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Macroeconomics Twelfth Edition

Robert J. Gordon Stanley G. Harris Professor in the Social Sciences Northwestern University

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Cover image: © Collier Campbell Lifeworks/CORBIS Photo credits: page v photo of Robert J. Gordon by Julie P. Gordon; Chapter 2, page 27: U.S. Department of Commerce; Chapter 5, page 135: Everett Collection/SuperStock; page 153: Fotosearch/SuperStock; Chapter 8, page 249: A. H. C./AGE Fotostock; Chapter 10, page 323: Robert Kradin/AP Images; page 325: MGM/The Kobal Collection; Chapter 11, page 366: Rob Crandall/The Image Works; Chapter 12, page 404: Iain Masterton/Alamy; page 405: Eye Ubiquitous/SuperStock; page 407: Holton Collection/SuperStock; Chapter 13, page 437: AFP/ Getty Images; page 440: Digital Vision; Chapter 14, page 454: VisionsofAmerica/Joe Sohm; page 474: Medioimages/Photodisc; Chapter 15, page 492: Bachrach/Getty Images; page 498: Caro/Alamy; Chapter 16, page 528: Dmitry Kalinovsky/Shutterstock; page 534: ClassicStock/Alamy; Chapter 17, page 545 top: Chuck Nacke/Alamy; page 545 bottom: Che Qingjiu/Imaginechina/AP Images; page 546: Charles Bennett/AP Images; Chapter 18, page 591: Directphoto/Alamy. Many of the designations used by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and Addison-Wesley was aware of a trademark claim, the designations have been printed in initial caps or all caps. Library of Congress Cataloging-in-Publication Data Gordon, Robert J. (Robert James), Macroeconomics/Robert Gordon.—12th ed. p. cm. Includes index. ISBN 978-0-13-801491-9 (student) 1. Macroeconomics. I. Title. HB172.5 G67 2012 339–dc22 2011006181 Copyright © 2012, 2009, 2006, 2003, 2000 Pearson Education, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. For information on obtaining permission for use of material in this work, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617-671-3447, or e-mail at http://www.pearsoned.com/legal/permission.htm ISBN-13 978-0-13-801491-9 ISBN-10 0-13-801491-4 1 2 3 4 5 6 7 8 9 10—RRD—15 14 13 12 11

About the Author Robert J. Gordon Robert J. Gordon is Stanley G. Harris Professor in the Social Sciences and Professor of Economics at Northwestern University. He did his undergraduate work at Harvard and then attended Oxford University in England on a Marshall Scholarship. He received his Ph.D. in 1967 at M.I.T. and taught at Harvard and the University of Chicago before coming to Northwestern in 1973, where he has taught for 38 years and was chair of the Department of Economics from 1992 to 1996. Professor Gordon is one of the world’s leading experts on inflation, unemployment, and productivity growth. His recent work on the rise and fall of the New Economy, the U.S. productivity growth revival, and the recent stalling of European productivity growth has been widely cited. He is the author of The Measurement of Durable Goods Prices, which has become known as the definitive work showing that government price indexes substantially overstate the rate of inflation. His book of collected essays, Productivity Growth, Inflation, and Unemployment, was published in 2004. He is editor of Milton Friedman’s Monetary Framework: A Debate with His Critics, The American Business Cycle, and The Economics of New Goods. In addition, he is the author of more than 100 scholarly articles and more than 60 published comments on the research of others. In addition to his main field of macroeconomics, he is also a frequently quoted expert and author on the airline industry and is the founder and president of an Internet chat group on airline management. Gordon is a Research Associate of the National Bureau of Economic Research and since 1978 a member of its Business Cycle Dating Committee, a Research Fellow of the Centre for Economic Policy Research (London), a Research Fellow of OFCE in Paris, a Guggenheim Fellow, a Fellow of the American Academy of Arts and Sciences, and a Fellow of the Econometric Society. He has served as the coeditor of the Journal of Political Economy and as an elected at-large member of the Executive Committee of the American Economic Association. He serves currently as advisor to the Brookings Panel on Economic Activity and on the economic advisory panel of the Bureau of Economic Analysis. He has served as a member of the Technical Panel on Assumptions and Methods of the Social Security Administration and on the national “Boskin Commission” to assess the accuracy of the U.S. Consumer Price Index. Gordon lives in Evanston, Illinois, with his wife, Julie, and their two dogs, Lucky and Toto (see the box on p. 325 for more about Toto).

v

with love, for Julie

Brief Contents Preface PART I

Introduction and Measurement

CHAPTER 1

What Is Macroeconomics?

CHAPTER 2

The Measurement of Income, Prices, and Unemployment

PART II

xvi

1 24

The Short Run: Business Cycles and Policy Responses Income and Interest Rates: The Keynesian Cross Model and the IS Curve

54

CHAPTER 4

Strong and Weak Policy Effects in the IS-LM Model

88

CHAPTER 5

Financial Markets, Financial Regulation, and Economic Instability

121

CHAPTER 6

The Government Budget, the Government Debt, and the Limitations of Fiscal Policy

158

International Trade, Exchanges Rates, and Macroeconomic Policy

190

CHAPTER 3

CHAPTER 7

PART III

The Price Level, Inflation, and Unemployment

CHAPTER 8

Aggregate Demand, Aggregate Supply, and the Great Depression

231

CHAPTER 9

Inflation: Its Causes and Cures

265

The Goals of Stabilization Policy: Low Inflation and Low Unemployment

314

CHAPTER 10

PART IV

The Long Run: Economic Growth, Success, and Failure

CHAPTER 11

The Theory of Economic Growth

358

CHAPTER 12

The Big Questions of Economic Growth

387

PART V

Monetary Policy and the Sources of Instability

CHAPTER 13

Money, Banks, and the Federal Reserve

424

CHAPTER 14

The Goals, Tools, and Rules of Monetary Policy

450

CHAPTER 15

The Economics of Consumption Behavior

481

CHAPTER 16

The Economics of Investment Behavior

517

PART VI

The Evolution of Macroeconomic Ideas

CHAPTER 17

New Classical Macro and New Keynesian Macro

543

CHAPTER 18

Conclusion: Where We Stand

571 vii

Contents Preface PART I CHAPTER 1

Introduction and Measurement What Is Macroeconomics?

1

1-1

How Macroeconomics Affects Our Everyday Lives

1

Global Economic Crisis Focus: What Makes It Unique?

3

1-2

Defining Macroeconomics

3

1-3

Actual and Natural Real GDP

4

1-4

Macroeconomics in the Short Run and Long Run

7

1-5

CASE STUDY: How Does the Global Economic Crisis Compare

to Previous Business Cycles?

11

1-6

Macroeconomics at the Extremes

13

1-7

Taming Business Cycles: Stabilization Policy

17

International Perspective: Differences Between the United States and Europe Before and During the Global Economic Crisis

18

Global Economic Crisis Focus: New Challenges for Monetary and Fiscal Policy

20

The “Internationalization” of Macroeconomics

20

The Measurement of Income, Prices, and Unemployment

24

2-1

Why We Care About Income

24

2-2

The Circular Flow of Income and Expenditure

24

2-3

What GDP Is, and What GDP Is Not

26

Where to Find the Numbers: A Guide to the Data

27

2-4

2-5 2-6 2-7

2-8

Components of Expenditure

30

Global Economic Crisis Focus: Which Component of GDP Declined the Most in the Global Economic Crisis?

34

The “Magic” Equation and the Twin Deficits

34

Global Economic Crisis Focus: Chicken or Egg in Recessions?

36

Where Does Household Income Come From?

37

Nominal GDP, Real GDP, and the GDP Deflator

39

How to Calculate Inflation, Real GDP Growth, or Any Other Growth Rate

41

Measuring Unemployment

42

Understanding the Global Economic Crisis: The Ranks of the Hidden Unemployed

44

APPENDIX TO CHAPTER 2: How We Measure Real GDP and the Inflation Rate viii

11

Global Economic Crisis Focus: How It Differs from 1982–83

1-8 CHAPTER 2

xvi

51

Contents

PART II CHAPTER 3

ix

The Short Run: Business Cycles and Policy Responses Income and Interest Rates: The Keynesian Cross Model and the IS Curve

54

3-1

54

3-2 3-3

3-4

Business Cycles and the Theory of Income Determination Global Economic Crisis Focus: What Were the Shocks That Made the 2008–09 Economic Crisis So Severe?

56

Income Determination, Unemployment, and the Price Level

56

Planned Expenditure

57

Global Economic Crisis Focus: Financial Market Instability as the Main Cause of the Global Economic Crisis

61

The Economy In and Out of Equilibrium

61

Understanding the Global Economic Crisis: How Changes in Wealth Influence Consumer Spending

62

3-5

The Multiplier Effect

67

3-6

Sources of Shifts in Planned Spending

69

3-7

How Can Monetary Policy Affect Planned Spending?

