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Macroeconomics
Tenth Edition
Global Edition
Andrew B. Abel
The Wharton School of the
University of Pennsylvania
Ben S. Bernanke
Brookings Institution
Dean Croushore
Robins School of Business
University of Richmond
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About the Authors
Andrew B. Abel
Ben S. Bernanke
Dean Croushore
The Wharton
School of the
University of
Pennsylvania
Brookings Institution
Robins School of
Business, University
of Richmond
Ronald A. Rosenfeld Professor of
Finance at The
Wharton
School
and professor of economics at the
University of Pennsylvania, Andrew
Abel received his A.B. summa cum laude
from Princeton University and his Ph.D.
from the Massachusetts Institute of
Technology.
He began his teaching career
at the University of Chicago and
Harvard University and has held
visiting appointments at both Tel Aviv
University and The Hebrew University
of Jerusalem.
A prolific researcher, Abel has
published extensively on fiscal policy,
capital formation, monetary policy, asset pricing, and Social Security—as well
as serving on the editorial boards of numerous journals. He has been honored
as an Alfred P. Sloan Fellow, a Fellow of
the Econometric Society, and a recipient
of the John Kenneth Galbraith Award
for teaching excellence. Abel has served
as a visiting scholar at the Federal Reserve Bank of Philadelphia, as a member of the Panel of Economic Advisers
at the Congressional Budget Office, and
as a member of the Technical Advisory
Panel on Assumptions and Methods for
the Social Security Advisory Board. He
is also a Research Associate of the National Bureau of Economic Research
and a member of the Advisory Board of
the Carnegie-Rochester–NYU Conference Series.
Ben Bernanke is
currently
Distinguished Fellow in
Residence with the
Economic
Studies Program at the
Brookings Institution. From February 2006 to January 2014,
he was Chairman of the Board of Governors of the Federal Reserve System. Before
that, he served as Chair of the President’s
Council of Economic Advisors from June
2005 to January 2006 and was a Governor
of the Federal Reserve System from August 2002 to June 2005. Prior to his work
in public service, he was the Howard
Harrison and Gabrielle Snyder Beck Professor of Economics and Public Affairs at
Princeton University. He received his B.A.
in economics from Harvard University
summa cum laude—capturing both the Allyn Young Prize for best Harvard undergraduate economics thesis and the John H.
Williams prize for outstanding senior in
the Economics Department. Like coauthor
Abel, he holds a Ph.D. from the Massachusetts Institute of Technology.
Bernanke began his career at the
Stanford Graduate School of Business
in 1979. In 1985 he moved to Princeton
University, where he served as chair
of the Economics Department from
1995 to 2002. He has twice been visiting professor at MIT and once at New
York University, and has taught in undergraduate, M.B.A., M.P.A., and Ph.D.
programs. He has authored more than
60 publications in macroeconomics,
macroeconomic history, and finance.
Bernanke has served as a visiting scholar and advisor to the Federal
Reserve System. He is a Guggenheim
Fellow and a Fellow of the Econometric Society. He has also been variously
honored as an Alfred P. Sloan Research
Fellow, a Hoover Institution National
Fellow, a National Science Foundation
Graduate Fellow, and a Research Associate of the National Bureau of Economic Research. He has served as editor of
the American Economic Review.
Dean Croushore is
professor of economics and Rigsby
Fellow at the University of Richmond. He received his A.B. from Ohio
University and his Ph.D. from Ohio
State University.
Croushore began his career at
Pennsylvania State University in 1984.
After teaching for 5 years, he moved
to the Federal Reserve Bank of Philadelphia, where he was vice president
and economist. His duties during his 14
years at the Philadelphia Fed included
heading the macroeconomics section,
briefing the bank’s president and board
of directors on the state of the economy
and advising them about formulating
monetary policy, writing articles about
the economy, administering two national
surveys of forecasters, and researching
current issues in monetary policy. In his
role at the Fed, he created the Survey of
Professional Forecasters (taking over
the defunct ASA/NBER survey and
revitalizing it) and developed the RealTime Data Set for Macroeconomists.
Croushore returned to academia
at the University of Richmond in 2003.
The focus of his research in recent years
has been on forecasting and how data
revisions affect monetary policy, forecasting, and macroeconomic research.
Croushore’s publications include articles in many leading economics journals
and a textbook on money and banking.
He is associate editor of several journals
and a visiting scholar at the Federal Reserve Bank of Philadelphia and an adjunct associate professor in the business
school at Columbia University.
3
Brief Contents
Preface 15
PART
1 Introduction
1
2
PART
PART
The Measurement and Structure of the National Economy
Productivity, Output, and Employment
89
Consumption, Saving, and Investment
138
Saving and Investment in the Open Economy
Long-Run Economic Growth
48
202
236
The Asset Market, Money, and Prices
274
3 Business Cycles and Macroeconomic Policy
8
9
Business Cycles
10
Classical Business Cycle Analysis: Market-Clearing
Macroeconomics 401
11
Keynesianism: The Macroeconomics of Wage and Price Rigidity 441
313
The IS–LM/AD–AS Model: A General Framework for Macroeconomic
Analysis 350
4 Macroeconomic Policy: Its Environment
and Institutions
12
13
Unemployment and Inflation
14
15
Monetary Policy and the Federal Reserve System
483
Exchange Rates, Business Cycles, and Macroeconomic Policy
in the Open Economy 515
Government Spending and Its Financing
Appendix A: Some Useful Analytical Tools 655
Glossary 663
Name Index 675
Subject Index 677
4
27
2 Long-Run Economic Performance
3
4
5
6
7
PART
Introduction to Macroeconomics
614
567
Detailed Contents
2.2 Gross Domestic Product 52
Preface 15
PART
CHAPTER 1
The Product Approach to Measuring GDP 52
1 Introduction
I N TO U C H W I T H D ATA A N D R E S E A R C H :
Natural Resources, the Environment, and the National
Income Accounts 55
Introduction to Macroeconomics
27
The Expenditure Approach to Measuring GDP 57
The Income Approach to Measuring GDP 60
1.1 What Macroeconomics Is About 27
Long-Run Economic Growth
2.3 Saving and Wealth 63
28
Business Cycles
30
Measures of Aggregate Saving
Unemployment
31
The Uses of Private Saving
65
Relating Saving and Wealth
67
Inflation
32
The International Economy
Macroeconomic Policy
Aggregation
33
2.4 Real GDP, Price Indexes, and Inflation 70
34
Real GDP 70
36
Price Indexes
1.2 What Macroeconomists Do 36
Macroeconomic Forecasting
Macroeconomic Analysis
37
Macroeconomic Research
37
Data Development
The Computer Revolution and Chain-Weighted GDP
74
I N TO U C H W I T H D ATA A N D R E S E A R C H :
CPI Inflation Versus Core Inflation 77
APPLICATION The Federal Reserve’s Preferred Inflation
38
Developing and Testing an Economic Theory
Measures
39
79
2.5 Interest Rates 80
1.3 Why Macroeconomists Disagree 40
Classicals Versus Keynesians
73
I N TO U C H W I T H D ATA A N D R E S E A R C H :
36
IN TOUC H W I TH DATA AND RESEARC H:
41
PART
A Unified Approach to Macroeconomics 43
CHAPTER 3
CHAPTER 2
63
The Measurement and Structure of the
National Economy 48
2 Long-Run Economic Performance
Productivity, Output, and Employment
89
3.1 How Much Does the Economy Produce? The
Production Function 90
APPLICATION The Production Function and Changes of
Productivity in the European Union 91
2.1 National Income Accounting: The
Measurement of Production, Income,
and Expenditure 48
The Shape of the Production Function 93
IN TOUC H W I TH DATA AND RESEARC H:
The Marginal Product of Capital
94
95
The National Income and Product Accounts in Malaysia
50
The Marginal Product of Labor
Why the Three Approaches Are Equivalent
51
Supply Shocks
97
5
Detailed Contents
6
3.2 The Demand for Labor 99
APPLICATION The Idiosyncrasy of Singapore’s Aggregate
The Marginal Product of Labor and Labor Demand:
An Example 100
A Change in the Wage
Consumption
143
Effect of Changes in Wealth
145
Effect of Changes in the Real Interest Rate
102
The Marginal Product of Labor and the Labor
Demand Curve 102
Fiscal Policy
Factors That Shift the Labor Demand Curve 104
Interest Rates
Aggregate Labor Demand
APPLICATION How Investors Respond to Tax Incentives
146
148
I N TO U C H W I T H D ATA A N D R E S E A R C H :
106
3.3 The Supply of Labor 106
149
153
4.2 Investment 155
The Income–Leisure Trade-Off
107
The Desired Capital Stock
Real Wages and Labor Supply
108
Changes in the Desired Capital Stock
APPLICATION How Big Is the Gig Economy?
110
156
158
APPLICATION Measuring the Effects of Taxes on Investment
161
The Labor Supply Curve
111
From the Desired Capital Stock to Investment 163
Aggregate Labor Supply
112
Investment in Inventories and Housing
I N TO U C H W I T H D ATA A N D R E S E A R C H :
3.4 Labor Market Equilibrium 113
Full-Employment Output
Investment and the Stock Market
115
The Saving–Investment Diagram
117
118
APPENDIX 4.A A Formal Model of Consumption
and Saving 185
I N TO U CH WITH DATA AND RESEARC H:
Labor Market Data in Kazakhstan
118
CHAPTER 5
APPLICATION Unemployment During the European Debt
Crisis
119
How Long Are People Unemployed?
121
Why There Always Are Unemployed People 122
I N TO U CH WITH DATA AND RESEARC H:
Alternative Measures of Unemployment Rate
124
APPLICATION Recent Trends in Labor Supply
125
CHAPTER 4
Saving and Investment in the Open
Economy 202
5.1 Balance of Payments Accounting 203
The Current Account
203
I N TO U C H W I T H D ATA A N D R E S E A R C H :
The Balance of Payments Accounts in Malaysia
205
APPLICATION Current Account Balance and Trade Openness
Around the World 206
3.6 Relating Output and Unemployment:
Okun’s Law 126
The Financial Account
The Growth Rate Form of Okun’s Law
137
Consumption, Saving, and Investment
138
APPENDIX 3.A
169
APPLICATION Macroeconomic Consequences of the Boom and Bust
in Stock Prices 173
3.5 Unemployment 117
Changes in Employment Status
166
4.3 Goods Market Equilibrium 168
APPLICATION Output, Employment, and the Real Wage During
Oil Price Shocks 115
Measuring Unemployment
165
208
The Relationship Between the Current Account
and the Financial Account 209
Net Foreign Assets and the Balance of Payments
Accounts 211
APPLICATION The United States as an International Debtor
4.1 Consumption and Saving 139
The Consumption and Saving Decision of an
Individual 140
5.2 Goods Market Equilibrium in an Open
Economy 214
Effect of Changes in Current Income
5.3 Saving and Investment in a Small Open
Economy 215
141
Effect of Changes in Expected Future Income 142
212
Detailed Contents
The Effects of Economic Shocks in a Small Open
Economy 219
I N TO U C H W I T H D ATA A N D R E S E A R C H :
Monetary Aggregates in the United Kingdom
278
I N TO U C H W I T H D ATA A N D R E S E A R C H :
5.4 Saving and Investment in Large Open
Economies 219
The Effect of Dollarization on the United States and Other
Nations 279
APPLICATION The Impact of Globalization on the
U.S. Economy 221
7.2 Portfolio Allocation and the Demand
for Assets 281
APPLICATION Recent Trends in the U.S. Current Account
Deficit 223
Expected Return
5.5 Fiscal Policy and the Current Account 225
Risk
281
282
The Critical Factor: The Response of National
Saving 255
Liquidity
The Government Budget Deficit and National
Saving 226
Types of Assets and Their Characteristics
APPLICATION The Twin Deficits
The Housing Crisis of 2007 to 2011
CHAPTER 6
282
Asset Demands
236
286
288
7.3 The Demand for Money 289
The Price Level
239
289
Real Income
290
APPLICATION Waves of Productivity Growth over Time
242
Interest Rates
290
APPLICATION The Rebound in U.S. Productivity Growth
243
The Money Demand Function
6.2 Long-Run Growth: The Solow Model 246
Setup of the Solow Model
291
Other Factors Affecting Money Demand
APPLICATION Bitcoin and Cryptocurrencies
247
292
294
Velocity and the Quantity Theory of Money
The Fundamental Determinants of Long-Run
Living Standards 254
296
7.4 Asset Market Equilibrium 299
Economic Models, Endogenous Variables, and
Exogenous Variables 258
APPLICATION The Growth of Emerging Economies
284
I N TO U C H W I T H D ATA A N D R E S E A R C H :
6.1 The Sources of Economic Growth 237
Growth Accounting
282
Time to Maturity
227
Long-Run Economic Growth
7
Asset Market Equilibrium: An Aggregation
Assumption 299
260
The Asset Market Equilibrium Condition
6.3 Endogenous Growth Theory 262
301
7.5 Money Growth and Inflation 302
6.4 Government Policies to Raise Long-Run
Living Standards 264
APPLICATION Money Growth and Inflation in European Countries
in Transition
303
Policies to Affect the Saving Rate 264
The Inflation Rate and the Nominal Interest Rate 305
Policies to Raise the Rate of Productivity
Growth 265
APPLICATION Inflation Expectations and Linkers
APPLICATION The Changing Distribution of Income
in the United States 266
CHAPTER 7
The Asset Market, Money, and Prices
7.1 What Is Money? 274
IN TOUC H W I TH DATA AND RESEARC H:
Money in a Prisoner-of-War Camp
The Functions of Money
275
276
PART
306
3 Business Cycles and
Macroeconomic Policy
274
CHAPTER 8
Business Cycles
313
8.1 What Is a Business Cycle? 314
8.2 The American Business Cycle: The Historical
Record 316
8
Detailed Contents
The Pre–World War I Period
The Great Depression and World War II
316
Post–World War II U.S. Business Cycles
318
The “Long Boom”
The Great Recession
9.4 General Equilibrium in the Complete IS–LM
Model 365
316
Applying the IS–LM Framework: A Temporary
Adverse Supply Shock 366
319
APPLICATION The Oil Price Shock of 2008
319
Have American Business Cycles Become
Less Severe? 320
APPLICATION Do Economic Expansions Die of Old Age?
323
The Cyclical Behavior of Economic Variables:
Direction and Timing 324
325
Expenditure
327
The Effects of a Monetary Expansion
370
Classical Versus Keynesian Versions of the
IS–LM Model 374
Employment and Unemployment
328
APPLICATION The Job Finding Rate and the Job Loss Rate
329
Average Labor Productivity and the Real Wage 332
Money Growth and Inflation
Financial Variables
Econometric Models and Macroeconomic Forecasts for Monetary
Policy Analysis 368
9.5 Price Adjustment and the Attainment
of General Equilibrium 370
8.3 Business Cycle Facts 324
Production
368
I N TO U C H W I T H D ATA A N D R E S E A R C H :
333
International Aspects of the Business Cycle 335
I N TO U CH WITH DATA AND RESEARC H:
336
8.4 Business Cycle Analysis: A Preview 340
I N TO U CH WITH DATA AND RESEARC H:
The Seasonal Cycle and the Business Cycle
341
Aggregate Demand and Aggregate Supply: A Brief
Introduction 342
CHAPTER 9 The IS–LM/AD–AS Model: A General Frame-
work for Macroeconomic Analysis 350
9.1 The FE Line: Equilibrium in the Labor
Market 351
Factors That Shift the FE Line
351
9.2 The IS Curve: Equilibrium in the Goods
Market 353
Factors That Shift the IS Curve
355
9.3 The LM Curve: Asset Market
Equilibrium 357
376
The Aggregate Supply Curve
378
381
Monetary Neutrality in the AD–AS
Model 381
APPENDIX 9.A Worked-Out Numerical Exercise for Solving
the IS–LM/AD–AS Model 391
Algebraic Versions of the IS–LM/AD–AS
394
APPENDIX 9.B
Model
CHAPTER 10
Classical Business Cycle Analysis:
Market-Clearing Macroeconomics 401
10.1 The Real Business Cycle Theory 402
APPLICATION Calibrating the Business Cycle
405
10.2 Fiscal Policy Shocks in the Classical
Model 411
10.3 Unemployment in the Classical
Model 415
Jobless Recoveries
418
10.4 Money in the Classical Model 420
The Interest Rate and the Price of a Nonmonetary
Asset 358
The Equality of Money Demanded and Money
Supplied 358
Factors That Shift the LM Curve
The Aggregate Demand Curve
Equilibrium in the AD–AS Model
334
Coincident and Leading Indexes
9.6 Aggregate Demand and Aggregate
Supply 375
361
Monetary Policy and the Economy
420
Monetary Nonneutrality and Reverse
Causation 420
The Nonneutrality of Money: Additional
Evidence 421
Detailed Contents
10.5 The Misperceptions Theory and the
Nonneutrality of Money 423
APPENDIX 11.A
Rigidity
Monetary Policy and the Misperceptions
Theory 426
IN TOUC H W I TH DATA AND RESEARC H:
Worked-Out Numerical Exercise for
Solving the Classical AD–AS Model with
Misperceptions 438
An Algebraic Version of the Classical
AD–AS Model with Misperceptions 439
APPENDIX 10.B
Keynesianism: The Macroeconomics
of Wage and Price Rigidity 441
11.1 Real-Wage Rigidity 442
Some Reasons for Real-Wage Rigidity
The Efficiency Wage Model
442
443
Wage Determination in the Efficiency Wage
Model 444
Employment and Unemployment in the Efficiency
Wage Model 445
Efficiency Wages and the FE Line 447
IN TOUC H W I TH DATA AND RESEARC H:
Efficiency Wages
4 Macroeconomic Policy:
Its Environment and Institutions
CHAPTER 12
Unemployment and Inflation
483
12.1 Unemployment and Inflation: Is There a
Trade-Off? 483
The Expectations-Augmented Phillips Curve
The Shifting Phillips Curve
486
489
12.2 Macroeconomic Policy and the Phillips
Curve 494
I N TO U C H W I T H D ATA A N D R E S E A R C H :
The Lucas Critique
495
The Long-Run Phillips Curve
496
12.3 The Problem of Unemployment 497
The Costs of Unemployment
497
The Long-Term Behavior of the Unemployment
Rate 498
501
I N TO U C H W I T H D ATA A N D R E S E A R C H :
Sources of Price Stickiness: Monopolistic
Competition and Menu Costs 449
Indexed Contracts
11.3 Monetary and Fiscal Policy in the Keynesian
Model 455
503
12.5 Fighting Inflation: The Role of Inflationary
Expectations 505
I N TO U C H W I T H D ATA A N D R E S E A R C H :
455
The Sacrifice Ratio
458
507
The U.S. Disinflation of the 1980s and 1990s
11.4 The Keynesian Theory of Business Cycles
and Macroeconomic Stabilization 462
Keynesian Business Cycle Theory
Macroeconomic Stabilization
PART
The Multiplier in the Keynesian Model 481
The Costs of Inflation
11.2 Price Stickiness 449
Fiscal Policy
APPENDIX 11.C
479
12.4 The Problem of Inflation 500
448
Monetary Policy
Worked-Out Numerical Exercise for
Calculating the Multiplier in a Keynesian Model
430
APPENDIX 10.A
CHAPTER 11
Labor Contracts and Nominal-Wage
476
APPENDIX 11.B
Rational Expectations and the Role of Monetary
Policy 428
Are Price Forecasts Rational?
9
462
464
Supply Shocks in the Keynesian Model
467
IN TOUC H W I TH DATA AND RESEARC H:
DSGE Models and the Classical–Keynesian Debate
469
CHAPTER 13
509
Exchange Rates, Business Cycles, and
Macroeconomic Policy in the Open
Economy 515
13.1 Exchange Rates 516
Nominal Exchange Rates
516
10
Detailed Contents
CHAPTER 14
I N TO U CH WITH DATA AND RESEARC H:
Exchange Rates
517
Real Exchange Rates
518
Appreciation and Depreciation
Purchasing Power Parity
14.1 Principles of Money Supply
Determination 568
519
520
Open-Market Operations
I N TO U CH WITH DATA AND RESEARC H:
The Money Multiplier
McParity 521
The Real Exchange Rate and Net Exports
523
APPLICATION The Value of the Hong Kong Dollar and Net
Exports 525
13.2 How Exchange Rates Are Determined:
A Supply-and-Demand Analysis 527
Macroeconomic Determinants of the Exchange Rate
and Net Export Demand 529
13.3 The IS–LM Model for an Open Economy 532
The Open-Economy IS Curve
532
13.4 Macroeconomic Policy in an Open Economy
with Flexible Exchange Rates 538
538
544
Fixed Versus Flexible Exchange Rates
550
550
APPLICATION Is Either the United States or Europe an Optimum
Currency Area?
