Macroeconomics, Sixth Edition PDF

 Flexible Organization Macroeconomics, sixth edition is organized around two central parts: A core and a set of two major extensions. The text’s flexible organization emphasizes an integrated view of macroeconomics, while enabling professors to focus on...

 Flexible Organization Macroeconomics, sixth edition is organized around two central parts: A core and a set of two major extensions. The text’s flexible organization emphasizes an integrated view of macroeconomics, while enabling professors to focus on the theories, models, and applications that they deem central to their particular course. The flowchart below quickly illustrates how the chapters are organized and fit within the book’s overall structure. For a more detailed explanation of the Organization, and for an extensive list of Alternative Course Outlines, see pages xiii–xv in the preface. INTRODUCTION A Tour of the World Chapter 1 A Tour of the Book Chapter 2 THE CORE The Short Run The Goods Market Chapter 3 Financial Markets Chapter 4 Goods and Financial Markets: The IS-LM Model Chapter 5 The Medium Run The Labor Market Chapter 6 Putting All Markets Together: The AS-AD Model Chapter 7 The Natural Rate of Unemployment and The Phillips Curve Chapter 8 The Crisis Chapter 9 The Long Run The Facts of Growth Chapter 10 Saving, Capital Accumulation, and Output Chapter 11 Technological Progress and Growth Chapter 12 Technological Progress: The Short, the Medium, and the Long Run Chapter 13 EXPECTATIONS THE OPEN ECONOMY Expectations: The Basic Tools Chapter 14 Financial Markets and Expectations Chapter 15 EXTENSIONS Openness in Goods and Financial Markets Chapter 18 The Goods Market in an Open Economy Chapter 19 Expectations, Consumption, and Investment Chapter 16 Output, the Interest Rate, and the Exchange Rate Chapter 20 Expectations, Output, and Policy Chapter 17 Exchange Rate Regimes Chapter 21 BACK TO POLICY Should Policy Makers Be Restrained? Chapter 22 Fiscal Policy: A Summing Up Chapter 23 Monetary Policy: A Summing Up Chapter 24 EPILOGUE The Story of Macroeconomics Chapter 25 This page intentionally left blank  Sixth Edition MACROECONOMICS Olivier Blanchard International Monetary Fund Massachusetts Institute of Technology David R. Johnson Wilfrid Laurier University Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montréal Toronto Delhi Mexico City São Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo Editor in Chief: Donna Battista Permissions Specialist: Jill Dougan AVP/Executive Editor: David Alexander Image Manager: Rachel Youdelman Senior Editorial Project Manager: Lindsey Sloan Executive Media Producer: Melissa Honig Executive Marketing Manager: Lori DeShazo MyEconLab Content Lead: Noel Lotz Senior Managing Editor: Nancy Fenton Project Management, Page Makeup, and Design: Senior Production Project Manager: Nancy PreMediaGlobal Freihofer Printer/Binder: R.R. Donnelley / Willard Senior Manufacturing Buyer: Carol Melville Cover Printer: Lehigh Phoenix Cover Designer: Jonathan Boylan Text Font: Utopia 10/12 Cover Photo: © Alan Z. Uster/Fotolia Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this text- book appear on the appropriate page within text and on pages C-1–C-3. Copyright © 2013, 2011, 2009 by Pearson Education, Inc., publishing as Prentice Hall. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Permissions Department, One Lake Street, Upper Saddle River, New Jersey 07458, or you may fax your request to 201-236-3290. Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. Cataloging-in-Publication Data is on file at the Library of Congress 10 9 8 7 6 5 4 3 2 1 ISBN-13: 978-0-13-306163-5 ISBN-10: 0-13-306163-9 To Noelle and Susan About the Authors Olivier Blanchard is the Robert M. Solow Professor of Economics at the Massachusetts Institute of Technology. He did his undergraduate work in France and received a Ph.D. in economics from MIT in 1977. He taught at Harvard from 1977 to 1982 and has taught at MIT since 1983. He has frequently received the award for best teacher in the department of economics. He is cur- rently on leave from MIT and serves as the Chief Economist at the International Monetary Fund. He has done research on many macroeconomic issues, including the effects of fiscal policy, the role of expectations, price rigidities, speculative bubbles, unemployment in Western Europe, transition in Eastern Europe, the role of labor market institutions, and the various aspects of the current crisis. He has done work for many governments and many international organizations, including the World Bank, the IMF, the OECD, the EU Commission, and the EBRD. He has published over 150 articles and edited or written over 20 books, including Lectures on Macroeconomics with Stanley Fischer. He is a research associate of the National Bureau of Economic Research, a fellow of the Econometric Society, a member of the American Academy of Arts and Sciences, and a past Vice President of the American Economic Association. He currently lives in Washington, D.C. with his wife, Noelle. He has three daughters: Marie, Serena, and Giulia. David Johnson is Professor of Economics at Wilfrid Laurier University and Education Policy Scholar at the C. D. Howe Institute. Professor Johnson’s areas of specialty are macroeconomics, international finance, and, more recently, the economics of education. His published work in macroeconomics includes studies of Canada’s international debt, the influence of American interest rates on Canadian interest rates, and the determination of the exchange rate between Canada and the United States. His 2005 book Signposts of Success, a comprehensive analysis of elemen- tary school test scores in Ontario, was selected as a finalist in 2006 for both the Donner Prize and the Purvis Prize. He has also written extensively on inflation targets as part of monetary policy in Canada and around the world. His primary teaching area is macroeconomics. He is coauthor with Olivier Blanchard of Macroeconomics (fourth Canadian edition). Professor Johnson received his undergraduate degree from the University of Toronto, his Master’s degree from the University of Western Ontario, and his Ph.D. in 1983 from Harvard University, where Olivier Blanchard served as one of his supervisors. He has worked at the Bank of Canada and visited at the National Bureau of Economic Research, Cambridge University, and most recently at the University of California, Santa Barbara as Canada-U.S. Fulbright Scholar and Visiting Chair. Professor Johnson lives in Waterloo, Ontario, with his wife Susan, who is also an eco- nomics professor. They have shared the raising of two children, Sarah and Daniel. When not studying or teaching economics, David plays Oldtimers’ Hockey and enjoys cross-country skiing in the winter and sculling in the summer. For a complete change of pace, Professor Johnson has been heavily involved in the Logos program, an after-school program for chil- dren and youth at First Mennonite Church in Kitchener, Ontario. iv  Brief Contents THE CORE EXTENSIONS Introduction 1 Expectations 289 Chapter 1 A Tour of the World 3 Chapter 14 Expectations: The Basic Tools 291 Chapter 2 A Tour of the Book 19 Chapter 15 Financial Markets and Expectations 313 Chapter 16 Expectations, Consumption, The Short Run 41 and Investment 337 Chapter 3 The Goods Market 43 Chapter 17 Expectations, Output, Chapter 4 Financial Markets 63 and Policy 357 Chapter 5 Goods and Financial Markets: The IS–LM Model 85 The Open Economy 377 Chapter 18 Openness in Goods and Financial Markets 379 The Medium Run 109 Chapter 19 The Goods Market in an Open Chapter 6 The Labor Market 111 Economy 399 Chapter 7 Putting All Markets Together: Chapter 20 Output, the Interest Rate, and The AS–AD Model 133 the Exchange Rate 423 Chapter 8 The Phillips Curve, the Natural Rate Chapter 21 Exchange Rate Regimes 445 of Unemployment, and Inflation 161 Chapter 9 The Crisis 183 Back to Policy 471 Chapter 22 Should Policymakers Be The Long Run 205 Restrained? 