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MACROECONOMICS

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N. GREGORY MANKIW Harvard University

Worth Publishers

EIGHTH EDITION

MACROECONOMICS

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Senior Vice President, Editorial and Production: Catherine Woods

Publisher: Charles Linsmeier

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Composition: MPS Limited

Printing and Binding: Quad/Graphics

Cover Art: Jylian Gustlin, Fibonacci 48

Library of Congress Control Number: 2012933861

ISBN-13: 978-1-4292-4002-4

ISBN-10: 1-4292-4002-4

© 2013, 2010, 2007, 2003 by Worth Publishers

All rights reserved.

Printed in the United States of America

First printing 2012

Worth Publishers

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New York, NY 10010

www.worthpublishers.com

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http://www.worthpublishers.com

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about the author

P h

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b y

Jo rd

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ab ré

N. Gregory Mankiw is the Robert M. Beren 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 courses

in macroeconomics. He is also author of the best-selling introductory textbook

Principles of Economics (Cengage Learning).

Professor Mankiw is a regular participant in academic and policy debates. His

research ranges across macroeconomics and includes work on price adjustment,

consumer behavior, financial markets, monetary and fiscal policy, and economic

growth. In addition to his duties at Harvard, he has been a research associate of

the National Bureau of Economic Research, a member of the Brookings Panel

on Economic Activity, and an adviser to Congressional Budget Office and the

Federal Reserve Banks of Boston and New York. From 2003 to 2005 he was

chairman of the President’s Council of Economic Advisers.

Professor Mankiw lives in Wellesley, Massachusetts, with his wife, Deborah;

children, Catherine, Nicholas, and Peter; and their border terrier, Tobin.

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To Deborah

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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 persons who cry down Logic will generally warn you against

Political Economy. It is unfeeling, they will tell you. It recognises unpleasant

facts. For my part, the most unfeeling thing I know of is the law of gravitation:

it breaks the neck of the best and most amiable person without scruple, if he

forgets for a single moment to give heed to it. The winds and waves too are very

unfeeling. Would you advise those who go to sea to deny the winds and waves –

or to make use of them, and find the means of guarding against their dangers?

My advice to you is to study the great writers on Political Economy, and hold

firmly by whatever in them you find true; and depend upon it that if you are not

selfish or hardhearted already, Political Economy will not make you so.

John Stuart Mill, 1867

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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 45 Chapter 3 National Income: Where It Comes

From and Where It Goes 47

Chapter 4 The Monetary System: What It Is and How It Works 81

Chapter 5 Inflation: Its Causes, Effects, and Social Costs 101

Chapter 6 The Open Economy 133 Chapter 7 Unemployment 177

part III Growth Theory: The Economy in the Very Long Run 203 Chapter 8 Economic Growth I: Capital

Accumulation and Population Growth 205

Chapter 9 Economic Growth II: Technology, Empirics, and Policy 235

part IV Business Cycle Theory: The Economy in the Short Run 271 Chapter 10 Introduction to Economic

Fluctuations 273

Chapter 11 Aggregate Demand I: Building the IS–LM Model 303

Chapter 12 Aggregate Demand II: Applying the IS–LM Model 327

Chapter 13 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime 355

Chapter 14 Aggregate Supply and the Short- Run Tradeoff Between Inflation and Unemployment 397

part V Topics in Macroeconomic Theory 427 Chapter 15 A Dynamic Model of Aggregate

Demand and Aggregate Supply 429

Chapter 16 Understanding Consumer Behavior 465

Chapter 17 The Theory of Investment 497

part VI Topics in Macroeconomic Policy 519 Chapter 18 Alternative Perspectives on

Stabilization Policy 521

Chapter 19 Government Debt and Budget Deficits 543

Chapter 20 The Financial System: Opportunities and Dangers 569

Epilogue What We Know, What We Don’t 593

Glossary 601 Index 611

brief contents

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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 5

1-2 How Economists Think 7 Theory as Model Building 8

� FYI Using Functions to Express Relationships Among Variables 11 The Use of Multiple Models 12

Prices: Flexible Versus Sticky 12

Microeconomic Thinking and Macroeconomic Models 13

� FYI Nobel Macroeconomists 14

1-3 How This Book Proceeds 15

Chapter 2 The Data of Macroeconomics 17

2-1 Measuring the Value of Economic Activity: Gross Domestic Product 18 Income, Expenditure, and the Circular Flow 18

