4

1-2 The United States 6 Low Interest Rates and the Zero Lower Bound  7  •  How Worrisome Is Low  Productivity Growth? 8

1-3 The Euro Area 9 Can European Unemployment Be   Reduced?  11  •  What Has the Euro  Done for Its Members?  12

1-4 China 13 1-5 Looking Ahead 15 Appendix: Where to Find the Numbers 18

Chapter 2 A Tour of the Book 21 2-1 Aggregate Output 22

GDP: Production and Income  22  •  Nominal and Real GDP  24  •  GDP: Level versus Growth Rate  26

2-2 The Unemployment Rate 27 Why Do Economists Care about  Unemployment?  29

2-3 The Inflation Rate 31 The GDP Deflator  31  •  The Consumer  Price Index  31  •  Why Do Economists  Care about Inflation? 33

2-4 Output, Unemployment, and the Inflation Rate: Okun’s Law and the Phillips Curve 33 Okun’s Law  34  •  The Phillips Curve  34

2-5 The Short Run, the Medium Run, and the Long Run 35

2-6 A Tour of the Book 36 The Core  36  •  Extensions  37  •  Back  to Policy  38  •  Epilogue  38

Appendix: The Construction of Real GDP and Chain-Type Indexes 42

The Short Run 45 Chapter 3 The Goods Market 47

3-1 The Composition of GDP 48

3-2 The Demand for Goods 50 Consumption (C)  50  •  Investment  ( I )  52  •  Government Spending (G)  52

3-3 The Determination of Equilibrium Output 53 Using Algebra  54  •  Using a  Graph  55  •  Using Words  57  •  How Long Does It Take for Output  to Adjust? 58

3-4 Investment Equals Saving: An Alternative Way of Thinking about Goods-Market Equilibrium 60

3-5 Is the Government Omnipotent? A Warning 62

Chapter 4 Financial Markets I 67 4-1 The Demand for Money 68

Deriving the Demand for Money  69

4-2 Determining the Interest Rate: I 71 Money Demand, Money Supply, and  the Equilibrium Interest Rate  71  •  Monetary Policy and Open Market  Operations  74  •  Choosing Money or  Choosing the Interest Rate?  76

4-3 Determining the Interest Rate: II 76 What Banks Do  76  •  The  Demand  and Supply for Central Bank   Money  78  •  The Federal Funds Market  and the Federal Funds Rate  79

4-4 The Liquidity Trap 80 Appendix: The Determination of the Interest Rate When People Hold Both Currency and Checkable Deposits 85

Chapter 5 Goods and Financial Markets; The IS-LM Model 89 5-1 The Goods Market and the

IS Relation 90

Contents

Contents vii

Investment, Sales, and the  Interest  Rate  90  •  Determining Output  91  •  Deriving the IS Curve  93  •  Shifts of  the IS Curve  93

5-2 Financial Markets and the LM Relation 94 Real Money, Real Income, and the   Interest Rate  94  •  Deriving the LM Curve  95

5-3 Putting the IS and the LM Relations Together 96 Fiscal Policy  96  •  Monetary Policy  98

5-4 Using a Policy Mix 99 5-5 How Does the IS-LM Model Fit the

Facts? 104

Chapter 6 Financial Markets II: The Extended IS-LM Model 111 6-1 Nominal versus Real Interest

Rates 112 Nominal and Real Interest Rates in the  United States since 1978  114  •  Nominal  and Real Interest Rates: The Zero Lower  Bound and Deflation 115

6-2 Risk and Risk Premia 116 6-3 The Role of Financial

Intermediaries 117 The Choice of Leverage  118  •  Leverage  and Lending  119

6-4 Extending the IS-LM 121 Financial Shocks and Policies  122

6-5 From a Housing Problem to a Financial Crisis 123 Housing Prices and Subprime   Mortgages  123  •  The Role of   Financial Intermediaries  125  •  Macroeconomic Implications  127  •  Policy  Responses  127

The Medium Run 135 Chapter 7 The Labor Market 137

7-1 A Tour of the Labor Market 138 The Large Flows of Workers  138

7-2 Movements in Unemployment 141 7-3 Wage Determination 143

Bargaining  144  •  Efficiency Wages  144  •  Wages, Prices, and Unemployment  146  •  The Expected Price Level  146  •  The Unemployment Rate  146  •  The Other Factors  147

