Macroeconomics, 4th edition

Macroeconomics


This page intentionally left blank


Macroeconomics
Fourth Edition

R. Glenn Hubbard
Columbia University

Anthony Patrick O’Brien
Lehigh University

Boston Columbus Indianapolis New York San Francisco Upper Saddle River
Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montréal Toronto
Delhi Mexico City São Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo


Editorial Director: Sally Yagan
Editor in Chief: Donna Battista
AVP/Executive Editor: David Alexander
VP/Development Director: Stephen Deitmer
Executive Development Editor:
Lena Buonanno
Editorial Project Manager: Lindsey Sloan
Editorial Assistant: Emily Brodeur
Marketing Director: Patrice Jones
AVP/Executive Marketing Manager:

Lori DeShazo
Marketing Assistant: Courtney Kamauf
Senior Managing Editor: Nancy H. Fenton
Production Project Manager:
Carla Thompson
Manufacturing Director: Evelyn Beaton
Senior Manufacturing Buyer: Carol Melville
Senior Media Buyer: Ginny Michaud

Creative Director: Christy Mahon
Senior Art Director, Cover: Jonathan Boylan
Image Manager: Rachel Youdelman
Text Permissions Project Supervisor:
Michael Joyce
Media Director: Susan Schoenberg
Content Lead, MyEconLab: Noel Lotz
Senior Media Producer:
Melissa Honig
Associate Production Project Manager:
Alison Eusden
Full-Service Project Management/Interior
Design/Photo Research/Composition:
PreMediaGlobal, Inc.
Printer/Binder: Courier, Kendallville
Cover Printer: Courier, Kendallville
Text Font: Minion

Credits and acknowledgments borrowed from other sources and reproduced, with
permission, in this textbook appear on appropriate page within text (or on page C-1).
Microsoft® and Windows® are registered trademarks of the Microsoft Corporation in

the U.S.A. and other countries. Screen shots and icons reprinted with permission from the
Microsoft Corporation. This book is not sponsored or endorsed by or affiliated with the
Microsoft Corporation.
Copyright © 2013, 2010, 2009, 2008, 2006 Pearson Education, Inc. All rights reserved.
Manufactured in the United States of America. This publication is protected by Copyright, and
permission should be obtained from the publisher prior to any prohibited reproduction, storage
in a retrieval system, or transmission in any form or by any means, electronic, mechanical,
photocopying, recording, or likewise. To obtain permission(s) to use material from this work,
please submit a written request to Pearson Education, Inc., Permissions Department, One Lake
Street, Upper Saddle River, New Jersey 07458, or you may fax your request to 201-236-3290.
Many of the designations by manufacturers and sellers to distinguish their products are claimed
as trademarks. Where those designations appear in this book, and the publisher was aware of a
trademark claim, the designations have been printed in initial caps or all caps.
Cataloging-in-Publication Data is on file at the Library of Congress

10 9 8 7 6 5 4 3 2 1

ISBN 13: 978-0-13-283220-5
ISBN 10: 0-13-283220-8


For Constance, Raph, and Will
—R. Glenn Hubbard

For Cindy, Matthew, Andrew, and Daniel
—Anthony Patrick O’Brien


This page intentionally left blank

ABOUT THE
AUTHORS
Glenn Hubbard, policymaker, professor, and
researcher. R. Glenn Hubbard is the dean and Russell L.
Carson Professor of Finance and Economics in the Graduate
School of Business at Columbia University and professor of
economics in Columbia’s Faculty of Arts and Sciences. He is also
a research associate of the National Bureau of Economic Research
and a director of Automatic Data Processing, Black Rock
Closed-End Funds, KKR Financial Corporation, and MetLife.
He received his Ph.D. in economics from Harvard University in
1983. From 2001 to 2003, he served as chairman of the White
House Council of Economic Advisers and chairman of the OECD Economy Policy
Committee, and from 1991 to 1993, he was deputy assistant secretary of the U.S. Treasury
Department. He currently serves as co-chair of the nonpartisan Committee on Capital
Markets Regulation. Hubbard’s fields of specialization are public economics, financial
markets and institutions, corporate finance, macroeconomics, industrial organization,
and public policy. He is the author of more than 100 articles in leading journals, including
American Economic Review, Brookings Papers on Economic Activity, Journal of Finance,
Journal of Financial Economics, Journal of Money, Credit, and Banking, Journal of Political
Economy, Journal of Public Economics, Quarterly Journal of Economics, RAND Journal of
Economics, and Review of Economics and Statistics. His research has been supported by
grants from the National Science Foundation, the National Bureau of Economic Research,
and numerous private foundations.

Tony O’Brien, award-winning professor and
researcher. Anthony Patrick O’Brien is a professor of
economics at Lehigh University. He received his Ph.D. from the
University of California, Berkeley, in 1987. He has taught principles

of economics for more than 15 years, in both large sections and
small honors classes. He received the Lehigh University Award
for Distinguished Teaching. He was formerly the director of the
Diamond Center for Economic Education and was named a Dana
Foundation Faculty Fellow and Lehigh Class of 1961 Professor of
Economics. He has been a visiting professor at the University of
California, Santa Barbara, and the Graduate School of Industrial Administration at Carnegie
Mellon University. O’Brien’s research has dealt with such issues as the evolution of the U.S.
automobile industry, sources of U.S. economic competitiveness, the development of U.S.
trade policy, the causes of the Great Depression, and the causes of black-white income
differences. His research has been published in leading journals, including American
Economic Review, Quarterly Journal of Economics, Journal of Money, Credit, and Banking,
Industrial Relations, Journal of Economic History, and Explorations in Economic History. His
research has been supported by grants from government agencies and private foundations.
In addition to teaching and writing, O’Brien also serves on the editorial board of the Journal
of Socio-Economics.

vii


BRIEF
CONTENTS
Preface
A Word of Thanks

xxi
xlvii

PART 1: Introduction
Chapter 1: Economics: Foundations and Models

Appendix: Using Graphs and Formulas
Chapter 2: Trade-offs, Comparative Advantage, and the
Market System
Chapter 3: Where Prices Come From: The Interaction of
Demand and Supply
Chapter 4: Economic Efficiency, Government
Price Setting, and Taxes
Appendix: Quantitative Demand and Supply
Analysis
Chapter 5: The Economics of Health Care

2
26

Chapter 12: Aggregate Expenditure and Output
in the Short Run
Appendix: The Algebra of Macroeconomic Equilibrium

38
68
100

Chapter 13: Aggregate Demand and Aggregate
Supply Analysis
Appendix: Macroeconomic Schools of Thought

374
415
418
451

PART 5: Monetary and Fiscal Policy

131

Chapter 14: Money, Banks, and the Federal Reserve System

454

136

Chapter 15: Monetary Policy

490

Chapter 16: Fiscal Policy

530

Appendix: A Closer Look at the Multiplier
Chapter 17: Inflation, Unemployment, and Federal
Reserve Policy

Chapter 6: Firms, the Stock Market, and Corporate
Governance

168

Appendix: Tools to Analyze Firms’ Financial
Information

195
204

PART 3: Macroeconomic Foundations
and Long-Run Growth
Chapter 8: GDP: Measuring Total Production and Income

