xxvi

An economist must be “mathematician, historian, statesman, philosopher, in some degree. . . as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.” So remarked John Maynard Keynes, the great British economist who, as much as anyone, could be called the father of macroeconomics. No single statement summarizes better what it means to be an economist.

As Keynes’s assessment suggests, students who aim to learn economics need to draw on many disparate talents. The job of helping students find and develop these talents falls to instructors and textbook authors. When writing this textbook for intermediate-level courses in macroeconomics, our goal was to make macroeconomics understandable, relevant, and (believe it or not) fun. Those of us who have chosen to be professional macroeconomists have done so because we are fascinated by the field. More important, we believe that the study of macroeconomics can illuminate much about the world and that the lessons learned, if properly applied, can make the world a better place. We hope this book conveys not only our profession’s accumulated wisdom but also its enthusiasm and sense of purpose.

Although macroeconomists share a common body of knowledge, they do not all have the same perspective on how that knowledge is best taught. Let us begin this new edition by recapping four of our objectives, which together define this book’s approach to the field.

First, we try to offer a balance between short-run and long-run issues in macroeconomics. All economists agree that public policies and other events influence the economy over different time horizons. We live in our own short run, but we also live in the long run that our parents bequeathed us. As a result, courses in macroeconomics need to cover both short-run topics, such as the business cycle and stabilization policy, and long-run topics, such as economic growth, the natural rate of unemployment, persistent inflation, and the effects of government debt. Neither time horizon trumps the other.

Second, we integrate the insights of Keynesian and classical theories. Although Keynes’s General Theory provides the foundation for much of our current understanding of economic fluctuations, it is important to remember that classical economics provides the right answers to many fundamental questions. In this book we incorporate many of the contributions of the classical economists before Keynes and the new classical economists of the past three decades. Substantial coverage is given, for example, to the loanable-funds theory of the interest rate, the quantity theory of money, and the problem of time inconsistency. At the same time, we recognize that many of the ideas of Keynes and the new Keynesians are necessary for understanding economic fluctuations. Substantial coverage is given also to the IS–LM model of aggregate demand, the short-run tradeoff between inflation and unemployment, and modern models of business-cycle fluctuations.

xxvii

Third, we present macroeconomics using a variety of simple models. Instead of pretending that there is one model that is complete enough to explain all facets of the economy, we encourage students to learn how to use and compare a set of prominent models. This approach has the pedagogical value that each model can be kept relatively simple and presented within one or two chapters. More important, this approach asks students to think like economists, who always keep various models in mind when analyzing economic events or public policies.

Fourth, we emphasize that macroeconomics is an empirical discipline, motivated and guided by a wide array of experience. This book contains numerous case studies that use macroeconomic theory to shed light on real-world data or events. To highlight the broad applicability of the basic theory, we have drawn the case studies both from current issues facing the world’s economies and from dramatic historical episodes. The case studies analyze the policies of Mark Carney (Governor of the Bank of Canada), our current Finance Minister, many former Canadian politicians and central bankers, government initiatives in other countries, and even the policies of Henry Ford. They teach the reader how to apply economic principles to issues from fourteenth-century Europe, the island of Yap, the land of Oz, and today’s newspaper.

Economics instructors are vigilant in keeping their lectures up to date as the economic landscape changes. Textbook authors cannot be less so. This book is therefore revised every few years. Each revision reflects new research about the best way to understand macroeconomic developments, and discussion of the new events in the economy—especially those that have stimulated new research.

In our Fourth Edition, this general principle that guides revisions led to two major changes. First, we introduced students to the New Neoclassical Synthesis—a dynamic version of aggregate supply and demand analysis that is more explicitly based on microeconomic theory. This chapter exposed students to ideas that are prominent at the research and policy frontier. In so doing, it extended our earlier treatment of “macroeconomics without the LM curve” that still appears in the Appendix to Chapter 11. These discussions are all the more relevant in recent years as the zero lower bound on nominal interest rates has been an ever more binding constraint on the conduct of monetary policy. The second major addition was material on housing markets, bank capital requirements and leverage, so that the financial crisis could be understood.

