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CHAPTER

The challenge of economic development

12

I believe in materialism. I believe in everything that comes

from a healthy materialism—good cooking, dry houses, dry
feet, drainage, sewers, drainage pipes, hot water, bathrooms,
electric light, automobiles, good roads, lighted streets, long
vacations away from town, new ideas, fast horses, agile
conversations, theaters, operas, orchestras, music bands—I
believe in all of this for everyone. The man who dies without
knowing these things can be as exquisite as a saint, and as rich
as a poet; but this is despite their privations, not thanks to them.
francis hackett

At present, planet Earth has a population with enormous a demographic analysis, and then continue with a
differences in their living standards. at one end description of the characteristics of developing countries.
There is the opulent condition of North America and Subsequently, the second part of the chapter examines
Western Europe, where the richest 1% of the population alternative approaches to economic growth in developing
enjoys approximately 20% of world income and countries, particularly successful models from Asia, along
consumption. At the other extreme are the destitute of with the failed communist experiment in Russia.
Africa andwith
Asia, a billion
few people
comforts, living
almost in absolute
always poverty,
ignorant of
where their next meal will come from.

What causes the great differences in the wealth of

nations? Can the world survive peacefully with such
poverty in the midst of plenty?
What steps can the poorest countries take to improve
their living standards? What are the responsibilities of
rich countries?
These questions regarding the obstacles facing
developing countries are among the greatest challenges
facing the modern economy. This is where the tools of the
economy make the biggest difference in the daily life of
the population; This is where economics can literally make
the difference between life and death. This chapter starts
with
A. POPULATION GROWTH AND
DEVELOPMENT
MALTHUS AND DEPRESSING SCIENCE
Can technology keep its pace of growth parallel to that of
the population in poor countries? Is Africa condemned to
live in rags and at the limit of subsistence, given its high
birth rate and its baggage of diseases such as AIDS?
These questions have figured prominently in economics
for nearly two centuries.
247
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248
The economic analysis of the population starts
from the Rev. TR Malthus, who was mentioned in the
context of the analysis of economic growth.
co in the previous chapter. Malthus developed his
views while discussing his father's perfectionist view
that the human race was always improving. Finally,
the son became so agitated that he wrote An Essay
on the Principle of Population (1798), which was a
world-wide bestseller, dealing with population and
economic growth.
Malthus began with Benjamin Franklin's observation
that in the American colonies, where resources were
plentiful, the population tended to double every 25
years or so. He then postulated the universal tendency
for the population—unless prevented by limited food
supplies—to grow exponentially, or geometrically. In
the end, a population that doubles every generation—
1, 2, 4, 8, 16, 32, 64, 128, 256, 512, 1,024…—becomes
so large that there is not enough space in the world
for all that population survives.
After invoking exponential growth, Malthus made
a further argument. At this point he released the
demon of diminishing returns, arguing that since land
is fixed, the supply of food would tend to grow only by
following an arithmetic progression. It could not keep
up with the exponential growth (or geometric
progression) of work.
(Compare 1, 2, 3, 4… with 1, 2, 4, 8…). Malthus'
gloomy conclusions are paraphrased below:
As the population doubles and doubles again...it's like
the globe splits in half and then in half again, until finally
it shrinks so much that food production is below the level
needed to sustain it. hold the entire population.
When the law of diminishing returns is applied to a
fixed endowment of land, food production cannot keep
pace with the geometric progression of population.
In fact, Malthus did not say that population
necessarily increased at a geometric rate. Just that it
was the trend if it got out of hand. He described the
controls that work, at all times and places, to keep the
population within its limits. In its first edition, it
emphasized the “positive” controls that increase
mortality: plagues, famines and wars.
He later maintained that he hoped that population
growth could be slowed by "moral restraint," such as
abstinence or deferred marriage.
This important application of diminishing returns
illustrates the profound effects that
CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT
have a simple theory. Malthus's ideas had wide
repercussions. His book was used to support a
rigorous revision of the English poor laws. Influenced
by Malthus's writings, it was believed that poverty
should be as uncomfortable as possible. From this
point of view, the government cannot improve the
welfare of the poor, because any increase in the
income of the poor will only cause workers to reproduce
until they are all immersed in a minimum subsistence
standard of living.
Compound Interest and Exponential
Growth Now it is worth recalling
exponential growth and compound interest,
which are important tools in economics.
Exponential (or geometric) growth occurs when a variable
increases at a constant proportional rate from period to period.
Thus, if a population of 200 grows 3% per year, it would equal
200 in year 0, 200 1.03 in year 1, 200 1.03 1.03 in year 2,…
200 (1.03)10 in year 10, and so on. .
When money is invested continuously, it earns compound
interest, which means that interest is earned on the previous
interest. The compound interest generated by money grows
geometrically. An interesting calculation is to determine how
much the $26 received by the Indians as payment for
Manhattan Island would now be worth if it had been deposited
at compound interest. If these funds had been placed at 6%
annual interest since 1626, they would be worth 136,000
million dollars in 2010.
A useful rule of thumb about compound interest is the
rule of 70, which states that a quantity that grows at rate g
per year will double in (70/g) years. For example, a human
population that grows 2% per year will double in 35 years,
whereas if you invest your funds at 7% per year, they will
double in value every 10 years.
Malthus's failed prophecies. Despite careful
statistical studies of Malthus, demographers today
believe that his views were too simplistic. Malthus did
not anticipate the technological miracle of the Industrial
Revolution; nor did he understand that the family
planning movement and new technologies would give
families the possibility of reducing the birth rate. In
fact, population growth in most Western countries
began to slow after 1870, just as living standards and
real wages grew most rapidly.
In the century that followed Malthus, technological
advance shifted the frontier of possibility to the right.
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A. POPULATION GROWTH AND DEVELOPMENT
production data from European countries and North
America. Technological change outpaced the
population, causing a rapid rise in real wages.
However, the seeds of truth in Malthus's doctrines are
still important for understanding population trends in
some poor countries, where the race between
population and food supply is still going on.
Population implosion? Before turning to the issues
for poor countries to resolve, it is important to
recognize that the problem facing many rich countries
is the downward trend in population growth, not the
population explosion. Today, virtually every rich
country in the world has zero or negative growth in its
native population, which means that the average
number of adult children per woman is 2 or less. Most
of the advanced countries grow today only because of
immigration. A stable or declining population with an
increasing life expectancy places great stress on
countries' fiscal conditions, due to the need to finance
health care and public pensions.
Limits to growth and neo-Malthusianism
Previous ideas are often reborn, in the light of new
social trends or scientific findings. Time and again neo-
Malthusian ideas have surfaced as many opponents
of growth and environmentalists argue that economic
growth is limited by the finite nature of resources and
by environmental constraints.
Concerns about the viability of growth came to the
fore in the early 1970s, with a series of studies carried
out by a group with the ominous name, the “Club of
Rome”. Analysis of this school appeared in a famous
computer study called The Limits of Growth , and its
1992 sequel Beyond the Limits . The predictions of
the neo-Malthusians were even more depressing than
those of Malthus himself:
If current trends of world population growth,
industrialization, pollution, food problems, and resource
depletion continue unchanged, the limits to growth on
this planet will be reached in the next hundred years.
The most likely results will be a sudden and uncontrolled
decline, both in population and industrial capacity.
These critics of growth found a receptive audience,
given the growing alarm of rapid population growth in
developing countries and, in the 1970s, the upward
spiral of
249
oil prices and the sharp drop in productivity growth. A
second wave of pessimism regarding growth emerged
in the past decade as a result of growing concern
about environmental constraints on long-term economic
growth. Among today's concerns are global warming,
because the use of fossil fuels is heating up the
atmosphere; extensive evidence of acid rain; the
appearance of the “ozone hole” in Antarctica, along
with ozone depletion in temperate regions;
deforestation, especially in tropical rainforests, which
can upset the global ecological balance; soil erosion,
which threatens the long-term viability of agriculture;
the acidification of the oceans due to the increased
amount of carbon dioxide in the atmosphere; and
species extinction, which threatens many precious
ecosystems and biological resources.
The economic analysis underlying the neo-
Malthusian principles is closely related to the theory
Malthusian estuary. Whereas Malthus argued that
production would be constrained by diminishing returns
to food production, today's growth pessimists argue
that growth will be constrained by the absorptive
capacity of the environment. It is only possible, some
say, to burn a finite amount of fossil fuels before facing
the possibility of dangerous climate disruption. The
need to reduce the use of fossil fuels could well slow
down economic growth in the long run.
However, there is a fundamental difference. The
first analyzes were related to market products such as
land, food and oil. Many of today's concerns refer to
externalities and public goods, where prices in an
unregulated market send distorted signals.
What is the empirical evidence for the effects of
resource depletion and environmental limits on
economic growth? The facts are that the prices of
most basic commodities, such as grain, electricity,
and lumber, have risen more slowly than the general
price level. However, many economists are concerned
with externalities, particularly global public goods such
as global warming. It has not been easy for countries
to negotiate cooperative agreements to reduce global
warming. The difficulty that international cooperation
entails in reaching global agreements is evident when
reviewing the tortuous history of nuclear proliferation.
The future of the global economy depends on solutions
to these new Malthusian dilemmas.
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250 CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT

Several interesting features emerge from the table.

B. ECONOMIC GROWTH IN POOR
COUNTRIES
CHARACTERISTICS OF A COUNTRY
DEVELOPING
What exactly is a developing country? Its most
important characteristic is that it has a low per capita
income. In addition, in developing countries the
population often has poor health, low levels of literacy,
malnutrition and little capital to work with. Many poor
countries have weak market and government
institutions, corruption, and social conflict. It is common
for these countries to experience emigration, especially
of their skilled workers.
Table 12-1 is a key source of data for understanding
the big players in the world economy, as well as
relevant indicators of underdevelopment.
Low- and middle-income countries are grouped into
six broad regions.
It is evident that low-income countries are much poorer
than advanced countries, such as the United States.
People in the poorest countries earn only one-twentieth
of what people in high-income countries earn.
Calculations supported by purchasing power parity
(PPP) were used to measure income in the data in the
table. Exchange rates tend to underestimate earnings
in low-wage countries. (The use of exchange rates to
determine purchasing power parity to assess living
standards is discussed in Chapter 13.) Also, consider
that the early part of this century was a period of
strong growth in the world economy, and that this
growth spilled over to the poorest regions as well.
In addition, many health and social indicators show
the effects of poverty in low-income countries. Life
expectancy is lower than in high-income countries,
and educational attainment and literacy are often low.

GDP Migration
Population per capita Education net

Migration
Growth life Adult illiteracy rate (per
Total rate, 2000-2006 expectancy at Growth, (%, 15 years 1,000
number, (annual %) be born 2000-2006 and older) people)
Region 2006 (millions) (years) 2006 ($) (annual %)

East Asia and Pacific

(Chinese, Indonesian, . . .) 1,900 0.9 71 6 820 7.6 9 2.0
Eastern Europe
and Central
Asia (Russia, Poland, . . .) 460 0.0 69 9660 5.7 2 0.4
Latin America and the
Caribbean (Brazil, 556 1.3 73 8800 1.8 10 1.2
Mexico,
Africa Middle East and . . .)
North

(Egypt, Iran, . . .) 311 1.8 70 6,450 23 27 0.9

Southeast Asia
(India, Pakistan, . . .) Sub- 1 493 1.7 63 3440 5.1 42 0.2
Saharan Africa
(Nigeria, Ethiopia, . . .) 770 23 47 2030 23 41 0.1

TABLE 12-1. Important Indicators for Different Groups of Countries The World

Bank groups developing countries into six regions, and important indicators of economic development for each are
shown here. Note that low-income countries tend to have high illiteracy and emigration. Some low-income countries
have a life expectancy close to that of rich countries.

Source: World Bank, World Development Report, and data from www.worldbank.org.
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B. ECONOMIC GROWTH IN POOR COUNTRIES 251

There is great diversity among developing in families where women are not educated, but mortality rates are also
countries. Some remain on the very brink of famine: much higher here than in countries with good health systems.

these are the poorest countries, like the Congo,

Ethiopia and Liberia. Other countries that were in that The majority of the population in your country works in agriculture.

category two or three decades ago have moved into Few can leave food production to work in factories. You work with sixty
times less horsepower than a prosperous American worker uses. He
the group of middle-income countries. Those that have
knows little about science, but a lot about the traditions of his village.
been most successful—Slovenia, Singapore, and
South Korea—have graduated from the developing
group, and of these, the most successful have per
He is often hungry, and the food he eats is mainly rice or poor
capita incomes reaching industrialized country levels.
quality food. Although you are one of those who had some primary
The outstanding developing countries of yesterday will
education, like most of your friends, you did not have a secondary
be the high-income countries of tomorrow.
education, and only the richest attend university. He works long hours
in the fields without the help of machinery. At night he sleeps on a mat.
You have little furniture in your home, perhaps a table and a radio. His
Life in low-income countries To highlight the only mode of transportation is an old pair of boots.
contrasts between advanced and developing
economies, imagine that you are an ordinary 21-year-
old in a low-income country like Mali, India, or
Bangladesh. You are poor. Even if you add the goods you produce and
consume, your annual income only averages $2,000. Its counterpart in
North America, in the same span, could fetch over $30,000 on average. MILLENNIUM DECLARATION
Perhaps you can comfort yourself with the thought that only one in four
people in the world average an annual income of more than $5,000.
Progress achieved in the
case of Latin America and the
Caribbean The Millennium Declaration, approved by
189 countries at the United Nations (UN) Millennium
For every one of your fellow citizens who can read, there is another Summit in September 2000, contains the Millennium
one like you who is illiterate. Their life expectancy is 4/5 of that of an Development Goals (MDG) to achieve by 2015. This
average person in an advanced country; already two of his sisters and statement is an excellent exercise in understanding
brothers have died before reaching adulthood. Birth rates are high, how development is measured in practice, as it
particularly provides a number of specific indicators and

Goal 1: eradicate extreme poverty and hunger

Target 1A: Halve, between 1990 and 2015, the percentage of people with an income of less than 1990 1999 2005
one dollar

1.1 Percentage of population with income of less than 1.25 dollars/day (2005 PPP) 11.3 10.9 8.2
1.2 Poverty gap ratio at $1.25 per day (2005 PPP) 3.5 3.4 2.3
— — 2.9
1.3 Proportion of income or consumption of the poorest quintile of the population

Target 1B: Achieve full and productive employment and decent work for all, including women 1991 2000 2008
and youth 1.4 GDP growth rate per person employed 1.5 Employment-to-population ratio (%)
— –0.3(1998) 2.9
55.0 58.5 61.3
1.6 Percentage of employed population with income of less than 1 PPP dollar/day 1.7 Percentage 12.7 12.3 6.4
of self-employed workers and contributors in total employment 35.4 32.4 31.9

Target 1C: Halve, between 1990 and 2015, the percentage of people who suffer from hunger 1990-1992 2004-2006 2008
1.8 Prevalence of underweight children under 5 years of age 1.9 Percentage of the population
11(1990) — 6(2007)
below the minimum level of dietary energy consumption (undernourishment)

12 8 8
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252 CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT

measures that make up the quality of life of the
population of a country or region. The MDGs are made
up of eight goals and 21 quantifiable targets, which
are monitored by 60 indicators. Below is a summary
of the progress made by Latin America and the
Caribbean, extracted from the 2009 UNDP Annual
Report:
Human development
This journey through life in the world's poorest
countries reminds us of the importance of having an income
adequate to meet basic needs, as well as the fact that
life goes beyond market income. Thoughtful economists
like Nobel Prize winner Amartya Sen and Yale's
Gustav Ranis emphasize that there are other factors
that must be considered in assessing a country's
situation. Factors such as health and life expectancy,
school enrollment, adult literacy, and women's
independence are important goals for developing
countries, along with increasing per capita consumption.

Goal 2: achieve universal primary education

Target 2A: Ensure that, by 2015, girls and boys everywhere can complete a full course 1991 2000 2007
of primary education 2.1 Primary school net enrollment rate (%)
86.7 94.3 94.9
2.2 Percentage of students starting first grade who reach the
— 96.6(1999) 100.0
last grade of primary school
1985-1994 1995-2004 2005-2007
2.3 Literacy rate for ages 15-24 86.6 89.7 91.0

Goal 3: Promote gender equality and empower women

Target 3A: Eliminate gender inequalities in primary and secondary education, preferably 1990 2000 2007
by 2005, and at all levels of education by the end of 2015

3.1 Ratio of girls to boys in primary, secondary and higher education 3.2 Percentage of women 0.99(1991) 0.97 0.97
among paid employees in the non-agricultural sector 3.3 Percentage of seats held by women in 36.5 40.7 42.7
the national parliament 11.9 14.8 22.2

Goal 4: reduce child mortality

Goal 4A: reduce by two thirds, between 1990 and 2015, the mortality of children under 1990 2000 2007
5 years of age
4.1 Mortality rate of children under 5 years of age 54 33 24
4.2 Infant mortality rate 4.3 43 28 21
Percentage of 1-year-old children vaccinated against measles 76 92 93

Goal 5: improve maternal health

Target 5A: reduce, between 1990 and 2015, maternal mortality by three quarters 5.1 1990 2005 2007
180 130 —
Maternal mortality rate (per 100,000)
70 — 87
5.2 Percentage of deliveries attended by specialized health personnel

Target 5B: Achieve universal access to reproductive health by 2015 5.3 1990 2006
62 71.8 —
Contraceptive prevalence rate 5.4 Adolescent birth rate (per 1,000)
77.4 71.8 —
79 95 —
5.5 Antenatal care coverage 5.6 Unmet
12.5(1995) 10.5 —
need for family planning
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B. ECONOMIC GROWTH IN POOR COUNTRIES 253

Goal 6: Combat HIV/AIDS, malaria and other diseases

Target 6A: have stopped and begun to reduce, by the year 2015, the spread of HIV/AIDS 1990 2000 2007
6.1 Prevalence of AIDS among the population aged 15 to 24 (%)
0.2 0.5 0.6
— — —
6.2 Condom use in high-risk sexual practices (%)
6.3 Percentage of the population between the ages of 15 and 24 with adequate and comprehensive
— — —
knowledge of HIV/AIDS 6.4 Ratio between the enrollment of orphaned children and the
enrollment of non-orphaned children aged 10 to 14
— — —

Target 6B: Achieve, by 2010, universal access to AIDS treatment for those who need it 2006 2007
6.5 Percentage of people with advanced AIDS infection with access to medi
57 62
antiretroviral drugs

Target 6C: Have begun to reduce, by 2015, the incidence of malaria and other serious 1990 2000 2006
diseases
— — 5
6.6 Mortality and incidence rates associated with malaria (cases/1000)
6.7 Percentage of children under 5 years of age who sleep under mosquito nets
two with insecticide — — —

6.8 Percentage of children under 5 years of age with fever who are treated with appropriate
— — —
antimalarial drugs
6.9 Tuberculosis prevalence rate (new cases/100,000) 84 55 44 (2007)
6.10 Proportion of tuberculosis cases detected and cured with short course under direct
— 81 76
observation

Goal 7: ensure environmental sustainability

Target 7A: Incorporate sustainable development principles into national policies and 1990 2000 2006
programs and reverse loss of environmental resources 7.1 Proportion of land area
49.9 47.2 —
covered by forests 7.2 Total carbon dioxide emissions, per capita and per $1 GDP (PPP) in
million metric tons
2.4 2.6 2.7
7.3 Total consumption of substances that deplete the ozone layer (tonnes) 76 048 31 087 7 386
— — —
7.4 Proportion of fish stocks within safe biological limits

Target 7B: Reduce the loss of biological diversity achieving, by 2010, a significant reduction 1990 2000 2008
in the rate of loss 7.5 Proportion of total water resources used 7.6 Proportion of terrestrial and
— 1.4 —
marine protected areas 7.7 Proportion of species not threatened with extinction birds 7.8 Proportion
of non-endangered species mammals 7.3 14.4 18.8
93.10 (1998) — 92.95
87.09 (1998) — 86.56

Target 7C: Halve, by 2015, the percentage of people without sustainable access to drinking 1990 2006
water 7.8 Proportion of the population using drinking water sources

ble improved 84 92
7.9 Proportion of the population using improved sanitation services 68 79

Target 7D: Have significantly improved, by the year 2020, the lives of at least 100 million 1990 2000 2005
slum dwellers 7.10 Proportion of urban population living in households with at least one of the
following four characteristics: a) lack of access to a better water supply; b) lack of access to better
sanitation; c) overcrowding (3 or more people per room), and d) houses built with short-
lived material.

33.7 29.2 27.0

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254 CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT

Goal 8: Foster a global partnership for development

Target 8A: Further develop an open, rule-based, predictable and non-discriminatory trading
and financial system

Target 8B: address the special needs of the least developed countries

Target 8C: Address the special needs of landlocked countries and small island developing
States

Target 8D: Comprehensively address developing country debt problems with national and 1990 2000 2007
international measures to make debt sustainable
able in the long term.
Official development assistance (ODA) 8.1 to 8.5: goals in number of countries or overall.
Access to markets 8.6 to 8.9: targets in number of countries or overall
Debt sustainability
8.10 Number of countries reaching decision and completion points in the Heavily Indebted Countries
Debt Initiative 8.11 Low Debt Relief: Heavily Indebted Poor Countries Debt Initiative and the
Multilateral Debt Relief Initiative

20.6 21.8 8.0

8.12 Debt service as a percentage of exports of goods and services
cios

Target 8E: In cooperation with pharmaceutical companies, provide access to essential medicines
in developing countries 8.13 Proportion of the population with stable access to essential medicines
at reasonable prices
— — —

Goal 8F: in collaboration with the private sector, ensure that the benefits of new technologies 1990 2000 2007
can be exploited, particularly information and communication technologies 8.14 Telephone lines
per 100 inhabitants 8.15 Cell phone subscribers per 100 inhabitants 8.16 Internet users per 100
inhabitants 6.3 14.6 17.9
0.8 12.2 67
0.1 3.9 25.7

Source: Own elaboration with data from the United Nations Organization. —: data
not given or not applicable due to not breaking down by region.

Figure 12-1 shows a graph of life expectancy and
GDP per capita. The correlation is strong, but there
are exceptions to this overall positive relationship.
Some countries, such as Botswana, Equatorial Guinea
and South Africa, have low life expectancies relative
to their income due to the onset of AIDS. No country
has high life expectancies, but countries like Greece
and Costa Rica have expectations that are equal to or
higher than those of the United States, due to poorly
designed US health systems.
nes of life It was already discussed in Chapter 11 that
economic growth in the United States—growth
of its potential product—is based on four pillars: 1)
human resources, 2) natural resources, 3) capital,
and 4) technology. These four pillars exist in rich and
poor countries, although the mix and strategy for
combining them will differ according to the degree of
development. Consider how each of the four pillars
operates in developing countries, as well as how public
policy can steer the development process in a
favorable direction.

THE FOUR ELEMENTS Human resources

DEVELOPMENT
Having seen what it means to be in a developing
country, we now look at the process by which low-
income countries improve their conditions.
The demographic explosion: the legacy of Malthus.
Many poor countries always work hard just to stay in
the same place. Even if its GDP grows, so does its
population. Remember the exhibition
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B. ECONOMIC GROWTH IN POOR COUNTRIES 255

100

Japan
80 China Norway

USA

60
botswana
expectancy
(years)
Life
Equatorial Guinea

40
Sierra Leone

twenty

0
0 10,000 20,000 30,000 40,000

Per capita income (US dollars, PPP)

FIGURE 12-1. Life expectancy and income, 2000

Life expectancy is highly correlated with per capita income. Higher incomes allow for
greater investments in the health sector, and a healthier population is also more
productive. Note that some middle-income African countries have been hard hit by the
AIDS epidemic, which threatens their economic development and health status.
Source: United Nations Development Programme, Human Development Report, 2002.

the Malthusian demographic trap, where the population
increases so rapidly that incomes remain at subsistence
levels. Although high-income countries left Malthus
behind long ago, Africa is still caught in the Malthusian
web of high birth rates and income stagnation.
And population growth has not stopped; specialists
project that poor countries will add about another 1
billion people in the next 25 years.
It is difficult for poor countries to overcome poverty
with such high birth rates. But there are evacuation
routes for overpopulation. One strategy is to actively
participate in slowing population growth, even when
such actions go against prevailing religious norms.
Many countries have introduced educational campaigns
and have subsidized birth control.
And for countries that want to raise their per capita
income, there is the prospect of achieving the
demographic transition, which occurs when a
population stabilizes with low birth and death rates.
Once countries become wealthy enough and infant
mortality drops, people voluntarily reduce their birth
rates. When women are educated and leave behind a
situation of subordination, they tend to decide
dir spend less time of your life raising children. Families
substitute quality for quantity: They spend more time
and money on better education for fewer children.
Mexico, Korea and Taiwan have registered a significant
decline in their birth rates as their incomes have risen
and their populations have received better education.
Little by little, the results of economic development
and birth control are emerging. The birth rate in poor
countries has fallen from 44 per 1,000 per year in
1960 to 27 per 1,000 in 2005, but these figures are
still significantly higher than the 11 per 1,000 birth rate
in high-income countries . The fight against poverty
induced by excessive demographic growth continues.
However, the demographic transition has not been
achieved in all corners of the world. The fertility
ity remains very high in much of tropical Africa, despite
the fact that the AIDS epidemic destroys the population
and reduces life expectancy, in a way not experienced
since the great plagues of previous centuries. The
specter of Malthus haunts much of central Africa.
Human capital. In addition to facing excessive
population growth, developing countries also
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256
they must be concerned with the quality of their human
resources. In this sense, economic planners in
developing countries highlight the following strategies:
1. Disease control and improvement of health and
nutrition. Raising the health levels of the population
not only makes it happier, but also makes it more
productive. Health clinics and the provision of
drinking water are part of a vitally useful social
capital.
2. Improvement in education, reduction of illiteracy and
training for workers. The educated population is
more productive, because it can use capital more
effectively, adopt new technologies, and learn from
its mistakes. For advanced learning in science,
engineering, medicine, and management, countries
benefit from sending their best brains abroad to
return with the latest advances. But countries must
guard against brain drain, where the most competent
individuals are drawn to high-wage countries.
3. Above all, the importance of human resources
should not be underestimated. Most of the above
factors can be purchased on the international
market. Most of the work is domestic, although the
labor supply can sometimes be increased through
immigration. The crucial role played by job
qualifications has been demonstrated time and time
again when state-of-the-art machinery and technology
for mining, defense or manufacturing falls into
underutilization and even disuse, due to the fact that
the labor of developing countries have not acquired
the necessary skills for its operation and maintenance.
Natural resources
Some poor countries in Africa and Asia have a meager
endowment of natural resources, and the land and
minerals they hold must be divided among large populations.capital, developing countries must build their
Perhaps the most valuable natural resource in
developing countries is agricultural land. Much of the
labor force in developing countries is used in agriculture. depends. For example, a regional agricultural technician
Thus productive use of the land—with proper
conservation, fertilizers, and cultivation—will do much
to raise the output of a poor country.
Likewise, land tenure schemes are decisive in
providing peasants with strong incentives to invest in
capital and in technologies that increase the yield of
their plots. When peasants own their land, they have
more incen
CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT
tives to make improvements, such as irrigation systems,
and use appropriate land conservation practices.
Some economists believe that the natural wealth of
having oil or minerals is not an unconditional blessing.
Countries like the United States, Canada, and Norway
have used their natural wealth to form the solid platform
for their industrial expansion.
In other countries, wealth has been subject to looting
and rent-seeking by corrupt leaders and military groups.
Countries like Nigeria and the Congo (formerly Zaire),
which are incredibly rich in terms of mineral resources,
were unable to convert such assets into human capital
or tangible capital, due to corrupt rulers converting that
wealth into deposits in their own bank accounts and in
conspicuous consumption.
Capital
A modern economy requires an immense variety of
capital goods. Countries must abstain from current
consumption to achieve profitable self-sustaining
production. But therein lies the obstacle, since the
poorest countries are almost at a subsistence level.
When one is poor to begin with, reducing current
consumption and favoring future consumption seems
an impossible task.
Leaders in the growth race invest at least 20% of
their product in capital formation. By contrast, the
poorest agricultural countries can often save only 5% of
their national income. Furthermore, much of the low
level of savings goes to provide a growing population
with housing and simple tools. Little remains for
development.
But suppose a country has succeeded in raising its
saving rate. Still, it takes many decades to accumulate
roads, telecommunication systems, hospitals, power
generation plants, and other capital assets that make
up a productive economic structure.
However, even before acquiring the most advanced
infrastructure, or indirect equity, which constitutes the
large-scale projects on which a market economy
may train farmers in a certain area on new seeds or
crops; a road network connects the different markets; a
public health program vaccinates the population against
diphtheria or typhoid, and protects it from people who
have not been vaccinated. In each of these cases it
would be impossible for a private company to take
advantage of the social benefits derived from them,
because it cannot
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B. ECONOMIC GROWTH IN POOR COUNTRIES 257

charge thousands or even millions of beneficiaries. benefit and benefit the recipient if you invest in high-yield
Given the large indivisibilities and externalities of infrastructure, the projects abroad.
government must step in to ensure and even make the necessary However, the risk is the forced companion of the profits
investments. of foreign loans. The history of lending from rich countries
to poor countries shows a cycle of opportunities, loans,
In many developing countries the most important problem is that profits, overexpansion, speculation, crises, and the
there is very little saving. Particularly in the poorest regions, urgent current depletion of funds, followed by a new round of lending by
consumption competes with investment for scarce resources. The result another group of dreamy investors. No sooner has one
is an insufficient level of investment in productive capital, essential for crisis been forgotten than another arises.
rapid economic growth. It is useful to review the saga of emerging markets, a
name often given to high-growth low- and middle-income
countries that offer promising areas for foreign investment.
In the 1990s, investors from rich countries sent funds
abroad in search of higher returns; Poor countries, hungry
Borrowing from abroad and debt crises for capital, welcomed this flow of foreign funds. From
Thailand to South Africa, both lending and equity
If there are so many obstacles to finding investment boomed during the 1990s.
domestic savings that allow capital formation,
why not get foreign loans? Economic theory says that a Figure 12-2 shows the interest rate differential on
rich country, which has already exhausted its own high- emerging market securities. This differential represents
return investment projects, can the risk premium that they would have to pay to

14

12
Mexican
crisis
debt

payment
Russia's
Asian
crisis
non-
East
and

10

percentage)
emerging
(annual
8 States
United
from

premium
Market
debt
risk banking
housing
crisis
and

0 1993 nineteen ninety five 1997 1999 2001 2003 2005 2007 2009
Year

FIGURE 12-2. Emerging Market Bond Spread, 1993-2008

The spread shows the risk premium paid by borrowers from emerging market countries. It is
the premium paid above the yield on safe US dollar securities. Note how the premium soared
during the 1995 Mexican crisis and the 1998 emerging market crisis and Russian default.
Then market participants returned to optimism during the market expansion in the early
1990s. 2000. This all ended with the 2007-2009 credit crisis when the spread increased again.

Source: International Monetary Fund.

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258 CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT

attract funds, who borrow in emerging market countries.
When the risk is perceived to be low, the spread is low.
When investors become so concerned that countries may
default on their loans, or in periods when the price of risk
rises, spreads skyrocket.
As long as emerging market growth held up, all was
quiet and returns were strong. But slowing growth,
combined with a series of banking crises, led to massive
outflows of short-term funds from Thailand, Indonesia and
South Korea.
Bankers who had invested heavily claimed their money.
This led to a sharp increase in supply
of the currencies of these countries. Most countries had
fixed exchange rate systems, and the sale overwhelmed
their foreign exchange reserves. One after another,
Southeast Asian currencies tumbled. Many asked for the
help of the International Monetary Fund (IMF) to obtain
short-term funds, but the IMF demanded the application of
restrictive monetary and fiscal policies. All of these factors
produced strong recessions throughout Southeast Asia.
When Russia defaulted on its debt in 1998, the EM market
panicked and credit spreads skyrocketed.
Within three years, most of these countries recovered
from the crisis after a period of adjustment: slow output
growth, reduced real wages, debt rescheduling, and trade
surpluses. Economic growth has resumed. the world has
survived
to another financial crisis. As Exhibit 12-2 shows, the
spread, or risk premium, gradually declined over the next
ten years, until the next crisis erupted in the US financial
market.
Technological innovation and change
The last and most important pillar is technological
advancement. Here, developing countries have a
quickly became the world leaders in the automotive
industry.
Japan was late to the industrial race, sending
students abroad only at the end of the 19th century to
learn Western technology. The Japanese government
played an active role in stimulating the pace of
development and in building railways and public
services. By adopting productive foreign technologies,
Japan moved to its current position as the world's
second largest industrial economy. The examples of
the United States and Japan show how countries can
prosper by adapting foreign science and technology to
the conditions of their local markets.
Entrepreneurship and innovation. From the histories
of the United States and Japan it might appear that the
adaptation of foreign technology is an easy recipe for
development. It could be said, “It is enough to go out,
copy the most efficient methods and apply them at
home; then you have to sit and wait for the additional
product to arrive.”
Unfortunately, the application of technological
change is not so simple. A textbook of
Poorland, but without qualified scientists, engineers,
entrepreneurs, and adequate capital, Poorland couldn't
even think of building a functioning petrochemical plant.
Advanced technology was developed to meet the
specific needs of advanced countries, including the
availability of highly skilled engineers and workers, a
reliable electricity supply, and readily available spare
parts and repair services. These conditions do not exist
in poor countries.
One of the key tasks of economic development is

fundamental advantage: they can expect to benefit by promote an entrepreneurial spirit. A country cannot
prosper without a group of owners or managers who
relying on the technological progress of more advanced countries.
are willing to take risks, start new companies, adopt
Imitation of technology. Poor countries don't have to new technologies and import new ways of doing
find modern Newtons to discover the law of gravity; business. At the most fundamental level, innovation
You can read about it in any physics book. They don't and entrepreneurship flourish when property rights are
have to repeat the slow, zigzagging route of the clear and comprehensive, and taxes and other burdens
Industrial Revolution; they can buy tractors, computers on profits (such as corruption) are low and predictable.
and electric looms never dreamed of by the great The government can also encourage entrepreneurship
merchants of the past. through targeted investments: establishing agricultural
Japan and the United States clearly illustrate this in extension services, educating and training the
their historical development. The United States offers workforce, and establishing management schools.
a powerful example to the rest of the world. The key
inventions that followed from the automobile originated Poor countries often suffer from widespread
almost exclusively abroad. However, Ford and General corruption. The following explanation by economic
Motors took advantage of foreign inventions and became development specialist Robert Klitgaard prescribes
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B. ECONOMIC GROWTH IN POOR COUNTRIES 259

Explain how corruption undermines economic

development: Low saving
and investment

In its broadest sense, corruption is the misuse of the

position for unofficial purposes. The catalog of corrupt
acts includes bribery, extortion, influence peddling,
nepotism, easy money, fraud, embezzlement, and Low income on Low rate of
more. capital accumulation
average
Corruption that undermines the rules of the game
—for example, the judicial system, property rights, or
banking or credit—devastates economic and political
development. Corruption allows polluters to dirty rivers
Low
or hospitals to extort money from their patients; it can
productivity
be corrosive both environmentally and socially. When
corruption becomes the norm, its effects are crippling.
Although all countries have some degree of corruption, FIGURE 12-3. The vicious cycle of poverty
its variety and extent are different. The corruption that Many obstacles to development reinforce each other.
kills is the systematic corruption that destroys the rules Low income levels prevent saving, retard the growth of
of the game. capital, hurt productivity growth, and keep income low.
It is one of the main reasons why the most Successful development may require taking steps to break
underdeveloped parts of our planet remain in that the chain into several links.
situation.

Fighting corruption is particularly difficult because the

government, which is the instrument of justice, is often
corrupt.

From vicious circles to virtuous circles

It has been emphasized that poor countries face such yt + 1 = f( yt )
great obstacles in combining the four elements of
progress: labor, capital, resources, and innovation.
Furthermore, countries find that difficulties reinforce
each other in a vicious cycle of poverty.
Figure 12-3 illustrates how one obstacle leads to Income
1)
in
+
(t

additional obstacles. Low income prevents saving;
insufficient saving retards the growth of capital; scarce
capital prevents the introduction of new machinery
and rapid productivity growth; low productivity leads
to lower income. Other elements of poverty are also
reinforced. Poverty is accompanied by low levels of
education, literacy and skills; this in turn prevents the
adoption of new and better technologies, and leads to
rapid population growth, which eats up improvements
in total and food output.
Countries that suffer from a vicious cycle can be
stuck in a poverty trap. This syndrome arises when
there are multiple equilibria, and one of the equilibria
may be particularly pernicious.
Low-level traps are found in many areas of the natural
and social sciences, and are illustrated in Figure 12-4.
This graph shows the average income in period t on
the horizontal axis and the average income in period
(t 1) on the vertical axis. The nonlinear growth curve
yt1 f(yt ) shows how
A
45°
0 Y* Y** Y***
income in t
FIGURE 12-4. Countries can get stuck in poverty traps
When vicious cycles lead to downward spirals, countries
can be locked into low-income traps, such as Y*. Note that
a country starting between 0 and Y** will gravitate back to
the low income trap.
Follow the arrows from A and see how they lead to Y*.
However, if a country can make a big effort to get out of the
trap by pushing beyond Y**, then the country enters a
virtuous circle of growth to reach a high level of income like
Y***. Low-income traps can arise from the interaction of low
income, poor health, low savings, low investment, and low
productivity.
Machine Translated by Google
260
that income moves in time. The 45º line shows the
division between positive growth and decline. When a
point on the growth curve is above the 45º line, income
at (t 1) is greater than income at t, so income is growing.
When the growth curve intersects the 45º line, income
is constant and there is economic equilibrium.
The unusual feature of the S -shaped growth curve
is that it leads to multiple equilibria. The lower crossover
represents a low-level equilibrium trap on Y*, while the
upper crossover is a benign high-level equilibrium on
Y***. Modern economic development theory suggests
that low-level traps come from rapid population growth,
low productivity, or low “connectivity.”
Breaking out of the poverty trap may require a
concerted effort on many fronts, and some development
economists recommend a “big push” forward to break
the vicious cycle. If a country is lucky, simultaneous
steps to invest more, improve health and education,
develop skills, and slow population growth can break
the vicious cycle of poverty and stimulate a virtuous
cycle of rapid economic growth.
If the country can propel itself to the right of Y** in Figure
12-4, then it will take off toward sustained economic
growth.
DEVELOPMENT STRATEGIES
ECONOMIC
See how countries must combine labor, resources,
capital, and technology in order to grow rapidly. But this
is not the real formula; is the equivalent of saying that
an Olympic sprinter should run like the wind. Why do
some countries succeed in running faster than others?
How do poor countries get started on the path of
economic development?
For a long time, historians and social scientists have
been fascinated by the differences in the rate of
economic growth between countries. Some pioneering
theories highlighted the climate, pointing out that all
advanced countries are in the temperate zone of the
planet. Others have claimed that customs, culture or
religion are a key factor. Max Weber singled out the
“Protestant ethic” as the driving force behind capitalism.
More recently, Mancur Olson has argued that countries
begin their decline when their decision structures
weaken, and
CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT
interest groups or oligarchies prevent economic and
social change.
There is no doubt that each of these theories has
some validity in a particular time and place. But they do
not hold up as universal explanations of economic
development. Weber's theory leaves unexplained why
the cradle of civilization appeared in the Near East and
Greece, while the Europeans, who later ruled, lived in
caves, worshiped mythological beings, and wore
bearskins. Where is the Protestant ethic in bustling
China? How to explain that a country like Japan, with a
rigid social structure and powerful lobby groups, has
become one of the most powerful economies in the
world?
Even in the modern era, people cling to simplistic,
totalitarian explanations of economic development. At
one time, import substitution (replacing imports with
domestically manufactured products) was considered
the safest development strategy. Then, in the 1970s, it
was believed that it was convenient to rely on labor-
intensive techniques. Today, as will be seen, economists
tend to emphasize the outward-oriented basis of market
forces. This account should serve as a warning
that leads to distrust simplistic approaches to explain
complex processes.
Nevertheless, historians and development
economists have learned a great deal from studying
changes in economic growth. What are some of the
lessons? What follows is a montage of important ideas
that have been formulated in recent years. Each
approach describes how countries could break the
vicious cycle of poverty, and start building the four pillars
of economic development.
The backwardness
hypothesis One point of view emphasizes the
international context of development. It has already
been analyzed that the poorest countries have important
advantages that the pioneers did not have on the path of industrializat
Developing countries can now rely on capital, skills and
technology from more advanced countries. A hypothesis
put forward by Alexander Gerschenkron of Harvard
suggests that relative backwardness can help
development. Countries can buy modern textile
machines, efficient pumps, miracle seeds, chemical
fertilizers, and medical supplies. Because they can rely
on the technology of the most advanced countries,
today's developing countries can grow faster than Britain
or Western Europe did in the 1970s.
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B. ECONOMIC GROWTH IN POOR COUNTRIES
1780-1850. To the extent that low-income countries
rely on the most productive technologies of the
leaders, it is to be expected that they will converge on
the technological frontier. Convergence occurs when
countries or regions that initially had low incomes tend
to grow faster than countries that enjoy high incomes.
Industrialization and agriculture In
most countries the income of urban areas is almost
twice the income of rural areas. And in affluent
countries, a large part of the economy is based on
industry and services. Therefore, many nations jump
to the conclusion that industrialization is the cause and
not the effect of affluence.
Care must be taken with these deductions, which
confuse the association of two characteristics with their
causality. Some say, "The rich drive BMWs, but
driving a BMW will not make you rich." Similarly, there
is no economic justification for a poor country to insist
on having its own airline and its own big steel company.
Those are not the needs
fundamentals of economic growth.
Lessons from decades of efforts to accelerate
industrialization at the expense of agriculture have led
many analysts to rethink the role of agriculture.
Industrialization is capital intensive, attracts workers
to agglomeration of cities, and often generates high
levels of unemployment. Raising the productivity of
agriculture can require less capital, while providing
productive employment for surplus labor. Indeed, if
Bangladesh could increase the productivity of its
agricultural sector by 20%, such progress would do
more to free up resources and channel them into the
production of other goods than to try to build a national
steel industry to displace imports.
The State versus the market
The cultures of many developing countries are hostile
to the functioning of markets. Often, competition
between companies or the pursuit of profit is contrary
to traditional practices, religious beliefs or vested
interests. But decades of experience suggest that a
strong market base is the most effective way to run an
economy and promote rapid economic growth.
What are the important elements of a market-
oriented policy? They include the predominance of
private ownership, an outward orientation in trade
policy, low tariffs, and few restrictions.
261
quantitative measures to trade, the promotion of small
businesses and the promotion of competition.
Furthermore, markets work best in a stable
macroeconomic environment, where taxes are
predictable and inflation is low.
Growth and outward
orientation
A fundamental issue of economic development
concerns a country's attitude toward international
trade. Should developing countries try to be self-
sufficient, to replace most imports with domestic
production? (This is known as the import substitution
strategy .) Or should a country struggle to pay for the
imports it needs, improving its efficiency and
competitiveness, developing external markets, and
keeping barriers to trade low? (This is called an
outward-facing or openness strategy.)
Import substitution policies were popular in several
Latin American countries until the 1980s. The most
widely used measure to achieve this end was to build
high tariff walls around and around the local
manufacturing industry, so that domestic firms could
make and sell goods that would otherwise have been
imported.
An open policy keeps trade barriers to a minimum,
through the use of tariffs and not tariffs and not quotas
and other non-tariff barriers.
It minimizes interference with financial flows and
allows supply and demand to operate in financial
markets. Avoid a government monopoly on exports
and imports. It keeps government regulation to the
minimum necessary for an orderly market economy.
But above all, it relies fundamentally on a private
market system of profit and loss to guide production,
rather than the public ownership and control that
underlies a government planning system.
The success of outward-oriented policies is best
illustrated by the success of the countries of Southeast
Asia. A generation ago, countries like Taiwan, South
Korea, and Singapore had per capita incomes that
were one-fourth to one-third that of the richest Latin
American countries. However, by saving large fractions
of their national income and channeling it into high-
return export industries, Southeast Asian countries
surpassed all Latin American countries in the late
1980s. The secret to success was not a policy
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262
laissez-faire doctrinaire , since governments did engage in
selective planning and intervention.
Rather, openness and outward orientation allowed
countries to reap economies of scale and the benefits of
international specialization, thereby increasing employment,
making efficient use of their domestic resources, and
enjoying rapid productivity growth. and bring enormous
gains to their living standards.
Although openness offers many benefits, when it is
excessive, particularly in short-term financial flows, it is an
invitation to speculative attacks. What investors lent,
investors can get back. This syndrome can cause financial
and banking crises, as already noted in this chapter, as it
did in the economies of Southeast Asia.
Summary of criteria
Decades of experience in dozens of countries have led
many development economists to the following summary
of how governments can best promote economic
development:
Government has an essential role to play in establishing
and maintaining a healthy economic environment. It must
ensure respect for the rule of law, guarantee compliance
with contracts, combat corruption, and direct its policies
towards competition and innovation. The government must
play a leading role in investments in indirect social capital—
in education, health, communications, energy, and
transportation—but it must consider the private sector when
it does not have a comparative advantage. The government
must resist the temptation to produce everything at home.
A strong commitment to openness to trade and foreign
investment will help a country to move rapidly towards
world best practices in different sectors.
C. ALTERNATIVE DEVELOPMENT MODELS
Individuals continually seek ways to improve their standards
of living. The improvement in economic matters is
particularly imperative for poor countries, which are looking
for a route to the riches that they see around them. This
book has taken an in-depth look at America's mixed market
economy, which fundamentally combines free markets with
a obtain
CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT
good size government sector. What other alternatives are
there?
A CLUSTER OF “ISMS”
At one extreme is free market absolutism.
which holds that the best government is the least
government. At the other extreme is outright communism,
where the government operates a collectivized economy in
which there is hardly a first person singular. Between the
two extremes of laissez-faire and communism lie mixed
capitalism, managed markets, socialism, and many
combinations of these models. This section briefly describes
some of the most influential alternative strategies for growth
and development:
1. The Asian approach to managed markets. South Korea,
Taiwan, Singapore, and other Southeast Asian countries
have fashioned their own brand of economics,
combining strong government oversight with powerful
market forces.
2. Socialism. Socialist thought encompasses a wide variety
of different approaches. In Western Europe, after World
War II, socialist governments operating in a democratic
framework expanded the welfare state, nationalized
industries, and planned their economies. However, in
recent years these countries returned to a free market
framework with extensive deregulation and privatization.
3. Soviet-style communism. For many years the clearest alternative to
the market economy
it was the Soviet Union. In the Soviet model, the state
owned all the land and most of the capital, set wages
and most prices, and ran the microeconomic operation
of the country.
The central dilemma: market versus orders
A review of alternative economic systems
It may seem like an overwhelming diversity of economic
“isms”. And there are, of course, a wide variety of ways in
which countries organize their economies.
A fundamental aspect that is always present in all the
great debates on alternative economic systems: should
economic decisions be made mainly by the market or by
the public sector?
At one end of the spectrum is the market economy. In
a market system, people act voluntarily and primarily to
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C. ALTERNATIVE DEVELOPMENT MODELS 263

financial benefits or utility. Firms buy factors and an economy of command. The tension between the systems

manufacture products, selecting inputs and outputs in
such a way as to maximize their profits. Consumers
contribute factors and buy consumer goods to maximize
their utility. Agreements on production and consumption
are made voluntarily and with the use of money, at prices
determined in free markets, and based on arrangements
between buyers and sellers. Although individuals differ
greatly in terms of their economic power, relationships
between individuals and firms are horizontal in nature,
essentially voluntary, and non-hierarchical.
At the other end of the spectrum is the command
economy, where decisions are made by a government
bureaucracy. Under this approach, individuals are linked
by a vertical relationship, and control is exercised by a
multi-level hierarchy. The planning bureaucracy determines
what goods are produced, how they are produced, and
for whom they are produced. At the top level of this
pyramid, major decisions are made and the elements of
the plan for the economy are developed. The plan is
subdivided and transmitted down to the various
bureaucratic levels, where the lower levels are charged
with executing the plan, with increasing attention to detail.
Individuals are motivated by coercion and legal sanctions;
organizations force individuals to accept superior orders.
Transactions and orders may or may not require the use
of money; the exchange may or may not take place at the
stated prices.
Between these extremes lie the socialist and managed
market economies. In both cases, the government plays
an important role in guiding and directing the economy,
Market and command relationships exist in all discussions
of alternative economic systems. watch each other
in more detail some of the alternatives to mixed market
economies.
THE ASIAN MODELS
The Asian Dragons
Developers sometimes look to the countries of Southeast
Asia as examples of successful development strategies.
The rapid economic growth of South Korea, Singapore,
and Taiwan over the past half century is known as the
Asian miracle.
Table 12-2 compares the performance of the “Asian
dragons” with that of other large areas in recent years.
Latin America and sub-Saharan Africa have been growing
at a positive rate. However, look at the Southeast Asia
and Pacific region, and especially China. The countries of
this region have had a phenomenal growth rate,
particularly in the last 30 years.
The World Bank conducted a study of the economic
policies of different regions to see if any particular
patterns emerged.1 The results confirmed common
views, but also threw up some surprises. Here are the
highlights:
• Investment rates. The Asian dragons followed the
classic recipe of high investment rates to ensure that
their economies were equipped with the latest technology.
one

See the Further Reading section of this chapter for the World Bank
although much less than in study on the Southeast Asian miracle.

Average growth of real GDP per capita

Region 1962-1973 1973-1995 1995-2006

Southeast Asia and Pacific 3.6 4.8 6.4

China 4.0 4.7 8.2
South Asia 2.0 2.5 4.4
India 2.2 23 4.9
Latin America and the Caribbean 4.0 1.7 1.5
Sub-Saharan Africa 2.8 0.7 1.7

TABLE 12-2. Focus on economic fundamentals sparked growth in Asian dragons

Source: World Development Indicators (2008), available at www.worldbank.org/

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264
state-of-the-art technology and could build the
necessary infrastructure. The investment rates of the
Asian dragons were almost 20% higher than those
of other regions.
• Fundamentals of macroeconomics. Successful
countries had a firm hand on macroeconomic
policies, keeping inflation low and savings rates high.
They invested heavily in human capital, as well as
physical capital, and did more to promote education
than any other region in the developing world.
Financial systems were managed to ensure monetary
stability and a sound currency. • Exterior orientation.
The Asian dragons turned outward, often keeping
exchange rates undervalued to promote exports,
encouraging them with tax incentives, and seeking
technological advances by adopting best-practice
techniques from high-income countries.
the rise of china
One of the great surprises in economic development in
these thirty years has been the rapid growth of the
Chinese economy. After the 1949 revolution, China
initially adopted a Soviet-style central planning system.
Centralization reached
its climax with the Cultural Revolution of 1966-1969,
which led to China's economic backwardness. After the
death of the revolutionary leader Mao Tse-tung, a new
generation concluded that economic reform was
necessary if the Communist Party was to survive. Under
the leadership of Den Xiaoping from 1977 to 1997, China
considerably decentralized economic power and
promoted competition. However, the economic reform
was not accompanied by a political reform; the democracy
movement was mercilessly crushed in Tiananmen
Square in 1989, and the Communist Party has continued
to monopolize the political process.
To foster economic growth, the Chinese leadership
has taken substantial steps such as establishing “special
economic zones” where it allows capitalist and foreign
companies to operate. The fastest growing areas of
China have been the coastal regions, such as the
southern region near Hong Kong and greater Shanghai.
These areas have been closely integrated with countries
outside of China and have attracted considerable foreign
investment. In addition, China has allowed private and
foreign companies to operate, free from government
planning or control, alongside state-owned companies.
you are inno
CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT
Vative forms of ownership have grown rapidly and by
the turn of this century, they were producing more than
half of China's GDP.
The rapid and continuous growth of the Chinese
economy has surprised observers almost as much as
the collapse of the Soviet economy. As Table 12-2
demonstrates, growth in GDP per capita accelerated
from 4.0% a year in 1962-1973, to 8.2% in 1995-2006.
China's exports to the United States have grown by more
than 17% over the past decade.
By 2008, China had annual exports of nearly $2 trillion
and had accumulated foreign exchange reserves of $1.5
trillion.
The future of the Chinese economic model is being closely watched
around the world. The undoubted success of
Outward orientation, particularly towards foreign
investment, is a particularly notable feature of Chinese
economic policy.
SOCIALISM
As a doctrine, socialism developed from the ideas of
Karl Marx and other radical thinkers of the 19th century.
Socialism is somewhere in between laissez-faire
capitalism and the central planning model, which is
discussed in the next section. A few elements characterize
most socialist philosophies:
• Government ownership of productive resources.
Socialists traditionally believe that the role of private
property should be reduced. Strategic industries
such as railways and banking should be nationalized
(that is, owned and operated by the state). In recent
years, because of the poor performance of many
state-owned companies, enthusiasm for
nationalizations has waned in most advanced
democracies.
• Planning. Socialists are suspicious of the "chaos" of
the market and question the distributive efficiency of
the invisible hand. They insist that a planning
mechanism is required to coordinate different sectors.
In recent years, planners have attached great
importance to subsidies to promote the rapid
development of high-tech industries such as
microelectronics, aircraft manufacturing, and
biotechnology; these policies are sometimes known
as “industrial policies”. • Income redistribution.
Inherited wealth and increased income will have to be
reduced by vigorous application of the government's
fiscal powers; in some Western European countries,
rates
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C. ALTERNATIVE DEVELOPMENT MODELS
Marginal taxes have reached 98%. Social security
benefits, free medical care, and cradle-to-grave
care services, provided by the government and
paid for by progressive taxes, increase the well-
being of the underprivileged and guarantee
minimum standards of living for all. • Peaceful and
democratic evolution. Socialists often propose the
peaceful and gradual extension of government
ownership: an evolution with votes, not a revolution
with bullets.
Socialist approaches have fallen out of favor with the
collapse of communism, European stagnation, and
the success of market-oriented economies. There are
socialist thinkers searching among the wreckage for a
future role for this branch of economic thought.
THE FAILED MODEL: THE ECONOMIES
OF CENTRAL PLANNING
For many years developing countries looked to the
Soviet Union and other communist countries as
models for their industrialization. Communism offered
both a theoretical critique of Western capitalism and
an apparently viable strategy for economic
development. First you have to review the theoretical
foundations of Marxism and communism, and then
see how the Soviet-style command economy worked
in practice.
Karl Marx: The Economist as Revolutionary
Karl Marx (1818-1883) apparently lived an
uneventful life, poring over the books he
consulted in the British Museum, writing
newspaper articles, and working on his academic studies
of capitalism. Although originally drawn to German
universities, his atheism, pro-constitutionalism, and radical
ideas led him to journalism. Finally he was exiled to Paris
and London where he wrote his extensive critique of
capitalism, Capital (1867, 1885, 1894).
The central part of Marx's work is an incisive analysis
of the strengths and weaknesses of capitalism. Marx
argued that the value of any commodity is determined by
its labor content, both direct labor and indirect labor
embodied in the capital equipment. For example, the
value of a shirt comes from the effort of the textile workers
who make it, plus the effort of the workers who made the
looms. By assigning the entire value of the product to
labor, Marx tried to show that profits—the part of the
product that workers generate, but
265
received by capitalists—mean "unearned income."
From Marx's point of view, the injustice of capitalists
receiving an income they have not earned justifies the
transfer of ownership of factories and other means of
production from capitalists to workers. He proclaimed his
message in The Communist Manifesto (1848): “Let the
ruling classes tremble at the communist revolution. The
proletarians have nothing to lose except their chains. And
the ruling capitalist classes did tremble at Marxism for
over a century!
Like many great economists, but with more passion
than most, Marx was deeply moved by the struggle of the
working class and hoped to improve their living conditions.
He wrote the words that appear on his epitaph: “Until
now, philosophers have limited themselves to interpreting
the world in various ways. However, it is about transforming
it!” Another epitaph for Marx could be the comment of the
distinguished historian and intellectual, Sir Isaiah Berlin:
"No 19th century thinker has had such a direct, deliberate
and powerful influence on humanity as Karl Marx."
The sinister prophecies
Marx concluded that capitalism inevitably led to
socialism. In Marx's world, technological advances
allow capitalists to replace workers with machinery as
a means of making higher profits. But this increasing
accumulation of capital has two contradictory
consequences. As the available supply of capital
increases, the rate of profit on capital falls. At the
same time, with fewer jobs, the unemployment rate
goes up and wages go down. In Marx's terms, the
"reserve army of the unemployed" would grow and the
working class would become increasingly "miserable,"
that is, working conditions would deteriorate and
workers would progressively alienate themselves from
their jobs.
As profits shrink and domestic investment
opportunities dry up, the ruling capitalist classes turn
to imperialism.
Capital tends to seek higher rates of profit abroad.
And, according to this theory (particularly in Lenin's
expanded version), the foreign policy of the imperialist
countries would increasingly try to win colonies and
then ruthlessly strip them of their surplus value.
Marx believed that the capitalist system could not
continue this unbalanced development forever.
Marx predicted a growing inequality under capitalism,
together with a gradual rise of class consciousness of
the oppressed proletariat. business cycles
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266
Trades would become more and more violent as the
poverty of the masses caused macroeconomic
underconsumption. Finally, a cataclysmic depression
would ring the death bells of capitalism. As once with
feudalism, capitalism contained the seeds of its own
destruction.
The economic interpretation of history is one of
Marx's most enduring contributions to Western thought.
Marx held that economic interests explain and
determine values. Why do corporate executives vote
for conservative candidates, while labor leaders
support those who propose raising the minimum wage
or higher unemployment benefits? The reason, said
Marx, is that the beliefs and ideologies of the population
reflect the material interests of their social and
economic class.
In fact, Marx's approach is hardly alien to mainstream
economic thought.
Marx generalizes Adam Smith's analysis of self-
interest from market dollar votes to political election
votes to barricade bullet votes.
From textbooks to tactics:
Soviet-style command economy
Marx wrote prolifically about the failures of capitalism,
but he left no plans for reaching the socialist promised
land. His arguments suggested that communism
would emerge in the most industrialized countries.
Rather, it was feudal Russia that adopted the Marxist
view. Pay attention to this fascinating and terrifying
chapter of economic history.
historical roots. An Analysis of Soviet Communism
it is of greater importance for economics, since the
Soviet Union served as a laboratory for theories on the
operation of a command economy.
Some economists argued that socialism simply
wouldn't work; Soviet experience proved them wrong.
Its supporters held that communism would dominate
capitalism; Soviet history also refutes this thesis.
Although Czarist Russia grew rapidly from 1880 to
1914, it was considerably less developed than
industrialized countries like the United States or Great
Britain. World War I brought
severe difficulties for Russia, and opened the space
for the communists to seize power. From 1917 to 1933,
the Soviet Union experimented with different socialist
models before adopting central planning. But
dissatisfaction with the pace of the industry
CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT
In 1928, Stalin led Stalin to undertake a radical new
initiative: the collectivization of agriculture, forced
industrialization, and central planning of the economy.
With the collectivization of agriculture between
1929 and 1935, 94% of Soviet peasants were forced
to join collective farms. In the process, many wealthy
peasants were deported, and conditions became so
bad that many perished. The other part of the Soviet
"great leap forward" came with the introduction of
economic planning for rapid industrialization. The
planners created the first five-year plan for the period
1928-1933.
This plan established the priorities of Soviet planning:
heavy industry would be favored over light industry,
and consumer goods would be the residual sector
after all other priorities had been satisfied. Although
there were many reforms and shifts in emphasis, the
Stalinist model of a command economy was applied in
the Soviet Union and Eastern Europe until the fall of
Soviet communism in the late 1980s.
How command economy worked. In the Soviet-style
command economy, the broad product categories
were determined by political decisions. Military
spending in the Soviet Union always received a
substantial part of the product and scientific resources,
while the other great priority was investment.
Consumption claimed what was left of the product after
the quotas of the highest priority sectors had been
satisfied.
To a large extent, the decisions about the way in
which the goods were to be produced were made by
the planning authorities. The planners first decided the
quantities of final product (the what). Next, the inputs
required and the flows between the different companies.
Planners specified investment decisions in great detail,
while firms had considerable flexibility in deciding their
mix of labor inputs.
It is evident that no planning system could specify
all the activities of all the companies, this would have
required trillions of orders every year. Many details
were left to the managers of the individual factories. It
was here, in what is known as the principal-agent
problem, that command economics had its biggest
problems.
The principal-agent problem arises because the
person at the top of a hierarchy (the "principal") wishes
to offer appropriate incentives to the decision-maker.
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C. ALTERNATIVE DEVELOPMENT MODELS
decisions at the lower echelons (the “agents”) to be
handled according to the wishes of the principal. In a
market economy profits and prices serve as the
coordinating mechanism of producers and consumers.
A command economy has failed to find an efficient
substitute for profits and prices to incentivize its agents.
you.
A useful example of the inability to solve the principal-
agent problem was found in Soviet book publishing. In
a market economy, business decisions on the books are
made primarily on the basis of profit and loss. In the
Soviet Union, because profits were a taboo subject,
planners insisted on quantitative targets.
A first approach was to reward companies according to
the number of books published, so thousands of small
volumes were published that were not read.
Faced with a clear incentive problem, the (main) center
modified the system so that producers (agents) were
rewarded based on the number of pages printed, and
the result was thick books printed in onionskin and large
print. . Later, the planners changed the criteria to the
number of words, to which publishers responded by
printing huge volumes in small type.
None of these mechanisms could effectively serve the
wishes of consumers.
The principal-agent problem arises in the
organizations of all countries, but the Soviet model had
few mechanisms (such as bankruptcy in market
economies and elections in public goods) to verify and
correct what did not work.
Comparative economic performance. From World
War II until the mid-1980s, the United States and the
Soviet Union were locked in a superpower competition
for public opinion, military superiority, and economic
dominance. How well have command economies
performed in the race for economic growth?
Any attempt to answer this question is doomed for lack
of reliable statistics.
Until recently, most economists believed that the Soviet
Union had grown rapidly from 1928 until the mid-1960s,
with growth rates perhaps surpassing those of North
America and Western Europe. In the second half of the
1960s, growth in the Soviet Union stagnated and output
began to decline.
A revealing comparison of the performance of market
and command economies can be made
267
contrasting the experiences of East Germany and West
Germany. These countries started with roughly equal
levels of productivity and similar industrial structures at
the end of World War II. After four decades of capitalism
in the West and Soviet-style socialism in the East,
productivity in East Germany had fallen to an estimated
level between one quarter and one third that of West
Germany. Furthermore, growth in East Germany tended
to emphasize the production of intermediate goods and
low-value merchandise for consumers. Quantity, not
quality, was the
goal.
Balance. Is there a final balance of Soviet central
planning? The Soviet model demonstrated that a
command economy can work: it is capable of mobilizing
capital and labor and producing cannons and butter. But
the Soviet economy, with borders closed to trade,
technology and people, fell further and further behind.
Innovation withered because of poor incentives. In
competition with free-market economies, particularly as
the world turned to high-quality goods and services,
Russia was able to export virtually nothing except raw
materials and military equipment.
Growth slowed, and per capita income fell in the
final period of central planning. Ultimately, its leaders
abandoned Soviet central planning, as it was considered
morally, politically, and economically bankrupt.
From Marx to the market
Beginning in 1989, the countries of Eastern Europe and
the former Soviet Union rejected the communist
experiment and introduced market economies. A cruel
joke heard in Eastern Europe is “Question: What is
communism? Answer: It is the longest route from
capitalism to capitalism.”
The road back to capitalism turned out to be a
difficult one for many countries. Among the challenges
were the following: 1) the liberalization of prices to allow
supply and demand to determine prices, 2) the imposition
of severe budgetary restrictions on subsidized
companies, 3) the privatization of companies, so that
that purchase, sale, price, production, indebtedness and
credit granting decisions were taken by private agents
and 4) the establishment of market institutions, such as
a modern banking system, the legal framework for trade
and policy tools monetary and fiscal.
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268
Some countries, such as Slovenia and the Czech
Republic, made the transition relatively quickly and
are now increasingly integrated into the European
Union as functioning market democracies. Russia has
once again nationalized much of its energy industry
and has become a power in this area. Other countries,
particularly the former Soviet republics in Asia, are still
trapped in autocracy, corruption and rigid economic
structures. The lessons to be drawn from all this are
useful to any country trying to establish the institutions
of a market economy.
A final note of cautious optimism This
chapter has described the problems and prospects of
poor countries struggling to be rich and free to provide
dry housing, education, electric light, fast horses,
automobiles, and the long vacations mentioned in the
opening paragraph of this chapter. chapter. What are
the prospects for reaching these goals?
RESUME
A. Population growth and development 1.
Malthus' theory of population rests on the law of diminishing
returns. He maintained that the population, if left
unchecked, tended to grow at a geometric (or
exponential) rate, roughly doubling every generation.
But each member of the growing population would have
less and less land and natural resources with which to
work. Because of diminishing returns, income would
grow, at most, at an arithmetic rate; the product per
person would tend to fall so much that it would stabilize
the population at a subsistence level.
2. In the intervening 200 years, Malthus and his followers
have been criticized from many angles. Among the
major criticisms are that the Malthusians omitted the
possibility of technological advances, and overlooked
the significance of birth control as a force to reduce
population growth. Neo-Malthusians see limits to growth
due to environmental constraints, particularly global
warming, where markets send distorted signals.
B. Economic growth in poor countries 3. Most of
the world's population lives in developing countries, which
have relatively low per capita income . These countries
often have high population growth, low literacy, poor
CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT
This chapter closes with a sober assessment of
Jeffrey Sachs of Columbia University and the Earth
Institute, one of today's leading development
economists, and his coauthor Andrew Warner:
The world economy (today) looks a lot like the world
economy at the end of the 19th century. A global
capitalist system is taking shape, drawing nearly every
region of the world into free trade agreements and
harmonized economic institutions. As then, this new
round of globalization promises to bring economic
convergence to countries that join the system.
And yet, there are still deep risks for the consolidation
of market reforms in Russia, China and Africa, as well
as for the maintenance of international agreements
between the leading countries… The spread of capitalism
in the (last) twenty-five years is a A very promising and
significant historical fact, but whether we are celebrating
(25 years from now) the consolidation of a democratic,
market-based world system will depend on our vision
and sound judgment in the years to come.
sanitary conditions, and a high proportion of its
population lives and works in agriculture.
4. The key to development lies in four fundamental factors:
human resources, natural resources, capital and
technology. A population explosion causes problems,
such as the Malthusian prediction that diminishing
returns haunt the poorest countries.
In a constructive agenda, the improvement of the
population's health, their education and their technical
training have high priority.
5. Saving and investment rates in poor countries are low,
because incomes are so depressed that little can be
saved for the future. International financing of investment
in poor countries has seen many crises in the last 200
years.
6. Technological progress is frequently associated with
investment and new machinery. Such a change offers
great hope to developing countries because they can
adopt the most productive technologies of advanced
countries. This calls for entrepreneurial spirit. One task
of development is to foster the internal growth of the scarce
entrepreneurship.
7. Numerous theories of economic development help to
explain why the four fundamental pillars of economic
development are present or absent at a certain moment.
Today's development economists stress the advantage
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FURTHER READING AND WEBSITES
for the growth of relative backwardness, the need to respect
the role of agriculture, and the art of finding the appropriate
limit between State and markets. The most recent general
opinion refers to the advantages of openness.
8. Countries must be careful not to fall into the poverty trap, which
is a vicious cycle where poverty leads to poor performance,
which locks the country into continued poverty.
9. Remember the summary of criteria on the role of government
policies: a) promote the rule of law, b) make strategic
investments in human capital and indirect social capital, c)
limit the public sector to open areas of advantage comparative
to the private company, d) keep the economy open to trade
and foreign investment.
C. Alternative models for development 10.
Many “isms” have competed with the mixed market economy as
models for economic development.
Alternative strategies include the managed market approach
of East Asian countries, socialism, and the Soviet-style
command economy.
11. The managed market approach of Japan and Asian dragons
such as South Korea, Hong Kong, Taiwan, and Singapore
proved remarkably successful during the
CONCEPTS FOR REVIEW
Population theory vicious cycles, virtuous cycles, poverty
trap lag hypothesis
Malthus population theory geometric
and arithmetic growth
Economic development Alternative models for
development the basic
developing country
development indicators dilemma of market and orders socialism
four elements of development versus communism
FURTHER READING AND WEBSITES
further reading
One of the most influential books of all time is TR Malthus's Essay
on Population (1798, many editions).
An online version can be found at www.ac.wwu. edu/ ~stephan/
malthus/ malthus.0.html. Influential neo-Malthusian books include
Donella H. Meadows, Dennos L. Meadows, and Jorgen Randers,
The Limits to Growth (Potomac, Washington, DC, 1972) and
Beyond the Limits (Chelsea Green, Post Mills, Vt., 1992). .
The study on the East Asia Miracle comes in the World Bank, The
East Asia Miracle; Economic Growth and Government
269
last quarter century. Among the key ingredients were
macroeconomic stability, high investment rates, a sound
financial system, rapid improvements in education, and an
outward orientation in trade and technology policies.
12. Socialism occupies a middle position between capitalism and
communism, emphasizing government ownership of the
means of production, state planning, income redistribution,
and a peaceful transition to a more equal world.
13. By tradition, Marxism had its deepest economic roots in semi-
feudal Russia, and then spread to the rest of the Soviet Union
and Eastern Europe. Studies of the distribution of resources
in these countries show that resources were distributed
through centralized planning, imposing severe distortions on
prices and output. In its early decades, the Soviet economy
depended primarily on energy-intensive heavy industry and
military industry. Stagnation and poor incentives to innovate
left Russia and other centrally planned countries with income
levels well below those of North America, Japan, and Western
Europe. All these countries have rejected the centralized
command economy to implement some variant of mixed
economy.
the principal-agent problem of
command economy
Policies (World Bank, Washington, DC, 1993). The final quote is
from Jeffrey Sachs and Andrew Warner, "Economic Reform and
the Process of Global Integration," Brookings Papers on Economic
Activity, no. 1, 1995, p. 63-64.
For a very entertaining account of developments in the economic
history of the Soviet Union, see Alec Nove, An Economic History
of the USSR, 3a. ed. (Penguin, Baltimore, 1990). A careful study
of the Soviet economic system is that of
Paul R. Gregory and Robert C. Stuart, Russian and Soviet
Economic Performance and Structure, 6a. ed. (Harper & Row,
New York, 1997).
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270
Web Sites
The World Bank has information on its programs and publications on its
website, www.worldbank.org; the International Monetary Fund (IMF) offers
similar information at www.imf. org. The United Nations Web site has links to
most international institutions and their databases at www.unsystem.org. A
good source of information on high-income countries is the Organization for
Economic Cooperation and Development (OECD) Web site, www.oecd.org.
US trade data is available at www.census.gov. You can find
DISCUSSION QUESTIONS
1. A geometric progression is a sequence of terms (g1, g2 , . . . , gt , gt
1, . . .), in which each term is the same multiple of its predecessor:
gt1
g2
___ g ··· ____
g1 ___3 g 2 gt
Yes
1 i 1, the terms grow exponentially like compound interest,
where i is the interest rate.
An arithmetic progression is a sequence (to 1, to 2, to 3,
. . . , at , at 1, . . .), where the difference between each term and its
predecessor is the same constant:
···
to
2 a1 a3 a2 · · · at 1 at
Give examples of each. Check for yourself that any geometric
progression where 1 must ultimately exceed any arithmetic progression.
Relate
this to Malthus's theory.
2. Remember that Malthus stated that an uncontrolled population would
grow geometrically, while the supply of food—limited by diminishing
returns—would grow only arithmetically. Use a numerical example to
show why per capita food production must fall if population is left out of
control, while diminishing returns lead food production to grow more
slowly than labor input.
3. Do you agree with the celebration of material well-being expressed in the
opening quote of the chapter?
What would you add to the list of benefits of economic development?
4. Outline each of the four important factors that drive economic development.
Related to these, how did high-income oil-exporting countries get rich?
What hope is there for a country like Mali, which has very few per capita
resources of capital, land and technology?
5. Some fear the "vicious circle of underdevelopment." In a poor country,
rapid population growth devours any improvements that occur in
technology and reduces living standards. With a low per capita income,
the country cannot save and invest, and it dedicates itself mainly
CHAPTER 12 • THE CHALLENGE OF ECONOMIC DEVELOPMENT
information on many countries through their statistical offices. A compendium
of US state agencies is at www.census.gov.máin.
United Nations population data is available at www.un.org/ popin/. One of
the best sources for studies on developing countries is the World Bank,
especially the World Development Review yearbook at www. worldbank.org.
Klitgaard's quote was published in Finance and Development, March 1998,
and can be found at www. gwdg.de/ ~uwvw/ icr.htm.
subsistence agriculture. With the majority of the population engaged in
agricultural activities, there is little hope of education, decline in fertility,
or industrialization. If you were to advise a country, how would you
break this vicious circle?
6. Compare the situation a developing country faces today with one it might
have faced (at an equivalent level of per capita income) 200 years ago.
Considering the four pillars of economic development, explain the
advantages and disadvantages that the developing country could
experience today.
7. Some economists are currently questioning whether it is appropriate to
allow a full opening of both the current account and finances. They
argue that allowing the free flow of short-term financial movements
increases vulnerability to speculative attacks. Point out the pros and
cons of limiting short-term financial movements. Might you want to use
a tax on short-term flows, instead of quantitative restrictions?
8. Analyze the way in which the what, how, and for whom are solved in a
Soviet-style command economy, and compare your analysis with the
solution of the three central questions in a market economy.
9. Advanced Problem (Builds on growth accounting in Chapter 11.) To
extend the growth accounting equation, include three factors and
formulate the following equation:
gQ sL gL sK gK sR gR AT
where gQ is the growth rate of output, gi is the growth rate of inputs (i
production inputs: L for labor, K for capital, and R for land and other
natural resources), and if the contribution of each input to output growth,
as measured by its share in national income (0 1 and sL sk sR 1). AT
measures technological change. a) In the poorest developing countries,
the share of capital is close to zero, the main resource is agricultural
Yeah
land (which is constant), and there is little technological change. Can
you use this to explain the
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DISCUSSION QUESTIONS
Malthusian hypothesis that per capita output is likely
to stagnate or even decline (ie, g Q g L)? b) In
advanced economies the share of land resources
falls almost to zero. Why does this lead to the growth
accounting equation studied
in the previous chapter? Can you use this to explain
how countries can avoid the Malthusian trap of
income stagnation?
271
c) According to economists who have a pessimistic view
of the future (including a group of neo-Malthusians
from the Club of Rome), AT is close to zero, the
available supply of natural resources is declining,
and the share of resources is big and rising. Does
this explain why the future for industrial societies
could be bleak? What neo-Malthusian assumptions
would you question?
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CHAPTER

