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CHAPTER 1
Introduction to Macroeconomics
1-1 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• How much richer are we than our
parents?
• How much richer will our children be
than our grandparents were?
• Will changing jobs be easy or hard in
five years?
• How many of us will have jobs in five
years?
Questions
• Will the businesses we work for
vanish as demand for the products
they make dries up?
• Will inflation make us poor by
destroying our savings or rich by
eliminating our debts?
Macroeconomics...
• is the subdiscipline of economics

that tries to answer these six
questions
• is the branch of economics related

to the economy as a whole
Macroeconomists...
• try to figure out why overall economic
activity rises and falls
• try to understand what determines
the level and rate of change of the
price level
• study other variables that play a
major role in determining the overall
levels of production, income,
employment, and prices
Why Macroeconomics Matters
• Cultural Literacy
– ability to follow and participate in public
debates and discussions
– understanding of news reports on

changes in the economy
Figure 1.1 - The Daily Flow of Economic
News
• Self-Interest
– effects of macroeconomy on our daily
lives
– understanding of changing opportunities

as the economy fluctuates
• Civic Responsibility
– more informed voting
– more responsible macroeconomic policy
Macroeconomic Policy
• Growth Policy
– policies to accelerate or decelerate long-
run economic growth
– most important policies for the long-run
Figure 1.2 - Long-Run Economic Growth:
Sweden and Argentina, 1900-2000
Macroeconomic Policy
• Stabilization Policy
– policies to smooth out the business cycle
by diminishing the depth of recessions
and depressions
– business cycles are fluctuations in
production and employment
• booms or expansions occur when
production grows and unemployment falls
• recessions or depressions occur when
production falls and unemployment rises
Figure 1.3 - The American Business Cycle:
Fluctuations in Total Production Relative to the
Long-Run Growth Trend
Macroeconomics versus
Microeconomics
• Macroeconomists
– examine the economy as a whole
– focus on the feedback from one
component of the economy to another
– study the total level of production and
employment
– believe that imbalances between supply
and demand may be resolved by changes
in quantities rather than prices
Macroeconomics versus
Microeconomics
• Microeconomists
– study the markets for single commodities
and the behavior of individual households
and firms
– focus on how competitive markets allocate
resources to create consumer and producer
surplus
– assume that imbalances between demand
and supply are resolved by changes in
prices
Economic Statistics and
Economic Activity
• Economic activity is the pattern of
transactions in which things of real,
useful value are created, transformed,
and exchanged.
• National Income and Product Accounts

(NIPA)
– reported by the U.S. Commerce
Department’s Bureau of Economic
Analysis
Table 1.2 - The Flow of Economic Data,
2000-2001
Six Key Economic Variables
• Real Gross Domestic Product (GDP)
– is corrected for changes in the price level
(real)
– includes the replacement of worn-out
and obsolete equipment and structures
as well as new investment (gross)
– counts economic activity that happens in
the United States (domestic)
– represents the production of final goods
and services (product)
• Real Gross Domestic Product
– often divided by the number of workers
in the economy
– measures how well the economy
produces goods and services that people
find useful
– does not indicate the relative distribution
of the nation’s economic product
– is an imperfect measure of economic
well-being
Figure 1.4 - Officially Measured Real GDP
per Worker in the United States
• The Unemployment Rate
– to be unemployed, a person must want
to work and be actively looking for a job
(but have not yet found one)
– the labor force consists of those who
are employed and those who are
unemployed
– the unemployment rate is equal to the
number of unemployed people divided by
the labor force
Figure 1.5 - The U.S. Unemployment Rate
• The Unemployment Rate
– frictional unemployment occurs because
workers and firms spend time searching
for the best match
– cyclical unemployment occurs during
recessions and depressions
– the unemployment rate is the best

indicator of how well the economy is
doing relative to its productive potential
• The Inflation Rate
– is a measure of how fast the overall price
level is rising
– hyperinflation occurs when the price

level is rising by more than 20% per
month
Figure 1.6 - Inflation in the United States
• The Interest Rate
– is important because it governs the
redistribution of purchasing power across
time
– the many different interest rates in the
economy vary by duration and degree of
risk
• often move up and down together
• The Interest Rate
– nominal interest rate is the interest rate
in terms of money
• does not take into account the effects of
inflation
– real interest rate is the interest rate in
terms of goods and services
• does take into account the effects of inflation
Figure 1.7 - U.S. Real Interest Rates,
1960-1999
• The Stock Market
– is heard about most often (every day)
– is an index of expectations for the future

• a high value means that investors expect
economic growth to be rapid, profits to be
high, and unemployment to be low
Figure 1.8 - Real Stock Index Prices
• The Exchange Rate
– governs the terms on which international
trade and investment take place
– nominal exchange rate is the rate at
which monies of different countries can
be exchanged for one another
– real exchange rate is the rate at which
the goods and services produced in
different countries can be exchanged for
one another
– if domestic currency appreciates
• its value in terms of other currencies
increases
• foreign-produced goods are relatively cheap
for domestic buyers
– imports are likely to be high
• domestic-made goods are relatively
expensive for foreigners
– exports are likely to be low
– if domestic currency depreciates
• its value in terms of other currencies declines
• domestic-produced goods are relatively cheap
for foreign buyers
– exports are likely to be high
• foreign-made goods are relatively expensive
for domestic buyers
– imports are likely to be low
Figure 1.9 - The U.S. Real Exchange Rate:
The Dollar against a Composite Index
of Foreign Currencies
The Current
Macroeconomic Situation
• The United States - 2001
– economic growth has slowed to a very
weak pace
• forecast for 2001 is that real GDP will grow by
no more than 1.8%
– interest rates lowered through Fed policy
• due to lags, effects of lower interest rates will
not be felt until end of 2001 (at the earliest)
– inflation continues to be low
The Current
• The United States - recent past
– from early 1990s to 2000, there was an
economic boom
– unemployment fell during the 1990s
• lowest unemployment rate in two decades
(4%)
– real wages increased only slightly
• helped to keep inflation low
The Current
• Europe
– economic growth in countries belonging
to the European Monetary Union slowing
– low inflation
• less than 2% per year
– relatively high unemployment
• near 10%
The Current
• Japan
– slow growth rate
• real GDP grew only 1.8% in 2000
• real GDP is expected to grow only by 1.4% in
2001
– deflation is occurring
• the overall price level fell by 0.7% in 2000
Chapter Summary
• Macroeconomics is the study of the
overall economy.
• There are three key reasons to
study macroeconomics
– to gain cultural literacy
– to understand how economic trends
affect you personally
– to exercise your responsibility as a
voter and citizen
Chapter Summary
• The key indicators in macroeconomics
are
– real GDP
– the unemployment rate
– the inflation rate
– the interest rate
– the level of the stock market
– the exchange rate
CHAPTER 2
Measuring the Macroeconomy
Questions
• What key data do macroeconomists
look at?
• How are key macroeconomic data
estimated and calculated?
• What is the difference between
“nominal” and “real” values?
• How are stock market values related
to interest rates?
Questions
• How are interest rates related to the
price level and the inflation rate?
• How is unemployment related to total
production?
• What is right--and what is wrong--
with the key measure of economic
activity, real GDP?
The Importance of Data
• Economists use quantitative data to
examine and understand behavior
– prices
– quantities
– values
• Data can be used in two ways
– make quantitative forecasts
– test economic theories
Most Important
Macroeconomic Data
• real GDP
• the unemployment rate
• the inflation rate
• the interest rate
• the level of the stock market
• the exchange rate
Table 2.1 - The Six Key Economic Variables
The Exchange Rate
• The nominal exchange rate is the
relative price of two different
currencies
– determined in the foreign exchange
market
• Example
– €1.00 equals $1.20
– $1.00 equals €0.83
The Exchange Rate
• Domestic exporters earn foreign
currency when they export products
– need to trade the foreign currency for
dollars
• Foreign producers earn dollars when
U.S. residents import their products
– need to trade the dollars for foreign
currency
Figure 2.1 - The Market for Foreign Exchange
The Exchange Rate
• The real exchange rate is the
nominal exchange rate adjusted for
changes in the value of the currency
– depends on the nominal exchange rate
and the price level
The Exchange Rate
• Example 1
– nominal exchange rate changes from
$1.20 = €1.00 to $2.40 = €1.00
– price level doubles
– real exchange rate is unchanged
• Example 2
– nominal exchange rate remains at the
same level ($1.20 = €1.00)
– price level doubles
– real exchange rate falls by half
The Exchange Rate
• Example 3
– nominal exchange rate increases from
$1.20 = €1.00 to $2.30 = €1.00
– price level remains the same
– real exchange rate doubles
The Exchange Rate
• To calculate the real exchange rate (ε),
you need three pieces of information
– price level in the home country (P)
– price level abroad (P*)
– nominal exchange rate (e)
P
ε = e×
P*
The Exchange Rate
• There are many different currencies in
the world
– many different exchange rates
• Economists construct an exchange
rate index to represent “the”
exchange rate
– each country receives a weight equal to its
share of total U.S. trade
The Exchange Rate
• The exchange rate index is by
averaging each country’s current
exchange rate relative to its exchange
rate in the base year (1992)
(Current exchange rate) 

Index = 100 × ∑  × (1992 share of trade)
all  (1992 exchange rate) 
countries
Figure 2.2 - The Exchange Rate Index,
1992-1998
The Stock Market
• The most representative index of the
U.S. stock market is the Standard and
Poor’s Composite Index (S&P 500)
• The most commonly discussed index

of the U.S. stock market is the Dow-
Jones Industrial Average
The Stock Market
• Stock market averages are in nominal
terms
– must divide by some measure of the
price level to get the real value of the
stock market
• The real value of the stock market is a
sensitive indicator of the relative
optimism or pessimism of investors
– can forecast future investment spending
The Stock Market
• Investors face a choice between
holding stocks and holding bonds
– stocks are shares of ownership of a
corporation
• entitles you to a portion of the company’s
profits
– bonds are debts that the corporation
owes you
• pays periodic interest payments and returns
principal to you at maturity
The Stock Market
• Rates of return
– for bonds, the rate of return is the
interest rate (r)
– for stocks, the rate of return is the ratio
of earnings per share (Es) to the price
paid (Ps)
• Stocks are risky
– investors may require a risk premium (σs)
The Stock Market
• Investors will hold only stocks if
Es s
> r + σ
Ps
• Investors will hold only bonds if

Es s
< r + σ
Ps
The Stock Market
• Investors will hold both stocks and
bonds if
Es s
= r + σ
Ps
• This means that the value of a stock is

equal to
s
s E
P = s
r+σ
The Stock Market
• How can we measure Es?
– newspaper reports what the firm’s
accountants have calculated (Ea)
– investors are interested in some long-run
average of expected future earnings (Es)
– need an estimate of the relationship
between Ea and Es
Figure 2.3 - Calculating the Value of a
Basket of Stocks
The Stock Market
• provides information on
– the current level of profits (earnings)
– whether investors are optimistic or
pessimistic
– the current cost of capital
– attitudes toward risk
The Interest Rate
• is the price at which purchasing power
can be shifted from the future into the
present
• is not a single lump sum, but an
ongoing stream of payments made
over time
– is a flow variable
The Interest Rate
• There is a large number of different
interest rates that vary by
– risk
– duration
– tax treatment
• Published interest rates are nominal
interest rates
real interest rate = nominal interest rate - inflation rate
Figure 2.4 - The Real versus the Nominal
Interest Rate
The Price Level
• is most frequently measured by the
Consumer Price Index (CPI) which
– is calculated monthly by the Bureau of
Labor Statistics
– is an expenditure-weighted index
Table 2.5 - Calculating a Price Index for
Fruit: An Example
The Consumer Price Index
• Price index formula
Price of oranges today

Index = × (orange index weight) +
Base - year price of oranges
Price of apples today
× (apple index weight) +
Base - year price of apples
Price of pears today
× (pear index weight) +
Base - year price of pears
Price of bananas today
× (banana index weight)
Base - year price of bananas
• In the base year, the price index will
equal 100
$0.75 $1.20
Index = × (45) + × (42) +
$0.75 $1.20
$0.90 $0.40
× (9) + × (4) = 100
$0.90 $0.40
• In the subsequent year, the price
index will equal 138
$1.50 $1.00
Index = × (45) + × (42) +
$0.75 $1.20
$0.90 $0.40
× (9) + × (4) = 138
$0.90 $0.40
Kinds of Index Numbers
• Laspeyres index
– uses relative expenditure levels in a
fixed base year as weights
– example: Consumer Price Index
• Paasche index
– uses current, variable expenditure
levels as weights
– example: GDP deflator
• All price indices are imperfect
– the Laspeyres index overstates the
effects of price increases
• based on a fixed market basket
• does not take into account that consumers
substitute relatively cheaper goods for
relatively more expensive goods when prices
rise (substitution bias)
• All price indices are imperfect
– the Paasche index understates the
effects of price increases
• does take account of substitution
• does not take into account the fact that
substituted items are less-valued than the
items they replace
The Inflation Rate
• is a measure of the rate of change in
the price level over time
• can be measured using different price
indices
– Consumer Price Index (CPI)
– GDP deflator
Figure 2.5 - Different Measures of U.S. Inflation,
1960-2000
The Unemployment Rate
• is the fraction of people who
– want a job
– are looking for a job
– cannot find a job
• is calculated using the Current
Population Survey
– monthly survey by the Bureau of Labor
Statistics
• Individuals are classified into one of
four categories
– those who are employed
– those who are out of the labor force and
do not want a job currently
– those who do want a job currently, but
have given up looking for one
– those who do want a job and are
currently looking for one
Labor force = (Employed) + (Looking for Work)
Looking for Work

Unemployment Rate =
Labor Force
Looking for Work
=
(Employed) + (Looking for Work)
Figure 2.6 - The U.S. Unemployment Rate
since 1950
• is a stock variable
• may underestimate the real
experience of unemployment
– discouraged workers
– workers who are part-time for economic
reasons
• vary by demographic group
Figure 2.7 - U.S. Unemployment Rates by
Demographic Group, 1960-2000
Okun’s Law
• describes the relationship between
unemployment and output in the U.S.
% change in real GDP = (% growth in potential output) -
2.5 × (percentage - point change in unemployme nt)
• implies that a 1 percentage-point fall

in unemployment is associated with
an extra 2.5 percentage points of
growth in real GDP
Figure 2.8 - Okun’s Law
Real GDP
• is calculated by adding up the value of
all final goods and services produced
in the economy
• includes final goods and services
purchased by
– consumers
– firms
– the government
Nominal versus Real GDP
• Nominal GDP measures current
output using current-year prices
– changes in nominal GDP can occur from
changes in either output or prices
• Real GDP measures current output

using prices from a base year
– changes in real GDP can only occur if
output changes
• Example
Base-
Base- Current
Year Current
Product Year Price
Price Output
Output ($/lb.)
($/lb.)
Oranges 6 lbs. $0.75 8 lbs. $1.00
Apples 3.5 lbs. $1.20 3.5 lbs. $1.20
Pears 1 lb. $0.90 1 lb. $0.50
Bananas 1 lb. $0.40 1 lb. $0.40
• Base Year
– Nominal GDP = $10.00
– Real GDP = $10.00
• Current Year
– Nominal GDP = $13.10
– Real GDP = $11.50
More on GDP
• Intermediate goods
– are goods sold to a firm for use in further
production
– are excluded from GDP
• Changes in inventories
– are counted as part of investment
• Imputations
– are made for goods and services not sold
through markets
Components of Real GDP (Y)
• Consumption (C)
• Investment (I) Y = C + I + G + NX
– residential structures
– non-residential structures
– producers’ durable equipment
– changes in business inventories
• Government purchases (G)
• Net exports (NX)
Table 2.8 - Components of GDP, Third
Quarter of 2000
What Is and Is Not in GDP
• Included in GDP (but should not be)
– replacement of worn-out or obsolete
capital
– government purchases which could be
counted as intermediate goods
• Not included in GDP (but should be)
– household production
– depletion of scarce natural resources
– “bads”
Figure 2.9 - Labor Force Participation Rates
by Gender, 1948-1996
Chapter Summary
• Because goods and services are
bought and sold with prices attached,
economists have a lot of quantitative
data to work with
• The real exchange rate is the relative
price at which two countries’ goods
exchange for each other
– calculated by adjusting the nominal
exchange rate for changes in the price
levels of the two countries
Chapter Summary
• The level of the stock market reflects
the variables which affect investment
– current profits
– investors’ optimism or pessimism
– the real rate of interest
– attitudes toward risk
• The real interest rate is calculated by
subtracting the inflation rate from
nominal interests rates
Chapter Summary
• The most-commonly seen measure of
the price level is the Consumer Price
Index (CPI)
– the inflation rate is the rate of change in
the CPI
• Unemployment and output are linked
through Okun’s law
– a 1 percentage-point decrease in the
unemployment rate leads to a 2.5
percent increase in output
Chapter Summary
• Real GDP is the most commonly-seen
measure of the overall level of
economic activity
– calculated using prices from a base year
• What is and what is not included in
GDP is the result of economists’
beliefs in the 1940s and 1950s about
what would be possible to measure
easily
CHAPTER 3
Thinking Like an Economist
Questions
• Is economics a science?
• What do economists mean by a
model?
• Why do economists use
mathematical models so much?
• What patterns and habits of
thought must you learn to
successfully think like an
economist?
Economics
• is a social science
– focuses on human beings and how they
behave
• debates within economics last longer than
those in natural sciences
– less likely to end in consensus
• economists are unable to undertake large-
scale experiments
• the subjects studied by economists--people--
have minds of their own
– expectations of the future play an important role
The Importance of
Expectations: An Example
• The stock market crash of 1929
changed what Americans expected
about the future of the economy
↓ spending ↓ production layoffs ↓ income
• Expectations that future income would

be lower became realized
Figure 3.1 - The Stock Market, 1928-1932
Economics
• is a quantitative science
– uses arithmetic to measure economic
variables of interest
– uses mathematical models to relate
economic variables of interest
• involves a particular way of thinking about
the world using
– unique technical language
– a specific set of data
Economists
• use a special set of analogies and
metaphors to describe the
functioning of the macroeconomy
– curves “shift”
– money has a “velocity”
– the central bank “pushes the
economy up the Phillips curve”
Figure 3.2 - Pushing the Economy Up the
Phillips Curve
Dominant Concepts
• the image of the “circular flow of
economic activity”
• the use of the word “market”
• the idea of “equilibrium”
• use of graphs and diagrams
– equations depicted by geometric curves
– situations of equilibrium occur where
curves cross
– changes in economy demonstrated by
shifts in the curves
The Circular Flow
• patterns of spending, income,

and production flowing through
the economy
– flow of purchasing power
The Circular Flow
• “income side”
– firms buy the factors of production from
households
– money payments flow from firms to
households
• “expenditure side”
– households buy goods and services from
firms
– money payments flow from households to
firms
Figure 3.3 - The Circular Flow Diagram
Circular Flow
• can be made to be more realistic
by adding
– the government
– financial markets
– international trade and finance
Figure 3.4 - The Circular Flow of
Economic Activity
Different Measures of the
Circular Flow
• “expenditure side” measure
– consumption
– investment
– government purchases
– net exports
• “income side” measure
– purchases of labor, capital, and
natural resources owned directly or
indirectly by households
Different Measures of the
Circular Flow
• “uses of income” measure
– where households decide to use their
income
• saving
• taxes
• consumption
Markets
• are used as a metaphor for the
complex processes of matching
and exchange that take place in
the economy
– economists assume that buyers and
sellers are well-informed about
prevailing prices and quantities
Equilibrium
• is a point (or points) of balance at
which some economic quantity is
neither rising nor falling
– once equilibrium is identified,
economists can determine how fast
economic forces will push the
economy to the points of equilibrium
Graphs and Equations
• an algebraic equation relating two
variables can also be represented
as a curve drawn on a graph
• the solution to a set of two

equations is the point on a graph
where the two curves that
represent the equations intersect
Figure 3.5 - Two Forms of the Production
Function
Using Graphs Instead of
Equations
• behavioral relationships become
curves that shift around on a
graph
• conditions of economic equilibrium

can be represented by the points
where the curves describing
behavioral relationships intersect
Using Graphs Instead of
Equations
• changes in the state of the
economy can be shown as
movements in the intersection of
the curves
Building Models
• restrict the problem to only a few
behavioral relationships and
equilibrium conditions
• capture these relationships and
equilibrium conditions in simple
algebraic equations
– use diagrams to represent the
equations
• apply the model to the real world
Important Concepts in
Macroeonomic Models
• representative agents
– assume that all participants in the
economy are the same
– examine the decision-making of one
individual and then generalize to the
economy as a whole
Macroeonomic Models
• opportunity costs
– occur when any decision is made
– measured by the value of the best
alternative foregone
Macroeonomic Models
• expectation formation
– macroeconomic models must explain
• the amount of time people spend
thinking about the future
• the information that people have
available
• the rules of thumb used to turn
information into expectations
Macroeonomic Models
– static expectations
• decision makers do not think about the
future
– adaptive expectations
• decision makers assume that the future
is going to be like the recent past
Macroeonomic Models
– rational expectations
• decision makers spend as much time as
they can thinking about the future and
know as much about the structure and
behavior of the economy as the model
builder does
Building and Solving an
Economic Model
• write equations that represent
behavioral relationships
– state how the “effects” are related to
the “causes”
• draw a diagram to help visualize
the relationship
• consider equilibrium conditions
– can be shown as intersections on
diagram
Economic Model: An Example
• The production function relates
– the economy’s capital-labor ratio
(K/L)
– the level of technology or efficiency of
the labor force (E)
of real
– the levelY/L per
GDP E
= F(K/L, ) worker (Y/L)t
• Cobb-Douglas production function

