Economics:Eighth Edition

William A. McEachernUniversity of Connecticut

SOUTH-WESTERNCENGAGE Learning-

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

Part 1 Introduction to Economics ^1 The Art and Science of Economic Analysis

2 Economic Tools and Economic Systems

3 Economic Decision Makers

4 Demand, Supply, and Markets

Part 2 Introduction to the Market System5 Elasticity of Demand and Supply

6 Consumer Choice and Demand

7 Production and Cost in the Firm

Part 3 Market Structure and Pricing8 Perfect Competition

9 Monopoly

10 Monopolistic Competition and Oligopoly

Part 4 Resources Markets11 Resource Markets

12 Labor Markets and Labor Unions

13 Capital, Interest, and Corporate Finance

14 Transaction Costs, Imperfect Information, and Market Behavior

Part 5 Market Failure and Public Policy15 Economic Regulation and Antitrust Policy

16 Public Goods and Public Choice

17 Externalities and the Environment

18 Income Distribution and Poverty

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Chapter Number in

Macroeconomics MicroeconomicsA Contemporary A Contemporary

Introduction Introduction

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Brief Contents vii

Part 6 Fundamentals of Macroeconomics19 Introduction to Macroeconomics

20 Productivity and Growth

21 Tracking the U.S. Economy

22 Unemployment and Inflation

23 Aggregate Expenditure

24 Aggregate Expenditure and Aggregate Demand !

25 Aggregate Supply

Part 7 Fiscal and Monetary Policy26 Fiscal Policy

27 Federal Budgets and Public Policy

28 Money and the Financial System

29 Banking and the Money Supply

30 Monetary Theory and Policy

31 Macro Policy Debate: Active or Passive?

Part 8 The International Setting32 International Trade

33 International Finance

34 Developing and Transitional Economics

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cPart 1 Introduction to Economics L

Chapter 1

The Art and Science of Economic Analysis 1

The Economic Problem: Scarce Resources, UnlimitedWants 2

Resources-2/Goods and Services 3/Economic Decision Makers 4/A Simple Circular-Flow Model 4

The Art of Economic Analysis 6

Rational Self-interest 6/Choice Requires Time and Information 6/Economic Analysis is Marginal Analysis II Microeconomics andMacroeconomics 7

The Science of Economic Analysis 8

The Role of Theory 8/The Scientific Method 8/Normative VersusPositive 10/Economists Tell Stories 11/Case Study A Yen for VendingMachines 11/Predicting Average Behavior 12/Some Pitfalls of FaultyEconomic Analysis 12/ If Economists Are So Smart, Why Aren't TheyRich? 13/Case Study: College Major and Annual Earnings 14

Appendix: Understanding Graphs 20

Drawing Graphs 20/The Slopes of Straight Lines 21/The Slope, Unitsof Measurement and Marginal Analysis 21/The Slopes of CurvedLines 22/Line Shirts 24

Chapter 2Economic Tools and Economic Systems

Choice and Opportunity Cost

27

28

Opportunity Cost 28/ Case Study: The Opportunity Cost of College 28/Opportunity Cost Is Subjective 30/Sunk Cost and Choice 31

Compare Advantage, Specialization, and Exchange 31

The Law of Comparative Advantage 32/ Absolute Advantage VersusComparative Advantage 32/ Specialization and Exchange 33/Division of Labor and Gains from Specialization 34

The Economy's Production Possibilities 34

Efficiency and the Production Possibilities Frontier 35/ Inefficient andUnattainable Production 35/The Shape of the Production Possibilities

Frontier 36/What Can Shift the Production Possibilities Frontier? 37/Case Study: Rules of the Game and Economic Development 39/What We Learn from the PPF 41

Economic Systems 41

Three Questions Every Economic System Must Answer 41 / PureCapitalism 42/ Pure Command System 43/ Mixed and TransitionalEconomies 44/ Economies Based on Custom or Religion 45

Chapter 3Economic Decision Makers 49

The Household 50

The Evolution of the Household 50/Household Maximize Utility 50/Households as Resource Supplier 51/ Households as Demanders ofGoods and Services 52

