Timothy Taylor’s Principles of Economics Economics and the Economy Second Edition Timothy Taylor Journal of Economic Perspectives Macalester College For instructors: • Instructor's manual • PowerPoint ® slides • Computerized test disk Free to students: • e-Textbook available as Micro and Macro splits • e-Study Guide • e-Lecture Guide • e-Pamphlet (with video): Using Adobe ® Reader for the Maximum e-Book Experience • e-Pamphlet (with audio): Study Tips for the College Student
Transcript
Timothy Taylor’s
Principles of EconomicsEconomics and the Economy
Second Edition
Timothy TaylorJournal of Economic Perspectives
Macalester College
For instructors:• Instructor'smanual• PowerPoint®slides• Computerizedtestdisk
Free to students: • e-TextbookavailableasMicroandMacrosplits• e-StudyGuide• e-LectureGuide• e-Pamphlet(withvideo):UsingAdobe®ReaderfortheMaximume-BookExperience• e-Pamphlet(withaudio):StudyTipsfortheCollegeStudent
When ordering this title, use ISBN 1-930789-13-0
To order the Micro version, use ISBN 1-930789-21-1To order the Macro version, use ISBN 1-930789-25-5
ParT I: ThEINTERCoNNECTEDECoNoMy 1. The Interconnected Economy 1
2. Choice in a World of Scarcity 15
3. International Trade 39
ParT II: SUPPLyANDDEMAND 4. Demand and Supply 59
5. Labor and Financial Capital Markets 87
6. Globalization and Protectionism 103
ParT III: ThEFUNDAMENTALSoFMICRoECoNoMICThEoRy 7. Elasticity 127
8. Household Decision Making 149
9. Cost and Industry Structure 169
10. Perfect Competition 187
11. Monopoly 209
12. Monopolistic Competition and Oligopoly 225
ParT IV: MICRoECoNoMICPoLICyISSUESAPPLICATIoNS13. Competition and Public Policy 241
14. Environmental Protection and Negative Externalities 259
15. Technology, Positive Externalities, and Public Goods 275
16. Poverty and Economic Inequality 291
17. Issues in Labor Markets: Unions, Discrimination, Immigration 311
18. Information, Risk, and Insurance 331
19. Financial Markets 347
20. Public Choice 369
ParT V: ThEMACRoECoNoMICPERSPECTIVEANDGoALS21. The Macroeconomic Perspective 381
22. Economic Growth 399
23. Unemployment 417
24. Inflation 437
25. The Balance of Trade 461
ParT VI: AFRAMEWoRkFoRMACRoECoNoMICANALySIS26. The Aggregate Supply-Aggregate Demand
Model 479
27. The Keynesian Perspective 501
28. The Neoclassical Perspective 533
ParT VII: MoNETARyANDFISCALPoLICy29. Money and Banks 547
30. Monetary Policy and Bank Regulation 563
31. Exchange Rates and International Capital Flows 589
32. Government Budgets and Fiscal Policy 617
33. Government Borrowing and National Savings 641
34. Macroeconomic Policy around the World 657
Appendices 675
Glossary 715
Index 727
v
Preface xv
About the Author xvii
1 The Interconnected Economy 1What Is an Economy? 2
Market-Oriented vs. Command Economies 2The Interconnectedness of an Economy 2
The Division of Labor 4Why the Division of Labor Increases Production 4Trade and Markets 5The Rise of Globalization 5
Microeconomics and Macroeconomics 7Microeconomics: The Circular Flow Diagram 7Macroeconomics: Goals, Frameworks, and Tools 10
Studying Economics Doesn’t Mean Worshiping the Economy 10
Key Concepts and Summary 12Review Questions 13
2 Choice in a World of Scarcity 15Choosing What to Consume 16
A Consumption Choice Budget Constraint 16How Changes in Income and Prices Affect the Budget
Constraint 16 Personal Preferences Determine Specific
Choices 18From a Model with Two Goods to the Real World of
Many Goods 19Choosing between Labor and Leisure 20
An Example of a Labor-Leisure Budget Constraint 20
How a Change in Wages Affects the Labor-Leisure Budget Constraint 20
Making a Choice Along the Labor-Leisure Budget Constraint 20
Choosing between Present and Future Consumption 22
Interest Rates: The Price of Intertemporal Choice 22The Power of Compound Interest 24An Example of Intertemporal Choice 24
Three Implications of Budget Constraints: Opportunity Cost, Marginal Decision-Making, and Sunk Costs 26
Opportunity Cost 26Marginal Decision-Making and Diminishing Marginal
Utility 27Sunk Costs 28
