ECO N O M ICS
MOSS
Second Edition
Praise for
“An incredibly clear and sophisticated introduction to macroeconomics.”
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A CONCISE GUIDE TO
is the John G. McLean
Professor of Business Administration at
Harvard Business School. He is the author
of Socializing Security: Progressive-Era Economists
and the Origins of American Social Policy and
When All Else Fails: Government as the Ultimate Risk
Manager, and is the founder of the Tobin
Project, a nonprofit research organization.
DAVID A. MOSS
Second
Edition
M ACROECONOM ICS
EVG E N IA E LI S E EVA
A CONCISE GUIDE TO MACROECONOMICS
—RICHARD VIETOR,
Senator John Heinz Professor of the Environment at Harvard Business School;
author of How Countries Compete
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A CONCISE GUIDE TO
M ACRO
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What Managers, Executives, and Students Need to Know
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9 781625 271969
H A R VA R D B U S I N E S S R E V I E W P R E S S
UNDERSTANDING
THE GROUND RULES FOR
THE GLOBAL ECONOMY
I
n this revised and updated edition of A
Concise Guide to Macroeconomics, David A. Moss
draws on his years of teaching at Harvard
Business School to explain important macro
concepts using clear and engaging language.
This guidebook covers the essentials of
macroeconomics and examines, in a simple
and intuitive way, the core ideas of output,
money, and expectations. Early chapters leave
you with an understanding of everything
from fiscal policy and central banking to
business cycles and international trade. Later
chapters provide a brief monetary history
of the United States as well as the basics of
macroeconomic accounting. You’ll learn why
countries trade, why exchange rates move,
and what makes an economy grow.
Moss’s detailed examples will arm you with
a clear picture of how the economy works and
how key variables impact business and will
equip you to anticipate and respond to major
macroeconomic events, such as a sudden
depreciation of the real exchange rate or a
steep hike in the federal funds rate.
Read this book from start to finish for a
complete overview of macroeconomics, or
use it as a reference when you’re confronted
with specific challenges, like the need to
make sense of monetary policy or to read a
balance of payments statement. Either way,
you’ll come away with a broad understanding
of the subject and its key pieces, and you’ll
be empowered to make smarter business
decisions.
A CONCI S E G U I DE TO
Macroeconomics
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A CONCI S E G U I DE TO
Macroeconomics
What Managers, Executives, and
Students Need to Know
Second Edition
David A. Moss
Harvard Business Review Press
Boston, Massachusetts
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For my students
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CONTENTS
Acknowledgements
ix
Introduction
1
Part I Understanding the Macro Economy
1
Output
7
Measuring National Output 8
Exchange of Output across Countries 11
What Makes Output Go Up and Down? 18
Isn’t Wealth More Important Than Output? 27
2
Money
33
Money and Its Effect on Interest Rates, Exchange Rates,
and Inflation 34
Nominal versus Real 39
Money and Banking 55
The Art and Science of Central Banking 58
3
Expectations
67
Expectations and Inflation 68
Expectations and Output 73
Expectations and Other Macro Variables 83
Part II Selected Topics—Background and Mechanics
4
A Short History of Money and Monetary
Policy in the United States
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Contents
Defining the Unit of Account and the Price of Money 90
The Gold Standard: A Self-Regulating Mechanism? 91
The Creation of the Federal Reserve 93
Finding the Right Monetary Rule under a Floating
Exchange Rate 95
The Transformation of American Monetary Policy 98
5
The Fundamentals of GDP Accounting
101
Three Measurement Approaches 102
The Nuts and Bolts of the Expenditure Method 103
Depreciation 106
GDP versus GNP 107
Historical and Cross-Country Comparisons 108
Investment, Savings, and Foreign Borrowing 111
6
Reading a Balance of Payments Statement
117
A Typical Balance of Payments Statement 118
Understanding Credits and Debits 120
The Power and Pitfalls of BOP Accounting 124
7
Understanding Exchange Rates
131
The Current Account Balance 131
Inflation and Purchasing Power Parity 133
Interest Rates 134
Making Sense of Exchange Rates 135
Conclusion
139
Output 139
Money 140
Expectations 143
Uses and Misuses of Macroeconomics 146
Epilogue
149
Glossary
159
Notes
183
Index
191
About the Author
211
viii
ACKNOWLEDGMENTS
This volume began as a note on macroeconomics for my
­students, and I am deeply indebted to them and to my colleagues
in the Business, Government, and the International Economy
(BGIE) unit at Harvard Business School for encouraging me to
turn the note into a book. I am particularly grateful to Julio
Rotemberg, Dick Vietor, and Lou Wells for reading and commenting on the entire manuscript, and to Alex Dyck, Walter
Friedman, Lakshmi Iyer, Andrew Novo, Huw Pill, Mitch Weiss,
and Jim Wooten for providing vital feedback along the way, and
to all my BGIE colleagues over the years, from whom I have
learned so much about macroeconomics and how to teach it.
Jeff Kehoe, my editor at Harvard Business Review Press, was
extraordinarily supportive at every stage, and offered superb
advice on how to recast the original note for a broader audience.
Chapter 5, on GDP accounting, draws heavily on a Harvard
Business School case entitled “National Economic Accounting:
Past, Present, and Future,” which I coauthored with Sarah
Brennan. Most of what I know about the intricacies of GDP
accounting I learned working with Sarah, and I remain exceedingly grateful to her for her commitment to that project and for
being such a terrific researcher, coauthor, and friend.
In preparing this second edition, Jonathan Schlefer played a
tremendous role, particularly in helping to update data throughout the volume and in clarifying the IMF’s new approach to balance of payments accounting. He did a masterful job, and I am
ix
Acknowledgments
enormously appreciative of his contributions, without which
there would be no second edition.
Finally, I wish to thank my parents, who, in so many ways,
inspired this book by teaching me not to lose sight of the big
picture; and my wife and daughters—Abby, Julia, and Emily—
for their unending support and patience and for making every
day so much fun!
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x
Introduction
Macroeconomic forces affect all of us in our daily lives. Inflation
rates influence the prices we pay for goods and services and, in
turn, the value of our incomes and our savings. Interest rates
determine the cost of borrowing and the yield on bank accounts
and bonds, while exchange rates affect our command over
­foreign products as well as the value of our foreign assets. And all
of this represents just the tip of the iceberg. Numerous macro
variables—ranging from unemployment to productivity—are
equally important in shaping the economic environment in
which we live.
For most business managers, a basic understanding of macroeconomics allows a more complete—as well as a more
nuanced—conception of market conditions, on both the demand
side and the supply side. It also ensures that they are better
1
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Introduction
equipped to anticipate and to respond to major macroeconomic
events, such as a sudden depreciation of the real exchange rate
or steep hike in the federal funds rate.
Although managers can enjoy success even if they don’t truly
understand these sorts of macro variables, they have the potential to outperform their competitors—to see hidden opportunities and to avoid unnecessary (and sometimes very costly)
mistakes—after incorporating basic macro concepts and relationships into their management toolbox. In the 1990s, for
example, managers who knew how to read and interpret a balance of payments statement had a definite leg up in dealing with
the Mexican and Asian currency crises. Similarly, those who
understood the essential dynamic of a bank run—and the power
of negative expectations—were better positioned to cope with
the financial crisis of 2007–2009.
Nor is the practical value of macroeconomics confined to
business. A basic understanding of the subject is important to us
as consumers, as workers, as investors, and even as voters.
Whether our elected officials (and the individuals they appoint
to lead crucial agencies, such as the Federal Reserve and the
Treasury Department) manage the macro economy well or poorly
obviously has great significance for our quality of life, both now
and in the future. Whether a large budget deficit is advantageous
or disadvantageous at a particular moment in time is something
that voters should be able to evaluate for themselves.
Unfortunately, even many well-educated citizens have never
studied macroeconomics. And those who have studied the subject too often learned more about how to solve artificial problem
sets than about the true fundamentals of the macro economy.
Macroeconomics is frequently taught with a heavy focus on
equations and graphs, which, for many students, obscure the
essential ideas and intuition that make the subject meaningful.
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Introduction
This book attempts to provide a conceptual overview of
­macroeconomics, emphasizing essential principles and relationships, rather than mathematical models and formulas. The purpose is to convey the fundamentals—the building blocks—and
to do so in a way that is both accessible and relevant.
The approach employed here is one I have helped to develop
over the past two decades at Harvard Business School. In fact,
I drafted the first version of this book as a primer for my students, and it has since been adopted as required reading in many
programs at HBS. Although the approach is quite different from
what one would find in a standard macro textbook (graduate or
undergraduate), it is an approach that we have found to be very
effective and that has also been well received by students and
executives alike.
As the remainder of this volume makes clear, macroeconomics
may be thought of as resting on three basic pillars: output,
money, and expectations. Because output is the central pillar, we
begin with that topic in chapter 1 and follow with money and
expectations in chapters 2 and 3, respectively. Together, chapters
1 through 3 comprise part I of the book, which covers the fundamentals of macroeconomics in as compact a form as possible.
For readers interested in digging a bit deeper, chapters 4
through 7 (part II) provide more detailed coverage in several key
areas. These chapters are not meant to be comprehensive, but
rather to address a handful of macro topics that typically provoke the most questions in the classroom. Chapter 4 provides a
brief historical survey of US monetary policy, tracing management of the nation’s money supply from the dawn of the republic
down to the present. Experience suggests that a historical
approach proves particularly effective in conveying both the
logic and limits of monetary policy and central banking.
Chapters 5 and 6 cover the basics of macroeconomic accounting.
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Introduction
Just as knowledge of how to read an income statement and a
­balance sheet is essential for assessing a company, knowledge of
how to read a GDP account (chapter 5) and a balance of payments statement (chapter 6) is essential for assessing a country
and the performance of its economy. Finally, chapter 7 surveys
the topic of exchange rates, focusing on factors that are thought
to drive currencies to appreciate or depreciate. Although the
path of an exchange rate, like the trajectory of a stock, is notoriously difficult to predict, there are certainly a number of important economic relationships one should take into account
when—for either personal or business reasons—a prediction is
required.
Unlike a standard textbook, this volume is designed to be read
in just a few sittings. Although readers may wish to return to
particular sections from time to time (to brush up on exchange
rates or fiscal policy, for example), they are likely to get the most
out of the book if they first read it (or at least read part I) in its
entirety—the goal being to develop a broad understanding of the
subject, its key pieces, and how they fit together.
With that in mind, we begin at the conceptual heart of
­macroeconomics, with an exploration of national output in
chapter 1.
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I
Understanding the
Macro Economy
Ch01.indd 5
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Ch01.indd 6
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Chapter ONE
Output
The notion of national output lies at the heart of macroeconomics.
The total amount of output (goods and services) that a country
produces constitutes its ultimate budget constraint. A country
can use more output than it produces only if it borrows the difference from foreigners. Large volumes of output—not large
quantities of money—are what make nations prosperous.
A national government could print and distribute all the money
it wanted, turning all of its residents into millionaires. But collectively they would be no better off than before unless national
output increased as well. And even with all that money, they
would find themselves worse off if national output declined.
7
Ch01.indd 7
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Understanding the Macro Economy
Measuring National Output
The most widely accepted measure of national output is gross
domestic product (GDP). In order to understand what GDP is, it
is first necessary to figure out how it is measured.
The central challenge in measuring national output (GDP) is
to avoid counting the same output more than once. It might
seem obvious that total output should simply equal the value of
all the goods and services produced in an economy—every
pound of steel, every tractor, every bushel of grain, every loaf of
bread, every meal sold at a restaurant, every piece of paper, every
architectural blueprint, every building constructed, and so forth.
But this isn’t quite right, because counting every good and service actually ends up counting the same output again and again,
at multiple stages of production.
A simple example illustrates this problem. Imagine that
Company A, a forestry company, cuts trees in a forest it owns
and sells the wood to Company B for $1,000. Company B, a furniture company, cuts and sands the wood and fashions it into
tables and chairs, which it then sells to a retailer, Company C, for
$2,500. Company C ultimately sells the tables and chairs to consumers for $3,000. If, in calculating total output, one added up
the sales price of every transaction ($1,000 + $2,500 + $3,000),
the result ($6,500) would overstate the amount of output
because it would count the value of the lumber three times (in all
three transactions) and the value of the carpentry twice (in the
final two).
A good way to avoid the over-counting problem is to focus
on the value added—that is, the new output created—at each
stage of production. If a tailor bought an unfinished shirt for
$50, sewed on buttons costing $1, and then sold the finished
8
Ch01.indd 8
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Output
shirt for $60, we would not say that he created $60 worth of
output. Rather, he added $9 of value to the unfinished shirt
and buttons, and thus created $9 worth of output. More precisely, value added (or output created) equals the sales price of
a good or service minus the cost of all nonlabor inputs used to
produce it.
We can easily apply this method to the A-B-C example just
given. Because Company A sold the raw wood it had cut for
$1,000, and had purchased no material inputs, it added $1,000
of value (output) to the economy. Company B added another
$1,500 in value, since it paid $1,000 for inputs (from
Company A) and sold its output (to Company C) for $2,500.
Finally, Company C added another $500 in value, having purchased $2,500 in inputs (from Company B) and sold $3,000
worth of final output to consumers. If one sums the value added
at each stage ($1,000 + $1,500 + $500), one finds that a total of
$3,000 worth of output was created.
Another—and far simpler—way to avoid the over-counting
problem is to focus exclusively on final sales, which implicitly
account for the output created in all prior stages of production.
Since consumers paid Company C, the retailer, $3,000 for the
final tables and chairs, we can conclude that $3,000 worth of
total output was created. Note that this was precisely the same
answer we came to using the value-added approach in the previous paragraph. (See figure 1-1.)
Although both methods are correct, the second method—
known as the expenditure method—has emerged as the standard approach for calculating GDP in most countries. The
essential logic of the expenditure method is that if we add up all
expenditures on final goods and services, then that sum must
exactly equal the total value of national output produced, since
every piece of output must eventually be purchased in one way
9
Ch01.indd 9
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Understanding
Understandingthe
theMacro
MacroEconomy
Economy
FIGURE 1-1
Calculating total output: an example
Sales price
–
Cost of material inputs
=
Value added
Company A
(forestry company)
↓
Company B
(furniture company)
↓
Company C
(retailer, to consumer)
$1,000
$0
$1,000
$2,500
$1,000
$1,500
$3,000
$2,500
$500
Total
$6,500
$3,500
$3,000
1
or another.
As a officials
result, thetypically
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definition
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final
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all final
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ingGovernment
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(G), exports
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five categories:
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5.
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important thing
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is that all of
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(IM).
One canincludes
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ness investment
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most
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Although
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For massive
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als)
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Another
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tables and chairs would not.2
10
Ch01.indd 10
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Output
Another possible source of over-counting (in the expenditure
method) involves imports. If American consumers bought televisions from Asia, we would have to be careful not to count those
consumer expenditures in American GDP, since the output being
purchased was foreign, not domestic. For this reason, imports
are subtracted from total expenditures and thus appropriately
excluded from GDP.
Putting these various pieces together yields one of the most
important identities in macroeconomics:
National Output (GDP) = C + I + G + EX – IM.
This tells us that national output equals total expenditure on
final goods and services, excluding imports. As we have seen,
national output also equals the sum of value added (i.e., the
incremental value added at every stage of production) throughout the domestic economy.
A third way to measure total output is to focus on income
(though again, in practice, the expenditure method is used more
often in calculating GDP). Income is the amount paid to factors
of production, labor and capital, for their services—typically in
the form of wages, salaries, interest, dividends, rent, and royalties. Since income is just payment for the production of output,
it makes sense that total income should ultimately equal total
output. After all, all of the proceeds of production ultimately
have to end up somewhere, including in your pocket and mine.3
Exchange of Output across Countries
Sometimes, one country may wish to exchange its output for
that of another country. For example, the United States may
wish to exchange commercial aircraft (such as Boeing 747s)
11
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Understanding the Macro Economy
for Japanese automobiles (such as Hondas or Toyotas). If the
value of the US aircraft exactly equaled the value of the
Japanese automobiles at the moment of exchange, then both
countries’ trade accounts would be in balance. That is, exports
would exactly equal imports in both the United States and
Japan.
One puzzle is why any country would want to run a trade
surplus, which involves giving more of its output away to foreigners (in the form of exports) than it receives in return (in the
form of imports). Why would any country wish to give away
more than it received? The answer, in a nutshell, is that countries
running trade surpluses today expect to get back additional output from their trading partners in the future.4 This transfer across
time is ensured through international lending and borrowing.
When a country exports more than it imports, it inevitably lends
an equivalent amount of funds abroad, which allows the foreigners to purchase its surplus production. Conversely, when a
country imports more than it exports, it must borrow from foreigners to finance the difference. By borrowing, it is promising to
pay back the difference—typically with interest—at some point
in the future.
If, for instance, the United States were to import automobiles
from Japan without exporting anything in return, it could pay
for these automobiles only by borrowing from Japan. This borrowing could take many different forms: Americans could borrow directly from Japanese banks or they could give the Japanese
stocks or bonds or other securities. Whatever form the borrowing took, the Japanese would end up with assets, such as stocks
or bonds, promising a claim on future US output. Eventually,
when the Japanese decided to sell their American stocks and
bonds and use the proceeds to buy American airplanes, movies,
and software, the trade balances of the two countries would flip.
12
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Output
Now the United States would be required to run a trade surplus,
shipping some of its output to Japan, and thus forcing Americans
to consume less than they produced. The Japanese, meanwhile,
would now run a trade deficit, permitting their consumption to
exceed their production (with the difference coming from the
United States).
All international transactions of this sort are recorded in a
country’s balance of payments (BOP) statement. (See table 1-1.)
Current transactions, such as exports and imports of goods and
services, are recorded in the current account. Financial transactions, including sales of stocks and bonds to foreigners, are
recorded in the financial account (which was formerly called the
capital account). Deficits on the current account are necessarily
accompanied by capital inflows (borrowing) on the financial
account, whereas surpluses on the current account are accompanied by capital outflows (lending) on the financial account. As a
result, the current account and the financial account are perfect
opposites, with a deficit in one necessarily accompanied by a
surplus of the same amount in the other. (For pointers on reading a BOP statement, see chapter 6.)
Current account deficits should not necessarily be interpreted
in a negative light, since they can indicate either weakness or
strength, depending on the context. In some cases, current
account deficits imply that a country is living beyond its means,
increasing its consumption to an unsustainable level. But current
account deficits can also arise when a country is borrowing from
abroad in order to raise its level of domestic investment (and
thus increase its future output). The question for deficit countries, therefore, is whether they are using the additional output
well, whereas for surplus countries it is whether they can expect
a good return in the future on the output they are giving to others today.
13
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Understanding the Macro Economy
TABLE 1-1
GDP and the balance of payments—a hypothetical example
GDP accounts
for Country X, 2010 (millions of $)
Balance of payments
for Country X, 2010 (millions of $)
Consumption (C)
Investment (I)
Government (G)
Exports (EX)
Imports (IM)
Current account
−50
balance on merchandise −200
balance on services 150
net investment income −25
unilateral transfers
25
1,000
200
300
500
550
GDP (C + I + G + EX – IM)
Financial account 50
net direct investment −125
net portfolio investment 150
−25
errors and omissions
50
change in official reserves
1,450
Explanation: In this example, Country X is buying more final output than it produces. We
know this because C + I + G (domestic expenditure) is greater than total GDP (1,500 vs.
1,450). For this to be possible, Country X must import more than it exports, as is indeed
the case. As shown in the left panel, imports (of goods and services) exceed exports (of
goods and services) by 50, which is exactly the amount by which domestic expenditure
exceeds domestic output. Clearly the difference between domestic expenditure and
domestic output is being imported from abroad. The panel on the right side, the balance
of payments, offers a more detailed account of Country X’s transactions with the rest of
the world. The current account is in deficit, reflecting the fact that Country X buys more
from foreigners than it sells to foreigners. (Although the current account on the BOP does
not always equal the difference between exports and imports as recorded in the GDP
accounts, it is often close.) The surplus on the financial account represents a net capital
inflow from abroad, which is necessary to finance the deficit on the current account. The
capital inflows that make up the financial account take a variety of forms, including foreign
direct investment (FDI), portfolio flows, and so on. For a more detailed treatment of GDP
accounting and balance of payments accounting, see chapters 5 and 6.
Although balance of payments accounting may be unfamiliar to you, it is not really as difficult as it may seem. In fact, the
fundamental issues should become a good deal clearer through
a simple analogy to your own personal budget. The amount of
output that you produce—that is, your individual output—is
reflected in your personal income. If you are employed, you
are paid wages or a salary for your contribution to output. If
you own capital (such as bank accounts, bonds, or stocks),
you are paid interest or dividends for its contribution to output. If you wish to spend more than you produce (i.e., to buy
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more than your total income permits), then you have to borrow (or at least draw down your savings) to finance the difference. This excess spending may be used to finance increased
consumption (such as a two-week holiday in Europe) or a new
personal investment (such as additional education or an entrepreneurial venture) that promises to increase your earning
power in the future. Either way, for you to borrow, someone
else has to lend, which in turn means that that person is producing more than he or she is spending (and saving the difference so it can be lent to you). Someday you will have to repay
the loan, presumably with interest. When you do that, you
will have to consume less than you produce (i.e., consume less
than your income would otherwise permit) because you will
have to turn over part of your income to your creditor in the
form of interest and principal repayments.
For a country, it is basically the same thing. If a nation is
running a deficit on its current account (by importing more
than it exports, for example), then it is using more output than
it is producing, and it is borrowing the difference from foreigners, which registers as a surplus—a capital inflow—on the
financial account of its BOP statement. The key point is that
for a country, as for a person, the long-term constraint on consumption and investment is the amount of output that can be
produced. A country, like a person, can use more output than
it produces in the short run (by financing the difference
through borrowing) but not over the long run. A nation’s
­output—its GDP—thus represents its ultimate budget constraint, which is why the notion of national output lies at the
heart of macroeconomics. (On the relationship between output and trade, see “A Brief Aside on the Theory of Comparative
Advantage.”)
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A Brief Aside on the Theory of
Comparative Advantage
O
ne of the most important principles in all of economics is
that of comparative advantage, first articulated by the
British political economist David Ricardo in 1817. Intent on persuading British lawmakers to abandon their protectionist trade
policies, Ricardo set out to prove the extraordinary power of trade
to increase total world output and thus consumption and living
standards. On the basis of a simple model with just two countries
and two goods, he showed that every country—even one enjoying an absolute productivity advantage in both goods—would
benefit from specializing in what it was relatively best at producing and then engaging in trade for everything else.
In his now-famous example, Ricardo imagined that Portugal
was more productive than England in making both wine and
cloth. Specifically, he assumed the Portuguese could produce,
over a year, a particular quantity of wine (say, 8,000 gallons) with
just 80 men, as compared with 120 men in England; and, similarly, that the Portuguese could produce a particular quantity of
cloth (say, 9,000 yards) with just 90 men, as compared with
100 men in England. In other words, Portugal’s productivity was
100 gallons of wine or 100 yards of cloth per worker per year,
whereas England’s was only 66.67 gallons of wine or 90 yards of
cloth per worker per year. Given Portugal’s absolute advantage in
both industries, why would the Portuguese ever choose to buy
either wine or cloth from England?
Ricardo’s surprising answer was that both countries would
benefit from trade, so long as both specialized in what they were
relatively best at producing. In Ricardo’s example, although
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Portugal was better at making both wine and cloth, its advantage
was greater in wine. As a result, Portugal enjoyed a comparative
advantage in wine, and, conversely, England enjoyed a comparative advantage in cloth. Ricardo concluded that if each country
followed its comparative advantage—with Portugal producing
only wine and England only cloth—and the two then engaged in
trade with one another, each would be able to consume more
wine and more cloth than if it had tried to produce both goods
on its own.
To make this more concrete, assume that each country had
1,200 workers, and that each allocated 700 to wine and 500
to cloth. This would mean that Portugal produced 70,000 gallons of wine and 50,000 yards of cloth, whereas England produced 46,667 gallons of wine and 45,000 yards of cloth.
However, if each country devoted all 1,200 workers to its comparative advantage, Portugal would produce 120,000 gallons
of wine and England 108,000 yards of cloth. If they now
traded, say, 48,000 gallons of wine for 55,000 yards of cloth,
Portugal would end up with 72,000 gallons of wine and
55,000 yards of cloth, and England with 48,000 gallons of
wine and 53,000 yards of cloth. Both countries, in other words,
would end up with more of both goods as a result of specializing and trading. (See table 1-2.) In fact, to have produced
these quantities on their own would have required 1,270 workers in Portugal and 1,309 workers in England. It is as if, as a
result of specializing and trading according to the principle of
comparative advantage, both countries got the output of many
extra workers for free.
Economists have since shown that Ricardo’s result can be generalized to as many countries and to as many goods as one wants
to include. Although we can certainly specify conditions under
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TABLE 1-2
Comparative advantage and gains from trade:
a numeric example
Wine
(gallons)
Cloth
(yards)
Portuguese productivity
(output per worker per year)
100
100
English productivity
(output per worker per year)
66.67
90
1.5
(Portuguese
comparative
average)
1.1
(English
comparative
average)
Portuguese output under autarchy
(700 wine workers, 500 cloth workers)
70,000
50,000
English output under autarchy
(700 wine workers, 500 cloth workers)
46,667
45,000
Portuguese output under specialization
(1,200 wine workers)
Ratio of Portuguese productivity to
English productivity
120,000
0
English output under specialization
(1,200 cloth workers)
0
108,000
Portuguese consumption after trade
(e.g., 48,000 gallons of wine for 55,000
yards of cloth
72,000
55,000
English consumption after trade
(e.g., 55,000 yards of cloth for 48,000
gallons of wine)
48,000
53,000
which mutual gains from trade break down, most economists
tend to believe that these conditions—these possible exceptions
to free trade—occur relatively rarely in practice. Indeed, the Nobel
What Makes Output Go Up and Down?
Many macroeconomists regard the question of what makes
national output go up and down as the most important question
of all. Although there is remarkably little agreement on the answer,
there are at least a few things on which most economists do agree.
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Prize-winning economist Paul Samuelson once acknowledged
that “it is a simplified theory. Yet, for all its oversimplification, the
theory of comparative advantage provides a most important
glimpse of truth. Political economy has found few more pregnant
principles. A nation that neglects comparative advantage may pay
a heavy price in terms of living standards and growth.”
Remarkably, most of us—even those who have never studied
the theory of comparative advantage—tend to live by it in our own
personal affairs every day. For the most part, we all try to do what
we’re relatively best at and trade for everything else. Take an
investment banker, for example. Even if that investment banker
were better at painting houses than any professional painter in
town, she would still probably be wise (from an economic standpoint) to focus on investment banking and to pay others to paint
her house for her, rather than to paint it herself. This is because
her comparative advantage is presumably in investment banking,
not house painting. Taking time away from her high-paying investment banking job in order to paint her house would likely prove
quite costly, ultimately reducing the amount of money she could
earn and, in turn, the amount of output she could consume. In
order to maximize output, in other words, it makes sense for each
of us to specialize in our comparative advantage and to trade for
the rest.
Sources of Growth
Beginning with the question of what makes output rise over
time, economists often point to three basic sources of economic
growth: increases in labor, increases in capital, and increases in
the efficiency with which these two factors are used. The
amount of labor can rise if existing workers work longer hours
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or if the workforce is expanded through new entrants (such as
occurred in the United States in the 1970s, when previously
nonemployed women began entering the paid workforce in
large numbers). Capital stock rises when businesses enhance
their productive capacity by adding more plant and equipment
(through investment). Efficiency increases when producers are
able to get more output from the same amount of labor and
capital—as a result of organizational innovation, for example.
As an illustration of these different sources of growth, consider
a simple textile factory with 10 employees and 10 sewing
machines. If each employee, making whole shirts on a sewing
machine, were able to produce 10 shirts per day, then the total
output of the factory would be 100 shirts per day. Now imagine
that the factory owner doubled both the number of workers and
the number of sewing machines. Output would undoubtedly
rise—perhaps to 200 shirts per day. Thus, one strategy for increasing output is to increase labor, capital, or a combination of the
two. A very different strategy, however, would aim for an increase
in efficiency, rather than labor and capital inputs. The factory
owner, for example, might try to enhance efficiency by reorganizing the shop floor, setting up something resembling an assembly
line. Under the new arrangement, instead of each worker making
whole shirts, some workers would make collars, others sleeves,
and so on. Workers at the end of the line would assemble the
various pieces. If this approach were substantially more efficient,
the factory—with its original 10 workers and 10 sewing
machines—might now be able to produce as many as 200 shirts
per day, or more, even with no increase in labor or capital.5
Economists often refer to such efficiency as total factor productivity (or TFP). (For further discussion of TFP, see “Productivity.”)
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Although the illustration just given involved but a single
­factory, the same basic principles can be applied to entire economies. A national economy may increase its GDP by increasing
the total number of person-hours worked (labor), by increasing
the total amount of plant and equipment in use (capital), or by
increasing the efficiency with which labor and capital are used
(TFP).
So-called supply-side economists focus their attention on
how to grow all three of these factors, in order to increase the
total potential output—the supply side—of an economy. One
favorite method among “supply-siders” in the United States is
the reduction of tax rates. Supply-side economists argue that
because lower tax rates allow everyone in the private sector to
keep more of what they earn, tax relief provides citizens with
strong incentives to work longer hours (thus increasing labor),
to save and invest more of their income (thus increasing capital), and to devote more attention to innovation of all kinds
(thus increasing efficiency, or TFP). For all of these reasons,
supply-siders in the United States have often favored reductions in tax rates as the best way to grow GDP over the
long run.
Other economists, including many outside of the United
States, have at times argued almost exactly the opposite—that
government led investment (in public infrastructure, education,
and R&D, for example) can be the best way to build the capital
stock, enhance the labor force, and promote innovation and thus
the best way to boost long-run economic growth. Although they,
too, focus on the supply side, they have a very different conception of the optimal use of public policy in boosting potential output (supply).
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Productivity
A
lthough total factor productivity is an important macroeconomic concept, it is not typically what economists and other
analysts have in mind when they refer simply to “productivity.”
Instead, the word is commonly used as shorthand for labor productivity, defined as output per worker hour (or, in some cases, as
output per worker). If you read in the newspaper that hourly productivity increased by 3 percent last year, this means that real
GDP (output) divided by the total number of hours worked
nationwide was 3 percent higher at the end of last year than it
was at the end of the previous year. In general, countries with
high labor productivity enjoy higher wages and living standards
than countries with low labor productivity.
There are many reasons why labor productivity might be
higher in one country than another, or why it might grow in a
given country from one year to the next. In particular, greater
availability of machinery and other capital equipment is typically
associated with higher labor productivity. As one economist has
noted, “Railroad workers, on average, can each move more tons
Causes of Economic Downturns (Recessions and Depressions)
Another question of great importance among macroeconomists
is what makes output decline or grow more slowly. Clearly, anything that causes labor, capital, or TFP to fall could potentially
cause a decline in output, or at least a decline in its rate of
growth. A massive earthquake, for example, could reduce output
by destroying vast amounts of physical capital. Similarly, a deadly
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of freight than the average bicyclist.”a Better educated workers
also tend to be more productive than their less educated
­counterparts, with college-educated workers generally producing
more output per hour (and earning higher wages) than
­high-school-educated workers.
Economic analysts often pay close attention to the relationship
between productivity and wages. When a country’s wages are
­rising faster than its labor productivity, economists say that its unit
labor costs (i.e., the cost of labor needed to produce a unit of
output) are rising. When, conversely, increases in labor productivity outpace increases in wages, unit labor costs are said to be
falling. Countries whose unit labor costs (as measured in a common currency) are rising faster than those of their trade partners
are often said to be “losing competitiveness” in the global
­marketplace.
a. Forest Reinhardt, “Accounting for Productivity Growth,” Case no. 794-051
(Boston: Harvard Business School, 1994): 3. When labor productivity rises by
more than one would expect from an increase in the capital stock alone, economists attribute the difference to total factor productivity, which broadly measures the ­efficiency with which labor and capital are used.
epidemic could reduce output by decimating the labor force.
Even something as seemingly noneconomic as religious strife
could reduce output, by increasing tensions among employees of
different faiths and thus reducing their collective efficiency and,
in turn, TFP.
In some cases, however, output may decline sharply even in
the absence of any earthquakes or epidemics. From 1929 to
1933, for example, national output declined by more than
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30 ­percent in the United States. Economists and policy makers
alike were as p
­ uzzled as they were horrified. President Herbert
Hoover observed in October 1930 that although the economy
was in a depression, “the fundamental assets of the Nation…
have been unimpaired… The gigantic equipment and unparalleled organization for production and distribution are in many
parts even stronger than two years ago.”6 Similarly, in his
­inaugural address in early 1933, President Franklin Roosevelt
maintained that “our distress comes from no failure of substance.
We are stricken by no plague of locusts… Plenty is at our doorstep, but a generous use of it languishes in the very sight of the
­supply.”7 Since all the necessary inputs (labor and capital) were
there, why had output fallen so dramatically in just a few short
years?
The British economist John Maynard Keynes claimed to have
the answer. “If our poverty were due to earthquake or famine or
war—if we lacked material things and the resources to produce
them,” he wrote in 1933, “we could not expect to find the means
to prosperity except in hard work, abstinence, and invention. In
fact, our predicament is notoriously of another kind. It comes
from some failure in the immaterial devices of the mind…
Nothing is required, and nothing will avail, except a little clear
thinking.”8 His key insight, implied by the phrase “immaterial
devices of the mind,” was that the problem was mainly one of
expectations and psychology. For some reason, people had gotten
it into their heads that the economy was in trouble, and that belief
rapidly became self-fulfilling. Families decided that they had better save more to prepare for the future. Seeing a drop in consumption on the horizon, businesses decided to scale back both
investment and production, leading to layoffs, which reduced
workers’ incomes and thus exacerbated the drop in c­ onsumption.
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Driven by nothing more than expectations, which Keynes
would later refer to as “animal spirits,” the economy had fallen
into a vicious downward spiral. Although the economy’s potential output remained large (since all the same factories were still
there and the same workers still available, if called upon),
actual output had collapsed as a result of a severe shortfall in
demand.
In principle, such a collapse could not have occurred had
prices been perfectly flexible and adjusted instantly to
­reequilibrate supply and demand. For example, if wages had
fallen fast enough (and far enough) to reflect a reduced
demand for labor, all unemployed workers would quickly
have found new jobs, though admittedly at lower wages than
they had enjoyed before. The point is that even with sudden
changes in expectations, resources would never go to waste—
or remain unemployed—if the price mechanism worked
­perfectly.
In practice, however, markets sometimes falter. For reasons
that are still not fully understood, prices can be rigid or sticky,
meaning that they don’t always adjust as quickly or as completely
as they should. As a result, a negative shock—including a sudden downturn in expectations—truly can drive an economy into
an extended recession, where real incomes decline and both
human and physical resources are left unemployed.