The Firm 52

The Evolution of the Firm 52/Types of Firms 53/Cooperatives 53/Not-for-Profit Organizations 56/ Case Study: User-GeneratedProducts 56/ Why Does Household Production Still Exist? 57/Case Study: The Electronic Cottage 58

The Government 59

The Role of Government 59/The Size and Growth of Government 62/Sources of Government Revenue 63/Tax Principles and TaxIncidence 63

The Rest of the World 65

International Trade 66/Exchange Rates 66/Trade Restrictions 66

Chapter 4Demand, Supply, and Markets 71

Demand 72

The Law of Demand 72/The Demand Schedule and Demand Curve 73

Shifts of the Demand Curve . 75

Changes in Consumer Income 75/ Changes in the Prices of OtherGoods 76/Changes in Consumer Expectations 76/Changes in theNumber of Composition of Consumers 77/Changes in ConsumerTastes 77

VIII

Contents IX

Shifts of the Supply Curve 79

Changes in Technology 79/ Changes in the Prices of RelevantResources 80/Changes in the Prices of Alternative Goods 80/Changes in Producer Expectations 80/ Changes in the Number ofProducers 81

Demand and Supply Create a Market 81

Markets 81/Market Equilibrium 82

i

Changes in Equilibrium Price and Quantity v. _-83

Shifts of the Demand Curve 83/Shifts of the Supply Curve 84/Simultaneous Shifts of Demand and Supply Curves 85/Case Study: The Market for Professional Basketball 87

Disequilibrium 88

Price Floors 88/Price Ceilings 89/Case Study: Rent Ceilings inNew York City 90

Conclusion 91

Part 2 Introduction to the Market System

Chapter 5Elasticity of Demand and Supply 97

Price Elasticity of Demand 98

Calculating Price Elasticity of Demand 98/ Categories of Price Elasticityof Demand 100/Elasticity and Total Revenue 100/Price Elasticity andthe Linear Demand Curve 101/Constant-Elasticity DemandCurves 102

Determinants of the Price Elasticity of Demand 104

Availability of Substitutes 104/Share of the Consumer's BudgetSpent on the Good 105/Length of Adjustment Period 105/ElasticityEstimates 107/Case Study Deterring Young Smokers 108

Price Elasticity of Supply 109

Constant Elasticity Supply Curves 110/ Determinants of Supply Elasticity 111

Other Elasticity Measures 112

Income Elasticity of Demand 112/ Case Study: The Market for Foodand the "Farm Problem" 17/Cross-Price Elasticity of Demand 115

Conclusion

Chapter 6Consumer Choice and Demand

116

123

Utility Analysis 124

Tastes and Preferences 124/TheLawof Diminishing Marginal Utility 125

Measuring Utility 126

Units of Utility 126/ Utility Maximization in a World WithoutScarcity 127/ Utility Maximization in a World of Scarcity 128/Utility-Maximizing Conditions 129/ Case Study: Water, Water,Everywhere 129/ Marginal Utility and the Law of Demand 130/Consumer Surplus 132/Market Demand and ConsumerSurplus 134/Case Study: The Marginal Value of FreeMedical Care 135

The Role of Time in Demand

Conclusion

Appendix: Indifference Curves and UtilityMaximization

136

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141

Consumer Preferences 141/The Budget Line 143/ConsumerEquilibrium at the Tangency 144/Effects of a Change in Price 145/Income and Substitution Effects 145

Chapter 7Product ion and Cost in the Firm 149

Cost and Profit 150

Explicit and Implicit Costs 150/Alternative Measures of Profit 151

Production in the Short Run 152

Fixed and Variable resources 152/The Law of Diminishing MarginalReturns 152/The Total and Marginal Product Curves 154

Costs in the Short Run 154

Total Cost and Marginal Cost in the Short Run 154/ Average Costin the Short Run 158/ The Relationship Between Marginal Cost andAverage Cost 158

Costs in the Long Run 160

Economics of Scale 160/Diseconomies of Scale 161/TheLong-Run Average Cost Curve 161/ Case Study: Scale Economiesand Diseconomies at the Movies 163/ Economies and Diseconomiesof Scale at the Firm Level 164/ Case Study: Scale Economies andDiseconomies at McDonald's 164

