Macroeconomics, by N.Gregory Mankiw, 8th edition

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MACROECONOMICS

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EIGHTH EDITION

MACROECONOMICS
N. GREGORY MANKIW
Harvard University

Worth Publishers

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Senior Vice President, Editorial and Production: Catherine Woods
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Worth Publishers
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Photo by Jordi Cabré

about the author

N. Gregory Mankiw is the Robert M. Beren 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 best-selling 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 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.
|v

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To Deborah

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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
Political 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 whatever in them you find true; and depend upon it that if you are not
selfish or hardhearted already, Political Economy will not make you so.
John Stuart Mill, 1867

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brief contents
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 45
Chapter 3 National Income: Where It Comes

From and Where It Goes 47
Chapter 4 The Monetary System: What It Is and
How It Works 81
Chapter 5 Inflation: Its Causes, Effects, and
Social Costs 101
Chapter 6 The Open Economy 133
Chapter 7 Unemployment 177

Chapter 11 Aggregate Demand I: Building the
IS–LM Model 303
Chapter 12 Aggregate Demand II: Applying the
IS–LM Model 327
Chapter 13 The Open Economy Revisited:
The Mundell–Fleming Model and
the Exchange-Rate Regime 355
Chapter 14 Aggregate Supply and the ShortRun Tradeoff Between Inflation and
Unemployment 397

part V
Topics in Macroeconomic Theory 427
Chapter 15 A Dynamic Model of Aggregate
Demand and Aggregate Supply 429
Chapter 16 Understanding Consumer
Behavior 465
Chapter 17 The Theory of Investment 497

part III
Growth Theory: The Economy in the
Very Long Run 203
Chapter 8 Economic Growth I: Capital

Accumulation and Population
Growth 205
Chapter 9 Economic Growth II: Technology,
Empirics, and Policy 235

part VI
Topics in Macroeconomic Policy 519
Chapter 18 Alternative Perspectives on
Stabilization Policy 521
Chapter 19 Government Debt and Budget
Deficits 543
Chapter 20 The Financial System: Opportunities
and Dangers 569

part IV
Business Cycle Theory: The Economy
in the Short Run 271

Epilogue What We Know, What We Don’t 593

Chapter 10 Introduction to Economic
Fluctuations 273

Glossary 601
Index 611

viii |

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contents
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

1-2

How Economists Think 7
Theory as Model Building

8

᭤ FYI Using Functions to Express Relationships Among Variables

The Use of Multiple Models 12
Prices: Flexible Versus Sticky 12

Microeconomic Thinking and Macroeconomic Models
᭤ FYI Nobel Macroeconomists

1-3

5

11

13

14

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
᭤ FYI Stocks and Flows

18

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

The Components of Expenditure

26

27

᭤ FYI What Is Investment?

28
᭤ CASE STUDY GDP and Its Components
Other Measures of Income
Seasonal Adjustment 31

2-2

28

29

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
Does the CPI Overstate Inflation? 35
᭤ CASE STUDY The Billion Prices Project

36
| ix

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x | Contents

2-3

Measuring Joblessness: The Unemployment Rate
The Household Survey

᭤ CASE STUDY Trends in Labor-Force Participation

The Establishment Survey

2-4

36

37

38

40

Conclusion: From Economic Statistics to Economic Models

41

part II Classical Theory:
The Economy in the Long Run 45
Chapter 3 National Income: Where It Comes From
and Where It Goes 47
3-1

What Determines the Total Production of Goods and Services?
The Factors of Production 49
The Production Function 50
The Supply of Goods and Services

3-2

49

50

How Is National Income Distributed to the Factors
of Production? 51
Factor Prices 51
The Decisions Facing a Competitive Firm

The Firm’s Demand for Factors 53
The Division of National Income 56

52

᭤ CASE STUDY The Black Death and Factor Prices

The Cobb—Douglas Production Function

58

58

᭤ FYI The Growing Gap Between Rich and Poor

62
᭤ CASE STUDY Labor Productivity as the Key Determinant of Real Wages 62

3-3

What Determines the Demand for Goods and Services?