Starting around the time of Keynes, therefore, economists
began to realize that there was more to economic growth than
just the supply side. Demand mattered a great deal as well, particularly since it could sometimes fall short. In fact, over roughly
the next 40 years, it became an article of faith among leading
economists and government officials that it was the government’s
responsibility to “manage demand” through fiscal and monetary
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Understanding the Macro Economy
policy, so as to reduce the duration and the severity of economic
recessions and thus help stabilize the business cycle.* (Figure 1-2
charts the US business cycle.)
We will return to these topics in greater detail in chapter 3.
But for now it is worth remembering that actual output can fall
short of potential output when demand falters. Labor, capital,
and TFP are all very important, but so too are expectations.a
* Economists commonly distinguish between long-term (secular) trends and
short-term (cyclical) fluctuations. Recessions, which tend to come and go, are
generally regarded as cyclical phenomena. Although there is no universally
accepted definition of a recession, one rule of thumb is that a recession involves
at least two consecutive quarters of negative real GDP growth.
FIGURE 1-2
The US business cycle, 1930–2010
30
25
Real GDP (% annual change)
Unemployment rate (%)
20
15
10
5
0
–5
–10
–15
1930
1940
1950
1960
1970
1980
1990
2000
2010
Sources: GPD growth: Bureau of Economic Analysis, Table 1.1.1. “Percent Change from Preceding
Period in Real Gross Domestic Product,” revised May 30, 2013; unemployment for 1930–1944:
Historical Statistics of the United States, Millennial Edition Online, edited by Susan B. Carter et al.
(New York: Cambridge University Press, 2006), Table Ba470–477, “Labor force, employment, and
unemployment: 1890–1990”; unemployment for 1945–2010: Bureau of Labor Statistics, Current
Population Survey, “Employment status of the civilian noninstitutional population, 1942 to date,”
accessed June 2013.
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Isn’t Wealth More Important Than Output?
With all this focus on output, even a loyal reader may be starting
to entertain some doubts. One might be wondering, for instance,
whether wealth isn’t more important than output in determining
a nation’s well-being. Although this is a very good question, the
answer, in a word, is “no.”
Unquestionably, people feel rich when they own lots of financial assets, such as stocks and bonds. But the reason they feel
rich is that these assets provide them, indirectly, with a claim on
future output. If they own stock in a company, for example, then
they are entitled to a share of its future profits, which are in turn
based on the output the company produces and sells. Another
way to look at this is that people who own lots of financial assets
feel rich because they believe they can always sell the assets for
money and use the proceeds to buy any goods and services their
hearts desire. In this sense as well, wealth simply represents a
claim on future output.9 Clearly, if the production of output collapsed and there were few goods or services to buy (because of a
massive epidemic, for example), then most assets—including
stocks and bonds—would quickly lose much of their value, with
some even becoming worthless. Indeed, this is why financial
assets typically lose value in a depression, when output falls.
At root, most financial assets represent claims on real productive assets (such as plant and equipment), which in turn are
expected to generate output in the future. But of course, all of
these productive assets were once output themselves. One of the
most important decisions that a society has to make—at least
implicitly—is what to do with the output it produces. One option
is simply to consume all of it every year. The problem with focusing solely on the present is that it may eliminate the chance for a
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brighter future. Instead of consuming everything today, a better
strategy might be to save something for tomorrow. In fact, it
might be possible to produce far more output in the future if
some fraction of today’s resources were used to make productive
assets (such as the sewing machines needed to make clothes)
rather than just consumables (such as the clothes themselves).
Current output that is intended to increase future output is
called investment. Fundamentally, investment can be financed in
one of two ways—either through domestic savings (which
implies reduced consumption today) or through borrowing from
abroad (which implies reduced consumption tomorrow). In the
United States at the present time, Americans do some of
both. (See figure 1-3.)
F igure 1- 3
Domestic expenditure, domestic output, and sources of
investment in the United States, 2012
Domestic expenditure (uses of output)
Private and government consumption
Private and government investment
Total
Share of GDP (%)
84
19 ¬
103
Sources of investment
16
3
19
Domestic savings
Net borrowing from abroad
Total
Expenditure versus output
Total domestic expenditure
Total domestic output (GDP)
Difference (= net borrowing from abroad)
103
100
® 3
Source: Bureau of Economic Analysis, US Department of Commerce.
Note: In the United States in 2012, domestic expenditures (uses of output) exceeded domestic
production of output (GDP) by about 3%. Similarly, total domestic investment exceeded total
domestic ­savings—again by about 3% (19% investment minus 16% savings). In both cases, the
difference was made up by “borrowing” 3% of output from abroad (as expressed in the current
account deficit).
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In a market economy, decision making about savings and
investment is highly decentralized. Based on expected returns
and the cost of borrowing, as well as their own preferences,
households decide how much to save, firms decide how much to
invest, and foreigners decide how much to lend. In some cases,
the government may try to influence the result—by offering, for
example, an investment tax credit or other incentives to
­encourage additional business expenditure on plant and equipment. For the most part, however, these critical decisions are
made privately in the marketplace every single day, by households, firms, and foreign investors.
Ultimately, the output the market allocates to investment
(rather than to consumption) adds to the nation’s capital stock.
There is no question that capital is vital in a capitalist economy.
Hence the name. But it is equally important to remember that
capital is derived from output and, ultimately, that it is but a
means to an end—the end being to produce (and to have access
to) more output in the future. Indeed, a nation is generally
­classified as rich or poor depending on its output per person
(GDP per capita), with the United States near the top of the list
($49,922 GDP per capita in 2012) and the Democratic Republic
of the Congo ($237) and Burundi ($282) near the bottom.10
(For more on the relationship between saving, investment, and
output, see “The Pension Dilemma and the Centrality of
Output.”)
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The Pension Dilemma and the Centrality of Output
A
s is well known, many nations’ pay-as-you-go pension systems
are expected to run into trouble in the coming years. As the
baby boomers retire, each active worker paying into a national pension system will have to support an ever-larger number of retirees.
Although the debate over pension reform has become highly
contentious (and highly technical) in many countries, the essential
problem is really quite simple, and it boils down to output. Each
year, there is only so much national output to go around, and it
somehow has to be divided between active workers (who produce
it) and a growing number of retirees (who mainly just consume it).
This, at root, is the job of a pension system—to divide national output between active workers and retirees. Keeping this simple point
in mind is helpful in thinking about the basic challenges ahead and
about the trade-offs involved in various reform proposals.
One proposed reform envisions the creation of new
government-sponsored individual retirement accounts (IRAs).
­
Whereas a pay-as-you-go pension system offers retirees an implicit
claim on labor (since benefits are generally financed through a
payroll tax on employment), a system based on IRAs would offer
retirees a claim on capital (as represented by the stocks and bonds
they held in their accounts). In other words, the pay-as-you-go
approach and the IRA approach simply offer two different ways to
divide the pie.
Unfortunately, some proponents of the IRA approach suggest
that there is a “free lunch” to be had: if only Americans could use
their Social Security contributions to buy stocks and bonds, rather
than to pay for the benefits of current retirees, they could build
nice nest eggs and comfortably retire without being a drain on
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anyone. Current benefits, meanwhile, could be financed through
borrowing until the transition was complete.
Not surprisingly, this free lunch argument rests on several fallacies. One basic mistake is to treat a portfolio of stocks and bonds
as if it were a stockpile of actual output that an elderly person
could consume straightaway. Although all of us are accustomed
to thinking that we can sell our financial assets for cash at a
moment’s notice and then use the cash to buy goods and services, this obviously wouldn’t work if everyone tried to do it at
once. If a large number of senior citizens liquidated their financial
assets at the same time, in order to buy needed goods and services, they would soon find that the proceeds were much smaller
than they had expected. Simply giving the elderly more pieces of
paper—more stocks and bonds—does not guarantee that there
will be more output for them to consume in the future.
A related—but even more subtle—mistake is to view every contribution to an IRA as an addition to national savings, which would
in turn raise national output in the future. The problem, once
again, is that stocks and bonds are just pieces of paper. They represent legal claims on productive assets, but are not productive
assets themselves. If every company in America decided to split
its stock, doubling the number of shares in every American’s portfolio, this would obviously not increase national savings. As we
have seen, the only way to increase national savings at any
moment in time is to reduce national consumption, and thus to
devote more of the nation’s precious output to investment in productive assets in order to raise output in the future. Whether or
not IRAs would contribute to national savings depends entirely on
how they were financed. If individuals or the government financed
contributions to the new IRAs through borrowing, for example,
then total savings would fail to rise as a result. To increase savings
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through the pension system, either current workers would have to
put more of their income aside each year, or current retirees
would have to accept lower benefits. Unfortunately, there’s no
free lunch.
The key question from a macroeconomic standpoint, therefore, is not whether the senior citizens of tomorrow have IRAs or
traditional Social Security benefits, but whether they (or others)
reduced their consumption to prepare for their eventual retirement. Unless savings are increased today, the division of output
between active workers and retirees will be no less onerous
tomorrow, regardless of whether we have a fully funded pension
system based on individual accounts or a traditional pay-as-yougo system based on payroll taxes.
If this seems surprising—or even confusing—don’t worry. The
impending pension crisis is one of the toughest problems facing
policy makers all around the world. But the underlying problem is
more straightforward than it seems. The amount of output a country produces is its ultimate budget constraint, regardless of how
many stocks or bonds or Social Security cards may be floating
around. Unless its output grows, a country cannot give more to its
retirees without giving less to its workers. The key point to remember is that as a society, it is mainly output, not wealth (and especially not financial wealth), that we have to rely on in the end.
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CHAPTER TWO
Money
Although output is more important than wealth in the study of
macroeconomics, one particular form of wealth—money—­
occupies a very special place in the field. Money serves many
purposes in a market economy, but one of the most vital is to
facilitate exchange. Without money, the exchange of goods and
services would be far less efficient. As the British philosopher
David Hume put it in the middle of the eighteenth century,
money is not one “of the wheels of trade: It is the oil which renders the motion of the wheels more smooth and easy.”1
Just imagine how complicated trade could become in the
absence of money. If you were a farmer who grew wheat and
wanted to take your family out to dinner, you would have to find
a restaurant willing to accept a few bushels in exchange for a
meal. Otherwise, you would have to figure out what the
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Understanding the Macro Economy
r­estaurant owner wanted—say, new chairs—and then find a
­furniture maker who was willing to trade chairs for wheat. And
think what would happen if the furniture maker wasn’t interested in wheat, but wanted a new hammer instead.
Clearly, having one convenient commodity that everyone was
willing (or required) to accept as payment would simplify the
process immensely. And this is precisely why money is used as a
medium of exchange in every market economy around the
world. In a monetized economy (where people transact with
money), anyone wishing to purchase your wheat would simply
pay money for it, allowing you to buy a meal at a restaurant or
anything else you might want, subject solely to your having
enough money to cover the cost.
At least since the dawn of the nation state, national governments have taken charge of defining what money is in their economies (see chapter 4). Eventually, almost every national
government also took charge of creating its own currency, either
by coining it or printing it itself. As we will see, how a government
does this has enormous implications for how its economy functions and what types of risk its residents face in the marketplace.
Money and Its Effect on Interest Rates, Exchange Rates,
and Inflation
Although money plays a vital role facilitating exchange, it also
affects several variables that are of great interest to macroeconomists: interest rates, exchange rates, and the aggregate price
level. In an important sense, all three of these variables constitute
“prices” of money.
The interest rate can be thought of as the price of holding
money or, alternatively, as the cost of investment funds.
34
Money
In g­ eneral, most people would prefer to receive $100 in cash
now than to receive the same $100 in cash a year from now.
Economists characterize this trade-off as the “time value of
money.” A consumer may take out a loan (and agree to pay interest on it in the future) in order to receive cash to spend immediately. Perhaps this consumer prefers to start enjoying a new
television set right away rather than saving up for a year before
enjoying it. Similarly, business managers may wish to borrow
from a bank or float bonds when the interest rate on borrowing
is lower than the return they expect they can make on a new
investment. When interest rates rise, money obviously becomes
more expensive, both for individuals and for firms, and thus the
cost of buying things today (relative to tomorrow or next year)
goes up. In part for these reasons, rising interest rates tend to
slow the growth of output in the economy (by slowing current
consumption and investment), whereas falling interest rates tend
to accelerate the growth of output (by stimulating current consumption and investment).
An exchange rate, meanwhile, is simply the price of one currency in terms of another. If it costs 100 yen to buy one dollar,
then the yen-to-dollar exchange rate is 100. Conversely, the
dollar-to-yen exchange rate is 0.01. If the yen-to-dollar
exchange rate subsequently fell to 90, this would mean that the
dollar had depreciated (and the yen had appreciated), since it
now took more dollars to buy one yen (and fewer yen to buy
one dollar).* When a country’s exchange rate depreciates,
* It is important to note that when a country’s exchange rate is expressed in
terms of another currency (i.e., the other currency is in the denominator), an
increase in the rate indicates depreciation of the country’s currency, and a
decrease indicates appreciation. For example, if the yen-to-dollar exchange
rate “falls” from 100 to 90, then the Japanese yen has appreciated relative to the
US dollar, since it now takes fewer yen to buy one dollar (and, what is the same
thing, one yen buys more dollars—or, in this case, a larger fraction of a dollar).
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Understanding the Macro Economy
f­oreigners will find it cheaper to buy that country’s currency,
which may lead them to buy more of the country’s goods as
well. It is for this reason that a depreciating exchange rate is
often regarded as being favorable for a country’s exports. There
is no free lunch, however. A depreciating exchange rate also
means that foreign currencies (and thus foreign goods) appear
more expensive to the country’s citizens, thus reducing their
overall purchasing power.
The aggregate price level (sometimes called the price deflator) is a bit more complicated, since it is not the price of any
one thing in particular. Broadly speaking, the aggregate price
level reflects the average price of all goods and services—or at
least of a broad subset of goods and services—in terms of
money. In a healthy economy, the money prices of individual
goods and services are changing all the time. At any moment,
some may be rising and others falling. For example, the price of
milk might be rising while the price of computers is falling.
There are times, however, when one can detect trends across all
(or at least most) prices. In a period of inflation, when the aggregate price level is increasing, most prices tend to rise, though
some will inevitably rise more than others. In a period of deflation, by contrast, when the aggregate price level is decreasing,
most prices tend to fall, though again some will fall more than
others. It should not be hard to see that the value—or price—of
money in terms of goods and services moves in exactly the
opposite direction as the aggregate price level. When the price
level rises (in a period of inflation), the value of money falls;
and when the price level falls (in a period of deflation), the
value of money rises. (See figure 2-1.)
As it turns out, changes in the quantity of money may affect all
three of these variables—that is, all three “prices” of money.
36
Money
FIGURE
F I G U R E2-1
2-1
The three “prices” of money
1. Price relative to time (or, more precisely, bonds)
Interest rate
2. Price relative to foreign currency
Exchange rate
3. Price relative to all goods and services
Aggregate price level
(price deflator)
A nation’s central bank can increase the money supply by printmore
currency
andand
injecting
the
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37
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UnderstandingthetheMacro
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FIGURE
F I G U R E2-2
2-2
Money: standard “textbook” relationships
Interest rate falls
Increase in money supply
Exchange rate depreciates
Price level rises (inflation)
Interest rate rises
Decrease in money supply
Exchange rate appreciates
Price level falls (deflation)
38
38
Money
Nominal versus Real
These relationships between money and other macroeconomic
variables become somewhat more complex when the variables
begin to interact. A good example involves the interaction of
interest rates and inflation. Although an increase in the money
supply is expected to drive down interest rates, it is also expected
to drive up inflation, which may in turn push long-term interest
rates (and, eventually, short-term rates) higher, rather than lower.
To understand why, it is first necessary to understand one of the
central dichotomies in macroeconomics: nominal versus real.
Nominal versus Real GDP
We’ll start with nominal versus real GDP. During an inflationary
period, when all prices are generally on an upward trend, GDP
may rise even if no additional goods and services are being produced. This is because GDP is measured in terms of current (market) prices. Recall that in calculating GDP, officials add up the
value of all final goods and services produced in an economy in a
given year, and they value these goods based on the prices at
which they are sold.
As an illustration, suppose that an island economy produced
only two final goods, coconut milk and rice. Imagine further
that in the year 2010, it produced 1 million gallons of coconut
milk, which it sold at $10 per gallon, and 2 million pounds of
rice, which it sold at $4 per pound. Just a little bit of calculation
reveals that the island’s GDP in 2010 was $18 million. (See
table 2-1.) Now suppose that for some reason the island still
produced 1 million gallons of coconut milk and 2 million
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TABLE 2-1
Final output of island economy, 2010 (in current island $)
Output
Quantity
Price
Value of final output
Coconut milk
1 million gallons
$10/gallon
$10 million
Rice
2 million pounds
$4/pound
$8 million
$18 million (= 2010 GDP)
TABLE 2-2
Final output of island economy, 2011 (in current island $)
Output
Quantity
Price
Value of final output
Coconut milk
1 million gallons
$20/gallon
$20 million
Rice
2 million pounds
$8/pound
$16 million
$36 million (= 2011 GDP)
pounds of rice in 2011, but that the prices of these products on
the island had doubled to $20 per gallon and $8 per pound,
respectively. Naturally, the country’s GDP would rise to
$36 ­million in 2011, though its actual output (i.e., gallons of
coconut milk and pounds of rice produced) had not increased at
all. (See table 2-2.) In this case, we would say that the island had
experienced a 100 percent inflation rate (since prices had doubled), that its nominal GDP had also increased by 100 ­percent
(having gone from $18 to $36 million), but that its real GDP
(i.e., its GDP after controlling for inflation) had not changed.
Recall from the previous chapter that macroeconomists pay
a great deal of attention to the quantity of goods and services
an economy produces. This is because the more goods and
services a nation produces (with a stable population), the
higher the standard of living for those who live and work
there. Whereas nominal GDP may increase either because of
changes in price or changes in quantity, real GDP increases
40
Money
only with changes in quantity. Real GDP, in other words,
­measures the quantity of all final goods and services produced
in a country in a given year. Another way of expressing this is
in the following identity:
Nominal GDP = P × Q,
where P is the aggregate price level (or price deflator) and Q is
the total quantity of final output (real GDP).
To reiterate, a country’s prosperity depends on its real GDP
(Q), not its nominal GDP (P × Q). As we saw in the island example, when nominal GDP rises solely because of price changes,
residents are left no better off than they were before, since their
command over real goods and services has not increased. Only
when their access to goods and services rises—because of an
increase in Q—are they truly better off in economic terms.
One way to calculate real GDP from year to year is to use a
constant set of prices. In the island example, this would involve
applying the prices in 2010 ($10 per gallon of coconut milk and
$4 per pound of rice) to the output produced in both 2010 and
2011. Doing this would yield a real GDP of $18 million in 2010
and a real GDP of $18 million in 2011, accurately reflecting the
fact that the quantity of output had not increased.
Naturally, the price deflator (P) can immediately be calculated
for both 2010 and 2011, since we know both nominal and real
GDP for both years. For any given year,
Price deflator (P) =
Nominal GDP
Real GDP (Q)
This means that the price deflator (P) increased from 1.00 (i.e.,
$18 million/$18 million) in 2010 to 2.00 (i.e., $36 million/$18 million) in 2011, accurately reflecting the fact that prices doubled on
the island from one year to the next.2 (See table 2-3.)
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TABLE 2-3
Island economy: nominal versus real GDP, 2010–2011
Year
Nominal GDP
=
Price deflator (P)
×
Real GDP (Q)
2010
$18 million
1.00
$18 million2010 $
2011
$36 million
2.00
$18 million2010 $
In a more typical example, we might see both nominal and real
GDP rising, but nominal GDP rising faster. This would imply that
national output was increasing, but that inflation was also present.
In the United States between 1980 and 2010, for example, nominal GDP growth averaged 5.7 percent per year, while real GDP
growth averaged 2.8 percent per year. The annual inflation rate
(which will roughly equal the difference between nominal and
real GDP growth) averaged 2.8 percent, meaning that prices were
rising, on average, by 2.8 percent per year. (See table 2-4.) One
way to characterize US economic performance from 1980 to
2010, therefore, is to say that about half of nominal GDP growth
during these years was attributable to increases in quantity (real
GDP) while the remainder, also about half, was attributable to
price increases (inflation). Had there been no inflation at all, nominal GDP growth and real GDP growth would have been exactly
equal.
Nominal versus Real Interest Rates
The same basic distinction—between nominal and real—can be
applied to interest rates as well. A nominal interest rate is one
that you find quoted at a bank or listed in the newspaper. If you
borrowed $1,000 from a bank for one year at a nominal interest
rate of 5 percent, at the end of that year you would owe the bank
$1,050 (i.e., the original $1,000 in principal plus $1,000 × 5
percent, or $50, in interest). In 2005, the nominal interest rate
42
Money
TABLE 2-4
US economic performance, 1980–2010
1980
2010
1980–2010
CAGRa
Nominal GDP (P × Q)
$2,862 billion
$14,958 billion
5.7%
Real GDP, 2009 $ (Q)
$6,443 billion
$14,779 billion
2.8%
GDP deflator, 2010 = 100 (P)
43.9
100.0
2.8%
CAGR stands for “compound annual growth rate.” The formula for calculating a CAGR is
as ­follows: CAGR = [(Final value/Starting value)[1/(final year – starting year)] – 1] × 100%. This formula is
derived from the following growth equation: Final value = Starting value × (1 + r)(number of years),
where r is the ­average annual growth rate of the variable in question.
a
on overnight bank lending in the United States (the so-called
federal funds rate) averaged 3.22 percent; the nominal interest
rate on 10-year US government bonds, 4.29 percent; and the
nominal interest rate on 10-year home mortgages, 5.94 percent.
(The first of these, the overnight bank rate, is a short-term interest rate, whereas the second and third are long-term interest
rates.)3 By comparison, in 2012, when the Federal Reserve was
keeping interest rates unusually low to encourage investment
and spending in the wake of the 2007–2009 financial crisis, the
federal funds rate averaged 0.14 percent; the nominal interest
rate on 10-year US government bonds, 1.80 percent; and the
nominal interest rate on 10-year home mortgages, 3.69 percent.
As already noted, nominal interest rates tend to rise with inflation. If a bank charged 5 percent interest on a loan when it anticipated zero inflation, it might charge 8 percent when it anticipated
3 percent inflation. In the latter scenario, the nominal rate would
be 8 percent while the so-called real interest rate would remain at
5 percent. The approximate relationship between real and nominal interest rates can be expressed as follows:
Real interest rate (iR) » Nominal interest rate (iN)
− Expected inflation (Pe)
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Simply put, the real interest rate represents the effective rate of
interest on a loan after controlling for inflation.
Nominal interest rates rise with inflation because creditors care
about their command over real output, not their command over
money per se. Imagine, for example, that a dairy farmer (let’s call
him Bill) agreed to lend his neighbor (Tom) 10 milk cows for an
entire season on the condition that Tom would return all 10 plus
one more cow at the end of the year. This would constitute a oneyear loan at a 10 percent rate of interest. Now suppose that after
repaying the loan at the end of the year (by delivering 11 cows to
Bill), Tom wanted to do the same thing again—that is, he wanted
to borrow 10 cows from Bill for one year at a 10 percent rate of
interest. The only difference was that this time he proposed repaying the loan in money rather than in cows. Since a cow cost $1,000
at the time of the agreement, Tom promised that he would pay Bill
$11,000 at the end of the year. Bill thought this sounded fine and
agreed to the deal. Unfortunately for Bill, however, the price of a
cow increased by 10 percent that year, rising from $1,000 to
$1,100. As a result, when Tom made good on the loan by paying
Bill $11,000 at the end of the year, Bill was only able to buy 10
cows, not 11, with that sum of money. It was as if Bill had lent his
original 10 cows at no interest at all!
Economists would say that under the second arrangement,
the nominal interest rate was 10 percent but that the real interest
rate was zero. For Bill to have maintained an effective (real) rate
of interest of 10 percent—that is, with regard to output rather
than money—he would have had to raise his nominal interest
rate to approximately 20 percent (or 21 percent, to be exact). At
a 21 percent nominal rate of interest, Tom would have been
required to repay $12,100 at the end of the year ($10,000
­principal plus $2,100 interest), which would have been just
enough to allow Bill to buy 11 cows at the new price of $1,100
44
Money
each (since 11 × $1,100 = $12,100). It is easy to see from this
­example that if the price of cows had increased by one-tenth
(i.e., if cow inflation were 10 percent), Bill would have had to
roughly double the nominal rate of interest (in terms of money)
to preserve a real rate of interest (in terms of cows) of 10 ­percent.
In assessing whether the cost of borrowing in an economy is
high or low, economists typically focus on real rates rather than
nominal rates. Once again, this is because output—not money—
is what matters most.
Clearly, in a context of zero inflation, a 1,000 percent interestrate loan would be very difficult to repay. If you borrowed
$20,000 this year at 1,000 percent interest, you would have to
repay $220,000 next year ($20,000 principal plus $200,000
interest). Since inflation was zero, both the real and nominal rate
of interest would equal 1,000 percent. To consume an additional
$20,000 worth of output this year, you would have to give up
$220,000 worth of output the following year. By almost any
standard, this would be very expensive credit.4
However, if inflation itself reached 1,000 percent, a nominal
interest rate of 1,000 percent would no longer look burdensome
for most borrowers—in fact, it would look very cheap—since
wages and prices were rising by 1,000 percent as well. Under
this second scenario, the nominal rate of interest would still be
1,000 percent, but the real rate of interest (i.e., nominal minus
inflation) would have fallen to zero. As a result, borrowers lucky
enough to get loans at 1,000 percent interest in an environment
of 1,000 percent inflation would feel as if they were paying no
interest at all, since—in terms of what it could actually buy—the
$220,000 repayment would be no greater than the original
$20,000 lent.5 (See table 2-5.)
With all this in mind, we are now ready to reconsider why the
relationship between money growth and interest rates can be
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TA B L E 2 - 5
Example:
TABLE
2-5
real versus nominal interest rates
Example: real versus nominal interest rates
Scenario 1:
Scenario 2:
Nominal (posted)
interest rate on loan
Nominal (posted)
1,000% rate on
interest
loan
1,000%
Rate of
inflation
Rate of
0%
­inflation
Real
Effective cost
interest rate
of borrowing
Effective cost
Real
1,000%
Very high
interest of borrowing
rate0%
Very low
1,000%
Scenario 1:
1,000%
0%
1,000%
Scenario 2:
1,000%
1,000%
0%
Very high
Very low
ambiguous. Normally, when the central bank increases the money
ambiguous.
Normally,expect
when interest
the central
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money
supply, economists
rates—especially
short-term
supply,
expect
interest
rates—especially
interest economists
rates—to fall.
However,
growth
in the moneyshort-term
supply—
interest
rates—to
fall. However, growth
in theinflationary
money supply—
particularly
if it is substantial—may
also spark
expecparticularly
if it isinsubstantial—may
sparklong-term
inflationarynominal
expectations, which
turn will tend also
to push
tations,
in turn will
tend
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interestwhich
rates upward.
And
if inflation
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if inflation
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nominal And
interest
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inal
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Becauseand
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on nominal
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increase
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Real of
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are very
money
is ambiguous.
Real rates
interest
are surely
very likely
to
likely tosupply
fall. Short-term
nominal
willrates
almost
fall imfall.
Short-term
nominal
rates
almost kicks
surelyin.
fallAnd
immediately,
mediately,
but may
rise later
onwill
if inflation
long-term
but
may rise
if inflation
kicksthe
in.same,
And long-term
nominal
rateslater
mayonfall,
rise, or stay
dependingnominal
mainly
rates
mayhappens
fall, rise,toor
stay the same,
depending
mainly
what
on what
inflationary
expectations.
(See
figureon
2-3.)
happens to inflationary expectations. (See figure 2-3.)
F I G U R E2-3
2-3
FIGURE
(nominal
Money growth, inflation, and interest rates (nominal
versus real)
Nominal interest rate falls
Increase in
money supply
?
Real interest rate falls
Inflation may rise
46
46
Nominal interest rate rises
Money
Nominal versus Real Exchange Rates
The distinction between nominal and real can be applied to
exchange rates as well. Even if a country’s nominal exchange
rate is depreciating, its real exchange rate will depreciate less (or
may even appreciate) if inflation is rising faster than in other
countries.
To understand why, we should start with nominal exchange
rates. As we have seen, if a country’s currency depreciates relative
to other currencies, then it will appear cheaper to foreigners.
This, in turn, will make the country’s goods and services look
cheaper to foreigners, which may well entice them to buy more
of the country’s exports. The country’s own citizens, meanwhile,
will find it more expensive to buy foreign currencies, which may
deter them from buying as many imports from abroad. It is in
this sense that depreciation of a country’s currency is seen as
favorable to its trade balance (since its exports will tend to rise
and its imports will tend to fall).
A simple illustration should help make this clear. Imagine that
the yen-to-dollar exchange rate was 100 (i.e., 100 yen to 1 dollar)
and that a Japanese-made calculator cost ¥900 in Japan and an
American-made calculator cost $10 in the United States. If
­transportation costs were low, Americans would prefer to import
Japanese-made calculators, since they would cost only $9 at the
prevailing exchange rate (plus a bit more for transportation), as
compared with $10 for American-made calculators. Now
­suppose that the dollar depreciated by 20 percent, driving the
yen-to-dollar exchange rate to 80. If the price of domestically
produced calculators didn’t change in either country, Americans
would start buying American calculators, since Japanese
calculators would now cost $11.25 (i.e., 900/80) plus
­
47
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Understanding the Macro Economy
t­ ransportation costs, while American calculators would still cost
$10. Simultaneously, Japanese might now prefer American-made
calculators as well, since they would cost only ¥800 at the new
exchange rate (plus transportation costs), as compared with
¥900 for Japanese-made calculators. Thus, after its currency
depreciated, America’s imports would fall and its exports would
rise. (See table 2-6.)
This result could be completely negated, however, if the
United States experienced rising inflation at the same time.
Suppose, as in the previous example, the US dollar depreciated
by 20 percent (to a yen-to-dollar exchange rate of 80), but that
this time the United States experienced 30 percent inflation,
while Japan experienced no inflation at all. Because of the rise in
American inflation, the price of an American-made calculator
would likely rise by 30 percent to $13 or ¥1,040 (at the exchange
rate of 80 yen to the dollar). Since Japanese calculators would still
cost only ¥900 or $11.25 (at the exchange rate of 80 yen to the
dollar), both Japanese and Americans would likely revert to buying Japanese-made calculators. American imports would rise, and
American exports would fall—just as if its currency had appreciated. In fact, although its nominal exchange rate had ­depreciated
by 20 percent, its real exchange rate (i.e., the effective exchange
TABLE 2-6
Cost of calculators, in $ and ¥, before and after nominal
depreciation of the dollar
Cost of
Cost of
Cost of
Cost of
Japanese- JapaneseUS-made US-made made
made
¥/$ ER ­calculator ­calculator c
­ alculator ­calculator
Before
After
100
$10
¥1,000
¥900
$9.00
80
$10
¥800
¥900
$11.25
48
Country
from which
calculators
bought
Japan
US
Money
rate after controlling for inflation) had actually appreciated,
because its inflation rate (relative to Japan’s) had increased by
more than 20 percent.
The relationship between real and nominal exchange rates in
this example can be expressed in the following approximation
(which obviously can be applied to any two countries, not just
the United States and Japan):
% DReal exchange rate (¥/$)
» % DNominal exchange rate (¥/$)
− (Japanese inflation % − US inflation %)
If we assume, for convenience, that foreign inflation is zero,
then (by rearranging terms) we can also say that the real appreciation of a country’s currency approximately equals the country’s inflation rate minus its nominal depreciation rate—that is:
Real appreciation of Currency X
» Inflation rate of Country X
− Nominal depreciation of Currency X
where all of these changes are expressed in percentages. (See
table 2-7.)
Although the notion of a real exchange rate remains unfamiliar to many business managers and investors, those
involved in international transactions ignore it at their peril.
Consider just one example. In the early 1990s, as US investment was pouring into Mexico, many American portfolio managers celebrated Mexico’s pegged nominal exchange rate as an
important safeguard of their investments.6 But they seemed to
pay scant attention to Mexico’s rapidly appreciating real
49
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Understanding the Macro Economy
TABLE 2-7
Nominal versus real exchange rates—four scenarios
% change
Approx. %
in nominal
change in Expected
¥/$
real ¥/$
effect on US
exchange Inflation rate Inflation exchange balance of
rate
(Japan)
rate (US) rate
trade
Scenario 1:
−20%
(depreciation of $)
0%
30%
10%
(appreciation of $)
Unfavorable
(¯ BOT)
Scenario 2:
−20%
(depreciation of $)
0%
20%
0%
Neutral
Scenario 3:
−20%
(depreciation of $)
0%
10%
−10%
(depreciation of $)
Favorable
(� BOT)
Scenario 4:
−20%
(depreciation of $)
30%
30%
−20%
(depreciation of $)
Favorable
(� BOT)
exchange rate, which resulted from the combination of its
pegged nominal rate against the dollar on the one hand and
inflation that was running higher than inflation in the United
States on the other. To be sure, the peso’s dramatic real appreciation offered an important signal of potential trouble ahead,
undermining Mexico’s trade position and thus intensifying its
dependence on ever-larger inflows of foreign capital.
Particularly well-informed investors may have recognized that
a large real appreciation could presage a substantial depreciation of the nominal exchange rate (and thus a sharp decline in
the dollar value of their peso-denominated assets). Most investors, however, were apparently caught by surprise—and suffered big losses—when the peso collapsed in a full-blown
currency crisis beginning in late 1994. Clearly, the concept of
a real exchange rate, though rather academic-sounding, can be
of profound practical significance in business transactions.
(See “Real Exchange Rates and Foreign Investment.”)
50
Money
Real Exchange Rates and Foreign Investment
A
basic understanding of real exchange rates (and how they
affect company sales and profits) is vital for any business
manager engaged in international trade or investment.
Consider, for example, a manager responsible for the Chinese
production subsidiary of an American mobile phone company.
Because China (like many developing countries) essentially pegs
its exchange rate to the dollar, the manager would be wise to
think hard about the implications of a sudden surge in Chinese
inflation. After all, if prices rose faster in China than in the United
States, then the yuan would appreciate in real terms against the
dollar, even though the nominal exchange rate (that is, the one
reported in the newspaper and on the web) remained steady as
a rock, held in place by an official exchange rate peg.
This real appreciation of the yuan would generate three
(potentially conflicting) effects on the subsidiary in China:
1. More intense price competition from foreign imports into the
Chinese market
2. More intense price competition from foreign producers within
foreign markets; and
3. A more favorable effective rate of repatriation on profit margins earned within China
Clearly, the first two effects would be quite negative for the
­subsidiary, while the third would be positive, so long as there
were still some profits left to repatriate.
The reason that price competition would become stiffer for the
American subsidiary operating in China is that it would face higher
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Understanding the Macro Economy
production costs (including higher wages and higher domestic
input prices) as a consequence of rising Chinese inflation. If the
subsidiary tried to pass these higher costs along to consumers in
the form of higher prices, then it would risk losing market share—
both in and outside of China—to American (and other foreign)
producers that didn’t face comparable cost increases at home.
