Ebook Principles of macroeconomics (10th edition): Part 1

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TENTH EDITION

Principles of

Macroeconomics


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Macroeconomic Theory and Policy
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World Trade and Payments: An Introduction
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TENTH EDITION

Principles of

Macroeconomics

Karl E. Case
Wellesley College

Ray C. Fair
Yale University

Sharon M. Oster
Yale University

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Dedicated To
Professor Richard A. Musgrave
and
Professor Robert M. Solow
and
Professor Richard Caves

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Library of Congress Cataloging-in-Publication Data
Case, Karl E.
Principles of macroeconomics / Karl E. Case, Ray C. Fair, Sharon M. Oster.—10th ed.
p. cm.
Includes index.
ISBN-13: 978-0-13-139140-6
1. Macroeconomics. I. Fair, Ray C. II. Oster, Sharon M. III. Title.
HB172.5.C375 2012
339—dc22
2010049926
10 9 8 7 6 5 4 3 2 1

ISBN 13: 978-0-13-139140-6
ISBN 10: 0-13-139140-2


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About the Authors
Karl E. Case is Professor of Economics Emeritus at Wellesley College where he has taught for 34
years and served several tours of duty as Department Chair. He is a Senior Fellow at the Joint
Center for Housing Studies at Harvard University and a founding partner in the real estate

research firm of Fiserv Case Shiller Weiss, which produces the S&P Case-Shiller Index of home
prices. He serves as a member of the Index Advisory Committee of Standard and Poor’s, and along
with Ray Fair he serves on the Academic Advisory Board of the Federal Reserve Bank of Boston.
Before coming to Wellesley, he served as Head Tutor in Economics (director of undergraduate studies) at Harvard, where he won the Allyn Young Teaching Prize. He was Associate Editor of
the Journal of Economic Perspectives and the Journal of Economic Education, and he was a member
of the AEA’s Committee on Economic Education.
Professor Case received his B.A. from Miami University in 1968; spent three years on active
duty in the Army, and received his Ph.D. in Economics from Harvard University in 1976.
Professor Case’s research has been in the areas of real estate, housing, and public finance. He
is author or coauthor of five books, including Principles of Economics, Economics and Tax Policy,
and Property Taxation: The Need for Reform, and he has published numerous articles in professional journals.
For the last 25 years, his research has focused on real estate markets and prices. He has authored
numerous professional articles, many of which attempt to isolate the causes and consequences of
boom and bust cycles and their relationship to regional and national economic performance.
Ray C. Fair is Professor of Economics at Yale University. He is a member of the Cowles
Foundation at Yale and a Fellow of the Econometric Society. He received a B.A. in Economics
from Fresno State College in 1964 and a Ph.D. in Economics from MIT in 1968. He taught at
Princeton University from 1968 to 1974 and has been at Yale since 1974.
Professor Fair’s research has primarily been in the areas of macroeconomics and econometrics,
with particular emphasis on macroeconometric model building. He also has done work in the areas
of finance, voting behavior, and aging in sports. His publications include Specification, Estimation,
and Analysis of Macroeconometric Models (Harvard Press, 1984); Testing Macroeconometric Models
(Harvard Press, 1994); and Estimating How the Macroeconomy Works (Harvard Press, 2004).
Professor Fair has taught introductory and intermediate macroeconomics at Yale. He has
also taught graduate courses in macroeconomic theory and macroeconometrics.
Professor Fair’s U.S. and multicountry models are available for use on the Internet free of
charge. The address is . Many teachers have found that having students work with the U.S. model on the Internet is a useful complement to an introductory
macroeconomics course.
Sharon M. Oster is the Dean of the Yale School of Management, where she is also the Frederic
Wolfe Professor of Economics and Management. Professor Oster joined Case and Fair as a coauthor in the ninth edition of this book. Professor Oster has a B.A. in Economics from Hofstra

University and a Ph.D. in Economics from Harvard University.
Professor Oster’s research is in the area of industrial organization. She has worked on problems of
diffusion of innovation in a number of different industries, on the effect of regulations on business,
and on competitive strategy. She has published a number of articles in these areas and is the author of
several books, including Modern Competitive Analysis and The Strategic Management of Nonprofits.
Prior to joining the School of Management at Yale, Professor Oster taught for a number of
years in Yale’s Department of Economics. In the department, Professor Oster taught introductory
and intermediate microeconomics to undergraduates as well as several graduate courses in industrial organization. Since 1982, Professor Oster has taught primarily in the Management School,
where she teaches the core microeconomics class for MBA students and a course in the area of competitive strategy. Professor Oster also consults widely for businesses and nonprofit organizations
and has served on the boards of several publicly traded companies and nonprofit organizations.