Y/L = (K/L)α × E1t- α
• Equilibrium condition for balanced
growth
– the ratio of the economy’s capital
stock (K) to its level of output (Y)
must be constant
s
K/Y = κ* =
n+g+δ
• Equilibrium condition for balanced
growth s
K/Y = κ* =
n+g+δ
• s=share of total income in the economy
saved and invested
• n=proportional growth rate of the labor force
• g=proportional growth rate of the efficiency
of the labor force
• δ=the depreciation rate
• arithmetic can be used to
determine the steady-state output
per worker
– Let E=$10,000, α=1/2, s=25%, n=1%,
g=1%, and δ=3%.
s 25%
K/Y = κ* = = =5
n + g + δ 1% + 1% + 3%
s 25%
K/Y = κ* = = =5
n + g + δ 1% + 1% + 3%
• since K/Y=5, this must imply that
K/L=5 × Y/L
• substituting for α and Et in the
Cobb-Douglas production function
(0.5) (0.5)
Y/L = (K/L) × 10,000
• in equilibrium, both conditions must
hold
K/L = 5 × Y/L = 5 × K/L × 100
K/L = $250,000
Y/L = $50,000
• algebra can be used to determine the
steady-state output per worker
Y/L = (K/L)α × E1- α
α 1- α
Y/L = [(Y/L) × (K/Y)] × E
(Y/L)1- ∂ = (K/Y)α × E1- α
α
1− α
(Y/L) = (K/Y) ×E
• putting in the balanced-growth

condition
α
 s  1− α
(Y/L) =   ×E
n + g + δ 
• Let E=$10,000, α=1/2, s=25%,
n=1%, g=1%, and δ=3%
0.5
 0.25  0.5
(Y/L) =   × 10,000
 .01 + .01 + .03 
(Y/L) = $50,000
• graphs can also be used to show
the steady-state output per worker
– the production function can be drawn
with output per worker (Y/L) on the
vertical axis and capital per worker
(K/L) on the horizontal axis
– the equilibrium condition for balanced
growth can also be shown
• K/L=s/(n+g+δ)
Figure 3.6 - Equilibrium Output per Worker
The Advantages of Using
Algebra
• best way to summarize cause-and-
effect behavioral relationships
– allows us to consider different
possible systematic relationships by
changing the value of parameters
Figure 3.7 - A Single Equation, a Host
of Relationships
Figure 3.8 - Changing Parameter Values and the
Shape of the Cobb-Douglas Production Function
Figure 3.9 - The Effect of Changes in the
Efficiency of Labor on the Shape of the
Production Function
Chapter Summary
• Don’t be surprised to find economists’
ways of thinking strange and new--
that is always the case when you
learn any new intellectual discipline
• Don’t be surprised to find economics
more abstract than you thought
– Today’s economic courses focus more on
analytic tools and chains of reasoning
and less on institutional descriptions
Chapter Summary
• Economics is a relatively
mathematical subject because so
much of what it analyzes can be
measured
– Economists use arithmetic to count things
and use algebra because it is the best
way to analyze and understand
arithmetic
Chapter Summary
• When macroeconomists build models,
they usually follow four key strategies
– strip down a complicated process to a
few economy-wide behavioral
relationships and equilibrium conditions
– ignore differences between people in the
economy
– look at opportunity costs
– focus on expectations of the future
CHAPTER 4
The Theory of Economic Growth
Questions
• What are the principal
determinants of long-run
economic growth?
• What equilibrium condition is
useful in analyzing long-run
growth?
• How quickly does an economy
head for its steady-state growth
path?
Questions
• What effect does faster population
growth have on long-run growth?
• What effect does a higher savings
rate have on long-run growth?
Long-Run Economic
Growth...
• is the most important aspect of
how the economy performs
• can be accelerated by good
economic policies
• can be retarded by bad economic
policies
Long-Run Economic
Growth
• Policies and initial conditions affect
growth through two channels
– their impact on the level of
technology
• multiplies the efficiency of labor
– their impact on the capital intensity
of the economy
• the stock of machines, equipment, and
buildings that the average worker has at
his or her disposal
Technology
• leads to a higher efficiency of
labor
– skills and education of the labor force
– ability of the labor force to handle
modern machines
– the efficiency with which the
economy’s businesses and markets
function
• Economists are good at analyzing
1-152
the consequences
Copyright © 2002 by The
of better
McGraw-Hill Companies, Inc. All rights reserved.
technology
Capital Intensity
• There is a direct relationship between
capital-intensity and productivity
• Two principal determinants
– investment effort
• the share of total production saved and
invested in order to increase the capital stock
– investment requirements
• how much of new investment is used to equip
new workers with the standard level of capital
or to replace worn-out or obsolete capital
Standard Growth Model
• Also called the Solow model
• Steady-state balanced-growth
equilibrium
– the capital intensity of the economy is
stable
– the economy’s capital stock and level
of real GDP are growing at the same
rate
– the economy’s capital-output ratio is
constant
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-154
• First component is the production
function
– tells us how the productive resources
of the economy can be used to
produce and determine the level of
output(Y/L) = F[(K/L), E]
• Cobb-Douglas production function
(Y/L) = (K/L)α × (E)1- α
(Y/L) = (K/L)α × (E)1- α
• Parameters of the model

– E is the efficiency of labor
• a higher level of E means that more
output per worker can be produced for
each possible value of the capital stock
per worker
– α measures how fast diminishing
marginal returns to investment set in
α 1- α
(Y/L) = (K/L) × (E)
• 0<α<1
– a level of α near zero means that the
extra amount of output made
possible by each additional unit of
capital declines very quickly as the
capital stock increases
Figure 4.1 - The Cobb-Douglas Production
Function for Parameter α Near Zero
(Y/L) = (K/L)α × (E)1- α
• 0<α<1
– a level of α near one means that the
next additional unit of capital makes
possible almost as large an increase
in output as the last unit of capital
– a level of α equal to one means that
changes in output are proportional to
changes in capital
Function for Parameter α Near 1
Function is Flexible
• Growth in labor force (L)
– assume that L is growing at a
constant rate (n)
L t +1 = (1 + n) × L t
– if this year’s labor force is equal to 10
million and the growth rate is 2% per
year, next year’s labor force will be
L t +1 = (1 + 0.02) × 10 = 10.2 million
Figure 4.4 - Constant Proportional Labor-Force
Growth (at Rate n = 2 Percent per Year)
• Growth in the efficiency of labor
(E)
– assume that E is growing at a
+1 = (1 + g) ×
constantEtproportional rate
Et (g)
– if this year’s efficiency of labor is $10,000
and the growth rate is 1.5% per year,
next year’s efficiency of labor will be
Et +1 = (1 + 0.015) × $10,000 = $10,150
Figure 4.5 - Constant Proportional Growth
in the Efficiency of Labor
(at Rate g = 1.5 Percent per Year)
• Saving and investment
– assume that a constant share of real
GDP is saved and invested each year
(s)
– capital stock does not grow by full
amount of gross investment
• δ represents the fraction of the capital
stock that wears out or is scrapped each
K t +1 = K t + (s × Yt ) - (δ × K t )
year
Figure 4.6 - Changes in the Capital Stock
• An example of capital accumulation
– current real GDP = $8 trillion
– current capital stock = $24 trillion
– savings rate = 20%
– depreciation rate = 4%
K t +1 = K t + (s × Yt ) - (δ × K t )
K t +1 = $24 + (0.2 × $8) - (0.04 × $24)
K t +1 = $24.64 trillion
Figure 4.7 - Additions to and Subtractions
from the Capital Stock
Summary of Standard
Growth Model
• Three assumptions
– labor force grows at proportional rate
n
– efficiency of labor grows at
proportional rate g
– there is a constant proportion of real
GDP saved and invested each year
(s)
• The capital stock changes over
1-170 time due © 2002
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investment and Inc. All rights reserved.
depreciation
Equilibrium in Standard
Growth Model
• Key economic variables in the
growth model are never constant
• Equilibrium occurs when the
variables are growing together at
the same proportional rate
• Steady-state balanced growth
– occurs when the capital-output ratio
is constant over time
Three Mathematical Rules
• The proportional growth rate of a
product (P×Q) is the sum of the
proportional growth rates of each P
and Q
quotient (E/Q) is the difference of
the proportional growth rates of
the dividend (E) and the divisor
(Q)
Three Mathematical Rules
quantity raised to an exponent
(Qy) is equal to the exponent (y)
times the growth rates of the
quantity (Q)
Growth of Capital per Worker
• The proportional growth rate of
capital per worker [g(kt)] is
(K t +1 /L t +1 ) − (K t /L t )
g(k t ) =
(K t /L t )
• Since this is a growth rate of a

quotient, it will be equal to the growth
rate of capital minus the growth rate
of labor (n)
Figure 4.8 - Calculating the Proportional
Growth Rate of the Capital-per-Worker
Ratio
• The growth rate of capital stock is
K t +1 − K t
Kt
• Next year’s capital stock is
K t +1 = K t + (s × Yt ) - (δ × K t )
• Making the substitution, we get
(K t + (s × Yt ) − (δ × K t )) − K t s × Yt
= −δ
Kt Kt
• The proportional growth rate of
capital per worker is
s
g(k t ) = −δ −n
(K t /L t )
• Let κ represent the capital-output
ratio (K/Y)
g(k t ) = (s/κ t ) − δ − n
g(k t ) = (s/κ t ) − δ − n
• All else equal, the rate of growth of
capital per worker will be lower
– the higher the rate of labor force growth
(n)
– the higher the rate of depreciation (δ)
– the lower the rate of saving (s)
– the higher the capital-output ratio (κ)
Figure 4.9 - Capital-per-Worker Growth
as a Function of the Capital-Output Ratio
Growth of Output per Worker
• With the Cobb-Douglas production
function, output per worker is
1− α
(Yt /L t ) = (K t /L t )α × (Et )
• The growth rate of output per worker
[g(yt)] will be
g(y t ) = [α × g(k t )] + (1 − α) × g
Figure 4.10 - Calculating the Growth Rate
of Output per Worker
Growth of Output per Worker
g(y t ) = [α × g(k t )] + (1 − α) × g
• Since g(kt) is equal to [(s/κt)-δ-n], we
can substitute
g(y t ) = [α × {s/κ t - δ - n}] + (1 − α) × g
• and simplify to get
g(y t ) = g + [α × {s/κ t - (n + g + δ)}]
Growth of Capital-Output Ratio
• Equilibrium occurs when the
capital-output ratio (κ=K/Y) is
constant
• The growth rate of the capital-
output ratio [g(κt)] is equal to the
difference in the growth rate of
capital [g(kt)] and the growth rate
g(κ t ) = g(k t ) − g(y t )
of output [g(yt)]
g(κ t ) = g(k t ) − g(y t )
• We can make substitutions for [g(kt)]

and [g(yt)]
g(κ t ) = {s/κ t − δ − n} − [g + α × {s/κ t − (n + g + δ)}]
• and simplify to get
g(κ t ) = (1 − α) × {s/κ t − (n + g + δ)}
g(κ t ) = (1 − α) × {s/κ t − (n + g + δ)}
• The growth rate of the capital-output

ratio depends on the balance between
– investment requirements (n+g+δ)
– investment effort (s)
• All else equal, a higher investment
requirement will mean a lower growth
rate of the capital-output ratio
Figure 4.11 - Growth of the
Capital-Output Ratio
Steady-State Growth
Equilibrium
• occurs when the capital-output ratio is
constant
g(κ t ) = (1 − α) × {s/κ t − (n + g + δ)}
• If κt>[s/(n+g+δ)]
– the capital-output ratio will be shrinking
• If κt<[s/(n+g+δ)]
– the capital-output ratio will be growing
Figure 4.12 - Growth of the Capital-
Output Ratio as a Function of the Level of
the Capital-Output Ratio
Steady-State Growth
Equilibrium
g(κ t ) = (1 − α) × {s/κ t − (n + g + δ)}
• If κt=[s/(n+g+δ)]
– the growth rate of the capital-output ratio
will be zero
– the capital-output ratio will be stable
(neither shrinking nor growing)
• κ*=[s/(n+g+δ)] is the equilibrium
level of the capital-output ratio
Figure 4.13 - Convergence of the Capital-
Output Ratio to Its Steady-State Value
Steady-State Growth
Equilibrium
• When the capital-output ratio (κt) is at
its steady state value (κ*)
– output per worker [g(yt)] is growing at
proportional rate g
– capital stock per worker is growing at the
same proportional rate g
– the economy wide capital stock is
growing at the proportional rate n+g
– real GDP is also growing at proportional
rate n+g
Steady-State Growth Path
• When the capital-output ratio is at
its equilibrium value (κ*), the
economy is on its steady-state
growth path
• From Chapter 3, we know that as
long as we are on the steady-state
α
 α 
growth paths  1 − α  
(Yt /L t ) =   × Et = κ * 1− α  ×Et
n + g + δ 
Figure 4.14 - Calculating Steady-State
Output per Worker along the
• An increase in the capital-output
ratio increases the capital stock
directly and indirectly
– extra output generated by new
capital is source for additional saving
and investment
• This leads to a multiplier effect
of anything that raises κ*
Figure 4.16 - The Growth Multiplier: The
Effect of Increasing the Capital-Output
Ratio on the Steady-State Output per
Worker
• Let the growth multiplier (λ) equal
[α/1- α]
• Output per worker along the
steady-state growth path will be
 Yt 
  = κ *λ ×Et
 Lt 
• To calculate output per worker
when the economy is on its
steady-state growth path
– calculate the steady-state capital-
output ratio [κ*=s/(n+g+δ)]
– amplify the steady-state capital-
output ratio (κ*) by the growth
multiplier [λ=α/(1- α)]
– multiply by the current value of the
efficiency of labor (Et)
Figure 4.15 - Output per Worker on the
Reaching the Steady-State
Growth Path
• How long does it take for the
capital-output ratio to adjust to its
steady-state value (κ*)?
– an economy that is not on its steady-
state growth path will close a fraction
[(1- α)×(n+g+δ)] of the gap between
the steady state value (κ*) and its
current value (κt) in a year
Figure 4.17 - West German Convergence
to Its Steady-State Growth Path
Labor Force Growth
• The faster the growth of the labor
force, the lower will be the economy’s
steady-state capital-output ratio
– the larger the share of current
investment that must go to equip new
workers with the capital they need
• A sudden, permanent increase in
labor force growth will lower output
per worker on the steady-state
growth path
Figure 4.18 - Labor Force Growth and
GDP-per-Worker Levels
Figure 4.19 - Effects of a Rise in
Population Growth on the Economy’s
Growth Path
Increases in the
Depreciation Rate
• The higher the depreciation rate,
the lower will be the economy’s
– existing capital stock wears out and
must be replaced more quickly
• An increase in the depreciation
rate will lower output per worker
on the steady-state growth path
Productivity Growth
• The faster the growth rate of
productivity, the lower will be the
economy’s steady-state capital-
output ratio
– past investment will be small relative
to current output
• An increase in productivity growth
will raise output per worker along
the steady-state growth path
Increases in the Saving
Rate
• The higher the share of real GDP
devoted to saving and investment,
the higher will be the economy’s
– more investment increases the
amount of new capital
• A higher saving rate also increases
output per worker along the
steady-state growth path
Figure 4.20 - National Investment Shares
and GDP-per-Worker Levels
Chapter Summary
• One principal force driving long-
run growth in output per worker is
the set of improvements in the
efficiency of labor springing from
technological progress
Chapter Summary
• A second principal force driving
long-run growth in output per
worker are the increases in the
capital stock which the average
worker has at his or her disposal
and which further multiplies
productivity
Chapter Summary
• An economy undergoing long-run
growth converges toward and settles
onto an equilibrium steady-state
growth path, in which the economy’s
capital-output ratio is constant
Chapter Summary
• The steady-state level of the capital-
output ratio is equal to the economy’s
saving rate divided by the sum of its
labor force growth rate, labor
efficiency growth rate, and
depreciation rate
CHAPTER 5
The Reality of Economic Growth:

History and Prospect
Questions
• What is modern economic growth?
• What was the post-1973
productivity slowdown?
– What were its causes?
– Is the productivity slowdown now
over?
• Why are some nations so
(relatively) rich and other nations
so (relatively) poor?
Questions
• What policies can make economic
growth faster?
• What are the prospects for
successful and rapid economic
development in tomorrow’s world?
Looking Back into Deep
Time
• Up until 1500, there had been
almost zero growth of output per
worker
• After 1800, we see large sustained
increases in worldwide standards
of living
– population growth accelerated
– output per capita grew
Table 5.1 - Economic Growth
through Deep Time
Figure 5.1 - World Population Growth since 1000
Premodern Economic
“Growth”
• Thomas R. Malthus
– first academic professor of economics
– introduced the idea that increases in
technology inevitably run into natural
resource scarcity
• implies that increases in technology lead
to an increase in the size of the
population but not to an increase in the
standard of living
The End of the
Malthusian Age
• Over time, the rate of
technological progress rose
– by 1500, it was sufficiently high so
that natural resource scarcity could
not surpass it
– sustained increases in the population
and the productivity of labor followed
The Demographic
Transition
• As material standards of living rise
far above subsistence, countries
undergo a demographic
transition
– birth rates rise
– death rates fall
– birth rates fall
Figure 5.2 - Stylized Picture of the
Demographic Transition
The Demographic
Transition
• In the world today, not all
countries have gone through their
demographic transitions
– Nigeria, Iraq, Pakistan, and the
Congo are projected to have
population growth rates greater than
2% per year over the next generation
Figure 5.3 - Expected Population Growth
Rates, 1997-2015
Figure 5.3 - Expected Population Growth
Rates, 1997-2015
The Industrial Revolution
• The industrial revolution began the
era of modern economic growth
– new technological leaps
revolutionized industries and
generated major improvements in
living standards
• Great Britain was the center of the
industrial revolution
– English became the world’s de facto
second language
The Industrial Revolution
• The new technologies were not
confined to Great Britain
– spread rapidly to western Europe and
the United States
– spread less rapidly to southern and
eastern Europe and Japan
Figure 5.4 - Industrialized Areas of the
World, 1870
American Long-Run
Growth, 1800-1973
• Growth in the second half of the
nineteenth century was faster than
it had been in the first half
• Growth accelerated further in the
early part of the twentieth century
– a second wave of industrialization
occurred from new inventions and
innovations
American Long-Run
Growth, 1800-1973
• Growth slowed slightly during the
Great Depression and World War II
– 1.4 percent per year from 1929 to
1950
• Growth accelerated from 1950 to
1973
Figure 5.5 - U.S. Measured Economic
Growth: Real GDP per Worker 1995
Prices,
1890-1995
American Long-Run
Growth, 1800-1973
• Many economists believe that
official estimates of output per
worker overstate inflation and
understate real economic growth
by 1 percent per year
– national income accountants have a
hard time valuing the boost to
productivity and standards of living
generated by new inventions
American Long-Run
Growth, 1800-1973
• Structural changes also occurred
– large drop in the proportion of the
labor force working as farmers
occurred
– new methods of travel were
developed
– large number of innovative
technologies and business practices
were adopted
American Long-Run
Growth, 1800-1973
• The U.S. became the world’s
leader (in terms of technology)
during the twentieth century
because
– the U.S. had an exceptional
commitment to education
– the U.S. was the largest market in
the world
– the U.S. was extraordinarily rich in
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natural resources
American Economic
Growth Since 1973
• Between 1973 and 1995 measured
output per worker grew at only 0.6
percent per year
• The other major industrial
economies in western Europe,
Japan and Canada also
experienced a slowdown in
productivity
Table 5.3 - The Magnitude of the Post-
1973 Productivity Slowdown in the G-7
Economies
American Economic
Growth Since 1973
• Suggested causes of the
productivity slowdown include
– environmental protection measures
– increased problems of economic
measurement
– the baby boom generation
– the tripling of world oil prices in 1973
• The actual cause of the
productivity slowdown remains a
1-236 mystery
American Economic
Growth Since 1973
• Slower economic growth has made
Americans feel much less well off
than they had expected that they
would be
– for some workers, the post-1973
productivity slowdown has been
accompanied by stagnant or declining
real wages
– increased income inequality has also
occurred
1-237
Figure 5.6 - Measured Real Mean
Household Income, by Quintile
American Economic
Growth Since 1973
• Since 1995, productivity growth in
the U.S. has accelerated to a pace
of 2.1 percent per year
• Investment began rising in 1992
– business fixed investment grew at
almost three times the rate of GDP
• much of the additional investment has
gone to purchase computers and related
equipment
Modern Economic Growth
around the World
• The industrial core of the world
economy experienced a large
increase in its level of material
productivity and living standards
during the nineteenth and
twentieth centuries
• Elsewhere the growth of
productivity levels and living
standards was slower
• The world has become a more and
Figure 5.7 - World Distribution of Income
Today, Selected Countries
Figure 5.7 - World Distribution of Income
Today, Selected Countries
around the World
• The U.S. has not been the fastest-
growing economy in the world
– a number of other countries at
different levels of industrialization,
development, and material
productivity a century ago have now
converged
– their current levels of productivity,
economic structures, and standards
of living are very close to those of the
1-243 U.S.Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 5.8 - Convergence among the G-7
Economies: Output per Capita as a Share
of U.S. Level
around the World
• The economies that have
converged belong to the
Organization for Economic
Cooperation and Development
(OECD)
– group of countries that gave or
received aid under the Marshall Plan
to help rebuild or reconstruct after
World War II
around the World
• The OECD countries adopted a
common set of economic policies
– large private sectors free of
government regulation of prices
– investment with its direction
determined by profit-seeking
businesses
– large social insurance systems to
redistribute income
– governments committed to avoiding
mass unemployment
around the World
• The OECD countries ended up with
mixed economies
– markets direct the flow of resources
– governments stabilize the economy,
provide social-insurance safety nets,
and encourage entrepreneurship and
enterprise
around the World
• As the OECD countries became
richer, they completed their
demographic transitions
• The policy emphasis on free
enterprise boosted investment
• Steady-state capital-output ratios
rose
• Diffusion of technology from the
U.S. occurred
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around the World
• Economic growth has not been
limited to OECD countries
– since World War II, several countries
in east Asia have experienced
stronger growth than has ever been
seen anywhere in world history
– these successful east Asian countries
are somewhat similar to the OECD
economies in terms of economic
policy and structure
around the World
• Many countries have not been so
fortunate
• Countries that have been ruled by
communists in the twentieth
century have remained poor
Figure 5.9 - The Iron Curtain
Table 5.4 - The Iron Curtain: GDP-per-
Capita Levels of Matched Pairs of
Countries
Sources of Divergence
• The principal cause of the large
variation in output per worker
between countries today are
differences in their steady-state
capital-output ratios
– differences in the share of investment
in national product
– difference in labor force growth
• A second cause of the large
differences in the level of
education
– the efficiency of labor is highly
correlated with the level of education
• educated workers can use modern
technologies
Figure 5.10 - GDP-per-Worker Levels and
Average Years of Schooling
• An additional cause of the large
differences in access to technology
– difficult to measure
Cause and Effect,
Effect and Cause
• High population growth and low
output per worker go together
– rapid population growth reduces the
– poor countries have not undergone
their demographic transition
Cause and Effect,
Effect and Cause
• Other vicious circles can occur
– poor countries will have a high
relative price of capital
• implies that poor countries get less
investment out of any given effort at
saving
– good education is harder to provide in
poor countries
• Setting the demographic transition
in motion
Copyright
will
© 2002
offset
by The
these
McGraw-Hill Companies, Inc. All rights reserved.
1-258
problems
Hopes for Convergence
• The context of economic
“stagnation” and “failure” are
relative terms
– net national product in Argentina is
about three times what it was in 1900
– net national product in Norway is
about nine times what it was in 1900
• The world’s industrial leaders
provide a benchmark of how much
1-259
things
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Companies, Inc. All rights reserved.
Hopes for Convergence
• Differences in productivity and
living standards between national
economies should be eroded over
time due to
– world trade
– migration
– flows of capital
– developing countries entering the
demographic transition
Policies for Saving,
Investment, and
Education
• Policies to boost saving include
– ensuring that savers get a reasonable
rate of return on their savings
– minimizing restrictions on
entrepreneurship
– keeping inflation low
– keeping government deficits to a
minimum
Investment, and
Education
• Policies to boost investment for a
given level of savings include
– welcoming money from foreign
investors
– allowing businesses to freely earn
and spend foreign exchange
• reducing tariffs and quotas
• subsidizing investment and expansion by
businesses that successfully compete in
world markets
Investment, and
Education
• Promoting universal access to
education can provide two
important benefits
– a better-educated workforce is likely
to be more productive
– educated women will likely pursue
opportunities outside the home
• the birth rate will likely fall
• the demographic transition will occur
more quickly
Policies for Technological
Advance
• Technological progress has two
components
– science
– research and development
• amounts to 3 percent of GDP in the U.S.
Advance
• Businesses conduct investments in
research and development to
increase profit
• Research and development is a
public good
– other firms can copy it
– patents limit the ability of other firms
to do so
Advance
• Governments seeking to establish
patent laws face a dilemma
– if the patent laws are strong, much of
the modern technology in the
economy will be restricted in use
– if the patent laws are weak, profits
that innovators and inventors can
earn will be low
• pace of technological improvement will
slow
Will Governments Follow
Good Policies?
• The broad experience of growth in
developing countries (with the
exception of east Asian and OECD
countries) has been that
governments often won’t
Good Policies?
• Typical systems of regulation in
developing countries have retarded
development by
– embarking on “prestige”
industrialization programs that keep
resources from shifting to activities in
which the country had a long-run
comparative advantage
Good Policies?
– inducing firms and entrepreneurs to
devote their energies to seeking rents
by lobbying governments, instead of
seeking profits by lowering costs
– creating systems of regulation and
project approval that have
degenerated into extortion machines
for manufacturing bribes for the
bureaucrats
Good Policies?
• Neoliberalism describes much of
the recent thinking about the
proper role of government in
economic growth
– the government has a sphere of core
competencies at which it is effective
• administration of justice, maintenance of
macroeconomic stability, provision of
social insurance, some infrastructure
development
– governments should limit role to their
core competencies
Chapter Summary
• Back before the commercial
revolution (before 1500 or so),
economic was very slow
– populations grew at a glacial pace
– there were no significant increases in
standards of living for millennia
before 1500
– humanity was caught in a Malthusian
trap
Chapter Summary
• The way out of the Malthusian trap
opened about 1500
– populations grew
– standards of living grew
– levels of material productivity grew
Chapter Summary
• The industrial revolution was the
start of the current epoch: the
epoch of modern growth
– starting in the mid-eighteenth
century, the pace of invention and
innovation increased
• key inventions replaced muscle with
machine power
• material productivity levels boomed
Chapter Summary
• Modern economic growth is well-
described by the standard growth
model
– output per worker and capital per
worker increase at a pace measured
in percent per year
• the pace has been extraordinarily rapid in
long-term historical perspective
Chapter Summary
• Looking across nations, the world
is an astonishing unequal place in
relative terms
– the gap between rich and poor
nations in material productivity is
much greater than it has ever been
before
Chapter Summary
• Combine the determinants of the
with the proximate determinants
(the level of technological
knowledge and average
educational attainment in a
country after World War II) and
you can account for most of the
variation in the relative wealth and
1-276 povertyCopyright 2002 by The McGraw-Hill
of©nations today Companies, Inc. All rights reserved.
Chapter Summary
• Macro policies to increase
economic growth are policies to
– accelerate the demographic transition
(through education)
– increase savings rates
– boost the amount of real investment
a country gets for a given savings
effort
– increase the rate of invention or
1-277
technology transfer
CHAPTER 6
Building Blocks of the Flexible-Price