Confronted with a real appreciation of the yuan, the subsidiary’s manager would thus face the unenviable choice of either
squeezing margins to protect market share or surrendering market share to maintain margins. Either way, it would be bad news
for the subsidiary’s bottom line.
In fact, the only possible good news would involve repatriation.
If the subsidiary had enjoyed, say, a 10 percent margin on sales
before the real appreciation, and if it somehow managed to preserve this margin afterward (a rather big if, to be sure), the same
10 percent margin would now—because of Chinese inflation—
translate into a larger number of nominal yuan. And, with the
nominal exchange rate still pegged to the dollar (at the same
official rate), a larger number of yuan would inevitably translate
into a larger number of dollars, once repatriated.
The point is that the effects of a real appreciation, triggered by
inflation, will closely mimic the effects of a nominal appreciation,
both favorable and unfavorable, even though the nominal
exchange rate hasn’t budged. Unfortunately, many business
managers—­particularly those with little experience in international
markets—remain far more alert to changes in nominal exchange
rates than to changes in real exchange rates, even though the latter may be every bit as important in determining the health and
vitality of their firms.
52
oss_02_33to66
Money
We return to exchange rates in subsequent sections (and in
chapter 7). But for now, it is worth noting how the ­nominal–real
divide can affect the relationship between money growth,
exchange rates, and the balance of trade. As already suggested,
substantial money growth in a country is likely to cause the
country’s nominal exchange rate to depreciate. But substantial
money growth can also spark domestic inflation, which can
cause the real exchange rate to move in the other direction. The
key question is whether domestic inflation is greater than
exchange-rate depreciation—or, more precisely, whether the difference between domestic and foreign inflation is larger than the
depreciation of the domestic currency relative to the ­foreign currency. If the inflation-rate differential (domestic minus foreign)
exceeds the nominal rate of depreciation of the exchange rate,
4/12/07 1:51 PM Page 54
then the real exchange rate will appreciate, placing downward
pressure on the balance of trade. If the inflation-rate differential
is less than the nominal rate of depreciation of the exchange rate,
then the real exchange rate will depreciate, placing upward
­pressure on the balance of trade. (See figure 2-4.)
Understanding the Macro Economy
F I G U R E2-4
2-4
FIGURE
Money growth, inflation, and exchange rates (nominal
(nominal
versus real)
Nominal exchange rate may depreciate
Increase in
money supply
Real exchange rate may depreciate
?
Inflation may rise
Real exchange rate
may appreciate
nominal rate of depreciation of the exchange rate, then the real
exchange rate will depreciate, placing upward pressure on the
balance of trade. (See figure 2-4.)
53
Money Illusion and Sticky Wages
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Understanding the Macro Economy
Money Illusion and Sticky Wages
In an ideal world, individuals would always be able to ­distinguish
real economic changes from merely nominal ones. If a worker’s
wage rose by exactly the same percentage as the overall price
level, she would recognize that her purchasing power had not
increased as a result. Even though her monthly payroll checks
would look larger in nominal terms, she would still not be able to
buy more goods and services than before because the prices of
those goods and services would have increased exactly in proportion to her pay, thus leaving her real wage unchanged.
Although in principle this distinction should be clear, in practice it can be murky. One potential problem, which remains controversial among economists, is the notion that many individuals
suffer from “money illusion.” That is, they may sometimes appear
to be more concerned about nominal values than real values.
Workers, for example, may worry more about the size of their
nominal wage than about their real purchasing power. If true,
money illusion could help to explain why nominal wages tend to
be sticky, particularly on the downside. When prices rise, workers may fail to demand sufficient wage increases to prevent the
inflation from cutting into their purchasing power. However,
when prices fall, these same workers may—if influenced by
money illusion—fiercely oppose any suggestion of nominal wage
reductions, even though their real purchasing power has grown
dramatically as a result of the deflation.
Some economists view wage stickiness as a cause of unemployment during periods of deflation (falling prices). If workers
refused to accept smaller nominal wages during such periods
(potentially as a result of money illusion), their real wages would
rise rapidly as prices fell. Eventually, their real wages would reach
a level that their employers simply could no longer afford to pay,
54
Money
and the workers would be laid off. If only the workers had
focused on maintaining their real wages rather than their nominal
wages, the argument goes, they might have kept their jobs.
The notion of money illusion dates back a long way. In fact,
the American economist Irving Fisher published a seminal book
on the subject in 1928.7 Although few economists today regard
money illusion as a major source of wage rigidity, it nonetheless
stands out as an early—if now contested—explanation for why
wages may not always adjust as rapidly in practice as they should
in theory.
Money and Banking
So far, we have talked quite a bit about money without saying
much about where it comes from or about the different forms it
takes.
In most countries, only the government can issue currency,
which is “legal tender” and therefore required by law to be
accepted as payment for all debts. Take a look at a dollar bill and
note what is imprinted on the front: “This note is legal tender for
all debts, public and private.” Currency thus serves as a very reliable and convenient means of payment for many transactions.
Typically, national central banks take responsibility for deciding
how much currency to issue. In the United States, the central
bank is called the Federal Reserve. If you take another look at
that dollar bill, you will notice the words “Federal Reserve Note”
printed at the very top, indicating that the bill is an obligation of
the Federal Reserve.8
Although the central bank decides how much currency to
issue, it is important to recognize that the central bank is not the
only institution that creates money. Commercial banks play a
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Understanding the Macro Economy
crucial role as well. This is because currency is not the only form
of money. According to a standard definition of the money supply known as M1, checking accounts also count as money since
checks are widely accepted as a means of payment and are highly
liquid—that is, they can easily be converted to currency.
Because checking accounts allow the account holders either to
withdraw or to transfer the deposited funds on demand, economists typically refer to these accounts as “demand deposits.” And
demand deposits are an important component of the money
supply. At the end of 2012, there was a total of $1.091 trillion
worth of US currency (i.e., one-dollar bills, five-dollar bills, tendollar bills, and so forth) in circulation. At the same time, banks
and thrifts held a total of $1.345 trillion in demand (and other
checkable) deposits. As just noted, M1 money supply includes
these two items: currency in circulation and demand deposits,
both of which are widely used—and widely accepted—as means
of payment.9
Because checking accounts constitute an important form of
money, commercial banks play a vital role in money creation.
Through a process of taking deposits and lending out most of the
funds received, banks actually expand the money supply beyond
the amount of currency in circulation.
Imagine, for example, that you go to the bank and deposit
$100 in cash into your checking account. At that moment, the
size of the overall money supply doesn’t change. You have an
additional $100 in your checking account, but the $100 you
once had in your pocket is now in a bank vault. Because the cash
is no longer in circulation, it is not included in M1 money supply. However, in most cases, the bank will quickly lend out most
of that cash, limited only by a legal reserve requirement (which
compels the bank to keep about 10 percent of the cash on
56
Money
reserve). Now the money supply has increased. You have your
$100 in the form of a demand deposit (checking account), and
the person who borrowed from the bank has, say, $90 of the cash
that you used to have in your pocket. So the money supply has
increased by $90. As you may have guessed, however, the process doesn’t end there. If the borrower buys something with that
cash and the recipient deposits it in his bank, then the process
will start all over again, and even more money will be created.
To see how much money will be created based on an additional dollar of deposits, economists calculate the so-called
money multiplier. The money multiplier simply equals one over
the proportion not lent out (also known as the “leakage” from
the deposit and lending process). Thus,
Money multiplier = 1/(proportion of leakage).
If banks always lent out 90 percent of deposited funds and all
lent funds were ultimately redeposited, then the leakage would
be 10 percent (or 0.10) and the money multiplier would be 10
(i.e., 1/0.10). This implies that a single dollar of currency would
turn into 10 dollars of total M1 as a result of the deposit and
lending process. (In practice, the money multiplier is much
smaller than 10, in part because individuals don’t deposit nearly
all of their cash in checking accounts, meaning that total leakage
is considerably higher than 10 percent. Even so, banks still play
a very large role in money creation.)
One obvious problem with this mechanism is that if everyone
who had deposited funds in a bank asked to withdraw their cash
at the same time, the bank would not be able to comply, since it
had lent out a large proportion of their funds. Normally, this is
not a problem, since total withdrawals tend to be relatively small
57
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Understanding the Macro Economy
(and thus manageable) on any given day. But the simple fact is
that if a large proportion of depositors demand their cash at the
same time (either because they all need it for some reason or out
of fear that their bank is in trouble), then the bank will fail. This
is known as a bank run or bank panic. Before the introduction of
federal deposit insurance in 1933, banking panics were a recurring feature of American economic life. A very similar dynamic
was visible during the financial crisis of 2007–2009, although
this time mainly among so-called shadow banks, which operated
without federal insurance.
The Art and Science of Central Banking
Although commercial banks certainly help create money, central
banks are particularly important to macroeconomists because
they have the power to expand and contract the money supply.
Central banks can literally create money at will, and they can
also destroy it.
Prior to the financial crisis of 2007–2009, central bankers typically regarded short-term interest rates, not the money supply
itself, as the primary instrument of monetary policy, and they
manipulated the money supply as needed to produce the interest
rates they desired. If the directors of a national central bank
decided, for example, that they wanted to lower the overnight
bank rate from 3.0 percent to 2.5 percent, they would announce
the change in policy and would increase money growth as much
as was necessary to drive the overnight rate down to 2.5 percent.
In fact, if the central bank was highly credible, the announcement itself might be enough to drive the rate down to 2.5 ­percent.
Even so, the central bank would still probably accelerate money
growth to support the new rate.10
58
Money
Despite the importance of the short-term interest rate, money
is actually the factor that central banks control most directly. In
fact, they exercise complete (monopolistic) control over the
monetary base, including the nation’s supply of currency, and
they are able to move interest rates only because of that control.
If the government ever gave up its monopoly over legal-tender
currency, the central bank’s ability to set short-term interest rates
would disappear as well.
It is a bit like the relationship between the speedometer and
the gas pedal on a car. When drivers wish to go faster, they press
on the gas pedal and watch the speedometer. Although increased
gas flow to the engine is what makes the car go faster, drivers
generally set their targets in terms of speed (miles per hour)
rather than gallons per hour of gas flow. In monetary policy,
although money is ultimately the gas that makes the car go, central bankers generally focus on the short-term interest rate as
their main policy instrument, rather than the money supply
itself. However, after the US Federal Reserve had pushed the
short-term interest rate essentially to zero to combat the financial
crisis of 2007–2009 and the resulting economic downturn,
American central bankers began to rely more heavily on monetary expansion itself. The term “quantitative easing”—which in
the US context implied the purchase of longer-term instruments
ranging from mortgage-backed securities to corporate debt,
­ideally to help lower longer-term interest rates—became part of
the economic lexicon. (For a fuller definition, see the glossary.)
In principle, central bankers can use monetary policy in the
pursuit of many different objectives. If they believe GDP is
growing too slowly or that unemployment is too high, they
can reduce interest rates in order to stimulate economic activity. Conversely, they can raise interest rates if they think inflation is too high or is about to become too high as a result of
59
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Understanding the Macro Economy
rapid and unsustainable GDP growth (overheating). They can
also target a particular exchange rate, raising interest rates
when their currency falls in value relative to other currencies,
and lowering interest rates when it rises relative to other currencies. Or they can reduce interest rates (and expand the
money supply) in times of financial turmoil to help stabilize
the financial system.
In practice, most central bankers are mindful of all these
objectives—vigorous but sustainable GDP growth, low unemployment, low inflation, steady exchange rates, a stable ­financial
The Phillips Curve
I
n 1958, economist A. W. Phillips published a major study purporting to demonstrate an inverse relationship between inflation and
unemployment. The study was based on nearly a hundred years of
British wage and unemployment data. The essential finding was
that high rates of inflation were generally associated with low unemployment rates and, conversely, that low inflation rates were generally associated with high rates of unemployment. The Phillips curve,
shown in this box, graphically represents the trade-off between inflation and unemployment that Professor Phillips made famous. The
precise relationship Phillips identified was subsequently challenged
by other leading economists (including Milton Friedman and
Edmund Phelps), who emphasized the importance of inflationary
expectations and the possibility that a Phillips curve could move
over time. Although policy makers might be able to push unemployment temporarily below its “natural rate” by stimulating inflation
through aggressive fiscal or monetary policy, people would soon
60
Money
Money
Curve”).and
An increase
the interest
ratethat
maythere
even are
cause
the
system,
so forth.inNote,
however,
often
s currency
to appreciate,
weaken
If a centralwhich
bankcould
raisesfurther
interest
rates the
to
­tnation’
rade-offs
involved.
domestic
economy
by
undercutting
exports.
Clearly,
it
is
not
posreduce inflation, for example, it may slow GDP growth and
sible unemployment
to achieve all of the
various
simultaneously.
In by
reraise
at the
sameobjectives
time, a trade-off
suggested
cent­so-called
years, most
central
bankers
appear
to have
made low
the
Phillips
curve
(see “The
Phillips
Curve”).
An
inflation
their
dominant
policy
objective.
increase in the interest rate may even cause the nation’s curIn chapters
3 and which
4 we return
the question
what
central
rency
to appreciate,
couldtofurther
weakenofthe
domestic
banks are by
trying
to achieve exports.
by raisingClearly,
and lowering
rates.
economy
undercutting
it is notinterest
possible
to
First,
however,
we
need
to
identify
the
tools
that
they
have
at
achieve all of the various objectives simultaneously. In recent
their disposal
to do bankers
this.
times,
most central
appear to have made low inflation
“Overheating”
Inflation
rate (%)
The traditional Phillips curve
suggests an inverse relationship
between inflation and unemployment.
“Recession”
Unemployment rate (%)
monetary policy, people would soon adapt to higher expected inadapt to higher expected inflation, and unemployment would return
flation, and unemployment would return to its “natural rate” (but
to its “natural rate” (but now with a higher background rate of inflanow with a higher background rate of inflation). The “stagflation”
tion). The “stagflation” of the 1970s certainly proved that inflation
of the 1970s certainly proved that inflation and unemployment
and unemployment could rise together, at least under certain
could rise together, at least under certain circumstances.
­circumstances.
Although Phillips’s model has since been improved in a numAlthough Phillips’s model has since been improved in a number of important ways, a modified version of the original Phillips
ber of important ways, a modified version of the original Phillips
curve (frequently referred to as an “expectations-augmented”
curve (frequently referred to as an “expectations-augmented”
Phillips curve) remains to this day a staple of modern macroPhillips curve) remains to this day a staple of modern macroecoeconomic thought.
nomic thought.
61
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Understanding the Macro Economy
their ­dominant policy objective. Yet in the heat of the 2007–2009
crisis, financial stability seemed to become the top p
­ riority—at
least for the Federal Reserve. In late 2012, moreover, with high
joblessness persisting, the Fed announced that it would remain
particularly attentive to unemployment as well as inflation,
continuing to keep the federal funds rate near zero “as long as
the unemployment rate remains above 6-1/2 ­percent, inflation
between one and two years ahead is projected to be no more
than a half percentage point above the Committee’s 2 ­percent
longer-run goal, and longer-term inflation expectations continue to be well anchored.”11
In chapters 3 and 4 we return to the question of what central
banks are trying to achieve by raising and lowering interest rates.
First, however, we need to identify the tools that they have at
their disposal to do this.
The Three Basic Tools of Monetary Policy
Traditionally, macroeconomists have highlighted three basic
tools of monetary policy. To begin with, a central bank has the
power to lend to commercial banks at any interest rate that it
chooses. This interest rate, known as the discount rate in the
United States, represents one of the three basic tools of monetary
policy. By lowering its discount rate, a central bank can encourage commercial banks to borrow from it, since they in turn can
lend out the borrowed money at a higher interest rate and make
a profit on the deal. When commercial banks come to borrow
that money, the central bank simply issues new money and lends
it to them, thus increasing the money supply. And because there’s
a money multiplier (based on the iterative deposit and lending
process), the initial increase in the so-called monetary base (i.e.,
the money that the central bank issues) will eventually spawn an
62
Money
even larger increase in M1 (i.e., currency plus demand deposits).
In this way, the central bank can increase the money supply by
lowering its discount rate. Conversely, the central bank can contract the money supply (or slow its growth) by raising its discount rate.
Another tool the central bank can use to manage the money
supply is the reserve requirement on bank deposits. The reserve
requirement—which is set by the central bank—dictates what
proportion of every deposit banks are required to hold in reserve
(and thus not lend out). Since the reserve requirement represents a leakage from the deposit and lending process (and since
the money multiplier is inversely related to the leakage), a higher
reserve requirement will diminish the money multiplier and, in
turn, reduce the money supply. A lower reserve requirement, by
contrast, will raise the money multiplier and thus expand the
money supply. In the example given earlier, where we assumed
no leakages other than a reserve requirement of 10 percent, the
money multiplier was 10 (i.e., 1/0.10). Starting with a monetary
base of $100, M1 money supply (including both currency in
circulation and demand deposits) would swell to $1,000 as a
result of the deposit and lending process. If the central bank
reduced the reserve requirement to 5 percent, the money multiplier would rise to 20 (i.e., 1/0.05) and M1 would expand to
$2,000. If, instead, the central bank increased the reserve
requirement to 20 percent, the money multiplier would fall to 5
(i.e., 1/0.20) and the money supply would contract to just $500.
(See figure 2-5.) The point is that a central bank can influence
the money supply via the money multiplier by adjusting the
reserve ­requirement.
Finally, the third basic tool of monetary policy involves central
bank purchases and sales of financial securities on the open market, known as open market operations. When the central bank
63
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4
5
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7
8
9
0
1
2
3
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2
the money supply would contract to just $500. (See figure 2-5.)
The point is that a central bank can influence the money supply
via the money multiplier by adjusting the reserve requirement.
Understanding the Macro Economy
F I G U R E2-5
2-5
FIGURE
The three tools of monetary policy
Discount rate
Borrowing by
↑ Discount rate → ↓ commercial → ↓ Monetary base → ↓ Money supply
banks
Borrowing by
↓ Discount rate → ↑ commercial → ↑ Monetary base → ↑ Money supply
banks
Reserve requirement
↑
Reserve
→ ↑ Leakage → ↓ Money multiplier → ↓ Money supply
requirement
↓
Reserve
→ ↓ Leakage → ↑ Money multiplier → ↑ Money supply
requirement
Open market operations
Open market
Injection
→
→ ↑ Monetary base → ↑ Money supply
purchases
of liquidity
Open market
Withdrawal
→
→ ↓ Monetary base → ↓ Money supply
sales
of liquidity
wants to expand the money supply, it buys government bonds
or other assets from private financial institutions, injecting cash
into the economy. This is called an open market purchase, since
63
the central bank is purchasing financial assets. When the central
bank wishes to contract the money supply (or slow its growth),
it executes an open market sale, selling assets to financial institutions and thus withdrawing cash from the economy.
In the United States, open market operations represent the
dominant method the Federal Reserve (“the Fed”) uses to move
the overnight bank rate, known in the United States as the federal funds rate.* Prior to the financial crisis of 2007–2009, it had
* The federal funds rate is the interest rate commercial banks charge one
another for overnight lending. It is called the federal funds rate because banks
typically lend and borrow funds (reserves) that are on deposit at the Federal
Reserve. Despite the name, no lending or borrowing by the federal government
is involved.
64
Money
become quite rare for the Fed to lend directly to commercial
banks through its discount window. In fact, the discount rate
had become largely symbolic, playing almost no tangible role in
US monetary policy. (This changed during the crisis—as the discount window became active again—but such direct lending
diminished greatly once the crisis ended.) Reserve requirements,
meanwhile, are adjusted occasionally, but not often. Open market operations have long been—and remain—the principal
mechanism through which the Fed attempts to influence the
money supply. It is worth repeating, however, that the purpose
of open market operations—at least in a modern context, and
apart from recent experiments with so-called quantitative
­easing—has generally been to move a particular short-term
interest rate (such as the federal funds rate) to a desired level.
Although once fashionable, particularly in academic circles, the
notion of aiming for a specific monetary target (such as a regular
3.5 ­percent rate of growth in the money supply) is rarely
regarded as an end in itself anymore.
Theory versus Practice: A Warning
In thinking about the sorts of economic relationships highlighted
throughout this book, one very important thing to keep in mind
is that they are not meant literally as descriptions of reality, but
rather as baselines against which to compare and make sense of
reality. A favorite expression among economists is ceteris paribus,
which means “with all other things constant.” If all other factors
were held constant as money supply rose, we would expect
interest rates to fall. But, as everyone knows, in real life other factors hardly ever remain constant. Imagine, for instance, that just
as the Federal Reserve executed an open market purchase to
increase the money supply, Americans all across the country suddenly decided that they needed to hold more money—in their
65
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8
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1
2
Understanding the Macro Economy
wallets, under their mattresses, or in their checking accounts.
Perhaps they had just received a warning about a major terrorist
threat and thought it would be wise to keep more money on
hand, even if this required liquidating some other assets, such as
savings bonds or certificates of deposit. Whatever the case,
demand for money would rise, and this would place upward
pressure on interest rates, just as more demand for oil (or any
other product) will tend to raise its price. The Federal Reserve
might well find that although it had increased the money supply,
its action was offset by an even larger increase in money demand,
leading interest rates to rise rather than fall.
The point of this little example is simply to remind you that
the economic relationships described in these pages (and in the
pages of economics textbooks) are not immutable laws of nature.
In fact, they break down in practice all the time. If you take a
look at data on money supply and interest rates for any country
over any significant period of time, you’ll find plenty of examples
of interest rates rising as the money supply expands and interest
rates falling as money growth slows, precisely the opposite of
what an economics textbook would predict. But this does not
mean that learning about these relationships is useless. Far from
it. Only by understanding the baseline relationships can you
begin to recognize departures from the rule and, most important, begin to formulate reasoned explanations for what might be
driving them.
66
CHAPTER THREE
Expectations
A final topic of great importance in macroeconomics is expectations. Expectations about the future play a pivotal role in every
market economy, influencing in one way or another nearly every
economic transaction and decision. As we have seen, expectations can drive an entire economy in one direction or another
and can even become self-fulfilling. If depositors expect a bank
to fail, it very well might if fearful depositors begin pulling their
money out en masse. Similarly, for the economy as a whole,
expectations of inflation can produce the real thing; and an economy can fall into recession if enough people expect it to falter.
These sorts of expectations are of particular interest to macroeconomists.
The good news is that expectations can push economic reality
not only in a negative direction, but in a positive one as well.
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Sometimes these favorable expectations emerge on their own. At
other times, many macroeconomists believe, the government has
to help cultivate them. In fact, managing expectations may well
be the most important function of macroeconomic policy, both
monetary and fiscal.
Expectations and Inflation
Naturally, neither firms nor individuals want to come out on the
losing side of inflation. If workers expect consumer prices to rise
in the months and years ahead, they will likely demand higher
wages to ensure that their real incomes—that is, their incomes
after adjusting for inflation—don’t fall. By the same token, if
firms expect wages and other input prices to rise, they are likely
to try to raise their prices to ensure that their earnings don’t fall.
Prices and wages will therefore rise in reality as individuals and
firms try to protect themselves against expected price increases.
In this way, expectations of inflation can powerfully drive reality.
One of the main tasks of any central bank is to convince the public that the price level is unlikely to rise by very much in the
future—or, in other words, that inflation will be low. This way,
expectations can become an ally rather than an enemy. If this is to
occur, central banks must be credible. That is, for expectations of
inflation to be low, the public must believe that the central bank will
aggressively and effectively combat inflation (through interest rate
hikes, for example) the moment the price level begins to rise too
much. Once a central bank achieves such credibility on the inflation front, its job becomes much easier, since high inflation itself
becomes much less likely. Conversely, a central bank that suffers
from low credibility will find itself in a heap of trouble, with inflationary pressures potentially popping up everywhere all the time.
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Expectations
The reason that credibility of this sort is difficult to obtain is
that combating inflation can be very painful. To fight inflation, a
central bank typically has to raise interest rates (which likely
involves cutting, or at least slowing the growth of, the money
supply). As interest rates rise with tighter monetary policy, consumption and investment may slow, since both consumer and
business borrowing become more expensive. Output itself may
grow at a slower pace, or even contract, and unemployment is
likely to rise.
To kill the high inflation of the 1970s, Federal Reserve
Chairman Paul Volcker pushed the federal funds rate to unprecedented levels (20 percent at its peak), inducing what was then
the worst economic downturn since the 1930s. Real GDP fell by
about 2 percent in 1982, and unemployment reached nearly
10 percent that year. Politicians from both political parties
expressed outrage. A Republican candidate for the US Senate
charged in January 1982 that Volcker’s “policy of high interest
rates is strangling the American economy and throwing millions
of Americans out of work.”1 Although today Volcker is widely
credited with having slain double-digit inflation, he was widely
criticized (even reviled) at the time he did it.
Had Chairman Volcker been subject to a direct election, he
might well have felt compelled to bow to public pressure and
ease his assault on inflation. After all, given that he was at least
partly—and perhaps mainly—responsible for driving unemployment to its highest rate in nearly a half-century, his odds
of winning reelection would have been long indeed. But
Volcker, like all Fed chairmen, was a presidential appointee
who could not be fired from the central bank until the end
of his 14-year term as a Fed governor (and could not easily
be removed as chairman until the end of the 4-year term for
that post).
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It is precisely for this reason that most monetary economists
prefer that central banks be “independent”—independent of the
short-term democratic process and, to a significant extent, independent of politicians and politics altogether. Because fighting
inflation can inflict so much pain on the public in the short run,
elected politicians are often not very credible inflation fighters.
Although it is always difficult for those in power to cede control
over monetary policy to an independent central bank, which
could very well undercut political incumbents by raising interest
rates at election time, most developed nations have long since
taken the plunge—and a growing number of developing nations
have done the same. In the United States, the Federal Reserve
was not truly independent when it was created in 1913, but it
gained additional autonomy as a result of legislation in 1935 and
achieved essentially full independence in 1951. The Bank of
England, one of the world’s oldest central banks, dating back to
the seventeenth century, was not made operationally independent until 1997.2
Although controlling inflation is normally regarded as the
responsibility of central banks, sometimes inflation becomes so
virulent that policy makers outside the central bank feel compelled to take matters into their own hands. One extreme
approach, which clearly lies outside the domain of central banking, involves the imposition of wage and price controls. If policy
makers conclude that high inflation is being driven mainly by
inflationary expectations, then wage and price controls may look
like an attractive way to change expectations and thus break the
inflationary spiral. Why would anyone expect prices to increase
over subsequent months and years if the government had
declared all price increases to be illegal?
There are at least two potential problems with this approach,
however. First, it is unlikely to work unless the government is
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Expectations
absolutely credible in its commitment to maintain the controls as
long as necessary and to punish violators. Second, and even
more important, rigid wage and price controls inevitably create
distortions in the economy, thus reducing overall efficiency.
When the supply of a good, such as oil, declines, its price normally rises, signaling producers to produce more and consumers
to conserve on its use, to find substitutes, or simply to be prepared to pay more. If the government prohibits the price from
rising, however, buyers will continue to consume oil exactly as
they had before until it runs out, leaving others with no access to
oil at all. Price controls, in other words, can potentially be effective in shaping expectations, but are often poorly executed and,
even when well executed, can wreak all sorts of economic havoc
along the way.
One reason why, despite these pitfalls, governments sometimes turn to radical solutions such as price controls is that central banks themselves often find entrenched inflationary
expectations extremely difficult to reverse. An obvious solution
would simply be to cut back on money growth, starving the
inflationary engine of the fuel it needs to run. Unfortunately,
since high inflation brings high money demand, an attempt to
reduce money supply sharply could potentially send interest
rates skyrocketing and thus provoke a severe economic contraction. Imagine barreling down the track in a race car at 100 miles
per hour and then suddenly throwing the transmission into
reverse. Although the car would indeed slow down, its deceleration would likely be rather violent.3
Over the past two-and-a-half decades, many central banks
around the world have adopted a strategy of inflation ­targeting.
They pick (and often announce) a specific inflation target—
say, 2 percent—and then raise and lower interest rates as necessary to keep inflation at (or near) that target level. One of the
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Understanding the Macro Economy
many attractions of inflation targeting is that it may p
­ revent an
economy from ever falling into an inflationary spiral. If the
central bank can be absolutely credible in its commitment to
beat back any modicum of inflation above its target, then it
may never have to worry about fighting a raging inflation
because one should never arise. So long as a policy of inflation
targeting remains credible, inflationary expectations—and
thus inflation itself—should always remain in check. This, at
least, is the theory.
Until the financial crisis of 2007–2009, many
­inflation-targeting programs appeared remarkably effective.
During the financial crisis, however, officials at the US Federal
Reserve seemed willing to depart somewhat from inflation targeting, making financial stability their top priority. The
European Central Bank, by contrast, remained more faithful to
strict inflation targeting—at least through 2011. The differing
strategies pursued by the Fed and the ECB can be thought of
as a grand natural experiment that future economists may look
back on in evaluating the best approach to monetary policy,
particularly during a crisis.
A related question, which has not yet been tested, is how central bankers who are committed to inflation targeting would
react to a major supply shock—such as another oil shock, reminiscent of the 1970s. If inflationary expectations began to rise,
would central bankers be willing to induce high unemployment
in order to stem the tide? Would they hold the anti-inflation line,
or would they falter? Whatever the answer, there is no question
that the job of the central bankers would prove a great deal easier
if people believed absolutely that the central bank would hold the
line. Expectations, in other words, remain paramount in determining the effectiveness of monetary policy and, ultimately, the
trajectory of prices.
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Expectations
Expectations and Output
Of course, expectations can affect real output as well. The French
economist J. B. Say posited in the early nineteenth century that
supply creates its own demand—a dictum that has become
known as Say’s law.4 Since production generates income equal to
the full value of the product that is sold, total income should
always be sufficient to buy all the output that is produced.
Unfortunately, negative expectations sometimes intrude on this
happy circle of production and consumption. If individuals
anticipate bad times ahead, they may hold back on their expenditure, including both consumption and investment, thus opening up a gap between potential GDP (i.e., feasible supply) and
actual GDP (effective demand).
The archetypal downward spiral is the result: as nervous consumers decide to save more and spend less, firms lay off workers
and reduce new investment so as not to produce goods and services that cannot be sold; rising unemployment depresses income,
which further undercuts demand and thus continues and intensifies the downward spiral. Although productive capacity still
exists, output falls as productive resources—both people and
equipment—are left idle in the face of collapsing demand. Keynes
referred to this as the “paradox of poverty in the midst of plenty.”5
Monetary Policy
One potential strategy for countering such a decline in demand
involves expansionary monetary policy. To revive consumption
and especially investment, the central bank may decide to lower
interest rates (presumably by expanding the money supply).
A lower rate of interest may encourage consumption by making
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saving appear less attractive (since it now pays less) and—what
is essentially the same thing—by reducing the cost of consumer
borrowing. Similarly, from a business standpoint, a lower interest rate may encourage investment by making new plant and
equipment cheaper to finance. In terms of net present value, a
lower discount (interest) rate will increase the NPV for any given
stream of earnings, thus enticing business managers to reconsider investment proposals that had been seen as nonstarters at a
higher rate of interest.
Some economists have worried, however, that under sufficiently extreme circumstances, even aggressive monetary policy
might not provide enough stimulus to get a deteriorating economy out of its funk. Keynes speculated that new investment
might not look attractive at any realistic interest rate when
expectations of future demand were severely depressed.
Keynes also suggested that central bankers might not be able
to push interest rates as low as they would like—that is, low
enough to stimulate new investment—because of the existence of
a “liquidity trap.” At a certain point, when interest rates were very
low but still above zero, individuals might decide that holding
money was more desirable than holding any other asset (since
other assets might now be perceived as no longer paying enough
interest to compensate for their additional risk). The more money
the central bank pushed into the economy, the more money people would want to hold. With money demand now rising in tandem with money supply, interest rates would stop falling, even as
the central bank injected ever larger amounts of money into the
economic system. As some economists have described it, pushing
more money at this point is about as effective as “pushing on a
string.” Although the notion of a liquidity trap remains controversial, it nevertheless suggests one means by which monetary
policy could be rendered impotent in a depression.
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Expectations
Another potential constraint on expansionary monetary ­policy
is the prospect of deflation. In a bad recession or depression,
prices may fall as a result of declining demand. Falling prices can
in turn exert perverse effects on the cost of borrowing. Even if
the nominal rate of interest is somehow brought all the way to
zero, the real rate of interest will remain positive and potentially
even very high if deflation is severe. This is because when prices
are falling, a dollar next year will buy more goods and services
than the same dollar buys this year. For a borrower, this means
that repaying a loan—even one with a nominal interest rate of
zero—will be costly in terms of actual goods and services.
(See table 3-1.)
This is precisely what borrowers experienced in the United
States in the early 1930s. By 1932, many nominal interest rates
had fallen to fantastically low levels. The average interest rate on
three-month government bonds, for example, had reached
0.88 percent. Still, real rates remained extremely high, since
deflation was estimated at about 10 percent that year. The
Federal Reserve, meanwhile, kept the discount rate higher than
one might have expected (between 2.5 and 3.5 percent in 1932),
in large measure to maintain the nation’s gold standard. Nominal
interest rates for business borrowers also remained relatively
TABLE 3-1
Real interest rates under conditions of deflation
Real interest rate » Nominal interest rate − Expected inflation
Since deflation is simply negative inflation:
Real interest rate » Nominal interest rate + Expected deflation
Therefore, if one expects deflation (falling prices), the real interest rate will be
­positive even if the nominal interest rate is zero.
Example: If the nominal interest rate is 0.5% and expected deflation is 10%,
then the real interest rate is approximately (0.5% + 10%), or 10.5%.
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high during the early 1930s, presumably in part because of the
discount rate but also perhaps to compensate for the additional
risk of default stemming from the Depression. In fact, the rates
that banks charged on business loans in US cities averaged nearly
5 percent in 1932. This implies that the real interest rate on
­business loans was about 15 percent, which may help to explain
why business borrowing (and private investment) fell sharply at
this time.6
Ideally, monetary policy would be managed in such a way as
to prevent extreme deflation from ever taking hold in the first
place. But many macroeconomists believe that once deflation of
this magnitude becomes a reality, monetary policy is rendered
virtually useless to turn things around.
Fiscal Policy
Another macroeconomic tool government officials have at their
disposal is fiscal policy, which rests on government spending,
taxation, and budget deficits. Keynes reasoned that if an economy was faltering because expectations of future demand were
gloomy, the government could signal better times ahead and
thus begin to get things moving again by spending more than it
received in taxes and thus running a large budget deficit. As
individuals and firms saw the government aggressively creating
new demand (by buying goods and services itself), their expectations about the future would turn brighter and they themselves might begin spending again. In this way, the vicious spiral
that had taken the economy down could be reversed to bring the
economy back up to full employment. The key role for
­government, according to Keynes and his followers, was to coordinate expectations in a favorable direction through expansionary fiscal ­policy.7
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Expectations
Keynes himself described the mechanism in terms of an
income “multiplier.” Because he believed that a burst of deficit
spending by the government would lead both consumption and
investment to rise, Keynes concluded that national income (or
GDP) would increase by more than the original increase in
g­ overnment spending.
