NINTH EDITION MACROECONOMICS

NINTH EDITION

MACROECONOMICS Theories and Policies

Richard T. Froyen University of North Carolina Chapel Hill

PEARSON

Prentice Hall Upper Saddle River, New Jersey 07458

Contents Preface PART ONE

xix INTRODUCTION AND MEASUREMENT

CHAPTER 1 Introduction 2 N 1.1 What Is Macroeconomics? 2 1.2 Post-World War II U.S. Economic Performance

1.3

Output 3 Unemployment 4 Inflation 5 Inflation and Unemployment 6 The U.S. Federal Budget and Trade Deficits 8 Central Questions in Macroeconomics 10 Instability of Output 10 Movements in the Inflation Rate 10 The Output-Inflation Relationship 10 Growth Slowdown and Turnaround? 11 Implications of Deficits and Surpluses 11

1.4

Conclusion

l

3

12

CHAPTER 2 Measurement of Macroeconomic Variables 2.1 The National Income Accounts 13 2.2 Gross Domestic Product 14 Currently Produced 14 Final Goods and Services 14 Evaluated at Market Prices 15 2.3 National Income 17 2.4 Personal and Disposable Personal Income 20 2.5 Some National Income Accounting Identities 21 2.6 Measuring Price Changes: Real versus Nominal GDP Real GDP in Prices from a Base Year Chain-Weighted Real GDP 25

24

13

23

x

CONTENTS

2.7

The Consumer Price Index and the Producer Price Index

2.8

Measures of Cyclical Variation in Output

2.9

Conclusion 29 Perspectives 2.1 What GDP Is Not 18 Perspectives 2.2 National Income Accounts for England and Wales in 1688 22 Perspectives 2.3 Dating Business Cycles 29

PART T W O

27

CLASSICAL ECONOMICS A N D THE KEYNESIAN REVOLUTION 31

CHAPTER 3 . 3.1

Classical Macroeconomics (I): Output and Employment 32

The Starting Point

32

3.2

The Classical Revolution

3.3

Production

3.4

Employment 37 Labor Demand 37 Labor Supply 39

3.5

Equilibrium Output and Employment 42 The Determinants of Output and Employment 44 Factors That Do Not Affect Output 48

3.6

Conclusion 48 Perspectives 3-1 Real Business Cycles: A First Look

CHAPTER 4 4.1

26

33

34

48

Classical Macroeconomics (II): Money, Prices, and Interest 51

The Quantity Theory of Money 51 The Equation of Exchange 51 The Cambridge Approach to the Quantity Theory The Classical Aggregate Demand Curve 54

53

4.2

The Classical Theory of the Interest Rate

56

4.3

Policy Implications of the Classical Equilibrium Model 60 Fiscal Policy 60 Monetary Policy 66

4.4

Conclusion 66 Perspectives 4-1 Money in Hyperinflations 57 Perspectives 4-2 Supply-Side Economics—A Modern Classical View 65

CONTENTS

CHAPTER 5 The Keynesian System (I): The Role of Aggregate Demand 68 5.1 5.2

The Problem of Unemployment 68 The Simple Keynesian Model: Conditions for Equilibrium Output 71 5.3 The Components of Aggregate Demand 76 Consumption 76 Investment 78 Government Spending and Taxes 80 5.4 Determining Equilibrium Income 80 5.5 Changes in Equilibrium Income 83 5.6 Fiscal Stabilization Policy 88 5.7 Exports and Imports in the Simple Keynesian Model ^5.8 Conclusion 93 Perspectives 5-1 Macroeconomic Controversies Perspectives 5-2 Fiscal Policy in Practice 90

90

72

CHAPTER 6 6.1

6.2

6.3

The Keynesian System (II): Money, Interest, and Income 97 Money in the Keynesian System 97

Interest Rates and Aggregate Demand 97 The Keynesian Theory of the Interest Rate 99 The Keynesian Theory of Money Demand 103 The Effects of an Increase in the Money Supply 107 Some Implications of Interest on Money 107 Going Forward 109 The IS-LM Model 109 Money Market Equilibrium: The LM Schedule 110 Product Market Equilibrium: The IS Schedule 119 The IS and LM Schedules Combined 129 Conclusion 131 Appendix: The A Igebra of the IS-LM Model 132 Perspectives 6-1 Residential Construction and the Interest Rate 100

