1.2 contents

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Preface

part I Introduction

Chapter 1 The Science of Macroeconomics

1-1 What Macroeconomists Study

CASE STUDY The Historical Performance of the Canadian Economy

1-2 How Economists Think

Theory as Model Building

FYI Using Functions to Express Relationships Among Variables

The Use of Multiple Models

Prices: Flexible Versus Sticky

FYI Nobel Macroeconomists

Microeconomic Thinking and Macroeconomic Models 15

1-3 How This Book Proceeds

Chapter 2 The Data of Macroeconomics

2-1 Measuring the Value of Economic Activity: Gross Domestic Product

Income, Expenditure, and the Circular Flow

Some Rules for Computing GDP

FYI Stocks and Flows

Real GDP Versus Nominal GDP

The GDP Deflator

Chain-Weighted Measures of Real GDP

The Components of Expenditure

FYI Two Arithmetic Tricks for Working with Percentage Changes

FYI What Is Investment?

CASE STUDY GDP and Its Components

Several Measures of Income

CASE STUDY Seasonal Adjustment

2-2 Measuring the Cost of Living: The Consumer Price Index

The Price of a Basket of Goods

The CPI Versus the GDP Deflator

CASE STUDY Difficulties in Measuring Inflation

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2-3 Measuring Joblessness: The Unemployment Rate

CASE STUDY Trends in Labour-Force Participation

Unemployment, GDP, and Okun’s Law

2-4 Conclusion: From Economic Statistics to Economic Models

part II Classical Theory: The Economy in the Long Run

Chapter 3 National Income: Where It Comes From and Where It Goes

3-1 What Determines the Total Production of Goods and Services?

The Factors of Production

The Production Function

The Supply of Goods and Services

3-2 How Is National Income Distributed to the Factors of Production?

Factor Prices

The Decisions Facing the Competitive Firm

The Firm’s Demand for Factors

The Division of National Income

CASE STUDY The Black Death and Factor Prices

The Cobb–Douglas Production Function

CASE STUDY Labour Productivity as the Key Determinant of Real Wages

3-3 What Determines the Demand for Goods and Services?

Consumption

Investment

FYI The Many Different Interest Rates

Government Purchases

3-4 What Brings the Supply and Demand for Goods and Services Into Equilibrium?

Equilibrium in the Market for Goods and Services: The Supply and Demand for the Economy’s Output

Equilibrium in the Financial Markets: The Supply and Demand for Loanable Funds

FYI The Growing Gap Between Rich and Poor

Changes in Saving: The Effects of Fiscal Policy

CASE STUDY Wars and Interest Rates in the United Kingdom, 1730–1920

CASE STUDY Fiscal Policy in the 1980s and 1990s

Changes in Investment Demand

3-5 Conclusion

FYI The Identification Problem

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Chapter 4 Money and Inflation

4-1 What Is Money?

The Functions of Money

The Types of Money

CASE STUDY Money in a POW Camp

The Development of Fiat Money

CASE STUDY Money and Social Conventions on the Island of Yap

How the Quantity of Money Is Controlled

How the Quantity of Money Is Measured

FYI How Do Credit Cards and Debit Cards Fit into the Monetary System?

