Macroeconomics PDF 6th Edition

Macroeconomics Sixth Edition Global Edition STEPHEN D. 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ISBN 10: 1-292-21576-3 ISBN 13: 978-1-29-221576-1 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Typeset in ITC Berkeley Oldstyle Pro by SPi Global Printed and bound by Vivar in Malaysia The Pearson Series in Economics Abel/Bernanke/Croushore Macroeconomics*† Acemoglu/Laibson/List Economics*† Bade/Parkin Foundations of Economics*† Daniels/VanHoose International Monetary & Financial Economics Heilbroner/Milberg The Making of the Economic Society Downs An Economic Theory of Democracy Heyne/Boettke/Prychitko The Economic Way of Thinking Berck/Helfand The Economics of the Environment Ehrenberg/Smith Modern Labor Economics Holt Markets, Games, and Strategic Behavior Bierman/Fernandez Game Theory with Economic Applications Farnham Economics for Managers Hubbard/O’Brien Economics*† Blanchard Macroeconomics*† Blau/Ferber/Winkler The Economics of Women, Men, and Work Boardman/Greenberg/Vining/ Weimer Cost-Benefit Analysis Boyer Principles of Transportation Economics Folland/Goodman/Stano The Economics of Health and Health Care Fort Sports Economics Ehrenberg/Smith Modern Labor Economics Froyen Macroeconomics: Theories and Policies Money, Banking, and the Financial System* Hubbard/O’Brien/Rafferty Macroeconomics* Hughes/Cain American Economic History Husted/Melvin International Economics Jehle/Reny Advanced Microeconomic Theory Fusfeld The Age of the Economist Johnson-Lans A Health Economics Primer Gerber International Economics*† Keat/Young/Erfle Managerial Economics Branson Macroeconomic Theory and Policy González-Rivera Forecasting for Economics and Business Klein Mathematical Methods for Economics Bruce Public Finance and the American Economy Gordon Macroeconomics* Krugman/Obstfeld/Melitz International Economics: Theory & Policy*† Brander/Perloff Managerial Economics and Strategy*† Carlton/Perloff Modern Industrial Organization* Case/Fair/Oster Principles of Economics*† Chapman Environmental Economics: Theory, Application, and Policy Cooter/Ulen Law and Economics Greene Econometric Analysis† Gregory Essentials of Economics Laidler The Demand for Money Leeds/von Allmen The Economics of Sports Gregory/Stuart Russian and Soviet Economic Performance and Structure Leeds/von Allmen/Schiming Economics* Hartwick/Olewiler The Economics of Natural Resource Use Lynn Economic Development: Theory and Practice for a Divided World Miller Economics Today* Understanding Modern Economics Miller/Benjamin The Economics of Macro Issues Miller/Benjamin/North The Economics of Public Issues Mills/Hamilton Urban Economics Mishkin The Economics of Money, Banking, and Financial Markets*† The Economics of Money, Banking, and Financial Markets, Business School Edition* Macroeconomics: Policy and Practice* Murray Econometrics: A Modern Introduction O’Sullivan/Sheffrin/Perez Economics: Principles, Applications and Tools*† Parkin Economics*† Perloff Microeconomics*† Microeconomics: Theory and Applications with Calculus*† Phelps Health Economics Pindyck/Rubinfeld Microeconomics*† Riddell/Shackelford/Stamos/ Schneider Economics: A Tool for Critically Understanding Society Roberts The Choice: A Fable of Free Trade and Protection Rohlf Introduction to Economic Reasoning Roland Development Economics Scherer Industry Structure, Strategy, and Public Policy Schiller The Economics of Poverty and Discrimination Sherman Market Regulation Stock/Watson Introduction to Econometrics† Studenmund Using Econometrics: A Practical Guide† Tietenberg/Lewis Environmental and Natural Resource Economics Environmental Economics and Policy Todaro/Smith Economic Development Waldman/Jensen Industrial Organization: Theory and Practice Walters/Walters/Appel/Callahan/ Centanni/Maex/O’Neill Econversations: Today’s Students Discuss Today’s Issues Weil Economic Growth Williamson Macroeconomics† *denotes Pearson MyLab Economics titles. Visit www.myeconlab.com to learn more. †denotes availability of Global Edition. CONTENTS PART I Chapter 1 Introduction and Measurement Issues 21 Introduction 22 What Is Macroeconomics? 23 Gross Domestic Product, Economic Growth, and Business Cycles 23 Macroeconomic Models 29 Microeconomic Principles 31 Disagreement in Macroeconomics 32 What Do We Learn from Macroeconomic Analysis? 33 Understanding Recent and Current Macroeconomic Events 36 Chapter Summary 53 Problems 56 Key Terms 54 Working with the Data 57 Questions for Review 55 Chapter 2 Measurement 58 Measuring GDP: The National Income and Product Accounts 59 The Components of Aggregate Expenditure 66 Nominal and Real GDP and Price Indices 68 Problems with Measuring Real GDP and the Price Level 75 Macroeconomics in Action: Comparing Real GDP Across Countries and the Penn Effect 76 Macroeconomics in Action: House Prices and GDP Measurement 77 Savings, Wealth, and Capital 79 Labor Market Measurement 81 Macroeconomics in Action: Alternative Measures of the Unemployment Rate 82 Chapter Summary 84 Problems 86 Key Terms 84 Working with the Data 89 Questions for Review 86 Chapter 3 Business Cycle Measurement 90 Regularities in GDP Fluctuations 91 5 6 Contents Comovement 93 Macroeconomics in Action: Economic Forecasting and the Financial Crisis 94 The Components of GDP 101 The Price Level and Inflation 104 Labor Market Variables 105 Macroeconomics in Action: Jobless Recoveries 108 Seasonal Adjustment 109 Macroeconomics in Action: The Great Moderation and the 2008–2009 Recession 112 Comovement Summary 112 Chapter Summary 113 Problems 115 Key Terms 114 Working with the Data 116 Questions for Review 115 PART II Chapter 4 Basic Macroeconomic Models: A One-Period Model and Models of Search and Unemployment 117 Consumer and Firm Behavior: The Work–Leisure Decision and Profit Maximization 118 The Representative Consumer 119 Macroeconomics in Action: How Elastic Is Labor Supply? 140 The Representative Firm 142 Macroeconomics in Action: Henry Ford and Total Factor Productivity 151 Theory Confronts the Data: Total Factor Productivity and the U.S. Aggregate Production Function 152 Chapter Summary 156 Problems 158 Working with the Data 160 Key Terms 156 Questions for Review 157 Chapter 5 A Closed-Economy One-Period Macroeconomic Model 162 Government 163 Competitive Equilibrium 164 Optimality 170 Working with the Model: The Effects of a Change in Government Purchases 177 Working with the Model: A Change in Total Factor Productivity 179 Theory Confronts the Data: Government Spending in World War II 180 Contents Theory Confronts the Data: Total Factor Productivity and Real GDP 186 Macroeconomics in Action: Government Expenditures and the American Recovery and Reinvestment Act of 2009 187 A Distorting Tax on Wage Income, Tax Rate Changes, and the Laffer Curve 191 A Model of Public Goods: How Large Should the Government Be? 197 Chapter Summary 202 Problems 204 Key Terms 202 Working with the Data 206 Questions for Review 203 Chapter 6 Search and Unemployment 207 Labor Market Facts 208 Macroeconomics in Action: Unemployment and Employment in the United States and Europe 214 A One-Sided Search Model of Unemployment 216 A Two-Sided Model of Search and Unemployment 225 Working with the Two-Sided Search Model 233 Macroeconomics in Action: Unemployment Insurance and Incentives 236 Theory Confronts the Data: Productivity, Unemployment, and Real GDP in the United States and Canada: The 2008–2009 Recession 242 Macroeconomics in Action: The Natural Rate of Unemployment and the 2008–2009 Recession 244 Chapter Summary 246 Problems 248 Key Terms 247 Working with the Data 249 Questions for Review 247 PART III Economic Growth 251 Chapter 7 Economic Growth: Malthus and Solow 252 Economic Growth Facts 254 The Malthusian Model of Economic Growth 259 The Solow Model: Exogenous Growth 269 Theory Confronts the Data: The Solow Growth Model, Investment Rates, and Population Growth 283 Macroeconomics in Action: Resource Misallocation and Total Factor Productivity 285 Macroeconomics in Action: Recent Trends in Economic Growth in the United States 286 7 8 Contents Growth Accounting 289 Macroeconomics in Action: Development Accounting 294 Chapter Summary 296 Problems 298 Key Terms 297 Working with the Data 300 Questions for Review 297 Chapter 8 Income Disparity Among Countries and Endogenous Growth 301 Convergence 302 Theory Confronts the Data: Is Income Per Worker Converging in the World? 307 Macroeconomics in Action: Measuring Economic Welfare: Per Capita Income, Income Distribution, Leisure, and Longevity 308 Endogenous Growth: A Model of Human Capital Accumulation 310 Macroeconomics in Action: Education and Growth 319 Chapter Summary 320 Problems 321 Key Terms 321 Working with the Data 323 Questions for Review 321 PART IV Savings, Investment, and Government Deficits 325 Chapter 9 A Two-Period Model: The Consumption–Savings Decision and Credit Markets 326 A Two-Period Model of the Economy 328 Theory Confronts the Data: Consumption Smoothing and the Stock Market 345 The Ricardian Equivalence Theorem 357 Macroeconomics in Action: Default on Government Debt 363 Chapter Summary 365 Problems 368 Key Terms 366 Working with the Data 370 Questions for Review 367 Chapter 10 Credit Market Imperfections: Credit Frictions, Financial Crises, and Social Security 371 Credit Market Imperfections and Consumption 373 Credit Market Imperfections, Asymmetric Information, and the Financial Crisis 377 Theory Confronts the Data: Asymmetric Information and Interest Rate Spreads 379 Credit Market Imperfections, Limited Commitment, and the Financial Crisis 380 Contents Social Security Programs 383 Theory Confronts the Data: The Housing Market, Collateral, and Consumption 384 Macroeconomics in Action: Social Security and Incentives 392 Chapter Summary 395 Problems 396 Key Terms 395 Working with the Data 398 Questions for Review 396 Chapter 11 A Real Intertemporal Model with Investment 399 The Representative Consumer 401 The Representative Firm 409 Theory Confronts the Data: Investment and the Interest Rate Spread 419 Government 421 Competitive Equilibrium 422 The Equilibrium Effects of a Temporary Increase in G: Stimulus, the Multiplier, and Crowding Out 434 The Equilibrium Effects of a Decrease in the Current Capital Stock K 437 Theory Confronts the Data: Government Expenditure Multipliers in the Recovery from the 2008–2009 Recession 438 The Equilibrium Effects of an Increase in Current Total Factor Productivity z 441 The Equilibrium Effects of an Increase in Future Total Factor Productivity, z′: News About the Future and Aggregate Economic Activity 443 Theory Confronts the Data: News, the Stock Market, and Investment Expenditures 445 Credit Market Frictions and the Financial Crisis 447 Sectoral Shocks and Labor Market Mismatch 449 Theory Confronts the Data: The Behavior of Real GDP, Employment, and Labor Productivity in the 1981–1982 and 2008–2009 Recessions 452 Chapter Summary 455 Problems 458 Key Terms 457 Working with the Data 460 Questions for Review 457 PART V Chapter 12 Money and Business Cycles 461 Money, Banking, Prices, and Monetary Policy 462 What Is Money? 463 A Monetary Intertemporal Model 465 9 10 Contents A Level Increase in the Money Supply and Monetary Neutrality 480 Shifts in Money Demand 484 Theory Confronts the Data: Instability in the Money Demand Function 487 Conventional Monetary Policy, the Liquidity Trap, and Unconventional Monetary Policy 489 Macroeconomics in Action: Quantitative Easing in the United States 492 Chapter Summary 494 Problems 496 Key Terms 494 Working with the Data 497 Questions for Review 495 Chapter 13 Business Cycle Models with Flexible Prices and Wages 498 The Real Business Cycle Model 500 A Keynesian Coordination Failure Model 509 Macroeconomics in Action: Business Cycle Models and the Great Depression 510 Macroeconomics in Action: Uncertainty and Business Cycles 524 Chapter Summary 525 Problems 527 Key Terms 526 Working with the Data 528 Questions for Review 526 Chapter 14 New Keynesian Economics: Sticky Prices 529 The New Keynesian Model 531 The Nonneutrality of Money in the New Keynesian Model 533 The Role of Government Policy in the New Keynesian Model 535 Macroeconomics in Action: The Timing of the Effects of Fiscal and Monetary Policy 540 The Liquidity Trap and Sticky Prices 542 Macroeconomics in Action: New Keynesian Models, the Zero Lower Bound, and Quantitative Easing 544 Criticisms of Keynesian Models 546 Macroeconomics in Action: How Sticky Are Nominal Prices? 