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Macroeconomics as a Second Language Macroeconomics as a Second Language Martha L Olney University of California, Berkeley John Wiley & Sons, Inc VP & PUBLISHER ACQUISITIONS EDITOR PROJECT EDITOR SENIOR EDITORIAL ASSISTANT ASSOCIATE DIRECTOR OF MARKETING ASSISTANT MARKETING MANAGER PRODUCTION MANAGER ASSISTANT PRODUCTION EDITOR CREATIVE DIRECTOR SENIOR DESIGNER COVER DESIGNER George Hoffman Lacey Vitetta Jennifer Manias Emily McGee Amy Scholz Diane Mars Janis Soo Elaine S Chew Harry Nolan Kevin Murphy RDC Publishing Group Sdn Bhd This book was set in 10/12 Times by Laserwords Private Limited, Chennai, India and printed and bound by Courier Westford The cover was printed by Courier Westford Founded in 1807, John Wiley & Sons, Inc has been a valued source of knowledge and understanding for more than 200 years, helping people around the world meet their needs and fulfill their aspirations Our company is built on a foundation of principles that include responsibility to the communities we serve and where we live and work In 2008, we launched a Corporate Citizenship Initiative, a global effort to address the environmental, social, economic, and ethical challenges we face in our business Among the issues we are addressing are carbon impact, paper specifications and procurement, ethical conduct within our business and among our vendors, and community and charitable support For more information, please visit our website: http://www.wiley.com/go/citizenship Copyright © 2011 John Wiley & Sons, Inc All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978)750-8400, fax 978-646-8600 or on the web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, (201)748-6011, fax (201)748-6008, or online at http://www.wiley.com/go/permissions Evaluation copies are provided to qualified academics and professionals for review purposes only, for use in their courses during the next academic year These copies are licensed and may not be sold or transferred to a third party Upon completion of the review period, please return the evaluation copy to Wiley Return instructions and a free of charge return mailing label are available at www.wiley.com/go/returnlabel If you have chosen to adopt this textbook for use in your course, please accept this book as your complimentary desk copy Outside of the United States, please contact your local sales representative To order books or for customer service please, call 1-800-CALL WILEY (225-5945) Library of Congress Cataloging-in-Publication Data Olney, Martha L., 1956- author Macroeconomics as a Second Language / Martha L Olney p cm Includes index ISBN 978-0-470-50538-0 (pbk.) Macroeconomics Macroeconomics—Terminology I Title HB172.5.O46 2010 339—dc22 2010047243 Printed in the United States of America 10 To my students This one’s for you! About the Author Martha L Olney is an award-winning teacher of economics and the author of several economics textbooks She is the recipient of Distinguished Teaching Awards from the University of California at Berkeley and the University of Massachusetts, Amherst; the Jonathan Hughes Prize for Excellence in Teaching Economic History from the Economic History Association; and was recognized in 2007 by the Stavros Center for Free Enterprise and Economics Education of Florida State University as one of the nation’s Great Teachers of Economics Her previous textbooks include Microeconomics as a Second Language (Wiley, 2009), Macroeconomics, co-authored with Brad DeLong (McGraw-Hill, 2006), and Essentials of Economics, co-authored with Paul Krugman and Robin Wells (Worth, 2007) She currently serves as Adjunct Professor of Economics at the University of California, Berkeley Her open-access website includes course materials for Principles of Economics and other courses: http://www.econ.berkeley.edu/∼olney vi Preface Economics is all around us all the time Much of it is quite intuitive But you’d never know it if by some cruel turn of fate you were dropped into the middle of an “Intro to Econ” lecture at your local college or university That’s because the intuition gets lost in the language With apologies to Through the Looking Glass author Lewis Carroll, whom I paraphrase: Economists use words to mean exactly what we want them to mean Words like “rational” have a perfectly fine dictionary meaning Economists use “rational” in a different way, to mean “behavior that is consistent with trying to maximize something.” Or, what about “market”? You might think that means a store, a place you go to buy something Not to an economist The “market for tomatoes” doesn’t exist at your local farmer’s market, or grocery store A “market” is an idea, an abstraction, a collection