Macroeconomics seventh edition

MACROECONOMICS
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MACROECONOMICS
SEVENTH EDITION
N
.
GREGORY MANKIW
Harvard University
Worth Publishers
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Encaustic on Wood Panel 24'' x 24'' © 2005
Library of Congress Cataloging-in-Publication Number: 2009924581
ISBN-13: 978-1-4292-1887-0
ISBN-10: 1-4292-1887-8
© 2010, 2007, 2003 by N. Gregory Mankiw

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v
about the author
N. Gregory Mankiw 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 the
popular introductory textbook 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 Federal Reserve Bank of Boston and
the Congressional Budget Office. 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.
Photo by Deborah Mankiw
To Deborah
T
hose branches of politics, or of the laws of social life, on which there
exists a collection of facts sufficiently sifted and methodized to form

the beginning of a science should be taught ex professo. Among the
chief of these is Political Economy, the sources and conditions of wealth and
material prosperity for aggregate bodies of human beings. . . .
The same persons who cry down Logic will generally warn you against Polit-
ical Economy. It is unfeeling, they will tell you. It recognises unpleasant facts. For
my part, the most unfeeling thing I know of is the law of gravitation: it breaks
the neck of the best and most amiable person without scruple, if he forgets for a
single moment to give heed to it. The winds and waves too are very unfeeling.
Would you advise those who go to sea to deny the winds and waves – or to make
use of them, and find the means of guarding against their dangers? My advice to
you is to study the great writers on Political Economy, and hold firmly by what-
ever in them you find true; and depend upon it that if you are not selfish or hard-
hearted already, Political Economy will not make you so.
John Stuart Mill, 1867
viii |
Preface xxiii
Supplements and Media xxxii
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 79
Chapter 5 The Open Economy 119
Chapter 6 Unemployment 163
part III

Growth Theory: The Economy in the
Very Long Run 189
Chapter 7 Economic Growth I: Capital
Accumulation and Population
Growth 191
Chapter 8 Economic Growth II: Technology,
Empirics, and Policy 221
part IV
Business Cycle Theory: The Economy
in the Short Run 255
Chapter 9 Introduction to Economic
Fluctuations 257
Chapter 10 Aggregate Demand I: Building the
IS–LM Model 287
Chapter 11 Aggregate Demand II: Applying the
IS–LM Model 311
Chapter 12 The Open Economy Revisited: The
Mundell–Fleming Model and the
Exchange-Rate Regime 339
Chapter 13 Aggregate Supply and the Short-Run
Tradeoff Between Inflation and
Unemployment 379
Chapter 14 A Dynamic Model of Aggregate
Demand and Aggregate Supply 409
part V
Macroeconomic Policy Debates 443
Chapter 15 Stabilization Policy 445
Chapter 16 Government Debt and Budget
Deficits 467
part VI

More on the Microeconomics Behind
Macroeconomics 493
Chapter 17 Consumption 495
Chapter 18 Investment 525
Chapter 19 Money Supply, Money Demand, and
the Banking System 547
Epilogue What We Know, What We Don’t 567
Glossary 575
Index 585
brief contents
| ix
Preface xxiii
Supplements and Media xxxii
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 4
1-2 How Economists Think 7
Theory as Model Building 7
᭤ 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
᭤ FYI Nobel Macroeconomists 14
1-3 How This Book Proceeds 15
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 25
Chain-Weighted Measures of Real GDP 25
᭤ FYI Two Arithmetic Tricks for Working With Percentage Changes 26
The Components of Expenditure 27
᭤ FYI What Is Investment? 28
᭤ 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 32
The Price of a Basket of Goods 32
The CPI Versus the GDP Deflator 33
᭤ CASE STUDY Does the CPI Overstate Inflation? 35
2-3 Measuring Joblessness: The Unemployment Rate 36
The Household Survey 36
contents
x | Contents
᭤ CASE STUDY Trends in Labor-Force Participation 38
The Establishment Survey 39
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 48
The Supply of Goods and Services 48
3-2 How Is National Income Distributed to the Factors of