We have extended both of these themes in this Fifth Edition, by adding important further material concerning the financial system, and by extending the discussion of novel monetary policies and the zero lower bound on nominal interest rates. As a result, there is a new Chapter 20 in the “More on the Microeconomics Behind Macroeconomics” section, entitled “The Financial System: Opportunities and Dangers.” With the financial crisis and economic downturn of 2008 and 2009, economists have developed a new appreciation of the crucial linkages between the financial system and the broader economy. Chapter 20 gives students a deeper look at this topic. It begins by discussing the functions of the financial system. It then explores the causes and effects of financial crises, as well as government policies that aim to deal with crises and to prevent future ones. Since some government reactions to private-sector problems have led to sovereign debt crises, the chapter closes with material on this topic as well.

xxviii

Taken together, the two new chapters added in the Fourth and Fifth Editions—that introduce students to dynamic stochastic general equilibrium (DSGE) models with simplicity and rigour, and that flesh out important features of the financial system—really do bring the book up to date. Current research is very much focused on bringing financial frictions into the DSGE framework. With these chapters, then, we hope to have addressed two goals: to better prepare students of macroeconomics to proceed with further studies, and—whether or not students pursue further study—to provide readers with a better understanding of how the financial system and the real economy interact, and, in particular, of how they have interacted in recent times.

Of course, there are many smaller updates involved in this Fifth Edition, such as the addition of the latest numbers in all the tables and graphs of historical data. Here is a list of some of the notable features of this new edition, in the order that they appear:

As always, all the changes that we made in this Fifth Edition, and the many others that we considered, were evaluated keeping in mind the benefits of brevity. From our own experience as students, we know that long books are less likely to be read. Our goal in this book has been to offer the clearest, most up-to-date, most accessible course in macroeconomics in the fewest words possible.

Maintaining brevity was not our only concern as we wrote this book. We were determined to strengthen the other feature of the earlier editions that have been most appreciated by users—that the book truly integrates theory and policy. All important policy issues are covered in this way. To mention just a few:

Systematically relating macro theory to the “big” issues in Canadian policy debates is one of the ways we hope to transfer our excitement about our discipline to as many readers as possible.

Finally, there are two important things concerning the new Canadian edition that are not in the book itself. Two of the many supplements are available in Canadian editions. Students will value the Student Guide and Workbook, and instructors will be grateful for the Test Bank, both of which has been revised to coordinate with this Fifth Edition.

xxx

This Fifth Edition maintains the strategy of first examining the long run when prices are flexible and then examining the short run when prices are sticky. That is, it begins with classical models of the economy and explains fully the long-run equilibrium before discussing deviations from that equilibrium. Our text was the first to adopt this now-standard practice. This strategy has several advantages. First, because the classical dichotomy permits the separation of real and monetary issues, the long-run material is easier for students to understand. Second, when students begin studying short-run fluctuations, they understand fully the long-run equilibrium around which the economy is fluctuating. Third, beginning with market-clearing models makes clearer the link between macroeconomics and microeconomics. Fourth, students learn first the material that is less controversial among macroeconomists. For all these reasons, the strategy of beginning with long-run classical models simplifies the teaching of macroeconomics.

Let’s now move from strategy to tactics. What follows is a whirlwind tour of the book.

Part One: Introduction

The introductory material in Part One is brief so that students can get to the core topics quickly. Chapter 1 discusses the broad questions that macroeconomists address and the economist’s approach of building models to explain the world. Chapter 2 introduces the key data of macroeconomics, emphasizing gross domestic product, the consumer price index, and the unemployment rate.

Part Two: Classical Theory: The Economy in the Long Run

Part Two examines the long run over which prices are flexible. Chapter 3 presents the basic classical model of national income. In this model, the factors of production and the production technology determine the level of income, and the marginal products of the factors determine its distribution to households. In addition, the model shows how fiscal policy influences the allocation of the economy’s resources among consumption, investment, and government purchases, and it highlights how the real interest rate equilibrates the supply and demand for goods and services.

Money and the price level are introduced in Chapter 4. Because prices are assumed to be fully flexible, the chapter presents the prominent ideas of classical monetary theory: the quantity theory of money, the inflation tax, the Fisher effect, the social costs of inflation, and the causes and costs of hyperinflation.

The study of open-economy macroeconomics begins in Chapter 5. Maintaining the assumption of full employment, this chapter presents models to explain the trade balance and the exchange rate. Various policy issues are addressed: the relationship between the budget deficit and the trade deficit, the macroeconomic impact of protectionist trade policies, the effect of monetary policy on the value of a currency in the market for foreign exchange, and the effects of government debt reduction and tax reform on standards of living.

xxxi

Chapter 6 relaxes the assumption of full employment by discussing the dynamics of the labour market and the natural rate of unemployment. It examines various causes of unemployment, including job search, minimum-wage laws, union power, and efficiency wages. It also presents some important facts about patterns of unemployment and policy options concerning less-skilled workers.

Part Three: Growth Theory: The Economy in the Very Long Run

Part Three makes the classical analysis of the economy dynamic by developing the tools of modern growth theory. Chapter 7 introduces the Solow growth model as a description of how the economy evolves over time. This chapter emphasizes the roles of capital accumulation and population growth. Chapter 8 then adds technological progress to the Solow model. It uses the model to discuss growth experiences around the world as well as public policies that influence the level and growth of the standard of living. Finally, Chapter 8 introduces students to the modern theories of endogenous growth.