72

3-8

The Relation of Autonomous Planned Spending to the Interest Rate

73

Understanding the Global Economic Crisis: A Central Explanation of Business Cycles Is the Volatility of Investment

74

The IS Curve

76

Conclusion: The Missing Relation

78

Learning About Diagrams: The IS Curve

79

3-9 3-10

APPENDIX TO CHAPTER 3: Allowing for Income Taxes and

Income-Dependent Net Exports CHAPTER 4

Strong and Weak Policy Effects in the IS-LM Model

85

88

4-1

Introduction: The Power of Monetary and Fiscal Policy

88

4-2

Income, the Interest Rate, and the Demand for Money

88

4-3 4-4 4-5 4-6

4-7

4-8 4-9

The LM Curve

91

Learning About Diagrams: The LM Curve

93

The IS Curve Meets the LM Curve

94

Global Economic Crisis Focus: Causes of a Leftward Shift in the IS Curve

95

Monetary Policy in Action

96

How Fiscal Expansion Can “Crowd Out” Private Investment

97

Global Economic Crisis Focus: How Monetary Policy Can Be Ineffective in the IS-LM Model

99

Strong and Weak Effects of Monetary Policy

99

Understanding the Global Economic Crisis: How Easy Money Helped to Create the Housing Bubble and Bust

102

Strong and Weak Effects of Fiscal Policy

105

Using Fiscal and Monetary Policy Together

107

International Perspective: Monetary Policy Hits the Zero Lower Bound in Japan and in the United States

110

APPENDIX TO CHAPTER 4: The Elementary Algebra of the IS-LM Model

117

x

Contents CHAPTER 5

Financial Markets, Financial Regulation, and Economic Instability 5-1

Introduction: Financial Markets and Macroeconomics

121

5-2

CASE STUDY: Dimensions of the Global Economic Crisis

122

5-3

Financial Institutions, Balance Sheets, and Leverage

127

A Hardy Perennial: Bubbles and Crashes

133

5-4

5-5 5-6

5-7 5-8

CHAPTER 6

Understanding the Global Economic Crisis: Two Bubbles: 1927–29 in the Stock Market Versus 2000–06 in the Housing Market

134

Financial Innovation and the Subprime Mortgage Market

137

The IS-LM Model, Financial Markets, and the Monetary Policy Dilemma

139

Why Do Asset Purchases Reduce Interest Rates?

144

Understanding the Global Economic Crisis: The IS-LM Summary of the Causes of the Global Economic Crisis

146

The Fed’s New Instrument: Quantitative Easing

146

How the Crisis Became Worldwide and the Dilemma for Policymakers

151

International Perspective: Weighing the Causes: Why Did Canada Perform Better?

153

The Government Budget, the Government Debt, and the Limitations of Fiscal Policy 6-1

158

Introduction: Can Fiscal Policy Rescue Monetary Policy from Ineffectiveness?

158

6-2

The Pervasive Effects of the Government Budget

159

6-3

CASE STUDY: The Government Budget in Historical Perspective

160

6-4

Automatic Stabilization and Discretionary Fiscal Policy

162

Global Economic Crisis Focus: Automatic Stabilization and Fiscal Stimulus in the Crisis

165

Government Debt Basic Concepts

167

6-5 6-6

Will the Government Remain Solvent?

169

International Perspective: The Debt-GDP Ratio: How Does the United States Compare?

171

6-7

CASE STUDY: Historical Behavior of the Debt-GDP Ratio Since 1790

172

6-8

Factors Influencing the Multiplier Effect of a Fiscal Policy Stimulus

174

6-9 6-10

6-11 CHAPTER 7

121

CASE STUDY: The Fiscal Policy Stimulus of 2008–11

177

Government Spending and Transfers to States/Localities

181

Understanding the Global Economic Crisis: Comparing the Obama Stimulus with FDR’s New Deal

182

Conclusion: Strengths and Limitations of Fiscal Policy

185

International Trade, Exchanges Rates, and Macroeconomic Policy

190

7-1

Introduction

190

7-2

The Current Account and Balance of Payments

191

7-3

Exchange Rates

199

7-4

The Market for Foreign Exchange

200

Real Exchange Rates and Purchasing Power Parity

205

International Perspective: Big Mac Meets PPP

208

7-5

Contents 7-6

Exchange Rate Systems

7-7

CASE STUDY: Asia Intervenes with Buckets to Buy Dollars and Finance

the U.S. Current Account Deficit—How Long Can This Continue?

215

7-9

The Real Exchange Rate and Interest Rate

218

Effects of Monetary and Fiscal Policy with Fixed and Flexible Exchange Rates

220

Global Economic Crisis Focus: Is the United States Prevented from Implementing a Fiscal Policy Stimulus by Its Flexible Exchange Rate?

223

Summary of Monetary and Fiscal Policy Effects in Open Economies

224

Conclusion: Economic Policy in the Open Economy

224

The Price Level, Inflation, and Unemployment Aggregate Demand, Aggregate Supply, and the Great Depression

231

8-1

Combining Aggregate Demand with Aggregate Supply

231

8-2

Flexible Prices and the AD Curve

232

8-3

Shifting the Aggregate Demand Curve with Monetary and Fiscal Policy

234

Global Economic Crisis Focus: The Crisis Was a Demand Problem Not Involving Supply

236

Learning About Diagrams: The AD Curve

237

8-4

Alternative Shapes of the Short-Run Aggregate Supply Curve

237

8-5

The Short-Run Aggregate Supply (SAS) Curve When the Nominal Wage Rate Is Constant

239

Learning About Diagrams: The SAS Curve

242

8-6

Fiscal and Monetary Expansion in the Short and Long Run

243

Summary of the Economy’s Adjustment to an Increase in Aggregate Demand

245

8-7

Classical Macroeconomics: The Quantity Theory of Money and the Self-Correcting Economy

246

8-8

The Keynesian Revolution: The Failure of Self-Correction

249

Global Economic Crisis Focus: The Zero Lower Bound as Another Source of Monetary Impotence

250

CASE STUDY: What Caused the Great Depression?

253

International Perspective: Why Was the Great Depression Worse in the United States Than in Europe?

258

8-9

CHAPTER 9

212

Determinants of Net Exports

7-11

CHAPTER 8

208

7-8 7-10

PART III

xi

Inflation: Its Causes and Cures

265

9-1

Introduction

265

9-2

Real GDP, the Inflation Rate, and the Short-Run Phillips Curve

268

The Adjustment of Expectations

271

9-3

Learning About Diagrams: The Short-Run (SP) and Long-Run (LP) Phillips Curves

273

9-4

Nominal GDP Growth and Inflation

273

9-5

Effects of an Acceleration in Nominal GDP Growth

275

9-6

Expectations and the Inflation Cycle

277

xii

Contents 9-7

Recession as a Cure for Inflation

280

International Perspective: Did Disinflation in Europe Differ from That in the United States?

282

Global Economic Crisis Focus: Policymakers Face the Perils of Deflation

283

9-8

The Importance of Supply Shocks

284

Types of Supply Shocks and When They Mattered

286

9-9

The Response of Inflation and the Output Ratio to a Supply Shock

288

Understanding the Global Economic Crisis: The Role of Inflation During the Housing Bubble and Subsequent Economic Collapse

290

9-10

Inflation and Output Fluctuations: Recapitulation of Causes and Cures

293

9-11

How Is the Unemployment Rate Related to the Inflation Rate?

APPENDIX TO CHAPTER 9: The Elementary Algebra of the SP-DG Model CHAPTER 10

The Goals of Stabilization Policy: Low Inflation and Low Unemployment 10-1 10-2 10-3

10-4 10-5

Global Economic Crisis Focus: Inflation Versus Unemployment in the Crisis

314

The Costs and Causes of Inflation

315

Money and Inflation

316

International Perspective: Money Growth and Inflation

319

Why Inflation Is Not Harmless

320

Global Economic Crisis Focus: The Housing Bubble as Surprise Inflation Followed by Surprise Deflation

322

The Wizard of Oz as a Monetary Allegory

325

Indexation and Other Reforms to Reduce the Costs of Inflation

328

The Indexed Bond (TIPS) Protects Investors from Inflation

329

The Government Budget Constraint and the Inflation Tax

330 332

10-6

Starting and Stopping a Hyperinflation

334

10-7

Why the Unemployment Rate Cannot Be Reduced to Zero

337

Sources of Mismatch Unemployment

340

10-9 10-10

Global Economic Crisis Focus: The Crisis Raises the Incidence of Structural Unemployment

342

Turnover Unemployment and Job Search

342

The Costs of Persistently High Unemployment

346

Understanding the Global Economic Crisis: Why Did Unemployment Rise Less in Europe Than in the United States After 2007?