552
APPLICATION European Monetary Unification
553
Worked-Out Numerical Exercise for the
Open-Economy IS–LM Model 561
APPENDIX 13.A
An Algebraic Version of the Open-Economy
IS–LM Model 564
APPENDIX 13.B
575
14.2 Monetary Control in the United States 580
The Federal Reserve System
580
The Federal Reserve’s Balance Sheet and
Open-Market Operations 581
Reserve Requirements
583
Discount Window Lending
584
585
586
14.3 Setting Monetary Policy Targets 586
Targeting the Federal Funds Rate
586
14.4 Making Monetary Policy in Practice 590
590
Conducting Monetary Policy Under
Uncertainty 592
Monetary Policy and the Fixed Exchange Rate 547
Currency Unions
APPLICATION The Money Multiplier During Severe Financial
Crises
Lags in the Effects of Monetary Policy
541
13.5 Fixed Exchange Rates 544
Fixing the Exchange Rate
571
574
Interest Rate on Reserves
The International Transmission of Business
Cycles 537
A Monetary Contraction
Bank Runs
570
APPLICATION The Lender of Last Resort
Factors That Shift the Open-Economy
IS Curve 535
A Fiscal Expansion
Monetary Policy and the Federal Reserve
System 567
Monetary Policy in the Great Recession
594
APPLICATION Is There Really a Zero Lower Bound?
595
APPLICATION Contagion Effects of the 2008 Global Financial
Crisis
599
14.5 The Conduct of Monetary Policy: Rules
Versus Discretion 600
The Monetarist Case for Rules
601
Rules and Central Bank Credibility
The Taylor Rule
604
Other Ways to Achieve Central Bank
Credibility 607
APPLICATION Inflation Targeting
608
603
Detailed Contents
CHAPTER 15
Government Spending and Its
Financing 614
15.4 Deficits and Inflation 641
The Deficit and the Money Supply
15.1 The Government Budget: Some Facts and
Figures 614
Government Outlays
Taxes
614
616
Deficits and Surpluses
Real Seignorage Collection and
Inflation 643
APPLICATION Quantitative Easing and Inflation
APPENDIX 15.A
The Debt–GDP Ratio
646
653
620
15.2 Government Spending, Taxes, and the
Macroeconomy 622
Fiscal Policy and Aggregate Demand
Government Capital Formation
625
Incentive Effects of Fiscal Policy
625
APPLICATION Supply-Side Economics
622
628
15.3 Government Deficits and Debt 630
The Growth of the Government Debt
630
APPLICATION Social Security in France: How Can It Be
Fixed?
641
632
APPENDIX A
Some Useful Analytical Tools 655
A.1 Functions and Graphs 655
A.2 Slopes of Functions 656
A.3 Elasticities 657
A.4 Functions of Several Variables
A.5 Shifts of a Curve 658
A.6 Exponents 659
A.7 Growth Rate Formulas 659
Problems 660
Glossary 663
The Burden of the Government Debt on Future
Generations 634
Name Index 675
Budget Deficits and National Saving: Ricardian
Equivalence Revisited 635
Subject Index 677
Departures from Ricardian Equivalence 638
IN TOUC H W I TH DATA AND RESEARC H:
Japan’s Fiscal Policy Since the “Lost Decade”
639
658
11
12
Detailed Contents
Summary Tables
Key Diagrams
1
Measures of Aggregate Saving
64
2
Comparing the Benefits and Costs of Changing the
Amount of Labor 102
3
Factors That Shift the Aggregate Labor Demand
Curve 106
4
Factors That Shift the Aggregate Labor Supply
Curve 113
5
Determinants of Desired National Saving
6
Determinants of Desired Investment
7
Equivalent Measures of a Country’s International
Trade and Lending 211
8
The Fundamental Determinants of Long-Run Living
Standards 255
9
Macroeconomic Determinants of the Demand for
Money 293
10
The Cyclical Behavior of Key Macroeconomic
Variables (the Business Cycle Facts) 326
11
Factors That Shift the Full-Employment (FE)
Line 352
12
Factors That Shift the IS Curve
355
13
Factors That Shift the LM Curve
361
14
Factors That Shift the AD Curve
380
15
Terminology for Changes in Exchange Rates 520
16
Determinants of the Exchange Rate (Real or
Nominal) 531
17
Determinants of Net Exports
18
International Factors That Shift the IS Curve 537
19
Factors Affecting the Monetary Base, the Money
Multiplier, and the Money Supply 584
152
165
531
1
The production function
130
2
The labor market
3
The saving–investment diagram
4
National saving and investment in a small open
economy 230
5
National saving and investment in large open
economies 231
6
The IS–LM model
7
The aggregate demand–aggregate supply
model 386
8
The misperceptions version of the AD–AS
model 432
131
178
385
Applying Macroeconomics to the Real World
Applications
The Federal Reserve’s Preferred Inflation Measures 79
The Production Function and Changes of Productivity in
the European Union 91
How Big Is the Gig Economy? 110
Output, Employment, and the Real Wage During Oil
Price Shocks 115
Unemployment During the European Debt Crisis 119
Recent Trends in Labor Supply 125
The Idiosyncrasy of Singapore’s Aggregate
Consumption 143
How Investors Respond to Tax Incentives 153
Measuring the Effects of Taxes on Investment 161
Macroeconomic Consequences of the Boom
and Bust in Stock Prices 173
Current Account Balance and Trade Openness Around
the World 206
The United States as an International Debtor 212
The Impact of Globalization on the U.S. Economy 221
Recent Trends in the U.S. Current Account Deficit 223
The Twin Deficits 227
Waves of Productivity Growth over Time 242
The Rebound in U.S. Productivity Growth 243
The Growth of China 260
The Changing Distribution of Income
in the United States 266
Bitcoin and Cryptocurrencies 294
Money Growth and Inflation in European
Countries in Transition 303
Inflation Expectations and Linkers 306
Do Economic Expansions Die of Old Age? 323
The Job Finding Rate and the Job Loss Rate 329
The Oil Price Shock of 2008 368
Calibrating the Business Cycle 405
The Value of the Hong Kong Dollar and Net
Exports 525
Is Either the United States or Europe an Optimum
Currency Area? 552
European Monetary Unification 553
The Money Multiplier During Severe Financial Crises 575
The Lender of Last Resort 585
Is There Really a Zero Lower Bound? 595
Contagion Effects of the 2008 Global Financial
Crisis 599
Inflation Targeting 608
Supply-Side Economics 628
Social Security in France: How Can It Be Fixed?
Quantitative Easing and Inflation 646
632
In Touch with Data and Research
Developing and Testing an Economic Theory 39
The National Income and Product Accounts in
Malaysia 50
Natural Resources, the Environment, and the National
Income Accounts 55
The Computer Revolution and Chain-Weighted
GDP 74
CPI Inflation Versus Core Inflation 77
Labor Market Data in Kazakhstan 118
Alternative Measures of Unemployment Rate 124
Interest Rates 149
Investment and the Stock Market 166
The Balance of Payments Accounts in Malaysia 205
Money in a Prisoner-of-War Camp 275
Monetary Aggregates in the United Kingdom 278
The Effect of Dollarization on the United States and
Other Nations 279
The Housing Crisis of 2007 to 2011 286
Coincident and Leading Indexes 336
The Seasonal Cycle and the Business Cycle 341
Econometric Models and Macroeconomic Forecasts for
Monetary Policy Analysis 368
Are Price Forecasts Rational? 430
Efficiency Wages 448
DSGE Models and the Classical–Keynesian
Debate 469
The Lucas Critique 495
Indexed Contracts 503
The Sacrifice Ratio 507
Exchange Rates 517
McParity 521
Japan’s Fiscal Policy Since the “Lost Decade” 639
13
Symbols Used in This Book
A
B
BASE
C
CA
CU
DEP
E
FA
G
I
INT
K
M
MC
MPK
MPN
MRPN
N
N
NFP
NM
NX
P
Pe
Psr
R
RES
S
Spvt
Sgovt
T
TR
V
14
productivity
government debt
monetary base
consumption
current account balance
currency held by nonbank public
bank deposits
worker effort
financial account balance
government purchases
investment
net interest payments
capital stock
money supply
marginal cost
marginal product of capital
marginal product of labor
marginal revenue product of labor
employment, labor
full-employment level of
employment
net factor payments
nonmonetary assets
net exports
price level
expected price level
short-run price level
real seignorage revenue
bank reserves
national saving
private saving
government saving
taxes
transfers
velocity
W
Y
Y
a
c
cu
d
e
enom
enom
i
im
k
n
pK
r
rw
ra-t
res
s
t
u
u
uc
w
y
p
pe
hY
t
nominal wage
total income or output
full-employment output
individual wealth or assets
individual consumption;
consumption per worker
currency–deposit ratio
depreciation rate
real exchange rate
nominal exchange rate
official value of nominal
exchange rate
nominal interest rate
nominal interest rate on money
capital–labor ratio
growth rate of labor force
price of capital goods
expected real interest rate
world real interest rate
expected real after-tax interest rate
reserve–deposit ratio
individual saving; saving rate
income tax rate
unemployment rate
natural unemployment rate
user cost of capital
real wage
individual labor income; output
per worker
inflation rate
expected inflation rate
income elasticity of money demand
tax rate on firm revenues
Preface
New to This Edition
Listed below is a summary of the changes made in this textbook for the tenth
edition. See the following section for further details on these changes.
■■ Added material on data revisions (Chapter 2)
■■ New discussion of calculating growth rates (Chapter 2)
■■ New application on the gig economy (Chapter 3)
■■ New application on recent trends in labor supply (Chapter 3)
■■ Expanded discussion of gains and losses from increased international trade
■■
■■
■■
■■
■■
■■
■■
■■
■■
■■
■■
■■
■■
■■
(Chapter 5)
New discussion of trade balances and tariffs (Chapter 5)
New application on waves of productivity growth over time (Chapter 6)
Discussion of causes of productivity slowdown since 2008 (Chapter 6)
New material discussing economic models, endogenous variables, and
exogenous variables (Chapter 6)
New application on the U.S. income distribution and how it has changed over
time (Chapter 6)
New application on Bitcoin and cryptocurrencies (Chapter 7)
New application on whether expansions die of old age (Chapter 7)
Added distinction between different types of lags in fiscal and monetary
policies (Chapters 10, 11, and 14)
Table comparing Keynesian and classical views (Chapter 11)
Added discussion of costs of severe recessions (Chapter 12)
Expanded discussion of Big Mac index to account for differences in real GDP
per capita across countries (Chapter 13)
Impact of United Kingdom withdrawal from European Union (Chapter 13)
Discussion of bank regulation after the recent financial crisis (Chapter 14)
New material on the tax cut of 2017 (Chapter 15)
New and Updated Coverage
What is taught in intermediate macroeconomics courses—and how it is taught—
has changed substantially in recent years. Previous editions of Macroeconomics
played a major role in these developments. The tenth edition provides lively
coverage of a broad spectrum of macroeconomic issues and ideas, including a
variety of new and updated topics:
■■ Long-term economic growth. Because the rate of economic growth plays a central
role in determining living standards, we devote much of Part 2 to growth
15
16
Preface
■■
■■
■■
■■
and related issues. We first discuss factors contributing to growth, such as
productivity (Chapter 3) and rates of saving and investment (Chapter 4); then
in Chapter 6 we turn to a full-fledged analysis of the growth process, using
tools such as growth accounting and the Solow model. Growth-related topics
covered include the factors that determine long-run living standards and the
productivity rebound of the 1990s.
Revised coverage: A discussion of waves of productivity growth over time and
the implications for job displacement, causes of the productivity slowdown
since 2008, and changes in the U.S. income distribution over time (Chapter 6).
International macroeconomic issues. We address the increasing integration of the
world economy in two ways. First, we frequently use cross-country comparisons
and applications that draw on the experiences of nations other than the United
States. For example, in Chapter 6 we compare the long-term economic growth
rates of several countries; in Chapter 7 we compare inflation experiences among
European countries in transition; in Chapter 8 we compare the growth in industrial production in several countries; in Chapter 12 we compare sacrifice ratios
among various countries; and in Chapter 14 we discuss strategies used for making monetary policy around the world. Second, we devote two chapters, 5 and 13,
specifically to international issues. In Chapter 5 we show how the trade balance
is related to a nation’s rates of saving and investment, and then apply this framework to discuss issues such as the U.S. trade deficit and the relationship between
government budget deficits and trade deficits. In Chapter 13 we use a simple
supply–demand framework to examine the determination of exchange rates. The
chapter features innovative material on fixed exchange rates and currency unions,
including an explanation of why a currency may face a speculative run.
Revised coverage: The text includes expanded discussion of the gains and losses
from increased international trade and a new discussion of trade balances and
the impact of tariffs (Chapter 5), as well as a discussion of the United Kingdom’s
withdrawal from the European Union and an expanded discussion of the Big
Mac index to account for differences in real GDP per capita across countries
(Chapter 13).
Business cycles. Our analysis of business cycles begins with facts rather than theories. In Chapter 8 we give a history of U.S. business cycles and then describe
the observed cyclical behavior of a variety of important economic variables
(the “business cycle facts”). In Chapters 9–11 we evaluate alternative classical
and Keynesian theories of the cycle by how well they explain the facts.
New to this edition: The text now includes a discussion of whether economic
expansions die of old age (Chapter 8) and the costs of severe recessions
(Chapter 12).
Monetary and fiscal policy. The effects of macroeconomic policies are considered
in nearly every chapter, in both theory and applications. We present classical
(Chapter 10), Keynesian (Chapter 11), and monetarist (Chapter 14) views on
the appropriate use of policy.
New or substantially revised coverage: We distinguish between different lags in
monetary and fiscal policy (Chapters 10, 11, and 14), add material on DoddFrank and bank regulation in response to the financial crisis (Chapter 14), and
describe the tax cut of 2017 (Chapter 15).
Labor market issues. We pay close attention to issues relating to employment,
unemployment, and real wages. We introduce the basic supply–demand model
Preface
MyLab Economics
17
of the labor market, as well as unemployment, early, in Chapter 3. We discuss
unemployment more extensively in Chapter 12, which covers the inflation–
unemployment trade-off, the costs of unemployment, and government policies for reducing unemployment. Other labor market topics include efficiency
wages (Chapter 11) and the effects of marginal and average tax rate changes on
labor supply (Chapter 15).
New coverage: The text now discusses the gig economy and looks at recent trends
in the labor force participation rate (Chapter 3).
■■ Data use. Throughout the text, we emphasize macroeconomic data and how to
use it and analyze it. Numerous boxes called In Touch with Data and Research
provide descriptions of macroeconomic data. At the end of almost every
chapter, problems in the Working with Macroeconomic Data section give students hands-on experience with manipulating data to help them understand
macroeconomic theory and how it applies to the world.
New coverage: We add material on data revisions and on calculating growth
rates in different ways (Chapter 2).
■■ Modeling. The central theme of the textbook is to develop a complete macroeconomic model that students can use to understand the world’s economies. We
build the model in pieces in Part 2, Chapters 3–7, and put the pieces together
in Part 3, Chapters 8–11.
New material: We add a discussion of economic models, endogenous variables,
and exogenous variables (Chapter 6) and provide a contrast of Keynesian and
classical views (Chapter 11).
■■ Pearson eText: A New Way of Learning. Available through Pearson MyLab Economics, the Pearson eText gives students access to their textbook anytime,
anywhere. In addition to notetaking, highlighting, and bookmarking, the
Pearson eText also offers sharing features. Instructors can share comments or
highlights, and students can add their own, for a tight community of learners
in any class.
Program Introduction
From February 2006 to January 2014, Ben Bernanke was chairman of the Board of
Governors of the Federal Reserve System. Federal ethics rules prohibited him from
working on the sixth, seventh, and eighth editions, but he has returned to make
substantive contributions to the most recent ninth and tenth editions.
In preparing the tenth edition, we viewed our main objective to keep the
book fresh and up-to-date, especially in light of the recent crises in the United States and Europe and the many new tools used by the Federal Reserve
in response to these crises. We have also added new applications, boxes, and
problems throughout and made many revisions of the text to reflect recent events
and developments in the field. In addition, the empirical problems at the end
of most chapters direct students to appropriate data in the FRED database on
the website of the Federal Reserve Bank of St. Louis. Because this database is
frequently updated and is available free of charge, students will develop familiarity and facility with a current data source that they can continue to use after
completing the course.
To improve student results, we recommend pairing the text content with
MyLab Economics, which is the teaching and learning platform that empowers
18
Preface
you to reach every student. By combining trusted author content with digital tools
and a flexible platform, MyLab personalizes the learning experience and will help
your students learn and retain key course concepts while developing skills that
future employers are seeking in their candidates. From Animated Graphs to Realtime Data Analysis Exercises, MyLab Economics helps you teach your course,
your way. Learn more at www.pearson.com/mylab/economics.
Solving Teaching and Learning Challenges
The tenth edition builds on the strengths that underlie the book’s lasting ability
to help solve teaching and learning challenges for instructors and students alike,
including:
■■ Real-world applications. A perennial challenge for instructors is to help students
■■
■■
■■
■■
make active use of the economic ideas developed in the text. The rich variety of applications in this book shows by example how economic concepts can
be put to work in explaining real-world issues such as the housing crisis of
2007–2011 and the financial crisis of 2008, the slowdown and revival in productivity growth, the challenges facing the Social Security system and the Federal
budget, the impact of globalization on the U.S. economy, and new approaches
to making monetary policy that were used in response to the financial crisis in
2008 and the slow recovery since 2009. The tenth edition offers new applications
as well as updates of the best applications and analyses of previous editions.
Broad modern coverage. From its inception, Macroeconomics has responded
to students’ desires to investigate and understand a wider range of macroeconomic issues than is permitted by the course’s traditional emphasis on
short-run fluctuations and stabilization policy. This book provides a modern
treatment of these traditional topics but also gives in-depth coverage of other
important macroeconomic issues such as the determinants of long-run economic growth, the trade balance and financial flows, labor markets, and the
institutional framework of policymaking.
Innovative pedagogy. The tenth edition, like its predecessors, provides a variety of
useful tools to help students study, understand, and retain the material. Features
such as detailed full-color graphs that use color to demonstrate the shifts in
curves, worked numerical problems at the end of selected chapters, real-world
data that is regularly fed in from FRED, and end-of-chapter review and self-test
material help encourage better comprehension and retention of the material.
Reliance on a set of core economic ideas. Although we cover a wide range of topics, we avoid developing a new model or theory for each issue. Instead we
emphasize the broad applicability of a set of core economic ideas (such as the
production function, the trade-off between consuming today and saving for
tomorrow, and supply–demand analysis). Using these core ideas, we build
a theoretical framework that encompasses all the macroeconomic analyses
presented in the book: long-run and short-run, open-economy and closedeconomy, and classical and Keynesian.
A balanced presentation. Macroeconomics is full of controversies, which can
make it difficult to determine the best method of presentation. Sometimes
the controversies overshadow the broad common ground shared by both the
classicals and Keynesians (of the old, new, and neo-varieties). We emphasize
Preface
19
that common ground. First, we pay greater attention to long-run issues
(on which classicals and Keynesians have less disagreement). Second, we
develop the classical and Keynesian analyses of short-run fluctuations within
a single overall framework, in which we show that the two approaches differ
principally in their assumptions about how quickly wages and prices adjust.
Where differences in viewpoint remain—for example, in the search versus
efficiency-wage interpretations of unemployment—we present and critique
both perspectives. This balanced approach exposes students to all the best
ideas in modern macroeconomics. At the same time, an instructor of either
classical or Keynesian inclination can easily base a course on this book.
