Macroeconomics
Principles
v. 2.0This is the book Macroeconomics Principles (v. 2.0).
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ii

Table of Contents
About the Authors................................................................................................................. 1
Acknowledgments................................................................................................................. 3
Preface..................................................................................................................................... 6
Chapter 1: Economics: The Study of Choice .................................................................... 9
Defining Economics ..................................................................................................................................... 10
The Field of Economics................................................................................................................................ 18
The Economists’ Tool Kit............................................................................................................................. 28
Review and Practice..................................................................................................................................... 36

Chapter 2: Confronting Scarcity: Choices in Production ........................................... 40
Factors of Production .................................................................................................................................. 42
The Production Possibilities Curve ............................................................................................................ 50
Applications of the Production Possibilities Model ................................................................................. 68
Review and Practice..................................................................................................................................... 83

Chapter 3: Demand and Supply........................................................................................ 92
Demand ......................................................................................................................................................... 94
Supply.......................................................................................................................................................... 108
Demand, Supply, and Equilibrium............................................................................................................ 120
Review and Practice................................................................................................................................... 138

Chapter 4: Applications of Demand and Supply......................................................... 146
Putting Demand and Supply to Work ...................................................................................................... 148
Government Intervention in Market Prices: Price Floors and Price Ceilings ..................................... 159
The Market for Health-Care Services ...................................................................................................... 169
Review and Practice................................................................................................................................... 177

Chapter 5: Macroeconomics: The Big Picture ............................................................. 182
Growth of Real GDP and Business Cycles................................................................................................. 186
Price-Level Changes................................................................................................................................... 196
Unemployment........................................................................................................................................... 212
Review and Practice................................................................................................................................... 223

Chapter 6: Measuring Total Output and Income........................................................ 228
Measuring Total Output ............................................................................................................................ 230
Measuring Total Income............................................................................................................................ 247
GDP and Economic Well-Being ................................................................................................................. 256
Review and Practice................................................................................................................................... 265

iii

Chapter 7: Aggregate Demand and Aggregate Supply .............................................. 271
Aggregate Demand..................................................................................................................................... 273
Aggregate Demand and Aggregate Supply: The Long Run and the Short Run.................................... 285
Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium ............................. 299
Review and Practice................................................................................................................................... 312

Chapter 8: Economic Growth .......................................................................................... 319
The Significance of Economic Growth ..................................................................................................... 321
Growth and the Long-Run Aggregate Supply Curve .............................................................................. 331
Determinants of Economic Growth .......................................................................................................... 341
Review and Practice................................................................................................................................... 350

Chapter 9: The Nature and Creation of Money........................................................... 356
What Is Money? .......................................................................................................................................... 358
The Banking System and Money Creation .............................................................................................. 368
The Federal Reserve System ..................................................................................................................... 384
Review and Practice................................................................................................................................... 393

Chapter 10: Financial Markets and the Economy ...................................................... 398
The Bond and Foreign Exchange Markets............................................................................................... 400
Demand, Supply, and Equilibrium in the Money Market ...................................................................... 412
Review and Practice................................................................................................................................... 429

Chapter 11: Monetary Policy and the Fed.................................................................... 435
Monetary Policy in the United States ...................................................................................................... 437
Problems and Controversies of Monetary Policy ................................................................................... 450
Monetary Policy and the Equation of Exchange ..................................................................................... 463
Review and Practice................................................................................................................................... 474

Chapter 12: Government and Fiscal Policy.................................................................. 481
Government and the Economy ................................................................................................................. 483
The Use of Fiscal Policy to Stabilize the Economy.................................................................................. 494
Issues in Fiscal Policy................................................................................................................................. 504
Review and Practice................................................................................................................................... 512

Chapter 13: Consumption and the Aggregate Expenditures Model ....................... 518
Determining the Level of Consumption................................................................................................... 519
The Aggregate Expenditures Model......................................................................................................... 532
Aggregate Expenditures and Aggregate Demand................................................................................... 555
Review and Practice................................................................................................................................... 563

iv

Chapter 14: Investment and Economic Activity ......................................................... 570
The Role and Nature of Investment ......................................................................................................... 572
Determinants of Investment..................................................................................................................... 582
Investment and the Economy ................................................................................................................... 592
Review and Practice................................................................................................................................... 597

Chapter 15: Net Exports and International Finance.................................................. 603
The International Sector: An Introduction ............................................................................................. 605
International Finance ................................................................................................................................ 616
Exchange Rate Systems ............................................................................................................................. 628
Review and Practice................................................................................................................................... 639

Chapter 16: Inflation and Unemployment ................................................................... 645
Relating Inflation and Unemployment .................................................................................................... 647
Explaining Inflation–Unemployment Relationships .............................................................................. 656
Inflation and Unemployment in the Long Run ....................................................................................... 665
Review and Practice................................................................................................................................... 678

Chapter 17: A Brief History of Macroeconomic Thought and Policy ..................... 685
The Great Depression and Keynesian Economics ................................................................................... 687
Keynesian Economics in the 1960s and 1970s ......................................................................................... 697
Macroeconomics for the 21st Century..................................................................................................... 711
Review and Practice................................................................................................................................... 725

Chapter 18: Inequality, Poverty, and Discrimination ............................................... 729
Income Inequality ...................................................................................................................................... 732
The Economics of Poverty......................................................................................................................... 743
The Economics of Discrimination ............................................................................................................ 760
Review and Practice................................................................................................................................... 769

Chapter 19: Economic Development ............................................................................. 775
The Nature and Challenge of Economic Development........................................................................... 778
Population Growth and Economic Development.................................................................................... 793
Keys to Economic Development ............................................................................................................... 803
Review and Practice................................................................................................................................... 813

Chapter 20: Socialist Economies in Transition ........................................................... 816
The Theory and Practice of Socialism...................................................................................................... 818
Socialist Systems in Action ....................................................................................................................... 826
Economies in Transition: China and Russia ............................................................................................ 834
Review and Practice................................................................................................................................... 848

v

Appendix A: Graphs in Economics................................................................................. 850
How to Construct and Interpret Graphs.................................................................................................. 851
Nonlinear Relationships and Graphs without Numbers ........................................................................ 868
Using Graphs and Charts to Show Values of Variables .......................................................................... 876

Appendix B: Extensions of the Aggregate Expenditures Model.............................. 888
The Algebra of Equilibrium....................................................................................................................... 889
The Aggregate Expenditures Model and Fiscal Policy ........................................................................... 893
Review and Practice................................................................................................................................... 899

viAbout the Authors
Libby Rittenberg
Libby Rittenberg has been a professor of economics at Colorado College in Colorado
Springs since 1989. She teaches principles of economics, intermediate
macroeconomic theory, comparative economic systems, and international political
economy. She received her B. A. in economics-mathematics and Spanish from
Simmons College and her Ph.D. in economics from Rutgers University.
Prior to joining the faculty at Colorado College, shetaught at Lafayette College and at the Rutgers
University Graduate School of Management. She served
as a Fulbright Scholar in Istanbul, Turkey, and as a
research economist at Mathematica, Inc., in Princeton,
New Jersey.
Dr. Rittenberg specializes in the internationallyoriented areas of economics, with numerous articles in journals and books oncomparative and development economics. Much of her work focuses on transition
issues and on the Turkish economy.
She has been very involved in study abroad education and has directed programs incentral Europe and Turkey.

Tim Tregarthen
There is one word that captures the essence of Dr. Timothy Tregarthen—inspiring.
Tim was first diagnosed with multiple sclerosis (MS) in 1975. Yet, he continued aremarkable academic career of teaching and research. In 1996, he published thefirst edition of his principles of economics textbook to great acclaim, and it became
widely used in colleges around the country. That same year, MS made him
wheelchair-bound. The disease forced his retirement from teaching at the
University of Colorado at Colorado Springs in 1998. He lost the use of his arms in2001 and has been quadriplegic ever since. In 2002, Tim’s doctor expected him todie.

1About the Authors

He was placed in the Pikes Peak Hospice program and was twice given his last rites
by his priest. UCCS Chancellor Shockley-Zalabak says, “I really thought that Tim
would die in hospice. That’s what the doctors told me, and I really believed that. I
remember one day they called me and told me to try to come see him. They didn't
expect him to live through the night.”
Not only did he live through the night, but he eventually recovered to the pointthat he moved from hospice to a long-term care facility. There, he never let his
disease get him down. In fact, he turned back to his love of writing and teaching for
inspiration. He obtained a voice-activated computer, recruited a coauthor, Libby
Rittenberg of Colorado College, and turned his attention to revising his principles of
economics book. Unnamed Publisher is honored to publish a new, first-edition
relaunch of this wonderful book, and is proud to bring Tim’s incredible talents as ateacher back to life for future generations of students to learn from.
In addition to completing the rewrite of his textbook, Tim recently completed an
autobiography about the 32 years he has had MS, titled Suffering, Faith, andWildflowers. He is nearing completion of a novel, Cool Luck, based on the life of afriend. It is the story of a young couple facing the husband’s diagnosis of ALS—Lou
Gehrig’s disease. Remarkably, in 2007, he was able to return to the classroom at
UCCS, where he had taught economics for 27 years. In January of 2009, Tim married
Dinora Montenegro (now Dinora Tregarthen); the couple lives in San Gabriel,
California.
Perhaps Tim’s approach to life is best summed up by an observation by UCCS
English Professor Thomas Naperierkowski: “One of the remarkable things is, heck, I
can wake up with a headache and be a pretty grouchy character, but given his
physical trials, which he faces every minute of his life these days, I’ve never seen
him grouchy, I’ve never seen him cranky.” Carry on, Tim.

2

Acknowledgments
The authors would like to thank to the following individuals who reviewed the text
and whose contributions were invaluable in shaping the final product:
Carlos Aguilar

El Paso Community College

Jeff Ankrom

Wittenberg University

Lee AshSkagit Valley Community College

Randall Bennett

Gonzaga University

Joseph Calhoun

Florida State University

Richard Cantrell

Western Kentucky University

Gregg Davis

Flathead Valley Community College

Kevin Dunagan

Oakton Community College

Mona El Shazly

Columbia College

Jose Esteban

Palomar College

Maurita Fawls

Portland Community College

Fred Foldvary

Santa Clara University

Richard Fowles

University of Utah

Doris GeideStevenson

Weber State University

Sarmila Ghosh

University of Scranton, Kania School of Management

David Gordon

Illinois Valley Community College

Clinton Greene

University of Missouri–St. LouisJames Holcomb

University of Texas at El Paso

Phil Holleran

Mitchell Community College

Yu Hsing

Southeastern Louisiana University

Thomas Hyclak

Lehigh University

Bruce Johnson

Centre College

James Kahiga

Georgia Perimeter College

Andrew Kohen

James Madison University3

Acknowledgments

Monaco Kristen

California State University–Long BeachMark Maier

Glendale Community College

David McClough

Bowling Green State University

Ann McPherren

Huntington University

John Min

Northern Virginia Community College

Shahriar Mostashari

Campbell University, Lundy-Fetterman School ofBusiness

Francis Mummery

Fullerton College

Robert Murphy

Boston College

Kathryn Nantz

Fairfield University

Paul OkelloTarrant County College–South Campus

Nicholas Peppes

St. Louis Community College

Ramoo Ratha

Diablo Valley College

Teresa Riley

Youngstown State University

Michael Robinson

Mount Holyoke College

Anirban Sengupta

Texas A&M University

John Solow

The University of Iowa

John Somers

Portland Community College

Charles Staelin

Smith College

Richard Stratton

The University of Akron

Kay E. Strong

Bowling Green State University–Firelands

Della Sue

Marist College

John Vahaly

University of LouisvilleRobert Whaples

Wake Forest University

Mark Wheeler

Western Michigan University

Leslie Wolfson

The Pingry School

Sourushe Zandvakili

University of Cincinnati

We would like to extend a special thank you to the following instructors who classtested the text in their courses:

4

Acknowledgments

Johnathan Millman University of Massachusetts–Boston
John Min

Northern Virginia Community College

Kristen Monaco

California State University–Long Beach

Steve Skinner

Western Connecticut State University

Richard Stratton

University of Akron

5

Preface
Greek philosopher Heraclitis said more than 2,500 years ago that “Nothing endures
but change.” Forecasting is a tricky business, but this sentiment strikes us as being
as safe a bet as one can make. Change—rapid change—underlies all our lives. As wewere completing this textbook, the world entered a period of marked economic
uncertainty that led many students, and indeed people from all walks of life, to tune
into economic events as never before to try to understand the economic world
around them. So, while we as economists have the public’s attention, we see anopportunity to share economics principles and the economic way of thinking in a
way that emphasizes their relevance to today’s world. We use applications fromsports, politics, campus life, current events, and other familiar settings to illustrate
the links between theoretical principles and common experiences. Because of theincreasingly global nature of economic activity, we also recognize the need for aclear and consistent international focus throughout an economics text. In addition,
we have tried to provide a sense of the intellectual excitement of the field and an
appreciation for the gains it has made, as well as an awareness of the challenges
that lie ahead.
To ensure students realize that economics is a unified discipline and not abewildering array of seemingly unrelated topics, we develop the presentation of
microeconomics and of macroeconomics around integrating themes.
The integrating theme for microeconomics is the marginal decision rule, a simple
approach to choices that maximize the value of some objective. Following its
presentation in an early microeconomics chapter, the marginal decision rule
becomes an integrating device throughout the discussion of microeconomics.
Instead of a hodgepodge of rules for different market conditions, we give a single
rule that can be applied within any market setting.
The integrating theme for macroeconomics is the model of aggregate demand andaggregate supply. Following its presentation in an early macroeconomics chapter,
this model allows us to look at both short-run and long-run concepts and to addressa variety of policy issues and debates.
Recognizing that a course in economics may seem daunting to some students, wehave tried to make the writing clear and engaging. Clarity comes in part from theintuitive presentation style, but we have also integrated a number of pedagogicalfeatures that we believe make learning economic concepts and principles easier andmore fun. These features are very student-focused.

6Preface

The chapters themselves are written using a “modular” format. In particular,
chapters generally consist of three main content sections that break down aparticular topic into manageable parts. Each content section contains not only an
exposition of the material at hand but also learning objectives, summaries,
examples, and problems. Each chapter is introduced with a story to motivate thematerial and each chapter ends with a wrap-up and additional problems. Our goal isto encourage active learning by including many examples and many problems ofdifferent types.
A tour of the features available for each chapter may give a better sense of what wemean:• Start Up—Chapter introductions set the stage for each chapter with an
example that we hope will motivate readers to study the material that
follows. These essays, on topics such as the value of a college degree inthe labor market or how policy makers reacted to a particular
economic recession, lend themselves to the type of analysis explainedin the chapter. We often refer to these examples later in the text todemonstrate the link between theory and reality.
• Learning Objectives—These succinct statements are guides to thecontent of each section. Instructors can use them as a snapshot of theimportant points of the section. After completing the section, students
can return to the learning objectives to check if they have mastered
the material.
• Heads Up!—These notes throughout the text warn of common errors
and explain how to avoid making them. After our combined teachingexperience of more than 50 years, we have seen the same mistakes
made by many students. This feature provides additional clarificationand shows students how to navigate possibly treacherous waters.
• Key Takeaways—These statements review the main points covered ineach content section.
• Key Terms—Defined within the text, students can review them incontext, a process that enhances learning.
• Try It! questions—These problems, which appear at the end of eachcontent section and which are answered completely in the text, give
students the opportunity to be active learners. They are designed togive students a clear signal as to whether they understand the material
before they go on to the next topic.
• Cases in Point—These essays included at the end of each content
section illustrate the influence of economic forces on real issues andreal people. Unlike other texts that use boxed features to presentinteresting new material or newspaper articles, we have written eachcase ourselves to integrate them more clearly with the rest of the text.

7

Preface• Summary—In a few paragraphs, the information presented in thechapter is pulled together in a way that allows for a quick review of thematerial.
• End-of-chapter concept and numerical problems—These are bountiful
and are intended to check understanding, to promote discussion of theissues raised in the chapter, and to engage students in critical thinking
about the material. Included are not only general review questions totest basic understanding but also examples drawn from the news andfrom results of economics research. Some have students working withreal-world data.
• Chapter quizzes—Each chapter also includes online, supplementary
multiple choice questions that provide students with feedback on bothcorrect and incorrect responses. These provide yet another way forstudents to test themselves on the material.

Additional Material for Instructors
The authors have been personally involved in the generation of a huge Test Bank
that includes multiple choice, true/false, and short essays questions. These
questions are scored in terms of level of difficulty and include multiple ways oftesting the material.
The Solutions Manual, with which the authors were also involved, contains answers
for all concept and numerical problems found at the end of each text chapter.
The PowerPoint Slides include all the exhibits contained in the text to allow ease ofuse in class.
We hope that users will find this text an engaging and enjoyable way of becoming
acquainted with economics principles and that mastery of the material will lead tolooking at the world in a deeper and more meaningful way. We welcome all
feedback.

Libby Rittenberg
Timothy Tregarthen

8

Chapter 1
Economics: The Study of ChoiceStart Up: Economics in the News
Economic issues dominated the news in 2011, just as they dominate news in mostyears. What happens to economic phenomena such as growth, unemployment,
gasoline and food prices, house values, and the national debt matters—and these
phenomena matter a great deal.
What causes the prices of some goods to rise while the prices of other goods fall?
Price determination is one of the things that we will study in this book. We willconsider factors that lead an economy to grow more or less rapidly, thedetermination of unemployment rates, and even the process through whichgovernments make choices that can lead to the kind of dilemma the United States
faced in 2011 as the national debt soared past the nation’s debt limit.
While the investigation of these problems surely falls within the province ofeconomics, economics encompasses a far broader range of issues. Ultimately,
economics is the study of choice. Because choices range over every imaginableaspect of human experience, so does economics. Economists have investigated thenature of family life, the arts, education, crime, sports, law—the list is virtually
endless because so much of our lives involves making choices.
Consider some of the choices you face. Would you like better grades? More time torelax? More time watching movies? Getting better grades probably requires moretime studying, and perhaps less relaxation and entertainment. Not only must we
make choices as individuals, we must make choices as a society. Do we want acleaner environment? Faster economic growth? Both may be desirable, but efforts
to clean up the environment may conflict with faster economic growth. Society
must make choices.
Economics is defined less by the subjects economists investigate than by the way inwhich economists investigate them. Economists have a way of looking at the worldthat differs from the way scholars in other disciplines look at the world. It is the
economic way of thinking; this chapter introduces that way of thinking.

9

Chapter 1 Economics: The Study of Choice

1.1 Defining Economics
LEARNING OBJECTIVES
1. Define economics.
2. Explain the concepts of scarcity and opportunity cost and how they
relate to the definition of economics.
3. Understand the three fundamental economic questions: What should be
produced? How should goods and services be produced? For whomshould goods and services be produced?

Economics1 is a social science that examines how people choose among thealternatives available to them. It is social because it involves people and their
behavior. It is a science because it uses, as much as possible, a scientific approach inits investigation of choices.

Scarcity, Choice, and Cost
All choices mean that one alternative is selected over another. Selecting amongalternatives involves three ideas central to economics: scarcity, choice, andopportunity cost.

Scarcity
Our resources are limited. At any one time, we have only so much land, so manyfactories, so much oil, so many people. But our wants, our desires for the things
that we can produce with those resources, are unlimited. We would always likemore and better housing, more and better education—more and better ofpractically everything.
If our resources were also unlimited, we could say yes to each of our wants—and
there would be no economics. Because our resources are limited, we cannot say yes
to everything. To say yes to one thing requires that we say no to another. Whether
we like it or not, we must make choices.
1. A social science that examines
how people choose among thealternatives available to them.

Our unlimited wants are continually colliding with the limits of our resources,
forcing us to pick some activities and to reject others. Scarcity2 is the condition of

2. The condition of having tochoose among alternatives.

10Chapter 1 Economics: The Study of Choicehaving to choose among alternatives. A scarce good3 is one for which the choice of
one alternative use of the good requires that another be given up.
Consider a parcel of land. The parcel presents us with several alternative uses. We
could build a house on it. We could put a gas station on it. We could create a smallpark on it. We could leave the land undeveloped in order to be able to make adecision later as to how it should be used.
Suppose we have decided the land should be used for housing. Should it be a large
and expensive house or several modest ones? Suppose it is to be a large andexpensive house. Who should live in the house? If the Lees live in it, the Nguyens
cannot. There are alternative uses of the land both in the sense of the type of use
and also in the sense of who gets to use it. The fact that land is scarce means thatsociety must make choices concerning its use.
Virtually everything is scarce. Consider the air we breathe, which is available inhuge quantity at no charge to us. Could it possibly be scarce?
The test of whether air is scarce is whether it has alternative uses. What uses can we
make of the air? We breathe it. We pollute it when we drive our cars, heat ourhouses, or operate our factories. In effect, one use of the air is as a garbage dump.
We certainly need the air to breathe. But just as certainly, we choose to dump
garbage in it. Those two uses are clearly alternatives to each other. The moregarbage we dump in the air, the less desirable—and healthy—it will be to breathe. If
we decide we want to breathe cleaner air, we must limit the activities that generate
pollution. Air is a scarce good because it has alternative uses.
Not all goods, however, confront us with such choices. A free good4 is one for which
the choice of one use does not require that we give up another. One example of afree good is gravity. The fact that gravity is holding you to the earth does not meanthat your neighbor is forced to drift up into space! One person’s use of gravity is not
an alternative to another person’s use.

3. A good for which the choice of
one alternative requires that
another be given up.
4. A good for which the choice of
one use does not require that
another be given up.

1.1 Defining Economics

There are not many free goods. Outer space, for example, was a free good when the
only use we made of it was to gaze at it. But now, our use of space has reached thepoint where one use can be an alternative to another. Conflicts have already arisenover the allocation of orbital slots for communications satellites. Thus, even parts ofouter space are scarce. Space will surely become scarcer as we find new ways to use
it. Scarcity characterizes virtually everything. Consequently, the scope of
economics is wide indeed.

11Chapter 1 Economics: The Study of Choice

Scarcity and the Fundamental Economic Questions
The choices we confront as a result of scarcity raise three sets of issues. Everyeconomy must answer the following questions:
1. What should be produced? Using the economy’s scarce resources to
produce one thing requires giving up another. Producing better
education, for example, may require cutting back on other services,such as health care. A decision to preserve a wilderness area requires
giving up other uses of the land. Every society must decide what it willproduce with its scarce resources.
2. How should goods and services be produced? There are all sorts ofchoices to be made in determining how goods and services should be
produced. Should a firm employ a few skilled or a lot of unskilledworkers? Should it produce in its own country or should it use foreign
plants? Should manufacturing firms use new or recycled raw materials
to make their products?
3. For whom should goods and services be produced? If a good orservice is produced, a decision must be made about who will get it. A
decision to have one person or group receive a good or service usuallymeans it will not be available to someone else. For example,
representatives of the poorest nations on earth often complain thatenergy consumption per person in the United States is many times
greater than energy consumption per person in the world’s scores ofpoorest countries. Critics argue that the world’s energy should be more
evenly allocated. Should it? That is a “for whom” question.
Every economy must determine what should be produced, how it should be
produced, and for whom it should be produced. We shall return to these questions
again and again.

Opportunity Cost
It is within the context of scarcity that economists define what is perhaps the mostimportant concept in all of economics, the concept of opportunity cost.
Opportunity cost5 is the value of the best alternative forgone in making any choice.

5. The value of the bestalternative forgone in making
any choice.

1.1 Defining Economics

The opportunity cost to you of reading the remainder of this chapter will be thevalue of the best other use to which you could have put your time. If you choose tospend $20 on a potted plant, you have simultaneously chosen to give up the benefitsof spending the $20 on pizzas or a paperback book or a night at the movies. If thebook is the most valuable of those alternatives, then the opportunity cost of the12Chapter 1 Economics: The Study of Choice

plant is the value of the enjoyment you otherwise expected to receive from thebook.
The concept of opportunity cost must not be confused with the purchase price of an
item. Consider the cost of a college or university education. That includes the valueof the best alternative use of money spent for tuition, fees, and books. But the mostimportant cost of a college education is the value of the forgone alternative uses oftime spent studying and attending class instead of using the time in some otherendeavor. Students sacrifice that time in hopes of even greater earnings in the
future or because they place a value on the opportunity to learn. Or consider thecost of going to the doctor. Part of that cost is the value of the best alternative useof the money required to see the doctor. But the cost also includes the value of thebest alternative use of the time required to see the doctor. The essential thing to seein the concept of opportunity cost is found in the name of the concept. Opportunity
cost is the value of the best opportunity forgone in a particular choice. It is not
simply the amount spent on that choice.
The concepts of scarcity, choice, and opportunity cost are at the heart of economics.
A good is scarce if the choice of one alternative requires that another be given up.
The existence of alternative uses forces us to make choices. The opportunity cost of
any choice is the value of the best alternative forgone in making it.

KEY TAKEAWAYS• Economics is a social science that examines how people choose among
the alternatives available to them.
• Scarcity implies that we must give up one alternative in selecting
another. A good that is not scarce is a free good.
• The three fundamental economic questions are: What should be
produced? How should goods and services be produced? For whomshould goods and services be produced?
• Every choice has an opportunity cost and opportunity costs affect the
choices people make. The opportunity cost of any choice is the value ofthe best alternative that had to be forgone in making that choice.

1.1 Defining Economics

13

Chapter 1 Economics: The Study of Choice

TRY IT!
Identify the elements of scarcity, choice, and opportunity cost in each of thefollowing:
1. The Environmental Protection Agency is considering an order that a
500-acre area on the outskirts of a large city be preserved in its naturalstate, because the area is home to a rodent that is considered an
endangered species. Developers had planned to build a housingdevelopment on the land.
2. The manager of an automobile assembly plant is considering whether toproduce cars or sport utility vehicles (SUVs) next month. Assume thatthe quantities of labor and other materials required would be the samefor either type of production.
3. A young man who went to work as a nurses’ aide after graduating fromhigh school leaves his job to go to college, where he will obtain training
as a registered nurse.

1.1 Defining Economics

14

Chapter 1 Economics: The Study of Choice

Case in Point: Canadians Make a Choice© Thinkstock

Canadian Prime Minister Stephen Harper, head of the Conservative Party, hadwalked a political tightrope for five years as the leader of a minority
government in Canada’s parliamentary system. His opponents, upset by policies
such as a reduction in corporate tax rates, sought a no-confidence vote in
Parliament in 2011. It passed Parliament overwhelmingly, toppling Harper’s
government and forcing national elections for a new Parliament.
The political victory was short-lived—the Conservative Party won the May 2011
election easily and emerged as the ruling party in Canada. This allowed Mr.
Harper to continue to pursue a policy of deficit and tax reduction.
Canadian voters faced the kinds of choices we have been discussing. Opposition
parties—the New Democratic Party (NDP) and the more moderate Liberal
Party—sought higher corporate tax rates and less deficit reduction than thoseadvocated by the Conservatives. Under Mr. Harper, the deficit had fallen by
one-third in 2010. He promises a surplus budget by 2015, a plan theInternational Monetary Fund has termed “strong and credible.”
Canada’s unemployment rate in May, 2011 was 7.4 percent compared to a U.S.
rate that month of 9.1 percent. GDP growth in Canada was 3.1 percent in 2010;

1.1 Defining Economics

15

Chapter 1 Economics: The Study of Choice

the Bank of Canada projects 4.2 for its growth rate the first quarter of 2011,
compared to a U.S. rate for that quarter of 1.8 percent.
Mr. Stephens employed a stimulus package to battle the recession that began in
Canada in 2008. He scaled back that effort in 2010 and 2011, producing
substantial reductions in the deficit.
Writing on the eve of the election, Wall Street Journal columnist Mary Anastasia
O’Grady termed the vote a “referendum on limited government.” Whether or
not that characterization was accurate, Canadians clearly made a choice thatwill result in lower taxes and less spending than the packages offered by the
NDP and Liberal Party.
While the issue did not seem to figure prominently in the 2011 campaign, theNDP platform promised to reduce Canada’s greenhouse gas emissions, whichhave increased with the development of huge oil deposits in Alberta, deposits
that have put Canada in third place (behind Venezuela and Saudi Arabia) in theworld in terms of oil reserves. Mr. Harper and the Conservatives have promised
to proceed with this development as a key factor in Canada’s growth, while theNDP would restrict it sharply. It is a classic case of the problem when choices
are made between environmental quality and economic growth.
Sources: Kathleen Harris, “A Vote for the Economy,” Canadian Business, 84(6),May 9, 2011; Nirmala Menon and Paul Vieira, “Canada’s Conservatives Win
Majority,” The Wall Street Journal online, May 3, 2011; Paul Vieira, “Canada’s
Budget Deficit Shrinks on Strong Growth,” The Wall Street Journal online, April 22,
2011; Mary Anastasia O’Grady, “Canada’s Capitalism Referendum, The Wall Street
Journal online, May 2, 2011. The platform of the NDP is available at
http://xfer.ndp.ca/2011/2011-Platform/NDP-2011-Platform-En.pdf.

1.1 Defining Economics

16

Chapter 1 Economics: The Study of Choice

ANSWERS TO TRY IT! PROBLEMS
1. The 500-acre area is scarce because it has alternative uses: preservationin its natural state or a site for homes. A choice must be made between
these uses. The opportunity cost of preserving the land in its naturalstate is the forgone value of the land as a housing development. The
opportunity cost of using the land as a housing development is theforgone value of preserving the land.
2. The scarce resources are the plant and the labor at the plant. The
manager must choose between producing cars and producing SUVs. The
opportunity cost of producing cars is the profit that could be earned
from producing SUVs; the opportunity cost of producing SUVs is the
profit that could be earned from producing cars.
3. The man can devote his time to his current career or to an education;
his time is a scarce resource. He must choose between these alternatives.
The opportunity cost of continuing as a nurses’ aide is the forgone
benefit he expects from training as a registered nurse; the opportunity
cost of going to college is the forgone income he could have earned
working full-time as a nurses’ aide.

1.1 Defining Economics

17

Chapter 1 Economics: The Study of Choice

1.2 The Field of Economics
LEARNING OBJECTIVES
1. Explain the distinguishing characteristics of the economic way of
thinking.
2. Distinguish between microeconomics and macroeconomics.

We have examined the basic concepts of scarcity, choice, and opportunity cost in
economics. In this section, we will look at economics as a field of study. We begin
with the characteristics that distinguish economics from other social sciences.

The Economic Way of Thinking
Economists study choices that scarcity requires us to make. This fact is not what
distinguishes economics from other social sciences; all social scientists areinterested in choices. An anthropologist might study the choices of ancient peoples;a political scientist might study the choices of legislatures; a psychologist might
study how people choose a mate; a sociologist might study the factors that have led
to a rise in single-parent households. Economists study such questions as well. Whatis it about the study of choices by economists that makes economics different fromthese other social sciences?
Three features distinguish the economic approach to choice from the approaches
taken in other social sciences:
1. Economists give special emphasis to the role of opportunity costs intheir analysis of choices.
2. Economists assume that individuals make choices that seek tomaximize the value of some objective, and that they define theirobjectives in terms of their own self-interest.
3. Individuals maximize by deciding whether to do a little more or a little
less of something. Economists argue that individuals pay attention to
the consequences of small changes in the levels of the activities they
pursue.
The emphasis economists place on opportunity cost, the idea that people makechoices that maximize the value of objectives that serve their self-interest, and a

18

Chapter 1 Economics: The Study of Choice

focus on the effects of small changes are ideas of great power. They constitute thecore of economic thinking. The next three sections examine these ideas in greater
detail.

Opportunity Costs Are Important
If doing one thing requires giving up another, then the expected benefits of thealternatives we face will affect the ones we choose. Economists argue that anunderstanding of opportunity cost is crucial to the examination of choices.
As the set of available alternatives changes, we expect that the choices individuals
make will change. A rainy day could change the opportunity cost of reading a book;
we might expect more reading to get done in bad than in good weather. A highincome can make it very costly to take a day off; we might expect highly paid
individuals to work more hours than those who are not paid as well. If individuals
are maximizing their level of satisfaction and firms are maximizing profits, then achange in the set of alternatives they face may affect their choices in a predictableway.
The emphasis on opportunity costs is an emphasis on the examination ofalternatives. One benefit of the economic way of thinking is that it pushes us tothink about the value of alternatives in each problem involving choice.

Individuals Maximize in Pursuing Self-Interest
What motivates people as they make choices? Perhaps more than anything else, it isthe economist’s answer to this question that distinguishes economics from otherfields.
Economists assume that individuals make choices that they expect will create themaximum value of some objective, given the constraints they face. Furthermore,
economists assume that people’s objectives will be those that serve their own selfinterest.
Economists assume, for example, that the owners of business firms seek tomaximize profit. Given the assumed goal of profit maximization, economists canpredict how firms in an industry will respond to changes in the markets in which
they operate. As labor costs in the United States rise, for example, economists are
not surprised to see firms moving some of their manufacturing operations overseas.

1.2 The Field of Economics

19

Chapter 1 Economics: The Study of Choice

Similarly, economists assume that maximizing behavior is at work when theyexamine the behavior of consumers. In studying consumers, economists assume
that individual consumers make choices aimed at maximizing their level ofsatisfaction. In the next chapter, we will look at the results of the shift from skiing
to snowboarding; that is a shift that reflects the pursuit of self-interest by
consumers and by manufacturers.
In assuming that people pursue their self-interest, economists are not assuming
people are selfish. People clearly gain satisfaction by helping others, as suggestedby the large charitable contributions people make. Pursuing one’s own self-interest
means pursuing the things that give one satisfaction. It need not imply greed or
selfishness.

Choices Are Made at the Margin
Economists argue that most choices are made “at the margin.” The margin6 is thecurrent level of an activity. Think of it as the edge from which a choice is to be
made. A choice at the margin7 is a decision to do a little more or a little less ofsomething.
Assessing choices at the margin can lead to extremely useful insights. Consider, forexample, the problem of curtailing water consumption when the amount of water
available falls short of the amount people now use. Economists argue that one way
to induce people to conserve water is to raise its price. A common response to thisrecommendation is that a higher price would have no effect on water consumption,
because water is a necessity. Many people assert that prices do not affect water
consumption because people “need” water.

6. The current level of an activity.

But choices in water consumption, like virtually all choices, are made at the margin.
Individuals do not make choices about whether they should or should not consume
water. Rather, they decide whether to consume a little more or a little less water.
Household water consumption in the United States totals about 105 gallons perperson per day. Think of that starting point as the edge from which a choice at themargin in water consumption is made. Could a higher price cause you to use lesswater brushing your teeth, take shorter showers, or water your lawn less? Could ahigher price cause people to reduce their use, say, to 104 gallons per person perday? To 103? When we examine the choice to consume water at the margin, thenotion that a higher price would reduce consumption seems much more plausible.
Prices affect our consumption of water because choices in water consumption, likeother choices, are made at the margin.

7. A decision to do a little more ora little less of something.

1.2 The Field of Economics

20

Chapter 1 Economics: The Study of Choice

The elements of opportunity cost, maximization, and choices at the margin can befound in each of two broad areas of economic analysis: microeconomics andmacroeconomics. Your economics course, for example, may be designated as a“micro” or as a “macro” course. We will look at these two areas of economic
thought in the next section.

Microeconomics and Macroeconomics
The field of economics is typically divided into two broad realms: microeconomics
and macroeconomics. It is important to see the distinctions between these broad
areas of study.
Microeconomics8 is the branch of economics that focuses on the choices made byindividual decision-making units in the economy—typically consumers andfirms—and the impacts those choices have on individual markets.
Macroeconomics9 is the branch of economics that focuses on the impact of choiceson the total, or aggregate, level of economic activity.
Why do tickets to the best concerts cost so much? How does the threat of global
warming affect real estate prices in coastal areas? Why do women end up doing
most of the housework? Why do senior citizens get discounts on public transit
systems? These questions are generally regarded as microeconomic because they
focus on individual units or markets in the economy.
Is the total level of economic activity rising or falling? Is the rate of inflation
increasing or decreasing? What is happening to the unemployment rate? These are
the questions that deal with aggregates, or totals, in the economy; they areproblems of macroeconomics. The question about the level of economic activity, forexample, refers to the total value of all goods and services produced in theeconomy. Inflation is a measure of the rate of change in the average price level forthe entire economy; it is a macroeconomic problem. The total levels of employment
and unemployment in the economy represent the aggregate of all labor markets;
unemployment is also a topic of macroeconomics.
8. The branch of economics that
focuses on the choices made by
consumers and firms and theimpacts those choices have on
individual markets.
9. The branch of economics that
focuses on the impact ofchoices on the total, or
aggregate, level of economic
activity.

1.2 The Field of Economics

Both microeconomics and macroeconomics give attention to individual markets.
But in microeconomics that attention is an end in itself; in macroeconomics it isaimed at explaining the movement of major economic aggregates—the level of total
output, the level of employment, and the price level.
We have now examined the characteristics that define the economic way of
thinking and the two branches of this way of thinking: microeconomics and21

Chapter 1 Economics: The Study of Choice

macroeconomics. In the next section, we will have a look at what one can do withtraining in economics.

Putting Economics to Work
Economics is one way of looking at the world. Because the economic way of
thinking has proven quite useful, training in economics can be put to work in awide range of fields. One, of course, is in work as an economist. Undergraduate
work in economics can be applied to other careers as well.

Careers in Economics
Economists generally work in three types of organizations: government agencies,
business firms, and colleges and universities.
Economists working for business firms and government agencies sometimes
forecast economic activity to assist their employers in planning. They also apply
economic analysis to the activities of the firms or agencies for which they work or
consult. Economists employed at colleges and universities teach and conduct
research.
Look at the website of your college or university’s economics department. Chances
are the department will discuss the wide variety of occupations that theireconomics majors enter. Unlike engineering and accounting majors, economics andother social science majors tend to be distributed over a broad range ofoccupations.

Applying Economics to Other Fields
Suppose that you are considering something other than a career in economics.
Would choosing to study economics help you?
The evidence suggests it may. Suppose, for example, that you are considering law
school. The study of law requires keen analytical skills; studying economics
sharpens such skills. Economists have traditionally argued that undergraduate
work in economics serves as excellent preparation for law school. Economist
Michael Nieswiadomy of the University of North Texas collected data on Law School
Admittance Test (LSAT) scores for the 12 undergraduate majors listed most often by
students hoping to enter law school in the class of 2008–9. Table 1.1 "LSAT Scoresfor Students Taking the Exam in 2008" gives the scores, as well as the ranking for

1.2 The Field of Economics

22Chapter 1 Economics: The Study of Choiceeach of these majors in 2008. Economics majors tied philosophy majors for thehighest average score.
Table 1.1 LSAT Scores for Students Taking the Exam in 2008
Rank

Major

Average LSAT Score # of Students

1

Economics

157.4

3,047

1

Philosophy

157.4

2,184

3

Engineering

156.2

2,197

4

History

155.9

4,166

5

English

154.7

5,120

6

Finance

153.4

2,267

7

Political science

153.0

14,964

8

Psychology

152.5

4,355

9

Sociology

150.7

1,902

10

Communications

150.5

2,230

11

Business administration

149.1

1,971

12

Criminal justice

145.5

3,306

Here are the average LSAT scores and rankings for the 12 undergraduate majors
with more than 1,900 students taking the test to enter law school in the 2008–2009
academic year.
Source: Michael Nieswiadomy, “LSAT Scores of Economics Majors: The 2008–09
Class Update” Journal of Economic Education, 41:3 (Summer 2010): 331–333.
Did the strong performance by economics and philosophy majors mean thattraining in those fields sharpens analytical skills tested in the LSAT, or thatstudents with good analytical skills are more likely to major in them? Both were
probably at work. Economics and philosophy clearly attract students with goodanalytical skills—and studying economics or philosophy helps to develop thoseskills.
Of course, you may not be interested in going to law school. One consideration
relevant to selecting a major is potential earnings in that field. The National

1.2 The Field of Economics

23Chapter 1 Economics: The Study of Choice

Association of Colleges and Employers conducts a quarterly survey of salary offers
received by college graduates with various majors. The results for the summer 2011
survey for selected majors are given in Table 1.2 "Average Yearly Salary Offers,
Summer 2011". If you are going for the big bucks, the best strategy is to major in
petroleum engineering. But as the table suggests, economics majors as a group did
quite well in 2011.
Table 1.2 Average Yearly Salary Offers, Summer 2011
Major

Average Offer

Petroleum engineering$80,849

Chemical engineering

65,617

Computer engineering

64,499Computer science

63,402

Electrical engineering

61,021Engineering

60,465

Mechanical engineering

60,345

Information science

57,499Economics

53,906

Finance

52,351

Accounting

49,671Business administration

44,825

History

40,051English39,611

Psychology

34,000Source: National Association of Colleges and Employers, Average Salary Offer toCollege Class of 2011 Rises 4.8 Percent, press release at http://www.naceweb.org/Press/
Releases/Average_Salary_Offer_to_College_Class_of_2011_Rises_4_8_Percent.aspx.
For psychology, median salary offer is reported.
One’s choice of a major is not likely to be based solely on considerations of potential
earnings or the prospect of landing a spot in law school. You will also consider yourinterests and abilities in making a decision about whether to pursue further study
in economics. And, of course, you will consider the expected benefits of alternative

1.2 The Field of Economics

24Chapter 1 Economics: The Study of Choicecourses of study. What is your opportunity cost of pursuing a study of economics?
Does studying more economics serve your interests and will doing so maximize
your satisfaction level? These considerations may be on your mind as you begin to
study economics at the college level and obviously students will make manydifferent choices. But, should you decide to pursue a major in economics, you
should know that a background in this field is likely to serve you well.

KEY TAKEAWAYS• Economists focus on the opportunity costs of choices, they assume that
individuals make choices in a way that maximizes the value of an
objective defined in terms of their own self-interest, and they assume
that individuals make those choices at the margin.
• Economics is divided into two broad areas: microeconomics andmacroeconomics.
• A wide range of career opportunities is open to economics majors.
Empirical evidence suggests that students who enter the job market
with a major in economics tend to earn more than do students in manyother majors. Further, economics majors do particularly well on theLSAT.

TRY IT!
The Department of Agriculture estimated that the expenditures a middleincome, husband–wife family of three would incur to raise one additionalchild from birth in 2005 to age 17 would be $250,530. In what way does thisestimate illustrate the economic way of thinking? Would the Department’s
estimate be an example of microeconomic or of macroeconomic analysis?
Why?

1.2 The Field of Economics

25

Chapter 1 Economics: The Study of Choice

Case in Point: Opportunity Cost with The Simpsons© Thinkstock

In the animated television comedy The Simpsons, Homer’s father, Grampa
Simpson, faced a classic problem in the allocation of a scarce resource—histime. He wanted to spend the day with his girlfriend, Bea—it was, after all, herbirthday. His alternative was to spend the day with Homer and the family,
which he did not really want to do, partly because they never visited him
anyway.
Homer and his family prevailed, however, and insisted on taking Grampa to“Discount Lion Safari,” a local amusement park. The cost of Grampa’s day withhis family is the enjoyment he anticipated from spending time with Bea. It allends up badly for Grampa anyway—Homer’s car breaks down on the way to thepark. As for the forgone alternative, Bea dies that day, possibly because of abroken heart from not being able to spend the day with Grampa.
Sources: R. Andrew Luccasen and M. Kathleen Thomas, “Simpsonomics:
Teaching Economics Using Episodes of The Simpsons,” The Journal of Economic
Education, 41(2), Spring 2010, 136–149. The Simpsons, Episode no. 30, firstbroadcast 28 March 1991 by Fox, directed by David Silverman and written by
Jay Kogen and Wallace Wolodarsky.

1.2 The Field of Economics

26

Chapter 1 Economics: The Study of Choice

ANSWER TO TRY IT! PROBLEM
The information given suggests one element of the economic way of
thinking: assessing the choice at the margin. The estimate reflects the costof one more child for a family that already has one. It is not clear from theinformation given how close the estimate of cost comes to the economic
concept of opportunity cost. The Department of Agriculture’s estimate
included such costs as housing, food, transportation, clothing, health care,child care, and education. An economist would add the value of the bestalternative use of the additional time that will be required for the child. If
the couple is looking far ahead, it may want to consider the opportunity costof sending a child to college. And, if it is looking very far ahead, it may wantto consider the fact that nearly half of all parents over the age of 50 support
at least one child over the age of 21. This is a problem in microeconomic
analysis, because it focuses on the choices of individual households.

1.2 The Field of Economics

27

Chapter 1 Economics: The Study of Choice

1.3 The Economists’ Tool Kit
LEARNING OBJECTIVES
1. Explain how economists test hypotheses, develop economic theories,
and use models in their analyses.
2. Explain how the all-other-things unchanged (ceteris paribus) problem
and the fallacy of false cause affect the testing of economic hypotheses
and how economists try to overcome these problems.
3. Distinguish between normative and positive statements.

Economics differs from other social sciences because of its emphasis on opportunity
cost, the assumption of maximization in terms of one’s own self-interest, and theanalysis of choices at the margin. But certainly much of the basic methodology of
economics and many of its difficulties are common to every social science—indeed,to every science. This section explores the application of the scientific method toeconomics.
Researchers often examine relationships between variables. A variable10 issomething whose value can change. By contrast, a constant11 is something whose
value does not change. The speed at which a car is traveling is an example of avariable. The number of minutes in an hour is an example of a constant.

10. Something whose value canchange.
11. Something whose value does
not change.
12. A systematic set of procedures
through which knowledge iscreated.
13. An assertion of a relationshipbetween two or more variables
that could be proven to befalse.

Research is generally conducted within a framework called the scientific method12,
a systematic set of procedures through which knowledge is created. In the scientificmethod, hypotheses are suggested and then tested. A hypothesis13 is an assertionof a relationship between two or more variables that could be proven to be false. A
statement is not a hypothesis if no conceivable test could show it to be false. The
statement “Plants like sunshine” is not a hypothesis; there is no way to test
whether plants like sunshine or not, so it is impossible to prove the statement false.
The statement “Increased solar radiation increases the rate of plant growth” is ahypothesis; experiments could be done to show the relationship between solar
radiation and plant growth. If solar radiation were shown to be unrelated to plant
growth or to retard plant growth, then the hypothesis would be demonstrated to befalse.
If a test reveals that a particular hypothesis is false, then the hypothesis is rejectedor modified. In the case of the hypothesis about solar radiation and plant growth,
we would probably find that more sunlight increases plant growth over some range

28

Chapter 1 Economics: The Study of Choice

but that too much can actually retard plant growth. Such results would lead us tomodify our hypothesis about the relationship between solar radiation and plant
growth.
If the tests of a hypothesis yield results consistent with it, then further tests are
conducted. A hypothesis that has not been rejected after widespread testing andthat wins general acceptance is commonly called a theory14. A theory that has been
subjected to even more testing and that has won virtually universal acceptancebecomes a law15. We will examine two economic laws in the next two chapters.
Even a hypothesis that has achieved the status of a law cannot be proven true.
There is always a possibility that someone may find a case that invalidates the
hypothesis. That possibility means that nothing in economics, or in any other social
science, or in any science, can ever be proven true. We can have great confidence ina particular proposition, but it is always a mistake to assert that it is “proven.”

Models in Economics
All scientific thought involves simplifications of reality. The real world is far too
complex for the human mind—or the most powerful computer—to consider.
Scientists use models instead. A model16 is a set of simplifying assumptions aboutsome aspect of the real world. Models are always based on assumed conditions thatare simpler than those of the real world, assumptions that are necessarily false. A
model of the real world cannot be the real world.
We will encounter an economic model in Chapter 2 "Confronting Scarcity: Choicesin Production". For that model, we will assume that an economy can produce only
two goods. Then we will explore the model of demand and supply. One of theassumptions we will make there is that all the goods produced by firms in aparticular market are identical. Of course, real economies and real markets are notthat simple. Reality is never as simple as a model; one point of a model is to simplify
the world to improve our understanding of it.
14. A hypothesis that has not been
rejected after widespread
testing and that wins general
acceptance.
15. A theory that has been
subjected to even more testing
and that has won virtually
universal acceptance.
16. A set of simplifying
assumptions about some aspectof the real world.

1.3 The Economists’ Tool Kit

Economists often use graphs to represent economic models. The appendix to thischapter provides a quick, refresher course, if you think you need one, on
understanding, building, and using graphs.
Models in economics also help us to generate hypotheses about the real world. In
the next section, we will examine some of the problems we encounter in testing
those hypotheses.

29Chapter 1 Economics: The Study of Choice

Testing Hypotheses in Economics
Here is a hypothesis suggested by the model of demand and supply: an increase in
the price of gasoline will reduce the quantity of gasoline consumers demand. How
might we test such a hypothesis?
Economists try to test hypotheses such as this one by observing actual behavior andusing empirical (that is, real-world) data. The average retail price of gasoline in the
United States rose from an average of $2.12 per gallon on May 22, 2005 to $2.88 per
gallon on May 22, 2006. The number of gallons of gasoline consumed by U.S.
motorists rose 0.3% during that period.
The small increase in the quantity of gasoline consumed by motorists as its pricerose is inconsistent with the hypothesis that an increased price will lead to a
reduction in the quantity demanded. Does that mean that we should dismiss theoriginal hypothesis? On the contrary, we must be cautious in assessing thisevidence. Several problems exist in interpreting any set of economic data. One
problem is that several things may be changing at once; another is that the initial
event may be unrelated to the event that follows. The next two sections examine
these problems in detail.

The All-Other-Things-Unchanged Problem
The hypothesis that an increase in the price of gasoline produces a reduction in thequantity demanded by consumers carries with it the assumption that there are noother changes that might also affect consumer demand. A better statement of the
hypothesis would be: An increase in the price of gasoline will reduce the quantity
consumers demand, ceteris paribus. Ceteris paribus17 is a Latin phrase that means“all other things unchanged.”But things changed between May 2005 and May 2006. Economic activity andincomes rose both in the United States and in many other countries, particularly
China, and people with higher incomes are likely to buy more gasoline. Employment
rose as well, and people with jobs use more gasoline as they drive to work.
Population in the United States grew during the period. In short, many things
happened during the period, all of which tended to increase the quantity of gasoline
people purchased.

17. A Latin phrase that means, “allother things unchanged.“

1.3 The Economists’ Tool Kit

Our observation of the gasoline market between May 2005 and May 2006 did notoffer a conclusive test of the hypothesis that an increase in the price of gasoline
would lead to a reduction in the quantity demanded by consumers. Other thingschanged and affected gasoline consumption. Such problems are likely to affect any

30

Chapter 1 Economics: The Study of Choiceanalysis of economic events. We cannot ask the world to stand still while we
conduct experiments in economic phenomena. Economists employ a variety ofstatistical methods to allow them to isolate the impact of single events such as pricechanges, but they can never be certain that they have accurately isolated theimpact of a single event in a world in which virtually everything is changing all thetime.
In laboratory sciences such as chemistry and biology, it is relatively easy to conduct
experiments in which only selected things change and all other factors are held
constant. The economists’ laboratory is the real world; thus, economists do not
generally have the luxury of conducting controlled experiments.

The Fallacy of False Cause
Hypotheses in economics typically specify a relationship in which a change in one
variable causes another to change. We call the variable that responds to the change
the dependent variable18; the variable that induces a change is called the
independent variable19. Sometimes the fact that two variables move together cansuggest the false conclusion that one of the variables has acted as an independent
variable that has caused the change we observe in the dependent variable.
Consider the following hypothesis: People wearing shorts cause warm weather.
Certainly, we observe that more people wear shorts when the weather is warm.
Presumably, though, it is the warm weather that causes people to wear shorts
rather than the wearing of shorts that causes warm weather; it would be incorrect
to infer from this that people cause warm weather by wearing shorts.
Reaching the incorrect conclusion that one event causes another because the two
events tend to occur together is called the fallacy of false cause20. The
accompanying essay on baldness and heart disease suggests an example of thisfallacy.

18. A variable that responds tochange.
19. A variable that induces achange.
20. The incorrect assumption that
one event causes anotherbecause the two events tend tooccur together.

1.3 The Economists’ Tool Kit

Because of the danger of the fallacy of false cause, economists use special statisticaltests that are designed to determine whether changes in one thing actually do causechanges observed in another. Given the inability to perform controlled
experiments, however, these tests do not always offer convincing evidence that
persuades all economists that one thing does, in fact, cause changes in another.
In the case of gasoline prices and consumption between May 2005 and May 2006,
there is good theoretical reason to believe the price increase should lead to a
reduction in the quantity consumers demand. And economists have tested the31Chapter 1 Economics: The Study of Choice

hypothesis about price and the quantity demanded quite extensively. They havedeveloped elaborate statistical tests aimed at ruling out problems of the fallacy offalse cause. While we cannot prove that an increase in price will, ceteris paribus,
lead to a reduction in the quantity consumers demand, we can have considerable
confidence in the proposition.

Normative and Positive Statements
Two kinds of assertions in economics can be subjected to testing. We have alreadyexamined one, the hypothesis. Another testable assertion is a statement of fact,
such as “It is raining outside” or “Microsoft is the largest producer of operating
systems for personal computers in the world.” Like hypotheses, such assertions canbe demonstrated to be false. Unlike hypotheses, they can also be shown to becorrect. A statement of fact or a hypothesis is a positive statement21.
Although people often disagree about positive statements, such disagreements canultimately be resolved through investigation. There is another category ofassertions, however, for which investigation can never resolve differences. A
normative statement22 is one that makes a value judgment. Such a judgment is theopinion of the speaker; no one can “prove” that the statement is or is not correct.
Here are some examples of normative statements in economics: “We ought to do
more to help the poor.” “People in the United States should save more.” “Corporate
profits are too high.” The statements are based on the values of the person who
makes them. They cannot be proven false.
Because people have different values, normative statements often provoke
disagreement. An economist whose values lead him or her to conclude that weshould provide more help for the poor will disagree with one whose values lead to aconclusion that we should not. Because no test exists for these values, these two
economists will continue to disagree, unless one persuades the other to adopt a
different set of values. Many of the disagreements among economists are based onsuch differences in values and therefore are unlikely to be resolved.

21. A statement of fact or ahypothesis.
22. A statement that makes a value
judgment.

1.3 The Economists’ Tool Kit

32

Chapter 1 Economics: The Study of Choice

KEY TAKEAWAYS• Economists try to employ the scientific method in their research.
• Scientists cannot prove a hypothesis to be true; they can only fail toprove it false.
• Economists, like other social scientists and scientists, use models to
assist them in their analyses.
• Two problems inherent in tests of hypotheses in economics are the allother-things-unchanged problem and the fallacy of false cause.
• Positive statements are factual and can be tested. Normative statements
are value judgments that cannot be tested. Many of the disagreements
among economists stem from differences in values.

TRY IT!
Look again at the data in Table 1.1 "LSAT Scores for Students Taking theExam in 2008". Now consider the hypothesis: “Majoring in economics will
result in a higher LSAT score.” Are the data given consistent with thishypothesis? Do the data prove that this hypothesis is correct? What fallacy
might be involved in accepting the hypothesis?

1.3 The Economists’ Tool Kit

33

Chapter 1 Economics: The Study of Choice

Case in Point: Does Baldness Cause Heart Disease?

© 2010 Jupiterimages Corporation

A website called embarrassingproblems.com received the following email:“Dear Dr. Margaret,“I seem to be going bald. According to your website, this means I’m more likely
to have a heart attack. If I take a drug to prevent hair loss, will it reduce my riskof a heart attack?”
What did Dr. Margaret answer? Most importantly, she did not recommend thatthe questioner take drugs to treat his baldness, because doctors do not thinkthat the baldness causes the heart disease. A more likely explanation for the
association between baldness and heart disease is that both conditions areaffected by an underlying factor. While noting that more research needs to bedone, one hypothesis that Dr. Margaret offers is that higher testosterone levels
might be triggering both the hair loss and the heart disease. The good news forpeople with early balding (which is really where the association with increased
risk of heart disease has been observed) is that they have a signal that mightlead them to be checked early on for heart disease.

1.3 The Economists’ Tool Kit

34

Chapter 1 Economics: The Study of Choice

Source: http://www.embarrassingproblems.com/problems/
problempage230701.htm. No longer posted.

ANSWER TO TRY IT! PROBLEM
The data are consistent with the hypothesis, but it is never possible to provethat a hypothesis is correct. Accepting the hypothesis could involve thefallacy of false cause; students who major in economics may already havethe analytical skills needed to do well on the exam.

1.3 The Economists’ Tool Kit

35

Chapter 1 Economics: The Study of Choice

1.4 Review and PracticeSummary
Choices are forced on us by scarcity; economists study the choices that people make. Scarce goods are those forwhich the choice of one alternative requires giving up another. The opportunity cost of any choice is the valueof the best alternative forgone in making that choice.
Some key choices assessed by economists include what to produce, how to produce it, and for whom it should be
produced. Economics is distinguished from other academic disciplines that also study choices by an emphasis on
the central importance of opportunity costs in evaluating choices, the assumption of maximizing behavior thatserves the interests of individual decision makers, and a focus on evaluating choices at the margin.
Economic analyses may be aimed at explaining individual choice or choices in an individual market; suchinvestigations are largely the focus of microeconomics. The analysis of the impact of those individual choices onsuch aggregates as total output, the level of employment, and the price level is the concern of macroeconomics.
Working within the framework of the scientific method, economists formulate hypotheses and then test them.
These tests can only refute a hypothesis; hypotheses in science cannot be proved. A hypothesis that has been
widely tested often comes to be regarded as a theory; one that has won virtually universal acceptance is a law.
Because of the complexity of the real world, economists rely on models that rest on a series of simplifying
assumptions. The models are used to generate hypotheses about the economy that can be tested using realworld data.
Statements of fact and hypotheses are positive statements. Normative statements, unlike positive statements,
cannot be tested and provide a source for potential disagreement.

36

Chapter 1 Economics: The Study of Choice

PROBLEMS
1. Why does the fact that something is scarce require that we makechoices?
2. Does the fact that something is abundant mean it is not scarce in theeconomic sense? Why or why not?
3. In some countries, such as Cuba and North Korea, the government
makes most of the decisions about what will be produced, how it will be
produced, and for whom. Does the fact that these choices are made by
the government eliminate scarcity in these countries? Why or why not?
4. Explain what is meant by the opportunity cost of a choice.
5. What is the approximate dollar cost of the tuition and other fees
associated with the economics course you are taking? Does this dollar
cost fully reflect the opportunity cost to you of taking the course?
6. In the Case in Point “Canadians Make a Choice,” what would be some of
the things that would be included in an estimate of the opportunity costof preserving part of northern Alberta Canada by prohibiting heavy
crude oil extraction? Do you think that the increased extraction
represents the best use of the land? Why or why not?
7. Indicate whether each of the following is a topic of
microeconomics or macroeconomics:
a. The impact of higher oil prices on the production of steelb. The increased demand in the last 15 years for exotic dietary
supplementsc. The surge in aggregate economic activity that hit much of
Asia late in the early 2000s
d. The sharp increases in U.S. employment and total output
that occurred between 2003 and 2007
e. The impact of preservation of wilderness areas on thelogging industry and on the price of lumber
8. Determine whether each of the following raises a “what,” “how,”or “for whom” issue. Are the statements normative or positive?
a. A requirement that aluminum used in cars be made fromrecycled materials will raise the price of automobiles.
b. The federal government does not spend enough for children.
c. An increase in police resources provided to the inner city
will lower the crime rate.
d. Automation destroys jobs.

1.4 Review and Practice37

Chapter 1 Economics: The Study of Choicee. Efforts to improve the environment tend to reduce
production and employment.
f. Japanese firms should be more willing to hire additional
workers when production rises and to lay off workers when
production falls.
g. Access to health care should not be limited by income.
9. Your time is a scarce resource. What if the quantity of time wereincreased, say to 48 hours per day, and everyone still lived as many days
as before. Would time still be scarce?
10. Most college students are under age 25. Give two explanations for
this—one based on the benefits people of different ages are likely toreceive from higher education and one based on the opportunity costs ofa college education to students of different ages.
11. Some municipal water companies charge customers a flat fee eachmonth, regardless of the amount of water they consume. Others meterwater use and charge according to the quantity of water customers use.
Compare the way the two systems affect the cost of water use at themargin.
12. How might you test each of the following hypotheses? Suggest
some problems that might arise in each test due to the ceterisparibus (all-other-things-unchanged) problem and the fallacy offalse cause.
a. Reducing the quantity of heroin available will increase total
spending on heroin and increase the crime rate.
b. Higher incomes make people happier.
c. Higher incomes make people live longer.
13. Many models in physics and in chemistry assume the existence of aperfect vacuum (that is, a space entirely empty of matter). Yet we knowthat a perfect vacuum cannot exist. Are such models valid? Why aremodels based on assumptions that are essentially incorrect?
14. Suppose you were asked to test the proposition that publishing students’teacher evaluations causes grade inflation. What evidence might you
want to consider? How would the inability to carry out controlled
experiments make your analysis more difficult?
15. Referring to the Case in Point “Baldness and Heart Disease,” explain thepossible fallacy of false cause in concluding that baldness makes aperson more likely to have heart disease.
16. In 2005 the Food and Drug Administration ordered that Vioxx and otherpopular drugs for treating the pain of arthritis be withdrawn from themarket. The order resulted from a finding that people taking the drugs

1.4 Review and Practice38

Chapter 1 Economics: The Study of Choice

had an increased risk of cardiovascular problems. Some researchers
criticized the government’s action, arguing that concluding that thedrugs caused the cardiovascular problems represented an example ofthe fallacy of false cause. Can you think of any reason why this might be
the case?

1.4 Review and Practice39

Chapter 2
Confronting Scarcity: Choices in Production
Start Up: An Attempt to Produce Safer Air Travel
In the wake of the terrorist attacks on the United States on September 11, 2001,
American taxpayers continue to give up a great deal of money, and airline
passengers continue to give much of their time—and a great deal of theirprivacy—in an effort to ensure that other terrorists will not turn their flights into
tragedies.
The U.S. effort is run by the Transportation Security Administration (TSA), a federal
agency created in response to the 2001 attacks. TSA requirements became a bit
more onerous after Richard Reid, an Englishman and member of al-Qaeda, tried in
December of that same year to blow up an American Airlines flight with a bomb hehad concealed in his shoe. Reid was unsuccessful, but passengers must now remove
their shoes so TSA agents can check them for bombs.
TSA restrictions became dramatically more stringent after Umar Farouk
Abdulmutallab, a jihadist from Nigeria, tried—again without success—to blow up aplane flying from Amsterdam to Detroit on Christmas Day, 2009, using a bomb
concealed in his underwear. The subsequent tightening of TSA regulations, and theintroduction of body-scan machines and “patdown inspections,” were quick tofollow. Each new procedure took additional money and time and further reduced
passenger privacy. It was a production choice that has created many irate
passengers but has also been successful, to date, in preventing subsequent terrorist
attacks.

1. The rules that define how an
economy’s resources are to beowned and how decisions
about their use are to be made.

While the TSA procedures represent an unusual production choice, it is still a
production choice—one that is being made all over the world as countries grapple
with the danger of terrorist attacks. In this chapter we introduce our first model,
the production possibilities model1, to examine the nature of choices to produce
more of some goods and less of others. As its name suggests, the production
possibilities model shows the goods and services that an economy is capable ofproducing—its possibilities—given the factors of production and the technology it
has available. The model specifies what it means to use resources fully andefficiently and suggests some important implications for international trade. We

40

Chapter 2 Confronting Scarcity: Choices in Production

can also use the model to illustrate economic growth, a process that expands the setof production possibilities available to an economy.
We then turn to an examination of the type of economic system in which choices
are made. An economic system2 is the set of rules that define how an economy’s
resources are to be owned and how decisions about their use are to be made. We
will see that economic systems differ—primarily in the degree of government
involvement—in terms of how they answer the fundamental economic questions.
Many of the world’s economic systems, including the systems that prevail in North
America, Europe, much of Asia, and parts of Central and South America, rely on
individuals operating in a market economy to make those choices. Other economic
systems rely principally on government to make these choices. Different economic
systems result in different choices and thus different outcomes; that market
economies generally outperform the others when it comes to providing more of thethings that people want helps to explain the dramatic shift from governmentdominated toward market-dominated economic systems that occurred throughout
the world in the last two decades of the 20th century. The chapter concludes withan examination of the role of government in an economy that relies chiefly onmarkets to allocate goods and services.

2. The set of rules that define how
an economy’s resources are to
be owned and how decisions
about their use are to be made.

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Chapter 2 Confronting Scarcity: Choices in Production

2.1 Factors of Production
LEARNING OBJECTIVES
1. Define the three factors of production—labor, capital, and natural
resources.
2. Explain the role of technology and entrepreneurs in the utilization of
the economy’s factors of production.

Choices concerning what goods and services to produce are choices about an
economy’s use of its factors of production3, the resources available to it for the
production of goods and services. The value, or satisfaction, that people derive fromthe goods and services they consume and the activities they pursue is calledutility4. Ultimately, then, an economy’s factors of production create utility; they
serve the interests of people.
The factors of production in an economy are its labor, capital, and natural
resources. Labor5 is the human effort that can be applied to the production of
goods and services. People who are employed—or are available to be—are
considered part of the labor available to the economy. Capital6 is a factor of
production that has been produced for use in the production of other goods andservices. Office buildings, machinery, and tools are examples of capital. Natural
resources7 are the resources of nature that can be used for the production of goods
and services.
3. The resources available to theeconomy for the production of
goods and services.
4. The value, or satisfaction, thatpeople derive from the goods
and services they consume andthe activities they pursue.
5. The human effort that can beapplied to the production of
goods and services.

In the next three sections, we will take a closer look at the factors of production we
use to produce the goods and services we consume. The three basic building blocksof labor, capital, and natural resources may be used in different ways to produce
different goods and services, but they still lie at the core of production. We will thenlook at the roles played by technology and entrepreneurs in putting these factors of
production to work. As economists began to grapple with the problems of scarcity,
choice, and opportunity cost more than two centuries ago, they focused on theseconcepts, just as they are likely to do two centuries hence.

6. A factor of production that has
been produced for use in the
production of other goods andservices.

Labor

7. The resources of nature thatcan be used for the productionof goods and services.

Labor is the human effort that can be applied to production. People who work to
repair tires, pilot airplanes, teach children, or enforce laws are all part of theeconomy’s labor. People who would like to work but have not found42

Chapter 2 Confronting Scarcity: Choices in Production

employment—who are unemployed—are also considered part of the labor available
to the economy.
In some contexts, it is useful to distinguish two forms of labor. The first is thehuman equivalent of a natural resource. It is the natural ability an untrained,
uneducated person brings to a particular production process. But most workers
bring far more. Skills a worker has as a result of education, training, or experiencethat can be used in production are called human capital8. Students are acquiring
human capital. Workers who are gaining skills through experience or throughtraining are acquiring human capital.
The amount of labor available to an economy can be increased in two ways. One is
to increase the total quantity of labor, either by increasing the number of people
available to work or by increasing the average number of hours of work per time
period. The other is to increase the amount of human capital possessed by workers.

CapitalLong ago, when the first human beings walked the earth, they produced food bypicking leaves or fruit off a plant or by catching an animal and eating it. We knowthat very early on, however, they began shaping stones into tools, apparently foruse in butchering animals. Those tools were the first capital because they were
produced for use in producing other goods—food and clothing.
Modern versions of the first stone tools include saws, meat cleavers, hooks, andgrinders; all are used in butchering animals. Tools such as hammers, screwdrivers,
and wrenches are also capital. Transportation equipment, such as cars and trucks, iscapital. Facilities such as roads, bridges, ports, and airports are capital. Buildings,
too, are capital; they help us to produce goods and services.
Capital does not consist solely of physical objects. The score for a new symphony iscapital because it will be used to produce concerts. Computer software used bybusiness firms or government agencies to produce goods and services is capital.
Capital may thus include physical goods and intellectual discoveries. Any resourceis capital if it satisfies two criteria:
1. The resource must have been produced.
2. The resource can be used to produce other goods and services.
8. The skills a worker has as aresult of education, training, or
experience that can be used in
production.

2.1 Factors of Production

One thing that is not considered capital is money. A firm cannot use money directly
to produce other goods, so money does not satisfy the second criterion for capital.

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Chapter 2 Confronting Scarcity: Choices in Production

Firms can, however, use money to acquire capital. Money is a form of financial
capital. Financial capital9 includes money and other “paper” assets (such as stocks
and bonds) that represent claims on future payments. These financial assets are notcapital, but they can be used directly or indirectly to purchase factors of production
or goods and services.

Natural Resources
There are two essential characteristics of natural resources. The first is that they
are found in nature—that no human effort has been used to make or alter them. The
second is that they can be used for the production of goods and services. That
requires knowledge; we must know how to use the things we find in nature before
they become resources.
Consider oil. Oil in the ground is a natural resource because it is found (notmanufactured) and can be used to produce goods and services. However, 250 years
ago oil was a nuisance, not a natural resource. Pennsylvania farmers in theeighteenth century who found oil oozing up through their soil were dismayed, notdelighted. No one knew what could be done with the oil. It was not until the midnineteenth century that a method was found for refining oil into kerosene that
could be used to generate energy, transforming oil into a natural resource. Oil is
now used to make all sorts of things, including clothing, drugs, gasoline, and plastic.
It became a natural resource because people discovered and implemented a way touse it.
Defining something as a natural resource only if it can be used to produce goods
and services does not mean that a tree has value only for its wood or that a
mountain has value only for its minerals. If people gain utility from the existence ofa beautiful wilderness area, then that wilderness provides a service. The wilderness
is thus a natural resource.
The natural resources available to us can be expanded in three ways. One is thediscovery of new natural resources, such as the discovery of a deposit of ore
containing titanium. The second is the discovery of new uses for resources, as
happened when new techniques allowed oil to be put to productive use or sand to
be used in manufacturing computer chips. The third is the discovery of new ways to
extract natural resources in order to use them. New methods of discovering andmapping oil deposits have increased the world’s supply of this important natural
resource.
9. Includes money and other“paper” assets (such as stocks
and bonds) that represent
claims on future payments.

2.1 Factors of Production

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Chapter 2 Confronting Scarcity: Choices in Production

Technology and the Entrepreneur
Goods and services are produced using the factors of production available to theeconomy. Two things play a crucial role in putting these factors of production towork. The first is technology10, the knowledge that can be applied to the
production of goods and services. The second is an individual who plays a key rolein a market economy: the entrepreneur. An entrepreneur11 is a person who,
operating within the context of a market economy, seeks to earn profits by finding
new ways to organize factors of production. In non-market economies the role ofthe entrepreneur is played by bureaucrats and other decision makers who respondto incentives other than profit to guide their choices about resource allocation
decisions.
The interplay of entrepreneurs and technology affects all our lives. Entrepreneurs
put new technologies to work every day, changing the way factors of production areused. Farmers and factory workers, engineers and electricians, technicians andteachers all work differently than they did just a few years ago, using newtechnologies introduced by entrepreneurs. The music you enjoy, the books you
read, the athletic equipment with which you play are produced differently thanthey were five years ago. The book you are reading was written and manufactured
using technologies that did not exist ten years ago. We can dispute whether all thechanges have made our lives better. What we cannot dispute is that they have madeour lives different.