CHAPTER 7 7.1

The Keynesian System (III): Policy Effects in the IS-LM Model 136 Factors That Affect Equilibrium Income and the Interest Rate 136

Monetary Influences: Shifts in the LM Schedule Real Influences: Shifts in the IS Schedule 137

136

xi

xii

CONTENTS 7.2

7.3

The Relative Effectiveness of Monetary and Fiscal Policy Policy Effectiveness and the Slope of the IS Schedule 144 Monetary Policy Effectiveness and the Slope of the IS Schedule Policy Effectiveness and the Slope of the LM Schedule 148 Conclusion 152 Appendix: Monetary and Fiscal Policy Multipliers in the IS-LM Model 157 Perspectives 7-1 The Monetary-Fiscal Policy Mix: Some Historical Examples 142 Perspectives 7-2 Japan in a Slump and the Liquidity Trap

143 144

153

CHAPTER 8 The Keynesian System (IV): Aggregate Supply and Demand 160 8.1

The Keynesian Aggregate Demand Schedule

8.2

The Keynesian Aggregate Demand Schedule Combined with the Classical Theory of Aggregate Supply 166

8.3

A Contractual View of the Labor Market 167 Sources of Wage Rigidity 167 A Flexible Price-Fixed Money Wage Model 169 Labor Supply and Variability in the Money Wage 174 Classical and Keynesian Theories of Labor Supply 174 The Keynesian Aggregate Supply Schedule with a Variable Money Wage 176 Policy Effects in the Variable-Wage Keynesian Model 176 The Effects of Shifts in the Aggregate Supply Schedule 180 Factors That Shift the Aggregate Supply Schedule 181 More Recent Supply Shocks 184

8.4

8.5

8.6

160

Conclusion: Keynes versus the Classics 188 Keynesian versus Classical Theories ofAggregate Demand 188 Keynesian versus Classical Theories ofAggregate Supply 188 Keynesian versus Classical Policy Conclusions 189 Perspectives 8-1 Price and Quantity Adjustment in Great Britain, 1929-36 169

PART THREE MACROECONOMIC THEORY AFTER KEYNES

191 ]

CHAPTER 9 The Monetarist Counterrevolution 9.1 Monetarist Propositions 192 9.2

192

The Reformulation of the Quantity Theory of Money Money and the Early Keynesians 194 Friedman's Restatement of the Quantity Theory 196 Friedman's Monetarist Position 200

193

CONTENTS 9.3

9.4

. 9.5

Fiscal and Monetary Policy 203 Fiscal Policy 203 Monetary Policy 205 Unstable Velocity and the Declining Policy Influence of Monetarism 206 Recent Instability in the Money-Income Relationship 207 Monetarist Reaction 207 Conclusion 208 Perspectives 9.1 The Monetarist View of the Great Depression

197

CHAPTER 10 Output, Inflation, and Unemployment: Alternative Views 210 10.1 The Natural Rate Theory

210

10.2 Monetary Policy, Output, and Inflation: Friedman's Monetarist View 213 Monetary Policy in the Short Run 213 Monetary Policy in the Long Run 213 10.3 A Keynesian View of the Output-Inflation Trade-Off 217 The Phillips Curve: A Keynesian Interpretation 218 Stabilization Policies for Output and Employment: The Keynesian View 221 10.4 Evolution of the Natural Rate Concept 222 Determinants of the Natural Rate of Unemployment 222 Time-Varying Natural Rates of Unemployment 223 Explaining Changing Natural Rates of Unemployment 224 Recent Trends 225 10.5 Conclusion

225

CHAPTER 11 New Classical Economics 11.1 The New Classical Position 227

227

A Review of the Keynesian Position 228 The Rational Expectations Concept and Its Implications New Classical Policy Conclusions 233 11.2 A Broader View of the New Classical Position