The Production Possibilities Frontier and Social Choices 29
The Shape of the Production Possibilities Frontier and Diminishing Marginal Returns 30
Productive Efficiency and Allocative Efficiency 32Why Society Must Choose 33
Confronting Objections to the Economic Approach 33A First Objection: People, Firms, and Society Don’t
Act Like This 33A Second Objection: People, Firms, and Society
Shouldn’t Do This 34Facing Scarcity and Making Trade-offs 36Key Concepts and Summary 36Review Questions 38
3 International Trade 39Absolute Advantage 41
A Numerical Example of Absolute Advantage and Trade 41
Trade and Opportunity Cost 44Limitations of the Numerical Example 45
Comparative Advantage 46Identifying Comparative Advantage 47Mutually Beneficial Trade with Comparative
Advantage 48How Opportunity Cost Sets the Boundaries of
Trade 50Comparative Advantage Goes Camping 51The Power of the Comparative Advantage
Example 52
vi Contents
Intra-industry Trade between Similar Economies 52The Prevalence of Intra-industry Trade between
Similar Economies 52Gains from Specialization and Learning 53Economies of Scale, Competition, Variety 54Dynamic Comparative Advantage 55
The Size of Benefits from International Trade 56From Interpersonal to International Trade 57Key Concepts and Summary 58Review Questions 58
4 Demand and Supply 59Demand, Supply, and Equilibrium in Markets for Goods
and Services 60Demand for Goods and Services 60Supply of Goods and Services 61Equilibrium: Where Demand and Supply Cross 63
Shifts in Demand and Supply for Goods and Services 64
The Ceteris Paribus Assumption 65An Example of a Shifting Demand Curve 65Factors That Shift Demand Curves 66Summing Up Factors That Change Demand 67An Example of a Shift in a Supply Curve 67 Factors That Shift Supply Curves 68Summing Up Factors That Change Supply 70
Shifts in Equilibrium Price and Quantity: The Four-Step Process 71
Good Weather for Salmon Fishing 71Seal Hunting and New Drugs 72The Interconnections and Speed of Adjustment in
Real Markets 73Price Ceilings and Price Floors in Markets for Goods
and Services 74Price Ceilings 75Price Floors 77Responses to Price Controls: Many Margins for
Action 78Policy Alternatives to Price Ceilings and Price
Floors 79Supply, Demand, and Efficiency 81
Consumer Surplus, Producer Surplus, Social Surplus 81
Inefficiency of Price Floors and Price Ceilings 82 Demand and Supply as a Social Adjustment
Mechanism 84Key Concepts and Summary 84Review Questions 86
5 Labor and Financial Capital Markets 87Demand and Supply at Work in Labor Markets 87
Equilibrium in the Labor Market 88Shifts in Labor Demand 89 Shifts in Labor Supply 90Technology and Wage Inequality: The Four-Step
Process 90Price Floors in the Labor Market: Living Wages and
Minimum Wages 92The Minimum Wage as an Example of a Price
Floor 92Demand and Supply in Financial Capital Markets 94
Who Demands and Who Supplies in Financial Capital Markets 94
Equilibrium in Financial Capital Markets 95Shifts in Demand and Supply in Financial Capital
Markets 96The United States as a Global Borrower: The Four-Step
Process 97Price Ceilings in Financial Capital Markets: Usury
Laws 98Don’t Kill the Price Messengers 99Key Concepts and Summary 101Review Questions 102
6 Globalization and Protectionism 103Protectionism: An Indirect Subsidy from Consumers to
Producers 104Demand and Supply Analysis of Protectionism 105Who Benefits and Who Pays? 106
International Trade and Its Effects on Jobs, Wages, and Working Conditions 108
Fewer Jobs? 108Trade and Wages 109Labor Standards 110
The Infant Industry Argument 112The Dumping Argument 113
The Growth of Anti-Dumping Cases 113Why Might Dumping Occur? 113Should Anti-Dumping Cases Be Limited? 114
The Environmental Protection Argument 114The Race to the Bottom Scenario 115Pressuring Low-Income Countries for Higher
Environmental Standards 116The Unsafe Consumer Products Argument 117The National Interest Argument 117How Trade Policy Is Enacted: Global, Regional, and
