TENTH EDITION

MICHAEL PARKINUniversity of Western Ontario

Addison-Wesley

Boston Columbus Indianapolis New York San Francisco Upper Saddle River

Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto

Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

PART ONEINTRODUCTION lCHAPTER 1 What Is Economics? 1CHAPTER 2 The Economic Problem 29

PART T W OHOW MARKETS WORK 55CHAPTER 3 D e m a n d and Supply 55

CHAPTER 4 Elasticity 83CHAPTER 5 Efficiency and Equity 105CHAPTER 6 Governmen t Actions in Markets 1 27

CHAPTER 7 Global Markets in Act ion 151

PART THREEHOUSEHOLDS'CHOICES 179CHAPTER 8 Utility and Demand 179CHAPTER 9 Possibilities, Preferences, and Choices

203

PART FOUR -FIRMS AND MARKETS 227CHAPTER 1 0 Organizing Production 227CHAPTER 1 1 Output and Costs 251

CHAPTER 1 2 Perfect Competition 273

CHAPTER 13 Monopoly 299

CHAPTER 1 4 Monopolistic Competition 323CHAPTER 15 Oligopoly 341

PART FIVEMARKET FAILURE AND GOVERNMENT 371CHAPTER 16 Public Choices and Public Goods 371

CHAPTER 17 Economics of the Environment 393

PART SIXFACTOR MARKETS, INEQUALITY,AND UNCERTAINTY 417CHAPTER 1 8 Markets for Factors of Production 417CHAPTER 19 Economic Inequality 441CHAPTER 20 Uncertainty and Information 465

PART SEVEN

489

CHAPTER 21 Measuring GDP and EconomicGrowth 489

CHAPTER 22 Monitoring Jobs and Inflation 513

PART EIGHTMACROECONOMIC TRENDS 539CHAPTER 23 Economic Growth 539

CHAPTER 24 Finance, Saving, and Investment 565CHAPTER 25 Money, the Price Level, and Inflation

589

CHAPTER 26 The Exchange Rate and the Balance ofPayments 617

PART NINEMACROECONOMIC FLUCTUATIONS 647CHAPTER 27 Aggregate Supply and Aggregate

Demand 647CHAPTER 28 Expenditure Multipliers: The Keynesian

Model 671CHAPTER 29 U.S. Inflation, Unemployment, and

Business Cycle 701

PART TEN727

CHAPTER 30 Fiscal Policy 727CHAPTER 31 Monetary Policy 753

/ \ Tlrbti

X/OKIOI\CHAPTER 1 O WHAT IS ECONOMICS? l

Definition of Economics 2

Two Big Economic Questions 3 ' - —-What, How, and For Whom? 3Can the Pursuit of Self-interest Promote the

Social Interest? 5

The Economic Way of Thinking 8A Choice Is a Tradeoff 8Making a Rational Choice 8Benefit: What You Gain 8Cost: What You Must Give Up 8How Much? Choosing at the Margin 9Choices Respond to Incentives 9

Economics as Social Science andPolicy Tool 10

Economist as Social Scientist 10Economist as Policy Adviser 10

Summary (Key Points and Key Terms), Study PlanProblems and Applications, and Additional Problemsand Applications appear at the end of each chapter.

APPENDIX Graphs in Economics 13

Graphing Data 13Scatter Diagrams 14

Graphs Used in Economic Models 16Variables That Move in the Same Direction 16Variables That Move in Opposite Directions 17Variables That Have a Maximum or a

Minimum 18Variables That Are Unrelated 19

The Slope of a Relationship 20The Slope of a Straight Line 20The Slope of a Curved Line 21

Graphing Relationships Among More ThanTwo Variables 22

Ceteris Paribus 22When Other Things Change 23

MATHEMATICAL NOTEEquations of Straight Lines 24

Contents

CHAPTER 2 O THE ECONOMIC PROBLEM 29

Production Possibilities and OpportunityCost 30

Production Possibilities Frontier 30Production Efficiency 31Tradeoff Along the PPF 31Opportunity Cost 31

