- •About the author
- •Brief Contents
- •Contents
- •Preface
- •This Book’s Approach
- •What’s New in the Seventh Edition?
- •The Arrangement of Topics
- •Part One, Introduction
- •Part Two, Classical Theory: The Economy in the Long Run
- •Part Three, Growth Theory: The Economy in the Very Long Run
- •Part Four, Business Cycle Theory: The Economy in the Short Run
- •Part Five, Macroeconomic Policy Debates
- •Part Six, More on the Microeconomics Behind Macroeconomics
- •Epilogue
- •Alternative Routes Through the Text
- •Learning Tools
- •Case Studies
- •FYI Boxes
- •Graphs
- •Mathematical Notes
- •Chapter Summaries
- •Key Concepts
- •Questions for Review
- •Problems and Applications
- •Chapter Appendices
- •Glossary
- •Translations
- •Acknowledgments
- •Supplements and Media
- •For Instructors
- •Instructor’s Resources
- •Solutions Manual
- •Test Bank
- •PowerPoint Slides
- •For Students
- •Student Guide and Workbook
- •Online Offerings
- •EconPortal, Available Spring 2010
- •eBook
- •WebCT
- •BlackBoard
- •Additional Offerings
- •i-clicker
- •The Wall Street Journal Edition
- •Financial Times Edition
- •Dismal Scientist
- •1-1: What Macroeconomists Study
- •1-2: How Economists Think
- •Theory as Model Building
- •The Use of Multiple Models
- •Prices: Flexible Versus Sticky
- •Microeconomic Thinking and Macroeconomic Models
- •1-3: How This Book Proceeds
- •Income, Expenditure, and the Circular Flow
- •Rules for Computing GDP
- •Real GDP Versus Nominal GDP
- •The GDP Deflator
- •Chain-Weighted Measures of Real GDP
- •The Components of Expenditure
- •Other Measures of Income
- •Seasonal Adjustment
- •The Price of a Basket of Goods
- •The CPI Versus the GDP Deflator
- •The Household Survey
- •The Establishment Survey
- •The Factors of Production
- •The Production Function
- •The Supply of Goods and Services
- •3-2: How Is National Income Distributed to the Factors of Production?
- •Factor Prices
- •The Decisions Facing the Competitive Firm
- •The Firm’s Demand for Factors
- •The Division of National Income
- •The Cobb–Douglas Production Function
- •Consumption
- •Investment
- •Government Purchases
- •Changes in Saving: The Effects of Fiscal Policy
- •Changes in Investment Demand
- •3-5: Conclusion
- •4-1: What Is Money?
- •The Functions of Money
- •The Types of Money
- •The Development of Fiat Money
- •How the Quantity of Money Is Controlled
- •How the Quantity of Money Is Measured
- •4-2: The Quantity Theory of Money
- •Transactions and the Quantity Equation
- •From Transactions to Income
- •The Assumption of Constant Velocity
- •Money, Prices, and Inflation
- •4-4: Inflation and Interest Rates
- •Two Interest Rates: Real and Nominal
- •The Fisher Effect
- •Two Real Interest Rates: Ex Ante and Ex Post
- •The Cost of Holding Money
- •Future Money and Current Prices
- •4-6: The Social Costs of Inflation
- •The Layman’s View and the Classical Response
- •The Costs of Expected Inflation
- •The Costs of Unexpected Inflation
- •One Benefit of Inflation
- •4-7: Hyperinflation
- •The Costs of Hyperinflation
- •The Causes of Hyperinflation
- •4-8: Conclusion: The Classical Dichotomy
- •The Role of Net Exports
- •International Capital Flows and the Trade Balance
- •International Flows of Goods and Capital: An Example
- •Capital Mobility and the World Interest Rate
- •Why Assume a Small Open Economy?
