Macroeconomics Tenth Edition PDF

Books Are The Ever-burning Lamps on Your Way to Success - Curtis www.BookX.net MACROECONOMICS TENTH EDITION MACROECONOMICS N. GREGORY MANKIW Harvard University Senior Vice President, Content Strategy: Charles Linsmeier Program Director, Social Sciences: Shani Fisher Executive Program Manager: Simon Glick Development Editor: Jane E. Tufts Assistant Editor: Courtney Lindwall Editorial Assistant: Amanda Gaglione Marketing Manager: Andrew Zierman Marketing Assistant: Chelsea Simens Director of Media Editorial & Assessment, Social Sciences: Noel Hohnstine Associate Media Editor: Nikolas Toner Assessment Manager: Kristyn Brown Assessment Editor: Joshua Hill Media Project Manager: Andrew Vaccaro Director, Content Management Enhancement: Tracey Kuehn Senior Managing Editor: Lisa Kinne Senior Photo Editor: Robin Fadool Director of Design, Content Management: Diana Blume Design Services Manager: Natasha A. S. Wolfe Cover Designer: John Callahan Text Designer: Kall Design Senior Workflow Manager: Susan Wein Composition: Lumina Datamatics, Inc. Cover Art: Kirsten Hinte/Shutterstock Library of Congress Control Number: 2018941309 ISBN: 978-1-319-10605-8 (epub) © 2019, 2016, 2013, 2010 by Worth Publishers All rights reserved. 1 2 3 4 5 6 23 22 21 20 19 18 Worth Publishers One New York Plaza Suite 4500 New York, NY 10004-1562 www.macmillanlearning.com About the Author 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. At - Harvard, he has taught 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, a trustee of the Urban Institute, and an adviser to the Congressional Budget Office and the Federal Reserve Banks of Boston and New York. From 2003 to 2005, he was chair of the President’s Council of Economic Advisers. Professor Mankiw lives in Massachusetts with his wife, Deborah, and their children, Catherine, Nicholas, and Peter. To Deborah Those branches of politics, or of the laws of social life, in which there exists a collection of facts or thoughts 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 Brief Contents Media and Resources from Worth Publishers Prelude: Celebrating the Tenth Edition Preface Part I Introduction Chapter 1 The Science of Macroeconomics Chapter 2 The Data of Macroeconomics Part II Classical Theory: The Economy in the Long Run Chapter 3 National Income: Where It Comes From and Where It Goes Chapter 4 The Monetary System: What It Is and How It Works Chapter 5 Inflation: Its Causes, Effects, and Social Costs Chapter 6 The Open Economy Chapter 7 Unemployment and the Labor Market Part III Growth Theory: The Economy in the Very Long Run Chapter 8 Economic Growth I: Capital Accumulation and Population Growth Chapter 9 Economic Growth II: Technology, Empirics, and Policy Part IV Business Cycle Theory: The Economy in the Short Run Chapter 10 Introduction to Economic Fluctuations Chapter 11 Aggregate Demand I: Building the IS–LM Model Chapter 12 Aggregate Demand II: Applying the IS–LM Model Chapter 13 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime Chapter 14 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment Part V Topics in Macroeconomic Theory and Policy Chapter 15 A Dynamic Model of Economic Fluctuations Chapter 16 Alternative Perspectives on Stabilization Policy Chapter 17 Government Debt and Budget Deficits Chapter 18 The Financial System: Opportunities and Dangers Chapter 19 The Microfoundations of Consumption and Investment Epilogue What We Know, What We Don’t Glossary Index Media and Resources from Worth Publishers Digital Resources for Students and Instructors Worth Publishers’ new online course system, SaplingPlus, combines Learning-Curve with an integrated e- book, robust homework, improved graphing, and fully digital end-of-chapter problems, including Work It Outs. Online homework helps students get better grades with targeted instructional feedback tailored to the individual. And it saves instructors time preparing for and managing a course by providing personalized support from a Ph.D. or master’s level colleague trained in Sapling’s system. Worth Publishers has worked closely with Greg Mankiw and a team of talented economics instructors to assemble a variety of resources for instructors and students. We have been delighted by all of the positive feedback we have received. For Instructors Instructor’s Resource Manual Robert G. Murphy (Boston College) has revised the impressive resource manual for instructors. For each chapter of this book, the manual contains notes to the instructor, a detailed lecture outline, additional case studies, and coverage of advanced topics. Instructors can use the manual to prepare their lectures, and they can reproduce whatever pages they choose as handouts for students. Each chapter also contains a Moody’s Analytics Economy.com Activity (www.economy.com), which challenges students to combine the chapter knowledge with a high-powered business database and analysis service that offers real-time monitoring of the global economy. Solutions Manual Mark Gibson (Washington State University) has updated the Solutions Manual for all the Questions for Review and Problems and Applications found in the text. Test Bank The Test Bank has been extensively revised and improved for the tenth edition. Based on reviewer feedback, Worth Publishers, in collaboration with Daniel Moncayo (Brigham Young University), has checked every question, retained only the best, and added fresh new questions. The Test Bank now includes more than 2,200 multiple-choice questions, numerical problems, and short-answer graphical questions to accompany each chapter. The Test Bank provides a wide range of questions appropriate for assessing students’ comprehension, interpretation, analysis, and synthesis skills. Lecture Slides Ryan Lee (Indiana University) has revised his lecture slides for the material in each chapter. They feature graphs with careful explanations and additional case studies, data, and helpful notes to the instructor. Designed to be customized or used as is, the slides include easy directions for instructors who have little PowerPoint experience. End-of-Chapter Problems The end-of-chapter problems from the text have been converted to an interactive format with answer-specific feedback. These problems can be assigned as homework assignments or in quizzes. Graphing Questions Powered by improved graphing, multi-step questions paired with helpful feedback guide students through the process of problem solving. Students are asked to demonstrate their understanding by simply clicking, dragging, and dropping a line to a predetermined location. The graphs have been designed so that students’ entire focus is on moving the correct curve in the correct direction, virtually eliminating grading issues for instructors. Homework Assignments Each chapter contains prebuilt assignments, providing instructors with a curated set of multiple-choice and graphing questions that can be easily assigned for practice or graded assessments. For Students LearningCurve LearningCurve is an adaptive quizzing engine that automatically adjusts questions to a student’s mastery level. With LearningCurve activities, each student follows a unique path to understanding the material. The more questions a student answers correctly, the more difficult the questions become. Each question is written specifically for the text and is linked to the relevant e-book section. LearningCurve also provides a personal study plan for students as well as complete metrics for instructors. LearningCurve, which has been proved to raise student performance, serves as an ideal formative assessment and learning tool. Work It Out Tutorials These skill-building activities pair sample end-of-chapter problems (identified with this icon: ) with targeted feedback and video explanations to help students solve a similar problem step by step. This approach allows students to work independently, tests their comprehension of concepts, and prepares them for class and exams. Fed Chairman Game Created by the Federal Reserve Bank of San Francisco, the game allows students to become Chairman of the Fed and to make macroeconomic policy decisions based on news events and economic statistics. This fun-to- play simulation gives students a sense of the complex interconnections that influence the economy. Prelude: Celebrating the Tenth Edition I started writing the first edition of this book in 1988. My department chair had asked me to teach intermediate macroeconomics, a required course for Harvard economics majors. I happily accepted the assignment and continued teaching intermediate macro for the next 15 years. (I stepped away only when asked to take over the principles course.) As I prepared for the course by surveying existing texts, I realized that none of them fully satisfied me. While many were excellent books, I felt that they did not provide the right balance between long- run and short-run perspectives, between classical and Keynesian insights. And some were too long and comprehensive to be easily taught in one semester. Thus, this book was born. Since its initial publication in 1991, the book has found an eager audience. My publisher tells me that it has been the best-selling intermediate macroeconomics text throughout most of its life. That is truly heartening. I am grateful to the numerous instructors who have adopted the book and, over many editions, have helped me improve it with their input. Even more heartening are the letters and emails from students around the world, who tell me how the book helped them navigate the exciting and challenging field of macroeconomics. Over the past 30 years, macroeconomics has evolved as history has presented new questions and research has offered new answers. When the first edition came out, no one had heard of digital currencies such as bitcoin, Europe did not have a common currency, John Taylor had not devised his eponymous rule for monetary policy, behavioral economists like David Laibson and Richard Thaler had not proposed new ways to explain consumer behavior, and the economics profession had yet to be forced by the events of 2008 to focus anew on financial crises. Because of these and many other developments, I have updated this book every three years to ensure that students always have access to state-of-the-art thinking. We macroeconomists still have much to learn. But the current body of macroeconomic knowledge offers students much insight into the world in which they live. Nothing delights me more than knowing that this book has helped convey this insight to the next generation. Preface An economist must be “mathematician, historian, statesman, philosopher, in some degree... as aloof and incorruptible as an artist, yet sometimes as near to earth as a politician.” So remarked John Maynard Keynes, the great British economist who could be called the father of macroeconomics. No single statement summarizes better what it means to be an economist. As Keynes suggests, students learning economics must draw on many disparate talents. The job of helping students develop these talents falls to instructors and textbook authors. My goal for this book is to make macroeconomics understandable, relevant, and (believe it or not) fun. Those of us who have chosen to be macroeconomists have done so because we are fascinated 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 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 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 topics. 