Model
Questions
• What is a full-employment
analysis?
• What keeps the economy at full
employment when wages and
prices are flexible?
• What determines the level of
consumption spending?
investment spending?
Questions
• What determines the level of net
exports?
• What determines the level of the
exchange rate?
Full-Employment Analysis
• We will now look at the economy over
the short-run
– a period in which its productive
resources are fixed
• We will assume that wages and prices
are flexible so that all markets clear
– supply equals demand in the labor
market
– full-employment analysis
Flexible-Price Model
• Two sets of factors determine the
levels of potential output and real
wages
– the production function
– the balance of supply and demand in
the labor market
The Production Function
• Potential output (Y*) is determined
by
– the size of the labor force (L)
– the economy’s capital stock (K)
– the efficiency of labor (E)
– a parameter indicating how quickly
returns to investment diminish (α)
α 1− α
Y* = (K) (LE)
Figure 6.1 - The Production Function
• The assumption that wages and
prices are flexible was commonly
made by “classical” economists
• Thus, this assumption is often
called the classical assumption
– guarantees that markets work
– guarantees full employment
– guarantees that actual output is equal
to potential output
• The flexible-price assumption is
not always a good one
– a market economy does not always
produce full employment
• The “Keynesian” model assumes
that wages and prices are sticky
– this will be covered in Section III of
text
• The Classical assumption simplifies
Copyright © 2002
1-286 the analysis The McGraw-Hill
ofby the economy Companies, Inc. All rights reserved.
Table 6.1 - Classical Flexible-Price versus
Keynesian Sticky-Price Analyses
The Labor Market
• Assume there are K identical firms
– each firm owns one unit of the
economy’s capital stock
– each firm hires L workers and pays
them the same wage W
– each firm sells Y units of output at a
per-unit price of P
– no firm has control over the price it
receives or the wage it pays
• these are determined by the market
The Labor Market
• To determine how many workers
to hire, the firm follows two rules
– hire workers to boost output
– stop hiring when the extra revenue
from the output hired by the last
worker just equals his or her wage
The Labor Market
• The value of the output produced
by the last worker hired is the
product price (P) multiplied by the
marginal product of labor (MPL)
• The cost of hiring the last worker
is his or her wage (W)
• The firm will keep hiring until
P × MPL - W = 0
The Labor Market
• The marginal product of labor is
the difference between what the
firm can produce with its current
labor force (Lfirm) and what it could
produce if it hired one more
worker
• At its current labor force, the
output of the firm will be
Yfirm = F(1, L firm )
The Labor Market
• Therefore, the marginal product of
labor (MPL) must be equal to
MPL = F(1, L firm + 1) − F(1, L firm )
Figure 6.2 - The Firm’s Output as a
Function of the Firm’s Employment
The Labor Market
• Using the Cobb-Douglas form of
the production function
MPL = (K firm )α × E1− α (L firm + 1)1− α − (K firm )α × E1− α (L firm )1− α
• Since Kfirm=1
MPL = (1)α × E1− α (L firm + 1)1− α − (1)α × E1− α (L firm )1− α
MPL = E1− α [(L firm + 1)1− α − (L firm )1− α ]
The Labor Market
MPL = E1− α [(L firm + 1)1− α − (L firm )1− α ]
• The term in the brackets is a

growth rate of a variable raised to
a power1− α 1− α 1
[(L firm + 1) − (L firm ) ] = (1 − α) × α
(L firm )
(1 − α)E1− α
MPL = α
(L firm )
The Labor Market
• The firm hires workers up to the
point where the product price
multiplied by the marginal product
of labor equals the wage
P × MPL - W = 0
• Substituting for MPL
(1 - α)E1- α
P× α
=W
(L firm )
Figure 6.3 - The Typical Firm’s Hiring
Policy
The Labor Market
• The typical firm’s demand for labor is
1/α
1- α
 (1 - α)E 
L firm =  
 (W/P) 
• Because there are K firms in the
economy, total economy-wide
employment will be
1/α
1- α
d  (1 - α)E 
L = K 
 (W/P) 
The Labor Market
• If there are more workers than
firms want to hire at the current
wage
– some of the unemployed will
underbid their fellow employed
workers
– those who are employed will respond
by accepting a lower wage to keep
their jobs
– real wages will fall and firms will hire
1-299 © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
moreCopyright
workers
The Labor Market
• If there are fewer workers than
firms want to hire at the current
wage
– some firms will try to bid workers
away by offering higher wages
– the real wage will rise and firms will
reduce the quantity of labor
demanded
• Equilibrium occurs in the labor
market when
Copyright © 2002
labor
by The
demand
McGraw-Hill Companies, Inc.
is All rights reserved.
1-300
equal to the labor force
Figure 6.4 - Equilibrium in the Labor
Market
The Labor Market
• Equilibrium in the labor market means
that
1/α
1- α
d (1 - α)E 
L = L = K 
 (W/P) 
• This means that the equilibrium real
wage is equal to
α
W 1- α  K  Y
= [(1 - α)E ]  = (1 - α) 
P L  L 
The Labor Market
• When the labor market is in
equilibrium, the typical firm
produces an output level equal to
Yfirm = (1)α (E)1- α (L/K)1- α
• Total output will be K multiplied by

the typical firm’s output
Y = K × Yfirm = (K)α (E)1- α (L)1- α
The Labor Market
Y = K × Yfirm = (K)α (E)1- α (L)1- α
• Simplifying, we get the Cobb-Douglas

production function
Y = (K)α (LE)1- α = Y *
• If markets work well, the actual level

of output in the economy (Y) will be
equal to the economy’s potential
output (Y*)
Figure 6.5 - In a Full-Employment
Economy, Real GDP Equals Potential
Output
Domestic Spending
• National income can be divided
into four components
– consumption spending (C)
– investment spending (I)
– government purchases (G)
– net exports (NX)
C + I + G + NX = Y
Figure 6.6 - The Four Components of
Spending Add Up to Real GDP
Consumption Spending
• Households use income (Y) in
three ways
– pay net taxes (T)
• assume that T = t × Y, where t is an
average tax rate
• disposable income is equal to income
minus taxes [YD = Y-T = (1-t)Y]
– save (SH)
– consume (C)
D H H
C = Y -S = Y-T-S
Figure 6.7 - From National Income to
• Consumption spending can be
broken down into two components
– a baseline level of consumption (C0)
• the amount that households would spend
on consumption goods if they had no
income
– a fraction of disposable income (Cy ×
YD)
• Cy is the marginal propensity to
consume, amount by which
consumption spending rises in response
to a $1 increase in disposable income
D
C = C0 + C y × Y = C0 + C y × (1 - t)Y
• Consumption is assumed to be a
linear function of real GDP (Y)
• There are other factors that affect
consumption besides disposable
income
– assumed to affect baseline consumption
(C0) only
Figure 6.8 - Other Determinants of
• Cy is the marginal propensity to
consume
• 0<Cy<1
– if incomes rise, households will use
some of their extra income to
increase their consumption spending
– as incomes rise, households will also
increase their saving
Figure 6.9 - The Consumption Function
• Example
– the tax rate (t) = 25%, national
income (Y) = $10 trillion, the baseline
level of consumption (C0) = $2
trillion, and the marginal propensity
to consume (Cy) = 0.6
Y D = (1 - 0.25) × $10 trillion = $7.5 trillion
C = $2 trillion + (0.6 × $7.5 trillion) = $6.5 trillion
Investment Spending
• Fluctuations in investment
spending have two sources
– the interest rate
• a higher real interest rate makes
investment projects more expensive and
lowers investment
– business managers’ and investors’
confidence
• the higher their confidence, the higher is
investment spending
Investment Spending
• Firms invest because their
managers believe that the
investment projects will be
profitable
– this means that the discounted
returns on the investments must be
greater than the investments’ costs
– the most relevant interest rate for
determining the profitability of an
investment is the long-term, real,
riskyCopyright
interest rate
Investment Spending
• Investment spending has two
components
– the baseline level of investment (I0)
– the responsiveness of investment to
changes in the interest rate (Ir)
I = I0 - (Ir × r)
Figure 6.10 - The Investment Function
Investment Spending
• Example
– the baseline level of investment (I0)
= $2 trillion, the interest-sensitivity
of investment (Ir) = $10 trillion, and
the real interest rate = 5%
I = $2 trillion - ($10 trillion × 0.05) = $1.5 trillion
Investment Spending
• An alternative way of looking at
investment is to see the level of
investment as a function of the
level of the stock market
• The same things that determine
the value of the stock market also
determine the level of investment
– expected future profits (confidence)
– the real interest rate
Government Purchases
• Government purchases (G) include
purchases of labor and other goods
and services by federal, state, and
local governments
• Government purchases do not
include transfer payments
– transfer payments are negative taxes
• Economists do not inquire into
what determines G (or the tax rate
1-322 t) Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 6.11 - Government Purchases,
Transfer Payments, and Taxes
International Trade
• Net exports (NX) is the difference
between gross exports (GX) and
imports (IM)
NX = GX - IM
Figure 6.12 - Gross Exports, Imports, and
Net Exports
Gross Exports
• The volume of gross exports (GX)
depends on two variables
– the real GDP of the country’s trading
partners (Yf)
– the real exchange rate (ε)
f
GX = (X yf × Y ) + (X ε × ε)
– Xyf is the increase in exports generated
by an increase in foreign GDP
– Xε is the increase in exports from an
increase in the real exchange rate
Figure 6.13 - Gross U.S. Exports and the
Real Exchange Rate, 1980-1990
Gross Exports
• In the real world, there are
substantial lags that occur
between changes in the real
exchange rate and changes in the
level of gross exports
– a change in the real exchange rate
this year will have little or no effect
on gross exports this year, but will
have effects on gross exports one,
two, and three years into the future
Figure 6.14 - The J-Curve in the 1980s
Gross Imports
• The value of demand for imports
depends on domestic real GDP (Y)
• The quantity of imports demanded
depends also on the real exchange
rate (ε)
– however, the value of imports is largely
independent of the real exchange rate
– gross imports will be a constant share of
real GDP
IM = IMy × Y
Net Exports
• Net exports (NX) are the difference
between gross exports (GX) and
imports (IM)
NX = GX - IM = (X yf × Y f ) + (X ε × ε) - (IMy × Y)
• Net exports depend on three things

– the level of real GDP abroad (Yf)
– the level of real GDP at home (Y)
The Exchange Rate
• The lives of foreign exchange
speculators are ruled by fear and greed
– a higher U.S. interest rate means that an
individual can profit from buying U.S. bonds
• the greater this interest differential, the higher
the greed factor
– if the U.S. real exchange rate rises, profits
from holding U.S. bonds will be lower
• the higher the greed factor, the lower must be
the exchange rate in order for fear to offset the
greed
Figure 6.15 - Greed and Fear in Foreign
Exchange Markets
The Exchange Rate
• The real exchange rate is determined
by two components
– the average foreign exchange trader’s
opinion of what the exchange rate should
be if there was no interest differential (ε0)
– the sensitivity of the exchange rate (εr)
to the interest rate differential between
domestic real interest rates (r) and
foreign real interest rates (rf)
ε = ε0 - [εr × (r - r f )]
Net Exports
NX = GX - IM = (X yf × Y f ) + (X ε × ε) - (IMy × Y)
• Substituting in for the real

exchange rate, we get
NX = (X yf × Y f ) + (X ε × ε 0 ) - (X ε × εr × r) + (X ε × εr × r f ) - (IMy × Y)
• Having the definition of net exports in

this form tells us directly how
domestic and foreign interest rates
affect net exports
Chapter Summary
• When the economy is at full
employment, the level of real GDP
is equal to potential output--the
level of output generated by the
aggregate production function,
given the current stocks of labor
and capital and the current level of
the efficiency of labor
Chapter Summary
• When wages and prices are
flexible, the working of the labor
market keeps the economy at full
employment
– if labor demand is less than the labor
force, falling wages raise employment
– if labor demand is greater than the
labor force, rising wages soon curb
labor demand
Chapter Summary
• The level of consumption spending
is determined by many things, but
the most important of them is the
level of disposable income
• The level of investment spending
is primarily determined by
business managers’ degree of
optimism and by the real interest
rate
Chapter Summary
• The stock market is a useful
indicator of the likely future level
of investment spending because its
value depends on the same factors
that determine investment
spending
– the general degree of optimism about
future profits
– the real interest rate
Chapter Summary
• The exchange rate is determined
by two factors
– foreign exchange traders’ view of the
long-run equilibrium level of the
exchange rate
– the interest rate differential between
investments at home and abroad
Chapter Summary
• The level of net exports has three
determinants
– the level of the exchange rate
– the level of real GDP at home
• determines the level of imports
– the level of real GDP abroad
• affects the level of exports
CHAPTER 7
Equilibrium in the Flexible-Price

Model
Questions
• When wages and prices are
flexible, what economic forces
keep total production equal to
aggregate demand?
• Why does the flow-of-funds
through financial markets have to
balance?
• What are the components of
savings flowing into financial
1-343 markets?Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Questions
• What is a “comparative statics”
analysis?
• What are “supply shocks”?
• What are “real business cycles”?
Y = Y* C = C0 + C y × (1 - t) × Y
I = I0 + Ir × r G=G
f
NX = (X yf × Y ) + (X ε × ε0 ) - (X ε × εr × r)
f
+ (X ε × εr × r ) - (IMy × Y)
f
ε = ε0 - εr × (r - r )
• Aggregate demand is the sum of
the four components of
expenditure (E)
• In equilibrium, aggregate demand
will equal real GDP (Y)
E = C + I + G + NX = Y
• The real interest rate (r) plays the
key balancing role in making sure
that the economy reaches and
stays at equilibrium
• To understand how, we need to
examine the market in which the
real interest rate functions as the
price
– the market for loanable funds
The Flow-of-Funds
• The circular-flow principle ensures
that if supply equals demand in
the flow-of-funds through financial
markets, then real GDP will be
equal to aggregate demand
Y = Y* = C + I + G + NX
Y * -C - G - NX = I
(Y * -C - T) + (T - G) - NX = I
The Flow-of-Funds
(Y * -C - T) + (T - G) - NX = I
• The right-hand side of the

equation is investment
– the demand for loanable funds
• The left-hand side of the equation
is total savings from households,
the government, and foreigners
– the supply of loanable funds
Figure 7.1 - The Flow-of-Funds through
Financial Markets
The Flow-of-Funds
• (Y*-C-T) = households’ savings
• (T-G) = government savings
• (-NX) = the net flow of purchasing
power that foreigners channel into
domestic financial markets
– dollars earned by foreigners selling
imports above what is needed to buy
our exports are used to purchase
domestic assets
Figure 7.2 - Imports Minus Exports Equal
the Capital Inflow
Flow-of-Funds Equilibrium
• Equilibrium occurs in the loanable
funds market when the supply of
loanable funds (saving) is equal to
the demand for loanable funds
(investment)
(Y * -C - T) + (T - G) - NX = I
Figure 7.3 - Equilibrium in the Flow-of-
Funds
Flow-of-Funds Equilibrium
(Y * -C - T) + (T - G) - NX = I
• If the left-hand side > right-hand

side
– financial institutions will find
purchasing power piling up
– they will try to underbid their
competitors by accepting a lower
interest rate
– as the interest rate falls, the amount
of investment will increase
1-355
– the process will continue until
Figure 7.4 - Excess Supply of Savings in
the Flow-of-Funds
Solving the Model
• The determinants of saving are
Y * -C - T = [1 - t - (1 - t)C y ]Y * -C0
T - G = tY * -G
f f
- NX = IMy Y + X ε εrr - X yf Y - X ε ε0 - X ε εrr
• The supply of saving is upward sloping

– when the interest rate rises, the total
savings flow increases
Solving the Model
• The demand for loanable funds is
the investment function
I = I0 − Irr
• The demand for loanable funds is