- •The Model
- •How Policies Influence the Trade Balance
- •Evaluating Economic Policy
- •Nominal and Real Exchange Rates
- •The Real Exchange Rate and the Trade Balance
- •The Determinants of the Real Exchange Rate
- •How Policies Influence the Real Exchange Rate
- •The Effects of Trade Policies
- •The Special Case of Purchasing-Power Parity
- •Net Capital Outflow
- •The Model
- •Policies in the Large Open Economy
- •Conclusion
- •Causes of Frictional Unemployment
- •Public Policy and Frictional Unemployment
- •Minimum-Wage Laws
- •Unions and Collective Bargaining
- •Efficiency Wages
- •The Duration of Unemployment
- •Trends in Unemployment
- •Transitions Into and Out of the Labor Force
- •6-5: Labor-Market Experience: Europe
- •The Rise in European Unemployment
- •Unemployment Variation Within Europe
- •The Rise of European Leisure
- •6-6: Conclusion
- •7-1: The Accumulation of Capital
- •The Supply and Demand for Goods
- •Growth in the Capital Stock and the Steady State
- •Approaching the Steady State: A Numerical Example
- •How Saving Affects Growth
- •7-2: The Golden Rule Level of Capital
- •Comparing Steady States
- •The Transition to the Golden Rule Steady State
- •7-3: Population Growth
- •The Steady State With Population Growth
- •The Effects of Population Growth
- •Alternative Perspectives on Population Growth
- •7-4: Conclusion
- •The Efficiency of Labor
- •The Steady State With Technological Progress
- •The Effects of Technological Progress
- •Balanced Growth
- •Convergence
- •Factor Accumulation Versus Production Efficiency
- •8-3: Policies to Promote Growth
- •Evaluating the Rate of Saving
- •Changing the Rate of Saving
- •Allocating the Economy’s Investment
- •Establishing the Right Institutions
- •Encouraging Technological Progress
- •The Basic Model
- •A Two-Sector Model
- •The Microeconomics of Research and Development
- •The Process of Creative Destruction
- •8-5: Conclusion
- •Increases in the Factors of Production
- •Technological Progress
- •The Sources of Growth in the United States
- •The Solow Residual in the Short Run
- •9-1: The Facts About the Business Cycle
- •GDP and Its Components
- •Unemployment and Okun’s Law
- •Leading Economic Indicators
- •9-2: Time Horizons in Macroeconomics
- •How the Short Run and Long Run Differ
- •9-3: Aggregate Demand
- •The Quantity Equation as Aggregate Demand
- •Why the Aggregate Demand Curve Slopes Downward
- •Shifts in the Aggregate Demand Curve
- •9-4: Aggregate Supply
- •The Long Run: The Vertical Aggregate Supply Curve
- •From the Short Run to the Long Run
- •9-5: Stabilization Policy
- •Shocks to Aggregate Demand
- •Shocks to Aggregate Supply
- •10-1: The Goods Market and the IS Curve
- •The Keynesian Cross
- •The Interest Rate, Investment, and the IS Curve
- •How Fiscal Policy Shifts the IS Curve
- •10-2: The Money Market and the LM Curve
- •The Theory of Liquidity Preference
- •Income, Money Demand, and the LM Curve
- •How Monetary Policy Shifts the LM Curve
- •Shocks in the IS–LM Model
- •From the IS–LM Model to the Aggregate Demand Curve
- •The IS–LM Model in the Short Run and Long Run
- •11-3: The Great Depression
- •The Spending Hypothesis: Shocks to the IS Curve
- •The Money Hypothesis: A Shock to the LM Curve
- •Could the Depression Happen Again?
- •11-4: Conclusion
- •12-1: The Mundell–Fleming Model
- •The Goods Market and the IS* Curve
- •The Money Market and the LM* Curve
- •Putting the Pieces Together
- •Fiscal Policy
- •Monetary Policy
- •Trade Policy
- •How a Fixed-Exchange-Rate System Works
- •Fiscal Policy
- •Monetary Policy
- •Trade Policy
- •Policy in the Mundell–Fleming Model: A Summary
- •12-4: Interest Rate Differentials
- •Country Risk and Exchange-Rate Expectations
- •Differentials in the Mundell–Fleming Model
- •Pros and Cons of Different Exchange-Rate Systems
- •The Impossible Trinity
- •12-6: From the Short Run to the Long Run: The Mundell–Fleming Model With a Changing Price Level
- •12-7: A Concluding Reminder
- •Fiscal Policy
- •Monetary Policy
- •A Rule of Thumb
- •The Sticky-Price Model
- •Implications
- •Adaptive Expectations and Inflation Inertia
- •Two Causes of Rising and Falling Inflation
- •Disinflation and the Sacrifice Ratio
- •13-3: Conclusion
- •14-1: Elements of the Model
- •Output: The Demand for Goods and Services
- •The Real Interest Rate: The Fisher Equation
- •Inflation: The Phillips Curve
- •Expected Inflation: Adaptive Expectations
- •The Nominal Interest Rate: The Monetary-Policy Rule
- •14-2: Solving the Model
- •The Long-Run Equilibrium
- •The Dynamic Aggregate Supply Curve
- •The Dynamic Aggregate Demand Curve
- •The Short-Run Equilibrium
- •14-3: Using the Model
- •Long-Run Growth
- •A Shock to Aggregate Supply
- •A Shock to Aggregate Demand
- •A Shift in Monetary Policy
- •The Taylor Principle
- •14-5: Conclusion: Toward DSGE Models
- •15-1: Should Policy Be Active or Passive?
