PRINCIPLES OF
MACROECONOMICS
S T U DY G U I D E
PROF. ONUR BASER
GROSS DOMESTIC PRODUCT ..........................................................................5
GDP AND THE MACROECONOMY ..........................................................................5
GDP MEASURES TOTAL SPENDING, OUTPUT, AND INCOME ...................................7
WHAT GDP CAPTURES AND WHAT IT MISSES ........................................................10
REAL AND NOMINAL GDP .....................................................................................11
MILLIONS, BILLIONS, AND TRILLIONS ....................................................................12
ONE PAGE SUMMARY ...........................................................................................14
ECONOMIC GROWTH ...................................................................................15
ECONOMIC GROWTH FACTS ................................................................................15
THE INGREDIENTS OF ECONOMIC GROWTH ........................................................16
THE ANALYTICS OF ECONOMIC GROWTH ............................................................19
PUBLIC POLICY: WHY INSTITUTIONS MATTER FOR GROWTH .................................23
ONE PAGE SUMMARY ...........................................................................................24
UNEMPLOYMENT ..........................................................................................25
EMPLOYMENT AND UNEMPLOYMENT ...................................................................25
THE DYNAMICS OF THE LABOR MARKET ...............................................................26
THE COSTS OF UNEMPLOYMENT ...........................................................................31
ONE PAGE SUMMARY ...........................................................................................34
INFLATION AND MONEY ..............................................................................35
MEASURING INFLATION .......................................................................................35
DIFFERENT MEASURES OF INFLATION ...................................................................37
ADJUSTING FOR THE EFFECTS OF INFLATION .......................................................38
THE ROLE OF MONEY AND THE COSTS OF INFLATION .........................................39
ONE PAGE SUMMARY ...........................................................................................43
CONSUMPTION AND SAVING ......................................................................44
CONSUMPTION, SAVING, AND INCOME .............................................................44
THE MICRO FOUNDATIONS OF CONSUMPTION ...................................................45
THE MACROECONOMICS OF CONSUMPTION ......................................................47
WHAT SHIFTS CONSUMPTION? .............................................................................49
SAVING .................................................................................................................50
ONE PAGE SUMMARY ...........................................................................................52
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INVESTMENT .................................................................................................53
WHAT IS INVESTMENT? .........................................................................................53
TOOLS TO ANALYZE INVESTMENTS .......................................................................55
MAKING INVESTMENT DECISIONS .......................................................................56
THE MACROECONOMICS OF INVESTMENT...........................................................57
THE MARKET FOR LOANABLE FUNDS ....................................................................58
ONE PAGE SUMMARY ...........................................................................................61
THE FINANCIAL SECTOR ................................................................................62
BANKS ...................................................................................................................62
THE BOND MARKET ...............................................................................................64
THE STOCK MARKET ..............................................................................................66
WHAT DRIVES FINANCIAL PRICES ..........................................................................67
PERSONAL FINANCE .............................................................................................70
ONE PAGE SUMMARY ...........................................................................................72
INTERNATIONAL FINANCE AND EXCHANGE RATE ........................................73
INTERNATIONAL TRADE AND GLOBAL FINANCIAL FLOWS ....................................73
EXCHANGE RATES .................................................................................................74
SUPPLY AND DEMAND OF CURRENCIES ................................................................76
THE REAL EXCHANGE RATE AND NET EXPORTS .....................................................79
THE BALANCE OF PAYMENTS ................................................................................80
ONE PAGE SUMMARY ...........................................................................................82
BUSINESS CYCLES .........................................................................................83
MACROECONOMIC TRENDS AND CYCLES ............................................................83
COMMON CHARACTERISTICS OF BUSINESS CYCLES.............................................84
ANALYZING MACROECONOMIC DATA .................................................................85
ONE PAGE SUMMARY ...........................................................................................87
LINKING INTEREST RATES AND OUTPUT USING IS-MP ANALYSIS .................88
AGGREGATE EXPENDITURE....................................................................................88
THE IS CURVE: OUTPUT AND THE REAL INTEREST RATE ..........................................89
THE MP CURVE: WHAT DETERMINES THE INTEREST RATE .......................................91
THE IS-MP FRAMEWORK ........................................................................................92
MACROECONOMIC SHOCKS ................................................................................93
ONE PAGE SUMMARY ...........................................................................................96
The Phillips Curve and In ation ....................................................................97
INFLATION EXPECTATIONS ....................................................................................97
THE PHILLIPS CURVE ...............................................................................................99
SUPPLY SHOCKS SHIFT THE PHILLIPS CURVE .........................................................101
ONE PAGE SUMMARY .........................................................................................103
The Fed Model: Linking Interest Rates, Output, and In ation .....................104
THE FED MODEL...................................................................................................104
ANALYZING MACROECONOMIC SHOCKS ..........................................................105
DIAGNOSING THE CAUSES OF MACROECONOMIC CHANGES ..........................107
ONE PAGE SUMMARY .........................................................................................108
Aggregate Demand and Aggregate Supply ...............................................109
THE AD-AS FRAMEWORK .....................................................................................109
AGGREGATE DEMAND .........................................................................................110
AGGREGATE SUPPLY.............................................................................................113
MACROECONOMIC SHOCKS AND COUNTERCYCLICAL POLICY ..........................114
AGGREGATE SUPPLY IN THE SHORT RUN AND THE LONG RUN ...........................116
ONE PAGE SUMMARY ..........................................................................................119
MONETARY POLICY .....................................................................................120
THE FEDERAL RESERVE .........................................................................................120
THE FED S POLICY GOALS AND DECISION-MAKING FRAMEWORK .....................122
HOW THE FED SETS INTEREST RATES ....................................................................124
ALTERNATIVE TOOLS THE FED USES TO MEET ITS DUAL MANDATE ......................126
ONE PAGE SUMMARY .........................................................................................128
Government Spending, Taxes, and Fiscal Policy .........................................129
THE GOVERNMENT SECTOR ................................................................................129
FISCAL POLICY .....................................................................................................132
GOVERNMENT DEFICITS AND DEBT .....................................................................134
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ONE PAGE SUMMARY .........................................................................................138
CHAPTER OBJECTIVE: MEASURE AND ANALYZE TOTAL ECONOMIC ACTIVITY
1. GDP and the Macroeconomy: Learn how to measure the size of an economy using
gross domestic product.
2. GDP Measures Total Spending, Output, and Income: Analyze GDP as a measure of
total spending, output, and income.
3. What GDP Captures and What It Misses: Assess GDP as a measure of living
standards.
4. Real and Nominal GDP: Distinguish between real changes in quantities and the
effects of changing prices.
5. Millions, Billions, and Trillions: Scale large numbers into something more
manageable.
GDP AND THE MACROECONOMY
From Microeconomics to Macroeconomics
What shifts is our focus — from individual income, output, or spending decisions and the
implications for individual markets to the total amount of income, output, or spending across
all the households, businesses, and levels of government that collectively make up the
economy.
The Circular Flow
The circular ow illustrates interdependence in the macroeconomy.
In macroeconomics, your choices depend on what others do, and what others do depends on
what people like you do. It’s the interdependence principle at work.
The circular ow diagram is a simple model of the economy that illustrates how households
and businesses are linked.
Businesses and households interact in the markets for both inputs and outputs.
The circular ow diagram highlights two types of interactions. The top of the diagram shows
the market for outputs, where consumers demand nished products and businesses supply
them. The bottom of the diagram shows the market for inputs, where businesses demand
labor and capital, and households provide them in return for wages and pro ts.
All ows of resources are matched by ows of money.
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The circular ow shows that there are two ways to track what’s going on in the economy. The
rst is the ow of real resources — the ow of actual inputs (like the labor that households sell
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GROSS DOMESTIC PRODUCT
Total income, total output, and total spending are all equal.
The ow of money is a measure of the market value of the resources that are bought, sold,
produced, and earned. This reveals the following:
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All output produced gets sold at some market price. Thus, the market value of total
output must be equal to total spending.
Every dollar that someone spends is a dollar of income for someone else, and so total
spending must be equal to total income.
Digging into the De nition of GDP
The gross domestic product (GDP) is the market value of all nal goods and services produced
within a country in a year. If you tally up the value of all the goods and services people
produce, you’ll know what our collective output is.
In 2021, U.S. GDP totaled $20.5 trillion. A number this big can be hard to wrap your mind
around and can be of limited use when comparing GDP over time or across countries. That’s
why we’ll focus on GDP per person (sometimes called GDP per capita), which is total GDP
divided by the population. The GDP per person was $62,600 in 2021. Let’s unpack the
de nition piece by piece.
“The market value …”
The grand total of $20.5 trillion is the market value of everything that was produced in 2021.
Getting to this grand total requires adding up the value of everything that was produced. We
can add up all that was produced because they are expressed in a common unit: the dollar.
This means that GDP values each good according to its market price.
“… of all …”
GDP includes both goods (such as armchairs) and services (such as zoo visits). It’s not just
the stuff that you buy for yourself but also the things that the government purchases for you,
such as public education and national defense.
However, it doesn’t include economic activity that occurs outside of markets. This means that
the vacuum that you purchased is part of GDP, but the cleaning services you provide your
household when you use it are not. Paradoxically, if you hire people to use your vacuum to
clean your oors, their work is counted as GDP.
“… nal goods and services …”
GDP counts only nal goods and services, which are nished goods or services sold to their
nal user.
This means that GDP doesn’t separately include intermediate goods and services, which are
those goods and services used as inputs in the production of other products. You don’t want to
count both the value of a couch and the value of the wood that went into it, because that would
be effectively counting the cost of the wood twice.
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“… produced …”
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to businesses) and the ow of actual outputs (like the goods and services that businesses sell
to households). The second is the ow of money exchanged for resources, which shows us the
market value of these resource ows. Each ow of real resources is matched by an equal and
opposite ow of money.
Because GDP measures production, it doesn’t count resale of existing nished goods. So when
you buy a second-hand item, your purchase won’t add to GDP because it doesn’t involve any
new production. Second-hand sales merely change the ownership of goods that were
previously counted in GDP.
“… within a country …”
GDP measures what we’re collectively producing domestically, meaning within the United
States. It includes everything produced in workplaces in the United States — even if a foreignowned company makes them and even if the goods are sold to people outside the United
States. It excludes any goods produced in other countries, even if produced in Americanowned factories.
“… in a year.”
When you measure GDP, you add up all the activity that’s occurred during a given time
period. Most countries add up all the activity that occurs within a year.
GDP MEASURES TOTAL SPENDING, OUTPUT, AND
INCOME
Learning Objective: Analyze GDP as a measure of total spending, output, and income.
The fact that GDP is three things at once — total spending, total output, and total income — is
not just a surprising insight; it’s also useful. It means that there are three different ways to
measure GDP:
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by adding up every dollar of spending;
by adding up every dollar’s worth of output produced; or
by adding up every dollar of income earned.
Perspective 1: GDP Measures Total Spending
Tracking spending is useful because you can gure out who’s doing all that spending —
whether it’s businesses, households, governments, or foreigners — and what they’re buying.
GDP is total spending on nal goods.
GDP includes only spending on nal goods, so the key transaction occurs when the nal user
purchases an item.
GDP includes new inventories.
Because GDP is a measure of production, it counts goods in the year they’re made, regardless
of the year in which they’re sold. This means that it’s important to count new inventories as
part of GDP. The inclusion of inventories in GDP ensures that total spending equals total
output.
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GDP is the sum of consumption, investment, government purchases, and net exports.
Economists often use abbreviations to describe each type of spending: consumption is denoted
C, investment is I, government purchases are G, and net exports is NX. Finally, GDP is
denoted Y. Because GDP is the sum of each type of spending, it’s calculated as follows:
Y = C + I + G + NX
This equation is an identity, which means that it’s always true because it describes the
de nition of GDP.
Household purchases are typically called consumption.
When your household buys goods and services, it’s counted in GDP as consumption. It
includes nondurable and durable goods as well as services, including rents. This raises a
tricky issue because homeowners enjoy a similar stream of bene ts in terms of shelter and
comfort but don’t pay any rent. In order to treat all housing services equally, GDP also counts
an imputed rent — an estimate of the rental value of your home — that you (the consumer of
housing services) effectively pay to yourself (the homeowner).
Business purchases are typically called investment.
Economists use the word investment to refer to spending on new capital assets that increase
the economy’s productive capacity. It includes both the purchase and the production of longlived assets that contribute to future production.
Most investment is done by businesses, but purchasing a newly built home also counts as
investment because it increases the economy’s capacity to provide housing services. So newly
built houses are added to GDP as residential investment. But if you buy an existing house,
you’re simply changing who owns an existing asset, so your purchase isn’t included in GDP.
Government purchases are called … government purchases.
Whenever the government purchases goods and services, it’s counted as government
purchases. This includes local government spending on schools, state government
expenditures on highways, and federal government outlays on the military.
But a lot of government outlays don’t count as government purchases. For instance, the
government sends out billions of dollars in Social Security and unemployment insurance
checks. These are examples of transfer payments, which transfer income from one entity (the
government) to another (an individual). Because transfer payments involve no new
production of goods or services, they’re not counted in GDP.
Foreign purchases of our goods less our purchases of foreign goods is called net exports.
Remember that GDP measures domestic production. Exports are goods and services that we
produce domestically in the United States and sell to people and businesses in other countries.
Because exports are produced domestically, this spending is included in GDP. Imports are
goods and services that are produced in other countries and purchased by domestic American
buyers. Because imports aren’t produced domestically, they’re excluded from GDP.
All imports of nal goods are already counted as either consumption, investment, or
government purchases (depending on who bought them). So to exclude any in uence of
foreign-produced goods from GDP, we need to subtract spending on imports from total
spending.
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As a result, GDP adds in exports and subtracts imports. This is why it counts net exports,
which is spending on exports minus spending on imports. But don’t let this confuse you into
thinking that imports subtract from GDP. They don’t. They’re simply excluded from GDP:
they’re neither a positive nor a negative.
Perspective 2: GDP Is Total Output
Viewing GDP as output is a useful perspective because it highlights what’s being made and by
whom. It provides an economy-wide benchmark against which you can compare your
company’s size and productivity.
GDP is the sum of value added at each stage of production.
Economists have devised a clever way to measure the output of each business involved in a
complicated production process. It’s based on the idea that each step of the production
process makes something more valuable.
Value added represents the amount by which the value of an item is increased at each stage of
production:
Value added = Total sales – Intermediate inputs
Each stage of the production process before the nal sale adds value.
Total GDP is the sum of the value added across all businesses in the economy.
Total output and total spending are equal (and they both equal GDP).
This calculation of total output yields the exact same answer as calculating GDP based on
spending on nal goods.
Production of services dominates goods.
Once you’ve measured the value added by businesses in different sectors of the economy,
measuring total output simply requires adding up the output across each of these sectors.
These data are particularly valuable because they reveal the structure of production. They
show that the modern U.S. economy is dominated by the service sector, which accounts for
83% of output. By contrast, goods account for only 17% of the economy.
Perspective 3: GDP Measures Total Income
This is a particularly useful perspective because GDP per person measures average income,
which you can use to assess the material living standards in a country and determine
whether they’re improving.
GDP is total income, which is the sum of total wages and total pro ts.
There are two sides to every transaction — a buyer and a seller — and so every dollar that a
buyer spends also registers as a dollar of income to a seller. This means that we can also
measure GDP by adding up the total income earned in productive activities. In other words,
we add up all of the wages earned by workers as well as the pro ts that shareholders and
business owners earn.
Capital gains and losses aren’t counted as new income.
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Capital gains don’t count as GDP even when you sell assets at a higher price than you paid for
them because they’re simply the resale of existing assets rather than income earned from
productive activity.
Labor’s share of total income is declining.
The labor share of income describes the share of total income that goes to workers such as
wages, salaries, and bene ts. The labor share has declined over recent decades. In turn, the
capital share — the share of income that goes to the owners of capital — has risen. Because
capital is owned by a smaller and richer group of Americans, this rising capital share has led
to rising income inequality.
Putting It All Together
While total production, total spending, and total income are the same in theory, they get
different names because in real-world measurements can differ because each relies on
different sources of imperfect data.
WHAT GDP C APTURES AND WHAT IT MISSES
Learning Outcome: Assess GDP as a measure of living standards.
Limitations of GDP
GDP misses a lot of what’s important. Let’s explore some of the most important limitations of
GDP.
Limitation 1: Prices are not values.
The argument for valuing goods at their market prices is that in a perfectly competitive
market, the price is equal to the marginal bene t of a good. But this still misses a lot. The
problem is that GDP counts only your spending on a good, but your bene t is often much
larger if you enjoy consumer surplus.
Limitation 2: Nonmarket activities — including household production — are excluded.
GDP measures only goods and services that are sold in markets, which misses a lot of
productive activity. One recent estimate suggests that the value of all the uncounted
housework, cooking, odd jobs, yard work, shopping, and child care that we do for ourselves
over the course of a year adds up to roughly $9,000 per person.
Limitation 3: The shadow economy is missing.
A large amount of economic activity occurs “in the shadows,” purposely conducted out of view
of the government because it involves illegal products and services. Together, these activities
are called the shadow economy. Many of these activities occur deep enough in the shadows
that they’re unmeasured, and thus they’re effectively excluded from GDP.
Limitation 4: Environmental degradation isn’t counted.
Effectively, GDP treats natural resources as if they have no value until they’re transformed
into something else. What you might see as destruction GDP counts as production. Because
GDP treats nature as if it’s free, it ignores the costs of environmental degradation, fails to
account for biodiversity, and takes no account of global warming.
Limitation 5: Leisure doesn’t count.
GDP counts the bene t of work (more income!) but omits the cost (which is less leisure).
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Limitation 6: GDP ignores distribution.
You can think of GDP as measuring the size of our economic pie, with GDP per person
measuring the size of the average slice. But what really matters to people is their actual slice,
not the average slice. And so the distribution of income matters, too.
GDP as a Measure of Living Standards
It’s not that GDP measures what matters but rather that it measures the resources that a
society has available to pursue what matters. If we use those resources well, then people who
live in countries with high GDP per person will live happier, more ful lling lives.
People who live in countries with higher GDP per person tend to enjoy better life outcomes.
Also, in countries with higher GDP per person, people get more education, live to older ages on
average, and have fewer babies who die before their rst birthday. This is partly because
higher GDP is associated with better access to a variety of necessities. People in countries
with high GDP also tend to enjoy more rights and personal freedoms and to live in more
inclusive societies. For all of its shortcomings, GDP appears to be closely related to many
other indicators of the quality of life.
REAL AND NOMINAL GDP
Learning Objective: Distinguish between real changes in quantities and the effects of changing
prices.
In 2021, GDP was $20.5 trillion, compared to a value of $10.25 trillion in 2000. But total
economic activity didn’t double over this period. The problem is that the market value of total
production could double because we’re making twice the quantity of stuff or because we’re
making the same quantity of stuff but market prices are twice as high. This distinction
matters because an increase in the quantity of stuff we produce raises living standards, while
a change in the price tags attached to that stuff doesn’t change anyone’s quality of life. When
we look at an increase in GDP, we need to determine if it is changing due to a change in
production, a change in prices, or a combination of both.
Real and Nominal GDP
Nominal GDP is GDP measured in today’s prices. To calculate nominal GDP, you add up the
market value of total production in a year using the current prices prevailing in that year.
Nominal GDP is useful if you want to know what GDP is right now. The problem is that when
prices rise over time, nominal GDP will rise even when actual production is unchanged.
Real GDP is GDP measured in constant dollars, so that it excludes the effects of price changes.
By focusing only on changes in GDP due to changes in the quantity of output produced, real
GDP isolates economic growth. It’s calculated by adding up GDP as if no prices changed
between last year and this year.
How to Calculate Real GDP
Calculate nominal GDP using current prices.
Nominal GDP is calculated as the market value of total output in each year, where each year’s
output is valued based on the market price in the year it was produced. It’s sometimes
referred to as GDP at current prices.
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Calculate real GDP using constant prices.
Real GDP is calculated by computing growth in the value of output between this year and last
year, where that output is valued using an unchanging, or constant, set of prices. As a result,
it’s sometimes referred to as GDP at constant prices.
There’s a trick for moving quickly between real and nominal GDP growth.
The growth rate of real GDP is the growth rate of nominal GDP, less the average growth rate of
prices.
MILLIONS, BILLIONS, AND TRILLIONS
Learning Objective: Scale large numbers into something more manageable.
The Problem of Big Numbers
Psychologists have found that people often have faulty intuitions about large numbers, noting
that once numbers get beyond a certain point, they start to lose meaning to people.
Start by visualizing the difference.
Want to picture the total amount of annual GDP for the United States? It’s a bit more than
$20.5 trillion. Imagine your favorite football stadium, and ll it with $100 bills from ground
level all the way up to the nosebleed seats. That’s roughly annual U.S. GDP.
Four Strategies for Scaling Big Numbers
Strategy 1: Evaluate what it means per person.
Total GDP in 2021 was $20.5 trillion, but it’s far more intuitive to think of this as $62,600 per
person. Keeping a few baseline numbers in the back of your mind will help you apply this
strategy as you encounter more macroeconomic data:
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The world population is nearly 8 billion.
The United States population is about 330 million.
There are around 100 million households in the United States.
When you encounter other large numbers, you’ll better comprehend their scale if you bring
them down to size by converting them to per person or per household measure.
Strategy 2: Compare big numbers to the size of the economy.
An alternative approach scales big numbers by comparing them to the size of the total
economy. For example, in 2021, the federal government’s budget de cit was $779 billion.
Without further context, it can be hard to make sense of a number this big. But compare it to
total GDP, and you’ll discover that the budget de cit was equal to 3.8% of GDP, which gives you
a better sense of the scale of the problem.
Strategy 3: Compare big numbers to their own history.
Another way to scale big numbers is to evaluate their size relative to their previous values.
This is what percent changes do.
Strategy 4: Use the Rule of 70 to evaluate long-run growth rates.
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The Rule of 70 says that you can gure out approximately how many years it will take
something to double if you divide 70 by its annual growth rate.
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You can use this approximation to gure out how long it will take you to double your savings,
how long it will take a country to double its average income, and how long it will take your
business to double your number of customers.
ONE PAGE SUMMARY
ECONOMIC GROWTH
Chapter objective: Understand what determines the rate of
economic growth.
1. Economic Growth Facts: Learn how economies have grown over time.
2. The Ingredients of Economic Growth: Uncover the ingredients for economic growth.
3. The Analytics of Economic Growth: Understand how workers, capital accumulation, and
technological progress work together to create economic growth.
4. Public Policy: Why Institutions Matter for Growth: Find out why government institutions
matter for economic growth.
ECONOMIC GROW TH FACTS
Learning Objective: Learn how economies have grown over time.
Economic Growth Since 1 Million b.c.e.
Economists estimate that from around 1 million b.c.e. until around 1200 c.e., GDP per person
was only around $200 per year in today’s dollars. From 1200 c.e., it took roughly 600 years
for GDP per person to double. At the start of 1800, world annual real GDP per person was
roughly $400.
Agricultural advances meant more food and less hunger.
Most people’s primary job was securing enough food to avoid starvation. But as agricultural
techniques improved over the centuries, people could produce more food with less work.
Taken together, these developments meant less hunger, and fewer people needed to work on
farms.
The Industrial Revolution created an engine of economic growth.
The Industrial Revolution brought machine power to our productive efforts and the
transportation of food and goods. Inventors pioneered revolutionary new products such as
the steam engine, sewing machine, telephone, and light bulb.
The invention of machines that could substitute for human or animal labor brought enormous
growth in what people could produce. Workers moved from farms to factories, and their
ability to produce output increased at a rapid pace. (Farms were able to produce more with
fewer workers, too.) This was the real beginning of increasing income and living standards.
Global GDP per person more than doubled between the early 1800s and the early 1900s.
Economic growth exploded, with worldwide GDP per person doubling again by the 1950s, and
then again by 1975, again by the early 2000s, and again by 2020.
Economic growth means rising living standards and longer lives.
When people produce more, they can consume more. Fewer people go hungry, and more
people have a comfortable place to live, sanitary conditions, and more resources to invest in
their health and education. Growth doesn’t just mean you consume more stuff; it’s what
enables you to live and thrive.
In 1800, average life expectancy in every country was below age 50. Today, the average
person in many of the richest countries in the world can expect to live well into their 80s.
Economic Growth over the Past Two Centuries
Small differences in growth rates can have big effects.
The Industrial Revolution fueled more economic growth in some parts of the world than
others. What may seem like small differences in growth rates lead to enormous differences
over time. Only a few tenths of a percentage point in annual growth rates differentiates
today’s economically developed countries from less-developed countries.
There have been growth successes and disasters.
The facts about economic growth are astonishing. During the last 200 years, the global
economy has grown enormously, transforming our quality of life. But this development has
been uneven, creating remarkable disparities with average income in some countries many
times larger than in others. For instance, Argentina, which was once richer than Spain,
Japan, and South Korea, has now fallen behind those countries’ economies. In 2017,
Argentina’s average income was about one-third that in the United States.
THE INGREDIENTS OF ECONOMIC GROWTH
Learning Objective: Uncover the ingredients for economic growth.
What determines how much output each country produces?
The Production Function
A production function describes the methods by which inputs are transformed into outputs. It
determines the total production that’s possible with a given set of ingredients.
A production function is like a cookbook.
Think of the production function as the whole cookbook. A cookbook is a collection of the most
important recipes, and each page lists a different production technique you might choose,
depending on the ingredients you have available. A cookbook and a production function both
describe how different mixtures of inputs can be combined to produce valuable output.
A production function describes how a business transforms inputs into outputs.
Your company’s production function describes the cookbook of management techniques you
can use to transform your inputs into output. By this view, running a business is a lot like
baking a cake, and your job as a manager is to acquire the right ingredients — the right people,
skills, and machinery — and mix them in the appropriate proportions to produce valuable
output.
The aggregate production function links GDP to labor, human capital, and physical capital.
The aggregate production function relates total output — that is, GDP — to the quantity of
inputs employed. The key ingredients are labor, human capital, and physical capital.
A production function describes how output varies with inputs.
The aggregate production function captures the idea that when you use more ingredients —
more labor, more human capital, and more physical capital — you’ll get more output. It
quanti es this relationship, telling you how much extra output businesses will produce as
they add more labor, human capital, or physical capital:
Y = f(L, H, K).
Ingredient 1: Labor and Total Hours Worked
The total quantity of labor input is measured as the sum of all hours worked across the whole
economy. It re ects four factors: the size of the population, the fraction who are of working
age, the share of those working-age people who choose to work, and the number of hours each
worker puts in.
Population boosts total GDP, but not GDP per person.
The total population of a country provides the upper limit to how much labor it can supply,
which explains why the countries with the largest populations tend to produce the most GDP.
But that doesn’t mean that a larger population will yield higher living standards because that
larger GDP gets shared over more people. Population is a key determinant of GDP but not GDP
per person. That is why we focus on per person variables such as hours worked per person,
human capital per person, and physical capital per person.
Unfavorable demographics can slow economic growth.
The demographic structure of the population matters because children and the elderly rarely
work. The dependency ratio measures the number of people either too young (under 18) or
too old (65 or older) to work, per 100 people of working age.
This dependency ratio is projected to rise sharply over the next few decades, as the baby
boomer generation (those born after World War II) begins to retire, and it will remain high due
to increased longevity. The rising share of dependents is likely to slow economic growth in
richer countries over the coming decades.
Women’s increased employment created economic growth.
The labor pool grows when a larger share of the working-age population chooses to work. The
main driver of the rising labor force participation in many countries over the past century
has been an extraordinary transformation in attitudes toward women in the workplace.
Between the early 1900s and the early 2000s in the United States, that share had almost
tripled.
Shorter workweeks reduce GDP but may raise well-being.
Total labor input re ects not only the number of workers but also how many hours each
person works, on average. The more hours that people work, the more GDP they’ll produce.
As countries get richer, people tend to choose more leisure over work time. The reduction in
the average workweek has slowed GDP growth but probably improved well-being.
Ingredient 2: Human Capital
The more each worker produces per hour, the higher GDP will be. Economists refer to output
per hour of work as labor productivity.
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Your labor productivity depends critically on your human capital, which describes the skills
and knowledge that you develop through education, training, and practice.
Primary education develops literacy, which is a key tool for further learning.
Literacy is essential for economic life: You need to be able to read to follow written
instructions, communicate with co-workers, execute written contracts, look things up online,
read a newspaper, or evaluate political candidates. Literacy is nearly universal among
industrialized countries, but it remains a substantial barrier in many poorer countries.
Secondary education promotes greater productivity in a range of jobs.
One of the key reasons the United States was one of the fastest-growing economies in the
twentieth century is that it invested more in the education of its citizens than other countries
did.
Further gains in human capital will come from expanding college education.
Now that primary education and secondary education are nearly universal in the United
States, further gains in human capital accumulation will come from more people completing a
college education.
The rate of return to making these investments is high: Each year of college raises your
earnings by around 8%, and employers pay this premium because the skills you learn in
college tend to make workers more productive.
When common international exams are given across countries, the United States is no longer
a world leader. This explains why so many education policy debates are focused on improving
the quality of education.
Ingredient 3: Capital Accumulation
The third factor that determines how much you can produce per hour is the equipment
available for use. The capital stock is the total quantity of physical capital, and it includes all
equipment and structures used in the production of goods and services.
Physical capital is a complement to labor.
Workers produce more when they have the right tools available to them, so physical capital is
best viewed as a complement to labor. Although some people worry that machines are a
substitute for labor, the reality is that they help workers get more done.
Investment depends on the savings rate.
Companies grow their capital stock by investing in new equipment and structures.
Investment occurs out of resources that are saved rather than consumed. And so, the savings
rate is a critical determinant of investment, which ultimately determines the amount of
capital each worker has to work with.
Foreign investment builds the capital stock.
The other way to grow the American capital stock is through foreign investment. The wages
that are paid will accrue to the American workers employed by foreign companies, and the
pro ts will go to the foreign investors. The production that occurs within our borders,
however, still contributes to our GDP.
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New Recipes for Combining Ingredients: Technological Progress
This points to the nal source of economic growth: new ideas, recipes, or production
techniques. Economists refer to new methods for combining existing resources as
technological progress.
Technological progress is like a new recipe for combining ingredients.
Technological progress can involve new production techniques that build on scienti c
discoveries to allow more output from existing inputs. Technological change can result from
new and better ways of managing techniques. Sometimes technological change literally is just
a new recipe.
Computers embody technological progress.
The technological progress that sparked the computer revolution is also a new recipe. The key
ingredient of computers is sand (or silicone dioxide), and it has existed for thousands of
years. Builders used it as an ingredient in their cement mixes, and artisans in Venice melted
it to create glass. What’s new is the understanding that silica can both conduct and block
electricity, which means that it’s a semiconductor.
T H E A N A LY T I C S O F E C O N O M I C G R O W T H
Learning Objective: Understand how workers, capital accumulation, and
technological progress work together to create economic growth.
Where does economic growth come from, and will it continue?
Analyzing the Production Function
The production function generates a number of important insights into the process of
economic growth.
Insight 1: Constant returns to scale means doubling inputs will double output.
Most economists believe that doubling all of the inputs to the aggregate production function —
the labor, physical capital, and human capital used — will lead to twice the output. This implies
that the production function has constant returns to scale, which means that increasing all
inputs by some proportion will cause output to rise by the same proportion.
Insight 2: There are diminishing returns to capital.
What happens if you double your physical capital and don’t change the number of workers?
You’ll produce more, but you won’t produce twice as much. How much extra this produces
depends on how much capital you have to begin with.
The law of diminishing returns says that when one input is held constant, increases in the
other inputs will, at some point, yield smaller and smaller increases in output. Each additional
investment is less helpful than the previous one when at least one factor of production is held
constant.
So when workers don’t have many tools to work with, the marginal bene t of adding one more
unit of capital per person will lead to large gains in output. But once each worker has a lot of
capital, adding more capital has a smaller effect.
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Insight 3: Poor countries can enjoy catch-up growth.
If a relatively poor country starts investing in machines, factories, and other equipment, it
will experience relatively rapid output growth. The rapid growth that occurs when a
relatively poor country invests in capital is known as catch-up growth. It raises the possibility
that if poor countries make similar investments to rich countries, the gap between poor and
rich countries will narrow.
Capital Accumulation and the Solow Model
Can capital accumulation, by itself, serve as an engine for ongoing growth in output per
person? To answer this question, we’ll need to consider the Solow model.
Insight 4: The capital stock will grow as long as investment outpaces depreciation.
Investments in new equipment and structures boost the capital stock and, therefore, the
economy’s capacity to produce output. But each year some proportion of the existing capital
stock is destroyed by depreciation. This means that the capital stock and the economy will
grow as long as investment exceeds depreciation.
Insight 5: Capital per worker will eventually stop growing.
