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NINTH E ITION

MACROECONOMICS

Theories and Policies

Richard T Froyen

University

of North

Carolina Chapel

Hill

PEARSON

Prentice

Hall

Upper SaddleRiver New Jersey 07458

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Contents

Preface xix

PART ONE INT RO DU CT ION AND MEASUREMENT l

CH AP TE R 1 Introduction 2

N

1.1 W hat Is Macroeconom ics? 2

1.2 Post-W orld War IIU.S. Econom ic Performance 3

Output 3

Unemployment 4

Inflation 5

Inflation and Une mploymen t 6

The U.S.

Federal

Budget and

Trade Deficits

8

1.3 Cen tra l Qu est ions in Macro econom ics 10

Instability

of Output 10

Movements in

the Inflation

Rate 10

The Output-Inflation

Relationship

10

Growth Slowdown and

Turnaround?

11

ImplicationsofDeficitsa n dSurpluses 11

1.4 Co nclu sion 12

CH AP TE R 2 Measurement of Macroeconom ic Variables 13

2.1 The National Income Accoun ts 13

2.2 Gross Dom estic Product 14

Currently Produced 14

Final Goods and Services 14

Evaluated at Market Prices 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: Rea l versus Nom inal GD P 23

Real GDP

in

Prices from a Base

Year

24

Chain-WeightedReal GDP 25

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x ONTENTS

2.7

The

Consum er P r i ce Index

and the

P rod ucer Pr ice Index

26

2.8 Measures

of

Cyclical Variation

in

O u t p u t

27

2.9 Conclusion

29

Perspectives2.1 What GDP Is Not

18

Perspectives

2.2

National

Income

Accountsfor

England

and

Wales

in

1688

22

Perspectives

2.3

Dating Business Cycles 29

PART TWO CLASSICAL ECONOMICS AND THE KEYNESIAN

REVOLUTION 31

CHAPTER 3 Classical Macroeconomics I): Output

and Employment 32

.

3.1 The

Start ing Point

32

3.2

The

Classical Revo lution

33

3.3 Product ion

34

3 .4 Employment

37

Labor Deman d

37

Labor Supply

39

3.5 Equi l ibr ium Ou tput

and

E m p l o y m e n t

42

The

DeterminantsofOutput

and Employmen t

44

Factors That

Do Not Affect Output

48

3.6 Conclusion

48

Perspectives3-1 RealBusinessCycles: AFirstLook

48

CHAPTER 4 Classical Macroeconomics II): Money,

Prices, and Interest 51

4.1 The Quantity Theory of Money 51

The Equation of E xchange

51

The

Cambridge

Approach to the Quan tity The ory

53

The Classical

Aggregate

Demand

Curve 54

4.2

The

Classical Theo ry

of

the In te res t Ra te

56

4.3 Policy Im plicatio ns

of

the Classical

Equi l ib r ium M ode l

60

Fiscal Policy 60

Monetary Policy

66

4.4 Conclusion

66

Perspectives4-1

Mon ey in

Hyperinflations 57

Perspectives4-2Supply-Side

Economics A Modern

Classical View

65

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ONTENTS x i

CH A PT ER 5 The Keynesian System (I): The Ro le of

Aggregate Dem and 68

5.1 The Problem of Unem ploym ent 68

5.2 The Simple Keynesian Model: Con ditions for

Equilibrium Outpu t 71

5.3 The Com ponents of Aggregate Dem and 76

Consumption 76

Investment 78

Government Spending and Taxes 80

5.4 Determ ining Equilibrium Income 80

5.5 Changes in Equilibrium Income 83

5.6 Fiscal Stab ilization Policy 88

5.7 Exp orts and Impo rts in the Simple Keynesian Model 90

^5.8 Conclusion 93

Perspectives5-1Macroeconomic Controversies

72

Perspectives

5-2

Fiscal Policyin Practice 90

CH AP TE R 6 The Keynesian System II): Money, Interest,

and Income 97

6.1 Money in the Keynesian System 97

Interest Rates and AggregateDemand 97

The KeynesianTheory ofthe Interest Rate 99

The KeynesianTheory of Mone y Deman d 103

The Effects of an

Increase

in the Mon ey Supply 107

Some Implicationso fIntereston Mone y 107

GoingForward 10 9

6.2 The IS-LM Model 109

Mon ey M arket Equilibrium:

The

LM Schedule 11 0

Product

Marke t Equilibrium: The IS Schedule 11 9

The IS an dLM SchedulesCombine d 129

6.3 Co nclus ion 131

Appendix:TheAIgebraoftheIS-LM Mode l 132

Perspectives

6-1

Residential Constructionan d theInterest Rate 10 0

CH AP TE R 7 The Keynesian System

III):

Policy Effects

in the

IS LM Model

136

7.1 Factors That Affect Equilibrium Income and the

Interest Ra te 136

Monetary

Influen ces:Shifts

in the

LM S chedule

13 6

Real Influen ces:

Shifts

in

theIS Schedule

13 7

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7.2 The Relative Effectiveness of Monetary and Fiscal Policy 143

Policy Effectivenessan dtheSlope of the

IS Sch edule

144

Monetary Policy Effectiveness

a n d

the

Slope of theIS Schedule

144

Policy Effectiveness

an d

the

Slope of theLM Schedule

148

7.3 Conclusion

152

Appendix:

Monetary

a n d

Fiscal Policy Multipliers

in the

IS-LM Model

157

Perspectives

7-1The

Monetary-Fiscal PolicyMix:

Some

Historical

Examples

142

Perspectives

7-2

Japan

in a Slump an d

the

Liquidity

Trap

153

CH AP TE R 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

Sourceso fWage Rigidity

167

A

Flexible Price-Fixed

Money

Wage

Model

169

8.4 La bo r Supply and Variabil ity

in the

M o n e y W a ge

174

Classical

an d

Keynesian Theories

of Labor Supply

174

The Keynesian Aggregate

Supply

Schedule

with a

Variable

Money

Wage 176

PolicyE ffects inthe Variable-Wage KeynesianModel

176

8.5

The

Effects

of

Shifts

in the

Agg regate Supply Sch edule

180

Factors ThatShiftthe AggregateSupplySchedule

181

More

Recent

Supply Shocks

184

8.6 Con clusion: Key nes versus

the

Classics

188

Keynesian versus Classical Theories

o f

Aggregate

Demand

188

Keynesian versus Classical Theories

o f

Aggregate

Supply

188

Keynesian versus Classical Policy Conclusions 189

Perspectives8-1Pricea n dQuantityAdjustmen t in

Great

Britain ,

1929-36 169

PART THREE M A CR OE CO NO M IC THEORY AFTER KEYNES 191

CHAPTER 9 The Monetarist Counterrevolution 192

9.1 Monetarist Propositions 192

9.2 The Reformulation of the Quantity Theory of Money 193

Money and

the

Early

Keynesians 194

Friedman s Restatement

of the Quan tity The ory

196

Friedman s Monetarist Position

200

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xiv ONTENTS

CH AP TE R 12 Real Business Cycles and Ne w

Keynesian Econ om ics 246

12.1 Re al Business Cycle Models 246

Central Features

o f

Real Business Cycle

Models 246

A Simple Real Business CycleModel 248

Effects o f a

Positive Technology

Shock 249

Macroeconomic Policyin a RealBusiness CycleModel 250

Questions

About

Real Business Cycle

Models 253

Concluding

Commen t 254

12.2 New Keynesian Econom ics 254

Sticky

Price

Me n u

Cost)

Models 256

Efficiency Wage

Models 258

Insider-Outsider Modelsan dHysteresis 260

12.3 Con clusion 262

Perspectives 12-1

Robert Lucas and

Real Business

CycleTheory 252

Perspectives 12-2

Labor Marke t

Flows

255

Perspectives 12-3

A re

Prices Sticky?

