Macroeconomics 6th edition

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Macroeconomics

SIXTH EDITION

Andrew B. Abel

The Wharton School of the
University of Pennsylvania

Ben S. Bernanke

Dean Croushore

Robins School of Business
University of Richmond

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Library of Congress Cataloging-in-Publication Data
Abel, Andrew B., 1952Macroeconomics / Andrew B. Abel, Ben S. Bernanke, Dean Croushore. -6th ed.
p. em. - (Addison-Wesley series in economics)
Includes bibliographical references and indexes.
ISBN 0-321-41554-X
1. Macroeconomics. 2. United States-Economic conditions. 1. Bernanke, Ben.
II. Dean Croll shore. III. Title.
HBl72.5.A24
339-dc22

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2006052451

Copyright © 2008 Pearson Education, Inc.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
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ISBN 13: 978-0-321-41554-7
ISBN 10: 0-321-41554-X

1 2 3 4 5 6 7 8 9 10-DOW-1O 09 08 07 06


o rs
Andrew B. AbeL

The Wharton
School of the
University of
Pennsylvania

Ronald A. Rosen­
feld Professor of
Finance a t The
Wharton School
and professor of economics at the Uni­
versity of Pennsylvania, Andrew Abel
received his A.B. summa cum laude from
Princeton University and his Ph.D.
from the Massachusetts Institute of
Technology.
He began his teaching career at the
University of Chicago and Harvard Uni­
versity, and has held visiting appoint­
ments at both Tel Aviv University and
The Hebrew University of Jerusalem.
A prolific researcher, Abel has pub­
lished extensively on fiscal policy, cap­
ital formation, monetary policy, asset

pricing, and Social Security-as well as
serving on the editorial boards of
numerous journals. He has been hon­
ored as an Alfred P. Sloan Fellow, a
Fellow of the Econometric Socie ty,
and a recipient of the John Kenneth
Galbraith Award for teaching excel­
lence. Abel has served as a visiting
scholar at the Federal Reserve Bank of
Philadelphia, as a member of the Panel
of Economic Advisers at the Congres­
sional Budget Office, and as a member
of the Technical Ad visory Panel on
Assumptions and Methods for the
Social Security Advisory Board. He is
also a Research Associa t e of the
National Bureau of Economic Research
and a member of the Advisory Board
of the Carnegie-Rochester Conference
Series.

Ben S.
Bernanke

Previously the
Howard Harrison
Gabrielle
and
Snyder Beck Pro­
fessor of Economics and Public Affairs at

Princeton University, Ben Bernanke
received his B.A. in economics from Har­
vard University sUlI1ma cllm laude-cap­
turing both the Allyn Young Prize for
best Harvard undergraduate economics
thesis and the John H. Williams prize for
outstanding senior in the economics
department. Like coauthor Abel, he
holds a PhD. from the Massachusetts
Institute of Technology.
Bernanke began his career a t the
Stanford Graduate School of Business
in 1979. In 1985 he moved to Princeton
University, where he served as chair of
the Economics Department from 1995
to 2002. He has twice been visiting pro­
fessor at M.I.T. and once at New York
University, and has taught in under­
graduate, M.B.A., M.P.A., and Ph.D.
programs. He has authored more than
60 publications in macroeconomics,
macroeconomic history, and finance.
Bernanke has served as a visiting
scholar and advisor to the Federal
Reserve System. He is a Guggenheim
Fellow and a Fellow of the Econometric
Society. He has also been variously hon­
ored as an Alfred P. Sloan Research
Fellow, a Hoover Institution National
Fellow, a National Science Foundation

Graduate Fellow, and a Research Asso­
ciate of the National Bureau of Economic
Research. He has served as editor of the
American Economic Review. In 2005 he
became Chairman of the President's
Council of Economic Advisors. He is
currently Chairman and a member of
the Board of Governors of the Federal
Reserve System.

Dean
Croushore

Robins School of
Business, University
ofRichmond
Dean Croushore is
associate professor
of economics and
Rigsby Fellow at
the University of Richmond . He
received his A.B. from Ohio University
and his PhD. from Ohio State University.
Croushore began his career at Penn­
sylvania State University in 1984. After
teaching for five years, he moved to the
Federal Reserve Bank of Philadel­
phia, where he was vice president and
economist. His duties during his four­
teen years a t the Philadelphia Fed

included heading the macroeconomics
section, briefing the bank's president
and board of directors on the state of the
economy and advising them about for­
mulating monetary policy, writing arti­
cles about the economy, administering
two national surveys of forecasters, and
researching current issues in monetary
policy. In his role a t the Fed, he crea ted
the Survey of Professional Forecasters
(taking over the defunct ASAjNBER
survey and revita lizing it) and devel­
oped the Real-Time Data Set for Macro­
economists.
Croushore returned to academia at
the University of Richmond in 2003.
The focus of his research in recent
years has been on forecasting and on
how data revisions affect monetary
policy, forecasting, and macroeconomic
research. Croushore's publications
include articles in many leading eco­
nomics journals and a textbook on
money and banking. He is associate
editor of several journals and visiting
scholar at the Federal Reserve Bank of
Philadelphia.

v

•

ne
Prelace

on en s

xv

Introduction 1

PART 1

1 Introduction to Macroeconomics 2
2

The Measurement and Structure of the National Economy

long-Run Economic Performance

PART 2

23

61

3 Productivity, Output, and Employment 62
4 Consumption, Saving, and Investment 110
5 Saving and Investment in the Open Economy 173

6

Long-Run Economic Growth 212

7 The Asset Market, Money, and Prices 247
PART 3

Business Cycles and Macroeconomic Policy 281

8 Business Cycles 282
9 The IS-LM/AO-AS Model: A General Framework
for Macroeconomic Analysis

310

10 Classical Business Cycle Analysis: Market-Clearing Macroeconomics 360
11

Keynesianism: The Macroeconomics of Wage and Price Rigidity

PART 4

Macroeconomic Policy: Its Environment
and Institutions 443

12 Unemployment and Inflation 444
13 Exchange Rates, Business Cycles, and Macroeconomic Policy
in the Open Economy

476

14 Monetary Policy and the Federal Reserve System 529
15 Government Spending and Its Financing 573
Appendix A:
Glossarv

617

Name Index
Subject Index
VI
•

Some Useful Analytical Tools 610

629
631

398


•

e al e
Preface

xv

on en s
2.2 Gross Domestic Product

27

The Product Approach to Measuring GOP 27

PART 1 Introduction 1

BOX 2.1

Natural Resources, the Environment,

and the National Income Accounts

CHAPTER 1

30

The Expenditure Approach to Measuring GOP 31

Introduction to Macroeconomics

2

1. 1 What Macroeconomics Is About

The Income Approach to Measuring GOP 34

2

2.3 Saving and Wealth

37

Long-Run Economic Growth 3

Measures of Aggregate Saving 37

Business Cycles 4

The Uses of Private Saving 39

Unemployment 5

Relating Saving and Wealth 40

Inflation 6

APPLICATION

The International Economy 8

46

Real GOP 46

10

Price Indexes 48

Macroeconomic Forecasting

Macroeconomic Analysis

12

Macroeconomic Research

13

BOX 2.2 The Computer Revolution

11

1.2 What Macroeconomists Do

BOX 1.1

42

2.4 Real GOP, Price Indexes, and Inflation

Macroeconomic Policy 9
Aggregation

Wealth Versus Saving

and Chain-Weighted GDP

11

BOX 2.3 Does CPI Inflation Overstate Increases in the

Cost of Living?