350

10-11 Conclusion: Solutions to the Inflation and Unemployment Dilemma

CHAPTER 11

314

Understanding the Global Economic Crisis: How a Large Recession Can Create a Large Fiscal Deficit

10-8

PART IV

297 306

350

The Long Run: Economic Growth, Success, and Failure The Theory of Economic Growth 11-1 11-2

358

The Importance of Economic Growth

358

Standards of Living as the Consequence of Economic Growth

359

International Perspective: The Growth Experience of Seven Countries Over the Past Century

360

Contents

xiii

11-3

The Production Function and Economic Growth

362

11-4

Solow’s Theory of Economic Growth

365

11-5

Technology in Theory and Practice

369

11-6

Puzzles That Solow’s Theory Cannot Explain

372

11-7

Human Capital, Immigration, and the Solow Puzzles

375

11-8

Endogenous Growth Theory: How Is Technological Change Produced?

377

11-9

Conclusion: Are There Secrets of Growth?

379

APPENDIX TO CHAPTER 11: General Functional Forms and the Production

Function CHAPTER 12

The Big Questions of Economic Growth Answering the Big Questions

387

12-2

The Standard of Living and Concepts of Productivity

389

12-3

The Failure of Convergence

392

12-4

Human Capital and Technology

398

12-5

Political Capital, Infrastructure, and Geography

399

International Perspective: A Symptom of Poverty: Urban Slums in the Poor Cities

401

International Perspective: Institutions Matter: South Korea Versus North Korea

404

International Perspective: Growth Success and Failure in the Tropics

407

CASE STUDY: Uneven U.S. Productivity Growth Across Eras

408

Global Economic Crisis Focus: Lingering Effects of the 2007–09 Recession on Long-Term Economic Growth

414

12-7

CASE STUDY: The Productivity Growth Contrast Between Europe

and the United States 12-8

CHAPTER 13

Conclusion on the Great Questions of Growth

415 419

Monetary Policy and the Sources of Instability Money, Banks, and the Federal Reserve

424

13-1

Money as a Tool of Stabilization Policy

424

13-2

Definitions of Money

425

13-3

High-Powered Money and Determinants of the Money Supply

427

13-4

The Fed’s Three Tools for Changing the Money Supply

431

13-5

13-6 CHAPTER 14

387

12-1

12-6

PART V

385

Theories of the Demand for Money

436

International Perspective: Plastic Replaces Cash, and the Cell Phone Replaces Plastic

440

Why the Federal Reserve “Sets” Interest Rates

443

The Goals, Tools, and Rules of Monetary Policy 14-1

14-2

The Central Role of Demand Shocks

450 450

Global Economic Crisis Focus: The Weakness of Monetary Policy After 2008 Reveals a More General Problem

451

Stabilization Targets and Instruments in the Activists’ Paradise

451

Rules Versus Activism in a Nutshell: The Optimism-Pessimism Grid

454

xiv

Contents 14-3

Policy Rules

455

14-4

Policy Pitfalls: Lags and Uncertain Multipliers

457

14-5

CASE STUDY: Was the Fed Responsible for the Great Moderation

of 1986–2007? 14-6

Time Inconsistency, Credibility, and Reputation

14-7

CASE STUDY: The Taylor Rule and the Changing Fed Attitude

Toward Inflation and Output

14-8 14-9 CHAPTER 15

466 468

Global Economic Crisis Focus: Taylor’s Rule Confronts the Zero Lower Bound

471

Rules Versus Discretion: An Assessment

471

International Perspective: The Debate About the Euro

474

CASE STUDY: Should Monetary Policy Target the Exchange Rate?

476

The Economics of Consumption Behavior

481

15-1

Consumption and Economic Stability

481

15-2

CASE STUDY: Main Features of U.S. Consumption Data

482

15-3

Background: The Conflict Between the Time-Series and Cross-Section Evidence

485

15-4

Forward-Looking Behavior: The Permanent-Income Hypothesis

488

15-5

Forward-Looking Behavior: The Life-Cycle Hypothesis

492

Global Economic Crisis Focus: The Modigliani Theory Helps Explain the Crisis and Recession of 2007–09

493

Rational Expectations and Other Amendments to the Simple Forward-Looking Theories

497

15-6

15-7 15-8

Understanding the Global Economic Crisis: Did Households Spend or Save the 2008 Economic Stimulus Payments?

498

Bequests and Uncertainty

501

International Perspective: Why Do Some Countries Save So Much?

502

CASE STUDY: Did the Rise and Collapse of Household Assets

Cause the Decline and Rise of the Household Saving Rate? 15-9 15-10 CHAPTER 16

461

506

Why the Official Household Saving Data Are Misleading

509

Conclusion: Does Consumption Stabilize the Economy?

512

The Economics of Investment Behavior

517

16-1

Investment and Economic Stability

517

16-2

CASE STUDY: The Historical Instability of Investment

518

16-3

The Accelerator Hypothesis of Net Investment

521

16-4

CASE STUDY: The Simple Accelerator and the Postwar U.S. Economy

524

16-5

The Flexible Accelerator

526

Tobin’s q: Does It Explain Investment Better Than the Accelerator or Neoclassical Theories?

528

16-6

The Neoclassical Theory of Investment Behavior

528

16-7

User Cost and the Role of Monetary and Fiscal Policy

531

16-8

Business Confidence and Speculation

533

Investment in the Great Depression and World War II

534

International Perspective: The Level and Variability of Investment Around the World

536

Contents 16-9 16-10

PART VI CHAPTER 17

Investment as a Source of Instability of Output and Interest Rates

536

Conclusion: Investment as a Source of Instability

538

The Evolution of Macroeconomic Ideas New Classical Macro and New Keynesian Macro

543

17-1

Introduction: Classical and Keynesian Economics, Old and New

543

17-2

Imperfect Information and the “Fooling Model”

544

17-3

The Lucas Model and the Policy Ineffectiveness Proposition

546

17-4

The Real Business Cycle Model

548

17-5

New Classical Macroeconomics: Limitations and Positive Contributions

551

International Perspective: Productivity Fluctuations in the United States and Japan

552

Global Economic Crisis Focus: The 2007–09 Crisis and the Real Business Cycle Model

554

17-6

Essential Features of the New Keynesian Economics

556

17-7

Why Small Nominal Rigidities Have Large Macroeconomic Effects

557

17-8

Coordination Failures and Indexation

561

17-9

Long-Term Labor Contracts as a Source of the Business Cycle

562

The New Keynesian Model Evolves into the DSGE Model

564

17-10 CHAPTER 18

xv

Conclusion: Where We Stand 18-1

571

The Evolution of Events and Ideas

571

Global Economic Crisis Focus: Can Economics Explain the Crisis or Does the Crisis Require New Ideas?

572

18-2

The Reaction of Ideas to Events, 1923–47

572

18-3

The Reaction of Ideas to Events, 1947–69

575

18-4

The Reaction of Ideas to Events, 1970–2010

578

Global Economic Crisis Focus: Termites Were Nibbling Away at the Prosperity of 2003–07

583

The Reaction of Ideas to Events in the World Economy

586

Macro Mysteries: Unsettled Issues and Debates

588

International Perspective: How Does Macroeconomics Differ in the United States and Europe?

590

18-5 18-6

APPENDIXES A

Time Series Data for the U.S. Economy: 1875–2010

B

International Annual Time Series Data for Selected Countries: 1960–2010

A-10

C

Data Sources and Methods

A-17

Glossary Index

A-1

G-1 I-1

Preface As in previous editions this book begins with business cycles, unemployment, and inflation. Experience teaches us that students want to understand what is happening today, and particularly why the Global Economic Crisis occurred and why the unemployment rate was above 9 percent during the first two years of the economic recovery. The curiosity of students about what is wrong with today’s economy engages them with the subject matter, in no small measure because they know that the economy will influence their job prospects after graduation. This book provides an immediate payoff to that curiosity within the first few chapters by placing its treatment of business cycles first. The economics of long-term growth are important but should come later, after students learn about the models, answers, and puzzles surrounding business cycles.