To understand this, we need to return to the ­GDP–­expenditure
identity we saw near the beginning of chapter 1. Recall:
GDP = C + I + G + EX − IM,
where C is consumption, I is investment, G is government
spending, EX is exports, and IM is imports. Clearly, if G rises
without causing any other variable to fall (Keynes called this an
“autonomous” increase in government spending), then GDP has
to rise. This is why Keynes focused on deficit spending. Had the
government financed increased spending through additional
taxes, then consumption and investment may have fallen in the
face of higher tax rates. But if the government financed the additional spending through a deficit—that is, if it borrowed the
additional funds by issuing bonds—then no other expenditure
variable would have to decline.
Naturally, if this initial effect were the only effect, then GDP
would merely rise by the amount of the autonomous increase in
government spending, and Keynes’s income multiplier would
equal 1 (i.e., the change in GDP would equal 1 times the change
in government spending). But Keynesians believe that as GDP
rises, individuals and businesses will increase their levels of consumption and investment, thus driving GDP still higher. In fact,
this dynamic will repeat itself again and again, as new consumption and investment cause GDP to rise, which in turn encourages
still more consumption and investment, and so on.
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Understanding the Macro Economy
For convenience, imagine that the effect worked only through
consumption. Suppose further that households consumed
80 percent of every new dollar of income and saved the rest. In
this case, if the government initiated an additional $100 in deficit spending, the first-round effect would be for GDP (national
income) to rise by $100. Faced with an additional $100 of
income, households would spend 80 percent of it, or $80, which
would thus increase GDP by another $80. Now, with another
$80 of income, households would spend 80 percent of it, or $64,
which would again increase GDP by the same amount. So far,
GDP would have increased by $244 (i.e., $100 + $80 + $64),
based on the government’s original $100 in deficit spending. But
the process wouldn’t end there. The virtuous circle would continue to go round and round and round, and GDP would continue to rise, with each increment of growth equal to 80 percent
of the one before (i.e., $100 + $80 + $64 + $51.20 + $40.96 +
$32.77 + $26.21 + …). Eventually, the increments would
become too small to matter. In the meantime, however, GDP
would have grown by about $500. (See figure 3-1.) Keynes noted
that the whole process can be boiled down to the following
­formula:
Change in GDP = (Change in deficit spending by
government) × Income multiplier,
where the income multiplier = (1/proportion leakage from the
income–expenditure cycle). In this case, since the proportion of
leakage (that is, the amount of new income not spent) equals
20 percent (or 0.20), the income multiplier equals 1/0.20,
or 5. Thus:
Change in GDP = $100 × 5 = $500.
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where the income multiplier = (1/proportion leakage from the
income–expenditure cycle). In this case, since the proportion
of leakage (that is, the amount of new income not spent) equals
Expectations
F I G U R E 3 -1
FIGURE 3-1
IIIustration of Keynesian income multiplier
Illustration of Keynesian income multiplier
Illustration is based on $100 increase in government deficit spending and
leakage of 20%.
GDP
=
C
+
I
+ 100
+
G
+
EX
–
IM
+ 100
+ 80
+80
+ 64
+64
:
:
∆GDP = +500
This analysis suggests that an increase in deficit spending will
increase nominal GDP. In the example given, the increase in GDP
is 5 times as large as the original increase in deficit spending,
78 and the income multiplier is
since leakage is only 20 percent
therefore equal to 5. What is not clear, however, is whether the
increase in nominal GDP will come mainly from an increase in
the price level (P) or from an increase in the quantity of output
(Q). Recall that nominal GDP depends on both of these variables, since nominal GDP = P × Q.
Keynes believed that in times of high unemployment, the
increase would come mainly from the quantity of output (that is,
mainly from an increase in real GDP). In a depression, with many
productive resources lying idle, the first thing business managers
would do in the face of increased demand would be to put idle
resources back to work. They would rehire workers, turn equipment back on, and bring their factories back to life. As a result of
all this, production (real GDP) would increase toward the
e­ conomy’s potential.
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Understanding the Macro Economy
Eventually, however, if the government kept running large
would
that ineven
this after
latterall
scenario,
actual
GDP
(demand)idle
exbudget say
deficits
or most
of the
previously
8
ceeded potential
(supply)
andtothat
the economy
was overheating.
resources
had been
put back
work,
business managers
would
(See figure
respond
to 3-2.)
increased demand simply by raising prices. This is
Keynes’
s
proposal
to stimulate
GDP
spending
because it would
be difficult
for them
to through
ramp updeficit
production
any
was
thus
intended
for
periods
of
economic
contraction,
when
further. Nominal GDP would still rise, but now the increase
real GDP
was severely
Duringinmore
normal
times,
would
be coming
mainlydepressed.
from an increase
the price
level
(P),
deficit
spending
was
expected
to
be
inflationary.
not from an increase in the quantity of output (Q). Economists
Although
there
werelatter
plenty
of skeptics
in GDP
the early
days,
would
say that
in this
scenario,
actual
(demand)
Keynes’s ideas
received
a big boost
s experience
exceeded
potential
(supply)
and from
that America’
the economy
was
8 War II. Since the United States finally pulled out of
during
World
­overheating. (See figure 3-2.)
itsKeynes’
long depression
the war,
and
since the
war spending
effort ins proposalduring
to stimulate
GDP
through
deficit
volved
extraordinary
of deficit
spending,
Keynes’s predicwas
thus
intended forlevels
periods
of economic
contraction,
when
tion
that
deficit
spending
would
revive
the
economy
appeared
to
real GDP was severely depressed. During more normal times,
have been
confirmed.
Keynesianism
spread rapidly among acadeficit
spending
was expected
to be inflationary.
demic
economists
and ultimately
in
Although
there were
plenty of became
skepticshighly
in theinfluential
early days,
policy circles
well. In afact,
Richard
Nixon
is said to
Keynes’
s ideasasreceived
big President
boost from
America’
s experience
have declared
in early
1972,the
“We
are all
Keynesians
now.” out of
during
World War
II. Since
United
States
finally pulled
FIGURE 3-2
Keynesian fiscal stimulus, in good times and bad
↑
Government
budget deficit
↑ Demand
↑
Nominal GDP (P × Q),
via income multiplier
In periods of high unemployment:
↑
Government
budget deficit
↑ Demand
↑ Q (increase in real GDP) [recovery]
In periods of full employment:
↑
Government
budget deficit
↑ Demand
↑ P (inflation)
[overheating]
In normal times (modest unemployment):
↑
Government
budget deficit
↑ Demand
↑ Q & ↑ P (both real GDP and
inflation rise)
80
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its long depression during the war, and since the war effort
involved extraordinary levels of deficit spending, Keynes’s prediction that deficit spending would revive the economy appeared
to have been confirmed. Keynesianism spread rapidly among
academic economists and ultimately became highly influential in
policy circles as well. In fact, President Richard Nixon is said to
have declared in early 1972, “We are all Keynesians now.”
Faith in Keynesian deficit spending appears to have waned
since its heyday in the 1960s and early 1970s. In fact, there are
good reasons to believe that deficit spending may not always
deliver as much bang for the buck as many people once learned
in their economics classes in college. One reason, as we have
seen, is that deficit spending may prove to be inflationary, leading to an increase in prices rather than output. But there are
other reasons as well.
In the illustration of the income multiplier given previously,
the only leakage was household savings. Because this leakage
was just 20 percent, the income multiplier was 5. In most times
and places, however, the true income multiplier is probably not
nearly that large. In part, this is because there are other leakages
besides savings. Taxes represent an additional leakage, as do
imports, since spending on foreign goods does not contribute to
domestic GDP.
Some economists, moreover, point to another form of leakage,
under the heading “rational expectations.” The argument here is
that if individuals are perfectly rational, they should anticipate
that budget deficits eventually will require higher taxes to pay off
the accumulated debt. If individuals wish to prepare for these
looming taxes, then they might save every dollar of new income
derived from deficit spending, thus causing a leakage of
100 ­percent and driving the multiplier down to 1. Since the
underlying idea for this mechanism stems from the
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­ ineteenth-century economist David Ricardo, it has come to be
n
called “Ricardian equivalence.”
Another problem is that deficit spending may drive up interest rates and undercut private investment and consumption—a
phenomenon known as “crowding out.” When the government
runs a budget deficit, spending more than it collects in taxes, it
obtains the difference by borrowing on the open market. It
issues government bonds and auctions them off to the highest
bidders. In doing this, the government is competing with private borrowers for funds. Naturally, competition for investment
funds will drive up the price of these funds, meaning that the
interest rate will rise. As this occurs, some potential borrowers
in the private sector—including both firms and individuals—
may decide not to borrow at the higher rates and simply scuttle
the projects they were planning to pursue. Recall that Keynes
wanted the increase in government spending to be
­autonomous—that is, not associated with a reduction in any
other form of expenditure (such as consumption or investment).
Unfortunately, higher interest rates may cause both consumption and investment to decline, which means that crowding out
can reduce—or, in the extreme, even eliminate—the effectiveness of Keynesian deficit spending.
A related issue is that the central bank may itself react to an
increase in deficit spending by raising interest rates. Specifically,
if central bankers expect the increased budget deficit to be inflationary, they may try to counteract it (and thus preempt the
expected inflation) through tighter monetary policy. Once again,
such a reaction on the part of the central bank would reduce or
negate the stimulative effect of deficit spending.
Nevertheless, despite all of these qualifications and criticisms,
most macroeconomists still believe that a small income multiplier does exist. When national economies fall into recession,
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moreover, most policy makers are still quick to run budget deficits in the hope of getting things back on track (as they did in the
United States and in numerous other countries during the financial crisis of 2007–2009 and the ensuing economic slowdown).
Sometimes these deficits are based on increased spending, sometimes on tax cuts, and sometimes—indeed, most often—on a
combination of the two. Either way, a key goal is to stimulate
aggregate demand by signaling that brighter days are ahead. If
the public interprets the deficit as a sign of weakness rather than
strength, the economy may continue to deteriorate. But if—as
Keynes hoped—the public interprets the additional burst of
expenditure as a good sign, the economy may very well revive on
the basis of improved expectations. In a market economy, expectations can literally drive reality, and Keynesian fiscal policy is all
about expectations.
Expectations and Other Macro Variables
Not surprisingly, expectations strongly influence other macroeconomic variables as well, including interest rates and exchange
rates. If, for instance, a bond trader expects interest rates to rise,
she might decide to sell bonds in order to avoid taking a capital
loss (since existing bonds generally depreciate in value when
the interest rate rises). If a large number of traders follow the
same course, long-term interest rates will in fact rise as a result.
The sales will drive bond prices down and bond yields (their
effective interest rates) up.9 For this reason, bond markets often
anticipate action by the central bank, pushing bond yields (and
thus ­interest rates) up when they expect the central bank to
tighten monetary policy and pushing them down when they
expect the central bank to loosen.
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Similarly, currency traders drive exchange rates up and down
on the basis of expectations. If they expect the euro to appreciate, for example, they buy euros (or sell dollars). If they expect
the euro to depreciate, they sell euros (or buy dollars). Either
way, their expectation actually drives the result. In some cases,
they base their expectation on news about macroeconomic data.
A dramatic increase in the US trade deficit, for instance, might
lead currency traders to sell dollars, if they think the mounting
trade deficit makes it more likely that the dollar will depreciate.
At other times, traders may be influenced by policy actions. If
currency traders expect the Federal Reserve to tighten monetary
policy, they are likely to buy dollars, believing that a higher interest rate will make the dollar more attractive and thus cause it to
appreciate.
Finally, a word of warning: although expectations are obviously very powerful, one should not conclude from this discussion that they are all that matter. If expectations are fundamentally
out of line with reality, they will ultimately be dashed. When, in
the 1990s, American investors expected unprecedented performance from internet companies, they rushed out to buy internet
stocks and dramatically bid up their prices. Eventually, however,
when it became clear that the original expectations were overblown, the prices of internet stocks plummeted (i.e., the bubble
burst) and many internet investors experienced a tough dose of
reality. A similar, but even more devastating, boom and bust
occurred in the United States less than a decade later, when reckless subprime mortgage lending and securitization—based in
large part on expectations of ever-increasing housing prices—
contributed to a massive real estate bubble, which ultimately
precipitated the financial crisis of 2007–2009.
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Expectations can thus affect the macro economy as a whole.
Positive expectations may help bring a depressed economy back
up to its potential. But once that potential is reached and the
nation’s industries are back up to full capacity, further euphoria
will only produce inflation or a bubble, not a further acceleration
of real growth. Expectations matter a great deal, but they are not
all that matter. Ultimately, economic expectations cannot survive
for long outside the confines of economic reality, as dictated by
the technical limits of production over time.
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II
Selected Topics
Background and Mechanics
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CHAPTER FOUR
A Short History of Money and
Monetary Policy in the
United States
In an attempt to link theory with practice, this chapter offers a
brief monetary history of the United States, from the original creation of the US dollar in the late eighteenth century to the execution of modern monetary policy in the early twenty-first. This
history illustrates many of the macroeconomic principles and
relationships highlighted in the previous chapters (especially
chapter 2), and locates them in context, against the backdrop of
a maturing national economy. Ideally, you should be able to see
monetary economics at work all along the way.
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Defining the Unit of Account and the Price of Money
In establishing a new country, one of the first things g­ overnment
officials have to do is define a unit of account—that is, a standard metric for accounting and transaction purposes. The ­dollar
is the unit of account in the United States. In the nation’s earliest days, US policy makers defined the value of the dollar in
terms of precious metals. The Continental Congress unanimously resolved in 1785 that “the money unit of the United
States be one dollar.”1 The following year, the Board of Treasury
announced that the “Money Unit or Dollar will contain” 375.64
grains of fine silver.2 This definition was modified slightly after
ratification of the new Constitution a couple years later.
The Coinage Act of 1792 set the dollar equal to 371.25 grains of
fine silver, or an equivalent value in gold (24.75 grains of
fine gold).3
In these early years, the US government didn’t produce much
money itself—mostly just silver and gold coins. Commercial
banks produced paper notes that looked official (much like
today’s government-issued currency) and could be redeemed for
coins. Interestingly, these privately issued bank notes functioned
as the most common form of money through the early part of the
nineteenth century. Later, checking accounts—which economists call demand deposits—became increasingly important.
Individuals and firms established accounts at local banks (either
by depositing coins and bank notes or by taking out loans) and
then could write checks on the accounts to pay for things they
purchased from vendors or to withdraw funds from the bank
itself, either in the form of coins or bank notes.
By comparison with today, the most striking thing about the
government’s role in the monetary system during these early
years is how limited it was. The federal government did little
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with respect to monetary policy other than to define the value of
the dollar (in terms of gold and silver) and to mint coins. There
was no central bank in the United States for most of the
­nineteenth century. As already noted, paper money was issued
mostly by private banks.
Nevertheless, by defining the value of the dollar, the federal
government had done something extremely important: it had set
a fixed exchange rate. This meant that the price of the dollar
would remain stable over time relative to gold and silver—as
well as to other currencies, such as the British pound, that were
similarly fixed against precious metals. The nation’s bimetallic
standard (based on gold and silver) evolved into a straight gold
standard over the nineteenth century.
The Gold Standard: A Self-Regulating Mechanism?
Although many observers today regard a fixed exchange rate as a
heavy-handed form of government intervention, it started out as
precisely the opposite. Indeed, a fixed exchange rate (against
gold and silver) was the least invasive thing the government
could do, short of refusing to create any common unit of account
or medium of exchange whatsoever.
Even in the absence of a central bank, the fixed exchange rate
was supposed to keep the whole economic system in balance—
and to do so automatically. If the domestic economy began to
overheat and the country experienced inflation (rising prices),
imports would increase (because foreign prices would immediately look more attractive than domestic ones) and exports
would fall (for the same reason). As the trade balance deteriorated, precious metals would presumably flow out of the country, since it was often assumed that international traders paid for
their purchases with gold and silver. Because the domestic
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money supply was tied directly to these precious metals, it was
expected to fall as domestic reserves of precious metals declined.
A declining money supply, in turn, would help to rein in prices,
thus counteracting the original inflationary surge. Conversely, if
prices fell at home and the country experienced deflation, the
balance of trade would improve, gold would flow in, the money
supply would increase, and prices would be pushed back up to
an appropriate level. This, at least, is how the self-adjusting
mechanism was supposed to work.
In practice, however, the system did not always come back
into balance very rapidly. Tying the dollar rigidly to gold didn’t
ensure price stability because the quantity of gold—and thus the
price of gold—was itself unstable. Through most of the 1880s
and 1890s, as the world’s gold supply barely inched forward, the
overall price level fell in the United States. Since the price of gold
was rising (because of its scarcity), the prices of almost everything else (in terms of gold) were falling. Believing that this
ongoing deflation was strangling the economy, presidential candidate William Jennings Bryan urged monetary reform in 1896,
declaring, “You shall not crucify mankind upon a cross of gold.”
Ironically, the world was just then on the verge of a dramatic
increase in gold supply. The price level began rising the following year and continued upward for more than a decade.4
By 1913, one of the nation’s leading economists, Irving Fisher,
was so frustrated with the instability of prices that he proposed a
radical reform, which he called “standardizing the dollar.” As
gold fell in price relative to other goods, the gold content of the
dollar was to be proportionately increased, so that the dollar
would remain stable relative to other goods. Conversely, when
gold increased in price relative to other goods, he suggested, the
gold content of the dollar should be proportionately reduced,
again to ensure the stability of the dollar relative to other goods.
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This way, the dollar would never waver in value, and the overall
price level (and thus the cost of living) would be stabilized. As
Fisher himself explained his proposal, “It aims merely … to convert our dollar into a fixed yardstick of purchasing power.”5
The Creation of the Federal Reserve
Although the government did not adopt Fisher’s proposal, major
monetary reform was indeed just around the corner. A serious
banking panic in 1907 had convinced economists and policy
makers alike that a new institution was required, one that would
have the power to issue currency at will. In 1914, the Federal
Reserve, America’s central bank (“the Fed”), was established. Its
creators hoped that it would satisfy seasonal demands for money
and could serve as a lender of last resort to commercial banks in
times of financial distress.
In prior years, interest rates had often swung wildly in
response to changing seasonal demands for money, and they frequently had surged to dizzying heights during financial panics.
Since the supply of money was so inflexible—tied rigidly to the
quantity of gold—changes in money demand (at harvest time,
for example) could cause dramatic changes in interest rates.
The establishment of the Fed was supposed to solve this problem by creating a more “elastic” money supply. When money
demand surged, the Fed could simply issue more currency to
help satisfy it; when demand declined, the Fed could issue less.
Initially, the Fed relied mainly on its discount window to inject
cash into—or withdraw cash from—the economy, setting the
discount rate low when it wanted commercial banks to borrow
liberally (so as to increase the money supply) and setting it high
when it wanted them to borrow less (and therefore slow or
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reverse money growth). In this way, it was thought, the Fed
could help smooth the business cycle.
Although the Fed had discretion over how much money to
create, it did not have unlimited room to maneuver. The law
required that the Fed keep a gold reserve equal to at least 40 percent of the currency it issued and that it freely exchange gold for
currency at the long-standing rate of $20.67 per ounce. This
meant that if currency traders ever believed that too much currency had been issued—such that a dollar was no longer worth
its weight in gold, so to speak—they would aggressively trade
their dollars for gold at the Fed. As soon as its gold reserve
threatened to fall below the 40 percent requirement, the Fed
would be forced to raise its discount rate in order to contract the
money supply and make the dollar more attractive. The gold
standard thus continued to be seen as a crucial source of discipline—a necessary check on monetary excess and a powerful
weapon against inflation.
By the early 1930s, however, many analysts had concluded
that the gold standard was exerting too much discipline. Even as
the economy fell into the Great Depression and unemployment
soared, the Fed was reluctant to lower its discount rate too far—
and even raised the rate in 1931—so as to avoid sparking a run
on its gold reserve. Had William Jennings Bryan still been alive,
he likely would have reiterated his charge that America was
being crucified “on a cross of gold.”
President Franklin Roosevelt sharply curtailed the gold standard in 1933, requiring private citizens to turn in their gold (other
than jewelry), ending the practice of exchanging gold for currency at banks, and declaring gold clauses in all contracts to be
void. He also depreciated the dollar relative to gold, raising the
official gold price from $20.67 to $35 per ounce. One Harvard
Business School professor, Arthur Dewing, was so upset about
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this that he initially refused to turn in his gold and (some say)
nearly went to jail in protest.6 Although a modified international
gold standard was restored after World War II, it eventually fell
out of favor as well and was dropped for good in the early 1970s.
The dollar was thus left to float on international currency markets.
Finding the Right Monetary Rule under
a Floating Exchange Rate
With the dollar no longer fixed against gold or any major currency, the key question for officials at the Federal Reserve was
how to decide how much money to create. Indeed, monetary
economists continually wrestled with this question. Because they
kept coming up with new ideas—or, at least, kept rediscovering
old ones—“preferred” monetary rules came and went, like fads.
Some economists, following Milton Friedman, favored placing
M1 money supply on a controlled upward growth path—of, say,
3 to 5 percent every year—to stabilize the price level and ensure
a healthy growth rate of real GDP.* Others sought to issue just
enough money to stabilize interest rates at low levels—again to
* Those who favored this approach and endorsed the assumptions that lay
behind it were known as monetarists. A favorite identity of monetarists is:
M × V = P × Q,
where M is the money supply, V is the velocity of money (which may be
thought of as the speed at which money circulates in the economy), P is the
price level (or deflator), and Q is quantity of output (real GDP). Assuming that
V was fairly stable (a controversial assumption), monetarists concluded that
the best way to ensure very low inflation and a healthy (and steady) growth
rate of real GDP was to put the money supply on a steady upward path, at a
rate of increase equal to the rate that economists expected (or hoped) real GDP
would grow—say 4 percent per year.
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encourage growth without inflation. Still others thought low
unemployment should be the target—that more money should
be issued in order to lower interest rates and stimulate the economy whenever unemployment was rising.
Although the Fed never explicitly committed to any of these
monetary rules, it seemed to experiment with several of them. Most
of these rules, however, were ultimately discredited by the high
inflation of the 1970s and the financial tumult of the early 1980s.
By the 1990s, although the Fed still refused to commit to a specific
monetary rule, a rough consensus had emerged among many monetary economists about the benefits of “inflation targeting.” The
basic idea was that central bankers should target a low and stable
inflation rate of, say, 2 percent—expanding the money supply
whenever inflation threatened to fall below the target and reducing
money growth whenever inflation threatened to rise above it.
In fact, in conceiving of how to achieve the inflation target,
most economists now focused more on the short-term interest
rate than on the money supply itself. Although the so-called discount rate (the rate at which the Fed lent to commercial banks)
had long since been abandoned as an important monetary tool,
Fed officials had become extremely skilled at controlling one very
specific short-term interest rate through open market operations
(which involved the buying and selling of government securities
on the open market). The critical rate in question was the
­so-called federal funds rate—the rate at which commercial banks
lent funds to each other overnight. The Federal Reserve could
move the federal funds rate just about anywhere it wanted—­
usually with extraordinary accuracy—simply by pushing or pulling on the money supply through open market operations.
Naturally, economists who favored inflation targeting believed
the Fed should raise the federal funds rate when inflation began
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creeping above the target and decrease it when the opposite
occurred. Although the Fed would not say so publicly, many analysts believed it had been following an implicit inflation-­targeting
strategy since the 1980s. The European Central Bank, meanwhile,
had adopted a more explicit strategy of inflation targeting to guide
its monetary policy.7 Although some critics charged that monetary policy was too loose in one market or too tight in the other,
inflation had—as of 2013—remained well under control in both
the United States and the European Union for nearly two decades.
Inflation targeting was tested, however, during the financial
crisis of 2007–2009 and the subsequent sovereign debt crisis in
Europe. Whereas the Federal Reserve aggressively eased monetary policy as the financial crisis took hold, even in the face of
inflation that exceeded 4 percent in late 2007 and much of 2008,
officials at the European Central Bank appeared more sensitive to
the inflation rate, in accordance with their legal mandate to target inflation. In fact, as late as July 2008, the ECB actually raised
its short-term interest rate from 4 to 4.25 percent, apparently in
response to several recent increases in monthly inflation. By this
time in the United States, the Fed—deeply concerned about the
continuing financial turmoil—had already reduced its target
interest rate to 2 percent and would essentially bring the rate
down to zero by mid-December 2008. Although the ECB had
begun reducing its short-term rate in October, it moved neither
as far nor as fast as the Fed, and it again began raising its target
rate in April 2011 (following a slight increase in inflation in
March), even as a serious sovereign debt crisis was taking hold
across Europe. At the time of this writing, it is still too soon to
say whether one monetary strategy or the other will be judged
superior in retrospect. Early indications, however, give an edge
to the Federal Reserve, since by the end of 2013, the United States
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exhibited both low inflation and postcrisis economic growth
that, while lackluster, was significantly higher than in Europe.
The Transformation of American Monetary Policy
From the moment Congress declared the dollar to be the unit of
account in the United States back in the eighteenth century, it
became incumbent upon the government to manage money in
some way to make this declaration meaningful—to make the
dollar a reliable metric for transaction and accounting purposes.
Policy makers began by tying the dollar to precious metals at a
specified price. By setting the price of the dollar, the government
allowed its quantity to be determined by supply and demand in
the marketplace.
One way to think about how money and monetary policy
were transformed in the twentieth century—at least up through
the early 1980s—is to conceive of the government as gradually
shifting its strategy, from setting the price of the dollar (and letting quantity vary) to setting its quantity (and letting price vary).
Milton Friedman’s proposal in the second half of the twentieth
century that the Federal Reserve simply aim for a steady rate of
growth in the quantity of money—roughly equal to the growth
of real GDP—can thus be thought of as the polar opposite of the
original gold standard.
Another—and far more comprehensive—way to think about
the transition over the twentieth century is that in setting monetary
policy, the government gradually shifted from targeting one price
of money (the exchange rate) to targeting another (the overall price
level). The goal was always to make the dollar a reliable metric of
value that would maximally grease the wheels of commerce without inducing either inflation or deflation. But economists’
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­ nderstanding of what constituted a reliable metric and how best
u
to grease the wheels of commerce changed significantly over time.
Early on, the gold standard was viewed as the best way to
ensure a reliable monetary metric, since it guaranteed that the
dollar would remain stable relative to gold. The gold standard
did not ensure, however, that the dollar would remain stable relative to other goods. As a result, the overall price level (a weighted
average of the prices of all goods) fluctuated quite considerably
as the price of gold itself rose and fell with seemingly random
changes in the global gold supply. Even supporters of the gold
standard recognized this problem. Professor E. W. Kemmerer of
Princeton declared in 1927:
There is probably no defect in the world’s economic
organization today more serious than the fact that we use as
our unit of value, not a thing with a fixed value, but a fixed
weight of gold with a widely varying value. In a little less than
a half century here in the United States, we have seen our
yardstick of value, namely, the value of the gold dollar, exhibit
the following gyrations: from 1879 to 1896 it rose [and thus
the overall price level fell] 27 percent. From 1896 to 1920 it
fell [and thus the overall price level rose] 70 percent. From
1920 to September, 1927, it rose [and thus the overall price
level fell] 56 percent. If, figuratively speaking, we say that the
yard-stick of value was thirty-six inches long in 1879 . . . then
it was forty-six inches long in 1896, thirteen and a half inches
long in 1920 and is twenty-one inches long today.8
As economists became convinced that the right thing to stabilize was the purchasing power of the dollar relative to goods and
services in general (output), rather than to gold in particular,
monetary policy clearly had to change.
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Until the financial crisis of 2007–2009, the Federal Reserve
had for some time appeared to be following an implicit strategy
of inflation targeting, seeking to ensure that the value (or price)
of the dollar in terms of a broad basket of goods declined (­ i.e., the
price level rose) at a stable rate of about 2 percent per year.9 To
do this, it manipulated the quantity of money through open market operations to set one price of money, the short-term interest
rate. It then pushed that rate up and down as needed to stabilize
the trajectory of another price of money, the overall price level.
Although officials at the Fed seemed to depart somewhat from
inflation targeting during the financial crisis, apparently concluding that financial stability had to be the top priority to ensure
a healthy economy, the US central bank has perhaps already
returned—or will soon return—to an implicit policy of inflation
targeting as the worst of the crisis fades from view. If the policy is
successful, inflation should be kept at a modest and predictable
level, and the dollar should remain a reliable yardstick—not in
terms of how much gold it is worth, but of how much total ­output
it can buy.
Even in the context of money and monetary policy, therefore,
output remains absolutely central—the conceptual linchpin of
modern macroeconomic thought and practice.
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CHAPTER FIVE
The Fundamentals of
GDP Accounting
Because output lies at the heart of macroeconomics, considerable
attention has been devoted to the question of how best to
­measure it. In fact, macroeconomists have developed a whole
accounting system precisely for this purpose. The goal of
national economic accounting—also known as GDP accounting—is to measure the value of all output a nation produces over
a particular period of time, typically a year. This chapter ­provides
a quick primer on GDP accounting and the essential challenges
and trade-offs involved in measuring national output.1
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Three Measurement Approaches
As noted in chapter 1, economists have devised three distinct
approaches for determining the value of total output, which
focus on value added, income, and expenditure.
Value added. Under the first approach, economists calculate
output by summing the value added at each stage of
­production, where “value added” is defined simply as sales
revenue minus the cost of nonlabor inputs (i.e., inputs
­purchased from other firms). The sum of all value added for
every good and service produced within a nation will equal
that nation’s total output, or GDP.
Income. Since the value added at each stage of production
must ultimately be allocated to members of the public in the
form of income, another way to calculate total output is to
measure total income. Specifically, the returns to an
­economy’s productive factors—labor and capital—can be
­calculated as the sum of wages and salaries, interest,
­dividends, rent, and royalties. After a few adjustments
(including the addition of depreciation and indirect business
taxes), total income will exactly equal total output, or GDP.
Expenditure. Under the third approach, economists measure
the value of total output by calculating the nation’s spending
on final goods and services. A good or service is considered
final if it does not represent an input into the current
­production of another good or service. For example, if an
individual buys coffee beans to grind and brew at home, they
constitute a final product, the value of which is counted in
GDP. But if a café purchases the beans, they are considered
intermediate goods and are not included in GDP. Including
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The Fundamentals of GDP Accounting
both the café’s purchase of coffee beans and its sales of
brewed coffee to the public would constitute double
­counting, since the price of a cup of coffee includes the cost
of the beans.
Whichever method one chooses—value added, income, or
expenditure—the aim of GDP accounting is to estimate the value
of output, or product. As a consequence, transactions not associated with the production of new goods or services—such as government welfare payments, capital gains and losses, and the sale
of used goods—are excluded.2
The Nuts and Bolts of the Expenditure Method
Although all three methods for calculating GDP are correct (and
ultimately should produce the same result), the expenditure
approach—with its focus on final sales rather than value added
or income—is by far the most widely used of the three. It gained
ascendancy because of its perceived usefulness in macroeconomic forecasting and policy making. As a result, the most common definition of GDP is simply the market value of all final
goods and services produced within a nation’s borders over a
given year.
As we have seen, the expenditure approach breaks spending
into four basic categories, the sum of which exactly equals
GDP. The four categories are household consumption,
­investment, government expenditure, and net exports. (See
table 5-1.) Thus,
GDP = Consumption (C) + Investment (I) + Government
expenditure (G) + Net exports (EX – IM), where:
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TABLE 5-1
Expenditure approach to GDP accounting, United States
(2012)
Components of GDP (types of expenditure)
Billions $ % of GDP
Personal consumption
Goods
Services
C
$11,150
7,380
3,770
68.6%
45.4%
23.2%
Gross private domestic investment
Fixed investment
Nonresidential
Structures
Equipment
Intellectual property products
Residential
Change in private inventories
I
$2,475
2,409
1,970
437
908
625
439
66
15.2%
14.8%
12.1%
2.7%
5.6%
3.8%
2.7%
0.4%
Government consumption and gross
investment
Government consumption (Gc)
Federal
State and local
Gross government investment (GI)
Federal
State and local
Exports
Goods
Services
G
$3,167
19.5%
2,548
1,012
1,536
619
284
335
$2,196
1,536
660
15.7%
6.2%
9.5%
3.8%
1.7%
2.1%
13.5%
9.5%
4.1%
Imports
Goods
Services
IM
$2,743
2,295
448
16.9%
14.1%
2.8%
Gross domestic product = C + I + G + (EX – IM)
GDP
$16,245
100.0%
EX
Source: Data drawn from US Bureau of Economic Analysis.
• Consumption includes all household purchases of new
goods and services for current use.
• Investment includes expenditures that are intended to
increase future output of final goods and services.
It includes business spending on fixed structures,
­equipment, intellectual property (such as software or
research and development), and inventory, as well as the
cost of new owner-occupied homes.3 Many countries
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include government investment—such as spending on
new roads and bridges—in this category, but others
(including the United States) do not.
• Government expenditure includes government spending on
goods and services, at all levels of government (federal,
state, and local). It may or may not include government
spending on fixed capital stock, depending on how
­government investment is classified (i.e., as government
expenditure or as investment). Under neither definition,
however, does government expenditure include transfer
payments—such as welfare and Social Security benefits—
since transfers are not associated with the production of
output.
• Net exports is simply the difference between exports and
imports. Exports are added to domestic expenditure
because they constitute domestic output, even though
they are purchased by foreigners. Imports, by contrast,
must be subtracted from domestic expenditure because
they are produced abroad and are thus not part of
­domestic output.
In most cases, a single item may be categorized in a variety of
ways, depending on who purchases it and for what purpose.
Consider a coffeemaker, for example. A coffeemaker purchased
for home use is classified as household consumption, whereas
the same coffeemaker purchased for use in a café is classified as
investment. If a café in Italy purchases a coffeemaker made in
Seattle, this counts as a US export and is added to domestic
expenditure in calculating US GDP. Conversely, if a Seattle café
purchases a coffeemaker made in Italy, this expenditure counts
as domestic investment but also as an import, which is deducted
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from domestic expenditure. Because the investment (a plus) and
the import (a minus) cancel each other out, the imported coffeemaker will exert no net effect on US GDP, which is appropriate
since no domestic production was involved.
Depreciation
It is important to remember that gross domestic product excludes
deductions for depreciation. Sometimes called “consumption of
fixed capital,” depreciation is formally defined as “the value of
wear and tear, obsolescence, accidental damage, and aging.”
(Returning to our coffeemaker example, a café’s coffeemaker
depreciates in value each year owing to wear and tear from brewing coffee. This wear and tear may be thought of as an input, just
like the coffee beans used to make the coffee.) The US Commerce
Department’s official measure of depreciation also covers reductions of the capital stock stemming from disasters, such as hurricanes and floods.4
If capital depreciation is very large across an entire economy,
even substantial levels of gross investment may not be sufficient
to support rapid growth over the long term. It is for this reason
that students of economic development often pay close attention
to net domestic product (NDP), which is GDP less depreciation.
NDP, or net output, essentially measures the amount of output
that can be consumed, leaving the capital stock intact.