KEY TAKEAWAYS

10. The knowledge that can beapplied to the production of
goods and services.
11. A person who, operating
within the context of a market
economy, seeks to earn profits
by finding new ways toorganize factors of production.

2.1 Factors of Production• Factors of production are the resources the economy has available toproduce goods and services.
• Labor is the human effort that can be applied to the production of goods
and services. Labor’s contribution to an economy’s output of goods andservices can be increased either by increasing the quantity of labor or byincreasing human capital.
• Capital is a factor of production that has been produced for use in the
production of other goods and services.
• Natural resources are those things found in nature that can be used forthe production of goods and services.
• Two keys to the utilization of an economy’s factors of production aretechnology and, in the case of a market economic system, the efforts ofentrepreneurs.

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Chapter 2 Confronting Scarcity: Choices in Production

TRY IT!
Explain whether each of the following is labor, capital, or a natural resource.
1.
2.
3.
4.
5.
6.
7.

2.1 Factors of Production

An unemployed factory worker
A college professor
The library building on your campus
Yellowstone National Park
An untapped deposit of natural gas
The White House
The local power plant46

Chapter 2 Confronting Scarcity: Choices in Production

Case in Point: Technology Cuts Costs, Boosts
Productivity, Profits, and Utility© 2010 Jupiterimages
Corporation

Technology can seem an abstract force in the economy—important, butinvisible.
It is not invisible to the 130 people who work on a Shell Oil Company oil rig
called Mars, located in the deep waters of the Gulf of Mexico, about 160 miles
southwest of Pensacola, Florida. The name Mars reflects its otherworld
appearance—it extends 300 feet above the water’s surface and has steel tendonsthat reach 3,000 feet down to extract the Gulf’s oil deposits. This facility would
not exist if it were not for the development of better oil discovery methods that
include three-dimensional seismic mapping techniques, satellites that locate oilfrom space, and drills that can make turns as drilling foremen steer them bymonitoring them on computer screens from the comfort of Mars. “We don’t hit
as many dry holes,” commented Shell manager Miles Barrett. As a result of
these new technologies, over the past two decades, the cost of discovering abarrel of oil dropped from $20 to under $5. And the technologies continue toimprove. Three-dimensional surveys are being replaced with four-dimensional
ones that allow geologists to see how the oil fields change over time.

2.1 Factors of Production

47

Chapter 2 Confronting Scarcity: Choices in Production

The Mars project was destroyed by Hurricane Katrina in 2005. Royal Dutch Shell
completed repairs in 2006, at a cost of $200 million. But the facility is again
pumping 130,000 barrels of oil per day and 150 million cubic feet of natural gas,
the energy equivalent of an additional 26,000 barrels of oil. Shell announced a
new Mars-like project, Mars B Olympus, in 2010. The second Mars hub will belocated 100 miles south of New Orleans and is expected to begin production in2015.
Technology is doing more than helping energy companies track oil deposits. It
is changing the way soft drinks and other grocery items are delivered to retailstores. For example, when a PepsiCo delivery driver arrives at a 7-Eleven, thedriver keys into a handheld computer the store’s inventory of soft drinks,
chips, and other PepsiCo products. The information is transmitted to a main
computer at the warehouse that begins processing the next order for that store.
The result is that the driver can visit more stores in a day and PepsiCo cancover a given territory with fewer drivers and trucks.
New technology is even helping to produce more milk from cows. Ed Larsen,
who owns a 1,200-cow dairy farm in Wisconsin, never gets up before dawn tomilk the cows, the way he did as a boy. Rather, the cows are hooked up toelectronic milkers. Computers measure each cow’s output, and cows producing
little milk are sent to a “hospital wing” for treatment. With the help of suchtechnology, as well as better feed, today’s dairy cows produce 50% more milk
than did cows roughly 20 years ago. Even though the number of dairy cows in
the United States in the last 20 years has fallen 17%, milk output has increased25%.
Who benefits from technological progress? Consumers gain from lower prices
and better service. Workers gain: Their greater ability to produce goods andservices translates into higher wages. And firms gain: Lower production costs
mean higher profits. Of course, some people lose as technology advances. Somejobs are eliminated, and some firms find their services are no longer needed.
One can argue about whether particular technological changes have improved
our lives, but they have clearly made—and will continue to make—them far
different.
Sources: David Ballingrud, “Drilling in the Gulf: Life on Mars,” St. Petersburg
Times (Florida), August 5, 2001, p. 1A; Barbara Hagenbaugh, “Dairy Farms Evolveto Survive,” USA Today, August 7, 2003, p. 1B; Del Jones and Barbara Hansen,

2.1 Factors of Production

48Chapter 2 Confronting Scarcity: Choices in Production“Special Report: A Who’s Who of Productivity,” USA Today, August 30, 2001, p.
1B; Christopher Helman, Shell Shocked, Forbes Online, July 27, 2006; “Shell Plans
Second Deep Water Production Hub,” September 9, 2010 at
http://www.greentechmedia.com/industry/read/shell-plans-second-deepwater-production-hub-in-the-gulfs-pro-15227/.

ANSWERS TO TRY IT! PROBLEMS
1. An unemployed factory worker could be put to work; he or she counts aslabor.
2. A college professor is labor.
3. The library building on your campus is part of capital.
4. Yellowstone National Park. Those areas of the park left in their naturalstate are a natural resource. Facilities such as visitors’ centers, roads,
and campgrounds are capital.
5. An untapped deposit of natural gas is a natural resource. Once extracted
and put in a storage tank, natural gas is capital.
6. The White House is capital.
7. The local power plant is capital.

2.1 Factors of Production

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Chapter 2 Confronting Scarcity: Choices in Production

2.2 The Production Possibilities Curve
LEARNING OBJECTIVES
1. Explain the concept of the production possibilities curve andunderstand the implications of its downward slope and bowed-out
shape.
2. Use the production possibilities model to distinguish between full
employment and situations of idle factors of production and between
efficient and inefficient production.
3. Understand specialization and its relationship to the production
possibilities model and comparative advantage.

An economy’s factors of production are scarce; they cannot produce an unlimited
quantity of goods and services. A production possibilities curve12 is a graphicalrepresentation of the alternative combinations of goods and services an economy
can produce. It illustrates the production possibilities model. In drawing the
production possibilities curve, we shall assume that the economy can produce only
two goods and that the quantities of factors of production and the technology
available to the economy are fixed.

Constructing a Production Possibilities Curve
To construct a production possibilities curve, we will begin with the case of ahypothetical firm, Alpine Sports, Inc., a specialized sports equipment manufacturer.
Christie Ryder began the business 15 years ago with a single ski production facility
near Killington ski resort in central Vermont. Ski sales grew, and she also saw
demand for snowboards rising—particularly after snowboard competition eventswere included in the 2002 Winter Olympics in Salt Lake City. She added a second
plant in a nearby town. The second plant, while smaller than the first, was designed
to produce snowboards as well as skis. She also modified the first plant so that it
could produce both snowboards and skis. Two years later she added a third plant inanother town. While even smaller than the second plant, the third was primarily
designed for snowboard production but could also produce skis.

12. A graphical representation of
the alternative combinations ofgoods and services an economy
can produce.

We can think of each of Ms. Ryder’s three plants as a miniature economy andanalyze them using the production possibilities model. We assume that the factorsof production and technology available to each of the plants operated by Alpine
Sports are unchanged.

50Chapter 2 Confronting Scarcity: Choices in Production

Suppose the first plant, Plant 1, can produce 200 pairs of skis per month when it
produces only skis. When devoted solely to snowboards, it produces 100
snowboards per month. It can produce skis and snowboards simultaneously as well.
The table in Figure 2.1 "A Production Possibilities Curve" gives three combinationsof skis and snowboards that Plant 1 can produce each month. Combination A
involves devoting the plant entirely to ski production; combination C means
shifting all of the plant’s resources to snowboard production; combination B
involves the production of both goods. These values are plotted in a production
possibilities curve for Plant 1. The curve is a downward-sloping straight line,
indicating we have assumed that there is a linear, negative relationship between
the production of the two goods.
Neither skis nor snowboards is an independent or a dependent variable in the
production possibilities model; we can assign either one to the vertical or to thehorizontal axis. Here, we have placed the number of pairs of skis produced permonth on the vertical axis and the number of snowboards produced per month on
the horizontal axis.
The negative slope of the production possibilities curve reflects the scarcity of theplant’s capital and labor. Producing more snowboards requires shifting resources
out of ski production and thus producing fewer skis. Producing more skis requires
shifting resources out of snowboard production and thus producing fewer
snowboards.
The slope of Plant 1’s production possibilities curve measures the rate at which
Alpine Sports must give up ski production to produce additional snowboards.
Because the production possibilities curve for Plant 1 is linear, we can compute theslope between any two points on the curve and get the same result. Between points
A and B, for example, the slope equals −2 pairs of skis/snowboard (equals −100 pairsof skis/50 snowboards). (Many students are helped when told to read this result as“−2 pairs of skis per snowboard.”) We get the same value between points B and C,
and between points A and C.

2.2 The Production Possibilities Curve

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Chapter 2 Confronting Scarcity: Choices in Production

Figure 2.1 A Production Possibilities Curve

The table shows the combinations of pairs of skis and snowboards that Plant 1 is capable of producing each month.
These are also illustrated with a production possibilities curve. Notice that this curve is linear.

To see this relationship more clearly, examine Figure 2.2 "The Slope of a Production
Possibilities Curve". Suppose Plant 1 is producing 100 pairs of skis and 50
snowboards per month at point B. Now consider what would happen if Ms. Ryder
decided to produce 1 more snowboard per month. The segment of the curve aroundpoint B is magnified in Figure 2.2 "The Slope of a Production Possibilities Curve".
The slope between points B and B′ is −2 pairs of skis/snowboard. Producing 1
additional snowboard at point B′ requires giving up 2 pairs of skis. We can think ofthis as the opportunity cost of producing an additional snowboard at Plant 1. This
opportunity cost equals the absolute value of the slope of the production
possibilities curve.

2.2 The Production Possibilities Curve

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Chapter 2 Confronting Scarcity: Choices in Production

Figure 2.2 The Slope of a Production Possibilities Curve

The slope of the linear production possibilities curve in Figure 2.1 "A Production Possibilities Curve" is constant; it is−2 pairs of skis/snowboard. In the section of the curve shown here, the slope can be calculated between points B andB′. Expanding snowboard production to 51 snowboards per month from 50 snowboards per month requires a
reduction in ski production to 98 pairs of skis per month from 100 pairs. The slope equals −2 pairs of skis/snowboard(that is, it must give up two pairs of skis to free up the resources necessary to produce one additional snowboard).
To shift from B′ to B″, Alpine Sports must give up two more pairs of skis per snowboard. The absolute value of theslope of a production possibilities curve measures the opportunity cost of an additional unit of the good on thehorizontal axis measured in terms of the quantity of the good on the vertical axis that must be forgone.

The absolute value of the slope of any production possibilities curve equals theopportunity cost of an additional unit of the good on the horizontal axis. It is theamount of the good on the vertical axis that must be given up in order to free up
the resources required to produce one more unit of the good on the horizontal axis.
We will make use of this important fact as we continue our investigation of the
production possibilities curve.
Figure 2.3 "Production Possibilities at Three Plants" shows production possibilities
curves for each of the firm’s three plants. Each of the plants, if devoted entirely tosnowboards, could produce 100 snowboards. Plants 2 and 3, if devoted exclusively
to ski production, can produce 100 and 50 pairs of skis per month, respectively. The
exhibit gives the slopes of the production possibilities curves for each plant. The
opportunity cost of an additional snowboard at each plant equals the absolutevalues of these slopes (that is, the number of pairs of skis that must be given up per
snowboard).

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Figure 2.3 Production Possibilities at Three Plants

The slopes of the production possibilities curves for each plant differ. The steeper the curve, the greater theopportunity cost of an additional snowboard. Here, the opportunity cost is lowest at Plant 3 and greatest at Plant 1.

The exhibit gives the slopes of the production possibilities curves for each of thefirm’s three plants. The opportunity cost of an additional snowboard at each plant
equals the absolute values of these slopes. More generally, the absolute value of theslope of any production possibilities curve at any point gives the opportunity costof an additional unit of the good on the horizontal axis, measured in terms of thenumber of units of the good on the vertical axis that must be forgone.
The greater the absolute value of the slope of the production possibilities curve, thegreater the opportunity cost will be. The plant for which the opportunity cost of anadditional snowboard is greatest is the plant with the steepest production
possibilities curve; the plant for which the opportunity cost is lowest is the plantwith the flattest production possibilities curve. The plant with the lowest
opportunity cost of producing snowboards is Plant 3; its slope of −0.5 means that
Ms. Ryder’s firm must give up half a pair of skis in that plant to produce anadditional snowboard. In Plant 2, she must give up one pair of skis to gain one more
snowboard. We have already seen that an additional snowboard requires giving up
two pairs of skis in Plant 1.

Comparative Advantage and the Production Possibilities Curve
To construct a combined production possibilities curve for all three plants, we canbegin by asking how many pairs of skis Alpine Sports could produce if it were
producing only skis. To find this quantity, we add up the values at the verticalintercepts of each of the production possibilities curves in Figure 2.3 "Production

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Possibilities at Three Plants". These intercepts tell us the maximum number of pairsof skis each plant can produce. Plant 1 can produce 200 pairs of skis per month,
Plant 2 can produce 100 pairs of skis at per month, and Plant 3 can produce 50 pairs.
Alpine Sports can thus produce 350 pairs of skis per month if it devotes its
resources exclusively to ski production. In that case, it produces no snowboards.
Now suppose the firm decides to produce 100 snowboards. That will require shifting
one of its plants out of ski production. Which one will it choose to shift? The
sensible thing for it to do is to choose the plant in which snowboards have thelowest opportunity cost—Plant 3. It has an advantage not because it can produce
more snowboards than the other plants (all the plants in this example are capableof producing up to 100 snowboards per month) but because it is the least productiveplant for making skis. Producing a snowboard in Plant 3 requires giving up just halfa pair of skis.
Economists say that an economy has a comparative advantage13 in producing agood or service if the opportunity cost of producing that good or service is lower forthat economy than for any other. Plant 3 has a comparative advantage insnowboard production because it is the plant for which the opportunity cost ofadditional snowboards is lowest. To put this in terms of the production possibilities
curve, Plant 3 has a comparative advantage in snowboard production (the good on
the horizontal axis) because its production possibilities curve is the flattest of thethree curves.

13. In producing a good or service,
the situation that occurs if theopportunity cost of producingthat good or service is lower
for that economy than for any
other.

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Figure 2.4 The Combined Production Possibilities Curve for Alpine Sports

The curve shown combines the production possibilities curves for each plant. At point A, Alpine Sports produces 350
pairs of skis per month and no snowboards. If the firm wishes to increase snowboard production, it will first use
Plant 3, which has a comparative advantage in snowboards.

Plant 3’s comparative advantage in snowboard production makes a crucial point
about the nature of comparative advantage. It need not imply that a particularplant is especially good at an activity. In our example, all three plants are equally
good at snowboard production. Plant 3, though, is the least efficient of the three inski production. Alpine thus gives up fewer skis when it produces snowboards in
Plant 3. Comparative advantage thus can stem from a lack of efficiency in the
production of an alternative good rather than a special proficiency in the
production of the first good.
The combined production possibilities curve for the firm’s three plants is shown in
Figure 2.4 "The Combined Production Possibilities Curve for Alpine Sports". We
begin at point A, with all three plants producing only skis. Production totals 350
pairs of skis per month and zero snowboards. If the firm were to produce 100
snowboards at Plant 3, ski production would fall by 50 pairs per month (recall thatthe opportunity cost per snowboard at Plant 3 is half a pair of skis). That would

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bring ski production to 300 pairs, at point B. If Alpine Sports were to produce still
more snowboards in a single month, it would shift production to Plant 2, the facility
with the next-lowest opportunity cost. Producing 100 snowboards at Plant 2 would
leave Alpine Sports producing 200 snowboards and 200 pairs of skis per month, atpoint C. If the firm were to switch entirely to snowboard production, Plant 1 would
be the last to switch because the cost of each snowboard there is 2 pairs of skis.
With all three plants producing only snowboards, the firm is at point D on the
combined production possibilities curve, producing 300 snowboards per month andno skis.
Notice that this production possibilities curve, which is made up of linear segmentsfrom each assembly plant, has a bowed-out shape; the absolute value of its slope
increases as Alpine Sports produces more and more snowboards. This is a result oftransferring resources from the production of one good to another according tocomparative advantage. We shall examine the significance of the bowed-out shapeof the curve in the next section.

The Law of Increasing Opportunity Cost
We see in Figure 2.4 "The Combined Production Possibilities Curve for Alpine
Sports" that, beginning at point A and producing only skis, Alpine Sports
experiences higher and higher opportunity costs as it produces more snowboards.
The fact that the opportunity cost of additional snowboards increases as the firm
produces more of them is a reflection of an important economic law. The law of
increasing opportunity cost14 holds that as an economy moves along its
production possibilities curve in the direction of producing more of a particular
good, the opportunity cost of additional units of that good will increase.

14. As an economy moves along its
production possibilities curvein the direction of producing
more of a particular good, theopportunity cost of additional
units of that good will increase.

We have seen the law of increasing opportunity cost at work traveling from point A
toward point D on the production possibilities curve in Figure 2.4 "The Combined
Production Possibilities Curve for Alpine Sports". The opportunity cost of each of
the first 100 snowboards equals half a pair of skis; each of the next 100 snowboards
has an opportunity cost of 1 pair of skis, and each of the last 100 snowboards has anopportunity cost of 2 pairs of skis. The law also applies as the firm shifts fromsnowboards to skis. Suppose it begins at point D, producing 300 snowboards permonth and no skis. It can shift to ski production at a relatively low cost at first. The
opportunity cost of the first 200 pairs of skis is just 100 snowboards at Plant 1, a
movement from point D to point C, or 0.5 snowboards per pair of skis. We would saythat Plant 1 has a comparative advantage in ski production. The next 100 pairs ofskis would be produced at Plant 2, where snowboard production would fall by 100
snowboards per month. The opportunity cost of skis at Plant 2 is 1 snowboard perpair of skis. Plant 3 would be the last plant converted to ski production. There, 50

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pairs of skis could be produced per month at a cost of 100 snowboards, or an
opportunity cost of 2 snowboards per pair of skis.
The bowed-out shape of the production possibilities curve illustrates the law of
increasing opportunity cost. Its downward slope reflects scarcity.
Figure 2.5 "Production Possibilities for the Economy" illustrates a much smootherproduction possibilities curve. This production possibilities curve in Panel (a)includes 10 linear segments and is almost a smooth curve. As we include more andmore production units, the curve will become smoother and smoother. In an actual
economy, with a tremendous number of firms and workers, it is easy to see that the
production possibilities curve will be smooth. We will generally draw production
possibilities curves for the economy as smooth, bowed-out curves, like the one in
Panel (b). This production possibilities curve shows an economy that produces only
skis and snowboards. Notice the curve still has a bowed-out shape; it still has anegative slope. Notice also that this curve has no numbers. Economists often use
models such as the production possibilities model with graphs that show thegeneral shapes of curves but that do not include specific numbers.
Figure 2.5 Production Possibilities for the Economy

As we combine the production possibilities curves for more and more units, the curve becomes smoother. It retains
its negative slope and bowed-out shape. In Panel (a) we have a combined production possibilities curve for Alpine
Sports, assuming that it now has 10 plants producing skis and snowboards. Even though each of the plants has alinear curve, combining them according to comparative advantage, as we did with 3 plants in Figure 2.4 "TheCombined Production Possibilities Curve for Alpine Sports", produces what appears to be a smooth, nonlinear curve,
even though it is made up of linear segments. In drawing production possibilities curves for the economy, we shallgenerally assume they are smooth and “bowed out,” as in Panel (b). This curve depicts an entire economy that
produces only skis and snowboards.

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Movements Along the Production Possibilities Curve
We can use the production possibilities model to examine choices in the productionof goods and services. In applying the model, we assume that the economy can
produce two goods, and we assume that technology and the factors of production
available to the economy remain unchanged. In this section, we shall assume thatthe economy operates on its production possibilities curve so that an increase in
the production of one good in the model implies a reduction in the production of
the other.
We shall consider two goods and services: national defense and security and a
category we shall call “all other goods and services.” This second category includes
the entire range of goods and services the economy can produce, aside fromnational defense and security. Clearly, the transfer of resources to the effort toenhance national security reduces the quantity of other goods and services that canbe produced. In the wake of the 9/11 attacks in 2001, nations throughout the world
increased their spending for national security. This spending took a variety offorms. One, of course, was increased defense spending. Local and state governments
also increased spending in an effort to prevent terrorist attacks. Airports aroundthe world hired additional agents to inspect luggage and passengers.
The increase in resources devoted to security meant fewer “other goods andservices” could be produced. In terms of the production possibilities curve in Figure
2.6 "Spending More for Security", the choice to produce more security and less ofother goods and services means a movement from A to B. Of course, an economy
cannot really produce security; it can only attempt to provide it. The attempt toprovide it requires resources; it is in that sense that we shall speak of the economy
as “producing” security.
At point A, the economy was producing SA units of
security on the vertical axis—defense services andvarious forms of police protection—and OA units ofother goods and services on the horizontal axis. The
decision to devote more resources to security and less toother goods and services represents the choice we
discussed in the chapter introduction. In this case wehave categories of goods rather than specific goods.
Thus, the economy chose to increase spending on
security in the effort to defeat terrorism. Since we haveassumed that the economy has a fixed quantity ofavailable resources, the increased use of resources for

2.2 The Production Possibilities Curve

Figure 2.6 Spending Morefor Security

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security and national defense necessarily reduces thenumber of resources available for the production ofother goods and services.
The law of increasing opportunity cost tells us that, as
the economy moves along the production possibilities
curve in the direction of more of one good, its
opportunity cost will increase. We may conclude that, as
the economy moved along this curve in the direction ofgreater production of security, the opportunity cost of
the additional security began to increase. That is
because the resources transferred from the productionof other goods and services to the production of security
had a greater and greater comparative advantage inproducing things other than security.

Here, an economy that can
produce two categories of goods,
security and “all other goods andservices,” begins at point A on its
production possibilities curve.
The economy produces SA unitsof security and OA units of allother goods and services perperiod. A movement from A to B
requires shifting resources out ofthe production of all other goods
and services and into spending
on security. The increase in
spending on security, to SA unitsof security per period, has anopportunity cost of reduced
production of all other goods andservices. Production of all othergoods and services falls by OA OB units per period.

The production possibilities model does not tell us
where on the curve a particular economy will operate.
Instead, it lays out the possibilities facing the economy.
Many countries, for example, chose to move along theirrespective production possibilities curves to produce more security and national
defense and less of all other goods in the wake of 9/11. We will see in the chapter on
demand and supply how choices about what to produce are made in themarketplace.

Producing on Versus Producing Inside the Production
Possibilities Curve
An economy that is operating inside its production possibilities curve could, by
moving onto it, produce more of all the goods and services that people value, suchas food, housing, education, medical care, and music. Increasing the availability ofthese goods would improve the standard of living. Economists conclude that it isbetter to be on the production possibilities curve than inside it.
Two things could leave an economy operating at a point inside its production
possibilities curve. First, the economy might fail to use fully the resources available
to it. Second, it might not allocate resources on the basis of comparative advantage.
In either case, production within the production possibilities curve implies the
economy could improve its performance.

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Idle Factors of Production
Suppose an economy fails to put all its factors of production to work. Some workers
are without jobs, some buildings are without occupants, some fields are without
crops. Because an economy’s production possibilities curve assumes the full use of
the factors of production available to it, the failure to use some factors results in alevel of production that lies inside the production possibilities curve.
If all the factors of production that are available for use under current market
conditions are being utilized, the economy has achieved full employment15. An
economy cannot operate on its production possibilities curve unless it has full
employment.
Figure 2.7 Idle Factors and Production

15. Situation in which all thefactors of production that areavailable for use under current
market conditions are being
utilized.

The production possibilities curve shown suggests an economy that can produce two goods, food and clothing. As aresult of a failure to achieve full employment, the economy operates at a point such as B, producing FB units of foodand CB units of clothing per period. Putting its factors of production to work allows a move to the production
possibilities curve, to a point such as A. The production of both goods rises.

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Figure 2.7 "Idle Factors and Production" shows an economy that can produce foodand clothing. If it chooses to produce at point A, for example, it can produce FA
units of food and CA units of clothing. Now suppose that a large fraction of theeconomy’s workers lose their jobs, so the economy no longer makes full use of one
factor of production: labor. In this example, production moves to point B, where theeconomy produces less food (FB) and less clothing (CB) than at point A. We often
think of the loss of jobs in terms of the workers; they have lost a chance to work andto earn income. But the production possibilities model points to another loss: goods
and services the economy could have produced that are not being produced.

Inefficient Production
Now suppose Alpine Sports is fully employing its factors of production. Could it still
operate inside its production possibilities curve? Could an economy that is using allits factors of production still produce less than it could? The answer is “Yes,” andthe key lies in comparative advantage. An economy achieves a point on its
production possibilities curve only if it allocates its factors of production on thebasis of comparative advantage. If it fails to do that, it will operate inside the curve.

16. When an economy is operating
on its production possibilities
curve.
17. Situation in which theeconomy is using the same
quantities of factors of
production but is operating
inside its production
possibilities curve.

Suppose that, as before, Alpine Sports has been producing only skis. With all threeof its plants producing skis, it can produce 350 pairs of skis per month (and nosnowboards). The firm then starts producing snowboards. This time, however,imagine that Alpine Sports switches plants from skis to snowboards in numericalorder: Plant 1 first, Plant 2 second, and then Plant 3. Figure 2.8 "Efficient Versus
Inefficient Production" illustrates the result. Instead of the bowed-out production
possibilities curve ABCD, we get a bowed-in curve, AB′C′D. Suppose that Alpine
Sports is producing 100 snowboards and 150 pairs of skis at point B′. Had the firmbased its production choices on comparative advantage, it would have switched
Plant 3 to snowboards and then Plant 2, so it could have operated at a point such as
C. It would be producing more snowboards and more pairs of skis—and using thesame quantities of factors of production it was using at B′. Had the firm based its
production choices on comparative advantage, it would have switched Plant 3 tosnowboards and then Plant 2, so it would have operated at point C. It would be
producing more snowboards and more pairs of skis—and using the same quantities
of factors of production it was using at B′. When an economy is operating on its
production possibilities curve, we say that it is engaging in efficient production16.
If it is using the same quantities of factors of production but is operating inside its
production possibilities curve, it is engaging in inefficient production17. Inefficient
production implies that the economy could be producing more goods without using
any additional labor, capital, or natural resources.

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Points on the production possibilities curve thus satisfy
two conditions: the economy is making full use of its
Figure 2.8 Efficient Versus
factors of production, and it is making efficient use ofInefficient Production
its factors of production. If there are idle or inefficiently
allocated factors of production, the economy will
operate inside the production possibilities curve. Thus,
the production possibilities curve not only shows what
can be produced; it provides insight into how goods andservices should be produced. It suggests that to obtain
efficiency in production, factors of production should beallocated on the basis of comparative advantage.
Further, the economy must make full use of its factorsof production if it is to produce the goods and services it
When factors of production areis capable of producing.

Specialization
The production possibilities model suggests thatspecialization will occur. Specialization18 implies thatan economy is producing the goods and services inwhich it has a comparative advantage. If Alpine Sports
selects point C in Figure 2.8 "Efficient Versus Inefficient
Production", for example, it will assign Plant 1
exclusively to ski production and Plants 2 and 3
exclusively to snowboard production.
Such specialization is typical in an economic system.
Workers, for example, specialize in particular fields inwhich they have a comparative advantage. People workand use the income they earn to buy—perhaps
import—goods and services from people who have acomparative advantage in doing other things. The result
is a far greater quantity of goods and services thanwould be available without this specialization.

18. Situation in which an economy
is producing the goods andservices in which it has acomparative advantage.

allocated on a basis other thancomparative advantage, theresult is inefficient production.
Suppose Alpine Sports operates
the three plants we examined in
Figure 2.3 "Production
Possibilities at Three Plants".
Suppose further that all threeplants are devoted exclusively to
ski production; the firm operates
at A. Now suppose that, toincrease snowboard production,it transfers plants in numericalorder: Plant 1 first, then Plant 2,
and finally Plant 3. The result isthe bowed-in curve AB′C′D.
Production on the production
possibilities curve ABCD requiresthat factors of production betransferred according tocomparative advantage.

Think about what life would be like without specialization. Imagine that you aresuddenly completely cut off from the rest of the economy. You must produce
everything you consume; you obtain nothing from anyone else. Would you be able
to consume what you consume now? Clearly not. It is hard to imagine that most of
us could even survive in such a setting. The gains we achieve through specialization
are enormous.

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Nations specialize as well. Much of the land in the United States has a comparativeadvantage in agricultural production and is devoted to that activity. Hong Kong,
with its huge population and tiny endowment of land, allocates virtually none of its
land to agricultural use; that option would be too costly. Its land is devoted largely
to nonagricultural use.

KEY TAKEAWAYS• A production possibilities curve shows the combinations of two goods an
economy is capable of producing.
• The downward slope of the production possibilities curve is an
implication of scarcity.
• The bowed-out shape of the production possibilities curve results fromallocating resources based on comparative advantage. Such an
allocation implies that the law of increasing opportunity cost will hold.
• An economy that fails to make full and efficient use of its factors of
production will operate inside its production possibilities curve.
• Specialization means that an economy is producing the goods andservices in which it has a comparative advantage.

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TRY IT!
Suppose a manufacturing firm is equipped to produce radios or calculators.
It has two plants, Plant R and Plant S, at which it can produce these goods.
Given the labor and the capital available at both plants, it can produce the
combinations of the two goods at the two plants shown.
Output per day, Plant R
Combination Calculators Radios
A

100

0

B

50

25

C

0

50

Output per day, Plant S
Combination Calculators Radios
D

50

0

E

25

50

F

0

100

Put calculators on the vertical axis and radios on the horizontal axis. Draw
the production possibilities curve for Plant R. On a separate graph, draw the
production possibilities curve for Plant S. Which plant has a comparativeadvantage in calculators? In radios? Now draw the combined curves for thetwo plants. Suppose the firm decides to produce 100 radios. Where will it
produce them? How many calculators will it be able to produce? Where will
it produce the calculators?

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Case in Point: The Cost of the Great Depression© 2010 Jupiterimages Corporation

The U.S. economy looked very healthy in the beginning of 1929. It had enjoyedseven years of dramatic growth and unprecedented prosperity. Its resourceswere fully employed; it was operating quite close to its production possibilities
curve.
In the summer of 1929, however, things started going wrong. Production andemployment fell. They continued to fall for several years. By 1933, more than
25% of the nation’s workers had lost their jobs. Production had plummeted byalmost 30%. The economy had moved well within its production possibilities
curve.
Output began to grow after 1933, but the economy continued to have vast
numbers of idle workers, idle factories, and idle farms. These resources were
not put back to work fully until 1942, after the U.S. entry into World War II
demanded mobilization of the economy’s factors of production.

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Between 1929 and 1942, the economy produced 25% fewer goods and services
than it would have if its resources had been fully employed. That was a loss,
measured in today’s dollars, of well over $3 trillion. In material terms, theforgone output represented a greater cost than the United States would
ultimately spend in World War II. The Great Depression was a costly experience
indeed.

ANSWER TO TRY IT! PROBLEM
The production possibilities curves for the two plants are shown, along withthe combined curve for both plants. Plant R has a comparative advantage inproducing calculators. Plant S has a comparative advantage in producing
radios, so, if the firm goes from producing 150 calculators and no radios toproducing 100 radios, it will produce them at Plant S. In the production
possibilities curve for both plants, the firm would be at M, producing 100
calculators at Plant R.

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2.3 Applications of the Production Possibilities Model
LEARNING OBJECTIVES
1. Understand the argument for unrestricted international trade in termsof economic specialization and comparative advantage.
2. Define economic growth in terms of the production possibilities modeland discuss factors that make such growth possible.
3. Explain the classification of economic systems, the role of government
in different economic systems, and the strengths and weaknesses ofdifferent systems.

The production possibilities curve gives us a model of an economy. The model
provides powerful insights about the real world, insights that help us to answer
some important questions: How does trade between two countries affect thequantities of goods available to people? What determines the rate at which
production will increase over time? What is the role of economic freedom in theeconomy? In this section we explore applications of the model to questions ofinternational trade, economic growth, and the choice of an economic system.

Comparative Advantage and International Trade
One of the most important implications of the concepts of comparative advantage
and the production possibilities curve relates to international trade. We can thinkof different nations as being equivalent to Christie Ryder’s plants. Each will have acomparative advantage in certain activities, and efficient world production requiresthat each nation specialize in those activities in which it has a comparativeadvantage. A failure to allocate resources in this way means that world production
falls inside the production possibilities curve; more of each good could be produced
by relying on comparative advantage.
If nations specialize, then they must rely on each other. They will sell the goods inwhich they specialize and purchase other goods from other nations. Suppose, forexample, that the world consists of two continents that can each produce twogoods: South America and Europe can produce food and computers. Suppose they
can produce the two goods according to the tables in Panels (a) and (b) of Figure 2.9"Production Possibilities Curves and Trade". We have simplified this example byassuming that each continent has a linear production possibilities curve; the curves
are plotted below the tables in Panels (a) and (b). Each continent has a separate

68Chapter 2 Confronting Scarcity: Choices in Production

production possibilities curve; the two have been combined to illustrate a world
production possibilities curve in Panel (c) of the exhibit.
Figure 2.9 Production Possibilities Curves and Trade

Suppose the world consists of two continents: South America and Europe. They can each produce two goods: foodand computers. In this example, we assume that each continent has a linear production possibilities curve, as shownin Panels (a) and (b). South America has a comparative advantage in food production and Europe has a comparativeadvantage in computer production. With free trade, the world can operate on the bowed-out curve GHI, shown inPanel (c). If the continents refuse to trade, the world will operate inside its production possibilities curve. If, forexample, each continent were to produce at the midpoint of its production possibilities curve, the world would
produce 300 computers and 300 units of food per period at point Q. If each continent were to specialize in the good inwhich it has a comparative advantage, world production could move to a point such as H, with more of both goods
produced.

The world production possibilities curve assumes that resources are allocatedbetween computer and food production based on comparative advantage. Notice
that, even with only two economies and the assumption of linear production
possibilities curves for each, the combined curve still has a bowed-out shape. At
point H, for example, South America specializes in food, while Europe produces only
computers. World production equals 400 units of each good. In this situation, we
would expect South America to export food to Europe while Europe exports
computers to South America.
But suppose the regions refuse to trade; each insists on producing its own food andcomputers. Suppose further that each chooses to produce at the midpoint of its own
production possibilities curve. South America produces 100 units of computers and
200 units of food per period, while Europe produces 200 units of computers and 100
units of food per period. World production thus totals 300 units of each good perperiod; the world operates at point Q in Figure 2.9 "Production Possibilities Curves
and Trade". If the two continents were willing to move from isolation to trade, the

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world could achieve an increase in the production of both goods. Producing at point
H requires no more resources, no more effort than production at Q. It does,
however, require that the world’s resources be allocated on the basis ofcomparative advantage.
The implications of our model for trade are powerful indeed. First, we see that tradeallows the production of more of all goods and services. Restrictions on trade thus
reduce production of goods and services. Second, we see a lesson often missed in
discussions of trade: a nation’s trade policy has nothing to do with its level of
employment of its factors of production. In our example, when South America andEurope do not engage in trade and produce at the midpoints of each of theirrespective production possibilities curves, they each have full employment. With trade,the two nations still operate on their respective production possibilities curves: theyeach have full employment. Trade certainly redistributes employment in the twocontinents. In South America, employment shifts from computer production to foodproduction. In Europe, it shifts from food production to computer production. Oncethe shift is made, though, there is no effect on employment in either continent.
Of course, this idealized example would have all of South America’s computer
experts becoming farmers while all of Europe’s farmers become computer geeks!
That is a bit much to swallow, but it is merely the result of assuming linear
production possibilities curves and complete specialization. In the real world,
production possibilities curves are concave, and the reallocation of resources
required by trade is not nearly as dramatic. Still, free trade can require shifts inresources from one activity to another. These shifts produce enormous benefits, butthey do not come without costs.
Nearly all economists agree that largely unrestricted trade between countries isdesirable; restrictions on trade generally force the world to operate inside its
production possibilities curve. In some cases restrictions on trade could bedesirable, but in the main, free trade promotes greater production of goods andservices for the world’s people. The role of international trade is explored ingreater detail in subsequent chapters of this book.

Economic Growth

19. The process through which an
economy achieves an outward
shift in its production
possibilities curve.

An increase in the physical quantity or in the quality of factors of production
available to an economy or a technological gain will allow the economy to produce
more goods and services; it will shift the economy’s production possibilities curve
outward. The process through which an economy achieves an outward shift in its
production possibilities curve is called economic growth19. An outward shift in a
production possibilities curve is illustrated in Figure 2.10 "Economic Growth and

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the Production Possibilities Curve". In Panel (a), a point such as N is not attainable;
it lies outside the production possibilities curve. Growth shifts the curve outward,
as in Panel (b), making previously unattainable levels of production possible.
Figure 2.10 Economic Growth and the Production Possibilities Curve

An economy capable of producing two goods, A and B, is initially operating at point M on production possibilities
curve OMR in Panel (a). Given this production possibilities curve, the economy could not produce a combinationsuch as shown by point N, which lies outside the curve. An increase in the factors of production available to theeconomy would shift the curve outward to SNT, allowing the choice of a point such as N, at which more of both
goods will be produced.

The Sources of Economic Growth
Economic growth implies an outward shift in an economy’s production possibilities
curve. Recall that when we draw such a curve, we assume that the quantity andquality of the economy’s factors of production and its technology are unchanged.
Changing these will shift the curve. Anything that increases the quantity or qualityof the factors of production available to the economy or that improves thetechnology available to the economy contributes to economic growth.
Consider, for example, the dramatic gains in human capital that have occurred in
the United States since the beginning of the past century. In 1900, about 3.5% of U.S.
workers had completed a high school education. By 2009, that percentage rosealmost to 92. Fewer than 1% of the workers in 1900 had graduated from college; aslate as 1940 only 3.5% had graduated from college. By 2009, over 32% had graduatedfrom college. In addition to being better educated, today’s workers have received
more and better training on the job. They bring far more economically usefulknowledge and skills to their work than did workers a century ago.

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Moreover, the technological changes that have occurred within the past 100 years
have greatly reduced the time and effort required to produce most goods andservices. Automated production has become commonplace. Innovations intransportation (automobiles, trucks, and airplanes) have made the movement ofgoods and people cheaper and faster. A dizzying array of new materials is available
for manufacturing. And the development of modern information
technology—including computers, software, and communications equipment—that
seemed to proceed at breathtaking pace especially during the final years of the lastcentury and continuing to the present has transformed the way we live and work.
Look again at the technological changes of the last few years described in the Casein Point on advances in technology. Those examples of technological progress
through applications of computer technology—from new ways of mapping oil
deposits to new methods of milking cows—helped propel the United States andother economies to dramatic gains in the ability to produce goods and services.
They have helped shift the countries’ production possibilities curve outward. They
have helped fuel economic growth.
Table 2.1 "Sources of U.S. Economic Growth, 1960–2007" summarizes the factorsthat have contributed to U.S. economic growth since 1960. When looking at theperiod of 1960–2007 as a whole we see that about 65% of economic growth stems
from increases in quantities of capital and labor and about 35% from increases inqualities of the factors of production and improvements in technology or
innovation. Looking at the three shorter subperiods (1960–1995, 1995-2000, and2000-2007), we see that the share attributed to quantity increases declined (from
68% to 56% and then 50%), while the share attributed to improvement in thequalities of the factors of production and to technological improvement grew (from
32% to 44% and then to 50%).
Table 2.1 Sources of U.S. Economic Growth, 1960–2007

PeriodPercentage Contribution to
GrowthYears 1960–2007

3.45%

Increase in quantity of labor

0.74%

Increase in quantity ofcapital

1.48%

Increase in quality of labor

0.23%

Increase in quality of capital

0.58%

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Period Growth
Rate

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PeriodImproved technology

Percentage Contribution to
GrowthPeriod Growth
Rate

0.41%

Years 1960–1995

3.42%

Increase in quantity of labor

0.80%

Increase in quantity ofcapital

1.55%

Increase in quality of labor

0.24%

Increase in quality of capital

0.56%

Improved technology

0.28%

Years 1995–2000

4.52%

Increase in quantity of labor

1.09%

Increase in quantity ofcapital

1.43%

Increase in quality of labor

0.20%

Increase in quality of capital

0.89%

Improved technology

0.90%

Years 2000–2007

2.78%

Increase in quantity of labor

0.17%

Increase in quantity ofcapital

1.21%

Increase in quality of labor

0.22%

Increase in quality of capital

0.46%

Improved technology

0.72%

Total output for the period shown increased nearly fivefold. The chart shows thepercentage of growth accounted for by increases in the quantity of labor and of
capital and by increases in the quality of labor and of capital and improvements intechnology.
Source: Dale W. Jorgenson, Mun Ho, and Jon Samuels, “Information Technology andU.S. Productivity Growth: Evidence from a Prototype Industry Production Account,”
prepared for Matilde Mas and Robert Stehrer, Industrial Productivity in Europe: Growthand Crisis, November 19, 2010.

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Another way of looking at these data is to note that while the contribution of
improved technology has increased over time (from 8% for the 1960–1995 period, to
20% for the 1995–2000 period, and 26% for the 2000–2007 period), most growthcomes from more and better-quality factors of production. The study by economists
Dale Jorgenson, Mun Ho, and Jon Samuels, on which the data shown in Table 2.1"Sources of U.S. Economic Growth, 1960–2007" are derived, concludes that “thegreat preponderance of economic growth in the U.S. involves the replication ofexisting technologies through investment in equipment and software andexpansion of the labour force. Replication generates economic growth with noincrease in productivity. Productivity growth is the key economic indicator ofinnovation…Although innovation contributes only a modest portion of growth, thisis vital to long-term gains in the American standard of living.”Dale W. Jorgenson,
Mun Ho, and Jon Samuels, “Information Technology and U.S. Productivity Growth:
Evidence from a Prototype Industry Production Account,” in Industrial Productivity inEurope: Growth and Crisis, ed. Matilde Mas and Robert Stehrer (Gloucestershire, UK:
Edward Elgar, forthcoming).

Waiting for Growth
One key to growth is, in effect, the willingness to wait, to postpone current
consumption in order to enhance future productive capability. When Stone Agepeople fashioned the first tools, they were spending time building capital rather
than engaging in consumption. They delayed current consumption to enhance their
future consumption; the tools they made would make them more productive in the
future.
Resources society could have used to produce consumer goods are being used to
produce new capital goods and new knowledge for production instead—all toenhance future production. An even more important source of growth in manynations has been increased human capital. Increases in human capital often require
the postponement of consumption. If you are a college student, you are engaged inprecisely this effort. You are devoting time to study that could have been spentworking, earning income, and thus engaging in a higher level of consumption. If
you are like most students, you are making this choice to postpone consumption
because you expect it will allow you to earn more income, and thus enjoy greater
consumption, in the future.
Think of an economy as being able to produce two goods, capital and consumer
goods (those destined for immediate use by consumers). By focusing on the
production of consumer goods, the people in the economy will be able to enjoy ahigher standard of living today. If they reduce their consumption—and theirstandard of living—today to enhance their ability to produce goods and services in
the future, they will be able to shift their production possibilities curve outward.

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That may allow them to produce even more consumer goods. A decision for greater
growth typically involves the sacrifice of present consumption.

Arenas for Choice: A Comparison of Economic Systems
Under what circumstances will a nation achieve efficiency in the use of its factors of
production? The discussion above suggested that Christie Ryder would have an
incentive to allocate her plants efficiently because by doing so she could achieve
greater output of skis and snowboards than would be possible from inefficient
production. But why would she want to produce more of these two goods—or of any
goods? Why would decision makers throughout the economy want to achieve such
efficiency?
Economists assume that privately owned firms seek to maximize their profits. The
drive to maximize profits will lead firms such as Alpine Sports to allocate resources
efficiently to gain as much production as possible from their factors of production.
But whether firms will seek to maximize profits depends on the nature of theeconomic system within which they operate.

Classifying Economic Systems
Each of the world’s economies can be viewed as operating somewhere on aspectrum between market capitalism and command socialism. In a market
capitalist economy20, resources are generally owned by private individuals who
have the power to make decisions about their use. A market capitalist system isoften referred to as a free enterprise economic system. In a command socialist
economy21, the government is the primary owner of capital and natural resources
and has broad power to allocate the use of factors of production. Between these twocategories lie mixed economies22 that combine elements of market capitalist and ofcommand socialist economic systems.
20. Economy in which resources
are generally owned by private
individuals who have thepower to make decisions about
their use.
21. Economy in which governmentis the primary owner of capitaland natural resources and has
broad power to allocate the useof factors of production.
22. Economy that combine
elements of market capitalist
and of command socialist
economic systems.

No economy represents a pure case of either market capitalism or commandsocialism. To determine where an economy lies between these two types of systems,
we evaluate the extent of government ownership of capital and natural resources
and the degree to which government is involved in decisions about the use offactors of production.
Figure 2.11 "Economic Systems" suggests the spectrum of economic systems.
Market capitalist economies lie toward the left end of this spectrum; commandsocialist economies appear toward the right. Mixed economies lie in between. The
market capitalist end of the spectrum includes countries such as the United States,
the United Kingdom, and Chile. Hong Kong, though now part of China, has a long

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history as a market capitalist economy and is generally regarded as operating at themarket capitalist end of the spectrum. Countries at the command socialist end of
the spectrum include North Korea and Cuba.
Figure 2.11 Economic Systems

Some European economies, such as France, Germany, and Sweden, have asufficiently high degree of regulation that we consider them as operating more
toward the center of the spectrum. Russia and China, which long operated at thecommand socialist end of the spectrum, can now be considered mixed economies.
Most economies in Latin America once operated toward the right end of thespectrum. While their governments did not exercise the extensive ownership ofcapital and natural resources that are one characteristic of command socialist
systems, their governments did impose extensive regulations. Many of thesenations are in the process of carrying out economic reforms that will move themfurther in the direction of market capitalism.
The global shift toward market capitalist economic systems that occurred in the
1980s and 1990s was in large part the result of three important features of sucheconomies. First, the emphasis on individual ownership and decision-making powerhas generally yielded greater individual freedom than has been available undercommand socialist or some more heavily regulated mixed economic systems that lie
toward the command socialist end of the spectrum. People seeking political,
religious, and economic freedom have thus gravitated toward market capitalism.
Second, market economies are more likely than other systems to allocate resourceson the basis of comparative advantage. They thus tend to generate higher levels of
production and income than do other economic systems. Third, market capitalisttype systems appear to be the most conducive to entrepreneurial activity.
Suppose Christie Ryder had the same three plants we considered earlier in thischapter but was operating in a mixed economic system with extensive government
regulation. In such a system, she might be prohibited from transferring resourcesfrom one use to another to achieve the gains possible from comparative advantage.
If she were operating under a command socialist system, she would not be theowner of the plants and thus would be unlikely to profit from their efficient use. If
that were the case, there is no reason to believe she would make any effort to assure
the efficient use of the three plants. Generally speaking, it is economies toward the

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market capitalist end of the spectrum that offer the greatest inducement to allocate
resources on the basis of comparative advantage. They tend to be more productive
and to deliver higher material standards of living than do economies that operate ator near the command socialist end of the spectrum.
Figure 2.12 Economic Freedom and Income

The graph shows the relationship between economic freedom and per capita income by region. Countries withhigher degrees of economic freedom tended to have higher per capita incomes.
Source: Terry Miller and Kim R. Holmes, 2011 Index of Economic Freedom (Washington, D.C.: The Heritage
Foundation and Dow Jones & Company, Inc., 2011), at www.heritage.org/index.

Market capitalist economies rely on economic freedom. Indeed, one way we canassess the degree to which a country can be considered market capitalist is by the
degree of economic freedom it permits. Several organizations have attempted tocompare economic freedom in various countries. One of the most extensive
comparisons is a joint annual effort by the Heritage Foundation and the Wall Street
Journal. The 2011 rating was based on policies in effect in 183 nations early thatyear. The report ranks these nations on the basis of such things as the degree of
regulation of firms, tax levels, and restrictions on international trade. Hong Kong
ranked as the freest economy in the world. North Korea received the dubious
distinction of being the least free.
It seems reasonable to expect that the greater the degree of economic freedom acountry permits, the greater the amount of income per person it will generate. This
proposition is illustrated in Figure 2.12 "Economic Freedom and Income". The study
also found a positive association between the degree of economic freedom andoverall well-being using a measure that takes into account such variables as health,

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education, security, and personal freedom. We must be wary of slipping into thefallacy of false cause by concluding from this evidence that economic freedom
generates higher incomes. It could be that higher incomes lead nations to opt for
greater economic freedom. But in this case, it seems reasonable to conclude that, ingeneral, economic freedom does lead to higher incomes.

Government in a Market Economy
The production possibilities model provides a menu of choices among alternative
combinations of goods and services. Given those choices, which combinations will
be produced?
In a market economy, this question is answered in large part through theinteraction of individual buyers and sellers. As we have already seen, government
plays a role as well. It may seek to encourage greater consumption of some goods
and discourage consumption of others. In the United States, for example, taxes
imposed on cigarettes discourage smoking, while special treatment of property
taxes and mortgage interest in the federal income tax encourages home ownership.
Government may try to stop the production and consumption of some goods
altogether, as many governments do with drugs such as heroin and cocaine.
Government may supplement the private consumption of some goods by producing
more of them itself, as many U.S. cities do with golf courses and tennis courts. In
other cases, there may be no private market for a good or service at all. In the
choice between security and defense versus all other goods and services outlined at
the beginning of this chapter, government agencies are virtually the sole providersof security and national defense.
All nations also rely on government to provide defense, enforce laws, andredistribute income. Even market economies rely on government to regulate theactivities of private firms, to protect the environment, to provide education, and to
produce a wide range of other goods and services. Government’s role may belimited in a market economy, but it remains fundamentally important.

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KEY TAKEAWAYS• The ideas of comparative advantage and specialization suggest that
restrictions on international trade are likely to reduce production of
goods and services.
• Economic growth is the result of increasing the quantity or quality of an
economy’s factors of production and of advances in technology.
• Policies to encourage growth generally involve postponing consumption
to increase capital and human capital.
• Market capitalist economies have generally proved more productive
than mixed or command socialist economies.
• Government plays a crucial role in any market economy.

TRY IT!
Draw a production possibilities curve for an economy that can produce twogoods, CD players and jackets. You do not have numbers for this one—justdraw a curve with the usual bowed-out shape. Put the quantity of CD players
per period on the vertical axis and the quantity of jackets per period on thehorizontal axis. Now mark a point A on the curve you have drawn; extend
dotted lines from this point to the horizontal and vertical axes. Mark the
initial quantities of the two goods as CDA and JA, respectively. Explain why,in the absence of economic growth, an increase in jacket production
requires a reduction in the production of CD players. Now show how
economic growth could lead to an increase in the production of both goods.

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Case in Point: The Prospects for World Economic Growth© Thinkstock

What will happen to world economic growth in the next 10 years? The
prognosis, according to economists Dale W. Jorgenson of Harvard University
and Khuong M. Vu of the National University of Singapore, suggests that world
growth is likely to be somewhat slower in the next decade than it was in thelast.
The two economists, who have written extensively on the problem of
estimating world economic growth, estimate that the world economy (based on
their sample of 122 countries that account for 95% of world GDP) grew at a rateof just 2.20% from 1990–1995. That increased to 3.37% per year from 1995–2000.
During the period from 2000–2005 the annual growth rate accelerated again to3.71%. Despite the recession and financial crisis that began in 2008, world
growth slowed a bit but was still 3.06% from 2005 to 2009. Growth at 3% would
double world economic income every 24 years. Think for a moment about whatthat implies—world income would quadruple in just 48 years. Growth at the
1990–1995 pace of 2.20% per year would take 33 years for income to double.

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Might the world growth rates from 2000 to 2009 of above 3% be repeated during
the next 10 years? Under their base-case scenario, the economists project theworld growth rate between 2010 and 2020 to be about 3.37%.
What do they think the economic world will look like then? They predict thatover the next 10-year period: the U.S. growth rate will slow down compared to
the last two decades, primarily due to slower growth in labor quality, but the
U.S. growth rate will still lead among the G7 countries (a group of seven large
industrialized countries that includes Canada, France, Germany, Italy, Japan,
the United Kingdom, and the United States); the overall growth in the G7
countries will continue to decline; and growth in the developing countries ofAsia (Bangladesh Cambodia, China, Hong Kong, India, Indonesia, Malaysia,
Nepal, Pakistan, Philippines, Singapore, South Korean, Sri Lanka, Taiwan,
Thailand, and Vietnam) will slow a bit from the recent past but will be highenough that those countries’ GDPs will comprise nearly 37% of world GDP in
2020, as compared to 29% in 2010. In terms of size of GDP in 2020, they predict
the following new order: China, the United States, India, Japan, Russia,
Germany, and Brazil. If their predictions are realized, it will mark the end of aperiod of more than a century in which the United States has been the world’s
largest economy.
Sources: Dale W. Jorgenson and Khoung M. Vu, “The Rise of Developing Asiaand the New Economic Order,” Journal of Policy Modeling 33:5
(September–October 2011), forthcoming.

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ANSWER TO TRY IT! PROBLEM
Your first production possibilities curve should resemble the one in Panel(a). Starting at point A, an increase in jacket production requires a move
down and to the right along the curve, as shown by the arrow, and thus a
reduction in the production of CD players. Alternatively, if there is economic
growth, it shifts the production possibilities curve outward, as in Panel (b).
This shift allows an increase in production of both goods, as suggested by
the arrow.

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Chapter 2 Confronting Scarcity: Choices in Production

Summary
Economics deals with choices. In this chapter we have examined more carefully the range of choices in
production that must be made in any economy. In particular, we looked at choices involving the allocation of an
economy’s factors of production: labor, capital, and natural resources.
In addition, in any economy, the level of technology plays a key role in determining how productive the factorsof production will be. In a market economy, entrepreneurs organize factors of production and act to introduce
technological change.
The production possibilities model is a device that assists us in thinking about many of the choices about
resource allocation in an economy. The model assumes that the economy has factors of production that are fixedin both quantity and quality. When illustrated graphically, the production possibilities model typically limits ouranalysis to two goods. Given the economy’s factors of production and technology, the economy can produce
various combinations of the two goods. If it uses its factors of production efficiently and has full employment, it
will be operating on the production possibilities curve.
Two characteristics of the production possibilities curve are particularly important. First, it is downward
sloping. This reflects the scarcity of the factors of production available to the economy; producing more of one
good requires giving up some of the other. Second, the curve is bowed out. Another way of saying this is to saythat the curve gets steeper as we move from left to right; the absolute value of its slope is increasing. Producing
each additional unit of the good on the horizontal axis requires a greater sacrifice of the good on the verticalaxis than did the previous units produced. This fact, called the law of increasing opportunity cost, is theinevitable result of efficient choices in production—choices based on comparative advantage.
The production possibilities model has important implications for international trade. It suggests that free trade
will allow countries to specialize in the production of goods and services in which they have a comparativeadvantage. This specialization increases the production of all goods and services.
Increasing the quantity or quality of factors of production and/or improving technology will shift the
production possibilities curve outward. This process is called economic growth. In the last 50 years, economic
growth in the United States has resulted chiefly from increases in human capital and from technologicaladvance.
Choices concerning the use of scarce resources take place within the context of a set of institutionalarrangements that define an economic system. The principal distinctions between systems lie in the degree towhich ownership of capital and natural resources and decision making authority over scarce resources are heldby government or by private individuals. Economic systems include market capitalist, mixed, and command

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Chapter 2 Confronting Scarcity: Choices in Productionsocialist economies. An increasing body of evidence suggests that market capitalist economies tend to be mostproductive; many command socialist and mixed economies are moving in the direction of market capitalist
systems.
The presumption in favor of market-based systems does not preclude a role for government. Government isnecessary to provide the system of laws on which market systems are founded. It may also be used to provide
certain goods and services, to help individuals in need, and to regulate the actions of individuals and firms.

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CONCEPT PROBLEMS
1. How does a college education increase one’s human capital?
2. Why does the downward-sloping production possibilities curve imply
that factors of production are scarce?
3. In what ways are the bowed-out shape of the production possibilities
curve and the law of increasing opportunity cost related?
4. What is the relationship between the concept of comparative advantage
and the law of increasing opportunity cost?
5. Suppose an economy can produce two goods, A and B. It is now
operating at point E on production possibilities curve RT. An
improvement in the technology available to produce good A shifts thecurve to ST, and the economy selects point E′. How does this change
affect the opportunity cost of producing an additional unit of good B?

6. Could a nation’s production possibilities curve ever shift inward?
Explain what such a shift would mean, and discuss events that mightcause such a shift to occur.
7. Suppose blue-eyed people were banned from working. How would thisaffect a nation’s production possibilities curve?
8. Evaluate this statement: “The U.S. economy could achieve greater
growth by devoting fewer resources to consumption and more toinvestment; it follows that such a shift would be desirable.”

2.4 Review and Practice86Chapter 2 Confronting Scarcity: Choices in Production

9. Two countries, Sportsland and Foodland, have similar total quantities oflabor, capital, and natural resources. Both can produce two goods, figs
and footballs. Sportsland’s resources are particularly well suited to the
production of footballs but are not very productive in producing figs.
Foodland’s resources are very productive when used for figs but are notcapable of producing many footballs. In which country is the cost ofadditional footballs generally greater? Explain.
10. Suppose a country is committed to using its resources based on thereverse of comparative advantage doctrine: it first transfers thoseresources for which the cost is greatest, not lowest. Describe thiscountry’s production possibilities curve.
11. The U.S. Constitution bans states from restricting imports of goods andservices from other states. Suppose this restriction did not exist andthat states were allowed to limit imports of goods and services produced
in other states. How do you think this would affect U.S. output? Explain.
12. By 1993, nations in the European Union (EU) had eliminated all barriers
to the flow of goods, services, labor, and capital across their borders.
Even such things as consumer protection laws and the types of plugs
required to plug in appliances have been standardized to ensure that
there will be no barriers to trade. How do you think this elimination of
trade barriers affected EU output?
13. How did the technological changes described in the Case in Point“Technology Cuts Costs, Boosts Productivity and Profits” affect the
production possibilities curve for the United States?

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NUMERICAL PROBLEMS

1. Nathan can mow four lawns in a day or plant 20 trees in a day.
1. Draw Nathan’s production possibilities curve for mowing
lawns and planting trees. Assume the production possibilities
curve is linear and put the quantity of lawns mowed per day
on the horizontal axis and the quantity of trees planted per
day on the vertical axis.
2. What is Nathan’s opportunity cost of planting trees?
3. What is Nathan’s opportunity cost of mowing lawns?
2. David can mow four lawns in a day or plant four trees in a day.
1. Draw David’s production possibilities curve for mowing
lawns and planting trees. Again, assume a linear production
possibilities curve and put the quantity of lawns mowed per
day on the horizontal axis.
2. What is David’s opportunity cost of planting trees?
3. What is David’s opportunity cost of mowing lawns?
3. Given the production information in problems 1 and 2 above, who has
the comparative advantage in planting trees? Mowing lawns?
4. The exhibits below describe the production possibilities forGermany and Turkey.

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1. What is the slope of Germany’s production possibilities
curve?
2. What is the slope of Turkey’s production possibilities curve?
3. What is the opportunity cost of producing T-shirts inGermany?
4. What is the opportunity cost of producing T-shirts in
Turkey?
5. What is the opportunity cost of producing optical
instruments in Germany?
6. What is the opportunity cost of producing optical
instruments in Turkey?
7. In which good does Germany have a comparative advantage?
8. In which good does Turkey have a comparative advantage?
5. The nation of Leisureland can produce two goods, bicycles andbowling balls. The western region of Leisureland can, if it devotes
all its resources to bicycle production, produce 100 bicycles permonth. Alternatively, it could devote all its resources to bowlingballs and produce 400 per month—or it could produce any
combination of bicycles and bowling balls lying on a straight line
between these two extremes.
1. Draw a production possibilities curve for western
Leisureland (with bicycles on the vertical axis).
2. What it is the opportunity cost of producing an additional
bowling ball measured in terms of forgone bicycles inwestern Leisureland?
3. Suppose that eastern Leisureland can, if it devotes all its
resources to the production of bicycles, produce 400. If it
devotes all its resources to bowling ball production, though,it can produce only 100. Draw the production possibilities
curve for eastern Leisureland (again, assume it is linear andput bicycles on the vertical axis).
4. What is the opportunity cost of producing an additional
bowling ball measured in terms of forgone bicycles ineastern Leisureland?
5. Explain the difference in opportunity cost between westernand eastern Leisureland. Which region has a comparativeadvantage in producing bowling balls? Bicycles?
6. Draw the production possibilities curve for Leisureland, onethat combines the curves for western and eastern
Leisureland.

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7. Suppose it is determined that 400 bicycles must be produced.
How many bowling balls can be produced?
8. Where will these goods be produced?
6. The table below shows the production possibilities schedule foran economy.
Production
Alternatives

Capital goods perperiodConsumer goods perperiod

A

0

40

B

1

36

C

2

28

D

3

16

E

4

0

1. Putting capital goods per period on the horizontal axis andconsumer goods per period on the vertical axis, graph the
production possibilities curve for the economy.
2. If the economy is producing at alternative B, what is theopportunity cost to it of producing at alternative C instead?
3. If the economy is producing at alternative C, what is theopportunity cost to it of producing at alternative D instead?
4. Is it possible for this economy to produce 30 units ofconsumer goods per period while producing 1 unit of capital
goods? Would this combination of goods represent efficient
or inefficient production? Explain.
5. Which point, B or C, would lead to higher economic growth?
Explain your answer.
7. The exhibit below shows the sources of growth in the UnitedStates between 1909 and 1929 and between 1950 and 1979,
according to a study by Edward Denison.Edward Denison, The
Sources of Economic Growth in the United States (New York:
Committee for Economic Development, 1962) and Edward
Denison, Trends in American Growth 1929–1982 (Washington, D.C.:
Brookings Institutions, 1985). (Note: The sources of economic
growth are cumulative and, taken collectively, explain 100% of
total growth over the period.)

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1. Approximately what percentage of U.S. growth between 1909
and 1929 was due to increases in quantities of factors of
production?
2. Approximately what percentage of U.S. growth between 1909
and 1929 was due to increases in quality of factors of
production and technological improvement?
3. Approximately what percentage of U.S. growth between 1950
and 1979 was due to increases in quantities of factors of
production?
4. Approximately what percentage of U.S. growth between 1950
and 1979 was due to increases in quality of factors of
production and technological improvement?

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Demand and Supply
Start Up: Crazy for Coffee
Starbucks Coffee Company has revolutionized the coffee-drinking habits of millions
of people all over the world. Starbucks, whose bright green-and-white logo isalmost as familiar as the golden arches of McDonald’s, began in Seattle in 1971.
Fifteen years later it had grown into a chain of four stores in the Seattle area. Thenin 1987 Howard Schultz, a former Starbucks employee, who had become intriguedby the culture of Italian coffee bars, bought the company from its founders for $3.8
million. In 2011, Americans were willingly paying $5 or more for a cappuccino or alatté, and Starbucks had grown to become an international chain, withapproximately 17,000 stores in more than 50 countries.
The change in American consumers’ taste for coffee and the profits raked in by
Starbucks lured other companies to get into the game. Retailers such as Seattle’s
Best Coffee and Gloria Jean’s Coffees entered the market, and today there arethousands of coffee bars, carts, drive-throughs, and kiosks in downtowns, malls,
and airports all around the country. Even McDonald’s began selling specialty
coffees.
But over the last decade the price of coffee beans has been quite volatile, nearly
doubling between 2009 and 2011, primarily due to bad harvests in central America.
Cappuccinos and lattés were suddenly more expensive.
Markets1, the institutions that bring together buyers and sellers, are always
responding to events, such as bad harvests and changing consumer tastes that
affect the prices and quantities of particular goods. The demand for some goods
increases, while the demand for others decreases. The supply of some goods rises,
while the supply of others falls. As such events unfold, prices adjust to keep markets
in balance. This chapter explains how the market forces of demand and supply
interact to determine equilibrium prices and equilibrium quantities of goods andservices. We will see how prices and quantities adjust to changes in demand andsupply and how changes in prices serve as signals to buyers and sellers.
1. The institutions that bring
together buyers and sellers.

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Chapter 3 Demand and Supply

The model of demand and supply that we shall develop in this chapter is one of themost powerful tools in all of economic analysis. You will be using it throughout
your study of economics. We will first look at the variables that influence demand.
Then we will turn to supply, and finally we will put demand and supply together toexplore how the model of demand and supply operates. As we examine the model,
bear in mind that demand is a representation of the behavior of buyers and that
supply is a representation of the behavior of sellers. Buyers may be consumers
purchasing groceries or producers purchasing iron ore to make steel. Sellers may befirms selling cars or households selling their labor services. We shall see that theideas of demand and supply apply, whatever the identity of the buyers or sellers
and whatever the good or service being exchanged in the market. In this chapter,
we shall focus on buyers and sellers of goods and services.

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3.1 Demand
LEARNING OBJECTIVES
1. Define the quantity demanded of a good or service and illustrate it using
a demand schedule and a demand curve.
2. Distinguish between the following pairs of concepts: demand andquantity demanded, demand schedule and demand curve, movement
along and shift in a demand curve.
3. Identify demand shifters and determine whether a change in a demand
shifter causes the demand curve to shift to the right or to the left.

How many pizzas will people eat this year? How many doctor visits will people
make? How many houses will people buy?
Each good or service has its own special characteristics that determine the quantity
people are willing and able to consume. One is the price of the good or service itself.
Other independent variables that are important determinants of demand include
consumer preferences, prices of related goods and services, income, demographic
characteristics such as population size, and buyer expectations. The number of
pizzas people will purchase, for example, depends very much on how much they
like pizza. It also depends on the prices for alternatives such as hamburgers or
spaghetti. The number of doctor visits is likely to vary with income—people withhigher incomes are likely to see a doctor more often than people with lower
incomes. The demands for pizza, for doctor visits, and for housing are certainly
affected by the age distribution of the population and its size.
While different variables play different roles in influencing the demands fordifferent goods and services, economists pay special attention to one: the price ofthe good or service. Given the values of all the other variables that affect demand, ahigher price tends to reduce the quantity people demand, and a lower price tends
to increase it. A medium pizza typically sells for $5 to $10. Suppose the price were$30. Chances are, you would buy fewer pizzas at that price than you do now.
Suppose pizzas typically sold for $2 each. At that price, people would be likely to
buy more pizzas than they do now.
We will discuss first how price affects the quantity demanded of a good or service
and then how other variables affect demand.

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Price and the Demand Curve
Because people will purchase different quantities of a good or service at different
prices, economists must be careful when speaking of the “demand” for something.
They have therefore developed some specific terms for expressing the general
concept of demand.
The quantity demanded2 of a good or service is the quantity buyers are willing andable to buy at a particular price during a particular period, all other things
unchanged. (As we learned, we can substitute the Latin phrase “ceteris paribus” for“all other things unchanged.”) Suppose, for example, that 100,000 movie tickets are
sold each month in a particular town at a price of $8 per ticket. That
quantity—100,000—is the quantity of movie admissions demanded per month at a
price of $8. If the price were $12, we would expect the quantity demanded to be less.
If it were $4, we would expect the quantity demanded to be greater. The quantity
demanded at each price would be different if other things that might affect it, suchas the population of the town, were to change. That is why we add the qualifier that
other things have not changed to the definition of quantity demanded.
A demand schedule3 is a table that shows the quantities of a good or service
demanded at different prices during a particular period, all other things
unchanged. To introduce the concept of a demand schedule, let us consider thedemand for coffee in the United States. We will ignore differences among types ofcoffee beans and roasts, and speak simply of coffee. The table in Figure 3.1 "ADemand Schedule and a Demand Curve" shows quantities of coffee that will be
demanded each month at prices ranging from $9 to $4 per pound; the table is ademand schedule. We see that the higher the price, the lower the quantity
demanded.

2. The quantity buyers are willing
and able to buy of a good orservice at a particular priceduring a particular period, allother things unchanged.
3. A table that shows thequantities of a good or service
demanded at different prices
during a particular period, allother things unchanged.

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Chapter 3 Demand and Supply

Figure 3.1 A Demand Schedule and a Demand Curve

The table is a demand schedule; it shows quantities of coffee demanded per month in the United States at particular
prices, all other things unchanged. These data are then plotted on the demand curve. At point A on the curve, 25
million pounds of coffee per month are demanded at a price of $6 per pound. At point B, 30 million pounds of coffee
per month are demanded at a price of $5 per pound.

The information given in a demand schedule can be presented with a demand
curve4, which is a graphical representation of a demand schedule. A demand curvethus shows the relationship between the price and quantity demanded of a good orservice during a particular period, all other things unchanged. The demand curve in
Figure 3.1 "A Demand Schedule and a Demand Curve" shows the prices andquantities of coffee demanded that are given in the demand schedule. At point A,
for example, we see that 25 million pounds of coffee per month are demanded at a
price of $6 per pound. By convention, economists graph price on the vertical axis
and quantity on the horizontal axis.

4. A graphical representation of ademand schedule.

3.1 Demand

Price alone does not determine the quantity of coffee or any other good that people
buy. To isolate the effect of changes in price on the quantity of a good or service
demanded, however, we show the quantity demanded at each price, assuming thatthose other variables remain unchanged. We do the same thing in drawing a graph96Chapter 3 Demand and Supplyof the relationship between any two variables; we assume that the values of othervariables that may affect the variables shown in the graph (such as income or
population) remain unchanged for the period under consideration.
A change in price, with no change in any of the other variables that affect demand,
results in a movement along the demand curve. For example, if the price of coffee
falls from $6 to $5 per pound, consumption rises from 25 million pounds to 30
million pounds per month. That is a movement from point A to point B along thedemand curve in Figure 3.1 "A Demand Schedule and a Demand Curve". A
movement along a demand curve that results from a change in price is called achange in quantity demanded5. Note that a change in quantity demanded is not achange or shift in the demand curve; it is a movement along the demand curve.
The negative slope of the demand curve in Figure 3.1 "A Demand Schedule and a
Demand Curve" suggests a key behavioral relationship in economics. All otherthings unchanged, the law of demand6 holds that, for virtually all goods andservices, a higher price leads to a reduction in quantity demanded and a lower priceleads to an increase in quantity demanded.
The law of demand is called a law because the results of countless studies are
consistent with it. Undoubtedly, you have observed one manifestation of the law.
When a store finds itself with an overstock of some item, such as running shoes ortomatoes, and needs to sell these items quickly, what does it do? It typically has asale, expecting that a lower price will increase the quantity demanded. In general,
we expect the law of demand to hold. Given the values of other variables that
influence demand, a higher price reduces the quantity demanded. A lower priceincreases the quantity demanded. Demand curves, in short, slope downward.

