mankiw & ball - macroeconomics and the financial system (2011)

MACROECONOMICS
and the FINANCIAL SYSTEM
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N. GREGORY MANKIW
Harvard University
LAURENCE M. BALL
Johns Hopkins University
Worth Publishers
MACROECONOMICS
and the FINANCIAL SYSTEM
Senior Publisher: Catherine Woods
Executive Editor: Charles Linsmeier
Senior Acquisitions Editor: Sarah Dorger
Executive Marketing Manager: Scott Guile
Consulting Editor: Paul Shensa
Senior Development Editor: Marie McHale
Development Editors: Jane Tufts and Barbara Brooks
Associate Media Editor: Tom Acox
Editorial Assistant: Mary Walsh
Associate Managing Editor: Tracey Kuehn
Project Editor: Dana Kasowitz
Photo Editor: Ted Szczepanski
Art Director: Babs Reingold
Cover and Text Designer: Kevin Kall
Production Manager: Barbara Anne Seixas
Composition: MPS Limited, a Macmillan Company
Printing and Binding: Quad/Graphics Versailles
Cover Artist: George Mamos
Library of Congress Cataloging-in-Publication Number: 2010932595
ISBN-13: 978-1-4292-5367-3

ISBN-10: 1-4292-5367-3
© 2011 by Worth Publishers
All rights reserved.
Printed in the United States of America
First Printing 2010
Worth Publishers
41 Madison Avenue
New York, NY 10010
www.worthpublishers.com
To Deborah and Patricia
about the authors
N. Gregory Mankiw (pictured on the left) is Professor of Economics at Harvard
University. He began his study of economics at Princeton University, where he
received an A.B. in 1980. After earning a Ph.D. in economics from MIT, he began
teaching at Harvard in 1985 and was promoted to full professor in 1987. Today, he
regularly teaches both undergraduate and graduate courses in macroeconomics.
He is also author of Macroeconomics (Worth Publishers) and Principles of Economics
(Cengage Learning).
Professor Mankiw is a regular participant in academic and policy debates. His
research ranges across macroeconomics and includes work on price adjustment,
consumer behavior, financial markets, monetary and fiscal policy, and economic
growth. In addition to his duties at Harvard, he has been a research associate of
the National Bureau of Economic Research, a member of the Brookings Panel
on Economic Activity, and an adviser to the Congressional Budget Office and
the Federal Reserve Banks of Boston and New York. From 2003 to 2005 he was
chairman of the President’s Council of Economic Advisers.
Professor Mankiw lives in Wellesley, Massachusetts, with his wife, Deborah;
children, Catherine, Nicholas, and Peter; and their border terrier, Tobin.
Christina Micek
vi |

Laurence M. Ball (pictured on the right) is Professor of Economics at Johns
Hopkins University. He received a B.A. in economics from Amherst College in
1980 and a Ph.D. in economics from MIT in 1986. He taught at New York Uni-
versity and Princeton University before his appointment at Johns Hopkins in
1994. He teaches both undergraduate and graduate courses in macroeconomics
and is the author of Money, Banking, and Financial Markets (Worth Publishers).
Professor Ball’s research areas include price adjustment and inflation, monetary
and fiscal policy, and unemployment. He and Professor Mankiw have coauthored
nine academic papers. Professor Ball is a research associate of the National Bureau
of Economic Research and has been a visiting scholar at the Federal Reserve, the
Bank of England, the Bank of Japan, the Central Bank of Norway, the Reserve
Bank of Australia, the Reserve Bank of New Zealand, the Hong Kong Monetary
Authority, and the International Monetary Fund.
Professor Ball lives in Baltimore with his wife, Patricia; son, Leverett; and their
German shepherd, Bamboo.
About the Authors | vii
viii |
Preface xxiii
Supplements and Media xxxi
part I
Introduction 1
Chapter 1 The Science of Macroeconomics 3
Chapter 2 The Data of Macroeconomics 17
part II
Classical Theory: The Economy
in the Long Run 43
Chapter 3 National Income: Where It
Comes From and Where It Goes 45
Chapter 4 Money and Inflation 77
Chapter 5 The Open Economy 121

