We review the key aspects of supply and demand and the price system, done in five chapters. We present incentives as the most important idea in microeconomics. Microeconomics should be intuitive, should teach the skill of thinking like an economist, and should be drawn from examples from everyday life. Along these lines, these chapters run as follows.

Chapter 1: The Big Ideas in Economics What is economics all about? We present the core ideas of incentives, opportunity cost, trade, the importance of economic growth, thinking on the margin, and some of the key insights of economics such as that tampering with the laws of supply and demand has consequences and good institutions align self-interest with the social interest. The point is to make economics intuitive and compelling and to hook the student with examples from everyday life.

Chapter 2: The Power of Trade and Comparative Advantage Why is trade so important and why is it a central idea of economics? We introduce ideas of gains from trade, the production possibilities frontier, and comparative advantage to show the student some core ideas behind the economic way of thinking. The key here is to illustrate the power of economic concepts in explaining the prosperity of the modern world. An instructor can either use this material to entice the student, or postpone the subject and move directly to the supply and demand chapters.

Chapter 3: Supply and Demand This chapter focuses on demand curves, supply curves, how and why they slope, and how they shift. The chapter presents some basic fundamentals of economic theory, using the central example of the market for oil. We also take special care to illustrate how demand and supply curves can be read “horizontally” or “vertically.” That is, a demand curve tells you the quantity demanded at every price and the maximum willingness to pay (per unit) for any quantity.

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It takes a bit more work to explain these concepts early on, but students who learn to read demand curves in both ways get a deeper understanding of the curves and they find consumer and producer surplus, taxes, and the analysis of price controls much easier to understand.

Chapter 4: Equilibrium: How Supply and Demand Determine Prices Market clearing is an essential idea for both microeconomics and macroeconomics. In this chapter, students learn how a well functioning market operates, how prices clear markets, the meaning of maximizing gains from trade, and how to shift supply and demand curves. The chapter concludes with a section on understanding the price of oil, a topic that recurs throughout the text.

Chapter 5: Price Ceilings and Floors There is no better way to understand how the price system works than to see what happens when the price system does not work very well. That price controls bring shortages is one of the most basic and most solid results of microeconomics. When it comes to price controls, however, the bad consequences extend far beyond shortages. Price controls lead to quality reductions, wasteful lines, excess search, corruption, rent-seeking behavior, misallocated resources, and many other secondary consequences. Price controls are an object lesson in many important economic ideas and we teach the topic as such. Sometimes we’re all better off if the university charges more for parking! Price controls also offer a good chance to teach some political economy lessons about why bad economic policies happen in the first place.

Sometimes governments prop up prices instead of keeping them down—the minimum wage for labor is one example, and airline regulation before the late 1970s is another. As with price ceilings, price floors bring misallocated resources, distortions in the quality of the good or service being sold, and rent seeking. Maybe the government can prop up the price of an airline ticket, as it did in 1974, but each airline will offer lobster dinners to lure away customers.

Why are some nations rich, while others are mired in terrible poverty? How can growth be extended to all parts of our world? Students are eager to understand the key issues of growth and development and economics has much of importance to teach on this vital topic. Thus, we begin the macroeconomics part of the book with economic growth.

Chapter 6: GDP and the Measurement of Progress A visitor to India can see squalor in the streets but also cell phones, new stores, rising literacy, and better fed people. In the United States, the economy moves from a boom in which jobs are easy to find to a bust when people tighten their belts and hope for better times. How do we measure these changes? We focus on the definition, limitations, and meaning of GDP and the motivation for studying GDP as a measure of economic change. GDP chapters can be dry so we enliven our treatment through real-world examples and comparisons.

Chapter 7: The Wealth of Nations and Economic Growth We present the basic facts of economic growth: (1) GDP per capita varies enormously between nations, (2) everyone used to be poor, and (3) there are growth miracles and growth disasters. The key factors behind economic growth include capital, labor, and technology, but we also offer the student a deeper understanding of the importance of incentives and institutions. It is important to connect the physical factors of production with an understanding of how they got there. That means combining Solow and Romer–like models with institutional economics and an analysis of property rights.