240

Chapter 9: Unemployment and Inflation

266

Chapter 10: Economic Growth, the Financial System,
and Business Cycles

302

viii

336

PART 4: Short-Run Fluctuations

PART 2: Firms in the Domestic and
International Economies

Chapter 7: Comparative Advantage and the Gains
from International Trade

Chapter 11: Long-Run Economic Growth: Sources
and Policies

570
576

PART 6: The International Economy
Chapter 18: Macroeconomics in an Open Economy

608

Chapter 19: The International Financial System

638

Appendix: The Gold Standard and the Bretton
Woods System

662

Glossary
Company Index
Subject Index
Credits

G-1
I-1
I-2
C-1

CONTENTS
Preface
A Word of Thanks

xxix
lvii

PART 1: Introduction
Chapter 1: Economics: Foundations
and Models
Why Are Some Doctors Leaving Private Practice?
1.1 Three Key Economic Ideas
People Are Rational
People Respond to Economic Incentives
Making the Connection: Does Health Insurance Give
People an Incentive to Become Obese?
Optimal Decisions Are Made at the Margin
Solved Problem 1.1: A Doctor Makes a Decision
at the Margin
1.2 The Economic Problem That Every Society
Must Solve
What Goods and Services Will Be Produced?
How Will the Goods and Services Be Produced?
Who Will Receive the Goods and Services Produced?
Centrally Planned Economies versus Market Economies
The Modern “Mixed” Economy
Efficiency and Equity
1.3 Economic Models

The Role of Assumptions in Economic Models
Forming and Testing Hypotheses in
Economic Models
Normative and Positive Analysis
Economics as a Social Science
Don’t Let This Happen to You Don’t Confuse
Positive Analysis with Normative Analysis
Making the Connection: Should Medical School
Be Free?
1.4 Microeconomics and Macroeconomics
1.5 A Preview of Important Economic Terms
Conclusion
An Inside Look: Doctors Moving Less,
Retiring Later
*Chapter Summary and Problems

2
3
4
5
5
5
7
8
8
9
9
9
10
10

11
12
12
13
14
14
15
15
16
17
19
20
22

Key Terms, Summary, Review Questions, Problems
and Applications

Appendix: Using Graphs and Formulas
Graphs of One Variable
Graphs of Two Variables
Slopes of Lines
Taking into Account More Than Two Variables
on a Graph

26
27
28
29
29

Positive and Negative Relationships
Determining Cause and Effect
Are Graphs of Economic Relationships Always
Straight Lines?
Slopes of Nonlinear Curves
Formulas
Formula for a Percentage Change
Formulas for the Areas of a Rectangle and a Triangle
Summary of Using Formulas
Problems and Applications

33
34
34
34
35
35
36

Chapter 2: Trade-offs, Comparative
Advantage, and the Market System

38

Managers Making Choices at BMW
2.1 Production Possibilities Frontiers
and Opportunity Costs
Graphing the Production Possibilities Frontier
Solved Problem 2.1: Drawing a Production
Possibilities Frontier for Rosie’s Boston Bakery

Making the Connection: Facing Trade-offs
in Health Care Spending
Increasing Marginal Opportunity Costs
Economic Growth
2.2 Comparative Advantage and Trade
Specialization and Gains from Trade
Absolute Advantage versus Comparative Advantage
Comparative Advantage and the Gains from Trade
Don’t Let This Happen to You Don’t Confuse
Absolute Advantage and Comparative
Advantage
Solved Problem 2.2: Comparative Advantage
and the Gains from Trade
2.3 The Market System
The Circular Flow of Income
The Gains from Free Markets
The Market Mechanism
Making the Connection: A Story of the Market
System in Action: How Do You Make an iPad?
The Role of the Entrepreneur
The Legal Basis of a Successful Market System
Conclusion
An Inside Look: Managers at General Motors
Approve Production of a Plug-in Cadillac

30
31

39
40

40
42
43
44
45
46
46
48
49

49
50
51
52
52
54
55
56
57
59
60

Chapter 3: Where Prices Come From: The
Interaction of Demand and Supply

68

The Tablet Computer Revolution
3.1 The Demand Side of the Market
Demand Schedules and Demand Curves

The Law of Demand
What Explains the Law of Demand?

69
70
70
71
71

*These end-of-chapter resource materials repeat in all chapters.

ix


x

CONTENTS

Holding Everything Else Constant: The Ceteris
paribus Condition
Variables That Shift Market Demand
Making the Connection: Are Quiznos Sandwiches Normal
Goods and Subway Sandwiches Inferior Goods?
Making the Connection: The Aging of the Baby
Boom Generation
A Change in Demand versus a Change in Quantity
Demanded
Making the Connection: Forecasting the Demand
for iPads
3.2 The Supply Side of the Market

Supply Schedules and Supply Curves
The Law of Supply
Variables That Shift Market Supply
A Change in Supply versus a Change in Quantity
Supplied
3.3 Market Equilibrium: Putting Demand and Supply
Together
How Markets Eliminate Surpluses and Shortages
Demand and Supply Both Count
Solved Problem 3.3: Demand and Supply
Both Count: A Tale of Two Letters
3.4 The Effect of Demand and Supply Shifts on
Equilibrium
The Effect of Shifts in Supply on Equilibrium
Making the Connection: The Falling Price
of Blu-ray Players
The Effect of Shifts in Demand on Equilibrium
The Effect of Shifts in Demand and Supply over Time
Solved Problem 3.4: High Demand and Low
Prices in the Lobster Market?
Don’t Let This Happen to You Remember: A Change
in a Good’s Price Does Not Cause the Demand or
Supply Curve to Shift
Shifts in a Curve versus Movements along a Curve
Conclusion
An Inside Look: Will Shortage of Display Screens
Derail Computer Tablet Sales?
Chapter 4: Economic Efficiency,
Government Price Setting, and Taxes
Should the Government Control Apartment Rents?

4.1 Consumer Surplus and Producer Surplus
Consumer Surplus
Making the Connection: The Consumer Surplus
from Broadband Internet Service
Producer Surplus
What Consumer Surplus and Producer
Surplus Measure
4.2 The Efficiency of Competitive Markets
Marginal Benefit Equals Marginal Cost in
Competitive Equilibrium
Economic Surplus
Deadweight Loss
Economic Surplus and Economic Efficiency

72
72
73
74
75
77
78
78
79
79
81
82
83
84
84
85

85
86
87
87
88

90
91
91
92

100
101
102
102
104
105
106
107
107
108
108
108

4.3 Government Intervention in the Market:
Price Floors and Price Ceilings
Price Floors: Government Policy in Agricultural
Markets
Making the Connection: Price Floors in Labor
Markets: The Debate over Minimum Wage Policy

Price Ceilings: Government Rent Control Policy in
Housing Markets
Don’t Let This Happen to You Don’t Confuse
“Scarcity” with “Shortage”
Black Markets
Solved Problem 4.3: What’s the Economic Effect
of a Black Market for Apartments?
The Results of Government Price Controls:
Winners, Losers, and Inefficiency
Positive and Normative Analysis of Price Ceilings
and Price Floors
4.4 The Economic Impact of Taxes
The Effect of Taxes on Economic Efficiency
Tax Incidence: Who Actually Pays a Tax?
Solved Problem 4.4: When Do Consumers Pay
All of a Sales Tax Increase?
Making the Connection: Is the Burden of the
Social Security Tax Really Shared Equally
between Workers and Firms?
Conclusion
An Inside Look at Policy: . . . and the RentControlled Apartment Goes to . . . Actress
Faye Dunaway!