63

Consumption 64
Investment 65
᭤ FYI The Many Different Interest Rates

67

Government Purchases 67

3-4

What Brings the Supply and Demand for Goods and Services
Into Equilibrium? 68
Equilibrium in the Market for Goods and Services: The Supply and Demand
for the Economy’s Output 69
Equilibrium in the Financial Markets: The Supply and Demand for
Loanable Funds 70
Changes in Saving: The Effects of Fiscal Policy 72
᭤ CASE STUDY Wars and Interest Rates in the United Kingdom, 1730–1920

Changes in Investment Demand

3-5

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Conclusion

73

74

76

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Contents | xi

Chapter 4 The Monetary System: What It Is and How It Works 81
4-1

What Is Money?

81

The Functions of Money 82
The Types of Money 82
᭤ CASE STUDY Money in a POW Camp

The Development of Fiat Money

83

84

᭤ CASE STUDY Money and Social Conventions on the Island of Yap

84

How the Quantity of Money Is Controlled 85
How the Quantity of Money Is Measured 85
᭤ FYI How Do Credit Cards and Debit Cards Fit Into the Monetary System?

4-2

4-3

The Role of Banks in the Monetary System

87

100-Percent-Reserve Banking 88
Fractional-Reserve Banking 88
Bank Capital, Leverage, and Capital Requirements

90

How Central Banks Influence the Money Supply
A Model of the Money Supply 92
The Instruments of Monetary Policy

92

94

᭤ CASE STUDY Quantitative Easing and the Exploding Monetary Base

Problems in Monetary Control

Conclusion

95

96

᭤ CASE STUDY Bank Failures and the Money Supply in the 1930s

4-4

87

97

98

Chapter 5 Inflation: Its Causes, Effects, and Social Costs 101
5-1

The Quantity Theory of Money

102

Transactions and the Quantity Equation 102
From Transactions to Income 103
The Money Demand Function and the Quantity Equation
The Assumption of Constant Velocity 105
Money, Prices, and Inflation 106
᭤ CASE STUDY Inflation and Money Growth

5-2

106

Seigniorage: The Revenue From Printing Money
᭤ CASE STUDY Paying for the American Revolution

5-3

Inflation and Interest Rates

104

109

109

110

Two Interest Rates: Real and Nominal
The Fisher Effect 110

110

᭤ CASE STUDY Inflation and Nominal Interest Rates

Two Real Interest Rates: Ex Ante and Ex Post

111

112

᭤ CASE STUDY Nominal Interest Rates in the Nineteenth Century

5-4

The Nominal Interest Rate and the Demand for Money

113

114

The Cost of Holding Money 114
Future Money and Current Prices 114

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xii | Contents

5-5

The Social Costs of Inflation

116

The Layman’s View and the Classical Response

116

᭤ CASE STUDY What Economists and the Public Say

About Inflation 117
The Costs of Expected Inflation 117
The Costs of Unexpected Inflation 119

᭤ CASE STUDY The Free Silver Movement, the Election of 1896, and

The Wizard of Oz

120

One Benefit of Inflation

5-6

Hyperinflation

121

121

The Costs of Hyperinflation 122
The Causes of Hyperinflation 122
᭤ CASE STUDY Hyperinflation in Interwar Germany
᭤ CASE STUDY Hyperinflation in Zimbabwe

5-7

123

125

Conclusion: The Classical Dichotomy 126
Appendix: The Cagan Model: How Current and Future Money Affect
the Price Level 130

Chapter 6 The Open Economy 133
6-1

The International Flows of Capital and Goods

134

The Role of Net Exports 134
International Capital Flows and the Trade Balance 136
International Flows of Goods and Capital: An Example 138
᭤ FYI The Irrelevance of Bilateral Trade Balances

6-2

139

Saving and Investment in a Small Open Economy

139

Capital Mobility and the World Interest Rate 139
Why Assume a Small Open Economy? 140
The Model 141
How Policies Influence the Trade Balance 142
Evaluating Economic Policy 144
᭤ CASE STUDY The U.S. Trade Deficit

146
᭤ CASE STUDY Why Doesn’t Capital Flow to Poor Countries? 148

6-3

Exchange Rates

149

Nominal and Real Exchange Rates 149
The Real Exchange Rate and the Trade Balance 151
The Determinants of the Real Exchange Rate 151
How Policies Influence the Real Exchange Rate 153
The Effects of Trade Policies 154
The Determinants of the Nominal Exchange Rate 156
᭤ CASE STUDY Inflation and Nominal Exchange Rates

The Special Case of Purchasing-Power Parity
᭤ CASE STUDY The Big Mac Around the World

6-4

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157

159

160

Conclusion: The United States as a Large Open Economy
Appendix: The Large Open Economy 166