Changes in Demand

5. A movement along a demand
curve that results from achange in price.
6. For virtually all goods andservices, a higher price leads toa reduction in quantity
demanded and a lower priceleads to an increase in quantity
demanded.
7. A shift in a demand curve.

3.1 Demand

Of course, price alone does not determine the quantity of a good or service thatpeople consume. Coffee consumption, for example, will be affected by suchvariables as income and population. Preferences also play a role. The story at the
beginning of the chapter illustrates how Starbucks “turned people on” to coffee. We
also expect other prices to affect coffee consumption. People often eat doughnuts or
bagels with their coffee, so a reduction in the price of doughnuts or bagels might
induce people to drink more coffee. An alternative to coffee is tea, so a reduction in
the price of tea might result in the consumption of more tea and less coffee. Thus, achange in any one of the variables held constant in constructing a demand schedule
will change the quantities demanded at each price. The result will be a shift in theentire demand curve rather than a movement along the demand curve. A shift in ademand curve is called a change in demand7.

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Suppose, for example, that something happens to increase the quantity of coffee
demanded at each price. Several events could produce such a change: an increase inincomes, an increase in population, or an increase in the price of tea would each be
likely to increase the quantity of coffee demanded at each price. Any such change
produces a new demand schedule. Figure 3.2 "An Increase in Demand" shows such achange in the demand schedule for coffee. We see that the quantity of coffee
demanded per month is greater at each price than before. We show that graphicallyas a shift in the demand curve. The original curve, labeled D1, shifts to the right to
D2. At a price of $6 per pound, for example, the quantity demanded rises from 25
million pounds per month (point A) to 35 million pounds per month (point A′).
Figure 3.2 An Increase in Demand

An increase in the quantity of a good or service demanded at each price is shown as an increase in demand. Here,the original demand curve D1 shifts to D2. Point A on D1 corresponds to a price of $6 per pound and a quantity
demanded of 25 million pounds of coffee per month. On the new demand curve D2, the quantity demanded at thisprice rises to 35 million pounds of coffee per month (point A′).

Just as demand can increase, it can decrease. In the case of coffee, demand mightfall as a result of events such as a reduction in population, a reduction in the priceof tea, or a change in preferences. For example, a definitive finding that the caffeine
in coffee contributes to heart disease, which is currently being debated in thescientific community, could change preferences and reduce the demand for coffee.
A reduction in the demand for coffee is illustrated in Figure 3.3 "A Reduction in
Demand". The demand schedule shows that less coffee is demanded at each pricethan in Figure 3.1 "A Demand Schedule and a Demand Curve". The result is a shift in

3.1 Demand98Chapter 3 Demand and Supply

demand from the original curve D1 to D3. The quantity of coffee demanded at a priceof $6 per pound falls from 25 million pounds per month (point A) to 15 million
pounds per month (point A″). Note, again, that a change in quantity demanded,ceteris paribus, refers to a movement along the demand curve, while a change indemand refers to a shift in the demand curve.
Figure 3.3 A Reduction in Demand

A reduction in demand occurs when the quantities of a good or service demanded fall at each price. Here, thedemand schedule shows a lower quantity of coffee demanded at each price than we had in Figure 3.1 "A Demand
Schedule and a Demand Curve". The reduction shifts the demand curve for coffee to D3 from D1. The quantity
demanded at a price of $6 per pound, for example, falls from 25 million pounds per month (point A) to 15 million
pounds of coffee per month (point A″).

A variable that can change the quantity of a good or service demanded at each priceis called a demand shifter8. When these other variables change, the all-otherthings-unchanged conditions behind the original demand curve no longer hold.
Although different goods and services will have different demand shifters, thedemand shifters are likely to include (1) consumer preferences, (2) the prices ofrelated goods and services, (3) income, (4) demographic characteristics, and (5)buyer expectations. Next we look at each of these.

Preferences

8. A variable that can change thequantity of a good or service
demanded at each price.

3.1 Demand

Changes in preferences of buyers can have important consequences for demand. We
have already seen how Starbucks supposedly increased the demand for coffee.
Another example is reduced demand for cigarettes caused by concern about theeffect of smoking on health. A change in preferences that makes one good or service

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more popular will shift the demand curve to the right. A change that makes it lesspopular will shift the demand curve to the left.

Prices of Related Goods and Services
Suppose the price of doughnuts were to fall. Many people who drink coffee enjoy
dunking doughnuts in their coffee; the lower price of doughnuts might therefore
increase the demand for coffee, shifting the demand curve for coffee to the right. A
lower price for tea, however, would be likely to reduce coffee demand, shifting thedemand curve for coffee to the left.
In general, if a reduction in the price of one good increases the demand for another,
the two goods are called complements9. If a reduction in the price of one good
reduces the demand for another, the two goods are called substitutes10. These
definitions hold in reverse as well: two goods are complements if an increase in theprice of one reduces the demand for the other, and they are substitutes if anincrease in the price of one increases the demand for the other. Doughnuts andcoffee are complements; tea and coffee are substitutes.
Complementary goods are goods used in conjunction with one another. Tennis
rackets and tennis balls, eggs and bacon, and stationery and postage stamps arecomplementary goods. Substitute goods are goods used instead of one another.
iPODs, for example, are likely to be substitutes for CD players. Breakfast cereal is a
substitute for eggs. A file attachment to an e-mail is a substitute for both a fax
machine and postage stamps.

9. Two goods for which anincrease in price of one reduces
the demand for the other.
10. Two goods for which anincrease in price of one
increases the demand for theother.

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IncomeAs incomes rise, people increase their consumption of many goods and services, andas incomes fall, their consumption of these goods and services falls. For example, anincrease in income is likely to raise the demand for gasoline, ski trips, new cars, andjewelry. There are, however, goods and services for which consumption falls asincome rises—and rises as income falls. As incomes rise, for example, people tend to
consume more fresh fruit but less canned fruit.
A good for which demand increases when income increases is called a normal
good11. A good for which demand decreases when income increases is called aninferior good12. An increase in income shifts the demand curve for fresh fruit (anormal good) to the right; it shifts the demand curve for canned fruit (an inferiorgood) to the left.

Demographic Characteristics
The number of buyers affects the total quantity of a good or service that will bebought; in general, the greater the population, the greater the demand. Other
demographic characteristics can affect demand as well. As the share of the
population over age 65 increases, the demand for medical services, ocean cruises,
and motor homes increases. The birth rate in the United States fell sharply between
1955 and 1975 but has gradually increased since then. That increase has raised thedemand for such things as infant supplies, elementary school teachers, soccer
coaches, in-line skates, and college education. Demand can thus shift as a result ofchanges in both the number and characteristics of buyers.

Buyer Expectations

11. A good for which demand
increases when income
increases.

The consumption of goods that can be easily stored, or whose consumption can bepostponed, is strongly affected by buyer expectations. The expectation of newer TV
technologies, such as high-definition TV, could slow down sales of regular TVs. If
people expect gasoline prices to rise tomorrow, they will fill up their tanks today to
try to beat the price increase. The same will be true for goods such as automobiles
and washing machines: an expectation of higher prices in the future will lead tomore purchases today. If the price of a good is expected to fall, however, people arelikely to reduce their purchases today and await tomorrow’s lower prices. The
expectation that computer prices will fall, for example, can reduce current demand.

12. A good for which demanddecreases when income
increases.

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Heads Up!

It is crucial to distinguish between a change in quantity demanded, which is amovement along the demand curve caused by a change in price, and a change
in demand, which implies a shift of the demand curve itself. A change indemand is caused by a change in a demand shifter. An increase in demand is a
shift of the demand curve to the right. A decrease in demand is a shift in the
demand curve to the left. This drawing of a demand curve highlights thedifference.

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KEY TAKEAWAYS• The quantity demanded of a good or service is the quantity buyers arewilling and able to buy at a particular price during a particular period,
all other things unchanged.
• A demand schedule is a table that shows the quantities of a good orservice demanded at different prices during a particular period, allother things unchanged.
• A demand curve shows graphically the quantities of a good or service
demanded at different prices during a particular period, all other things
unchanged.
• All other things unchanged, the law of demand holds that, for virtually
all goods and services, a higher price induces a reduction in quantity
demanded and a lower price induces an increase in quantity demanded.
• A change in the price of a good or service causes a change in thequantity demanded—a movement along the demand curve.
• A change in a demand shifter causes a change in demand, which isshown as a shift of the demand curve. Demand shifters include
preferences, the prices of related goods and services, income,demographic characteristics, and buyer expectations.
• Two goods are substitutes if an increase in the price of one causes anincrease in the demand for the other. Two goods are complements if anincrease in the price of one causes a decrease in the demand for theother.
• A good is a normal good if an increase in income causes an increase indemand. A good is an inferior good if an increase in income causes a
decrease in demand.

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TRY IT!
All other things unchanged, what happens to the demand curve for DVD
rentals if there is (a) an increase in the price of movie theater tickets, (b) adecrease in family income, or (c) an increase in the price of DVD rentals? In
answering this and other “Try It!” problems in this chapter, draw andcarefully label a set of axes. On the horizontal axis of your graph, show thequantity of DVD rentals. It is necessary to specify the time period to whichyour quantity pertains (e.g., “per period,” “per week,” or “per year”). On thevertical axis show the price per DVD rental. Since you do not have specificdata on prices and quantities demanded, make a “free-hand” drawing of thecurve or curves you are asked to examine. Focus on the general shape andposition of the curve(s) before and after events occur. Draw new curve(s) toshow what happens in each of the circumstances given. The curves could
shift to the left or to the right, or stay where they are.

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Case in Point: Solving Campus Parking Problems Without
Adding More Parking Spaces© 2010 Jupiterimages Corporation

Unless you attend a “virtual” campus, chances are you have engaged in morethan one conversation about how hard it is to find a place to park on campus.
Indeed, according to Clark Kerr, a former president of the University ofCalifornia system, a university is best understood as a group of people “heldtogether by a common grievance over parking.”
Clearly, the demand for campus parking spaces has grown substantially overthe past few decades. In surveys conducted by Daniel Kenney, Ricardo Dumont,and Ginger Kenney, who work for the campus design company Sasaki and
Associates, it was found that 7 out of 10 students own their own cars. They haveinterviewed “many students who confessed to driving from their dormitories toclasses that were a five-minute walk away,” and they argue that thedeterioration of college environments is largely attributable to the increased
use of cars on campus and that colleges could better service their missions by
not adding more parking spaces.
Since few universities charge enough for parking to even cover the cost ofbuilding and maintaining parking lots, the rest is paid for by all students as part

3.1 Demand105

Chapter 3 Demand and Supplyof tuition. Their research shows that “for every 1,000 parking spaces, themedian institution loses almost $400,000 a year for surface parking, and morethan $1,200,000 for structural parking.” Fear of a backlash from students andtheir parents, as well as from faculty and staff, seems to explain why campus
administrators do not simply raise the price of parking on campus.
While Kenney and his colleagues do advocate raising parking fees, if not all at
once then over time, they also suggest some subtler, and perhaps politicallymore palatable, measures—in particular, shifting the demand for parking
spaces to the left by lowering the prices of substitutes.
Two examples they noted were at the University of Washington and the
University of Colorado at Boulder. At the University of Washington, car poolers
may park for free. This innovation has reduced purchases of single-occupancy
parking permits by 32% over a decade. According to University of Washington
assistant director of transportation services Peter Dewey, “Without vigorously
managing our parking and providing commuter alternatives, the university
would have been faced with adding approximately 3,600 parking spaces, at a
cost of over $100 million…The university has created opportunities to makecapital investments in buildings supporting education instead of structures forcars.” At the University of Colorado, free public transit has increased use of
buses and light rail from 300,000 to 2 million trips per year over the last decade.
The increased use of mass transit has allowed the university to avoid
constructing nearly 2,000 parking spaces, which has saved about $3.6 million
annually.
Sources: Daniel R. Kenney, “How to Solve Campus Parking Problems Without
Adding More Parking,” The Chronicle of Higher Education, March 26, 2004, Section
B, pp. B22-B23.

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ANSWER TO TRY IT! PROBLEM
Since going to the movies is a substitute for watching a DVD at home, anincrease in the price of going to the movies should cause more people toswitch from going to the movies to staying at home and renting DVDs. Thus,
the demand curve for DVD rentals will shift to the right when the price ofmovie theater tickets increases [Panel (a)].
A decrease in family income will cause the demand curve to shift to the left
if DVD rentals are a normal good but to the right if DVD rentals are aninferior good. The latter may be the case for some families, since staying at
home and watching DVDs is a cheaper form of entertainment than taking
the family to the movies. For most others, however, DVD rentals areprobably a normal good [Panel (b)].
An increase in the price of DVD rentals does not shift the demand curve for
DVD rentals at all; rather, an increase in price, say from P1 to P2, is amovement upward to the left along the demand curve. At a higher price,
people will rent fewer DVDs, say Q2 instead of Q1, ceteris paribus [Panel (c)].

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3.2 Supply
LEARNING OBJECTIVES
1. Define the quantity supplied of a good or service and illustrate it using a
supply schedule and a supply curve.
2. Distinguish between the following pairs of concepts: supply and quantity
supplied, supply schedule and supply curve, movement along and shift
in a supply curve.
3. Identify supply shifters and determine whether a change in a supply
shifter causes the supply curve to shift to the right or to the left.

What determines the quantity of a good or service sellers are willing to offer forsale? Price is one factor; ceteris paribus, a higher price is likely to induce sellers tooffer a greater quantity of a good or service. Production cost is another
determinant of supply. Variables that affect production cost include the prices offactors used to produce the good or service, returns from alternative activities,
technology, the expectations of sellers, and natural events such as weather changes.
Still another factor affecting the quantity of a good that will be offered for sale isthe number of sellers—the greater the number of sellers of a particular good orservice, the greater will be the quantity offered at any price per time period.

Price and the Supply Curve
The quantity supplied13 of a good or service is the quantity sellers are willing tosell at a particular price during a particular period, all other things unchanged.
Ceteris paribus, the receipt of a higher price increases profits and induces sellers toincrease the quantity they supply.

13. The quantity sellers are willingto sell of a good or service at aparticular price during aparticular period, all otherthings unchanged.

In general, when there are many sellers of a good, an increase in price results in an
increase in quantity supplied, and this relationship is often referred to as the law ofsupply. We will see, though, through our exploration of microeconomics, that there
are a number of exceptions to this relationship. There are cases in which a higher
price will not induce an increase in quantity supplied. Goods that cannot be
produced, such as additional land on the corner of Park Avenue and 56th Street in
Manhattan, are fixed in supply—a higher price cannot induce an increase in thequantity supplied. There are even cases, which we investigate in microeconomic
analysis, in which a higher price induces a reduction in the quantity supplied.

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Generally speaking, however, when there are many sellers of a good, an increase in
price results in a greater quantity supplied. The relationship between price andquantity supplied is suggested in a supply schedule14, a table that shows quantities
supplied at different prices during a particular period, all other things unchanged.
Figure 3.4 "A Supply Schedule and a Supply Curve" gives a supply schedule for thequantities of coffee that will be supplied per month at various prices, ceterisparibus. At a price of $4 per pound, for example, producers are willing to supply 15
million pounds of coffee per month. A higher price, say $6 per pound, induces
sellers to supply a greater quantity—25 million pounds of coffee per month.
Figure 3.4 A Supply Schedule and a Supply Curve

The supply schedule shows the quantity of coffee that will be supplied in the United States each month at particular
prices, all other things unchanged. The same information is given graphically in the supply curve. The values given
here suggest a positive relationship between price and quantity supplied.

14. A table that shows quantities
supplied at different prices
during a particular period, allother things unchanged.
15. A graphical representation of a
supply schedule.

3.2 Supply

A supply curve15 is a graphical representation of a supply schedule. It shows therelationship between price and quantity supplied during a particular period, allother things unchanged. Because the relationship between price and quantity
supplied is generally positive, supply curves are generally upward sloping. The

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supply curve for coffee in Figure 3.4 "A Supply Schedule and a Supply Curve" showsgraphically the values given in the supply schedule.
A change in price causes a movement along the supply curve; such a movement iscalled a change in quantity supplied16. As is the case with a change in quantity
demanded, a change in quantity supplied does not shift the supply curve. By
definition, it is a movement along the supply curve. For example, if the price rises
from $6 per pound to $7 per pound, the quantity supplied rises from 25 million
pounds per month to 30 million pounds per month. That’s a movement from point
A to point B along the supply curve in Figure 3.4 "A Supply Schedule and a Supply
Curve".

Changes in Supply
When we draw a supply curve, we assume that other variables that affect thewillingness of sellers to supply a good or service are unchanged. It follows that achange in any of those variables will cause a change in supply17, which is a shift inthe supply curve. A change that increases the quantity of a good or service supplied
at each price shifts the supply curve to the right. Suppose, for example, that theprice of fertilizer falls. That will reduce the cost of producing coffee and thusincrease the quantity of coffee producers will offer for sale at each price. The supply
schedule in Figure 3.5 "An Increase in Supply" shows an increase in the quantity ofcoffee supplied at each price. We show that increase graphically as a shift in the
supply curve from S1 to S2. We see that the quantity supplied at each price increases
by 10 million pounds of coffee per month. At point A on the original supply curve
S1, for example, 25 million pounds of coffee per month are supplied at a price of $6
per pound. After the increase in supply, 35 million pounds per month are suppliedat the same price (point A′ on curve S2).

16. Movement along the supply
curve caused by a change inprice.
17. A shift in the supply curve.

3.2 Supply

110Chapter 3 Demand and Supply

Figure 3.5 An Increase in Supply

If there is a change in supply that increases the quantity supplied at each price, as is the case in the supply schedule
here, the supply curve shifts to the right. At a price of $6 per pound, for example, the quantity supplied rises fromthe previous level of 25 million pounds per month on supply curve S1 (point A) to 35 million pounds per month on
supply curve S2 (point A′).

An event that reduces the quantity supplied at each price shifts the supply curve tothe left. An increase in production costs and excessive rain that reduces the yields
from coffee plants are examples of events that might reduce supply. Figure 3.6 "A
Reduction in Supply" shows a reduction in the supply of coffee. We see in the
supply schedule that the quantity of coffee supplied falls by 10 million pounds ofcoffee per month at each price. The supply curve thus shifts from S1 to S3.
Figure 3.6 A Reduction in Supply

3.2 Supply

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A change in supply that reduces the quantity supplied at each price shifts the supply curve to the left. At a price of$6 per pound, for example, the original quantity supplied was 25 million pounds of coffee per month (point A). Witha new supply curve S3, the quantity supplied at that price falls to 15 million pounds of coffee per month (point A″).

A variable that can change the quantity of a good or service supplied at each price iscalled a supply shifter18. Supply shifters include (1) prices of factors of production,(2) returns from alternative activities, (3) technology, (4) seller expectations, (5)natural events, and (6) the number of sellers. When these other variables change,
the all-other-things-unchanged conditions behind the original supply curve nolonger hold. Let us look at each of the supply shifters.

Prices of Factors of Production
A change in the price of labor or some other factor of production will change thecost of producing any given quantity of the good or service. This change in the costof production will change the quantity that suppliers are willing to offer at any
price. An increase in factor prices should decrease the quantity suppliers will offer
at any price, shifting the supply curve to the left. A reduction in factor prices
increases the quantity suppliers will offer at any price, shifting the supply curve tothe right.
Suppose coffee growers must pay a higher wage to the workers they hire to harvest
coffee or must pay more for fertilizer. Such increases in production cost will cause
them to produce a smaller quantity at each price, shifting the supply curve forcoffee to the left. A reduction in any of these costs increases supply, shifting the
supply curve to the right.

Returns from Alternative Activities
To produce one good or service means forgoing the production of another. The
concept of opportunity cost in economics suggests that the value of the activity
forgone is the opportunity cost of the activity chosen; this cost should affect supply.
For example, one opportunity cost of producing eggs is not selling chickens. An
increase in the price people are willing to pay for fresh chicken would make it more
profitable to sell chickens and would thus increase the opportunity cost of
producing eggs. It would shift the supply curve for eggs to the left, reflecting adecrease in supply.

18. A variable that can change thequantity of a good or service
supplied at each price.

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Technology
A change in technology alters the combinations of inputs or the types of inputs
required in the production process. An improvement in technology usually meansthat fewer and/or less costly inputs are needed. If the cost of production is lower,
the profits available at a given price will increase, and producers will produce more.
With more produced at every price, the supply curve will shift to the right, meaning
an increase in supply.
Impressive technological changes have occurred in the computer industry in recent
years. Computers are much smaller and are far more powerful than they were only
a few years ago—and they are much cheaper to produce. The result has been a hugeincrease in the supply of computers, shifting the supply curve to the right.
While we usually think of technology as enhancing production, declines in
production due to problems in technology are also possible. Outlawing the use ofcertain equipment without pollution-control devices has increased the cost of
production for many goods and services, thereby reducing profits available at any
price and shifting these supply curves to the left.

Seller Expectations
All supply curves are based in part on seller expectations about future market
conditions. Many decisions about production and selling are typically made long
before a product is ready for sale. Those decisions necessarily depend on
expectations. Changes in seller expectations can have important effects on priceand quantity.
Consider, for example, the owners of oil deposits. Oil pumped out of the ground andused today will be unavailable in the future. If a change in the international
political climate leads many owners to expect that oil prices will rise in the future,they may decide to leave their oil in the ground, planning to sell it later when theprice is higher. Thus, there will be a decrease in supply; the supply curve for oil will
shift to the left.

Natural Events
Storms, insect infestations, and drought affect agricultural production and thus the
supply of agricultural goods. If something destroys a substantial part of an
agricultural crop, the supply curve will shift to the left. The terrible cyclone thatkilled more than 50,000 people in Myanmar in 2008 also destroyed some of the

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country’s prime rice growing land. That shifted the supply curve for rice to the left.
If there is an unusually good harvest, the supply curve will shift to the right.

The Number of Sellers
The supply curve for an industry, such as coffee, includes all the sellers in theindustry. A change in the number of sellers in an industry changes the quantity
available at each price and thus changes supply. An increase in the number ofsellers supplying a good or service shifts the supply curve to the right; a reductionin the number of sellers shifts the supply curve to the left.
The market for cellular phone service has been affected by an increase in thenumber of firms offering the service. Over the past decade, new cellular phonecompanies emerged, shifting the supply curve for cellular phone service to theright.

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Heads Up!
There are two special things to note about supply curves. The first is similar to
the Heads Up! on demand curves: it is important to distinguish carefully
between changes in supply and changes in quantity supplied. A change insupply results from a change in a supply shifter and implies a shift of the supply
curve to the right or left. A change in price produces a change in quantity
supplied and induces a movement along the supply curve. A change in pricedoes not shift the supply curve.
The second caution relates to the interpretation of increases and decreases insupply. Notice that in Figure 3.5 "An Increase in Supply" an increase in supply
is shown as a shift of the supply curve to the right; the curve shifts in the
direction of increasing quantity with respect to the horizontal axis. In Figure
3.6 "A Reduction in Supply" a reduction in supply is shown as a shift of the
supply curve to the left; the curve shifts in the direction of decreasing quantitywith respect to the horizontal axis.
Because the supply curve is upward sloping, a shift to the right produces a new
curve that in a sense lies “below” the original curve. It is easy to make themistake of thinking of such a shift as a shift “down” and therefore as a
reduction in supply. Similarly, it is easy to make the mistake of showing an
increase in supply with a new curve that lies “above” the original curve. Butthat is a reduction in supply!
To avoid such errors, focus on the fact that an increase in supply is an increasein the quantity supplied at each price and shifts the supply curve in the
direction of increased quantity on the horizontal axis. Similarly, a reduction in
supply is a reduction in the quantity supplied at each price and shifts the
supply curve in the direction of a lower quantity on the horizontal axis.

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KEY TAKEAWAYS• The quantity supplied of a good or service is the quantity sellers arewilling to sell at a particular price during a particular period, all otherthings unchanged.
• A supply schedule shows the quantities supplied at different prices
during a particular period, all other things unchanged. A supply curveshows this same information graphically.
• A change in the price of a good or service causes a change in thequantity supplied—a movement along the supply curve.
• A change in a supply shifter causes a change in supply, which is shown
as a shift of the supply curve. Supply shifters include prices of factors of
production, returns from alternative activities, technology, seller
expectations, natural events, and the number of sellers.
• An increase in supply is shown as a shift to the right of a supply curve; adecrease in supply is shown as a shift to the left.

TRY IT!
If all other things are unchanged, what happens to the supply curve for DVD
rentals if there is (a) an increase in wages paid to DVD rental store clerks, (b)an increase in the price of DVD rentals, or (c) an increase in the number of
DVD rental stores? Draw a graph that shows what happens to the supply
curve in each circumstance. The supply curve can shift to the left or to theright, or stay where it is. Remember to label the axes and curves, andremember to specify the time period (e.g., “DVDs rented per week”).

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Case in Point: The Monks of St. Benedict’s Get Out of the
Egg Business© 2010 Jupiterimages Corporation

It was cookies that lured the monks of St. Benedict’s out of the egg business,
and now private retreat sponsorship is luring them away from cookies.
St. Benedict’s is a Benedictine monastery, nestled on a ranch high in the
Colorado Rockies, about 20 miles down the road from Aspen. The monastery’s
20 monks operate the ranch to support themselves and to provide help for poor
people in the area. They lease out about 3,500 acres of their land to cattle andsheep grazers, produce cookies, and sponsor private retreats. They used to
produce eggs.
Attracted by potential profits and the peaceful nature of the work, the monks
went into the egg business in 1967. They had 10,000 chickens producing theirMonastery Eggs brand. For a while, business was good. Very good. Then, in thelate 1970s, the price of chicken feed started to rise rapidly.

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Chapter 3 Demand and Supply“When we started in the business, we were paying $60 to $80 a ton for
feed—delivered,” recalls the monastery’s abbot, Father Joseph Boyle. “By thelate 1970s, our cost had more than doubled. We were paying $160 to $200 a ton.
That really hurt, because feed represents a large part of the cost of producing
eggs.”The monks adjusted to the blow. “When grain prices were lower, we’d pull ahen off for a few weeks to molt, then return her to laying. After grain prices
went up, it was 12 months of laying and into the soup pot,” Fr. Joseph says.
Grain prices continued to rise in the 1980s and increased the costs ofproduction for all egg producers. It caused the supply of eggs to fall. Demandfell at the same time, as Americans worried about the cholesterol in eggs. Times
got tougher in the egg business.
“We were still making money in the financial sense,” Fr. Joseph says. “But wetried an experiment in 1985 producing cookies, and it was a success. We finallydecided that devoting our time and energy to the cookies would pay off better
than the egg business, so we quit the egg business in 1986.”
The mail-order cookie business was good to the monks. They sold 200,000
ounces of Monastery Cookies in 1987.
By 1998, however, they had limited their production of cookies, selling only
locally and to gift shops. Since 2000, they have switched to “providing private
retreats for individuals and groups—about 40 people per month,” according to
Fr. Micah Schonberger.
The monks’ calculation of their opportunity costs revealed that they would
earn a higher return through sponsorship of private retreats than in either
cookies or eggs. This projection has proved correct.
And there is another advantage as well.
“The chickens didn’t stop laying eggs on Sunday,” Fr. Joseph chuckles. “When
we shifted to cookies we could take Sundays off. We weren’t hemmed in theway we were with the chickens.” The move to providing retreats is even better

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in this regard. Since guests provide their own meals, most of the monastery’s
effort goes into planning and scheduling, which frees up even more of theirtime for other worldly as well as spiritual pursuits.
Source: Personal interviews and the monastery’s website at
http://www.snowmass.org.

ANSWER TO TRY IT! PROBLEM
DVD rental store clerks are a factor of production in the DVD rental market.
An increase in their wages raises the cost of production, thereby causing the
supply curve of DVD rentals to shift to the left [Panel (a)]. (Caution: It is
possible that you thought of the wage increase as an increase in income, ademand shifter, that would lead to an increase in demand, but this would beincorrect. The question refers only to wages of DVD rental store clerks. They
may rent some DVD, but their impact on total demand would be negligible.
Besides, we have no information on what has happened overall to incomesof people who rent DVDs. We do know, however, that the cost of a factor of
production, which is a supply shifter, increased.)
An increase in the price of DVD rentals does not shift the supply curve at all;rather, it corresponds to a movement upward to the right along the supply
curve. At a higher price of P2 instead of P1, a greater quantity of DVD rentals,
say Q2 instead of Q1, will be supplied [Panel (b)].
An increase in the number of stores renting DVDs will cause the supply
curve to shift to the right [Panel (c)].

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3.3 Demand, Supply, and Equilibrium
LEARNING OBJECTIVES
1. Use demand and supply to explain how equilibrium price and quantity
are determined in a market.
2. Understand the concepts of surpluses and shortages and the pressureson price they generate.
3. Explain the impact of a change in demand or supply on equilibrium
price and quantity.
4. Explain how the circular flow model provides an overview of demandand supply in product and factor markets and how the model suggests
ways in which these markets are linked.

In this section we combine the demand and supply curves we have just studied into
a new model. The model of demand and supply19 uses demand and supply curves
to explain the determination of price and quantity in a market.

The Determination of Price and Quantity
The logic of the model of demand and supply is simple. The demand curve shows
the quantities of a particular good or service that buyers will be willing and able topurchase at each price during a specified period. The supply curve shows thequantities that sellers will offer for sale at each price during that same period. By
putting the two curves together, we should be able to find a price at which thequantity buyers are willing and able to purchase equals the quantity sellers willoffer for sale.

19. Model that uses demand andsupply curves to explain thedetermination of price andquantity in a market.
20. The price at which quantity
demanded equals quantity
supplied.
21. The quantity demanded andsupplied at the equilibrium
price.

Figure 3.7 "The Determination of Equilibrium Price and Quantity" combines thedemand and supply data introduced in Figure 3.1 "A Demand Schedule and a
Demand Curve" and Figure 3.4 "A Supply Schedule and a Supply Curve". Notice thatthe two curves intersect at a price of $6 per pound—at this price the quantities
demanded and supplied are equal. Buyers want to purchase, and sellers are willingto offer for sale, 25 million pounds of coffee per month. The market for coffee is inequilibrium. Unless the demand or supply curve shifts, there will be no tendency
for price to change. The equilibrium price20 in any market is the price at whichquantity demanded equals quantity supplied. The equilibrium price in the market
for coffee is thus $6 per pound. The equilibrium quantity21 is the quantity
demanded and supplied at the equilibrium price. At a price above the equilibrium,

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there is a natural tendency for the price to fall. At a price below the equilibrium,
there is a tendency for the price to rise.
Figure 3.7 The Determination of Equilibrium Price and Quantity

When we combine the demand and supply curves for a good in a single graph, the point at which they intersect
identifies the equilibrium price and equilibrium quantity. Here, the equilibrium price is $6 per pound. Consumers
demand, and suppliers supply, 25 million pounds of coffee per month at this price.

With an upward-sloping supply curve and a downward-sloping demand curve, there
is only a single price at which the two curves intersect. This means there is only one
price at which equilibrium is achieved. It follows that at any price other than theequilibrium price, the market will not be in equilibrium. We next examine what
happens at prices other than the equilibrium price.

Surpluses
Figure 3.8 "A Surplus in the Market for Coffee" shows the same demand and supply
curves we have just examined, but this time the initial price is $8 per pound ofcoffee. Because we no longer have a balance between quantity demanded and3.3 Demand, Supply, and Equilibrium

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quantity supplied, this price is not the equilibrium price. At a price of $8, we readover to the demand curve to determine the quantity of coffee consumers will bewilling to buy—15 million pounds per month. The supply curve tells us what sellers
will offer for sale—35 million pounds per month. The difference, 20 million poundsof coffee per month, is called a surplus. More generally, a surplus22 is the amountby which the quantity supplied exceeds the quantity demanded at the current price.
There is, of course, no surplus at the equilibrium price; a surplus occurs only if thecurrent price exceeds the equilibrium price.
Figure 3.8 A Surplus in the Market for Coffee

At a price of $8, the quantity supplied is 35 million pounds of coffee per month and the quantity demanded is 15
million pounds per month; there is a surplus of 20 million pounds of coffee per month. Given a surplus, the price will
fall quickly toward the equilibrium level of $6.

22. The amount by which thequantity supplied exceeds thequantity demanded at thecurrent price.

A surplus in the market for coffee will not last long. With unsold coffee on themarket, sellers will begin to reduce their prices to clear out unsold coffee. As theprice of coffee begins to fall, the quantity of coffee supplied begins to decline. At thesame time, the quantity of coffee demanded begins to rise. Remember that the
reduction in quantity supplied is a movement along the supply curve—the curve
itself does not shift in response to a reduction in price. Similarly, the increase in

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quantity demanded is a movement along the demand curve—the demand curve does
not shift in response to a reduction in price. Price will continue to fall until itreaches its equilibrium level, at which the demand and supply curves intersect. At
that point, there will be no tendency for price to fall further. In general, surplusesin the marketplace are short-lived. The prices of most goods and services adjust
quickly, eliminating the surplus. Later on, we will discuss some markets in which
adjustment of price to equilibrium may occur only very slowly or not at all.

Shortages
Just as a price above the equilibrium price will cause a surplus, a price below
equilibrium will cause a shortage. A shortage23 is the amount by which the quantity
demanded exceeds the quantity supplied at the current price.
Figure 3.9 "A Shortage in the Market for Coffee" shows a shortage in the market forcoffee. Suppose the price is $4 per pound. At that price, 15 million pounds of coffee
would be supplied per month, and 35 million pounds would be demanded permonth. When more coffee is demanded than supplied, there is a shortage.
Figure 3.9 A Shortage in the Market for Coffee

23. The amount by which thequantity demanded exceeds
the quantity supplied at thecurrent price.

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At a price of $4 per pound, the quantity of coffee demanded is 35 million pounds per month and the quantity
supplied is 15 million pounds per month. The result is a shortage of 20 million pounds of coffee per month.

In the face of a shortage, sellers are likely to begin to raise their prices. As the pricerises, there will be an increase in the quantity supplied (but not a change in supply)
and a reduction in the quantity demanded (but not a change in demand) until theequilibrium price is achieved.

Shifts in Demand and Supply
Figure 3.10 Changes in Demand and Supply

A change in demand or in supply changes the equilibrium solution in the model. Panels (a) and (b) show an increase
and a decrease in demand, respectively; Panels (c) and (d) show an increase and a decrease in supply, respectively.

A change in one of the variables (shifters) held constant in any model of demandand supply will create a change in demand or supply. A shift in a demand or supply
curve changes the equilibrium price and equilibrium quantity for a good or service.
Figure 3.10 "Changes in Demand and Supply" combines the information about

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changes in the demand and supply of coffee presented in Figure 3.2 "An Increase in
Demand", Figure 3.3 "A Reduction in Demand", Figure 3.5 "An Increase in Supply",and Figure 3.6 "A Reduction in Supply" In each case, the original equilibrium priceis $6 per pound, and the corresponding equilibrium quantity is 25 million pounds ofcoffee per month. Figure 3.10 "Changes in Demand and Supply" shows what
happens with an increase in demand, a reduction in demand, an increase in supply,
and a reduction in supply. We then look at what happens if both curves shift
simultaneously. Each of these possibilities is discussed in turn below.

An Increase in Demand
An increase in demand for coffee shifts the demand curve to the right, as shown inPanel (a) of Figure 3.10 "Changes in Demand and Supply". The equilibrium pricerises to $7 per pound. As the price rises to the new equilibrium level, the quantity
supplied increases to 30 million pounds of coffee per month. Notice that the supply
curve does not shift; rather, there is a movement along the supply curve.
Demand shifters that could cause an increase in demand include a shift in
preferences that leads to greater coffee consumption; a lower price for acomplement to coffee, such as doughnuts; a higher price for a substitute for coffee,
such as tea; an increase in income; and an increase in population. A change in buyer
expectations, perhaps due to predictions of bad weather lowering expected yields
on coffee plants and increasing future coffee prices, could also increase current
demand.

A Decrease in Demand
Panel (b) of Figure 3.10 "Changes in Demand and Supply" shows that a decrease indemand shifts the demand curve to the left. The equilibrium price falls to $5 perpound. As the price falls to the new equilibrium level, the quantity supplied
decreases to 20 million pounds of coffee per month.
Demand shifters that could reduce the demand for coffee include a shift in
preferences that makes people want to consume less coffee; an increase in the priceof a complement, such as doughnuts; a reduction in the price of a substitute, such astea; a reduction in income; a reduction in population; and a change in buyer
expectations that leads people to expect lower prices for coffee in the future.

An Increase in Supply
An increase in the supply of coffee shifts the supply curve to the right, as shown inPanel (c) of Figure 3.10 "Changes in Demand and Supply". The equilibrium price

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falls to $5 per pound. As the price falls to the new equilibrium level, the quantity ofcoffee demanded increases to 30 million pounds of coffee per month. Notice thatthe demand curve does not shift; rather, there is movement along the demand
curve.
Possible supply shifters that could increase supply include a reduction in the priceof an input such as labor, a decline in the returns available from alternative uses of
the inputs that produce coffee, an improvement in the technology of coffee
production, good weather, and an increase in the number of coffee-producing
firms.

A Decrease in Supply
Panel (d) of Figure 3.10 "Changes in Demand and Supply" shows that a decrease insupply shifts the supply curve to the left. The equilibrium price rises to $7 perpound. As the price rises to the new equilibrium level, the quantity demanded
decreases to 20 million pounds of coffee per month.
Possible supply shifters that could reduce supply include an increase in the prices of
inputs used in the production of coffee, an increase in the returns available fromalternative uses of these inputs, a decline in production because of problems intechnology (perhaps caused by a restriction on pesticides used to protect coffee
beans), a reduction in the number of coffee-producing firms, or a natural event,such as excessive rain.

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Heads Up!

You are likely to be given problems in which you will have to shift a demand or
supply curve.
Suppose you are told that an invasion of pod-crunching insects has gobbled up
half the crop of fresh peas, and you are asked to use demand and supply
analysis to predict what will happen to the price and quantity of peasdemanded and supplied. Here are some suggestions.
Put the quantity of the good you are asked to analyze on the horizontal axis andits price on the vertical axis. Draw a downward-sloping line for demand and an
upward-sloping line for supply. The initial equilibrium price is determined by
the intersection of the two curves. Label the equilibrium solution. You may findit helpful to use a number for the equilibrium price instead of the letter “P.”Pick a price that seems plausible, say, 79¢ per pound. Do not worry about the
precise positions of the demand and supply curves; you cannot be expected toknow what they are.
Step 2 can be the most difficult step; the problem is to decide which curve toshift. The key is to remember the difference between a change in demand or
supply and a change in quantity demanded or supplied. At each price, ask
yourself whether the given event would change the quantity demanded. Wouldthe fact that a bug has attacked the pea crop change the quantity demanded ata price of, say, 79¢ per pound? Clearly not; none of the demand shifters havechanged. The event would, however, reduce the quantity supplied at this price,and the supply curve would shift to the left. There is a change in supply and areduction in the quantity demanded. There is no change in demand.

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Next check to see whether the result you have obtained makes sense. The graphin Step 2 makes sense; it shows price rising and quantity demanded falling.
It is easy to make a mistake such as the one shown in the third figure of thisHeads Up! One might, for example, reason that when fewer peas are available,
fewer will be demanded, and therefore the demand curve will shift to the left.
This suggests the price of peas will fall—but that does not make sense. If only
half as many fresh peas were available, their price would surely rise. The error
here lies in confusing a change in quantity demanded with a change in demand.
Yes, buyers will end up buying fewer peas. But no, they will not demand fewer
peas at each price than before; the demand curve does not shift.

Simultaneous Shifts
As we have seen, when either the demand or the supply curve shifts, the results areunambiguous; that is, we know what will happen to both equilibrium price andequilibrium quantity, so long as we know whether demand or supply increased or
decreased. However, in practice, several events may occur at around the same timethat cause both the demand and supply curves to shift. To figure out what happens
to equilibrium price and equilibrium quantity, we must know not only in which
direction the demand and supply curves have shifted but also the relative amountby which each curve shifts. Of course, the demand and supply curves could shift inthe same direction or in opposite directions, depending on the specific events
causing them to shift.
For example, all three panels of Figure 3.11 "Simultaneous Decreases in Demandand Supply" show a decrease in demand for coffee (caused perhaps by a decrease in
the price of a substitute good, such as tea) and a simultaneous decrease in the
supply of coffee (caused perhaps by bad weather). Since reductions in demand andsupply, considered separately, each cause the equilibrium quantity to fall, theimpact of both curves shifting simultaneously to the left means that the new
equilibrium quantity of coffee is less than the old equilibrium quantity. The effecton the equilibrium price, though, is ambiguous. Whether the equilibrium price ishigher, lower, or unchanged depends on the extent to which each curve shifts.

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Figure 3.11 Simultaneous Decreases in Demand and Supply

Both the demand and the supply of coffee decrease. Since decreases in demand and supply, considered separately,each cause equilibrium quantity to fall, the impact of both decreasing simultaneously means that a new equilibrium
quantity of coffee must be less than the old equilibrium quantity. In Panel (a), the demand curve shifts farther to theleft than does the supply curve, so equilibrium price falls. In Panel (b), the supply curve shifts farther to the left
than does the demand curve, so the equilibrium price rises. In Panel (c), both curves shift to the left by the sameamount, so equilibrium price stays the same.

If the demand curve shifts farther to the left than does the supply curve, as shownin Panel (a) of Figure 3.11 "Simultaneous Decreases in Demand and Supply", thenthe equilibrium price will be lower than it was before the curves shifted. In this casethe new equilibrium price falls from $6 per pound to $5 per pound. If the shift tothe left of the supply curve is greater than that of the demand curve, theequilibrium price will be higher than it was before, as shown in Panel (b). In thiscase, the new equilibrium price rises to $7 per pound. In Panel (c), since both curves
shift to the left by the same amount, equilibrium price does not change; it remains$6 per pound.
Regardless of the scenario, changes in equilibrium price and equilibrium quantity
resulting from two different events need to be considered separately. If both events

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cause equilibrium price or quantity to move in the same direction, then clearly
price or quantity can be expected to move in that direction. If one event causes
price or quantity to rise while the other causes it to fall, the extent by which eachcurve shifts is critical to figuring out what happens. Figure 3.12 "Simultaneous
Shifts in Demand and Supply" summarizes what may happen to equilibrium priceand quantity when demand and supply both shift.
Figure 3.12 Simultaneous Shifts in Demand and Supply

If simultaneous shifts in demand and supply cause equilibrium price or quantity to move in the same direction, thenequilibrium price or quantity clearly moves in that direction. If the shift in one of the curves causes equilibrium
price or quantity to rise while the shift in the other curve causes equilibrium price or quantity to fall, then therelative amount by which each curve shifts is critical to figuring out what happens to that variable.

As demand and supply curves shift, prices adjust to maintain a balance between thequantity of a good demanded and the quantity supplied. If prices did not adjust, thisbalance could not be maintained.
Notice that the demand and supply curves that we have examined in this chapter
have all been drawn as linear. This simplification of the real world makes thegraphs a bit easier to read without sacrificing the essential point: whether the
curves are linear or nonlinear, demand curves are downward sloping and supply
curves are generally upward sloping. As circumstances that shift the demand curve

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or the supply curve change, we can analyze what will happen to price and what will
happen to quantity.

An Overview of Demand and Supply: The Circular Flow Model
Implicit in the concepts of demand and supply is a constant interaction andadjustment that economists illustrate with the circular flow model. The circularflow model24 provides a look at how markets work and how they are related toeach other. It shows flows of spending and income through the economy.
A great deal of economic activity can be thought of as a process of exchange
between households and firms. Firms supply goods and services to households.
Households buy these goods and services from firms. Households supply factors of
production—labor, capital, and natural resources—that firms require. The payments
firms make in exchange for these factors represent the incomes households earn.
The flow of goods and services, factors of production, and the payments theygenerate is illustrated in Figure 3.13 "The Circular Flow of Economic Activity". This
circular flow model of the economy shows the interaction of households and firms
as they exchange goods and services and factors of production. For simplicity, themodel here shows only the private domestic economy; it omits the government andforeign sectors.

24. Model that provides a look at
how markets work and how
they are related to each other.

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Figure 3.13 The Circular Flow of Economic Activity

This simplified circular flow model shows flows of spending between households and firms through product andfactor markets. The inner arrows show goods and services flowing from firms to households and factors of
production flowing from households to firms. The outer flows show the payments for goods, services, and factors of
production. These flows, in turn, represent millions of individual markets for products and factors of production.

The circular flow model shows that goods and services that households demand aresupplied by firms in product markets25. The exchange for goods and services isshown in the top half of Figure 3.13 "The Circular Flow of Economic Activity". The
bottom half of the exhibit illustrates the exchanges that take place in factor
markets. factor markets26 are markets in which households supply factors of
production—labor, capital, and natural resources—demanded by firms.
25. Markets in which firms supply
goods and services demandedby households.
26. Markets in which households
supply factors of
production—labor, capital, andnatural resources—demanded
by firms.

Our model is called a circular flow model because households use the income theyreceive from their supply of factors of production to buy goods and services fromfirms. Firms, in turn, use the payments they receive from households to pay for
their factors of production.

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Chapter 3 Demand and Supply

The demand and supply model developed in this chapter gives us a basic tool forunderstanding what is happening in each of these product or factor markets andalso allows us to see how these markets are interrelated. In Figure 3.13 "TheCircular Flow of Economic Activity", markets for three goods and services thathouseholds want—blue jeans, haircuts, and apartments—create demands by firms
for textile workers, barbers, and apartment buildings. The equilibrium of supply
and demand in each market determines the price and quantity of that item.
Moreover, a change in equilibrium in one market will affect equilibrium in related
markets. For example, an increase in the demand for haircuts would lead to anincrease in demand for barbers. Equilibrium price and quantity could rise in bothmarkets. For some purposes, it will be adequate to simply look at a single market,
whereas at other times we will want to look at what happens in related markets as
well.
In either case, the model of demand and supply is one of the most widely used toolsof economic analysis. That widespread use is no accident. The model yields resultsthat are, in fact, broadly consistent with what we observe in the marketplace. Your
mastery of this model will pay big dividends in your study of economics.

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KEY TAKEAWAYS• The equilibrium price is the price at which the quantity demanded
equals the quantity supplied. It is determined by the intersection of thedemand and supply curves.
• A surplus exists if the quantity of a good or service supplied exceeds thequantity demanded at the current price; it causes downward pressure
on price. A shortage exists if the quantity of a good or service demanded
exceeds the quantity supplied at the current price; it causes upward
pressure on price.
• An increase in demand, all other things unchanged, will cause theequilibrium price to rise; quantity supplied will increase. A decrease indemand will cause the equilibrium price to fall; quantity supplied will
decrease.
• An increase in supply, all other things unchanged, will cause theequilibrium price to fall; quantity demanded will increase. A decrease insupply will cause the equilibrium price to rise; quantity demanded will
decrease.
• To determine what happens to equilibrium price and equilibrium
quantity when both the supply and demand curves shift, you must know
in which direction each of the curves shifts and the extent to which eachcurve shifts.
• The circular flow model provides an overview of demand and supply in
product and factor markets and suggests how these markets are linked
to one another.

TRY IT!
What happens to the equilibrium price and the equilibrium quantity of DVD
rentals if the price of movie theater tickets increases and wages paid to DVD
rental store clerks increase, all other things unchanged? Be sure to show all
possible scenarios, as was done in Figure 3.11 "Simultaneous Decreases in
Demand and Supply". Again, you do not need actual numbers to arrive at an
answer. Just focus on the general position of the curve(s) before and after
events occurred.

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Chapter 3 Demand and Supply

Case in Point: Demand, Supply, and Obesity© 2010 Jupiterimages Corporation

Why are so many Americans fat? Put so crudely, the question may seem rude,but, indeed, the number of obese Americans has increased by more than 50%
over the last generation, and obesity may now be the nation’s number one
health problem. According to Sturm Roland in a recent RAND Corporation
study, “Obesity appears to have a stronger association with the occurrence ofchronic medical conditions, reduced physical health-related quality of life andincreased health care and medication expenditures than smoking or problem
drinking.”
Many explanations of rising obesity suggest higher demand for food. What
more apt picture of our sedentary life style is there than spending theafternoon watching a ballgame on TV, while eating chips and salsa, followed bya dinner of a lavishly topped, take-out pizza? Higher income has also
undoubtedly contributed to a rightward shift in the demand curve for food.
Plus, any additional food intake translates into more weight increase because
we spend so few calories preparing it, either directly or in the process ofearning the income to buy it. A study by economists Darius Lakdawalla andTomas Philipson suggests that about 60% of the recent growth in weight may be
explained in this way—that is, demand has shifted to the right, leading to anincrease in the equilibrium quantity of food consumed and, given our less

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Chapter 3 Demand and Supply

strenuous life styles, even more weight gain than can be explained simply by
the increased amount we are eating.
What accounts for the remaining 40% of the weight gain? Lakdawalla andPhilipson further reason that a rightward shift in demand would by itself leadto an increase in the quantity of food as well as an increase in the price of food.
The problem they have with this explanation is that over the post-World War II
period, the relative price of food has declined by an average of 0.2 percentage
points per year. They explain the fall in the price of food by arguing that
agricultural innovation has led to a substantial rightward shift in the supply
curve of food. As shown, lower food prices and a higher equilibrium quantity offood have resulted from simultaneous rightward shifts in demand and supply
and that the rightward shift in the supply of food from S1 to S2 has been
substantially larger than the rightward shift in the demand curve from D1 to D2.

Sources: Roland, Sturm, “The Effects of Obesity, Smoking, and Problem
Drinking on Chronic Medical Problems and Health Care Costs,” Health Affairs,
2002; 21(2): 245–253. Lakdawalla, Darius and Tomas Philipson, “The Growth of
Obesity and Technological Change: A Theoretical and Empirical Examination,”
National Bureau of Economic Research Working Paper no. w8946, May 2002.

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Chapter 3 Demand and Supply

ANSWER TO TRY IT! PROBLEM
An increase in the price of movie theater tickets (a substitute for DVD
rentals) will cause the demand curve for DVD rentals to shift to the right. An
increase in the wages paid to DVD rental store clerks (an increase in the costof a factor of production) shifts the supply curve to the left. Each event
taken separately causes equilibrium price to rise. Whether equilibrium
quantity will be higher or lower depends on which curve shifted more.
If the demand curve shifted more, then the equilibrium quantity of DVD
rentals will rise [Panel (a)].
If the supply curve shifted more, then the equilibrium quantity of DVD
rentals will fall [Panel (b)].
If the curves shifted by the same amount, then the equilibrium quantity of
DVD rentals would not change [Panel (c)].

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3.4 Review and PracticeSummary
In this chapter we have examined the model of demand and supply. We found that a demand curve shows thequantity demanded at each price, all other things unchanged. The law of demand asserts that an increase in
price reduces the quantity demanded and a decrease in price increases the quantity demanded, all other things
unchanged. The supply curve shows the quantity of a good or service that sellers will offer at various prices, allother things unchanged. Supply curves are generally upward sloping: an increase in price generally increases
the quantity supplied, all other things unchanged.
The equilibrium price occurs where the demand and supply curves intersect. At this price, the quantity
demanded equals the quantity supplied. A price higher than the equilibrium price increases the quantity
supplied and reduces the quantity demanded, causing a surplus. A price lower than the equilibrium priceincreases the quantity demanded and reduces the quantity supplied, causing a shortage. Usually, market
surpluses and shortages are short-lived. Changes in demand or supply, caused by changes in the determinants ofdemand and supply otherwise held constant in the analysis, change the equilibrium price and output. The
circular flow model allows us to see how demand and supply in various markets are related to one another.

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Chapter 3 Demand and Supply

CONCEPT PROBLEMS
1. What do you think happens to the demand for pizzas during the Super
Bowl? Why?
2. Which of the following goods are likely to be classified as normal
goods or services? Inferior? Defend your answer.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.

Beans
Tuxedos
Used cars
Used clothing
Computers
Books reviewed in The New York Times
Macaroni and cheese
Calculators
Cigarettes
CaviarLegal services

3. Which of the following pairs of goods are likely to be classified as
substitutes? Complements? Defend your answer.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.

Peanut butter and jelly
Eggs and ham
Nike brand and Reebok brand sneakers
IBM and Apple Macintosh brand computers
Dress shirts and ties
Airline tickets and hotels
Gasoline and tires
Beer and wine
Faxes and first-class mail
Cereal and milk
Cereal and eggs

4. A study found that lower airfares led some people to substituteflying for driving to their vacation destinations. This reduced thedemand for car travel and led to reduced traffic fatalities, since
air travel is safer per passenger mile than car travel. Using the
logic suggested by that study, suggest how each of the following
events would affect the number of highway fatalities in any one
year.

3.4 Review and Practice139Chapter 3 Demand and Supply

1. An increase in the price of gasoline
2. A large reduction in rental rates for passenger vans
3. An increase in airfares
5. Children under age 2 are now allowed to fly free on U.S. airlines; theyusually sit in their parents’ laps. Some safety advocates have urged thatthey be required to be strapped in infant seats, which would mean theirparents would have to purchase tickets for them. Some economists haveargued that such a measure would actually increase infant fatalities. Can
you say why?
6. The graphs below show four possible shifts in demand or in
supply that could occur in particular markets. Relate each of theevents described below to one of them.

1. How did the heavy rains in South America in 1997 affect themarket for coffee?
2. The Surgeon General decides french fries are not bad foryour health after all and issues a report endorsing their use.
What happens to the market for french fries?

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Chapter 3 Demand and Supply

3. How do you think rising incomes affect the market for ski
vacations?
4. A new technique is discovered for manufacturing computersthat greatly lowers their production cost. What happens to
the market for computers?
5. How would a ban on smoking in public affect the market for
cigarettes?
7. As low-carb diets increased in popularity, egg prices rose sharply. How
might this affect the monks’ supply of cookies or private retreats? (Seethe Case in Point on the Monks of St. Benedict’s.)
8. Gasoline prices typically rise during the summer, a time of heavy tourist
traffic. A “street talk” feature on a radio station sought tourist reaction
to higher gasoline prices. Here was one response: “I don’t like ’em [thehigher prices] much. I think the gas companies just use any excuse tojack up prices, and they’re doing it again now.” How does this tourist’s
perspective differ from that of economists who use the model of demandand supply?
9. The introduction to the chapter argues that preferences for coffeechanged in the 1990s and that excessive rain hurt yields from coffee
plants. Show and explain the effects of these two circumstances on thecoffee market.
10. With preferences for coffee remaining strong in the early part of the
century, Vietnam entered the market as a major exporter of coffee.
Show and explain the effects of these two circumstances on the coffee
market.
11. The study on the economics of obesity discussed in the Case in Point inthis chapter on that topic also noted that another factor behind risingobesity is the decline in cigarette smoking as the price of cigarettes has
risen. Show and explain the effect of higher cigarette prices on themarket for food. What does this finding imply about the relationshipbetween cigarettes and food?
12. In 2004, The New York Times reported that India might be losing its
outsourcing edge due to rising wagesNoam Scheiber, “As a Center for
Outsourcing, India Could Be Losing Its Edge,” New York Times, May 9,
2004, p. BU3. The reporter noted that a recent report “projected that if
India continued to produce college graduates at the current rate,
demand would exceed supply by 20% in the main outsourcing markets
by 2008.” Using the terminology you learned in this chapter, explain
what he meant to say was happening in the market for Indian workers
in outsourcing jobs. In particular, is demand for Indian workers
increasing or decreasing? Is the supply of Indian workers increasing or
decreasing? Which is shifting faster? How do you know?

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13. For more than a century, milk producers have produced skim milk,
which contains virtually no fat, along with regular milk, which contains
4% fat. But a century ago, skim milk accounted for only about 1% of total
production, and much of it was fed to hogs. Today, skim and otherreduced-fat milks make up the bulk of milk sales. What curve shifted,
and what factor shifted it?
14. Suppose firms in the economy were to produce fewer goods andservices. How do you think this would affect household spending on
goods and services? (Hint: Use the circular flow model to analyze thisquestion.)

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NUMERICAL PROBLEMS
Problems 1–5 are based on the graph below.

1. At a price of $1.50 per dozen, how many bagels are demanded permonth?
2. At a price of $1.50 per dozen, how many bagels are supplied per month?
3. At a price of $3.00 per dozen, how many bagels are demanded permonth?
4. At a price of $3.00 per dozen, how many bagels are supplied per month?
5. What is the equilibrium price of bagels? What is the equilibrium
quantity per month?
Problems 6–9 are based on the model of demand and supply for coffee asshown in Figure 3.10 "Changes in Demand and Supply". You can graph theinitial demand and supply curves by using the following values, with allquantities in millions of pounds of coffee per month:
Price Quantity demanded Quantity supplied
$3

40

10

4

35

15

5

30

20

6

25

25

7

20

30

8

15

35

9

10

40

1. Suppose the quantity demanded rises by 20 million pounds of coffee permonth at each price. Draw the initial demand and supply curves basedon the values given in the table above. Then draw the new demand

3.4 Review and Practice143Chapter 3 Demand and Supply

curve given by this change, and show the new equilibrium price andquantity.
2. Suppose the quantity demanded falls, relative to the values given in theabove table, by 20 million pounds per month at prices between $4 and $6
per pound; at prices between $7 and $9 per pound, the quantity
demanded becomes zero. Draw the new demand curve and show the
new equilibrium price and quantity.
3. Suppose the quantity supplied rises by 20 million pounds per month ateach price, while the quantities demanded retain the values shown in
the table above. Draw the new supply curve and show the new
equilibrium price and quantity.
4. Suppose the quantity supplied falls, relative to the values given in thetable above, by 20 million pounds per month at prices above $5; at a
price of $5 or less per pound, the quantity supplied becomes zero. Draw
the new supply curve and show the new equilibrium price and quantity.
Problems 10–15 are based on the demand and supply schedules for gasoline
below (all quantities are in thousands of gallons per week):
Price per gallon Quantity demanded Quantity supplied
$1

8

0

2

7

1

3

6

2

4

5

3

5

4

4

6

3

5

7

2

6

8

1

7

1. Graph the demand and supply curves and show the equilibrium priceand quantity.
2. At a price of $3 per gallon, would there be a surplus or shortage ofgasoline? How much would the surplus or shortage be? Indicate thesurplus or shortage on the graph.
3. At a price of $6 per gallon, would there be a surplus or shortage ofgasoline? How much would the surplus or shortage be? Show the surplus
or shortage on the graph.
4. Suppose the quantity demanded increased by 2,000 gallons per month ateach price. At a price of $3 per gallon, how much would the surplus or

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Chapter 3 Demand and Supply

shortage be? Graph the demand and supply curves and show the surplus
or shortage.
5. Suppose the quantity supplied decreased by 2,000 gallons per month ateach price for prices between $4 and $8 per gallon. At prices less than $4
per gallon the quantity supplied becomes zero, while the quantities
demanded retain the values shown in the table. At a price of $4 per
gallon, how much would the surplus or shortage be? Graph the demandand supply curves and show the surplus or shortage.
6. If the demand curve shifts as in problem 13 and the supply curve shifts
as in problem 14, without drawing a graph or consulting the data, canyou predict whether equilibrium price increases or decreases? Whatabout equilibrium quantity? Now draw a graph that shows what the new
equilibrium price and quantity are.

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Chapter 4
Applications of Demand and Supply
Start Up: A Composer Logs On“Since the age of seven, I knew that I would be a musician. And from age fourteen, I
knew that I would be a composer,” says Israeli-born Ofer Ben-Amots. What he did
not know was that he would use computers to carry out his work. He is now aprofessor of music at Colorado College, and Dr. Ben-Amots’s compositions andoperas have been performed in the United States, Europe, and Japan.
For over 20 years, he has used musical composition software in creating his music.
“The output is extremely elegant. Performers enjoy looking at such a clear andclean score. The creation of parts out of a full score is as easy as pressing the<ENTER> key on the keyboard.” Changes can easily be inserted into the notation
file, which eliminates the need for recopying. In addition, Dr. Ben-Amots uses
computers for playback. “I can listen to a relatively accurate ‘digital performance’of the score at any given point, with any tempo or instrumentation I choose. The
sound quality has improved so much that digital files sound almost identical to real
performance.” He can also produce CDs on his own and create podcasts so thatanyone in the world can hear his music. He engages in self-publication of scores andself-marketing. “In my case, I get to keep the copyrights on all of my music. This
would have been impossible ten to twelve years ago when composers transferred
their rights to publishers. Home pages on the World Wide Web allow me to promote
my own work.” Professor Ben-Amots also changed the way he teaches music
composition. New application software, such as GarageBand, has opened the way
for anyone interested to try to compose music. Whereas his music composition
classes used to have music theory prerequisites, today his classes are open to all.
Dr. Ben-Amots started out in 1989 with a Macintosh SE30 that had 4 megabytes ofrandom access memory (RAM) and an 80-megabyte hard drive. It cost him about$3,000. Today, he uses a Macintosh MacBook Pro with 4 gigabytes of memory (a bitin a computer has a value of 0 or 1, a byte is 8 bits, a megabyte is slightly more than
1 million bytes, and a gigabyte is slightly more than 1,000 megabytes), built-in DVD/CD burner, and wireless Internet connections. His new computer cost about $2,200.
Put another way, his first computer had a cost per megabyte of RAM of about $750.
His present computer costs about $0.75 per megabyte of RAM and is far more
powerful. The dramatic rise in the power of personal computers as they fell so146

Chapter 4 Applications of Demand and Supply

steeply in price is just one of the stories about markets we will tell in this chapter,
which aims to help you understand how the model of demand and supply applies tothe real world.
In the first section of this chapter, we will look at several markets that you arelikely to have participated in or be familiar with—the market for personal
computers, the markets for crude oil and for gasoline, and the stock market. You
probably own or have access to a computer. We have all been affected by the sharp
swings in the prices of oil and gasoline in recent years. The performance of thestock market is always a major news item and may affect you personally, if not now
then in the future. The concepts of demand and supply go a long way in explaining
the behavior of equilibrium prices and quantities in all of these markets. The
purpose of this section is to allow you to practice using the model of demand andsupply and to get you to start thinking about the myriad ways the model of demandand supply can be applied.
In the second part of the chapter we will look at markets in which the government
plays a large role in determining prices. By legislating maximum or minimum
prices, the government has kept the prices of certain goods below or above
equilibrium. We will look at the arguments for direct government intervention incontrolling prices as well as the consequences of such policies. As we shall see,preventing the price of a good from finding its own equilibrium often has
consequences that may be at odds with the intentions of the policy makers who put
the regulations in place.
In the third section of the chapter we will look at the market for health care. This
market is important because how well (or poorly) it works can be a matter of lifeand death and because it has special characteristics. In particular, markets in which
participants do not pay for goods directly but rather have insurers who then pay
the suppliers of the goods, operate somewhat differently from those in which
participants pay directly for their purchases. This extension of demand and supply
analysis, while only scratching the surface on the issues associated with the market
for health care, reveals much about how such markets operate. This analysis has
become particularly important in the wake of the passage of the Patient Protection
and Affordable Care Act in the United States in 2010—sometimes referred to(especially by opponents) as “Obamacare.”147

Chapter 4 Applications of Demand and Supply

4.1 Putting Demand and Supply to WorkLEARNING OBJECTIVES
1. Learn how to apply the model of demand and supply to the behavior of
equilibrium prices and output in a variety of markets.
2. Learn basic vocabulary on the organization of firms and explain how themodel of demand and supply can be used to understand prices of sharesof stock.

A shift in either demand or supply, or in both, leads to a change in equilibrium priceand equilibrium quantity. We begin this chapter by examining markets in which
prices adjust quickly to changes in demand or supply: the market for personal
computers, the markets for crude oil and gasoline, and the stock market. These
markets are thus direct applications of the model of demand and supply.

The Personal Computer Market
In the 1960s, to speak of computers was to speak of IBM, the dominant maker oflarge mainframe computers used by business and government agencies. Thenbetween 1976, when Apple Computer introduced its first desktop computer, and1981, when IBM produced its first personal computers (PCs), the computer usage
expanded dramatically. Only 8.2% of U. S. households owned a personal computer in
1984. By 2003, 62% did. After that, the U.S. Census Bureau began asking only about
Internet usage. By 2009, more than two-thirds of households had home Internet
access. The tools of demand and supply tell the story from an economic perspective.
Technological change has been breathtakingly swift in the computer industry.
Because personal computers have changed so dramatically in performance and in
the range of the functions they perform, we shall speak of “quality-adjusted”
personal computers. The price per unit of quality-adjusted desktop computers fellby about half every 50 months during the period 1976–1989. In the first half of the
1990s, those prices fell by half every 28 months. In the second half of the 1990s, the“halving time” fell to every 24 months.Ilkka Tuomi, “The Lives and Death of
Moore’s Law.” http://www.firstmonday.org/issues/issue7_11/tuomi/index. First
Monday (http://www.firstmonday.org) is a peer-reviewed journal on the Internet.
There are other indicators of the phenomenal change in computers. Between 1993
and 1998, the Bureau of Labor Statistics estimates that central processing unit (CPU)148

Chapter 4 Applications of Demand and Supply

speed rose 1,263%, system memory increased 1,500%, hard drive capacity soared by
3,700%, and monitor size went up 13%. It seems safe to say that the dizzying pace ofchange recorded in the 1990s has increased in this century. A “computer” today is
not the same good as a “computer” even five years ago. To make them comparable,
we must adjust for changes in quality.
Initially, most personal computers were manufactured by Apple or Compaq; bothcompanies were very profitable. The potential for profits attracted IBM and otherfirms to the industry. Unlike large mainframe computers, personal computer clones
turned out to be fairly easy to manufacture. As shown in Table 4.1 "Personal
Computer Shipments, Market Percentage Shares by Vendors, World and UnitedStates, 2011", the top six personal computer manufacturers produced only 43.3% of
the personal computers sold in the world in 2011, and the largest manufacturer,
Hewlett-Packard (HP), sold only about 17.5% of the total in that year. This is a far
cry from the more than 90% of the mainframe computer market that IBM once held.
The market has become far more competitive.
Table 4.1 Personal Computer Shipments, Market Percentage Shares by Vendors,
World and United States, 2011

Company

Percentage of World
Shipments

Company

Percentage of U.S.
Shipments

HP

17.5

HP

26.9

Dell

12.5

Dell

22.6

Lenovo

12.0

Apple

10.7

Acer
Group

10.9

Toshiba

9.6

Asus

5.2

Acer
Group

9.3

Toshiba

5.2

Others20.9

Others36.7

Source: “Gartner Says Worldwide PC Shipments Increased 2.3 Percent in Second
Quarter of 2011,” Gartner Newsroom, July 13, 2011, http://www.gartner.com/it/
page.jsp?id=1744216. Totals may not add due rounding.
Figure 4.1 "The Personal Computer Market" illustrates changes that have occurredin the computer market. The horizontal axis shows the quantity of quality-adjusted

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Chapter 4 Applications of Demand and Supply

personal computers. Thus, the quantity axis can be thought of as a unit ofcomputing power. Similarly, the price axis shows the price per unit of computing
power. The rapid increase in the number of firms, together with dramatic
technological improvements, led to an increase in supply, shifting the supply curvein Figure 4.1 "The Personal Computer Market" to the right from S1 to S2.
Demand also shifted to the right from D1 to D2, asincomes rose and new uses for computers, from e-mailand social networking to Voice over Internet Protocol(VoIP) and Radio Frequency ID (RFID) tags (which allow
wireless tracking of commercial shipments via desktop
computers), altered the preferences of consumer andbusiness users. Because we observe a fall in equilibrium
price and an increase in equilibrium quantity, we
conclude that the rightward shift in supply has
outweighed the rightward shift in demand. The powerof market forces has profoundly affected the way welive and work. One indication of the increasing
importance of computers was that in August 2011,
Exxon Mobil, an oil company that had been largest
company in the United States in terms of the value of its
outstanding stock, was the surpassed by Apple
Computer Inc., whose value reached $350 billion.

Figure 4.1 The Personal
Computer Market

The supply curve for qualityadjusted personal computersshifted markedly to the right,
reducing the equilibrium pricefrom P1 to P2 and increasing theequilibrium quantity from Q1 to
Q2 in 2011.

The Markets for Crude Oil and for Gasoline
The market for crude oil took a radical turn in 1973. The
price per barrel of crude oil quadrupled between 1973 and 1974. Price remained
high until the early 1980s but fell back drastically and remained low for about two
decades. In 2004, the price of oil began to move upward and by 2008 had reached$147 per barrel.
What caused the dramatic increase in gasoline and oil prices in 2008? It appeared to
be increasing worldwide demand outpacing producers’ ability—or willingness—toincrease production much. This increase in demand is illustrated in Figure 4.2"Increasing Demand for Crude Oil".

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Chapter 4 Applications of Demand and Supply

Figure 4.2 Increasing Demand for Crude Oil

The price of oil was $35 per barrel at the beginning of 2004, as determined by the intersection of world demand, D1,
and world supply, S1. Increasing world demand, prompted largely by increasing demand from China as well as fromother countries, shifted world demand to D2, pushing the price as high as $140 per barrel by the middle of 2008.

Higher oil prices also increase the cost of producing virtually every good or service
since the production of most goods requires transportation. These costs inevitablytranslate into higher prices for nearly all goods and services. Supply curves of thegoods and services thus affected shift to the left, putting downward pressure on
output and upward pressure on prices.
Graphically, the impact of higher gasoline prices on businesses that use gasoline is
illustrated in Figure 4.3 "The Impact of Higher Gasoline Prices". Because higher
gasoline prices increase the cost of doing business, they shift the supply curves fornearly all businesses to the left, putting upward pressure on prices and downward
pressure on output. In the case shown here, the supply curve in a typical industry
shifts from S1 to S2. This increases the equilibrium price from P1 to P2 and reduces
the equilibrium quantity from Q1 to Q2.

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Chapter 4 Applications of Demand and Supply

Figure 4.3 The Impact of Higher Gasoline Prices

Higher gasoline prices increase the cost of producing virtually every good or service. In the case shown here, thesupply curve in a typical industry shifts from S1 to S2. This increases the equilibrium price from P1 to P2 and reduces
equilibrium quantity from Q1 to Q2.

As the world economy slowed dramatically in the second half of 2008, the demand
curve for oil shifted to the left. By November 2008, the price per barrel had dropped
to below $60 per barrel. As gas prices also subsided, so did the threat of higher
prices in other industries.

The Stock Market
The circular flow model suggests that capital, like other factors of production, is
supplied by households to firms. Firms, in turn, pay income to those households forthe use of their capital. Generally speaking, however, capital is actually owned byfirms themselves. General Motors owns its assembly plants, and Wal-Mart owns its
stores; these firms therefore own their capital. But firms, in turn, are owned bypeople—and those people, of course, live in households. It is through theirownership of firms that households own capital.