14

Data Development

14

1.3 Why Macroeconomists Disagree

Classicals Versus Keynesians

51

2.5 Interest Rates

Developing and Testing

an Economic Theory

48

52

Real Versus Nominal Interest Rates 53

15

16

PART 2

A Unified Approach to Macroeconomics 18

CHAPTER 2
The M easurement and Structure
of the National Economy 23
2.1 National Income Accounting:
The Measurement of Production,
Income, and Expenditure 23
In Touch with the Macroeconomy:

The National Income and Product Accounts 25

Long-Run Economic
Performance 61

CHAPTER 3
Productivity. Output. and Employment

62

3.1 How Much Does the Economy Produce?
The Production Function 63
APPLICATION

The Production Function of the U.S.

Economy and U.S. Productivity Growth

64

The Shape of the Production Function 66
Supply Shocks

71

Why the Three Approaches Are Equivalent 26

VII
• •


viii

Detailed Contents

72

3.2 The Demand for Labor

APPLICATION

Consumer Sentiment

The Marginal Product of Labor and
Labor Demand: An Example 73

and Forecasts of Consumer Spending

A Change in the Wage 75

Effect of Changes in the Real Interest Rate 119

The Marginal Product of Labor and the
Labor Demand Curve 75

Fiscal Policy

Factors That Shift the Labor Demand Curve 77

Interest Rates

Aggregate Labor Demand
3.3 The Supply of Labor

Effect of Changes in Wealth

79

118

121

I n Touch with the Macroeconomy:
APPLICATION

79

115

4.2 Investment

122
A Ricardian Tax Cut?

1 25

127

The Income-Leisure Trade-off 80

The Desired Ca pitaI Stock

Real Wages and Labor Supply 80

Changes in the Desired Capital Stock 130

The Labor Supply Curve 83

APPLICATION

Aggregate Labor Supply 84

of Taxes on Investment

APPLICATION

Comparing U.S. and European

Labor Markets

85

From the Desired Capital
Stock to Investment 135

3.4 Labor Market Equilibrium

87

BOX 4.1

APPLICATION

90

APPLICATION

91

3.5 Unemployment

Investment and the Stock Market

139

Macroeconomic Consequences of the

Boom and Bust in Stock Prices

144

Appendix 4.A A Formal Model
of Consumption and Saving 156

93

Measuring Unemployment 94
In Touch with the Macroeconomy:

Labor Market Data 95

CHAPTER 5

Changes in Employment Status 95
How Long Are People Unemployed? 96

Saving and Investment in
the Open Economy 173

Why There Always Are Unemployed People 97

5.1 Balance of Payments Accounting

174

3.6 Relating Output and Unemployment:
Okun's Law 99

The Current Account 174

Appendix 3.A

The Balance of Payments Accounts 176

of Okun's Law

In Touch with the Macroec o no my:

The Growth Rate Form

109

The Capital and Financial Account 177
The Relationship Between the Current Account
and the Capital and Financial Account 179

CHAPTER 4
Consumption. Saving. and Investment

1 38

The Saving-Investment Diagram 140

Technical Change and

Wage Inequality

1 34

4.3 Goods Market Equilibrium

Output, Employment, and

the Real Wage During Oil Price Shocks

Measuring the Effects

Investment in Inventories and Housing 137

Full-Employment Output 89
APPLICATION

127

110

4.1 Consumption and Saving 111

BOX 5.1

Does Mars Have a Current

Account Surplus?

181

Net Foreign Assets and the Balance
of Payments Accounts 181

The Consumption and Saving
Decision of an Individual 112

APPLICATION

Effect of Changes in Current Income 114

as International Debtor

Effect of Changes in Expected Future Income 114

The United States

183


IX

Detailed Contents

CHAPTER 7

5.2 Goods Market Equilibrium
in an Open Economy 184

The Asset M arket, Money, and Prices

5.3 Saving and Investment in a
Small Open Economy 185

7.1 What Is Money?

The Effects of Economic Shocks in
a Small Open Economy 189

BOX 7.1

APPLICATION

APPLICATION

191

193

196

The Monetary Aggregates

251

Where Have All the Dollars Gone?

252

7.2 Portfolio Allocation and
the Demand for Assets 253

The Critical Factor: The Response

of National Saving 200

Expected Return 254
Risk 254

The Government Budget Deficit
and National Saving 201
The Twin Deficits

248

In Touch with the Macroeconomy:

BOX 7.2

5.5 Fiscal Policy and the
Current Account 199

APPLICATION

Money in a Prisoner-of-War Camp

The Money Supply 251

Recent Trends in the U.S.

Current Account Deficit

247

Measuring Money: The Monetary Aggregates 250

The Impact of Globalization

on the U.S. Economy

2 47

The Functions of Money 248

5.4 Saving and Investment in
Large Open Economies

•

Liquidity 254
Time to Maturity 255

202

Asset Demands 256

CHAPTER 6
Long-Run Economic G rowth

7. 3 The Demand for Money

212

The Price Level

6.1 The Sources of Economic G rowth

213

Growth Accounting 215
APPLICATION

The Post-1973 Slowdown

in Productivity Growth
APPLICATION

220

The Money Demand Function 259
Elasticities of Money Demand 261
Financial Regulation, Innovation,

and the Instability of Money Demand

7.4 Asset Market Equilibrium

The Fundamental Determinants of
Long-Run Living Standards 231

264

266

Asset Market Equilibrium: An
Aggregation Assumption 266
236

Endogenous Growth Theory 238
6.3 Government Policies to Raise
Long-Run Living Standards 240

Policies to Affect the Saving Rate 240
Policies to Raise the Rate of
Productivity Growth 241

Interest Rates 258

APPLICATION

Setup of the Solow Model 224

The Growth of China

Real Income 257

Velocity and the Quantity Theory of Money 262

6.2 Growth Dynamics:
The Solow Model 223

APPLICATION

257

Other Factors Affecting Money Demand 260

217

The Recent Surge in U.S.