of all the behavior and potential behavior of those who want to buy and those who want to sell something The key to “getting” economics is to view it as a second language You need to become conversant in econ-speak just as you would in French or Japanese or any other new-to-you language The ideas of economics are intuitive The expression of economics is a second language ABOUT THIS BOOK Macroeconomics as a Second Language “cuts to the chase.” It zeroes in on the concepts, assumptions, and models that you need to learn This book is a student study aid in the Principles of Macroeconomics We take a bare-bones approach here Our focus is the principles of macroeconomics and the language used to express them What if you’re not currently enrolled in a macroeconomics course? This book is a good aid for you, too Trying to pick up some economics concepts and language? This book will help you out Trying to follow the news about the economy? This book is for you Rather than wade through a 700–900 page principles textbook, Macroeconomics as a Second Language gives you the basics to get you up to speed quickly ORGANIZATION Macroeconomics is a story, a rather long story at that Think of it as a novel, with characters introduced in the early chapters, the action unveiled in the middle chapters, and the characters’ experiences placed into a context in the final chapters Reading just the first chapter won’t give you a sense of the story Jumping in at the middle creates confusion about who is who Reading only the last chapter leaves you baffled as to how it all fit together vii viii Preface For those who have studied microeconomics, the study of macroeconomics can be a bit of a jolt Economists agree on what is to be taught in micro In microeconomics, there is one story and one basic approach: start from supply and demand, then examine the various sources of market failure Macroeconomics enjoys little of that agreement Pick up six textbooks at random and you’ll probably find four—or more—different approaches to macroeconomics Terminology accounts for some of the difference But that’s not all What order should the material be presented in? What topics should be included—and omitted? What relationships should be emphasized? While the companion volume Microeconomics as a Second Language can help you out in nearly any microeconomics class taught in any classroom, the same promise can’t be made for this book In Macroeconomics as a Second Language, I chose to present the material in the order and with the emphasis that makes sense to the thousands of students I have taught Part I contains the basics An overview of macroeconomics is provided in Chapter Economics principles are often expressed with equations and graphs, so Chapter also presents the math and graphing tools you need We dive into economics in Chapter with the model of the Production Possibilities Frontier (PPF), which is about the choices we make in deciding what goods and services will be produced Demand and Supply is the most often used model in economics; Chapter helps you master it How we measure the macroeconomy—output, unemployment, and inflation—is covered in Chapter Macroeconomics is the study of long-run growth and short-run fluctuations Long-run growth—how does the standard of living change from generation to generation—is addressed in Chapter The remainder of the book focuses on short-run fluctuations: Why an economy’s unemployment and inflation rates change from year to year? Keynesian principles (Part III) are the basics of most macroeconomic analysis, even by people who assert “I’m not a Keynesian.” Those principles are: • The amount of output that firms produce depends upon the total (or, aggregate) demand for goods and services (Chapter 6) • Total (or, aggregate) demand is the sum of consumption, investment, government, and net export spending (Chapter 7) • Because consumption depends on income, any initial change in aggregate demand has a multiplied effect on total output (Chapter 8) Policy is studied in Part IV, starting with an overview of fiscal and monetary policy in Chapter Fiscal policy, government deficits and debt are covered in Chapter 10 Monetary policy takes up the next three chapters Money is not created by a government printing press; money is created by banks making loans (Chapter 11) The central bank—in the United States, the Fed—can change the amount of money in the economy, but must choose between pursuing a money supply target and an interest rate target (Chapter 12) Monetary policy changes interest rates, which affect aggregate demand (Chapter 13) 322 Answers to “TRY” Questions literally use the Taylor Rule to make their decisions, but their complex deliberations are captured