What’s New in This Edition? • The book’s organization is an ideal home for systematic treatment of the Global Economic Crisis, the single most important macroeconomic event since the Great Depression. It poses a challenge for intermediate macro instructors whose students will be expecting answers, not only about the causes of the Crisis but also the reasons why the recovery has been so slow. Fortunately, the structure of previous editions allows the treatment of the Crisis and recovery to fit seamlessly into the existing organization. Chapter 4 on the IS-LM model has always ended with sections on “strong and weak effects of monetary and fiscal policy” (pp. 102–06 in this edition). • The new Chapter 5, “Financial Markets, Financial Regulation, and Economic Instability,” introduces the concepts relevant to the housing bubble and financial market meltdown, including risk, leverage, securitization, and bubbles. Balance sheets are introduced to contrast traditional banks with the “wild west” of finance in which loans are financed not from deposits but by borrowing. The post-2001 housing bubble is compared with the stock market bubble of 1927–29 that led to the Great Depression. • Financial market concepts are integrated into the IS-LM analysis of monetary policy weakness. The “zero lower bound” is interpreted as a horizontal LM curve lying along the horizontal axis to the left of full employment, and the economy’s problem is portrayed as a leftward shift in the IS curve that pushes its full-employment equilibrium interest rate into negative territory, below the zero lower bound. In addition to shifting leftward, the IS curve becomes steeper, i.e., less sensitive to interest rate changes, due to the effect of the post-bubble “hangover” on demand (foreclosures and excess consumer debt) and on supply (too many unsold houses and condos). xvi

Preface

• Term premium and risk premium add to the Fed’s problem and motivate quantitative easing. The traditional textbook focus on a single short-term interest rate is supplemented by the government bond rate, which exceeds the short-term rate by the term premium. And the corporate bond rate relevant for the borrowing of business firms exceeds the government bond rate by the risk premium. These two premiums provide the context for the new concept “quantitative easing” as the attempt by the Fed, hamstrung by the zero lower bound for the short rate, to reduce the term premium and/or the risk premium. • Bank and Federal Reserve balance sheets. A colorful graph shows not only the now-familiar explosion of the Fed’s assets in 2008–11 but also the counterpart of that explosion on the liability side, that is, the emergence of more than $1 trillion of excess reserves. A comparison shows that excess reserves were about the same share of GDP in 2009–10 as in 1938–39, one of many comparisons in the book of the Global Economic Crisis and the Great Depression. • Chapter 6 asks, “Can fiscal policy come to the rescue?” It includes material from the previous edition on the deficit-GDP and debt-GDP ratios, the structural deficit, automatic stabilizers vs. discretionary policy, and stability conditions to avoid a long-term explosion of the debt-GDP ratio. The debate about the Obama stimulus motivates a new section that explains why fiscal multipliers are so different for alternative types of policies and why it is so difficult to design a stimulus program (e.g., multipliers of tax cuts may be small, “shovel-ready” projects may not be available in sufficient numbers). A unique set of graphs compares fiscal policy in 1933–41 with 2005–10. • The twin concepts of the “output gap” and the “unemployment gap” are introduced in the first chapter. Students become familiar from the outset with the concept of an aggregate demand shock. Charts in several chapters compare aspects of output and labor-market behavior in the 1980–86 and 2006–11 cycles, and students learn about the stark difference in the causes and cures of the two largest postwar cycles. • New “Global Economic Crisis Focus” in-text mini-boxes. A new pedagogical tool uses the reality of the Crisis and its aftermath to energize student learning throughout the book. Sprinkled throughout many chapters, at a rate of roughly two or three per chapter, are small in-text boxes of one or two paragraphs called “Global Economic Crisis Focus.” These are used not just to reinforce the teaching of the causes and cures of the Crisis itself, but also to provide the student with a jolt that emphasizes “a basic concept about which you are reading right now is directly relevant to understanding the Crisis.” Just within the first three chapters, including the introductory and measurement chapters, there are seven of these focus mini-boxes. • ”International Perspective” boxes. In addition to these mini-boxes, every chapter in the book has one or more topic boxes, usually appearing as a two-page spread on a left and right page. Continuing the tradition from previous editions, some of these are called “International Perspective Box” and highlight differences among countries. In this edition all of these “IP” boxes have been updated to provide new material relevant to understanding the Crisis.

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• New “Understanding the Global Economic Crisis” topic boxes. Several new topic boxes are directly relevant to explanations of the Global Economic Crisis. An example in an early chapter is “How Changes in Wealth Affect Consumer Spending” (pp. 62–63), which traces the aftermath of the housing and stock market debacles for household assets, liabilities, net worth, and the household saving rate. Another example in Chapter 5 (pp. 134–35) is “Two Bubbles: 1927–29 in the Stock Market Versus 2000–06 in the Housing Market.” • Theoretical treatment has been simplified. Numerical examples have been removed from the graphs in Chapter 3 and 4 on the Keynesian 45-degree model and the IS-LM model; this simplifies the exposition while still allowing numerical examples both within the text itself and also in the end-of-chapter questions and problems. The derivation of the short-run aggregate supply (SAS) curve in Chapter 8 (previous Chapter 7) has been simplified to eliminate graphs showing the demand for and supply of labor. • Sections have been moved to improve the book’s organization. The introduction to financial institutions has been moved from Chapter 13 to the new Chapter 5. Material on the debt-GDP ratio and the solvency condition has been moved from the previous Chapter 12 to the new Chapter 6. To make room for new content on the Crisis, the last half of the previous Chapter 12 (supply-side economics and Social Security) has been deleted. • Unique custom-made graphs. This book’s tradition continues of providing unique data graphs that go far beyond the standard graphs that other textbooks download from government data Web sites. From the beginning of Chapter 1, students view custom graphs illustrating the concepts of the output and unemployment gaps, the disparate behavior of unemployment and productivity growth since 2007 for Europe versus the United States, and the comparison of the zero-lower-bound periods in the United States in the late 1930s and since 2009. Unique graphs include the price level versus the output gap in the Great Depression, the real and nominal prices of oil compared with the overall inflation rate, the actual and natural rates of unemployment, the failure of convergence of many poor countries, and many others.

Guiding Principles of the Text This text has been guided by five organizing principles since its inception, and the Twelfth Edition develops them further. 1. Macro questions have answers. The use of traditional macro models can be enormously fruitful in developing answers to macro puzzles. Unlike other texts, this book introduces the natural level of output and natural rate of unemployment in the first few pages of Chapter 1. Students learn from the beginning that the output and unemployment gaps move in opposite directions and that to understand why output is so low is the same as understanding why unemployment is so high. Similarly, the fully developed dynamic inflation model of Chapter 9 shows that we have a solid answer to the puzzle of why inflation was so high in the 1970s and so low in the 1990s.

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When an economic model fails, this is not swept under the rug but rather is used to highlight what the model misses, as in the lively treatment in Chapter 11 of “Puzzles That Solow’s [Growth] Theory Cannot Explain” (see pp. 372–77). The Solow failure opens the way to a unique treatment of the debate between the new institutional economics versus the exponents of a tropical geography explanation for the failure of poor countries to converge to the income level of rich countries (pp. 398–408). 2. Up-front treatment of business cycles and inflation. Students come to the macro classroom caring most about today’s economy, starting with how they and their family members can avoid unemployment. Responding to this basic curiosity of students, a core principle of this book is that students should be taught about business cycles first, instead of beginning the text with the dry abstractions of classical economics and growth theory. Accordingly, this text introduces the IS-LM model immediately after the first two introductory chapters, with a goal in each edition of having the IS and LM curves cross by p. 100 (it happens on p. 95 of this edition). An integrated treatment links the standard monetary and fiscal policy multipliers with the cases when monetary and fiscal policy could be weak or strong. This is immediately followed by the new Chapter 5 that creates links between the IS-LM framework and the new analysis of balance sheets, leverage, securitization, and bubbles. After a comprehensive chapter on international economics and exchange rates, the AS-AD model then allows an in-depth treatment of the Great Depression and its similarities and differences with the recent Global Economic Crisis. The static AS-AD model then flows naturally into the dynamic version of the AS-AD model, called the SP (for short-run Phillips curve) and DG (for demand growth) model. The treatment in this textbook allows us to explain why both inflation and unemployment were both so high in the 1970s and so low in the late 1990s; this is a parallel overlooked by most other competing intermediate macro texts. By the end of Chapter 9, students have learned the core theory of business cycles and inflation, and the text then turns to growth theory, the puzzles that Solow’s theory cannot explain, and the big issues of economic growth and the non-convergence of so many poor countries. 3. Integration of models. The challenge many instructors face is that most intermediate macro texts overload the simple models, offering a new model every chapter or two without telling students how the models connect and work together. This book adopts the core distinction between short-run macro, devoted to explaining business cycles and their prevention, and longrun macro, dedicated to explaining economic growth. This text is unique in its cohesive presentation of the macro concepts. The aggregate demand curve is explicitly derived from the IS-LM model (pp. 231–36), and then the short-run Phillips Curve is explicitly derived from the short-run aggregate supply curve (pp. 267–70). In discussing the biggest question of economic growth—why so many nations are still so poor—the text provides an integration of the production function in the Solow growth theory with the added elements of human capital, political capital (i.e., legal systems and property rights), geography, and infrastructure (pp. 398–408). 4. Simple graphs can convey important research results. The graphs in this book go beyond those in the typical macro textbook in several dimensions, including the use of original data, the double-stacking of graphs plotting related concepts (see pp. 266 and 284), the extensive use of shading between

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lines to convey concepts like a positive and negative output gap, and the integrated use of color. 5. The economy is open from the start. Students come to their macroeconomics classroom concerned about the open economy. They carry iPhones made in China, and they worry about whether their future jobs will be outsourced to India and whether a further slump in the dollar will make future trips to Europe unaffordable. This text avoids the false distinction between the closed and open economy. As early as pp. 34–35, the linkage between saving, investment, government budget, and foreign lending or borrowing is emphasized by the label “magic equation” to dramatize the importance of a basic accounting identity. In the IS-LM model of aggregate demand, net exports can be a source of instability from the start. Fiscal deficits can be financed by foreign borrowing, but international crowding out and growing international indebtedness reduce the future standard of living.