Using Resources Efficiently 33The PPF and Marginal Cost 33Preferences and Marginal Benefit 34Allocative Efficiency 35

Economic Growth 36The Cost of Economic Growth 36A Nation's Economic Growth 37

Gains from Trade 38Comparative Advantage and Absolute

Advantage 38Achieving the Gains from Trade 39

Economic Coordination 41Firms 41Markets 42Property Rights 42Money 42Circular Flows Through Markets 42Coordinating Decisions 42

READING BETWEEN THE LINESThe Rising Opportunity Cost of Food 44

Understanding the Scope of EconomicsYour Economic Revolution 51

Talking withJagdish Bhagwati 52

CHAPTER 3 O DEMAND AND SUPPLY 55

Markets and Prices 56

Demand 57The Law of Demand 57Demand Curve and Demand Schedule 57A Change in Demand 58A Change in the Quantity Demanded Versus a

Change in Demand 60

Supply 62The Law of Supply 62Supply Curve and Supply Schedule 62A Change in Supply 63A Change in the Quantity Supplied Versus a

Change in Supply \64

Market Equilibrium 66Price as a Regulator 66Price Adjustments 67

Predicting Changes in Price and Quantity 68An Increase in Demand 68A Decrease in Demand 68An Increase in Supply 70A Decrease in Supply 70All the Possible Changes in Demand and

Supply 72

READING BETWEEN THE LINESDemand and Supply: The Price of Coffee 74

MATHEMATICAL NOTEDemand, Supply, and Equilibrium 76

Contents

CHAPTER 4 O ELASTICITY 83

Price Elasticity of Demand 84Calculating Price Elasticity of Demand 85Inelastic and Elastic Demand 86

.' Elasticity Along a Linear Demand Curve 87Total Revenue and Elasticity 88Your Expenditure and Your Elasticity 89The Factors That Influence the Elasticity of

Demand 89

More Elasticities of Demand 91Cross Elasticity of Demand 91Income Elasticity of Demand 92

Elasticity of Supply 94Calculating the Elasticity of Supply 94The Factors That Influence the Elasticity of

Supply 95

READING BETWEEN THE LINESThe Elasticities of Demand and Supply for

Tomatoes 98

CHAPTER 5 • EFFICIENCY AND EQUITY 105

Resource Allocation Methods 106Market Price 106Command 106Majority Rule 106Contest 106First-Come, First-Served 106Lottery 107Personal Characteristics 107Force 107

Benefit, Cost, and Surplus 108Demand, Willingness to Pay, and Value 108Individual Demand and Market Demand 108Consumer Surplus 109Supply and Marginal Cost 109Supply, Cost, and Minimum Supply-Price 110Individual Supply and Market Supply 110Producer Surplus 111

Is the Competitive Market Efficient? 112Efficiency of Competitive Equilibrium 112Market Failure 113Sources of Market Failure 1 14Alternatives to the Market 1 15

Is the Competitive Market Fair? 116It's Not Fair If the Result Isn't Fair 116It's Not Fair If the Rules Aren't Fair 118Case Study: A Water Shortage in a Natural

Disaster 118

READING BETWEEN THE LINESIs the Global Market for Roses Efficient? 120

Contents

CHAPTER 6 O GOVERNMENT ACTIONS INMARKETS 127

A Housing Market With a Rent Ceiling 128A Housing Shortage 128Increased Search Activity 128A Black Market 128Inefficiency of a Rent Ceiling 129Are Rent Ceilings Fair? 130

A Labor Market With a Minimum Wage 131Minimum Wage Brings Unemployment 131Inefficiency of a Minimum Wage 131Is the Minimum Wage Fair? 132

Taxes 133

Tax Incidence 133A Tax on Sellers 133A Tax on Buyers 134Equivalence of Tax on Buyers and Sellers 134Tax Incidence and Elasticity of Demand 135Tax Incidence and Elasticity of Supply 136Taxes and Efficiency 137Taxes and Fairness 13 8