v


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Brief Contents
PART I

Introduction to Economics

1

PART IV

1 The Scope and Method of Economics 1

Further Macroeconomics
Issues 287

2 The Economic Problem: Scarcity and Choice 25

15 Financial Crises, Stabilization, and Deficits 287

3 Demand, Supply, and Market Equilibrium 47

16 Household and Firm Behavior in the Macroeconomy:
A Further Look 303

4 Demand and Supply Applications 79

17 Long-Run Growth 323

PART II

Concepts and Problems in
Macroeconomics 97

5 Introduction to Macroeconomics 97

PART V

The World Economy

351

6 Measuring National Output and National
Income 111

19 International Trade, Comparative Advantage, and

Protectionism 351

7 Unemployment, Inflation, and Long-Run
Growth 129

20 Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates 375

PART III

The Core of Macroeconomic
Theory 145

21 Economic Growth in Developing and Transitional
Economies 401

Glossary 423

8 Aggregate Expenditure and Equilibrium Output 147

Index 429

9 The Government and Fiscal Policy 165

Photo Credits 439

10 The Money Supply and the Federal Reserve
System 189
11 Money Demand and the Equilibrium Interest
Rate 213

12 Aggregate Demand in the Goods and Money
Markets 229
13 Aggregate Supply and the Equilibrium Price
Level 247
14 The Labor Market In the Macroeconomy 269

vi

18 Alternative Views in Macroeconomics 337


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Contents
PART I Introduction To Economics 1

1

The Scope and Method of
Economics 1

Why Study Economics? 2
To Learn a Way of Thinking 2
To Understand Society 4
To Understand Global Affairs 5
To Be an Informed Citizen 5
ECONOMICS IN PRACTICE iPod and the World 6
The Scope of Economics 6
Microeconomics and Macroeconomics 6
The Diverse Fields of Economics 7

ECONOMICS IN PRACTICE Trust and Gender 9
The Method of Economics 9
Descriptive Economics and Economic Theory 10
Theories and Models 10
Economic Policy 13
An Invitation 15
Summary 15

Review Terms and Concepts 16

2

The Economic Problem: Scarcity
and Choice 25

Scarcity, Choice, and Opportunity Cost 26
Scarcity and Choice in a One-Person Economy 26
Scarcity and Choice in an Economy of Two or
More 27
ECONOMICS IN PRACTICE Frozen Foods and
Opportunity Costs 28
The Production Possibility Frontier 33
The Economic Problem 38
ECONOMICS IN PRACTICE Trade-Offs among the
Rich and Poor 39
Economic Systems and the Role of
Government 39
Command Economies 40
Laissez-Faire Economies: The Free Market 40
Mixed Systems, Markets, and Governments 42

Looking Ahead 42
Summary 43

Review Terms and Concepts 43

Problems 44

Problems 16

Appendix: How to Read and Understand Graphs 17

vii


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viii

3

Contents

Demand, Supply, and Market
Equilibrium 47

Firms and Households: The Basic DecisionMaking Units 47
Input Markets and Output Markets: The Circular
Flow 48
Demand in Product/Output Markets 50
Changes in Quantity Demanded versus Changes in
Demand 51

Price and Quantity Demanded: The Law of
Demand 51
Other Determinants of Household Demand 54
ECONOMICS IN PRACTICE Kindle in the College
Market? 55
Shift of Demand versus Movement Along a
Demand Curve 56
From Household Demand to Market Demand 58
Supply in Product/Output Markets 60
Price and Quantity Supplied: The Law of
Supply 61
Other Determinants of Supply 62
Shift of Supply versus Movement Along a Supply
Curve 63
From Individual Supply to Market Supply 65
Market Equilibrium 66
Excess Demand 66
Excess Supply 68
Changes in Equilibrium 69
ECONOMICS IN PRACTICE High Prices for
Tomatoes 70
Demand and Supply in Product Markets: A
Review 72
Looking Ahead: Markets and the Allocation of
Resources 72
ECONOMICS IN PRACTICE Why Do the Prices of
Newspapers Rise? 73
Summary 74

Review Terms and Concepts 75

Problems 76

4

Demand and Supply
Applications 79

The Price System: Rationing and Allocating
Resources 79
Price Rationing 79
ECONOMICS IN PRACTICE Prices and Total
Expenditure: A Lesson From the Lobster Industry in
2008–2009 81
Constraints on the Market and Alternative
Rationing Mechanisms 82
Prices and the Allocation of Resources 86
Price Floor 86
Supply and Demand Analysis: An Oil Import
Fee 86
ECONOMICS IN PRACTICE The Price Mechanism at
Work for Shakespeare 87
Supply and Demand and Market Efficiency 89
Consumer Surplus 89
Producer Surplus 90
Competitive Markets Maximize the Sum of
Producer and Consumer Surplus 91
Potential Causes of Deadweight Loss From Underand Overproduction 92
Looking Ahead 93
Summary 93

Review Terms and Concepts 94

Problems 94


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Contents

6

PART II Concepts and Problems in
Macroeconomics

5

Introduction to
Macroeconomics

97

97

Macroeconomic Concerns 98
Output Growth 98
Unemployment 99
Inflation and Deflation 100
The Components of the Macroeconomy 100
The Circular Flow Diagram 101
The Three Market Arenas 102

The Role of the Government in the
Macroeconomy 103
A Brief History of Macroeconomics 103
ECONOMICS IN PRACTICE Macroeconomics in
Literature 105
The U.S. Economy Since 1970 105
ECONOMICS IN PRACTICE John Maynard
Keynes 107
Summary 108