7-4 Price Determination 147

7-5 The Natural Rate of Unemployment 148 The Wage-Setting Relation  148  •  The  Price-Setting Relation  149  •  Equilibrium  Real Wages and Unemployment  150

7-6 Where We Go from Here 151

Appendix: Wage- and Price-Setting Relations versus Labor Supply and Labor Demand 155

Chapter 8 The Phillips Curve, the Natural Rate of Unemployment, and Inflation 157 8-1 Inflation, Expected Inflation,

and Unemployment 158

8-2 The Phillips Curve and Its Mutations 160 The Early Incarnation  160  •  The   Apparent Trade-Off and Its   Disappearance  160

8-3 The Phillips Curve and the Natural Rate of Unemployment 163

8-4 A Summary and Many Warnings 165 Variations in the Natural Rate across  Countries  166  •  Variations in the  Natural Rate over Time  166  •  High  Inflation and the Phillips Curve  Relation  168  •  Deflation and the  Phillips Curve Relation  170

Appendix: Derivation of the Relation to a Relation between Inflation, Expected Inflation, and Unemployment 175

Chapter 9 From the Short to the Medium Run: The IS-LM-PC Model 177 9-1 The IS-LM-PC model 178 9-2 Dynamics and the Medium Run

Equilibrium 181 The Role of Expectations   Revisited  183  •  The Zero Lower Bound  and Debt Spirals  183

9-3 Fiscal Consolidation Revisited 186 9-4 The Effects of an Increase in the

Price of Oil 187 Effects on the Natural Rate of   Unemployment  189

9-5 Conclusions 192 The Short Run versus the Medium  Run  192  •  Shocks and Propagation  Mechanisms  192

viii Contents

The Long Run 197 Chapter 10 The Facts of Growth 199

10-1 Measuring the Standard of Living 200

10-2 Growth in Rich Countries since 1950 203 The Large Increase in the Standard  of Living since 1950  205  •  The   Convergence of Output per Person  206

10-3 A Broader Look across Time and Space 207 Looking across Two Millennia  207  •  Looking across Countries  207

10-4 Thinking about Growth: A Primer 209 The Aggregate Production Function  210  •  Returns to Scale and Returns to  Factors  210  •  Output per Worker and  Capital per Worker  211  •  The Sources  of Growth  211

Chapter 11 Saving, Capital Accumulation, and Output 217 11-1 Interactions between Output and

Capital 218 The Effects of Capital on Output  218  •  The Effects of Output on Capital  Accumulation  219  •  Output and  Investment  219  •  Investment  and Capital Accumulation  220

11-2 The Implications of Alternative Saving Rates 221 Dynamics of Capital and Output  221  •  The Saving Rate and Output  223  •  The Saving Rate and Consumption  227

11-3 Getting a Sense of Magnitudes 228 The Effects of the Saving Rate on  Steady-State Output  230  •  The  Dynamic Effects of an Increase in the  Saving Rate  231  •  The U.S. Saving  Rate and the Golden Rule  233

11-4 Physical versus Human Capital 234 Extending the Production Function  234  •  Human Capital, Physical Capital,  and Output  235  •  Endogenous  Growth  236

Appendix: The Cobb-Douglas Production Function and the Steady State 239

Chapter 12 Technological Progress and Growth 241 12-1 Technological Progress and the Rate

of Growth 242 Technological Progress and  the Production Function  242 

•  Interactions between Output and  Capital  244  •  Dynamics of Capital and  Output  246  •  The Effects of the Saving  Rate  247

12-2 The Determinants of Technological Progress 248 The Fertility of the Research  Process  249  •  The Appropriability  of Research Results  250  •  Management, Innovation,  and  Imitation  252

12-3 Institutions, Technological Progress, and Growth 252

12-4 The Facts of Growth Revisited 256 Capital Accumulation versus  Technological Progress in Rich  Countries since 1985  256  •  Capital  Accumulation versus Technological  Progress in China  257

Appendix: Constructing a Measure of Technological Progress 261

Chapter 13 Technological Progress: The Short, the Medium, and the Long Run 263 13-1 Productivity, Output, and

Unemployment in the Short Run 264 The Empirical Evidence  266

13-2 Productivity and the Natural Rate of Unemployment 267 Price Setting and Wage Setting  Revisited  267  •  The Natural Rate of  Unemployment  268  •  The Empirical  Evidence  269