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. Keynes’s General Theory is the foundation for much of our understanding of economic fluctuations, but classical economics provides the right answers to many questions. In this book I incorporate 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, the ideas of Keynes and the new Keynesians are necessary for understanding fluctuations. Substantial coverage is also given 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 complete enough to explain all facets of the economy, I encourage students to learn how to use a set of prominent models. This approach has the pedagogical value that each model can be kept 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, motivated 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 and events. To highlight the broad applicability of the theory, I have drawn the case studies both from current issues facing the world’s economies and from dramatic historical episodes. 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 Tenth Edition? Here is a brief rundown of the notable changes in this edition: ► Scraping the barnacles. tl;dr. For those not familiar with Internet slang, this abbreviation means “too long, didn’t read.” Sadly, many students take this approach to textbooks. My main goal in this revision, therefore, has been a renewed commitment to brevity. In particular, I took up the task of scraping off the barnacles that have accumulated over many editions. More important than what has been added to this edition is what has been taken out. This task has benefited from surveys of instructors who use the book. I have kept what most instructors consider essential and taken out what most consider superfluous. ► Streaming coverage of consumption and investment. The material on the microeconomic foundations of consumption and investment has been condensed into a single, more accessible chapter. ► New topic in Chapter 9. The role of culture in economic growth. ► New topic in Chapter 12. The curious case of negative interest rates. ► New topic in Chapter 18. The stress tests that regulators are using to evaluate banks’ safety and soundness. ► New assessment tool. This edition includes a new pedagogical feature. Every chapter concludes with a Quick Quiz of six multiple-choice questions. Students can use these quizzes to immediately test their understanding of the core concepts in the chapter. The quiz answers are available at the end of each chapter. ► Updated data. As always, the book has been fully updated. All the data are as current as possible. Despite these changes, my goal remains the same as in previous editions: to offer students the clearest, most up-to-date, most accessible course in macroeconomics in the fewest words possible. The Arrangement of Topics My strategy for teaching macroeconomics is first to examine the long run, when prices are flexible, and then to examine the short run, when prices are sticky. This approach has several advantages. First, because the classical dichotomy permits the separation of real and monetary issues, the long-run material is easier for students. Second, when students begin studying short-run fluctuations, they understand the long-run equilibrium around which the economy is fluctuating. Third, beginning with market-clearing models clarifies the link between macroeconomics and microeconomics. Fourth, students learn first the material that is less controversial. For all these reasons, the strategy of beginning with long-run classical models simplifies the teaching of macroeconomics. Let’s now move from strategy to tactics. What follows is a whirlwind tour of the book. Part One, Introduction The introductory material in Part One is brief so that students can get to the core topics quickly. Chapter 1 discusses the questions that macroeconomists address and the economist’s approach of building models to explain the world. Chapter 2 introduces the data of macroeconomics, emphasizing gross domestic product, the consumer price index, and the unemployment rate. Part Two, Classical Theory: The Economy in the Long Run Part Two examines the long run, over which prices are flexible. Chapter 3 presents the classical model of national income. In this model, the factors of production and the production technology determine the level of income, and the marginal products of the factors determine its distribution to households. In addition, the model shows how fiscal policy influences the allocation of the economy’s resources among consumption, investment, and government purchases, and it highlights how the real interest rate equilibrates the supply and demand for goods and services. Money and the price level are introduced next. Chapter 4 examines the monetary system and the tools of monetary policy. Chapter 5 begins the discussion of the effects of monetary policy. Because prices are assumed to be flexible, the chapter presents the ideas of classical monetary theory: the quantity theory of money, the inflation tax, the Fisher effect, the social costs of inflation, and the causes and costs of hyperinflation. The study of open-economy macroeconomics begins in Chapter 6. Maintaining the assumption of full employment, this chapter presents models that explain the trade balance and the exchange rate. Various policy issues are addressed: the relationship between the budget deficit and the trade deficit, the macroeconomic impact of protectionist trade policies, and the effect of monetary policy on the value of a currency in the market for foreign exchange. Chapter 7 relaxes the assumption of full employment, discussing the dynamics of the labor market and the natural rate of unemployment. It examines various causes of unemployment, including job search, minimum- wage laws, union power, and efficiency wages. It also presents some important facts about patterns of unemployment. Part Three, Growth Theory: The Economy in the Very Long Run Part Three makes the classical analysis of the economy dynamic with the tools of growth theory. Chapter 8 introduces the Solow growth model, emphasizing capital accumulation and population growth. Chapter 9 then adds technological progress to the Solow model. It uses the model to discuss growth experiences around the world as well as public policies that influence the level and growth of the standard of living. Chapter 9 also introduces students to the modern theories of endogenous growth. Part Four, Business Cycle Theory: The Economy in the Short Run Part Four examines the short run, when prices are sticky. It begins in Chapter 10 by examining the key facts that describe short-run fluctuations in economic activity. The chapter then introduces the model of aggregate supply and aggregate demand, as well as the role of stabilization policy. Subsequent chapters refine the ideas introduced in this chapter. Chapters 11 and 12 look more closely at aggregate demand. Chapter 11 presents the Keynesian cross and the theory of liquidity preference and uses these models as building blocks for the IS–LM model. Chapter 12 uses the IS–LM model to explain economic fluctuations and the aggregate demand curve, concluding with an extended case study of the Great Depression. The discussion of short-run fluctuations continues in Chapter 13, which focuses on aggregate demand in an open economy. This chapter presents the Mundell–Fleming model and shows how monetary and fiscal policies affect the economy under floating and fixed exchange-rate systems. It also discusses the question of whether exchange rates should be floating or fixed. Chapter 14 looks more closely at aggregate supply. It examines various approaches to explaining the short- run aggregate supply curve and discusses the short-run tradeoff between inflation and unemployment. Part Five, Topics in Macroeconomic Theory and Policy Once students have a solid command of standard models, the book offers them various optional chapters that dive deeper into macroeconomic theory and policy. Chapter 15 develops a dynamic model of aggregate demand and aggregate supply. It builds on ideas that students have already encountered and uses those ideas as stepping-stones to take students closer to the frontier of knowledge about short-run fluctuations. The model presented here is a simplified version of modern dynamic, stochastic, general equilibrium (DSGE) models. Chapter 16 considers the debate over how policymakers should respond to short-run fluctuations. It emphasizes two questions: Should monetary and fiscal policy be active or passive? Should policy be conducted by rule or discretion? The chapter presents arguments on both sides of these questions. Chapter 17 focuses on debates over government debt and budget deficits. It gives a broad picture of the magnitude of government indebtedness, discusses why measuring budget deficits is not always straightforward, recaps the traditional view of the effects of government debt, presents Ricardian equivalence as an alternative view, and examines various other perspectives on government debt. As in the previous chapter, students are not handed conclusions but are given tools to evaluate alternative viewpoints on their own. Chapter 18 discusses the financial system and its linkages to the overall economy. It begins by examining what the financial system does: financing investment, sharing risk, dealing with asymmetric information, and fostering growth. It then discusses the causes of financial crises, their macroeconomic impact, and the policies that might mitigate their effects and reduce their likelihood. Chapter 19 analyzes some of the microeconomics behind consumption and investment decisions. It discusses various theories of consumer behavior, including the Keynesian consumption function, Modigliani’s life-cycle hypothesis, Friedman’s permanent-income hypothesis, Hall’s random-walk hypothesis, and Laibson’s model of instant gratification. It also examines the theory behind the investment function, focusing on business fixed investment and including topics such as the cost of capital, Tobin’s q, and the role of financing constraints. Epilogue The book ends with an epilogue that reviews the broad lessons about which most macroeconomists agree and some important open questions. Regardless of which chapters an instructor covers, this capstone chapter can be used to remind students how the many models and themes of macroeconomics relate to one another. Here and throughout the book, I emphasize that despite the disagreements among macroeconomists, there is much that we know about how the economy works. Alternative Routes Through the Text Instructors of intermediate macroeconomics have different preferences about the choice and organization of topics. I kept this in mind while writing the book so that it would offer a degree of flexibility. Here are a few ways that instructors might consider rearranging the material: ► Some instructors are eager to cover short-run economic fluctuations. For such a course, I recommend covering Chapters 1 through 5 so that students are grounded