reasonably well by that one equation 14 .a Inflation rate goal = 2%; GDP growth rate goal = 3% b i interest rate target = 0.04 + 1/2(0) + 1/4(0) = 4% ii interest rate target = 0.04 + 1/2(0.04) + 1/4(0) = 6% iii interest rate target = 0.04 + 1/2(0) + 1/4(0.03) = 3.25% 15 An inflation hawk is very aggressive in fighting inflation, even though the cost is higher unemployment An inflation dove fights inflation, but not as aggressively, because of the unemployment costs The Taylor Rule in question 14 probably characterizes an FOMC dominated by hawks 16 Decreased aggregate demand: Fed will decrease interest rates to fight the recession 17 a Taylor Rule 1: interest rate target = 7% Taylor Rule 2: interest rate target = 1% b Inflation hawks: Taylor Rule Inflation doves: Taylor Rule c The mix of inflation hawks and doves on the Fed matters when the economy is experiencing both rising inflation and falling output (stagflation) and the FOMC has to decide which problem to fight more aggressively Free trade refers to trade unencumbered by trade promotion or trade restriction policies Trade is opposed because the costs of specializing are not borne evenly, because infant industries sometimes cannot compete, and because of national security concerns, as well as for other reasons Embargo: total ban on trade with a specific country Quota: numerical limit to imports of particular product from specific country Tariff: tax placed on imported products .a 2005 U.S merchandise trade balance with China = 41.1−243.9 = −$202.8 billion Merchandise trade deficit: United States Merchandise trade surplus: China b 2005 U.S balance of trade in goods and services with China = (41.1 + 9.0) − (243.9 + 6.7) = −$200.5 billion Deficit in trade of goods and services: United States Surplus in trade of goods and services: China c 2005 U.S balance on current account with China = (41.1 + 9.0 + 4.9)−(243.9 + 6.7 + 21.4 + 2.2) =−$219.2 billion Current account deficit: United States Current account surplus: China 2005 U.S balance on financial account with China = 224.7 − 5.4 = $219.3 billion Financial account surplus: United States Financial account deficit: China 18 When the target predicted by the Taylor Rule is negative, the target for the federal funds rate will be at the zero lower bound When the U.S financial account is in deficit, U.S people, businesses, and government agencies are borrowing less from foreigners than they are lending CHAPTER 16: OPEN ECONOMY MACROECONOMICS The “gains from trade” are the increases in total worldwide output due to specialization and trade There was a U.S current account deficit and U.S financial account surplus U.S overall balance of payments = −748.7 + (1295.2−532.6) = +$13.9 billion, a balance of Answers to “TRY” Questions payments surplus U.S reserve accounts of foreign currency decreased The U.S financial account was in deficit from 1890 until 1970, and in surplus since 1975 10 .a A U.S recession: supply of foreign currency, no effect; demand for foreign currency, decrease; dollar price of foreign currency, decrease The dollar rises b Economic boom in China: supply of foreign currency, increase; demand for foreign currency, no effect; dollar price of foreign currency, decrease The dollar rises c U.S interest rates decrease: supply of foreign currency, decrease; demand for foreign currency, increase; dollar price of foreign currency, increase The dollar falls d Interest rates decrease in all countries: supply of foreign currency, no effect; demand for foreign currency, no effect; dollar price of foreign currency, no effect The dollar does not change e Interest rates rise in Europe and Asia, but not in the United States: supply of foreign currency, decrease; demand for foreign currency, increase; dollar price of foreign currency, increase The dollar falls 11 .a When the U.S economy enters a recession, U.S demand for foreign currency will decrease If the other country does not maintain the peg, the U.S dollar price of its currency will fall The dollar rises b If the other country does not maintain the peg, U.S imports from the country will first fall (because of the drop in income) and then recover somewhat (because of the rise of the dollar) U.S exports to that country will fall (because of the rise of the dollar) 323 c If the other country does maintain the peg, its government must buy its own currency and sell dollars in order to maintain the peg The demand curve returns to its original position d The U.S recession has a larger effect on U.S imports when the other country does maintain the peg There is no rise of the dollar that offsets the initial recession-driven drop in imports into the United States The U.S recession has a larger effect on U.S exports