Preface: To the Instructor vii
Preface: To the Student xix
Introduction 1
Ten Principles of Economics 3
How People Make Decisions 4
People Face Trade-offs 4
The Cost of Something Is What You Give Up to Get It 5
Rational People Think at the Margin 6
People Respond to Incentives 7
How People Interact 8
Trade Can Make Everyone Better Off 8
Markets Are Usually a Good Way to Organize Economic Activity 9
Governments Can Sometimes Improve Market Outcomes 10
FYI: Adam Smith and the Invisible Hand 10
How the Economy as a Whole Works 11
A Country's Standard of Living Depends on Its Ability to Produce Goods and Services 12
Prices Rise When the Government Prints Too Much Money 12
Society Faces a Short-Run Trade-off between Inflation and Unemployment 13
FYI: How to Read This Book 14
Conclusion 14
Summary 15
Key Concepts 15
Questions for Review 16
Problems and Applications 16
Thinking Like an Economist 19
TheEconomist as Scientist 20
The Scientific Method: Observation, Theory and More Observation 20
The Role of Assumptions 21
Economic Models 22
Our First Model: The Circular-Flow Diagram 22
Our Second Model: The Production Possibilities Frontier 24
Microeconomics and Macroeconomics 26
FYI: Who Studies Economics? 27
The Economist as Policy Adviser 28
Positive versus Normative Analysis 28
Economists in Washington 29
In the News: Super Bowl Economics 30
Case Study: Mr. Mankiw Goes to Washington 31
Why Economists Disagree 32
Differences in Scientific Judgments 32
Differences in Values 33
Perception versus Reality 33
Let's Get Going 34
In the News: Why You Should Study Economics 35
Summary 36
Key Concepts 36
Questions for Review 36
Problems and Applications 36
Graphing: A Brief Review 38
Graphs of a Single Variable 38
Graphs of Two Variables: The Coordinate System 39
Curves in the Coordinate System 40
Slope 42
Cause and Effect 44
Interdependence and the Gains From Trade 47
A Parable for the Modern Economy 48
Production Possibilities 48
Specialization and Trade 50
Comparative Advantage: The Driving Force of Specialization 52
Absolute Advantage 52
Opportunity Cost and Comparative Advantage 52
Comparative Advantage and Trade 54
FYI: The Legacy of Adam Smith and David Ricardo 55
Applications of Comparative Advantage 55
Should Tiger Woods Mow His Own Lawn? 55
In the News: Evolution and Economics 56
Should the United States Trade with Other Countries? 56
Conclusion 58
Summary 58
Key Concepts 59
Questions for Review 59
Problems and Applications 59
How Markets Work 61
The Market Forces of Supply and Demand 63
Markets and Competition 64
What Is a Market? 64
What Is Competition? 64
Demand 65
The Demand Curve: The Relationship between Price and Quantity Demanded 65
Market Demand versus Individual Demand 66
Shifts in the Demand Curve 67
Case Study: Two Ways to Reduce the Quantity of Smoking Demanded 69
Supply 71
The Supply Curve: The Relationship between Price and Quantity Supplied 71
Market Supply versus Individual Supply 71
Shifts in the Supply Curve 72
Supply and Demand Together 75
Equilibrium 75
Three Steps to Analyzing Changes in Equilibrium 77
In the News: Political Unrest Shifts the Supply Curve 81
Conclusion: How Prices Allocate Resources 82
Summary 84
Key Concepts 84
Questions for Review 85
Problems and Applications 85
Elasticity and its Application 89
The Elasticity of Demand 90
The Price Elasticity of Demand and Its Determinants 90
Computing the Price Elasticity of Demand 91
The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities 92
The Variety of Demand Curves 93
Total Revenue and the Price Elasticity of Demand 93
Elasticity and Total Revenue along a Linear Demand Curve 95
In the News: On the Road with Elasticity 98
Other Demand Elasticities 98
The Elasticity of Supply 99
The Price Elasticity of Supply and Its Determinants 100
Computing the Price Elasticity of Supply 100
The Variety of Supply Curves 100
Three Applications of Supply, Demand, and Elasticity 103
Can Good News for Farming Be Bad News for Farmers? 103
Why Did OPEC Fail to Keep the Price of Oil High? 105