Pedagogy The Use of Color The graphs in the Twelfth Edition continue to use consistent colors to connect macro concepts and discussions, thereby strengthening conceptual ties throughout the text. The supply curve of money, the LM curve, and plots of short-term interest rates are always shown in green. Government expenditures are red, and revenues are green; a government surplus is shown by green shading and a deficit by red shading. The government debt and long-term interest rates appear in purple. Data on inflation and the AD curve are plotted in orange. The SAS and SP curves are plotted in blue. Long-run “natural” concepts like natural real GDP, the natural rate of unemployment, the LAS curve, and the LP curve are all plotted in black. Color is also used consistently for country-specific data. The U.S. is always red, the U.K. (or EU) is blue, Canada is gray, Japan is orange, Germany is black, France is purple, and Italy is green.

Continuing Pedagogical Features The Twelfth Edition retains the main pedagogical features of the previous editions that aid student understanding. • Key terms are introduced in bold type, defined in the margin, and listed at the end of each chapter. • Self-Test questions appear at intervals within each chapter, so that students can immediately determine whether they understand what they have read. Answers are provided at the end of every chapter. • Learning About Diagrams boxes. Each of these boxes covers on a single page every aspect of the key schedules—IS, LM, AS, AD, and SP—and discusses why they slope as they do, what makes them rotate and shift, and what is true on and off the curves. There are also summary boxes, including one summarizing all the sources of negative demand shocks in 2007–09 and another summarizing the different effects of monetary and fiscal policy in an open economy.

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• End-of-chapter elements include a summary, a list of key terms, a revised and expanded set of questions and problems, and answers to the self-test questions. • The Glossary at the end of the book lists definitions to every key term, with a cross-reference to the sections where they are first introduced. • Data Appendixes provide annual data for the U.S. back to 1875, quarterly data for the U.S. back to 1947, and annual data since 1960 for other leading nations. This data can now be downloaded from the book’s Companion Website for use in your course. Appendix C lists data sources and Web sites that offer the latest data on key macroeconomic variables. • Data diagrams have been replotted electronically to ensure accuracy, and include annual and quarterly data to the end of 2010.

Supplements With each edition, the supplements get more robust with the aim of helping you to prepare your lectures and your students to master the material. • MyEconLab. This powerful assessment and tutorial system works handin-hand with Macroeconomics. MyEconLab includes comprehensive homework, quiz, test, and tutorial options, where instructors can manage all assessment needs in one program. Here are the key features of MyEconLab: • Select end-of-chapter Questions and Problems, including algorithmic, graphing, and numerical, are available for student practice, or instructor assignment. • Test Item File questions are available for assignment as homework. • The Custom Exercise Builder allows instructors the flexibility of creating their own problems for assignment. • The powerful Gradebook records each student’s performance and time spent on the Tests and Study Plan and generates reports by student or chapter. Visit www.myeconlab.com for more information and an online demonstration of instructor and student features. MyEconLab content has been created through the efforts of Melissa Honig, Executive Media Producer, and Noel Lotz, Content Lead. • Online Instructor’s Manual. Subarna Samanta of the College of New Jersey revised the manual for this edition, providing chapter outlines, chapter overviews, a discussion of how the Twelfth Edition differs from the Eleventh Edition, and answers to the end-of-chapter questions and problems. The manual is available for download as PDF or Word files on the Instructor’s Resource Center (www.pearsonhighered .com/irc). • Online Test Item File. Completely revised by Mihajlo Balic of Palm Beach Community College, the Online Test Item File offers more than 2,000 questions specific to the book. It is available in Word format on the Instructor’s Resource Center. • Online Computerized Test Bank. The Computerized Test Bank reproduces the Test Item File material in the TestGen software that is available for Windows and Macintosh. With TestGen, instructors can easily edit

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existing questions, add questions, generate tests, and print the tests in a variety of formats. It is available in both Mac and PC formats on the Instructor’s Resource Center. Online PowerPoint with Art, Figures, and Lecture Notes. PowerPoint presentations, revised by Richard Stahnke of Bryn Mawr College, contain the figures and tables in the text, as well as new lecture notes that correspond with the information in each chapter. The PowerPoint presentations are available on the Instructor’s Resource Center. Companion Website. The open-access Web site http://www.pearsonhighered.com/gordon/ offers the following resources: The Data Appendixes from the text are available for download, as is the robust data set created explicitly for the text that includes the historical data and natural level of output. Excel®-based problems, written by David Ring of SUNY College at Oneonta, offer students one to two questions per chapter using the Excel program and data. Solutions to all Excel-based problems are available on the Instructor’s Resource Center.

Acknowledgments I remain grateful to all those who have given thoughtful comments on this book over the years. In recent years, these colleagues include: Terence J. Alexander, Iowa State University Mihajlo Balic, Palm Beach Community College Jeffrey H. Bergstrand, University of Notre Dame William Branch, University of California, Irvine John P. Burkett, University of Rhode Island Henry Chen, University of West Florida Andrew Foshee, McNeese State University Donald E. Frey, Wake Forest University John Graham, Rutgers University Luc Hens, Vesalius College, Vrije Universiteit Brussel Tracy Hofer, University of Wisconsin, Stevens Point Brad R. Humphreys, University of Illinois, Urbana-Champaign Alan G. Isaac, American University Thomas Kelly, Baylor University Barry Kotlove, Edmonds Community College Philip Lane, Fairfield University Sandeep Mazumder, Wake Forest University Ilir Miteza, University of Michigan, Dearborn Gary Mongiovi, St. John’s University Jan Ondrich, Syracuse University Chris Papageorgiou, International Monetary Fund Walter Park, American University Prosper Raynold, Miami University, Oxford Michael Reed, University of Kentucky Kevin Reffett, WP Cary School of Business, ASU Charles F. Revier, Colorado State University

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David Ring, State University of New York, Oneonta Wayne Saint Aubyn Henry, University of the West Indies Subarna K. Samanta, The College of New Jersey Richard Sheeham, University of Notre Dame William Doyle Smith, University of Texas, El Paso Richard Stahnke, Bryn Mawr College Manly E. Staley, San Francisco State University Mark Thoma, University of Oregon David Tufte, Southern Utah University Kristin Van Gaasbeck, California State University, Sacramento Anne Ramstetter Wenzel, San Francisco State University Henry Woudenberg, Kent State University An expanded set of questions and problems was provided by David Ring of SUNY at Oneonta. In addition, the book contains a great deal of data, some of it originally created for this book, both in the text and the Data Appendix. Geoffrey Bery with speed, accuracy, and frequent intiative created all the data, tables and graphs, as well as the Data Appendix. Many thanks go to the staff at Addison-Wesley. I am extremely grateful to David Alexander for suggesting and then implementing the development of the Twelfth Edition. Lindsey Sloan handled her role as assistant editor with enthusiasm and accuracy. The final stages of handling proofs and other pre-publication details were managed efficiently, with tact and courtesy, by Nancy Fenton of Pearson and Allison Campbell of Integra. Thanks to Lori DeShazo, the marketing manager, and to Kimberly Lovato, the marketing assistant for this title, for their marketing efforts. Finally, thanks go to my wife, Julie, for her patience at the distractions not just of writing the revised edition but also of the endless extra weeks of proofreading. A real bonus of modern technology for our household is the conversion of this revision to electronic editing, which allows my corrections to be made on the computer screen and then instantly e-mailed to the publisher. That has eliminated the role both of Fed Ex and of vast piles of paper in the revision process, which has been a great relief for me and especially to Julie. As always, her unfailing encouragement and welcome diversions made the book possible. Robert J. Gordon Evanston, IL February 2011

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CHAPTER

What Is Macroeconomics?