473 Chapter 23 Fiscal Policy: A Summing Up 493 Chapter 10 The Facts of Growth 207 Chapter 24 Monetary Policy: A Summing Up 517 Chapter 11 Saving, Capital Accumulation, and Output 225 Chapter 25 Epilogue: The Story of Macroeconomics 539 Chapter 12 Technological Progress and Growth 249 Chapter 13 Technological Progress: The Short, the Medium, and the Long Run 267 v Contents Preface xiii THE CORE The Short Run 41 Introduction 1 Chapter 3 The Goods Market 43 3-1 The Composition of GDP 44 Chapter 1 A Tour of the World 3 3-2 The Demand for Goods 45 1-1 The Crisis 4 Consumption (C) 46 Investment 1-2 The United States 6 ( I ) 48 Government Spending (G) 48 Should You Worry about the United 3-3 The Determination of Equilibrium States Deficit? 8 Output 49 1-3 The Euro Area 9 Using Algebra 50 Using a Graph 51 How Can European Unemployment Using Words 53 How Long Does It Be Reduced? 10 What Has the Euro Take for Output to Adjust? 54 Done for Its Members? 12 3-4 Investment Equals Saving: An 1-4 China 13 Alternative Way of Thinking 1-5 Looking Ahead 15 about Goods—Market Appendix: Where to Find the Numbers 17 Equilibrium 56 3-5 Is the Government Omnipotent? A Chapter 2 A Tour of the Book 19 Warning 59 2-1 Aggregate Output 20 GDP: Production and Income 20 Chapter 4 Financial Markets 63 Nominal and Real GDP 22 GDP: 4-1 The Demand for Money 64 Level versus Growth Rate 24 Deriving the Demand for Money 66 2-2 The Unemployment Rate 25 4-2 Determining the Interest Rate: I 67 Why Do Economists Care about Money Demand, Money Supply, Unemployment? 27 and the Equilibrium Interest 2-3 The Inflation Rate 28 Rate 68 Monetary Policy and Open The GDP Deflator 29 The Consumer Market Operations 70 Choosing Price Index 29 Why Do Economists Money or Choosing the Interest Rate? 72 Money, Bonds, and Other Care about Inflation? 30 Assets 72 2-4 Output, Unemployment, and the 4-3 Determining the Interest Rate: II 73 Inflation Rate: Okun’s Law and the What Banks Do 73 The Supply Phillips Curve 31 and the Demand for Central Bank Okun’s Law 31 The Phillips Curve 32 Money 74 2-5 The Short Run, the Medium Run, the 4-4 Two Alternative ways of looking at Long Run 33 the Equilibrium 79 2-6 A Tour of the Book 34 The Federal Funds Market and the The Core 35 Extensions 35 Back to Federal Funds Rate 79 The Supply of Policy 36 Epilogue 36 Money, the Demand for Money, and the Money Multiplier 80 Understanding the Appendix: The Construction of Real GDP, Money Multiplier 80 and Chain-Type Indexes 39 vi Chapter 5 Goods and Financial Markets: Chapter 7 Putting All Markets Together: The IS-LM Model 85 The AS–AD Model 133 5-1 The Goods Market and the IS 7-1 Aggregate Supply 134 Relation 86 7-2 Aggregate Demand 136 Investment, Sales, and the Interest 7-3 Equilibrium in the Short Run and in Rate 86 Determining Output 87 the Medium Run 139 Deriving the IS Curve 89 Shifts of the IS Curve 89 Equilibrium in the Short Run 139 From the Short Run to the Medium Run 140 5-2 Financial Markets and the LM 7-4 The Effects of a Monetary Relation 90 Expansion 142 Real Money, Real Income, and the Interest Rate 90 Deriving the The Dynamics of Adjustment 142 LM Curve 91 Shifts of the LM Going Behind the Scenes 143 The Curve 92 Neutrality of Money 144 5-3 Putting the IS and the LM Relations 7-5 A Decrease in the Budget Together 93 Deficit 146 Fiscal Policy, Activity, and the Interest Deficit Reduction, Output, and the Rate 94 Monetary Policy, Activity, and Interest Rate 147 Budget Deficits, the Interest Rate 96 Output, and Investment 148 5-4 Using a Policy Mix 98 7-6 An Increase in the Price of Oil 149 Effects on the Natural Rate of 5-5 How Does the IS-LM Model Fit the Unemployment 150 The Dynamics of Facts? 102 Adjustment 151 Appendix: An Alternative Derivation 7-7 Conclusions 154 of the LM Relation as an Interest Rate The Short Run versus the Medium Rule 107 Run 154 Shocks and Propagation Mechanisms 155 Where We Go from The Medium Run 109 Here 156 Chapter 6 The Labor Market 111 Chapter 8 The Phillips Curve, the Natural 6-1 A Tour of the Labor Market 112 Rate of Unemployment, and The Large Flows of Workers 112 Inflation 161 6-2 Movements in Unemployment 115 8-1 Inflation, Expected Inflation, and 6-3 Wage Determination 117 Unemployment 162 Bargaining 118 Efficiency 8-2 The Phillips Curve 164 Wages 119 Wages, Prices, and The Early Incarnation 164 Unemployment 120 The Expected Mutations 164 The Phillips Price Level 120 The Unemployment Curve and the Natural Rate of Rate 121 The Other Factors 121 Unemployment 169 The Neutrality 6-4 Price Determination 122 of Money, Revisited 171 6-5 The Natural Rate of 8-3 A Summary and Many Unemployment 122 Warnings 171 The Wage-Setting Relation 123 Variations in the Natural Rate across The Price–Setting Relation 123 Countries 172 Variations in the Natural Equilibrium Real Wages and Rate over Time 172 Disinflation, Unemployment 124 From Credibility, and Unemployment 172 Unemployment to Employment 125 High Inflation and the Phillips Curve From Employment to Output 126 Relation 177 Deflation and the Phillips Curve Relation 178 6-6 Where We Go from Here 127 Appendix: From the Aggregate Appendix: Wage- and Price-Setting Supply Relation to a Relation between Relations versus Labor Supply and Labor Inflation, Expected Inflation, and Demand 131 Unemployment 182 Contents vii Chapter 9 The Crisis 183 11-3 Getting a Sense of Magnitudes 238 9-1 From a Housing Problem to a The Effects of the Saving Rate on Steady-State Output 238 The Financial Crisis 184 Dynamic Effects of an Increase in the Housing Prices and Subprime Saving Rate 239 The U.S. Saving Rate Mortgages 184 The Role of and the Golden Rule 241 Banks 185 11-4 Physical versus Human 9-2 The Use and Limits of Policy 189 Capital 242 Initial Policy Responses 191 The Extending the Production Limits of Monetary Policy: The Liquidity Function 242 Human Capital, Physical Trap 192 The Limits of Fiscal Policy: Capital, and Output 243 Endogenous High Debt 196 Growth 244 9-3 The Slow Recovery 196 Appendix: The Cobb-Douglas Production Function and the Steady State 247 The Long Run 205 Chapter 12 Technological Progress and Growth 249 Chapter 10 The Facts of Growth 207 12-1 Technological Progress and the Rate 10-1 Measuring the Standard of of Growth 250 Living 208 Technological Progress and the 10-2 Growth in Rich Countries since Production Function 250 Interactions 1950 211 between Output and Capital 252 Dynamics of Capital and Output 254 The The Large Increase in the Standard Effects of the Saving Rate 255 of Living since 1950 213 The Convergence of Output per Person 214 12-2 The Determinants of Technological 10-3 A Broader Look across Time and Progress 256 Space 215 The Fertility of the Research Process 257 The Appropriability of Looking across Two Millennia 215 Research Results 258 Looking across Countries 215 12-3 The Facts of Growth Revisited 260 10-4 Thinking About Growth: Capital Accumulation versus A Primer 217 Technological Progress in Rich Countries The Aggregate Production since 1985 260 Capital Accumulation Function 