Productivity Growth

256

The Asset Market Equilibrium Condition 268
7,5 Money Growth and Inflation
APPLICATION

269

Money Growth and Inflation

in European Countries in Transition

270

The Expected Inflation Rate and the
Nominal Interest Rate 272
APPLICATION

Measuring Inflation Expectations

273

x

Detailed Contents

PART 3

Business Cycles and
Macroeconomic Policy

CHAPTER 8
Business Cycles

281

8.1 What Is a Business Cycle?

283

9.2 The IS Curve: Equilibrium
in the Goods Market 313

Factors That Shift the IS Curve

The Pre-World War I Period 285
The Great Depression and World War II 285
Post-World War II U.s. Business Cycles 287

290

Factors That Shift the LM Curve 321
9.4 General Equilibrium in the
Complete IS-LM Model 325

291

Applying the IS-LM Framework: A Temporary
Adverse Supply Shock 326

In Touch with the Macroeconomy:

292

APPLICATION

Expenditure 294

BOX 9.1

Employment and Unemployment 295

InternationaI Aspects of the Business Cycle 300

the Business Cycle

301

Aggregate Demand and Aggregate Supply:
A Brief Introduction 302

Econometric Models and Macroeconomic
329

The Effects of a Monetary Expansion 330

Financial Variables 299

The Seasonal Cycle and

328

9.5 Price Adjustment and the Attainment
of General Equilibrium 330

Money Growth and Inflation 298

BOX 8.1

Oil Price Shocks Revisited

Forecasts for Monetary Policy Analysis

Average Labor Productivity and the
Real Wage 297

8.4 Business Cycle Analysis: A Preview

9.3 The LM Curve: Asset
Market Equilibrium 317

The Equality of Money Demanded
and Money Supplied 318

The Cyclical Behavior of Economic
Variables: Direction and Timing 290

Leading Indicators

315

The Interest Rate and the Price
of a Nonmonetary Asset 318

288

Have American Business Cycles
Become Less Severe? 288

Production

310

Factors That Shift the FE Line 312

8.2 The American Business Cycle:
The Historical Record 285

8.3 Business Cycle Facts

Framework for Macroeconomic Analysis
9.1 The FE Line: Equilibrium
in the Labor Market 311

282

The "Long Boom"

CHAPTER 9
The IS-LM/AO-AS Model: A General

301

Classical Versus Keynesian Versions of
the IS-LM Model 334
9.6 Aggregate Demand and Aggregate Supply

336

The Aggregate Demand Curve 336
The Aggregate Supply Curve 338
Equilibrium in the AD-AS Model 341
Monetary Neutrality in the AD-AS Model 341
Appendix 9.A Worked-Out Numerical Exercise
for Solving the IS-LMIAD-AS Model 351
Appendix 9.B Algebraic Versions of the IS-LM
and AD-AS Models 353


Detailed Contents

CHAPTER 10

11.2 Price Stickiness

Classical Business Cycle Analysis:
Market-Clearing Macroeconomics

361

The Real Business Cycle Theory 361
APPLICATION

11.3 Monetary and Fiscal Policy in
the Keynesian Model 412

Monetary Policy 412

Calibrating the Business Cycle

364

Fiscal Policy Shocks in the Classical Model 371
Unemployment in the Classical Model 375
Household Prod uction 377
10.2 Money in the Classical Model

406

Sources of Price Stickiness: Monopolistic

Competition and Menu Costs 406

360

10.1 Business Cycles in the Classical Model

Fiscal Policy 416
11.4 The Keynesian Theory of Business Cycles
and Macroeconomic Stabilization 419

Keynesian Business Cycle Theory 419

378

Macroeconomic Stabilization 422

Monetary Policy and the Economy 378

APPLICATION

Monetary Nonneutrality and Reverse Causation 378

Supply Shocks in the Keynesian Model 427

The Nonneutrality of Money: Additional
Evidence 379

BOX 11.2

10.3 The Misperceptions Theory and

the Nonneutrality of Money 380

3B7

Appendix 10.A Worked-Out Numerical
Exercise for Solving the Classical AD-AS
Model with Misperceptions 395

DSGE Models and the

Classical-Keynesian Debate

429

Appendix 11.C The Multiplier
in the Keynesian Model 441

PART 4

Appendix 10.B An Algebraic Version
of the Classical AD-AS Model with
Misperceptions 396

Macroeconomic Policy:
Its Enviro
nt and
Institutions 443

CHAPTER 12

CHAPTER 11

Unemployment and Inflation

Keynesi a n i sm: The Macroeconomics
of Wage and Price Rigid ity 398
11.1 Real-Wage Rigidity

444

12.1 Unemployment and Inflation:
Is There a Trade-Off? 445

399

Some Reasons for Real-Wage Rigidity

424

Appendix 11.B Worked-Out Numerical
Exercise for Calculating the Multiplier in a
Keynesian Model 439

Rational Expectations and the Role
of Monetary Policy 385
Are Price Forecasts Rational?

The Zero Bound

Appendix 11.A Labor Contracts and

Nominal-Wage Rigidity 436

Monetary Policy and the
Misperceptions Theory 383

BOX 10.1

XI

The Expectations-Augmented Phillips Curve 447
399

The Shifting Phillips Curve 451

The Efficiency Wage Model 400

Macroeconomic Policy and the Phillips Curve 455

Wage Determination in the
Efficiency Wage Model 401

BOX 12.1

Efficiency Wages and the FE Line 404
Henry Ford's Efficiency Wage

456

The Long-Run Phillips Curve 457

Employment and Unemployment in
the Efficiency Wage Model 402
BOX 11.1

The Lucas Critique

405

•


xii

Detailed Contents

12. 2 The Problem of Unemployment

458

458

The Costs of Unemployment

A Fiscal Expansion 499

The Long-Term Behavior of the
Unemployment Rate 459
12.3 The Problem of Inflation

A Monetary Contraction 502

462

The Costs of Inflation 462
BOX 12.2

Indexed Contracts

464

The Sacrifice Ratio

468

CHAPTER 13
Exchange Rates, B usi ness Cycles,
and M acroeconomic Policy i n the
Open Economy 476
477

Nominal Exchange Rates 477
Real Exchange Rates 478
Appreciation and Depreciation 480
Purchasing Power Parity 480
BOX 13.1