13
Exchange rates and the
international financial system

The benefit of international trade: a more efficient use of the

world's productive forces.
john stuart mill

From an economic point of view, no country is an
island by itself. When the bell rings of a recession or a
financial crisis, the sound travels around the world.
This point is dramatically illustrated by the twentieth
century, which can be divided into two distinct periods.
The first period, from 1914 to 1945, was characterized
by destructive competition, shrinking international
trade, increasing financial isolation, hot and cold
commercial and military wars, dictatorships, and
depression. In contrast, after World War II, most of the
world enjoyed increasing economic cooperation,
expanding trade links, increasingly integrated financial
markets, expanding democracy, and rapid economic
growth. economic. This sharp contrast highlights the
very high stakes that are at stake for good management
of the national and global economy.
What are the economic links between countries?
Important economic concepts concern international
trade and finance. International trade in goods and
services allows countries to raise their standard of
living by specializing in the areas in which they have a
comparative advantage: they export products in which
they are relatively efficient and import those in which
they are relatively inefficient. In a modern economy,
trade is carried out through the use of currencies of
various countries. The financial system
272
International trade is the lubricant that facilitates trade
and finance by allowing people to use and exchange
different currencies.
Sometimes international trade is seen as zero
sum, like a Darwinian conflict. This point is misleading
to say the least, and even wrong. International trade
and finance, like all voluntary exchanges, can improve
the welfare of all who participate in it.
When the United States sells wheat to Japan and
imports automobiles using the dollar and yen as its
means of exchange, these transactions lower prices
and raise living standards in both countries.
But economic integration (sometimes called
globalization) is not without its risks. Some periods,
like the beginning of this century, were relatively calm,
but others suffered crisis after crisis.
The 1930s were the scene of the collapse of the gold
standard and the international trade regime.
The 1970s saw the fall of the system of fixed exchange
rates, oil embargoes and a sharp rise in inflation. The
1990s saw a succession of financial crises: a crisis of
surety in the exchange rate regime in Europe in
1991-1992, the capital flight from Mexico in 1994-1995,
the banking and currency panic in Southeast Asia in
1997, the moratorium on Russian debt payments and
the astrin global monetary agency in 1998, as well as
a series of currency problems in Latin America.
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EXCHANGE RATES AND THE INTERNATIONAL FINANCIAL SYSTEM 273

After a period of relative calm, the world was
shocked again in 2007-2009 with the bursting of the
house price bubble, foreclosures and bankruptcies in
the financial system of the world's most advanced
economy, that of the United States. In 2007-2009, the
global nature of the economic system became
apparent as the financial crisis in the United States
spread to the entire world. All these crises required
careful management by the monetary and fiscal
authorities of the large countries affected.
This chapter and the next review international
macroeconomics. This subject includes the principles
that regulate the international monetary system, the
focus of this chapter, as well as the impact of foreign
trade on output, employment and prices, which will be
the subject of the next chapter.
International macroeconomics addresses many of
the most controversial questions these days: does
international trade raise or lower output and
employment? What is the link between domestic
savings, domestic investment, and the trade balance?
What are the causes of the occasional financial crisis?
Because they spread so quickly from one country to
another? What has been the effect of the European
Monetary Union on Europe's macroeconomic
performance? And why has the United States become
the world's largest debtor in the last ten years? The
challenge of finding an answer to each of these
questions is enormous.
TRENDS IN TRADE
INTERNATIONAL
An economy that participates in international trade is
known as an open economy. A measure with
coming from the commercial opening is the ratio of
exports or imports to the GDP of a country. Figure
13-1 shows the trend in the ratio of imports and
exports to GDP in the United States over the past 50
years. The great surplus of exports stands out in the
first years that followed the Second World War, when
the United States financed the reconstruction of
Europe. But that fraction of imports and exports was
low in the 1950s and 1960s. With the growth in the

18

16
Imports/GDP

14

12

(percentages)
fraction
GDP
of

10
exports
Imports
and
as

Exports/GDP
8

2
1950 1960 1970 1980 1990 2000 2010
Year

FIGURE 13-1. America's Growing Openness Like

all major market economies, the United States has increasingly opened its borders to
foreign trade since World War II. This has led to a growing participation of the product and
consumption related to foreign trade.
Since the 1980s, imports have considerably exceeded exports, making the United States
the world's most indebted nation.

Source: US Bureau of Economic Analysis.

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274 CHAPTER 13 • EXCHANGE RATES AND THE INTERNATIONAL FINANCIAL SYSTEM

140 nals. Economists keep their records by analyzing

income statements and balance sheets. In the area of
120
international economics, the fundamental accounts
100 are the international balance of payments of the
countries. These accounts offer a systematic record
(percentage)
GDP
to
80 of all economic transactions carried out between the
60 residents of a country and the rest of the world. Its
Merchandise
trade
ratio

fundamental components are the current account and

40 the capital account. The basic structure of the balance
of payments is shown in Table 13-1, and each element
twenty
is discussed below.

ItalyChina
Japan France Mexico
Germany
United Kingdom
USA Russian Federation
FIGURE 13-2. Openness varies wildly between regions
Large countries, such as the United States, have a low share of international
trade in their economies, while very small countries, such as Singapore, trade
more than they produce.
Source: World Trade Organization. Data are the ratio of merchandise
trade to GDP for the period 2002-2005.
and a reduction in trade barriers, this fraction of trade
grew steadily and averaged 13% of GDP in 2008.
The reader might be surprised to learn that the
United States is a relatively self-sufficient economy.
Figure 13-2 shows the share of trade in some nations.
Small countries and those in highly integrated regions,
such as Western Europe, are more open than the
Canada Netherlands Hong Kong Singapore
Debits and Credits
Like other accounts, the balance of payments records
each transaction with a positive or negative sign. The
general rule of balance of payments accounting is as
follows:
If a transaction generates foreign currency for the
country, it is considered a credit and recorded as a
positive entry. If a transaction requires the payment of
foreign currency, it is a debit and is recorded as a
negative entry. In general, exports are credits and
imports are debits.
Exports contribute foreign currency, so they are
credits. Imports require spending in foreign currency,
so they are debits. How is the importation into the
United States of a Japanese camera registered? Since
it is finally paid in yen, it is clear that it is a debit. How
to treat income from interest and dividends from
investments that receive
I. Current account

United States. Furthermore, the degree of openness Merchandise (or “trade balance”)
Services
is much higher in many US industries than in the
global economy. investment income
Unilateral transfers
Particularly noteworthy are manufacturing industries
II. Financial account
such as steel, textiles, consumer electronics, and
private
automobiles. In contrast, other sectors, such as Government
education and health care, are quite isolated from Changes in official reserves
international trade. Others

TABLE 13-1. Basic Elements of the Balance of Payments The

A. THE INTERNATIONAL BALANCE balance of payments has two main components. The current account, which
OF PAYMENTS represents spending and receipts of goods and services, along with transfers.
The capital account, which includes the purchase and sale of financial assets
and liabilities.
BALANCE OF PAYMENTS ACCOUNTS An important principle is that the two accounts must always sum to zero:

This chapter begins with an overview of the way in

which nations keep their international accounts. Current account Financial account I II 0
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A. THE INTERNATIONAL BALANCE OF PAYMENTS
Americans abroad? It is evident that they are credit
entries like exports, since they contribute foreign currency.
Details of the balance of payments
The current account balance. The entirety of the entries in Section I of
Table 13-1 is the balance in
current account. This includes all items of income and
expenditure: imports and exports of goods and services,
investment income, and payment of transfers. The
current account balance is similar to the
net income of a country. From a conceptual point of
view, it is equivalent to net exports in the national
product accounts. In the past, many specialists focused
on the balance of trade, which consists of the imports
and exports of merchandise. The composition of the
import and export of merchandise is basically primary
goods (such as food and fuel) and manufactured items.
In an earlier age mercantilists strove to have trade
surpluses (a surplus of exports over imports), which they
called a "favorable balance of trade." They hoped to
avoid an "unfavorable balance of trade," which is
equivalent to a trade deficit (an excess of imports over
exports). Even today traces of mercantilism appear
when nations try to
maintain trade surpluses.
Today, economists avoid this language because a
trade deficit is not necessarily harmful. As will be seen
below, the trade deficit is actually a reflection of the
imbalance between domestic investment and domestic
savings. Often a country runs a trade deficit because it
has a low savings rate (perhaps because there is a
government deficit). It could also run a trade deficit
because its domestic investment may be being used for
productive purposes (as is the case in the United States).
The opposite case, a trade surplus, occurs when a
country has high savings with few possibilities for
productive investment at home (as is the case with Saudi
Arabia, with ample oil revenues but few opportunities to
invest them).
Additionally, services are increasingly important in
international trade. Services refer to operations such as
freight, financial services and foreign tourism. A third
item on the checking account is investment income,
which includes earnings from foreign investments (such
as earnings on overseas US assets). One of the most
notable aspects of the
275
past two decades is the growth of services and
investment income. A final element is transfers, which
represent all those payments that do not correspond to
goods and services.
Table 13-2 presents a summary of the international
balance of payments in 2007. Note its two main
components: the current account and the capital account.
Each item is listed by name in column (a). Credits are
entered in column (b), while column (c) shows debits.
Column (d) lists the net credits or debits; A credit is
shown at the end if the item raised the foreign currency
stock, or a debit if the total was subtracted from the
foreign currency stock.
In 2007, US exports totaled credits for 1,149 billion
dollars. But at the same time, merchandise imports led
to debts of 1.965 billion dollars. The net difference was
a merchandise trade deficit of 815,000
millions of dollars. This trade deficit is included in column
(d). (Make sure you understand why the algebraic sign
is shown as instead of .) The table shows that net
services and net investment income were positive. The
total current account deficit, including merchandise
transactions, services, investment income, and unilateral
transfers, was $739 billion in 2007.
(An additional item was omitted from the accounts,
called the capital transfers account. This line is extremely
small and can be omitted in most cases.)
Financial account. The analysis of the current account
has already been completed. But how did the United
States “finance” its current account deficit of 739 billion
dollars in 2007? He should have borrowed or he should
have reduced his assets abroad, because, by definition,
when you buy something, you have to pay for it or get
loans for it. This identity means that the international
balance of payments as a whole must show, by definition,
a final balance equal to zero.
Capital account transactions are transactions in
financial assets between Americans.
ses and foreigners. Theseoccur, for example, when a
Japanese pension fund buys US government securities
or when an American buys shares in a German company.
Credits and debits are somewhat more complicated
in financial accounts. The general rule, which is taken
from the double-entry concept of business accounting,
is as follows: the increase in assets and
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276 CHAPTER 13 • EXCHANGE RATES AND THE INTERNATIONAL FINANCIAL SYSTEM

US balance of payments, 2007 (billions of

dollars)

(a) (b) (c) (d)

credits() Debits Net credits
games () () or debits ()

I. Current account 739

a. Merchandise trade balance b. 1 149 1 965 815
Services c. investment income d. 479 372 107
Unilateral transfers 782 708 74
104

II. Capital account [lend () or borrow ()] a. Receipt or granting 739

of private loans b. Government United States official reserve 1 451 1 183 268
assets, changes Official foreign assets in the United States,
changes 24
413

c. Statistical discrepancy or errors and omissions 83

III. Sum of current and capital accounts 0

TABLE 13-2. Basic Elements of the US Balance of Payments, 2007

Source: US Bureau of Economic Analysis. Note that the totals may not be equal to the sum of the components due to
rounding of figures.

the decrease in a country's liabilities are recorded as
debits; conversely, the decrease in assets and the increase
in its liabilities are recorded as credits. A debit entry is
represented by a negative sign (–) and a credit entry by a
positive sign ().
In general, one can more easily arrive at the correct
answer if one remembers this simplified rule: Think of the
United States as an exporter and importer of stocks, bonds,
and other obligations.
When you borrow from abroad, you send IOUs (in the form
of Treasury bonds or corporate stock) and receive foreign
money. Is this a credit or a debit?
It is evident that it is a credit, because it contributed foreign
currency to the United States.
Similarly, if US banks are lending abroad to finance a
computer assembly plant in Mexico, US banks are
importing Mexican IOUs and the US is losing foreign
currency; it is clear that it is a debit item in the US balance
of payments.
Line II shows that in 2007 the United States was a net
borrower : the United States borrowed more abroad than it
lent to foreigners. The United States was a net exporter of
notes (a borrower
net income) in the amount of 739 billion dollars.1
The paradox of rich borrowers What
is the usual pattern of country surpluses or
deficits? Poor countries might be thought to
have higher capital productivity, so they would
tend to borrow from rich countries. On the contrary, the rich
countries would have exhausted their investment possibilities,
so they would lend to the poor countries.
In fact, this pattern held through most of American history.
In the 19th century, the United States imported more than it
exported. Europe lent the difference, which allowed the United
States to build its capital stock.
The United States was a growing, fledgling, and debtor nation.
From about 1873 to 1914, the balance
1 As with all economic statistics, balance of payments accounts
necessarily contain statistical errors (called “statistical
discrepancy” or errors and omissions).
These errors reflect the fact that many real and financial flows
(from small money transactions to drug trafficking) go
unrecorded. This is included in line II(c) of
Table 13-2.
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B. THE DETERMINATION OF EXCHANGE RATES 277

US trade moved into surplus. Later, during World Wars I
and World War II, the United States lent money to its
allies, France and Great Britain, for war equipment and
relief for postwar needs. The United States emerged from
the wars as a creditor country, running a surplus from
foreign investment earnings, along with a trade deficit.
At present, the existing pattern around the world is
quite different due to financial globalization. In a liberalized
financial market, the pattern of trade surpluses and deficits
is largely determined by the balance of savings and
investment. Table 13-3 shows a resu
menu of the great regions of today. This table shows that
the pattern of granting and receiving loans is practically
unrelated to the levels of economic development.
rather, it is fundamentally determined by saving and
investment patterns. The most interesting case on the list
is that of the United States, which is a rich country that
borrows abroad. The reasons for this rich borrower
paradox are explored in the next chapter.
In 2008, most of the countries in the Americas
Latin America were net recipients of foreign resources,
with the exception of Argentina, Brazil, Chile, Ecuador,
Trinidad and Tobago and the Bolivarian Republic of
Venezuela, whose net resource transfers were negative.
Only the Plurinational State of Bolivia, Ecuador and
Venezuela had a surplus in their current account,
explained by the surplus in the trade balance.
It should be noted that the Bolivarian Republic of
Venezuela accounts for more than 70% of why the region
was a net issuer of resources to the rest of the world that year.
world for an amount close to 40 billion net dollars.
B. THE DETERMINATION OF
EXCHANGE RATES
EXCHANGE RATES
Domestic trade is often a very familiar affair: when you
buy oranges from Florida or computers from California,
you naturally want to pay in dollars. Fortunately, the
orange farmer and the computer manufacturer want their
payment in US currency, so all this co

40,000
BALANCE OF PAYMENTS IN SELECTED LATIN AMERICAN COUNTRIES (2008)

30,000

20,000

10,000

Millions
dollars
of

Brazil Chili Peru

Mexico
Argentina Colombia Nicaragua Paraguay Panama
Uruguay
guatemala honduras
Costa Rica El Salvador Ecuador
10,000
Bolivia (EP of)

Dominican Republic
20,000

30,000
Capital account with errors and omissions

Current account
40,000

Source: International Monetary Fund

Balance of payments in Latin America

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278 CHAPTER 13 • EXCHANGE RATES AND THE INTERNATIONAL FINANCIAL SYSTEM

mercio can be realized in dollars. Economic transactions within a current account balance
country are relatively simple.
(billions of dollars)

Region 2007
But suppose you are in the business of selling Japanese
bicycles. Here the transaction is complicated. The bicycle Rich with low savings:
manufacturer wants to be paid in Japanese currency and not in USA 739
US dollars. Therefore, in order for Japanese bicycles to be Rich with high savings:
imported, they must first purchase yen (¥) and use it to pay the Japan 211
Japanese manufacturer. Similarly, if the Japanese want to obtain other rich countries 160
US merchandise, they must first obtain US dollars. This new Rich in resources and in diversification:
complication requires an exchange of coins. OPEC/Middle East 257
Russia 76

Poor and high savings:

China 372
Foreign trade requires the use of different national currencies.
Poor and Low
The exchange rate is the price of one currency in terms of another Savings: Sub-Saharan Africa 25
currency. The exchange rate is determined in the exchange
Others Four. Five

market, which is the market in which different currencies are

bought and sold.
The first fact is that most of the big countries have their own
currencies: the dollar in the United States, the Japanese yen, the
Mexican peso, etc. (European countries are an exception, since
they have a common currency, the euro.) The convention indicates
the need to measure exchange rates, denoted by the symbol e,
as the amount of foreign currency that can be exchanged. buy
with 1 unit of domestic currency. For example, the dollar exchange
rate might be 100 yen to one US dollar (¥100/$).
TABLE 13-3. Pattern of current accounts around the world,
2007
The United States is the world's largest borrower, with its low
savings rate and stable investment climate. Important savers are
rich, high-saving countries (such as Japan), resource-rich countries
seeking financial diversification (such as Russia and the OPEC
countries), and poor, high-saving countries (such as China, which
has a savings rate even higher than its high investment rate). The
poorest countries receive some small investment flows.
Source: International Monetary Fund, World Economic Outlook, available
online at www.imf.gov.

When exchanging the money of one country for that of

another, the corresponding exchange rate is applied. For example,
if you traveled to Mexico in the summer of 2008, you would have Companies and tourists do not have to know anything more

received about 11 Mexican pesos for one US dollar. There is an than this to carry out their import and export operations. But the

exchange rate between US dollars and the currency of any other economics of exchange rates is not understood until you analyze

country. In 2008 the exchange rate per US dollar was 0.68 euros, the underlying forces in the supply and demand of currencies and

0.54 pounds sterling and 103 yen. the operation of the exchange market.

With the purchase of foreign currency, it is possible to acquire The exchange rate is the price of one currency in terms of
a Japanese bicycle. Suppose your price is 20,000 yen and you another currency. The exchange rate (e) is measured as the
find in the newspaper that the exchange rate is ¥100/$. You can amount of foreign currency that can be purchased with 1 unit of
go to the bank and convert $200 into 20,000 yen. Already with domestic currency:
Japanese money, the bicycle can then be paid to the exporter in
the currency he wishes. foreign currency and in
euro
and
__________________ ____ ______ ···

You should be able to show what Japanese importers of US
trucks would have to do if they want to buy a $36,000 truck from
a US exporter. In this case, the yen must be converted to dollars.
You will see that when the exchange rate is 100 yen to the dollar,
the truck costs them ¥3,600,000.
domestic currency $ $
THE EXCHANGE MARKET
Like most other prices, exchange rates fluctuate week to week
and month to month, according to the forces of supply and
demand. The foreign exchange market is the market in which the
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B. THE DETERMINATION OF EXCHANGE RATES
currencies of different countries and exchange rates
are determined. Foreign currency is negotiated at
retail in many banks and companies specialized in
these operations. There are organized markets in New
York, Tokyo, London and Zurich, trading hundreds of
billions of dollars worth of currencies every day.
Supply and demand curves serve to illustrate how
markets determine the price of foreign currencies.
Figure 13-3 shows the supply and demand for US
dollars generated by transactions with Japan.2 The
supply of US dollars comes from people in the United
States who need yen to buy Japanese goods, services,
or financial assets. The demand for dollars comes
from people in Japan who buy American goods,
services, or investments, and who therefore need
dollars to pay for their operations.
The price of a foreign currency—the exchange rate—
is established at the point where supply and demand
for that currency are in equilibrium.
First consider the supply side. The supply of US dollars in the
exchange market is
It originates when Americans need yen to buy
Japanese cars, cameras, and other goods, go on
vacations to Tokyo, and more. Also, that currency is
required if Americans want to buy Japanese assets,
such as shares in Japanese companies. In short,
Americans are offering dollars when they buy foreign
goods, services, and assets.
In Figure 13-3, the vertical axis is the foreign
exchange rate (e), measured in units of foreign
currency per unit of domestic currency: yen per dollar,
Mexican pesos per dollar, etc. Make sure you
understand the units here. The horizontal axis shows
the amount of dollars bought and sold in the exchange
market.
The supply of US dollars is represented by the
upward -sloping OO curve. The upward slope indicates
that as the exchange rate rises, the amount of yen
that can be purchased per dollar also rises. This
means that, all else equal, the price of Japanese
goods will fall relative to that of US goods. For
Therefore, Americans will tend to buy more Japanese
goods, and the supply of dollars will increase.
To see why the supply curve slopes upward, take
the example of bicycles.
2 This is a simplified example where only bilateral trade between
Japan and the United States is considered.
279
and
D. EITHER
Exchange
rate
$)
(¥
100
AND
EITHER
D.
0 $
Exchange rate (dollars)
FIGURE 13-3. Determination of the exchange
rate Behind the supply and demand for foreign currency are
the purchases of goods, services and financial assets.
Behind the demand for dollars is the Japanese desire to
acquire American assets and investments. The supply of
dollars comes from Americans who want Japanese goods
and assets. Equilibrium is at E. If the exchange rate were
above E, there would be an excess supply of dollars. Unless
the government buys this surplus out of its official reserves,
market forces would push the exchange rate back to the
supply-demand equilibrium at E.
If the exchange rate were to rise from ¥100/$ to
¥200/$, the bicycle that costs 20,000 yen would drop
in price from 200 to 100 dollars. All else being equal,
Japanese bikes would be more attractive and
Americans would sell more dollars in the foreign
exchange market to buy more bikes. Therefore, the
quantity of dollars supplied would be greater at a higher exchan
What is behind the demand for dollars (represented
in Exhibit 13-3 by the demand curve DD? Foreigners
demand US dollars when they buy US goods, services,
and assets. For example, suppose a Japanese student
buys an economics book or travels to the United
States. She will need US dollars to pay for expenses.
Or when Japan Airlines buys a Boeing 787 for its fleet,
it makes a transaction that increases the demand for
US dollars. If the
Japanese pension funds invest in US stocks, they
should buy dollars. they extract them
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280 CHAPTER 13 • EXCHANGE RATES AND THE INTERNATIONAL FINANCIAL SYSTEM
Travelers demand US dollars to pay for their purchases of US
goods, services and assets.
The demand curve in Exhibit 13-3 slopes downward to indicate
that as the value of the dollar falls (and thus the yen becomes
more expensive), Japanese residents will want to buy more goods,
services, and investment in the outside. Therefore, they will
demand more dollars in the exchange market. See what happens
when the dollar exchange rate falls from ¥100/$ to ¥50/$. US
computers, which used to sell for $2,000 (¥100/$) ¥200,000, are
now only selling for $2,000 (¥50/$) ¥100,000. Consequently,
Japanese buyers will tend to buy more US computers, and the
quantity of dollars demanded at that exchange rate will increase.
Market forces move the exchange rate up or down to balance
supply and demand. The price will be established at the equilibrium
exchange rate, which is the rate at which the dollars that are
voluntarily bought are equal to the dollars that are voluntarily sold.
The balance of supply and demand for foreign currency
determines the exchange rate of a currency.
At the market exchange rate of 100 yen to the dollar, shown at
point E in Figure 13-3, the exchange rate is in equilibrium and
tends neither to rise nor fall.
The exchange market has been exposed in terms of supply
and demand for dollars. But in this market, there are two currencies
involved, so it is just as easy to analyze the supply and demand
for yen. To see it, you must draw a diagram of supply and demand
on the horizontal axis and the exchange rate of the yen ($ to ¥) on
the vertical axis. If ¥100/$ is the equilibrium from the point of view
of the dollar, then $0.01/¥ is the reciprocal exchange rate. As an
exercise, do the analysis in this section for the reciprocal market.
You will see that in this simple two-way world, for every point
expressed in relation to dollars there is an exact counterpart in the
yen: the supply of dollars is the demand for yen; the demand for
dollars is the supply of ye
nes.
There is only one additional extension needed to get to the
real exchange markets. In fact, there are many different currencies.
Therefore, it is necessary to find the supply and demand for each
of these currencies. And in a world of many countries, it is the
multiple relationships of exchange and trade, with demands and
offers coming from all parts of the world, that determine the full
range of exchange rates.
foreign exchange terminology
Foreign exchange markets have a vocabulary
special river. By definition, a fall in the price
of one currency in terms of another or of
all others, is called depreciation. An increase in the price of
one currency in terms of another or all of the others is called
appreciation. In the example above, when the price of the
dollar rose from ¥100/$ to ¥200/$, the dollar appreciated, of
course, the ¥ depreciated.
On the supply and demand diagram for US dollars, a fall
in the exchange rate (e) is a depreciation of the dollar, and a
rise in e represents an appreciation.
A different set of terms is used when a currency has a
fixed exchange rate. When a country reduces the official price
of its currency in the market, it carries out a devaluation. A
revaluation occurs when the official exchange rate rises.
For example, in December 1994, Mexico devalued its
currency when it reduced its official price or parity from 3.5
pesos per dollar to 3.8 pesos per dollar. Soon, Mexico found
that it could not defend the new parity and "floated" its exchange rate.
At that point, the peso fell, or depreciated further.
When a country's currency falls in value relative to another
country's, the domestic currency has depreciated, while the
foreign currency has appreciated.
When the official exchange rate of a country is reduced,
that currency undergoes a devaluation. An increase in the
official exchange rate is called a revaluation.
Effects of changes in trade What would happen
if there were changes in the demand for foreign currency? For
example, if Japan suffers a recession, its demand for imports falls.
As a result, the demand for US dollars would be reduced. The
result is shown in Figure 13-4.
The decline in purchases of US goods, services and investments
reduces the demand for dollars in the market. This change is
represented by a shift to the left of the demand curve.
The result will be a lower exchange rate, that is, the dollar will
depreciate and the yen will appreciate. At that lower level of the
exchange rate, the amount of dollars supplied by Americans in the
market will be reduced, because Japanese goods are now more
expensive. Likewise, the quantity of dollars demanded by the
Japanese will fall due to the recession. How much will exchange
rates move? Barely enough to bring the supply and demand of
currencies back into balance.
In the example shown in Figure 13-4, the dollar has depreciated
from ¥100/$ to ¥75/$.
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B. THE DETERMINATION OF EXCHANGE RATES
and
D.
D.
Exchange
rate
$)
(¥
100
75 AND
EITHER
0 $
Exchange rate (dollars)
FIGURE 13-4. A reduction in the demand for dollars
leads to depreciation of the dollar
Suppose that a recession or deflation in Japan reduces the
Japanese demand for dollars. This would cause the demand for
dollars to shift to the left from DD to D D The dollar exchange.
rate depreciates while the yen appreciates. Why does the new
exchange rate discourage purchases of Japanese goods and
favor those of the United States?
In today's world it is common for exchange rates to
react to changes that refer to the capital account.
Suppose the Federal Reserve raises interest rates.
This would make US dollar assets more attractive than
foreign assets, as dollar interest rates rise relative to
interest rates on securities.
foreign. As a result, the demand for dollars increases
and the dollar appreciates. This sequence is shown in
Figure 13-5.
Exchange Rates and the Balance of
Payments What is the connection between exchange
rates and balance of payments adjustments? In the
simplest case, assume that exchange rates are
determined by private supply and demand without
government intervention. Consider what happened in
1990 after German reunification, when the German
central bank decided to raise interest rates to dampen
inflation. After the currency tightening, foreigners moved
some of their assets into the German marks to take
advantage of the high
281
and
EITHER
D. D.
EITHER
125
Exchange
rate
$)
(¥
AND
AND
100 AND
D.
D.
EITHER
D.
D.
0 $
Exchange rate (dollars)
FIGURE 13-5. Shortage of money increases demand
dollars and produces the appreciation of
the dollar Monetary policy can affect the exchange rate through
the capital account. If the Federal Reserve raises dollar interest
rates, it will induce investors to buy dollar securities and the
demand for dollars will rise.
This will cause an appreciation of the dollar. (Explain why this
leads to a depreciation of the euro.)
interest rates prevailing in that country. This produced
an excessive demand for German marks at the previous
exchange rate. In other words, at the previous exchange
rate, people were buying Deutschmarks and selling
other currencies. (Figure 13-5 can be redrawn to show
this situation.)
Here the exchange rate appears as a balancing
element. As the demand for German marks increased,
this caused an appreciation of the German mark and a
depreciation of other currencies, such as the US dollar.
The movement in the exchange rate continued until the
capital and current accounts were back in balance.
This movement in the exchange rate has a
significant effect on trade flows. As the German mark
appreciated, German goods became more expensive
in foreign markets and foreign goods became cheaper
in Germany. This led to a drop in German exports and
an increase in its imports. As a result, the trade balance
moved into deficit. The deficit in the account
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282 CHAPTER 13 • EXCHANGE RATES AND THE INTERNATIONAL FINANCIAL SYSTEM
current was the counterpart of the capital account
surplus, induced by higher interest rates.
Exchange rate movements serve as a compensation
mechanism to eliminate imbalances in the balance of
payments.
Purchasing power parity and
exchange rates In the short term,
exchange rates, determined by the market, react with
great volatility in response to monetary policy, political
events and changes in expectations. But in the long run,
exchange rates are mainly determined by the relative
prices of goods in different countries. An important
consequence is the theory of purchasing power parity
(PPP) in exchange rates. According to this theory, the
exchange rate of a country will tend to equalize the cost
of buying domestic goods with the cost of buying those
goods abroad.
The PPC theory can be illustrated with a simple
example. Suppose that the price of a basket of goods
(cars, jewelry, oil, and food, among others) costs $1,000
in the United States and 10,000 pesos in Mexico. At an
exchange rate of 100 pesos per dollar, this basket would
cost 100 dollars in Mexico. Given these relative prices
and the free trade between the two countries, it is to be
expected that US businesses and consumers will rush
to the border to take advantage of the lower Mexican
prices. The result would be higher imports from Mexico
and, consequently, a higher demand for Mexican pesos.
That would cause the Mexican peso to appreciate in
relation to the state dollar.
unidense, so you would need more dollars to buy the
same number of pesos. As a result, the prices of Mexican
goods in dollar terms would rise even if the prices in
pesos remain unchanged.
Where does this process end? Assuming that
domestic prices have not changed, it would end when
the peso exchange rate fell to 10 pesos per dollar. Only
at this exchange rate would the market price of the
basket be the same in both countries. At 10 pesos to the
dollar, the currencies have equal purchasing power in
terms of the goods exchanged. (You can assert your
mastery of this exposure by calculating the price of the
basket, in both Mexican pesos and US dollars, before
and after the appreciation of the peso.)
The PPP doctrine also states that countries with
high inflation rates will tend to have money.
give them depreciation For example, if the inflation of the
country A is 10% and inflation in country B is 2%, the
currency of country A will tend to depreciate relative to
that of country B by an amount equal to the difference in
inflation rates, that is, 8% per year. Another example
would be runaway inflation causing prices in Russia to
rise 100 times in the course of a year, while prices in the
United States remain unchanged. According to the PPP
theory, the ruble should depreciate 99% in order to bring
the prices of US and Russian goods back into equilibrium.
THE BIG MAC INDEX AND PARITY
OF PURCHASING POWER
An informal index published by The Econo mist magazine
relates the price of the multinational McDonald's
hamburger in different parts of the world.
The Big Mac index is based on the theory of purchasing
power parity (PPP) which establishes that, in the long
term, the exchange rate between two currencies must
move in order to equalize in both countries the price of a
basket of identical goods. The basket in this case
It is the Big Mac, a hamburger that is made with the
same recipe in more than 80 countries. The Big Mac's
PPP is the exchange rate that would make the hamburger
cost the same in the United States as it does in the rest
of the world. Comparing this with the current value is a
proof of the under or overvaluation of the currency.
Below is a graph showing the price of a hamburger
in dollars in the United States and in several Latin
American countries in mid-2009. With the exception of
Brazil, hamburgers are cheaper in Latin America than in
the United States, reflecting an undervaluation of
currencies according to this index.
One caveat: PPP theory only approximates and
cannot accurately predict the precise movement of
exchange rates. One reason it is not exact is that many
of the goods and services covered by price indices are
not traded. For example, if the PPP uses the consumer
price index, then it must be taken into account that
housing is a service that is not traded, and that prices for
housing of comparable quality can vary greatly depending
on space. Also, even for goods that do trade, there is no
“one price law” that applies uniformly to all goods. If you
look at the same item on amazon.com and amazon.co.uk,
you'll find that (even after applying the current exchange
rate) the price is often different. The differences of
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C. THE INTERNATIONAL MONETARY SYSTEM
5 3.57 4.02
3.02
4
dollars
Price
(EU)
in
3
2
one
Brazil
Argentina
USA
Prices for the same good may have their origin in
tariffs, taxes, and transportation costs.
Likewise, financial flows can cancel out the effects of
prices in the short term. Thus, while PPP theory is a
useful guide to long-term exchange rates, they can
drift away from their PPP levels for many years.
PPP and the size of countries
By any measure, the United States still has
the largest economy in the world. But which
country is the second largest economy? Is it
Japan, Germany, Russia, or some other country? Maybe you
think this question is easy to answer, like measuring height or
weight. The problem, however, is that Japan expresses its
national product in yen, while Russia's national product is
given in rubles and the United States' is denominated in dollars.
To make a comparison, you need to convert everything to the
same currency.
The usual approach is to apply market exchange rates to
convert each currency into dollars, and by that measure Japan
has the second largest economy. But there are two difficulties
with using the market exchange rate. First, because market
rates can go up and down suddenly, the “size” of countries
could change 10% overnight. Also, the use of these exchange
rates tends to underestimate the national product of low-
income countries.
Today economists often prefer the use of PPP exchange
rates to compare living standards in different countries. The
difference between market exchange rates and PPP exchange
rates can be
283
Big Mac Price (July
2009)
3.19 2.66 3.34 3.43 2.63
2.39
Chili Peru
Mexico Uruguay
Colombia
Costa Rica
drastically, as shown in Figure 13-6. When market exchange
rates are used, the income and outputs of low-income
countries, such as China and India, tend to be underestimated.
This phenomenon is explained because a substantial part of
the product of these countries comes from labor-intensive
services, which are usually extremely cheap in low-income
countries. Therefore, when PPP exchange rates are calculated,
including the prices of non-tradable goods, the GDP of low-
income countries is raised relative to that of high-income
countries. For example, when PPP exchange rates are used,
China's GDP is 2.3 times that calculated using market
exchange rates.
C. THE MONETARY SYSTEM
INTERNATIONAL
Although the simple supply and demand diagrams of
the foreign exchange market explain the major
determinants, they do not capture the central, basic
importance of the international monetary system.
There have been recurring crises in international
finance: in Europe in 1991-1992, in Mexico and Latin
America in 1994-1995, in Southeast Asia and Russia
in 1997-1998, and again in Latin America in 1998-2002. .
What is the international monetary system?
This term denotes the institutions under which
payments are made for those transactions that cross
national borders. In particular, the system
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284 CHAPTER 13 • EXCHANGE RATES AND THE INTERNATIONAL FINANCIAL SYSTEM

USA

10,000
China

Japan
India
Germany

exchange
dollars,
rates)
PPC

(United
States,
billions
GDP

1,000

Egypt

45°
100
100 1,000 10,000

GDP (United States, billions of dollars, dollar exchange rates)

FIGURE 13-6. PPP calculations change the relative size of the economies of the
countries, 2006

Using PPP exchange rates instead of market exchange rates changes the economic
classification of countries. After correcting to include the purchasing power of income, China
moves from fourth largest to second largest. Note that the points along the 45º line are those
for which the GDP calculations with both rates turned out to be the same. Points above the
line, such as China, are those for which GDP estimates based on PPP are above those
estimated using market exchange rates. Japan is below the line because relative prices in
Japan are high due to high rents and trade barriers.

Source: World Bank. Note that the products are shown on a ratio scale.

International monetary policy determines how exchange rates are set and • A system of fixed exchange rates • A system of
how governments can affect exchange rate regimes. flexible or floating exchange rates, determined by market forces •
Managed exchange rates, countries intervene to moderate exchange
The importance of the international monetary system rate fluctuations or move their currency toward the zone fixed as
was well described by the economist Robert Solomon:

Like traffic lights in a city, the international monetary

goal
system is automatically taken for granted, until it begins to
break down and affect people's lives… A well-functioning
monetary system will facilitate international trade and
investment, and smooth adaptation To the change. A
FIXED EXCHANGE RATES:
malfunctioning monetary system can not only discourage
THE CLASSIC GOLD STANDARD
the development of trade and investment between
countries, but subject their economies to disruptive shocks At one extreme is the system of fixed exchange rates, in which
when necessary adjustments are avoided or delayed.
governments specify the exact rate at which dollars are converted into
pesos, yen, and other currencies. In history, the most important exchange
The central element of the internal monetary system rate system was the gold standard, which was used intermittently from
tional includes the arrangements by which exchange rates are established. 1717 to 1936. In this system, each country defined the value of its
In recent years, countries have used one of three major exchange currency in terms of
systems:
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C. THE INTERNATIONAL MONETARY SYSTEM
us of a fixed amount of gold, thereby establishing
fixed exchange rates between countries according to
the gold standard.3 The operation of the gold standard
can be easily seen in a simplified example.
Suppose people everywhere insisted on being paid in
chunks of pure gold. So buying a bicycle in Britain
would simply require payment in gold, at a price
expressed in ounces of gold. By definition, there would
be no problems with the exchange rate. Gold would be
the common currency of the world.
This example captures the essence of the gold
standard. Once gold became the medium of exchange
or money, foreign trade no longer differed from
domestic trade; everything could be paid for in gold.
The only difference between countries is that they
could choose different units for their gold coins. Thus,
Queen Victoria decided to make English coins around
¼ ounce of gold (the pound) and President McKinley
decided to make the US unit 1 ÿ20 ounce of gold (the
dollar). In this case, since the English pound was five
times heavier than the dollar, the exchange rate was
$5/£1. This was the essence of the gold standard. In
practice, countries tended to use their own
currencies. But anyone was free to melt down currency
and sell it at the going gold price. So exchange rates
were fixed for all countries on the gold standard.
The exchange rates (also called “par value” or “parity”)
of the different currencies were determined by the gold
content of their currency units.
Hume's Adjustment Mechanism
The purpose of an exchange rate system is to promote
international trade and finance while facilitating
adjustment to shocks. How exactly does the
international adjustment mechanism work ? What
happens if a country's wages and prices rise so rapidly
that its goods are no longer competitive on the world
market? In a flexible exchange rate regime, the
country's exchange rate could depreciate to offset
domestic inflation. But with kinds of
3
Why was gold used as the standard of exchange and means of
payment, instead of some other commodity? It is true that other
materials could have been used, but gold had the advantages of
being in limited supply, being relatively indestructible, and having few
industrial uses. Can it be understood why wine, wheat, or cattle could
not be useful means of payment between countries?
285
fixed exchange rates, the balance must be restored by
deflation at home or inflation abroad.
The international adjustment mechanism with a
fixed exchange rate regime can be illustrated for two
countries, the United States and Great Britain. Suppose
that US inflation has made US goods no longer
competitive. Consequently, US imports go up and its
exports go down. In doing so, it runs a trade deficit
with Great Britain. To cover it, the United States would
have to send gold to Britain. In the end, if there were
no adjustments in the United States or Great Britain,
the United States would run out of gold.
In fact, there is an automatic adjustment
mechanism, as the English philosopher David Hume
demonstrated in 1752; it showed that the outflow of
gold was part of a mechanism that tended to keep
international payments in equilibrium. His argument,
although almost 250 years old, offers important insights
into understanding how trade flows balance in today's
economy.
Hume's explanation rested in part on the quantity
theory of prices, which is a theory of the general level
of prices that was discussed in macroeconomics. This
doctrine holds that the general level of prices in an
economy is proportional to the money supply. Under
the gold standard, gold was an important part of the
money supply, either directly in the form of gold coins,
or indirectly when the government used gold as backing
for its paper money.
What would be the impact of a country's loss of
gold? First, that country's money supply would fall,
either because the gold coins would be exported or
because some of the gold backing the currency would
leave the country. If both consequences are put
together, a loss of gold would lead to a reduction in the money s
According to the quantity theory, the next step would
be that prices and costs would also change in
proportion to the change in the money supply. If the
United States lost 10% of its gold to pay its trade
deficit, quantity theory predicts that US prices, costs,
and revenues would fall 10%.
In other words, the economy would deflate.
The four-point mechanism. Now consider Hume's
international balance of payments theory.
Suppose the United States runs a large trade deficit
and begins to lose gold. According to the quantity
theory of prices, this loss of gold reduces the supply of
money in the United States, pushing
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286 CHAPTER 13 • EXCHANGE RATES AND THE INTERNATIONAL FINANCIAL SYSTEM

pushing down US prices and costs. As a result, 1) the
United States reduces its imports from England and
other foreign goods, which have become relatively
expensive; and 2) as US domestically produced goods
have become relatively cheap on world markets, US
exports are increasing.
The opposite effect occurs in Great Britain and
other countries. Since English exports are growing
rapidly, he receives gold in return. Consequently, the
money supply in Great Britain increases, pushing up
prices and costs as established by the quantity theory.
At this point, two more points of the Hume mechanism
come into play: 3) exports in
English and other countries have become more
expensive, so the volume of goods exported to the
United States and elsewhere is reduced, and 4)
English citizens, faced with a higher domestic price
level, now import more low-cost goods. US price.
Figure 13-7 illustrates the logic of Hume's
mechanism. Make sure you can follow the logic chain
from the original deficit at the top, through the
adjustments, and to the new balance at the bottom.
The result of Hume's four-pronged gold flow
mechanism is an improvement in the balance of

The US has a deficit in the

balance of payments

US loses gold;
GB wins gold

Lower money Increase the

supply in the US money supply in GB

Prices drop in Prices go up

in GB
the US

Step 1: US imports of Step 2: Upload the Step 3: Upload the Step 4: GB exports of
goods fall exports of US imports of goods goods fall
goods from GB

Equilibrium in the US balance Equilibrium in

of payments is restored GB's balance of payments is
restored

FIGURE 13-7. Hume's four-pronged international adjustment mechanism

Hume explained how an imbalance in the balance of payments would cause automatic
adjustments to reach equilibrium under the gold standard. Follow the lines from the
original imbalance at the top, through price changes, to the restored equilibrium at the
bottom. This mechanism works in a modified form in any system of fixed exchange rates.
Modern economics reinforces this mechanism by replacing the fourth line with "prices,
output, and employment fall in the United States" and "prices, output, and employment
rise in Britain."
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C. THE INTERNATIONAL MONETARY SYSTEM 287

payments of the country that loses the gold and a worsening in MONETARY INSTITUTIONS
the country that gains it. In the end, the balance of international INTERNATIONAL AFTER
trade and finance is restored with the new relative prices, which THE SECOND WORLD WAR
maintain the balance of international trade and credit without a net
In the early 20th century, even countries that were ostensibly at
flow of gold. This equilibrium is stable and does not require tariffs
peace engaged in trade wars and competitive devaluations that
or any other government intervention.
weakened them.
After World War II, international institutions were established to
foster economic cooperation between countries. These institutions
continue to be the means by which countries coordinate their
Hume update on modern
economic policies and seek solutions to problems.
macroeconomics
Today Hume's theories are no longer so important. There is no more common.
gold standard and quantity theory is no longer used to explain
The United States emerged from World War II with its
price movements. However, the basis of Hume's theory can be
economy intact, able and willing to help rebuild friendly and enemy
reinterpreted in the light of modern macroeconomics. The essence
countries alike.
of Hume's argument is to explain the adjustment mechanism for
The postwar international political system responded to the needs
imbalances between countries in a system of fixed exchange
of countries devastated by war, founding lasting institutions that
rates. The fixed exchange rate could be a gold standard (as it
facilitated the rapid recovery of the international economy.
existed before 1936), a dollar standard (as happened with the
international economic institutions
Bretton Woods system from 1945 to 1971), or a euro standard
(among the countries of the European Union today). .
The most important of the postwar period were the General
Agreement on Tariffs and Trade (GATT, today known as the World
Trade Organization, acquired in 1995), the Bretton Woods
If exchange rates are not free to move when prices or incomes
exchange system, the International Monetary Fund, and the World
in different countries misalign, then output and domestic prices
Bank. These four institutions helped industrial democracies rebuild
must adjust to restore equilibrium. If domestic prices rise too much
and grow rapidly after the destruction of World War II, and remain
relative to import prices, in a fixed exchange rate system, full
the four largest international institutions today.
adjustment will only occur when domestic prices fall. This will
occur when domestic output falls sufficiently for the country's price
level to decline relative to world prices. At that point, the country's
balance of payments will return to equilibrium. Suppose that prices
in Greece rise too much relative to the rest of the European Union
The International Monetary Fund
and you are out of competition in the market. Greece will find its
An integral part of the Bretton Woods system was the establishment
exports down and its imports up, reducing its net exports. In the
of the International Monetary Fund (or IMF), which still manages
end, as wages and prices in Greece fall relative to those in the
rest of Europe, Greece will become competitive again and will be the international monetary system and operates as the central
bank of central banks. Member nations that subscribe their capital
able to restore full employment.
lend their currency to the IMF; The IMF then lends these funds to
help countries that have balance of payments difficulties. The
main function of the IMF is to make temporary loans to countries
that have problems with their balance of payments or that are
under speculative attack in the financial markets.

When a country adopts a fixed exchange rate, it faces an

inescapable fact: real domestic output and employment must be The World Bank
adjusted to ensure that the country's relative prices are in line with Another international financial institution created from
those of its trading partners. after World War II it was the World Bank. The Bank is financed
with contributions from
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288 CHAPTER 13 • EXCHANGE RATES AND THE INTERNATIONAL FINANCIAL SYSTEM
high-income countries that subscribe their capital in
proportion to their economic importance, in terms of their
GDP and other factors. The Bank grants long-term, low-
interest loans to countries that present economically sound
projects, but cannot obtain financing from the private
sector. As a result of these long-term loans, goods and
services flow from advanced to developing countries.
The Bretton Woods system
After World War II, governments were determined to
replace the gold standard with another, more flexible
system. For this they established the Bretton Woods
system, which was a system with fixed exchange rates. In
this case, the novelty was that the exchange rates were
fixed, but adjustable. When a currency strayed too far from
what was considered its "fundamental" or proper value, its
parity could be changed.
The Bretton Woods system worked well for
the quarter century that followed the Second World War.
Ultimately, the system collapsed when the dollar became
overvalued. The United States left the Bretton Woods
system in 1973, and the world moved into the modern era.
How to ensure a credible exchange rate
under a "rigid exchange rate regime"
Although the collapse of the Bretton Woods
system marked the end of a system dominated
by fixed exchange rates, countries continued to rely on fixed
exchange rates. A recurring problem with these systems is
that they were subject to speculative attacks when the country
had low foreign exchange reserves. (We will return to this
problem in the next chapter.) How can countries improve the
credibility of their fixed exchange rate systems? Are there
“strong” fixed exchange rate systems that better resist
speculative attacks?
Specialists in this area stress the importance of
establishing credibility. In this case, credibility can be enhanced
by creating a system that makes it difficult for the country to
alter its exchange rate. This approach is similar to the military
strategy of burning the bridges after the army has passed, so
that the army cannot retreat and the soldiers have to fight to
the death. Indeed, the Argentine president tried to instill
credibility in his system by proclaiming that he would opt for
"death rather than devaluation."
One solution is to create money tips. A currency board is
an institution that issues only money that is backed by foreign
assets in a strong currency, usually the US dollar or the euro.
A currency board defends an exchange rate that is fixed by
law, and not just
because it is determined by politics. The currency board is
usually independent, and sometimes even private. When there
is currency advice, a payments shortfall often triggers Hume's
automatic adjustment mechanism. In other words, a deficit in
the balance of payments will reduce the money supply, leading
to an economic contraction, which will finally force the reduction
of domestic prices and the restoration of equilibrium.
A currency board system has worked well in Hong Kong, but
this system could not withstand the economic and political
turmoil in Argentina, and there it collapsed in 2002.
A fixed exchange rate is even more credible when
countries adopt a common currency in a monetary union.
The United States has had a common currency since 1789. The
The most important recent example is the euro, which has
been adopted by 18 countries of the European Union. This is
a particularly unusual arrangement, as the common currency
integrates many powerful sovereign countries. From a
macroeconomic point of view, a common currency is the
strongest arrangement of all, because all the currencies of
different countries are defined as one. A variant of this
approach is called “dollarization”, which occurs when a country
(usually a small country) adopts a hard currency as its currency
of exchange. About a dozen small countries, like El Salvador,
have taken this route.
Fixed exchange rates have lost popularity among large
countries. Only China continues to use a fixed exchange rate,
and it is under intense pressure from other countries to let the
yuan float. Outside of China, every major region of the world
has adopted some variant of flexible exchange rates, which
will be discussed shortly.
Intervention
When a government sets the exchange rate, it must
"intervene" in the currency markets to maintain it. In this
sense, government intervention occurs when you buy or
sell foreign money to affect the exchange rate. For example,
the Japanese government on a given day could buy 1
billion Japanese yen with US dollars. This would cause a
rise in value, or an appreciation of the yen.
Consider the case of China. Chinese is the last
large country that operates on a fixed exchange rate. In
2008 the official rate was $0.144 per yuan. However, at
this exchange rate, China had a huge current account
surplus, as Table 13-3 shows. China has pursued an export-
led growth strategy, and this requires an undervalued
exchange rate to make its exports as competitive. So while
US and European policymakers have been pressuring
China to revalue its currency, China has in
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C. THE INTERNATIONAL MONETARY SYSTEM 289

EITHER investments in dollars were relatively more

attractive, while yuan investments would become less
attractive. This would cause investors to sell yuan and
shift the yuan supply curve to the right so that it passes
through point B, producing the desired exchange rate.
0.25 AND

(dollars
yuan)
per
(A new O -curve leading to induced equilibrium can be
drawn in pencil .)
Exchange
China
rate
for

0.15
BA
D.
Exchange rate (yuan)
FIGURE 13-8. The Chinese government intervenes to
keep the exchange rate fixed Since China has established
a fixed exchange rate, it must intervene in the exchange
market to defend the rate it has established. Suppose the
market equilibrium without government intervention were
$0.25 per yuan, shown as point E at the intersection of market
supply and demand. However, the government has set an
official exchange rate of $0.15 per yuan.
At that lower rate, there is excess demand for the yuan, which
represents the distance between A and B. (Make sure you
understand why this is excess demand.) Therefore, the
Chinese government sells a certain amount of yuan, equivalent
to distance AB, to prevent its exchange rate from appreciating.
insisted that it will continue with its current policy of fixed
parity.
How exactly does China maintain this system?
Figure 13-8 illustrates the mechanism. Assume that the
forces of supply and demand reach an equilibrium at point
E, with a market-determined exchange rate of $0.25 per
yuan. At the fixed exchange rate of 0.15, the yuan is
“undervalued” relative to market parity. What can the
Chinese government do to keep the yuan below its market
value?
• One possibility is to intervene by buying dollars and
selling yuan. In this approach, if the central bank of
China sells the amount of yuan represented by the
distance AB, it will increase the supply of yuan to match
the amount demanded and maintain the official
exchange rate.
• The alternative would be to use monetary policy.
China could induce the private sector to increase its
supply of yuan by lowering interest rates. Lower interest
rates would make
These two operations are not really as different as
they seem. In one case the Chinese government sells yuan
and buys dollars; in the other case, the private sector does
exactly the same. Both approaches require monetary
expansion. One of the complications of managing an open
economy with a fixed exchange rate is that the need to use
monetary policy to manage the exchange rate may conflict
with the application of monetary policy for the purpose of
stabilizing the exchange rate. domestic business cycle.
FLEXIBLE EXCHANGE RATES
The international monetary system of the large countries
is currently based mainly on flexible exchange rates.
(Another frequently used term is floating rates, which
means the same thing.)
In this system, exchange rates are determined by the
interaction of supply and demand. Here, the government
does not announce an official exchange rate or intervene
to enforce it, and changes in the exchange rate are mainly
determined by private supply and demand for goods,
services, and investment.
As noted above, virtually all large and medium-sized
countries, except China, rely on flexible exchange rates.
The example of Mexico illustrates how this system works.
In 1994 the peso was under attack in the currency markets,
and the Mexicans allowed the peso to float. At the original
exchange rate of approximately 4 pesos to the dollar, there
was a surplus of pesos. This meant that with that exchange
rate, the supply of pesos from Mexicans who wanted to
buy goods and assets from the United States and other
countries, exceeded the demand for pesos from Americans
and others who wanted to buy goods and assets from
Mexico.
Which it was the result? The peso depreciated against
the dollar. How far did exchange rates move? Just enough
so that—at the depreciated exchange rate of about 6 pesos
to the dollar—the quantities supplied and demanded were
in equilibrium.
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290 CHAPTER 13 • EXCHANGE RATES AND THE INTERNATIONAL FINANCIAL SYSTEM
What is behind the balance of supply and demand?
Two basic forces are at work: 1) with the dollar
becoming more expensive, it is more difficult for
Mexicans to buy US goods, services and investments,
which causes the supply of pesos to fall in the usual
way, 2) with the depreciation of the peso, the Mexican
goods and assets become cheaper for foreigners.
This raises the demand for pesos in the market. (Note
that this simplified exposition assumes that all
transactions occur only between the two countries; a
more complete exposition would include the demand
for and supply of money in all countries.)
THE HYBRID SYSTEM OF TODAY
Unlike previous uniform systems with the
gold standard or the Bretton Woods standard, today's
exchange rate system does not fit either mold well.
Without anyone planning it, the world has moved into
a hybrid exchange system. Its main characteristics are
the following:
• A few countries allow their currencies to float freely.
Under this approach, a country allows the markets
to determine the value of its currency and rarely
intervenes. The United States has followed this
pattern for most of the last 30 years. Although the
euro is just an infant as a common currency, it is
clear that Europe is in the free-floating group. •
Some large countries have managed but flexible
exchange rates. Today this group includes Canada,
Japan, and many developing countries. In this
system a country will buy or sell its currency to
reduce the daily volatility that results from its
fluctuations. Also, sometimes a country will
systematically intervene to move its currency
toward what it considers to be a more appropriate
level.
RESUME
A. The international balance of
payments 1. The international balance of payments is the
set of accounts that measures all economic transactions
between a country and the rest of the world. This
balance includes exports and imports of goods, services
and financial instruments. Exports are split
• A few small countries and China align their
currencies to a major currency or a “basket” of
currencies at a fixed exchange rate. Sometimes
the aligned coin is allowed to slide smoothly up or
down in a system known as sliding or crawling
alignment. Some countries have a currency
council, and others adopt the dollar as their current
currency in a process called dollarization.
• Furthermore, almost all countries tend to intervene
when markets get “disordered”, or when exchange
rates appear to be too far from their “fundamental
value”, that is, when they are highly inappropriate
for price levels and flows. existing commercials.
Comments as conclusion
The world has undergone a major transition in its
international financial system in the last 30 years.
In earlier times most currencies were linked to each
other in a system of fixed exchange rates, where
parities were tied to gold or the dollar. At present, with
the exception of China, all the major countries have
flexible exchange rates. This new system has the
disadvantage that exchange rates are highly volatile
and can deviate greatly from their fundamental
economic value. But this system also
it also has the advantage of reducing the dangers of
speculation that led to the elimination of previous fixed-
rate systems. Even more important in a world of
increasingly open financial markets, flexible exchange
rates allow countries to pursue monetary policies
designed to stabilize domestic business cycles. This
is the macroeconomic advantage that most economists
consider to be the most relevant in this new regime.
credit, while imports are debit.
Expressed more generally, credit items are transactions
that increase a country's foreign currency holdings,
debit items are those that reduce its foreign currency
holdings.
2. The major components of the balance of payments are:
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CONCEPTS FOR REVIEW 291

I. The current account (merchandise trade, services, investment in the long term than in the short term. When this theory is used to
income, transfers) measure the purchasing power of different countries' incomes, the
II. The capital account (private sector, government and changes in per capita output of low-income nations rises.
official reserves)
The fundamental rule of balance of payments accounting is that the
C. The international monetary system
sum of all items must equal zero: I II 0
7. A well-functioning international economy requires an exchange
system that works smoothly, which denotes the existence of
B. The determination of exchange rates 3. institutions that govern financial transactions between countries.
International trade and finance involve the new element of different Two important exchange systems are: a) flexible exchange rates, in
national currencies, which are linked by their relative prices, called which a country's exchange rate is determined by market supply
exchange rates. When Americans buy Japanese goods, they must and demand forces; and b) fixed exchange rates, such as the gold
ultimately pay in Japanese yen. On the foreign exchange market, standard or Bretton Woods system, in which countries establish and
the Japanese yen could trade at ¥100/$ (or, reciprocally, ¥1 would defend a given exchange rate structure.
trade at $0.01). This price is called the exchange rate.