Production? 49
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 56
The Cobb–Douglas Production Function 56
᭤ CASE STUDY Labor Productivity as the Key Determinant of Real Wages 59
3-3 What Determines the Demand for Goods and Services? 60
Consumption 61
Investment 62
᭤ FYI The Many Different Interest Rates 64
Government Purchases 64
3-4 What Brings the Supply and Demand for Goods and Services
Into Equilibrium? 65
Equilibrium in the Market for Goods and Services: The Supply and Demand for
the Economy’s Output 66
Equilibrium in the Financial Markets: The Supply and Demand for Loanable
Funds 67
Changes in Saving: The Effects of Fiscal Policy 68
᭤ FYI The Financial System: Markets, Intermediaries, and the Crisis of
2008–2009 69
᭤ CASE STUDY Wars and Interest Rates in the United Kingdom, 1730–1920 70
Changes in Investment Demand 72
3-5 Conclusion 74
Contents | xi
Chapter 4 Money and Inflation 79
4-1 What Is Money? 80
The Functions of Money 80
The Types of Money 81

᭤ CASE STUDY Money in a POW Camp 82
The Development of Fiat Money 82
᭤ CASE STUDY Money and Social Conventions on the Island of Yap 83
How the Quantity of Money Is Controlled 83
How the Quantity of Money Is Measured 84
᭤ FYI How Do Credit Cards and Debit Cards Fit Into the Monetary System? 85
4-2 The Quantity Theory of Money 86
Transactions and the Quantity Equation 87
From Transactions to Income 87
The Money Demand Function and the Quantity Equation 88
The Assumption of Constant Velocity 89
Money, Prices, and Inflation 89
᭤ CASE STUDY Inflation and Money Growth 90
4-3 Seigniorage: The Revenue From Printing Money 92
᭤ CASE STUDY Paying for the American Revolution 93
4-4 Inflation and Interest Rates 94
Two Interest Rates: Real and Nominal 94
The Fisher Effect 94
᭤ CASE STUDY Inflation and Nominal Interest Rates 95
Two Real Interest Rates: Ex Ante and Ex Post 96
᭤ CASE STUDY Nominal Interest Rates in the Nineteenth Century 97
4-5 The Nominal Interest Rate and the Demand for Money 98
The Cost of Holding Money 98
Future Money and Current Prices 98
4-6 The Social Costs of Inflation 100
The Layman’s View and the Classical Response 100
᭤ CASE STUDY What Economists and the Public Say About Inflation 101
The Costs of Expected Inflation 102
The Costs of Unexpected Inflation 103
᭤ CASE STUDY The Free Silver Movement, the Election of 1896, and the

Wizard of Oz 104
One Benefit of Inflation 105
4-7 Hyperinflation 106
The Costs of Hyperinflation 106
᭤ CASE STUDY Life During the Bolivian Hyperinflation 107
The Causes of Hyperinflation 108
᭤ CASE STUDY Hyperinflation in Interwar Germany 109
᭤ CASE STUDY Hyperinflation in Zimbabwe 111
4-8 Conclusion: The Classical Dichotomy 112
Appendix: The Cagan Model: How Current and Future Money Affect
the Price Level 116
Chapter 5 The Open Economy 119
5-1 The International Flows of Capital and Goods 120
The Role of Net Exports 120
International Capital Flows and the Trade Balance 122
International Flows of Goods and Capital: An Example 124
᭤ FYI The Irrelevance of Bilateral Trade Balances 124
5-2 Saving and Investment in a Small Open Economy 125
Capital Mobility and the World Interest Rate 125
Why Assume a Small Open Economy? 126
The Model 127
How Policies Influence the Trade Balance 128
Evaluating Economic Policy 131
᭤ CASE STUDY The U.S. Trade Deficit 131
᭤ CASE STUDY Why Doesn’t Capital Flow to Poor Countries? 134
5-3 Exchange Rates 135
Nominal and Real Exchange Rates 135
The Real Exchange Rate and the Trade Balance 137
The Determinants of the Real Exchange Rate 138
How Policies Influence the Real Exchange Rate 139