� FYI Stocks and Flows 20 Rules for Computing GDP 20

Real GDP Versus Nominal GDP 23

The GDP Deflator 25

Chain-Weighted Measures of Real GDP 25

� FYI Two Arithmetic Tricks for Working With Percentage Changes 26 The Components of Expenditure 27

� FYI What Is Investment? 28 � CASE STUDY GDP and Its Components 28 Other Measures of Income 29

Seasonal Adjustment 31

2-2 Measuring the Cost of Living: The Consumer Price Index 32 The Price of a Basket of Goods 32

The CPI Versus the GDP Deflator 33

Does the CPI Overstate Inflation? 35

� CASE STUDY The Billion Prices Project 36

contents

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2-3 Measuring Joblessness: The Unemployment Rate 36 The Household Survey 37

� CASE STUDY Trends in Labor-Force Participation 38 The Establishment Survey 40

2-4 Conclusion: From Economic Statistics to Economic Models 41

part II Classical Theory: The Economy in the Long Run 45

Chapter 3 National Income: Where It Comes From and Where It Goes 47

3-1 What Determines the Total Production of Goods and Services? 49 The Factors of Production 49

The Production Function 50

The Supply of Goods and Services 50

3-2 How Is National Income Distributed to the Factors of Production? 51 Factor Prices 51

The Decisions Facing a Competitive Firm 52

The Firm’s Demand for Factors 53

The Division of National Income 56

� CASE STUDY The Black Death and Factor Prices 58 The Cobb—Douglas Production Function 58

� FYI The Growing Gap Between Rich and Poor 62 � CASE STUDY Labor Productivity as the Key Determinant of Real Wages 62

3-3 What Determines the Demand for Goods and Services? 63 Consumption 64

Investment 65

� FYI The Many Different Interest Rates 67 Government Purchases 67

3-4 What Brings the Supply and Demand for Goods and Services Into Equilibrium? 68 Equilibrium in the Market for Goods and Services: The Supply and Demand

for the Economy’s Output 69

Equilibrium in the Financial Markets: The Supply and Demand for Loanable Funds 70

Changes in Saving: The Effects of Fiscal Policy 72

� CASE STUDY Wars and Interest Rates in the United Kingdom, 1730–1920 73 Changes in Investment Demand 74

3-5 Conclusion 76

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Chapter 4 The Monetary System: What It Is and How It Works 81

4-1 What Is Money? 81 The Functions of Money 82

The Types of Money 82

� CASE STUDY Money in a POW Camp 83 The Development of Fiat Money 84

� CASE STUDY Money and Social Conventions on the Island of Yap 84 How the Quantity of Money Is Controlled 85

How the Quantity of Money Is Measured 85

� FYI How Do Credit Cards and Debit Cards Fit Into the Monetary System? 87

4-2 The Role of Banks in the Monetary System 87 100-Percent-Reserve Banking 88

Fractional-Reserve Banking 88

Bank Capital, Leverage, and Capital Requirements 90

4-3 How Central Banks Influence the Money Supply 92 A Model of the Money Supply 92

The Instruments of Monetary Policy 94

� CASE STUDY Quantitative Easing and the Exploding Monetary Base 95 Problems in Monetary Control 96

� CASE STUDY Bank Failures and the Money Supply in the 1930s 97

4-4 Conclusion 98

Chapter 5 Inflation: Its Causes, Effects, and Social Costs 101

5-1 The Quantity Theory of Money 102 Transactions and the Quantity Equation 102

From Transactions to Income 103

The Money Demand Function and the Quantity Equation 104

The Assumption of Constant Velocity 105

Money, Prices, and Inflation 106

� CASE STUDY Inflation and Money Growth 106

5-2 Seigniorage: The Revenue From Printing Money 109 � CASE STUDY Paying for the American Revolution 109

5-3 Inflation and Interest Rates 110 Two Interest Rates: Real and Nominal 110

The Fisher Effect 110

� CASE STUDY Inflation and Nominal Interest Rates 111 Two Real Interest Rates: Ex Ante and Ex Post 112

� CASE STUDY Nominal Interest Rates in the Nineteenth Century 113

5-4 The Nominal Interest Rate and the Demand for Money 114 The Cost of Holding Money 114

Future Money and Current Prices 114

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5-5 The Social Costs of Inflation 116 The Layman’s View and the Classical Response 116