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Chapter 4 Applications of Demand and Supply

A firm may be owned by one individual (a sole proprietorship1), by several
individuals (a partnership2), or by shareholders who own stock in the firm (acorporation3). Although most firms in the United States are sole proprietorships orpartnerships, the bulk of the nation’s total output (about 90%) is produced bycorporations. Corporations also own most of the capital (machines, plants,buildings, and the like).
This section describes how the prices of shares of corporate stock4, shares in theownership of a corporation, are determined by the interaction of demand andsupply. Ultimately, the same forces that determine the value of a firm’s stock
determine the value of a sole proprietorship or partnership.
When a corporation needs funds to increase its capital or for other reasons, onemeans at its disposal is to issue new stock in the corporation. (Other means include
borrowing funds or using past profits.) Once the new shares have been sold in what
is called an initial public offering (IPO), the corporation receives no further funding
as shares of its stock are bought and sold on the secondary market. The secondary
market is the market for stocks that have been issued in the past, and the dailynews reports about stock prices almost always refer to activity in the secondary
market. Generally, the corporations whose shares are traded are not involved inthese transactions.
The stock market5 is the set of institutions in which shares of stock are bought andsold. The New York Stock Exchange (NYSE) is one such institution. There are manyothers all over the world, such as the DAX in Germany and the Bolsa in Mexico. To
buy or sell a share of stock, one places an order with a stockbroker who relays theorder to one of the traders at the NYSE or at some other exchange.

1. A firm owned by one
individual.
2. A firm owned by several
individuals.
3. A firm owned by shareholders
who own stock in the firm.
4. Shares in the ownership of acorporation.
5. The set of institutions in whichshares of stock are bought andsold.

The process through which shares of stock are bought and sold can seem chaotic. At
many exchanges, traders with orders from customers who want to buy stock shout
out the prices those customers are willing to pay. Traders with orders from
customers who want to sell shout out offers of prices at which their customers arewilling to sell. Some exchanges use electronic trading, but the principle is the same:if the price someone is willing to pay matches the price at which someone else iswilling to sell, the trade is made. The most recent price at which a stock has tradedis reported almost instantaneously throughout the world.
Figure 4.4 "Demand and Supply in the Stock Market" applies the model of demandand supply to the determination of stock prices. Suppose the demand curve forshares in Intel Corporation is given by D1 and the supply by S1. (Even though thetotal number of shares outstanding is fixed at any point in time, the supply curve is
not vertical. Rather, the supply curve is upward sloping because it represents how

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many shares current owners are prepared to sell at each price, and that number
will be greater at higher prices.) Suppose that these curves intersect at a price of$25, at which Q1 shares are traded each day. If the price were higher, more shareswould be offered for sale than would be demanded, and the price would quickly fall.
If the price were lower, more shares would be demanded than would be supplied,
and the price would quickly rise. In general, we can expect the prices of shares ofstock to move quickly to their equilibrium levels.
The intersection of the demand and supply curves forshares of stock in a particular company determines theequilibrium price for a share of stock. But what
determines the demand and supply for shares of acompany’s stock?
The owner of a share of a company’s stock owns a shareof the company, and, hence, a share of its profits;
typically, a corporation will retain and reinvest some ofits profits to increase its future profitability. The profits
kept by a company are called retained earnings6.
Profits distributed to shareholders are called
dividends7. Because a share of stock gives its owner aclaim on part of a company’s future profits, it follows
that the expected level of future profits plays a role indetermining the value of its stock.

Figure 4.4 Demand andSupply in the Stock Market

The equilibrium price of stock
shares in Intel Corporation is
initially $25, determined by theintersection of demand andsupply curves D1 and S1, at which
Q1 million shares are traded eachday.

Of course, those future profits cannot be known withcertainty; investors can only predict what they mightbe, based on information about future demand for thecompany’s products, future costs of production, information about the soundness ofa company’s management, and so on. Stock prices in the real world thus reflect
estimates of a company’s profits projected into the future.
The downward slope of the demand curve suggests that at lower prices for thestock, more people calculate that the firm’s future earnings will justify the stock’spurchase. The upward slope of the supply curve tells us that as the price of thestock rises, more people conclude that the firm’s future earnings do not justify
holding the stock and therefore offer to sell it. At the equilibrium price, the numberof shares supplied by people who think holding the stock no longer makes sensejust balances the number of shares demanded by people who think it does.
6. Profits kept by a company.
7. Profits distributed toshareholders.

What factors, then, cause the demand or supply curves for shares of stocks to shift?
The most important factor is a change in the expectations of a company’s future

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profits. Suppose Intel announces a new generation of computer chips that will leadto faster computers with larger memories. Current owners of Intel stock would
adjust upward their estimates of what the value of a share of Intel stock should be.
At the old equilibrium price of $25 fewer owners of Intel stock would be willing tosell. Since this would be true at every possible share price, the supply curve for Intelstock would shift to the left, as shown in Figure 4.5 "A Change in Expectations
Affects the Price of Corporate Stock". Just as the expectation that a company will be
more profitable shifts the supply curve for its stock to the left, that same change in
expectations will cause more people to want to purchase the stock, shifting thedemand curve to the right. In Figure 4.5 "A Change in Expectations Affects the Priceof Corporate Stock", we see the supply curve shifting to the left, from S1 to S2, while
the demand curve shifts to the right, from D1 to D2.
Other factors may alter the price of an individual
corporation’s share of stock or the level of stock prices
in general. For example, demographic change and risingincomes have affected the demand for stocks in recent
years. For example, with a large proportion of the U.S.
population nearing retirement age and beginning tothink about and plan for their lives during retirement,
the demand for stocks has risen.
Information on the economy as a whole is also likely toaffect stock prices. If the economy overall is doing welland people expect that to continue, they may become
more optimistic about how profitable companies will bein general, and thus the prices of stocks will rise.
Conversely, expectations of a sluggish economy, as
happened in the fall of 2008, could cause stock prices ingeneral to fall.

Figure 4.5 A Change in
Expectations Affects thePrice of Corporate StockIf financial investors decide thata company is likely to be more
profitable, then the supply of thestock shifts to the left (in thiscase, from S1 to S2), and thedemand for the stock shifts to theright (in this case, from D1 to D2),
resulting in an increase in pricefrom P1 to P2.

The stock market is bombarded with new information
every minute of every day. Firms announce their profits
of the previous quarter. They announce that they plan
to move into a new product line or sell their goods inanother country. We learn that the price of Company
A’s good, which is a substitute for one sold by Company B, has risen. We learn thatcountries sign trade agreements, launch wars, or make peace. All of thisinformation may affect stock prices because any information can affect how buyers
and sellers value companies.

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KEY TAKEAWAYS• Technological change, which has caused the supply curve for computing
power to shift to the right, is the main reason for the rapid increase inequilibrium quantity and decrease in equilibrium price of personal
computers.
• The increase in crude oil and gasoline prices in 2008 was driven
primarily by increased demand for crude oil, an increase that was
created by economic growth throughout the world. Crude oil and gas
prices fell markedly as world economic growth subsided later in theyear.
• Higher gasoline prices increased the cost of producing virtually every
good and service, shifting supply curves for most goods and services tothe left. This tended to push prices up and output down.
• Demand and supply determine prices of shares of corporate stock. The
equilibrium price of a share of stock strikes a balance between those
who think the stock is worth more and those who think it is worth lessthan the current price.
• If a company’s profits are expected to increase, the demand curve for its
stock shifts to the right and the supply curve shifts to the left, causing
equilibrium price to rise. The opposite would occur if a company’s
profits were expected to decrease.
• Other factors that influence the price of corporate stock include
demographic and income changes and the overall health of theeconomy.

TRY IT!
Suppose an airline announces that its earnings this year are lower than
expected due to reduced ticket sales. The airline spokesperson gives noinformation on how the company plans to turn things around. Use themodel of demand and supply to show and explain what is likely to happen to
the price of the airline’s stock.

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Case in Point: The Great Recession, the Arab Spring, andthe Oil Market© Thinkstock

Oil markets have been on a roller coaster ride for the last few years. Even after
the official start of the recession in the United States in December 2007, oilprices continued to climb, peaking in the summer of 2008 at over $130 per
barrel. Although demand in the United States and Europe was alreadyweakening, growth in the rest of the world, particularly in China and India, wasstill strong. Overall, demand was rising.
Oil prices dropped precipitously following the start of the financial crisis andthe deepening of the recession in the fall of 2008. Within a few months, theprice of oil had dropped to around $40 and was in the $70 to $80 range for muchof the rest of 2009 and the first half of 2010.
The so-called Arab Spring actually began with demonstrations late in 2010 inTunisia. They quickly spread to Egypt, Bahrain, Syria, Yemen, Algeria, Jordan,
Morocco, and Yemen. There were demonstrations in Saudi Arabia, Kuwait,
Lebanon, Mauritania, and Sudan. By the fall of 2011, the movement had toppled
the regimes of Zine El Abidine Ben Ali in Tunisia, Hosni Mubarak in Egypt, andMuammar al-Gaddafi in Libya.
The movement had a large impact on oil prices as it raised questions about the
security of oil supplies. The supply curve of oil shifted to the left, forcing theprice upward. Not only were several key suppliers of oil affected, but at times
the ability to transport oil through the Suez Canal was affected.

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Oil prices rose to well over $100 per barrel by early 2011. They then began to
subside again as some of the uprisings were subdued or ending, especially inthe oil-rich Gulf countries. By the fall of 2011, oil prices had fallen about 20% ascompared to earlier in the year.

ANSWER TO TRY IT! PROBLEM
The information given in the problem suggests that the airline’s profits arelikely to fall below expectations. Current owners of the airline’s stock andpotential buyers of the stock would adjust downward their estimates of what
the value of the corporation’s stock should be. As a result the supply curvefor the stock would increase, shifting it to the right, while the demand curvefor the stock would decrease, shifting it to the left. As a result, equilibrium
price of the stock falls from P1 to P2. What happens to equilibrium quantity
depends on the extent to which each curve shifts. In the diagram,equilibrium quantity is shown to decrease from Q1 to Q2.

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4.2 Government Intervention in Market Prices: Price Floors and Price
Ceilings
LEARNING OBJECTIVES
1. Use the model of demand and supply to explain what happens when thegovernment imposes price floors or price ceilings.
2. Discuss the reasons why governments sometimes choose to control
prices and the consequences of price control policies.

So far in this chapter and in the previous chapter, we have learned that markets
tend to move toward their equilibrium prices and quantities. Surpluses andshortages of goods are short-lived as prices adjust to equate quantity demandedwith quantity supplied.
In some markets, however, governments have been called on by groups of citizens
to intervene to keep prices of certain items higher or lower than what would result
from the market finding its own equilibrium price. In this section we will examine
agricultural markets and apartment rental markets—two markets that have often
been subject to price controls. Through these examples, we will identify the effectsof controlling prices. In each case, we will look at reasons why governments havechosen to control prices in these markets and the consequences of these policies.

Agricultural Price Floors
Governments often seek to assist farmers by setting price floors in agricultural
markets. A minimum allowable price set above the equilibrium price is a pricefloor8. With a price floor, the government forbids a price below the minimum.
(Notice that, if the price floor were for whatever reason set below the equilibrium
price, it would be irrelevant to the determination of the price in the market sincenothing would prohibit the price from rising to equilibrium.) A price floor that is
set above the equilibrium price creates a surplus.

8. A minimum allowable price set
above the equilibrium price.

Figure 4.6 "Price Floors in Wheat Markets" shows the market for wheat. Suppose
the government sets the price of wheat at PF. Notice that PF is above the equilibrium
price of PE. At PF, we read over to the demand curve to find that the quantity ofwheat that buyers will be willing and able to purchase is W1 bushels. Reading overto the supply curve, we find that sellers will offer W2 bushels of wheat at the price159

Chapter 4 Applications of Demand and Supply

floor of PF. Because PF is above the equilibrium price, there is a surplus of wheat
equal to (W2 − W1) bushels. The surplus persists because the government does notallow the price to fall.
Why have many governments around the world set
price floors in agricultural markets? Farming haschanged dramatically over the past two centuries.
Technological improvements in the form of new
equipment, fertilizers, pesticides, and new varieties ofcrops have led to dramatic increases in crop output per
acre. Worldwide production capacity has expanded
markedly. As we have learned, technologicalimprovements cause the supply curve to shift to theright, reducing the price of food. While such pricereductions have been celebrated in computer markets,
farmers have successfully lobbied for government
programs aimed at keeping their prices from falling.

Figure 4.6 Price Floors in
Wheat Markets

A price floor for wheat creates asurplus of wheat equal to (W2 W1) bushels.

While the supply curve for agricultural goods has
shifted to the right, the demand has increased withrising population and with rising income. But asincomes rise, people spend a smaller and smaller
fraction of their incomes on food. While the demand for food has increased, that
increase has not been nearly as great as the increase in supply. Figure 4.7 "Supply
and Demand Shifts for Agricultural Products" shows that the supply curve has
shifted much farther to the right, from S1 to S2, than the demand curve has, from D1
to D2. As a result, equilibrium quantity has risen dramatically, from Q1 to Q2, andequilibrium price has fallen, from P1 to P2.
On top of this long-term historical trend in agriculture, agricultural prices are
subject to wide swings over shorter periods. Droughts or freezes can sharply reduce
supplies of particular crops, causing sudden increases in prices. Demand for
agricultural goods of one country can suddenly dry up if the government of anothercountry imposes trade restrictions against its products, and prices can fall. Suchdramatic shifts in prices and quantities make incomes of farmers unstable.

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The Great Depression of the 1930s led to a major federalrole in agriculture. The Depression affected the entire
economy, but it hit farmers particularly hard. Prices
received by farmers plunged nearly two-thirds from1930 to 1933. Many farmers had a tough time keeping up
mortgage payments. By 1932, more than half of all farmloans were in default.
Farm legislation passed during the Great Depression has
been modified many times, but the federal government
has continued its direct involvement in agricultural
markets. This has meant a variety of government
programs that guarantee a minimum price for some
types of agricultural products. These programs havebeen accompanied by government purchases of any
surplus, by requirements to restrict acreage in order tolimit those surpluses, by crop or production
restrictions, and the like.

Figure 4.7 Supply and
Demand Shifts for
Agricultural Products

A relatively large increase in the
supply of agricultural products,
accompanied by a relatively
small increase in demand, hasreduced the price received by
farmers and increased thequantity of agricultural goods.

To see how such policies work, look back at Figure 4.6"Price Floors in Wheat Markets". At PF, W2 bushels of
wheat will be supplied. With that much wheat on the market, there is market
pressure on the price of wheat to fall. To prevent price from falling, thegovernment buys the surplus of (W2 - W1) bushels of wheat, so that only W1 bushels
are actually available to private consumers for purchase on the market. The
government can store the surpluses or find special uses for them. For example,
surpluses generated in the United States have been shipped to developing countries
as grants-in-aid or distributed to local school lunch programs. As a variation on thisprogram, the government can require farmers who want to participate in the pricesupport program to reduce acreage in order to limit the size of the surpluses.
After 1973, the government stopped buying the surpluses (with some exceptions)and simply guaranteed farmers a “target price.” If the average market price for acrop fell below the crop’s target price, the government paid the difference. If, forexample, a crop had a market price of $3 per unit and a target price of $4 per unit,
the government would give farmers a payment of $1 for each unit sold. Farmers
would thus receive the market price of $3 plus a government payment of $1 perunit. For farmers to receive these payments, they had to agree to remove acres fromproduction and to comply with certain conservation provisions. These restrictions
sought to reduce the size of the surplus generated by the target price, which acted
as a kind of price floor.

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What are the effects of such farm support programs? The intention is to boost andstabilize farm incomes. But, with price floors, consumers pay more for food thanthey would otherwise, and governments spend heavily to finance the programs.
With the target price approach, consumers pay less, but government financing of
the program continues. U.S. federal spending for agriculture averaged well over $22
billion per year between 2003 and 2007, roughly $70 per person.
Help to farmers has sometimes been justified on the grounds that it boosts incomesof “small” farmers. However, since farm aid has generally been allotted on the basisof how much farms produce rather than on a per-farm basis, most federal farm
support has gone to the largest farms. If the goal is to eliminate poverty among
farmers, farm aid could be redesigned to supplement the incomes of small or poor
farmers rather than to undermine the functioning of agricultural markets.
In 1996, the U.S. Congress passed the Federal Agriculture Improvement and ReformAct of 1996, or FAIR. The thrust of the new legislation was to do away with thevarious programs of price support for most crops and hence provide incentives forfarmers to respond to market price signals. To protect farmers through a transition
period, the act provided for continued payments that were scheduled to decline
over a seven-year period. However, with prices for many crops falling in 1998, theU.S. Congress passed an emergency aid package that increased payments tofarmers. In 2008, as farm prices reached record highs, Congress passed a farm billthat increased subsidy payments to $40 billion. It did, however, for the first time
limit payments to the wealthiest farmers. Individual farmers whose farm incomes
exceed $750,000 (or $1.5 million for couples) would be ineligible for some subsidy
programs.

Rental Price Ceilings
The purpose of rent control is to make rental units cheaper for tenants than theywould otherwise be. Unlike agricultural price controls, rent control in the UnitedStates has been largely a local phenomenon, although there were national rent
controls in effect during World War II. Currently, about 200 cities and counties havesome type of rent control provisions, and about 10% of rental units in the UnitedStates are now subject to price controls. New York City’s rent control program,which began in 1943, is among the oldest in the country. Many other cities in the
United States adopted some form of rent control in the 1970s. Rent controls havebeen pervasive in Europe since World War I, and many large cities in poorer
countries have also adopted rent controls.
Rent controls in different cities differ in terms of their flexibility. Some cities allow
rent increases for specified reasons, such as to make improvements in apartments

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or to allow rents to keep pace with price increases elsewhere in the economy. Often,
rental housing constructed after the imposition of the rent control ordinances is
exempted. Apartments that are vacated may also be decontrolled. For simplicity,
the model presented here assumes that apartment rents are controlled at a pricethat does not change.
Figure 4.8 "Effect of a Price Ceiling on the Market for
Apartments" shows the market for rental apartments.
Notice that the demand and supply curves are drawn tolook like all the other demand and supply curves you
have encountered so far in this text: the demand curveis downward-sloping and the supply curve is upwardsloping.
The demand curve shows that a higher price (rent)
reduces the quantity of apartments demanded. For
example, with higher rents, more young people will
choose to live at home with their parents. With lower
rents, more will choose to live in apartments. Higher
rents may encourage more apartment sharing; lower
rents would induce more people to live alone.

Figure 4.8 Effect of a Price
Ceiling on the Market for
Apartments

A price ceiling on apartment
rents that is set below theequilibrium rent creates ashortage of apartments equal to(A2 − A1) apartments.

The supply curve is drawn to show that as rent
increases, property owners will be encouraged to offer
more apartments to rent. Even though an aerial
photograph of a city would show apartments to be fixed
at a point in time, owners of those properties will decide how many to rent
depending on the amount of rent they anticipate. Higher rents may also induce
some homeowners to rent out apartment space. In addition, renting out apartments
implies a certain level of service to renters, so that low rents may lead someproperty owners to keep some apartments vacant.
Rent control is an example of a price ceiling9, a maximum allowable price. With aprice ceiling, the government forbids a price above the maximum. A price ceilingthat is set below the equilibrium price creates a shortage that will persist.

9. A maximum allowable price.

Suppose the government sets the price of an apartment at PC in Figure 4.8 "Effect ofa Price Ceiling on the Market for Apartments". Notice that PC is below theequilibrium price of PE. At PC, we read over to the supply curve to find that sellers
are willing to offer A1 apartments. Reading over to the demand curve, we find that
consumers would like to rent A2 apartments at the price ceiling of PC. Because PC is

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below the equilibrium price, there is a shortage of apartments equal to (A2 - A1).
(Notice that if the price ceiling were set above the equilibrium price it would haveno effect on the market since the law would not prohibit the price from settling at
an equilibrium price that is lower than the price ceiling.)
If rent control creates a shortage of apartments, why dosome citizens nonetheless clamor for rent control andwhy do governments often give in to the demands? The
reason generally given for rent control is to keep
apartments affordable for low- and middle-income
tenants.

Figure 4.9 The Unintended
Consequences of Rent
Control

But the reduced quantity of apartments supplied mustbe rationed in some way, since, at the price ceiling, thequantity demanded would exceed the quantity supplied.
Current occupants may be reluctant to leave theirdwellings because finding other apartments will bedifficult. As apartments do become available, there will Controlling apartment rents at
be a line of potential renters waiting to fill them, any of PC creates a shortage of (A2 − A1)
apartments. For A1 apartments,
whom is willing to pay the controlled price of PC or
more. In fact, reading up to the demand curve in Figure consumers are willing and able topay PB, which leads to various
4.9 "The Unintended Consequences of Rent Control"“backdoor” payments tofrom A1 apartments, the quantity available at PC, youapartment owners.
can see that for A1 apartments, there are potential
renters willing and able to pay PB. This often leads tovarious “backdoor” payments to apartment owners,
such as large security deposits, payments for things renters may not want (such as
furniture), so-called “key” payments (“The monthly rent is $500 and the key price is$3,000”), or simple bribes.
In the end, rent controls and other price ceilings often end up hurting some of thepeople they are intended to help. Many people will have trouble finding apartments
to rent. Ironically, some of those who do find apartments may actually end up
paying more than they would have paid in the absence of rent control. And many ofthe people that the rent controls do help (primarily current occupants, regardlessof their income, and those lucky enough to find apartments) are not those they areintended to help (the poor). There are also costs in government administration andenforcement.
Because New York City has the longest history of rent controls of any city in the
United States, its program has been widely studied. There is general agreement that

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the rent control program has reduced tenant mobility, led to a substantial gap
between rents on controlled and uncontrolled units, and favored long-term
residents at the expense of newcomers to the city.Richard Arnott, “Time for
Revisionism on Rent Control,” Journal of Economic Perspectives 9(1) (Winter, 1995):
99–120. These distortions have grown over time, another frequent consequence of
price controls.
A more direct means of helping poor tenants, one that would avoid interfering withthe functioning of the market, would be to subsidize their incomes. As with pricefloors, interfering with the market mechanism may solve one problem, but it
creates many others at the same time.

KEY TAKEAWAYS• Price floors create surpluses by fixing the price above the equilibrium
price. At the price set by the floor, the quantity supplied exceeds thequantity demanded.
• In agriculture, price floors have created persistent surpluses of a wide
range of agricultural commodities. Governments typically purchase theamount of the surplus or impose production restrictions in an attempt
to reduce the surplus.
• Price ceilings create shortages by setting the price below theequilibrium. At the ceiling price, the quantity demanded exceeds thequantity supplied.
• Rent controls are an example of a price ceiling, and thus they create
shortages of rental housing.
• It is sometimes the case that rent controls create “backdoor”
arrangements, ranging from requirements that tenants rent items thatthey do not want to outright bribes, that result in rents higher thanwould exist in the absence of the ceiling.

TRY IT!
A minimum wage law is another example of a price floor. Draw demand andsupply curves for unskilled labor. The horizontal axis will show the quantityof unskilled labor per period and the vertical axis will show the hourly wage
rate for unskilled workers, which is the price of unskilled labor. Show andexplain the effect of a minimum wage that is above the equilibrium wage.

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Case in Point: Corn: It Is Not Just Food Any More

© 2010 Jupiterimages
Corporation

Government support for corn dates back to the Agricultural Act of 1938 and, in
one form or another, has been part of agricultural legislation ever since. Typesof supports have ranged from government purchases of surpluses to target
pricing, land set asides, and loan guarantees. According to one estimate, theU.S. government spent nearly $42 billion to support corn between 1995 and2004.
Then, during the period of rising oil prices of the late 1970s and mounting
concerns about dependence on foreign oil from volatile regions in the world,
support for corn, not as a food, but rather as an input into the production of
ethanol—an alternative to oil-based fuel—began. Ethanol tax credits were partof the Energy Act of 1978. Since 1980, a tariff of 50¢ per gallon against imported
ethanol, even higher today, has served to protect domestic corn-based ethanolfrom imported ethanol, in particular from sugar-cane-based ethanol from
Brazil.
The Energy Policy Act of 2005 was another milestone in ethanol legislation.
Through loan guarantees, support for research and development, and tax
credits, it mandated that 4 billion gallons of ethanol be used by 2006 and 7.5

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billion gallons by 2012. Ethanol production had already reached 6.5 billion
gallons by 2007, so new legislation in 2007 upped the ante to 15 billion gallons
by 2015.
Beyond the increased amount the government is spending to support corn andcorn-based ethanol, criticism of the policy has three major prongs:
1. Corn-based ethanol does little to reduce U.S. dependence on
foreign oil because the energy required to produce a gallon ofcorn-based ethanol is quite high. A 2006 National Academy of
Sciences paper estimated that one gallon of ethanol is needed tobring 1.25 gallons of it to market. Other studies show an even lessfavorable ratio.
2. Biofuels, such as corn-based ethanol, are having detrimental
effects on the environment, with increased deforestation,
stemming from more land being used to grow fuel inputs,
contributing to global warming.
3. The diversion of corn and other crops from food to fuel iscontributing to rising food prices and an increase in world hunger.
C. Ford Runge and Benjamin Senauer wrote in Foreign Affairs thateven small increases in prices of food staples have severe
consequences on the very poor of the world, and “Filling the
25-gallon tank of an SUV with pure ethanol requires over 450
pounds of corn—which contains enough calories to feed one
person for a year.”
Some of these criticisms may be contested as exaggerated: Will the ratio ofenergy-in to energy-out improve as new technologies emerge for producing
ethanol? Did not other factors, such as weather and rising food demand
worldwide, contribute to higher grain prices? Nonetheless, it is clear that cornbased ethanol is no free lunch. It is also clear that the end of government
support for corn is nowhere to be seen.
Sources: Alexei Barrionuevo, “Mountains of Corn and a Sea of Farm Subsidies,”
New York Times, November 9, 2005, online version; David Freddoso, “Children of
the Corn,” National Review Online, May 6, 2008; C. Ford Runge and BenjaminSenauer, “How Biofuels Could Starve the Poor,” Foreign Affairs, May/June 2007,
online version; Michael Grunwald, “The Clean Energy Scam,” Time 171:14 (April
7, 2008): 40–45.

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ANSWER TO TRY IT! PROBLEM
A minimum wage (Wmin) that is set above the equilibrium wage would create
a surplus of unskilled labor equal to (L2 - L1). That is, L2 units of unskilledlabor are offered at the minimum wage, but companies only want to use L1
units at that wage. Because unskilled workers are a substitute for a skilledworkers, forcing the price of unskilled workers higher would increase thedemand for skilled labor and thus increase their wages.

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4.3 The Market for Health-Care Services
LEARNING OBJECTIVE
1. Use the model of demand and supply to explain the effects of thirdparty payers on the health-care market and on health-care spending.

There has been much discussion over the past three decades about the health-care
problem in the United States. Much of this discussion has focused on rising
spending for health care. In this section, we will apply the model of demand andsupply to health care to see what we can learn about some of the reasons behindrising spending in this important sector of the economy.
Figure 4.10 "Health-Care Spending as a Percentage of U.S. Output, 1960–2009" shows
the share of U.S. output devoted to health care since 1960. In 1960, about 5% of total
output was devoted to health care; by 2009 this share had risen to 17.6%. Thatmeans that we are devoting more of our spending to health care and less to othergoods and services.
The Affordable Care Act of 2010 dramatically impacted health care services. Amongits provisions is a requirement that individuals purchase health insurance (the socalled individual mandate). That provision may well result in the entire Act being
ruled unconstitutional by the courts. As this book went to press, the Act was
pending before the court system, and a ruling against it, or at least against parts ofit, seemed possible.
The Act requires insurance companies to provide coverage for children on theirparent’s policies up to the age of 26. It also bars health insurance companies fromdenying coverage based on pre-existing conditions.
Provisions of the Act are extensive. It applies to virtually every aspect of health careservices. It allows people to acquire health care insurance regardless of pre-existing
conditions. It also allows employers to opt out of providing health insurance and to
pay a fee instead.

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Why were Americans willing to increase their spendingon health care so dramatically? The model of demandand supply gives us part of the answer. As we apply themodel to this problem, we will also gain a better
understanding of the role of prices in a market
economy.

Figure 4.10 Health-CareSpending as a Percentage of
U.S. Output, 1960–2009

The Demand and Supply for Health Care
When we speak of “health care,” we are speaking of theentire health-care industry. This industry produces
services ranging from heart transplant operations totherapeutic massages; it produces goods ranging from
X-ray machines to aspirin tablets. Clearly each of thesegoods and services is exchanged in a particular market.
To assess the market forces affecting health care, wewill focus first on just one of these markets: the market
for physician office visits. When you go to the doctor,
you are part of the demand for these visits. Your doctor,
by seeing you, is part of the supply.
Figure 4.11 "Total Spending for Physician Office Visits"
shows the market, assuming that it operates in a fashion
similar to other markets. The demand curve D1 and the
supply curve S1 intersect at point E, with an equilibrium
price of $30 per office visit. The equilibrium quantity ofoffice visits per week is 1,000,000.

Health care’s share of total U.S.
output rose from about 5% in
1960 to 17.6% in 2009.
Data for period 1960–1992 from
Health Care Finance Association(which was the predecessor to
the Centers for Medicare andMedicaid Services); Data for
period 1993–2009 from Centers
for Medicare and Medicaid
Services, Office of the Actuary:
National Health Statistics Grouphttps://www.cms.gov/
NationalHealthExpendData/
downloads/tables.pdf.

Figure 4.11 Total Spending
for Physician Office Visits

We can use the demand and supply graph to show total
spending, which equals the price per unit (in this case,$30 per visit) times the quantity consumed (in this case,
1,000,000 visits per week). Total spending for physician
office visits thus equals $30,000,000 per week ($30 times
1,000,000 visits). We show total spending as the area of arectangle bounded by the price and the quantity. It is
the shaded region in Figure 4.11 "Total Spending for
Physician Office Visits".
Total spending on physician
The picture in Figure 4.11 "Total Spending for Physician
Office Visits" misses a crucial feature of the market.
Most people in the United States have health insurance,
provided either by private firms, by private purchases,

4.3 The Market for Health-Care Services

office visits is $30 per visit
multiplied by 1,000,000 visits per
week, which equals $30,000,000. It

170Chapter 4 Applications of Demand and Supply

or by the government. With health insurance, people
agree to pay a fixed amount to the insurer in exchange
for the insurer’s agreement to pay for most of thehealth-care expenses they incur. While insurance plansdiffer in their specific provisions, let us suppose that allindividuals have plans that require them to pay $10 for
an office visit; the insurance company will pay the rest.

is the shaded area bounded byprice and quantity.

How will this insurance affect the market for physician office visits? If it costs only
$10 for a visit instead of $30, people will visit their doctors more often. The quantity
of office visits demanded will increase. In Figure 4.12 "Total Spending for Physician
Office Visits Covered by Insurance", this is shown as a movement along the demand
curve. Think about your own choices. When you get a cold, do you go to the doctor?
Probably not, if it is a minor cold. But if you feel like you are dying, or wish you
were, you probably head for the doctor. Clearly, there are lots of colds in between
these two extremes. Whether you drag yourself to the doctor will depend on theseverity of your cold and what you will pay for a visit. At a lower price, you are
more likely to go to the doctor; at a higher price, you are less likely to go.
In the case shown, the quantity of office visits rises to 1,500,000 per week. But thatsuggests a potential problem. The quantity of visits supplied at a price of $30 per
visit was 1,000,000. According to supply curve S1, it will take a price of $50 per visit
to increase the quantity supplied to 1,500,000 visits (Point F on S1). But
consumers—patients—pay only $10.
Insurers make up the difference between the fees doctors receive and the pricepatients pay. In our example, insurers pay $40 per visit of insured patients to
supplement the $10 that patients pay. When an agent other than the seller or thebuyer pays part of the price of a good or service, we say that the agent is a thirdparty payer10.
Notice how the presence of a third-party payer affects total spending on officevisits. When people paid for their own visits, and the price equaled $30 per visit,
total spending equaled $30 million per week. Now doctors receive $50 per visit andprovide 1,500,000 visits per week. Total spending has risen to $75 million per week($50 times 1,500,000 visits, shown by the darkly shaded region plus the lightly
shaded region).

10. An agent other than the seller
or the buyer who pays part ofthe price of a good or service.

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Chapter 4 Applications of Demand and Supply

Figure 4.12 Total Spending for Physician Office Visits Covered by InsuranceWith insurance, the quantity of physician office visits demanded rises to 1,500,000. The supply curve shows that it
takes a price of $50 per visit to increase the quantity supplied to 1,500,000 visits. Patients pay $10 per visit andinsurance pays $40 per visit. Total spending rises to $75,000,000 per week, shown by the darkly shaded region plus
the lightly shaded region.

The response described in Figure 4.12 "Total Spending for Physician Office Visits
Covered by Insurance" holds for many different types of goods and services coveredby insurance or otherwise paid for by third-party payers. For example, theavailability of scholarships and subsidized tuition at public and private universities
increases the quantity of education demanded and the total expenditures on higher
education. In markets with third-party payers, an equilibrium is achieved, but it is
not at the intersection of the demand and supply curves. The effect of third-party
payers is to decrease the price that consumers directly pay for the goods andservices they consume and to increase the price that suppliers receive. Consumers
use more than they would in the absence of third-party payers, and providers areencouraged to supply more than they otherwise would. The result is increased total
spending.

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Chapter 4 Applications of Demand and Supply

KEY TAKEAWAYS• The rising share of the output of the United States devoted to healthcare represents a rising opportunity cost. More spending on health caremeans less spending on other goods and services, compared to what
would have transpired had health-care spending not risen so much.
• The model of demand and supply can be used to show the effect of thirdparty payers on total spending. With third-party payers (for example,
health insurers), the quantity of services consumed rises, as does
spending.

TRY IT!
The provision of university education through taxpayer-supported state
universities is another example of a market with a third-party payer. Use
the model of demand and supply to discuss the impact this has on the higher
education market. Specifically, draw a graph similar to Figure 4.12 "Total
Spending for Physician Office Visits Covered by Insurance". How would youlabel the axes? Show the equilibrium price and quantity in the absence of athird-party payer and indicate total spending on education. Now show the
impact of lower tuition As a result of state support for education. How mucheducation do students demand at the lower tuition? How much tuition must
educational institutions receive to produce that much education? How muchspending on education will occur? Compare total spending before and after
a third-party payer enters this market.

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Chapter 4 Applications of Demand and Supply

Case in Point: The Oregon Plan

© 2010 Jupiterimages
Corporation

The health-care industry presents us with a dilemma. Clearly, it makes sense
for people to have health insurance. Just as clearly, health insurance generates
a substantial increase in spending for health care. If that spending is to belimited, some mechanism must be chosen to do it. One mechanism would be torequire patients to pay a larger share of their own health-care consumption
directly, reducing the payments made by third-party payers. Allowing people toaccumulate tax-free private medical savings accounts is one way to do this.
Another option is to continue the current trend to use insurance companies as
the agents that limit spending. A third option is government regulation; thisCase in Point describes how the state of Oregon tried to limit health-carespending by essentially refusing to be a third-party payer for certain services.
Like all other states, Oregon has wrestled with the problem of soaring Medicaid
costs. Its solution to the problem illustrates some of the choices society mightmake in seeking to reduce health-care costs.
Oregon used to have a plan similar to plans in many other states. Households
whose incomes were lower than 50% of the poverty line qualified for Medicaid.
In 1987, the state began an effort to manage its Medicaid costs. It decided that it

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would no longer fund organ transplants and that it would use the money saved
to give better care to pregnant women. The decision turned out to be a painfulone; the first year, a seven-year-old boy with leukemia, who might have beensaved with a bone marrow transplant, died. But state officials argued that theshift of expenditures to pregnant women would ultimately save more lives.
The state gradually expanded its concept of determining what services to fundand what services not to fund. It collapsed a list of 10,000 different diagnoses
that had been submitted to its Medicaid program in the past into a list of morethan 700 condition-treatment pairs. One such pair, for example, is appendicitisappendectomy. Health-care officials then ranked these pairs in order ofpriority. The rankings were based on such factors as the seriousness of aparticular condition and the cost and efficacy of treatments. The state
announced that it would provide Medicaid to all households below the poverty
line, but that it would not fund any procedure ranked below a certain level,
initially number 588 on its list. The plan also set a budget limit for any one year;
if spending rose above that limit, the legislature must appropriate additional
money or drop additional procedures from the list of those covered by the plan.
The Oregon Health Plan officially began operation in 1994.
While the Oregon plan has been applied only to households below the poverty
line that are not covered by other programs, it suggests a means of reducing
health-care spending. Clearly, if part of the health-care problem is excessive
provision of services, a system designed to cut services must determine what
treatments not to fund.
Professors Jonathan Oberlander, Theodore Marmor, and Lawrence Jacobs
studied the impact of this plan in practice through the year 2000 and foundthat, in contrast to initial expectations, excluded procedures were generally
ones of marginal medical value, so the “line in the sand” had little practicalsignificance. In addition, they found that patients were often able to receive
supposedly excluded services when physicians, for example, treated an
uncovered illness in conjunction with a covered one. During the period of thestudy, the number of people covered by the plan expanded substantially andyet rationing of services essentially did not occur. How do they explain thisseeming contradiction? Quite simply: state government increased revenues
from various sources to support the plan. Indeed, they argue that, because
treatments that might not be included were explicitly stated, political pressure
made excluding them even more difficult and may have inadvertently
increased the cost of the program.

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In the early 2000s, Oregon, like many other states, confronted severe budgetarypressures. To limit spending, it chose the perhaps less visible strategy of
reducing the number of people covered through the plan. Once serving morethan 100,000 people, budget cuts reduced the number served to about 17,000.
Whereas in 1996, 11% of Oregonians lacked health insurance, in 2008 16% did.
Trailblazing again, in 2008 Oregon realized that its budget allowed room forcoverage for a few thousand additional people. But how to choose among the
130,000 eligibles? The solution: to hold a lottery. More than 90,000 people
queued up, hoping to be lucky winners.
Sources: Jonathan Oberlander, Theodore Marmor, and Lawrence Jacobs,“Rationing Medical Care: Rhetoric and Reality in the Oregon Health Plan,”
Canadian Medical Association Journal 164: 11 (May 29, 2001): 1583–1587; William
Yardley, “Drawing Lots for Health Care,” The New York Times, March 13, 2008: p.
A12.

ANSWER TO TRY IT! PROBLEM
Without a third-party payer for education, the graph shows equilibrium
tuition of P1 and equilibrium quantity of education of Q1. State support for
education lowers tuition that students pay to P2. As a result, students
demand Q2 courses per year. To provide that amount of education,
educational institutions require tuition per course of P3. Without a thirdparty payer, spending on education is 0P1EQ1. With a third-party payer,
spending rises to 0P3FQ2.

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4.4 Review and PracticeSummary
In this chapter we used the tools of demand and supply to understand a wide variety of market outcomes. We
learned that technological change and the entry of new sellers has caused the supply curve of personal
computers to shift markedly to the right, thereby reducing equilibrium price and increasing equilibrium
quantity. Market forces have made personal computers a common item in offices and homes.
Crude oil and gasoline prices soared in 2008 and then fell back, rising again in 2011 as a result of the disruption
created by the Arab Spring. We looked at the causes of these increases as well as their impacts. Crude oil pricesrose in large part As a result of increased demand, particularly from China. Higher prices for crude oil led tohigher prices for gasoline. Those higher prices not only hurt consumers of gasoline, they also put upward
pressure on the prices of a wide range of goods and services. Crude oil and gasoline prices then decreased
dramatically in the last part of 2008, as world growth declined.
The model of demand and supply also explains the determination of stock prices. The price per share ofcorporate stock reflects the market’s estimate of the expected profitability of the firm. Any information about
the firm that causes potential buyers or current owners of corporate stock to reevaluate how profitable they
think the firm is, or will be, will cause the equilibrium price of the stock to change.
We then examined markets in which some form of government price control keeps price permanently above or
below equilibrium. A price floor leads to persistent surpluses because it is set above the equilibrium price,whereas a price ceiling, because it is set below the equilibrium price, leads to persistent shortages. We saw thatinterfering with the market mechanism may solve one problem but often creates other problems at the sametime. We discussed what some of these unintended consequences might be. For example, agricultural pricefloors aimed at boosting farm income have also raised prices for consumers and cost taxpayers dearly, and thebulk of government payments have gone to large farms. Rent controls have lowered rents, but they have also
reduced the quantity of rental housing supplied, created shortages, and sometimes led to various forms of“backdoor” payments, which sometimes force the price of rental housing above what would exist in the absenceof controls.
Finally, we looked at the market for health care and a special feature behind demand and supply in this market
that helps to explain why the share of output of the United States that is devoted to health care has risen. Healthcare is an example of a market in which there are third-party payers (primarily private insurers and thegovernment). With third-party payers the quantity of health-care services consumed rises, as does health-carespending.

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CONCEPT PROBLEMS
1. Like personal computers, digital cameras have become a common
household item. Digital camera prices have plunged in the last 10 years.
Use the model of demand and supply to explain the fall in price andincrease in quantity.
2. Enron Corp. was one of several corporations convicted of fraud in its
accounting practices during the early part of this decade. It had createddummy corporations to hide massive borrowing and to give it theappearance of extraordinary profitability. Use the model of demand andsupply to explain the likely impact of such convictions on the stocks ofother corporations.
3. During World War II there was a freeze on wages, and corporations
found they could evade the freeze by providing other fringe benefits
such as retirement funds and health insurance for their employees. The
Office of Price Administration, which administered the wage freeze,
ruled that the offer of retirement funds and health literature was not a
violation of the freeze. The Internal Revenue Service went along withthis and ruled that employer-financed retirement and health insurance
plans were not taxable income. Was the wage freeze an example of aprice floor or a price ceiling? Use the model of demand and supply to
explain why employers began to offer such benefits to their employees.
4. The text argues that political instability in potential suppliers of oil suchas Iraq and Venezuela accounts for a relatively steep supply curve for
crude oil such as the one shown in Figure 4.2 "Increasing Demand for
Crude Oil". Suppose that this instability eases considerably and that theworld supply curve for crude oil becomes much flatter. Draw such a
curve, and explain its implications for the world economy and for
typical consumers.
5. Suppose that technological change affects the dairy industry in the sameway it has affected the computer industry. However, suppose that dairy
price supports remain in place. How would this affect government
spending on the dairy program? Use the model of demand and supply tosupport your answer.
6. People often argue that there is a “shortage” of child care. Using themodel of demand and supply, evaluate whether this argument is likely
to be correct.
7. “During most of the past 50 years the United States has had a surplus offarmers, and this has been the root of the farm problem.” Comment.
8. Suppose the Department of Agriculture ordered all farmers to reduce
the acreage they plant by 10%. Would you expect a 10% reduction infood production? Why or why not?

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9. The text argues that the increase in gasoline prices had a particularly
strong impact on low-income people. Name some other goods andservices for which a sharp increase in price would have a similar impact
on people with low incomes.
10. Suppose that the United States and the European Union impose a priceceiling on crude oil of $25 per barrel. Explain, and illustrate graphically,
how this would affect the markets for crude oil and for gasoline in the
United States and in the European Union.
11. Given that rent controls can actually hurt low-income people, devise ahousing strategy that would provide affordable housing for those whose
incomes fall below the poverty line (in 2010, this was about $22,314 for afamily of four).
12. Using the model of demand and supply, show and explain how anincrease in the share individuals must pay directly for medical careaffects the quantity they consume. Explain how this would address thetotal amount of spending on health care.
13. Given that people pay premiums for their health insurance, how can we
say that insurance lowers the prices people pay for health-care services?
14. Suppose that physicians now charge $30 for an office visit and insurance
policies require patients to pay 33 1/3% of the amount they pay thephysicians, so the out-of-pocket cost to consumers is $10 per visit. In aneffort to control costs, the government imposes a price ceiling of $27 per
office visit. Using a demand and supply model, show how this policy
would affect the market for health care.
15. Do you think the U.S. health-care system requires reform? Why or why
not? If you think reform is in order, explain the approach to reform you
advocate.

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Chapter 4 Applications of Demand and Supply

NUMERICAL PROBLEMS
Problems 1–4 are based on the following demand and supply schedules forcorn (all quantities are in millions of bushels per year).
Price per bushel Quantity demanded Quantity supplied
$0

6

0

1

5

1

2

4

2

3

3

3

4

2

4

5

1

5

6

0

6

1. Draw the demand and supply curves for corn. What is the equilibrium
price? The equilibrium quantity?
2. Suppose the government now imposes a price floor at $4 per bushel.
Show the effect of this program graphically. How large is the surplus ofcorn?
3. With the price floor, how much do farmers receive for their corn? Howmuch would they have received if there were no price floor?
4. If the government buys all the surplus wheat, how much will it spend?
Problems 5–9 are based on the following hypothetical demand and supply
curves for apartments

Number of Apts.

Number of Apts.

Demanded/Month

Supplied/Month$0120,000

0200

100,000

20,000400

80,00040,000600

60,00060,000800

40,00080,000Rent/Month

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Chapter 4 Applications of Demand and Supply

Number of Apts.

Number of Apts.

Demanded/Month

Supplied/Month1000

20,000100,000

1200

0

120,000

Rent/Month

1. Draw the demand and supply curves for apartments.
2. What is the equilibrium rent per month? At this rent, what is thenumber of apartments demanded and supplied per month?
3. Suppose a ceiling on rents is set at $400 per month. Characterize thesituation that results from this policy.
4. At the rent ceiling, how many apartments are demanded? How many aresupplied?
5. How much are people willing to pay for the number of apartments
supplied at the ceiling? Describe the arrangements to which thissituation might lead.

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Chapter 5
Macroeconomics: The Big Picture
Start Up: Economy Limps AlongThe U.S. economy seemed to be doing well overall after the recession of 2001.
Growth had been normal, unemployment had stayed low, and inflation seemed to
be under control. The economy began to unravel at the end of 2007—total output
fell in the fourth quarter and again in the first quarter of 2008. It
recovered—barely—in the second quarter. Then things went sour…very sour. The
economies of the United States and those of much of the world were rocked by theworst financial crisis in nearly 80 years.
A good deal of the U.S. economy’s momentum when things were going well had
been fueled by rising house prices. Between 1995 and 2007, housing prices in the
United States more than doubled. As house prices rose, consumers who ownedhouses felt wealthier and increased their consumption purchases. That helped fueleconomic growth. The boom in housing prices had been encouraged by policies of
the nation’s monetary authority, the Federal Reserve, which had shifted to an
expansionary monetary policy that held short-term interest rates below the
inflation rate. Another development, subprime mortgages—mortgage loans tobuyers whose credit or income would not ordinarily qualify for mortgage
loans—helped bring on the ultimate collapse. When they were first developed,
subprime mortgage loans seemed a hugely profitable investment for banks and agood deal for home buyers. Financial institutions developed a wide range of
instruments based on “mortgage-backed securities.” As long as house prices kept
rising, the system worked and was profitable for virtually all players in themortgage market. Many firms undertook investments in mortgage-backed
securities that assumed house prices would keep rising. Large investment banks bet
heavily that house prices would continue rising. Powerful members of Congresspressured two government-sponsored enterprises, Fannie Mae (the Federal
National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage
Corporation), to be even more aggressive in encouraging banks to make mortgage
loans to low-income families. The pressure came from the executive branch of
government as well—under both Democratic and Republican administrations. In
1996, the Department of Housing and Urban Development (under Bill Clinton, a
Democrat) required that 12% of mortgages purchased by Fannie Mae and Freddie
Mac be for households with incomes less than 60% of the median income in theirregion. That target was increased to 20% in 2000, 22% in 2005 (then under George

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W. Bush, a Republican), and was to have increased to 28% in 2008.Russell Roberts,“How Government Stoked the Mania,” Wall Street Journal, October 3, 2008, p. A21.
But that final target would not be reached, as both Fannie Mae and Freddie Mac
were seized by the government in 2008. To top things off, a loosening in bank andinvestment bank regulations gave financial institutions greater leeway in goingoverboard with purchases of mortgage-backed securities. As house prices beganfalling in 2007, a system based on the assumption they would continue rising began
to unravel very fast. The investment bank Bear Stearns and insurance company
American International Group (AIG) required massive infusions of federal money tokeep them afloat. In September of 2008, firm after firm with assets tied to
mortgage-backed securities began to fail. In some cases, the government rescued
them; in other cases, such as Lehman Brothers, they were allowed to fail.
The financial crisis had dramatic and immediate effects on the economy. The
economy’s total output fell at an annual rate of 3.7% in the third quarter of 2008
and 8.9% in the fourth quarter of 2008. Consumers, having weathered higher
gasoline prices and higher food prices for most of the year, reduced theirconsumption expenditures as the value of their houses and the stocks they held
plunged—consumption fell at an annual rate of 3.8% in the third quarter and 5.1%
in the fourth quarter. As cold fear gripped financial markets and expectations offurther slowdown ensued, firms cut down on investment spending, which includes
spending on plant and equipment used in production. While this nonresidential
investment component of output fell at an annual rate of 0.8%, the residential
component fell even faster as housing investment sank at an annual rate of 23.9%.
Government purchases and net exports rose, but not enough to offset reductions in
consumption and private investment. As output shrank, unemployment rose
sharply. Through the first nine months of 2008 there was concern that price levelsin the United States and in most of the world economies were rising rapidly, but
toward the end of the year the concern shifted to whether or not the price level
might fall.
This recession, which officially began in December 2007 and ended in June 2009, wasbrutal: At 18 months in length, it was the longest U.S. recession since World War II.
The nation’s output fell by more than 5%. The unemployment rate rose
dramatically, hitting 10% in October 2009 and remaining above 9% throughout 2010.
To many people in 2010 and 2011, it certainly did not feel as if the “GreatRecession,” as many had begun to refer to it, had really ended. The unemployment
rate had come down some but still remained elevated. Housing prices still seemed
to be falling or, at best, crawling along a floor. There was, though, a little good news
at the end of 2011: real GDP had increased at an annual rate of 3.0% in the fourth
quarter, the largest quarterly increase that year. For the entire year, however, real
GDP had risen by just 1.7%.

183Chapter 5 Macroeconomics: The Big Picture

Even the relatively good news in the fourth quarter came with a sour note: most of
the increase in GDP had come as firms had increased their inventories, andeconomists warned that growth was likely to slow in 2012 as firms began cuttingback on those expanded inventories. Sure enough, real GDP increased at an annual
rate of just 1.9% in the first quarter of 2012, according to the Commerce
Department.
An important question, of course, is why the recovery has been so slow. Since therecovery began in June 2009, this has been the slowest recovery since World War II.
Several factors have contributed to the slow pace of expansion.
First, the financial crisis that developed in 2008, as mentioned, was particularly
severe. Financial crises shake confidence and limit investment. Uncertainty was
also created by increased government regulation of economic activity and by thepossibility of increased taxes.
Furthermore, the impact of massive government debts—propelled by government
deficits going into the recession, the fall in revenue due to the recession, andmassive government stimulus programs in response to the recession—added to a
general uncertainty about what future policies might be required. Domestic
political battles may have contributed to this uncertainty as well. External factors,
such as economic crises in Europe and the rising price of oil, also threatened theeconomy.
Output, employment, and the price level are the key variables in the study ofmacroeconomics, which is the analysis of aggregate values of economic variables.
What determines a country’s output, and why does output in some economies
expand while in others it contracts? Why do some economies grow faster thanothers? What causes prices throughout an economy to fluctuate, and how do such
fluctuations affect people? What causes employment and unemployment? Why doesa country’s unemployment rate fluctuate? Why do different countries havedifferent unemployment rates?
We would pronounce an economy “healthy” if its annual output of goods andservices were growing at a rate it can sustain, its price level stable, and its
unemployment rate low. What would constitute “good” numbers for each of thesevariables depends on time and place, but those are the outcomes that most people
would agree are desirable for the aggregate economy. When the economy deviatesfrom what is considered good performance, there are often calls for thegovernment to “do something” to improve performance. How government policies
affect economic performance is a major topic of macroeconomics. When thefinancial and economic crises struck throughout the world in 2008, there was184

Chapter 5 Macroeconomics: The Big Picture

massive intervention from world central banks and from governments throughout
the world in an effort to stimulate their economies.
This chapter provides a preliminary sketch of the most important macroeconomic
issues: growth of total output and the business cycle, changes in the price level, andunemployment. Grappling with these issues will be important to you not only inyour exploration of macroeconomics but throughout your life.

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5.1 Growth of Real GDP and Business Cycles
LEARNING OBJECTIVES
1. Define real gross domestic product and explain how its calculation
avoids both double-counting and the effects of changes in the pricelevel.
2. Identify the phases of a business cycle.
3. Relate business cycles to the overall long-run trend in real GDP in the
United States.

To determine whether the economy of a nation is growing or shrinking in size,
economists use a measure of total output called real GDP. Real GDP1, short for real
gross domestic product, is the total value of all final goods and services produced
during a particular year or period, adjusted to eliminate the effects of changes inprices. Let us break that definition up into parts.
Notice that only “final” goods and services are included in GDP. Many goods andservices are purchased for use as inputs in producing something else. For example,
a pizza parlor buys flour to make pizzas. If we counted the value of the flour and thevalue of the pizza, we would end up counting the flour twice and thus overstating
the value of total production. Including only final goods avoids double-counting. If
the flour is produced during a particular period but has not been sold, then it is a“final good” for that period and is counted.

1. The total value of all final
goods and services produced
during a particular year or
period, adjusted to eliminate
the effects of changes in prices.
2. The total value of final goods
and services for a particularperiod valued in terms ofprices for that period.

We want to determine whether the economy’s output is growing or shrinking. If
each final good or service produced, from hammers to haircuts, were valued at its
current market price, and then we were to add the values of all such items
produced, we would not know if the total had changed because output changed or
because prices changed or both. The market value of all final goods and services
produced can rise even if total output falls. To isolate the behavior of total output
only, we must hold prices constant at some level. For example, if we measure thevalue of basketball output over time using a fixed price for valuing the basketballs,
then only an increase in the number of basketballs produced could increase thevalue of the contribution made by basketballs to total output. By making such an
adjustment for basketballs and all other goods and services, we obtain a value forreal GDP. In contrast, nominal GDP2, usually just referred to as gross domestic
product (GDP), is the total value of final goods and services for a particular period
valued in terms of prices for that period. For example, real GDP fell in the third186

Chapter 5 Macroeconomics: The Big Picture

quarter of 2008. But, because the price level in the United States was rising, nominal
GDP rose 3.6%.
We will save a detailed discussion of the computation of GDP for another chapter. In
this section, our goal is to use the concept of real GDP to look at the businesscycle3—the economy’s pattern of expansion, then contraction, then expansion
again—and at growth of real GDP.

Phases of the Business Cycle
Figure 5.1 "Phases of the Business Cycle" shows a stylized picture of a typicalbusiness cycle. It shows that economies go through periods of increasing anddecreasing real GDP, but that over time they generally move in the direction ofincreasing levels of real GDP. A sustained period in which real GDP is rising is an
expansion4; a sustained period in which real GDP is falling is a recession5.
Typically, an economy is said to be in a recession when real GDP drops for two
consecutive quarters, but in the United States, the responsibility of defining
precisely when the economy is in recession is left to the Business Cycle Dating
Committee of the National Bureau of Economic Research (NBER). The committee
defines a recession as a “significant decline in economic activity spread across the
economy, lasting more than a few months, normally visible in real GDP, real
income, employment, industrial production, and wholesale-retail sales.”“TheNBER’s Recession Dating Procedure,” National Bureau of Economic Research,
January 7, 2008.

3. The economy’s pattern of
expansion, then contraction,then expansion again.
4. A sustained period in whichreal GDP is rising.
5. A sustained period in whichreal GDP is falling.
6. The point of the business cycle
at which an expansion ends
and a recession begins.
7. The point of the business cycle
at which a recession ends andan expansion begins.

At time t1 in Figure 5.1 "Phases of the Business Cycle",an expansion ends and real GDP turns downward. The
Figure 5.1 Phases of thepoint at which an expansion ends and a recession begins Business Cycle
is called the peak6 of the business cycle. Real GDP thenfalls during a period of recession. Eventually it starts
upward again (at time t2). The point at which arecession ends and an expansion begins is called thetrough7 of the business cycle. The expansion continues
until another peak is reached at time t3.Someeconomists prefer to break the expansion phase into
two parts. The recovery phase is said to be the period
between the previous trough and the time when the
The business cycle is a series of
economy achieves its previous peak level of real GDP.
expansions and contractions in
The “expansion” phase is from that point until thereal GDP. The cycle begins at afollowing peak. A complete business cycle is defined by
the passage from one peak to the next.

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Chapter 5 Macroeconomics: The Big Picture

Because the Business Cycle Dating Committee dates
peaks and troughs by specific months, and because real peak and continues through a
GDP is estimated only on a quarterly basis by the Bureau recession, a trough, and anof Economic Analysis, the committee relies on a variety expansion. A new cycle begins at
the next peak. Here, the firstof other indicators that are published monthly,
peak occurs at time t1, the troughincluding real personal income, employment, industrial at time t2, and the next peak at
production, and real wholesale and retail sales. The
time t3. Notice that there is acommittee typically determines that a recession has
tendency for real GDP to rise overtime.
happened long after it has actually begun andsometimes ended! In large part, that avoids problems
when data released about the economy are revised, andthe committee avoids having to reverse itself on its
determination of when a recession begins or ends, something it has never done. In
December 2008, the committee announced that a recession in the United States had
begun in December 2007. In September 2010, the committee announced that thisrecession had ended in June 2009.

Business Cycles and the Growth of Real GDP in the United States
Figure 5.2 "Expansions and Recessions, 1960–2011" shows movements in real GDP in
the United States from 1960 to 2011. Over those years, the economy experienced
eight recessions, shown by the shaded areas in the chart. Although periods ofexpansion have been more prolonged than periods of recession, we see the cycle ofeconomic activity that characterizes economic life.
Figure 5.2 Expansions and Recessions, 1960–2011

The chart shows movements in real GDP since 1960. Recessions—periods of falling real GDP—are shown as shaded
areas. On average, the annual rate of growth of real GDP over the period was 3.1% per year.

5.1 Growth of Real GDP and Business Cycles

188Chapter 5 Macroeconomics: The Big Picture

Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised February 29, 2012). Real Gross Domestic Product,
Chained Dollars [Billions of chained (2005) dollars]. Seasonally adjusted at annual rates.

Real GDP clearly grew between 1960 and 2011. While the economy experienced
expansions and recessions, its general trend during the period was one of rising realGDP. The average annual rate of growth of real GDP was about 3.1%.
During the post–World War II period, the average expansion has lasted 58 months,
and the average recession has lasted about 11 months. The 2001 recession, whichlasted eight months, was thus slightly shorter than the average. The 2007–2009
recession lasted 18 months; it was the longest of the post–World War II period.
Economists have sought for centuries to explain the forces at work in a businesscycle. Not only are the currents that move the economy up or down intellectuallyfascinating but also an understanding of them is of tremendous practicalimportance. A business cycle is not just a movement along a curve in a textbook. It
is new jobs for people, or the loss of them. It is new income, or the loss of it. It is thefunds to build new schools or to provide better health care—or the lack of funds to
do all those things. The story of the business cycle is the story of progress andplenty, of failure and sacrifice.
During the most recent recession, the job outlook for college graduates
deteriorated. According to a National Association of Colleges and Employers study,
20% of college graduates seeking jobs were able to obtain one after graduation in2009. In 2010, that percentage rose to 24%, but the average salary had slipped 1.7%
from the previous year. The unemployment rate for college graduates under age 25
rose from 3.7% in April 2007 to 8% in April 2010. Over the same two-year period, theunemployment rate for high school graduates who had never enrolled in college
rose from 11.4% to 24.5%.Steven Greenhouse, “Job Market Gets Better for U.S.
Graduates, but Only Slightly: Offers Will Increase 5% Over Last Year; AverageStarting Salaries Are Down,” The International Herald Tribune, May 26, 2010, Finance16.
The effects of recessions extend beyond the purely economic realm and influence
the social fabric of society as well. Suicide rates and property crimes—burglary,larceny, and motor vehicle theft tend to rise during recessions. Even popular music
appears to be affected. Terry F. Pettijohn II, a psychologist at Coastal Carolina
University, has studied Billboard No. 1 songs from 1955 to 2003. He finds that during
recessions, popular songs tend to be longer and slower, and to have more serious
lyrics. “It’s ‘Bridge over Troubled Water’ or ‘That’s What Friends Are For’,” he says.
During expansions, songs tend to be faster, shorter, and somewhat sillier, such as

5.1 Growth of Real GDP and Business Cycles

189Chapter 5 Macroeconomics: The Big Picture“At the Hop” or “My Sharona.”Tamar Lewin, “A Hemline Index, Updated,” New YorkTimes, October 19, 2008, Section WK, 1.
In our study of macroeconomics, we will gain an understanding of the forces atwork in the business cycle. We will also explore policies through which the public
sector might act to make recessions less severe and, perhaps, to prolong
expansions. We turn next to an examination of price-level changes andunemployment.

KEY TAKEAWAYS• Real gross domestic product (real GDP) is a measure of the value of all
final goods and services produced during a particular year or period,
adjusted to eliminate the effects of price changes.
• The economy follows a path of expansion, then contraction, then
expansion again. These fluctuations make up the business cycle.
• The point at which an expansion becomes a recession is called the peakof a business cycle; the point at which a recession becomes an expansion
is called the trough.
• Over time, the general trend for most economies is one of rising realGDP. On average, real GDP in the United States has grown at a rate ofover 3% per year since 1960.

5.1 Growth of Real GDP and Business Cycles

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Chapter 5 Macroeconomics: The Big Picture

TRY IT!
The data below show the behavior of real GDP in Turkey from the firstquarter of 2001 through the third quarter of 2002. Use the data to plot real
GDP in Turkey and indicate the phases of the business cycle.
PeriodReal GDP (billions of New Turkish lira, 1987
prices)First quarter, 2001

24.1

Second quarter,
2001

26.0

Third quarter, 2001

33.1

Fourth quarter, 2001

27.1

First quarter, 2002

24.6

Second quarter,
2002

28.3

Third quarter, 2002

35.7

5.1 Growth of Real GDP and Business Cycles

191Chapter 5 Macroeconomics: The Big Picture

Case in Point: The Art of Predicting Recessions

People who make a living tracking the economy and trying to predict its future
do not do a very good job at predicting turning points in economic activity. The
52 economists surveyed by the Wall Street Journal each month did predict thatthe economy would slip into a recession in the third quarter of 2008. They madethat prediction, however, in October—after the third quarter had ended. In
September, the last month of the third quarter, the average forecast among the
52 economists had the economy continuing to grow through the third andfourth quarters of 2008. That September survey was taken before the financial
crisis hit, a crisis that took virtually everyone by surprise. Of course, as we havealready noted, the third-quarter downturn had not been identified as arecession by the NBER’s Business Cycle Dating Committee as of November of2008.
Predicting business cycle turning points has always been a tricky business. The
experience of the recession of 2001 illustrates this. As the accompanying tableshows, even as late as September 10, 2001, only 13 out of the 100 Blue Chip
forecasters had answered in the affirmative to the question, “Has the UnitedStates slipped into a recession?” even though we now know the recession had
begun the previous March. Comparing the data that were originally released by
the U.S. Bureau of Economic Analysis shortly after the end of each quarter withthe revised data that were released after July 2002 provides an important
insight into explaining why the forecasters seem to have done so badly. As thegraph on pre-revision and post-revision estimates of real GDP growth shows,the data released shortly after the end of each quarter showed an economy

5.1 Growth of Real GDP and Business Cycles

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Chapter 5 Macroeconomics: The Big Picture

expanding through the second quarter of 2001, whereas the revised data show
the economy contracting modestly in the first quarter of 2001 and then moreforcefully in the second quarter. Only after the attacks on the World Trade
Center in New York City and the Pentagon in Washington, D.C., on September
11, 2001, did most of the Blue Chip forecasters realize the economy was inrecession.
The National Bureau of Economic Research (NBER) Business Cycle Dating
Committee in November 2001 released a press announcement dating the onsetof the recession as March 2001. The committee argued that “before the attacks
of September 11, it is possible that the decline in the economy would have been
too mild to qualify as a recession. The attacks clearly deepened the contraction
and may have been an important factor in turning the episode into a
recession.” While surprising at the time, the revised data suggest that thecommittee made a good call.
This episode in economic history also points out the difference between thecommon definition of a recession as two consecutive quarters of declining real
GDP and the NBER Dating Committee’s continued insistence that it does notdefine a recession in this way. Rather the committee looks not only at real GDP
but also at employment, income, and other factors. The behavior of
employment during 2001 seems to have been an important factor in theNovember 2001 decision to proclaim March 2001 as the peak despite themisleading information on real GDP coming out of the Bureau of Economic
Analysis at the time. The slow pickup in employment may also, though, havemade it hesitate to call November 2001 the trough until July 2003.
Question posed: “Has the United States slipped into a recession?”
Date

Percent of Blue Chip
responders answering“Yes”

Percent of Blue Chip
responders answering“No”

February
2001

5

95

June 2001

7

93

July 2001

13

87

August2001

585

5.1 Growth of Real GDP and Business Cycles

193Chapter 5 Macroeconomics: The Big Picture

Question posed: “Has the United States slipped into a recession?”
Date

Percent of Blue Chip
responders answering“Yes”

Percent of Blue Chip
responders answering“No”

September
10, 2001

13

87

September
19, 2001

82

18

Sources: Phil Izzo, “Economists Expect Crisis to Deepen,” Wall Street Journal
Online, October 10, 2008; Kevin L. Kliesen, “The 2001 Recession: How Was It
Different and What Developments May Have Caused It?” Federal Reserve Bank of
St. Louis Review, September/October 2003: 23–37; http://www.nber.org/cycles/;“Press Release,” Business Cycle Dating Committee, National Bureau of Economic
Research, press release, Cambridge, Massachusetts, July 17, 2002.

5.1 Growth of Real GDP and Business Cycles

194Chapter 5 Macroeconomics: The Big Picture

ANSWER TO TRY IT! PROBLEM

5.1 Growth of Real GDP and Business Cycles

195Chapter 5 Macroeconomics: The Big Picture

5.2 Price-Level Changes
LEARNING OBJECTIVES
1. Define inflation and deflation, explain how their rates are determined,
and articulate why price-level changes matter.
2. Explain what a price index is and outline the general steps in computing
a price index.
3. Describe and compare different price indexes.
4. Explain how to convert nominal values to real values and explain why it
is useful to make this calculation.
5. Discuss the biases that may arise from price indexes that employ fixedmarket baskets of goods and services.

Concern about changes in the price level has always dominated economic
discussion. With inflation in the United States generally averaging only between 2%
and 3% each year since 1990, it may seem surprising how much attention the
behavior of the price level still commands. Yet inflation was a concern in 2004 when
there was fear that the rising price of oil could trigger higher prices in other areas.
Just the year before, when inflation fell below 2%, there was talk about the risk of
deflation. That did not happen; prices continued rising. Inflation rose substantiallyin the first half of 2008, renewing fears about subsequent further increases. And2010 brought renewed concern of possible deflation. Just what are inflation anddeflation? How are they measured? And most important, why do we care? These aresome of the questions we will explore in this section.
Inflation8 is an increase in the average level of prices, and deflation9 is a decreasein the average level of prices. In an economy experiencing inflation, most prices arelikely to be rising, whereas in an economy experiencing deflation, most prices arelikely to be falling.
There are two key points in these definitions:

8. An increase in the averagelevel of prices.
9. A decrease in the average levelof prices.

1. Inflation and deflation refer to changes in the average level of prices,not to changes in particular prices. An increase in medical costs is not
inflation. A decrease in gasoline prices is not deflation. Inflation means
the average level of prices is rising, and deflation means the averagelevel of prices is falling.

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Chapter 5 Macroeconomics: The Big Picture

2. Inflation and deflation refer to rising prices and falling prices,
respectively; therefore, they do not have anything to do with the levelof prices at any one time. “High” prices do not imply the presence of
inflation, nor do “low” prices imply deflation. Inflation means a
positive rate of change in average prices, and deflation means a negative
rate of change in average prices.

Why Do We Care?
What difference does it make if the average level of prices changes? First, consider
the impact of inflation.
Inflation is measured as the annual rate of increase in the average level of prices.
Figure 5.3 "Inflation, 1960–2011" shows how volatile inflation has been in the
United States over the past four decades. In the 1960s the inflation rate rose, and it
became dramatically worse in the 1970s. The inflation rate plunged in the 1980s andcontinued to ease downward in the 1990s. It remained low in the early 2000s, began
to accelerate in 2007, and has remained low since then.
Figure 5.3 Inflation, 1960–2011

The U.S. inflation rate, measured as the annual rate of change in the average level of prices paid by consumers,
varied considerably over the 1960–2011 period.
Source: Bureau of Labor Statistics, All Urban Consumers CPI-U, 1982–84 = 100, Dec.–Dec. inflation rate.

5.2 Price-Level Changes

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Chapter 5 Macroeconomics: The Big Picture

Whether one regards inflation as a “good” thing or a “bad” thing depends verymuch on one’s economic situation. If you are a borrower, unexpected inflation is agood thing—it reduces the value of money that you must repay. If you are a lender,
it is a bad thing because it reduces the value of future payments you will receive.
Whatever any particular person’s situation may be, inflation always produces thefollowing effects on the economy: it reduces the value of money and it reduces thevalue of future monetary obligations. It can also create uncertainty about the
future.
Suppose that you have just found a $10 bill you stashed away in 1990. Prices haveincreased by about 50% since then; your money will buy less than what it would
have purchased when you put it away. Your money has thus lost value.
Money loses value when its purchasing power falls. Since inflation is a rise in thelevel of prices, the amount of goods and services a given amount of money can buy
falls with inflation.
Just as inflation reduces the value of money, it reduces the value of future claims on
money. Suppose you have borrowed $100 from a friend and have agreed to pay itback in one year. During the year, however, prices double. That means that when
you pay the money back, it will buy only half as much as it could have bought when
you borrowed it. That is good for you but tough on the person who lent you themoney. Of course, if you and your friend had anticipated such rapid inflation, you
might have agreed to pay back a larger sum to adjust for it. When people anticipate
inflation, they can adjust for its consequences in determining future obligations.
But unanticipated inflation helps borrowers and hurts lenders.
Inflation’s impact on future claims can be particularly hard on people who must live
on a fixed income, that is, on an income that is predetermined through some
contractual arrangement and does not change with economic conditions. An
annuity, for example, typically provides a fixed stream of money payments.
Retirement pensions sometimes generate fixed income. Inflation erodes the valueof such payments.
Given the danger posed by inflation for people on fixed incomes, many retirement
plans provide for indexed payments. An indexed payment is one whose dollar
amount changes with the rate of change in the price level. If a payment changes atthe same rate as the rate of change in the price level, the purchasing power of thepayment remains constant. Social Security payments, for example, are indexed tomaintain their purchasing power.