Does Drug Interdiction Increase or Decrease Drug-Related Crime? 107
Conclusion 108
Summary 109
Key Concepts 109
Questions for Review 109
Problems and Applications 110
Supply, Demand, and Government Policies 113
Controls on Prices 114
How Price Ceilings Affect Market Outcomes 114
Case Study: Lines at the Gas Pump 116
Case Study: Rent Control in the Short Run and Long Run 117
How Price Floors Affect Market Outcomes 118
In the News: Rent Control in New York 120
Case Study: The Minimum Wage 120
Evaluating Price Controls 123
Taxes 124
How Taxes on Buyers Affect Market Outcomes 124
How Taxes on Sellers Affect Market Outcomes 126
Case Study: Can Congress Distribute the Burden of a Payroll Tax? 128
Elasticity and Tax Incidence 129
Case Study: Who Pays the Luxury Tax? 129
Conclusion 131
Summary 131
Key Concepts 132
Questions for Review 132
Problems and Applications 132
Markets and Welfare 135
Consumers, Producers, and the Efficiency of Markets 137
Consumer Surplus 138
Willingness to Pay 138
Using the Demand Curve to Measure Consumer Surplus 139
How a Lower Price Raises Consumer Surplus 140
What Does Consumer Surplus Measure? 142
Producer Surplus 143
Cost and the Willingness to Sell 143
Using the Supply Curve to Measure Producer Surplus 144
How a Higher Price Raises Producer Surplus 146
Market Efficiency 147
The Benevolent Social Planner 147
Evaluating the Market Equilibrium 148
In the News: Ticket Scalping 151
Case Study: Should There Be a Market in Organs? 152
In the News: The Miracle of the Market 153
Conclusion: Market Efficiency and Market Failure 154
Summary 155
Key Concepts 155
Questions for Review 155
Problems and Applications 156
Application: The Costs of Taxation 159
The Deadweight Loss of Taxation 160
How a Tax Affects Market Participants 161
Deadweight Losses and the Gains from Trade 163
The Determinants of the Deadweight Loss 165
Case Study: The Deadweight Loss Debate 165
Deadweight Loss and Tax Revenue as Taxes Vary 167
FYI: Henry George and the Land Tax 169
Case Study: The Laffer Curve and Supply-Side Economics 170
In the News: On the Way to France 171
Conclusion 172
Summary 173
Key Concept 173
Questions for Review 173
Problems and Applications 173
Application: International Trade 177
The Determinants of Trade 178
The Equilibrium without Trade 178
The World Price and Comparative Advantage 179
The Winners and Losers from Trade 179
The Gains and Losses of an Exporting Country 180
The Gains and Losses of an Importing Country 181
In the News: Cheap Clothes from China 183
The Effects of a Tariff 184
FYI: Import Quotas: Another Way to Restrict Trade 186
The Lessons for Trade Policy 186
The Arguments for Restricting Trade 187
FYI: Other Benefits of International Trade 188
The Jobs Argument 188
In the News: Offshore Outsourcing 189
The National-Security Argument 190
The Infant-Industry Argument 190
The Unfair-Competition Argument 191
The Protection-as-a-Bargaining-Chip Argument 191
Case Study: Trade Agreements and the World Trade Organization 192
In the News: Globalization 193
Conclusion 194
Summary 195
Key Concepts 195
Questions for Review 196
Problems and Applications 196
The Economics of the Public Sector 201
Externalities 203
Externalities and Market Inefficiency 204
Welfare Economics: A Recap 205
Negative Externalities 206
Positive Externalities 207
Case Study: Technology Spillovers, Industrial Policy, and Patent Protection 208
Private Solutions to Externalities 209
The Types of Private Solutions 209
The Coase Theorem 210
Why Private Solutions Do Not Always Work 211
Public Policies toward Externalities 212
Command-and-Control Policies: Regulation 212
Market-Based Policy 1: Corrective Taxes and Subsidies 213
In the News: Conserving Fuel 214
Case Study: Why Is Gasoline Taxed So Heavily? 215
Market-Based Policy 2: Tradable Pollution Permits 216
In the News: Controlling Carbon 218
Objections to the Economic Analysis of Pollution 219
Conclusion 219
Summary 220
Key Concepts 220
Questions for Review 220
Problems and Applications 221