in the basics of classical theory and then jumping to Chapters 10, 11, 12, and 14 to cover the model of aggregate demand and aggregate supply. ► Some instructors are eager to cover long-run economic growth. These instructors can cover Chapters 8 and 9 immediately after Chapter 3. ► An instructor who wants to defer (or even skip) open-economy macroeconomics can put off Chapters 6 and 13 without loss of continuity. ► An instructor who wants to emphasize macroeconomic policy can skip Chapters 8, 9, and 15 in order to get to Chapters 16, 17, and 18 more quickly. ► An instructor who wants to stress the microeconomic foundations of macroeconomics can cover Chapter 19 early in the course, even after Chapter 3. The successful experiences of hundreds of instructors with previous editions suggest this text nicely complements a variety of approaches to the field. Learning Tools I am pleased that students have found the previous editions of this book user-friendly. I have tried to make this tenth edition even more so. Case Studies Economics comes to life when it is applied to understanding actual events. Therefore, the numerous case studies are an important learning tool, integrated closely with the theoretical material presented in each chapter. The frequency with which these case studies occur ensures that a student does not have to grapple with an overdose of theory before seeing the theory applied. Students report that the case studies are their favorite part of the book. FYI Boxes These boxes present ancillary material “for your information.” I use these boxes to clarify difficult concepts, to provide additional information about the tools of economics, and to show how economics impacts our daily lives. Graphs Understanding graphical analysis is a central part of learning macroeconomics, and I have worked hard to make the figures easy to follow. I often use comment boxes within figures to describe and draw attention to the key points that the figures illustrate. The pedagogical use of color, detailed captions, and comment boxes makes it easier for students to learn and review the material. Mathematical Notes I use occasional mathematical footnotes to keep difficult material out of the body of the text. These notes make an argument more rigorous or present a proof of a mathematical result. They can be skipped by students who have not been introduced to the necessary mathematical tools. Quick Quizzes Every chapter ends with six multiple-choice questions, which students can use to test themselves on what they have just read. The answers are provided at the end of each chapter. These quizzes are new to this edition. Chapter Summaries Every chapter includes a brief, nontechnical summary of its major lessons. Students can use the summaries to place the material in perspective and to review for exams. Key Concepts Learning the language of a field is a major part of any course. Within the chapter, each key concept is in boldface when it is introduced. At the end of the chapter, the key concepts are listed for review. Questions for Review Students are asked to test their understanding of a chapter’s basic lessons in the Questions for Review. Problems and Applications Every chapter includes Problems and Applications designed for homework assignments. Some are numerical applications of the theory in the chapter. Others encourage students to go beyond the material in the chapter by addressing new issues that are closely related to the chapter topics. In most of the core chapters, a few problems are identified with this icon:. For each of these problems, students can find a Work It Out tutorial on SaplingPlus for Macroeconomics, 10e: https://macmillanlearning.com/sapling. Chapter Appendices Several chapters include appendices that offer additional material, sometimes at a higher level of mathematical sophistication. These appendices are designed so that instructors can cover certain topics in greater depth if they wish. The appendices can be skipped altogether without loss of continuity. Glossary To help students become familiar with the language of macroeconomics, a glossary of more than 250 terms is provided at the back of the book. International Editions The English-language version of this book has been used in dozens of countries. To make the book more accessible for students around the world, editions are (or will soon be) available in 17 other languages: Armenian, Chinese (Simplified and Complex), French, German, Greek, Hungarian, Indonesian, Italian, Japanese, Korean, Portuguese, Romanian, Russian, Spanish, Ukrainian, and Vietnamese. In addition, a Canadian adaptation coauthored with William Scarth (McMaster University) and a European adaptation coauthored with Mark Taylor (University of Warwick) are available. Instructors who would like information about these versions of the book should contact Worth Publishers. Acknowledgments Since I started writing the first edition of this book, I have benefited from the input of many reviewers and colleagues in the economics profession. Now that the book is in its tenth edition, these people are too numerous to list in their entirety. However, I continue to be grateful for their willingness to have given up their scarce time to help me improve the economics and pedagogy of this text. Their advice has made this book a better teaching tool for hundreds of thousands of students around the world. I would like to mention the instructors whose recent input shaped this new edition: David Aadland University of Wyoming Lian An University of Northern Florida Samuel K. Andoh Southern Connecticut State University Dennis Avola Northeastern University Mustapha Ibn Boamah University of New Brunswick, Saint John Jeffrey Buser The Ohio State University Kenneth I. Carlaw University of British Columbia, Okanagan Sel Dibooglu University of Missouri, St. Louis Oguzhan Dincer Illinois State University Christi-Anna Durodola University of Winnipeg Per Fredriksson University of Louisville Mark J. Gibson Washington State University Lisa R. Gladson St. Louis University David W. Johnson University of Wisconsin–Madison J.B. Kim Oklahoma State University Ryan Lee Indiana University Meghan Millea Mississippi State University Daniel Moncayo Brigham Young University Robert Murphy Boston College John Neri University of Maryland Russell M. Price Howard University Raul Razo-Garcia Carleton University Subarna Samanta The College of New Jersey Ruben Sargsyan California State University, Chico Fahlino F. Sjuib Framingham State University Julie K. Smith Lafayette College Peter Summers High Point University Ariuntungalag Taivan University of Minnesota–Duluth Kiril Tochkov Texas Christian University Christian vom Lehn Brigham Young University Paul Wachtel New York University In addition, I am grateful to Nina Vendhan, a student at Harvard, who helped me update the data and refine my prose. Nina, along with my son Nick Mankiw, also helped me proofread the book. The people at Worth Publishers have continued to be congenial and dedicated. I would like to thank Catherine Woods, Vice President, Content Management; Charles Linsmeier, Senior Vice President, Content Strategy; Shani Fisher, Director of Content and Assessment; Simon Glick, Executive Program Manager; Andrew Zierman, Marketing Manager; Travis Long, Learning Solutions Specialist; Noel Hohnstine, Director of Media Editorial; Nikolas Toner, Associate Media Editor; Assessment Manager, Kristyn Brown; Joshua Hill, Assessment Editor; Lukia Kliossis, Development Editor; Courtney Lindwall, Assistant Editor; Amanda Gaglione, Editorial Assistant; Hannah Aronowitz, Editorial Intern; Lisa Kinne, Senior Managing Editor; Tracey Kuehn, Director, Content Management Enhancement; Diana Blume, Director of Design, Content Management; and Kitty Wilson, Copyeditor. Many other people have made valuable contributions as well. Most important, Jane Tufts, freelance developmental editor, worked her magic on this book once again, confirming that she’s the best in the business. Alexandra Nickerson did a great job preparing the index. Deborah Mankiw, my wife and in-house editor, continued to be the first reader of new material, providing the right mix of criticism and encouragement. Finally, I would like to thank my three children, Catherine, Nicholas, and Peter. They helped immensely with this revision—both by providing a pleasant distraction and by reminding me that textbooks are written for the next generation. May 2018 Contents Cover About This Ebook IFC Half Title Title Page Copyright About the Author Dedication Front Matter Brief Contents Media and Resources from Worth Publishers Prelude: Celebrating the Tenth Edition Preface Part I Introduction Chapter 1 The Science of Macroeconomics 1-1 What Macroeconomists Study CASE STUDY The Historical Performance of the U.S. Economy 1-2 How Economists Think Theory as Model Building The Use of Multiple Models FYI Using Functions to Express Relationships Among Variables Prices: Flexible Versus Sticky Microeconomic Thinking and Macroeconomic Models FYI The Early Lives of Macroeconomists 1-3 How This Book Proceeds Chapter 2 The Data of Macroeconomics 2-1 Measuring the Value of Economic Activity: Gross Domestic Product Income, Expenditure, and the Circular Flow FYI Stocks and Flows Rules for Computing GDP Real GDP Versus Nominal GDP The GDP Deflator Chain-Weighted Measures of Real GDP FYI Two Helpful Hints for Working with Percentage Changes The Components of Expenditure FYI What Is Investment? CASE STUDY GDP and Its Components Other Measures of Income Seasonal Adjustment 2-2 Measuring the Cost of Living: The Consumer Price Index The Price of a Basket of Goods How the CPI Compares to the GDP and PCE Deflators Does the CPI Overstate Inflation? 2-3 Measuring Joblessness: The Unemployment Rate The Household Survey CASE STUDY Men, Women, and Labor-Force Participation The Establishment Survey 2-4 Conclusion: From Economic Statistics to Economic Models Part II Classical Theory: The Economy in the Long Run Chapter 3 National Income: Where It Comes From and Where It Goes 3-1 What Determines the Total Production of Goods and Services? 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 a Competitive Firm The Firm’s Demand for Factors The Division of National Income CASE STUDY The Black Death and Factor Prices The Cobb–Douglas Production Function CASE STUDY Labor Productivity as the Key Determinant of Real Wages FYI The Growing Gap Between Rich and Poor 3-3 What Determines the Demand for Goods and Services? Consumption Investment Government Purchases FYI The Many Different Interest Rates 3-4 What Brings the Supply and Demand for Goods and Services into Equilibrium? Equilibrium in the Market for Goods and Services: The Supply and Demand for the Economy’s Output Equilibrium in the Financial Markets: The Supply and Demand for Loanable Funds Changes in Saving: The Effects of Fiscal Policy Changes in Investment Demand 3-5 Conclusion Chapter 4 The Monetary System: What It Is and How It Works 4-1 What Is Money? The Functions of Money The Types of Money CASE STUDY Money in a POW Camp The Development of Fiat Money CASE STUDY Money and Social Conventions on the Island of Yap FYI Bitcoin: The Strange Case of a Digital Money How the Quantity of Money Is Controlled How the Quantity of Money Is Measured FYI How Do Credit Cards and Debit Cards Fit into the Monetary System? 