Chapter 6 Unemployment 165
part III
Growth Theory: The Economy
in the Very Long Run 191
Chapter 7 Economic Growth I: Capital
Accumulation and Population
Growth 193
Chapter 8 Economic Growth II: Technology,
Empirics, and Policy 223
part IV
Business Cycle Theory:
The Economy in the Short Run 251
Chapter 9 Introduction to Economic
Fluctuations 253
Chapter 10 Aggregate Demand I: Building the
IS–LM Model 281
Chapter 11 Aggregate Demand II: Applying the
IS–LM Model 305
Chapter 12 Aggregate Supply and the Short-Run
Tradeoff Between Inflation and
Unemployment 333
part V
Macroeconomic Policy
Debates 359
Chapter 13 Stabilization Policy 361
Chapter 14 Government Debt and Budget
Deficits 381
part VI
The Financial System and
the Economy 407

Chapter 15 Introduction to the Financial
System 409
Chapter 16 Asset Prices and Interest Rates 431
Chapter 17 Securities Markets 465
Chapter 18 Banking 499
Chapter 19 Financial Crises 537
Glossary 575
Index 587
brief contents
| ix
Preface xxiii
Supplements and Media xxxi
part I Introduction 1
Chapter 1 The Science of Macroeconomics 3
1-1 What Macroeconomists Study 3
᭤ CASE STUDY The Historical Performance of the U.S. Economy 5
1-2 How Economists Think 7
Theory as Model Building 8
᭤ FYI Using Functions to Express Relationships Among Variables 11
The Use of Multiple Models 12
Prices: Flexible Versus Sticky 12
Microeconomic Thinking and Macroeconomic Models 13
1-3 How This Book Proceeds 14
Chapter 2 The Data of Macroeconomics 17
2-1 Measuring the Value of Economic Activity: Gross Domestic
Product 18
Income, Expenditure, and the Circular Flow 18
᭤ FYI Stocks and Flows 20
Rules for Computing GDP 20
Real GDP Versus Nominal GDP 23

The GDP Deflator 24
Chain-Weighted Measures of Real GDP 25
᭤ FYI Two Arithmetic Tricks for Working With Percentage Changes 26
The Components of Expenditure 26
᭤ FYI What Is Investment? 27
᭤ CASE STUDY GDP and Its Components 28
Other Measures of Income 29
Seasonal Adjustment 31
2-2 Measuring the Cost of Living: The Consumer Price Index 31
The Price of a Basket of Goods 32
The CPI Versus the GDP Deflator 32
᭤ CASE STUDY Does the CPI Overstate Inflation? 34
2-3 Measuring Joblessness: The Unemployment Rate 35
The Household Survey 36
contents
x | Contents
᭤ CASE STUDY Trends in Labor-Force Participation 37
The Establishment Survey 38
2-4 Conclusion: From Economic Statistics to Economic Models 40
part II Classical Theory: The Economy in the Long Run 43
Chapter 3 National Income: Where It Comes From and
Where It Goes 45
3-1 What Determines the Total Production of Goods and Services? 47
The Factors of Production 47
The Production Function 47
The Supply of Goods and Services 48
3-2 How Is National Income Distributed to the Factors of Production? 48
Factor Prices 49
The Decisions Facing the Competitive Firm 50
The Firm’s Demand for Factors 51