8. Classical economists, such as David Hume, used the gold flow

4. In a foreign exchange market where there are only two countries, the
supply of US dollars comes from Americans who want to buy goods,
services and investments from Japan; the demand for dollars comes
from the Japanese who want to import goods or financial assets
from the United States. The interaction of these
Supply and demand determines the exchange rate. Expressed
more generally, exchange rates are determined by the complex
interaction of many countries buying and selling with each other.
When trade or financial flows change, supply and demand shift, and
this changes the equilibrium exchange rate.
mechanism to explain the international adjustments caused by trade
imbalances. According to this process, movements in gold would
change the money supply and the price level. For example, a trade
deficit would lead to an outflow of gold and a fall in domestic prices
that would a) raise exports and b) weaken imports of the countries
that lose gold, while c) reducing exports and d) imports of the country
that earns gold rise. This mechanism shows that when there are
fixed exchange rates, countries that have problems with their
balance of payments must make the adjustments by modifying the
domestic levels of prices and output.

5. A drop in the market price of a currency is a depreciation; an increase

in the value of that currency is called appreciation. In a system
where governments announce official exchange rates, a reduction
in the official exchange rate is known as a devaluation, while an
increase is a revaluation.
6. According to the purchasing power parity (PPP) theory of exchange
rates, these tend to move with changes in the relative price levels of
different countries. PPC theory is best applied
9. After World War II, countries created a group of economic institutions
to organize international trade and finance. With the Bretton Woods
system, countries "aligned" their currencies to the dollar and gold,
to establish fixed but flexible exchange rates. After the collapse of
the Bretton Woods system in 1973, today's hybrid system was
installed. At present, practically all large and medium-sized countries
(except China) have flexible exchange rates.

CONCEPTS FOR REVIEW

Balance of payments Exchange rates The international monetary system

Balance of payments exchange rate, foreign exchange market exchange rate systems: flexible
I. Current account currency supply and demand exchange
II. capital account balance rate terminology: appreciation and fixed (gold standard,
of payments identity: II 0 depreciation revaluation and devaluation Bretton Woods, currency board)
Yo common currency
debits and credits mechanism of international adjustments four-
pointed mechanism of the flow of gold, by
Hume
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292 CHAPTER 13 • EXCHANGE RATES AND THE INTERNATIONAL FINANCIAL SYSTEM

FURTHER READING AND WEBSITES

further reading Some of the most popular writing on international economics is

A fascinating collection of essays on international macroeconomics is
Paul Krugman's Pop International (MIT Press, Cambridge, Mass. 1997).
The quote on the international monetary system is from Robert Solomon,
The International Monetary System, 1945-1981: An Insider's View
(Harper & Row, New York, 1982), pp. 1, 7.
Web Sites
Trade and financial data for different countries can be found at the sites
listed in Chapter 12.
found in The Economist, which can be found on the web at
www.economist.com. One of the best sources for policy writing on
international economics is www.iie.com/ homepage.htm, the site of the
Peterson Institute for International Economics. One of the most
distinguished journalist-scholars today is Paul Krugman of Princeton.
His blog at krugman.blogs.nytimes.com contains many interesting
articles on economics.
international.

DISCUSSION QUESTIONS

1. Table 13-4 shows some exchange rates (in units of foreign currency
per dollar), at the end of 2008.
Complete the last column of the table with the reciprocal price of
the dollar in terms of each foreign currency, taking special care to
write the relevant units between the parentheses.
2. Figure 13-3 shows the supply and demand for US dollars, in an
example where Japan and the United States trade only with each
other. a) Describe and draw the reciprocal supply and demand
curves of the Japanese yen. Explain why the supply of yen is
equivalent to the demand for dollars. Also explain and draw
the curve that corresponds to the supply of dollars. Find the
equilibrium price of the yen in this new diagram and relate it to
the equilibrium in Figure 13-3.
b) Suppose Americans start to like Japanese products. Show what
would happen to the supply and demand of the yen. I know
Would the yen appreciate or depreciate relative to the dollar?
explain.
3. Prepare a list of entries that correspond to the credit side of the
balance of international payments, and another list of entries that
correspond to the debit side.
What is meant by trade surplus? What about the balance in the
current account?
4. Suppose China has a fixed exchange rate system, and has a large
current account surplus. The government supports the system by
buying large amounts of dollars in the exchange market. Suppose
that the resulting increase in the supply of yuan leads to an increase
in bank reserves.
a) Explain why this would lead to monetary expansion and lower
interest rates in China. Also explain why this would lead to an
expansion in aggregate demand, higher output, and a higher
price level. (This answer is supported by the analysis presented
in Chapters 9 and 10.)

Price

Foreign currency units

per US dollar US dollars per unit of foreign currency
Currency

Dollar (Canada) 0.9861 1,014 (US dollar/Canadian dollar)

Royal (Brazil) 1,656
Chinese yuan 6,942 ((( ))

Weight (Mexico) 10.38 ( )

Pound (Great Britain) 0.5054
Euro 0.6368
Dollar (Zimbabwe) 255 771 415 ((( )))

TABLE 13-4.
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DISCUSSION QUESTIONS
b) Explain why, as prices rise because of the effects you
described in a), Hume's four-pronged mechanism would
ultimately reduce China's current account surplus. Please
interpret your answer as the modern, up-to-date version of
Hume's mechanism.
8. A country records the following data for 2008: exports of cars
5. Consider the situation in Germany described on page 281. Using
a figure similar to 13-3, show the supply and demand for German
marks before and after the crash. Identify in your figure the
excess demand for marks before their appreciation. Then show
how this appreciation would end the excess demand or shortage
of German marks.
6. A country in the Middle East suddenly discovers that it has huge
oil deposits. Show how your balance of trade and current account
suddenly go into surplus. Show how you can acquire assets in
New York as an offset to your capital account. Then, when you
use the assets for domestic investment, show how your current
and financial entries are reversed.
7. Consider the following quote from the Economic Report of the
President 1984:
In the long term, the exchange rate tends to follow the trend of the
differential between the domestic and foreign price level. If a country's
price level becomes too out of line with other countries' prices, there
will eventually be a drop in demand for its goods, leading to a real
depreciation of its currency.
answer change if the question referred to the United States?
Explain how the first sentence relates to the PPP theory of
exchange rates. Explain the reasoning behind the PPC theory;
Also, with a diagram of
293
supply and demand like that in Figure 13-3, explain the sequence
of events, described in the second sentence of the quote, by
which a country whose price level is relatively high will find its
exchange rate to depreciate. .
(100 dollars) and corn (150 dollars); imports of oil (150 dollars)
and steel (75 dollars); tourism expenses abroad (25 dollars);
private loans granted to foreign countries ($50); loans obtained
in foreign countries (40 dollars); and changes in the official
reserve ($30 of foreign currency purchased by the central bank).
Calculate the statistical discrepancy (errors and omissions) and
include them in private loans granted to other countries.
Construct a balance of payments similar to the balance in Table
13-2.
9. Consider the following three exchange rate systems: the classical
gold standard, freely floating exchange rates, and the Bretton
Woods system. Compare and contrast the three systems with
respect to the following characteristics: a) Role of government
compared to the market in determining exchange rates b)
Degree of volatility of exchange rates c) Method of price
adjustment relative between countries d) Need for international
cooperation and consultations to determine exchange rates e)
Possibility of establishing and maintaining severe misalignments
in exchange rates 10. Analyze the European Monetary
Union. List your pros and cons. How would you approach the
issue of the desirability of a monetary union? Would your
Machine Translated by Google
CHAPTER
14
Before I build a wall, I would have to
know what I am enclosing or leaving out. .
Robert Frost
The international business cycle has a powerful effect on
every country in the world. Shocks in one area can cause
swells around the world. Political unrest in the Middle
East can cause oil prices to spiral, which in turn trigger
inflation and unemployment. Missing payments can rock
stock markets and shake the confidence of businesses
in faraway lands. The interconnectedness of countries
was dramatically illustrated in the financial crisis of
2007-2009. When American financial institutions suffered
enormously
After months of losses, global stock and bond markets
also declined, and a banking crisis broke out in Europe
almost at the same time as in the United States.
The previous chapter analyzed the great concepts of
international macroeconomics: the balance of payments,
the determination of exchange rates and the international
monetary system. This chapter continues the story by
showing how macroeconomic shocks in one country
cause surges in output and inflation in other countries.
The paradoxical finding that trade balances are mainly
determined by the levels of domestic savings and
investment is explored. The chapter concludes with a
review of some of the world's key international issues with
temporary.
294
Macroeconomics in an
open economy
.
A. FOREIGN TRADE AND
ECONOMIC ACTIVITY
Net exports and output in an open economy
The macroeconomics of an open economy is the study
gave of the way in which the economy is conducted when
considering the commercial and financial links between
the different countries. The previous chapter described
the basic concepts of the balance of payments; which
are restated in terms of the national income and product
accounts.
Foreign trade refers to imports and exports. Although
the United States produces most of what it consumes, it
still consumes a large amount of imports, which are
goods and services produced abroad and consumed in
the domestic market. Exports are goods and services
produced in the domestic market and purchased by
people abroad.
Net exports are defined as exports of goods and
services minus imports of goods and services. In 2007,
net exports from the United States were minus $708
billion.
lares, which are calculated by subtracting from the 1,662
billion dollars of exports the 2,370 billion dollars
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A. FOREIGN TRADE AND ECONOMIC ACTIVITY
of imports. When a country has positive net exports, it
accumulates net assets. The counterpart to net exports is
net foreign investment, which denotes net US savings
abroad, and is approximately equal to the value of net
exports. Since the United States had negative net exports,
its net foreign investment was negative, which means that
US borrowing abroad was growing.
In other words, foreigners were making a significant
contribution to American investment. Why did an affluent
country like the United States borrow so much abroad? As
will be seen later in this chapter, this paradox is explained
by a relatively low US saving rate, a high foreign saving rate,
and an attractive investment climate in the United States.
In an open economy, a country's expenditures
may differ from its production. Total household
expenditures (sometimes called household demand)
are equal to household consumption plus household investment.
Exports are the mirror image of imports: US exports are
plus government purchases. This measure differs from
gross domestic product (or GDP) for two reasons. First,
some portion of domestic spending will go toward the
acquisition of goods produced abroad, and these goods are
imports (denoted by Im), such as Mexican oil or Japanese
cars. In addition, some of the US domestic production will
be sold abroad as exports (denoted by Ex), products such
as Iowa wheat and Boeing airplanes. The difference between
the national product and domestic spending is exports minus
imports, which is equal to net exports, or Ex Im X.
To calculate the total production of US goods and
services, it is necessary to add trade to domestic demand.
That is, it is necessary to know the total production of US
residents, as well as the net production of foreigners. This
total includes domestic expenses (CI G) plus sales abroad
(Ex) minus domestic purchases by foreigners (Im). Total
product, or GDP, is equal to consumption plus domestic
investment plus government purchases plus net exports:
Total domestic product GDP
CIGX
Determinants of trade and net exports
What determines the level of exports and
imports and, therefore, of net exports? Is better
295
Think of the components of net exports, imports and exports,
separately.
Imports into the United States are positively related to
US income and output. When US GDP goes up, imports
into the US go up 1) because some of CIG 's biggest
purchases (like cars and shoes) come from foreign
production, and also 2) because the US uses inputs (like
oil). or wood) in the production of their own goods. The
demand for imports depends on the relative price of foreign
and domestic goods. If the price of domestic cars rises
relative to the price of Japanese cars because of an
appreciation of the dollar exchange rate, then Americans
will buy more Japanese cars and fewer American cars.
Therefore, the volume and value of imports will be affected
by the domestic product and by the relative prices of local
and foreign goods.
the imports of other countries. Consequently, US exports
depend on foreign production as well as on the prices of
US exports relative to the prices of foreign goods. As foreign
production rises, or the dollar depreciates, the volume and
value of US exports will tend to grow.
Figure 14-1 shows US net exports as a proportion of
GDP. For most of the period after World War II, the external
accounts of the United States were in balance or in surplus.
Beginning in the early 1980s, a decline in national savings,
fueled by large federal budget deficits, led to a sharp
appreciation of the dollar. Foreign economies grew less
rapidly than the US economy, which depressed its exports.
The net effect was a large trade deficit and growing foreign
debt. Was it something positive or negative? The following
comment from the Chairman of the Council of Economic
Advisers puts the US trade deficit in an economic context:
By themselves, foreign trade and current account deficits are neither
good nor bad. What matters are the reasons for the deficits. Today, the
main reason for deficits appears to be the strength of the US economic
expansion relative to slow or negative growth in many other countries…
These deficits are essentially a macroeconomic phenomenon.
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296 CHAPTER 14 • MACROECONOMICS IN AN OPEN ECONOMY

bubble
dollar

0 Abundance
Savings
World

(percentage)
exports/
GDP
Net

Vietnam
deficit
War

Reconstruction
Postwar
Marshall
Plan
and
The

8
1950 1960 1970 1980 1990 2000 2010
Year

FIGURE 14-1. US net exports have been in deficit for many years

The United States ran a large trade surplus after World War II, when it helped rebuild
Europe. Note that net exports took a severe decline in the early 1980s as US saving
declined. Net exports became even more negative with the abundance of global savings.

Source: US Bureau of Economic Analysis.

nomic, which reflects a higher rate of domestic
investment than national saving. The growth of the
deficit…reflects increasing investment, rather than
decreasing saving.
THE SHORT TERM IMPACT
OF TRADE IN GDP
How do changes in the trade flow of a country affect
its GDP and its level of employment? This issue is first
discussed in the context of the short-run model of
output determination, the multiplier model of Chapter
7. The multiplier model shows how, in the short run,
when resources are unemployed, changes in trade
will affect aggregate demand, output and employment.
There are two fundamental new macroeconomic
elements in the presence of international trade: first,
a fourth component of spending, net exports, which
are added to aggregate demand.
Second, an open economy has different multipliers
for private investment and domestic government
spending, because some of the spending trickles
down to the rest of the world.
Table 14-1 shows how the introduction of net
exports affects the determination of output. This table
starts with the same components that exist in a closed
economy. (Refer to Table 7-2 to refresh your memory
about the large components and how they add up to
arrive at total spending.) Total domestic demand in
column (2) is composed of
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A. FOREIGN TRADE AND ECONOMIC ACTIVITY 297

Determination of the product with foreign trade

(billions of dollars)

(one) (2) (3) (4) (5) (6) (7)

Level Demand exports Imports net Spent Trend
initial domestic exports total resulting from
of GDP (IGC) Ex Im (X Ex Im) (CIGX ) the economy

4 100 4,000 250 410 160 3840 Contraction

3800 3800 250 380 130 3 670 Contraction
3,500 3,600 250 350 100 3,500 Balance
3,200 3,400 250 320 70 3330 Expansion
2,900 3,200 250 290 40 3 160 Expansion

TABLE 14-1. Net exports are added to the aggregate demand of the economy To the domestic

demand CI G, the net exports of X Ex Im are added to obtain the total aggregate demand for the product of a
country. Higher net exports affect aggregate demand as do investment and government purchases.

set by consumption, investment and government
purchases, already analyzed. Column (3) adds exports
of goods and services. As explained above, exports
depend on external income and output, prices and
exchange rates, which is also considered given in this
analysis. Exports are assumed to remain at a constant
level of $250 billion of external spending on domestic
goods and services.
The new element of interest arises from the imports,
which are shown in column (4). Like exports, imports
depend on exogenous variables, such as prices and
exchange rates. But, in addition, imports depend on
domestic income and product, which obviously change
in the different rows of Table 14-1. For simplicity, assume
that the country always imports 10% of its total product,
so the imports in column (4) are 10% of column (1).
Subtracting column (4) from column (3) gives the
net exports in column (5). Net exports are a negative
number when imports exceed exports, and a positive
number when exports exceed imports. Net exports in
column (5) are the contribution of foreign trade to the
stream of expenditures. Total domestic product spending
in column (6) is equal to domestic demand in column (2)
plus net exports in column (5). The equilibrium product
in an economy
Open mine occurs when the net expenditures, both
domestic and foreign, in column (6) are exactly equal to
the total domestic product in column (1). In this case,
equilibrium is reached with net exports of 100, indicating
that the country is importing more than it is exporting. In
this equilibrium, note that the domestic demand is
greater than the product.
Figure 14-2 graphically shows the equilibrium for an
open economy. The line with positive slope marked with
CIG is the same curve that was used in Figure 7-10. To
this line must be added the level of net exports that
corresponds to each level of GDP. The net exports in
column (5) of Table 14-1 are added to arrive at the total
aggregate demand or total expenditure line (colored).
When this line is below the gray line, imports exceed
exports and net exports are negative. When the colored
line is above the gray line, the country has a net export
surplus and the product is greater than domestic demand.
Equilibrium GDP occurs at the point where the total
spending line intersects the 45º line. This intercept is at
exactly the same point, at $3.5 trillion, which is shown
as equilibrium GDP in Table 14-1. At just $3.5 trillion,
GDP equals exactly what consumers, businesses,
governments, and foreigners want to spend on goods
and services produced in the domestic economy.
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298 CHAPTER 14 • MACROECONOMICS IN AN OPEN ECONOMY

CI G

CIGX
Net export
deficit
3,500
AND

spending
(billions
dollars)
Total
of

3,000

2,500

45°
2,500 3,000 3,500 GDP 4,000
Gross Domestic Product (billions of dollars)

FIGURE 14-2. Adding net exports to domestic demand yields equilibrium GDP for
an open economy. The gray line represents domestic demand (CIG ), which is purchases
by consumers, businesses, and domestic governments. To this must be added net foreign
spending. Net exports plus domestic demand give the total expenditure line. Equilibrium
is obtained at point E, where total GDP equals total spending on goods and services
produced in the United States. Note that the slope of the total demand curve is less than
that of domestic demand, to reflect the leakage of spending towards imports.

The Marginal Propensity to Import and
the Expenditure Line Notice that the
aggregate demand curve, the CIG line in Figure 14-2,
slopes slightly less than the domestic demand curve. The
explanation for this is that there is an additional filtering of
spending to imports. This new leak arises from the
assumption that 10 cents of every dollar is spent on
imports. To continue with the analysis, it is necessary to
introduce a new term, the marginal propensity to import.
The marginal propensity to import, denoted as PMi, is the
increase in the value of imports in dollars for each increase
of 1 dollar in GDP.
The marginal propensity to import is closely related to
the marginal propensity to save (PMa). Remember that
the PMa tells what fraction of each additional dollar of
income is not spent, but trickles down to savings. The
marginal propensity to import tells how much additional
output and income leaks into imports. In this example, the
PMi is 0.10 because each $300 billion increase leads to a
$30 billion increase in imports. (What is the marginal
propensity to import in an economy without foreign trade?
Zero.)
Now examine the slope of the total spending line in
Figure 14-2. This line shows the total spending
Machine Translated by Google
A. FOREIGN TRADE AND ECONOMIC ACTIVITY
at CIG X. Note that the slope of the total expenditure line
is less than the slope of the domestic demand line at CI G.
When GDP and total income rise by $300, consumption
spending rises by an equal amount to the change in income
times the PMa (assumed to be two-thirds), or $200. At the
same time, spending on imports, or goods from abroad,
also rises by $30.
Consequently, spending on household goods rises by only
$170 ( $200 $30), and the slope of the total spending line
falls from 0.667 in a closed economy to $170/$300 0.567
in an open economy.
The Open Economy Multiplier It is surprising
that opening an economy reduces the spending multiplier.
One way to understand the spending multiplier in an
open economy is to calculate the spending rounds
generated by an additional dollar of government spending,
investment, or exports. Suppose Germany needs to buy
American computers to upgrade outdated facilities located
in East Germany. Each additional dollar of US computers
will generate $1 of US income, of which $2/3 $0.667 will
be spent by Americans as consumption. However, since
the marginal propensity to import is 0.10, one-tenth of
every dollar of extra income, or $0.10, will be spent on
foreign goods and services, leaving only $0.567 of spending
on domestically produced goods. . This $0.567 of household
spending will generate $0.567 of income in the United
States, of which $0.567 $0.567 $0.321 will be spent on the
consumption of household goods and services in the next
round. Therefore, the total increase in output, or the
multiplier in an open economy, will be
open economy
multiplier 1 0.567 (0.567)2 . . .
one
(2
one
ÿ10) (2 1ÿ10) 2
...
ÿ3 1
__________ ÿ3 ___1
23
1 2 ÿ3 1 ÿ10 13ÿ30
This can be compared to a closed economy multiplier of 1/
2
(1 ÿ3) 3.
Another way of calculating the multiplier is as follows:
remember that the multiplier in the simplest model is 1/
PMa, where PMa is the “leakage” into savings. As is
known, imports are another leak. The total leakage is the
dollars that leak to savings (PMa) plus the dollars that leak
to imports (PMi). Hence the multiplier of an open economy
is 1/ (PMa – PMi )
299
1/(0.333 0.1) 1/0.433 2.3. Note that both the leak
analysis and the round analysis offer exactly the same
answer.
To sum up:
Since a fraction of any increase in income leaks into
imports in an open economy, the open economy multiplier
is less than the closed economy multiplier.
The exact relationship is
one
Open economy multiplier ____________ PMa PMi
where PMa marginal propensity to save and PMi
marginal propensity to import.
TRADE AND FINANCE OF
UNITED STATES WITH TYPES
FLEXIBLE CHANGE
It is worth reviewing the main trends in US trade and
finance during the period of flexible exchange rates, which
began after the abandonment of the Bretton Woods system
in 1973 (remember what was discussed in the previous
chapter). ).
First we must examine the movements in the price of
the dollar, shown in Exhibit 14-3; there is an index of the
real exchange rate of the US dollar against other hard
currencies. The real exchange rate corrects for movements
in price levels in different countries. Note that the exchange
rate was relatively stable when fixed rates were used.
So, as with all market-determined asset prices, exchange
rates have been more volatile in the era of floating rates.
Figure 14-4 shows the real component of net exports.
It is the share of real net exports in real GDP. Earlier we
saw that an increase in real net exports tends to be
expansionary, while a fall in real net exports tends to
reduce output. Two periods of United States history are
described to understand the role of international trade in
domestic production.
Trade movements reinforce monetary
tightness of the 1980s The decade of the 1980s
witnessed a cycle of abrupt appreciation and depreciation
of the dollar. The rise in the value of the dollar began in
1980, after
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300 CHAPTER 14 • MACROECONOMICS IN AN OPEN ECONOMY

140

130
Fixed exchange rate period Flexible exchange rate period

120

110

exchange
(March
dollar
1973
100)
rate
US

100

90

80

70 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Year

FIGURE 14-3. The dollar exchange

rate In the period of the fixed exchange rate (Bretton Woods), the value of the dollar
was stable in the exchange markets. After the United States moved to flexible
exchange rates in 1973, the value of the dollar became more volatile. When the
United States applied restrictive monetary policies in the early 1980s, high interest
rates pushed the dollar up. With large current account deficits and the accumulation
of dollar-denominated assets abroad, the dollar began to depreciate after 2000.
Source: Federal Reserve System, at www.federalreserve.gov/ releases/ h10/ summary

that the application of a restrictive monetary policy and
an expansive fiscal policy in the United States would
trigger interest rates to rise. High domestic interest
rates and economic turmoil abroad have attracted
funds into financial investments in US dollars. Figure
14-3 shows that in the period from 1979 to early 1985,
the real exchange rate of the dollar rose by about 80%.
Many economists believe that the dollar was overvalued
in 1985; an overvalued currency has a high value
relative to its long-term or sustainable level.
As the dollar rose, the price of US exports also
rose, and the prices of goods imported into the United
States fell.
Figure 14-5 shows the important relationship between
real exchange rates and the trade deficit. The graph
illustrates the dramatic effect of the appreciation of the
dollar on trade flows. From the 1980 trough to the 1986
peak, the trade deficit increased by 3% of GDP as the
net exports reinforced the decline in domestic demand
induced by a restrictive monetary policy. The end result
was the deepest recession in 50 years.
Countercyclical net exports in the
period 1995-2000
The end of the nineties tells the opposite story.
After 1995 the combination of low real interest rates
and an expanding stock market led to rapid growth in
US domestic demand, particularly from private
investment. Unemployment fell drastically. A rapid
increase in foreign demand for US assets led to a
sudden appreciation of the dollar.
In contrast to the early 1980s, the macroeconomic
impact of the appreciation of the dollar in this period
was appropriate.
As the US economy neared

dollar appreciated. full employment, the price of imports rose, exports

By itself, this severe increase in the trade deficit declined and the external sector exerted a counterweight
had a contractionary effect. The drop in the in the economy. If the dollar had depressed
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A. FOREIGN TRADE AND ECONOMIC ACTIVITY 301

one

one

2
growth
of depreciation
exports
dollar
with

(percent)
Exports/
GDP
Real
Real
Net

3 overvaluation
dollar Bretton
Woods
in

bubble
Budget
deficit
dollar
and

6
1950 1960 1970 1980 1990 2000 2010
Year

FIGURE 14-4. Real net exports have been an important component of demand

With a sharp rise in the US exchange rate and weak economic growth abroad, real US net
exports turned deeply negative in the early 1980s. This change put a massive damper on
aggregate spending in the CIGX equation and helped generate the deep recession of
1982. The growing deficit in the period after 1990 moderated output growth. Note that net
exports increased after the depreciation of the dollar at the end of 2000.

Source: US Bureau of Economic Analysis.

By increasing instead of appreciating, the external macroeconomic policies in an open economy?

sector would have had an expansive effect, the US
economy would have suffered rising inflation, and the
Fed would have found it necessary to limit money to
slow down the expansion. Thus, in the late 1990s, an
appreciation of the dollar and a decline in net exports
were just what the macroeconomic doctor ordered.
THE TRANSMISSION MECHANISM
MONETARY IN AN OPEN ECONOMY
The analysis of the multiplier of business cycles and
economic growth focused on policies in a closed
economy. Now we look at how monetary and fiscal
policies can help stabilize the business cycle. How
does the impact of
In what way is the monetary transmission mechanism
different in this situation? It may come as a surprise,
but the answer to these questions crucially depends
on whether the country has a fixed exchange rate or
a flexible exchange rate.
Here the study will focus on high-income countries,
whose financial markets are closely linked to each
other: the United States, Japan, and the countries of
the European Union. When financial investments can
flow easily between countries and regulatory barriers
to financial investment are low, these countries have
high capital mobility.
Fixed exchange rates. The key characteristic of
countries with fixed exchange rates and high capital
mobility is that their interest rates must be closely aligned.
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302 CHAPTER 14 • MACROECONOMICS IN AN OPEN ECONOMY

3.5 130

3.0
120
2.5
(1973
100)

2.0 110

1.5
100
percentage
deficit
Trade
GDP
as
of
a
1.0
exchange
dollar
rate
real
US

0.5 90

0
Trade deficit/GDP 80
Real effective exchange
0.5
(left scale) rate (right scale)
1.0 70
1976 1980 1985 1990 nineteen ninety five 2000
Year

FIGURE 14-5. Trade and exchange rates

Trade flows respond to changes in exchange rates, but with a certain lag. The real
appreciation of the dollar in the early 1980s increased the price of US exports and
lowered the price of imported goods into the United States. As a result, the trade deficit
increased considerably. When the dollar depreciated after 1985, the trade deficit began
to shrink. The increase in the current account deficit came from the appreciation of the
dollar and slow growth outside the United States.

Source: Council of Economic Advisers, Economic Report of the President, 2000.

each. Any divergence in interest rates between two of these Economics with flexible exchange rates operates quite
countries will attract speculators who will sell one currency differently from fixed exchange rates. A flexible exchange
and buy the other, until interest rates level off. rate reinforces monetary policy.

Take the case of a small country that aligns its exchange
rate with the currency of a larger country. Since the small
country's interest rates are determined by the big country's
monetary policy, the small country can no longer pursue an
independent monetary policy. The small country's monetary
policy must be dedicated to ensuring that its interest rates
are in line with those of its partner.
The macroeconomic policy in such a situation is therefore
exactly the same as the case described above in the
multiplier model. From the point of view of the small country,
investment is exogenous, because it is determined by world
interest rates. Fiscal policy is very effective because there is
no monetary reaction to changes in government spending or
taxes.
Flexible exchange rates. An important element of judgment
in this area is that macroecopolitics
Consider the case of the United States. The mechanism
The mode of monetary transmission has changed significantly
in this country in recent decades, as a result of greater
openness and the shift towards a flexible exchange rate. In
the modern era, international trade and finance have come
to play an increasingly important role in US macroeconomic
policy.
Figure 14-6 shows the monetary transmission mechanism
in a flexible exchange rate regime. Panel (a) shows the
relationship between net exports and the exchange rate, the
history of which was seen in Figure 14-5. The relationship is
inverse because a depreciation stimulates exports and
discourages imports. Suppose the Fed decides to lower
interest rates to stimulate the economy. The fall in interest
rates leads to a depreciation of the dollar as financial
investors move from the dollar
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A. FOREIGN TRADE AND ECONOMIC ACTIVITY 303

a) Net exports and the exchange rate b) Total expenses and product

e (exchange rate) GT

C + I + G + X(e**)

and*

C + I + G + X(e*)

and**
X(e)

45°

x* 0 X** Q* Q**
net exports total product

FIGURE 14-6. With flexible exchange rates, the monetary transmission mechanism
is reinforced

Suppose the central bank lowers interest rates. This will tend to reduce the exchange rate
from e* to e** in a flexible exchange rate system. Such a depreciation will stimulate net exports
with a downward movement along the net export curve. This increase in net exports from
X(e*) to X(e**) shifts the total spending curve upward, increasing total output from Q* to Q**.

to non-dollar-denominated stocks and bonds. Depreciation
is represented in Figure 14-6 as a movement from e* to
e**. This depreciation changes a net export deficit of X*
to a net export surplus of X**. The drop in interest rates
would also tend to increase domestic investment, but this
effect is omitted in the exposure.
The results of this net expansion of exports appear
in Figure 14-6b). (This assumes, as with all multiplier
analyses, a situation where there are idle resources.)
The increase in net exports shifts the total spending
The monetary policy raised interest rates in the United
States, drawing funds into dollar securities. This increase
in the demand for dollars led to an appreciation of the
dollar. The high value of the dollar reduced net exports
and contributed to the recession of 1981-1983, as
described above. The impact on net exports in such a
situation would be the opposite of that shown in Figure
14-6.
Foreign trade creates a powerful new link
lo in the monetary transmission mechanism when

curve upward, from CIG X(e*) to CIG X(e **). The result
is an increase in total spending and an increase in output
from Q* to Q**. All the changes shown in Figure 14-6
illustrate the policies and reactions during the period
1995-2000 analyzed.
in the previous section.
Suppose the opposite case: the Fed decides to cool
the economy, as it did after 1979. Tightness
a country has a flexible exchange rate. When monetary
policy alters interest rates, exchange rates and net
exports are affected, as well as domestic investment.
Monetary tightening leads to an appreciation of the
exchange rate and a corresponding drop in net exports;
greater monetary slack does the opposite. The impact of
changes in interest rates on net exports reinforces the
impact on domestic investment.
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304
B. INTERDEPENDENCE IN
THE GLOBAL ECONOMY
ECONOMIC GROWTH
IN THE OPEN ECONOMY
The first section described the short-term impact of
international trade and policy changes in an open
economy. These issues are crucial for open economies
seeking to combat unemployment and inflation. But
countries must also pay attention to the consequences
of their policies for long-term economic growth.
Particularly for small open economies, the effective
use of international trade and finance is essential to
promote economic growth.
Economic growth covers a wide range of issues,
as explained in Chapter 11. Perhaps the most
important instrument for promoting rapid economic
growth is ensuring high levels of saving and investment.
But economic growth requires other elements
besides capital. It requires moving towards the
technological frontier with the adoption of the best
technological practices. It requires the development of
institutions that encourage investment and
entrepreneurship. Other matters—commercial policies, rightsprivate saving (S) of families and companies plus the
STG
r **
interest
rate
real
r*
** _ I*
investment, savings
CHAPTER 14 • MACROECONOMICS IN AN OPEN ECONOMY
intellectual property, direct investment policies, and
the global macroeconomic climate—are essential
ingredients in the growth of open economies.
SAVINGS AND INVESTMENT
IN THE OPEN ECONOMY
In a closed economy, total investment equals domestic
savings. However, open economies can rely on world
financial markets to obtain investment funds, and other
countries can be destination points for domestic
savings. (Remember Table 13-3, which shows net
savings for important regions.) First, the savings-
investment relationship is reviewed, and then the
mechanisms for allocating savings among different
countries.
The savings-investment relationship in an economy
open
It is convenient to pause to remember the
savings-investment identities already seen in
chapter 5:
IXS (TG ) Yo
you
This expression states that total national investment (I
T) consists of investment in domestic capital (I) plus
investment or net exports (X). This must equal the total
FIGURE 14-7. Saving and investment in a closed
economy
Investment is inversely related to the real interest rate, while
STG private saving and public saving are relatively unresponsive to
the interest rate. Equilibrium saving and investment are reached
at r *. Suppose the government's military spending increases.
This raises the government deficit and thereby reduces public
savings.
The result is a leftward shift of the national savings curve to ST
G, which raises the market interest rate to r ** and reduces
saving and investment
nationals to I **.
Go )
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B. INTERDEPENDENCE IN THE GLOBAL ECONOMY 305

total public saving, which is given by the government surplus government ravit. The equilibrium price is the real
(T – G). interest rate, which adjusts to balance the levels of
To emphasize the components of net exports, saving and investment.
this identity is rewritten as follows: Figure 6-7 shows how national saving and
XS (TG ) Yo
investment balance in a closed economy with full
employment. The ST – G curve shows national saving,
either

which is assumed to grow slightly with the real interest

Net exports (private savings government savings)
domestic investment
This important equation shows that net exports are the
difference between domestic saving and domestic investment.
Table 14-2 presents the components of total US domestic
investment in recent decades.
you.
Determining Saving and Investment at Full
Employment It is necessary to go beyond
identities to understand the mechanism by which
saving and investment are equalized in an open
economy. This analysis is re
It refers mainly to the long term in which there is full
employment and where output equals its potential level.
In other words, the way in which saving and investment
are distributed in the long run is considered in
a "classical" economy.
rate. Also, as we saw in Chapter 6, there is an inverse
relationship between investment and the interest rate.
Higher interest rates reduce spending on housing and
business plant and equipment.
Therefore, the investment curve is represented as I(r)
to indicate that investment depends on the real interest
rate, r.
The saving and investment curves intersect in
Figure 14-7 to determine an interest rate at r*, with
high levels of saving and investment.
Suppose now that the government increases its
purchases without raising taxes, for example due to
an increase in military spending destined for the
battlefronts abroad. This will shift the savings curve to
the left at ST G. As a result, the real interest rate
increases to balance saving and investment, and the
level of investment decreases. A similar result would
occur if the government cut taxes or if the private
sector had lower desired savings.

Closed economy. Suppose a closed economy where In a closed economy with full employment (all else
there is no inflation or uncertainty. In this case, equal), higher government spending, lower taxes, or
investment must equal private savings plus surplus. lower desired savings by

Savings and investment as a percentage of the PIN

Sector 1959-1981 1982-2001 2002-2007

Net household savings 11.5 6.4 1.7

Net private saving 11.6 8.8 4.6
Net government savings 0.1 2.5 2.8
Net domestic investment (in capital) 11.1 8.5 7.7
net foreign investment 0.4 2.1 6.0

TABLE 14-2. The decline in the US savings rate

The table shows the change in the structure of savings in the United States over the past half
century. For most of the period 1959-1981, saving and investment were roughly equal and
high. Later, after 1981, government saving declined as the federal budget moved into deficit. This
decline was favored in the early years of the new millennium, when personal savings and other
private savings plummeted. In the period 2002-2007, most of the capital investment in the United
States was financed by foreign savings, which is the counterpart of the large current account deficit.

Source: Bureau of Economic Analysis.

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306 CHAPTER 14 • MACROECONOMICS IN AN OPEN ECONOMY

the private sector will raise the real interest rate and
reduce equilibrium saving and investment.
Equilibrium of an open economy. Now consider the
situation of an open economy, where the world financial
markets are. an open economy
ta has alternative sources of investment and options for
use for savings. Simplify the case by assuming that the
economy is small and cannot affect interest rates in the
world. This situation is illustrated in Figure 14-8: a small
open economy with high capital mobility. A small open
economy must set its domestic interest rate equal to the
real world interest rate, rW. Since financial markets are
open, international capital flows will match domestic and
foreign interest rates.
Figure 14-8 helps explain the determination of
saving, investment, and net exports in an open economy.
At the interest rate prevailing in the world, domestic
investment shows up at point A, which is the intersection
of the investment curve and the interest rate. Total
national saving is given by point B on the total saving
curve, ST G. The difference between them—given by
the segment of line AB —is net exports. (This equality
is shown by the saving-investment identity in the box on
page 304.)
Therefore, net exports are determined by the
difference between national savings and national
investment, which in turn depends on domestic factors
and the world interest rate.

S+TG

Yo

C. x
w r w
interest
rate
real

r
A B.

Yo

exports
I domestic domestic s
net
I, S, X
Investment, savings, net exports
FIGURE 14-8. Saving and Investment in a Small Open Economy
Household investment and saving are determined by income, interest rates, and
government fiscal policy, as in Figure 14-7. But the real interest rates of a small open
economy with free movement of capital are determined in world financial markets. At
the relatively high real interest rate rW , domestic saving exceeds domestic investment,
and excess saving flows into more lucrative investment opportunities abroad. The
difference between national saving and domestic investment is net exports (also
equivalent to net foreign investment), shown as X in the figure. A trade surplus, as
seen in the cases of Japan and China, is the consequence of the interaction between
high domestic savings and low domestic investment.
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B. INTERDEPENDENCE IN THE GLOBAL ECONOMY
This exposition refers to the mechanism by which
a country adjusts its trade, savings and investment. In
this case it is the exchange rate that plays the crucial
role in reaching equilibrium. Changes in exchange
rates are the mechanism through which savings and
investment are adjusted. In other words, exchange
rates move to ensure that the level of net exports
balances the difference between domestic savings
and investment.
This analysis helps to explain the trends, in recent
years, in saving, investment and trade patterns in the
main industrialized countries. Figure 14-8 well
describes Japan's role in the world economy. It is
traditional for Japan to have a high domestic savings
rate. But in recent years—because of high domestic
production costs and competitive conditions in
neighboring newly industrializing countries—the return
on Japanese capital has been depressed. Therefore,
Japanese savings have sought destinations abroad,
which has resulted in a high trade surplus and strong
net exports from that country.
The United States, for its part, has undergone an
interesting shift in its savings and investment position,
as shown in Table 14-2. Until 1980 the United States
had a moderately positive net export position. But in
the early 1980s, the US government's fiscal position
turned sharply toward deficit. This can be illustrated
by a new ST – G line in Figure 14-8, which intersects
the real interest rate line at point C. Total national
saving can be seen to decline with a larger government
deficit. Domestic investment remains unchanged. Net
exports turn negative and are given by the distance
CA.
This analysis also explains the mechanism through
which net exports adjust to provide the necessary
investment when the government runs a budget deficit.
Consider the case of a country with a net export
surplus such as that shown in Figure 14-8. Suppose
the government suddenly starts running a large budget
deficit. This change will cause an imbalance in the
savings-investment market, which would tend to put
upward pressure on domestic interest rates in relation
to
with the world interest rate. The rise in the domestic
interest rate will attract funds from abroad and will lead
to an appreciation of the exchange rate of the country
that incurs the deficit. The appreciation will lead to a
decrease in their exports and an increase in their
imports, or to a reduction in net exports. This trend will
continue until net exports have dropped as low as
307
enough to close the gap between saving and
investment.
Other important examples of saving investment
theory, in the case of a small open economy, are the
following:
• An increase in private saving or lower government
spending will raise national saving, as indicated by
the right shift of the national saving curve in Figure
14-8. This will cause the exchange rate to
depreciate until net exports have increased
sufficiently to balance the increase in domestic
savings.
• A pick-up in domestic investment triggered by a
better business climate or a wave of innovations
will lead to an appreciation of the exchange rate
until net exports fall enough to balance saving and
investment. In this case, domestic investment
displaces foreign investment. • An increase in
world interest rates
reduces the level of investment. This will lead to a
widening of the difference between savings and
investment, a depreciation in the exchange rate
and an increase in net exports and foreign
investment. (This would be illustrated by a
movement along the investment curve.)
Table 14-3 summarizes the main results for the
case of a small open economy. Make sure you can
work the cases of declines in the government's fiscal
deficit, in private saving, in investment, and in world
interest rates. This helpful table and its explanation
deserve close study.1
The integration of a country into the world economy
adds an important new dimension to macroeconomic
performance and policy. The main conclusions are:
• The external sector is an important source of
financing for domestic investment and offers a
possible outlet for domestic savings. • Higher
domestic savings—whether in the form of higher
private or public savings—will lead to higher net
exports.
one
This exposure covers “small” open economies that cannot
influence world interest rates. In the case of “large” open
economies, such as the United States, the impact would be
somewhere between the small economy and the closed
economy. This more complex case is covered in intermediate
level books (see the Further Reading section in Chapter 4).
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308 CHAPTER 14 • MACROECONOMICS IN AN OPEN ECONOMY
Change in policy or exogenous variable
Increase in G or decrease in T
Increment in private S
Increase in investment demand
Increase in world interest rates
TABLE 14-3. Major conclusions of the savings-investment model in small open
economies
Make sure you understand the mechanism by which each of these cases occurs.
• A country's trade balance is a reflection of its
national savings and investment balance, rather
than its productivity or absolute wealth. •
Adjustments in a country's trade accounts require a
change in domestic savings or investment. • In the
long term, the adjustments in the trade accounts
will derive from movements in the relative prices of
the country, often through movements in the
exchange rate.
THE PROMOTION OF GROWTH
IN AN OPEN ECONOMY
Raising output growth in an open economy requires
more than just creating a magic ticket that attracts
investors or savers. A favorable saving and investment
climate encompasses a wide range of policies, as well
as a stable macroeconomic environment, well-
established property rights, and, above all, predictable
and attractive returns for investment. This section
reviews some of the ways that open economies can
improve their growth rates by using the world market
to their advantage.
In the long term, the single most important way to
raise per capita output and living standards is to
ensure that the country adopts best practice techniques
in its production processes. There is no point in having
a high investment rate if investments are allocated to
the wrong technology. This point was amply
demonstrated in the later years of Soviet central
planning (discussed in Chapter 12), when the rate of
investment was extremely high, but much of the
investment was poorly planned, left unfinished, or was
assigned to unproductive sectors.
Furthermore, individual poor countries do not need
Modification in Change in the change in
the exchange rate investment net exports
and
0 x
and
0 x
and Yo x
and Yo x
Start from scratch to design your own turbines,
machinery, computers, and management systems.
Often, to reach the technological frontier it is enough
to form strategic alliances with foreign companies,
which in turn requires that the institutional framework
be welcoming to foreign capital.
Another important set of policies is that of trade
policies. Evidence shows that free trade promotes
competitiveness and the adoption of best practice
technologies. By keeping tariffs and other barriers to
trade low, countries ensure that domestic firms feel
the spurs of competition, and that foreign firms are
allowed to enter domestic markets when domestic
producers sell at inefficient prices. high or monopolize
specific sectors.
When countries consider their saving and
investment, they should not focus only on physical
capital. Intangible capital is of similar importance.
Studies corroborate that countries that invest in human
capital through education tend to perform well and are
more resilient to shocks. Many countries have a
valuable inventory of natural resources—forests,
minerals, oil and gas, fisheries, and arable land—that
must be carefully managed to provide maximum return.
One of the most complex factors in the growth of
a country refers to immigration and emigration. In its
history, the United States has attracted large flows of
immigrants who have not only increased the size of its
labor force, but have also raised the quality of its
culture and scientific research.
More recently, however, immigrants have brought with
them less education and fewer skills than the domestic
labor force. As a result, according to some studies,
immigration has depressed the relative wages of low-
income workers.
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B. INTERDEPENDENCE IN THE GLOBAL ECONOMY 309

income in the United States. Countries that “export”
labor, such as Mexico, obtain a continuous flow of
remittances that workers send to their families in their
country of origin, and this can be a good complement
to export earnings.
One of the most important, but subtle, influences
concerns market institutions. The most successful
open economies—such as the Netherlands and
Luxembourg in Europe, or Taiwan and Hong Kong in
Asia—have offered a safe environment for
entrepreneurial investment and talent. This required
the establishment of a set of property rights, guided
by the rule of law. Something that is increasingly
important is the development of intellectual property
rights, so that inventors and artists can be certain that
they will be able to obtain some benefit from their
activities. Countries must fight corruption, which is a
kind of private tax system, which preys on the most
lucrative companies, creates
Uncertainty about property rights drives up costs and
freezes investment.
A stable macroeconomic climate means that taxes
are reasonable and predictable and inflation is low, so
lenders don't have to worry about inflation seizing their
investments. It is crucial that the exchange rate be
relatively stable, with convertibility allowing easy and
relatively cheap trading of the local currency. Countries
that offer a favorable institutional structure attract
strong inflows of foreign capital, while countries with
weak institutions attract relatively little foreign funding
and suffer from “capital flight” when local residents
transfer their funds abroad to avoid paying bills. taxes,
expropriation or loss of value.
Figure 14-9 illustrates the impact of the investment
climate on national investment. The left panel re

a) Low-risk country b) High-risk country

r high risk wr risk premium

Risk
Domestic
interest
rate
real Domestic
interest
rate
real

premium

low risk r w
r
wr wr
Go)
Go)

Yo
low risk Yo
high risk
Investment Investment

FIGURE 14-9. The business climate affects the interest rate and the level of investment
In the low-risk country, a), a stable economic climate leads to a low domestic interest rate
at r w
and at a high level of investment in I low risk. In the high-risk country,
dominated by political conflict, corruption, and economic uncertainty, investors require a
large risk premium for their investments, so the domestic interest rate is well above the
average. world interest rate. The result is a decline in the level of investment, as foreign
investors seek safer ground.
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310 CHAPTER 14 • MACROECONOMICS IN AN OPEN ECONOMY
presents a country that has a favorable climate for
investment; so the domestic interest rate is equal to the
world interest rate. The overall level of investment will
be high there, and the country will be able to attract
funds from abroad to finance domestic investment.
Panel b) shows a high-risk country. Turn back to
Figure 12-2, which shows the premium on emerging
market bonds. In periods of crisis, these countries could
pay interest rates of 8, 10 or 12 percentage points above
the rate paid by investors in advanced countries. This
high risk premium could arise from high inflation,
unpredictable taxes, nationalizations, default, corruption,
an unstable exchange rate, or sometimes just panic and
contagion. Therefore, the real cost of capital would
certainly be high. The high-risk country will have trouble
attracting foreign and domestic investment , and the
final level of investment will be low.
Compare the equilibrium level of investment in the low-
risk country panel a) with the high-risk country panel b).
Promoting economic growth in an open economy
requires making sure that businesses are attractive to
foreign and domestic investors, who have a wide range
of investment possibilities in the global economy. The
purpose of the policy is to have high rates of savings
and investment in productive channels, and to ensure
that companies apply best practice techniques. Achieving
these goals requires creating a stable macroeconomic
climate, ensuring well-established property rights for
both tangible investment and intellectual property,
allowing free currency conversion so that investors take
home their profits, and maintain confidence in the
political and economic stability of the country.
C. INTERNATIONAL ECONOMIC
AFFAIRS
In this final section, the tools of international economics
are applied to examine two of the central issues that
have been of interest to countries in recent years. The
first part examines the issue related to the difference
between competitiveness and productivity. In the second
part, it delves into the birth of the European Monetary
Union.
THE COMPETITIVENESS
AND PRODUCTIVITY
"The Deindustrialization
of the United States"
Often, when the trade deficit widens, the population
worries about the country's productivity and
competitiveness. A situation of this type occurred in the
United States in the 1980s, and it resurfaced again in
the early years of the new millennium. A review of this
history will be a useful reminder of the determinants of
trade flows.
The appreciation of the dollar in the 1980s led to
severe economic difficulties for many US sectors
exposed to international trade. Industries such as the
automobile, steel, and textile industries found that
demand for their products contracted, to the extent that
the appreciation of the dollar led to higher prices relative
to those of their foreign competitors. Unemployment
soared in the US manufacturing sector, plants were
closed, and the Midwest became known as the "rust
belt."
Many who were not economists interpreted the US
trade problems as an indicator that "the United States
was going into a downright decline." They feared that
America's technological leadership was deteriorating as
a result.
of unfair external competition, excessive regulation, less
innovation and business indolence. Some called for the
cancellation of the North American Free Trade
Agreement (NAFTA).
It was said that the United States was a land condemned
to serve French fries while others manufactured
computer chips.
Economists realized that this was a different
syndrome, a classic ailment of an overvalued exchange
rate. To understand the fundamental aspects, a
distinction must be made between the competitiveness
and the productivity of a country. Competitiveness refers
to the extent to which a country's goods can compete in
the market ; this depends mainly on the relative prices
of domestic and foreign products. Competitiveness
should not be confused with productivity, which is
measured as output per unit of input. Productivity is
essential for improving the living standards of a nation;
in fact, the real income of a country grows according to
the growth of its productivity.
It is true that US competitiveness declined sharply
during the 1980s and again in the early years of the new
millennium. However, these changes
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C. INTERNATIONAL ECONOMIC AFFAIRS
they were not caused by a deterioration in productivity
growth. In fact, productivity grew as much as the trade
deficit. The macroeconomics
They believe that competitiveness was damaged
because the decline in US national savings led to an
appreciation of the dollar, which raised US prices relative
to those of its trading partners.
Productivity Trends The real
story about real US income is not about competitiveness,
but about productivity. Remember that productivity
measures output per unit of input (such as labor hours).
The chapter on economic growth showed that increases
in real wages depend mainly on growth in the productivity
of the national labor force.
Competitiveness is important for trade, but it is not
intrinsically related to the level or growth of real income.
China enjoyed a massive trade surplus in the early years
of the new millennium, at the same time that the United
States was running a large trade deficit. But does this
mean that Americans would be willing to trade their living
standards for those of China, where you pay $1 per hour
worked? The loss of competitiveness in international
markets is a consequence
that the prices of a country misalign with the prices of
its trading partners; does not have a connection
Latin America and the Caribbean
Place occupied in the Global Competitiveness Index
(2009/2008) in descending order
2009 2008
(ICG)
Index
Chili Brazil
Panama Mexico
Barbados Costa Rica
Puerto Rico Uruguay Colombia El Salvador
Source: Own elaboration with data from the World Economic Forum. Annual reports for 2009-2010 and 2008-2009.
311
with the way in which a country's productivity compares
with that of other countries.
Studies of differences in productivity between
countries highlight the importance of competition and
outward orientation. An essential aspect of policy
designed to increase productivity is forcing domestic
industries to compete with foreign firms, which often
have superior, cutting-edge technologies. Foreign direct
investment from the most productive countries (such as
the Japanese automobile plants operating in the United
States) has contributed to a drastic improvement in
productivity, both by introducing cutting-edge technologies
and by stimulating competition. .
THE GLOBAL COMPETITIVENESS INDEX
IN LATIN AMERICAN COUNTRIES
An indicator that captures a large part of the elements
studied in this chapter regarding the competitiveness of
a country and its business climate is the Global
Competitiveness Index (GCI) developed by the World
Economic Forum from 2004.
This index (ICG) is based on twelve pillars, which
provide a comprehensive diagnosis of the global
competitiveness of 133 countries in the world at different
stages of development. The pillars analyzed include 110
indicators linked to institutional quality, infrastructure,
Peru
bolivian
Paraguayan
Guatemala Argentina Trinidad and Tobago Honduras Jamaica Dominican
R. Ecuador RB of Venezuela Nicaragua
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312 CHAPTER 14 • MACROECONOMICS IN AN OPEN ECONOMY
macroeconomic stability, health and human capital
(primary education, higher education and training, among
others), efficiency of the goods, factor and financial
markets, technology, innovation, entrepreneurial talent
and business climate, among other factors. These ratings
are obtained based on both public and private information
obtained through specific studies of the agency and its
network of affiliated institutes.
In its Global Competitiveness Report, 2009, the
World Economy Forum ranked seven economies from
Latin America and the Caribbean in the first half of the
ranking in descending order: Chile (30), Puerto Rico (42),
Barbados (44), Costa Rica (55), Brazil (56), Panama (59),
Mexico ( 60) and Uruguay (65). To contextualize the value
of the index, Switzerland ranked first worldwide in 2009,
with an ICG index of 5.60, while Burundi ranked last, with
a score of 2.58.
Uruguay's performance in this period stands out in
the graph on the previous page, with an advance of ten
places in relation to the 2008 index, Brazil (up eight
places), Trinidad and Tobago (advance of six places),
Colombia and Peru (advanced five places in both cases)
and Costa Rica (advanced four places) in the midst of the
global economic crisis.
Uruguay, the country with the highest degree of
progress in 2009, has implemented a model of continuous
productivity improvement in recent years, supported by an
emphasis on education, public health, and high standards
of institutional quality. Also in the am
macroeconomic bit has had significant achievements in
reducing its public debt, from 116.51% of GDP in 2006 to
53% in 2008. However, it continues to have problems in
terms of labor flexibility, in which its qualification in the
corresponding subindex occupies the 119th place in the
world scale.
Conclusion on productivity and competitiveness.
As the theory of comparative advantage demonstrates,
countries do not have an inherently non-competitive
nature. Rather, they become uncompetitive when their
prices misalign with those of their trading partners. The
surest route to high productivity and high living standards
is to expose domestic industries to world markets and
stimulate vigorous domestic competition with foreign
companies that have adopted the most advanced
technologies.
THE EUROPEAN MONETARY UNION
An ideal exchange rate regime is one that allows for high
levels of relative price forecasting while at the same time
while stabilizing the economy against economic shocks.
In a well-functioning system, people can trade and invest
in other countries without worrying that the exchange rate
will change abruptly and wipe out the profitability of their
operations.
However, since the early 1990s, fixed exchange rate
regimes have been destabilizing rather than stabilizing.
Time and again they were subjected to intense speculative
attacks, which spread by contagion to other countries.
This was seen in Europe in 1991-1992, in Mexico in
1994-1995, in Russia and Southeast Asia in 1997-1998,
and in Latin America from 1998 to 2002.
Nowhere were exchange rate problems more
persistent and deeper than in Western Europe. As a
result, the countries of the European Union took the giant
step of linking their economic fortunes through the
European Monetary Union, which forged a common
currency: the euro.
The Fundamental Trilemma of Fixed Exchange
Rates “You can't have it all” is one of the central
tenets of economics. This happened in
macroeconomic matters on several occasions in
the 1990s. As countries with fixed exchange rates liberalized their
financial markets, they encountered a fundamental trilemma of
fixed exchange rates: A country can have only two of the following
elements: a) a fixed but adjustable exchange rate , b) free capital
mobility and c) an independent domestic monetary policy.
This inconsistency between the three objectives was explained
by Paul Krugman as follows:
The point is that you can't have everything. A country must
choose two out of three. You can fix your exchange rate
without emasculating your central bank, but only if you
maintain controls on capital flows (like China today); it can
free up capital movements and retain its monetary
autonomy, but only if it lets its exchange rate fluctuate (like
Britain or Canada); Or you can choose to free up capital
and stabilize your currency, but only if you give up any
possibility of adjusting interest rates to fight inflation or
recession (like Argentina today, or eventually most of Europe).2
Towards a common currency: the euro
Since World War II, the democratic countries of Western
Europe have sought ever greater economic integration,
with the main aim
2 See the Further Reading section of this chapter.
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C. INTERNATIONAL ECONOMIC AFFAIRS
to promote economic stability after two devastating wars.
Peace and trade go hand in hand, according to many
political scientists. Starting in 1957, with a free trade
agreement, Western Europeans have gradually removed
all trade barriers for goods, services and finance. The
final step in economic integration was to adopt a common
currency. This would not only foster closer economic
ties, but would also solve the problem of currency
instability that plagued previous fixed exchange rate
systems.
Eleven European countries formed the European
Monetary Union (EMU) in 1999. These countries,
sometimes called the Eurozone, have adopted the euro
as their unit of account and medium of exchange. The
first thing was to start transactions in euros. The most
difficult step was on January 1, 2002, when the Eurozone
countries substituted their national currencies for euro
coins and banknotes, saying, in effect: “Au revoir, French
franc; Bonjour, Euro”. The euro launched without a hitch
and now occupies a place among the world's major
currencies.
The monetary structure of the Eu Monetary Union
ropea resembles that of the United States. Control over
European monetary policy is exercised by the European
Central Bank (ECB), which directs the monetary policy
of the signatory countries of the agreement. The ECB
carries out operations on the open market, thereby
determining interest rates for the euro.
One of the great questions of monetary policy refers
to the objectives of the central bank. The ECB, according
to its statutes, must pursue “price stability” as its primary
objective, although it can pursue other goals for the
entire community as long as price stability is not put at
risk. The ECB defines price stability as an increase in
consumer prices in the Eurozone of less than 2% per
year in the medium term.
Costs and benefits of the monetary union
What are the costs and benefits of the European
Monetary Union? Supporters of monetary union identify
important benefits. With a common currency, the volatility
of exchange rates in Europe will be reduced to zero, so
that trade and finance will no longer have to face the
price uncertainty induced by exchange rate shocks. The
first result will be a reduction in transaction costs between
countries. As national financial markets become
segmented, moving to a common currency may allow for
a more efficient allocation of capital between countries.
Some believe that
313
Firm macroeconomic discipline will be preserved by
having an independent European central bank committed
to strict inflation targets. Perhaps the most important
benefit is the political integration and stability of Western
Europe, a region that has been at peace for half a
century now after being at internal wars for most of its
history.
Some economists are skeptical of the wisdom of the
European Monetary Union, pointing out that there are
significant costs to such a union. The overriding concern
is that individual countries will lose the ability to manage
their monetary policy and exchange rates as tools of
macroeconomic adjustment. This matter is related to the
monetary area
optimal ria, a concept first proposed by Robert Mundell
of Columbia, who won the Nobel Prize in 1999 for his
contribution to the field. An optimal currency area is an
area whose regions have high labor mobility or have
common and synchronized aggregate supply or demand
shocks. In an optimal currency area, no substantive
changes to exchange rates are required to ensure rapid
macroeconomic adjustment.
Most economists believe that the United States is an
optimal currency area. When the United States faces a
shock that affects different regions asymmetrically, labor
migration tends to restore balance. For example, workers
left the crisis-ridden northern states and migrated to the
oil-abundant southeastern states after the oil shocks of
the 1970s.
Is Europe an optimal currency area? Some
economists do not think so, due to the rigidity of its salary
structure and the low degree of labor mobility between
different countries. When a shock occurs—for example,
after German reunification in 1990—the lack of wage
and price flexibility led to rising inflation in regions with
higher demand, and a rise in unemployment in depressed
regions. . Therefore, monetary union could condemn
disadvantaged regions to persistent low growth and high
unemployment.
What is the initial verdict on the European Monetary
Union? The creation of the euro has eliminated one of
the great sources of instability in the European economy:
movements in intra-European exchange rates. In
addition, it has caused a convergence of interest rates
and inflation among the European countries. On the
other hand, Europe has continued to experience high
unemployment rates since the introduction of the euro.
The financial crisis of 2007-2009 was the first
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314 CHAPTER 14 • MACROECONOMICS IN AN OPEN ECONOMY
Just a grand test of the European Monetary System,
and economists will have to study how well this new
supranational institution weathers the storm.
The European Monetary Union is one of the great
economic experiments in history. Never before has
such a large and powerful group of countries handed
over their economic destiny to a multinational body
like the European Central Bank. Never before has a
central bank had the responsibility of taking charge of
the destiny of a large group of nations with 325 million
people, who produce goods and services worth 16
trillion dollars. Optimists point to the macroeconomic
benefits of a larger market and lower transaction costs.
But pessimists worry that monetary union is a threat
in terms of stagnation and unemployment, due to a
lack of price and wage flexibility, and insufficient labor
mobility between countries. The financial crisis of
2007-2009 is the first major test of this new monetary
system.
FINAL COMMENTS
This panorama of the international economy reveals a
mixed picture, with successes and failures. It is true
that market economies sometimes suffer from inflation
and recession. Also, in the recent economic contraction
of 2007-2009, unemployment skyrocketed and many
financial giants were on the brink of bankruptcy.
However, if one goes back a bit in time, an impartial
jury of historians would certainly consider that the past
half century was an unprecedented success for the
countries of North America (United States and Canada)
and Western Europe:
RESUME
A. International Trade and Economic Activity 1. An open economy
is an economy that participates in international trade in goods, services,
and investment. Exports are goods and services sold to buyers
located outside the country, while imports are goods and services
purchased from foreigners. The difference between exports and
imports of goods and services is called exports.
nes net.
2. When foreign trade is introduced, domestic demand may differ from
domestic product. the one of
• Robust economic performance. This period has
seen the fastest and most sustained economic
growth in history. It is the only period since the
Industrial Revolution in which these countries have
avoided a deep depression and the cancer of
hyperinflation. • The emerging monetary system. The
international monetary system continues to be a
source of instability, with frequent crises in which
countries face foreign exchange or balance of
payments difficulties. However, a system is
emerging in which the large economic regions—
the United States, Europe, and Japan—conduct
independent monetary policies with flexible
exchange rates, while smaller countries float or
have “hard” fixed exchange rates aligned to one of
the big blocks. A primary challenge for the future
will be to integrate the Asian giants China and
India into the international trading and financial
systems. • The reemergence of the free market. It is
common to hear that imitation is the sincerest form
of flattery. In economics, imitation occurs when
one country adopts the economic structure of
another, in the hope that it will generate growth
and stability. In the past two decades, country after
country has thrown off the shackles of communism
and the crippling rigidity of central planning. This
happened not only because the economics
textbooks explained the miracle of the free market,
but mainly because people could see with their
own eyes how the countries of the West prospered,
while centrally planned command economies took
hold. they collapsed. For the first time, an empire
collapsed because it could not produce enough
butter along with its cannons.
Domestic demand includes consumption, investment and government
purchases (CI G). To obtain GDP, exports (Ex) must be added and
imports (Im) subtracted, so that
GDP CIGX
where X net exports Ex – Im. Imports are determined by domestic
income and output together with the price of domestic goods relative
to foreign goods; exports are the mirror image, determined by income
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RESUME
and external product along with relative prices. The dollar
increase in imports for each dollar increase in GDP is known
as the marginal propensity to import (PMi).
3. Foreign trade has an effect on GDP similar to that of
investment or government purchases. As net exports rise,
there is an increase in aggregate demand for the domestic
product. Therefore, net exports have a multiplying effect on
output. But the spending multiplier in an open economy will
be smaller than in a closed economy, due to the leakage of
spending towards imports. The multiplier is
one
Multiplier in an open economy ____________
PMa PMi
It is clear that, all else equal, the multiplier in an open
economy will be smaller than the multiplier in a closed
economy, where PMi 0.
4. The implementation of monetary policy has new consequences
in an open economy. A pertinent example refers to the
implementation of monetary policy in a small open economy,
which has high capital mobility. Said country must link its
interest rate to that of the countries with which it has aligned
its exchange rate. This means that countries operating with
a fixed exchange rate essentially lose their ability to use
monetary policy as an independent macroeconomic policy
instrument. In contrast, fiscal policy becomes a powerful
instrument because fiscal stimulus is not diluted by changes
in interest rates.
5. An open economy that operates with a flexible exchange rate
can use monetary policy, which operates independently of
other countries, for macroeconomic stabilization. In this case,
international linkages add another powerful channel to the
domestic mechanism of monetary transmission. Monetary
tightness leads to higher interest rates, attracting capital from
abroad and causing a rise (or appreciation) of the exchange
rate. Exchange rate appreciation tends to depress net
exports, so this impact reinforces the restrictive effect of
higher interest rates on domestic investment.
B. Interdependence in the global economy 6. In
the longer term, the operation in the global market offers new
limitations and opportunities for countries to improve their
economic growth. Perhaps the most important element refers
to savings and investment, which are highly mobile and
respond to incentives and the business climate in different
countries.
7. The external sector is another source of funds for investment
and another destination for savings. Higher domestic savings
—either private savings or government fiscal surpluses
315
government—will increase the sum of domestic investment
and net exports. remember the identity
XS ( TG ) I
either
Net exports private savings government
savings domestic
investment
In the long run, a country's trade position primarily reflects its
national savings and investment rates.
Zion. Reducing a fiscal deficit requires changing domestic
saving and investment. An important mechanism for aligning
trade flows with domestic savings and investment is the
exchange rate.
8. In addition to promoting high savings and investment,
countries increase their growth through a wide range of
policies and institutions. Relevant aspects in this regard are
a stable macroeconomic climate, well-established property
rights for tangible investments and for intellectual property, a
convertible currency with few restrictions on financial flows,
and political and economic stability.
C. International economic affairs
9. Popular analysis sees large trade deficits as signifying
"deindustrialization." But this analysis overlooks the important
difference between productivity and competitiveness.
Competitiveness refers to how well a nation's goods can
compete in the global market, and this situation is determined
by relative prices. Productivity denotes the level of output per
unit of input. Real income and living standards depend on
productivity, while current account and trade balance positions
depend on competitiveness. There are no close links between
competitiveness and productivity.
10. Fixed exchange rates are a source of instability in a world of
high capital mobility. Remember the fundamental trilemma of
fixed exchange rates: a country cannot simultaneously have
a fixed but adjustable exchange rate, free capital mobility,
and an autonomous domestic monetary policy.
11. In 1999, European countries decided to move to a common
currency and a single central bank. A common currency is
appropriate when a region forms an optimal currency area.
Supporters of the European Monetary Union point out that its
behavior is more predictable, that transaction costs are
reduced and that there is more room for a better allocation of
capital. Skeptics worry that a common currency—like any
irrevocably fixed exchange rate system—requires flexible
wages and prices to promote adjustment when macroeconomic
shocks occur.
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316 CHAPTER 14 • MACROECONOMICS IN AN OPEN ECONOMY
CONCEPTS FOR REVIEW
CIGX curve in an economy in an open economy
open 1/ (PMa) PMi )
net exports X Ex Im domestic demand impact of trade flows and exchange rates
and spending in GDP marginal propensity on GDP savings-investment identity in
to import (PMi) spending multiplier:
open economies X S
in a closed economy 1/ PMa ( TG ) I
FURTHER READING AND WEBSITES
further reading
Citation from Economic Report of the President, 2000 (Government
Printing Office, Washington, DC, 2000) can also be found at
fraser.stlouisfed.org/ publications/ ERP, pp. 231-235.
Web Sites
Trade and finance data for different countries can be found in the Web
sites section of Chapter 12.
DISCUSSION QUESTIONS
1. Suppose that an expansionary monetary policy leads to a short-
term decline or depreciation of the US dollar, relative to the
currencies of the US's trading partners, with idle resources.
Explain the mechanism by which this will produce an economic
expansion in the United States. Explain how the trade effect
reinforces the impact on domestic investment.
2. Explain the short-run impact of the following events in the multiplier
model on net exports and GDP. Use Table 14-1 whenever
possible: a) An increase in investment (I) of $100 billion
b) A reduction in government purchases (G) of
50 billion dollars
c) An increase in the foreign product that raised exports by 10,000
million dollars d) A depreciation of the exchange rate that
raised exports by 30,000 million dollars and reduced imports by
20,000 million dollars at each level of the GDP
3. What would be the spending multiplier in an economy without
government spending or taxes, where the MPC is 0.8 and the
PMi is 0? Where is PMi 0? Where is the PMi
equilibrium in the savings market
investment in closed and open
economies
growth policies in an open economy
competitiveness and productivity
Robert Mundell won the Nobel Prize in 1999 for his contribution to
international macroeconomics. Visit www.nobel.se/ laureates to read
about their contributions.
The European Central Bank website, at www.ecb.int/ ecb/ html/
index.en.html, explains some of the issues relating to the administration
of the euro. see also
the sites listed in Chapter 12.
0.9? Explain why the multiplier could even be less than 1.
4. Consider Table 14-3.
a) Explain each of the entries in the table. b) Add another
column headed “Changes in Interest Rates” to Table 14-3. Then,
based on the graph in Figure 14-7, fill in the gaps in the table
for a closed economy.
5. A distinguished macroeconomist recently wrote: “Moving towards
a monetary union through the adoption of a common currency is
not really a matter
of coins. The most important factor is that the members of the
union must accept a single monetary policy for the entire region.
Explain this statement. Why might adopting a single monetary
policy cause problems?
6. Take the case of the city of Cielo Nuevo, which has a very open
economy. The city exports reliquaries and has no investment or
taxes. City residents consume 50% of their disposable income
and 90% of all their purchases are imported from the rest of the
country. The municipal president proposes to collect a tax of 100
million dollars to allocate it to a public works program. Mayor
Cains argues that the product and income in the city will rise
considerably
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DISCUSSION QUESTIONS
mind by something called "the multiplier." Estimate the impact of the
public works program on Cielo Nuevo's revenues and product. Do
you agree with what the municipal president said?
7. Review the bulleted list of the three interactions of saving, investment,
and trade on page 307. Prepare a graph like Figure 14-8 to illustrate
each of the impacts. Make sure you can explain the opposite cases
mentioned in the paragraph that follows the list.
8. Politicians often condemn the large US trade deficit. Economists argue
that reducing it would require an increase in taxes or a cut in
government spending. I explained that the point of view of economists
using the savings-investment balance analysis framework of the
Figure 14-8. Also, explain the quote from Economic Report 2000 on
page 295.
9. Go back to Figure 12-2 and make sure you understand it. Now try
applying it to an emerging market country, like Brazil or Argentina. a)
Draw a diagram like the one in Figure 14-9b) for the country in good
economic times, when the risk premium on its credit is low. Name this
diagram figure A. b) Next consider a shock that raises the risk
premium by a large amount. Draw a new diagram with the new
prime and the new equilibrium. Name this diagram figure B. c)
Now compare the equilibria in figures A and B.
Be specific and explain the difference in i) the equilibrium
domestic real interest rate; ii) domestic investment, iii) the
exchange rate and iv) exports .
nes net.
10. Consider the example of small open economies, such as Belgium or
the Netherlands, which have high capital mobility and fixed exchange
rates, but also large government budget deficits. Suppose that
317
These countries are in economic depression, with a low level of
product and high unemployment. Explain why they cannot use
monetary policy to stimulate their economies. Why would fiscal
expansion be effective if they could tolerate higher government
deficits?
11. Advanced problem. After German reunification, expenditures to
rebuild the eastern part of the country led to a large expansion of
national aggregate demand. The German Central Bank responded
by raising real interest rates. These actions had
This took place in the context of the European Monetary System,
where most countries maintained fixed exchange rates and where
the German central bank enjoyed a dominant position in monetary
policy. a) Explain why European countries with fixed exchange rates
and following the lead of the German Central Bank, would find that
their interest rates would rise along with German interest rates.
Explain why the effect would be that other European countries
would sink further into a deep recession. b) Explain why
countries would prefer the European Monetary Union to the previous
system. c) Look for an explanation of why this German monetary
tightness would be expected to lead to a depreciation of the dollar.
Explain why depreciation would stimulate economic activity in
the United States.
Joined.
12. Advanced problem. Reread the definition of the fundamental trilemma,
as well as Paul Krugman's discussion on page 312. Explain why the
three elements cannot go together. Why isn't there a fundamental
trilemma in the system of fixed exchange rates, between "California
dollars" and "Texas dollars"? Explain how the trilemma would apply
to China today. Explain the arguments for and against each of the
three possible options in the trilemma described by Krug.
man.
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PA R.you
AND
C.OR
AyouR.
EITHER