162

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Contents | xiii

Net Capital Outflow 166
The Model 168
Policies in the Large Open Economy
Conclusion 174

Chapter 7 Unemployment
7-1
7-2

170

177

Job Loss, Job Finding, and the Natural Rate of Unemployment
Job Search and Frictional Unemployment 180
Causes of Frictional Unemployment 181
Public Policy and Frictional Unemployment

181

᭤ CASE STUDY Unemployment Insurance and the Rate of Job Finding

7-3

Real-Wage Rigidity and Structural Unemployment
Minimum-Wage Laws

182

183

184

᭤ CASE STUDY The Characteristics of Minimum-Wage Workers

Unions and Collective Bargaining
Efficiency Wages 187

188

Labor-Market Experience: The United States
The Duration of Unemployment

185

186

᭤ CASE STUDY Henry Ford’s $5 Workday

7-4

178

189

189

᭤ CASE STUDY The Increase in U.S. Long-Term Unemployment and the Debate Over

Unemployment Insurance

190

Variation in the Unemployment Rate Across Demographic Groups
Transitions Into and Out of the Labor Force 193

7-5

192

Labor-Market Experience: Europe 194
The Rise in European Unemployment 194
Unemployment Variation Within Europe 196
᭤ CASE STUDY The Secrets to Happiness

The Rise of European Leisure

7-6

Conclusion

197

198

200

part III Growth Theory: The Economy
in the Very Long Run 203
Chapter 8 Economic Growth I: Capital Accumulation and
Population Growth 205
8-1

The Accumulation of Capital

206

The Supply and Demand for Goods 206
Growth in the Capital Stock and the Steady State 209
Approaching the Steady State: A Numerical Example 211
᭤ CASE STUDY The Miracle of Japanese and German Growth

How Saving Affects Growth

᭤ CASE STUDY Saving and Investment Around the World

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213

214

215

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xiv | Contents

8-2

The Golden Rule Level of Capital

217

Comparing Steady States 217
Finding the Golden Rule Steady State: A Numerical Example
The Transition to the Golden Rule Steady State 222

8-3

Population Growth

224

The Steady State With Population Growth
The Effects of Population Growth 226

225

᭤ CASE STUDY Population Growth Around the World

Alternative Perspectives on Population Growth

8-4

220

228

229

Conclusion 231

Chapter 9 Economic Growth II: Technology, Empirics,
and Policy 235
9-1

Technological Progress in the Solow Model
The Efficiency of Labor 236
The Steady State With Technological Progress
The Effects of Technological Progress 238

9-2

236

237

From Growth Theory to Growth Empirics

239

Balanced Growth 239
Convergence 240
Factor Accumulation Versus Production Efficiency

241

᭤ CASE STUDY Is Free Trade Good for Economic Growth?

9-3

Policies to Promote Growth

242

243

Evaluating the Rate of Saving 244
Changing the Rate of Saving 245
Allocating the Economy’s Investment

246

᭤ CASE STUDY Industrial Policy in Practice

Establishing the Right Institutions

247

248

᭤ CASE STUDY The Colonial Origins of Modern Institutions

Encouraging Technological Progress

249

250

᭤ CASE STUDY The Worldwide Slowdown in Economic Growth

9-4

Beyond the Solow Model: Endogenous
Growth Theory 253
The Basic Model 254
A Two-Sector Model 255
The Microeconomics of Research and Development
The Process of Creative Destruction 257

9-5

251

256

Conclusion 258
Appendix: Accounting for the Sources of Economic Growth

262

Increases in the Factors of Production 262
Technological Progress 264
The Sources of Growth in the United States 265
᭤ CASE STUDY Growth in the East Asian Tigers

The Solow Residual in the Short Run

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266

267

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Contents | xv

part IV Business Cycle Theory: The Economy
in the Short Run 271
Chapter 10 Introduction to Economic Fluctuations 273
10-1 The Facts About the Business Cycle

274

GDP and Its Components 274
Unemployment and Okun’s Law 277
Leading Economic Indicators 279

10-2 Time Horizons in Macroeconomics
How the Short Run and Long Run Differ

281
281

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

The Model of Aggregate Supply and Aggregate Demand

10-3 Aggregate Demand

284

285

The Quantity Equation as Aggregate Demand 285
Why the Aggregate Demand Curve Slopes Downward
Shifts in the Aggregate Demand Curve 287