Public Goods and Common Resources 223
The Different Kinds of Goods 224
Public Goods 225
The Free-Rider Problem 226
Some Important Public Goods 226
Case Study: Are Lighthouses Public Goods? 228
The Difficult Job of Cost-Benefit Analysis 229
Case Study: How Much Is a Life Worth? 230
Common Resources 231
The Tragedy of the Commons 231
Some Important Common Resources 232
In the News: A Solution to City Congestion 233
Case Study: Why the Cow Is Not Extinct 234
In the News: Should Yellowstone Charge as Much as Disney World? 235
Conclusion: The Importance of Property Rights 236
Summary 236
Key Concepts 237
Questions for Review 237
Problems and Applications 237
The Design of the Tax System 241
A Financial Overview of the U.S. Government 242
The Federal Government 242
Case Study: The Fiscal Challenge Ahead 246
State and Local Government 248
Taxes and Efficiency 249
Deadweight Losses 250
Case Study: Should Income or Consumption Be Taxed? 250
Administrative Burden 251
Marginal Tax Rates versus Average Tax Rates 252
Case Study: Iceland's Natural Experiment 252
Lump-Sum Taxes 253
Taxes and Equity 253
The Benefits Principle 254
The Ability-to-Pay Principle 254
Case Study: How the Tax Burden Is Distributed 255
In the News: Tax Reform around the World 257
Case Study: Horizontal Equity and the Marriage Tax 257
Tax Incidence and Tax Equity 259
Case Study: Who Pays the Corporate Income Tax? 259
Conclusion: The Trade-off between Equity and Efficiency 260
Summary 261
Key Concepts 261
Questions for Review 261
Problems and Applications 262
Firm Behavior and the Organization of Industry 265
The Costs of Production 267
What Are Costs? 268
Total Revenue, Total Cost, and Profit 268
Costs as Opportunity Costs 268
The Cost of Capital as an Opportunity Cost 269
Economic Profit versus Accounting Profit 270
Production and Costs 271
The Production Function 271
From the Production Function to the Total-Cost Curve 273
The Various Measures of Cost 274
Fixed and Variable Costs 275
Average and Marginal Cost 276
Cost Curves and Their Shapes 277
Typical Cost Curves 278
Costs in the Short Run and in the Long Run 280
The Relationship between Short-Run and Long-Run Average Total Cost 280
Economies and Diseconomies of Scale 281
FYI: Lessons from a Pin Factory 282
Conclusion 282
Summary 283
Key Concepts 284
Questions for Review 284
Problems and Applications 285
Firms in Competitive Markets 289
What Is a Competitive Market? 290
The Meaning of Competition 290
The Revenue of a Competitive Firm 290
Profit Maximization and the Competitive Firm's Supply Curve 292
A Simple Example of Profit Maximization 292
The Marginal-Cost Curve and the Firm's Supply Decision 293
The Firm's Short-Run Decision to Shut Down 295
Spilt Milk and Other Sunk Costs 297
Case Study: Near-Empty Restaurants and Off-season Miniature Golf 298
The Firm's Long-Run Decision to Exit or Enter a Market 298
Measuring Profit in Our Graph for the Competitive Firm 299
The Supply Curve in a Competitive Market 301
The Short Run: Market Supply with a Fixed Number of Firms 301
The Long Run: Market Supply with Entry and Exit 302
Why Do Competitive Firms Stay in Business If They Make Zero Profit? 303
A Shift in Demand in the Short Run and Long Run 304
Why the Long-Run Supply Curve Might Slope Upward 304
Conclusion: Behind the Supply Curve 306
Summary 307
Key Concepts 307
Questions for Review 307
Problems and Applications 308
Monopoly 311
Why Monopolies Arise 312
Monopoly Resources 313
Case Study: The DeBeers Diamond Monopoly 313
Government-Created Monopolies 313
Natural Monopolies 314
How Monopolies Make Production and Pricing Decisions 315
Monopoly versus Competition 316
A Monopoly's Revenue 317
Profit Maximization 318
A Monopoly's Profit 320
FYI: Why a Monopoly Does Not Have a Supply Curve 321
Case Study: Monopoly Drugs versus Generic Drugs 322
The Welfare Cost of Monopoly 323
The Deadweight Loss 323
The Monopoly's Profit: A Social Cost? 325
Public Policy toward Monopolies 326
Increasing Competition with Antitrust Laws 326
Regulation 327
