- •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
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12 months, M1 had grown at an extremely high 12-percent rate, while M2 had grown at an extremely low 0.5-percent rate. Depending on how much weight was given to each of these two measures, monetary policy was either very loose, very tight, or somewhere in between.
Since then, the Fed has conducted policy by setting a target for the federal funds rate, the short-term interest rate at which banks make loans to one another. It adjusts the target interest rate in response to changing economic conditions. Under such a policy, the money supply becomes endogenous: it is allowed to adjust to whatever level is necessary to keep the interest rate on target. Chapter 14 presented a dynamic model of aggregate demand and aggregate supply in which an interest rate rule for the central bank is explicitly incorporated into the analysis of short-run economic fluctuations.
19-3 Conclusion
Money is at the heart of much macroeconomic analysis. Models of money supply and money demand can help shed light on the long-run determinants of the price level and the short-run causes of economic fluctuations. The rise of near money in recent years has shown that there is still much to be learned. Building reliable microeconomic models of money and near money remains a central challenge for macroeconomists.
Summary
1.The system of fractional-reserve banking creates money, because each dollar of reserves generates many dollars of demand deposits.
2.The supply of money depends on the monetary base, the reserve–deposit ratio, and the currency–deposit ratio. An increase in the monetary base leads to a proportionate increase in the money supply. A decrease in the reserve–deposit ratio or in the currency–deposit ratio increases the money multiplier and thus the money supply.
3.The Federal Reserve changes the money supply using three policy instruments. It can increase the monetary base by making an open-market purchase of bonds or by lowering the discount rate. It can reduce the reserve–deposit ratio by relaxing reserve requirements.
4.To start a bank, the owners must contribute some of their own financial resources, which become the bank’s capital. Because banks are highly leveraged, however, a small decline in the value of their assets can potentially have a major impact on the value of bank capital. Bank regulators require that banks hold sufficient capital to ensure that depositors can be repaid.
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5.Portfolio theories of money demand stress the role of money as a store of value. They predict that the demand for money depends on the risk and return on money and alternative assets.
6.Transactions theories of money demand, such as the Baumol–Tobin model, stress the role of money as a medium of exchange. They predict that the demand for money depends positively on expenditure and negatively on the interest rate.
7.Financial innovation has led to the creation of assets with many of the attributes of money. These near moneys make the demand for money less stable, which complicates the conduct of monetary policy.
K E Y C O N C E P T S
Reserves |
Money multiplier |
Capital requirement |
100-percent-reserve banking |
High-powered money |
Portfolio theories |
Balance sheet |
Open-market operations |
Dominated asset |
Fractional-reserve banking |
Reserve requirements |
Transactions theories |
Financial intermediation |
Discount rate |
Baumol–Tobin model |
Monetary base |
Excess reserves |
Near money |
Reserve–deposit ratio |
Bank capital |
|
Currency–deposit ratio |
Leverage |
|
Q U E S T I O N S F O R R E V I E W
1.Explain how banks create money.
2.What are the three ways in which the Federal Reserve can influence the money supply?
3.Why might a banking crisis lead to a fall in the money supply?
4.Explain the difference between portfolio and transactions theories of money demand.
5.According to the Baumol–Tobin model, what determines how often people go to the bank? What does this decision have to do with money demand?
6.In what way does the existence of near money complicate the conduct of monetary policy? How has the Federal Reserve responded to this complication?
P R O B L E M S A N D A P P L I C A T I O N S
1.The money supply fell from 1929 to 1933 because both the currency–deposit ratio and the reserve–deposit ratio increased. Use the model of the money supply and the data in Table 19-1 to answer the following hypothetical questions about this episode.
a.What would have happened to the money supply if the currency–deposit ratio had risen but the reserve–deposit ratio had remained the same?
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b.What would have happened to the money supply if the reserve–deposit ratio had risen but the currency–deposit ratio had remained the same?
c.Which of the two changes was more responsible for the fall in the money supply?
2.To increase tax revenue, the U.S. government in 1932 imposed a two-cent tax on checks written on deposits in bank accounts. (In today’s dollars, this tax was about 25 cents per check.)
a.How do you think the check tax affected the currency–deposit ratio? Explain.
b.Use the model of the money supply under fractional-reserve banking to discuss how this tax affected the money supply.
c.Now use the IS–LM model to discuss the impact of this tax on the economy. Was the check tax a good policy to implement in the middle of the Great Depression?
3.Give an example of a bank balance sheet with a leverage ratio of 10. If the value of the bank’s assets rises by 5 percent, what happens to the value of the owners’ equity in this bank? How large a decline in the value of bank assets would it take to reduce this bank’s capital to zero?
4.Suppose that an epidemic of street crime sweeps the country, making it more likely that your wallet will be stolen. Using the Baumol–Tobin model, explain (in words, not equations) how this crime wave will affect the optimal frequency of trips to the bank and the demand for money.
5.Let’s see what the Baumol–Tobin model says about how often you should go to the bank to withdraw cash.
a.How much do you buy per year with currency (as opposed to checks or credit cards)? This is your value of Y.
b.How long does it take you to go to the bank? What is your hourly wage? Use these two figures to compute your value of F.
c.What interest rate do you earn on the money you leave in your bank account? This is your value of i. (Be sure to write i in decimal form—that is, 6 percent should be expressed 0.06.)
d.According to the Baumol–Tobin model, how many times should you go to the bank each year, and how much should you withdraw each time?
e.In practice, how often do you go to the bank, and how much do you withdraw?
f.Compare the predictions of the Baumol–Tobin model to your behavior. Does the model describe how you actually behave? If not, why not? How would you change the model to make it a better description of your behavior?
6.In Chapter 4, we defined the velocity of money as the ratio of nominal expenditure to the quantity of money. Let’s now use the Baumol–Tobin model to examine what determines velocity.
a.Recalling that average money holdings equal Y/(2N ), write velocity as a function of the number of trips to the bank N. Explain your result.
b.Use the formula for the optimal number of trips to express velocity as a function of expenditure Y, the interest rate i, and the cost of a trip to the bank F.
c.What happens to velocity when the interest rate rises? Explain.
d.What happens to velocity when the price level rises? Explain.
e.As the economy grows, what should happen to the velocity of money? (Hint: Think about how economic growth will influence Y and F.)
f.Suppose now that the number of trips to the bank is fixed rather than discretionary. What does this assumption imply about velocity?
E P I L O G U E
What We Know, What We Don’t
If all economists were laid end to end, they would not reach a conclusion.
—George Bernard Shaw
The theory of economics does not furnish a body of settled conclusions
immediately applicable to policy. It is a method rather than a doctrine, an
apparatus of the mind, which helps its possessor to draw correct conclusions.
—John Maynard Keynes
The first chapter of this book states that the purpose of macroeconomics is to understand economic events and to improve economic policy. Now that we have developed and used many of the most important models in
the macroeconomist’s toolbox, we can assess whether macroeconomists have achieved these goals.
Any fair assessment of macroeconomics today must admit that the science is incomplete. There are some principles that almost all macroeconomists accept and on which we can rely when trying to analyze events or formulate policies. Yet there are also many questions about the economy that remain open to debate. In this last chapter, we briefly review the central lessons of macroeconomics, and we discuss the most pressing unresolved questions.
The Four Most Important Lessons
of Macroeconomics
We begin with four lessons that have recurred throughout this book and that most economists today would endorse. Each lesson tells us how policy can influence a key economic variable—output, inflation, or unemployment—either in the long run or in the short run.
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