4-2 The Quantity Theory of Money

Transactions and the Quantity Equation

From Transactions to Income

The Money Demand Function and the Quantity Equation

The Assumption of Constant Velocity

Money, Prices, and Inflation

CASE STUDY Inflation and Money Growth

4-3 Seigniorage: The Revenue from Printing Money

CASE STUDY American and Russian Inflations

4-4 Inflation and Interest Rates

Two Interest Rates: Real and Nominal

The Fisher Effect

CASE STUDY Inflation and Nominal Interest Rates

Two Real Interest Rates: Ex Ante and Ex Post

CASE STUDY Nominal Interest Rates in the Nineteenth Century

4-5 The Nominal Interest Rate and the Demand for Money

The Cost of Holding Money

Future Money and Current Prices

CASE STUDY Canadian Monetary Policy

4-6 The Social Costs of Inflation

The Layman’s View and the Classical Response

CASE STUDY What Economists and the Public Say About Inflation

The Costs of Expected Inflation

The Costs of Unexpected Inflation

CASE STUDY The Wizard of Oz

One Possible Benefit of Inflation

4-7 Hyperinflation

FYI Keynes (and Lenin) on the Cost of Inflation

The Costs of Hyperinflation

CASE STUDY Life During the Bolivian Hyperinflation

The Causes of Hyperinflation

CASE STUDY Hyperinflation in Interwar Germany

CASE STUDY Hyperinflation in Zimbabwe

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4-8 Conclusion: The Classical Dichotomy

Appendix: The Cagan Model: How Current and Future Money Affect the Price Level

Chapter 5 The Open Economy

5-1 The International Flows of Capital and Goods

The Role of Net Exports

Net Foreign Investment and the Trade Balance

International Flows of Goods and Capital: An Example

FYI The Irrelevance of Bilateral Trade Balances

5-2 Saving and Investment in a Small Open Economy

Capital Mobility and the World Interest Rate

The Model

How Policies Influence the Trade Balance

Evaluating Economic Policy

CASE STUDY The U.S. Trade Deficit

CASE STUDY Why Doesn’t Capital Flow to Poor Countries?

5-3 Exchange Rates

Nominal and Real Exchange Rates

FYI How Newspapers Report the Exchange Rate

The Real Exchange Rate and the Trade Balance

CASE STUDY Traders Respond to the Exchange Rate

The Determinants of the Real Exchange Rate

How Policies Influence the Real Exchange Rate

The Effects of Trade Policies

CASE STUDY The “Neo-Conservative” Policy Agenda in the 1980s and 1990s

The Determinants of the Nominal Exchange Rate

CASE STUDY Inflation and Nominal Exchange Rates

The Special Case of Purchasing-Power Parity

CASE STUDY The Big Mac Around the World

5-4 Large Versus Small Open Economies

Appendix: The Open Economy in the Very Long Run

Foreign Debt

Fiscal Policy

Trickle-Down Economics

Chapter 6 Unemployment

6-1 Job Loss, Job Finding, and the Natural Rate of Unemployment

6-2 Job Search and Frictional Unemployment

Public Policy and Frictional Unemployment

CASE STUDY Employment Insurance and the Rate of Job Finding

6-3 Real-Wage Rigidity and Structural Unemployment

Minimum-Wage Laws

Unions and Collective Bargaining

Efficiency Wages

CASE STUDY Henry Ford’s $5 Workday

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6-4 Labour Market Experience: Canada

The Duration of Unemployment

Variation in the Unemployment Rate Across Age Groups and Regions

Trends in Unemployment

CASE STUDY Comparing Unemployment in the United States and Canada

6-5 Labour Market Experience: Europe

The Rise in European Unemployment

Unemployment Variation Within Europe

CASE STUDY The Secrets to Happiness

The Rise of European Leisure

6-5 Conclusion

Appendix: Unemployment, Inequality, and Government Policy

Inequality

Government Policy

The Globalization Challenge

part III Growth Theory: The Economy in the Very Long Run

Chapter 7 Economic Growth I: Capital Accumulation and Population Growth

7-1 The Accumulation of Capital

The Supply and Demand for Goods

Growth in the Capital Stock and the Steady State

Approaching the Steady State: A Numerical Example

CASE STUDY The Miracle of Japanese and German Growth

How Saving Affects Growth

CASE STUDY Saving and Investment Around the World

7-2 The Golden Rule Level of Capital

Comparing Steady States

Finding the Golden Rule Steady State: A Numerical Example

The Transition to the Golden Rule Steady State

7-3 Population Growth

The Steady State with Population Growth

The Effects of Population Growth

CASE STUDYPopulation Growth Around the World

CASE STUDYThe Aging of Canada

Alternative Perspectives on Population Growth

7-4 Conclusion

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Chapter 8 Economic Growth II: Technology, Empirics, and Policy

8-1 Technological Progress in the Solow Model

The Efficiency of Labour

The Steady State with Technological Progress

The Effects of Technological Progress

8-2 From Growth Theory to Growth Empirics

Balanced Growth

Convergence

Factor Accumulation Versus Production Efficiency

CASE STUDY Is Free Trade Good for Economic Growth?