when the other country does not maintain the peg; with the peg, there’s no change in U.S exports e Maintaining the peg hurts the other country’s GDP when the U.S economy enters a recession Their imports fall more than would be the case if the currency was allowed to float 12 Monetary policy has a larger initial effect on planned aggregate expenditure in an open economy, because net exports also respond to interest rates 13 Compare two economies Economy O is an open economy Economy C is a closed economy a Economy C has a larger spending multiplier, so it has the greater change in GDP following a drop in investment spending b This is ambiguous Economy C has a larger spending multiplier, so the effect of an initial change in spending is greater in Economy C than in Economy O But Economy O has a larger initial change in spending, because both investment and net export spending change in response to expansionary monetary policy c Economy C has the greater change in GDP after expansionary fiscal policy, because it has a larger spending multiplier (The answer assumes that interest rates are held constant.) Index A Absolute advantage, 29 Absolute value, 7–8 Accommodation of fiscal policy, 180 Aggregate demand (AD), 91, 106–133, 239–246 AD curve, 242–246 foreign trade effect, 241–242 interest rate effect, 239–240 interest rates and, 267–268 output and, 92–94 planned AE, 239 prices and AE, 239 wealth effect, 240–241 Aggregate expenditure, 91 Aggregate production function, 74–78 capital-labor ratio, 76 diminishing marginal returns, 76–77 economies of scale, 77–78 Aggregate spending, 90–91 Aggregate supply (AS), 238, 246–256, See also AS/AD approach AS curve, shifts of, 254–256 cost shock, 254 supply shock, 254 from GDP to P, 252–253 long-run aggregate supply curve, 247–248 from P to GDP, 250–251 potential output, 248 short-run aggregate supply curve, 248–250 supply side, 246 American Recovery and Reinvestment Act (ARRA), 167 AS/AD approach, 237–262, See also Aggregate demand (AD); Aggregate supply (AS) AS/AD equilibrium, 256–258 cost-push inflation, 257 demand-pull inflation, 257 dynamic AS/AD model, 258–262 macroeconomic equilibrium changes, 256–258 static AS/AD model, 259 Assets, 114, 184 Austerity plan, 182 Automatic stabilizers, 174–175 Availability of credit, 116 Average price level, 239 Average propensity to consume, 121–123 to save, 121–123 B Balance of payments, 288–293 deficit, 292 surplus, 292 Balance on current account, 289–290 Balance on financial account, 290–291 financial inflows, 291 financial outflows, 291 overall balance, 291–293 Balanced budget, 176 Banks, 188–193 banking system, 189 clearinghouse, 189 excess reserves, 192 federal funds rate, 192 fractional reserve system, 191 required reserve ratio, 192 required reserves, 191 reserve balance at the Fed, 189 total deposits, 188 total reserves, 190–193 vault cash, 191 325 326 Index Barriers to trade, 288 Beige book, 276 Budget balance, 175 Budget surplus, 176 C Capital productivity, 79 Capital stock, 80 Capital-labor ratio, 76 Cash, 185 Central bank, 162 Check clearing, 188–193 Circular flow, 94–96 Civilian labor force, 60 Clearinghouse, 189 Closed economy multiplier, 153 Coins, 185 Commodity money, 185 Comparative advantage, 29–31 Complementary goods, 38–39 Complements in production, 44 Concave to the origin, 17 Constant returns to scale, 77 Construction, 109 Consumer expectations, 116 Consumer Price Index (CPI), 65 Consumption spending, 108, 113–127, 230 consumption function, 117–120 determinants, 113–117 shifts of consumption function, 124–127 Contractionary fiscal policy, 163–164 Convex to the origin, 18 Corporate bond rates, 223 Corporate prime rate, 223 Cost shock, 254 Cost-push inflation, 257 Costs of inputs, 43 Counterfactual, 167 Credibility, 233 Credit card rates, 223 Crowding out, 180 Currency, 185 Current account, 289–290 Cyclical unemployment, 63 Cyclically-adjusted government budget deficit, 177 D Debt, 175–177 Deficit, 175–177 Deflation, 65, 67 Demand, 37–40 curve, 37 individual demand, 37 market, 36–37 move along demand curve, 38 prices of other products, 38–39 quantity demanded, 37 schedule, 37 shift, 38 substitute goods, 39 and supply, 35–48 model of, 36 wealth, 40 Demand for money, 203–207 increase in, consequences, 218 nominal money demand (MD), 206 non-money assets, 203 price of money, 206 real money demand (MD/P), 206 speculation motive, 205 transactions motive, 204 wealth portfolio, 203 Dependent variables, Depreciation rate, 80 Depression, 59 Diminishing marginal returns, 76–77 Direct fiscal policy, 161 Directly related variable, 14 Discount bond, 216 Discount rate, 193, 214, 223 Discount window, 193 Discouraged worker, 61 Discretion, 232–233 Discretionary fiscal policy, 