Production Quotas and Subsidies 139Production Quotas 139

Subsidies 140

Markets for Illegal Goods 142A Free Market for a Drug , 142A Market for an Illegal Drug 142Legalizing and Taxing Drugs 143

READING BETWEEN THE LINESGovernment Actions in Labor Markets 144

CHAPTER 7 O GLOBAL MARKETS IN ACTION151

How Global Markets WorkInternational Trade Today

152152

What Drives International Trade? 152Why the United States Imports T-Shirts 153Why the United States Exports Airplanes 154

Winners, Losers, and the Net Gain fromTrade 155

Gains and Losses from Imports 155Gains and Losses from Exports 156Gains for All 156

International Trade Restrictions 157Tariffs 157Import Quotas 160Other Import Barriers 162Export Subsidies ' 162

The Case Against Protection 163The Infant-Industry Argument 163The Dumping Argument 163Saves Jobs 164Allows Us to Compete with Cheap Foreign

Labor 164Penalizes Lax Environmental Standards 164Prevents Rich Countries from Exploiting

Developing Countries 165Offshore Outsourcing 165Avoiding Trade Wars 166Why Is International Trade Restricted? 166Compensating Losers 167

READING BETWEEN THE LINESA Tarriff on Tires 168

Understanding How Markets WorkThe Amazing Market 175

Talking withSusan Athey 176

Contents

PART THREEHOUSEHOLDS' CHOICES 179

CHAPTER 8 O UTILITY AND DEMAND 179

Consumption Choices 180Consumption Possibilities 180Preferences 181

Utility-Maximizing Choice 183A Spreadsheet Solution 1 83Choosing at the Margin 1 84The Power of Marginal Analysis 186Revealing Preferences 1 86

Predictions of Marginal Utility Theory 187A Fall in the Price of a Movie 187A Rise in the Price of Soda 189A Rise in Income 190The Paradox of Value 191Temperature: An Analogy 192

New Ways of Explaining ConsumerChoices 194

Behavioral Economics 194Neuroeconomics 195Controversy 195

READING BETWEEN THE LINESA Paradox of Value: Paramedics and Hockey

Players 196

CHAPTER 9 O POSSIBILITIES, PREFERENCES,

AND CHOICES 203

Consumption Possibilities 204Budget Equation 205

Preferences and Indifference Curves 207Marginal Rate of Substitution 208Degree of Substitutability 209

Predicting Consumer Choices 210Best Affordable Choice 210A Change in Price 21 1A Change in Income 213Substitution Effect and Income Effect 214

READING BETWEEN THE LINESPaper Books Versus e-Books 216

IPOUnderstanding Households' ChoicesMaking the Most of Life 223

Talking withSteven D. Levitt 224

Contents

CHAPTER 10 O ORGANIZING

PRODUCTION 227

The Firm and Its Economic Problem 228The Firm's Goal 228Accounting Profit 228Economic Accounting 228A Firm's Opportunity Cost of Production 228Economic Accounting: A Summary 229Decisions 229The Firm's Constraints 230

Technological and Economic Efficiency 231Technological Efficiency 231Economic Efficiency 231

Information and Organization 233Command Systems 233Incentive Systems 233Mixing the Systems 233The Principal-Agent Problem 234Coping with the Principal-Agent Problem 234Types of Business Organization 234Pros and Cons of Different Types of Firms 235

Markets and the Competitive Environment 237Measures of Concentration^ 238Limitations of a Concentration Measure 240

Produce or Outsource? Firms and Markets 242Firm Coordination 242Market Coordination 242Why Firms? 242

READING BETWEEN THE LINESBattling for Markets in Internet Advertising 244

CHAPTER 11 O OUTPUT AND COSTS 251

Decision Time Frames 252The Short Run 252The Long Run 252

Short-Run Technology Constraint 253Product Schedules 253Product Curves 253Total Product Curve 254Marginal Product Curve 254Average Product Curve 256