5.2 Price-Level Changes

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Chapter 5 Macroeconomics: The Big Picture

Because inflation reduces the purchasing power of money, the threat of future
inflation can make people reluctant to lend for long periods. From a lender’s pointof view, the danger of a long-term commitment of funds is that future inflation will
wipe out the value of the amount that will eventually be paid back. Lenders are
reluctant to make such commitments.
Uncertainty can be particularly pronounced in countries where extremely highinflation is a threat. Hyperinflation10 is generally defined as an inflation rate inexcess of 200% per year. It is always caused by the rapid printing of money. Several
countries have endured episodes of hyperinflation. The worst case was in Hungary
immediately after World War II, when Hungary’s price level was tripling every day.
The second-worst case of hyperinflation belongs to Zimbabwe, which is the first
country to have experienced hyperinflation in the 21st century. Zimbabwe’s priceindex was doubling daily: a loaf of bread that cost 200,000 Zimbabwe dollars in
February 2008 cost 1.6 trillion Zimbabwe dollars by August.“Zimbabwe Inflation
Hits 11,200,000%,” CNN.com, August 19, 2008, available at http://edition.cnn.com/
2008/BUSINESS/08/19/zimbabwe.inflation/index.html. The annual inflation rate
reached 89.7 sextillion percent in November of that year.Steve H. Hanke, “R.I.P.
Zimbabwe Dollar,” Cato Institute, May 3, 2010, available at http://www.cato.org/
zimbabwe. (On the off chance you haven’t been counting in the sextillions a lot
lately, 89.7 sextillion equates to 897 followed by 20 zeroes.) Two months later,
Zimbabwe finally gave up on printing money and took the Zimbabwe dollar out ofcirculation. Exchange is now carried out using U.S. dollars or South African
rand—and Zimbabwe’s period of hyperinflation has come to an end.
Do the problems associated with inflation imply that deflation would be a goodthing? The answer is simple: no. Like inflation, deflation changes the value ofmoney and the value of future obligations. It also creates uncertainty about the
future.
If there is deflation, the real value of a given amount of money rises. In other words,
if there had been deflation since 2000, a $10 bill you had stashed away in 2000 would
buy more goods and services today. That sounds good, but should you buy $10
worth of goods and services now when you would be able to buy even more for your
$10 in the future if the deflation continues? When Japan experienced deflation in
the late 1990s and early 2000s, Japanese consumers seemed to be doing justthat—waiting to see if prices would fall further. They were spending less per person
and, as we will see throughout our study of macroeconomics, less consumption
often meant less output, fewer jobs, and the prospect of a recurring recession.

10. An inflation rate in excess of
200% per year.

5.2 Price-Level Changes

And, if you had to use the $10 to pay back a debt you owed, the purchasing power ofyour money would be higher than when you borrowed the money. The lender

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Chapter 5 Macroeconomics: The Big Picture

would feel good about being able to buy more with the $10 than you were able to,but you would feel like you had gotten a raw deal.
Unanticipated deflation hurts borrowers and helps lenders. If the parties anticipate
the deflation, a loan agreement can be written to reflect expected changes in theprice level.
The threat of deflation can make people reluctant to borrow for long periods.
Borrowers become reluctant to enter into long-term contracts because they fearthat deflation will raise the value of the money they must pay back in the future. In
such an environment, firms may be reluctant to borrow to build new factories, forexample. This is because they fear that the prices at which they can sell their output
will drop, making it difficult for them to repay their loans.
Deflation was common in the United States in the latter third of the 19th century.
In the 20th century, there was a period of deflation after World War I and again
during the Great Depression in the 1930s.

Price Indexes
How do we actually measure inflation and deflation (that is, changes in the pricelevel)? Price-level change is measured as the percentage rate of change in the levelof prices. But how do we find a price level?
Economists measure the price level with a price index. A price index11 is a number
whose movement reflects movement in the average level of prices. If a price index
rises 10%, it means the average level of prices has risen 10%.
There are four steps one must take in computing a price index:

11. A number whose movement
reflects movement in the
average level of prices.
12. A time period against whichcosts of the market basket inother periods will be comparedin computing a price index.

5.2 Price-Level Changes

1. Select the kinds and quantities of goods and services to be included in
the index. A list of these goods and services, and the quantities of each,is the “market basket” for the index.
2. Determine what it would cost to buy the goods and services in themarket basket in some period that is the base period for the index. Abase period12 is a time period against which costs of the market basket
in other periods will be compared in computing a price index. Mostoften, the base period for an index is a single year. If, for example, aprice index had a base period of 1990, costs of the basket in otherperiods would be compared to the cost of the basket in 1990. We will200

Chapter 5 Macroeconomics: The Big Picture

encounter one index, however, whose base period stretches over three
years.
3. Compute the cost of the market basket in the current period.
4. Compute the price index. It equals the current cost divided by thebase-period cost of the market basket.
Equation 5.1

Price index = current cost of basket/base-period cost of basket(While published price indexes are typically reported with this number multipliedby 100, our work with indexes will be simplified by omitting this step.)
Suppose that we want to compute a price index for movie fans, and a survey ofmovie watchers tells us that a typical fan rents 4 movies on DVD and sees 3 movies
in theaters each month. At the theater, this viewer consumes a medium-sized softdrink and a medium-sized box of popcorn. Our market basket thus might include 4
DVD rentals, 3 movie admissions, 3 medium soft drinks, and 3 medium servings of
popcorn.
Our next step in computing the movie price index is to determine the cost of themarket basket. Suppose we surveyed movie theaters and DVD-rental stores in 2011
to determine the average prices of these items, finding the values given in Table 5.1"Pricing a Market Basket". At those prices, the total monthly cost of our movie
market basket in 2011 was $48. Now suppose that in 2012 the prices of movie
admissions and DVD rentals rise, soft-drink prices at movies fall, and popcorn
prices remain unchanged. The combined effect of these changes pushes the 2012
cost of the basket to $50.88.
Table 5.1 Pricing a Market Basket
Quantity in
Basket2011
Price

Cost in 2011
Basket2012
Price

Cost in 2012
Basket

DVD rental

4

$2.25

$9.00

$2.97

$11.88Movie
admission

3

7.75

23.25

8.00

24.00

Popcorn

3

2.25

6.75

2.25

6.75

Soft drink

3

3.00

9.00

2.75

8.25

Item

5.2 Price-Level Changes

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Chapter 5 Macroeconomics: The Big Picture

Item
Total cost ofbasketQuantity in
Basket2011
Price

Cost in 2011
Basket2012
Price

Cost in 2012
Basket2011$48.002012$50.88To compute a price index, we need to define a market basket and determine its
price. The table gives the composition of the movie market basket and prices for2011 and 2012. The cost of the entire basket rises from $48 in 2011 to $50.88 in 2012.
Using the data in Table 5.1 "Pricing a Market Basket", we could compute priceindexes for each year. Recall that a price index is the ratio of the current cost of thebasket to the base-period cost. We can select any year we wish as the base year; take2011. The 2012 movie price index (MPI) is thus

MPI 2012 = $50.88/$48 = 1.06
The value of any price index in the base period is always 1. In the case of our movie
price index, the 2011 index would be the current (2011) cost of the basket, $48,
divided by the base-period cost, which is the same thing: $48/$48 = 1.

The Consumer Price Index (CPI)
One widely used price index in the United States is the consumer price index(CPI)13, a price index whose movement reflects changes in the prices of goods andservices typically purchased by consumers. When the media report the U.S.
inflation rate, the number cited is usually a rate computed using the CPI. The CPI is
also used to determine whether people’s incomes are keeping up with the costs ofthe things they buy. The CPI is often used to measure changes in the cost of living,
though as we shall see, there are problems in using it for this purpose.
The market basket for the CPI contains thousands of goods and services. The
composition of the basket is determined by the Bureau of Labor Statistics (BLS), an
agency of the Department of Labor, based on Census Bureau surveys of householdbuying behavior. Surveyors tally the prices of the goods and services in the basket
each month in cities all over the United States to determine the current cost of thebasket. The major categories of items in the CPI are food and beverages, housing,apparel, transportation, medical care, recreation, education and communication,and other goods and services.
13. A price index whose movement
reflects changes in the pricesof goods and services typicallypurchased by consumers.

5.2 Price-Level Changes

The current cost of the basket of consumer goods and services is then compared tothe base-period cost of that same basket. The base period for the CPI is 1982–1984;202

Chapter 5 Macroeconomics: The Big Picture

the base-period cost of the basket is its average cost over this period. Each month’s
CPI thus reflects the ratio of the current cost of the basket divided by its baseperiod cost.
Equation 5.2

CPI = current cost of basket/1982–1984 cost of basket
Like many other price indexes, the CPI is computed with a fixed market basket. The
composition of the basket generally remains unchanged from one period to thenext. Because buying patterns change, however, the basket is revised accordingly
on a periodic basis. The base period, though, was still 1982–1984.

The Implicit Price Deflator
Values for nominal and real GDP, described earlier in this chapter, provide us with
the information to calculate the most broad-based price index available. The
implicit price deflator14, a price index for all final goods and services produced, isthe ratio of nominal GDP to real GDP.
In computing the implicit price deflator for a particular period, economists define
the market basket quite simply: it includes all the final goods and services produced
during that period. The nominal GDP gives the current cost of that basket; the real
GDP adjusts the nominal GDP for changes in prices. The implicit price deflator isthus given by
Equation 5.3

Implicit price deflator = nominal GDP/real GDP
For example, in 2011, nominal GDP in the United States was $15,094.5 billion, andreal GDP was $13,315.3 billion. Thus, the implicit price deflator was 1.134. Following
the convention of multiplying price indexes by 100, the published number for the
implicit price deflator was 113.4.
In our analysis of the determination of output and the price level in subsequent
chapters, we will use the implicit price deflator as the measure of the price level inthe economy.
14. A price index for all final goods
and services produced; it is theratio of nominal GDP to realGDP.

5.2 Price-Level Changes

203Chapter 5 Macroeconomics: The Big Picture

The PCE Price Index
The Bureau of Economic Analysis also produces price index information for each of
the components of GDP (that is, a separate price index for consumer prices, prices
for different components of gross private domestic investment, and government
spending). The personal consumption expenditures price index15, or PCE priceindex, includes durable goods, nondurable goods, and services and is provided
along with estimates for prices of each component of consumption spending.
Because prices for food and energy can be volatile, the price measure that excludes
food and energy is often used as a measure of underlying, or “core,” inflation. Notethat the PCE price index differs substantially from the consumer price index,
primarily because it is not a “fixed basket” index.For a comparison of pricemeasures, including a comparison of the PCE price index and the Consumer Price
Index, see Brian C. Moyer, “Comparing Price Measures—The CPI and PCE Price
Index” (lecture, National Association for Business Economics, 2006 Washington
Economic Policy Conference, March 13–14, 2006), available at http://www.bea.gov/
papers/pdf/Moyer_NABE.pdf. The PCE price index has become a politicallyimportant measure of inflation since the Federal Reserve (discussed in detail inlater chapters) uses it as its primary measure of price levels in the United States.

Computing the Rate of Inflation or Deflation
The rate of inflation or deflation is the percentage rate of change in a price index
between two periods. Given price-index values for two periods, we can calculate therate of inflation or deflation as the change in the index divided by the initial valueof the index, stated as a percentage:
Equation 5.4

Rate of inflation or deflation = percentage change in index/initial value of
To calculate inflation in movie prices over the 2011–2012 period, for example, we
could apply Equation 5.4 to the price indexes we computed for those two years as
follows:

Movie inflation rate in 2012 = (1.06 − 1.00) /1.00 = 0.06 = 6%

15. A price index that includes
durable goods, nondurable
goods, and services and isprovided along with estimatesfor prices of each componentof consumption spending.

5.2 Price-Level Changes

The CPI is often used for calculating price-level change for the economy. For
example, the rate of inflation in 2011 can be computed from the December 2010
price level (2.186) and the December 2011 level (2.263):

Inflation rate = (2.263 − 2.186) /2.186 = 0.035 = 3.5%

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Chapter 5 Macroeconomics: The Big Picture

Computing Real Values Using Price Indexes
Suppose your uncle started college in 2001 and had a job busing dishes that paid $5
per hour. In 2011 you had the same job; it paid $6 per hour. Which job paid more?
At first glance, the answer is straightforward: $6 is a higher wage than $5. But $1
had greater purchasing power in 2001 than in 2011 because prices were lower in2001 than in 2011. To obtain a valid comparison of the two wages, we must use
dollars of equivalent purchasing power. A value expressed in units of constantpurchasing power is a real value16. A value expressed in dollars of the current
period is called a nominal value17. The $5 wage in 2001 and the $6 wage in 2011 arenominal wages.
To convert nominal values to real values, we divide by a price index. The real value
for a given period is the nominal value for that period divided by the price index forthat period. This procedure gives us a value in dollars that have the purchasing
power of the base period for the price index used. Using the CPI, for example, yields
values expressed in dollars of 1982–1984 purchasing power, the base period for the
CPI. The real value of a nominal amount X at time t, Xt, is found using the priceindex for time t:
Equation 5.5

Real value of X t = X t /price index at timet
Let us compute the real value of the $6 wage for busing dishes in 2011 versus the $5
wage paid to your uncle in 2001. The CPI in 2001 was 177.1; in 2011 it was 224.9. Realwages for the two years were thus

Real wage in 2001 = $5/1.771 = $2.82
Real wage in 2011 = $6/2.249 = $2.67
Given the nominal wages in our example, you earned about 5% less in real terms in2011 than your uncle did in 2001.

16. A value expressed in units ofconstant purchasing power.
17. A value expressed in dollars of
the current period.

5.2 Price-Level Changes

Price indexes are useful. They allow us to see how the general level of prices haschanged. They allow us to estimate the rate of change in prices, which we report as
the rate of inflation or deflation. And they give us a tool for converting nominal
values to real values so we can make better comparisons of economic performanceacross time.

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Are Price Indexes Accurate Measures of Price-Level Changes?
Price indexes that employ fixed market baskets are likely to overstate inflation (andunderstate deflation) for four reasons:
1. Because the components of the market basket are fixed, the index does
not incorporate consumer responses to changing relative prices.
2. A fixed basket excludes new goods and services.
3. Quality changes may not be completely accounted for in computing
price-level changes.
4. The type of store in which consumers choose to shop can affect theprices they pay, and the price indexes do not reflect changes
consumers have made in where they shop.
To see how these factors can lead to inaccurate measures of price-level changes,
suppose the price of chicken rises and the price of beef falls. The law of demandtells us that people will respond by consuming less chicken and more beef. But if we
use a fixed market basket of goods and services in computing a price index, we will
not be able to make these adjustments. The market basket holds constant thequantities of chicken and beef consumed. The importance in consumer budgets of
the higher chicken price is thus overstated, while the importance of the lower beef
price is understated. More generally, a fixed market basket will overstate theimportance of items that rise in price and understate the importance of items thatfall in price. This source of bias is referred to as the substitution bias.
The new-product bias, a second source of bias in price indexes, occurs because it
takes time for new products to be incorporated into the market basket that makes
up the CPI. A good introduced to the market after the basket has been defined will
not, of course, be included in it. But a new good, once successfully introduced, islikely to fall in price. When VCRs were first introduced, for example, they generally
cost more than $1,000. Within a few years, an equivalent machine cost less than$200. But when VCRs were introduced, the CPI was based on a market basket that
had been defined in the early 1970s. There was no VCR in the basket, so the impactof this falling price was not reflected in the index. The DVD player was introduced
into the CPI within a year of its availability.
A third price index bias, the quality-change bias, comes from improvements in thequality of goods and services. Suppose, for example, that Ford introduces a new carwith better safety features and a smoother ride than its previous model. Suppose
the old model cost $20,000 and the new model costs $24,000, a 20% increase in price.
Should economists at the Bureau of Labor Statistics (BLS) simply record the newmodel as being 20% more expensive than the old one? Clearly, the new model is not

5.2 Price-Level Changes

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the same product as the old model. BLS economists faced with such changes try toadjust for quality. To the extent that such adjustments understate quality change,
they overstate any increase in the price level.
The fourth source of bias is called the outlet bias. Households can reduce some of
the impact of rising prices by shopping at superstores or outlet stores (such as T.J.
Maxx, Wal-Mart, or factory outlet stores), though this often means they get lesscustomer service than at traditional department stores or at smaller retail stores.
However, since such shopping has increased in recent years, it must be that for
their customers, the reduction in prices has been more valuable to them than lossof service. Prior to 1998, the CPI did not account for a change in the number ofhouseholds shopping at these newer kinds of stores in a timely manner, but the BLS
now does quarterly surveys and updates its sample of stores much more frequently.
Another form of this bias arises because the government data collectors do notcollect price data on weekends and holidays, when many stores run sales.
Economists differ on the degree to which these biases result in inaccuracies inrecording price-level changes. In late 1996, Michael Boskin, an economist at
Stanford University, chaired a panel of economists appointed by the Senate FinanceCommittee to determine the magnitude of the problem in the United States. The
panel reported that the CPI was overstating inflation in the United States by 0.8 to
1.6 percentage points per year. Their best estimate was 1.1 percentage points, as
shown in Table 5.2 "Estimates of Bias in the Consumer Price Index". Since then, theBureau of Labor Statistics has made a number of changes to correct for thesesources of bias and since August 2002 has reported a new consumer price index
called the Chained Consumer Price Index for all Urban Consumers (C-CPU-U) that
attempts to provide a closer approximation to a “cost-of-living” index by utilizing
expenditure data that reflect the substitutions that consumers make across item
categories in response to changes in relative prices.Robert Cage, John Greenlees,
and Patrick Jackman, “Introducing the Chained Consumer Price Index” (paper,
Seventh Meeting of the International Working Group on Price Indices, Paris, France,
May 2003), available at http://stats.bls.gov/cpi/superlink.htm. However, a 2006
study by Robert Gordon, a professor at Northwestern University and a member ofthe original 1996 Boskin Commission, estimates that the total bias is still about 0.8
percentage points per year, as also shown in Table 5.2 "Estimates of Bias in theConsumer Price Index".
Table 5.2 Estimates of Bias in the Consumer Price Index
Sources of Bias
Substitution

5.2 Price-Level Changes

1997 Estimate 2006 Estimate
0.4

0.4

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Chapter 5 Macroeconomics: The Big Picture

Sources of Bias

1997 Estimate 2006 Estimate

New products and quality change

0.6

0.3

Switching to new outlets

0.1

0.1

Total

1.1

0.8

0.8–1.6—

Plausible range

The Boskin Commission reported that the CPI overstates the rate of inflation by 0.8
to 1.6 percentage points due to the biases shown, with a best-guess estimate of 1.1.
A 2006 study by Robert Gordon estimates that the bias fell but is still about 0.8
percentage points.
Source: Robert J. Gordon, “The Boskin Commission Report: A Retrospective One
Decade Later” (National Bureau of Economic Research Working Paper 12311, June
2006), available at http://www.nber.org/papers/w12311.
These findings of upward bias have enormous practical significance. With annual
inflation running below 2% in three out of the last 10 years and averaging 2.7% overthe 10 years, it means that the United States has come close to achieving pricestability for almost a decade.
To the extent that the computation of price indexes overstates the rate of inflation,then the use of price indexes to correct nominal values results in anunderstatement of gains in real incomes. For example, average nominal hourly
earnings of U.S. production workers were $13.01 in 1998 and $17.42 in 2007.
Adjusting for CPI-measured inflation, the average real hourly earnings was $7.98 in1998 and $8.40 in 2007, suggesting that real wages rose about 5.3% over the period.
If inflation was overstated by 0.8% per year over that entire period, as suggested byGordon’s updating of the Boskin Commission’s best estimate, then, adjusting forthis overstatement, real wages should have been reported as $7.98 for 1998 and$9.01 for 2007, a gain of nearly 13%.
Also, because the CPI is used as the basis for calculating U.S. government paymentsfor programs such as Social Security and for adjusting tax brackets, this price index
affects the government’s budget balance, the difference between government
revenues and government expenditures. The Congressional Budget Office has
estimated that correcting the biases in the index would have increased revenue by$2 billion and reduced outlays by $4 billion in 1997. By 2007, the U.S. government’s
budget would have had an additional $140 billion if the bias were removed.

5.2 Price-Level Changes

208Chapter 5 Macroeconomics: The Big Picture

KEY TAKEAWAYS• Inflation is an increase in the average level of prices, and deflation is adecrease in the average level of prices. The rate of inflation or deflationis the percentage rate of change in a price index.
• The consumer price index (CPI) is the most widely used price index in
the United States.
• Nominal values can be converted to real values by dividing by a priceindex.
• Inflation and deflation affect the real value of money, of future
obligations measured in money, and of fixed incomes. Unanticipatedinflation and deflation create uncertainty about the future.
• Economists generally agree that the CPI and other price indexes that
employ fixed market baskets of goods and services do not accurately
measure price-level changes. Biases include the substitution bias, thenew-product bias, the quality-change bias, and the outlet bias.

TRY IT!
Suppose that nominal GDP is $10 trillion in 2003 and $11 trillion in 2004, andthat the implicit price deflator has gone from 1.063 in 2003 to 1.091 in 2004.
Compute real GDP in 2003 and 2004. Using the percentage change in theimplicit price deflator as the gauge, what was the inflation rate over theperiod?

5.2 Price-Level Changes

209Chapter 5 Macroeconomics: The Big Picture

Case in Point: Take Me Out to the Ball Game …

The cost of a trip to the old ball game rose 2% in 2011, according to Team
Marketing Report, a Chicago-based newsletter. The report bases its estimate onits fan price index, whose market basket includes four adult average-priced
tickets, two small draft beers, four small soft drinks, four regular-sized hot
dogs, parking for one car, two game programs, and two least expensive, adultsized adjustable baseball caps. The average price of the market basket was$197.35 in 2011.
Team Marketing compiles the cost of the basket for each of major league
baseball’s 30 teams. According to this compilation, the Boston Red Sox was themost expensive team to watch in 2011; the Arizona Diamondbacks was thecheapest. The table shows the cost of the fan price index market basket for2011.
Source: Team Marketing Report, “TMR’s Fan Cost Index Major
League Baseball 2011,” available at
http://www.teammarketing.com.

Team

5.2 Price-Level Changes

BasketCost

Team

BasketCost

Boston Red Sox$339.01 Baltimore Orioles$174.10

New York Yankees$338.32 Cleveland Indians$170.96

Chicago Cubs

$305.60 Florida Marlins$170.24

Chicago White Sox$258.68 Atlanta Braves$169.02

New York Mets

$241.74 Cincinnati Reds

$162.24

Philadelphia Phillies$240.66 Colorado Rockies$161.00

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Team

BasketCost

Team

BasketCost

Los Angeles Dodgers$226.36 Milwaukee Brewers$160.40

St. Louis Cardinals$223.18 Kansas City Royals$159.80

Houston Astros$221.36 Texas Rangers$159.40

Minnesota Twins$213.16 Tampa Bay Rays

$139.68

Toronto Blue Jays

$212.68 Los Angeles Angels$129.50

San Francisco Giants$208.15 Pittsburgh Pirates$127.71

Detroit Tigers$207.28 San Diego Padres$125.81

Washington
Nationals$196.34

ArizonaDiamondbacks$120.96

Seattle Mariners$183.59

Oakland Athletics$178.09 MLB Average$197.35ANSWER TO TRY IT! PROBLEM
Rearranging Equation 5.3, real GDP = nominal GDP/implicit price deflator.
Therefore,
Real GDP in 2003 = $10 trillion/1.063 = $9.4 trillion.
Real GDP in 2004 = $11 trillion/1.091 = $10.1 trillion.
Thus, in this economy in real terms, GDP has grown by $0.7 trillion.
To find the rate of inflation, we refer to Equation 5.4, and we calculate:
Inflation rate in 2004 = (1.091 − 1.063)/1.063 = 0.026 = 2.6%
Thus, the price level rose 2.6% between 2003 and 2004.

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5.3 Unemployment
LEARNING OBJECTIVES
1. Explain how unemployment is measured in the United States.
2. Define three different types of unemployment.
3. Define and illustrate graphically what is meant by the natural level of
employment. Relate the natural level of employment to the natural rateof unemployment.

For an economy to produce all it can and achieve a solution on its production
possibilities curve, the factors of production in the economy must be fully
employed. Failure to fully employ these factors leads to a solution inside theproduction possibilities curve in which society is not achieving the output it iscapable of producing.
In thinking about the employment of society’s factors of production, we place
special emphasis on labor. The loss of a job can wipe out a household’s entire
income; it is a more compelling human problem than, say, unemployed capital, suchas a vacant apartment. In measuring unemployment, we thus focus on labor rather
than on capital and natural resources.

Measuring Unemployment
The Bureau of Labor Statistics defines a person as unemployed if he or she is notworking but is looking for and available for work. The labor force18 is the total
number of people working or unemployed. The unemployment rate19 is thepercentage of the labor force that is unemployed.

18. The total number of people
working or unemployed.
19. The percentage of the labor
force that is unemployed.

To estimate the unemployment rate, government surveyors fan out across thecountry each month to visit roughly 60,000 households. At each of these randomly
selected households, the surveyor asks about the employment status of each adult(everyone age 16 or over) who lives there. Many households include more than one
adult; the survey gathers information on about roughly 100,000 adults. The
surveyor asks if each adult is working. If the answer is yes, the person is counted as
employed. If the answer is no, the surveyor asks if that person has looked for work
at some time during the previous four weeks and is available for work at the time ofthe survey. If the answer to that question is yes, the person is counted as
unemployed. If the answer is no, that person is not counted as a member of the212Chapter 5 Macroeconomics: The Big Picturelabor force. Figure 5.4 "Computing the Unemployment Rate" shows the survey’s
results for the civilian (nonmilitary) population for February 2012. The
unemployment rate is then computed as the number of people unemployed divided
by the labor force—the sum of the number of people not working but available andlooking for work plus the number of people working. In February 2012, theunemployment rate was 8.3%.
Figure 5.4 Computing the Unemployment Rate

A monthly survey of households divides the civilian adult population into three groups. Those who have jobs arecounted as employed; those who do not have jobs but are looking for them and are available for work are counted as
unemployed; and those who are not working and are not looking for work are not counted as members of the labor
force. The unemployment rate equals the number of people looking for work divided by the sum of the number ofpeople looking for work and the number of people employed. Values are for February 2012. All numbers are in
thousands.

There are several difficulties with the survey. The old survey, designed during the
1930s, put the “Are you working?” question differently depending on whether the
respondent was a man or woman. A man was asked, “Last week, did you do any
work for pay or profit?” A woman was asked, “What were you doing for work last
week, keeping house or something else?” Consequently, many women who werelooking for paid work stated that they were “keeping house”; those women were
not counted as unemployed. The BLS did not get around to fixing thesurvey—asking women the same question it asked men—until 1994. The first time
the new survey question was used, the unemployment rate among women rose by
0.5 percentage point. More than 50 million women are in the labor force; thechange added more than a quarter of a million workers to the official count of theunemployed.For a description of the new survey and other changes introduced in

5.3 Unemployment

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Chapter 5 Macroeconomics: The Big Picture

the method of counting unemployment, see Janet L. Norwood and Judith M. Tanur,“Unemployment Measures for the Nineties,” Public Opinion Quarterly 58, no. 2(Summer 1994): 277–94.
The problem of understating unemployment among women has been fixed, butothers remain. A worker who has been cut back to part-time work still counts as
employed, even if that worker would prefer to work full time. A person who is outof work, would like to work, has looked for work in the past year, and is available
for work, but who has given up looking, is considered a discouraged worker.
Discouraged workers are not counted as unemployed, but a tally is kept each monthof the number of discouraged workers.
The official measures of employment and unemployment can yield unexpected
results. For example, when firms expand output, they may be reluctant to hire
additional workers until they can be sure the demand for increased output will besustained. They may respond first by extending the hours of employees previously
reduced to part-time work or by asking full-time personnel to work overtime. Noneof that will increase employment, because people are simply counted as “employed”
if they are working, regardless of how much or how little they are working. In
addition, an economic expansion may make discouraged workers more optimistic
about job prospects, and they may resume their job searches. Engaging in a search
makes them unemployed again—and increases unemployment. Thus, an economic
expansion may have little effect initially on employment and may even increase
unemployment.

Types of Unemployment
Workers may find themselves unemployed for different reasons. Each source of
unemployment has quite different implications, not only for the workers it affects
but also for public policy.
Figure 5.5 "The Natural Level of Employment" applies the demand and supply
model to the labor market. The price of labor is taken as the real wage, which is thenominal wage divided by the price level; the symbol used to represent the real wage
is the Greek letter omega, ω. The supply curve is drawn as upward sloping, thoughsteep, to reflect studies showing that the quantity of labor supplied at any one timeis nearly fixed. Thus, an increase in the real wage induces a relatively small increasein the quantity of labor supplied. The demand curve shows the quantity of labordemanded at each real wage. The lower the real wage, the greater the quantity oflabor firms will demand. In the case shown here, the real wage, ω e, equals theequilibrium solution defined by the intersection of the demand curve D1 and the
supply curve S1. The quantity of labor demanded, Le, equals the quantity supplied.

5.3 Unemployment

214Chapter 5 Macroeconomics: The Big Picture

The employment level at which the quantity of labor demanded equals the quantity
supplied is called the natural level of employment20. It is sometimes referred to as
full employment.
Figure 5.5 The Natural Level of Employment

The employment level at which the quantity of labor demanded equals the quantity supplied is called the naturallevel of employment. Here, the natural level of employment is Le, which is achieved at a real wage ωe.

Even if the economy is operating at its natural level of employment, there will still
be some unemployment. The rate of unemployment consistent with the naturallevel of employment is called the natural rate of unemployment21. Business cycles
may generate additional unemployment. We discuss these various sources of
unemployment below.
20. The employment level at which
the quantity of labordemanded equals the quantity
supplied.
21. The rate of unemployment
consistent with the naturallevel of employment.

5.3 Unemployment

Frictional Unemployment
Even when the quantity of labor demanded equals the quantity of labor supplied,
not all employers and potential workers have found each other. Some workers arelooking for jobs, and some employers are looking for workers. During the time it

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Chapter 5 Macroeconomics: The Big Picture

takes to match them up, the workers are unemployed. Unemployment that occurs
because it takes time for employers and workers to find each other is called
frictional unemployment22.
The case of college graduates engaged in job searches is a good example of frictional
unemployment. Those who did not land a job while still in school will seek work.
Most of them will find jobs, but it will take time. During that time, these newgraduates will be unemployed. If information about the labor market were costless,firms and potential workers would instantly know everything they needed to know
about each other and there would be no need for searches on the part of workers
and firms. There would be no frictional unemployment. But information is costly.
Job searches are needed to produce this information, and frictional unemployment
exists while the searches continue.
The government may attempt to reduce frictional unemployment by focusing on its
source: information costs. Many state agencies, for example, serve as
clearinghouses for job market information. They encourage firms seeking workers
and workers seeking jobs to register with them. To the extent that such efforts
make labor-market information more readily available, they reduce frictional
unemployment.

Structural Unemployment
Another reason there can be unemployment even if employment equals its naturallevel stems from potential mismatches between the skills employers seek and theskills potential workers offer. Every worker is different; every job has its special
characteristics and requirements. The qualifications of job seekers may not match
those that firms require. Even if the number of employees firms demand equals thenumber of workers available, people whose qualifications do not satisfy what firms
are seeking will find themselves without work. Unemployment that results from amismatch between worker qualifications and the characteristics employers requireis called structural unemployment23.

22. Unemployment that occurs
because it takes time for
employers and workers to findeach other.
23. Unemployment that resultsfrom a mismatch between
worker qualifications and thecharacteristics employers
require.

5.3 Unemployment

Structural unemployment emerges for several reasons. Technological change may
make some skills obsolete or require new ones. The widespread introduction of
personal computers since the 1980s, for example, has lowered demand for typists
who lacked computer skills.
Structural unemployment can occur if too many or too few workers seek training or
education that matches job requirements. Students cannot predict precisely how
many jobs there will be in a particular category when they graduate, and they are
not likely to know how many of their fellow students are training for these jobs.

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Structural unemployment can easily occur if students guess wrong about how many
workers will be needed or how many will be supplied.
Structural unemployment can also result from geographical mismatches. Economic
activity may be booming in one region and slumping in another. It will take time for
unemployed workers to relocate and find new jobs. And poor or costlytransportation may block some urban residents from obtaining jobs only a few
miles away.
Public policy responses to structural unemployment generally focus on job training
and education to equip workers with the skills firms demand. The government
publishes regional labor-market information, helping to inform unemployedworkers of where jobs can be found. The North American Free Trade Agreement(NAFTA), which created a free trade region encompassing Mexico, the UnitedStates, and Canada, has created some structural unemployment in the three
countries. In the United States, the legislation authorizing the pact also provided
for job training programs for displaced U.S. workers.
Although government programs may reduce frictional and structural
unemployment, they cannot eliminate it. Information in the labor market will
always have a cost, and that cost creates frictional unemployment. An economy
with changing demands for goods and services, changing technology, and changing
production costs will always have some sectors expanding and others
contracting—structural unemployment is inevitable. An economy at its naturallevel of employment will therefore have frictional and structural unemployment.

Cyclical Unemployment
Of course, the economy may not be operating at its natural level of employment, so
unemployment may be above or below its natural level. In a later chapter we will
explore what happens when the economy generates employment greater or lessthan the natural level. Cyclical unemployment24 is unemployment in excess of theunemployment that exists at the natural level of employment.

24. Unemployment in excess of theunemployment that exists atthe natural level of
employment.

5.3 Unemployment

Figure 5.6 "Unemployment Rate, 1960–2011" shows the unemployment rate in the
United States for the period from 1960 through 2011. We see that it has fluctuatedconsiderably. How much of it corresponds to the natural rate of unemployment
varies over time with changing circumstances. For example, in a country with ademographic “bulge” of new entrants into the labor force, frictional unemployment
is likely to be high, because it takes the new entrants some time to find their firstjobs. This factor alone would raise the natural rate of unemployment. A
demographic shift toward more mature workers would lower the natural rate.

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Chapter 5 Macroeconomics: The Big Picture

During recessions, highlighted in Figure 5.6 "Unemployment Rate, 1960–2011", thepart of unemployment that is cyclical unemployment grows. The analysis offluctuations in the unemployment rate, and the government’s responses to them,will occupy center stage in much of the remainder of this book.
Figure 5.6 Unemployment Rate, 1960–2011

The chart shows the unemployment rate for each year from 1960 to 2011. Recessions are shown as shaded areas.
Source: Economic Report of the President, 2012, Table B-42.

KEY TAKEAWAYS• People who are not working but are looking and available for work at
any one time are considered unemployed. The unemployment rate is thepercentage of the labor force that is unemployed.
• When the labor market is in equilibrium, employment is at the naturallevel and the unemployment rate equals the natural rate ofunemployment.
• Even if employment is at the natural level, the economy will experiencefrictional and structural unemployment. Cyclical unemployment isunemployment in excess of that associated with the natural level of
employment.

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Chapter 5 Macroeconomics: The Big Picture

TRY IT!
Given the data in the table, compute the unemployment rate in Year 1 and inYear 2. Explain why, in this example, both the number of people employed
and the unemployment rate increased.

5.3 Unemployment

Year

Number employed (inmillions)

Number unemployed (inmillions)

1

20

2

2

21

2.4

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Chapter 5 Macroeconomics: The Big Picture

Case in Point: Might Increased Structural Unemployment
Explain the “Jobless Recovery” Following the 2001
Recession?

The U.S. 2001 recession was mild by historical standards, but recovery in termsof increased employment seemed painfully slow in coming. Economists Erica
Goshen and Simon Potter at the Federal Reserve Bank of New York think thereason for the slow recovery in jobs may have actually reflected structuralchanges in the U.S. economy. They argue that during the recession permanentrather than temporary layoffs predominated and that it takes longer for firms
to hire workers into new positions than to hire them back into former jobs.
What is their evidence? When the layoff is temporary, the employer “suspends”
the job, due to slack demand, and the employee expects to be recalled once
demand picks up. With a permanent layoff, the employer eliminates the job. So,
they looked at the contribution of temporary layoffs to the unemployment rateduring the recent recession compared to the situation in the four recessions
before 1990. In the earlier recessions, unemployment from temporary layoffsrose when the economy was shrinking and fell after the economy began torecover. In both the 1991 and 2001 recessions, temporary layoffs were minor.
Then, the authors examined job flows in 70 industries. They classified layoffs in
an industry as being cyclical in nature if the job losses during the recession
were reversed during the recovery but structural if job losses for the industry
continued during the recovery. Their analysis revealed that during the

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recession of the early 1980s, job losses were about evenly split between cyclicaland structural changes. In the 1991 recession and then more strongly in the2001 recession, structural changes dominated. “Most of the industries that lostjobs during the [2001] recession—for example, communications, electronicequipment, and securities and commodities brokers—[were] still losing jobs” in
2003. “The trend revealed . . . is one in which jobs are relocated from someindustries to others, not reclaimed by the same industries that lost themearlier.”
The authors suggest three possible reasons for the recent increased role ofstructural change: (1) The structural decline in some industries could be theresult of overexpansion in those industries during the 1990s. The high tech andtelecommunications industries in particular could be examples of industries
that were overbuilt before the 2001 recession. (2) Improved government
policies may have reduced cyclical unemployment. Examination ofmacroeconomic policy in future chapters will return to this issue. (3) New
management strategies to reduce costs may be promoting leaner staffing. For
firms adopting such strategies, a recession may provide an opportunity toreorganize the production process permanently and reduce payrolls in theprocess.
Goshen and Potter point out that, for workers, finding new jobs is harder thansimply returning to old ones. For firms, making decisions about the nature of
new jobs is time consuming at best. The uncertainty created by the war in Iraq
and the imposition of new accounting standards following the “Enron”-likescandals may have further prolonged the creation of new jobs.
Source: Erica L. Goshen and Simon Potter, “Has Structural Change Contributed
to a Jobless Recovery?” Federal Reserve Bank of New York Current Issues in
Economics and Finance 9, no. 8 (August 2003): 1–7.

5.3 Unemployment

221Chapter 5 Macroeconomics: The Big Picture

ANSWER TO TRY IT! PROBLEM
In Year 1 the total labor force includes 22 million workers, and so theunemployment rate is 2/22 = 9.1%. In Year 2 the total labor force numbers
23.4 million workers; therefore the unemployment rate is 2.4/23.4 = 10.3%.
In this example, both the number of people employed and theunemployment rate rose, because more people (23.4 − 22 = 1.4 million)
entered the labor force, of whom 1 million found jobs and 0.4 million werestill looking for jobs.

5.3 Unemployment

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Chapter 5 Macroeconomics: The Big Picture

5.4 Review and PracticeSummary
In this chapter we examined growth in real GDP and business cycles, price-level changes, and unemployment.
We saw how these phenomena are defined and looked at their consequences.
Examining real GDP, rather than nominal GDP, over time tells us whether the economy is expanding orcontracting. Real GDP in the United States shows a long upward trend, but with the economy going throughphases of expansion and recession around that trend. These phases make up the business cycle. An expansion
reaches a peak, and the economy falls into a recession. The recession reaches a trough and begins an expansion
again.
Inflation is an increase in the price level and deflation is a decrease in the price level. The rate of inflation or
deflation is the percentage rate of change in a price index. We looked at the calculation of the consumer priceindex (CPI) and the implicit price deflator. The CPI is widely used in the calculation of price-level changes. There
are, however, biases in its calculation: the substitution bias, the new-product bias, the quality-change bias, andthe outlet bias.
Inflation and deflation affect economic activity in several ways. They change the value of money and of claims
on money. Unexpected inflation benefits borrowers and hurts lenders. Unexpected deflation benefits lenders
and hurts borrowers. Both inflation and deflation create uncertainty and make it difficult for individuals andfirms to enter into long-term financial commitments.
The unemployment rate is measured as the percentage of the labor force not working but seeking work.
Frictional unemployment occurs because information about the labor market is costly; it takes time for firms
seeking workers and workers seeking firms to find each other. Structural unemployment occurs when there is amismatch between the skills offered by potential workers and the skills sought by firms. Both frictional andstructural unemployment occur even if employment and the unemployment rate are at their natural levels.
Cyclical unemployment is unemployment that is in excess of that associated with the natural level of
employment.

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Chapter 5 Macroeconomics: The Big Picture

CONCEPT PROBLEMS
1. Describe the phases of a business cycle.
2. On the basis of recent news reports, what phase of the business cycle do
you think the economy is in now? What is the inflation or deflation rate?
The unemployment rate?
3. Suppose you compare your income this year and last year and find thatyour nominal income fell but your real income rose. How could this have
happened?
4. Suppose you calculate a grocery price inflation rate. Using thearguments presented in the chapter, explain possible sources of upwardbias in the rate you calculate, relative to the actual trend of food prices.
5. Name three items you have purchased during the past year that haveincreased in quality during the year. What kind of adjustment would you
make in assessing their prices for the CPI?
6. Why do some people gain and other people lose from inflation anddeflation?
7. Suppose unemployed people leave a state to obtain jobs in other states.
What do you predict will happen to the unemployment rate in the stateexperiencing the out-migration? What might happen to theunemployment rates in the states experiencing in-migration?
8. Minority teenagers have the highest unemployment rates of any group.
One reason for this phenomenon is high transportation costs for many
minority teens. What form of unemployment (cyclical, frictional, or
structural) do high transportation costs suggest?
9. Welfare reforms enacted in 1996 put more pressure on welfare
recipients to look for work. The new law mandated cutting off benefits
after a certain length of time. How do you think this provision might
affect the unemployment rate?
10. American workers work more hours than their European counterparts.
Should Congress legislate a shorter workweek?

5.4 Review and Practice224Chapter 5 Macroeconomics: The Big Picture

NUMERICAL PROBLEMS
1. Plot the quarterly data for real GDP for the last two years. (You can findthe data online at http://www.whitehouse.gov/administration/eop/
cea/economic-indicators. Relate recent changes in real GDP to theconcept of the phases of the business cycle.)
2. Suppose that in 2013, the items in the market basket for our movie priceindex cost $53.40. Use the information in the chapter to compute theprice index for that year. How does the rate of movie price inflationfrom 2012 to 2013 compare with the rate from 2011 to 2012?
3. Recompute the movie price indexes for 2011 and 2012 using 2012 as thebase year. Now compute the rate of inflation for the 2011–2012 period.
Compare your result to the inflation rate calculated for that same periodusing 2011 as the base year.
4. Here are some statistics for August 2006. Compute theunemployment rate for that month (all figures are in thousands).
Population (Civilian, noninstitutional) 229,167
Civilian Labor Force

151,698

Participation Rate

66.2%

Not in Labor Force

77,469

Employed

144,579

Unemployed

7,119

5. Suppose an economy has 10,000 people who are not working but looking
and available for work and 90,000 people who are working. What is its
unemployment rate? Now suppose 4,000 of the people looking for work
get discouraged and give up their searches. What happens to theunemployment rate? Would you interpret this as good news for the
economy or bad news? Explain.
6. The average price of going to a baseball game in 2011, based on
the observations in the Case in Point, was $197.35. Using thisaverage as the equivalent of a base year, compute fan priceindexes for:a. The New York Yankees.
b. The Chicago Cubs.
c. The Boston Red Sox.

5.4 Review and Practice225

Chapter 5 Macroeconomics: The Big Pictured. The Tampa Bay Rays.
e. The team of your choice.
7. Suppose you are given the following data for a small economy:
Number of unemployed workers: 1,000,000.
Labor force: 10,000,000.
Based on this data, answer the following:a. What is the unemployment rate?
b. Can you determine whether the economy is operating at its
full employment level?
c. Now suppose people who had been seeking jobs become
discouraged, and give up their job searches. The labor force
shrinks to 900,500 workers, and unemployment falls to
500,000 workers. What is the unemployment rate now? Has
the economy improved?
8. Nominal GDP for an economy is $10 trillion. Real GDP is $9 trillion. Whatis the value of the implicit price deflator?
9. Suppose you are given the following data for an economy:

5.4 Review and Practice

MonthReal GDP

Employment1$10.0 trillion

100 million

2$10.4 trillion

104 million

3$10.5 trillion

105 million

4$10.3 trillion

103 million

5$10.2 trillion

102 million

6$10.3 trillion

103 million

7$10.6 trillion

106 million

8$10.7 trillion

107 million

9$10.6 trillion

106 million

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Chapter 5 Macroeconomics: The Big Picturea. Plot the data for real GDP, with the time period on thehorizontal axis and real GDP on the vertical axis.
b. There are two peaks. When do they occur?
c. When does the trough occur?
10. The Consumer Price Index in Period 1 is 107.5. It is 103.8 in Period 2. Is
this a situation of inflation or deflation? What is the rate?

5.4 Review and Practice227

Chapter 6
Measuring Total Output and Income
Start Up: The Lockup
It is early morning when a half-dozen senior officials enter the room at theCommerce Department in Washington. Once inside, they will have nocommunication with the outside world until they have completed their work laterthat day. They will have no telephone, no computer links. They will be able to slipout to an adjoining restroom, but only in pairs. It is no wonder the room is called“the Lockup.” The Lockup produces one of the most important indicators of
economic activity we have: the official estimate of the value of the economy’s total
output, known as its gross domestic product (GDP).
When the team has finished its computations, the results will be placed in a sealed
envelope. A government messenger will hand carry the envelope to the Executive
Office Building and deliver it to a senior adviser to the president of the UnitedStates. The adviser will examine its contents, then carry it across the street to theWhite House and give it to the president.
The senior officials who meet in secret to compute GDP are not spies; they are
economists. The adviser who delivers the estimate to the president is the chairmanof the Council of Economic Advisers.
The elaborate precautions for secrecy do not end there. At 7:30 the next morning,
journalists from all over the world will gather in an electronically sealed
auditorium at the Commerce Department. There they will be given the GDP figure
and related economic indicators, along with an explanation. The reporters will havean hour to prepare their reports, but they will not be able to communicate withanyone else until an official throws the switch at 8:30. At that instant their
computers will connect to their news services, and they will be able to file theirreports. These will be major stories on the Internet and in the next editions of thenation’s newspapers; the estimate of the previous quarter’s GDP will be one of thelead items on television and radio news broadcasts that day.
The clandestine preparations for the release of quarterly GDP figures reflect theimportance of this indicator. The estimate of GDP provides the best available

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Chapter 6 Measuring Total Output and Income

reading of macroeconomic performance. It will affect government policy, and it will
influence millions of decisions in the private sector. Prior knowledge of the GDP
estimate could be used to anticipate the response in the stock and bond markets, so
great care is taken that only a handful of trusted officials have access to theinformation until it is officially released.
The GDP estimate took on huge significance in the fall of 2008 as the United Statesand much of the rest of the world went through the wrenching experience of theworst financial crisis since the Great Depression of the 1930s. The expectation thatthe financial crisis would lead to an economic collapse was widespread, and thequarterly announcements of GDP figures were more anxiously awaited than ever.
The primary measure of the ups and downs of economic activity—the businesscycle—is real GDP. When an economy’s output is rising, the economy creates morejobs, more income, and more opportunities for people. In the long run, an
economy’s output and income, relative to its population, determine the material
standard of living of its people.
Clearly GDP is an important indicator of macroeconomic performance. It is the
topic we will consider in this chapter. We will learn that GDP can be measured
either in terms of the total value of output produced or as the total value of income
generated in producing that output. We will begin with an examination of measuresof GDP in terms of output. Our initial focus will be on nominal GDP: the value of
total output measured in current prices. We will turn to real GDP—a measure of
output that has been adjusted for price level changes—later in the chapter. We willrefer to nominal GDP simply as GDP. When we discuss the real value of the measure,
we will call it real GDP.

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Chapter 6 Measuring Total Output and Income

6.1 Measuring Total Output
LEARNING OBJECTIVES
1. Define gross domestic product and its four major spending components
and illustrate the various flows using the circular flow model.
2. Distinguish between measuring GDP as the sum of the values of final
goods and services and as the sum of values added at each stage of
production.
3. Distinguish between gross domestic product and gross national product.

An economy produces a mind-boggling array of goods and services every year. For
example, Domino’s Pizza produces hundreds of millions of pizzas. The United States
Steel Corporation, the nation’s largest steel company, produces tens of millions oftons of steel. A small logging company in Colorado produces a couple million board
feet of lumber. A university football team draws more than half a million fans to its
home games. A pediatric nurse in Los Angeles delivers hundreds of babies and takes
care of several hundred additional patients. A list of all the goods and services an
economy produces in any year would be virtually endless.
So—what kind of year is the year we are looking at? We would not get very far
trying to wade through a list of all the goods and services produced that year. It is
helpful to have instead a single number that measures total output in the economy;
that number is GDP.

The Components of GDP
We can divide the goods and services produced during any period into four broad
components, based on who buys them. These components of GDP are personal
consumption (C), gross private domestic investment (I), government purchases (G),and net exports (Xn). Thus
Equation 6.1
GDP

GDP

=

consumption (C)

=

C

+

private investment (I)

+

I

or

+

government purchases (G)

+

+

G

+

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Chapter 6 Measuring Total Output and Income

We will examine each of these components, and we will see how each fits into thepattern of macroeconomic activity. Before we begin, it will be helpful to distinguishbetween two types of variables: stocks and flows. A flow variable1 is a variable thatis measured over a specific period of time. A stock variable2 is a variable that is
independent of time. Income is an example of a flow variable. To say one’s income
is, for example, $1,000 is meaningless without a time dimension. Is it $1,000 per
hour? Per day? Per week? Per month? Until we know the time period, we have noidea what the income figure means. The balance in a checking account is an
example of a stock variable. When we learn that the balance in a checking accountis $1,000, we know precisely what that means; we do not need a time dimension. We
will see that stock and flow variables play very different roles in macroeconomic
analysis.

Personal Consumption
Personal consumption3 is a flow variable that measures the value of goods andservices purchased by households during a time period. Purchases by households ofgroceries, health-care services, clothing, and automobiles—all are counted asconsumption.
The production of consumer goods and services accounts for about 70% of total
output. Because consumption is such a large part of GDP, economists seeking tounderstand the determinants of GDP must pay special attention to the determinantsof consumption. In a later chapter we will explore these determinants and theimpact of consumption on economic activity.

1. A variable that is measured
over a specific period of time.
2. A variable that is independentof time.

Personal consumption represents a demand for goods and services placed on firms
by households. In the chapter on demand and supply, we saw how this demand
could be presented in a circular flow model of the economy. Figure 6.1 "Personal
Consumption in the Circular Flow" presents a circular flow model for an economy
that produces only personal consumption goods and services. (We will add theother components of GDP to the circular flow as we discuss them.) Spending forthese goods flows from households to firms; it is the arrow labeled “Personal
consumption.” Firms produce these goods and services using factors of production:
labor, capital, and natural resources. These factors are ultimately owned byhouseholds. The production of goods and services thus generates income tohouseholds; we see this income as the flow from firms to households labeled “Factor
incomes” in the exhibit.

3. A flow variable that measuresthe value of goods and services
purchased by households
during a time period.

6.1 Measuring Total Output

231

Chapter 6 Measuring Total Output and Income

In exchange for payments that flow from households tofirms, there is a flow of consumer goods and services
from firms to households. This flow is shown in Figure
6.1 "Personal Consumption in the Circular Flow" as anarrow going from firms to households. When you buy asoda, for example, your payment to the store is part of
the flow of personal consumption; the soda is part of theflow of consumer goods and services that goes from thestore to a household—yours.
Similarly, the lower arrow in Figure 6.1 "Personal
Consumption in the Circular Flow" shows the flow offactors of production—labor, capital, and natural
resources—from households to firms. If you work for afirm, your labor is part of this flow. The wages you
receive are part of the factor incomes that flow fromfirms to households.

Figure 6.1 Personal
Consumption in the Circular
Flow

Personal consumption spendingflows from households to firms.
In return, consumer goods andservices flow from firms tohouseholds. To produce the goods
and services households demand,
firms employ factors of
production owned by households.
There is thus a flow of factor
services from households tofirms, and a flow of payments offactor incomes from firms tohouseholds.

There is a key difference in our interpretation of thecircular flow picture in Figure 6.1 "Personal
Consumption in the Circular Flow" from our analysis of
the same model in the demand and supply chapter.
There, our focus was microeconomics, which examines
individual units of the economy. In thinking about theflow of consumption spending from households tofirms, we emphasized demand and supply in particularmarkets—markets for such things as blue jeans, haircuts, and apartments. In
thinking about the flow of income payments from firms to households, we focusedon the demand and supply for particular factors of production, such as textile
workers, barbers, and apartment buildings. Because our focus now ismacroeconomics, the study of aggregates of economic activity, we will think interms of the total of personal consumption and the total of payments to households.

Private Investment

4. The value of all goods
produced during a period foruse in the production of othergoods and services.

6.1 Measuring Total Output

Gross private domestic investment4 is the value of all goods produced during aperiod for use in the production of other goods and services. Like personal
consumption, gross private domestic investment is a flow variable. It is often simply
referred to as “private investment.” A hammer produced for a carpenter is private
investment. A printing press produced for a magazine publisher is private
investment, as is a conveyor-belt system produced for a manufacturing firm. Capital
includes all the goods that have been produced for use in producing other goods; it232

Chapter 6 Measuring Total Output and Income

is a stock variable. Private investment is a flow variable that adds to the stock of
capital during a period.

Heads Up!
The term “investment” can generate confusion. In everyday conversation, we
use the term “investment” to refer to uses of money to earn income. We say wehave invested in a stock or invested in a bond. Economists, however, restrict“investment” to activities that increase the economy’s stock of capital. The
purchase of a share of stock does not add to the capital stock; it is notinvestment in the economic meaning of the word. We refer to the exchange offinancial assets, such as stocks or bonds, as financial investment to distinguishit from the creation of capital that occurs as the result of investment. Only
when new capital is produced does investment occur. Confusing the economic
concept of private investment with the concept of financial investment cancause misunderstanding of the way in which key components of the economy
relate to one another.

Gross private domestic investment includes three flows that add to or maintain thenation’s capital stock: expenditures by business firms on new buildings, plants,
tools, equipment, and software that will be used in the production of goods andservices; expenditures on new residential housing; and changes in business
inventories. Any addition to a firm’s inventories represents an addition toinvestment; a reduction subtracts from investment. For example, if a clothing store
stocks 1,000 pairs of jeans, the jeans represent an addition to inventory and are partof gross private domestic investment. As the jeans are sold, they are subtracted
from inventory and thus subtracted from investment.
By recording additions to inventories as investment and reductions frominventories as subtractions from investment, the accounting for GDP records
production in the period in which it occurs. Suppose, for example, that Levi Strauss
manufactures 1 million pairs of jeans late in 2011 and distributes them to stores atthe end of December. The jeans will be added to inventory; they thus count as
investment in 2011 and enter GDP for that year. Suppose they are sold in January
2012. They will be counted as consumption in GDP for 2012 but subtracted frominventory, and from investment. Thus, the production of the jeans will add to GDP
in 2011, when they were produced. They will not count in 2012, save for any
increase in the value of the jeans resulting from the services provided by the retailstores that sold them.

6.1 Measuring Total Output

233

Chapter 6 Measuring Total Output and Income

Private investment accounts for about 15% of GDP—but, at times, even less. Despite
its relatively small share of total economic activity, private investment plays acrucial role in the macroeconomy for two reasons:
1. Private investment represents a choice to forgo current consumption
in order to add to the capital stock of the economy. Private investment
therefore adds to the economy’s capacity to produce and shifts its
production possibilities curve outward. Investment is thus one
determinant of economic growth, which is explored in anotherchapter.
2. Private investment is a relatively volatile component of GDP; it canchange dramatically from one year to the next. Fluctuations in GDP areoften driven by fluctuations in private investment. We will examine
the determinants of private investment in a chapter devoted to thestudy of investment.
Private investment represents a demand placed on firms for the production ofcapital goods. While it is a demand placed on firms, it flows from firms. In thecircular flow model in Figure 6.2 "Private Investment in the Circular Flow", we see aflow of investment going from firms to firms. The production of goods and services
for consumption generates factor incomes to households; the production of capital
goods for investment generates income to households as well.
Figure 6.2 "Private Investment in the Circular Flow"
shows only spending flows and omits the physical flows
represented by the arrows in Figure 6.1 "Personal
Consumption in the Circular Flow". This simplification
will make our analysis of the circular flow model easier.
It will also focus our attention on spending flows, which
are the flows we will be studying.

Figure 6.2 Private
Investment in the Circular
Flow

Government Purchases
Government agencies at all levels purchase goods andservices from firms. They purchase office equipment,
vehicles, buildings, janitorial services, and so on. Many
government agencies also produce goods and services.
Police departments produce police protection. Publicschools produce education. The National Aeronautics
and Space Administration (NASA) produces space
exploration.

6.1 Measuring Total Output

Private investment constitutes a
demand placed on firms by otherfirms. It also generates factor
incomes for households. To
simplify the diagram, only the
spending flows are shown—thecorresponding flows of goods andservices have been omitted.

234

Chapter 6 Measuring Total Output and Income

Government purchases5 are the sum of purchases of goods and services from firmsby government agencies plus the total value of output produced by government
agencies themselves during a time period. Government purchases make up about
20% of GDP.
Government purchases are not the same thing as government spending. Much
government spending takes the form of transfer payments6, which are paymentsthat do not require the recipient to produce a good or service in order to receive
them. Transfer payments include Social Security and other types of assistance toretired people, welfare payments to poor people, and unemployment compensation
to people who have lost their jobs. Transfer payments are certainly
significant—they account for roughly half of all federal government spending in the
United States. They do not count in a nation’s GDP, because they do not reflect the
production of a good or service.
Government purchases represent a demand placed on firms, represented by theflow shown in Figure 6.3 "Government Purchases in the Circular Flow". Like all thecomponents of GDP, the production of goods and services for government agencies
creates factor incomes for households.

Net Exports

5. The sum of purchases of goods
and services from firms bygovernment agencies plus thetotal value of output produced
by government agencies
themselves during a time
period.
6. Payments that do not require
the recipient to produce a goodor service in order to receivethem.
7. Sales of a country’s goods andservices to buyers in the rest of
the world during a particulartime period.
8. Purchases of foreign-produced
goods and services by acountry’s residents during aperiod.
9. Exports minus imports.

6.1 Measuring Total Output

Sales of a country’s goods and services to buyers in therest of the world during a particular time period
represent its exports7. A purchase by a Japanese buyerof a Ford Taurus produced in the United States is a U.S.
export. Exports also include such transactions as thepurchase of accounting services from a New Yorkaccounting firm by a shipping line based in Hong Kongor the purchase of a ticket to Disney World by a tourist
from Argentina. Imports8 are purchases of foreignproduced goods and services by a country’s residents
during a period. United States imports include suchtransactions as the purchase by Americans of cars
produced in Japan or tomatoes grown in Mexico or astay in a French hotel by a tourist from the UnitedStates. Subtracting imports from exports yields net
exports9.

Figure 6.3 Government
Purchases in the Circular
Flow

Purchases of goods and services
by government agencies create
demands on firms. As firms
produce these goods and services,
they create factor incomes forhouseholds.

Equation 6.2

Exports (X) − imports (M) = net exports (X n )235

Chapter 6 Measuring Total Output and Income

In 2011, foreign buyers purchased $2,087.5 billion worth of goods and services fromthe United States. In the same year, U.S. residents, firms, and government agencies
purchased $2,664.4 billion worth of goods and services from foreign countries. The
difference between these two figures, −$576.9 billion, represented the net exports of
the U.S. economy in 2011. Net exports were negative because imports exceededexports. Negative net exports constitute a trade deficit10. The amount of the deficit
is the amount by which imports exceed exports. When exports exceed imports
there is a trade surplus11. The magnitude of the surplus is the amount by which
exports exceed imports.
The United States has recorded more deficits than surpluses since World War II, but
the amounts have typically been relatively small, only a few billion dollars. The
trade deficit began to soar, however, in the 1980s and again in the 2000s. We will
examine the reasons for persistent trade deficits in another chapter. The rest of theworld plays a key role in the domestic economy and, as we will see later in the book,there is nothing particularly good or bad about trade surpluses or deficits. Goods
and services produced for export represent roughly 14% of GDP, and the goods andservices the United States imports add significantly to our standard of living.
In the circular flow diagram in Figure 6.4 "Net Exports in the Circular Flow", net
exports are shown with an arrow connecting firms to the rest of the world. Thebalance between the flows of exports and imports is net exports. When there is atrade surplus, net exports are positive and add spending to the circular flow. A
trade deficit implies negative net exports; spending flows from firms to the rest of
the world.
The production of goods and services for personal
consumption, private investment, government
Figure 6.4 Net Exports inpurchases, and net exports makes up a nation’s GDP.
the Circular FlowFirms produce these goods and services in response to
demands from households (personal consumption),from other firms (private investment), fromgovernment agencies (government purchases), andfrom the rest of the world (net exports). All of thisproduction creates factor income for households. Figure
6.5 "Spending in the Circular Flow Model" shows thecircular flow model for all the spending flows we havediscussed. Each flow is numbered for use in the exercise Net exports represent thebalance between exports andat the end of this section.
imports. Net exports can bepositive or negative. If they are

10. Negative net exports.
11. Positive net exports.

6.1 Measuring Total Output

236

Chapter 6 Measuring Total Output and Income

The circular flow model identifies some of the forces atwork in the economy, forces that we will be studying inlater chapters. For example, an increase in any of theflows that place demands on firms (personal
consumption, private investment, government
purchases, and exports) will induce firms to expand
their production. This effect is characteristic of the
expansion phase of the business cycle. An increase inproduction will require firms to employ more factors of
production, which will create more income forhouseholds. Households are likely to respond with moreconsumption, which will induce still more production,
more income, and still more consumption. Similarly, a
reduction in any of the demands placed on firms willlead to a reduction in output, a reduction in firms’ useof factors of production, a reduction in householdincomes, a reduction in income, and so on. Thissequence of events is characteristic of the contraction
phase of the business cycle. Much of our work in
macroeconomics will involve an analysis of the forcesthat prompt such changes in demand and an
examination of the economy’s response to them.
Figure 6.6 "Components of GDP, 2011 in Billions of
Dollars" shows the size of the components of GDP in
2011. We see that the production of goods and services
for personal consumption accounted for about 70% of
GDP. Imports exceeded exports, so net exports were
negative.

6.1 Measuring Total Output

positive, net export spendingflows from the rest of the world
to firms. If they are negative,
spending flows from firms to therest of the world.

Figure 6.5 Spending in the
Circular Flow Model

GDP equals the sum of
production by firms of goods andservices for personal
consumption (1), private
investment (2), government
purchases (3), and net exports(4). The circular flow modelshows these flows and shows thatthe production of goods andservices generates factor incomes(5) to households.

237

Chapter 6 Measuring Total Output and Income

Figure 6.6 Components of GDP, 2011 in Billions of Dollars

Consumption makes up the largest share of GDP. Net exports were negative in 2011. Total GDP—the sum of personal
consumption, private investment, government purchases, and net exports—equaled $15,094.4 billion in 2011.
Source: Bureau of Economic Analysis, National Income and Product Accounts, Table 1.1.5 (revised February 29,
2012)

Final Goods and Value Added
GDP is the total value of all final goods and services produced during a particularperiod valued at prices in that period. That is not the same as the total value of all
goods and services produced during a period. This distinction gives us anothermethod of estimating GDP in terms of output.
Suppose, for example, that a logger cuts some trees and sells the logs to a sawmill.
The mill makes lumber and sells it to a construction firm, which builds a house. The
market price for the lumber includes the value of the logs; the price of the houseincludes the value of the lumber. If we try to estimate GDP by adding the value ofthe logs, the lumber, and the house, we would be counting the lumber twice and thelogs three times. This problem is called “double counting,” and the economists who
compute GDP seek to avoid it.
In the case of logs used for lumber and lumber produced for a house, GDP would
include the value of the house. The lumber and the logs would not be counted as

6.1 Measuring Total Output

238

Chapter 6 Measuring Total Output and Income

additional production because they are intermediate goods that were produced foruse in building the house.
Another approach to estimating the value of final production is to estimate for eachstage of production the value added12, the amount by which the value of a firm’s
output exceeds the value of the goods and services the firm purchases from otherfirms. Table 6.1 "Final Value and Value Added" illustrates the use of value added in
the production of a house.
Table 6.1 Final Value and Value Added
Good
Logs

Produced by

Price

Value Added

Sawmill$12,000$12,000

Construction firm

$25,000$13,000

Construction firm Household$125,000$100,000

Final Value$125,000

LoggerLumber Sawmill
House

Purchased by

Sum of Values Added$125,000If we sum the value added at each stage of the production of a good or service, we
get the final value of the item. The example shown here involves the constructionof a house, which is produced from lumber that is, in turn, produced from logs.
Suppose the logs produced by the logger are sold for $12,000 to a mill, and that themill sells the lumber it produces from these logs for $25,000 to a construction firm.
The construction firm uses the lumber to build a house, which it sells to ahousehold for $125,000. (To simplify the example, we will ignore inputs other thanlumber that are used to build the house.) The value of the final product, the house,
is $125,000. The value added at each stage of production is estimated as follows:a. The logger adds $12,000 by cutting the logs.
b. The mill adds $13,000 ($25,000 − $12,000) by cutting the logs into
lumber.
c. The construction firm adds $100,000 ($125,000 − $25,000) by using thelumber to build a house.
12. The amount by which the valueof a firm’s output exceeds thevalue of the goods and services
the firm purchases from otherfirms.

6.1 Measuring Total Output

The sum of values added at each stage ($12,000 + $13,000 + $100,000) equals the final
value of the house, $125,000.

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Chapter 6 Measuring Total Output and Income

The value of an economy’s output in any period can thus be estimated in either of
two ways. The values of final goods and services produced can be added directly, or
the values added at each stage in the production process can be added. The
Commerce Department uses both approaches in its estimate of the nation’s GDP.

GNP: An Alternative Measure of Output
While GDP represents the most commonly used measure of an economy’s output,
economists sometimes use an alternative measure. Gross national product (GNP)13
is the total value of final goods and services produced during a particular periodwith factors of production owned by the residents of a particular country.
The difference between GDP and GNP is a subtle one. The GDP of a country equals
the value of final output produced within the borders of that country; the GNP of acountry equals the value of final output produced using factors owned by residentsof the country. Most production in a country employs factors of production owned
by residents of that country, so the two measures overlap. Differences between thetwo measures emerge when production in one country employs factors of
production owned by residents of other countries.
Suppose, for example, that a resident of Bellingham, Washington, owns andoperates a watch repair shop across the Canadian–U.S. border in Victoria, British
Columbia. The value of watch repair services produced at the shop would becounted as part of Canada’s GDP because they are produced in Canada. That value
would not, however, be part of U.S. GDP. But, because the watch repair services
were produced using capital and labor provided by a resident of the United States,
they would be counted as part of GNP in the United States and not as part of GNP in
Canada.
Because most production fits in both a country’s GDP as well as its GNP, there isseldom much difference between the two measures. The relationship between GDP
and GNP is given by
Equation 6.3

GDP + net income received from abroad by residents of a nation = GNP
13. The total value of final goods
and services produced during aparticular period with factorsof production owned by theresidents of a particularcountry.

6.1 Measuring Total Output

In the third quarter of 2011, for example, GDP equaled $15,176.1 billion. We add
income receipts of $792.2 billion earned by residents of the United States from therest of the world and then subtract income payments of $524.9 billion that wentfrom the United States to the rest of the world to get GNP of $15,443.4 billion for the240Chapter 6 Measuring Total Output and Income

third quarter of 2011. GNP is often used in international comparisons of income; weshall examine those later in this chapter.

KEY TAKEAWAYS• GDP is the sum of final goods and services produced for consumption (C),private investment (I), government purchases (G), and net exports (Xn).
Thus GDP = C + I + G + Xn.
• GDP can be viewed in the context of the circular flow model.
Consumption goods and services are produced in response to demands
from households; investment goods are produced in response to
demands for new capital by firms; government purchases include goods
and services purchased by government agencies; and net exports equal
exports less imports.
• Total output can be measured two ways: as the sum of the values of final
goods and services produced and as the sum of values added at eachstage of production.
• GDP plus net income received from other countries equals GNP. GNP is
the measure of output typically used to compare incomes generated bydifferent economies.

6.1 Measuring Total Output

241

Chapter 6 Measuring Total Output and Income

TRY IT!
Here is a two-part exercise.

1. Suppose you are given the following data for an economy:
Personal consumption$1,000Home construction

100

Increase in inventories

40

Equipment purchases by firms

60

Government purchases

100

Social Security payments to households

40

Government welfare payments

100

Exports

50

Imports

150

Identify the number of the flow in Figure 6.5 "Spending in the
Circular Flow Model" to which each of these items corresponds.
What is the economy’s GDP?
2. Suppose a dairy farm produces raw milk, which it sells for $1,000 to adairy. The dairy produces cream, which it sells for $3,000 to an ice cream
manufacturer. The ice cream manufacturer uses the cream to make ice
cream, which it sells for $7,000 to a grocery store. The grocery store sells
the ice cream to consumers for $10,000. Compute the value added ateach stage of production, and compare this figure to the final value ofthe product produced. Report your results in a table similar to thatgiven in Table 6.1 "Final Value and Value Added".

6.1 Measuring Total Output

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Chapter 6 Measuring Total Output and Income

Case in Point: The Spread of the Value Added Tax

Outside the United States, the value added tax (VAT) has become commonplace.
Governments of more than 120 countries use it as their primary means ofraising revenue. While the concept of the VAT originated in France in the
1920s, no country adopted it until after World War II. In 1948, France became
the first country in the world to use the VAT. In 1967, Brazil became the first
country in the Western Hemisphere to do so. The VAT spread to other western
European and Latin American countries in the 1970s and 1980s and then tocountries in the Asia/Pacific region, central European and former Soviet Unionarea, and Africa in the 1990s and early 2000s.
What is the VAT? It is equivalent to a sales tax on final goods and services but iscollected at each stage of production.
Take the example given in Table 6.1 "Final Value and Value Added", which is a
simplified illustration of a house built in three stages. If there were a sales tax
of 10% on the house, the household buying it would pay $137,500, of which theconstruction firm would keep $125,000 of the total and turn $12,500 over to thegovernment.
With a 10% VAT, the sawmill would pay the logger $13,200, of which the logger
would keep $12,000 and turn $1,200 over to the government. The sawmill would
sell the lumber to the construction firm for $27,500—keeping $26,200, which is
the $25,000 for the lumber itself and $1,200 it already paid in tax. The
government at this stage would get $1,300, the difference between the $2,500
the construction firm collected as tax and the $1,200 the sawmill already paidin tax to the logger at the previous stage. The household would pay theconstruction firm $137,500. Of that total, the construction firm would turn overto the government $10,000, which is the difference between the $12,500 it

6.1 Measuring Total Output

243Chapter 6 Measuring Total Output and Income

collected for the government in tax from the household and the $2,500 in tax
that it already paid when it bought the lumber from the sawmill. The tablebelow shows that in the end, the tax revenue generated by a 10% VAT is thesame as that generated by a 10% tax on final sales.
Why bother to tax in stages instead of just on final sales? One reason is simply
record keeping, since it may be difficult to determine in practice if any
particular sale is the final one. In the example, the construction firm does notneed to know if it is selling the house to a household or to some intermediarybusiness.
Also, the VAT may lead to higher revenue collected. For example, even if
somehow the household buying the house avoided paying the tax, thegovernment would still have collected some tax revenue at earlier stages of
production. With a tax on retail sales, it would have collected nothing. The VAT
has another advantage from the point of view of government agencies. It has
the appearance at each stage of taking a smaller share. The individual amounts
collected are not as obvious to taxpayers as a sales tax might be.