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A quick tour of the world shows why the student needs to learn different approaches to understanding economic growth.

Let’s say we wish to understand why South Korea is wealthy, while North Korea starves. The best approach is to consider the roles of property rights and incentives in the two countries, a topic we cover in Chapter 7. Let’s say we want to understand why China had been growing at 10% a year for almost 30 years. Then, the students need to learn the Solow model and the idea of “catching-up,” which we cover in the first half of Chapter 8. Finally, let’s say we want to understand why growth rates today are higher than in the nineteenth century, or why the future might bring a very high standard of living. We then need to turn to the Romer model and the idea of increasing returns to scale, which we cover in the second half of Chapter 8. Our approach to economic growth presents all these ideas in an integrated fashion.

Chapter 8: Growth, Capital Accumulation, and the Economics of Ideas: Catching Up vs. the Cutting Edge Yes, the Solow model finally has come to a principles book. Maybe that sounds daunting, but we offer a super simple version of Solow, intuitive every step along the way. One reviewer for the chapter wrote:

This chapter is by itself one of the greatest selling points of the book. The chapter is superbly written and presents a difficult concept in a way that an intro-level student would not have trouble understanding. The authors . . . have done a great service to both instructors and students.

Another wrote:

My first reaction was “No way the Solow model belongs in macro principles” However, after reading both the growth chapters, I changed my mind. These are excellent.

The Solow model stands at the foundation of modern approaches to economic growth. We cover some math but focus on the intuition behind the model, for instance, how diminishing returns to capital explains why China can grow faster than the United States. We cover capital growth, investment, and depreciation as concepts relevant for economic growth. We explain how an increase in the investment rate increases GDP per capita but in the long run does not increase the growth rate. We also cover why ever more capital cannot be the reason for longrun economic growth and the importance of ideas for economic growth. The appendix offers the quantitative relations of the Solow model in a simple spreadsheet.

The Solow model also leads into a discussion of how ideas are generated and why incentives and spillovers matter for idea generation. Modern Principles introduces the notion of increasing returns, as can arise from the production of ideas, and explains its economic importance. Larger economies might grow faster than smaller economies, and growth rates might increase over time, for reasons explained by the work of Paul Romer and other economists.

Chapter 9: Savings, Investment, and the Financial System Financial intermediation doesn’t always receive a lot of attention from macro textbooks, but recent events have shown that the topic is critical. Modern Principles presents basic concepts behind intermediation, including consumption smoothing, the demand and supply of savings, equilibrium in the market for loanable funds, and the role of banks, bonds, and stock markets. We explain bank failures, panics, illiquidity, insolvency, and what happens when financial intermediation fails, with an emphasis on the financial crisis of 2007-2009. Students should understand why it is bad if a country has a broken banking system and how it got that way. All of this analysis will later be integrated with aggregate demand and supply. At the end of the chapter, an appendix presents bond pricing in terms of a spreadsheet and shows economically why bond prices and interest rates vary inversely. Modern macroeconomics is very much about banking and this chapter reflects the importance of the topic.

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Chapter 10: Stock Markets and Personal Finance The stock market is the one topic that just about every student of economics cares about, and yet it is neglected in many textbooks. We view the stock market as a “teaching moment” as well as an important topic in its own right. What other economic topic commands so much attention from the popular press? Yet not every principles course gives the student the tools to understand media discussions or to dissect fallacies. We remedy that state of affairs. This chapter covers passive vs. active investing, the trade-off between risk and return, “how to really pick stocks,” diversification, why high fees should be avoided, compound returns, and asset price bubbles. The operation of asset markets is something students need to know if they are to understand today’s economy and the financial crisis.