downward sloping
– when the interest rate rises, investment
falls
Solving the Model
• Equilibrium occurs where the
supply of savings is equal to
investment
{[1 - t - (1 - t)C y ]Y * -C0 } + {tY * -G}
+ {IMy Y + X ε εrr - X yf Y f - X ε ε0 - X ε εrr f }
= I0 - Irr
Solving the Model
• Solving for the real interest rate
(r) f f
(C0 + I0 + G) (Xyf Y + Xεε0 + Xεεrr )
r= +
(Ir + Xεεr ) (Ir + Xεεr )
{1- [(1- t)Cy - IMy ]}Y *
-
(Ir + Xεεr )
Solving the Model: An Example
• Y*=$10,000 billion • Xyf=0.1
• C0=$3,000 billion • Yf=$10,000 billion
• I0=$1,000 billion • ε0=100
• G=$2,000 billion • Xε=10
• t=25% • Ir=9,000
• Cy=0.67 • εr=600
• IMy=0.2
(6,000) + (2,000) - (7,000)
r= = 0.0667
15,000
• At an equilibrium interest
rate=6.67%
– private savings=-$500 billion
– government savings=$500 billion
– capital inflow from abroad (-
NX)=$400 billion
– total saving is $400 billion
– investment is $400 billion
• The flow-of-funds through financial
1-362 marketsCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
balances
• At an equilibrium interest
rate=6.67%
– consumption spending=$8,000 billion
– investment spending=$400 billion
– government purchases=$2,000 billion
– net exports=-$400 billion
– total expenditure=$10,000 billion
– potential output=$10,000 billion
• Aggregate demand is equal to real
1-363 GDP Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Comparative Statics
• We can determine the response of
the economy to a particular shift in
the economic environment or
policy
– first, look at the initial equilibrium
position of the economy
– second, look at the equilibrium
position of the economy after the
shift
– last, identify the difference in the two
equilibrium positions as the change in
An Increase in
• Policy makers decide to increase
annual government purchases by
∆G
– no change in consumption [∆C=0]
– change in investment due to the
change in the interest rate [∆I=-Ir∆r]
– change in net exports due to the
change in the interest rate [∆NX=-
Xεεr∆r]
1-365 Copyright © 2002
– no change in potential Companies, Inc.
by The McGraw-Hilloutput rights reserved.
or Allreal
GDP [∆Y= ∆Y*=0]
An Increase in
∆Y = ∆C + ∆I + ∆G + ∆NX
0 = 0 - Ir ∆r + ∆G - X ε εr ∆r
• Solving for ∆r
∆G
∆r =
Ir + X ε εr
Figure 7.5 - Flow of Funds: An Increase in
An Increase in
• More government purchases mean
less government savings
– the real interest rate rises
– the quantity of funds demanded for
investment falls
– the amount of international saving
flowing into domestic financial
markets rises
– the exchange rate falls
An Increase in
∆Y = 0 ∆C = 0 ∆ G = ∆G
- Ir - X ε εr
∆I = ∆G ∆NX = ∆G
Ir + X ε εr Ir + X ε εr
- Xε
∆ε = ∆G
Ir + X ε εr
An Increase in
• The increase in government
purchases leads to an increase in
interest rates
– the higher real interest rates leads to
a drop in investment and an
appreciation in the home currency
– the appreciation in the home
currency leads to a decline in net
exports
– the decline in net exports and
1-370
investment equal the increase in
Figure 7.6 - The Interest Rate, the
Exchange Rate, and the Capital Inflow
Figure 7.8 - The Impact of a Change in
the Domestic Interest Rate on the
Exchange Rate
A Decrease in Tax Rates
• The effects of a cut in tax rates are
very similar but not identical to an
increase in government purchases
– a tax cut increases household
incomes, leading to a rise in
consumption and household saving
Investors Become More
Optimistic
• If investors become more
optimistic, I0 will rise by ∆I0
– no change in consumption or
government purchases [∆C=∆G=0]
change in optimism and the change
in the interest rate [∆I=∆I0-Ir∆r]
change in the interest rate [∆NX=-
Xεεr∆r]
1-374
Optimistic
∆Y = ∆C + ∆I + ∆G + ∆NX
0 = 0 + ∆I0 - Ir ∆r + 0 - X ε εr ∆r
∆I0
∆r =
Ir + X ε εr
Figure 7.9 - Flow of Funds: An
Investment Boom
Optimistic
• The increase in investment
increases the demand for loanable
funds
markets rises
– net exports falls
Optimistic
∆Y = 0 ∆C = 0 ∆G = 0
X ε εr - X ε εr
∆I = ∆I0 ∆NX = ∆I0
- εr
∆ε = ∆I0
Ir + X ε εr
Figure 7.10 - The International
Consequences of an Investment Boom
An Increase in Foreign
Interest Rates
• The foreign real interest rate rises
by ∆rf
changes in both foreign and domestic
interest rates [∆NX=-Xεεr(∆r-∆rf)]
change in the domestic interest rate
[∆I=-Ir∆r]
– no change in consumption or
Interest Rates
∆Y = ∆C + ∆I + ∆G + ∆NX
f
0 = 0 - Ir ∆r + 0 - X ε εr (∆r - ∆r )
f
X ε εr ∆r
∆r =
Ir + X ε εr
Interest Rates
∆Y = 0 ∆C = 0 ∆G = 0
f f
X ε εr ∆r X ε εr ∆r
∆I = −Ir × ∆NX = Ir ×
f
εr ∆r
∆ε = Ir ×
Ir + X ε εr
Figure 7.11 - Flow-of-Funds: An Increase
in Interest Rates Abroad
Interest Rates
• The rise in foreign interest rates
reduces the supply of loanable
funds
– the domestic real interest rate rises
(but by less than the increase in the
foreign interest rate)
– the amount of investment falls
– the exchange rate rises
– net exports rises
Figure 7.12 - The Real Exchange Rate and
Domestic Interest Rates
A Decline in Confidence in
the Currency
• If foreign exchange speculators
lose confidence in the currency, ε0
will change by ∆ε0
change in both the domestic interest
rate and confidence [∆NX=Xε∆ε0 -
Xεεr∆r]
change in the domestic interest rate
[∆I=-Ir∆r]
– no change by The McGraw-Hill Companies,
in consumption or Inc. All rights reserved.
the Currency
∆Y = ∆C + ∆I + ∆G + ∆NX
0 = 0 - Ir ∆r + 0 + X ε ∆ε0 - X ε εr ∆r
X ε ∆ε 0
∆r =
Ir + X ε εr
the Currency
∆Y = 0 ∆C = 0 ∆G = 0
- Ir Ir X ε ∆ε0
∆I = X ε ∆ε 0 ∆NX =
Ir ∆ε0
∆ε =
Ir + X ε εr
Figure 7.13 - Flow of Funds: A Decline in
Exchange Rate Confidence
the Currency
• The drop in confidence decreases
the supply of saving
– the exchange rate rises
– net exports rises
Supply Shocks
• Supply shocks are shocks that
change aggregate supply and
potential output (Y*)
– changes in oil prices
– new inventions and innovations
• When a supply shock occurs, real
GDP does change because
potential output changes
An Adverse Supply Shock
• Suppose oil prices rise and potential
output falls by ∆Y*
– change in consumption due to the change
in income [∆C=Cy(1-t)∆Y*]
– change in investment due to the change
in the interest rate [∆I=-Ir∆r]
– change in net exports due to the changes
in both the interest rate and income
[∆NX=-Xεεr∆r-IMy∆Y*]
– no change in government purchases
[∆G=0]
∆Y = ∆C + ∆I + ∆G + ∆NX
∆Y = C y (1 - t)∆Y * -Ir ∆r + 0 - X ε εr ∆r - IMy ∆Y *
 1 - C y (1 - t) + IMy 
∆r = − ∆Y *
 Ir + X ε εr 
Figure 7.14 - Flow of Funds: An Adverse
Supply Shock
• The drop in real GDP lowers
income and reduces household
saving
markets rises
– net exports by The McGraw-Hill Companies, Inc. All rights reserved.
falls
∆C = C y (1 - t)∆Y * ∆G = 0
 1 + IMy - C y (1 - t) 
∆I = Ir  ∆Y * 
 1 + IMy - C y (1 - t) 
∆NX = X ε εr  ∆Y * 
 1 + IMy - C y (1 - t) 
∆ε = εr  ∆Y * 
Real Business Cycles
• Economist Joseph Schumpeter
believed that changes in
technology were the principal force
driving business cycles
– booms occurred when new
technology diffused rapidly
throughout the economy
– periods of relative stagnation
occurred when the pace of
technological innovation and diffusion
1-397 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
was Copyright
much© slower
A Shift in Technology
• Suppose a shift in technology occurs
that involves two components
– a sudden increase in the efficiency of
labor
– a sudden rise in investment demand
• This shock will have both supply and
demand components
– potential output will rise
– there is an increase in the demand for
funds
• To examine the effects of such a
change, we can add together the
effects of a supply shock to the effects
of an increase in investment demand
 1 - C y (1 - t) + IMy  ∆I0
∆r = − ∆Y * +
 Ir + X ε εr  Ir + X ε εr
Figure 7.15 - Flow of Funds: A
Schumpeterian Combined Productivity
and Investment Shock
• Higher productivity
– household savings increase as incomes
rise
– this will put downward pressure on the
interest rate
• Increase in investment demand
– this will put upward pressure on interest
rates
• The end result depends on which
effect is dominant
∆C = C y (1 - t)∆Y * ∆G = 0
X ε εr  1 + IMy - C y (1 - t) 
∆I = ∆I0 + Ir  ∆Y * 
Ir + X ε εr  Ir + X ε εr 
 1 + IMy - C y (1 - t)  X ε εr ∆I0
∆NX = X ε εr  ∆Y *  -
 1 + IMy - C y (1 - t)  εr ∆I0
∆ε = εr  ∆Y *  -
• This technology shock produced
–a rise in output
–a sharp rise in investment
–a decline in the exchange rate
–a decrease in net exports
• These shifts in the economy are
typically found in a business cycle
boom
Real Business Cycle
Theory
• While the real business cycle
theory may be able to explain
booms
– it contains no mention of changes in
unemployment
• full employment is assumed throughout
– it is unable to fully explain recessions
or depressions
Chapter Summary
• When the economy is at full
employment, real GDP is equal to
potential output
• In a flexible-price economy, the
interest rate shifts in response to
changes in policy or the economic
environment to keep real GDP
equal to potential output
Chapter Summary
• The real interest rate balances the
supply of loanable funds
committed to financial markets by
savers with the demand for funds
to finance investments. The
circular-flow principle guarantees
that when savings equals
investment, aggregate demand
and real GDP will equal potential
1-406 output Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• How does the full-employment
equilibrium of an economy shift in
response to economic policy or
shocks to the economic
environment?
– This is what the flexible-price
macroeconomic model can analyze
• Supply shocks are sharp, sudden
changes in costs that shift the
1-407 efficiency of labor
Chapter Summary
• Real business cycle theory
attempts to use this chapter’s
model to account for not just
changes in the short-run
composition of real GDP but
changes in the short-run level of
real GDP as well
– it may be (and it may not be) a good
theory for booms, but it is hard to
see how it could ever become a good
explanation of recessions or
CHAPTER 8
Money, Prices, and Inflation
Questions
• What do economists mean by
“money”?
• Why is money useful?
• What do economists mean when
they say that money is a unit of
account?
• What determines the price level
and the inflation rate?
Questions
• Why would a government ever
generate “hyperinflation”?
money demand?
• What determines the level of the
money supply?
• Why is inflation seen as something
to be avoided?
Inflation
• In the 1970s, the United States
experienced an episode of
relatively mild inflation
– prices rose between five and ten
percent per year
– caused significant economic and
political trauma
• avoiding a repeat of the inflation of the
1970s remains a major goal of economic
policy
Figure 8.1 - Post-World War II Inflation in
the United States, 1951-2000
The Flexible-Price Model
• The Classical dichotomy implies
that real variables (real GDP, real
investment spending, or the real
exchange rate) can be analyzed
and calculated without considering
nominal variables (price level)
– money is “neutral”
• This is a special feature of the full-
employment flexible-price model
Money
• is wealth that is held in a readily-
spendable form
• is made up of
– coin and currency
– checking account balances
– other assets that can be turned into
cash or demand deposits nearly
instantaneously, without risk or cost
The Usefulness of Money
• Without money, market transactions
would have to be performed through
barter
• In a barter economy, market
exchange would require the
coincidence of wants
– you would have to have some good or
service that someone wants and he or
she would have to have some good or
service that you want
Figure 8.2 - Coincidence of Wants
The Usefulness of Money
• Money also serves as a unit of
account
– money is used as a yardstick to
measure value or quote prices
• Anything that alters the real value
of money in terms of its
purchasing power will also alter
the real terms of existing contracts
that use the money as a unit of
1-418 accountCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Demand for Money
• Businesses and households have a
demand for money
– they want to hold a certain amount of
wealth in the form of readily-spendable
purchasing power to carry out
transactions
• a higher level of spending means a larger
money demand
• There is a cost of holding money
– cash and checking deposits earn little or
no interest
Figure 8.3 - Reasons for and Opportunity
Cost of Holding Money
The Quantity Theory of Money
• assumes that the only important
determinant of the demand for money
is the flow of spending
• can be summarized using
– the Cambridge money-demand function
1
M = × (P × Y)
V
– the quantity equation
M× V = P × Y
The Quantity Theory of Money
M× V = P × Y
• (P × Y) represents the total
nominal flow of spending
• M is the quantity of money
• V is a measure of how fast money
moves through the economy
– how many times the average unit of
money is used to buy a final good or
service
Figure 8.4 - The Velocity of Money
Determining the Price
Level
• In the flexible-price model of the
macroeconomy
– real GDP (Y) is equal to potential GDP
(Y*)
– the velocity of money is determined by
the sophistication of the banking system
– the money supply is determined by the
central bank
V
P = ×M
Y
Level
V
P= ×M
Y
• If the price level is higher than the
quantity equation predicts
– households and businesses will have less
wealth in the form of money than they
wish
• they will cut back on purchases
– sellers will note demand is weak and
lower prices
Level
V
P= ×M
Y
• If the price level is lower than the
quantity equation predicts
– households and businesses will have
more wealth in the form of money than
they wish
• they will increase purchases
– sellers will note demand is strong and
raise prices
Level
• Example (third quarter of 1998)
– real GDP = $7,566 billion
– money stock = $1,072 billion
– velocity = 7.964
V  7.964 
P = ×M =   × $1,072 = 1.1284
Y  $7,556 
• In the third quarter of 1998, the price
level was equal to 112.84% of its
1992 level
The Money Stock
• The Federal Reserve determines
the money stock in the U.S.
– the determination of the money stock
is the basic task of monetary policy
• The Federal Reserve can directly
impact the monetary base
– the sum of currency in circulation and
deposits at the Federal Reserve’s
twelve branches
The Money Stock
• To reduce the monetary base, the
Federal Reserve sells short-term
government securities
• To increase the monetary base,
the Federal Reserve buys short-
term government securities
• These transactions are called open
market operations
Figure 8.5 - Open Market Operations
The Money Stock
• The Federal Reserve directly controls
the monetary base
• The other measures of the money
stock are determined by the
interaction of the monetary base with
the banking sector
– regulatory requirements
– the incentive of financial institutions to
have enough funds on hand to satisfy
depositors’ demands
The Money Stock
• Besides the monetary base (H), there
are other definitions of the money
stock such as
– M1 (currency, checking accounts,
travelers checks)
– M2 (M1 plus savings accounts, small
term deposits, money held in money
market accounts)
– M3 (M2 plus large term deposits and
institutional money market balances)
Table 8.1 - Measures of the Money Stock
Inflation
• The inflation rate is the proportional
rate of change in the price level
• Since V
P= ×M
Y
• the inflation rate (π) will be
π = v +m- y
– v=growth rate of velocity
– m=growth rate of the money stock
– y=growth rate of real GDP
Inflation
• Example
– growth rate of real GDP=4% per year
– growth rate of velocity=2% per year
– growth rate of the money stock=5% per
year
π = v + m - y = 2% + 5% - 4% = 3%
Inflation
• The bulk of changes in the rate of
inflation are due to changes in the
growth rate of the money stock
– the growth rate of the money stock
(m) can change quickly and
substantially
– changes in the growth rates of real
GDP (y) and velocity (v) are generally
smaller
Inflation
• In the real world, inflation is not
always proportional to money growth
– in the 1980s, both inflation and velocity
fell sharply but the money stock grew
– in the first half of the 1990s, velocity fell
• meant that high growth of the money stock
did not lead to high inflation
– in the second half of the 1990s, velocity
grew
• money supply growth was negative to keep
inflation from rising
Figure 8.6 - Money Growth and Inflation
Are Not Always Parallel
Money Demand
• Economic theory implies that
money demand should be
inversely related to the nominal
interest rate
– cash and checking account balances
earn little or no interest
– the purchasing power of money
erodes at the rate of inflation
– the expected real return on money is
-πe
Money Demand
• The opportunity cost of holding
money is the difference between
the rate of return on other assets
(r) and the rate of return on
money (-πe)
– the opportunity cost of holding
money is the nominal interest rate
[i=r+πe]
• As the opportunity cost of holding
1-440
money (i) rises, the quantity of
money balances demanded falls

Figure 8.7 - Money Demand and the
Inflation Rate
Money Demand
• The velocity of money can be
represented by
L e
V = V × [V0 + Vi(r + π )]
– VL represents the financial technology-
driven trend in velocity
– V0+Vi(r+πe) represents the dependence
of the demand for money on the nominal
interest rate
Money Demand
• The demand for nominal money
balances is
P×Y
M= L e
V × [V0 + Vi(r + π )]
Money, Prices, and
Inflation
• Suppose that the rate of growth of
the money stock permanently
increases
– the inflation rate will rise
– if the real interest rate is stable, the
opportunity cost of holding money
will rise
– the velocity of money will increase
– if the money stock and real GDP
remain fixed, the price level will jump
suddenly and discontinuously
Figure 8.8 - Effects of a Rise in Money Growth
The Costs of Inflation
• The costs of expected inflation
are small
– requires you to make more trips to
the bank
– firms must spend resources changing
their prices
– households find it difficult to
determine a good deal from a bad
one
– our tax laws are not designed to deal
well with inflation
The Costs of Inflation
• The costs of unexpected inflation
are more significant
– redistributes wealth from creditors to
debtors
• creditors receive less purchasing power
than they had anticipated
• debtors find the payments they must
make less burdensome than they had
expected
Hyperinflation
• occurs when inflation rises to more
than 20 percent per month
• arises when governments attempt
to obtain extra revenue by printing
money
– financing its spending by levying a
tax on holdings of cash
– known as an inflation tax
Figure 8.9 - The Inflation Tax
Hyperinflation
• Eventually prices rise so rapidly
that the monetary system breaks
down
– people would rather deal in barter
terms
• Real GDP begins to fall
– the economy loses the benefits of the
division of labor
• In the end, the currency becomes
1-450 worthless
Chapter Summary
• By “money” economists mean
something special: wealth in the form
of readily-spendable purchasing power
• Without money it is hard to imagine
how our economy could successfully
function
– the fact that everyone will accept money
as payment for goods and services is
necessary for the market economy to
function
Chapter Summary
• Money is not only a medium of
exchange, it is also a unit of
account: a yardstick that we use
to measure values and to specify
contracts
Chapter Summary
• Money demand is determined by
– businesses’ and households’ desire to
hold wealth in the form of readily-
spendable purchasing power to carry
out transactions
– businesses’ and households’
recognition that there is a cost to
holding money
• wealth in the form of readily-spendable
purchasing power pays little or no
interest
Chapter Summary
• The velocity of money is how many
transactions a given piece of
money manages to facilitate in a
year
– the principal determinant of velocity
is the economy’s “transactions
technology”
• The stock of money is determined
by the central bank
1-454
– the Federal Reserve
Copyright © 2002 in the
by The McGraw-Hill U.S.
Companies, Inc. All rights reserved.
Chapter Summary
• The price level is equal to the
money stock times the velocity of
money divided by the level of real
GDP
• The inflation rate is equal to the
proportional growth rate of the
money stock plus the proportional
growth rate of velocity minus the
proportional growth rate of real
1-455 GDP Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Governments cause hyperinflation
because printing money is a way
of taxing the public, and a
government that cannot tax any
other way will be strongly tempted
to resort to it
CHAPTER 9
The Income-Expenditure
Framework: Consumption and the
Multiplier
Questions
• What are “sticky” prices?
• What factors might make prices
sticky?
• When prices are sticky, what
determines the level of real GDP in
the short run?
Questions
happens to real GDP if some
component of aggregate demand
falls?
happens to real GDP if some
component of aggregate demand
rises?
• What determines the size of the
1-459 spending © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Copyrightmultiplier?
Real GDP in U.S. History
• The flexible-price model does not
give a complete picture of the
macroeconomy
– real GDP does not always grow by the
same rate as potential output
– the unemployment rate is not always
at the natural rate
– inflation is not always steady
Figure 9.1 - Real GDP per Worker and
Potential Output, 1960-2000
Business Cycles
• Fluctuations in economic growth
are called business cycles
• A business cycle has two phases
– expansion or boom
• production, employment, and prices all
grow rapidly
– recession or depression
• production falls, unemployment rises,
and inflation falls
Business Cycles
• To understand business cycles, we
need a model that does not always
guarantee full employment
• We will no longer assume that prices
are flexible
• Instead, prices will be assumed to be
“sticky”
– they will remain fixed at predetermined
levels as businesses expand or contract
production
A Decrease in Autonomous
Consumption (C0)
• Suppose that autonomous
consumption falls from $2,000
billion to $1,800 billion per year
• In the flexible-price model, real
GDP would be unaffected
– the economy would remain at full
employment
– real GDP would equal potential output
Figure 9.2 - Labor Market Equilibrium
Consumption (C0)
• In the flexible-price model, a fall in
consumption means an increase in
savings
– the real interest rate falls
– the equilibrium level of investment
and net exports increases by $200
billion per year
Figure 9.3 - The Effect on Savings of a
Fall in Consumption Spending in the
Consumption (C0)
• Under the flexible-price model, the
decline in the real interest rate will
lead to a decline in the velocity of
money
– the price level will fall
Consumption (C0)
• In the flexible-price model, the
consequences of a fall in
consumers’ desired baseline
consumption are
– a drop in consumption
– an increase in savings
– a decline in the real interest rate
– a rise in investment
– a rise in the value of the exchange
rate
Consumption (C0)
• In the sticky-price model, a drop in
consumption leads to a drop in
aggregate demand
• As businesses see the demand for
their products falling, they cut
back production
– they will fire some of their workers
– incomes will fall
Consumption (C0)
• In the sticky-price model, a drop in
consumption does not lead to an
increase in savings
– the increase in savings (from the fall
in consumption) is exactly offset by a
decrease in savings (from the fall in
income)
• The real interest rate is unaffected
– no change in investment or net
1-471 Copyright © 2002 by The McGraw-Hill Companies, Inc.
exports All rights reserved.
Figure 9.4 - The Effect on Savings of a
Fall in Consumption Spending in the
Sticky-Price Model
Consumption (C0)
• In the sticky-price model, the
consequences of a fall in
consumers’ desired baseline
consumption are
– a drop in consumption
– a decline in production
– a decline in employment
– a decrease in national income
– no change in the real interest rate,
investment, or the exchange rate
Expectations
• Price stickiness causes problems
only in the short run
• If individuals had time to foresee
and gradually adjust their wages
and prices to changes in aggregate
demand, sticky prices would not
be a problem
– both the stickiness of prices and the
failure to accurately foresee changes
1-474
are needed to create business cycles
Short Run vs. Long Run
• In the short run, prices are sticky
– shifts in policy or in the economic
environment that affect the level of
aggregate demand will affect real
GDP and employment
• In the long run, prices are flexible
– individuals have time to react and
adjust to changes in policy or the
economic environment
– real GDP and employment are
unaffected
Why Prices Are Sticky
• Menu costs are costs associated
with changing prices
– changing prices can be costly for a
variety of reasons
– managers and workers may prefer to
keep prices and wages stable as long
as the shocks that affect the
economy are relatively small
• Managers and workers lack full
information about the state of the
economy
• They may confuse changes in
economy-wide spending with
changes in demand for their
particular products
– cut production rather than cutting the
price of the product
• The level of prices is often
determined by “what is fair”
• Work effort and work intensity
depend on whether or not workers
feel that they are treated fairly
– most managers are reluctant to cut
wages
– if wages are sticky, firms will adjust
employment when aggregate demand
changes
1-478
• Managers and workers may suffer
from money illusion
– confuse changes in nominal prices
with changes in real prices
• firms react to higher nominal prices by
believing that it is profitable to produce
more
• workers react to higher nominal wages
by searching more intensively for jobs
and working more hours
The Multiplier Process
• If prices are sticky, higher
aggregate demand boosts
production
• Incomes rise
• Higher incomes give a further
boost to production which
increases aggregate demand even
more
Figure 9.5 - The Multiplier Process
Building Up Aggregate Demand
• Aggregate demand (planned
expenditure) has four components
– consumption (C)
– investment (I)
– government purchases (G)
– net exports (NX)
E = C + I + G + NX
The Consumption Function
• As incomes rise, consumption
spending rises
– less than dollar for dollar
• The share of an extra dollar of income
that shows up as additional
consumption is equal to the marginal
propensity to consume times the
share of income that escapes taxation
C = C0 + C y (1 - t)Y
Figure 9.6 - The Consumption Function
and the Marginal Propensity to Consume
• The slope of the consumption
function is smaller than the
marginal propensity to consume
(Cy)
– because of the tax system, a one-
dollar increase in national income
means less than a one-dollar increase
in disposable income
Figure 9.7 - Consumption as a Function of
After-Tax Disposable Income
• Example
– Cy = 0.75
– t = 0.40
– when Y = $8 trillion, C = $5.5 trillion
C = C0 + C y (1 - t)Y $5.5 = C0 + 0.45($8)
C = C0 + 0.75(1 - 0.4)Y $5.5 = C0 + $3.6
C = C0 + 0.45Y C0 = $1.9
C = $1.9 + 0.45Y
Other Components of
Aggregate Demand
• Investment is determined by the
real interest rate and assessments
of profitability made by firms’
managers I = I0 − Irr
• Government purchases is set by

politics
Other Components of
Aggregate Demand
• Net exports are equal to gross
exports minus imports
– gross exports are a function of the
real exchange rate (ε) and the level
of foreign real GDP (Yf)
f
NX = GX - IM = (X f Y + X ε ε ) - IMy Y
Figure 9.8 - Components of Aggregate
Demand, 1995
Components of
Expenditure
• The components of aggregate
demand can be divided into two
groups
– autonomous spending (A)
• components of aggregate demand that
do not depend directly on national
income
– the marginal propensity to expend
(MPE) times the level of national
income (Y)
Components of
Expenditure
E = [C0 + C y (1 - t)Y] + I + G + [GX - IMy ]
E = [C0 + I + G + GX] + [C y (1 - t) - IMy ]Y
E = A + MPE × Y
• A = autonomous expenditure
[A=C0+I+G+GX]
• MPE=marginal propensity to expend
[MPE=Cy(1-t)-IMy]
Figure 9.9 - The Income-Expenditure
Diagram
Diagram
• The intercept of the planned
expenditure or aggregate demand
line is the level of autonomous
spending (A)
– a change in the value of any
component of autonomous spending
will shift the planned expenditure line
up or down
Figure 9.10 - An Increase in Autonomous
Spending
Diagram
• The slope of the planned
expenditure or aggregate demand
line is the marginal propensity to
expend (MPE)
– changes in the marginal propensity to
consume (Cy), the tax rate (t), or in
the propensity to spend on imports
(IMy) will change the MPE and the
slope of the planned expenditure line
Figure 9.11 - An Increase in the Marginal
Propensity to Expend
Calculating the MPE
• Example
– Cy = 0.75
– t = 0.40
– IMy = 0.15
MPE = [C y (1 - t) - IMy ]
MPE = [0.75(1 - 0.40) - 0.15]