The Effects of Trade Policies 141
The Determinants of the Nominal Exchange Rates 143
᭤ CASE STUDY Inflation and the Nominal Exchange Rate 144
The Special Case of Purchasing-Power Parity 145
᭤ CASE STUDY The Big Mac Around the World 147
5-4 Conclusion: The United States as a Large Open Economy 149
Appendix: The Large Open Economy 153
Net Capital Outflow 153
The Model 155
Policies in the Large Open Economy 157
Conclusion 161
Chapter 6 Unemployment 163
6-1 Job Loss, Job Finding, and the Natural Rate of Unemployment 164
6-2 Job Search and Frictional Unemployment 166
Causes of Frictional Unemployment 167
Public Policy and Frictional Unemployment 167
᭤ CASE STUDY Unemployment Insurance and the Rate of Job Finding 168
6-3 Real-Wage Rigidity and Structural Unemployment 169
Minimum-Wage Laws 170
xii |
Contents
᭤ CASE STUDY The Characteristics of Minimum-Wage Workers 171
Unions and Collective Bargaining 172
Efficiency Wages 174
᭤ CASE STUDY Henry Ford’s $5 Workday 175
6-4 Labor-Market Experience: The United States 176
The Duration of Unemployment 176
Variation in the Unemployment Rate Across Demographic Groups 177
Trends in Unemployment 178
Transitions Into and Out of the Labor Force 179

6-5 Labor-Market Experience: Europe 180
The Rise in European Unemployment 180
Unemployment Variation Within Europe 182
᭤ CASE STUDY The Secrets to Happiness 183
The Rise of European Leisure 184
6-6 Conclusion 186
part III Growth Theory: The Economy in the
Very Long Run 189
Chapter 7 Economic Growth I: Capital Accumulation
and Population Growth 191
7-1 The Accumulation of Capital 192
The Supply and Demand for Goods 192
Growth in the Capital Stock and the Steady State 195
Approaching the Steady State: A Numerical Example 197
᭤ CASE STUDY The Miracle of Japanese and German Growth 200
How Saving Affects Growth 200
᭤ CASE STUDY Saving and Investment Around the World 202
7-2 The Golden Rule Level of Capital 203
Comparing Steady States 204
Finding the Golden Rule Steady State: A Numerical Example 207
The Transition to the Golden Rule Steady State 208
7-3 Population Growth 211
The Steady State With Population Growth 211
The Effects of Population Growth 213
᭤ CASE STUDY Population Growth Around the World 214
Alternative Perspectives on Population Growth 216
7-4 Conclusion 218
Contents | xiii
Chapter 8 Economic Growth II: Technology, Empirics,
and Policy 221

8-1 Technological Progress in the Solow Model 222
The Efficiency of Labor 222
The Steady State With Technological Progress 223
The Effects of Technological Progress 224
8-2 From Growth Theory to Growth Empirics 225
Balanced Growth 225
Convergence 226
Factor Accumulation Versus Production Efficiency 227
᭤ CASE STUDY Is Free Trade Good for Economic Growth? 228
8-3 Policies to Promote Growth 229
Evaluating the Rate of Saving 230
Changing the Rate of Saving 231
Allocating the Economy’s Investment 232
Establishing the Right Institutions 234
᭤ CASE STUDY The Colonial Origins of Modern Institutions 234
Encouraging Technological Progress 235
᭤ CASE STUDY The Worldwide Slowdown in Economic Growth: 1972–1995 236
8-4 Beyond the Solow Model: Endogenous Growth Theory 238
The Basic Model 239
A Two-Sector Model 240
The Microeconomics of Research and Development 241
The Process of Creative Destruction 242
8-5 Conclusion 244
Appendix: Accounting for the Sources of Economic Growth 247
Increases in the Factors of Production 247
Technological Progress 249
The Sources of Growth in the United States 251
᭤ CASE STUDY Growth in the East Asian Tigers 251
The Solow Residual in the Short Run 252
part IV Business Cycle Theory: The Economy in