13-3 Technological Progress, Churning, and Inequality 271 The Increase in Wage Inequality  272  •  The Causes of Increased Wage  Inequality  274  •  Inequality and the  Top 1%  277

exTensions

Expectations 283 Chapter 14 Financial Markets and

Expectations 285 14-1 Expected Present Discounted

Values 286 Computing Expected Present Discounted  Values  286  •  A  General Formula  287 

Contents ix

•  Using Present Values: Examples  288  •  Constant  Interest Rates  288  •  Constant Interest Rates and Payments  288  •  Constant Interest  Rates and Payments Forever  289  •  Zero Interest Rates  289  •  Nominal  versus Real Interest Rates and Present  Values  289

14-2 Bond Prices and Bond Yields 290 Bond Prices as Present Values  292  •  Arbitrage and Bond Prices  293  •  From Bond Prices to Bond Yields  294  •  Reintroducing Risk  295  •  Interpreting the Yield Curve  296

14-3 The Stock Market and Movements in Stock Prices 298 Stock Prices as Present Values  298  •  The Stock Market and Economic  Activity  301  •  A Monetary Expansion  and the Stock Market  301  •  An  Increase in Consumer Spending and  the Stock Market  302

14-4 Risk, Bubbles, Fads, and Asset Prices 304 Stock Prices and Risk  304  •  Asset  Prices, Fundamentals, and  Bubbles  304

Appendix: Deriving the Expected Present Discounted Value Using Real or Nominal Interest Rates 310

Chapter 15 Expectations, Consumption, and Investment 311 15-1 Consumption 312

The Very Foresighted Consumer  312  •  An Example  313  •  Toward  a More Realistic Description  314  •  Putting Things Together: Current  Income, Expectations, and  Consumption  317

15-2 Investment 318 Investment and Expectations of  Profit  318  •  Depreciation  319  •  The Present Value of Expected  Profits  319  •  The Investment  Decision  320  •  A Convenient  Special Case  320  •  Current versus  Expected Profit  322  •  Profit and  Sales  324

15-3 The Volatility of Consumption and Investment 326

Appendix: Derivation of the Expected Present Value of Profits under Static Expectations 330

Chapter 16 Expectations, Output, and Policy 331 16-1 Expectations and Decisions: Taking

Stock 332 Expectations, Consumption, and  Investment Decisions  332  •  Expectations and the IS Relation  332

16-2 Monetary Policy, Expectations, and Output 335 Monetary Policy Revisited  335

16-3 Deficit Reduction, Expectations, and Output 338 The Role of Expectations about the  Future  339  •  Back to the Current  Period  339

The Open Economy 347 Chapter 17 Openness in Goods and Financial

Markets 349 17-1 Openness in Goods Markets 350

Exports and Imports  350  •  The Choice  between Domestic Goods and Foreign  Goods  352  •  Nominal Exchange  Rates  352  •  From Nominal to Real  Exchange Rates  354  •  From Bilateral to  Multilateral Exchange Rates  357

17-2 Openness in Financial Markets 358 The Balance of Payments  359  •  The  Choice between Domestic and Foreign  Assets  361  •  Interest Rates and   Exchange Rates  363

17-3 Conclusions and a Look Ahead 365

Chapter 18 The Goods Market in an Open Economy 369 18-1 The IS Relation in the Open

Economy 370 The Demand for Domestic Goods  370  •  The Determinants of C, I, and G 370 •  The Determinants of Imports  371  •  The Determinants of Exports  371  •  Putting the Components  Together  371

18-2 Equilibrium Output and the Trade Balance 373

18-3 Increases in Demand—Domestic or Foreign 374 Increases in Domestic Demand  374  •  Increases in Foreign Demand  376  •  Fiscal Policy Revisited  377

x Contents

20-4 Choosing between Exchange Rate Regimes 422 Common Currency Areas  423  •  Hard Pegs, Currency Boards, and  Dollarization  425

Appendix 1: Deriving the IS relation under Fixed Exchange Rates 431 Appendix 2: The Real Exchange Rate and Domestic and Foreign Real Interest Rates 431

Back to Policy 433 Chapter 21 Should Policy Makers Be

Restrained? 435 21-1 Uncertainty and Policy 436

How Much Do Macroeconomists  Actually Know?  436  •  Should  Uncertainty Lead Policy Makers to  Do Less?  438  •  Uncertainty and  Restraints on Policy Makers  438

