- •About the author
- •Brief Contents
- •Contents
- •Preface
- •This Book’s Approach
- •What’s New in the Seventh Edition?
- •The Arrangement of Topics
- •Part One, Introduction
- •Part Two, Classical Theory: The Economy in the Long Run
- •Part Three, Growth Theory: The Economy in the Very Long Run
- •Part Four, Business Cycle Theory: The Economy in the Short Run
- •Part Five, Macroeconomic Policy Debates
- •Part Six, More on the Microeconomics Behind Macroeconomics
- •Epilogue
- •Alternative Routes Through the Text
- •Learning Tools
- •Case Studies
- •FYI Boxes
- •Graphs
- •Mathematical Notes
- •Chapter Summaries
- •Key Concepts
- •Questions for Review
- •Problems and Applications
- •Chapter Appendices
- •Glossary
- •Translations
- •Acknowledgments
- •Supplements and Media
- •For Instructors
- •Instructor’s Resources
- •Solutions Manual
- •Test Bank
- •PowerPoint Slides
- •For Students
- •Student Guide and Workbook
- •Online Offerings
- •EconPortal, Available Spring 2010
- •eBook
- •WebCT
- •BlackBoard
- •Additional Offerings
- •i-clicker
- •The Wall Street Journal Edition
- •Financial Times Edition
- •Dismal Scientist
- •1-1: What Macroeconomists Study
- •1-2: How Economists Think
- •Theory as Model Building
- •The Use of Multiple Models
- •Prices: Flexible Versus Sticky
- •Microeconomic Thinking and Macroeconomic Models
- •1-3: How This Book Proceeds
- •Income, Expenditure, and the Circular Flow
- •Rules for Computing GDP
- •Real GDP Versus Nominal GDP
- •The GDP Deflator
- •Chain-Weighted Measures of Real GDP
- •The Components of Expenditure
- •Other Measures of Income
- •Seasonal Adjustment
- •The Price of a Basket of Goods
- •The CPI Versus the GDP Deflator
- •The Household Survey
- •The Establishment Survey
- •The Factors of Production
- •The Production Function
- •The Supply of Goods and Services
- •3-2: How Is National Income Distributed to the Factors of Production?
- •Factor Prices
- •The Decisions Facing the Competitive Firm
- •The Firm’s Demand for Factors
- •The Division of National Income
- •The Cobb–Douglas Production Function
- •Consumption
- •Investment
- •Government Purchases
- •Changes in Saving: The Effects of Fiscal Policy
- •Changes in Investment Demand
- •3-5: Conclusion
- •4-1: What Is Money?
- •The Functions of Money
- •The Types of Money
- •The Development of Fiat Money
- •How the Quantity of Money Is Controlled
- •How the Quantity of Money Is Measured
- •4-2: The Quantity Theory of Money
- •Transactions and the Quantity Equation
- •From Transactions to Income
- •The Assumption of Constant Velocity
- •Money, Prices, and Inflation
- •4-4: Inflation and Interest Rates
- •Two Interest Rates: Real and Nominal
- •The Fisher Effect
- •Two Real Interest Rates: Ex Ante and Ex Post
- •The Cost of Holding Money
- •Future Money and Current Prices
- •4-6: The Social Costs of Inflation
- •The Layman’s View and the Classical Response
- •The Costs of Expected Inflation
- •The Costs of Unexpected Inflation
- •One Benefit of Inflation
- •4-7: Hyperinflation
- •The Costs of Hyperinflation
- •The Causes of Hyperinflation
- •4-8: Conclusion: The Classical Dichotomy
- •The Role of Net Exports
- •International Capital Flows and the Trade Balance
- •International Flows of Goods and Capital: An Example
- •Capital Mobility and the World Interest Rate
- •Why Assume a Small Open Economy?