National 119The World Trade Organization 119Regional Trading Agreements 120
viiContents
Trade Policy at the National Level 121Long-Term Trends in Barriers to Trade 121
The Trade-offs of Trade Policy 123Key Concepts and Summary 124Review Questions 126
7 Elasticity 127Price Elasticity of Demand 128
Calculating the Elasticity of Demand 129A Possible Confusion, a Clarification, and a Warning 131
Price Elasticity of Supply 132Calculating the Elasticity of Supply 132
Elastic, Inelastic, and Unitary Elasticity 134Applications of Elasticity 137
Does Raising Price Bring in More Revenue? 137Passing on Costs to Consumers? 138Long-Run vs. Short-Run Impact 141
Elasticity as a Gener al Concept 142Income Elasticity of Demand 142Cross-Price Elasticity of Demand 143Elasticity in Labor and Financial Capital Markets 143Stretching the Concept of Elasticity 144
Conclusion 145 Key Concepts and Summary 145Review Questions 146
8 Household Decision Making 149Consumption Choices 149
Total Utility and Diminishing Marginal Utility 150Choosing with Marginal Utility 152A Rule for Maximizing Utility 152Measuring Utility with Numbers 153
How Changes in Income and Prices Affect Consumption Choices 154
How Changes in Income Affect Consumer Choices 154
How Price Changes Affect Consumer Choices 155The Foundations of Demand Curves 156Applications in Business and Government 157
Labor-Leisure Choices 159The Labor-Leisure Budget Constraint 160Applications of Utility Maximizing with the Labor-
Leisure Budget Constraint 161Intertemporal Choices in Financial Capital
Markets 163Using Marginal Utility to Make Intertemporal
Choices 163Applications of the Model of Intertemporal
Choice 166
The Unifying Power of the Utility-Maximizing Budget Set Framework 167
Key Concepts and Summary 167Review Questions 168
9 Cost and Industry Structure 169The Structure of Costs in the Short Run 170
Fixed and Variable Costs 170Average Costs, Average Variable Costs, Marginal
Costs 173Lessons Taught by Alternative Measures of Costs 174A Variety of Cost Patterns 175
The Structure of Costs in the Long Run 176Choice of Production Technology 176Economies of Scale 178Shapes of Long-Run Average Cost Curves 179The Size and Number of Firms in an Industry 181Shifting Patterns of Long-Run Average Cost 183
Conclusion 184Key Concepts and Summary 185Review Questions 186
10 Perfect Competition 187Quantity Produced by a Perfectly Competitive
Firm 188Comparing Total Revenue and Total Cost 188Comparing Marginal Revenue and Marginal
Costs 190Marginal Cost and the Supply Curve 191Profits and Losses with the Average Cost
Curve 192The Shutdown Point 192Short-Run Outcomes for Perfectly Competitive
Firms 194Entry and Exit in the Long Run Output 196
How Entry and Exit Lead to Zero Profits 196Economic Profit vs. Accounting Profit 197The Economic Function of Profits 198
Factors of Production in Perfectly Competitive Markets 199
The Derived Demand for Labor 199The Marginal Revenue Product of Labor 200Are Workers Paid as Much as They Deserve? 201Physical Capital Investment and the Hurdle Rate 202Physical Capital Investment and Long-Run Average
Cost 203Efficiency in Perfectly Competitive Markets 204Conclusion 205Key Concepts and Summary 205Review Questions 207
viii Contents
11 Monopoly 209Barriers to Entry 210
Legal Restrictions 210Control of a Physical Resource 211Technological Superiority 211Natural Monopoly 212Intimidating Potential Competition 213Summing Up Barriers to Entry 214
How a Profit-Maximizing Monopoly Chooses Output and Price 214
Demand Curves Perceived by a Perfectly Competitive Firm and by a Monopoly 214
Total and Marginal Revenue for a Monopolist 216Marginal Revenue and Marginal Cost for a
Monopolist 216Illustrating Monopoly Profits 219The Inefficiency of Monopoly 220
Conclusion 221Key Concepts and Summary 222Review Questions 223
12 Monopolistic Competition and Oligopoly 225Monopolistic Competition 226
Differentiated Products 226Perceived Demand for a Monopolistic Competitor 227How a Monopolistic Competitor Chooses Price and