the Short Run 255
Chapter 9 Introduction to Economic Fluctuations 257
9-1 The Facts About the Business Cycle 258
GDP and Its Components 258
Unemployment and Okun’s Law 260
Leading Economic Indicators 263
xiv |
Contents
9-2 Time Horizons in Macroeconomics 265
How the Short Run and Long Run Differ 265
᭤ CASE STUDY If You Want to Know Why Firms Have Sticky Prices, Ask Them 266
The Model of Aggregate Supply and Aggregate Demand 268
9-3 Aggregate Demand 269
The Quantity Equation as Aggregate Demand 269
Why the Aggregate Demand Curve Slopes Downward 270
Shifts in the Aggregate Demand Curve 270
9-4 Aggregate Supply 271
The Long Run: The Vertical Aggregate Supply Curve 272
The Short Run: The Horizontal Aggregate Supply Curve 273
From the Short Run to the Long Run 275
᭤ CASE STUDY A Monetary Lesson From French History 276
᭤ FYI David Hume on the Real Effects of Money 278
9-5 Stabilization Policy 278
Shocks to Aggregate Demand 279
Shocks to Aggregate Supply 280
᭤ CASE STUDY How OPEC Helped Cause Stagflation in the 1970s and Euphoria in
the 1980s 282
9-6 Conclusion 283
Chapter 10 Aggregate Demand I: Building the IS–LM Model 287
10-1 The Goods Market and the IS Curve 289

The Keynesian Cross 289
᭤ CASE STUDY Cutting Taxes to Stimulate the Economy: The Kennedy and
Bush Tax Cuts 296
᭤ CASE STUDY Increasing Government Purchases to Stimulate the Economy:
The Obama Spending Plan 297
The Interest Rate, Investment, and the IS Curve 298
How Fiscal Policy Shifts the IS Curve 299
10-2 The Money Market and the LM Curve 301
The Theory of Liquidity Preference 301
᭤ CASE STUDY Does a Monetary Tightening Raise or Lower Interest Rates? 303
Income, Money Demand, and the LM Curve 304
How Monetary Policy Shifts the LM Curve 305
10-3 Conclusion: The Short-Run Equilibrium 306
Chapter 11 Aggregate Demand II: Applying the IS–LM Model 311
11-1 Explaining Fluctuations With the IS–LM Model 312
How Fiscal Policy Shifts the IS Curve and Changes the Short-Run
Equilibrium 312
How Monetary Policy Shifts the LM Curve and Changes the Short-Run
Equilibrium 313
Contents | xv
The Intersection Between Monetary and Fiscal Policy 315
᭤ CASE STUDY Policy Analysis With Macroeconomic Models 317
Shocks in the IS–LM Model 318
᭤ CASE STUDY The U.S. Recession of 2001 319
What Is the Fed’s Policy Instrument—The Money Supply or the
Interest Rate? 320
11-2 IS–LM as a Theory of Aggregate Demand 321
From the IS–LM Model to the Aggregate Demand Curve 321
The IS–LM Model in the Short Run and Long Run 324
11-3 The Great Depression 326

The Spending Hypothesis: Shocks to the IS Curve 327
The Money Hypothesis: A Shock to the LM Curve 328
The Money Hypothesis Again: The Effects of Falling Prices 329
Could the Depression Happen Again? 331
᭤ CASE STUDY The Financial Crisis and Economic Downturn of
2008 and 2009 332
᭤ FYI The Liquidity Trap 334
11-4 Conclusion 335
Chapter 12 The Open Economy Revisited: The Mundell–Fleming
Model and the Exchange-Rate Regime 339
12-1 The Mundell–Fleming Model 340
The Key Assumption: Small Open Economy With Perfect Capital Mobility 341
The Goods Market and the IS* Curve 341
The Money Market and the LM* Curve 343
Putting the Pieces Together 343
12-2 The Small Open Economy Under Floating Exchange Rates 345
Fiscal Policy 345
Monetary Policy 347
Trade Policy 348
12-3 The Small Open Economy Under Fixed Exchange Rates 349
How a Fixed-Exchange-Rate System Works 350
᭤ CASE STUDY The International Gold Standard 351
Fiscal Policy 352
Monetary Policy 352
᭤ CASE STUDY Devaluation and the Recovery From the Great Depression 354
Trade Policy 354
Policy in the Mundell–Fleming Model: A Summary 355
12-4 Interest Rate Differentials 356
Country Risk and Exchange-Rate Expectations 356
Differentials in the Mundell–Fleming Model 357