MPE = [0.45 - 0.15] = 0.30
Sticky-Price Equilibrium
• The economy will be in equilibrium
when planned expenditure equals
real GDP
– there will be no short-run forces
pushing for an immediate expansion
or contraction of national income,
real GDP, and aggregate demand
Figure 9.12 - Equilibrium in the Income-
Expenditure Diagram, 1996
• Equilibrium occurs when planned
expenditure (E) is equal to real GDP
(Y)
Y = E = A + MPE × Y
A
Y =E=
1 - MPE
• Example
– A = $5,600 billion Y = E = $5,600 = $8,000 billion
0.70
– MPE = 0.30
• If the economy is not on the 45-
degree line, the economy is not in
equilibrium
– planned expenditure (E) does not
equal real GDP (Y)
• If Y>E
– there is excess supply of goods
• If Y<E
– there is excess demand for goods
Figure 9.13 - Inventory Adjustment and
Equilibrium: Goods Market Equilibrium
and the Income-Expenditure Diagram
Inventory Adjustment
• Excess supply
– production > aggregate demand
– inventories are rising rapidly
– firms will cut production
• Excess demand
– production < aggregate demand
– inventories are being depleted
– firms will expand production
Figure 9.14 - The Inventory Adjustment
Process: An Income-Expenditure Diagram
The Multiplier
• Suppose that autonomous
spending increases
– the planned expenditure line will shift
up
– planned expenditure > national
income
• inventories would fall
• businesses would boost production
– how much production would expand
depends on the magnitude of the
change in autonomous spending and
the value of the multiplier
Figure 9.17 - The Multiplier Effect
The Multiplier
• The value of the multiplier
depends on the slope of the
planned expenditure line
– the higher is the MPE, the steeper is
the planned expenditure line and the
greater is the multiplier
Figure 9.18 - Determining the Size of the
Multiplier
The Multiplier
• Equilibrium means that
A
Y =E=
1 - MPE
1
∆Y = E = × ∆A
1 - MPE
1
∆Y = E = × ∆A
1 - [C y (1 - t) - IMy ]
The Multiplier
• 1/[1-MPE] is the multiplier
– it multiplies the upward shift in the
planned expenditure line into a
change in the equilibrium level of real
GDP, total income, and aggregate
demand
– because autonomous spending is
influenced by many factors, almost
every change in economic policy or
the economic environment will set the
1-511 multiplier
Copyright ©process in motion
2002 by The McGraw-Hill Companies, Inc. All rights reserved.
The Multiplier
• Example
Y = E = $9.0 trillion
– A = $5.6
trillion
MPE
––∆A = $0.1
= 0.3trillion Y = E = $9.143 trillion
∆Y 0.143
multiplier = = = 1.43
∆A 0.1
1 1
multiplier = = = 1.43
1 - MPE 0.7
The Multiplier
• One factor that tends to minimize
the multiplier is the government’s
fiscal automatic stabilizers
– proportional taxes
– social welfare programs
• An economy that is more open to
world trade will have a smaller
multiplier than a less open
economy
Chapter Summary
• Business-cycle fluctuations can push
real GDP away from potential output
and unemployment far away from its
average rate
• If prices were perfectly and
instantaneously flexible, there would
be no such thing as business cycle
fluctuations
– models in which prices are sticky must
play a large role in macroeconomics
Chapter Summary
• There are a number of reasons that
prices might be sticky
– menu costs, imperfect information,
concerns of fairness, or money illusion
– there is no overwhelming evidence as to
which is most important
• In the short run, while prices are
sticky, the level of real GDP is
determined by the level of aggregate
demand
Chapter Summary
• The short-run equilibrium level of real
GDP is that level at which aggregate
demand (as a function of national
income) is equal to the level of
national income (real GDP)
• Two quantities summarize planned
expenditure as a function of total
income
– the level of autonomous spending and
the marginal propensity to expend (MPE)
Chapter Summary
• The level of autonomous spending
is the intercept of the planned
expenditure function on the
income-expenditure diagram
– tells us what the level of planned
expenditure would be if national
income was zero
Chapter Summary
• The MPE is the slope of the
planned expenditure function on
the income-expenditure diagram
– tells us how much planned
expenditure increases for each one
dollar increase in national income
Chapter Summary
• The value of the MPE depends on
the tax rate (t), the marginal
propensity to consume (Cy), and
the share of spending on imports
(IMy)
MPE = C y (1 - t) - IMy
Chapter Summary
• In the simple macro models, an
increase in any component of
autonomous spending causes a
more than proportional increase in
real GDP
– the result is the multiplier process
• The size of the multiplier depends
on the MPE∆Y = 1
∆A 1 - MPE
CHAPTER 10
Investment, Net Exports, and

Interest Rates
Questions
• How are the determinants of
investment different in a sticky-price
than in a flexible-price model?
• How are the determinants of net
exports different in a sticky-price than
in a flexible-price model?
• How do changes in interest rates
affect the equilibrium level of
production and income in a sticky-
price model?
Questions
• What is the “IS Curve”?
– What use is it?
• What determines the equilibrium
level of real GDP when the central
bank’s policy is to keep the real
interest rate constant?
The Importance of
Investment
• Changes in investment are the
driving force behind the business
cycle
– reductions in investment have played
a powerful role in every recession and
depression
– increases in investment have spurred
every boom
The Importance of
Investment
• Understanding the causes and
consequences of changes in
investment will help us to
understand business cycles
Figure 10.1 - Investment as a Share of
Real GDP, 1970-2000
The Role of Investment
• In the flexible-price model, the
real interest rate is a market-
clearing price
– it is pushed up or down by supply and
demand to equate the flow of savings
to the flow of investment
The Role of Investment
• In the sticky-price model, the interest
rate is not set in the loanable funds
market
– it is set directly by the central bank or
indirectly by the combination of the stock
of money and the liquidity preferences of
households and businesses
– businesses match the quantity they
produce to aggregate demand
• automatically creates balance in the financial
market
Fluctuations in Investment
• Fluctuations in investment have
two sources
– changes in the real interest rate
– shifts in investors’ expectations about
future growth, profits, and risk
I = I0 - Ir × r
Investment and the
Interest Rate
• The opportunity cost of an
investment project is the real
interest rate
– the higher the interest rate, the lower
the number and value of investment
projects that will return more than
their current cost and the lower the
level of investment spending
Investment and the
Interest Rate
• The interest rate that is relevant
for determining investment
spending is a long-term interest
rate
– when considering an investment
project, a manager must compare the
potential profits of the project to the
opportunity to make money from a
long-term commitment of the funds
elsewhere
Investment and the
Interest Rate
• Long-term and short-term interest
rates are different and do not
always move in step
– long-term interest rates are usually
higher than short-term interest rates
– the term premium is the premium
in the interest rate that the market
charges on long-term loans vis-à-vis
short term loans
Figure 10.2 - Bond Yield Curves
Investment and the
Interest Rate
• The interest rate that is relevant
for investment spending decisions
is the real interest rate
Figure 10.3 - Gaps between Real and
Nominal Interest Rates
Investment and the
Interest Rate
• The interest rate that a firm faces
is the interest rate charged to
risky borrowers
– the premium that lenders charge for
loans to companies rather than to
safe government borrowers is called
the risk premium
Figure 10.4 - The Risk Premium: Safe and
Risky Interest Rates
Investment and the
Interest Rate
I = I0 - Ir × r
• In the investment function the

relevant interest rate (r) is the
long-term, real, risky interest
rate
• As r rises, the level of investment
spending will decline
Figure 10.5 - Investment as a Decreasing
Function of the Long-Term, Real,
Risky Interest Rate
Exports and Autonomous
Spending
• Gross exports depend on
– foreign total incomes (Yf)
• the real exchange rate depends on the
domestic real interest rate (r)
• Like investment, gross exports are
affected by changes in the real
interest rate
Exports and Autonomous
Spending
A = C0 + (I0 - Ir × r) + G + (X f Y f + X ε ε 0 + X ε εr × r f ) - X ε εr × r
• A higher interest rate reduces

autonomous spending (A) by
reducing exports (Xεεr × r) as well
as by reducing investment (Ir × r)
Exports and the
Interest Rate
• A higher real interest rate reduces
gross exports
– investing in the home country is more
attractive
• foreign exchange speculators shift their
portfolio holdings to include more home
currency-denominated assets
• exports are more expensive to foreigners
Figure 10.6 - From the Real Interest Rate
to the Change in Exports
Autonomous Spending and
the Real Interest Rate
A = [C0 + I0 + G + (X f Y f + X ε ε 0 + X ε εr × r f )] - (Ir + X ε εr ) × r
• A one-percentage-point increase in
the real interest rate (r) reduces
autonomous spending by (Ir +
Xεεr)
Figure 10.7 - Autonomous Spending as a
Function of the Real Interest Rate
The Investment-Saving
(IS) Curve
• Because a change in the real
interest rate changes autonomous
spending, it will change the
equilibrium level of real GDP
– the effect will be equal to the interest
sensitivity of autonomous spending
(Ir + Xεεr) times the multiplier
(IS) Curve
• The relationship between the level
of the real interest rate and the
equilibrium level of real GDP is the
IS curve
– IS stands for “Investment-Saving”
(IS) Curve
• To find a point on the IS curve:
– pick a value for the real interest rate
and determine the level of
autonomous spending at that interest
rate
– use the income-expenditure diagram
to determine the equilibrium level of
real GDP
• Repeat this procedure to find other
on the
1-548 pointsCopyright © 2002 IS McGraw-Hill Companies, Inc. All rights reserved.
by Thecurve
Figure 10.8 - The IS Curve
The IS Curve
A = [C0 + I0 + G + (X f Y f + X ε ε 0 + X ε εr × r f )] - (Ir + X ε εr ) × r
• Define baseline autonomous

spending (A0) to include the
determinants of autonomous
spending that do not depend on
the real interest rate
f f
A 0 = [C0 + I0 + G + (X f Y + X ε ε 0 + X ε εr × r )]
A = A 0 - (Ir + X ε εr ) × r
The IS Curve
• Recall that real GDP is equal to
autonomous spending (A) divided
by (1-MPE) A - (I + X ε ) × r
0 r ε r
Y =
1 - MPE
• Substituting, we get
[C0 + I0 + G + (X f Y f + X ε ε 0 + X ε εrr f )] (Ir + X ε εr )
Y= - ×r
1 - (C y (1 - t) - IMy ) 1 - (C y (1 - t) - IMy )
The IS Curve
[C0 + I0 + G + (X f Y f + X ε ε 0 + X ε εrr f )] (Ir + X ε εr )
Y= - ×r
1 - (C y (1 - t) - IMy ) 1 - (C y (1 - t) - IMy )
• The term on the left is the

horizontal intercept of the IS
curve
– the value of equilibrium real GDP if
the real interest rate was equal to
zero
• The term on the right is the slope
of the IS curve
– the responsiveness of real GDP to
Figure 10.9 - The IS Curve
The Slope of the IS Curve
 1 
IS slope =   × (Ir + X ε εr )
 1 - (C (1 - t) - IM ) 
 y y 
• The first term is the multiplier

(1/1-MPE)
• The second term shows how large
a change in investment or exports
is generated by a change in the
real interest rate
The Position of the IS
Curve
• The position of the IS curve
depends on the baseline level of
autonomous spending times the
multiplier
A0 [C0 + I0 + G + (X f Y f + X ε ε 0 + X ε εrr f )]
=
1 - MPE 1 - (C y (1 - t) - IMy )
• Changes in any of these determinants

will shift the position of the IS curve
Figure 10.10 - A Change in Fiscal Policy
and the Position of the IS Curve
Changes in the Interest Rate
• To calculate how much a change in
the interest rate will shift the
equilibrium level of real GDP, you
need to know four things:
– the marginal propensity to spend
(MPE)
– the interest sensitivity of investment
(Ir)
– the interest sensitivity of the
exchange rate (εr)
– the exchange rate sensitivity of
Moving to the IS Curve
• If the economy is above the IS curve:
– real GDP > planned expenditure
• inventories rise
• firms cut production
• employment, real GDP, and national income
fall
• If the economy is below the IS curve:
– planned expenditure > real GDP
• inventories fall
• firms expand production
• employment, real GDP, and national income
rise
Figure 10.11 - Off of the IS Curve
Shifting the IS Curve
• Two kinds of government policies
directly affect the position of the
IS curve
– a shift in tax rates changes both the
position and the slope of the IS curve
– a change in the level of government
purchases changes the position of the
IS curve
Shifting the IS Curve
• Example - an increase in government
spending
– ∆G = $200 billion
– MPE = 0.5 ∆A 0 Ir + X ε εr
– Ir = $0.11 ∆Y = - × ∆r
1 - MPE 1 - MPE
– Xεεr = $0.015
– r = 4%
$0.2 $0.11 + $0.015
∆Y = - × 0 = $0.4 trillion
1 - 0.5 1 - 0.5
Moving along the IS Curve
• Changes in the real interest rate
will move the economy along the
IS curve
– a higher real interest rate will
produce a lower level of aggregate
demand and equilibrium real GDP
– a lower real interest rate will produce
a higher level of aggregate demand
and equilibrium real GDP
Moving along the IS Curve
• Example - cutting interest rates to
boost equilibrium real GDP by $500
billion Ir + X ε εr
IS slope =
– MPE = 0.5 1 - MPE
– Ir = $0.11 ($0.11 + 5 × $0.003)
=
– Xε = 5% 1 - 0.5
– εr = $0.003 = $0.25 trillion
• To boost real GDP by $500 billion, the
real interest rate must fall by 2
percentage points
Figure 10.12 - Cutting Target Interest
Rates and Raising Real GDP
Changing Interest Rates
• The Federal Reserve controls
interest rates through open
market operations
– buying and selling short-term
government bonds for cash
Open Market Operations
• When the Federal Reserve buys
government bonds
– the total cash in the hands of the
public and bank reserves increases
– households, businesses, and banks
find that they are holding more
money than they would like
• use the money to buy assets (such as
bonds)
– bond prices rise and interest rates fall
Open Market Operations
• When the Federal Reserve sells
government bonds
– the total cash in the hands of the
public and bank reserves decreases
– households, businesses, and banks
find that they are holding less money
than they would like
• try to get money by selling assets (such
as bonds)
– bond prices fall and interest rates rise
Figure 10.13 - Open Market Operations
Difficulties
• Our knowledge of the structure of
the economy is imperfect
• Even when policies have their
expected effects, these effects do
not necessarily arrive on schedule
• The interest rates the Federal
Reserve can control are short-
term, nominal, safe interest rates
The IS Curve of the 1960s
• In the 1960s, there was a
rightward shift in the IS curve
– increased optimism on the part of
businesses
– a cut in income taxes
– extra government expenditures
(Vietnam War)
Figure 10.14 - Real GDP and the Interest
Rate, 1960-1999
• In the late 1960s, there was a
movement down along the IS
curve as real interest rates
declined
– the drop in real interest rates was
caused (in part) by an increase in
inflation
Figure 10.15 - Shifting Out and Moving
along the IS Curve, 1960s
The IS Curve of the
Late 1970s
• From 1977 to 1979, the U.S.
economy moved down and to the
right of the IS curve
– the expansion toward potential
output was accompanied by high and
rising inflation
• In 1979, the Federal Reserve
began fighting inflation
– raised real interest rates from 1979
to 1982
Figure 10.16 - Moving along the IS Curve,
Late 1970s
• The 1980s began with a large
outward shift in the IS curve
– an increase in military spending
– a cut in income taxes
– an increase in investor optimism
• The Federal Reserve responded to
this shift by raising real interest
rates
Figure 10.17 - Shifting the IS Curve Out,
Early 1980s
• As inflation remained low through
the mid- and late- 1980s, Federal
Reserve policymakers gained
confidence
– began reducing real interest rates
causing a movement along the IS
curve
Figure 10.18 - Moving along the IS Curve,
Late 1980s
• In the second half of 1990, there
was a leftward shift of the IS curve
– a drop in investment as firms worried
about the price of oil after the Iraqi
invasion of Kuwait
• The Federal Reserve took no steps
to reduce real interest rates to
offset the recession
• In 1993, the Federal Reserve
began a policy of maintaining
lower interest rates in response to
the reduction in the federal budget
deficit
– the goal of the policy was to increase
investment
• During the last half of the 1990s,
interest rates remained low
Copyright
1-581• Inflation © 2002 by The McGraw-Hill
remained low Companies, Inc. All rights reserved.
as well
Figure 10.19 - The Recession of 1990-
1992
Chapter Summary
• In the sticky-price model, the
investment function is the same as in
the flexible-price model
– in the flexible price model, the level of
savings determined investment and the
investment function determined the real
interest rate
– in the sticky-price model, the real
interest rate is determined outside the IS
framework, and the level of investment
powerfully affects the level of real GDP
Chapter Summary
• The international sector of the sticky-
price model is essentially the same as
the international sector of the flexible-
price model
Chapter Summary
• The income-expenditure diagram
takes autonomous spending as given,
and then determines the equilibrium
levels of real GDP, aggregate demand,
and national income as functions of
autonomous spending and the
marginal propensity to spend
Chapter Summary
• The IS curve incorporates the
effect of changing interest rates on
autonomous spending and adds
this effect of changing interest
rates on autonomous spending to
the income-expenditure diagram
Chapter Summary
• The IS curve slopes downward
because a higher interest rate
lowers both investment and
exports and these reductions in
autonomous spending in turn
lower aggregate demand and
equilibrium real GDP
Chapter Summary
• When the central bank’s policy
involves targeting the real interest
rate, the position of the IS curve
and the central bank’s interest rate
target together determine the
equilibrium level of aggregate
demand and real GDP
CHAPTER 11
Extending the Sticky-Price Model:

IS-LM, International Side,
and AS-AD
Questions
• What is money-market
equilibrium?
• What is the LM curve?
• What determines the equilibrium
level of real GDP when the central
bank policy is to keep the money
supply constant?
• What is the IS-LM framework?
Questions
• What is an IS shock?
• What is an LM shock?
• What is the relationship between
shifts in the equilibrium on the IS-
LM diagram and changes in the
real exchange rate?
Questions
• What is the relationship between
shifts in the equilibrium on the IS-
LM diagram and changes in the
balance of trade?
• What is the aggregate supply
curve?
• What is the aggregate demand
curve?
• Three facts about business and
household demand for money
– money demand is proportional to
total nominal income (P×Y)
– money demand has a time trend, the
result of slow changes in the banking
sector structure and technology
– money demand is inversely related to
the nominal interest rate
• Money demand is inversely related
to the nominal interest rate
(i=r+π) because the nominal
interest rate is the opportunity
cost of holding money
– money balances lose purchasing
power at the rate of inflation (π)
– if money balances were placed in
some other asset, they would earn
the prevailing market real interest
rate (r)
• To keep our model simple, we will
ignore the time trend in velocity
• The demand for money can be
expressed as
Md Y
=
P V0 + Vi × (r + πe )
• Money demand is proportional to real
GDP and a decreasing function of the
nominal interest rate
Money Market Equilibrium
• In a sticky-price model, the price level
is predetermined
– it cannot move instantly to make money
supply equal to money demand
• The nominal interest rate must adjust
to keep the money market in
equilibrium

 (Y × P)  − V
s 0
e
i = (r + π ) =  M 
Vi
Figure 11.1 - Money Demand and
Money Supply
• If money supply < money demand
– businesses and households want to hold
larger money balances and try to borrow
to increase their cash holdings
– banks respond by raising interest rates
– as the nominal interest rate rises, the
quantity of money demanded falls
– this process continues until the quantity
of money demanded is equal to the
money supply
• If money supply > money demand
– businesses and households are holding
larger money balances than they want so
they deposit them at the bank
– banks want to increase loans and thus
respond by lowering interest rates
– as the nominal interest rate falls, the
quantity of money demanded rises
– this process continues until the quantity
of money demanded is equal to the
money supply
The LM Curve
• Because the demand for money
depends on the level of real GDP,
if the money stock is constant, the
equilibrium nominal interest rate
will vary whenever real GDP varies
Figure 11.2 - Money Demand Varies as
Total Income Y Varies
The LM Curve
• The LM curve shows the
relationship between the level of
real GDP and the equilibrium
nominal interest rate that clears
the money market
• The LM curve slopes upward
– at a higher level of real GDP, money
demand is higher and therefore the
equilibrium nominal interest rate is
higher
1-602
Figure 11.3 - From Money Demand to the
LM Curve
The LM Curve
• The equation for the LM curve is
M e
Y = [V0 + Vi × (r + π )] ×  
P
• Increases in the money supply shift

the LM curve to the right
• A decline in the price level shifts the
LM curve to the right
The IS-LM Framework
• As long as we know the expected
inflation rate, we can plot the IS
and LM curves on the same axis
• The equilibrium levels of real GDP
and the interest rate occur at the
point where the IS and LM curves
intersect
– the economy is in equilibrium in both
the goods market and the money
1-605
market
Figure 11.4 - The IS-LM Diagram
IS-LM Equilibrium
• Example (assume that π is
constant at 3%)
– IS curve: Y = $10,000 - $20,000r
– LM curve: Y = $1,000 +
$100,000(r+π)
$10,000 - $20,000r = $1,000 + $100,000(r + 3)
$6,000 = $120,000r
r = 0.05 = 5%
Y = $9,000 billion
Figure 11.5 - IS-LM Equilibrium Example
IS Shocks
• Any change in economic policy or the
economic environment that increases
autonomous spending shifts the IS
curve to the right
– the new equilibrium will have a higher
level of real GDP and a higher real
interest rate
– how the total effect is divided between
increased interest rates and increased
real GDP depends on the slope of the LM
curve
Figure 11.6 - Effect of a Positive IS Shock
An IS Shock
• Example
– initial IS curve: Y = $10,000 - $20,000r
– LM curve: Y = $1000 + $100,000(r+3)
– initial equilibrium: r=5%; Y = $9,000
– autonomous spending increases
– new IS curve: Y = $10,300 - $20,000r
$10,300 - $20,000r = $1,000 + $100,000(r + 3)
r = 0.0525 = 5.25%
Y = $9,250 billion
Figure 11.7 - Calculating the Effect of an
IS Shift
LM Shocks
• An increase in the money stock will
shift the LM curve to the right
– the new equilibrium position will have
a higher level of equilibrium real GDP
and a lower interest rate
Figure 11.8 - Effect of an Expansionary
LM Shock
An LM Shock
• Example
– IS curve: Y = $10,000 - $20,000r
– initial LM curve: Y=$1000+$100,000(r+3)
– initial equilibrium: r=5%; Y=$9,000
– the money supply increases
– new LM curve: Y=$2200 + $100,000(r+3)
$10,000 - $20,000r = $2200 + $100,000(r + 3)
r = 0.04 = 4%
Y = $9,200 billion
Figure 11.9 - An Expansionary Shift in the
LM Curve
Interest Rate Targets
• The case in which the central bank
is targeting the interest rate can
be viewed in the IS-LM framework
• An interest rate target can be seen
as a flat, horizontal LM curve at
the target level of the interest rate
Figure 11.10 - IS-LM Framework with an
Interest Rate Target
Changes that Affect the
LM Curve
• Any change in the nominal money
stock, in the price level, or in the
trend velocity of money will shift
the LM curve
• Any change in the interest
sensitivity of money demand will
change the slope of the LM curve
LM Curve
• The IS-LM diagram is drawn with
the long-term, risky, real interest
rate on the vertical axis
• The LM curve is a relationship
between the short-run nominal
interest rate and the level of real
GDP at a fixed level of the money
supply
LM Curve
• As long as the spread between the
short-term, safe, nominal interest
rate and the long-term, risky, real
interest rate is constant, there are
no complications in drawing the LM
curve onto the same diagram as
the IS curve
LM Curve
• If the expected rate of inflation,
the risk premium, or the term
premium between short- and long-
term interest rates changes, the
LM curve will shift
– changes in financial market
expectations of future Federal
Reserve policy, future interest rates,
or changes in the risk tolerance of
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LM curve
Figure 11.11 - An Increase in Expected
Inflation Moves the LM Curve Downward
IS Curve
• Shifts in the IS curve are more
frequent than shifts in the LM
curve
• Any change in the interest
sensitivity of investment, the
sensitivity of exports to the
exchange rate, or the sensitivity of
the exchange rate to the domestic
interest rate will change the slope
1-624 of theCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
IS curve
IS Curve
• Anything that affects MPE will
change the slope and the position
of the IS curve
– this includes changes in the MPC, tax
rates, and the propensity to import
• Any change in autonomous
spending will shift the IS curve
The IS-LM Framework and
the Exchange Rate
• In the sticky-price model, the real
exchange rate (ε) is equal to
ε = ε0 - εr (r - r f )
• As long as the domestic real interest