- •The Model
- •How Policies Influence the Trade Balance
- •Evaluating Economic Policy
- •Nominal and Real Exchange Rates
- •The Real Exchange Rate and the Trade Balance
- •The Determinants of the Real Exchange Rate
- •How Policies Influence the Real Exchange Rate
- •The Effects of Trade Policies
- •The Special Case of Purchasing-Power Parity
- •Net Capital Outflow
- •The Model
- •Policies in the Large Open Economy
- •Conclusion
- •Causes of Frictional Unemployment
- •Public Policy and Frictional Unemployment
- •Minimum-Wage Laws
- •Unions and Collective Bargaining
- •Efficiency Wages
- •The Duration of Unemployment
- •Trends in Unemployment
- •Transitions Into and Out of the Labor Force
- •6-5: Labor-Market Experience: Europe
- •The Rise in European Unemployment
- •Unemployment Variation Within Europe
- •The Rise of European Leisure
- •6-6: Conclusion
- •7-1: The Accumulation of Capital
- •The Supply and Demand for Goods
- •Growth in the Capital Stock and the Steady State
- •Approaching the Steady State: A Numerical Example
- •How Saving Affects Growth
- •7-2: The Golden Rule Level of Capital
- •Comparing Steady States
- •The Transition to the Golden Rule Steady State
- •7-3: Population Growth
- •The Steady State With Population Growth
- •The Effects of Population Growth
- •Alternative Perspectives on Population Growth
- •7-4: Conclusion
- •The Efficiency of Labor
- •The Steady State With Technological Progress
- •The Effects of Technological Progress
- •Balanced Growth
- •Convergence
- •Factor Accumulation Versus Production Efficiency
- •8-3: Policies to Promote Growth
- •Evaluating the Rate of Saving
- •Changing the Rate of Saving
- •Allocating the Economy’s Investment
- •Establishing the Right Institutions
- •Encouraging Technological Progress
- •The Basic Model
- •A Two-Sector Model
- •The Microeconomics of Research and Development
- •The Process of Creative Destruction
- •8-5: Conclusion
- •Increases in the Factors of Production
- •Technological Progress
- •The Sources of Growth in the United States
- •The Solow Residual in the Short Run
- •9-1: The Facts About the Business Cycle
- •GDP and Its Components
- •Unemployment and Okun’s Law
- •Leading Economic Indicators
- •9-2: Time Horizons in Macroeconomics
- •How the Short Run and Long Run Differ
- •9-3: Aggregate Demand
- •The Quantity Equation as Aggregate Demand
- •Why the Aggregate Demand Curve Slopes Downward
- •Shifts in the Aggregate Demand Curve
- •9-4: Aggregate Supply
- •The Long Run: The Vertical Aggregate Supply Curve
- •From the Short Run to the Long Run
- •9-5: Stabilization Policy
- •Shocks to Aggregate Demand
- •Shocks to Aggregate Supply
- •10-1: The Goods Market and the IS Curve
- •The Keynesian Cross
- •The Interest Rate, Investment, and the IS Curve
- •How Fiscal Policy Shifts the IS Curve
- •10-2: The Money Market and the LM Curve
- •The Theory of Liquidity Preference
- •Income, Money Demand, and the LM Curve
- •How Monetary Policy Shifts the LM Curve
- •Shocks in the IS–LM Model
- •From the IS–LM Model to the Aggregate Demand Curve
- •The IS–LM Model in the Short Run and Long Run
- •11-3: The Great Depression
- •The Spending Hypothesis: Shocks to the IS Curve
- •The Money Hypothesis: A Shock to the LM Curve
- •Could the Depression Happen Again?