Public Ownership 328
Doing Nothing 329
Price Discrimination 329
In the News: Public Transport and Private Enterprise 330
A Parable about Pricing 330
The Moral of the Story 332
The Analytics of Price Discrimination 333
Examples of Price Discrimination 334
Conclusion: The Prevalence of Monopoly 335
In the News: TKTS and Other Schemes 336
Summary 338
Key Concepts 339
Questions for Review 339
Problems and Applications 340
Oligopoly 345
Between Monopoly and Perfect Competition 346
Markets with Only a Few Sellers 347
In the News: The Growth of Oligopoly 348
A Duopoly Example 348
Competition, Monopolies, and Cartels 349
The Equilibrium for an Oligopoly 350
In the News: The Global Fight against Cartels 351
How the Size of an Oligopoly Affects the Market Outcome 352
Game Theory and the Economics of Cooperation 353
The Prisoners' Dilemma 354
Oligopolies as a Prisoners' Dilemma 355
Case Study: OPEC and the World Oil Market 356
Other Examples of the Prisoners' Dilemma 357
The Prisoners' Dilemma and the Welfare of Society 359
Why People Sometimes Cooperate 359
Case Study: The Prisoners' Dilemma Tournament 360
Public Policy toward Oligopolies 360
Restraint of Trade and the Antitrust Laws 361
Case Study: An Illegal Phone Call 361
Controversies over Antitrust Policy 362
Case Study: The Microsoft Case 364
Conclusion 365
In the News: Antitrust in the New Economy 366
Summary 367
Key Concepts 367
Questions for Review 367
Problems and Applications 368
Monopolistic Competition 373
Competition with Differentiated Products 374
The Monopolistically Competitive Firm in the Short Run 374
The Long-Run Equilibrium 375
Monopolistic versus Perfect Competition 377
Monopolistic Competition and the Welfare of Society 379
FYI: Is Excess Capacity a Social Problem? 380
Advertising 380
The Debate over Advertising 381
Case Study: Advertising and the Price of Eyeglasses 382
Advertising as a Signal of Quality 382
FYI: Galbraith versus Hayek 383
Brand Names 384
Conclusion 386
Summary 387
Key Concept 387
Questions for Review 387
Problems and Applications 388
The Economics of Labor Markets 391
The Markets for the Factors of Production 393
The Demand for Labor 394
The Competitive Profit-Maximizing Firm 394
The Production Function and the Marginal Product of Labor 395
The Value of the Marginal Product and the Demand for Labor 397
What Causes the Labor-Demand Curve to Shift? 398
FYI: Input Demand and Output Supply: Two Sides of the Same Coin 399
FYI: The Luddite Revolt 400
The Supply of Labor 401
The Trade-off between Work and Leisure 401
What Causes the Labor-Supply Curve to Shift? 401
Equilibrium in the Labor Market 402
Shifts in Labor Supply 402
Shifts in Labor Demand 404
Case Study: Productivity and Wages 405
FYI: Monopsony 406
The Other Factors of Production: Land and Capital 406
Equilibrium in the Markets for Land and Capital 407
FYI: What Is Capital Income? 408
Linkages among the Factors of Production 408
Case Study: The Economics of the Black Death 409
Conclusion 410
Summary 410
Key Concepts 410
Questions for Review 411
Problems and Applications 411
Earnings and Discrimination 413
Some Determinants of Equilibrium Wages 414
Compensating Differentials 414
Human Capital 414
Case Study: The Increasing Value of Skills 415
Ability Effort, and Chance 416
In the News: The Loss of Manufacturing Jobs 417
Case Study: The Benefits of Beauty 418
An Alternative View of Education: Signaling 419
The Superstar Phenomenon 419
In the News: Are Elite Colleges Worth the Cost? 420
Above-Equilibrium Wages: Minimum-Wage Laws, Unions, and Efficiency Wages 421
The Economics of Discrimination 422
Measuring Labor-Market Discrimination 422
Case Study: Is Emily More Employable than Lakisha? 424
Discrimination by Employers 424
Case Study: Segregated Streetcars and the Profit Motive 425
Discrimination by Customers and Governments 426
Case Study: Discrimination in Sports 426
Conclusion 427
Summary 428
Key Concepts 428
Questions for Review 428
Problems and Applications 429
Income Inequality and Poverty 431