174–175 Index Diseconomies of scale, 78 Disposable income, 105, 113–114, 123–124 Durable goods, 52 Dynamic AS/AD model, 258–262 E Easy money, 163 Economic growth, 27–28 Economic models, 6–7 Economics tools, 3–20 as a social science, 5–6 Economies of scale, 77–78 Efficient combination of output, 27 Embargo, 288 Empirical evidence, Employment, 51, 60, 90 civilian labor force, 60 output and, 90–91 Equation of exchange, 230 Equilibrium in model of demand and supply, 44–45 changes of, 45–48 shift of demand, 45–47 shift of supply, 47–48 equilibrium price, 36 equilibrium quantity, 36 market, 44 Equilibrium amount of money, 203 Equilibrium interest rate, 208 Equilibrium money stock, 208 European Central Bank, 163 Excess reserves, 192 Exchange rates, 131, 293–299 between Dollars and Euros, 295 managed or dirty float exchange rate, 297 peg, 297 regimes, 297 fixed exchange rates, 297 floating exchange rates, 297 Expansionary fiscal policy, 163–164 Expectations of future, 116–117 327 Expected rate of return on capital, 127–128 Expenditure, 51 Export spending, 110–111 net export spending determinants, 131–133 Export subsidy, 287 External finance, 128 F Fed changing money supply, 212–213 changing discount rate, 214 changing required reserve ratio, 213 choice between money and interest rates, 216–219 Fed credibility, 233 Fed watchers, 221 Federal funds rate, 166, 192, 223–224, 266–267 Federal Open Market Committee (FOMC), 221 Federal Open Market Operations (FOMO), 212, 214–215 and interest rates, 215–216 Federal Reserve Note, 185 Federal Reserve System, 163 Fiat money, 185 Financial account balance on, 289 surplus, 291 Financial crisis, 165 Financial inflows, 291 Financial institutions, 188, See also Banks productivity and, 82 Financial outflows, 291 Fiscal policy, 161–163, 169–182 automatic stabilizers, 174–175 contractionary, 163–164 debt, 175–177 deficit, 175–177 direct, 161 discretionary fiscal policy, 174–175 economic effect, 181 328 Index Fiscal policy, (continued ) expansionary, 163–164 government spending (G), 161, 170–173 in Great Recession of 2007–2009, 165–168 indirect, 161 limit to borrowing, 181–182 structural deficit, 177 tax multipliers, 170–173 taxes (TA), 161 transfer payments (TR), 161 transfer payments multiplier, 171 Fiscal year, 176 Fixed exchange rates, 297 Fixed investment, 108 Floating exchange rates, 297 Flow variable, 115 Foreign exchange rates, 293–299 Foreign trade effect, 241–242 Fractional reserve system, 191 Free trade, 287 Frictional unemployment, 63 Full employment, 63–64 output, 158–160 Functional notation, G Gains from trade, 29–34 absolute advantage, 29 theory of comparative advantage, 29 GDP deflator, 66 GDP price index, 66 General Agreement on Tariffs and Trades (GATT), 288 General Theory of Employment, Interest, and Money, The, 51 Government borrowing, concerns expressed about, 179–180 Government debt, 176 Government deficit, financing, 177–182 Government securities, See Treasuries Government spending, 109, 161, 170–173 budget balance, 175 defined, 109 determinants of, 130–131 outlays, 175 receipts, 175 Graphing tools, 10–20 basics, 10–11 concave to the origin, 17 convex to the origin, 18 curves, 12–13 horizontal axis, 10 nonlinear curve, 16–19 plotting data, 11–12 quadrants, 10–11 reading graphs, 13 slope, 13–14 straight line, 15 truncated axes, 12 two-dimensional graph, 10 vertical axis, 10 Great Recession of 2007–2009 fiscal and monetary policy in, 165–168 monetary policy during, 234 Gross domestic product (GDP), 52 real versus nominal GDP, 54–55 Gross national product, (GNP), 54 Growth, economic, 72–74, See also Long-run economic growth growth rate of economy, 73 measuring, 57–59, 73–74 omissions in, 74 production possibilities frontier (PPF), 72 Growth accounting, 78 Growth recession, 59 H High-employment government budget deficit, 177 Home equity rates, 223 Index Home mortgage rates, 223 Horizontal axis, graph, 10 Human capital, 82 Hyperinflation, 65 I Implementation lag, 164 Import spending, 110–111 Imports, 148–153 Income, 39–40, 51, 123–124 disposable, 123–124 Independent variables, Indirect fiscal policy, 161 Individual demand, 37 Individual supply, 40 Inefficient combinations of output, 27 Infant industries, 287 Inferior good, 40 Inflation, 65–68 Consumer Price Index (CPI), 65 deflation, 65 GDP deflator, 66 GDP price index, 66 hyperinflation, 65 and money, 230–231 pattern of, 67–68 rate of change of prices, 66 Inflation dove, 278 Inflation hawk, 278 Inflationary expectations, 233 change in, 272–273 Inflationary gap, 159 Inflation-targeting, 222 Insufficient aggregate demand, 159 Intellectual property rights, 82 Interest rates, 222–228 and consumption spending, 230 discount rate, 223 effect, 116, 128–129, 162, 