Unfortunately, this won’t continue forever. First, there’s the problem of rising depreciation: As
the capital stock grows, total depreciation will grow, too. We will need larger and larger
amounts of investment merely to replace the capital lost to depreciation. Second, there’s the
problem of diminishing returns. Each increment of capital creates a smaller and smaller
addition to output.
This combination of diminishing returns and depreciation means that, at some point, the
amount of new investment the economy generates will no longer exceed the amount of capital
lost to depreciation.
Insight 6: Capital accumulation can’t sustain long-term economic growth.
The key question the Solow model asks is whether capital accumulation can generate
sustained economic growth. A virtuous cycle exists, but this process peters out. Each
successive cycle of increased capital yields successively smaller boosts in output and smaller
boosts in investment. But on each successive cycle, the economy’s depreciation bill keeps
rising. Eventually, the process stalls because the economy grows to the point where new
investment in capital merely offsets depreciation. The capital stock remains at a rest point
that we call the steady state.
We’ve discovered that although capital accumulation by itself can’t support sustained
economic growth, it can explain why poor countries will experience rapid growth as they
catch up or converge to the rich countries. But capital accumulation can’t explain why rich
countries such as the United States and much of Europe have enjoyed sustained economic
growth. In other words, there is economic growth in developed countries that the Solow model
cannot explain.
Technological Progress
The key to sustained economic growth is technological progress. The development of new
production methods creates new ways to combine existing resources to produce more
valuable output.
Technological progress shifts the production function.
That means it increases the output that’s produced from any given level of inputs.
Technological progress can make investing in capital more productive and more valuable as
the new production function is steeper than the original. This means that the extra output
you get from investing in one more machine has risen.
So technological progress both leads to more output from existing inputs and also spurs
capital accumulation, raising the level of inputs. By this view, the key to sustained economic
growth is sustained technological progress, continually pushing the production function up.
Technological progress relies on new ideas.
New technology is fundamentally about new ideas. New ideas create new ways to transform
existing physical inputs into more valuable outputs.
Two things drive technological progress: how quickly new ideas are created and how many
resources are devoted to generating new ideas. Workers can produce either goods and
services or new ideas. There’s a trade-off here: In the short run, if everyone produced goods
and services, our economy would produce more goods and services. But in the long run, with
no one investing in technological progress, there would be no economic growth.
Only if enough resources are devoted to ongoing research and development, will the economy
yield a steady stream of new ideas, powering ongoing economic growth.
The absence of technological progress explains why growth took so long to occur.
You can think about all this through the lens of the opportunity cost principle: The true cost of
something is the most valuable alternative you must give up. Back when humans weren’t
producing enough food to prevent starvation, the opportunity cost of producing new ideas
instead of farming was producing less food, which translated to starvation and death. Today,
the opportunity cost of having people work on innovation is lower, and so we do more of it.
Technological progress allowed us to break the cycle of poverty.
Thomas Malthus, an eighteenth-century economist, believed that food production would
never successfully outpace population growth, so the world was forever doomed to
subsistence living. Malthus was wrong about the future because technological progress in
agriculture vastly outpaced population growth. The earth’s ability “to produce subsistence for
humanity” was much greater than he ever thought possible, and that change occurred
because of new ideas about how to produce more with less.
There are no limits to technological progress.
Modern-day concerns about the limits of economic growth have often focused on energy
consumption. It turns out that even as countries like the United States have continued to
grow, we haven't much increased our energy consumption. Indeed, the total amount of energy
that Americans consumed barely changed in the rst two decades of the twenty- rst century,
and our use of fossil fuels has actually declined. This doesn’t mean that you shouldn’t worry
about pollution; it just means that you can’t conclude that it means economic growth is
limited.
As long as we keep coming up with new ways to do more with less, the economy can keep
growing. As a result, most economists expect that we will enjoy ongoing economic growth and
continually rising living standards for the foreseeable future.
Ideas can generate unlimited growth.
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Idea-driven, rather than capital-driven, economic growth can be sustained because ideas are
different from physical capital in three ways:
● Ideas can be freely shared. Economists refer to this as nonrival, which means that one
person’s use of an idea doesn’t subtract from another’s.
● Ideas do not depreciate with use.
● Ideas may promote other ideas. Ideas can beget new ideas through spillover effects.
This means that ideas can create a virtuous cycle of more ideas, more growth, and then
even more ideas.
The problem with ideas is that they are often nonexcludable, which means that it’s hard for
you to prevent others from using and hence pro ting off your idea. It’s a problem that can
lead people to underinvest in coming up with new ideas, creating innovations, and bringing
them to the market. As a result, businesses will devote fewer resources to innovation than is
in society’s best interests.
PUBLIC POLICY: WHY INSTITUTIONS MATTER FOR
GROW TH
Learning Objective: Find out why government institutions matter for economic
growth.
What factors determine whether people will invent new ideas and invest in human or physical
capital?
The most common reasons that countries fail to grow are related to their institutions and
government. Two countries may have the same amount of physical and human capital, but
what they produce depends on how ef ciently workers, workers’ skills, and physical capital
are allocated across the economy. And that allocation has a lot to do with the “rules of the
game,” or the institutional structure in a country. The government also plays an important
role in encouraging investment in physical and human capital and funding research into new
ideas.
Property Rights
Property rights determine who controls a tangible or intangible resource. When property
rights are well de ned, the rules are clear, and people can spend less time ghting over a
particular resource.
To have well-de ned property rights requires having a clear set of laws that establish your
rights and a stable, trusted system of enforcing those rights. Without property rights and a
trusted enforcement system, people do not create wealth because they fear that they will lose
it. That means that trusted and ef cient enforcement institutions play an important role in
creating the right environment for economic growth.
Sometimes the government does too little to enforce property rights and the rule of law, and
sometimes the government itself becomes part of the problem. In corrupt countries and
political systems, people fear that government will strip them of their wealth.
Government Stability
Corruption and political instability can discourage investment and innovation. Turmoil at
home creates the incentives for political leaders to extract resources for their personal gain,
and it discourages investment because political uncertainty means people can’t count on
receiving the returns on their investment.
Ef ciency of Regulation
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In general, regulatory oversight in the United States is lighter than in most of the rest of the
world. The World Bank estimates that it takes six days to start a business in the United States.
Compare that with Argentina, where it takes 25 days to open a business and 230 days in
Venezuela.
This is the trap a lot of countries are in: it’s hard to invest or innovate because of excessive
red tape. But even though there’s too much red tape, there’s often insuf cient enforcement of
property rights and government corruption. Together, this creates few incentives to invest
and innovate, which is an important reason that some countries are poor.
Government Policy to Encourage Innovation
Government policy is important for helping to create incentives and support the development
of new ideas. One way it does that is by protecting investments in new ideas to ensue those
who invest in them are able to pro t off their investment. Another way is by directly paying
research and development. Let’s explore these ideas a little further.
Innovation strategy 1: Create incentives through intellectual property laws.
The government uses intellectual property laws to protect the value of your innovation. These
laws typically give you an exclusive right to use your idea, ensuring that other businesses
that want to use it will have to pay you for the right to do so. One form of intellectual property
right is copyright, which gives authors and artists exclusive rights to their work. Trademarks
protect rms from competitors who want to use their brand names. And patents grant people
and companies exclusive rights to inventions, whether it’s the design for the iPhone or how to
make a new pharmaceutical drug.
Innovation strategy 2: Subsidize research and development.
Governments can directly subsidize research into new ideas. When the government helps
lower the cost of innovation, businesses do more of it. In the United States, research and
development subsidies go to companies, the government
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O N E PA G E S U M M A R Y
UNEMPLOYMENT
Chapter objective: Learn to assess the causes and costs of unemployment.
1. Employment and Unemployment: Understand what unemployment is and how it’s
measured.
2. The Dynamics of the Labor Market: Learn how people move in and out of jobs and in and
out of the labor market.
3. Understanding Unemployment: Analyze the causes of unemployment.
4. The Costs of Unemployment: Learn about the economic and social costs of
unemployment.
E M P LOY M E N T A N D U N E M P LOY M E N T
Learning Objective: Understand what unemployment is and how it’s measured.
The Employed and the Unemployed
The working-age population is composed of those age 16 or older who are not in the military
or institutionalized.
The Bureau of Labor considers everyone age 16 and older to be of working age.
The employed are working-age people who are working. As long as people work at least one
hour during the week for pay of some kind, they are considered employed.
The unemployed are the working-age population without jobs who are trying to get jobs. To be
counted among the unemployed, you must be
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part of the working-age population;
not currently working;
actively searching for work; and
able to accept a job that is offered.
Notice that to be unemployed, you have to do more than want a job: You must be actually
trying to get a job and available to work if you nd a job.
The employed plus the unemployed are the labor force.
The labor force is the part of the working-age population that is employed or unemployed —
the people who are available to produce goods and services.
Everyone in the working-age population falls into one of three categories: employed,
unemployed, or a third category called not in the labor force. This third category includes
those who are not in the labor force (neither employed nor unemployed), are still workingage, and are not institutionalized (for example, in school, a hospital, or jail).
Labor Force Participation
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The labor force participation rate is the percentage of the working-age population that is
either employed or unemployed:
The labor force participation rate patterns differ for men and women.
There were two strong trends in the labor force participation rate during the twentieth
century: the growth in women’s participation and the decline in men’s. The growth in
women’s labor force participation more than offset the decline in male participation for most
of the twentieth century, but women’s participation peaked in 1999.
The Unemployment Rate
The unemployment rate is the percentage of the labor force that’s unemployed:
Unemployment rates vary for different groups.
The unemployment rate is lower for those with more education. The unemployment rate also
differs by race and ethnicity. Asian Americans have the lowest unemployment rate. The
unemployment rate among White Americans is slightly higher. Black Americans and Hispanic
Americans have the highest unemployment rates. Unemployment rates don’t really differ
between men and women.
Unemployment rates differ around the world.
The United States has a lower unemployment rate than many other countries.
The unemployment rate uctuates over time, but it’s never zero.
The unemployment rate also varies over time as the economy strengthens and weakens.
When the economy is growing fast, the unemployment rate tends to fall, and when the
economy is slowing down, it tends to rise.
The equilibrium unemployment rate is the long-run unemployment rate to which the economy
tends to return. The unemployment rate tends to uctuate around this level.
T H E DY N A M I C S O F T H E L A B O R M A R K E T
Learning Objective: Learn how people move in and out of jobs and in and out of the labor
market.
Every day, hundreds of thousands of people leave and start jobs. People leave jobs for all sorts
of reasons: they may get laid off or red, they may quit for a better job, or they may quit to
exit the labor force.
Labor Market Flows
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In any given month, more than 6 million people in the United States start a new job, and over
6 million people leave jobs.
A dynamic labor market makes it easier for people to nd new jobs.
The largest source of job openings comes from people leaving existing jobs, and even declining
sectors continue to have a lot of people leaving jobs and new people being hired.
There can be a lot of hiring even in a declining sector. Because it’s a declining sector, some
people won’t nd jobs, and others will have a long wait for a new job. In contrast, it’s easier to
nd a job in an expanding sector because the number of jobs being created exceeds the
number of people leaving jobs, making it easier for everyone to nd a job.
Most job seekers are employed.
One aspect of a dynamic labor market is that most people seeking new jobs are already
employed. This makes nding a job harder for the unemployed because they are competing
against both other people without jobs and also people with current jobs.
Most unemployment spells are short.
The typical person who becomes unemployed will be back in a job within 10 weeks, and most
unemployed people will be back in a job within a month. But some nd themselves
unemployed for a long time. The long-term unemployed are people who have been unemployed
for six consecutive months or longer.
Discrimination and skill loss make it hard for the long-term unemployed to nd work.
Workers who have similar skills but have a long spell of unemployment on their resume are
less likely to be given an interview and less likely to be hired. Also, the long-term unemployed
may lose skills and connections the longer they are out of work.
Alternative Measures of Unemployment
There are two groups of people we need to consider: those who are not in the labor force but
who would work under the right conditions and those currently working but want more work.
Some people not in the labor force would work under the right conditions.
When people are not currently searching for a job but have searched for a job within the past
year, they are called marginally attached to the labor force. The marginally attached aren’t in
the labor force and aren’t counted among the unemployed. However, a broader measure of
unemployment includes the unemployed plus the marginally attached. Roughly a quarter of
those who are marginally attached are called discouraged workers. They are called
discouraged because the reason they give for not looking for work is that they don’t believe
there are jobs available for them. In other words, they report that they want to work but have
given up trying to nd a job.
Some people who are employed would prefer better jobs.
Other broader measures of unemployment consider people who are underemployed. There are
two ways to be underemployed. The rst is that you want a full-time job but aren’t getting fulltime hours. The second is that your job isn’t adequately using your skills. For example, if you
have a college degree, working as a restaurant server might be considered underemployment.
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When you have a part-time job but you want a full-time job, you are considered involuntarily
part time.
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Some sectors have lost jobs, partially due to labor-saving technological change. But there are
also expanding sectors that are adding even more jobs.
Alternative measures of unemployment tend to follow movements in unemployment.
Typically, when the unemployment rate goes down, so does the share of people who’ve
recently given up searching for a job or are involuntarily part time. A good guess is that the
broadest measure of unemployment is roughly twice the unemployment rate.
UNDERSTANDING UNEMPLOYMENT
Learning Objective: Analyze the causes of unemployment.
To understand what causes unemployment, we start with supply and demand in the market
for labor. Workers supply their labor, selling it for a price (their wage). Like other markets,
supply is upward-sloping, meaning that workers supply more labor when wages are high.
Employers demand less when the price of labor is high, so the demand for labor is downwardsloping. Employers hire fewer people when wages are high and more when wages are low.
If market forces worked perfectly, wages would adjust to the point where the quantity of labor
demanded is equal to the quantity of labor supplied. At this equilibrium, no one who is willing
to work for the equilibrium wage is left unemployed. At any other wage, there are either
unemployed workers or jobs that aren’t lled.
Types of Unemployment
Unemployment re ects the failure of the market to bring the demand for labor in balance with
its supply. Why does this happen?
Unemployment type 1: Frictional unemployment.
Frictional unemployment occurs because it takes time for employers to search for workers
and for workers to search for jobs. Labor demand and labor supply might be in balance. In
other words, there might be enough jobs for all the people who want them. But the process of
matching workers and jobs isn’t instantaneous.
Unemployment type 2: Structural unemployment.
Structural unemployment occurs when there are structural barriers that prevent wages from
falling to the point where labor demand and labor supply are in equilibrium. Because wages
remain higher than the equilibrium level, more workers want to work, but employers offer
fewer jobs.
Unemployment type 3: Cyclical unemployment.
Cyclical unemployment occurs when there is a temporary downturn in the economy. It
explains why the unemployment rate was so high during the 2020 recession and why it came
down as the economy recovered. Cyclical unemployment re ects the fact that during a
downturn there are lots of unused resources in the economy, and unfortunately, that includes
workers.
Frictional Unemployment: It Takes Time to Find a Job
Three major factors determine how much time it takes for workers and jobs to nd each other,
and thus, how much frictional unemployment there is.
Factor #1: The ef ciency of the resources employers and workers use to nd each other.
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Employers and workers have to nd each other. They may rely on word of mouth, online job
postings, recruiting rms, or career centers on college campuses. Since frictional
unemployment re ects an information problem, anything that affects the information that’s
available can affect the amount of frictional unemployment.
The more ef cient the resources available for workers and managers to nd each other, the
lower frictional unemployment is likely to be. Research shows that when workers get access
to job-search assistance, they are reemployed faster.
Factor #2: The alignment of the skills workers have and the skills employers desire.
When workers all differ in their skills and personalities and jobs differ in their attributes and
the skills that they need, it becomes hard for workers and businesses to nd each other.
There can also be skills mismatch, meaning that the skills workers have are not the skills that
employers want. Technological change and international trade lead to changes in the mix of
industries and occupations in which jobs are available, and this can lead to skills mismatch.
Public policy can respond by helping workers learn what jobs do t their skills, helping them
identify regions where job growth is occurring, and offering job-retraining programs.
Retraining programs can reduce frictional unemployment by helping workers develop the
skills that are in demand by employers.
Factor #3: Unemployment insurance and other income support during unemployment.
Unemployment insurance is a program through which the government provides nancial
assistance to workers who’ve lost their job through no fault of their own. The goal is to reduce
the hardships people face as they struggle to pay for housing, food, and other necessities while
unemployed.
To understand why unemployment insurance can lead to longer unemployment durations,
apply the opportunity cost principle. The opportunity cost of staying unemployed to focus on
searching for a better job is the wage you could earn by taking whatever would be the easiest
job for you to get.
Unemployment insurance reduces the opportunity cost of another day spent searching
because if you took the job, you’d get the wage but lose the unemployment insurance check.
Not surprisingly, when people have unemployment insurance, they tend to spend more days
searching and focus their search more on the jobs that are the best t for them.
Without suf cient savings or unemployment insurance, some people end up settling for worse
jobs because continuing to search means not having enough to eat or losing their housing. In
these situations, income support during a job search can lead workers to better long-term
outcomes.
Structural Unemployment: When Wages Are Stuck Above the Supply-Equals-Demand
Equilibrium Wage
In a well-functioning labor market, equilibrium occurs at the intersection of the labor supply
and labor demand curves.
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But sometimes wages are prevented from falling to the supply-equals-demand equilibrium
point. Employers demand fewer workers when the prevailing market wage is above the
market equilibrium wage. Yet the quantity of labor supplied is higher because more people
want to work at higher wages. As shown in Figure 10, when the prevailing market wage is
above the supply-equals-demand equilibrium wage, there’s structural unemployment. The
number of people unemployed is equal to the difference between the quantity of labor supplied
at the prevailing market wage and the quantity of labor demanded.
Ef ciency wages: One cause of structural unemployment.
In 1914, Henry Ford more than doubled wages to what has famously become known as the $5
day when the prevailing market wage was $2.25. To get a job with Ford in 1914, you had to be
two things: a good worker and lucky. If you came in drunk, failed to show up, or couldn’t keep
up with the work, you were red. But even if you were a hard worker, there were more
workers hoping to land a $5-a-day job than there were positions at Ford. That’s why you also
had to be lucky.
Ef ciency wages make it unpro table for employers to lower wages.
An ef ciency wage is a wage above the prevailing market wage, paid to encourage greater
worker productivity. When you’re paid a wage that’s higher than what you would get
elsewhere, you’re more careful not to lose it, meaning you don’t slack off, skip work, or
antagonize co-workers or managers. Highly paid workers are also more likely to feel valued,
inspiring them to give back to their employer in the form of greater effort.
Ef ciency wages can lower total labor costs.
Ford’s problem of rapid turnover ended with the $5 wage. And his workers became even more
productive. Workers who quit knew that their next job would probably pay only $2.25 a day.
Since the marginal bene t of a new job offer was low compared to what they currently had,
Ford’s workers stayed focused on their tasks to avoid being red. Ford later referred to the $5
wage as one of his greatest cost-saving moves.
Ef ciency wages create unemployment.
To understand why labor supply increases, apply the marginal bene t principle: The marginal
bene t of each day spent waiting outside the factory rises due to the higher ef ciency wage.
But not everyone can get hired at the higher wage.
For some workers, the marginal bene t of standing outside the Ford factory will be big enough
that they’ll give up working elsewhere or they’ll enter the labor market in order to stand in
line and hope to get their lucky break at the Ford plant.
When you search for a job today, you don’t typically line up a factory gate. But job search still
takes effort and sometimes people are so busy searching that they are unable to work.
Institutions: Additional Causes of Structural Unemployment
The labor market has many unique institutional features that can keep the wage above its
supply-equals-demand equilibrium wage. These causes of structural unemployment make
workers with jobs better off, but their higher wages and compensation or their more secure
jobs make jobs scarce for others.
Unions can keep wages high for some workers.
Unions are organizations representing workers who band together to negotiate jointly with
their employers. Unionized workers earn about 15% more than a comparable worker in a
nonunion job and often receive better bene ts. Union wages mean that more workers want
union jobs than there are union jobs available and that employers might demand fewer
workers at the higher wage. The result is structural unemployment.
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Job protection regulations make it hard to re workers.
If you want to reduce the number of people unemployed, why not just make it harder for
businesses to re people?
While job protection policies succeed in reducing the number of people who lose their job, they
also reduce the number of workers businesses want to hire at any given wage. These policies
are good for people who are already employed and want to stay in their current jobs. But they
are not good for the unemployed workers and those who want to change jobs or employers.
The minimum wage keeps wages from falling below the set minimum wage.
If the minimum wage is higher than the equilibrium wage, businesses want to hire fewer
workers. Yet more workers want to work at the higher wage. The resulting gap between the
labor supplied and labor demanded is structural unemployment.
Economists who’ve studied the effects of raising the minimum wage suggest that raising the
minimum wage leads to a negligible change in overall unemployment. Most workers earn
wages well above the minimum wage. Many studies show that raising the minimum wage
results in only small changes in the number of such workers hired, although economists
disagree about just how big or small the effect is. The change in unemployment also depends
on just how high the minimum wage is relative to the supply-equals-demand wage: the higher
it is, the more structural unemployment there will be.
Understanding Frictional and Structural Unemployment
Frictional and structural unemployment explain why the equilibrium unemployment rate is
above zero.
T H E C O S T S O F U N E M P LOY M E N T
Learning Objective: Learn about the economic and social costs of unemployment.
When workers are unemployed, everyone loses: workers, their families, and the communities
in which they live. When more people are unemployed, more people suffer.
The Economic Costs of Unemployment
The unemployed often end up with lower wages and worse career opportunities.
Even when people nd work again, they often receive lower pay for decades. This earnings
loss is especially acute if they lose their job during a recession. Men who are laid off as part of
a mass layoff lose an average of 1.4 years of earnings when the overall unemployment rate is
low. But when the unemployment rate is high, such men lose 2.8 years of earnings.
Permanent unemployment can arise from periods of high unemployment.
Unemployed workers may also lose skills or important contacts or be unable to keep up with
changing technology and other developments. The loss of skills, loss of hope, and
discrimination against the long-term unemployed all contribute to lower lifetime earnings for
those who experience long-term unemployment.
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Hysteresis occurs when a period of high unemployment leads to a higher equilibrium
unemployment rate. In other words, the temporarily bad economy makes it harder for people
to nd jobs, even after the economy recovers. So even when enough jobs are nally available,
it takes people longer to nd them. As a result, a temporary period of high unemployment
permanently creates more frictional unemployment.
High unemployment means that the government receives lower tax revenues but spends
more.
When fewer people are working and paying income and payroll taxes, they’re unable to
provide for themselves and are contributing less to public goods. Meanwhile, higher
unemployment can strain government budgets because more people need to use the social
safety net.
The Social Costs of Unemployment
The costs of unemployment are greater than lost wages and output. There are also costs in
terms of health, well-being, crime, and children’s outcomes.
Unemployment can be isolating and painful.
Surveys reveal that the unemployed are more dissatis ed with their lives than the employed.
They’re more likely to experience depression, anxiety, poverty, and divorce. All of these
negative outcomes also come with a higher risk of death, including suicide. Unemployment
can lead to social isolation and a loss of self-con dence and meaning in life.
Long-term unemployment is associated with worse outcomes.
Studies also show that long-term unemployment leads to greater permanent earnings losses
because the wages that long-term unemployed workers receive when they do nd work are
much lower than those that they were previously earning. The long-term unemployed also are
more likely to have health problems. A job loss nearly doubles their chances of dying a year
later, and their death rates are higher for decades later.
Children whose parents experience unemployment suffer.
The children of laid-off workers suffer from the lost household income and from the stress
that the family goes through. These children end up with worse academic outcomes, worse
mental health outcomes, and worse employment outcomes, making less money as adults.
Protecting Yourself from the Harmful Effects of Unemployment
Do more job searching than you really want to do.
Too often people procrastinate nding a job by doing too little search until their savings start
to run out or their unemployment insurance is about to end.
Build up a nest egg.
You should save up if you are not eligible for unemployment insurance. Anyone can end up
unemployed, but the experience is less painful if you have some money in the bank.
Build new skills.
Continuing to learn and build your skills is necessary not only to advance your career, but to
stay employed — and to land on your feet if you nd yourself unemployed.
Keep an eye out for better opportunities when you’re employed.
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Keeping an eye out for better opportunities when you’re employed can help you advance in
your career by identifying jobs that use recent skills you’ve built, but it can also help if things
start to get rocky in your current position. Such searching increases the chance that you’ll
avoid unemployment by being able to start a new job right away.
Build a strong professional network and tap into it if you become unemployed.
Avoid long-term unemployment.
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Sometimes you’re offered a job that’s not quite as good as you think is possible. If it’s your rst
week searching, you might want to turn it down, but don’t keep turning jobs down forever.
You’ve learned about the scarring effects of long-term unemployment. The good news is that
you can keep searching for a better job even while you’re employed.
ONE PAGE SUMMARY
INFLATION AND MONEY
Chapter objective: Evaluate the rate of in ation and its
consequences.
1. Measuring In ation: Understand what in ation is and how to measure it.
2. Different Measures of In ation: Pick the right in ation measure for the task at hand.
3. Adjusting for the Effects of In ation: Learn to account for the in uence of in ation before
making big decisions.
4. The Role of Money and the Costs of In ation: Analyze the role of money so that you can
assess the costs of in ation.
MEASURING INFL ATION
Learning Objective: Understand what in ation is and how to measure it.
In ation is a generalized rise in the overall level of prices. In ation can also be described as a
rise in the cost of living. It means that prices are rising on average.
The Price of a Basket of Goods and Services
The in ation measure that’s most relevant to consumers is calculated using the consumer
price index (CPI). The CPI is an index that tracks the average price consumers pay over time
for a representative “basket” of goods and services.
The in ation rate is the percentage change in the price of a xed basket of goods.
The CPI measures how much prices change on average. But not all prices rise by the same
amount; some prices will rise more than others, and some prices will even fall. To know how
much in ation is occurring, we need to tally up all these price changes.
To do so, we use a representative basket of goods to measure the average price level in the
economy. The in ation rate is the average annual increase in this price level, and it’s
calculated as the percentage change in the price of this basket of goods and services:
Not every price change is a sign of in ation. You should distinguish the macroeconomic
phenomena of in ation, which is a generalized rise in prices, from the microeconomic
phenomena of relative price adjustment.
Constructing the Consumer Price Index and Measuring In ation
The government agency in charge of measuring consumer prices is the Bureau of Labor
Statistics (BLS). In order to construct the CPI, the BLS needs to know what people buy, how
much they pay for it, and how those prices are changing over time.
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Step 1: Find out what people typically buy.
The rst challenge is guring out what to put into the basket. To do that, the BLS surveys
thousands of people to nd out what they buy. Statisticians use these surveys to construct a
basket of goods and services that represents the average household’s purchases.
Step 2: Collect prices from the stores where people do their shopping.
Once you’ve assembled a representative basket of goods and services, you need to track how
much it costs to buy everything in it.
Step 3: Tally up the price of the basket of goods and services.
The total cost in dollars of this representative basket of stuff is scaled to create a price index.
The idea is to pick an arbitrary year (called a base year) and track changes in the cost of that
basket of goods and services over time. Economists tend to scale the cost of the basket in the
base year to $100.
Step 4: Calculate the in ation rate.
The nal step is to calculate the in ation rate, remembering that it’s the percentage change in
the price of that xed basket of goods over a year.
De ation happens when average prices fall. De ation may sound good, but it actually can
cause big problems in the economy because some people stop buying goods and services in
order to wait for them to become cheaper.
The Challenges of Measuring the True Cost of Living
The problem with the CPI is that it tracks the changing price of a xed basket of goods,
whereas in reality, consumers’ buying patterns change often. Failing to account for these
changing buying patterns tends to overstate changes in the cost of living.
Quality improvements can hide price decreases.
Businesses are constantly introducing new and improved products. How should we think
about price changes that come with quality changes? In 2022, a 128-GB iPhone 13 Pro cost
$999, a price increase of 66% over the rst iPhone, but the rst iPhone lacked many of the
features of today’s smartphones.
To measure in ation accurately, we need to compare price changes on a quality-adjusted
basis. That means that the CPI overstates in ation because quality improvements are not
accounted for in adjustments.
New products can make you better off, thereby reducing your cost of living.
The BLS doesn’t attempt to compare new products to the products being replaced in the
basket. Over time, the BLS adds new products to the basket and removes others. Once they
become part of the typical person’s basket of goods and services, changes in the prices of the
new goods and services will be included as part of changes in the overall price level.
The fact that you were made better off by the invention of the new good or service is never
included in the CPI. Because the CPI tracks only the changing prices of existing goods and
services, it doesn’t account for gains we get from the invention of new ones.
You can save money by changing the things you buy.
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When prices rise, you can substitute what’s in your shopping basket to nd cheaper ways to
achieve the same quality of life. Substituting low-in ation goods and services for high-in ation
ones is a good strategy. But the CPI assumes that people keep buying the same number of
goods no matter how expensive they get. This is called substitution bias — the overstating of
in ation that occurs because people substitute toward goods and services whose prices rise by
less.
How much does the CPI overstate in ation?
Economists disagree about exactly how big these measurement problems are. Careful studies
suggest that these three biases (changes in quality, introduction of new goods, and
substitution) together lead the CPI to overstate the rising cost of living by nearly 1% per year.
DIFFERENT MEASURES OF INFL ATION
Learning Objective: Pick the right in ation measure for the task at hand.
In ation data are used for many different tasks: They’re a guideline for cost-of-living
adjustments, an input to adjusting nancial and economic indicators, a guidepost for Federal
Reserve policymakers, and an indicator that forecasters use to project where the economy’s
going. Each role is best served by slightly different measures of in ation.
Consumer Prices
The CPI is used for cost-of-living adjustments.
CPI is used by the government to adjust Social Security and other payments automatically so
that they keep pace with the rising cost of living. These automatic adjustments to compensate
for in ation are known as indexation.
Monetary policy focuses on the personal consumption expenditure de ator.
One key goal of the Federal Reserve is to achieve low and stable in ation. But rather than
focus on the CPI, the Fed sets this target in terms of the personal consumption expenditure
de ator. This alternative measure of in ation is based on a slightly different basket of goods
and services that also includes items that you consume but don’t pay for directly, like medical
care paid for you by your employer or the government. The personal consumption
expenditure (PCE) basket is continually updated. This means that the PCE de ator does not
suffer substitution bias.
When forecasters look for the underlying trend in in ation, they consult an alternative
measure of in ation that excludes food and energy. This measure is called core in ation. They
are excluded not because they aren’t important but because their prices are often volatile and
hard to predict. It provides a clearer reading of underlying in ation trends.
Business Prices
In ation experienced by businesses is measured by the producer price index.
The producer price index (PPI) measures the price of inputs into the production process. It’s
worth tracking the in ation that businesses are facing because rising input prices eventually
cause businesses to raise their prices. It’s also a useful way to track what’s likely happening to
your competitors’ costs.
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The GDP de ator tells us about the changing prices of all goods and services produced.
When you’re adjusting dollar amounts describing what the economy produces, you should
focus on the GDP de ator, which is an alternative price index that’s calculated based on a
basket of goods and services that represents everything the U.S. economy produces. Unlike
the CPI, it includes capital goods but excludes imported goods.
ADJUSTIN G FOR THE EFFECTS OF INFL ATION
Learning Objective: Learn to account for the in uence of in ation before
making big decisions.
Comparing Dollars over Time
Rising prices effectively mean that the value of a dollar has declined over time. That makes it
dif cult to compare dollar amounts from different time periods because past amounts are
measured in dollars that were more valuable than today’s dollars.
Use the in ation adjustment formula to adjust for changing prices.
You’ll make better judgments if you compare dollar amounts from different eras using a
common metric. To do this, multiply the dollar amount from another time by the ratio of
today’s price level to the price level at that time:
Real and Nominal Variables
Real variables adjust for in ation.
A nominal variable is measured in dollars whose values may uctuate over time. As a result,
nominal variables can rise or fall due to either changing quantities or in ation. By contrast, a
real variable has been adjusted to account for the in uence of in ation. You can convert
nominal variables into real variables by converting dollar amounts from different time
periods into the equivalent number of today’s dollars.
By analyzing dollar amounts once they’ve been converted into dollars from some xed year,
you’re effectively holding the average price level constant, which means that you’ve stripped
out the effects of in ation.
Focus on real variables.
Real variables give you a better sense of the underlying trade-offs, particularly when you’re
making comparisons over time.
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You can calculate real growth as nominal growth minus in ation.
For relatively small percentage changes, you can use the following formula:
Percent change in real value ≈ Percent change in nominal value – Percent change in prices
Real and Nominal Interest Rates
Let’s see how all this applies to the bene ts and costs of saving or borrowing money.
The nominal interest rate measures the return in dollars.
The nominal interest rate is the stated interest rate without a correction for the effects of
in ation. It re ects the percentage earned measured in dollars for a year.