Short-Run Cost 257Total Cost 257Marginal Cost 258Average Cost 258Marginal Cost and Average Cost 258Why the Average Total Cost Curve Is

U-Shaped 258s

Cost Curves and Product Curves 260Shifts in the Cost Curves 260

Long-Run Cost 262The Production Function 262Short-Run Cost and Long-Run Cost 262The Long-Run Average Cost Curve 264Economies and Diseconomies of Scale 264

READING BETWEEN THE LINESCutting the Cost of Producing Electricity 266

Contents

CHAPTER 12 O PERFECT COMPETITION 273

What Is Perfect Competition? 274• How Perfect Competition Arises 274

Price Takers 274Economic Profit and Revenue 274The Firm's Decisions 275

The Firm's Output Decision 276Marginal Analysis and the Supply Decision 277Temporary Shutdown Decision 278The Firm's Supply Curve 279

Output, Price, and Profit in the Short Run 280Market Supply in the Short Run 280Short-Run Equilibrium 281A Change in Demand 281Profits and Losses in the Short Run 281Three Possible Short-Run Outcomes 282

Output, Price, and Profit in the Long Run 283Entry and Exit 283A Closer Look at Entry 284A Closer Look at Exit 284Long-Run Equilibrium 285

Changing Tastes and AdvancingTechnology 286

A Permanent Change in Demand 286External Economies and Diseconomies 287Technological Change 289

Competition and Efficiency 290Efficient Use of Resources 290Choices, Equilibrium, and Efficiency 290

READING BETWEEN THE LINESPerfect Competition in Corn 292

CHAPTER 13 O MONOPOLY 299

Monopoly and How It Arises 300How Monopoly Arises 300Monopoly Price-Setting Strategies 301

A Single-Price Monopoly's Output andPrice Decision 302

Price and Marginal Revenue 302Marginal Revenue and Elasticity 303Price and Output Decision 304

Single-Price Monopoly andCompetition Compared 306

Comparing Price and Output 306Efficiency Comparison 307Redistribution of Surpluses 308Rent Seeking 308Rent-Seeking Equilibrium 308

Price Discrimination 309Capturing Consumer Surplus 309Profiting by Price Discriminating 310Perfect Price Discrimination 311Efficiency and Rent Seeking with Price

Discrimination 312

Monopoly Regulation 313Efficient Regulation of a Natural MonopolySecond-Best Regulation of a Natural

Monopoly 314

READING BETWEEN THE LINESIs Google Misusing Monopoly Power? 316

313

Contents

CHAPTER 14 O MONOPOLISTIC

COMPETITION 323

What fs Monopolistic Competition? 324Large Number of Firms 324Product Differentiation 324Competing on Quality, Price, and Marketing

324Entry and Exit 325Examples of Monopolistic Competition 325

Price and Output in MonopolisticCompetition 326

The Firm's Short-Run Output and PriceDecision 326

Profit Maximizing Might Be LossMinimizing 326

Long-Run: Zero Economic Profit 327Monopolistic Competition and Perfect

Competition 328Is Monopolistic Competition Efficient? 329

Product Development and Marketing 330Innovation and Product Development 330Advertising 330Using Advertising to Signal Quality 332Brand Names 333Efficiency of Advertising and Brand Names 333

READING BETWEEN THE LINESProduct Differentiation and Entry in the Market

for Smart Phones 334

CHAPTER 15 O OLIGOPOLY 341

What Is Oligopoly? 342Barriers to Entry 342Small Number of Firms 343Examples of Oligopoly 343

Oligopoly Games 344What Is a Game? 344The Prisoners' Dilemma 344An Oligopoly Price-Fixing Game 346Other Oligopoly Games 350The Disappearing Invisible Hand 351A Game of Chicken 352

Repeated Games and SequentialGames 353

A Repeated Duopoly Game 353A Sequential Entry Game in a Contestable

Market 354

Antitrust Law 356The Antitrust Laws 356Price Fixing Always Illegal 357Three Antitrust Policy Debates 357Mergers and Acquisitions 359