109
110
111
112
113
113
114

115
115
115
116
116
117

119
121

122

Appendix: Quantitative Demand and Supply Analysis
Demand and Supply Equations
Calculating Consumer Surplus and Producer Surplus

131
131
132

Chapter 5: The Economics of Health Care

136

Small Businesses Feel the Pinch of Escalating
Health Care Costs
5.1 The Improving Health of People in the
United States
Changes over Time in U.S. Health
The Rise and Fall and Rise of American Heights

Reasons for Long-Run Improvements in
U.S. Health
5.2 Health Care around the World
The U.S. Health Care System
The Health Care Systems of Canada, Japan, and the
United Kingdom
Comparing Health Care Outcomes around the World
5.3 Information Problems and Externalities
in the Market for Health Care
Adverse Selection and the Market for “Lemons”
Asymmetric Information in the Market for Health
Insurance
Don’t Let This Happen to You Don’t Confuse
Adverse Selection with Moral Hazard
Solved Problem 5.3: Dealing with Adverse Selection

137
138
138
139
140
141
141
142
143
145
146
146
148
149

CONTENTS

Externalities in the Market for Health Care
Making the Connection: Should the Government
Run the Health Care System?
5.4 The Debate over Health Care Policy in the
United States
The Rising Cost of Health Care
Explaining Rapid Increases in Health Care Spending
The Debate over Health Care Policy
Making the Connection: How Much Is That
MRI Scan?
Making the Connection: Health Exchanges, Small
Businesses, and Rising Medical Costs
Conclusion
An Inside Look at Policy: Health Care Spending
Expected to Increase 70 Percent by End
of Decade

150
150
152
152
153
155
157
159
161

162

PART 2: Firms in the Domestic and
International Economies
Chapter 6: Firms, the Stock Market, and
Corporate Governance
How Can You Buy a Piece of Facebook?
6.1 Types of Firms
Who Is Liable? Limited and Unlimited Liability
Corporations Earn the Majority of Revenue and
Profits
Making the Connection: How Important Are Small
Businesses to the U.S. Economy?
6.2 The Structure of Corporations and the
Principal–Agent Problem
Corporate Structure and Corporate Governance
Solved Problem 6.2: Does the Principal–Agent
Problem Apply to the Relationship between
Managers and Employees?
6.3 How Firms Raise Funds
Sources of External Funds
Making the Connection: The Rating Game: Is the
U.S. Treasury Likely to Default on Its Bonds?
Stock and Bond Markets Provide Capital—and
Information
Don’t Let This Happen to You When Google
Shares Change Hands, Google Doesn’t Get the
Money
Why Do Stock Prices Fluctuate So Much?

Making the Connection: Following Abercrombie &
Fitch’s Stock Price in the Financial Pages
6.4 Using Financial Statements to Evaluate a
Corporation
The Income Statement
The Balance Sheet
6.5 Corporate Governance Policy and the
Financial Crisis of 2007–2009
The Accounting Scandals of the Early 2000s
The Financial Crisis of 2007–2009

Did Principal–Agent Problems Help Bring on the
Financial Crisis?
Making the Connection: Are Buyers of Facebook
Stock Getting a Fair Deal?
Conclusion
An Inside Look: Shares of Private Companies
Available to Qualified Investors
Appendix: Tools to Analyze Firms’ Financial
Information
Using Present Value to Make Investment Decisions
Solved Problem 8A.1: How to Receive Your
Contest Winnings
Using Present Value to Calculate Bond Prices
Using Present Value to Calculate Stock Prices
A Simple Formula for Calculating Stock Prices
Going Deeper into Financial Statements
Analyzing Income Statements
Analyzing Balance Sheets
Chapter 7: Comparative Advantage

and the Gains from International Trade

168
169
170
170
171
172
173
173

174
174
175
176
177

178
179
180
181
182
183
183
183
184

Does the Federal Government’s “Buy American” Policy
Help U.S. Firms?
7.1 The United States in the International Economy

The Importance of Trade to the U.S. Economy
U.S. International Trade in a World Context
Making the Connection: How Caterpillar
Depends on International Trade
7.2 Comparative Advantage in International Trade
A Brief Review of Comparative Advantage
Comparative Advantage in International Trade
7.3 How Countries Gain from International Trade
Increasing Consumption through Trade
Solved Problem 7.3: The Gains from Trade
Why Don’t We See Complete Specialization?
Does Anyone Lose as a Result of International Trade?
Don’t Let This Happen to You Remember
That Trade Creates Both Winners and Losers
Where Does Comparative Advantage Come From?
Making the Connection: Leave New York City?
Risky for Financial Firms
Comparative Advantage over Time: The Rise and Fall—
and Rise—of the U.S. Consumer Electronics Industry
7.4 Government Policies That Restrict
International Trade
Tariffs
Quotas and Voluntary Export Restraints
Measuring the Economic Effect of the Sugar
Quota
Solved Problem 7.4: Measuring the Economic
Effect of a Quota
The High Cost of Preserving Jobs with Tariffs
and Quotas
Making the Connection: Save Jobs Making

Hangers . . . and Lose Jobs in Dry Cleaning

xi

185
185
187
188
195
195
197
197
198
199
200
200
201

204
205
206
206
207
208
209
209
210
211
211
212

214
214
214
215
216
217
217
219
220
220
221
222
223


xii

CONTENTS

Gains from Unilateral Elimination of Tariffs
and Quotas
Other Barriers to Trade
7.5 The Arguments over Trade Policies
and Globalization
Why Do Some People Oppose the World Trade
Organization?
Making the Connection: The Unintended
Consequences of Banning Goods Made
with Child Labor
Dumping

Positive versus Normative Analysis (Once Again)
Conclusion
An Inside Look at Policy: Did Home Depot
Knowingly Defy the “Buy American” Policy?

224
224

Ford Motor Company Feels the Effects of the
Recession
8.1 Gross Domestic Product Measures
Total Production
Measuring Total Production: Gross Domestic Product
Solved Problem 8.1: Calculating GDP
Production, Income, and the Circular-Flow Diagram
Components of GDP
Don’t Let This Happen to You Remember What
Economists Mean by Investment
An Equation for GDP and Some Actual Values
Making the Connection: Will U.S. Consumers Be
Spending Less?
Measuring GDP Using the Value-Added Method
8.2 Does GDP Measure What We Want It to Measure?
Shortcomings in GDP as a Measure of
Total Production
Making the Connection: Why Do Many Developing
Countries Have Such Large Underground
Economies?
Shortcomings of GDP as a Measure of Well-being
Making the Connection: Did World War II Bring

Prosperity?
8.3 Real GDP versus Nominal GDP
Calculating Real GDP
Solved Problem 8.3: Calculating Real GDP
Comparing Real GDP and Nominal GDP
The GDP Deflator
8.4 Other Measures of Total Production
and Total Income
Gross National Product (GNP)
National Income
Personal Income
Disposable Personal Income