The Division of National Income 54
᭤ CASE STUDY The Black Death and Factor Prices 55
The Cobb–Douglas Production Function 56
᭤ CASE STUDY Labor Productivity as the Key Determinant of Real Wages 58
3-3 What Determines the Demand for Goods and Services? 59
Consumption 60
Investment 61
᭤ FYI The Many Different Interest Rates 63
Government Purchases 63
3-4 What Brings the Supply and Demand for Goods and
Services Into Equilibrium? 64
Equilibrium in the Market for Goods and Services: The Supply and
Demand for the Economy’s Output 64
Equilibrium in the Financial Markets: The Supply and Demand for
Loanable Funds 65
Changes in Saving: The Effects of Fiscal Policy 67
᭤ CASE STUDY Wars and Interest Rates in the United Kingdom,
1730–1920 68
Changes in Investment Demand 70
3-5 Conclusion 72
Chapter 4 Money and Inflation 77
4-1 What Is Money? 78
The Functions of Money 78
The Types of Money 79
Contents | xi
᭤ CASE STUDY Money in a POW Camp 80
The Development of Fiat Money 80
᭤ CASE STUDY Money and Social Conventions on the Island of Yap 81
How the Quantity of Money Is Controlled 81
How the Quantity of Money Is Measured 82

᭤ FYI How Do Credit Cards and Debit Cards Fit Into the Monetary System? 83
4-2 The Quantity Theory of Money 84
Transactions and the Quantity Equation 84
From Transactions to Income 85
The Money Demand Function and the Quantity Equation 85
The Assumption of Constant Velocity 86
Money, Prices, and Inflation 87
᭤ CASE STUDY Inflation and Money Growth 88
4-3 Seigniorage: The Revenue from Printing Money 90
᭤ CASE STUDY Paying for the American Revolution 91
4-4 Inflation and Interest Rates 91
Two Interest Rates: Real and Nominal 91
The Fisher Effect 92
᭤ CASE STUDY Inflation and Nominal Interest Rates 92
Two Real Interest Rates: Ex Ante and Ex Post 94
᭤ CASE STUDY Nominal Interest Rates in the Nineteenth Century 94
4-5 The Nominal Interest Rate and the Demand for Money 95
The Cost of Holding Money 95
Future Money and Current Prices 96
4-6 The Social Costs of Inflation 97
The Layman’s View and the Classical Response 97
᭤ CASE STUDY What Economists and the Public Say About Inflation 98
The Costs of Expected Inflation 99
The Costs of Unexpected Inflation 100
᭤ CASE STUDY The Free Silver Movement, the Election of 1896, and the
Wizard of Oz 101
One Benefit of Inflation 102
4-7 Hyperinflation 103
The Costs of Hyperinflation 103
᭤ CASE STUDY Life During the Bolivian Hyperinflation 104

The Causes of Hyperinflation 105
᭤ CASE STUDY Hyperinflation in Interwar Germany 106
᭤ CASE STUDY Hyperinflation in Zimbabwe 108
4-8 Conclusion: The Classical Dichotomy 109
Appendix: The Money Supply and the Banking System 113
100-Percent-Reserve Banking 113
Fractional-Reserve Banking 114
A Model of the Money Supply 116
The Instruments of Monetary Policy 117
᭤ CASE STUDY Bank Failures and the Money Supply in
the 1930s 119
Chapter 5 The Open Economy 121
5-1 The International Flows of Capital and Goods 122
The Role of Net Exports 122
International Capital Flows and the Trade Balance 124
International Flows of Goods and Capital: An Example 126
᭤ FYI The Irrelevance of Bilateral Trade Balances 126
5-2 Saving and Investment in a Small Open Economy 127
Capital Mobility and the World Interest Rate 127
Why Assume a Small Open Economy? 128
The Model 129
How Policies Influence the Trade Balance 130
Evaluating Economic Policy 133
᭤ CASE STUDY The U.S. Trade Deficit 133
᭤ CASE STUDY Why Doesn’t Capital Flow to Poor Countries? 135
5-3 Exchange Rates 137
Nominal and Real Exchange Rates 137
The Real Exchange Rate and the Trade Balance 138
The Determinants of the Real Exchange Rate 139
How Policies Influence the Real Exchange Rate 140