8-3 Policies to Promote Growth

Evaluating the Rate of Saving

Changing the Rate of Saving

CASE STUDY Tax Incentives for Saving and Investment

Allocating the Economy’s Investment

Establishing the Right Institutions

CASE STUDY The Colonial Origins of Modern Institutions

Encouraging Technological Progress

CASE STUDY The Worldwide Slowdown in Economic Growth: 1972–1995

8-4 Beyond the Solow Model: Endogenous Growth Theory

The Basic Model

A Two-Sector Model

The Microeconomics of Research and Development

CASE STUDY The Process of Creative Destruction

8-5 Conclusion

Appendix: Accounting for the Sources of Economic Growth

Increases in the Factors of Production

Technological Progress

The Sources of Growth in Canada

CASE STUDY Growth in the East Asian Tigers

The Solow Residual in the Short Run

part IV Business Cycle Theory: The Economy in the Short Run

Chapter 9 Introduction to Economic Fluctuations

9-1 Time Horizons in Macroeconomics

How the Short Run and the Long Run Differ

CASE STUDY If You Want to Know Why Firms Have Sticky Prices, Ask Them

The Model of Aggregate Supply and Aggregate Demand

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9-2 Aggregate Demand

The Quantity Equation as Aggregate Demand

Why the Aggregate Demand Curve Slopes Downward

Shifts in the Aggregate Demand Curve

9-3 Aggregate Supply

The Long Run: The Vertical Aggregate Supply Curve

The Short Run: The Horizontal Aggregate Supply Curve

From the Short Run to the Long Run

CASE STUDY A Monetary Lesson from French History

FYI David Hume on the Real Effects of Money

FYI The Short Run, the Long Run, and the Very Long Run

9-4 Stabilization Policy

Shocks to Aggregate Demand

Shocks to Aggregate Supply

CASE STUDY How OPEC Helped Cause Stagflation in the 1970s

9-5 Conclusion

Chapter 10 Aggregate Demand I: Building the IS–LM Model

10-1 The Goods Market and the IS Curve

The Keynesian Cross

CASE STUDY Modest Expectations Concerning Job Creation

CASE STUDY The 2009 Stimulus Package

The Interest Rate, Investment, and the IS Curve

How Fiscal Policy Shifts the IS Curve

A Loanable-Funds Interpretation of the IS Curve

10-2 The Money Market and the LM Curve

The Theory of Liquidity Preference

CASE STUDY Tight Money and Rising Interest Rates

Income, Money Demand, and the LM Curve

How Monetary Policy Shifts the LM Curve

A Quantity-Equation Interpretation of the LM Curve

10-3 Conclusion: The Short-Run Equilibrium

Chapter 11 Aggregate Demand II: Applying the IS–LM Model

11-1 Explaining Fluctuations with the IS–LM Model

How Fiscal Policy Shifts the IS Curve and Changes the Short-Run Equilibrium

How Monetary Policy Shifts the LM Curve and Changes the Short-Run Equilibrium

The Interaction Between Monetary and Fiscal Policy

CASE STUDY Policy Analysis with Macroeconometric Models

Shocks in the IS–LM Model

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FYI What Is the Bank of Canada’s Policy Instrument—the Money Supply or the Interest Rate? And What Is Quantitative Easing?

11-2 IS–LM as a Theory of Aggregate Demand

From the IS–LM Model to the Aggregate Demand Curve

The IS–LM Model in the Short Run and the Long Run

11-3 The Great Depression

The Spending Hypothesis: Shocks to the IS Curve

The Money Hypothesis: A Shock to the LM Curve

The Money Hypothesis Again: The Effects of Falling Prices

Could the Depression Happen Again?