Conclusion 165

Appendix: A Close Look at Production and Cost 169

The Production Function and Efficiency 169/lsoquants 169/lsocostLines 171/The Choice of Input Combinations 172/The ExpansionPath 172

Contents

Part 3 Market Structure and Pricing

Chapter 8Perfect Competition

An Introduction of Perfect Competition

175

176

Perfectly Competitive Market Structure 176/ Demand Under PerfectCompetition 177

Short-Run Profit Maximization ; 178

Total Revenue Minus Total Cost 178/ Marginal Revenue EqualsMarginal Cost 179/Economic Profit in the Short Run 181

Minimizing Short-Run Losses 181

Fixed Cost and Minimizing Losses 181/ Marginal Revenue EqualsMarginal Cost 182/Shutting Down in the Short-Run 184

The Firm and Industry Short-Run Supply Curves 184

The Short-Run Firm Supply Curve 185/ The Short-Run IndustrySupplyCurve 186/Firm Supply and Market Equilibrium 186/Case Study: Auction Markets 187

Perfect Competit ion in the Long Run 188

Zero Economic Profit in the Long Run 189/ The Long-Run Adjustmentto a Change in Demand 190

The Long-Run Industry Supply Curve 192

Constant-Cost Industries 193/Increasing-Cost Industries 193

Perfect Competit ion and Efficiency 195

Productive Efficiency: Making Stuff Right 195/ Allocative Efficiency:Making the Right Stuff 195/ What's So Perfect About PerfectCompetition? 196/Case Study: Experimental Economics 197

Conclusion

Chapter 9Monopoly

Barriers to Entry

198

203

204

Demand, Average Revenue, and Marginal Revenue 208/The Gains and Loss from Selling One More Unit 209/Revenue Schedules 209/Revenue Curves 210

The Firm's Costs and Profit Maximization 212

Profit Maximization 212/ Short-Run Losses and the ShutdownDecision 214/Long-Run Profit Maximization 216

Monopoly and the Allocation of Resources 216

Price and Output Under Perfect Competition 216/ Price and OutputUnder Monopoly 216/ Allocative and Distributive Effects 217

Problems Estimating the Deadweight 216

Why the Deadweight Loss of Monopoly Might Be Lower 218/Why the Deadweight Loss Might Be Higher 218/ Case Study:The Mall Monopoly 219

Price Discrimination 220

Conditions for Price Discrimination 220/ A Model of PriceDiscrimination 221/Examples of Price Discrimination 222/PerfectPrice Discrimination: The Monopolist's Dream 222

Conclusion 224

Chapter 10Monopolistic Competition and Oligopoly^ 227

Monopolistic Competition 228

Characteristics of Monopolistic Competition 228/ Short-Run ProfitMaximization or Loss Minimization 229/ Zero Economic Profitin the Long Run 231/ Case Study: Fast Forward to CreativeDeconstruction 232/ Monopolistic Competition and PerfectCompetition Compared 233

An Introduction to Oligopoly 235

Varieties of Oligopoly 235/Economies of Scale 236/The High Cost ofEntry 236/ Crowding Out the Competition 237

Models of Oligopoly 238

Legal Restrictions 204/Economies of Scale 205/Control of EssentialResources 205/ Case Study: Is a Diamond Forever? 206

Collusion and Cartels 238/Price Leadership 240/Game Theory 241/Comparison of Oligopoly and Perfect Competition 245/Case Study: Timely Fashions Boost Profit for Zara 246

Conclusion 247

Revenue for the Monopolist 208

Contents XI

Part 4 Resource Markets

Chapter 11Resource Markets

The Once-Over

Resource Demand 252/ Resource Supply 252

The Demand and Supply of Resources

Present Value and Discounting 302

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252

253

The Market Demand for Resources 253/ Case Study: Lumber Pricesand Housing Markets 254/The Market Supply of Resources 255/Temporary and Permanent Resources Price Differences 255/Opportunity Cost and Economic Rent 257