The Effects of Trade Policies 143
The Determinants of the Nominal Exchange Rate 144
᭤ CASE STUDY Inflation and Nominal Exchange Rates 145
The Special Case of Purchasing-Power Parity 146
᭤ CASE STUDY The Big Mac Around the World 148
5-4 Conclusion: The United States as a Large Open Economy 150
Appendix: The Large Open Economy 154
Net Capital Outflow 154
The Model 156
Policies in the Large Open Economy 158
Conclusion 162
Chapter 6 Unemployment 165
6-1 Job Loss, Job Finding, and the Natural Rate of
Unemployment 166
6-2 Job Search and Frictional Unemployment 168
Causes of Frictional Unemployment 169
Public Policy and Frictional Unemployment 169
᭤ CASE STUDY Unemployment Insurance and the Rate of
Job Finding 170
xii | Contents
6-3 Real-Wage Rigidity and Structural Unemployment 171
Minimum-Wage Laws 172
᭤ CASE STUDY The Characteristics of Minimum-Wage Workers 173
Unions and Collective Bargaining 174
Efficiency Wages 176
᭤ CASE STUDY Henry Ford’s $5 Workday 177
6-4 Labor-Market Experience: The United States 178
The Duration of Unemployment 178
Variation in the Unemployment Rate Across Demographic
Groups 179

Trends in Unemployment 180
Transitions Into and Out of the Labor Force 181
6-5 Labor-Market Experience: Europe 182
The Rise in European Unemployment 182
Unemployment Variation Within Europe 184
᭤ CASE STUDY The Secrets to Happiness 185
The Rise of European Leisure 186
6-6 Conclusion 188
part III Growth Theory:
The Economy in the Very Long Run 191
Chapter 7 Economic Growth I: Capital Accumulation and
Population Growth 193
7-1 The Accumulation of Capital 194
The Supply and Demand for Goods 194
Growth in the Capital Stock and the Steady State 197
Approaching the Steady State: A Numerical Example 199
᭤ CASE STUDY The Miracle of Japanese and German Growth 202
How Saving Affects Growth 202
᭤ CASE STUDY Saving and Investment Around the World 204
7-2 The Golden Rule Level of Capital 205
Comparing Steady States 206
Finding the Golden Rule Steady State: A Numerical Example 209
The Transition to the Golden Rule Steady State 210
7-3 Population Growth 213
The Steady State With Population Growth 213
The Effects of Population Growth 215
᭤ CASE STUDY Population Growth Around the World 216
Alternative Perspectives on Population Growth 218
7-4 Conclusion 220
Contents | xiii

Chapter 8 Economic Growth II: Technology, Empirics, and Policy 223
8-1 Technological Progress in the Solow Model 224
The Efficiency of Labor 224
The Steady State With Technological Progress 225
The Effects of Technological Progress 226
8-2 From Growth Theory to Growth Empirics 227
Balanced Growth 227
Convergence 228
Factor Accumulation Versus Production Efficiency 229
᭤ CASE STUDY Is Free Trade Good for Economic Growth? 230
8-3 Policies to Promote Growth 231
Evaluating the Rate of Saving 231
Changing the Rate of Saving 233
᭤ CASE STUDY How to Get People to Save More 234
Allocating the Economy’s Investment 235
Establishing the Right Institutions 237
᭤ CASE STUDY The Colonial Origins of Modern Institutions 238
Encouraging Technological Progress 239
᭤ CASE STUDY The Worldwide Slowdown in Economic
Growth: 1972–1995 239
8-4 Beyond the Solow Model: Endogenous Growth Theory 241
The Basic Model 242
A Two-Sector Model 243
The Microeconomics of Research and Development 244
The Process of Creative Destruction 245
8-5 Conclusion 247
part IV Business Cycle Theory:
The Economy in the Short Run 251
Chapter 9 Introduction to Economic Fluctuations 253
9-1 The Facts About the Business Cycle 254