READING BETWEEN THE LINESGillete and Schick in a Duopoly Game 360

Understanding Firms and MarketsManaging Change and Limiting MarketPower 367

Talking withThomas Hubbard 368

Contents

CHAPTER 16 0 PUBLIC CHOICES AND

PUBLIC GOODS 371 . _-

Public Choices 372Why Governments Exist 372Public Choice and the Political Marketplace 372Political Equilibrium 373What is a Public Good? 374A Fourfold Classification 374Mixed Goods and Externalities 374Inefficiencies that Require Public Choices 376

Providing Public Goods 377The Free-Rider Problem 377Marginal Social Benefit from a Public

Good 377Marginal Social Cost of a Public Good 378Efficient Quantity of a Public Good 378Inefficient Private Provision 378Efficient Public Provision 378Inefficient Public Overprovision 380

Providing Mixed Goods with ExternalBenefits 381

Private Benefits and Social Benefits 381Government Actions in the Market for a Mixed

Good with External Benefits 382Bureaucratic Inefficiency and Government

Failure 383Health-Care Services 384

CHAPTER 17 O ECONOMICS OF THE

ENVIRONMENT 393

Negative Externalities: Pollution 394Sources of Pollution 394Effects of Pollution 394Private Cost and Social Cost of Pollution 395Production and Pollution: How Much? 396Property Rights 396The Coase Theorem 397Government Actions in a Market with External

Costs 398

The Tragedy of the Commons 400Sustainable Use of a Renewable Resource 400The Overuse of a Common Resource 402Achieving an Efficient Outcome 403

READING BETWEEN THE LINESTax Versus Cap-and-Trade 406

Understanding Market Failure andGovernmentWe, the People, ... 413

Talking withCaroline M. Hoxby 414

READING BETWEEN THE LINESReforming Health Care 386

Contents

CHAPTER 18 O MARKETS FOR FACTORS OF

PRODUCTION 417

The Anatomy of Factor Markets 418Markets for Labor Services 41 8Markets for Capital Services 418Markets for Land Services and Natural

Resources 418Entrepreneurship 418

The Demand for a Factor of Production 419Value of Marginal Product 419A Firm's Demand for Labor 419A Firm's Demand for Labor Curve 420Changes in a Firm's Demand for Labor 421

Labor Markets- 422A Competitive Labor Market 422A Labor Market with a Union 424Scale of the Union—Nonunion Wage

Gap 426Trends and Differences in Wage Rates 427

Capital and Natural Resource Markets 428Capital Rental Markets 42 8:

Land Rental Markets 428 *Nonrenewable Natural Resource Markets 429

READING BETWEEN THE LINESThe Labor Market in Action 432

CHAPTER 19 O ECONOMIC INEQUALITY 441

Economic Inequality in the United States 442The Distribution of Income 442The Income Lorenz Curve 443The Distribution of Wealth 444Wealth or Income? 444Annual or Lifetime Income and Wealth? 445Trends in Inequality 445Poverty 446

Inequality in the World Economy 448Income Distributions in Selected Countries 448Global Inequality and Its Trends 449

The Sources of Economic Inequality 450Human Capital 450Discrimination 452Contests Among Superstars 453Unequal Wealth 454

Income Redistribution 455Income Taxes 455Income Maintenance Programs 455Subsidized Services 455The Big Tradeoff 456

READING BETWEEN THE LINESTrends in Incomes of the Super Rich 458

MATHEMATICAL NOTEPresent Value and Discounting 434

xviii Contents

CHAPTER 20 O UNCERTAINTY AND

INFORMATION 465

Decisions in the Face of Uncertainty 466Expected Wealth 466Risk Aversion 466Utility of Wealth 466Expected Utility 467Making a Choice with Uncertainty 468

Buying and Selling Risk 469Insurance Markets 469A Graphical Analysis of Insurance 470Risk That Can't Be Insured 471

