F O U R T H E D I T I O N d

E
DITOR
: Kristin Van Gaasbeck
T
EXT
D
ESIGN AND
C
OMPOSITION
: Archetype Book Composition
C
OVER
D
ESIGN
: Walker Printing
ISBN: 1-60229-239-6
Copyright © 2007 by Horizon Textbook Publishing, LLC
All rights reserved. Printed in the United States of America. No part of this book may be used or reproduced in any manner whatsoever without written permission, except in the case of brief quotations embodied in critical articles and reviews. For information address Horizon Textbook Publishing, LLC,
P.O. Box 494658, Redding, CA 96049-4658.

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Preface xi
CHAPTER 1 ECONOMICS—THE SCIENCE OF CHOICE AND
EXCHANGE
What? How? For Whom?
Deciding What to Produce: Opportunity Cost
Deciding How to Produce: Efficiency and Entrepreneurship
Deciding Who Will Do Which Work: The Division of Labor
Deciding for Whom Goods will be Produced: Positive and Normative
Economics
Coordinating Economic Choices
A Non-economic Example
Spontaneous Order in Markets
The Role of Hierarchy
Economic Method
Theories and Models
The Use of Graphs4
Theory and Evidence
Theories and Forecasts
Theory and Policy
Summary
Key Terms
Problems and Topics for Discussion
Case for Discussion
End Notes
Appendix to Chapter 1: Working with Graphs
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CHAPTER 2 SUPPLY AND DEMAND: THE BASICS
Law of Demand
The Demand Curve
Shifts in the Demand Curve1
THE LAW OF Supply
The Supply Curve
Shifts in the Supply Curve
The Interaction of Market Supply and Demand: Market Mechanism
Market Equilibrium
Equilibrium as Spontaneous Order
Shortages
Surpluses
Changes in Market Conditions: Outside Shocks to Market Mechanism)
Price Floors and Ceilings: An Application
Price Supports: The Market for Milk
Price Ceilings: The Case of Rent Control
Summary
Key Terms
Problems and Topics for Discussion
Case for Discussion
End Notes
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CHAPTER 3 SUPPLY, DEMAND, AND ELASTICITY
Elasticity Of Demand
Price Elasticity of Demand
Calculating Elasticity of Demand
Varying- and Constant-Elasticity Demand Curves
Determinants of Elasticity of Demand
Income Elasticity of Demand
Cross-Elasticity of Demand
Price Elasticity of Supply
Applications of Elasticity
Elasticity and Tax Incidence
Elasticity and Prohibition
Summary
Key Terms
Problems and Topics for Discussion
Case for Discussion
End Notes
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CHAPTER 4 IN SEARCH OF PROSPERITY AND STABILITY
Macroeconomics in the Long Run: Economic Growth
Measuring Economic Growth
Sources of Economic Growth
The Benefits and Costs of Economic Growth
Short-Run Macroeconomics and: The Business Cycle
Phases of the Business Cycle
Employment and the Business Cycle
Price Stability
Short-Run Costs of Inflation
Long-Run Costs of Inflation
Summary
Key Terms
Problems and Topics For Discussion
Case for Discussion
End Notes
CHAPTER 5 THE CIRCULAR FLOW OF INCOME AND PRODUCT 121
The Circular Flow
Gross Domestic Product and Gross Domestic Income
Components of GDP
Injections and Leakages
The Determinants of Planned Expenditure
Planned Versus Unplanned Expenditure
Consumption Expenditure
Planned Investment
Government Purchases
Net Exports
Equilibrium in The Circular Flow
An Expansion of Planned Expenditure
A Contraction of Planned Expenditure
The Multiplier Effect and the Business Cycle
Summary
Key Terms
Problems and Topics For Discussion
Case for Discussion
End Notes
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Appendix to Chapter 5: The Planned Expenditure Model
CHAPTER 6 MEASURING ECONOMIC ACTIVITY
The National Income Accounts in Nominal Terms
Gross Domestic Product
The Expenditure Approach to Measuring GDP
The Income Approach to Measuring Aggregate Economic Activity
Measuring International Linkages
The Current Account
The Capital and Financial Account
Relationship of the Accounts
Measuring Real Income and the Price Level
Real Gross Domestic Product and the Deflator
Producer Price Indexes
How Good are the National Income Accounts?