1

Business will be better or worse. —Calvin Coolidge, 1928

1-1 How Macroeconomics Affects Our Everyday Lives Macroeconomics is concerned with the big economic issues that determine your own economic well-being as well as that of your family and everyone you know. Each of these issues involves the overall economic performance of the nation rather than whether one particular individual earns more or less than another. The nation’s overall macroeconomic performance matters, not only for its own sake but because many individuals experience its consequences. The Global Economic Crisis that began in late 2007 has created enormous losses of income and jobs for millions of American families. Not only were almost 15 million people unemployed in late 2010, but many more have given up looking for jobs, have been forced to work part-time instead of full-time, or have experienced pay cuts or furlough days when they have not been paid. By one estimate, more than half of American families since 2007 have experienced the job loss of a family member, a pay cut, or being forced to work parttime instead of full-time. Macroeconomic performance can also determine whether inflation will erode the value of family savings, as occurred in the 1970s when the annual inflation rate reached 10 percent. Today’s students also care about economic growth, which will determine whether in their future lives they will have a higher standard of living than their parents do today.

Macroeconomics is the study of the major economic totals, or aggregates.

The Global Economic Crisis is the crisis that began in 2007 that simultaneously depressed economic activity in most of the world’s economies.

The “Big Three” Concepts of Macroeconomics Each of these connections between the overall economy and the lives of individuals involves a central macroeconomic concept introduced in this chapter— unemployment, inflation, and economic growth. The basic task of macroeconomics is to study the causes of good or bad performance of these three concepts, why each matters to individuals, and what (if anything) the government can do to improve macroeconomic performance. While there are numerous other important macroeconomic concepts, we start by focusing just on these, which are the “Big Three” concepts of macroeconomics: 1. The unemployment rate. The higher the overall unemployment rate, the harder it is for each individual who wants a job to find work. College seniors who want permanent jobs after graduation are likely to have fewer job offers if the national unemployment rate is high, as in 2009–10, than low, as

The unemployment rate is the number of persons unemployed (jobless individuals who are actively looking for work or are on temporary layoff) divided by the total of those employed and unemployed.

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The inflation rate is the percentage rate of increase in the economy’s average level of prices.

Productivity is the aggregate output produced per hour.

in 2005–2007. All adults fear a high unemployment rate, which raises the chances that they will be laid off, be unable to pay their bills, have their cars repossessed, lose their health insurance, or even lose their homes through mortgage foreclosures. In “bad times,” when the unemployment rate is high, crime, mental illness, and suicide also increase. The widespread consensus that unemployment is the most important macroeconomic issue has been further highlighted by the dismal labor market of 2009–10, when fully half of the unemployed were jobless for more than six months. And the recognized harm created by high unemployment is nothing new. Robert Burton, an English clergyman, wrote in 1621 that “employment is so essential to human happiness that indolence is justly considered the mother of misery.” 2. The inflation rate. A high inflation rate means that prices, on average, are rising rapidly, while a low inflation rate means that prices, on average, are rising slowly. An inflation rate of zero means that prices remain essentially the same, month after month. In inflationary periods, retired people, or those about to retire, lose the most, since their hard-earned savings buy less as prices go up. Even college students lose as the rising prices of room, board, and textbooks erode what they have saved from previous summer and after-school jobs. While a high inflation rate harms those who have saved, it helps those who have borrowed. Great harm comes from this capricious aspect of inflation, taking from some and giving to others. People want their lives to be predictable, but inflation throws a monkey wrench into individual decision making, creating pervasive uncertainty. 3. Productivity growth. “Productivity” is the aggregate output per hour of work that a nation produces in total goods and services; it was about $61 per worker-hour in the United States in 2010. The faster aggregate productivity grows, the easier it is for each member of society to improve his or her standard of living. If productivity were to grow at 3 percent from 2010 to the year 2030, U.S. productivity would rise from $61 per worker-hour to $111 per worker-hour. When multiplied by all the hours worked by all the employees in the country, this extra $50 per worker-hour would make it possible for the nation to have more houses, cars, hospitals, roads, schools, and to combat greenhouse gas emissions that worsen global warming. But if the growth rate of productivity were zero instead of 3 percent, U.S. productivity would remain at $61 in the year 2030. To have more houses and cars, we would have to sacrifice by building fewer hospitals and schools. Such an economy, with no productivity growth, has been called the “zero-sum society,” because any extra good or service enjoyed by one person requires that something be taken away from someone else. Many have argued that the achievement of rapid productivity growth and the avoidance of a zero-sum society form the most important macroeconomic challenge of all. The first two of the “Big Three” macroeconomic concepts, the unemployment and inflation rates, appear in the newspaper every day. When economic conditions are poor—as in 2009–10—daily headlines announce that one large company or another is laying off thousands of workers. In the past, sharp increases in the rate of inflation have also made headlines, as when the price of gasoline jumped during 2006–08. The third major concept, productivity growth, has received widespread attention since 1995 as a source of an improving American standard of living compared to that in Europe and Japan.

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Defining Macroeconomics

Macroeconomic concepts also play a big role in politics. Incumbent political parties benefit when unemployment and inflation are relatively low, as in the landslide victories of Lyndon Johnson in 1964 and Richard Nixon in 1972. Incumbent presidents who fail to gain reelection often are the victims of a sour economy, as in the cases of Herbert Hoover in 1932, Jimmy Carter in 1980, and more recently George W. Bush in 2008. The defeat of Al Gore by George W. Bush in 2000 was an exception since the strong economy of 2000 should have helped Gore’s incumbent Democratic party win the presidency.

GLOBAL ECONOMIC CRISIS FOCUS What Makes It Unique? The Global Economic Crisis that started in 2008 is by most measures the most severe downturn since the Great Depression of the 1930s. Its severity is most apparent in the high level of the unemployment rate (10 percent) reached in 2009–10, in the relatively long duration of unemployment suffered by those who lost their jobs, and in the prediction that the unemployment rate would not return to its normal level of around 5 percent until perhaps 2015 or 2016. Thus, of our three big macro concepts, the Global Economic Crisis mainly affected the unemployment rate, while the inflation rate remained low and productivity growth was relatively robust.

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Defining Macroeconomics

How Macroeconomics Differs from Microeconomics Most topics in economics can be placed in one of two categories: macroeconomics or microeconomics. Macro comes from a Greek word meaning large; micro comes from a Greek word meaning small. Put another way, macroeconomics deals with the totals, or aggregates, of the economy, and microeconomics deals with the parts. Among these crucial economic aggregates are the three central concepts introduced on pp. 1–2. Microeconomics is devoted to the relationships among the different parts of the economy. For example, in micro we try to explain the wage or salary of one type of worker in relation to another. For example, why is a professor’s salary more than that of a secretary but less than that of an investment banker? In contrast, macroeconomics asks why the total income of all citizens rises strongly in some periods but declines in others.

Economic Theory: A Process of Simplification Economic theory helps us understand the economy by simplifying complexity. Theory throws a spotlight on just a few key relations. Macroeconomic theory examines the behavior of aggregates such as the unemployment rate and the inflation rate while ignoring differences among individual households. It studies the causes and possible cures of the Global Economic Crisis at the level of individual nations, instead of trying to explain why some individuals are more prone than others to losing their jobs. It is this process of simplification that makes the study of economics so exciting. By learning a few basic macroeconomic relations, you can quickly

An aggregate is the total amount of an economic magnitude for the economy as a whole.

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learn how to sift out the hundreds of irrelevant details in the news in order to focus on the few key items that foretell where the economy is going. You also will begin to understand which national and personal economic goals can be attained and which are “pie in the sky.” You will learn when it is fair to credit a president for strong economic performance or blame a president for poor performance.

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Gross domestic product is the value of all currently produced goods and services sold on the market during a particular time interval.

Actual real GDP is the value of total output corrected for any changes in prices.

Natural real GDP designates the level of real GDP at which the inflation rate is constant, with no tendency to accelerate or decelerate.