217 Returns to Scale and versus Technological Progress in Returns to Factors 218 Output China 261 per Worker and Capital per Worker 219 The Sources of Appendix: Constructing a Measure of Growth 220 Technological Progress 265 Chapter 11 Saving, Capital Accumulation, Chapter 13 Technological Progress: and Output 225 The Short, the Medium, and 11-1 Interactions between Output the Long Run 267 and Capital 226 13-1 Productivity, Output, and The Effects of Capital on Unemployment in the Short Output 226 The Effects of Output on Run 268 Capital Accumulation 227 Technological Progress, 11-2 The Implications of Alternative Aggregate Supply, and Aggregate Saving Rates 229 Demand 268 The Empirical Evidence 270 Dynamics of Capital and Output 229 Steady-State Capital and 13-2 Productivity and the Natural Rate of Output 232 The Saving Rate and Unemployment 272 Output 232 The Saving Rate and Price Setting and Wage Setting Consumption 235 Revisited 272 The Natural Rate of Unemployment 273 The Empirical Evidence 274 viii Contents  13-3 Technological Progress, Churning, and Economic Activity 325 A and Distribution Effects 276 Monetary Expansion and the Stock Market 326 An Increase in Consumer The Increase in Wage Inequality 279 Spending and the Stock Market 327 The Causes of Increased Wage Inequality 279 15-3 Risk, Bubbles, Fads, and Asset 13-4 Institutions, Technological Progress, Prices 328 and Growth 281 Stock Prices and Risk 328 Asset Prices, Fundamentals, and Bubbles 330 Chapter 16 Expectations, Consumption, EXTENSIONS and Investment 337 16-1 Consumption 337 Expectations 289 The Very Foresighted Consumer 338 An Example 338 Toward a More Chapter 14 Expectations: Realistic Description 340 Putting The Basic Tools 291 Things Together: Current Income, 14-1 Nominal versus Real Interest Expectations, and Consumption 343 Rates 292 16-2 Investment 344 Nominal and Real Interest Rates in the Investment and Expectations of United States since 1978 294 Profit 344 A Convenient Special 14-2 Nominal and Real Interest Rates, Case 346 Current versus Expected Profit 348 Profit and Sales 350 and the IS–LM Model 297 14-3 Money Growth, Inflation, Nominal 16-3 The Volatility of Consumption and and Real Interest Rates 298 Investment 352 Revisiting the IS–LM Model 298 Nominal Appendix: Derivation of the Expected and Real Interest Rates in the Short Present Value of Profits under Static Run 298 Nominal and Real Interest Expectations 356 Rates in the Medium Run 300 From the Short to the Medium Run 301 Chapter 17 Expectations, Output, and Evidence on the Fisher Hypothesis 302 Policy 357 14-4 Expected Present Discounted 17-1 Expectations and Decisions: Taking Values 304 Stock 358 Computing Expected Present Expectations, Consumption, and Invest- Discounted Values 305 Using Present ment Decisions 358 Expectations and Values: Examples 307 Nominal the IS Relation 358 The LM Relation versus Real Interest Rates, and Present Revisited 361 Values 308 17-2 Monetary Policy, Expectations, and Appendix: Deriving the Expected Output 362 Present Discounted Value Using Real or From the Short Nominal Rate to Current Nominal Interest Rates 311 and Expected Real Rates 362 Monetary Policy Revisited 363 Chapter 15 Financial Markets and 17-3 Deficit Reduction, Expectations, and Expectations 313 Output 367 15-1 Bond Prices and Bond Yields 314 The Role of Expectations about the Bond Prices as Present Future 368 Back to the Current Values 315 Arbitrage and Bond Period 369 Prices 316 From Bond Prices to Bond Yields 318 Interpreting the Yield Curve 319 The Yield Curve and The Open Economy 377 Economic Activity 319 Chapter 18 Openness in Goods and Financial 15-2 The Stock Market and Movements in Markets 379 Stock Prices 322 18-1 Openness in Goods Markets 380 Stock Prices as Present Exports and Imports 380 The Choice Values 323 The Stock Market between Domestic Goods and Foreign Contents ix  Goods 382 Nominal Exchange 20-4 The Effects of Policy in an Open Rates 382 From Nominal to Real Economy 431 Exchange Rates 383 From Bilateral to The Effects of Fiscal Policy in an Open Multilateral Exchange Rates 387 Economy 431 The Effects of Monetary 18-2 Openness in Financial Markets 388 Policy in an Open Economy 433 The Balance of Payments 389 The 20-5 Fixed Exchange Rates 435 Choice between Domestic and Foreign Pegs, Crawling Pegs, Bands, the Assets 391 Interest Rates and EMS, and the Euro 435 Pegging Exchange Rates 393 the Exchange Rate, and Monetary 18-3 Conclusions and a Look Ahead 395 Control 436 Fiscal Policy under Fixed Exchange Rates 437 Chapter 19 The Goods Market in an Open Economy 399 Appendix: Fixed Exchange Rates, Interest Rates, and Capital Mobility 442 19-1 The IS Relation in the Open Economy 400 Chapter 21 Exchange Rate Regimes 445 The Demand for Domestic Goods 400 21-1 The Medium Run 446 The Determinants of C, I and G 400 Aggregate Demand under Fixed The Determinants of Imports 401 The Exchange Rates 447 Equilibrium Determinants of Exports 401 Putting in the Short Run and in the Medium the Components Together 401 Run 448 The Case For and Against a 19-2 Equilibrium Output and the Trade Devaluation 450 Balance 403 21-2 Exchange Rate Crises under Fixed 19-3 Increases in Demand, Domestic or Exchange Rates 451 Foreign 404 21-3 Exchange Rate Movements under Increases in Domestic Demand 404 Flexible Exchange Rates 455 Increases in Foreign Demand 406 Exchange Rates and the Current Fiscal Policy Revisited 407 Account 457 Exchange Rates 19-4 Depreciation, the Trade Balance, and Current and Future Interest and Output 409 Rates 457 Exchange Rate Depreciation and the Trade Balance: Volatility 457 The Marshall-Lerner Condition 410 21-4 Choosing between Exchange Rate The Effects of a Depreciation 410 Regimes 459 Combining Exchange Rate and Fiscal Common Currency Areas 459 Hard Policies 411 Pegs, Currency Boards, and 19-5 Looking at Dynamics: The Dollarization 462 J-Curve 413 Appendix 1: Deriving Aggregate 19-6 Saving, Investment, and the Current Demand under Fixed Exchange Account Balance 415 Rates 467 Appendix: Derivation of the Marshall- Appendix 2: The Real Exchange Rate Lerner Condition 421 and Domestic and Foreign Real Interest Rates 468 Chapter 20 Output, the Interest Rate, and the Exchange Rate 423 20-1 Equilibrium in the Goods Market 424 Back to Policy 471 20-2 Equilibrium in Financial Chapter 22 Should Policy Makers Be Markets 425 Restrained? 473 Money versus Bonds 425 Domestic 22-1 Uncertainty and Policy 474 Bonds versus Foreign Bonds 426 How Much Do Macroeconomists 20-3 Putting Goods and Financial Actually Know? 474 Should Markets Together 428 x Contents  Uncertainty Lead Policy Makers to Do 24-3 The Design of Monetary Policy 524 Less? 477 Uncertainty and Restraints Money Growth Targets and Target on Policy Makers 477 Ranges 525 Inflation Targeting 526 22-2 Expectations and Policy 478 Interest Rate Rules 529 Hostage Takings and Negotiations 479 24-4 Challenges from the Crisis 530 Inflation and Unemployment The Liquidity Trap 530 Macro Revisited 479 Establishing Prudential Regulation 532 Credibility 480 Time Consistency and Restraints on Policy Makers 482 Chapter 25 Epilogue: The Story of 22-3 Politics and Policy 482 Macroeconomics 539 Games between Policy Makers and 25-1 Keynes and the Great Voters 483 Games between Policy Depression 540 Makers 484 Politics and Fiscal 25-2 The Neoclassical Synthesis 540 Restraints 485 Progress on All Fronts 541 Keynesians Chapter 23 Fiscal Policy: A Summing Up 493 versus Monetarists 542 23-1 What We Have Learned 494 25-3 The