547 Chapter Summary 548 Problems 549 Key Terms 549 Working with the Data 550 Questions for Review 549 Chapter 15 Inflation: Phillips Curves and Neo-Fisherism 551 Introduction 551 Inflation in a Basic New Keynesian Model 554 Theory Confronts the Data: The Phillips Curve 559 Macroeconomics in Action: Forward Guidance in the United States after 2008 566 Contents Neo-Fisherism, and a New Keynesian Rational Expectations (NKRE) Model 568 Chapter Summary 578 Problems 579 Key Terms 578 Working with the Data 580 Questions for Review 579 PART VI Chapter 16 International Macroeconomics 581 International Trade in Goods and Assets 582 A Two-Period Small Open-Economy Model: The Current Account 584 Theory Confronts the Data: Is a Current Account Deficit a Bad Thing? 588 Theory Confronts the Data: Greece and Sovereign Default 592 Production, Investment, and the Current Account 595 Chapter Summary 601 Problems 602 Key Terms 602 Working with the Data 603 Questions for Review 602 Chapter 17 Money in the Open Economy 604 The Nominal Exchange Rate, the Real Exchange Rate, and Purchasing Power Parity 606 Flexible and Fixed Exchange Rates 607 Theory Confronts the Data: The PPP Relationship for the United States and Canada 608 A Monetary Small Open-Economy Model with a Flexible Exchange Rate 611 A Monetary Small Open Economy with a Fixed Exchange Rate 618 Macroeconomics in Action: Sovereign Debt and the EMU 626 Capital Controls 628 Macroeconomics in Action: Do Capital Controls Work in Practice? 631 A New Keynesian Sticky Price Open-Economy Model 632 Chapter Summary 638 Problems 641 Key Terms 639 Working with the Data 643 Questions for Review 640 PART VII Money, Banking, and Inflation 645 Chapter 18 Money, Inflation, and Banking: A Deeper Look 646 Alternative Forms of Money 647 Macroeconomics in Action: Commodity Money and CommodityBacked Paper Money, Yap Stones, and Playing Cards 650 11 12 Contents Money and the Absence of Double Coincidence of Wants: The Role of Commodity Money and Fiat Money 651 Long-Run Inflation in the Monetary Intertemporal Model 654 Macroeconomics in Action: Should the Fed Reduce the Inflation Rate to Zero or Less? 662 Financial Intermediation and Banking 664 Macroeconomics in Action: Banks, Nonbank Financial Intermediaries, Too-Big-to-Fail, and Moral Hazard 675 Macroeconomics in Action: Bank Failures and Banking Panics in the United States and Canada 678 Chapter Summary 679 Problems 681 Key Terms 680 Working with the Data 683 Questions for Review 681 Appendix Mathematical Appendix 684 Chapter 4: Consumer and Firm Behavior 684 Chapter 5: A Closed-Economy One-Period Macroeconomic Model 688 Chapter 6: Search and Unemployment 692 Chapters 7 and 8: Economic Growth 697 Chapter 9: A Two-Period Model 702 Chapter 11: A Real Intertemporal Model with Investment 706 Chapter 12: Money, Banking, Prices, and Monetary Policy 707 Chapter 18: Money, Inflation, and Banking: A Deeper Look 712 Index 717 PREFACE This book follows a modern approach to macroeconomics by building macroeconomic models from microeconomic principles. As such, it is consistent with the way that macroeconomic research is conducted today. This approach has three advantages. First, it allows deeper insights into economic growth processes and business cycles, the key topics in macroeconomics. Second, an emphasis on microeconomic foundations better integrates the study of macroeconomics with approaches that students learn in courses in microeconomics and in field courses in economics. Learning in macroeconomics and microeconomics thus becomes mutually reinforcing, and students learn more. Third, in following an approach to macroeconomics that is consistent with current macroeconomic research, students will be better prepared for advanced study in economics. What’s New in the Sixth Edition The first five editions of Macroeconomics had an excellent reception in the market. In the sixth edition, I build on the strengths of the first five editions, while producing a framework for students of macroeconomics that captures all of the latest developments in macroeconomic thinking, applied to recent economic events and developments in macroeconomic policy. Previous editions of this text used available macroeconomic models and new ideas to analyze the events of the global financial crisis of 20082009. Now, with the financial crisis receding in the rear-view mirror, there are new challenges that macroeconomists and policymakers need to address, and that students should come to terms with. What are the causes and consequences of the low rates of labor force participation and employment in the United States? What is unconventional monetary policy, and why are many central banks in the world engaging in such policies? What are the macroeconomic implications of default on debt by sovereign governments? Why are real rates of interest so low in world? Can inflation be too low, and what should governments do about too-low inflation? What is the role of fiscal policy in a liqudidity trap? What is Neo-Fisherism? What is secular stagnation? These questions, and more, are answered in this revised sixth edition. In detail, the key changes in the sixth edition are: Chapter 6, “Search and Unemployment,” has been revised to include a section on the “one-sided search model,” an approach to modeling the behavior of the unemployed. This model determines the reservation wage for an unemployed worker, 13 14 Preface and shows how unemployment benefits, job offer rates, and separations determine the unemployment rate. Chapter 12, “Money, Banking, Prices, and Monetary Policy,” includes a new section about unconventional monetary policy and the zero lower bound. Unconventional policies include quantitative easing and negative nominal interest rates. In Chapter 13, there is a new section on business cycle theories as they relate to the 2008–2009 recession in particular. Chapter 14 address how New Keynesian models fit the data, and the chapter contains new material on the liquidity trap. Chapter 15 is entirely new, and analyzes inflation and its causes in a New Keynesian framework. A basic New Keynesian model shows how monetary policy is conducted, in conventional circumstances, and when the zero lower bound on the nominal interest rate is a problem. The chapter discusses how secular stagnation or world savings gluts can lead to low real interest rates, and zero lower bound monetary policies. Finally, a dynamic New Keynesian rational expectations model is used to introduce Neo-Fisherism—the idea that central banks should correct too-low inflation by increasing nominal interest rates. New end-of-chapter problems have been added. New “Theory Confronts the Data” features include “Government Expenditure Multipliers in the Recovery from the 2008-2009 Recession” (Chapter 11), “The Phillips Curve” (Chapter 15), and “Greece and Sovereign Default” (Chapter 16). New “Macroeconomics in Action” features include “Default on Government Debt” (Chapter 9), “Social Security and Incentives” (Chapter 10), and “Quantitative Easing in the United States” (Chapter 12). Data figures all have been revised to include the most recent data. Structure The text begins with Part I, which provides an introduction and study of measurement issues. Chapter 1 describes the approach taken in the book and the key ideas that students should take away. It previews the important issues that will be addressed throughout the book, along with some recent issues in macroeconomics, and the highlights of how these will be studied. Measurement is discussed in Chapters 2 and 3, first with regard to gross domestic product, prices, savings, and wealth, and then with regard to business cycles. In Chapter 3, we develop a set of key business cycle facts that will be used throughout the book, particularly in Chapters 13–15, where we investigate how alternative business cycle theories fit the facts. Our study of macroeconomic theory begins in Part II. In Chapter 4, we study the behavior of consumers and firms in detail. In the one-period model developed in Chapter 5, we capture the behavior of all consumers and all firms in the economy with a single representative consumer and a single representative firm. The one-period model is used to show how changes in government spending and total factor Preface productivity affect aggregate output, employment, consumption, and the real wage, and we analyze how proportional income taxation matters for aggregate activity and government tax revenue. In Chapter 6, two search models of unemployment are studied, which can capture some important details of labor market behavior in a macroeconomic context. These search models permit an understanding of the determinants of unemployment, and an explanation for some of the recent unusual labor market behavior observed in the United States. With a basic knowledge of static macroeconomic theory from Part II, we proceed in Part III to the study of the dynamic process of economic growth. In Chapter 7 we discuss a set of economic growth facts, which are then used to organize our thinking in the context of models of economic growth. The first growth model we examine is a Malthusian growth model, consistent with the late-eighteenth century ideas of Thomas Malthus. The Malthusian model predicts well the features of economic growth in the world before the Industrial Revolution, but it does not predict the sustained growth in per capita incomes that occurred in advanced countries after 1800. The Solow growth model, which we examine next, does a good job of explaining some important observations concerning modern economic growth. Finally, Chapter 7 explains growth accounting, which is an approach to disentangling the sources of growth. In Chapter 8, we discuss income disparities across countries in light of the predictions of the Solow model, and introduce a model of endogenous growth. In Part IV, we first use the theory of consumer and firm behavior developed in Part II to construct (in Chapter 9) a two-period model that can be used to study consumption-savings decisions and the effects of government deficits on the economy. Chapter 10 extends the two-period model to include credit market imperfections, an approach that is important for understanding the recent global financial crisis, fiscal policy, and social security. The two-period model is then further extended to include investment behavior and to address a wide range of macroeconomic issues in the real intertemporal model of Chapter 11. This model will then serve as the basis for much of what is done in the remainder of the book. In Part V, we include monetary phenomena in the real intertemporal model of Chapter 11, so as to construct a monetary intertemporal model. This model is used in Chapter 12 to study the role of money and alternative means of payment, to examine the effects of changes in the money supply on the economy, and to study the role of monetary policy. Then, in Chapters 13 and 14, we study theories of the business cycle with flexible wages and prices, as well as New Keynesian business cycle theory. These theories are compared and contrasted, and we examine how alternative business cycle theories fit the data and how they help us to understand recent business cycle behavior in the United States. Chapter 15 extends the New Keynesian sticky price model of Chapter 14, so that the causes and consequences of inflation can be studied, along with the control of inflation by central banks. This chapter also introduces Neo-Fisherian theory, which is a provocative alternative to conventional central banking theories of inflation control. Part VI is