McParity

481

The Real Exchange Rate and Net Exports 483

APPLICATION

The Value of the Dollar

and U.S. Net Exports

504

Monetary Policy and the Fixed Exchange Rate 508
Fixed Versus Flexible Exchange Rates 511

The U.s. Disinflation of the
1980s and 1990s 469

13.1 Exchange Rates

13. 5 Fixed Exchange Rates

Fixing the Exchange Rate 505

Fighting Inflation: The Role of
Inflationary Expectations 466
BOX 12.3

13. 4 Macroeconomic Policy in an Open Economy
with Flexible Exchange Rates 499

485

13.2 How Exchange Rates Are Determined:

A Supply-and-Demand Analysis 487
I n Touch with the Macroeconomy:

Currency Unions 511
APPLICATION

European Monetary Unification

APPLICATION

Crisis in Argentina

Appendix 13.B An Algebraic Version
of the Open-Economy IS-LM Model 526

CHAPTER 14
Monetary Policy and the
Federal Reserve System

529

14.1 Principles of Money Supply
Determination 530

The Money Supply in an All-Currency
Economy 530
The Money Supply Under Fractional
Reserve Banking 531
Bank Runs 534
The Money Supply with Both Public Holdings

of Currency and Fractional Reserve Banking 535
Open-Market Operations 537

Macroeconomic Determinants of the Exchange
Rate and Net Export Demand 489

APPLICATION

The Open-Economy IS Curve 493
Factors That Shift the Open-Economy
IS Curve 495
The International Transmission
of Business Cycles 498

515

Appendix 13.A Worked-Out Numerical
Exercise for the Open-Economy
IS-LM Model 523

Exchange Rates 487

13. 3 The IS-LM Model for an
Open Economy 492

512

The Money Multiplier

During the Great Depression

538

14.2 Monetary Control in the United States

541

The Federal Reserve System 541
The Federal Reserve's Balance Sheet
and Open-Market Operations 542
Other Means of Controlling the Money Supply 543
Intermediate Targets 547
Making Monetary Policy in Practice

550


Detailed Contents

14.3 The Conduct of Monetary Policy: Rules
Versus Discretion 552
BOX 14.1

The Credit Channel

of Monetary Policy
BOX 14.2

The Monetarist Case for Rules

555

Rules and Central Bank Credibility 557
APPLICATION

Money-Growth Targeting

and Inflation Targeting

563

Other Ways to Achieve Central Bank
Credibility 566

591

The Burden of the Government
Debt on Future Generations 594
Budget Deficits and National Saving: Ricardian
Equivalence Revisited 594
Departures from Ricardian Equivalence 597
15.4 Deficits and Inflation

5 98

The Deficit and the Money Supply 598
Real Seignorage Collection and Inflation 600

CHAPTER 15
Government Spending

and Its Financing 573
15. 1 The Government Budget:
Some Facts and Figures 573

Government Outlays 573
Taxes 575
Deficits and Surpluses 579
15.2 Government Spending, Taxes,
and the Macroeconomy 581

Fiscal Policy and Aggregate Demand 581

Appendix 15.A

Incentive Effects of Fiscal Policy 584
Labor Supply and Tax

Reform in the 1980s

586

The Debt-GOP Ratio

Appendix A

Some Useful Analytical Tools

610

A.l Functions and Graphs 610

A.2 Slopes of Functions 611
A.3 Elasticities 612
A.4 Functions of Several Variables 613
A.5 Shifts of a Curve 614
A.6 Exponents 614
A.7 Growth Rate Formulas 614
Problems 615

Government Capital Formation 583
APPLICATION

Social Security:

How Can It Be Fixed?
554

589

The Growth of the Government Debt 589
APPLICATION

553

The Taylor Rule

15.3 Government Deficits and Debt

Glossary

617

Name Index
Subject Index

629
631

609

XIII

•••


xiv

Detailed Contents

s

Key Diagrams

mary Tables

1 Measures of Aggregate Saving 38

1

2 Comparing the Benefits and Costs of Changing
the Amount of Labor 75

2 The labor market

3 Factors That Shift the Aggregate
Labor Demand Curve 79

Determinants of Desired Investment

137

7 Equivalent Measures of a Country's
International Trade and Lending 182
8 The Fundamental Determinants
of Long-Run Living Standards 232
9 Macroeconomic Determinants
of the Demand for Money 260
10 The Cyclical Behavior of Key Macroeconomic
Variables (The Business Cycle Facts) 293
Factors That Shift the
Full-Employment (FE) Line 312

12 Factors That Shift the IS Curve 315
13 Factors That Shift the LM Curve 321
14 Factors That Shift the AD Curve

340

15 Terminology for Changes
in Exchange Rates 480
16

Determinants of the Exchange Rate
(Real or Nominal) 491

17 Determinants of Net Exports 492
18 International Factors
That Shift the IS Curve 498
19

3 The saving-investment diagram 149

5 National saving and investment
in large open economies 206

5 Determinants of Desired National Saving 125

11

103

4 National saving and investment
in a small open economy 205

4 Factors That Shift the Aggregate
Labor Supply Curve 85
6

The production function 102

Factors Affecting the Monetary Base, the Money

Multiplier, and the Money Supply 545

6 The IS-LM model 345
7 The aggregate demand-aggregate
supply model 346
8 The misperceptions version
of the AD-AS model 389


re ace
ince February 2006, Ben Bernanke has been chairman of the Board of Governors
of the Federal Reserve System. Federal ethics rules prohibited him from making
substantive contributions to the sixth edition. Dean Croushore, associate pro­
fessor of economics and Rigsby Fellow at the University of Richmond, has helped
prepare this new edition as a coauthor. Dean has been closely associated with Macro­
economics since the first edition, having written or co-written the Instructor's Manual
and Test Bank for the first through fifth editions, the Study Guide for the third through
fifth editions, and having assisted with manuscript preparation in previous editions,
taking a major role in the fifth edition. Dean has been able to draw on his fourteen
years of experience at the Federal Reserve Bank of Philadelphia, twelve of which as
head of the Macroeconomics Section, as well as his teaching experience at Penn State
University, Temple University, the Wharton School of the University of Pennsylvania,
Johns Hopkins University, Princeton University, and the University of Richmond, to
help keep the book fresh, applied to real-world economic developments, and
appealing to students.
In the sixth edition, we have added new material to keep the text up-to-date,
while building on the strengths that underlie the book's lasting appeal to instruc­
tors and students, including:

Real-world applications. A perennial challenge for instructors is to help stu­

dents make active use of the economic ideas developed in the text. The rich
variety of applications in this book shows by example how economic concepts
can be put to work in explaining real-world issues such as the contrasting
behavior of unemployment in the United States and Europe, the slowdown
and revival in productivity growth, the challenges facing the Social Security
system and the Federal budget, the impact of globalization on the u.s. economy,
and alternative approaches to making monetary policy. The sixth edition offers
new applications as well as updates of the best applications and analyses of
previous editions.
Broad modern coverage. From its conception, Macroeconomics has responded to
students' desires to investigate and understand a wider range of macroeconomic
issues than is permitted by the course's traditional emphasis on short-run fluc­
tuations and stabilization policy. This book provides a modern treatment of these
traditional topics but also gives in-depth coverage of other important macro­
economic issues such as the determinants of long-run economic growth, the
trade balance and financial flows, labor markets, and the institutional framework
of policymaking. This comprehensive coverage also makes the book a useful tool
for instructors with differing views about course coverage and topic sequence.
Reliance on a set of core economic ideas. Although we cover a wide range of topics,
we avoid developing a new model or theory for each issue. Instead we empha­
size the broad applicability of a set of core economic ideas (such as the produc­
tion function, the trade-off between consuming today and saving for tomorrow,
and supply-demand analysis). Using these core ideas, we build a theoretical

xv


xvi

Preface

framework that encompasses all the macroeconomic analyses presented in the
book: long-run and short-run, open-economy and closed-economy, and classi­
cal and Keynesian.
A balanced presentation. Macroeconomics is full of controversies, many of which
arise from the split between classicals and Keynesians (of the old, new, and
neo-varieties). Sometimes the controversies overshadow the broad common
ground shared by the two schools. We emphasize that common ground. First,
we pay greater attention to long-run issues (on which classicals and Keynesians
have less disagreement). Second, we develop the classical and Keynesian
analyses of short-run fluctuations within a single overall framework, in which
we show that the two approaches differ principally in their assumptions about
how quickly wages and prices adjust. Where differences in viewpoint
remain for example, in the search versus efficiency-wage interpretations of
unemployment we present and critique both perspectives. This balanced
approach exposes students to all the best ideas in modern macroeconomics. At
the same time, an instructor of either classical or Keynesian inclination can
easily base a course on this book.
Innovative pedagogy. The sixth edition, like its predecessors, provides a variety
of useful tools to help students study, understand, and retain the material.
Described in more detail later in the preface, these tools include summary
tables, key diagrams, key terms, and key equations to aid students in organiz­
ing their study, and four types of questions and problems for practice and
developing understanding, including problems that encourage students to do
their own empirical work, using data readily available on the Internet. Several
appendices illustrate how to solve numerical exercises that are based on the
algebraic descriptions of the IS-LM/AS-AD model.
N ew a n d U p d ated C o v e ra g e

What is taught in intermediate macroeconomics courses and how it is taught­

has changed substantially in recent years. Previous editions of Macroeconomics
played a major role in these developments. The sixth edition provides lively cov­
erage of a broad spectrum of macroeconomic issues and ideas, including a variety
of new and updated topics:

Long-term economic growth. Because the rate of economic growth plays a central
role in determining living standards, we devote much of Part 2 to growth and
related issues. We first discuss factors contributing to growth, such as produc­
tivity (Chapter 3) and rates of saving and investment (Chapter 4); then in
Chapter 6 we turn to a full-fledged analysis of the growth process, using tools
such as growth accounting and the Solow model. Growth-related topics covered
include the post-1973 productivity slowdown, the factors that determine long­
run living standards, and the productivity "miracle" of the 1990s. New to this edition:
The text now includes a discussion of the recent growth of China's economy.
International macroeconomic issues. We address the increasing integration of the
world economy in two ways. First, we frequently use cross-country compar­
isons and applications that draw on the experiences of nations other than
the United States. For example, in Chapter 3, we compare U.s. and European
labor markets; in Chapter 6 we compare the long-term economic growth rates


U

•

Ion


CHAPTER

•

n ro u c I o n

•

acroeco n o m l cs

1.1

What Macroeconomics Is About
Macroeconomics is the study of the structure and performance of national

economies and of the policies that governments use to try to affect economic per­
formance. The issues that macroeconomists address include the following:

What determines a nation 's long-run economic growth? In 1870, income per capita
was smaller in Norway than in Argentina. But today, income per capita is
about three times as high in Norway as in Argentina. Why do some nations'
economies grow quickly, providing their citizens with rapidly improving living
standards, while other nations' economies are relatively stagnant?
What causes a nation's economic activity to fluctuate? After nearly a decade of pros­
perity during the 1980s, the U.s. economy began to falter in 1990. By the spring
of 1991, output in the United States had fallen by more than 1.5% from its level
nine months earlier. Economic growth was slow for a few more years before
rising sharply in 1994. But then, for the remainder of the 1990s, the U.s. econo­
my grew rapidly. Why do economies sometimes experience sharp short-run
fluctuations, lurching between periods of prosperity and periods of hard times?
What causes unemployment? During the 1930s, one-quarter of the work force in
the United States was unemployed. A decade later, during World War II, less

than 2% of the work force was unemployed. Why does unemployment some­
times reach very high levels? Why, even during times of relative prosperity, is
a significant fraction of the work force unemployed?
What causes prices to rise? The rate of inflation in the United States crept steadi­
ly upward during the 1970s, and exceeded 10% per year in the early 1980s,
before dropping to less than 4% per year in the mid 1980s and dropping even
further to less than 2% per year in the late 1990s. Germany's inflation experi­
ence has been much more extreme: Although Germany has earned a reputation
for low inflation in recent decades, following its defeat in World War I Germany
experienced an eighteen-month period (July 1922-December 1923) during
which prices rose by a factor of several billion! What causes inflation and what
can be done about it?