258

CH AP TE R 13 Macroeconomic Models: A Summary 264

13.1 Theoretical Issues 264

13.2 Policy Issues 268

13.3 Consensus as Well as Controversy 269

PART FOUR OPEN ECO NO MY MA CRO ECO NO MICS 2 71

CHAPTER 14 Exchange Rates and the International

M onetary System 272

14.1 The

U.S.

Balan ce of Paym ents Acco unts 272

The Current Account 273

The Capital Account 274

Statistical Discrepancy

274

Official Reserve Transactions

275

14.2 Exch ange Ra tes and the M arke t for Fore ign Exch ange 275

Deman d an d Supply in

the

Foreign ExchangeMarket 277

Exchange Rate

De termination:

Flexible

Exchange

Rates

279

Exchange Rate

De termination:

Fixed Exchange Rates

281

14.3 The Cu rrent Exch ange Ra te System 284

Exchange

Rate Arrange men ts 284

How Much

Managing?

How Much

Floating?

285

The Breakdown ofthe

Bretton Woods

System 286

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16.4 Bank Reserves and Bank Depo sits 331

A M odel of DepositCreation 33 2

Depos it Creation: More General Cases 336

Open-Market

Operations

a n d

the Federal

Funds Rate 338

16.5 Wh o Co ntrols the Mo ney Supply? 339

16.6 Con clusion 344

Perspectives 16-1 TheMon ey Supply During the

Great Depression 34 2

CHAPTER 17 Optimal Monetary Policy 346

17.1 The Mone tary Policymaking Process 346

17.2 Com peting Strategies for Mo netary Policy: Targeting Monetary Aggregates or

Interest Ra tes 347

Targeting Monetary Aggregates 34 9

Targeting Interest Rate 350

17.3 M one y versus Interest Ra te Targets in the P resen ce

of Shocks 350

Implicationso fTargeting a Monetary Aggregate 351

Implications

o f

Targeting the Interest Rate

354

11A The Relative Merits of theTwoStrategies 357

Th e Sourceso fUncertaintya n dthe Choiceo f aMonetary

Policy Strategy

358

OtherConsiderations 358

17.5 The Ev olutio n of Fed eral Re ser ve Strategy 359

1970-79:Targeting the Federal Funds Rate 35 9

1979-82: Targeting Monetary Aggregates 359

1982-2007:

A

Gradual Return

to

Federal

Funds

Rate

Targeting

360

1994-2007:

A Move

toward Greater Transparency

360

17.6 Chan ges in Cen tra l Ban k Inst itut ions: Re cen t Intern at ional

Experience 362

The

Time Inconsistency

Problem 362

Other Arguments for

Inflation Targeting

36 4

17.7 Co nclus ion 366

The Effect of Income

Tax Cuts

on Labor Supply

403

Regulation

As a

Source

of Inflation an d Slow Growth

403

19 A

Gro wth Policies From R onald R eaga n To Geo rge W. Bush

404

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 AdministrationofGeorge

W

Bush

406

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19.5 Conclusion 409

Perspectives 19-1 Growth

an d

Productivity Slowdowns

in

Other

Industrialized Economies 394

Perspectives 19-2

The

Laffer Curve 401

Perspectives 19-3 Equality

a n d

Efficien cy:

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

an d

the Aggregate Production Function 410

Sources

o f

Growth

in

the Neoclassical Model 414

20.2 Recent Developments in the Theory of Economic Growth 416

Endogenous Growth Models 417

Implicationso fEndogenous Technological Change

419

Policy Implications

of

Endogenous Growth 420

20.3 Intercountry Income Differences Revisited 420

Perspectives 20-1 Growth Accountingforthe UnitedStates :

An

Example 417

Perspectives 20-2Muck

Money,

an dthe Moral Consequencesof

Economic Growth 423

20.4 Conclusion 424

lossary 425

Index 430