In practice, GDP is used much more frequently than NDP. As
the Commerce Department explained back in 1947, net product
is “theoretically preferable…. It suffers, however, from the serious obstacle that there is no satisfactory operational definition of
the consumption of fixed capital.”5 Having decided that it was
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difficult to measure depreciation accurately, the Commerce
Department chose to emphasize gross rather than net product,
and has done so ever since (as have most other countries).
GDP versus GNP
Gross domestic product (GDP) measures the market value of all
final goods and services produced within a country’s borders
over a given year. By contrast, gross national product (GNP)
measures output produced by a country’s residents, regardless of
where they produce it.
When Toyota manufactures automobiles at a plant located in
the United States, the value of this output is factored into US
GDP in precisely the same way as would automobiles produced
by General Motors in Detroit. In calculating US GNP, however,
Toyota’s profits on US production are subtracted from final output. Conversely, Toyota’s production in the United States does
not factor into Japanese GDP at all, but the profits it earns in the
United States are included in Japanese GNP.
In technical terms, GDP excludes net income payments from
abroad (sometimes called net international factor payments),
while GNP includes them. As a result, “net exports” (EX – IM) is
defined differently for GDP than for GNP.6
Many analysts consider GDP to be a more useful short-term
policy variable, as it appears more closely correlated with employment, productivity, industrial output, and fixed ­investment than
GNP. GNP, meanwhile, may be more informative for analyzing
the sources and uses of income. In recent years, many statistical
agencies have begun to use the terminology gross national
income (GNI) rather than GNP.
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In some cases, a nation’s GNP may be considerably lower than
its GDP (when substantial factor returns are paid to foreign capital or nonresident labor). In 2011, countries with especially low
GNP-to-GDP ratios included Luxembourg (GNP was 72 percent
of GDP) and Ireland (82 percent). Both of these countries had
received sizable foreign investments in their economies and thus
paid substantial remittances abroad, reducing GNP. Of course, a
nation’s GNP could also be higher than its GDP (due to returns
from labor and capital abroad). Countries with unusually high
GNP-to-GDP ratios in 2011 included Lesotho (GNP was 121
percent of GDP), Bangladesh (109 percent), and Moldova (108
percent). For most nations, GNP and GDP are fairly similar. In
the United States, which shifted from reporting GNP to reporting
GDP in 1991, the two measures of gross output were nearly
identical.7
Historical and Cross-Country Comparisons
Because GDP is normally calculated on the basis of current prices
expressed in a home currency, adjustments are necessary to facilitate historical and cross-country comparisons.
Controlling for Inflation
To begin with, it is necessary to control for changes in the aggregate price level (inflation) in comparing the market value of o­ utput
over time. Suppose, for example, that a country’s real ­output
(e.g., the number of cars produced, the tons of apples harvested)
remained exactly the same from one year to the next but that the
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The Fundamentals of GDP Accounting
average price of every product doubled. In this case, nominal GDP
(i.e., the market value of final output) would obviously double as
well, even though the actual amount of output available for consumption—and thus the nation’s standard of living—was left
unchanged. To address this problem, economists developed various methods allowing them to control for changes in the price
level and thus to produce estimates of real (inflation-adjusted)
output. The US Commerce Department first began publishing
official estimates of real GNP in 1951.
For a long time, Commerce Department officials relied on a
fixed-price method for constructing real GNP (and later real
GDP). They selected a base year (say, 1950) and then calculated
the value of final goods and services produced in other years
using the prices that existed during the base year. In this way,
real GDP would not rise as a result of inflation, since prices were
held constant. (Simply by dividing nominal GDP by real GDP,
economists could also derive an implicit price deflator, a measure
of the aggregate price level that allowed them to track overall
inflation—or deflation—from year to year.8)
The fixed-price method was not without problems, however.
Arthur Burns, a member of the original team at the Commerce
Department that helped to develop US GDP accounting (and a
future chairman of the Federal Reserve), noted as early as 1930
that a base-year approach failed to account for the introduction
of new goods, the disappearance of old goods, and improvements in the quality of existing goods. A related problem was
that base-year prices eventually produced a distorted measure
of real GDP growth because consumption patterns evolved
over time, as consumers bought ever greater quantities of
goods whose relative prices were falling.9 The further away
from the base year, the more severe this problem (known as the
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s­ ubstitution effect) became. As one observer explained: “Take
1998 as an example: The growth rate of fixed [price] weight
real GDP in this year was 4.5 percent if we use 1995 as the base
year; using 1990 prices it was 6.5 percent; using 1980 prices it
was 18.8 percent; and using 1970 prices, it was a stunning
37.4 percent!”10
The Commerce Department sought to address these problems
by updating the base year frequently and, especially in the
1980s, by introducing a variety of adjustments for changes in
product quality, such as the increasing speed of personal computers.11 By far the biggest reform came in 1996, when
Commerce Department officials adopted a chained method in
place of the traditional fixed-price approach for calculating real
GDP.12 Under the chained method, every year became a base
year, but only for years that were immediately adjacent to it.
Officials could therefore calculate the change in real GDP from
1995 to 1996, from 1996 to 1997, from 1997 to 1998, and so
on, and then link all the individual changes into a seamless
chain. Because the base year was effectively updated annually,
the chained approach did a much better job accounting for
changes in the mix of goods and services sold in the marketplace. One unfortunate by-product, however, was that the components of GDP, after being deflated with a chained price index,
no longer necessarily summed exactly to real GDP.
Controlling for Differences in Purchasing Power
Adjustments have also been necessary to facilitate comparisons
of GDP across countries. Since each country’s GDP is first calculated in that country’s home currency, national estimates must
ultimately be converted to a common currency unit (such as US
dollars) before international comparisons can be made. Market
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exchange rates provide a convenient means of making the conversion, but they can be misleading, since they reflect only those
goods and services that are actually traded internationally.
Particularly in developing countries, products that are not traded
internationally (from haircuts to health care) may comprise a
large portion of GDP. If, using market exchange rates, the cost of
the same high-quality haircut was $5 in India and $50 in France,
then the use of a market exchange rate to convert GDP into a
common currency unit would underestimate the value of output
in India relative to France.
The standard solution for this problem is to create an index
of purchasing power parity (PPP), essentially calculating the
value of goods and services in each country using the prices of
a common country, such as the United States. Continuing with
the haircut example, the value of high-quality haircuts in India
and France would each be revalued using the price of highquality haircuts in the US (say, $40). Since the late 1960s, a
consortium of international agencies, in conjunction with the
University of Pennsylvania, have produced PPP-adjusted estimates of GDP for an increasing number of nations. (See
table 5-2.)13
Investment, Savings, and Foreign Borrowing
GDP accounting is useful because it allows us to calculate the
value of current output and to measure changes in output over
time. Many economists also believe that it provides important
clues about the underlying sources of economic growth and
about the sustainability of growth into the future.
Naturally, investment constitutes a critical link between current and future output. GDP accounting not only tells us the
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TABLE 5-2
GDP per capita, exchange rate versus purchasing power
parity (assorted countries, 2012)
GDP per capita,
US$ (market
exchange rate)
GDP per capita, PPP/ER ratio
PPP (purchasing
power parity)
Argentina
$11,560
$18,020
1.6
Brazil
$11,570
$12,100
1.0
$281
$627
2.2
$993
$2,530
2.5
$52,152
$42,580
0.8
Burundi
Cambodia
Canada
China
$6,290
$9,460
1.5
Egypt
$3,020
$6,420
2.1
Ethiopia
$434
$1,190
2.7
France
$41,060
$36,720
0.9
Germany
$41,620
$40,640
1.0
$1,538
$3,920
2.5
India
Indonesia
$3,540
$4,900
1.4
Iraq
$6,190
$5,060
0.8
Ireland
$45,920
$42,520
0.9
Israel
$30,497
$31,430
1.0
Japan
$47,300
$36,230
0.8
Malaysia
$10,387
$17,050
1.6
Mexico
$10,238
$17,908
1.7
Nigeria
$1,640
$1,920
1.2
Norway
$99,760
$64,790
0.6
$2,410
$4,090
1.7
Russia
Philippines
$14,212
$17,610
1.2
Saudi Arabia
$25,160
$31,380
1.2
Singapore
$51,400
$47,520
0.9
South Africa
$7,880
$11,930
1.5
Turkey
$10,560
$15,010
1.4
United States
$49,959
$49,959
1.0
Source: Economist Intelligence Unit (EIU) Country Data, including EIU estimates.
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value of current investment but also permits us to identify how
this investment is funded. As we have seen,
Gross product = C + I + G + (EX – IM).
Interestingly, gross product also equals gross income,
which—when adjusted to include transfer payments
­­(Tr)—­necessarily equals the sum of consumption (C), private
savings (S), and taxes (T), since all income must ultimately be
used in one of these three ways. As a result, we can say that
Gross product = C + I + G + (EX – IM) = C + S + T – Tr.
Some simple manipulation produces the following identity
regarding the sources of investment:
I = S + (T – G – Tr) + (IM – EX),
where T – G – Tr (the government budget surplus) reflects government savings, and IM – EX (net imports) reflects foreign borrowing, since any excess of imports over exports can only be
funded through borrowing from abroad.
What this tells us is that investment is funded out of these
three basic sources: private savings (personal savings plus the
retained earnings of firms), government savings (the government
budget surplus), and borrowing from abroad (net imports). If a
nation wishes to increase its level of investment, it must either
reduce its private consumption (to increase private savings),
reduce its government spending or raise taxes (to increase
­government savings), increase its foreign borrowing, or perhaps
do some combination of all of these. (See table 5-3.)
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TABLE 5-3
Investment, savings, and foreign borrowing
(United States, 2012)
Billions $
% of GDP
Private investment (I)
[ = Private savings + Government savings
+ Net foreign borrowing]
$2,475.2
15.2%
Private saving, gross (Sp )
$,3540.9
21.8%
687.4
4.2%
Personal saving
Undistributed corporate profits (with inventory
valuation and capital consumption adjustment)
Private consumption of fixed capital (depreciation)
804.3
5.0%
2,049.3
12.6%
–$1,487.7
–9.2%
4,259.2
26.2%
5,746.9
35.4%
Net foreign borrowing (IM – EX)
[ = Net imports = Imports – Exports]c
$439
2.7%
Statistical discrepancy
–$17
–0.1%
Government saving (SG)
[ = Government receipts – Government
­expenditure = Budget surplus]
Total government receipts (taxes), all levels of
governmenta (T)
Total government expenditures, all levels of
­government, including income transfersb (G + Tr)
Source: Data drawn from US Bureau of Economic Analysis.
a. Less capital transfer receipts.
b. Less capital transfer payments and net purchases of nonproduced assets.
c. Less net income receipts, net transfers in, and net capital account inflows.
Although national economic accounting says nothing about
whether any one of these funding methods is better or worse
than the others, some students of economic development have
suggested that foreign borrowing may be more volatile than
domestic savings and may therefore constitute a less reliable
source of investment. When a nation’s foreign borrowing
becomes very large, moreover, critics often warn that the
country is living beyond its means, since foreign borrowing
(i.e., IM – EX > 0) implies that the nation’s domestic ­expenditure
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(C + I + G) exceeds its domestic output (GDP). This is why
analysts sometimes view economic growth as unsustainable
when a large and persistent current account deficit—and thus
heavy reliance on foreign borrowing—is involved.14
In Mexico in the early 1990s, for example, real GDP was growing, but the growth was being fueled (at least in part) by increasingly heavy borrowing from abroad. Many country analysts view
a current account deficit of more than 5 percent of GDP as a possible red flag. In Mexico’s case, the current account deficit had
jumped from 3 percent of GDP in 1990 to 7 percent in 1994.
This shift was also visible on the GDP accounts, with net imports
(IM – EX) having increased from 1.1 to 4.8 percent of GDP over
the same years. Foreign capital, in other words, as well as foreign
goods and services, were pouring into the country.
Some foreign investors and many Mexican officials claimed
that the huge capital inflow reflected a high degree of investor
confidence in Mexico’s economic prospects. Yet total domestic
investment was falling (as a share of GDP), and consumption
was rising. Mexico, it appears, was living beyond its means,
importing foreign goods and services (on the basis of foreign
borrowing) and using the additional output to increase consumption rather than investment. Although experts disagree
about the exact causes, Mexico ultimately suffered a severe currency ­crisis in 1994–1995, driving down consumption along
with the peso and erasing nearly all of the apparent gains of the
previous years. A careful review of the nation’s GDP accounts
prior to the collapse might well have given some indication of
the problems ahead.
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CHAPTER SIX
Reading a Balance of Payments
Statement
Balance of payments accounting is a close cousin to GDP
accounting in the field of macroeconomics. In fact, both are
essential gear in the macroeconomist’s toolbox. Whereas a GDP
account reports a nation’s output and its component parts, a balance of payments (BOP) statement provides a record of the country’s cross-border transactions. As in a GDP account, all of the
figures that appear in a BOP statement are flows, indicating the
value of exports or imports, income receipts or payments, or
new foreign borrowing or lending that have occurred over a particular period of time—typically a year. This chapter presents a
primer on BOP accounting and the best strategies for reading
and interpreting a BOP statement.
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Selected Topics
A Typical Balance of Payments Statement
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A BOP statement normally includes at least the following line
items (or some variations thereof):a
Current Account
• Balance on trade in goods and services
–– Balance on merchandise trade (goods)
–– Balance on trade in services
• Net income (net factor receipts)
• Net unilateral transfers
Capital and Financial Account
• Net capital account
• Financial account
–– Net foreign direct investment
–– Net portfolio flows
–– Other capital flows, net
–– Change in official reserves
• Errors and omissions (statistical discrepancy)
a. An alternative approach that the International Monetary Fund (IMF) is
adopting and that various nations are planning to adopt as well uses different
terms for some categories. However, essential balance-of-payments concepts
remain the same. (See “Presenting the Balance of Payments: An Evolving
Approach,” at the end of this chapter, for details.)
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Reading a Balance of Payments Statement
Several of these line items require some explanation. Under
the current account, merchandise (or goods) are tangible products, ranging from raw materials to manufactured items. Services
are intangible products, such as shipping, investment banking,
or consulting services. Income receipts and payments include
financial returns (such as interest, dividends, and remitted or
reinvested earnings) on cross-border investments and compensation (including wages and salaries) for cross-border work.
Unilateral transfers (sometimes called “net current transfers”) are
nonreciprocal transactions such as foreign aid or cross-border
charitable assistance (given through the Red Cross, for example).
Regarding the “capital and financial account,” the first thing
that requires explanation here is the heading itself. Until the
1990s, most countries recorded all cross-border financial transactions (i.e., changes in assets and liabilities) under the heading
“capital account.” Beginning in 1993, however, officials at the
International Monetary Fund (IMF) substituted the term “financial account” for “capital account” and (making matters even
more confusing) assigned a new and far narrower definition to
the term “capital account.” Under this new definition, which is
now widely accepted around the world, the capital account
includes only unilateral transfers of capital, such as the forgiveness of one country’s debts by the government of another country. In most cases, the newly defined capital account is a very
small (almost negligible) item on the balance of payments.
The new “financial account” is far more important, since it
includes all other financial transactions, such as cross-border
trades of stocks and bonds. Although analysts still sometimes
use the term “capital account” with its old, expansive meaning in
mind (in speaking about “capital account liberalization,” for
example), most national governments now use the IMF’s new
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Selected Topics
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definitions of the capital and financial accounts in preparing
their balance of payments statements.
As for the items listed under the financial account, direct
investment (sometimes referred to as foreign direct investment,
or FDI) involves the cross-border purchase of an equity stake
in a company—a stake large enough (usually greater than
10 ­percent) to give the new owner managerial influence in the
­company. When Daimler-Benz bought Chrysler in 1998, this
represented German FDI in the United States. Portfolio investment, by contrast, involves cross-border purchases of stocks,
bonds, and other financial instruments (but not in sufficient
concentrations to allow managerial influence). Portfolio investment is sometimes referred to as “hot money,” since portfolio
investors can often liquidate their holdings and exit a country
at almost a moment’s notice. “Changes in official reserves”
reflect increases or decreases in the government’s stockpile of
monetary gold and foreign currencies (foreign exchange).
Finally, “errors and omissions” is a residual category reflecting
statistical discrepancies in the compilation of BOP data.
Understanding Credits and Debits
In reading a balance of payments statement (such as the one
for the US presented at the end of this chapter), it is important
to recognize that every cross-border transaction involves two
entries, a credit (+) and a debit (−). Among other things, this
means that all of the various positive and negative ­balances on
a balance of payments (BOP) statement must add up to zero.b
b. The alternative (IMF) approach to the balance of payments, mentioned in
the previous footnote and outlined in “Presenting the Balance of Payments: An
Evolving Approach” at the end of this chapter, treats the financial account
somewhat differently, although its underlying structure remains the same.
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Reading a Balance of Payments Statement
Naturally, knowing the difference between a credit and a debit
is essential. One useful way to think about this is that every
source of funds (e.g., foreign exchange) is a credit, while every
use of funds is a debit.
On the current account, exports of goods and services, income
receipts (such as interest, dividends, or compensation from foreigners), and unilateral transfers from abroad are all credits
because they all may be thought of as sources of foreign exchange.
Conversely, imports of goods and services, payments of income
to foreigners, and unilateral transfers given to foreigners are all
debits, since they all may be thought of as uses of foreign
exchange.
On the financial account, the same basic rules apply. Foreign
purchases of domestic financial assets, which constitute a capital
inflow (lending from abroad), are recorded as credits, since they
provide a source of foreign exchange.1 Domestic purchases of
­foreign financial assets, which constitute a capital outflow (lending to foreigners), are recorded as debits because they are a use of
foreign exchange. (See figure 6-1.)
A more precise way to distinguish credits from debits on the
financial account is to think specifically in terms of changes in
assets and liabilities, where assets represent domestic claims
on foreigners and liabilities represent foreign claims on domestic residents and institutions. Thus, a deposit held by a domestic resident in a foreign bank is an asset, whereas a foreign
deposit in a domestic bank is a liability. From an accounting
standpoint, every increase in a liability or decrease in an asset is
recorded as a credit on the financial account, while every increase
in an asset or decrease in a liability is recorded as a debit. When a
foreigner obtains a domestic stock, bond, or bank account
(three forms of capital inflow), this is indicated with a credit
on the financial account, since there has been an increase in a
liability to a foreigner. When a domestic resident obtains
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inflow (lending from abroad), are recorded as credits, since they
provide a source of foreign exchange. Domestic purchases of foreign financial assets, which constitute a capital outflow (lending
to foreigners), are recorded as debits because they are a use of
Selected
foreign exchange. (See figure
6-1.)Topics
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FIGURE 6-1
Debits and credits on a balance of payments statement
Debits (–)
Credits (+)
Examples:
Examples:
• Imports
• Exports
• Income payments (such as interest
and dividends paid to foreigners)
• Income receipts (such as interest
and dividends earned on foreign
investments)
• Unilateral transfers to foreigners
(such as foreign aid or charitable
assistance given to foreigners)
• Unilateral transfers from abroad
(such as foreign aid or charitable
assistance received from foreigners)
• Capital outflows (such as an
increase in domestic deposits in
foreign banks or domestic purchases
of foreign companies, stocks, or
bonds)
• Capital inflows (such as an increase
in foreign deposits in domestic banks
or foreign purchases of domestic
companies, stocks, or bonds)
• Increase in official reserves
(government stocks of gold or
foreign exchange)
• Decrease in official reserves
(government stocks of gold or
foreign exchange)
Rules (regarding BOP debits):
Rules (regarding BOP credits):
• Uses of foreign exchange
• Sources of foreign exchange
• Increase in an asset (i.e., an
increase in a domestic claim on a
foreign entity)
• Increase in a liability (i.e., an
increase in a domestic obligation
to foreigners)
• Decrease in a liability (i.e., a
decrease in a domestic obligation
to foreigners)
• Decrease in an asset (i.e., a
decrease in a domestic claim on
a foreign entity)
a ­foreign stock, bond, or bank account (three forms of capital
119
outflow), this is indicated with a debit on the financial account,
since there has been an increase in an asset (a claim against a
foreigner).
To see how this works in a specific transaction, imagine that a
US company buys a thousand cell phones from a Chinese company and pays for them with a check drawn on a US bank.2
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In this case, we would see a debit (−) on the US current account,
reflecting the import of cell phones from China; and we would
see a credit (+) on the US financial account, reflecting the payment that was made to the Chinese company by check against a
US bank. Once the check arrives in China, it represents a claim
on the United States and thus an increase in a domestic (US) liability to foreigners. Until the Chinese exercise that claim to purchase
some sort of American output, their willingness to hold the
check (or any other financial instrument into which they could
convert it) constitutes a loan from China to the United States—a
loan that the Chinese can essentially call at their discretion in the
future.
In some cases, one side of a transaction will be misrecorded or
not picked up at all by government officials. The errors-andomissions line reflects the net value of all of these discrepancies.
It is calculated simply by adding up all of the other lines on the
balance of payments and reversing the sign, thus ensuring that
all of the lines (including errors and omissions) sum to zero.
Often, the underlying mistakes and discrepancies are innocuous.
In some instances, however, a large debit or credit on the errorsand-omissions line stems from a large flow of output or capital
that is intentionally being hidden from the authorities, such as
the import or export of illegal drugs or the surreptitious movement of large volumes of US currency across national borders.
When a rich family from a developing country sneaks millions of
dollars of cash into the US packed in a suitcase, this secret
­transfer of capital will show up as a debit on errors and ­omissions
in the developing country’s BOP statement and a credit on errors
and omissions in the US balance of payments. In fact, when a
country suffers a severe financial crisis, one sometimes sees
unusually large negative errors-and-omissions numbers on the
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country’s BOP statement in the months leading up to the crisis,
suggesting that those “in the know” were secretly removing capital from the country (i.e., engaging in capital flight) before the
collapse.
The Power and Pitfalls of BOP Accounting
Clearly, a country’s balance of payments can be extremely revealing. One should not be surprised to discover, however, that not
every BOP statement is prepared in exactly the same way. As a
case in point, the organization of the US BOP statement shown
in table 6-1 is a bit different from the generic form presented at
the beginning of this chapter. Specifically, the current account in
the US statement is broken first into “exports” and “imports,”
and the financial account is divided first into “assets” and “liabilities.” In addition, the statistical discrepancy line (errors and
omissions) appears outside the capital and financial account,
rather than within it.
Nevertheless, if you understand the basics of BOP accounting, such variations should not present too great a problem as
you seek to make sense of a country’s BOP statement. Indeed,
figuring out a country’s balance of payments is well worth the
effort, as it offers a unique window on the country’s cross-­
border transactions and, more broadly, its relationship to the
global economy.
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TABLE 6-1
US balance of payments, 1970–2010 ­(billions of dollars)
1970
1980
1990
2005
2010
2.3
2.3
–416.3
–739.8
–449.5
(2) Exports
56.6
271.8
535.2 1,072.8
1,288.3
1,844.5
(3) Goods
42.5
224.3
387.4
784.8
911.7
1,288.8
(4) Services
14.2
47.6
147.8
288.0
376.6
555.7
(5) Imports
−54.4
−291.2
−616.1 −1,450.1 −1,996.2 −2,343.8
(6) Goods
−39.9
−249.8
−498.4 −1,231.7 −1,695.8 −1,939.0
(7) Services
−14.5
−41.5
−117.7
−218.4
−300.4
(8) Income receipts
11.7
72.6
171.7
352.5
537.3
678.1
(9) Income payments
−5.5
−42.5
−143.2
−333.3
−469.7
−500.4
(10) Unilateral transfers,
net
−6.2
−8.3
−26.7
−58.2
−99.5
−127.8
(11) Capital and financial −2.1
account
−24.9
50.9
477.7
713.8
437.9
(1) Current account
–79.0
2000
−404.9
(12) Capital account, net
0.0
0.0
-7.2
0.0
13.1
−0.2
(13) Assets, net (excluding ­financial derivatives)
−9.3
−87.0
−81.2
−560.5
−546.6
−910.0
2.5
(14) US official reserve
assets, net
−1.6
(15) US government
(­ nonreserve) assets,
net
(16) US private assets, −10.2
net
Of which:
(17) direct investment −7.6
(18) foreign securities −1.1
−8.2
−2.2
−0.3
14.1
−1.8
−5.2
2.3
−0.9
5.5
7.5
−73.7
−81.4
−559.3
−566.3
−915.7
−19.2
−3.6
−37.2
−28.8
−159.2
−127.9
−36.2
−251.2
−301.1
−139.1
139.4 1,038.2
1,247.3
1,333.9
(19) Liabilities, net
(excluding financial
derivatives)
(20) To foreign official
agencies
(21) US government
securities
(22) Other liabilities, net
Of which:
(23) direct ­investment
(24) US Treasury
securities
(25) other securities
7.2
62.0
7.8
16.6
33.9
42.8
259.3
398.3
9.4
11.9
30.2
35.7
213.3
353.3
−0.6
45.4
105.4
995.5
988.1
935.6
1.5
0.1
16.9
2.6
48.5
−2.5
321.3
−70.0
112.6
132.3
205.9
298.3
2.2
5.5
1.6
459.9
450.4
140.9
(continued )
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TABLE 6-1 (continued)
US balance of payments, 1970–2010 ­(billions of dollars)
1970
(26) Financial derivatives,
net
(27) Statistical
­discrepancy
1980
1990
2000
2005
2010
n/a
n/a
n/a
n/a
n/a
14.1
−0.2
22.6
28.1
-61.4
26.0
11.6
Source: Adapted from the Bureau of Economic Analysis.
Note that on a BOP statement, the terms “assets” and “liabilities” always refer to changes in assets
and changes in liabilities in the year or quarter indicated, not to total assets or total liabilities held as
of that year or quarter. On the US BOP statement shown in table 6-1, for example, American
­holdings of foreign assets increased by $910.0 billion in the year 2010 (recall that an increase in an
asset is recorded as a debit in this accounting system), and American obligations to foreigners
increased by $1,333.9 billion (recall that an increase in a liability is recorded as a credit). Although
total American holdings of foreign assets and total foreign holdings of American assets are naturally
much larger, they are not recorded on the BOP statement.
Presenting the Balance of Payments: An Evolving
Approach
D
ifferent organizations sometimes use different methods in
producing balance of payments statements. The
International Monetary Fund’s presentation of the US balance of
payments, for example, differs from that of the US Bureau of
Economic Analysis (BEA). Fortunately, once one understands
basic balance of payments concepts, it is relatively easy to make
sense of alternative approaches.
At the time of this writing, the IMF has begun to implement a
new presentation of the balance of payments, detailed in the sixth
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Reading a Balance of Payments Statement
edition of its Balance of Payments Manual (BPM6). The US BEA
and many other national agencies will be adopting variations on
this approach over the coming years. (See table 6-2 for a prototype of the way the BEA expects to implement BPM6.) The new
approach is designed to better reflect real-world transactions, and
some people may find that they grasp it more intuitively than the
earlier approach.
The data in headline categories—the net current account, capital account, financial account, and errors and omissions—will not
change in BPM6.a Current-account categories also remain familiar, such as exports and imports of goods and services. However,
the new system presents both exports and imports as positive
numbers. Thus, the balance of trade equals exports minus
imports, rather than exports plus imports. In addition, some labels
are changing: “income” will be called “primary income,” and
“transfers” will be called “secondary income.”
Throughout the new balance of payments, some types of
transactions are being reclassified. As an example, suppose a US
firm buys smartphones from a Chinese manufacturer and then
sells them to French consumers. Formerly, the US firm was considered to be performing a manufacturing service. The value
added (profits minus expenses) was included under service
exports. In the new system, the United States is considered to
have imported the cell phones and then reexported them to
France. The transaction is thus recorded under goods (both as an
import and an export), rather than under services.
a. The 2010 headline data in the prototype table 6-2 vary from those in table 6-1
only because the BEA constructed its prototype table using preliminary data
released in June 2011, while table 6-1 was created with better data, revised in
June 2013.
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TABLE 6-2
Prototype of planned presentation of the US balance of
payments under the new method, 2006–2010
­(billions of ­dollars)
2006
2007
2008
2009
2010
−800.6
−710.3
−677.1
−376.5
−470.9
−832.9
−814.6
−825
−502.5
−642.2
Exports
1,042.2
1,168.2
1,312.7
1,072.9
1,292.4
Imports
1,875.1
1,982.8
2,137.6
1,575.4
1,934.6
Services
balance
79.6
118
126.6
121.3
142.2
Exports
418.5
488.2
532.5
504.8
546.8
Imports
338.9
370.2
405.9
383.6
404.7
44.2
101.5
147.1
128
165.2
Current
account
balance
Goods
­balance
Primary
income
­balance
Receipts
Payments
Secondary
income
(transfers)
balance
693
843.9
823.5
607.2
670.7
648.9
742.4
676.4
479.2
505.5
−91.5
−115.1
−125.9
−123.3
−136.1
Receipts
67.9
70.3
83.5
84.7
83.7
Payments
159.5
185.4
209.3
208
219.8
−1.8
0.4
6
−0.1
−0.2
−809.1
−617.3
−730.6
−245.9
−254.2
Financial
­derivatives,
net
−29.7
−6.2
32.9
−49.5
−13.7
Direct
investment,
net
1.8
192.9
19
145
115.1
Assets
296.1
532.9
351.7
303.6
393.7
Liabilities
294.3
340.1
332.7
158.6
278.6
Capital
account
­balance, net
Financial
account, net
(continued )
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2006
2007
2008
2009
2010
−633
−776.9
−809.4
9.9
−520.8
493.7
379.7
-285.7
369.8
186.1
Liabilities
1,126.7
1,156.6
523.7
359.9
706.9
Other
investment,
net
−145.8
−27.1
22
−403.6
163.3
Assets
549.5
659.8
−380.3
−586.3
465.9
Liabilities
695.3
686.9
−402.4
−182.7
302.6
Reserve
assets
−2.4
0.1
4.8
52.3
1.8
Net errors
and
­omissions
−6.7
92.7
−59.5
130.8
216.8
Portfolio ­
investment,
net
Assets
Source: Adapted from Bureau of Economic Analysis, “Table A. U.S. International
Transactions (Prototype),” http://www.bea.gov/international/modern.htm. Based on data
released in June 2011.
By far the most important changes in the BPM6 approach
involve the financial account. Under the new system, net investment in any category, such as direct or portfolio investment,
equals the accumulation of assets minus the buildup (or “incurrence”) of liabilities. Both an increase in an asset and an increase
in a liability are recorded as positive numbers, and both a
decrease in an asset and a decrease in a liability are recorded as
negative numbers. For example, if an American buys a Mexican
bond or stock with a check on an American bank, the new s­ ystem
records the increase in US assets (the foreign stock or bond) as a
positive number, whereas under the earlier system, it would have
been recorded as a negative number. The new system also
records the increased liability in this transaction (the check w
­ ritten
to a foreigner) as a positive number, but ultimately subtracts the
change in liabilities from the change in assets in determining
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each category or balance in the financial account (i.e., direct
investment, portfolio investment, and other investment) as well
as the balance on the financial account itself. Bottom line: net
lending abroad is recorded in the new system as a positive
­balance on the financial account, and net borrowing as a
­negative balance—just the opposite of the traditional system.
As a consequence of the new approach, it will no longer be
true that the main BOP accounts (current account, capital account,
financial account, and errors and omissions) will sum to zero.
Instead, under the new system, the current account plus the capital account plus errors and omissions minus the financial account
will equal zero.
To see how all of this plays out in practice, consider one more
transaction: a US firm exports a machine tool to an Italian firm,
which pays for the machine tool with a check on an Italian bank.
The transaction will be recorded as an increase in US goods
exports, a positive number on the current account, as well as an
increase in US assets (the check from a foreigner), a positive
number on the financial account. The increase in exports minus
the increase in financial assets will equal zero.
Fortunately, this rather significant change in the way financial
transactions are accounted for under the emerging IMF system is
relatively easy to understand once one knows the new rules.
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CHAPTER SEVEN
Understanding Exchange Rates
For anyone engaged in cross-border transactions, grappling with
exchange rates is a necessary fact of life. Although no one can
predict with great confidence how a currency will move over a
given time period—whether it will appreciate or depreciate, let
alone by how much—we can identify key factors that are likely
to influence exchange-rate movements, over both the short term
and the long term. This chapter offers a brief overview of the
most important factors, why they matter, and how they interact.
The Current Account Balance
A country’s trade balance—or, more precisely, its current account
balance—is one factor that can influence exchange rates. If, for
example, a country’s consumers developed an enormous ­appetite
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for foreign products, the country’s current account balance
would presumably deteriorate and its currency depreciate.
Depreciation would occur as increased domestic demand for foreign products bid up the price of the foreign currencies needed
to buy them.
As it turns out, however, buoyant demand for goods and services, whether foreign or domestic, is not the only possible
driver of a current account deficit. If, for example, foreigners
developed an enormous appetite for a country’s financial assets,
the c­ ountry’s current account balance would deteriorate (the
flip side of its improving financial account balance), but its currency would most likely appreciate. Appreciation would occur
as a result of increased foreign demand for the country’s domestic financial assets (and for the currency in which they are
denominated). In this case, a current account deficit would be
associated with appreciation, rather than depreciation, of the
currency.
In principle, the key question is not whether a country’s current account is in surplus or deficit, but rather what factors are
driving the surplus or deficit—namely, demand for goods and
services or demand for capital. Increased foreign demand for a
country’s goods and services will likely bolster both the ­country’s
current account balance and its currency, whereas increased foreign demand for a country’s financial assets will likely cause the
country’s currency to appreciate even as its current account
deteriorates.
Precisely because it is difficult to disentangle these factors in
practice, experts frequently disagree on how a particular
­country’s current account surplus or deficit is likely to influence
its exchange rate. In general, though, sustained current account
­deficits appear to be more typically associated with long-term c­ urrency
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d­ epreciation than with long-term appreciation (and the opposite is
­generally true of sustained current account surpluses).
Inflation and Purchasing Power Parity
A closely related factor that has the potential to affect exchange
rates is inflation. In general, when one country experiences a
consistently higher inflation rate than another, economists
expect that the first country’s currency will depreciate relative to
that of the other country.
One way to understand this is to focus on the trade (or current account) balance—and especially on the domestic demand
for foreign products. Rising prices (i.e., inflation) in Country X
will make imports from Country Y increasingly attractive to
Country X’s consumers, assuming Country Y’s prices haven’t
increased as fast. As a result, Country X will see its trade balance
with Country Y deteriorate and its currency depreciate
(as domestic demand for Country Y’s products, and thus for
Country Y’s currency, grows).
Economists generally view this relationship between inflation
and exchange rates through a purchasing power parity model of
exchange rate determination. The basic idea, drawn from the
so-called Law of One Price, is that a unit of currency (say, a
­dollar) should always have the same purchasing power in one
country as in another, excluding transportation costs and taxes.
Yet inflation threatens to undermine this parity. If, for example,
prices rose faster in the United States than in Britain, Americans
would discover that a dollar purchased more in Britain than in
the US (since US prices were now higher as a result of US
­inflation). For purchasing power parity to be restored, the dollar
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would have to depreciate relative to the pound, until a dollar
could once again purchase the same quantity of (identical)
goods and services in the United States as it could in Britain.
