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NINTH

EDITIO N

MACROECONOMICS

Theories and Policies

Richard T. Froyen

University of North Carolina Chapel Hill

PEARSON

Prentice

Hall

Upper Saddle River, New Jersey 07458

Contents

Preface

xix

PART ONE

INTRODUCTION AND MEASUREMENT

l

CHAPTER 1

Introduction

2

N 1.1

What Is Macroeconomics?

2

1.2

Post-World War I I U.S. Economic Performance

3

Output 3

Unemployment 4

Inflation

Inflation and Unemployment

5

6

The U.S. Federal Budget and Trade Deficits

8

1.3 Central Questions in Macroeconomics 10

Instability of Output

Movements in the Inflation Rate 10

10

The Output-Inflation Relationship

10

Growth Slowdown and Turnaround? 11 Implications of Deficits and Surpluses 11

1.4 Conclusion 12

CHAPTER 2

Measurement of Macroeconomic Variables

13

2.1 The National Income Accounts 13

2.2 Gross Domestic Product 14

Currently Produced

14

Final Goods and Services Evaluated at Market Prices

14

15

2.3 National Income 17

2.4 Personal and Disposable Personal Income 20

2.5 Some National Income Accounting Identities 21

2.6 Measuring Price Changes: Real versus Nominal GDP 23

Real GDP in Prices from a Base Year

Chain-Weighted Real GDP

25

24

x

CONTENTS

2.7

The Consumer Price Index and the Producer Price Index 26

2.8

Measures of Cyclical Variation in Output 27

2.9

 
 

Conclusion 29 Perspectives 2.1 What GDP Is Not

Perspectives 2.2 National Income Accounts for England and

18

Wales in 1688

22

Perspectives 2.3 Dating Business Cycles

29

PART TW O

CLASSICAL ECONOMICS AN D THE KEYNESIAN

REVOLUTION

31

CHAPTER 3

Classical Macroeconomics (I): Output

and Employment

32

.

3.1

The Starting Point

32

3.2

The Classical Revolution

33

3.3

Production 34

 

3.4

Employment

37

 

Labor Demand

37

Labor Supply

39

 

3.5

Equilibrium Output and Employment The Determinants of Output and Employment

42

44

 

Factors That Do Not Affect Output

48

 

3.6

Conclusion

48

Perspectives 3-1 Real Business Cycles: A First Look

CHAPTER 4

Classical Macroeconomics (II): Money, Prices, and Interest 51

4.1 The Quantity Theory of Money

51

The Equation of Exchange

The Cambridge Approach to the Quantity Theory

The Classical Aggregate Demand Curve

51

54

4.2 The Classical Theory of the Interest Rate

4.3 Policy Implications of the Classical Equilibrium Model 60 Fiscal Policy 60 Monetary Policy 66

4.4 Conclusion

66

56

53

Perspectives 4-1 Money in Hyperinflations

Perspectives 4-2 Supply-Side EconomicsA Modern

57

Classical View

65

48

CONTENTS

xi

CHAPTER 5

The Keynesian System (I): The Role of

Aggregate Demand

68

5.1

The Problem of Unemployment

68

5.2

The Simple Keynesian Model: Conditions for

Equilibrium Output

71

5.3

The Components of Aggregate Demand Consumption 76

76

Investment

78

Government Spending and Taxes

80

5.4

Determining Equilibrium Income 80

 

5.5

Changes in Equilibrium Income 83

5.6

Fiscal Stabilization Policy 88

 

5.7

Exports and Imports in the Simple Keynesian Model 90

^5.8

Conclusion

93

Perspectives 5-1 Macroeconomic Controversies

Perspectives 5-2 Fiscal Policy in Practice

90

72

CHAPTER 6

The Keynesian System (II): Money, Interest,

and Income

6.1 Money in the Keynesian System

97

97

Interest Rates and Aggregate Demand

97

The Keynesian Theory of the Interest Rate 99

The Keynesian Theory of Money Demand 103 The Effects of an Increase in the Money Supply 107

Some Implications of Interest on Money

Going Forward

109

107

6.2 The IS-LM Model 109

Money Market Equilibrium: The LM Schedule

110

Product Market Equilibrium: The IS Schedule

119

The IS and LM Schedules Combined

129

6.3 Conclusion 131 Appendix: The A Igebra of the IS-LM Model 132 Perspectives 6-1 Residential Construction and the Interest Rate