GDP and Its Components 254
Unemployment and Okun’s Law 256
Leading Economic Indicators 259
9-2 Time Horizons in Macroeconomics 260
How the Short Run and Long Run Differ 261
᭤ CASE STUDY If You Want to Know Why Firms Have Sticky Prices,
Ask Them 262
The Model of Aggregate Supply and Aggregate Demand 264
9-3 Aggregate Demand 264
xiv | Contents
The Quantity Equation as Aggregate Demand 265
Why the Aggregate Demand Curve Slopes Downward 266
Shifts in the Aggregate Demand Curve 266
9-4 Aggregate Supply 267
The Long Run: The Vertical Aggregate Supply Curve 267
The Short Run: The Horizontal Aggregate Supply Curve 268
From the Short Run to the Long Run 270
᭤ CASE STUDY A Monetary Lesson from French History 272
9-5 Stabilization Policy 273
Shocks to Aggregate Demand 273
Shocks to Aggregate Supply 274
᭤ CASE STUDY How OPEC Helped Cause Stagflation in the 1970s and
Euphoria in the 1980s 276
9-6 Conclusion 278
Chapter 10 Aggregate Demand I: Building the
IS
–
LM
Model 281
10-1 The Goods Market and the IS Curve 283

The Keynesian Cross 283
᭤ CASE STUDY Cutting Taxes to Stimulate the Economy: The Kennedy and
Bush Tax Cuts 289
᭤ CASE STUDY Increasing Government Purchases to Stimulate the Economy:
The Obama Spending Plan 290
The Interest Rate, Investment, and the IS Curve 292
How Fiscal Policy Shifts the
IS
Curve 294
10-2 The Money Market and the
LM
Curve 295
The Theory of Liquidity Preference 295
᭤ CASE STUDY Does a Monetary Tightening Raise or Lower
Interest Rates? 297
Income, Money Demand, and the
LM
Curve 298
How Monetary Policy Shifts the
LM
Curve 299
10-3 Conclusion: The Short-Run Equilibrium 300
Chapter 11 Aggregate Demand II: Applying the
IS
–
LM
Model 305
11-1 Explaining Fluctuations With the
IS
–

LM
Model 306
How Fiscal Policy Shifts the
IS
Curve and Changes the
Short-Run Equilibrium 306
How Monetary Policy Shifts the
LM
Curve and Changes the
Short-Run Equilibrium 307
The Interaction Between Monetary and Fiscal Policy 309
᭤ CASE STUDY Policy Analysis With Macroeconometric Models 311
Shocks in the IS–LM Model 312
᭤ CASE STUDY The U.S. Recession of 2001 313
What Is the Fed’s Policy Instrument—The Money Supply or
the Interest Rate? 314
Contents | xv
11-2 IS–LM as a Theory of Aggregate Demand 315
From the IS–LM Model to the Aggregate Demand Curve 315
The IS–LM Model in the Short Run and Long Run 318
11-3 The Great Depression 320
The Spending Hypothesis: Shocks to the
IS
Curve 321
The Money Hypothesis: A Shock to the
LM
Curve 322
The Money Hypothesis Again: The Effects of Falling Prices 323
Could the Depression Happen Again? 325
᭤ CASE STUDY The Financial Crisis and Economic Downturn of