Actual and Natural Real GDP

We have learned that the “Big Three” macroeconomic concepts are the unemployment rate, the inflation rate, and the rate of productivity growth. Linked to each of these is the total level of output produced in the economy. The higher the level of output, the lower the unemployment rate. The higher the level of output, the faster tends to be the rate of inflation. Finally, for any given number of hours worked, a higher level of output automatically boosts output per hour, that is, productivity. The official measure of the economy’s total output is called gross domestic product and is abbreviated GDP. As you will learn in Chapter 2, real GDP includes all currently produced goods and services sold on the market within a given time period and excludes certain other types of economic activity. As you will also learn, the adjective “real” means that our measure of output reflects the quantity produced, corrected for any changes in prices. Actual real GDP is the amount an economy actually produces at any given time. But we need some criterion to judge the desirability of that level of actual real GDP. Perhaps actual real GDP is too low, causing high unemployment. Perhaps actual real GDP is too high, putting upward pressure on the inflation rate. Which level of real GDP is desirable, neither too low nor too high? This intermediate compromise level of real GDP is called “natural,” a level of real GDP in which there is no tendency for the rate of inflation to rise or fall. Figure 1-1 illustrates the relationship between actual real GDP, natural real GDP, and the rate of inflation. In the upper frame the red line is actual real GDP. The lower frame shows the inflation rate. The thin dashed vertical lines connect the two frames. The first dashed vertical line marks time period t0. Notice in the bottom frame that the inflation rate is constant at t0, neither speeding up nor slowing down. By definition, natural real GDP is equal to actual real GDP when the inflation rate is constant. Thus, in the upper frame, at t0 the red actual real GDP line is crossed by the black natural real GDP line. To the right of t0, actual real GDP falls below natural real GDP, and we see in the bottom frame that inflation slows down. This continues until time period t1, when actual real GDP once again is equal to natural real GDP. Here the inflation rate stops falling and is constant for a moment before it begins to rise. This cycle repeats itself again and again. Only when actual real GDP is equal to natural real GDP is the inflation rate constant. For this reason, natural real GDP is a compromise level to be singled out for special attention. During a period of low actual real GDP, designated by the blue area, the inflation rate slows down. During a period of high actual real GDP, designated by the shaded red area, the inflation rate speeds up.

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Why Too Much Real GDP Is Undesirable

Natural real GDP

Real GDP

Actual real GDP

Actual and Natural Real GDP

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Figure 1-1 The Relation Between Actual and Natural Real GDP and the Inflation Rate In the upper frame the solid black line shows the steady growth of natural real GDP—the amount the economy can produce at a constant inflation rate. The red line shows the path of actual real GDP. In the blue region in the top frame, actual real GDP is below natural real GDP, so the inflation rate, shown in the bottom frame, slows down. In the region designated by the red area, actual real GDP is above natural real GDP, so in the bottom frame inflation speeds up.

Inflation rate

Inflation rate

Inflation slows down t0

Inflation speeds up t1

Inflation speeds up t2

t3

Inflation slows down t4

Time

Unemployment: Actual and Natural When actual real GDP is low, many people lose their jobs, and the unemployment rate is high, as shown in Figure 1-2. The top frame duplicates Figure 1-1 exactly, comparing actual real GDP with natural real GDP. The blue line in the bottom frame is the actual percentage unemployment rate, the first of the three central concepts of macroeconomics. The thin vertical dashed lines connecting the upper frame and lower frame show that whenever actual and natural real GDP are equal in the top frame, the actual unemployment rate is equal to the natural rate of unemployment in the bottom frame. The definition of the natural rate of unemployment corresponds exactly to natural real GDP, describing a situation in which there is no tendency for the inflation rate to change. When the actual unemployment rate is high, actual real GDP is low (shown by blue shading in both frames), and the inflation rate slows down. In periods when actual real GDP is high and the economy prospers, the actual unemployment rate is low (shown by red shading in both frames) and the inflation rate speeds up. It is easy to remember the mirrorimage behavior of real GDP and the unemployment rate. We use the shorthand

The natural rate of unemployment designates the level of unemployment at which the inflation rate is constant, with no tendency to accelerate or decelerate.

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Unemployment Cycles Are the Mirror Image of Real GDP Cycles

Natural real GDP

Actual real GDP

Unemployment rate (percent)

Figure 1-2 The Behavior Over Time of Actual and Natural Real GDP and the Actual and Natural Rates of Unemployment When actual real GDP falls below natural real GDP, designated by the blue shaded areas in the top frame, the actual unemployment rate rises above the natural rate of unemployment as indicated in the bottom frame. The red shaded areas designate the opposite situation. When we compare the blue shaded areas of Figures 1-1 and 1-2, we see that the time intervals when unemployment is high (1–2) also represent time intervals when inflation is slowing down (1–1). Similarly, the red shaded areas represent time intervals when inflation is speeding up and unemployment is low.

Real GDP

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Actual unemployment rate

Natural unemployment rate

t0

t1

t2

t3

t4

Time

The GDP gap is the percentage difference between actual real GDP and natural real GDP. Another name for this concept is the “output gap.” The unemployment gap is the difference between the actual unemployment rate and the natural rate of unemployment.

label GDP gap for the percentage difference between actual real GDP and natural real GDP. We use the parallel shorthand label unemployment gap for the difference between the actual unemployment rate and the natural rate of unemployment. In recessions when the GDP gap is negative, the unemployment gap is positive, and both of the gaps are represented by the blue shaded areas in Figure 1-2. In highly prosperous periods like the late 1990s, the GDP gap is positive and the unemployment gap is negative, as indicated by the red shaded areas in Figure 1-2. Another name for the GDP gap is the “output gap.” Figures 1-1 and 1-2 summarize a basic dilemma faced by government policymakers who are attempting to achieve a low unemployment rate and a low inflation rate at the same time. If the inflation rate is high, lowering it requires a decline in actual real GDP and an increase in the actual unemployment rate. This happened in the early 1980s, when inflation was so high that the government deliberately pushed unemployment to its highest level since the 1930s. If, to the contrary, the policymaker attempts to provide jobs for everyone and keep the actual unemployment rate low then the inflation rate will speed up, as occurred in the 1960s and late 1980s.

1-4

Macroeconomics in the Short Run and Long Run

7

Real GDP and the Three Macro Concepts The total amount that the economy produces, actual real GDP, is closely related to the three central macroeconomic concepts introduced earlier in this chapter. First, as we see in Figure 1-2, the difference between actual and natural real GDP moves inversely with the difference between the actual and natural unemployment rates. When actual real GDP is high, unemployment is low, and vice versa. The second link is with inflation, since inflation tends to speed up when actual real GDP is higher than natural real GDP (as in Figure 1-1). The third link is with productivity, which is defined as actual real GDP per hour; data on actual real GDP are required to calculate productivity. Each of these links with the central macroeconomic concepts requires that actual real GDP be compared with something else in order to be meaningful. It must be compared to natural real GDP to provide a link with unemployment and inflation, or it must be divided by the number of hours worked to compute productivity. Actual real GDP by itself, without any such comparison, is not meaningful, which is why it is not included on the list of the three major macro concepts.

SELF-TEST 1. When actual real GDP is above natural real GDP, is the actual unemployment rate above, below, or equal to the natural unemployment rate? 2. When actual real GDP is below natural real GDP, is the actual unemployment rate above, below, or equal to the natural unemployment rate? 3. When the actual unemployment rate is equal to the natural rate of unemployment, is the actual rate of inflation equal to the natural rate of inflation?

1-4 Macroeconomics in the Short Run and Long Run Macroeconomic theories and debates can be divided into two main groups: (1) those that concern the “short-run” stability of the economy, and (2) those that concern its “long-run” growth rate. Much of macroeconomic analysis concerns the first group of topics involving the short run, usually defined as a period lasting from one year to five years, and focuses on the first two major macroeconomic concepts introduced in Section 1-1, the unemployment rate and the inflation rate. We ask why the unemployment rate and the inflation rate over periods of a few years are sometimes high and sometimes low, rather than always low as we would wish. These ups and downs are usually called “economic fluctuations” or business cycles. Much of this book concerns the causes of these cycles and the efficacy of alternative government policies to dampen or eliminate the cycles. The other main topic in macroeconomics concerns the long run, which is a longer period ranging from one decade to several decades. It attempts to explain the rate of productivity growth, the third key concept introduced in Section 1-1, or more generally, economic growth. Learning the causes of growth helps us predict whether successive generations of Americans will be better off than their predecessors, and why some countries remain so poor in a world

Business cycles consist of expansions occurring at about the same time in many economic activities, followed by similarly general recessions and recoveries. Economic growth is the topic area of macroeconomics that studies the causes of sustained growth in real GDP over periods of a decade or more.

Chapter 1

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What Is Macroeconomics?

where other countries by contrast are so rich. The remarkable achievement of China in achieving economic growth of 8 to 9 percent per year consistently over the past three decades raises a new question about economic growth—how long will it take the Chinese economy to catch up to the American level of real GDP per person?