The real interest rate measures what you can buy with those dollars.
If you want to accurately measure the bene t you’ll get from saving or borrowing, you’ll need
to account for the in uence of in ation.
The real interest rate is the interest rate in terms of changes in your purchasing power. It
shifts your focus from how many extra dollar bills you’ll receive to what you can buy with
those dollar bills.
Real interest rate ≈ Nominal interest rate – In ation rate
Overcoming Money Illusion
Money illusion is the (mistaken) tendency to focus on nominal dollar amounts instead of
in ation-adjusted amounts.
Money illusion can distort decisions.
Don’t let money illusion fool you into focusing on the price in dollar terms; pay attention to the
real opportunity cost instead.
Money illusion can lead to mis-pricing.
Failing to account for in ation can lead homeowners to sell their houses at prices that are too
low. The best guide to the value of a home isn’t what price it sold for years ago, rather it’s the
prices that similar houses in the neighborhood have sold for recently.
Money illusion creates nominal wage rigidity.
Nominal wage rigidity is the reluctance to cut nominal wages.
But when workers’ wages stay unchanged, money illusion led workers to feel okay because
their wage isn’t being cut. However, the reality is that if in ation is 2%, their real wages falls
by 2%.
THE ROLE OF MONEY AND THE COSTS OF INFL ATION
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Learning Objective: Analyze the role of money so that you can assess the costs
of in ation.
The Functions of Money
Money is any asset that’s regularly used in transactions.
Function 1: Money is a medium of exchange.
You’re using money as a medium of exchange whenever you hand it over to buy stuff or when
you accept it from your employer. If there were no such thing as money, you would have to
make everything you need for yourself or barter for it. The problem with barter is that it
requires a double coincidence of wants. Money eliminates this constraint, creating
opportunities for you to specialize. However, money can be an effective medium of exchange
only if it’s widely accepted.
Function 2: Money is a unit of account.
Money is also a unit of account, which means that it’s a common unit that people use to
measure economic value. Using a common unit is useful because it makes it easier to apply the
opportunity cost principle and ask, “Or what?”
The value of a dollar needs to be relatively stable for it to be a reliable unit of account.
Function 3: Money is a store of value.
Do you want to create goods and services to consume in retirement? You can do this by
earning money today, saving or storing that money, and using it in the future to buy stuff. Do
you want to consume goods and services today that you’ll produce in the future? Borrow
money today, and pay it back in the future when you produce more goods and services.
Money successfully functions as a store of value when it’s easy to store and can reliably hold
its value over time.
In ation undermines the productive bene t of money.
High or unpredictable in ation erodes the functions of money. In extreme cases, it can feel
more secure to barter than to accept an unknown value of money.
The Costs of Hyperin ation
Hyperin ation is an extremely high rates of in ation.
Hyperin ation can make life harder.
Venezuela’s recent experiences illustrate how the logistical challenges of dealing with
hyperin ation come to dominate everyday life. In late 2016, Venezuela’s highestdenomination note, the 100 bolivar note, was worth less than a U.S. nickel.
Hyperin ation erodes all the functions of money.
The hassle required to get cash in Venezuela also made the bolivar an unattractive medium of
exchange. Instead, people gured out workarounds. Barter became more common, and the
well-connected used U.S. dollars instead of Venezuelan bolivars.
A problem that arises in every episode of hyperin ation is that when money no longer works
as it should, every facet of economic life becomes more dif cult.
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The Costs of Expected In ation
Some economists argue that the 2% in ation rate that the United States aims for is close
enough to price stability that it imposes few costs. But when in ation creeps a bit higher, it
becomes more disruptive.
Cost 1: In ation creates menu costs for sellers.
Menu costs is the marginal cost of adjusting prices. The marginal bene t of adjusting your
price is that you’ll shift to a price that covers the rising cost of your inputs. The higher
in ation is, the larger this marginal bene t is. As a result, higher in ation leads to more
frequent price adjustments. In ation is costly because it leads businesses to devote valuable
resources to reprinting menus and adjusting price tags.
Cost 2: In ation creates shoe-leather costs for buyers.
The marginal bene t of withdrawing an extra dollar is the convenience of having more
available to spend right away. The marginal cost comes partly from the opportunity cost
principle, which reminds you that every dollar you withdraw would otherwise stay in your
savings account earning a real interest rate. In ation adds another cost: As prices rise, the
cash in your wallet comes to be worth less. So in ation will also lead you to hold less of these
other forms of money. That means you’ll need to visit your bank more often, withdraw money
only as you need it, and rush to spend it quickly. The time and effort this takes are called shoeleather costs because they arise from running around town (which wears down the leather on
your shoes).
The Costs of Unexpected In ation
Cost 3: In ation confuses the signals that prices send.
Prices play a key role in coordinating economic activity, but macroeconomics teaches us that
when in ation causes all prices to rise, there’s no reason to expand production because the
higher price of your output is matched by an equal rise in the price of your inputs.
The problem is that when a price rises, it can be hard for producers to gure out whether that
higher price is due to increased demand or to a burst of unexpected in ation. In the resulting
confusion, some managers will respond to unexpected in ation by expanding production. At
other times, they’ll fail to expand production when demand for their product has risen
because they mistakenly guessed that the higher price re ected an unexpected burst of
in ation.
Cost 4: In ation redistributes.
Unexpected in ation redistributes from savers and lenders toward borrowers. This occurs
because most loans specify repayment schedules in nominal terms, and unexpected in ation
changes the real value of your repayments.
If you borrow money at the bank and in ation ends up being higher than expected, you’ll gain,
and your bank will lose. Even though you’ll keep repaying the same amount each month, the
dollars you send your bank aren’t worth as much. When in ation is lower than anticipated,
the opposite happens.
The In ation Fallacy
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People worry about in ation because they go to the store and see higher prices. That sounds
bad. If you have to pay more for what you’re buying, then you can’t buy as much as before,
right? Surveys show that more than three-quarters of people agree that in ation erodes their
purchasing power. But that’s true only if your income stays the same. In ation means that, on
average, all prices are rising. This means that wages and salaries are also rising.
The in ation fallacy is the mistaken belief that in ation destroys purchasing power. It’s a
fallacy because it tells only half the story. Although a $1 price rise makes a buyer $1 poorer, it
also makes the seller $1 richer. It follows that higher prices don’t destroy purchasing power.
Moreover, in ation is a generalized rise in all prices, and so it raises the price of what you sell
just as much as it raises the price of what you buy. You sell your labor, and in ation typically
boosts the price of labor.
The in ation fallacy re ects a psychological bias. People are quick to blame in ation for the
higher prices they pay but they interpret the parallel rise in their nominal wages as an earned
reward for their hard work, unrelated to in ation.
It’s the real stuff that matters, not how it’s measured.
Imagine doubling all prices and the value of all assets — essentially replacing each $1 with $2.
If you have $1,000 in the bank, it becomes $2,000. If you earn $15 an hour, it becomes $30. If
your heating bill is $50, it becomes $100. If you owe $12,000, it becomes $24,000. If this is
done correctly, everything is exactly the same as before, even though all the numbers are
different.
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Across the whole economy, this is purely a nominal change and has no effect on real variables.
There will be no change in the total amount of each good purchases, the quantity of
production, or the purchasing power of your income.
ONE PAGE SUMMARY
C O N S U M P T I O N A N D S AV I N G
Chapter objective: See the connections between your spending and savings
decisions and the macroeconomy.
1. Consumption, Saving, and Income: Understand how consumption and saving vary with
income.
2. The Micro Foundations of Consumption: Apply the core principles of economics to
consumption decisions.
3. The Macroeconomics of Consumption: Predict the behavior of total consumption in the
economy.
4. What Shifts Consumption?: Assess how changing macroeconomic conditions shift
consumption.
5. Saving: Learn how to form a smart saving plan.
C O N S U M P T I O N , S AV I N G , A N D I N C O M E
Learning Objective: Understand how consumption and saving vary with
income.
Consumption refers to household spending on nal goods and services. Consumption is
sometimes referred to as consumer spending because it includes spending on things like food,
rent, clothes, electricity, medical bills, cell phones, cars, computers, and internet service.
Consumption and Income
The consumption function is a curve plotting the level of consumption associated with each
level of income.
The consumption function plots the level of consumption associated with each level of income.
The consumption function is a summary of household’s spending plans, showing how total
consumption spending varies with the level of total income. The consumption function is
upward-sloping because when people have more income, they tend to spend more.
The marginal propensity to consume tells you how much consumption rises when income
rises.
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The fraction of each extra dollar of income that households spend on consumption is called
the marginal propensity to consume. You can measure the marginal propensity to consume by
observing how consumption responds to a change in income. It’s the ratio of the change in
consumption to the change in income. Most people will spend some of their extra income right
away, but they will also typically save some of it (to spend later). So the marginal propensity
to consume, which is the proportion of each extra dollar consumed, is typically greater than
zero but less than one. The marginal propensity to consume determines the slope of the
consumption function.
The marginal propensity to consume is an important concept in macroeconomics because it
tells you how much consumption will increase when total income or GDP increases.
Saving and Income
Saving is the portion of income that you don’t spend on consumption in a given period.
Because every dollar you don’t spend is saved, your consumption decisions determine your
saving.
Saving = Income − Consumption
Alternatively, when your consumption exceeds your income in a given period, you are
dissaving (sometimes referred to as negative saving). Whether you fund this gap between
your spending and your income by borrowing money or by withdrawing money from your
savings, it counts as dissaving.
Your net wealth is the amount by which your assets exceed your debts.
THE MICRO FOUNDATIONS OF CONSUMPTION
Learning Objective: Apply the core principles of economics to consumption
decisions.
Choosing How Much to Spend and How Much to Save
The key consumption decision you face is how many dollars you should spend this month
given your income. Your answer will determine not only how much you’ll consume but also
how much you’ll need to borrow or be able to save for next month. The interdependence
principle says that the choices available to you in the future depend on the decisions you
make today.
According to the marginal principle, you should break this question into a series of smaller
marginal choices, asking if you should increase your current consumption by one more dollar.
At each iteration, the cost-bene t principle says that you should increase your consumption
by a dollar if the bene t of an extra dollar of consumption exceeds the cost. Then turn to the
opportunity cost principle “Or what?” You could consume an extra dollar this month, or you
could save that dollar, earn interest, and then spend that dollar plus interest in the future.
So the opportunity cost of an extra dollar of consumption today is the marginal bene t of
consuming a dollar-plus-interest in the future.
The Rational Rule for Consumers
The Rational Rule for Consumers is this: Consume more today if the marginal bene t of a
dollar of consumption today is greater than (or equal to) the marginal bene t of spending a
dollar-plus-interest in the future.
Compare the marginal bene t of spending a dollar today to the marginal bene t of spending a
dollar-plus-interest in the future.
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The Rational Rule for Consumers effectively advises being forward-looking, so that you should
spend another dollar today only if it yields a larger marginal bene t than spending a dollarplus-interest in the future.
You should keep spending until the marginal bene t is the same over time.
The Rational Rule for Consumers says that you should keep increasing today’s consumption
and decreasing future consumption until the marginal bene t of a dollar of consumption is the
same today as it will be tomorrow. Make consumption plans so that the marginal bene t of the
last dollar of consumption is the same in the present as in every future period.
Consumption Smoothing
Consumption smoothing describes the way people maintain a steady or smooth path for
consumption spending over time, even as income uctuates.
Consumption smoothing helps you avoid diminishing marginal bene ts.
Diminishing marginal bene t says that the marginal bene t of the rst few dollars of spending
is high but declines as you spend more. In other words, the rst dollars are spent on
necessities, which yield greater bene ts. But as your spending continues, the marginal bene t
of each dollar you spend falls. The items you buy are things that are needed or wanted less.
Following the logic behind the Rational Rule for Consumers, it suggests reallocating your
spending from times when your consumption is high (and the marginal bene t of an
additional dollar of spending is low) to times when consumption is low (and the marginal
bene t of an additional dollar of spending is high). This will lead your consumption to be
relatively smooth or stable over time. Indeed, each move you make toward more equal
consumption over time raises your well-being because you’re moving your spending from
times when the marginal bene t is low to times when the marginal bene t is high.
It’s like making a deal with your future self.
If you put too much weight on your future self, you’ll spend too little today. If you put too
much weight on your current self, you’ll spend too much. Your current and future selves have
to gure out how to split your resources over time.
The timing of your income is irrelevant.
The timing of your income should not be relevant to your consumption choices. You should
allocate your consumption to whenever it’ll yield the largest marginal bene t.
Permanent Income Hypothesis
Your income does constrain your consumption. Instead of your current income, you should
focus on your permanent income, which is your best estimate of your long-term average
income. It measures the resources that are available for you to consume, on average, over the
course of your lifetime.
A higher permanent income means that you can afford to take on more student loans and
spend more in your student years, knowing that you’ll nd it easy to repay those loans out of
the big bucks you expect to earn after graduation. The idea that people choose how much to
consume based on their permanent income (rather than their current income) is called the
permanent income hypothesis.
Consumption smoothing requires saving and borrowing.
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If you set your consumption level based on your permanent income, then you’ll need to
borrow or save whenever your current income and permanent income differ. This suggests
that you can gauge whether you should be saving or dissaving by comparing your current
income with your permanent income.
Saving will vary over your life course.
Relatively constant consumption explains why people tend to borrow while they’re young,
save during their working years, and spend down their savings during retirement.
THE MACROECONOMICS OF CONSUMPTION
Learning Objective: Predict the behavior of total consumption in the economy.
The Relationship Between Consumption and Income
Insight 1: A temporary change in income leads to a small change in consumption.
The desire to spread a temporary spike in income out over your lifetime is why a temporary
increase yields only a relatively small increase in consumption. A temporary increase yields a
marginal propensity to consume (MPC) out of a transitory rise in income.
Insight 2: A permanent change in income leads to a large increase in consumption.
The marginal propensity to consume out of permanent income is much higher than it is out of
temporary income. The marginal propensity to consume out of a rise in permanent income is
typically fairly high. In fact, it could be as high as 1:
An unanticipated change in income that’s likely to continue every year for the rest of your life
yields an equally large change in permanent income, so there is a correspondingly large
increase in consumption.
Insight 3: An anticipated change in income leads to no change in consumption.
Your permanent income already factors in anticipated future changes in your income. If you
set your consumption in line with your permanent income, then anticipated changes in
income won’t affect your consumption. As a result, the marginal propensity to consume out of
anticipated changes in income is zero.
Insight 4: Learning about a future income change leads to a change in consumption.
When does consumption respond to changes in future income? If you’re basing your
consumption on your permanent income, then you’ll respond when you get the news about a
change in your future permanent income rather than when the money actually arrives.
The broader point is that today’s consumption can be quite sensitive to expectations about
future income. This also suggests that changes in macroeconomic policy begin to have an
effect on consumption when they’re announced rather than when they are implemented.
Insight 5: It’s hard to forecast changes in consumption.
This insight doesn’t say that the level of consumption is dif cult to forecast. In fact, it’s not:
The level of consumption is usually about two-thirds of GDP. Instead, it says that future
changes in consumption are hard to predict.
Adding Behavioral Economics and Credit Constraints to Our Analysis
There are limitations to how much people can smooth their consumption. The ability to do so
relies on people knowing a lot about their future income and being able to both borrow and
save when required. Unfortunately, borrowing and saving aren’t always easy or even possible.
People can’t always borrow.
Some people don’t follow the Rational Rule for Consumers simply because credit constraints
limit the amount they can borrow. If you don’t have savings or credit, you can’t smooth your
consumption. Credit constraints arise because banks are often reluctant to lend money to
fund consumption when the loan isn’t backed by collateral.
It’s hard to make deliberate forward-looking plans and stick to them.
Following the Rational Rule for Consumers requires you to constantly compare the present to
the future, to make plans about when to spend and when to save, and to follow through on
those plans. The reality is that not all people can be this deliberate about their choices all the
time.
Cognitive or behavioral limitations mean that some people don’t smooth their consumption.
They don’t save enough, they run up debt without a plan to pay it back, and they make
impulse purchases. People are impulsive, they procrastinate, and when it comes to making
trade-offs between today and tomorrow, they can be impatient. Instead, some people will
simply spend what they have at the moment.
Hand-to-mouth consumers spend their current income; consumption smoothers spend
permanent income.
Because some people don’t smooth their consumption, their consumption re ects their
current income rather than their permanent income. Economists call these folks “hand-tomouth consumers.” Their marginal propensity to consume is 1, whether the change in income
is anticipated or unanticipated and whether it is temporary or permanent.
Total consumption is a mix of hand-to-mouth consumers and consumption smoothers.
The macroeconomy includes all the people who smooth their consumption and everyone who
lives hand to mouth. How will total consumption across the economy respond to a change in
income?
● Hybrid insight 1: Temporary changes in income will lead to a small change in
consumption for consumption smoothers and a large change in consumption for handto-mouth consumers. Total consumption re ects the spending decisions of both groups,
so the average marginal propensity to consume out of a temporary income change will
be larger when there are more hand-to-mouth consumers in a society.
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● Hybrid insight 2: A permanent change in income will lead to a large change in
consumption from both consumption smoothers and hand-to-mouth consumers,
leading to a large change in total consumption. The marginal propensity to consume
out of permanent changes in income remains close to 1, regardless of the mix of handto-mouth and consumption smoothers.
● Hybrid insight 3: An anticipated change in income will lead to no change in the
consumption of consumption smoothers but a large change for hand-to-mouth
consumers who consume their income as it arrives. The marginal propensity to
consume out of anticipated income changes will depend on the share of hand-to-mouth
consumers: The larger the share of hand-to-mouth consumers, the higher the marginal
propensity to consume out of an anticipated change in income.
● Hybrid insight 4: Learning about a future income change will lead to a large change in
consumption from consumption smoothers (who respond to news about future income
straight away) but no change from hand-to-mouth consumers (who won’t respond until
the extra income arrives). The marginal propensity to consume out of anticipated
income changes will depend on the share of hand-to-mouth consumers. The larger the
share of hand-to-mouth consumers, the smaller the marginal propensity to consume.
● Hybrid insight 5: Forecasting changes in consumption depends on the share of hand-tomouth consumers. Hand-to-mouth consumers spend what they have, so you can
forecast changes in their consumption if you know how their income will change.
Consumption smoothers, however, don’t change their consumption in response to
anticipated income changes. Therefore, your ability to forecast changes in consumption
depends on the mix of consumption smoothers and hand-to-mouth consumers.
Putting it all together, on average, the economy shows some in uence of permanent income
driving consumption and some in uence of current income driving consumption.
WHAT SHIFTS CONSUMPTION?
Learning Objective: Assess how changing macroeconomic conditions shift
consumption.
The consumption function shows how consumption depends on income. So a change in income
doesn’t shift the consumption function. Instead, it leads to a movement along the consumption
function. But other factors — including the real interest rate, expectations, taxes, and wealth
— will change consumption at any given level of income. As a result, they shift the
consumption function.
Consumption Shifter 1: Real Interest Rates
One bene t of saving is that you’ll earn interest. A higher real interest rate raises the bene t
of saving, and the cost-bene t principle tells you that a higher real interest rate leads to an
increase in saving.
The effects of a higher interest rate on current consumption are a bit more complicated
because there are two forces that sometimes work in opposition to each other:
● First, a higher real interest rate is an incentive to substitute toward more consumption
tomorrow and less today. This is the substitution effect. The higher the real interest
rate, the higher this opportunity cost, leading consumers to reduce their current
consumption in favor of more saving.
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● Second, a higher real interest rate boosts your income if you’re a lender and decreases
it if you’re a borrower. So if you’re a lender, higher interest rates boost your income,
and this income effect leads to higher consumption. But if you’re a borrower, higher
interest rates effectively reduce the income, and this income effect reduces your
consumption.
The net effect of these two sometimes con icting forces could go either way, but most evidence
suggests a decrease in consumption.
Consumption Shifter 2: Expectations
Optimism about future economic growth means that people expect their future incomes will
be higher. And to the extent that consumption is driven by permanent income, optimistic
expectations translate into higher consumption.
Consumption Shifter 3: Taxes
Higher taxes reduce your disposable income — that is, your after-tax income — which leads to
lower consumption at any given level of pre-tax income. On the ip side, tax cuts increase
disposable income, shifting the consumption function upward, leading to higher consumption
at any level of GDP. This is why governments sometimes use tax cuts to stimulate spending
when the economy slows.
Consumption Shifter 4: Wealth
Your total resources include not just your income but also your accumulated stock of wealth
(which can be negative if you’re in debt). Greater wealth leads to an increase in consumption
at any given level of income, shifting the consumption function upward.
S AV I N G
Learning Objective: Learn how to form a smart saving plan.
There are four key motives that drive saving.
Saving Motive 1: Changing Income over the Life Cycle
The logic of consumption smoothing is that you should save money in those phases of your life
when your income will be predictably higher so that you can spend more than your income
when it’s lower. As a result, people tend to spend more than their meager incomes in their 20s
and thus accumulate debt. As their earnings grow, they pay down their debt and accumulate
savings in their 30s, 40s, and 50s. People tend to spend down their accumulated assets
starting around the mid-60s, as they head into retirement.
Saving Motive 2: Changing Needs over the Life Cycle
The Rational Rule for Consumers says that if your needs are similar over time, then you
should smooth your consumption. But if your needs are changing, then your consumption
should also change over time. That means that you’ll need to save more in those phases of
your life when your needs aren’t so great.
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Saving Motive 3: Bequests
The third motive for saving is that you might want to build up a stock of wealth that you’ll
pass on when you die. The bequest motive helps explain why many people don’t spend down
all their wealth.
Saving Motive 4: Precautionary Saving
Saving to be prepared for a nancial emergency is called precautionary saving because you’re
building up that buffer as a precaution.
Save enough to weather the nancial risks you face.
To evaluate how much you’ll need to save, think through the sorts of nancial risks you face
and the amount of money you’ll need to have on hand to weather them.
Precautionary saving is why national savings go up when economic uncertainty rises.
The more uncertain your economic future looks, the larger your emergency fund should be.
Whenever economic uncertainty rises, millions of people increase their precautionary saving.
Savings and consumption are two sides of the same coin: to save more, they have to consume
less. As a result, growing uncertainty can lead to a decline in total consumption.
Smart Saving Strategies
Set a budget and stick to it.
Research shows that people nd it easier to make good decisions in advance. Once you’ve
made that plan, stick to it. If your plan isn’t working, then go back and reassess it.
Make sure you can handle an unexpected cost.
Unless you can borrow money easily, you also want to accumulate an emergency fund to
protect yourself in case your car breaks down, or you have an unexpected health cost.
Sign up for your employer’s retirement plan.
Even if you have student loans or other debts, in most cases you should sign up for the
retirement plan. That’s because most employers match your contributions to their retirement
plan, usually kicking in extra money. Never miss the opportunity to get free money from your
boss. Don’t procrastinate. Sign up for your employer’s retirement plan on your rst day of
work.
Plan to save more tomorrow.
One plan for building your retirement savings is to plan to keep making your student loan
payments forever. Once you’ve paid off your loans, you can keep making those payments —
but make them to your retirement account. You’ll never miss the money because it was never
a part of your regular expenditures.
Keep as much of your money as you can.
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It sounds obvious, but there are lots of sneaky ways that money can get away from you if you
are not careful.
ONE PAGE SUMMARY
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INVESTMENT
Chapter objective: Analyze how managers can make good investment decisions.
1. What Is Investment? Learn what macroeconomists mean by investment and assess the
role that it plays in the economy.
2. Tools to Analyze Investments: Master two tools for comparing sums of money at
different points in time: compounding and discounting.
3. Making Investment Decisions: Evaluate whether an investment opportunity is worth
pursuing.
4. The Macroeconomics of Investment: Assess how macroeconomic conditions drive
investment.
5. The Market for Loanable Funds: Forecast the long-run real interest rate.
WHAT IS INVESTMENT?
Learning Objective: Learn what macroeconomists mean by investment and
assess the role that it plays in the economy.
De ning Investment
The term “investment” is a tricky one because it has a formal (and relatively narrow)
de nition within macroeconomics, yet the same word is often used more loosely in casual
conversation where it takes on a broader de nition.
Macroeconomic investment refers to spending on new capital.
When macroeconomists talk about investment, they mean the purchases of new capital,
which increase the economy’s productive capacity. Macroeconomic investment includes
purchases of new business equipment, of ces, factories, and housing, as well as inventories.
It’s the capital “I” in the de nition of GDP (remember, Y = C + I + G + NX).
The word investment also has a (different but related) colloquial meaning.
People often talk about making an “investment” even when they are not buying new capital.
People talk about investing in their brand, in their education, or in a new suit because they
are hoping these reap future rewards after incurring these up-front costs. Notice that the
formal macroeconomic de nition of investment is narrower than its colloquial meaning.
Don’t confuse investment and saving.
It is easy to confuse saving with investment. Saving is the money you have left over after
paying for your consumption spending, which you might put in your savings at the bank, in a
stock portfolio, or under the mattress. Investment is the purchase of new capital.
Investment adds to the capital stock; depreciation subtracts from it.
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The total quantity of capital at a point in time is called the capital stock. Investment is the ow
of new purchases of capital that add to this stock. But capital also declines over time due to
depreciation, which includes wear and tear, obsolescence, accidental damage, and aging. As a
result, this year’s capital stock is equal to last year’s capital stock, less depreciation, plus new
investment over the past year. The capital stock rises when new investment exceeds
depreciation but declines when depreciation exceeds investment.
Types of Investment
Macroeconomists break investment into three primary categories.
Investment type 1: Business investment.
The money that businesses spend on new capital assets is called business investment, and it
accounts for the bulk of investment in the economy.
Investment type 2: Housing investment.
Housing investment refers to spending on building new houses or apartments, as well as
improvements to existing housing. It includes both homes that you buy to live in and housing
that you plan to rent.
Building a new home counts as an investment because it increases the stock of capital —
increasing the economy’s capacity to generate rent. However, sales of existing homes simply
transfer ownership from one person to another and hence don’t count as investment because
they don’t increase the economy’s productive capacity.
Investment type 3: Inventories.
Businesses also invest by maintaining inventories of raw materials, work-in-progress, and
unsold goods. It’s necessary to keep at least some level of inventories on hand as part of the
production process. They’re counted as part of the capital stock, and therefore, an increase in
inventories is counted as investment.
Investment Is a Key Economic Variable
Economists pay close attention to investment because it has an extraordinarily important
impact on the economy.
Investment drives the business cycle.
Investment uctuates dramatically as business conditions change, so it plays an outsized role
in driving the year-to-year economic uctuations known as the business cycle. Typically,
investment changes more from year to year than GDP does.
Investment is very sensitive to business conditions partly because managers can easily delay
or cancel expansion plans. Moreover, because investment decisions are forward-looking,
they’re extremely sensitive to expectations about the future state of the economy. Investment
is also sensitive to interest rates and lending standards because businesses often have to get a
loan to fund their investments.
Investment changes quickly, but the capital stock changes slowly.
Today’s capital stock is the accumulation of investments made over many previous years. As
a result, even though investment — the ow of new spending on capital — often uctuates
quite dramatically, the capital stock moves slowly.
Investment is a key driver of long-term prosperity.
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The more capital your workers have to work with, the more output they’ll be able to produce.
T O O L S T O A N A LY Z E I N V E S T M E N T S
Learning Objective: Master two tools for comparing sums of money at different
points in time: compounding and discounting.
Investment Tool 1: Compounding
Compounding helps you calculate how much money grows over time when you leave it to
accumulate interest. More generally, for each dollar that you put in the bank today, a year
later you will get your dollar back, plus interest of r cents per dollar.
Future value in one year = Present value (1 + r)
Each year you leave your money in the bank, it is multiplied by 1+ r.
This is the magic of compound interest: You earn interest not only on your initial deposit but
also on previously earned interest, so your wealth compounds. The future value of your
money is the amount that your money will grow into by a future date, as a result of earning
interest.
This leads to the compounding formula:
Future value in t years = Present value × (1 + r)t
Use a spreadsheet to apply the compounding formula.
Investment Tool 2: Discounting
Discounting re ects the opportunity cost of bene ts you receive in the future.
The present value is the amount of money that you’d need to invest today in order to produce
a speci c bene t in the future. The process to calculate present value is called discounting,
which means converting future values into their equivalent present values. The discounting
formula shows how much money you’d need today to create a speci c future value in t years’
time.
This is the discounting formula:
Present value = Future value in t years
Discounting converts future values into present values.
Just as the compounding formula converts the money you have in the present into its
potential future values, the discounting formula converts potential future values into their
equivalent present values.
Use a spreadsheet to apply the discounting formula.
This time, you enter the future value and let the spreadsheet calculate the present value by
applying the discounting formula.
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Present values tell you how much you should pay for a future payoff.
To see how present value calculations can be useful, let’s return to Jonathan Holdeen, the
eccentric New York lawyer. During the Great Depression, rich heirs and heiresses who fell on
hard times found themselves in the awkward position of being poor today but expecting a big
inheritance in the future. He offered to buy the rights to their inheritance, usually at a steep
discount. Holdeen used discounting to gure out how much he’d be willing to pay for an
inheritance in the future.
Real versus Nominal Interest Rates
You can use the compounding and discounting formulas to gure out how much either the
nominal or real value of your money changes through time. If you’re evaluating the nominal
(real) value of your funds, make sure that you plug the nominal (real) interest rate into the
compounding or discounting formula.
MAKING INVESTMENT DECISIONS
Learning Objective: Evaluate whether an investment opportunity is worth
pursuing.
How to Evaluate an Investment Opportunity: A Four-Step Recipe
Follow these steps to analyze an investment opportunity.
Step 1: Calculate the up-front cost. This is really just the cost part of the cost-bene t principle.
Step 2: Predict future pro ts, taking account of depreciation. The bene ts of investing are the
future annual pro ts that the investment will generate.
Step 3: Calculate the present value of all bene ts and costs. Current and future dollars are not
the same, and so we need to convert them both into their equivalent so that we can compare
them.
A step 3 shortcut: Use the valuation formula to calculate the present value of a stream of
future pro ts.
The valuation formula says that the present value of a stream of payments that starts with
next year’s pro t and of subsequent payments that decline or depreciate each year by d
percent is:
Present value of a stream of payments
It’s called the valuation formula because it tells you how much you would value this future
stream of pro t in today’s dollars.
Step 4: Invest if the present value of bene ts exceeds the present value of costs.
If the many years of future revenue in present value exceed the up-front cost, then it is a
pro table investment.
The Rational Rule for Investors
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The Rational Rule for Investors is this: Pursue an investment opportunity if the present value
of future revenues exceeds the up-front cost, C. This means you should invest when:
An Alternative Perspective: The User Cost of Capital
Instead of asking whether to invest in something you plan to keep for many decades, you
might ask: Should I buy it for one more year? That is, should you buy even if you plan to sell in
a year’s time?
The cost-bene t principle says your answer should be yes if the marginal bene ts exceed the
marginal costs. This alternative perspective focuses on the marginal bene t and marginal cost
of using that extra capital good for one more year.
The user cost of capital is forgone interest plus depreciation.
There are two costs to consider:
● Depreciation: When you buy capital equipment and sell it a year later, you can expect to
lose an amount equal to the depreciation rate times the cost of the investment: d × C.
● Forgone interest: This opportunity cost is equal to the forgone rate of return times the
cost of the machine: r × C.
Putting the two pieces together yields the user cost of capital, which is the extra cost
associated with using one more machine next year:
User cost of capital = (r + d) × C
Compare the user cost of capital with next year’s additional pro t.
The cost-bene t principle tells you to compare the user cost of capital to the corresponding
marginal bene t of adding that extra capital good, which is the extra pro t you’ll earn next
year. You should invest in an additional capital good next year if:
Next year’s pro t > (r + d) × C
Rearranging the equation above by dividing both sides by (r + d), you will see that we’ve
rediscovered the formula for the Rational Rule for Investors.
THE MACROECONOMICS OF INVESTMENT
Learning Objective: Assess how macroeconomic conditions drive investment.
The investment rule focuses our attention on the key macroeconomic variables that
determine investment. It says that investment will depend on expectations about future
pro ts and on the real interest rate, the depreciation rate, and the real cost of capital.
The Real Interest Rate and Investment
The real interest rate plays a central role in investment decisions. Consequently, higher real
interest rates lead managers to invest less in buying new capital.
Investment declines as the real interest rate rises.
High real interest rates lead to lower levels of investment across the whole economy. The
investment line illustrates how the quantity of investment rises as the real interest rate falls.
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Factors That Shift the Investment Line
Investment shifter 1: Technological advances.
Technological advances that make capital equipment more productive will boost the revenue
that you’ll generate from buying that equipment, providing an incentive to invest more. This
shifts the investment line to the right.
Investment shifter 2: Expectations.