258
259

Chapter 9: Unemployment and Inflation

266

260

224
225

226
228
228
229
230

PART 3: Macroeconomic Foundations
and Long-Run Growth
Chapter 8: GDP: Measuring Total
Production and Income

The Division of Income
Conclusion
An Inside Look at Policy: Analysts Lower Estimates
for New Car Sales in 2011 and 2012

240
241
243
243
244
244
246
247
247
248
250
250
250

251
252
253
254
254

254
255
256
257
257
257
258
258

Bank of America Announces Plans to Lay
Off 30,000 Employees
9.1 Measuring the Unemployment Rate, the
Labor Force Participation Rate, and the Employment–
Population Ratio
The Household Survey
Solved Problem 9.1: What Happens if You
Include the Military?
Problems with Measuring the Unemployment
Rate
Trends in Labor Force Participation
Unemployment Rates for Different Groups
How Long Are People Typically Unemployed?
Making the Connection: How Unusual Was the
Unemployment Situation Following
the 2007–2009 Recession?
The Establishment Survey: Another Measure of
Employment
Revisions in the Establishment Survey Employment
Data: How Bad Was the 2007–2009 Recession?
Job Creation and Job Destruction over Time

9.2 Types of Unemployment
Frictional Unemployment and Job Search
Structural Unemployment
Cyclical Unemployment
Full Employment
Making the Connection: How Should We
Categorize Unemployment at Bank of
America?
9.3 Explaining Unemployment
Government Policies and the Unemployment Rate
Labor Unions
Efficiency Wages
9.4 Measuring Inflation
The Consumer Price Index
Is the CPI Accurate?
Don’t Let This Happen to You Don’t Miscalculate
the Inflation Rate
The Producer Price Index
9.5 Using Price Indexes to Adjust for the Effects
of Inflation
Solved Problem 9.5: Calculating Real Average
Hourly Earnings
9.6 Real versus Nominal Interest Rates
9.7 Does Inflation Impose Costs on the Economy?
Inflation Affects the Distribution of Income
The Problem with Anticipated Inflation
The Problem with Unanticipated Inflation
Making the Connection: What’s So Bad about
Falling Prices?

267

268
268
270
271
272
273
273

274
275
276
277
277
278
279
279
279

279
280
280
282
282
282
283
284
285
286

286
287
288
289
290
290
291
291


CONTENTS

Conclusion
An Inside Look: Will Pink Slips Be in the Mail
for Postal Workers?
Chapter 10: Economic Growth, the
Financial System, and Business Cycles
Growth and the Business Cycle at Boeing
10.1 Long-Run Economic Growth
Making the Connection: The Connection between
Economic Prosperity and Health
Calculating Growth Rates and the Rule of 70
What Determines the Rate of Long-Run Growth?
Solved Problem 10.1: The Role of Technological
Change in Growth
Making the Connection: What Explains Rapid
Economic Growth in Botswana?
Potential GDP
10.2 Saving, Investment, and the Financial System
An Overview of the Financial System

The Macroeconomics of Saving and Investment
The Market for Loanable Funds
Making the Connection: Ebenezer Scrooge:
Accidental Promoter of Economic Growth?
Solved Problem 10.2: How Would a Consumption
Tax Affect Saving, Investment, the Interest
Rate, and Economic Growth?
10.3 The Business Cycle
Some Basic Business Cycle Definitions
How Do We Know When the Economy Is
in a Recession?
Making the Connection: Can a Recession Be
a Good Time for a Business to Expand?
What Happens during the Business Cycle?
Don’t Let This Happen to You Don’t Confuse
the Price Level and the Inflation Rate
Will the U.S. Economy Return to Stability?
Conclusion
An Inside Look: Airlines Face the Business Cycle
Chapter 11: Long-Run Economic
Growth: Sources and Policies
Google’s Dilemma in China
11.1 Economic Growth over Time and around
the World
Economic Growth from 1,000,000 b.c. to
the Present
Making the Connection: Why Did the Industrial
Revolution Begin in England?
Small Differences in Growth Rates Are Important
Why Do Growth Rates Matter?

Don’t Let This Happen to You Don’t Confuse the
Average Annual Percentage Change with
the Total Percentage Change
“The Rich Get Richer and . . .”
Making the Connection: Is Income All That Matters?

293
294

302
303
304
306
307
308
309
310
311
312
312
314
315
316

319
320
320
321
321
322

325
327
329
330

336
337

11.2 What Determines How Fast Economies Grow?
The Per-Worker Production Function
Which Is More Important for Economic Growth:
More Capital or Technological Change?
Technological Change: The Key to Sustaining
Economic Growth
Making the Connection: What Explains the
Economic Failure of the Soviet Union?
Solved Problem 11.2: Using the Economic
Growth Model to Analyze the Failure of
the Soviet Economy
New Growth Theory
Joseph Schumpeter and Creative Destruction
11.3 Economic Growth in the United States
Economic Growth in the United States since 1950
What Caused the Productivity Slowdown
of 1973–1994?
Can the United States Maintain High Rates of
Productivity Growth?
11.4 Why Isn’t the Whole World Rich?
Catch-up: Sometimes but Not Always
Solved Problem 11.4: The Economic Growth

Model’s Prediction of Catch-up
Why Haven’t Most Western European Countries,
Canada, and Japan Caught Up to the United States?
Why Don’t More Low-Income Countries Experience
Rapid Growth?
Making the Connection: What Do Parking Tickets
in New York City Tell Us about Poverty in the
Developing World?
The Benefits of Globalization
11.5 Growth Policies
Enhancing Property Rights and the Rule of Law
Making the Connection: Will China’s Standard
of Living Ever Exceed That of the United States?
Improving Health and Education
Policies That Promote Technological Change
Policies That Promote Saving and Investment
Is Economic Growth Good or Bad?
Conclusion
An Inside Look at Policy: Despite a Plan for Change,
Investment Still Spurs China’s Growth

xiii

343
344
345
345
346

347

347
349
349
350
350
351
352
352
354
355
357

358
360
361
361
361
362
363
363
364
365
366

PART 4: Short-Run Fluctuations

338
338
339
340

340

341
341
342

Chapter 12: Aggregate Expenditure
and Output in the Short Run
Fluctuating Demand Helps—and Hurts—Intel
and Other Firms
12.1 The Aggregate Expenditure Model
Aggregate Expenditure
The Difference between Planned Investment
and Actual Investment
Macroeconomic Equilibrium
Adjustments to Macroeconomic Equilibrium

374
375
376
376
377
377
378


xiv

CONTENTS

12.2 Determining the Level of Aggregate Expenditure
in the Economy
Consumption
Making the Connection: Do Changes in Housing
Wealth Affect Consumption Spending?
The Relationship between Consumption and
National Income
Income, Consumption, and Saving
Solved Problem 12.2: Calculating the Marginal
Propensity to Consume and the Marginal
Propensity to Save
Planned Investment
Making the Connection: Intel Tries to Jump
Off the Roller Coaster of Information
Technology Spending
Government Purchases
Net Exports
12.3 Graphing Macroeconomic Equilibrium
Showing a Recession on the 45°-Line Diagram
The Important Role of Inventories
A Numerical Example of Macroeconomic
Equilibrium
Don’t Let This Happen to You Don’t Confuse
Aggregate Expenditure with Consumption
Spending
Solved Problem 12.3: Determining Macroeconomic
Equilibrium
12.4 The Multiplier Effect
Making the Connection: The Multiplier in
Reverse: The Great Depression of the 1930s