= Value
Added Tax

$1,200− $0= $1,200$13,000$2,500− $1,200= $1,300$100,000$12,500− $2,500= $10,000$16,200−$3,700= $12,500

Price

Logs

$12,000$12,000

Lumber$25,000

House$125,000

Total

6.1 Measuring Total Output− Tax
Already
Paid

Value
Tax
Added Collected

Good

244

Chapter 6 Measuring Total Output and Income

ANSWER TO TRY IT! PROBLEM

1. GDP equals $1,200 and is computed as follows (the numbers inparentheses correspond to the flows in Figure 6.5 "Spending in
the Circular Flow Model"):Personal consumption (1)$1,000Private investment (2)200

Housing100

Equipment and software

60

Inventory change

40

Government purchases (3)100Net exports (4)

−100

GDP

$1,200

Notice that neither welfare payments nor Social Security
payments to households are included. These are transfer
payments, which are not part of the government purchases
component of GDP.
2. Here is the table of value added.
Produced byPurchased by

Price

Value
Added

Raw milk

Dairy farm

Dairy

$1,000$1,000

Cream

Dairy

Ice cream
maker

3,000

2,000

Ice cream

Ice cream
manufacturer

Grocery store

7,000

4,000

Retail ice
cream

Grocery store

Consumer

10,000

3,000

Final Value$10,000

Good

6.1 Measuring Total Output

245

Chapter 6 Measuring Total Output and Income

Good

Produced byPurchased by
Sum ofValuesAdded

6.1 Measuring Total Output

Price

Value
Added
$10,000

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Chapter 6 Measuring Total Output and Income

6.2 Measuring Total Income
LEARNING OBJECTIVES
1. Define gross domestic income and explain its relationship to grossdomestic product.
2. Discuss the components of gross domestic income.
3. Define disposable personal income and explain how to calculate it fromGDP.

We saw in the last section that the production of goods and services generates
factor incomes to households. The production of a given value of goods and services
generates an equal value of total income. Gross domestic income (GDI)14 equals
the total income generated in an economy by the production of final goods andservices during a particular period. It is a flow variable. Because an economy’s total
output equals the total income generated in producing that output, GDP = GDI. We
can estimate GDP either by measuring total output or by measuring total income.
Consider a $4 box of Cheerios. It is part of total output and thus is part of GDP. Whogets the $4? Part of the answer to that question can be found by looking at the
cereal box. Cheerios are made from oat flour, wheat starch, sugar, salt, and a varietyof vitamins and minerals. Therefore, part of the $4 goes to the farmers who grew
the oats, the wheat, and the beets or cane from which the sugar was extracted.
Workers and machines at General Mills combined the ingredients, crafted all thoselittle O’s, toasted them, and put them in a box. The workers were paid part of the $4
as wages. The owners of General Mills and the capital it used received part of the $4
as profit. The box containing the Cheerios was made from a tree, so a lumber
company somewhere received part of the $4. The truck driver who brought the boxof cereal to the grocery store got part of the $4, as did the owner of the truck itself
and the owner of the oil that fueled the truck. The clerk who rang up the sale at thegrocery store was paid part of the $4. And so on.

14. The total income generated inan economy by the productionof final goods and services
during a particular period.

How much of the $4 was income generated in the production of the Cheerios? The
answer is simple: all of it. Some of the money went to workers as wages. Some went
to owners of the capital and natural resources used to produce it. Profits generated
along the way went to the owners of the firms involved. All these items represent
costs of producing the Cheerios and also represent income to households.

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Chapter 6 Measuring Total Output and Income

Part of the $4 cost of the Cheerios, while it makes up a portion of GDI, does not
represent ordinary income actually earned by households. That part results fromtwo other production costs: depreciation and taxes related to the production of theCheerios. Nevertheless, they are treated as a kind of income; we will examine theirrole in GDI below.
As it is with Cheerios, so it is with everything else. The value of output equals theincome generated as the output is produced.

The Components of GDI
Employee compensation is the largest among the components of factor income.
Factor income also includes profit, rent, and interest. In addition, GDI includes
charges for depreciation and taxes associated with production. Depreciation andproduction-related taxes, such as sales taxes, make up part of the cost of producing
goods and services and must be accounted for in estimating GDI. We will discusseach of these components of GDI next.

Employee Compensation
Compensation of employees in the form of wages, salaries, and benefits makes up
the largest single component of income generated in the production of GDP. In thethird quarter of 2011, employee compensation represented 55% of GDI.
The structure of employee compensation has changed dramatically in the last
several decades. In 1950, virtually all employee compensation—95% of it—came in
the form of wages and salaries. The remainder, about 5%, came in the form of
additional benefits such as employer contributions to retirement programs andhealth insurance. In 2011, the share of benefits was nearly 20% of total employeecompensation.

Profits
The profit component of income earned by households equals total revenues offirms less costs as measured by conventional accounting. Profits amounted to about
17% of GDI in 2011, down sharply from five decades earlier, when profits
represented about 25% of the income generated in GDI.Although reported
separately by the Department of Commerce, we have combined proprietors’ income(typically independent business owners and farmers) with corporate profits tosimplify the discussion.

6.2 Measuring Total Income248Chapter 6 Measuring Total Output and Income

Profits are the reward the owners of firms receive for being in business. The
opportunity to earn profits is the driving force behind production in a market
economy.

Rental Income
Rental income, such as the income earned by owners of rental housing or payments
for the rent of natural resources, is the smallest component of GDI (less than 3%); it
is the smallest of the income flows to households. The meaning of rent in thecomputation of GDI is the same as its meaning in conventional usage; it is a charge
for the temporary use of some capital asset or natural resource.If you have studied
microeconomics, you know that the term “rent” in economics has a quite different
meaning. The national income and product accounts use the accounting, not theeconomic, meaning of “rent.”

Net Interest
Businesses both receive and pay interest. GDI includes net interest, which equals
interest paid less interest received by domestic businesses, plus interest received
from foreigners less interest paid to foreigners. Interest payments on mortgage andhome improvement loans are counted as interest paid by businesses, because
homeowners are treated as businesses in the income accounts. In 2011, net interest
accounted for about 5% of GDI.

Depreciation
Over time the machinery and buildings that are used to produce goods and services
wear out or become obsolete. A farmer’s tractor, for example, wears out as it isused. A technological change may make some equipment obsolete. The introductionof personal computers, for example, made the electric typewriters used by many
firms obsolete. Depreciation15 is a measure of the amount of capital that wears out
or becomes obsolete during a period. Depreciation is referred to in official reports
as the consumption of fixed capital.
Depreciation is a cost of production, so it represents part of the price charged forgoods and services. It is therefore counted as part of the income generated in the
production of those goods and services. Depreciation represented about 13% of GDI
in 2011.
15. A measure of the amount of
capital that wears out or
becomes obsolete during aperiod.

6.2 Measuring Total Income249

Chapter 6 Measuring Total Output and Income

Indirect Taxes
The final component of the income measure of GDI is indirect business taxes.The
adjustment for indirect business taxes includes two other minor elements: transfer
payments made by business firms and surpluses or deficits of government
enterprises. Indirect taxes16 are taxes imposed on the production or sale of goods
and services or on other business activity. (By contrast, a direct tax17 is a tax
imposed directly on income; the personal income and corporate income taxes are
direct taxes.) Indirect taxes, which include sales and excise taxes and property
taxes, make up part of the cost to firms of producing goods and services. Like
depreciation, they are part of the price of those goods and services and are
therefore treated as part of the income generated in their production. Indirectbusiness taxes amounted to nearly 8% of GDI in 2011.
Table 6.2 "GDP and GDI, 2011" shows the components of GDI in the third quarter of
2011. Employee compensation represented the largest share of GDI. The exhibit also
shows the components of GDP for the same year.
In principle, GDP and GDI should be equal, but their estimated values never are,because the data come from different sources. Output data from a sample of firms
are used to estimate GDP, while income data from a sample of households are used
to estimate GDI. The difference is the statistical discrepancy shown in the righthand column of Table 6.2 "GDP and GDI, 2011". Some of the difficulties with thesedata are examined in the Case in Point feature on discrepancies between GDP and
GDI.
Table 6.2 GDP and GDI, 2011
Grossdomestic
product

16. Taxes imposed on the
production or sale of goods andservices or on other businessactivity.
17. Taxes imposed directly on
income.

6.2 Measuring Total Income$15,176.1 Gross domestic income$15,214.8

Personal
consumption $10,784.5 Compensation of employees
expenditures

8,347.3

Grossprivatedomestic
investment

ProfitsProfit is corporate profit ($1,519.3) plus
$1,906.6 proprietors’ income ($1,113.7), both with inventory
valuation and capital consumption adjustment.

2,633.0

Government
consumption
expenditures$3,047.3 Rental income of persons

406.3

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Chapter 6 Measuring Total Output and Income

and grossinvestment
Net exportsof goods andservices−$562.3 Net interest

710.3

Taxes on production and importsIndirect taxes
include taxes on production and imports of $1,100.0
plus business transfer payments ($133.7) lesssubsidies ($64.2) and current surplus of government
enterprise ($14.5). Prior to the 2003 National Income
and Product Accounts (NIPA) revisions, the category“taxes on production and imports” was, with sometechnical and other minor adjustments, referred to as“indirect business taxes.” See Brent R. Moulton andEugene P. Seskin, “Preview of the 2003
Comprehensive Revision of the National Income andProduct Accounts,” Bureau of Economic Analysis,
Survey of Current Business, June 2003, pp. 17–34.

1,155.1

Consumption of fixed capital (depreciation)

1,962.8

Statistical discrepancy−38.7

The table shows the composition of GDP and GDI in the third quarter of 2011 (inbillions of dollars at an annual rate). Notice the rough equality of the two measures.
(They are not quite equal because of measurement errors; the difference is due to astatistical discrepancy and is reduced significantly over time as the data arerevised.)Source: Bureau of Economic Analysis, National Income and Product Accounts, Tables
1.10 and 1.1.5 (revised February 29, 2012).

Tracing Income from the Economy to Households
We have seen that the production of goods and services generates income forhouseholds. Thus, the value of total output equals the value of total income in an
economy. But we have also seen that our measure of total income, GDI, includes
such things as depreciation and indirect business taxes that are not actually
received by households. Households also receive some income, such as transfer
payments, that does not count as part of GDP or GDI. Because the income
households actually receive plays an important role in determining theirconsumption, it is useful to examine the relationship between a nation’s total
output and the income households actually receive.

6.2 Measuring Total Income251Chapter 6 Measuring Total Output and Income

Table 6.3 "From GDP to Disposable Personal Income" traces the path we take ingoing from GDP to disposable personal income18, which equals the income
households have available to spend on goods and services. We first convert GDP to
GNP and then subtract elements of GNP that do not represent income received byhouseholds and add payments such as transfer payments that households receive
but do not earn in the production of GNP. Disposable personal income is either
spent for personal consumption or saved by households.
Table 6.3 From GDP to Disposable Personal Income
GDP + net factor earnings from abroad= gross national product (GNP)

GNP − depreciation (consumption of fixed capital)= net national product (NNP)

NNP − statistical discrepancy= national income (NI)NI − income earned but not received [e.g., taxes on
production and imports, social security payroll
taxes, corporate profit taxes, and retained earnings]+ transfer payments and other income received but
not earned in the production of GNP= personal income (PI)PI − personal income taxes= disposable personal income (DPI)

GDP, a measure of total output, equals GDI, the total income generated in the
production of goods and services in an economy. The chart traces the path from
GDP to disposable personal income, which equals the income households actually
receive. We first convert GDP to GNP. Then, we subtract depreciation to obtain net
national product and subtract the statistical discrepancy to arrive at national
income (i.e., gross national income [GNI] net of depreciation and the statistical
discrepancy). Next, we subtract components of GNP and GNI that do not represent
income actually received by households, such as taxes on production and imports,
corporate profit and payroll taxes (contributions to social insurance), and corporate
retained earnings. We add items such as transfer payments that are income tohouseholds but are not part of GNP and GNI. The adjustments shown are the mostimportant adjustments in going from GNP and GNI to disposable personal income;several smaller adjustments (e.g., subsidies, business current transfer payments[net], and current surplus of government enterprises) have been omitted.

18. The income households haveavailable to spend on goods
and services.

6.2 Measuring Total Income252Chapter 6 Measuring Total Output and Income

KEY TAKEAWAYS• Gross domestic product, GDP, equals gross domestic income, GDI, which
includes compensation, profits, rental income, indirect taxes, anddepreciation.
• We can use GDP, a measure of total output, to compute disposable
personal income, a measure of income received by households andavailable for them to spend.

TRY IT!
The following income data refer to the same economy for which you had
output data in the first part of the previous Try It! Compute GDI from thedata below and confirm that your result equals the GDP figure you computedin the previous Try It! Assume that GDP = GNP for this problem (that is,
assume all factor incomes are earned and paid in the domestic economy).
Employee compensation

6.2 Measuring Total Income$700

Social Security payments to households

40

Welfare payments

100

Profits

200

Rental income

50

Net interest

25

Depreciation

50

Indirect taxes

175

253

Chapter 6 Measuring Total Output and Income

Case in Point: The GDP–GDI Gap

GDP equals GDI; at least, that is the way it is supposed to work. But in anenormously complex economy, the measurement of these two variables
inevitably goes awry. Estimates of the two are never quite equal. In recent
years, the absolute value of the gap has been quite sizable, while in other years,
it has been quite small. For example, for the years 2006 through 2010, GDI has
differed from GDP by −242.3, −12.0, −2.4, 77.4, and 0.8 billion per year,
respectively.
Although the gap seems large at times, it represents a remarkably small
fraction of measured activity—around 1% or less. Of course, 1% of a big number
is still a big number. But it is important to remember that, relative to the size ofthe economy, the gap between GDI and GDP is not large. The gap is listed as a“statistical discrepancy” in the Department of Commerce reporting of the two
numbers.
Why does the gap exist? From an accounting point of view, it should not. The
total value of final goods and services produced must be equal to the total valueof income generated in that production. But output is measured from sales andinventory figures collected from just 10% of commercial establishments.
Preliminary income figures are obtained from household surveys, but these
represent a tiny fraction of households. More complete income data areprovided by income tax returns, but these are available to the economists who
estimate GDI only after a two- to four-year delay.
The Department of Commerce issues revisions of its GDP and GDI estimates as
more complete data become available. With each revision, the gap between GDP
and GDI estimates is significantly reduced.

6.2 Measuring Total Income

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Chapter 6 Measuring Total Output and Income

While GDP and GDI figures cannot provide precise measures of economic
activity, they come remarkably close. Indeed, given that the numbers comefrom entirely different sources, the fact that they come as close as they doprovides an impressive check of the accuracy of the department’s estimates of
GDP and GDI.

ANSWER TO TRY IT! PROBLEM
GDI equals $1,200. Note that this value equals the value for GDP obtained
from the estimate of output in the first part of the previous Try It! Here isthe computation:
Employee compensation$700

Profits

200

Rental income

50

Net interest

25

Depreciation

50

Indirect taxes

175

GDI

$1,200Once again, note that Social Security and welfare payments to households
are transfer payments. They do not represent payments to household
factors of production for current output of goods and services, and therefore
are not included in GDI.

6.2 Measuring Total Income255Chapter 6 Measuring Total Output and Income

6.3 GDP and Economic Well-Being
LEARNING OBJECTIVES
1. Discuss and give examples of measurement and conceptual problems inusing real GDP as a measure of economic performance and of economic
well-being.
2. Explain the use of per capita real GNP or GDP to compare economic
performance across countries and discuss its limitations.

GDP is the measure most often used to assess the economic well-being of a country.
Besides measuring the pulse of a country, it is the figure used to compare living
standards in different countries.
Of course, to use GDP as an indicator of overall economic performance, we must
convert nominal GDP to real GDP, since nominal values can rise or fall simply as aresult of changes in the price level. For example, the movie Avatar, released in 2009,
brought in $761 million—the highest amount to date in gross box office receipts,
while Gone with the Wind, released in 1939, earned only $199 million and ranks 117th
in terms of nominal receipts. But does that mean that Avatar actually did better
than Gone with the Wind? After all, the average price of a movie ticket in 1939 wasabout 25 cents. At the time of Avatar, the average ticket price was about $7.50. A
better way to compare these two movies in terms of popularity is to control for the
price of movie tickets—the same strategy that economists use with real GDP inorder to determine whether output is rising or falling. Adjusting the nominal boxoffice receipts using 2012 movie prices to obtain real revenue reveals that in realterms Gone with the Wind continues to be the top real grosser of all time with real
box-office receipts of about $1.6 billion. Avatar’s real box-office receipts amounted
to a mere $776 million.Based on estimates at “Domestic Grosses Adjusted for Ticket
Price Inflation,” Box Office Mojo, accessed April 10, 2012,
http://boxofficemojo.com/alltime/adjusted.htm. As illustrated by this example onrevenues from popular movies, we might draw erroneous conclusions about
performance if we base them on nominal values instead of on real values. In
contrast, real GDP, despite the problems with price indexes that were explained inanother chapter, provides a reasonable measure of the total output of an economy,
and changes in real GDP provide an indication of the direction of movement in total
output.

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Chapter 6 Measuring Total Output and Income

We begin this section by noting some of the drawbacks of using real GDP as ameasure of the economic welfare of a country. Despite these shortcomings, we will
see that it probably remains our best single indicator of macroeconomic
performance.

Measurement Problems in Real GDP
There are two measurement problems, other than those associated with adjustingfor price level changes, in using real GDP to assess domestic economic performance.

Revisions
The first estimate of real GDP for a calendar quarter is called the advance estimate.
It is issued about a month after the quarter ends. To produce a measure so quickly,
officials at the Department of Commerce must rely on information from relatively
few firms and households. One month later, it issues a revised estimate, and amonth after that it issues its final estimate. Often the advance estimate of GDP and
the final estimate do not correspond. The recession of 2001, for example, began in
March of that year. But the first estimates of real GDP for the second and third
quarters of 2001 showed output continuing to rise. It was not until later revisions
that it became clear that a recession had been under way.
But the revision story does not end there. Every summer, the Commerce
Department issues revised figures for the previous two or three years. Once every
five years, the department conducts an extensive analysis that traces flows of
inputs and outputs throughout the economy. It focuses on the outputs of somefirms that are inputs to other firms. In the process of conducting this analysis, thedepartment revises real GDP estimates for the previous five years. Sometimes therevisions can paint a picture of economic activity that is quite different from theone given even by the revised estimates of GDP. For example, revisions of the data
for the 1990–1991 recession issued several years later showed that the recession had
been much more serious than had previously been apparent, and the recovery was
more pronounced. Concerning the most recent recession, the first estimates offourth quarter 2008 GDP showed that the U.S. economy shrank by 3.8%. The firstrevision, however, showed a drop of 6.8%, and the second revision showed a drop of
8.9%!

The Service Sector
Another problem lies in estimating production in the service sector. The output ofgoods in an economy is relatively easy to compute. There are so many bushels ofcorn, so many pounds of beef. But what is the output of a bank? Of a hospital? It is

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easy to record the dollar value of output to enter in nominal GDP, but estimating
the quantity of output to use in real GDP is quite another matter. In some cases, theDepartment of Commerce estimates service sector output based on the quantity oflabor used. For example, if this technique were used in the banking industry andbanking used 10% more labor, the department would report that production has
risen 10%. If the number of employees remains unchanged, reported output
remains unchanged. In effect, this approach assumes that output per
worker—productivity—in those sectors remains constant when studies haveindicated that productivity has increased greatly in the service sector. Since 1990
progress has been made in measurement in this area, which allows in particular for
better estimation of productivity changes and price indexes for different service
sector industries, but more remains to be done in this large sector of the U.S.
economy.Jack E. Triplett and Barry P. Bosworth, “The State of Data for Services
Productivity Measurement in the United States,” International Productivity Monitor 16(Spring 2008): 53–70.

Conceptual Problems with Real GDP
A second set of limitations of real GDP stems from problems inherent in theindicator itself. Real GDP measures market activity. Goods and services that are
produced and exchanged in a market are counted; goods and services that are
produced but that are not exchanged in markets are not.There are two exceptions
to this rule. The value of food produced and consumed by farm households iscounted in GDP. More important, an estimate of the rental values of owneroccupied homes is included. If a family rents a house, the rental payments areincluded in GDP. If a family lives in a house it owns, the Department of Commerce
estimates what the house would rent for and then includes that rent in the GDP
estimate, even though the house’s services were not exchanged in the marketplace.

Household Production
Suppose you are considering whether to eat at home for dinner tonight or to eat
out. You could cook dinner for yourself at a cost of $5 for the ingredients plus anhour or so of your time. Alternatively, you could buy an equivalent meal at arestaurant for perhaps $15. Your decision to eat out rather than cook would add $10
to the GDP.
But that $10 addition would be misleading. After all, if you had stayed home you
might have produced an equivalent meal. The only difference is that the value of
your time would not have been counted. But surely your time is not worthless; it isjust not counted. Similarly, GDP does not count the value of your efforts to clean
your own house, to wash your own car, or to grow your own vegetables. In general,

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GDP omits the entire value added by members of a household who do household
work themselves.
There is reason to believe this omission is serious. Economists J. Steven Landefeld
and Stephanie H. McCulla of the U.S. Bureau of Economic Analysis estimated in a2000 paper the value of household output from 1946 to 1997. Their estimate ofhousehold output in 1946 was 50% of reported GDP. Since then, that percentage has
fallen, because more women have entered the workforce, so that more productionthat once took place in households now occurs in the market. Households now eat
out more, purchase more prepared foods at the grocery store, hire out child-careservices they once performed themselves, and so on. Their estimate for 1997, forexample, suggests that household production amounted to 36% of reported GDP.J.
Steven Landefeld and Stephanie H. McCulla, “Accounting for Nonmarket Household
Production within a National Accounts Framework,” Review of Income & Wealth 46,
no. 3 (September 2000): 289–307.
This problem is especially significant when GDP is used to make comparisons acrosscountries. In low-income countries, a much greater share of goods and services is
not exchanged in a market. Estimates of GDP in such countries are adjusted toreflect nonmarket production, but these adjustments are inevitably imprecise.

Underground and Illegal Production
Some production goes unreported in order to evade taxes or the law. It is not likely
to be counted in GDP. Legal production for which income is unreported in order toevade taxes generally takes place in what is known as the “underground economy.”
For example, a carpenter might build a small addition to a dentist’s house in
exchange for orthodontic work for the carpenter’s children. Although income has
been earned and output generated in this example of bartering, the transaction isunlikely to be reported for income tax or other purposes and thus is not counted inGDP. Illegal activities are not reported for income taxes for obvious reasons and arethus difficult to include in GDP.

LeisureLeisure is an economic good. All other things being equal, more leisure is better
than less leisure.
But all other things are not likely to be equal when it comes to consuming leisure.
Consuming more leisure means supplying less work effort. And that means
producing less GDP. If everyone decided to work 10% fewer hours, GDP would fall.
But that would not mean that people were worse off. In fact, their choice of more

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leisure would suggest they prefer the extra leisure to the goods and services theygive up by consuming it. Consequently, a reduction in GDP would be accompanied
by an increase in satisfaction, not a reduction.

The GDP Accounts Ignore “Bads”
Suppose a wave of burglaries were to break out across the United States. One would
expect people to respond by buying more and louder burglar alarms, better locks,
fiercer German shepherds, and more guard services than they had before. To theextent that they pay for these by dipping into savings rather than replacing otherconsumption, GDP increases. An epidemic might have much the same effect on GDP
by driving up health-care spending. But that does not mean that crime and disease
are good things; it means only that crime and disease may force an increase in the
production of goods and services counted in the GDP.
Similarly, the GDP accounts ignore the impact of pollution on the environment. We
might produce an additional $200 billion in goods and services but create pollutionthat makes us feel worse off by, say, $300 billion. The GDP accounts simply report
the $200 billion in increased production. Indeed, some of the environmental
degradation might itself boost GDP. Dirtier air may force us to wash clothes more
often, to paint buildings more often, and to see the doctor more often, all of which
will tend to increase GDP!

Conclusion: GDP and Human Happiness
More GDP cannot necessarily be equated with more human happiness. But more
GDP does mean more of the goods and services we measure. It means more jobs. It
means more income. And most people seem to place a high value on these things.
For all its faults, GDP does measure the production of most goods and services. And
goods and services get produced, for the most part, because we want them. We
might thus be safe in giving two cheers for GDP—and holding back the third inrecognition of the conceptual difficulties that are inherent in using a single number
to summarize the output of an entire economy.

International Comparisons of Real GDP and GNP
Real GDP or GNP estimates are often used in comparing economic performance
among countries. In making such comparisons, it is important to keep in mind thegeneral limitations to these measures of economic performance that we noted
earlier. Further, countries use different methodologies for collecting and compilingdata.

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Three other issues are important in comparing real GDP or GNP for different
countries: the adjustment of these figures for population, adjusting to a common
currency, and the incorporation of nonmarket production.
In international comparisons of real GNP or real GDP, economists generally makecomparisons not of real GNP or GDP but of per capita real GNP or GDP19, whichequals a country’s real GNP or GDP divided by its population. For example, suppose
Country A has a real GDP of about $4,000 billion and Country B has a real GDP of
about $40 billion. We can conclude that Country A produced 100 times more goods
and services than did Country B. But if Country A has 200 times as many people asCountry B (for example, 200 million people in Country A and 1 million in CountryB), then Country A’s per capita output will be half that of Country B ($20,000 versus$40,000 in this example).
Figure 6.7 "Comparing Per Capita Real GNP, 2010" compares per capita real GNP for
11 countries in 2010. It is based on data that uses a measure called “international
dollars” in order to correct for differences in the purchasing power of $1 acrosscountries. The data also attempt to adjust for nonmarket production (such as thatof rural families that grow their own food, make their own clothing, and produce
other household goods and services themselves).
Figure 6.7 Comparing Per Capita Real GNP, 2010

There is a huge gap between per capita income in one of the poorest countries in the world, the Democratic Republicof Congo, and wealthier nations such as the United States and Luxembourg.
Source: World Bank, World Development Indicators Online

19. A country’s real GNP or GDP
divided by its population.

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The disparities in income are striking; Luxembourg, the country with the highest
per capita real GNP, had an income level nearly 200 times greater than the
Democratic Republic of Congo, the country with the lowest per capita real GNP.
What can we conclude about international comparisons in levels of GDP and GNP?
Certainly we must be cautious. There are enormous difficulties in estimating any
country’s total output. Comparing one country’s output to another presents
additional challenges. But the fact that a task is difficult does not mean it is
impossible. When the data suggest huge disparities in levels of GNP per capita, forexample, we observe real differences in living standards.

KEY TAKEAWAYS• Real GDP or real GNP is often used as an indicator of the economic wellbeing of a country.
• Problems in the measurement of real GDP, in addition to problems
encountered in converting from nominal to real GDP, stem fromrevisions in the data and the difficulty of measuring output in some
sectors, particularly the service sector.
• Conceptual problems in the use of real GDP as a measure of economic
well-being include the facts that it does not include nonmarket
production and that it does not properly adjust for “bads” produced in
the economy.
• Per capita real GDP or GNP can be used to compare economic
performance in different countries.

TRY IT!
What impact would each of the following have on real GDP? Would economic
well-being increase or decrease as a result?
1. On average, people in a country decide to increase the number of hours
they work by 5%.
2. Spending on homeland security increases in response to a terrorist
attack.
3. The price level and nominal GDP increase by 10%.

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Case in Point: Per Capita Real GDP and Olympic Medal
CountsIn the popular lore, the Olympics provide an opportunity for the finest athletes
in the world to compete with each other head-to-head on the basis of raw
talent and hard work. And yet, contenders from Laos tend to finish last or close
to it in almost any event in which they compete. One Laotian athlete garnered
the unenviable record of having been the slowest entrant in the nearly halfcentury long history of the 20-kilometer walk. In contrast, U.S. athletes won
103 medals at the 2004 Athens Olympics and 110 medals at the 2008 Beijing
Olympics. Why do Laotians fare so poorly and Americans so well, with athletes
from other countries falling in between?
Economists Daniel K. N. Johnson and Ayfer Ali have been able to predict withastonishing accuracy the number of medals different countries will win on thebasis of a handful of factors, including population, climate, political structure,and real per capita GDP. For example, they predicted that the United States
would win 103 medals in Athens and that is precisely how many the UnitedStates won. They predicted 103 medals for the United States in Beijing; 110
were won. They did not expect the Laotians to win any medals in either Athensor Beijing, and that was indeed the outcome.
Johnson and Ali estimated that summer game participant nations average one
more medal per additional $1,000 of per capita real GDP. With per capita real
GDP in Laos less than the equivalent of $500 compared to per capita real GDP in
the United States of about $38,000, the results for these two nations could beconsidered a foregone conclusion. According to Johnson and Ali, “Highproductive capacity or income per person displays an ability to pay the costs
necessary to send athletes to the Games, and may also be associated with ahigher quality of training and better equipment.” For example, a Laotian
swimmer at Athens, Vilayphone Vongphachanh, had never practiced in an

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Olympic-size pool, and a runner, Sirivanh Ketavong, had worn the samerunning shoes for four years.
The good news is that as the per capita real GDP in some relatively poor
countries has risen, the improved living standards have led to increased
Olympic medal counts. China, for instance, won 28 medals in 1988 and 63 in
2004. As the host for the 2008 games, it won an impressive total of 100 medals.
While not a perfect measure of the well-being of people in a country, per capita
real GDP does tell us about the opportunities available to the average citizen ina country. Americans would surely find it hard to imagine living at the level ofconsumption of the average Laotian. In The Progress Paradox: How Life Gets Better
While People Feel Worse, essayist Gregg Easterbrook notes that a higher material
standard of living is not associated with higher reported happiness. But, heconcludes, the problems of prosperity seem less serious than those of poverty,
and prosperity gives people and nations the means to address problems. The
Olympic medal count for each nation strongly reflects its average standard ofliving and hence the opportunities available to its citizens.
Sources: Gregg Easterbrook, The Progress Paradox: How Life Gets Better While
People Feel Worse (New York: Random House, 2003); Daniel K. N. Johnson and
Ayfer Ali, “A Tale of Two Seasons: Participation and Medal Counts at theSummer and Winter Olympic Games,” Social Science Quarterly 84, no. 4(December 2004): 974–93; David Wallechinsky, “Why I’ll Cheer for Laos,” Parade
Magazine, August 8, 2004, p. 8.

ANSWER TO TRY IT! PROBLEM
1. Real GDP would increase. Assuming the people chose to increase theirwork effort and forgo the extra leisure, economic well-being would
increase as well.
2. Real GDP would increase, but the extra expenditure in the economy wasdue to an increase in something “bad,” so economic well-being would
likely be lower.
3. No change in real GDP. For some people, economic well-being might
increase and for others it might decrease, since inflation does not affecteach person in the same way.

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6.4 Review and PracticeSummaryThis chapter focused on the measurement of GDP. The total value of output (GDP) equals the total value ofincome generated in producing that output (GDI). We can illustrate the flows of spending and income throughthe economy with the circular flow model. Firms produce goods and services in response to demands fromhouseholds (personal consumption), other firms (private investment), government agencies (government
purchases), and the rest of the world (net exports). This production, in turn, creates a flow of factor incomes tohouseholds. Thus, GDP can be estimated using two types of data: (1) data that show the total value of output and(2) data that show the total value of income generated by that output.
In looking at GDP as a measure of output, we divide it into four components: consumption, investment,
government purchases, and net exports. GDP equals the sum of final values produced in each of these areas. It
can also be measured as the sum of values added at each stage of production. The components of GDP measured
in terms of income (GDI) are employee compensation, profits, rental income, net interest, depreciation, andindirect taxes.
We also explained other measures of income such as GNP and disposable personal income. Disposable personal
income is an important economic indicator, because it is closely related to personal consumption, the largest
component of GDP.
GDP is often used as an indicator of how well off a country is. Of course, to use it for this purpose, we must be
careful to use real GDP rather than nominal GDP. Still, there are problems with our estimate of real GDP.
Problems encountered in converting nominal GDP to real GDP were discussed in the previous chapter. In thischapter we looked at additional measurement problems and conceptual problems.
Frequent revisions in the data sometimes change our picture of the economy considerably. Accounting for theservice sector is quite difficult. Conceptual problems include the omission of nonmarket production and ofunderground and illegal production. GDP ignores the value of leisure and includes certain “bads.”
We cannot assert with confidence that more GDP is a good thing and that less is bad. However, real GDP remains
our best single indicator of economic performance. It is used not only to indicate how any one economy isperforming over time but also to compare the economic performance of different countries.

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CONCEPT PROBLEMS
1. GDP is used as a measure of macroeconomic performance. What,
precisely, does it measure?
2. Many economists have attempted to create a set of social accounts thatwould come closer to measuring the economic well-being of the society
than does GDP. What modifications of the current approach would you
recommend to them?
3. Every good produced creates income for the owners of the factors of
production that created the product or service. For a recent purchase
you made, try to list all the types of factors of production involved in
making the product available, and try to determine who received
income as a result of your purchase.
4. Explain how the sale of used textbooks in your campus bookstore affects
the GDP calculation.
5. Look again at the circular flow diagram in Figure 6.5 "Spending
in the Circular Flow Model" and assume it is drawn for theUnited States. State the flows in which each of the following
transactions would be entered.
a. A consumer purchases fresh fish at a local fish market.
b. A grocery store acquires 1,000 rolls of paper towels for later
resale.
c. NASA purchases a new Saturn rocket.
d. People in France flock to see the latest Brad Pitt movie.
e. A construction firm builds a new house.
f. A couple from Seattle visits Guadalajara and stays in a hotel
there.
g. The city of Dallas purchases computer paper from a local
firm.
6. Suggest an argument for and an argument against counting in GDP allhousehold-produced goods and services that are not sold, such as thevalue of child care or home-cooked meals.
7. Suppose a nation’s firms make heavy use of factors of production owned
by residents of foreign countries, while foreign firms make relatively
little use of factors owned by residents of that nation. How does thenation’s GDP compare to its GNP?
8. Suppose Country A has the same GDP as Country B, and that neither
nation’s residents own factors of production used by foreign firms, nordo either nation’s firms use factors of production owned by foreign
residents. Suppose that, relative to Country B, depreciation, indirect

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9.

10.

11.
12.

6.4 Review and Practicebusiness taxes, and personal income taxes in Country A are high, while
welfare and Social Security payments to households in Country A are
relatively low. Which country has the higher disposable personal
income? Why?
Suppose that virtually everyone in the United States decides to take life
a little easier, and the length of the average workweek falls by 25%. How
will that affect GDP? Per capita GDP? How will it affect economic
welfare?
Comment on the following statement: “It does not matter that the valueof the labor people devote to producing things for themselves is notcounted in GDP; because we make the same ‘mistake’ every year, relativevalues are unaffected.”
Name some of the services, if any, you produced at home that do getcounted in GDP. Are there any goods you produce that are not counted?
Marijuana is sometimes estimated to be California’s largest cash crop. It
is not included in estimates of GDP. Should it be?

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NUMERICAL PROBLEMS

1. Given the following nominal data, compute GDP. Assume net
factor incomes from abroad = 0 (that is, GDP = GNP).
Nominal Data for GDP and NNP$ Billions

Consumption

2,799.8

Depreciation

481.6

Exports

376.2

Gross private domestic investment

671.0

Indirect taxes

331.4

Government purchases

869.7

Government transfer payments

947.8

Imports

481.7

2. Find data for each of the following countries on real GDP and
population. Use the data to calculate the GDP per capita for eachof the following countries:
a.
b.
c.
d.
e.
f.
g.
h.
i.

Mozambique
India
Pakistan
United States
CanadaRussiaBrazilIranColombia

3. Now construct a bar graph showing your results in the previous
problem, organizing the countries from the highest to the lowest GNP
per capita, with countries on the horizontal axis and GNP per capita on
the vertical axis.
4. Suppose Country A has a GDP of $4 trillion. Residents of thiscountry earn $500 million from assets they own in foreigncountries. Residents of foreign countries earn $300 million fromassets they own in Country A. Compute:

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a. Country A’s net foreign income.
b. Country A’s GNP.
5. Suppose a country’s GDP equals $500 billion for a particular year.
Economists in the country estimate that household production
equals 40% of GDP.
a. What is the value of the country’s household production forthat year?
b. Counting both GDP and household production, what is thecountry’s total output for the year?
6. A miner extracts iron from the earth. A steel mill converts theiron to steel beams for use in construction. A construction
company uses the steel beams to make a building. Assume thatthe total product of these firms represents the only componentsof the building and that they will have no other uses. Complete
the following table:
Company

Product

Total Sales Value Added

Acme Mining

iron ore$100,000?

Fuller Mill

steel beams$175,000?

$1,100,000?

Crane Construction building
Total Value Added?

7. You are given the data below for 2008 for the imaginary countryof Amagre, whose currency is the G.

6.4 Review and PracticeConsumption

350 billion G

Transfer payments

100 billion G

Investment

100 billion G

Government purchases

200 billion G

Exports

50 billion G

Imports

150 billion G

Bond purchases

200 billion G

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a.
b.
c.
d.

6.4 Review and Practice

Earnings on foreign investments

75 billion G

Foreign earnings on Amagre investment

25 billion G

Compute net foreign investment.
Compute net exports.
Compute GDP.
Compute GNP.

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Chapter 7
Aggregate Demand and Aggregate Supply
Start Up: The Great Warning
The first warning came from the Harvard Economic Society, an association of
Harvard economics professors, early in 1929. The society predicted in its weekly
newsletter that the seven-year-old expansion was coming to an end. Recession wasahead. Almost no one took the warning seriously. The economy, fueled by soaring
investment, had experienced stunning growth. The 1920s had seen the emergenceof many entirely new industries—automobiles, public power, home appliances,synthetic fabrics, radio, and motion pictures. The decade seemed to have acquired amomentum all its own. Prosperity was not about to end, no matter what a few
economists might say.
Summer came, and no recession was apparent. The Harvard economists withdrew
their forecast. As it turned out, they lost their nerve too soon. Indeed, industrial
production had already begun to fall. The worst downturn in our history, the Great
Depression, had begun.
The collapse was swift. The stock market crashed in October 1929. Real GDP plunged
nearly 10% by 1930. By the time the economy hit bottom in 1933, real GDP had
fallen 30%, unemployment had increased from 3.2% in 1929 to 25% in 1933, andprices, measured by the implicit price deflator, had plunged 23% from their 1929
level. The depression held the economy in its cruel grip for more than a decade; it
was not until World War II that full employment was restored.
In this chapter we go beyond explanations of the main macroeconomic variables tointroduce a model of macroeconomic activity that we can use to analyze problems
such as fluctuations in gross domestic product (real GDP), the price level, andemployment: the model of aggregate demand and aggregate supply. We will use thismodel throughout our exploration of macroeconomics. In this chapter we will
present the broad outlines of the model; greater detail, more examples, and morethorough explanations will follow in subsequent chapters.
We will examine the concepts of the aggregate demand curve and the short- andlong-run aggregate supply curves. We will identify conditions under which an271

Chapter 7 Aggregate Demand and Aggregate Supply

economy achieves an equilibrium level of real GDP that is consistent with full
employment of labor. Potential output1 is the level of output an economy canachieve when labor is employed at its natural level. Potential output is also called
the natural level of real GDP. When an economy fails to produce at its potential,
there may be actions that the government or the central bank can take to push theeconomy toward it, and in this chapter we will begin to consider the pros and consof doing so.

1. The level of output an economy
can achieve when labor isemployed at its natural level.

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7.1 Aggregate Demand
LEARNING OBJECTIVES
1. Define potential output, also called the natural level of GDP.
2. Define aggregate demand, represent it using a hypothetical aggregate
demand curve, and identify and explain the three effects that cause thiscurve to slope downward.
3. Distinguish between a change in the aggregate quantity of goods andservices demanded and a change in aggregate demand.
4. Use examples to explain how each component of aggregate demand canbe a possible aggregate demand shifter.
5. Explain what a multiplier is and tell how to calculate it.

Firms face four sources of demand: households (personal consumption), other firms(investment), government agencies (government purchases), and foreign markets(net exports). Aggregate demand2 is the relationship between the total quantity ofgoods and services demanded (from all the four sources of demand) and the pricelevel, all other determinants of spending unchanged. The aggregate demand
curve3 is a graphical representation of aggregate demand.

The Slope of the Aggregate Demand Curve

2. The relationship between the
total quantity of goods andservices demanded (from all
the four sources of demand)and the price level, all other
determinants of spending
unchanged.

We will use the implicit price deflator as our measure of the price level; theaggregate quantity of goods and services demanded is measured as real GDP. The
table in Figure 7.1 "Aggregate Demand" gives values for each component of
aggregate demand at each price level for a hypothetical economy. Various points on
the aggregate demand curve are found by adding the values of these components at
different price levels. The aggregate demand curve for the data given in the table isplotted on the graph in Figure 7.1 "Aggregate Demand". At point A, at a price levelof 1.18, $11,800 billion worth of goods and services will be demanded; at point C, a
reduction in the price level to 1.14 increases the quantity of goods and services
demanded to $12,000 billion; and at point E, at a price level of 1.10, $12,200 billion
will be demanded.

3. A graphical representation of
aggregate demand.

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Chapter 7 Aggregate Demand and Aggregate Supply

Figure 7.1 Aggregate Demand

An aggregate demand curve (AD) shows the relationship between the total quantity of output demanded (measured
as real GDP) and the price level (measured as the implicit price deflator). At each price level, the total quantity ofgoods and services demanded is the sum of the components of real GDP, as shown in the table. There is a negative
relationship between the price level and the total quantity of goods and services demanded, all other things
unchanged.

The negative slope of the aggregate demand curve suggests that it behaves in thesame manner as an ordinary demand curve. But we cannot apply the reasoning we
use to explain downward-sloping demand curves in individual markets to explain
the downward-sloping aggregate demand curve. There are two reasons for anegative relationship between price and quantity demanded in individual markets.
First, a lower price induces people to substitute more of the good whose price has
fallen for other goods, increasing the quantity demanded. Second, the lower pricecreates a higher real income. This normally increases quantity demanded further.
Neither of these effects is relevant to a change in prices in the aggregate. When weare dealing with the average of all prices—the price level—we can no longer say thata fall in prices will induce a change in relative prices that will lead consumers to
buy more of the goods and services whose prices have fallen and less of the goods

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and services whose prices have not fallen. The price of corn may have fallen, but theprices of wheat, sugar, tractors, steel, and most other goods or services produced in
the economy are likely to have fallen as well.
Furthermore, a reduction in the price level means that it is not just the prices
consumers pay that are falling. It means the prices people receive—their wages, therents they may charge as landlords, the interest rates they earn—are likely to befalling as well. A falling price level means that goods and services are cheaper, but
incomes are lower, too. There is no reason to expect that a change in real income
will boost the quantity of goods and services demanded—indeed, no change in real
income would occur. If nominal incomes and prices all fall by 10%, for example, real
incomes do not change.
Why, then, does the aggregate demand curve slope downward? One reason for the
downward slope of the aggregate demand curve lies in the relationship between
real wealth (the stocks, bonds, and other assets that people have accumulated) andconsumption (one of the four components of aggregate demand). When the pricelevel falls, the real value of wealth increases—it packs more purchasing power. For
example, if the price level falls by 25%, then $10,000 of wealth could purchase moregoods and services than it would have if the price level had not fallen. An increase
in wealth will induce people to increase their consumption. The consumption
component of aggregate demand will thus be greater at lower price levels than at
higher price levels. The tendency for a change in the price level to affect real wealthand thus alter consumption is called the wealth effect4; it suggests a negative
relationship between the price level and the real value of consumption spending.

4. The tendency for a change inthe price level to affect real
wealth and thus alter
consumption.
5. The tendency for a change inthe price level to affect theinterest rate and thus to affect
the quantity of investment
demanded.

7.1 Aggregate Demand

A second reason the aggregate demand curve slopes downward lies in therelationship between interest rates and investment. A lower price level lowers thedemand for money, because less money is required to buy a given quantity of goods.
What economists mean by money demand will be explained in more detail in a later
chapter. But, as we learned in studying demand and supply, a reduction in the
demand for something, all other things unchanged, lowers its price. In this case, the“something” is money and its price is the interest rate. A lower price level thus
reduces interest rates. Lower interest rates make borrowing by firms to build
factories or buy equipment and other capital more attractive. A lower interest ratemeans lower mortgage payments, which tends to increase investment in residential
houses. Investment thus rises when the price level falls. The tendency for a change
in the price level to affect the interest rate and thus to affect the quantity ofinvestment demanded is called the interest rate effect5. John Maynard Keynes, aBritish economist whose analysis of the Great Depression and what to do about it
led to the birth of modern macroeconomics, emphasized this effect. For this reason,
the interest rate effect is sometimes called the Keynes effect.

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A third reason for the rise in the total quantity of goods and services demanded as
the price level falls can be found in changes in the net export component of
aggregate demand. All other things unchanged, a lower price level in an economy
reduces the prices of its goods and services relative to foreign-produced goods andservices. A lower price level makes that economy’s goods more attractive to foreign
buyers, increasing exports. It will also make foreign-produced goods and services
less attractive to the economy’s buyers, reducing imports. The result is an increasein net exports. The international trade effect6 is the tendency for a change in theprice level to affect net exports.
Taken together, then, a fall in the price level means that the quantities ofconsumption, investment, and net export components of aggregate demand may all
rise. Since government purchases are determined through a political process, we
assume there is no causal link between the price level and the real volume ofgovernment purchases. Therefore, this component of GDP does not contribute to
the downward slope of the curve.
In general, a change in the price level, with all other determinants of aggregate
demand unchanged, causes a movement along the aggregate demand curve. A
movement along an aggregate demand curve is a change in the aggregate
quantity of goods and services demanded7. A movement from point A to point B
on the aggregate demand curve in Figure 7.1 "Aggregate Demand" is an example.
Such a change is a response to a change in the price level.
Notice that the axes of the aggregate demand curve graph are drawn with a breaknear the origin to remind us that the plotted values reflect a relatively narrow
range of changes in real GDP and the price level. We do not know what might
happen if the price level or output for an entire economy approached zero. Such aphenomenon has never been observed.

Changes in Aggregate Demand

6. The tendency for a change inthe price level to affect net
exports.
7. Movement along an aggregate
demand curve.

Aggregate demand changes in response to a change in any of its components. An
increase in the total quantity of consumer goods and services demanded at every
price level, for example, would shift the aggregate demand curve to the right. Achange in the aggregate quantity of goods and services demanded at every pricelevel is a change in aggregate demand8, which shifts the aggregate demand curve.
Increases and decreases in aggregate demand are shown in Figure 7.2 "Changes inAggregate Demand".

8. Change in the aggregate
quantity of goods and services
demanded at every price level.

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Figure 7.2 Changes in Aggregate Demand

An increase in consumption, investment, government purchases, or net exports shifts the aggregate demand curve
AD1 to the right as shown in Panel (a). A reduction in one of the components of aggregate demand shifts the curve tothe left, as shown in Panel (b).

What factors might cause the aggregate demand curve to shift? Each of thecomponents of aggregate demand is a possible aggregate demand shifter. We shalllook at some of the events that can trigger changes in the components of aggregate
demand and thus shift the aggregate demand curve.

Changes in Consumption
Several events could change the quantity of consumption at each price level andthus shift aggregate demand. One determinant of consumption is consumer
confidence. If consumers expect good economic conditions and are optimistic about
their economic prospects, they are more likely to buy major items such as cars or
furniture. The result would be an increase in the real value of consumption at each
price level and an increase in aggregate demand. In the second half of the 1990s,
sustained economic growth and low unemployment fueled high expectations andconsumer optimism. Surveys revealed consumer confidence to be very high. That
consumer confidence translated into increased consumption and increased
aggregate demand. In contrast, a decrease in consumption would accompany
diminished consumer expectations and a decrease in consumer confidence, as
happened after the stock market crash of 1929. The same problem has plagued theeconomies of most Western nations in 2008 as declining consumer confidence has
tended to reduce consumption. A survey by the Conference Board in September of

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2008 showed that just 13.5% of consumers surveyed expected economic conditionsin the United States to improve in the next six months. Similarly pessimistic views
prevailed in the previous two months. That contributed to the decline in
consumption that occurred in the third quarter of the year.
Another factor that can change consumption and shift aggregate demand is tax
policy. A cut in personal income taxes leaves people with more after-tax income,which may induce them to increase their consumption. The federal government in
the United States cut taxes in 1964, 1981, 1986, 1997, and 2003; each of those tax
cuts tended to increase consumption and aggregate demand at each price level.
In the United States, another government policy aimed at increasing consumption
and thus aggregate demand has been the use of rebates in which taxpayers are
simply sent checks in hopes that those checks will be used for consumption. Rebates
have been used in 1975, 2001, and 2008. In each case the rebate was a one-time
payment. Careful studies by economists of the 1975 and 2001 rebates showed little
impact on consumption. Final evidence on the impact of the 2008 rebates is not yetin, but early results suggest a similar outcome. In a subsequent chapter, we will
investigate arguments about whether temporary increases in income produced byrebates are likely to have a significant impact on consumption.
Transfer payments such as welfare and Social Security also affect the income people
have available to spend. At any given price level, an increase in transfer payments
raises consumption and aggregate demand, and a reduction lowers consumption
and aggregate demand.

Changes in Investment
Investment is the production of new capital that will be used for future productionof goods and services. Firms make investment choices based on what they thinkthey will be producing in the future. The expectations of firms thus play a criticalrole in determining investment. If firms expect their sales to go up, they are likely
to increase their investment so that they can increase production and meet
consumer demand. Such an increase in investment raises the aggregate quantity ofgoods and services demanded at each price level; it increases aggregate demand.
Changes in interest rates also affect investment and thus affect aggregate demand.
We must be careful to distinguish such changes from the interest rate effect, whichcauses a movement along the aggregate demand curve. A change in interest rates
that results from a change in the price level affects investment in a way that isalready captured in the downward slope of the aggregate demand curve; it causes a

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movement along the curve. A change in interest rates for some other reason shifts
the curve. We examine reasons interest rates might change in another chapter.
Investment can also be affected by tax policy. One provision of the Job and Growth
Tax Relief Reconciliation Act of 2003 was a reduction in the tax rate on certain
capital gains. Capital gains result when the owner of an asset, such as a house or afactory, sells the asset for more than its purchase price (less any depreciation
claimed in earlier years). The lower capital gains tax could stimulate investment,
because the owners of such assets know that they will lose less to taxes when theysell those assets, thus making assets subject to the tax more attractive.

Changes in Government Purchases
Any change in government purchases, all other things unchanged, will affectaggregate demand. An increase in government purchases increases aggregate
demand; a decrease in government purchases decreases aggregate demand.
Many economists argued that reductions in defense spending in the wake of thecollapse of the Soviet Union in 1991 tended to reduce aggregate demand. Similarly,
increased defense spending for the wars in Afghanistan and Iraq increased
aggregate demand. Dramatic increases in defense spending to fight World War II
accounted in large part for the rapid recovery from the Great Depression.

Changes in Net Exports
A change in the value of net exports at each price level shifts the aggregate demand
curve. A major determinant of net exports is foreign demand for a country’s goods
and services; that demand will vary with foreign incomes. An increase in foreign
incomes increases a country’s net exports and aggregate demand; a slump in
foreign incomes reduces net exports and aggregate demand. For example, several
major U.S. trading partners in Asia suffered recessions in 1997 and 1998. Lower real
incomes in those countries reduced U.S. exports and tended to reduce aggregate
demand.

9. The price of a currency interms of another currency or
currencies.

7.1 Aggregate Demand

Exchange rates also influence net exports, all other things unchanged. A country’s
exchange rate9 is the price of its currency in terms of another currency or
currencies. A rise in the U.S. exchange rate means that it takes more Japanese yen,for example, to purchase one dollar. That also means that U.S. traders get more yen
per dollar. Since prices of goods produced in Japan are given in yen and prices ofgoods produced in the United States are given in dollars, a rise in the U.S. exchange
rate increases the price to foreigners for goods and services produced in the UnitedStates, thus reducing U.S. exports; it reduces the price of foreign-produced goods

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and services for U.S. consumers, thus increasing imports to the United States. A
higher exchange rate tends to reduce net exports, reducing aggregate demand. A
lower exchange rate tends to increase net exports, increasing aggregate demand.
Foreign price levels can affect aggregate demand in the same way as exchange
rates. For example, when foreign price levels fall relative to the price level in the
United States, U.S. goods and services become relatively more expensive, reducing
exports and boosting imports in the United States. Such a reduction in net exports
reduces aggregate demand. An increase in foreign prices relative to U.S. prices has
the opposite effect.
The trade policies of various countries can also affect net exports. A policy by Japan
to increase its imports of goods and services from India, for example, would
increase net exports in India.

The Multiplier
A change in any component of aggregate demand shifts the aggregate demand
curve. Generally, the aggregate demand curve shifts by more than the amount bywhich the component initially causing it to shift changes.
Suppose that net exports increase due to an increase in foreign incomes. As foreign
demand for domestically made products rises, a country’s firms will hire additional
workers or perhaps increase the average number of hours that their employees
work. In either case, incomes will rise, and higher incomes will lead to an increasein consumption. Taking into account these other increases in the components ofaggregate demand, the aggregate demand curve will shift by more than the initial
shift caused by the initial increase in net exports.
The multiplier10 is the ratio of the change in the quantity of real GDP demanded ateach price level to the initial change in one or more components of aggregate
demand that produced it:
Equation 7.1

10. The ratio of the change in thequantity of real GDP demanded
at each price level to the initialchange in one or morecomponents of aggregate
demand that produced it.

7.1 Aggregate Demand

Multiplier =Δ (real GDP demanded at each price level)
initial Δ (component of AD )We use the capital Greek letter delta (Δ) to mean “change in.” In the aggregate
demand–aggregate supply model presented in this chapter, it is the number bywhich we multiply an initial change in aggregate demand to obtain the amount by

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which the aggregate demand curve shifts as a result of the initial change. In otherwords, we can use Equation 7.1 to solve for the change in real GDP demanded ateach price level:
Equation 7.2

Δ (real GDP demanded at each price level) = multiplier × initial Δ (compSuppose that the initial increase in net exports is $100 billion and that the initial$100-billion increase generates additional consumption of $100 billion at each pricelevel. In Panel (a) of Figure 7.3 "The Multiplier", the aggregate demand curve shifts
to the right by $200 billion—the amount of the initial increase in net exports times
the multiplier of 2. We obtained the value for the multiplier in this example byplugging $200 billion (the initial $100-billion increase in net exports plus the$100-billion increase that it generated in consumption) into the numerator of
Equation 7.1 and $100 billion into the denominator. Similarly, a decrease in net
exports of $100 billion leads to a decrease in aggregate demand of $200 billion ateach price level, as shown in Panel (b).
Figure 7.3 The Multiplier

A change in one component of aggregate demand shifts the aggregate demand curve by more than the initialchange. In Panel (a), an initial increase of $100 billion of net exports shifts the aggregate demand curve to the rightby $200 billion at each price level. In Panel (b), a decrease of net exports of $100 billion shifts the aggregate demand
curve to the left by $200 billion. In this example, the multiplier is 2.

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KEY TAKEAWAYS• Potential output is the level of output an economy can achieve whenlabor is employed at its natural level. When an economy fails to produce
at its potential, the government or the central bank may try to push theeconomy toward its potential.
• The aggregate demand curve represents the total of consumption,
investment, government purchases, and net exports at each price levelin any period. It slopes downward because of the wealth effect on
consumption, the interest rate effect on investment, and theinternational trade effect on net exports.
• The aggregate demand curve shifts when the quantity of real GDP
demanded at each price level changes.
• The multiplier is the number by which we multiply an initial change inaggregate demand to obtain the amount by which the aggregate demand
curve shifts at each price level as a result of the initial change.

TRY IT!
Explain the effect of each of the following on the aggregate demand curvefor the United States:
1.
2.
3.
4.

7.1 Aggregate Demand

A decrease in consumer optimism
An increase in real GDP in the countries that buy U.S. exports
An increase in the price level
An increase in government spending on highways

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Case in Point: The Multiplied Economic Impact of SARS
on China’s Economy

Severe Acute Respiratory Syndrome (SARS), an atypical pneumonia-like
disease, broke onto the world scene in late 2002. In March 2003, the World
Health Organization (WHO) issued its first worldwide alert and a month later its
first travel advisory, which recommended that travelers avoid Hong Kong andthe southern province of China, Guangdong. Over the next few months,
additional travel advisories were issued for other parts of China, Taiwan, andbriefly for Toronto, Canada. By the end of June, all WHO travel advisories had
been removed.
To estimate the overall impact of SARS on the Chinese economy in 2003,
economists Wen Hai, Zhong Zhao, and Jian Want of Peking University’s China
Center for Economic Research conducted a survey of Beijing’s tourism industryin April 2003. Based on findings from the Beijing area, they projected thetourism sector of China as a whole would lose $16.8 billion—of which $10.8
billion came from an approximate 50% reduction in foreign tourist revenue and$6 billion from curtailed domestic tourism, as holiday celebrations werecancelled and domestic travel restrictions imposed.
To figure out the total impact of SARS on China’s economy, they argued thatthe multiplier for tourism revenue in China is between 2 and 3. Since the SARS
outbreak only began to have a major economic impact after March, they
assumed a smaller multiplier of 1.5 for all of 2003. They thus predicted that the
Chinese economy would be $25.3 billion smaller in 2003 as a result of SARS.
Source: Wen Hai, Zhong Zhao, and Jian Wan, “The Short-Term Impact of SARS
on the Chinese Economy,” Asian Economic Papers 3, no. 1 (Winter 2004): 57–61.

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ANSWER TO TRY IT! PROBLEM
1. A decline in consumer optimism would cause the aggregate demand
curve to shift to the left. If consumers are more pessimistic about the
future, they are likely to cut purchases, especially of major items.
2. An increase in the real GDP of other countries would increase thedemand for U.S. exports and cause the aggregate demand curve to shift
to the right. Higher incomes in other countries will make consumers inthose countries more willing and able to buy U.S. goods.
3. An increase in the price level corresponds to a movement up along theunchanged aggregate demand curve. At the higher price level, theconsumption, investment, and net export components of aggregate
demand will all fall; that is, there will be a reduction in the total
quantity of goods and services demanded, but not a shift of theaggregate demand curve itself.
4. An increase in government spending on highways means an increase ingovernment purchases. The aggregate demand curve would shift to theright.

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7.2 Aggregate Demand and Aggregate Supply: The Long Run and the
Short RunLEARNING OBJECTIVES
1. Distinguish between the short run and the long run, as these terms areused in macroeconomics.
2. Draw a hypothetical long-run aggregate supply curve and explain what
it shows about the natural levels of employment and output at various
price levels, given changes in aggregate demand.
3. Draw a hypothetical short-run aggregate supply curve, explain why itslopes upward, and explain why it may shift; that is, distinguish betweena change in the aggregate quantity of goods and services supplied and achange in short-run aggregate supply.
4. Discuss various explanations for wage and price stickiness.
5. Explain and illustrate what is meant by equilibrium in the short run andrelate the equilibrium to potential output.

In macroeconomics, we seek to understand two types of equilibria, one
corresponding to the short run and the other corresponding to the long run. The
short run11 in macroeconomic analysis is a period in which wages and some otherprices do not respond to changes in economic conditions. In certain markets, as
economic conditions change, prices (including wages) may not adjust quickly
enough to maintain equilibrium in these markets. A sticky price12 is a price that isslow to adjust to its equilibrium level, creating sustained periods of shortage or
surplus. Wage and price stickiness prevent the economy from achieving its naturallevel of employment and its potential output. In contrast, the long run13 inmacroeconomic analysis is a period in which wages and prices are flexible. In thelong run, employment will move to its natural level and real GDP to potential.
11. In macroeconomic analysis, aperiod in which wages andsome other prices are sticky
and do not respond to changes
in economic conditions.
12. A price that is slow to adjust to
its equilibrium level, creating
sustained periods of shortage
or surplus.

We begin with a discussion of long-run macroeconomic equilibrium, because thistype of equilibrium allows us to see the macroeconomy after full market adjustment
has been achieved. In contrast, in the short run, price or wage stickiness is an
obstacle to full adjustment. Why these deviations from the potential level of output
occur and what the implications are for the macroeconomy will be discussed in thesection on short-run macroeconomic equilibrium.

13. In macroeconomic analysis, aperiod in which wages andprices are flexible.

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The Long Run
As we saw in a previous chapter, the natural level of employment occurs where thereal wage adjusts so that the quantity of labor demanded equals the quantity oflabor supplied. When the economy achieves its natural level of employment, it
achieves its potential level of output. We will see that real GDP eventually moves topotential, because all wages and prices are assumed to be flexible in the long run.

Long-Run Aggregate Supply
The long-run aggregate supply (LRAS) curve14 relates the level of output
produced by firms to the price level in the long run. In Panel (b) of Figure 7.4"Natural Employment and Long-Run Aggregate Supply", the long-run aggregate
supply curve is a vertical line at the economy’s potential level of output. There is asingle real wage at which employment reaches its natural level. In Panel (a) of
Figure 7.4 "Natural Employment and Long-Run Aggregate Supply", only a real wageof ωe generates natural employment Le. The economy could, however, achieve thisreal wage with any of an infinitely large set of nominal wage and price-levelcombinations. Suppose, for example, that the equilibrium real wage (the ratio ofwages to the price level) is 1.5. We could have that with a nominal wage level of 1.5
and a price level of 1.0, a nominal wage level of 1.65 and a price level of 1.1, anominal wage level of 3.0 and a price level of 2.0, and so on.
Figure 7.4 Natural Employment and Long-Run Aggregate Supply

14. A graphical representation that
relates the level of output
produced by firms to the pricelevel in the long run.

When the economy achieves its natural level of employment, as shown in Panel (a) at the intersection of the demandand supply curves for labor, it achieves its potential output, as shown in Panel (b) by the vertical long-run aggregate
supply curve LRAS at YP.

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In Panel (b) we see price levels ranging from P1 to P4. Higher price levels would
require higher nominal wages to create a real wage of ω e, and flexible nominal
wages would achieve that in the long run.
In the long run, then, the economy can achieve its natural level of employment andpotential output at any price level. This conclusion gives us our long-run aggregate
supply curve. With only one level of output at any price level, the long-run
aggregate supply curve is a vertical line at the economy’s potential level of output
of YP.

Equilibrium Levels of Price and Output in the Long Run
The intersection of the economy’s aggregate demand curve and the long-run
aggregate supply curve determines its equilibrium real GDP and price level in thelong run. Figure 7.5 "Long-Run Equilibrium" depicts an economy in long-run
equilibrium. With aggregate demand at AD1 and the long-run aggregate supply
curve as shown, real GDP is $12,000 billion per year and the price level is 1.14. If
aggregate demand increases to AD2, long-run equilibrium will be reestablished atreal GDP of $12,000 billion per year, but at a higher price level of 1.18. If aggregate
demand decreases to AD3, long-run equilibrium will still be at real GDP of $12,000
billion per year, but with the now lower price level of 1.10.

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Figure 7.5 Long-Run Equilibrium

Long-run equilibrium occurs at the intersection of the aggregate demand curve and the long-run aggregate supply
curve. For the three aggregate demand curves shown, long-run equilibrium occurs at three different price levels, but
always at an output level of $12,000 billion per year, which corresponds to potential output.

The Short Run
Analysis of the macroeconomy in the short run—a period in which stickiness ofwages and prices may prevent the economy from operating at potential
output—helps explain how deviations of real GDP from potential output can and do
occur. We will explore the effects of changes in aggregate demand and in short-run
aggregate supply in this section.

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Short-Run Aggregate Supply
The model of aggregate demand and long-run aggregate
supply predicts that the economy will eventually movetoward its potential output. To see how nominal wage
and price stickiness can cause real GDP to be either
above or below potential in the short run, consider the
response of the economy to a change in aggregate
demand. Figure 7.6 "Deriving the Short-Run Aggregate
Supply Curve" shows an economy that has been
operating at potential output of $12,000 billion and a
price level of 1.14. This occurs at the intersection of AD1
with the long-run aggregate supply curve at point B.
Now suppose that the aggregate demand curve shifts to
the right (to AD2). This could occur as a result of anincrease in exports. (The shift from AD1 to AD2 includes
the multiplied effect of the increase in exports.) At theprice level of 1.14, there is now excess demand andpressure on prices to rise. If all prices in the economy
adjusted quickly, the economy would quickly settle atpotential output of $12,000 billion, but at a higher pricelevel (1.18 in this case).

Figure 7.6 Deriving the
Short-Run Aggregate Supply
Curve

The economy shown here is in
long-run equilibrium at theintersection of AD1 with the longrun aggregate supply curve. If
aggregate demand increases to
AD2, in the short run, both real
GDP and the price level rise. If
aggregate demand decreases to
AD3, in the short run, both real
GDP and the price level fall. A
line drawn through points A, B,
and C traces out the short-run
aggregate supply curve SRAS.

Is it possible to expand output above potential? Yes. It
may be the case, for example, that some people who
were in the labor force but were frictionally or
structurally unemployed find work because of the easeof getting jobs at the going nominal wage in such anenvironment. The result is an economy operating at point A in Figure 7.6 "Deriving
the Short-Run Aggregate Supply Curve" at a higher price level and with output
temporarily above potential.
Consider next the effect of a reduction in aggregate demand (to AD3), possibly due
to a reduction in investment. As the price level starts to fall, output also falls. The
economy finds itself at a price level–output combination at which real GDP is below
potential, at point C. Again, price stickiness is to blame. The prices firms receive are
falling with the reduction in demand. Without corresponding reductions in nominal
wages, there will be an increase in the real wage. Firms will employ less labor andproduce less output.
By examining what happens as aggregate demand shifts over a period when priceadjustment is incomplete, we can trace out the short-run aggregate supply curve by

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drawing a line through points A, B, and C. The short-run aggregate supply (SRAS)
curve15 is a graphical representation of the relationship between production andthe price level in the short run. Among the factors held constant in drawing a shortrun aggregate supply curve are the capital stock, the stock of natural resources, thelevel of technology, and the prices of factors of production.
A change in the price level produces a change in the aggregate quantity of goods
and services supplied16 and is illustrated by the movement along the short-run
aggregate supply curve. This occurs between points A, B, and C in Figure 7.6"Deriving the Short-Run Aggregate Supply Curve".
A change in the quantity of goods and services supplied at every price level in the
short run is a change in short-run aggregate supply17. Changes in the factors held
constant in drawing the short-run aggregate supply curve shift the curve. (These
factors may also shift the long-run aggregate supply curve; we will discuss themalong with other determinants of long-run aggregate supply in the next chapter.)
One type of event that would shift the short-run aggregate supply curve is anincrease in the price of a natural resource such as oil. An increase in the price of
natural resources or any other factor of production, all other things unchanged,
raises the cost of production and leads to a reduction in short-run aggregate supply.
In Panel (a) of Figure 7.7 "Changes in Short-Run Aggregate Supply", SRAS1 shifts
leftward to SRAS2. A decrease in the price of a natural resource would lower the costof production and, other things unchanged, would allow greater production fromthe economy’s stock of resources and would shift the short-run aggregate supply
curve to the right; such a shift is shown in Panel (b) by a shift from SRAS1 to SRAS3.
Figure 7.7 Changes in Short-Run Aggregate Supply

15. A graphical representation of
the relationship between
production and the price levelin the short run.
16. Movement along the short-run
aggregate supply curve.
17. A change in the aggregate
quantity of goods and services
supplied at every price level inthe short run.

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A reduction in short-run aggregate supply shifts the curve from SRAS1 to SRAS2 in Panel (a). An increase shifts it to
the right to SRAS3, as shown in Panel (b).

Reasons for Wage and Price Stickiness
Wage or price stickiness means that the economy may not always be operating at
potential. Rather, the economy may operate either above or below potential output
in the short run. Correspondingly, the overall unemployment rate will be below or
above the natural level.
Many prices observed throughout the economy do adjust quickly to changes inmarket conditions so that equilibrium, once lost, is quickly regained. Prices for
fresh food and shares of common stock are two such examples.
Other prices, though, adjust more slowly. Nominal wages, the price of labor, adjust
very slowly. We will first look at why nominal wages are sticky, due to theirassociation with the unemployment rate, a variable of great interest in
macroeconomics, and then at other prices that may be sticky.

Wage Stickiness
Wage contracts fix nominal wages for the life of the contract. The length of wage
contracts varies from one week or one month for temporary employees, to one year
(teachers and professors often have such contracts), to three years (for most union
workers employed under major collective bargaining agreements). The existence ofsuch explicit contracts means that both workers and firms accept some wage at thetime of negotiating, even though economic conditions could change while theagreement is still in force.
Think about your own job or a job you once had. Chances are you go to work eachday knowing what your wage will be. Your wage does not fluctuate from one day to
the next with changes in demand or supply. You may have a formal contract withyour employer that specifies what your wage will be over some period. Or you may
have an informal understanding that sets your wage. Whatever the nature of youragreement, your wage is “stuck” over the period of the agreement. Your wage is an
example of a sticky price.
One reason workers and firms may be willing to accept long-term nominal wage
contracts is that negotiating a contract is a costly process. Both parties must keep
themselves adequately informed about market conditions. Where unions are

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involved, wage negotiations raise the possibility of a labor strike, an eventualitythat firms may prepare for by accumulating additional inventories, also a costly
process. Even when unions are not involved, time and energy spent discussing
wages takes away from time and energy spent producing goods and services. In
addition, workers may simply prefer knowing that their nominal wage will be fixed
for some period of time.
Some contracts do attempt to take into account changing economic conditions,such as inflation, through cost-of-living adjustments, but even these relatively
simple contingencies are not as widespread as one might think. One reason might
be that a firm is concerned that while the aggregate price level is rising, the prices
for the goods and services it sells might not be moving at the same rate. Also, costof-living or other contingencies add complexity to contracts that both sides may
want to avoid.
Even markets where workers are not employed under explicit contracts seem tobehave as if such contracts existed. In these cases, wage stickiness may stem from adesire to avoid the same uncertainty and adjustment costs that explicit contracts
avert.
Finally, minimum wage laws prevent wages from falling below a legal minimum,
even if unemployment is rising. Unskilled workers are particularly vulnerable toshifts in aggregate demand.