Review Terms and Concepts 109

Problems 109

ix

Measuring National Output and
National Income 111

Gross Domestic Product 111
Final Goods and Services 112
Exclusion of Used Goods and Paper
Transactions 112
Exclusion of Output Produced Abroad by
Domestically Owned Factors of Production 113
Calculating GDP 113
The Expenditure Approach 114
ECONOMICS IN PRACTICE Where Does eBay Get
Counted? 115
The Income Approach 117

ECONOMICS IN PRACTICE GDP: One of the Great
Inventions of the 20th Century 119
Nominal versus Real GDP 120
Calculating Real GDP 120
Calculating the GDP Deflator 122
The Problems of Fixed Weights 122
Limitations of the GDP Concept 123
GDP and Social Welfare 123
The Underground Economy 124
Gross National Income per Capita 124
Looking Ahead 125
Summary 125

Review Terms and Concepts 126

Problems 127


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x

Contents

7

Unemployment, Inflation, and
Long-Run Growth 129

Unemployment 129
Measuring Unemployment 129

Components of the Unemployment Rate 131
ECONOMICS IN PRACTICE A Quiet Revolution:
Women Join the Labor Force 133
The Costs of Unemployment 134
Inflation 135
The Consumer Price Index 136
The Costs of Inflation 137
ECONOMICS IN PRACTICE The Politics of Cost-ofLiving Adjustments 138
Long-Run Growth 140
Output and Productivity Growth 140
Looking Ahead 142
Summary 143

Review Terms and Concepts 143

Problems 143

PART III The Core of Macroeconomic
Theory

8

145

Aggregate Expenditure and
Equilibrium Output 147

The Keynesian Theory of Consumption 148
Other Determinants of Consumption 151
ECONOMICS IN PRACTICE Behavioral Biases in

Saving Behavior 152
Planned Investment (I) 152
The Determination of Equilibrium Output
(Income) 153
The Saving/Investment Approach to
Equilibrium 156
Adjustment to Equilibrium 157
The Multiplier 157
The Multiplier Equation 159
ECONOMICS IN PRACTICE The Paradox of
Thrift 160
The Size of the Multiplier in the Real World 161
Looking Ahead 161
Summary 162

Review Terms and Concepts 162

Appendix: Deriving the Multiplier Algebraically 164

Problems 162


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Contents

9

The Government and Fiscal
Policy 165

Government in the Economy 166
Government Purchases (G), Net Taxes (T), and
Disposable Income (Yd) 166
The Determination of Equilibrium Output
(Income) 168
Fiscal Policy at Work: Multiplier Effects 170
The Government Spending Multiplier 170
The Tax Multiplier 172
The Balanced-Budget Multiplier 174
The Federal Budget 175
The Budget in 2009 176
Fiscal Policy Since 1993: The Clinton, Bush, and
Obama Administrations 177
The Federal Government Debt 179
The Economy’s Influence on the Government
Budget 180
Automatic Stabilizers and Destabilizers 180
ECONOMICS IN PRACTICE Governments Disagree
on How Much More Spending Is Needed 181
Full-Employment Budget 181
Looking Ahead 182
Summary 182

Review Terms and Concepts 183

Problems 183

Appendix A: Deriving the Fiscal Policy Multipliers 185
Appendix B: The Case in Which Tax Revenues Depend on
Income

185

10

xi

The Money Supply and the
Federal Reserve System 189

An Overview of Money 189
What Is Money? 189
Commodity and Fiat Monies 190
ECONOMICS IN PRACTICE Dolphin Teeth as
Currency 191
Measuring the Supply of Money in the United
States 192
The Private Banking System 193
How Banks Create Money 193
A Historical Perspective: Goldsmiths 194
The Modern Banking System 195
The Creation of Money 196
The Money Multiplier 198
The Federal Reserve System 199
Functions of the Federal Reserve 200
Expanded Fed Activities Beginning in 2008 201
The Federal Reserve Balance Sheet 201
How the Federal Reserve Controls the Money
Supply 203
The Required Reserve Ratio 203

The Discount Rate 204
Open Market Operations 205
Excess Reserves and the Supply Curve for
Money 208
Looking Ahead 209
Summary 209

Review Terms and Concepts 209

Problems 210


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xii

Contents

11

Money Demand and the
Equilibrium Interest Rate

213

Interest Rates and Bond Prices 213
ECONOMICS IN PRACTICE Professor Serebryakov
Makes an Economic Error 214
The Demand for Money 214
The Transaction Motive 215
The Speculation Motive 218

The Total Demand for Money 218
ECONOMICS IN PRACTICE ATMs and the Demand
for Money 219
The Effect of Nominal Income on the Demand for
Money 219
The Equilibrium Interest Rate 220
Supply and Demand in the Money Market 220
Changing the Money Supply to Affect the Interest
Rate 222
Increases in P•Y and Shifts in the Money Demand
Curve 222
Zero Interest Rate Bound 223
Looking Ahead: The Federal Reserve and
Monetary Policy 223
Summary 223