CHAPTER 7

The Keynesian System (III): Policy Effects

in the IS-LM

Model

136

100

7.1 Factors That Affect Equilibrium Income and the

Interest Rate

136

Monetary Influences: Shifts in the LM Schedule

Real Influences: Shifts in the IS Schedule

137

136

xii

CONTENTS

7.2 The Relative Effectiveness of Monetary and Fiscal Policy

143

Policy Effectiveness and the Slope of the IS Schedule

144

Monetary Policy Effectiveness and the Slope of the IS Schedule

144

Policy Effectiveness and the Slope of the LM Schedule

7.3 Conclusion 152

148

Appendix: Monetary and Fiscal Policy Multipliers in the

IS-LM Model

157

Perspectives 7-1 The Monetary-Fiscal Policy Mix: Some

142

Perspectives 7-2 Japan in a Slump and the Liquidity Trap

Historical Examples

153

CHAPTER 8

The Keynesian System (IV): Aggregate Supply

and Demand

160

8.1 The Keynesian Aggregate Demand Schedule 160

8.2 The Keynesian Aggregate Demand Schedule Combined with the Classical Theory of Aggregate Supply 166

8.3 A Contractual View of the Labor Market

167

Sources of Wage Rigidity

167

A Flexible Price-Fixed Money Wage Model

169

8.4 Labor Supply and Variability in

th e Money Wage

174

Classical and Keynesian Theories of Labor Supply 174

The Keynesian Aggregate Supply Schedule with a Variable

Money Wage

176

Policy Effects in the Variable-Wage Keynesian Model

176

8.5 The Effects of Shifts in the Aggregate Supply Schedule 180

Factors That Shift the Aggregate Supply Schedule

More Recent Supply Shocks

184

181

8.6 Conclusion: Keynes versus the Classics 188 Keynesian versus Classical Theories ofAggregate Demand 188 Keynesian versus Classical Theories ofAggregate Supply 188 Keynesian versus Classical Policy Conclusions 189 Perspectives 8-1 Price and Quantity Adjustment in

Great Britain, 1929-36

169

PART THREE

MACROECONOMIC THEORY AFTER KEYNES

CHAPTER 9

The Monetarist Counterrevolution

192

9.1 Monetarist Propositions

9.2 The Reformulation of the Quantity Theory of Money 193 Money and the Early Keynesians 194

192

Friedman's Restatement of the Quantity Theory

Friedman's Monetarist Position

200

196

191

]

CONTENTS

xiii

 

9.3

Fiscal and Monetary Policy 203 Fiscal Policy 203 Monetary Policy 205

9.4

Unstable Velocity and the Declining Policy Influence

 

of Monetarism

206

.

9.5

Recent Instability in the Money-Income Relationship 207 Monetarist Reaction 207 Conclusion 208 Perspectives 9.1 The Monetarist View of the Great Depression 197

CHAPTER 10

Output, Inflation, and Unemployment:

Alternative Views 210

10.1 The Natural Rate Theory

10.2 Monetary Policy, Output, and Inflation: Friedman's

213

210

Monetarist View

Monetary Policy in the Short Run

213

Monetary Policy in the Long Run

213

10.3 A Keynesian View of the Output-Inflation Trade-Off

The Phillips Curve: A Keynesian Interpretation

218

217

Stabilization Policies for Output and Employment:

The Keynesian View

221

10.4 Evolution of the Natural Rate Concept 222

Determinants of the Natural Rate of Unemployment 222

Time-Varying Natural Rates of Unemployment

223

Explaining Changing Natural Rates of Unemployment 224

Recent Trends 225

10.5 Conclusion 225

CHAPTER 11 New Classical Economics

11.1 The New Classical Position

227

227

A Review of the Keynesian Position 228

The Rational Expectations Concept and Its Implications

New Classical Policy Conclusions

233

228

11.2 A Broader View of the New Classical Position 238

11.3 The Keynesian Countercritique 239

The Question of Persistence

The Extreme Informational Assumptions of Rational Expectations 240

239

Auction Market Versus Contractual Views of the Labor Market

242

11.4 Conclusion 244

Perspectives 11.1 U.S. Stock Prices: Rational Expectations or Irrational

Exuberance?