rate does not change, domestic
conditions will have no impact on the
exchange rate
the Exchange Rate
• Changes in the IS and LM curves that
change the domestic real interest rate
will alter the real exchange rate by an
amount equal to (εr × ∆r)
– a rightward shift in the IS curve or a
leftward shift in the LM curve will lower
the real exchange rate
– a leftward shift in the IS curve or a
rightward shift in the LM curve will raise
the real exchange rate
Figure 11.12 - IS-LM and the Exchange
Rate
the Balance of Trade
• Changes in the domestic interest
rate affect the real exchange rate
which affects gross exports
• Changes in total income affect
imports
• The effect on net exports is the
difference∆NX
between
= ∆GX - these
∆IM two
effects
∆NX = −(εr × ∆r) - (IMy × ∆Y)
Figure 11.13 - Effect of a Change in
Domestic Conditions on the Exchange
Rate and the Balance of Trade
An LM Shock and the
Balance of Trade
• Example
– initial IS curve: Y=$10,000 - $20,000r
– initial LM curve: Y=$1000+$100,000(r+3)
– initial equilibrium: r=5%; Y=$9,000
– the money supply increases
– new LM curve: Y=$2200+$100,000(r+3)
– new equilibrium: r=4%; Y=$9,200
Figure 11.14 - Effects of Expansionary
Monetary Policy
An LM Shock and the
Balance of Trade
• Example (continued)
– the decrease in the real interest rate
increases the exchange rate by [(-εr × ∆r)=
-10 × (-.01)=0.10] and the rise in the real
exchange rate increases gross exports by
[(Xε × ∆ε)=$200 × 0.1=$20]
– the increase in real national income
increases imports by [(IMy × ∆Y)=$0.15 ×
$200=$30]
– net exports falls by $10
International Shocks
• Three types of international shocks
will affect the IS-LM equilibrium
– a shift in foreign demand for exports
– a shift in the foreign real interest rate
– a change in foreign exchange
speculators’ view about the
fundamental value of the exchange
rate
• An increase in export demand is an
increase in autonomous spending
(A0)
– the IS curve shifts rightward by an
amount equal to ∆A0/(1-MPS)
– equilibrium real GDP rises and the
real interest rate rises as well (if the
LM curve is upward sloping)
Figure 11.15 - Effect of an Increase in
Foreign Demand for Exports
• An increase in the foreign interest
rate raises the value of the
exchange rate and boosts exports
– the IS curve shifts to the right
– equilibrium real GDP rises and the
real interest rate also increases (if
the LM curve is upward sloping)
• If foreign exchange speculators
lose confidence in their home
currency, the exchange rate will
rise
– the IS curve will shift to the right
– equilibrium real GDP will rise and the
real interest rate will increase
(assuming that the LM curve is
upward sloping)
• Example
– LM curve: Y = $1000 +
$100,000(r+3)
– initial IS curve: Y = $10,000 -
$20,000r
– initial equilibrium: r=5%; Y= $9,000
– foreign exchange speculators lose
confidence in the value of home
currency
– new IS curve: Y = $10,120 -
$20,000r
Aggregate Demand
• If the nominal money supply is
fixed, an increase in the price level
shifts the LM curve to the left
– the equilibrium real interest rate rises
– the equilibrium level of real GDP falls
• If we plot the level of equilibrium
real GDP for each possible price
level, we will get the aggregate
demand curve
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be downward sloping Companies, Inc. All rights reserved.
Figure 11.16 - An Increase in the Price
Level Shifts the LM Curve Left (If the
Nominal Money Supply is Fixed)
Figure 11.17 - From the IS-LM Diagram
to the Aggregate Demand Curve
Monetary Policy and
Aggregate Demand
• Modern central banks alter the
money supply in response to
changes in the economy
– when inflation rises, the central bank
tends to increase the real interest
rate
Monetary Policy and
Aggregate Demand
• The Taylor rule is a simple model
of how central banks act
– the central bank has a target value of
inflation (π’) and an estimate of what
the normal real interest rate should
be (r*)
– if inflation is higher than π’, the
central bank raises the real interest
rate
– if inflation is lower than π’, the central
bank lowers the real interest rate
Monetary Policy and
Aggregate Demand
• The Taylor rule can be expressed
in equation form:
r = r * + φ"×(π - π' )
• where φ” determines how aggressively
the central bank reacts to inflation
Monetary Policy and
Aggregate Demand
• The Taylor rule can be
substituted into the equation for
 the
A 0 IS curve
Ir + X ε εr  φ"×(Ir + X ε εr )
Y= − × r * − × (π - π' )
1 - MPE 1 - MPE  1 - MPE
• Simplifying, we get
Y = Y0 − φ'×(π - π' )
Monetary Policy and
Aggregate Demand
Y = Y0 − φ'×(π - π' )
• The monetary policy function is
a relationship between the inflation
rate and real GDP
– it assumes that the Federal Reserve
is engaged in the economy trying to
keep inflation close to its target
Figure 11.18 - The Monetary Policy Reaction
Function
Aggregate Supply
• When real GDP is greater than
potential output, inflation is likely
to be higher than previously
anticipated
– inflation will like accelerate
• When real GDP is lower than
potential output, inflation is likely
to be lower than previously
anticipated
– the inflation rate McGraw-Hill
by The will likelyCompanies,
fallInc. All rights reserved.
(may
even end up with deflation)
Aggregate Supply
• The relationship between real GDP
(relative to potential output) and the
rate of inflation (relative to its
previously-expected value) is the
short-run aggregate supply curve
Aggregate Supply
• The short-run aggregate supply curve
can be expressed in equation form
Y-Y*  P - Pe 
e
= θ ×  
Y*  P 
Y-Y*
= θ × (π - πe )
Y*
Figure 11.19 - Output Relative to
Potential and the Inflation Rate
Aggregate Supply and
Aggregate Demand
• Where the aggregate supply and
aggregate demand curves cross is
the current level of real GDP and
the current inflation rate
Figure 11.20 - Aggregate Supply and
Aggregate Demand
Short-Run Aggregate
Supply
• High levels of real GDP are
associated with high inflation and a
high price level for many reasons
– when demand for products is
stronger than anticipated, firms raise
their prices
– when aggregate demand is higher
than potential output, some
industries may reach the limits of
capacity
Chapter Summary
• The money market is in
equilibrium when the level of total
incomes and of the short-term
nominal interest rate is just right
to make households and
businesses want to hold all the real
money balances that exist in the
economy
Chapter Summary
• When the central bank’s policy keeps
the money supply fixed--or when
there is no central bank--the LM curve
consists of those combinations of
interest rates and real GDP levels at
which money demand equals money
supply
Chapter Summary
• When the central bank’s policy keeps
the money supply fixed--or when
there is no central bank--then the
point at which the IS and LM curves
cross determines the equilibrium level
of real GDP and the interest rate
Chapter Summary
• The IS-LM framework consists of
two equilibrium conditions
– the IS curve shows those
combinations of interest rates and
real GDP levels at which aggregate
demand is equal to total production
– the LM curve shows those
combinations of interest rates and
real GDP levels at which money
demand is equal to money supply
Chapter Summary
• An IS shock is any shock to the
level of total spending as a
function of the domestic real
interest rate
– an IS shock shifts the position of the
IS curve
– an expansionary IS shock raises real
GDP and the real interest rate
Chapter Summary
• An LM shock is a shock to money
demand or money supply
– an LM shock shifts the position of the
LM curve
– an expansionary LM shock raises real
GDP and lowers the real interest rate
Chapter Summary
• Anything that affects the level of
the real interest rate on the IS-LM
diagram affects the real exchange
rate
– increases in the real interest rate
reduce the value of the real exchange
rate, holding other things constant
Chapter Summary
• A number of different international
shocks can also affect the real
exchange rate
– a collapse in foreign exchange
speculator confidence in the currency
raises the real exchange rate
– an increase in the real interest rate
abroad also raises the real exchange
rate
Chapter Summary
• The aggregate supply curve
captures the relationship between
aggregate demand and the price
level
– the higher is real GDP, the higher the
price level and inflation rate are likely
to be
Chapter Summary
• The aggregate demand
relationship arises because
changes in the price level and
inflation rates cause shifts in the
determinants of aggregate
demand--either directly as
changes in the price level change
the money stock, or indirectly as
changes in the inflation rate
1-665
change the interest rate target of
the central bank

Chapter Summary
• Together, the aggregate demand
and aggregate supply curves make
up the AS-AD framework, which
allows us to analyze the impact of
changes in economic policy and
the economic environment not just
on real GDP but also on the price
level and the inflation rate as well
CHAPTER 12
The Phillips Curve and Expectations
Questions
• What is the Phillips curve?
• How has the natural rate of
unemployment changed in the U.S.
over the past two generations?
• What determines the expected rate of
inflation?
• How can we tell how expectations of
inflation are formed--whether they
are static, adaptive, or rational?
Questions
• How useful is the aggregate demand-
aggregate supply framework--the IS-
LM model and the Phillips curve--for
understanding macroeconomic events
in the U.S. over the past two
generations?
• How do we connect up the sticky-
price model with the flexible-price
model?
Okun’s Law
• Okun’s law shows the relationship
between the unemployment rate and
real GDP
 Y - Y *
u - u* = -0.4 ×  
 Y* 
• or
 Y - Y *
  = -2.5 × (u - u*)
 Y* 
The Three Faces of
Aggregate Supply
• Aggregate supply relates the price
level to the level of real GDP
• Aggregate supply can also relate
the inflation rate to the level of
real GDP
• Using Okun’s law, aggregate
supply can also relate the inflation
rate to the unemployment rate
– this relationship is known as a
Phillips curve
The Phillips Curve
• Aggregate supply can relate the
inflation rate to the level of real GDP
 Y - Y * e
  = θ × (π - π )
 Y* 
• The right-hand side of this equation
can be substituted into Okun’s Law
- 2.5 × (u - u*) = θ × (π - πe )
2.5e
π=π - × (u - u*)
θ
The Phillips Curve
• Letting β=2.5/θ, we get the Phillips
curve
e
π = π - β × (u - u*)
• To allow for supply shocks, we will

add an extra term to the Phillips curve
(εs)
e s
π = π - β × (u - u*) + ε
Figure 12.1 - The Phillips Curve
Figure 12.2 - Three Faces of Aggregate Supply
The Phillips Curve
• The slope of the Phillips curve
depends on how sticky prices and
wages are
– the stickier are wages and prices, the
smaller is parameter β, and the flatter is
the Phillips curve
• When the Phillips curve is flat, even
large changes in the unemployment
rate have little effect on the price
level
The Phillips Curve
• Whenever unemployment is equal
to its natural rate, inflation is equal
to expected inflation
– the position of the Phillips curve can
be determined if we know the natural
rate of unemployment and the
expected inflation rate
The Phillips Curve
• The Phillips curve shifts if either
expected inflation or the natural rate
of unemployment changes or if a
supply shock occurs
– a higher natural rate moves the Phillips
curve to the right
– higher expected inflation moves the
Phillips curve up
– adverse supply shocks move the Phillips
curve up
Figure 12.3 - Shifts in the Phillips Curve
Aggregate Demand
• The aggregate demand function
developed in Chapter 11 shows how
real GDP relates to the inflation rate
Y = Y0 - φ'×(π − π' )
• We can use Okun’s Law to develop an
aggregate demand equation with
unemployment on the left-hand side
u = u0 - φ × (π − π' )
Aggregate Demand
u = u0 - φ × (π − π' )
• The parameter φ is the product of
three things
– how much the central bank raises the
real interest rate in response to inflation
– how much real GDP changes in response
to a change in the real interest rate
– how large a change in unemployment is
produced by a change in real GDP
Equilibrium Levels of
Inflation and
Unemployment
• Together, the unemployment form
of the aggregate demand
relationship and the Phillips curve
equation allow us to determine
what the inflation and
unemployment rates will be in the
economy
– the economy’s equilibrium is where
the two curves cross
Figure 12.4 - Equilibrium Levels of
Unemployment and Inflation
Equilibrium
• The economy’s equilibrium inflation
and unemployment rates depend on
– the natural rate of unemployment (u*)
– the expected rate of inflation (πe)
– supply shocks (εs)
– the level of unemployment when the real
interest rate is at what the central bank
thinks is its long-run average (u0)
– the central bank’s target level of inflation
(π’)
Solving for Equilibrium
• To solve for the equilibrium
unemployment rate, substitute the
Phillips curve equation into the
monetary policy reaction function
 1 φβ  φ e φ
u =  u0 + u *  + (π − π' ) + εs
 1 + φβ 1 + φβ  1 + φβ 1 + φβ
Solving for Equilibrium
• To solve for the equilibrium
inflation rate, substitute the
monetary policy reaction function
into the Phillips curve
 1 e φβ  β 1
π =  π + π'  + (u * −u0 ) + εs
 1 + φβ 1 + φβ  1 + φβ 1 + φβ
A Decrease in Exports
• If export demand falls, and the central
bank does nothing, u0 will rise by ∆u0
• The effect on the equilibrium level of
unemployment will be
1
∆u = ∆u0
1 + φβ
• The effect on the equilibrium level of
inflation will be
-β
∆π = ∆u0
1 + φβ
Figure 12.5 - Effects of a Fall in Exports
The Natural Rate of
Unemployment
• Unemployment cannot be reduced
below its natural rate without
accelerating inflation
• If the natural rate of
unemployment is high,
expansionary fiscal and monetary
policy are largely ineffective as
tools to reduce unemployment
• Most estimates of the current
natural rate in the U.S. lie between
1-689 4.5 andCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
5.0 percent
Figure 12.6 - Fluctuations in
Unemployment and the Natural Rate
The Natural Rate of
Unemployment
• Four sets of factors influence the
natural rate of unemployment
– demography
• the relative age and educational
distribution of the labor force
– institutions
• labor unions, worker mobility, taxes
– productivity growth
• wage growth
– past levels of unemployment
Figure 12.7 - Real Wage Growth
Aspirations and Productivity
Expected Inflation
• The natural rate of unemployment
and expected inflation together
determine the position of the
Phillips curve
– higher expected inflation moves the
Phillips curve upward
Expected Inflation
• There are three basic scenarios for
how inflation expectations are formed
– static expectations
• prevail when people ignore the fact that
inflation can change
– adaptive expectations
• prevail when people assume the future will be
like the recent past
– rational expectations
• prevail when people use all the information
they have as best they can
The Phillips Curve under
Static Expectations
• If inflation expectations are static,
expected inflation never changes
– the trade-off between inflation and
unemployment will not change from
year to year
• If inflation has been low and
stable, businesses will probably
hold static inflation expectations
Figure 12.9 - Static Expectations of
Inflation
Static Expectations of
Inflation in the 1960s
• In the 1960s, the Phillips curve did
not shift up or down in response to
changes in expected inflation
– when unemployment was above
5.5%, inflation was below 1.5%
– when unemployment was below 4%,
inflation was above 4%
• The economy moved along a
stable Phillips curve
Figure 12.10 - Static Expectations and the
Phillips Curve, 1960-1968
Adaptive Expectations
• If the inflation rate varies too
much for workers and businesses
to ignore it and if last year’s
inflation rate is a good guide to
inflation this year, individuals are
likely to hold adaptive expectations
– inflation will be forecasted by
assuming that this year will be like
last year
– forecast will be good only if inflation
changes slowly
• The Phillips curve can be written
* s
πt = πt -1 - β(ut - ut ) + ε t
• The Phillips curve will shift up and