Price Stickiness
Rigidity of other prices becomes easier to explain in light of the arguments about
nominal wage stickiness. Since wages are a major component of the overall cost of
doing business, wage stickiness may lead to output price stickiness. With nominal
wages stable, at least some firms can adopt a “wait and see” attitude before
adjusting their prices. During this time, they can evaluate information about why
sales are rising or falling (Is the change in demand temporary or permanent?) andtry to assess likely reactions by consumers or competing firms in the industry to
any price changes they might make (Will consumers be angered by a price increase,for example? Will competing firms match price changes?).
In the meantime, firms may prefer to adjust output and employment in response tochanging market conditions, leaving product price alone. Quantity adjustments
have costs, but firms may assume that the associated risks are smaller than those
associated with price adjustments.

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Another possible explanation for price stickiness is the notion that there areadjustment costs associated with changing prices. In some cases, firms must print
new price lists and catalogs, and notify customers of price changes. Doing this too
often could jeopardize customer relations.
Yet another explanation of price stickiness is that firms may have explicit longterm contracts to sell their products to other firms at specified prices. For example,
electric utilities often buy their inputs of coal or oil under long-term contracts.
Taken together, these reasons for wage and price stickiness explain why aggregate
price adjustment may be incomplete in the sense that the change in the price levelis insufficient to maintain real GDP at its potential level. These reasons do not leadto the conclusion that no price adjustments occur. But the adjustments require
some time. During this time, the economy may remain above or below its potential
level of output.

Equilibrium Levels of Price and Output in the Short Run
To illustrate how we will use the model of aggregate demand and aggregate supply,
let us examine the impact of two events: an increase in the cost of health care andan increase in government purchases. The first reduces short-run aggregate supply;
the second increases aggregate demand. Both events change equilibrium real GDP
and the price level in the short run.

A Change in the Cost of Health CareIn the United States, most people receive health insurance for themselves and theirfamilies through their employers. In fact, it is quite common for employers to pay alarge percentage of employees’ health insurance premiums, and this benefit is often
written into labor contracts. As the cost of health care has gone up over time, firms
have had to pay higher and higher health insurance premiums. With nominal wages
fixed in the short run, an increase in health insurance premiums paid by firms
raises the cost of employing each worker. It affects the cost of production in thesame way that higher wages would. The result of higher health insurance premiumsis that firms will choose to employ fewer workers.
Suppose the economy is operating initially at the short-run equilibrium at theintersection of AD1 and SRAS1, with a real GDP of Y1 and a price level of P1, as shownin Figure 7.8 "An Increase in Health Insurance Premiums Paid by Firms". This is theinitial equilibrium price and output in the short run. The increase in labor cost

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shifts the short-run aggregate supply curve to SRAS2. The price level rises to P2 andreal GDP falls to Y2.
Figure 7.8 An Increase in Health Insurance Premiums Paid by Firms

An increase in health insurance premiums paid by firms increases labor costs, reducing short-run aggregate supply
from SRAS1 to SRAS2. The price level rises from P1 to P2 and output falls from Y1 to Y2.

A reduction in health insurance premiums would have the opposite effect. There
would be a shift to the right in the short-run aggregate supply curve with pressure
on the price level to fall and real GDP to rise.

A Change in Government Purchases
Suppose the federal government increases its spending for highway construction.
This circumstance leads to an increase in U.S. government purchases and anincrease in aggregate demand.

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Assuming no other changes affect aggregate demand, the increase in government
purchases shifts the aggregate demand curve by a multiplied amount of the initial
increase in government purchases to AD2 in Figure 7.9 "An Increase in Government
Purchases". Real GDP rises from Y1 to Y2, while the price level rises from P1 to P2.
Notice that the increase in real GDP is less than it would have been if the price level
had not risen.
Figure 7.9 An Increase in Government Purchases

An increase in government purchases boosts aggregate demand from AD1 to AD2. Short-run equilibrium is at theintersection of AD2 and the short-run aggregate supply curve SRAS1. The price level rises to P2 and real GDP rises to
Y 2.

In contrast, a reduction in government purchases would reduce aggregate demand.
The aggregate demand curve shifts to the left, putting pressure on both the pricelevel and real GDP to fall.
In the short run, real GDP and the price level are determined by the intersection of
the aggregate demand and short-run aggregate supply curves. Recall, however, thatthe short run is a period in which sticky prices may prevent the economy from

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reaching its natural level of employment and potential output. In the next section,
we will see how the model adjusts to move the economy to long-run equilibrium
and what, if anything, can be done to steer the economy toward the natural level of
employment and potential output.

KEY TAKEAWAYS• The short run in macroeconomics is a period in which wages and someother prices are sticky. The long run is a period in which full wage andprice flexibility, and market adjustment, has been achieved, so that theeconomy is at the natural level of employment and potential output.
• The long-run aggregate supply curve is a vertical line at the potential
level of output. The intersection of the economy’s aggregate demandand long-run aggregate supply curves determines its equilibrium real
GDP and price level in the long run.
• The short-run aggregate supply curve is an upward-sloping curve thatshows the quantity of total output that will be produced at each pricelevel in the short run. Wage and price stickiness account for the shortrun aggregate supply curve’s upward slope.
• Changes in prices of factors of production shift the short-run aggregate
supply curve. In addition, changes in the capital stock, the stock ofnatural resources, and the level of technology can also cause the shortrun aggregate supply curve to shift.
• In the short run, the equilibrium price level and the equilibrium level of
total output are determined by the intersection of the aggregate
demand and the short-run aggregate supply curves. In the short run,
output can be either below or above potential output.

TRY IT!
The tools we have covered in this section can be used to understand theGreat Depression of the 1930s. We know that investment and consumption
began falling in late 1929. The reductions were reinforced by plunges in net
exports and government purchases over the next four years. In addition,
nominal wages plunged 26% between 1929 and 1933. We also know that real
GDP in 1933 was 30% below real GDP in 1929. Use the tools of aggregate
demand and short-run aggregate supply to graph and explain what
happened to the economy between 1929 and 1933.

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Case in Point: The U.S. Recession of 2001

What were the causes of the U.S. recession of 2001? Economist Kevin Kliesen of
the Federal Reserve Bank of St. Louis points to four factors that, taken together,shifted the aggregate demand curve to the left and kept it there for a longenough period to keep real GDP falling for about nine months. They were thefall in stock market prices, the decrease in business investment both forcomputers and software and in structures, the decline in the real value ofexports, and the aftermath of 9/11. Notable exceptions to this list of culpritswere the behavior of consumer spending during the period and new residential
housing, which falls into the investment category.
During the expansion in the late 1990s, a surging stock market probably made iteasier for firms to raise funding for investment in both structures andinformation technology. Even though the stock market bubble burst well before
the actual recession, the continuation of projects already underway delayed thedecline in the investment component of GDP. Also, spending for information
technology was probably prolonged as firms dealt with Y2K computing issues,that is, computer problems associated with the change in the date from 1999 to
2000. Most computers used only two digits to indicate the year, and when theyear changed from ’99 to ’00, computers did not know how to interpret thechange, and extensive reprogramming of computers was required.
Real exports fell during the recession because (1) the dollar was strong during
the period and (2) real GDP growth in the rest of the world fell almost 5% from2000 to 2001.
Then, the terrorist attacks of 9/11, which literally shut down transportationand financial markets for several days, may have prolonged these negative
tendencies just long enough to turn what might otherwise have been a mild
decline into enough of a downtown to qualify the period as a recession.

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During this period the measured price level was essentially stable—with the
implicit price deflator rising by less than 1%. Thus, while the aggregate demand
curve shifted left as a result of all the reasons given above, there was also aleftward shift in the short-run aggregate supply curve.
Source: Kevin L. Kliesen, “The 2001 Recession: How Was It Different and What
Developments May Have Caused It?,” The Federal Reserve Bank of St. Louis Review,
September/October 2003, 23–37.

ANSWER TO TRY IT! PROBLEM
All components of aggregate demand (consumption, investment,
government purchases, and net exports) declined between 1929 and 1933.
Thus the aggregate demand curve shifted markedly to the left, moving from
AD1929 to AD1933. The reduction in nominal wages corresponds to an increasein short-run aggregate supply from SRAS1929 to SRAS1933. Since real GDP in
1933 was less than real GDP in 1929, we know that the movement in theaggregate demand curve was greater than that of the short-run aggregate
supply curve.

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7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic
Equilibrium
LEARNING OBJECTIVES
1. Explain and illustrate graphically recessionary and inflationary gaps andrelate these gaps to what is happening in the labor market.
2. Identify the various policy choices available when an economy
experiences an inflationary or recessionary gap and discuss some of thepros and cons that make these choices controversial.

The intersection of the economy’s aggregate demand and short-run aggregate
supply curves determines equilibrium real GDP and price level in the short run. Theintersection of aggregate demand and long-run aggregate supply determines its
long-run equilibrium. In this section we will examine the process through which an
economy moves from equilibrium in the short run to equilibrium in the long run.
The long run puts a nation’s macroeconomic house in order: only frictional andstructural unemployment remain, and the price level is stabilized. In the short run,stickiness of nominal wages and other prices can prevent the economy fromachieving its potential output. Actual output may exceed or fall short of potential
output. In such a situation the economy operates with a gap. When output is above
potential, employment is above the natural level of employment. When output isbelow potential, employment is below the natural level.

Recessionary and Inflationary GapsAt any time, real GDP and the price level are determined by the intersection of theaggregate demand and short-run aggregate supply curves. If employment is below
the natural level of employment, real GDP will be below potential. The aggregate
demand and short-run aggregate supply curves will intersect to the left of the longrun aggregate supply curve.
Suppose an economy’s natural level of employment is Le, shown in Panel (a) of
Figure 7.10 "A Recessionary Gap". This level of employment is achieved at a real
wage of ωe. Suppose, however, that the initial real wage ω1 exceeds this equilibrium
value. Employment at L1 falls short of the natural level. A lower level of
employment produces a lower level of output; the aggregate demand and short-run

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aggregate supply curves, AD and SRAS, intersect to the left of the long-run
aggregate supply curve LRAS in Panel (b). The gap between the level of real GDP and
potential output, when real GDP is less than potential, is called a recessionary
gap18.
Figure 7.10 A Recessionary Gap

If employment is below the natural level, as shown in Panel (a), then output must be below potential. Panel (b)shows the recessionary gap YP − Y1, which occurs when the aggregate demand curve AD and the short-run
aggregate supply curve SRAS intersect to the left of the long-run aggregate supply curve LRAS.

Just as employment can fall short of its natural level, it can also exceed it. If
employment is greater than its natural level, real GDP will also be greater than its
potential level. Figure 7.11 "An Inflationary Gap" shows an economy with a naturallevel of employment of Le in Panel (a) and potential output of YP in Panel (b). If thereal wage ω1 is less than the equilibrium real wage ωe, then employment L1 will
exceed the natural level. As a result, real GDP, Y1, exceeds potential. The gap
between the level of real GDP and potential output, when real GDP is greater thanpotential, is called an inflationary gap19. In Panel (b), the inflationary gap equals Y1− Y P.
18. The gap between the level ofreal GDP and potential output,
when real GDP is less thanpotential.
19. The gap between the level ofreal GDP and potential output,
when real GDP is greater thanpotential.

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Figure 7.11 An Inflationary Gap

Panel (a) shows that if employment is above the natural level, then output must be above potential. The inflationarygap, shown in Panel (b), equals Y1 − YP. The aggregate demand curve AD and the short-run aggregate supply curve
SRAS intersect to the right of the long-run aggregate supply curve LRAS.

Restoring Long-Run Macroeconomic Equilibrium
We have already seen that the aggregate demand curve shifts in response to achange in consumption, investment, government purchases, or net exports. The
short-run aggregate supply curve shifts in response to changes in the prices offactors of production, the quantities of factors of production available, or
technology. Now we will see how the economy responds to a shift in aggregate
demand or short-run aggregate supply using two examples presented earlier: achange in government purchases and a change in health-care costs. By returning tothese examples, we will be able to distinguish the long-run response from the shortrun response.

A Shift in Aggregate Demand: An Increase in Government Purchases
Suppose an economy is initially in equilibrium at potential output YP as in Figure
7.12 "Long-Run Adjustment to an Inflationary Gap". Because the economy isoperating at its potential, the labor market must be in equilibrium; the quantities oflabor demanded and supplied are equal.

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Now suppose aggregate demand increases because one
or more of its components (consumption, investment,
government purchases, and net exports) has increased
at each price level. For example, suppose government
purchases increase. The aggregate demand curve shifts
from AD1 to AD2 in Figure 7.12 "Long-Run Adjustment toan Inflationary Gap". That will increase real GDP to Y2
and force the price level up to P2 in the short run. The
higher price level, combined with a fixed nominal wage,
results in a lower real wage. Firms employ moreworkers to supply the increased output.
The economy’s new production level Y2 exceeds
potential output. Employment exceeds its natural level.
The economy with output of Y2 and price level of P2 isonly in short-run equilibrium; there is an inflationary
gap equal to the difference between Y2 and YP. Because
real GDP is above potential, there will be pressure on
prices to rise further.

Figure 7.12 Long-Run
Adjustment to an
Inflationary Gap

An increase in aggregate demand
to AD2 boosts real GDP to Y2 andthe price level to P2, creating an
inflationary gap of Y2 − YP. In thelong run, as price and nominal
wages increase, the short-run
aggregate supply curve moves to
SRAS2. Real GDP returns topotential.

Ultimately, the nominal wage will rise as workers seek
to restore their lost purchasing power. As the nominal
wage rises, the short-run aggregate supply curve will
begin shifting to the left. It will continue to shift as long as the nominal wage rises,
and the nominal wage will rise as long as there is an inflationary gap. These shifts inshort-run aggregate supply, however, will reduce real GDP and thus begin to close
this gap. When the short-run aggregate supply curve reaches SRAS2, the economy
will have returned to its potential output, and employment will have returned to its
natural level. These adjustments will close the inflationary gap.

A Shift in Short-Run Aggregate Supply: An Increase in the Cost of Health
Care
Again suppose, with an aggregate demand curve at AD1 and a short-run aggregate
supply at SRAS1, an economy is initially in equilibrium at its potential output YP, ata price level of P1, as shown in Figure 7.13 "Long-Run Adjustment to a RecessionaryGap". Now suppose that the short-run aggregate supply curve shifts owing to a risein the cost of health care. As we explained earlier, because health insurance
premiums are paid primarily by firms for their workers, an increase in premiums
raises the cost of production and causes a reduction in the short-run aggregate
supply curve from SRAS1 to SRAS2.

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As a result, the price level rises to P2 and real GDP falls
to Y2. The economy now has a recessionary gap equal tothe difference between YP and Y2. Notice that thissituation is particularly disagreeable, because bothunemployment and the price level rose.

Figure 7.13 Long-Run
Adjustment to a
Recessionary Gap

With real GDP below potential, though, there will
eventually be pressure on the price level to fall.
Increased unemployment also puts pressure on nominal
wages to fall. In the long run, the short-run aggregate
supply curve shifts back to SRAS1. In this case, real GDP
returns to potential at YP, the price level falls back to P1,
and employment returns to its natural level. These
A decrease in aggregate supply
adjustments will close the recessionary gap.
How sticky prices and nominal wages are will determine
the time it takes for the economy to return to potential.
People often expect the government or the central bankto respond in some way to try to close gaps. This issue isaddressed next.

from SRAS1 to SRAS2 reduces real
GDP to Y2 and raises the pricelevel to P2, creating arecessionary gap of YP − Y2. In
the long run, as prices andnominal wages decrease, theshort-run aggregate supply
curve moves back to SRAS1 andreal GDP returns to potential.

Gaps and Public Policy
If the economy faces a gap, how do we get from thatsituation to potential output?

20. A policy choice to take noaction to try to close arecessionary or an inflationarygap, but to allow the economy
to adjust on its own to its
potential output.
21. A policy in which thegovernment or central bankacts to move the economy toits potential output.

Gaps present us with two alternatives. First, we can do nothing. In the long run, real
wages will adjust to the equilibrium level, employment will move to its naturallevel, and real GDP will move to its potential. Second, we can do something. Facedwith a recessionary or an inflationary gap, policy makers can undertake policies
aimed at shifting the aggregate demand or short-run aggregate supply curves in a
way that moves the economy to its potential. A policy choice to take no action to try
to close a recessionary or an inflationary gap, but to allow the economy to adjust on
its own to its potential output, is a nonintervention policy20. A policy in which thegovernment or central bank acts to move the economy to its potential output iscalled a stabilization policy21.

Nonintervention or Expansionary Policy?
Figure 7.14 "Alternatives in Closing a Recessionary Gap" illustrates the alternatives
for closing a recessionary gap. In both panels, the economy starts with a real GDP of

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Y1 and a price level of P1. There is a recessionary gap equal to YP − Y1. In Panel (a),the economy closes the gap through a process of self-correction. Real and nominal
wages will fall as long as employment remains below the natural level. Lower
nominal wages shift the short-run aggregate supply curve. The process is a gradual
one, however, given the stickiness of nominal wages, but after a series of shifts inthe short-run aggregate supply curve, the economy moves toward equilibrium at a
price level of P2 and its potential output of YP.
Figure 7.14 Alternatives in Closing a Recessionary Gap

Panel (a) illustrates a gradual closing of a recessionary gap. Under a nonintervention policy, short-run aggregate
supply shifts from SRAS1 to SRAS2. Panel (b) shows the effects of expansionary policy acting on aggregate demand to
close the gap.

Panel (b) illustrates the stabilization alternative. Faced with an economy operating
below its potential, public officials act to stimulate aggregate demand. For example,
the government can increase government purchases of goods and services or cut
taxes. Tax cuts leave people with more after-tax income to spend, boost theirconsumption, and increase aggregate demand. As AD1 shifts to AD2 in Panel (b) of
Figure 7.14 "Alternatives in Closing a Recessionary Gap", the economy achieves
output of YP, but at a higher price level, P3. A stabilization policy designed toincrease real GDP is known as an expansionary policy22.

Nonintervention or Contractionary Policy?
22. A stabilization policy designed
to increase real GDP.

Figure 7.15 "Alternatives in Closing an Inflationary Gap" illustrates the alternatives
for closing an inflationary gap. Employment in an economy with an inflationary gap

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exceeds its natural level—the quantity of labor demanded exceeds the long-run
supply of labor. A nonintervention policy would rely on nominal wages to rise in
response to the shortage of labor. As nominal wages rise, the short-run aggregate
supply curve begins to shift, as shown in Panel (a), bringing the economy to its
potential output when it reaches SRAS2 and P2.
Figure 7.15 Alternatives in Closing an Inflationary Gap

Panel (a) illustrates a gradual closing of an inflationary gap. Under a nonintervention policy, short-run aggregate
supply shifts from SRAS1 to SRAS2. Panel (b) shows the effects of contractionary policy to reduce aggregate demand
from AD1 to AD2 in order to close the gap.

A stabilization policy that reduces the level of GDP is a contractionary policy23.
Such a policy would aim at shifting the aggregate demand curve from AD1 to AD2 toclose the gap, as shown in Panel (b). A policy to shift the aggregate demand curve tothe left would return real GDP to its potential at a price level of P3.

23. A stabilization policy designed
to reduce real GDP.
24. The use of government
purchases, transfer payments,
and taxes to influence the levelof economic activity.

For both kinds of gaps, a combination of letting market forces in the economy closepart of the gap and of using stabilization policy to close the rest of the gap is also an
option. Later chapters will explain stabilization policies in more detail, but there
are essentially two types of stabilization policy: fiscal policy and monetary policy.
Fiscal policy24 is the use of government purchases, transfer payments, and taxes toinfluence the level of economic activity. Monetary policy25 is the use of central
bank policies to influence the level of economic activity.

25. The use of central bank policies
to influence the level of
economic activity.

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To Intervene or Not to Intervene: An Introduction to the Controversy
How large are inflationary and recessionary gaps? Panel (a) of Figure 7.16 "Real GDP
and Potential Output" shows potential output versus the actual level of real GDP in
the United States since 1960. Real GDP appears to follow potential output quite
closely, although you see some periods where there have been inflationary or
recessionary gaps. Panel (b) shows the sizes of these gaps expressed as percentagesof potential output. The percentage gap is positive during periods of inflationary
gaps and negative during periods of recessionary gaps. Over the last 50 years, theeconomy has seldom departed by more than 5% from its potential output. So thesize and duration of the recessionary gap from 2009 to 2011 certainly stand out.
Figure 7.16 Real GDP and Potential Output

Panel (a) shows potential output (the blue line) and actual real GDP (the purple line) since 1960. Panel (b) shows thegap between potential and actual real GDP expressed as a percentage of potential output. Inflationary gaps areshown in green and recessionary gaps are shown in yellow.
Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised February 29, 2012). Real Gross Domestic Product,
Chained Dollars [Billions of chained (2005) dollars]. Seasonally adjusted at annual rates; Congressional Budget
Office, The Budget and Economic Outlook: An Update, August 2011.

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Panel (a) gives a long-run perspective on the economy. It suggests that the economy
generally operates at about potential output. In Panel (a), the gaps seem minor.
Panel (b) gives a short-run perspective; the view it gives emphasizes the gaps. Bothof these perspectives are important. While it is reassuring to see that the economy
is often close to potential, the years in which there are substantial gaps have realeffects: Inflation or unemployment can harm people.
Some economists argue that stabilization policy can and should be used whenrecessionary or inflationary gaps exist. Others urge reliance on the economy’s own
ability to correct itself. They sometimes argue that the tools available to the public
sector to influence aggregate demand are not likely to shift the curve, or they argue
that the tools would shift the curve in a way that could do more harm than good.
Economists who advocate stabilization policies argue that prices are sufficiently
sticky that the economy’s own adjustment to its potential will be a slow
process—and a painful one. For an economy with a recessionary gap, unacceptably
high levels of unemployment will persist for too long a time. For an economy withan inflationary gap, the increased prices that occur as the short-run aggregate
supply curve shifts upward impose too high an inflation rate in the short run. These
economists believe it is far preferable to use stabilization policy to shift theaggregate demand curve in an effort to shorten the time the economy is subject to agap.
Economists who favor a nonintervention approach accept the notion thatstabilization policy can shift the aggregate demand curve. They argue, however,that such efforts are not nearly as simple in the real world as they may appear on
paper. For example, policies to change real GDP may not affect the economy formonths or even years. By the time the impact of the stabilization policy occurs, thestate of the economy might have changed. Policy makers might choose an
expansionary policy when a contractionary one is needed or vice versa. Other
economists who favor nonintervention also question how sticky prices really are
and if gaps even exist.
The debate over how policy makers should respond to recessionary and inflationary
gaps is an ongoing one. These issues of nonintervention versus stabilization policies
lie at the heart of the macroeconomic policy debate. We will return to them as we
continue our analysis of the determination of output and the price level.

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KEY TAKEAWAYS• When the aggregate demand and short-run aggregate supply curvesintersect below potential output, the economy has a recessionary gap.
When they intersect above potential output, the economy has an
inflationary gap.
• Inflationary and recessionary gaps are closed as the real wage returns toequilibrium, where the quantity of labor demanded equals the quantity
supplied. Because of nominal wage and price stickiness, however, suchan adjustment takes time.
• When the economy has a gap, policy makers can choose to do nothing
and let the economy return to potential output and the natural level of
employment on its own. A policy to take no action to try to close a gap is
a nonintervention policy.
• Alternatively, policy makers can choose to try to close a gap by using
stabilization policy. Stabilization policy designed to increase real GDP iscalled expansionary policy. Stabilization policy designed to decrease real
GDP is called contractionary policy.

TRY IT!
Using the scenario of the Great Depression of the 1930s, as analyzed in theprevious Try It!, tell what kind of gap the U.S. economy faced in 1933,
assuming the economy had been at potential output in 1929. Do you thinkthe unemployment rate was above or below the natural rate ofunemployment? How could the economy have been brought back to its
potential output?

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Case in Point: This Time Is Different, Or Is It?

In an analysis that spans 66 countries over nearly eight centuries, economists
Carmen Reinhart and Kenneth Rogoff investigate hundreds of financial crises
and the economic busts each leaves in its wake. With a database that includes
crisis episodes that go back as far as 12th-century China and medieval Europe
and continue until the financial crisis of 2007–2008, the authors look at thepatterns of economic behavior that characterize the periods leading up tofinancial crises and the patterns that characterize the recoveries.
They argue that looking over a long period of history is necessary because
financial crises are “rare” events. Financial crises occur at varying intervals,
and researchers studying a period of 25 years or so may not encounter theequivalent of a 100-year, category 5 hurricane that hits a major, low-lying citywith a faulty levee system.
In general, such crises follow periods of relative economic calm. For example,
the period in the United States from the mid-1980s until 2007 was often
referred to as the Great Moderation. During such periods, inflationary andrecessionary gaps may occur, but they are relatively small and short-lived.
Societies begin to feel that they have tamed the business cycle, that policy
makers have gotten smarter, and that moderation will continue.
But then it happens. The accumulation of too much debt by governments,
businesses, or consumers leads to a financial meltdown. As housing prices are
run up, for example, people tend to find ways to justify their heavy borrowing
and to rationalize the ascent in prices: Demographics have changed; mortgage
terms have improved; the regulation we have put in place is better this time;it’s better to buy now, before prices go up even more; housing prices won’t fall.
Memories of the last crisis fade. “This time is different,” they argue.

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But Reinhart and Rogoff provide convincing evidence that “this time” is usually
not different. Large-scale debt buildups lead to crises of confidence, and afinancial crisis ensues. The aftermath is typically a severe and prolonged
recessionary gap. On average, they find the following to be true:
1. The collapse in asset market prices is large and long-lasting.
Housing prices decline an average of 35% over 6 years, and stock
prices decline an average of 56% over 3.5 years.
2. Peak-to-trough GDP falls 9% on average, and the recession
averages 2 years in length.
3. The unemployment rate rises 7 percentage points over a 4-year
period.
4. Government debt swells due to bailout costs and, more
importantly, because tax revenues fall off due to lower GDP.
5. V-shaped recoveries in stock prices are more common than Vshaped recoveries in housing prices or employment.
To what extent is the financial crisis of the late 2000s likely to follow thistypical pattern? The authors argue that experience with expansionary fiscal
policy in such circumstances is actually quite limited. Most often, governments
are shut out of borrowing markets when crises hit. Japan’s government
explicitly tried to implement fiscal stimulus, but the authors warn against
drawing conclusions from one such example. The authors caution thatgovernments should weigh any potential benefit of fiscal stimulus against the
problem of higher public debt. They also note that central banks in 2007–2008
acted quickly and aggressively with expansionary monetary policies. But, they
caution against “push[ing] too far the conceit that we are smarter than ourpredecessors” (p. 238). The global nature of the current situation only adds tothe difficulty of recovering fully.
There was a company failure around 15 years ago that looked like a big deal at
the time, but now seems like little more than a blip. The authors quote a trader
who, during this event, presciently remarked, “More money has been lost
because of four words than at the point of a gun. Those words are ‘This time isdifferent.’”
Source: Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight
Centuries of Financial Folly (Princeton: Princeton University Press, 2009).

7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium

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Chapter 7 Aggregate Demand and Aggregate Supply

ANSWER TO TRY IT! PROBLEM
To the graph in the previous Try It! problem we add the long-run aggregate
supply curve to show that, with output below potential, the U.S. economy in1933 was in a recessionary gap. The unemployment rate was above thenatural rate of unemployment. Indeed, real GDP in 1933 was about 30%
below what it had been in 1929, and the unemployment rate had increased
from 3% to 25%. Note that during the period of the Great Depression, wages
did fall. The notion of nominal wage and other price stickiness discussed inthis section should not be construed to mean complete wage and priceinflexibility. Rather, during this period, nominal wages and other prices
were not flexible enough to restore the economy to the potential level of
output. There are two basic choices on how to close recessionary gaps.
Nonintervention would mean waiting for wages to fall further. As wages fall,
the short-run aggregate supply curve would continue to shift to the right.
The alternative would be to use some type of expansionary policy. This
would shift the aggregate demand curve to the right. These two options
were illustrated in Figure 7.15 "Alternatives in Closing an Inflationary Gap".

7.3 Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium

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Chapter 7 Aggregate Demand and Aggregate Supply

7.4 Review and PracticeSummary
In this chapter, we outlined the model of aggregate demand and aggregate supply. We saw that the aggregate
demand curve slopes downward, reflecting the tendency for the aggregate quantity of goods and services
demanded to rise as the price level falls and to fall as the price level rises. The negative relationship between theprice level and the quantity of goods and services demanded results from the wealth effect for consumption, theinterest rate effect for investment, and the international trade effect for net exports. We examined the factorsthat can shift the aggregate demand curve as well. Generally, the aggregate demand curve shifts by a multiple ofthe initial amount by which the component causing it to shift changes.
We distinguished between two types of equilibria in macroeconomics—one corresponding to the short run, aperiod of analysis in which nominal wages and some prices are sticky, and the other corresponding to the longrun, a period in which full wage and price flexibility, and hence market adjustment, have been achieved. Longrun equilibrium occurs at the intersection of the aggregate demand curve with the long-run aggregate supply
curve. The long-run aggregate supply curve is a vertical line at the economy’s potential level of output. Shortrun equilibrium occurs at the intersection of the aggregate demand curve with the short-run aggregate supply
curve. The short-run aggregate supply curve relates the quantity of total output produced to the price level inthe short run. It is upward sloping because of wage and price stickiness. In short-run equilibrium, output can be
below or above potential.
If an economy is initially operating at its potential output, then a change in aggregate demand or short-run
aggregate supply will induce a recessionary or inflationary gap. Such a gap will be closed in the long run bychanges in the nominal wage, which will shift the short-run aggregate supply curve to the left (to close an
inflationary gap) or to the right (to close a recessionary gap). Policy makers might respond to a recessionary or
inflationary gap with a nonintervention policy, or they could use stabilization policy.

312Chapter 7 Aggregate Demand and Aggregate Supply

CONCEPT PROBLEMS

1. Explain how the following changes in aggregate demand or
short-run aggregate supply, other things held unchanged, arelikely to affect the level of total output and the price level in the
short run.
a.
b.
c.
d.

An increase in aggregate demand
A decrease in aggregate demand
An increase in short-run aggregate supply
A reduction in short-run aggregate supply

2. Explain why a change in one component of aggregate demand will cause
the aggregate demand curve to shift by a multiple of the initial change.
3. Use the model of aggregate demand and short-run aggregate
supply to explain how each of the following would affect real
GDP and the price level in the short run.
a.
b.
c.
d.

An increase in government purchases
A reduction in nominal wages
A major improvement in technology
A reduction in net exports

4. How would an increase in the supply of labor affect the natural level of
employment and potential output? How would it affect the real wage,
the level of real GDP, and the price level in the short run? How would it
affect long-run aggregate supply? What kind of gaps would be created?
5. Give three reasons for the downward slope of the aggregate demand
curve.
6. “When the price level falls, people’s wealth increases. When wealthincreases, the real volume of consumption increases. Therefore, adecrease in the price level will cause the aggregate demand curve toshift to the right.” Do you agree? Explain.
7. Suppose the economy has a recessionary gap. We know that if we donothing, the economy will close the gap on its own. Alternatively, we
could arrange for an increase in aggregate demand (say, by increasing
government spending) to close the gap. How would your views about thedegree of price stickiness in the economy influence your views on
whether such a policy would be desirable?
8. The cost of hiring workers includes not only payments made directly toworkers, that is, wages, but payments made on behalf of workers as well,such as contributions by employers to pension plans and to health-care

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Chapter 7 Aggregate Demand and Aggregate Supply

insurance for employees. How would a decrease in the cost of employerprovided health insurance affect the economy? Using Figure 7.8 "An
Increase in Health Insurance Premiums Paid by Firms" as a guide, draw agraph to illustrate your answer.
9. Suppose nominal wages never changed. What would be the significanceof such a characteristic?
10. Suppose the minimum wage were increased sharply. How would thisaffect the equilibrium price level and output level in the model ofaggregate demand and aggregate supply in the short run? In the longrun?
11. Explain the short-run impact of each of the following.
a. A discovery that makes cold fusion a reality, greatly reducing
the cost of producing energyb. An increase in the payroll tax

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Chapter 7 Aggregate Demand and Aggregate Supply

NUMERICAL PROBLEMS

1. Suppose the aggregate demand and short-run aggregate supply
schedules for an economy whose potential output equals $2,700
are given by the table.
Aggregate Quantity of Goods and Services
Price Level

Demanded

Supplied

0.50$3,500$1,000

0.75

3,000

2,000

1.00

2,500

2,500

1.25

2,000

2,700

1.50

1,500

2,800

a. Draw the aggregate demand, short-run aggregate supply,and long-run aggregate supply curves.
b. State the short-run equilibrium level of real GDP and theprice level.
c. Characterize the current economic situation. Is there an
inflationary or a recessionary gap? If so, how large is it?
d. Now suppose aggregate demand increases by $700 at each
price level; for example, the aggregate quantity of goods andservices demanded at a price level of 0.50 now equals $4,200.
Show the new aggregate demand curve, state the new shortrun equilibrium price level and real GDP, and state whether
there is an inflationary or a recessionary gap and give its
size.
2. An economy is characterized by the values in the table foraggregate demand and short-run aggregate supply. Its potential
output is $1,500.
Aggregate Quantity of Goods and Services

7.4 Review and PracticePrice Level

Demanded

Supplied

0.50$2,500$1,500

0.75

2,000

2,000

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Chapter 7 Aggregate Demand and Aggregate Supply

Aggregate Quantity of Goods and Services
1.00

1,500

2,300

1.25

1,000

2,500

1.50

500

2,600

a. Draw the aggregate demand, short-run aggregate supply,and long-run aggregate supply curves.
b. State the equilibrium level of real GDP and the price level.
c. Characterize the current economic situation. Is there an
inflationary or a recessionary gap? If so, how large is it?
d. Now suppose that nominal wages rise and that the price level
required to induce a particular level of total output rises by
0.50. For example, a price level of 1.00 is now required toinduce producers to produce a real GDP of $1,500. Show the
new short-run aggregate supply curve, state the new
equilibrium price level and real GDP, and state whether there
is an inflationary or a recessionary gap and give its size. Why
might such a change occur?
3. Suppose the price level in a particular economy equals 1.3 and that thequantity of real GDP demanded at that price level is $1,200. An increaseof 0.1 point in the price level reduces the quantity of real GDP demanded
by $220, and a reduction of 0.1 point would produce an increase in thequantity of real GDP demanded of $220. Draw the aggregate demand
curve and show the price level and quantity of real GDP demanded atthree points.
4. Suppose an economy is described by the following aggregate
demand and short-run aggregate supply curves. The potential
level of output is $10 trillion.
Aggregate Quantity of Goods and Services

7.4 Review and PracticePrice Level

Demanded

Supplied

3.0$11.0 trillion$9.0 trillion

3.4$10.8 trillion$9.2 trillion

3.8$10.6 trillion$9.4 trillion

4.2$10.4 trillion$9.6 trillion

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Chapter 7 Aggregate Demand and Aggregate Supply

Aggregate Quantity of Goods and Services
4.6$10.2 trillion$9.8 trillion

5.0$10.0 trillion$10.0 trillion

5.4$9.8 trillion$10.2 trillion

5.8$9.6 trillion$10.4 trillion

6.2$9.4 trillion$10.6 trillion

6.6$9.2 trillion$10.8 trillion

7.0$9.0 trillion$11.0 trillion

a. Draw the aggregate demand and short-run aggregate supply
curves.
b. What is the initial real GDP?
c. What is the initial price level?
d. What kind of gap, if any, exists?
e. After the increase in health-care costs, each level of real GDP
requires an increase in the price level of 0.8. For example,
producing $9.0 trillion worth of goods and services now
requires a price level of 3.8. What is the short-run
equilibrium level of real GDP?
f. After the health-care cost increase, what is the new
equilibrium price level in the short run?
g. What sort of gap, if any, now exists?
5. According to Alaskan state economist Mark Edwards, the multipliereffect of Alaska’s trade with Japan is such that for every $1 billion
exported from Alaska to Japan another $600 million is added to thestate’s economy.Matt Volz, “Trade Officials Hopeful for Japanese
Recovery,” Associated Press and Local Wire, June 22, 2004, BC cycle.
Calculate the size of the export multiplier.
6. The Nottinghamshire Research Observatory in England calculated thatstudents who attend Nottingham Technical University spend about£2,760 each in the local economy for a total of £50.45 million. In total,
the impact of their spending on the local economy is £63
million.“University Brings in £250m to Economy,” Nottingham Evening
Post, November 4, 2004, p. 37. Calculate the size of the student spending
multiplier.
7. In Goa, India, the multiplier effect of iron ore exports is calculated to be
1.62.Vidyut Kumar Ta, “Iron Ore Mining Gives Impetus to Goa’s

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Chapter 7 Aggregate Demand and Aggregate Supply

Economy,” Times of India, April 30, 2003. Calculate the impact of anadditional 1,000 rupees of iron ore exports on the economy of Goa.

7.4 Review and Practice318

Chapter 8
Economic GrowthStart Up: How Important Is Economic Growth?
How important is economic growth? The best way to answer that question is toimagine life without growth—to imagine that we did not have the gains growthbrings.
For starters, divide your family’s current income by six and imagine what your life
would be like. Think about the kind of housing your family could afford, the size ofyour entertainment budget, whether you could still attend school. That will give
you an idea of life a century ago in the United States, when average householdincomes, adjusted for inflation, were about one-sixth what they are today. People
had far smaller homes, they rarely had electricity in their homes, and only a tiny
percentage of the population could even consider a college education.
To get a more recent perspective, consider how growth has changed living
standards over the past half century or so. In 1950, the United States was theworld’s richest nation. But if households were rich then, subsequent economic
growth has made them far richer. Average per capita real income has tripled sincethen. Indeed, the average household income in 1950, which must have seemed lofty
then, was below what we now define as the poverty line for a household of four,even after adjusting for inflation. Economic growth during the last 60-plus years
has dramatically boosted our standard of living—and our standard of what it takes
to get by.
One gauge of rising living standards is housing. A half century ago, most families
did not own homes. Today, about two-thirds do. Those homes have gotten a lot
bigger: new homes built today are more than twice the size of new homes built 50
years ago. Some household appliances, such as telephones or washing machines,that we now consider basic, were luxuries a half century ago. In 1950, less than twothirds of housing units had complete plumbing facilities. Today, over 99% do.
Economic growth has brought gains in other areas as well. For one thing, we areable to afford more schooling. In 1950, the median number of years of school
completed by adults age 25 or over was 6.8. Today, about 87% have completed 12319

Chapter 8 Economic Growthyears of schooling and about 30% have completed 4 years of college. We also live
longer. A baby born in 1950 had a life expectancy of 68 years. A baby born in 2008
had an expected life of nearly 10 years longer.
Of course, while economic growth can improve our material well-being, it is no
panacea. Americans today worry about the level of violence in society,environmental degradation, and what seems to be a loss of basic values. But while itis easy to be dismayed about many challenges of modern life, we can surely be
grateful for our material wealth. Our affluence gives us the opportunity to grapple
with some of our most difficult problems and to enjoy a range of choices that people
only a few decades ago could not have imagined.
We learned a great deal about economic growth in the context of the production
possibilities curve. Our purpose in this chapter is to relate the concept of economic
growth to the model of aggregate demand and aggregate supply that we developedin the previous chapter and will use throughout our exploration ofmacroeconomics. We will review the forces that determine a nation’s economic
growth rate and examine the prospects for growth in the future. We begin bylooking at the significance of growth to the overall well-being of society.

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Chapter 8 Economic Growth

8.1 The Significance of Economic Growth
LEARNING OBJECTIVES
1. Define economic growth and explain it using the production possibilities
model and the concept of potential output.
2. State the rule of 72 and use it to show how even small differences ingrowth rates can have major effects on a country’s potential output overtime.
3. Calculate the percentage rate of growth of output per capita.

To demonstrate the impact of economic growth on living standards of a nation, wemust start with a clear definition of economic growth and then study its impact
over time. We will also see how population growth affects the relationship between
economic growth and the standard of living an economy is able to achieve.

Defining Economic Growth
Economic growth is a long-run process that occurs as an economy’s potential
output increases. Changes in real GDP from quarter to quarter or even from year toyear are short-run fluctuations that occur as aggregate demand and short-run
aggregate supply change. Regardless of media reports stating that the economy
grew at a certain rate in the last quarter or that it is expected to grow at aparticular rate during the next year, short-run changes in real GDP say little about
economic growth. In the long run, economic activity moves toward its level ofpotential output. Increases in potential constitute economic growth.
Earlier we defined economic growth as the process through which an economy
achieves an outward shift in its production possibilities curve. How does a shift in
the production possibilities curve relate to a change in potential output? To
produce its potential level of output, an economy must operate on its production
possibilities curve. An increase in potential output thus implies an outward shift in
the production possibilities curve. In the framework of the macroeconomic modelof aggregate demand and aggregate supply, we show economic growth as a shift tothe right in the long-run aggregate supply curve.
There are three key points about economic growth to keep in mind:

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Chapter 8 Economic Growth

1. Growth is a process. It is not a single event; rather, it is an unfolding
series of events.
2. We define growth in terms of the economy’s ability to produce goods
and services, as indicated by its level of potential output.
3. Growth suggests that the economy’s ability to produce goods andservices is rising. A discussion of economic growth is thus a discussionof the series of events that increase the economy’s ability to produce
goods and services.
Figure 8.1 "A Century of Economic Growth" shows the record of economic growth
for the U.S. economy over the past century. The graph shows annual levels of actual
real GDP and of potential output. We see that the economy has experienced
dramatic growth over the past century; potential output has soared nearly 20-fold.
The figure also reminds us of a central theme of our analysis of macroeconomics:
real GDP fluctuates about potential output. Real GDP sagged well below its potential(initially more than 40% below and then remaining at about 20% below for most of
the decade) during the Great Depression of the 1930s and rose well above its
potential (about 30% above) as the nation mobilized its resources to fight WorldWar II. With the exception of these two periods, real GDP has remained fairly close
to the economy’s potential output. In the recession of 1981, real GDP was about 6.5%
below its potential, and during the recession that began at the end of 2007, real GDP
fell nearly 8% below its potential. In 2011, the economy was still about 6.8% below
its potential. Nonetheless, since 1950, the actual level of real GDP has deviated frompotential output by an average of less than 2%.

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Chapter 8 Economic Growth

Figure 8.1 A Century of Economic Growth

At the start of the 21st century, the level of potential output reached a level nearly 20 times its level a century
earlier. Over the years, actual real GDP fluctuated about a rising level of potential output.
Sources: 1910–1949 data from Christina D. Romer, “World War I and the Postwar Depression: A Reinterpretation
Based on Alternative Estimates of GNP,” Journal of Monetary Economics 22 (1988): 91–115; data for 1950–2010 from
Congressional Budget Office, The Budget and Economic Outlook: An Update, August 2011 and from Bureau of
Economic Analysis, NIPA Table 1.1.6.

We urge you to take some time with Figure 8.1 "A Century of Economic Growth".
Over the course of the last century, it is economic growth that has taken center
stage. Certainly, the fluctuations about potential output have been important. The
recessionary gaps—periods when real GDP slipped below its potential—were often
wrenching experiences in which millions of people endured great hardship. The
inflationary gaps—periods when real GDP rose above its potential level—often
produced dramatic increases in price levels. Those fluctuations mattered. It was theunemployment and/or the inflation that came with them that made headlines. But
it was the quiet process of economic growth that pushed living standards everhigher. We must understand growth if we are to understand how we got where weare, and where we are likely to be going during the 21st century.

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Chapter 8 Economic Growth

Figure 8.2 "Cyclical Change Versus Growth" tells us why we use changes in potential
output, rather than actual real GDP, as our measure of economic growth. Actual
values of real GDP are affected not just by changes in the potential level of output,
but also by the cyclical fluctuations about that level of output.
Given our definition of economic growth, we would say that the hypothetical
economy depicted in Figure 8.2 "Cyclical Change Versus Growth" grew at a 2.5%
annual rate throughout the period. If we used actual values of real GDP, however,
we would obtain quite different interpretations. Consider, for example, the first
decade of this period: it began with a real GDP of $900 billion and a recessionarygap, and it ended in year 10 with a real GDP of $1,408 billion and an inflationary
gap. If we record growth as the annual rate of change between these levels, we findan annual rate of growth of 4.6%—a rather impressive performance.
Now consider the second decade shown in Figure 8.2"Cyclical Change Versus Growth". It began in year 10,
and it ended in year 20 with a recessionary gap. If wemeasure the growth rate over that period by looking at
beginning and ending values of actual real GDP, we
compute an annual growth rate of 0.5%. Viewed in thisway, performance in the first decade is spectacularwhile performance in the second is rather lackluster.
But these figures depend on the starting and ending
points we select; the growth rate of potential output was
2.5% throughout the period.
By measuring economic growth as the rate of increasein potential output, we avoid such problems. One way to
do this is to select years in which the economy was
operating at the natural level of employment and thento compute the annual rate of change between those
years. The result is an estimate of the rate at which
potential output increased over the period in question.
For the economy shown in Figure 8.2 "Cyclical Change
Versus Growth", for example, we see that real GDP
equaled its potential in years 5 and 15. Real GDP in year
5 was $1,131, and real GDP in year 15 was $1,448. The
annual rate of change between these two years was
2.5%. If we have estimates of potential output, of course,
we can simply compute annual rates of change between
any two years.

8.1 The Significance of Economic Growth

Figure 8.2 Cyclical Change
Versus Growth

The use of actual values of real
GDP to measure growth can givemisleading results. Here, an
economy’s potential output(shown in green) grows at a
steady rate of 2.5% per year, withactual values of real GDP
fluctuating about that trend. If
we measure growth in the first 10
years as the annual rate ofchange between beginning and324

Chapter 8 Economic Growth

The Rule of 72 and Differences in Growth
Rates

ending values of real GDP, we geta growth rate of 4.6%. The rate
for the second decade is 0.5%.
Growth estimates based onchanges in real GDP are affectedby cyclical changes that do not
represent economic growth.

The Case in Point on presidents and growth at the endof this section suggests a startling fact: the U.S. growthrate began slowing in the 1970s, did not recover until
the mid-1990s, only to slow down again in the 2000s.
The question we address here is: does it matter? Does apercentage point drop in the growth rate make muchdifference? It does. To see why, let us investigate what
happens when a variable grows at a particular percentage rate.

Suppose two economies with equal populations start out at the same level of real
GDP but grow at different rates. Economy A grows at a rate of 3.5%, and Economy B
grows at a rate of 2.4%. After a year, the difference in real GDP will hardly be
noticeable. After a decade, however, real GDP in Economy A will be 11% greaterthan in Economy B. Over longer periods, the difference will be more dramatic. After
100 years, for example, income in Economy A will be nearly three times as great as
in Economy B. If population growth in the two countries has been the same, thepeople of Economy A will have a far higher standard of living than those inEconomy B. The difference in real GDP per person will be roughly equivalent to thedifference that exists today between Great Britain and Mexico.
Over time, small differences in growth rates create large differences in incomes. An
economy growing at a 3.5% rate increases by 3.5% of its initial value in the firstyear. In the second year, the economy increases by 3.5% of that new, higher value.
In the third year, it increases by 3.5% of a still higher value. When a quantity grows
at a given percentage rate, it experiences exponential growth1. A variable thatgrows exponentially follows a path such as those shown for potential output in
Figure 8.1 "A Century of Economic Growth" and Figure 8.2 "Cyclical Change Versus
Growth". These curves become steeper over time because the growth rate is applied
to an ever-larger base.

1. When a quantity grows at agiven percentage rate.
2. A variable’s approximate
doubling time equals 72
divided by the growth rate,stated as a whole number.

A variable growing at some exponential rate doubles over fixed intervals of time.
The doubling time is given by the rule of 722, which states that a variable’s
approximate doubling time equals 72 divided by the growth rate, stated as a whole
number. If the level of income were increasing at a 9% rate, for example, its
doubling time would be roughly 72/9, or 8 years.Notice the use of the words roughly
and approximately. The actual value of an income of $1,000 growing at rate r for aperiod of n years is $1,000 × (1 + r)n. After 8 years of growth at a 9% rate, income
would thus be $1,000 (1 + 0.09)8 = $1,992.56. The rule of 72 predicts that its value will

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Chapter 8 Economic Growth

be $2,000. The rule of 72 gives an approximation, not an exact measure, of the
impact of exponential growth.
Let us apply this concept of a doubling time to the reduction in the U.S. growth rate.
Had the U.S. economy continued to grow at a 3.5% rate after 1970, then its potential
output would have doubled roughly every 20 years (72/3.5 = 20). That means
potential output would have doubled by 1990, would double again by 2010, andwould double again by 2030. Real GDP in 2030 would thus be eight times as great asits 1970 level. Growing at a 2.4% rate, however, potential output doubles only every
30 years (72/2.4 = 30). It would take until 2000 to double once from its 1970 level,
and it would double once more by 2030. Potential output in 2030 would thus be fourtimes its 1970 level if the economy grew at a 2.4% rate (versus eight times its 1970
level if it grew at a 3.5% rate). The 1.1% difference in growth rates produces a 100%
difference in potential output by 2030. The different growth paths implied by thesegrowth rates are illustrated in Figure 8.3 "Differences in Growth Rates".
Figure 8.3 Differences in Growth Rates

The chart suggests the significance in the long run of a small difference in the growth rate of real GDP. We begin in
1970, when real GDP equaled $2,873.9 billion. If real GDP grew at an annual rate of 3.5% from that year, it would
double roughly every 20 years: in 1990, 2010, and 2030. Growth at a 2.4% rate, however, implies doubling every 30
years: in 2000 and 2030. By 2030, the 3.5% growth rate leaves real GDP at twice the level that would be achieved by
2.4% growth.

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Chapter 8 Economic Growth

Growth in Output per Capita
Of course, it is not just how fast potential output grows that determines how fast
the average person’s material standard of living rises. For that purpose, we examine
economic growth on a per capita basis. An economy’s output per capita3 equals
real GDP per person. If we let N equal population, thenEquation 8.1

Output per capita =real GDPN

In the United States in the third quarter of 2010, for example, real GDP was$13,277.4 billion (annual rate). The U.S. population was 311.0 million. Real U.S.
output per capita thus equaled $42,693.
We use output per capita as a gauge of an economy’s material standard of living. If
the economy’s population is growing, then output must rise as rapidly as the
population if output per capita is to remain unchanged. If, for example, population
increases by 2%, then real GDP would have to rise by 2% to maintain the current
level of output per capita. If real GDP rises by less than 2%, output per capita will
fall. If real GDP rises by more than 2%, output per capita will rise. More generally,
we can write:
Equation 8.2% rate of growth of output per capita ≅ % rate of growth of output − % rat
For economic growth to translate into a higher standard of living on average,
economic growth must exceed population growth. From 1970 to 2004, for example,
Sierra Leone’s population grew at an annual rate of 2.1% per year, while its real GDP
grew at an annual rate of 1.4%; its output per capita thus fell at a rate of 0.7% per
year. Over the same period, Singapore’s population grew at an annual rate of 2.1%
per year, while its real GDP grew 7.4% per year. The resultant 5.3% annual growth in
output per capita transformed Singapore from a relatively poor country to a
country with the one of the highest per capita incomes in the world.

3. Real GDP per person.

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Chapter 8 Economic Growth

KEY TAKEAWAYS• Economic growth is the process through which an economy’s
production possibilities curve shifts outward. We measure it as the rate
at which the economy’s potential level of output increases.
• Measuring economic growth as the rate of increase of the actual level ofreal GDP can lead to misleading results due to the business cycle.
• Growth of a quantity at a particular percentage rate implies exponential
growth. When something grows exponentially, it doubles over fixedintervals of time; these intervals may be computed using the rule of 72.
• Small differences in rates of economic growth can lead to large
differences in levels of potential output over long periods of time.
• To assess changes in average standards of living, we subtract thepercentage rate of growth of population from the percentage rate of
growth of output to get the percentage rate of growth of output percapita.

TRY IT!
Suppose an economy’s potential output and real GDP is $5 million in 2000
and its rate of economic growth is 3% per year. Also suppose that its
population is 5,000 in 2000, and that its population grows at a rate of 1% per
year. Compute GDP per capita in 2000. Now estimate GDP and GDP per capita
in 2072, using the rule of 72. At what rate does GDP per capita grow? What is
its doubling time? Is this result consistent with your findings for GDP per
capita in 2000 and in 2072?

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Chapter 8 Economic Growth

Case in Point: Presidents and Economic Growth

Annual Increase in RealGDP (%)

Growth Rate(%)

Truman 1949–1952

5.4

4.4

Eisenhower 1953–1960

2.5

3.3

Kennedy-Johnson
1961–1968

5.1

4.4

Nixon-Ford 1969–1976

2.8

3.4

Carter 1977–1980

3.2

3.1

Reagan 1981–1988

3.5

3.1

G. H. W. Bush 1989–1992

2.1

2.9

Clinton 1993–2000

3.8

3.3

G. W. Bush 2001–2008

1.6

2.6

President

Presidents are often judged by the rate at which the economy grew while they
were in office. This test is unfair on two counts. First, a president has little to dowith the forces that determine growth. And second, such tests simply computethe annual rate of growth in real GDP over the course of a presidential term,
which we know can be affected by cyclical factors. A president who takes officewhen the economy is down and goes out with the economy up will look like aneconomic star; a president with the bad luck to have reverse circumstances willseem like a dud. Here are annual rates of change in real GDP for each of the
postwar presidents, together with rates of economic growth, measured as theannual rate of change in potential output.
The presidents’ economic records are clearly affected by luck. Presidents
Truman, Kennedy, Reagan, and Clinton, for example, began their terms whenthe economy had a recessionary gap and ended them with an inflationary gap
or at about potential output. Real GDP thus rose faster than potential output

8.1 The Significance of Economic Growth329

Chapter 8 Economic Growthduring their presidencies. The Eisenhower, Nixon-Ford, G. H. W. Bush, and G. W.
Bush administrations each started with an inflationary gap or at about
potential and ended with a recessionary gap, thus recording rates of real GDP
increase below the rate of gain in potential. Only Jimmy Carter, who came tooffice and left it with recessionary gaps, presided over a relatively equivalent
rate of increase in actual GDP versus potential output.
How did Barack Obama fare? As this case was written after he was in office forless than a full term, you will have to check for yourself!

ANSWER TO TRY IT! PROBLEM
GDP per capita in 2000 equals $1,000 ($5,000,000/5,000). If GDP rises 3% per
year, it doubles every 24 years (= 72/3). Thus, GDP will be $10,000,000 in
2024, $20,000,000 in 2048, and $40,000,000 in 2072. Growing at a rate of 1%
per year, population will have doubled once by 2072 to 10,000. GDP per
capita will thus be $4,000 (= $40,000,000/10,000). Notice that GDP rises by
eight times its original level, while the increase in GDP per capita is fourfold.
The latter value represents a growth rate in output per capita of 2% per
year, which implies a doubling time of 36 years. That gives two doublings in
GDP per capita between 2000 and 2072 and confirms a fourfold increase.

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8.2 Growth and the Long-Run Aggregate Supply Curve
LEARNING OBJECTIVES
1. Explain and illustrate graphically the concept of the aggregate
production function. Explain how its shape relates to the concept ofdiminishing marginal returns.
2. Derive the long-run aggregate supply curve from the model of the labormarket and the aggregate production function.
3. Explain how the long-run aggregate supply curve shifts in responses toshifts in the aggregate production function or to shifts in the demandfor or supply of labor.

Economic growth means the economy’s potential output is rising. Because the longrun aggregate supply curve is a vertical line at the economy’s potential, we candepict the process of economic growth as one in which the long-run aggregate
supply curve shifts to the right.
Figure 8.4 "Economic Growth and the Long-Run
Aggregate Supply Curve" illustrates the process of
economic growth. If the economy begins at potential
output of Y1, growth increases this potential. The figure
shows a succession of increases in potential to Y2, thenY3, and Y4. If the economy is growing at a particular
percentage rate, and if the levels shown represent
successive years, then the size of the increases will
become larger and larger, as indicated in the figure.
Because economic growth can be considered as aprocess in which the long-run aggregate supply curve
shifts to the right, and because output tends to remainclose to this curve, it is important to gain a deeper
understanding of what determines long-run aggregate
supply (LRAS). We shall examine the derivation of LRAS
and then see what factors shift the curve. We shall begin
our work by defining an aggregate production function.

Figure 8.4 Economic Growth
and the Long-Run Aggregate
Supply Curve

Because economic growth is theprocess through which theeconomy’s potential output isincreased, we can depict it as aseries of rightward shifts in thelong-run aggregate supply curve.
Notice that with exponential
growth, each successive shift in
LRAS is larger and larger.

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Chapter 8 Economic Growth

The Aggregate Production Function
An aggregate production function4 relates the total output of an economy to thetotal amount of labor employed in the economy, all other determinants ofproduction (that is, capital, natural resources, and technology) being unchanged.
An economy operating on its aggregate production function is producing its
potential level of output.
Figure 8.5 "The Aggregate Production Function" shows an aggregate production
function (PF). It shows output levels for a range of employment between 120 millionand 140 million workers. When the level of employment is 120 million, the economy
produces a real GDP of $11,500 billion (point A). A level of employment of 130
million produces a real GDP of $12,000 billion (point B), and when 140 million
workers are employed, a real GDP of $12,300 billion is produced (point C). In
drawing the aggregate production function, the amount of labor varies, buteverything else that could affect output, specifically the quantities of other factorsof production and technology, is fixed.
The shape of the aggregate production function shows that as employment
increases, output increases, but at a decreasing rate. Increasing employment from
120 million to 130 million, for example, increases output by $500 billion to $12,000
billion at point B. The next 10 million workers increase production by $300 billion
to $12,300 billion at point C. This example illustrates diminishing marginal returns.
Diminishing marginal returns5 occur when additional units of a variable factor
add less and less to total output, given constant quantities of other factors.

4. Function that relates the total
output of an economy to thetotal amount of labor
employed in the economy, allother determinants ofproduction (capital, natural
resources, and technology)
being unchanged.
5. Situation that occurs when
additional units of a variablefactor add less and less to total
output, given constantquantities of other factors.

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Chapter 8 Economic Growth

Figure 8.5 The Aggregate Production Function

An aggregate production function (PF) relates total output to total employment, assuming all other factors of
production and technology are fixed. It shows that increases in employment lead to increases in output but at adecreasing rate.

It is easy to picture the problem of diminishing marginal returns in the context of asingle firm. The firm is able to increase output by adding workers. But because thefirm’s plant size and stock of equipment are fixed, the firm’s capital per worker falls
as it takes on more workers. Each additional worker adds less to output than theworker before. The firm, like the economy, experiences diminishing marginal
returns.

The Aggregate Production Function, the Market for Labor, andLong-Run Aggregate Supply
To derive the long-run aggregate supply curve, we bring together the model of thelabor market, introduced in the first macro chapter and the aggregate production
function.

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Chapter 8 Economic Growth

As we learned, the labor market is in equilibrium at the natural level of
employment. The demand and supply curves for labor intersect at the real wage at
which the economy achieves its natural level of employment. We see in Panel (a) of
Figure 8.6 "Deriving the Long-Run Aggregate Supply Curve" that the equilibrium
real wage is ω1 and the natural level of employment is L1. Panel (b) shows that with
employment of L1, the economy can produce a real GDP of YP. That output equals
the economy’s potential output. It is that level of potential output that determines
the position of the long-run aggregate supply curve in Panel (c).
Figure 8.6 Deriving the Long-Run Aggregate Supply Curve

Panel (a) shows that the equilibrium real wage is ω1, and the natural level of employment is L1. Panel (b) shows thatwith employment of L1, the economy can produce a real GDP of YP. That output equals the economy’s potential
output. It is at that level of potential output that we draw the long-run aggregate supply curve in Panel (c).

Changes in Long-Run Aggregate Supply
The position of the long-run aggregate supply curve is determined by the aggregate
production function and the demand and supply curves for labor. A change in anyof these will shift the long-run aggregate supply curve.
Figure 8.7 "Shift in the Aggregate Production Function and the Long-Run Aggregate
Supply Curve" shows one possible shifter of long-run aggregate supply: a change inthe production function. Suppose, for example, that an improvement in technology
shifts the aggregate production function in Panel (b) from PF1 to PF2. Other
developments that could produce an upward shift in the curve include an increasein the capital stock or in the availability of natural resources.

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Chapter 8 Economic Growth

Figure 8.7 Shift in the Aggregate Production Function and the Long-Run Aggregate Supply Curve

An improvement in technology shifts the aggregate production function upward in Panel (b). Because labor is moreproductive, the demand for labor shifts to the right in Panel (a), and the natural level of employment increases to L2.
In Panel (c) the long-run aggregate supply curve shifts to the right to Y2.

The shift in the production function to PF2 means that labor is now more productive
than before. This will affect the demand for labor in Panel (a). Before thetechnological change, firms employed L1 workers at a real wage ω1. If workers are
more productive, firms will find it profitable to hire more of them at ω 1. The
demand curve for labor thus shifts to D2 in Panel (a). The real wage rises to ω2, andthe natural level of employment rises to L2. The increase in the real wage reflects
labor’s enhanced productivity6, the amount of output per worker. To see how
potential output changes, we see in Panel (b) how much output can be produced
given the new natural level of employment and the new aggregate production
function. The real GDP that the economy is capable of producing rises from Y1 to Y2.
The higher output is a reflection of a higher natural level of employment, alongwith the fact that labor has become more productive as a result of the technologicaladvance. In Panel (c) the long-run aggregate supply curve shifts to the right to thevertical line at Y2.

6. The amount of output per
worker.

This analysis dispels a common misconception about the impact of improvements
in technology or increases in the capital stock on employment. Some people believethat technological gains or increases in the stock of capital reduce the demand forlabor, reduce employment, and reduce real wages. Certainly the experience of theUnited States and most other countries belies that notion. Between 1990 and 2007,
for example, the U.S. capital stock and the level of technology increased
dramatically. During the same period, employment and real wages rose, suggestingthat the demand for labor increased by more than the supply of labor. As somefirms add capital or incorporate new technologies, some workers at those firms may

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Chapter 8 Economic Growth

lose their jobs. But for the economy as a whole, new jobs become available and theygenerally offer higher wages. The demand for labor rises.
Another event that can shift the long-run aggregate supply curve is an increase in
the supply of labor, as shown in Figure 8.8 "Increase in the Supply of Labor and theLong-Run Aggregate Supply Curve". An increased supply of labor could result from
immigration, an increase in the population, or increased participation in the labor
force by the adult population. Increased participation by women in the labor force,for example, has tended to increase the supply curve for labor during the past
several decades.
Figure 8.8 Increase in the Supply of Labor and the Long-Run Aggregate Supply Curve

An increase in the supply of labor shifts the supply curve in Panel (a) to S2, and the natural level of employment
rises to L2. The real wage falls to ω2. With increased labor, the aggregate production function in Panel (b) showsthat the economy is now capable of producing real GDP at Y2. The long-run aggregate supply curve in Panel (c)shifts to LRAS2.

In Panel (a), an increase in the labor supply shifts the supply curve to S2. The
increase in the supply of labor does not change the stock of capital or natural
resources, nor does it change technology—it therefore does not shift the aggregate
production function. Because there is no change in the production function, there is
no shift in the demand for labor. The real wage falls from ω 1 to ω2 in Panel (a), andthe natural level of employment rises from L1 to L2. To see the impact on potential
output, Panel (b) shows that employment of L2 can produce real GDP of Y2. The
long-run aggregate supply curve in Panel (c) thus shifts to LRAS2. Notice, however,that this shift in the long-run aggregate supply curve to the right is associated witha reduction in the real wage to ω2.

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Chapter 8 Economic Growth

Of course, the aggregate production function and the supply curve of labor can shift
together, producing higher real wages at the same time population rises. That has
been the experience of most industrialized nations. The increase in real wages in
the United States between 1990 and 2007, for example, came during a period inwhich an increasing population increased the supply of labor. The demand for labor
increased by more than the supply, pushing the real wage up. The accompanying
Case in Point looks at gains in real wages in the face of technological change, anincrease in the stock of capital, and rapid population growth in the United States
during the 19th century.
Our model of long-run aggregate supply tells us that in the long run, real GDP, thenatural level of employment, and the real wage are determined by the economy’s
production function and by the demand and supply curves for labor. Unless an
event shifts the aggregate production function, the demand curve for labor, or the
supply curve for labor, it affects neither the natural level of employment nor
potential output. Economic growth occurs only if an event shifts the economy’s
production function or if there is an increase in the demand for or the supply oflabor.

KEY TAKEAWAYS• The aggregate production function relates the level of employment to
the level of real GDP produced per period.
• The real wage and the natural level of employment are determined by
the intersection of the demand and supply curves for labor. Potential
output is given by the point on the aggregate production function
corresponding to the natural level of employment. This output level isthe same as that shown by the long-run aggregate supply curve.
• Economic growth can be shown as a series of shifts to the right in LRAS.
Such shifts require either upward shifts in the production function or
increases in demand for or supply of labor.

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Chapter 8 Economic Growth

TRY IT!
Suppose that the quantity of labor supplied is 50 million workers when thereal wage is $20,000 per year and that potential output is $2,000 billion per
year. Draw a three-panel graph similar to the one presented in Figure 8.8"Increase in the Supply of Labor and the Long-Run Aggregate Supply Curve"
to show the economy’s long-run equilibrium. Panel (a) of your graph should
show the demand and supply curves for labor, Panel (b) should show theaggregate production function, and Panel (c) should show the long-run
aggregate supply curve. Now suppose a technological change increases the
economy’s output with the same quantity of labor as before to $2,200 billion,
and the real wage rises to $21,500. In response, the quantity of labor
supplied increases to 51 million workers. In the same three panels you havealready drawn, sketch the new curves that result from this change. Explain
what happens to the level of employment, the level of potential output, andthe long-run aggregate supply curve. (Hint: you have information for only
one point on each of the curves you draw—two for the supply of labor;
simply draw curves of the appropriate shape. Do not worry about getting thescale correct.)

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Chapter 8 Economic Growth

Case in Point: Technological Change, Employment, andReal Wages During the Industrial Revolution

Technological change and the capital investment that typically comes with it
are often criticized because they replace labor with machines, reducing
employment. Such changes, critics argue, hurt workers. Using the model ofaggregate demand and aggregate supply, however, we arrive at a quite
different conclusion. The model predicts that improved technology will
increase the demand for labor and boost real wages.
The period of industrialization, generally taken to be the time between the Civil
War and World War I, was a good test of these competing ideas. Technologicalchanges were dramatic as firms shifted toward mass production andautomation. Capital investment soared. Immigration increased the supply oflabor. What happened to workers?
Employment more than doubled during this period, consistent with theprediction of our model. It is harder to predict, from a theoretical point of view,the consequences for real wages. The latter third of the 19th century was aperiod of massive immigration to the United States. Between 1865 and 1880,
more than 5 million people came to the United States from abroad; most wereof working age. The pace accelerated between 1880 and 1923, when more than
23 million people moved to the United States from other countries.
Immigration increased the supply of labor, which should reduce the real wage.
There were thus two competing forces at work: Technological change andcapital investment tended to increase real wages, while immigration tended toreduce them by increasing the supply of labor.
The evidence suggests that the forces of technological change and capital
investment proved far more powerful than increases in labor supply. Real

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Chapter 8 Economic Growth

wages soared 60% between 1860 and 1890. They continued to increase after
that. Real wages in manufacturing, for example, rose 37% from 1890 to 1914.
Technological change and capital investment displace workers in someindustries. But for the economy as a whole, they increase worker productivity,
increase the demand for labor, and increase real wages.
Sources: Wage data taken from Clarence D. Long, Wages and Earnings in the
United States, 1860–1990 (Princeton, NJ: Princeton University Press, 1960), p. 109,and from Albert Rees, Wages in Manufacturing, 1890–1914 (Princeton, NJ:
Princeton University Press, 1961), pp. 3–5. Immigration figures taken from Gary
M. Walton and Hugh Rockoff, History of the American Economy, 6th ed. (New York:
Harcourt Brace Jovanovich, 1990), p. 371.

ANSWER TO TRY IT! PROBLEM
The production function in Panel (b) shifts up to PF2. Because it reflects
greater productivity of labor, firms will increase their demand for labor, andthe demand curve for labor shifts to D2 in Panel (a). LRAS1 shifts to LRAS2 in
Panel (c). Employment and potential output rise. Potential output will begreater than $2,200 billion.

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8.3 Determinants of Economic Growth
LEARNING OBJECTIVES
1. Discuss the sources of economic growth.
2. Discuss possible reasons why countries grow at different rates.

In this section, we review the main determinants of economic growth. We also
examine the reasons for the widening disparities in economic growth rates among
countries in recent years.

The Sources of Economic Growth
As we have learned, there are two ways to model economic growth: (1) as an
outward shift in an economy’s production possibilities curve, and (2) as a shift tothe right in its long-run aggregate supply curve. In drawing either one at a point in
time, we assume that the economy’s factors of production and its technology areunchanged. Changing these will shift both curves. Therefore, anything that
increases the quantity or quality of factors of production or that improves thetechnology available to the economy contributes to economic growth.
The sources of growth for the U.S. economy in the 20th century were presented in
the chapter on choices in production. There we learned that the main sources ofgrowth for the United States from 1960 to 2007 were divided between increases in
the quantities of labor and of physical capital (about 65%) and in improvements inthe qualities of the factors of production and technology (about 35%). Since 2000,
however, the contributions from improvements in factor quality and technology
have accounted for about half the economic growth in the United States.
In order to devote resources to increasing physical and human capital and to
improving technology—activities that will enhance future production—society must
forgo using them now to produce consumer goods. Even though the people in theeconomy would enjoy a higher standard of living today without this sacrifice, they
are willing to reduce present consumption in order to have more goods and services
available for the future.
As a college student, you personally made such a choice. You decided to devote time
to study that you could have spent earning income. With the higher income, you341

Chapter 8 Economic Growth

could enjoy greater consumption today. You made this choice because you expect toearn higher income in the future and thus to enjoy greater consumption in the
future. Because many other people in the society also choose to acquire moreeducation, society allocates resources to produce education. The education
produced today will enhance the society’s human capital and thus its economic
growth.
All other things equal, higher saving allows more resources to be devoted toincreases in physical and human capital and technological improvement. In otherwords, saving, which is income not spent on consumption, promotes economic
growth by making available resources that can be channeled into growthenhancing uses.