CASE STUDY The Financial Crisis and Economic Downturn of 2008 and 2009

11-4 Conclusion

FYI The Liquidity Trap

Appendix: Aggregate Demand Theory Without the LM Curve

Aggregate Demand in a Closed Economy

Aggregate Demand in a Small Open Economy

Chapter 12 The Open Economy Revisited: The Mundell–Fleming Model and the Exchange-Rate Regime

12-1 The Mundell–Fleming Model

Components of the Model

The Model on a Yr Graph

The Model on a Ye Graph

12-2 The Small Open Economy Under Floating Exchange Rates

Fiscal Policy

Monetary Policy

CASE STUDY Tight Monetary Policy Combined with Loose Fiscal Policy

Trade Policy

World Interest-Rate Changes

12-3 The Small Open Economy Under Fixed Exchange Rates

How a Fixed-Exchange-Rate System Works

CASE STUDY The International Gold Standard

Fiscal Policy

Monetary Policy

CASE STUDY Devaluation and the Recovery From the Great Depression

Trade Policy

World Interest-Rate Changes

Policy in the Mundell–Fleming Model: A Summary

CASE STUDY Regional Tensions Within Canada

12-4 Interest-Rate Differentials

Country Risk and Exchange-Rate Expectations

Differentials in the Mundell–Fleming Model

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CASE STUDY International Financial Crisis: Mexico 1994–1995

CASE STUDY International Financial Crisis: Asia 1997–1998

12-5 Should Exchange Rates Be Floating or Fixed?

Pros and Cons of Different Exchange-Rate Systems

CASE STUDYMonetary Union: The Debate Over the Euro

Speculative Attacks, Currency Boards, and Dollarization

The Impossible Trinity

CASE STUDY The Chinese Currency Controversy

12-6 From the Short Run to the Long Run: The Mundell–Fleming Model with a Changing Price Level

12-7 A Concluding Reminder

Appendix: Extensions to the Mundell–Fleming Model

The Exchange Rate and the CPI

Flexible Domestic Prices

Exchange-Rate Expectations

An Attempt at Perspective

Chapter 13 Aggregate Supply and the Short-Run Tradeoff Between Inflation and Unemployment

13-1 The Basic Theory of Aggregate Supply

The Sticky-Price Model

An Alternative Theory: The Imperfect-Information Model

CASE STUDY International Differences in the Aggregate Supply Curve

Implications

13-2 Inflation, Unemployment, and the Phillips Curve

Deriving the Phillips Curve from the Aggregate Supply Curve

FYI The History of the Modern Phillips Curve

Adaptive Expectations and Inflation Inertia

Two Causes of Rising and Falling Inflation

The Short-Run Tradeoff Between Inflation and Unemployment

CASE STUDY Inflation and Unemployment in Canada

FYI How Precise Are Estimates of the Natural Rate of Unemployment?

Disinflation and the Sacrifice Ratio

Rational Expectations and the Possibility of Painless Disinflation

CASE STUDY The Sacrifice Ratio in Practice

Challenges to the Natural-Rate Hypothesis

13-3 Conclusion

Appendix: A Big, Comprehensive Model

Special Case 1: The Classic Closed Economy

Special Case 2: The Classic Small Open Economy

Special Case 3: The Basic Model of Aggregate Demand and Aggregate Supply

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Special Case 4: The IS–LM Model

Special Case 5: The Mundell–Fleming Model with a Floating Exchange Rate

Special Case 6: The Mundell–Fleming Model with a Fixed Exchange Rate

Chapter 14 A Dynamic Model of Aggregate Demand and Aggregate Supply

14-1 Elements of the Model

Output: The Demand for Goods and Services

The Real Interest Rate: The Fisher Equation

Inflation: The Phillips Curve

Expected Inflation: Adaptive Expectations

The Nominal Interest Rate: The Monetary-Policy Rule

CASE STUDY The Taylor Rule

14-2 Solving the Dynamic Model

The Long-Run Equilibrium

The Dynamic Aggregate Supply Curve

The Dynamic Aggregate Demand Curve

The Short-Run Equilibrium

14-3 Using the Model

Long-Run Growth

A Shock to Aggregate Supply

FYI The Numerical Calibration and Simulation 476

A Shock to Aggregate Demand

A Shift in Monetary Policy

14-4 Two Applications: Lessons for Monetary Policy

The Tradeoff Between Output Variability and Inflation Variability

CASE STUDY The United States Fed Versus the European Central Bank

The Taylor Principle

CASE STUDY What Caused the Great Inflation?