down depending on whether last
year’s inflation was higher or lower
than the previous year’s
– inflation accelerates when unemployment
is less than the natural rate
• Example
– the government pushes the
unemployment rate down 2 percentage
points below the natural rate
– β=1/2
– last year’s inflation rate = 4%
πt = πt -1 - β × 2
This year’s inflation rate = 4+1/2×2=5
Next year’s inflation rate = 5+1/2×2=6
And so on
Figure 12.11 - Accelerating Inflation
Adaptive Expectations and
the Volcker Disinflation
• At the end of the 1970s, expected
inflation gave the U.S. an
unfavorable short-run Phillips
curve trade-off
• Between 1979 and the mid-1980s,
Fed chairman Paul Volcker reduced
inflation from 9 to 3 percent per
year
• The fall in inflation triggered a fall
1-703 in expected inflation
Figure 12.12 - The Phillips Curve before
and after the Volcker Disinflation
Rational Expectations
• If the economy is changing rapidly
enough that adaptive expectations
lead to large errors, individuals will
switch to rational expectations
– People form their forecasts of future
inflation not by looking backward but
by looking forward
• they look at what current and expected
government policies tell us about what
inflation will be
Rational Expectations
• The Phillips curve will shift as
rapidly as changes in economic
policy that affect aggregate
demand
• Anticipated changes in economic
policy turn out to have no effect on
the level of production or
employment
Government Policy to
Stimulate the Economy
• Suppose that the unemployment
rate is equal to its natural rate and
inflation is equal to expected
inflation
• The government takes steps to
stimulate the economy by cutting
taxes and raising government
spending to reduce the
unemployment rate below the
1-707 natural Copyright
rate © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Figure 12.13 - Government Attempts to
• If the policy comes as a surprise,
the economy moves up and to the
left along the Phillips curve in
response to the change in
government policy
• Unemployment will be lower,
production will be higher, and the
rate of inflation will be higher
Figure 12.14 - Results if the Shift in Policy
Comes as a Surprise
• If the policy is anticipated,
individuals will take the policy into
account when they form their
expectations of inflation
• The Phillips curve will shift up
• There will be no effect on
unemployment or output
• The rate of inflation will rise
Figure 12.15 - Results if the Shift in Policy Is
Anticipated
What Kind of Expectations
Do We Have?
• If inflation is low and stable,
expectations are probably static
• If inflation is moderate and
fluctuates slowly, expectations are
probably adaptive
• When shifts in inflation are clearly
related to changes in monetary
policy, swift to occur, and large
enough to seriously affect
profitability, expectations are
1-713 probablyCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
rational
From the Short Run
to the Long Run
• In the case of an anticipated shift
in economic policy under rational
expectations, the long run is now
• In the absence e
of supply shocks
π = π - β × (u - u*)
• If expectations are rational and
changes in policy foreseen, expected
inflation will be equal to actual
inflation and unemployment will be at
its natural rate
Figure 12.16 - Rational Expectations: The
Long Run Is Now
From the Short Run
to the Long Run
• If expectations are adaptive, the
economy will approach the long
run gradually
– an expansionary shock will lower
unemployment, increase real GDP,
and lead to an increase in the
inflation rate
– individuals will raise their
expectations of inflation in the next
periods
– as time passes, the gaps between
actual unemployment and its natural
rate Copyright
and actual and expected inflation
will shrink to zero
Figure 12.17 - Adaptive Expectations
Convergence to the Longer Run
From the Short Run
to the Long Run
• Under static expectations, the long
run never arrives
– the gap between expected and actual
inflation can grow arbitrarily large as
different shocks hit the economy
• if the gap between actual and expected
inflation becomes large, individuals will
not remain so foolish as to retain static
expectations
Chapter Summary
• The location of the Phillips curve is
determined by the expected rate of
inflation and the natural rate of
unemployment (and possibly by
current, active supply shocks)
– in the absence of current, active supply
shocks, the Phillips curve passes through
the point at which inflation is equal to its
expected value and unemployment is
equal to its natural rate
Chapter Summary
• The slope of the Phillips curve is
determined by the degree of price
stickiness in the economy
– the more sticky are prices, the flatter is
the Phillips curve
• The natural rate of unemployment in
the U.S. has exhibited moderate
swings in the past two generations
Chapter Summary
• Three significant supply shocks have
affected the rate of inflation over the
past two generations
– the oil price increases of 1973 and 1979
and the oil price decrease of 1986
Chapter Summary
• The principal determinant of the
expected rate of inflation is the past
behavior of inflation
– if inflation has been low and steady,
expectations are probably static
– if inflation has been variable but
moderate, expectations are probably
adaptive
– if inflation has been high or has varied
rapidly, expectations are probably
rational
Chapter Summary
• The best way to gauge how
expectations are formed is to consider
the past history of inflation
– would adaptive expectations have
provided a significant edge over static
ones?
– would rational expectations have
provided a significant edge over adaptive
ones?
Chapter Summary
• How fast the flexible price model
becomes relevant depends on the
type of inflation expectations in the
economy
– under static expectations, the flexible-
price model never becomes relevant
– under adaptive expectations, the flexible-
price model becomes relevant gradually
– under rational expectations, the flexible-
price model is relevant always
CHAPTER 13
Stabilization Policy
Questions
• What principles should guide
stabilization policy?
• What aspects of stabilization policy do
economists argue about today?
• Is monetary policy or fiscal policy
more effective as a stabilization
policy?
• How does uncertainty affect the way
stabilization policy should be made?
Questions
• How long are lags associated with
stabilization policy?
• Is it better for stabilization policy to
be conducted according to fixed rules
or to be conducted by authorities with
substantial discretion?
Government Policy
• There are two kinds of government
policy
– fiscal policy
• shifts the IS curve
– monetary policy
• shifts the LM curve
• The government uses policy to
stabilize the macroeconomy by
minimizing the impact of shocks
Monetary Policy
Institutions
• Monetary policy in the U.S. is
made by the Federal Reserve
which is the central bank
– the principal policy-making body of
the Federal Reserve system is the
Federal Open Market Committee
(FOMC)
• the FOMC lowers and raises interest rates
and increases and decreases the money
supply
Monetary Policy
Institutions
• The Federal Reserve has a central
office and 12 regional offices
– the central office is the Board of
Governors in Washington, DC
– the 12 regional offices are the 12
Federal reserve banks scattered
around the U.S.
– the members of the Board of
Governors and the Presidents of the
regional Federal Reserve Banks make
up the FOMC
Figure 13.1 - Structure of the Federal
Reserve System
Figure 13.2 - Composition of the Federal
Open Market Committee
Monetary Policy
Institutions
• The FOMC meets approximately
once a month to set interest rates
– emergency meetings can also be
scheduled on short notice
• When the FOMC decides on a
policy change, it is implemented
immediately
– it takes only minutes for interest
rates to shift in response to FOMC
actions
1-733
Monetary Policy
Institutions
• The FOMC changes interest rates
by carrying out open-market
operations
– in an expansionary open-market
operation, the Federal Reserve buys
government bonds, increasing bank
reserves, and lowering interest rates
– in a contractionary open-market
operation, the Federal Reserve sells
government bonds, decreasing bank
1-734 Copyright ©
reserves, 2002 by
and The McGraw-Hill
raising Companies, Inc.
interest ratesAll rights reserved.
Monetary Policy
Institutions
• The Federal Reserve can also alter
interest rates in two other ways
– the Board of Governors can alter
legally required bank reserves
– the Board of Governors can lend
money directly to financial institutions
• These tools are used very rarely
Fiscal Policy Institutions
• Fiscal policy in the U.S. is managed by
Congress
– the Congress creates the tax laws that
determine the amount of taxes imposed
by the federal government
– the Congress’s spending bills determine
the level of government purchases
• Tax and spending levels are set
through a process called the budget
cycle
Figure 13.4 - The Budget Process
Government Expenditures
• Mandatory expenditures include
spending for Social Security,
Medicare, Medicaid, unemployment
insurance, and food stamps
• Discretionary expenditures must
be appropriated each year by
Congress
– these include defense spending,
NASA, highway spending, education
1-738
spending, and so forth
Figure 13.5 - Major Federal Government
Expenditures by Category, 1960-2000
Figure 13.6 - Federal Government Discretionary
Spending, Excluding Defense (2000)
Fiscal Policy Institutions
• Because of the way the budget
process is set up, making fiscal
policy in the U.S. is complicated
and time-consuming
– the time between when a policy
proposal is made and when it
becomes effective (the inside lag)
can take years
– the inside lag associated with
monetary policy changes can be
measured in days or weeks
The History of Economic Policy
• The Employment Act of 1946
– established Congress’s Joint Economic
Committee and the President’s Council of
Economic Advisors
– called on the President to estimate and
forecast the current and future level of
economic activity in the U.S.
– announced that it was the responsibility
of the federal government to foster and
promote free enterprise and the general
welfare
• Before the Great Depression, the
general belief was that the
government could not stabilize the
economy and should not try to do so
• It was largely due to the writings of
John Maynard Keynes that economists
and politicians became convinced that
governments could halt depressions
and smooth out the business cycle
• Because of the low and stable inflation
and unemployment rates of the
1960s, economists and politicians
thought that the business cycle was
dead
• However, in the 1970s, expected
inflation rose and the Phillips curve
shifted up
– the result was stagflation
Figure 13.7 - The U.S. Phillips Curve(s),
1955-1980
• By the end of the 1970s, many
economists were convinced that active
monetary policy did more harm than
good
– they argued that the U.S. would be better
off with an “automatic” monetary policy
• one idea is to fix the money stock to a stable
long-run growth path
• the instability of velocity has reduced the
number of advocates of this policy
Figure 13.8 - The Velocity of Money before 1980
The Power and Limits of
• Economists today have varied
views as to how the central bank
and fiscal authorities should
manage the economy
– some (such as Milton Friedman) feel
that activist attempts to manage the
economy are likely to do more harm
than good
– some believe that the appropriate
government policy can do a lot to
stabilize the economy after shocks
The Power and Limits of
• Even the most activist of
economists recognize the limits of
stabilization policy
– stabilization policy requires us to
know where the economy is and
where it is going
• use large-scale macroeconomic models to
forecast the future
• search for leading indicators
– the level of the stock market is often used
The Lucas Critique
• Expectations of the future affect
decision-making in the present
• Robert Lucas argued that, because
expectations of the future include
expectations of government policies, if
policies are changed the structure of
the economy may change as well
– economic models from the past may not
be useful in forecasting the future effects
of policy
Leading Indicators
• The index of leading indicators
contains ten components
• The leading indicator that has been
most closely watched is the money
supply
– there are four measures of the
money supply (M1, M2, M3, and L)
– these four monetary aggregates do
not behave in the same way
Figure 13.9 - Different Measures of the
Money Stock Behave Differently
The Money Multiplier
• Open market operations change
the monetary base
– the effects on the money supply are
less direct and less certain
• Changes in the monetary base
cause changes in the money
supply through a process called
the money multiplier (µ)
The Money Multiplier
• The money multiplier can be affected
by the the currency-to-deposits ratio
that households and businesses keep
and the level of excess reserves held
by banks
(curr/dep) + 1
µ=
(curr/dep) + (req/dep) + (exc/dep)
– (curr/dep)=currency-to-deposits ratio
– (req/dep)=ratio of required reserves
– (exc/dep)=excess reserves-to-deposits
Figure 13.10 - Changes in the Currency-to-
Deposits Ratio
Long Lags & Variable
Effects
• Even with reliable forecasts,
changes in policy affect the
economy with long lags and have
variable effects
– Changes in interest rates take time to
affect investment, aggregate
demand, and real GDP
– The level of GDP today is determined
by what long-run risky interest rates
existed more than a year and a half
1-756 ago Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Monetary vs. Fiscal Policy
• At the end of the World War II era,
most economists and policy
makers believed that the principal
stabilization policy tool would be
fiscal policy
• Today, the overwhelming
consensus is that monetary policy
has proven itself to be faster
acting and more reliable than fiscal
1-757 policyCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Monetary vs. Fiscal Policy
• Fiscal policy takes a longer amount of
time to work
– delays due to the political process
• This means that the Federal Reserve
can neutralize the effects of any
change in fiscal policy on aggregate
demand
– swings in tax laws and appropriations
have little effect on real GDP unless the
Federal Reserve wishes them to
Automatic Stabilizers
• Automatic stabilizers include tax
collections and social transfer
programs such as food stamps and
unemployment insurance
• These work without new policies
having to be created and therefore
can moderate the business cycle
much more quickly than can
discretionary policy
How Monetary Policy
Works
• Monetary policy takes time to work
as well
– the Federal Open Market Committee
must first recognize that there is a
problem and then formulate a policy
– while changes in interest rates will
occur almost immediately, it takes
over a year for changes in interest
rates to change national output and
unemployment
How Monetary Policy
Works
• The Federal Reserve can either target
real interest rates or keep the money
stock growing smoothly
– if the principal instability in the economy
is a shifting IS curve, targeting interest
rates will not stabilize the economy
– if the instability in the economy occurs
because money demand is unstable or
because the currency-to-deposits and the
reserves-to-deposits ratios vary, then
targeting interest rates is wiser
Rules vs. Authorities
• Should monetary policy be conducted
“automatically” according to rules or
should it be left to the discretion of
authorities?
– the first reason for automatic rules is that
we fear that the people appointed to
authorities will be incompetent
– the second reason for fixed rules is that
authorities might not have the right
objectives
• political business cycle
Figure 13.11 - The Politically-Influenced
Business Cycle: Relative Growth in the
Second Year of Presidential Terms
Central Bank
Independence
• Research has suggested that the
more independent a central bank,
the better its performance
– more independent central banks
presided over lower average inflation
and less variable inflation
– countries with independent banks did
not have higher unemployment rates,
lower real GDP growth, or larger
business cycles
Figure 13.12 - Inflation and Central Bank
Insulation from Politics
Credibility & Commitment
• In the short run, pursuing a more
expansionary monetary policy can
seem to have great benefits
– higher real GDP, lower unemployment,
little impact on inflation
• In the long run, however, a central
bank is wiser to keep low inflation as
its top priority
– keeps expected inflation low and
maintains credibility
Credibility & Commitment
• Economists call this conflict between
short-run and long-run interests
dynamic inconsistency
– some economists have argued that this is
another reason to have a fixed set of
rules for monetary policy
– others believe that central banks are
concerned with their long-term reputation
and will resist the temptation to make
inflation and money growth higher than
expected
Modern Monetary Policy
• What guidelines for monetary policy
should the central bank follow?
– Economists believe that the central bank
should not target real economic variables
such as the growth rate of real GDP or
the unemployment rate
• these are determined in the long run by the
growth of potential output and the natural
rate of unemployment
– Policies which target nominal variables
will work better
Modern Monetary Policy
• The Taylor rule provides a policy
proposal for the central bank
– the central bank chooses a target for the
inflation rate and then raises interest
rates when inflation is above and lowers
interest rates when inflation is below this
target
r = r * + φ'×(π - π' )
Financial Crises
• The Federal Reserve has other
important tools that can be used to
try to stem depressions
– deposit insurance insulates bank
depositors from the effects of
financial crises
– if a financial crisis is severe enough,
the Federal Reserve will act as a
lender of last resort
Financial Crises
• A financial crisis sees investors as
a group suddenly become
convinced that their investments
have become overly risky
– they try to exchange their
investments for relatively safe, liquid
assets
– interest rates spike upward
– investment can fall sharply sending
the economy into a depression
Financial Crises
• In a financial crisis, the Federal
Reserve can do a lot of good by
rapidly expanding the money supply
to keep interest rates from rising
sharply
• The Federal Reserve can also reduce
the chance of a financial crisis
occurring by doing a good job as the
supervisor and regulator of the
banking system
Lender of Last Resort
• The Federal Reserve can also help
by lending directly to institutions
that are fundamentally solvent but
are temporarily illiquid
– it can do harm if it bails out
institutions that have gone bankrupt
because that encourages other
institutions to take excessive risks
hoping that the central bank will bail
them out in the future
Deposit Insurance
• One of the reforms of the New Deal
was the institution of deposit
insurance by the Federal Deposit
Insurance Corporation
– federal deposit insurance acts as a
monetary automatic stabilizer
• eliminates the risk of keeping funds in a bank
– the availability of deposit insurance
creates moral hazard
• banks may decide to make risky high-interest
loans
Chapter Summary
• Macroeconomic policy should attempt
to stabilize the economy: to avoid
extremes of high unemployment and
of high and rising inflation
• Long and variable lags make
stabilization policy extremely difficult
Chapter Summary
• Economists arrange themselves along
a spectrum, with some advocating
more aggressive management of the
economy and others concentrating on
establishing a stable framework and
economic environment
– compared to differences of opinion
among economists in the past,
differences of opinion today are minor
Chapter Summary
• In today’s environment, monetary
policy is the stabilization tool of
choice, largely because it operates
with shorter lags than does
discretionary fiscal policy
• The fiscal “automatic stabilizers” built
into the tax system nevertheless play
an important role in reducing the size
of the multiplier
Chapter Summary
• Uncertainty about the structure of
the economy or the effectiveness
of policy should lead policy makers
to be cautious
– blunt policy tools should be used
carefully and cautiously lest they do
more harm than good
Chapter Summary
• The advantage of having economic
policy made by an authority is that
the authority can use its own
judgment to devise the best
response to a changing--and
usually unforeseen--situation
Chapter Summary
• The advantages to having economic
policy made by a rule are threefold
– rules do not assume competence in
authorities where it may not exist
– rules reduce the possibility that the policy
will not be made in the public interest but
in some special interest
– rules make it easier to avoid dynamic
inconsistency
Chapter Summary
• Dynamic inconsistency arises
whenever a central bank finds that it
wishes to change its previously
announced policy in an inflationary
direction
– it is always in the central bank’s short-
term interest to have money growth be
higher, interest rates be lower, and
inflation be a little higher than had been
previously expected
Chapter Summary
• Today, however, central banks are
generally successful in taking a
long-term view
– they pay great attention to
establishing and maintaining the
credibility of their policy
commitments
CHAPTER 14
The Budget Balance, the National

Debt, and Investment
Questions
• From the standpoint of analyzing
stabilization policy, what is the best
measure of the government’s budget
balance?
• From the standpoint of analyzing the
effect of changes in the national debt
on long-run growth, what is the best
measure of the government’s budget
balance?
Questions
• What is the typical pattern America’s
debt follows over time?
• How has recent experience in the
past generation deviated from this
traditional pattern of debt behavior?
• What are the reasons that we should
worry about a rising national debt?
• What are the reasons that we
shouldn’t worry too much about a
rising national debt?
Debt & Deficits
• The national debt (D) is the amount
of money that the government owes
those from whom it has borrowed
– when government spending < tax
revenues, the difference is the
government surplus (-d)
• the national debt falls by d
– when government spending > tax
collections, the difference is the
government deficit (d)
• the national debt rises by d
Debt & Deficits
• Economists are interested in the debt
and the deficit for two reasons
– the deficit is an index of how government
spending and tax plans affect the IS
curve
– the debt and deficit are closely connected
with national savings and investment
• a rising debt tends to depress capital
formation
• a high national debt means that future taxes
will have to be higher to pay interest charges
The Deficit & the IS Curve
• An increase in government purchases
or a decrease in taxes increases
aggregate demand
– the IS curve shifts out
• The appropriate measure of fiscal
policy is the full-employment
deficit (or surplus)
– it measures what the government’s
budget balance would be if the economy
was at full employment
Figure 14.1 - An Increase in the Full-
Employment Deficit Shifts
the IS Curve Outward
Measuring the Budget Balance
• The government budget balance
reported in the news is generally the
unified cash balance
– the difference between the money the
government actually spends in a year
and the money it takes in
– unifies all of the government’s accounts
and trust funds
– doesn’t take account of changes in the
value of government-owned assets or
future liabilities
Measuring the Budget Balance
• The full-employment budget balance
is a better index than the unified cash
balance
– the cash budget balance can change even
when there is no change in government
policy to shift the IS curve
• tighter monetary policy raises interest rates
and lowers real GDP and tax collections
– we must adjust the cash balance deficit
(surplus) for the automatic fiscal
stabilizers
Figure 14.2 - A Fall in Real GDP
Figure 14.3 - The Full-Employment and
the Cash Budget Deficit
Inflation
• A good measure of the deficit
should be a measure of whether
the government is spending more
in the way of resources than it is
taking in
– we should correct the officially-
reported cash budget balance for
inflation
r cr
– the real deficit (d
d = d -) π D
is ×related to the
cash deficit (dc) by
Figure 14.4 - The Cash Balance and the
Inflation-Adjusted Budget Balance
Public Investment
• Private spending on long-lived assets
is called investment
– standard accounting treatment of long-
lived assets is to spread out their costs
over their useful lives (amortization)
• The government spends money on
long-lived assets
– shouldn’t the government amortize these
assets?
• which government expenditures are capital
expenditures?
Liabilities & Generational
Accounting
• The correct way to count the
government’s debt is to look at all
of its promises to pay money out
in the future
– this system is called generational
accounting
• it would examine the lifetime impact of
taxes and spending programs on
individuals born in specific years and
would come up with a balance that could
beCopyright
used © for long-term planning
2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-797
The Steady-State Debt-to-
GDP Ratio
• Fiscal policy is sustainable if the
debt-to-GDP ratio (D/Y) is heading
for a steady state
– D and Y must be growing at the same
proportional rate
• Y grows at a proportional rate equal to
the sum of the annual rate of growth of
the labor force (n) and the annual rate of
growth of labor efficiency (g)
growth rate of Y = n + g
GDP Ratio
• The debt next year will be equal to
Dt +1 = (1 - π)Dt + d
• Since tax revenues and spending

grow with real GDP, it makes sense to
focus on the deficit as a share of GDP
(δ=d/Y)
GDP Ratio
• The proportional growth rate of the
debt is
Dt +1 - Dt  Yt 
= -π + δ ×  
Dt  Dt 
GDP Ratio
• The debt-to-GDP ratio will be
stable when this proportional
growth rates of the debt and GDP
are equal
n + g = -π + δ × (Y/D)
D δ
=
Y n+g+ π
GDP Ratio
• Example
– growth rate of labor force (n) = 2%
– growth rate of output/worker (g) =
1%
D
– inflation 4%
δrate (π) = 5% 1
= = =
Y n + g + π 2% + 1% + 5% 2
– if the current debt-to-GDP ratio<1/2, the
debt-to-GDP ratio will rise
– if the current debt-to-GDP ratio>1/2, the
debt-to-GDP ratio will fall
Sustainability
• The higher the debt-to-GDP ratio, the
more risky an investment do
financiers judge the debt of a country
– if the government changes hands, the
new government must decide whether to
honor the debt issued by previous
governments
– the government can lower the real value
of its debt by increasing the rate of
inflation
Sustainability
• A deficit is sustainable only if the
associated steady-state debt-to-GDP
ratio is low enough that investors
judge the debt safe enough to be
willing to hold it
• If a government’s has too much debt
to be considered safe, the interest
rates it must pay will rise dramatically
– the government will then be faced with a
larger deficit (because of interest costs)
The Debt-to-GDP Ratio in
the U.S.
• The typical pattern the U.S. has
followed is one of sharp spikes in
the debt-to-GDP ratio during
wartime, followed by the paying-
off of the debt during peacetime
– the greatest peaks in the debt-to-
GDP ratio occurred after the Civil
War, World War I, and World War II
– the debt-to-GDP ratio also rose
during the Great Depression and the
Reagan and Bush presidencies
Figure 14.5 - U.S. Debt-to-GDP Ratio
Since the Revolutionary War
Figure 14.6 - Federal Revenues and
Expenditures as Shares of National
Product since the Civil War
Effects of Deficits
• A deficit can have three significant
effects on the economy
– it may affect the political equilibrium
that determines the government’s tax
and spending levels
– it may affect the level of real GDP in
the short run (if the central bank
allows it)
– it will affect the level of real GDP in
the long run
Political Consequences
• The possibility of financing
government spending through
borrowing makes the government
less effective at advancing public
welfare
– the benefits from higher government
spending today are clear and visible
to voters
– the costs of higher taxes in the future
are distant and excessively
discounted
Political Consequences
• Since the 1980s, some have argued
for deficits created by tax cuts
– in this view, the political system delivers
steadily-rising government spending
unless it is placed under pressure to
reduce the deficit
– thus, the only way to avoid an ever-
growing inefficient government share of
GDP is to run a constant deficit that
politicians feel the need to try to reduce
Short-Run Consequences
• A deficit produced by either a cut in
taxes or an increase in government
spending raises aggregate demand
and shifts the IS curve to the right
– if monetary policy is unchanged, output
and employment will rise
– if the Federal Reserve does not want
inflation to rise, it will respond by raising
interest rates, neutralizing the
expansionary effect of the deficit
Open-Economy Effects
• An increase in the government’s
budget deficit also leads to an
increase in the trade deficit
– the outward shift of the IS curve
pushes interest rates up
– higher interest rates mean an
appreciated dollar
– imports rise and exports fall
Long-Run Effects
• Higher full-employment deficits
lead to low investment
– a deficit shifts the IS curve out,
leading to lower national savings,
higher real interest rates, and lower
investment
• Low investment reduces capital
accumulation and productivity
growth
the economy
– putsCopyright on a lower steady-
© 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-813
state growth path
Figure 14.7 - Higher Full-Employment
Deficits Reduce Investment
Long-Run Effects
• If the deficits continue for long,
they will affect the economy’s
capital intensity
• A lower steady-state capital-output
ratio implies a lower level of
output per worker for any given
level of the efficiency of labor
Figure 14.8 - Long-Run Effects of
Persistent Deficits on Economic Growth
Long-Run Effects
• A higher deficit also implies a
higher debt, which means that the
government owes more in the way
of interest payments to
bondholders
– over time, the increase in interest
payments will require tax increases
– these tax increases will discourage
entrepreneurship and economic
activity
Chapter Summary
• The U.S. is usually a moderate-debt
country
– the level of national debt with which
politicians and voters are comfortable is
not large relative to the debts of other
countries
– only immediately after total wars does
the U.S. national debt reach a high value
relative to real GDP
Chapter Summary
• The 1980s and 1990s, however, saw
steep rises in the national debt--
unprecedented rises in peacetime
– the era of deficits is now at an end
– The United States’ national debt is
significantly below the level at which
economists begin serious worrying about
the consequences of the debt for the
health of the economy
Chapter Summary
stabilization policy, the best
measure of the government’s
stance is the full-employment
deficit
– the full-employment deficit is not a
bad measure of the net effect of
government policy on the location of
the IS curve
Chapter Summary
the effect of changes in the
national debt on long-run growth,
the debt and deficit need to be
adjusted for inflation and
government investment
– a third adjustment--for outstanding
government liabilities--has been
proposed and has some very
attractive features, but is not usually
1-821 usedCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Summary
• Persistent deficits--a rising
national debt--threaten to diminish
national savings, reduce the level
of output per worker along the
economy’s steady-state growth
path, and retard economic growth
Chapter Summary
• Past deficits--a high current debt-to-
GDP ratio-- threaten to reduce
national prosperity because the higher
taxes required to service the national
debt act as a drag on economic
activity
CHAPTER 15
International Economic Policy
Questions
• How has the world organized its
international monetary system?
• What is a fixed exchange rate
system?
• What is a floating exchange rate
system?
• What are the costs and benefits of
fixed exchange rates vis-à-vis floating
exchange rates?
Questions
• Why do most countries today have
floating exchange rates?
• Why has western Europe recently
created a “monetary union”--an
irrevocable commitment to fixed
exchange rates within western
Europe?
• What were the causes of the three
major currency crises of the 1990s?
The Gold Standard
• Before World War I, nearly all of the
world economy was on the gold
standard
– a government would define a unit of its
currency as worth a particular amount of
gold
– the currency was convertible
• could be converted into gold freely
– the currency’s price in terms of gold was
its parity
Figure 15.2 - Growth of the Gold
Standard
The Gold Standard
• When two countries were on the gold
standard, their nominal exchange rate
was fixed at the ratio of their gold
parities
– at World War II parities
• the U.S. dollar was equal to 1/35 of an ounce
of gold
• the British pound sterling was set to equal
1/15.58333 ounces of gold
• the exchange rate of the dollar for the pound
was £1.00=$2.40
The Gold Standard
• Example of currency arbitrage
– the U.S. government is willing to buy
gold at $35 per ounce
– the British government is willing to buy
gold at £15.58333 per ounce
– the pound trades for $2.64 (10% higher
than the ratio of the gold parities -
$2.40)
The Gold Standard
• Someone with an ounce of gold could
– trade it to the British Treasury for
£15.58333
– trade those pounds for dollars in the
foreign exchange market and get $38.50
– trade the $38.50 to the U.S. Treasury for
1.1 ounces of gold
– repeat the process as quickly as possible,
making a 10% profit each time the circle
is completed
Figure 15.1 - How to Profit in the Foreign-
Exchange Market
Weaknesses of the
Gold Standard
• The gold standard tended to be
deflationary
– under some circumstances, it pushed
countries to raise their interest rates
which reduced output and increased
unemployment
– it never provided a countervailing
push to other countries to lower their
interest rates
Weaknesses of the
Gold Standard
• If the exchange rate is floating,
foreigners’ domestic currency
earnings must be used to buy
exports or to invest in the home
country NX + NFI = 0
• The exchange rate moves up or down
in response to the supply and demand
for foreign exchange in order to make
it so
Weaknesses of the
Gold Standard
• Under a gold standard, foreign-
currency earnings can also be used
to purchase gold from the foreign
country’s Treasury
NX + NFI - FG = 0
• If a country’s net exports plus net
foreign investment are less than zero,
its Treasury will find itself losing gold
– the country’s gold reserves shrink
Weaknesses of the
Gold Standard
• If a country’s gold reserves are
shrinking, it has a choice
– abandon the fixed exchange rate system
– make it more attractive for foreigners to
invest by raising domestic interest rates
• puts contractionary pressure on the economy
• Countries gaining gold face no
incentive to lower interest rates in
order to stay on the gold standard
Collapse of the Gold
Standard
• The gold standard was suspended
during World War I
• After the war ended, politicians
and central bankers sought to
restore it
– they believed it was an important
step in restoring prosperity
• After the Great Depression began,
the gold standard broke apart
Standard
• Four factors made the gold
standard a less secure monetary
system
– everyone knew that governments
could abandon their gold parities in
an emergency
– everyone knew that governments
were trying to keep interest rates low
enough to produce full employment
Standard
• Four factors made the gold
standard a less secure monetary
– after World War I, countries held their
system
reserves in foreign currencies rather than
gold
– the post-war surplus economies did not
lower interest rates as gold flowed in
Standard
• As soon as a recession hit,
governments found themselves
under pressure to raise interest
rates and lower output
– could either stay on the gold standard
and face a deep depression or
abandon the gold standard
– the further countries moved away
from their gold-standard rates, the
faster they recovered from the Great
Depression
Figure 15.3 - Economic Performance and
Degree of Exchange Rate Depreciation
During the Great Depression
The Bretton Woods
System
• The Bretton Woods System was the
result of an international monetary
conference that took place in 1944
• Three principles guided this system
– in ordinary times, exchange rates should
be fixed
– in extraordinary times, exchange rates
should be changed
– an institution was needed to watch over
the international financial system
• the International Monetary Fund (IMF)
The Bretton Woods
System
• The Bretton Woods System broke
down in the early 1970s
– the U.S. found itself with a large trade
deficit and sought to devalue its currency
• Since then, the exchange rates of the
major industrial powers have been
floating exchange rates
– fluctuate according to supply and
demand
How a Fixed Exchange
Rate System Works
• A fixed exchange rate is a
commitment by a country to buy
and sell its currency at fixed,
unchanging prices (in terms of
other currencies)
– the central bank or Treasury must
maintain foreign exchange reserves
– these reserves are limited
Rate System Works
• If there is a high degree of capital
mobility, the real exchange rate is
set by
ε = ε0 - εr (r - r f )
• The higher the interest rate