� CASE STUDY What Economists and the Public Say About Inflation 117

The Costs of Expected Inflation 117

The Costs of Unexpected Inflation 119

� CASE STUDY The Free Silver Movement, the Election of 1896, and The Wizard of Oz 120

One Benefit of Inflation 121

5-6 Hyperinflation 121 The Costs of Hyperinflation 122

The Causes of Hyperinflation 122

� CASE STUDY Hyperinflation in Interwar Germany 123 � CASE STUDY Hyperinflation in Zimbabwe 125

5-7 Conclusion: The Classical Dichotomy 126 Appendix: The Cagan Model: How Current and Future Money Affect the Price Level 130

Chapter 6 The Open Economy 133

6-1 The International Flows of Capital and Goods 134 The Role of Net Exports 134

International Capital Flows and the Trade Balance 136

International Flows of Goods and Capital: An Example 138

� FYI The Irrelevance of Bilateral Trade Balances 139

6-2 Saving and Investment in a Small Open Economy 139 Capital Mobility and the World Interest Rate 139

Why Assume a Small Open Economy? 140

The Model 141

How Policies Influence the Trade Balance 142

Evaluating Economic Policy 144

� CASE STUDY The U.S. Trade Deficit 146 � CASE STUDY Why Doesn’t Capital Flow to Poor Countries? 148

6-3 Exchange Rates 149 Nominal and Real Exchange Rates 149

The Real Exchange Rate and the Trade Balance 151

The Determinants of the Real Exchange Rate 151

How Policies Influence the Real Exchange Rate 153

The Effects of Trade Policies 154

The Determinants of the Nominal Exchange Rate 156

� CASE STUDY Inflation and Nominal Exchange Rates 157 The Special Case of Purchasing-Power Parity 159

� CASE STUDY The Big Mac Around the World 160

6-4 Conclusion: The United States as a Large Open Economy 162 Appendix: The Large Open Economy 166

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Net Capital Outflow 166

The Model 168

Policies in the Large Open Economy 170

Conclusion 174

Chapter 7 Unemployment 177

7-1 Job Loss, Job Finding, and the Natural Rate of Unemployment 178 7-2 Job Search and Frictional Unemployment 180

Causes of Frictional Unemployment 181

Public Policy and Frictional Unemployment 181

� CASE STUDY Unemployment Insurance and the Rate of Job Finding 182

7-3 Real-Wage Rigidity and Structural Unemployment 183 Minimum-Wage Laws 184

� CASE STUDY The Characteristics of Minimum-Wage Workers 185 Unions and Collective Bargaining 186

Efficiency Wages 187

� CASE STUDY Henry Ford’s $5 Workday 188

7-4 Labor-Market Experience: The United States 189 The Duration of Unemployment 189

� CASE STUDY The Increase in U.S. Long-Term Unemployment and the Debate Over Unemployment Insurance 190

Variation in the Unemployment Rate Across Demographic Groups 192

Transitions Into and Out of the Labor Force 193

7-5 Labor-Market Experience: Europe 194 The Rise in European Unemployment 194

Unemployment Variation Within Europe 196

� CASE STUDY The Secrets to Happiness 197 The Rise of European Leisure 198

7-6 Conclusion 200

part III Growth Theory: The Economy in the Very Long Run 203

Chapter 8 Economic Growth I: Capital Accumulation and Population Growth 205

8-1 The Accumulation of Capital 206 The Supply and Demand for Goods 206

Growth in the Capital Stock and the Steady State 209

Approaching the Steady State: A Numerical Example 211

� CASE STUDY The Miracle of Japanese and German Growth 213 How Saving Affects Growth 214

� CASE STUDY Saving and Investment Around the World 215

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8-2 The Golden Rule Level of Capital 217 Comparing Steady States 217

Finding the Golden Rule Steady State: A Numerical Example 220

The Transition to the Golden Rule Steady State 222

8-3 Population Growth 224 The Steady State With Population Growth 225

The Effects of Population Growth 226

� CASE STUDY Population Growth Around the World 228 Alternative Perspectives on Population Growth 229