Developing Employability Skills
For students to succeed in a rapidly changing job market, they should be aware
of their career options and how to go about developing a variety of skills. With
Macroeconomics, tenth edition and MyLab Economics, we focus on developing
these skills in the following ways:
■■ Working with Macroeconomic Data. In nearly every chapter of Macroeconomics,
tenth edition, end-of-chapter questions ask students to download data from
macroeconomic databases and to manipulate the data to illustrate theoretical ideas. These questions give students the opportunity to get hands-on
experience with data while doing a variety of empirical exercises, which
provides experience that employers find valuable. In addition, MyLab
Economics provides Real-Time Data Analysis Exercises, which use current
macro data to help students understand the impact of changes in economic
variables. Real-Time Data Analysis Exercises communicate directly with the
Federal Reserve Bank of St. Louis FRED® site and update automatically as
new data become available.
■■ Applications. Applications in each chapter show students how they can use
theory to understand an important episode or issue. Examples of topics covered in Applications include the production function of the European Union
(Chapter 3), the macroeconomic consequences of the boom and bust in stock
prices (Chapter 4), how investors respond to tax incentives (Chapter 4), the
United States as international debtor (Chapter 5), the recent surge in U.S. productivity growth (Chapter 6), the 2008 oil price shock (Chapter 9), calibrating
the business cycle (Chapter 10), inflation targeting, the lender of last resort,
and whether there is a zero lower bound on nominal interest rates (Chapter
14), and supply-side economics (Chapter 15).
■■ In Touch with Data and Research. These boxes give the reader further insight into
new developments in economic research as well as a guide to keeping abreast
of new developments in the economy. Research topics in these boxes include
discussions of biases in inflation measurement (Chapter 2), alternative measures of unemployment (Chapter 3), the link between capital investment and
the stock market (Chapter 4), the effects of dollarization (Chapter 7), DSGE
models and the classical–Keynesian debate (Chapter 10), the Lucas critique
(Chapter 12), and the impact on the economy of fiscal stimulus packages
(Chapter 15). Keeping abreast of the economy requires an understanding of
what data are available, as well as their strengths and shortcomings. We provide a series of boxes to show where to find key macroeconomic data—such
20
Preface
as labor market data (Chapter 3), balance of payments data (Chapter 5), and
exchange rates (Chapter 13)—and how to interpret them.
A Flexible Organization
The tenth edition maintains the flexible structure of earlier editions. In Part 1
(Chapters 1–2), we introduce the field of macroeconomics and discuss issues of
economic measurement. In Part 2 (Chapters 3–7), we focus on long-run issues, including productivity, saving, investment, the trade balance, growth, and inflation.
We devote Part 3 (Chapters 8–11) to the study of short-run economic fluctuations
and stabilization policy. Finally, in Part 4 (Chapters 12–15), we take a closer look
at issues and institutions of policymaking. Appendix A at the end of the book reviews useful algebraic and graphical tools.
Instructors of intermediate macroeconomics have different preferences as to
course content, and their choices are often constrained by their students’ backgrounds and the length of the term. The structure of Macroeconomics accommodates various needs. In planning how to use the book, instructors might find it
useful to consider the following points:
■■ Core chapters. We recommend that every course include these six chapters:
Chapter 1
Chapter 2
Chapter 3
Chapter 4
Chapter 7
Chapter 9
Introduction to Macroeconomics
The Measurement and Structure of the National Economy
Productivity, Output, and Employment
Consumption, Saving, and Investment
The Asset Market, Money, and Prices
The IS–LM/AD–AS Model: A General Framework for Macroeconomic Analysis
Chapters 1 and 2 provide an introduction to macroeconomics, including national income accounting. The next four chapters in the list make up the analytical core of the book: Chapter 3 examines the labor market, Chapters 3 and 4
together develop the goods market, Chapter 7 discusses the asset market, and
Chapter 9 combines the three markets into a general equilibrium model usable
for short-run analysis (in either a classical or Keynesian mode).
■■ Suggested additions. To a syllabus containing these six chapters, instructors
can add various combinations of the other chapters, depending on the course
focus. The following are some possible choices:
Short-run focus. Instructors who prefer to emphasize short-run issues (business
cycle fluctuations and stabilization policy) may omit Chapters 5 and 6 without
loss of continuity. They could also go directly from Chapters 1 and 2 to Chapters
8 and 9, which introduce business cycles and the IS–LM/AD–AS framework.
Although the presentation in Chapters 8 and 9 is self-contained, it will be helpful for instructors who skip Chapters 3–7 to provide some background and motivation for the various behavioral relationships and equilibrium conditions.
Classical emphasis. For instructors who want to teach the course with a modern classical emphasis, we recommend assigning all the chapters in Part 2. In
Part 3, Chapters 8–10 provide a self-contained presentation of classical business cycle theory. Other material of interest includes the Friedman–Phelps
Preface
21
interpretation of the Phillips curve (Chapter 12), the role of credibility in
monetary policy (Chapter 14), and Ricardian equivalence with multiple generations (Chapter 15).
Keynesian emphasis. Instructors who prefer a Keynesian emphasis may choose
to omit Chapter 10 (classical business cycle analysis). As noted, if a short-run
focus is preferred, Chapter 5 (full-employment analysis of the open economy)
and Chapter 6 (long-run economic growth) may also be omitted without loss
of continuity.
International focus. Chapter 5 discusses saving, investment, and the trade
balance in an open economy with full employment. Chapter 13 considers exchange rate determination and macroeconomic policy in an openeconomy model in which short-run deviations from full employment
are possible. (Chapter 5 is a useful but not essential prerequisite for
Chapter 13.) Both chapters may be omitted for a course focusing on the
domestic economy.
Instructor Teaching Resources
This program comes with the following teaching resources.
Supplements available to instructors at
www.pearsonglobaleditions.com
Features of the Supplement
Instructor’s Manual
authored by Dean Croushore from
University of Richmond
• Chapter-by-chapter summaries
• Teaching outlines
• Suggested topics for class discussion
• Solutions to end-of-chapter questions and
problems in the book
Test Bank
authored by Dean Croushore from
University of Richmond
Over 1,600 multiple-choice, true/false, short- answer,
and graphing questions with these annotations:
• Difficulty level (1 for straight recall, 2 for some
analysis, 3 for complex analysis)
• Type (Multiple-choice and short-answer)
• Topic (The section that covers the term or concept
being tested)
• Learning outcome
Computerized TestGen
TestGen allow instructors to:
• Customize, save, and generate classroom tests
• Edit, add, or delete questions from the Test Item Files
• Analyze test results
• Organize a database of tests and student results
PowerPoints
authored by Dean Croushore from
University of Richmond
Slides include all key text material including graphs,
tables, and equations in the textbook.
These PowerPoints meet accessibility standards for
students with disabilities. Features include, but not
limited to:
• Keyboard and Screen Reader access
• Alternative text for images
• High color contrast between background and
foreground colors
22
Preface
Acknowledgments
A textbook isn’t the lonely venture of its author or coauthors but rather is the joint
project of dozens of skilled and dedicated people. We extend special thanks to
Ashley Bryan, Portfolio Manager and Nancy Freihofer, Content Producer for their
superb work on the tenth edition. For their efforts, care, and craft, we also thank
Allison Campbell, project manager from Integra; Melissa Honig, digital studio
project manager; and Noel Lotz, digital content team lead.
We also appreciate the contributions of the reviewers and colleagues who have
offered valuable comments on succeeding drafts of the book in all ten editions
thus far:
Ugur Aker, Hiram College
John Campbell, Harvard University
Joe Daniels, Marquette University
Krishna Akkina, Kansas State University
Kevin Carey, The World Bank
Edward Day, University of Central Florida
Terence J. Alexander, Iowa State
University
J. Lon Carlson, Illinois State University
Luis De Araujo, Michigan State University
Edward Allen, University of Houston
Wayne Carroll, University of Wisconsin,
Eau Claire
Robert Dekle, University of Southern
California
Richard G. Anderson, Lindenwood
University
Arthur Schiller Casimir, Western New
England University
Greg Delemeester, Marietta College
David Aschauer, Bates College
Stephen Cecchetti, Brandeis University
Martin A. Asher, The Wharton School,
University of Pennsylvania
Paul Chambers, University of Central
Missouri
David Backus, New York University
Anthony Chan, JPMorgan Chase
James Devine, Loyola Marymount
University
Daniel Barbezat, Amherst College
Leo Chan, Utah Valley University
Wael William Diab, Broadcom
Reza Bavafa, University of Southern California
S. Chandrasekhar, Indira Gandhi Institute
of Development Research
Peter Dohlman, International Monetary
Fund
Henry Chappell, American University of
Sharjah
Patrick Dolenc, Keene State College
Parantap Basu, Durham University
Valerie R. Bencivenga, University of Texas
Haskel Benishay, Kellogg Graduate School
of Management, Northwestern University
Jen–Chi Cheng, Wichita State University
Charles A. Bennett, Gannon University
Menzie Chinn, University of Wisconsin
John F. Berdell, DePaul University
K. A. Chopra, State University of New
York, Oneonta
Joydeep Bhattacharya, Iowa State University
David Black, University of Toledo
Robert A. Blewett, Saint Lawrence University
Scott Bloom, Missouri State University
Bruce R. Bolnick, Nathan Associates
Nan-Ting Chou, University of Louisville
Jens Christiansen, Mount Holyoke College
Reid W. Click, George Washington
University
Wouter J. Den Haan, London School of
Economics
Johan Deprez, Texas Tech University
David Doorn, West Chester University of
Pennsylvania
Allan Drazen, University of Maryland
Robert Driskill, Vanderbilt University
Bill Dupor, Federal Reserve Bank of St Louis
Donald H. Dutkowsky, Syracuse
University
James E. Eaton, Bridgewater College
Janice C. Eberly, Northwestern University
Andrew Economopoulos, Ursinus College
David Brasfield, Murray State University
John P. Cochran, Metropolitan State College
of Denver
Viacheslav Breusov, Alliance Bernstein
Juan Carlos Cordoba, Iowa State University
Alejandra Cox Edwards, California State
University, Long Beach
Audie Brewton, Northeastern Illinois
University
Steven R. Cunningham, University of
Connecticut
Martin Eichenbaum, Northwestern
University
Stacey Brook, University of Iowa
Waclaw Dajnowiec, Ryerson University,
Chang School
Carlos G. Elias, Radford University
Bruce R. Dalgaard, Carleton College
Abel Embaye, University of Arkansas
Betty C. Daniel, University at
Albany—SUNY
Sharon J. Erenburg, Eastern Michigan
University
Nancy Burnett, University of Wisconsin,
Oshkosh
Maureen Burton, California Polytechnic
University, Pomona
Kirk Elwood, James Madison University
Preface
Christopher Erickson, New Mexico State
University
James Fackler, University of Kentucky
Steven Fazzari, Washington University
J. Peter Ferderer, Macalester College
Abdollah Ferdowsi, Ferris State
University
David Hammes, University of Hawaii
Michael Klein, Tufts University
Reza Hamzaee, Missouri Western State
University
Peter Klenow, Stanford University
Robert Stanley Herren, North Dakota
University
Douglas Koritz, Buffalo State College
Charles Himmelberg, Goldman Sachs
23
Kenneth Koelln, University of North Texas
Eugene Kroch, Villanova University
Corinne Krupp, University of North
Carolina, Chapel Hill
David W. Findlay, Colby College
Barney F. Hope, California State
University, Chico
Thomas J. Finn, Wayne State University
Fenn Horton, Naval Postgraduate School
Charles C. Fischer, Pittsburg State
University
Christopher House, University of Michigan
E. Philip Howrey, University of Michigan
Krishna B. Kumar, University of Southern
California
John A. Flanders, Central Methodist
College
John Huizinga, University of Chicago
Andre Kurmann, Drexel University
Nayyer Hussain, Rockland Community
College
Maureen Lage, Miami University
Juergen Fleck, Hollins College
Adrian Fleissig, California State University,
Fullerton
Syed Muhammad Hussain, Virginia
Commonwealth University
R. N. Folsom, San Jose State University
Steven Husted, University of Pittsburgh
Sven R. Larson, Skidmore College
Kevin Foster, City University of New York
Matthew Hyle, Winona State University
James Lee, Fort Hays State University
J. E. Fredland, U.S. Naval Academy
Matteo Iacoviello, Boston College
Junsoo Lee, University of Alabama
Selo Imrohoroglu, University of Southern
California
Keith J. Leggett, Davis and Elkins College
James R. Gale, Michigan Technological
University
Edward N. Gamber, Congressional Budget
Office
William T. Ganley, Buffalo State College
Charles B. Garrison, University of Tennessee, Knoxville
Kathie Gilbert, Mississippi State University
Roger Goldberg, Ohio Northern University
Joao Gomes, The Wharton School,
University of Pennsylvania
Kishore Kulkarni, Metropolitan State
College of Denver
John S. Lapp, North Carolina State
University
G. Paul Larson, University of North Dakota
Kenneth Inman, Neustar College
Carol Scotese Lehr, Virginia Commonwealth University
Liana Jacobi, University of Melbourne
John Leyes, Florida International University
Zuzana Janko, San Francisco State
University
Xuan Liu, East Carolina University
Philip N. Jefferson, Swarthmore College
Mary Lorely, Syracuse University
Urban Jermann, The Wharton School,
University of Pennsylvania
Cara Lown, Federal Reserve Bank of
New York
Charles W. Johnston, Baker College
Richard MacDonald, St. Cloud State
University
Ming Chien Lo, University of Virginia
Fred C. Graham, Federal Housing Finance
Agency
Barry E. Jones, Binghamton University
John W. Graham, Rutgers University
James Kahn, Yeshiva University
Stephen A. Greenlaw, University of Mary
Washington
George Karras, University of Illinois,
Chicago
Alan F. Gummerson, Florida International
University
Roger Kaufman, Smith College
Kathryn G. Marshall, Cal Poly San Luis
Obispo
A. R. Gutowsky, California State
University, Sacramento
Adrienne Kearney, University of Maine
Patrick Mason, Florida State University
James Keeler, Kenyon College
Ben Matta, New Mexico State University
David R. Hakes, University of Northern
Iowa
Patrick R. Kelso, West Texas State University
Stephen McCafferty, Ohio State University
Kusum Ketkar, Seton Hall University
J. Harold McClure, Jr., Thomson Reuters
Michael Haliassos, Goethe University
Frankfurt
F. Khan, University of Wisconsin, Parkside
Ken McCormick, University of Northern
Iowa
George J. Hall, Brandeis University
John C. Haltiwanger, University of
Maryland
James Hamilton, University of California,
San Diego
Paul Junk, University of Minnesota
Jinill Kim, Korea University
Robert King, Boston University
Ruby P. Kishan, Texas State University
Thampy Mammen, St. Norbert College
Linda M. Manning, University of Missouri
Michael Marlow, California Polytechnic
State University
John McDermott, University of South
Carolina
Milka S. Kirova, Saint Louis University
Michael B. McElroy, North Carolina State
University
Nobuhiro Kiyotaki, Princeton University
Randolph McGee, University of Kentucky
24
Preface
Michael McPherson, University of North
Texas
Stephen M. Miller, University of Nevada,
Las Vegas
Tim Miller, Denison University
Kerk Phillips, Brigham Young University
Paul Pieper, University of Illinois, Chicago
Andrew J. Policano, University of California, Irvine
Bruce Mizrach, Rutgers University
Richard Pollock, University of Hawaii,
Manoa
Tommaso Monacelli, Bocconi University
Jay B. Prag, Claremont McKenna College
Basil Moore, Wesleyan University
Kojo Quartey, Monroe County Community
College
W. Douglas Morgan, University of
California, Santa Barbara
Vaman Rao, Western Illinois University
Jon Nadenichek, California State
University, Northridge
Neil Raymon, University of Missouri,
Columbia
K. R. Nair, West Virginia Wesleyan College
Colin Read, SUNY Plattsburgh
Emi Nakamura, Columbia University
Michael Redfearn, Citigroup
Aimee Narcisenfeld, The Bullis School
Robert R. Reed, University of Alabama
John Neri, University of Maryland
Charles Revier, Colorado State University
Alexandra Nica, University of Iowa
Patricia Reynolds, International Monetary
Fund
Jeffrey Nugent, University of Southern
California
Maurice Obstfeld, University of California,
Berkeley
Jack Rezelman, State University of New
York, Potsdam
Daria Sevastianova, University of
Southern Indiana
William Seyfried, Rollins College
Tayyeb Shabbir, Wharton School,
University of Pennsylvania
Andrei Shevchenko, Michigan State
University
Virginia Shingleton, Valparaiso
University
Dorothy Siden, Salem State University
Scott Simkins, North Carolina A&T State
University
Tara Sinclair, George Washington
University
Abdol Soofi, University of Wisconsin,
Platteville
Nicholas Souleles, The Wharton School,
University of Pennsylvania
David E. Spencer, Brigham Young
University
Don Stabile, St. Mary’s College
Robert Rich, Federal Reserve Bank of New
York
Richard Startz, University of California,
Santa Barbara
Libby Rittenberg, Colorado College
Gabriel Talmain, University of Glasgow
Helen Roberts, University of Illinois,
Chicago
Bryan Taylor, Global Financial Data
Athanasios Orphanides, Massachusetts
Institute of Technology
Kenneth Rogoff, Harvard University
M. Dek Terrell, Louisiana State University
Rosemary Rossiter, Ohio University
Henry S. Terrell, University of Maryland
Spencer Pack, Connecticut College
Glenn Rudebusch, Federal Reserve Bank of
San Francisco
Willem Thorbecke, George Mason
University
Benjamin Russo, University of North
Carolina, Charlotte
Stephen J. Turnovsky, University of
Washington
Heajin Heidi Ryoo, La Trobe University
Michael Twomey, University of Michigan,
Dearborn
Stephen A. O’Connell, Swarthmore College
William P. O’Dea, State University of New
York, Oneonta
Heather O’Neill, Ursinus College
Walter Park, American University
Randall Parker, East Carolina University
Allen Parkman, University of New Mexico
David Parsley, Vanderbilt University
Susan Washburn Taylor, Millsaps College
James E. Payne, University of New Orleans
Plutarchos Sakellaris, Athens University of
Economics and Business
Rowena Pecchenino, National University
of Ireland Maynooth
Christine Sauer, University of New Mexico
Victor Valcarcel, Texas Tech University
Perihan Saygin, University of Florida
Dietrich Vollrath, University of Houston
Mark Pernecky, St. Olaf College
Edward Schmidt, Randolph–Macon
College
Ronald Warren, University of Georgia
Christopher Phelan, University of Minnesota
Stacey Schreft, Scout Investments
Peter Pedroni, Williams College
Michael Ulan, U.S. Department of State
Chong K. Yip, Chinese University
of Hong Kong
We thank John Haltiwanger of the University of Maryland for supplying
data on job creation and destruction used in Chapter 10 and Shigeru Fujita of
the Federal Reserve Bank of Philadelphia for data on the rates of job loss and job
finding used in Chapter 8. We would also like to thank Robert H. Rasche, former
research director at the Federal Reserve Bank of St. Louis, for assisting us in our
use of the FRED database cited at the end of each chapter in the Working with
Macroeconomic Data exercises.
Preface
25
Finally, we thank Mark Gertler, Rick Mishkin, and Steve Zeldes for valuable
assistance with the first edition. Also, we are grateful to several cohorts of students
at the University of Pennsylvania, Princeton University, and the University of Richmond who—not entirely of their own free will but nonetheless very graciously—
assisted us in the development of this textbook. Last and most important, we thank
our families for their patience and support. We dedicate this book to them.
A. B. A.
Wynnewood, PA
B. S. B.
Washington, DC
D. C.
Richmond, VA
Global Edition Acknowledgments
Pearson would like to thank the following contributors and reviewers for their
valuable work on the Global Edition:
Monal Abdel-Baki, Durban University of
Technology, Egypt
Soo Keong Yong, National University of
Singapore
Glenn Otto, UNSW Australia Business
School
Eliane Haykal, Notre Dame University,
Lebanon
Kwan Wai Ko, The Chinese University of
Hong Kong
Simone Salotti, Oxford Brookes University
Patrick Terroir, Sciences Po, France
Daniela Lenzi-Fagschlunger, Management
Center Innsbruck
Dariya Ainekova, Kimep University
Eddie Cheung Chi Leung, The Open
University of Hong Kong
Zuraidah Ismail, Universiti Teknologi MARA
Ephias Makaudze, University of the Western
Cape
Fatimah Setapa, Universiti Teknologi MARA
Stefan Fink, University of Linz
Tamar Mdivnishvili, National Bank of
Georgia
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Chapter
1
Introduction to
Macroeconomics
1.1 What Macroeconomics Is About
Summarize the
primary issues
addressed in
macroeconomics.