14-5 Conclusion: Toward DSGE Models

Appendix: Components of the Synthesis

The Theory of Real Business Cycles

The Economics of Robinson Crusoe

The Interpretation of the Labour Market

The Importance of Technology Shocks

The Neutrality of Money

CASE STUDY Testing for Monetary Neutrality

The Flexibility of Wages and Prices

New Keynesian Economics

Small Menu Costs and Aggregate-Demand Externalities

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CASE STUDY How Large are Menu Costs?

Recessions as Coordination Failure

CASE STUDY Experimental Evidence on Coordination Games

The Staggering of Wages and Prices

Conclusion

part V Macroeconomic Policy Debates

Chapter 15 Stabilization Policy

15-1 Should Policy Be Active or Passive?

Lags in the Implementation and Effects of Policies

CASE STUDY Profit Sharing as an Automatic Stabilizer

The Difficult Job of Economic Forecasting

CASE STUDY Two Episodes in Economic Forecasting

Ignorance, Expectations, and the Lucas Critique

The Historical Record

CASE STUDY Is the Stabilization of the Economy a Figment of the Data?

15-2 Should Policy Be Conducted by Rule or by Discretion?

Distrust of Policymakers and the Political Process

The Time Inconsistency of Discretionary Policy

CASE STUDY Alexander Hamilton Versus Time Inconsistency

Rules for Monetary Policy

CASE STUDY Inflation Targeting: Rule or Constrained Discretion?

CASE STUDY Central Bank Independence

CASE STUDY The Bank of Canada’s Low-Inflation Target: Implications for Fiscal Policy

15-3 Conclusion: Making Policy in an Uncertain World

Appendix: Time Inconsistency and the Tradeoff Between Inflation and Unemployment

Chapter 16 Government Debt and Budget Deficits

16-1 The Size of the Government Debt

CASE STUDY Canadian Deficits and Debt: Past, Present, and Future

16-2 Problems in Measurement

Measurement Problem 1: Inflation

Measurement Problem 2: Capital Assets

Measurement Problem 3: Uncounted Liabilities

CASE STUDY Accounting for TARP

Measurement Problem 4: The Business Cycle

Summing Up

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16-3 The Traditional View of Government Debt

FYI Taxes and Incentives

16-4 The Ricardian View of Government Debt

The Basic Logic of Ricardian Equivalence

Consumers and Future Taxes

CASE STUDY A Test of Ricardian Equivalence

CASE STUDY Why Do Parents Leave Bequests?

Making a Choice

FYI Ricardo on Ricardian Equivalence

16-5 Other Perspectives on Government Debt

Balanced Budgets Versus Optimal Fiscal Policy

Effects on Monetary Policy

Debt and the Political Process

International Dimensions

CASE STUDYThe Benefits of Indexed Bonds

16-6 Conclusion

Appendix: Estimating the Benefits of Deficit and Debt Reduction

part VI More on the Microeconomics Behind Macroeconomics

Chapter 17 Consumption

17-1 John Maynard Keynes and the Consumption Function

Keynes’s Conjectures

The Early Empirical Successes

Secular Stagnation, Simon Kuznets, and the Consumption Puzzle

17-2 Irving Fisher and Intertemporal Choice

The Intertemporal Budget Constraint

Consumer Preferences

FYI Present Value, or Why a $1,000,000 Prize Is Worth Only $623,000

Optimization

How Changes in Income Affect Consumption

How Changes in the Real Interest Rate Affect Consumption

Constraints on Borrowing

17-3 Franco Modigliani and the Life-Cycle Hypothesis

The Hypothesis

Implications

CASE STUDY The Consumption and Saving of the Elderly

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17-4 Milton Friedman and the Permanent-Income Hypothesis

The Hypothesis

Implications

CASE STUDY Income Taxes Versus Sales Taxes as an Instrument for Stabilization Policy

17-5 Robert Hall and the Random-Walk Hypothesis

The Hypothesis

Implications

CASE STUDY Do Predictable Changes in Income Lead to Predictable Changes in Consumption?