Rational Expectations Critique 543 23-2 The Government Budget Constraint: The Three Implications of Rational Deficits, Debt, Spending, and Expectations 544 The Integration of Taxes 495 Rational Expectations 545 The Arithmetic of Deficits and Debt 495 Current versus Future 25-4 Developments in Macroeconomics Taxes 497 The Evolution of the to the 2009 Crisis 547 Debt-to-GDP Ratio 500 New Classical Economics and Real Business Cycle Theory 547 New 23-3 Ricardian Equivalence, Cyclical Keynesian Economics 548 New Adjusted Deficits, and War Growth Theory 549 Toward an Finance 502 Integration 549 Ricardian Equivalence 502 Deficits, 25-5 First Lessons for Macro-economics Output Stabilization, and the Cyclically Adjusted Deficit 503 Wars and after the Crisis 550 Deficits 504 Appendix 1 An Introduction to National 23-4 The Dangers of High Debt 506 Income and Product High Debt, Default Risk, and Vicious Accounts A-1 Cycles 506 Debt Default 509 Money Finance 510 Appendix 2 A Math Refresher A-7 Chapter 24 Monetary Policy: Appendix 3 An Introduction to A Summing Up 517 Econometrics A-12 24-1 What We Have Learned 518 Glossary G-1 24-2 The Optimal Inflation Rate 519 Index I-1 The Costs of Inflation 520 The Benefits of Inflation 522 The Optimal Inflation Credits C-1 Rate: The Current Debate 524 Contents xi Focus Boxes Real GDP, Technological Progress, and the Price of Famous Bubbles: From Tulipmania in Seventeenth-Century Computers 25 Holland to Russia in 1994 331 Did Spain Have a 24% Unemployment Rate in 1994? 28 The Increase in U.S. Housing Prices: Fundamentals or a The Lehman Bankruptcy, Fears of Another Great Depression, Bubble? 332 and Shifts in the Consumption Function 55 Up Close and Personal: Learning from Panel Data Sets 339 The Paradox of Saving 58 Do People Save Enough for Retirement? 342 Semantic Traps: Money, Income and Wealth 65 Investment and the Stock Market 347 Who Holds U.S. Currency? 67 Profitability versus Cash Flow 350 Bank Runs, Deposit Insurance, and Wholesale Funding 75 The Liquidity Trap, Quantitative Easing, and the Role of Deficit Reduction: Good or Bad for Investment? 97 Expectations 365 Focus: The U.S. Recession of 2001 99 Rational Expectations 367 The Current Population Survey 114 Can a Budget Deficit Reduction Lead to an Output Expansion? Ireland in the 1980s 370 Henry Ford and Efficiency Wages 119 Can Exports Exceed GDP? 382 How Long Lasting Are the Real Effects of Money? 145 GDP versus GNP: The Example of Kuwait 392 Oil Price Increases: Why Were the 2000s so Different from the 1970s? 153 Buying Brazilian Bonds 394 Theory Ahead of Facts: Milton Friedman and Edumnd The G20 and the 2009 Fiscal Stimulus 409 Phelps 170 The U.S. Current Account Deficit: Origins and Implications 416 What Explains European Unemployment? 173 Sudden Stops, Safe Havens, and the Limits to the Interest Why Has the U.S. Natural Rate of Unemployment Fallen Since Parity Condition 429 the Early 1990s and How Will the Crisis Affect It? 175 Monetary Contraction and Fical Expansion: The United States in Increasing Leverage and Alphabet Soup: SIVs, AIG, and the Early 1980s 434 CDSs 187 German Reunification, Interest Rates, and the EMS 438 Japan, the Liquidity Trap, and Fiscal Policy 197 The Return of Britain to the Gold Standard: Keynes versus Do Banking Crises Affect the Natural Level of Output? 200 Churchill 452 The Construction of PPP Numbers 210 The 1992 EMS Crisis 454 Does Money Lead to Happiness? P 212 The Euro: A Short History 461 Capital Accumulation and Growth in France in the Aftermath of Lessons from Argentina’s Currency Board 463 World War II 231 Twelve Macroeconometric Models 476 Social Security, Saving, and Capital Accumulation in the United Was Alan Blinder Wrong in Speaking the Truth? 482 States 236 The Stability and Growth Pact: A Short History 486 The Diffusion of New Technology: Hybrid Corn 258 Inflation Accounting and the Measurement of Deficits 496 Job Destruction, Churning, and Earnings Losses 278 How Countries Decreased Their Debt Ratios after The Importance of Institutions: North and South Korea 283 World War II 501 What is behind Chinese Growth? 284 Deficits, Consumption, and Investment in the United States Why Deflation Can Be Very Bad: Deflation and the Real Interest during World War II 505 Rate in the Great Depression 296 The U.S. Budget Deficit Challenge 507 Nominal Interest Rates and Inflation across Latin America in the Money Illusion 522 Early 1990s 303 The Unsuccessful Search for the Right Monetary The Vocabulary of Bond Markets 315 Aggregate 527 The Yield Curve and the Liquidity Trap 322 LTV Ratios and Housing Price Increases from 2000 to Making (Some) Sense of (Apparent) Nonsense: Why the Stock 2007 534 Market Moved Yesterday, and Other Stories 329 xii  Preface We had two main goals in writing this book: the role of the financial system to the constraints on macroeconomic policy. To make close contact with current macroeconomic events. What makes macroeconomics exciting is the Material on depressions and slumps has been relo- light it sheds on what is happening around the world, cated from later chapters to Chapter 9, and the material from the major economic crisis which has engulfed on very high inflation has been reduced and included the world since 2008, to the budget deficits of the in Chapter 23. United States, to the problems of the Euro area, to high A rewritten Chapter 23, on fiscal policy, focuses on the growth in China. These events—and many more—are current debt problems of the United States. described in the book, not in footnotes, but in the text or in detailed boxes. Each box shows how you can use Chapters 23, 24, and 25 draw the implications of the what you have learned to get an understanding of these crisis for the conduct of fiscal and monetary policy in events. Our belief is that these boxes not only convey particular, and for macroeconomics in general. the “life” of macroeconomics, but also reinforce the Many new Focus boxes have been introduced and look lessons from the models, making them more concrete at various aspects of the crisis, among them the follow- and easier to grasp. ing: “The Lehman Bankruptcy, Fears of Another Great To provide an integrated view of macroeconomics. The Depression, and Shifts in the Consumption Function” book is built on one underlying model, a model that in Chapter 3; “Bank Runs, Deposit Insurance, and draws the implications of equilibrium conditions in Wholesale Funding” in Chapter 4; “The Liquidity Trap, three sets of markets: the goods market, the financial Quantitative Easing, and the Role of Expectations” in markets, and the labor market. Depending on the issue Chapter 17; “The G20 and the 2009 Fiscal Stimulus” at hand, the parts of the model relevant to the issue in Chapter 19; “How Countries Decreased Their Debt are developed in more detail while the other parts are Ratios after World War II” in Chapter 23; and “LTV simplified or lurk in the background. But the underly- Ratios and Housing Price Increases from 2000 to 2007 ing model is always the same. This way, you will see in Chapter 24. macroeconomics as a coherent whole, not a collection Figures and tables have been updated using the latest of models. And you will be able to make sense not only data available. of past macroeconomic events, but also of those that unfold in the future. Organization New to this Edition The book is organized around two central parts: A core, Chapter 1 starts with a history of the crisis, giving a and a set of two major extensions. An introduction