A Closer Look at Resource Demand 260

The Firm's Demand for a Resource 260/ Marginal RevenueProduct 260/Marginal Resource Cost 262/Changes in ResourceDemand 264/The Optimal Use of More Than One Resource 265/Case Study:The McMinimum Wage 266

Conclusion 267

Chapter 12Labor Markets and Labor Unions 271

Labor Supply 272

Labor Supply and Utility Maximization 272/ Wages and IndividualLabor Supply 274/Nonwage Determinants of Labor Supply 276/Market Supply of Labor 278/Why Wages Differ 278/Case Study:Winner-Take-All Labor Markets 281

Present Value of Payment One Year Hence 302/ Present Value forPayments in Later years 303/Present Value of an Income Stream 303/Present Value of an Annuity 304/Case Study: The Million-DollarLottery? 304

Corporate Finance 305

Corporate Stock and Retained Earnings 306/Corporate Bonds 306/Securities Exchanges 307

Conclusion 307

Chapter 14Transaction Costs, Imperfect Information, and MarketBehavior 311

Rationale for the Firm and its Scope of Operation 312

The Firm Reduces Transaction Costs 312/The Boundaries of theFirm 313/Case Study:TheTrendToward Outsourcing 316/Economies of Scope 317

Market Behavior with Imperfect Information 318

Optimal Search with Imperfect Information 318/The Winner's Curse 320

Asymmetric Information in Product Markets 320

Hidden Characteristics: Adverse Selection 321/ Hidden Actions:The Principal-Agent Problem 321/ Asymmetric Information inInsurance Markets 322/Coping with Asymmetric Information 323

Unions and Collective Bargaining

Types of Unions 282/ Collective Bargaining, Mediation, andArbitration 283/The Strike 283

282 Asymmetric Information in Labor Markets

Adverse Selection in Labor Markets 324/ Signaling andScreening 324/Case Study: Reputation of a Big Mac 325

323

Union Wages and Employment 283 Conclusion 326

Inclusive, or Industrial, Unions: Negotiating a Higher IndustryWage 284/Exclusive; or Craft, Unions: Reducing Labor Supply 286/Increasing Demand for Union Labor 287/ Recent Trends in UnionMembership 288/Case Study: Dock Unions Thrive 289

Conclusion 290

Chapter 13Capital, Interest, and Corporate Finance 293

The Role of Time in Production and Consumption 294

Production, Saving, and Time 294/ Consumption, Saving, andTime 295/Optimal Investment 295/Case Study: The Value of aGood Idea—Intellectual Property 298/The Market for LoanableFunds 299/ Why Interest Rates Differ 300

Part 5 Market Failure and Public Policy

Chapter 15Types of Government Regulation

Regulating a Natural Monopoly

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330

Unregulated Profit Maximization 331/ Setting Price Equal To MarginalCost 332/ Subsidizing the Natural Monopolist 332/ Setting Price Equalto Average Cost 333/The Regulatory Dilemma 333

Alternative Theories of Economic Regulation

Producers' Special Interest in Economic Regulation 334/Case Study: Airline Regulation and Deregulation 334

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XII Contents

Antitrust Law and Enforcement 336

Origins of Antitrust Policy 336/Antitrust Enforcement 337/Per Se Illegality and the Rule of Reason 337/ Mergers and PublicPolicy 338/Merger Waves 339

Chapter 16Public Goods and Public Choice 349

Public Goods 350

Private Goods, Public Goods, and In Between 350/ Optimal Provisionof Public Goods 351/Paying for Public Goods 353 V~ •• — '

Public Choice in Representative Democracy 353

Median-Voter Model 353/ Special Interest and Rational Ignorance 354/Distribution of Benefits and Costs 355/ Rent Seeking 359/ Case Study:Campaign Finance Reform 360/The Underground Economy 361

Bureaucracy and Representative Democracy 362

Ownership and Funding of Bureaus 362/ Ownership andOrganizational Behavior 362/ Bureaucratic Objectives 363/ Privateversus Public Production 364