2


1.1

What Macroeconomics Is About

3

How does being part of a global economic system affect nations' economies? In the late
1990s, the U.s. economy was the engine of worldwide economic growth. The
wealth gained by Americans in the stock market led them to increase their
spending on consumer goods, including products made abroad, spurring
greater economic activity in many countries. How do economic links among
nations, such as international trade and borrowing, affect the performance of
individual economies and the world economy as a whole?
Can government policies be used to improve a nation's economic performance? In the

1980s and 1990s, the U.s. economy's output, unemployment rate, and inflation
rate fluctuated much less than they did in the 1960s and 1970s. Some econo­
mists credit good goverrunent policy for the improvement in economic per­
formance. How should economic policy be conducted so as to keep the
economy as prosperous and stable as possible?
Macroeconomics seeks to offer answers to such questions, which are of great
practical importance and are constantly debated by politicians, the press, and the
public. In the rest of this section, we consider these key macroeconomic issues in
more detail.
l o n g - R u n E c o n o m i c G rowth

If you have ever traveled in a developing country, you could not help but observe
the difference in living standards relative to those of countries such as the United
States. The problems of inadequate food, shelter, and health care experienced by the
poorest citizens of rich nations often represent the average situation for the people
of a developing country. From a macroeconomic perspective, the difference between
rich nations and developing nations may be summarized by saying that rich nations
have at some point in their history experienced extended periods of rapid economic
growth but that the poorer nations either have never experienced sustained growth
or have had periods of growth offset by periods of economic decline.
Figure 1.1 summarizes the growth in output of the U.s. economy since 1869.1 The
record is an impressive one: Over the past century and a third, the annual output of
U.s. goods and services has increased by more than 100 times. The performance of the
u.s. economy is not unique, however; other industrial nations have had similar, and
in some cases higher, rates of growth over the same period of time. This massive
increase in the output of industrial economies is one of the central facts of modern his­
tory and has had enormous political, military, social, and even cultural implications.
In part, the long-term growth of the U.s. economy is the result of a rising pop­
ulation, which has meant a steady increase in the number of available workers. But
another significant factor is the increase in the amount of output that can be pro­

duced with a given amount of labor. The amount of output produced per unit of
labor input for example, per worker or per hour of work is called average labor
productivity. Figure 1 .2 shows how average labor productivity, defined in this
case as output per employed worker, has changed since 1900. In 2005, the average
U.s. worker produced more than six times as much output as the average worker
'Output is measured in Fig. 1.1 by two very similar concepts, real gross national product (real GNP)
until 1929 and real gross domestic product (real GOP) since 1929, both of which measure the physical
volume of production in each year. We discuss the measurement of output in detail in Chapter 2.


4

Chapter 1

Figure

1.1

Introduction to Macroeconomics

Output of the U.S.
economy, 1869-2005

In this graph the output
of the U.s. economy is
measured by real gross
domestic product (real
GOP) for the period
1929-2005 and by real
gross national product

(real GNP) for the period
prior to 1929, with goods
and services valued at
their 2000 prices in both
cases (see Chapter 2).
Note the strong upward
trend in output over
time, as well as sharp
fluctuations during
the Great Depression
(1929-1940), World War II
(1941-1945), and the
recessions of 1973-1975,
1981-1982, 1990-1991,
and 200l.
Sources: Real GNP ]869-1928
from Christina D. Romer,
"The Prewar Business Cycle
Reconsidered : New Estimates
of Gross National Product,
1869-1908," Jotlmal of Political
Economy, 97, 1 (February 1989),
pp. 22-23; real CDP 1929-2005
from FRED database, Federal
Reserve Bank of St. Louis,

resenrell.sflOllisfcd. orglfred2/seriesl
COpeA.

Data from Romer

were rescaled to 2000 prices.

-

;::I... tI'I
1
2
...
..!S
::1 o 0
_ "e
� g 10
O:: iil
-

�

o
-

2001

recess I O n
•

\

1990-1991
•

recession

8

.�

1981-1 982

.�

•

recesSIOn

.:::

- 6

1973-1975

recess ion
4

Great Depressi on Wor l d War II
(1929-1 940)

2

�

Wor ld War I

\

(1917-1918)

(1 941-1 945)

\

\

\

\

REA L

OUTPUT

��
8�7 0 1 880 1 890 1 900 1 9 1 0 1 920 1 930 1 940 1 950 1 960 1 970 1 980 1 990 2000 2005
Year

at the beginning of the twentieth century, despite working fewer hours over the
course of the year. Because today's typical worker is so much more productive,
Americans enjoy a significantly higher standard of living than would have been
possible a century ago.
Although the long-term record of productivity growth in the U.s. economy is
excellent, productivity growth slowed from the early 1970s to the mid-1990s and

only recently has picked up. Output per worker grew about 2.5% per year from
1949 to 1973, but only 1.1 % per year from 1973 to 1995. More recently, from 1995 to
2005, output per worker has increased 2.0% per year, a pace that has improved the
health of the U.s. economy significantly.
Because the rates of growth of output and, particularly, of output per worker
ultimately determine whether a nation will be rich or poor, understanding what
determines growth is one of the most important goals of macroeconomics. Unfor­
tunately, explaining why economies grow is not easy. Why, for example, did
resource-poor Japan and Korea experience growth rates that transformed them in a
generation or two from war-torn nations into industrial powers, whereas several
resource-rich nations of Latin America have had erratic or even negative growth in
recent years? Although macroeconomists have nothing close to a complete answer
to the question of what determines rates of economic growth, they do have some
ideas to offer. For example, as we discuss in some detail in this book, most macro­
economists believe that rates of saving and investment are important for growth.
Another key determinant of growth we discuss is the rate at which technological
change and other factors help increase the productivity of machines and workers.
B usi n e s s Cyc l es

If you look at the history of U.s. output in Fig. 1 .1, you will notice that the growth
of output isn't always smooth but has hills and valleys. Most striking is the period
between 1929 and 1945, which spans the Great Depression and World War II.
During the 1929-1933 economic collapse that marked the first major phase of the


1.1

Figure

What Macroeconomics Is About

5

1 .2

Average labor
productivity in the
United States,

1900-2005
Average labor produc­
tivity (output per
employed worker) has
risen over time, with a
peak during World War II
reflecting increased
wartime production.
Productivity growth was
particularly strong in the
19505 and 19605, slowed
in the 19705, and picked
up again in the mid
19905. For the calculation
of productivity, output is
measured as in Fig. l.l.

� -

� � 90
� �

0� .g 80
",, 0
" 0
>' 0
O N

-

0. 0
= '"
�

Q.I
"'C
� "
" ..
0. ",

70

-= g 5 0
o. ..c:
,,

Wor ld Wa r II

-

o

-..
"

�

\
Mi d

60

40

Great
Depression

30

\

�

10
O L- �
1 900 1 9 1 0
__

\

1 970s
prod uct ivity

l owd own
s
1 950s-1960s
prod uct ivity
spee d up

AV ERAGE LA BO R
PR O D UCT IVITY
�

__

L-

__
__

1 920

1 930

-L

__

�

__

1 940

L-

__
__

1 950

-1990s
prod uct ivity
speed up

-L

__

1 960

�
__

__

1 970

�

__

1 980

-L
�

__

1 990

___

2000 2005
Year

Sources: Employment in
thousands of workers 14 and
older for 1 900-1947 from

Historical Stntistics of the Ullited
States, Colollial Times to 1970,
pp. 126�127; workers 16 and
older for 1948-2005 from
FRED database, Federal
Reserve Bank of St. Louis,

research.stlouisfed.orglfred/ series/
CE160V. Average labor pro­
ductivity is output divided by
employment, where output is
from Fig. 1.1.