8-4 Conclusion 231

Chapter 9 Economic Growth II: Technology, Empirics, and Policy 235

9-1 Technological Progress in the Solow Model 236 The Efficiency of Labor 236

The Steady State With Technological Progress 237

The Effects of Technological Progress 238

9-2 From Growth Theory to Growth Empirics 239 Balanced Growth 239

Convergence 240

Factor Accumulation Versus Production Efficiency 241

� CASE STUDY Is Free Trade Good for Economic Growth? 242

9-3 Policies to Promote Growth 243 Evaluating the Rate of Saving 244

Changing the Rate of Saving 245

Allocating the Economy’s Investment 246

� CASE STUDY Industrial Policy in Practice 247 Establishing the Right Institutions 248

� CASE STUDY The Colonial Origins of Modern Institutions 249 Encouraging Technological Progress 250

� CASE STUDY The Worldwide Slowdown in Economic Growth 251

9-4 Beyond the Solow Model: Endogenous Growth Theory 253 The Basic Model 254

A Two-Sector Model 255

The Microeconomics of Research and Development 256

The Process of Creative Destruction 257

9-5 Conclusion 258 Appendix: Accounting for the Sources of Economic Growth 262 Increases in the Factors of Production 262

Technological Progress 264

The Sources of Growth in the United States 265

� CASE STUDY Growth in the East Asian Tigers 266 The Solow Residual in the Short Run 267

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part IV Business Cycle Theory: The Economy in the Short Run 271

Chapter 10 Introduction to Economic Fluctuations 273

10-1 The Facts About the Business Cycle 274 GDP and Its Components 274

Unemployment and Okun’s Law 277

Leading Economic Indicators 279

10-2 Time Horizons in Macroeconomics 281 How the Short Run and Long Run Differ 281

� CASE STUDY If You Want to Know Why Firms Have Sticky Prices, Ask Them 282 The Model of Aggregate Supply and Aggregate Demand 284

10-3 Aggregate Demand 285 The Quantity Equation as Aggregate Demand 285

Why the Aggregate Demand Curve Slopes Downward 286

Shifts in the Aggregate Demand Curve 287

10-4 Aggregate Supply 288 The Long Run: The Vertical Aggregate Supply Curve 288

The Short Run: The Horizontal Aggregate Supply Curve 290

From the Short Run to the Long Run 291

� CASE STUDY A Monetary Lesson From French History 293 � FYI David Hume on the Real Effects of Money 294

10-5 Stabilization Policy 294 Shocks to Aggregate Demand 295

Shocks to Aggregate Supply 296

� CASE STUDY How OPEC Helped Cause Stagflation in the 1970s and Euphoria in the 1980s 298

10-6 Conclusion 299

Chapter 11 Aggregate Demand I: Building the IS–LM Model 303

11-1 The Goods Market and the IS Curve 305 The Keynesian Cross 305

� CASE STUDY Cutting Taxes to Stimulate the Economy: The Kennedy and Bush Tax Cuts 312

� CASE STUDY Increasing Government Purchases to Stimulate the Economy: The Obama Spending Plan 313

The Interest Rate, Investment, and the IS Curve 314

How Fiscal Policy Shifts the IS Curve 316

11-2 The Money Market and the LM Curve 317 The Theory of Liquidity Preference 317

� CASE STUDY Does a Monetary Tightening Raise or Lower Interest Rates? 319 Income, Money Demand, and the LM Curve 320

How Monetary Policy Shifts the LM Curve 321

11-3 Conclusion: The Short-Run Equilibrium 322

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Chapter 12 Aggregate Demand II: Applying the IS–LM Model 327

12-1 Explaining Fluctuations With the IS–LM Model 328 How Fiscal Policy Shifts the IS Curve and Changes the Short-Run

Equilibrium 328

How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium 329

The Interaction Between Monetary and Fiscal Policy 331

� CASE STUDY Policy Analysis With Macroeconometric Models 333 Shocks in the IS–LM Model 334

� CASE STUDY The U.S. Recession of 2001 335 What Is the Fed’s Policy Instrument—The Money Supply

or the Interest Rate? 336

12-2 IS–LM as a Theory of Aggregate Demand 337 From the IS–LM Model to the Aggregate Demand Curve 337

The IS–LM Model in the Short Run and Long Run 340

12-3 The Great Depression 342 The Spending Hypothesis: Shocks to the IS Curve 343

The Money Hypothesis: A Shock to the LM Curve 344

The Money Hypothesis Again: The Effects of Falling Prices 345

Could the Depression Happen Again? 347

� CASE STUDY The Financial Crisis and Economic Downturn of 2008 and 2009 348

� FYI The Liquidity Trap (Also Known as the Zero Lower Bound) 350

12-4 Conclusion 351

Chapter 13 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime 355

13-1 The Mundell–Fleming Model 357 The Key Assumption: Small Open Economy With Perfect Capital Mobility 357