devoted to international macroeconomics. In Chapter 16, the models of Chapters 9 and 11 are used to study the determinants of the current account surplus, and the effects of shocks to the macroeconomy that come from abroad. Then, in Chapter 17, we show how exchange rates are determined, and we investigate the roles 15 16 Preface of fiscal and monetary policy in an open economy that trades goods and assets with the rest of the world. Finally, Part VII examines some important topics in macroeconomics. In Chapter 18, we study in more depth the role of money in the economy, the effects of money growth on inflation and aggregate economic activity, banking, and deposit insurance. Features Several key features enhance the learning process and illuminate critical ideas for the student. The intent is to make macroeconomic theory transparent, accessible, and relevant. Real-World Applications Applications to current and historical problems are emphasized throughout in two running features. The first is a set of “Theory Confronts the Data” sections, which show how macroeconomic theory comes to life in matching (or sometimes falling short of matching) the characteristics of real-world economic data. A sampling of some of these sections includes consumption smoothing and the stock market; government expenditure multipliers in the recovery from the 2008-2009 recession; and the Phillips curve. The second running feature is a series of “Macroeconomics in Action” boxes. These real-world applications relating directly to the theory encapsulate ideas from front-line research in macroeconomics, and they aid students in understanding the core material. For example, some of the subjects examined in these boxes are the default on government debt; business cycle models and the Great Depression; and quantitative easing in the United States. Art Program Graphs and charts are plentiful in this book, as visual representations of macroeconomic models that can be manipulated to derive important results, and for showing the key features of important macro data in applications. To aid the student, graphs and charts use a consistent two-color system that encodes the meaning of particular elements in graphs and of shifts in curves. End-of-Chapter Summary and List of Key Terms Each chapter wraps up with a bullet-point summary of the key ideas contained in the chapter, followed by a glossary of the chapter’s key terms. The key terms are listed in the order in which they appear in the chapter, and they are highlighted in bold typeface where they first appear. Questions for Review These questions are intended as self-tests for students after they have finished reading the chapter material. The questions relate directly to ideas and facts covered in the Preface chapter, and answering them will be straightforward if the student has read and comprehended the chapter material. Problems The end-of-chapter problems will help the student in learning the material and applying the macroeconomic models developed in the chapter. These problems are intended to be challenging and thought-provoking. “Working with the Data” Problems These problems are intended to encourage students to learn to use real-world macroeconomic data from sources such as the World Bank, the International Monetary Fund, and the FRED database at the St. Louis Federal Reserve Bank These organizations assemble important macroeconomic data for various countries in one place and allow the student to manipulate the data and easily produce charts. The problems are data applications relevant to the material in the chapter. Notation For easy reference, definitions of all variables used in the text are contained at the end of the textbook. Mathematics and Mathematical Appendix In the body of the text, the analysis is mainly graphical, with some knowledge of basic algebra required; calculus is not used. However, for students and instructors who desire a more rigorous treatment of the material in the text, a mathematical appendix develops the key models and results more formally, assuming a basic knowledge of calculus and the fundamentals of mathematical economics. The Mathematical Appendix also contains problems on this more advanced material. Flexibility This book was written to be user-friendly for instructors with different preferences and with different time allocations. The core material that is recommended for all instructors is the following: Chapter 1. Chapter 2. Chapter 3. Chapter 4. Introduction Measurement Business Cycle Measurement Consumer and Firm Behavior: The Work-Leisure Decision and Profit Maximization Chapter 5. A Closed-Economy One-Period Macroeconomic Model 17 18 Preface Chapter 9. A Two-Period Model: The Consumption-Savings Decision and Credit Markets Chapter 11. A Real Intertemporal Model with Investment Some instructors find measurement issues uninteresting, and may choose to omit parts of Chapter 2, though at the minimum instructors should cover the key national income accounting identities. Parts of Chapter 3 can be omitted if the instructor chooses not to emphasize business cycles, but there are some important concepts introduced here that are generally useful in later chapters, such as the meaning of correlation and how to read scatter plots and time series plots. Chapter 6 introduces two search models of unemployment: a one-sided search model, and a two-sided search model. These models allow for an explicit treatment of the determinants of unemployment by including a search friction. This allows for an interesting treatment of labor market issues, but it is possible to skip this chapter, or to put it later in the sequence, if the instructor and students prefer to focus on other topics. Chapters 7 and 8 introduce economic growth at an early stage, in line with the modern role of growth theory in macroeconomics. However, Chapters 7 and 8 are essentially self-contained, and nothing is lost from leaving growth until later in the sequence—for example, after the business cycle material in Chapters 13-15. Though the text has an emphasis on microfoun-dations, Keynesian analysis receives a balanced treatment. For example, we study a Keynesian coordination failure model in Chapter 13, and examine a New Keynesian sticky price model in Chapters 14 and 15. Keynesian economics is fully integrated with flexible-wage-and-price approaches to business cycle analysis, and the student does not need to learn a separate modeling framework, as for example the New Keynesian sticky price model is simply a special case of the general modeling framework developed in Chapter 12. Those instructors who choose to ignore Keynesian analysis can do so without any difficulty. Instructors can choose to emphasize economic growth or business cycle analysis, or they can give their course an international focus. As well, it is possible to deemphasize monetary factors. As a guide, the text can be adapted as follows: Focus on Models with Flexible Wages and Prices. Omit Chapters 14 and 15. Focus on Economic Growth. Include Chapters 7 and 8, and consider dropping Chapters 12, 13, 14, and 15, depending on time available. Focus on Business Cycles. Drop Chapters 7 and 8, and include Chapters 6, 12, 13, 14, and 15. International Focus. Chapters 16 and 17 can be moved up in the sequence. Chapter 16 can follow Chapter 11, and Chapter 17 can follow Chapter 12. Advanced Mathematical Treatment. Add material as desired from the Mathematical Appendix. Supplements The following materials that accompany the main text will enrich the intermediate macroeconomics course for instructors and students alike. Preface Instructor’s Manual and Test Bank Written by the author, the Instructor’s Manual provides strong instructor support. The Instructor’s Manual contains sections on Teaching Goals, which give an aerial view of the chapters; classroom discussion topics, which explore lecture-launching ideas and questions; chapter outlines; and solutions to all Problems found in the text. The Test Bank contains multiple-choice questions and answers. The Test Bank is also available in Test Generator format. This software is available for Windows and Macintosh. TestGen’s friendly graphical interface enables instructors to easily view, edit, and add questions; export questions to create tests; and print tests in a variety of fonts and forms. Search and sort features let the instructor quickly locate questions and arrange them in a preferred order. The Instructor’s Manual and Test Bank can be found on the Instructor’s Resource Center, accessible from www.pearsonglobaleditions.com/williamson. Powerpoint Slides: A full set of Powerpoint slides is available for instructors. The slides cover the material for each chapter in detail, including the key figures in the text. Acknowledgments Special thanks go to Neeraj Bhalla, Nicole Suddeth, and Pavithra Kumari, and the extended team at Pearson, who provided so much help and encouragement. I am also indebted to Dave Andolfatto, Scott Baier, Ken Beauchemin, Edward Kutsoati, Kuhong Kim, Young Sik Kim, Mike Loewy, B. Ravikumar, Ping Wang, and Bradley Wilson, who used early versions of the manuscript in their classes. Key critical input was also provided by the following reviewers, who helped immensely in improving the manuscript: Terry Alexander, Iowa State University; Alaa AlShawa, University of Western Ontario; David Aschauer, Bates College; Irasema Alonso, University of Rochester; David Andolfatto, Simon Fraser University; Scott Baier, Clemson University; Ken Beauchemin, State University of New York at Albany; Joydeep Bhattacharya, Iowa State University; Michael Binder, University of Maryland; William Blankenau, Kansas State University; Marco Cagetti, University of Virginia; Mustafa Caglayan, University of Liverpool; Gabriele Camera, Purdue University; Leo Chan, University of Kansas; Troy Davig, College of William and Mary; Matthias Doepke, UCLA; Ayse Y. Evrensel, Portland State University; Timothy Fuerst, Bowling Green State University; Lisa Geib-Gundersen, University of Maryland; John Graham, Rutgers University; Yu Hsing, Southeastern Louisiana University; Petur O. Jonsson, Fayetteville State University; Bryce Kanago, University of Northern Iowa; George Karras, University of Illinois; John Knowles, University of Pennsylvania; Hsien-Feng Lee, Taiwan University; Igor Livshits, University of Western Ontario; Michael Loewy, University of South Florida; Kathryn Marshall, Ohio State University; Steve McCafferty, Ohio State University; Oliver Morand, University of Connecticut; Douglas Morgan, University of California, Santa Barbara; Giuseppe Moscarini, Yale University; Daniel Mulino, doctoral candidate, Yale University; Liwa Rachel Ngai, London School of Economics; Christopher Otrok, University of Virginia; Stephen Parente, University of Illinois at Urbana-Champaign; Prosper Raynold, Miami University; Kevin Reffett, Arizona State University; Robert J. Rossana, Wayne State University; Thomas Tallarini, Carnegie Mellon University; Paul Wachtel, Stern School of Business, 19 20 Preface New York University; Ping Wang, Vanderbilt University; Bradley Wilson, University of Alabama; Paul Zak, Claremont Graduate University; and Christian Z immermann, University of Connecticut. Finally, I wish to thank those economists who specifically reviewed material on economic growth for this edition: Laurence Ales, Carnegie Mellon University; Matthew Chambers, Towson University; Roberto E. Duncan, Ohio University; Rui Zhao, Emory University; Marek Kapicka, University of California, Santa Barbara. Pearson would like to thank Kwan Wai KO, United International College; Gabriela Sterian, Romanian-American University; Stefan Fink, University of Linz; and Tamar Mdivnishvili, National Bank of Georgia, for their work on the Global Edition. About the Author Stephen Williamson is a Vice President at the Federal Reserve Bank of St. Louis. He received a B.Sc. in Mathematics and an M.A. in Economics from Queen’s University in Kingston, Canada, and his Ph.D. from the University of Wisconsin-Madison. He has