10-4 Aggregate Supply

282

286

288

The Long Run: The Vertical Aggregate Supply Curve 288
The Short Run: The Horizontal Aggregate Supply Curve 290

From the Short Run to the Long Run 291
᭤ CASE STUDY A Monetary Lesson From French History
᭤ FYI David Hume on the Real Effects of Money

10-5 Stabilization Policy

293

294

294

Shocks to Aggregate Demand 295
Shocks to Aggregate Supply 296
᭤ CASE STUDY How OPEC Helped Cause Stagflation in the 1970s and

Euphoria in the 1980s 298

10-6 Conclusion

299

Chapter 11 Aggregate Demand I: Building the IS–LM Model

303

11-1 The Goods Market and the IS Curve 305
The Keynesian Cross

305

᭤ CASE STUDY Cutting Taxes to Stimulate the Economy: The Kennedy and Bush

Tax Cuts

312

᭤ CASE STUDY Increasing Government Purchases to Stimulate the Economy:

The Obama Spending Plan 313
The Interest Rate, Investment, and the IS Curve 314
How Fiscal Policy Shifts the IS Curve 316

11-2 The Money Market and the LM Curve 317
The Theory of Liquidity Preference

317

᭤ CASE STUDY Does a Monetary Tightening Raise or Lower Interest Rates?

319

Income, Money Demand, and the LM Curve 320
How Monetary Policy Shifts the LM Curve 321

11-3 Conclusion: The Short-Run Equilibrium

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xvi | Contents

Chapter 12 Aggregate Demand II: Applying the IS–LM Model

327

12-1 Explaining Fluctuations With the IS–LM Model 328
How Fiscal Policy Shifts the IS Curve and Changes the Short-Run
Equilibrium 328
How Monetary Policy Shifts the LM Curve and Changes the Short-Run
Equilibrium 329
The Interaction Between Monetary and Fiscal Policy 331
᭤ CASE STUDY Policy Analysis With Macroeconometric Models

333

Shocks in the IS–LM Model 334
᭤ CASE STUDY The U.S. Recession of 2001

335

What Is the Fed’s Policy Instrument—The Money Supply
or the Interest Rate? 336

12-2 IS–LM as a Theory of Aggregate Demand

337

From the IS–LM Model to the Aggregate Demand Curve 337
The IS–LM Model in the Short Run and Long Run 340

12-3 The Great Depression

342

The Spending Hypothesis: Shocks to the IS Curve 343
The Money Hypothesis: A Shock to the LM Curve 344
The Money Hypothesis Again: The Effects of Falling Prices
Could the Depression Happen Again? 347

345

᭤ CASE STUDY The Financial Crisis and Economic Downturn

of 2008 and 2009 348
᭤ FYI The Liquidity Trap (Also Known as the Zero Lower Bound) 350

12-4 Conclusion

351

Chapter 13 The Open Economy Revisited: The Mundell–Fleming
Model and the Exchange-Rate Regime 355
13-1 The Mundell–Fleming Model

357

The Key Assumption: Small Open Economy With Perfect Capital Mobility
The Goods Market and the IS* Curve 358
The Money Market and the LM* Curve 358
Putting the Pieces Together 360

13-2 The Small Open Economy Under Floating Exchange Rates

357

361

Fiscal Policy 362
Monetary Policy 363
Trade Policy 364

13-3 The Small Open Economy Under Fixed Exchange Rates
How a Fixed-Exchange-Rate System Works

365

366

᭤ CASE STUDY The International Gold Standard

367

Fiscal Policy 368
Monetary Policy 368
᭤ CASE STUDY Devaluation and the Recovery From the Great Depression

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Contents | xvii

Trade Policy 370
Policy in the Mundell–Fleming Model: A Summary

13-4 Interest Rate Differentials

371

372

Country Risk and Exchange-Rate Expectations 372
Differentials in the Mundell–Fleming Model 373
᭤ CASE STUDY International Financial Crisis: Mexico 1994–1995
᭤ CASE STUDY International Financial Crisis: Asia 1997–1998

13-5 Should Exchange Rates Be Floating or Fixed?
Pros and Cons of Different Exchange-Rate Systems
᭤ CASE STUDY The Debate Over the Euro

375
376

377
377

378

Speculative Attacks, Currency Boards, and Dollarization
The Impossible Trinity 381
᭤ CASE STUDY The Chinese Currency Controversy