The Goods Market and the IS* Curve 358

The Money Market and the LM* Curve 358

Putting the Pieces Together 360

13-2 The Small Open Economy Under Floating Exchange Rates 361 Fiscal Policy 362

Monetary Policy 363

Trade Policy 364

13-3 The Small Open Economy Under Fixed Exchange Rates 365 How a Fixed-Exchange-Rate System Works 366

� CASE STUDY The International Gold Standard 367 Fiscal Policy 368

Monetary Policy 368

� CASE STUDY Devaluation and the Recovery From the Great Depression 370

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Trade Policy 370

Policy in the Mundell–Fleming Model: A Summary 371

13-4 Interest Rate Differentials 372 Country Risk and Exchange-Rate Expectations 372

Differentials in the Mundell–Fleming Model 373

� CASE STUDY International Financial Crisis: Mexico 1994–1995 375 � CASE STUDY International Financial Crisis: Asia 1997–1998 376

13-5 Should Exchange Rates Be Floating or Fixed? 377 Pros and Cons of Different Exchange-Rate Systems 377

� CASE STUDY The Debate Over the Euro 378 Speculative Attacks, Currency Boards, and Dollarization 380

The Impossible Trinity 381

� CASE STUDY The Chinese Currency Controversy 382

13-6 From the Short Run to the Long Run: The Mundell–Fleming Model With a Changing Price Level 383

13-7 A Concluding Reminder 386 Appendix: A Short-Run Model of the Large Open Economy 390 Fiscal Policy 392

Monetary Policy 393

A Rule of Thumb 394

Chapter 14 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment 397

14-1 The Basic Theory of Aggregate Supply 398 The Sticky-Price Model 399

An Alternative Theory: The Imperfect-Information Model 401

� CASE STUDY International Differences in the Aggregate Supply Curve 403 Implications 404

14-2 Inflation, Unemployment, and the Phillips Curve 406 Deriving the Phillips Curve From the Aggregate Supply Curve 406

� FYI The History of the Modern Phillips Curve 408 Adaptive Expectations and Inflation Inertia 408

Two Causes of Rising and Falling Inflation 409

� CASE STUDY Inflation and Unemployment in the United States 409 The Short-Run Tradeoff Between Inflation and Unemployment 412

� FYI How Precise Are Estimates of the Natural Rate of Unemployment? 413 Disinflation and the Sacrifice Ratio 414

Rational Expectations and the Possibility of Painless Disinflation 414

� CASE STUDY The Sacrifice Ratio in Practice 416 Hysteresis and the Challenge to the Natural-Rate Hypothesis 417

14-3 Conclusion 419 Appendix: The Mother of All Models 422

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part V Topics in Macroeconomic Theory 427

Chapter 15 A Dynamic Model of Aggregate Demand and Aggregate Supply 429

15-1 Elements of the Model 430 Output: The Demand for Goods and Services 430

The Real Interest Rate: The Fisher Equation 431

Inflation: The Phillips Curve 432

Expected Inflation: Adaptive Expectations 433

The Nominal Interest Rate: The Monetary-Policy Rule 434

� CASE STUDY The Taylor Rule 435

15-2 Solving the Model 437 The Long-Run Equilibrium 437

The Dynamic Aggregate Supply Curve 439

The Dynamic Aggregate Demand Curve 440

The Short-Run Equilibrium 442

15-3 Using the Model 443 Long-Run Growth 444

A Shock to Aggregate Supply 444

� FYI The Numerical Calibration and Simulation 447 A Shock to Aggregate Demand 448

A Shift in Monetary Policy 449

15-4 Two Applications: Lessons for Monetary Policy 453 The Tradeoff Between Output Variability and Inflation

Variability 453

� CASE STUDY The Fed Versus the European Central Bank 455 The Taylor Principle 456

� CASE STUDY What Caused the Great Inflation? 459

15-5 Conclusion: Toward DSGE Models 460

Chapter 16 Understanding Consumer Behavior 465

16-1 John Maynard Keynes and the Consumption Function 466 Keynes’s Conjectures 466

The Early Empirical Successes 467

Secular Stagnation, Simon Kuznets, and the Consumption Puzzle 468

16-2 Irving Fisher and Intertemporal Choice 470 The Intertemporal Budget Constraint 470