Review Terms and Concepts 224

Problems 224

Appendix A: The Various Interest Rates in the U.S. Economy

225

Appendix B: The Demand For Money: A Numerical Example 227

12

Aggregate Demand in the Goods
and Money Markets 229

Planned Investment and the Interest Rate 230
Other Determinants of Planned Investment 230
ECONOMICS IN PRACTICE Small Business and the
Credit Crunch 231
Planned Aggregate Expenditure and the Interest
Rate 231
Equilibrium in Both the Goods and Money
Markets: The IS-LM Model 232
Policy Effects in the Goods and Money
Markets 233
Expansionary Policy Effects 233
Contractionary Policy Effects 235
The Macroeconomic Policy Mix 236
The Aggregate Demand (AD) Curve 237
The Aggregate Demand Curve: A Warning 237
Other Reasons for a Downward-Sloping Aggregate
Demand Curve 239
Shifts of the Aggregate Demand Curve from Policy
Variables 239
Looking Ahead: Determining the Price
Level 241
Summary 241

Review Terms and Concepts 242

Appendix: The IS-LM Model

243

Problems 242


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Contents

13

Aggregate Supply and the
Equilibrium Price Level 247

The Aggregate Supply Curve 247
The Aggregate Supply Curve: A Warning 247
Aggregate Supply in the Short Run 248
Shifts of the Short-Run Aggregate Supply
Curve 249
The Equilibrium Price Level 250
The Long-Run Aggregate Supply Curve 251
ECONOMICS IN PRACTICE The Simple “Keynesian”
Aggregate Supply Curve 252
Potential GDP 252
Monetary and Fiscal Policy Effects 253
Long-Run Aggregate Supply and Policy Effects 255
Causes of Inflation 255
Demand-Pull Inflation 255
Cost-Push, or Supply-Side, Inflation 256
Expectations and Inflation 256
Money and Inflation 257
ECONOMICS IN PRACTICE Inflationary
Expectations in China 258

Sustained Inflation as a Purely Monetary
Phenomenon 259
The Behavior of the Fed 259
Targeting the Interest Rate 259
The Fed’s Response to the State of the Economy 260
ECONOMICS IN PRACTICE Markets Watch the
Fed 261
Fed Behavior Since 1970 262
Interest Rates Near Zero 263
Inflation Targeting 264
Looking Ahead 264
Summary 264

Review Terms and Concepts 265

Problems 265

14

xiii

The Labor Market In the
Macroeconomy 269

The Labor Market: Basic Concepts 269
The Classical View of the Labor Market 270
The Classical Labor Market and the Aggregate
Supply Curve 271
The Unemployment Rate and the Classical
View 271

Explaining the Existence of Unemployment 272
Sticky Wages 272
Efficiency Wage Theory 273
ECONOMICS IN PRACTICE Does Unemployment
Insurance Increase Unemployment or Only Protect the
Unemployed? 274
Imperfect Information 275
Minimum Wage Laws 275
An Open Question 275
The Short-Run Relationship Between the
Unemployment Rate and Inflation 276
The Phillips Curve: A Historical Perspective 277
Aggregate Supply and Aggregate Demand Analysis
and the Phillips Curve 278
Expectations and the Phillips Curve 280
Inflation and Aggregate Demand 280
The Long-Run Aggregate Supply Curve,
Potential Output, and the Natural Rate of
Unemployment 281
The Nonaccelerating Inflation Rate of
Unemployment (NAIRU) 282
Looking Ahead 283
Summary 283

Review Terms and Concepts 284

Problems 284


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xiv

Contents

PART IV Further Macroeconomics Issues 287

15

Financial Crises, Stabilization,
and Deficits 287

The Stock Market, the Housing Market, and
Financial Crises 288
Stocks and Bonds 288
Determining the Price of a Stock 288
The Stock Market Since 1948 289
ECONOMICS IN PRACTICE Bubbles or Rational
Investors? 291
Housing Prices Since 1952 292
Household Wealth Effects on the Economy 292
Financial Crises and the 2008 Bailout 292
Asset Markets and Policy Makers 293
ECONOMICS IN PRACTICE Financial Reform
Bill 294
Time Lags Regarding Monetary and Fiscal
Policy 294
Stabilization 295
Recognition Lags 296
Implementation Lags 296
Response Lags 296

Summary 297
Government Deficit Issues 298
Deficit Targeting 298
Summary 300

Review Terms and Concepts 301

Problems 301

16

Household and Firm Behavior in
the Macroeconomy: A Further
Look 303

Households: Consumption and Labor Supply
Decisions 303
The Life-Cycle Theory of Consumption 303
The Labor Supply Decision 305
Interest Rate Effects on Consumption 307
Government Effects on Consumption and Labor
Supply: Taxes and Transfers 307
A Possible Employment Constraint on
Households 308
A Summary of Household Behavior 309
The Household Sector Since 1970 309
ECONOMICS IN PRACTICE Household Reactions to
Winning the Lottery 310
Firms: Investment and Employment
Decisions 312

Expectations and Animal Spirits 312
Excess Labor and Excess Capital Effects 313
Inventory Investment 313
A Summary of Firm Behavior 315
The Firm Sector Since 1970 315
Productivity and the Business Cycle 317
The Short-Run Relationship Between Output and
Unemployment 318
The Size of the Multiplier 319
Summary 320

Review Terms and Concepts 321

Problems 321


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Contents

17

Long-Run Growth

18

323

The Growth Process: From Agriculture to
Industry 324
Sources of Economic Growth 325