380

382

13-6 From the Short Run to the Long Run: The Mundell–Fleming
Model With a Changing Price Level 383
13-7 A Concluding Reminder 386
Appendix: A Short-Run Model of the Large Open Economy 390
Fiscal Policy 392
Monetary Policy 393
A Rule of Thumb 394

Chapter 14 Aggregate Supply and the Short-Run Tradeoff Between
Inflation and Unemployment 397
14-1 The Basic Theory of Aggregate Supply

398

The Sticky-Price Model 399
An Alternative Theory: The Imperfect-Information Model 401

᭤ CASE STUDY International Differences in the Aggregate Supply Curve

403

Implications 404

14-2 Inflation, Unemployment, and the Phillips Curve

406

Deriving the Phillips Curve From the Aggregate Supply Curve
᭤ FYI The History of the Modern Phillips Curve

406

408

Adaptive Expectations and Inflation Inertia 408
Two Causes of Rising and Falling Inflation 409
᭤ CASE STUDY Inflation and Unemployment in the United States

409

The Short-Run Tradeoff Between Inflation and Unemployment

412

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

Disinflation and the Sacrifice Ratio 414

Rational Expectations and the Possibility of Painless Disinflation
᭤ CASE STUDY The Sacrifice Ratio in Practice

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414

416

Hysteresis and the Challenge to the Natural-Rate Hypothesis

14-3 Conclusion 419
Appendix: The Mother of All Models

413

417

422

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xviii | Contents

part V Topics in Macroeconomic Theory 427
Chapter 15 A Dynamic Model of Aggregate Demand
and Aggregate Supply 429
15-1 Elements of the Model

430

Output: The Demand for Goods and Services 430
The Real Interest Rate: The Fisher Equation 431
Inflation: The Phillips Curve 432
Expected Inflation: Adaptive Expectations 433
The Nominal Interest Rate: The Monetary-Policy Rule
᭤ CASE STUDY The Taylor Rule

15-2 Solving the Model

434

435

437

The Long-Run Equilibrium 437
The Dynamic Aggregate Supply Curve 439
The Dynamic Aggregate Demand Curve 440
The Short-Run Equilibrium 442

15-3 Using the Model

443

Long-Run Growth 444
A Shock to Aggregate Supply

444

᭤ FYI The Numerical Calibration and Simulation 447

A Shock to Aggregate Demand 448
A Shift in Monetary Policy 449

15-4 Two Applications: Lessons for Monetary Policy

453

The Tradeoff Between Output Variability and Inflation
Variability 453
᭤ CASE STUDY The Fed Versus the European Central Bank

The Taylor Principle

455

456

᭤ CASE STUDY What Caused the Great Inflation?

15-5 Conclusion: Toward DSGE Models

459

460

Chapter 16 Understanding Consumer Behavior 465
16-1 John Maynard Keynes and the Consumption Function

Keynes’s Conjectures 466
The Early Empirical Successes 467
Secular Stagnation, Simon Kuznets, and the Consumption Puzzle

16-2 Irving Fisher and Intertemporal Choice
The Intertemporal Budget Constraint

466

468

470

470

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

Consumer Preferences
Optimization 474

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472

473

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Contents | xix

How Changes in Income Affect Consumption 475
How Changes in the Real Interest Rate Affect Consumption
Constraints on Borrowing 477

16-3 Franco Modigliani and the Life-Cycle Hypothesis

476

479

The Hypothesis 480
Implications 481
᭤ CASE STUDY The Consumption and Saving of the Elderly

483

16-4 Milton Friedman and the Permanent-Income Hypothesis

484

The Hypothesis 484
Implications 485
᭤ CASE STUDY The 1964 Tax Cut and the 1968 Tax Surcharge
᭤ CASE STUDY The Tax Rebates of 2008

486

486

16-5 Robert Hall and the Random-Walk Hypothesis

487

The Hypothesis 488
Implications 488
᭤ CASE STUDY Do Predictable Changes in Income Lead to Predictable

Changes in Consumption?