- •11-4: Conclusion
- •12-1: The Mundell–Fleming Model
- •The Goods Market and the IS* Curve
- •The Money Market and the LM* Curve
- •Putting the Pieces Together
- •Fiscal Policy
- •Monetary Policy
- •Trade Policy
- •How a Fixed-Exchange-Rate System Works
- •Fiscal Policy
- •Monetary Policy
- •Trade Policy
- •Policy in the Mundell–Fleming Model: A Summary
- •12-4: Interest Rate Differentials
- •Country Risk and Exchange-Rate Expectations
- •Differentials in the Mundell–Fleming Model
- •Pros and Cons of Different Exchange-Rate Systems
- •The Impossible Trinity
- •12-6: From the Short Run to the Long Run: The Mundell–Fleming Model With a Changing Price Level
- •12-7: A Concluding Reminder
- •Fiscal Policy
- •Monetary Policy
- •A Rule of Thumb
- •The Sticky-Price Model
- •Implications
- •Adaptive Expectations and Inflation Inertia
- •Two Causes of Rising and Falling Inflation
- •Disinflation and the Sacrifice Ratio
- •13-3: Conclusion
- •14-1: Elements of the Model
- •Output: The Demand for Goods and Services
- •The Real Interest Rate: The Fisher Equation
- •Inflation: The Phillips Curve
- •Expected Inflation: Adaptive Expectations
- •The Nominal Interest Rate: The Monetary-Policy Rule
- •14-2: Solving the Model
- •The Long-Run Equilibrium
- •The Dynamic Aggregate Supply Curve
- •The Dynamic Aggregate Demand Curve
- •The Short-Run Equilibrium
- •14-3: Using the Model
- •Long-Run Growth
- •A Shock to Aggregate Supply
- •A Shock to Aggregate Demand
- •A Shift in Monetary Policy
- •The Taylor Principle
- •14-5: Conclusion: Toward DSGE Models
- •15-1: Should Policy Be Active or Passive?
- •Lags in the Implementation and Effects of Policies
- •The Difficult Job of Economic Forecasting
- •Ignorance, Expectations, and the Lucas Critique
- •The Historical Record
- •Distrust of Policymakers and the Political Process
- •The Time Inconsistency of Discretionary Policy
- •Rules for Monetary Policy
- •16-1: The Size of the Government Debt
- •16-2: Problems in Measurement
- •Measurement Problem 1: Inflation
- •Measurement Problem 2: Capital Assets
- •Measurement Problem 3: Uncounted Liabilities
- •Measurement Problem 4: The Business Cycle
- •Summing Up
- •The Basic Logic of Ricardian Equivalence
- •Consumers and Future Taxes
- •Making a Choice
- •16-5: Other Perspectives on Government Debt
- •Balanced Budgets Versus Optimal Fiscal Policy
- •Fiscal Effects on Monetary Policy
- •Debt and the Political Process
- •International Dimensions
- •16-6: Conclusion
- •Keynes’s Conjectures
- •The Early Empirical Successes
- •The Intertemporal Budget Constraint
- •Consumer Preferences
- •Optimization
- •How Changes in Income Affect Consumption
- •Constraints on Borrowing
- •The Hypothesis
- •Implications
- •The Hypothesis
- •Implications
- •The Hypothesis
- •Implications
- •17-7: Conclusion
- •18-1: Business Fixed Investment
- •The Rental Price of Capital
- •The Cost of Capital
- •The Determinants of Investment
- •Taxes and Investment
- •The Stock Market and Tobin’s q
- •Financing Constraints
- •Banking Crises and Credit Crunches
- •18-2: Residential Investment
- •The Stock Equilibrium and the Flow Supply
- •Changes in Housing Demand
- •18-3: Inventory Investment
- •Reasons for Holding Inventories
- •18-4: Conclusion
- •19-1: Money Supply
- •100-Percent-Reserve Banking
- •Fractional-Reserve Banking
- •A Model of the Money Supply
- •The Three Instruments of Monetary Policy
- •Bank Capital, Leverage, and Capital Requirements
- •19-2: Money Demand
- •Portfolio Theories of Money Demand
- •Transactions Theories of Money Demand
- •The Baumol–Tobin Model of Cash Management
- •19-3 Conclusion
- •Lesson 2: In the short run, aggregate demand influences the amount of goods and services that a country produces.
- •Question 1: How should policymakers try to promote growth in the economy’s natural level of output?