4-2 The Role of Banks in the Monetary System 100-Percent-Reserve Banking Fractional-Reserve Banking Bank Capital, Leverage, and Capital Requirements 4-3 How Central Banks Influence the Money Supply A Model of the Money Supply The Instruments of Monetary Policy CASE STUDY Quantitative Easing and the Exploding Monetary Base Problems in Monetary Control CASE STUDY Bank Failures and the Money Supply in the 1930s 4-4 Conclusion Chapter 5 Inflation: Its Causes, Effects, and Social Costs 5-1 The Quantity Theory of Money Transactions and the Quantity Equation From Transactions to Income The Money Demand Function and the Quantity Equation The Assumption of Constant Velocity Money, Prices, and Inflation CASE STUDY Inflation and Money Growth 5-2 Seigniorage: The Revenue from Printing Money CASE STUDY Paying for the American Revolution 5-3 Inflation and Interest Rates Two Interest Rates: Real and Nominal The Fisher Effect CASE STUDY Inflation and Nominal Interest Rates Two Real Interest Rates: Ex Ante and Ex Post 5-4 The Nominal Interest Rate and the Demand for Money The Cost of Holding Money Future Money and Current Prices 5-5 The Social Costs of Inflation The Layman’s View and the Classical Response CASE STUDY What Economists and the Public Say About Inflation The Costs of Expected Inflation The Costs of Unexpected Inflation CASE STUDY The Free Silver Movement, the Election of 1896, and the Wizard of Oz One Benefit of Inflation 5-6 Hyperinflation The Costs of Hyperinflation The Causes of Hyperinflation CASE STUDY Hyperinflation in Interwar Germany CASE STUDY Hyperinflation in Zimbabwe 5-7 Conclusion: The Classical Dichotomy Chapter 6 The Open Economy 6-1 The International Flows of Capital and Goods The Role of Net Exports International Capital Flows and the Trade Balance International Flows of Goods and Capital: An Example The Irrelevance of Bilateral Trade Balances 6-2 Saving and Investment in a Small Open Economy Capital Mobility and the World Interest Rate Why Assume a Small Open Economy? The Model How Policies Influence the Trade Balance Evaluating Economic Policy CASE STUDY The U.S. Trade Deficit CASE STUDY Why Doesn’t Capital Flow to Poor Countries? 6-3 Exchange Rates 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 Determinants of the Nominal Exchange Rate CASE STUDY Inflation and Nominal Exchange Rates The Special Case of Purchasing-Power Parity CASE STUDY The Big Mac Around the World 6-4 Conclusion: The United States as a Large Open Economy Appendix The Large Open Economy Chapter 7 Unemployment and the Labor Market 7-1 Job Loss, Job Finding, and the Natural Rate of Unemployment 7-2 Job Search and Frictional Unemployment Causes of Frictional Unemployment Public Policy and Frictional Unemployment CASE STUDY Unemployment Insurance and the Rate of Job Finding 7-3 Real-Wage Rigidity and Structural Unemployment Minimum-Wage Laws Unions and Collective Bargaining Efficiency Wages CASE STUDY Henry Ford’s $5 Workday 7-4 Labor-Market Experience: The United States The Duration of Unemployment CASE STUDY The Increase in U.S. Long-Term Unemployment and the Debate over Unemployment Insurance Variation in the Unemployment Rate Across Demographic Groups Transitions into and out of the Labor Force CASE STUDY The Decline in Labor-Force Participation: 2007 to 2017 7-5 Labor-Market Experience: Europe The Rise in European Unemployment Unemployment Variation Within Europe The Rise of European Leisure 7-6 Conclusion Part III Growth Theory: The Economy in the Very Long Run Chapter 8 Economic Growth I: Capital Accumulation and Population Growth 8-1 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 CASE STUDY The Miracle of Japanese and German Growth How Saving Affects Growth 8-2 The Golden Rule Level of Capital Comparing Steady States Finding the Golden Rule Steady State: A Numerical Example The Transition to the Golden Rule Steady State 8-3 Population Growth The Steady State with Population Growth The Effects of Population Growth CASE STUDY Investment and Population Growth Around the World Alternative Perspectives on Population Growth 8-4 Conclusion Chapter 9 Economic Growth II: Technology, Empirics, and Policy 9-1 Technological Progress in the Solow Model The Efficiency of Labor The Steady State with Technological Progress The Effects of Technological Progress 9-2 From Growth Theory to Growth Empirics Balanced Growth Convergence Factor Accumulation Versus Production Efficiency CASE STUDY Good Management as a Source of Productivity 9-3 Policies to Promote Growth Evaluating the Rate of Saving Changing the Rate of Saving Allocating the Economy’s Investment CASE STUDY Industrial Policy in Practice Establishing the Right Institutions CASE STUDY The Colonial Origins of Modern Institutions Supporting a Pro-growth Culture Encouraging Technological Progress CASE STUDY Is Free Trade Good for Economic Growth? 9-4 Beyond the Solow Model: Endogenous Growth Theory The Basic Model A Two-Sector Model The Microeconomics of Research and Development The Process of Creative Destruction 9-5 Conclusion Appendix Accounting for the Sources of Economic Growth Part IV Business Cycle Theory: The Economy in the Short Run Chapter 10 Introduction to Economic Fluctuations 10-1 The Facts About the Business Cycle GDP and Its Components Unemployment and Okun’s Law Leading Economic Indicators 10-2 Time Horizons in Macroeconomics How the Short Run and the Long Run Differ CASE STUDY If You Want to Know Why Firms Have Sticky Prices, Ask Them The Model of Aggregate Supply and Aggregate Demand 10-3 Aggregate Demand The Quantity Equation as Aggregate Demand Why the Aggregate Demand Curve Slopes Downward Shifts in the Aggregate Demand Curve 10-4 Aggregate Supply The Long Run: The Vertical Aggregate Supply Curve The Short Run: The Horizontal Aggregate Supply Curve From the Short Run to the Long Run CASE STUDY A Monetary Lesson from French History 10-5 Stabilization Policy Shocks to Aggregate Demand Shocks to Aggregate Supply CASE STUDY How OPEC Helped Cause Stagflation in the 1970s and Euphoria in the 1980s 10-6 Conclusion Chapter 11 Aggregate Demand I: Building the IS–LM Model 11-1 The Goods Market and the IS Curve The Keynesian Cross CASE STUDY Cutting Taxes to Stimulate the Economy: The Kennedy and Bush Tax Cuts CASE STUDY Increasing Government Purchases to Stimulate the Economy: The Obama Stimulus CASE STUDY Using Regional Data to Estimate Multipliers The Interest Rate, Investment, and the IS Curve How Fiscal Policy Shifts the IS Curve 11-2 The Money Market and the LM Curve The Theory of Liquidity Preference CASE STUDY Does a Monetary Tightening Raise or Lower Interest Rates? Income, Money Demand, and the LM Curve How Monetary Policy Shifts the LM Curve 11-3 Conclusion: The Short-Run Equilibrium Chapter 12 Aggregate Demand II: Applying the IS–LM Model 12-1 Explaining Fluctuations with the IS–LM Model How Fiscal Policy Shifts the IS Curve and Changes the Short-Run Equilibrium How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium The Interaction Between Monetary and Fiscal Policy Shocks in the IS–LM Model CASE STUDY The U.S. Recession of 2001 What Is the Fed’s Policy Instrument—The Money Supply or the Interest Rate? 12-2 IS–LM as a Theory of Aggregate Demand From the IS–LM Model to the Aggregate Demand Curve The IS–LM Model in the Short Run and Long Run 12-3 The Great Depression The Spending Hypothesis: Shocks to the IS Curve The Money Hypothesis: A Shock to the LM Curve The Money Hypothesis Again: The Effects of Falling Prices Could the Depression Happen Again? CASE STUDY The Financial Crisis and Great Recession of 2008 and 2009 The Liquidity Trap (Also Known as the Zero Lower Bound) FYI The Curious Case of Negative Interest Rates 12-4 Conclusion Chapter 13 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime 13-1 The Mundell–Fleming Model The Key Assumption: Small Open Economy with Perfect Capital Mobility The Goods Market and the IS* Curve The Money Market and the LM* Curve Putting the Pieces Together 13-2 The Small Open Economy Under Floating Exchange Rates Fiscal Policy Monetary Policy Trade Policy 13-3 The Small Open Economy Under Fixed Exchange Rates How a Fixed-Exchange-Rate System Works CASE STUDY The International Gold Standard Fiscal Policy Monetary Policy CASE STUDY Devaluation and the Recovery from the Great Depression Trade Policy Policy in the Mundell–Fleming Model: A Summary 13-4 Interest Rate Differentials Country Risk and Exchange-Rate Expectations Differentials in the Mundell–Fleming Model CASE STUDY International Financial Crisis: Mexico 1994–1995 CASE STUDY International Financial Crisis: Asia 1997–1998 13-5 Should Exchange Rates Be Floating or Fixed? Pros and Cons of Different Exchange-Rate Systems CASE STUDY The Debate over the Euro Speculative Attacks, Currency Boards, and Dollarization The Impossible Trinity CASE STUDY The Chinese Currency Controversy 13-6 From the Short Run to the Long Run: The Mundell–Fleming Model with a Changing Price Level 13-7 A Concluding Reminder Appendix A Short-Run Model of the Large Open Economy Chapter 14 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment 14-1 The Basic Theory of Aggregate Supply The Sticky-Price Model An Alternative Theory: The Imperfect-Information Model CASE STUDY International Differences in the Aggregate Supply Curve Implications 14-2 Inflation, Unemployment, and the Phillips Curve Deriving the Phillips Curve from the Aggregate Supply Curve FYI The History of the Modern Phillips Curve Adaptive Expectations and Inflation Inertia Two Causes of Rising and Falling Inflation CASE STUDY Inflation and Unemployment in the United States The Short-Run Tradeoff Between Inflation and Unemployment Disinflation and the Sacrifice Ratio FYI How Precise Are Estimates of the Natural Rate of Unemployment? Rational Expectations and the Possibility of Painless Disinflation CASE STUDY The Sacrifice Ratio in Practice Hysteresis and the Challenge to the Natural-Rate Hypothesis 14-3 Conclusion Appendix The Mother of All Models Part V Topics in Macroeconomic Theory and Policy Chapter 15 A Dynamic Model of Economic Fluctuations 15-1 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 CASE STUDY The Taylor Rule 15-2 Solving the Model The Long-Run Equilibrium The Dynamic Aggregate Supply Curve The Dynamic Aggregate Demand Curve The Short-Run Equilibrium 15-3 Using the Model Long-Run Growth A Shock to Aggregate Supply A Shock to Aggregate Demand FYI The Numerical Calibration and Simulation A Shift in Monetary Policy 15-4 Two Applications: Lessons for Monetary Policy The Tradeoff Between Output Variability and Inflation Variability CASE STUDY Different Mandates, Different Realities: The Fed Versus the ECB The Taylor Principle CASE STUDY What Caused the Great Inflation? 15-5 Conclusion: Toward DSGE Models Chapter 16 Alternative Perspectives on Stabilization Policy 16-1 Should Policy Be Active or Passive? Lags in the Implementation and Effects of Policies The Difficult Job of Economic Forecasting CASE STUDY Mistakes in Forecasting Ignorance, Expectations, and the Lucas Critique The Historical Record CASE STUDY Is the Stabilization of the Economy a Figment of the Data? CASE STUDY How Does Policy Uncertainty Affect the Economy? 