Learning
Objectives
1.1 Summarize
the primary issues
addressed in
macroeconomics.
1.2 Describe
the activities and
objectives of
macroeconomists.
1.3 Differentiate
between the classical
and Keynesian
approaches to
macroeconomics.
Macroeconomics is the study of the structure and performance of national
economies and of the policies that governments use to try to affect economic
performance. The issues that macroeconomists address include the following:
■■ What determines a nation’s long-run economic growth? In 1870, income per
capita was smaller in Norway than in Argentina. But today, income per
capita is four times as high in Norway as in Argentina. Why do some
nations’ economies grow quickly, providing their citizens with rapidly
improving living standards, whereas other nations’ economies are relatively stagnant?
■■ What causes a nation’s economic activity to fluctuate? The 1990s exhibited the
longest period of uninterrupted economic growth in U.S. economic history,
but economic performance in the 2000s was much weaker. A mild recession
in 2001 was followed by a weak recovery that lasted only until December
2007. The recession that began at the end of 2007 was worsened by the financial crisis in 2008, which contributed to a sharp decline in output at the
end of 2008 and in early 2009. Why do economies sometimes experience
sharp short-run fluctuations, lurching between periods of prosperity and
periods of hard times?
■■ What causes unemployment? During the 1930s, one-quarter of the work force
in the United States was unemployed. A decade later, during World War II,
less than 2% of the work force was unemployed. Why does unemployment
sometimes reach very high levels? Why, even during times of relative prosperity, is a significant fraction of the work force unemployed?
■■ What causes prices to rise? The rate of inflation in the United States crept
steadily upward during the 1970s, and exceeded 10% per year in the early
1980s, before dropping to less than 4% per year in the mid-1980s and dropping even further to less than 2% per year in the late 1990s. Germany’s
inflation experience has been much more extreme: Although Germany
has earned a reputation for low inflation in recent decades, following its
defeat in World War I, Germany experienced an 18-month period (July
1922–December 1923) during which prices rose by a factor of several
billion! What causes inflation, and what can be done about it?
27
28
PART 1 | INTRODUCTION
■■ How does being part of a global economic system affect nations’ economies? In the late
1990s, the U.S. economy was the engine of worldwide economic growth. From
2007 to 2009, when the U.S. economy fell into a deep decline, most of the rest
of the world followed. How do economic links among nations, such as international trade and borrowing, affect the performance of individual economies
and the world economy as a whole?
■■ Can government policies be used to improve a nation’s economic performance? In the
1980s and 1990s, the U.S. economy’s output, unemployment rate, and inflation
rate fluctuated much less than in the 1960s and 1970s. Some economists credit
good government policy for the improvement in economic performance. In the
financial crisis of 2008, the Federal Reserve and the federal government used
extraordinary measures to keep banks and other financial institutions from failing. But some economists criticized these measures for going too far in trying
to stabilize the economy, at the expense of creating incentives for increased risk
taking by financial firms. Other economists criticized the Federal Reserve for
not going far enough because the unemployment rate remained persistently
high for years after the end of the recession in 2009. How should economic
policy be conducted to keep the economy as prosperous and stable as possible?
Macroeconomics seeks to offer answers to such questions, which are of great
practical importance and are constantly debated by politicians, the press, and the
public. In the rest of this section, we consider these key macroeconomic issues in
more detail.
Long-Run Economic Growth
If you have ever traveled in a developing country, you could not help but observe
the difference in living standards relative to those of countries such as the United
States. The problems of inadequate food, shelter, and health care experienced by the
poorest citizens of rich nations often represent the average situation for the people
of a developing country. From a macroeconomic perspective, the difference between
rich nations and developing nations may be summarized by saying that rich nations
have at some point in their history experienced extended periods of rapid economic
growth but that the poorer nations either have never experienced sustained growth
or have had periods of growth offset by periods of economic decline.
Figure 1.1 summarizes the growth in output of the U.S. economy since 1869.1
The record is an impressive one: Over the past 148 years, the annual output of U.S.
goods and services has increased by more than 150 times. The performance of the
U.S. economy is not unique, however; other industrial nations have had similar, and
in some cases higher, rates of growth over the same period of time. This massive increase in the output of industrial economies is one of the central facts of modern history and has had enormous political, military, social, and even cultural implications.
In part, the long-term growth of the U.S. economy is the result of a rising population, which has meant a steady increase in the number of available workers.
But another significant factor is the increase in the amount of output that can be
1
Output is measured in Fig. 1.1 by two very similar concepts, real gross national product (real GNP)
prior to 1929 and real gross domestic product (real GDP) since 1929, both of which measure the
inflation-adjusted amount of production in each year. We discuss the measurement of output in detail
in Chapter 2.
CHAPTER 1 | Introduction to Macroeconomics
29
Output of the U.S.
economy, 1869–2017
In this graph the output
of the U.S. economy is
measured by real gross
domestic product (real
GDP) for the period
1929–2017 and by real
gross national product
(real GNP) for the period
prior to 1929, with goods
and services valued at
their 2009 prices in both
cases (see Chapter 2).
Note the strong upward
trend in output over
time, as well as sharp
fluctuations during the
Great Depression
(1929–1940), World War II
(1941–1945), and the
recessions of 1973–1975,
1981–1982, 1990–1991,
2001, and 2007–2009.
Sources: Real GNP 1869–1928
from Christina D. Romer,
“The Prewar Business Cycle
Reconsidered: New Estimates
of Gross National Product,
1869–1908,” Journal of Political
Economy, 97, 1 (February 1989),
pp. 22–23; real GDP 1929
onward from FRED database,
Federal Reserve Bank of St.
Louis, fred.stlouisfed.org/series/
GDPCA. Data from Romer
were rescaled to 2009 prices.
Real output
(trillions of [chained] 2012 dollars)
FIGURE 1.1
20
18
2001
recession
16
1990–1991
recession
14
1981–1982
recession
12
1973–1975
recession
10
8
6
4
Great Depression
(1929–1940)
World War I
(1917–1918)
World War II
(1941–1945)
2007–2009
recession
REAL
OUTPUT
2
0
1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Year
produced with a given amount of labor. The amount of output produced per unit
of labor input—for example, per worker or per hour of work—is called average
labor productivity. Figure 1.2 shows how average labor productivity, defined in
this case as output per employed worker, has changed since 1900. In 2017, the
average U.S. worker produced more than seven times as much output as the average worker at the beginning of the twentieth century, despite working fewer
hours over the course of the year. Because today’s typical worker is so much more
productive, Americans enjoy a significantly higher standard of living than would
have been possible a century ago.
Although the long-term record of productivity growth in the U.S. economy is
excellent, productivity growth varies significantly over time. Output per worker
grew about 2.6% per year from 1949 to 1973, but only 1.1% per year from 1973 to
1995. More recently, from 1995 to 2007, output per worker increased 1.9% per year,
but grew only 1.0% per year from 2007 to 2017.
Because the rates of growth of output and, particularly, of output per worker ultimately determine whether a nation will be rich or poor, understanding what determines growth is one of the most important goals of macroeconomics. Unfortunately,
explaining why economies grow is not easy. Why, for example, did resource-poor
Japan and Korea experience growth rates that transformed them in a generation
or two from war-torn nations into industrial powers, whereas several resource-rich
nations of Latin America have had erratic or even negative growth in recent decades? Although macroeconomists have nothing close to a complete answer to the
question of what determines rates of economic growth, they do have some ideas to
offer. For example, as we discuss in some detail in this book, most macroeconomists
believe that rates of saving and investment are important for growth. Another key
determinant of growth we discuss is the rate at which technological change and
other factors help increase the productivity of machines and workers.
30
PART 1 | INTRODUCTION
FIGURE 1.2
Real output per employed worker
(thousands of [chained] 2012 dollars per worker)
Average labor productivity
in the United States,
1900–2017
Average labor productivity (output per employed
worker) has risen over
time, with a peak during
World War II reflecting increased wartime
production. Productivity
growth was particularly
strong in the 1950s and
1960s, slowed in the
1970s, and picked up
again in the mid-1990s.
For the calculation of
productivity, output is
measured as in Fig. 1.1.
Sources: Employment in thousands of workers 14 and older
for 1900–1947 from Historical
Statistics of the United States,
Colonial Times to 1970, p. 126;
workers 16 and older for 1948
onward from FRED database,
Federal Reserve Bank of St.
Louis, fred.stlouisfed.org/series/
CE16OV. Average labor productivity is output divided by
employment, where output is
from Fig. 1.1.
120
100
80
World War II
60
Great
Depression
40
1990s
tech boom
1970s
productivity slowdown
1950s–1960s
productivity speedup
20
AVERAGE LABOR
PRODUCTIVITY
0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Year
Business Cycles
If you look at the history of U.S. output in Fig. 1.1, you will notice that the growth
of output isn’t always smooth but has hills and valleys. Most striking is the period between 1929 and 1945, which spans the Great Depression and World War II.
During the 1929–1933 economic collapse that marked the first major phase of the
Great Depression, the output of the U.S. economy fell by nearly 30%. Over the period 1939–1944, as the United States entered World War II and expanded production of armaments, output nearly doubled. No fluctuations in U.S. output since
1945 have been as severe as those of the 1929–1945 period. However, during the
postwar era there have been periods of unusually rapid economic growth, such
as during the 1960s and 1990s, and times during which output actually declined
from one year to the next, as in 1973–1975, 1981–1982, 1990–1991, and 2007–2009.
Macroeconomists use the term business cycle to describe short-run, but sometimes sharp, contractions and expansions in economic activity.2 The downward
phase of a business cycle, during which national output may be falling or perhaps growing only very slowly, is called a recession. Even when they are relatively
mild, recessions mean hard economic times for many people. Recessions are also a
major political concern because almost every politician wants to be reelected and
the chances of reelection are better if the nation’s economy is expanding rather
than contracting. Macroeconomists put a lot of effort into trying to figure out what
causes business cycles and deciding what can or should be done about them. In
this book, we describe a variety of features of business cycles, compare alternative explanations for cyclical fluctuations, and evaluate the policy options that are
available for affecting the course of the cycle.
2
A more exact definition is given in Chapter 8. Business cycles do not include fluctuations lasting only
a few months, such as the increase in activity that occurs around Christmas.
CHAPTER 1 | Introduction to Macroeconomics
31
FIGURE 1.3
Unemployment
(percent of civilian labor force)
The U.S. unemployment
rate, 1890–2017
The figure shows the
percentage of the civilian
labor force (excluding
people in the military)
that was unemployed
in each year since 1890.
Unemployment peaked
during the depression
of the 1890s and the
Great Depression of
the 1930s, and reached
low points in 1920 and
during World War II.
Since World War II, the
highest unemployment
rates occurred during the
1981–1982 and 2007–2009
recessions.
Sources: Civilian unemployment rate (people aged 14 and
older until 1947, aged 16 and
older after 1947) for 1890–1947
from Historical Statistics of the
United States, Colonial Times to
1970, p. 135; for 1948 onward
from FRED database, Federal
Reserve Bank of St. Louis, fred.
stlouisfed.org/series/UNRATE.
30
Great
Depression
25
1890s
Depression
20
15
10
UNEMPLOYMENT
RATE
1990−1991
recession
1981−1982
recession
2007−2009
1973−1975
recession
recession
World War II
2001
recession
5
0
1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Year
Unemployment
One important aspect of recessions is that they usually are accompanied by an increase in unemployment, or the number of people who are available for work and
are actively seeking work but cannot find jobs. Along with growth and business
cycles, the problem of unemployment is a third major issue in macroeconomics.
The best-known measure of unemployment is the unemployment rate, which is
the number of unemployed divided by the total labor force (the number of people
either working or seeking work). Figure 1.3 shows the unemployment rate in the
United States over the past century and a quarter. The highest and most prolonged
period of unemployment occurred during the Great Depression of the 1930s. In 1933,
the unemployment rate was 24.9%, indicating that about one of every four potential
workers was unable to find a job. In contrast, the tremendous increase in economic
activity that occurred during World War II significantly reduced unemployment. In
1944, at the peak of the wartime boom, the unemployment rate was 1.2%.
Recessions have led to significant increases in unemployment in the postwar
period. For example, during the 1981–1982 recession the U.S. unemployment rate
reached 10.8% and during the 2007–2009 recession it rose to 10.0%.3 Even during periods of economic expansion, however, the unemployment rate remains well above
zero, as you can see from Fig. 1.3. In 2000, after nine years of economic growth with
no recession, the unemployment rate was still about 4%. Why the unemployment
rate can remain fairly high even when the economy as a whole is doing well is another important question in macroeconomics.
3
The unemployment rate was 10.8% in November and December 1982. The unemployment rate plotted in Fig. 1.3 is not this high because the graph only shows annual data—the average unemployment
rate over the 12 months of each year—which was 9.7% in 1982.
32
PART 1 | INTRODUCTION
FIGURE 1.4
Prior to World War II, the
average level of prices
faced by consumers
remained relatively flat,
with periods of inflation
(rising prices) offset by
periods of deflation (falling prices). Since World
War II, however, prices
have risen more than
tenfold. In the figure, the
average level of prices
is measured by the consumer price index, or
CPI (see Chapter 2). The
CPI measures the cost
of a fixed set, or basket,
of consumer goods and
services relative to the
cost of the same goods
and services in a base
period—in this case,
1982–1984. Thus a CPI of
245.1 in 2017 means that
a basket of consumer
goods and services that
cost $100 in 1982–1984
would cost $245.10 in
2017.
Sources: Consumer price index,
1800–1946 (1967 = 100) from
Historical Statistics of the United
States, Colonial Times to 1970,
pp. 210–211; 1947 onward
(1982–1984 = 100) from FRED
database, Federal Reserve
Bank of St. Louis, fred.stlouisfed.
org/series/CPIAUCSL. Data
prior to 1947 were rescaled to a
base with 1982–1984 = 100.
Consumer price index
(1982–1984 = 100)
Consumer prices in the
United States, 1800–2017
300
CONSUMER
PRICE INDEX
250
200
Post–World
War II
inflation
150
100
50
World War I
War of 1812
Civil War
inflation
inflation
inflation
(1917–1918)
(1812–1814)
Postwar (1861–1865)
deflation
Postwar
deflation
0
1800
1820
1840
1860
1880
1900
1920
Deflation
of Great
Depression
(1929–1933)
1940
1960
1980
2000
Year
Inflation
When the prices of most goods and services are rising over time, the economy is said
to be experiencing inflation. Figure 1.4 shows a measure of the average level of prices
faced by consumers in the United States over the past two centuries.4 Note that prior to
World War II inflation usually occurred only during wartime, such as during the War
of 1812, the Civil War, and World War I. These wartime periods of inflation were followed by periods of deflation, during which the prices of most goods and services fell.
The result of these offsetting periods of inflation and deflation was that, over the long
run, the level of prices was fairly constant. For example, prices at the end of World War
I (1918) stood at about the same level as in 1800, more than a century earlier.
The last significant deflation in the United States occurred during 1929–1933,
the initial phase of the Great Depression. Since then, inflation, without offsetting
deflation, has become the normal state of affairs, although inflation was fairly low
in the 1990s and 2000s. Figure 1.4 shows that consumer prices have risen significantly since World War II, with the measure of prices shown increasing tenfold.
The percentage increase in the average level of prices over some period, often
a year, is called the inflation rate. If the inflation rate in consumer prices is 10%
per year, for example, then on average the prices of items that consumers buy are
rising by 10% per year. Rates of inflation may vary dramatically both over time
and by country, from 1 or 2 percent per year in low-inflation countries (such as
Switzerland) to 1000% per year or more in countries (such as a number of the former Soviet republics in the early 1990s) that are experiencing hyperinflations, or
4
This measure is called the consumer price index, or CPI, which is discussed in Chapter 2.
Conceptually, the CPI is intended to measure the cost of buying a certain fixed set, or “basket,” of
consumer goods and services. However, the construction of a consumer price index over a period
as long as two centuries involves many compromises. For instance, the basket of goods and services
priced by the CPI is not literally the same over the entire period shown in Fig. 1.4 but is changed from
time to time to reflect the different mix of consumer goods and services available at different times.
CHAPTER 1 | Introduction to Macroeconomics
33
extreme inflations. When the inflation rate reaches an extremely high level, with
prices changing daily or hourly, the economy tends to function poorly. High inflation also means that the purchasing power of money erodes quickly. This situation
forces people to scramble to spend their money almost as soon as they receive it.
The International Economy
Today every major economy is an open economy, or one that has extensive
trading and financial relationships with other national economies. (In contrast,
a closed economy doesn’t interact economically with the rest of the world.)
Macroeconomists study patterns of international trade and borrowing to understand better the links among national economies. For example, an important topic
in macroeconomics is how international trade and borrowing relationships can
help transmit business cycles from country to country.
Another issue for which international considerations are central is trade imbalances. Figure 1.5 shows the historical behavior of the imports and exports of
U.S. exports and imports,
1869–2017
The figure shows U.S.
exports (black) and U.S.
imports (red), each expressed as a percentage
of total output. Exports
and imports need not
be equal in each year:
U.S. exports exceeded
imports (shaded gray)
during much of the
twentieth century.
During the 1980s, 1990s,
and 2000s, however, U.S.
exports were smaller
than U.S. imports
(shaded pink).
Sources: Imports and exports of
goods and services: 1869–1959
from Historical Statistics of the
United States, Colonial Times
to 1970, pp. 864–865; 1960
onward from International
Transactions Accounts, U.S.
Bureau of Economic Analysis,
bea.gov/iTable/index_ita.cfm,
Table 1.1; nominal output:
1869–1928 from Christina D.
Romer, “The Prewar Business
Cycle Reconsidered: New
Estimates of Gross National
Product, 1869–1908,” Journal
of Political Economy, 97, 1
(February 1989), pp. 22–23;
1929 onward from FRED
database, fred.stlouisfed.org/
series/GDPA.
Exports and imports
(percent of total output)
FIGURE 1.5
25
Trade deficits
of the 1980s, 1990s,
and 2000s
20
World War I
World War II
15
EXPORTS
10
5
IMPORTS
0
1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Year
34
PART 1 | INTRODUCTION
goods and services by the United States. U.S. imports are goods and services
produced abroad and purchased by people in the United States; U.S. exports
are goods and services produced in the United States and sold to people in
other countries. To give you a sense of the relative importance of international
trade, Fig. 1.5 expresses exports and imports as percentages of total U.S. output. Currently, both exports and imports are larger fractions of U.S. output than
they were during the 1950s and 1960s, reflecting both the recovery of trade from
the disruptions of the Great Depression and World War II and the trend toward
greater economic interdependence among nations. Note, though, that a century
ago exports and imports already were important relative to the size of the overall economy.
Figure 1.5 demonstrates that exports and imports need not be equal in each
year. For example, following World War I and World War II, U.S. exports outstripped U.S. imports because the country was sending large quantities of supplies to countries whose economies had been damaged by war. When exports
exceed imports, a trade surplus exists. In the 1980s, however, U.S. exports declined
sharply relative to imports, a situation that has persisted through the 1990s, 2000s,
and into the 2010s, as you can see from Fig. 1.5. This recent excess of imports over
exports, or trade deficit, has received considerable attention from policymakers
and the news media. What causes these trade imbalances? Are they bad for the
U.S. economy or for the economies of this country’s trading partners? These are
among the questions that macroeconomists try to answer.
Macroeconomic Policy
A nation’s economic performance depends on many factors, including its natural
and human resources, its capital stock (buildings, machines, software, and intellectual property), its technology, and the economic choices made by its citizens,
both individually and collectively. Another extremely important factor affecting economic performance is the set of macroeconomic policies pursued by the
government.
Macroeconomic policies affect the performance of the economy as a whole.
The two major types of macroeconomic policies are fiscal policy and monetary
policy. Fiscal policy, which is determined at the national, state, and local levels,
concerns government spending and taxation. Monetary policy determines the
rate of growth of the nation’s money supply and is under the control of a government institution known as the central bank. In the United States, the central bank
is the Federal Reserve System, or the Fed.