Conclusion 365

Chapter 17Externalities and the Environment 369

Externalities and the Common-Pool Problem 370

Renewable Resources 370/ Resolving the Common-Pool Problem 371

Optimal Level of Pollution 372

External Costs with Fixed Technology 372/ External Costs with VariableTechnology 374/Case Study: The Lungs of the Planet 376/The Coase Theorem 377/ Markets for Pollution Rights 378/Pollution Rights and Public Choice 380

Environmental Protection

Air Pollution 381/Water Pollution 384/Hazardous Waste and theSuperfund 384/Solid Waste: "Paper or Plastic?" 385

Positive Externalities

Conclusion

Chapter 18Income Distribution and Poverty

The Distribution of Household Income

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394

Income Distribution byQuintiles 394/The LorenzCurve 394/WhyIncomes Differ 396/A College Education Pays More 397/CaseStudy: Marital Sorting and Income Inequality 398/ Problems withDistribution Benchmarks 399

Redistribution Programs 397

Official Poverty Level 399/Programs to Help the Poor 401

Who Are the Poor? 404

Poverty and Age 404/Poverty and Public Choice 404/TheFeminization of Poverty 405/ Poverty and Discrimination 408/Affirmative Action 408

Unintended Consequences of Income Assistance 409

Welfare Reform 410

Recent Reforms 410

Conclusion 413

Part 6 Fundamentals of Macroeconomics 417

Chapter 19Introduction to Macroeconomics

The National Economy

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418

What's Special about the National Economy? 418/The Human Bodyand the U.S. Economy 419/ Knowledge and Performance 419

Economic Fluctuations and Growth 420

U.S. Economic Fluctuations 420/ Leading Economic Indicators 423

Aggregate Demand and Aggregate Supply 425

Aggregate Output and the Price Level 425/ Aggregate DemandCurve 425/Aggregate Supply Curve 427/Equilibrium 427

Brief History of the U.S. Economy 428

The Great Depression and Before 428/ The Age of Keynes: After theGreat Depression to the Early 1970s 429/Stagflation: 1973-1980 430/Normal Times Since 1980 431/Case Study: Nearly Eight Decades ofReal GDP and Price Levels 432

Conclusion

Chapter 20Productivity and Growth

Theory of Productivity and Growth

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437

438

Growth and the Production Possibilities Frontier 438/ What isProductivity? 440/ Labor Productivity 440/ Per-Worker ProductionFunction 441/Technological Change 442/Rules of the Game 443

Productivity and Growth in Practice

Education and Economic Development 444/ U.S. LaborProductivity 445/Slowdown and Rebound in Productivity

444

Contents XIII

Growth 446/ Case Study: Computers, the Internet, andProductivity Growth 447/Output per Capita 449/InternationalComparisons 450

Other Issues of Technology and Growth 451

Does Technological Change Lead to Unemployment? 451/ Researchand Development 452/ Industrial Policy 454/ Do EconomiesConverge? 455/Case Study: Income and Happiness 456

Conclusion 457

Chapter 21Tracking the U.S. Economy 461

The Product of a Nation 462

National Income Accounts 462/GDP Based on the ExpenditureApproach 463/ GDP Based on Income Approach 464

Circular Flow of Income and Expenditure 465

Income Half of the Circular Flow 465/ Expenditure Half of the CircularFlow 467/ Leakages Equal Injections 468

Inflation 497

Limitations of National Income Accounting 468

Some Production is not Included in GDP 468/ Leisure, Quality, andVariety 469/ What's Gross about Gross Domestic Product? 469/ GDPDoes Not Reflect All Costs 470/GDP and Economic Welfare 470

Accounting for Price Changes 470

Price Indexes 471/ Problems with the CPI 472/ Case Study: PriceCheck on Aisle 2 472/The GDP Price Index 474/ Moving from FixedWeights to Chain Weights 475

Conclusion

Appendix: National Income Accounts

National Income

476

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481

Personal and Disposable Income 481/Summary of National IncomeAccounts 482

Summary Income Statement of the Economy 482

Chapter 22Unemployment and Inflation 485

Unemployment 486

Measuring Unemployment 486/ Labor Force ParticipationRate 487/Unemployment over Time 488/Unemployment inVarious Groups 489/ Unemployment Varies Across Occupations andRegions 492/Sources of Unemployment 492/The Meaning of FullEmployment 494/ Unemployment Compensation 495/ InternationalComparisons of Unemployment 495/ Problems with OfficialUnemployment Figures 496