2008 and 2009 326
᭤ FYI The Liquidity Trap 328
11-4 Conclusion 329
Chapter 12 Aggregate Supply and the Short-Run Tradeoff
Between Inflation and Unemployment 333
12-1 The Basic Theory of Aggregate Supply 334
The Sticky-Price Model 335
An Alternative Theory: The Imperfect-Information Model 337
᭤ CASE STUDY International Differences in the Aggregate
Supply Curve 339
Implications 340
12-2 Inflation, Unemployment, and the Phillips Curve 342
Deriving the Phillips Curve From the Aggregate Supply Curve 342
᭤ FYI The History of the Modern Phillips Curve 344
Adaptive Expectations and Inflation Inertia 344
Two Causes of Rising and Falling Inflation 345
᭤ CASE STUDY Inflation and Unemployment in the
United States 346
The Short-Run Tradeoff Between Inflation and Unemployment 347
᭤ FYI How Precise Are Estimates of the Natural Rate of Unemployment? 349
Disinflation and the Sacrifice Ratio 349
Rational Expectations and the Possibility of Painless Disinflation 350
᭤ CASE STUDY The Sacrifice Ratio in Practice 352
Hysteresis and the Challenge to the Natural-Rate Hypothesis 353
12-3 Conclusion 354
part V Macroeconomic Policy Debates 359
Chapter 13 Stabilization Policy 361
13-1 Should Policy Be Active or Passive? 362
Lags in the Implementation and Effects of Policies 362
The Difficult Job of Economic Forecasting 364

xvi | Contents
᭤ CASE STUDY Mistakes in Forecasting 364
Ignorance, Expectations, and the Lucas Critique 365
The Historical Record 367
᭤ CASE STUDY Is the Stabilization of the Economy
a Figment of the Data? 368
13-2 Should Policy Be Conducted by Rule or by Discretion? 369
Distrust of Policymakers and the Political Process 369
The Time Inconsistency of Discretionary Policy 370
᭤ CASE STUDY Alexander Hamilton Versus Time Inconsistency 372
Rules for Monetary Policy 373
᭤ CASE STUDY Inflation Targeting: Rule or Constrained
Discretion? 374
᭤ CASE STUDY John Taylor’s Rule for Monetary Policy 375
᭤ CASE STUDY Central-Bank Independence 376
13-3 Conclusion: Making Policy in an Uncertain World 378
Chapter 14 Government Debt and Budget Deficits 381
14-1 The Size of the Government Debt 382
᭤ CASE STUDY The Troubling Long-Term Outlook for
Fiscal Policy 384
14-2 Problems in Measurement 386
Measurement Problem 1: Inflation 386
Measurement Problem 2: Capital Assets 387
Measurement Problem 3: Uncounted Liabilities 388
᭤ CASE STUDY Accounting for TARP 388
Measurement Problem 4: The Business Cycle 389
Summing Up 390
14-3 The Traditional View of Government Debt 390
᭤ FYI Taxes and Incentives 392
14-4 The Ricardian View of Government Debt 393

The Basic Logic of Ricardian Equivalence 393
Consumers and Future Taxes 394
᭤ CASE STUDY George Bush’s Withholding Experiment 395
᭤ CASE STUDY Why Do Parents Leave Bequests? 397
Making a Choice 397
᭤ FYI Ricardo on Ricardian Equivalence 398
14-5 Other Perspectives on Government Debt 399
Balanced Budgets Versus Optimal Fiscal Policy 399
Fiscal Effects on Monetary Policy 400
Debt and the Political Process 401
International Dimensions 401
᭤ CASE STUDY The Benefits of Indexed Bonds 402
14-6 Conclusion 403
Contents | xvii
part VI The Financial System and
the Economy 407
Chapter 15 Introduction to the Financial System 409
15-1 Financial Markets 410
Bonds 410
Stocks 411
15-2 Economic Functions of Financial Markets 411
Matching Savers and Investors 411
Risk Sharing 412
᭤ CASE STUDY The Perils of Employee Stock Ownership 413
15-3 Asymmetric Information 415
Adverse Selection 415
Moral Hazard 416
15-4 Banks 417
What Is a Bank? 418
Banks Versus Financial Markets 418