᭤ CASE STUDY International Financial Crisis: Mexico 1994–1995 358
᭤ CASE STUDY International Financial Crisis: Asia 1997–1998 360
xvi | Contents
12-5 Should Exchange Rates Be Floating or Fixed? 361
Pros and Cons of Different Exchange-Rate Systems 361
᭤ CASE STUDY Monetary Union in the United States and Europe 362
Speculative Attacks, Currency Boards, and Dollarization 363
The Impossible Trinity 364
᭤ CASE STUDY The Chinese Currency Controversy 365
12-6 From the Short Run to the Long Run: The Mundell–Fleming Model
With a Changing Price Level 366
12-7 A Concluding Reminder 369
Appendix: A Short-Run Model of the Large Open Economy 373
Fiscal Policy 375
Monetary Policy 376
A Rule of Thumb 377
Chapter 13 Aggregate Supply and the Short-Run Tradeoff Between
Inflation and Unemployment 379
13-1 The Basic Theory of Aggregate Supply 380
The Sticky-Price Model 381
An Alternative Theory: The Imperfect-Information Model 383
᭤ CASE STUDY International Differences in the Aggregate Supply Curve 385
Implications 386
13-2 Inflation, Unemployment, and the Phillips Curve 388
Deriving the Phillips Curve From the Aggregate Supply Curve 388
᭤ FYI The History of the Modern Phillips Curve 390
Adaptive Expectations and Inflation Inertia 390
Two Causes of Rising and Falling Inflation 391
᭤ CASE STUDY Inflation and Unemployment in the United States 391
The Short-Run Tradeoff Between Inflation and Unemployment 393

᭤ FYI How Precise Are Estimates of the Natural Rate of Unemployment? 395
Disinflation and the Sacrifice Ratio 395
Rational Expectations and the Possibility of Painless Disinflation 396
᭤ CASE STUDY The Sacrifice Ratio in Practice 398
Hysteresis and the Challenge of the Natural-Rate Hypothesis 399
13-3 Conclusion 401
Appendix: The Mother of All Models 405
Chapter 14 A Dynamic Model of Aggregate Demand and Aggregate
Supply 409
14-1 Elements of the Model 410
Output: The Demand for Goods and Services 410
The Real Interest Rate: The Fisher Equation 411
Inflation: The Phillips Curve 412
Expected Inflation: Adaptive Expectations 413
Contents | xvii
The Nominal Interest Rate: The Monetary-Policy Rule 414
᭤ CASE STUDY The Taylor Rule 415
14-2 Solving the Model 417
The Long-Run Equilibrium 418
The Dynamic Aggregate Supply Curve 418
The Dynamic Aggregate Demand Curve 420
The Short-Run Equilibrium 422
14-3 Using the Model 423
Long-Run Growth 423
A Shock to Aggregate Supply 424
᭤ FYI The Numerical Calibration and Simulation 425
A Shock to Aggregate Demand 427
A Shift in Monetary Policy 429
14-4 Two Applications: Lessons for Monetary Policy 432
The Tradeoff Between Output Variability and Inflation Variability 432

᭤ CASE STUDY The Fed Versus the European Central Bank 435
The Taylor Principle 436
᭤ CASE STUDY What Caused the Great Inflation? 437
14-5 Conclusion: Toward DSGE Models 439
part V Macroeconomic Policy Debates 443
Chapter 15 Stabilization Policy 445
15-1 Should Policy Be Active or Passive? 446
Lags in the Implementation and Effects of Policies 447
The Difficult Job of Economic Forecasting 448
᭤ CASE STUDY Mistakes in Forecasting 449
Ignorance, Expectations, and the Lucas Critique 450
The Historical Record 451
᭤ CASE STUDY Is the Stabilization of the Economy a Figment of the Data? 452
15-2 Should Policy Be Conducted by Rule or by Discretion? 453
Distrust of Policymakers and the Political Process 453
The Time Inconsistency of Discretionary Policy 454
᭤ CASE STUDY Alexander Hamilton Versus Time Inconsistency 456
Rules for Monetary Policy 457
᭤ CASE STUDY Inflation Targeting: Rule or Constrained Discretion? 458
᭤ CASE STUDY Central-Bank Independence 459
15-3 Conclusion: Making Policy in an Uncertain World 460
Appendix: Time Inconsistency and the Tradeoff Between Inflation and
Unemployment 463
xviii | Contents
Chapter 16 Government Debt and Budget Deficits 467
16-1 The Size of the Government Debt 468
᭤ CASE STUDY The Troubling Long-Term Outlook for Fiscal Policy 470
16-2 Problems in Measurement 472
Measurement Problem 1: Inflation 472
Measurement Problem 2: Capital Assets 473