held academic positions at Queen’s University, the University of Western Ontario, the University of Iowa and Washington University in St. Louis, and has worked as an economist at the Federal Reserve Bank of Minneapolis and the Bank of Canada. Professor Williamson has been an academic visitor at the Federal Reserve Banks of Atlanta, Cleveland, Kansas City, Minneapolis, New York, Philadelphia, the Bank of Canada, and the Board of Governors of the Federal Reserve System. He has also been a long-term visitor at the London School of Economics; the University of Edinburgh; Tilburg University, the Netherlands; Victoria University of Wellington, New Zealand; Seoul National University; Hong Kong University; Queen’s University; Fudan University; Indiana University; and the University of Sydney. Professor Williamson has published scholarly articles in the American Economic Review, the Journal of Political Economy, the Quarterly Journal ofEconomics, the Review of Economic Studies, the Journal of Economic Theory, and the Journal of Monetary Economics, among other prestigious economics journals. This text reflects the author’s views, and does not necessarily reflect the views of the Federal Reserve Bank of St. Louis, the Board of Governors of the Federal Reserve System, or the Federal Reserve System. PART I Introduction and Measurement Issues Part I contains an introduction to macroeconomic analysis and a description of the approach in this text of building useful macroeconomic models based on microeconomic principles. We discuss the key ideas that are analyzed in the rest of this text as well as some current issues in macroeconomics. Then, to lay a foundation for what is done later, we explore how the important variables relating to macroeconomic theory are measured in practice. Finally, we analyze the key empirical facts concerning business cycles. The macroeconomic theory developed in Parts II to VII is aimed at understanding the key ideas and issues discussed in the introduction, and in showing the successes and failures of theory in organizing our thinking about empirical facts. Chapter 1 Introduction Learning Objectives After studying Chapter 1, students will be able to: 1.1 State the two focuses of study in macroeconomics, the key differences between microeconomics and macroeconomics, and the similarities between microeconomics and macroeconomics. 1.2 Explain the key features of trend growth and deviations from trend in per capita gross domestic product in the United States from 1900 to 2014. 1.3 Explain why models are useful in macroeconomics. 1.4 Discuss how microeconomic principles are important in constructing useful macroeconomic models. 1.5 Explain why there is disagreement among macroeconomists, and what they disagree about. 1.6 List the 12 key ideas that will be covered in this book. 1.7 List the key observations that motivate questions we will try to answer in this book. This chapter frames the approach to macroeconomics that we take in this text, and it foreshadows the basic macroeconomic ideas and issues that we develop in later chapters. We first discuss what macroeconomics is, and we then go on to look at the two phenomena that are of primary interest to macroeconomists—economic growth and business cycles—in terms of post–1900 U.S. economic history. Then, we explain the approach this text takes—building macroeconomic models with microeconomic principles as a foundation—and discuss the issue of disagreement in macroeconomics. Finally, we explore the key lessons that we learn from macroeconomic theory, and we discuss how macroeconomics helps us understand recent and current issues. 22 Introduction Chapter 1 What Is Macroeconomics? LO 1.1 State the two focuses of study in macroeconomics, the key differences between microeconomics and macroeconomics, and the similarities between microeconomics and macroeconomics. Macroeconomists are motivated by large questions and by issues that affect many people and many nations of the world. Why are some countries exceedingly rich while others are exceedingly poor? Why are most Americans so much better off than their parents and grandparents? Why are there fluctuations in aggregate economic activity? What causes inflation? Why is there unemployment? Macroeconomics is the study of the behavior of large collections of economic agents. It focuses on the aggregate behavior of consumers and firms, the behavior of governments, the overall level of economic activity in individual countries, the economic interactions among nations, and the effects of fiscal and monetary policy. Macroeconomics is distinct from microeconomics in that it deals with the overall effects on economies of the choices that all economic agents make, rather than on the choices of individual consumers or firms. Since the 1970s, however, the distinction between microeconomics and macroeconomics has blurred in that microeconomists and macroeconomists now use much the same kinds of tools. That is, the economic models that macroeconomists use, consisting of descriptions of consumers and firms, their objectives and constraints, and how they interact, are built up from microeconomic principles, and these models are typically analyzed and fit to data using methods similar to those used by microeconomists. What continues to make macroeconomics distinct, though, is the issues it focuses on, particularly long-run growth and business cycles. Long-run growth refers to the increase in a nation’s productive capacity and average standard of living that occurs over a long period of time, whereas business cycles are the short-run ups and downs, or booms and recessions, in aggregate economic activity. An important goal in this text is to consistently build up macroeconomic analysis from microeconomic principles. There is some effort required in taking this type of approach, but the effort is well worth it. The result is that you will understand better how the economy works and how to improve it. Gross Domestic Product, Economic Growth, and Business Cycles LO 1.2 Explain the key features of trend growth and deviations from trend in per capita gross domestic product in the United States from 1900 to 2014. To begin our study of macroeconomic phenomena, we must first understand what facts we are trying to explain. The most basic set of facts in macroeconomics has to do with the behavior of aggregate economic activity over time. One measure of aggregate economic activity is gross domestic product (GDP), which is the quantity of goods and 23 24 Part I Introduction and Measurement Issues services produced within a country’s borders during some specified period of time. GDP also represents the quantity of income earned by those contributing to domestic output. In Figure 1.1 we show real GDP per capita for the United States for the period 1900–2014. This is a measure of aggregate output that adjusts for inflation and population growth, and the unit of measure is thousands of 2009 dollars per person. The first observation we can make concerning Figure 1.1 is that there has been sustained growth in per capita GDP during the period 1900–2014. In 1900, the average income for an American was $5,188 (2009 dollars), and this grew to $50,051 (2009 dollars) in 2014. Thus, the average American became almost ten times richer in real terms over the course of 114 years, which is quite remarkable! The second important observation from Figure 1.1 is that, while growth in per capita real GDP was sustained over long periods of time in the United States during the period 1900–2014, this growth was certainly not steady. Growth was higher at some times than at others, and there were periods over which per capita real GDP declined. These fluctuations in economic growth are business cycles. Figure 1.1 Per Capita Real GDP (in 2009 dollars) for the United States, 1900–2014 Per capita real GDP is a measure of the average level of income for a U.S. resident. Two unusual, though key, events in the figure are the Great Depression, when there was a large reduction in living standards for the average American, and World War II, when per capita output increased greatly. 55 Per capita income in thousands of 2009 dollars 50 45 40 35 30 25 20 WWII 15 10 5 1900 Great Depression 1920 1940 1960 Year 1980 2000 2020 Introduction Chapter 1 Two key, though unusual, business cycle events in U.S. economic history that show up in Figure 1.1 are the Great Depression and World War II, and these events dwarf any other twentieth-century business cycle events in the United States in terms of the magnitude of the short-run change in economic growth. During the Great Depression, real GDP per capita dropped from a peak of $8,677 (2009 dollars) per person in 1929 to a low of $6,192 (2009 dollars) per person in 1933, a decline of about 29%. At the peak of war production in 1944, GDP had risen to $16,181 (2009 dollars) per person, an increase of 161% from 1933. These wild gyrations in aggregate economic activity over a 15-year period are as phenomenal, and certainly every bit as interesting, as the long-run sustained growth in per capita GDP that occurred from 1900 to 2014. In addition to the Great Depression and World War II, Figure 1.1 shows other business cycle upturns and downturns in the growth of per capita real GDP in the United States that, though less dramatic than the Great Depression or World War II, represent important macroeconomic events in U.S. history. Figure 1.1, thus, raises the following fundamental macroeconomic questions, which motivate much of the material in this book: 1. What causes sustained economic growth? 2. Could economic growth continue indefinitely, or is there some limit to growth? 3. Is there anything that governments can or should do to alter the rate of economic growth? 4. What causes business cycles? 5. Could the dramatic decreases and increases in economic growth that occurred during the Great Depression and World War II be repeated? 6. Should governments act to smooth business cycles? In analyzing economic data to study economic growth and business cycles, it often proves useful to transform the data in various ways, so as to obtain sharper insights. For economic time series that exhibit growth, such as per capita real GDP in Figure 1.1, a useful transformation is to take the natural logarithm of the time series. To show why this is useful, suppose that yt is an observation on an economic time series in period t; for example, yt could represent per capita real GDP in year t, where t = 1900, 1901, 1902, etc. Then, the growth rate from period t - 1 to period t in yt can be denoted by gt, where yt gt = - 1. yt - 1 Now, if x is a small number, then ln (1 + x) ≈ x, that is, the natural logarithm of 1 + x is approximately equal to x. Therefore, if gt is small, ln (1 + gt) ≈ gt, or ln ¢ yt ≤ ≈ gt, yt - 1 25 26 Part I Introduction and Measurement Issues or ln yt - ln yt - 1 ≈ gt. Because ln yt - ln yt - 1 is the slope of the graph of the natural logarithm of yt between periods t - 1 and t, the slope of the graph of the natural logarithm of a time series yt is a good approximation to the growth rate of yt when the growth rate is small. In Figure 1.2, we graph the natural logarithm of real per capita GDP in the United States for the period 1900–2014. As explained above, the slope of the graph is a good approximation to the growth rate of real per capita GDP, so that changes in the slope (e.g., when there is a slight increase in the slope of the graph in the 1950s and 1960s) represent changes in the growth rate of real per capita GDP. It is striking that in Figure 1.2, except for the Great Depression and World War II, a straight line would fit the graph quite well. That is, over the period 1900–2014 (again, except for the Great Depression and World War II), growth in per capita real GDP has been “roughly” constant at about 2.0% per year. Figure 1.2 Natural Logarithm of Per Capita Real GDP Here, the slope of the graph is approximately equal to the growth rate of per capita real GDP. Excluding the Great Depression and World