Why Banks Exist 418
15-5 The Financial System and Economic Growth 420
The Allocation of Saving 420
Evidence on the Financial System and Growth 421
᭤ CASE STUDY Unit Banking and Economic Growth 422
᭤ CASE STUDY Microfinance 424
Markets Versus Central Planning 425
᭤ CASE STUDY Investment in the Soviet Union 426
15-6 Conclusion 427
Chapter 16 Asset Prices and Interest Rates 431
16-1 Valuing Income Streams 432
Future Value 432
Present Value 432
16-2 The Classical Theory of Asset Prices 435
The Present Value of Income 435
What Determines Expectations? 437
What Is the Relevant Interest Rate? 437
The Gordon Growth Model of Stock Prices 438
16-3 Fluctuations in Asset Prices 439
Why Do Asset Prices Change? 439
᭤ CASE STUDY The Fed and the Stock Market 439
Which Asset Prices Are Most Volatile? 441
16-4 Asset-Price Bubbles 442
How Bubbles Work 442
xviii | Contents
Looking for Bubbles 443
᭤ CASE STUDY The U.S. Stock Market, 1990–2010 444
16-5 Asset-Price Crashes 447
How Crashes Work 447
᭤ CASE STUDY The Two Big Crashes 448

Crash Prevention 449
16-6 Measuring Interest Rates and Asset Returns 450
Yield to Maturity 450
The Rate of Return 451
Returns on Stocks and Bonds 452
Rate of Return Versus Yield to Maturity 453
16-7 The Term Structure of Interest Rates 453
The Term Structure Under Certainty 454
The Expectations Theory of the Term Structure 456
Accounting for Risk 456
The Yield Curve 457
᭤ CASE STUDY Inverted Yield Curves 460
16-8 Conclusion 461
Chapter 17 Securities Markets 465
17-1 Participants in Securities Markets 465
Individual Owners 466
Securities Firms 466
Other Financial Institutions 468
Financial Industry Consolidation 468
᭤ CASE STUDY The Upheaval in Investment Banking, 2008 469
17-2 Stock and Bond Markets 470
Primary Markets 470
Secondary Markets 472
Finding Information on Security Prices 475
17-3 Capital Structure: What Securities Should Firms Issue? 475
Is Capital Structure Irrelevant? 476
Why Capital Structure Does Matter 477
Debt Maturity 478
17-4 Asset Allocation: What Assets Should Savers Hold? 478
The Risk–Return Tradeoff 478

Choosing the Mix 480
᭤ CASE STUDY Age and Asset Allocation 482
17-5 Which Stocks? 483
The Efficient Markets Hypothesis 483
Choosing Between Two Kinds of Mutual Funds 485
Can
Anyone
Beat the Market? 486
᭤ CASE STUDY The Oracle of Omaha 487
Contents | xix
17-6 Derivatives 488
Futures 489
Options 489
Credit Default Swaps 490
Hedging With Derivatives 491
Speculating With Derivatives 492
᭤ CASE STUDY Credit Default Swaps and the
AIG Fiasco 492
17-7 Conclusion 493
Chapter 18 Banking 499
18-1 The Banking Industry 500
Types of Banks 500
Large Versus Small Banks 501
Subprime Lenders 502
18-2 Securitization 505
The Securitization Process 505
Fannie and Freddie 506
Why Securitization Occurs 507
The Spread of Securitization 508
᭤ CASE STUDY The Subprime Mortgage Fiasco 508

18-3 The Business of Banking 511
The Bank Balance Sheet 511
Measuring Profits 512
Liability Management 514
Liquidity Management 514
18-4 Risk Management at Banks 515
Managing Credit Risk 515
Managing Interest Rate Risk 516
Equity and Insolvency Risk 517
᭤ CASE STUDY The Banking Crisis of the 1980s 519
18-5 Bank Runs, Deposit Insurance, and Moral Hazard 520
How Bank Runs Happen 521
An Example 522
᭤ CASE STUDY The Run on Northern Rock Bank 523
Bank Panics 524
᭤ CASE STUDY Bank Panics in the 1930s 524
Deposit Insurance 525
Moral Hazard in Banking 526
The Problem With Deposit Insurance 527
18-6 Bank Regulation 527
Who Regulates Banks? 528
Restrictions on Balance Sheets 528
xx | Contents
Supervision 529
Closing Insolvent Banks 530
18-7 Conclusion 532
Chapter 19 Financial Crises 537
19-1 The Mechanics of Financial Crises 538
Events in the Financial System 538
Financial Crises and the Economy 539