Summary
Key Terms
Problems and Topics for Discussion
Case for Discussion
End Notes
Appendix to Chapter 6: Computation of Price Indexes
CHAPTER 7 MONEY AND THE BANKING SYSTEM
Money: What It Is and What It Does
The Functions of Money
Money as a Liquid Asset
Measuring the Stock of Money
Why Money Matters
The Banking System
Types of Depository Institutions
The Banking Balance Sheet
The Central Bank
Ensuring the Safety and Stability of the Banking System
Risks of Banking
Policies to Ensure Safety and Soundness
International Banking
Summary
Key Terms
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Problems and Topics For Discussion
Case for Discussion
End Notes
CHAPTER 8 CENTRAL BANKING AND MONETARY POLICY
Determining the Quantity Money
A Balance-Sheet View of Money
The Monetary Base
A Closer Look at Bank Reserves
How Banks Create Money
Limits to Banks’ Ability to Create Money
The Instruments of Monetary Policy
Open Market Operations
The Discount Rate
Changes in Required-Reserve Ratios
Other Factors Affecting the Money Multiplier
Central Banking in the International Economy
The Structure of the Foreign-Exchange Market
Supply and Demand in the Foreign-Exchange Market
Central Bank Intervention in the Foreign-Exchange Market
Summary
Key Terms
Problems and Topics for Discussion
Case for Discussion
End Notes
CHAPTER 9 MONEY AND INTEREST RATES 221
The Demand for Money
The Demand for Money as a Stock
Money Demand and Nominal Income
Opportunity Cost and the Demand for Money
The Money Demand Curve
Supply, Demand, and Interest Rates
Equilibrium in the Monetary Sector (Equilibrium of Money Market)
Effects of a Change in the Money Supply
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Effects of an Increase in Income 229
The Monetary Sector, Interest Rates, and Planned Expenditure 230
Monetary Policy Instruments and Targets 232
Summary
Key Terms
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Contents vii
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Problems and Topics for Discussion
Case for Discussion
End Notes
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CHAPTER 10 PRICES AND REAL OUTPUT IN THE SHORT RUN
The Aggregate Demand Curve
Aggregate and Market Demand Curves
The Slope of the Aggregate Demand Curve
The Elasticity of Aggregate Demand
Shifts in the Aggregate Demand Curve
The Aggregate Supply curve
The Importance of Input Prices
Long-Run and Short-Run Aggregate Supply Curves
Shifts in the Short-Run Aggregate Supply Curve
Shifts in the Long-Run Aggregate Supply Curve
The Interaction of Aggregate Supply and Demand in the Short Run
Characteristics of Short- and Long-Run Equilibrium
Short-Run Effects of an Increase in Aggregate Demand
Transition to a New Long-Run Equilibrium
Effects of a Decrease in Aggregate Demand
Aggregate Supply, Demand, and the Business Cycle
Summary
Key Terms
Problems and Topics for Discussion
Case for Discussion
End Notes
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CHAPTER 11 FISCAL POLICY AND ECONOMIC STABILITY
The Theory of Fiscal Policy
Using Government Purchases to Combat a Negative Output Gap
Using a Change in Taxes or Transfer Payments to Combat a Negative
Output Gap
Fiscal Policy and Inflation
Automatic Fiscal Policy
The Budget Process
The Federal Budgetary System
Fiscal Policy and the Federal Deficit
Automatic Fiscal Policy: The Structural Versus Cyclical Deficit
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Economic Priorities
International Comparisons
The Deficit as a Policy Issue
Reasons Not to Worry About the Deficit
Reasons to Worry About the Deficit
Summary
Key Terms
Problems and Topics for Discussion
Case for Discussion
End Notes
CHAPTER 12 AN INTEGRATED VIEW OF MONETARY AND
FISCAL POLICY
Short-Run Effects of Monetary Policy
Long-Run Effects and the Neutrality of Money
Money and Fiscal Policy
The Crowding-Out Effect
Fiscal Policy in the Long Run
The Importance of the Fiscal-Monetary Policy Mix
Monetarism Versus Keynesianism: A Historical Note
Summary
Key Terms
Problems and Topics for Discussion
Case for Discussion
End Notes
CHAPTER 13 POLICIES FOR PRICE STABILITY
Inflation and Deflation in the Aggregate Supply and Demand Model
Demand-Side (Pull) Inflation
Supply-Side (Cost-Push) Inflation and Supply Shocks
Inflationary Expectations and Inflationary Recession
Deflation and Recession
The Phillips Curve
The Phillips Curve as a Policy Menu
The Phillips Curve and the Natural Rate of Unemployment
The Long-Run Phillips Curve (Monetarists’ View)
Strategies for Lasting Price Stability
What Policy Instruments Are Available?