Quantity 227Monopolistic Competitors and Entry 230Monopolistic Competition and Efficiency 231The Benefits of Variety and Product Differentiation 232
Oligopoly 233Why Do Oligopolies Exist? 233Collusion or Competition? 234The Prisoner’s Dilemma 234The Oligopoly Version of the Prisoner’s Dilemma 235How to Enforce Cooperation 236
Trade-offs of Imperfect Competition 238Key Concepts and Summary 239Review Questions 240
13 Competition and Public Policy 241Corporate Mergers 242
Regulations for Approving Mergers 242The Four-Firm Concentration Ratio 244The Herfindahl-Hirshman Index 245New Directions for Antitrust 246
Regulating Anticompetitive Behavior 247Restrictive Practices 247The Microsoft® Case 248An Evolving Set of Standards 249
When Breaking Up Is Hard to Do: Regulating Natural Monopolies 249
The Choices in Regulating a Natural Monopoly 250Cost-Plus versus Price Cap Regulation 251
The Great Deregulation Experiment 252Doubts about Regulation of Prices and
Quantities 252The Effects of Deregulation 253Frontiers of Deregulation 254
Around the World: From Nationalization to Privatization 255
Key Concepts and Summary 256Review Questions 257
14 Environmental Protection and Negative Externalities 259Externalities 261Pollution as a Negative Externality 261Command-and-Control Regulation 263Market-Oriented Environmental Tools 264
Facts about Union Membership and Pay 313Higher Wages for Union Workers 314The Decline in U.S. Union Membership 317Concluding Thoughts about the Economics of
Unions 319Employment Discrimination 320
Earnings Gaps by Race and Gender 320Investigating the Female/Male Earnings Gap 321Investigating the Black/White Earnings Gap 322Competitive Markets and Discrimination 323Public Policies to Reduce Discrimination 324An Increasingly Diverse Workforce 325
Immigration 326Historical Patterns of Immigration 3261Economic Effects of Immigration 326Proposals for Immigration Reform 327
Conclusion 328Key Concepts and Summary 328Review Questions 329
18 Information, Risk, and Insurance 331The Problem of Imperfect Information 332
“Lemons” and Other Examples of Imperfect Information 332
How Imperfect Information Can Affect Equilibrium Price and Quantity 333
When Price Mixes with Imperfect Information about Quality 334
Mechanisms to Reduce the Risk of Imperfect Information 334
Insurance and Imperfect Information 336How Insurance Works 337Risk Groups and Actuarial Fairness 339The Moral Hazard Problem 339The Adverse Selection Problem 341Government Regulation of Insurance 342
Conclusion 344Key Concepts and Summary 344Review Questions 346
19 Financial Markets 347How Businesses Raise Financial Capital 348
Early Stage Financial Capital 348Profits as a Source of Financial Capital 349Borrowing: Banks and Bonds 349Corporate Stock and Public Firms 350How Firms Choose between Sources of Financial
Capital 351How Households Supply Financial Capital 353
Bank Accounts 353Bonds 355Stocks 357Mutual Funds 361Housing and Other Tangible Assets 361The Trade-offs between Return and Risk 363
How to Become Rich 364Why It’s Hard to Get Rich Quick: The Random Walk
Theory 364 Getting Rich the Slow, Boring Way 365
How Capital Markets Transform Financial Flows 366
Key Concepts and Summary 366Review Questions 368
x Contents
20 Public Choice 369When Voters Don’t Participate 370Special-Interest Politics 372Identifiable Winners, Anonymous Losers 373Pork Barrels and Logrolling 374Voting Cycles 375Where Is Government’s Self-Correcting
Mechanism? 376A Balanced View of Markets and Government 377Key Concepts and Summary 378Review Questions 379
21 The Macroeconomic Perspective 381Measuring the Size of the Economy: Gross Domestic
Product 383GDP Measured by Components of Demand 383GDP Measured by What Is Produced 386The Problem of Double Counting 387
Comparing GDP among Countries 388Converting Currencies with Exchange Rates 388Converting to Per Capita GDP 390
The Pattern of GDP over Time 391How Well Does GDP Measure the Well-Being of
Society? 393Some Differences between GDP and Standard of
Living 393Does a Rise in GDP Overstate or Understate the Rise