A Formula for the Multiplier
Summarizing the Multiplier Effect
Solved Problem 12.4: Using the Multiplier Formula
The Paradox of Thrift
12.5 The Aggregate Demand Curve
Conclusion
An Inside Look: Turnaround Projected for
the Restaurant Industry

379
379
381
384
385

386
387

388
389
390
392
394
395
396

397
398
399
401

402
403
404
405
405
407
408

Appendix: The Algebra of Macroeconomic
Equilibrium

415

Chapter 13: Aggregate Demand and
Aggregate Supply Analysis

418

The Fortunes of FedEx Follow the Business Cycle
13.1 Aggregate Demand
Why Is the Aggregate Demand Curve Downward
Sloping?
Shifts of the Aggregate Demand Curve versus
Movements along It
The Variables That Shift the Aggregate
Demand Curve
Don’t Let This Happen to You Understand
Why the Aggregate Demand Curve Is
Downward Sloping

419
420
421
422
422

423

Solved Problem 13.1: Movements along the
Aggregate Demand Curve versus Shifts of the
Aggregate Demand Curve
Making the Connection: Which Components of
Aggregate Demand Changed the Most during
the 2007–2009 Recession?
13.2 Aggregate Supply
The Long-Run Aggregate Supply Curve
The Short-Run Aggregate Supply Curve
Shifts of the Short-Run Aggregate Supply
Curve versus Movements along It
Variables That Shift the Short-Run Aggregate
Supply Curve
13.3 Macroeconomic Equilibrium in the Long
Run and the Short Run
Recessions, Expansions, and Supply Shocks
Making the Connection: Does It Matter What
Causes a Decline in Aggregate Demand?
Making the Connection: How Long Does It Take
to Return to Potential GDP? Economic Forecasts
Following the Recession of 2007–2009
13.4 A Dynamic Aggregate Demand and Aggregate

Supply Model
What Is the Usual Cause of Inflation?
The Recession of 2007–2009
Solved Problem 13.4: Showing the Oil Shock of
1974–1975 on a Dynamic Aggregate
Demand and Aggregate Supply Graph
Conclusion
An Inside Look: Smaller Freight Volumes Signal
Continued Economic Troubles
Appendix: Macroeconomic Schools of Thought
The Monetarist Model
The New Classical Model
The Real Business Cycle Model
Making the Connection: Karl Marx: Capitalism’s
Severest Critic

423

426
427
427
428
430
430
431
433
434

437
438

439
440

442
443
444
451
451
452
452
452

PART 5: Monetary and Fiscal Policy
Chapter 14: Money, Banks, and the
Federal Reserve System
Coca-Cola Dries Up as Money Floods Zimbabwe
14.1 What Is Money, and Why Do We Need It?
Barter and the Invention of Money
The Functions of Money
What Can Serve as Money?
Making the Connection: Apple Didn’t Want
My Cash!
14.2 How Is Money Measured in the United States
Today?
M1: The Narrowest Definition of the Money
Supply

454
455
456

456
457
458
459
459
460


CONTENTS

Making the Connection: Do We Still Need
the Penny?
M2: A Broader Definition of Money
Don’t Let This Happen to You Don’t Confuse
Money with Income or Wealth
Solved Problem 14.2: The Definitions of M1 and M2
What about Credit Cards and Debit Cards?
14.3 How Do Banks Create Money?
Bank Balance Sheets
Using T-Accounts to Show How a Bank Can
Create Money
The Simple Deposit Multiplier
Don’t Let This Happen to You Don’t Confuse
Assets and Liabilities
Solved Problem 14.3: Showing How Banks Create
Money
The Simple Deposit Multiplier versus the RealWorld Deposit Multiplier
14.4 The Federal Reserve System
The Establishment of the Federal Reserve System
How the Federal Reserve Manages the Money Supply

The “Shadow Banking System” and the Financial
Crisis of 2007–2009
14.5 The Quantity Theory of Money
Connecting Money and Prices: The Quantity
Equation
The Quantity Theory Explanation of Inflation
How Accurate Are Estimates of Inflation Based
on the Quantity Theory?
High Rates of Inflation
Making the Connection: The German
Hyperinflation of the Early 1920s
Conclusion
An Inside Look at Policy: Increased Lending
Boosts Money Supply Growth
Chapter 15: Monetary Policy
Monetary Policy, Toll Brothers, and the
Housing Market
15.1 What Is Monetary Policy?
The Goals of Monetary Policy
15.2 The Money Market and the Fed’s Choice
of Monetary Policy Targets
Monetary Policy Targets
The Demand for Money
Shifts in the Money Demand Curve
How the Fed Manages the Money Supply:
A Quick Review
Equilibrium in the Money Market
A Tale of Two Interest Rates
Choosing a Monetary Policy Target
The Importance of the Federal Funds Rate

15.3 Monetary Policy and Economic Activity
How Interest Rates Affect Aggregate Demand
The Effects of Monetary Policy on Real GDP
and the Price Level

461
462
462
463
463
463
463
464
466
467
468
470
471
471
472
474
476
476
477
478
479
479
481
482
490

491
492
492
494
494
494
495
496
496
498
498
498
499
500
500

Making the Connection: Too Low for Zero:
The Fed Tries “Quantitative Easing” and
“Operation Twist”
Can the Fed Eliminate Recessions?
Making the Connection: Trying to Hit a Moving
Target: Making Policy with “Real-Time Data”
A Summary of How Monetary Policy Works
Don’t Let This Happen to You Remember That
with Monetary Policy, It’s the Interest Rate—
Not the Money—That Counts
15.4 Monetary Policy in the Dynamic Aggregate
Demand and Aggregate Supply Model
The Effects of Monetary Policy on Real GDP and
the Price Level: A More Complete Account

Using Monetary Policy to Fight Inflation
Solved Problem 15.4: The Effects of Monetary
Policy
15.5 A Closer Look at the Fed’s Setting of Monetary
Policy Targets
Should the Fed Target the Money Supply?
Why Doesn’t the Fed Target Both the Money
Supply and the Interest Rate?
The Taylor Rule
Should the Fed Target Inflation?
Making the Connection: How Does the Fed
Measure Inflation?
15.6 Fed Policies during the 2007–2009 Recession
The Inflation and Deflation of the Housing
Market Bubble
The Changing Mortgage Market
The Role of Investment Banks
Making the Connection: The Wonderful World
of Leverage
The Fed and the Treasury Department Respond
Conclusion
An Inside Look at Policy: Fed Attempts to Stimulate
Housing Market . . . Again

xv

502
503
504
505

506
506
507
508
509
511
511
511
512
513
514
515
515
517
517
518
519
521
522

Chapter 16: Fiscal Policy

530

Does Government Spending Create Jobs?
16.1 What Is Fiscal Policy?
What Fiscal Policy Is and What It Isn’t
Automatic Stabilizers versus Discretionary
Fiscal Policy