� FYI Present Value, or Why a $1,000,000 Prize Is Worth Only $623,000 472 Consumer Preferences 473

Optimization 474

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How Changes in Income Affect Consumption 475

How Changes in the Real Interest Rate Affect Consumption 476

Constraints on Borrowing 477

16-3 Franco Modigliani and the Life-Cycle Hypothesis 479 The Hypothesis 480

Implications 481

� CASE STUDY The Consumption and Saving of the Elderly 483

16-4 Milton Friedman and the Permanent-Income Hypothesis 484 The Hypothesis 484

Implications 485

� CASE STUDY The 1964 Tax Cut and the 1968 Tax Surcharge 486 � CASE STUDY The Tax Rebates of 2008 486

16-5 Robert Hall and the Random-Walk Hypothesis 487 The Hypothesis 488

Implications 488

� CASE STUDY Do Predictable Changes in Income Lead to Predictable Changes in Consumption? 489

16-6 David Laibson and the Pull of Instant Gratification 490 � CASE STUDY How to Get People to Save More 491

16-7 Conclusion 492

Chapter 17 The Theory of Investment 497

17-1 Business Fixed Investment 498 The Rental Price of Capital 499

The Cost of Capital 500

The Determinants of Investment 502

Taxes and Investment 504

The Stock Market and Tobin’s q 505

� CASE STUDY The Stock Market as an Economic Indicator 506 Alternative Views of the Stock Market: The Efficient Markets Hypothesis Versus

Keynes’s Beauty Contest 507

Financing Constraints 509

17-2 Residential Investment 510 The Stock Equilibrium and the Flow Supply 510

Changes in Housing Demand 511

17-3 Inventory Investment 514 Reasons for Holding Inventories 514

How the Real Interest Rate and Credit Conditions Affect Inventory Investment 515

17-4 Conclusion 515

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part VI Topics in Macroeconomic Policy 519

Chapter 18 Alternative Perspectives on Stabilization Policy 521

18-1 Should Policy Be Active or Passive? 522 Lags in the Implementation and Effects of Policies 522

The Difficult Job of Economic Forecasting 524

� CASE STUDY Mistakes in Forecasting 524 Ignorance, Expectations, and the Lucas Critique 526

The Historical Record 527

� CASE STUDY Is the Stabilization of the Economy a Figment of the Data? 528

18-2 Should Policy Be Conducted by Rule or by Discretion? 529 Distrust of Policymakers and the Political Process 529

The Time Inconsistency of Discretionary Policy 530

� CASE STUDY Alexander Hamilton Versus Time Inconsistency 532 Rules for Monetary Policy 532

� CASE STUDY Inflation Targeting: Rule or Constrained Discretion? 533 � CASE STUDY Central-Bank Independence 534

18-3 Conclusion: Making Policy in an Uncertain World 536 Appendix: Time Inconsistency and the Tradeoff Between Inflation and Unemployment 539

Chapter 19 Government Debt and Budget Deficits 543

19-1 The Size of the Government Debt 544 � CASE STUDY The Troubling Long-Term Outlook for Fiscal Policy 547

19-2 Problems in Measurement 548 Measurement Problem 1: Inflation 549

Measurement Problem 2: Capital Assets 549

Measurement Problem 3: Uncounted Liabilities 550

Measurement Problem 4: The Business Cycle 551

Summing Up 551

19-3 The Traditional View of Government Debt 552 � FYI Taxes and Incentives 554

19-4 The Ricardian View of Government Debt 554 The Basic Logic of Ricardian Equivalence 555

Consumers and Future Taxes 556

� CASE STUDY George Bush’s Withholding Experiment 557 � CASE STUDY Why Do Parents Leave Bequests? 559 Making a Choice 559

� FYI Ricardo on Ricardian Equivalence 560

19-5 Other Perspectives on Government Debt 561 Balanced Budgets Versus Optimal Fiscal Policy 561

Fiscal Effects on Monetary Policy 562

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Debt and the Political Process 563