Part Four: Business Cycle Theory: The Economy in the Short Run

Part Four examines the short run when prices are sticky. It begins in Chapter 9 by introducing the model of aggregate supply and aggregate demand as well as the role of stabilization policy. Subsequent chapters refine the ideas introduced here.

Chapters 10 and 11 look more closely at aggregate demand. Chapter 10 presents the Keynesian cross and the theory of liquidity preference and uses these models as building blocks for developing the IS–LM model. Chapter 11 uses the IS–LM model to explain economic fluctuations and the aggregate demand curve. It concludes with an extended case study of the Great Depression.

The study of short-run fluctuations continues in Chapter 12, which focuses on aggregate demand in an open economy. This chapter presents the Mundell–Fleming model and shows how monetary and fiscal policies affect the economy under floating and fixed exchange-rate systems. It also discusses the debate over whether exchange rates should be floating or fixed. Several extensions to the basic model are covered in the appendix, where the zero lower bound on nominal interest rates problem is further discussed.

Chapter 13 looks more closely at aggregate supply. It examines various approaches to explaining the short-run aggregate supply curve and discusses the short-run tradeoff between inflation and unemployment and challenges to the natural-rate hypothesis.

Chapter 14 develops a dynamic model of aggregate demand and aggregate supply. It builds on ideas that students have already encountered and uses those ideas as stepping-stones to take the student close to the frontier of knowledge concerning short-run economic fluctuations. The appendix provides more discussion of recent research within the two schools of thought that lie behind this dynamic synthesis—New Classical and New Keynesian theory.

Part Five: Macroeconomic Policy Debates

xxxii

Once the student has command of standard long-run and short-run models of the economy, the book uses these models as the foundation for discussing some of the key debates over economic policy. Chapter 15 considers the debate over how policymakers should respond to short-run economic fluctuations. It emphasizes two broad questions. Should monetary and fiscal policy be active or passive? Should policy be conducted by rule or by discretion? The chapter presents arguments on both sides of these questions.

Chapter 16 focuses on the various debates over government debt and budget deficits. It gives some sense of the magnitude of government indebtedness, discusses why measuring budget deficits is not always straightforward, recaps the traditional view of the effects of government debt, presents Ricardian equivalence as an alternative view, and discusses various other perspectives on government debt. As in the previous chapter, students are not handed conclusions but are given the tools to evaluate the alternative viewpoints on their own, and to evaluate the debate on the “fiscal dividend.”

Part Six: More on the Microeconomics Behind Macroeconomics

After developing theories to explain the economy in the long run and in the short run and then applying those theories to macroeconomic policy debates, the book turns to several topics that refine our understanding of the economy. The last four chapters analyze more fully the microeconomics behind macroeconomics. These chapters can be presented at the end of a course, or they can be covered earlier, depending on an instructor’s preferences.

Chapter 17 presents the various theories of consumer behaviour, including the Keynesian consumption function, Fisher’s model of intertemporal choice, Modigliani’s life-cycle hypothesis, Friedman’s permanent-income hypothesis, Hall’s random-walk hypothesis, and Laibson’s model of instant gratification. Chapter 18 examines the theory behind the investment function and the relationship between investment and the stock market. Chapter 19 provides additional material on the money market, including the role of the banking system in determining the money supply, monetary policy indicators, and the Baumol-Tobin model of money demand. Finally, the new Chapter 20 examines the financial crisis and sovereign debt challenges.

Epilogue

The book ends with a brief epilogue that reviews the broad lessons about which most macroeconomists agree and discusses some of the most important open questions. Regardless of which chapters an instructor chooses to cover, this capstone chapter can be used to remind students how the many models and themes of macroeconomics relate to one another. Here and throughout the book we emphasize that, despite the disagreements among macroeconomists, there is much that we know about how the economy works.

xxxiii

Although we have organized the material in the way that we prefer to teach intermediate-level macroeconomics, we understand that other instructors have different preferences. We tried to keep this in mind as we wrote the book, so that it would offer a degree of flexibility. Here are a few ways that instructors might consider rearranging the material:

Experience with previous editions suggests this text complements well a variety of approaches to the field.

We are pleased that students have found the previous edition of this book user friendly. We have tried to make this Fifth Edition even more so.

Case Studies

Economics comes to life when it is applied to understanding actual events. Therefore, the numerous case studies (many new or revised in this edition) are important learning tools that are integrated closely with the theoretical material presented in each chapter. The frequency with which these case studies occur ensures that a student does not have to grapple with an overdose of theory before seeing the theory applied. Students report that the case studies are their favourite part of the book.