An Overview of Government Spending and Taxes
Making the Connection: Is Spending on Social
Security and Medicare a Fiscal Time Bomb?
16.2 The Effects of Fiscal Policy on Real GDP
and the Price Level
Expansionary and Contractionary Fiscal Policy
Don’t Let This Happen to You Don’t Confuse
Fiscal Policy and Monetary Policy
A Summary of How Fiscal Policy Affects Aggregate
Demand
16.3 Fiscal Policy in the Dynamic Aggregate
Demand and Aggregate Supply Model

531
532
532
532
533
535
536
537
538
538
539


xvi

CONTENTS

16.4 The Government Purchases and Tax Multipliers
The Effect of Changes in Tax Rates
Taking into Account the Effects of Aggregate
Supply
The Multipliers Work in Both Directions
Solved Problem 16.4: Fiscal Policy Multipliers
16.5 The Limits of Using Fiscal Policy to Stabilize the
Economy
Does Government Spending Reduce Private
Spending?
Crowding Out in the Short Run
Crowding Out in the Long Run
Fiscal Policy in Action: Did the Stimulus Package
of 2009 Work?
Making the Connection: Why Was the Recession of
2007–2009 So Severe?
16.6 Deficits, Surpluses, and Federal
Government Debt
How the Federal Budget Can Serve as an Automatic
Stabilizer
Making the Connection: Did Fiscal Policy Fail
during the Great Depression?
Solved Problem 16.6: The Effect of Economic
Fluctuations on the Budget Deficit
Should the Federal Budget Always Be Balanced?
The Federal Government Debt
Is Government Debt a Problem?
16.7 The Effects of Fiscal Policy in the Long Run
The Long-Run Effects of Tax Policy
Tax Simplification

The Economic Effect of Tax Reform
How Large Are Supply-Side Effects?
Conclusion
An Inside Look at Policy: Obama Proposes
Additional Spending to Stimulate the
Economy

540
543

Appendix: A Closer Look at the Multiplier
An Expression for Equilibrium Real GDP
A Formula for the Government Purchases
Multiplier
A Formula for the Tax Multiplier
The “Balanced Budget” Multiplier
The Effects of Changes in Tax Rates on
the Multiplier
The Multiplier in an Open Economy

570
570

Chapter 17: Inflation, Unemployment, and
Federal Reserve Policy
Why Does CarMax Worry about Monetary Policy?
17.1 The Discovery of the Short-Run Trade-off
between Unemployment and Inflation
Explaining the Phillips Curve with Aggregate
Demand and Aggregate Supply Curves

Is the Phillips Curve a Policy Menu?
Is the Short-Run Phillips Curve Stable?

543
544
544
545
546
546
547
548
550
553
553
554
555
556
557
557
558
558
559
559
560
561

The Long-Run Phillips Curve
The Role of Expectations of Future Inflation
Making the Connection: Do Workers Understand
Inflation?

17.2 The Short-Run and Long-Run Phillips Curves
Shifts in the Short-Run Phillips Curve
How Does a Vertical Long-Run Phillips Curve
Affect Monetary Policy?
Making the Connection: Does the Natural Rate of
Unemployment Ever Change?
Solved Problem 17.2: Changing Views
of the Phillips Curve
17.3 Expectations of the Inflation Rate and
Monetary Policy
The Effect of Rational Expectations
on Monetary Policy
Is the Short-Run Phillips Curve Really Vertical?
Real Business Cycle Models
17.4 Federal Reserve Policy from the 1970s to the Present
The Effect of a Supply Shock on the Phillips
Curve
Paul Volcker and Disinflation
Don’t Let This Happen to You Don’t Confuse
Disinflation with Deflation
Solved Problem 17.4: Using Monetary Policy
to Lower the Inflation Rate
Alan Greenspan, Ben Bernanke, and the Crisis in
Monetary Policy
Has the Fed Lost Its Independence?
Conclusion
An Inside Look at Policy: Can the Fed Balance the
Trade-off between Unemployment and Inflation?

580

581
582
583
584
584
586
587
587
588
589
590
590
590
591
593
593
595
597
599
600

PART 6: The International Economy
562

571
572
572
573
573

576
577
578
579
580
580

Chapter 18: Macroeconomics in
an Open Economy
A Strong Dollar Hurts McDonald’s Profits
18.1 The Balance of Payments: Linking the
United States to the International Economy
The Current Account
The Financial Account
The Capital Account
Why Is the Balance of Payments Always Zero?
Don’t Let This Happen to You Don’t Confuse the
Balance of Trade, the Current Account
Balance, and the Balance of Payments
Solved Problem 18.1: Understanding the
Arithmetic of Open Economies
18.2 The Foreign Exchange Market and
Exchange Rates
Making the Connection: Exchange Rate Listings
Equilibrium in the Market for Foreign Exchange
How Do Shifts in Demand and Supply Affect the
Exchange Rate?

608
609

610
610
611
612
613

613
614
615
615
616
617


CONTENTS

Making the Connection: What Explains the
Fall and Rise and Fall of the Dollar?
Some Exchange Rates Are Not Determined by
the Market
How Movements in the Exchange Rate Affect
Exports and Imports
Don’t Let This Happen to You Don’t Confuse
What Happens When a Currency Appreciates
with What Happens When It Depreciates
Solved Problem 18.2: The Effect of Changing
Exchange Rates on the Prices of Imports and
Exports
The Real Exchange Rate
18.3 The International Sector and National Saving

and Investment
Net Exports Equal Net Foreign Investment
Domestic Saving, Domestic Investment, and
Net Foreign Investment
Solved Problem 18.3: Arriving at the Saving and
Investment Equation
18.4 The Effect of a Government Budget Deficit on
Investment
Making the Connection: Why Is the United States
Called the “World’s Largest Debtor”?
18.5 Monetary Policy and Fiscal Policy in
an Open Economy
Monetary Policy in an Open Economy
Fiscal Policy in an Open Economy
Conclusion
An Inside Look: Struggling Economy
Contributes to a Weak Dollar

619
620
620

621

621
622
622
622
623
624

625
626
628
628
628
629
630

Don’t Let This Happen to You Remember
That Modern Currencies Are Fiat Money
19.2 The Current Exchange Rate System
The Floating Dollar
Making the Connection: The Canadian
Province of . . . Arizona?
What Determines Exchange Rates in
the Long Run?
Making the Connection: The Big Mac Theory of
Exchange Rates
Solved Problem 19.2: Calculating Purchasing
Power Parity Exchange Rates Using
Big Macs
The Euro
Making the Connection: Can the Euro Survive?
Pegging against the Dollar
Making the Connection: Crisis and Recovery
in South Korea
19.3 International Capital Markets
Conclusion
An Inside Look at Policy: Can Tariffs Offset the
Effect of Overvaluation?