The Measurement of Inequality 432
U.S. Income Inequality 432
Inequality around the World 433
The Poverty Rate 434
In the News: The Global Distribution of Income 435
Problems in Measuring Inequality 437
Economic Mobility 438
The Political Philosophy of Redistributing Income 439
Utilitarianism 439
Liberalism 440
Libertarianism 441
Policies to Reduce Poverty 442
Minimum-Wage Laws 442
Welfare 443
In the News: Hurricane Katrina and Its Aftermath 444
Negative Income Tax 444
In-Kind Transfers 445
In the News: Child Labor 446
Antipoverty Programs and Work Incentives 447
Conclusion 449
Summary 450
Key Concepts 450
Questions for Review 450
Problems and Applications 451
Topics for Further Study 453
The Theory of Consumer Choice 455
The Budget Constraint: What the Consumer Can Afford 456
Preferences: What the Consumer Wants 457
Representing Preferences with Indifference Curves 458
Four Properties of Indifference Curves 459
Two Extreme Examples of Indifference Curves 460
Optimization: What the Consumer Chooses 462
The Consumer's Optimal Choices 462
FYI: Utility: An Alternative Way to Describe Preferences and Optimization 463
How Changes in Income Affect the Consumer's Choices 464
How Changes in Prices Affect the Consumer's Choices 465
Income and Substitution Effects 466
Deriving the Demand Curve 468
Three Applications 469
Do All Demand Curves Slope Downward? 469
How Do Wages Affect Labor Supply? 471
Case Study: Income Effects on Labor Supply: Historical Trends, Lottery Winners, and the Carnegie Conjecture 472
How Do Interest Rates Affect Household Saving? 474
Conclusion: Do People Really Think This Way? 477
Summary 478
Key Concepts 478
Questions for Review 478
Problems and Applications 479
Frontiers of Microeconomics 483
Asymmetric Information 484
Hidden Actions: Principals, Agents, and Moral Hazard 484
Case Study: Corporate Management 485
Hidden Characteristics: Adverse Selection and the Lemons Problem 486
In the News: The Fruits of Moral Hazard 487
Signaling to Convey Private Information 487
Case Study: Gifts as Signals 488
Screening to Induce Information Revelation 489
Asymmetric Information and Public Policy 489
Political Economy 490
The Condorcet Voting Paradox 490
Arrow's Impossibility Theorem 491
The Median Voter Is King 492
In the News: Farm Policy and Politics 494
Politicians Are People Too 494
Behavioral Economics 496
People Aren't Always Rational 496
People Care about Fairness 497
People Are Inconsistent over Time 498
Conclusion 499
In the News: The Psychology of Saving 500
Summary 501
Key Concepts 501
Questions for Review 501
Problems and Applications 501
The Data of Macroeconomics 505
Measuring a Nation's Income 507
The Economy's Income and Expenditure 508
The Measurement of Gross Domestic Product 510
"GDP Is the Market Value..." 510
"...Of All..." 510
"...Final..." 511
"...Goods and Services..." 511
"...Produced..." 511
"...Within a Country..." 511
"...In a Given Period of Time" 511
The Components of GDP 512
Consumption 512
FYI: Other Measures of Income 513
Investment 513
Government Purchases 514
Net Exports 514
Case Study: The Components of U.S. GDP 515
Real versus Nominal GDP 515
A Numerical Example 516
The GDP Deflator 517
Case Study: Real GDP over Recent History 518
In the News: GDP Lightens Up 519
In the News: The Underground Economy 520
Is GDP a Good Measure of Economic Well-Being? 520
Case Study: International Differences in GDP and the Quality of Life 522
Case Study: Who Wins at the Olympics? 523
Conclusion 524
Summary 525
Key Concepts 525
Questions for Review 525
Problems and Applications 526
Measuring the Cost of Living 529
The Consumer Price Index 530
How the Consumer Price Index Is Calculated 530
Problems in Measuring the Cost of Living 532
FYI: What Is in the CPI's Basket? 533
In the News: Accounting for Quality Change 534
The GDP Deflator versus the Consumer Price Index 536
Correcting Economic Variables for the Effects of Inflation 538
Dollar Figures from Different Times 538
Case Study: Mr. Index Goes to Hollywood 539
Indexation 539