Case Study: Hyperinflation in Brazil 497/Two Sources of Inflation 498/A Historical Look at Inflation and the Price Level 499/ AnticipatedVersus Unanticipated Inflation 501/The Transaction Costs of VariableInflation 501/Inflation Obscures Relative Price Changes 501/Inflation Across Metropolitan Areas 502/ International Comparisonsof Inflation 502/ Inflation and Interest Rates 503/ Why is InflationUnpopular? 505

Conclusion

Chapter 23Aggregate Expenditure

Consumption

506

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510

A First Look at Consumption and Income 510/The ConsumptionFunction 511/ Marginal Propensities to Consume and to Save 511/MPC, MPS, and the Slope of the Consumption and SavingFunctions 512/ Nonincome Determinants of Consumption 513/Case Study: The Life-Cycle Hypothesis 517

Investment 518

The Demand for Investment 518/From Micro to Macro 519/Investment and Disposable Income 520/Nonincome Determinantsof Investment 520/ Case Study: Investment Varies Much More thanConsumption 522

Government 523

Government Purchase Function 523/Net Taxes 523

Net Exports 524

Net Exports and Income 524/ Nonincome Determinants of NetExports 524

Composition of Aggregate Expenditure 525

Conclusion 526

Appendix: Variable Net Exports 529

Net Exports and Income 529/ Shifts of Net Exports 530

Chapter 24Aggregate Expenditure and Aggregate Demand 531

Aggregate Expenditure and Income 532

The Components of Aggregate Expenditure 532/ Real GDPDemanded 533/What if Spending Exceeds Read GPD? 534/What ifReal GPD Exceeds Spending? 534

The Simple Spending Multiplier 534

An Increase in Spending 535/ Using the Simple Spending Multiplier 537/Case Study: The Ripple Effect on the Economy of 9/11 538

XIV Contents

The Aggregate Demand Curve

A Higher Price Level 539/A Lower Price Level 541/The Multiplierand Shifts in Aggregate Demand 541/ Case Study: Falling WealthTriggered Japan's Recession 543

539 Including Aggregate Supply 575

Discretionary Fiscal Policy to Close a Contractionary Gap 575/Discretionary Fiscal Policy to Close an Expansionary Gap 577/TheMultiplier and the Time Horizon 578

Conclusion 544

Appendix A: Variable Net Exports Revisited 546

Net Exports and the Spending Multiplier 547/ A Change in.Autonomous Spending 547/ Appendix A Question 547 ^

Appendix B: The Algebra of Income and Expenditure 549

The Aggregate Expenditure Line 549/ A More General Form ofIncome and Expenditure 549/ Varying Net Exports 550/ Appendix BQuestion 550

Chapter 25Aggregate Supply

Aggregate Supply in the Short Run

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552

Labor and Aggregate Supply 552/ Potential Output and the NaturalRate of Unemployment 553/ Actual Price Level is Higher thanExpected 553/ Why Costs Rise When Output Exceeds Potential 554/An Actual Price Level Lower Than Expected 555/The Short-RunAggregate Supply Curve 555

From the Short Run to the Long Run 556

Closing an Expansionary Gap 556/Closing a Contractionary Gap 558/Tracing Potential Output 560/Wage Flexibility and Employment 560/Case Study: U.S. Output Gaps and Wage Flexibility 562

Shifts of the Aggregate Supply Curve 564

Aggregate Supply Increases 564/ Decreases in Aggregate Supply 566/Case Study: Why is Unemployment So High in Europe? 567

Conclusion 568

The Evolution of Fiscal Policy 578

Prior to the Great Depression 578/The Great Depression andWorld War II 579/ Automatic Stabilizers 580/ From the GoldenAge to Stagflation 581/ Fiscal Policy and the Natural Rate ofUnemployment 581/ Case Study: Fiscal Policy and PresidentialElections 582/ Lags in Fiscal Policy 583/ Discretionary Fiscal Policyand Permanent Income 583/The Feedback Effects of Fiscal Policy onAggregate Supply 584/ Case Study:The Supply-Side Experiment 584/Since 1990: From Deficits to Surpluses Back to Deficits 585