One of the main macroeconomic policy issues of recent years in the United
States has been in the realm of fiscal policy. Large Federal budget surpluses
emerged in the late 1990s, but these gave way to large Federal budget deficits, averaging 2% of gross domestic product (GDP) from 2001 to 2008, and more than
8% of GDP from 2009 to 2011. The recent behavior of the Federal budget is put
into a long-term perspective in Figure 1.6, which presents data on Federal government spending and tax revenues for the past 149 years.5 Again, so that their
5
Government spending includes both government purchases of goods and services, such as
purchases of military equipment and the salaries of government officials, and government benefits
paid to individuals, such as Social Security payments.
CHAPTER 1 | Introduction to Macroeconomics
35
U.S. Federal government
spending and tax
collections, 1869–2017
U.S. Federal government
spending (red) and U.S.
Federal government tax
collections (black) are
shown as a percentage
of total output. Deficits
(excesses of spending
over tax collections)
are shaded pink, and
surpluses (excesses of
taxes over spending) are
shaded gray. The government sector’s share of
the economy has grown
since World War II. Large
deficits occurred during
the two world wars, the
Great Depression, and
during most of the period since the mid-1970s,
except for 1998–2001,
when the government
ran large surpluses.
Sources: Federal spending and
receipts for 1869–1929 from
Historical Statistics of the United
States, Colonial Times to 1970, p.
1104; nominal output,
1869–1929: same as in
Fig. 1.5; Federal spending
and receipts as percentage
of output, 1930–2017 from
Historical Tables, Budget of the
U.S. Government, Table 1.2,
www.whitehouse.gov/omb/
historical-tables.
Federal government spending and tax collections
(percent of total output)
FIGURE 1.6
45
World War II
40
35
Federal government
deficits of the Federal government
1980s and early deficits of the 2000s
and mid-1990s
and 2010s
30
25
World War I
20
15
GOVERNMENT
SPENDING
Great
Depression
10
5
TAXES
Federal government
surpluses of 1998
to 2001
0
1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Year
importance relative to the economy as a whole is indicated, spending, tax collections,
and government budget deficits and surpluses are expressed as percentages of
total output.
Two obvious features of Fig. 1.6 are the peaks in government spending
and deficits that resulted from military buildups in World War I and World
War II. At its high point during World War II, Federal government spending exceeded 43% of total output. Significant deficits also occurred during the Great
Depression of the 1930s because the government increased its spending on
various programs designed to help the economy, such as government-financed
jobs programs. Also shown clearly is the increase in the size of the government
sector since World War II, an increase reflected in the major upward shift in
government spending and in tax collections relative to national output that occurred in about 1940 as well as the mild upward trend in both variables that has
occurred since then.
The large and persistent Federal budget deficits of the 1980s and early and
mid-1990s were historically unusual in that they occurred during a period of peace
and relative prosperity. The emergence of large Federal deficits in the 1980s coincided with the emergence of large trade deficits (see Fig. 1.5). Indeed, the Federal
budget deficit and the trade deficit have been called the “twin deficits.” Are these
deficits related? If so, what can be done about them? These questions also fall
within the purview of macroeconomics.
The possible link between the government’s budget deficit and the trade imbalance illustrates an important aspect of macroeconomics: Macroeconomic issues and problems are frequently interconnected. For this reason, studying one
macroeconomic question, such as the effects of the government budget deficit, in
isolation generally is not sufficient. Instead, macroeconomists usually study the
economy as a complete system, recognizing that changes in one sector or market
may affect the behavior of the entire economy.
36
PART 1 | INTRODUCTION
Aggregation
Macroeconomics is one of two broad areas within the field of economics; the other
is microeconomics. Macroeconomics and microeconomics have many basic economic ideas and methods in common; the difference between them is the level at
which the economy is studied. Microeconomists focus on individual consumers,
workers, and firms, each of which is too small to have an impact on the national
economy. Macroeconomists ignore the fine distinctions among the many different kinds of goods, firms, and markets that exist in the economy and instead
focus on national totals. For example, in their analyses macroeconomists do not
care whether consumers are buying Microsoft Xboxes or Sony PlayStations, beef
or chicken, Pepsi or Coke. Instead, they add consumer expenditures on all goods
and services to get an overall total called aggregate consumption. The process of
summing individual economic variables to obtain economy-wide totals is called
aggregation. The use of aggregation and the emphasis on aggregate quantities
such as aggregate consumption, aggregate investment, and aggregate output are
the primary factors that distinguish macroeconomics from microeconomics.
1.2 What Macroeconomists Do
Describe the
activities and
objectives of
macroeconomists.
How do macroeconomists use their skills, and what do they do with all the data
they gather and the theories they develop? Besides teaching economics, macroeconomists engage in a wide variety of activities, including forecasting, macroeconomic analysis, basic research, and data development for government, nonprofit
organizations, and private businesses.
Macroeconomic Forecasting
Many people believe that economists spend most of their time trying to forecast the
performance of the economy. In fact, except for a relatively small number of forecasting specialists, forecasting is a minor part of what macroeconomists do. One
reason macroeconomists don’t emphasize forecasting is that on the whole they are
not terribly good at it! Forecasting is difficult not only because our understanding
of how the economy works is imperfect, but also because it is impossible to take
into account all the factors—many of them not strictly economic—that might affect future economic trends. Here are some questions that a forecaster, in trying to
project the course of the economy, might have to try to answer: How will events
abroad affect congressional authorizations for military spending over the next few
years? Will there be a severe drought in agricultural regions, with effects on global
markets for commodities? Will productivity rise as rapidly in the future as it did in
the late 1990s and early 2000s as businesses increasingly adopted computer technology? Because answers to such questions are highly uncertain, macroeconomic
forecasters rarely offer a single prediction. Instead, they usually combine a “most
likely” forecast with “optimistic” and “pessimistic” alternative scenarios.
Does the fact that macroeconomics can’t be used to make highly accurate forecasts of economic activity mean that it is a pointless field of study? Some people
may think so, but that’s really an unreasonable standard. Meteorology is an example of a field in which forecasting is difficult (will it definitely be sunny this weekend?) but in which there is also a lot of useful knowledge (meteorologists helped
CHAPTER 1 | Introduction to Macroeconomics
37
discover the depletion of the earth’s ozone layer and pointed out its dangers).
Similarly, cardiologists usually can’t predict if or when a patient will have a heart
attack—they can only talk about probabilities. Like meteorologists and doctors,
economists deal with a system whose complexity makes gaining a thorough understanding difficult and forecasting the system’s behavior even more difficult.
Rather than predicting what will happen, most macroeconomists are engaged in
analyzing and interpreting events as they happen (macroeconomic analysis) or
in trying to understand the structure of the economy in general (macroeconomic
research).
Macroeconomic Analysis
Macroeconomic analysts monitor the economy and think about the implications
of current economic events. Many analysts are employed in the private sector,
such as in banks or large corporations. Private-sector analysts try to determine
how general economic trends will affect their employers’ financial investments,
their opportunities for expansion, the demand for their products, and so on. Some
private firms specialize in macroeconomic analysis and assist clients on a fee-forservice basis.
The public sector, which includes national and regional governments and
international agencies such as the World Bank and the International Monetary
Fund, also employs many macroeconomic analysts. The main function of publicsector analysts is to assist in policymaking—for example, by writing reports that
assess various macroeconomic problems and by identifying and evaluating possible policy options. Among U.S. policymakers, the officials who set monetary
policy may call on the aid of several hundred Ph.D. economists employed within
the Federal Reserve System, and the President has the advice of the Council of
Economic Advisers and the professional staffs of numerous departments and
agencies. For members of Congress, a frequent source of macroeconomic analysis is the Congressional Budget Office. Economic policymakers also often go
outside the government to seek the advice of macroeconomists from business or
academia.
Macroeconomic Research
Macroeconomic research takes an amazing variety of forms, from abstract
mathematical analysis to psychological experimentation to simulation projects in which computers are used to generate random numbers that represent
the randomness of day-to-day economic activity. Nevertheless, the goal of all
macroeconomic research is to make general statements about how the economy works. The general insights about the economy gained from successful
research form the basis for the analyses of specific economic problems, policies,
or situations.
To see why research is important, imagine that you are an economist with the
International Monetary Fund whose task is to help a small African country control
its high rate of inflation. On what basis can you offer advice? Basically, you should
know what inflation-fighting policies other countries have used in the past, what
the results have been, how the results have depended on the characteristics of
the country employing the policy, and so on. Particularly if the situation you are
analyzing is not identical to any of the previous cases, having some theoretical
38
PART 1 | INTRODUCTION
principles would also help you identify and understand the main factors contributing to that country’s inflation. Analyzing the historical cases and working out
the theoretical principles by yourself from scratch might involve many years’ effort. The value of ongoing research activities is that many of the results and ideas
that you need will already be available in books or professional journals or circulated in unpublished form. Because it forms the basis for activities such as economic analysis and forecasting, macroeconomic research is the engine that pulls
the whole enterprise of macroeconomics behind it.
Macroeconomic research takes place primarily in colleges and universities,
in nonprofit institutions (such as the National Bureau of Economic Research, the
Brookings Institution, and the American Enterprise Institute), and in the public
sector (the government and international agencies). Particularly in the public
sector, the line between economic analysis and macroeconomic research is much
fuzzier than we have drawn it here. The reason is that many economists move
back and forth between analysis of specific problems (such as an African country’s
inflation problem) and more basic macroeconomic research (such as an analysis of
inflation in general).
Economic Theory. How is macroeconomic research carried out? As in many
other fields, macroeconomic research proceeds primarily through the formulation
and testing of theories. An economic theory is a set of ideas about the economy that
has been organized in a logical framework. Most economic theories are developed
in terms of an economic model, which is a simplified description of some aspect
of the economy, usually expressed in mathematical form. Economists evaluate an
economic model or theory by applying four criteria:
1. Are its assumptions reasonable and realistic?
2. Is it understandable and manageable enough to be used in studying real
problems?
3. Does it have implications that can be tested by empirical analysis? That is,
can its implications be evaluated by comparing them with data obtained in
the real world?
4. When the implications and the data are compared, are the implications of the
theory consistent with the data?
For a theory or model—of any type, not just economic—to be useful, the answer
to each of these questions must be “yes.” Unfortunately, though, economists may not
always agree in their evaluation of a particular model, with the result that controversies sometimes persist about the best way to model a given economic situation.
We present a summary of the main steps in developing and testing an economic theory or model in “In Touch with Data and Research: Developing and
Testing an Economic Theory,” p. 39.
Data Development
The collection of economic data is a vital part of macroeconomics, and many economists are involved in the data development process. In the United States as well
as all other major countries, data on thousands of economic variables are collected
and analyzed. We have already presented some important macroeconomic data
CHAPTER 1 | Introduction to Macroeconomics
39
IN TOUCH WITH DATA AND RESEARCH
Developing and Testing an Economic Theory
To illustrate the process of developing and testing an economic theory, suppose
that we want to develop a theory that explains the routes that people take when
they commute from home to work and back. Such a theory would be useful, for
example, to a traffic planner who is concerned about how a proposed housing development will affect traffic patterns. Here are the steps we would take.
Step 1. State the research question.
Example: What determines traffic flows in the city during rush hours?
Step 2. Make provisional assumptions that describe the economic setting and the
behavior of the economic actors. These assumptions should be simple yet capture
the most important aspects of the problem.
Example: The setting is described by the map of the city. The assumption about
behavior is that commuters choose routes that minimize driving time.
Step 3. Work out the implications of the theory.
Example: Use the map of the city to plot a route that minimizes driving time
between home and place of work.
Step 4. Conduct an empirical analysis to compare the implications of the theory
with the data.
Example: Conduct a survey of commuters to identify (1) home locations, (2) work locations, and (3) routes taken to work. Then determine whether the routes predicted
by the model are generally the same as those reported in the commuter survey.
Step 5. Evaluate the results of your comparisons.
If the theory fits the data well: Use the theory to predict what would happen if the
economic setting or economic policies change.
Example: Use the minimum-driving-time assumption to evaluate the traffic effects
of a new housing development by figuring out which routes the residents of the
development are likely to take.
If the theory fits the data poorly: Start from scratch with a new model. Repeat Steps 2–5.
Example: Change the provisional behavioral assumption to the following: Commuters choose the route that minimizes the distance they must drive (not the time
they spend driving).
If the theory fits the data moderately well: Either make do with a partially successful
theory or modify the model with additional assumptions and then repeat Steps 3–5.
Example: A possible modification of the minimum-driving-time assumption is that
commuters will choose more scenic over less scenic routes, if driving time is not
increased by more than a certain number of minutes. To test the model with this
modified assumption, you must determine which routes are more scenic (those
that pass a lake) and which are less scenic (those that pass a dump).
series, such as measures of output and the price level, and we will look at these
and others in more detail in Chapter 2. Macroeconomists use economic data to assess the current state of the economy, make forecasts, analyze policy alternatives,
and test macroeconomic theories.
40
PART 1 | INTRODUCTION
Most economic data are collected and published by the Federal government—
for example, by agencies such as the Bureau of the Census, the Bureau of Labor
Statistics, and the Bureau of Economic Analysis in the United States, and by central banks such as the Federal Reserve. To an increasing degree, however, these
activities also take place in the private sector. For example, marketing firms and
private economic forecasting companies are important collectors, users, and sellers of economic data. In this book, many of the boxes called “In Touch with Data
and Research” describe major macroeconomic data series and tell you how they
are collected and where to find them; other “In Touch with Data and Research”
boxes describe topics and issues in macroeconomic research.
Much of the data collection and preparation process is routine. However,
because providers of data want their numbers to be as useful as possible while
keeping costs down, the organization of major data collection projects is typically
the joint effort of many skilled professionals. Providers of data must decide what
types of data should be collected on the basis of who is expected to use the data
and how. They must take care that measures of economic activity correspond to
abstract concepts (such as “capital” and “labor”) that are suggested by economic
theory. In addition, data providers must guarantee the confidentiality of data that
may reveal information about individual firms and people in the economy. In a
large data-gathering organization such as the Bureau of the Census, each of these
issues is exhaustively analyzed by economists and statisticians before data collection begins.6
1.3 Why Macroeconomists Disagree
Differentiate
between the
classical and
Keynesian
approaches to
macroeconomics.
Over the years, the efforts of thousands of analysts, data collectors, and researchers have greatly enhanced the understanding of macroeconomic phenomena. Yet
no matter what the macroeconomic issue, the news media seemingly can find an
economist to argue either side of it. Why do macroeconomists appear to disagree
so much?7
To a certain extent, the amount of disagreement among macroeconomists is
exaggerated by the tendency of the public and the media to focus on the most
difficult and controversial issues. In addition, the fact that economic policy and
performance are of such broad interest and concern contributes to the intensity of
debate: More than controversies in many other fields, debates in macroeconomics tend to take place in public, rather than in the seminar room or the laboratory.
Although important disagreements among macroeconomists certainly exist, there
also are many areas of substantial agreement in macroeconomics.
We can provide an insight into why macroeconomists disagree by drawing
the important distinction between positive and normative analyses of economic
6
For a readable discussion of issues that face statistical agencies, see Keith Hall, former Commissioner
of the Bureau of Labor Statistics, “The Challenges of Producing Economic Data For the 21st
Century,” testimony before Congress, June 12, 2012, available online at: www.mercatus.org/publication/
challenges-producing-economic-data-21st-century.
7
Not only do macroeconomists often seem to disagree with one another, but they also sometimes are
accused of not being able to agree with themselves. President Harry Truman expressed the frustration
of many policymakers when he said he wanted a one-handed economist—one who wouldn’t always
say, “On the one hand, . . . ; on the other hand. . . .”
CHAPTER 1 | Introduction to Macroeconomics
41
policy. A positive analysis of an economic policy examines the economic consequences of a policy but doesn’t address the question of whether those consequences are desirable. A normative analysis of policy tries to determine whether a
certain policy should be used. For example, if an economist is asked to evaluate the
effects on the economy of a 5% reduction in the income tax, the response involves
a positive analysis. But if asked whether the income tax should be reduced by 5%,
the economist’s response requires a normative analysis. This normative analysis
will involve not only the economist’s objective, scientific understanding of how
the economy works but also personal value judgments—for example, about the
appropriate size of the government sector or the amount of income redistribution
that is desirable.
Economists may agree on the positive analysis of a question yet disagree on
the normative part because of differences in values. Value differences also are
common in other fields: Physicists may be in general agreement about the consequences of a meltdown of a nuclear reactor (a positive analysis). Yet there might
be extensive disagreement among these physicists about whether a new nuclear
power plant should be built (a normative question).
Disagreement may occur on positive issues, however, and these differences
are important in economics. In macroeconomics there always have been many
schools of thought, each with a somewhat different perspective on how the economy works. Examples include monetarism and supply-side economics, both of
which we discuss in this book. However, the most important—and enduring—
disagreements on positive issues in macroeconomics involve the two leading
schools of thought: the classical approach and the Keynesian approach.
Classicals Versus Keynesians
The classical approach and the Keynesian approach are the two major intellectual traditions in macroeconomics. We discuss the differences between the two
approaches briefly here and in much greater detail later in the book.
The Classical Approach. The origins of the classical approach go back more than
two centuries, at least to the famous Scottish economist Adam Smith. In 1776 Smith
published his classic, The Wealth of Nations, in which he proposed the concept of the
“invisible hand.” The idea of the invisible hand is that if there are free markets and
individuals conduct their economic affairs in their own best interests, the overall
economy will work well. As Smith put it, in a market economy, individuals pursuing their own self-interests seem to be led by an invisible hand to maximize the
general welfare of everyone in the economy.
However, we must not overstate what Smith claimed: To say that an invisible
hand is at work does not mean that no one in a market economy will be hungry or
dissatisfied; free markets cannot insulate a nation from the effects of drought, war,
or political instability. Nor does the invisible hand rule out the existence of great
inequalities between the rich and the poor because in Smith’s analysis, he took the
initial distribution of wealth among people as given. Rather, the invisible-hand
idea says that given a country’s resources (natural, human, and technological) and
its initial distribution of wealth, the use of free markets will make people as economically well off as possible.
Validity of the invisible-hand idea depends on a key assumption: The various
markets in the economy, including financial markets, labor markets, and markets
42
PART 1 | INTRODUCTION
for goods and services, must function smoothly and without impediments such as
minimum wages and interest rate ceilings. In particular, wages and prices must
adjust rapidly to equate quantities demanded and supplied. In a market in which
there are no impediments, equating quantities demanded and supplied will bring
the market into equilibrium—a situation in which there is no pressure for wages
or prices to change. In markets where quantity demanded exceeds quantity supplied, prices must rise to bring the market into equilibrium. In markets where
more of a good is available than people want to buy, prices must fall to bring the
market into equilibrium.
Wage and price flexibility is crucial to the invisible-hand idea because in a
free-market system, changes in wages and prices are the signals that coordinate
the actions of people in the economy. To illustrate, suppose that war abroad
disrupts oil imports. This drop in supply will drive up the price of oil. A higher
oil price will make it profitable for domestic oil suppliers to pump more oil and
to drill more wells. The higher price will also induce domestic consumers to
conserve oil and to switch to alternative sources of energy. Increased demand
for alternative energy sources will raise their prices and stimulate their production, and so on. Thus, in the absence of impediments such as government price
controls, the adjustment of prices helps the free-market economy respond in a
constructive and coordinated way to the initial disruption of supplies.
The classical approach to macroeconomics builds on Smith’s basic assumptions that people pursue their own economic self-interests and that prices adjust
reasonably quickly to achieve equilibrium in all markets. With these two assumptions as a basis, followers of the classical approach attempt to construct models
of the macroeconomy that are consistent with the data and that can be used to
answer the questions raised at the beginning of this chapter.
The use of the classical approach carries with it some strong policy implications.
Because the classical assumptions imply that the invisible hand works well, classical
economists often argue (as a normative proposition) that the government should
have, at most, a limited role in the economy. As a positive proposition, classical economists also often argue that government policies will be ineffective or counterproductive at achieving their stated goals. Thus, for example, most classicals believe
that the government should not try actively to eliminate business cycles.
The Keynesian Approach. Compared with the classical approach, the Keynesian
approach is relatively recent. The book that introduced it, The General Theory of
Employment, Interest, and Money by British economist John Maynard Keynes, appeared in 1936—160 years after Adam Smith’s The Wealth of Nations. In 1936 the
world was suffering through the Great Depression: Unprecedentedly high rates of
unemployment had afflicted most of the world’s economies for years, and the invisible hand of free markets seemed completely ineffective. From the viewpoint of
1936, the classical theory appeared to be seriously inconsistent with the data, creating a need for a new macroeconomic theory. Keynes provided this theory.