Real and Nominal Interest Rates 540
Case Study: Interest Rates in the U.S. Economy 541
Conclusion 542
Summary 543
Key Concepts 544
Questions for Review 544
Problems and Applications 544
The Real Economy in the Long Run 547
Production and Growth 549
Economic Growth around the World 550
FYI: A Picture Is Worth a Thousand Statistics 552
FYI: Are You Richer Than the Richest American? 554
Productivity: Its Role and Determinants 554
Why Productivity Is So Important 554
How Productivity Is Determined 555
FYI: The Production Function 557
Case Study: Are Natural Resources a Limit to Growth? 557
Economic Growth and Public Policy 558
Saving and Investment 559
Diminishing Returns and the Catch-Up Effect 559
Investment from Abroad 561
Education 562
Health and Nutrition 562
In the News: Promoting Human Capital 563
Property Rights and Political Stability 564
Free Trade 565
Research and Development 566
Population Growth 566
In the News: Rich Farmers versus the World's Poor 567
In the News: Foreign Aid 568
Conclusion: The Importance of Long-Run Growth 571
Summary 571
Key Concepts 572
Questions for Review 572
Problems and Applications 572
Saving, Investment, and the Financial System 575
Financial Institutions in the U.S. Economy 576
Financial Markets 576
Financial Intermediaries 578
FYI: How to Read the Newspaper's Stock Tables 579
Summing Up 581
Saving and Investment in the National Income Accounts 581
Some Important Identities 582
The Meaning of Saving and Investment 583
The Market for Loanable Funds 584
Supply and Demand for Loanable Funds 584
Saving Incentives 586
Investment Incentives 587
Government Budget Deficits and Surpluses 588
Case Study: The History of U.S. Government Debt 590
Conclusion 592
Summary 593
Key Concepts 593
Questions for Review 593
Problems and Applications 594
The Basic Tools of Finance 597
Present Value: Measuring the Time Value of Money 598
FYI: The Magic of Compounding and the Rule of 70 600
Managing Risk 600
Risk Aversion 600
The Markets for Insurance 601
FYI: The Peculiarities of Health Insurance 602
Diversification of Firm-Specific Risk 603
The Trade-off between Risk and Return 604
Asset Valuation 605
Fundamental Analysis 606
The Efficient Markets Hypothesis 606
Case Study: Random Walks and Index Funds 607
In the News: Nobel Caliber Investment Advice 608
Market Irrationality 609
Conclusion 609
Summary 610
Key Concepts 610
Questions for Review 610
Problems and Applications 611
Unemployment 613
Identifying Unemployment 614
How Is Unemployment Measured? 614
Case Study: Labor-Force Participation of Men and Women in the U.S. Economy 617
Does the Unemployment Rate Measure What We Want It To? 618
In the News: The Rise of Adult Male Joblessness 620
How Long Are the Unemployed without Work? 620
Why Are There Always Some People Unemployed? 622
Job Search 623
Why Some Frictional Unemployment Is Inevitable 623
Public Policy and Job Search 623
In the News: German Unemployment 624
Unemployment Insurance 626
Minimum-Wage Laws 627
FYI: Who Earns the Minimum Wage? 628
Unions and Collective Bargaining 629
The Economics of Unions 629
Are Unions Good or Bad for the Economy? 630
In the News: Should You Join a Union? 631
The Theory of Efficiency Wages 632
Worker Health 632
Worker Turnover 632
Worker Quality 633
Worker Effort 633
Case Study: Henry Ford and the Very Generous {dollar}5-a-Day Wage 634
Conclusion 634
Summary 635
Key Concepts 635
Questions for Review 636
Problems and Applications 636
Money and Prices in the Long Run 639
The Monetary System 641
The Meaning of Money 642
The Functions of Money 642
The Kinds of Money 643
In the News: The History of Money 644
Money in the U.S. Economy 645
FYI: Credit Cards, Debit Cards, and Money 647
Case Study: Where Is All the Currency? 647
The Federal Reserve System 648
The Fed's Organization 648
The Federal Open Market Committee 649
Banks and the Money Supply 650
The Simple Case of 100-Percent-Reserve Banking 650
Money Creation with Fractional-Reserve Banking 651
The Money Multiplier 652