489

16-6 David Laibson and the Pull of Instant Gratification
᭤ CASE STUDY How to Get People to Save More

16-7 Conclusion

490

491

492

Chapter 17 The Theory of Investment 497
17-1 Business Fixed Investment

498

The Rental Price of Capital 499
The Cost of Capital 500

The Determinants of Investment 502
Taxes and Investment 504
The Stock Market and Tobin’s q 505
᭤ CASE STUDY The Stock Market as an Economic Indicator

506

Alternative Views of the Stock Market: The Efficient Markets Hypothesis Versus
Keynes’s Beauty Contest 507
Financing Constraints 509

17-2 Residential Investment

510

The Stock Equilibrium and the Flow Supply
Changes in Housing Demand 511

17-3 Inventory Investment

510

514

Reasons for Holding Inventories 514
How the Real Interest Rate and Credit Conditions Affect Inventory
Investment 515

17-4 Conclusion

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xx | Contents

part VI Topics in Macroeconomic Policy 519
Chapter 18 Alternative Perspectives on Stabilization Policy 521
18-1 Should Policy Be Active or Passive?

522

Lags in the Implementation and Effects of Policies
The Difficult Job of Economic Forecasting 524
᭤ CASE STUDY Mistakes in Forecasting

522

524

Ignorance, Expectations, and the Lucas Critique
The Historical Record 527

526

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

18-2 Should Policy Be Conducted by Rule or by Discretion?

528

529

Distrust of Policymakers and the Political Process 529
The Time Inconsistency of Discretionary Policy 530
᭤ CASE STUDY Alexander Hamilton Versus Time Inconsistency

Rules for Monetary Policy

532

532

᭤ CASE STUDY Inflation Targeting: Rule or Constrained Discretion?
᭤ CASE STUDY Central-Bank Independence

533

534

18-3 Conclusion: Making Policy in an Uncertain World 536
Appendix: Time Inconsistency and the Tradeoff Between Inflation
and Unemployment 539
Chapter 19 Government Debt and Budget Deficits 543
19-1 The Size of the Government Debt

544

᭤ CASE STUDY The Troubling Long-Term Outlook for Fiscal Policy

19-2 Problems in Measurement

547

548

Measurement Problem 1: Inflation 549
Measurement Problem 2: Capital Assets 549
Measurement Problem 3: Uncounted Liabilities 550
Measurement Problem 4: The Business Cycle 551
Summing Up 551

19-3 The Traditional View of Government Debt
᭤ FYI Taxes and Incentives

552

554

19-4 The Ricardian View of Government Debt
The Basic Logic of Ricardian Equivalence
Consumers and Future Taxes 556

554

555

᭤ CASE STUDY George Bush’s Withholding Experiment
᭤ CASE STUDY Why Do Parents Leave Bequests?

Making a Choice

559

᭤ FYI Ricardo on Ricardian Equivalence

560

19-5 Other Perspectives on Government Debt
Balanced Budgets Versus Optimal Fiscal Policy
Fiscal Effects on Monetary Policy 562

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557

559

561
561

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Contents | xxi

Debt and the Political Process 563

International Dimensions 563
᭤ CASE STUDY The Benefits of Indexed Bonds

19-6 Conclusion

564

565

Chapter 20 The Financial System: Opportunities and Dangers 569
20-1 What Does the Financial System Do?
Financing Investment 570
Sharing Risk 571
Dealing With Asymmetric Information
Fostering Economic Growth 573

570

572

᭤ CASE STUDY Microfinance: Professor Yunus’s Profound Idea

20-2 Financial Crises

574

575

The Anatomy of a Crisis

576

᭤ FYI The TED Spread

578
᭤ CASE STUDY Who Should Be Blamed for the Financial Crisis
of 2008–2009? 580
Policy Responses to a Crisis 581
Policies to Prevent Crises 585
᭤ FYI CoCo Bonds

586

᭤ CASE STUDY The European Sovereign Debt Crisis

20-3 Conclusion

587

588

Epilogue What We Know, What We Don’t 593
The Four Most Important Lessons of Macroeconomics

593

Lesson 1: In the long run, a country’s capacity to produce goods and services
determines the standard of living of its citizens. 594
Lesson 2: In the short run, aggregate demand influences the amount of goods
and services that a country produces. 594

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. 595
Lesson 4: In the short run, policymakers who control monetary and fiscal policy
face a tradeoff between inflation and unemployment. 595

The Four Most Important Unresolved Questions of Macroeconomics

596

Question 1: How should policymakers try to promote growth in the economy’s
natural level of output? 596
Question 2: Should policymakers try to stabilize the economy? If so, how? 597
Question 3: How costly is inflation, and how costly is reducing inflation? 598
Question 4: How big a problem are government budget deficits? 599

Conclusion 600
Glossary 601
Index 611

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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 textbook 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 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, I 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 I incorporate many of the contributions of the classical economists before
Keynes and the new classical economists of the past several 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
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