That is, the country with higher inflation will tend to see its
­currency depreciate.
Interest Rates
Interest rates are yet another important factor that can influence
the behavior of exchange rates. In fact, many financial experts
and currency traders regard interest rates as the single most
­powerful driver of exchange rates, particularly over short time
horizons.
At a practical level, a country’s currency will tend to appreciate when its interest rate rises relative to that of other countries
(and to depreciate when its interest rate falls). The essential logic
here is that a rising interest rate within a country makes foreigners more eager to invest there, attracted by the prospect of a
higher return on their invested funds. The resulting capital
inflows drive up the value of the country’s currency, as foreigners
compete to invest in the country’s financial markets.
However, one of the most important exchange-rate models
economists have developed seems to predict a very different
result. According to the uncovered interest rate parity model, if
Country A’s interest rate rises above Country B’s (with no additional investment risk), then we should expect Country A’s currency to undergo an immediate appreciation but then to
depreciate in value after that. The basic reasoning behind this
model stems once again from the Law of One Price. For a given
level of risk, a dollar (or a euro or a yen) should be expected to
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Understanding Exchange Rates
earn the same average return regardless of where it is invested.
Thus, if a higher interest rate is being paid in one country than
another, then investors should expect the country’s currency
ultimately to depreciate—and to depreciate by just enough to
wipe out any excess returns that would have accrued from
investing there.
Although this interest rate parity model is conceptually bulletproof, it doesn’t always hold up well in practice. Most studies
suggest that, if anything, a country’s currency tends to appreciate
after a rise in its interest rate and to depreciate after a fall, not the
other way around.
Making Sense of Exchange Rates
So what is one to make of all this? Perhaps the most important lesson of all is simply that currency markets are unpredictable—and
that this remains true no matter how much training in economics
one has. (See “The US Dollar: Defying the Experts.”) As a column
in the Financial Times once observed, “Explaining FX market
moves coherently has always been difficult . . . Ask 10 traders, and
you will be likely to get 10 different explanations . . .”1
Nevertheless, although exchange rates are often volatile and
never perfectly predictable, it is still reasonable to conclude that
they are subject to the basic pressures of supply and demand in
the marketplace. Since an exchange rate is simply the price of
one currency in terms of another, anything that raises the
demand for a currency (or reduces the demand for other currencies) will create pressure for appreciation. Anything that reduces
demand for the currency (or increases demand for other currencies) will create pressure for depreciation.
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The US Dollar: Defying the Experts
I
n 2005 and 2006, the US dollar defied the predictions of many
of the best in the business, including billionaire investor Warren
Buffett and former Treasury secretary Robert Rubin. Both believed
that America’s massive current account deficits (5.1 percent of
GDP in 2004 and 5.6 percent of GDP in 2005) would eventually
drive the dollar to depreciate. Although both may prove right over
the long term—Rubin said he thought his prediction “was right,
probabilistically”—both lost large sums in the short run, when the
dollar refused to collapse on cue. Buffett is said to have lost nearly
$1 billion for Berkshire Hathaway and Rubin more than $1 million
of his own money.a
The point is that no one—not even the world’s most respected
authorities—can know for sure how a currency will move in the
future. Making predictions based on fundamentals, including the
factors reviewed in this chapter, should increase the odds of getting it right, but certainly cannot guarantee the success of any
particular prediction. As Robert Rubin suggested, when it comes
to exchange rate forecasts, the very best one can do is to try to be
“right, probabilistically.”
a. David Leonhardt, “A Gamble Bound to Win, Eventually,” New York Times,
November 1, 2006.
A sudden surge in American demand for foreign goods or
financial assets, for example, will tend to weaken the dollar (and
simultaneously strengthen other currencies). A burst of European
inflation would tend to weaken the euro and strengthen the
­dollar at the same time. An unexpected increase in British
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Understanding Exchange Rates
i­nterest rates, meanwhile, would likely strengthen the pound,
particularly in the short term, though it is possible that the Law
of One Price would require a subsequent depreciation of the
pound over the long term.
In fact, the reason why exchange rate movements are so difficult to predict in practice is that currencies are subject to a myriad of pressures at the same time—ups and downs in aggregate
demand, currency interventions by governments, interest rate
movements, inflation here, deflation there, financial panics,
political crises, oil shocks, new technologies, abrupt changes in
expectations, and on and on. In general, though, the best predictors are probably:
• Interest rates for short-term movements (with interest-rate
increases and decreases associated with rapid appreciation
and depreciation, respectively);
• Inflation for medium-term movements (with relatively high
inflation associated with depreciation and relatively low
inflation with appreciation); and
• Current account imbalances for longer-term movements
(with deficits associated with depreciation and surpluses
with appreciation, over extended periods of time).
Although there are no perfect predictors, these simple relationships at least represent reasonable rules of thumb for the
business manager (or foreign investor or traveler) trying to make
sense of exchange rates in an increasingly complex and dynamic
global economy.
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Conclusion
Putting the Pieces Together
We have clearly covered a lot of ground over the previous chapters. To help keep things in perspective, it is worth returning to
the three core concepts of macroeconomics presented in part I:
output, money, and expectations. All three—as well as some of
the key relationships between them—are represented graphically in figure C-1.
Output
Output, which comprises the goods and services produced in an
economy, lies at the heart of macroeconomics. The amount of
output a country produces (or, more precisely, its amount of output per capita) determines its level of prosperity. A standard
139
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Conclusion
Figure
F
I G U R EC-1
C-1
The macro “M”
Actual
versus
potential
Nominal
versus
real
Output
Inflation
Interest rates
Exchange rates
GDP
BOP
Money
Expectations
“Animal spirits”
“Irrational
exuberance”
Inflationary
expectations
Monetary and fiscal policy
measure of national output is gross domestic product, or GDP.
Nominal GDP measures the total value—at current market
measure ofall
national
output
gross domestic
or GDP.
prices—of
final goods
andisservices
producedproduct,
in a country
in a
Nominal
GDP
measures
the
total
value—at
current
market
given year. Although a country may temporarily consume more
prices—of
all finalit goods
services
producedmore
in a country
in
than
it produces,
can doand
so only
by importing
goods and
a given year.
a country
temporarily
more
services
thanAlthough
it exports
and bymay
borrowing
fromconsume
foreigners
to
than
it
produces,
it
can
do
so
only
by
importing
more
goods
and
finance the difference. All of these cross-border transactions are
services than
it exports
and
by borrowing
from(BOP).
foreigners to
accounted
for in
a country’
s balance
of payments
finance the difference. All of these cross-border transactions are
accounted for in a country’s balance of payments (BOP).
Money
Money
Money is critical for facilitating
the exchange of goods and services within an economy. It can also influence many other imporMoney
is critical
for facilitating
theinterest
exchange
of exchange
goods andrates,
sertant
economic
variables,
including
rates,
vicesthe
within
an economy.
It can
also influence
manyanother
imand
aggregate
price level
(inflation).
In general,
increase
portant
economic
variables,
including
interest
exchange
in
the money
supply
is expected
to drive
downrates,
interest
rates,
140
134
Conclusion.indd 140
19/05/14 11:29 PM
Conclusion
cause the exchange rate to depreciate, and increase the aggregate
price level.
When the price level rises, nominal values will rise with it,
but real ones will not. Nominal values (such as nominal GDP
or nominal wages) are measured in terms of current market
prices, whereas real values (such as real GDP or real wages) are
measured in terms of constant prices and thus reflect underlying quantities, after controlling for inflation. A 5 percent
increase in real GDP, for example, means that output—the variable that macroeconomists most care about—has increased by
5 percent, regardless of the inflation rate. Although inflation
itself is determined by many factors, money may well be the
most important one.
In fact, precisely because money is such a pivotal factor in the
economy, governments worldwide assume responsibility for
managing the money supply and typically delegate this responsibility to independent central banks. Although they cannot completely control the money supply (since a large part of it is
created by private commercial banks in the form of checking
accounts), central banks can exert a great deal of influence over
the money supply—by determining how much currency to
issue, for example. A central bank’s primary tools for influencing
the money supply are the discount rate, the reserve requirement,
and open market operations. In the United States, almost all
monetary policy is now conducted through open market operations, which involve the buying and selling of government bonds
on the secondary market. Through these open market operations
(which expand or contract the money supply), central banks can
effectively set the short-term interest rate, which has long been
regarded as the primary instrument of modern monetary policy.
In recent years, following the financial crisis of 2007–2009, the
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Conclusion
Federal Reserve also sought to influence longer-term interest
rates by purchasing a range of longer-term instruments (such as
mortgage-backed securities) through a policy known as “quantitative easing.” This nontraditional policy remained controversial,
however, with little agreement—even among monetary
experts—about whether it would ultimately be seen as a success
or a failure.
Central bankers typically have many goals in conducting
monetary policy. They wish to maintain economic growth at the
highest sustainable level; they hope to keep unemployment to an
absolute minimum; they aim to keep exchange rates stable; they
hope to maintain interest rates at reasonable levels (so as not to
discourage investment); and they seek to keep inflation low.
Although central bankers would, ideally, like to achieve all of
these goals simultaneously, there is now a broad consensus that a
primary objective must be to stabilize the price level. One strategy for achieving this goal is inflation targeting, which requires
that central bankers raise interest rates (by slowing money
growth) when inflation begins to rise above a target level—such
as 2 percent—and that they lower interest rates (by accelerating
money growth) when inflation threatens to fall below that target.
Although inflation targeting remains a preferred strategy in
most monetary circles, the financial crisis of 2007–2009
reminded many observers that financial stability also must be a
paramount goal. Indeed, when the two objectives—price stability and financial stability—briefly appeared to come into conflict
during the crisis, the Federal Reserve made clear that financial
stability took precedence. In addition, weak job growth since the
crisis led the Fed in late 2012 to explicitly list lower unemployment (specifically, an upper-bound target of 6.5 percent) as a
policy goal, though—importantly—it also made clear that this
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Conclusion
commitment was contingent on inflation remaining at or near its
2 percent target.
Expectations
Finally, in all aspects of macroeconomics, expectations constitute
a powerful force for both good and ill. As we have seen, expectations can literally drive reality—particularly in the short run. If
individuals and firms expect inflation, they may actually create it
by preemptively demanding wage and price increases. If currency traders sell dollars en masse on the expectation that the
dollar is about to depreciate, their selling—in most cases—will
cause it to depreciate immediately. The same is true of interest
rates. If bond traders expect the interest rate to rise, they will
drive the long-term interest rate upward as they sell bonds in an
effort to limit their own capital loss.
Negative expectations can prove particularly brutal when they
relate to the economy as a whole. If business managers as a group
suddenly become pessimistic about future demand, their gloomy
expectation can become self-fulfilling. They might prepare for
“bad times” by canceling investment projects and laying off
workers, thus causing a reduction in aggregate demand. At this
point, the Keynesian income multiplier works in reverse, as consumers and business managers respond to the drop in demand
by cutting back further on consumption and investment, potentially setting off a disastrous downward spiral. When this occurs,
actual GDP falls below potential GDP because many productive
resources (including both people and equipment) are thrown
out of work. Real GDP falls, unemployment rises, and prices
tend to decline. (Conversely, if people become overly optimistic
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Conclusion
about their economic fortunes, they may drive demand far
beyond the true productive capacity of the economy. If this
occurs, actual GDP will rise above potential, the economy will
“overheat,” and inflation will increase—all because of irrationally
exuberant expectations.)1
Basic Concepts, Broad Applications: From Dairy
Farmers to Debtor Nations
A
s the reader has no doubt noticed, many of the illustrations
provided in this book—such as the one in chapter 2 in which
Farmer Bill lends 10 cows to Farmer Tom—are contrived. But since
they are rooted in truly fundamental economic problems and
issues, they should nonetheless prove useful to you as you work
to understand real-world economic phenomena.
In our dairy farmer example, Bill lent Tom 10 cows at the
beginning of the year, and Tom promised to repay the loan in
money with10 percent interest. Since the original price of cows
was $1,000 a head, Tom agreed to repay $11,000 at the end of
the year (to cover the original 10 cows plus one more, as interest). The problem arose when the price of cows increased by
10 percent, meaning that Bill would only be able to purchase 10
cows—not 11—with the ultimate repayment of $11,000. Although
this example was useful in illustrating the distinction between real
and nominal interest rates, one might regard it as terribly unrealistic. After all, aren’t loans always paid and repaid in money? When’s
the last time you heard of a loan that was made in goods but was
to be repaid in dollars?
As it turns out, this illustration is not nearly as unrealistic as it
may seem. In fact, the entire US trade deficit rests on precisely
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Conclusion
this type of loan. Consider the US trade deficit with China, for
example. Each year, China exports more output (such as electronics and clothing) to America than it receives in return from
America. The difference, which is composed of real goods and
services (real output), is actually being lent to the United States.
In exchange, the Chinese receive US financial assets, which are
promises to repay—in dollars—in the future. Just like the original
dairy farmer in our illustration, therefore, the Chinese are lending
real output in exchange for a promised repayment in dollars.
Ideally, since the financial assets the Chinese receive generate at
least some interest and dividends (again, in dollars), the recouped
dollars should provide the Chinese with command over more
real output in the future, just as the original dairy farmer expected
to use the $11,000 repayment of his loan to buy 11 new cows
(one more than the original 10 he lent). One problem for the
Chinese is that if US prices rise in the meantime (that is, if the US
suffers inflation), then the Chinese will end up with less command over American goods and services than they expected (just
as, after the price of cows had increased, the first dairy farmer
was surprised that he could only buy 10, rather than 11, cows
with the proceeds of his loan).a Clearly, the dangers of price inflation are not limited to dairy farmers. They are of profound practical significance to all creditors and debtors, including creditor
nations and debtor nations all around the world.
Although this is just one example, there are countless others
like it. If treated with care, the essential principles of macroeconomics can provide profound insight into economic and business
matters, both national and global.
a. Similarly, a depreciation of the US dollar relative to the yuan would leave the
Chinese creditors with less command over Chinese goods and services than they
had expected when they originally made the loans.
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Conclusion
In a sense, one of the main jobs of macroeconomic policy
makers is to manage expectations. During the Great Depression,
when real GDP had fallen sharply and unemployment had
reached dizzying heights, the British economist John Maynard
Keynes recommended aggressive deficit spending (expansionary fiscal policy) to help turn things around. In his view, large
deficits would create new demand for goods and services and,
as a result, would lead people to revise their expectations
upward. As consumers and business managers became more
confident, they would increase their own expenditures, setting
off a virtuous spiral upward, and the economy would come
roaring back to life. (In principle, government policy makers
could also cool expectations during periods of overheating by
running budget surpluses, and thus reducing demand, though
in practice the strategic use of budget surpluses has proved relatively rare.)
Expectations are central not only to fiscal policy, but to
monetary policy as well. By credibly committing to fight inflation relentlessly whenever it appears, central banks can help
kill off inflationary expectations, thus making it far less likely
that their anti-inflation weapons will ever have to be used.
Naturally, the same basic idea also applies to controlling deflation. If central bankers make clear that they will respond
aggressively to even a small drop in the price level, people are
unlikely to expect deflation and, as a result, deflation is less
likely to occur.
Uses and Misuses of Macroeconomics
There can be little doubt that macroeconomists have a great deal
to teach us about the world. At the same time, it is essential to
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Conclusion
keep in mind that macroeconomics is a very inexact science. Just
as it is dangerous to become overconfident about one’s economic
prospects or about the prospects of the economy as a whole, it is
also dangerous to become overconfident about one’s understanding of how the macro economy works. Economic relationships
that seem perfectly compelling in theory do not always hold in
practice. To give just two examples: interest rates do not always
fall when money supply rises, and stagnant economies don’t
always improve in response to deficit spending.
If this is the case, then why study macroeconomics? The
answer, in short, is that macroeconomic theory provides us with
a baseline against which to compare and assess reality and, more
broadly, with a framework for understanding economic events.
When standard macroeconomic relationships break down in
practice (such as when interest rates rise despite increased
money growth), a good understanding of macroeconomics
should help us to ask the right questions and potentially identify
what factor or factors might be causing such a departure from
the rule.
Unfortunately, some students of macroeconomics are so confident about what they have learned that they refuse to see departures at all, preferring to believe that the economic relationships
defined in their textbooks are inviolable rules. This sort of arrogance (or narrow-mindedness) becomes a true hazard to society
when it infects macroeconomic policy making. The policy maker
who believes he or she knows exactly how the economy will
respond to a particular stimulus is a very dangerous policy maker
indeed.
The good news is that when interpreted judiciously, the basic
principles of macroeconomics—which draw connections
between output, money, and expectations—can prove enormously illuminating. Admittedly, we could only scratch the sur-
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Conclusion
face of macroeconomic knowledge in this short book. But if you
keep your eyes open, you may notice that the basic principles
and relationships we have explored here help to shed light on a
surprisingly broad range of phenomena, many of which shape
the business environment and—more concretely—affect the relative risks and rewards of decisions that all of us (including business managers) make every day.
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E p i log u e
The financial crisis of 2007–2009 caught nearly everyone by
­surprise, including the vast majority of economists. In fact, in the
years leading up to the calamity, many economists used the
phrase “The Great Moderation” to characterize the previous two
decades, seeing the period as one of exceptional macroeconomic
stability. Although Ben Bernanke did not invent the term, he
made it famous in a widely celebrated speech in 2004, two years
before he became chairman of the Federal Reserve. Highlighting
a “substantial decline in macroeconomic volatility” since the
mid-1980s, Bernanke suggested that monetary economists and
central bankers deserved a good deal of the credit for taming the
business cycle. As he put it, “improvements in monetary policy,
though certainly not the only factor, have probably been an
1
important source of the Great Moderation.” The idea that a
financial and economic crisis of extraordinary proportions was
just around the corner seemed almost unimaginable, except
­perhaps to a relatively small number of dissident thinkers who
saw the associated run-up in asset prices as an unsustainable
2
bubble.
In retrospect, the moniker “Great Moderation” reveals a certain myopia. To be sure, GDP growth was less volatile than in
earlier periods, and inflation remained subdued. But many other
economic trends that preceded the crisis—including exceptionally low interest rates, a steep rise in housing prices, the proliferation of subprime mortgages, and large increases in leverage
(debt) all across the financial system—were anything but
149
0
1
2
3
4
5
6
7
8
9
0
1
2
3
4
5
6
7
8
9
0
1
2
Epilogue
moderate and, ultimately, laid the basis for collapse. Indeed, it is
difficult to dismiss altogether those who see the financial crisis of
2007–2009 as a challenge to modern economics or, at least, as
3
evidence of its limits.
Yet, at the same time, the response to the crisis—particularly
in the United States—reflected dramatic progress relative to the
early 1930s, when poor macroeconomic policy almost certainly
compounded the nation’s mounting economic troubles and may
well have ensured a deep depression. American policy makers in
the early thirties largely pursued tight fiscal and monetary policies, with lawmakers from both major political parties endorsing
balanced budgets as a weapon against the economic downturn
and officials at the Federal Reserve championing a policy of “liquidationism” for ailing banks and strict adherence to the gold
standard, even to the point of sharply raising interest rates in
October 1931 to stem gold outflows.
By contrast, in responding to the mounting crisis of 2007–
2009, key US policy makers from both parties implemented
expansionary fiscal policies, including tax cuts and spending
increases, and officials at the Federal Reserve dramatically eased
monetary policy, lending aggressively to troubled financial institutions and going to unprecedented lengths to drive down interest rates (see table E-1). Despite ongoing debates among
macroeconomists, the fact that the financial crisis of 2007–2009
never turned into a Second Great Depression suggests that
American policy makers may have learned something important
since the 1930s about how to manage economic policy in the
face of a major financial crisis.
Bernanke, no doubt, will remain a controversial figure for
many years to come. His decisions as Federal Reserve chairman
to help rescue key financial institutions, to push the federal
funds rate essentially to zero, and to engage in nontraditional
150
−9.3
−8.9
−7.1
−4.3
2010
2011
2012
2013
0.07
0.09
0.04
0.13
0.05
0.14
3.06
5.17
Federal
funds rate
(%)a
4,033
2,926
2,926
2,421
2,234
2,240
891
871
Total assets of
the Federal
Reserve
($ billions)a
5
11
31
80
1,227
515
2
0
Total deposits of
failed or assisted
banks ($ billions)b
1.9
2.8
1.8
2.5
−2.8
−0.3
1.8
2.7
Real GDP
growth
(annual %
change)b
6.7
7.9
8.5
9.4
9.9
7.3
5.0
4.4
Unemployment
rate (%)a
1,848.36
1,426.19
1.5
1,257.60
2.1
1,257.64
1,115.10
903.25
1,468.36
1,418.30
S&P500
Indexa
3.2
1.6
−0.4
3.8
2.8
3.2
Inflation
rate (%
change
CPI)b
a. At end of year.
b. For full calendar year.
Sources: Federal deficit: Historical Budget Data, February 2014, Congressional Budget Office, http://www.cbo.gov/publication/45067; federal funds rate: “Selected Interest
Rates (Daily),” Federal Reserve Statistics Release H.15, http://www.federalreserve.gov/releases/h15/data.htm; total assets of the Federal Reserve: “Factors Affecting Reserve
Balances,” Federal Reserve Statistical Release H.4.1, http://www.federalreserve.gov/releases/H41/default.htm; total deposits of failed or assisted banks: “Federal Deposit
Insurance Corporation Failures and Assistance Transactions United States and Other Areas,” Table BF01, FDIC website, http://www2.fdic.gov/hsob; real GDP growth: National
Income and Product Account Tables: Percent Change From Preceding Period in Real Gross Domestic Product (Table 1.1.1), Bureau of Economic Analysis, http://www.bea.
gov/iTable/index_nipa.cfm; unemployment rate: “Labor Force Statistics from the Current Population Survey: Unemployment Rate,” Bureau of Labor Statistics, http://data.bls.
gov/timeseries/LNS14000000); inflation rate (CPI): Consumer Price index, All Urban Consumers (CPI-U), Avg-Avg, Percent Change, Bureau of Labor Statistics, ftp://ftp.bls.gov/
pub/special.requests/cpi/cpiai.txt; S&P500 index: S&P500 Historical Prices, Yahoo Finance, http://finance.yahoo.com/q/hp?s=^GSPC+Historical+Prices.
−4.4
−10.8
2009
−2.4
2007
2008
−3.2
2006
Federal surplus
(+) or deficit (-),
on-budget
(% GDP)a
Financial crisis: response and recovery in the United States, 2006–2013
TABLE E-1
0
1
2
3
4
5
6
7
8
9
0
1
2
3
4
5
6
7
8
9
0
1
2
Epilogue
and very-large-scale asset purchases (known as quantitative
­easing), which expanded the Fed’s balance sheet more than fourfold from 2007 to 2013, are widely thought to have tested the
limits of monetary policy. These choices were informed by
decades of academic research, particularly in the field of economic history, which suggested US policy responses in the early
years of the Great Depression could hardly have been worse. The
gold standard, in particular, seemed to operate as a straitjacket in
the early 1930s, forcing central bankers to tighten monetary policy at precisely the moment when markets desperately needed
additional liquidity. In fact, Bernanke had himself made important contributions to this literature—as an economics professor
at Princeton—and thus it should not be entirely surprising that
he would chart such an aggressive course as Fed chairman in
responding to the financial crisis of 2007–2009. As a student of
both economic history and macroeconomics, he believed that
overly restrictive Fed policies in the early 1930s had proved catastrophic, and he was determined not to fall into the same trap.
It is still too early to say how history will judge Bernanke’s
approach to fighting the financial crisis. Critics claim that the
ultra-low interest rates and quantitative easing he helped engineer will ultimately prove inflationary, and that the massive
­bailouts he made possible will invite financial recklessness in the
future (as a result of moral hazard). Critics also contend that the
economy would have recovered on its own—and perhaps even
more rapidly—without these radical measures. Supporters,
meanwhile, believe that Bernanke’s bold steps helped to head off
a far more severe crisis, and perhaps even prevented a Second
Great Depression.
A similar debate has been swirling around fiscal policy as well.
Proponents maintain that fiscal expansion in the form of
increased budget deficits prevented a devastating downward
152
Epilogue
economic spiral and helped to get the economy moving again
after the crisis, while opponents of these intentional deficits view
them as an assault on business confidence and an unnecessary
burden on future generations of taxpayers.
It will be up to historians, over subsequent decades, to sort
out these conflicting views. At the time of this writing, however,
early indications suggest that aggressive monetary and fiscal policy may have played a positive role—and potentially a very significant one. Diverging macroeconomic policies in Europe and
the United States in response to the financial crisis offer a precious window onto the effectiveness of alternative approaches.
In both Europe and the United States, central bankers cut
interest rates and injected large amounts of liquidity as the crisis
intensified. Policy makers in both regions also passed a variety of
stimulus packages, intentionally increasing budget deficits to
boost economic activity as demand slumped in the wake of the
crisis. But officials in the United States proved more aggressive
on both fronts. The Federal Reserve dropped short-term rates
both further and faster than did the European Central Bank.
Significantly, the ECB held more rigidly to a policy of inflation
targeting, which led it to reduce interest rates more slowly—and
even to raise rates slightly in July 2008, as the financial storm
was gaining strength—because inflation remained above its
2 percent target. Similarly, on fiscal matters, budget officials in
the United States pursued expansionary policies (that is,
increased budget deficits) on a larger scale and over a longer time
period than their counterparts in Europe, who ultimately
adopted austerity programs more quickly than in America.
Although it is still too early to draw a definitive conclusion,
more expansionary macro policies in the United States appear to
have been associated with a stronger recovery—higher GDP
growth, without significant inflation—as compared to the
153
0
1
2
3
4
5
6
7
8
9
0
1
2
3
4
5
6
7
8
9
0
1
2
Epilogue
euro area. Certainly, the American economic recovery remained
­anemic through the end of 2013, with annual real growth rates
consistently under 3 percent. But growth was smaller still in the
euro area and even turned negative in 2012 and 2013. (For a
summary of macro policies and outcomes in the United States
and the euro area from 2006 to 2013, see table E-2.)
Notably, by the start of 2014, the British experience seemed to
fall squarely between those of the United States and the euro
area. The Bank of England reduced interest rates further and
faster than the ECB, but neither as far nor as fast as the Federal
Reserve. Similarly, British fiscal policy was arguably more expansionary than in the euro area during the early stages of the crisis,
but turned toward austerity more rapidly and more decisively
than in the United States. Perhaps in part as a result, Britain’s
economic performance also occupied a middle position, with
real GDP growth slower than the United States but faster than
the euro area by 2012–2013 (see table E-2).
There is no guarantee that these trends will hold up over the
coming years. For example, the US economy could falter, while
the economies of Britain and the euro area could surge ahead.
Critics of expansionary policies claim that the American economy has become dangerously dependent on monetary and fiscal
stimulation, that ultra-low interest rates have generated a stock
market bubble, and that consumer inflation will soon rear its
ugly head in the United States. Whatever the case, it seems likely
that economic historians will look back at the years since 2007
as a grand natural experiment for assessing the effectiveness of
alternative macroeconomic responses to a financial crisis. Early
indications are that more activist policies have proved dramatically more successful than the orthodox policies of the early
1930s, particularly in the United States, and that America’s more
aggressive stance (in both monetary and fiscal policy) has given
154
−12.2
−10.7
−9.3
−6.5
2010
2011
2012
2013
3.06
0.14
0.05
0.13
0.04
0.09
0.07
−2.1
−6.4
−6.2
−4.1
−3.7
−2.9
−5.1
−6.9
−6.2
−7.9
−10.0
−11.2
5.17
−0.7
b
Fed
−1.4
euro area
−3.0
−2.9
UK
0.50
0.50
0.50
0.50
0.50
2.00
5.50
5.00
UK
0.25
0.75
1.00
1.00
1.00
2.50
4.00
3.50
ECB
Central bank: benchmark
interest rate (end of year)
1.7
2.8
1.8
2.5
−2.8
−0.3
1.8
2.7
US
1.4
0.1
1.1
1.7
−5.2
−0.8
3.4
2.8
UK
−0.4
−0.6
1.6
1.9
−4.4
0.2
3.0
3.4
euro area
1.5
2.1
3.1
1.6
−0.3
3.8
2.9
3.2
US
2.6
2.8
4.5
3.3
2.2
3.6
2.3
2.3
UK
1.4
2.5
2.7
1.6
0.3
3.3
2.1
2.2
euro area
7.5
8.1
8.9
9.6
9.3
5.8
4.6
4.6
US
7.8
7.9
8.1
7.9
7.6
5.7
5.4
5.5
UK
12.0
11.3
10.1
10.0
9.5
7.5
7.5
8.3
euro
area
Real GDP growth (annual Consumer price inflation Unemployment rate
% change)
(annual % change)
(annual average, %)
General notes: US figures presented in this table may differ from figures in table E-1 because most columns are drawn from a different data source (OECD) for ease of ­comparison to the
United Kingdom and the euro area. Also, data drawn from the OECD includes partial estimates for 2013.
a. Figures differ from table E-1 because the data here reflects general government deficits (federal and state), whereas table E-1 presents federal deficits only.
b. The rates shown here reflect the actual federal funds rate, not the targeted rate.
Sources: OECD Economic Outlook 94 Database, Annex Table 27 (General government financial balances), Annex Table 1 (Real GDP), Annex Table 18 (Consumer price ­indices), Annex
Table 13 (Unemployment rates: commonly used definitions), http://www.oecd.org/eco/outlook/economicoutlookannextables.htm; “Selected Interest Rates (Daily),” Federal Reserve
Statistics Release H.15, http://www.federalreserve.gov/releases/h15/data.htm; Key ECB Interest Rates, European Central Bank http://www.ecb.europa.eu/stats/monetary/rates/html/
index.en.html; Monetary Policy Committee Decisions, Bank of England, http://www.bankofengland.co.uk/monetarypolicy/Pages/­decisions.aspx.
−7.2
−12.8
2009
−3.7
2007
2008
−3.1
2006
US
a
General government
surplus/deficit (% GDP)
Macroeconomic policy and performance in the United States, United Kingdom, and euro area, 2006–2013
TABLE E-2
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Epilogue
it an edge over Europe in recent years. But, of course, the jury is
still out.
The financial crisis of 2007–2009 leaves us with many questions: about what sorts of macroeconomic policies are most
effective, but also, perhaps, about the limits of macroeconomic
policy and macroeconomics itself. Whether effective or not, the
dramatic and unconventional measures that the Federal Reserve
deployed during and after the crisis—ranging from financial rescues to quantitative easing—have provoked growing debate
about the meaning of central bank independence, the limits of
technocratic solutions, and the need for democratic accountability. In a 2013 speech about central bank independence, the former vice chairman of the Federal Reserve Board of Governors,
Donald Kohn, observed:
We are going through an extraordinary period in business
cycles and central banking. The too-calm, too-confident
veneer of the Great Moderation was shattered by the worst
financial crisis in eighty years. The Federal Reserve—indeed
central banks all over the industrial world—took
extraordinary actions to make sure the crisis was not
followed by an economic result like that of the 1930s, and
they continue to pursue policies that not so long ago would
have been considered unthinkable.
Naturally, understandably, and appropriately, these
circumstances have increased the scrutiny of central banks
and raised questions about the goals, governance, and
accountability of these institutions. . . The risks and threats
4
to independence have increased.
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Epilogue
The Federal Reserve’s unprecedented response to the financial
crisis, in other words, should provoke us to think in new ways
not only about the economics of monetary policy, but about the
politics—and possibly the political limits—of monetary policy
as well.
Ultimately, the crisis should remind us that macroeconomics
must be a humble discipline. The fact that the crisis seemed to
strike without warning and provoked such intense debate among
experts about how best to respond suggests, as I wrote in the
final paragraphs of the first edition, that “macroeconomics is a
very inexact science.” Although macroeconomists have a great
deal to teach us, they surely don’t have a crystal ball. We also
have to be careful not to become infatuated with the orderliness
of simple models, since the real world remains a very messy
place. A good understanding of macroeconomics can help us
think about the economy in a more systematic and more productive way, but it cannot eliminate uncertainty or the countless
shocks and surprises that shape economic life. My hope is that
readers of this volume will come to appreciate both the power
and the limits of macroeconomic thinking, particularly now, in
the wake of the financial crisis of 2007–2009.
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G los sary
actual output
See potential output.
aggregate price level
See price level.
balance of payments (Bop) accounts
Summary record of a country’s cross-border transactions,
­typically over a given year. See also current account, ­financial
account.
balance on goods and services
Exports of goods and services minus imports of goods and
services, where “goods” refers to tangible products (merchandise) and “services” refers to intangible products (such as
shipping, investment banking, or consulting services). See
also trade balance.
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Glossary
bank run
A scenario in which a large proportion of a bank’s depositors
try to withdraw their funds at the same time, potentially
“breaking” the bank (i.e., forcing it into default).
bubble (or speculative mania)
A steep increase in asset prices not justified by economic fundamentals; an unsustainable increase in asset prices that may
be followed by a sudden and sharp drop (i.e., a crash).
business cycle
Temporary fluctuations in overall economic activity; temporary
departures above and below an economy’s long-term growth trend.
capacity utilization
Measures the degree to which a nation’s (or a firm’s or an
industry’s) capital stock is actually employed in the production of output. The capacity utilization rate is the ratio of
actual output to an estimate of capacity, where capacity is
defined as maximum sustainable output given existing plant
and equipment and realistic work hours.
capital account
A line item on the balance of payments that reflects unilateral
transfers of capital, such as the forgiveness of one country’s
debts by the government of another country. Prior to the
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Glossary
1990s, the “capital account” on the balance of payments
recorded all cross-border capital (financial) flows, but this
account is now called the “financial account.” See also
­financial account.
central bank
Historically, a bank that provided banking services to other
banks and, often, to the government; today, a central bank is
typically the institution that exercises authority over a nation’s
monetary policy. The central bank in the United States is
called the Federal Reserve.
consumption
Component of GDP that includes all expenditures by households on new goods and services for current use.
crawling peg
See pegged exchange rate.
crowding out
The reduction in private investment that may ensue when the
government runs a budget deficit. Note that a budget deficit
(i.e., new government borrowing) implies increased government demand for investment funds, which may “crowd out”
private investment by bidding up the interest rate faced by
private investors.
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Glossary
currency
The most liquid form of money, including bills and coins,
­typically issued by the government. Currency is said to be “in
circulation” when it is held outside of a bank vault. The term
“currency” may also be used to refer to a national unit of
account—such as the US dollar or the Mexican peso.
current account
A major item on the balance of payments that records a c­ ountry’s
international transactions for current use, including net exports of
goods and services, net income, and net transfers. (Note, in the
International Monetary Fund’s revised presentation of balance of
payments [BPM6], net income and net transfers are referred to as
“primary income” and “secondary income.”) The current account
also reflects the amount of net lending to foreigners (or, in the case
of a current account deficit, net borrowing from foreigners).
cyclical fluctuations
Temporary departures from the long-term (secular) trend of
an economic variable. See also secular trend.
deficit spending
Government spending financed on the basis of borrowed
funds, rather than tax revenues.
demand deposit
A bank account, such as a checking account, in which the
deposited funds can be withdrawn or transferred by the
account holder on demand.