- •Lags in the Implementation and Effects of Policies
- •The Difficult Job of Economic Forecasting
- •Ignorance, Expectations, and the Lucas Critique
- •The Historical Record
- •Distrust of Policymakers and the Political Process
- •The Time Inconsistency of Discretionary Policy
- •Rules for Monetary Policy
- •16-1: The Size of the Government Debt
- •16-2: Problems in Measurement
- •Measurement Problem 1: Inflation
- •Measurement Problem 2: Capital Assets
- •Measurement Problem 3: Uncounted Liabilities
- •Measurement Problem 4: The Business Cycle
- •Summing Up
- •The Basic Logic of Ricardian Equivalence
- •Consumers and Future Taxes
- •Making a Choice
- •16-5: Other Perspectives on Government Debt
- •Balanced Budgets Versus Optimal Fiscal Policy
- •Fiscal Effects on Monetary Policy
- •Debt and the Political Process
- •International Dimensions
- •16-6: Conclusion
- •Keynes’s Conjectures
- •The Early Empirical Successes
- •The Intertemporal Budget Constraint
- •Consumer Preferences
- •Optimization
- •How Changes in Income Affect Consumption
- •Constraints on Borrowing
- •The Hypothesis
- •Implications
- •The Hypothesis
- •Implications
- •The Hypothesis
- •Implications
- •17-7: Conclusion
- •18-1: Business Fixed Investment
- •The Rental Price of Capital
- •The Cost of Capital
- •The Determinants of Investment
- •Taxes and Investment
- •The Stock Market and Tobin’s q
- •Financing Constraints
- •Banking Crises and Credit Crunches
- •18-2: Residential Investment
- •The Stock Equilibrium and the Flow Supply
- •Changes in Housing Demand
- •18-3: Inventory Investment
- •Reasons for Holding Inventories
- •18-4: Conclusion
- •19-1: Money Supply
- •100-Percent-Reserve Banking
- •Fractional-Reserve Banking
- •A Model of the Money Supply
- •The Three Instruments of Monetary Policy
- •Bank Capital, Leverage, and Capital Requirements
- •19-2: Money Demand
- •Portfolio Theories of Money Demand
- •Transactions Theories of Money Demand
- •The Baumol–Tobin Model of Cash Management
- •19-3 Conclusion
- •Lesson 2: In the short run, aggregate demand influences the amount of goods and services that a country produces.
- •Question 1: How should policymakers try to promote growth in the economy’s natural level of output?
- •Question 2: Should policymakers try to stabilize the economy?
- •Question 3: How costly is inflation, and how costly is reducing inflation?
- •Question 4: How big a problem are government budget deficits?
- •Conclusion
- •Glossary
- •Index
C H A P T E R 1 4 A Dynamic Model of Aggregate Demand and Aggregate Supply | 439
14-5 Conclusion: Toward DSGE Models
If you go on to take more advanced courses in macroeconomics, you will likely learn about a class of models called dynamic, stochastic, general equilibrium models, often abbreviated as DSGE models. These models are dynamic because they trace the path of variables over time. They are stochastic because they incorporate the inherent randomness of economic life. They are general equilibrium because they take into account the fact that everything depends on everything else. In many ways, they are the state-of-the-art models in the analysis of shortrun economic fluctuations.