16-2 Should Policy Be Conducted by Rule or Discretion? Distrust of Policymakers and the Political Process The Time Inconsistency of Discretionary Policy CASE STUDY Alexander Hamilton Versus Time Inconsistency Rules for Monetary Policy CASE STUDY Inflation Targeting: Rule or Constrained Discretion? CASE STUDY Central-Bank Independence 16-3 Conclusion Appendix Time Inconsistency and the Tradeoff Between Inflation and Unemployment Chapter 17 Government Debt and Budget Deficits 17-1 The Size of the Government Debt CASE STUDY The Troubling Long-Term Outlook for Fiscal Policy 17-2 Measurement Problems Problem 1: Inflation Problem 2: Capital Assets Problem 3: Uncounted Liabilities Problem 4: The Business Cycle Summing Up 17-3 The Traditional View of Government Debt FYI Taxes and Incentives 17-4 The Ricardian View of Government Debt The Basic Logic of Ricardian Equivalence Consumers and Future Taxes CASE STUDY George H. W. Bush’s Withholding Experiment Making a Choice FYI Ricardo on Ricardian Equivalence 17-5 Other Perspectives on Government Debt Balanced Budgets Versus Optimal Fiscal Policy Fiscal Effects on Monetary Policy Debt and the Political Process International Dimensions 17-6 Conclusion Chapter 18 The Financial System: Opportunities and Dangers 18-1 What Does the Financial System Do? Financing Investment Sharing Risk Dealing with Asymmetric Information Fostering Economic Growth 18-2 Financial Crises The Anatomy of a Crisis FYI The Efficient Markets Hypothesis Versus Keynes’s Beauty Contest FYI The TED Spread CASE STUDY Who Should Be Blamed for the Financial Crisis of 2008–2009? Policy Responses to a Crisis Policies to Prevent Crises CASE STUDY The European Sovereign Debt Crisis 18-3 Conclusion Chapter 19 The Microfoundations of Consumption and Investment 19-1 What Determines Consumer Spending? John Maynard Keynes and the Consumption Function Franco Modigliani and the Life-Cycle Hypothesis Milton Friedman and the Permanent-Income Hypothesis CASE STUDY The 1964 Tax Cut and the 1968 Tax Surcharge CASE STUDY The Tax Rebates of 2008 Robert Hall and the Random-Walk Hypothesis CASE STUDY Do Predictable Changes in Income Lead to Predictable Changes in Consumption? David Laibson and the Pull of Instant Gratification CASE STUDY How to Get People to Save More The Bottom Line on Consumption 19-2 What Determines Investment Spending? The Rental Price of Capital The Cost of Capital The Cost-Benefit Calculus of Investment Taxes and Investment The Stock Market and Tobin’s q CASE STUDY The Stock Market as an Economic Indicator Financing Constraints The Bottom Line on Investment 19-3 Conclusion: The Key Role of Expectations Epilogue What We Know, What We Don’t The Four Most Important Lessons of Macroeconomics Lesson 1: In the long run, a country’s capacity to produce goods and services determines the standard of living of its citizens. Lesson 2: In the short run, aggregate demand influences the amount of goods and services that a country produces. 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. Lesson 4: In the short run, policymakers who control monetary and fiscal policy face a tradeoff between inflation and unemployment. The Four Most Important Unresolved Questions of Macroeconomics 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? If so, how? 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 CHAPTER 1 The Science of Macroeconomics The whole of science is nothing more than a refinement of everyday thinking. —Albert Einstein When Albert Einstein made the above observation, he was probably referring to the natural sciences like physics and chemistry. But the statement also applies to social sciences such as economics. As a participant in the economy, and as a citizen in a democracy, you cannot help but think about economic issues as you go about your life or when you enter the voting booth. But if you are like most people, your everyday thinking about economics has been casual rather than rigorous (or at least it was before you took your first economics course). The goal of studying economics is to refine that thinking. This book aims to help you in that endeavor, focusing on the part of the field called macroeconomics, which studies the forces that influence the economy as a whole. 1-1 What Macroeconomists Study Why have some countries experienced rapid growth in incomes over the past century while others have stayed mired in poverty? Why do some countries have high rates of inflation while others maintain stable prices? Why do all countries experience recessions and depressions — recurrent periods of falling incomes and rising unemployment — and how can government policy reduce the frequency and severity of these episodes? Macroeconomics attempts to answer these and many related questions. To appreciate the importance of macroeconomics, you need only visit a news website. Every day you can see headlines such as INCOME GROWTH REBOUNDS, FED MOVES TO COMBAT INFLATION, or JOBS REPORT SENDS STOCKS LOWER. These macroeconomic events may seem abstract, but they touch all of our lives. Business executives forecasting the demand for their products must guess how fast consumers’ incomes will grow. Senior citizens living on fixed incomes wonder how quickly prices will rise. Recent college graduates looking for employment hope that the economy will boom and that firms will be hiring. Because the state of the economy affects everyone, macroeconomic issues play a central role in national political debates. Voters are aware of how the economy is doing, and they know that government policy can affect the economy in powerful ways. As a result, the popularity of an incumbent president often rises when the economy is doing well and falls when it is doing poorly. Macroeconomic issues are also central to world politics, and the international news is filled with macroeconomic questions. Was it a good move for much of Europe to adopt a common currency? Should China maintain a fixed exchange rate against the U.S. dollar? Why is the United States running large trade deficits? How can poor nations raise their standards of living? When world leaders meet, these topics are often high on the agenda. Although the job of making economic policy belongs to world leaders, the job of explaining the workings of the economy as a whole falls to macroeconomists. To this end, macroeconomists collect data on incomes, prices, unemployment, and many other variables from different time periods and different countries. They then attempt to formulate general theories to explain these data. Like astronomers studying the evolution of stars or biologists studying the evolution of species, macroeconomists usually cannot conduct controlled experiments in a laboratory. Instead, they must make use of the data that history gives them. Macroeconomists observe that economies differ across countries and that they change over time. These observations provide both the motivation for developing macroeconomic theories and the data for testing them. To be sure, macroeconomics is an imperfect science. The macroeconomist’s ability to predict the future course of economic events is no better than the meteorologist’s ability to predict next month’s weather. But, as you will see, macroeconomists know quite a lot about how economies work. This knowledge is useful both for explaining economic events and for formulating economic policy. Every era has its own economic problems. In the 1970s, Presidents Richard Nixon, Gerald Ford, and Jimmy Carter all wrestled in vain with a rising inflation rate. In the 1980s, inflation subsided, but Presidents Ronald Reagan and George H. W. Bush presided over large federal budget deficits. In the 1990s, with President Bill Clinton in the Oval Office, the economy and stock market enjoyed a remarkable boom, and the federal budget turned from deficit to surplus. As Clinton left office, however, the stock market was in retreat, and the economy was heading into recession. In 2001, President George W. Bush reduced taxes to help end the recession, but the tax cuts contributed to a reemergence of budget deficits. President Barack Obama moved into the White House in 2009 during a period of heightened economic turbulence. The economy was reeling from a financial crisis driven by falling housing prices, rising mortgage defaults, and the bankruptcy or near-bankruptcy of many large and economically significant financial institutions. As the crisis spread, it raised the specter of the Great Depression of the 1930s, when in its worst year one out of four Americans who wanted to work could not find a job. In 2008 and 2009, officials in the Treasury, Federal Reserve, and other parts of government acted vigorously to prevent a recurrence of that outcome. In some ways, policymakers succeeded; the unemployment rate peaked at 10 percent in 2009. But the downturn was nonetheless severe, and the subsequent recovery was slow. Total income in the economy, adjusted for inflation, grew at an average rate of 1.3 percent per year from 2006 to 2016, well below the historical norm of 3.2 percent per year. These events helped set the stage for President Donald Trump’s campaign slogan of 2016: “Make America Great Again.” Macroeconomic history is not a simple story, but it provides a rich motivation for macroeconomic theory. While the basic principles of macroeconomics do not change from decade to decade, the macroeconomist must apply these principles with flexibility and creativity to meet changing circumstances. CASE STUDY The Historical Performance of the U.S. Economy Economists use many types of data to measure the performance of an economy. Three macroeconomic variables are especially important: real gross domestic product (GDP), the inflation rate, and the unemployment rate. Real GDP measures the total income of everyone in the economy (adjusted for the level of prices). The inflation rate measures how fast prices are rising. The unemployment rate measures the fraction of the labor force that is out of work. Macroeconomists study how these variables are determined, why they change over time, and how they interact with one another. Figure 1-1 shows real GDP per person in the United States. Two aspects of this figure are noteworthy. First, real GDP grows over time. Real GDP per person today is more than eight times higher than it was in 1900. This growth in average income allows us to enjoy a much higher standard of living than our great-grandparents did. Second, although real GDP rises in most years, this growth is not steady. There are repeated periods during which real GDP falls, the most dramatic instance being the early 1930s. Such periods are called recessions if they are mild and depressions if they are more severe. Not surprisingly, periods of declining income are associated with substantial economic hardship. FIGURE 1-1 Real GDP Per Person in the U.S. Economy Real GDP measures the total income of everyone in the economy, and real GDP per person measures the income of the average person in the economy. This figure shows that real GDP per person tends to grow over time and that this normal growth is sometimes interrupted by periods of declining income, called recessions or depressions. Note: Real GDP is plotted here on a logarithmic