In his book, Keynes offered an explanation of persistently high unemployment.8 He based this explanation on an assumption about wage and price adjustment that was fundamentally different from the classical assumption. Instead of
8
Actually, Keynes presented a number of explanations of unemployment in his book, and debate
continues about “what Keynes really meant.” Our interpretation of what Keynes meant is the one
adopted by his major followers.
CHAPTER 1 | Introduction to Macroeconomics
43
assuming that wages and prices adjust rapidly to equate quantities demanded
and supplied in each market, as in the classical tradition, Keynes assumed that
wages and prices adjust slowly. Slow wage and price adjustment meant that quantities demanded might not equal quantities supplied for long periods of time. In
the Keynesian theory, unemployment can persist because wages and prices don’t
adjust to equalize the number of people that firms want to employ with the number of people who want to work.
Keynes’s proposed solution to high unemployment was to have the government increase its purchases of goods and services, thus raising the demand for
output. Keynes argued that this policy would reduce unemployment because, to
meet the higher demands for their products, businesses would have to employ
more workers. In addition, Keynes suggested, the newly hired workers would
have more income to spend, creating another source of demand for output
that would raise employment further. More generally, in contrast to classicals,
Keynesians tend to be skeptical about the invisible hand and thus are more willing to advocate a role for government in improving macroeconomic performance.
The Evolution of the Classical–Keynesian Debate. Because the Great Depression
so strongly shook many economists’ faith in the classical approach, the Keynesian approach dominated macroeconomic theory and policy from World War II until about
1970. At the height of Keynesian influence, economists widely believed that, through
the skillful use of macroeconomic policies, the government could promote economic
growth while avoiding inflation or recession. The main problems of macroeconomics
apparently had been solved, with only some details to be filled in.
However, in the 1970s the United States suffered from both high unemployment and high inflation—called stagflation, or stagnation plus inflation. This experience weakened economists’ and policymakers’ confidence in the traditional
Keynesian approach, much as the Great Depression had undermined the traditional classical approach. In addition, the Keynesian assumption that prices and
wages adjust slowly was criticized as being without sound theoretical foundations. While the Keynesian approach was coming under attack, developments in
economic theory made classical macroeconomics look more interesting and attractive to many economists. Starting in the early 1970s, a modernized classical approach enjoyed a major resurgence among macroeconomic researchers, although
classical macroeconomics did not achieve the dominance that Keynesianism had
enjoyed in the early postwar years.
In the past three decades, advocates of both approaches have reworked them
extensively to repair their weaknesses. Economists working in the classical tradition have improved their explanations of business cycles and unemployment.
Keynesians have worked on the development of sound theoretical foundations
for the slow adjustment of wages and prices, and Keynesian models can now accommodate stagflation. Currently, excellent research is being conducted with both
approaches, and substantial communication and cross-fertilization are occurring
between them.
A Unified Approach to Macroeconomics
In writing this book, we needed a strategy to deal with the fact that there
are two major macroeconomic schools of thought. One strategy would have
been to emphasize one of the two schools of thought and to treat the other
44
PART 1 | INTRODUCTION
only briefly. The problem with that strategy is that it would not expose you
to the full range of ideas and insights that compose modern macroeconomics. Alternatively, we might have presented the two approaches separately
and then compared and contrasted their conclusions—but you would have
missed the opportunity to explore the large common ground shared by the
two schools of thought.
Our choice was to take an approach to macroeconomics that is as balanced
and unified as possible. In keeping with this unified approach, all our analyses
in this book—whether of economic growth, business cycles, inflation, or policy,
and whether classical or Keynesian in spirit—are based on a single economic model,
or on components or extensions of the basic model. This economic model, which
draws heavily from both the classical and Keynesian traditions, has the following
characteristics.
1. Individuals, firms, and the government interact in goods markets, asset markets, and
labor markets. We have already discussed the need for aggregation in macroeconomics. In the economic model of this book, we follow standard macroeconomic practice and aggregate all the markets in the economy into three major
markets: the market for goods and services, the asset market (in which assets
such as money, stocks, bonds, and real estate are traded), and the labor market. We show how participants in the economy interact in each of these three
markets and how these markets relate to one another and to the economy as
a whole.
2. The model’s macroeconomic analysis is based on the analysis of individual behavior.
Macroeconomic behavior reflects the behaviors of many individuals and firms
interacting in markets. To understand how individuals and firms behave, we
take a “bottom-up” approach and focus our analysis at the level of individual
decision making (as in “In Touch with Data and Research: Developing and
Testing an Economic Theory,” p. 39, where we discuss a model of individual
choices about the route to take to work). The insights gained are then used for
studying the economy as a whole.
The guiding principle in analyzing the behavior of individuals and firms
is the assumption that they try to maximize their own economic satisfaction, given
their needs, desires, opportunities, and resources. Although the founder of classical
economics, Adam Smith, emphasized this assumption, it is generally accepted
by Keynesians and classicals alike, and it is used in virtually all modern macroeconomic research.
3. Although Keynesians reject the classical assumption that wages and prices
quickly adjust in the short run, Keynesians and classicals both agree that, in the
long run, prices and wages fully adjust to achieve equilibrium in the markets for
goods, assets, and labor. Because complete flexibility of wages and prices in the
long run is not controversial, we examine the long-term behavior of the economy (Chapters 3–7) before discussing short-run issues associated with business cycles (Chapters 8–13).
4. The basic model that we present may be used with either the classical assumption
that wages and prices are flexible or the Keynesian assumption that wages and prices
are slow to adjust. This aspect of the model allows us to compare classical and
Keynesian conclusions and policy recommendations within a common theoretical framework.
CHAPTER 1 | Introduction to Macroeconomics
45
C H APT E R SUMMARY
1.
2.
3.
4.
Macroeconomics is the study of the structure and
performance of national economies and the policies
that governments use to try to affect economic performance. Important topics in macroeconomics include
the determinants of long-run economic growth, business cycles, unemployment, inflation, international
trade and lending, and macroeconomic policy.
Because macroeconomics covers the economy as a
whole, macroeconomists ignore the fine distinctions
among different kinds of goods, firms, or markets
and focus on national totals such as aggregate consumption. The process of adding individual economic variables to obtain economywide totals is
called aggregation.
The activities engaged in by macroeconomists include (in addition to teaching) forecasting, macroeconomic analysis, macroeconomic research, and data
development.
The goal of macroeconomic research is to make
general statements about how the economy works.
Macroeconomic research makes progress toward this
goal by developing economic theories and testing
them empirically—that is, by seeing whether they are
consistent with data obtained from the real world. A
useful economic theory is based on reasonable and
realistic assumptions, is easy to use, has implications
that can be tested in the real world, and is consistent
5.
6.
7.
with the data and the observed behavior of the realworld economy.
A positive analysis of an economic policy examines
the economic consequences of the policy but does not
address the question of whether those consequences
are desirable. A normative analysis of a policy tries
to determine whether the policy should be used.
Disagreements among macroeconomists may arise
because of differences in normative conclusions, as
the result of differences in personal values and beliefs, and because of differences in the positive analysis of a policy proposal.
The classical approach to macroeconomics is based
on the assumptions that individuals and firms act in
their own best interests and that wages and prices
adjust quickly to achieve equilibrium in all markets.
Under these assumptions the invisible hand of the
free-market economy works well, with only a limited
scope for government intervention in the economy.
The Keynesian approach to macroeconomics assumes
that wages and prices do not adjust rapidly and thus
the invisible hand may not work well. Keynesians
argue that, because of slow wage and price adjustment, unemployment may remain high for a long
time. Keynesians are usually more inclined than classicals to believe that government intervention in the
economy may help improve economic performance.
K EY T E RMS
aggregation, p. 36
equilibrium, p. 42
normative analysis, p. 41
average labor productivity, p. 29
fiscal policy, p. 34
open economy, p. 33
classical approach, p. 42
inflation, p. 32
positive analysis, p. 41
closed economy, p. 33
invisible hand, p. 41
stagflation, p. 43
deflation, p. 32
Keynesian approach, p. 42
trade deficit, p. 34
economic model, p. 38
macroeconomics, p. 27
trade surplus, p. 34
economic theory, p. 38
monetary policy, p. 34
unemployment, p. 31
empirical analysis, p. 38
RE VIE W QUE ST IONS
1. How have total output and output per worker changed
3. Why is macroeconomic forecasting so difficult? Does
over time in the United States? How have these changes
affected the lives of typical people?
this difficulty mean economics is a worthless field of
study?
2. What is a business cycle? How does the unemploy-
4. What is meant by aggregation? Why is aggregation
ment rate behave over the course of a business cycle?
Does the unemployment rate ever reach zero?
important for macroeconomic analysis?
46
PART 1 | INTRODUCTION
5. Why is wage and price flexibility crucial to the idea
desirability of implementing the policy? Explain your
answer.
6. List the principal professional activities of macro-
9. Compare the classical and Keynesian views on the
of the invisible hand?
economists. What role does macroeconomic research
play in each of these activities?
7. What steps are involved in developing and testing an
economic theory or model? What are the criteria for a
useful theory or model?
8. Might two economists agree about the effects of a
speed of wage and price adjustment. What are the
important consequences of the differences in their
views?
10. What was stagflation, and when did it oc-
cur? How did it change economists’ views about
macroeconomics?
particular economic policy but disagree about the
NUMERIC AL PROBL E MS
MyLab Economics
Visit www.pearson.com/mylab/
economics to complete these exercises online and get
instant feedback. Exercises that update with real-time data
are marked with
.
1. The following table contains data related to Peru’s employment and output for 2001 and 2017.
Employment (millions of
workers)
Output (million tons of cereal
grains)
Unemployed (thousands of
workers)
Prices (index points)
2001
2017
3256
4104
1778
5066
260
328
86.8
151.6
Assuming that Peru produces only cereal grains,
calculate each of the following macroeconomic variables, being sure to give units.
a. Average labor productivity in 2001 and 2017.
b. The growth rate of average labor productivity
between 2001 and 2017.
c. The unemployment rate in 2001 and 2017.
d. The inflation rate between 2001 and 2017.
2. In the FRED database, find data on Germany’s nominal gross domestic product (a measure of total output), nominal exports, and nominal imports for 2000,
2010, and 2017. Next, find the German government’s
current receipts and current expenditures in the
International Monetary Fund (IMF) database for the
same years.
a. For each year, calculate the ratio of exports to
GDP, the ratio of imports to GDP, and the ratio of
the trade imbalance to GDP. Is there any trend apparent in the data?
b. For each year, calculate the ratio of general
government receipts to GDP, the ratio of general
government expenditures to GDP, and the ratio of
the budget deficit to GDP. Is there any trend apparent in the data?
A NA LY TICAL PROBL E MS
1. Can average labor productivity fall even though total
output is rising? Can the unemployment rate rise even
though total output is rising?
2. Prices were much higher in the United States in 2018
than in 1890. Does this fact mean that people were
economically better off in 1890? Why or why not?
3. State a theory for why people vote Republican or
Democratic that potentially could satisfy the criteria
for a useful theory given in the text. How would you
go about testing your theory?
4. Which of the following statements are positive in nature and which are normative?
a. A tax cut will raise interest rates.
b. A reduction in the payroll tax would primarily
benefit poor and middle-class workers.
c. Payroll taxes are too high.
d. A cut in the payroll tax would improve the
President’s popularity ratings.
e. Payroll taxes should not be cut unless capital
gains taxes are also cut.
CHAPTER 1 | Introduction to Macroeconomics
5. In 2002, President George W. Bush imposed tariffs on
certain types of imported steel. He argued that foreign
steel producers were dumping their steel on the U.S.
market at low prices. The foreign steel producers were
able to sell steel cheaply because they received subsidies from their governments. The Bush administration
47
argued that the influx of steel was disrupting the U.S.
economy, harming the domestic steel industry, and causing unemployment among U.S. steel workers. What
might a classical economist say in response to these
claims? Would a Keynesian economist be more or less
sympathetic to the imposition of tariffs? Why?
W O RKING WIT H MACROE C ON O M I C DATA
MyLab Economics
Visit www.pearson.com/mylab/
economics to complete these exercises online and get
instant feedback. Exercises that update with real-time data
are marked with
.
For data to use in these exercises, go to the Federal Reserve
Bank of St. Louis FRED database at fred.stlouisfed.org.
1. a. Calculate the total percentage growth in average
labor productivity in the Japanese economy for the
1980s, 1990s, 2000s, and 2010s. To do this, calculate
average labor productivity in the last year of each
decade beginning in 1980 as real gross domestic
product divided by employed population of the
year. In which decades did average labor productivity grow the most quickly overall? The most
slowly? Express the growth rates for each decade in
annualized terms by using the formula
11 + g2 10 = 1 + G
where g is the annual growth rate, expressed as
a decimal (for example, 0.05 for 5%), and G is the
growth rate for the decade (the change in productivity during the decade divided by the initial productivity level). For each of the four decades, use your
calculated values for G and the formula above to
solve for g.
b. Calculate annual labor productivity growth rates
for each year since 2010 for which data are available. (Define average labor productivity for each
year as real gross domestic product in the last
quarter of the year divided by non-farm payroll
employment in the last month of the year.) How
do the recent growth rates compare with those of
the four previous decades?
2. Graph the behavior of the civilian unemployment
rate in the euro area from 1991 until the present. In
terms of the unemployment rate, when did the euro
area perform the worst? How does the behavior of
the unemployment rate over the 1990s and 2010s
compare to that in the 2000s? Using the graph, explain the consequence of the financial crisis of 2008
on employment in Europe. Does it indicate another
crisis?
3. Using quarterly data on the consumer price index
(CPI), calculate the French inflation rate as the percentage change in the price index of the decades
between the last quarter of 1960 and the last quarter of 2018. Calculate the average annual rate of
inflation for each of these decades. In which period
did France experience the highest inflation rates?
During which period were the prices the most
stable (that is, roughly constant from one year to
the next)?
4. In FRED, find data for GDP for the United States,
Japan, and Mexico. Calculate the annual average
growth rate of GDP for the last five years for which
the data are available. How do the growth rates compare to each other? Which country grew the fastest
over the past five years? Which country grew the
slowest?
5. Plot the FRED data on gross federal debt as a percent
of GDP for Argentina since 1992. In which periods
did Argentina experience prolonged low rate of debt
relative to GDP? In which periods did the ratio of debt
to GDP rise rapidly? Explain the main causes of the
increases in the ratio of debt to GDP, particularly with
respect to the financial crisis in Argentina.
Chapter
2
The Measurement
and Structure of the
National Economy
Learning
Objectives
2.1 Differentiate
among the three
approaches to national
income accounting.
2.2 Explain how GDP
is measured.
2.3 Discuss the
measurement of
aggregate saving and
its relation to wealth.
2.4 Explain the
calculation of real
GDP, price indexes,
and inflation.
2.5 Define real and
nominal interest rates.
Measurement is a crucial part of scientific study. Accurate measurement is
essential for making new discoveries, evaluating competing theories, and
predicting future events or trends. During the first half of the twentieth century, painstaking research by economists such as Nobel Prize winner Simon
Kuznets (the first person to obtain comprehensive measures of national
output) and the team of Arthur Burns and Wesley Mitchell (who performed
detailed measurements of the stages of the business cycle) showed that careful
economic measurement is not only possible but also necessary for any serious
understanding of the economy. Their work, and the efforts of many other
researchers, transformed economics from a field in which scholars relied on
informal observations and broad generalizations to one in which numbers and
statistical analysis play an essential role.
In this chapter we present some of the conceptual and practical issues involved in measuring the macroeconomy. We focus on the national income accounts, a framework for measuring economic activity that is widely used by
economic researchers and analysts. Learning about the national income accounts will familiarize you with some useful economic data. In addition, because the national income accounts are set up in a logical way that mirrors the
structure of the economy, working through these accounts is an important first
step toward understanding how the macroeconomy works. When you finish
this chapter, you will have a clearer understanding of the relationships that
exist among key macroeconomic variables and among the different sectors of
the economy.
2.1 National Income Accounting: The Measurement
of Production, Income, and Expenditure
Differentiate
among the three
approaches to
national income
accounting.
48
The national income accounts are an accounting framework used in measuring current economic activity. Almost all countries have some form of
official national income accounts. (See “In Touch with Data and Research: The
National Income and Product Accounts in Malaysia,” p. 50, for an example of
how official national income accounts work.)
CHAPTER 2 | The Measurement and Structure of the National Economy
49
The national income accounts are based on the idea that the amount of economic activity that occurs during a period of time can be measured in terms of
1. the amount of output produced, excluding output used up in intermediate
stages of production (the product approach);
2. the incomes received by the producers of output (the income approach); and
3. the amount of spending by the ultimate purchasers of output (the expenditure
approach).
Each approach gives a different perspective on the economy. However, the
fundamental principle underlying national income accounting is that, except for
problems such as incomplete or misreported data, all three approaches give identical
measurements of the amount of current economic activity.
We can illustrate why these three approaches are equivalent by an example.
Imagine an economy with only two businesses, called OrangeInc and JuiceInc.
OrangeInc owns and operates orange groves. It sells some of its oranges directly to
the public. It sells the rest of its oranges to JuiceInc, which produces and sells orange
juice. The following table shows the transactions of each business during a year.
OrangeInc Transactions
Wages paid to OrangeInc employees
Taxes paid to government
Revenue received from sale of oranges
Oranges sold to public
Oranges sold to JuiceInc
JuiceInc Transactions
Wages paid to JuiceInc employees
Taxes paid to government
Oranges purchased from OrangeInc
Revenue received from sale of orange juice
$15,000
5,000
35,000
10,000
25,000
$10,000
2,000
25,000
40,000
OrangeInc pays $15,000 per year in wages to workers to pick oranges, and
it sells these oranges for $35,000 ($10,000 worth of oranges to households and
$25,000 worth of oranges to JuiceInc). Thus OrangeInc’s profit before taxes is
+35,000 - +15,000 = +20,000. Because OrangeInc pays taxes of $5000, its after-tax
profit is $15,000.
JuiceInc buys $25,000 of oranges from OrangeInc and pays wages of $10,000
to workers to process the oranges into orange juice. It sells the orange juice for
$40,000, so its profit before taxes is $5000 (+40,000 - +25,000 - +10,000). After
paying taxes of $2000, its after-tax profit is $3000.
What is the total value, measured in dollars, of the economic activity generated by these two businesses? The product approach, income approach, and
expenditure approach are three different ways of arriving at the answer to this
question; all yield the same answer.
1. The product approach measures economic activity by adding the market
values of goods and services produced, excluding any goods and services
used up in intermediate stages of production. This approach makes use of
the value-added concept. The value added of any producer is the value of its
output minus the value of the inputs it purchases from other producers. The
product approach computes economic activity by summing the value added
by all producers.
50
PART 1 | INTRODUCTION
IN TOUCH WITH DATA AND RESEARCH
The National Income and Product Accounts in Malaysia
In Malaysia, the national income accounts are officially compiled, produced, and
disseminated by the National Accounts Statistics Division in the Department of
Statistics Malaysia (DOSM), which is placed under the Prime Minister’s Department.
Established in 1949, the DOSM was then known as Bureau of Statistics and
produced statistics limited to only external trade and estate agriculture. However,
since 1965, its functions have expanded to also include data on the economy and
social areas. Currently, National Accounts Statistics are compiled quarterly and
annually by types of economic activity, while expenditure on GDP is compiled
by type of expenditure at current and constant prices. On the production side,
the data is compiled by industry and on the expenditure side by type of final
consumption. The DOSM also compiles and produces other national accounts
statistics such as national income, national income per capita, consumption, savings, and other economic variables.
In the past, most of the statistical data were disseminated in printed form. Since
1955, the DOSM has compiled and published national accounts statistics at current
prices on an annual basis. The annual national income data are also available in
the economic report published by the Ministry of Finance. This report is released
in conjunction with the National Budget in September every year. In addition, the
Economic Planning Unit (EPU) of the Prime Minister’s Department has a summary
of GDP tables for annual series and quarterly series (from 2000). Reports are released two months after each quarter end and are available through the DOSM and
Bank Negara Malaysia (BNM).
National income data are now being made available and accessible online.