Private Information 472Asymmetric Information: Examples and

Problems 472The Market for Used Cars 472The Market for Loans 475The Market for Insurance 476

Uncertainty, Information, and the InvisibleHand 477

Information as a Good 477Monopoly in Markets that Cope with

Uncertainty 477

READING BETWEEN THE LINES ,Grades as Signals 478

Understanding Factor Markets,Inequality, and UncertaintyFor Whom? 485

Talking withDavid Card 486

CHAPTER 21 O MEASURING GDP AND

ECONOMIC GROWTH 489

Gross Domestic Product 490GDP Defined 490GDP and the Circular Flow of Expenditure

and Income 491Why Is Domestic Product "Gross"? 492

Measuring U.S. GDP 493The Expenditure Approach 493The Income Approach 493Nominal GDP and Real GDP 495Calculating Real GDP 495

The Uses and Limitations of Real GDP 496The Standard of Living Over Time 496The Standard of Living Across Countries 498Limitations of Real GDP 499

READING BETWEEN THE LINESReal GDP Forecasts in the Uncertain Economy

of 2010 502

APPENDIX Graphs in Macroeconomics 504

MATHEMATICAL NOTEChained-Dollar Real GDP 506

Contents xix

CHAPTER 22 O MONITORING JOBS AND

INFLATION 513

Employment and Unemployment 514Why Unemployment Is a Problem 514Current Population Survey 515Three Labor Market Indicators 515Other Definitions of Unemployment 517Most Costly Unemployment 518Alternative Measure of Unemployment 51 8

Unemployment and Full Employment 519Frictional Unemployment 519Structural Unemployment 519Cyclical Unemployment 519"Natural" Unemployment 519Real GDP and Unemployment Over the

Cycle 520

The Price Level, Inflation, and Deflation 522Why Inflation and Deflation are Problems 522The Consumer Price Index 523Reading the CPI Numbers 523Constructing the CPI 523Measuring the Inflation Rate 524Distinguishing High Inflation from a High Price

Level 525The Biased CPI 525The Magnitude of the Bias 526Some Consequences of the Bias 526Alternative Price Indexes 526Core CPI Inflation 527The Real Variables in Macroeconomics 527

READING BETWEEN THE LINESJobs Growth Lags Recovery 528

CHAPTER 23 O ECONOMIC GROWTH 539

The Basics of Economic Growth 540Calculating Growth Rates 540The Magic of Sustained Growth 540Applying the Rule of 70 541

Economic Growth Trends 542Growth in the U.S. Economy 542Real GDP Growth in the World Economy 543

How Potential GDP Grows 545What Determines Potential GDP? 545What Makes Potential GDP Grow? 547

Why Labor Productivity Grows 550Preconditions for Labor Productivity

Growth 550Physical Capital Growth 551Human Capital Growth 551Technological Advances 551

Growth Theories, Evidence, and Policies 553Classical Growth Theory 553Neoclassical Growth Theory 553New Growth Theory 554New Growth Theory Versus Malthusian

Theory 556Sorting Out the Theories 556The Empirical Evidence on the Causes of

Economic Growth 556Policies for Achieving Faster Growth 556

READING BETWEEN THE LINESEconomic Growth in China 558

Monitoring Macroeconomic PerformanceThe Big Picture 535

Talking withRichard Clarida 536

Contents

CHAPTER 24 O FINANCE, SAVING, AND

INVESTMENT 565

Financial Institutions and Financial Markets 566finance and Money 566Physical Capital and Financial Capital 566Capital and Investment 566Wealth and Saving 566Financial Capital Markets 567Financial Institutions 568Insolvency and Illiquidity 569Interest Rates and Asset Prices 570

The Loanable Funds Market 570Funds that Finance Investment 570The Real Interest Rate 571The Demand for Loanable Funds 572The Supply of Loanable Funds 573Equilibrium in the Loanable Funds Market 574Changes in Demand and Supply 574