Investment is motivated by expectations about the reward of future revenues. If managers
are optimistic about future economic conditions, they’ll forecast that new investments are
likely to yield robust revenues. These optimistic expectations will lead them to invest more at
a given real interest rate, shifting the investment line to the right. By contrast, pessimism
about future economic conditions will lead managers to revise downward their revenue
forecasts. These pessimistic expectations will lead them to conclude that fewer investment
projects will be pro table, shifting the investment line to the left.
Investment shifter 3: Corporate taxes.
The higher the corporate tax rate, the smaller the share of future pro ts that your company
gets to keep. As such, higher corporate tax rates effectively reduce the revenue that you’ll get
to keep from your investment. This leads to less investment at any given interest rate,
shifting the investment line to the left.
Investment shifter 4: Lending standards and cash reserves.
The dif culty investment poses is that you need to pay costs up-front, but you’ll get the
offsetting revenues only in the future. This creates a nancing problem: How will you nance
your new investments?
Often companies will borrow the funds from a bank. But even if you’re willing to pay the
prevailing interest rate, it can be hard to get nancing for risky projects. When you can’t get
nancing, you’ll be able to invest only if you can pay the up-front cost out of your cash
reserves. Thus, less restrictive lending standards or more abundant cash reserves lead to
more investment at any given interest rate, shifting the investment line to the right.
THE MARKET FOR LOANABLE FUNDS
Learning Objective: Forecast the long-run real interest rate.
Supply and Demand of Loanable Funds
The market for loanable funds is the market for the funds used to buy, rent, or build capital. It
brings together savers who want to lend their funds and investors who want to borrow those
funds. This market determines the long-run real interest rate, and therefore, the quantity of
investment.
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Savers supply funds, and investors demand them.
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The real interest rate is a key determinant of investment, but it’s not the only factor. The
Rational Rule for Investors highlights that a favorable change in business conditions will lead
to an increase in investment if it increases expectations of future pro ts, decreases the price
of capital goods, or reduces the depreciation rate. Such a change will shift the investment line
to the right.
In this market, savers are the suppliers, supplying their funds to businesses who want to
borrow them. Investors are the demanders, demanding funds to help fund their investments
in new capital. The nancial sector — which includes banks, the bond market, and the stock
market — is the marketplace where suppliers of funding (savers) meet demanders
(investors).
The price of a loan is the real interest rate. The long-run interest rate is determined by the
forces of supply and demand for loanable funds.
The supply curve is upward-sloping because a higher real interest rate raises the bene ts of
saving, leading to a larger quantity of loanable funds supplied. The demand curve is
downward-sloping because a higher real interest rate makes fewer investment projects
pro table, leading to a smaller quantity of loanable funds demanded.
The real interest rate is determined by supply and demand.
Equilibrium in the market for loanable funds occurs at the point where the supply and
demand curves cross, and it determines the equilibrium real interest rate.
The neutral real interest rate is the interest rate that operates when the economy is in
neutral — producing neither above nor below its potential.
Shifts in the Supply of Loanable Funds
A shift in saving at any given real interest rate will shift the supply of loanable funds, causing
the neutral real interest rate to change. The supply of loanable funds will shift only if there’s a
change in savings by one or more of the three types of economic actors who supply loanable
funds.
Supply shifter 1: Changes in personal saving by private savers.
Personal saving refers to saving by households of whatever income they don’t spend or pay as
taxes. Any factor that shifts people’s willingness to save will shift the supply of loanable
funds.
Supply shifter 2: Government saving shifts due to changing budget surpluses and de cits.
Government saving refers to saving by the government. When the government’s revenues
exceed its outlays, the government’s budget is in surplus, and so it accumulates extra funds.
This budget surplus adds to the supply of loanable funds. By contrast, a budget de cit means
that the government is dissaving, thereby reducing the supply of loanable funds available to
businesses. Instead, the government must borrow to fund its de cit.
As a result, an increase in the budget de cit will make government saving even more
negative, which shifts the supply of loanable funds to the left. The decline in private
investment due to a larger budget de cit is called crowding out. It arises because government
borrowing leads to higher real interest rates, which effectively crowds out some of the rms
looking for loans to fund their own investments.
Conversely, shifting from a budget de cit to a surplus will increase government saving, which
shifts the supply of loanable funds to the right. The new equilibrium has a lower real interest
rate, which makes more investment projects viable. This boost to private investment as a
result of government saving is sometimes called “crowding in.”
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Supply shifter 3: Foreign saving shifts due to global shocks.
The funding that comes from foreigners lending money to Americans is called foreign savings,
or net nancial in ows. A rise in foreign saving shifts the supply of loanable funds to the right.
Shifts in the Demand for Loanable Funds
The demand for loanable funds re ects businesses borrowing to fund their investments. This
means that any factor that shifts the investment line will also shift the demand for loanable
funds.
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Based on our earlier analysis, it follows that the demand for loanable funds will increase (or
shift to the right) in response to technological advances, expectations of stronger future
revenues, corporate tax cuts, and easier lending standards.
ONE PAGE SUMMARY
THE FINANCIAL SECTOR
Chapter objective: Understand the role played by the nancial sector.
1. Banks: Assess the role that banks play in funneling money from savers to investors.
2. The Bond Market: Understand how companies and governments raise money by issuing
bonds.
3. The Stock Market: Learn how companies raise money by issuing stock.
4. What Drives Financial Prices? Discover what drives nancial prices.
5. Personal Finance: Make better decisions in nancial markets.
BANKS
Learning Objective: Assess the role that banks play in funneling money from
savers to investors.
Banks are an important funding source for many of life’s major investments. Banks provide
car loans to fund your car purchase, home loans to help you buy a home, and small business
loans to help you start or expand your business.
What Do Banks Do?
When you put your money in a bank, your bank takes your money and puts it to work by
lending it out. Putting your money to work is how the bank earns itself a pro t.
Banks make money by charging higher interest rates than they pay.
When you deposit your money in the bank, the bank is not storing your money for you.
Instead, it’s borrowing money from you. The price your bank pays to borrow your money is
the interest you receive. But your bank is just an intermediary. Your bank makes money by
lending your deposits out to someone else at a higher interest rate.
There are ve important functions that banks provide:
Function 1: Banks pool savings from many savers.
Your bank pools the savings of many savers and lends that pool of savings to a speci c
borrower. This is a valuable service for savers because even if you have only a small amount of
savings, you can earn interest on it. It’s also easier for borrowers to go to one bank than it is
for them to try to borrow from dozens of individual lenders.
Function 2: Banks spread the risk of lending money across many borrowers.
Banks also make lending your money much less risky because they lend to a diverse array of
borrowers. Your bank doesn’t lend all your savings to one borrower. Instead, your bank pools
money from thousands of savers and lends that money to thousands of borrowers. The more
diverse this portfolio of loans is, the less risky it is.
Function 3: Banks solve information problems.
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Your bank is also an important information intermediary. It doesn’t lend your money out to
just anyone. Before borrowers can get a loan, the bank will delve into their credit history to
identify which borrowers will be able to repay their loans.
Function 4: Banks provide payment services.
The other reason that you want a bank account is that it makes your economic life a lot
simpler. You’ll likely nd it easier and safer to have your pay deposited directly into a bank
account than to go and collect cash. Similarly, you might nd it convenient to be able to pay
electronically and to use a credit card.
Function 5: Banks create long-term loans from short-term deposits.
Your bank borrows money from savers who expect to be able to withdraw their funds
whenever they want. It then lends this money to borrowers who don’t have to repay their loan
on demand. Instead, borrowers tend to repay over a xed (and long) period of time.
In other words, by making your funds available to you on demand, your bank effectively gets
its money from taking short-term (overnight) loans from people like you. But it needs to use
those funds to make longer-term loans. What it’s doing is called maturity transformation —
using short-term loans to make long-term loans. Maturity transformation ensures that
investors can fund long-term projects, even when no savers are willing to make a long-term
loan.
Bank Runs
A bank run occurs when a much larger number of customers than usual try to withdraw their
savings at the same time. When this happens, it can cause a bank to collapse.
Bank runs can cause a bank to collapse.
If you believe that tomorrow will be a typical day, then you can go to bed con dent that if you
need your money, your bank will be able to pay you. Given this, you’re happy keeping your
savings in the bank if you don’t need it.
If you believe that tomorrow will not be a typical day, then you shouldn’t feel so reassured.
You realize that an abnormally large number of withdrawals might clean your bank out of
cash, and so you can’t afford to wait to withdraw your money. Your best response is to
withdraw your savings before other customers beat you there.
A bank run is likely whenever people believe that a bank run is likely.
If you believe that others are going to run to withdraw their savings, then your best response
is to try to get there rst. And if other people believe that you’re going to run to the bank,
their best response is to try to get there rst, no matter the reason. This is the
interdependence principle at work: Your best choice depends on what others will do, and their
best choice depends on what you will do.
Bank runs can be contagious.
Because many people panic when someone else panics, it’s also easy to see how bank runs can
be contagious across banks.
Deposit insurance makes bank runs much less likely.
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Bank runs are not very common in the United States, but there was one time in particular
when they were problematic. During the Great Depression in the early 1930s, over one-third
of all existing banks failed. Struggling banks resulted in more bank runs, and the problem of
bank failures grew. In response, the federal government introduced deposit insurance, which
effectively guarantees that you’ll always get your savings back, even if your bank collapses.
This ensures that you won’t lose the money you deposit in the bank (up to $250,000 per
account).
Deposit insurance is designed to break the interdependence that leads to self-ful lling panics.
When you have deposit insurance, you know that your savings are safe, no matter what other
people do.
Shadow Banks
A shadow bank refers to any nancial rm that acts like a bank but, since it is not actually a
bank, does not have to follow the same rules as a bank.
Shadow banks are susceptible to bank runs.
Most people understand that their money is at greater risk when it’s in a shadow bank,
particularly because there is no deposit insurance. The problem is with no deposit insurance,
they are vulnerable to bank runs. Bear Sterns was a shadow bank that failed in 2008 due to a
bank run.
Fire sales can cause shadow bank runs to spread.
A shadow bank facing a bank run has to sell its assets quickly in order to repay its depositors.
Putting billions of dollars of nancial assets up for sale at once oods the market, pushing the
price of those assets down. Then the interdependence principle kicks in. Because other
shadow banks hold similar assets, a re sale of assets by one shadow bank reduces the market
value of other shadow banks’ assets. And that reduction in the market value makes
customers of other shadow banks more nervous, leading to further bank runs.
Shadow banks are opaque.
The shadow banking system is incredibly opaque, and so when one nancial institution can’t
pay its debts, it’s hard to know who will be hurt.
THE BOND MARKET
Learning Objective: Understand how companies and governments raise money
by issuing bonds.
What Does the Bond Market Do?
A bond is basically an IOU. It is a promise to pay back a loan with interest. The bond is just the
piece of paper recording the terms of the IOU. The bond market performs four key functions.
Function 1: The bond market channels funds from savers to borrowers.
The bond market is a market where companies can borrow the large sums of money that they
need to fund their investments and savers can lend the funds they aren’t using.
Function 2: The bond market funds government debt.
It’s not just companies that borrow by issuing bonds: so do governments. Whenever you hear
about government debt, realize that it borrowed all that money by issuing bonds.
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Function 3: The bond market spreads risk.
With borrowing spread across many lenders, bonds spread the risk that a company won’t
repay its loan across many lenders.
If you were an investor who had a billion dollars, you probably wouldn’t want to lend it all to
the same company. Instead, you would diversify your portfolio, buying a variety of bonds
issued by many different companies. By not holding all your eggs in one basket, you’ll make
sure that if one company collapses, you won’t lose all your savings.
Function 4: The bond market creates liquidity.
The problem with lending someone money for 10 years is that you might suddenly discover
you need the cash before the loan is due. Fortunately, you can sell your bond. So the bond
market creates liquidity, which is the ability to quickly and easily convert your bonds into
cash, with little or no loss in value. In this way, the bond market — like banks — creates longterm loans from short-term loans. This maturity transformation is done through the ability to
resell bonds in the bond market.
Evaluating Risks
Bonds hold some speci c risks. The rst is the chance that the company goes bust: default
risk. The second is term risk, and the third is liquidity risk.
Risk 1: Default risk is the risk of not getting paid.
The risk that you won’t be repaid (or won’t be repaid in a timely fashion) is called default risk.
Companies like Fitch, Standard and Poor’s, and Moody’s evaluate companies and
governments and assign credit ratings, which are like credit scores for businesses. Because
it’s dif cult for each investor to assess a company or a government’s chances of default,
investors rely on these credit ratings to assess default risk.
Risk 2: Term risk arises when there’s uncertainty about future interest rates.
The opportunity cost principle reminds you that tying up your money comes with an
opportunity cost: You could put that money in the bank and earn interest on it. The problem is
that when you buy a bond, you don’t know what future interest rates will be, so you are taking
a risk as to what the opportunity cost will be over the term of the bond.
The risk that arises from uncertainty about future interest rates is called term risk because
the risk is connected to the length, or term, of the loan. The more uncertain you are about
future interest rates, the greater this risk is. The longer the term, the more interest rates
might change, and so the higher the term risk.
Risk 3: Liquidity risk arises when your bond will be hard to sell.
To “withdraw” your money from a bond, you have to sell it. Although the bond market creates
liquidity, there is a risk that you won’t be able to nd a buyer for your bonds quickly. Liquidity
risk refers to the risk that if you need to sell an asset quickly, you may not be able to get a
good price for it.
U.S. government bonds are the safest investment.
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The safest thing you can do with your savings is to buy bonds issued by the U.S. government,
which are often called Treasuries. They’re considered safe because the U.S. government can
always pay its debts by printing more money. U.S. government bonds are also the most
heavily traded bonds in the world, and so they carry no liquidity risk. And a short-term loan
carries almost no term risk, which is why the interest rate on short-term loans to the federal
government is often described as a risk-free interest rate.
THE STOCK MARKET
Learning Objective: Learn how companies raise money by issuing stock.
What Do Stocks Do?
A stock represents partial ownership in a rm. When you own stock in a company, you own a
share of the company, which is why a stock is also called a share.
A stock entitles you to a share of future pro ts.
You stand to bene t from your ownership in two ways:
● Dividends: Dividends are the share of pro ts that a company pays to its shareholders.
o Retained earnings: The pro ts not sent out as dividends are called retained
earnings, and they are reinvested into the company.
● Rising values: The value of your shares can rise.
Stocks perform three key functions.
Function 1: Stocks channel funds from savers to investors.
The primary reason that businesses issue stock is to raise money to fund their investments.
When a business issues stock, it is essentially expanding by taking on new partners who will
each own part of the company.
When companies raise money by issuing new stock, they usually sell those shares directly to
the public through what’s known as an initial public offering (IPO).
Function 2: Stocks spread risk.
Shareholders gain when the company gains. If the company has a poor performance, however,
fewer or even no dividends might be paid, and the value of the stock might decline. Stocks,
therefore, spread the risk of business performance across many shareholders, reducing the
risk that any one person has in the business.
Function 3: Stocks reallocate control.
As a shareholder who owns part of a company, you also get a chance to have a say in how the
company is run. Shareholders get to vote in shareholder meetings. The shareholders elect
boards of directors. They also get to vote on major issues like whether to merge with another
company and what to pay senior management. Each share buys you one vote.
The stock market creates liquidity and makes it easier to own stocks.
The stock market is a market for second-hand stock, where people buy and sell existing
stocks. A company gets nothing when you buy pre-owned stock on the stock market. Stock
market trading creates liquidity, meaning that if you need access to your cash, it will be easy
to sell a stock at something close to a fair price.
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Comparing Stocks and Bonds
Bonds pay certain annual interest payments, while stocks pay uncertain dividends.
Companies can raise money by issuing bonds and by issuing new stock. Borrowing by issuing
bonds commits the company to a known set of future payments: A bond speci es exactly what
interest payments (the coupon payments) will be made each year. In contrast, a stock pays a
dividend that depends on how well the company is performing.
For an investor, this makes bonds a safer bet than stocks. But for a company looking to fund a
big expansion, getting funding from stocks instead of bonds is less risky because it means
of oading some of your risk onto your shareholders. Because bonds are safer bets than
stocks, the returns are lower because of less risk. Stocks often have larger returns over longer
periods of time to compensate for the higher risk.
Bondholders get paid before stockholders if a company declares bankruptcy.
When a company declares bankruptcy, its assets are sold and used to pay off its debts.
Because a bond is a debt, bondholders get paid out of the proceeds of this sell-off. Stockholders
get nothing unless there’s money left over after the company pays all its debts. This makes
bankruptcy a much greater nancial risk for stockholders than it is for bondholders.
Stockholders help control how a company is run.
A bondholder has no say in how a company is managed, but a stockholder is a partial owner
and therefore has some say in how it’s run. The more shares you have, the more signi cant
your vote is. Corporate raiders will often use this power to try to force a company to make
changes that they believe will enhance their pro ts.
Understanding Stock Market Data
Stocks and stock markets often have their own jargon (or language) used to describe
information and what is happening.
WHAT DRIVES FINANCIAL PRICES
Learning Objective: Discover what drives nancial prices.
Valuing Stocks
What determines the price of a stock or any other nancial asset? As with just about
everything else, it’s all about supply and demand.
There’s a demand curve for a company’s stocks describing how many shares investors will
buy at each price, just as there’s a supply curve describing how many shares investors will
sell at each price. As in other markets, the price moves to the equilibrium point where supply
equals demand.
Fundamental value is the present value of future pro ts.
The goal of fundamental analysis is to assess an asset’s fundamental value. The bene t of
owning stock is that it entitles you to a share of a company’s future pro ts. As such, the
fundamental value of a business is the present value of the future pro ts it will earn. The
fundamental value of a rm determines the fundamental value of stock in that rm. A stock is
a good deal when its price is below its fundamental value.
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Assessing a business’s fundamental value is a four-step process:
1. Forecast future pro ts. Analysts typically project the business’s revenues and costs in
each of the next 5 to 10 years. The difference between revenues and costs is the
business’s expected pro ts for that year. Beyond that time horizon, analysts consider
that pro ts will grow at some constant rate.
2. Discount these pro ts. Convert each year’s pro ts into their present values to account
for this opportunity cost.
3. Add up the sum of those discounted future pro ts. It provides you the estimate of a
company’s fundamental value.
4. Divide the company’s fundamental value by the total number of shares.
If you nd the stock cheaper than this, then the cost-bene t principle says you should buy the
stock. Here’s the big caveat: This investment strategy will succeed only if your estimate of the
fundamental value is more accurate than the stock price.
Relative valuation relies on comparable businesses.
Relative valuation assesses the value of an asset by comparing it to similar assets. The idea is
that you assess the price of something by comparing it with an almost identical “twin.”
Relative valuation gets a bit more dif cult when you can’t nd an identical twin. To get around
the problem of comparable size, you can look at nancial ratios that abstract from each rm’s
size. The following are two of the relative-valuation ratios used by Wall Street analysts:
● The price-to-book ratio measures a rm’s stock price relative to the book value per
share, which is a measure of the business’s net assets per share.
● The price-to-earnings ratio measures a rm’s stock price, relative to last year’s pro ts,
measured as earnings per share.
The key to getting a relative valuation right is to make sure that you’re comparing
companies that are otherwise quite similar.
The Ef cient Markets Hypothesis
Demand to buy a stock comes from investors who believe that its fundamental value is higher
than the price. Supply of a stock comes from investors who want to sell it because they believe
its fundamental value is lower than the price. In equilibrium, demand equals supply, which
means that a stock price moves to the exact point where there are the same number of bets
placed that the stock is overpriced as there are bets placed that the stock is underpriced. This
perspective suggests that a stock price represents the market’s collective judgment about a
company’s fundamental value.
Stock prices re ect all publicly available information about a company’s fundamental value.
The ef cient markets hypothesis is the theory that at any point in time, stock prices re ect all
publicly available information.
It’s tough to beat the market.
The ef cient markets hypothesis doesn’t mean that a stock’s price is always exactly equal to
its fundamental value. Rather, it says that it’s impossible to predict whether it is under- or
overpriced based on publicly available information. This explains why it’s hard to make
money buying and selling stocks.
Financial prices move unpredictably.
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The logic of the ef cient markets hypothesis also suggests that it will be impossible to predict
whether stock prices will rise or fall over the next minute, hour, day, week, or year. If forward-
looking traders eliminate all predictable stock price changes, all that’s left will be
unpredictable changes. It follows that stock price changes are unpredictable. When a price
moves in an unpredictable way, we say it follows a random walk, which means that it follows
an unpredictable path.
Technical analysis looks for patterns — even where none exist.
All this means that technical analysis — studying graphs of nancial prices over time, nding
patterns, and trying to use those patterns to predict the future — doesn’t work.
The Value of Expert Advice
Thousands of researchers — including both university professors and Wall Street analysts —
have conducted careful studies trying to assess whether they can predict where stocks are
going. The conclusion tends to be that it’s incredibly hard to predict stock prices, although it
may not be impossible.
Not even experts can beat the market consistently.
Although some expert investors make money, even more lose money relative to a strategy of
buying a small chunk of each company.
Most people who hold stocks do so through mutual funds, which buy a portfolio of stocks (and
sometimes bonds) on their behalf. There are two types of mutual funds:
● Actively managed mutual funds: These funds pay handsome salaries to expert stock
pickers who put your money in the stocks that they think are likely to do particularly
well.
● Index funds: These funds don’t pay for fancy stock pickers. Instead, they program a
computer to buy automatically every stock that is in the S&P 500 or some other broad
market index.
A careful analysis of major mutual funds between 2003 and 2018 found that simply putting
your money in the S&P 500 earned an annual average return of 7.77% and that the average of
all comparable actively managed mutual funds run by expert stock pickers earned an annual
return of 6.28%.
What explains this? It’s not that professional stock pickers are particularly bad at picking
stocks. The stocks they pick rise roughly in line with the S&P 500, but they charge you a lot of
money for their “expertise.” These high fees make investing with them a bad bet.
Past performance is no guarantee of future performance.
Whatever made a stock picker do well in the past isn’t helping them in the future, as research
shows. It’s the sort of pattern that suggests that no stock picker is better than the market all
the time, but some of them get lucky some of the time.
The ef cient markets hypothesis teaches you the value of modesty.
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Even if you don’t believe the ef cient markets hypothesis is exactly right, it sounds an
important warning that you should always bear in mind: Be modest about your ability to pick
stocks or any nancial asset. Before you trade, you should ask yourself these questions: Is it
likely that the market has overlooked the information you’re relying on? Is it likely that your
analysis is smarter than the collective wisdom of thousands of traders who spend their lives
studying that stock? Always remember that if a stock’s price doesn’t align with your
valuation, there’s a good chance that your valuation is wrong, not the stock price.
The stock market can help predict economic changes.
Stock prices re ect what people think will happen to individual companies and the economy
overall. If stocks in many companies are rising, that’s a signal that traders are expecting good
times ahead, and if stocks are falling, that’s a signal that perhaps there’s bad news ahead.
As a result, stock prices are a closely watched macroeconomic indicator. That said, stock
prices are extremely volatile, and not every blip translates into changing economic
conditions.
Financial Bubbles
When the price of an asset — like a stock — rises above what appears to be its fundamental
value, we call it a speculative bubble because prices are highly in ated. And just like a bubble,
it can keep in ating for a while until it bursts.
The stock market is like a puppy beauty contest.
People buy an investment because they expect other people to buy it from them at a higher
price. This is called the “greater fool” theory because it means that you’ll buy a stock at 5
times what it is really worth, as long as you think there’s some greater fool out there who will
be willing to pay 10 times what it is worth next week. If everyone believes that everyone else
believes that tech stocks will keep rising, then everyone will keep buying tech stocks in hopes
of selling them later at an even higher price. And that’s how a bubble keeps getting in ated.
Even if it’s a bubble, it might not be about to burst.
Why aren’t speculative bubbles stopped by other investors taking the opposite position?
There are three key reasons why bubbles persist.
1. It can be hard to spot a speculative bubble.
2. Even if you spot a speculative bubble, it can be hard to bet against it.
3. You don’t know when the bubble will burst.
PERSONAL FINANCE
Learning Objective: Make better decisions in nancial markets.
Lesson 1: Harness the power of compound interest.
You should start saving early and keep investing your gains. Over the past century, stocks
have had a much larger average annual return than bonds, which means effectively more
compound interest if you use your dividend payments to buy more stocks.
Lesson 2: Don’t pick individual stocks.
Research shows that many investors are overcon dent, believing that they have the ability to
beat the collective wisdom of the market, even though most of them actually can’t. Give up on
trying to pick individual stocks that will outperform the market.
Lesson 3: Diversify your portfolio to reduce risk.
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Diversi cation will reduce how much your wealth will move up and down each year, making it
less risky. The easiest way to diversify your stock holdings is to buy index funds, which do all
the work for you of buying a basket of many different stocks.
Lesson 4: Past performance is no guarantee of future performance.
Not only is past performance no guarantee of future performance; they’re almost unrelated.
Don’t believe professional stock pickers who promise that they’ll beat the market.
Lesson 5: Minimize fees.
Don’t buy and sell stock a lot. Buying and selling will cost you brokerage fees, and the stock
you’re buying probably won’t be any better than the stock you’re selling. Avoid actively
managed mutual funds that charge hefty fees for their useless “expertise.” And if you’re
looking at passively managed indexed funds, shop around to nd the fund that charges the
lowest fees.
Lesson 6: Follow all ve rules with low-cost index funds.
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The easiest way to follow all of these lessons is to invest in low-cost index funds.
ONE PAGE SUMMARY
INTERNATIONAL FINANCE AND
EXC HANGE RATE
Chapter objective: Understand the linkages between the exchange
rate, imports, exports, and international nancial ows.
1. International Trade and Global Financial Flows: See the connections between the domestic
economy and the global economy.
2. Exchange Rates: Analyze prices that are quoted in different currencies.
3. Supply and Demand of Currencies: Analyze the market for currencies and forecast the
nominal exchange rate.
4. The Real Exchange Rate and Net Exports: Assess how exchange rates and relative prices
affect exports and imports.
5. The Balance of Payments: Track how money ows around the world using the current account
and the nancial account.
INTERNATIONAL TRADE AND GLOBAL FINANCIAL
FLOWS
Learning Objective: See the connections between the domestic economy and the
global economy.
International Trade
Exports are goods and services produced domestically and purchased by foreign buyers. Imports are
goods and services produced in a foreign country and purchased by domestic buyers.
Global trade is a large share of worldwide consumption and production.
Globalization describes the increasing global integration of economies, cultures, political institutions,
and ideas.
Sharp reductions in the cost of international transport and communication have led to explosive
growth in trade over the past several decades. Governments in nearly every country have tried to
take advantage of these new opportunities by negotiating trade deals that give their citizens (both
consumers and businesses) access to foreign markets.
Imports and exports have grown rapidly in the United States.
The share of both U.S. imports and U.S. exports relative to the size of the economy is roughly three
times as large now as they were a half century ago. Keep in mind that we don’t export only goods. A
third of our exports are services. When it comes to imports, it’s important to think beyond consumer
goods because more than half of all imports are intermediate goods or raw materials that are used as
inputs by U.S. businesses. Our imports and exports are closely linked due to the global supply chains
that connect businesses around the world.
The net exports are the spending on exports minus spending on imports, which is also referred to as
the trade balance. Negative net exports are sometimes called a trade de cit.
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The United States trades with nearly every country.
The United States trades with nearly every country in the world. Our top three trading partners are
China, Canada, and Mexico. The total of our imports and exports with European Union countries is so
large that Europe ends up being as important a trading partner as China is.
Many countries import and export more than the United States.
Even though international trade is a big part of the U.S. economy, it plays a bigger role in most other
countries. In fact, almost every country in the world exports a larger share of what they produce than
the United States. This is partly because the U.S. economy is so large that a lot of commerce occurs
across states rather than national boundaries.
Global Financial Flows
Goods and services are ying around the world, but investment dollars matter as well. Financial ows
re ect investors buying and selling assets in a global capital market. Financial in ows refer to
foreigners investing in the United States. They’re called in ows because their funds ow into the
United States. Financial out ows describe Americans investing their money in other countries.
They’re out ows because these funds ow out of the United States.
Financial ows are large and include investment in foreign physical assets, nancial assets, and
loans.
Financial ows take three main forms. When foreigners invest in physical assets in the United States,
it’s called foreign direct investment. When foreigners buy American stocks or bonds, it’s called
portfolio investment. And when foreigners lend money to Americans, it falls in a nal category of
deposits and loans. In each case, these nancial in ows help fund investment in new capital assets
within the United States. In return, foreigners enjoy the pro ts, dividends, or interest that their
investments generate.
Financial linkages are becoming more important over time.
Financial ows between the United States and the rest of the world have risen sharply over the past
50 years, a trend sometimes called nancial globalization.
Financial ows started rising in the 1970s and 1980s as many countries removed capital controls.
Deregulation of the nancial sector also led to new opportunities for money to roam the world looking
for better returns. Large institutional investors have become more important over time, and they’re
more likely to look abroad to diversify their portfolios. And technology has led to more rapid
transmission of information, making investors more comfortable about sending their money overseas.
Financial innovation has created sophisticated new ways for investors to take advantage of new
opportunities to diversify and hedge their risks in foreign markets. The result is that both nancial
in ows and out ows have grown.
Foreign ownership is becoming more common.
As a result of these nancial in ows, foreigners have acquired a rising stock of assets in the United
States, and the stock of foreign assets owned by Americans has also risen dramatically.
Financial linkages help diversify risk across the world.
From a macroeconomic perspective, the rise in cross-border ownership means that disruptions in
foreign markets have an immediate effect reducing the wealth of Americans. From a risk management
perspective, this rising cross-border ownership is a good thing for everyone. Greater diversi cation
reduces the total risk that both Americans and foreigners face.
Just about all business is international.
The linkages between the U.S. economy and the global economy — through both international trade
and global nancial ows — have become more important over time.
EXC HANGE RATES
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Learning Objective: Analyze prices that are quoted in different currencies.
Exchanging U.S. Dollars for Foreign Currencies
The price of a country’s currency in terms of another country’s currency is called the nominal
exchange rate.
Use the nominal exchange rate formula to nd the price of a country’s currency.
The nominal exchange rate de nes the ratio at which you exchange units of a foreign currency like
yen for U.S. dollars. This gives us the nominal exchange rate formula:
Nominal exchange rate
Rearrange the nominal exchange rate formula to convert dollars into yen.
You can rearrange the nominal exchange rate formula to tell how many yen is a certain amount of
dollars.
Number of yen = Number of dollars × Nominal exchange rate
Rearrange the nominal exchange rate formula to convert yen into dollars.
If you want to buy something in Japan, you may wonder how many dollars it is worth. To do that, you
need to rearrange the nominal exchange rate formula:
Number of dollars
Don’t accidentally get the exchange rate backward.
When you look up an exchange rate, make sure to pay attention to whether you’re learning the price
of a dollar (which is measured in yen) or the price of a yen (measured in fractions of a dollar). Getting
this wrong could lead to some costly mistakes.
Remember the three uses of the nominal exchange rate formula.
The nominal exchange rate formula serves three purposes: It de nes the nominal exchange rate, it
can be rearranged to convert dollars to foreign currency, and it can be rearranged to convert foreign
currency to dollars.
Exchange Rates and the Price of Foreign Goods
When an exchange rate changes, it will automatically affect how much it costs to buy millions of
imported or exported goods.
Currencies appreciate when they become more expensive and depreciate when they become less
expensive.
When the number of yen you’re charged to buy $1 goes up — that is, the price of a dollar rises — we
describe this as an appreciation of the dollar. Conversely, when the number of yen that are needed to
buy $1 goes down — that is, the price of the dollar falls — we describe this as a depreciation of the
dollar.
An appreciating dollar makes imports cheaper and exports more expensive.
When the dollar appreciates, the goods we import from other countries become less expensive in
U.S. dollars. Some people describe an appreciation as leading to a stronger dollar; it’s stronger
because it buys more foreign goods and services.
Although an appreciation in the dollar is good news for importers, it’s bad news for exporters. An
appreciation of the dollar causes American exports to become more expensive for foreign buyers.
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A depreciating dollar makes imports more expensive and exports cheaper.
On the ip side, when the dollar depreciates, the goods we import from other countries become more
expensive in terms of U.S. dollars. Some people refer to a depreciation in the dollar as leading to a
weaker dollar because it buys fewer foreign goods.
Although depreciation is bad news for importers, it’s good news for American exporters. Even if they
don’t adjust the price that they charge in U.S. dollars, foreign buyers will nd that they now pay less in
their currency, leading them to buy more exports.
S U P P LY A N D D E M A N D O F C U R R E N C I E S
Learning Objective: Analyze the market for currencies and forecast the nominal
exchange rate.
International trade is possible only if there’s a market where they can exchange one currency for
another. That market is the foreign exchange market. It’s the market in which currencies like the U.S.
dollar and the Japanese yen are bought and sold.