The DOSM home page at www.statistics.gov.my provides access to current and
historical data. Data on National Income Accounts are also disseminated through
other agencies’ websites such as Malaysian National News Agency, EPU, and
BNM and through international statistical agency websites such as the United
Nations Statistics Division and ASEAN Secretariat.
CHAPTER 2 | The Measurement and Structure of the National Economy
51
In our example, OrangeInc produces output worth $35,000 and JuiceInc
produces output worth $40,000. However, measuring overall economic activity by simply adding $35,000 and $40,000 would “double count” the $25,000
of oranges that JuiceInc purchased from OrangeInc and processed into
juice. To avoid this double counting, we sum value added rather than output: Because JuiceInc processed oranges worth $25,000 into a product worth
$40,000, JuiceInc’s value added is $15,000 (+40,000 - +25,000). OrangeInc
doesn’t use any inputs purchased from other businesses, so its value added equals its revenue of $35,000. Thus total value added in the economy is
+35,000 + +15,000 = +50,000.
2. The income approach measures economic activity by adding all income received by producers of output, including wages received by workers and profits received by owners of firms. As you have seen, the (before-tax) profits of
OrangeInc equal its revenues of $35,000 minus its wage costs of $15,000, or
$20,000. The profits of JuiceInc equal its revenues of $40,000 minus the $25,000
the company paid to buy oranges and the $10,000 in wages paid to its employees, or $5000. Adding the $20,000 profit of OrangeInc, the $5000 profit of
JuiceInc, and the $25,000 in wage income received by the employees of the two
companies, we get a total of $50,000, the same amount determined by the product approach.
In this calculation we added the before-tax incomes of workers and firm
owners. Equivalently, we could have added the after-tax incomes of producers of output and the taxes received by the government. Recall that, when
taxes are subtracted, OrangeInc’s after-tax profits are $15,000 and JuiceInc’s
after-tax profits are $3000. Adding the two firms’ after-tax profits of $18,000,
total wage income of $25,000 (we assumed that workers pay no taxes), and
the $7000 in taxes received by the government, we again obtain $50,000 as the
measure of economic activity.
3. Finally, the expenditure approach measures activity by adding the amount
spent by all ultimate users of output. In this example, households are ultimate
users of oranges. JuiceInc is not an ultimate user of oranges because it sells
the oranges (in processed, liquid form) to households. Thus ultimate users
purchase $10,000 of oranges from OrangeInc and $40,000 of orange juice from
JuiceInc for a total of $50,000, the same amount computed in both the product
and the income approaches.1
Why the Three Approaches Are Equivalent
That the product, income, and expenditure approaches all give the same answer is
no accident. The logic of these three approaches is such that they must always give
the same answer.
To see why, first observe that the market value of goods and services produced in a given period is by definition equal to the amount that buyers must
spend to purchase them. JuiceInc’s orange juice has a market value of $40,000
only because that is what people are willing to spend to buy it. The market value
of a good or service and the spending on that good or service are always the
1
In the example, each business also purchases labor services from employees, but because these services are used in production, they aren’t counted as services purchased by ultimate users.
52
PART 1 | INTRODUCTION
same, so the product approach (which measures market values) and the expenditure approach (which measures spending) must give the same measure of economic activity.2
Next, observe that what the seller receives must equal what the buyers spend.
The seller’s receipts in turn equal the total income generated by the economic activity, including the incomes paid to workers and suppliers, taxes paid to the government, and profits (whatever is left over). Thus total expenditure must equal
total income generated, implying that the expenditure and income approaches
must also produce the same answer. Finally, as both product value and income
equal expenditure, they also must be equal.
Because of the equivalence of the three approaches, over any specified time period
total production = total income = total expenditure,
(2.1)
where production, income, and expenditure all are measured in the same units
(for example, in dollars). Equation (2.1) is called the fundamental identity of national income accounting and forms the basis for national income accounting.
(An identity is an equation that is true by definition.) In Section 2.2, we show how
this fundamental identity is used in measuring current economic activity for the
economy as a whole.
2.2 Gross Domestic Product
Explain how GDP is
measured.
The broadest measure of aggregate economic activity, as well as the best-known and
most often used, is gross domestic product, or GDP. As in the example in Section 2.1, a
country’s GDP may be measured by the product approach, the expenditure approach,
or the income approach. Although the three approaches arrive at the same value for
GDP, each views GDP differently. Using all three approaches gives a more complete
picture of an economy’s structure than any single approach could.
The Product Approach to Measuring GDP
The product approach defines a nation’s gross domestic product (GDP) as the
market value of final goods and services newly produced within a nation during
a fixed period of time. In working through the various parts of this definition, we
discuss some practical issues that arise in measuring GDP.
Market Value. Goods and services are counted in GDP at their market values—
that is, at the prices at which they are sold. The advantage of using market values
is that it allows adding the production of different goods and services. Imagine, for
example, that you want to measure the total output of an economy that produces
7 cars and 100 pairs of shoes. Adding the number of cars and the number of pairs
of shoes to get a total output of 107 wouldn’t make much sense because cars and
shoes aren’t of equal economic value. But suppose that each car sells for $20,000
and each pair of shoes sells for $80. Taking these market-determined prices as
measures of relative economic values, you can calculate the value of cars produced
as +140,000 (7 * +20,000) and the value of shoes produced as +8000 (100 * +80).
2
Our explanation implicitly assumes that everything produced is sold. What if a firm produces some
goods that it can’t sell? As we discuss shortly, the national income accounts treat unsold goods as though
they were purchased by the firm from itself; that is, accumulation of unsold goods in inventory is treated
as part of expenditure. Thus expenditure and production remain equal even if some goods remain unsold.
CHAPTER 2 | The Measurement and Structure of the National Economy
53
The total market value of production, or GDP, is $140,000 + $8000 = $148,000.
Using market values to measure production makes sense because it takes into
account differences in the relative economic importance of different goods and
services.
A problem with using market values to measure GDP is that some useful
goods and services are not sold in formal markets. Ideally, GDP should be adjusted upward to reflect the existence of these goods and services. However,
because of the difficulty of obtaining reliable measures, some nonmarket goods
and services simply are ignored in the calculation of GDP. Homemaking and
child-rearing services performed within the family without pay, for example,
are not included in GDP, although homemaking and child care that are provided
for pay (for example, by professional housecleaners or by private day-care centers) are included. Similarly, because the benefits of clean air and water aren’t
bought and sold in markets, actions to reduce pollution or otherwise improve
environmental quality usually are not reflected in GDP (see “In Touch with Data
and Research: Natural Resources, the Environment, and the National Income
Accounts,” p. 55).
Some nonmarket goods and services are partially incorporated in official GDP
measures. An example is activities in the so-called underground economy. The
underground economy includes both legal activities hidden from government record keepers (to avoid payment of taxes or compliance with regulations, for example) and illegal activities such as drug dealing, prostitution, and (in some places)
gambling. Some might argue that activities such as drug dealing are “bads” rather
than “goods” and shouldn’t be included in GDP anyway—although a consistent
application of this argument might rule out many goods and services currently
included in GDP, such as cigarette production. Clearly, though, the services of
a housepainter who is paid in cash to avoid taxes should be included in GDP.
Government statisticians are unable to reliably adjust GDP figures to include estimates of the underground economy’s size, but they do make some adjustments
for underreported income.3
A particularly important component of economic activity that does not pass
through markets is the value of the services provided by government, such as defense, public education, and the building and maintenance of roads and bridges.
The fact that most government services are not sold in markets implies a lack of
market values to use when calculating the government’s contribution to GDP. In
this case, the solution that has been adopted is to value government services at
their cost of production. Thus the contribution of national defense to GDP equals
the government’s cost of providing defense: the salaries of service and civilian
personnel, the costs of building and maintaining weapons and bases, and so on.
Similarly, the contribution of public education to GDP is measured by the cost of
teachers’ salaries, new schools and equipment, and so on.
Newly Produced Goods and Services. As a measure of current economic activity, GDP includes only goods or services that are newly produced within the current period. GDP excludes purchases or sales of goods that were produced in
previous periods. Thus, although the market price paid for a newly constructed
3
Discussion of NIPA adjustments for the underground economy is given in “Taking the Pulse of the
Economy: Measuring GDP” by J. Steven Landefeld, Eugene P. Seskin, and Barbara M. Fraumeni, Journal
of Economic Perspectives 22 (Spring 2008), pp. 193–216. On estimating the size of the underground economy, see Edgar Feige, “Measuring Underground (Unobserved, Non-observed, Unrecorded) Economies
in Transition Countries: Can We Trust GDP?” Journal of Comparative Economics 36 (June 2008), pp. 287–306.
54
PART 1 | INTRODUCTION
house would be included in GDP, the price paid in the sale of a used house is not
counted in GDP. (The value of the used house would have been included in GDP
for the year it was built.) However, the value of the services of the real estate agent
involved in the sale of the used house is part of GDP, because those services are
provided in the current period.
Final Goods and Services. Goods and services produced during a period of time
may be classified as either intermediate goods and services or final goods and services. Intermediate goods and services are those used up in the production of other
goods and services in the same period that they themselves were produced. For example,
flour that is produced and then used to make bread in the same year is an intermediate good. The trucking company that delivers the flour to the bakery provides an
intermediate service.
Final goods and services are those goods and services that are not intermediate. Final goods and services are the end products of a process. For example, bread
produced by the bakery is a final good, and a shopper’s bus ride home from the
bakery is a final service. Because the purpose of economic activity is the production of final goods and services, with intermediate goods being but a step along
the way, only final goods and services are counted in GDP.
Sometimes the distinction between intermediate goods and final goods is subtle. For example, is a new lathe sold to a furniture manufacturer an intermediate
good or a final good? Although the lathe is used to produce other goods, it is not
used up during the year. Hence it is not an intermediate good; it is a final good.
In particular, the lathe is an example of a type of final good called a capital good.
Other more general examples of capital goods include factories, office buildings,
equipment, software, and intellectual property, such as copyrights. A capital good
is a good that is itself produced (which rules out natural resources such as land)
and is used to produce other goods; however, unlike an intermediate good, a
capital good is not used up in the same period that it is produced. The preparers of
the national income accounts decided to classify capital goods as final goods and
thus to include their production in GDP. Their reasoning was that the addition to
productive capacity from new capital goods represents economic activity.
Another subtle distinction between intermediate and final goods arises in
the treatment of inventory investment. Inventories are stocks of unsold finished
goods, goods in process, and raw materials held by firms. Inventory investment
is the amount by which inventories increase during the year.4 For example, suppose that a baker began the year with $1000 worth of flour in her storeroom
and that at the end of the year she is holding $1100 worth of flour. The difference between her beginning and ending stocks, or $100 worth of flour, equals
the baker’s inventory investment during the year. Even though the ultimate
purpose of the baker’s flour is for making bread, her increase in inventory represents production of flour that is not used up during the year.5 As in the case of
capital goods, inventory investment is treated as a final good and thus part of
GDP because increased inventories on hand imply greater productive capacity
in the future.
4
When inventories decline during the year, inventory investment is negative.
Inventory investment is the change in the physical quantity of goods in inventory multiplied by their
price. Changes in the valuation of inventories arising from price changes (capital gains or losses) are
not considered inventory investment.
5
CHAPTER 2 | The Measurement and Structure of the National Economy
55
In the OrangeInc–JuiceInc example, we showed that total economic activity
could be measured by summing the value added (value of output minus value of
purchased inputs) for each producer. The advantage of the value-added technique is
that it automatically includes final goods and excludes intermediate goods from the
measure of total output. If you go back to that example, you will see that, by summing
the value added of the two companies, we obtained a measure of economic activity
that included the value of final sales of the two businesses to the public but excluded
the intermediate goods (unprocessed oranges) sold to JuiceInc by OrangeInc.
GNP Versus GDP. Until 1991, most economists working with U.S. data focused
on a measure of economic activity known as gross national product (GNP) rather
than on GDP. However, in 1991, primarily to conform with national income accounting practices in other major industrialized countries, the Department of
Commerce began to use GDP as its basic measure of economic activity. The difference between GNP and GDP lies in the treatment of output produced by capital and labor working outside their home (domestic) country. Specifically, gross
national product is the market value of final goods and services newly produced
by domestic factors of production during the current period, whereas GDP is production taking place within a country.
IN TOUCH WITH DATA AND RESEARCH
Natural Resources, the Environment, and the National Income Accounts
Much of any country’s economic well-being flows from natural, rather than
human-made, assets—land, rivers and oceans, natural resources (such as oil and
timber), and indeed the air that everyone breathes. Ideally, for the purposes of
economic and environmental planning, the use and misuse of natural resources
and the environment should be appropriately measured in the national income
accounts. Unfortunately, they are not. There are at least two important conceptual
problems with the way the national income accounts currently handle the economic use of natural resources and the environment.
1. Natural resource depletion. When an oil driller pumps oil from an underground field, the value of the oil produced is counted as part of the nation’s GDP;
there is no offsetting deduction to account for the fact that nonrenewable resources
are being depleted. In principle, the draining of the oil field can be thought of as a
type of negative inventory investment because in a sense it reduces the inventory
of oil. If it were included in the national income accounts, this negative inventory
investment would reduce the computed value of GDP.
2. The costs and benefits of pollution control. Imagine that a company has the
following choices: It can produce $100 million worth of output and in the process
pollute the local river by dumping its wastes; alternatively, by using 10% of its
workers to dispose properly of its wastes, it can avoid polluting but will get only
$90 million of output. Under current national income accounting rules, if the firm
chooses to pollute rather than not to pollute, its contribution to GDP will be larger
($100 million rather than $90 million) because the national income accounts attach
no explicit value to a clean river. In an ideal accounting system, the economic costs
(continued)
56
PART 1 | INTRODUCTION
of environmental degradation would be subtracted in the calculation of a firm’s
contribution to output, and activities that improve the environment—because
they provide real economic benefits—would be added to output.
Discussing the national income accounting implications of resource depletion and pollution may seem to trivialize these important problems. Actually, because GDP and related statistics are used frequently in policy analyses, abstract
questions of measurement often may turn out to have significant real effects.
For example, economic development experts have expressed concern that some
poor countries, in attempting to raise measured GDP as quickly as possible, have
done so in part by overexploiting their natural resources and harming the environment. Conceivably, explicitly incorporating “hidden” resource and environmental costs into official measures of economic growth might cause these
policies to be modified. Similarly, in industrialized countries, political debates
about the environment at times have emphasized the impact on conventionally
measured GDP of proposed pollution control measures, rather than their impact
on overall economic welfare. Better accounting for environmental quality might
serve to refocus these debates to the more relevant question of whether, for any
particular environmental proposal, the benefits (economic and noneconomic) exceed the costs.
When U.S. capital and labor—also called factors of production—are used
abroad, they produce output and earn income. This output and income are included in U.S. GNP but not in U.S. GDP because they don’t represent production taking place within the United States. So, for example, the value of roads
built by a U.S. construction company in Saudi Arabia, as measured by the fees
that the construction company receives from the Saudi government, is counted
in U.S. GNP but not in U.S. GDP. Similarly, when foreign capital or labor is used
in the United States, the output produced and the income earned are part of
U.S. GDP (because the production occurs within the United States) but not of
U.S. GNP (they are counted in the foreign country’s GNP instead). For example,
the portion of the value of Japanese cars built in the United States that is attributable to Japanese capital and management counts in Japanese GNP and U.S.
GDP, but not in U.S. GNP.
We define net factor payments from abroad (NFP) to be income paid to domestic factors of production by the rest of the world minus income paid to foreign
factors of production by the domestic economy. Using this concept, we express the
relationship between GDP and GNP as
GDP = GNP - NFP.
(2.2)
For the United States, GDP and GNP give similar measures of economic activity. For example, in 2017 the U.S. GDP was $19,485.4 billion and the U.S. GNP was
$19,729.1 billion, a difference of less than 2%. The distinction between GNP and
GDP is more important for countries such as Egypt and Turkey that have many
citizens working abroad. The reason is that income earned by workers abroad is
part of a country’s GNP but not its GDP.
CHAPTER 2 | The Measurement and Structure of the National Economy
57
The Expenditure Approach to Measuring GDP
A different perspective on the components of GDP is obtained by looking at the
expenditure side of the national income accounts. The expenditure approach measures GDP as total spending on final goods and services produced within a nation
during a specified period of time. Four major categories of spending are added to
get GDP: consumption, investment, government purchases of goods and services,
and net exports of goods and services. In symbols,
Y = GDP = total production (or output)
= total income
= total expenditure;
C = consumption;
I = investment;
G = government purchases of goods and services;
NX = net exports of goods and services.
With these symbols, we express the expenditure approach to measuring GDP as
(2.3)
Y = C + I + G + NX.
TABLE 2.1
Expenditure Approach to Measuring GDP in the United States, 2017
Billions of dollars
Personal consumption expenditures (C)
Percent of GDP
13,321
68.4
1407
7.2
Nondurable goods
2750
14.1
Services
9165
47.0
Consumer durables
Gross private domestic investment (I)
3368
17.3
Business fixed investment
2588
13.3
Nonresidential structures
585
3.0
Equipment
1150
5.9
Intellectual property products
852
4.4
Residential investment
755
3.9
Inventory investment
26
0.1
3374
17.3
1265
6.5
Government purchases of goods and services (G)
Federal
National defense
744
3.8
Nondefense
521
2.7
State and local
2109
10.8
Net exports (NX)
- 578
- 3.0
2350
12.1
Exports
Imports
Total (equals GDP) (Y)
2929
15.0
19,485
100.0
Note: Numbers may not add to totals shown owing to rounding.
Source: Bureau of Economic Analysis website, www.bea.gov, NIPA Table 1.1.5, July 27, 2018.
58
PART 1 | INTRODUCTION
Equation (2.3), like Eq. (2.1), is one of the basic relationships in macroeconomics. Equation (2.3) is called the income–expenditure identity because it states that
income, Y, equals total expenditure, C + I + G + NX. Recent U.S. data for the
four categories of spending, along with some major subcategories, are given in
Table 2.1. As you read the rest of this section, you should look at Table 2.1 to get a
feel for the relative sizes of different components of spending in the U.S. economy.
Consumption. Consumption is spending by domestic households on final goods
and services, including those produced abroad.6 It is the largest component of expenditure, usually accounting for a little more than two-thirds of GDP in the United
States. Consumption expenditures are grouped into three categories:
1. consumer durables, which are long-lived consumer items, such as cars, televisions, furniture, and major appliances (but not houses, which are classified
under investment);
2. nondurable goods, which are shorter-lived items, such as food, clothing, and
fuel; and
3. services, such as education, health care, financial services, and transportation.
Investment. Investment includes both spending for new capital goods, called
fixed investment, and increases in firms’ inventory holdings, called inventory investment. Fixed investment in turn has two major components:
1. business fixed investment, which is spending by businesses on structures (factories, warehouses, and office buildings, for example), equipment (such as
machines, vehicles, computers, and furniture), and intellectual property products (such as software, investment in research and development, and literary,
entertainment, and artistic originals); and
2. residential investment, which is spending on the construction of new houses
and apartment buildings. Houses and apartment buildings are treated as capital goods because they provide a service (shelter) over a long period of time.
Like consumption, investment includes spending on foreign-produced goods.
Fixed investment in the United States is volatile, ranging from about 13% to almost
20% of GDP.
As we have mentioned, increases in inventories are included in investment
spending, regardless of why inventories rose. In particular, if a firm produces
goods that it can’t sell, the resulting rise in inventories counts as investment by
the firm. For the purposes of national income accounting, the firm has, in effect,
purchased the unsold goods from itself. This accounting rule is useful because it
guarantees that production and expenditure will always be equal in the national
income accounts. Anything that is produced must, by definition, either be bought
by a customer or “purchased” by the firm itself.
Government Purchases of Goods and Services. Government purchases
of goods and services, which include any expenditure by the government for a
6
Later, we subtract imports from total expenditures and add exports to calculate total spending on the
goods and services produced by the domestic economy.
CHAPTER 2 | The Measurement and Structure of the National Economy
59
currently produced good or service, foreign or domestic, is the third major component of spending. Government purchases in the United States recently have been
about one-sixth of GDP. Note in Table 2.1 that in the United States the majority of
government purchases are made by state and local governments, not the Federal
government.