And, yes, we do offer students some very direct and practical investment advice. Most people should diversify and “buy and hold,” and we explain why In terms of direct, practical value, we try to make this book worth its price!

Chapter 11: Unemployment and Labor Force Participation We define the different kinds of unemployment: frictional, structural, and cyclical. We consider how unemployment is linked to economic growth and how so much unemployment can arise from business cycles. We cover structural unemployment in both Europe and the United States, and we also cover labor force participation rates to a greater extent than in other textbooks. Why is it, for example, that in Belgium only one-third of men ages 55—64 are working, while in the United States only one-third of men this age are retired! The chapter helps students to understand employment protection laws, labor force participation, lifecycle effects, minimum wages, taxes, pensions, and even how the pill increased female labor force participation. All of these points also will provide foundations for the later discussion of unemployment, wage stickiness, and aggregate demand.

Chapter 12: Inflation and the Quantity Theory of Money We start with a vivid example, namely hyperinflation in Zimbabwe, and explain how the rate of inflation rose into the quadrillions. We then introduce the quantity of money as a central concept in macroeconomics that will be used to explain inflation and, in future chapters, aggregate demand. We define inflation and present various price indices, including CPI, PPI, and the GDP deflator. As Milton Friedman explained, “Inflation is always and everywhere a monetary phenomenon.” The chapter covers the costs of inflation in detail: price confusion and money illusion, the redistribution of wealth, the breakdown of financial intermediation, and the interaction of inflation with the tax system. We explain why inflation happens and why inflation can be so difficult to end. An appendix creates a real price series for homes using Excel and the Internet.

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Chapter 13: Business Fluctuations: Aggregate Demand and Supply In this chapter, we present our AD/AS model that allows for a balanced treatment of real shocks and aggregate demand shocks. We present the simplest real business cycle model and relate it to real-world concepts and examples. Supply-side fluctuations show up as shifts in the long-run aggregate supply curve, while an aggregate demand curve is based on the quantity theory. Using the quantity theory to derive an AD curve reduces the number of models students must learn and allows us to proceed quickly to sophisticated analyses of monetary and fiscal policy. We then introduce sticky prices and a short-run aggregate supply curve, responsive to both real and nominal shocks. The chapter ends by considering how the model can be used to explain the Great Depression of the 1930s.

An instructor’s appendix available online (http://www.SeeTheInvisibleHand.com) discusses transition dynamics for both real and aggregate demand shocks.

Chapter 14: Transmission and Amplification Mechanisms In this chapter, which is optional, we explain in greater detail how economic forces can amplify shocks and transmit them across sectors of the economy and through time. When a shock is amplified, a mild negative shock can be transformed into a more serious reduction in output and a positive shock can be transformed into a boom. In addition, we show in this chapter how real shocks and aggregate demand shocks can interact—one type of shock can lead to the other, for example.

We illustrate real-world shocks and we give intuitive explanations of transmission mechanisms such as intertemporal substitution, uncertainty and irreversible investments, labor adjustment costs, time bunching, and damage to collateral value.

The material in this chapter provides a richer understanding of business fluctuations that goes beyond shifting the curves. Using the material in this chapter, a teacher can better relate the model to historical and contemporary events, illustrate the differences among recessions as well as their commonalities, and show how economists adapt models to think about unique events.

Chapter 15: The Federal Reserve System and Open Market Operations To understand the Federal Reserve system, we introduce key concepts such as the U.S. money supplies, fractional reserve banking, the reserve ratio, the money multiplier, open market operations, and Fed influence on interest rates. With these tools in hand, we revisit concepts of aggregate demand, in particular through monetary policy. We cover all the core tools of monetary policy, including the recent innovations at the Fed, such as the term auction facility and quantitative easing, in response to the financial crisis. We treat the Federal Reserve as a major manager of systemic risk and analyze when the Fed is likely to succeed in this task and why the task is a difficult one, with attention to the concepts of moral hazard and also confidence building. The appendix covers the money multiplier process in detail.