- •Question 2: Should policymakers try to stabilize the economy?
- •Question 3: How costly is inflation, and how costly is reducing inflation?
- •Question 4: How big a problem are government budget deficits?
- •Conclusion
- •Glossary
- •Index
500 | P A R T V I More on the Microeconomics Behind Macroeconomics
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 Keynes relates current consumption to current income. This relationship, however, is incomplete at best. When people decide how much to consume and how much to save, they consider both the present and the future.The more consumption they enjoy today, the less they will be able to enjoy tomorrow. In making this tradeoff, households must look ahead to the income they expect to receive in the future and to the consumption of goods and services they hope to be able to afford.
The economist Irving Fisher developed the model with which economists analyze how rational, forward-looking consumers make intertemporal choices— that is, choices involving different periods of time. Fisher’s model illuminates the constraints consumers face, the preferences they have, and how these constraints and preferences together determine their choices about consumption and saving.
The Intertemporal Budget Constraint
Most people would prefer to increase the quantity or quality of the goods and services they consume—to wear nicer clothes, eat at better restaurants, or see more movies.The reason people consume less than they desire is that their consumption is constrained by their income. In other words, consumers face a limit on how much they can spend, called a budget constraint. When they are deciding how much to consume today versus how much to save for the future, they face an intertemporal budget constraint, which measures the total resources available for consumption today and in the future. Our first step in developing Fisher’s model is to examine this constraint in some detail.
To keep things simple, we examine the decision facing a consumer who lives for two periods. Period one represents the consumer’s youth, and period two represents the consumer’s old age.The consumer earns income Y1 and consumes C1 in period one, and earns income Y2 and consumes C2 in period two. (All variables are real—that is, adjusted for inflation.) Because the consumer has the opportunity to borrow and save, consumption in any single period can be either greater or less than income in that period.
Consider how the consumer’s income in the two periods constrains consumption in the two periods. In the first period, saving equals income minus consumption.That is,
S = Y1 − C1,
C H A P T E R 1 7 Consumption | 501
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 consumption in period two. Because there is no third period, the consumer does not save in the second period.
Note that the variable S can represent either saving or borrowing and that these equations hold in both cases. If first-period consumption is less than first-period income, the consumer is saving, and S is greater than zero. If first-period consumption exceeds first-period income, the consumer is borrowing, and S is less than zero. For simplicity, we assume that the interest rate for borrowing is the same as the interest rate for saving.
To derive the consumer’s budget constraint, combine the two preceding equations. Substitute the first equation for S into the second equation to obtain
C2 = (1 + r)(Y1 − C1) + Y2.
To make the equation easier to interpret, we must rearrange terms. To place all the consumption terms together, bring (1 + r)C1 from the right-hand side to the left-hand side of the equation to obtain
(1 + r)C1 + C2 = (1 + r)Y1 + Y2. Now divide both sides by 1 + r to obtain
C1 |
C2 |
Y2 |
+ = Y1 |
+ . |
|
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1 + r |
1 + r |
This equation relates consumption in the two periods to income in the two periods. It is the standard way of expressing the consumer’s intertemporal budget constraint.
The consumer’s budget constraint is easily interpreted. If the interest rate is zero, the budget constraint shows that total consumption in the two periods equals total income in the two periods. In the usual case in which the interest rate is greater than zero, future consumption and future income are discounted by a factor 1 + r. This discounting arises from the interest earned on savings. In essence, because the consumer earns interest on current income that is saved, future income is worth less than current income. Similarly, because future consumption is paid for out of savings that have earned interest, future consumption costs less than current consumption. The factor 1/(1 + r) is the price of sec- ond-period consumption measured in terms of first-period consumption: it is the amount of first-period consumption that the consumer must forgo to obtain 1 unit of second-period consumption.