International Dimensions 563

� CASE STUDY The Benefits of Indexed Bonds 564

19-6 Conclusion 565

Chapter 20 The Financial System: Opportunities and Dangers 569

20-1 What Does the Financial System Do? 570 Financing Investment 570

Sharing Risk 571

Dealing With Asymmetric Information 572

Fostering Economic Growth 573

� CASE STUDY Microfinance: Professor Yunus’s Profound Idea 574

20-2 Financial Crises 575 The Anatomy of a Crisis 576

� FYI The TED Spread 578 � CASE STUDY Who Should Be Blamed for the Financial Crisis

of 2008–2009? 580 Policy Responses to a Crisis 581

Policies to Prevent Crises 585

� FYI CoCo Bonds 586 � CASE STUDY The European Sovereign Debt Crisis 587

20-3 Conclusion 588

Epilogue What We Know, What We Don’t 593

The Four Most Important Lessons of Macroeconomics 593 Lesson 1: In the long run, a country’s capacity to produce goods and services

determines the standard of living of its citizens. 594

Lesson 2: In the short run, aggregate demand influences the amount of goods and services that a country produces. 594

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. 595

Lesson 4: In the short run, policymakers who control monetary and fiscal policy face a tradeoff between inflation and unemployment. 595

The Four Most Important Unresolved Questions of Macroeconomics 596 Question 1: How should policymakers try to promote growth in the economy’s

natural level of output? 596

Question 2: Should policymakers try to stabilize the economy? If so, how? 597

Question 3: How costly is inflation, and how costly is reducing inflation? 598

Question 4: How big a problem are government budget deficits? 599

Conclusion 600

Glossary 601

Index 611

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| xxiii

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 better what it means to be an economist.

As Keynes’s assessment suggests, students who aim to learn economics need to draw on many disparate talents. The job of helping students find and develop these talents falls to instructors and textbook authors. When writing this textbook for intermediate-level courses in macroeconomics, my goal was to make macroeco- nomics understandable, relevant, and (believe it or not) fun. Those of us who have chosen to be professional macroeconomists have done so because we are fasci- nated by the field. More important, we believe that the study of macroeconomics can illuminate much about the world and that the lessons learned, if properly applied, can make the world a better place. I hope this book conveys not only our profession’s accumulated wisdom but also its enthusiasm and sense of purpose.

This Book’s Approach

Macroeconomists share a common body of knowledge, but they do not all have the same perspective on how that knowledge is best taught. Let me begin this new edition by recapping four of my objectives, which together define this book’s approach to the field.

First, I try to offer a balance between short-run and long-run issues in macro- economics. All economists agree that public policies and other events influence the economy over different time horizons. We live in our own short run, but we also live in the long run that our parents bequeathed us. As a result, courses in macroeconomics need to cover both short-run topics, such as the business cycle and stabilization policy, and long-run topics, such as economic growth, the natural rate of unemployment, persistent inflation, and the effects of government debt. Neither time horizon trumps the other.

Second, I integrate the insights of Keynesian and classical theories. Although Keynes’s General Theory provides the foundation for much of our current under- standing of economic fluctuations, it is important to remember that classical economics provides the right answers to many fundamental questions. In this book I incorporate many of the contributions of the classical economists before Keynes and the new classical economists of the past several decades. Substantial coverage is given, for example, to the loanable-funds theory of the interest rate, the quantity theory of money, and the problem of time inconsistency. At the same time, I recognize that many of the ideas of Keynes and the new Keynesians are necessary for understanding economic fluctuations. Substantial coverage is given

preface

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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. Instead of pretending that there is one model that is complete enough to explain all facets of the economy, I encourage students to learn how to use and compare a set of prominent models. This approach has the pedagogical value that each model can be kept relatively simple and presented within one or two chapters. More important, this approach asks students to think like economists, who always keep various models in mind when analyzing economic events or public policies.

Fourth, I emphasize that macroeconomics is an empirical discipline, moti- vated and guided by a wide array of experience. This book contains numerous Case Studies that use macroeconomic theory to shed light on real-world data or events. To highlight the broad applicability of the basic theory, I have drawn the Case Studies both from current issues facing the world’s economies and from dramatic historical episodes. The Case Studies analyze the policies of Alexander Hamilton, Henry Ford, George Bush (both of them!), and Barack Obama. They teach the reader how to apply economic principles to issues from fourteenth- century Europe, the island of Yap, the land of Oz, and today’s newspaper.

What’s New in the Eighth Edition?

Economics instructors are vigilant in keeping their lectures up to date as the economic landscape changes. Textbook authors cannot be less so. This book is therefore updated about every three years. Each revision reflects new events in the economy as well as new research about the best way to understand macro- economic developments.