War II, the growth rate of per capita real GDP is remarkably close to being constant for the period 1900–2014. That is, a straight line would fit the graph fairly well. Natural Logarithm of Per Capita Income 4 3.5 3 WWII 2.5 2 Great Depression 1.5 1900 1920 1940 1960 Year 1980 2000 2020 27 Introduction Chapter 1 Figure 1.3 Natural Logarithm of Real Per Capita GDP and Trend Sometimes it is useful to separate long-run growth from business cycle fluctuations. In the figure, the black line is the natural log of per capita real GDP, while the colored line denotes a smooth growth trend fit to the data. The deviations from the smooth trend then represent business cycles. Natural Log of Per capita income and trend 4 3.5 3 Trend 2.5 2 Actual 1.5 1900 1920 1940 1960 Year 1980 2000 A second useful transformation to carry out on an economic time series is to separate the series into two components: the growth or trend component, and the business cycle component. For example, the business cycle component of real per capita GDP can be captured as the deviations of real per capita GDP from a smooth trend fit to the data. In Figure 1.3, we show the trend in the natural log of real per capita GDP as a colored line,1 while the natural log of actual real per capita GDP is the black line. We then define the business cycle component of the natural log of real per capita GDP to be the difference between the black line and the colored line in Figure 1.3. The logic behind this decomposition of real per capita GDP into trend and business cycle components is that it is often simpler and more productive to consider separately the theory 1 Trend GDP was computed using a Hodrick–Prescott filter, as in E. Prescott, Fall 1986. “Theory Ahead of Business Cycle Measurement,” Federal Reserve Bank of Minneapolis Quarterly Review 10, 9–22 2020 28 Part I Introduction and Measurement Issues Figure 1.4 Percentage Deviation from Trend in Real Per Capita GDP The Great Depression and World War II represent extremely large deviations from trend relative to post– World War II business cycle activity and business cycles before the Great Depression. 25 20 WWII Percentage Deviation From Trend 15 10 5 0 −5 −10 −15 Great Depression −20 1900 1920 1940 1960 Year 1980 2000 2020 that explains trend growth and the theory that explains business cycles, which are the deviations from trend. In Figure 1.4, we show only the percentage deviations from trend in real per capita GDP. The Great Depression and World War II represent enormous deviations from trend in real per capita GDP relative to anything else during the time period in the figure. During the Great Depression the percentage deviation from trend in real per capita GDP was close to -20,, whereas the percentage deviation from trend was about 20% during World War II. In the period after World War II, which is the focus of most business cycle analysis, the deviations from trend in real per capita GDP are at most about { 5,.2 2 The extremely large deviation from trend in real per capita GNP in the late 1920s is principally a statistical artifact of the particular detrending procedure used here, which is akin to drawing a smooth curve through the time series. The presence of the Great Depression forces the growth rate in the trend to decrease long before the Great Depression actually occurs. Introduction Chapter 1 Macroeconomic Models LO 1.3 Explain why models are useful in macroeconomics. Economics is a scientific pursuit involving the formulation and refinement of theories that can help us better understand how economies work and how they can be improved. In some sciences, such as chemistry and physics, theories are tested through laboratory experimentation. In economics, experimentation is a new and growing activity, but for most economic theories experimental verification is simply impossible. For example, suppose an economist constructs a theory that implies that U.S. output would drop by half if there were no banks in the United States. To evaluate this theory, we could shut down all U.S. banks for a year to see what would happen. Of course, we know in advance that banks play a very important role in helping the U.S. economy function efficiently, and that shutting them down for a year would likely cause significant irreparable damage. It is extremely unlikely, therefore, that the experiment would be performed. In macroeconomics, most experiments that could be informative are simply too costly to carry out, and in this respect macroeconomics is much like meteorology or astronomy. In predicting the weather or how planets move in space, meteorologists and astronomers rely on models, which are artificial devices that can replicate the behavior of real weather systems or planetary systems, as the case may be. Just like researchers in meteorology or astronomy, macroeconomists use models, which in our case are organized structures to explain long-run economic growth, why there are business cycles, and what role economic policy should play in the macroeconomy. All economic models are abstractions. They are not completely accurate descriptions of the world, nor are they intended to be. The purpose of an economic model is to capture the essential features of the world needed for analyzing a particular economic problem. To be useful then, a model must be simple, and simplicity requires that we leave out some “realistic” features of actual economies. For example, an electronic roadmap is a model of a part of the earth’s surface, and it is constructed with a particular purpose in mind, to help motorists guide themselves through the road system from one point to another. A roadmap is hardly a realistic depiction of the earth’s surface, as it does not capture the curvature of the earth, and it does not typically include a great deal of information on topography, climate, and vegetation. However, this does not limit the map’s usefulness; a roadmap serves the purpose for which it was constructed, and it does so without a lot of extraneous detail. To be specific, the basic structure of a macroeconomic model is a description of the following features: 1. 2. 3. 4. 5. The consumers and firms that interact in the economy The set of goods that consumers wish to consume Consumers’ preferences over goods The technology available to firms for producing goods The resources available 29 30 Part I Introduction and Measurement Issues In this text, the descriptions of the above five features of any particular macroeconomic model are provided in mathematical and graphical terms. Once we have a description of the main economic actors in a model economy (the consumers and firms), the goods consumers want, and the technology available to firms for producing goods from available resources, we want to then use the model to make predictions. This step requires that we specify two additional features of the model. First, we need to know what the goals of the consumers and firms in the model are. How do consumers and firms behave given the environment they live in? In all the models we use in this book, we assume that consumers and firms optimize, that is, they do the best they can given the constraints they face. Second, we must specify how consistency is achieved in terms of the actions of consumers and firms. In economic models, this means that the economy must be in equilibrium. Several different concepts of equilibrium are used in economic models, but the one that we use most frequently in this book is competitive equilibrium. In a competitive equilibrium, we assume that goods are bought and sold on markets in which consumers and firms are price-takers; they behave as if their actions have no effect on market prices. The economy is in equilibrium when market prices are such that the quantity of each good offered for sale (quantity supplied) is equal to the quantity that economic agents want to buy (quantity demanded) in each market. Once we have a working economic model, with a specification of the economic environment, optimizing firms and consumers, and a notion of equilibrium, we can then begin to ask the model questions.3 One way to think of this process is that the economic model is an experimental apparatus, and we want to attempt to run experiments using this apparatus. Typically, we begin by running experiments for which we know the answers. For example, suppose that we build an economic model so that we can study economic growth. The first experiment we might like to run is to determine, by working through the mathematics of the model, using graphical analysis, or running the model on a computer, whether in fact the model economy will grow. Further, will it grow in a manner that comes close to matching the data? If it does not, then we want to ask why and to determine whether it would be a good idea to refine the model in some way or to abandon it altogether and start over. Ultimately, once we are satisfied that a model reasonably and accurately captures the economic phenomenon in which we are interested, we can start running experiments on the model for which we do not know the answers. An experiment we might want to conduct with the economic growth model is to ask, for example, how historical growth performance would have differed in the United States had the level of government spending been higher. Would aggregate economic activity have grown at a higher or a lower rate? How would this have affected the consumption of goods? Would economic welfare have been higher or lower? In keeping with the principle that models should be simple and designed specifically for the problem at hand, we do not stick to a single all-purpose model in this book. 3 The following description of macroeconomic science is similar to that provided by Robert Lucas in “Methods and Problems in Business Cycle Theory,” reprinted in Studies in Business Cycle Theory, 1981, MIT Press, pp. 271–296. Introduction Chapter 1 Instead, we use an array of different models for different purposes, though these models share a common approach and some of the same principal building blocks. For example, sometimes it proves useful to build models that do not include international trade, macroeconomic growth, or the use of money in economic exchange, whereas at other times it is crucial for the issue at hand that we explicitly model one, two, or perhaps all of these features. Generally, macroeconomic research is a process whereby we continually attempt to develop better models, along with better methods for analyzing those models. Economic models continue to evolve in a way that helps us better understand the economic forces that shape the world in which we live, so that we can promote economic policies that make society better off. Microeconomic Principles LO 1.4 Discuss how microeconomic principles are important in constructing useful macroeconomics models. This text emphasizes building macroeconomic models on sound microeconomic principles. Because the macroeconomy consists of many consumers and firms, each making decisions at the micro level, macroeconomic behavior is the sum of many microeconomic decisions. It is not immediately obvious, however, that the best way to construct a macroeconomic model is to work our way up from decision making at the microeconomic level. In physics, for example, there is often no loss in ignoring micro behavior. If I throw a brick from the top of a five-story building, and if I know the force that I exert on the brick and the force of gravity on the brick, then Newtonian physics does a very accurate job of predicting when and where the brick lands. However, Newtonian physics ignores micro behavior, which in this case is the behavior of the molecules in the brick. Why is it that there may be no loss in ignoring the behavior of molecules in a brick, but that ignoring the microeconomic behavior of consumers and firms when doing macroeconomics could be devastating? Throwing a brick from a building does not affect the behavior of the molecules within the brick in any way that would significantly change the trajectory of the brick. Changes in government policy, however, generally alter the behavior of consumers and firms in ways that significantly affect the behavior of the economy as a whole. Any change in government policy effectively alters the features of the economic environment in which consumers and firms must make their decisions. To confidently predict the effects of a policy change on aggregate behavior, we must analyze how the change in policy affects individual consumers and firms. For example, if the federal government changes the income tax rate, and we are interested in the macroeconomic effects of this policy change, the most productive approach is first to use microeconomic principles to determine how a change in the tax rate affects an individual consumer’s labor supply and consumption decisions, based on optimizing behavior. Then, we can aggregate these decisions to arrive at a conclusion that is consistent with how the individuals in the economy behave. 