The Market for U.S. Dollars
The market for currencies is like any other competitive market where the forces of supply and
demand determine the equilibrium price and quantity. In the foreign exchange market, the products
are currencies like the U.S. dollar. Demanders are those looking to buy U.S. dollars in order to
purchase U.S. goods and services. Suppliers are folks who are looking to sell their U.S. dollars in
return for a foreign currency. The price in this market is the price of a U.S. dollar, or the nominal
exchange rate, which measures the amount of foreign currency you need to buy one U.S. dollar.
The demand for dollars re ects foreigners buying U.S. exports and investing in the United States.
Every dollar of exports from the United States creates a demand in the foreign exchange market for
one U.S. dollar. In addition, every dollar of nancial in ows creates a demand for a U.S. dollar.
The demand curve for U.S. dollars illustrates how the quantity of U.S. dollars demanded varies with
the price of U.S. dollars. This downward-sloping demand curve shows that a lower price for U.S.
dollars leads to a larger quantity of dollars demanded.
The supply of dollars re ects Americans buying imports and investing abroad.
Every dollar of imports creates a supply in foreign exchange markets of one U.S. dollar. In addition,
each dollar of nancial out ows creates a supply of one U.S. dollar.
The supply curve for U.S. dollars illustrates how the quantity of U.S. dollars supplied varies with the
price of U.S. dollars. This upward-sloping supply curve shows that a higher price of U.S. dollars leads
to a larger quantity of dollars supplied.
The exchange rate is determined by supply and demand.
The foreign exchange market operates much like any other competitive market, with the forces of
supply and demand determining the equilibrium price and quantity. The vertical axis represents the
price of a U.S. dollar, and the horizontal axis shows the quantity of dollars exchanged for a foreign
currency. The price of a U.S. dollar describes how many of a foreign currency a buyer has to pay to
get one U.S. dollar.
The exchange rate will change when macroeconomic conditions change.
A change in the price — which in this case is a change in the exchange rate — will not shift either the
demand or supply curve.
Shifts in Currency Demand
The demand curve for U.S. dollars shifts right whenever people want more dollars at any given
exchange rate. The demand curve shifts left whenever people want fewer dollars at any given
exchange rate. Anything — besides the exchange rate — that shifts either how much foreigners
spend on exports or how much they invest in the United States (that is, nancial in ows) will shift the
demand for dollars.
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Demand shifter 1: Exports from the United States
Any factor that shifts the dollar value of exports at a given exchange rate will shift the demand for
dollars. As a result, exports from the United States — and hence demand for dollars — shift in
response to the following factors:
● Strength of the global economy: An increase in the GDP of our major trading partners usually
causes an increase in U.S. exports, shifting the demand for U.S. dollars to the right.
● Barriers to trade in foreign market: When foreign governments provide easier access to their
markets, exports will increase, shifting the demand for U.S. dollars to the right.
● Domestic innovation and marketing: Successful innovation and marketing of U.S. goods and
services to foreign customers will increase exports, shifting the demand curve for U.S. dollars
to the right.
● Foreign prices: When foreign prices are higher than their U.S. counterparts, foreign customers
switch to buying the American-made goods instead. This increased demand for U.S. exports
will shift the demand curve for U.S. dollars to the right.
● Domestic prices: When American sellers cut their prices, it leads to a large increase in exports,
thereby increasing the demand for dollars.
These same in uences also operate in reverse: A decrease in exports would lead to a decrease in the
demand for dollars, which causes the exchange rate to depreciate.
Demand shifter 2: Financial in ows into the United States.
Foreign investors are usually seeking a combination of a healthy return on their investment and
relatively low risk. This means that nancial in ows — and hence demand for dollars — change in
response to the following factors:
● Interest rate differentials: A higher interest rate differential — due to either higher interest rates in
the United States or lower interest rates in a foreign country — will increase nancial in ows,
shifting the demand curve for dollars to the right.
● Business pro tability: Any change that creates a more investment-friendly business climate in the
United States will lead to more nancial in ows, shifting the demand curve for dollars to the
right.
● Political risk: Whenever foreign risks rise relative to political risk in the United States, nancial
in ows into the United States increase, and thus so does the demand for U.S. dollars, shifting
the demand curve to the right.
● Expected exchange rate movements: Any news that might cause the dollar to rise in the future
has an immediate impact, as speculators rush to buy dollars in anticipation of those dollars
later rising in value. Increased demand for U.S. dollars by speculators shifts the demand curve
for U.S. dollars to the right.
These same in uences also operate in reverse: A decrease in nancial in ows would lead to a
decrease in the demand for dollars, which causes the exchange rate to depreciate.
Shifts in Currency Supply
The supply of U.S. dollars comes from Americans who need to exchange their dollars for foreign
currency so that they can buy imports or invest their savings abroad, and those decisions depend on
developments in other markets. Anything — besides the exchange rate — that shifts either how much
people spend on imports or how much they invest abroad will shift the supply of dollars.
Supply shifter 1: Imports into the United States
Any factor that shifts how much Americans spend on imports will shift the supply of dollars. As a
result, imports — and hence the supply of dollars — shift in response to the following factors:
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● Strength of the domestic economy: An increase in American incomes means more imports,
shifting the supply of U.S. dollars to the right.
These same in uences also operate in reverse: A decrease in imports leads to a decrease in the
supply of dollars, shifting the supply of dollars to the left, which causes the exchange rate to
appreciate.
Supply shifter 2: Financial out ows from the United States
The decisions that American investors make about whether to invest their funds abroad or at home
lead nancial out ows — and hence the supply of dollars — to respond to the following:
● Interest rate differentials: A lower interest rate differential will increase nancial out ows as
Americans seek better investment opportunities outside of the United States, shifting the
supply curve for dollars to the right.
● Business pro tability: Any change that creates a less investment-friendly business climate in the
United States will lead to more nancial out ows, shifting the supply curve for dollars to the
right.
● Political risk: Whenever foreign political risks decline, U.S. investors are more interested in
investing internationally, increasing the supply of U.S. dollars, shifting the supply curve to the
right.
● Expected exchange rate movements: Any news that might cause the dollar to fall in the future has
an immediate impact because speculators rush to sell dollars in anticipation of those dollars
later falling in value. An increased supply of U.S. dollars by speculators shifts the supply curve
for U.S. dollars to the right.
When investing abroad becomes a better bet, American investors invest less here and more abroad,
increasing nancial out ows. When foreigners follow suit and also invest less here and more abroad,
the result is a decrease in nancial in ows.
Forecasting Exchange Rate Movements
Apply the same three-step recipe you use to predict the results of any supply-and-demand analysis:
● Step 1: Is the supply or demand curve shifting (or both)?
● Step 2: Is this an increase that will shift the curve to the right or a decrease that will shift the curve
to the left?
● Step 3: How will the price — that is, the exchange rate — change in equilibrium?
Government Intervention in Foreign Exchange Markets
The foreign exchange market as determined purely by the forces of supply and demand is called a
oating exchange rate. Most countries have a oating exchange rate.
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Some countries x their exchange rate.
A xed exchange rate is one where the government effectively sets the price of the currency. A central
bank achieves this by buying or selling as much currency as needed to prevent the price from
moving.
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● Trade barriers protecting domestic producers: When the United States reduces tariffs and other
barriers that make it dif cult for foreign companies to sell their goods to Americans, demand
for imports will increase, and thus so will the supply of U.S. dollars.
● Foreign innovation and marketing: Innovation in foreign products and better marketing of foreign
products to Americans will lead to an increase in American demand for imports.
● Domestic prices: If American producers raise their prices relative to foreign alternatives, American
buyers will switch from buying domestically produced goods and services to buying more
imported ones. The result is an increase in imports, which shifts the supply of U.S. dollars to
the right.
● Foreign prices: Lower foreign prices usually lead to an increase in the quantity of dollars supplied,
shifting the supply of U.S. dollars to the right.
THE REAL EXC HANGE RATE AND NET EXPORTS
Learning Objective: Assess how exchange rates and relative prices affect exports
and imports.
A company’s international competitiveness determines its foreign and domestic sales. And for a
country, the international competitiveness of its businesses is a major factor in determining how much
it imports and exports.
Real Exchange Rate and Competitiveness
The real exchange rate is the ratio of domestic to foreign prices, measured in the same currency.
The real exchange rate is the domestic price of a product divided by the foreign price (after converting
that price into domestic currency):
Real exchange rate
In practice, the price charged by foreign producers is typically quoted in foreign currency, so we’ll
need to convert it into dollars to make it comparable. As such, we calculate the real exchange rate as
this:
Real exchange rate
The real exchange rate measures the (un)competitiveness of U.S. products.
A low real exchange rate means that American goods are cheap relative to their foreign rivals —
which means that they’re internationally competitive. This is why the real exchange rate is often
described as a measure of international competitiveness, or international uncompetitiveness. A higher
real exchange rate means that you’re less competitive.
A real exchange rate depreciation leads to fewer imports and more exports.
A lower real exchange rate means that American products have become cheaper relative to their
foreign counterparts, and this will do the following:
● Decrease imports: American buyers will switch to buying the relatively cheaper local goods rather
than imported foreign goods.
● Increase exports: Foreign buyers will switch to buying the relatively cheaper goods exported from
America rather than their foreign alternative.
The same logic also operates in reverse, implying that a higher real exchange rate will lead to an
increase in imports and a decrease in exports.
The real exchange rate is the exchange rate for output.
The real exchange rate is also the rate at which you can exchange American goods for foreign goods.
By this view, the real exchange rate is the rate at which you can exchange one country’s output for
another country’s output. It’s the exchange rate for real goods and services, while the nominal
exchange rate is the rate at which you can exchange one country’s currency for another’s.
The Real Exchange Rate Determines Net Exports
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An economy-wide real depreciation will lead total exports to increase and total imports to decrease.
(And a real appreciation will decrease total exports and increase total imports.)
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Some countries operate between these extremes, in what’s called a managed exchange rate (or a
“dirty” oat).
China is an important example of a country that manages its exchange rate. It of cially abandoned its
xed exchange rate in 2005. But in an effort to boost the competitiveness of China’s exporters, China
held the value of its currency arti cially low for much of the next decade by selling trillions of yuan
(and buying trillions of dollars).
An economy-wide real exchange rate re ects broad changes in competitiveness.
The economy-wide version of the real exchange rate compares the price of a typical basket of goods
and services in each country by comparing movements in the consumer price index and by adjusting
for changes due to the nominal exchange rate:
Real exchange rate
The real exchange rate drives imports and exports.
The real exchange rate is a key factor driving net exports. After all, if American businesses have
become more competitive, they’ll be able to outcompete foreign rms in foreign markets, and they’ll
export more. They’ll also do a better job competing with the foreign businesses that Americans import
from, leading to fewer imports into the United States.
T H E B A L A N C E O F PAY M E N T S
Learning Objective: Track how money ows around the world using the current
account and the nancial account.
The Current Account and the Financial Account
The current account tracks how much income crosses national borders each year, and the nancial
account tallies up nancial ows across borders.
The current account tallies up income ows into and out of a country.
The current account balance measures the difference between the income that Americans receive
from abroad and the income that Americans pay to people abroad. It’s a broader measure than net
exports, which tracks only the income earned from exports less the income paid for imports.
Notice that the current account doesn’t count the sale of assets as income. A transfer of existing
assets doesn’t generate any new income, which is why it’s not part of the current account. However,
these nancial ows are important because they re ect the changing international ownership of
assets.
The nancial account tallies up changes in the ownership of assets.
The nancial account balance measures the difference between nancial in ows and nancial
out ows.
The United States has run a current account de cit and nancial account surplus for decades.
The United States has run a persistent current account de cit since the early 1990s. This de cit
means that the income that Americans have paid foreigners has exceeded the income that Americans
have earned from abroad. However, through this same period, the United States has also consistently
run a nancial account surplus, meaning that each year more funds have been invested in the United
States from abroad than Americans have invested overseas.
Put these two pieces together, and the current account de cit describes a net out ow of funds that is
exactly offset by the net in ow of funds from the nancial account surplus.
In ows of dollars must equal out ows of dollars.
This close connection between the current account and the nancial account balance re ects a
deeper truth: You can buy a dollar only if someone sells it to you, just as you can sell a dollar only if
someone buys it from you. And so in ows of dollars from abroad must be equal to the out ow of
dollars. Thus, it follows that:
Financial in ows + Income from abroad = Financial out ows + Income paid abroad
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Equality between in ows and out ows implies equality between the current and nancial accounts.
Income paid abroad − Income from abroad = Financial in ows − Financial out ows
The left-hand side of this equation is the current account de cit, and the right-hand side is the
nancial account surplus. It says that the current account de cit must always be matched by an equal
nancial account surplus.
Saving, Investment, and the Current Account
Recall that the total output of the U.S. economy is measured as: Y = C + I + G + NX.
A current account de cit arises when we spend more than we earn.
We can rearrange the expression above to make the current account de cit the focus (remembering
that the current account de cit equals −NX):
Current account de cit = C + I + G − Y
This says that the United States has a current account de cit because total spending exceeds total
income.
The current account de cit re ects the imbalance between saving and investment.
Another important perspective on the current account focuses on the role of saving. If we add and
subtract tax revenues (abbreviated as T) on the right-hand side of the previous equation, we get the
following:
Current account de cit = C + I + G + (T − T) − Y
And if we then rearrange this expression, we get the following:
Current account de cit = I − (Y − C − T) − (T − G) = I − S
The rst expression in parentheses is personal saving. The second expression in parentheses is
government saving. This says that the current account de cit arises because investment exceeds
total national saving.
Investment is funded by a combination of domestic saving and savings from abroad.
Recall that a country’s current account de cit must be equal to its nancial account surplus, and we
rearrange the previous expression to make investment the focus:
I = S + Financial account surplus
The right-hand side of this equation illustrates that investment must be funded either out of national
savings or from the savings of foreigners.
Current Account Controversies
Should the United States be worried about its current account de cit?
A current account de cit can re ect people living beyond their means.
Some people bemoan the “international imbalances” that lead to current account de cits. They note
that as Americans spend more than they earn, they fund the gap by selling assets and borrowing from
overseas. As a result, foreigners are increasingly taking ownership of American factories and
equipment, and Americans are going into debt to foreigners. This might be a signal of a country living
beyond its means, especially if the spending is wasteful and if the people who are borrowing money
have no idea how they’ll ever pay it back.
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A current account de cit can re ect valuable investments in the future.
Others argue that the U.S. current account de cit might best be thought of as a sign of economic
health. The ip-side of the U.S. current account de cit is a nancial account surplus, and this in ow of
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If we take this in ows-equals-out ows equation and do a quick bit of rearranging, we get the
following:
funding from foreign investors has increased the supply of loanable funds and spurred more
investment.
Reducing the current account de cit would do more harm than good, preventing businesses from
making valuable investments that could be the foundation of future economic growth.
Don’t worry about bilateral trade balances.
One thing nearly all economists agree on is that you shouldn’t worry about bilateral trade balances —
how much we buy from one speci c country compared to how much they buy from us.
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ONE PAGE SUMMARY
Chapter objective: Learn how to track the ups and downs of the
economy.
1. Macroeconomic Trends and Cycles: Distinguish between long-run economic trends and
short-run uctuations.
2. Common Characteristics of Business Cycles: Describe the common features of business
cycles.
3. Analyzing Macroeconomic Data: Learn to use macroeconomic data to track the economy.
M AC RO E C O N O M I C T R E N D S A N D C YC L E S
Learning Objective: Distinguish between long-run economic trends and short-run
uctuations.
Business cycles are short-term uctuations in economic activity.
Trend Growth and the Output Gap
Long-run economic growth re ects growth in an economy’s potential output, which is the level of
output that occurs when all resources are fully employed. It re ects the quantity and quality of our
inputs to production.
In the short run, the economy may fail to meet its potential. Sometimes GDP is higher than potential
output, and sometimes it’s lower.
The ups and downs of the business cycle are very disruptive.
In a typical recession, GDP may decline by a few percentage points. This may seem small, but when
you’re in the midst of a downturn, businesses fail, and workers lose their jobs.
The unemployment rate begins to rise in a recession and often continues rising for a few years after
the recession of cially ends before it slowly declines.
Recessions usually don’t last long, but they have a lasting impact on people’s careers. Researchers
have found that even decades later, folks who graduated in a recession tend to earn less than those
who graduated in better economic times.
The output gap measures how far GDP is from its potential.
The business cycle re ects the tendency for economies to deviate from potential output. We measure
this deviation using the output gap:
Output gap
A negative output gap means there are idle resources. A positive output gap means that the economy
is using its resources with an unsustainable intensity.
A business cycle runs from a peak, through a recession, to a trough, then into an expansion.
A peak is a high point in economic activity, its opposite is a trough — which is a low point in economic
activity. A recession is a period of falling economic activity. When economic activity is rising, it’s called
an expansion.
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Levels tell you where the economy is; changes tell you where it is going.
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B U S I N E S S C YC L E S
GDP measures the level of output. GDP growth rates are about changes, describing the rate at which
the size of the economy is expanding or contracting.
Business cycle peaks and troughs describe levels. But whether an economy is in an expansion or a
recession is not about levels. It’s about change — whether economic activity is rising or falling. So
when the economy begins expanding, there is a positive change, and the recession ends.
Business Cycles Are Not Cycles
Business cycle is an important term, but it’s a somewhat misleading choice of words. The word cycle
makes it sound like the economy rises and falls at regular intervals. But the economy’s uctuations
are anything but rhythmic, reliable, or predictable.
C O M M O N C H A R AC T E R I S T I C S O F B U S I N E S S C YC L E S
Learning Objective: Describe the common features of business cycles.
Although each business cycle is unique, all business cycles tend to have some common features.
Recessions Are Short and Sharp; Expansions Are Long and Gradual
A typical business cycle involves a short, sharp recession, followed by a long and gradual expansion.
Since World War II, the average recession has lasted only one year, and the average economic
expansion has lasted ve years.
The disruptions that cause an economy to go into recession are varied and have included slowing
productivity, oil price hikes, credit controls, high interest rates, banking crises, overvaluation of
technology stocks, a housing market meltdown, a nancial crisis, and, most recently, a global
pandemic.
Business Cycles Are Persistent
Macroeconomic conditions show persistence, which means that the state of the economy this year is
closely related to conditions next year.
The Business Cycle Impacts Many Parts of the Economy
Many economic variables move up and down together over the business cycle, which is known as
comovement.
Different states rise and fall together.
The business cycle also affects economic conditions in just about every state in the country. When a
recession hits, the effects ripple across the country. There are some differences across, no state is
immune from the business cycle.
Different economic indicators rise and fall together.
There are many different indicators that track economic activity, and they tend to move together. If
GDP is rising, then it’s also likely that industrial production is rising, retail sales are rising, and
employment is rising. And other indicators — the creation of new businesses, housing construction,
automobile sales, imports from overseas, new investment projects, business pro ts, workers’ real
wages, stock prices, in ation and interest rates — all tend to rise and fall together over the business
cycle.
Different sectors rise and fall together.
Whatever industry you’re in, a recession is usually bad for business, while an expansion is usually
good for business. There’s an exception to this rule: The business cycle is really about the private
sector, while the public sector often follows a different pattern.
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Some variables lead the cycle, while others lag.
Leading indicators are variables that tend to predict the future path of the economy. Important leading
indicators include business con dence, consumer con dence, and the stock market.
Lagging indicators are variables that tend to follow business cycle movements with a bit of a delay.
Unemployment tends to be a lagging indicator.
Okun’s Rule of Thumb Links the Output Gap and the Unemployment Rate
Economic activity starts to increase at the end of a recession, but the economy will continue to have
unused resources until the output gap is closed. One of those resources is workers, and there is a
clear relationship between the output gap and the unemployment rate. When output is below
potential, unemployment is high, and when output is above potential, unemployment tends to be low.
When output is at potential, the unemployment rate is equal to the equilibrium unemployment rate.
The equilibrium unemployment rate isn’t zero, and over the past century, the equilibrium
unemployment rate in the United States has been around 5%.
Okun’s rule of thumb quanti es the relationship between output and the unemployment rate. It says
that for every percentage point that actual output is less than potential output, the unemployment rate
will be around half a percentage point higher.
A N A LY Z I N G M A C R O E C O N O M I C D A T A
Learning Objective: Learn to use macroeconomic data to track the economy.
The Basics of Macroeconomic Data
Seasonally adjusted data take out seasonal patterns.
For lots of data series, you need to choose between “seasonally adjusted” and “not seasonally
adjusted.” This choice re ects a reality of the economy: There are some strong seasonal patterns in
the things that we do. Seasonally adjusted data remove these predictable seasonal in uences.
Whenever there’s a choice between data that are seasonally adjusted or not, you’re usually better off
focusing on the seasonally adjusted numbers.
The frequency of different data series varies, but you can compare annualized rates.
Data converted into an annualized rate is data converted to the rate that would occur if the same rate
had occurred throughout the year. This option may be available for data from a time period of less
than a year. They make comparing growth rates measured across different time periods easier.
You typically want to focus on real data.
The problem with nominal data is that it’s hard to tell whether an increase re ects price increases or
rising output, which is why you’ll typically use real data, such as real GDP, to track the economy’s
performance over time.
Pay attention to data revisions.
Some data are frequently revised, so when you look up data, realize that it might be different from the
last time you looked at it. Updates to earlier estimates are called revisions, and they can be quite
substantial because initial estimates can be based on incomplete data.
Top Economic Indicators
Indicator 1: Real GDP is the broadest measure of economic activity.
You should focus on GDP growth to see how fast the economy is growing.
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Indicator 2: Real GDI provides a useful cross-check on GDP.
An alternative measure called gross domestic income (GDI) is calculated by adding up total income.
Because every dollar of spending is also a dollar of income for whomever received it, GDP and GDI
should be equal. In practice, these measurements can differ because they’re each constructed using
different data sources with different shortcomings. Early reports of the income data are often more
reliable than the spending data, so GDI often shows warning signs for the economy sooner than GDP
does.
Indicator 3: Nonfarm payrolls tell you if the labor market is improving.
Nonfarm payrolls track how many jobs are created each month. This indicator is one of the most
important because it’s released soon after the end of each month and provides an early and reliable
look at how quickly the economy is creating jobs.
Indicator 4: The unemployment rate is an indicator of excess capacity
It’s a snapshot of how strong the labor market is and how easy it is to nd a job.
Indicator 5: Initial unemployment claims provide a timely indicator
Initial unemployment claims tell you how many people lost their jobs and applied for unemployment
insurance during the previous week. They’re valuable because they’re available quickly and offer
timely insight into what was happening as recently as last week.
Indicator 6: Business con dence tells you what managers are planning
Business con dence is a leading indicator. When it starts to fall, a recession might be on the horizon.
The most closely watched data series is the Institute for Supply Management’s Purchasing Managers’
Index. It surveys business executives to nd out if they’re planning to increase or decrease
production, hiring, prices, and more.
Indicator 7: Consumer con dence tells you what consumers are thinking.
When the consumer con dence index rises, that means consumers are becoming more upbeat about
the economy and are likely to spend more, particularly on big-ticket items like cars or consumer
durables. Like business con dence, consumer con dence is a leading indicator.
Indicator 8: The rate of in ation tells you what’s happening with prices.
Economists pay close attention to the consumer price index because it provides a sense of how much
economy-wide prices are growing. Rising prices indicate an economy that is potentially operating
above potential, and falling prices indicate that the economy may be below potential.
Indicator 9: The employment cost index tells you what’s happening with wages.
The employment cost index tells you how fast wages and bene ts are rising. Rising compensation is
a sign of a healthy economy, and higher wages often translate into more spending. The employment
cost index accounts for both wages and bene ts, so it measures the rise in labor costs experienced
by businesses. Because higher costs often lead to higher prices, this index is a leading indicator of
in ationary pressure.
Indicator 10: The stock market tells you about the future expected pro ts of businesses.
A strong overall stock market suggests that traders are optimistic about the future of business
pro tability, and thus it’s a vote of con dence in the economy more generally. If the stock market is
falling, there’s reason to be worried. Stock prices are often the rst sign of either a strengthening or
weakening economy, although it’s also been known to send false signals.
Put the indicators together in a dashboard.
And if you want to see the latest numbers, the dashboard is online at https://research.stlouisfed.org/
dashboard/17183.
An Economy Watcher’s Guide
Here are the ve tips that will give you a toolkit for tracking the economy.
Tip 1: Track many indicators.
Our measures of the economy are still imperfect, and the U.S. economy is large and complex. It’s
best to follow many different indicators to get a full view of the economy.
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Tip 2: Broad indicators beat narrow indicators.
Some indicators are a better re ection of the economy than others, and you should give more weight
to indicators that account for a greater share of the economy.
Tip 3: Seek just-in-time data, and distinguish between leading and lagging indicators.
Some indicators are published several months after the fact, and others are published only a few
days later. To stay up to date, it’s best to give more weight to indicators that are published quickly.
But although you want to pay attention to just-in-time data, also remember that some indicators lead
the business cycle, and others lag it.
Tip 4: Find the signal amid the noise.
Macroeconomic data are often rough estimates based on incomplete samples. This means they
contain a lot of noise, jumping up and down for reasons unrelated to the underlying trends. That noise
makes it harder to discern the signal about where the economy is going. Averaging over the past few
data points can help you minimize the in uence of this noise, allowing a clearer picture to emerge.
Another strategy for nding the signal in the noise is to look past highly volatile components of the
data, so the trend can shine through.
Tip 5: Adjust your outlook when data differ from expectations.
When the data matches your expectations, there isn’t much news there. But if the data show that the
economy is stronger or weaker than you expected, then that’s news, and you’ll need to adjust your
outlook.
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ONE PAGE SUMMARY
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LINKING INTEREST RATES AND
O U T P U T U S I N G I S - M P A N A LY S I S
Chapter objective: Analyze the links between spending, interest rates,
nancial markets, and output that shape the business cycle.
1. Aggregate Expenditure: Assess the role of aggregate expenditure in driving short-run
uctuations in output.
2. The IS Curve: Output and the Real Interest Rate: Use the IS curve to analyze the relationship
between the real interest rate and output.
3. The MP Curve: What Determines the Interest Rate: Use the MP curve to summarize how the
real interest rate is determined.
4. The IS-MP Framework: Forecast economic conditions and how they’ll respond to monetary and
scal policy.
5. Macroeconomic Shocks: Use the IS-MP framework to forecast the effects of macroeconomic
shocks.
AGGREGATE EXPENDITURE
Learning Objective: Assess the role of aggregate expenditure in driving short-run
uctuations in output.
Aggregate Expenditure and Short-Run Fluctuations
At least in the short run, changes in demand drive changes in output.
Aggregate expenditure is the sum of everyone’s spending plans.
Aggregate expenditure refers to the total amount of goods and services that people want to buy
across the whole economy. Aggregate expenditure is the sum of four components:
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Consumption: The buying of goods and services by households
Planned investment: The purchasing of new capital by businesses
Government purchases: The buying of goods and services by the government
Net exports: The spending by foreigners on American-made exports less the spending by
Americans on foreign-made imports
The measure of investment that’s counted in aggregate expenditure is planned investment, which
includes all the spending on new capital that businesses do but excludes unplanned changes in
inventories.
Output adjusts to meet aggregate expenditure.
When the total quantity of output exceeds aggregate expenditure, businesses will cut back their
production. And when output is less than aggregate expenditure, businesses will ramp up production.
An equilibrium describes a stable situation with no tendency to change, so macroeconomic
equilibrium occurs when the quantity of output that suppliers collectively produce is equal to the
quantity of output that buyers collectively want to purchase. As such, macroeconomic equilibrium
occurs when the total production of output (measured by GDP) equals aggregate expenditure:
This equation states that across the whole economy, businesses will adjust their production so that
total output matches total spending. And this implies that — at least in the short run — demand
conditions determine output.
The Demand-Driven Short Run and the Supply-Driven Long Run
In the short run, actual output may fail to meet potential.
Weak aggregate expenditure can lead the economy to adjust to an equilibrium in which actual output
falls short of potential output. An economic slump can be an equilibrium because businesses don’t
want to produce output that people won’t buy, and people don’t want to spend more because the
economy is weak.
Actual output can exceed the economy’s potential, but this is not sustainable.
Actual output can exceed the economy’s potential, but this is not sustainable. Output can exceed
potential only if available resources are more than fully employed. When actual output exceeds
potential output, this can spark in ation.
The output gap focuses on the balance between the short-run demand and long-run supply of output.
Potential output describes the economy’s maximum sustainable rate of output. The output gap
measures the gap between actual and potential output, as a percentage of potential output:
Output gap
When actual output is greater than potential, the output gap is a positive number. And when the
economy is producing less than potential, the output gap is a negative number.
When output fails to rise as much as potential, you should say the result is a more negative output
gap. And when output rises more than potential, you should say the result is a more positive output
gap.
Focusing on the output gap is helpful because it provides a way to disentangle the roles of the
demand- and supply-side determinants of output. The supply side of the economy determines
potential output. But actual output moves in ts and starts, suggesting that demand-side factors can
drive it to deviate quite substantially from potential output.
Be careful not to confuse equilibrium output with potential output.
Equilibrium output describes the level of output at the point of macroeconomic equilibrium (where the
economy will come to rest).
THE IS CURVE: OUTPUT AND THE REAL INTEREST RATE
Learning Objective: Use the IS curve to analyze the relationship between the real
interest rate and output.
The real interest rate may be the most important price in the economy. That’s because it represents
the opportunity cost of spending. It is also critical because it’s one of the levers policy makers adjust
to in uence the economy. The Federal Reserve raises the interest rate when it wants to induce
people to spend less. And when the Fed wants to stimulate more spending, it cuts the interest rate,
which reduces the opportunity cost of spending money today.
Lower Interest Rates Boost Aggregate Expenditure
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Lower interest rates boost consumption.
Spending decisions depend on the real interest rate because of the opportunity cost principle: The
opportunity cost of spending money today is saving that money and earning interest. The lower the
real interest rate is, the lower the opportunity cost of spending.
Lower interest rates boost investment.
Money you spend on new equipment or structures is money that is not in the bank earning interest.
Thus, the opportunity cost of investing in new capital is lower when real interest rates are lower. As a
result, low real interest rates lead to more investment spending.
Lower interest rates boost government purchases.
Low interest rates reduce the interest payments the government pays on its debt. Low interest
payments mean that there’s more money left in the government budget for spending on roads,
bridges, and other forms of aggregate expenditure. As a result, lower interest rates can lead to an
increase in government purchases.
Lower interest rates boost net exports.
A low real interest rate in the United States leads international money managers to send their funds to
other countries that offer better returns. This means foreign investors will demand fewer U.S. dollars,
and American investors will supply more U.S. dollars. This increased demand and decreased supply
leads the dollar to become cheaper. So the initial effect of a lower interest rate is that it takes fewer
foreign currencies to buy an American dollar. This cheaper dollar increases exports and reduces
imports.
The IS Curve Describes the Link Between the Real Interest Rate and the Output Gap
Lower interest rates boost aggregate expenditure.
Consumption, investment, government purchases, and net exports all increase when the real interest
rate is lower. Therefore, aggregate expenditure — which is the sum of each of these forms of
spending — is higher when the real interest rate is lower.
A rise in aggregate expenditure is matched by a rise output.
Businesses adjust their output to meet demand, so that output adjusts until it’s equal to aggregate
expenditure. As a result, a lower real interest rate that boosts aggregate expenditure will lead to a
higher level of output.
Higher output translates to a more positive output gap.
When actual output rises even as potential output is unchanged, the output gap becomes more
positive.
The IS curve illustrates the link between interest rates, output, and the output gap.
The IS curve illustrates how lower real interest rates lead to a more positive output gap.
The IS curve is like a macroeconomic demand curve.
The IS curve is similar to a demand curve. It shows this year’s demand for all types of output. You can
think of it as showing the macroeconomic demand for output.
The IS curve is downward-sloping, like a typical demand curve.
That’s because a lower real interest rate decreases the opportunity cost of making purchases this
year, leading people across the whole economy to respond by buying more goods and services.
How to Use the IS Curve
The IS curve is a valuable tool for forecasting economic conditions. Locate, on the curve, the real
interest rate. The corresponding level of GDP is your forecast.
If other things change, so should your forecast.
This is your forecast, holding other things constant. If other factors change, then so should your
forecast.
A change in the real interest rate leads to a movement along the IS curve.
THE MP CURVE: WHAT DETERMINES THE INTEREST RATE
Learning Objective: Use the MP curve to summarize how the real interest rate is
determined.
The Federal Reserve Sets the Risk-Free Interest Rate
Eight times a year, policy makers meet at the Federal Reserve in Washington, D.C., to decide how to
set the interest rate. As policy makers discuss what interest rates to set, they consult their estimates
of the IS curve in order to assess the implications of each possible choice. This process of setting
interest rates to in uence economic conditions is called monetary policy.