Government in the Loanable Funds Market 577A Government Budget Surplus 577A Government Budget Deficit 577

The Global Loanable Funds Market 579International Capital Mobility 579International Borrowing and Lending 579Demand and Supply in the Global and National

Markets 579

READING BETWEEN THE LINESCrowding Out in the Global Recession 582

CHAPTER 25 O MONEY, THE PRICE LEVEL,

AND INFLATION 589

What Is Money? 590Medium of Exchange 590Unit of Account 590Store of Value 591Money in the United States Today 591

Depository Institutions 593Types of Depository Institution 593What Depository Institutions Do 593Economic Benefits Provided by Depository

Institutions 594How Depository Institutions Are Regulated 594Financial Innovation 595

The Federal Reserve System 596The Structure of the Fed 596The Fed's Balance Sheet 597The Fed's Policy Tools 597

How Banks Create Money 599Creating Deposits by Making Loans 599The Money Creation Process 600The Money Multiplier 601

The Money Market 602The Influences on Money Holding 602The Demand for Money 603Shifts in the Demand for Money Curve 603 .Money Market Equilibrium 604

The Quantity Theory of Money 606

READING BETWEEN THE LINESCan More Money Keep the Recovery Going? 608

MATHEMATICAL NOTEThe Money Multiplier 610

Contents

CHAPTER 26 • THE EXCHANGE RATE AND

THE BALANCE OF PAYMENTS

617

The Foreign Exchange Market 618Trading Currencies 618Exchange Rates 618Questions About the U.S. Dollar Exchange

Rate 618An Exchange Rate Is a Price 618The Demand for One Money Is the Supply of

Another Money 619Demand in the Foreign Exchange Market 619Demand Curve for U.S. Dollars 620Supply in the Foreign Exchange Market 621Supply Curve for U.S. Dollars 621Market Equilibrium 622

Exchange Rate Fluctuations 623Changes in the Demand for U.S. Dollars 623Changes in the Supply of U.S. Dollars 624Changes in the Exchange Rate 624Fundamentals, Expectations, and Arbitrage 626The Real Exchange Rate 627

Exchange Rate Policy 628Flexible Exchange Rate 628Fixed Exchange Rate 628Crawling Peg 629

Financing International Trade 631Balance of Payments Accounts 631Borrowers and Lenders 633Debtors and Creditors 633Is U.S. Borrowing for Consumption? 633Current Account Balance 634Net Exports 634Where Is the Exchange Rate? 635

READING BETWEEN THE LINESThe Dollar and "Carry Trade" 636

Understanding Macroeconomic TrendsExpanding the Frontier 643

Talking withXavier Sala-i-Martin 644

Contents

CHAPTER 27 O AGGREGATE SUPPLY AND

AGGREGATE DEMAND 647

Aggregate Supply 648Quantity Supplied and Supply 648Long-Run Aggregate Supply 648Short-Run Aggregate Supply 649Changes in Aggregate Supply 650

Aggregate Demand 652The Aggregate Demand Curve 652Changes in Aggregate Demand 653

Explaining Macroeconomic Trends andFluctuations 656

Short-Run Macroeconomic Equilibrium 656Long-Run Macroeconomic Equilibrium 657Economic Growth and Inflation in the AS-AD

Model 657The Business Cycle in the AS-AD Model 658Fluctuations in Aggregate Demand 660Fluctuations in Aggregate Supply 661

Macroeconomic Schools of Thought 662The Classical View 662The Keynesian View 662The Monetarist View 663The Way Ahead 663

READING BETWEEN THE LINESAggregate Supply and Aggregate Demandin Action 664

CHAPTER 28 O EXPENDITURE MULTIPLIERS:

THE KEYNESIAN MODEL 671

Fixed Prices and Expenditure Plans 672Expenditure Plans 672Consumption and Saving Plans 672Marginal Propensities to Consume and Save

674Slopes and Marginal Propensities 674Consumption as a Function of Real GDP 675Import Function 675