180–181, 216–219, 222, 239–240, 265–266 federal funds rate, 223–224 FOMO and, 215–216 329 ‘The’ interest rate, 227–228 inverted yield curve, 226 investment spending and, 228–229 long-term rates, 225 and net exports, 229 nominal interest rate, 227 normal yield curve, 226 real interest rate, 227 risk premium, 225 short-term rates, 225 targeting, 276–279, See also Taylor rule treasury rates, 223 yield curve, 225 Internal finance, 128 International trade policies, 286–288 International transfer payments, 289 Inventory accumulation, 93 Inventory depletion, 93 Inversely related variable, 15 Inverted yield curve, 226 Investment spending, 108–109, 127–130 determinants of, 127–130 expected rate of return on capital, 127–128 investment demand curve, 129–130 Investment, 80 J Judicial system, productivity and, 82 K Keynes, John Maynard, 51 Keynesian cross diagram, 99–104 45◦ line, 99 L Labor force participation rate (LFPR), 62 Labor productivity, 79–80 Laspeyres index, 65 330 Index Law of increasing opportunity cost, 24 Lender of last resort, 214 Liabilities, 114 Limit to borrowing, 181–182 45◦ Line, 99–101 Liquidity, 185 Loans, money creation by, 193–199 Long-run aggregate supply curve (LRAS), 247–248 Long-run economic growth, 71–85, See also Aggregate production function; Sources of growth Long-run growth, 57 Long-term rates, 225 Lump-sum taxes, 123, 144, 170 M M1, 186 M2, 186 Macroeconomic equilibrium, 93 with equations, 97–99 Macroeconomic policy, 157–168, See also Fiscal policy; Monetary policy policy lags, 164–165 Macroeconomics, 4–6, See also Measuring macroeconomy history of, 50–52 Marginal propensity to consume, 121–123, 139 to import, 150 to save, 121–123 Marginally attached to the labor force, 61 Market, 36, See also Money market equilibrium, 44 shortage, 45 size of, 40, 44 supply, 40 surplus, 45 Math, 3–20 mathematical tools, 7–9, See also Variables absolute value, 7–8 change ( ), decimals, fractions, functional notation, Measuring macroeconomy, 49–68, See also Unemployment, measuring depression, 59 growth, 57–59 long-run growth, 57 peak, 58 real GDP per capita, 58 recession, 57–59 recovery, 57–59 short-run fluctuations, 57 stagnation, 57–59 standard of living, 58 trough, 58 Merchandise trade balance, 289 Microeconomics, Monetarism, 231 Monetary policy, 162–163, 220–234, 263–282 central bank, 162 contractionary, 163–164 European Central Bank, 163 expansionary, 163–164 Fed’s choice of target, 265–266 Fed policy, 279–282 Following increase in aggregate demand, 279–280 Following increase in inflationary expectations, 280–281 Federal Reserve System, 163 in Great Recession of 2007–2009, 165–168, 234 inflation-targeting, 222 interest rate target, 222, 265–267 interest rates (i), 162 and aggregate demand, 267–268 and macroeconomy, 228–230 interest rates, 228–229 investment spending, 228–229 monetarism, 231 Index money supply (MS), 162 money supply target, 222 price of money, 162 rules versus discretion, 232–233 targets, 221–222 tools, 221–222 unemployment and inflation trade-offs, 268–276, See also Phillips curve Money, description, 184–188 cash, 185 coins, 185 commodity money, 185 currency, 185 definition, 184 fiat money, 185 liquidity, 185 M1, 186 M2, 186 measurement, 185–186 what money is not, 186–188 Money creation, 183–201, See also Banks by making loans, 193–199 money multiplier, 199–201 T-accounts for, 195–199 Money market, 202–219, See also Demand: for money equilibrium amount of money, 203 money stock, 203 supply of money, 203, 207–208 Fed changing, 212–213 Money market equilibrium, 208–209 adjustment to equilibrium, 209–211 changes of, 211–212 equilibrium interest rate, 208 equilibrium money stock, 208 Money supply (MS), 162 Money supply target, 216–219, 222 Move along versus shift of a curve, 19 Multiplier/Multiplier process, 135–138 effect when spending falls, 142–143 with imports, 148–153 331 with lump-sum taxes, 149 marginal propensity to consume (mpc), 139 size of, 138–143 N National Income and Product Accounts (NIPA), 51 Natural rate of unemployment, 64–65 Negative slope, 14–16 Net export spending determinants, 131–133 Net exports, 229 Net taxes, 105 Nominal GDP, 54–55 Nominal interest rate, 227 Nominal money demand (MD), 206 Nonaccelerating inflation rate of unemployment (NAIRU), 64 Nondurable goods, 52 Nonlinear curve, 16–19 Non-money assets, 203 Normal good, 39 Normal yield curve, 226 Normative economics, North American Free Trade Agreement (NAFTA), 288 O Official reserve transactions (ORTs), 292 Open economy macroeconomics, 299–300 international trade policies, 286–288 Open economy multiplier, 151 Opportunity costs, 23 law of increasing opportunity cost, 24 Out of the labor force, 61 Outlays, 175 Outlier, 168 332 Index Output, 74, 90–91 