Conclusion 586

Appendix: The Algebra of Demand-Side Equilibrium 589

Net Tax Multiplier 589/The Multiplier when both G and NTChange 589/The Multiplier with a Proportional Income Tax 590/Including Variable Net Exports 590/Appendix Questions 591

Chapter 27Federal Budgets and Public Policy

The Federal Budget Process

593

594

The Presidential and Congressional 595/ Problems with the FederalBudget Process 595/ Possible Budget Reforms 596

The Fiscal Impact of the Federal Budget 597

The Rationale for Deficits 597/ Budget Philosophies and Deficits 597/Federal Deficits Since the Birth of the Nation 598/Why Have DeficitsPersisted? 599/ Deficits, Surpluses, Crowding Out, and CrowdingIn 599/The Twin Deficits 600/ The Short-Lived Budget Surplus 600/Case Study: Reforming Social Security and Medicare 602/ TheRelative Size of the Public Sector 603

The National Debt 604

Part 7 Fiscal and Monetary Policy

Chapter 26Fiscal Policy 571

Theory of Fiscal Policy ' 572

Fiscal Policy Tools 572/Changes in Government Purchases 572/Changes in Net Taxes 573

Measuring the National Debt 605/ International Perspective on PublicDebt 605/ Interest on the National Debt 606/ Who Bears the Burdenof the Debt? 607/Crowding Out and Capital Formation 608/Case Study: An Intergenerational View of Deficits and Debt 609

Conclusion

Chapter 28Money and the Financial System

610

615

Contents XV

The Evolution of Money 616

Barter and the Double Coincidence of Wants 616/The EarliestMoney and its Functions 616/Properties of the Ideal Money 618/Coins 618/Case Study: The Hassle of Small Changes 619/Moneyand Banking 620/ Representative Money and Fiat Money 621/The Value of Money 622/When Money Performs Poorly 622/CaseStudy: When Monetary Systems Break Down 623

Financial Institutions in the United States 624

Commercial Banks and Thrifts 624/Birth of the Fed 625/,Powers ofthe Federal Reserve System 625/ Banking Troubles During the GreatDepression 626/ Banks Lost Deposits When Inflation Increases 628/Banking Deregulation 629/ Saving Banks on the Ropes 629/Commercial Banks Were Failing Too 630/ U.S. Banking StructureToday 631/Top Banks in America and the World 632

Conclusion

Chapter 29Banking and the Money Supply

Money Aggregates

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638

Narrow Definition of Money: Ml 638/Case Study: Faking It 639/Broader Definition of Money: M2 640/ Credit Cards and Debit Cards:What's the Difference? 640

How Banks Work 642

Banks Are Financial Intermediaries 642/Starting a Bank 643/Reserve Accounts 644/Liquidity Versus Profitability 644

How Banks Create Money 645

Creating Money Through Excess Reserves 645/A Summary of theRounds 647/ Reserve Requirements and Money Expansion 648/Limitations on Money Expansion 649/ Multiple Contraction of theMoney Supply 649/ Case Study: Banking on the Net '650

The Fed's Tools of Monetary Control 651

Open-Market Operations and the Federal Funds Rate 651/TheDiscount Rate 652/ Reserve Requirements 652/ Coping with FinancialCrises 652/The Fed is a Money Machine 653

Money and Aggregate Demand in the Short Run 663

Interest Rates and Investment 663/ Adding the Short-RunAggregate Supply Curve 665/ Case Study:Targeting the FederalFunds Rate 666

Money and Aggregate Demand in the Long Run 668

The Equation Exchange 668/ The Quantity Theory of MoneyWhat Determines the Velocity of Money? 670/ How Stable isVelocity? 671/Case Study: The Money Supply and InflationAround the World 673

Targets for Monetary Policy 674

Contrasting Policies 674/Targets Before 1982 676/Targets After1982 676/International Considerations 676