Figure 17-3 graphs the consumer’s budget constraint.Three points are marked on this figure. At point A, the consumer consumes exactly his income in each period (C1 = Y1 and C2 = Y2), so there is neither saving nor borrowing between
502 | P A R T V I More on the Microeconomics Behind Macroeconomics
FIGURE 17-3
Second-period |
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consumption, C2 B |
Consumer’s |
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(1 r)Y1 Y2 |
budget |
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constraint |
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Saving |
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Y2 |
A |
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Borrowing |
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C |
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Y1 |
Y1 Y2/(1 r) |
The Consumer’s Budget Constraint
This figure shows the combinations of first-period and second-period consumption the consumer can choose. If he chooses points between A and B, he consumes less than his income in the first period and saves the rest for the second period. If he chooses points between A and C, he consumes more than his income in the first period and borrows to make up the difference.
First-period consumption, C1
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
FYI
Present Value, or Why a $1,000,000 Prize Is Worth Only $623,000
The use of discounting in the consumer’s budget constraint illustrates an important fact of economic life: a dollar in the future is less valuable than a dollar today. This is true because a dollar today can be deposited in an interest-bearing bank account and produce more than one dollar in the future. If the interest rate is 5 percent, for instance, then a dollar today can be turned into $1.05 dollars next year, $1.1025 in two years, $1.1576 in three years, . . . , or $2.65 in 20 years.
Economists use a concept called present value to compare dollar amounts from different times. The present value of any amount in the future is the amount that would be needed today, given available interest rates, to produce that future amount. Thus, if you are going to be paid X dollars in T years and the interest rate is r, then the present value of that payment is
Present Value = X/(1 + r)T.
In light of this definition, we can see a new interpretation of the consumer’s budget constraint in our two-period consumption problem. The intertemporal budget constraint states that the present value of consumption must equal the present value of income.
The concept of present value has many applications. Suppose, for instance, that you won a million-dollar lottery. Such prizes are usually paid out over time—say, $50,000 a year for 20 years. What is the present value of such a delayed prize? By applying the above formula to each of the 20 payments and adding up the result, we learn that the million-dollar prize, discounted at an interest rate of 5 percent, has a present value of only $623,000. (If the prize were paid out as a dollar a year for a million years, the present value would be a mere $20!) Sometimes a million dollars isn’t all it’s cracked up to be.
C H A P T E R 1 7 Consumption | 503
first-period consumption C1 is Y1 + Y2/(1 + r).These are only three of the many combinations of firstand 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 represented by indifference curves. An indifference curve shows the combinations of first-period and second-period consumption that make the consumer equally happy.
Figure 17-4 shows two of the consumer’s many indifference curves.The consumer is indifferent among combinations W, X, and Y, because they are all on the same curve. Not surprisingly, if the consumer’s first-period consumption is reduced, say from point W to point X, second-period consumption must increase to keep him equally happy. If first-period consumption is reduced again, from point X to point Y, the amount of extra second-period consumption he requires for compensation is greater.
The slope at any point on the indifference curve shows how much secondperiod consumption the consumer requires in order to be compensated for a 1-unit reduction in first-period consumption. This slope is the marginal rate of substitution between first-period consumption and second-period consumption. It tells us the rate at which the consumer is willing to substitute sec- ond-period consumption for first-period consumption.
Notice that the indifference curves in Figure 17-4 are not straight lines; as a result, the marginal rate of substitution depends on the levels of consumption in the two periods. When first-period consumption is high and second-period consumption is low, as at point W, the marginal rate of substitution is low: the consumer requires only a little extra second-period consumption to give up
FIGURE 17-4
Second-period consumption, C2
Y
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Z |
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X |
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IC2 |
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W |
IC1 |
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First-period consumption, C1 |
The Consumer’s Preferences
Indifference curves represent the consumer’s preferences over first-period and secondperiod consumption. An indifference curve gives the combinations of consumption in the two periods that make the consumer equally happy. This figure shows two of many indifference curves. Higher indifference curves such as IC2 are preferred to lower curves such as IC1. The consumer is equally happy at points W, X, and Y, but prefers point Z to points W, X, or Y.