Increase in Labor Supply 326
Increase in Physical Capital 327
Increase in the Quality of the Labor Supply
(Human Capital) 328
ECONOMICS IN PRACTICE Education and Skills in
the United Kingdom 329
Increase in the Quality of Capital (Embodied
Technical Change) 329
Disembodied Technical Change 330
More on Technical Change 330
U.S. Labor Productivity: 1952 I–2010 I 331
Growth and the Environment and Issues of
Sustainability 332
Summary 334

Review Terms and Concepts 335

Problems 335

xv

Alternative Views in
Macroeconomics 337

Keynesian Economics 337
Monetarism 338
The Velocity of Money 338
The Quantity Theory of Money 338
Inflation as a Purely Monetary Phenomenon 340
The Keynesian/Monetarist Debate 341

Supply-Side Economics 341
The Laffer Curve 342
Evaluating Supply-Side Economics 342
New Classical Macroeconomics 343
The Development of New Classical
Macroeconomics 343
Rational Expectations 344
ECONOMICS IN PRACTICE How Are Expectations
Formed? 345
Real Business Cycle Theory and New Keynesian
Economics 346
Evaluating the Rational Expectations
Assumption 347
Testing Alternative Macroeconomic Models 348
Summary 348

Review Terms and Concepts 349

Problems 349


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xvi

Contents

PART V The World Economy 351

19

International Trade,
Comparative Advantage, and
Protectionism 351

Trade Surpluses and Deficits 352
The Economic Basis for Trade: Comparative
Advantage 353
Absolute Advantage versus Comparative
Advantage 353
Terms of Trade 357
Exchange Rates 358
The Sources of Comparative Advantage 360
The Heckscher-Ohlin Theorem 360
Other Explanations for Observed Trade Flows 361
Trade Barriers: Tariffs, Export Subsidies, and
Quotas 361
U.S. Trade Policies, GATT, and the WTO 362
ECONOMICS IN PRACTICE Tariff Wars 364
Free Trade or Protection? 364
The Case for Free Trade 364
The Case for Protection 366
ECONOMICS IN PRACTICE A Petition 367
An Economic Consensus 370
Summary 370

20

Review Terms and Concepts 371

Problems 371

Open-Economy
Macroeconomics: The Balance
of Payments and Exchange
Rates 375

The Balance of Payments 376
The Current Account 376
The Capital Account 378
ECONOMICS IN PRACTICE The Composition of
Trade Gaps 379
The United States as a Debtor Nation 379
Equilibrium Output (Income) in an Open
Economy 380
The International Sector and Planned Aggregate
Expenditure 380
Imports and Exports and the Trade Feedback
Effect 382
ECONOMICS IN PRACTICE The Recession Takes Its
Toll on Trade 383
Import and Export Prices and the Price Feedback
Effect 383

The Open Economy with Flexible Exchange
Rates 384
The Market for Foreign Exchange 384
Factors That Affect Exchange Rates 387
The Effects of Exchange Rates on the
Economy 389
ECONOMICS IN PRACTICE China’s Increased

Flexibility 390
ECONOMICS IN PRACTICE Losing Monetary Policy
Control 392
An Interdependent World Economy 393
Summary 393

Review Terms and Concepts 394

Problems 395

Appendix: World Monetary Systems Since 1900 396

21

Economic Growth in
Developing and Transitional
Economies 401

Life in the Developing Nations: Population and
Poverty 402
Economic Development: Sources and
Strategies 403
The Sources of Economic Development 404
ECONOMICS IN PRACTICE Corruption 406
Strategies for Economic Development 407
ECONOMICS IN PRACTICE Cell Phones Increase
Profits for Fishermen in India 410
Two Examples of Development: China and
India 411
Development Interventions 411

Random and Natural Experiments: Some New
Techniques in Economic Development 411
Education Ideas 412
Health Improvements 413
Population Issues 414
The Transition to a Market Economy 415
Six Basic Requirements for Successful Transition 415
Summary 419

Glossary
Index

Review Terms and Concepts 420

423

429

Photo Credits

439

Problems 421


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Preface
Our goal in the 10th edition, as it was in the first edition, is to instill in students a fascination
with both the functioning of the economy and the power and breadth of economics. The

first line of every edition of our book has been “The study of economics should begin with a
sense of wonder.” We hope that readers come away from our book with a basic understanding of how market economies function, an appreciation for the things they do well, and a
sense of the things they do poorly. We also hope that readers begin to learn the art and science of economic thinking and begin to look at some policy and even personal decisions in a
different way.

What’s New in This Edition?
Ⴇ The years 2008–2009 became the fifth recession in the United States since 1970. One of

Ⴇ

Ⴇ

Ⴇ

the new features of this edition is a discussion of this recession in the context of the
overall history of the U.S. economy. This most recent recession, however, required more
than the usual revisions, both because of its severity and because of the unusual nature
of both the events leading up to it and some of the remedies employed by the government to deal with it.
In June 2010, the balance sheet of the Federal Reserve had assets of $2.3 billion. Of these
assets, half, or just over $1.1 billion, was held in the form of mortgage-backed securities.
In 2007, the Fed held no mortgage-backed securities. In June 2010, commercial banks in
the United States held more than $900 billion in excess reserves at the Fed. In the past,
banks have held almost no excess reserves. These extraordinary changes at the Fed follow on the heels of interventions by the federal government in financial operations of
numerous private banks like J.P. Morgan and Goldman Sachs, as well as in companies
like AIG and General Motors. These extraordinary actions required substantial changes
throughout the macroeconomic chapters of this book. New material describing these
interventions appear in a number of chapters, both in the text itself and in the Economics
in Practice boxes. Revisions were also necessary in the background discussions of monetary policy, since the existence of excess reserves considerably complicates the usual
workings of monetary policy.
This edition has augmented the current research focus of many of the Economics in