21-2 Expectations and Policy 439 Hostage Takings and Negotiations  440  •  Inflation and Unemployment  Revisited  440  •  Establishing  Credibility  441  •  Time Consistency  and Restraints on Policy Makers  443

21-3 Politics and Policy 443 Games between Policy Makers and  Voters  443  •  Games between Policy  Makers  445  •  Politics and Fiscal  Restraints  448

Chapter 22 Fiscal Policy: A Summing Up 453 22-1 What We Have Learned 454

22-2 The Government Budget Constraint: Deficits, Debt, Spending, and Taxes 455 The Arithmetic of Deficits and  Debt  455  •  Current versus Future  Taxes  457  •  The Evolution of the  Debt-to-GDP Ratio  459

22-3 Ricardian Equivalence, Cyclical Adjusted Deficits, and War Finance 462 Ricardian Equivalence  462  •  Deficits,  Output Stabilization, and the Cyclically  Adjusted Deficit  463  •  Wars and  Deficits  464

22-4 The Dangers of High Debt 466 High Debt, Default Risk, and Vicious  Cycles  466  •  Debt Default  468  •  Money Finance  468

18-4 Depreciation, the Trade Balance, and Output 379 Depreciation and the Trade Balance:  The Marshall-Lerner Condition  380  •  The Effects of a Real Depreciation  380  •  Combining Exchange Rate and Fiscal  Policies  381

18-5 Looking at Dynamics: The J-Curve 384

18-6 Saving, Investment, and the Current Account Balance 386

Appendix: Derivation of the Marshall- Lerner Condition 390

Chapter 19 Output, the Interest Rate, and the Exchange Rate 391 19-1 Equilibrium in the Goods

Market 392

19-2 Equilibrium in Financial Markets 393 Domestic Bonds versus Foreign  Bonds  393

19-3 Putting Goods and Financial Markets Together 397

19-4 The Effects of Policy in an Open Economy 399 The Effects of Monetary Policy in an  Open Economy  399  •  The Effects of  Fiscal Policy in an Open Economy  399

19-5 Fixed Exchange Rates 403 Pegs, Crawling Pegs, Bands, the  EMS, and the Euro  403  •  Monetary  Policy when the Exchange Rate Is  Fixed  404  •  Fiscal Policy when the  Exchange Rate Is Fixed  404

Appendix: Fixed Exchange Rates, Interest Rates, and Capital Mobility 409

Chapter 20 Exchange Rate Regimes 411 20-1 The Medium Run 412

The IS Relation under Fixed Exchange  Rates  413  •  Equilibrium in the Short  and the Medium Run  413  •  The Case  for and against a Devaluation  414

20-2 Exchange Rate Crises under Fixed Exchange Rates 416

20-3 Exchange Rate Movements under Flexible Exchange Rates 419 Exchange Rates and the Current  Account  420  •  Exchange Rates  and Current and Future Interest  Rates  421  •  Exchange Rate  Volatility  421

Contents xi

Chapter 23 Monetary Policy: A Summing Up 477 23-1 What We Have Learned 478

23-2 From Money Targeting to Inflation Targeting 479 Money Targeting  479  •  Inflation  Targeting  481  •  The Interest Rate  Rule  482

23-3 The Optimal Inflation Rate 483 The Costs of Inflation  483  •  The  Benefits of Inflation  486  •  The   Optimal Inflation Rate: The State of the   Debate  487

23-4 Unconventional Monetary Policy 488

23-5 Monetary Policy and Financial Stability 490 Liquidity Provision and Lender of Last Resort  490  •  Macroprudential  Tools  490

Chapter 24 Epilogue: The Story of Macroeconomics 497 24-1 Keynes and the Great

Depression 498

24-2 The Neoclassical Synthesis 498 Progress on All Fronts  499  •  Keynesians versus Monetarists  500

24-3 The Rational Expectations Critique 501 The Three Implications of Rational  Expectations  502  •  The Integration  of Rational Expectations  503

24-4 Developments in Macroeconomics up to the 2009 Crisis 504 New Classical Economics and Real  Business Cycle Theory  505  •  New  Keynesian Economics  505  •  New  Growth Theory  506  •  Toward an  Integration  507