236

Perspectives 11.2 The Great Depression: New Classical Views

243

xiv

CONTENTS

CHAPTER 12 Real Business Cycles and New

Keynesian Economics

12.1 Real Business Cycle Models

246

246

Central Features of Real Business Cycle Models 246 A Simple Real Business Cycle Model 248 Effects of a Positive Technology Shock 249 Macroeconomic Policy in a Real Business Cycle Model Questions About Real Business Cycle Models 253 Concluding Comment 254

250

12.2 New Keynesian Economics 254 Sticky Price (Menu Cost) Models 256 Efficiency Wage Models 258 Insider-Outsider Models and Hysteresis 260

12.3 Conclusion 262

Perspectives 12-1 Robert Lucas and Real Business

Cycle Theory

252

Perspectives 12-2 Labor Market Flows Perspectives 12-3 Are Prices Sticky?

255

258

CHAPTER 13 Macroeconomic Models: A Summary

13.1 Theoretical Issues 264

13.2 Policy Issues 268

13.3 Consensus as Well as Controversy 269

264

PART FOUR

OPEN ECONOMY MACROECONOMICS

2 71

CHAPTER 14 Exchange Rates and the International

Monetary System

272

14.1 The U.S. Balance of Payments Accounts

The Current Account 273 The Capital Account 274

Statistical Discrepancy

Official Reserve Transactions

274

275

272

14.2 Exchange Rates and the Market for Foreign Exchange 275 Demand and Supply in the Foreign Exchange Market 277 Exchange Rate Determination: Flexible Exchange Rates 279 Exchange Rate Determination: Fixed Exchange Rates 281

14.3 The Current Exchange Rate System 284 Exchange Rate Arrangements 284 How Much Managing? How Much Floating? 285 The Breakdown of the Bretton Woods System 286

14.4 Advantages of Alternative Exchange Rate Regimes

Advantages of Exchange Rate Flexibility Arguments for Fixed Exchange Rates 292

287

CONTENTS

287

xv

14.5 Experience with Floating Exchange Rates

293

The Dollar in Decline, 1976-80

296

The Rising Dollar, 1981-85

297

The Dollar's Slide, 1985-88

298

The Dollar: 1990 to the Present

299

14.6 Global Trade Imbalances

300

Implication of Some Identities

301

Causes and Effects of Global Trade Imbalances

302

14.7 Conclusion 303

Perspectives 14-1 U.S. Current Account DeficitsAre

They Sustainable?

276

Perspectives 14-2 Currency Boards and Dollarization

Perspectives 14-3 The Euro 299

CHAPTER 15

Monetary and Fiscal Policy in the

Open Economy

305

285

15.1 The Mundell-Fleming Model 305

15.2 Imperfect Capital Mobility 308 Policy Under Fixed Exchange Rates 308 Policy Under Flexible Exchange Rates 311

15.3 Perfect Capital Mobility 314 Policy Effects Under Fixed Exchange Rates 315 Policy Effects Under Flexible Exchange Rates 317

15.4 Conclusion 321 Perspectives 15-1 The Saving-Investment Correlation Puzzle 319

PART FIVE

ECONOMIC POLICY

323

CHAPTER 16

Money, the Banking System, and Interest Rates 324

16.1 The Definition of Money The Functions of Money

Components of the Money Supply 325

16.2 Interest Rates and Financial Assets 326

16.3 The Federal Reserve System 327

The Structure of the Central Bank

324

324

327

Federal Reserve Control of the Money Supply 328

The Tools of Federal Reserve Control

329

xvi

CONTENTS

16.4 Bank Reserves and Bank Deposits

A Model of Deposit Creation

Deposit Creation: More General Cases

332

331

336

Open-Market Operations and the Federal

Funds Rate

338

16.5 Who Controls the Money Supply? 339

16.6 Conclusion 344

Perspectives 16-1 The Money Supply During the

Great Depression

342

CHAPTER 17 Optimal Monetary Policy

346

17.1 The Monetary Policymaking Process 346

17.2 Competing Strategies for Monetary Policy: Targeting Monetary Aggregates or

Interest Rates

347

Targeting Monetary Aggregates

Targeting Interest Rate

350

349

17.3 Money versus Interest Rate Targets in the Presence of Shocks 350 Implications of Targeting a Monetary Aggregate 351 Implications of Targeting the Interest Rate 354