228

238

11.3 The Keynesian Countercritique 239 The Question of Persistence 239 The Extreme Informational Assumptions of Rational Expectations 240 Auction Market Versus Contractual Views of the Labor Market 242 11.4 Conclusion 244 Perspectives 11.1 U.S. Stock Prices: Rational Expectations or Irrational Exuberance? 236 Perspectives 11.2 The Great Depression: New Classical Views 243

xiii

xiv

CONTENTS

CHAPTER 12 Real Business Cycles and New Keynesian Economics 246 12.1 Real Business Cycle Models 246 Central Features of Real Business Cycle Models 246 A Simple Real Business Cycle Model 248 Effects of a Positive Technology Shock 249 Macroeconomic Policy in a Real Business Cycle Model Questions About Real Business Cycle Models 253 Concluding Comment 254

250

12.2 New Keynesian Economics 254 Sticky Price (Menu Cost) Models 256 Efficiency Wage Models 258 Insider-Outsider Models and Hysteresis 260 12.3 Conclusion 262 Perspectives 12-1 Robert Lucas and Real Business Cycle Theory 252 Perspectives 12-2 Labor Market Flows 255 Perspectives 12-3 Are Prices Sticky? 258

CHAPTER 13 Macroeconomic Models: A Summary 13.1 Theoretical Issues 264 13.2 Policy Issues 268 13.3 Consensus as Well as Controversy

PART FOUR

264

269

OPEN ECONOMY MACROECONOMICS

2 71

CHAPTER 14 Exchange Rates and the International Monetary System 272 14.1 The U.S. Balance of Payments Accounts

272

The Current Account 273 The Capital Account 274 Statistical Discrepancy 274 Official Reserve Transactions 275 14.2 Exchange Rates and the Market for Foreign Exchange 275 Demand and Supply in the Foreign Exchange Market 277 Exchange Rate Determination: Flexible Exchange Rates 279 Exchange Rate Determination: Fixed Exchange Rates 281 14.3 The Current Exchange Rate System 284 Exchange Rate Arrangements 284 How Much Managing? How Much Floating? 285 The Breakdown of the Bretton Woods System 286

CONTENTS

14.4 Advantages of Alternative Exchange Rate Regimes Advantages of Exchange Rate Flexibility 287 Arguments for Fixed Exchange Rates 292 14.5 Experience with Floating Exchange Rates 293 The Dollar in Decline, 1976-80 296 The Rising Dollar, 1981-85 297 The Dollar's Slide, 1985-88 298 The Dollar: 1990 to the Present 299 14.6 Global Trade Imbalances 300 Implication of Some Identities 301 Causes and Effects of Global Trade Imbalances 302 14.7 Conclusion 303 Perspectives 14-1 U.S. Current Account Deficits—Are They Sustainable? 276 Perspectives 14-2 Currency Boards and Dollarization Perspectives 14-3 The Euro 299

287

285

CHAPTER 15 Monetary and Fiscal Policy in the Open Economy 305 15.1 The Mundell-Fleming Model

305

15.2 Imperfect Capital Mobility 308 Policy Under Fixed Exchange Rates 308 Policy Under Flexible Exchange Rates 311 15.3 Perfect Capital Mobility 314 Policy Effects Under Fixed Exchange Rates 315 Policy Effects Under Flexible Exchange Rates 317 15.4 Conclusion 321 Perspectives 15-1 The Saving-Investment Correlation Puzzle

PART FIVE

ECONOMIC POLICY

323

CHAPTER 16 Money, the Banking System, and Interest Rates 324 16.1 The Definition of Money 324 The Functions of Money 324 Components of the Money Supply 325 16.2 Interest Rates and Financial Assets

326

16.3 The Federal Reserve System 327 The Structure of the Central Bank 327 Federal Reserve Control of the Money Supply The Tools of Federal Reserve Control 329

328

319

xv

xvi

CONTENTS

16.4 Bank Reserves and Bank Deposits

331

A Model of Deposit Creation 332 Deposit Creation: More General Cases 336 Open-Market Operations and the Federal Funds Rate 338 16.5 Who Controls the Money Supply? 339 16.6 Conclusion 344 Perspectives 16-1 The Money Supply During the Great Depression 342