24-5 First Lessons for Macroeconomics after the Crisis 508

Appendix 1 An Introduction to National Income and Product Accounts A-1

Appendix 2 A Math Refresher A-7

Appendix 3 An Introduction to Econometrics A-12

Glossary G-1

Index I-1

Credits C-1

xii

Real GDP, Technological Progress, and the Price of   Computers  27

Unemployment and Happiness  30

The Lehman Bankruptcy, Fears of Another Great Depression,  and Shifts in the Consumption Function  59

The Paradox of Saving  63

Semantic Traps: Money, Income, and Wealth  69

Who Holds U.S. Currency?  71

The Liquidity Trap in Action 81

Focus: The U.S. Recession of 2001  100

Deficit Reduction: Good or Bad for Investment?  103

Bank Runs  120

The Current Population Survey  140

Henry Ford and Efficiency Wages  145

Theory ahead of Facts: Milton Friedman  and Edmund Phelps  164

What Explains European Unemployment?  167

Changes in the U.S. Natural Rate of Unemployment since  1990  169

Okun’s Law across Time and Countries  180

Deflation in the Great Depression 185

Oil Price Increases: Why Were the 2000s  So Different from the 1970s?  191

The Construction of PPP Numbers  202

Does Money Lead to Happiness?  204

Capital Accumulation and Growth in France  in the Aftermath of World War II  224

Social Security, Saving, and Capital Accumulation  in the United States  229

The Diffusion of New Technology: Hybrid Corn  250

Management Practices: Another Dimension  of Technological Progress  252

The Importance of Institutions: North Korea  and South Korea  254

What Is behind Chinese Growth?  255

Job Destruction, Churning, and Earnings Losses  273

The Long View: Technology, Education, and Inequality  275

The Vocabulary of Bond Markets  292

The Yield Curve, the Zero Lower Bound, and Liftoff  297

Making (Some) Sense of (Apparent) Nonsense: Why the  Stock Market Moved Yesterday and Other Stories  303

Famous Bubbles: From Tulipmania in 17th-Century Holland to  Russia in 1994  305

The Increase in U.S. Housing Prices: Fundamentals  or Bubble?  306

Up Close and Personal: Learning from  Panel Data Sets  313

Do People Save Enough for Retirement?  316

Investment and the Stock Market  321

Profitability versus Cash Flow  324

Rational Expectations  337

Can a Budget Deficit Reduction Lead to an Output Expansion?  Ireland in the 1980s  341

Can Exports Exceed GDP?  352

GDP versus GNP: The Example of Kuwait  362

Buying Brazilian Bonds  364

The G20 and the 2009 Fiscal Stimulus  378

The Disappearance of Current Account Deficits in Euro  Periphery Countries: Good News or Bad News?  382

Sudden Stops, Safe Havens, and the Limits to the Interest   Parity Condition  394

Monetary Contraction and Fiscal Expansion:  The United States in the Early 1980s  402

German Reunification, Interest Rates, and the EMS  405

The Return of Britain to the Gold Standard:  Keynes versus Churchill  415

The 1992 EMS Crisis  418

The Euro: A Short History  425

Lessons from Argentina’s Currency Board  426

Was Alan Blinder Wrong in Speaking the Truth?  443

Euro Area Fiscal Rules: A Short History  446

Inflation Accounting and the Measurement of Deficits  456

How Countries Decreased Their Debt Ratios after  World War II  461

Deficits, Consumption, and Investment in the United States   during World War II  465

Money Financing and Hyperinflations  470

Should You Worry about U.S. Public Debt?  471

Money Illusion  485

LTV Ratios and Housing Price Increases  from 2000 to 2007  492

A Guide to Understanding Econometric Results  A-14

Focus Boxes

xiii

Preface

I had two main goals in writing this book:

■■ To make close contact with current macroeconomic events. What makes macroeconomics exciting is the light it sheds on what is happening around the world, from the major economic crisis which has engulfed the world since 2008, to monetary policy in the United States, to the problems of the Euro area, to growth in China. These events—and many more—are described in the book, not in footnotes, but in the text or in detailed boxes. Each box shows how you can use what you have learned to get an understanding of these events. My belief is that these boxes not only convey the “life” of macroeconomics, but also reinforce the lessons from the models, making them more concrete and easier to grasp.

■■ To provide an integrated view of macroeconomics. The book is built on one underlying model, a model that draws the implications of equilibrium conditions in three sets of markets: the goods market, the financial markets, and the labor market. Depending on the issue at hand, the parts of the model relevant to the issue are developed in more detail while the other parts are simplified or lurk in the background. But the underlying model is always the same. This way, you will see macroeconomics as a coherent whole, not a collection of models. And you will be able to make sense not only of past macroeconomic events, but also of those that unfold in the future.