The Fed sets the nominal interest rate to in uence the real interest rate.
When the Federal Reserve announces that it’s setting the interest rate at 3%, it’s actually setting the
nominal interest rate, but we’ll describe the Federal Reserve as setting the real interest rate because
in practical terms, that’s what it is doing.
The Fed’s decisions percolate throughout the whole economy.
The Fed’s policy tool is a speci c interest rate called the federal funds rate, which is the interest rate
on a set of overnight loans that are almost certain to be repaid the next day. There’s no such thing as
a loan with zero risk, but these overnight loans come pretty close — so close, in fact, that for our
purposes, you can think of the Federal Reserve as effectively setting the risk-free interest rate.
Changes in the risk-free interest rate then percolate through the rest of the economy. But the Fed is
not the only force that affects interest rates.
The Financial Sector Adds a Risk Premium
There’s another critical factor that affects interest rates: risk.
The interest rate on any loan re ects the risk-free rate plus a risk premium.
Banks and other lenders demand to be paid extra for taking on these risks. The extra interest that
they charge to account for risk is called the risk premium. As a result, the real interest rate re ects two
in uences: It’s the risk-free rate (which is set by the Fed) plus the risk premium (which is determined
by nancial markets).
Real interest rate = Risk-free real interest rate + Risk premium
The risk premium is determined in nancial markets.
The buyers and sellers of risk — mainly big banks and other nancial institutions — trade risk. They
do this by buying and selling complicated nancial contracts that allow them to reallocate the risks in
their portfolios — including the risks associated with the money they have loaned you.
The risk premium is the price at which lenders are willing to bear the risk associated with lending you
money. This price is determined by the forces of supply and demand, and so it re ects changing
nancial conditions and sentiments in nancial markets.
The MP Curve
The MP curve stands for monetary policy because we use it to illustrate the current real interest rate,
which is largely shaped by monetary policy. The MP curve illustrates how changes in the risk
premium affect the real interest rate.
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The MP curve illustrates the real interest rate.
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A change in the real interest rate leads the economy to move from one point on the IS curve to
another point on the same curve. The point of the IS curve is to illustrate how the output gap
responds to changes in the real interest rate, and so changes in the real interest rate lead to a
movement along the IS curve.
The MP curve illustrates the current real interest rate, so it is horizontal. If the interest rate changes —
either because the Fed changes monetary policy or changes in nancial markets shift the risk
premium — the MP curve will shift to illustrate this.
You can measure the risk premium using interest rate spreads.
Here’s a simple trick you can use to track the risk premium: Calculate the difference between the
interest rate at which you can borrow and the risk-free interest rate (for loans of the same duration).
This difference, which is called an interest rate spread, is an estimate of the risk premium.
The MP curve is simple because monetary policy is simple.
The MP curve is pretty simple: you just draw a horizontal line to show what the current interest rate is.
That’s because the Federal Reserve simply announces where it wants to set the interest rate, and the
MP curve re ects that.
THE IS-MP FRAMEWORK
Learning Objective: Forecast economic conditions and how they’ll respond to
monetary and scal policy.
The IS curve illustrates how the output gap depends on the real interest rate. And the MP curve tells
you what the real interest rate will be. Put them together, and you’ll have a complete story of what
determines the state of the economy.
IS-MP Equilibrium
The intersection between IS and MP curves determines the macroeconomic equilibrium.
Fluctuating Demand and Business Cycles
Strong aggregate expenditure leads to an economic boom and full employment.
Optimistic spending plans lead to a macroeconomic equilibrium with an output gap of zero, which
means that GDP is at its highest sustainable level. In this booming economy, output is high,
unemployment is low, and the economic outlook is sunny enough that continued economic optimism
is warranted.
Insuf cient spending can lead to an economic bust and unemployment.
Pessimism leads to a decrease in aggregate expenditure at any given real interest rate and level of
income. This decrease in spending causes the IS curve to shift left. This lower level of aggregate
expenditure yields a new macroeconomic equilibrium at a much lower level of output. The output gap
is now negative, which means that the economy is producing below its potential. The result is an
economic bust, in which people have lower incomes and unemployment is widespread.
Changes in aggregate expenditures create macroeconomic uctuations.
The economy shifts from between periods of boom to bust, due to changes in aggregate expenditure
shifting the IS curve. Many of the ups and downs of the business cycle re ect shifts in aggregate
expenditure.
Recessions can be individually rational and collectively terrible.
The economy can be in macroeconomic equilibrium even when output is far below its potential and
unemployment is widespread. It is a macroeconomic equilibrium in which the economy produces less
than its potential. If nothing changes, the economy will get stuck in this rut. That’s because the
economy is in a bust, and unfortunately, this unhappy outcome is also an equilibrium.
Each person is individually making the best decision they can, but those decisions add up to a
collectively terrible outcome in which the economy is stuck producing less than potential — and less
than required to employ everyone.
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Analyzing Monetary Policy
Monetary policy shifts the MP curve.
When the Fed changes the real interest rate, it shifts the MP curve. Cutting the real interest rate shifts
the MP curve down and leads to a new equilibrium with higher GDP at a lower real interest rate.
Analyzing Fiscal Policy and the Multiplier
The government can also in uence the economy through scal policy, adjusting its own spending and
tax policies. When the federal government adjusts scal policy, it shifts the IS curve.
An increase in spending has a multiplied effect on aggregate expenditure.
As this initial boost in spending reverberates though the economy, it illustrates the importance of the
interdependence principle for understanding macroeconomic developments. This interdependence
arises because one person’s spending is another person’s income. It means that extra spending on
schools stimulates extra spending in the tness, food, and childcare industries. As the initial burst of
government purchases ripples through the economy, it has a multiplied effect, leading to an even
larger boost to aggregate expenditure.
The multiplier summarizes the effect of an initial burst of spending on output.
The multiplier measures how much extra GDP is generated by each extra dollar of spending. For
instance, if the multiplier is 2, then an initial $1 boost to spending will generate a total of $2 in
additional spending and greater output. When people have a greater propensity to spend any
additional income they receive, the ripple effects of an initial burst of spending will be larger, leading
the multiplier to be larger. You can use it to forecast the effects of changes in spending as follows:
The multiplier determines how far the IS curve shifts.
The multiplier is relevant to our IS-MP analysis because it determines how far the IS curve shifts
following an initial burst of spending. The IS curve shifts by an amount equal to the initial change in
spending times the multiplier. This shift in the IS curve leads to a new equilibrium, which involves
higher GDP but no change in the real interest rate.
MACROECONOMIC SHOC KS
Learning Objective: Use the IS-MP framework to forecast the effects of
macroeconomic shocks.
Spending Shocks Shift the IS Curve
Shifts in the IS curve are driven by spending shocks, which change the level of aggregate
expenditure associated with a given real interest rate and level of income.
Spending shock 1: Consumption increases when people feel more prosperous.
Any development that makes people feel more prosperous leads to an increase in consumption. This
means that consumption will shift in response to changes in the following factors:
● Wealth: When the stock market booms or house prices rise, stockholders and homeowners feel
more prosperous and spend some of their newfound wealth. Consumption will increase.
● Consumer con dence: When you feel con dent that your income will grow in the future, you might
ramp up your spending in advance. As a result, consumption increases when an improved
economic outlook boosts consumer con dence.
● Taxes and government assistance: When the government cuts your taxes or when it increases
government assistance payments, you’ll have more disposable income. And so consumption
increases.
● Inequality: People with low incomes tend to spend a larger share of their income. It follows that
redistributing income from rich people to poor people tends to increase consumption.
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Spending shock 2: Investment increases when it’s pro table for businesses to expand.
As a manager, you’ll invest in new machinery when you believe that it will be pro table to expand
your production. As a result, investment will shift in response to changes in the following factors:
● An expanding economy: When the economy is expanding, so is the demand for your products. To
keep up with demand, investment in new equipment increases when the economy is
expanding more rapidly.
● Business con dence: Because capital investments tend to last for years, assessments about
whether to buy new equipment depend not only on today’s pro ts but also on expected future
pro tability. That’s why investment rises when managers are more con dent about their longterm pro tability.
● Corporate taxes: Corporate taxes lower after-tax pro ts, reducing the return on investing in new
equipment. As a result, investment falls in response to higher corporate taxes.
● Lending standards and cash reserves: If your business cannot borrow money at a reasonable
interest rate, you’ll buy new equipment only when your company has the cash to do so. So
investment increases when loans are easier to get or when businesses have large cash
reserves.
● Uncertainty: If you’re uncertain about the economic outlook, remember that you usually have the
option to postpone major investments until the outlook is clearer. Lower uncertainty leads
managers to restart these shelved projects, leading to an increase in investment.
Spending shock 3: Government purchases increase in response to scal policy.
For example, Congress may pass legislation to spend more on roads and bridges, invest in pandemic
preparedness, or purchase new military equipment. In addition, some government programs —
known as automatic stabilizers — automatically increase spending when the economy is weak.
Spending shock 4: Net exports increase due to global factors.
Net exports rise when people in other countries want to buy a lot of American-made goods and
services. They shift in response to the following:
● Global economic growth: When foreign economies do well, their consumers and businesses buy
more goods, including more American-made goods, leading net exports to rise.
● The exchange rate: When the U.S. dollar becomes cheaper, our goods become cheaper to foreign
buyers, leading exports to rise. A cheaper U.S. dollar also means that foreign goods become
more expensive (in dollars) for American buyers, leading imports to fall. Both forces — rising
exports and falling imports — cause net exports to increase.
● Trade barriers: Exports increase when there are fewer barriers for American businesses in foreign
markets, while imports increase when there are fewer barriers for foreign businesses in the
United States. Because trade agreements typically reduce barriers on both, their effect on net
exports is unclear.
Anything that shifts any component of aggregate expenditure shifts the IS curve.
The IS curve shifts in response to an increase in any component of aggregate expenditure (C, I, G,
and NX).
Financial Shocks Shift the MP Curve
When the Federal Reserve adjusts the risk-free real interest rate or shifts in nancial markets change
the risk premium, the real interest rate will shift, leading the MP curve to shift. We call these changes
in borrowing conditions that shift the MP curve nancial shocks.
Financial shock 1: Changes in monetary policy.
When the Federal Reserve decides to raise its benchmark interest rate, interest rates rise throughout
the rest of the economy. This higher real interest rate shifts the MP curve up.
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But that’s not the only way the Fed can shift the MP curve. Longer-term interest rates are based partly
on the current short-term interest rate and partly on expectations about how that interest rate will
evolve over the coming months and years. The Fed will often try to in uence these expectations. A
signal that it expects to raise interest rates in the future is often enough to increase the long-term
interest rate, thereby shifting the MP curve up.
Financial shock 2: Financial market risks shift the risk premium.
A rise in the risk premium raises the real interest rate, which shifts the MP curve up. The risk premium
will shift in response to changes in the following risk factors:
● Default risk: When there’s an increased risk that borrowers will default, lenders demand a larger
risk premium, which leads the MP curve to shift upward.
● Liquidity risk: When banks need cash, they can usually get it by selling some of their loans to
other lenders. Liquidity risk arises when there aren’t enough buyers willing to pay a
reasonable price. A rise in liquidity risk increases the risk premium, which shifts the MP curve
upward.
● Interest rate risk: The long-term interest rate you offer today might turn out to be a bad deal if
future interest rates or in ation are unexpectedly higher. As a result, this greater uncertainty
increases the risk premium, shifting the MP curve up.
● Risk aversion: When lenders become more risk-averse, they’ll be willing to make a loan only if
they can charge a higher risk premium, shifting the MP curve up.
Any change in the real interest rate shifts the MP curve.
The MP curve shifts whenever the real interest rate shifts.
Forecasting Macroeconomic Outcomes
To assess the likely effects of any change in economic conditions, ask yourself the following:
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● Step 1: Is there a spending shock (which shifts the IS curve) or a nancial shock (which shifts the
MP curve)?
● Step 2: In which direction and how far does this shift the IS or MP curve?
● Step 3: What happens to output in the new equilibrium?
ONE PAGE SUMMARY
THE PHILLIPS CURVE AND
INFL ATION
Chapter objective: Assess the causes of in ation.
1. Three In ationary Forces: Identify the three causes of in ation: in ation expectations,
demand-pull in ation, and supply shocks.
2. In ation Expectations: Explore how in ation expectations lead to in ation.
3. The Phillips Curve: Analyze the link between the output gap and in ation.
4. Supply Shocks Shift the Phillips Curve: Assess how shocks to production costs shift the
Phillips curve.
THREE INFLATIONARY FORCES
Learning Objective: Identify the three causes of in ation: in ation expectations,
demand-pull in ation, and supply shocks.
In ationary Force 1: In ation Expectations
In ation expectations represent the rate at which average prices are anticipated to rise next year.
Managers across the economy raise their prices in line with their in ation expectations. As a result,
in ation expectations create in ation.
In ationary Force 2: Demand-Pull In ation
When the whole economy booms, the actual output exceeds potential output. Millions of businesses
experience demand outstripping their productive capacity. So they will raise prices. These widespread
price increases create demand-pull in ation, which arises when demand exceeds the economy’s
productive capacity, pulling prices up.
In ationary Force 3: Supply Shocks and Cost-Push In ation
Cost-push in ation occurs when prices rise in response to an unexpected rise in production costs, the
typical consequence of a supply shock.
Understanding In ation
Put all the pieces together, and we’ve sketched out the three causes of in ation:
In ation = Expected in ation + Demand-pull in ation + Cost-pull in ation
INFL ATION EXPECTATIONS
Learning Objective: Explore how in ation expectations lead to in ation.
Data can tell you what’s happened in the past, but we need to know what’s going to happen in the
future. That’s why expectations matter.
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Why In ation Expectations Matter
Your in ation expectations describe the rate at which you expect prices to rise, on average, across
the whole economy over the next year.
Set your prices to take account of in ation expectations.
Two key factors drive most pricing decisions:
● Your marginal costs: If you want to maintain your pro t margin, you’ll have to charge higher prices
to make up for the higher marginal costs you expect to pay.
● Your competitors’ prices: Raising your prices by the same percentage that you expect your
competitors to raise their prices will maintain your competitive positioning.
Both factors suggest that — at least as a starting point — you should raise next year’s prices in line
with your in ation expectations. This logic gives a powerful role to expectations, suggesting that you
should raise your prices for next year because you expect other businesses — both your suppliers
and competitors — to raise their prices.
In ation expectations create in ation.
There are millions of managers across the country making similar calculations, and in each case,
their in ation expectations are central to how they set next year’s prices. In other words, they raise
prices and create in ation because they expect in ation.
We’ve isolated the rst major cause of in ation: in ation expectations. Higher in ation expectations
create higher in ation.
In ation expectations create a self-ful lling prophecy.
Whatever rate of in ation managers expect, they’ll end up raising their prices by that amount. It’s a
self-ful lling prophecy: The widespread expectation of any particular in ation rate is enough to push
suppliers to raise their prices so that they’ll create that in ation. This means that any in ation rate can
become a long-run equilibrium because the rate people expect feeds through and determines the
price rises that suppliers set.
Monetary policy tries to shape in ation expectations.
In the long run, the key to achieving persistently low in ation is to convince people that in ation is
going to be low. Once you get them to believe it, it will turn out to be true. The challenge is that
in ation can occur because of demand or supply factors, and potentially shape expectations about
future in ation.
Measuring In ation Expectations
There are three ways to track in ation expectations over time.
Surveys ask people about their in ation expectations.
The simplest way to nd out average in ation expectations is to survey a representative group of
people.
In ation forecasts reveal the in ation expectations of economists.
Another indicator of in ation expectations relies on the in ation forecasts that professional
economists publish.
Financial markets bet on the future path of in ation.
The Federal Reserve publishes a 10-year break-even rate, which tells you how much you need to
earn in interest to be able to buy the same amount of stuff in 10 years with your savings. It’s an
informative measure because it summarized the collective wisdom of many sophisticated nancial
traders.
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In ation expectations can be adaptive, anchored, rational, or sticky.
What determines people’s in ation expectations? Economists focus on four different ways people
might form their expectations:
● Adaptive expectations: Expect recent levels of in ation to continue.
● Anchored expectations: Believe that the Federal Reserve will deliver on its promise to ensure that
in ation will be around 2%.
● Rational expectations: Use all available data and a deep understanding of macroeconomic
relationships to come up with a forecast.
● Sticky expectations: Rarely revisit their views about in ation.
THE PHILLIPS CURVE
Learning Objective: Analyze the link between the output gap and in ation.
Excess demand occurs when suppliers face a quantity demanded at the prevailing price that exceeds
the quantity supplied. In the long run, if business continues to boom, it’s worth increasing capacity, but
in the short run, you’re stuck with your existing capacity. In this situation, what can businesses do?
Demand-Pull In ation
When demand for your product exceeds your capacity, it’s time to think about raising your prices.
Excess demand leads in ation to rise above in ation expectations.
Businesses respond to excess demand by raising their prices by a bit more than the level of expected
in ation. The result is demand-pull in ation, which occurs when excess demand pulls in ation up, so
that it rises above expected in ation.
Insuf cient demand leads in ation to fall below in ation expectations.
Demand-pull in ation can also pull in ation below in ation expectations when demand is
unexpectedly weak. Insuf cient demand occurs when the quantity demanded at the prevailing market
price is below what is supplied.
When the economy is operating at full capacity, in ation equals in ation expectations.
Demand-pull in ation is a separate force that operates in addition to in ation expectations. When
there’s excess demand, it pulls in ation to rise above in ation expectations, and when there’s
insuf cient demand, it pulls in ation to fall below in ation expectations.
When there’s no demand-pull in ation, there’s no pressure for prices to rise faster or slower than
expected. Therefore, when the economy is operating at full capacity, in ation is equal to in ation
expectations.
The output gap measures the imbalance between output and productive capacity.
Demand-pull in ation is driven by the output gap, which measures actual output relative to potential
output.
The Phillips Curve Framework
Observation 1: Demand-pull in ation is driven by the output gap.
The more positive the output gap is, the greater the degree of excess demand, and hence the greater
the pressure to raise prices. The more negative the output gap is, the greater the degree of
insuf cient demand, and hence the greater the pressure for price restraint.
Observation 2: Demand-pull in ation leads in ation to diverge from in ation expectations.
Unexpected in ation is the difference between in ation and in ation expectations:
Unexpected in ation = In ation − In ation expectations
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The Phillips curve describes how the output gap is linked to unexpected in ation.
We’ve isolated the second major cause of in ation: demand-pull in ation. The output gap drives
in ation to rise above or fall below in ation expectations.
Demand-pull in ation creates a link between the output gap and unexpected in ation. The Phillips
curve is the curve illustrating this link between the output gap and unexpected in ation. It is named
after Bill Phillips, who rst discovered it.
Unexpected in ation goes on the vertical axis, and the output gap goes on the horizontal axis.
Make sure you put the output gap (which is about quantities) on the horizontal axis and unexpected
in ation (which is about prices) on the vertical axis. Both the output gap and unexpected in ation can
be either positive or negative, so it’s usually a good idea to extend both axes into negative territory.
The Phillips curve is upward-sloping.
The Phillips curve is upward-sloping because higher output relative to potential output leads to
greater in ationary pressure, causing in ation to rise above in ation expectations.
When output is equal to potential output, then in ation is equal to expected in ation.
The Phillips curve passes through the origin, which is the point at which the output gap is zero and
unexpected in ation is zero. So when actual output is equal to potential output, actual in ation is
equal to expected in ation.
The Phillips curve predicts how far in ation will diverge from expected in ation.
The Phillips curve is all about unexpected in ation. When it says that unexpected in ation will be
negative, this simply means that actual in ation will be less than expected in ation. And positive rates
of unexpected in ation tell you that actual in ation will be greater than expected in ation.
The Phillips Curve in the United States
Discover the Phillips curve for the United States.
To construct our measure of unexpected in ation, we need to collect data on both the actual in ation
rate each year and expected in ation.
The Phillips curve is an imprecise relationship. The data reveal that the Phillips curve prediction isn’t
always right. Even so, it remains an important tool because accounting for the output gap leads to
more accurate in ation forecasts. The fact that the data do not lie exactly along this Phillips curve
suggests that other factors also play a role.
Use the Phillips curve to forecast future in ation.
Economists forecast in ation by using estimates of the Phillips curve. It’s a two-step process:
● Step 1: Assess in ation expectations. You can measure in ation expectations by analyzing
surveys of in ation expectations, surveys of economists, or nancial market-based measures.
● Step 2: Forecast unexpected in ation. Start with your estimate of what the output gap will be, look
up to the corresponding point on the Phillips curve, and then look across to nd your forecast
for unexpected in ation.
Your in ation forecast should be the sum of your forecasts for expected in ation and unexpected
in ation.
An Alternative Illustration: The Labor Market Phillips Curve
The labor market Phillips curve links unexpected in ation to the unemployment rate.
Unemployed workers are an unused resource, so the unemployment rate provides an alternative
measure of whether the economy is producing above or below its productive capacity. This alternative
version of the Phillips curve links low unemployment to higher demand-pull in ation.
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Both versions of the Phillips curve tell the same story.
The labor market Phillips curve is a Phillips curve that links unexpected in ation to the unemployment
rate. It summarizes the exact same ideas as the Phillips curve, but it relies on a different measure of
excess demand. It arises only because excess demand corresponds with a high level of output
relative to potential output and a low unemployment rate.
In ation is stable at the equilibrium unemployment rate.
The in ation rate will be stable only when in ation is equal to in ation expectations, and this occurs at
the point where unexpected in ation is 0%. The corresponding unemployment rate is called the
equilibrium unemployment rate. When unemployment is lower than the equilibrium unemployment
rate, in ation starts to creep up.
Demand-pull in ation is driven by too much demand.
Excess demand creates demand-pull in ation, which causes in ation to rise above in ation
expectations.
S U P P LY S H O C K S S H I F T T H E P H I L L I P S C U R V E
Learning Objective: Assess how shocks to production costs shift the Phillips curve.
How Supply Shocks Shift the Phillips Curve
Cost-push in ation happens when an unexpected boost to production costs pushed sellers to raise
their prices.
Rising production costs shift the Phillips curve up.
Any factor that leads to an unexpected rise in production costs will cause the Phillips curve to shift
upward.
We’ve isolated the second major cause of in ation: cost-push in ation. An unexpected rise in
production costs will cause higher in ation.
Three types of supply shocks shift the Philips Curve.
A supply shock is an unexpected change in production costs that shifts the Phillips curve. There are
three key types of supply shocks that might shift the Phillips curve: shifts in input prices, shifts in
productivity, and shifts in exchange rates.
Phillips Curve Shifter 1: Input Prices
Rising input prices lead to rising prices for output, and because this boosts in ation at any given level
of the output gap, it shifts the Phillips curve up.
Oil and commodity prices are important input prices.
Oil is a major input in many sectors of the economy, and so the changing price of oil has frequently
been an important source of cost-push in ation. A rise in the price of oil has ripple effects throughout
the economy.
Other commodity prices — including agricultural goods, in particular — can create supply shocks,
especially when severe weather disrupts harvests.
Rising wages can cause a wage-price spiral.
A sharp rise in the wages you have to pay to attract quality workers will raise your company’s
marginal costs, causing many managers to raise their prices. Higher wages will quickly generate costpush in ation.
Wages are particularly important because they can amplify the effects of a temporary in ation shock
and make it persistent. This is because a wage-price spiral can take hold, in which workers respond
to in ation by demanding higher nominal wages to maintain their spending power, leading businesses
to respond to higher wages by raising prices.
An initial in ationary impulse can cause workers to seek higher nominal wages. The result is higher
in ation that persists long after the initial in ationary impetus has receded.
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Phillips Curve Shifter 2: Productivity
Your company’s productivity also changes your production costs because a more productive rm
needs less of each input to produce the same output. As a result, stronger productivity growth shifts
the Phillips curve down — a form of negative cost-push in ation.
Phillips Curve Shifter 3: Exchange Rates
The nominal exchange rate also creates cost-push in ation.
Direct effect: When the U.S. dollar depreciates, foreign goods are more expensive.
When the U.S. dollar depreciates, then each U.S. dollar buys less foreign currency. In turn, that
means it will take more U.S. dollars to pay for imported goods. And so a depreciating U.S. dollar
directly increases the price of foreign-made goods, boosting in ation.
Indirect effects: More expensive foreign goods lead to higher prices on domestic goods.
There are also indirect effects that lead American producers to raise their prices:
● For businesses that rely on imported inputs: A depreciating U.S. dollar raises the cost (in dollars)
of their imported inputs, and these higher marginal costs lead them to raise their prices.
● For businesses that compete with imported products: A depreciating U.S. dollar raises the price (in
dollars) of goods made by foreign competitors. This weakens competitive pressure on
domestic businesses, leading some of them to raise their prices.
● For businesses that export their products: A depreciating U.S. dollar means that their foreign
customers are now willing to pay more (in dollars) for their products. This increased pressure
from foreign customers may lead some companies to raise the prices they charge their
American customers.
A depreciating U.S. dollar shifts the Phillips curve up; an appreciating U.S. dollar shifts the Phillips
curve down.
A depreciating U.S. dollar boosts in ation at any level of the output gap, thereby shifting the Phillips
curve up.
Shifts versus Movements Along the Phillips Curve
Demand-pull in ation leads to movement along the Phillips curve.
The Phillips curve illustrates the impact of demand-pull factors, showing how in ation changes in
response to the output gap. Thus, booms and busts represent movements along the Phillips curve.
Cost-push in ation leads to a shift in the Phillips curve.
Any other factor that changes producers’ pricing decisions for a given output gap leads to a shift in
the Phillips curve.
The Phillips curve is about short-run trade-offs, while in ation expectations remain relevant in the long
run.
In ation expectations neither shift the Phillips curve nor cause a movement along it. The Phillips
curve focuses on the short run in which in ation deviates from in ation expectations, thus explaining
unexpected in ation. By contrast, rising in ation expectations lead to a rise in expected in ation.
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Is it a demand shock or a supply shock?
Supply shocks can lead to higher in ation, even when output has declined. Demand-pull in ation
always leads the output gap and unexpected in ation to move in the same direction. If in ation rises
in line with measures of in ation expectations, then you can infer that in ation expectations have
shifted.
ONE PAGE SUMMARY
Chapter objective: Put the pieces together into a complete model of
business cycles.
1. The Fed Model: Analyze the Fed model, which puts together the IS curve, the MP curve, and
the Phillips curve.
2. Analyzing Macroeconomic Shocks: Use the Fed model to analyze the consequences of
nancial shocks, spending shocks, and supply shocks.
3. Diagnosing the Causes of Macroeconomic Changes: Use the Fed model to diagnose the
causes of economic uctuations.
THE FED MODEL
Learning Objective: Analyze the Fed model, which puts together the IS curve, the
MP curve, and the Phillips curve.
The Fed model is the framework that uses the IS curve, the MP curve, and the Phillips curve to link
interest rates, the output gap, and in ation. It is the framework that policymakers at the Federal
Reserve use to analyze, forecast, and tweak the economy. They use it because it represents the state
of the art for understanding business cycles.
The Fed Model Combines the IS, MP, and Phillips Curves
The Fed model isn’t a distinct mode of analysis. Rather, it puts together the pieces you’ve already
developed. That’s why it’s sometimes also called IS-MP-PC analysis because it combines IS-MP
analysis with the Phillips curve.
Forecasting Economic Outcomes
Start by nding the output gap.
Begin your analysis with the IS-MP framework, which determines the output gap. The MP curve is a
horizontal line illustrating the current real interest rate, and the IS curve is a downward-sloping line
illustrating how a lower real interest rate stimulates more spending and output. The macroeconomic
equilibrium occurs where the MP curve cuts the IS curve. You can look down from the point where the
curves cross to nd the resulting output gap.
Next, assess in ation.
Use the Phillips curve to gure out the in ationary implications of this output gap. Once you’ve found
the Phillips curve, you need to look across to nd out what will happen to in ation. So to forecast
actual in ation, you’ll add this forecast of unexpected in ation to the latest reading of in ation
expectations.
You can see why Fed economists like this style of analysis. It delivers a complete set of forecasts:
real interest rate, the output gap, unexpected in ation, and in ation.
Three Types of Macroeconomic Shocks
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There are nancial shocks, spending shocks, and supply shocks.
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THE FED MODEL: LINKING INTEREST
RATES, OUTPUT, AND INFL ATION
The beauty of the Fed model is that it brings together three curves, which are shifted by the three
kinds of shocks. So to forecast the consequences of whatever might happen next to the economy,
you need to gure out if you’re dealing with a nancial shock, a spending shock, or a supply shock.
A N A LY Z I N G M A C R O E C O N O M I C S H O C K S
Learning Objective: Use the Fed model to analyze the consequences of nancial
shocks, spending shocks, and supply shocks.
One of the most important uses of a macroeconomic framework like the Fed model is to forecast how
the economy will respond if a macroeconomic shock knocks it off its current path.
A Three-Step Recipe for Analyzing Macroeconomic Shocks
Step 1: Identify the shock to determine which curve to shift in which direction.
The rst thing you need to do is to identify the shock, so you can shift the relevant curve in the
appropriate direction.
Step 2: Find the output gap.
Look at the intersection of the (new) IS and MP curves to nd the equilibrium output gap and real
interest rate.
Step 3: Assess in ation.
Finally, trace the output gap down from the IS-MP graph to the (potentially shifted) Phillips curve to
nd the in ationary implications of this output gap. Then add this forecast of unexpected in ation to
the latest reading of in ation expectations.
Analyzing Financial Shocks
A nancial shock occurs whenever borrowing conditions change the real interest rate at which you
can borrow money, thereby shifting the MP curve.
The MP curve shifts in response to monetary policy and nancial market risks.
The MP curve shifts in response to changes in the following:
● Monetary policy: When the Federal Reserve raises or lowers the risk-free real interest rate, the
rate borrowers pay also changes, shifting the MP curve.
● Financial market risks: Any change that makes banks more reluctant to lend money at a given
interest rate will raise the risk premium, raise the interest rate that borrowers pay, and shift the
MP curve.
Higher interest rates lead to lower output and lower in ation.
Use the three-step recipe to gure out the consequences of an adverse nancial shock that raises the
real interest rate:
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● Step 1: Shift the curve. Higher real interest rates shift the MP curve up.
● Step 2: Find the output gap. The new equilibrium occurs where this new MP curve cuts the IS
curve. In this example, this occurs when output shrinks below potential output.
● Step 3: Assess in ation. Trace this output gap down onto the Phillips curve to assess the
in ationary consequences. The output gap will cause unexpected in ation to decline. Thus, if
expected in ation is unchanged, actual in ation will fall.
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● Financial shocks: Any change in borrowing conditions that affects the real interest rate will shift the
MP curve.
● Spending shocks: Any change in aggregate expenditure at a given real interest rate and level of
income will shift the IS curve.
● Supply shocks: Any change in production costs that leads suppliers to change the prices they
charge at any given level of output will shift the Phillips curve.
We conclude that a nancial shock that leads to higher real interest rates will also lead to lower output
and lower in ation.
Analyzing Spending Shocks
Spending shocks occur whenever there’s been a change in spending at a given real interest rate and
level of income.
The IS curve shifts in response to changes in aggregate expenditure.
IS curve will shift in response to changes in the following:
● Consumption, which may be driven by changes in wealth, consumer con dence, government
assistance, taxes, or inequality;
● Planned investment, which changes in response to changes in future economic growth, business
con dence, investment tax credits, corporate taxes, lending standards, cash reserves, or
uncertainty;
● Government spending, which re ects the government’s scal policy, and the operation of
automatic stabilizers; and
● Net exports, which are driven by economic growth among our trading partners, trade policy, and
exchange rates.
The IS curve shifts by the change in spending times the multiplier.
A spending shock will set off a chain reaction that will lead aggregate expenditure to decline by the
spending times the multiplier. As a result, the IS curve shifts to the left by that amount.
Decreased aggregate expenditure leads to lower output and lower in ation.
Work through the three-step recipe:
● Step 1: Shift the curve. We’ve established that a reduction in aggregate expenditure will shift the
IS curve to the left.
● Step 2: Find the output gap. Analyze where this new IS curve crosses the MP curve. In this
example, this occurs when output shrinks below potential output.
● Step 3: Assess in ation. Trace this output gap down onto the Phillips curve to assess the
in ationary consequences. In this case, the output gap will cause unexpected in ation to
decline. Thus, actual in ation will fall.
A negative spending shock will result in lower output, lower in ation, and no effect on the real interest
rate.
Analyzing Supply Shocks
Supply shocks occur whenever there’s an unexpected change in sellers’ production costs that will
lead to price changes at a given output gap.
The Phillips curve shifts in response to changes in production costs.
Production costs shift in response to the following:
● Input prices: When the price of important inputs rises, so will production costs, shifting the Phillips
curve up.