CHAPTER 17 Optimal Monetary Policy

346

17.1 The Monetary Policymaking Process 346 17.2 Competing Strategies for Monetary Policy: Targeting Monetary Aggregates or Interest Rates 347 Targeting Monetary Aggregates 349 Targeting Interest Rate 350 17.3 Money versus Interest Rate Targets in the Presence of Shocks 350 Implications of Targeting a Monetary Aggregate 351 Implications of Targeting the Interest Rate 354

11A The Relative Merits of the Two Strategies

357

The Sources of Uncertainty and the Choice of a Monetary Policy Strategy 358 Other Considerations 358 17.5 The Evolution of Federal Reserve Strategy 359 1970-79: Targeting the Federal Funds Rate 359 1979-82: Targeting Monetary Aggregates 359 1982-2007: A Gradual Return to Federal Funds Rate Targeting 360 1994-2007: A Move toward Greater Transparency 360 17.6 Changes in Central Bank Institutions: Recent International Experience 362 The Time Inconsistency Problem 362 Other Arguments for Inflation Targeting 364 17.7 Conclusion 366 Perspectives 17-1 Central Bank Independence and Economic Performance 348 Perspectives 17-2 The Taylor Rule 361 Perspectives 17-3 Inflation Targeting in Practice: The New Zealand Experiment 363 Perspectives 17-4 Inflation Targeting for the United States: Three Influential Views 365

<

CONTENTS CHAPTER 18 Fiscal Policy

xvii

368

18.1 The Goals of Macroeconomic Policy

368

18.2 The Goals of Macroeconomic Policymakers 369 The Public-Choice View 369 The Partisan Theory 372 Public-Choice and Partisan Theories from the Perspective of2007 372 18.3 The Federal Budget

374

18.4 The Economy and the Federal Budget: The Concept of Automatic Fiscal Stabilizers 379 18.5 Fiscal Policy Controversies: From the Reagan Years to the Present 384 The Pros and Cons of Fiscal Policy Rules 384 What About the Deficit? 385 The Federal Budget in the Late 1990s and into the Twenty-First Century 387 18.6 Conclusion 388 Perspectives 18-1 Rational Expectations and the Partisan Theory 373 Perspectives 18-2 State and Local Government Finances

PART SIX

ECONOMIC GROWTH

391

CHAPTER 19 Policies for Intermediate-Run Growth 19.1 U.S. Economic Growth, 1960-2006

377

392

393

19.2 The Supply-Side Position 394 Intermediate-Run Output Growth Is Supply-Determined 395 Saving and Investment Depend on After- Tax Rates of Return 396 Labor Supply Is Responsive to Changes in the After-Tax Real Wage 399 Government Regulation Contributed to the Slowdown in the U.S. Economic Growth Rate 400 19.3 The Keynesian Critique of Supply-Side Economics 402 The Supply-Determined Nature of Intermediate-Run Growth 402 Saving and Investment and After- Tax Rates of Return 402 > The Effect of Income Tax Cuts on Labor Supply 403 Regulation As a Source of Inflation and Slow Growth 403 19 A Growth Policies From Ronald Reagan To George W. Bush 404 Economic Redirection in the Reagan Years 404 Initiatives in the First Bush Administration 405 Growth Policies During the Clinton Administrations 406 Tax Cuts During the Administration of George W. Bush 406

xviii

CONTENTS 19.5 Conclusion 409 Perspectives 19-1 Growth and Productivity Slowdowns in Other Industrialized Economies 394 Perspectives 19-2 The Laffer Curve 401 Perspectives 19-3 Equality and Efficiency: The Big Trade-off 407 CHAPTER 20 Long-Run Economic Growth: Origins of the Wealth of Nations 410 20.1 The Neoclassical Growth Model 410 Growth and the Aggregate Production Function 410 Sources of Growth in the Neoclassical Model 414 20.2 Recent Developments in the Theory of Economic Growth 416 Endogenous Growth Models 417 Implications of Endogenous Technological Change 419 Policy Implications of Endogenous Growth 420 20.3 Intercountry Income Differences Revisited 420 Perspectives 20-1 Growth Accounting for the United States: An Example 417 Perspectives 20-2 Muck, Money, and the Moral Consequences of Economic Growth 423 20.4 Conclusion

Glossary Index

425 430

424