scale. On such a scale, equal distances on the vertical axis represent equal percentage changes. Thus, the distance between $5,000 and $10,000 (a 100 percent change) is the same as the distance between $10,000 and $20,000 (a 100 percent change). Data from: U.S. Department of Commerce, Economic History Association. Figure 1-2 shows the U.S. inflation rate. You can see that inflation varies substantially over time. In the first half of the twentieth century, the inflation rate averaged only slightly above zero. Periods of falling prices, called deflation, were almost as common as periods of rising prices. By contrast, inflation has been the norm during the past half century. Inflation became most severe during the late 1970s, when prices rose at a rate of almost 10 percent per year. In recent years, the inflation rate has been about 2 percent per year, indicating that prices have been fairly stable. FIGURE 1-2 The Inflation Rate in the U.S. Economy The inflation rate measures the percentage change in the average level of prices from the year before. When the inflation rate is above zero, prices are rising. When it is below zero, prices are falling. If the inflation rate declines but remains positive, prices are rising but at a slower rate. Note: The inflation rate is measured here using the GDP deflator. Data from: U.S. Department of Commerce, Economic History Association. Figure 1-3 shows the U.S. unemployment rate. Notice that there is always some unemployment in the economy. In addition, although the unemployment rate has no long-term trend, it varies substantially from year to year. Recessions and depressions are associated with unusually high unemployment. The highest rates of unemployment were reached during the Great Depression of the 1930s. The worst economic downturn since the Great Depression occurred in the aftermath of the financial crisis of 2008–2009, when unemployment rose substantially. Even several years after the crisis (called the “Great Recession”), unemployment remained high. Unemployment did not return to its 2007 level until 2016. FIGURE 1-3 The Unemployment Rate in the U.S. Economy The unemployment rate measures the percentage of people in the labor force who do not have jobs. This figure shows that the economy always has some unemployment and that the amount fluctuates from year to year. Data from: U.S. Department of Labor, U.S. Census Bureau. These three figures offer a glimpse at the history of the U.S. economy. In the chapters that follow, we first discuss how these variables are measured and then develop theories to explain how they behave. 1-2 How Economists Think Economists often study politically charged issues, but they try to address these issues with a scientist’s objectivity. Like any science, economics has its own set of tools — terminology, data, and a way of thinking — that can seem foreign and arcane to the layperson. The best way to become familiar with these tools is to practice using them, and this book affords you ample opportunity to do so. To make these tools less forbidding, however, let’s discuss a few of them here. Theory as Model Building Children learn about the world by playing with toy versions of real objects. For instance, they often put together models of cars, trains, or planes. These models are not realistic, but the model-builder learns a lot from them nonetheless. The model illustrates the essence of the object it is designed to resemble. (In addition, for many children, building models is fun.) Economists also use models to understand the world, but an economist’s model is more likely to be made of symbols and equations than plastic and glue. Economists build their “toy economies” to explain economic variables, such as GDP, inflation, and unemployment. Economic models illustrate, often in mathematical terms, the relationships among the variables. Models are useful because they help us dispense with irrelevant details and focus on underlying connections. (In addition, for many economists, building models is fun.) Models have two kinds of variables: endogenous variables and exogenous variables. Endogenous variables are those variables that a model explains. Exogenous variables are those variables that a model takes as given. The purpose of a model is to show how the exogenous variables influence the endogenous variables. In other words, as Figure 1-4 illustrates, exogenous variables come from outside the model and serve as the model’s input, whereas endogenous variables are determined within the model and are the model’s output. FIGURE 1-4 How Models Work Models are simplified theories that show the key relationships among economic variables. The exogenous variables are those that come from outside the model. The endogenous variables are those that the model explains. The model shows how changes in the exogenous variables affect the endogenous variables. To make these ideas more concrete, let’s review the most celebrated of all economic models — the model of supply and demand. Imagine that an economist wants to figure out what factors influence the price of pizza and the quantity of pizza sold. She would develop a model to describe the behavior of pizza buyers, the behavior of pizza sellers, and their interaction in the market for pizza. For example, the economist supposes that the quantity of pizza demanded by consumers Qd depends on the price of pizza P and on aggregate income Y. This relationship is expressed in the equation Qd=D(P, Y), where D( ) represents the demand function. Similarly, the economist supposes that the quantity of pizza supplied by pizzerias Qs depends on the price of pizza P and on the price of materials Pm, such as cheese, tomatoes, flour, and anchovies. This relationship is expressed as Qs= S(P, Pm), where S( ) represents the supply function. Finally, the economist assumes that the price of pizza adjusts to bring the quantity supplied and quantity demanded into balance: Qs = Qd. These three equations compose a model of the market for pizza. The economist illustrates the model with a supply-and-demand diagram, as in Figure 1-5. The demand curve shows the relationship between the quantity of pizza demanded and the price of pizza, holding aggregate income constant. The demand curve slopes downward because a higher price of pizza encourages consumers to buy less pizza and switch to, say, hamburgers and tacos. The supply curve shows the relationship between the quantity of pizza supplied and the price of pizza, holding the price of materials constant. The supply curve slopes upward because a higher price of pizza makes selling pizza more profitable, which encourages pizzerias to produce more of it. The equilibrium for the market is the price and quantity at which the supply and demand curves intersect. At the equilibrium price, consumers choose to buy the amount of pizza that pizzerias choose to produce. FIGURE 1-5 The Model of Supply and Demand The most famous economic model is that of supply and demand for a good or service — in this case, pizza. The demand curve is a downward-sloping curve relating the price of pizza to the quantity of pizza that consumers demand. The supply curve is an upward-sloping curve relating the price of pizza to the quantity of pizza that pizzerias supply. The price of pizza adjusts until the quantity supplied equals the quantity demanded. The point where the two curves cross is the market equilibrium, which shows the equilibrium price of pizza and the equilibrium quantity of pizza. This model of the pizza market has two exogenous variables and two endogenous variables. The exogenous variables are aggregate income and the price of materials. The model does not explain them but instead takes them as given (perhaps to be explained by another model). The endogenous variables are the price of pizza and the quantity of pizza exchanged. These are the variables that the model explains. The model can be used to show how a change in any exogenous variable affects both endogenous variables. For example, if aggregate income increases, then the demand for pizza increases, as in panel (a) of Figure 1-6. The model shows that both the equilibrium price and the equilibrium quantity of pizza rise. Similarly, if the price of materials increases, then the supply of pizza decreases, as in panel (b) of Figure 1-6. The model shows that in this case, the equilibrium price of pizza rises, while the equilibrium quantity of pizza falls. Thus, the model shows how changes either in aggregate income or in the price of materials affect price and quantity in the market for pizza. FIGURE 1-6 Changes in Equilibrium In panel (a), a rise in aggregate income causes the demand for pizza to increase: at any given price, consumers now want to buy more pizza. This is represented by a rightward shift in the demand curve from D1 to D2. The market moves to the new intersection of supply and demand. The equilibrium price rises from P1 to P2, and the equilibrium quantity of pizza rises from Q1 to Q2. In panel (b), a rise in the price of materials decreases the supply of pizza: at any given price, pizzerias find that the sale of pizza is less profitable and therefore choose to produce less pizza. This is represented by a leftward shift in the supply curve from S1 to S2. The market moves to the new intersection of supply and demand. The equilibrium price rises from P1 to P2, and the equilibrium quantity falls from Q1 to Q2. Like all models, this model of the pizza market makes simplifying assumptions. The model does not take into account, for example, that every pizzeria is in a different location. For each customer, one pizzeria is more convenient than the others, and thus pizzerias have some ability to set their own prices. The model assumes that there is a single price for pizza, but in fact there could be a different price at each pizzeria. How should we react to the model’s lack of realism? Should we discard the simple model of pizza supply and demand? Should we attempt to build a more complex model with diverse pizza prices? The answers to these questions depend on our purpose. If our goal is to explain how the price of cheese affects the average price of pizza and the amount of pizza sold, then the diversity of pizza prices is probably not important. The simple model of the pizza market does a good job of addressing that issue. Yet if our goal is to explain why towns with ten pizzerias have lower pizza prices than towns with only two, the simple model is less useful. The art in economics lies in judging when a simplifying assumption (such as assuming a single price of pizza) clarifies our thinking and when it misleads us. Simplification is a necessary part of building a useful model: any model constructed to be completely realistic would be too complicated for anyone to understand. Yet if models assume away features of the economy that are crucial to the issue at hand, they may lead us to wrong conclusions. Economic modeling therefore requires care and common sense. FYI Using Functions to Express Relationships Among Variables All economic models express relationships among economic variables. Often, these relationships are expressed as functions. A function is a mathematical concept that shows how one variable depends on a set of other