᭤ CASE STUDY Disaster in the 1930s 541
19-2 Financial Rescues 541
Liquidity Crises and the Lender of Last Resort 542
Giveaways of Government Funds 543
᭤ CASE STUDY The Continental Illinois Rescue 544
Risky Rescues 545
19-3 The U.S. Financial Crisis of 2007–2009 546
2006–2007 547
The Subprime Crisis and the First Signs of Panic 547
2008 550
Bear Stearns and the Calm Before the Storm 550
Disaster Strikes: September 7–19, 2008 551
An Economy in Freefall 553
The Policy Response 557
2009 and Beyond 557
The Aftermath 557
᭤ FYI Specifics of Some Federal Reserve Responses to the Financial Crisis 558
19-4 The Future of Financial Regulation 560
Regulating Nonbank Financial Institutions 560
Addressing Too Big To Fail 562
Discouraging Excessive Risk Taking 563
Changing Regulatory Structure 564
᭤ CASE STUDY The Financial Reforms of 2010 565
19-5 Financial Crises in Emerging Economies 566
Capital Flight 566
Capital Flight and Financial Crises 567
᭤ CASE STUDY Argentina’s Financial Crisis, 2001–2002 568
Recent Crises 570
The Role of the International Monetary Fund 571
19-6 Conclusion 572

Glossary 575
Index 587
Contents | xxi
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| xxiii
E
conomists have long understood that developments in the overall economy
and developments in the financial system are inextricably intertwined. But
if we needed reminding, the financial crisis and economic downturn that
started in 2007 provided a wake-up call that is hard to ignore.
This book is designed for courses in intermediate-level macroeconomics that
include ample coverage of the role of the economy’s financial system. It is born
of two parents. One of those parents is Greg Mankiw’s text Macroeconomics. The
other is Larry Ball’s Money, Banking, and Financial Markets. Like any child, this
book resembles both its parents but also has a personality of its own. As with a
traditional book in macroeconomics, it covers such topics as monetary theory,
growth theory, and the study of short-run economic fluctuations. But it also in-
cludes substantial material on asset prices, securities markets, banking, and finan-
cial crises. The integration of this material will foster interest in macroeconomics,
especially among students looking toward careers in business and finance.
The great British economist John Maynard Keynes once remarked that 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.” As this assessment suggests, students who aim to learn economics
need to draw on many disparate talents. The job of helping students find and de-
velop these talents falls to instructors and textbook authors.
When writing this book,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 im-
portant, we believe that the study of macroeconomics and the financial system 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 pro-
fession’s accumulated wisdom but also its enthusiasm and sense of purpose.
The Arrangement of Topics
Our strategy for teaching macroeconomics is first to examine the long run when
prices are flexible and then to examine the short run when prices are sticky. This
approach 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 fluctu-
ating. Third, beginning with market-clearing models makes clearer the link be-
tween macroeconomics and microeconomics. Fourth, students learn first the
material that is less controversial among macroeconomists. For all these reasons,
preface
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 l 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 do-
mestic 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 pres-
ents 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 pur-
chases, 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.
Chapter 5 introduces the study of open-economy macroeconomics. Main-
taining the assumption of full employment, this chapter presents models to ex-
plain the trade balance and the exchange rate. Various policy issues are addressed:
the relationship between the budget deficit and the trade deficit, the macroeco-
nomic impact of protectionist trade policies, and the effect of monetary policy
on the value of a currency in the market for foreign exchange.
Chapter 6 relaxes the assumption of full employment by discussing the dy-
namics of the labor 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.
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 em-
phasizes 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.
xxiv | Preface