The Importance of Credibility
Inflation Targeting
Exchange-Rate Based Stabilization Policy
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Problems with ERB Stabilization
Summary
Key Terms
Problems and Topics for Discussion
Case for Discussion
End Notes
CHAPTER 14 ECONOMIC GROWTH, PRODUCTIVITY, AND
SAVING
Economic Growth and Demand Management
Demand Management as Inputs Grow
Demand Management and Productivity Growth
Recent Trends in Economic Growth and Productivity
Explaining the Productivity Slowdown and Its Reversals
International Productivity Trends
Measurement Problems
Policies for Promoting Economic Growth and Saving
Economic Growth and the Fiscal-Monetary Policy Mix
Growth and Saving
How Much Saving Is Enough?
Summary
Key Terms
Problems and Topics for Discussion
Case for Discussion
End Notes
Glossary
Index
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T H E M O S T R E L I A B L E constant of life in a market economy is constant change.
Sitting down to work on this new edition of this textbook has brought many changes to my attention..
Some of them are trivial. One chapter mentioned some authors who were on the best-seller list at the time of the last edition—good books they wrote, but just as the market economy is in constant change, so is the publishing industry. Out they go, to be replaced by J.K. Rowling and Dan Brown.
Other changes are much more fundamental, such as the trend toward globalization of both the macro- and micro-economy. Professional economists will know that this trend is not really new. If one looks at the data, trends in imports and exports, integration of labor and financial markets, and global brand penetration started long ago. Yet, although statistically well established, these trends have clearly hit a new threshold of public awareness in the first decade of the 21st century. For that reason alone, a modern textbook must reflect the global nature of the economy.
One of the signs of its increased global outlook is the disappearance of a separate chapter on foreign exchange markets and international monetary policy. Because these topics are more important than ever, it is no longer appropriate to isolate them in the last chapter of the macroeconomics course, too easily skipped in the rush toward final exams. Instead, topics like the effects of exchange rates on aggregate demand and the relationship between price stability and exchange rate policy are now integrated directly into the various macro chapters that deal with related issues for the domestic economy. The result is a book that is both more up-to-date and more streamlined. Numerous globally-oriented cases and topics appear in the micro chapters as well.
One final change is in the textbook market itself. Earlier editions of this book reflected the college publishing world of the past: Fat, heavy volumes with fat, heavy price tags that, over time, came to be one of the most resented financial burdens of a college education. And students didn’t even get their money’s worth from those texts xi

xii Preface of an earlier era. The technology of the day meant long lead times and the sheer costs of production meant substantial intervals between revisions, so that textbooks were often several years out of date before they hit the classroom. Things were even worse for students who, because of financial pressure, depended on lower-cost used copies of earlier editions. Happily, that model of publishing is now in retreat.
It is a great pleasure to me to see this new edition come out through Horizon
Textbook Publishing. The advantages of working with a publisher who uses the latest technology to bring the book to market just a few months after final revisions are made makes the pleasure all the greater. I hope you, as a user of the book, will complete the cycle by providing me, as author, with your feedback so that your suggested changes can be quickly incorporated in future editions.
My first thanks must go to my long-time co-author, David E. Lindsey, with whom I worked on earlier editions of this text over a period of many years. During his years as Deputy Director of the Division of Monetary Affairs of the Board of Governors of the Federal Reserve System, David was able to find the ideal balance between the theory and practice of economics. Although he did not contribute directly to preparation of this new edition, his strong influence can still be seen in both the macroeconomic and microeconomic chapters.
Second, I would like to thank Kristin van Gaasbeck, Ph.D for her innovative work in updating data sources, news items, and many other elements for the new edition. Her work has made a big difference in keeping the content of the book fresh and up to date, and in bringing it to market faster than could ever have been done without her able contribution.
Finally, I thank the entire publishing and editorial staff of Horizon Textbook Publishing for introducing me to this great new concept in college publishing. I hope you, the user, benefit as much as I have.
EDWIN G. DOLAN
Lopez Island, Washington
The last few months have been very exciting time of my life. I not only added my favorite ways of explaining concepts to this textbook, but also derived satisfaction in interacting with numerous colleagues and students who complimented on the earlier edition of this book. After making numerous changes to the original product created by Prof. Dolan, I am satisfied and confident that the book will be able to clarify macro concepts in the easiest possible way. This edition uses as little mathematics as is necessary, and gives abundant real world examples to make the concepts more applied and interesting.