variables. For example, in the model of the pizza market, we said that the quantity of pizza demanded depends on the price of pizza and on aggregate income. To express this, we use functional notation to write Qd = D(P, Y). This equation says that the quantity of pizza demanded Qd is a function of the price of pizza P and aggregate income Y. In functional notation, the variable preceding the parentheses denotes the function. In this case, D( ) is the function expressing how the variables in parentheses determine the quantity of pizza demanded. If we knew more about the pizza market, we could give a numerical formula for the quantity of pizza demanded. For example, we might be able to write Qd = 60 − 10P + 2Y. In this case, the demand function is D(P, Y) = 60 − 10P + 2Y. For any price of pizza and aggregate income, this function gives the corresponding quantity of pizza demanded. For example, if aggregate income is $10 and the price of pizza is $2, then the quantity of pizza demanded is 60 pies; if the price of pizza rises to $3, the quantity of pizza demanded falls to 50 pies. Functional notation allows us to express the idea that variables are related, even when we do not have enough information to indicate the precise numerical relationship. For example, we might know that the quantity of pizza demanded falls when the price rises from $2 to $3, but we might not know by how much it falls. In this case, functional notation is useful: as long as we know that a relationship among the variables exists, we can express that relationship using functional notation. The Use of Multiple Models Macroeconomists study many facets of the economy. For example, they examine the role of saving in economic growth, the impact of minimum-wage laws on unemployment, the effect of inflation on interest rates, and the influence of trade policy on the trade balance and exchange rate. Economists use models to address all of these issues, but no single model can answer every question. Just as carpenters use different tools for different tasks, economists use different models to explain different phenomena. Students of macroeconomics must keep in mind that there is no single “correct” model that applies to every economic question. Instead, there are many models, each of which is useful for shedding light on a particular facet of the economy. The field of macroeconomics is like a Swiss Army knife — a set of complementary but distinct tools that can be applied in different ways in different circumstances. This book presents many different models that address different questions and make different assumptions. Remember that a model is only as good as its assumptions and that an assumption that is useful for some purposes may be misleading for others. When using a model, the economist must keep in mind the underlying assumptions and judge whether they are reasonable for studying the matter at hand. Prices: Flexible Versus Sticky Throughout this book, one group of assumptions will prove especially important: those concerning the speed at which wages and prices adjust to changing conditions. Economists normally presume that the price of a good or a service moves quickly to bring quantity supplied and quantity demanded into balance. In other words, they assume that markets are normally in equilibrium, so the price of any good or service is found where the supply and demand curves intersect. This assumption, called market clearing, is central to the model of the pizza market discussed earlier. For answering most questions, economists use market-clearing models. However, the assumption of continuous market clearing is not entirely realistic. For markets to clear continuously, prices must adjust instantly to changes in supply and demand. In fact, many wages and prices adjust slowly. Labor contracts often set wages for up to three years. Many firms leave their product prices the same for long periods of time; for example, magazine publishers change their newsstand prices only every three or four years. Although market-clearing models assume that all wages and prices are flexible, in the real world some wages and prices are sticky. The apparent stickiness of prices does not make market-clearing models useless. After all, prices are not stuck forever; eventually, they adjust to changes in supply and demand. Market-clearing models might not describe the economy at every instant, but they do describe the equilibrium toward which the economy gravitates. Therefore, most macroeconomists believe that price flexibility is a good assumption for studying long-run issues, such as the growth in real GDP that we observe from decade to decade. For studying short-run issues, such as year-to-year fluctuations in real GDP and unemployment, the assumption of price flexibility is less plausible. Over short periods, many prices in the economy are fixed at predetermined levels. Therefore, most macroeconomists believe that price stickiness is a better assumption for studying the short-run behavior of the economy. Microeconomic Thinking and Macroeconomic Models Microeconomics is the study of how households and firms make decisions and how these decisionmakers interact in the marketplace. A central principle of microeconomics is that households and firms optimize — they do the best they can for themselves, given their objectives and the constraints they face. In microeconomic models, households choose their purchases to maximize their level of satisfaction, called utility, and firms make production decisions to maximize their profits. Because economy-wide events arise from the interaction of many households and firms, macroeconomics and microeconomics are inextricably linked. When we study the economy as a whole, we must consider the decisions of individual economic actors. For example, to understand what determines total consumer spending, we must think about a family deciding how much to spend today and how much to save for the future. To understand what determines total investment spending, we must think about a firm deciding whether to build a new factory. Because aggregate variables are the sum of the variables describing many individual decisions, macroeconomic theory rests on a microeconomic foundation. Although microeconomic decisions underlie all economic models, in many models the optimizing behavior of households and firms is implicit rather than explicit. The model of the pizza market we discussed earlier is an example. Households’ decisions about how much pizza to buy underlie the demand for pizza, and pizzerias’ decisions about how much pizza to produce underlie the supply of pizza. Presumably, households make their decisions to maximize utility, and pizzerias make their decisions to maximize profit. Yet the model does not focus on how these microeconomic decisions are made; instead, it leaves these decisions in the background. Similarly, although microeconomic decisions underlie macroeconomic phenomena, macroeconomic models do not necessarily focus on the optimizing behavior of households and firms; again, they sometimes leave that behavior in the background. FYI The Early Lives of Macroeconomists How do people choose to become macroeconomists? There is no single path into the career. Here are the stories from some economists who later won Nobel Prizes for their work.1 Milton Friedman (Nobel 1976): “I graduated from college in 1932, when the United States was at the bottom of the deepest depression in its history before or since. The dominant problem of the time was economics. How to get out of the depression? How to reduce unemployment? What explained the paradox of great need on the one hand and unused resources on the other? Under the circumstances, becoming an economist seemed more relevant to the burning issues of the day than becoming an applied mathematician or an actuary.” James Tobin (Nobel 1981): “I was attracted to the field for two reasons. One was that economic theory is a fascinating intellectual challenge, on the order of mathematics or chess. I liked analytics and logical argument.... The other reason was the obvious relevance of economics to understanding and perhaps overcoming the Great Depression.” Franco Modigliani (Nobel 1985): “For a while it was thought that I should study medicine because my father was a physician.... I went to the registration window to sign up for medicine, but then I closed my eyes and thought of blood! I got pale just thinking about blood and decided under those conditions I had better keep away from medicine.... Casting about for something to do, I happened to get into some economics activities. I knew some German and was asked to translate from German into Italian some articles for one of the trade associations. Thus I began to be exposed to the economic problems that were in the German literature.” Robert Solow (Nobel 1987): “I came back [to college after being in the army] and, almost without thinking about it, signed up to finish my undergraduate degree as an economics major. The time was such that I had to make a decision in a hurry. No doubt I acted as if I were maximizing an infinite discounted sum of one-period utilities, but you couldn’t prove it by me. To me it felt as if I were saying to myself: ‘What the hell.’ ” Robert Lucas (Nobel 1995): “In public school science was an unending and not very well organized list of things other people had discovered long ago. In college, I learned something about the process of scientific discovery, but what little I learned did not attract me as a career possibility.... What I liked thinking about were politics and social issues.” George Akerlof (Nobel 2001): “When I went to Yale, I was convinced that I wanted to be either an economist or an historian. Really, for me it was a distinction without a difference. If I was going to be an historian, then I would be an economic historian. And if I was to be an economist, I would consider history as the basis for my economics.” Edward Prescott (Nobel 2004): “Through discussion with [my father], I learned a lot about the way businesses operated. This was one reason why I liked my microeconomics course so much in my first year at Swarthmore College. The price theory that I learned in that course rationalized what I had learned from him about the way businesses operate. The other reason was the textbook used in that course, Paul A. Samuelson’s Principles of Economics. I loved the way Samuelson laid out the theory in his textbook, so simply and clearly.” Edmund Phelps (Nobel 2006): “Like most Americans entering college, I started at Amherst College without a predetermined course of study and without even a career goal. My tacit assumption was that I would drift into the world of business — of money, doing something terribly smart. In the first year, though, I was awestruck by Plato, Hume, and James. I would probably have gone on to major in philosophy were it not that my father cajoled and pleaded with me to try a course in economics, which I did the second year.... I was hugely impressed to see that it was possible to subject the events in those newspapers I had read about to a formal sort of analysis.” Christopher Sims (Nobel 2011): “[My Uncle] Mark prodded me regularly, from about age 13 onward, to study economics. He gave me von Neumann and Morgenstern’s Theory of Games for Christmas when I was in high school. When I took my first course in economics, I remember arguing with him over whether it was possible for the inﬂation rate to explode upward if the money supply were held constant. I took the monetarist position. He questioned whether I had a sound argument to support it. For years I thought he was having the opposite of his intended effect, and I studied no economics until my junior year of college. But as I began to doubt that I wanted to be immersed for my whole career in the abstractions of pure mathematics, Mark’s efforts had left me with a pretty clear idea of an alternative.” 