The dynamic AD –AS model we have presented in this chapter is a simplified version of these DSGE models. Unlike analysts using advanced DSGE models, we have not started with the household and firm optimizing decisions that underlie the macroeconomic relationships. But the macro relationships that this chapter has posited are similar to those found in more sophisticated DSGE models. The dynamic AD –AS model is a good stepping-stone between the basic model of aggregate demand and aggregate supply we saw in earlier chapters and the more complex DSGE models you might see in a more advanced course.
The dynamic AD –AS model also yields some important lessons. It shows how various macroeconomic variables—output, inflation, and real and nominal interest rates—respond to shocks and interact with one another over time. It demonstrates that, in the design of monetary policy, central banks face a tradeoff between variability in inflation and variability in output. Finally, it suggests that central banks need to respond vigorously to inflation to prevent it from getting out of control. If you ever find yourself running a central bank, these are good lessons to keep in mind.
Summary
1.The dynamic model of aggregate demand and aggregate supply combines five economic relationships: an equation for the goods market, which relates quantity demanded to the real interest rate; the Fisher equation, which relates real and nominal interest rates; the Phillips curve equation, which determines inflation; an equation for expected inflation; and a rule for monetary policy, according to which the central bank sets the nominal interest rate as a function of inflation and output.
2.The long-run equilibrium of the model is classical. Output and the real interest rate are at their natural levels, independent of monetary policy. The central bank’s inflation target determines inflation, expected inflation, and the nominal interest rate.
440 | P A R T I V Business Cycle Theory: The Economy in the Short Run
3.The dynamic AD –AS model can be used to determine the immediate impact on the economy of any shock and can also be used to trace out the effects of the shock over time.
4.Because the parameters of the monetary-policy rule influence the slope of the dynamic aggregate demand curve, they determine whether a supply shock has a greater effect on output or inflation. When choosing the parameters for monetary policy, a central bank faces a tradeoff between output variability and inflation variability.
5.The dynamic AD –AS model typically assumes that the central bank responds to a 1-percentage-point increase in inflation by increasing the nominal interest rate by more than 1 percentage point, so the real interest rate rises as well. If the central bank responds less vigorously to inflation, the economy becomes unstable. A shock can send inflation spiraling out of control.
K E Y C O N C E P T S
Taylor rule |
Taylor principle |
Q U E S T I O N S F O R R E V I E W
1.On a carefully labeled graph, draw the dynamic aggregate supply curve. Explain why it has the slope it has.
2.On a carefully labeled graph, draw the dynamic aggregate demand curve. Explain why it has the slope it has.
3.A central bank has a new head, who decides to raise the target inflation rate from 2 to 3 percent. Using a graph of the dynamic AD –AS model, show the effect of this change. What
happens to the nominal interest rate immediately upon the change in policy and in the long run? Explain.
4.A central bank has a new head, who decides to increase the response of interest rates to inflation. How does this change in policy alter the response of the economy to a supply shock? Give both a graphical answer and a more intuitive economic explanation.
P R O B L E M S A N D A P P L I C A T I O N S
1.Derive the long-run equilibrium for the
dynamic AD –AS model. Assume there are no
shocks to demand or supply (et = ut = 0) and inflation has stabilized (pt = pt −1), and then use
the five equations to derive the value of each variable in the model. Be sure to show each step you follow.
C H A P T E R 1 4 A Dynamic Model of Aggregate Demand and Aggregate Supply | 441
2. Suppose the monetary-policy rule has the wrong natural rate of interest. That is, the central bank follows this rule:
i = p + r' + vp(p − p*) +
t t t t
where r' does not equal r, the natural rate of interest in the equation for goods demand. The rest of the dynamic AD –AS model is the same as in the chapter. Solve for the long-run equilibrium under this policy rule. Explain in words the intuition behind your solution.
3.“If a central bank wants to achieve lower nominal interest rates, it has to raise the nominal interest rate.” Explain in what way this statement makes sense.
4.The sacrifice ratio is the accumulated loss in output that results when the central bank lowers its target for inflation by 1 percentage point. For the parameters used in the text simulation, what is the implied sacrifice ratio? Explain.
5.The text analyzes the case of a temporary shock to the demand for goods and services.
Suppose, however, that et were to increase permanently. What would happen to the econo-
my over time? In particular, would the inflation rate return to its target in the long run? Why or why not? (Hint: It might be helpful to solve for the long-run equilibrium
without the assumption that et equals zero.) How might the central bank alter its policy
rule to deal with this issue?