● Import prices: Higher import prices both directly feed through into higher prices for American
consumers and also affect the price of imported inputs available to domestic producers.
● Productivity: Faster productivity growth leads to more rapid declines in production costs, shifting
the Phillips curve down.
● Exchange rates: A depreciating U.S. dollar leads imported inputs to become more expensive and
makes foreign competitors less competitive, both of which lead domestic prices to rise, shifting
the Phillips curve up.
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Increased production costs lead to higher in ation and no change in output.
Work through the three-step recipe:
A supply shock leads to higher in ation with no effect on the real interest rate or the output gap.
A caveat: A supply shock can cause output to decline.
In addition to their effect on in ation, supply shocks can disrupt both actual output and potential
output. These effects are important but are not captured by the model.
A supply shock can cause higher in ation and also short-run stagnation as output declines. This
combination of economic stagnation and high in ation is called stag ation.
DIAGNOSING THE CAUSES OF MACROECONOMIC
CHANGES
Learning Objective: Use the Fed model to diagnose the causes of economic
uctuations.
A Diagnosis Tool
Financial, spending, and supply shocks each leave behind a different pattern of footprints. We can
use these differences to diagnose the cause of any recent macroeconomic change. In particular,
notice the following:
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1. If the real interest rate changes, that’s evidence that the economy has been hit by a nancial
shock.
2. If the output gap has shifted without much movement in the real interest rate, it suggests that
there’s been a spending shock.
3. If in ation rises in a weak economy or if it falls in a strong economy, that points to a supply
shock as the cause.
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● Step 1: Shift the curve. We’ve established that higher production costs will shift the Phillips curve
upward.
● Step 2: Find the output gap. Because a supply shock shifts neither of the IS and MP curves, the
output gap remains unchanged.
● Step 3: Assess in ation. Trace this output gap down to the new Phillips curve to assess the
in ationary consequences. In this case, the unchanged output gap corresponds with higher
unexpected in ation. Thus, actual in ation will rise.
ONE PAGE SUMMARY
AGGREGATE DEMAND AND
A G G R E G A T E S U P P LY
Chapter objective: Analyze how aggregate demand and aggregate
supply determine macroeconomic outcomes.
1. The AD-AS Framework: Understand how aggregate demand and aggregate supply determine
macroeconomic equilibrium.
2. Aggregate Demand: Assess the total quantity of goods and services that purchasers want to
buy.
3. Aggregate Supply: Evaluate the total quantity of goods and services that businesses want to
supply.
4. Macroeconomic Shocks and Countercyclical Policy: Forecast how the economy will
respond to changing conditions.
5. Aggregate Supply in the Short Run and the Long Run: Distinguish between the immediate
effects, short-run effects, medium-run effects, and long-run consequences of economic shocks.
6.
THE AD- AS FRAMEWORK
Learning Objective: Understand how aggregate demand and aggregate supply
determine macroeconomic equilibrium.
Introducing Aggregate Demand and Aggregate Supply
Aggregate demand and aggregate supply describe the forces that determine aggregate outcomes
such as total output and average prices across the economy as a whole.
Use the AD-AS framework to forecast output and the average price level.
The AD-AS framework focuses on two key macroeconomic outcomes:
● The quantity of output produced across the economy as a whole, which is measured by real GDP;
and
● The price of that output, which is measured by the GDP de ator.
This framework isn’t about explaining the price and quantity of any individual good but rather explains
what’s happening to total output and average prices across the economy as a whole.
The aggregate demand curve is downward-sloping.
The aggregate demand curve shows the relationship between the price level and the total quantity of
output that buyers collectively plan to purchase.
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The aggregate supply curve is upward-sloping.
The aggregate supply curve shows the relationship between the price level and the total quantity of
output that suppliers collectively produce.
Macroeconomic equilibrium occurs where the curves cross.
The macroeconomic equilibrium occurs when the quantity of output that buyers collectively want to
purchase is equal to the quantity of output that suppliers collectively produce.
Macroeconomic versus Microeconomic Forces
The AD-AS framework looks a lot like the microeconomic supply-equals-demand framework.
In macro, as in micro, equilibrium occurs where the curves cross. And when market conditions
change, you’ll forecast what will happen next by shifting the curves and nding the new equilibrium.
But the AD-AS framework summarizes a different set of macroeconomic forces.
In a microeconomic context, the key opportunity cost of buying gasoline is that you could otherwise
spend your money on something else. But in a macroeconomic context, we’re focused on spending
on all goods and services rather than substitution between goods. As a result, the relevant
opportunity cost of buying output today is that you can’t save that money to buy more output in the
future. In micro, the key trade-offs are across products, whereas in macro, the key trade-offs are
across time.
AGGREGATE DEMAND
Learning Objective: Assess the total quantity of goods and services that purchasers
want to buy.
Aggregate Expenditure
Aggregate expenditure refers to the total amount of goods and services that people want to buy
across the whole economy. Aggregate expenditure is the sum of four components:
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Consumption: When households buy goods and services
Planned investment: When businesses purchase new capital
Government purchases: When the government buys goods and services
Net exports: Spending by foreigners on American-made exports, less spending by Americans on
foreign-made imports
Why Aggregate Demand Is Downward-Sloping
The real interest rate shapes aggregate expenditure and hence aggregate demand. The Fed sets that
interest rate based at least partly on what’s happening to the price level. As such, the Fed is a central
player in shaping the relationship between the price level and aggregate expenditure, and hence, the
aggregate demand curve.
A higher price level leads to a higher in ation rate.
In ation is the rate of change of the price level, so given last year’s prices, the higher the price level
this year, the higher the in ation rate.
Higher in ation leads the Fed to raise the real interest rate.
The Federal Reserve tries to keep the in ation rate stable at its target level. When the in ation rate is
either too high or too low, the Federal Reserve will adjust the real interest rate to bring in ation back
toward its target level. The Fed responds to higher in ation by raising the real interest rate.
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A higher real interest rate leads to lower aggregate expenditure.
Therefore, higher real interest rates reduce aggregate expenditure and hence the aggregate demand
for output.
The aggregate demand curve is downward-sloping because a higher price level leads to less
aggregate demand.
Put the links together, and you’ve explained why the aggregate demand curve is downward-sloping:
The higher this year’s average price level, the higher the in ation rate. The Fed responds to in ation
by raising the real interest rate, and this higher interest rate leads to lower levels of spending and
hence less aggregate demand. Because the Fed plays an important role in this process, this is
sometimes called the Fed channel.
The Fed channel operated differently in the past.
Earlier economists described the Fed channel somewhat differently, calling it instead an interest rate
effect. This is because, in the 1970s, the Fed didn’t set interest rates directly. Instead, it focused on
hitting pre-announced targets for the nominal money supply.
A decrease in the real money supply has the effect of pushing the real interest rate up, which in turn
reduces output. This is the underlying insight of the interest rate effect. The only difference is that
today, the Fed sets the interest rate directly rather than setting the nominal money supply and
passively allowing the interest rate to respond.
There are other economic forces that also lead the aggregate demand curve to be downward-sloping.
In addition to the Fed channel, there’s an international trade effect, in which a higher price level in the
United States leads American-made products to become more expensive relative to foreign goods.
This reduces net exports and hence aggregate expenditure. Because net exports is a small
component of aggregate expenditure, this effect tends to be small.
There’s also a wealth effect, in which a higher price level reduces real wealth by reducing the
purchasing power of assets whose values are xed in nominal dollars. Lower real wealth leads
people to spend less. This effect is likely small.
Analyzing Aggregate Demand
The aggregate demand curve is useful because you can use it to forecast the consequences of
changing market conditions.
Changes in the price level lead to movements along the aggregate demand curve.
The aggregate demand curve illustrates how different price levels lead to differences in the quantity of
output demanded. It’s useful because when the price level changes, you can consult this curve to
gure out the new quantity of output demanded.
Other Changes in spending shift the aggregate demand curve.
Any other factor other than a change in the price level that causes consumers, investors, the
government, or foreigners to change their spending plans causes the aggregate demand curve to
shift.
Higher spending increases aggregate demand, shifting the curve to the right.
An increase in aggregate demand causes the economy to move to a new equilibrium output and
higher price level. An increase in aggregate demand leads to a period of rising output.
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Lower spending decreases aggregate demand, shifting the curve to the left.
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A higher real interest rate means that fewer investment projects will be pro table enough to offset the
opportunity cost of keeping your money in the bank to earn interest. A higher real interest rate also
reduces consumption partly because it raises the cost of borrowing to fund big-ticket items like a car.
It can also cause net exports to decline through an exchange rate effect, in which in ows of foreign
savings cause the U.S. dollar to appreciate, making American exports more expensive for foreigners.
A decrease in aggregate demand causes the economy to move to a new equilibrium output and lower
price level. A decrease in aggregate demand leads to recession.
Aggregate Demand Shifters
Demand shifter 1: Consumption increases when people feel more prosperous.
Any development that makes people feel more prosperous leads to an increase in consumption,
thereby increasing aggregate demand. This means that aggregate demand will shift in response to
the following:
● Wealth: As stockholders and homeowners spend some of their newfound wealth, consumption will
increase.
● Consumer con dence: When you feel con dent that your income will grow in the future, you might
increase your spending in advance.
● Taxes and government assistance: When the government cuts taxes or when it increases
government assistance payments, people have more disposable income that they can use to
buy stuff.
● Inequality: People with low incomes tend to spend a larger share of their income than do those
with higher incomes. It follows that redistributing income from those with higher incomes to
those with lower incomes tends to increase consumption.
Demand shifter 2: Investment increases when it’s pro table for businesses to expand.
As a manager, you’ll invest in new machinery when you believe that it will be pro table to expand
your production. As a result, aggregate demand will shift when investment changes in response to the
following:
● An expanding economy: When the economy is expanding, so is the demand for goods and
services. In order to produce more, managers will need to expand their production capacity,
and entrepreneurs will see an opportunity to start new businesses.
● Business con dence: Because capital investments tend to last for years or even decades, your
assessments about whether to buy new equipment should depend not only on today’s pro ts
but also on your expectations about future pro tability.
● Corporate taxes: Lower corporate taxes increase the after-tax pro ts that entrepreneurs earn from
investing in new equipment. As a result, investment increases in response to a cut in
corporate tax rates or to targeted investment tax credits.
● Lending standards and cash reserves: If your business nds it hard to borrow money at a
reasonable interest rate, you can only invest if your company has the cash on hand to do so. It
follows that investment tends to increase when loans are easier to get or businesses have
large cash reserves.
● Uncertainty: If you’re uncertain about the economic outlook, you usually have the option to
postpone investment projects until the outlook is a bit clearer. Lower uncertainty leads
managers to restart these shelved projects.
Demand shifter 3: Government purchases increase when policymakers decide to spend more on
goods and services.
In some cases, spending bills have the explicit goal of stimulating an increase in aggregate demand.
In addition, some government programs — known as automatic stabilizers — automatically increase
spending when the economy is weak. Remember that government spending directly increases
aggregate expenditure — and hence shifts the aggregate demand curve — only when the
government purchases goods and services.
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Demand shifter 4: Net exports increase due to global factors.
Net exports rise when people in other countries want to buy a lot of American-made goods and
services. Aggregate demand will shift when net exports rise or fall in response to the following:
● Global economic growth: When the economies of Europe, Japan, and China do well, their
consumers and businesses have more money to spend, so they buy more goods, including
more American-made goods, leading net exports to increase.
● The exchange rate: When the U.S. dollar becomes cheaper, our goods become cheaper to foreign
buyers, leading exports to rise. A cheaper U.S. dollar also means that foreign goods become
more expensive (in dollars) for American buyers, leading imports to fall. Both forces cause net
exports to increase.
● Trade barriers: Exports increase when there are fewer barriers preventing American businesses
from selling their goods in other countries, and imports increase when there are fewer barriers
preventing foreign businesses from selling to buyers in the United States. Because trade
agreements typically reduce barriers to both imports and exports, their effect on net exports is
unclear.
Anything that shifts any component of aggregate expenditure shifts the aggregate demand curve.
The aggregate demand curve shifts in response to an increase in any component of aggregate
expenditure.
A G G R E G A T E S U P P LY
Learning Objective: Evaluate the total quantity of goods and services that
businesses want to supply.
The aggregate supply curve describes the production and pricing decisions that suppliers make and
the ways they respond as macroeconomic conditions change.
Why Aggregate Supply Is Upward-Sloping
Higher output leads to higher prices.
A strong economy can lead to excess demand given companies' limited capacity. In the long run, if
businesses continue to boom, it’s worth expanding capacity. In the short run, such expansion is not
possible, so businesses tend to raise prices. The result is that in periods of high GDP, the average
price level will be a bit higher than it would otherwise be.
Lower output leads to lower prices.
When GDP is low, businesses face insuf cient demand. Consumers lack the extra income to spend
or are reluctant to spend what they do have. Because businesses are producing below capacity, their
marginal costs are lower than the case at full capacity. They’ll respond to insuf cient demand with
lower prices. The result is that in periods of low GDP, the average price level across the whole
economy will tend to be a bit lower than it would otherwise be.
The aggregate supply curve is upward-sloping because higher output leads to a higher price level.
Lower output levels are associated with a lower average price level, and higher output levels are
associated with a higher average price level. So the aggregate supply curve is upward-sloping.
Analyzing Aggregate Supply
The aggregate supply curve is helpful to forecast how economic conditions will change.
Changes in the price level lead to movements along the aggregate supply curve.
You can use the aggregate supply curve to assess how the price level will respond to changes in
output (or equivalently, you can use it to assess how output will respond to changes in the price level).
Changes in production costs shift the aggregate supply curve.
Changing production costs cause suppliers to change the prices they’ll charge at any given level of
output, thereby causing the aggregate supply curve to shift.
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Lower production costs lead businesses to charge lower prices.
Lower production costs lead to an increase in aggregate supply (shift right). This increase arises
because lower production costs boost the pro tability of producing stuff, leading suppliers to increase
the quantity of output they’ll produce at any given price level. So an increase in aggregate supply
leads to both higher GDP and a lower price level; it causes an economic expansion accompanied by
de ation.
Higher production costs lead businesses to charge higher prices.
Higher production costs lead to a decrease in aggregate supply. Any factor that increases production
costs will shift the aggregate supply curve up or to the left, leading to a new equilibrium with lower
output and a higher price level.
A hint: It might be simpler to describe production costs as shifting the aggregate supply curve up or
down.
While we usually describe curves shifting left or right, it’s just as accurate to describe them as shifting
up or down.
Shifts in Aggregate Supply
There are four key factors that shift production costs and hence the aggregate supply curve: shifts in
input prices, import prices, productivity, and the exchange rate.
Supply shifter 1: Higher input prices raise production costs.
Any time the price of your inputs rises, so will your marginal costs, and higher marginal costs lead
sellers to raise their prices, shifting the aggregate supply curve upward (or, equivalently, to the left).
Supply shifter 2: Higher import prices re ect international shocks.
When American consumers pay higher prices for imported cars, clothes, or computers, these higher
import prices directly raise the average price level in the United States, shifting the aggregate supply
upward. This means that higher import prices shift the aggregate supply curve upward (or to the left),
while lower import prices shift the curve downward (or to the right).
Supply shifter 3: Weaker productivity raises production costs.
Productivity refers to the quantity of output a business produces per unit of input. Higher productivity
means doing more, with less. Conversely, when businesses are relatively unproductive, they have to
buy more inputs to produce the same output, and so their production costs are higher.
Supply shifter 4: A depreciating U.S. dollar raises production costs and reduces competition from
abroad.
Changes in the nominal exchange rate also shift pricing decisions and hence aggregate supply.
This really matters for businesses that rely on imported inputs because a depreciating U.S. dollar
raises the cost of their imported inputs.
Consequently, a depreciation in the U.S. dollar leads suppliers to set higher prices at any level of
output, shifting the aggregate supply curve upward (or to the left). By contrast, an appreciation of the
dollar leads suppliers to set lower prices at any level of output, shifting the curve downward (or to the
right).
Anything that shifts production costs shifts the AS curve.
The aggregate supply curve shifts in response to changes in production costs.
M AC RO E C O N O M I C S H O C K S A N D C O U N T E RC YC L I C A L
POLICY
Learning Objective: Forecast how the economy will respond to changing conditions.
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Monetary Policy
● An in ation-induced response: When the Fed is worried that in ation is too low, it responds by
cutting the real interest rate. We call this an in ation-induced response.
● An output-induced response: The Fed may keep interest rates lower in an effort to combat a
decline in output. We call this an output-induced response.
An in ation-induced change in interest rates does not shift the aggregate demand curve.
An in ation-induced response by the Fed is caused by a change in the price level. A change in the
price level leads to a movement along the aggregate demand curve but not a shift.
Any other change in the real interest rate shifts the aggregate demand curve.
Any change in the real interest rate — other than the Fed’s systematic in ation-induced response to
changes in the price level — will change the amount of aggregate expenditure at a given price level,
thereby shifting the aggregate demand curve.
Lower real interest rates are expansionary.
The Fed is said to be pursuing an expansionary monetary policy when it reduces the real interest rate
lower than would be expected given its usual response to in ation. An expansionary monetary policy
leads to an increase in aggregate demand. It shifts the aggregate demand curve to the right, leading
to a new equilibrium with a higher level of output and higher prices.
Higher real interest rates are contractionary.
If the Fed sets a higher interest rate than would be expected given its usual response to in ation, it
would be described as pursuing a contractionary monetary policy. Contractionary monetary policy
leads to less spending at any given price level. This shifts the aggregate demand curve to the left,
leading to a lower level of output and prices.
Fiscal Policy and the Multiplier
The government can also in uence the economy by adjusting its own spending and tax policies —
that is, through scal policy.
An increase in spending has a multiplied effect on aggregate expenditure.
An initial burst of spending will have repercussions throughout the economy. It means that extra
spending by the government stimulates extra spending by workers, which stimulates extra spending
in the tness, food, and child care industries. As the initial burst of government purchases ripples
through the economy, it has a multiplier effect, leading to an even larger boost to aggregate
expenditure.
A burst of government spending will crowd out some private spending.
As spending boosts the demand for output, some businesses will run into capacity constraints. As a
result, they’ll raise their prices, and the resulting boost to in ation might lead the Fed to raise the real
interest rate. These higher interest rates reduce private-sector spending. Thus, a burst of government
spending might end up crowding out some private spending. The overall effect on the economy
depends on how much of the multiplier effect is dampened by crowding out.
The multiplier summarizes the effect of an initial burst of spending on output.
The multiplier measures how much GDP changes as a result of both the direct and indirect effects
owing from each extra dollar of spending. The multiplier is useful because you can use it to forecast
the effects of changes in spending, as follows:
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– GDP = – Spending × Multiplier
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The Fed cuts interest rates in response to both low in ation and weak output.
This process of the Fed setting and adjusting interest rates in an effort to in uence economic
conditions is called monetary policy. There are two reasons that might cause Fed policymakers to cut
interest rates:
Forecasting Macroeconomic Outcomes
Apply the three-step recipe to forecast macroeconomic outcomes.
● Step 1: Is this a shift in aggregate demand or aggregate supply?
● Step 2: Is that shift an increase, shifting the curve to the right? Or is it a decrease, shifting the
curve to the left?
● Step 3: How will the price level and quantity of output change in the new equilibrium?
Forecast how the economy responds to macroeconomic shocks.
In ation will be lower when you forecast that the price level will be lower than it otherwise would be.
De ation is rare because in ation often has its own momentum, and so prices are often rising for
other reasons. Think of your forecast as suggesting that this year’s price level will be lower than it
otherwise would be. In other words, you’ll often be more accurate if you describe your forecast as
likely to lead to lower in ation rather than outright de ation.
Summarizing the effects of different macroeconomic shocks.
The AD-AS framework is useful because it means that forecasting the consequences of whichever of
the zillion things that might happen next to the economy doesn’t require a zillion different kinds of
analysis. Rather, you need to gure out if you’re dealing with an aggregate demand shock (such as
when consumers freak out), or an aggregate supply shock (like supply chain disruptions).
A G G R E G A T E S U P P LY I N T H E S H O R T R U N A N D T H E
LONG RUN
Learning Objective: Distinguish between the immediate effects, short-run effects,
medium-run effects, and long-run consequences of economic shocks.
Changes in aggregate demand often have a fairly immediate effect. But because businesses take a
while to change the prices they charge and the wages they pay, supply-side responses can take a
while to play out. This can really matter because when suppliers have yet to adjust their prices, they
often adjust the quantity of their output instead. Thus, the initial impact of a macroeconomic shock
may be quite different from the longer-term effect.
Aggregate Supply in the Long Run with Flexible Prices
Long-run analysis is relevant over time periods long enough for the adjustment process to be
complete — typically several years or longer. Over this time horizon, you can think of all prices as
responding exibly to changing conditions.
In the long run, a change in the average price level has no effect on real variables.
How will suppliers change the quantity of output they’ll produce at different average price levels? In
the long run, the answer is: not at all.
This re ects an idea called the classical dichotomy, and it informs us how economists think about the
long-run effects of changes in purely nominal variables, like the price level. It is a dichotomy because
we can analyze separately what’s happening in the real economy — like the quantity of output that
businesses produce — versus changes in purely nominal variables like the average price level. And
it’s classical because it comes from the classical economists whose insights best apply to the long
run.
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The long-run aggregate supply curve is vertical.
The vertical long-run aggregate supply curve illustrates the idea that over time, the economy will
return to producing its potential output — the level of output that’s produced when all resources are
fully employed. The economy gravitates toward its potential output because market prices adjust to
ensure that the demand for labor, capital, and raw materials will be equal to the supply.
Aggregate demand is irrelevant to long-run output.
In the long run, aggregate demand is irrelevant in determining output. This insight is the reason that
most economic analyses of the long-run determinants of output focus on supply-side factors such as
the quantities of capital, labor, and human capital that are available, and the technology that
producers use to combine them.
Aggregate Supply in the Very Short Run with Fixed Prices
Very short run describes a period of time so brief that no business has had a chance to change its
price. In the very short run, all prices are effectively xed, which means that the aggregate supply
curve must be horizontal.
The very-short-run aggregate supply curve is horizontal.
This very-short run aggregate supply curve illustrates the idea that in the immediate aftermath of an
economic shock, the only way that businesses can respond to changing conditions is to adjust the
quantity of output they produce. So changes in aggregate demand will — in the very short run — lead
to large changes in output.
The response of suppliers depends on the time horizon you’re analyzing.
Our analysis so far yields a stark contrast: Shifts in aggregate demand lead to large changes in
output in the very short run but no change in output in the long run. These ndings might sound
contradictory, but they’re not. These different responses over different time horizons arise because in
the very short run, prices don’t adjust at all, leaving the burden of adjustment to quantities; while in
the long run, prices fully adjust, leaving none of the burden of adjustment to quantities.
Aggregate Supply in the Short Run and Medium Run with Sticky Prices
The cost-bene t principle says that it’s worth adjusting your prices only if the bene ts of doing so
exceed these menu costs. This logic leads many businesses to have sticky prices, which adjust
sporadically. As a result prices respond only sluggishly to changes in market conditions.
Sticky prices explain why the short-run aggregate supply curve is upward-sloping.
Across the whole economy, some businesses are ready to change their prices now, and others will
decide not to change their prices for now. So when output is below potential, sporadic price cutting in
response to insuf cient demand leads to a somewhat lower average price level.
Similar dynamics apply to periods of excess demand, but in reverse: Faced with more customers than
they can serve, some suppliers will raise their prices, but others will not. So when output exceeds
potential, sporadic price rises in response to excess demand will lead to a somewhat higher price
level.
As a result of this partial but incomplete adjustment of prices, the short-run aggregate supply curve is
upward-sloping.
The aggregate supply curve is steeper in the medium run.
With time, managers are also more likely to think it’s worth paying the menu cost to change their
prices in response to insuf cient or excess demand that persists for a year or two rather than just a
few months. As a result, in the medium run, prices are less sticky as more sellers adjust their prices to
economic conditions. Therefore, the medium-run aggregate supply curve is steeper than the short-run
aggregate supply curve. More generally, the longer the time horizon you’re analyzing, the steeper the
relevant aggregate supply curve will be.
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Getting from the Very Short Run to the Long Run
Over longer time periods, price adjustments will bear more of the burden of adjustment, leading to an
increasingly vertical aggregate supply curve.
You can forecast the effect of a shift over time by evaluating this shift relative to the economy’s
aggregate supply curve in the very short run, short run, medium run, and long run.
ONE PAGE SUMMARY
MONETARY POLICY
Chapter objective: Understand how the Federal Reserve makes and
implements monetary policy.
1. The Federal Reserve: Learn how the Federal Reserve makes monetary policy decisions.
2. The Fed’s Policy Goals and Decision-Making Framework: Discover how the Federal
Reserve assesses its goals and makes interest rate choices.
3. How the Fed Sets Interest Rates: Understand how the Federal Reserve implements monetary
policy decisions.
4. Alternative Tools the Fed Uses to Meet Its Dual Mandate: Learn about some additional tools
the Federal Reserve uses to ensure maximum employment and stable prices.
THE FEDERAL RESERVE
Learning Objective: Learn how the Federal Reserve makes monetary policy
decisions.
Monetary policy is the process through which a central bank sets interest rates in an effort to
in uence economic conditions. In the United States, the Federal Reserve is our central bank. It was
created by Congress, which gave it instructions to “promote effectively the goals of maximum
employment, stable prices, and moderate long-term interest rates.” The Fed interprets Congress’s
instructions as a dual mandate to promote maximum employment, while keeping in ation low and
stable.
The Federal Reserve System
The Federal Reserve System is comprised of the Board of Governors in Washington, D.C., and 12
Federal Reserve district banks scattered across the country. The Board of Governors is an
independent government agency that guides the operation of the Federal Reserve System. It ensures
that monetary policy ful lls the instructions given by Congress. The Board of Governors also oversees
the operations of the Federal Reserve district banks.
The Federal Reserve system is regionally diverse.
Even though monetary policy decisions re ect national economic conditions, there are differences
across the country, and the 12 Fed bank presidents bring information from their districts to policy
discussions.
Central bank independence is important for macroeconomic stability.
The Federal Reserve Board of Governors is independent for a reason. A problem with political
pressure is that policymakers can achieve temporarily higher output by overheating the economy,
which might unleash future in ation.
Research shows that countries that give their central banks more independence have lower in ation
rates on average. This means that if you reduce independence, you should expect higher in ation.
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There is a lot of government oversight of the Fed.
The Fed governors are selected by the president of the United States. The U.S. Senate must con rm
the president’s nominations. There are seven governors of the Federal Reserve, and each serves a
term of up to 14 years. The president, with con rmation by the Senate, selects one of the governors
to serve a four-year term as the Fed chair.
The Fed is also audited by the General Accountability Of ce (GAO), which reviews the Fed’s nances
and activities. By law, the Federal Reserve board chair must testify before Congress at least twice a
year.
The Federal Open Market Committee
The Federal Open Market Committee (FOMC) decides on U.S. interest rates. It consists of the Fed
governors and district Fed bank presidents.
Step into the meeting.
To decide monetary policy, each member must be prepared to answer three questions:
1. What are your forecasts for the U.S. economy?
2. What are the right policy choices given the economic outlook?
3. How should the Fed communicate its plans effectively to the public?
Members prepare their answers to these questions in advance, and they’ll often arrive at the meeting
with quite different views. The meeting is a time for them to discuss their answers to these three
questions, develop a consensus view, and make a decision.
Question 1: What are your forecasts for the U.S. economy?
The Fed chair asks everyone to share their views on current economic conditions and their short- and
medium-term forecasts for the economy. The Fed tracks literally thousands of variables, each of
which provides clues about the future path of in ation and employment. People arrive at the meeting
with different forecasts re ecting their unique knowledge, different readings of noisy data, and their
expectations about what will happen if their preferred monetary policy decision is implemented.
Question 2: What are the right policy choices given the economic outlook?
The FOMC will raise the real interest rate when it wants to induce people to spend less today and
save more for later. By reducing spending today, we reduce output, which lowers in ationary
pressure. And the FOMC will lower the real interest rate when it wants to stimulate greater spending,
which will lead to higher output and higher employment. In the long run, stable in ation and maximum
sustainable employment are both achieved when output is equal to potential output.
Discussion at most meetings focuses on where the economy appears to be relative to where it was at
the previous meeting and assessing outcomes of the decisions that were made in previous meetings.
Had they raised rates enough? Not enough? Too fast or too slow?
Once the members have debated the options and assessed the risks associated with each possible
action, the Fed chair typically recommends a course of action, and the FOMC votes on it.
Question 3: How should the Fed communicate effectively to the public?
After each meeting, the Fed issues a statement, and the Fed chair holds a press conference
announcing and explaining its decisions. After every other meeting, it publishes its forecasts. In
between meetings, Fed of cials give speeches that often explain their thinking. And twice a year, the
Fed chair testi es before Congress to explain the Fed’s monetary policy actions and plans.
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These communication choices re ect strategic decisions: The Fed wants to convince people that it
will follow through and achieve its goals. Businesses will be more likely to hire if they believe the Fed
will deliver a strong economy, and they’re more likely to restrain their price increases if they believe
the Fed will meet its goal of price stability.
THE FED’S POLICY GOALS AND DECISION-MAKING
FRAMEWORK
Learning Objective: Discover how the Federal Reserve assesses its goals and
makes interest rate choices.
The Fed’s two goals of stable prices and maximum sustainable employment are known as the Fed’s
dual mandate.
The Fed’s Dual Mandate: Stable Prices and Maximum Sustainable Employment
If in ation is low enough not to in uence or distort people’s choices, it has few costs. Low and stable
in ation has a precise meaning for the Fed. It means that in ation is close to its in ation target, a
publicly stated goal for the in ation rate.
Price stability means in ation that is near or at the Fed’s in ation target.
The Fed has an in ation target of 2%. By setting an in ation target and telling the public what it is, the
central bank hopes to convince price-setters that in ation will be stable at its announced low rate. It’s
trying to set in motion a virtuous cycle: If people believe that in ation will be low and stable, then price
increases will be small, ensuring that in ation, in fact, remains low and stable. Thus, the more
credible the Fed’s commitment to low and stable in ation is, the easier it will be to achieve.
Hitting the in ation target promotes maximum sustainable employment.
You might be wondering: Why is the Fed targeting in ation instead of targeting employment?
There are two answers to this question. The rst is that the in ation rate over the long run is primarily
determined by monetary policy, and so it’s easily targeted by monetary policy. By contrast,
employment is in uenced by multiple factors unrelated to monetary policy. The second is that in ation
and unemployment are interdependent. Keeping in ation low and stable at its target also requires
keeping the unemployment rate near its lowest sustainable level. So targeting low and stable in ation
is consistent with targeting the lowest sustainable unemployment rate.
Why not target zero in ation?
There are four reasons not to aim for zero:
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● Reason 1: In ation greases the wheels of the labor market. Employers often nd it dif cult to cut
nominal wages, even when real wage cuts are needed to save jobs. But with 2% in ation,
they can do it quietly. Failing to give someone a nominal raise this year effectively cuts their
real wages by 2%. If in ation were 0%, they would have to cut nominal wages by 2% in order
to achieve the same real wage cut. But in order to avoid creating friction with their workers,
many employers are reluctant to cut their nominal wages. This means that if in ation is zero,
they’ll rarely cut real wages, which can sound great at rst. But recessions cause a decrease
in labor demand, and when employers can’t cut real wages, they lay off more workers than
they otherwise would. This suggests that a 0% in ation target will lead unemployment to rise
more during recessions.
● Reason 2: The Fed can lower real interest rates by more when in ation is above zero. The Fed
faces an important constraint: It effectively can’t set nominal interest rates below zero.
Economists refer to this as the zero lower bound. For instance, if in ation is 2%, then setting
the nominal interest rate at the zero lower bound results in a real interest rate of −2%. But if
in ation were 0%, this would be impossible, and the lowest the Fed could set the real interest
rate would be 0%.
● Reason 3: A 0% in ation rate target runs the risk of de ation. If the Fed set a 0% target, it would
risk in ation sometimes being below 0%. De ation occurs when prices are falling on average,
so that the in ation rate is negative. It can cause problems because falling prices lead people
to delay spending today in favor of buying stuff in the future when prices are even lower. This
How the Fed Chooses the Interest Rate
Factor 1: The Fed starts with the neutral real interest rate.
The neutral real interest rate is the real interest rate at which real GDP is equal to potential GDP, and
hence the output gap is zero.
The neutral real interest rate is important because it tells policymakers which real interest rate will
ensure both that the economy doesn’t underperform its potential and also that it won’t overheat from
running ahead of its capacity. Setting the real interest rate higher than the neutral real interest rate will
push actual output below potential output. And setting the real interest rate lower than the neutral real
interest rate will push actual output above potential output.
Factor 2: The Fed targets the nominal interest rate when trying to in uence the real interest rate.