The Short Run: Business Cycles The main short-run concern of macroeconomists is to minimize fluctuations in the unemployment and inflation rates. This requires that fluctuations in real GDP be minimized. Figure 1-3 contrasts two imaginary economies: “Volatilia” in the left frame and “Stabilia” in the right frame. The black “natural real GDP” lines in both frames are absolutely identical. The two economies differ only in the size of their business cycles, shown by the size of their GDP gap, which is simply the difference between actual and natural real GDP shown by blue and red shading. In the left frame, Volatilia is a macroeconomic hell, with severe business cycles and large gaps between actual and natural real GDP. In the right frame, Stabilia is macroeconomic heaven, with mild business cycles and small gaps between actual and natural real GDP. All macroeconomists prefer the economy depicted by the right-hand frame to that depicted by the left-hand frame. But the debate between macro schools of thought starts in earnest when we ask how to achieve the economy of the right-hand frame. Active do-something policies? Do-nothing, hands-off policies? There are economists who support each of these alternatives, and more besides. But everyone agrees that Stabilia

Economic Failure and Success

Natural real GDP

Natural real GDP

Real GDP

Real GDP

8

Actual real GDP

Actual real GDP Time (a) Volatilia

Time (b) Stabilia

Figure 1-3 Business Cycles in Volatilia and Stabilia The left frame shows the huge business cycles in a hypothetical nation called Volatilia. Short-run macroeconomics tries to dampen business cycles so that the path of actual real GDP is as close as possible to natural real GDP, as shown in the right frame for a nation called Stabilia.

1-4

Macroeconomics in the Short Run and Long Run

A Succession of Cycles

Peak Trough Real output

Expansion

Recession

Expansion

Recession

Peak Trough

Recession

Real GDP

Peak Trough

Figure 1-4 Basic Business-Cycle Concepts The real output line exhibits a typical succession of business cycles. The highest point reached by real output in each cycle is called the peak and the lowest point the trough. The recession is the period between peak and trough; the expansion is the period between the trough and the next peak.

Time

is a more successful economy than Volatilia. To achieve the success of Stabilia, Volatilia must find a way to eliminate its large real GDP gap. The hallmark of business cycles is their pervasive character, which affects many different types of economic activity at the same time. This means that they occur again and again but not always at regular intervals, nor are they the same length. Business cycles in the past have ranged in length from one to twelve years.1 Figure 1-4 illustrates two successive business cycles in real output. Although a simplification, Figure 1-4 contains two realistic elements that have been common to most real-world business cycles. First, the expansions last longer than the recessions. Second, the two business cycles illustrated in the figure differ in length.

The Long Run: Economic Growth For a society to achieve an increasing standard of living, total output per person must grow, and such economic growth is the long-run concern of macroeconomists. Look at Figure 1-5, which contrasts two economies. Each has mild business cycles, like Stabilia in Figure 1-3. But in Figure 1-5, the left frame presents a country called “Stag-Nation,” which experiences very slow growth in real GDP. In contrast, the right-hand frame depicts “Speed-Nation,” a country with very fast growth in real GDP. If we assume that population growth in each country is the same, then growth in output per person is faster in Speed-Nation. In SpeedNation everyone can purchase more consumer goods, and there is plenty of output left to provide better schools, parks, hospitals, and other public services. In Stag-Nation people must constantly face debates, since more money for schools or parks requires that people sacrifice consumer goods.

1

A comprehensive source for the chronology of and data on historical business cycles, as well as research papers by distinguished economists, is Robert J. Gordon, ed., The American Business Cycle: Continuity and Change (Chicago: University of Chicago Press, 1986). An up-to-date chronology and a discussion of the 2007–09 recession can be found at www.nber.org/cycles/cyclesmain.html.

9

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Chapter 1

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What Is Macroeconomics?

Economic Failure and Success in Another Dimension

Real GDP

Real GDP

Natural real GDP

Actual real GDP

Natural real GDP Actual real GDP

Time

Time (b) Speed-Nation

(a) Stag-Nation

Figure 1-5 Economic Growth in Stag-Nation and Speed-Nation In both frames the business cycle has been tamed, but in the left frame there is almost no economic growth, while economic growth in the right frame is rapid. For Speed-Nation there can be more of everything, while Stag-Nation in the left frame is a “zero-sum society,” in which an increase in one type of economic activity requires that another economic activity be cut back.

Over the past decade, countries like Stag-Nation include Germany, Italy, and Japan. Countries like Speed-Nation include China and India. The United States has been between these extremes. How do we achieve faster economic growth in output per person? In Chapters 11 and 12 we study the sources of economic growth and the role of government policy in helping to determine the growth in America’s future standard of living, as well as the reasons why some countries remain so poor.

SELF-TEST Indicate whether each item in the following list is more closely related to shortrun (business cycle) macro or to long-run (economic growth) macro: 1. The Federal Reserve reduces interest rates in a recession in an attempt to reduce the unemployment rate. 2. The federal government introduces national standards for high school students in an attempt to raise math and science test scores. 3. Consumers cut back spending because news of layoffs makes them fear for their jobs. 4. The federal government gives states and localities more money to repair roads, bridges, and schools.

1-5

1-5 CASE STUDY

How Does the Global Economic Crisis Compare to Previous Business Cycles? This section examines U.S. macroeconomic history since the early twentieth century. You will see that unemployment in the past four decades did not come close to the extreme crisis levels of the 1930s.

Real GDP Figure 1-6 is arranged just like Figure 1-2. But whereas Figure 1-2 shows hypothetical relationships, Figure 1-6 shows the actual historical record. In the top frame the solid black line is natural real GDP, an estimate of the amount the economy could have produced each year without causing acceleration or deceleration of inflation. The red line in the top frame plots actual real GDP, the total production of goods and services each year measured in the constant prices of 2005. Can you pick out those years when actual and natural real GDP are roughly equal? Some of these years were 1900, 1910, 1924, 1964, 1987, 1997, and 2007. In years marked by blue shading, actual real GDP fell below natural real GDP. A maximum deficiency occurred in 1933, when actual real GDP was only 64 percent of natural GDP; about 35 percent of natural real GDP was thus “wasted,” that is, not produced. In some years actual real GDP exceeded natural real GDP, shown by the shaded red areas. The largest red area occurred during World War II in 1942–45.

Unemployment In the middle frame of Figure 1-6, the blue line plots the actual unemployment rate. By far the most extreme episode was the Great Depression, when the actual unemployment rate remained above 10 percent for ten straight years, 1931–40. The black line in the middle frame of Figure 1-6 displays the natural rate of unemployment, the minimum attainable level of unemployment that is compatible with avoiding an acceleration of inflation. The red shaded areas mark years when actual unemployment fell below the natural rate, and the blue shaded areas mark years when unemployment exceeded the natural rate. Notice now the relationship between the top and middle frames of Figure 1-6. The blue shaded areas in both frames designate periods of low production, low real GDP, and high unemployment, such as the Great Depression of the 1930s. The red shaded areas in both frames designate periods of high production and high actual real GDP, and low unemployment, such as World War II and other wartime periods. ◆

GLOBAL ECONOMIC CRISIS FOCUS How It Differs from 1982–83 The bottom frame of Figure 1-6 magnifies the middle frame by starting the plot in 1970 instead of 1900. Over the past four decades there have been three big recessions with unemployment reaching its peak in 1975, then 1982–83, and most recently in 2009–10. The recent episode of high unemployment is more serious (continued)

Case Study

11

A Historical Report Card on Real GDP and Unemployment

15,000

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300 1900

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Actual unemployment rate

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20 15 Natural unemployment rate 10 5 0 1900

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9 8 7

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6 5 4

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3 2 1 0 1970

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Figure 1-6 Actual and Natural GDP and Unemployment, 1900–2010 A historical report card for two important economic magnitudes. In the top frame the black line indicates natural real GDP. The red line shows actual real GDP, which was well below natural real GDP during the Great Depression of the 1930s and well above it during World War II. In the middle frame the black line indicates the natural rate of unemployment, and the blue line indicates the actual unemployment rate. Actual unemployment was much higher during the Great Depression of the 1930s than at any other time during the century. The bottom frame magnifies the middle frame to focus on unemployment since 1970. There we see that the 2009–10 levels of high unemployment were equivalent to 1982–83. However, the increase in unemployment was greater in 2007–10 than in 1980–82 since that economy started from a lower unemployment rate. Sources: See Appendix A-1 and C-4.

1-6

Macroeconomics at the Extremes

and harmful than in 1982–83 for several reasons. Notice that the unemployment rate dropped sharply from 1983 to 1984, while the decline in the unemployment rate in 2011–12 is forecast to be very slow. In the recent episode a larger share of the unemployed have been without jobs for six months or more, and a much larger share of the labor force than in 1982–83 has been forced to work on a parttime basis rather than their desired full-time status.

1-6

Macroeconomics at the Extremes

Most of macroeconomics treats relatively normal events. Business cycles occur, and unemployment goes up and down, as does inflation. Economic growth registers faster rates in some decades than in others. Yet there are times when the economy’s behavior is anything but normal. The normal mechanisms of macroeconomics break down, and the consequences can be dire. Three examples of unusual macroeconomic behavior involving our “Big Three” concepts are the Great Depression of the 1930s, the German hyperinflation of the 1920s, and the stark difference in economic growth between two Asian nations over the past 50 years.