Appendix: The Gold Standard and the
Bretton Woods System
The Gold Standard and the Bretton
Woods System
The Gold Standard
The End of the Gold Standard
The Bretton Woods System
The Collapse of the Bretton Woods System
Glossary

Chapter 19: The International
Financial System

638

Airbus Deals with Fluctuating Exchange Rates
19.1 Exchange Rate Systems

639
640

xvii

641
641
641
642
643
644

645
646
647
649
652
653
655
656

662
662
662
662
663
664
G-1

Company Index

I-1

Subject Index

I-2

Credits

C-1

FLEXIBILITY
CHART

The following chart helps you organize your syllabus based on your teaching preferences and
objectives:

Core
Chapter 1: Economics: Foundations and
Models

Optional

Policy

Chapter 1 Appendix: Using Graphs
and Formulas

Chapter 2: Trade-offs, Comparative
Advantage, and the Market System
Chapter 3: Where Prices Come From: The
Interaction of Demand and Supply
Chapter 4 Appendix: Quantitative
Demand and Supply Analysis

Chapter 4: Economic Efficiency,
Government Price Setting, and
Taxes
Chapter 5: The Economics of
Health Care

Chapter 6: Firms, the Stock Market,
and Corporate Governance
Chapter 6 Appendix: Tools to
Analyze Firms’ Financial Information
Chapter 7: Comparative Advantage and
the Gains from International Trade
Chapter 8: GDP: Measuring Total
Production and Income
Chapter 9: Unemployment and Inflation

Chapter 10: Economic Growth, the
Financial System, and Business Cycles
Chapter 11: Long-Run Economic Growth:
Sources and Policies

xviii


Core

Optional

Policy

Chapter 12: Aggregate Expenditure
and Output in the Short Run
Chapter 12 Appendix: The Algebra
of Macroeconomic Equilibrium
Chapter 13: Aggregate Demand and
Aggregate Supply Analysis

Chapter 13 Appendix:
Macroeconomic Schools of
Thought
Chapter 14: Money, Banks, and the
Federal Reserve System
Chapter 15: Monetary Policy

Chapter 16 Appendix: A Closer
Look at the Multiplier

Chapter 16: Fiscal Policy

Chapter 17: Inflation,
Unemployment, and Federal
Reserve Policy
Chapter 18: Macroeconomics in
an Open Economy
Chapter 19: The International
Financial System
Chapter 19 Appendix: The Gold
Standard and the Bretton Woods
System

xix


This page intentionally left blank


PREFACE

When George Lucas was asked why he made Star Wars, he replied, “It’s the kind of movie
I like to see, but no one seemed to be making them. So, I decided to make one.” We realized
that no one seemed to be writing the kind of textbook we wanted to use in our classes. So,
after years of supplementing texts with fresh, lively, real-world examples from newspapers,
magazines, Web sites, and professional journals, we decided to write an economics text that
delivers complete economics coverage with many real-world business examples. Our goal
was to keep our classes “widget free.”

New to the Fourth Edition
The severe economic downturn that began in 2007 with the bursting of the housing bubble
was still affecting the economy in 2011. Unemployment had risen to levels not seen in decades and remained above 9 percent for more than two and a half years. The crisis in the
financial system was the worst since the Great Depression of the 1930s. Policy debates intensified as Congress passed and President Barack Obama enacted the American Recovery and
Reinvestment Act of 2009, the largest package of spending increases and tax cuts in history.
The Federal Reserve sailed into uncharted waters as it developed new policy tools to deal
with the unprecedented financial turmoil. Other long-running policy debates continued
as well, as comprehensive health care legislation, looming cost increases for Social Security
and Medicare, huge long-run budget deficits, environmental problems, income inequality,
and changes to the tax system all received attention from economists, policymakers, and the
public.
In this new edition, we help students understand recent economic events and the policy
responses to them. As in the earlier editions, we place applications at the forefront of the
discussion. We believe that students find the study of economics more interesting and easier
to master when they see economic analysis applied to real-world issues that concern them.
Here is a summary of the changes in this fourth edition. Please see the next section,
starting on the next page, for details on each of these changes:
• A new Chapter 5, “The Economics of Health Care,” covers health care around the world,
information problems and externalities in the market for health care, and the debate
over President Obama’s Patient Protection and Affordable Care Act.
• There is new coverage of the slow recovery from the recession and financial crisis of
2007–2009.

• There is new coverage of initiatives by the Federal Reserve, including quantitative easing and Operation Twist.
• There is new coverage of fiscal policy, including analysis of the debate over fiscal stimulus and the magnitude of multipliers for government spending and taxes.
• All companies in the chapter openers have been either replaced with new companies or
updated with current information.
• All chapters include new An Inside Look newspaper articles and analyses to help students apply economic thinking to current events and policy debates.
• There are 21 new Making the Connection features to help students tie economic concepts to current events and policy issues.
• Figures and tables have been updated, using the latest data available.
• Many of the end-of-chapter problems have been either replaced or updated.
In this new edition, we have taken the opportunity to make many changes throughout
the text, while concentrating on the key areas described in the following sections.
xxi


xxii

PREFACE

Policy debates, including health care, trade, and pollution. The number of jobs in the
health care sector continues to increase. In Chapter 1, “Economics: Foundations and Models,” we use the debate about whether public policy is resulting in physicians leaving private
practice to introduce students to positive and normative economic analysis. In Chapter 7,
“Comparative Advantage and the Gains from International Trade,” we explore the “Buy
American” provision in the 2009 stimulus package.
As this book goes to press, the debate continues over the consequences of the 2010
overhaul of the U.S. health care system. In Chapter 2, “Trade-offs, Comparative Advantage, and the Market System,” we discuss the trade-offs involved in health care spending
and the Medicare and Medicaid programs. We revisit the topic of health care in the new
Chapter 5, “The Economics of Health Care,” where we discuss projections of health care
spending and the role of the U.S. government in the health care system.
The recession and financial crisis of 2007–2009 and its aftermath. Today’s students feel
the effects of the slow recovery from the worst economic crisis since the Great Depression
of the 1930s. The problems in the financial system in the United States and the euro zone

have proven that it is important for students in both microeconomics and macroeconomics
courses to understand the basics of how financial markets work and the role of government
in financial regulation. In Chapter 6, “Firms, the Stock Market, and Corporate Governance,”
we cover the basics of the stock and bond markets, discuss why stock prices fluctuate, and
examine the role of the principal–agent problem in the financial meltdown of 2007–2009.
Chapter 13, “Aggregate Demand and Aggregate Supply Analysis,” covers the origins of the
recession and includes a new discussion of how long it takes the economy to return to potential GDP. The housing bust and subprime crisis are discussed in Chapter 14, “Money, Banks,
and the Federal Reserve System,” and Chapter 15, “Monetary Policy.”
New initiatives by the Federal Reserve. During 2008, the Fed dramatically broke with precedent by setting up a number of new “lending facilities” and by participating in actions such
as the purchase of Bear Stearns by JPMorgan Chase. In this new edition, we provide students with a basic background on investment banks and the process of securitization; the
mortgage-backed securities market, including the roles of Fannie Mae and Freddie Mac; and
the debate among economists concerning the Fed’s two rounds of quantitative easing and
“Operation Twist.”
Real-world company examples and newspaper articles. As in previous editions, we open
each chapter by highlighting a company to establish a real-world context for learning and
to spark students’ interest in economics. We have chosen new companies for some chapters
and updated the information in the other chapters. As in previous editions, each chapter
closes with the An Inside Look feature, which shows students how to apply the concepts from
the chapter to the analysis of a news article. We have replaced all the An Inside Look features
in this edition. Here is a snapshot of some of these changes:
Chapter 3, “Where Prices Come From: The Interaction of Demand and Supply,”
opens with a discussion of the iPad and the tablet reader revolution. The An Inside
Look feature presents an article and analysis of how a shortage of display screens
could affect the sale of tablet readers.
Chapter 5, “The Economics of Health Care,” opens with a discussion of the rising
health care costs for small businesses. The An Inside Look feature presents an article
and analysis of health care spending and the Patient Protection and Affordable Care
Act of 2010.
Chapter 6, “Firms, the Stock Market, and Corporate Governance,” opens with a discussion of the runaway success of the private company Facebook and how some of the
company’s stock is available for sale in private markets. An Inside Look features Internet

companies that allow qualified investors a chance to buy stock in private companies.
Chapter 8, “GDP: Measuring Total Production and Income,” opens with a discussion
of Ford Motor Company’s performance following the 2007–2009 recession. The An