aggregate demand and, 92–94 aggregate spending and, 91 equalling income, 96–97 gap, 159 NIPA, 52–57 P Paasche index, 66 Pattern of unemployment, 62 Payments for factor incomes, 289 Peak, 58 Peg, 297 Personal saving, 105 Phillips curve, 268–276 changes in productivity growth, 274–275 inflationary expectations, change in, 272–273 ‘The Phillips Curve Is Dead’, 269–272 shifts of, 272 spiraling inflation, 1969–1980, 270 stagflation, 269 supply shocks, 274 Planned aggregate expenditure (AE), 239 Plotting data, 11–12 Policy lags, 164–165 implementation lag, 164 recognition lag, 164 response lag, 165 Political institutions, productivity and, 82 Positive economics, Positive slope, 14–16 Price of money, 162, 206 Prices and aggregate expenditure, 239 Prices of related output, 43–44 Producer durable goods, 109 Production possibilities frontier (PPF), 22–27, 72 trade-off, 22 Productivity, 28 growth changes in, 274–275 productivity growth resurgence, 83–85 productivity growth slowdown, 83–85 of inputs, 43 Property rights, productivity and, 82 intellectual property rights, 82 Proportional taxes, 123, 144, 174 Q Quadrants, 10–11 Quantity demand, 37 Quantity supplied, 40 Quantity theory approach, 230–231 Quota, 288 R Rate, unemployment, 61 Rate of change, calculating, Reading graphs, 13 Real GDP, 54–55 per capita, 58 rate of change of, 56 U.S pattern, 56–57 Real interest rate, 227 Real money demand (MD/P), 206 Receipts, 175 Recession, measuring, 57–59 Recessionary gap, 159 Recognition lag, 164 Recovery, measuring, 57–59 Remittances, 290 Required reserve ratio, 192 Required reserves, 191 Research and development, productivity and, 82 Reserve account, 292 Reserve balance at the Fed, 189 Residual growth, 79 Index Resources, scarce, 22 Response lag, 165 Retaliatory tariffs, 288 Ricardian model, 29 Risk premium, 225 Rule of 70, 73 Rules versus discretion, 232–233 Run on the bank, 191 S Saving, 120–121 saving rate, 122 Scale of production, 77 Scarce resources, 22 Seasonal unemployment, 63 Shift, 38 Shortage, market, 45 Short-run aggregate supply curve (SRAS), 248–250 Short-run fluctuations, 57 Short-term rates, 225 Slope, graph, 13–14 negative, 14–16, 18 positive, 14–17 Sources of growth, 78–83 capital, 79–80 productivity, 81–83 labor, 79–80 residual growth, 79 total factor productivity (TFP), 79 Sovereign default, 181 Speculation motive, 205 Spending multiplier, 134–153, See also Multiplier/Multiplier process closed economy multiplier, 153 marginal propensity to import, 150 open economy multiplier, 151 Spending types, 107–113, See also Aggregate demand (AD) aggregate expenditures, 107–108 consumption spending, 108 exports, 110–111 government spending, 109, 333 imports, 110 investment spending, 108–109 total spending, distribution, 111–113 Spiraling inflation, 1969–1980, 270 Stagflation, 67, 269 Stagnation, measuring, 57–59 Standard of living, 58 Static AS/AD model, 259 Statistical discrepancy, 292 Sticky wages, 249 Stock variable, 115 Stock, money, 203 Straight line, 15 Structural deficit, 177 Structural unemployment, 63 Substitute goods, 39 Substitutes in production, 43 Supply, 36, 40–44, See also Demand costs of inputs, 43 individual supply, 40 market supply, 40 prices of related output, 43–44 complements in production, 44 substitutes in production, 43 productivity of inputs, 43 quantity supplied, 40 schedule, 41 Supply shock, 254, 274, 280–281 Supply-side, 246 Surplus, market, 45 T T-accounts, 195–197 for money creation, 197–199 Tariff, 288 Tastes and preferences, 40 Tax multipliers, 170–173 Taxes (TA), 161, 123–124, 144–148 lump-sum taxes, 123, 144 proportional taxes, 123, 144 Taylor Rule, 276–279 inflation dove, 278 334 Index Taylor Rule, (continued ) inflation hawk, 278 Temporary assistance to needy families (TANF), 161 Theory of comparative advantage, 29 Tight money, 163 Token money, 185 Total deposits, 188 Total factor productivity (TFP), 79 sources, 81–82 Total reserves, bank’s, 190–193 Total spending, distribution, 111–113 Trade balance, 289 Trade deficit, 289 Trade-off, 22 Trade promotion policy, 287 Trade protection policy, 287 Trade surplus, 289 Transactions motive, 204 Transfer payments (TR), 161 Transfer payments multiplier, 171 Transportation networks, productivity and, 82 Treasuries, 178 treasury bill, 178 treasury bond, 178 treasury note, 178 Treasury bill rates, 223–224 Troubled Asset Relief Program (TARP), 167 Trough, 58 Truncated axes, 12 Two-dimensional graph, 10 U Unattainable combination of output, 27 Underground economy, 53 Unemployment, measuring, 59–65 civilian labor force, 60 cyclical unemployment, 63 discouraged worker, 61 employed, 60 frictional unemployment, 63 full employment, 63–64 marginally attached to the labor force, 61 natural rate of unemployment, 64–65 out of the labor force, 61 pattern of unemployment, 1900–2009, 62 rate, 61 seasonal unemployment, 63 structural unemployment, 63 unemployed, 60 Unemployment and aggregate spending, 90–91 United States–Dominican Republic–Central America Free Trade Agreement (CAFTA), 288 V Variables, dependent, directly related variable, 14 independent, inversely related variable, 15 Vault cash, 191 Vertical axis, graph, 10 W Wealth effect, 240–241 Wealth portfolio, 203 Wealth, 40, 114–115 assets, 114 liabilities, 114 Worldwide recession, 165 Y Yield curve, 225 Z Zero Lower Bound, 166, 281–282 [...]