Not all the checks written by the government are for purchases of current
goods and services. Transfers, a category that includes government payments for
Social Security and Medicare benefits,7 unemployment insurance, welfare payments, and so on, are payments (primarily to individuals) by the government that
are not made in exchange for current goods or services. As a result, they are excluded from the government purchases category and are not counted in GDP as
calculated by the expenditure approach. Similarly, interest payments on the national debt are not counted as part of government purchases.
Much like the distinction between private-sector consumption and investment, some part of government purchases goes toward current needs (such as
employee salaries) and some is devoted to acquiring capital goods (such as office
buildings). In the U.S. national income and product accounts, government spending on capital goods (buildings, equipment, software, and intellectual property)
is often reported separately from other government purchases. Investment by the
government is fairly sizable—more than $600 billion annually in recent years, or
about one-fifth of the amount invested annually by the private sector. When we
speak of “investment” in the national income accounts, however, we are generally
referring to investment by the private sector, I; for simplicity, we include government investment as part of government purchases of goods and services, G.
Net Exports. Net exports are exports minus imports. As discussed in Chapter 1,
exports are the goods and services produced within a country that are purchased by
foreigners; imports are the goods and services produced abroad that are purchased
by a country’s residents. Net exports are positive if exports are greater than imports
and negative if imports exceed exports.
Exports are added to total spending because they represent spending (by
foreigners) on final goods and services produced in a country.8 Imports are subtracted from total spending because consumption, investment, and government
purchases are defined to include imported goods and services. Subtracting imports ensures that total spending, C + I + G + NX, reflects spending only on
output produced in the country. For example, an increase in imports may mean
that Americans are buying Japanese cars instead of American cars. For fixed total
spending by domestic residents, therefore, an increase in imports lowers spending
on domestic production.
7
Although it might seem that Medicare benefits are a current expenditure by the government and not
a transfer, in the NIPAs the medical expenditure is considered consumption spending by households,
and the government payment to cover the medical expenditure is a transfer payment from the government to the household.
8
Exports include intermediate goods, as well as final goods, that are sold abroad because the remaining process to turn them into final goods will not occur in the United States; hence these intermediate goods will not be “double-counted” in U.S. GDP. Similarly, imports include intermediate goods,
which are subtracted from GDP, so that only the part of the final goods that is produced in the United
States will be counted in GDP.
60
PART 1 | INTRODUCTION
The Income Approach to Measuring GDP
The third and final way to measure GDP is the income approach. It calculates GDP
by adding the incomes received by producers, including profits, and taxes paid
to the government. A key part of the income approach is a concept known as national income. National income is the sum of eight types of income (see Table 2.2
for recent U.S. data).
1. Compensation of employees. Compensation of employees is the income of workers (excluding the self-employed) and includes wages, salaries, employee benefits (including contributions by employers to pension plans), and employer
contributions to Social Security. As you can see from Table 2.2, compensation of employees is the largest component of national income, accounting
for 54.5% of GDP, on average, in the past 25 years, though only 53.4% in 2017.
2. Proprietors’ income. Proprietors’ income is the income of the nonincorporated
self-employed. Because many self-employed people own some capital (examples are a farmer’s tractor or a dentist’s X-ray machine), proprietors’ income
includes both labor income and capital income. Proprietors’ income has averaged about 7.4% of GDP over the past 25 years.
3. Rental income of persons. Rental income of persons, a small item, is the income
earned by individuals who own land or structures that they rent to others.
Some miscellaneous types of income, such as royalty income paid to authors,
TABLE 2.2
Income Approach to Measuring GDP in the United States, 2017
Billions of dollars
Compensation of employees
10,407
Percent of GDP
53.4
Proprietor’s income
1501
7.7
Rental income of persons
730
3.7
Corporate profits
2099
10.8
Net interest
576
3.0
Taxes on production and imports
1286
6.6
Business current transfer payments
161
0.8
-5
0.0
16,756
86.0
Plus Statistical discrepancy
- 143
- 0.7
Equals Net National Product
16,613
85.3
3116
16.0
19,729
101.3
957
4.9
Current surplus of government enterprises
Total (equals National Income)
Plus Consumption of fixed capital
Equals Gross National Product (GNP)
Less Factor income received from rest of world
Plus Payments of factor income to rest of world
Equals Gross Domestic Product (GDP)
713
3.7
19,485
100.0
Note: Numbers may not add to totals shown owing to rounding.
Source: Bureau of Economic Analysis website, www.bea.gov, NIPA Tables 1.7.5 and 1.12, July 27, 2018.
CHAPTER 2 | The Measurement and Structure of the National Economy
4.
5.
6.
7.
8.
61
recording artists, and others, also are included in this category. Rental income
of persons averaged 2.3% of GDP over the past 25 years.9
Corporate profits. Corporate profits are the profits earned by corporations and
represent the remainder of corporate revenue after wages, interest, rents, and
other costs have been paid. Corporate profits are used to pay taxes levied on
corporations, such as the corporate income tax, and to pay dividends to shareholders. The rest of corporate profits after taxes and dividends, called retained
earnings, are kept by the corporations. Corporate profits generally are a modest fraction of GDP (averaging 10.0% of GDP over the past 25 years), but the
amount of profits earned by corporations may change dramatically from year
to year or even from quarter to quarter. Table 2.2 shows that corporate profits
were 10.8% of GDP in 2017, somewhat higher than the 25-year average.
Net interest. Net interest is interest earned by individuals from businesses and
foreign sources minus interest paid by individuals. Net interest has varied
from 2.8% to 5.3% of GDP each year over the past 25 years, averaging 4.0%
of GDP.
Taxes on production and imports. Taxes on production and imports include indirect business taxes, such as sales and excise taxes, that are paid by businesses to Federal, state, and local governments, as well as customs duties and
taxes on residential real estate and motor vehicle licenses paid by households.
These taxes have averaged about 6.7% of GDP for the past 25 years.
Business current transfer payments (net). Business current transfer payments are
payments made by businesses to individuals or governments or foreigners,
but not for wages or taxes or as payment for services. Instead, such transactions as charitable donations, insurance payments, FDIC insurance premiums
paid by banks, and legal settlements are covered by this category of income.
Business current transfer payments have been between 0.6% and 0.9% of GDP
each year for the past 25 years.
Current surplus of government enterprises. Current surplus of government enterprises is essentially the profit of businesses that are owned by governments,
such as water, electric, and sewer companies; trash companies; mass transit
firms; and housing firms. Current surplus of government enterprises is often
negative when the firms suffer losses, as has occurred in each of the past
13 years, though the losses have never been more than 0.2% of GDP.
In addition to the eight components of national income just described, three
other items need to be accounted for to obtain GDP:
■■ statistical discrepancy;
■■ depreciation; and
■■ net factor payments from abroad.
Statistical discrepancy arises because data on income are compiled from different sources than data on production; the production measure minus the income
measure equals the statistical discrepancy. Thus, a positive statistical discrepancy
means that the income measure adds up to less than the production measure.
9
Rental income of persons is a tiny fraction of GDP because it represents net rental income, or rents received minus the cost of replacing worn-out or depreciated structures. Also, rental income of persons
does not include all rents paid in the economy because it excludes rents received by corporations.
62
PART 1 | INTRODUCTION
National income plus the statistical discrepancy equals net national product
(NNP), as indicated in Table 2.2.
Depreciation (also known as consumption of fixed capital) is the value of the
capital that wears out during the period over which economic activity is being measured.10 In the calculation of the components of national income (specifically, proprietors’ income, corporate profits, and rental income), depreciation is subtracted from
total, or gross, income. Thus, to compute the total or gross amount of income, we
must add back in depreciation. The sum of net national product and depreciation is
gross national product (GNP). Gross national product and gross domestic product
are called gross because they measure the nation’s total production or equivalently
output of goods and services without subtracting depreciation.
As we discussed earlier, to go from GNP to GDP we have to subtract net factor
payments from abroad, NFP (see Eq. 2.2). As we have already mentioned and as
you can see from Table 2.2, for the United States net factor payments are relatively
small and so GDP and GNP are very close.
Private Sector and Government Sector Income. In this section we have measured economic activity as the sum of all the incomes received in an economy.
Sometimes, however, economists need to know how much of total income was received by the private sector (households and businesses) and how much accrues
to the government sector, which in the United States consists of Federal, state, and
local governments. For example, in trying to predict the demand for consumer
goods, focusing on the income available to the private sector might be more useful
than focusing on the income of the economy as a whole.
The income of the private sector, known as private disposable income, measures the amount of income the private sector has available to spend. In general,
as for an individual family, the disposable income of the private sector as a whole
equals income received from private-sector activities, plus payments received by
the private sector from the government, minus taxes paid to the government. The
precise definition is
private disposable income = Y + NFP + TR + INT - T,
(2.4)
where
Y = gross domestic product (GDP);
NFP = net factor payments from abroad;
TR = transfers received from the government;
INT = interest on government debt;
T = taxes.
As you can see from Eq. (2.4), private disposable income equals private sector
income earned at home (GDP) and abroad (net factor payments from abroad, NFP);11
plus payments to the private sector from the government sector (transfers, TR, and
interest on government debt, INT);12 minus taxes paid to the government, T.
10
Depreciation (consumption of fixed capital) includes both capital that physically wears out and capital
that is scrapped because it is no longer economically useful. For instance, still-functioning computers that
are scrapped because they have been made obsolete by newer models would be included in depreciation.
11
Note that the sum of incomes earned at home and abroad, GDP + NFP, equals GNP.
12
Some of interest on government debt is paid to foreign investors, businesses and governments.
These interest payments should be deducted from INT in calculating private disposable income.
CHAPTER 2 | The Measurement and Structure of the National Economy
63
The part of GDP that is not at the disposal of the private sector is the net
income of the government sector. Net government income equals taxes paid by
the private sector, T, minus payments from the government to the private sector
(transfers, TR, and interest on government debt, INT):
net government income = T - TR - INT.
(2.5)
Adding Eqs. (2.4) and (2.5) yields the sum of private disposable income and net
government income, Y + NFP, which is gross national product.
2.3 Saving and Wealth
Discuss the
measurement of
aggregate saving
and its relation to
wealth.
If you wanted to assess the economic situation of a household, the current
income of the household would be an important piece of information. However,
someone with a high current income isn’t necessarily better off economically than
someone with a low current income. For example, a retired tycoon who has no
current earnings but owns real estate worth $10 million probably is economically
better off than a newly graduated doctor with a high salary but heavy debts left
over from medical school. To determine how well off a household is, in addition
to knowing current income, you also need to know what the household owns (its
assets) and owes (its liabilities). The value of assets minus the value of liabilities
is called wealth.
As for a household, the economic well-being of a country depends not only on
its income but also on its wealth. The wealth of an entire nation is called national
wealth.
An important determinant of wealth is the rate of saving: A family that puts
aside a quarter of its income each month will accumulate wealth much more
quickly than a family with the same income that saves only 2% of its income.
Similarly, the rate at which national wealth increases depends on the rate at which
individuals, businesses, and governments in the economy save. Thus rates of saving and wealth accumulation are closely related.
In this section we present some concepts of aggregate saving and wealth and
examine the relationships among them. Our main interest here is measurement.
Questions such as what determines the rate of saving in a country are covered in
later chapters.
Measures of Aggregate Saving
In general, the saving of any economic unit is the unit’s current income minus
its spending on current needs. The saving rate of an economic unit is its saving divided by its income. From a macroeconomic perspective, three important
measures of saving are private saving, government saving, and national saving.
Summary table 1 outlines the definitions of each measure.
Private Saving. The saving of the private sector, known as private saving, equals
private disposable income minus consumption. Using the definition of private disposable income from Eq. (2.4), we have
Spvt = private disposable income - consumption
= 1Y + NFP + TR + INT - T2 - C,
(2.6)
64
PART 1 | INTRODUCTION
where Spvt is private saving. Consumption is subtracted from private disposable income to obtain private saving because consumption represents the private sector’s
spending to meet current needs. Investment, although part of private sector spending, is not subtracted from private disposable income because capital goods are purchased to enhance future productive capacity rather than to satisfy current needs.
The private saving rate is private saving divided by private disposable income.
Government Saving. Government saving is defined as net government income,
Eq. (2.5), less government purchases of goods and services. Using Sgovt for government saving, we write this definition of government saving as
Sgovt = net government income - government purchases
= 1 T - TR - INT2 - G.
(2.7)
Equation (2.7) treats total government purchases, G, as the government’s
spending to meet current needs. Thus the definition of government saving fits the
general definition of saving as income less spending on current needs.
However, as we discussed earlier, not all government purchases are in fact devoted to satisfying current needs; some part of G is devoted to the acquisition of
long-lived capital, such as schools, highways, and dams. The national income and
product accounts break total government purchases into the portion devoted to
current needs (referred to as government consumption) and the portion spent on longlived capital goods (referred to as government investment). Under this breakdown,
government saving could be defined as net government income less government
consumption only, rather than net government income less all government purchases. This alternative approach would increase the amount of measured saving
and investment in the U.S. economy by the amount of government investment, an
amount exceeding $600 billion per year in most recent years.13
Although the alternative definition of government saving is conceptually
more correct, for most analyses in this book, keeping track of government consumption and government investment separately is an unnecessary complication.
SUMMARY 1
Measures of Aggregate Saving
Saving measure
Definition and formula
Private saving
Private disposable income less consumption
Government saving
National saving
Spvt = 1Y + NFP + TR + INT - T 2 - C
Net government income - government purchases
Sgovt = 1T - TR + INT 2 - G
Private saving plus government saving; also GNP (Y + NFP)
less consumption and government purchases
S = Spvt - Sgovt
= Y + NFP - C - G
13
Note that, by similar reasoning, household spending on cars and other long-lived consumer
durables should not be subtracted from private disposable income in the calculation of private
saving; however, in practice they are subtracted.
CHAPTER 2 | The Measurement and Structure of the National Economy
65
To keep things simple, we usually ignore government investment, assuming that
government purchases are made up entirely of government consumption. With
this assumption, we can use the traditional definition of government saving,
Eq. (2.7). When considering issues such as the government budget deficit, however, keep in mind that, in fact, some government spending is devoted to building
or acquiring long-lived capital goods.
Another, probably more familiar, name for government saving is the government budget surplus. The government budget surplus equals government
receipts minus government outlays. Government receipts equal tax revenue, T.
Government outlays are the sum of government purchases of goods and services, G, transfers, TR, and interest payments on government debt, INT. Thus the
government budget surplus equals T - 1G + TR + INT2, which, as you can see
from Eq. (2.7), is the same as government saving.
When government receipts are less than government outlays, the difference
between outlays and receipts is known as the government budget deficit. Thus,
when the government runs a budget deficit, with its outlays greater than its receipts, government saving is negative.
National Saving. National saving, or the saving of the economy as a whole,
equals private saving plus government saving. Using the definitions of private and
government saving, Eqs. (2.6) and (2.7), we obtain national saving, S:
S = Spvt + Sgovt
(2.8)
= 1 Y + NFP + TR + INT - C - T2 + 1T - TR - INT - G 2
= Y + NFP - C - G.
Equation (2.8) shows that national saving equals the total income of the economy,
Y + NFP (which equals GNP), minus spending to satisfy current needs (consumption, C, and government purchases, G).
Figure 2.1 shows national saving, government saving, and private saving in the United States since 1960—all expressed as percentages of GDP.
Government saving averaged −5.1% of GDP so that national saving fell short
of private saving by an average of 5.1% of GDP. Private saving fluctuated in
a narrower range (from 16.4% to 25.1% of GDP) than either government saving (−13.1% to 0.3% of GDP) or national saving (9.0% to 20.0% of GDP). Since
1990, the movements in national saving were very similar to the movements in
government saving.14
The Uses of Private Saving
How is private saving in an economy put to use? Private saving is used to fund
new capital investment, provide the resources the government needs to finance its
budget deficits, and acquire assets from or lend to foreigners.
14
The correlation between national saving and government saving, both expressed as a percentage of
GDP, was about 0.81 since 1990, and the correlation of national saving and private saving was −0.22
since 1990. The correlation between government saving and private saving was –0.75.
66
PART 1 | INTRODUCTION
Percent of GDP
FIGURE 2.1
U.S. saving measures
as a percentage of GDP,
1960Q1–2018Q1
Private saving has
fluctuated in a relatively
narrow range since 1960.
Movements in national
saving have generally
paralleled movements
in government saving,
especially since 1990.
Sources: Bureau of Economic
Analysis, National Income
and Product Accounts,
downloaded from Federal
Reserve Bank of St. Louis,
FRED database, fred.stlouisfed.
org/. Private saving: FRED
series GPSAVE. Government
saving: FRED series GGSAVE
(gross government saving,
ignoring gross government
investment as a component of outlays) minus
A782RC1Q027SBEA (gross
government investment).
National saving: sum of
private and government
saving. GDP: FRED
series GDP.
30
PRIVATE SAVING
25
20
15
NATIONAL SAVING
10
5
0
25
210
GOVERNMENT SAVING
215
220
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Year
To derive an important identity that illustrates the uses of private saving, we
first use the income–expenditure identity (Eq. 2.3) and substitute C + I + G + NX
for Y in the expression for national saving (Eq. 2.8):
S = 1C + I + G + NX 2 + NFP - C - G.
Simplifying this expression, we obtain
S = I + 1NX + NFP2.
(2.9)
S = I + CA.
(2.10)
The expression for national saving in Eq. (2.9) contains the term NX + NFP,
which is the sum of net exports and net factor payments, and is called the current
account balance, CA.15 The current account balance equals payments received
from abroad in exchange for currently produced goods and services (including
factor services), minus the analogous payments made to foreigners by the domestic economy. Substituting CA for NX + NFP in Eq. (2.9), we obtain
We now have an expression for national saving, S; our goal is an expression for
private saving, Spvt. Equation (2.8) shows that private saving, Spvt, equals national
saving, S, minus government saving, Sgovt. Then, subtracting Sgovt from both sides
of Eq. (2.10), we get
Spvt = I + 1 -Sgovt 2 + CA,
(2.11)
where -Sgovt is the government budget deficit.
15
Actually, the current account balance also includes the term net unilateral transfers, which measures
transfers between countries such as private gifts or official foreign aid (see Chapter 5). In our analysis
we generally ignore this term.
CHAPTER 2 | The Measurement and Structure of the National Economy
67
Equation (2.11) is another important macroeconomic identity, called the
uses-of-saving identity. It states that an economy’s private saving is used in three
ways.
1. Investment (I). Firms borrow from private savers to finance the construction
and purchase of new capital (including residential capital) and inventory
investment.
2. The government budget deficit ( -Sgovt). When the government runs a budget
deficit (so that Sgovt is negative and -Sgovt is positive), it must borrow from
private savers to cover the difference between outlays and receipts.
3. The current account balance (CA). When the U.S. current account balance is
positive, foreigners’ receipts of payments from the United States are not sufficient to cover the payments they make to the United States. To make up the
difference, foreigners must either borrow from U.S. private savers or sell to
U.S. savers some of their assets, such as land, factories, stocks, and bonds.
Thus financing the current account balance is a use of a country’s private
saving.
In contrast, when the U.S. current account balance is negative, as it was
during most of the 1980s, 1990s, and 2000s, U.S. receipts of payments from
foreigners are not sufficient to cover U.S. payments to foreigners. To offset this
excess of payments over receipts, the United States must borrow from foreigners or sell to foreigners some U.S. assets. In this case, foreigners use their saving to lend to the United States or to acquire U.S. assets.16
Figure 2.2 shows private saving, investment, the government budget deficit,
and the current account balance in the United States since 1960—all expressed as
percentages of GDP. Since the early 1990s, the current account balance has been
negative, so that foreigners have been buying U.S. assets, providing financing for
U.S. investment, and the government budget deficit. In some crisis periods, such
as 1975 and 2008–2010, we observe large increases in the government budget deficit accompanied by sharp declines in gross private domestic investment and increases in private saving. In periods of strong growth, such as the late 1990s, we
observe a decline in private saving and the government budget deficit, along with
a rise in investment.
Relating Saving and Wealth
Saving is a key economic variable because it is closely related to the rate of wealth
accumulation. In the rest of this section we discuss the relationship between saving and wealth. To do so, however, we must first introduce the concept of stocks
versus flows.
Stocks and Flows. The economic variables we have discussed so far in this
chapter—such as GDP and the various types of expenditure, income, and saving—
are measured per unit of time (for example, per quarter or per year). For instance,
16
The current account and its relationship to international borrowing and lending are discussed in
greater detail in Chapter 5.