17-6 David Laibson and the Pull of Instant Gratification

The Hypothesis

Implications

CASE STUDY How to Get People to Save More

17-7 Conclusion

Chapter 18 Investment

18-1 Business Fixed Investment

The Rental Price of Capital

The Cost of Capital

The Determinants of Investment

CASE STUDY The Burden of Higher Interest Rates

Taxes and Investment

CASE STUDY Canada’s Experience with Corporate Tax Concessions

The Stock Market and Tobin’s q

CASE STUDY The Stock Market as an Economic Indicator

Alternative Views of the Stock Market: The Efficient Markets Hypothesis Versus Keynes’s Beauty Contest

Financing Constraints

Banking Crises and Credit Crunches

18-2 Residential Investment

The Stock Equilibrium and the Flow Supply

Changes in Housing Demand

FYI What Price House Can You Afford?

The Tax Treatment of Housing

18-3 Inventory Investment

Reasons for Holding Inventories

The Accelerator Model of Inventories

How the Real Interest Rate and Credit Conditions Affect Inventory Investment

18-4 Conclusion

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Chapter 19 Money Supply and Money Demand

19-1 Money Supply

100-Percent-Reserve Banking

Fractional-Reserve Banking

A Model of the Money Supply

The Instruments of Monetary Policy

CASE STUDY Bank Failures, Quantitative Easing, and Deposit Insurance

Bank Capital, Leverage, and Capital Requirements

19-2 Money Demand

Portfolio Theories of Money Demand

CASE STUDY Currency and the Underground Economy

Transactions Theories of Money Demand

The Baumol–Tobin Model of Cash Management

CASE STUDY Empirical Studies of Money Demand

Financial Innovation and the Rise of Near Money

19-3 Conclusion

Chapter 20 The Financial System: Opportunities and Dangers

20-1 What Does the Financial System Do?

Financing Investment

Sharing Risk

Dealing with Asymmetric Information

Fostering Economic Growth

CASE STUDY Microfinance: Professor Yunus’s Profound Idea

20-2 Financial Crises

The Anatomy of a Crisis

FYI The TED Spread

CASE STUDY Who Should Be Blamed for the Financial Crisis of 2008–2009?

Policy Responses to a Crisis

Policies to Prevent Crises

FYI CoCo Bonds

CASE STUDY Did Recent Practice in Macroeconomic Policy Contribute to the Financial Crisis?

CASE STUDY The European Sovereign Debt Crisis

CASE STUDY Will Governments in North America Go the Way of the Indebted European Governments?

20-3 Conclusion

Epilogue What We Know, What We Don’t

The Four Most Important Lessons of Macroeconomics

Lesson No. 1: In the long run, a country’s capacity to produce goods and services determines the standard of living of its citizens.

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Lesson No. 2: In the short run, aggregate demand influences the amount of goods and services that a country produces.

Lesson No. 3: In the long run, the rate of money growth determines the rate of inflation, but it does not affect the rate of unemployment.

Lesson No. 4: In the short run, policymakers who control monetary and fiscal policy face a tradeoff between inflation and unemployment.

The Four Most Important Unresolved Questions of Macroeconomics

Question No. 1: How should policymakers try to promote growth in the economy’s natural level of output?

Question No. 2: Should policymakers try to stabilize the economy?

Question No. 3: How costly is inflation, and how costly is reducing inflation?

Question No. 4: How big a problem are government budget deficits?

Conclusion

Glossary

Index