Unemployment,
inflation and
economic policy
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CHAPTER

Unemployment and the bases of

fifteen
aggregate supply

Be nice to people when you go up because you

will meet them when you go down.
wilson mizner

Among the most persistent features of a market economy cient unemployment is the result of slow growth in
are business recessions, when employment and output aggregate demand in relation to potential output. Then
fall, and unemployment rises. the big policy issues related to unemployment are
For most of the period since World War II, the United examined.
States avoided long and deep recessions. However, even
during moderate economic contractions, unemployment
rose and incomes fell sharply.

A. BASES OF THE AGGREGATE

Frequently, and often without warning, countries
experience severe recessions and even depressions that
last decades, so that high unemployment persists for
several years and even a decade. This situation was experienced
in the United States during the 1930s, when the
unemployment rate rose above 10% of the labor force for
10 years.
The world's richest economies entered a recession
during 2007 that became much worse from 2008 to 2009.
Faced with a housing bubble, bankrupt banks, loss of
confidence in the economy, weak investment and a
liquidity trap, the unemployment rate shot up in the period
2007-2009. Although greater knowledge of the
macroeconomy has allowed most countries to apply
countercyclical measures, the prospect of a vigorous
recovery in output and employment is far off.
This chapter presents an analysis of the
macroeconomics of unemployment. Start with the bases
of the aggregate offer. It also shows the way in which a cre
OFFER
In previous chapters, aggregate demand and economic
growth were discussed. This section describes the factors
that determine aggregate supply. In the short term, the
nature of the inflationary process and the effectiveness of
countercyclical policies depend on aggregate demand.
Over a decade or more, economic growth and rising living
standards are closely linked to increases in aggregate
supply.
This distinction between short-run and long-run
aggregate supply is crucial in modern macroeconomics.
In the short run, the interaction between aggregate
supply and demand determines business cycle
fluctuations, inflation, unemployment, recessions, and
booms. But in the long run it is the growth of potential
output through aggregate supply that explains the trend
in output and living standards.
321
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322 CHAPTER 15 • UNEMPLOYMENT AND THE BASIS OF THE AGGREGATE SUPPLY
It is worth summarizing the key points from the beginning:
• Aggregate supply describes the behavior of the production side
of the economy. The aggregate supply curve, or OA curve,
is the curve that shows the level of total national product that
will be obtained at each possible level of prices, everything
else being considered.
tant.
• When analyzing aggregate supply, a fundamental distinction is
made between the long and short terms. The short run, which
corresponds to what happens in periods of a few months to a
few years, is related to the short-run aggregate supply
curve. In the short run, prices and wages have a certain
rigidity. As a result, there will be higher prices with increased
production of goods and services. This is shown as a positive
sloping OA curve . • The long run refers to periods associated
with economic growth, after most elements of business cycles
have been eliminated; refers to a period of several years or
decades. In the long run, prices and wages are completely
flexible. Output is determined by potential output and is
independent of the price level. This long-run aggregate
supply curve is represented as a vertical line.
This section is dedicated to explaining these central points.
SUPPLY DETERMINANTS
ADDED
Aggregate supply depends, fundamentally, on two sets of forces:
potential output and the cost of inputs. Each of these influences
are examined.
Potential Output The key
concept in understanding aggregate supply is potential output , or
potential GDP. Potential output is the maximum sustainable output
that can be obtained without triggering inflationary pressures.
In the long run, aggregate supply depends above all on
potential output. Therefore, the OA curve is determined by the
same factors that influence long-term economic growth: the quantity
and quality of work, the supply of capital and natural resources,
and the level of technology.
In general, macroeconomics uses the following definition of
potential output:
Potential GDP is the highest sustainable level of national
product. It is the level of product that is obtained
dry by removing the influence of the business cycle.
As an operational measure, potential GDP is measured as the
output that would be obtained at a reference level of the
unemployment rate called the nonaccelerating inflation rate of
unemployment (NAIRU ).
Potential product is a growing goal. As the economy grows,
potential output also grows, and the aggregate supply curve shifts
to the right. Table 15-1 shows the main determinants of aggregate
supply, broken down into the factors that affect potential output and
production costs. From the analysis of economic growth it is known
that the primary factors in determining the growth of potential output
are the growth of inputs and technological progress.
The potential product is not the maximum
product.
It is worth noting a subtle point about potential
output: potential output is the maximum
sustainable output, but not the physical limit or absolute maximum
output that an economy can produce. The economy can operate
with output levels above potential output for brief periods.
Factories and workers may work overtime for a time, but
production above potential level is not sustainable indefinitely. If
the economy produces beyond its potential output for a long
time, price inflation will tend to rise as unemployment falls,
factories work harder, and workers and firms try to get higher
wages and benefits, respectively.
A useful analogy is someone running a marathon. Think of
potential product as the maximum speed a marathon runner can
achieve without “overheating” and burning out. Clearly the
competitor may outrun his sustainable pace for some time, just
as the US economy grew faster than its potential growth rate
during the 1990s.
But over the whole race, the economy, like the marathon runner,
can produce only at a certain maximum sustainable "speed," and
this sustainable speed in output is the potential output.
Input Costs Not surprisingly,
higher potential output leads to higher aggregate supply. The role
of costs in OA is less obvious. However, the aggregate supply in
the short term is affected by production costs.
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A. BASES OF THE AGGREGATE OFFER 323

Variable Effect on aggregate supply

potential product
Supplies The supply of capital, labor and natural resources are the important inputs. Potential output is reached
when the use of labor and other inputs is at the maximum sustainable level. The growth of inputs raises
potential output and aggregate supply.
Technology and efficiency Innovation, technological improvements, and greater efficiency raise the level of potential output and
aggregate supply.

Production costs
Wages Lower wages will lead to lower production costs; Lower costs mean that the quantity supplied will be higher at
each price level for a given potential product.
Import prices A reduction in foreign prices or an appreciation of the exchange rate reduces the price of imports. This
nes leads to lower production costs and increases aggregate supply.

Costs of other inputs Lower oil prices reduce production costs and thereby increase aggregate supply.

TABLE 15-1. Aggregate supply depends on potential output and production costs

Aggregate supply is related to the total product supplied at that price level. The OA curve depends on fundamental
factors such as potential output and production costs. The factors listed in the table would increase aggregate supply,
shifting the OA curve down or to the right.

The intuitive explanation is the following: companies
have certain costs that are rigid in the short term.
For example, consider an airline that has a long-term lease
and a multi-year employment contract. If the demand for
air travel increases, the airline will want to add flights and
increase the price of tickets. In other words, both prices
and output increase with an increase in short-run demand.
OA displacements. The effects of changes in costs and
potential product are illustrated in Exhibit 15-1.
The left-hand panel shows that an increase in potential
output with no change in production costs would shift the
aggregate supply curve out of OA to OA. If production
costs were to increase with no change in potential output,
the curve would rise directly from OA to OA, as shown in
Figure 15-1b.

It is also clear that changes in production costs affect
aggregate supply in the short run. For example, see what
happened in the first years of the new millennium, when
the price of fuel for air transport rose in response to the
rise in the price of oil. Airlines were unable to adjust their
operations or ticket prices enough to offset their higher
costs. They were making huge losses. Therefore, they cut
some of their operations, abandoned routes, limited meal
service and temporarily withdrew a substantial number of
aircraft from service. This example illustrates how the cost
of inputs can affect supply behavior.
Table 15-1 shows some of the cost factors that affect
aggregate supply. In these examples, lower costs increase
OA, which means that the OA curve shifts downward.
OA movements in the real world are shown
tran in Figure 15-2. The curves are realistic empirical
estimates for two different years, the recessive year of
1982 and the peak year of 2000. The vertical lines indicate
potential output levels in both years. According to studies
in this regard, the real potential product grew around 72%
in this period.
The figure shows how the OA curve has shifted out
and up over this period. The causes of the outward shift
are the increase in potential output, which originated from
the growth of the labor force and the capital stock, and
improvements in technology. The upward shift was
generated by increases in production costs, such as
wages, oil prices and other inputs of a similar nature.
Adding the cost increases and potential output growth
yields the aggregate supply shift in Figure 15-2.
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324 CHAPTER 15 • UNEMPLOYMENT AND THE BASIS OF THE AGGREGATE SUPPLY

a) Increase in potential product b) Increase in costs

P P OAÿ
potential
potential
product
product
OA

OA OAÿ

Price
level Price
level

Q Q
p Qpÿ Qp
Q
actual product actual product

FIGURE 15-1. How do potential output growth and cost increases affect aggregate
supply?
In a), the growth in potential output with no change in production costs shifts the OA curve
to the right, from OA to OA. When production costs rise, because wages or the price of oil
rise, but with no change in potential output, the OA curve shifts vertically upward from OA to
OA at (b).

Aggregate supply and potential product FIGURE 15-2. In reality, shifts in aggregate
supply combine increases in costs and higher
Q120 p
Q Q
pÿ potential output Between 1982 and 2000, potential
output grew due to increases in the availability of
100 B. capital and labor inputs along with technological
improvements, shifting out the OA curve . At the same
OAÿ curve
time, increases in production costs pushed it up. The
80
in 2000 net effect was to shift the OA curve up and to the right.

60 A
(2000
Price
100)
level
=
OA curve in
1982
40

Potential
Product,
1982 Potential
Product,
2000

twenty

Q
0 2,000 4,000 6,000 8,000 10,000 12,000

Real GDP (billions, 2000 prices)

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A. BASES OF THE AGGREGATE OFFER 325

SHORT ADDED OFFER added. The classic or long-run OA curve is vertical

AND LONG TERMS
How do changes in aggregate supply affect output
and employment? The answer to this question is
different if it is about the short term (which applies to
business cycles) or the long term (which is used in
comparing a country over long periods or in
comparisons between countries). Both approaches
are illustrated in Figure 15-3.
The positively sloping short-run aggregate supply
curve is associated with the analysis called Keynesian
macroeconomics. In this case, changes in aggregate
demand have a significant effect on output. In other
words, this will lead to a drop in product and prices. In
relation to the graphical analysis, this means that the
OA curve is positively sloping, so a fall in AD will lead
to a fall in both prices and output.
The long-run approach, sometimes called classical
macroeconomics, holds that changes in AD affect
prices, but have no effect on actual output. In the long
run, prices and wages adjust completely to changes
in demand.
and, therefore, changes in aggregate demand have
no effect on output.
The reasons for the difference can be summarized
as follows: The short-run OA curve in Figure 15-3a)
indicates that firms are willing to increase their output
levels in response to changes in aggregate demand.
Clearly there must be idle resources in the economy.
But product expansion cannot continue indefinitely.
As output grows, labor shortages appear and plants
operate near full capacity. Wages and prices start to
rise faster. A larger fraction of the response to the
increase in aggregate demand comes in the form of
price increases, and a smaller fraction comes as an
increase in output.
Figure 15-3b) shows what happens in the long run,
after wages and prices have had time to fully react.
When all the adjustments have taken place, the long-
term OA curve becomes vertical or classical. In the
long run, the level of product supplied is independent
of aggregate demand.

short term b) Long term

P P OA
OA

potential
product

potential
product

Price
level Price
level

p Q p Q
Q Q
actual product actual product

FIGURE 15-3. The OA curve slopes upward in the short run, but is vertical in the
long run.
In a), the OA curve in the short run has a positive slope because many costs are inflexible in
the short run. But prices and wages that were inflexible adjust as time passes, so the long-
run OA curve in b) is vertical, and output is determined by potential output. Can you
understand why a Keynesian economist in a) might want to stabilize the economy through
policies that change aggregate demand, while a classical economist in b) would focus mostly
on increasing potential output?
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326 CHAPTER 15 • UNEMPLOYMENT AND THE BASIS OF THE AGGREGATE SUPPLY
Wage and Price Stickiness and the Upward-
Sloping OA Curve Economists generally agree
that the OA curve slopes upward in the short run,
meaning that both output and prices respond to changes
in demand. . It has proven very difficult to develop a
comprehensive theory to explain this relationship, and
the controversies over aggregate supply are among the
hottest in all of economic science.
nomic. Next, one of the important and enduring theories
is described, the one that refers to the rigidity of prices
and wages; but don't be surprised if you hear others as
well.
The puzzle that must be solved is to understand
why companies raise prices and output in the short term
as aggregate demand increases, while in the long term
increases in demand lead mainly to changes in prices.
The key to this puzzle lies in the behavior of prices and
wages in a modern market economy. Some cost
elements of companies are inflexible or rigid in the short
term. As a result of this lack of flexibility, firms can take
advantage of higher levels of aggregate demand by
working for higher output.
For example, suppose a war emergency leads to an
increase in military spending. Firms know that in the
short run many of their production costs are denominated
in dollars: workers are paid $15 an hour, rents are
$1,500 a month, and so on. In response to the increased
demand, companies in general raise the price of their
products and increase their production. This positive
association between prices and output is reflected in
the upward-sloping OA curve in Figure 15-3a).
“Rigid” or “inflexible” costs have been mentioned
repeatedly. What would be some examples? The most
significant is that of wages. Consider the case of
unionized workers. They are usually paid under a long-
term collective agreement that specifies a certain hourly
rate. During the term of the contract, the salary rate that
the company must pay is basically set in dollars. It is
very rare for wages to rise more than once a year, even
for non-salaried workers. It's even rarer for wages and
salaries to go down, except when it's clear that a
company is on the brink of bankruptcy.
Other prices and costs are similarly sticky in the
short run. When a company rents a building, it is
common for the lease to last a year or
more and that the rent is fixed in dollars. In addition,
companies sign contracts with their suppliers to specify
the prices that must be paid for materials or components.
Putting all these elements together, you can see the
rigidity that exists, in the short run, in prices and wages
in a modern market economy.
What happens in the long run? In the end, the
inflexible or rigid cost elements —salary contracts,
leases, and regulated prices, among others— become
more flexible and can be negotiated. Companies cannot
indefinitely take advantage of fixed wage rates in their
collective agreements; workers will soon realize that
prices have risen and will insist on increases in their
wages to make up for the rise. Over time, all costs will
adjust to higher product prices. If the general price level
rises by a certain percentage due to increased demand,
then wages, rents, regulated prices and other costs will
eventually respond by also moving up by a certain
percentage.
Once costs have adjusted upward as much as
prices, firms will no longer be able to benefit from the
higher level of aggregate demand. In the long run, after
all cost elements have been fully adjusted, firms will
have the same price-to-cost ratio as they did before the
change in demand. There will be an incentive for
companies to increase their production. Therefore, the
long-run OA curve tends to be vertical, which means
that the product offered is independent of the price and
cost level.
Aggregate demand differs depending on the period
in question. In the short term, rigid elements in prices
and wages will lead companies to respond to increased
demand, raising both production and prices. In the long
run, when costs respond fully, the entire response to
aggregate demand takes the form of higher prices.
While the short-run OA curve slopes upward, the long-
run OA curve is vertical because, given enough time, all
prices and costs fully adjust.
B. UNEMPLOYMENT
During the recession that began in 2007, the number of
unemployed people in the United States grew by more
than 4 million. Of the 11 million unemployed at the end
of 2008, half "had lost their jobs", they were people who
had been left without a job
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B. UNEMPLOYMENT 327

involuntary way. In previous periods, such as the Great 100

Depression or the early 1980s, the unemployment rate

rose much higher, reaching an all-time high of 25% in 80
1933.
The presence of involuntary unemployment in a force
labor
the
of

60
market economy raises momentous questions: How
can there be millions of unemployed when there is so
much useful work to be done? Is there a flaw in the 40
Percentage
population
status
by
of

market mechanism that forces so many who want to

work to remain idle? On the other hand, is high twenty

unemployment caused primarily by failures in

government programs (such as unemployment 0
insurance) that reduce incentives to work, or by the Teenagers Adults old age

intrinsic properties of a market economy? The remainder inactive Unemployed Employee

of this chapter offers an overview of what unemployment
means and provides some answers to these important
questions.
UNEMPLOYMENT MEASUREMENT
Changes in the unemployment rate make headlines
every month. Look again at Figure 4-3 on page 74 to
refresh your memory on the long-term trend. What is
behind the numbers? Statistics on unemployment and
FIGURE 15-4. Labor force status of population, 2007
How do Americans spend their time? This figure shows
how adolescents (ages 16-19), adults (25-54), and seniors
(65 and over) split their time between employment,
unemployment, and inactivity. Many young workers are out
of the labor force and in school, while the majority of older
workers are retired.
Source: Bureau of Labor Statistics.

the labor force are among the most

detailed and carefully designed and compiled from the

country. Data are collected each month following a
procedure called random population sampling . Every
month 60,000 families or so are interviewed about their
most recent employment history.
The survey divides the population aged 16 and over
into four groups:
• Employees. These are people who do any paid
work, as well as those who have a job but are
absent from work due to illness, strikes or vacations.
• Unemployed. People are classified as unemployed
if they do not have a job, have actively looked for one
in the previous four weeks, and are immediately
available for work. An important point is that
unemployment requires more than just not having a
job, it takes steps to find a job.
Figure 15-4 shows how the population of the United
States is divided into the categories of employed,
unemployed, and inactive. (The situation of the students
is examined in question 6 at the end of this chapter.)
The government uses the definition of labor force
status as follows:
People who have jobs are employed; the one who
does not have a job, but is looking for it, is unemployed;
people without work who are not looking for work, are
inactive or out of the labor force. The unemployment rate
employment is the number of unemployed divided by
the total labor force.
UNEMPLOYMENT IMPACT

High unemployment is both an economic and a social

• Inactive or out of the labor force. This includes
34% of the adult population who take care of
housework, are retired, too sick to work, or just not
looking for work.
• Labor force. This includes all those who are currently
employed or unemployed.
problem. Unemployment is an economic problem
because it represents the waste of a valuable resource.
It is also a huge social problem because it causes
enormous suffering as unemployed workers struggle to
survive on their meager earnings. In periods of high
unemployment, economic distress spills over and
affects people's emotions and lives.
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328 CHAPTER 15 • UNEMPLOYMENT AND THE BASIS OF THE AGGREGATE SUPPLY

Economic impact The futility of the job search can be read in

When the unemployment rate rises, in effect, the
economy discards the goods and services that
unemployed workers could have produced.
How much waste results from high unemployment?
What is the opportunity cost of a recession? Table 15-2
provides an estimate of how much output would fall short of
potential GDP in three periods of high unemployment in the
second half of the last century. The greatest economic loss
occurred during the Great Depression, but the oil and inflation
crises of the 1970s and 1980s also resulted in lost production
of more than a trillion dollars.
The economic losses in periods of high unemployment
are the largest ever documented in a modern economy. They
are many times greater than the estimated inefficiencies in
the microeconomic losses caused by monopolies or by tariffs
and quotas.
Social impact
The economic cost of unemployment is great indeed, but no
monetary figure can reflect the human and psychological
wear and tear caused by long periods of persistent involuntary
unemployment. The personal tragedy of unemployment has
been proven time and time again.
San Francisco during the Great Depression in the following
paragraph:
I got up at five in the morning to go to the pier.
Outside the Spreckles mill, before the gate, were a
thousand men. We knew very well that there would only be
three or four jobs. A subject with two small-sized guards
came out: “I need two men for the squad. Two men who
really work”. The thousand men would fight like a pack of
dogs to get through the gate.
Only four of us would.
Or you can listen to the memories of an unemployed
construction worker:
I called the people who put up the roofs and they didn't need me,
because they already had people who had been working with them
for five or six years. They didn't have that many vacancies. For the
Most of these had to have high school or some college.
And I was looking for any job, from washing cars or
anything else.
So what do you do all day? one goes home and
he sits. And you start to get frustrated staying there.
The family begins to pull out their nails. They all start
arguing over stupid things and the only reason is because
they get stuck in that space all the time. The family feels
crushed by unemployment.
Unemployment is not limited to unskilled labor, like many
administrators, professionals, and

lost production
waste of What
GDP ($, percentage
Average billions, of GDP
unemployment 2008 prices) during the
rate (%) period

Great Depression (1930-1939) 18.2 2,796 30.0

Oil crisis and inflation (1975-1984)
7.7 1 694 2.7
Lethargy after the dot.com
bubble (2001-2003) 5.5 509 1.4

TABLE 15-2. Economic costs of periods of high unemployment The

two major periods of high unemployment since 1929 occurred during the Great Depression and
in the aftermath of the oil shocks and high inflation from 1975 to 1984. Production losses are
calculated as the difference cumulative difference between potential GDP and real GDP. Note that
during the Great Depression, the losses in relation to GDP were 10 times greater than the losses
suffered from the slowdown caused by the oil crisis and inflation. The contraction in the first years of
the new millennium was moderate compared to previous declines.

Source: Authors' estimate based on official GDP and unemployment data.

Machine Translated by Google
B. UNEMPLOYMENT
Well-paid white-collar employees learned from the
corporate downsizing of the past two decades. In this
regard, pay attention to the story of a middle-aged
corporate manager who lost his job in 1988 and was
still unable to get a permanent job in 1992:
I have lost the fight to stay ahead in today's
economy… I was determined to find a job, but as the
months and then the years passed, depression set in.
You can be rejected so many times that you end up
questioning your personal worth.
OKUN'S LAW
The most traumatic consequence of a recession is the
accompanying rise in unemployment. As output
declines, companies need fewer workers, so new ones
are not hired, and those who are working begin to be
laid off. Note that, in general, the unemployment rate
moves inversely with output in the business cycle. This
movement is known as Okun's law:
Okun 's law states that for every 2% drop in GDP
relative to potential GDP, the unemployment rate rises
by almost 1 percentage point.
This means that if GDP starts at 100% of its
potential and drops to 98% of it, the unemployment
rate rises 1 percentage point, from 6 to 7%. Figure
15-5 shows how output and unemployment have
moved together over time.
Output and unemployment trends in the 1990s help
illustrate Okun's law. In the valley of the 1991 recession,
the unemployment rate rose to 7%. At that point it was
estimated that real GDP was 3% below potential
output. Then, over the next eight years, output grew
5% faster than potential output, so in 1999 real GDP
was estimated to be 2% above potential output.
According to Okun's law, the unemployment rate was
to drop from 2.5% (5/2) to 4.5% (7 ÿ 2.5). In fact, the
unemployment rate in 1999 was 4.25%, a remarkably
accurate prediction. This shows how Okun's law can
be used to relate changes in the unemployment rate
to growth in output.
An important consequence of Okun's law is that
real GDP must grow as fast as potential GDP, just to
keep the unemployment rate from rising. In a sense,
GDP has to run just to keep unemployment in the
same place. Also,
329
3
2
okun's law
one
unemployment
(percentage
Change
points)
rate
in
0
one
2
3 4 20246 8
Real GDP growth rate (percent)
FIGURE 15-5. Illustration of Okun's Law, 1955-2007
According to Okun's law, whenever output grows 2% faster
than potential GDP, the unemployment rate falls 1
percentage point. This chart shows that changes in
unemployment are well predicted by the growth rate of
GDP. What output growth would lead to no change in
unemployment according to the line?
Source: US Department of Commerce and Labor.
if the unemployment rate is to be brought down, real
GDP must be growing faster than potential GDP.
Okun's law provides the vital link between the
product market and the labor market. Describes the
association between short-term movements in real
GDP and changes in unemployment.
ECONOMIC INTERPRETATION
UNEMPLOYMENT
Given these facts, the cause of unemployment seems
clear: there are too many workers in the pursuit of too
few jobs. But this simple phenomenon has been a
tremendous puzzle for economists for many years.
Experience shows that prices go up or down to level
out competitive markets. At the market clearing price,
buyers are willing to buy what sellers are willing to sell.
But there is something that is not working well in the
job market, when so many hospitals are looking for
nurses and cannot find them.
Machine Translated by Google
330 CHAPTER 15 • UNEMPLOYMENT AND THE BASIS OF THE AGGREGATE SUPPLY
find, while thousands of coal miners want to work at
going wage but cannot find employment. Similar
symptoms of labor market failure are found in all market
economies.
Turn now to the analysis of unemployment. As with
other economic phenomena, it is convenient to
understand the reasons for unemployment. Why does
unemployment vary so drastically over the business
cycle, as well as why some groups have higher
unemployment rates than others? It will be seen that a
combination of imperfections in the labor market, as
well as personal search dynamics, are behind the
observed behavior.
equilibrium unemployment
First, unemployment is analyzed in the framework of
supply and demand. Consider equilibrium unemployment. employment. Workers unemployed voluntarily may
Equilibrium unemployment arises when people
voluntarily become unemployed by moving from one
job to another, or by entering and leaving the labor force. unemployment, perhaps looking for their first job. Or
This is sometimes known as frictional unemployment
because people cannot move immediately between
jobs. Here are some examples: Someone who works
at a hamburger stand might decide that the pay is too
low or the hours are inconvenient, and they quit to look
for a better job. Others might decide to take a break
between school and their first job. A new mother could
take three months off without pay. These workers have
chosen unemployment over work to find a balance in
their relative preferences for income, job characteristics, Read again the paragraphs about the experience of
fun, and family responsibilities.
This kind of unemployment is in equilibrium because healthy balance between the value of work and the
firms and workers are on their supply and demand
curves. The market is properly cleared in the sense
that workers who want to find a job at current wages,
and under current working conditions, find it, and
companies that want to hire staff by paying market
compensation can do so. . Some economists call this
voluntary unemployment to denote that people do not
have a job because they prefer that state to what the
labor market offers.
Equilibrium unemployment is shown in Figure
15-6(a). Workers have a labor supply curve shown as
OO. The left panel shows the usual picture of
competitive supply and demand, with a market
equilibrium at point E and a wage of W *. In the
competitive, market-clearing equilibrium, firms hire
voluntarily to all skilled workers who wish to work for
market wages. The number of employees is represented
by the line from A to E.
However, even when the market is in equilibrium,
some people would like to work, but only for a higher
wage rate. These unemployed workers, represented
by segment EF, are unemployed in the sense that they
choose not to work for the market wage rate. But this
is equilibrium unemployment in the sense that they do
not work because of their choice between working and
not working, given market wages.
The existence of equilibrium unemployment leads
to an often misunderstood point: unemployment can be
an efficient outcome in a situation where heterogeneous
workers seek work or try out different kinds of
prefer leisure, or other activities, to work under current
wage conditions. Or they may be on frictional
they could be low-productivity workers who prefer
retirement or unemployment insurance to a low-paying
job. There are countless reasons why people would
choose not to work at the current wage rate and still be
counted as unemployed in official statistics.
Disequilibrium Unemployment
the three workers. It is difficult for the situation at the
Spreckles sugar mill to have equilibrium conditions. In
fact, unemployed workers do not seem to seek a
value of play. Nor do they look like people who choose
unemployment while looking for a better job. Rather,
these workers are in a situation of disequilibrium
unemployment. This occurs when the labor market or
the macroeconomy is not working properly, and some
qualified people who are willing to work for current
wages are unable to find employment. Two examples
of imbalance are structural unemployment and cyclical
unemployment.
Structural unemployment means a mismatch
between the supply and demand for work. Mismatches
can occur because demand for one class of labor is
rising, while demand for another class is falling, and
markets do not adjust quickly. Structural imbalances
between occupations or regions are often observed,
when certain sectors grow while others decline. For
example, does
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B. UNEMPLOYMENT 331

a) Balance b) Imbalance

W W

EITHER
EITHER

D. Dÿ

salary
rate

involuntary
Employee unemployment
(dollars
Wage
hour)
rate
per

W**
J h G.
Employee
W* F W*
A AND AND

voluntary D. Dÿ
EITHER
unemployment EITHER

L L
L* L*
(labor force) (labor force)
Work (people) Work (people)

FIGURE 15-6. Equilibrium unemployment and disequilibrium unemployment

The different kinds of unemployment can be illustrated in the macroeconomic supply and
demand framework.
Panel a) shows a normal equilibrium where the market clears with flexible wages.
Here, wages drop to W * to clear the labor market is
unemployment and equalize supply and demand. All
voluntary.

Panel b) shows disequilibrium unemployment, with sticky wages that do not adjust to
clear the labor market. At too high a wage of W **, JH workers are employed, but HG
workers are involuntarily unemployed.

Shortly there arose a severe nursing shortage, as the
number of qualified nurses was growing slowly, while
the demand for their services was growing rapidly in
an aging population. It wasn't until nurse salaries rose
rapidly and supply tightened that the structural nursing
shortage subsided. In contrast, the demand for coal
miners has been depressed for decades given the
lack of geographic mobility of labor and capital; Today,
the unemployment rate in coal mining communities
remains high.
Cyclical unemployment exists when the global
demand for labor falls in line with the downturn in
business cycles, as described in the Keynesian theory
of the business cycle. For example, in the great
recession of 2007-2009, the demand for labor fell and
unemployment rose in virtually all
industries and regions. Similarly, in the long expansion
of the first years of the new millennium, the
unemployment rate actually fell in all entities of the
United States. The consequences of business cycles
on the labor market differ from case to case, from
moderate declines in employment growth to job losses
affecting a significant fraction of the population.
The key to understanding imbalance unemployment
is to see that labor markets are not in equilibrium of
supply and demand, as shown in Figure 15-6b. For
this example, it is assumed that wages are sticky in
the short run at the initial level of W **.
Consequently, when there is a decrease in the demand
for labor and said demand reduces the DD curve in
b), the market wage in W ** is above the wage that
clears the market in W *.
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332 CHAPTER 15 • UNEMPLOYMENT AND THE BASIS OF THE AGGREGATE SUPPLY

labo
forc
(per
Une
rate
of 3.6

3.4

3.2

3.0

2.8 2.8
Unemployment rate

Vacancy rate
6.8

6.4

6.0

5.6

5.2 5.2

2.6 4.8

2.4 4.4

2.2 4.0

(percentage
Vacancy
force)
labor
rate
of

2.0 3.6
2000 2001 2002 2003 2004 2005 2006 2007 2008
Year

Shaded areas are NBER recessions.

FIGURE 15-7. Unemployment rates and vacancy rate

Unemployment and vacancy rates move inversely in the business cycle. This is an
important prediction of the Keynesian stick-wage theory of unemployment.

Source: Bureau of Labor Statistics.

At an excessive wage rate, there are more skilled
workers seeking employment than there are vacancies
requesting workers to fill them. The number of workers
who want to work at wage W ** is at point G on the
supply curve, but firms want to hire only H workers, as
the demand curve shows.
Since the wage exceeds the level that clears the
market, there is a surplus of workers. The unemployed
workers represented by the dashed line segment HG
constitute disequilibrium unemployment.
On the other hand, they are called “involuntary
unemployed”, that is, they are skilled workers who
want to work at the prevailing wage, but cannot find
employment.
The opposite case occurs when the salary is below
the rate that clears the market. Here, in a worker-
shortage economy, employers can't find enough
employees to fill existing vacancies. Companies put
up solicitation signs in their windows, advertise in
newspapers or on Monster.com, and even recruit
people from other cities.
Figure 15-7 shows the vacancy rate along with the
unemployment rate for the past decade. both curves
they are inversely related, as predicted by the sticky
wage theory shown in Figure 15-6.
The college admissions analogy. The college
admissions example illustrates the kind of adjustment
that takes place when there is a shortage or a surplus
because prices do not adjust. Many universities have
been favored with an unusual number of
applications for admission in recent years. How did
they react? Did tuition increase enough to eliminate
excess demand? No, they raised their admissions
standards, demanding better high school grades and
better SAT score averages. Raising requirements
instead of changing prices and wages is exactly what
happens in the short run, when firms experience an
excess supply of labor.
Macroeconomic Bases of Wage
Stickiness
Economists have made many approaches to
understanding the macroeconomic bases of
unemployment. This issue continues to be one of the
deepest unknowns still unsolved in macroeconomics.
Machine Translated by Google
B. UNEMPLOYMENT
modern. This analysis underscores the importance of
price and wage stickiness. But this leads to the next
question: Why are prices and wages sticky? Why don't
wages go up and down to clear the market?
These are controversial questions. Few economists
today would support moving wages quickly to eliminate
labor shortages or surpluses. But no one fully understands
the reasons for the lethargy in the response of prices and
wages. Therefore, it is only possible to offer a tentative
assessment of the sources of wage rigidity.
Auction markets and managed markets. A useful
distinction is that of auction markets and managed markets.
An auction market is a
very organized and competitive market where the price
floats up or down to balance supply and demand. For
example, at the Chicago Board of Trade the price of
“number 2 red durum wheat delivered to Kansas City” or
“rotisserie 'A' chickens delivered to New York” changes
every minute to reflect market conditions. .
Auction markets are the exception. Most goods and
all labor are sold in managed markets. No one qualifies
workers as "grade B web developer" or "class AAA
economics assistant professor." No market specialist
ensures that every job and worker will soon be matched to
a wage that clears the market.
Rather, most companies manage their wages and
salaries by setting pay scales and hiring people at a base
wage or salary. These salary scales are usually set for a
year or two and when they are adjusted, the pay goes up
for all categories. For example, each pay level at a hospital
could receive a 4% increase for this year. Sometimes the
company might decide to move up or down a category
from the average. Under standard procedures, companies
will make only partial adjustments when there is a shortage
or surplus in a particular area.
In unionized labor markets, wage patterns are even
more rigid. Salary scales are usually set by contract for a
period of three years; in that period there are no salary
adjustments if there is a shortage or surplus in specific
positions.
Menu costs of price and salary adjustments.
What is the economic reason for the rigidity of wages and
salaries? Many economists believe that the stickiness
stems from the costs of administering offsets.
333
(known as “menu costs”). To take the example of unionized
wages, negotiating a contract is a lengthy process that
requires a lot of union and management time, and yields
no product. Because collective bargaining is so expensive,
these agreements are usually only negotiated once every
three years.
Establishing compensation for non-union workers is
less expensive, but still requires little management time
and has significant effects on employee morale. Every
time wages and salaries are set, every time additional
benefits are modified, compensation agreements are also
modified. Some workers believe the changes are unfair,
others will complain that the procedures are unfair, and
complaints may be triggered.
Consequently, personnel managers prefer a system in
which wages are rarely adjusted and most employees
receive the same pay increase, regardless of market
conditions for different skills or categories. This system
may seem inefficient because it does not allow for a perfect
adjustment of wages to reflect market supply and demand.
But it does save the scarce
managers' time and helps promote a sense of fair play and
equity in the company. Ultimately, it may be cheaper to
more aggressively recruit workers or change required
specifications than to upset a company's entire wage
structure just to hire a few new employees.
The microeconomic fundamentals can be summarized
cos as follows:
Most wages in market economies are administered by
companies or contracts.
Wages and salaries are infrequently adjusted due to the
costs of bargaining and wage setting. When labor supply
and demand change, given wage stickiness, the reaction
is reflected primarily in the number of workers employed,
rather than in wages.
RELEVANT MARKET ISSUES
LABOR
After analyzing the causes of unemployment, now the
major labor issues of today are studied.
Which groups are most likely to be unemployed? How
long will they be unemployed?
What explains the differences in unemployment in the different
countries?
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334 CHAPTER 15 • UNEMPLOYMENT AND THE BASIS OF THE AGGREGATE SUPPLY

Distribution
Unemployment rate of of total unemployment
different groups (% of between different groups
labor force) (% of total unemployment)

Crest Crest
labor market group Valley (March Valley (March
(1982) 2000) (1982) 2000)

By age:
16 -19 23.2 13.3 18.5 20.2
20 years and over 8.6 3.3 81.5 80.0
By breed:
Whites 8.6 3.6 77.2 77.6
blacks and others 17.3 7.3 22.8 22.4

By gender (adults only):

Men 8.8 3.8 58.5 50.5
Women 8.3 4.3 41.5 49.5

All workers 9.7 4.1 100.0 100.0

TABLE 15-3. Unemployment by demographic groups

This table shows how unemployment varies between different demographic groups in peak and trough years. The
first group of figures shows the unemployment rate for each group in 1982 and during the peak period of 2000. The
last two columns show the percentage of the total pool of unemployed that corresponds to each group.

Source: US Department of Labor, Employment and Earnings.

Who are the unemployed?
It is possible to diagnose labor market conditions by
comparing years in which output is above its potential
level (a recent period of this type is 1999-2000) with
years of deep recession (such as 1982). . The
differences between these years show how business
cycles affect the amount, sources, duration, and
distribution of unemployment.
Table 15-3 shows unemployment statistics in peak
and trough years. The first two columns of numbers
are the unemployment rates by age, race, and gender.
These data show that the unemployment rate for each
group tends to rise in recessions. The last two columns
show how total unemployment is distributed among
the different groups; note that the distribution of
unemployment across groups changes relatively little
throughout the business cycle.
Note also that white workers tend to experience
unemployment rates that are more than double those
of whites, in both peak and trough years.
Until the 1980s, women tended to have higher
unemployment rates than men; but in the
Over the past two decades, unemployment rates have
shown little difference due to gender. Adolescents,
with high frictional unemployment, generally had much
higher unemployment rates than adults.
duration of unemployment
Another key question concerns duration. How much
of the unemployment is long-term and of greatest
social concern, and how much is short-term as people
rush between jobs?
Figure 15-8 shows the duration of unemployment
in the period 2000-2007. A striking feature of US labor
markets is that a very large fraction of unemployment
is short-term. In 2003, a third of unemployed workers
were out of work for less than five weeks, and long-
term unemployment was somewhat rare.
In Europe, with less mobility and greater legal
obstacles to economic change, long-term unemployment
in the mid-1990s reached 50% of the unemployed.
Long-term unemployment is a serious social problem
because the resources
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B. UNEMPLOYMENT 335

40 worked. The average duration of adolescent

35 unemployment is only half that of adult unemployment;
30 in contrast, the average length of a typical job is 12
25 times longer for adults than for teens. In most years,
twenty
half of unemployed teens are “new entrants” who have
unemployed
Percentage
all
of

never had paid employment before.

fifteen

10
All these factors suggest that adolescent unemployment
5
is above all frictional; In other words, it represents the
0 job search and the rotation necessary for young people
<5 5-14 15-26 > 26
Weeks to discover their personal skills and learn what work is.
FIGURE 15-8. Duration of unemployment in the United
States, 2000-2007 But in the end, teens learn the skills and work habits
of more experienced employees. Gaining experience
Most unemployment is short-term in the United States. This
and training, coupled with a greater need and desire for
suggests a frictional interpretation where people move quickly
between jobs. a full-time job, is the reason many middle-aged workers
have much lower unemployment rates than teens.
Source: Bureau of Labor Statistics.

of families—savings, unemployment insurance, and Adolescent unemployment in minority groups.

good relationships with each other—begin to dry up
after just a few months.
Sources of joblessness Why
are people unemployed? Figure 15-9 shows how people
responded when asked the source of their unemployment, and unemployment rates for black and white adolescents
beginning with the recession of 1982 and the full
employment year of 2000.
There is always some frictional unemployment that
results from changes in people's place of residence or
life cycle: moving, entering the labor force for the first 16-19) were employed, compared to 35% of white teens.
time, etc. The big changes in the unemployment rate
during the business cycle arise from the increase in
those who lose their jobs. This source grows too large
in a recession for two reasons: first, because the number cos.
of people who lose their jobs rises, and second, because
it takes longer to find a new job.
Unemployment by age
How does unemployment vary over the life cycle? In
general, teens have the highest unemployment rate of
any demographic group, and non-white teens in recent
years have experienced unemployment levels between
30 and 50%. Is this unemployment frictional, structural
or cyclical?
Recent evidence suggests that, particularly for
whites, teen unemployment has a large frictional
component. Adolescents leave and enter the labor
market very frequently. Consi
find jobs quickly and often change jobs
Even though most of the evidence suggests that
unemployment is essentially frictional for white
adolescents, the labor market for young African
American workers has shown a rather different face. In
the first 10 years after World War II, the participation
were actually identical. Since then, however, black teen
unemployment rates have risen substantially relative to
other groups, while their labor force participation rates
have declined. By 2008, only 20% of black teens (ages
What is the explanation for this extraordinary
inequality of the experience of minority adolescents
with other groups? One reason could be that labor
market forces (such as the composition or location of
jobs) have worked against black workers in general.
This explanation does not tell the whole story. Although
adult black workers have consistently suffered higher
unemployment rates than adult whites—because of low
educational attainment, less contact with people who
might offer them employment, restricted job training,
and racial discrimination—the reason for unemployment
rates
employment of adult blacks to whites has not increased
since World War II.
Not even the numerous studies of the rising
unemployment rate among black adolescents have
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336 CHAPTER 15 • UNEMPLOYMENT AND THE BASIS OF THE AGGREGATE SUPPLY

Valley Causes of

unemployment (percentage
of the labor force that is
unemployed for different reasons)

lose job 5.7

Crest

2.2 1.8 lose job

Re-entry

1.3 Re-entry
New entry 1.1
0.3 New entry
quits job 0.8 0.5 quits job
1982 2000
FIGURE 15-9. The distribution of the causes of unemployment, 1982
and 2000 Why do people become unemployed? Very few were unemployed in the 2000
full employment year because they lost their job, and almost 2% were new entrants to the
labor force (for example, recent college graduates) or re-entries (people who previously
exited the labor market and is back looking for a job). However, the big shift in unemployment
from peak to trough is in the number of job losers. From 1982 to 2000, the fraction of workers
who became unemployed because they lost their job fell from 5.7 to 1.8%.

Source: Bureau of Labor Statistics at www.bls.gov/ data.

provided a clear explanation of this trend. One possible
source is discrimination, but for this it would be
necessary to observe a rise in the disbursement differential.adolescent unemployment in minority groups.
white-black employment, even with greater legal
protections for minority workers. Another theory holds
that a high minimum wage, coupled with rising benefit
costs, tends to push low-productivity black adolescents
into unemployment.
Does high teen unemployment do lasting damage
to the labor market, with skills levels and wages always
low? This question is a current topic of intense
research, and the tentative answer is yes, particularly
for minority adolescents. It seems that when young
people are unable to develop job skills and attitudes
on the job, they get lower wages and suffer from higher
unemployment when they are older. Is with
This conclusion suggests that public policy has a
fundamental role in the design of programs to reduce
Unemployment Trends in the United
States and Europe Unemployment rates
in the United States and Europe show
mixed trends in recent years. Unemployment
in Europe was low until the supply shocks in the 1970s
and has been relatively high ever since. Unemployment
rates in the United States have generally been lower than
those in Europe over the past 25 years. Figure 15-10
shows the history of unemployment rates in both regions.
How to explain the divergence of labor markets in
both regions? It is likely that part of the reason lies in
differences in macroeconomic policies. During
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B. UNEMPLOYMENT 337

12
Creation of
10 the euro zone

USA
8

Unemployment
(percent)
rate

4
European Union (15)

0 1970 1975 1980 1985 1990 1995 2000 2005 2010

Year

FIGURE 15-10. Unemployment in the United States and

Europe While unemployment has remained low in the United States, in Europe it has
risen too high in the past 20 years. Many believe that the rising unemployment was caused
by the rigidity of the labor market, while others believe that the responsibility must be attributed
to a fragmented monetary policy. With the introduction of the euro and the integrated European
Central Bank in 1999, unemployment in Europe has gradually declined.
Source: US Department of Labor, OECD and Eurostat. The data are for the 15 countries of the European Union.

For nearly a century, the United States has had a single
central bank, the Federal Reserve (Fed), which keeps a
careful eye on the US economy. When unemployment
starts to rise, the Fed cuts interest rates to stimulate
aggregate demand, increase output, and dampen
unemployment growth.
Until recently, central banking in Europe was
fragmented. Until 1999, Europe was a confederation of
countries whose monetary policies were dominated by the
German central bank, the Bundesbank. The Bundesbank
was too independent and aimed above all at maintaining
price stability in Germany. When unemployment rose in
the rest of Europe and inflation rose in Germany—as it did
after German reunification in 1990—the Bun disbank raised
interest rates. This tended to depress output and raise
unemployment in countries whose monetary policies were
tied to Germany's. This syndrome can be seen in the
increase in unemployment in Europe after 1990.
A second characteristic of European unemployment
refers to a growing structural unemployment. Europe was
the birthplace of the welfare state; Countries like Germany,
France, and Sweden approved generous social assistance
measures, unemployment insurance, minimum wages, and
job protection. These policies tend to increase real wages
because workers have greater bargaining power and more
attractive options for occupying their time.
People who collect money under welfare or unemployment
may be involuntarily unemployed but are generally counted
as unemployed in current statistics. The United States has
been less generous in its welfare and unemployment
policies.
What is the remedy for the high level of unemployment
in Europe? Some economists emphasize reducing barriers
in labor markets and welfare measures. Other economists
believe that the new European Central Bank can maintain
a better balance of aggregate supply and demand in that
region. (Remember the explanation of the European
Monetary Union in Chapter 14.) It turns out that European
unemployment has declined since the introduction of the
euro in 1999, although it is still above the level of
unemployment in the United States.
In this new millennium the results in the market
Latin American labor market have been favourable,
registering continuous improvements in real wages, a
permanent creation of jobs in the formal sector and a
recovery of the minimum wage. It should be noted,
however, that these improvements have not been
homogeneous among the countries of the region, which
is why some have chosen to emphasize labor flexibility,
others ponder the creation of formal jobs and others po
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338
300
2 250
0
B. 0 200
a 0
150
yes
=
and
100
one
0
0 fifty
Brazil
Argentina
Formal employment Real average wages Real Minimum Wage
Source: Own elaboration with data from the Center for Latin American Studies (CEPAL) and the International
Labor Organization (ILO).
They need to guarantee a significant recovery of the
minimum wage, even well above the increase in
general real wages, as can be seen in the graph.
Unemployment has also managed to fall gradually
in the region, but it continues to be high, partly as a
result of greater labor participation, which according to
figures from household surveys, exceeds the 1990
level by 2.4%. fundamentally due to the increasing
insertion of women in the labor market.
However, the regional panorama is less
encouraging going forward, both in the short term, due
to the global recessive environment, and in a longer-
term scenario, since structural problems persist linked
to the great magnitude of informality and the scarce
incorporation. poration of the population to social
assistance mechanisms.
The situation of the labor market is especially
relevant for Latin America, since according to studies
by the International Labor Organization (ILO) and the
Center for Latin American Studies (CEPAL),
remuneration from work represents about 79% of the
household income. Thus, the labor market continues
to be a determining factor in the high social inequalities:
in the countries of the region, labor income explains
between 71
CHAPTER 15 • UNEMPLOYMENT AND THE BASIS OF THE AGGREGATE SUPPLY
Latin America. Labor indicators Selected countries 2008
Chili Peru
Mexico Panama
Nicaragua Uruguay
Guatemala
Costa Rica
and 92% of inequality measured by the Gini coefficient.
And even though the unemployment rate in the poorest
decile of households fell from 30.2 to 23.8% between
2002 and 2006, the gap with the richest decile still
exceeds 20 percentage points.
In the region's labor markets, structural and racial
and gender equity problems also persist, such as
higher unemployment among women, youth, and
minority ethnic groups. Youth unemployment showed
a sharp decline between 2002 and 2006, but remains
much higher than for other age groups. Racial
differences also persist. According to ILO data, higher
unemployment rates are observed among people of
African origin and indigenous people compared to the
rest of the population in several countries, such as
Ecuador, Chile, Uruguay, Brazil and Mexico. For
example, in the Brazilian labor market, in 2006 the
unemployment rate for white men was 5.6%, compared
to 7.1% in the case of men of African descent and
12.5% in the case of women of the same origin. The
Inter-American Development Bank (IDB) verifies these
results in a study carried out in the middle of
2009 where he finds differences in remuneration by
race and gender: with respect to the latter, the average
salary is up to 18% lower in the case of women.
Machine Translated by Google
RESUME
RESUME
A. Bases of aggregate demand
1. Aggregate supply describes the relationship between the output that
firms are willing to produce and the general price level, all other things
being equal. The factors underlying aggregate supply are a) potential
output, determined by the inputs of labor, capital, and natural resources
available in an economy, together with the technology or efficiency with
which these factors of production are used, and b) the cost of inputs,
such as wages and the price of oil. Changes in these underlying factors
will shift the OA curve.
2. A fundamental distinction in OA analysis is that of the
long and short terms. The short term, which corresponds to the behavior
in business cycles from a few months to a few years, refers to the short-
term aggregate supply. In the short run, prices and wages are somewhat
rigid. As a result, higher prices are associated with increases in the
production of goods and services. This is shown as a positively sloping
OA curve . The short-run analyzes of OA and DA are used in the
Keynesian analysis of business cycles.
3. The long run refers to periods associated with economic growth, after
most elements of the business cycle have been eliminated. In the long
run, prices and wages are perfectly flexible; output is determined by
potential output and is independent of the price level. The long-run
aggregate supply curve is vertical. The long-run OA and AD analyzes
are used in the classical analysis of economic growth.
B. Unemployment
4. The government collects monthly statistics on unemployment, employment,
and the labor force in a population sample. Employed people are
included in the category of employed; those who do not have a job but
are looking for work are said to be unemployed; and unemployed people
who are not looking for work are considered to be out of the labor force
or inactive.
5. There is a clear connection between movements in output and the
unemployment rate in the business cycle. According to Okun's law, for
every 2% drop in real GDP relative to potential GDP, the unemployment
rate rises 1 percentage point. This rule is useful for translating cyclical
movements in GDP into movements in unemployment.
6. Economists distinguish between equilibrium unemployment and
disequilibrium unemployment. Equilibrium unemployment arises when
people leave work for their
339
will when moving between jobs, or in and out of the labor force. This is
also known as frictional unemployment.
7. Disequilibrium unemployment occurs when the labor market or
macroeconomy is not working properly, and some qualified people who
are willing to work for going wages cannot find employment. Two
examples of imbalance are structural unemployment and cyclical
unemployment. Structural unemployment occurs when workers are
found in regions or industries that are persistently lethargic due to
imbalances in the labor market or high real wages. Cyclical unemployment
is a situation in which workers are laid off when the global economy
it contracts.
8. Understanding the causes of unemployment has turned out to be one of
the main challenges of modern macroeconomics.
The discussion here highlights that involuntary unemployment arises
because slow wage adjustment produces surpluses (unemployment)
and shortages (vacations) in individual labor markets. If sticky wages
are above market-clearing levels, some workers will be employed, but
equally skilled workers will be unable to find work.
9. Salaries are rigid because of the costs associated with the administration
of the compensation system. Frequent compensation changes to match
market conditions would take too much management time, damage the
perception of fairness among workers, and undermine their morale and
productivity.
10. A careful review of unemployment statistics reveals several regularities:
a) Recessions hit all segments of the labor force, from the unskilled to
the highly skilled and educated. b) A substantial part of unemployment
in the United States is short-term. The average duration of
unemployment rises sharply when there are deep and prolonged
recessions. c) In most years, a significant part of unemployment is
caused by simple turnover, or frictional causes, when people first
enter or re-enter the labor force. Only during recessions are the
unemployed as a whole, above all, those who lose their jobs. d)
The difference between unemployment rates in Europe and the United
States reflects both structural policies and the effectiveness of the
administration
monetary.
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340 CHAPTER 15 • UNEMPLOYMENT AND THE BASIS OF THE AGGREGATE SUPPLY
CONCEPTS FOR REVIEW
Bases of Aggregate Demand Short-term and
long-term OA
Aggregate Supply, OA Curve
Underlying and Changing Factors
of Aggregate Supply Aggregate
Supply: Role of Potential Output and Unemployment
Production Costs population status:
unemployed employed
FURTHER READING AND WEBSITES
further reading
Text citations are from Studs Terkel, Hard Times: An Oral History
of the Great Depression in America (Pantheon, New York, 1970)
for the Great Depression; Harry Maurer, Not Working: An Oral
History of the Unemployed (New York, Holt, 1979) for construction
workers; and Business Week, March 23, 1992, for corporate
managers.
Web Sites
Analysis of employment and unemployment in the United States
is from the Bureau of Labor Statistics, at www.bls.gov. The
DISCUSSION QUESTIONS
1. Give a detailed explanation of what the aggregate supply
curve means. Distinguish between movements along the
curve and displacements of the curve. What could increase
production by moving along the OA curve? What could
increase production by shifting the OA curve?
2. Construct a table parallel to Table 15-1. Illustrate it with facts
that lead to a decline in aggregate supply. (Use your
imagination, rather than just using the same examples.)
3. What would be the effect, if any, of each of the following
events on the OA curve, in both the short run and the long
run, all else being equal?
a) Potential product increases 25%. b) Oil prices
double due to growing demand from China and India, with
a fixed supply of oil. c) Consumers are pessimistic and
increasing
lower your savings rate.
4. Suppose the unemployment rate is 7% and the GDP is 4,000
trillion dollars. What would be an estimate
labor force
out of the workforce
unemployment rate
Okun's law
equilibrium and imbalance
unemployment rigid
wages, unemployment, vacancies
Unemployment statistics in Europe and other OECD countries
can be found at www.oecd.org. The BLS site also has an online
version of The Monthly Labor Review at www.bls.gov/ opub/ mlr/
mlrhome.htm, which is an excellent source for studies on
unemployment, labor issues, and compensation. This magazine
contains a wide variety of articles ranging from “The Sandwich
Generation” (www.bls.gov/opub/ mlr/ 2006/09/ contents.htm) to
an analysis of the effect of going to war on market performance.
( www.bls.gov/opub/mlr/2007/12/contents.htm ).
approximate ratio of potential GDP if the NAIRU is 5%?
Assume that potential GDP grows at the rate of 3% per year.
What will potential GDP be in two years? How fast will GDP
have to grow to reach potential GDP in two years?
5. What is the state of the workforce in each of the following
situations? a) An adolescent who submits job applications in
Looking for your first job.
b) A worker in the automotive industry who was laid off and
who would like to work, but has given up hope of finding
a job or being called back to his old job. c) A retired
person who has moved to Florida and answers part-time
job advertisements. d) A parent who works part-time wants
a full-time job, but doesn't have time to look for it.
e) A teacher who has a job, but is too sick to work.
6. In explaining its procedures, the Department of Labor offers
the following examples:
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DISCUSSION QUESTIONS
a) “Joan Howard told the interviewer that she has
applied to three companies for the purpose of finding
employment for the summer. However, it's only April
and you don't want to start working before June 15,
at least because you're in school.
Although she has taken specific steps to find
employment, Joan has been classified as inactive
because she is not currently available for work.”
b) “James Kelly and Elyse Martin attend Jefferson High
School. James works after school at the North Star
Café and Elyse looks for a part-time job at the same
establishment (also after school). James's job takes
precedence over his school attendance, and so does
Elyse's job search. Therefore, James is considered
employed and Elyse is considered unemployed”.
Explain each of these examples. Take a sample of your
classmates. With the above examples
341
Have people classify themselves in terms of their
employment status as employed, unemployed, or inactive.
7. Suppose Congress considers a law that would set a
minimum wage for adolescents above the market-
clearing wage but below that for adult workers. Using
supply and demand diagrams, show the impact of the
minimum wage on employment, unemployment, and the
income of both groups of workers. Is any unemployment
voluntary or involuntary?
What would be your recommendation to Congress if you
were called to testify on the wisdom of this measure?
8. Do you think that the economic costs and the personal
stress of an adolescent unemployed for a month in the
summer could be more or less equivalent to that of a
head of the family unemployed for a year? Do you think
this suggests that public policy should take a different
approach for these two groups?
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CHAPTER

16
Inflation

Lenin is said to have declared that the best way to destroy the
capitalist system was to corrupt the currency. With a continuous
process of inflation, governments can confiscate, secretly and
without being observed, a significant part of the wealth of their citizens.
JM Keynes

For most of the past quarter century, the United States
was able to maintain low and stable inflation.
This was possible thanks to the success of his
monetary and fiscal policies in keeping production in a
narrow corridor between inflationary excesses and
sudden falls, although a favorable experience in
commodity prices and moderate wage increases
helped reinforce such policies.
A new factor in the inflationary equation was the
collapse and countries face the danger of deflation.
What are the macroeconomic dynamics of inflation?
Why does deflation pose such a significant challenge
to policy makers? This chapter will examine the
meaning and determinants of inflation and describe
important policy issues that arise in this regard.

increasing “globalization” of production. As the United

States became more integrated into world markets,
domestic firms found their prices constrained by the A. DEFINITION AND IMPACT
prices of their international competitors. OF INFLATION

Even when sales of clothing and electronics were WHAT IS INFLATION?

doing well, domestic companies could not raise their
The most important price indices and inflation were already
prices too much for fear of losing market share to
described in Chapter 5, but it will be useful to reiterate
foreign producers.
their basic definition here:

The first years of the new millennium were a
turbulent period for prices. In the first part of this
decade, inflation woke up from its long sleep.
In particular, with the momentum of rising oil and food
prices, prices rose rapidly. Later, a deep recession that
began in 2007 caused merchandise prices to drop.
342
Inflation occurs when the general price level rises.
Currently it is calculated using price indices, weighted
averages of the prices of thousands of individual
products. The consumer price index (CPI) measures
the cost of a basket of consumer goods and services
at market prices, relative to the cost of said basket in
a base year.
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A. DEFINITION AND IMPACT OF INFLATION 343

100,000

postwar
inflation
10,000

First World War

Napoleonic Wars

Price level
wages
1264)
(equal
year
Price
100
the
real
and
in
to

1,000
gold and
silver
USA

100

actual wage beginning of

the
Industrial Revolution

10
1200 1300 1400 1500 1600 1700 1800 1900 2000
Year

FIGURE 16-1. The price level and the real wage in England, 1264-2007 (1270 100)
The graph shows the history of prices and real wages in England since the Middle Ages.
In the early years, price increases were related to increases in the money supply, such
as the discoveries of New World treasures and the printing of money during the
Napoleonic Wars. Note that the real wage wandered aimlessly before the Industrial
Revolution. Since then, real wages have risen vigorously and continuously.