Practice boxes. Historically, the boxes have focused principally on newspaper excerpts
related to the subject of the chapter. Beginning last edition and pushed through more
strongly this edition, we have added boxes that we hope will demonstrate more
clearly the ideas that lie at the heart of economic thinking. Thus, two thirds of the
boxes in the chapters relate an economic principle either to a personal observation or
to a recent piece of economic research (for example, new work by Rachel Croson on
gender and trust). When possible, we focus on work by younger scholars and on
more recent research. It is our hope that new students will be inspired by the wide
breadth and exciting nature of the research currently going on in economics as they
read these boxes.
Many graphs and tables have been heavily revised and updated to include the most
recent data available from 2008 to as recent as the fall of 2010. The inclusion of up-todate studies and data is essential to promoting a better understanding of recent macroeconomic developments.

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Preface

Ⴇ A number of the chapters have been reworked to improve their readability. The growth
Ⴇ

chapter, Chapter 17, has been completely rewritten. The other major changes concern
the new discussion needed for the 2008–2009 recession and the new policy initiatives.
We have added many new problems in the end-of-chapter materials, aiming for more
text-specific questions.

Economics is a social science. Its value is measured in part in terms of its ability to help

us understand the world around us and to grapple with some of the social issues of the
times. As we go to press in 2010, the U.S. economy is slowly recovering from a very difficult
downturn, with many people still unsuccessfully seeking work. What causes an economy
to falter and unemployment rates to grow? More generally, how do we measure and
understand economic growth? Are there government policies that can help prevent downturns or at least reduce their severity? In 2010, in the United States we hear increasing worries about the growing size of the government debt. Where did this debt come from, and
are people right to be worried? These question are macroeconomic questions. The years
2008–2010 have been very challenging years in the macroeconomy for most of the world.
In the United States the government has used policies never used before, and we have all—
macroeconomists and policy makers alike—struggled to figure out what works and what
does not. For someone studying macroeconomics, we are in the middle of an enormously
exciting time.

The Foundation
The themes of Principles of Macroeconomics, 10th edition, are the same themes of the first
nine editions. The purposes of this book are to introduce the discipline of economics and to
provide a basic understanding of how economies function. This requires a blend of economic theory, institutional material, and real-world applications. We have maintained a balance between these ingredients in every chapter. The hallmark features of our book are its:
1. Three-tiered explanations of key concepts (stories-graphs-equations)
2. Intuitive and accessible structure
3. International coverage

Three-Tiered Explanations: Stories-Graphs-Equations
Professors who teach principles of economics are faced with a classroom of students with different abilities, backgrounds, and learning styles. For some students, analytical material is difficult no matter how it is presented; for others, graphs and equations seem to come naturally.
The problem facing instructors and textbook authors is how to convey the core principles of
the discipline to as many students as possible without selling the better students short. Our
approach to this problem is to present most core concepts in the following three ways:
First, we present each concept in the context of a simple intuitive story or example in
words often followed by a table. Second, we use a graph in most cases to illustrate the story
or example. And finally, in many cases where appropriate, we use an equation to present the
concept with a mathematical formula.

Macroeconomic Structure
We remain committed to the view that it is a mistake simply to throw aggregate demand and
aggregate supply curves at students in the first few chapters of a principles book. To understand the AS and AD curves, students need to know about the functioning of both the goods
market and the money market. The logic behind the simple demand curve is wrong when it
is applied to the relationship between aggregate demand and the price level. Similarly, the


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Preface

logic behind the simple supply curve is wrong when it is applied to the relationship between
aggregate supply and the price level.
Part of teaching economics is teaching economic reasoning. Our discipline is built around
deductive logic. Once we teach students a pattern of logic, we want and expect them to apply it
to new circumstances. When they apply the logic of a simple demand curve or a simple supply
curve to the aggregate demand or aggregate supply curve, the logic does not fit. We believe that
the best way to teach the reasoning embodied in the aggregate demand and aggregate supply
curves without creating confusion for students is to build up to those topics carefully.
In Chapter 8, “Aggregate Expenditure and Equilibrium Output,” and Chapter 9, “The
Government and Fiscal Policy,” we examine the market for goods and services. In Chapter 10,
“The Money Supply and the Federal Reserve System,” and Chapter 11, “Money Demand
and the Equilibrium Interest Rate,” we examine the money market. We bring the two markets together in Chapter 12, “Aggregate Demand in the Goods and Money Markets,” which
explains the links between aggregate output (Y) and the interest rate (r) and derives the
AD curve. In Chapter 13, “Aggregate Supply and the Equilibrium Price Level,” we introduce the AS curve and determine the equilibrium price level (P). We then explain in
Chapter 14, “The Labor Market in the Macroeconomy,” how the labor markets fits into this
macroeconomic picture. The figure below (Figure III.1 from page 145) gives you an
overview of this structure.
One of the big issues in the organization of the macroeconomic material is whether
long-run growth issues should be taught before short-run chapters on the determination of
national income and countercyclical policy. In the last three editions, we moved a significant discussion of growth to Chapter 7, “Unemployment, Inflation, and Long-Run

Growth,” and highlighted it. However, while we wrote Chapter 17, the major chapter on
long-run growth, so that it can be taught before or after the short-run chapters, we remain
convinced that it is easier for students to understand the growth issue once they have come
to grips with the logic and controversies of short-run cycles, inflation, and unemployment.