Real GDP with a Fixed Price Level 676Aggregate Planned Expenditure 676Actual Expenditure, Planned Expenditure, and

Real GDP 677Equilibrium Expenditure 678Convergence to Equilibrium 679

The Multiplier 680The Basic Idea of the Multiplier 680The Multiplier Effect 680Why Is the Multiplier Greater than 1? 681The Size of the Multiplier 681The Multiplier and the Slope of the

AE Curve 682Imports and Income Taxes 683The Multiplier Process 683Business Cycle Turning Points 684

The Multiplier and the Price Level 685Adjusting Quantities and Prices 685Aggregate Expenditure and Aggregate

Demand 685Deriving the Aggregate Demand Curve 685Changes in Aggregate Expenditure and Aggregate

Demand 686Equilibrium Real GDP and the Price Level 687

READING BETWEEN THE LINESInventory Investment in the 2010 Expansion 690

MATHEMATICAL NOTEThe Algebra of the Keynesian Model 692

Contents xxin

CHAPTER 29 O U.S. INFLATION,

UNEMPLOYMENT, AND

BUSINESS CYCLE 701

Inflation Cycles 702Demand-Pull Inflation 702Cost-Push Inflation 704Expected Inflation 706Forecasting Inflation 707Inflation and the Business Cycle 707

Inflation and Unemployment:The Phillips Curve 708

The Short-Run Phillips Curve 708The Long-Run Phillips Curve 709Changes in the Natural Unemployment Rate

709

The Business Cycle 711Mainstream Business Cycle Theory 711Real Business Cycle Theory 712

READING BETWEEN THE LINESThe Shifting Inflation—UnemploymentTradeoff 716

Understanding Macroeconomic FluctuationsBoom and Bust 723

Talking with *Ricardo J. Cabellero 724

i i

CHAPTER 30 O FISCAL POLICY 727

The Federal Budget 728The Institutions and Laws 728Highlights of the 2011 Budget 729The Budget in Historical Perspective 730Budget Balance and Debt 732State and Local Budgets 733

Supply-Side Effects of Fiscal Policy 734Full Employment and Potential GDP 734The Effects of the Income Tax 734Taxes on Expenditure and the Tax Wedge 735Taxes and the Incentive to Save and Invest 736Tax Revenues and the Laffer Curve 737The Supply-Side Debate 737

Generational Effects of Fiscal Policy 738Generational Accounting and Present Value 738The Social Security Time Bomb 738Generational Imbalance 739International Debt 739

Fiscal Stimulus 740Automatic Fiscal Policy and Cyclical and

Structural Budget Balances 740Discretionary Fiscal Stimulus 743

READING BETWEEN THE LINESObama Fiscal Policy 746

Contents ICHAPTER 31 O MONETARY POLICY 753

Monetary Policy Objectives andframework 754

t Monetary Policy Objectives 754-Operational "Stable Prices" Goal 755Operational "Maximum Employment" Goal

7 5 5 • . _.

Responsibility for Monetary Policy 756

The Conduct of Monetary Policy 756The Monetary Policy Instrument 756The Fed's Decision-Making Strategy 757

Monetary Policy Transmission 759Quick Overview 759Interest Rate Changes 759Exchange Rate Fluctuations 760Money and Bank Loans 761The Long-Term Real Interest Rate 761Expenditure Plans 761The Change in Aggregate Demand, Real GDP,

and the Price Level 762The Fed Fights Recession 762The Fed Fights Inflation 764Loose Links and Long and Variable Lags 765

Extraordinary Monetary Stimulus 767The Key Elements of the Crisis 767The Policy Actions 768Persistently Slow Recovery 768Policy Strategies and Clarity 769

READING BETWEEN THE LINESThe Fed's Monetary Policy Dilemma 770

Understanding Macroeconomic PolicyTradeoffs and Free Lunches 777

Talking withStephanie Schmitt-Grohe 778

Glossary G-1Index 1-1Credits C-l