31 32 Part I Introduction and Measurement Issues Macroeconomists were not always sympathetic to the notion that macro models should be microeconomically sound. Indeed, before the rational expectations revolution in the 1970s, which generally introduced more microeconomics into macroeconomics, most macroeconomists worked with models that did not have solid microeconomic foundations, though there were some exceptions.4 The argument that macroeconomic policy analysis can be done in a sensible way only if microeconomic behavior is taken seriously was persuasively expressed by Robert E. Lucas, Jr. in a journal article published in 1976.5 This argument is often referred to as the Lucas critique. Disagreement in Macroeconomics LO 1.5 Explain why there is disagreement among macroeconomists, and what they disagree about. There is little disagreement in macroeconomics concerning the general approach to be taken to construct models of economic growth. The Solow growth model,6 studied in Chapters 7 and 8, is a widely accepted framework for understanding the economic growth process, and endogenous growth models, which model the economic mechanism determining the rate of economic growth and are covered in Chapter 7, have been well received by most macroeconomists. This is not to say that disagreement has been absent from discussions of economic growth in macroeconomics, only that the disagreement has not generally been over basic approaches to modeling growth. The study of business cycles in macroeconomics, however, is another story. As it turns out, there is much controversy among macroeconomists concerning business cycle theory and the role of the government in smoothing business cycles over time. In Chapters 13 and 14, we study some competing theories of the business cycle. Roughly, business cycle theories can be differentiated according to whether they are Keynesian or non-Keynesian. Traditional Old Keynesian models, in the spirit of J. M. Keynes’s General Theory of Employment, Interest, and Money, published in 1936, are based on the notion that wages and prices are sticky in the short run, and do not change sufficiently quickly to yield efficient outcomes. In the Old Keynesian world, government intervention through monetary and fiscal policy can correct the inefficiencies that exist in private markets. The rational expectations revolution produced some non-Keynesian theories of the business cycle, including real business cycle theory, initiated by Edward Prescott and Finn Kydland in the early 1980s. Real business cycle theory implies that government policy aimed at smoothing business cycles is at best ineffective and at worst detrimental to the economy’s performance. 4 See M. Friedman, 1968. “The Role of Monetary Policy,” American Economic Review 58, 1–17. 5 See R. E. Lucas, 1976. “Econometric Policy Evaluation: A Critique,” Carnegie-Rochester Conference Series on Public Policy 1, 19–46. 6 See R. Solow, 1956. “A Contribution to the Theory of Economic Growth,” Quarterly Journal of Economics 70, 65–94. Introduction Chapter 1 In the 1980s and 1990s, Keynesians used the developments in macroeconomics that came out of the rational expectations revolution to integrate Keynesian economics with modern macroeconomic thought. The result was two new strands of Keynesian thought—coordination failures and New Keynesian economics. In a coordination failure model of the business cycle, the economy can be stuck in a bad equilibrium, not because of sticky wages and prices, but because economic agents are self-fulfillingly pessimistic. Alternatively, New Keynesian models include sticky wages and prices, as in traditional Old Keynesian models, but New Keynesians use the microeconomic tools that all modern macroeconomists use. In Chapters 11 through 14, we will study a host of modern business cycle models, which show how changes in monetary factors, changes in productivity, or waves of optimism and pessimism can cause business cycles, and we will show what these models tell us about the conduct of macroeconomic policy. In Chapter 13 we study a Keynesian coordination failure model, and in Chapter 14 we examine a New Keynesian sticky price model. Chapter 13 contains an examination of the real business cycle model. In this book, we seek an objective view of the competing theories of the business cycle. In Chapters 12 and 13, we study the key features of each of the above theories of the business cycle, and we evaluate the theories in terms of how their predictions match the data. What Do We Learn from Macroeconomic Analysis? LO 1.6 List the 12 key ideas that will be covered in this book. At this stage, it is useful to map out some of the basic insights that can be learned from macroeconomic analysis and which we develop in the remainder of this book. These are the following: 1. What is produced and consumed in the economy is determined jointly by the economy’s productive capacity and the preferences of consumers. In Chapters 4 and 5, we develop a one-period model of the economy, which specifies the technology for producing goods from available resources, the preferences of consumers over goods, and how optimizing consumers and firms come together in competitive markets to determine what is produced and consumed. 2. In free market economies, there are strong forces that tend to produce socially efficient economic outcomes. Social inefficiencies can arise, but for reasons that are wellunderstood. The notion that an unregulated economy peopled by selfish individuals could result in a socially efficient state of affairs is surprising, and this idea goes back at least as far as Adam Smith’s Wealth of Nations, written in the eighteenth century. In Chapter 5, we show this result in our one-period model, and we explain the circumstances under which social inefficiencies can arise in practice. 3. Unemployment is painful for individuals, but it is a necessary evil in modern economies. There will always be unemployment in a well-functioning 33 34 Part I Introduction and Measurement Issues 4. 5. 6. 7. economy. Unemployment is measured as the number of people who are not employed and are actively seeking work. Since all of these people are looking for something they do not have, unemployment might seem undesirable, but the time unemployed people spend searching for jobs is in general well spent from a social point of view. It is economically efficient for workers to be well matched with jobs, in terms of their skills, and if an individual spends a longer time searching for work, this increases the chances of a good match. However, when the average unemployed person needs to spend a longer time searching for work than seems normal, there may be a role for government intervention. In Chapter 6, we explore a modern model of search and matching that can be used to make sense of labor market data and current phenomena. Improvements in a country’s standard of living are brought about in the long run by technological progress. In Chapters 7 and 8, we study the Solow growth model (along with the Malthusian model of economic growth and an endogenous growth model), which gives us a framework for understanding the forces that account for growth. This model shows that growth in aggregate output is produced by growth in a country’s capital stock, growth in the labor force, and technological progress. In the long run, however, growth in the standard of living of the average person comes to a stop unless there are continuous technological improvements. Thus, economic well-being ultimately cannot be improved simply by constructing more machines and buildings; economic progress depends on continuing advances in knowledge. A tax cut is not a free lunch. When the government reduces taxes, this increases current incomes in the private sector, and it may seem that this implies that people are wealthier and may want to spend more. However, if the government reduces taxes and holds its spending constant, it must borrow more, and the government will have to increase taxes in the future to pay off this higher debt. Thus, future incomes in the private sector must fall. In Chapter 9, we show that there are circumstances under which a current tax cut has no effects whatsoever; the private sector is no wealthier, and there is no change in aggregate economic activity. Credit markets and banks play key roles in the macroeconomy. The advocates of some mainstream economic theories—including theories of economic growth, real business cycle theory, and New Keynesian economics—have sometimes argued that consideration of credit markets, and the underlying frictions that make credit markets and banks work imperfectly, are safely ignored. Macroeconomic events during the global financial crisis of 2008–2009 have shown that this approach is hazardous. Some standard economic tools can be used to make sense of macroeconomic financial events, and to determine the appropriate fiscal and monetary policy responses to a financial crisis. In Chapter 10, we analyze credit market imperfections and show how they matter for financial crises, and we study some of the aggregate implications of financial crises in Chapters 11–14, along with some issues related to banking in Chapter 18. What consumers and firms anticipate for the future has an important bearing on current macroeconomic events. In Chapters 9–11, we consider two-period models in Introduction Chapter 1 8. 9. 10. 11. 