Conclusion 677

Chapter 31Macro Policy Debate: Active or Passive? 681

Active Policy Versus Passive Policy 682

Closing a Concretionary Gap 682/Closing an Expansionary Gap 684/Problems with Active Policy 685/The Problem of Lags 685/A Review of Policy Perspectives 687/ Case Study: Active VersusPassive Presidential Candidates 687

The Role of Expectations 689

Monetary Policy and Inflation Expectations 689/ AnticipatingMonetary Policy 690/Policy Credibility 692/ Case Study: CentralBank Independence and Price Stability 693

Policy Rules Versus Discretion 694

Limitations on Discretion 694/ Rules and Rational Expectations 695

The Phillips Curve 696

The Phillips Framework 696/The Short-Run Phillips Curve 697/TheLong-Run Phillips Curve 699/The Natural Rate Hypothesis 700/Evidence of the Phillips Curve 700

Conclusion 654Conclusion 701

Chapter 30Monetary Theory and Policy

The Demand and Supply of Money

659

660

The Demand for Money 660/Money Demand and Interest Rates 661/The Supply of Money and the Equilibrium Interest Rate 662

Part 8 The International Setting

Chapter 32International Trade

The Gains from Trade

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706

XVI Contents

A Profile of Exports and Imports 706/ Production PossibilitiesWithout Trade 707/Consumption Possibilities Based onComparative Advantage 709/ Reasons for InternationalSpecialization 711

Trade Restrictions and Welfare Loss 712

Consumer Surplus and Producer Surplus from Market Exchange 713/Tariffs 714/Import Quotas 715/Quotas in Practice 717/Tariffs andQuotas Compared 718/Other Trade Restrictions 718/Freer Tradeby Multilateral Agreement 718/The World Trade Organization 718/Case Study: Doha Round and Round 000/Common Markets 719__

Arguments for Trade Restrictions 721

National Defense Argument 721/Infant Industry Argument 722/Antidumping Argument 722/Jobs and Income Argument 722/Declining Industries Argument 723/ Problem with TradeProtection 724/Case Study: Steel Tariffs 724

Conclusion 725

Chapter 33

International Finance 729

Balance of Payments 730

International Economic Transactions 730/The Merchandise TradeBalance 730/ Balance on Goods and Services 732/ Net InvestmentIncome 732/Unilateral Transfers 733/The Financial Account 733/Deficits and Surpluses 734

Foreign Exchange Rates and Markets 735

Foreign Exchange 735/The Demand for Foreign Exchange 736/The Supply of Foreign Exchange 737/ Determining the ExchangeRate 737/Arbitrageurs and Speculators 738/Purchasing PowersParity 739/ Case Study:The Big Mac Index 740/ Flexible ExchangeRates 741/Fixed Exchange Rates 741

Development of the International Monetary System 742

The Bretton Woods Agreement 742/The Demise of the BrettonWoods System 743/The Current System: Managed Float 743/Case Study: What about China? 744

Chapter 34

Developing and Transitional Economies

Worlds Apart

749

750

Developing and Industrial Economies 750/ Health and Nutrition 751/High Birth Rates 753/Women in Developing Countries 755

Productivity: Key to Development 755

Low Labor Productivity 755/Technology and Education 756/Inefficient Use of Labor 756/Natural Resources 757/FinancialInstitutions 757/Capital Infrastructure 758/EntrepreneurialAbility 758/Rules of the Game 759/Case Study: The PoorestBillion 761/Income Distribution Within Countries 762

International Trade and Development 762

Trade Problems for Developing Countries 762/ Migration and theBrain Drain 763/ Import Substitution Versus Export Promotion 763/Trade Liberalization and Special Interests 764

Foreign Aid and Economic Development 765

Foreign Aid 765/ Does Foreign Aid Promote EconomicDevelopment? 765

Transitional Economies 766

Types of Economic Systems 766/ Enterprises and Soft BudgetConstraints 767/Case Study: Property Rights and Resource Use 768

Markets and Institutions 769

Institutions and Economic Development 769/The Big Bang VersusGradualism 770/ Privatization 770/ Institutional Requirements ofEfficient Markets 771

Conclusion

Glossary

Index

772

777

791

Conclusion 745