differential in favor of the home
country, the lower is the exchange
rate
Figure 15.4 - The Real Exchange Rate,
Long-Run Expectations, and
Interest Rate Differentials
Rate System Works
• If capital is highly mobile and the
fixed exchange rate (ε*) is lower than
ε
– foreign exchange speculators will want to
sell the home currency for foreign
currency
• the government spends down its reserves
– to keep the exchange rate at ε*, the
central bank must lower interest rates
• monetary policy no longer can play a role in
domestic stabilization
Figure 15.5 - Domestic Interest Rates Are
Set by Foreign-Exchange Speculators
and the Exchange Rate Target
Rate System Works
• The central bank must set the
domestic real interest rate equal to
f
ε0 - ε *
r =r +
εr
– an increase in foreign interest rates (rf)
requires a point-for-point increase in
domestic interest rates
– an increase in foreign exchange
speculators’ views of the long-run value
of the exchange rate (ε0) requires an
increase in domestic interest rates
Figure 15.6 - Effect of Foreign Shocks
under Fixed Exchange Rates
Rate System Works
• If capital mobility is low
– the exchange rate is also affected by
the speed at which the government is
accumulating or spending its foreign
exchange reserves (R)
ε = ε0 - εr (r - r f ) + εR × ∆R
– when the government is accumulating
reserves, the value of foreign currency is
higher than it would otherwise be
• it is increasing foreign currency demand
Figure 15.7 - With Limited Capital Mobility
a Central Bank Can Shift the
Exchange Rate by Spending Reserves
Rate System Works
• If capital mobility is low
– the central bank can use monetary
policy for domestic disturbances
• this is limited by the sensitivity of
exchange rates to the magnitude of
foreign-exchange market interventions
performed by the central bank and by
the amount of reserves
f
– the domestic real
ε0 - εinterest
* εR rate will be
r =r + + × ∆R
εr εr
Benefits of Fixed Exchange
Rates
• Floating exchange rate systems
add risk
– discourages international trade
– makes the international division of
labor less sophisticated
• This is an important reason behind
the decision of most of western
Europe to form a monetary union
– fix their exchange rates against each
1-854 irrevocably
otherCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Costs of Fixed Exchange
Rates
• Under fixed exchange rates, monetary
policy is tightly constrained by the
requirement of maintaining the
exchange rate at its fixed parity
• Fixed exchange rates also have the
disadvantage of rapidly transmitting
monetary of confidence shocks
– interest rates move in tandem all across
the world in response
• Fixed exchange rates also make large-
scale currency crises more likely
Fixed or Floating Exchange
Rates?
• Is it more important to preserve the
ability to use monetary policy to
stabilize the domestic economy rather
than dedicating monetary policy to a
constant exchange rate?
• Is it more important to preserve the
constancy of international prices and
thus expand the volume of trade and
the scope for the international division
of labor?
Fixed or Floating Exchange
Rates?
• Economist Robert Mundell argued that
the major reason to have floating
exchange rates is that they allow
adjustment to shocks that affect two
countries differently
– this benefit would be worth little if two
countries suffered the same shocks and
reacted to them in the same way
– this benefit would also be worth little if
factors of production are highly mobile
The European Currency
Crisis of 1992
• After reunification with East
Germany, the West German
government undertook a program
of massive public investment
– this shifted the IS curve out
– the German central bank raised
interest rates to keep inflation under
control
Figure 15.8 - German Fiscal Policy and
Monetary Response in the Early 1990s
Crisis of 1992
• The increase in interest rates
generated a rise in the German
exchange rate vis-à-vis the dollar
and the yen
– exports fell
• Other countries in western Europe
had fixed their exchange rates to
the German mark as part of the
European Exchange Rate
1-860 Mechanism
Crisis of 1992
• The rise in German interest rates
meant that these western
European countries were required
to raise interest rates as well
– the required interest rate increase
threatened to send the other
European countries into a recession
Figure 15.9 - Effect of German Policy on
Other European Countries
Crisis of 1992
• Foreign exchange speculators did
not believe that these western
European governments would keep
this promise to maintain the fixed
exchange rate parity when
unemployment began to rise
– ε0 rose which caused an additional
rise in the domestic real interest rate
required to maintain exchange rate
parity ε -ε*
r = rf + 0
εr
Crisis of 1992
• Different governments in western
Europe undertook different strategies
– some spent reserves in the hope that it
demonstrated their commitment to
maintaining the exchange rate parity
– some tried to demonstrate that they
would defend the parity no matter how
high the interest rate needed to be
– some abandoned the fixed exchange rate
and let their currencies float
• The end result was the formation of
the European Monetary Union
The Mexican Currency
Crisis of 1994-1995
• The Mexican currency crisis was a
surprise to most economic analysts
– the government’s budget was
balanced
– the government’s willingness to raise
interest rates was not in question
– the Mexican peso was not overvalued
• The peso lost half of its value in
four months starting in December
1-865
of 1994
Crisis of 1994-1995
• Concerns about political stability
reduced foreign exchange
speculators’ estimates of the long-
run value of the peso and raised
their assessment of ε0
– the Mexican government spent $50
billion in foreign reserves and
eventually ran out
• it devalued the peso and let it float
against the U.S. dollar
• the rise in ε caused a further increase in
1-866
ε0 Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
• the value of the Mexican government’s
Crisis of 1994-1995
• The Mexican government had two
options
– it could raise interest rates
• the level of interest rates required would
produce a Great Depression in Mexico
– it could keep interest rates low and
let the value of foreign currency rise
much further
• Mexican companies and the Mexican
government would be unable to pay their
dollar-denominated debts
• Mexico’s foreign trade would fall
drastically
Crisis of 1994-1995
• The U.S. made direct loans to
Mexico
– these loans built Mexico’s foreign-
exchange reserves back to a
comfortable level
• this allowed domestic interest rates to
remain relatively low
– the Mexican government was also
able to refinance its debt
• confidence was restored that the Mexican
government would not be forced to resort
to default or hyperinflation
Figure 15.10 - Mexico’s Nominal
Exchange Rate: The Value of the U.S.
Dollar
in Mexican Pesos
The East Asian Currency
Crisis of 1997-1998
• In mid-1997, foreign investors
began to worry about the long-run
sustainability of growth in East
Asia
– they began to change their opinions
of the fundamental long-term value
of East Asia’s exchange rates (ε0)
• the value of the currencies fell causing a
further change in ε0
Crisis of 1997-1998
• It also became clear that many of
East Asia’s banks and companies
had borrowed heavily abroad in
amounts denominated in dollars or
yen
– these loans had been used to make
non-profitable investments
– this lead to further decreases in ε0
Crisis of 1997-1998
• There was a vicious cycle created
– each decline in the exchange rate raised
the burden of foreign-denominated debt
and raised the probability of bankruptcy
– each rise in the perceived burden of
foreign-denominated debt caused a
further loss in the value of the exchange
rate
• The IMF stepped in with loans to
boost foreign exchange reserves
– promises to improve banking regulation
were made in return
Figure 15.11 - Exchange Rates During the
Asian Currency Crisis
Figure 15.11 - Exchange Rates During the
Asian Currency Crisis
Managing Crises
• The exchange rate equation offers a
country a menu of choices for its
value of the real exchange rate (ε)
and its value of the domestic real
interest rate (r)
f
ε = ε 0 - φ (r - r )
– the higher the domestic real interest rate,
the more appreciated is the exchange
rate
Managing Crises
• If international investors suddenly
lose confidence in the future of the
country’s economy, the menu of
choices that the country has
deteriorates
– if the domestic real interest rate is to
remain unchanged, the exchange rate
must depreciate
– if the exchange rate is to remain
unchanged, the domestic real interest
rate must rise
Managing Crises
• Because a large rise in domestic real
interest rates will likely create a
recession, letting the exchange rate
depreciate seems like the logical
policy choice
– throughout the 1990s, investors reacted
negatively when the exchange rate
depreciates
– this seems especially dangerous when
businesses and governments have
borrowed abroad in foreign-denominated
debt
Chapter Summary
• For most of the past century, the
world has operated with fixed
exchange rates--not, as today, with
floating exchange rates
• Under fixed exchange rates monetary
policy has only very limited freedom
to respond to domestic conditions
– the main goal of monetary policy is that
of adjusting interest rates to maintain the
fixed exchange rate
Chapter Summary
• A country would adopt fixed exchange
rates to make it easier to trade by
making foreign prices more
predictable and less volatile
– fixed exchange rate systems increase the
volume of trade and encourage the
international division of labor
Chapter Summary
• In the past generation, most countries
have concluded that the freedom to
set their own monetary policies to
satisfy domestic concerns is more
important than the international
integration benefits of fixed exchange
rates
– an exception is western Europe, which is
in the process of permanently fixing its
exchange rates via a monetary union
Chapter Summary
• Wide swings in foreign exchange
speculators’ views of countries’
future prospects have caused
three major currency crises in the
1990s
– such currency crises were greatly
worsened by poor bank regulation
and other policies that threatened to
send economies subject to capital
flight into a vicious spiral ending in
depression and hyperinflation
CHAPTER 16
Changes in the Macroeconomy and

Changes in Macroeconomic Policy
Questions
• How has the structure of the economy
changed over the course of the past
century?
• How has the business cycle changed
over the last century?
• How has economic policy changed
over the past century?
Questions
• What are future prospects for
successful management of the
business cycle?
• Why does unemployment in Europe
remain so high?
• Why does growth in Japan remain so
low?
Changes in the Macroeconomy
• Over the past century, the
structure of modern industrial
economies has changed
– significant decline in the share of the
labor force engaged in agriculture
– decline in the proportion of the labor
force involved in mining,
manufacturing, and construction
– rise in service-sector employment
Figure 16.1 - Occupational Distribution of
the Labor Force
– growth of the government’s social
insurance programs and progressive tax
system
• automatic stabilizers
– broader financial system
• allows households to smooth consumption
spending
• lowers the marginal propensity to consume
and the multiplier
– the creation of the deposit insurance
system
• reduces the number of financial panics
– improvements in labor productivity are
now the result of improvements in the
efficiency of labor (rather than capital
deepening)
• innovations in materials production, materials
handling, and organization
– research and development is now a key
component of investment
• Even with these changes, the U.S.
economy’s business cycle has
continued
– there are some signs that fluctuations in
unemployment have become smaller in
recent years
Table 16.1 - Business Cycle Indicators
Future Changes
• Consumption
– liquidity constraints will continue to
decline
• the marginal propensity to consume and
the multiplier will grow even smaller over
time
Future Changes
• Globalization
– international trade will continue to
expand
• increased trade will further lower the
multiplier
• the domestic economy will be less vulnerable
to domestic shocks but more vulnerable to
foreign shocks
– there will also be an increase in the
magnitude of international financial flows
• potential source of financial crisis and
macroeconomic volatility
Figure 16.2 - Globalization: Merchandise
Imports as a Share of Total Goods
Production
Future Changes
• Monetary Policy
– the increase in financial flexibility will
make it somewhat more difficult to
conduct monetary policy
– as more and more different kinds of
financial assets are traded, the supply
of Treasury bills will have less of an
effect on interest rates
Future Changes
• Inventories
– improvements in information
technology will improve businesses’
ability to control their inventories
• mismatches between production and
demand have been a principal source of
fluctuations in employment and output
throughout history
• better information technology will reduce
this component of macroeconomic
instability
Estimating Long-Run
Changes in Cyclical
Volatility
• To assess changes in the size of
the overall business cycle, we can
compare the cyclical behavior of
real GDP and unemployment over
the century
– good quality data exists only for the
post-World War II period
– a consistent division of the past
century into recessions and
expansions shows little difference in
the size of recession
Figure 16.3 - The Great Depression Relative to
Other Business Cycles: U.S. Unemployment
Estimating Long-Run
Changes in Cyclical
Volatility
• Two conclusions can be drawn
about the changing cyclical
variability of the American
economy
– the business cycle during the interwar
period was extraordinarily large
• there were three major contractions
during this period including the Great
Depression
– the post-World War II business cycle,
measured relative to the size of the
economy, has been a little smaller
than back before World War I
Figure 16.4 - Real GDP Relative to
Potential Output during the Great
Depression
How Economic Policy Has
Worked
• The fall in the multiplier, the
creation of automatic stabilizers,
and the increasing power of central
banks have allowed monetary
policy to offset many of the kinds
of shocks that generated pre-
Depression business cycles
– the post-World War II economy has
had fewer small recessions caused by
shocks to the IS and LM curves
Not Worked
• Economic policy has caused
recessions as well
– the Federal Reserve has engineered a
recession (or has accepted the risk of
a recession) in order to curb inflation
at least four times since World War II
– the post-World War II boom-and-bust
business cycle has been driven by
policies that have allowed rises in
inflation, followed by policies to fight
1-901 it Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Not Worked
• Why have policy makers found
themselves repeatedly driven to risk
recession in order to fight inflation?
– in the late 1940s, the Federal Reserve
kept interest rates low to reduce the cost
of the national debt
– in the 1960s and 1970s, inflation was
allowed to accelerate for a number of
possible reasons
• memory of the Great Depression
• mistaken economic theories
• political business cycle considerations
The Great Depression
• The speed and magnitude of the
economy’s collapse during the first
stages of the Great Depression was
unprecedented
– from 1929 to 1933, real GDP fell by
almost 40 percent
– by 1932, real investment spending was
less than one-ninth of what it had been in
1929
– by 1933, unemployment had reached 25
percent
Figure 16.5 - Movement along the IS
Curve: The Great Contraction, 1929-1932
• Investment and real GDP fell so
quickly because of an extraordinary
rise in real interest rates
– real interest rates increased from 4 to
nearly 13 percent from 1929 to 1931
– after 1932, investment spending
remained low even though real interest
rates returned to more normal values
• businesses put off expanding their capacity
• baseline investment (I0) fell
• The cause of high real interest
rates was rapid deflation
– falling production, employment, and
demand led to steep declines in
prices
• But there must have been an initial
shock to cause the start of the
downward spiral that was the
Great Depression
Figure 16.6 - Real and Nominal
Interest Rates and the Inflation Rate
in the Great Depression
• Economists have proposed many
candidates for the shock that
triggered the Great Depression
– the stock market crash of 1929
– the availability of consumer credit in the
1920s that led to a boom in consumption
spending and then came to a natural end
– recognition of excessive residential
investment that led to a decline in
baseline investment
– an increase in interest rates in 1928
• Economists have reached a consensus
that sufficiently aggressive monetary
policy could have stemmed the
deflation and thus ended the Great
Depression much earlier
– massive federal deficits funded by
printing money coupled with aggressive
open market purchases could have
produced inflation
• real interest rates would not have risen and
investment spending would have been less
affected
• In addition to reducing real GDP
through higher real interest rates,
deflation also redistributes wealth
from debtors to creditors
– businesses that are heavily in debt find
that they cannot pay and go bankrupt
– financial institutions that have loaned to
these business find that their loans are
worthless and go bankrupt as well
• more than one-third of U.S. banks failed
during the first years of the Great Depression
Stabilization
• If we divide the post-World War II era
into two periods with the breakpoint
chosen at the end of the Volcker
disinflation in the early 1980s, the
pre-1984 years show much more
business cycle volatility than do the
post-1984 years
– there have not been many shocks or any
truly large shocks to the economy
– maybe lessons have truly been learned
from the 1960s and 1970s
High European
Unemployment
• Unemployment rates in western
Europe at the end of the 1990s are
close to those achieved in the U.S.
during the Great Depression
– until the end of the 1970s, the
unemployment rate in western
Europe had been lower than that in
the U.S.
– after the 1970s, western European
unemployment rose during
recessions, but did not fall during
expansions
Figure 16.7 - European Unemployment
High European
Unemployment
• In the U.S., it is possible to explain
the comovements of
unemployment and inflation from
1960 to 2000 using the standard
Phillips curve
– movements in the expected rate of
inflation reflect changes in the
economic policy environment
– movements in the natural rate of
unemployment are relatively small
and can be linked to plausible factors
High European
Unemployment
• In western Europe, the
accelerationist Phillips curve never
fit the historical experience very
well
– each policy episode from 1970 on
seemed to shift the Phillips curve
further out and to further raise the
natural rate of unemployment
High European
Unemployment
• The dominant view expressed in
Europe in the early 1990s was that
high European unemployment was
the result of labor market rigidities
– this would mean that high
unemployment is an equilibrium,
because it is not caused by a
deficiency of aggregate demand
• But the rigidities in the European
labor market were stronger in the
1960sCopyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
1-916
– the unemployment rate was lower
High European
Unemployment
• Many economists see the western
European situation as reversible
– have central bankers and
governments shift to a more
expansionary monetary policy
• as demand rises, people will find the
natural rate of unemployment is falling
• the decline in the natural rate will create
further increases in demand and further
declines in the natural rate
– begin reducing and eliminating labor-
market rigidities
Japanese Stagnation
• The Japanese stock market and real
estate market rose far and fast in the
1980s
• Eventually, the market turned and
both the real estate and stock
markets collapsed
– many businesses and banks were
bankrupted
– no one was willing to lend money
• investment spending was depressed
Japanese Stagnation
• The Japanese economy has fallen into
a decade of economic stagnation
– growth has been almost zero
– unemployment has risen to high levels
– the IS curve has shifted far left
– even extremely low nominal interest
rates have not been enough to boost
investment and aggregate demand
Figure 16.8 - The Japanese Bubble
Economy: Before, during, and after
Japanese Stagnation
• What should policy makers do?
– have the government run a
substantial deficit
– have the central bank push the
interest rate it charges close to zero
– deliberately try to engineer moderate
inflation
• makes the alternative to investment
spending more risky
Moral Hazard
• In a financial crisis, the flow of funds
through financial markets will slow to
a trickle and the IS curve will shift far
and fast to the left
– the government needs to close down and
liquidate those organizations that are
fundamentally bankrupt
– the government needs to lend money to
organizations that would be solvent if
production and demand were at normal
levels
Moral Hazard
• Government support is necessary to
prevent a deep meltdown of the entire
financial system
• But government assistance must be
offered on terms unpleasant enough
and expensive enough that no one
wishes to get in a situation in which
they need to draw on it
– they need to prevent moral hazard
The Ultimate Lesson
• In many ways, it seems to be very
hard to learn the lessons of history
• The future of economic policy seems
likely to be similar to the past
– gross mistakes will be made
– historical analogies will be misapplied
– economists and other observers will find
major policy mistakes made by
governments and central banks to be
inexcusable (after the fact)
Chapter Summary
• The structure of the economy has
undergone mammoth changes over
the past century, yet these changes
appear to have had relatively little
impact on the size of the business
cycle
• Stabilization policy as we know it was
impossible a hundred years ago
– it is performed routinely and aggressively
since
Chapter Summary
• Since World War II, stabilization policy
has had some successes and failures
– its principal failure has been that it has
generated policy-induced recessions to
fight inflation
• these policy-reduced recessions have kept
policy from successfully stabilizing the
economy to a greater degree
• In the past two decades, stabilization
policy in the U.S. has been very
successful
Chapter Summary
• Certainly from the U.S. perspective
there is every reason to be optimistic
about the future of macroeconomic
policy and of the macroeconomy
• From a European perspective, there is
less reason to be optimistic
– European governments and central banks
have not learned how to deal with their
high levels of unemployment
Chapter Summary
• From a Japanese perspective,
there is less reason to be
optimistic
– the Japanese government has not
learned how to deal with its financial
meltdown
Chapter Summary
• Even from a U.S. perspective, it
seems hard to learn the lesson
that good economic policy during
an economic crisis is not a matter
of clinging to one principle, but of
balancing off the conflicting
requirements of several valid
principles

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CHAPTER 1

• is the subdiscipline of economics

• is the branch of economics related

– understanding of news reports on

– understanding of changing opportunities

– more responsible macroeconomic policy

– most important policies for the long-run

• National Income and Product Accounts

– the unemployment rate is the best

– hyperinflation occurs when the price

– is an index of expectations for the future

Measuring the Macroeconomy

(Current exchange rate) 

• The most commonly discussed index

• Investors will hold only bonds if

• This means that the value of a stock is

Price of oranges today

Labor force = (Employed) + (Looking for Work)

Looking for Work

• implies that a 1 percentage-point fall

• Real GDP measures current output

Apples 3.5 lbs. $1.20 3.5 lbs. $1.20

Pears 1 lb. $0.90 1 lb. $0.50

Bananas 1 lb. $0.40 1 lb. $0.40

Thinking Like an Economist

↓ spending ↓ production layoffs ↓ income

• Expectations that future income would

• patterns of spending, income,

• the solution to a set of two

• conditions of economic equilibrium

• Cobb-Douglas production function

(Y/L)1- ∂ = (K/Y)α × E1- α

• putting in the balanced-growth

The Theory of Economic Growth

• Parameters of the model

L t +1 = (1 + 0.02) × 10 = 10.2 million

Et +1 = (1 + 0.015) × $10,000 = $10,150

• Since this is a growth rate of a

• We can make substitutions for [g(kt)]

• and simplify to get

g(κ t ) = (1 − α) × {s/κ t − (n + g + δ)}

• The growth rate of the capital-output

The Reality of Economic Growth:

Building Blocks of the Flexible-Price

MPL = F(1, L firm + 1) − F(1, L firm )

MPL = E1− α [(L firm + 1)1− α − (L firm )1− α ]

• The term in the brackets is a

• Total output will be K multiplied by

• Simplifying, we get the Cobb-Douglas

• If markets work well, the actual level

C = $2 trillion + (0.6 × $7.5 trillion) = $6.5 trillion

• Net exports depend on three things

• Substituting in for the real

• Having the definition of net exports in

Equilibrium in the Flexible-Price

• The right-hand side of the

• If the left-hand side > right-hand

• The supply of saving is upward sloping

• The demand for loanable funds is

∆Y = C y (1 - t)∆Y * -Ir ∆r + 0 - X ε εr ∆r - IMy ∆Y *

Money, Prices, and Inflation

money balances demanded falls

C = C0 + 0.75(1 - 0.4)Y $5.5 = C0 + $3.6