11A The Relative Merits of the Two Strategies

357

The Sources of Uncertainty and the Choice of a Monetary

Policy Strategy

358

Other Considerations

358

17.5 The Evolution of Federal Reserve Strategy 359

1970-79: Targeting the Federal Funds Rate

1979-82: Targeting Monetary Aggregates 359

1982-2007:A Gradual Return to Federal Funds

359

Rate Targeting

360

1994-2007:A Move toward Greater Transparency

360

17.6 Changes in Central Bank Institutions: Recent International

Experience 362 The Time Inconsistency Problem 362 Other Arguments for Inflation Targeting 364

17.7 Conclusion 366

<

Perspectives 17-1 Central Bank Independence and

Economic Performance

348

Perspectives 17-2 The Taylor Rule 361

Perspectives 17-3 Inflation Targeting in Practice: The New Zealand

Experiment

363

Perspectives 17-4 Inflation Targeting for the United States:

Three Influential Views

365

CHAPTER 18

Fiscal Policy

368

18.1 The Goals of Macroeconomic Policy 368

18.2 The Goals of Macroeconomic Policymakers

The Public-Choice View

The Partisan Theory 372

369

369

CONTENTS

xvii

Public-Choice and Partisan Theories from the Perspective

of2007

372

18.3 The Federal Budget

18.4 The Economy and the Federal Budget: The Concept of Automatic Fiscal Stabilizers 379

18.5 Fiscal Policy Controversies: From the Reagan Years to

374

the Present

The Pros and Cons of Fiscal Policy Rules

What About the Deficit? 385 The Federal Budget in the Late 1990s and into the

384

384

Twenty-First Century

387

18.6 Conclusion 388

Perspectives 18-1 Rational Expectations and the

373

Partisan Theory

Perspectives 18-2 State and Local Government Finances

377

PART SIX

ECONOMI C GROWT H

391

CHAPTER 19

Policies for Intermediate-Run Growth

392

19.1

U.S. Economic Growth, 1960-2006 393

19.2

The Supply-Side Position 394 Intermediate-Run Output Growth Is Supply-Determined 395 Saving and Investment Depend on After- Tax Rates of Return 396

Labor Supply Is Responsive to Changes in the After-Tax Real Wage 399 Government Regulation Contributed to the Slowdown in the U.S. Economic Growth Rate

400

19.3

The Keynesian Critique of Supply-Side Economics 402 The Supply-Determined Nature of Intermediate-Run Growth 402 Saving and Investment and After- Tax Rates of Return 402 > The Effect of Income Tax Cuts on Labor Supply 403 Regulation As a Source of Inflation and Slow Growth 403

19A

Growth Policies From Ronald Reagan To George W. Bush Economic Redirection in the Reagan Years 404 Initiatives in the First Bush Administration 405 Growth Policies During the Clinton Administrations 406 Tax Cuts During the Administration of George W. Bush 406

404

xviii

CONTENTS

19.5 Conclusion 409

Perspectives 19-1 Growth and Productivity Slowdowns in Other

Industrialized Economies

394

Perspectives 19-2 The Laffer Curve 401 Perspectives 19-3 Equality and Efficiency: The Big Trade-off

407

CHAPTER 20

Long-Run Economic Growth: Origins of the Wealth of Nations 410

20.1 The Neoclassical Growth Model 410 Growth and the Aggregate Production Function 410 Sources of Growth in the Neoclassical Model 414

20.2 Recent Developments in the Theory of Economic Growth

Endogenous Growth Models

Implications of Endogenous Technological Change Policy Implications of Endogenous Growth 420

417

419

416

20.3 Intercountry Income Differences Revisited 420

Perspectives 20-1 Growth Accounting for the United States:

An Example

417

Perspectives 20-2 Muck, Money, and the Moral Consequences of

Economic Growth

423

20.4 Conclusion 424

Glossary

425

Index

430