in the Standard of Living? 395GDP Is Rough, but Useful 396
Conclusion 396Key Concepts and Summary 396Review Questions 397
22 Economic Growth 399The Relatively Recent Arrival of Economic
Growth 400Worker Productivity and Economic Growth 401The Power of Sustained Economic Growth 403The Aggregate Production Function 404
Components of the Aggregate Production Function 405
Growth Accounting Studies 407A Healthy Climate for Economic Growth 408
Future Economic Convergence? 409Arguments Favoring Convergence 410Arguments That Convergence Is Neither Inevitable
Nor Likely 412The Slowness of Convergence 413
Key Concepts and Summary 414Review Questions 415
23 Unemployment 417Unemployment and the Labor Force 418
In or Out of the Labor Force? 418Calculating the Unemployment Rate 419Controversies over Measuring Unemployment 419
Patterns of Unemployment 420The Historical U.S. Unemployment Rate 420Unemployment Rates by Group 421International Unemployment Comparisons 423
Why Unemployment Is a Puzzle for Economists 424Looking for Unemployment with Flexible
Wages 424Why Wages Might Be Sticky Downward 425
The Short Run: Cyclical Unemployment 426The Long Run: The Natural Rate of
Unemployment 427Frictional Unemployment 428Productivity Shifts and the Natural Rate of
Unemployment 429Public Policy and the Natural Rate of
Unemployment 430The Natural Rate of Unemployment in Recent
Years 432The Natural Rate of Unemployment in Europe 432
A Preview of Policies to Fight Unemployment 433Key Concepts and Summary 434Review Questions 435
24 Inflation 437Combining Prices to Measure the Inflation
Rate 438The Changing Price of a Basket of Goods 438Index Numbers 440Measuring Changes in the Cost of Living 442Practical Solutions for the Substitution and the
Quality/New Goods Biases 444Alternative Price Indexes: PPI, GDP Deflator, and
More 445Inflation Experiences 446
Historical Inflation in the U.S. Economy 446Inflation around the World 447
Adjusting Nominal Values to Real Values 448Nominal to Real GDP 448Nominal to Real Interest Rates 450
The Dislocations of Inflation 451The Land of Funny Money 451Unintended Redistributions of Purchasing
Power 452Blurred Price Signals 454Problems of Long-Term Planning 454Some Benefits of Inflation? 455
xiContents
Indexing and Its Limitations 455Indexing in Private Markets 456Indexing in Government Programs 456Might Indexing Reduce Concern Over
Inflation? 457A Preview of Policy Discussions of Inflation 457Key Concepts and Summary 458Review Questions 459
25 The Balance of Trade 461Measuring Trade Balances 462
Components of the U.S. Current Account Balance 462
Trade Balances in Historical and International Context 464
The Intimate Connection between Trade Balances and Flows of Financial Capital 465
The Parable of Robinson Crusoe and Friday 466The Balance of Trade as the Balance of
Payments 467The National Saving and Investment Identity 468
The National Saving and Investment Identity 468Domestic Saving and Investment Determine the Trade
Balance 469Exploring Trade Balances One Factor at a
Time 470How Short-Term Movements in the Business Cycle
Can Affect the Trade Balance 471When Are Trade Deficits and Surpluses Beneficial or
Harmful? 472The Difference between Level of Trade and the Trade
Balance 473Final Thoughts about Trade Balances 475Key Concepts and Summary 476Review Questions 477
26 The Aggregate Supply-Aggregate Demand Model 479Macroeconomic Perspectives on Demand and
Supply 480Say’s Law and the Macroeconomics of Supply 480Keynes’ Law and the Macroeconomics of
Demand 481Combining Supply and Demand in
Macroeconomics 482Building a Model of Aggregate Supply and Aggregate
Demand 482The Aggregate Supply Curve and Potential GDP 482The Aggregate Demand Curve 484Equilibrium in the Aggregate Supply-Aggregate
Demand Model 485AS and AD Are Macro, not Micro 485
Shifts in Aggregate Supply 487How Productivity Growth Shifts the AS Curve 487How Changes in Input Prices Shift the AS Curve 488
Shifts in Aggregate Demand 488How Changes by Consumers and Firms Can Affect