12. which consumers and firms make dynamic decisions; consumers save for future consumption needs, and firms invest in plant and equipment so as to produce more in the future. If consumers anticipate, for example, that their future incomes will be high, they want to save less in the present and consume more, and this has important implications for current aggregate production, employment, and interest rates. If firms anticipate that a new technological innovation will come on line in the future, this makes them more inclined to invest today in new plant and equipment, and this in turn also affects aggregate production, employment, and interest rates. Consumers and firms are forward-looking in ways that matter for current aggregate economic activity and for government policy. Money takes many forms, and society is much better off with it than without it. Once we have it, however, changing its quantity ultimately does not matter. What differentiates money from other assets is its value as a medium of exchange, and having a medium of exchange makes economic transactions much easier in developed economies. Currently in the United States, there are several assets that act as a medium of exchange, including U.S. Federal Reserve notes and transactions deposits at banks. In Chapters 12 and 18, we explore the role of money and banking in the economy. One important result in Chapter 12 is that a one-time increase in the money supply, brought about by the central bank, has no long-run effect on any real economic magnitudes in the economy; it only increases all prices in the same proportion. Business cycles are similar, but they can have many causes. In Chapter 3, we show that there are strong regularities in how aggregate macroeconomic variables fluctuate over the business cycle. In Chapters 12–14, we also study some theories that can potentially explain business cycles. The fact that there is more than one business cycle theory to choose from does not mean that only one can be right and all the others are wrong, though some may be more right than others. Potentially, all of these theories shed some light on why we have business cycles and what can be done about them. Countries gain from trading goods and assets with each other, but trade is also a source of shocks to the domestic economy. Economists tend to support the lifting of trade restrictions, as free trade allows a country to exploit its comparative advantage in production and, thus, make its citizens better off. However, the integration of world financial and goods markets implies that events in other countries can cause domestic business cycles. In Chapters 16 and 17, we explore how changes in goods prices and interest rates on world markets affect the domestic economy. In the long run, inflation is caused by growth in the money supply. Inflation, the rate of growth in the average level of prices, can vary over the short run for many reasons. Over the long run, however, the rate at which the central bank (the Federal Reserve System in the United States) causes the stock of money to grow determines what the inflation rate is. We study this process in Chapter 18. If there is a short-run trade-off between output and inflation, that has very different implications relative to the relationship between the nominal interest rate and inflation. In some countries and for some historical periods, a positive relationship appears 35 36 Part I Introduction and Measurement Issues to exist between the deviation of aggregate output from trend and the inflation rate. This relationship is called the Phillips curve, and in general the Phillips curve appears to be quite an unstable empirical relationship. Another key relationship observed in the macroeconomic data is the Fisher relation—a positive correlation between nominal interest rates and the inflation rate. So-called Neo-Fisherism takes the theory explaining that observation as a guide for monetary policy. For example, a central bank that wants to increase inflation may want to increase nominal interest rates, rather than reducing them, as Phillips curve reasoning might dictate. We discuss these issues in Chapter 15. Understanding Recent and Current Macroeconomic Events LO 1.7 List the key observations that motivate questions we will try to answer in this book. Part of the excitement of studying macroeconomics is that it can make sense of recent and currently unfolding economic events. In this section, we give an overview of some recent and current issues and how we can understand them better using macroeconomic tools. Aggregate Productivity A measure of productivity in the aggregate economy is average labor productivity, NY , where Y denotes aggregate output and N denotes employment. That is, we can measure aggregate productivity as the total quantity of output produced per worker. Aggregate productivity is important, as economic growth theory tells us that growth in aggregate productivity is what determines growth in living standards in the long run. In Figure 1.5, we plot the log of average labor productivity for the United States, measured as the log of real gross domestic product per worker. Here, we show the log of average labor productivity (the blue line), because then the slope of the graph denotes the growth rate in average labor productivity. The key features of Figure 1.5 are that average labor productivity grew at a high rate during the 1950s and most of the 1960s, growth slowed down from the late 1960s until the early 1980s, and then productivity growth increased beginning in the mid-1980s and remained high through the 1990s and into the twentyfirst century. Recently, from 2000 to 2015, we appear to have entered another period of low productivity growth, as can be observed in Figure 1.5. Why has productivity growth declined in the period after the global financial crisis? Is this because all the great elements of technological progress—electrification, running water, antibiotics, and information technology—are well behind us? Is this some lingering effect of the financial crisis, and only temporary? We explore these issues further in Chapters 7 and 8. Unemployment and Vacancies As explained previously, the phenomenon of unemployment need not represent a problem, since unemployment is in general a socially useful search activity that is necessary, though sometimes painful to the individuals involved. As macroeconomists, we are interested in what explains the level of unemployment and what the reasons are for 37 Introduction Chapter 1 Figure 1.5 Natural Logarithm of Average Labor Productivity Average labor productivity is the quantity of aggregate output produced per worker. Because the graph is of the log of average labor productivity (the blue line), the slope of the graph is approximately the growth rate in average labor productivity. Productivity growth was high in the 1950s and 1960s, and low from 1970–1980 and from 2010–2015. −2 Natural Log of Labor Productivity −2.2 −2.4 −2.6 −2.8 −3 −3.2 −3.4 1940 1950 1960 1970 1980 Year 1990 2000 2010 fluctuations in unemployment over time. If we can understand these features, we can go on to determine how macroeconomic policy can be formulated so that labor markets work as efficiently as possible. In Chapter 6, we introduce two models of search and unemployment, the second of which is based on the work of Nobel Prize winners Peter Diamond, Dale Mortensen, and Christopher Pissarides. These models allow us to explain the determinants of labor force participation, the unemployment rate, the vacancy rate (the fraction of firms searching for workers to hire), and market wages. Some of the features of labor market data that we would like to explain are in Figures 1.6 and 1.7. Figure 1.6 shows the unemployment rate—the percentage of people in the labor force who are actively searching for work—for the United States, over the period 1948–2015. In the second search model of unemployment studied in Chapter 6, unemployment is explained by the search behavior of firms and workers, 2020 38 Part I Introduction and Measurement Issues Figure 1.6 The Unemployment Rate for the United States The unemployment rate is determined by productivity, the generosity of government-provided unemployment insurance, and matching efficiency, among other factors. As the figure shows, the unemployment rate fluctuates significantly. 11 10 Unemployment Rate in Percent 9 8 7 6 5 4 3 2 1940 1950 1960 1970 1980 1990 2000 2010 2020 Year and by how efficiently searching workers and firms are matched. In general, the unemployment rate will be affected by productivity, the generosity of government-provided unemployment insurance, and matching efficiency. All of these factors come into play in explaining both the long-term trends and the fluctuations in the unemployment rate in Figure 1.6. An interesting feature of the recent labor market data is in Figure 1.7, which is a scatter plot of the vacancy rate (job openings as a percentage of job openings plus total employment) versus the unemployment rate for the period 2000–2015. The dots in the figure represent observations up to the end of 2007 (the beginning of the most recent recession), while the line tracks observations from January 2008 to November 2015. A downward sloping curve—called a Beveridge curve—would fit closely the observations from 2000 to 2007, but the last observations—beginning in mid-2009— fall well north of this Beveridge curve. Thus, given the vacancy rates that were observed 39 Introduction Chapter 1 Figure 1.7 The Beveridge Curve The points in the figure denote observations for the period 2000–2007, while the line connects observations from January 2008 to November 2015. The observations from 2000 to 2007 are fit well by an apparently stable downward-sloping Beveridge curve. However, the Beveridge curve appears to have shifted over the period January 2008 to November 2015. 4 November 2015 Vacancy Rate in Percent 3.5 3 January 2008 2.5 2 1.5 3 4 5 6 7 8 Unemployment Rate in Percent 9 from mid-2009 to November 2015, the unemployment rate would typically have been much lower pre-2008. Our search model of unemployment in Chapter 6 suggests that this shifting of the Beveridge curve could be due to mismatch in the labor market. This mismatch could result from differences between the skills that firms want and what would-be workers possess, or because job vacancies are not in the same geographical regions where the unemployed reside. Taxes, Government Spending, and the Government Deficit In Figure 1.8 we show total tax revenues (the black line) and government spending (the colored line) by all levels of government (federal, state, and local) in the United States from 1947 to 2015, as percentages of total GDP. Note the broad upward trend in both taxes and spending. Total taxes were almost 22% of GDP in 1947, and they increased to about 29% of GDP in 2015, while total spending rose from about 23% of 10 40 Part I Introduction and Measurement Issues Figure 1.8 Total Taxes and Total Government Spending An increase in the size of government is reflected in trend increases in both spending and taxes, though spending has outpaced taxes as a fraction of GDP since 2000. 38 36 Spending 34 Percentage of GDP 32 30 28 26 Taxes 24 22 20 18 1940 1950 1960 1970 1980 Year 1990 2000 2010 2020 GDP in 1947 to a high of about 33% of GDP in 2015. These trends generally reflect an increase in the size of government in the United States relative to the aggregate economy over this period, though spending has clearly outpaced taxes since 2000. What ramifications does a larger government have for the economy as a whole? How does higher government spending and taxation affect private economic activity? We show in Chapters 5 and 11 that increased government activity in general causes a crowding out of private economic activity. That is, the government competes for resources with the rest of the economy. If the size of the government increases, then through several economic mechanisms there is a reduction in the quantity of spending by private firms on new plant and equipment, and there is a reduction in private consumption expenditures. An interesting feature of Figure 1.8 is that governments in the United States sometimes spent more than they received in the form of taxes, and sometimes the reverse was true. Just as is the case for private consumers, the government can in principle 41 Introduction Chapter 1 Figure 1.9 The Total Government Surplus in the United States as a Percentage of GDP The government surplus declines on trend until the early 1990s, increases, and then decreases again in 2000 before increasing somewhat and then decreasing precipitously in the 2008–2009 recession. Except for a brief period in the late 1990s, the government surplus has been negative since the 1960s. 6 4 2 Percentage of GDP 0 −2 −4 −6 −8 −10 −12 1940 1950 1960 1970 1980 Year 1990 2000 2010 spend more than it earns by borrowing and accumulating debt, and it can earn more than it spends and save the difference, thus reducing its debt. Figure 1.9 shows the total government surplus or total government saving, which is the difference between taxes and spending, for the period 1947–2015. From Figure 1.9, the government surplus was positive for most of the period from 1948 until 1970, but from 1970 until the late 1990s the surplus was usually negative. When there is a negative government surplus, we say that the government is running a deficit; the government deficit is the negative of the government surplus. The largest government deficits over this period were in 1975, when the deficit exceeded 8% of GDP, and in late 2010, when it reached 11% of GDP. There was only a brief period after the late 1970s when governments in the United States ran a surplus; in 1999, the government surplus reached about 2% of GDP. However, the surplus declined dramatically after 1999, reaching -4, of GDP in 2003 before increasing again and then dropping precipitously in the 2008–2009 recession. 