Once the Fed has decided on a real interest rate it wants to hit, it needs to add in the in ation rate to
nd the corresponding nominal interest rate.
The interest rate that the Fed focuses on is the federal funds rate, which is the nominal interest rate
that banks pay to borrow from each other overnight in the federal funds market.
Factor 3: The Fed compares in ation with its in ation target.
The Fed looks at the gap between in ation and the in ation rate target and uses that difference as a
guideline for how much to change the real interest rate. Fed policymakers don’t just look at today’s
in ation; they also look ahead to forecasts of in ation. If they forecast that in ation is likely to rise or
fall above or below their in ation target at some future date, they’ll consider changing real interest
rates today to get ahead of the problem.
Factor 4: The Fed looks at the output gap.
The output gap hints at the future path of two variables the Fed cares a lot about: in ation and
unemployment. A positive output gap occurs when unemployment is below its lowest sustainable
level, and it will likely spark higher in ation. That’s why the Fed responds to a positive output gap by
setting the real interest rate above the neutral real interest rate in an attempt to cool the economy and
reduce in ationary pressure. A negative output gap corresponds to high unemployment and lower
in ation. And that will lead the Fed to respond by setting the real interest rate below the neutral real
interest rate so as to stimulate greater spending and output, which will reduce unemployment. The
Fed also looks at forecasts of the future output gap so that it can get ahead of any looming problems.
Putting it all together: The Fed rule-of-thumb approximates what the Fed does.
The Fed rule-of-thumb shows how the Fed combines the neutral real interest rate and estimates of
in ation and output in deciding how to adjust the interest rate. The following formula shows the Fed
rule-of-thumb:
Federal funds rate – In ation = Neutral real interest rate + × (In ation – 2%) + Output gap
Monetary policy choices are systematic but not automatic.
The Fed rule-of-thumb provides a pretty good prediction of the Fed’s actual interest rate decisions. It
is also known as the Taylor Rule.
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Fed decisions are systematic — meaning that the Fed responds in a reliable fashion to the state of
the economy. But they are not automatic — meaning that they aren’t simply an application of a single
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decrease in aggregate expenditure will reduce output, which leads prices to fall further, setting
off a vicious cycle of de ation and reduced spending.
● Reason 4: Measured in ation may be overstated. Many economists believe that the measured
in ation rate overstates the actual in ation rate. Consequently, a measured in ation rate of
zero may actually mean de ation.
The case for rules versus discretion.
Some economists have suggested that the Fed should follow a strict rule when setting interest rates.
Under the current system, the Fed could reduce interest rates enough to create a short-term boom
that would, in the long run, generate higher in ation. If businesses expect higher in ation, then they
make decisions to increase prices that ultimately lead to greater in ation. Following a rule rather than
using discretion would remove any temptation the Fed could have to overstimulate the economy and
create a short-term economic boom. The result of following a strict rule would be lower and more
stable in ation. In addition, it would make monetary policy more predictable.
However, strict adherence to a rule has some signi cant downsides. Most notably, the Fed can’t
reduce rates below zero even when that is what the Fed rule-of-thumb would suggest. Many Fed
of cials have argued that the prospect of being close to the zero lower bound or the possibility of
nancial instability means that they sometimes need to take stronger action than the Fed rule-ofthumb suggests.
HOW THE FED SETS INTEREST RATES
Learning Objective: Understand how the Federal Reserve implements monetary
policy decisions.
The Overnight Market for Interbank Loans
Reserves correspond to the cash that banks need to keep on hand to make payments. Banks face a
trade-off: If they loan more of their money out, they make more revenue from borrowers paying them
interest on those loans, but they also risk not having enough cash available to make payments. When
they don’t have enough cash on hand, they’ll need to borrow money to make those payments.
Sometimes banks do not have enough ready cash to make payments on a given day. As a result,
they have a demand for funds, which they can meet by borrowing money overnight from another bank
in the federal funds market. The forces of supply and demand determine the price in the market,
which is the interest rate charged on these overnight loans. But those forces are also shaped by the
Fed, which uses tools to shape the demand and supply for funds in this market. The interest rate is
called the federal funds rate. Let’s explore the tools the Fed uses to hit the interest rate it targets.
Tool 1: The Fed pays interest to banks on their reserves.
In order to in uence the federal funds rate, the Fed pays interest to banks on reserve balances. This
effectively creates a minimum interest rate that a bank will charge before loaning its funds to other
banks.
So the interest rate on reserves effectively serves as a oor on the interest rate at which banks will
loan their funds. The higher this interest rate, the fewer reserves are available to loan to other banks,
which will raise the interest rate on overnight loans. And so when the Fed wants to increase or
decrease the federal funds rate, it raises or lowers the interest rate it pays on reserves.
Tool 2: The Fed borrows money overnight from nancial institutions.
The Fed can borrow from nancial institutions and pay them interest on the loan. By engaging in
overnight borrowing, the Fed increases the demand for overnight loans, which leads to higher interest
rates. When it reduces such borrowing, it decreases the demand for overnight loans, which lowers
rates.
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The Open Market Trading Desk, informally known as the Desk, is a trading desk at the Federal
Reserve Bank of New York. Traders at the Desk buy and sell government bonds. The Fed is trading
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rule over time. Fed of cials argue that their decisions depart from the rule-of-thumb when their
superior information, economic insights, and decision-making abilities suggest that a different choice
will help it better meet its dual-mandate of price stability and maximum employment.
these bonds in order to in uence interest rates. The Desk engages in these trades in order to carry
out the directions of the FOMC to in uence the federal funds rate.
The Desk sells a government bond to a bank or other nancial institution overnight, with an
agreement to buy it back the next day at a higher price. These sales are called overnight reverse
repurchase agreements. They set an interest rate at which the Fed is willing to borrow money. These
loans effectively set a oor for the federal funds rate.
This method of implementing Fed policy for the federal funds rate is known as the oor framework
because it effectively sets a oor on how low of an interest rate a nancial institution will be willing to
lend to another.
Tool 3: The Fed lends to banks directly through the discount window.
The Fed can lend directly to banks through the discount window. Banks offer collateral and get a loan
from the Fed that helps them meet their reserve requirements.
The interest rate that the Fed offers through the discount window is called the discount rate, and it’s
typically set higher than the federal funds rate. It is primarily thought of as a backup source for banks
that need liquidity but are unable, for some reason, to get a loan from another bank at the federal
funds rate.
Tool 4: The Fed buys and sells government bonds.
Prior to 2007, rather than trying to in uence the federal funds rate by setting an interest rate oor and
ceiling, the Fed would buy and sell bonds until they achieved their desired interest rate in the federal
funds market. Open market operations refer to the Fed buying and selling government bonds.
Overnight reverse repurchase agreements are a form of open market operations. But historically,
open market operations through buying and selling bonds were the primary way that the Fed
implemented monetary policy decisions.
Today the Fed uses a oor framework plus the use of an effective price ceiling through the discount
rate. By setting the relevant prices — that is, a oor and ceiling for interest rates — and letting market
quantities adjust.
The Impact of Changing the Federal Funds Rate on the Rest of the Economy
People follow the Fed’s decisions closely because they eventually affect nearly every corner of the
economy, both in the United States and abroad.
A change in the federal funds rate percolates through to other interest rates.
When the federal funds rate changes, banks reset the rate they charge borrowers because the
marginal costs and bene ts of making loans has changed. The marginal bene t to your bank of
loaning money to you is the interest you pay. Its marginal cost is the opportunity cost — the interest it
could earn by leaving the money in its reserves instead.
The federal funds rate directly impacts short-term and variable interest rates. Changes in short-term
interest rates also percolate through to longer-term loans. A longer-term loan can be thought of as a
series of short-term loans. So when you pay a xed interest rate on a ve-year car loan, the bank can
think of adding up the different interest rates it would charge over each month of the ve years. As a
result, long-term interest rates move when the federal funds rate changes, and how much they move
depends on how long banks expect the federal funds rate to be at its new rate.
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Interest rates change the value of consuming today versus consuming tomorrow.
When the Fed changes the federal funds rate, the effects lter through to change the interest rates
you face on things like your savings account and credit cards, which affects your choices about how
much to save or borrow. Similarly, the return on savings for businesses change, as does the cost of
borrowing. Likewise, interest rates change how much the government pays to borrow, therefore
potentially affecting how much the government has available to spend on other things.
When the dollar depreciates, people around the world will discover that American goods will be
cheaper in terms of their own currency, leading them to buy more goods exported from the United
States.
The ip side is that it takes more dollars to buy goods priced in other currencies. That price rise leads
to a decline in the quantity of imported goods that Americans demand. If the quantity of imports
declines by enough to offset the higher prices, then total spending by Americans on imported goods
will also fall.
All this means that low interest rates lead to a cheaper U.S. dollar, causing exports to rise and imports
to fall, thereby increasing net exports. The opposite happens when interest rates rise: The value of
the dollar rises, making U.S. goods more expensive and foreign goods cheaper, and this leads to a
decrease in net exports.
ALTERNATIVE TOOL S THE FED USES TO MEET ITS DUAL
MANDATE
Learning Objective: Learn about some additional tools the Federal Reserve uses to
ensure maximum employment and stable prices.
Monetary Policy Choices When Nominal Interest Rates Are Zero
A zero lower bound means that the Fed thought it could not push the federal funds rate any lower, so
it had to start exploring other instruments that might encourage additional spending.
Forward guidance helps push down longer-term interest rates.
Communication is an important tool for the Fed because it is helping to shape expectations for the
future path of interest rates. This strategy of providing information about the future course of monetary
policy in order to in uence market expectations of future interest rates is called forward guidance.
The way it works is that the Fed promises that rates will stay low in the future. This pushes down
longer-term interest rates because the Fed is promising that people can count on low interest rates
for longer.
Quantitative easing aims to push interest rates below zero.
Quantitative easing (QE) is the name given to the Fed’s strategy of purchasing large quantities of
longer-term government bonds and other securities in an effort to put downward pressure on longterm interest rates, including mortgage rates.
Lender of Last Resort
The Fed plays a key role in ensuring stability in the U.S. nancial system. One way it does this is to
act as the lender of last resort.
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The lender of last resort can prevent a nancial crisis.
In 2008 and 2020, the Fed provided hundreds of billions of dollars in loans to prevent banks and other
nancial institutions from going bust.
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Interest rates change the value of the U.S. dollar.
Investors are global actors, seeking the highest risk-adjusted returns they can nd. When U.S.
interest rates fall, investing in the United States becomes less attractive. With fewer foreign investors
trying to buy U.S. dollars so that they can invest in America, the value of the dollar falls. This
depreciation means that it takes fewer foreign currencies to buy an American dollar.
The Fed can lose money when it acts as a lender of last resort.
When the Fed acts as a lender of last resort, it takes on some of the borrower’s risk. After all, if the
borrower can’t repay its loan, then it’s the Fed that stands to lose money.
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The Fed’s willingness to be a lender of last resort can lead borrowers to take bigger risks.
If any big nancial rm were to fail, it would create widespread economic chaos, which the Fed was
set up to prevent. The problem is that these nancial institutions understand that — from the Fed’s
perspective — they’re too big to fail. That creates incentives for these nancial institutions to take on
extra risk, knowing that the Fed is likely to bail them out.
ONE PAGE SUMMARY
GOVERNMENT SPENDING, TAXES,
AND FISCAL POLICY
Chapter objective: Analyze government spending, revenue, de cits,
and debt.
1. The Government Sector: Assess the size and scope of the government.
2. Fiscal Policy: Discover how scal policy can smooth business cycles.
3. Government De cits and Debt: Understand why governments run de cits and the implications
of government debt.
THE GOVERNMENT SECTOR
Learning Objective: Assess the size and scope of the government.
Together, the spending by federal, state, and local governments adds up to nearly two- fths of GDP.
Government Spending
In 2020, the federal government spent $6.9 trillion, state governments spent another $2.0 trillion, and
local governments spent $1.7 trillion. That adds up to more than $28,000 for each man, woman, and
child in the United States.
“The federal government is an insurance company with a military.”
Social insurance refers to government-provided insurance against bad outcomes such as illness,
outliving your savings, disability, or unemployment.
Taken together, social insurance programs plus spending on the military and veterans’ bene ts
account for roughly 80% of federal government spending. Interest on government debt takes a further
5% of the overall budget, leaving just 13% to pay for everything else. That remaining money gets
spread pretty thinly across programs such as education spending, highways and transportation,
housing, and international affairs.
States provide employment and income support, education, and health care.
State governments also spend much of their money on social insurance. On average, roughly half of
state government spending goes toward employment and income support. This spending includes
state contributions to Medicaid, unemployment insurance, employment services, and pensions for
state employees.
States spend nearly a fth of their budget on education, most of which goes to higher education. Your
state government also provides services like state police, prisons, highways, and parks.
Local government provides most of the government services you’ve interacted with so far in your life.
Your local government provides the public primary and secondary schools in your neighborhood. Your
local government also provides the community services your family might rely on. Things we use on a
regular basis (such as traf c lights, parks, and libraries) are usually provided by local governments.
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Evaluate government spending as a share of available resources.
Government spending expressed as a percentage of GDP allows you to make comparisons over time
and across countries.
In 1913, the Sixteenth Amendment was passed giving Congress the power to levy an income tax.
This gave the federal government the revenue source it would later need in order to expand.
Federal government spending has been roughly stable over recent decades.
In 2021, the federal government spending was 30% of GDP, well above its average over the previous
ve decades. The surge in spending in 2020 and 2021 was in response to the Covid-19 pandemic.
Similarly, spending surged in response to the 2008 recession, but in the decade that followed, federal
government spending fell back to its ve-decade average of 22%.
Government social insurance spending has grown over time.
Spending on social insurance has grown as a share of GDP, and spending on the military has
declined. However, since 1960, real GDP has grown more than vefold, so even though military
spending is lower as a share of GDP, we still spent roughly 1.6 times as much on the military in 2021
as we did in 1960 (after adjusting for in ation).
Much of future federal government spending is already determined.
Most social insurance programs convey an entitlement to a certain amount of spending if you meet
certain eligibility criteria, which is why they’re often called entitlement programs. Both Social Security
and Medicare programs are part of the federal budget called mandatory spending, which means that
the terms of the spending are written into the legislation that created the program.
In contrast, funding for federal agencies and most government programs is discretionary spending.
This is spending that Congress annually appropriates. By law, the government can spend only money
that Congress has appropriated. If it fails to appropriate the funds in time, the government shuts
down.
Government spending is lower in the United States than in other rich countries.
The combination of federal, state, and local spending in the United States added up to 38% of GDP in
2019, prior to the pandemic. This is a bit lower than in many other developed countries, some of
which devote half or more of their GDP to government spending. In those countries, the governments
tend to provide things publicly that we pay for privately in the United States.
Government Revenue
The federal government primarily collects revenue by taxing people’s incomes, and state and local
governments focus more on taxing people’s spending.
Federal government tax revenue comes primarily from income and payroll taxes.
Overall, 83% of the federal government’s revenue comes from either payroll taxes or income taxes.
The rest comes from corporate taxes and other taxes.
You pay income taxes on all income.
Income taxes are taxes collected on all income, regardless of its source. Don’t confuse this with
wealth, which is your stock of savings and assets.
Payroll taxes are used to fund social insurance.
Payroll taxes apply only to earned income. Your earned income is wages from an employer or net
earnings from self-employment. Payroll taxes are used to fund social insurance programs like Social
Security and Medicare. Payroll taxes are levied as a xed percentage of your earned income, and
your employer typically withholds them from your wages.
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Income taxes are progressive.
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The federal government has expanded over time.
State and local governments provided most government services throughout the 1800s and early
1900s. The federal government played a much smaller role and focused on national defense and
delivering mail.
The U.S. federal income tax is a progressive tax, which means that those with more income tend to
pay a higher share of their income in the tax. A tax is progressive when the tax rate you pay increases
with your income.
Your taxable income is the amount of your income that you pay taxes on. The tax rate you pay if you
earn another dollar is your marginal tax rate. The tax system is progressive; as you earn more, your
marginal tax rate increases. As a result, those with higher incomes will end up paying a larger share
of their income in tax.
Your taxable income is not the same thing as the income you earn. You can subtract many possible
deductions from your actual income in calculating your taxable income. You can subtract what’s called
the standard deduction as well as any other deduction you may qualify for.
Corporate taxes are paid by people.
The people who ultimately pay most of the corporate taxes are the owners of the corporations. For
publicly held companies, the owners are the shareholders. Workers also bear some of the burden of
corporate taxes. As taxes rise, businesses buy less capital, which makes their workers less
productive. And when workers are less productive, employers aren’t willing to pay them as much.
State and local governments collect sales, property, and income taxes.
A sales tax is a tax on purchases, and it’s typically a percentage of the purchase price of goods and
services. An excise tax is a tax on a speci c product, such as gas, cigarettes, or alcohol. Unlike a
regular sales tax, excise taxes are usually levied based on the quantity you buy, not the price you pay.
State and local governments raise 35% of their revenue through sales and excise taxes. These taxes
are the largest source of revenue for state and local governments on average.
Property taxes, which are a type of wealth tax based on the value of property (usually real estate)
provide roughly a third of state and local government revenue.
A regressive tax is one in which those with less income tend to pay a higher share of their income in
taxes. Excise, property, and sales taxes tend to be regressive because lower-income households
spend more of their income on things like gas, housing, groceries, and clothing.
Hidden Government Spending: Tax Expenditures
Tax expenditures describe the special deductions, exemptions, or credits that lower your tax
obligations and hence reduce government revenue.
Tax expenditures are a hidden form of government spending.
Let’s consider an example of tax expenditure: the American Opportunity Tax Credit. With this tax
credit, the government wants to help students afford college. The goal of this tax expenditure was for
federal government help more students afford college. The way it works is that you or your parents
might be able to subtract a portion of what you have paid in tuition (up to $2,500 a year) from your tax
bill.
Congress could have passed this program as a spending program — simply mailing each qualifying
student or family a $2,500 check each year. But these otherwise-identical alternatives look quite
different in the government’s budget because a direct-spending program shows up as government
spending, while a tax expenditure simply means there’s less government revenue than there
otherwise would be.
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Tax expenditures have a lower political cost.
Politicians who typically argue for a smaller government will often implement their preferred policies
as tax expenditures rather than government spending. Because tax expenditures are part of the tax
code, they don’t need to be renewed or evaluated each year as part of the budget process. This
matters because it means that tax expenditures are not part of the annual ght over what to include in
the discretionary budget.
Tax expenditures encourage spending on certain goods and services.
Some of the largest tax expenditures include tax breaks offered on employer-provided health
insurance, retirement plans, and owner-occupied housing. These tax breaks are the government’s
way of encouraging you to purchase health insurance, save for retirement, and buy your own home.
Tax expenditures primarily bene t those with high incomes.
More than half of tax expenditures go to the highest-income quintile. There are three reasons for this
disparity:
1. Reason 1: The value of tax exclusions and deductions is higher when your income tax rate is
higher.
2. Reason 2: Higher-income people tend to buy more tax-preferred goods and services.
3. Reason 3: Most tax expenditures don’t provide much help if your federal income tax bill is zero.
A refundable tax credit tries to solve this third cause by providing bene ts even to those folks whose
taxable income is zero because it doesn’t depend on owing income taxes. We say it’s refundable
because you can get a tax refund even if you don’t pay any taxes.
Tax expenditures are often inef cient, poorly targeted, and persistent.
The problem with tax expenditures is that the budgetary cost of tax expenditures is opaque and
obscures how inef cient some programs are.
Regulation
Regulation allows the government to require spending, while others pay the bill.
Governments often make laws or regulations requiring people or businesses to pay for things directly.
But asking employers to pay for it doesn’t change the cost; it merely shifts who pays from taxpayers
to employers. It’s also likely that employers will pass some of the costs on to workers in the form of
lower wages. So the cost doesn’t disappear; it’s just that someone else is paying the bill.
Regulation changes incentives.
When policy wonks try to gure out the best way to design a policy, they pay careful attention to how
people might adjust their behavior in response to the policy.
FISCAL POLICY
Learning Objective: Discover how scal policy can smooth business cycles.
A Countercyclical Force
Fiscal policy refers to the government’s use of spending and tax policies to attempt to stabilize the
economy.
Higher spending and lower taxes will boost output.
Typically, the government responds to weak output with an expansionary scal policy that involves
higher government spending and lower taxes. The resulting boost to aggregate expenditure increases
the demand for output, leading businesses to ramp up production, which raises GDP.
Lower spending and higher taxes will reduce output.
The government can counter an overheating economy with a contractionary scal policy that involves
lower government purchases and higher taxes. The same mechanisms operate in reverse as lower
spending or higher taxes decrease aggregate expenditure and hence output.
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Government spending can add to GDP directly and indirectly.
It’s worth distinguishing between two types of government spending. The rst is government
purchases, and the second is transfer payments. This distinction matters. Government purchases are
counted directly in GDP, but transfer payments don’t directly add to GDP because nothing is
purchased or produced.
The multiplier effect makes scal policy more potent.
The multiplier effect describes the possibility that an initial boost in spending will set off ripple effects
that ultimately lead to a larger rise in GDP. The same effects also operate in reverse, and an initial
decrease in aggregate expenditure due to a contractionary scal policy can also have a multiplied
effect that leads to a larger decline in GDP.
There’s a microeconomic rationale for countercyclical scal policy.
The opportunity cost principle suggests an investment is best done during an economic slump. That’s
because when unemployment is high, the next best use of a construction worker’s time might be
lower, as their next best alternative might be working in a job that doesn’t use their skills.
Discretionary government spending can involve substantial time lags.
Discretionary scal policy is a policy that temporarily increases spending or cuts taxes to boost the
economy. One of the biggest challenges with discretionary scal policy is getting the timing right,
because there are delays.
The delays involved in discretionary scal policy mean that during short downturns, it’s unlikely that
Congress will be able to act quickly enough to boost aggregate expenditure when it’s needed. When it
acts too late, the boost might arrive after the economy has already recovered. At worst, this can mean
that discretionary scal policies become procyclical instead of countercyclical, which would
destabilize the economy.
Fiscal policy works best when it’s timely, targeted, and temporary.
Fiscal policy works best when it is implemented before economic conditions have severely worsened,
when it targets those parts of the economy that are most affected, and when it’s used for only as long
as it’s needed.
Government spending can crowd out investment spending.
Sometimes a rise in government spending will lead to a decline in private spending (speci cally,
investment), creating an effect known as crowding out. Crowding out occurs when expansionary scal
policy leads to a higher real interest rate, which reduces investment spending. The extent of crowding
out depends on the time period being analyzed and the state of the economy.
In the short run, expansionary scal policy will boost output, and the Fed typically responds by raising
the real interest rate, which reduces investment. The level of crowding out depends on how much the
interest rate is changed by the Fed in response to the expansionary scal policy. During a deep
recession — when there’s a lot of excess capacity — both scal and monetary policy are likely working in
concert, and so the Fed is unlikely to change the real interest rate in response to an expansionary scal
policy. As a result, there won’t be much crowding out.
In the long run, expansionary scal policy involves the government dissaving, which decreases the
supply of loanable funds. This decrease in supply will raise the neutral real interest rate, and these
higher rates will deter investment. But in the long run, increased government spending won’t affect
potential output because it can’t affect the long-run level of output. By this view, in the long run, every
extra dollar of government spending will crowd out a dollar of private spending, and so scal stimulus
can have only temporary effects on output.
Automatic Stabilizers
An automatic stabilizer is a scal policy that adjusts as the economy expands and contracts without
policymakers taking any deliberate action. It’s automatic because no policymaker has to take any
action. And it’s stabilizing because these adjustments are countercyclical, boosting output during
recessions and reducing it during expansions.
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Government revenue automatically adjusts during business cycles.
During a recession, incomes fall. But there’s a silver lining to this loss of income: You’ll pay less in
taxes. This automatic stabilizer helps support after-tax incomes, ensuring that spending — and hence
output — won’t decline by as much as it otherwise might. As a result, the government takes in less
A similar dynamic operates — in reverse — during an economic boom. As such, the tax system acts
to counter both booms and busts, smoothing out business cycle uctuations.
Government spending automatically adjusts during business cycles.
Government spending also rises automatically during a recession. When income falls, more people
qualify for government bene ts for which eligibility is based at least partially on income. These
additional payments support aggregate expenditure by allowing those receiving support to spend
more than they would have otherwise been able to spend. The reverse happens during a boom, with
government spending on these programs falling automatically as the economy recovers.
Automatic stabilizers are timely, targeted, and temporary.
These automatic changes in taxes and spending are timely because they’re automatically triggered
whenever people’s incomes decline. They’re also well-targeted because taxes decline only for those
whose income has fallen, and eligibility for income support payments depends on each person’s
nancial or employment status. And they’re temporary because they automatically reverse course as
the economy reverses course.
Fiscal Policy and Monetary Policy Interactions
When the threat of a recession looms, policymakers have two main ways to respond. The Fed can
adopt an expansionary monetary policy by lowering interest rates, which will encourage more
spending. In addition — or instead — the government can adopt an expansionary scal policy by
increasing government purchases and cutting taxes.
Monetary policy is more nimble.
The advantage of monetary policy is that it can be implemented quickly. The disadvantage is that
changes in interest rates don’t immediately boost spending, and it can take a year or more before
lower interest rates stimulate more spending.
Fiscal policy can be more targeted.
Local economic struggles are hard for monetary policy to address but can be helped with scal policy.
Fiscal policy is particularly important at the zero lower bound.
When the Fed can’t cut short-term nominal rates any further — and its capacity to cut long-term rates
is limited — discretionary scal policy might be the only effective tool left to stabilize the economy.
GOVERNMENT DEFICITS AND DEBT
Learning Objective: Understand why governments run de cits and the implications
of government debt.
Government Budget De cits
A budget de cit is the difference between spending and revenue in a year in which spending exceeds
revenue. A budget surplus is the difference between spending and revenue in a year in which revenue
exceeds spending.
The government’s debt is the total accumulated amount of money that it owes. Its budget de cit in a
given year adds to the total debt, whereas a budget surplus can be used to repay its debt.
The federal government runs de cits.
There are four things to notice about federal government spending and revenue:
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1. The federal government typically runs budget de cits.
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tax revenue during a recession. This keeps more money in the hands of businesses and consumers,
and to the extent they spend it, they’ll boost aggregate expenditure and hence output.
2. Persistent large budget de cits are a relatively recent phenomenon. Since the 1980s, large
annual de cits have become a persistent feature of the U.S. federal government, with the
exception of a brief period in the 1990s.
3. Wars and pandemics require a sudden surge of spending that results in budget de cits.
4. Business cycles create budget de cit cycles. The federal government’s budget de cit tends to
rise during recessions and fall during expansions.
When should the government run de cits?
One way to think about budget de cits and surpluses is that they re ect a mismatch between when
the government spends money and when it takes in the revenue to pay for this spending. And there’s
no reason to expect the pattern of when it’s best to spend money to match the pattern of when it’s
best to raise revenue.
When the government spends on infrastructure, the bene ts of that spending will last for decades. So
why should it pay for it all up front? A related argument for de cit spending is that whenever there is a
need for a surge in spending — like during a pandemic — it’s inef cient to collect all the revenue at
once.
Budget de cits may re ect short-run political incentives.
Spending programs are popular with voters, but raising taxes to pay for those programs is not. That’s
why election-minded politicians like to spend money on programs that make voters happy but don’t
like raising taxes to pay for them. These unbalanced incentives might explain why the government
typically runs budget de cits.
Requiring a balanced budget would make business cycles worse.
If the federal government was required to balance its budget, then it would not be able to use scal
policy to counteract business cycles. Indeed, balancing the budget each year would require it to
implement a scal policy that would exacerbate an economic downturn.
De cit debates re ect both economic forces and value judgments.
The debate about de cits essentially comes down to two things: a value judgment and a concern
about debt’s impact on the economy. The value judgment is whether the next generation should help
pay for the spending priorities of the current generation. The concern about debt’s impact on the
economy is what we’re going to turn to now.
Government Debt
The government borrows by selling government bonds to savers in both the United States and
abroad. The total debts of the federal government — called the gross government debt — added up
to $31 trillion in 2022. But about $6.5 trillion of this debt is money that one part of the federal
government owes another part of the federal government. What really matters is the debt that the
federal government owes to others — to individuals, businesses, and other governments both here
and abroad. This is called net government debt, and it amounts to nearly $25 trillion.
Evaluate a country's debt relative to a country’s GDP.
It makes sense to think about a country’s debt relative to its capacity to repay it. That’s why
economists typically focus on the ratio of a country’s government debt to its annual GDP. In the
United States, this debt-to-GDP ratio in 2018 was 78%.
Government debt is currently high, relative to our history.
The debt-to-GDP ratio roughly doubled between 2008 and 2013 as the government increased
spending to ght the recession. The debt-to-GDP ratio grew more stable in the ensuing years, before
shooting up in 2020 and 2021, as government spending rose by unprecedented amounts to tackle the
pandemic. As GDP recovered, the debt-to-GDP ratio came down, but as of 2022 it remained
substantially higher than prior to the pandemic.
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U.S. government debt is comparable to that of other advanced countries.
Governments get by with a variety of debt levels, and the United States is in the middle of the pack.
Government debt is expected to grow rapidly over coming decades.
If the government maintains its current course, the debt-to-GDP ratio is expected to grow to over
200% of GDP by 2050. We have a fairly clear idea about where the debt is headed because much of
the federal budget re ects promises the government has made about future payments such as Social
Security and Medicare. These bene ts are an unfunded liability — a commitment to incur expenses in
the future without a plan to pay for them. The federal government has a lot of unfunded liabilities, and
they’re projected to be the primary driver of rising de cits and debt over coming decades.
In addition, the more the government borrows, the more interest it pays. As unfunded liabilities push
the debt higher, the government will have to make increasingly larger annual interest payments,
which in turn will also push de cits and debt higher still.
Reasons Not to Worry About the Debt
Reason 1: Most of our government debt is money owed by Americans to Americans.
To a large degree, it’s money that we owe ourselves. More than half of the debt is held by U.S.
investors. And so although the American people owe the debt, they are also owed much of the debt.
Reason 2: Future generations can help repay the debt.
Remember that the government — unlike a household — can repay its debt over many generations.
And so that means that the burden of the debt can be spread over not only the current population of
330 million but also hundreds of millions of people in future generations.
Reason 3: It wouldn’t take a big adjustment to repay the debt.
Recall that the government spends $30,000 a year per person on government services. So over your
lifetime, the government will likely spend well over $1 million on you. Your current “share” of the debt
is small relative to this. It follows that if the government decides to repay the debt, it wouldn’t have to
cut much of the spending it plans to do over your lifetime.
Reason 4: The government never really needs to repay the debt.
The U.S. government has been in debt more or less continuously since its formation. Yet that hasn’t
proved to be a problem. That’s because government debt doesn’t have to be fully repaid to be
sustainable. What matters is whether the government has the means to make the required payments.
Reason 5: The government has options that you don’t.
Contrary to you, the federal government can pretty easily raise more revenue: It just has to raise
taxes. The government has one more option that households don’t: It can literally print money and
use that money to repay its debt. But as seductive as this seems, it’s rarely a good idea.
Reasons to Worry About Government Debt
Reason 1: Slower economic growth
The problem is that the government borrows funds that might otherwise be used to nance
investments in productive capital. Without this funding, the private sector invests in less capital, which
makes workers less productive, and they produce less output.
Reason 2: Future scal choices are constrained.
Higher government debt makes it harder to borrow more when the government needs funds. It won’t
be able to easily borrow during national emergencies, such as wars, recessions, or natural disasters.
Reason 3: The risk of a crisis of con dence
The U.S. government pays just about the lowest interest rates in the world. That’s because investors
are con dent that when they loan the U.S. government money, they’ll be repaid in full and in a timely
manner. That con dence is a valuable asset, saving the government billions of dollars in interest
payments each year. That con dence is also fragile.
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A crisis of con dence — where investors’ fears spark a vicious cycle of higher interest rates and less
sustainable debt — can happen in the blink of an eye. Think of this as a self-ful lling prophecy, with
either a good or a bad outcome. The good outcome occurs when lenders think that the government
will repay them, leading them to charge low interest rates, and because interest rates are low, the
government easily makes its scheduled repayments. The bad outcome occurs when lenders think the
government won’t make its payments, so they charge higher interest rates, and this crippling interest
burden leads the government to miss its scheduled payments. The fact that the United States is
currently enjoying the good outcome is no guarantee that things won’t change tomorrow.
Reason 4: A debt crisis becomes more likely.
At its worst, high government debt can lead to a debt crisis in which the government simply can’t
repay its loans. The government stops making payments on its debt, and so investors abruptly refuse
to lend it any more money. When a government can’t borrow money, it must immediately balance its
budget either by raising taxes or cutting spending.
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