1 The first five quotations are from William Breit and Barry T. Hirsch, eds., Lives of the Laureates, 4th ed. (Cambridge, MA: MIT Press, 2004). The sixth, seventh, and ninth are from the Nobel website. The eighth is from Arnold Heertje, ed., The Makers of Modern Economics, vol. II (Aldershot, U.K.: Edward Elgar Publishing, 1995). 1-3 How This Book Proceeds This book has five parts. This chapter and the next make up Part One, the “Introduction.” Chapter 2 discusses how economists measure economic variables, such as aggregate income, the inflation rate, and the unemployment rate. Part Two, “Classical Theory: The Economy in the Long Run,” presents the classical model of how the economy works. The key assumption of the classical model is that prices are flexible. That is, with rare exceptions, the classical model assumes that markets clear. The assumption of price flexibility greatly simplifies the analysis, which is why we start with it. Yet because this assumption accurately describes the economy only in the long run, classical theory is best suited for analyzing a time horizon of at least several years. Part Three, “Growth Theory: The Economy in the Very Long Run,” builds on the classical model. It maintains the assumptions of price flexibility and market clearing but adds a new emphasis on growth in the capital stock, the labor force, and technological knowledge. Growth theory is designed to explain how the economy evolves over a period of several decades. Part Four, “Business Cycle Theory: The Economy in the Short Run,” examines the behavior of the economy when prices are sticky. The non-market-clearing model developed here is designed to analyze short- run issues, such as the reasons for economic fluctuations and the influence of government policy on those fluctuations. It is best suited for analyzing the changes in the economy we observe from month to month or from year to year. Part Five, “Topics in Macroeconomic Theory and Policy,” covers material to supplement, reinforce, and refine our long-run and short-run analyses. Some chapters present advanced material of a somewhat theoretical nature, including macroeconomic dynamics, models of consumer behavior, and theories of firms’ investment decisions. Other chapters consider what role the government should have in the economy and discuss the debates over stabilization policy, government debt, and financial crises. CHAPTER 2 The Data of Macroeconomics It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts. —Sherlock Holmes Scientists, economists, and detectives have much in common: they all want to figure out what’s going on in the world around them. To do this, they rely on theory and observation. They build theories to try to make sense of what they see happening. They then turn to more systematic observation to judge the theories’ validity. Only when theory and evidence come into line do they feel they understand the situation. This chapter discusses the types of observation that economists use to develop and test their theories. Casual observation is one source of information about what’s happening in the economy. When you go shopping, you notice whether prices are rising, falling, or staying the same. When you look for a job, you learn whether firms are hiring. Every day, as we go about our lives, we participate in some aspect of the economy and get some sense of economic conditions. A century ago, economists monitoring the economy had little more to go on than such casual observations. This fragmentary information made economic policymaking difficult. One person’s anecdote would suggest the economy was moving in one direction, while another’s would suggest otherwise. Economists needed some way to combine many individual experiences into a coherent whole. There was an obvious solution: as the old quip goes, the plural of “anecdote” is “data.” Today, economic data offer a systematic and objective source of information, and almost every day you can hear or read a story about some newly released statistic. Most of these statistics are produced by the government. Various government agencies survey households and firms to learn about their economic activity — how much they are earning, what they are buying, whether they have a job or are looking for work, what prices they are charging, how much they are producing, and so on. From these surveys, the agencies compute various statistics that summarize the state of the economy. Economists use these statistics to study the economy; policymakers use them to monitor developments and formulate policies. This chapter focuses on the three statistics that economists and policymakers use most often. Gross domestic product, or GDP, tells us the nation’s total income and the total expenditure on its output of goods and services. The consumer price index, or CPI, measures the level of prices. The unemployment rate tells us the fraction of workers who are unemployed. In the following pages, we see how these statistics are computed and what they tell us about the economy. 2-1 Measuring the Value of Economic Activity: Gross Domestic Product Gross domestic product, or GDP, is often considered the best measure of how well an economy is performing. In the United States, this statistic is computed every three months by the Bureau of Economic Analysis, a part of the U.S. Department of Commerce, from a large number of primary data sources. These primary sources include both (1) administrative data, which are byproducts of government functions such as tax collection, education programs, defense, and regulation and (2) statistical data, which come from government surveys of, for example, retail establishments, manufacturing firms, and farms. The purpose of GDP is to summarize all these data with a single number representing the dollar value of economic activity in a given period of time. There are two ways to view this statistic. One way to view GDP is as the total income of everyone in the economy; another way is as the total expenditure on the economy’s output of goods and services. From either viewpoint, it is clear why GDP is a gauge of economic performance. GDP measures something people care about — their incomes. Similarly, an economy with a large output of goods and services can better satisfy the demands of households, firms, and the government. How can GDP measure both the economy’s income and its expenditure on output? It can do so because these two quantities are really the same: for the economy as a whole, income must equal expenditure. That fact, in turn, follows from an even more fundamental one: because every transaction has a buyer and a seller, every dollar of expenditure by a buyer must become a dollar of income to a seller. When Jack paints Jill’s house for $10,000, that $10,000 is income to Jack and expenditure by Jill. The transaction contributes $10,000 to GDP, regardless of whether we are adding up all income or all expenditure. To understand the meaning of GDP more fully, we turn to national income accounting, the system used to measure GDP and many related statistics. Income, Expenditure, and the Circular Flow Imagine an economy that produces a single good, bread, from a single input, labor. Figure 2-1 illustrates all the economic transactions that occur between households and firms in this economy. FIGURE 2-1 The Circular Flow This figure illustrates the flows between firms and households in an economy that produces one good, bread, from one input, labor. The inner loop represents the flows of labor and bread: households sell their labor to firms, and the firms sell the bread they produce to households. The outer loop represents the corresponding flows of dollars: households pay the firms for the bread, and the firms pay wages and profit to the households. In this economy, GDP is both the total expenditure on bread and the total income from the production of bread. The inner loop in Figure 2-1 represents the flows of bread and labor. The households sell their labor to the firms. The firms use the labor of their workers to produce bread, which the firms in turn sell to the households. Hence, labor flows from households to firms, and bread flows from firms to households. The outer loop in Figure 2-1 represents the corresponding flow of dollars. The households buy bread from the firms. The firms use some of the revenue from these sales to pay the wages of their workers, and the remainder is the profit belonging to the owners of the firms (who themselves are part of the household sector). Hence, expenditure on bread flows from households to firms, and income in the form of wages and profit flows from firms to households. GDP measures the flow of dollars in this economy. We can compute it in two ways. GDP is the total income from the production of bread, which equals the sum of wages and profit — the top half of the circular flow of dollars. GDP is also the total expenditure on purchases of bread — the bottom half of the circular flow of dollars. To compute GDP, we can look at either the flow of dollars from firms to households or the flow of dollars from households to firms. These two ways of computing GDP must be equal because, by the rules of accounting, the expenditure of buyers on products is income to the sellers of those products. Every transaction that affects expenditure must affect income, and every transaction that affects income must affect expenditure. For example, suppose that a firm produces and sells one more loaf of bread to a household. Clearly this transaction raises total expenditure on bread, but it also has an equal effect on total income. If the firm produces the extra loaf without hiring any more labor (such as by making the production process more efficient), then profit increases. If the firm produces the extra loaf by hiring more labor, then wages increase. In both cases, expenditure and income increase equally. FYI Stocks and Flows Many economic variables measure a quantity of something — a quantity of money, a quantity of goods, and so on. Economists distinguish between two types of quantity variables: stocks and flows. A stock is a quantity measured at a given point in time, whereas a flow is a quantity measured per unit of time. A bathtub, shown in Figure 2-2, is the classic example used to illustrate stocks and flows. The amount of water in the tub is a stock: it is the quantity of water in the tub at a given point in time. The amount of water coming out of the faucet is a flow: it is the quantity of water being added to the tub per unit of time. Note that w

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