P R E FAC E

Inside Look feature presents an analysis of how uncertain economic conditions in
2011 and 2012 kept demand for automobiles below initial sales estimates
Chapter 15, “Monetary Policy,” opens with a discussion of homebuilder Toll Brothers.
The An Inside Look feature presents an analysis of the effects of “Operation Twist,”
the Federal Reserve’s attempt to boost the economy in late 2011 by stimulating the
sluggish housing market.

Further changes to the fourth edition
The following are further changes to the fourth edition:
• This edition provides many new Making the Connection features, which help students
tie economic concepts to current events and policy issues, as well as updated sections,
figures, and tables:
Chapter 1 opens with a new discussion of doctors in private practice and includes
two new Making the Connections, “Does Health Insurance Give People an Incentive
to Become Obese?” and “Should Medical School Be Free?”
Chapter 2 includes a new Making the Connection, “A Story of the Market System in
Action: How Do You Make an iPad?”
Chapter 3 opens with discussion of the tablet computer industry and includes three
new Making the Connections: “The Aging of the Baby Boom Generation,” “Forecasting the Demand for iPads,” and “Are Quiznos Sandwiches Normal Goods and Subway Sandwiches Inferior Goods?”
Chapter 5 is new to this edition and covers health care around the world; information problems and externalities in the market for health care; and the Patient Protection and Affordable Care Act in the United States. The chapter contains Making the
Connections titled “How Much Is That MRI Scan?” and “Health Exchanges, Small
Businesses, and Rising Medical Costs.”
Chapter 6 has a new section on the financial crisis of 2007–2009 and two new Making the Connections: “The Rating Game: Is the U.S. Treasury Likely to Default on Its

Bonds?” and “Are Buyers of Facebook Stock Getting a Fair Deal?”
Chapter 9 opens with a new discussion of Bank of America’s 2011 announcement to
lay off 30,000 workers and includes two new Making the Connections: “How Unusual
Was the Unemployment Situation Following the 2007–2009 Recession?” and “How
Should We Categorize Unemployment at Bank of America?”
Chapter 11 includes two new Making the Connections: “Is Income All That Matters?”
and “Will China’s Standard of Living Ever Exceed That of the United States?”
Chapter 13 includes two new Making the Connections: “Which Components of Aggregate Demand Changed the Most during the 2007–2009 Recession?” and “How
Long Does It Take to Return to Potential GDP? Economic Forecasts Following the
Recession of 2007–2009.”
Chapter 15 includes two new Making the Connections: “Too Low for Zero: The Fed
Tries ‘Quantitative Easing’ and ‘Operation Twist’” and “Trying to Hit a Moving Target: Making Policy with “Real-Time Data.’”
Chapter 16 opens with a new discussion of the role of government in creating jobs,
and includes a new section on “Fiscal Policy in Action: Did the Fiscal Stimulus Package Work?”; a new table showing competing estimates of the size of the government
spending and tax multipliers; and a new Making the Connection: “Why Was the Recession of 2007–2009 So Severe?”
Chapter 17 opens with a new discussion of CarMax.
Chapter 19 opens with a new discussion of Airbus and includes updated information
about the euro debt crisis.
• Figures and tables have been updated using the latest data available.

xxiii


xxiv

PREFACE

• Many of the end-of-chapter problems have been either replaced or updated.
• Finally, we have gone over the text literally line-by-line, tightening the discussion, rewriting unclear points, and making many other small changes. We are grateful to the
many instructors and students who made suggestions for improvements in the previous

edition. We have done our best to incorporate as many of those suggestions as possible.

The Foundation:
Contextual Learning and Modern Organization
Students come to study macroeconomics with a strong interest in understanding events
and developments in the economy. We try to capture that interest and develop students’
economic intuition and understanding in this text. We present macroeconomics in a way
that is modern and based in the real world of business and economic policy. And we believe
we achieve this presentation without making the analysis more difficult. We avoid the recent
trend of using simplified versions of intermediate models, which are often more detailed
and more complex than what students need to understand the basic macroeconomic issues.
Instead, we use a more realistic version of the familiar aggregate demand and aggregate
supply model to analyze short-run fluctuations and monetary and fiscal policy. We also
avoid the “dueling schools of thought” approach often used to teach macroeconomics at the
principles level. We emphasize the many areas of macroeconomics where most economists
agree. And we present throughout real business and policy situations to develop students’
intuition.
• A broad discussion of macro statistics. Many students pay at least some attention to the
financial news and know that the release of statistics by federal agencies can cause movements in stock and bond prices. A background in macroeconomic statistics helps clarify
some of the policy issues encountered in later chapters. In Chapter 8, “GDP: Measuring
Total Production and Income,” and Chapter 9, “Unemployment and Inflation,” we provide students with an understanding of the uses and potential shortcomings of the key
macroeconomic statistics, without getting bogged down in the minutiae of how the statistics are constructed. So, for instance, we discuss the important differences between the
payroll survey and the household survey for understanding conditions in the labor market. We explain why financial markets react more strongly to news from the payroll survey. New to this edition is a discussion of the employment–population ratio, which some
economists regard as a key measure of labor market performance. Chapter 15, “Monetary
Policy,” discusses why the Federal Reserve prefers to measure inflation using the personal
consumption expenditures price index rather than the consumer price index.
• Early coverage of long-run topics. We place key macroeconomic issues in their longrun context in Chapter 10, “Economic Growth, the Financial System, and Business Cycles,” and Chapter 11, “Long-Run Economic Growth: Sources and Policies.” Chapter 10
puts the business cycle in the context of underlying long-run growth and discusses what
actually happens during the phases of the business cycle. We believe this material is important if students are to have the understanding of business cycles they will need to interpret economic events; this material is often discussed only briefly or omitted entirely
in other books. We know that many instructors prefer to have a short-run orientation to

their macro courses, with a strong emphasis on policy. Accordingly, we have structured
Chapter 10 so that its discussion of long-run growth would be sufficient for instructors
who want to move quickly to short-run analysis. Chapter 11 uses a simple neoclassical
growth model to explain important growth issues. We apply the model to topics such
as the decline of the Soviet economy, the surprisingly strong growth performance of
Botswana, and the failure of many developing countries to sustain high growth rates.
And we challenge students with the discussion “Why Isn’t the Whole World Rich?”