pre- sense of the landscape, and setting up the issues to be cedes the core. The two extensions are followed by a dealt with throughout the book. review of the role of policy. The book ends with an epi- logue. A flowchart on the front endpaper makes it easy A new Chapter 9, which comes after the short- and to see how the chapters are organized, and fit within the medium-run architecture have been put in place, book’s overall structure. focuses specifically on the crisis. It shows how one can use and extend the short-run and medium run analy- Chapters 1 and 2 introduce the basic facts and issues of sis to understand the various aspects of the crisis, from macroeconomics. Chapter 1 focuses on the crisis, and xiii  then takes a tour of the world, from the United States, to Expectations play a major role in most economic deci- Europe, to China. Some instructors will prefer to cover sions, and, by implication, play a major role in the Chapter 1 later, perhaps after Chapter 2, which intro- determination of output. duces basic concepts, articulates the notions of short run, medium run, and long run, and gives the reader a Chapters 18 through 21 focus on the implications of quick tour of the book. openness of modern economies. Chapter 21 focuses on the implications of different exchange rate regimes, While Chapter 2 gives the basics of national income from flexible exchange rates, to fixed exchange rates, accounting, we have put a detailed treatment of currency boards, and dollarization. national income accounts to Appendix 1 at the end of the book. This decreases the burden on the beginning Chapters 22 through 24 return to macroeconomic reader, and allows for a more thorough treatment in policy. Although most of the first 21 chapters con- the appendix. stantly discuss macroeconomic policy in one form or another, the purpose of Chapters 22 through 24 is to Chapters 3 through 13 constitute the core. Chapters 3 tie the threads together. Chapter 22 looks at the role through 5 focus on the short run. These three chapters and the limits of macroeconomic policy in general. characterize equilibrium in the goods market and in Chapters 23 and 24 review monetary policy and fis- the financial markets, and they derive the basic model cal policy. Some instructors may want to use parts of used to study short–run movements in output, the IS– these chapters earlier. For example, it is easy to move LM model. forward the discussion of the government budget con- Chapters 6 through 8 focus on the medium run. straint in Chapter 23 or the discussion of inflation tar- Chapter 6 focuses on equilibrium in the labor market geting in Chapter 24. and introduces the notion of the natural rate of unem- Chapter 25 serves as an epilogue; it puts macroeco- ployment. Chapters 7 and 8 develop a model based on nomics in historical perspective by showing the evolu- aggregate demand and aggregate supply and show how tion of macroeconomics in the last 70 years, discussing that model can be used to understand movements in current directions of research, and the lessons of the activity and movements in inflation, both in the short crisis for macroeconomics. and in the medium run. The current crisis is a sufficiently important and com- plex event that it deserves its own chapter. Building on Changes from the Fifth to the Sixth and extending Chapters 6 to 8, Chapter 9 focuses on the Edition origins of the crisis, the role of the financial system, and The structure of the sixth edition, namely the organiza- the constraints facing fiscal and monetary policy, such tion around a core and two extensions, is fundamentally as the liquidity trap and the high level of public debt. the same as that of the fifth edition. This edition is, how- Chapters 10 through 13 focus on the long run. ever, dominated in many ways by the crisis, and the many Chapter 10 describes the facts, showing the evolution issues it raises. Thus, in addition to a first discussion of of output across countries and over long periods of the crisis in Chapter 1, and numerous boxes and discus- time. Chapters 11 and 12 develop a model of growth sions throughout the book, we have added a new chapter, and describe how capital accumulation and techno- Chapter 9, specifically devoted to the crisis. logical progress determine growth. Chapter 13 focuses At the same time, we have removed the two chapters on the effects of technological progress not only in the on pathologies in the fifth edition. The reason is simple, long run, but also in the short run and in the medium and in some ways, ironic. While we thought that it was run. This topic is typically not covered in textbooks important for macroeconomic students to know about but is important. And the chapter shows how one can such events as the Great Depression, or the long slump in integrate the short run, the medium run, and the long Japan, we did not expect the world to be confronted with run—a clear example of the payoff to an integrated many of the same issues any time soon. While far from approach to macroeconomics. being as bad as the Great Depression, the crisis raises many of the same issues as the Great Depression did. Chapters 14 through 21 cover the two major extensions. Thus, much of the material covered in the chapters on Chapters 14 through 17 focus on the role of expec- pathologies in the fifth edition has been moved to the core tations in the short run and in the medium run. and to the two extensions. xiv Preface  We have also removed Chapter 9 of the fifth edition, discussions of facts in the text itself, we have written a which developed a framework to think about the relation large number of Focus boxes, which discuss particular between growth, unemployment, and inflation. This was macroeconomic events or facts, from the United States or in response to teachers who found the framework too dif- from around the world. ficult for students to follow. Again, some of the material in We have tried to re-create some of the student– that chapter has been kept and integrated elsewhere, in teacher interactions that take place in the classroom by particular in Chapter 8. the use of margin notes, which run parallel to the text. The margin notes create a dialogue with the reader and, Alternative Course Outlines in so doing, smooth the more difficult passages and give a deeper understanding of the concepts and the results Within the book’s broad organization, there is plenty of derived along the way. opportunity for alternative course organizations. We have For students who want to explore macroeconomics made the chapters shorter than is standard in textbooks, further, we have introduced the following two features: and, in our experience, most chapters can be covered in an hour and a half. A few (Chapters 5 and 7 for example) Short appendixes to some chapters, which expand on might require two lectures to sink in. points made within the chapter. Short courses. (15 lectures or less) A Further Readings section at the end of most chap- ters, indicating where to find more information, includ- A short course can be organized around the two ing a number of key Internet addresses. introductory chapters and the core (Chapter 13 can be excluded at no cost in continuity). Informal pres- Each chapter ends with three ways of making sure entations of one or two of the extensions, based, for that the material in the chapter has been digested: example, on Chapter 17 for expectations (which A summary of the chapter’s main points. can be taught as a stand alone), and on Chapter 18 for the open economy, can then follow, for a total of A list of key terms. 