Chapter 16: Monetary Policy Building on the analysis of the Fed, we consider the dilemmas of monetary policy in detail. The relevant cases include, among others: negative shocks to aggregate demand, rules vs. discretion, analyzing a decline in the rate of monetary growth, how the Fed can contribute to asset price bubbles, and responding to negative real shocks. We devote special attention to the Fed as a manager of market confidence and to how the Fed should respond to positive shocks and possible asset price bubbles, including to the housing market.

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Chapter 17: The Federal Budget: Taxes and Spending Students need to understand the institutional details of government receipts and spending. That includes tax revenues (their size and nature), the individual income tax, taxes on capital gains and interest and dividends, the alternative minimum tax, Social Security and Medicare taxes, the corporate income tax, and the question of who really pays federal taxes. In addition, we cover state and local taxes and the components of spending, including Medicare, defense, discretionary spending, and other areas. Students should have a good sense of where the money comes from and what it is spent on. We also analyze the national debt, interest on the debt, and deficits. We consider the speculative question of whether the U.S. government will someday go bankrupt and what the answer to such a question depends on.

Chapter 18: Fiscal Policy What forms does fiscal policy take and when does it work best to improve macro-economic performance? What are the limits of fiscal policy and when will a fiscal stimulus work best? We cover crowding out, bond vs. tax finance of expansionary fiscal policy, tax rebates and tax cuts, automatic stabilizers, and Ricardian equivalence. Students also learn when fiscal policy is potent enough, when timing issues get in the way of effective fiscal policy, and whether fiscal policy can address the macroeconomic problems from negative real shocks, all with emphasis on the fiscal stimulus policies in response to the recent recession. When is government debt a problem and how can debt crises bring an economy to its knees? The overall purpose of this chapter is to teach students when fiscal policy is a good or bad idea.

Chapter 19: International Trade We build on the basics of international trade—the division of knowledge, economies of scale, and comparative advantage—covered in Chapter 2, to show students how they can use the tools of supply and demand to understand the microeconomics of trade. We consider the costs of protectionism, international trade and market power, trade and wages, and most of all trade and jobs. Is protectionism ever a good idea? The chapter also offers a brief history of globalization as it relates to trade. We emphasize that the principles covering trade across nations are the same as those that govern trade within nations.

Chapter 20: International Finance The multiplicity of currencies sometimes makes international finance a daunting topic, but we keep it simple and show how it applies core economic principles that students already understand. The topics include the U.S. trade deficit, the balance of payments, the current account, the capital account (the financial account), the Official Reserves account, and the two sides of accounting identity behind the balance of payments. All of these topics are explained in terms of consistent economic intuitions. We also consider what a trade deficit really means, and we relate that to the trading behavior of individuals. The chapter analyzes exchange rates and their determinants in terms of supply and demand analysis, as stems from goods markets and asset markets. Long-run exchange rates have an (imperfect) connection to purchasing power parity, due to trade and economic arbitrage. Building on aggregate demand analysis, we consider how monetary policy and fiscal policy affect exchange rates and so influence output and employment. In this framework, we consider the relative merits of fixed vs. floating exchange rates and consider the problems with the eurozone. The chapter closes with a presentation of the nature and functions of the IMF and World Bank.

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Chapter 21: Political Economy and Public Choice If economics is so good, why doesn’t the world always listen? Political economy is one of the most important topics. Economics has a lot to say about how politics works and the results aren’t always pretty. Voters have a rational incentive to be ignorant or underinformed, and the end result is that special interests have a big say over many economic policies. Dairy farmers have a bigger say over milk subsidies than do the people who drink milk, and that is why the United States has milk price supports.

That said, democratic systems still outperform the available alternatives. We present the median voter theorem and also explain why political competition produces results that are at least somewhat acceptable to the “person in the street.”