... effect of a policy all else constant —when nothing but the policy and all of its effects changes The challenge is that in the real world, “all else” is never constant What will happen when the Fed lowers interest rates? If “all else” was held constant and only interest rates changed, we could tell you But out there in the real world, lots of other things change, too So what will the news tell us tomorrow?... “Spending increases when wealth increases, but the increases in spending get smaller and smaller as wealth gets larger and larger.” Slope Calculating the actual slope of a straight line or along a curve is sometimes necessary Most of us learned in high school a formula for calculating slope: “slope 14 Chapter 1 Economics Tools—Math and Graphing Spending B B2 A A2 B1 A1 Wealth Figure 1.5 Graphs without... Oregon; Rajeev Goel, Illinois State University; Michael Lampert, Truckee Meadows Community College; Steven Pressman, Monmouth University; Virginia A Reilly, Ocean County College; Mark Siegler, California State University, Sacramento; David M Switzer, St Cloud State University; and, William Walsh, University of St Thomas A special call-out goes to David Switzer, a Berkeley alumnus, who blended his experiences... expressed in all three If you don’t understand the words, look at the graph If a graph doesn’t make sense, look at the equation or the words All three ways of expressing a model should reinforce each other Think of them as three languages all telling you the same thing Eventually you should understand all three expressions of any model, and be able to move back and forth between them MATHEMATICAL TOOLS In... Fed lowers interest rates ” But some assumptions are implicit—important assumptions, but not spoken aloud Whether explicit or implicit, changing an assumption can change the conclusion • Our observations about macroeconomics are all “real-world” observations What we read in the news is what we’re trying to explain But the real world is messy and complicated It doesn’t allow us to “hold all else... language of macroeconomics Family members struggle with unemployment gain insight into their predicaments with the language of macroeconomics A politician wants your vote analyze the promises with the language of macroeconomics Economics is all around you To become fully conversant in the language of economics, think econ All the time And now, let’s begin Acknowledgments Thank-yous are usually... variable family income Family spending and family income are both variables because the values of both can change In any one relationship, there is only one dependent variable, but no limit to the number of independent variables Mathematical Tools 9 Algebra In macroeconomics, we often solve algebraic equations with one unknown For example, what is the value of Y if Y = 100 + 0.6Y To solve this equation,... economist will predict one thing; another will predict something else And each will follow his or her first prediction with “On the other hand, the effect could instead be ” Two economists Four opinions You too might wonder, “What good is someone who can’t even tell me what will happen?” A lot of good, actually There are two keys to understanding macroeconomics and its relationship to the real world: •... the level of unemployment?” we use a different model Change the question and it’s a different model, a different economic story Alternatively, one simplification of the complex world we live in is to divide it into four groups: households, businesses, government, and the rest of the world When this simplification is made, we are using a macroeconomic model called the Keynesian model (which we’ll cover... values of spending and wealth From A, dash over to the vertical axis to find the value of spending, and dash down to the horizontal axis to find the level of wealth Point A represents the combination of wealth level A1 and spending level A2 Point B represents the combination of wealth level B1 and spending level B2 Reading Graphs It is as important to be able to “read” a graph as it is to be able
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