Measurement Problem 3: Uncounted Liabilities 474
᭤ CASE STUDY Accounting for TARP 474
Measurement Problem 4: The Business Cycle 475
Summing Up 476
16-3 The Traditional View of Government Debt 476
᭤ FYI Taxes and Incentives 478
16-4 The Ricardian View of Government Debt 479
The Basic Logic of Ricardian Equivalence 479
Consumers and Future Taxes 480
᭤ CASE STUDY George Bush’s Withholding Experiment 481
᭤ CASE STUDY Why Do Parents Leave Bequests? 483
Making a Choice 484
᭤ FYI Ricardo on Ricardian Equivalence 484
16-5 Other Perspectives on Government Debt 485
Balanced Budgets Versus Optimal Fiscal Policy 485
Fiscal Effects on Monetary Policy 486
Debt and the Political Process 487
International Dimensions 488
᭤ CASE STUDY The Benefits of Indexed Bonds 489
16-6 Conclusion 490
part VI More on the Microeconomics Behind
Macroeconomics 493
Chapter 17 Consumption 495
17-1 John Maynard Keynes and the Consumption Function 496
Keynes’s Conjectures 496
The Early Empirical Successes 497
Secular Stagnation, Simon Kuznets, and the Consumption Puzzle 498
17-2 Irving Fisher and Intertemporal Choice 500
The Intertemporal Budget Constraint 500
᭤ FYI Present Value, or Why a $1,000,000 Prize Is Worth Only $623,000 502

Consumer Preferences 503
Contents | xix
Optimization 504
How Changes in Income Affect Consumption 505
How Changes in the Real Interest Rate Affect Consumption 506
Constraints on Borrowing 507
17-3 Franco Modigliani and the Life-Cycle Hypothesis 509
The Hypothesis 510
Implications 511
᭤ CASE STUDY The Consumption and Saving of the Elderly 512
17-4 Milton Friedman and the Permanent-Income Hypothesis 514
The Hypothesis 514
Implications 515
᭤ CASE STUDY The 1964 Tax Cut and the 1968 Tax Surcharge 516
17-5 Robert Hall and the Random-Walk Hypothesis 516
The Hypothesis 517
Implications 517
᭤ CASE STUDY Do Predictable Changes in Income Lead to Predictable Changes in
Consumption? 518
17-6 David Laibson and the Pull of Instant Gratification 519
᭤ CASE STUDY How to Get People to Save More 520
17-7 Conclusion 521
Chapter 18 Investment 525
18-1 Business Fixed Investment 526
The Rental Price of Capital 527
The Cost of Capital 528
The Determinants of Investment 530
Taxes and Investment 532
The Stock Market and Tobin’s q 533
᭤ CASE STUDY The Stock Market as an Economic Indicator 534