6.Suppose a central bank does not satisfy the Tay-
lor principle; that is, vp is less than zero. Use a graph to analyze the impact of a supply shock.
Does this analysis contradict or reinforce the Taylor principle as a guideline for the design of monetary policy?
7.The text assumes that the natural rate of interest r is a constant parameter. Suppose instead that it varies over time, so now it has to be written as rt.
a.How would this change affect the equations for dynamic aggregate demand and dynamic aggregate supply?
b.How would a shock to rt affect output, inflation, the nominal interest rate, and the real interest rate?
c.Can you see any practical difficulties that a central bank might face if rt varied over time?
8.Suppose that people’s expectations of inflation are subject to random shocks. That is, instead of being merely adaptive, expected inflation in
period t, as seen in period t − 1, is Et–1pt = pt–1 + ht–1, where ht–1 is a random shock. This shock is normally zero, but it deviates from zero when some event beyond past inflation causes
expected inflation to change. Similarly, Etpt+1 =
pt + ht.
a.Derive the two equations for dynamic aggregate demand and dynamic aggregate supply in this slightly more general model.
b.Suppose that the economy experiences an inflation scare. That is, in period t, for some
reason people come to believe that inflation in period t + 1 is going to be higher, so ht is greater than zero (for this period only). What
happens to the DAD and DAS curves in period t? What happens to output, inflation, and nominal and real interest rates in that period? Explain.
c.What happens to the DAD and DAS curves in period t + 1? What happens to output,
inflation, and nominal and real interest rates in that period? Explain.
d.What happens to the economy in subsequent periods?
e.In what sense are inflation scares self-fulfilling?
9.Use the dynamic AD –AS model to solve for inflation as a function of only lagged inflation and the supply and demand shocks. (Assume target inflation is a constant.)
a.According to the equation you have derived, does inflation return to its target after a shock? Explain. (Hint: Look at the coefficient on lagged inflation.)
b.Suppose the central bank does not respond
to changes in output but only to changes
in inflation, so that vY = 0. How, if at all, would this fact change your answer to
part (a)?
442 | P A R T I V Business Cycle Theory: The Economy in the Short Run
c.Suppose the central bank does not respond
to changes in inflation but only to changes
in output, so that vp = 0. How, if at all, would this fact change your answer to
part (a)?
d.Suppose the central bank does not follow the Taylor principle but instead raises the
nominal interest rate only 0.8 percentage point for each percentage-point increase in inflation. In this case, what is vp? How does a shock to demand or supply influence the path of inflation?
P A R T V
Macroeconomic
Policy Debates
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C H A P T E R 15
Stabilization Policy
The Federal Reserve’s job is to take away the punch bowl just as the party gets
going.
—William McChesney Martin
What we need is not a skilled monetary driver of the economic vehicle
continuously turning the steering wheel to adjust to the unexpected
irregularities of the route, but some means of keeping the monetary passenger
who is in the back seat as ballast from occasionally leaning over and giving the
steering wheel a jerk that threatens to send the car off the road.
—Milton Friedman
How should government policymakers respond to the business cycle? The two quotations above—the first from a former chairman of the Federal Reserve, the second from a prominent critic of the Fed—show the
diversity of opinion over how this question is best answered.
Some economists, such as William McChesney Martin, view the economy as inherently unstable. They argue that the economy experiences frequent shocks to aggregate demand and aggregate supply. Unless policymakers use monetary and fiscal policy to stabilize the economy, these shocks will lead to unnecessary and inefficient fluctuations in output, unemployment, and inflation. According to the popular saying, macroeconomic policy should “lean against the wind,’’ stimulating the economy when it is depressed and slowing the economy when it is overheated.
Other economists, such as Milton Friedman, view the economy as naturally stable. They blame bad economic policies for the large and inefficient fluctuations we have sometimes experienced. They argue that economic policy should not try to fine-tune the economy. Instead, economic policymakers should admit their limited abilities and be satisfied if they do no harm.
This debate has persisted for decades, with numerous protagonists advancing various arguments for their positions. It became especially relevant as economies around the world sank into recession in 2008. The fundamental issue is how
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