New to this Edition The crisis that started in 2008, and is still lingering, forced macroeconomists to rethink much of macroeconomics. They clearly had understated the role of the financial sys- tem. They also had too optimistic a view of how the economy returned to equilibrium. Eight years later, I believe the main lessons have been absorbed, and this edition reflects the deep rethinking that has taken place. Nearly all chapters have been rewritten, and the main changes are as follows:

■■ A modified Chapter 5, and a modified presentation of the IS-LM. The traditional treatment of monetary policy assumed that the central bank chose the money sup- ply and then let the interest rate adjust. In fact, modern

central banks choose the interest rate and then let the money supply adjust. In terms of the IS-LM model used to describe the short run, the LM curve, instead of being upward sloping, should be treated as flat. This makes for a more realistic and a simpler model.

■■ A new Chapter 6. The chapter focuses on the role of the financial system in the economy. It extends the IS-LM model to allow for two interest rates, the interest rate set by monetary policy and the cost of borrowing for people or firms, with the state of the financial system determining the relation between the two.

■■ A new Chapter 9. The traditional aggregate supply- aggregate demand model was cumbersome and gave too optimistic a view of the return of output to potential. The model has been replaced by an IS-LM-PC model (where PC stands for Phillips curve), which gives a simpler and more accurate description of the role of monetary policy, and of output and inflation dynamics.

■■ The constraints on monetary policy, coming from the zero lower bound, and the constraints on fiscal policy, coming from the high levels of public debt, are recurring themes throughout the book.

■■ Many Focus boxes are new or extended. Among them: “Unemployment and Happiness” in Chapter 2; “The Liquidity Trap in Action” in Chapter 4; Bank Runs in Chapter 6; “Changes in the U.S. Natural Rate of Unem- ployment since 1990” in Chapter 8; “Okun’s Law” and “Deflation in the Great Depression” in Chapter 9; “The Construction of PPP Numbers” in Chapter 10; “The Long View: Technology, Education, and Inequality” in Chapter 13; “The Yield Curve, the Zero Lower Bound, and Lift-off” in Chapter 14; “The Disappearance of Current Account Deficits in Euro Periphery Countries: Good News or Bad News?” in Chapter 18; “Euro Area Fiscal Rules: A Short History” in Chapter 21; and “Money Financing and Hyperinflations” and “Should You Worry about U.S. Public Debt?” in Chapter 22.

■■ Figures and tables have been updated using the latest data available.

xiv Preface

In short, I see this edition as the first true post-crisis mac- roeconomics textbook. I hope it gives a clear guide not only to what has happened, and also to what may happen in the future.

Organization The book is organized around two central parts: A core, and a set of two major extensions. An introduction precedes the core. The two extensions are followed by a review of the role of policy. The book ends with an epilogue. A flowchart on the front endpaper makes it easy to see how the chapters are organized, and fit within the book’s overall structure.

■■ Chapters 1 and 2 introduce the basic facts and issues of macroeconomics. Chapter 1 focuses first on the cri- sis, and then takes a tour of the world, from the United States, to Europe, to China. Some instructors will prefer to cover Chapter 1 later, perhaps after Chapter 2, which introduces basic concepts, articulates the notions of short run, medium run, and long run, and gives the reader a quick tour of the book.

While Chapter 2 gives the basics of national income ac- counting, I have put a detailed treatment of national income accounts to Appendix 1 at the end of the book. This decreases the burden on the beginning reader, and allows for a more thorough treatment in the appendix.

■■ Chapters 3 through 13 constitute the core.

Chapters 3 through 6 focus on the short run. These four chapters characterize equilibrium in the goods market and in the financial markets, and they derive the basic model used to study short–run movements in output, the IS–LM model. Chapter 6 is new, and extends the basic IS-LM model to take into account the role of the financial system. It then uses it to describe what happened during the initial phase of the crisis.

Chapters 7 through 9 focus on the medium run. Chapter 7 focuses on equilibrium in the labor market and introduces the notion of the natural rate of unem- ployment. Chapter 8 derives and discusses the relation between unemployment and inflation, known as the Phillips curve. Chapter 9 develops the IS-LM-PC (PC for Phillips curve) model which takes into account equilib- rium in the goods market, in the financial markets, and in the labor market. It shows how this model can be used to understand movements in activity and movements in inflation, both in the short and in the medium run.