AD 489How Government Macroeconomic Policy Choices
Can Shift AD 491How the AS-AD Model Combines Growth,
Unemployment, Inflation, and the Balance of Trade 492
Growth and Recession in the AS-AD Diagram 493Unemployment in the AS-AD Diagram 493Inflationary Pressures in the AS-AD Diagram 493The Balance of Trade and the AS-AD Diagram 495
Keynes’ Law and Say’s Law in the AS-AD Model 496Key Concepts and Summary 498Review Questions 500
27 The Keynesian Perspective 501The Building Blocks of Keynesian Analysis 502
The Importance of Aggregate Demand in Recessions 502
Wage and Price Stickiness 503The Two Keynesian Assumptions in the AS-AD
Model 504The Components of Aggregate Demand 505
What Causes Consumption to Shift? 505What Causes Investment to Shift? 506What Causes Government Demand to Shift? 507What Causes Exports and Imports to Shift? 507
The Phillips Curve 509The Discovery of the Phillips Curve 509The Instability of the Phillips Curve 510Keynesian Policy for Fighting Unemployment and
Inflation 512The Expenditure-Output Model 513
The Axes of the Expenditure-Output Diagram 513The Potential GDP Line and the 45-degree Line 513The Aggregate Expenditure Schedule 514
Building the Aggregate Expenditure Schedule 514Consumption as a Function of National Income 515Investment as a Function of National Income 516 Government Spending and Taxes as a Function of
National Income 517Exports and Imports as a Function of National
Income 518Building the Combined Aggregate Expenditure
Function 519Equilibrium in the Keynesian Cross Model 520
Where Equilibrium Occurs 520Recessionary and Inflationary Gaps 521
xii Contents
The Multiplier Effect 523How Does the Multiplier Work? 523Calculating the Multiplier 525Calculating Keynesian Policy Interventions 526Multiplier Trade-offs: Stability vs. the Power of
Macroeconomic Policy 527Is Keynesian Economics Pro-Market or
Anti-Market? 528Key Concepts and Summary 529Review Questions 531
28 The Neoclassical Perspective 533The Building Blocks of Neoclassical Analysis 534
The Importance of Potential GDP in the Long Run 534The Role of Flexible Prices 535How Fast Is the Speed of Macroeconomic
Adjustment? 538Policy Implications of the Neoclassical
Perspective 539Fighting Recession or Encouraging Long-Term
Macroeconomists Riding Two Horses 543 Key Concepts and Summary 545Review Questions 546
29 Money and Banks 547Defining Money by Its Functions 548
Barter and the Double Coincidence of Wants 548Three Functions for Money 549
Measuring Money: Currency, M1, and M2 550How Banks Work 552
Banks as Financial Intermediaries 552A Bank’s Balance Sheet 554How Banks Go Bankrupt 555
How Banks Create Money 557The Story of System Bank 557The Money Multiplier 558Cautions about the Money Multiplier 559
Conclusions 560Key Concepts and Summary 561Review Questions 562
30 Monetary Policy and Bank Regulation 563Monetary Policy and the Central Bank 564
The Federal Reserve 564Other Tasks and Funding of Central Banks 564
How a Central Bank Affects the Money Supply 566Open Market Operations 566Reserve Requirements 568
The Discount Rate 569Quantitative Easing 569
Monetary Policy and Economic Outcomes 570The Effect of Monetary Policy on Interest Rates 570The Effect of Monetary Policy on Aggregate
Demand 571What the Federal Reserve Has Done 572
Pitfalls for Monetary Policy 574Long and Variable Time Lags 575Excess Reserves 575Unpredictable Movements of Velocity 576Is Unemployment or Inflation More Important? 578Should the Central Bank Tackle Asset Bubbles
and Leverage Cycles? 579Bank Regulation 581
Bank Runs 581A Weakened Banking Sector 582Deposit Insurance 582Bank Supervision 583Lender of Last Resort 583Summary 584
Conclusion 585Key Concepts and Summary 585Review Questions 586
31 Exchange Rates and International Capital Flows 589How the Foreign Exchange Market Works 590
The Extraordinary Size of the Foreign Exchange Markets 590
Demanders and Suppliers of Currency in Foreign Exchange Markets 590
Participants in the Exchange Rate Market 593Strengthening and Weakening Currency 594