2020 42 Part I Introduction and Measurement Issues What are the consequences of government deficits? We might think, in line with popular conceptions of household finance, that accumulating debt (running a deficit) is bad, whereas reducing debt (running a surplus) is good, but at the aggregate level the issue is not so simple. One principal difference between an individual and the government is that, when the government accumulates debt by borrowing from its citizens, then this is debt that we as a nation owe to ourselves. Then, it turns out that the effects of a government deficit depend on what the source of the deficit is. Is the government running a deficit because taxes have decreased or because government spending has increased? If the deficit is the result of a decrease in taxes, then the government debt that is issued to finance the deficit will have to be paid off ultimately by higher future taxes. Thus, running a deficit in this case implies that there is a redistribution of the tax burden from one group to another; one group has its current taxes reduced while another has its future taxes increased. Under some circumstances, these two groups might essentially be the same, in which case there would be no consequences of having the government run a deficit. This idea, that government deficits do not matter under some conditions, is called the Ricardian equivalence theorem, and we study it in Chapter 9. In the case of a government deficit resulting from higher government spending, there are always implications for aggregate economic activity, as discussed earlier in terms of the crowding out of private spending. We examine the effects of government spending in Chapters 5 and 11. Inflation Inflation, as mentioned earlier, is the rate of change in the average level of prices. The average level of prices is referred to as the price level. In Figure 1.10 we show the inflation rate, the black line in the figure, as the percentage rate of increase in the consumer price index over the period 1948–2015. The inflation rate was high in the late 1940s and during the Korean War, but was quite low in the early 1960s and then began climbing in the late 1960s, reaching peaks of about 12% per year in 1975 and about 14% per year in 1980. The inflation rate then declined steadily, falling into the negative range in early 2009, increasing, and then declining to close to zero in 2015. High inflation is economically costly, and the high inflation experienced during the 1970s was seen as a problem for monetary policy in the United States. At the time, monetary policymakers felt that growth in the money supply had been driving this high rate of inflation, and they successfully reduced money growth and inflation during the 1980s. The period from the 1980s until the Great Recession began in late 2007 was one of low inflation. However, in the period after the Great Recession ended in 2009, inflation fell, to the point where the inflation rate was consistently below the Fed’s 2% inflation target over the period 2013–2015. Now, a problem in the United States, and in other countries of the world, is that inflation is viewed by monetary policymakers as being too low—a situation that was perhaps unimaginable in the 1970s. Recently, central banks have failed in their attempts to increase inflation, through various unconventional means. This has caused macroeconomists to rethink theories of inflation, and to introduce newer, alternative theories that can better fit the data and be more useful for economic policy. We discuss these issues in depth in Chapters 12 and 15. 43 Introduction Chapter 1 Figure 1.10 The Inflation Rate Inflation increased on trend until the 1970s, and was reduced dramatically in the 1980s. From 2013–2015, inflation may be too low. 16 14 12 Inflation Rate in Percent 10 8 6 4 2 0 −2 −4 1940 1950 1960 1970 1980 1990 2000 2010 Year Interest Rates Interest rates are important, as they affect many private economic decisions, particularly the decisions of consumers as to how much they borrow and lend, and the decisions of firms concerning how much to invest in new plant and equipment. Further, movements in interest rates are an important element in the economic mechanism by which monetary policy affects real magnitudes in the short run. In Figure 1.11 we show the behavior of the short-term nominal interest rate (the blue line) in the United States over the period 1947–2015. This is the interest rate in money terms on 91-day U.S. Treasury bills, which are essentially riskless short-term government securities. The short-term nominal interest rate rose on trend through the 1950s, 1960s, and 1970s, reaching a high of more than 15% early in 1980. Since then, the nominal interest rate has declined on trend, and it has been close to 0% since late 2008. 2020 44 Part I Introduction and Measurement Issues Figure 1.11 The Nominal Interest Rate and the Inflation Rate Macroeconomic theory tells us that the nominal interest rate and the inflation rate are positively related. In the figure, the nominal interest rate tends to track the ups and downs in the inflation rate. 20 15 Interest Rate Percent 10 5 Inflation Rate 0 −5 1940 1950 1960 1970 1980 Year 1990 2000 2010 2020 What explains the level of the nominal interest rate? In the figure we have plotted the inflation rate as the black line, which is measured here by the rate of increase in the consumer price index. The inflation rate tracks the nominal interest rate reasonably closely. Also, several of the peaks in inflation, around 1970, in the mid-1970s, around 1980, around 1990, and in 2001, are coupled with peaks in the nominal interest rate. Thus, the nominal interest rate tends to rise and fall with the inflation rate. Why is this? Economic decisions are based on real rather than nominal interest rates. The real interest rate, roughly speaking, is the nominal interest rate minus the expected rate of inflation. That is, the real interest rate is the rate that a borrower expects to have to repay, adjusting for the inflation that is expected to occur over the period of time until the borrower’s debt is repaid. If Allen obtains a one-year car loan at an interest rate of 9%, and he expects the inflation rate to be 3% over the next year, then he faces a real interest rate on the car loan of 6%. Because economic decisions are based on real interest rates rather than nominal interest rates, market forces tend to determine the real 45 Introduction Chapter 1 Figure 1.12 Real Interest Rate The figure shows a measure of the real interest rate, which here is the short-term nominal interest rate minus the actual rate of inflation. Monetary policy can have a short-run effect on the real interest rate; for example, the low real interest rates during the 1990–1991, 2001, and 2008–2009 recessions can be attributed to monetary policy actions. 8 6 4 Percent 2 0 −2 −4 −6 −8 −10 1940 1950 1960 1970 1980 Year 1990 2000 2010 interest rate. Therefore, as the inflation rate rises, the nominal interest rate tends to rise along with it. In Chapters 9–12, we study the determination of real and nominal interest rates, and the relationship between real and nominal rates. But in Figure 1.11, we can also think of the positive correlation between the nominal interest rate and the inflation rate arising because high (low) nominal interest rates are causing high (low) inflation. Over the medium to long run, the Fisher effect is an important force determining how monetary policy affects inflation. Indeed, in neoFisherian theory, a central bank that conducts monetary policy by targeting the nominal interest rate may come to the conclusion that the best way to increase inflation is to increase its nominal interest rate target. In Figure 1.12 we plot an estimate of the real interest rate, which is the nominal interest rate minus the actual rate of inflation. Thus, this would be the actual real interest rate if consumers and firms could correctly anticipate inflation, so that actual 2020 46 Part I Introduction and Measurement Issues inflation is equal to expected inflation. Consumers and firms cannot correctly anticipate the actual inflation rate. However, given that inflation does not change too much from quarter to quarter, our estimate of the real interest rate has a reasonably small measurement error. The real interest rate fluctuates a great deal over time, and has sometimes been negative, having fallen to about -9% in the late 1940s, to -8% in the early 1950s, and to -7% in 1980. The real rate has been negative for most of the time since the beginning of the financial crisis in late 2008. The period in the mid-1980s was one of particularly high real interest rates. In the short run, the real interest rate is affected by monetary policy, though there is some disagreement among macroeconomists concerning why the central bank can control the real interest rate, and for how long it can do so. We can give the following interpretation to the path of the real interest rate from the mid-1970s to 2015 in Figure 1.12. First, the real interest rate was low in the mid to late 1970s because the Federal Reserve (the Fed) was causing the money supply to grow at a high rate; that is, monetary policy was expansionary and accommodating. As a result of the high inflation caused by this high money growth, the Fed embarked on a contractionary course in the early 1980s, reducing money supply growth and causing the real interest rate to rise. After the mid-1980s, the Fed remained seriously concerned about the possibility that high inflation could reemerge, and thus caused the real interest rate to be historically high. During the business cycle downturn in the early 1990s, the Fed temporarily relaxed, causing the real interest rate to dip to close to 0%. Then, in 2001, the Fed acted to reduce the real interest rate again, in response to a slowdown in aggregate economic activity. As there appeared to be no threat of serious inflation and economic activity had not picked up significantly, the real interest rate continued to fall through late 2003. Then, when the economy was growing at a high rate, and there was a greater threat from inflation, the real interest rate increased, through 2006. In 2008, the Fed aggressively reduced the real interest rate in response to the financial crisis and the developing recession. In Chapters 12–14, we study some theories of the business cycle that explain how the central bank can influence the real interest rate in the short run. While the rate of money growth may affect real interest rates in the long run, monetary policy is aimed not at setting the long-run real interest rate but at determining long-run inflation while staying in tune with the short-run effects of monetary policy. Business Cycles in the United States As was mentioned above, individual business cycle events may have many causes, and the causes that are important in one business cycle event may be very unimportant in others. For example, a particular recession might be attributed to monetary policy actions, while another recession may have been caused primarily by a downturn in aggregate productivity. As above, we define business cycles to be the deviations from trend in aggregate economic activity. In Figure 1.13, we show the percentage deviations from trend in real GDP for the period 1947–2015. Recessions in the figure are negative deviations from trend, and the significant recent recessions in the United States were those of 1974– 1975, 1981–1982, 1990–1991, 2001, and 2008–2009. What were the causes of these recessions? 47 Introduction Chapter 1 Figure 1.13 Percentage Deviation from Trend in Real GDP, 1947–2015 The key recessions occurring since 19

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