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Glossary
depreciation
Decrease in value of fixed capital owing to wear and tear,
­damage or destruction, or obsolescence. The term “depreciation” may also be used in relation to a national currency or
other financial asset to indicate decline in value due to market
conditions.
depression
An extended period of economic stagnation or contraction,
typically characterized by very low or negative real GDP
growth, high unemployment, and low capacity utilization. See
also recession.
discount rate
The rate of interest that a central bank charges on loans to
commercial banks. Traditionally, central banks made these
loans by buying assets from commercial banks at a small discount—hence the term “discount rate.”
errors and omissions
A residual category on the balance of payments reflecting
­statistical discrepancies in the compilation of BOP data.
exchange rate
The price of one national currency in terms of another (e.g.,
the number of Japanese yen needed to purchase 1 US
dollar).
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Glossary
exchange rate peg
See pegged exchange rate, fixed exchange rate.
expenditure method
A method for calculating GDP, based on expenditures for final
goods and services. According to this approach a country’s
GDP equals the sum of its consumption expenditures, investment expenditures, government expenditures, and net exports
(exports minus imports).
exports
Foreign purchases of domestically produced goods and
services.
federal funds rate
A key short-term interest rate in the United States that the
Federal Reserve targets in setting monetary policy; specifically,
the rate that commercial banks in the United States charge
each other on overnight loans.
final goods and services
Output that is expected to be used (in the current year) and
not resold.
financial account
A major item on the balance of payments that records a
­country’s international financial transactions, including net
flows of foreign direct investment and portfolio investment.
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Glossary
fiscal policy
Use of government taxation or spending to influence macroeconomic performance (GDP growth, unemployment, inflation, etc.).
fixed exchange rate
An exchange rate that is officially set by a national government
or central bank, typically by promising to buy or sell the
national currency for foreign exchange reserves, on demand,at
the fixed rate. See also floating exchange rate, gold standard.
floating exchange rate (or flexible exchange rate)
An exchange rate that is permitted to move freely (appreciate
or depreciate), based on supply and demand conditions
within the global marketplace. In a pure floating regime, the
government never uses its foreign currency reserves to stabilize (or otherwise influence) the exchange rate. See also fixed
exchange rate.
foreign borrowing
Capital inflows from abroad. These inflows (or borrowing)
may take many forms, including foreign deposits in
­domestic banks, foreign purchases of domestic securities
(including stocks and bonds), foreign direct investment
(including foreign purchases of domestic companies), and
so forth. A country engages in net borrowing from abroad
whenever its current account is in deficit, which broadly
indicates that the country’s expenditures exceed its
­production of output.
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foreign direct investment (FDI)
Involves the cross-border purchase of an equity stake in a
company that is large enough (usually greater than 10 ­percent)
to give the foreign owner managerial influence in the company. When Daimler-Benz bought Chrysler in 1998, this represented German FDI in the United States. See also portfolio
investment.
funded pension system
A retirement program in which workers save for their own
retirement (or in which other parties, such as their employers,
save on their behalf) by purchasing financial assets, from
which the workers will derive income when they retire.
gold standard
A type of fixed exchange rate in which the price of a currency is
officially set (or fixed) in terms of gold. For example, from 1946
to 1971, the US government set the price of the US d
­ ollar at $35
per ounce of gold (although in this case only foreign central
banks—not individuals or firms—were permitted to exchange
dollars for gold at this rate). See also fixed exchange rate.
government expenditure
Component of GDP that includes all government spending on
goods and services, at all levels of government (federal, state, and
local), but does not include transfer payments (such as welfare or
social security benefits). The definition may or may not include
government spending on fixed capital stock, depending on how
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Glossary
the country in question classifies government investment (i.e., as
government expenditure or as investment). See also investment.
Great Depression
The long period of economic decline and stagnation that characterized the 1930s in many countries around the world.
gross domestic product (GDP)
The most widely accepted measure of a country’s total output;
often defined as the market value of all final goods and services produced within a country over a given year. See also
gross national product, depreciation.
gross national product (GNP)
The market value of all final goods and services produced by a
country’s residents over a given year, regardless of where the
output is produced (i.e., at home or abroad). In technical
terms, gross national product (GNP) includes net income
receipts from abroad (sometimes called net international factor receipts), while gross domestic product (GDP) excludes
them. See also gross domestic product.
hot money
See portfolio investment.
imports
Domestic purchases of foreign-produced goods and services.
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Glossary
income
Payment to labor and capital for their respective contributions
to the production of output; distributed in the form of wages
and salaries, profit, interest, rent, and royalties.
income multiplier
The ratio of expected change in GDP to the autonomous
change in expenditure used to generate it. For example, if a
$100 increase in government deficit spending ultimately leads
to a $200 increase in GDP, then the income multiplier would
be $200/$100, or 2.
inflation
An increase in the average level of prices across an economy.
The term is sometimes used as a shorthand for “consumer
price inflation,” which refers to an increase in the average level
of consumer prices (as reflected, for example, by an increase in
the cost of a representative basket of consumer goods).
inflation targeting
A monetary strategy in which a central bank aims to keep the
rate of inflation at or near a target (e.g., 2 percent), typically
by raising or lowering the short-term interest rate, as needed.
inflationary expectations
Assumptions (or predictions) about future changes in the
price level (i.e., future inflation).
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Glossary
investment
Component of GDP that includes all expenditures intended to
increase future output of final goods and services. Investment
expenditures typically include business purchases of fixed
structures, equipment, software, and inventory, as well as the
cost of new owner-occupied homes. Many countries include
government investment—such as spending on new roads and
bridges—in this category, but others (including the United
States) do not.
labor productivity
See productivity.
Laffer curve
A graphic representation of the relationship between tax rates
and tax revenues (originally suggested by economist Arthur
Laffer), in which revenues are shown to be zero at tax rates of
both 0 percent and 100 percent; often used to suggest that tax
revenues may rise when tax rates are reduced from sufficiently
high levels.
lender of last resort
An institution—often a public institution, such as a central
bank—that is able and willing to lend to financial institutions
(and particularly to banks) during liquidity crises, when other
potential lenders in the private sector are either unwilling or
unable to lend.
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Glossary
liquidity trap
A scenario suggested by the British economist John Maynard
Keynes in which monetary policy could prove impotent, particularly within the context of a financial crisis. If, in the face
of very low interest rates, central bankers find it impossible to
lower interest rates further through open market purchases
(i.e., by purchasing government bonds with newly issued currency), then monetary policy will no longer be an effective
tool for stimulating additional consumption and investment.
As some economists have described it, pushing more money
at this point is about as effective as “pushing on a string.”
monetary base
Equal to the total liabilities of the central bank; includes all
currency outstanding plus commercial bank deposits at the
central bank (known as reserves).
monetary policy
The efforts of a central bank to influence economic performance (for example, to maintain a target rate of inflation)
through manipulation of the money supply and short-term
interest rates.
money
A medium of exchange that is widely accepted as payment for
goods and services and in financial transactions; a highly liquid form of wealth that is itself a means of payment or is easily
converted into a means of payment.
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Glossary
money identity
M × V = P × Q, where M is the money supply, V is the velocity
of money, P is the price level, and Q is the quantity of output
produced (i.e., real GDP). See also money supply, velocity of
money, price level, real.
money illusion
A phenomenon whereby individuals confuse nominal and
real values—e. g., mistakenly view changes in their nominal
wage, uncorrected for changes in the price level (inflation or
deflation), as an accurate measure of changes in their real purchasing power.
money multiplier
The ratio of the total money supply to the monetary base. If
the money multiplier is 2 and the central bank increases the
monetary base (i.e., its liabilities) by $100, then we would
expect total money supply to rise by $200. See also money
supply, monetary base.
money supply (or money stock)
The quantity of money at a particular moment in time.
Economists define a range of monetary aggregates—M1, M2,
M3, and so forth—that correspond to progressively broader
notions of money. For example, whereas M1 includes ­currency
in circulation and demand deposits, M2 includes currency in
circulation and demand deposits as well as time deposits (or
savings accounts).
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Glossary
national economic accounts
Another name for the GDP accounts, which normally include
measures of GDP as well as its major components (consumption, investment, government expenditure, exports, and
imports).
natural rate of unemployment
Also known as the nonaccelerating inflation rate of unemployment (NAIRU), it is the rate of unemployment below which
inflation is likely to accelerate.
net domestic product (NDP)
Gross domestic product (GDP), less depreciation of the capital
stock. See also gross domestic product.
net exports
Exports minus imports. See also exports, imports.
net factor receipts
See net income.
net income (or net factor receipts)
Income receipts minus income payments in the current
account of the balance of payments. Income receipts include
compensation paid by foreigners to domestic residents (e.g.,
for work done abroad), interest and dividends from foreign-
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Glossary
ers on domestic holdings of foreign assets, and reinvested
earnings on foreign direct investment (FDI) abroad; income
payments include compensation paid to foreigners by
domestic residents (or firms), interest and dividends paid to
foreigners on foreign holdings of domestic assets, and reinvested earnings on FDI in the domestic economy. Net
income is referred to as “primary income” in the International
Monetary Fund’s revised presentation of balance of payments (BPM6).
net present value (NPV)
The present discounted value of the revenues from a project
minus the present discounted value of its costs; used to assess
the project’s expected profitability.
net unilateral transfers (or net transfers)
An element of the current account on the balance of payments
that reflects nonreciprocal transactions such as foreign aid or
cross-border charitable assistance (given through the Red
Cross, for example). Net transfers are referred to as “secondary income” in the International Monetary Fund’s revised
­presentation of balance of payments (BPM6).
nominal
A measure expressed in (or relative to) current market prices
and thus uncorrected for inflation—e.g., nominal GDP, nominal wage, nominal interest rate, nominal exchange rate. See
also real.
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official reserves
An element of the financial account on the balance of payments
that reflects increases or decreases in the government’s stockpile
of foreign currencies (foreign exchange) and monetary gold.
open market operations
The purchase or sale of securities on the open market by the central bank, for the purpose of raising or lowering the monetary
base (and thus lowering or raising the short-term interest rate).
output
The goods and services produced in an economy.
overheating
Rapid and unsustainable GDP growth, in which actual GDP
exceeds potential GDP; typically associated with rising inflation.
pay-as-you-go pension system
A retirement program, often run by the government, in which
benefits are paid to current retirees solely on the basis of current contributions from—or taxes levied on—current workers
(i.e., future retirees).
pegged exchange rate
Generally the same as a fixed exchange rate (see fixed
exchange rate). However, under a “crawling peg,” the official
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Glossary
exchange rate (i.e., the peg) is allowed to change gradually
over time (e.g., by a small percentage per month) and, in some
cases, is allowed to float within a narrow band, the boundaries
of which are themselves allowed to change gradually over
time.
Phillips curve
A graphical representation of the apparent trade-off between
the rate of unemployment and the rate of inflation; based on
an empirical finding first highlighted by economist
A. W. Phillips.
portfolio investment (or portfolio flows)
Cross-border purchases of stocks, bonds, and other financial
instruments, but not in sufficient concentrations to allow
managerial influence. Portfolio investment is sometimes
referred to as “hot money,” since portfolio investors can often
liquidate their holdings and exit a country at almost a
moment’s notice.
potential output
The output (GDP) an economy could produce, given the
existing state of technology, if all of its resources (labor and
capital) were employed at a sustainable level of intensity.
When actual output is significantly below potential output,
the economy is said to be in recession; when actual output is
significantly greater than potential output, the economy is
said to be overheating.
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Glossary
price deflator (or price index)
A measure of the price level. The GDP price deflator (P) equals
nominal GDP divided by real GDP. See also price level.
price level
Essentially the average of all prices (or a subset thereof) at a
given moment in time. The percentage change in the price
level from one year to the next is the annual inflation rate.
price rigidity
Prices are said to be “rigid” (or “sticky”) when they do not
immediately adjust to bring supply and demand into balance
in the face of changing market conditions.
productivity
Output per unit of input. The term is often used as a shorthand for “labor productivity,” which is defined as output per
worker or output per worker hour. See also total factor
productivity.
purchasing power parity (PPP)
Drawn from the Law of One Price, the PPP model of exchangerate determination holds that a unit of currency should always
have the same purchasing power in one country as in another,
excluding transportation costs and taxes. If PPP exists between
two countries, and Country A then experiences higher inflation than Country B, the PPP model predicts that Country A’s
176
Glossary
currency will have to depreciate relative to Country B’s until
parity is restored. One shortcoming of this model is that markets do not ensure that the Law of One Price holds for goods
and services that are not traded in the international marketplace. To address this, economists have created PPP indexes
that estimate the purchasing power of a common unit of currency (typically a dollar) with respect to all goods and
­services—both those that are traded internationally (such as
cars) and those that are not (such as haircuts). If Country X
has a PPP index of 1.5 relative to the US dollar, then $1.00
worth of Currency X (at market exchange rates) would be able
to purchase goods and services in Country X worth $1.50 in
the United States. As a result, adjusting GDP per capita
according to a PPP index, rather than on the basis of market
exchange rates alone, may provide a more meaningful comparison of living standards across countries.
quantitative easing
Unconventional monetary measures that involve continued
open market purchases of financial assets by a central bank
even after the benchmark short-term interest rate has been
driven effectively to zero. Under conventional monetary policy, open market operations are typically used to set the
benchmark short-term interest rate (known as the federal
funds rate in the United States). In response to the financial
crisis of 2007–2009, the Federal Reserve had already pushed
the federal funds rate near zero by late 2008, yet it continued
large-scale purchases of assets (including long-term instruments, ranging from mortgage-backed securities to corporate
debt to government bonds)—a policy widely characterized as
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Glossary
“quantitative easing.” Many observers claimed that the Federal
Reserve adopted this policy in an effort to lower long-term
interest rates. The term “quantitative easing” was first used to
describe unconventional monetary measures adopted by the
Bank of Japan beginning in 2001.
rational expectations
Expectations (or forecasts) that are based on all available
information and that avoid systematic errors.
real
A measure expressed in (or relative to) constant prices, and
thus corrected for inflation (e.g., real GDP, real wage, real
interest rate, real exchange rate). See also nominal.
real exchange rate
A measure that adjusts the nominal exchange rate between
two countries to control for differences in inflation between
those two countries. If the nominal exchange rate of Currency
A in terms of Currency B has been stable, but Country A has
experienced sharply higher inflation than Country B, then
Country A’s real exchange rate will have appreciated.
recession
A period of general economic contraction, typically characterized by negative real GDP growth, a higher-than-normal unemployment rate, and a lower-than-normal capacity utilization
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Glossary
rate. Although there is no universally accepted definition of a
recession, one rule of thumb is that a recession involves at least
two consecutive quarters of negative real GDP growth.
reserve requirement
The proportion of total deposits that a bank must, by law,
hold on reserve (and thus not lend out). These reserves are
generally held as deposits at the central bank.
Ricardian equivalence
The notion that individuals will react to a government budget
deficit by increasing current savings (rather than consumption),
based on their rational expectation that increased government
borrowing today will require higher taxes in the future. If true,
this response on the part of individuals would limit or potentially negate the effects of expansionary fiscal policy.
secular trend
The long-term direction or trajectory of an economic variable.
See also cyclical fluctuations.
sticky wages
Wages are said to be “sticky” when they do not immediately adjust
to bring supply and demand into balance in the face of changing
market conditions. They are said to be “sticky on the downside”
when they rise more easily than they fall, even in the face of precisely opposite market pressures. See also price rigidity.
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total factor productivity
A measure of the efficiency with which labor and capital are
used in producing output in an economy. An increase in output that is not attributable to an increase in either labor or
capital is attributed, by definition, to an increase in total factor
productivity.
trade balance
Exports minus imports. This may refer either to the balance
on goods (merchandise) or to the balance on goods and
­services.
transfer payments
Payments—typically by governments in the form of welfare or
social security benefits—that are not associated with the production of output. Transfer payments are not counted as part
of government expenditure (G) in calculating GDP.
unemployment rate
The percentage of people in the labor force who are not working but are actively looking for work.
unit labor costs (ULC)
Employee compensation per unit of output produced. Unit
labor costs rise when compensation costs increase faster than
labor productivity, and fall when compensation costs increase
more slowly than labor productivity.
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Glossary
value added
The value of output as measured by its sales price, less the
cost of the nonlabor inputs used to produce it.
velocity of money
The ratio of nominal GDP (P × Q) to the money supply (M);
sometimes characterized loosely as the speed at which money
circulates within an economy.
wage and price controls
Legal restrictions on allowable movements (changes) of
wages, prices, or both.
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Notes
Chapter One
1. Products that remain unsold are also counted as part of GDP.
Specifically, they are classified as additions to business inventory and
thus as an implicit form of business expenditure (investment).
2. Ideally, the electric saw would be added to national output when
it was first purchased (as investment) and then gradually subtracted from
output as it depreciates (that is, as it is itself consumed in the production
process). This approach would yield a net measure of national output
(i.e., net of depreciation), commonly called net domestic product, or
NDP. Because depreciation can be difficult to measure, however, it is
often ignored in calculating national output. As a result, economists and
policy makers typically rely more heavily on gross domestic product
(GDP) than on net domestic product (NDP).
3. It is important to remember that income is not the same as
wealth. Your income is the amount you earn each year, through your
employment and the distributed returns on your investments. Wealth
reflects the investments themselves, derived from your accumulated
­savings over all previous years.
4. Another reason why countries sometimes wish to run trade
­surpluses (and aggressively pursue foreign markets) is to increase
demand for domestically produced goods and services—or, to put it
another way, to ensure an outlet for their production. We will return to
the concept of aggregate demand management later in this chapter and
in chapter 3.
5. The classic example of how efficiency can be increased through
reorganization and specialization of tasks comes from the eighteenthcentury economist Adam Smith. Smith maintained that the proper
­division of labor could sharply increase efficiency. Illustrating this point
by describing how pins are made, he observed that “a workman not
­educated to this business [of pin making]. . . could scarce, perhaps, with
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Notes
his utmost industry, make one pin in a day, and certainly could not make
twenty.” He proceeded to explain, however, that when tasks were appropriately divided and allocated among ten workers, they were able to
­produce “upwards of forty-eight thousand pins in a day.” The trick was
for each worker to specialize: “One man draws out the wire, another
straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for
receiving the head” and so on. See Adam Smith, An Inquiry into the Nature
and Causes of the Wealth of Nations (1776), bk. I, ch. 1, para. 3.
6. Herbert Hoover, address to the American Bankers’ Association,
October 2, 1930.
7. Franklin Roosevelt, inaugural address, March 4, 1933.
8. John Maynard Keynes, The Means to Prosperity (New York:
Harcourt Brace, 1933).
9. Some types of wealth—such as inventories of corn or other agricultural products—can actually be consumed directly, but most cannot.
10. International Monetary Fund, World Economic Outlook database, April 2013 (estimates of GDP per capita in US$ at market exchange
rates). Based on a purchasing power parity (PPP) measure, GDP per capita was $369 in the Democratic Republic of the Congo and $625 in
Burundi in 2012. On purchasing power parity, see chapter 5.
Chapter Two
1. David Hume, “Of Money,” in Political Discourses (1752).
2. It is not hard to see that the deflator had to equal 1.00 in 2005,
since we selected 2005 as the base year in this example (i.e., the year
from which a constant set of prices was derived). A standard convention
for presenting price deflators (in macroeconomic charts and tables) is to
multiply them by 100. A deflator of 1.00 would thus be presented as
100, and a deflator of 2.00 as 200.
3. When, in rare circumstances, short-term rates exceed long-term
rates, the yield curve is said to be inverted. Some economists interpret an
inverted yield curve as a sign of an impending recession.
4. An annual interest rate of 1,000 percent may seem fanciful.
However, loan sharks and other predatory lenders often charge exorbitant rates—in this range and even higher—on short-term loans to cashstarved borrowers. Note that a daily interest rate of just 0.66 percent is
equivalent to an annual rate of approximately 1,000 percent. In fact,
predatory lending of this sort is more common than generally thought.
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Notes
The US Department of Defense, for example, reported in 2006 that
­ redatory lending targeting members of the armed forces was “prevap
lent.” Of particular concern were so-called payday loans, in which military personnel borrowed small sums for approximately two weeks until
“the next payday” at interest rates ranging from 390 percent to
780 ­percent on an annual basis. See US Department of Defense, Report on
Predatory Lending Practices Directed at Members of the Armed Forces and
Their Dependents (Washington, DC, August 9, 2006), esp. 10.
5. Although inflations of this magnitude are rare, they are not
unheard of. Since 1970, more than a dozen countries have experienced
annual inflation of greater than 1,000 percent, including (among others)
Angola, Argentina, Bolivia, Brazil, Democratic Republic of the Congo,
Croatia, Kazakhstan, Peru, and Ukraine. During Israel’s triple-digit inflation of the early 1980s, an oft-repeated joke asked whether it was better
to travel from Tel Aviv to Jerusalem by bus or cab. The answer: in a time
of extreme inflation, it is better to travel by cab, since the traveler pays
for the bus at the beginning of the trip but for the cab at the end (by
which time, presumably, one’s money had already depreciated in value).
6. Under its exchange-rate peg, the Mexican central bank committed
to maintain the peso–dollar exchange rate within a relatively narrow band
(by agreeing to buy or sell pesos for dollars, as needed, at prices within
the band). This gave many foreign investors confidence that, so long
as the peg held, they would not face a sharp depreciation of the peso.
7. Irving Fisher, The Money Illusion (New York: Adelphi Co., 1928).
8. Although the Federal Reserve decides how much currency will be
issued, it does not actually print the currency itself. That task is left to the
US Treasury—more specifically, to the Bureau of Engraving and Printing
(bills) and the US Mint (coins).
9. At the end of 2012, M1 money supply totaled approximately
$2.4 trillion. A broader definition of the money supply, known as M2,
includes currency in circulation and demand deposits as well as time
deposits (or savings accounts). At the end of 2012, savings accounts
(including small-denomination CDs and money market funds) totaled
$8.0 trillion, which brought the total M2 money supply to $10.4 trillion.
See Economic Report of the President 2013 (Washington, DC: Government
Printing Office, 2013), tables b-69 and b-70.
10. Recall that since the interest rate may be thought of as the price of
money (or, more precisely, the price of purchasing money for a period of
time), an increase in the supply of money will tend to lower that price
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Notes
(i.e., lower the interest rate), just as an increase in the supply of any good
tends to lower the price of that good.
11. See Board of Governors of the Federal Reserve System, press
release, December 12, 2012, http://www.federalreserve.gov/newsevents/
press/monetary/20121212a.htm.
Chapter Three
1. Joseph F. Sullivan, “Bell Joins G.O.P. Primary for the Senate in
Jersey,” New York Times, January 28, 1982.
2. Although the Bank of England became “operationally independent” in 1997 after being granted responsibility for setting short-term
interest rates, it still lacked complete independence. The British
­government retained the authority to set the overall inflation target,
which the bank was expected to meet.
3. Although Paul Volcker essentially did this in the United States in
the early 1980s, he was confronting an inflation rate of less than
20 ­percent. In many countries, inflation rates have reached far higher
levels—sometimes as high as 1,000 percent per year or more. In Brazil,
for example, inflation in 1990 exceeded 2,500 percent.
4. Say himself expressed the idea this way: “[A] product is no sooner
created, than it, from that instant, affords a market for other products to
the full extent of its own value” [Jean-Baptiste Say, A Treatise on Political
Economy, trans. C. R. Prinsep, ed. Clement C. Biddle (Philadelphia:
Lippincott, Grambo & Co., 1855 [1803]): bk. I, chap. XV, para. 8].
Although the idea was developed by other classical economists (including James Mill, David Ricardo, and John Stuart Mill), the actual phrase
“supply creates its own demand,” now known as Say’s law, was coined
later—perhaps as late as 1936 by John Maynard Keynes, who was attacking the idea. See Keynes, The General Theory of Employment, Interest, and
Money (New York: Harcourt Brace Jovanovich, 1964 [1936]), 18, 25.
5. Keynes, General Theory, 30.
6. Bureau of the Census, US Department of Commerce, Historical
Statistics of the United States, Colonial Times to 1970, no. 1 (Washington,
DC: GPO, 1975): 1001, 1002, 1021.
7. I am deeply indebted to my former colleague, Huw Pill (who is
now an official at the European Central Bank), for helping me to see that
Keynes viewed expansionary fiscal policy fundamentally as a
­coordination device.
186
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Notes
8. When central bank officials believe the economy is overheating
(or is on the verge of overheating) because actual GDP exceeds (or is
about to exceed) their estimate of potential GDP, they will normally raise
the short-term interest under their control (i.e., tighten monetary policy)
in order to fight or preempt inflation. As a result, considerable weight
rests on the central bank’s estimates of potential output and its trajectory
going forward. If, for example, actual output is growing at 4 percent per
year and the central bank has estimated potential output growth at
3 ­percent per year, it is far more likely to tighten monetary policy
(i.e., raise the short-term interest rate) than if it believed potential output
was growing at 4.5 percent per year (which would suggest the economy
had additional room to grow without overheating).
9. As is well known, bond prices and bond yields move in opposite
directions. When many people want to buy bonds, this will obviously
bid up their price. But this will also drive down their yields. If the price
of a $100 bond that will pay $110 at the end of the year (i.e., 10 percent
interest) is bid up to $105, then the effective yield is driven down to just
4.8 percent (i.e., [110 – 105]/105). Another way to look at this is that as
more people want to buy bonds, a greater supply of investment funds
becomes available, which in turn means that the price of those investment funds (the interest rate) should fall.
Chapter Four
1. Journals of the Continental Congress, 1774–1789, ed. Worthington
C. Ford et al. (Washington, DC, 1904–37), 29: 499–500.
2. Journals of the Continental Congress 30 (1786): 162–163. The
Board of Treasury also noted that a “Dollar containing this number of
Grains of fine Silver, will be worth as much as the New Spanish Dollars.”
The so-called New Spanish Dollar, or Spanish milled dollar, was a foreign
coin that was widely used as money in the United States at the time.
3. Journal of the Senate 1 (January 12, 1792): 374.
4. Although attempts to measure the trajectory of prices—by tracking the prices of a broad basket of goods—can be traced all the way back
to 1806, “the first serious attempt to summarize comprehensive price
data for the United States in the form of index numbers was made by
Horatio C. Burchard, Director of the Mint,” in 1881. Bureau of the
Census, US Department of Commerce, Historical Statistics of the United
States, Colonial Times to 1970, no. 1 (Washington, DC: GPO, 1975): 183.
187
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Notes
5. Irving Fisher, “A Remedy for the Rising Cost of Living:
Standardizing the Dollar,” American Economic Review 3, no. 1 (Supplement,
March 1913): 20.
6. Albert Gordon, interview by author, New York City, October 22,
2003.
7. The European Central Bank might be said to have adopted a
weak version of inflation targeting, based on an “inflation objective”
rather than a hard target. Developed countries that had adopted even
stronger versions of inflation targeting included Sweden, Britain, and
New Zealand.
8. Quoted in Eldar Shafir, Peter Diamond, and Amos Tversky,
“Money Illusion,” Quarterly Journal of Economics 112, no. 2 (May 1997):
341–342.
9. Ben Bernanke, the former chairman of the Federal Reserve (who
was confirmed as chairman in 2006), was thought to favor explicit inflation targeting. By contrast, his predecessor, Alan Greenspan, had never
announced an explicit inflation target.
Chapter Five
1. This chapter is drawn (with some modifications) from David
Moss and Sarah Brennan, “National Economic Accounting: Past, Present,
and Future,” Case 703-026 (Boston: Harvard Business School, 2002).
2. Although used goods are not included in GDP, the sale of a used
good is often associated with the production of a new service, which is
included. The used items sold on eBay, for example, are not counted as
part of GDP. However, the commission paid to eBay for making an
online auction is counted as a new service and therefore included. It is
also worth noting that the components of GDP do reflect the net transfer of used goods across sectors of the economy. Consumption, for
example, includes the purchase of used rental cars by households
(Bureau of Economic Analysis, A Guide to the NIPAs, updated
August 31, 2001, http://www.bea.gov/bea/an/nipaguid.htm, M.8, M.9).
3. Investment also includes the wages and salaries a business may
pay to people hired as part of an investment project. For example, if a
café builds a specialized high-tech coffee maker, the wages of the
­computer programmer will show up in investment.
4. Shelby B. Herman, “Fixed Assets and Consumer Durable Goods,”
Survey of Current Business (April 2000): 18.
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Notes
5. US Department of Commerce, National Income, Supplement to the
Survey of Current Business, July 1947 (Washington, DC: GPO, 1947), 11.
6. Under the GDP definition, “net exports” is basically the balance
on goods and services (from the balance of payments accounts). Under
the GNP definition, by contrast, “net exports” approximately equals the
balance on goods and services plus net income payments (again, from the
balance of payments accounts).
7. World Development Indicators database, http://databank.­
worldbank.org/data/home.aspx (accessed June 2013). Note: GNP estimates were labeled GNI.
8. In the United States, the growth rate of the GDP deflator was
often (but not always) similar in magnitude to the growth rate of the
Consumer Price Index (CPI), which was constructed by tracking changes
in the sales price of a fixed basket of consumer goods.
9. Arthur F. Burns, “The Measurement of the Physical Volume of
Production,” Quarterly Journal of Economics 44, no. 2 (February 1930):
242–262.
10. Karl Whelan, “A Guide to the Use of Chain Aggregated NIPA
Data,” Federal Reserve Board, Division of Research and Statistics, June
2000, 4–5, http://www.federalreserve.gov/Pubs/feds/2000/200035/
200035pap.pdf.
11. J. Steven Landefeld and Bruce T. Grimm, “A Note on the Impact
of Hedonics and Computers on Real GDP,” Survey of Current Business
(December 2000): 17–22.
12. J. Steven Landefeld and Robert P. Parker, “BEA’s Chain Index,
Time Series, and Measures of Long-Term Economic Growth,” Survey of
Current Business (May 1997): 58–68.
13. World Bank, “International Comparison Program,” http://­
siteresources.worldbank.org/ICPEXT/Resources/ICP_2011.html; “The
International Comparison of Prices Program (ICP),” https://pwt.sas
.upenn.edu/icp.html.
14. Note that net imports (i.e., IM – EX) on the GDP accounts is
approximately equal to the current account deficit (excluding net income
and transfers) on the balance of payments.
Chapter Six
1. In practice, since official agencies don’t pick up every cross-­
border transaction, the “errors and omissions” category is necessary to
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Notes
ensure that the various parts of the BOP statement do indeed sum
to zero.
2. This example was inspired by a classroom exercise my colleague
Louis T. Wells developed.
Chapter Seven
1. Jennifer Hughes, “Online Effect Rebalances the FX Equation,”
Financial Times, July 30–31, 2005.
Conclusion
1. Federal Reserve Chairman Alan Greenspan is often credited with
coining the term “irrational exuberance” in a speech entitled “The
Challenge of Central Banking in a Democratic Society,” which he delivered at the American Enterprise Institute for Public Policy Research in
Washington, DC, December 5, 1996. See also Robert Shiller, Irrational
Exuberance (Princeton, NJ: Princeton University Press, 2000).
Epilogue
1. Ben S. Bernanke, “The Great Moderation” (remarks at the meetings of the Eastern Economic Association, Washington, DC, February
20, 2004), http://www.federalreserve.gov/BOARDDOCS/SPEECHES/
2004/20040220/default.htm.
2. See, for example, Dirk J. Bezemer, “‘No One Saw This Coming’:
Understanding Financial Crisis through Accounting Models,” working
paper, June 16, 2009, table 1, p. 9, http://mpra.ub.uni-muenchen.
de/15892/.
3. See David Colander et al., “The Financial Crisis and the Systemic
Failure of Academic Economics” (University of Copenhagen Department
of Economics Discussion Paper No. 09-03, March 9, 2009), http://ssrn.
com/abstract=1355882 or http://dx.doi.org/10.2139/ssrn.1355882.
4. Donald Kohn, “Federal Reserve Independence in the Aftermath of
the Financial Crisis: Should We Be Worried?,” Brookings, January 14,
2014 (based on a speech, January 13, 2013), http://www.brookings.edu/~/
media/research/files/papers/2014/01/16-federal-reserve-­independencefinancial-crisis-kohn/16-federal-reserve-independence-financial-crisiskohn.pdf.
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Index
Note: page numbers followed by f indicate figures; page numbers
­followed by t indicate tables; page numbers followed by n ­indicate
­footnotes; those followed by n and a number indicate endnotes.
actual GDP (actual output). See
output, actual vs. potential
aggregate demand, 22–26, 73–83,
137, 143, 183n4
aggregate price level. See price
level (P)
American Bankers’ Association,
184n6
“autonomous” increase in
­government spending,
77–78, 82, 168
(BPM6), International
Monetary Fund, 118n, 119,
121n, 126–130, 127t–128t,
162, 173
balance of trade. See trade balance
balance on goods and services,
118, 159, 180, 189n6
banking, 55–58, 62–63, 64f, 64n,
67, 76, 90, 91, 93, 141,
150, 151t
central banks. See central banks
commercial banks. See
commercial banks
bank notes, 90, 91
Bank of England, 70, 154, 186n2
Bank of Japan, 178
bank runs (panics), 58, 93,
137, 160
Berkshire Hathaway, 136
Bernanke, Ben, 149, 150,
152, 188n9
bimetallic standard, 91
Board of Treasury, 90, 187n2
Boeing, 11
baby boomers, 30
balance of payments, 2,
13–14, 14t, 117–130,
125–126t, 140
evolving approach to, 121n,
126–130, 128–129t
understanding debits and
­credits, 120–124, 122f
Balance of Payments and
International Investment
Position Manual, sixth edition
191
Index.indd 191
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Index
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
capital inflows and outflows, 13,
14t, 15, 115, 121–122, 122f,
124, 134, 165. See also
­foreign borrowing; foreign
investment
CDs (certificates of deposit), 66,
185n9
central banks, 58–65, 91, 161.