FYI Boxes

These boxes present ancillary material “for your information.” We use these boxes to clarify difficult concepts, to provide additional information about the tools of economics, and to show how economics relates to our daily lives. Several are new or revised in this edition. A particularly useful FYI box appears below.

Graphs

Understanding graphical analysis is a key part of learning macroeconomics, and we have worked hard to make the figures easy to follow. We use four colours and comment boxes within figures that describe briefly and draw attention to the important points that the figures illustrate. Both innovations should help students both learn and review the material.

xxxiv

Mathematical Notes

We use occasional mathematical footnotes to keep more difficult material out of the body of the text. These notes make an argument more rigourous or present a proof of a mathematical result. They can easily be skipped by those students who have not been introduced to the necessary mathematical tools.

Chapter Summaries

Every chapter ends with a brief, nontechnical summary of its major lessons. Students can use the summaries to place the material in perspective and to review for exams.

Key Concepts

Learning the language of a field is a major part of any course. Within the chapter, each key concept is in boldface when it is introduced. At the end of the chapter, the key concepts are listed for review.

Questions for Review

xxxv

After studying a chapter, students can immediately test their understanding of its basic lessons by answering the Questions for Review.

Problems and Applications

Every chapter includes Problems and Applications designed for homework assignments. Some of these are numerical applications of the theory in the chapter. Others encourage the student to go beyond the material in the chapter by addressing new issues that are closely related to the chapter topics.

Chapter Appendices

Several chapters include appendices that offer additional material, sometimes at a higher level of mathematical sophistication. These are designed so that professors can cover certain topics in greater depth if they wish. The appendices can be skipped altogether without loss of continuity.

Glossary

To help students become familiar with the language of macroeconomics, a glossary of more than 250 terms is provided at the back of the book.

Student Guide and Workbook

The study guide, by Roger Kaufman (Boston College) and William Scarth, offers various ways for students to learn the material in the text and assess their understanding.

Students may find the following features of the site produced for the associated U.S. edition of the text useful:

The following items on the website pertain to the U.S. economy. Nevertheless, since much of the book covers items which are not specific to the small open economy case, Canadian students may find these items instructive:

Additional supplements are available from Worth Publishers to help instructors enhance their courses.

Nancy Jianakopolos (Colorado State University) and William Scarth have produced a Test Bank that includes nearly 2,000 multiple-choice questions, numerical problems, and short-answer graphical questions to accompany each chapter of the text. The Test Bank is available on a CD-ROM that also includes our flexible test-generating software. Using the Diploma software, instructors can easily write and edit questions as well as create and print tests.

The following other instructor resources (produced for the associated U.S. edition of the text) may also be useful for Canadian instructors:

Instructor’s Resources

Robert G. Murphy (Boston College) has revised the impressive resource manual for instructors that appears on the instructor’s portion of the website. For each chapter, the manual contains notes to the instructor, a detailed lecture outline, additional case studies, and coverage of advanced topics.

xxxvii

Solutions Manual

Nora Underwood (University of Central Florida) has updated the Solutions Manual for all of the Questions for Review and Problems and Applications in the text. The manual also contains the answers to selected questions from the Student Guide and Workbook.

PowerPoint Slides

Ron Cronovich (Carthage College) has prepared PowerPoint presentations of the material in each chapter. They feature graphs with effective animation, careful explanations of the core material, additional case studies and data, helpful notes to the instructor, and innovative pedagogical features. Designed to be customized or used “as is,” they include easy instructions for professors who have little experience with PowerPoint. They are available on the website.

We benefited from the input of many reviewers, colleagues, and government agencies. Several Canadian economists were particularly helpful in the preparation of several Canadian editions. Norm Cameron (University of Manitoba), Bryan Campbell (Concordia University), Vincenzo Caponi (Ryerson University), Miquel Faig (University of Toronto), George Georgopoulos (York University), Brian Glabb (Carleton University), Ron Kneebone (University of Calgary), Dan Otchere (Concordia University), Tony Myatt (University of New Brunswick), Leon Sydor (University of Windsor), and Mary Ann Vaughan (University of Waterloo) all made many useful suggestions. In addition, we wish to acknowledge the discussions we have had with colleagues at our own universities and the input given by a number of economists teaching in the United States (whose helpful comments found their way into this Canadian edition). This latter group is listed in the eighth U.S. edition of the book.

The people at Worth Publishers have continued to be congenial, dedicated and effective. Thanks are due to Steven Rigolosi, Lukia Kliossis, Tracey Kuehn, Thomas Digiano, Lisa Kinne, Barbara Seixas, and Edgar Bonilla.

Finally, we would like to thank our families for being so understanding, supportive, and inspirational.

Cambridge, Massachusetts

February 2014

Hamilton, Ontario

February 2014

xxxix