Chapters 10 through 13 focus on the long run. Chapter 10 describes the facts, showing the evolution of output across countries and over long periods of time. Chapters 11

and 12 develop a model of growth and describe how capital accumulation and technological progress deter- mine growth. Chapter 13 focuses on the effects of tech- nological progress on unemployment and on inequality, not only in the long run, but also in the short run and in the medium run.

■■ Chapters 14 through 20 cover the two major extensions.

Chapters 14 through 16 focus on the role of expectations in the short run and in the medium run. Expectations play a major role in most economic decisions, and, by implica- tion, play a major role in the determination of output.

Chapters 17 through 20 focus on the implications of openness of modern economies. Chapter 20 focuses on the implications of different exchange rate regimes, from flexible exchange rates, to fixed exchange rates, currency boards, and dollarization.

■■ Chapters 21 through 23 return to macroeconomic policy. Although most of the first 20 chapters constantly discuss macroeconomic policy in one form or another, the purpose of Chapters 21 through 23 is to tie the threads together. Chapter 21 looks at the role and the limits of macroeconomic policy in general. Chapters 22 and 23 review fiscal and monetary policy. Some instruc- tors may want to use parts of these chapters earlier. For example, it is easy to move forward the discussion of the government budget constraint in Chapter 22 or the discussion of inflation targeting in Chapter 23.

■■ Chapter 24 serves as an epilogue; it puts macroeco- nomics in historical perspective by showing the evolu- tion of macroeconomics in the last 70 years, discussing current directions of research, and the lessons of the crisis for macroeconomics.

Alternative Course Outlines Within the book’s broad organization, there is plenty of op- portunity for alternative course organizations. I have made the chapters shorter than is standard in textbooks, and, in my experience, most chapters can be covered in an hour and a half. A few (Chapters 5 and 9 for example) might require two lectures to sink in.

■■ Short courses. (15 lectures or less)

A short course can be organized around the two intro- ductory chapters and the core (Chapter 13 can be ex- cluded at no cost in continuity). Informal presentations of one or two of the extensions, based, for example, on Chapter 16 for expectations (which can be taught as a stand alone), and on Chapter 17 for the open economy, can then follow, for a total of 14 lectures.

Preface xv

A short course might leave out the study of growth (the long run). In this case, the course can be organ- ized around the introductory chapters and Chapters 3 through 9 in the core; this gives a total of 9 lectures, leaving enough time to cover, for example, Chapter 16 on expectations, Chapters 17 through 19 on the open economy, for a total of 13 lectures.

■■ Longer courses (20 to 25 lectures)

A full semester course gives more than enough time to cover the core, plus one or both of the two extensions, and the review of policy.

The extensions assume knowledge of the core, but are otherwise mostly self-contained. Given the choice, the order in which they are best taught is probably the order in which they are presented in the book. Having studied the role of expectations first helps students to under- stand the interest parity condition, and the nature of exchange rate crises.

Features I have made sure never to present a theoretical result with- out relating it to the real world. In addition to discussions of facts in the text itself, I have written a large number of Fo- cus boxes, which discuss particular macroeconomic events or facts, from the United States or from around the world.

I have tried to re-create some of the student–teacher in- teractions that take place in the classroom by the use of mar- gin notes, which run parallel to the text. The margin notes create a dialogue with the reader and, in so doing, smooth the more difficult passages and give a deeper understanding of the concepts and the results derived along the way.

For students who want to explore macroeconomics further, I have introduced the following two features:

■■ Short appendixes to some chapters, which expand on points made within the chapter.

■■ A Further Readings section at the end of most chapters, indicating where to find more information, including a number of key Internet addresses.

Each chapter ends with three ways of making sure that the material in the chapter has been digested:

■■ A summary of the chapter’s main points. ■■ A list of key terms. ■■ A series of end-of-chapter exercises. “Quick Check” exer-

cises are easy. “Dig Deeper” exercises are a bit harder, and “Explore Further” typically require either access to the Internet or the use of a spreadsheet -program.

■■ A list of symbols on the back endpapers makes it easy to recall the meaning of the symbols used in the text.