Preface xiii
I am very thankful to the wonderful staff of Horizon Textbook Publishing Company for making this project possible in such a short time. My special thanks to my wonderful wife who understood my absences from many family obligations when I was working on this project. I dedicate this edition to her cheerfulness and co-operation. Our daughters Lina and Aditi deserve appreciation for making life so worthwhile.
Several of my colleagues have already used this book for their classes, and many more are seriously considering adopting it in future semesters. Notable amongst them are: Debasri Mukherjee, Western Michigan University, Jesus Valencia, Slippery
Rock University, Vani Kotcherlakota, University of Nebraska-Kearney, and Vijay
Sharma, University of Colorado-Denver. I am grateful to all these individuals. Most of all, thanks to hundreds (and probably thousands) of my students who would attend classes and read these chapters. Teaching is an enjoyable exercise when students show enthusiasm to learn, and are willing to study. I invite all of you to send me comments by e-mail.
KISHORE G. KULKARNI,
Denver, Colorado. E-mail: kulkarnk@mscd.edu
• State of the art pedagogy . An abundance of case studies introduce and illustrate the subject matter of every chapter.
• Integrated international economics.
As the world economy itself comes closer together, international economics must be more closely integrated into the principles course. Accordingly, topics in international economic theory and policy, ranging from balance of payments accounts to the foreign exchange operations of the Fed, are introduced in the chapters in which they occur naturally, rather than presented separately in a single chapter.
Test Bank
The accompanying Test Bank contains over 2,000 questions in a variety of formats including multiple choice, true/false, and essay questions.
Instructor’s Manual
The expanded Instructor’s Manual contains material which can be easily included in lectures. The manual also includes all of its traditional elements, including instructional objectives, lecture notes, and suggestions.

xiv Preface
Study Guide
The Study Guide has hands-on applications and self-testing programs. It is available in two versions, Macroeconomics, and Microeconomics.
Students can gain an advantage by reinforcing their reading and lecture notes with the following study guide features:
• Where You’re Going.
The objectives and terms for each chapter are recapped to tie concepts together.
• Walking Tour.
The “Walking Tour” section provides a narrative summary of the chapter and incorporates questions on key points. Answers are given in the margin.
• Hands On.
Geographical and numerical exercises clarify concepts and better prepare students for tests and quizzes.
• Economics in the News.
A news item illustrates how concepts covered in the chapter can appear in the real world. Questions and answers reinforce the concepts.
• Questions for Review.
These questions and answers follow the key chapter concepts, preparing students for the self-test.
• Self-Test.
Extra test preparation increases a student’s understanding and ability to succeed.
• Careers in Economics.
Formerly an appendix in the text, this material provides students with an understanding of where the study of economics could lead them.
Online Student Tutorial
Created to support and enhance the student's comprehension of the economic principles discussed in the textbook. The online tutorial includes chapters objectives and study questions. To access the tutorial please visit our Students section on our Web site www.htpublishing.com. Username: Economics Password: DolanLindsey

Contents xv
PROF. KISHORE G. KULKARNI has been teaching in Economics Department at the
Metropolitan State College of Denver for numerous years. He has taught on a visiting
(or Adjunct) basis at the University of Colorado-Boulder, Colorado School of Mines and University of Denver. After being a top ranked student in B.A. and M.A. degrees at the University of Poona, (India), he completed M.A. and Ph.D. degrees from University of Pittsburgh. He has received several awards including Distinguished Service to the College, Outstanding Teacher, Outstanding Researcher/Scholar and Outstanding Contributions to the Professional Development (8 times) from different institutions. An author of 4 other books and 75 journal articles, Prof. Kulkarni enjoys teaching and research. His unending love for the profession makes his classes exciting, rewarding and entertaining. He has taught on the Semester at Sea Program as well as visited several other countries on research missions.
EDWIN G. DOLAN was born in Oklahoma and grew up in a small town in Oregon.
He attended Earlham College and Indiana University, where he majored in Russian
Studies and received the Certificate of Indiana University’s famed Russian and East-
European Institute. After earning a doctorate in economics from Yale University, he taught at Dartmouth College, the University of Chicago, George Mason University and Gettysburg College. In 1990, he began teaching in Moscow, Russia, where he and his wife founded the American Institute of Business and Economics, an independent, not-for-profit MBA program. Since retiring as President of that institution in 2001, he has lectured on global macroeconomics and managerial economics in Riga, Latvia;
Budapest, Hungary; and Zagreb, Croatia. When not lecturing abroad, he makes his home in Washington’s San Juan Islands.
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