See also Federal Reserve;
European Central Bank
control of money supply, 46,
58, 63–64, 141
credibility of, 58, 68–69, 71–72
currency issuance, 55, 58,
59. See also open market
­operations; discount rate
discount rate, 62–63, 64f,
65, 75–76, 93, 94, 96,
141, 163
expansionary monetary policy,
73–74
independence of, 70, 141, 156,
186n2
inflationary expectations, 46,
60, 68–72, 140f, 152
inflation targeting by, 71–72,
96–98, 100, 142, 153
objectives of, 59–61
open market operations,
63–65, 64f, 82, 100, 141,
170, 174, 177
overheating economy and,
59–60, 61f, 187n8
reaction to deficit spending, 82
reserve requirement, 56–57,
63, 64f, 65, 141, 179
certificates of deposit (CDs), 66,
185n9
ceteris paribus, 65
bond prices, determination of,
187n9
BOP. See balance of payments
Bezemer, Dirk J., 190n2
Brennan, Sarah, 188n1
Bryan, William Jennings, 92, 94
bubbles, 84, 85, 144, 149,
154, 160
budget deficit/surplus, 2, 76–83,
80f, 111, 113, 146, 152–153,
161, 179. See also fiscal
­policy
Buffett, Warren, 136
Burchard, Horatio C., 187n4
Burns, Arthur, 109, 189n9
business cycle, 25–26, 26f,
93–94, 160
C. See consumption
CAGR (compound annual growth
rate), 43n
capital
depreciation, 106, 163
funded pension system, claim
on, 30
increases in, economic growth
and, 19–21
role in market economy, 29
unilateral transfers of, on
balance of payments, 118
capital account on balance of
­payments, 13, 118, 119,
120, 125t, 127, 128t, 130,
160–161. See also financial
account, on balance of
payments
capital equipment, 22
capital flight, 124
192
Index.indd 192
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Index
chained method, in calculating
price deflator, 110
change in reserves, 14t, 119, 120,
122f. See also balance of
­payments
checking account. See demand
deposits
China, 51–53, 123, 127, 130,
145, 145n
Chrysler, 120, 166
Coinage Act of 1792, 90
coins, 34, 90, 91, 162, 185n8,
187n2
Colander, David, 190n3
commercial banks, 56–58, 62-63,
64f, 64n, 67, 76, 90, 91, 93,
141, 150, 151t
bank notes issued by, 90, 91
borrowing from central banks,
62. See also discount rate
federal funds rate, 2, 43, 62,
64, 64n, 65, 69, 96–97
role in money supply,
56–58, 141
commissions, 188n1. See also
GDP accounting
comparative advantage, theory of,
16–19, 18t
competitiveness, 23
compound annual growth rate
(CAGR), 43n
Constitution (US), 90
Consumer Price Index (CPI),
151t, 189n8. See also implicit
price deflator; price index
consumption, 10–11, 14t,
103–104, 104t, 109–110
definition of, in GDP
­accounting, 103, 188n2
direct consumption of wealth,
184n9
encouragement of, through
monetary policy, 73–74
of fixed capital, 106, 107. See
also depreciation, in GDP
accounting
rising GDP and, 77–78
substitution effect, 110
vs. investment of current
­output, 29, 34–35, 113,
114t, 184n9
Continental Congress, 90, 187n1,
187n2
CPI (Consumer Price Index),
151t, 189n8. See also implicit
price deflator; price index
crawling peg. See pegged
exchange rate
credibility
of central banks, 58, 68–69,
71–72
of government, 70–71
cross-country comparisons, of
GDP, 108–110
crowding-out, 82, 161
currency. See also bank notes;
exchange rates; money;
money supply (M)
component of money supply,
56, 185n9
issued by central banks, 56,
185n8
issued by commercial banks
in form of bank notes,
90, 91
currency crises, 2, 49–50, 115
currency trading, 84, 94, 134,
143. See also exchange rates
193
Index.indd 193
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Index
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
depression. See also recession
in 1930s. See Great Depression
causes of, 22–26
expectations as cause of, 24
monetary policy impotent
in, 74
Dewing, Arthur, 94–95
Diamond, Peter, 188n8
direct investment. See foreign
direct investment (FDI)
disasters, 106
discount rate, 62–63, 64f, 65,
75–76, 93, 94, 96, 141, 163
discount window, 65, 93
division of labor, efficiency and,
183–184n5
dollar. See also currency; exchange
rates; money; money
­supply (M)
proposed standardization of,
92–93, 188n5
Spanish milled dollar, 187n2
as unit of account, 90, 91, 98,
162, 187n2
double counting, 8, 10–11, 103
downward spiral, 25, 73, 143,
152–153
current account balance, on
­balance of payments, 13–14,
14t, 15, 28n, 115, 118, 119,
121, 123, 124–126t, 127,
128t, 130, 131–133, 136,
137, 162, 165, 172, 173,
189n14
debits and credits in,
120–124, 122f
exchange rates and, 131–133,
136, 137
IMF approach to. See Balance of
Payments and International
Investment Position Manual,
sixth edition (BPM6)
line items in, 118–119
cyclical (short-term) fluctuations,
26n, 162
Daimler-Benz, 120, 166
deficit spending, 76–83, 137. See
also budget deficit/surplus;
fiscal policy
crowding-out, 82, 161
waning faith in, 81
during World War II, 80
deflation, 36, 38f, 54–55, 75–76,
75t, 92, 97, 98, 109, 137,
146, 171
deflator. See implicit price deflator
demand. See aggregate demand;
Say’s law
demand deposits, 56–57, 63, 66,
90, 141, 162, 171, 185n9
depreciation, in GDP accounting,
102, 106–107, 183n2
depreciation of currency. See
exchange rates
eBay, 188n2
economic growth
productivity and, 22–23,
183–184n5
sources of, 19–21, 183–184n5
economic relationships, theory vs.
practice, 54, 65–66, 147
economic shocks, 25, 72,
137, 157
education and productivity, 23
194
Index.indd 194
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Index
floating, 95, 165
forecasting, unpredictability
of, 136
foreign investment and, 51–53
gold standard. See gold
­standard
inflation and. See real
exchange rate
interest rates and, 134–135, 137
monetary policy goals and, 60,
140f, 142
nominal vs. real, 46–53, 50t
pegged, 49, 51, 174–175,
185n6. See also fixed
exchange rate
real, 2, 46–53, 50t
and trade balance, 47–50
expansionary fiscal policy. See
­fiscal policy
expansionary monetary policy.
See monetary policy
expectations, 2, 3, 67–85, 137,
139, 143–144, 147
as cause of recessions and
depressions, 24–25
fiscal policy and, 76–83, 79f,
80f, 140f, 146
inflation and, 46, 47f,
60–61, 62, 68–72, 85,
140f, 168
“irrational exuberance,” 140f,
144, 190n1
monetary policy and, 73–76,
75t, 83, 84, 140f, 146
output and, 26, 73–83
rational, 81–82, 178, 179
self-fulfilling, 24, 67, 143
“expectations-augmented”
Phillips curve, 61
efficiency
division of labor and,
183–184n5
increases in, economic growth
and, 19–20
reduced, through wage and
price controls, 70
total factor productivity (TFP)
as measure of, 20, 21,
22, 23n
“elastic” money supply, 93–94
errors and omissions, on balance
of payments, 119, 120,
123–124, 127, 129t, 130,
163, 189–190n1
European Central Bank (ECB),
72, 97, 153, 154, 188n7
European Union, 97, 153–154
EX. See exports (EX)
exchange, money used to facilitate, 33, 194n1
exchange-rate models, 133,
134–135
exchange-rate peg. See fixed
exchange rate; pegged
exchange rate
exchange rates, 1, 4, 34, 35–36,
35n, 37–38, 37f, 38f, 47–53,
83, 84, 91–97, 131–137
bimetallic standard, 91
currency crises, 2, 49–50, 115
current account balance and,
132–133, 136, 137
determination of, 131–137
effects of money on. See money
expectations and, 83, 84
fixed, 91–95, 165, 166, 174.
See also exchange-rate peg;
pegged exchange rate
195
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1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
inflation targeting by, 72,
96–98, 100, 143, 164, 168,
188n9
final goods and services, 9–10,
11, 39, 41, 102–103, 107
financial account, on balance of
payments, 13, 14t, 15, 118,
119–120, 121, 121n,
122–123, 124, 127, 128t,
129, 130, 132, 161, 164.
See also balance of payments
financial bubbles. See bubbles
financial crises. See also
­depression; recession
and balance of payments, 124
bank runs (panics), 58, 93,
137, 160
currency crises, 2, 49–50, 115
financial crisis of 2007–2009,
2, 43, 58–59, 62, 72, 83, 84,
97, 141–142, 149–157, 177
influence on exchange rates,
141–142
financial stability, and monetary
policy, 62, 72, 100, 142
fiscal policy, 4, 25–26, 60, 68,
76–83, 80f, 140f, 146, 150,
152–154, 179, 186n7. See
also deficit spending; Keynes,
John Maynard
Fisher, Irving, 55, 92–93, 185n7,
188n5
fixed exchange rate, 91–95, 165,
166, 174
fixed-price method, 109–110
floating exchange rate, 95, 165
Ford, Worthington C., 187n1
forecasting, 103, 136, 178
expenditures. See GDP
­accounting; income
­multiplier
expenditure method, in GDP
accounting, 9–10, 11,
77, 102–106, 104t,
105–106, 164
exports (EX), 10, 12, 13, 14t, 15,
36, 47, 48, 61, 77, 91,
103–106, 113, 114t, 117,
121, 122t, 123, 124, 125t,
127, 128, 129t, 130, 140,
159, 164. See also net
exports; trade, international
factor receipts. See income
receipts and payments
factors of production, 11
FDI (foreign direct investment),
14t, 51–52, 118, 120, 164,
165, 166, 173
federal deposit insurance, 58
federal funds rate, 2, 43, 62, 64,
64n, 65, 69, 96–97, 150,
164, 177
Federal Reserve, 2, 55, 65, 66,
70, 75, 84, 93–100, 142,
149, 150–157, 161, 185n8,
186n11, 190n1. See also
central banks
control of federal funds rate,
64–65, 64n, 69, 96–97, 164
establishment of (1914), 70,
93–95
financial crisis of 2007–2009
and, 43, 59, 62, 72, 97, 142,
149–157, 177–178
196
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foreign borrowing, 12–13, 28–29,
28f, 111, 113, 114–115,
114t, 121, 144–145, 165.
See also financial account,
in ­balance of payments
foreign direct investment (FDI),
14t, 51–52, 118, 120, 164,
165, 166, 173
foreign investment. See also
­foreign borrowing; foreign
direct investment
interest rates and, 134
pegged exchange rates
and, 49, 51, 174–175,
185n6
real exchange rates and, 51–53
foreign trade. See trade,
i­ nternational
free trade, 16–19. See also
c­ omparative advantage,
­theory of; trade
Friedman, Milton, 60, 95, 98
funded pension system,
30–32, 166
expenditure method, 9–10,
11, 77, 102–106, 104t,
105–106, 164
GNP and, 107–108
income method, 11, 102, 103
investment, savings, and f­ oreign
borrowing, 111–113, 114t
measurement approaches,
8–11, 10f, 102–103
purchasing power parity and,
110–111, 112t
GDP deflator. See implicit price
deflator
GDP per capita
as measure of standard of
­living, 29
PPP-adjusted estimates, 112t,
177, 184n10
General Motors, 107
General Theory of Employment,
Interest, and Money, The
(Keynes), 186n4, 186n5
GNP. See gross national product
(GNP)
GNP-to-GDP ratios, 107–108
gold standard, 75, 90, 91–95,
98–99, 150, 152, 166. See
also exchange rates, fixed
goods and services. See balance
payments; current account
balance; GDP accounting;
output
Gordon, Albert, 188n6
government. See also central
banks; Federal Reserve; fiscal
policy; monetary policy
attempts to influence
­investment, 29
G. See government expenditure
GDP. See GDP accounting; gross
domestic product (GDP)
GDP accounting, 8–11, 14t,
101–115
balance of payments accounting and, 117
commissions and, 188n1
controlling for inflation,
108–110
depreciation and, 102,
106–107, 183n2
197
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Index
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
components of, 10, 104–106, 104t
controlling for inflation in
­measurement of, 40, 43–44,
108–110, 141
vs. domestic expenditure, 115
GNP compared, 107–108
historical and cross-country
comparisons, 108–110
increase in, income multiplier
and, 77–79, 79f
items excluded from, 106, 107,
109, 188n2
PPP-adjusted estimates of GDP
per capita, 111, 112t
real. See real GDP
standard definition of, 10,
102–103, 167
gross national product (GNP),
107–108, 109, 167, 189n6
government (continued)
credibility of, wage and price
controls and, 70–71
role in early US monetary
­system, 90–91
government bonds, 43, 64, 75,
82, 141. See also open market
operations
government expenditure (G), in
GDP accounting, 10, 11, 14t,
103, 104t, 113, 114t, 115,
166. See also GDP accounting
“autonomous” increase in,
77–78, 82, 168
deficit spending. See deficit
spending; fiscal policy
government-led investment, 21
government saving (budget
­surplus), 113, 114t
government spending. See
­government expenditure (G)
Great Depression, 94, 146, 150, 152,
154, 167. See also depression
causes of, 23–24
effects on cost of borrowing,
75–76
gold standard and, 94–95, 152
Greenspan, Alan, 188n9, 190n1
Grimm, Bruce T., 189n11
gross domestic product (GDP),
8–11, 14t, 101–115,
139–140. See also GDP
­accounting; national output
actual and potential GDP
­compared, 73, 140f,
143–144, 175, 187n8
comparison of nominal vs. real
GDP, 39–43, 43t, 44t,
108–110, 140
Harvard Business School, 3, 94
Herman, Shelby B., 188n4
Honda, 12
Hoover, Herbert, 24, 184n6
“hot money,” 120, 175. See also
portfolio investment
Hughes, Jennifer, 190n1
Hume, David, 33, 194n1
I. See investment
IM. See imports (IM)
IMF (International Monetary
Fund), 118n, 119, 120, 121n,
126–127, 130, 162, 173. See
also Balance of Payments and
International Investment Position
Manual, sixth edition (BPM6)
198
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Index
implicit price deflator (or price
deflator), 36, 37f, 41, 42t,
95n, 109, 176, 184n2,
189n8. See also inflation;
price index; price level (P)
imports (IM), 10, 11, 12, 13, 14t,
47, 48, 51, 77, 81, 91, 104t,
105, 113, 114t, 115, 117,
121, 122f, 124, 125t, 127,
128t, 129, 133, 159, 164,
167, 172, 180, 189n14
income, 168
as compared to product,
107–108, 113
from cross-border investments.
See income receipts and
­payments
factors of production and, 11
measurement of total
income, 102
multiplier, 76–83, 79f, 143,
168. See also fiscal policy
personal, individual output
and, 14–15
wealth contrasted, 183n3
income-expenditure cycle,
­leakage from, 78–79, 81–82
income method, in GDP
­accounting 11, 102, 103
income multiplier, 76–83, 79f,
143, 168. See also fiscal p
­ olicy
income receipts and payments, on
balance of payments
(­investment income, factor
receipts, and payments), 14,
107, 113, 114t, 117, 118,
119, 121, 122f, 125t, 167,
172. See also balance of
­payments
independence of central banks,
70, 141, 156, 186n2. See also
central banks
individual retirement accounts
(IRAs), 30–32
inflation. See also aggregate price
level; Consumer Price Index;
implicit price deflator; price
index
controlling GDP for, 40, 43–44,
108–110, 141
defined, 36, 168
effect on daily lives, 1
and exchange rates, 46–53, 50t,
53f, 133–134, 137
expectations and, 46, 47f,
50–61, 62, 68–72, 85,
140f, 168
fiscal policy and, 80, 80f,
81, 82
and gold standard, 91–94
hyperinflation, 185n5,
186n3
inflation targeting, 71–72,
96–98, 100, 142, 143, 153,
164, 168, 186n2, 188n7,
188n9
and interest rates (nominal vs.
real), 43–46, 46f, 47f,
75, 144
monetary policy and, 38,
59–61, 68–72, 93–98, 141,
142, 146, 170, 186n3
Phillips curve and, 60–61,
61f, 175
real vs. nominal, 39–54, 140f,
141, 144–145
and unemployment, 60–61,
61f, 175
199
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Index
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
international exchange of output.
See trade, international
international lending and
­borrowing. See foreign
­borrowing; foreign direct
investment; foreign
­investment
International Monetary Fund
(IMF), 118n, 119, 120, 121n,
126–127, 130, 162, 173
internet bubble, 84
inventory, additions to, 183n1
inverted yield curve, 184n3
investment, 169. See also GDP
accounting; foreign direct
investment; foreign
­investment
additions to inventory
as, 183n1
and balance of payments
accounting, 118–124, 122t
crowding-out, 82, 161
definition of, in GDP
­accounting, 10, 28, 103,
104t, 105, 106, 107,
­111–113, 120, 164,
172, 183n3
depreciation, 102, 106,
183n2
and expectations, 24–25,
73, 143
fiscal policy and, 76–77,
81–82, 143, 146
government-led, 21
and growth, 19–23
monetary policy and, 69,
73–76, 142
portfolio investment. See
­portfolio investment
inflationary expectations. See
expectations, inflation and
inflationary spiral, preventing,
70–71
inflation targeting, 71–72, 96–98,
100, 142, 143, 153,
164, 168, 186n2, 188n7,
188n9
Inquiry into the Nature and Causes
of the Wealth of Nations, An
(Smith), 183–184n5
intangible products (services),
119
interest rate parity model, 134–135
interest rates
crowding-out, 82, 161
defined, 34–35, 161
demand for money and, 66
and effect on daily lives, 1
exchange rates and, 134–135,
137, 144–145
expectations and, 73–75, 83
long-term, 39, 43, 46, 83, 143,
178, 184n3
nominal vs. real, 42–46, 46t,
47f, 75, 75t, 76, 144
monetary policy and, 37, 38,
46f, 58–65, 66, 68–73, 93,
95–97, 100, 134–136, 137,
140–142, 150, 152, 153,
154, 164, 168, 170,
177–178, 185–186n10
real. See interest rates, nominal
vs. real
short-term. See short-term
interest rates
intermediate goods, 102
international comparisons of GDP
per capita, 108–110
200
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Index
Landefeld, J. Steven, 189n11,
189n12
Law of One Price, 133, 134, 137,
176, 177
leakage
from deposit and lending
­process (money multiplier),
57–58, 63
from income-expenditure cycle
(income multiplier), 78–79,
81–82
lending
by commercial banks, 42–43,
56–57, 75–76, 96
by central bank, 56–57,
62–65, 96
international (or foreign). See
foreign borrowing; foreign
investment
leakage from deposit and
­lending process, 57–58, 63
payday loans, 185n4
predatory lending, 184–185n
Leonhardt, David, 136n
liquidity trap, 74, 170
long-term (secular) trends,
26n, 179
sources of, 28, 28f, 111–115,
113t
vs. consumption of current
­output, 15, 27–29, 31, 113,
114t, 184n9
investment tax credits, 29
IRAs (individual retirement
accounts), 30–32
“irrational exuberance,” 140f,
144, 190n1
Irrational Exuberance (Shiller),
190n1
island economy (nominal
vs. real GDP), 39–41,
40t, 42t
Japan, 12–13, 35n, 47–49, 48t,
50t, 107, 178
Kemmerer, E. W., 99
Keynes, John Maynard, 24, 25,
73, 74, 76–77, 78, 79,
80–81, 82, 83, 146, 170,
186n4, 186n7
Keynesian fiscal policy, 25,
77–83, 79f, 80f, 143, 146.
See also fiscal policy
Kohn, Donald, 156, 190n4
M. See money supply (M)
macroeconomics
core concepts of, 139–146, 130f
exchange rates. See exchange rates
expectations and. See
­expectations
fiscal policy. See deficit
­spending; fiscal policy;
Keynes, John Maynard
importance to managers, 1–2
labor
division of, efficiency and,
183–184n5
increases in, economic growth
and, 19–20, 21
pension system claim on, 30
labor productivity, 22–23, 23n
201
Index.indd 201
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Index
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
macroeconomics (continued)
inflation. See inflation
interest rates. See interest rates
macroeconomic accounting. See
GDP accounting; balance of
payments
monetary policy. See central
banks; monetary policy
money and. See money
output and. See output
practical value of, 2
unemployment. See
­unemployment
uses and misuses of, 146–148
“Macro M,” 140f
Means to Prosperity, The (Keynes),
184n8
Mexico, 2, 49–50, 115, 129–130,
162, 185n6
Mill, James, 185n4
Mill, John Stuart, 185n4
monetarists, 95n
monetary base, 59, 62–63, 64f,
170, 171, 174
monetary policy, 25–26, 36–38,
55–65, 68–72, 73–76,
89–100, 140f, 141–142,
149–150, 153, 154, 157,
161, 170, 187n8. See also
central banks; Federal
Reserve; inflation; money
basic tools of, 62–65, 64f,
141–142
discount rate. See discount rate
effect on exchange rates,
37–38, 60, 98, 140f, 142
effect on interest rates. See
interest rates, monetary
­policy and
establishment of US currency,
90–91
expectations and, 73–76, 75t,
83, 84, 140f, 146
Federal Reserve. See Federal
Reserve
gold standard. See gold ­standard
history of, in United States,
89–100
objectives of, 59–61, 142
open market operations, 63–64,
64f, 65, 96, 100, 141, 174
quantitative easing and, 59, 65,
142, 152, 156, 177–178
reserve requirement, 56–57,
63, 64f, 65, 141, 179
short-term interest rates as key
monetary instrument, 58–59,
65, 96, 97, 100, 141, 153,
168, 170, 187n8
monetary targets, 65
monetized economy, 34
money, 3, 33–66, 68–72, 73–76,
89–100, 140–143, 170. See
also central banks; monetary
policy; money supply (M)
banking and, 55–58
central banks, 58–65. See also
central banks
Federal Reserve. See Federal
Reserve
gold standard. See gold
­standard
history of, in United States,
89–100
hot money, 120, 175
interest rates and. See interest
rates
money demand, 66, 71, 74, 93
202
Index.indd 202
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Index
money identity, 171
Phillips curve, 60–61, 61f, 175
“prices” of, 34, 36–37, 37f,
185n10
sticky wages and money
i­ llusion, 54–55
velocity of, 95n, 171, 181
money identity, 171
money illusion, 54–55, 171
Money Illusion, The (Fisher), 185n7
money market funds, 185n9
money multiplier, 57, 62, 63, 171
money supply (M). See also
­central banks; monetary
p
­ olicy; money
banking and, 55–58
central banking and, 58–65,
69, 73–74, 95–96, 141. See
also central banks
and creation of Federal Reserve,
93–95
effect on consumption and
investment, 73–74
effect on interest rate, exchange
rate, inflation, 37–38, 38f,
49, 46, 47f, 53–54, 53f,
65–66, 71, 140–141, 170
and gold standard, 90–91
government management of,
37, 141
M1, 56–58, 63, 95, 171, 185n9
M2, 171, 185n9
M3, 171
in monetarist approach, 95n
Moss, David, 188n1
M1 money supply, 56–58, 63, 95,
171, 185n9
M2 money supply, 171, 185n9
M3 money supply, 171
national economic accounting.
See GDP accounting
national output. See gross
­domestic product (GDP);
output
national savings. See savings
natural disasters, 22–23, 24, 106
natural rate of unemployment,
60–61, 172
NDP. See net domestic product
(NDP)
net capital account, 118. See also
balance of payments
net current transfers, 119. See also
balance of payments
net domestic product (NDP), 106,
107, 172, 183n2
net exports, 10, 77, 103, 104t,
106, 107, 172, 189n6. See
also balance of payments;
GDP accounting
net factor receipts. See net income
net imports, 115, 189n14. See
also foreign borrowing
net income (net factor receipts),
118, 172. See also income
receipts and payments, on
balance of payments
net international factor payments,
107, 167. See also income
receipts and payments, on
balance of payments
net present value (NPV), 74, 173
net unilateral transfers (net
­transfers), 14t, 118, 119,
121, 125t, 162, 173, 188n2.
See also balance of payments
New Spanish Dollar, 187n2
Nixon, Richard, 81
203
Index.indd 203
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Index
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
growth of, 19–21
measurement of. See GDP
accounting
quantity of (Q), 40–41, 43,
79–80, 95n
recessions and depressions,
23–26, 73–83
wealth and, 27–32
over-counting problem, 8–11. See
also GDP accounting
overheating economy
budget surplus to cool, 80,
80f, 146
gold standard and, 90–91
Keynesian fiscal stimulus and,
80f, 144
monetary policy and, 59–60,
61f, 187n8
and Phillips curve, 61f
overnight bank rate, 43, 58, 64,
64n, 96, 164. See also federal
funds rate
nominal exchange rates. See
exchange rates
nominal GDP. See gross domestic
product (GDP)
nominal interest rates. See interest
rates
nominal vs. real dichotomy, 39–54,
140f, 141, 144–145, 171
nonaccelerating inflation rate of
unemployment (NAIRU), 172
NPV (net present value), 74, 173
official reserves, on balance of
payments, 14t, 119, 120,
122f, 174. See also balance of
payments
oil shocks, 72, 137
open market operations, 63–65,
64f, 82, 96, 100, 141, 170,
174, 177. See also central
banks; monetary policy
open market purchase. See open
market operations
open market sale. See open
market operations
output, 3, 4, 7–32, 40, 45, 69,
73–83, 95n, 100, 101–115,
139–140, 140f, 144–145,
147–148, 183n2, 187n8. See
also gross domestic product
(GDP); real GDP
actual vs. potential, 21, 22–26,
31, 40, 73, 140f, 143–144,
175, 187n8
expectations and, 23–24,
73–83, 143–144, 146
future, financial assets as claim
on, 27
P. See implicit price deflator; price
index; price level
panics (bank runs), 58, 93, 137,
160
paper currency, 34, 55, 90, 91,
185n8
Parker, Robert B., 189n12
pay-as-you-go pension systems,
30–32, 174
payday loans, 185n4
payroll taxes, 30, 32
pegged exchange rate, 49, 51,
174–175, 185n6. See also
exchange rates, fixed
pension systems, 30–32, 174
204
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Index
Phelps, Edmund, 60
Phillips, A. W., 60, 175
Phillips curve, 60–61, 61f, 175
Pill, Huw, 186n7
portfolio investment (portfolio
flows), 14t, 49, 118,
120, 129, 129t, 130, 164,
175. See also balance of
p
­ ayments
potential output, 21, 25, 26, 73,
140f, 143–144, 175, 187n8.
See also output, actual vs.
potential
PPP. See purchasing power parity
(PPP)
precious metals, 90, 91–92, 98.
See also gold standard; silver
predatory lending, 184–185n
price deflator. See implicit price
deflator; price level (P)
price flexibility, 25
price index, 108, 171n8. See also
Consumer Price Index;
implicit price deflator;
­inflation; price level (P)
price level (P), 34, 36, 37f, 38,
38f, 40, 54, 68, 79–80, 92,
93, 95, 95n, 98–99,
108–110, 140–142. See also
implicit price deflator;
i­ nflation
price rigidity (stickiness), 25, 26,
54–55, 176
prices. See also implicit price
deflator; inflation; price
level (P); monetary policy;
price index
constant set of, in calculating
GDP. See real GDP
flexibility of. See price
­flexibility; price rigidity
of money. See money, “prices” of
and trade. See exchange rates
Princeton University, 96
private savings (S), 113, 114t. See
also savings
productivity, 1, 16–19, 20,
22–23, 107, 176, 180
labor productivity, 16–19, 18t,
22–23, 23n16, 176, 180
total factor productivity (TFP),
20, 21, 22, 23n, 180
public policy. See also fiscal
­policy; monetary policy
and economic growth, 21
imposition of wage and price
controls, 70–71
purchasing power parity (PPP),
110–111, 112t, 127, 184n10
cross-country comparisons of
GDP, 108–110
exchange rates and, 133–134
Q. See real GDP
quantitative easing, 59, 65, 142,
152, 156, 177–178
quantity of output (Q). See real GDP
rational expectations, 81–82,
178, 179
real. See nominal vs. real
­dichotomy
real estate bubble, 84
real exchange rate, 2, 46–53, 50t,
53f, 69, 178
and foreign investment, 49–53
205
Index.indd 205
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Index
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
S (private savings). See savings
Samuelson, Paul, 19
savings, 1, 28–29, 28f, 31–32, 66,
74, 81, 113–114, 114t, 171,
183n3, 185n9
Say, Jean-Baptiste, 73, 186n4
Say’s law, 73, 186n4
seasonal demand for money, 93
secular (long-term) trends, 26n,
179
self-fulfilling expectations, 24, 67,
143
shadow banks, 58
Shafir, Eldar, 188n8
Shiller, Robert, 190n1
short-term (cyclical) fluctuations,
26n, 162
short-term interest rates, 39, 43,
46, 58–59, 65, 96, 184n3,
186n2
controlling through open market operations, 96, 97, 174,
177. See also open market
operations
federal funds rate. See federal
funds rate
as instrument of monetary policy, 58–59, 65, 96, 97, 100,
141, 153, 168, 170, 187n8
silver, 90, 91, 187n2
Smith, Adam, 183–184n
Social Security benefits, 32, 105,
166, 180
Spanish milled dollar, 187n2
specialization, 16–17, 19, 183n5
speculative mania, 84, 85, 149,
154, 160
stagflation, 61
real GDP, 22, 26, 26f, 39–43, 69,
79, 80, 80f, 95, 95n,
108–110, 115, 141, 143,
146, 151t, 154, 155t, 178
calculation of, 109–110
nominal GDP vs., 39–43,
42t, 43t
real interest rate, 42–46, 46f, 75t,
76, 178
under conditions of deflation,
75–76, 75f
nominal interest rates vs.,
42–46, 46t, 47f, 75, 75t,
76, 144
recession, 22–26, 61f, 67, 82–83,
184n3
budget deficits during, 82–83
causes of, 22–26
defined, 26n, 178–179
and inverted yield curve,
184n3
Reinhardt, Forest, 23n
repatriation, effect of real
exchange rate on, 51–52
reserve requirement, 56–57,
63, 64f, 65, 141, 179
gold standard and, 94
as tool of monetary policy, 63,
64f, 65, 141
retirement, and pension reform,
30–32
Ricardian equivalence,
82, 179
Ricardo, David, 16–17, 82,
186n4
Roosevelt, Franklin D., 24, 94,
184n1
Rubin, Robert, 136
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sticky prices and wages, 25,
54–55, 176, 179
subprime mortgage lending,
84, 149
substitution effect, 110
Sullivan, Joseph F., 186n1
supply creates its own demand.
See Say’s law
supply-side economics, 21, 25
trade balance, 12–13, 47–50, 48t,
91–92, 133, 134, 144–145,
159, 180. See also balance of
payments; current account
balance; trade, international
on balance of payments, 13–15,
14t, 118, 127–129
effect of inflation on, 91–92,
133
exchange rates and, 47–53, 48t,
50t, 83–84, 131–132
trade deficit, 13, 44, 84,
144–145. See also trade
­balance
trade surplus, 12–13. See also
trade balance
transfer payments (Tr), 105, 113,
166, 180. See also GDP
accounting
Tversky, Amos, 188n8
T. See taxes
taxes (T), 32, 76, 77, 81–82, 83,
113, 114t, 150, 166. See
also GDP accounting; tax
rates
tax rates, 21, 29, 32, 77, 169
TFP. See total factor productivity
(TFP)
theory of comparative advantage.
See comparative advantage,
theory of
time deposits, 171, 185n9. See
also M2 money supply
time value of money, 35
total factor productivity (TFP),
20, 21, 22, 23n, 26, 180
Toyota, 12, 107
Tr (transfer payments), 105, 113,
166, 180. See also GDP
accounting
trade, international, 11–18,
47–50, 111, 127–129,
144–145, 177, 183n4. See
also balance of payments;
­comparative advantage,
­theory of; exports; imports;
net exports
ULC (unit labor costs), 23, 180
unemployment, 1, 25, 26f, 54,
59, 60–62, 69, 72, 73, 79,
80f, 94, 96, 142, 143, 146,
151t, 155t, 163, 165, 172,
175, 178, 180. See also
depression; recession
Keynesian fiscal policy and,
79, 80f
monetary policy and, 59,
60, 61, 62, 69, 72,
142–143
natural rate of, 60–61, 172
Phillips curve on inflation and,
60–61, 61f, 175
wage stickiness and, 54–55
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Index
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
unit of account, 90, 91, 98, 162.
See also money
University of Pennsylvania, 111
unsold goods in GDP accounting,
182n1
US Bureau of Economic Analysis
(BEA), 126–127, 127n,
188n2
US Bureau of Engraving and
Printing, 185n8
US Department of Commerce,
106, 107, 109–110, 186n6,
187n4, 189n5
US Department of Defense, 185n4
US Mint, 185n8, 187n4
US Treasury, 2, 185n8
used goods, and GDP accounting,
188n2
unilateral transfers, 14f, 74t, 118,
119, 121, 125t, 162, 173,
188n. See also balance of
­payments
United Kingdom
Bank of England, 70, 154,
186n
and comparative advantage,
16–19
inflation targeting, 188n7
United States, 11–13, 20, 21,
23–26, 26t, 28f, 29, 43,
47–50, 51, 55, 62, 64–65,
70, 74–75, 83, 84, 89–100,
104t, 105, 107, 108,
111, 120, 123, 127,
128–129t, 133–134, 141,
145, 150, 151t, 153–154,
155t, 161, 164, 166, 169,
177, 187n4
balance of payments,
1970–2010, 125–126t
GDP growth in, 26f, 42, 42t,
189n9
GDP per capita, 29, 112t, 177,
184n10
GNP-to-GDP ratio, 108
and Great Depression, 23–24,
75–76, 94–95, 152, 167
history of money and monetary
policy in, 70, 75, 80–81,
89–100, 169n2, 169n4,
186n3, 187n2
increased entry of women into
workforce, 20
interest rates in 2005, 42–43
savings and investment in, 28,
28f, 114t
unit labor costs (ULC), 23, 180
V (velocity of money), 95n, 171,
181
value-added approach, in GDP
accounting, 8–9, 10f, 11,
102, 103, 181. See also GDP
accounting, measurement
approaches
velocity of money (V), 95n, 171,
181
virtuous circle, 78, 146
Volcker, Paul, 69, 186n3
wage and price controls, 70–71,
181
wages (salaries), 11, 14, 22, 23,
25, 45, 52, 54–55, 60, 68,
70, 102, 119, 141, 143, 168,
179, 188n3
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Whelan, Karl, 189n1
World Bank, 189n13
World Development Indicators
database, 189n7
World War II, 80–81, 95
wealth, 27–29, 32–33, 183n3,
184n9
Wealth of Nations. See An Inquiry
into the Nature and Causes
of the Wealth of Nations
(Smith)
welfare payments, 103, 105, 166
Wells, Louis T., 190n2
yield curve, inverted, 184n3
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About the Author
David A. Moss is the John G. McLean Professor at Harvard Business
School. He earned his BA from Cornell University (1986) and his
PhD from Yale University (1992). After graduating from Yale,
Moss served as a senior economist at Abt Associates, a public policy consulting firm based in Cambridge, Massachusetts. He joined
the Business School faculty in July 1993.
Professor Moss has authored two previous books: Socializing
Security: Progressive-Era Economists and the Origins of American
Social Policy (Harvard University Press, 1996) and When All Else
Fails: Government as the Ultimate Risk Manager (Harvard University
Press, 2002). The latter explores the government’s pivotal role as
a risk manager in policies ranging from limited liability and bankruptcy law to social insurance and federal disaster relief. Moss has
also co-edited three books on economic regulation and has published numerous articles, book chapters, and case studies on topics ranging from economic policy and financial markets to
political institutions.
Professor Moss is the founder of the Tobin Project, a non-profit
research organization based in Cambridge, Massachusetts. He is
the recipient of numerous honors, including the Student
Association Faculty Award for outstanding teaching at Harvard
Business School and the American Risk and Insurance Association’s
Kulp-Wright Book Award for “the most influential text published
on the economics of risk management and i­nsurance.”
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