14 lectures. A series of end-of-chapter exercises. “Quick Check” A short course might leave out the study of growth exercises are easy. “Dig Deeper” exercises are a bit (the long run). In this case, the course can be organ- harder, and “Explore Further” typically require either ized around the introductory chapters and Chapters access to the Internet or the use of a spreadsheet 3 through 9 in the core; this gives a total of 9 lectures, program. leaving enough time to cover, for example, Chapter 17 A list of symbols on the back endpapers makes it on expectations, Chapters 18 through 20 on the open easy to recall the meaning of the symbols used in the text. economy, for a total of 13 lectures. Longer courses (20 to 25 lectures) The Teaching and Learning A full semester course gives more than enough time to Package cover the core, plus one or both of the two extensions, The book comes with a number of supplements to help and the review of policy. both students and instructors. The extensions assume knowledge of the core, but are otherwise mostly self contained. Given the For Instructors: choice, the order in which they are best taught is Instructor’s Manual. The Instructor’s manual dis- probably the order in which they are presented in cusses pedagogical choices, alternative ways of pre- the book. Having studied the the role of expecta- senting the material, and ways of reinforcing students’ tions first helps students to understand the interest understanding. Chapters in the manual include six parity condition, and the nature of exchange rate main sections: objectives, in the form of a motivat- crises. ing question; why the answer matters; key tools, con- cepts, and assumptions; summary; and pedagogy. Many chapters also include sections focusing on Features extensions and observations. The Instructor’s Manual We have made sure never to present a theoretical result also includes the answers to all end-of-chapter ques- without relating it to the real world. In addition to tions and exercises. Preface xv  Test Item File. The test bank is completely revised with or homework assignments. MyEconLab saves time by additional new multiple–choice questions for each automatically grading all questions and tracking results chapter. in an online gradebook. MyEconLab can even grade assignments that require students to draw a graph. TestGen—The printed Test Item File is designed for use with the computerized TestGen package, which Real-Time Data—The real-time data problems are allows instructors to customize, save, and generate new. These problems load the latest available data classroom tests. The test program permits instructors from FRED, a comprehensive up-to-date data set to edit, add, or delete questions from the test bank; maintained by the Federal Reserve Bank of St. Louis. edit existing graphics and create new graphics; ana- The questions are graded with feedback in exactly the lyze test results; and organize a database of tests and same way as those based on static data. student results. This software allows for extensive After registering for MyEconLab, instructors flexibility and ease of use. It provides many options have access to downloadable supplements such as an for organizing and displaying tests, along with search Instructor’s Manual, PowerPoint lecture notes, and a and sort features. The software and the Test Item File Test Item File. The Test Item File can also be used with can be downloaded from the Instructor’s Resource MyEconLab, giving instructors ample material from which Center. (www.pearsonhighered.com/blanchard) they can create assignments. Digital Image Library—We have digitized the com- MyEconLab is delivered in Pearson’s MyLab plete set of figures, graphs, and charts from the book. Mastering system, which offers advanced communica- These files can be downloaded from the Instructor’s tion and customization features. Instructors can upload Resource Center. (www.pearsonhighered.com/ course documents and assignments and use advanced blanchard) course management features. For more information about MyEconLab or to request an instructor access code, visit PowerPoint Lecture Slides—These electronic slides www.myeconlab.com. provide section titles, tables, equations, and graphs for each chapter and can be downloaded from the Instructor’s Resource Center. (www.pearsonhighered. com/blanchard) Acknowledgments and Thanks This book owes much to many. We thank Adam Ashcraft, Peter Berger, Peter Benczur, Efe Cakarel, Harry Gakidis, David Hwang, Kevin Nazemi, David Reichsfeld, Jianlong MyEconLab® Tan, Stacy Tevlin, Gaurav Tewari, Corissa Thompson, John Simon, and Jeromin Zettelmeyer for their research MyEconLab delivers rich online content and innovative assistance over the years. We thank the generations of stu- learning tools in your classroom. Instructors who use dents in 14.02 at MIT who have freely shared their reac- MyEconLab gain access to powerful communication and tions to the book over the years. assessment tools, and their students receive access to the We have benefited from comments from many col- additional learning resources described below. leagues and friends. Among them are John Abell, Daron Acemoglu, Tobias Adrian, Chuangxin An, Roland Benabou, Students and MyEconLab—This online homework Samuel Bentolila, and Juan Jimeno (who have adapted and tutorial system puts students in control of their the book for a Spanish edition); Francois Blanchard, own learning through a suite of study and practice tools Roger Brinner, Ricardo Caballero, Wendy Carlin, Martina correlated with the online, interactive version of the Copelman, Henry Chappell, Ludwig Chincarini, and textbook and other media tools. Within MyEconLab’s Daniel Cohen (who has adapted the book for a French structured environment, students practice what they edition); Larry Christiano, Bud Collier, Andres Conesa, learn, test their understanding, and then pursue a Peter Diamond, Martin Eichenbaum, Gary Fethke, David study plan that MyEconLab generates for them based Findlay, Francesco Giavazzi, and Alessia Amighini (who on their performance on practice tests. have adapted the book for an Italian edition); Andrew Instructors and MyEconLab—MyEconLab provides Healy, Steinar Holden, and Gerhard Illing (who has flexible tools that allow instructors to easily and effec- adapted the book for a German edition); Yannis Ioannides, tively customize online course materials to suit their Angelo Melino (who has adapted the book for a Canadian needs. Instructors can create and assign tests, quizzes, edition); P. N. Junankar, Sam Keeley, Bernd Kuemmel, Paul xvi Preface Krugman, Antoine Magnier, Peter Montiel, Bill Nordhaus, Nicole Crain, Lafayette College Tom Michl, Dick Oppermann, Athanasios Orphanides, Rosemary Cunningham, Agnes Scott College and Daniel Pirez Enri (who has adapted the book for a Latin American edition); Michael Plouffe, Zoran Popovic, Evren Damar, Pacific Lutheran University Jim Poterba, and Jeff Sheen (who has adapted the book for Dale DeBoer, University of Colorado at Colorado an Australasian edition); Ronald Schettkat, and Watanabe Springs Shinichi (who has adapted the book for a Japanese edition); Francesco Sisci, Brian Simboli, Changyong Rhee, Julio Adrian de Leon-Arias, Universidad de Guadalajara Rotemberg, Robert Solow, Andre Watteyne, and Michael Brad DeLong, UC Berkeley Woodford. We have benefited from comments from many read- Firat