Demand and Supply Shifts in Foreign Exchange Markets 597
Expectations about Future Exchange Rates 598Differences across Countries in Rates of Return 599Relative Inflation 599Purchasing Power Parity 600
Macroeconomic Effects of Exchange Rates 601Exchange Rates, Aggregate Demand, and Aggregate
Supply 601Fluctuations in Exchange Rates 603Exchange Rates, Trade Balances, and International
Capital Flows 605Summing Up Public Policy and Exchange Rates 607
Exchange Rate Policies 608Floating Exchange Rates 608Using Soft Pegs and Hard Pegs 609Trade-offs of Soft Pegs and Hard Pegs 611A Single Currency 612
xiiiContents
Conclusion 613Key Concepts and Summary 614Review Questions 616
32 Government Budgets and Fiscal Policy 617An Overview of Government Spending 618
Total U.S. Government Spending 618Keeping Federal Budget Numbers in
Perspective 620State and Local Government Spending 621
An Overview of Taxation 621State and Local Taxes 624
Federal Deficits and Debt 625Debt/GDP Ratio 626The Path from Deficits to Surpluses to Deficits 626
Using Fiscal Policy to Affect Recession, Unemployment, and Inflation 628
Automatic Stabilizers 631Counterbalancing Recession and Boom 631The Standardized Employment Deficit or
Surplus 632Practical Problems with Discretionary Fiscal
Policy 633Fiscal Policy and Interest Rates 634Long and Variable Time Lags 634Temporary and Permanent Fiscal Policy 635Structural Economic Change Takes Time 636The Limitations of Potential GDP and the Natural Rate
of Unemployment 636Educating Politicians 636Summing Up Discretionary Fiscal Policy 637
Requiring a Balanced Budget? 637Conclusion 638Key Concepts and Summary 638Review Questions 640
33 Government Borrowing and National Savings 641How Government Borrowing Affects Investment and the
Trade Balance 641The National Saving and Investment Identity 642What about Budget Surpluses and Trade
Surpluses? 642Fiscal Policy, Investment, and Economic Growth 643
Crowding Out Physical Capital Investment 644The Interest Rate Connection 644Public Investment in Physical Capital 646Public Investment in Human Capital 647How Fiscal Policy Can Improve Technology 649
Summary of Fiscal Policy, Investment, and Economic Growth 649
Will Private Saving Offset Government Borrowing? 650
Fiscal Policy and the Trade Balance 651Twin Deficits? 651Fiscal Policy and Exchange Rates 652From Budget Deficits to International Economic
Crisis 653Using Fiscal Policy to Address Trade
Imbalances 654Conclusion 655Key Concepts and Summary 655Review Questions 656
34 Macroeconomic Policy around the World 657The Diversity of Countries and Economies across the
World 658Economic Growth 659
Growth Policies for the Technological Leaders 660Growth Policies for the Converging Economies 660Growth Policies for the Technologically
Disconnected 661Lower Unemployment 663
Unemployment from a Recession 663The Natural Rate of Unemployment 664Undeveloped Labor Markets 665
Policies for Lower Inflation 666Policies for a Sustainable Balance of Trade 667
Concerns over International Trade in Goods and Services 668
Concerns over International Flows of Capital 668Final Thoughts on Economics and Market
Institutions 670Key Concepts and Summary 672Review Questions 673
ChapterAppendices
1 Interpreting Graphics 675
8 Indifference Curves 689
19 Present Discounted Value 705
27 An Algebraic Approach to the Expenditure-Output Model 709
Glossary 715
Index 727
xv
Whenauthorsdescribetheirreasonsforwritingan economics textbook, it seems customarytoproclaimloftygoals,liketeachingstudents
Thepreparationthatstudentsneedtoperformwellinanintroductoryeconomicsclasscanbedividedintothreeparts. First, an introductory economics class involvesmastering a specialized vocabulary. I sometimes tellstudents that learning economics is akin to learning aforeignlanguage–withtheaddeddifficultythattermsineconomicslike“demand”or“supply”or“money”soundlikestandardEnglish,andthuslearningeconomicsoftenrequiresthatstudentstodroptheirpreconceptionsaboutwhatcertainwordsmean.