Alternative Views of the Stock Market: The Efficient Markets Hypothesis Versus
Keynes’s Beauty Contest 536
Financing Constraints 537
Banking Crises and Credit Crunches 538
18-2 Residential Investment 539
The Stock Equilibrium and the Flow Supply 539
Changes in Housing Demand 540
18-3 Inventory Investment 543
Reasons for Holding Inventories 543
How the Real Interest Rate and Credit Conditions Affect Inventory
Investment 543
18-4 Conclusion 544
xx | Contents
Chapter 19 Money Supply, Money Demand, and the Banking
System 547
19-1 Money Supply 547
100-Percent-Reserve Banking 548
Fractional-Reserve Banking 549
A Model of the Money Supply 550
The Three Instruments of Monetary Policy 552
᭤ CASE STUDY Bank Failures and the Money Supply in the 1930s 553
Bank Capital, Leverage, and Capital Requirements 555
19-2 Money Demand 556
Portfolio Theories of Money Demand 557
᭤ CASE STUDY Currency and the Underground Economy 558
Transactions Theories of Money Demand 558
The Baumol–Tobin Model of Cash Management 559
᭤ CASE STUDY Empirical Studies of Money Demand 562
Financial Innovation, Near Money, and the Demise of the Monetary
Aggregates 563

19-3 Conclusion 564
Epilogue What We Know, What We Don’t 567
The Four Most Important Lessons of Macroeconomics 567
Lesson 1: In the long run, a county’s capacity to produce goods and services
determines the standard of living of its citizens. 568
Lesson 2: In the short run, aggregate demand influences the amount of goods
and services that a country produces. 568
Lesson 3: In the long run, the rate of money growth determines the rate of
inflation, but it does not affect the rate of unemployment. 569
Lesson 4: In the short run, policymakers who control monetary and fiscal policy
face a tradeoff between inflation and unemployment. 569
The Four Most Important Unresolved Questions of Macroeconomics 570
Question 1: How should policymakers try to promote growth in the economy’s
natural level of output? 570
Question 2: Should policymakers try to stabilize the economy? 571
Question 3: How costly is inflation, and how costly is reducing inflation? 572
Question 4: How big a problem are government budget deficits? 573
Conclusion 574
Glossary 575
Index 585
Contents | xxi
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xxiii
preface
A
n 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 text-
book for intermediate-level courses in macroeconomics, my 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. I hope this book
conveys not only our profession’s accumulated wisdom but also its enthusiasm
and sense of purpose.
This Book’s Approach
Macroeconomists share a common body of knowledge, but they do not all have
the same perspective on how that knowledge is best taught. Let me begin this
new edition by recapping four of my objectives, which together define this
book’s approach to the field.
First, I try to offer a balance between short-run and long-run issues in macro-
economics. 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 nat-
ural rate of unemployment, persistent inflation, and the effects of government
debt. Neither time horizon trumps the other.
Second, I integrate the insights of Keynesian and classical theories. Although
Keynes’s General Theory provides the foundation for much of our current under-
standing of economic fluctuations, it is important to remember that classical eco-
nomics provides the right answers to many fundamental questions. In this book
I 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, I 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 dynamics.
Third, I 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, I 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 impor-
tant, this approach asks students to think like economists, who always keep var-
ious models in mind when analyzing economic events or public policies.
Fourth, I 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, I 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 Alexander
Hamilton, Henry Ford, George Bush (both of them!), and Barack Obama. 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.
What’s New in the Seventh Edition?
This edition includes some of the most significant changes since the book was
first published in 1992. The revision reflects new events in the economy as well
as new research about the best way to understand macroeconomic developments.
By far the biggest change is the addition of Chapter 14, “A Dynamic Model
of Aggregate Demand and Aggregate Supply.” In recent years, academic
research and policy analyses of short-run economic fluctuations have increas-

ingly centered on dynamic, stochastic, general equilibrium models with nom-
inal rigidities. These models are too complex to present in full detail to most
undergraduate students, but the essential insights of these models can be taught
with both simplicity and rigor. That is the purpose of this new chapter. It
builds on ideas the students have seen before, both in previous chapters and in
previous courses, and it exposes students to ideas that are prominent at the
research and policy frontier.
The other chapters in the book have been updated to incorporate the latest
data and recent events, including recent turmoil in financial markets and the
economy more broadly. Here are some of the noteworthy additions:
➤ Chapter 3 includes a new FYI box called “The Financial System:
Markets, Intermediaries, and the Crisis of 2008 and 2009.”
➤ Chapter 4 has a new Case Study about the recent hyperinflation in
Zimbabwe.
➤ Chapter 9 includes a new Case Study called “A Monetary Lesson From
French History.”
xxiv | Preface