Great Depression, the output of the U.s. economy fell by nearly 30%. Over the
period 1939-1944, as the United States entered World War II and expanded pro­
duction of armaments, output nearly doubled. No fluctuations in U.s. output since
1945 have been as severe as those of the 1929-1945 period. However, during the
postwar era there have been periods of unusually rapid economic growth, such as
during the 1960s and 1990s, and times during which output actually declined from
one year to the next, as in 1973-1975, 1981-1982, and 1990-199l.
Macroeconomists use the term business cycle to describe short-run, but some­
times sharp, contractions and expansions in economic activity. 2 The downward
phase of a business cycle, during which national output may be falling or perhaps
growing only very slowly, is called a recession. Even when they are relatively mild,
recessions mean hard economic times for many people. Recessions are also a major
political concern, because almost every politician wants to be reelected and the
chances of reelection are better if the nation's economy is expanding rather than
declining. Macroeconomists put a lot of effort into trying to figure out what causes
business cycles and deciding what can or should be done about them. In this book
we describe a variety of features of business cycles, compare alternative explana­
tions for cyclical fluctuations, and evaluate the policy options that are available for
affecting the course of the cycle.
U n e m p l oy m e nt

One important aspect of recessions is that they usually are accompanied by an
increase in unemployment, or the nwnber of people who are available for work and
are actively seeking work but cannot find jobs. Along with growth and business
cycles, the problem of unemployment is a third major issue in macroeconomics.
2A more exact definition is given in Chapter 8. Business cycles do not inc1ude fluctuations lasting only
a few months, such as the increase in activity that occurs around Christmas.


6

Chapter 1

Figure

1 .3

Introduction to Macroeconomics

The U.S.
unemployment rate,

1890-2005
The figure shows the
percentage of the civilian
labor force (excluding
people in the military)
that was unemployed in
each year since 1890.
Unemployment peaked
during the depression of
the 18905 and the Great
Depression of the 1930s,
and reached low points
in 1920 and during
World War II. Since
World War II, the highest
unemployment rates
occurred during the
1973-1975 and 1981-1982

receSSIOns.
.

-

".. ..v 30
C;
E
>,­
o 0�
Q. .<>
E
.. � 25
-

_

" "
..
::J ;.:
••

>
••

v

-o 20
"
..

�
..
.9< 1 5

Stntistics of the Ullited Stntes,
Colol1ial Times to 1 970,
p. 135; for 1945--2()()S from FRED
database Federal Reserve Bank
of St. Louis, research.stlouisfed.

orglfred2/series/UNRATE.

/
1 890s
d epress i on

U N EMPLO YME N T
RATE

-

1 990-1991
1 981-1982
recession
1 973-1975
recession
War II
\
•

•

10

2001

5
O L- � -L
1 890 1 900 1 9 1 0
__

__

�

__

L-

__
__

�

__

-L

__

1920 1930 1 940

�

__

1950

L-

__
__

-L

__

-L

__

�
__
L-

__

_

1960 1 970 1 980 1 990 2000 2005

Year

Sources: Civilian
unemployment rate (people
aged 14 and older until 1 947,
aged 16 and older after 1947)
for 1 890-1947 from Historical

Great
Depress i on

The best-known measure of unemployment is the unemployment rate, which
is the number of unemployed divided by the total labor force (the number of
people either working or seeking work). Figure 1.3 shows the unemployment rate
in the United States over the past century. The highest and most prolonged period
of unemployment occurred during the Great Depression of the 1930s. In 1933, the
unemployment rate was 24.9%, indicating that about one of every four potential
workers was unable to find a job. In contrast, the tremendous increase in economic
activity that occurred during World War II significantly reduced unemployment. In
1944, at the peak of the wartime boom, the unemployment rate was 1.2%.
Recessions have led to significant increases in unemployment in the postwar
period. For example, during the 1981-1982 recession the U.s. unemployment rate
reached 10.8% 3 Even during periods of economic expansion, however, the unem­
ployment rate remains well above zero, as you can see from Fig. 1 .3. In 2000, after
nine years of economic growth with no recession, the unemployment rate was still
about 4%. Why the unemployment rate can remain fairly high even when the econ­
omy as a whole is doing well is another important question in macroeconomics.
I nf l a t i o n

When the prices of most goods and services are rising over time, the economy is

said to be experiencing inflation. Figure 1.4 shows a measure of the average level
3The unemployment rate was 10.8% in November and December 1982. The unemployment rate plotted
in Fig. 1.3 is not this high because the graph only shows annual data-the average unemployment
rate over the 12 months of each year-which was 9.7% in 1982.


Wh at M acroeconom i cs I s A b out

1.1

Figure

7

1 .4

Consumer prices in
the United States,

g
250
"'

1800-2005

.;:

Prior to World War II, the
average level of prices
faced by consumers

remained relatively flat,
with periods of inflation
(rising prices ) offset by
periods of deflation
(falling prices). Since
World War II, however,
prices have risen more
than tenfold. In the
figure, the average level
of prices is measured by
the consumer price index,
or CPJ (see Chapter 2).
The cpr measures the
cost of a fixed set, or
basket, of consumer
goods and services rela­
tive to the cost of the
same goods and services
in a base period-in this
case, 1982-1984. Thus a
cpr of 195.30 in 2005
means that a basket of
consumer goods and
services that cost $100 in
1982-1984 would cost
$195.30 in 2005.
Sources: Consumer price index,
1800-1946 (1967

=

100) from

Historical Statistics of the Ullited
States, Colollial Times to 1970,
pp. 210-211; 1947-2005
(1982-1984 100) from FRED
database, Federal Reserve
Bank of St. Louis, researc1l.
=

t1011isfed.orglfred21series!
CPIAUCSL. Data prior to 1971

5

were rescaled to a base with
1982-1984 100.
=

�

c ....