Source: EH Phelps Brown and SV Hopkins, Economica, 1956, updated by the authors.

given. The GDP deflator is the price of all the different history of inflation
components of GDP. Inflation is as old as market economies. Figure 16-1
The inflation rate is the percentage change in the illustrates the history of prices in England since the 13th
price level: century. In the long run, prices have generally risen, as
the colored line reveals. But also look at the black line,
Inflation rate in year t 100
Pt Pt1 _
________ which illustrates the path of real wages (the wage rate
Pt1 divided by consumer prices). Real wages lost their way
If you have trouble with the definitions, please reread until the Industrial Revolution. The COM
Chapter 5 and refresh your memory.
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344 CHAPTER 16 • INFLATION

250
200
150

100

fifty
40
WWII
Consumer
(2000
Index
100)
Price
=

30 war of
War of 1812
Independence First World War
twenty
Civil war
fifteen

10

5 1775 1800 1825 1850 1875 1900 1925 1950 1975 2000 2025
Year

FIGURE 16-2. Consumer Prices in the United States, 1776-2008

Until World War II, prices fluctuated in no direction: they rose precipitously with each war
and then fell after the war. But since then, the trend has been upward, both here and
abroad.
Source: US Department of Labor. Bureau of Labor Statistics for data since 1919.

The comparison of both lines shows that inflation is not
necessarily accompanied by a decline in real income.
The reader can also see that real wages have risen
continuously since around 1800, multiplying more than
10 times since then.
Figure 16-2 focuses on the behavior of consumer
prices in the United States since the War.
of Independence. Until World War II, the United States
generally applied a combination of gold and silver
standards, and price changes followed a certain
regularity. Prices skyrocketed in wartime and then
receded in the postwar period. But this rule changed
substantially after World War II. Prices and wages now
travel together on a one-way street, going only up.
They rise rapidly in periods of economic expansion and
slow down in times of slack.
Three Varieties of Inflation
Like diseases, inflation exhibits different levels of
severity. It is useful to classify them into three
categories: low inflation, runaway inflation, and
hyperinflation.
Low inflation. Low inflation is characterized by prices
that rise slowly and in a predictable way.
It is defined as inflation whose annual rates are in
single digits. When prices are more or less stable,
people trust money because it holds its value month
after month, year after year. People are willing to sign
long-term contracts in monetary terms because they
trust that the relative prices of the goods they buy and
sell will not misalign. Most countries have experienced
low inflation
in the last 10 years.

Figure 16-3 shows CPI inflation over the past half
century. You can see that inflation in recent years has
hovered between narrow bounds, fluctuating mainly
because of the volatility of food and energy prices.
Runaway inflation. It is inflation that is between the
double or triple digit limits of 20, 100 or 200% per year
and is called runaway inflation or “very high inflation”.
Runaway inflation is relatively common, particularly in
countries with weak governments,
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A. DEFINITION AND IMPACT OF INFLATION 3. 4. 5

16

Oil Price Shocks

12
Korean
war

8 First Persian
Turbulence at the beginning
Vietnam War Gulf War
percentage)
Inflation
annual
(CPI,
rate
of the new millennium

4 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Year

FIGURE 16-3. Inflation has remained low and stable in recent years
Historical inflation rates in the United States have been variable and reached unacceptably
high levels in the early 1980s. In the past 10 years, skillful monetary management by the
Federal Reserve, coupled with favorable supply shocks, have kept inflation low and within
tight limits.
Source: Bureau of Labor Statistics, www.bls.gov. This graph shows the inflation of the consumer price index.
Likewise, the inflation rate in the previous 12 months can be observed.

wars or revolutions. Many Latin American countries,
such as Argentina, Chile, and Brazil, had inflation
rates of 50 to 700% per year in the 1970s and 1980s.
Once runaway inflation takes hold, serious
economic distortions emerge. In general, most
contracts are linked to a price index or a strong
currency, such as the dollar. Under these conditions,
money loses its value very quickly, so people keep
only the minimum liquidity necessary for their day-to-
day transactions. Financial markets languish as capital
flees. People hoard assets, buy houses, and never
lend money at low nominal interest rates.
Hyperinflation is of special interest to students of
inflation because it exacerbates the disastrous effects.
Read this description of hyperinflation in the
Confederate States during the American Civil War:
We used to go to the stores with money in our bowls.
chairs and return with food in the basket. Now we
go with money in the basket and return with food in our
pockets. Everything is scarce, except money!
Prices are chaotic and production is haphazard.
A meal that used to cost the same as an opera ticket
now costs 20 times as much. Everyone tends to hoard
“stuff” and tries to get rid of the “bad” paper money that
drives the “good” metal money out of circulation. The
result is a partial return to the uncomfortable barter.

Hyperinflation. Although economies seem to survive

under runaway inflation, a third and deadly variety
emerges when the cancer of hyperinflation strikes.
Nothing good can be said about an economy where
prices go up a million or even a trillion percent a year.
The best documented case of hyperinflation
occurred in the Weimar Republic, Germany, during
the 1920s. Figure 16-4 shows how the government
loosened the reins of banknote printing, pushing up
both money and prices.
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346 CHAPTER 16 • INFLATION

german hyperinflation JM Keynes eloquently expressed the effect of

inflation:
100,000,000,000
As inflation deepens and the real value of money
10,000,000,000 fluctuates so wildly every month, all the permanent
1,000,000,000 relationships between debtors and creditors, which form
Money
100,000,000 the ultimate basis of capitalism, become so utterly
disordered as to be almost meaningless, and the process
(January
1922
1)
= 10,000,000
of accumulating wealth degenerates into a game and a
1,000,000
lottery.
100,000

wholesale
circulation
Currency
prices
and
in
10,000
Anticipated and Unanticipated Inflation
1,000 Prices
An important difference in the analysis of inflation is
100
whether price increases are anticipated or not. Suppose
10
all prices go up 3% a year and everyone expects this trend
to continue. Would there be any reason to get excited
one

1922 1923 1924

Year
FIGURE 16-4. Money and hyperinflation in Germany,
1992-1924
In the early 1920s, Germany couldn't collect enough taxes, so
it used money-printing machines to pay government bills. The
amount of money in circulation grew astronomically in January
about inflation? Would it make a difference if the actual
and expected rates of inflation were 1 or 3 or 5% per year?
In general, economists believe that inflation anticipated at
low rates has little effect on economic efficiency or on the
distribution of income and wealth. People would only adapt
their behavior to changes in the measuring stick of money.

from 1922 to December 1923, and prices continued to spiral

upward as people frantically tried to spend their money before
it lost all its value.
to astronomical levels. From January 1922 to November
1923, the price index rose from 1 to 10,000,000,000.
If a person had held German bonds worth 300 million
marks at the beginning of 1922, this amount would not
have been enough to pay for a piece of candy two years
later.
Several studies have found several characteristics
Common cases in hyperinflation. First, the real quantity of
money (measured by the quantity of money divided by the
price level) falls drastically. At the end of the German
hyperinflation, the real demand for money was only one-
thirtieth of its level two years earlier. People were seen
running from store to store, getting rid of money before it
lost its value. Second, relative prices became very
unstable. Under normal conditions, a person's real salary
moves only 1% or less from one month to the next. In
1923, German real wages changed on average one third
(up or down) each month. This huge variation in relative
prices and real wages —and the inequality and distortions
caused by these fluctuations— caused brutal losses to
workers and companies, which represents one of the
But the reality is that inflation is not usually anticipated.
For example, the Russians have been used to stable
prices for many decades. When prices were freed from
central planning controls in 1992, no one, not even
professional economists, assumed that prices would rise
400,000% in the next five years. The naive people who
put their money in ruble savings accounts saw their capital
evaporate. Those who were more astute manipulated the
system, and some even became fabulously wealthy
“oligarchs”.
In more stable countries like the United States, the
effect of unanticipated inflation is less profound, but the
same general point applies. An unexpected jump in prices
will make some poorer and others richer. How expensive
is this redistribution? Perhaps the word "cost" does not
describe the problem. The effect may be more social than
economic. An epidemic of theft may not reduce GDP, but
it causes great distress. Similarly, redistributing wealth
randomly through inflation is like forcing people to play a
lottery that they would rather avoid.
deflation quagmire

greatest costs of inflation. If inflation is so bad, should societies

instead strive towards deflation, a situation
in which prices
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A. DEFINITION AND IMPACT OF INFLATION
go down instead of up? Historical experience and
macroeconomic analysis suggest that deflation combined
with low interest rates can lead to serious economic
difficulties.
A small deflation, by itself, is not particularly harmful.
Rather, deflations often cause economic problems
because they can lead to a situation where monetary
policy is ineffective.
Typically, if prices start to fall due to a recession, the
central bank can stimulate the economy by increasing
bank reserves and lowering interest rates. But if prices
fall quickly, then real interest rates may turn out to be
relatively high. For example, if the nominal interest rate is
.25% and prices fall 3.25% per year, then the real interest
rate is 4% per year. At such a high real interest rate,
investment may choke, with recessionary consequences.
The central bank may decide to lower interest rates.
But the lower bound on nominal interest rates is zero.
Why? Because when interest rates are zero, bonds are
money at heart, and people hardly want to hold a bond
that pays negative interest when money has zero interest.
Now, when the central bank has cut interest rates to zero,
in this example, interest rates would still be 3.25% per
year, which might still be too high to stimulate the
economy. The central bank is stuck in a quagmire—a
quagmire known as the liquidity trap— where it can no
longer cut short-term interest rates. The central bank has
run out of ammunition.
Deflation was frequently observed in the 19th and
early 20th centuries. However, at the end of the 1990s,
Japan entered a sustained period of deflation. In part, this
was caused by a tremendous drop in asset prices,
particularly land and stocks, but also by a long recession.
In essence, short-term interest rates were zero after the
year 2000. For example, the yield on one-year bank
deposits was 0.032% per year in mid-2003. The Bank of
Japan could not maneuver with the deflation and zero
interest rates.
The United States entered liquidity trap territory in late
2008. Short-term, dollar-denominated, risk-free securities
(such as 90-day Treasuries) dipped to less than 1/10 of
1% at late 2008 and early 2009.
At the time, many economists believed that the Fed had
"run out of ammunition"; that is, it no longer had room to
reduce short-term interest rates.
Is there a remedy for deflation and for the liquidity
trap? One solution is to use fiscal policy, as the Obama
administration stressed when it emphasized a large fiscal
stimulus plan in early 2009. A fiscal stimulus will increase
aggregate demand, and there will be no crowding-out
effect on private spending from higher interest rates.
347
Monetary policy could also expand its arsenal of
instruments, as seen in chapter 10. For example, the Fed
could try to reduce long-term interest rates or lower the
risk premium on risky assets; but it has been difficult to
apply these measures. Many economists believe that the
best defense against a liquidity trap is a good offense.
Policy makers must check that the economy is safe from
deflation and the liquidity trap if full employment is
maintained, by ensuring a gradually rising price level and
avoiding booms and busts in the price of assets like those
experienced in the past decade.
ECONOMIC IMPACTS
INFLATION
Central bankers are united in their determination to
contain inflation. In periods of high inflation, opinion polls
frequently conclude that inflation is the number one
economic enemy. Why is it so dangerous and expensive?
It has already been pointed out that in periods of inflation
not all prices and wages move in unison; that is, there are
changes in relative prices. As a result of this distancing of
relative prices, two
definite effects of inflation:
• A redistribution of income and wealth between different
groups. • Distortions in relative prices and in the
production of different goods, or sometimes in the
production and employment of the economy as a
whole.
Impacts on income and wealth distribution
Inflation affects the distribution of income and
wealth, mainly because of the differences in the assets
and liabilities that people have. When people owe money,
a rise in prices results in a windfall. Suppose you borrow
$100,000 to buy a house and your annual payments on
your fixed-rate mortgage are $10,000. Suddenly, strong
inflation doubles all wages and income. Your nominal
mortgage payment is still $10,000 a year, but your real
cost has been cut in half. You will have to work only half
the time to pay your mortgage. High inflation has increased
your wealth by halving the real value of your mortgage
debt.
If you lend money and have assets in fixed-rate
mortgages or long-term bonds, you're on the other side of
the street. An unexpected rise in prices will leave you
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348
poorer, because the dollars you are paid will be worth
much less than the dollars you lent.
If inflation persists for a long time, people will come
to anticipate it and markets will begin to adapt. Little
by little, inflation will be incorporated into the market
interest rate. Suppose the economy starts with interest
rates of 3% and with stable prices. Since people expect
prices to rise 9% a year, bonds and mortgages will
tend to pay 12% instead of 3%. The 12% nominal
interest rate reflects a 3% real interest rate plus a 9%
premium for inflation. There are no further large
redistributions of income or wealth once interest rates
have incorporated the new rate of inflation. Chronic
adjustment of interest rates to inflation has been
observed in all countries with a long history of rising
prices.
Due to institutional changes, some old myths no
longer apply. Common stocks used to be thought of
as a good hedge against inflation, but today stocks
often move inversely with inflation. A common saying
was that inflation hurts widows and orphans; they are
now insulated from inflation because social security
benefits are indexed to consumer prices. Also,
unanticipated inflation benefits borrowers and hurts
lenders less than before, because many kinds of debt
(such as “variable rate” mortgages) have interest rates
that move up or down with interest rates. of market
interest.
The great redistributive effect of inflation comes
from its effect on the real value of people's wealth.
In general, unanticipated inflation redistributes wealth
from creditors to debtors by helping those who owe
and hurting those who lend. Unanticipated deflation
has the opposite effect. But inflation, fundamentally,
disrupts income and assets when it randomly
redistributes wealth among the population with a
significant result in any group.
Impacts on economic efficiency In
addition to redistributing income, inflation affects the
real economy in two specific areas: it can harm
economic efficiency and it can affect total output. See
what happens to the effect on efficiency.
Inflation harms economic efficiency because it
distorts prices and the signals they send out. In an
economy with low inflation, if the market price of a
good rises, buyers and sellers know that it has
CHAPTER 16 • INFLATION
there has been a change in the conditions of the offer or
the demand for that good, and can react appropriately.
For example, if all the supermarkets in the neighborhood
raise the price of beef by 50%, wise consumers know
that it is time to start eating more chickens. Similarly, if
the price of new computers drops 90%, you may decide
it's time to get rid of the old machine.
By contrast, in a high-inflation economy, it is much
more difficult to distinguish changes in relative prices
from changes in the general price level.
If inflation runs at 20 or 30% a month, price changes
are so frequent that relative price changes get lost in
the shuffle.
Inflation also distorts the use of money. The
Currency is money that has a nominal interest rate of
zero. If the inflation rate rises from 0 to 10% per year,
the real interest rate on money falls from 0 to -10% per
year. There is no way to correct this distortion.
As a result of the negative real interest rate on
money, people devote real resources to reducing their
money holdings in inflationary times. They go to the
bank more frequently, wasting the “bottom of their
shoes” and valuable time. Corporations apply elaborate
cash management mechanisms.
Therefore, real resources are consumed just to adjust
to changes in the monetary yardstick, rather than to
make productive investments.
Economists point to the distorting effects of inflation
on taxes. Part of the US tax code is written in terms of
money. When
prices rise, the real value of taxes paid rises, even
though real incomes have not changed. For example,
suppose you had to pay a 30% tax on your income
and, furthermore, that the nominal interest rate was
6% and the inflation rate was 3%. In reality, you would
end up paying a 60% tax rate on the 3% real interest
earnings. Today there are many similar distortions in
the tax code.
But these are not the only costs; some economists
point to the menu costs of inflation. The idea is that
when prices change, companies must devote real
resources to adjusting their prices. For example,
restaurants are printing their menus, mail-order
companies are reprinting their catalogs, taxi companies
are changing their fares, cities are adjusting their
parking meters, and stores are replacing the price tags
on their items. Sometimes the costs are intangible,
such as bringing people together to make new pricing
decisions.
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B. MODERN THEORY OF INFLATION
Macroeconomic Impacts
What are the macroeconomic effects of inflation?
This issue is discussed in the next section, so only
the main points are highlighted here.
Until the 1970s, high inflation in the United States was
accompanied by economic expansion; inflation tended
to rise when investment was high and jobs were
plentiful. The periods of deflation or downward inflation
—in the 1890s, the 1930s, and part of the 1950s—
were times of high unemployment for labor and capital.
But a closer examination of history reveals
An interesting fact: the positive association between
output and inflation appears to be only a temporary relationship.fall in certain sectors while raising them in others. But
In a longer-term scenario, there appears to be a U-
shaped relationship between inflation and output
growth. Table 16-1 shows the results of a multi-country
study on the association between inflation and growth.
These results indicate that economic growth is stronger
in countries with low inflation, while countries with high
inflation or deflation tend to grow more slowly. (But
beware of the ex post fallacy here, which will be
explored in question 7 at the end of this chapter.)
What is the optimal rate of inflation?
Most countries seek rapid economic growth, full
employment, and price stability. But what does “price
stability” mean? Exactly
Inflation rate (% per GDP growth
year) per capita (% per year)
ÿ20-0 0.7
0-10 2.4
1.8
10-20
20-40 0.4
100-200 1.7
1,000 6.5
TABLE 16-1. Inflation and economic growth The experience of
127 countries shows that faster growth is associated with low inflation rates.
Deflation and moderate inflation accompany slow growth, while hyperinflation
is associated with sharp drops in output.
Source: Michael Bruno and William Easterly, “Inflation Crises and Lon-Run
Growth,” Journal of Monetary Economics, 1998.
349
zero inflation? In what period? Or maybe it is low
inflation?
One school of thought holds that policy should aim
to achieve fully stable prices or zero inflation. If there
is confidence that the price level in 20 years will be
very close to today's price level, it is possible to make
better investment and saving decisions for the long
term.
Many macroeconomists believe that while a zero
inflation target might be desirable in an ideal economy,
one does not live in a frictionless system. One of these
frictions arises from the resistance of workers to accept
a decrease in their wages. When inflation is in fact
zero, efficient labor markets would require wages to
workers and companies are too reluctant to cut wages.
Some economists believe that, in the context of a
downward stickiness of nominal wages, a zero inflation
rate leads to higher unemployment on average.
An additional and more serious concern about zero
inflation is that economies could find themselves in the
aforementioned liquidity trap. If a country in zero
inflation were to face a large recessionary shock, it
might need negative real interest rates to get out of
recession through monetary policy. Although fiscal
policy would still be effective, most macroeconomists
believe that a better solution would be to aim for a
positive inflation rate, so as to minimize the threat of
liquidity traps.
The above exposition can be summarized as
follows:
Most economists agree that a small, predictable
rise in the price level offers the best climate for healthy
economic growth.
A careful analysis of the evidence suggests that low
inflation has little effect on productivity or real output.
In contrast, runaway inflation or hyperinflation can hurt
productivity and redistribute income and wealth
arbitrarily. A gradual rise in prices will help avoid the
deadly liquidity trap.
B. MODERN THEORY OF
INFLATION
What are the economic forces that cause inflation?
What is the relationship between unemployment and
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350
inflation in the short and long terms? How can countries
reduce an unacceptably high rate of inflation? What is
the role of inflation targeting in central bank policies?
Questions, questions, questions. But the answers
are crucial to the economic health of modern mixed
economies. The remainder of this chapter explores
modern inflation theory and discusses the costs of
reducing inflation.
PRICES IN THE OA-DA FRAMEWORK
There is no single source of inflation. Like illness,
inflation can occur for many reasons. Sometimes
inflation comes from the demand side; others, on the
supply side. But a fundamental feature of modern
inflation is that it develops an internal drive and is
expensive to stop once it occurs.
expected inflation
In modern economies like the United States, inflation
has great momentum and tends to persist at the same
rate. Expected inflation is like a lazy old dog. If the dog
is not “hit” by a foot push or a cat pull, it will continue to
lie down. Once on the move, the dog may chase the
cat, but eventually it will lie down somewhere else,
where it will stay until the next shock comes.
Over the past 30 years, prices in the United States
have risen an average of 3% a year, and most people
have come to expect this rate of inflation. This rate was
integrated into the institutional arrangements of the
economy: wage contracts between workers and
employers were designed around a 3% inflation rate;
the government's monetary and fiscal plans also
assumed a rate of 3%. In this period, the expected
inflation rate was 3% per year.
Another closely related concept is that of the
underlying inflation rate, which is a term frequently used
in monetary policy. It is the inflation rate without volatile
elements such as food and energy prices.
Although inflation may stay at the same rate for
some time, history shows that shocks in the economy
tend to push inflation up or down. The economy is
always subject to changes in aggregate demand, abrupt
changes in the price of oil and commodities, crop
failures, movements in the exchange rate, changes in
productivity, and a host of other things.
CHAPTER 16 • INFLATION
economic events that move inflation away from its
expected rate.
Inflation has a high degree of inertia in a modern
economy. People form an idea of the expected
inflation rate, and this is built into labor contracts and
other agreements. The expected inflation rate tends to
persist until a shock causes it to move up or down.
Demand Inflation One
of the big shocks to inflation is a change in aggregate
demand. In previous chapters we analyzed how
changes in investment, in government spending, or in
net exports can modify aggregate demand and push
output beyond its potential level. It was also studied
how the central bank of a country can influence
economic activity. Whatever the reason, demand
inflation occurs when aggregate demand rises faster
than the productive potential of the economy, pushing
prices up to balance aggregate supply and demand. In
effect, demand money competes for the limited supply
of commodities and pushes their prices up. As
unemployment falls and workers become scarcer,
wages rise and the inflationary process accelerates.
A very damaging form of demand inflation occurs
when governments run deficit spending and rely on the
money machine to pay their deficits. Large deficits and
rapid growth in money supply increase aggregate
demand, which in turn raises the price level. Thus,
when the German government financed its spending in
1922-1923 by printing billions and billions of marks in
paper money, which came to the market for bread and
fuel, it is not surprising that the level of German prices
went up a billion times.
This was demand inflation with a vengeance.
This scene was repeated in the early 1990s, when the
Russian government financed its budget deficit by
printing rubles. The result was an inflation rate that
averaged 25% per month, or 1,355% per year. (Make
sure you understand how 25% per month becomes
1,355% per year.)
Figure 16-5 illustrates the process of demand
inflation in terms of aggregate supply and demand.
Starting from an initial equilibrium at point E, suppose
there is a spending expansion that pushes the AD
curve up and to the right. The equilibrium of the
economy moves from E to E. At this higher level of
demand, prices have risen from P to P. Demand
inflation has arrived.
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B. MODERN THEORY OF INFLATION 351

P potential product P GIVES

OAÿ
Qp OA
OA

AND'
Pÿ
Price
level

Price
level

AND'

AND Pÿ
P GIVES'

AND

GIVES P

Q
actual product Q
Q'Q
FIGURE 16-5. Demand inflation occurs when excessive
actual product
spending chases too few goods. When aggregate
FIGURE 16-6. Increases in production costs can lead to
demand increases, increasing spending competes for limited
stagflation, with output falling and prices rising In
goods. Prices rise from P to P in demand inflation.
periods of rapidly rising production costs, such as oil price
shocks, countries may experience the dilemma of rising
inflation coupled with falling output, the combination of which
is known as stagflation. Policies to affect aggregate demand
can cure one problem or the other, but not both.
Cost inflation and “stagflation”
The classical economists understood the rudiments
of demand inflation and used this theory to explain
historical price movements. But a new phenomenon
arose in the past half century.
Today it is observed that inflation sometimes increases
due to the rise in costs, instead of being caused by
ria, would compensate for the drop in the product, but
increases in demand. This phenomenon is known as cost
would raise prices even more. Or an attempt to reduce
inflation or supply shock. It often leads to economic
inflation with tighter monetary policy would only lower
lethargy and a syndrome called "stagflation," or stagnation
with inflation. output further. Economists explain this situation by saying
that policy makers have two objectives or goals (low
inflation and low unemployment), but only one instrument
Figure 16-6 shows how supply shock inflation works.
(aggregate demand).
In 1973, 1978, 1999, and again at the end of the first
Policy makers often have to face this dilemma. When
decade of the new millennium, countries were going
inflation and unemployment rise simultaneously, what
about their macroeconomic business when there were
stance should the Federal Reserve or Central Bank take?
severe shortages in the oil markets. Crude oil prices grew
markedly, production costs increased, and then there
European? Should money be reduced to reduce inflation?
was a strong rebound in cost inflation. These events can
Or should we focus above all on reducing unemployment?
be represented as an upward shift of the OA curve.
Or find an intermediate solution between both goals?
Equilibrium output falls while prices and inflation rise.
Economics does not offer a definitive answer to this
dilemma. The answer will depend on societal values, as
well as the mandate imposed by local legislatures (such
as inflation targeting for the ECB, as opposed to a dual
Stagflation poses a serious dilemma for policy
mandate for the Fed).
makers. They can use monetary and fiscal policies to
change aggregate demand. However, changes in AD
cannot simultaneously increase output and reduce prices Inflation resulting from rising costs during periods of
and inflation. An outward shift of the AD curve in Figure high unemployment and low resource utilization is known
16-6, through a monetary expansion as supply shock inflation. This can lead to a stagflation
dilemma in
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352
politics, when the product falls at the same time that
inflation rises.
Expectations and inflation
Why, one might ask, does inflation have such strong
inertia? The answer is that most prices and wages are
set with an eye toward future economic conditions. When
prices and wages rise rapidly, and are expected to
continue to do so, firms and workers tend to integrate
the rapid rate of inflation into their price and wage
decisions.
Expectations of high or low inflation tend to be self-
fulfilling prophecies.
The role of expectations in the inflationary process is
illustrated with a hypothetical example: In 2009, Brass
Mills Inc., a non-union manufacturer of lighting fixtures,
was considering its annual price and wage decisions for
2010. Its sales they were growing. Brass Mills' chief
economist reported that no major inflationary or
deflationary shocks were anticipated, and major
consulting firms expected national wage growth of 4% in
2010. Brass Mills had conducted a survey of local
businesses and had detected that most employers
planned to increase compensation from 3 to 5% for the
following year. So, all signs pointed to wage increases of
around 4% from 2009 to 2010.
By examining its internal labor market, Brass Mills
concluded that their wages were in line with the market.
P FIGURE 16-7. An upward spiral of prices and
Level of potential product
Qp
prices
GIVES'''
Pÿ = (1.03)Pÿ
= (1.03) 2P
AND'''
Pÿ = 1.03P
AND'
P
actual product
CHAPTER 16 • INFLATION
local job market. Because managers did not want to fall
behind on local wages, Brass Mills decided that it would
try to accommodate local wage increases. Therefore, it
set salary increases according to the increase expected
in the market, an average of 4% for 2010.
The process of setting wages and salaries with an
eye toward anticipated future economic conditions can
be extended to all employers. This kind of reasoning also
applies to many product prices—such as college tuition,
car prices, and long-distance telephone rates—that
cannot be easily changed once they are set. Because of
the time it takes to change inflation expectations and
adjust most wages and many prices, expected inflation
will change only if there are large shocks or changes in
monetary policy.
Figure 16-7 illustrates the process of expected
inflation. Assume that potential output is constant and
that there are no supply or demand shocks. If everyone
expects costs and prices to rise 3% each year on
average, the OA curve will shift upward at 3% per year.
If there are no demand shocks, the AD curve will also
move up at that rate.
The intersection of the DA and OA curves will be at a 3%
higher price each year. Therefore, the macroeconomic
equilibrium moves from E to E to E. Prices rise 3% from
one year to the next and expected inflation has been
established at 3% .
wages occurs when aggregate supply and
demand move upward together
Suppose production costs and AD rise 3% per year.
OAÿ
The OA and AD curves would shift 3% upward each
AND"
year. As the equilibrium moves from E to E to E , prices
OAÿ are driven up at a constant pace by expected inflation.
OA
AND
GIVES"
GIVES'
GIVES
Q
Machine Translated by Google
B. MODERN THEORY OF INFLATION
perce
(annu
Increa
salari
year
per
in Sustained inflation occurs when the OA and DA curves
move steadily upward at the same speed.
Price Levels and Inflation Figure
16-7 allows us to distinguish between movements in the price
level and movements in inflation.
In general, an increase in aggregate demand will raise prices, all
other things being equal. Similarly, an upward movement of the
OA curve resulting from an increase in wages and other costs
will raise prices, all else being equal.
But, of course, the rest always changes; in particular, the DA
and OA curves never sit still.
For example, Figure 16-7 shows the curves OA and DA marching
upward together.
What if there was an unexpected shift in the OA or AD curve
during the third period? How would prices and inflation be
affected? Suppose, for example, that the third period AD moved
to the left to AD due to a monetary contraction. This could cause
a recession, with a new equilibrium at E on the OA curve . At this
point, the product would have fallen short of its potential; prices
and the inflation rate would be lower than in E, but the economy
would still be experiencing inflation because the price level in E
is still above the equilibrium E of the previous period with price P.
This example reminds us that supply and demand shocks
can drive the price level below what it would otherwise have been.
However, due to the inertia caused by inflation, the economy
can continue experiencing it.
PHILLIPS CURVE
The most important macroeconomic tool used to understand
inflation is the Phillips curve.
This curve shows the relationship between the unemployment
rate and inflation. The basic idea is that when output is high and
unemployment is low, prices and wages tend to rise faster. This
occurs because workers and unions push harder for wage
increases when jobs are plentiful and when companies can more
easily raise prices when sales are good.
The reverse is also true: high unemployment tends to slow down
inflation.
Short-Run Phillips Curve
Macroeconomists distinguish between the short-run Phillips
curve and the long-run Phillips curve.
353
8
4
P/P W/W
5
3 4
Phillips curve
2 3
one 2
percentage)
inflation
(annual
Price
0 one
1 2 3 4 5 6 7 8 9 10
Unemployment rate (percent)
FIGURE 16-8. The short-run Phillips curve illustrates
the tradeoff between inflation and unemployment A
short-run Phillips curve shows the inverse relationship
between inflation and unemployment. The wage change
scale on the vertical axis on the right hand side is greater
than the inflation scale on the left side, due to the
assumed growth rate of 1% of average labor productivity.
A common short-run Phillips curve is shown in Figure 16-8. On
the horizontal axis of the diagram is the unemployment rate. The
colored vertical scale on the right hand side shows the inflation
rate of nominal wages. As one moves to the
left on the Phillips curve as a consequence of a reduction in
unemployment, the growth rate of prices and wages indicated by
the
curve.
An important part of the arithmetic of inflation underlies this
curve. Suppose that the productivity of labor (product per worker)
rises at a constant rate of 1% per year, and further suppose that
firms set their prices based on average labor costs. Then prices
always change by the same magnitude as average labor costs
per unit of output. If wages are going up 4%, and productivity is
going up 1%, then average labor costs will go up 3%.
Consequently, prices will also rise 3%.
Using these arithmetic calculations of inflation, the relationship
between price and wage increases can be seen in Figure 16-8.
Both scales in the figure differ only by the assumed productivity
growth rate (so the 4% per year price change would correspond
to a 5% per year change in wages, if productivity grew 1% per
year and if prices rose at the same rate as average labor costs).
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354 CHAPTER 16 • INFLATION

slightly less than the 8.9% registered five years earlier,

Logic of Wage-Price Arithmetic The relationship
between prices, wages, and productivity can be formalized
as follows: The fact that prices are based on average labor
costs per unit of output means that P is always proportional
to WL/Q where P is the price level, W is the wage rate, L is labor hours, and
Q is output. Suppose that average labor productivity (Q/ L) grows uniformly
at the rate of 1% per year. Therefore, if wages grow at 4% per year, prices
will grow at 3% per year (4% growth in wages, 1% growth in productivity).
Expressed more generally:
although a quarter of the region's workers earn less than
two dollars a day. A crucial challenge for most countries in
Latin America and the Caribbean lies in creating quality job
opportunities for the working poor while reducing
unemployment.
In this sense, the organization points out that education,
professional training and lifelong learning favor the creation
of a virtuous circle of greater productivity, employment
growth in quantity and quality, income increase and
development in general.

Cup of Cup of growth rate

The increase in productivity reduces production costs
salary growth inflation of productivity and increases the profitability of investment; a portion of
This shows the relationship between price inflation and wage inflation. that increased profitability goes to higher revenues for
business owners and investors, and a portion is converted
It illustrates how close this relationship is with real numbers for a period into salary increases. This virtuous circle of productivity,
of high inflation and for a period of low inflation: the following table shows wages and employment is also stimulated by investment,
that the large long-term determinants of inflation are wage growth and the as companies reinvest part of the productivity gains in the
change in the productivity. From the first to the second periods, inflation rose innovation of their products and processes, which in turn
because wage growth picked up a bit while productivity plummeted. In the raises productivity.
third period, inflation was low because wage growth was limited while
productivity growth picked up. In the long term, the ILO points out, productivity is the
main determining factor for the growth of the national
product and family income. The application of a development
strategy based on the payment of low wages, the
employment of an unskilled labor force and low productivity,
Cup of
characteristic of many countries in Latin America and the
growth
Caribbean, is sustained in the long term and it is incompatible
Cup of Cup of of the
inflation growth
with the reduction of poverty. Investments in education and
productivity (%)
the acquisition of professional skills, or in other words, in
CPI (%) salary (%)
human capital, help to reorient economies towards activities
1958 -1973 2.9 5.4 3.1
with higher added value and greater dynamism.
1973 -1995 5.6 5.9 1.5
1995-2007 2.6 4.3 2.6

Experience shows that all the countries that have

Source: Bureau of Labor Statistics data on the business sector, at
www.bls.gov.
The traditional dilemma between inflation and
unemployment illustrated in the Phillips curve, as well as
the dilemma between wages and employment, can be
alleviated through improvements in productivity.
In 2008, the International Labor Organization (ILO)
published its Report on Skills for Productivity Enhancement,
Job Growth and Development. In it, he stresses that in Latin
America and the Caribbean, productivity increased
marginally, with barely an average annual growth of 0.6%
between 1997 and 2007. In 2007, unemployment was 8.5%,
managed to harmonize professional skills with productivity
have substantially oriented their professional skills
development policies towards three objectives that are
summarized in the diagram presented on the next page.
The first essential gear for the harmonization of
professional capacities is to align their supply and demand.
Vocational skills policies have to ensure the acquisition of
useful skills and promote lifelong learning. In this sense, the
ILO points out, the search for greater equality of opportunities
in access to education and work is essential to satisfy the
demand for professional training services from all sectors of
society.
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B. MODERN THEORY OF INFLATION 355

The virtuous circle of professional skills —productivity

— quantity and quality of employment

Meeting
the
demand for skills
professional
in
terms
ofYrelevance
quality.

Mitigating
Create capacity and knowledge adjustment
costs: labor
reorganization by advances
maintain
systems
economic
a sustainable
that
andpromote
social
process
development.
and of technology and new
demands causes
obsolescence of
some professional
skills.

Source: Own elaboration based on the Report on Qualifications for the Improvement of Productivity, Employment Growth and Development 2008 of the ILO.

Secondly, mitigating the adjustment costs is a The two-variable lips in Figure 16-8 was unstable.
priority gear to adapt to the creative destruction in labor Based on the theoretical work of Edmund Phelps and
matters, in order to update the labor force in the skills Milton Friedman, along with statistical tests derived
that the demand requires. from empirical evidence, macroeconomists developed
Ease of access and affordable training costs help the modern theory of inflation, which distinguishes
prevent long-term unemployment and its dire between the long run and the short run. The downward-
consequences. sloping Phillips curve in Figure 16-8 is valid only in the
Lastly, the ILO points out as a vitally important gear short run. In the long run, the Phillips curve is vertical,
the creation of capacity and knowledge systems that not downward sloping. This approach means that in the
promote and maintain a sustainable process of long run there is a minimum unemployment rate that is
economic and social development. consistent with sustained inflation. This is the Non-
The first two gears, linking skills demand and supply Accelerative Unemployment Inflation Rate, or NAIRU.
one

and mitigating adjustment costs, rest on a labor market

perspective and focus on skills development in response
The non-accelerating unemployment rate of
to technological and economic; They are short and
inflation (NAIRU) is the rate of unemployment
medium term goals.
consistent with a constant rate of inflation. In the NAIRU,
the upward and downward pressures on wage and
price inflation are balanced, so there is no tendency for
On the contrary, the third gear is a development
inflation to change. The NAIRU is the lowest
objective focused on the strategic role of education and
unemployment rate that can be sustained without
vocational training as permanent catalysts and stimuli
pushing up inflation.
for technological change, investment, diversification
and competitiveness (ILO, 2008). The idea behind the NAIRU is that the state of the
economy can be divided into three different situations:
Unemployment non-accelerating
inflation rate one

Sometimes other terms will be found. The original name of the

Economists who carefully analyzed inflationary periods NAIRU was “natural rate of unemployment”. This term is not
noted that the simple Phi curve satisfactory because there is nothing natural about the NAIRU.
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356 CHAPTER 16 • INFLATION

SRPCÿ

Long-term Phillips
curve

SRPC C.
Inflation in
B.
periods 2 and 3
Short-run Phillips curve for
inflation
Rate
of

period 3

Inflation in
A
period 1

Short-run Phillips curve for periods 1

and 2

U* = NAIRU

Unemployment rate

FIGURE 16-9. Changes in the Phillips Curve

This figure shows how economic expansion leads to an inflationary surprise and an
upward movement of the Phillips curve in the short run. The steps in this movement are
explained in the marked paragraphs in the text. Note that if you connect points A, B , and
C, the changes in the curve give a clock-like circuit.

• Excess demand. When markets are too tight, with
low unemployment and high capacity utilization,
prices and wages are subject to demand inflation.
• Excess supply. In recessive situations, with high
unemployment and idle plants, companies tend to
sell at discounts and workers less aggressively
demand wage increases. Price and wage inflation
tends to moderate. • Neutral pressures. Sometimes
the economy operates “in neutral”. Upward pressures
on wages from job vacancies offset downward
pressures on wages from unemployment. There
are no supply shocks for oil or other exogenous
sources. Here, the economy is in the NAIRU and
inflation does not rise or fall.
From the short run to the long
run How does the economy move from the short run
to the long run? The basic idea is that when price
changes are not anticipated, the short-term Phillips
curve tends to move up or down. This point is illustrated
by a series of steps in an "expansion loop" in Figure
16-9:
• Period 1: Unemployment is in NAIRU. There are no
supply or demand surprises, and the economy is at
point A on the short-run lower Phillips curve (SRPC)
in Figure 16-9. • Period 2: Next, suppose that there
is an economic expansion that reduces the
unemployment rate. As unemployment falls,
companies are recruiting more vigorously and
granting larger wage increases than before. As
production approaches full capacity, price margins
rise. Prices and wages begin to accelerate. In terms
of the curve
Phillips curve, the economy moves up and to the
left to point B on its short-run Phillips curve (along
SRPC in Figure 16-9). As shown in the figure,
inflation expectations have not yet changed, so the
economy is still on the original Phillips curve, or
SRPC. The lower unemployment rate raises inflation
in the second period.
• Period 3: when inflation has risen, it takes companies
and workers by surprise, and makes them revise
their inflationary expectations. They begin to
incorporate the higher inflation expected in their decisions
Machine Translated by Google
B. MODERN THEORY OF INFLATION
price and wage pressures. The result is a shift in the
short-run Phillips curve: the new curve is SRPC in
Figure 16-9. The new short-term Phillips curve is above
the original Phillips curve, and reflects the higher rate of
inflation expected. The curve is drawn so that the new
expected inflation rate for period 3 is equal to the actual
inflation rate for period 2. If a drop in economic activity
brings the unemployment rate back to the NAIRU in
period 3 , the economy moves to point C. Even if the
unemployment rate is the same as in period 1, real
inflation will be higher, reflecting the upward movement
of the short-run Phillips curve.
See the amazing result. Because the expected inflation
rate has risen, the inflation rate is higher in period 3 than in
period 1, even though the unemployment rate is the same.
The economy in period 3 will have the same real GDP and
the same unemployment rate as in period 1, even though
the nominal magnitudes (prices and nominal GDP) are now
growing faster than before the expansion rose. the expected
inflation rate.
It is also possible to trace a “recession cycle” that occurs
when unemployment rises and the actual inflation rate falls
below the expected rate. The expected inflation rate is
reduced in recessions and the economy has a lower inflation
rate when it returns to the NAIRU. This difficult cycle of
austerity occurred during the Carter-Volcker-Reagan wars
against inflation in 1979-1984.
Long-run vertical Phillips curve When the
unemployment rate diverges from the NAIRU, the inflation
rate will tend to change. What happens if the gap between
the actual unemployment rate and the NAIRU persists? For
example, the NAIRU is 5% while the actual unemployment
rate is 3%. Due to the gap, inflation will tend to grow from
year to year. Inflation could be 3% in the first year, 4% in
the second, 5% in the third, and could keep going up after
that. When would this spiral stop? It would stop only when
unemployment moved back into the NAIRU. In other words,
as long as unemployment is below the NAIRU, wage
inflation will tend to rise.
The opposite situation occurs with high unemployment.
In this case, inflation will tend to fall as long as unemployment
is above the NAIRU.
Only when unemployment is at the NAIRU will inflation
stabilize; only then will they be in balance
357
changes in supply and demand in different labor markets;
only then will inflation, whatever its inertial rate, tend neither
to rise nor to fall.
The modern theory of inflation has important implications
for economic policy. This theory establishes that there is a
minimum level of unemployment that an economy can
maintain in the long term. If the economy is pushed to very
high levels of production and employment, an upward spiral
of price and wage inflation will be unleashed. This theory
also offers a formula to discourage inflation. When the
inflation rate is too high, a country can reduce money
supply, trigger a recession, raise the unemployment rate
above the NAIRU, thereby lowering inflation.
The NAIRU defines the neutral zone between excessive
astringency/rising inflation and high unemployment/falling
inflation. In the short run, inflation can be reduced by raising
unemployment above the NAIRU, but in the long run, the
NAIRU is the lowest sustainable rate of unemployment.
Quantitative estimates
Although the NAIRU is a crucial macroeconomic concept,
its precise quantitative estimate has proven to be quite
elusive. Many macroeconomists have applied advanced
techniques to estimate the NAIRU. For this text, estimates
from the Congressional Budget Office (CBO) were adopted.
According to the CBO, the NAIRU has risen gradually since
the 1950s, peaked at 6.3% of the labor force around 1980,
and declined to 4.8% in 2008. The CBO estimates, together
with the rate of actual unemployment towards the end of
2008, are shown in Figure 16-10.
Doubts about the NAIRU
The concept of the non-accelerating inflation rate of
unemployment, along with its twin concept of potential GDP,
is crucial to understanding inflation and the connection
between the short run and the long run in macroeconomics.
But the more common point of view remains controversial.
Critics question whether the NAIRU is a stable and
trustworthy concept. The inflationary experience of the
United States has led economists to question whether there
is, in fact, a stable NAIRU for the country. Another question
is whether a long period of high unemployment will lead to
a deterioration of skills, loss of training and work experience,
and with
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358
eleven
10
8 NAIRU
Unemployment
(percent)
rate
2 1950 1960
Shaded areas are NBER recessions.
FIGURE 16-10. Real Unemployment Rate and NAIRU in the
United States The NAIRU is the unemployment rate at which the downward and upward
forces on inflation level off.
Source: Bureau of Labor Statistics Actual Unemployment Rate; NAIRU from Congressional Budget Office estimates.
this at a higher NAIRU. Might not slow real GDP
growth reduce investment and leave the country with
a smaller capital stock? Might not such a shortage of
capacity produce rising inflation even with
unemployment rates above the NAIRU?
The experience in Europe of the last 20 years
confirms some of these concerns (recall the comments
on the European unemployment riddle at the end of
the previous chapter). In the early 1960s, the labor
markets of Germany, France and England seemed to
be in equilibrium with unemployment rates between 1
and 2%. By the end of the 1990s, after a decade of
stagnation and slow job growth, the labor market
equilibrium seemed to have leveled off with
unemployment rates ranging from 6 to 12%. Based on
recent European experience, many macroeconomists
are looking for ways to explain the instability of the
NAIRU and its dependence on real unemployment as
well as labor market institutions.
CHAPTER 16 • INFLATION
real unemployment rate
1970 1980 1990 2000 2010
Year
Review
The most important points to understand are the
following:
• In the short term, an increase in aggregate demand
that reduces the unemployment rate below the
NAIRU will tend to raise the inflation rate.
Recessions and high unemployment tend to reduce
inflation. In the short run there is a tradeoff between
inflation and unemployment. • When inflation is
higher or lower than people expect, inflation
expectations are adjusted. Modifications to
inflationary expectations tend to move the Phillips
curve up or down. • The long-run Phillips curve is
vertical at the non-accelerating inflation rate of
unemployment (NAIRU). Unemployment above
(below) the NAIRU will tend to reduce (increase)
the rate of inflation.
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C. DILEMMAS OF THE ANTI-INFLATIONARY POLICY
C. POLITICAL DILEMMAS
ANTI-INFLATIONARY
The economy evolves in response to political forces
and technological change. Economic theories,
designed to explain things like inflation and
unemployment, must also adapt. In this final section
on the theory of inflation we examine the
but more important that arise in the fight against
inflation.
How long is the long run?
The NAIRU theory states that the Phillips curve is
vertical in the long run. But how long is the long run
for this purpose? The precise time required for the
economy to fully adjust to a shock is not known.
Recent studies suggest that a full adjustment takes at
least five or perhaps 10 years. The reason for this long
period is that expectations take years to adjust, as
well as the renegotiation of labor contracts and other
long-term contracts, and for all these effects to spread
throughout the economy.
How much does it cost to reduce inflation?
The analysis suggests that a country can reduce the
expected rate of inflation by decreasing output for a
while and raising unemployment. But policy makers
would like to know how much it costs to remove
inflation from the economy. How expensive is
disinflation, which denotes the policy of bringing down
the rate of inflation?
Studies on this subject conclude that the cost of
reducing inflation varies according to the country, the
initial inflation rate and the applied policy. The analyzes
carried out for the United States yield a reasonable
and consistent answer: reducing the expected inflation
rate by 1% costs the country around 4% of GDP for
one year. In terms of the current level of GDP, this
equates to a loss of output of nearly $600 billion (at
2008 prices) to reduce the inflation rate by one
percentage point.
To understand the cost of disinflation, consider
the Phillips curve. If that curve is relatively flat, reducingto the long-term Phillips curve for this period.
inflation will require a lot of unemployment and loss of
output; if it is steeper, a small increase in unemployment
will bring inflation down soon, and more or less
painlessly. Statistical analyzes indicate that when the
unemployment rate rises 1% above the NAIRU in a
359
10
8 1979
NAIRU
6 1982
4
percentage)
(annual
Inflation
rate
2
1986
0
4 5 6 7 8 9 10 11
Unemployment rate (percent)
FIGURE 16-11. The costs of disinflation, 1979-1987
This graph shows a disinflation cycle. High interest rates
led to slow economic growth and high unemployment in the
early 1980s. The result was unemployment above the
NAIRU and output below its potential level. Core inflation
fell by almost 5%, while the cumulative loss of output was
around 20% of GDP, leading to a sacrifice ratio of 4%.
year and then returns to the NAIRU, the inflation rate
will drop by about ½ percentage point. Consequently,
to reduce inflation by a full percentage point,
unemployment must be kept 2 percentage points
above the NAIRU for one year.
The loss associated with disinflationary policies is
called the sacrifice ratio. Stated more specifically,
the sacrifice ratio is the cumulative loss of output,
measured as a percentage of GDP for a year,
associated with a permanent reduction of 1 percentage
point in inflation.
The disinflation period after 1979 illustrates the
sacrifice ratio. The scatter diagram of inflation and
unemployment during this period is shown in Figure
16-11: an austerity cycle, or disinflation cycle, which is
the opposite of the boom cycle of Figure 16-9. In these
years the Fed applied energetic measures to reduce
inflation. Monetary tightening raised the unemployment
rate above 10% for two years and output was below
its potential level for seven years. The average NAIRU
appears as the vertical line, which is also equivalent
But monetary tightening did reduce underlying
inflation from almost 8 to 3% per year in this period.
The cumulative loss of output associated with this
disinflation is estimated at close to 20% of GDP. This
allows calculating the sacrifice ratio for this period at 4%
Machine Translated by Google
360
[(20% of GDP)/(5 percentage points of disinflation)].
In today's US economy, this means that reducing the
core inflation rate by 1 percentage point would cost
nearly $600 billion, or nearly $6,000 per US family.
Phillips curve theory illustrates how policy can
reduce inflation by raising unemployment above the
NAIRU for a period of time.
Estimates of the cost of disinflation are usually around
4% of a year's GDP for each point of disinflation. This
calculation shows why containing inflation is an
expensive policy and one that cannot be undertaken
lightly.
Credibility and Inflation One
of the most important questions in anti-inflation policy
is the role played by policy credibility. Many economists
argue that the Phillips curve approach is too pessimistic.
Dissenters argue that credible and publicly announced
policies—for example, the adoption of an inflation
targeting regime or nominal GDP targeting—would
allow anti-inflationary policies to reduce inflation with
lower output costs and unemployment.
This idea is supported by the fact that inflation is a
process that depends on people's expectations of
future inflation. A credible monetary policy—such as a
policy that always seeks moderate or fixed inflation—
could lead people to expect lower inflation in the
future, and this belief could become a self-fulfilling
prophecy in some ways. Those who emphasize
credibility back up their theories by citing fundamental
policy changes, such as the monetary and fiscal
reforms that ended hyperinflation in Austria and
Bolivia, at relatively little cost in terms of unemployment
or GDP losses.
Many economists were skeptical of claims that
credibility would substantially lower output costs of
disinflation.
While such policies might work in countries torn apart
by hyperinflation, war, or revolution, draconian anti-
inflation policies would be less credible in the United
States. Congress and the president are often
discouraged in the fight against
inflation, when unemployment spikes and farmers or
construction workers protest in front of the Capitol and
the White House.
The American experience in the 1980s, illustrated
in Figure 16-11, offers a good
CHAPTER 16 • INFLATION
orium to test the critique of credibility.
In this period, monetary policy tightened clearly and
vigorously. But the prices were still high, as the
calculation of the sacrifice indicates. The use of
aggressive policies, announced to improve credibility,
does not appear to have reduced the cost of disinflation
in the United States.
Because the United States has political and
economic institutions with a high degree of stability,
their experience may be unusual. Economists have
examined anti-inflationary policies in other countries
and have determined that such policies can sometimes
be expansionary. A recent study by Stanley Fischer,
Ratna Sahay, and Carlos A. Vegh concluded the
following:
Periods of high inflation are associated with poor
macroeconomic performance. In particular, high
inflation is bad for growth. The evidence is based on
a sample of 18 countries that have endured episodes
of high inflation. In such periods, real GDP per capita
fell by an average of 1.6% per year (in contrast to the
positive growth of 1.4% in years of low inflation)...
The stabilization supported by exchange rates seems
to lead to an initial expansion in real GDP and real
private consumption.
Policies to reduce unemployment
Given the costs of high unemployment, it is worth
asking: is the NAIRU the optimal level of
unemployment? If it is not, what can be done to reduce
it to a more desirable level? Some economists believe
that the NAIRU (sometimes also called the “natural
rate of unemployment”) represents the efficient level
of unemployment in the economy. They maintain that
it is the result of an efficient pattern of jobs, vacancies and job searc
In his view, holding the unemployment rate below the
NAIRU would be like driving a mobile car without a
spare tire.
Other economists disagree, considering that the
NAIRU is likely to be above the optimal unemployment
rate. His view is that economic welfare would rise if
the NAIRU were reduced. This group argues that there
are many spillovers, leaks, or externalities in the labor
market. For example, workers who have been laid off
suffer from various economic and social hardships.
But the bosses don't pay the cost of unemployment;
most of the costs (unemployment insurance, medical
costs, and family anguish, among others) spill over as
external costs and are absorbed by the worker or by
the government. In addition, there are many congestion
externalities when an unemployed worker adds
Machine Translated by Google
RESUME
tional makes it more difficult for other workers to find
employment. To the extent that unemployment has
external costs, the NAIRU is likely to be greater than the
optimal unemployment rate; consequently, reducing the
unemployment rate would raise the net economic welfare
of the country.
A large social dividend would reward the society that
figured out how to bring down the NAIRU. What measures
could reduce the NAIRU?
• The improvement of labor market services. Some
unemployment occurs because job openings are not
filled with unemployed workers. With better information,
the amount of frictional and structural unemployment
could be reduced. A recent innovation is Internet
search, operated by states or private companies,
which can help people find jobs and companies find
qualified personnel more quickly. • Support for training
programs. If you search the internet or look at the
newspaper ads for job seekers, you will see that most
job openings require qualified staff. Conversely, most
of the unemployed are unskilled or semi-skilled
workers, or workers in a depressed industry. Many
economists believe that government or private training
programs can help educate the unemployed for better
jobs in growing industries. If they succeed, it is
RESUME
A. The definition and impact of inflation
1. Remember that inflation occurs when the general level of
prices is rising. The inflation rate is the percentage change
in a price index from one period to the next. The major
price indices are the consumer price index (CPI) and the
GDP deflator.
2. Like illnesses, inflation can present itself with different
degrees of severity: In general, there is low inflation in the
United States (a few percentage points per year).
Sometimes, galloping inflation leads to price increases of
50, 100 or 200% each year. Hyperinflation invades an
economy when banknotes are printed and prices begin to
rise repeatedly each month. In history, hyperinflation has
almost always been linked to war and revolutions.
361
These programs offer the double advantage of helping
people lead productive lives and reducing the burden
of government transfer programs. • Reduce
disincentives to work. By shielding people from the
hardships of unemployment and poverty, the government
has simultaneously reduced the pain of unemployment
and the incentives to look for work. Some economists
call for reform of the unemployment insurance system
and health care, disability, and social security programs
to improve incentives to work. Others point out that
the lack of a national health insurance system can
increase the “employment lock” and reduce the mobility
of workers.
***
After reviewing the history and theory of unemployment
and inflation, we conclude with a cautious conclusion.
menu:
Critics believe that the high unemployment that often
prevails in North America and Europe is a central flaw in
modern capitalism. In fact, sometimes unemployment must
be kept above its socially optimal level to ensure price
stability, and the tension between price stability and low
unemployment is one of the cruelest dilemmas of modern
society.
3. Inflation affects the economy by redistributing income and
wealth and by impairing efficiency. Unanticipated inflation
tends to favor debtors, profit seekers, and reckless risk-
taking speculators. It hurts creditors, the fixed income
population and conservative investors. Inflation leads to
distortions in relative prices, in taxes, and in real interest
rates. People make more trips to the bank, taxes can rise,
and the measurement of income can become distorted.
B. The modern theory of inflation
4. At any time, an economy expects a certain rate of inflation.
It is the rate that people have come to anticipate and that
is built into labor and other contracts.
The expected inflation rate is a short-term equilibrium
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362 CHAPTER 16 • INFLATION

term and persists until there is a disturbance in the economy.
5. In reality, the economy receives incessant price shocks. The
main kinds of shocks that drive inflation away from its
expected rate are demand inflation and supply shocks.
Demand inflation results from excessive spending chasing
too few goods, causing the aggregate demand curve to shift
up and to the right. Afterwards, prices and wages rise in the
markets. Supply shock inflation is a new phenomenon in
modern industrial economies and occurs when production
costs rise, even in periods of high unemployment and slack
capacity.
6. The Phillips curve shows the relationship between inflation
and unemployment. In the short term, lowering one rate
means raising the other. But the short-run Phillips curve
tends to move over time as expected inflation and other
factors change. If policy makers try to keep unemployment
below the NAIRU for long periods, inflation will tend to spiral
up.
7. The modern theory of inflation is based on the concept of the
non-accelerating inflation rate of unemployment, or NAIRU,
which is the lowest sustainable unemployment rate that the
country can enjoy without risking an inflationary spiral. It
represents the level of resource unemployment at which the
labor and product markets are in inflationary equilibrium.
According to the NAIRU theory, there is no permanent
tradeoff between unemployment and inflation, and the long-
run Phillips curve is vertical.
C. The dilemmas of anti-inflationary policy 8. A
central concern of policy makers is the cost of reducing inflation.
current estimates
indicate that a sizeable recession is required to reduce
expected inflation.
9. Economists have made many proposals to reduce the NAIRU;
Notable proposals include improving information on labor
markets, improving education and training programs, and
rethinking government programs so that workers have
greater incentives to work.

CONCEPTS FOR REVIEW

The history and theories impacts of inflation short-term and long-term Phillips
of inflation (redistribution, on output and curves non-accelerating inflation
inflation rate in year t employment) anticipated and rate of unemployment (NAIRU) and the
unanticipated inflation costs of inflation: curve of
100
Pt Pt 1 _
________ Long Term Phillips
Pt 1
“sole of the shoes”
varieties of inflation: menu costs anti-inflationary policy

runaway low income and tax distortions cost of disinflation

hyperinflation loss of information measures to reduce the NAIRU
slaughter ratio

FURTHER READING AND WEBSITES

further reading Web Sites

The Stanley Fischer, Ratna Sahay, and Carlos A. Vegh quote is
Analysis of consumer price figures for the United States is from
from their article “Modern Hyper- and High Inflation,” Journal of
the Bureau of Labor Statistics, at www. bls.gov. This site also
Economic Literature, September 2002, pp. 837-880.
contains helpful discussions of inflation trends in the Monthly
A study of the factors influencing the NAIRU can be found in Labor Review, online at www.bls.gov/ opub/ mlr/ mlrhome.htm.
Congressional Budget Office, The Effect of Changes in Labor
Markets on the Natural Rate of Unemployment, April 2002,
available at www.cbo.gov.
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DISCUSSION QUESTIONS 363

DISCUSSION QUESTIONS

1. Consider the following effects of inflation: tax distortions, redistribution unemployment and loss of production.
of income and wealth, shoe-leather costs, and menu costs. For each, Prepare a short essay describing your point of view on the matter.
define the cost and provide an example.
7. Consider the data for annual inflation rates and per capita GDP growth
2. “In periods of inflation people use real resources to reduce their cash shown in Table 16-1. Can it be seen that low inflation is associated with
holdings. These activities produce a private benefit without a higher growth rates? What are the economic reasons that growth might
corresponding social gain, which illustrates the social cost of inflation. be lower when there is deflation or when there is hyperinflation? Explain
Explain what this quote means and give an example. why the ex post fallacy might apply here (see this discussion in Chapter
1).

3. Unanticipated deflation also produces serious social costs. For each of

the following cases, describe deflation and analyze their respective
costs: a) In the Great Depression, the prices of the most important crops
fell along with the prices of other goods. What will have happened to
the farmers who had large mortgages?
8. The following policies and phenomena have affected labor markets in
the past thirty years. Explain the possible effect of each of them on the
NAIRU: a) Unemployment insurance became taxable. b) Funds for
training programs for employees suffered a sharp cut from the federal
government.

b) Japan suffered moderate inflation in the 1990s. Suppose each

Japanese student borrowed 2 million yen (about $20,000) to pay
for their education, hoping that inflation would allow them to pay
off their debt in inflated yen. What would happen to these students
if prices and salaries began to fall 5% per year?
c) The fraction of the labor force affiliated with unions is
considerably reduced.
d) The 1996 welfare reform law drastically reduced payments to low-
income families and made work compulsory in order to receive
government payments.