MyEconLab

MyEconLab is a powerful assessment and tutorial system that works hand-in-hand with Macroeconomics. It includes comprehensive homework, quiz, test, and tutorial options, allowing students to test their knowledge and instructors to manage all assessment needs in one program. Students and instructors can register, create, and access all of their MyLab courses, regardless of discipline, from one conveni- ent online location: http://www.pearsonmylab.com.

Key innovations in the MyEconLab course for Macro- economics, seventh edition, include the following resources for students and instructors:

■■ MyEconLab Animation—The key figures in the seventh edition have been converted to digital figure animations where the figures from the textbook are presented in step-by-step animations with audio explanations of the action. The goal of this digital resource is to help students understand shifts in curves, movements along curves, and changes in equilibrium values. Having animated versions of a graph helps students who have difficulty interpreting the static version found in the printed text.

■■ MyEconLab Video—There are approximately 100 vid- eos featured in the new enhanced eText for the seventh edition. They provide real world explanations of key concepts with videos from the International Monetary Fund’s “World Economic Outlook” press conferences and interviews with author Olivier Blanchard. The videos include in depth market analysis and are accompanied by graded practice exercises to ensure mastery. These new videos are embedded in the eText and are accessible through MyEconLab

■■ Enhanced eText—The Pearson eText gives students access to their textbook anytime, anywhere. In addi- tion to notetaking, highlighting, and bookmarking, the Pearson eText offers interactive and sharing features. Students actively read and learn, through embedded and auto-graded practice, real-time data-graphs, anima- tions, author videos, and more. Instructors can share comments or highlights, and students can add their own, for a tight community of learners in any class.

■■ NEW: Math Review Exercises in MyEconLab. MyEconLab now offers a rich array of assignable and auto-graded exercises covering fundamental math con- cepts geared for macroeconomics students. Aimed at in- creasing student confidence and success, the new math skills review in Chapter R is accessible from the assign- ment manager and contains over 150 graphing, algebra, and calculus exercises for homework, quiz, and test use.

http://www.pearsonmylab.com
xvi Preface

■■ Practice. Algorithmically generated homework and study plan exercises with instant feedback ensure varied and productive practice that helps students improve their understanding and prepare for quizzes and tests. Exer- cises that require drawing figures encourage students to practice the language of economics.

■■ Learning Resources. Personalized learning aids such as Help Me Solve This Problem walkthroughs, Teach Me explanations of the underlying concept, and figure ani- mations provide on-demand help when students need it most.

■■ Study Plan. Customized study plans show students which sections to study next, give easy access to practice problems, and provide an automatically generated quiz to prove mastery of the course material.

■■ Current News Exercises. These exercises provide a turnkey approach to assign gradable news-based exercises in MyEconLab. Every week, Pearson scours the news, finds a current article appropriate for a macroeconomics course, creates an exercise based on this news article, and then automatically adds it to MyEconLab.

■■ MyEconLab Real-time data—Real-time data figures and exercises allow students and in- structors to use the very latest data

from the Federal Reserve Bank of St. Louis’s FRED site. These figures and exercises communicate directly with the FRED® site and update as new data are available.

■■ Digital Interactives. Focused on a single core topic and organized in progressive levels, each interactive immerses students in an assignable and auto-graded activity. Digital Interactives are lecture tools for tradi- tional, online, and hybrid courses, many incorporating real-time data, data displays, and analysis tools for rich classroom discussions.

■■ Experiments in MyEconLab. Flexible, easy to assign, auto-graded, and available in Single and Multiplayer ver- sions, the Experiments in MyEconLab make learning fun and engaging.

■■ Learning Catalytics. Learning Catalytics™ is a “bring your own device” student engagement, assessment, and classroom intelligence system that lets learners use their smartphone, tablet, or laptop to participate in and stay engaged in lecture. It allows instructors to gener- ate classroom discussion, guides lectures, and promotes peer-to-peer learning with real-time analytics. Now stu- dents can use any device to interact in the classroom, engage with content and even draw and share graphs.

Instructors can divide classes into pairs or groups based on learners’ response patterns, and learners with greater proficiency help motivate other learners while allowing instructors time to provide individualized and focused attention to learners who will benefit from it.

■■ Reporting Dashboard. Faculty can view, analyze, and report learning outcomes clearly and easily using the Re- porting Dashboard. It is available via the Gradebook and fully mobile-ready. The Reporting Dashboard presents student performance data at the class, section, and pro- gram levels in an accessible, visual manner.