The Fed's Tools of Monetary Control 653
Problems in Controlling the Money Supply 655
Case Study: Bank Runs and the Money Supply 655
FYI: The Federal Funds Rate 656
Conclusion 657
Summary 657
Key Concepts 658
Questions for Review 658
Problems and Applications 658
Money Growth and Inflation 661
The Classical Theory of Inflation 662
The Level of Prices and the Value of Money 662
Money Supply, Money Demand, and Monetary Equilibrium 663
The Effects of a Monetary Injection 664
A Brief Look at the Adjustment Process 665
The Classical Dichotomy and Monetary Neutrality 667
Velocity and the Quantity Equation 668
Case Study: Money and Prices during Four Hyperinflations 670
The Inflation Tax 671
In the News: The German Hyperinflation 672
The Fisher Effect 673
The Costs of Inflation 675
A Fall in Purchasing Power? The Inflation Fallacy 676
Shoeleather Costs 676
Menu Costs 677
Relative-Price Variability and the Misallocation of Resources 678
Inflation-Induced Tax Distortions 678
Confusion and Inconvenience 680
A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth 680
Case Study: The Wizard of Oz and the Free-Silver Debate 681
In the News: How to Protect Your Savings from Inflation 682
Conclusion 684
Summary 685
Key Concepts 685
Questions for Review 685
Problems and Applications 686
The Macroeconomics of Open Economies 689
Open-Economy Macroeconomics: Basic Concepts 691
The International Flows of Goods and Capital 692
The Flow of Goods: Exports, Imports, and Net Exports 692
Case Study: The Increasing Openness of the U.S. Economy 693
The Flow of Financial Resources: Net Capital Outflow 694
The Equality of Net Exports and Net Capital Outflow 695
Saving, Investment, and Their Relationship to the International Flows 696
In the News: Americans Rely on Capital Flows from Abroad 697
Summing Up 698
Case Study: Is the U.S. Trade Deficit a National Problem? 699
The Prices for International Transactions: Real and Nominal Exchange Rates 701
Nominal Exchange Rates 701
Real Exchange Rates 702
FYI: The Euro 703
A First Theory of Exchange-Rate Determination: Purchasing-Power Parity 704
The Basic Logic of Purchasing-Power Parity 705
Implications of Purchasing-Power Parity 705
Case Study: The Nominal Exchange Rate during a Hyperinflation 707
In the News: The Starbucks Index 708
Limitations of Purchasing-Power Parity 708
Case Study: The Hamburger Standard 710
Conclusion 711
Summary 711
Key Concepts 711
Questions for Review 712
Problems and Applications 712
A Macroeconomic Theory of the Open Economy 715
Supply and Demand for Loanable Funds and for Foreign-Currency Exchange 716
The Market for Loanable Funds 716
The Market for Foreign-Currency Exchange 718
FYI: Purchasing-Power Parity as a Special Case 720
Equilibrium in the Open Economy 720
Net Capital Outflow: The Link between the Two Markets 720
Simultaneous Equilibrium in Two Markets 721
FYI: Disentangling Supply and Demand 723
How Policies and Events Affect an Open Economy 724
Government Budget Deficits 724
In the News: The U.S. Trade Deficit 726
Trade Policy 727
Political Instability and Capital Flight 729
Case Study: Could Capital Flee from the United States? 731
Conclusion 732
Summary 733
Key Concepts 733
Questions for Review 734
Problems and Application 734
Short-Run Economic Fluctuations 737
Aggregate Demand and Aggregate Supply 739
Three Key Facts about Economic Fluctuations 740
Economic Fluctuations Are Irregular and Unpredictable 740
Most Macroeconomic Quantities Fluctuate Together 740
As Output Falls, Unemployment Rises 742
Explaining Short-Run Economic Fluctuations 742
The Assumptions of Classical Economics 742
In the News: Offbeat Indicators 743
The Reality of Short-Run Fluctuations 744
The Model of Aggregate Demand and Aggregate Supply 744
The Aggregate-Demand Curve 746
Why the Aggregate-Demand Curve Slopes Downward 746
Why the Aggregate-Demand Curve Might Shift 749
The Aggregate-Supply Curve 750
Why the Aggregate-Supply Curve Is Vertical in the Long Run 751
Why the Long-Run Aggregate-Supply Curve Might Shift 752
Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation 754
Why the Aggregate-Supply Curve Slopes Upward in the Short Run 755
Why the Short-Run Aggregate-Supply Curve Might Shift 758
Two Causes of Economic Fluctuations 760
The Effects of a Shift in Aggregate Demand 761
FYI: Monetary Neutrality Revisited 763
Case Study: Two Big Shifts in Aggregate Demand: The Great Depression and World War II 764
Case Study: The Recession of 2001 765
FYI: The Origins of Aggregate Demand and Aggregate Supply 766
The Effects of a Shift in Aggregate Supply 767
Case Study: Oil and the Economy 769
FYI: The Macroeconomic Impact of Hurricane Katrina 770
Conclusion 771
Summary 771
Key Concepts 772
Questions for Review 772
Problems and Applications 773
The Influence of Monetary and Fiscal Policy on Aggregate Demand 777
How Monetary Policy Influences Aggregate Demand 778
The Theory of Liquidity Preference 779
The Downward Slope of the Aggregate-Demand Curve 781
FYI: Interest Rates in the Long Run and the Short Run 782
Changes in the Money Supply 784
The Role of Interest-Rate Targets in Fed Policy 785
Case Study: Why the Fed Watches the Stock Market (and Vice Versa) 786
How Fiscal Policy Influences Aggregate Demand 787
Changes in Government Purchases 787
The Multiplier Effect 787
A Formula for the Spending Multiplier 788
Other Applications of the Multiplier Effect 789
The Crowding-Out Effect 790
Changes in Taxes 791
FYI: How Fiscal Policy Might Affect Aggregate Supply 792
Using Policy to Stabilize the Economy 793
The Case for Active Stabilization Policy 793
Case Study: Keynesians in the White House 794
The Case against Active Stabilization Policy 795
Automatic Stabilizers 796
Conclusion 796
Summary 797
Key Concepts 797
Questions for Review 798
Problems and Applications 798
The Short-Run Trade-Off Between Inflation and Unemployment 801
The Phillips Curve 802
Origins of the Phillips Curve 802
Aggregate Demand, Aggregate Supply, and the Phillips Curve 803
Shifts in the Phillips Curve: The Role of Expectations 805
The Long-Run Phillips Curve 805
The Meaning of "Natural" 808
Reconciling Theory and Evidence 808
The Short-Run Phillips Curve 809
The Natural Experiment for the Natural-Rate Hypothesis 811
In the News: How to Keep Expected Inflation Low 813
Shifts in the Phillips Curve: The Role of Supply Shocks 814
The Cost of Reducing Inflation 816
The Sacrifice Ratio 817
Rational Expectations and the Possibility of Costless Disinflation 818
The Volcker Disinflation 819
The Greenspan Era 821
In the News: The Case for Inflation Targeting 822
Case Study: Why Were Inflation and Unemployment So Low at the End of the 1990s? 822
Conclusion 824
Summary 825
Key Concepts 826
Questions for Review 826
Problems and Applications 827
Final Thoughts 831
Five Debates Over Macroeconomic Policy 833
Should Monetary and Fiscal Policymakers Try to Stabilize the Economy? 834
Pro: Policymakers Should Try to Stabilize the Economy 834
Con: Policymakers Should Not Try to Stabilize the Economy 834
In the News: The Fine-Tuning of George W. Bush 836
Should Monetary Policy Be Made by Rule Rather Than by Discretion? 836
Pro: Monetary Policy Should Be Made by Rule 837
In the News: Inflation Targeting as a Rule for Monetary Policy 838
Con: Monetary Policy Should Not Be Made by Rule 840
Should the Central Bank Aim for Zero Inflation? 841
Pro: The Central Bank Should Aim for Zero Inflation 841
Con: The Central Bank Should Not Aim for Zero Inflation 842
In the News: The Optimal Rate of Inflation 843
Should the Government Balance Its Budget? 844
Pro: The Government Should Balance Its Budget 844
Con: The Government Should Not Balance Its Budget 845
In the News: Dealing with Deficits 846
Should the Tax Laws Be Reformed to Encourage Saving? 848
Pro: The Tax Laws Should Be Reformed to Encourage Saving 848
In the News: Tax Reform 850
Con: The Tax Laws Should Not Be Reformed to Encourage Saving 850
Conclusion 851
Summary 852
Questions for Review 853
Problems and Applications 853
Quick Quiz Answers 857
Glossary 873
Index 879