4. The data in Table 16-2 describe inflation and unemployment in the

United States from 1979 to 1987. Note that the economy started near
the NAIRU in 1979 and ended near it in 1987. Can you explain the
Cup of
decline? of inflation in the intervening years? Do this by drawing short-
run and long-run Phillips curves for each of the years 1979 through 1987. unemployment Rate of inflation,
Year (%) CPI (% per year)

1979 5.8 11.3

5. Many economists argue: "Since there is no long-term trade-off between 1980 7.1 13.5
unemployment and inflation, there is no point in trying to smooth out the nineteen eighty one 7.6 10.3
peaks and troughs of the business cycle." This view suggests that there 1982 9.7 6.2
should be no concern about whether the economy is stable or volatile 1983 9.6 3.2
as long as the average level of unemployment remains the same. 1984 7.5 4.4
Analyze and critique this approach 1985 3.6
7.2
1986 7.0 1.9
that.
1987 6.2 3.6
6. A distinguished economist has written: “If you think about the social costs
of inflation, at least moderate inflation, it is difficult to avoid getting the
impression that they are minor compared to the costs TABLE 16-2. Inflation and unemployment data for the United States,
1979-1987
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CHAPTER

17 Frontiers of Macroeconomics

The task of economic stabilization requires preventing the

economy from drifting too far up or down the trajectory of
stationary high employment. One trajectory leads to inflation
and the other to recession. Flexible and cautious fiscal and
monetary policy will allow us to stay on the tight middle course.
President John F. Kennedy
(1962)

The American economy has changed enormously in the
past half century. The share of agriculture and
manufacturing has decreased. People work with
computers instead of tractors. Trade occupies an
increasing part of production and consumption. Technology
has revolutionized daily life. Advanced telecommunications
systems allow businesses to control their operations
across the country and around the world, and increasingly
powerful computers have eliminated many of the tedious
tasks that used to require so many people.
current frontier of science, but they will be commonplace
in economics classes within a generation. The
controversies related to short-term economic stabilization
are analyzed, including current questions about the role
of monetary and fiscal policies. Should governments stop
trying to moderate business cycles? Should policy makers
rely on fixed rules, instead of using discretion? It concludes
with an epilogue on the importance of economic growth.

you sound

And yet, even with these dramatic changes in the

American economic structure, the central goals of
macroeconomic policy remain the same: stable
employment, good pay, low unemployment, rising
productivity and real incomes, and moderate and stable
inflation. . The challenge remains to find policies that can
achieve these objectives.
This chapter uses the tools of macroeconomics to
examine some of the fundamental aspects of current
politics. It begins with an assessment of the consequences
of the government deficit and debt on economic activity.
New approaches to macroeconomics are presented later.
Some of these theories are located in the
364
A. ECONOMIC CONSEQUENCES OF
GOVERNMENT DEBT
When the United States entered the 21st century it
followed stable fiscal policies and the federal government
enjoyed a budget surplus. Then, like a monster rising
from the depths, the budget deficit rose to devour the
country's fiscal resources and terrorize its population.
The budget deficit widened even during the boom
years of the mid-1990s, when taxes were cut and
spending on new eligibility programs and on apparent
wars increased.
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A. ECONOMIC CONSEQUENCES OF GOVERNMENT DEBT
endless experiences in Iraq and Afghanistan. Later, the
country's banking system incurred monstrous losses
and the economy headed into a deep recession. Tax
revenues plummeted and hundreds of billions of dollars
were spent to boost the financial system and stimulate
the economy. By 2009, the federal government was
running an annual deficit of close to $2 trillion, which as
a percentage of GDP was the highest since World War
II.
How did the budget deficit get so big? What are the
economic effects of the federal deficit? These important
questions are answered in this section; You will learn
why popular concern about deficits has a sound
economic basis: deficit spending may be required to
reduce the length and depth of recessions, particularly
when the economy is in a liquidity trap; But large deficits
in periods of full employment can have serious
consequences, including lower national saving and
investment and slower economic growth in the long run.
Government budgets. Governments use the budget to
plan and control their public finances. A budget shows
the spending the government plans on its programs and
the revenue it expects from the tax system in a given
year. The budget usually contains a list of specific
programs (education, social assistance and defense,
among others), as well as the sources of income
(personal taxes and social security, among others).
A budget surplus occurs when all taxes and other
revenues exceed government spending in a given year.
A budget deficit is incurred when government spending
exceeds government revenue. When revenues and
expenditures are equal in a given period—a rare case at
the federal level—the government has a balanced
budget.
When the government runs such a budget deficit it
must borrow money from the public in order to pay its
bills. To get that money, the government issues bonds,
which are promissory notes that promise to pay a certain
amount of money in the future. Government debt
(sometimes known as public debt) consists of the total
borrowing accumulated by the government; is the total
money value of government bonds.
It is convenient to distinguish between total debt and
net debt. Net debt, also called debt held by the public,
excludes debt held by the government itself.
The net debt is in the hands of families, banks,
companies, the rest of the world and other
365
non-federal entities. Gross debt is equal to net debt plus
bonds held by the government, primarily by the social
security fund. This social security fund manages a large
surplus, so today the difference between these two
concepts is growing rapidly.
Debt and deficit
People often confuse debt with deficit. You
can remember the difference as follows: the
debt is the water in the bathtub, while the
deficit is the water that flows from the faucet into the bathtub.
Government debt is the total of government obligations. The
deficit is the flow of new debt that is incurred when the
government spends more than it takes in in taxes. For
example, when the government ran a $640 billion deficit in
2008, it added that amount to total government debt. By
contrast, when the government ran a surplus of $200 billion
in the year 2000, this reduced government debt by that
same amount.
FISCAL HISTORY
Like Sisyphus, federal policymakers fight tirelessly to
push the boulder of fiscal balance up the hill, only to see
it roll back down and crush them again. The government
enacted one law after another in the 1980s and 1990s
to stem its growing deficit. It took longer to bring its
deficit under control than it did for it to reappear and
grow rapidly after 2001. Was this commonplace, or is it
a new feature of the US economy?
Deficits are not new to the US economy, but large
peacetime deficits are a peculiar feature of recent
economic history. In the first two centuries since the
Revolutionary War, the US federal government
maintained a broadly balanced budget. Heavy wartime
military spending was financed by borrowing, so
government debt soared during these times. In times of
peace, the government paid part of its debt and the debt
burden was contracted.
Then, after 1940, public finances began to change
rapidly. Table 17-1 illustrates the fundamental trends.
This table lists the main categories of the federal budget
and their participation in the GDP in the period from
1940 to 2008. The most relevant characteristics were
the following:
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366 CHAPTER 17 • FRONTIERS OF MACROECONOMICS

percentage of GDP

Federal budget component 1940 1960 1980 2000 2008

Income 6.4 17.6 18.5 20.6 17.7

Personal income tax 0.9 7.7 8.8 10.2 8.1
Corporate income taxes 1.2 4.1 2.3 2.1 2.1
Social Security and other retirement income 1.8 2.8 5.7 6.7 6.3
Others 2.7 3.0 1.8 1.6 1.2

Costs 9.4 17.5 21.2 18.2 20.9

National defense and international affairs 1.8 9.7 5.3 3.2 4.4
Health 0.1 0.2 2.0 3.6 4.7
Security upon entry 1.5 1.4 3.1 2.6 3.0
Social Security 0.0 2.2 4.2 4.2 4.3
net interest 0.9 1.3 1.9 2.3 1.7
Others 5.2 2.7 4.7 2.4 2.5

deficit or surplus 2.9 0.1 2.6 2.4 3.2

TABLE 17-1. Federal Budget Trends, 1940-2008 Federal involvement in

the economy grew rapidly between 1940 and 1960 as the United States assumed an active military role in world affairs
during hot and cold wars. After 1960, the share of federal spending leveled off, but the composition of spending shifted
from the military to health care and other social spending. The federal budget deficit grew steeply in the early years of the
new millennium, when public revenue fell substantially as a result of personal income tax cuts.

Source: Data are for fiscal years and are from the Department of the Treasury, Office of Management and Budget, and the
Department of Commerce. They are summarized in Economic Indicators, available at origin.www.gpoaccess.gov/ indicators/.

• Fundamentally, the share of federal spending and BUDGET POLICY

taxes rose very quickly from 1940 to 1960, mainly
because of the expansion of military and civilian
spending. This growth was financed by a significant
increase in tax collection for individuals and
corporations. • The period from 1960 to 1980
marked the programs of the "New Society" in health,
income security and the expansion of social
security. As a result, the share of spending grew
dramatically. The share of federal revenue in GDP
stabilized in this period. • In early 1981, the
Republican and Democratic parties declared that
the era of big government was over. Presidents
Ronald Reagan and George W. Bush introduced
large tax cuts, which in each case led to large
government budget deficits.
GOVERNMENTAL
The federal budget performs two basic economic
functions. First, it is a mechanism through which the
government establishes the country's priorities,
distributes the national product between investment
and public and private consumption, and creates
incentives to increase or reduce the product in certain
sectors. From a macroeconomic point of view, it is
through fiscal policy that the budget affects key
macroeconomic goals. In other words, fiscal policy is
the establishment of taxes and public spending that
help smooth out the fluctuations of the business cycle
and contribute to maintaining a growing economy, with
high employment and free from high or volatile inflation.

Some of the early enthusiasts of the Keynesian

From 1980 to 2008, as shown in Table 17-1, the
ratio of total federal spending to GDP was actually
constant. Health care spending increased
substantially while other civilian programs
contracted.
approach believed that fiscal policy was like a knob
that they could turn to control or “out of tune” the pace
of the economy. A larger budget deficit meant more
stimulus to aggregate demand, which could reduce
unemployment and boost
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A. ECONOMIC CONSEQUENCES OF GOVERNMENT DEBT
pull the economy out of recession. A budget surplus
could slow down an overheated economy and abate the
threat of inflation.
Currently, few hold this idealized vision of fiscal
policy. Despite many decades of empirical experience,
economies still suffer from recessions and inflation.
Fiscal policy works better in theory than in practice. In
addition, monetary policy has become the preferred tool
for moderating fluctuations in the business cycle. Still,
when unemployment rises, there is usually strong public
pressure for the government to expand its spending. In
this section we review the fundamental ways in which
the government can use its fiscal policy and examine
the practical limitations that have come to light.
Real, structural and cyclical budgets
Modern public finances distinguish between the structural
deficit and the cyclical deficit. The idea is simple.
The structural part of the budget is active: it is determined
based on discretionary fiscal policies, such as those
related to tax rates, spending on public works or
education, or the amount of military spending. In
contrast, the cyclical part of the budget is determined
passively based on the state of the business cycle; that
is, depending on whether the national income and
product are low or high. The precise definitions are as
follows:
The actual budget records the actual expenditures,
revenues, and monetary deficits in a given period.
The structural budget calculates what government
revenues, expenditures, and deficits would be if the
economy were operating at its potential output.
The cyclical budget is the difference between the
actual budget and the structural budget. It measures the
effect of the business cycle on the budget and
incorporates the effect of the cycle on revenues,
expenses, and the deficit.
The difference between actual and structural
budgets is important for policy makers who want to
distinguish between long-term changes or budget trends,
and short-term changes induced primarily by the
business cycle. Structural spending and revenues
consist of discretionary fiscal policy programs authorized
by the legislature; Cyclical spending and deficits consist
of taxes and spending that automatically react to the
state of the economy.
367
The country's savings and investment balance is
affected primarily by the structural budget. Efforts to
change government savings should focus on the
structural budget, since a lasting change is not the result
simply because there is greater income derived from
economic expansion.
DEBT AND DEFICIT ECONOMICS
Today, no macroeconomic issue is more controversial
than the effect of a large government deficit on the
economy. Some argue that large deficits are placing a
heavy burden on future generations. Others say there is
little evidence of the effect of the deficit on interest rates
or investment. A third additional group indicates that
deficits are favorable for the economy in recessive times.
How can these conflicting views be understood? At
one extreme, the usual practice of assuming that public
debt is bad because it punishes private debtors should
be avoided. On the other hand, it must be recognized
that there are genuine problems associated with large
government deficits and the benefits of lower government
debt.
SHORT-TERM IMPACT OF THE DEFICIT
GOVERNMENTAL
Short term versus long term It is
convenient to separate the effect of fiscal policy in the
short and long terms. The short run in macroeconomics
considers situations in which something less than full
employment may prevail, that is, when actual output
may differ from potential output. It is the world of the
Keynesian multiplier model. The long run refers to a
situation of full employment, where real output is equal
to potential output.
It is the world of economic growth analysis.
The role of fiscal policy in the short run has already
been examined, so only a brief recounting is necessary
in this section. The long-term effect is more novel and
will be presented in the next section.
Fiscal policy and the multiplier model The
way in which fiscal policy affects the economy in the
short term, that is, in an economy below full employment,
has already been discussed in previous chapters.
Suppose the government buys computers for its
schools or shells for the army. The multiplier model
asserts that in the short run, with no change in interest
rates or exchange rates, the
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368 CHAPTER 17 • FRONTIERS OF MACROECONOMICS

GDP will go up by a multiple (perhaps 1.5 or 2) of the
increase in G. The same argument applies (with a
smaller multiplier) to the tax cut, T. Likewise, the
government deficit will go up because of cuts in T. or
increases in G that deteriorate the government's
balance sheet, which is equal to T ÿ G.
The basic result in the short run then is: with a
level of output below the full employment level,
increases in the structural deficit arising from
discretionary cuts in T, or increases in G, will tend to
yield a higher level of output and employment, and
perhaps higher inflation.
However, the simpler model of the multiplier
should be extended to incorporate the response of
financial markets and monetary policy. As production
increases and inflation threatens, central banks may
raise interest rates to discourage domestic investment.
Higher interest rates can also cause a country's
exchange rate to appreciate, if the country has a
flexible exchange rate; the appreciation generates a
drop in net exports. These financial reactions would
tend to stifle or drive out investment, with a resulting
drop in the spending multiplier of this simple model.
Fiscal policy tends to expand the economy in the
short term, when there are unemployed resources.
Higher spending and lower taxes raise aggregate
demand, output, employment, and inflation. However,
this expansive effect is reduced with the subsequent
reactions of interest rates and the exchange rate.
GDP, while rapid output growth with more or less
balanced peacetime budgets reduced the debt-to-GDP
ratio.
Figure 17-1 shows the debt-to-GDP ratio for the
United States over the past seven decades. The reader
You can see the dramatic effect of government deficits
during World War II, as well as in the 1980s and the
early years of the new millennium.
At present, most of the industrialized countries are
burdened with large public debts. Table 17-2 compares
the United States with seven other industrialized
countries. Japan's debt to GDP ratio has skyrocketed
over the past 20 years on the back of aggressive fiscal
policy and a prolonged Japanese recession. Many
economists worry that Japan is trapped in a vicious
cycle of high debt leading to high interest payments,
which in turn increases debt growth.
External Debt and Internal Debt
The first distinction to be made is between internal
debt and external debt. Domestic government debt is
something a country owes to its own residents. Many
insist that an internal debt does not mean a burden
because "it is the debt that a nation has with itself."
Although this statement is oversimplified, it does
represent a genuine view.
If every citizen owned government bonds for
Gross government debt
to GDP ratio (%)

GOVERNMENT DEBT AND 1980 1990 2000 2007

ECONOMIC GROWTH
Japan 37 47 106 161
Now we have to move from the short to the long term: Italy 53 93 104 96
to the effect of fiscal policy and, in particular, the effect France 30 40 47 52
United Kingdom 51 35 43 43
of large government debt on investment and economic
Germany 13 20 3. 4 39
growth. Here, the analysis will focus on the cost of USA 41 36
26 3. 4
servicing a large external debt, on the inefficiencies of South Korea 4 13 17 32
collecting taxes to pay the interest on the debt, and on Mexico 18 46 23 24
the effect of debt on capital accumulation.
TABLE 17-2. Central Government Debt in Eight Major Countries
Slow economic growth and increasing spending on qualifying programs
Historical trends
has led to creeping public debt in most major countries over the past 30
Before beginning the analysis of government debt, it
years. Japan's debt-to-GDP ratio led to a downgrade of its debt rating,
is worth reviewing its historical trends. Long-term data
even though Japan is one of the richest countries in the world.
for the United States appear in the figure on page 368
of this text, which shows the ratio of net federal debt
to GDP since 1789.
Note that the wars raised the debt ratio to Source: OECD at webnet.oecd.org/ whos/ index/ aspx.
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A. ECONOMIC CONSEQUENCES OF GOVERNMENT DEBT 369

120

100
WWII Supply-
cuts
side
tax
(I)
supply
side
cuts
Tax
the
(II)
on

80

60
(percent)
Federal
debt/
GDP

40

twenty

0 1940 1950 1960 1970 1980 1990 2000 2010

Year

FIGURE 17-1. US federal government debt-to-GDP ratio

This figure shows the ratio of net debt, or debt held by the public, to GDP. See the effect
of World War II and the two periods of supply-side tax cuts on the ratio.

Source: US Office of Management and Budget, available at www.gpoaccess.gov/ eop/ tables08.html. Table B-78.

$10,000 and would have to pay taxes just to service that
debt, it would make no sense to think of debt as a heavy
load of rocks that every citizen must carry on their back.
People simply owe that money to themselves.
The public debt to gross domestic product ratio has
been reduced considerably in Latin America and the
Caribbean in the last decade, thanks to greater fiscal
discipline and debt restructuring and reduction thanks to
the Debt Reduction Initiative Heavily Indebted Poor
Countries (HIPCs).
A favorable macroeconomic scenario until before
2008 also contributed to this result, which allowed the
application of active liability management policies and
reduced the region's financial vulnerability. However, the
effect on tax revenues of the global financial crisis was
considerable and in 2009 it already translated into a
contraction of around 2% of the region's GDP, with
strong heterogeneity among the different countries that
comprise it. In addition, fiscal expenditures had to
expand in order to carry out
carry out the anti-cyclical policies that the world
economic situation required.
In the ECLAC study entitled "The role of tax policy in
the face of the global crisis: consequences and
perspectives", the body separated the Latin American
countries into three categories of exposure (high, medium
or low) according to the effect on their tax revenue from
the global financial crisis. This exposure was assessed
based on various characteristics of the country in
question, such as its tax revenue structure, the capacity
of its tax administrations, and its political and institutional
rigidity.
Aspects related to the importance of income from
taxes on the exploitation of primary resources, the
participation of taxes from imports, the importance of
VAT or corporate income tax on tax income and the
weight of remittances in disposable personal income,
among others.
According to the results of this study, Ecuador,
Mexico, Guatemala and Panama would be the countries
with the greatest fiscal exposure to the global financial crisis.
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370 CHAPTER 17 • FRONTIERS OF MACROECONOMICS

Public debt non-financial public sector as a percentage

of GDP

Venezuela

Uruguay
Peru

Paraguayan
Panama

Mexico 2008
Honduras 1998
Guatemala

Ecuador

Colombia

Chili

Brazil

bolivian

Argentina

Latin America and the Caribbean

0 10 twenty 30 40 fifty 60 70 80

bal, derived above all from the difficulty of carrying out tax An external debt is a rather different situation.
reforms and excessive dependence on taxes from the ink. An external debt occurs when foreigners own a
exploitation of natural resources (with the exception of fraction of a country's assets. For example, given its large
Guatemala and Panama). current account deficit, this

Latin America and the caribbean

Selected countries 2008

12

10 Coefficient of exposure of tax collection

to the international crisis
8

0
Peru Chili Brazil
Mexico bolivian
Ecuador Panama Uruguay
Argentina
Guatemala El Salvador Paraguay Venezuela Colombia Costa Rica

Dominican Rep. Nicaragua

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A. ECONOMIC CONSEQUENCES OF GOVERNMENT DEBT
The United States owed the rest of the world 3,000 trillion
dollars at the end of 2008. This means that, later on,
US residents will have to export an equivalent amount
of goods and services, or sell the equivalent of national
assets to foreigners. Suppose the real interest rate on
that debt is 4% per year. So every year, US residents
must send out $150 billion (about $500 per capita) to
"service" foreign debt.
So an external debt, in short, means a net reduction
of the resources available for consumption in the debtor
nation. Developing countries have had this experience
time and again, particularly when their creditors wanted
to be paid early.
Efficiency losses in taxation A domestic
debt requires payment of interest to bondholders and
taxes must be collected for this purpose. But even if the
same people were taxed to pay the same amounts that
they receive as interest, there would be distorting effects
on incentives that are inescapably present in the case
of any tax. Taxing Paula's salary or interest income to
pay interest to Paula introduces macroeconomic
distortions. Paula could work less and save less; any of
these results should be considered as a distortion of the
efficiency and social welfare.
Capital drain
Perhaps the most serious consequence of large public
debt is that it drains capital from the nation's private
wealth stock. As a result, the pace of economic growth
slows and future living standards fall.
What is the mechanism by which debt affects
equity? Remember that people accumulate wealth for
various purposes, such as retirement, education, and
housing. The assets held by people can be of two types:
1) government debt and 2) capital, such as houses and
financial assets that would be, for example, corporate
shares that represent private equity ownership.
The effect of government debt is that people
accumulate government debt instead of private capital,
and the country's private capital stock is depleted by
public debt.
To illustrate this point, suppose people want to hold
precisely 1,000 units of wealth.
371
for your retirement and other purposes. As government
debt increases, holdings of other assets held by the
public will shrink dollar for dollar.
This occurs because when the government sells its
bonds, other assets must be reduced, since total
holdings of desired wealth are fixed. But these other
assets ultimately represent the private capital stock;
stocks, bonds and mortgages are the counterpart of
factories, balance and houses. If government debt goes
up 100 units, the holdings of equity and other private
assets held by people would go down 100 units. In this
case, the loss or loss of capital has been 100% (which
is equivalent to a 100% expulsion effect in the long
term).
It is unlikely that complete substitution or diversion
will occur in practice. Higher debt can increase interest
rates and stimulate household savings. Also, the
country can borrow abroad, instead of reducing its
domestic investment (as has been the case in the
United States in recent years). The exact amount of the
loss of capital will depend on the conditions of production
and the savings behavior of families, national and
foreign.
A geometric analysis. The process by which the
capital stock moves in the long run is illustrated in
Figure 17-2. The left panel shows the supply of and
demand for capital as a function of the real interest rate
or return on capital. As interest rates rise, businesses
demand less capital while individuals would like to raise
their contributions. The equilibrium shown refers to a
capital stock of 4,000 units with a real interest rate of
4%.
Now consider that government debt rises from 0 to
1,000 because of wars, recessions, supply-side fiscal
policies, or some other reason. The effect of the increase
in debt can be seen in the diagram on the right side of
Figure 17-2. This figure shows the 1,000-unit increase
in debt as a discount.
shifting of the capital curve (or OO). As can be seen,
the household capital supply curve shifts to the left by
1,000 units, to 00.
The increase in government debt is represented as
a shift to the left of the household capital supply curve.
Notice that since the OO curve represents the amount
of private capital that people are willing to hold at each
interest rate, capital holdings are equal to total wealth
holdings minus government debt holdings. Since the
amount of government debt (or other assets that are
not capital
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372 CHAPTER 17 • FRONTIERS OF MACROECONOMICS

As such) goes up by 1,000, the amount of private
capital that people can buy after they take on the 1,000
units of government debt is 1,000 less than total
wealth at each interest rate. Thus, if OO represents
the total wealth held by the people, OO (equals OO
minus 1,000) represents the total amount of capital
held by the people. In short, after 1,000 units of
government debt are sold, the new capital supply
curve is OO.
As the supply of capital dries up—when national
saving goes toward buying government bonds instead
of housing or corporate stocks and bonds—the market
equilibrium moves northwest along the demand curve.
K. Interest rates go up. Firms delay acquiring new
manufacturing plants, trucks, and computers.
In the new long-run equilibrium of the illustration,
the capital stock falls from 4,000 to 3,500. Thus, in
In this example, 1,000 units of government debt have
displaced 500 units of private equity. Of course, this
reduction has a significant economic effect. With less
capital, the nation's potential product, wages, and
income are less than they would otherwise be.
The diagrams in Figure 17-2 are illustrative.
Economists do not have a strong estimate of the
magnitude of this effect. When trends are reviewed
Historically, the best evidence suggests that domestic
capital is partly eroded by government debt, but that
some of the effect comes via higher external debt.
Debt and growth
Considering all the effects of government debt on the
economy, large government debt is likely to reduce
economic growth in the long run. Figure 17-3 illustrates
this connection. suppose

a) No debt b) With government debt

D.
D.

12
12
EITHER

8
8 percentage)
(annual
interest
Real
rate

percentage)
(annual
interest
Real
rate

EITHER
B. EITHER

6 1,000

EITHER
A
A 4
4
D.
D.

EITHER
EITHER

0
0 3,500 4,000 4,500
3,500 4,000 4,500
k
Private capital stock (K)
Private capital stock (K)

FIGURE 17-2. Government debt crowds out private capital

Businesses demand capital, while households supply capital by saving in private and
public assets. The demand curve is the downward-sloping demand of K firms , while the
supply curve is the upward-sloping supply of wealth from households.

Case a) before debt shows the equilibrium without government debt: K is 4,000 and
the real interest rate is 4%.
Case b) after debt shows the effect of 1,000 units of government debt. The new
equilibrium emerges in a northwesterly direction along the demand curve for K and
moves from point A to B. The interest rate is higher, firms have no incentive to hold
K , and the stock of capital.
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A. ECONOMIC CONSEQUENCES OF GOVERNMENT DEBT
Product (without debt)
Product (with debt)
Product,
capital
scale)
(ratio
Capital stock (without debt)
Capital stock (with debt)
growing debt
Time
FIGURE 17-3. Impact of government debt on economic
growth
The solid lines show the paths of capital and output if the
government balances its accounts and is debt free. When the
government incurs debt, private capital is reduced. The dotted
lines illustrate the effect on capital and output of higher
government debt.
gas that an economy would function without debt in
time. According to the principles of economic growth
outlined in Chapter 11, the capital stock and potential
output would follow the hypothesized path indicated by
the solid lines in Figure 17-3.
Here is a case of growing national debt. As debt
accumulates over time, more and more capital is
depleted, as shown by the dotted line for the capital
stock at the bottom of Exhibit 17-3. As new taxes are
levied to pay debt proceeds, inefficiencies further reduce
output. Likewise, an increase in the foreign debt reduces
national income and raises the fraction of the national
product that must be set aside to service the foreign
debt. Taken together, considering all effects, output and
consumption will grow more slowly than they would
have done without large government deficits and debt,
as can be seen by comparing the top lines of Figure
17-3.
What is the effect of a budget surplus and declining
government debt ? Here, the argument works in the
opposite direction. A lower national debt means that
more of the national wealth goes into capital, rather
than into government bonds. A larger capital stock will
increase
373
it slows the growth of the product and raises wages and
consumption per person.
This is the salient point about the long-term effect of
large government debt on economic growth. Large
government debt tends to reduce potential output growth
because it crowds out private capital, increases tax
inefficiency, and forces a country to reduce consumption
in order to service foreign debt.
Clarification of confusion
with the deficit
Having finished the analysis of the economic
effect of deficit and debt, it is possible to
summarize its fundamental aspects by unraveling some of
the great confusions in this area.
The effect of fiscal policy on the economy is one of the
least understood facets of macroeconomics. The confusion
stems from the fact that fiscal policy works differently
depending on the period in question:
• In the short term, higher spending and lower taxes tend
to increase aggregate demand and thereby raise output
and reduce unemployment. It is the Keynesian effect of
fiscal policy, which operates by raising real output
relative to potential output. It is to be expected that the
expansive effect of fiscal policy —the increase in utilized
capacity— will last a few more years, at most.
It could be nullified by monetary tightening, particularly
if the central government believes the economy is
operating near the inflation danger zone. • In the long
term, higher spending and lower taxes tend to depress the
growth rate of the economy. It is the effect of fiscal
policy on growth. The impact on growth refers to the
effect of the government deficit on the level of national
saving and investment of
a full employment economy. If taxes are cut, public
saving will fall, and since private saving is not likely to
rise enough to make up for the fall in public saving,
national saving and investment will fall. The reduction
in investment will lead
to a lower growth of the capital stock and, therefore, of
the potential product.
These two effects of fiscal policy can easily confuse
people and are the cause of much debate about fiscal
policy. Consider the following discussion between Senators
Halcón and Paloma:
Senator Paloma: The economy is headed for a recession.
We cannot afford to sit by while millions of people lose
their jobs. Now is the time for a big stimulus package
with tax cuts and new spending on infrastructure and
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374
attention to urgent public needs. Recessions are not
times to deal with outdated deficit dogmas.
Senator Falcon: A great stimulus package in this
moment would be the height of fiscal irresponsibility.
With more government spending, the deficit will
be even larger, interest rates will rise, and
businesses will reduce their spending on new
factories, equipment, and information technology.
With all the crucial needs facing the nation we can
induce a drop in economic growth in the next decade.
Check that you understand the implicit theories that
underlie the positions of the two distinguished senators.
They are both right… and they are also wrong.
B. ADVANCES IN
MODERN MACROECONOMICS
The philosophy in this book is to consider all the major
schools of thought. The modern Keynesian approach
has been highlighted as the best way to explain the
business cycle in market economies. At the same
time, the forces behind long-term economic growth are
best understood by applying the neoclassical growth
model.
Although the main task has been to present the
main currents of thought, experience shows how
important it is to keep an open mind to alternative
points of view. Time and time again in science, the
orthodoxies of one age are overthrown by new
discoveries in the next. Schools, like people, are
subject to hardening of the arteries. Students learn
embalmed truth from their teachers and from their holy
books, and the imperfections of orthodox doctrines are
considered trivial. For example, John Stuart Mill, one
of the greatest economists and philosophers of all
time, wrote in his classic 1848 text, Principles of
Political Economy: “Happily, there is nothing in the
laws of value that remains to be clarified in the present
and for any future writer”. However, the following
century and a half saw two momentous revolutions in
economics: the marginalist revolution in microeconomics
and the discovery of macroeconomics.
Historians observe that the advance of science is
discontinuous. New schools of thought emerge, their
influence spreads, and skeptics are won over. This
section outlines some of the
CHAPTER 17 • FRONTIERS OF MACROECONOMICS
main new lines of thought in modern macroeconomics.
CLASSICAL MACROECONOMICS
AND SAY'S LAW
Since the birth of economic science two years ago
For centuries, economists have wondered if a market
economy has a tendency to move in a
spontaneously toward a long-run full employment
equilibrium, without the need for government
intervention. In modern language, these approaches
that stress the self-correcting forces of an economy
are designated as classical . The classical approach
holds that prices and wages are flexible and the
economy is stable, such that the economy automatically
and rapidly moves toward its full employment
equilibrium.
Say's Law of Markets Before
Keynes formulated his macroeconomic theories, the
classical view of economics was generally accepted
by great economic thinkers, at least in the good old
days. Early economists knew about business cycles,
but viewed them as temporary and self-correcting
aberrations.
The classical analysis revolved around Say's law
of markets. This theory, proposed in 1803 by the
French economist JB Say, states that overproduction
is impossible by its very nature. This is sometimes
expressed by saying that “every supply creates its own
demand”. This law rests on the view that there is no
essential difference between a money economy and a
barter economy; in other words, people can afford to
buy whatever the factories can produce. Say's Law is
illustrated in Figure 17-4. In the classical world, output
is determined by aggregate supply, and aggregate
demand affects only the price level.
A long line of distinguished economists, including
David Ricardo (1817), John Stuart Mill (1848), and
Alfred Marshall (1890), supported the classical
macroeconomic view that overproduction was
impossible.
The classical view is that the economy automatically
moves toward its full employment equilibrium. Changes
in the money supply, fiscal policy, investment, and
other spending factors do not have a lasting effect on
output or employment. Prices and wages adjust flexibly
and quickly to maintain full employment.
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B. ADVANCES IN MODERN MACROECONOMICS
P GIVES OAÿ OA
Price
level
Q* *
AND'
Q*
AND
Q central factor in decision making; they influence how much
AND* * Y*
actual product
FIGURE 17-4. In the real business cycle, product
changes come from technological shocks. In the
classical approach, as well as in the real business cycle
(CRN), OA reflects classical flexible prices and wages, so it
is vertical. Output fluctuations come when technological
shocks permeate the entire economy.
This figure shows how a drop in productivity can be the
cause of a CRN recession. Can you spot why policies to
increase AD will affect prices but not output?
CLASSICAL MACROECONOMICS
MODERN
While the classical economists preached the impossibility
of persistent unemployment, the eclectic economists of the
1930s could hardly miss the existence of a vast army of
unemployed workers begging for work and selling pencils
on street corners. streets. Keynes 's General Theory of
Employment, Interest, and Money (1936) offered an
alternative macroeconomic theory, a new set of theoretical
glasses for looking at the effect of economic shocks and
policies. The analysis of business cycles and short-term
aggregate demand presented in this text reflects the modern
synthesis of the Keynesian approach.
Although traditional business cycle analysis relies
heavily on the Keynesian LO and AD model, a new branch
of the classical school questions the standard approach.
This theory, called the new neoclassical macroeconomics,
was formulated by Robert Lucas (University of Chicago),
Thomas Sargent (Stanford University and New York
University), and Robert Barro (Harvard University). This
approach retains much of the spirit of the classical approach.
375
because it highlights the role of price and wage flexibility,
but also adds a new feature called rational expectations to
explain observations like the Phillips curve.
rational expectations
The great innovation of neoclassical economics has been
to introduce the principle of rational expectations into
macroeconomics. Some background on expectations will
help explain this new approach.
In many areas of the economy, particularly those that refer
to financial and investment decisions, expectations are a
firms will spend on investment goods and whether
consumers will spend now or save for the future. For
example, suppose you are looking at how much you should
spend on your first home. Expectations about your future
income, the size of your family, and future home prices will
affect your decision.
How do people form their expectations? According to
the rational expectations hypothesis, the expectations
are unbiased and are based on all available information.
Here it is convenient to make a statistical parenthesis: a
forecast is not biased if it does not contain systematic
projection errors. Clearly, a forecast cannot always be
completely accurate: you cannot predict which way a coin
will land in a single toss. However, one should not commit
the statistical sin of bias by predicting that a coin will fall one
way only 25% of the time. One would be making an unbiased
forecast if one predicts that the coin will land on each side
50% of the time, or that each number on a die will appear,
on average, one sixth of the time.
People have rational expectations when, in addition
to being unbiased, they use all available information when
making their decisions. This means that people understand
how the economy works and what the government is doing.
Thus, suppose that the government always spends more in
election years to promote its candidates. When there are
rational expectations, people will anticipate this kind of
behavior and act in accordance with it. (Remember that this
principle is also an important assumption behind the efficient
market hypothesis of financial markets, as described in
Chapter 9.)
actual business cycles
The greatest application of modern classical macroeconomics
is in an exciting field known as macroeconomics theory .
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376
ry of real business cycles (CNR). This theory was
developed notably by Finn Kydland and Edward C.
Prescott, who won the Nobel Prize for their work in
this area. This approach holds that business cycles
are rooted in technology shocks and does not invoke
any monetary or demand-side forces.
In the CNR approach, shocks to technology,
investment, or labor supply alter the potential output
of the economy. In other words, the shocks shift a
vertical OA curve. These supply shocks are transmitted
to the actual product and are completely independent
of AD. Similarly, movements in the unemployment rate
are the result of movements in the natural rate of
unemployment (NAIRU) caused by macroeconomic
forces, such as the intensity of sectoral shocks, or by
tax policies or regulation. Standard Keynesian fiscal
and monetary policies have no effect on output or
employment in the CNR models; they only affect DA
and the price level. Figure 17-4 shows an example of
a CNR recession caused by a decline in productivity.
Ricardian View of Fiscal Policy One of the
most influential critiques of Keynesian macroeconomics
was a new view of the role of fiscal policy. This view,
known as the Ricardian view of fiscal policy, was
developed by Robert Barro of Harvard University, and
he argues that changes in tax rates have no effect on
consumer spending.
This idea is a logical consequence of the
consumption life-cycle model, presented in Chapter 6.
According to the Ricardian vision, individuals are
shrewd and form part of a succession of members of
the same family, like a dynasty. Parents are concerned
not only with their own consumption, but also with the
well-being of their children; the children, in turn, worry
about the well-being of their own children, etc. The
structure, called "dynastic preferences," means that
the horizon of the current generation is extended into
the indefinite future by the overlapping concerns of
each generation about its offspring.
This is where the surprising result comes in: if the
government cuts taxes but doesn't change its spending,
this necessarily requires it to borrow. But with the
same expenses, the government will have to raise
taxes at some point in the future to pay the interest on
its new debt. From the Ricardian perspective,
consumers have rational expectations about future
policies, so when a haircut occurs
CHAPTER 17 • FRONTIERS OF MACROECONOMICS
tax, they know they must increase their savings by the
amount of the cut, so their consumption will stay the
same. In addition, people take into account the well-
being of their children. So even if the future tax
increase lasts until the end of your life, you'll save
enough to increase your children's inheritance so they
can pay the additional taxes.
From the Ricardian perspective, the net result is
that tax changes have no effect on consumption.
Furthermore, government debt is not debt from the
point of view of households, because they offset such
assets in their mental calculations of the present value
of the taxes they must pay to service the government
debt.
The Ricardian view of debt and deficit has fueled
fierce controversy among macroeconomists. Its critics
point out that it requires extreme lucidity from families,
that they plan to leave an inheritance to their
descendants and that they always weigh their personal
interests with those of their relatives.
That chain would be broken if there were no children,
no inheritances or no concern for the children, or if
there was a bad forecast. To date, the empirical
evidence offers little evidence for the validity of this
view, but it is a useful reminder of the logical limitations
of fiscal policy.
Efficiency wages
Another important recent advance, combining
elements of classical and Keynesian economics, is
what is known as efficiency wage theory.
Edmund Phelps (Columbia University), Joseph Stiglitz
(Columbia University), and Janet Yellen (president of
the Federal Reserve Bank of San Francisco) formulated
this theory. The authors explain the rigidity of real
wages and the existence of involuntary unemployment
in terms of the efforts of companies to increase
productivity by maintaining wages above the level at
which the market clears. According to this theory,
higher wages lead to higher productivity because
workers are healthier, in a better mood, and less likely
to surf the internet for fear of losing their job, because
good workers are unlikely to quit and look for new
jobs, and because better wages can attract the best
workers.
As companies raise their wages to increase the
productivity of their workers, job seekers may be
willing to wait in line for a well-paying job, resulting in
involuntary unemployment. The innovation of this
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B. ADVANCES IN MODERN MACROECONOMICS
The theory is that involuntary unemployment is a
feature of equilibrium and will not disappear over time.
Supply-Side Economics In the
early 1980s, a group of economists and journalists
put forward a popular school of thought known as
supply-side economics, which emphasized incentives
and tax cuts as a means of increasing growth.
economic. Supply-side economics was vigorously
advocated by President Reagan in the United States
(1981-1989) and by Prime Minister Thatcher in Britain
(1979-1990).
Supporters of this theory argue that the Keynesians,
in their excessive concern with the business cycle,
had forgotten the effect of tax rates and incentives on
economic growth. According to them, high taxes lead
people to reduce their supply of labor and capital. In
fact, supply-side economists such as Arthur Laffer
have suggested that high tax rates may actually reduce
tax revenues. This Laffer curve proposition holds that
high tax rates shrink the tax base because they reduce
economic activity. To fix what they see as an inefficient
tax system, supply-side economists have proposed a
radical restructuring of the tax system through an
approach sometimes known as “supply-side tax cuts.”
After taking center stage in the 1980s, supply-side
theories largely faded after Ronald Reagan left office.
Studying this period, economists have concluded that
many of the claims of this supply-side theory were not
supported by empirical evidence. The supply-side tax
cuts produced less, not more, revenue.
Many of the supply-side policies were revived in
2001, when President George W. Bush successfully
negotiated another round of tax cuts.
These cuts were justified, not on the grounds that they
would raise revenues, but, on the contrary, on the
theory that they would improve the efficiency of the
tax system and raise the rate of economic growth in
the long term. Like their predecessors in 1981, these
cut measures led to lower, not higher, tax revenue
(see Table 17-1).
POLICY IMPLICATIONS
policy ineffectiveness
Neoclassical approaches have several important
consequences for macroeconomic policy. One of
377
The most important indications are the inefficiency of
the fiscal system and monetary policies to reduce
unemployment. Here, the basic idea is that a
predictable attempt to stimulate the economy would
be known in advance, so it would have no effect on
the economy.
For example, suppose the government has
stimulated the economy whenever elections approach.
After a couple of episodes of politically motivated fiscal
policy, people would rationally expect a repeat of that
behavior. Arguably:
The elections are coming. From what we have seen,
we know that the government always pumps money
into the economy before elections. You will likely get a
tax cut, but that will be followed by a sneaky tax hike
next year. They can't fool me into spending more,
working harder, and voting to stay in power.
This is the policy ineffectiveness theorem of
classical macroeconomics. With rational expectations
and flexible prices and wages, anticipated government
policy cannot affect real output or unemployment.
The convenience of having fixed
rules The monetarist argument for fixed rules was
already described in Chapter 10. Neoclassical
macroeconomics puts this argument on a firmer footing.
This approach holds that an economic policy can be
divided into two parts, a predictable part (the “rule”)
and an unpredictable part (the “discretionary”).
The new classical macroeconomists point out that
discretion is a lure and a deception. Policy makers,
they argue, cannot project the economy any better
than the private sector. Thus, by the time policymakers
act on the facts, price flexibility in markets populated
by well-informed buyers and sellers ensures that they
have already adjusted to the facts and have reached
an efficient balance of supply and demand. demand.
There are no additional discretionary steps the
government can take to improve the outcome or avoid
unemployment caused by temporary misperceptions
or real business cycle shocks.
While they can't make things better, government
policies can definitely make things worse. The
government can apply unpredictable discretionary
policies that send misleading signals to the economy,
confuse people, distort their economic behavior, and
encourage waste. In accordance with
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378
According to neoclassical macroeconomists,
governments should avoid any discretionary
macroeconomic policy rather than risk producing such
confusing “noise”.
A new synthesis?
After three decades of digesting the neoclassical
approach to macroeconomics, elements of a synthesis
of old and new theories are beginning to appear.
Currently, economists emphasize the importance of
expectations. A useful distinction is that between the
adaptive (backward or “retrospective”) approach and
the rational (forward or “prospective”) approach. The
adaptive assumption holds that people form their
expectations based on past information; the prospective
or rational approach has already been described. The
importance of forward expectations is crucial to
understanding behavior, especially in competitive
auction markets such as those in the financial sector.
Some macroeconomists have begun to combine
the neoclassical view of expectations with the
Keynesian view of labor and product markets. This
synthesis has been incorporated into macroeconomic
models that assume that 1) labor and product markets
have sticky prices and wages, 2) prices in financial
auction markets adjust promptly to shocks and
economic expectations, and 3) expectations in the
auction markets are formed with a forward-looking
vision.
An important forecast of these new approaches is
that forward-looking models tend to give large “jumps”
or discontinuous changes in interest rates.
rés, stock prices, exchange rates and oil prices in
response to important news.
Sudden reactions are often seen after elections or
when wars break out. For example, when the United
States invaded Iraq in March 2003, oil prices fell 35%
and stock prices rose 10% in a single week.
Neoclassical “jumping” price prediction echoes a
realistic feature of auction markets, and this suggests
an area where future expectations might be important
in the real world.
The neoclassical approach to macroeconomics
has provided many useful insights. Most importantly,
remember that there are savvy consumers and
investors in the economy who react to, and often
anticipate, policies. This reaction and counter-reaction
can actually change the way the economy is run.
CHAPTER 17 • FRONTIERS OF MACROECONOMICS
C. STABILIZATION OF
THE ECONOMY
The period since World War II has seen remarkable
economic progress for high-income market
democracies. Average incomes and employment grew
rapidly, international trade expanded and deepened,
and many poor countries, notably China and India,
began to close the gap between them and rich
countries.
The economies performed so well that some
heralded the time when business cycles were winding
down as the "Great Moderation." In fact, some “new”
economics books omitted the macroeconomic aspects
of business cycles.
This fantasy was shattered by the financial crisis
and deep recession that began in 2007. Words like
“recession” and “depression”, which had been
consigned to the history books, once again took on
meaning in the daily lives of people.
It is crucial to find policies that can help avoid the
excesses of the business cycle. It has been seen that
the path of output and prices is determined by the
interaction of aggregate demand and supply.
However, policies designed to stabilize the business
cycle must operate primarily through their effect on
aggregate demand. The government can affect the
growth of aggregate demand basically by using its
monetary and fiscal levers, thereby fighting recessions.
These observations leave two crucial questions
unanswered: What is the best mix of monetary and
fiscal policies to stabilize the economy? Should there
be strict rules on policy making or should policy makers
be allowed a great deal of discretion in their actions?
INTERACTION OF POLICIES
MONETARY AND FISCAL
In large economies, such as the United States or the
Euro zone, the best combination of monetary and
fiscal policies will depend on two factors: the need to
manage demand and the desired fiscal monetary mix.
Demand Management
The highest consideration in the administration of the ci
The business cycle is the global state of the economy and the
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C. STABILIZATION OF THE ECONOMY
need to adjust aggregate demand. When the economy
stagnates, monetary and fiscal policies can be used to
stimulate it and promote its recovery. When inflation is
a threat, monetary and fiscal policies can help slow the
economy and put out inflationary fires. These are
examples of demand management, which refer to the
active use of monetary and fiscal policies to affect the
level of aggregate demand.
Suppose, for example, that the economy enters a
severe recession. The product is low in relation to its
potential level. What can the government do to revive
a languishing economy? It can increase aggregate
demand by raising money growth or increasing
government spending, or both. After the economy has
responded to monetary and fiscal stimulus, output and
employment growth will rise and unemployment will fall.
(What steps could the government take in periods of
inflation?)
To answer, it is convenient to review the strengths
and weaknesses related to monetary policy and fiscal
policy.
The role of fiscal policy. In the early stages of the
Keynesian revolution, macroeconomists stressed that
fiscal policy was the most powerful and balanced
remedy for managing demand. Critics of fiscal policy
pointed to the drawbacks associated with the times,
politics, and macroeconomic theory.
One concern is the length of time between the
cyclical shock and the policy response. It takes time to
recognize that a cyclical tipping point has been reached;
It's a policy oversight.
For example, it took a year for the NBER to declare the
most recent business cycle peak. (The December 2007
peak was not announced until December 2008.) After
a tipping point is identified, it takes time for the president
to decide what policies are needed and then even more
time for Congress to act. Finally, even when taxes or
spending change, there is an effectiveness lag before
the economy responds.
Critics also point out that it is easier to cut taxes
than to raise them and easier to spend more than to
cut spending. In the 1960s, Congress was excited to
pass the Kennedy-Johnson tax cuts. Two years later,
when the expansion caused by the Vietnam War kicked
off inflationary pressures, contractionary policies were
required.
379
There are two situations in which countercyclical
fiscal policies appear to be particularly useful.
One is temporary tax cuts in recessions. These
temporary cuts may primarily target low- and middle-
income families. The reason is that these families have
a high marginal propensity to consume because they
have little savings to fall back on in difficult times.
Statistics indicate that these measures have been
effective in increasing aggregate demand in the short
term, without leading to long-term fiscal deficits.
An even more important situation is when the
economy is in a liquidity trap and the central bank has
no room to reduce short-term interest rates. (Remember
the analysis of the liquidity trap in Chapter 10.) This
was what happened during the 2007-2009 recession.
In its efforts to revive the economy, the Obama
administration worked with Congress in early 2009 to
authorize the largest fiscal stimulus package in US
history. Although some people worried about the long-
term effect of fiscal stimuli on government debt, most
macroeconomists believed that fiscal policy was the
only feasible way to reduce the depth and severity of
the contraction in this case.
Effectiveness of monetary policy. Compared to fiscal
policy, monetary policy operates much more indirectly
on the economy. While expansionary fiscal policy
actually buys goods and services or puts money in the
hands of consumers and businesses, monetary policy
affects spending by changing interest rates, credit
conditions, the exchange rate, and the price. of the
assets. In the early years of the Keynesian revolution,
some macroeconomists were skeptical about the
effectiveness of monetary policy, some saying:
"Monetary policy was like pulling a string." However, in
the past 20 years, these concerns have been forgotten
because the Federal Reserve has proven quite capable
of speeding up, or slowing down, the economy.
The Federal Reserve is in a better position to
conduct stabilization policies than fiscal policy makers.
Your group of professional economists can recognize
cyclical movements as well as anyone. And you can
act quickly if necessary. For example, a cascade of
bankruptcies of financial institutions caused a major
financial crisis when the investment bank Bear, Stearns
ran into serious liquidity problems on Friday, March 14,
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380
2008. The Fed needed to come up with a solution before the markets
opened the following Monday morning. By Sunday, along with the
US Treasury Department, the Fed had engineered JP Morgan's
takeover of Bear and had opened an entirely new line of credit to its
major creditors. It is hard to imagine that any legislature could take
such complex measures in such a short period of time.
A fundamental ingredient of Fed policy is its independence, and
the Fed has shown that it can withstand the attacks of making
politically unpopular decisions when they are necessary to slow
inflation. Most importantly, with some reservations, from a demand
management standpoint, monetary policy can make or break
anything that fiscal policy can do. The main limitation is that if the
economy is caught in a liquidity trap, with nominal interest rates at
zero or close to zero, then monetary policy loses its ability to
stimulate the economy. When the latter is in or close to a liquidity
trap, fiscal policy must assume the leading role in promoting
expansion.
The current state of monetary and fiscal policies can be
summarized as follows:
Given its political independence and quick decision-making, the
central bank is well placed in the forefront of the line of defense in
stabilizing the economy in the face of business cycle shocks.
A discretionary fiscal policy serves as a one-time stimulus in
recessions. When the economy approaches a liquidity trap, fiscal
policy should be the primary source of economic stimulus.
Monetary-fiscal mix
The second factor that affects monetary and fiscal policies is the
desired monetary-fiscal mix , which refers to the relative strength
of monetary and fiscal policies and their effect on the different
sectors of the economy. A change in the monetary and fiscal mix is
an approach that tightens one policy while softening the other, so
that aggregate demand, and hence total output, remain constant.
The basic idea is that fiscal policy and monetary policy can be used
as substitutes in demand management. But even if there are different
combinations of monetary and fiscal policies to stabilize the economy,
their effects are different on the composition of the result. By varying
the mix of taxes, government spending, and monetary policy, the
government can change the fraction of GDP spent on investment.
CHAPTER 17 • FRONTIERS OF MACROECONOMICS
of companies, consumption, net exports and government purchases
of goods and services.
Effect of changing the mix of monetary and fiscal policies. To
understand the effect of changing the monetary-fiscal mix, a specific
group of policies is examined. Suppose the federal government cuts
its budget deficit by $100 billion and the Fed cuts interest rates to
offset the recessive effect of that fiscal policy.
The effect can be estimated using a quantitative economic
model. Table 17-3 shows the results
two from this experiment. Two interesting facts emerge: first, the
stimulus indicates that a change in the monetary-fiscal mix would
certainly alter the composition of real GDP. While the deficit falls by
100 billion dollars, business investment rises by 30 billion. Investment
in housing is also
increases when interest rates fall. At the same time, personal
consumption falls, freeing up resources for investment. This
simulation shows how a change in the monetary-fiscal mix could
alter the composition of output.
The simulation contains a particularly interesting result: net
exports rise much more than investment in housing or fixed
investment by companies. This occurs due to the sharp depreciation
of the dollar resulting from the drop in interest rates. Although this
result is quite sensitive to the reaction of financial markets and
exchange rates to the deficit reduction package, it suggests that
some of the popular analyzes of the impact of such a package may
be misleading. Many analyzes argue that a deficit reduction package
would have a significant effect on domestic business investment
and productivity. However, to the extent that a lower deficit
fundamentally lifts net exports and housing, the country is likely to
see a relatively small increase in its productivity growth. According
to estimates, cutting the budget deficit by $100 billion will raise the
growth rate of potential output from 2.3% per year to 2.5% per year
over a 10-year period. Perhaps such a small result explains why it is
so difficult to gather political will to reduce the deficit.
Alternative mixes in practice
The monetary-fiscal mix has been much
debated in US economic policy.
Here are two great alternatives:
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C. STABILIZATION OF THE ECONOMY
Sector
investment sectors
Gross domestic private investment
living place
Fixed investment of companies
net exports
consumer sectors
Government purchases of goods and services
personal consumption expenses
Memorandum:
Change in real GDP
Change in the federal deficit
TABLE 17-3. Changes in the monetary-fiscal mix
What would be the effect of a change in the monetary-fiscal mix in the United States? This simulation
assumes that the federal deficit is cut by $100 billion through higher personal taxes and lower federal non-
military spending, while the Federal Reserve uses monetary policy to keep unemployment on a fixed path.
The simulation takes the average of the changes from the bottom line for the period 2000-2009.
Source: Simulation applying the DRJ model of the US economy.
• Loose fiscal policy—tight monetary policy. Suppose that the
economy starts in an initial situation in which there is low inflation
and output is at its potential level. A new president decides that
a sharp increase in defense spending without raising taxes is
necessary. In itself, this situation would raise the government
deficit and aggregate demand. In this case, the Federal Reserve
would need to tighten monetary policy to prevent the economy
from overheating. The result would be higher real interest rates
and an appreciation of the dollar exchange rate. Higher interest
rates would put downward pressure on investment, while an
appreciating dollar would reduce net exports. Therefore, the final
effect would be that higher defense spending would drive out
domestic investment and net exports. This policy was followed in
the United States in the 1980s and again in the early years of the
new millennium.
• Restrictive fiscal policy —loose monetary policy. Suppose a country
is concerned about its low national savings rate and wants to
raise investment and boost the growth rate of potential output.
To apply this approach, the country could raise consumption
taxes and reduce transfers, thereby contracting disposable
income and with it consumption (restrictive fiscal policy). This
would be accompanied by an expansive monetary policy to
reduce interest rates and raise the
381
Change in product ($,
billions, 2008 prices)
132
48
18
30
83
106
68
38
26
100
investment, decrease the exchange rate and increase net
exports. This would encourage private investment by raising
public saving. This was President Clinton's philosophy, which
was embodied in the 1993 budget law and led to a budget surplus
at the end of that decade.
THE RULES VERSUS THE CRITERION
It has been seen that monetary and fiscal policies can
in principle stabilize the economy. Many economists
believe that in practice countries should take steps to
smooth out the peaks and troughs of the business cycle.
Other economists are skeptical about the ability to
forecast cycles and take the right steps at the right
time for the right reasons; this second group concludes
that the government cannot be trusted to carry out
good economic policy, so its freedom to act must be
strictly limited.
For example, fiscal conservatives worry that it is
easier for Congress to raise spending and cut taxes
than the other way around. This means that it is easier
to increase the budget deficit in recessions, but much
more difficult to walk in the right direction.
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382
opposite direction and reduce the deficit in good times,
as a countercyclical fiscal policy would require. For
this reason, conservatives have made various attempts
to limit Congress's ability to allocate new funds or
raise the deficit.
Likewise, monetary conservatives would like to tie
the hands of central banks and force them to focus on
inflation. This policy would remove uncertainty about
policy and enhance the credibility of the central bank
as an inflation-fighting entity.
More generally, the “rules versus criteria” debate
boils down to whether the advantages of flexibility in
decision-making are outweighed by uncertainty and
the potential for unlimited decision abuse.
Those who believe that the economy has an inherently
unstable and complex nature, and that governments
generally make good decisions, are comfortable giving
policymakers wide latitude to exercise their discretion
and to react vigorously to stabilize the economy.
Those who believe that the government is the main
destabilizing force in the economy, and that policy
makers tend to be selfish and make bad decisions,
favor tying the hands of the monetary and fiscal
authorities.
Budget restrictions on
legislatures?
When deficits began to grow in the 1980s, many
people pointed out that Congress did not have the self-
restraint required to limit excessive spending and
ample government debt. One Conservative proposal
was a constitutional amendment to require a balanced
budget. This proposal was criticized by economists
because it would make it more difficult to use fiscal
policy to combat recessions. To date, none of the
constitutional amendment proposals have been
approved by Congress.
Rather, Congress legislated a series of budget
rules to limit spending and tax cuts. The first attempt
was the Gramm-Rudman Act of 1985, which required
that the deficit be reduced by a specified dollar amount
each year, and that the budget be balanced by 1991.
This initiative failed to limit spending and was
abandoned.
A second proposal was the pay as requested
budget rule, which was adopted in 1990. This rule
required Congress to find the necessary revenue to
pay for any new spending programs. In a sense, the
pay-as-demand principle places a budget constraint
on Congress, requiring that the cost of new programs
be recognized.
CHAPTER 17 • FRONTIERS OF MACROECONOMICS
explicitly, either through higher taxes or a reduction in
other spending.
What was the effect of budget restrictions on
Congress? Studies in this regard indicate that budget
rules produced significant fiscal discipline, helped
reduce the deficit in the 1990s, and ultimately led to a
surplus after 1998. However, when the deficit turned
into a surplus and fell In the urgency of reducing the
deficit, policy makers evaded previous budget ceilings
with tricks such as “emergency spending” for
predictable concepts such as the decennial census.
Finally, in 2002 budget ceilings were eliminated. Many
economists believe that the pay-as-you-go rule is a
useful mechanism for imposing budget limits on
legislatures, and there were attempts to reinstate them
in 2009.
Monetary rules for the Fed?
In the discussion of monetarism in Chapter 10, the
case for fixed policy rules was presented. The
traditional argument in favor of fixed rules is that the
private economy is relatively stable and that active
policymakers are likely to destabilize the economy,
rather than stabilize it. Also, to the extent that a central
bank is under government power and is tempted to
expand the economy before elections by creating a
political business cycle, fixed rules will tie its hands.
Furthermore, modern macroeconomists point to the
value of a stock's upfront commitment. If the central
bank can commit to follow a non-inflationary rule,
people's expectations will adapt to this rule and
inflationary expectations can be weakened.
One of the most important developments in the
last decade has been the trend towards inflation
targeting in many countries. Inflation targeting is the
official announcement of targets within a certain range
for the rate of inflation, together with an explicit
statement that low inflation, and the ultimate goal of
monetary policy, is stable.
Inflation targeting, in its hard or soft versions, has
been adopted in many industrialized countries,
including Canada, the United Kingdom, Australia, and
New Zealand. Likewise, the treaty creating the new
European Central Bank includes a mandate that
places price stability as the primary objective of the
ECB, although it does not formally require what regime
must be followed for this purpose.
Various economists and lawmakers are proposing that
the United States take this approach as well.
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D. ECONOMIC GROWTH AND HUMAN WELL-BEING 383

The inflation targeting regime means the following: interest and expanded credit throughout this period,
even as supply shocks were pushing inflation above
the Fed's “comfort zone.” If the Fed had simply
• The government, or the central bank, announces controlled inflation with a targeting approach of
that monetary policy will fight to keep inflation
inflation, would have raised interest rates, would have
close to a specific target in figures. • The goal is
made credit more expensive while reinforcing the
often a range, such as 1-3% per year, rather than
recessive trends and economic anxieties of this period.
literal price stability.
Instead, the Fed concentrated on trying to protect the
In general, the government sets the inflation target
economy from falling into a deep recession and
on the annual variation of a core CPI that excludes
avoiding a multitude of bankruptcies among financial
volatile food and energy prices.
institutions (see the comment on the Bear, Stearns in
previous paragraphs).
• Inflation is the primary goal or policy objective in
the medium and long terms. However, countries
Monetary policy cannot prevent all recessions or
always leave some room for short-term stabilization
eliminate all temporary spikes in inflation. However,
objectives, particularly with respect to output,
by working with fiscal policy, you can reduce the
unemployment, financial stability, and exchange
possibility of recessionary spirals or hyperinflation.
rates. These short-term targets recognize that
supply shocks can affect output and unemployment,
and that it may be desirable to temporarily deviate The debate between rules and criteria is one of
from the inflation target to avoid excessive output the oldest in political economy. This dilemma reflects
or unemployment losses. the difficult trade-offs that democracies must make
when making decisions between short-term policies,
which are intended to attract political support, and long-
Supporters of the inflation targeting regime point term policies, which are intended to improve general
to its many advantages. If there are no long-term trade- welfare. There is no single best approach for all times
offs between unemployment and inflation, a sensible and places. In the case of monetary policy, the United
inflation target is the rate that maximizes the efficiency States has solved this dilemma with the creation of an
of the price system. The discussion of inflation in independent central bank that is accountable to the
Chapter 16 suggested that a low and stable inflation Legislative Branch, but that has sufficient judgment to
rate would promote efficiency and minimize act energetically when economic or financial crises
unnecessary redistribution of income and wealth. arise.
Furthermore, some economists believe that a strong
and credible commitment to low and stable inflation
will blur the inflation-unemployment dilemma in the short term.
Finally, an explicit inflation target would improve the
transparency of monetary policy. D. ECONOMIC GROWTH AND
Inflation targeting is a compromise between rule- HUMAN WELL-BEING
based approaches and purely discretionary policies.
The main drawback would be if the central bank began
The end of this study of modern macroeconomics is
to rely too rigidly on the inflation rule, thereby allowing
coming. Now we go back a bit and reflect on the
excessive unemployment in periods of severe supply
central long-term message as expressed at the time
shocks. Skeptics worry that the economy is too
by the economist and journalist Paul Krugman:
complex to be governed by fixed rules. By analogy,
they wonder if one would set fixed speed limits for Productivity is not everything, but in the long run it is
automobiles or an autopilot system for airplanes in all almost everything. A country's ability to improve its
living standards depends almost entirely on its ability
kinds of weather and emergencies.
to raise its output per worker.