Demir, University of Oklahoma ers, reviewers, and class testers. Among them: Wouter Denhaan, UC San Diego John Abell, Randolph, Macon Woman’s College John Dodge, King College Carol Adams, Cabrillo College F. Trenery Dolbear, Brandeis University Gilad Aharonovitz, School of Economic Sciences Patrick Dolenc, Keene State College Terence Alexander, Iowa State University Brian Donhauser, University of Washington Roger Aliaga-Diaz, Drexel University Michael Donihue, Colby College Robert Archibald, College of William & Mary Vincent Dropsy, California State University John Baffoe-Bonnie, La Salle University Justin Dubas, St. Norbert College Fatolla Bagheri, University of North Dakota Amitava Dutt, University of Notre Dame Stephen Baker, Capital University John Edgren, Eastern Michigan University Erol Balkan, Hamilton College Eric Elder, Northwestern College Jennifer Ball, Washburn University Sharon J. Erenburg, Eastern Michigan University Richard Ballman, Augustana College Antonina Espiritu, Hawaii Pacific University King Banaian, St. Cloud State University J. Peter Federer, Clark University Charles Bean, London School of Economics and Rendigs Fels, Vanderbilt University Political Science John Flanders, Central Methodist University Scott Benson, Idaho State University Marc Fox, Brooklyn College Gerald Bialka, University of North Florida Yee-Tien (Ted) Fu, Stanford University Robert Blecker, American University Yee-Tien Fu, National Cheng-Chi University, Taiwan Scott Bloom, North Dakota State University Scott Fullwiler, Wartburg College Pim Borren, University of Canterbury, New Zealand Julie Gallaway, University of Missouri–Rolla LaTanya Brown-Robertson, Bowie State University Bodhi Ganguli, Rutgers, The State University of NJ James Butkiewicz, University of Delaware Fabio Ghironi, Boston College Colleen Callahan, American University Alberto Gomez-Rivas, University of Houston–Downtown Bruce Carpenter, Mansfield University Fidel Gonzalez, Sam Houston State University Kyongwook Choi, Ohio University College Harvey Gram, Queen College, City University of Michael Cook, William Jewell College New York Preface xvii  Randy Grant, Linfield College Hsien-Feng Lee, National Taiwan University Alan Gummerson, Florida International University Jim Lee, Texas A&M University–Corpus Christi Reza Hamzaee, Missouri Western State College John Levendis, Loyola University New Orleans Michael Hannan, Edinboro University Frank Lichtenberg, Columbia University Kenneth Harrison, Richard Stockton College Mark Lieberman, Princeton University Mark Hayford, Loyola University Shu Lin, Florida Atlantic University Thomas Havrilesky, Duke University Maria Luengo-Prado, Northeastern University George Heitmann, Muhlenberg College Mathias Lutz, University of Sussex Ana Maria Herrera, Michigan State University Bernard Malamud, University of Nevada, Las Vegas Peter Hess, Davidson College Ken McCormick, University of Northern Iowa Eric Hilt, Wellesley College William McLean, Oklahoma State University John Holland, Monmouth College B. Starr McMullen, Oregon State University Mark Hopkins, Gettysburg College Mikhail Melnik, Niagara University Takeo Hoshi, University of California, San Diego O. Mikhail, University of Central Florida Ralph Husby, University of Illinois, Urbana–Champaign Fabio Milani, University of California, Irvine Yannis Ioannides, Tufts University Rose Milbourne, University of New South Wales Aaron Jackson, Bentley College Roger Morefield, University of Saint Thomas Bonnie Johnson, California Lutheran University Shahriar Mostashari, Campbell University Louis Johnston, College of St. Benedict Eshragh Motahar, Union College Barry Jones, SUNY Binghamton Nick Noble, Miami University Fred Joutz, George Washington University Ilan Noy, University of Hawaii Cem Karayalcin, Florida International University John Olson, College of St. Benedict Okan Kavuncu, University of California Brian O’Roark, Robert Morris University Miles Kimball, University of Michigan Jack Osman, San Francisco State University Paul King, Denison University Emiliano Pagnotta, Northwestern University Michael Klein, Tufts University Biru Paksha Paul, SUNY Cortland Mark Klinedinst, University of Southern Mississippi Andrew Parkes, Mesa State College Shawn Knabb, Western Washington University Allen Parkman, University of Mexico Todd Knoop, Cornell College Jim Peach, New Mexico State University Paul Koch, Olivet Nazarene University Gavin Peebles, National University of Singapore Ng Beoy Kui, Nanyang Technical University, Singapore Michael Quinn, Bentley College Leonard Lardaro, University of Rhode Island Charles Revier, Colorado State University James Leady, University of Notre Dame Jack Richards, Portland State University Charles Leathers, University of Alabama Raymond Ring, University of South Dakota xviii Preface  Monica Robayo, University of North Florida Mark Wohar, University of Nebraska, Omaha Malcolm Robinson, Thomas Moore College Steven Wood, University of California, Berkeley Brian Rosario, University of California, Davis Michael Woodford, Princeton University Kehar Sangha, Old Dominion University Ip Wing Yu, University of Hong Kong Ahmad Saranjam, Bridgewater State College Chi-Wa Yuen, Hong Kong University of Science and Technology Carol Scotese, Virginia Commonwealth University Christian Zimmermann, University of Connecticut John Seater, North Carolina State University Liping Zheng, Drake University Peter Sephton, University of New Brunswick They have helped us beyond the call of duty, and each Ruth Shen, San Francisco State University has made a difference to the book. Kwanho Shin, University of Kansas We have many people to thank at Pearson/Prentice Hall: David Alexander, executive editor for Economics; Tara Sinclair, The George Washington University Lindsey Sloan, editorial project manager; Emily Brodeur, Aaron Smallwood, University of Texas, Arlington editorial assistant; Nancy Freihofer, production editor; and Lori DeShazo, the marketing manager for Economics, David Sollars, Auburn University and Lauren Foster at PreMediaGlobal. Liliana Stern, Auburn University Thanks from Olivier Edward Stuart, Northeastern Illinois University I want to single out Steve Rigolosi, the editor for the first Abdulhanid Sukaar, Cameron University edition; Michael Elia, the editor to the second and third editions; Amy Ray, the editor of the fourth edition; and Peter Summers, Texas Tech University Chris Rogers, the editor of the fifth edition. Steve forced Mark Thomas, University of Maryland Baltimore County me to clarify. Michael forced me to simplify. Amy forced me to simplify further. Together, they have made all the Brian Trinque, The University of Texas at Austin difference to the process and to the book. I thank all of Marie Truesdell, Marian College them deeply. At MIT, I continue to thank John Arditi for his abso- David Tufte, Southern Utah University lute reliability. Abdul Turay, Radford University I have also benefited from often-stimulating sugges- tions from my daughters, Serena, Giulia and Marie: I did Frederick Tyler, Fordham University not, however, follow all of them. At home, I continue to Pinar Uysal, Boston College thank Noelle for preserving my sanity. Olivier Blanchard Evert Van Der Heide, Calvin College Cambridge, MIT Kristin Van Gaasbeck, California State University, June 2012 Sacramento Thanks from David Lee Van Scyoc, University of Wisconsin, Oshkosh I have to thank Olivier for encouraging me to write the Paul Wachtel, New York University Stern Business