Second,studentsneedtoacquiresomebasicanalyticaltools.There are four central analyticalmodels in anintroductoryeconomicscourse:budgetconstraints,supply
Third, studentsmust learn to recognizewhen thesetermsandtoolsapplyandtopracticeusingthem.Ioftentellstudentsnottobothermemorizingparticularquestionsand answers from the textbook or homework, becausemyquizandexamquestionswillaskthemtoapplywhattheyhavelearnedincontextstheyhavenotseenbefore.To provide a variety of contexts, this book describesmany economic issues and events, drawn from recenttimesandpasthistory,andalsodrawnbothfromU.S.andinternationalexperiences.Whenstudentsseeaconceptoranalyticalskillappliedinanumberofways,theylearntofocusontheunderlyingandunifyingidea.I’vealsofoundthatstudentsdotakeawayknowledgeofmanyeconomicevents and episodes – althoughdifferent students seemtofocusonanunpredictable(tome)arrayofexamples,whichisperhapsasitshouldbeinanintroductorycourse.
Asaworkadayteacher,thegoalofhelpingstudentsmasterthematerialsothattheycanperformwellonmyquizzesandexamsisloftyenough—andtoughenough—forme.There’sanoldjokethateconomicsisthescienceoftakingwhatisobviousabouthumanbehaviorandmakingit incomprehensible.Actually, inmy experience, theprocessworksintheotherdirection.Manystudentsspendtheopeningweeksofanintroductoryeconomicscoursefeeling as if thematerial is difficult, even impossible,butbythemiddleandtheendoftheclass,whatseemedso difficult early in the termhas become obvious andstraightforward.As a course in introductory economicsfocusesononelessonafteranotherandonechapterafteranother,it’seasytogettunnelvision.Butwhenraiseyoureyesattheendofclass,itcanbequiteastonishingtolookbackandseehowfaryouhavecome.Asstudentsapply
Asalways,myfamilymakesasignificantcontributionto the existence of this book. In the three years sincethefirst edition, theU.S. andworldeconomyhasbeenconvulsed by aGreatRecession.The task of updatingfiguresandexamplesforthissecondeditionisinevitablylarge, but thinking about how to building connectionsfromtheconceptsinthetexttotheeconomiceventsof
Selected Papers“RecommendationsforFurtherReading,”Journal of Economic Perspectives.Aregularcolumn,eightpagesinlengthandcontaining25-30recommendedarticles,reports,orinterviewsthatTimTaylorhasbeenwritingforthisquarterlyjournalsincetheSpring2005issue.
“Medicare:Apocalypse…Later,”Milken Institute Review, ThirdQuarter2005,pp.42-47.Availableathttp://www.milken-inst.org.
“ShortfallsintheLongRun:PredictionsabouttheSocialSecurityTrustFund,”co-authoredwithJamesR.hinesJr.,Journal of Economic Perspectives, Spring2005,19:2,pp.3-9.
“TheEconomyinPerspective,”The Public Interest,Fall2004,pp.85-99.
“DumpingtheLump:ACenturyofMisunderstanding,”Milken Institute Review,ThirdQuarter2004,pp.82-87.Availableathttp://www.milken-inst.org.
xviii About the Author
“TheTruthaboutGlobalization,”The Public Interest,Spring2002,pp.24-44.Availableathttp://www.thepublicinterest.com.Reprintedinharf,JamesE.andMarkowenLombardi.2005.Taking Sides: Clashing Views on Controversial Global Issues.McGraw-hill/Dushkin,Dubuque,Iowa.pp.208-216.
LecturerforEconomics1atStanfordUniversity,atleastonequartereachyearfrom1989to 1993.Enrollment ranged from300-500 students. In 1992,winner of the award forexcellent teaching ina largeclass (more than30students) fromAssociatedStudentsofStanfordUniversity.