The promotion of a high and increasing standard

of living for the country's residents is one of the
Critics of this regime point to the 2007-2009 fundamental goals of macroeconomic policy. Since
financial crisis as an example of the danger of relying the current level of real income reflects the history of
on rigid targets. The Fed cut interest rates productivity growth , it is possible to measure success re
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384 CHAPTER 17 • FRONTIERS OF MACROECONOMICS

Country
GDP per capita, 2006
gico. Saving issues have already been discussed in
this chapter. Technological change includes not only
USA 44 070 new products and processes, but also improvements
Hong Kong 39 200
in administration, as well as in entrepreneurship and
United Kingdom 33 650
entrepreneurship, themes that will occupy the closing
Japan 32 840
Germany 32 680
of this exhibition.
Slovenia 23 970
South Korea 22 990
Poland 14 250
ENTREPRENEURSHIP
Mexico 11 990
Although investment is a central factor in economic
botswana 11730
11 670
growth, technological advance is perhaps even more
Argentina
China 4 660 important. If you took workers from 1900 and doubled
Nigeria 1 410 or tripled their capital in mules, saddles, picks, and
Congo 270 yokes, their productivity would be nowhere near that
of today's workers, using huge tractors, superhighways,
TABLE 17-4. Current revenue represents the effects of past
and supercomputers.
growth

The countries that grew fastest in the past have now reached the
highest levels of GDP per capita. Fostering Technological
Source: World Bank.
Advancement Although it is easy to see that
technological advancement promotes growth in
productivity and living standards, governments cannot
simply command people to think more or be smarter.
relative to past growth if we examine the GDP per Centrally planned socialist countries used “sticks” to
capita of different countries. A brief list is presented in promote science, technology and innovation, but their
Table 17-4. This table compares income using efforts failed because neither the institutions nor the
purchasing power parity exchange rates that measure “carrots” were there to encourage innovation and the
the purchasing power of different national currencies introduction of new technologies. Governments often
(or a number of goods and services that can be most effectively promote rapid technological change
purchased with them). It is clear that the United States when they establish a strong economic and legal
has been successful in terms of growth. Perhaps most framework with strong protection for intellectual
worrisome in recent years is that the growth in living property rights, and then allow great economic freedom
standards has not been universally shared around the within that framework. Free markets for capital, labor,
world. products, and ideas have proven to be the most fertile
In the study of growth rates, the numbers often ground for innovation and technological change.
seem minuscule. A successful policy could increase a
country's growth rate by just 1 percentage point per Within the framework of the free market,
year (recall the estimated effect of the inflation governments can foster rapid technological change,
reduction package in the previous section). But over both by stimulating new ideas and by ensuring that
long periods, this makes a big difference. Table 17-5 those technologies are used effectively. Policies can
shows how a small acorn can become a mighty oak focus on both the supply and demand sides.
tree when these small differences in growth rates
accumulate and settle over the years. A growth
difference of 4% a year leads to a 50-fold difference in Promoting the demand for better technologies.
income levels in a century. The world is full of superior technologies that have not
been adopted; Otherwise, how to explain the vast
differences in productivity shown in Table 17-4?
How public policy can boost economic growth? Therefore, when considering technology policies,
As highlighted in the chapters on economic growth, governments must ensure that companies and
the growth of output per worker and of living standards industries move towards the technological frontier,
depend on a country's savings rate and its technological adopting the best practice technology available in the
advance. global marketplace.
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D. ECONOMIC GROWTH AND HUMAN WELL-BEING
Real income per capita (constant prices)
Growth
rate (% per
year) 2000
0 $24,000
one 24,000
2 24,000
4 24,000
TABLE 17-5. Small differences in growth rates make up large income differentials over
decades
The great lesson is that "necessity is the mother
of invention." In other words, vigorous competition
between companies and industries is the ultimate
discipline that ensures innovation. Just as athletes
perform better when trying to outperform their
competitors, companies are under pressure to improve
their products and processes when victors receive
fame and fortune, while laggards may go out of
business.
Vigorous competition refers to both domestic and
foreign competitors. In large countries that are on the
technological frontier, domestic competition is
necessary to promote innovation. The move toward
deregulation in the past 30 years has brought
increased competition in airlines, energy,
telecommunications, and finance, and the positive
effect of innovation has been dramatic. In small
countries or those with a technological lag, competition
from imports is crucial for adopting advanced
technologies and ensuring their competition in the
product market.
Promoting the supply of new technologies.
Accelerated economic growth requires pushing the
technological frontier by increasing the supply of
inventions, as well as ensuring that there is adequate
demand for existing advanced technologies. There
are three ways in which governments can encourage
the supply of new technologies.
First, governments need to ensure that basic
science, engineering and technology are adequately
supported. In this sense, the world leader has been
the United States, which combines corporate support
for applied research with the highest quality basic
research generously financed with government funds.
Particularly noteworthy are the revolutionary
improvements in biomedical technology
385
2050 2100
$24,000 $24,000
39,471 64 916
64 598 173 872
170 560 1 212 118
with new drugs and equipment that have benefited
consumers in their daily lives. The government's role
in supporting research for profit is achieved with a
strong patent system, predictable and cost-effective
regulation, and tax incentives such as the current
research and development tax credit.
Second, governments can advance their domestic
technologies by encouraging investment from foreign
companies. As other countries reach and cross the
US technological frontier, they can also contribute to
American know-how by establishing operations in the
United States. The past two decades have brought a
number of Japanese automobile manufacturers to the
United States, and Japanese-owned plants have
introduced new technology and management practices
to the benefit of both Japanese shareholders and the
productivity of American workers.
Third, governments can promote new technologies
by pursuing sound macroeconomic policies that
include moderate and stable taxes on capital, as well
as a low cost of capital for firms. In fact, the importance
of the cost of capital leads us to close the circle by
returning to the issue of low savings rates and high
real interest rates. US companies are sometimes
accused of being myopic and unwilling to invest for
the long term. At least part of this myopia stems from
the fact that they have to deal with high real interest
rates, high real interest rates force US companies to
seek a quick payback on their investments. A change
in economic policy that lowered real interest rates
would change the “economic binoculars” through
which companies look when considering their
technology policies. If real interest rates were lower,
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386
Firms would consider long-term, high-risk projects
such as investments in more favorable technology,
and greater investment in knowledge would lead to
more rapid improvements in technology and
productivity.
Farewell to economic growth
Following the Keynesian revolution, the
leaders of market democracies believed that
they could soon flourish and grow. Using
the tools of modern economics, countries could moderate
the extremes of unemployment and inflation, of poverty
and wealth, of privilege and deprivation.
In practice, many of these goals were achieved as market
economies experienced a period of unprecedented output
expansion and employment growth.
RESUME
A. Economic Consequences of Government
Debt 1. Budgets are systems used by
governments and organizations to plan and control
expenditures and revenues. Budgets are in surplus (or
deficit) when the government has revenues greater (or
less) than its expenditures. Macroeconomic policy depends
on fiscal policy, which includes the overall spending and
tax situation.
2. Economists separate the real budget into its structural and
cyclical components. The structural budget calculates how
much the government would raise and spend if the
economy were operating at its potential output. The cyclical
budget responds to the effect of the business cycle on tax
revenues, expenditures, and the deficit.
To evaluate fiscal policy, close attention must be paid to
the structural deficit; changes in the cyclical deficit are a
result of changes in the economy, while structural deficits
are a cause of changes in the economy.
3. Government debt represents the amounts that have been
borrowed from the public. It is the sum of past deficits. A
useful measure of the size of the debt is the debt-to-GDP
ratio, which in the case of the United States has tended to
rise in times of war and fall in times of peace.
CHAPTER 17 • FRONTIERS OF MACROECONOMICS
Similarly, Marxists warned that capitalism was doomed
to be destroyed in a cataclysmic depression;
environmentalists feared that market economies would
drown in their own fumes; and liberals worried that
government planning would drag society into serfdom. But
pessimists overlook the entrepreneurial spirit, which is
fueled by an open society and free markets, and which has
led to a steady stream of technological improvements.
A farewell to John Maynard Keynes, as timely now as
it was in an earlier age, offers a convenient summary for
the study of modern economics:
It is the Enterprise that builds and improves the world's
possessions. If the Enterprise prepares to act, wealth will
accumulate no matter what happens to Frugality; and if the
Enterprise is asleep, wealth will decline no matter what
Frugality is doing.
4. To understand the effect of government deficit and debt, it
is crucial to distinguish between the short run and the long
run. Review the box on page 373 and verify that you
understand why a higher deficit can increase output in the
short run, while it can reduce it in the long run.
5. To the extent that foreign loans are obtained for consumption
and posterity is mortgaged, which will have to pay the
principal and interest on that foreign debt, the descendants
of the current generation will have to sacrifice their
consumption to pay off that debt. If future generations are
left with an internal debt, but without changes in the capital
stock, there will be several internal effects. The process of
taxing Pedro to pay Paula, or taxing Paula to pay Paula,
can mean various macroeconomic distortions of productivity
and efficiency, but should not be confused with owing
money to another country.
6. Economic growth can slow down if public debt crowds out
capital. This syndrome occurs when people substitute
public debt for private capital or assets, thereby reducing
the stock of private capital in the economy. In the long run,
higher government debt can slow potential output growth
and consumption, due to the costs of servicing foreign
debt, the inefficiencies that arise from imposing taxes to
pay the
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CONCEPTS FOR REVIEW
interest on debt and the lesser accumulation of capital that
comes with the movement of capital.
B. Advances in modern macroeconomics
7. Classical economists relied on Say's law of markets: “every
supply creates its own demand”. In modern language, the
classical approach means that flexible prices and wages
promptly eliminate any excess supply or demand, thereby
restoring full employment. In a classical system,
macroeconomic policy plays no role in stabilizing the real
economy, although it does affect the trajectory of prices.
8. Neoclassical macroeconomics holds that expectations are
rational, that prices and wages are flexible, and that
unemployment is largely involuntary. The policy ineffectiveness
theorem holds that predictable government policies cannot
affect real output and unemployment. Real business cycle
theory points to supply-side technological turmoil and
changes in the labor market as the keys to business cycle
fluctuations.
9. What is the evaluation of the contribution of the neoclassical
approach to short-term macroeconomics? The neoclassical
approach rightly insists that the economy has forward-looking
consumers and investors. These economic actors react to
and often anticipate policies, so they can change their
economic behavior. This lesson is especially important in
financial markets, where reactions and anticipation often
have dramatic effects.
C. The stabilization of the economy
10. Nations face two considerations when
end their monetary and fiscal policies: the right level
CONCEPTS FOR REVIEW
Economics of debt and Advances in macroeconomics
modern
government budget deficit budget
deficit, surplus and balanced Say's law of rational
budget: real (forward) markets
adjustable (retrospective)
structural expectations real business
cyclic cycle policy ineffectiveness theorem,
short-run effect of G and T on output efficiency wages
long-run effects on economic
growth: Ricardian view of fiscal policy
internal debt and external debt
tax distortions displacement of
capital
387
of aggregate demand and the best monetary-fiscal mix.
The mix of monetary and fiscal policies helps to define the
composition of GDP. A high investment strategy would
require a budget surplus, as well as low real interest rates.
11. Do governments have to follow fixed rules or their criteria?
The answer includes elements of both positive and normative
economics. Conservatives often opt for rules, while liberals
often propose active fine tuning to achieve economic goals.
More basic is the question of whether active and discretionary
policies stabilize or destabilize the economy. Economists
often stress the need
that policies are credible, whether that credibility is generated
by rigid rules or by wise leadership.
A recent international trend is inflation targeting in monetary
policy, which is a flexible rule-based system that sets medium-
term inflation targets while allowing short-term flexibility when
shocks occur. economics make scope too costly
of a rigid inflation target.
D. Economic growth and social welfare 12.
Remember the saying: "Productivity is not everything, but in the
long run it is almost everything." A country's ability to improve
its living standards over time depends almost entirely on its
ability to improve the technologies and capital used by the
labor force.
13. Promoting economic growth requires improving technology.
The government's main role is to make sure there are free
markets, provide strong protection for intellectual property
rights, promote vigorous competition, and support basic
science and technology.
Stabilization
demand management
monetary-fiscal mix
fixed rules and
inflation approach criteria
Long-term growth Reaching
the technological frontier and
pushing it out Keynes's
entrepreneurship
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388
FURTHER READING AND WEBSITES
further reading
Krugman's quote is from Paul Krugman, The Age of Diminished
Expectations (MIT Press, Cambridge, Mass. 1990), p. 9. Much of
the foundation of neoclassical economics was developed by
Robert Lucas and republished in Studies in Business-Cycle
Theory (MIT Press, Cambridge, Mass. 1990). The modern
efficiency wage theory is presented in Edmund Phelps, Structural
Slumps: The Modern Equilibrium Theory of Unemployment,
Interest, and Assets (Harvard University Press, Cambridge,
Mass. 1994).
A non-technical review of the different schools of macroeco
The economy is that of Paul Krugman, Peddling Prosperity: Economic
Sense and Nonsense in the Age of Diminished Expectations (Norton,
New York, 1994).
DISCUSSION QUESTIONS
1. There is often confusion between debt and deficit. Explain
each of the following concepts: a) A budget deficit leads to
government debt
growing mind.
b) Reducing the deficit does not reduce government debt.
c) The reduction of government debt requires having a
budget surplus. d) Even though the government deficit
was reduced in the period 1993-1998, the government debt
grew in those years anyway.
2. Is it possible that government promises could have a crowding
out effect along with government debt? So if the government
were to promise huge social security benefits to workers in
the future, would they feel richer? Could they reduce their
savings as a result of this? Could the capital stock end up
smaller? Illustrate your answers using Figure 17-2.
3. Track the effect on government debt, the country's capital
stock, and actual output of a government program that
borrows from abroad and spends the money on the following:
a) Capital to drill for oil for export (as Mexico did in the
1970s). b) Grains to feed its population (as Nigeria did in the
early years of the new millennium).
4. Construct a graph like the one in Figure 17-3 that shows
three:
a) The trajectories of consumption and net exports with large
government debt, and without this debt. b) The
trajectories of consumption with a balanced budget and with
a government fiscal surplus.
CHAPTER 17 • FRONTIERS OF MACROECONOMICS
Web Sites
Economic issues and data on fiscal policy, budgets, and debt
are regularly released by the nonpartisan Congressional Budget
Office, which is staffed by professional economists. Recent
documents are found at www.cbo.gov.
A summary of inflation targeting issues can be found in a 2003
speech by Fed Chairman Ben Bernanke, “A Perspective on
Inflation Targeting,” at www.federalreserve.gob/ Boarddocs/
Speeches/ 2003/ 20030925/ default.htm. Real Business Cycle
Theory has its own Web site at dge.repec.org/ index.html.
5. Review the debate between the senators on page 373.
Explain which senator would be right in the following
situations: a) The government increased its military spending
during the Great Depression. b) The government reduced
taxes during a period of full employment in the early
1960s. c) The government refused to raise taxes during the
full employment period of the Vietnam War.
6. Suppose someone proposes that monetary policy should
focus on a specific inflation rate each year: 2% per year for
the CPI. What are the different arguments for and against
this proposition? In particular, consider the difficulties of
reaching a strict inflation target after an abrupt supply shock
shifts the Phillips curve upward.
Compare a hard target with a flexible inflation target, where
the target would be reached after 5 years.
7. Political candidates have proposed the policies listed below
to accelerate economic growth in recent years. For each of
them, explain qualitatively its effect on the growth of potential
output and the growth of potential output per capita. If
possible, give a quantitative estimate of the increase in
potential output growth and potential output per capita over
the next decade. a) Cuts in the federal budget deficit (or
increase in the surplus) by 2% of GDP, increasing the ratio
of investment to GDP by the same amount. b) Increases to
the federal subsidy in R&D by .5% of GDP, assuming
that this subsidy will raise private R&D by the same
amount and that R&D has a rate
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DISCUSSION QUESTIONS
social return that is four times that of private
investment. c) Reductions in defense spending by
1% of full employment GDP. d) Reduce the number of
immigrants so that the labor force decreases 5%.
e) Raise investment in human capital (or education and
job training) by 1% of GDP.
8. JM Keynes wrote: “If the Treasury filled old bottles with
notes, buried them in abandoned coal mines, and
allowed private business to dig up the notes, there would
be no more unemployment, and the real income of the
community would probably be quite larger than it
currently is” (General Theory, p. 129). Explain why
Keynes' analysis of the utility of a discretionary public
works program might be correct in a depression. How
could well-designed monetary policies have the same
effect on employment, while inducing the production of
more useful goods and services?
9. What would be the prediction of the Keynesian and
neoclassical economists about the effect of each of the
following facts on the trajectory of prices, output and
employment? In each case, hold the tax and interest
rates constant, unless clearly stated otherwise:
a) A big tax cut. b) A big cut in
interest rates.
389
c) A wave of innovations that increases potential output
by 10%. d) A wave of exports.
10. Advanced problem (on rational expectations): Consider
the effect of rational expectations on consumer behavior.
a) Say the government is proposing a temporary tax cut
of $20 billion that will last for one year. Consumers
with adaptive expectations therefore assume that
their disposable income will be $20 billion higher
each year. What would be the effect on consumption
spending and GDP in the simple multiplier model of
Chapter 7? b) Suppose next that consumers have
rational expectations. They rationally anticipate that
the tax cut is only for one year. As “life-cycle” consumers,
they recognize that their average lifetime income
will rise by only $2 billion a year, not $20 billion a
year. What would be the reaction of such consumers?
Later analyze the
Effect of rational expectations on the effectiveness
of temporary tax cuts. c) Finally, suppose that
consumers behave according to the Ricardian point of
view.
What would be the effect of the tax cut on savings
and consumption? Explain the differences between
the models seen in a), b) and c).
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A consumption. Someone who buys (or sells)
Common actions. financial instrument
certain that represents ownership and, in
general, voting rights in a corporation.
Owning a certain amount of the shares of a
company
The company gives its owner the right to
this fraction of the votes, net profits and
assets of the corporation.
Common actions. Go to actions co
munes.
Asset. A physical property or intangible asset
that has economic value. Important
examples are plant, equipment, land,
patents, copyrights, and instrumentalities.
financial as money or bonds.
Financial assets. Monetary rights or obligations
of one party against another. Examples
are bonds, mortgages, bank loans, and
other financial securities.
Tangible assets. They are those assets, such
as land or capital goods, such as computers,
buildings, and automobiles, that are used
to produce other goods and services.
Risk averse. A person is risk averse when,
faced with a situation of uncertainty, the
displeasure of losing a given amount of
income is greater than the pleasure of
earning the same amount of money.
personal savings. Part of the income that is not
consumed; that is, it is the difference
between disposable income and
one
Words in bold within definitions appear as separate entries in the glossary. For a more detailed exposition of specific terms, the text offers a useful starting point. Fuller discussions are
found in Douglas Greenwald, ed., The McGraw Hill Encyclopedia of Economics (McGraw-Hill, New York, 1994) and David W. Pearce, The MIT Dictionary of Modern Economics, 4a. ed.
(Macmillan, London, 1992). For a comprehensive encyclopedia, see Steven N. Durlauf and Lawrence E. Blume, The New Palgrave Dictionary of Economics, 8 vols. (Macmillan, London,
2008). A reasonably accurate online dictionary of The Economist is at www.economist.com/ research/ economics.
390
Glossary1
a commodity or financial asset in order to
benefit from the
subsequent sale (or purchase) of such
merchandise or asset at a higher (or lower)
price.
Capital increase. The growth rate of the real
capital stock that is equal to the growth of
the labor force (or population), so that the
ratio of total capital to total labor remains
unchanged. (Contrast with capital
deepening.)
General equilibrium analysis. Analysis of the
equilibrium state for the economy as a
whole, in which the markets for all goods
and services are simultaneously in
Balance. In contrast, partial equilibrium
analysis refers to equilibrium in a single
market.
Partial equilibrium analysis. Analysis that
focuses on the effect of changes in an
individual market, all other things being
equal
(eg, omitting changes in income).
Appreciation (of a currency). See price (of a
coin).
Appreciation (or depreciation) of the
currency. See depreciation (of a currency).
Appropriable. Term applied to resources from
which the owner can extract full economic
value. In a well-functioning competitive
market, appropriable resources have a
price and a distribution.
efficient See also inna
ownable.
Arbitration. It is the purchase of a good or asset
in one market for its immediate resale in
another market, in order to take advantage
of a price discrepancy. Arbitrage is a major
force in eliminating price discrepancies,
thereby making the market work more
efficiently.
Optimum coin area. Grouping of regions or
countries where there is high labor mobility
or simultaneous supply or demand shocks
added. Under these conditions, no
significant changes in exchange rates are
needed to ensure rapid macroeconomic
adjustment, and countries can have fixed
exchange rates or a common currency.
Technological advance. See technological
change.
B.
Balance. Statement of financial position of an
entity (person, company, government) as
of a given date, listing assets in one column
and liabilities plus capital in the other.
Each item is listed at its current or estimated
money value. totals
Both columns must be the same because
equity is defined as assets minus liabilities.
Trade balance or food balance
cio of merchandise See balance of
Commerce.
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GLOSSARY
Balance of trade. balance part
of payments of a country that refers to the
imports or exports of goods, which include
products such as oil, capital goods and
automobiles. When services and other
current items are included, it is known as
the balance of the account.
stream. In the accounting of the
balance of payments, the current account
is financed with the financial account.
Current account balance. see ba
commercial spear.
International balance of payments. Financial
statement that shows all the transactions
of a country with the rest of the world in a
given period. Includes purchases and sales
of goods and services, gifts, government
transactions, and capital movements.
Merchandise trade balance.
See trade balance.
Fractional reserve banking. Regulation of
modern systems
whereby financial institutions are legally
required to keep a specified fraction of their
deposits in the form of central bank deposits
(or cash in safes).
Central bank. A government agency (in the
United States, the Federal Reserve
System) that is responsible for controlling
the country's money supply and credit
conditions, and for supervising the financial
system, especially commercial banks and
other institutions of deposit.
Commercial bank. Financial intermediary
whose first characteristic is that it accepts
deposits in checking accounts. All financial
institutions that have deposits in savings
and checking accounts are called depository
institutions.
Trade barrier. Any of several protectionist
measures by which countries discourage
imports. Fees and fees are the most visible
barriers, but in recent years the barriers are
not fees
Regulations (or NTBs), as cumbersome
and complex regulatory procedures, have
replaced more traditional measures.
Barriers to entry. Factors that impede entering
a market, for
that reduce competition or the number of
producers in an industry. Important
examples are legal barriers, regulation, and
product differentiation.
Monetary base. Net monetary liabilities of the
government held by the public. In the United
States, the monetary base is equal to
money and bank reserves. Sometimes
called high powered money.
Economic good. Well that it is small in relation
to the total amount that is desired of it.
Therefore, it must be rationed, usually by
charging a positive price.
good end. Good that is produced for final use
and not for resale or further manufacturing.
(Contrast with intermediate goods.)
lesser good. A good whose consumption falls
when income rises.
private good. See good public.
public good. Commodity whose benefits are
distributed indivisibly throughout the
community, whether or not specific
individuals want to consume said public
good.
For example, a public health measure that
eradicates polio protects everyone, not just
those who pay for the vaccine. They
contrast with private goods, such as bread,
which, if consumed by one person, cannot
be consumed by another.
Complementary goods. Two goods that "go
together" in the eyes of consumers (eg, the
left shoe and the right shoe). Goods are
substitutes when they compete with each
other (like gloves and mittens).
Independent goods. Goods whose demands
are relatively separated from each other. In
other words, goods A and B are independent
when a change in the price of good A has
no effect on the quantity demanded of good
B, if the other
things are held constant.
Intermediate goods. Goods that have gone
through some stage of manufacturing or
processing, but have not yet reached the
stage of final products. For example, steel
and cotton thread are intermediate goods.
Free goods. They are goods that are not
economic goods. like air or
391
sea water, exist in such large quantities
that they need not be rationed among those
who wish to use them. So its market price
is
zero.
Substitute goods. Competing goods (such as
gloves and mittens). In contrast, goods that
go together in the eyes of consumers (such
as the right and left shoe) are complementary.
Bond. Certificate bearing interest, issued by a
government or corporation, that promises
to pay a sum of money (principal) plus
interest at a specified date in the future.
Treasury Bonds (T-bills). Bonds or short-term
securities issued by the federal government.
C.
Change in demand and change in quantity
demanded. Change
in the quantity that buyers want to buy,
driven by any reason other than a price
change (eg, increase in income, change in
tastes), is a change in demand. in terms
In our graphics, it is a transfer of the
demand curve. If, in contrast, the decision
to buy more or less is driven by a change
in the price of the good, then it is a change
in the quantity demanded.
Dadaist. In graphical terms, a change in
the quantity demanded is a
movement along a demand curve that itself
does not move.
Change in supply and change in quantity
supplied. In the case of the offer
ta, the difference is similar to the difference
in demand, so see change in demand and
change in quantity demanded.
Technological change. Change in the
production process or the introduction of a
new product, of such a nature that more or
better production can be obtained from the
same group of inputs. Results in a shift out
on the curve of
production possibilities. Often called
technological advancement.
Quantity demanded. See change in demand
and change in quantity demanded.
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392
Quantity offered. see change in
supply and change in quantity supplied.
Capital. In accounting, total assets minus total
liabilities.
Capital (capital goods, capital equipment).
1) In economic theory, an element of the
third of inputs
productive (land, labor and capital). Capital
consists of manufactured articles of a
durable nature, which are used in
production. 2)
In accounting and finance, "capital" means
the total amount of money subscribed by
the shareholder-owners of a corporation,
in exchange for which they receive shares
of the company.
company.
Human capital. Inventory of technical
knowledge and skills that is embedded in
a country's labor force, resulting from its
investment in formal education and on-the-
job training.
Indirect share capital. Essential investments
on which economic development depends,
particularly sanitation and drinking water,
transport and communications; sometimes
called infrastructure
tour.
Capitalism. Economic system in which most of
the property (land and capital) is privately
owned. In this type of economy, private
markets are the primary vehicles for
distributing resources and generating
income.
Poster. Organization of independent companies
that collude to raise prices and restrict
production. Cartels are illegal under US
antitrust law.
Supply shock. In macroeconomics, a sudden
change in production costs or productivity
that has a profound and unexpected impact
on aggregate supply.
As a result of a supply shock, real GDP
and the price level change unexpectedly.
business cycles. Fluctuations in total national
output, income, and employment, typically
lasting periods of 2 to 10 years, marked by
broad and simultaneous expansion or
contraction in many sectors
nothing of the economy.
Coverage. Technique to avoid a risk by
carrying out a transaction in the opposite
direction. For example, if a farmer produces
wheat that will be harvested in the fall, he
can cancel or hedge the risk of price
fluctuations by selling the amount of wheat
he will harvest in the spring or summer.
Collusion. Agreement between different em
dams to cooperate by raising prices,
dividing up markets, or restricting
competition in some other way.
imperfect competition. Go competition,
imperfect.
Competition, imperfect. Term applied to
markets in which perfect competition does
not hold, because at least one seller (or
buyer) is large enough to affect the market
price, so it has a demand curve (or supply)
with downward slope. Imperfect competition
refers to any kind of market imperfection—
pure monopoly , oligopoly , or
monopolistic competition.
monopolistic competition. Market structure
in which there are many sellers offering
goods that are close but not perfect
substitutes. In such a market, each firm
can have some effect on the price of its
product.
perfect competition Go to competition,
perfect.
Competition, perfect. A term applied to
markets in which no firm or consumer is
large enough to affect the market price.
This situation arises when 1) the number
of sellers and buyers is very large, and 2)
the products offered by sellers are
homogeneous (or indistinguishable). Under
these conditions, each firm faces a
horizontal (or perfectly elastic) demand
curve.
imperfect competitor. Any firm that buys or
sells a good in quantities large enough to
affect the price of that good.
Communism. an economic system
communist (also called plan
GLOSSARY
Soviet-style central office) is a system in
which the state owns and controls the
means of production, in particular industrial
capital.
These economies are also characterized
They are driven by extensive central
planning, where the state sets many prices,
production levels, and other important
economic variables.
Consumption. In macroeconomics, it is the
total expenditure of individuals or a country
on consumer goods in a given period. In a
strict sense, consumption should be
applied only to those goods fully used,
enjoyed or “used up” in that period. In
practice, consumer spending includes all
consumer goods purchased, many of
which last well beyond
of the period in question—eg, furniture,
clothing, and automobiles.
Growth accounting. Technique
to estimate the contribution of different
factors to eco growth
nomic. With the theory of marginal
productivity, growth accounting
disaggregates the growth of output into
the growth of labor, land, capital, education,
technical knowledge, and other
miscellaneous sources.
Corporation. Dominant form of business
organization in modern capitalist
economies. A corporation is a business
that is owned by individuals or other
corporations. You have the same rights to
buy, sell and sign contracts as a person. It
is legally separate from those who own it,
and has limited liability.
Correlation. Degree to which two variables
are systematically associated
give one to another
Momentary run. Period that is so short that
production is fixed.
Short term. Period in which not all factors can
be fully adjusted. In microeconomics, the
inventory of capital and other “fixed” inputs
cannot be adjusted, and entry is not free
in the short run.
In macroeconomics, prices, wage contracts,
tax rates, and expectations may not
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GLOSSARY
be fully adjusted in the short term.
Opportunity cost. Value of the best
alternative use of an economic good.
So, let's say the best use of inputs
used to mine a ton of coal
was to grow 10 bushels of wheat. The
opportunity cost of a ton of coal is thus
the 10 bushels of wheat that could
have been grown, but were not.
Opportunity cost is particularly useful
for valuing goods that are not sold in
the market, such as environmental
health or safety.
Fixed cost. It is the cost that a firm would
incur even if its output for that period
were zero.
Total fixed cost is made up of individual
contract costs, such as interest
payments, mortgage payments, and
directors' fees.
Fixed cost. Go to cost, fixed.
Average fixed cost. Go to cost, fixed
average.
Cost, fixed average. Fixed cost (go to
cost, fixed) divided by the number of
units produced.
marginal cost. Go to cost, margi
nal.
Cost, marginal. It is the additional cost (or
increase in total cost) required to
produce 1 extra unit of product (or the
reduction in total cost for producing 1
less unit).
Minimal cost. Go at cost, minimal.
Minimal cost. It is the lowest achievable
cost per unit (either average, variable
or marginal). Any point on an average
cost curve is a minimum, in the sense
that it is the best the firm can achieve
relative to the cost to produce that
point represents. The minimum
average cost is the lowest point or
points, in
that curve.
Average cost. Go to cost, promise
it gave.
Average cost. Total cost (go to cost,
total) divided by the number of units
produced.
Total cost. Go to cost, total.
Total cost. It is the minimum total cost
achievable, given a particular level
of technology and set of prices of
inputs. The total cost of short
term takes existing plant and other
fixed costs as given. Long-run total
control is the cost that would be
incurred if the firm had complete
flexibility with respect to all inputs and
decisions.
Average variable cost. Go to cost,
moving average.
Cost, moving average. Variable cost (go
to cost, variable) divided by the
number of units produced.
Variable cost. Go to cost, variable.
Variable cost. Cost that varies with the
level of production, such as raw
material, labor, and fuel costs. variable
costs
equals total cost minus fixed cost.
Productivity growth. Rate of increase in
productivity from one period to the
next. For example, if a labor productivity
index is 100 in 2004 and 101.7 in
2005, the productivity growth rate is
1.7 percent per year from 2005 to 2004.
Economic growth. Increase
in the total product of a country over
time. Economic growth is generally
measured as
mo the annual rate of increase in the
Real GDP of a country (or real potential
GDP).
Credit. 1) In monetary theory, it is the use
of funds from a third party to
exchange for a promise to pay (usually
with interest) at a later date. The main
examples are short-term loans from a
bank, credit extended by suppliers,
and commercial paper. 2) In balance
of payments accounting, an item such
as exports, which earns foreign
currency from another country.
Current account. see balance eat
cial.
Financial account. see balance eat
cial.
Checking accounts (also checking
account deposits and bank money).
Deposit with a commercial bank or
other financial intermediary
money against which checks can be
written and therefore corresponds to
money for transactions (or M1).
393
Deposits in checking accounts are
about half of M1.
National income and product accounts
(NIPA). Set of accounts that measures
the expenditure, income and production
of the entire country in a quarter or a
year.
Share. A form of protection against imports
in which the total quantity of imports of
a particular good (eg, sugar or
automobiles) is limited in a given period.
Short-run average cost curve (SRAC or
SAC). Graph of the average minimum
cost of production of a commodity for
each level of output, using the given
state of technology, input prices, and
existing plants.
Long-Run Average Cost Curve (LRAC
or LAC). Graph of the average
minimum cost of production of a good
for each level of product, assuming
that the technology and the prices of
the inputs are given, but that the
producer is free to choose the optimal
size of the plants.
Money demand curve. Relationship
between money holdings and interest
rates. as they go up
interest rates, bonds and other
securities become more attractive,
reducing the quantity of money
sued. See also demand
of money.
Indifference curve. Curve on a graph
whose two axes measure quantities of
different goods with
submerged. Each point on a curve
(indicating different combinations of
the two goods) yields exactly the same
level of satisfaction
for a given consumer.
Isoproduct (or isoquant) curve. A line
on a graph showing the various
possible combinations of production
inputs that yield a given amount of
output.
Demand curve. A curve that shows the
amount of a good that buyers would
buy at each price, other things being
equal. usually a curve
Demand has price on the Y or vertical
axis and quantity demanded on the
horizontal or X axis. See also
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394
change in demand and change in
quantity demanded.
Aggregate demand curve (AD).
Curve showing the relationship between
the amount of goods and services that
people are willing to buy and the aggregate
level of prices, other things being equal
you. As with any demand curve, there are
important variables behind the demand
curve.
aggregate, eg, government spending,
exports, and the money supply.
Short-term aggregate demand curve. Curve
that shows the relationship between output
and prices in the short term, in which
changes in aggregate demand can affect
output; represented by an AS curve with an
upward or horizontal slope.
Supply curve (or supply graph). Graph
showing the quantity of a good that
suppliers in a given market want to sell
at each price, if the other things are
keep constant.
Aggregate supply curve (AS). Curve that
shows the relationship between the product
that companies would be willing to offer
and the aggregate level of prices, if other
things remain constant. The AS curve has
of to be vertical for potential output in the
very long run, but may be upward sloping
in the short run.
Lorenz curve. A graph used to show the degree
of inequality of income or wealth.
Phillips curve. Graph, first designed by AW
Phillips, showing the relationship between
unemployment and inflation. In mainstream
modern macroeconomic thought, the
downward-sloping Phillips “swap” curve is
generally considered to be valid only in
the short term; since in the long term it is
considered that the Phillips curve is vertical
to the inflation rate not
accelerated unemployment rate (NAIRU).
D.
Debit. 1) Accounting term meaning an increase
in assets or
a decrease in liabilities. 2) In the with
In balance of payments stability, a debit is
an item, such as imports, that reduces the
amount of foreign currency held by a
country.
Budget deficit. For a government, the excess
of total expenditures over total revenues,
where the latter exclude loan revenues.
This difference (the deficit) is usually
financed with loans.
mos.
Deflation. Fall in the general price level.
Deflation (of economic data).
Process of converting “nominal” variables
or in current money, in “real” terms. This is
accomplished by dividing the current
variables into
monetary units between an index
of prices.
GDP deflator. The “price” of GDP, that is, the
price index that measures the average
price of the components of GDP in relation
to a base year.
Aggregate demand. It is the total planned or
desired spending in the economy during a
certain period. It is determined by the
aggregate price level and is influenced by
domestic investment, net exports,
government spending, the consumption
function, and the money supply.
Demand with downward slope, law. Rule that
says that when the price of some good
falls, consumers will buy more of that good,
if the other things are equal
they were constant.
Demand for money. summary term
used by economists to explain why
individuals and firms hold balances of
money. The major motivations for holding
money are 1) transaction demand, which
means that people need money to buy
things, and 2) asset demand, which relates
to the desire to hold a highly liquid, risk-free
asset. .
Demand for money for transactions.
See demand for money.
Unit elasticity demand. locate
intermediate position between the demand
price elastic and price inelastic demand,
where the price elasticity is simply equal to
1 in
GLOSSARY
absolute terms. see also
price elasticity of demand.
Investment demand (or investment demand
curve). Curve showing the relationship
between the level of
investment and the cost of capital (or, to be
more specific, the real interest rate); also,
the graph of that relationship.
Derivative demand. Demand for a
factor of production that results (is "derived")
from the demand for a final good to which
it contributes. Thus, the demand for tires is
derived from the
demand for motor transport.
Price elastic demand (or elastic demand).
Situation in which the price elasticity of
demand exceeds 1 in absolute value. This
means that the percentage change in
quantity demanded is greater than the
percentage change in price.
Furthermore, elastic demand means that
total revenue (price times quantity) rises
when revenue falls, because the increase
in quantity demanded is so large.
(Contrast with price inelastic demand.)
Price inelastic demand (or inelastic demand).
Situation in which the price elasticity of
demand is below 1 in absolute terms. In
this case, when the price goes down, total
revenue goes down, and when the price
goes up, total revenue goes up.
Perfectly inelastic demand means that
there is no change in the quantity demanded.
when the price goes up or down. (Contrast
price elastic demand and unit inelastic
demand.)
Demography. Study of the behavior of a
population.
Installment deposit. Funds held in a bank,
subject to a minimum “withdrawal time”;
they are included in broad money, but not
in M1 because they are not accepted as a
means of payment. It is a concept similar
to savings deposits.
Depreciation (of an asset). Decrease in the
value of an asset. In both business
accounting and national accounting,
depreciation is the dollar estimate of the
measure
in which the capital "has been used up" or
worn out during the period in question. Also
called co
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GLOSSARY
mo capital consumption reserve in
national income accounting.
Depreciation (of a currency). A country's
currency is said to depreciate when its
value falls relative to that of other
currencies. For example, if the dollar
exchange rate falls from 200 to 100
Japanese yen to 1 US dollar, the value
of the dollar will have fallen, and the
dollar has depreciated. The opposite
of a depreciation is an appreciation,
which occurs when the exchange rate
of a currency rises.
Depression. A prolonged period
characterized by high unemployment,
low production and investment, low
business confidence, low prices and
extensive business failures. A more
moderate form of contraction in the
business is a recession, which shares
many of the characteristics of a
depression, but to a lesser degree.
Property rights. Rights that define the
ability of individuals or businesses to
own, buy, sell, and use capital goods
and other property in a market economy.
Intellectual Property Rights.
Laws that regulate patents, copyrights,
industrial secrets, electronic media
and other products that refer primarily
to information. In general, these laws
give the original creator the right to Cyclical unemployment. See frictional
control and be compensated for the
reproduction of their work.
Spills. See externalities.
dissaving. Negative saving; spend more
on consumer goods in a certain
period than disposable income in that
period (and the difference is financed
by borrowing or spending past savings).
Discount (from future income). Process
of converting future income into an
equivalent present value.
This process takes a future amount of
money and reduces it by applying a
discount factor that reflects the
appropriate interest rate.
For example, if someone promises you
$121 in two years, and the appropriate
interest rate or discount rate is 10
percent per year, then you can
We calculate the present value by
discounting the $121 by a discount
factor of (1.10)2. The rate at which
future income is discounted is called
the discount rate.
External diseconomies. situations in
that production or consumption
imposes uncompensated costs on
third parties. Steel mills that emit
sulfurous gases and fumes damage
local property and public health, but
affected parties are not paid for the
damage they suffer. Pollution is a
diseconomy
external.
Unemployed. An individual who is not
employed, but is actively looking for
work or expecting to return to work.
Involuntary unemployment. See
unemployment.
Unemployment. 1) In economic terms,
involuntary unemployment occurs
when there are skilled workers who
are willing to work at prevailing wages,
but cannot find work. 2) In the official
definition (US Bureau of Labor
Statistics), a worker is unemployed if
a) not working, or b) waiting to be
called back to work or has been
actively seeking
employment in the last 4 weeks.
See also frictional unemployment
and structural unemployment.
unemployment.
Equilibrium unemployment. Equilibrium
unemployment arises when people
become unemployed voluntarily, rather
than unemployed because the labor
market cannot liquidate unemployment.
An example is that of frictional
unemployment that occurs when
people voluntarily move from one em
employ someone else, or move in and out of the
labor force.
Structural unemployment. Unemployment
that results because the regional or
occupational pattern of job vacancies
does not conform to the pattern of
worker availability. There may be jobs,
but the unemployed workers may not
have the required skills or the jobs may
be in regions other than
395
where the unemployed workers live.
Frictional unemployment. Temporary
unemployment caused by changes in
individual markets. For example, while
it takes time for new workers to search
for different job opportunities, it is
common for even experienced workers
to experience a minimal period of
unemployment when moving from one
job to another. Thus, frictional
unemployment is different from cyclical
unemployment, which results from a
low level of aggregate demand in the
context of sticky wages and prices.
Imbalance. State in which an economy is
not in equilibrium. Disequilibrium can
arise when shocks (in income or in
prices) change the supply and demand
curves, but the price (or quantity) in
the market is not yet fully adjusted. In
macroeconomics, unemployment is
often considered to arise from market
imbalances.
Disinflation. Process of reducing a
high inflation rate. For example, the
deep recession of 1980-1983 led to
sharp disinflation in that
period.
Government debt. Total government
obligations in the form of shorter-term
bonds and loans. Government debt
held by the public excludes bonds held
by semi-governmental agencies, such
as the central bank.
national debt. It is the same as
government debt.
Public debt. See government debt.
Devaluation. A reduction in the official
price of a country's currency, usually
expressed in other countries' currencies
(such as the US dollar) or in terms of
gold (on the gold standard). The
opposite of devaluation is revaluation,
which occurs when one country raises
its exchange rate relative to another.
currency.
Diagram C + I + G + NX. Diagram showing
planned or desired levels of aggregate
demand for each level of GDP, or
graph showing
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396
show this diagram. This includes
consumption (C), investment (I), government
spending on goods and services (G) , and
net exports (NX).
Product differentiation. Existence of
characteristics that make similar products
less substitutes
how perfect Thus, differences in location
make similar types of gasoline sold at
separate outlets imperfect substitutes.
Firms that enjoy product differentiation face
a downward-sloping demand curve, rather
than the horizontal demand curve of a
product.
perfect competitor.
Compensating differentials. Differences in
wage rates between
jobs that serve to offset or cancel non-
monetary differences
employment rates. For example, unpleasant
jobs that require isolation for many months
in Alaska pay much higher wages than jobs
closer to civilization.
Money. Means of payment or exchange.
To identify the components of money, see
money supply.
Ample money (M2). A measure of the money
supply that includes money from transactions
(or M1) as well as savings accounts in
banks and similar assets that are very close
substitutes for transaction money.
Bank money. Money created by banks,
particularly for checking accounts (part of
M1) that is generated by the multiplied
expansion of bank reserves.
High powered money. Same as monetary
base.
Merchandise money. money with value
intrinsic; also the use of some merchandise
(livestock, accounts, etc.) as money.
Money for transactions (M1). A measure of
the money supply that consists of items
that are in fact for transactions, that is,
money and checking accounts.
Money, speed. Go at the speed of money.
Discrimination. Differences in earnings that
arise from unrelated personal characteristics
with work performance, especially those
that refer to gender, race, ethnic group,
sexual orientation or religion.
Price discrimination. Situation in which the
same product is sold to different consumers
at different
rent prices.
Statistical discrimination. Treatment
of individuals based on the
average behavior or characteristics of the
members of the group to which they belong.
Statistical discrimination can be self-fulfilling
by reducing the incentives for individuals to
exceed the stereotype.
Risk spread. The process of taking large risks
and dispersing them so that they are small
risks for a large number of people.
The main way to spread risk is insurance,
which is a kind of reverse gambling.
Distribution. In economics, the way in which
total output and income are divided among
individuals or factors (eg, the distribution of
income between labor and capital).
Resource distribution. way in
that an economy allocates its resources (its
factors of production) among their potential
uses, such as to produce a particular set of
final goods.
Division of labour. Method of organizing
Command economy. A mode of economic
production, whereby each worker specializes
in part of the production process. Labor
specialization yields a higher total product
because the worker becomes more skilled
at a particular task, and because specialized
machinery can be introduced to perform
more precisely defined subtasks.
take care.
duopoly. Market structure in which there are
only two sellers. (Contrasted with oligopoly.)
AND
Econometrics. branch of economics
which uses statistical methods to measure
and estimate quantitative economic
relationships.
Economy. Study of the way in which societies
use resources scale
you are to obtain valuable merchandise
GLOSSARY
and distribute them among different people
nas.
Open economy. An economy that carries out
international trade operations (that is,
imports and exports) of goods and capital
with other countries. A closed economy has
no imports or exports.
Closed economy. see open economy
ta.
classical economics. Predominant school of
economic thought before the advent of labor
Keynes jos; founded by Adam Smith in
1776. Other great figures who followed
Smith include David Ricardo, Thomas
Malthus, and John Stuart Mill. In general,
this school believed that economic laws
(particularly the selfish interest of individuals
and competition ) determine prices and
factor premiums, and that the price system
is the best possible mechanism for resource
allocation.
Information economy. Analysis of economic
situations that include information as a
commodity. Because information is
expensive to produce but cheap to
reproduce, it is common for there to be
failures in the markets for information goods
and services, such as inventions,
publications, and software.
organization in which the key economic
functions—what, how, and for whom — are
primarily determined by government
instructions. It is sometimes known as a
centrally planned economy.
Market economy. economy in
that the questions what, how, and for
whom related to the distribution of
resources, are mainly determined by supply
and demand in the markets. In this form of
economic organization, companies,
motivated by the desire to maximize their
profits, buy inputs, and produce and sell
products.
Families, armed with their factor income,
go to markets and determine the demand
for goods.
nes. The interaction of the supply of the
companies and the demand of the
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GLOSSARY
Families determine the prices and
quantities of goods.
Well-being economics. is the analysis
regulation of economic systems
cos, that is, the study of what is "right"
or "wrong" in the func
functioning of the economy.
Supply side economics. Point
from a point of view that emphasizes
the adoption of policy measures to affect
aggregate supply or potential output.
This approach holds that high marginal
tax rates on earned income and capital
reduce labor effort and savings.
Financial economics. echo branch
economy that analyzes the way in which
rational investors should invest
pour your funds to achieve your
objectives in the best possible way.
Keynesian economics. Body of
macroeconomic analysis developed
by John Maynard Keynes, who argues
that a market economy does not
automatically tend to an equilibrium of
full employment. According to Keynes,
the resulting equilibrium unemployment
could be cured by monetary or fiscal
policies to raise aggregate demand.
Mixed economy. The form of economic
organization in non-communist countries.
Mixed economies are
They rely primarily on the price system
for their economic organization, but use
a variety of government interventions
(such as taxes, spending, and regulation)
to manage macroeconomic instability
and market failures.
Monetary economy. economy in
that trade is carried out through a
common medium of exchange
mind accepted.
Normative and positive economics.
Normative economics considers “what
should be”—value judgments, or goals,
of public policy. In contrast, positive
economics is the analysis of facts and
behaviors in an economy, that is, "the
way things are."
positive economy. See normative and
positive economics.
Scale economics. increases in
productivity or reductions in
average cost of production, which arise
from increasing all factors of production
in the same proportion.
External economies. situations in
that production or consumption brings
positive benefits to third parties, without
the latter paying anything.
A company that hires a security guard
keeps burglars out of the neighborhood,
bringing in outside security services.
Along with external diseconomies, they
are often referred to as externali
data.
Quantitative equation of exchange.
It is the tautology MV = PQ, where M is
the money supply, V is the velocity of
money with respect to income, and PQ
(price per quantity) is the money value
of total output (nominal GDP). The
equation is always exactly valid, since V
is defined as PQ/M.
Exchange equation. Equation
which defines that MVP PQ, that is, the
inventory of money multiplied by the
speed of money, is equal to the price
level multiplied by the product. This
equation forms the core of monetarism.
effect of the money supply. Relationship
whereby a price rise operating on a fixed
nominal money supply produces
monetary tightness and reduces
aggregate spending.
Substitution effect (of a price change).
Tendency of consumers to consume
more than one good
when its relative price falls (to "substitute"
in favor of that good) and consume less
of the good when its
relative price goes up (to “substitute”
against that good). This substitution
effect of a price change leads to a
demand curve for
downward slope. (Contrast with effect
on income.)
Effect on income (of a price change).
Change in the quantity demanded of a
good because the change in its price
has the effect of modifying the real
income of a consumer. Thus, it
complements the substitution effect of
a
change of price.
Efficiency. Absence of waste, or use of
economic resources that
397
produce the maximum level of
satisfaction possible with the given
inputs and technology. It is a shorthand
expression for Pareto efficiency.
Pareto efficiency (or Pareto optimality). A
situation in which no amount of
reorganization or exchange could raise
the utility or satisfaction of a product.
individual, without reducing the utility or
satisfaction of another individual. In
Under certain limited conditions, perfect
competition leads to efficient distribution.
also known
as allocative efficiency.
Distributive efficiency. see efficiency
of Pareto.
Economic efficiency. See efficiency.
Productive efficiency. Situation in which an
economy cannot produce more of one
good without producing less of another
good; This means that the economy is
at its frontier of
production possibilities.
Elasticity. Term widely used in economics
to denote the sensitivity of a variable to
changes in another variable. Thus, the
elasticity of X with respect to Y means
the percentage change in X for every 1
percent change in Y. For especially
important examples, see Price Elasticity
of Demand and Price Elasticity of
Supply.
Cross elasticity of demand.
Measure of the influence of change
price of one good on the demand for
another good. To be more specific, the
cross-elasticity of demand is equal to
the percentage change in the demand
for good A when the
The price of good B changes by 1
percent, assuming constant all other
variables.
Income elasticity of demand.
The demand for any given good is
influenced not only by the price of the
good, but also by the income of the
buyers. Income elasticity measures this
sensitivity. Its precise definition is
percentage change in the quantity
demanded.
divided by the percentage change in
income. (Contrast with price elasticity
of demand.)
Price elasticity of demand.
A measure of the degree to which the
quantity demanded responds to a change
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398
Price. The coefficient of elasticity
(price elasticity of demand, Ep) is the
percentage change
bio in quantity demanded divi
divided by the percentage change in
price. To calculate the percentages,
use the averages of the old and new
quantities in the numerator, and the
old and new prices in the denominator;
ignore the minus sign. Also turn to
price elastic demand, price inelastic
demand, and unit elastic demand.
Price elasticity of supply. Concept
similar to that of price elasticity of
demand, except that it measures the
sensitivity of supply to a
change in price. More accurately, the
elasticity of supply measures the
percentage change in the quantity
supplied divided by the
percentage change in price.
The elasticities of supply are more
useful in perfect competition.
Implicit cost elements. Costs that do not
appear as explicit costs in money,
however, should be considered as
such (such as the cost of labor for the
owner of a small shop). Sometimes
called opportunity cost, although
“opportunity cost” has a broader
meaning.
Employee. According to official US
definitions, people are employed if
they do any paid work or if they have
jobs but are absent due to illness,
strike, or vacation.
Company (business). Private, productive
basic unit in an economy. It hires
labor, rents or owns capital and land,
and buys other inputs in order to
make and sell goods and services.
Classic approach. See classical economics.
Horizontal equity and vertical equity.
Horizontal equity refers to fairness or
equity in the treatment of people in
similar situations; the principle of
horizontal equity affirms that those
who are essentially equal should
receive equal treatment. Vertical
equity refers to the equal treatment
of those in different circumstances.
Vertical equity. See horizontal equity
and vertical equity.
Balance. State in which an economic
entity is at rest or in
that the forces that operate in the
entity are balanced, so that there is
no tendency to change.
Balance (for the individual consumer).
Position in which the consumer
maximizes his utility; that is, he has
chosen the group of goods that, given
his income and prices, best satisfies
the wants of the consumer.
Balance (for a company). The position
or level of output at which the firm
maximizes its utility, subject to any
constraints it may face, so it has no
incentive to change its level of output
or prices. In the standard theory of
the firm, this means that a firm has
chosen output in which marginal
revenue equals marginal cost.
Competitive balance. It is the equilibrium
of supply and demand in a market or
economy characterized by perfect
competition. Because perfectly
competitive sellers and buyers have
no individual power to influence the
market, price will move to the point
where it equals marginal cost and
marginal utility.
Balance, competitive. Go to competitive
balance.
Cooperative balance. In game theory it
is an outcome in which the parties act
in unison to find strategies that
optimize their joint payoffs.
Market equilibrium. It is the same as
competitive equilibrium.
Nash equilibrium. In game theory, a set
of strategies for the players, where
neither player can improve his results
given the strategy followed by the
other player. That is, given Player A's
strategy, Player B cannot outperform,
and given B's strategy, A cannot
outperform either. The Nash
equilibrium is sometimes known as
the noncooperative equilibrium.
Dominant balance. See dominant
strategy.
Balance overall. Go to general
equilibrium analysis.
GLOSSARY
Macroeconomic balance. GDP level at
which the aggregate demand that is
intended is equal to the aggregate
supply that is intended. At equilibrium,
desired consumption (C), government
spending (G), investment (I ), and net
exports (X) are equal to the quantity
that firms want to sell at the current
price level.
Macroeconomic balance. Go to balance,
macroeconomic.
Uncooperative balance. See Nash
equilibrium.
Shortage. The distinctive feature of
an economic goal. That an economic
good is scarce does not mean that it
is rare, but only that it is not freely
available to whoever wants to take
advantage of it. To obtain this good,
one must produce it or offer another
economic good in exchange for it.
bio.
Scarcity, law. Principle that most of the
things people want are available only
in limited supply (the exception is
free goods). Thus, goods are generally
in short supply, so they must be
rationed in some way, either by price
or some other means.
Chicago School of Economics. group
of economists (among whom Henry
Simmons, FA von Hayek, and Milton
Friedman have been the most
prominent) who believe that
competitive markets, free from
government intervention, lead to the
most efficient operation of the
economy.
Keynesian school. See Key Nenesian
economics.
Speculator. Someone who participates
in speculation, that is, someone who
buys (or sells) a good or financial
asset with the aim of making a profit
by selling (or buying) the item at a
higher (or lower) price.
Automatic (or built-in) stabilizers.
Ownership of a government tax and
spending system that cushions
changes in private sector revenue.
Examples include unemployment
compensation and progressive
income taxes.
Welfare state. Concept of the mixed
economy that arose in Euro
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GLOSSARY
pa in the late nineteenth century and
arrived in the United States in the
1930s. In the modern concept of the
welfare state, markets direct the
detailed activities of daily economic life.
target, at the same time that
governments regulate social conditions
and provide pensions, health care and
other aspects of the social safety net.
Profit and loss. See income statement.
Statement of income. Financial statement
of a company, covering a specific
period of time (usually a year), showing
the sales or revenue obtained in that
period.
year, all costs properly charged against
the goods sold, and the remaining
profit (net income) after deduction of
such costs. Also called state of
Profit and loss.
stagflation. Term coined in the early
1970s that describes the coexistence
of high unemployment, or stagflation ,
with persistent inflation. It is mainly
explained by the inertial nature of the
inflationary process.
dominant strategy. In game theory, a
situation where one player has a better
strategy, it does not matter which
strategy the other player follows. When
all players have a dominant strategy,
we say that the outcome is a dominant
equilibrium.
Consumer surplus. Difference
between the amount a consumer
would be willing to pay for an item and
the amount actually paid. This
difference arises because the marginal
utility (in money terms) of all but the
last unit exceeds its price. Under
certain conditions, the money value of
the surplus of the
consumer (with a demand curve) as
the area under the demand curve, but
above the price line.
Producer surplus. Difference between
the producer's sales income and the
corresponding cost.
In general, producer surplus is
measured as the area above the
supply curve but below the price line
to the quantity sold.
Economic surplus. Term that denotes the
surplus in satisfaction
tion or total utility over costs
of production; is equal to the sum of
the consumer surplus (consumer
satisfaction surplus
dor on the total value of the com
purchases) and producer surplus
(excess of income over producer
costs).
Existence and flow. See Flow and exist
Inc.
Expectations. Views or beliefs about
uncertain variables (such as future
interest rates, prices, or taxes).
Expectations are said to be rational if
they are not systematic
ethically flawed (or “biased”) and use
all available information.
Expectations are said to be adaptive
if people form their expectations
based on past behavior.
Adjustable expectations. see expectations
you go.
rational expectations. see expectations
you go.
Exports. Goods or services that are
produced in the first country and sold
to a second country. These include
trade in goods (such as automobiles),
services (such as transportation), and
interest on loans and investments.
Imports are simply flows in the opposite
direction—to the first country from the
second.
net exports. In the national production
accounts, it is the value of exports of
goods and services minus the value
of imports of goods and services.
Externalities. Activities that affect third
parties for better or worse, without
such third parties having to pay or be
paid for said activities. There are
externalities when
when the private costs or benefits do
not equal the social costs or benefits. deposit accounts
Its two great varieties are external
economies and external diseconomies. Production possibilities frontier (PPF).
F
Production factors. Productive inputs,
such as labor, land, and capital;
resources required for the production
of goods and services.
Also called supplies.
399
Fallacy of composition. Fallacy of
assuming that what is valid for
individuals is also valid for the group
or the entire system.
Post hoc fallacy. From the Latin, post hoc,
ergo propter hoc, meaning "after this,
then for this."
This fallacy arises when it is assumed
that since fact A precedes fact B, it
follows that A causes B.
Market failure. Imperfection in a price
system that prevents an efficient
distribution of resources.
Important examples are externalities
and imperfect competition.
Finance. Process by which economic
agents lend to each other in order to
save and spend.
Price flexibility. Price behavior in "auction"
markets (eg, for many commodities or
the stock market), where prices
respond immediately to changes in
demand or supply.
offer.
Cash flow. It is the account that tracks
the way money and other financial
instruments flow through the economy.
Flow and existence. A flow variable has a
dimension of time or flows over time
(such as the flow of a stream). An
existence variable measures a quantity
ity at a point of time (like water in a
lake). Income represents money
earned per year, so it is a flow. Wealth
in December 2005 is an existence.
Money funds. Abbreviated expression that
refers to very liquid, short-term financial
instruments, whose interest rates are
not regulated. The biggest examples
are stock market mutual funds.
money and bank money market
commercial.
Graph showing the menu of goods
that can be produced in an economy.
In a case
often quoted, the choice comes down
to two goods, cannon and butter.
Points outside of the PPF (northeast
of it) are untenable. The points inside
it are inefficient because the resources
do not
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400
are being used properly, or outdated
production technologies are used.
Out of the workforce. That part of the
adult population that does not work or
is looking for work.
Work force. In official US statistics, it is
the group of people 16 years of age
or older who are employed or
unemployed.
Saving function. Curve showing the
amount that families in a country will
save at each income level.
Consumption function. Ratio of total
consumption to disposable personal
income (DI). It is also common for
total wealth and other variables to be
assumed to influence
sumo.
Production function. Relationship (or
mathematical function) that specifies
the maximum production that can be
obtained with given inputs for a given
level of technology; it applies to a firm
or, as an aggregate production
function, to the economy as a whole.
Fusion. The acquisition of one corporation
by another, which usually occurs
when one company buys the stock of
another. Important examples are 1)
vertical mergers, which occur when
both companies are at different stages
of a production process (eg, iron ore
and steel); 2) horizontal mergers,
which occur when the two companies
produce in the same market (eg, two
car manufacturers), and 3)
conglomerate mergers, which occur
when both companies operate in
unrelated markets (eg , shoelaces and
oil refineries).
upright fusion. See merger.
G.
Capital gains. Increase in the value of a
capital asset, such as land or stock,
where the gain is the difference
between the sale price and the
purchase price of the asset.
Trade profits. The increase
added increase in welfare resulting
from voluntary exchange; equals the regressive tax. See progressive,
sum of consumer surplus and producer
profit gains. Income taxes, personal. Im since
deficit spending Government spending
on goods and services and transfer
payments above your income from
taxes and other sources of income.
The difference must be financed by
borrowing money from the public.
Graph (demand, supply, aggregate
demand, aggregate supply).
Interchangeable term with “curve”, as
in demand curve, supply curve, etc.
Long-term aggregate supply graph.
Graph showing the relationship
between output and the price level
after all price and wage adjustments
have been made, and the AS curve is
therefore vertical.
h
Hyperinflation. See inflation.
Rational expectations hypothesis.
Hypothesis that holds that people
make unbiased forecasts and, even
more so, that people use all available
information and economic theory to
make those forecasts.
Yo
Imports. See exports.
Consumption tax and sales tax. A
consumption tax is charged on the
purchase of a specific merchandise
or group of merchandise (eg, alcohol
or tobacco). A sales tax is charged on
all
merchandise except for a few specific
exclusions (eg, all purchases except
food).
Corporate income tax. Im put charged
on the annual net income of a
corporation.
Value Added Tax (VAT). I'm since a
company is charged as a percentage
of the value it adds.
Sales tax. See excise tax and sales tax.
Proportional tax. See progressive,
proportional and regressive taxes.
proportional and regressive taxes .
charged on income re
GLOSSARY
received by individuals in the form of
wages and salaries or property
income, such as rents, dividends, or
interest. In the United States, personal
income tax is progressive, which
means that people with higher incomes
are taxed at a higher average rate
than people with lower incomes.
direct taxes. Taxes charged directly to
individuals or
companies, which include taxes on
income, earned income and profits.
Direct taxes are in contrast to indirect
taxes, which are levied on goods and
services for which they are paid only
indirectly by people, such as sales
taxes and taxes on property, alcohol,
imports, and gasoline.
Indirect taxes. See direct taxes.
Progressive, proportional and regressive
taxes. A progressive tax burdens the
rich more; a regressive tax does the
opposite. More exactly, a tax is
progressive if the average tax rate
(that is, taxes divided by income) is
higher for those who earn higher
incomes; it is a regressive tax if the
average tax rate falls for those with
higher incomes; it is a proportional tax
if the average tax rate is equal at all
income levels.
inappropriateness See inappropriate.
inappropriate. Term applied to resources
for which the individual cost of use is
free or less than the full social costs.
These resources are characterized by
the presence of externalities, so
markets will allocate their use
inefficiently from a social point of view.
Incidence (or tax incidence).
The ultimate economic effect of a
tax on the actual income of producers
or consumers (in contrast to the legal
requirement to pay). Thus, a sales tax
may be paid by the retailer, but the
burden is likely to fall on the consumer.
The exact incidence of a tax depends
on the price elasticities of supply and
demand.
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GLOSSARY
Tax incidence. see incident
Inc.
Price index. An index number that shows
how the average price of a group of
goods changes over time. In calculating
the average, the prices of different
goods are usually weighted according
to their economic importance (eg, by
the share of each good in total
consumer spending in the consumer
price index). Consumer Price Index
(CPI). Price index that measures the
cost of a fixed basket of consumer
goods, in which the weight assigned to
each merchandise is the part of the
expenses made on that merchandise
in a
base year.
Producer price index. Price index of
goods sold at wholesale (such as
steel, wheat, oil). Herfindahl-
Hirschman Index (HHI).
Measure of market power frequently
used in the analysis
of market structures. I know
calculated by adding the square of the
percentages of market participation
of all those who participate in it.
Perfect competitors have an HHI of
almost zero, whereas an absolute
monopoly has an HHI of 10,000.
Indexing (or indexing). Mechanism by
which wages, prices, and contracts
are partially or fully adjusted to
compensate for changes in the general
price level.
Industry. Group of companies that
produce similar or identical products.
cos.
Young industry. In foreign trade theory,
it is an industry that has not had
enough time to develop experiences
or skills that allow it to take advantage
of the economies of scale that are
required to compete successfully with
more mature industries that produce
the same merchandise in other
countries. Young industries are often
seen as needing tariffs or quotas as
protection while they develop.
Inflation (or inflation rate). The inflation
rate is the percentage of annual
increase in a general level
of prices. Hyperinflation is inflation at
extremely low rates.
high (say, 1,000, 1 million, or even a
billion percent a year). Runaway
inflation is a rate of 50, 100, or 200
percent per year. Moderate inflation is
a rise in the price level that does not
seriously distort relative prices or
incomes.
Cost driven inflation. See supply shock
inflation.
Runaway inflation. See inflation.
Demand driven inflation. Price inflation
caused by excess demand for goods
in general, caused, for example, by a
strong increase in aggregate demand.
It is often contrasted with supply
shock inflation.
Inflation due to supply shock. It is the
inflation that originates from the supply
side of the markets due to a sharp rise
in costs. In the aggregate supply and
demand framework, the cost push is
illustrated as a move up
of the AS curve . is also known
as cost-driven inflation.
asymmetric information. situation in
that one party in a transaction has
better information than the other party.
This often leads to market failure or
even
that there is no market.
Income. Flow of salaries, interest
payments, dividends and other income
that correspond to an individual or
country during a certain period of time
(generally a year).
Disposable income (DI). Approximately
the money one takes home, or that
part of the national income that is
available to families for consumption
or savings.
To be more specific, it is equal to GDP
minus all taxes, business saving, and
depreciation plus other government
payments and transfers, and
government interest payments.
Marginal Revenue (MR). The additional
revenue that a firm would earn if it
sold an extra unit of product. In perfect
competition, MR is equal to price. In
imperfect competition, MR is less than
price because, in order to sell the unit
401
extra quality, the price of all units sold
with
anteriority.
Personal income. A measure of income
before taxes are deducted. In other
words, it is equal to disposable
personal income plus net taxes.
Personal income available. Personal
income minus taxes plus transfers.
Amount that families have for
consumption and savings.
Personal income available. Same as
disposable income.
Average income. It is the total income
divided by the total number of
units sold, that is, income per unit.
Average revenue is usually equal to
price.
Total income (TR). Price multiplied by
quantity, or total sales.
Innovation. A term particularly associated
with Joseph Schumpeter, who by him
meant 1) the arrival on the market of
a new and significantly different
product, 2) the introduction of a new
technique of
production or 3) the opening of a new
market. (See the contrast with
invention.)
Supplies. Goods or services used by
companies in their production
processes; also called two factors of
production.
Horizontal integration. See integration,
vertical and horizontal. horizontal
fusion. See merger.
Vertical integration. See vertical and
horizontal integration.
Integration, vertical and horizontal. The
production process is one of the stages
—eg, iron ore into steel ingots, ingots
into rolled steel plates, plates into
automobile bodies.
them-. Vertical integration is the
combination in a single company of
two or more different stages of this
process, (eg, iron ore in ingots).
Horizontal integration is the combination
in a single company of different units
that operate in the same stage of
production.
Strategic interaction. Situation in
oligopolistic markets in which the
business strategies of each company
depend on the plans of their rivals. A
formal analysis of the inter
strategic action is provided by game
theory.
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Interest. Yield paid to those who lend
money.
Compound interest. Interest calculated
on the total amount of interest and
principal. For example, suppose $100
(principal) is deposited into an account
that earns 10 percent interest
compounded annually.
At the end of year 1, interest of $10 is
earned. At the end of year 2, the
interest payment is $11, $10 on the
original principal and $1 on the interest,
and so on in future years.
Financial intermediaries. institution
companies that provide financial
products and services. These include
depository institutions (such as
commercial or savings banks) and
nondepository institutions (such as
money market mutual funds).
ro, financial brokerages, insurance
companies or pension funds).
Intervention. Activity that consists of a
government buying or selling its
currency in the foreign exchange
market, in order to affect its exchange
rate.
Invention. Creation of a new product or
discovery of a new
goes production technique. (This is
different from innovation.)
Investment. 1) Economic activity that
postpones consumption today to
increase the product in the future.
It includes tangible capital such as
houses, and intangible investments
such as education. The net investment is
Total investment value after a reserve
for depreciation has been set up.
Gross investment is investment without
reserve for depreciation. 2) In financial
terms, “investment” has a totally
different meaning, and denotes the
purchase of an obligation, such as a
stock or bond.
Net foreign investment. It is the net
saving of a country abroad, it is
approximately equal to its net exports.
Net investment. gross investment minus
depreciation of capital assets.
Isoquant. See isoproduct curve.
currency board. Monetary institution that
functions as a central bank in a
country that issues only currency that
is backed by assets
denominated in a currency ex
key foreign currency, often the US
dollar.
L
Laissez-faire (“Leave us alone”). View
that the government should interfere
as little as possible in economic
activity, and leave decisions to the
market. As expressed by classical
economists such as Adam Smith, this
view held that the role of government
should be limited to the maintenance
of law and order, national defense,
and the provision of certain public
goods that private corporations would
not take over. charge (eg, public health
and hygiene).
Long term. A term used to denote a period
in which full adjustment to any change
can be achieved. In microeconomics,
it refers to the time in which firms can
enter or exit an industry and the capital
stock can be replaced. In
macroeconomics, it is often used to
designate the period required for
prices, wage contracts, tax rates, and
expectations to fully adjust.
Law of demand with downward slope.
The almost universal observation that
when the price of a commodity rises
(all other things being equal), buyers
buy less of that commodity. Similarly,
when the price falls, other things being
equal, the quantity demanded increases.
Law of diminishing marginal utility.
See diminishing marginal utility, law.
Say's law of markets. Theory that “supply
creates its own demand”. JB Say
argued in 1803 that since total
purchasing power is exactly equal to
total income and output, there cannot
be excess demand or supply.
Keynes attacked Say's Law, noting
that an extra dollar of income does not
have to be fully spent (ie, the marginal
propensity to spend is not necessarily
unitary).
Law of diminishing returns.
See diminishing returns, law.
GLOSSARY
Oku's Law. Empirical relationship,
discovered by Arthur Okun, between
the cyclical movements of GDP and
unemployment. Said law states that
when real GDP falls 2 percent in
relation to potential GDP, the
unemployment rate rises approximately
1 percentage point. (Previous estimates
put the ratio at 3 to 1.)
Libertarianism. Economic philosophy that
emphasizes the importance of personal
freedom in economic and political
matters; sometimes also called
“liberalism.”
Free trade. Policy by which the government
does not interfere in trade between
countries through tariffs, quotas, or
other means.
Isocost line. A line on a graph showing
the various possible combinations of
factor inputs that can be purchased
with a given amount of money.
Line of consumption possibilities. See
budget line.
Budget line. Line indicating the mix of
goods that a consumer can buy with a
given income at a given set of prices.
It is sometimes also known as a budget
constraint.
m
M1. See money offer.
Macroeconomy. Analysis of the with
conduct of the economy as a whole
regarding production, income, price
level, foreign trade, unemployment
and other aggregate economic
variables. (Contrast with
microeconomics.)
Classic macroeconomics. See classical
theories.
Macroeconomics of rational
expectations. School of thought that
holds that markets sell off quickly and
that expectations are rational. Under
these and other conditions, predictable
macroeconomic policies can be shown
to have no effect on the economy.
output or actual unemployment.
Sometimes called macroeconomics
neoclassical.
Keynesian macroeconomics. Theory of
macroeconomic activity that
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GLOSSARY
It is used to explain business cycles.
It is based on an upward-sloping
aggregate supply curve, so changes
in aggregate demand can affect output
and employment.
Neoclassical macroeconomics. Theory
that holds that 1) prices and wages
are flexible and 2) people make
projections according to the rational
expectations hypothesis.
invisible hand. Concept introduced by
Adam Smith in 1996 to describe the
paradox of a laissez faire market
economy. The invisible hand doctrine
holds that, even when each participant
pursues its own self-interest, a market
system still works.
It works for the benefit of all, as if an
invisible benevolent hand were
directing the whole process.
Indifference map. Graph showing a
family of curves of indifference
rence for a consumer. In general, the
curves that are farther to the northeast
of the origin of the graph represent
higher levels of satisfaction.
Marxism. Set of social, political and
economic doctrines developed by Karl
Marx in the 19th century. Marxism
predicted that capitalism would
collapse as a result of its internal
contradictions, especially its tendency
to exploit the working classes.
Monetary transmission mechanism.
In macroeconomics, the path by which
changes in the supply of
money are translated into changes in the
production, employment, prices and
inflation.
Half. In statistics, it is the same as
"average." Thus, for the numbers 1, 3,
6, 10, 20, the mean is 8.
Median. In statistics, it is the figure that is
exactly in the middle of a series of
ordered or classified numbers.
listed from lowest to highest (eg,
income or qualifications). Thus, for the
numbers 1, 3, 6, 10, 20, the median is
6.
Market. An arrangement by which buyers
and sellers interact to determine the
prices and quantities of a commodity.
Some markets (such as the stock
market or a street market) develop
your activities in a physical location;
Other markets operate by telephone
or are organized by computer, and
now some markets are organized on
the Internet.
Competitive market. See perfect
competition.
Money market. Term that notes the set
of institutions that manage the
purchase or sale of short-term credit
instruments
term, such as Treasury bonds or
commercial paper.
foreign exchange market Market in which
the currencies of different countries
are traded.
Clearance market. A market in which
prices are flexible enough to balance
supply and demand very quickly. In
liquidating markets, there is no
rationing, unemployed resources, or
surplus supply and demand. In
practice, this is believed to apply to
many commodity and financial markets,
but not to the labor market or to many
other products.
Stock market. Organized market in which
common shares are traded. In the
United States, the largest stock market
is the New York Stock Exchange,
where the shares of the largest
American companies are traded.
Efficient market (also efficient market
theory). Market or theory in which all
new information is quickly absorbed
by market participants and immediately
incorporated into market prices. In
economics, efficient market theory
holds that all information currently
available
wearable is already built into the price
of common stock (or other assets).
Efficient financial market. Market
financial system that has the
characteristics of being an efficient market. stresses the importance of changes in
Capital markets (also financial markets).
Markets in which financial resources
(money, bonds, shares) are traded.
These, along with financial
intermediaries, are institutions through
which savings in the economy
is transferred to investors.
403
Financial markets. Markets whose
products and services consist of
financial instruments, such as stocks
and bonds.
Mercantilism. Political doctrine that
emphasizes the importance of
surpluses in the balance of payments
as a means to accumulate gold. His
supporters therefore advocated strict
government control of economic
policies, believing that laissez faire
policies could lead to a loss of gold.
Inflation target. It is the announcement of the
limits established for the official goals
of the inflation rate
tion, along with an explicit statement
that low and stable inflation is the
ultimate goal of monetary policy. Have
strict or lax versions of targets been
adopted?
of inflation in many industrialized
countries in recent years.
Monetary-fiscal mix. Combination
of monetary and fiscal policies used
to influence macroeconomic activity.
Tight monetary policy and loose fiscal
policy will tend to encourage
consumption and retard investment,
while loose monetary policy and tight
fiscal policy will tend to have the
opposite effect.
Microeconomics. Analysis of the with
conduct of individual elements in
an economy, such as the determination
of the price of a single product or the
behavior of a single consumer
dor or company (Contrast with
macroeconomics.)
Model. Formal framework to represent
the basic characteristics of a
complex system through a few central
relationships. Models take the form of
graphs, mathematical equations, and
computer programs.
Multiplier model. In macroeconomics, a
theory developed by JM Keynes that
autonomous spending (especially
investment, government spending,
and net exports) in determining
changes in output and employment.
See also multiplier.
Neoclassical model of growth.
A theory or model used to
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explain the long-term trends in the economic
growth of industrial companies. This model
stresses the importance of capital deepening
(ie, a rising capital-labor ratio) and
technological change in explaining potential
real GDP growth.
Currency. Coins and bills.
Common currency. Situation in which several
countries form a monetary union with a
single currency and a unified central bank;
eg, the European Monetary Union (EMU),
which introduced the euro in 1999.
Forced currency. Money, like paper money
today, without intrinsic value but ordered
(by decree) as legal currency by the
government. This money is accepted only
as long as people have confidence that it
will be accepted.
Legal currency. Money that by law must be
accepted as payment of debts.
All United States bills and coins are legal
tender, checks are not.
Monetarism. School of thought that holds that
changes in the money supply are the main
cause of macroeconomic fluctuations.
Monopoly. Market structure in which a
commodity is offered by a single firm. See
also natural monopoly.
Natural monopoly. A company or industry
whose average cost per unit of output drops
dramatically within the limits of its production, Spending multiplier. See multiplier.
such as in local electricity distribution. Thus,
a single company, a monopoly, can offer
all the production of the industry with
greater efficiency than many companies.
Monopsony. Mirror image of monopoly: market
in which there is only one buyer: it is a
"buyer's monopoly".
Movement of the single tax. Nineteenth-
century movement led by Henry George
who argued that continued poverty amid
steady economic progress was attributable
to scarcity of land and large rents flowing
to landlords
lieutenants. The “single tax” would have to
be a tax on the economic income derived
from land ownership.
MPC. See marginal propensity to con
sumo.
MPS. See marginal propensity to save
rro.
Multiplier. Macroeconomics term denoting the
change in an induced variable (such as
GDP or money supply) per unit change in
an external variable
(such as government spending or bank
reserves). The spending multiplier denotes
the increase in GDP that would result from
a $1 increase in spending (say, in
investment).
Open economy multiplier.
Analysis of the multiplier as applied to
economies that have foreign trade. The
open economy multiplier is smaller than the
closed economy multiplier because there is
a leakage from spending to imports as well
as to saving.
money supply multiplier.
Reason for increase in supply
of money (or in deposits) with respect to
the increase in bank reserves
dear. In general, the money supply multiplier
is equal to the inverse of the required
reserve ratio. For example, if the required
reserve ratio is 0.125, then the money
supply multiplier is 8.
Government spending multiplier.
Increase in GDP that results from a $1
increase in government purchases.
No.
NAIRU. See non-accelerating inflation rate
of unemployment.
Collective negotiation. Bargaining process
between a group of workers (usually a
union) and their employer. These
negotiations lead to contracts that determine
wages, benefits, and working conditions.
GLOSSARY
EITHER
Offer added. Total value of goods and services
that companies would be willing to produce
in a given space of time. Aggregate supply
is a function of available inputs, technology,
and the price level.
Money offer. the money supply
strictly defined (money is strict, or M1)
consists of coins, paper money, and all
deposits on demand or in checking
accounts; this is transaction money. The
broadly defined money supply (broad
money) includes all of the concepts of M1,
plus certain liquid or quasi-money assets:
savings deposits, money market funds, and
the like.
Job offer. Number of workers (or more
generally, the number of working hours)
available in an economy. The main
determinants of job supply
Low are population, real wages, and social
traditions.
Oligopoly. A situation of imperfect competition
in which an industry is dominated by a
small number of suppliers.
Collusive oligopoly. Market structure in which
a small number of firms (ie a few oligopolists)
collude and jointly make their decisions.
When they succeed in maximizing their
utility
jointly, the price and quantity in the market
are very close
those that prevail under monopoly conditions.
Public options (also theory of public options).
Branch of economics and political science
concerned with how governments make
their choices and run the economy. This
theory differs from
market theory by highlighting
the influence of maximizing the
vote for politicians, which contrasts with
profit maximization for firms.
Open market operations. Activity of a central
bank of com
purchase or sale of government bonds to
influence bank reserves, the money supply,
and
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GLOSSARY
interest rates. If securities are purchased,
the money paid by the central bank
increases the reserves of
commercial banks, and the money supply
increases. If the values
are sold, the money supply is
contract.
P moral hazard. Type of market failure in which
Transfer payments, government. Payments
made by a government to individuals, for
which they do not repay with any service.
Examples are social security and
unemployment insurance payments.
Developing country. Country with a per capita
income well below that of “developed”
countries (usually the latter include most of
the countries of North America and Western
Europe). It is the same as least developed
country.
Saving paradox. The principle, first proposed
by John Maynard Keynes, that a society's
attempt to increase its saving may actually
cause a reduction in the amount saved.
Paradox of value. Paradox that many necessities
of life (eg, water) have a “low” market value
while many luxuries (eg, diamonds) with
little “use” value have a high market price.
The paradox is explained by the fact that a
price reflects not the total utility of a
commodity, but its marginal utility.
Part of the market. Fraction of the output of an
industry that is supplied by an individual
firm or a group of firms.
Passives. In accounting, debts or financial
obligations owed to other people or
companies.
Patent. Exclusive right granted to an inventor to
control the use of an invention for, in the
United States, a period of 20 years. Patents
create temporary monopolies as a way to
reward inventive activities and, like other
intellectual property rights, are a tool to
promote the inventiveness of individuals or
small businesses.
Gold standard. A system in which a country 1)
declares that its monetary unit is equivalent
to some fixed weight of gold, 2) maintains
gold reserves to back its money, and 3) will
freely buy or sell gold at its stated price,
with no restrictions on the import or export
of gold.
the presence of insurance against an
insured risk increases the probability that
the risky event will occur. For example, the
owner of a 100 percent insured vehicle may
be careless and leave it unlocked, because
the presence of insurance reduces the
incentive to prevent theft.
Slope. On a graph, the change in the variable
on the vertical axis per unit change in the
variable on the
the horizontal axis. Upsloping lines have
positive slopes, downward-sloping curves
(such as demand curves) have negative
slopes, and horizontal lines have slopes of
zero.
Deadweight loss. The loss in real income or
consumer or producer surplus that arises
from monopolies or other distortions. For
example, when a monopoly raises its price,
the loss in consumer satisfaction is
greater than the monopoly's revenue gain,
and the difference is the deadweight loss to
society caused by the monopoly.
nominal GDP. See gross domestic product,
nominal.
potential GDP. high employment GDP; more
precisely, the maximum level of GDP that
can be sustained with a given state of
technology and population size, without
accelerating inflation. Currently, it is
considered to be equivalent to the level of
output corresponding to the non-accelerated
inflation rate of unemployment.
pleus (NAIRU). Potential product is not
necessarily maximum product.
real GDP. See gross domestic product,
real.
Full employment. Term that is used in many
senses. In other times it was taken as the
level of employment
405
at which involuntary unemployment does
not exist (or is minimal). Today, economists
rely on the concept of the non-accelerating
inflation rate of the
unemployment rate (NAIRU) to indicate
the highest sustainable level of
employment in the long run.
GNP. See gross national product.
Poverty. Currently, the US government defines
the “line of
poverty” as the minimum adequate standard
of living.
Market power. degree of control
that a firm or group of firms has on price
and production decisions in an industry. In
a monopoly, the firm has a high degree of
market power; firms in perfectly competitive
industries have no market power. The
reasons for concentrating
tion are the most widely used measures to
determine market power.
Fiscal policy. Government program regarding
1) the purchase of goods and services, and
spending on transfer payments, and 2) the
amount and type of taxes.
Monetary politics. A set of central bank
objectives in exercising control over money,
interest rates, and credit conditions.
The instruments of monetary policy are
mainly open market operations, reserve
requirements and the discount rate.
PPF. Look at the production possibilities
frontier.
Price. The cost in money of a good, service, or
asset. Price is measured in dollar units per
unit of the good (as in $3 for 1 hamburger).
Closing price (or point or rule). In the theory
of the firm, the closing point is reached at
the moment when
that the market price is just enough to cover
the average variable cost, and nothing
more. Therefore, the firm's losses per period
barely equal its fixed costs; might as well
close.
Market settlement price. It is the price in a
balance of supply and demand. This denotes
that all buy or sell orders
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406
they are satisfied at that price, so that
the books are “clean” of said orders.
GDP price. See GDP deflator.
Budget. Account, normally for one year,
of planned expenses and expected
income.
For a government, revenue is what it
gets from taxes.
See also actual, cyclical , and
structural budget.
Cyclical budget. See actual, cyclical
and structural budget .
Balanced budget. Go to budget,
balanced.
Budget, balanced. Budget in which total
expenses equal the same amount as
income (excluding loan income).
Structural budget. See actual, cyclical
and structural budget.
Real, cyclical and structural budget.
The actual budget deficit or surplus
is the amount recorded in a given
year. This is made up of the structural
budget, which calculates what
government revenues, expenditures,
and deficits would be if the economy
were operating at its potential output,
and the cyclical budget, which
measures the effect of the business
cycle on the budget.
Principle of ability to pay (of taxes).
Principle that the tax burden of each
one should depend on the ability to
pay as measured by income or
wealth. This principle does not specify
how much more those who have
more should pay.
Principle of exclusion. Criterion by
which public goods are distinguished
from private goods. When a producer
sells a commodity to person A and
can easily exclude B, C, D, etc., from
the benefits of that commodity, the
exclusion principle holds and the
good is private. If, as in public health
or national defense, people cannot
be easily excluded from reaping the
benefits of producing the good, then
the good has characteristics of a
public good.
Principle of profit (tax).
Principle that people should pay taxes
according to the benefits they receive
from government programs.
equimarginal principle. Principle to
decide the distribution of income
between different consumer goods.
According to this principle, consumer
utility is maximized when he chooses
Choose a group of consumer goods
such that the marginal utility per unit
of money spent is the same for all
goods.
marginal principle. The fundamental
idea that people will maximize their
income or profits when the marginal
costs and marginal benefits of their
actions are equal.
Productivity. Term referring to the ratio
of output to inputs (total output divided
by labor inputs is labor productivity).
Productivity increases if the same
amount of
inputs generates more output. Labor
productivity is increased by better
technology, improvements in
personnel training, or capital
deepening.
Productivity of capital, net. See rate of
return on capital.
Work productivity. See productivity.
Total factor productivity. Productivity
index that measures the total output
per unit of total inputs. The index
numerator
is total output (say, GDP), while the
denominator is a weighted average
of capital, labor, and resource inputs.
Total factor productivity growth is
often referred to as
considered as an index of progress
technological. It is sometimes also
known as multifactor productivity.
Product (or production) total. The total
quantity of a commodity produced,
measured in physical units such as
bushels of wheat, tons of steel, or
number of haircuts.
Marginal Revenue Product (MRP) (of
an input). Marginal revenue multiplied
by marginal product. It is the extra
income that a company can earn if it
buys an additional unit of an input,
puts it to work, and sells the extra
product it manufactures.
Gross domestic product, nominal (or
nominal GDP). Value, at current
market prices, of production
GLOSSARY
final total produced in a country in a
given year.
Real, gross domestic product (or real
GDP). Quantity of goods and services
produced in a country during a year.
Real GDP takes GDP
nominal and corrects it for price
increases.
Marginal product (MP). The extra product
that results from 1 extra unit of a
specific input when all other inputs
are held constant. Sometimes called
marginal physical product.
Product, marginal. Go to marginal
product.
Real gross national product (or real
GNP). GNP corrected for inflation;
that is, the real GNP is equal to the
nominal GNP divided by the deflac
gnp tor. This was the central
accounting concept in earlier times,
but it has been superseded by gross
domestic product.
potential product. It is the same as
potential GDP.
Average product. It is the product or
total production divided by the quantity
of one of the inputs. For
Therefore, the average product of
labor is defined as the total product
divided by the quantity of labor input,
and similarly for the other inputs.
Product, average. Go to average
product.
Products. The various useful goods and
services that are consumed or used
in subsequent production.
Differentiated products. Competing
products that are close substitutes
but not identical. Differences can be
manifested in the function,
appearance, location, quality, and
other attributes of the product.
Capital deepening. In the theory of
economic growth, an increase in the
capital-labor ratio. (Contrast with
capital increase.)
Marginal propensity to save (MPS).
It is the fraction of a monetary unit
additional rate of disposable income
saved. Note that, by definition, MRC
+ MPS = 1.
Marginal propensity to import (MPm).
In macroeconomics, the increase
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GLOSSARY 407