School Canadian editions of this book over the past decade. I enjoyed that work and I enjoyed teaching out of the Susheng Wang, Hong Kong University Canadian edition. I appreciated the opportunity to par- Donald Westerfield, Webster University ticipate in the sixth American edition. I would like to thank the many students in intermedi- Christopher Westley, Jacksonville State University ate macroeconomics at Wilfrid Laurier University whom I David Wharton, Washington College have taught over the years. I was blessed with four excel- lent instructors in macroeconomics at the graduate level: Jonathan Willner, Oklahoma City University Preface xix David Laidler, Michael Parkin, Benjamin Friedman and Finally I would like to thank my wife Susan. I benefit Olivier Blanchard. These professors taught macroeco- so much from her love and support. nomics in a way that made it engaging and exciting. David Johnson, Alastair Robertson, who was a superb colleague for Wilfred Laurier University many years in teaching intermediate macroeconomics at Waterloo, Ontario, WLU, taught me a lot about teaching. June 2012 xx Preface Introduction THE CORE The first two chapters of this book introduce you to the issues and the approach of macroeconomics. Chapter 1 Chapter 1 takes you on a macroeconomic tour of the world. It starts with a look at the economic crisis that has dominated the world economy since the late 2000s. The tour stops at each of the world’s major economic powers: the United States, the Euro area, and China. Chapter 2 Chapter 2 takes you on a tour of the book. It defines the three central variables of macroeconomics: output, unemployment, and inflation. It then introduces the three time periods around which the book is organized: the short run, the medium run, and the long run. 1 This page intentionally left blank A Tour of the World W hat is macroeconomics? The best way to answer is not to give you a formal definition, but rather to take you on an economic tour of the world, to describe both the main economic evolutions and the issues that keep macroeconomists and macroeconomic policy makers awake at night. The truth is, at the time of this writing (the fall of 2011), policy makers are not sleeping well and have not slept well in a long time. In 2008, the world economy entered a major macroeconomic crisis, the largest one since the Great Depression. World output growth, which typically runs at 4 to 5% a year, was actually negative in 2009. Since then, growth has turned positive, and the world economy is slowly recovering. But the crisis has left a number of scars, and many worries remain. Our goal is in this chapter is to give you a sense of these events and of some of the macroeconomic issues confronting different countries today. There is no way we can take you on a full tour, so, after an overview of the crisis, we focus on the three main economic powers of the world: the United States, the Euro area, and China. Section 1-1 looks at the crisis. Section 1-2 looks at the United States. Section 1-3 looks at the Euro area. Section 1-4 looks at China. Section 1-5 concludes and looks ahead. Read this chapter as you would read an article in a newspaper. Do not worry about the exact meaning of the words or about understanding all the arguments in detail: The words will be defined, and the arguments will be developed in later chapters. Regard this chapter as back- ground, intended to introduce you to the issues of macroeconomics. If you enjoy reading this chapter, you will probably enjoy reading this book. Indeed, once you have read the book, come back to this chapter; see where you stand on the issues, and judge how much progress you have made in your study of macroeconomics. 3  1-1 The Crisis Table 1-1 gives you output growth rates for the world economy, for advanced econ- omies and for other countries separately, since 2000. As you can see, from 2000 to 2007 the world economy had a sustained expansion. Annual average world output growth was 3.2%, with advanced economies (the group of 30 or so richest countries in the world) growing at 2.6% per year, and emerging and developing economies (the other 150 or so other countries in the world) growing at an even faster 6.5% per year. In 2007 however, signs that the expansion might be coming to an end started to appear. U.S. housing prices, which had doubled since 2000, started declining. In mid- 2007, as we wrote the previous edition of this book, we described how economists were divided as to whether this might lead to a recession—a decrease in output. Optimists believed that, while lower housing prices might lead to lower housing construction and to lower spending by consumers, the Fed (the short name for the U.S. central bank, formally known as the Federal Reserve Board) could lower interest rates to stimulate demand and avoid a recession. Pessimists believed that the decrease in interest rates might not be enough to sustain demand, and that the United States may go through a short recession. Even the pessimists turned out not to be pessimistic enough. As housing prices continued to decline, it became clear that many of the mortgage loans that had been given out during the earlier expansion were of poor quality. Many of the bor- rowers had taken too large a loan and were increasingly unable to make mortgage payments. And, with declining housing prices, the value of their mortgage often exceeded the price of the house, giving them an incentive to default. This was not “Banks” here actually means the worst of it: The banks that had issued the mortgages had often bundled and “banks and other financial in- packaged them together into new securities and then sold these securities to other  stitutions.” But this is too long banks and investors. These securities had often been repackaged into yet new se- to write and we do not want to curities, and so on. The result is that many banks, instead of holding the mortgages go into these complications in themselves, held these securities, which were so complex that their value was Chapter 1. nearly impossible to assess. This complexity and opaqueness turned a housing price decline into a major financial crisis, a development that very few economists had anticipated. Not know- ing the quality of the assets that other banks had on their balance sheets, banks became very reluctant to lend to each other for fear that the bank to which they lent might not be able to repay. Unable to borrow, and with assets of uncertain value, many banks found themselves in trouble. On September 15, 2008, a major bank, Lehman Brothers, went bankrupt. The effects were dramatic. Because the links be- tween Lehman and other banks were so opaque, many other banks looked appeared Table 1-1 World Output Growth since 2000 2000–2007 Percent (average) 2008 2009 2010 2011* 2012* World 3.2 1.5 −2.3 4.0 3.0 3.2 Advanced economies 2.6 0.1 −3.7 3.0 1.6 1.9 Emerging and developing economies 6.5 6.0 2.8 7.3 6.4 6.0 Output growth: Annual rate of growth of gross domestic product (GDP). *The numbers for 2011 and 2012 are forecasts, as of the fall of 2011. Source: World Economic Outlook database, September 2011 4 Introduction The Core  1.6 Figure 1-1 Stock prices in the United 1.4 States, the Euro area, Index, equal to 1.0 in January 2007 Emerging economies and emerging economies, 1.2 2007–2010 1.0 United States Source: Haver Analytics USA (S111ACD), Eurogroup (S023ACD), all emerging markets (S200ACD), 0.8 all monthly averages) 0.6 Euro area 0.4 0.2 0.0 1 6 1 6 1 6 1 6 1 –0