CHAPTERS 8–9
CHAPTER 13

The Goods-and-Services
Market
• Planned aggregate
expenditure
Consumption (C)
Planned investment (I)
Government (G)
• Aggregate output
(income) (Y)

Aggregate Supply
• Aggregate supply curve
The Labor Market

CHAPTER 12
Y

Connections between
the goods-and-services
market and the money
market
r

Y

CHAPTERS 10–11
Aggregate Demand
The Money Market
• The supply of money
• The demand for money
• Interest rate (r)

CHAPTER 14

P

• Aggregate demand
curve
P

Y

İ FIGURE III.1 The Core of Macroeconomic Theory

• Equilibrium interest
rate (r*)
• Equilibrium output
(income) (Y*)
• Equilibrium price
level (P*)

• The supply of labor

• The demand for labor
• Employment and
unemployment

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xx

Preface

International Coverage
As in previous editions, we continue to integrate international examples and applications
throughout the text. This probably goes without saying: The days in which an introductory
economics text could be written with a closed economy in mind have long since gone.

Tools for Learning
As authors and teachers, we understand the challenges of the principles of economics course.
Our pedagogical features are designed to illustrate and reinforce key economic concepts
through real-world examples and applications.

Economics in Practice
As described earlier, the Economics in Practice feature presents a real-world personal observation, current research work, or a news article that supports the key concept of the chapter
and helps students think critically about how economics is a part of their daily lives. The
end-of-chapter problem sets include a question specific to each Economics in Practice feature.
Students can visit www.myeconlab.com for additional updated news articles and related
exercises.

Graphs

Reading and interpreting graphs is a key part of understanding economic concepts. The
Chapter 1 Appendix, “How to Read and Understand Graphs,” shows readers how to interpret
the 200-plus graphs featured in this book. We use red curves to illustrate the behavior of
firms and blue curves to show the behavior of households. We use a different shade of red
and blue to signify a shift in a curve.

Problems and Solutions
Each chapter and appendix ends with a problem set that asks students to think about and
apply what they’ve learned in the chapter. These problems are not simple memorization
questions. Rather, they ask students to perform graphical analysis or to apply economics to a
real-world situation or policy decision. More challenging problems are indicated by an asterisk. Additional questions specific to the Economics in Practice feature have been added.
Several problems have been updated. The solutions to all of the problems are available in the
Instructor’s Manuals. Instructors can provide the solutions to their students so they can
check their understanding and progress.

P

Demand, or Shortage
At a price of $1.75 per bushel,
quantity demanded exceeds
quantity supplied. When excess
demand exists, there is a tendency
for price to rise. When quantity
demanded equals quantity supplied, excess demand is eliminated and the market is in
equilibrium. Here the equilibrium price is $2.50 and the equilibrium quantity is 35,000
bushels.

Price of soybeans per bushel ($)

Ī FIGURE 3.9 Excess

S

Equilibrium point

2.50
1.75

Excess demand
= shortage

0

25,000

35,000

Bushels of soybeans

D

50,000

Q


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Preface

MyEconLab

Both the text and supplement package provide ways for instructors and students to assess
their knowledge and progress through the course. MyEconLab, the new standard in personalized online learning, is a key part of Case, Fair, and Oster’s integrated learning package for
the 10th edition.

For the Instructor
MyEconLab is an online course
management, testing, and tutorial resource. Instructors can
choose how much or how little
time to spend setting up and
using MyEconLab. Each chapter
contains two Sample Tests, Study
Plan Exercises, and Tutorial
Resources. Student use of these
materials requires no initial setup
by their instructor. The online
Gradebook records each student’s performance and time spent on the Tests and Study Plan and
generates reports by student or by chapter. Instructors can assign tests, quizzes, and homework in
MyEconLab using four resources:

Ⴇ
Ⴇ
Ⴇ
Ⴇ

Preloaded Sample Tests
Problems similar to the end-of-chapter problems
Test Item File questions
Self-authored questions using Econ Exercise Builder

Exercises use multiple-choice, graph drawing, and free-response items, many of which

are generated algorithmically so that each time a student works them, a different variation is
presented. MyEconLab grades every problem, even those with graphs. When working homework exercises, students receive immediate feedback with links to additional learning tools.
Customization and Communication MyEconLab in CourseCompass™ provides additional
optional customization and communication tools. Instructors who teach distance learning
courses or very large lecture sections find the CourseCompass format useful because they
can upload course documents and assignments, customize the order of chapters, and use
communication features such as Digital Drop Box and Discussion Board.

Experiments in MyEconLab
Experiments are a fun and engaging way to promote active learning and mastery of important
economic concepts. Pearson’s experiments program is flexible and easy for instructors and students to use.