-

CON SUMER
PRICE I NDEX

.- II

00

� � 200 I
�

s g;
= 0
:a
1 50 o
U

1 00 50 o

1 800

War of 1 8 1 2
inf lati on
( 1 8 1 2-1814)
Postwar
d efl at i on
I

/

I

1 820

I

1 840

Post-Wor ld
War II
in fl at i on
Def lat i on
Worl d War I of Great
Ci vi l War
i n flat i on
i nf lat i on
Depressi on
( 1 861-1 865 ) ( 1 9 1 7-1 9 1 8) ( 1 929-1933)
Postwar
d ef lati on
/

/

1 860

I

1 880

1 900

I

1920

I

I

1940

I

I

1 960

I

I

I

I I

1980 2000 2005

Year

of prices faced by consumers in the United States over the past two centuries.4 Note
that prior to World War II inflation usually occurred only during wartime, such as
during the War of 1812, the Civil War, and World War 1. These wartime periods of
inflation were followed by periods of deflation, during which the prices of most

goods and services fell. The result of these offsetting periods of inflation and defla­
tion was that, over the long run, the level of prices was fairly constant. For exam­
ple, prices at the end of World War I (1918) stood at about the same level as in 1800,
more than a century earlier.
The last significant deflation in the United States occurred during 1929-1933,
the initial phase of the Great Depression. Since then, inflation, without offsetting
deflation, has become the normal state of affairs, although inflation was fairly low
in the 1990s and early 2000s. Figure 1 .4 shows that consumer prices have risen sig­
nificantly since World War II, with the measure of prices shown increasing tenfold.
The percentage increase in the average level of prices over a year is called the
inflation rate. If the inflation rate in consumer prices is 10%, for example, then on
average the prices of items that consumers buy are rising by 10% per year. Rates of
inflation may vary dramatically both over time and by country, from 1 or 2 percent
per year in low-inflation countries (such as Switzerland) to 1000% per year or more
in countries (such as a number of the former Soviet republics in the early 1990s) that
are experiencing hyperinflations, or extreme inflations. When the inflation rate
reaches an extremely high level, with prices changing daily or hourly, the economy
tends to function poorly. High inflation also means that the purchasing power of
money erodes quickly. This situation forces people to scramble to spend their money
almost as soon as they receive it.
4This measure is called the consumer price index, or CPT, which is discussed in Chapter 2. Conceptu­
ally, the CPI is intended to measure the cost of buying a certain fixed set, or "basket," of consumer
goods and services. However, the construction of a consumer price index over a period as long as two
centuries involves many compromises. For instance, the basket of goods and services priced by the
CPT is not literally the same over the entire period shown in Fig. 1.4 but is periodically changed to
reflect the different mix of consumer goods and services available at different times.


8

Chapter 1

Introduction to Macroeconomics

T h e Int e rna t i ona l E c o n o m y

Today every major economy is an open economy, or one that has extensive trading
and financial relationships with other national economies. (In contrast, a closed
economy doesn't interact economically with the rest of the world.) Macroecono­
mists study patterns of international trade and borrowing to understand better the
links among national economies. For example, an important topic in macroeco­
nomics is how international trade and borrowing relationships can help transmit
business cycles from country to country.
Another issue for which international considerations are central is trade imbal­
ances. Figure 1.5 shows the historical behavior of the imports and exports of goods
and services by the United States. U.s. imports are goods and services produced
abroad and purchased by people in the United States; U.s. exports are goods and
services produced in the United States and sold to people in other countries. To
give you a sense of the relative importance of international trade, Fig. 1.5 expresses
exports and imports as percentages of total U.s. output. Currently, both exports and
imports are larger fractions of U.s. output than they were during the 1950s and

Figure

1.5

U.S. exports and
imports, 1869-2005

The figure shows U.s.

exports (black) and U.S.
imports (red), each
expressed as a percent­
age of total output.
Exports and imports
need not be equa I in each
year: U.s. exports
exceeded imports
(shaded gray) during
much of the twentieth
century. During the
1980s, 19905 and early
20005, however, U.s.
exports were smaller
than U.s. imports
(shaded red).
Sources: Imports and exports of
goods and services: 1869-1959
from Historical Statistics of tfle

United States, Colonial Times
to 1970. pp. 864-865;

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Wor ld War I

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14

Wor ld War II

13
12
11
10

EXP O RTS

9
8
7
6

IMP O RTS

5

1960-2005 from FRED
database, Federal Reserve
Bank of St. Louis, researclJ.

4

and BOPM; output is from
Fig. 1 . 1 .

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of t h e 1 9805, 1 9905,
an d early 20005

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Year


1.1

What Macroeconomics Is About

9

1960s, reflecting both the recovery of trade from the disruptions of the Great
Depression and World War II and the trend toward greater economic interdepen­
dence among nations. Note, though, that a century ago exports and imports

already were important relative to the size of the overall economy.
Figure 1 .5 demonstrates that exports and imports need not be equal in each
year. For example, following World War I and World War II, U.s. exports out­
stripped U.s. imports because the country was sending large quantities of supplies
to countries whose economies had been damaged by war. When exports exceed
imports, a trade surplus exists. In the 1980s, however, U.s. exports declined sharply
relative to imports, a situation that has persisted through the 1990s and into the
2000s, as you can see from Fig. 1.5. This recent excess of imports over exports, or
trade deficit, has received considerable attention from policymakers and the news
media. What causes these trade imbalances? Are they bad for the U.s. economy or
for the economies of this country's trading partners? These are among the ques­
tions that macroeconomists try to answer.
M a cr o e c o n o m i c P o l i cy

A nation's economic performance depends on many factors, including its natural
and human resources, its capital stock (buildings, machines, and software), its
technology, and the economic choices made by its citizens, both individually and
collectively. Another extremely important factor affecting economic performance is
the set of macroeconomic policies pursued by the government.
Macroeconomic policies affect the performance of the economy as a whole. The
two major types of macroeconomic policies are fiscal policy and monetary policy.
Fiscal policy, which is determined at the national, state, and local levels, concerns
government spending and taxation. Monetary policy determines the rate of
growth of the nation's money supply and is under the control of a government
institution known as the central bank. In the United States, the central bank is the
Federal Reserve System, or the Fed.
One of the main macroeconomic policy issues of recent years in the United
States has been in the realm of fiscal policy. Large Federal budget surpluses
emerged in the late 1990s, but these gave way to large Federal budget deficits,
exceeding $300 billion each year from 2003 to 2005. The recent behavior of the

Federal budget is put into a long-term perspective in Fig. 1 .6, which presents data
on Federal government spending and tax revenues for the past century and a
third 5 Again, so that their importance relative to the economy as a whole is indi­
cated, spending, tax collections, and government budget deficits and surpluses
are expressed as percentages of total output.
Two obvious features of Fig. 1.6 are the peaks in government spending and
deficits that resulted from military buildups in World War I and World War II. At
its high point during World War II, Federal government spending exceeded 43%
of total output. Significant deficits also occurred during the Great Depression of
the 1930s because the government increased its spending on various programs
designed to help the economy, such as government-financed jobs programs.
SGovernment spending includes both government purchases of goods and services, such as purchases
of military equipment and the salaries of government officials, and government benefits paid to indi­
viduals, such as Social Security payments.