in money value of the imports that Business. A common measure is the optimal, sets the growth of the money
result from the increase in a monetary four-firm concentration ratio, which is supply at a fixed rate, and is held to
unit in the value the fraction of output represented by that rate against all odds
of GDP. the four largest firms. tide.

Marginal propensity to consume (MPC). Regulation. Government laws or rules

The extra amount people spend when Concentration ratio of four companies.
they receive an extra dollar See concentration ratio.
of disposable income. It must be Reason for required reserves. See
distinguished from the average reserves, bank.
propensity to consume, which is the Reason for sacrifice The reason for sacrifice
ratio of total consumption to total Trade is the cumulative loss of output,
disposable income. measured as a percentage of GDP for
Property, individual. A company that is a year, associated with a permanent
owned and operated by a single person. reduction of one percentage point in
inflation.
Protectionism. Any policy adopted by a Recession. Period of significant decline in Economic regulation. See regulation.
country to protect its domestic total output, income, and employment, Social regulation. See regulation.
industries against competition typically lasting from 6 months to a returns to scale. rate at which
import competition (most commonly, year, and marked by large contractions
tariffs or quotas are applied to such in many
imports). sectors of the economy. see also
Breakeven point (in my macroeconomics). well depression.
It is the level of income of an individual, Nonrenewable resources. Those natural
family, or community, of which 100 resources, such as oil and gas, that
percent is spent on consumption (ie, essentially have a fixed supply and
the point at which there is no saving or whose regeneration is not fast enough
dissaving). Positive saving begins at to be economically significant.
higher income levels.
renewable resources. natural resources
Zero utility point. for an em (such as agricultural land) whose
prey, is the price level at which the firm services are regularly restored and
is in equilibrium, covering all its costs which, if cared for, can render useful
but earning zero profit. services indefinitely.
nest.
Rule of 70. Useful shortcut to approximate
compound interest. A quantity growing
Q Diminishing returns to scale.
at a rate r per year will double in about
What, how and for whom. These are the 70/r years.
three fundamental problems of
economic organization. What is the Substitution rule. Rule that declares that
problem of how much of each possible if the price of a factor falls while the
good or service will be produced with other factors remain the same, the
the limited inventory of input resources? companies will benefit if they substitute
ours of society. How is the election the factor that is now cheaper for the
tion of the particular technique with other factors. The rule is a corollary of
which each good will be produced. For the minimum cost rule.
whom it refers to the distribution of
consumer goods among members Rule of minimum cost (of production).
bros of that society. The rule that the cost of obtaining a
specified level of output is minimized
when the ratio of the marginal revenue
R.
product of each input to the price of
Capital-output ratio. In economic growth that input is the same for all inputs.
theory, it is the ratio of total capital
inventory to annual GDP.
monetary rule. The central element of
Concentration reason. Percentage of the monetary economic philosophy
total production of an industry that is that the monetary rule that affirms
comes from the largest that a monetary policy is
designed to control the conduct of
businesses. The main classes are
economic regulation (affecting the
prices, input, or service of a single
industry, such as telephone service)
and social regulation (trying to correct
externalities that prevail in numerous
industries, such as construction). air
or water pollution.
output increases when all inputs
increase from
proportional mode. For example, if all
inputs are doubled and output is
exactly doubled, that process is said
to have constant returns to scale.
However, if output grows less than
100 percent when all inputs are
doubled, the process shows diminishing
returns to scale; if output more than
doubles, the process shows increasing
returns to
scale.
Constant returns to scale. see
returns to scale.
Increasing returns to scale. see
returns to scale.
See returns to scale.
Diminishing returns, law. Law that affirms
that the additional product of successive
increments of a
input eventually declines, when other
inputs remain constant
so many. From a technical point of
view, this law is equivalent to saying
that the marginal product of the input
that varies falls after a certain point.
Pure economic rent. See rent, cheap .
Economic rent. Go rent, cheap.
Rent, economic (or pure economic rent).
Term applied to income obtained from
land. The full offer
of available land (with minor reserves)
is fixed, and the yield paid to its owner
is rent. This term extends fre
count to paid performance
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408
to any factor in fixed offer; that is, to
any input that has a vertical or perfectly
inelastic supply curve.
Cost effectiveness. It is the same as the
interest rate or the rate of return on
an active.
Capital consumption reserve. See
depreciation (of an asset).
Bank reserves. Go to reservations, bank.
Reservations, bank. Portion of deposits
that a bank sets aside in the form of
cash on hand or deposits that do not
earn interest at Federal Reserve
banks. In this
In the United States, banks are
required to keep 10 percent of deposits
in checking accounts (or transaction
accounts) in the form of
Bookings.
International reserves. International
money held by a country to stabilize or
"fix" its exchange rate or provide
financing when the country has
difficulties with its balance of payments.
Currently, the bulk of reserves are held
in US dollars, with euros and Japanese
yen serving as the other major reserve
currencies.
Unlimited liability. See answer
limited sability
Limited Liability. Limit on a business
owner's loss up to the amount of capital
the owner has contributed to that
business
company. Limited liability is an
important factor in the rise of large
corporations. In contrast, the owners
of partnerships and sole proprietors
generally have unlimited liability for the
debts of these businesses.
Budget restriction. See budget line.
Results. See table of results.
Revaluation. Increase in the official rate
exchange rate of a currency. See also
devaluation.
Risk. In financial economics, it refers to
the variability of the returns of an
investment.
Wealth. The net value of tangible and
intangible assets owned by a country
or person at a point in time. It is equal
to all assets minus all liabilities.
S
actual wages. Purchasing power of a
worker's salary in terms of goods and
services. It is measured by the ratio of
the wage rate in money to the
consumer's price index.
Social Security. Compulsory insurance
granted by the government to improve
social welfare, avoiding losses created
by market failures, such as moral
hazard or adverse selection.
Insurance. System by which individuals
can reduce their exposure to the risk
of large losses, distributing it among a
large number of people.
adverse selection. A type of market failure
whereby those people who have the
greatest risk are the most likely to buy Socialism. Political theory that all (or
the insurance. Expressed more
broadly, adverse selection encompasses
those situations in which sellers and
buyers have different information about
a product, such as in the used car
market.
If all other things are held constant.
Phrase (sometimes expressed as
ceteris paribus) meaning that a factor
being considered is modified while all
other factors
remaining tors remain cons
many or no changes. For example, a
downward-sloping demand curve
shows that the quantity demanded will
fall as the price rises, while other things
(such as income) rise.
keep constant.
Federal Reserve System. Bank
Central United States; consists of the
Board of Governors and 12 regional
Federal Reserve banks.
Exchange rate system. Set of rules,
organization and institutions through
which payments are made between
countries. The most important
exchange rate systems in history have
been the
gold standard, the Bretton Woods
system and the current system of
flexible exchange rates.
Finance system. The markets, firms, and
other institutions that make the
financial decisions of
GLOSSARY
families, businesses, governments and
the rest of the world. Important parts
of the financial system include the
money market, markets for fixed-rate
assets such as bonds or mortgages,
equity markets related to corporate
ownership, and foreign exchange
markets that trade currencies. from
different countries.
International monetary system (also
international financial system
nal). Institutions under whose protection
payments are made to cover
transactions that cross national
borders. A central issue of his
Policy is determining how exchange
rates are set and how governments
can affect exchange rates.
almost all) of the means of production,
other than labor, should be owned by
the community. This allows the return
on capital to be shared more equally
than under capitalism.
Society. association of two or more
persons to conduct a business, which
is not the corporate form and has no
limited liability.
Subsidy. Payment by the government to a
company or family, which grants or
consumes a merchandise. For
example, governments frequently
subsidize food, paying part of the food
costs of low-income families.
Budget surplus. Excess of revenue over
government spending; it is the opposite
of a budget deficit.
you
Results table. In game theory, a table
used to describe the strategies and
outcomes of a game with two or more
players. The profits or payoffs of the
different players are the outcomes.
Rate. Lien or tax that is applied to each
unit of a merchandise imported into a
country.
Central inflation rate. It is the inflation
after removing the influence of volatile
elements such as food prices and the
Machine Translated by Google
GLOSSARY
Energy. Central banks frequently use
this concept to set inflation targets.
Discount rate. 1) The interest rate charged
by a Federal Reserve Bank (the central
bank) on a loan it makes to a
commercial bank. 2) The rate used to
calculate the present value of some
asset.
Unemployment rate. Percentage of the
labor force that is unemployed.
Federal funds rate. interest rate
interest that banks pay each other for
the use of bank reserves for a single
day.
Rate of inflation. See inflation.
Non-accelerated inflation rate of the
employment (NAIRU). Unemployment
rate that is consistent with a constant
inflation rate. in the NAIRU
the upward and downward forces on
price and wage inflation are balanced,
so there is no tendency for inflation to
change. The NAIRU is the rate of
unemployment at which the long-run
Phillips curve is vertical.
Interest rate. Price paid to obtain a loan
of money for a certain period of time,
normally expressed as a percentage
of the principal per year. Thus, if the
interest rate is 10 percent per year,
then $100 would be paid on a loan of
$1,000 for one year.
Nominal interest rate (or in money).
Interest rate paid on different assets.
This represents a return in dollars per
year for every dollar invested. Compare
it to the real interest rate, which
represents the return per year on the
property
per unit of goods invested.
Real interest rate. The interest rate
measured in terms of goods, rather
than money. So it is equal to the money
(or nominal) interest rate minus the
inflation rate.
Labor force participation rate. Ratio of
those in the labor force to the entire
population aged 16 and over.
Rate of return (or yield) of capital. Return
on an investment or a capital good.
Thus, an investment that costs $100
and
earns $12 annually has a rate of return
of 12 percent per year.
Investment rate of return. The
annual return in dollars for each dollar
of capital invested. For example, if a
$100 investment returns $12 per year,
the rate of return on the investment is
12 percent per year.
Exchange rate. Rate or price at which
currency is exchanged
one country for the currency of another country.
For example, if you can buy 10 Mexican
pesos for 1 US dollar, then the peso
exchange rate is 10. A country has a
fixed exchange rate if it pegs its
currency to a given exchange rate and
claims to defend that rate. exchange.
Exchange rates that are determined
by market supply and demand are
known as flexible exchange rates.
Effective tax rate. Total taxes paid as a
percentage of total income or other tax Distribution theory. See theory of
base; also known as the average tax
rate.
Expected rate of inflation. Constant
inflation process that occurs when
inflation is expected to persist and the Random path theory (of stock market
current rate of inflation is incorporated
into people's contracts and expectations.
Marginal tax rate. In an income tax, it is
the percentage of the last monetary
unit of
income paid in taxes. If a tax system
is progressive, the marginal tax rate is
higher than the average tax rate.
National savings rate. the saving
total, private and public, divided by the
net domestic product.
Natural rate of unemployment. It is the
same concept as the non-accelerating
inflation rate of unemployment.
pleus (NAIRU).
Personal savings rate. Ratio of personal
savings to personal disposable income,
in percentage.
Average tax rate. Total taxes divided by
total income; rate also known as
effective tax rate.
Policy ineffectiveness theorem.
Theorem that expresses that, with ex
409
Given rational expectations and
flexible prices and wages, anticipated
government monetary or fiscal policy
cannot affect real output or
unemployment.
Quantity theory of money and prices.
determination theory
of output and the general price level
which asserts that prices move in
proportion to the money supply. A
more cautious approach put forward
by monetists holds that the money
supply is the most important determinant
of changes in nominal GDP.
(see monetarism).
Games theory. An analysis of situations
involving two decision makers with
interests
at least partially in conflict. It can be
applied to the interaction of oligopolistic
markets, as well as to bargaining
situations, such as strikes, or to
conflicts such as games or war.
the distribution of income.
Income distribution theory.
Theory that explains the way in which
personal income and wealth are
distributed in a society.
prices). See efficient market.
Efficiency wage theory. ok
According to this theory, higher wages
lead to higher productivity.
This occurs because with higher
wages, workers are healthier, have a
better state of mind, and there is less
turnover.
Real business cycle (RBC) theory.
Theory that explains corporations
purely as shifts in aggregate supply,
mainly due to technological shocks,
without any reference to monetary and
other forces on the demand side.
Portfolio theory. An economic theory that
describes how rational investors
allocate
divide your wealth among different
financial assets; that is, the way in
which they accommodate their wealth
in a “portfolio”.
Marginal product theory of distribution.
distribution theory
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410
of income proposed by John B.
Clark, according to which each productive
input is paid according to its marginal
product.
Labor theory of value. Point of view,
frequently associated with Karl
Marx, that all commodities should be
valued according to the
amount of labor required for its production.
malthusian theory of growth
population. Hypothesis, first expressed
by Thomas Malthus, that the "natural"
tendency of the population is to grow
faster than the food supply. Thus, per
capita food production would decline
over time, putting a brake on the
population. In general, it is the view that
the population tends to grow faster when
the income or living standards of the
population rise.
Classical theories (in macroeconomics).
Theories that highlight the self-correcting
forces in the economy. In
In the classical approach, there is
generally full employment, and policies
to stimulate aggregate demand have no
impact on output.
Terms of trade (in international trade).
“Real” terms at which a country sells its
exports and buys its imports.
This measure is equal to the ratio of an
export price index to an import price
index.
Land. In classical and neoclassical
economics, one of the three basic
factors of production (along with labor
and capital). Expressed more generally,
land is considered to include land for
agricultural or industrial purposes, as
well as natural resources taken from
above.
or below ground.
Exchange rate. See foreign exchange rate.
Managed exchange rate. Currently, it is the
most frequent exchange system. In this
system, a country intervenes occasionally
to stabilize its currency, but there is no
fixed or announced peg.
Foreign exchange rate. The currency (or
other financial instruments) of different
countries that allows
a country pay debts to other countries
ses.
Fixed exchange rate. See foreign
exchange rate.
Flexible exchange rates. A cross-country
exchange rate system in which exchange
rates are determined predominantly by
private market forces (i.e., supply and
demand) without governments
determining and maintaining a particular
pattern of exchange rates. change; it is
also sometimes called floating rates.
When the government refrains from any
intervention in the exchange markets,
the system is known as a pure system
of flexible exchange rates.
Floating exchange rates. See flexible
exchange rates.
Barter. Direct exchange of one good for
another, without using money or any
other means of exchange.
OR
monetary union. Arrangement by which
several countries adopt a common
currency as their unit of account and
medium of exchange. The Union
The European Monetary Commission adopted
the euro as its common currency in 1999.
Usury. charging an interest rate
above a legal maximum on borrowed
money.
Utility. 1) In accounting, total revenue less
costs appropriately
charged against goods sold (see income
statement). 2) In economic theory, the
difference between sales revenue and
the full opportunity cost of the resources
required to produce those goods.
Utility (also total utility). Total satisfaction
derived from consumption
of goods or services. contrasts with
marginal utility, which is the additional
utility that arises from the consumption
of one additional unit of the good or being Value, paradox. Go to paradox of value.
vice.
Cardinal utility. See ordinal utility.
Zero economic profit. in an in
perfectly competitive industry in a long-
run equilibrium, there will be zero
economic profit.
This definition applies to all
GLOSSARY
revenue minus all costs, including
implicit costs of factors owned by firms.
Marginal utility (MU). The additional or
extra satisfaction that the consumption
of 1 additional unit of
a commodity, where quantities of other
goods consumed are
keep constant.
Diminishing marginal utility, law. Law that
says that the more and more a
commodity is consumed, the lower its
marginal utility.
ordinary utility. measure of utility without
figures that are applied in the theory of
demand. Ordinal utility allows one to say
that A is preferred to B, but we cannot
say by how much.
That is, you can classify any two groups
of goods in relation to each other, but
you cannot measure the absolute
difference between them.
the groups. This is in contrast to cardinal
utility, which is sometimes used in
behavior analysis.
towards risk. An example of a cardinal
measurement would be to say that a
substance at 100 K (Kelvin degrees) is
twice as hot as another at 50 K.
V
Value added. Difference between the value
of goods produced and the cost of
materials and supplies used in their
production. In a $1 loaf of bread that
incorporates $0.60 of wheat and other
ingredients, the value added is $0.40.
Value added consists of the wage,
interest, and profit components added
to output by a firm or industry.
Intrinsic value (of money). The commodity
value of a piece of money (eg, the
market value of the copper weight
contained in a copper coin).
Present value (of an asset). Today's value
of an asset that yields a stream of
income over time. The valuation of these
income streams in the
time required to calculate the value
Machine Translated by Google
GLOSSARY
present of each component of income,
which is achieved by applying a discount
rate (or interest rate) to future income
ros.
Values. Term used to designate a wide variety
of financial assets, such as stocks, bonds,
options, and notes; more precisely, the
documents used to establish ownership of
these assets.
Variable. Magnitude of interest that can be
defined and measured. Important variables
in the economy that interest us include
prices, quantities, interest rates, exchange
rates, wealth dollars, and so on.
vamente.
Exogenous and induced variables. Exogenous
variables are those that are determined by
conditions unrelated to the economy. They
are contrasted with
the induced variables, which are determined
by the internal functioning of the economic
system. The
changes in climate are exogenous; changes
in consumption are
frequently induced by changes in income.
External variables. Same as exogenous
variables.
Induced variables. See exó variables
genes and induced variables.
speed of money By fulfilling its function as a
medium of exchange
Bio, money moves from buyer to seller to
a new buyer and so on. Its “speed” refers
to the speed
of this movement.
Velocity of money with respect to income.
See velocity of money.
Absolute advantage (in international trade).
The ability of country A to produce a good
more efficiently (that is, with more output
per unit of input) than country B. Possession
of such an absolute advantage does not
necessarily mean that A can export this
good
411
country to B. Country B still has the
comparative advantage.
Comparative advantage (in international
trade). The law of comparative advantage
says that a country should specialize in the
production and export of those goods that
it can produce at a relatively low cost, and
that it should import those goods of which it
is a relatively high -cost producer . Is
That is, it is a comparative advantage, not
an absolute advantage, that should dictate
the patterns of trade.
Ricardian vision of fiscal policy.
A theory developed by Robert Barro of
Harvard, who argues that changes in tax
rates have no impact on consumer
spending, because households anticipate,
say, that today's tax cuts will require
tomorrow's tax increases, to meet financial
needs
government lie.
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analytical index

Note: Page numbers in bold refer to glossary

terms; numbers followed by “n” indicate notes.

A Technological advance, 228 Boeing Company, 158

Common as an economic product, 235 sources of, bonds

Stocks, 179 235 leading role of, 234-235 corporate, interest rate on, 164 indexed, 165-166
Stock Price Indices, 190 Illiquid,
163 Advances in Latin America and the Caribbean, Borjas, George, 62
Omitted 251-254 human development, Boskin, Michael, 106
252-254 Brealey, Richard A., 128
activities that do not go through the market,
103 New Economy Bubble, 134
Liquid Housing, 135 Speculative,
B.
189-190 and Crashes, 188-191
asset, 163
balance sheet, 185
non-liquid, 163
Trade
present value of a, 160-161
Assets, 175 balance, 275 Burke, Edmund, 3
payments, 275 Burns, Arthur F., 156
capital against, financial, 159 dollar-
denominated, 178 financial, 178 international payments, 274-277 Bush, George W., 366, 377
and interest rates, 160 current account, 77, 275 Sales search, 256
central bank
Management How do you determine interest rates?
C.
of the lawsuit, 378-379 short term, 201-203
international fi nancial, 77 essential elements of the, 199-201 and Technological Change, 228-230
risk averse, 188 the Federal Reserve System, 198-208 Actual purchasing power, 48
Central Capital (Marx), 265
Monetary Aggregate, 181
Hole in the ozone layer, 249 banks in Latin America and the Caribbean, 201 Capital, 33, 158, 185, 227-228
Savings with partial reserves, 186-187 development of, against financial assets, 159
and investment, from goldsmith shops, 185-186 and the money growth based on the sacrifice of

102 government, 219 supply, 185-187 current consumption,

alternative measures to, 121-122 33-34 profit or loss of, 188 human,
personal, 113 rate reduction, Mud, Robert, 375-376 255 intangible, 308 interest and
120-121 rate, 113 private, 102 total Baumol, William, 230, 245 profits, 158-174 investment and
or national, 102 Bell Labs, 235 formation of, 94-96 indirect social,
Berlin, Isaiah, 265 256 and private property, 34
Bernanke, Ben, 207, 227, 377-378, 388
Algebra of Real Interest Rates, 165n Beyond the Limits, 249
Allen, Franklin, 128 Capital Capitalism and Freedom (Friedman), 43
High capital mobility, 301 goods, 9 Capitalism, 26, 34, 158
Analysis intangible, 227 business cycles in, 39
of the cost-benefi ce of the systems of investment of, 166 excesses of, 40 laissez-faire,
redistribution, 39 tangible, 227 and 38 Carlyle, Thomas, 232
numeric, 144 property rights, 34 consumer, 88 Carter, Susan, 108 Causation,
Opening, 261 durable, 9 economic, 4 free, 4 relationship of, 5 Chicago
Apple, 32 inferior, 48 intermediate, 90 non- Board of Trade, 26 Supply
Optimum currency area, 313 excludable, 37 non-rival, 37 normal, shock, 351 Austerity or
Luxury items, 112 48 public, 36-38 and taxes, 36 disinflation cycle, 359 Business
International Economic Affairs, 310-314 related, 49 indirect social, 228 cycles, 4, 67-68, 131-132 characteristics of,
Relative delay, 260 132-134 fi nancial crises and, 134 definition, 39,
AT&T, 36 132 waste of, 14 real, 375-376 Can it be
automobiles avoided?, 141-142 and aggregate demand,
increase in demand for, 51 effects 131-157
on displacement of supply, 53-54

Factors Affecting the Demand Curve,

50
413
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414 ANALYTICAL INDEX

Economic cycles of production, 99 added (DA), 78, 137

waste of, and environmental GDP growth to aggregate supply, 219
degradation, 14 per capita in Mexico, 71 economic, changes in the, 139-140
Cigar Premiere without smoke, 28 39, 67, 73, 225-246, 226 negatively sloping curve, 138-139 impact
Current, 182 self-sustaining, 226 of taxes on, 149-150 theory,
Vicious circle of poverty, 259 in the open economy, 304 in 136-137 and business cycles, 136-142
Asset class, interest rates, 164 poor countries, 250-262 and increase in, 51 change in, vs. variation in the
Club of Rome, 249 human well-being, 383-386 quantity demanded, 51 curve of the, 46,
Coca-Cola Company, 158 macroeconomic, 35, 39-40 and 47-48 law of diminishing demand, 47 domestic,
Debt-to-GDP ratio, 23 stability, 39-40 new theory 295 of assets, 184 of capital, 166-167 of
Commerce of, 235 meaning of, in the long computers, 48-49 of investment curve
money and capital, 30-34 term, 225-226 population and development, of the, 124 of unit elasticity, 68 market, 48 shifts
electronic (e-commerce), 26 247-249 in, 49-50 effect of a shift in, 56-58 in a circular
specialization and division of labor, 31-33 foreign Debt flow diagram, 28-29 moves along the curve, 58
and economic activity, 294-303 and US finance crisis in Latin America, 33 table of the, 46 Deposits in checking accounts,
with fl exible exchange rates, 299-301 Keynesian Cross, 143 182 Depreciation, 96, 99 Depression, 73
Count, 89 Property rights, 34 Intellectual property, 235
Savings
Price accounts, 178
competition, 27 national income and product, 87 balance
imperfect, 35 of payments, 274-277 national, 87
perfect, 35 augmented, 103 details of, 91-102 derived
Competitiveness, 310 from business accounts, 89-90 beyond,
Government purchases, 78, 138 102-104
Computers price
drop of, 50 demand for, 51

Basic Concepts of Supply and Demand,

45-63 Aggregate demand curve, 79
Money Tips, 288 demand, 46-47 market
Consumers; see also entries for demand, 48 supply, 51, 52-54 cost
of production, 52-53 special items,
Consumption Determinants of Production, 53 government policy, 53 prices
27 in a Circular Flow Diagram, 28-29 of related goods, 53 input prices, Financial derivatives, 179
Average Income, 49-50 Prices as Signals 52-53 Economic Development
for, 27 Challenge, 247-271
Consumption, 78, 94, 110, 138 Discount in time, 167
determinants of, 118-119 of the aggregate supply, 322 Unemployed, 327
future vs. current, 12-13 of the short-term aggregate supply, 322 of the who are they, 334
personal expenses of, 94 long-term aggregate supply, 322 of the supply Unemployment,
permanent income and the model of the life with a positive slope, 52 of Laffer, 377 of 326-328 adolescent in minority groups,
cycle of, 118 income and savings, aggregate supply, 79 of Phillips, 353-355 335-338 high, 74 low, 74 cyclical,
113-117 national behavior of, 118-122 331 equilibrium, 330 imbalance, 332 duration
of, 334-335 robust economic, 314 structural,
short term, 353 330 frictional, 330 sources of, 335 impact of,
present vs. future, 166-167 vertical long term, 357 327-329 economic, 328 social, 328-329
marginal propensity to, 116 as displacement of a, 140 movement economic interpretation of, 329-333
geometric slope, 116-117 sacrificed for along a, 140 measurement of, 327 policies to reduce the,
capital growth, 33-34 subsidized, 39 and curves 360-361 by age, 335 rate of, 74, 327 non-
savings, 110-122 and investment, displacements of the, 22 accelerating inflation rate del, 355 voluntary,
110-130 Growth accounting, 238 equation movements along the, 22 non-linear, 330 and the bases of the aggregate offer,
fundamental of the, 238 numerical example, 21 321-341
239-240 Opportunity cost, 13 of production,
52 technological advances, 52-53 input prices,
D.
52-53 Costs, 122-123 menu of price and wage
adjustments, 333 Damage
environmental, omission of, 103
Dedrick, Jason, 43
Budget deficit, 365
Deflation, 75, 346-347
Deflator, 91
implicit GDP, 91
Demand; see also Aggregate Demand;
Domestic demand; Offer and imbalance, 143
demand Displacements of the curves, 22
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ANALYTICAL INDEX 415

Gross market, 8 Evolution of consumption in the 20th century,

debt, 365 definitions, 3-4 112-113
held by the public, 365 supply side, 377 stabilization Surplus, 56
external, 370 government, of, 378-383 global US capital stocks in 2008, 33, 158
365 interdependence in, 304-310
economic consequences of, 364-374 and keynesian, 70 laissez-faire, 8 Expansion, 132
economic growth, 368 historical trends, 368 mixed, 8, 25, 39 monetary, applications wartime, 81
of the, 213-219 normative, 6 positive, Expectations, 123-124
internal government, 368 6 Equation of exchange, 214 Edison, Monetarist
net, 365 public, 365 and Thomas A., 235 Effect Experiment, 216
growth, 372-374 Population explosion, 254-255
Exports, 97, 294
Multiple net, 77-78, 97, 138, 294
Curve Diagram, 23 Externalities, 36
Circular Flow Chart of a Market Economy, negative, 36
28-29 Supply and Demand, 23 income, 47, 48, 48n
Risk-Return, 188 wealth, 119
F
substitution, 47
Scatterplots, 23 tequila, 72 Efficiency, Factors
Dickens, Charles, 110 4, 13-14, 35-38 economic, of production, 9 of
Classical Dynamism of Smith and Malthus, 4; see also Productive Efficiency, 13 economic growth, 227
230-231 Eisenhower, Dwight D., 8 Choice and Fallacy
Money, 33-34, 178 Production Possibilities Frontier, 10-14 of composition, 6 post
banks and the offer of, 185-187 Emigration, 308 Employees, 327 hoc, 5
banking, 181 special case of, Employment Act, 68 Scientifi c
180-185 as merchandise, 181 Approach, 5 Cost Flow , 99 flow of products, Lighthouses, 37 Florida, 37
components of the offer of, 88, 99 income, 88 total spending, 142 Pricing, 36
181-183 costs of conserving the, 183 Keynesian macroeconomic policy, 147 Financing of public goods, 37
legal tender, 182 demand of, 183-185 Engel, Ernst, 111n Equity, 35, 38-39 Personal finance
Equilibrium, 58-59, 143 supply and strategies for, 193-194
demand, 54-61 market, 55 supply and Fisher, Irving, 167-168, 173
for transactions, 183 demand market, 27 market, 27 in the Flow
evolution of, 180-183 short term, 169-170 in the long term, 170 of goods, 87
functions of, 183 history end of the system, 187 macroeconomic, of funds, 178 of
of, 180-181 -commodity, 89- 81 Scarcity, 4, 56 and efficiency, 3-5 income, 88 of
181 -paper, 181 and the Specialization, 31 Essay on the Principle products, 88 focus
fi nancial system, 175-197 of Population (Malthus), 248, 269 Price stability, of, 88
35, 74 Economic stabilization, 39-40 Welfare Pension
diamond district of the city state, 40-41 accounting, 89 long-term stationary, funds, 179 money
New York, 26 234 Stagflation, 351 Strategies for economic market, 179 federal rate
Division of labor, 31 development, 260-262 Ethanol, subsidy, 53 determination, 207
Double counting, 90 Euro, 312
dollarization, 290 Mutualists, 179
Dow Jones Industrial Average (DJIA), 190 Forbes, 400 Richest Americans, 38 Franklin,
Benjamin, 248 Friedberg, Rachel M., 60n
Friedman, Benjamin, 245 Friedman, Milton, 40,
AND

43, 173, 128, 195, 216 Production Possibilities

e-capital, 158 Frontier ( PPF), 10, 28 continuous curve, 19
E-commerce (electronic commerce), 26 displacement of the curve and movement along
Econometrics, 5 it, 22 in practice, 10-13 graph of
Open production possibilities,
economy,
273 savings and investment in the,
304-308 balance of a, 306-309 growth
promotion in a, 308-310 savings-
investment ratio in a, 304 18
authoritarian, 8 Soviet-style command, special plots, 22-23 plots
266 balance, 267 how it worked, 266 with more than one curve, 23 scatter
comparative economic performance, 267 plots, 23 time series, 22-23 slope as
per capita income, 267 historical roots, marginal value, 22 slope of a curved
266 line, 21 slopes and lines, 19-20

Frost, Robert, 13, 294

Workforce, 327
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416 ANALYTICAL INDEX

Savings Taxes, 38, 76, 96, 99 fixed Compound interest, 248

function, 115
consumption,
114-115 national,
119 clearing house, 177 consumption,
23 reserve requirements, 205
aggregate production (APF), 227
Fundamentals of Economics, 3-24
G.
Galbraith, John Kenneth, 175, 195
Business
profits, 170 derived
from trade, 31
Secondary consumption expenditure, 146
Costs
total domestic, 295
government, 76
Gates, Bill, 235
Gerschenkron, Alexander, 260
Globalization, 31-33, 77, 272
Google, 32
graphic, 18
Time Series Plots, 22-23
Graham Bell, Alexander, 171
Great Inflation, 81
Great Restraint, 82
Great Depression, 83, 119
progressive taxation, 38
Great Unraveling: Losing Our Way in the New
Century (Krugman), 43
Tastes, 28, 49
exogenous, 145
h
Hackett, Francis, 247
Hall, Robert, 158 Hayek,
Friedrich, 40, 43 Heaven's
Door: Immigration Policy and the American
Economy (Borjas), 62 Heilbroner,
Robert, 16 Hyperinflation, 75, 134, 345-346
Subprime Mortgages, 121 Rational
Expectations Hypothesis, 375 Lag, 260-261
Life Cycle, 118 Fiscal History, 365-366
Macroeconomics: 1900-2008, 81
Hobsbawm, EJ, 225 Hopkins, SV, 343n
Hume, David, 285-288 , 291, 293 Hunt,
Jennifer, 60n
Yo
amount, 147 impact of, and exponential growth, 248
152-153 and public goods, Financial intermediation, 176
36-38 Financial intermediaries, 176
Inactive or out of the labor force, 327 Index Intermediate Microeconomics (Varian), 62
Economic Interpretation of History, 266
Big Mac, 282-283 Intervention, 288-289
of global competitiveness in countries of Domestic private investment, 78,
Latin America, 312 95, 122-127, 138 gross, 96,
consumer prices (CPI), 74, 104 producer 102, 122 demand for, 126
prices (PPI), 105 GDP prices, 105 social GDP changes in the curve, 126
prices, 93 Price indices, 74, 104-105
determinants of, 122-124 net
foreign, 295 fi nancial, 95 net, 96
Industrialization and Agriculture, 261 real, 95 meaning of, in the
Inflation, 69, 74, 342-363 economy, 122 iPod, 3, 32
anticipated, 346 low, 344
credibility and, 360 costs,
351 demand, 350
stagnation with, 351; see Irrational Exuberance (Shiller), 173
Stagfl ation expectations
and the, 352 runaway, 344-345 history of,
J
343-344 economic impacts of, 347-349
macroeconomic impacts, 349 price levels and, Johnson, Lyndon B., 81
353 unanticipated, 346 objectives of, 382 by Journal of Economic Perspectives, 173
supply shock , 351 what is the, 342-343 rate of,
74 optimal rate of, 349 modern theory of, 349-358
k
Kelvin, Lord (William Thompson), 87
Kennedy, John F., 81, 232, 364 Kennedy,
Robert, 104, 108-109 Keynes, John
Maynard, 67-70, 84, 123, 131, 156, 386 Kraemer,
Kenneth L., 43 Krugman, Paul, 43,
312, 383, 388 Kydland, Finn, 376
Special Influences, 49
Infrastructure, 256
L
Disposable income, 100,
118 national, 100 Laffer, Arthur, 377
permanent, 118 Laissez-faire, 40
personal, 100 Lebergott, Stanley, 128
disposable, 113 of Lenin, V., 265 Law of
GDP al, 100-102 Downsloping Demand,
Income, 122
Immigration, 308 57
infl uence of, on wages, 60 Declining Demand, 47, 57 Okun's, 329
Technological Antitrust Laws, 36 Engel's Laws, 111n
innovation, 228 Limits to Growth, 249 Linden, Greg, 43
and entrepreneurship, 258-259 Curved Lines, 21 Tangents, 21 Liquidity,
Innovative or Entrepreneurial, 171 163 Logic of Economics, 5-6 Lucas,
Market Robert E., 375, 388
institutions, 309
international monetary, 287-289
World Bank, 287-288
International Monetary Fund (IMF),
287
Bretton Woods system, 288
Policy instrument, 76
Credit market instruments, 179

m
Identities, 214n inputs, 9
Imitation of technology, 258 Economic Macroeconomics, 5, 67
Short-term impact of trade on the integration, 272 advances in the, modern, 374-378
GDP, 296-299 financial, 32 classical, 325 and Say's law of
Imports, 97, 294 Exchange, money as a means of, 33 markets, 374, 387
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ANALYTICAL INDEX 417

key concepts of the, 68-78 in an Millionaires, 38 Neo-Malthusianism, 249

open economy, 294-317 frontiers of the,
364-389 keynesian, 325 birth of the,
68-70 objectives and instruments of the,
70-77 overview of the, 67-86 Malkiel,
Burton, 173, 191n, 195 Malthus, TR,
230-231, 234, 244, 247-249, 254-255,
268-271, 248-249 and Dismal Science,
Mitchell, Wesley Clair, 156 New Americans, The (National Academy of
Mizner, Wilson, 321 Sciences), 62
Multiplier New York Mercantile Exchange, 26
model, 142-146 in perspective, New Classical Macroeconomics, 375
154 Keynesian, 142 fiscal New Society, 366
policy in the, 146-154 and
the business cycle, 153-154
EITHER

247-249 neoclassical economic growth,

231-232
Aggregate supply (OA), 78,
geometric analysis of, 233-234 322 in the short and long terms,
Communist Manifesto (Marx), 265 Asian 325-326 bases of the, 321-326
Mansfield, Edwin, 62 models determinants of the, 322-324 curve
China's rise, 264 Asian of the, 51, 52-54 demand and
Manpower, 9 dragons, 263 Fundamentals immigration, 59-60 table of la, 51 and
invisible, 28, 29, 30 of macroeconomics, 264 Outward orientation, aggregate demand, 78-79
doctrine of the, 35 264 Investment rate, 263-264 Development
visible of the State, 34-41 alternatives, 262-268
Brands curves, 78-80
as capital, 158 free market absolutism, 262 absolute Okun, Arthur M., 106, 156
Marshall, Alfred, 16, 62, 374 communism, 262 Soviet-style communism, Olson, Mancur, 260 Open
Marx, Karl, 264-267 262 Asian approach to managed markets, market operations, 202, 204 rediscount policies in
Hume's 262 socialism, 262 peaceful and support of, 205 Outward orientation, 261, 311
adjustment democratic evolution, 265 planning,
mechanism, 264 government ownership of productive
144, 285 international, resources, 264 income redistribution,
285 four-pronged, 285-287 264-265
P
monetary transmission, 175, 208-213 in an
open economy, 301-303 Economic Solidarity Pact (PSE), 71
Measuring Economic Activity, 87-109 Transfer payments, 38, 96
Modern Mixed Economy, 25-44 Developing country, 250
Measurement of Modigliani, Franco, 128 Low-income countries, life in, 251
saving in the national accounts, Mokyr, Joel, 230 Purchasing power parity, 250
121 in the balance sheet, 121 Common Random walk, 192
Market, 26 coin, 288 Liabilities, 185
exchange, 278-282 of overvalued, 300 Pattern
products, in a circular flow diagram, 28-29 of Monetarism, 214 growth rate in the United States, 236-243
work of values, 187-194 efficient fi Modern, 216 gold, 284 Household budget
nancial, 192 labor Twilight of, 216 spending patterns, 111-112 Pending, 19
Roots of, 214 and Perpetuities, 161 present value of, 161 Phelps,
the Quantity Theory of Money and Prices, Edmund, 343n, 355, 376, 388 GDP at
213-218 Monetary History of the current prices, 91 ; see Nominal Gross Domestic
relevant issues of, 333-338 United States (Friedman and Schwartz), 173 Product, 94 real, 94 in serial dollars, 93 Pigou, AC,
mechanism of, 26-30 size of, 49 Monopolistic, 36 Morgan, JP, 380 16 Theoretical approaches, 5 Vicious circle
Movement to Along the Demand Curve, 51, 54, 58 poverty, 258 trap, 259 Anti-inflationary policy
Managed Along the Supply Curve, 53-54 Movements Along the dilemmas, 359-361 of the budget governmental,
markets, 333 Curves, 22 Mullis, Kary, 171 Multiplier, 145-146 366 fiscal, 76-77, 366 multipliers of the, 151-154
centralized, 26 factors, Analysis of the, 154 Economics open, 299 role of the, 379 and multiplier model,
29 auctions, 333 government spending, 151 Spending 367-368
decentralized, 26 multipliers, 151 Mundell, Robert, 316 Myers,
efficient and random Stewart C., 128
walk, 191-192 financial, 120, 176 monopolistic,
35

Individual merchandise, 46
Central bank targets, 199-200
Indirect Production Methods, 33, 166
Monetary-fiscal mix, 380
Microeconomics, 5, 67
Microeconomics: Theory and Practice (Mansfield
and Yohe), 62
No.
Microsoft, 235
Asian Miracle, 263 NASDAQ Composite Index, 190
Mill, John Stuart, 272, 374 Nature of Capital and Income (Fisher), 167
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418
macroeconomic
tools of the, 77-78 role of
the, 82-83 monetary, 39,
76-77
effectiveness of, 379-380
in the long term, 213 in
the OA-DA framework, 212
in an open economy, 218 and
economy, 198-222 Trade policies,
77, 308 of reserve requirements, 202
fiscal, 39 Weighting in series, 93
Price, 27 of GDP, 91 that clears the
market, 55 Prices as signals, 27 of
factors, 28 of oil, 54 quantity theory of,
214-215 Prescott, Edward C., 376 Lender
of last resort, 205 Consumer loans,
interest rates on, 164 window or
rediscount, 163 from abroad and debt
crisis, 257-258 term/maturity, 163
Budget, 365 cyclical, 367 balanced,
365 structural, 367 real, 367 Premium
of Stock, 172 Risk Premiums, 32
Accelerator Principle, 153 Principles of
Economics (Marshall), 62 Principles of
Money, Banking, and Financial Markets
(Ritter, Silber, and Udell), 173 Index Number
Problem, 105 Principal- agent, 266
Problems in the housing market in 2007-2008,
32
in economic organization, 7-8
Production processes more intensive in
capital, 232
Indirect
production, 166
processes, more capital intensive, 243 total,
295
Productivity, 39, 227, 310-311
explosion of, in computers, 243 rebound in,
242-243 trends in, 311 recent trends in, 241-243
total factors, 240
Gross Domestic
Product, 70 (GDP), 70, 87, 98-99, 295
short-term impact of trade on the, 296-299
nominal, 70, 91
potential, 73
actual, 70, 91 net
domestic (PIN), 98-99 fi nal,
90 how government fiscal
policies affect marginal, 147 capital,
168-169 gross national (GNP ),
98 per person, 226 potential, 322
Producers, in a circular flowchart, 28-29
Products, 9
not measured, 243
Marginal
propensity to import, 298
marginal to consumption, 116
Private property, and capital, 34
Leveling Point, 113, 115
Ricardian View of Fiscal Policy, 376
R.
Rationing Through the Purse, 60 Radford, RA,
43 Random Walk Down Wall Street (Malkiel),
173 Ranis, Gustav, 252 Sacrifice Reason, 359
Reagan, Ronald W., 366, 377 Recession, 73, 132
Tax Cuts in the Kennedy-Johnson era, 6 Open
access resources, 34 capital, 9 human, 227, 256
natural, 227 Safety net, 39 Reemergence of the
free market, 314 Fixed monetary growth rule, 216
of 70, 248 Regulations, 36 Return on
capital, 168 graphical analysis of, 168-169
Diminishing returns, 166-168 Graphical
representation of prices and markets, 28 Legal
reserve requirements, 206-207 or reserve
requirements, 206 Reserves, 185 banking, 202
how alters the Federal Reserve, 204 nature of,
205 Implicit returns, 170 Industrial Revolution, 248
Keynesian, 39 Ricardo, David, 374 Risk, 171
implicit, 171 and return on different assets, 188
ANALYTICAL INDEX
Wealth, 118-119 in
rapidly growing
paper of the, 121 Wealth of
Nations (Smith), 5, 28, 30, 230 Ritter,
Lawrence S., 173 Road to Serfdom
(Hayek), 43 Roaring Nineties, The (Stiglitz) ,
43 Rogers, Will, 198 Romer, Paul, 235
S
Sachs, Jeffrey, 268-269
Macroeconomic Bases
of Wage Rigidity, 332 Sandburg, Carl, 13
Sargent, Thomas, 375 Say, JB, 374,
387 Schwartz, Anna Jacobson, 173, 195 Social
Security, 120 Unemployment Insurance, 7 Sen,
Amartya, 252 Shakespeare, William, 131 Shiller,
Robert, 173 Century of Growth, 388 Silber,
William L., 304 Modern Banking System, 187
Hybrid Exchange Today, 290 Integrated
Environmental and Economic Accounting
(SCAEI), 103 -104 Federal Reserve, 199
functions, 200 Global Positioning System (GPS),
37 financial, 176 functions of, 176 role of,
176-177 modern financial, 175 laissez-faire, 38
emerging monetary, 314 international monetary,
283-290 Redistribution systems, 39 alternative
economics, 8 Smith, Adam, 230-231, 244,
266 Consumer sovereignty, 45 Socialism, 40
Society with a border, 12 Econometric
Society, 167 urban, 12 Solomon, Robert, 284,
292 Solow, Robert M., 232, 245 Stalin,
Josef, 26 6 Standard & Poor's 500 companies
(the S&P 500), 190, 192 Stanley
Steamer, 28 Stigler, George, 16 Stiglitz,
Joseph E., 43, 376 Budget surplus, 365
Substitution, 14
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ANALYTICAL INDEX 419

you
exogenous, 134 Profits, 27, 170 as
internal, 134 risk-taking rewards, 171 as return on equity, 170
Demand schedule, 46-51 Term or expiration, 163 as implied returns, 170-171 as an innovation
Supply schedule, 51-54 Exchange terminology, 280 reward, 171 accounting, 170 corporate, 172
appreciation, 280 depreciation, economic, 170
Federal funds rate, 202 280 devaluation, 280
expected inflation, 350 non- revaluation, 280

accelerating unemployment
(or Keynesian Macroeconomic Theses, 216
NAIRU), 322, 355 V
doubts about the NAIRU, 357-358 Tesobonos, 72
Thatcher, Margaret, 377 Added
underlying, 350
interest, 123, 159 Theory of Interest (Fisher), 167, 173 value, 91
nominal, 163 real, Theory of Price (Stigler), 16 focus of, 91
163 Earth, 9 added in the lower circuit, 90-91 intrinsic,
return on capital assets, 159-160 return on Exchange rate, 278 181 marginal, 22 present, 160 general
investment, 159-160 short-term federal equilibrium, 280 formula to calculate the, 161-162
funds goal, 203 determination of, 279 fixed, maximization of, 162 Values, 178 equilibrium
290 reciprocal, 280 of prices and quantities, 80 Treasury Infl ation-
Protected (TIPS) Notes, 165-166 Variable, 19
Exchange rates, 277-278 Exogenous, 143 Macroeconomic Policy Variables,
Interest rates determination of, 277-283 fixed, 139 Exogenous, 140 Varian, Hal R., 32, 43, 62
review on, 179-180 and 574-577, 301-302 trilemma of, 312 Velocity of Money Relative to Income , 214 of
investment demand, 209 and asset fl exible, 289, 302-303 fl oating, money, 214 Sales of personal computers,
prices, 162 yield, 188 289 purchasing power parity theory 48-49 International links, 77-78, 218 Volcker, Paul,
81, 216
Temple, Jonathan, 245
Declining trend in growth (PPC) in the, 282
demographic, 249 and the international financial system,
Trends 272-273 and the balance of
basics of economic growth, payments, 281-282
236-238 TIPS (Treasury inflation-protected
economic, 7 in securities), 165-167
international trade, 273-274 Tobin, James, 67
Politics Ineffectiveness Theorem, 377 All else constant, 6
Theory Tortilla in Mexico, 48
quantitative of money and prices, 215 of Toyota, 28
Fisher on interest, 167-168 of Liquidity trap, 211, 347
aggregate demand, 126-127 of supply and Demographic transition, 255
W
demand, 45 of purchasing power parity Monetary Transmission in an Open Economy,
(PPP), 282 of cycles of real business, 376 218-219 Wall Street Journal, 162
from efficiency wages, 376 from endogenous Taxation of Warner, Andrew, 268-269
technological advance, 235 from capital, efficiency losses in the, 371 Warsh, David, 245
profits and interest, 166-172 from the efficient Barter, 33, 180 Weber, Max, 260
market, 191 Weil, David, 245
Wilde, Oscar, 45
OR
Microsoft Windows, 36
US Lighthouse Service, 37 Udell, Gregory F., 173
General theory of employment, interest and money European Monetary Union, 312-314
Y
(Keynes), 5, 14, 70 Annual Net Income, 125
Theories Yellen, Janet, 376
of Economic Growth, 226-235 Yohe, Gary, 62
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Government debt since the Independence of the United States of America

120 Debt-GDP ratio

110

100
WWII

90
postwar expansion

80

70

Deficit reduction and

percentage
domestic
product
Federal
(GDP)
gross
debt
as
of
a

60 expansion of the
“new economy”

fifty

40
Ratification of the Constitution

30
First World War

“Supply Side
twenty
Civil war Economics”

10
Great Depression

0 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
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US price level since 1800

120

80

60

40

Price level
twenty
Consumer
(2008
Index
100)
Price
US
=

16

12

1800 1825 1850 1875 1900 1925 1950 1975 2000

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Family tree of economics FAMILY TREE OF ECONOMICS

PHYSIOCRATS

Quesnay,
1758

David Richard,
1817

SOCIALISM

K. Marx, 1867
V. Lenin, 1917
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MERCANTILISTS

17th and 18th

centuries

Adam Smith,
1776

CLASSICAL SCHOOL

T. R. Malthus,
1798
JS Mill,
1848

ECONOMY
NEOCLASSICAL

Walras, Marshall.
Fisher, 1880-1910

JM Keynes,
1936

MAIN TRENDS
OF THE MODERN ECONOMY
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