Ⴇ Single-player experiments allow your students to play an experiment against virtual
Ⴇ

players from anywhere at anytime with an Internet connection.
Multiplayer experiments allow you to assign and manage a real-time experiment with
your class. In both cases, pre- and post-questions for each experiment are available for
assignment in MyEconLab.

For the Student
MyEconLab puts students in control of their learning through a collection of tests, practice,
and study tools tied to the online interactive version of the textbook, as well as other media
resources. Within MyEconLab’s structured environment, students practice what they learn,
test their understanding, and pursue a personalized Study Plan generated from their

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xxii

Preface

performance on Sample Tests and tests set by their instructors. At the core of MyEconLab are
the following features:

Ⴇ
Ⴇ
Ⴇ
Ⴇ

Sample Tests, two per chapter
Personal Study Plan
Tutorial Instruction
Graphing Tool

Sample
Tests Two
Sample Tests for each
chapter are preloaded in
MyEconLab, enabling students to practice what
they have learned, test
their understanding, and
identify areas in which
they need further work.
Students can study on
their own, or they can
complete assignments created by their instructor.
Personal Study Plan

Based on a student’s
performance on tests,
MyEconLab generates a
personal Study Plan that
shows where the student
needs further study. The
Study Plan consists of a
series of additional practice exercises with detailed
feedback and guided solutions that are keyed to
other tutorial resources.
Tutorial
Instruction
Launched from many of
the exercises in the Study Plan, MyEconLab provides tutorial instruction in the form of stepby-step solutions and other media-based explanations.
Graphing Tool A graphing tool is integrated into the Tests and Study Plan exercises to
enable students to make and manipulate graphs. This feature helps students understand how
concepts, numbers, and graphs connect.
Additional MyEconLab Tools MyEconLab includes the following additional features:
1. Economics in the News—This feature provides weekly updates during the school year of
news items with links to sources for further reading and discussion questions.
2. eText—While students are working in the Study Plan or completing homework assignments, one of the tutorial resources available is a direct link to the relevant page of the text
so that students can review the appropriate material to help them complete the exercise.
3. Glossary—This searchable version of the textbook glossary provides additional examples
and links to related terms.
4. Glossary Flashcards—Every key term is available as a flashcard, allowing students to quiz
themselves on vocabulary from one or more chapters at a time.
5. Research Navigator (CourseCompass™ version only)—This feature offers extensive help
on the research process and provides four exclusive databases of credible and reliable source
material, including the New York Times, the Financial Times, and peer-reviewed journals.

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Preface

MyEconLab content has been created through the efforts of:
Charles Baum, Middle Tennessee State University; Sarah Ghosh, University of Scranton;
Russell Kellogg, University of Colorado–Denver; Bert G. Wheeler, Cedarville University; and
Noel Lotz and Douglas A. Ruby, Pearson Education

Resources for the Instructor
The following supplements are designed to make teaching and testing flexible and easy.

Instructor’s Manual
Prepared by Tony Lima of California State University, East Bay (Hayward, California), the
Instructor’s Manual is designed to provide the utmost teaching support for instructors. It
includes the following content:

Ⴇ Detailed Chapter Outlines include key terminology, teaching notes, and lecture
Ⴇ
Ⴇ
Ⴇ
Ⴇ
Ⴇ
Ⴇ

suggestions.
Topics for Class Discussion provide topics and real-world situations that help ensure that
economic concepts resonate with students.
Unique Economics in Practice features that are not in the main text provide extra realworld examples to present and discuss in class.
Teaching Tips provide tips for alternative ways to cover the material and brief reminders

on additional help to provide students. These tips include suggestions for exercises and
experiments to complete in class.
Extended Applications include exercises, activities, and experiments to help make economics relevant to students.
Excel Workbooks, available for many chapters, make it easy to customize numerical
examples and produce graphs.
Solutions are provided for all problems in the book.

Three Test Item Files
We have tailored the Test Item Files to help instructors easily and efficiently assess student
understanding of economic concepts and analyses. Test questions are annotated with the following information:

Ⴇ
Ⴇ
Ⴇ
Ⴇ
Ⴇ

Difficulty: 1 for straight recall, 2 for some analysis, 3 for complex analysis
Type: Multiple-choice, true/false, short-answer, essay
Topic: The term or concept the question supports
Skill: Fact, definition, analytical, conceptual
AACSB: See description in the next section.

The Test Item Files include questions with tables that students must analyze to solve for
numerical answers. The Test Item Files also contain questions based on the graphs that appear in
the book. The questions ask students to interpret the information presented in the graph. Many
questions require students to sketch a graph on their own and interpret curve movements.
Macroeconomics Test Item File 1, by Randy Methenitis of Richland College: Test Item
File 1 (TIF1) includes over 2,900 questions. All questions are machine gradable and are either
multiple-choice or true/false. This Test Item File is for use with the 10th edition of Principles

of Macroeconomics in the first year of publication. This Test Item File is available in a computerized format using TestGen EQ test-generating software and included in MyEconLab.
Macroeconomics Test Item File 2, by Randy Methenitis of Richland College: This
additional Test Item File contains another 2,900 machine-gradable questions based on

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