Explaining Recent Disparities in Growth Rates
Toward the end of the 20th century, it appeared that some of the world’s more
affluent countries were growing robustly while others were growing more slowly oreven stagnating. This observation was confirmed in a major study by theOrganisation for Economic Co-operation and Development (OECD),The material inthis section is based on Organisation for Economic Co-operation and Development,
The Sources of Economic Growth in OECD Countries, 2003. whose members are listed inTable 8.1 "Growing Disparities in Rates of Economic Growth". The table shows thatfor the OECD countries as a whole, economic growth per capita fell from an averageof 2.2% per year in the 1980s to an average of 1.9% per year in the 1990s. The higher
standard deviation in the latter period confirms an increased disparity of growth
rates in the more recent period. Moreover, the data on individual countries showthat per capita growth in some countries (specifically, the United States, Canada,
Ireland, Netherlands, Norway, and Spain) picked up, especially in the latter half ofthe 1990s, while it decelerated in most of the countries of continental Europe andJapan.
Table 8.1 Growing Disparities in Rates of Economic Growth
Trend Growth of GDP per Capita
Country

1980–1990

1990–2000

1996–2000

United States

2.1

2.3

2.8

Japan

3.3

1.4

0.9

Germany

1.9

1.2

1.7

*Excludes Czech Republic, Hungary, Korea, Mexico, Poland, and Slovak Republic

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Chapter 8 Economic Growth

Trend Growth of GDP per Capita
Country

1980–1990

1990–2000

1996–2000

France

1.6

1.5

1.9

Italy

2.3

1.5

1.7

United Kingdom

2.2

2.1

2.3

Canada

1.4

1.7

2.6

Austria

2.1

1.9

2.3

Belgium

2.0

1.9

2.3

Denmark

1.9

1.9

2.3

Finland

2.2

2.1

3.9

Greece

0.5

1.8

2.7

Iceland

1.7

1.5

2.6

Ireland

3.0

6.4

7.9

Luxembourg

4.0

4.5

4.6

Netherlands

1.6

2.4

2.7

Portugal

3.1

2.8

2.7

Spain

2.3

2.7

3.2

Sweden

1.7

1.5

2.6

Switzerland

1.4

0.4

1.1

Turkey

2.1

2.1

1.9

Australia

1.6

2.4

2.8

New Zealand

1.4

1.2

1.8

Mexico

0.0

1.6

2.7

Korea

7.2

5.1

4.2

Hungary

—

2.3

3.5

Poland

—

4.2

4.8

Czech Republic

—

1.7

1.4

OECD24*

2.2

1.9

2.2

Standard Deviation of OECD24

0.74

1.17

1.37

*Excludes Czech Republic, Hungary, Korea, Mexico, Poland, and Slovak Republic

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Chapter 8 Economic Growth

Variation in the growth in real GDP per capita has widened among the world’s
leading industrialized economies.
Source: Excerpted from Table 1.1 Organisation for Economic Co-operation andDevelopment, Sources of Economic Growth in OECD Countries, 2003: p. 32–33.
The study goes on to try to explain the reasons for the divergent growth trends. The
main findings were:• In general, countries with accelerating per capita growth rates also
experienced significant increases in employment, while those withstagnant or declining employment generally experienced reductions in
per capita growth rates.
• Enhancements in human capital contributed to labor productivity andeconomic growth, but in slower growing countries such improvements
were not enough to offset the impact of reduced or stagnant labor
utilization.
• Information and communication technology has contributed toeconomic growth both through rapid technological progress within theinformation and communication technology industry itself as well as,
more recently, through the use of information and communication
technology equipment in other industries. This has made an important
contribution to growth in several of the faster growing countries.
• Other factors associated with more growth include: investments inphysical and human capital, sound macroeconomic policies (especially
low inflation), private sector research and development, trade
exposure, and better developed financial markets. Results concerning
the impact of the size of the government and of public sector researchand development on growth were more difficult to interpret.
• With qualifications, the study found that strict regulation of productmarkets (for example, regulations that reduce competition) and strict
employment protection legislation (for example, laws that make hiringand firing of workers more difficult) had negative effects on growth.
• All countries show a large number of firms entering and exiting
markets. But, a key difference between the United States and Europe isthat new firms in the United States start out smaller and lessproductive than those of Europe but grow faster when they aresuccessful. The report hypothesizes that lower start-up costs and lessstrict labor market regulations may encourage U.S. entrepreneurs toenter a market and then to expand, if warranted. European
entrepreneurs may be less willing to experiment in a market in thefirst place.

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Chapter 8 Economic Growth

The general concern in the second half of the 1970s and the 1980s was that
economic growth was slowing down and that it might not be possible to reverse thispattern. The 1990s and early 2000s, in which growth picked up in some countries
but not in others, suggested that the problem was not universal and led to a search
for the reasons for the disparities in growth rates that emerged. The OECD study
described above gives some possible explanations. The findings of that study
practically beg countries to examine closely their economic policies at a variety oflevels and to consider changes that may add flexibility to their economies.
To spur this process, in 2005, the OECD started a new annual publication called
Going for Growth. The inaugural edition identified five priority structural policy
areas specific to each OECD country. The policies were categorized as either
improving labor utilization or improving productivity. Suggestions for improved
labor utilization ranged from changing tax policies to improving incentives forfemales to enter, and for older people to remain in, the workforce. Suggestions for
improved productivity ranged from education reform to privatization of stateowned industries. As an example, the priorities proposed for the United States in2005 included (1) limiting increases in labor costs by reforming Medicare to restrain
health care costs, (2) encouraging private saving by shifting the burden of taxation
toward consumption, (3) improving primary and secondary education, (4) reducing
trade-distorting agricultural price supports, and (5) promoting transparency andaccountability of corporate governance.Organisation for Economic Co-operation
and Development, Economic Policy Reforms: Going for Growth 2005, available at
http://www.OECD.org/economics/goingforgrowth.
The 2010 edition of Going for GrowthOrganisation for Economic Co-operation andDevelopment, Economic Policy Reforms: Going for Growth 2010, available at
http://www.OECD.org/economics/goingforgrowth. took stock of the progress madeover the five-year period leading up to 2010. While two-thirds of the OECD countries
took some legislative action in at least one priority area, the scope and depth of thisprogress varied immensely across countries.
Figure 8.9 " of " summarizes this progress using two alternative measures. Panel (a)shows a responsiveness rate, which measures significant actions taken, and Panel(b) shows a follow-through rate, which measures whether priorities could be
dropped due to reform implementation.
As we can see, the responsiveness and follow-through rates vary widely. Turkey andthe Czech Republic stand out as the countries having undertaken substantial
reform. The United States stands out as the country having shown neither
responsiveness nor follow-through. While the relatively strong performance of theUnited States at the end of the 20th century, as shown in Table 8.1 "Growing

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Chapter 8 Economic Growth

Disparities in Rates of Economic Growth", could indicate relatively less need for
growth-enhancing reforms, the comparative lack of progress since 2005 raises
doubt concerning the ability to maintain strong economic growth going forward.
Figure 8.9 of Going for Growth Recommendations across Countries since 2005

Panel (a) measures the 2005 to 2009 rate of responsiveness to the reform priorities given to each country in 2005.
Panel (b) shows the reform follow-through rates. Growth-enhancing policy reforms across countries varied widely
during this period.
Source: Organisation for Economic Co-operation and Development, Going for Growth 2010, Figure 2.6, p. 75.

In closing, it is worth reiterating that economic freedom and higher incomes tend
to go together. Countries could not have attained high levels of income if they had
not maintained the economic freedom that contributed to high incomes in the firstplace. Thus, it is also likely that rates of economic growth in the future will be
related to the amount of economic freedom countries choose. We shall see in later
chapters that monetary and fiscal policies that are used to stabilize the economy inthe short run can also have an impact on long-run economic growth.

8.3 Determinants of Economic Growth346Chapter 8 Economic Growth

KEY TAKEAWAYS• The main sources of growth for the United States from 1948 to 2007
were divided between increases in the quantities of labor and of physicalcapital (about 65%) and in improvements in the qualities of the factorsof production and technology (about 35%). Since 2000, however,improvements in factor quality and technology have contributed toabout half the economic growth in the United States.
• There has been a growing disparity in the rates of economic growth inindustrialized countries in recent decades, which may reflect various
differences in economic structures and policies.

TRY IT!
All other things unchanged, compare the position of a country’s expected
production possibility curve and the expected position of its long-run
aggregate supply curve if:
1.
2.
3.
4.

8.3 Determinants of Economic Growth

Its labor force increases in size by 3% per year compared to 2% per year.
Its saving rate falls from 15% to 10%.
It passes a law making it more difficult to fire workers.
Its level of education rises more quickly than it has in the past.

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Chapter 8 Economic Growth

Case in Point: Economic Growth in Poor Countries … orLack Thereof

Economist William Easterly in his aptly named book The Elusive Quest for Growth:
Economists’ Adventures and Misadventures in the Tropics admits that after 50 yearsof searching for the magic formula for turning poor countries into rich ones,
the quest remains elusive.
Poor countries just need more physical capital, you say? Easterly points outthat between 1960 and 1985, the capital stock per worker in both Gambia andJapan rose by over 500%. The result? In Gambia, output per worker over the
25-year period rose 2%; in Japan, output per worker rose 260%.
So, it must be that poor countries need more human capital? Again, he finds
startling comparisons. For example, human capital expanded faster in Zambia
than in Korea, but Zambia’s annual growth rate is 7 percentage points below
Korea’s.
Too much population growth? Too little? More foreign aid? Too much? As
Easterly proceeds, writing a prescription for growth seems ever more difficult:“None has delivered as promised,” he concludes (p. xi).

8.3 Determinants of Economic Growth348Chapter 8 Economic Growth

While Easterly does not offer his own new panacea for how to move countries
to a higher level of per capita GDP, where the model presented in this chapter
does seem to provide some explanations of why a country’s growth rate mayvary over time or differ from another country’s, he does argue that creating
incentives for growth in poor countries is crucial. Acknowledging a role forplain luck, Easterly argues that good government policies—ones that keep low
such negatives as inflation, corruption, and red tape—and quality institutions
and laws—ones that, for example, honor contracts and reward merit—will help.
How to actually improve such incentives might constitute the next great quest:“We have learned once and for all that there are no magical elixirs to bring a
happy ending to our quest for growth. Prosperity happens when all the players
in the development game have the right incentives. It happens when
government incentives induce technological adaptation, high-quality
investment in machines, and high-quality schooling. It happens when donors
face incentives that induce them to give aid to countries with good policies
where aid will have high payoffs, not to countries with poor policies where aid
is wasted. It happens when the poor get good opportunities and incentives,
which requires government welfare programs that reward rather than penalize
earning income. It happens when politics is not polarized between antagonistic
interest groups. . . . The solutions are a lot more difficult to describe than the
problems. The way forward must be to create incentives for growth for thetrinity of governments, donors, and individuals.” (p. 289–90)
Source: William Easterly, The Elusive Quest for Growth: Economists’ Adventures andMisadventures in the Tropics (Cambridge: MIT Press, 2002).

ANSWER TO TRY IT! PROBLEM
Situations 1 and 4 should lead to a shift further outward in the country’s
production possibility curve and further to the right in its long-run
aggregate supply curve. Situations 2 and 3 should lead to smaller outward
shifts in the country’s production possibility curve and smaller rightward
shifts in its long-run aggregate supply curve.

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Chapter 8 Economic Growth

8.4 Review and PracticeSummary
We saw that economic growth can be measured by the rate of increase in potential output. Measuring the rate ofincrease in actual real GDP can confuse growth statistics by introducing elements of cyclical variation.
Growth is an exponential process. A variable increasing at a fixed percentage rate doubles over fixed intervals.
The doubling time is approximated by the rule of 72. The exponential nature of growth means that small
differences in growth rates have large effects over long periods of time. Per capita rates of increase in real GDP
are found by subtracting the growth rate of the population from the growth rate of GDP.
Growth can be shown in the model of aggregate demand and aggregate supply as a series of rightward shifts inthe long-run aggregate supply curve. The position of the LRAS is determined by the aggregate production
function and by the demand and supply curves for labor. A rightward shift in LRAS results either from an
upward shift in the production function, due to increases in factors of production other than labor or to
improvements in technology, or from an increase in the demand for or the supply of labor.
Saving plays an important role in economic growth, because it allows for more capital to be available for future
production, so the rate of economic growth can rise. Saving thus promotes growth.
In recent years, rates of growth among the world’s industrialized countries have grown more disparate. Recent
research suggests this may be related to differing labor and product market conditions, differences in the
diffusion of information and communications technologies, as well as differences in macroeconomic and trade
policies. Evidence on the role that government plays in economic growth was less conclusive.

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CONCEPT PROBLEMS
1. Suppose the people in a certain economy decide to stop saving andinstead use all their income for consumption. They do nothing to add totheir stock of human or physical capital. Discuss the prospects for
growth of such an economy.
2. Singapore has a saving rate that is roughly three times greater than thatof the United States. Its greater saving rate has been one reason why theSingapore economy has grown faster than the U.S. economy. Supposethat if the United States increased its saving rate to, say, twice theSingapore level, U.S. growth would surpass the Singapore rate. Wouldthat be a good idea?
3. Suppose an increase in air pollution causes capital to wear out more
rapidly, doubling the rate of depreciation. How would this affecteconomic growth?
4. Some people worry that increases in the capital stock will bring aboutan economy in which everything is done by machines, with no jobs left
for people. What does the model of economic growth presented in thischapter predict?
5. China’s annual rate of population growth was 1.2% from 1975 to 2003
and is expected to be 0.6% from 2003 through 2015. How do you think
this will affect the rate of increase in real GDP? How will this affect therate of increase in per capita real GDP?
6. Suppose technology stops changing. Explain the impact on economic
growth.
7. Suppose a series of terrorist attacks destroys half the capital in the
United States but does not affect the population. What will happen topotential output and to the real wage?
8. “Given the rate at which scientists are making new discoveries, we willsoon reach the point that no further discoveries can be made. Economic
growth will come to a stop.” Discuss.
9. Suppose real GDP increases during President Obama’s term in office at a
5% rate. Would that imply that his policies were successful in “growing
the economy”?
10. Suppose that for some country it was found that its economic growth
was based almost entirely on increases in quantities of factors of
production. Why might such growth be difficult to sustain?

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Chapter 8 Economic Growth

NUMERICAL PROBLEMS

1. The population of the world in 2003 was 6.314 billion. It grew
between 1975 and 2003 at an annual rate of 1.6%. Assume that it
continues to grow at this rate.
a. Compute the doubling time.
b. Estimate the world population in 2048 and 2093 (assuming allother things remain unchanged).
2. With a world population in 2003 of 6.314 billion and a projected
population growth rate of 1.1% instead (which is the United
Nations’ projection for the period 2003 to 2015).
a. Compute the doubling time.
b. State the year in which the world’s population would be
12.628 billion.
3. Suppose a country’s population grows at the rate of 2% per year
and its output grows at the rate of 3% per year.
a. Calculate its rate of growth of per capita output.
b. If instead its population grows at 3% per year and its output
grows at 2% per year, calculate its rate of growth of percapita output.
4. The rate of economic growth per capita in France from 1996 to2000 was 1.9% per year, while in Korea over the same period it
was 4.2%. Per capita real GDP was $28,900 in France in 2003, and$12,700 in Korea. Assume the growth rates for each country
remain the same.
a.
b.
c.
d.

Compute the doubling time for France’s per capita real GDP.
Compute the doubling time for Korea’s per capita real GDP.
What will France’s per capita real GDP be in 2045?
What will Korea’s per capita real GDP be in 2045?

5. Suppose real GDPs in country A and country B are identical at$10 trillion dollars in 2005. Suppose country A’s economic growth

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Chapter 8 Economic Growthrate is 2% and country B’s is 4% and both growth rates remain
constant over time.
a. On a graph, show country A’s potential output until 2025.
b. On the same graph, show country B’s potential output.
c. Calculate the percentage difference in their levels ofpotential output in 2025.
Suppose country A’s population grows 1% per year and country
B’s population grows 3% per year.
a. On a graph, show country A’s potential output per capita in
2025.
b. On the same graph, show country B’s potential output percapita in 2025.
c. Calculate the percentage difference in their levels ofpotential output per capita in 2025.
6. Two countries, A and B, have identical levels of real GDP per capita. In
Country A, an increase in the capital stock increases the potential
output by 10%. Country B also experiences a 10% increase in its potential
output, but this increase is the result of an increase in its labor force.
Using aggregate production functions and labor-market analyses for thetwo countries, illustrate and explain how these events are likely to affectliving standards in the two economies.
7. Suppose the information below characterizes an economy:
Employment (in millions) Real GDP (in billions)

8.4 Review and Practice

1

200

2

700

3

1,100

4

1,400

5

1,650

6

1,850

7

2,000

8

2,100

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Chapter 8 Economic Growth

Employment (in millions) Real GDP (in billions)
9

2,170

10

2,200

a. Construct the aggregate production function for thiseconomy.
b. What kind of returns does this economy experience? How do
you know?
c. Assuming that total available employment is 7 million, draw
the economy’s long-run aggregate supply curve.
Suppose that improvement in technology means that real GDP ateach level of employment rises by $200 billion.
a. Construct the new aggregate production function for thiseconomy.
b. Construct the new long-run aggregate supply curve for the
economy.
8. In Table 8.1 "Growing Disparities in Rates of Economic Growth",
we can see that Japan’s growth rate of per capita real GDP fell
from 3.3% per year in the 1980s to 1.4% per year in the 1990s.
a. Compare the percent increase in its per capita real GDP overthe 20-year period to what it would have been if it had
maintained the 3.3% per capita growth rate of the 1980s.
b. Japan’s per capita GDP in 1980 was about $24,000 (in U.S.
2000 dollars) in 1980. Calculate what it would have been if
the growth rate of the 1980s had been maintained Calculate
about how much it is, given the actual growth rates over thetwo decades.
c. In Table 8.1 "Growing Disparities in Rates of Economic
Growth", we can see that Ireland’s growth rate of per capita
real GDP grew from 3.0% per year in the 1980s to 6.4% peryear in the 1990s.
d. Compare the percent increase in its per capita real GDP overthe 20-year period to what it would have been if it had
maintained the 3.0% per capita growth rate of the 1980s.
e. Ireland’s per capita GDP in 1980 was about $10,000 (in U.S.
2000 dollars). Calculate what it would have been if the

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Chapter 8 Economic Growth

growth rate of the 1980s had been maintained. Calculate
about how much it is, given the actual growth rates over thetwo decades.

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Chapter 9
The Nature and Creation of Money
Start Up: How Many Macks Does It Cost?
Larry Levine helped a client prepare divorce papers a few years ago. He was paid inmackerel.
“It’s the coin of the realm,” his client, Mark Bailey told the Wall Street Journal. The
two men were prisoners at the time at the federal penitentiary at Lompoc,
California.
By the time his work on the case was completed, he had accumulated “a stack ofmacks,” Mr. Levine said. He used his fishy hoard to buy items such as haircuts at theprison barber shop, to have his laundry pressed, or to have his cell cleaned.
The somewhat unpleasant fish emerged as the currency of choice in many federal
prisons in 1994 when cigarettes, the previous commodity used as currency, werebanned. Plastic bags of mackerel sold for about $1 in prison commissaries. Almost
no one likes them, so the prison money supply did not get eaten. Prisoners knew
other prisoners would readily accept macks, so they were accepted in exchange forgoods and services. Their $1 price made them convenient as a unit of account. And,
as Mr. Levine’s experience suggests, they acted as a store of value. As we shall see,macks served all three functions of money—they were a medium of exchange, a unitof account, and a store of value.Justin Scheck, “Mackerel Economics in Prison Leads
to Appreciation for Oily Fish,” Wall Street Journal, October 2, 2008, p. A1.
In this chapter and the next we examine money and the way it affects the level ofreal GDP and the price level. In this chapter, we will focus on the nature of money
and the process through which it is created.
As the experience of the prisoners in Lompoc suggests, virtually anything can serve
as money. Historically, salt, horses, tobacco, cigarettes, gold, and silver have allserved as money. We shall examine the characteristics that define a good as money.

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We will also introduce the largest financial institution in the world, the Federal
Reserve System of the United States. The Fed, as it is commonly called, plays a keyrole in determining the quantity of money in the United States. We will see how theFed operates and how it attempts to control the supply of money.

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9.1 What Is Money?
LEARNING OBJECTIVES
1. Define money and discuss its three basic functions.
2. Distinguish between commodity money and fiat money, giving examplesof each.
3. Define what is meant by the money supply and tell what is included in
the Federal Reserve System’s two definitions of it (M1 and M2).

If cigarettes and mackerel can be used as money, then just what is money? Money1
is anything that serves as a medium of exchange. A medium of exchange2 isanything that is widely accepted as a means of payment. In Romania underCommunist Party rule in the 1980s, for example, Kent cigarettes served as a medium
of exchange; the fact that they could be exchanged for other goods and services
made them money.
Money, ultimately, is defined by people and what they do. When people use
something as a medium of exchange, it becomes money. If people were to begin
accepting basketballs as payment for most goods and services, basketballs would bemoney. We will learn in this chapter that changes in the way people use money
have created new types of money and changed the way money is measured inrecent decades.

The Functions of Money
Money serves three basic functions. By definition, it is a medium of exchange. It
also serves as a unit of account and as a store of value—as the “mack” did in
Lompoc.

A Medium of Exchange
1. Anything that serves as a
medium of exchange.
2. Anything that is widely
accepted as a means of
payment.
3. When goods are exchanged
directly for other goods.

The exchange of goods and services in markets is among the most universal
activities of human life. To facilitate these exchanges, people settle on somethingthat will serve as a medium of exchange—they select something to be money.
We can understand the significance of a medium of exchange by considering its
absence. Barter3 occurs when goods are exchanged directly for other goods.

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Because no one item serves as a medium of exchange in a barter economy, potential
buyers must find things that individual sellers will accept. A buyer might find aseller who will trade a pair of shoes for two chickens. Another seller might bewilling to provide a haircut in exchange for a garden hose. Suppose you werevisiting a grocery store in a barter economy. You would need to load up a truckfulof items the grocer might accept in exchange for groceries. That would be an
uncertain affair; you could not know when you headed for the store which items thegrocer might agree to trade. Indeed, the complexity—and cost—of a visit to a
grocery store in a barter economy would be so great that there probably would not
be any grocery stores! A moment’s contemplation of the difficulty of life in a barter
economy will demonstrate why human societies invariably selectsomething—sometimes more than one thing—to serve as a medium of exchange,
just as prisoners in federal penitentiaries accepted mackerel.

A Unit of AccountAsk someone in the United States what he or she paid for something, and that
person will respond by quoting a price stated in dollars: “I paid $75 for this radio,”or “I paid $15 for this pizza.” People do not say, “I paid five pizzas for this radio.”That statement might, of course, be literally true in the sense of the opportunity
cost of the transaction, but we do not report prices that way for two reasons. One isthat people do not arrive at places like Radio Shack with five pizzas and expect topurchase a radio. The other is that the information would not be very useful. Other
people may not think of values in pizza terms, so they might not know what wemeant. Instead, we report the value of things in terms of money.
Money serves as a unit of account4, which is a consistent means of measuring thevalue of things. We use money in this fashion because it is also a medium of
exchange. When we report the value of a good or service in units of money, we arereporting what another person is likely to have to pay to obtain that good orservice.

A Store of Value
The third function of money is to serve as a store of value5, that is, an item that
holds value over time. Consider a $20 bill that you accidentally left in a coat pocketa year ago. When you find it, you will be pleased. That is because you know the bill
still has value. Value has, in effect, been “stored” in that little piece of paper.
4. A consistent means ofmeasuring the value of things.
5. An item that holds value overtime.

9.1 What Is Money?

Money, of course, is not the only thing that stores value. Houses, office buildings,
land, works of art, and many other commodities serve as a means of storing wealthand value. Money differs from these other stores of value by being readily359

Chapter 9 The Nature and Creation of Moneyexchangeable for other commodities. Its role as a medium of exchange makes it aconvenient store of value.
Because money acts as a store of value, it can be used as a standard for future
payments. When you borrow money, for example, you typically sign a contract
pledging to make a series of future payments to settle the debt. These payments will
be made using money, because money acts as a store of value.
Money is not a risk-free store of value, however. We saw in the chapter that
introduced the concept of inflation that inflation reduces the value of money. In
periods of rapid inflation, people may not want to rely on money as a store of value,
and they may turn to commodities such as land or gold instead.

Types of Money
Although money can take an extraordinary variety of forms, there are really only
two types of money: money that has intrinsic value and money that does not have
intrinsic value.
Commodity money6 is money that has value apart from its use as money. Mackerelin federal prisons is an example of commodity money. Mackerel could be used tobuy services from other prisoners; they could also be eaten.
Gold and silver are the most widely used forms of commodity money. Gold andsilver can be used as jewelry and for some industrial and medicinal purposes, sothey have value apart from their use as money. The first known use of gold andsilver coins was in the Greek city-state of Lydia in the beginning of the seventh
century B.C. The coins were fashioned from electrum, a natural mixture of gold andsilver.

6. Money that has value apartfrom its use as money.

9.1 What Is Money?

One disadvantage of commodity money is that its quantity can fluctuate erratically.
Gold, for example, was one form of money in the United States in the 19th century.
Gold discoveries in California and later in Alaska sent the quantity of money
soaring. Some of this nation’s worst bouts of inflation were set off by increases in
the quantity of gold in circulation during the 19th century. A much greater problem
exists with commodity money that can be produced. In the southern part ofcolonial America, for example, tobacco served as money. There was a continuing
problem of farmers increasing the quantity of money by growing more tobacco. The
problem was sufficiently serious that vigilante squads were organized. They roamed
the countryside burning tobacco fields in an effort to keep the quantity of tobacco,360Chapter 9 The Nature and Creation of Moneyhence money, under control. (Remarkably, these squads sought to control themoney supply by burning tobacco grown by other farmers.)
Another problem is that commodity money may vary in quality. Given thatvariability, there is a tendency for lower-quality commodities to drive higherquality commodities out of circulation. Horses, for example, served as money incolonial New England. It was common for loan obligations to be stated in terms of aquantity of horses to be paid back. Given such obligations, there was a tendency touse lower-quality horses to pay back debts; higher-quality horses were kept out ofcirculation for other uses. Laws were passed forbidding the use of lame horses in
the payment of debts. This is an example of Gresham’s law: the tendency for alower-quality commodity (bad money) to drive a higher-quality commodity (goodmoney) out of circulation. Unless a means can be found to control the quality ofcommodity money, the tendency for that quality to decline can threaten its
acceptability as a medium of exchange.
But something need not have intrinsic value to serve as money. Fiat money7 ismoney that some authority, generally a government, has ordered to be accepted asa medium of exchange. The currency8—paper money and coins—used in the UnitedStates today is fiat money; it has no value other than its use as money. You will
notice that statement printed on each bill: “This note is legal tender for all debts,
public and private.”

7. Money that some authority,
generally a government, hasordered to be accepted as a
medium of exchange.
8. Paper money and coins.
9. Balances in checking accounts.
10. A written order to a bank totransfer ownership of acheckable deposit.

9.1 What Is Money?

Checkable deposits9, which are balances in checking accounts, and traveler’s
checks are other forms of money that have no intrinsic value. They can beconverted to currency, but generally they are not; they simply serve as a medium of
exchange. If you want to buy something, you can often pay with a check or a debitcard. A check10 is a written order to a bank to transfer ownership of a checkabledeposit. A debit card is the electronic equivalent of a check. Suppose, for example,
that you have $100 in your checking account and you write a check to your campus
bookstore for $30 or instruct the clerk to swipe your debit card and “charge” it $30.
In either case, $30 will be transferred from your checking account to thebookstore’s checking account. Notice that it is the checkable deposit, not the check ordebit card, that is money. The check or debit card just tells a bank to transfer money,in this case checkable deposits, from one account to another.
What makes something money is really found in its acceptability, not in whether or
not it has intrinsic value or whether or not a government has declared it as such.
For example, fiat money tends to be accepted so long as too much of it is notprinted too quickly. When that happens, as it did in Russia in the 1990s, people tend
to look for other items to serve as money. In the case of Russia, the U.S. dollar

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Chapter 9 The Nature and Creation of Money

became a popular form of money, even though the Russian government still
declared the ruble to be its fiat money.

Heads Up!
The term money, as used by economists and throughout this book, has the very
specific definition given in the text. People can hold assets in a variety of forms,
from works of art to stock certificates to currency or checking accountbalances. Even though individuals may be very wealthy, only when they areholding their assets in a form that serves as a medium of exchange do they,according to the precise meaning of the term, have “money.” To qualify as“money,” something must be widely accepted as a medium of exchange.

Measuring Money
The total quantity of money in the economy at any one time is called the money
supply11. Economists measure the money supply because it affects economic
activity. What should be included in the money supply? We want to include as partof the money supply those things that serve as media of exchange. However, theitems that provide this function have varied over time.
Before 1980, the basic money supply was measured as the sum of currency incirculation, traveler’s checks, and checkable deposits. Currency serves the mediumof-exchange function very nicely but denies people any interest earnings. (Checking
accounts did not earn interest before 1980.)
Over the last few decades, especially as a result of high interest rates and highinflation in the late 1970s, people sought and found ways of holding their financial
assets in ways that earn interest and that can easily be converted to money. For
example, it is now possible to transfer money from your savings account to yourchecking account using an automated teller machine (ATM), and then to withdraw
cash from your checking account. Thus, many types of savings accounts are easily
converted into currency.
11. The total quantity of money inthe economy at any one time.
12. The ease with which an asset
can be converted intocurrency.

9.1 What Is Money?

Economists refer to the ease with which an asset can be converted into currency as
the asset’s liquidity12. Currency itself is perfectly liquid; you can always change two$5 bills for a $10 bill. Checkable deposits are almost perfectly liquid; you can easily

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Chapter 9 The Nature and Creation of Money

cash a check or visit an ATM. An office building, however, is highly illiquid. It can beconverted to money only by selling it, a time-consuming and costly process.
As financial assets other than checkable deposits have become more liquid,
economists have had to develop broader measures of money that would correspondto economic activity. In the United States, the final arbiter of what is and what is
not measured as money is the Federal Reserve System. Because it is difficult todetermine what (and what not) to measure as money, the Fed reports several
different measures of money, including M1 and M2.
M113 is the narrowest of the Fed’s money supply definitions. It includes currency incirculation, checkable deposits, and traveler’s checks. M214 is a broader measure of
the money supply than M1. It includes M1 and other deposits such as small savings
accounts (less than $100,000), as well as accounts such as money market mutual
funds (MMMFs) that place limits on the number or the amounts of the checks thatcan be written in a certain period.
M2 is sometimes called the broadly defined money supply, while M1 is the narrowly
defined money supply. The assets in M1 may be regarded as perfectly liquid; theassets in M2 are highly liquid, but somewhat less liquid than the assets in M1. Even
broader measures of the money supply include large time-deposits, money market
mutual funds held by institutions, and other assets that are somewhat less liquidthan those in M2. Figure 9.1 "The Two Ms: January 2012" shows the composition of
M1 and M2 in October 2010.

13. The narrowest of the Fed’s
money supply definitions that
includes currency incirculation, checkable deposits,
and traveler’s checks.
14. A broader measure of themoney supply than M1 that
includes M1 and otherdeposits.

9.1 What Is Money?

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Chapter 9 The Nature and Creation of Money

Figure 9.1 The Two Ms: January 2012

M1, the narrowest definition of the money supply, includes assets that are perfectly liquid. M2 provides a broader
measure of the money supply and includes somewhat less liquid assets. Amounts represent money supply data inbillions of dollars for January 2012, seasonally adjusted.
Source: Federal Reserve Statistical Release H.6, Tables 3 and 4 (February 16, 2012). Amounts are in billions of dollars
for January 2012, seasonally adjusted.

Heads Up!
Credit cards are not money. A credit card identifies you as a person who has a
special arrangement with the card issuer in which the issuer will lend you
money and transfer the proceeds to another party whenever you want. Thus, if
you present a MasterCard to a jeweler as payment for a $500 ring, the firm thatissued you the card will lend you the $500 and send that money, less a service
charge, to the jeweler. You, of course, will be required to repay the loan later.
But a card that says you have such a relationship is not money, just as yourdebit card is not money.

9.1 What Is Money?

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Chapter 9 The Nature and Creation of Money

With all the operational definitions of money available, which one should we use?
Economists generally answer that question by asking another: Which measure ofmoney is most closely related to real GDP and the price level? As that changes, somust the definition of money.
In 1980, the Fed decided that changes in the ways people were managing theirmoney made M1 useless for policy choices. Indeed, the Fed now pays little attention
to M2 either. It has largely given up tracking a particular measure of the money
supply. The choice of what to measure as money remains the subject of continuingresearch and considerable debate.

KEY TAKEAWAYS• Money is anything that serves as a medium of exchange. Other functionsof money are to serve as a unit of account and as a store of value.
• Money may or may not have intrinsic value. Commodity money has
intrinsic value because it has other uses besides being a medium of
exchange. Fiat money serves only as a medium of exchange, because its
use as such is authorized by the government; it has no intrinsic value.
• The Fed reports several different measures of money, including M1 andM2.

TRY IT!
Which of the following are money in the United States today and which arenot? Explain your reasoning in terms of the functions of money.
1. Gold
2. A Van Gogh painting
3. A dime

9.1 What Is Money?

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Chapter 9 The Nature and Creation of Money

Case in Point: Fiat-less Money“We don’t have a currency of our own,” proclaimed Nerchivan Barzani, theKurdish regional government’s prime minister in a news interview in 2003. But,
even without official recognition by the government, the so-called “Swiss”
dinar certainly seemed to function as a fiat money. Here is how the Kurdish
area of northern Iraq, during the period between the Gulf War in 1991 and thefall of Saddam Hussein in 2003, came to have its own currency, despite thepronouncement of its prime minister to the contrary.
After the Gulf War, the northern, mostly Kurdish area of Iraq was separated
from the rest of Iraq though the enforcement of the no-fly-zone. Because ofUnited Nations sanctions that barred the Saddam Hussein regime in the southfrom continuing to import currency from Switzerland, the central bank of Iraq
announced it would replace the “Swiss” dinars, so named because they had
been printed in Switzerland, with locally printed currency, which became
known as “Saddam” dinars. Iraqi citizens in southern Iraq were given three
weeks to exchange their old dinars for the new ones. In the northern part ofIraq, citizens could not exchange their notes and so they simply continued touse the old ones.
And so it was that the “Swiss” dinar for a period of about 10 years, even without
government backing or any law establishing it as legal tender, served as
northern Iraq’s fiat money. Economists use the word “fiat,” which in Latinmeans “let it be done,” to describe money that has no intrinsic value. Suchforms of money usually get their value because a government or authority has
declared them to be legal tender, but, as this story shows, it does not reallyrequire much “fiat” for a convenient, in-and-of-itself worthless, medium of
exchange to evolve.

9.1 What Is Money?

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Chapter 9 The Nature and Creation of Money

What happened to both the “Swiss” and “Saddam” dinars? After the Coalition
Provisional Authority (CPA) assumed control of all of Iraq, Paul Bremer, thenhead of the CPA, announced that a new Iraqi dinar would be exchanged for bothof the existing currencies over a three-month period ending in January 2004 at
a rate that implied that one “Swiss” dinar was valued at 150 “Saddam” dinars.
Because Saddam Hussein’s regime had printed many more “Saddam” dinars
over the 10-year period, while no “Swiss” dinars had been printed, and because
the cheap printing of the “Saddam” dinars made them easy to counterfeit, overthe decade the “Swiss” dinars became relatively more valuable and theexchange rate that Bremer offered about equalized the purchasing power of thetwo currencies. For example, it took about 133 times as many “Saddam” dinars
as “Swiss” dinars to buy a man’s suit in Iraq at the time. The new notes,
sometimes called “Bremer” dinars, were printed in Britain and elsewhere andflown into Iraq on 22 flights using Boeing 747s and other large aircraft. In boththe northern and southern parts of Iraq, citizens turned in their old dinars forthe new ones, suggesting at least more confidence at that moment in the“Bremer” dinar than in either the “Saddam” or “Swiss” dinars.
Sources: Mervyn A. King, “The Institutions of Monetary Policy” (lecture,
American Economics Association Annual Meeting, San Diego, January 4, 2004),
available at http://www.bankofengland.co.uk/publications/Documents/
speeches/2004/speech208.pdf; Hal R. Varian, “Paper Currency Can Have Value
without Government Backing, but Such Backing Adds Substantially to Its
Value,” New York Times, January 15, 2004, p. C2.

ANSWER TO TRY IT! PROBLEM
1. Gold is not money because it is not used as a medium of exchange. In
addition, it does not serve as a unit of account. It may, however, serve asa store of value.
2. A Van Gogh painting is not money. It serves as a store of value. It ishighly illiquid but could eventually be converted to money. It is neither
a medium of exchange nor a unit of account.
3. A dime is money and serves all three functions of money. It is, of course,
perfectly liquid.

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9.2 The Banking System and Money Creation
LEARNING OBJECTIVES
1. Explain what banks are, what their balance sheets look like, and what ismeant by a fractional reserve banking system.
2. Describe the process of money creation (destruction), using the conceptof the deposit multiplier.
3. Describe how and why banks are regulated and insured.

Where does money come from? How is its quantity increased or decreased? The
answer to these questions suggests that money has an almost magical quality:
money is created by banks when they issue loans. In effect, money is created by thestroke of a pen or the click of a computer key.
We will begin by examining the operation of banks and the banking system. We willfind that, like money itself, the nature of banking is experiencing rapid change.

Banks and Other Financial Intermediaries
An institution that amasses funds from one group and makes them available toanother is called a financial intermediary15. A pension fund is an example of afinancial intermediary. Workers and firms place earnings in the fund for theirretirement; the fund earns income by lending money to firms or by purchasing
their stock. The fund thus makes retirement saving available for other spending.
Insurance companies are also financial intermediaries, because they lend some ofthe premiums paid by their customers to firms for investment. Mutual funds makemoney available to firms and other institutions by purchasing their initial offeringsof stocks or bonds.

15. An institution that amasses
funds from one group andmakes them available toanother.
16. A financial intermediary that
accepts deposits, makes loans,and offers checking accounts.

Banks play a particularly important role as financial intermediaries. Banks accept
depositors’ money and lend it to borrowers. With the interest they earn on theirloans, banks are able to pay interest to their depositors, cover their own operating
costs, and earn a profit, all the while maintaining the ability of the original
depositors to spend the funds when they desire to do so. One key characteristic ofbanks is that they offer their customers the opportunity to open checking accounts,
thus creating checkable deposits. These functions define a bank16, which is afinancial intermediary that accepts deposits, makes loans, and offers checking
accounts.

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Over time, some nonbank financial intermediaries have become more and more likebanks. For example, brokerage firms usually offer customers interest-earning
accounts and make loans. They now allow their customers to write checks on theiraccounts.
The fact that banks account for a declining share of U.S. financial assets alarms
some observers. We will see that banks are more tightly regulated than are otherfinancial institutions; one reason for that regulation is to maintain control over themoney supply. Other financial intermediaries do not face the same regulatory
restrictions as banks. Indeed, their relative freedom from regulation is one reason
they have grown so rapidly. As other financial intermediaries become more
important, central authorities begin to lose control over the money supply.
The declining share of financial assets controlled by “banks” began to change in2008. Many of the nation’s largest investment banks—financial institutions thatprovided services to firms but were not regulated as commercial banks—began
having serious financial difficulties as a result of their investments tied to homemortgage loans. As home prices in the United States began falling, many of thosemortgage loans went into default. Investment banks that had made substantial
purchases of securities whose value was ultimately based on those mortgage loans
themselves began failing. Bear Stearns, one of the largest investment banks in the
United States, required federal funds to remain solvent. Another large investmentbank, Lehman Brothers, failed. In an effort to avoid a similar fate, several otherinvestment banks applied for status as ordinary commercial banks subject to thestringent regulation those institutions face. One result of the terrible financial crisis
that crippled the U.S. and other economies in 2008 may be greater control of themoney supply by the Fed.

Bank Finance and a Fractional Reserve System
Bank finance lies at the heart of the process through which money is created. To
understand money creation, we need to understand some of the basics of bankfinance.

17. A financial statement showing
assets, liabilities, and net
worth.
18. Anything of value.
19. Obligations to other parties.
20. Assets less liabilities.

Banks accept deposits and issue checks to the owners of those deposits. Banks use
the money collected from depositors to make loans. The bank’s financial picture at
a given time can be depicted using a simplified balance sheet17, which is a financial
statement showing assets, liabilities, and net worth. Assets18 are anything of value.
Liabilities19 are obligations to other parties. Net worth20 equals assets lessliabilities. All these are given dollar values in a firm’s balance sheet. The sum ofliabilities plus net worth therefore must equal the sum of all assets. On a balance
sheet, assets are listed on the left, liabilities and net worth on the right.

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The main way that banks earn profits is through issuing loans. Because theirdepositors do not typically all ask for the entire amount of their deposits back at
the same time, banks lend out most of the deposits they have collected—tocompanies seeking to expand their operations, to people buying cars or homes, andso on. Banks keep only a fraction of their deposits as cash in their vaults and indeposits with the Fed. These assets are called reserves21. Banks lend out the rest of
their deposits. A system in which banks hold reserves whose value is less than thesum of claims outstanding on those reserves is called a fractional reserve banking
system22.
Table 9.1 "The Consolidated Balance Sheet for U.S. Commercial Banks, January2012" shows a consolidated balance sheet for commercial banks in the United States
for January 2012. Banks hold reserves against the liabilities represented by their
checkable deposits. Notice that these reserves were a small fraction of total deposit
liabilities of that month. Most bank assets are in the form of loans.
Table 9.1 The Consolidated Balance Sheet for U.S. Commercial Banks, January 2012
AssetsLiabilities and Net WorthReserves$1,592.9 Checkable deposits$8,517.9

Other assets$1,316.2 Borrowings

1,588.1

Loans$7,042.0 Other liabilities

1,049.4

Securities$2,546.1

Total assets$12,497.2 Total liabilities
Net worth$11,155.4$1,341.8

This balance sheet for all commercial banks in the United States shows theirfinancial situation in billions of dollars, seasonally adjusted, in January 2012.
Source: Federal Reserve Statistical Release H.8 (February 17, 2012).
In the next section, we will learn that money is created when banks issue loans.
21. Bank assets held as cash invaults and in deposits with theFederal Reserve.

Money Creation

22. System in which banks holdreserves whose value is lessthan the sum of claims
outstanding on those reserves.

To understand the process of money creation today, let us create a hypotheticalsystem of banks. We will focus on three banks in this system: Acme Bank, BellvilleBank, and Clarkston Bank. Assume that all banks are required to hold reserves

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Chapter 9 The Nature and Creation of Moneyequal to 10% of their checkable deposits. The quantity of reserves banks are
required to hold is called required reserves23. The reserve requirement isexpressed as a required reserve ratio24; it specifies the ratio of reserves tocheckable deposits a bank must maintain. Banks may hold reserves in excess of therequired level; such reserves are called excess reserves25. Excess reserves plus
required reserves equal total reserves.
Because banks earn relatively little interest on their reserves held on deposit with
the Federal Reserve, we shall assume that they seek to hold no excess reserves.
When a bank’s excess reserves equal zero, it is loaned up26. Finally, we shall ignore
assets other than reserves and loans and deposits other than checkable deposits. To
simplify the analysis further, we shall suppose that banks have no net worth; theirassets are equal to their liabilities.
Let us suppose that every bank in our imaginary system begins with $1,000 inreserves, $9,000 in loans outstanding, and $10,000 in checkable deposit balancesheld by customers. The balance sheet for one of these banks, Acme Bank, is shownin Table 9.2 "A Balance Sheet for Acme Bank". The required reserve ratio is 0.1: Eachbank must have reserves equal to 10% of its checkable deposits. Because reserves
equal required reserves, excess reserves equal zero. Each bank is loaned up.
Table 9.2 A Balance Sheet for Acme Bank
Acme Bank
AssetsLiabilities

Reserves $1,000 Deposits $10,000
Loans$9,000We assume that all banks in a hypothetical system of banks have $1,000 in reserves,$10,000 in checkable deposits, and $9,000 in loans. With a 10% reserve requirement,each bank is loaned up; it has zero excess reserves.
23. The quantity of reserves banks
are required to hold.
24. The ratio of reserves tocheckable deposits a bank must
maintain.
25. Reserves in excess of therequired level.
26. When a bank’s excess reserves
equal zero.

Acme Bank, like every other bank in our hypothetical system, initially holds
reserves equal to the level of required reserves. Now suppose one of Acme Bank’s
customers deposits $1,000 in cash in a checking account. The money goes into thebank’s vault and thus adds to reserves. The customer now has an additional $1,000
in his or her account. Two versions of Acme’s balance sheet are given here. The firstshows the changes brought by the customer’s deposit: reserves and checkabledeposits rise by $1,000. The second shows how these changes affect Acme’sbalances. Reserves now equal $2,000 and checkable deposits equal $11,000. With

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checkable deposits of $11,000 and a 10% reserve requirement, Acme is required tohold reserves of $1,100. With reserves equaling $2,000, Acme has $900 in excess
reserves.
At this stage, there has been no change in the money supply. When the customer
brought in the $1,000 and Acme put the money in the vault, currency in circulation
fell by $1,000. At the same time, the $1,000 was added to the customer’s checking
account balance, so the money supply did not change.
Figure 9.2

Because Acme earns only a low interest rate on its excess reserves, we assume it will
try to loan them out. Suppose Acme lends the $900 to one of its customers. It will
make the loan by crediting the customer’s checking account with $900. Acme’s
outstanding loans and checkable deposits rise by $900. The $900 in checkabledeposits is new money; Acme created it when it issued the $900 loan. Now you know
where money comes from—it is created when a bank issues a loan.
Figure 9.3

Presumably, the customer who borrowed the $900 did so in order to spend it. That
customer will write a check to someone else, who is likely to bank at some otherbank. Suppose that Acme’s borrower writes a check to a firm with an account at
Bellville Bank. In this set of transactions, Acme’s checkable deposits fall by $900.
The firm that receives the check deposits it in its account at Bellville Bank,

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increasing that bank’s checkable deposits by $900. Bellville Bank now has a check
written on an Acme account. Bellville will submit the check to the Fed, which will
reduce Acme’s deposits with the Fed—its reserves—by $900 and increase Bellville’s
reserves by $900.
Figure 9.4

Notice that Acme Bank emerges from this round of transactions with $11,000 incheckable deposits and $1,100 in reserves. It has eliminated its excess reserves by
issuing the loan for $900; Acme is now loaned up. Notice also that from Acme’s
point of view, it has not created any money! It merely took in a $1,000 deposit andemerged from the process with $1,000 in additional checkable deposits.
The $900 in new money Acme created when it issued a loan has not vanished—it is
now in an account in Bellville Bank. Like the magician who shows the audience thatthe hat from which the rabbit appeared was empty, Acme can report that it has notcreated any money. There is a wonderful irony in the magic of money creation:banks create money when they issue loans, but no one bank ever seems to keep themoney it creates. That is because money is created within the banking system, notby a single bank.
The process of money creation will not end there. Let us go back to Bellville Bank.
Its deposits and reserves rose by $900 when the Acme check was deposited in a
Bellville account. The $900 deposit required an increase in required reserves of $90.
Because Bellville’s reserves rose by $900, it now has $810 in excess reserves. Just as
Acme lent the amount of its excess reserves, we can expect Bellville to lend this

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Chapter 9 The Nature and Creation of Money$810. The next set of balance sheets shows this transaction. Bellville’s loans andcheckable deposits rise by $810.
Figure 9.5

The $810 that Bellville lent will be spent. Let us suppose it ends up with a customer
who banks at Clarkston Bank. Bellville’s checkable deposits fall by $810; Clarkston’srise by the same amount. Clarkston submits the check to the Fed, which transfers
the money from Bellville’s reserve account to Clarkston’s. Notice that Clarkston’s
deposits rise by $810; Clarkston must increase its reserves by $81. But its reserves
have risen by $810, so it has excess reserves of $729.
Figure 9.6

Notice that Bellville is now loaned up. And notice that it can report that it has notcreated any money either! It took in a $900 deposit, and its checkable deposits haverisen by that same $900. The $810 it created when it issued a loan is now at
Clarkston Bank.

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The process will not end there. Clarkston will lend the $729 it now has in excess
reserves, and the money that has been created will end up at some other bank,which will then have excess reserves—and create still more money. And thatprocess will just keep going as long as there are excess reserves to pass through thebanking system in the form of loans. How much will ultimately be created by thesystem as a whole? With a 10% reserve requirement, each dollar in reserves backs
up $10 in checkable deposits. The $1,000 in cash that Acme’s customer brought inadds $1,000 in reserves to the banking system. It can therefore back up an
additional $10,000! In just the three banks we have shown, checkable deposits haverisen by $2,710 ($1,000 at Acme, $900 at Bellville, and $810 at Clarkston). Additionalbanks in the system will continue to create money, up to a maximum of $7,290
among them. Subtracting the original $1,000 that had been a part of currency incirculation, we see that the money supply could rise by as much as $9,000.

Heads Up!
Notice that when the banks received new deposits, they could make new loans
only up to the amount of their excess reserves, not up to the amount of theirdeposits and total reserve increases. For example, with the new deposit of$1,000, Acme Bank was able to make additional loans of $900. If instead it madenew loans equal to its increase in total reserves, then after the customers who
received new loans wrote checks to others, its reserves would be less than therequired amount. In the case of Acme, had it lent out an additional $1,000, after
checks were written against the new loans, it would have been left with only
$1,000 in reserves against $11,000 in deposits, for a reserve ratio of only 0.09,
which is less than the required reserve ratio of 0.1 in the example.

The Deposit MultiplierWe can relate the potential increase in the money supply to the change in reserves
that created it using the deposit multiplier27 (md), which equals the ratio of the
maximum possible change in checkable deposits (∆D) to the change in reserves (∆R).
In our example, the deposit multiplier was 10:
Equation 9.1
27. The ratio of the maximum
possible change in checkabledeposits (∆D) to the change inreserves (∆R).

9.2 The Banking System and Money Creation

md =

∆D
$10,000== 10∆R$1,000375

Chapter 9 The Nature and Creation of Money

To see how the deposit multiplier md is related to the required reserve ratio, we use
the fact that if banks in the economy are loaned up, then reserves, R, equal therequired reserve ratio (rrr) times checkable deposits, D:
Equation 9.2

R = rrrD
A change in reserves produces a change in loans and a change in checkabledeposits. Once banks are fully loaned up, the change in reserves, ∆R, will equal therequired reserve ratio times the change in deposits, ∆D:
Equation 9.3∆R = rrr∆D
Solving for ∆D, we have
Equation 9.4

1∆R = ∆D
rrr
Dividing both sides by ∆R, we see that the deposit multiplier, md, is 1/rrr:
Equation 9.5

1
∆D
=
= md
rrr ∆R
The deposit multiplier is thus given by the reciprocal of the required reserve ratio. With arequired reserve ratio of 0.1, the deposit multiplier is 10. A required reserve ratio of
0.2 would produce a deposit multiplier of 5. The higher the required reserve ratio,
the lower the deposit multiplier.
Actual increases in checkable deposits will not be nearly as great as suggested by
the deposit multiplier. That is because the artificial conditions of our example are
not met in the real world. Some banks hold excess reserves, customers withdraw
cash, and some loan proceeds are not spent. Each of these factors reduces thedegree to which checkable deposits are affected by an increase in reserves. The

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Chapter 9 The Nature and Creation of Moneybasic mechanism, however, is the one described in our example, and it remains thecase that checkable deposits increase by a multiple of an increase in reserves.
The entire process of money creation can work in reverse. When you withdraw cashfrom your bank, you reduce the bank’s reserves. Just as a deposit at Acme Bank
increases the money supply by a multiple of the original deposit, your withdrawal
reduces the money supply by a multiple of the amount you withdraw. And just as
money is created when banks issue loans, it is destroyed as the loans are repaid. A
loan payment reduces checkable deposits; it thus reduces the money supply.
Suppose, for example, that the Acme Bank customer who borrowed the $900 makes
a $100 payment on the loan. Only part of the payment will reduce the loan balance;
part will be interest. Suppose $30 of the payment is for interest, while theremaining $70 reduces the loan balance. The effect of the payment on Acme’sbalance sheet is shown below. Checkable deposits fall by $100, loans fall by $70, andnet worth rises by the amount of the interest payment, $30.
Similar to the process of money creation, the money reduction process decreases
checkable deposits by, at most, the amount of the reduction in deposits times thedeposit multiplier.

The Regulation of Banks
Figure 9.7

Banks are among the most heavily regulated of financial
institutions. They are regulated in part to protect
individual depositors against corrupt business practices.
Banks are also susceptible to crises of confidence.
Because their reserves equal only a fraction of theirdeposit liabilities, an effort by customers to get all their
cash out of a bank could force it to fail. A few poorly
managed banks could create such a crisis, leading
people to try to withdraw their funds from well-managed banks. Another reason forthe high degree of regulation is that variations in the quantity of money haveimportant effects on the economy as a whole, and banks are the institutions
through which money is created.

Deposit Insurance
From a customer’s point of view, the most important form of regulation comes in
the form of deposit insurance. For commercial banks, this insurance is provided by
the Federal Deposit Insurance Corporation (FDIC). Insurance funds are maintained
through a premium assessed on banks for every $100 of bank deposits.

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If a commercial bank fails, the FDIC guarantees to reimburse depositors up to$250,000 (raised from $100,000 during the financial crisis of 2008) per insured bank,for each account ownership category. From a depositor's point of view, therefore, it
is not necessary to worry about a bank's safety.
One difficulty this insurance creates, however, is that it may induce the officers of abank to take more risks. With a federal agency on hand to bail them out if they fail,the costs of failure are reduced. Bank officers can thus be expected to take morerisks than they would otherwise, which, in turn, makes failure more likely. In
addition, depositors, knowing that their deposits are insured, may not scrutinize
the banks’ lending activities as carefully as they would if they felt that unwise loans
could result in the loss of their deposits.
Thus, banks present us with a fundamental dilemma. A fractional reserve systemmeans that banks can operate only if their customers maintain their confidence inthem. If bank customers lose confidence, they are likely to try to withdraw theirfunds. But with a fractional reserve system, a bank actually holds funds in reserve
equal to only a small fraction of its deposit liabilities. If its customers think a bankwill fail and try to withdraw their cash, the bank is likely to fail. Bank panics, inwhich frightened customers rush to withdraw their deposits, contributed to thefailure of one-third of the nation’s banks between 1929 and 1933. Deposit insurance
was introduced in large part to give people confidence in their banks and to prevent
failure. But the deposit insurance that seeks to prevent bank failures may lead toless careful management—and thus encourage bank failure.

Regulation to Prevent Bank Failure
To reduce the number of bank failures, banks are limited in what they can do. Banks
are required to maintain a minimum level of net worth as a fraction of total assets.
Regulators from the FDIC regularly perform audits and other checks of individual
banks to ensure they are operating safely.
The FDIC has the power to close a bank whose net worth has fallen below therequired level. In practice, it typically acts to close a bank when it becomesinsolvent, that is, when its net worth becomes negative. Negative net worth implies
that the bank’s liabilities exceed its assets.
When the FDIC closes a bank, it arranges for depositors to receive their funds. Whenthe bank’s funds are insufficient to return customers’ deposits, the FDIC uses moneyfrom the insurance fund for this purpose. Alternatively, the FDIC may arrange foranother bank to purchase the failed bank. The FDIC, however, continues toguarantee that depositors will not lose any money.

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Regulation in Response to Financial Crises
In the aftermath of the Great Depression and the banking crisis that accompanied
it, laws were passed to try to make the banking system safer. The Glass-Steagall Actof that period created the FDIC and the separation between commercial banks andinvestment banks. Over time, the financial system in the United States and in othercountries began to change, and in 1999, a law was passed in the United States thatessentially repealed the part of the Glass-Steagall Act that had created theseparation between commercial and investment banking. Proponents of eliminating
the separation between the two types of banks argued that banks could better
diversify their portfolios if allowed to participate in other parts of the financial
markets and that banks in other countries operated without such a separation.
Similar to the reaction to the banking crisis of the 1930s, the financial crisis of 2008
and the Great Recession led to calls for financial market reform. The result was the
Dodd-Frank Wall Street Reform and Consumer Protection Act, usually referred to as
the Dodd-Frank Act, which was passed in July 2010. More than 2,000 pages in length,
the regulations to implement most provisions of this act were set to take place overa nearly two-year period, with some provisions expected to take even longer toimplement. This act created the Consumer Financial Protection Agency to oversee
and regulate various aspects of consumer credit markets, such as credit card andbank fees and mortgage contracts. It also created the Financial Stability OversightCouncil (FSOC) to assess risks for the entire financial industry. The FSOC canrecommend that a nonbank financial firm, such as a hedge fund that is perhaps
threatening the stability of the financial system (i.e., getting “too big to fail”),
become regulated by the Federal Reserve. If such firms do become insolvent, aprocess of liquidation similar to what occurs when the FDIC takes over a bank can
be applied. The Dodd-Frank Act also calls for implementation of the Volcker rule,
which was named after the former chair of the Fed who argued the case. The
Volcker rule is meant to ban banks from using depositors’ funds to engage incertain types of speculative investments to try to enhance the profits of the bank, atleast partly reinstating the separation between commercial and investment banking
that the Glass-Steagall Act had created. There are many other provisions in thiswide-sweeping legislation that are designed to improve oversight of nonbank
financial institutions, increase transparency in the operation of various forms offinancial instruments, regulate credit rating agencies such as Moody’s and Standard& Poor’s, and so on. Given the lag time associated with fully implementing thelegislation, it will probably be many years before its impact can be fully assessed.

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KEY TAKEAWAYS• Banks are financial intermediaries that accept deposits, make loans, andprovide checking accounts for their customers.
• Money is created within the banking system when banks issue loans; it isdestroyed when the loans are repaid.
• An increase (decrease) in reserves in the banking system can increase(decrease) the money supply. The maximum amount of the increase(decrease) is equal to the deposit multiplier times the change inreserves; the deposit multiplier equals the reciprocal of the required
reserve ratio.
• Bank deposits are insured and banks are heavily regulated.
• Similar to the passage of the Glass-Steagall Act during the Great
Depression, the Dodd-Frank Act was the comprehensive financial reform
legislation that responded to the financial crisis in 2008 and the GreatRecession.

TRY IT!
1. Suppose Acme Bank initially has $10,000 in deposits, reserves of $2,000,
and loans of $8,000. At a required reserve ratio of 0.2, is Acme loaned
up? Show the balance sheet of Acme Bank at present.
2. Now suppose that an Acme Bank customer, planning to take cash on an
extended college graduation trip to India, withdraws $1,000 from her
account. Show the changes to Acme Bank’s balance sheet and Acme’sbalance sheet after the withdrawal. By how much are its reserves now
deficient?
3. Acme would probably replenish its reserves by reducing loans. Thisaction would cause a multiplied contraction of checkable deposits asother banks lose deposits because their customers would be paying offloans to Acme. How large would the contraction be?

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Case in Point: A Big Bank Goes Under

It was the darling of Wall Street—it showed rapid growth and made big profits.
Washington Mutual, a savings and loan based in the state of Washington, was a
relatively small institution whose CEO, Kerry K. Killinger, had big plans. He
wanted to transform his little Seattle S&L into the Wal-Mart of banks.
Mr. Killinger began pursuing a relatively straightforward strategy. He acquiredbanks in large cities such as Chicago and Los Angeles. He acquired banks up anddown the east and west coasts. He aggressively extended credit to low-income
individuals and families—credit cards, car loans, and mortgages. In making
mortgage loans to low-income families, WaMu, as the bank was known, quickly
became very profitable. But it was exposing itself to greater and greater risk,
according to the New York Times.
Housing prices in the United States more than doubled between 1997 and 2007.
During that time, loans to even low-income households were profitable. But, as
housing prices began falling in 2007, banks such as WaMu began to experiencelosses as homeowners began to walk away from houses whose values suddenly
fell below their outstanding mortgages. WaMu began losing money in 2007 as
housing prices began falling. The company had earned $3.6 billion in 2006, andswung to a loss of $67 million in 2007, according to the Puget Sound Business
Journal. Mr. Killinger was ousted by the board early in September of 2008. The
bank failed later that month. It was the biggest bank failure in the history of
the United States.

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The Federal Deposit Insurance Corporation (FDIC) had just rescued anotherbank, IndyMac, which was only a tenth the size of WaMu, and would have done
the same for WaMu if it had not been able to find a company to purchase it. But
in this case, JPMorgan Chase agreed to take it over—its deposits, bank branches,
and its troubled asset portfolio. The government and the Fed even negotiatedthe deal behind WaMu’s back! The then chief executive officer of the company,
Alan H. Fishman, was reportedly flying from New York to Seattle when the deal
was finalized.
The government was anxious to broker a deal that did not require use of the
FDIC’s depleted funds following IndyMac’s collapse. But it would have done so if
a buyer had not been found. As the FDIC reports on its Web site: “Since the
FDIC’s creation in 1933, no depositor has ever lost even one penny of FDICinsured funds.”
Sources: Eric Dash and Andrew Ross Sorkin, “Government Seizes WaMu andSells Some Assets,” New York Times, September 25, 2008, p. A1; Kirsten Grind,“Insiders Detail Reasons for WaMu’s Failure,” Puget Sound Business Journal,
January 23, 2009; and FDIC Web site at https://www.fdic.gov/edie/
fdic_info.html.

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ANSWER TO TRY IT! PROBLEM

1. Acme Bank is loaned up, since $2,000/$10,000 = 0.2, which is therequired reserve ratio. Acme’s balance sheet is:

2. Acme Bank’s balance sheet after losing $1,000 in deposits:

Required reserves are deficient by $800. Acme must hold 20% of
its deposits, in this case
$1,800 (0.2 × $9,000 = $1,800) , as reserves, but it
has only $1,000 in reserves at the moment.
3. The contraction in checkable deposits would be∆D = (1/0.2) × (−$1,000) = −$5,000

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9.3 The Federal Reserve System
LEARNING OBJECTIVES
1.
2.
3.
4.

Explain the primary functions of central banks.
Describe how the Federal Reserve System is structured and governed.
Identify and explain the tools of monetary policy.
Describe how the Fed creates and destroys money when it buys and sells
federal government bonds.

The Federal Reserve System of the United States, or Fed, is the U.S. central bank.
Japan’s central bank is the Bank of Japan; the European Union has established theEuropean Central Bank. Most countries have a central bank. A central bank28
performs five primary functions: (1) it acts as a banker to the central government,(2) it acts as a banker to banks, (3) it acts as a regulator of banks, (4) it conductsmonetary policy, and (5) it supports the stability of the financial system.
For the first 137 years of its history, the United States did not have a true central
bank. While a central bank was often proposed, there was resistance to creating an
institution with such enormous power. A series of bank panics slowly increased
support for the creation of a central bank. The bank panic of 1907 proved to be thefinal straw. Bank failures were so widespread, and depositor losses so heavy, thatconcerns about centralization of power gave way to a desire for an institution thatwould provide a stabilizing force in the banking industry. Congress passed theFederal Reserve Act in 1913, creating the Fed and giving it all the powers of acentral bank.

Structure of the Fed

28. A bank that acts as a banker tothe central government, acts asa banker to banks, acts as aregulator of banks, conductsmonetary policy, and supports
the stability of the financial
system.

In creating the Fed, Congress determined that a central bank should be as
independent of the government as possible. It also sought to avoid too muchcentralization of power in a single institution. These potentially contradictory goalsof independence and decentralized power are evident in the Fed’s structure and in
the continuing struggles between Congress and the Fed over possible changes inthat structure.
In an effort to decentralize power, Congress designed the Fed as a system of 12
regional banks, as shown in Figure 9.8 "The 12 Federal Reserve Districts and the
Cities Where Each Bank Is Located". Each of these banks operates as a kind of384

Chapter 9 The Nature and Creation of Moneybankers’ cooperative; the regional banks are owned by the commercial banks intheir districts that have chosen to be members of the Fed. The owners of eachFederal Reserve bank select the board of directors of that bank; the board selects
the bank’s president.
Figure 9.8 The 12 Federal Reserve Districts and the Cities Where Each Bank Is LocatedSeveral provisions of the Federal Reserve Act seek to maintain the Fed’s
independence. The board of directors for the entire Federal Reserve System is called
the Board of Governors. The seven members of the board are appointed by thepresident of the United States and confirmed by the Senate. To ensure a large
measure of independence from any one president, the members of the Board ofGovernors have 14-year terms. One member of the board is selected by thepresident of the United States to serve as chairman for a four-year term.
As a further means of ensuring the independence of the Fed, Congress authorized it
to buy and sell federal government bonds. This activity is a profitable one thatallows the Fed to pay its own bills. The Fed is thus not dependent on a Congress thatmight otherwise be tempted to force a particular set of policies on it. The Fed islimited in the profits it is allowed to earn; its “excess” profits are returned to theTreasury.
It is important to recognize that the Fed is technically not part of the federal
government. Members of the Board of Governors do not legally have to answer toCongress, the president, or anyone else. The president and members of Congress

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Chapter 9 The Nature and Creation of Moneycan certainly try to influence the Fed, but they cannot order it to do anything.
Congress, however, created the Fed. It could, by passing another law, abolish theFed’s independence. The Fed can maintain its independence only by keeping the
support of Congress—and that sometimes requires being responsive to the wishes ofCongress.
In recent years, Congress has sought to increase its oversight of the Fed. The
chairman of the Federal Reserve Board is required to report to Congress twice eachyear on its monetary policy, the set of policies that the central bank can use to
influence economic activity.

Powers of the Fed
The Fed’s principal powers stem from its authority to conduct monetary policy. It
has three main policy tools: setting reserve requirements, operating the discountwindow and other credit facilities, and conducting open-market operations.

Reserve Requirements
The Fed sets the required ratio of reserves that banks must hold relative to theirdeposit liabilities. In theory, the Fed could use this power as an instrument ofmonetary policy. It could lower reserve requirements when it wanted to increase
the money supply and raise them when it wanted to reduce the money supply. In
practice, however, the Fed does not use its power to set reserve requirements inthis way. The reason is that frequent manipulation of reserve requirements would
make life difficult for bankers, who would have to adjust their lending policies tochanging requirements.
The Fed’s power to set reserve requirements was expanded by the Monetary
Control Act of 1980. Before that, the Fed set reserve requirements only forcommercial banks that were members of the Federal Reserve System. Most banks
are not members of the Fed; the Fed’s control of reserve requirements thus
extended to only a minority of banks. The 1980 act required virtually all banks tosatisfy the Fed’s reserve requirements.

The Discount Window and Other Credit Facilities

29. The interest rate charged by
the Fed when it lends reserves
to banks.

9.3 The Federal Reserve System

A major responsibility of the Fed is to act as a lender of last resort to banks. Whenbanks fall short on reserves, they can borrow reserves from the Fed through its
discount window. The discount rate29 is the interest rate charged by the Fed when
it lends reserves to banks. The Board of Governors sets the discount rate.

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Lowering the discount rate makes funds cheaper to banks. A lower discount rate
could place downward pressure on interest rates in the economy. However, whenfinancial markets are operating normally, banks rarely borrow from the Fed,
reserving use of the discount window for emergencies. A typical bank borrows fromthe Fed only about once or twice per year.
Instead of borrowing from the Fed when they need reserves, banks typically rely on
the federal funds market to obtain reserves. The federal funds market30 is amarket in which banks lend reserves to one another. The federal funds rate31 is
the interest rate charged for such loans; it is determined by banks’ demand for andsupply of these reserves. The ability to set the discount rate is no longer an
important tool of Federal Reserve policy.

30. A market in which banks lend
reserves to one another.
31. The interest rate charged when
one bank lends reserves toanother.
32. A promise by the issuer of thebond to pay the owner of thebond a payment or a series of
payments on a specific date ordates.
33. The buying and selling offederal government bonds by
the Fed.

9.3 The Federal Reserve System

To deal with the recent financial and economic conditions, the Fed greatly
expanded its lending beyond its traditional discount window lending. As fallinghouse prices led to foreclosures, private investment banks and other financial
institutions came under increasing pressure. The Fed made credit available to awide range of institutions in an effort to stem the crisis. In 2008, the Fed bailed out
two major housing finance firms that had been established by the government toprop up the housing industry—Fannie Mae (the Federal National Mortgage
Association) and Freddie Mac (the Federal Home Mortgage Corporation). Together,
the two institutions backed the mortgages of half of the nation’s mortgage
loans.Sam Zuckerman, “Feds Take Control of Fannie Mae, Freddie Mac,” The San
Francisco Chronicle, September 8, 2008, p. A-1. It also agreed to provide $85 billion to
AIG, the huge insurance firm. AIG had a subsidiary that was heavily exposed to
mortgage loan losses, and that crippled the firm. The Fed determined that AIG was
simply too big to be allowed to fail. Many banks had ties to the giant institution, andits failure would have been a blow to those banks. As the United States faced theworst financial crisis since the Great Depression, the Fed took center stage.
Whatever its role in the financial crisis of 2007–2008, the Fed remains an importantbackstop for banks and other financial institutions needing liquidity. And for that,it uses the traditional discount window, supplemented with a wide range of othercredit facilities. The Case in Point in this section discusses these new credit
facilities.

Open-Market Operations
The Fed’s ability to buy and sell federal government bonds has proved to be its mostpotent policy tool. A bond32 is a promise by the issuer of the bond (in this case thefederal government) to pay the owner of the bond a payment or a series of
payments on a specific date or dates. The buying and selling of federal government
bonds by the Fed are called open-market operations33. When the Fed buys or sells

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government bonds, it adds or subtracts reserves from the banking system. Suchchanges affect the money supply.
Suppose the Fed buys a government bond in the open market. It writes a check on
its own account to the seller of the bond. When the seller deposits the check at abank, the bank submits the check to the Fed for payment. The Fed “pays” the checkby crediting the bank’s account at the Fed, so the bank has more reserves.
The Fed’s purchase of a bond can be illustrated using a balance sheet. Suppose the
Fed buys a bond for $1,000 from one of Acme Bank’s customers. When that
customer deposits the check at Acme, checkable deposits will rise by $1,000. The
check is written on the Federal Reserve System; the Fed will credit Acme’s account.
Acme’s reserves thus rise by $1,000. With a 10% reserve requirement, that will
create $900 in excess reserves and set off the same process of money expansion as
did the cash deposit we have already examined. The difference is that the Fed’spurchase of a bond created new reserves with the stroke of a pen, where the cash
deposit created them by removing $1,000 from currency in circulation. The
purchase of the $1,000 bond by the Fed could thus increase the money supply by asmuch as $10,000, the maximum expansion suggested by the deposit multiplier.
Where does the Fed get $1,000 to purchase the bond? It
simply creates the money when it writes the check topurchase the bond. On the Fed’s balance sheet, assets
increase by $1,000 because the Fed now has the bond;bank deposits with the Fed, which represent a liability
to the Fed, rise by $1,000 as well.

Figure 9.9

When the Fed sells a bond, it gives the buyer a federal
government bond that it had previously purchased andaccepts a check in exchange. The bank on which the check was written will find its
deposit with the Fed reduced by the amount of the check. That bank’s reserves andcheckable deposits will fall by equal amounts; the reserves, in effect, disappear. The
result is a reduction in the money supply. The Fed thus increases the money supply
by buying bonds; it reduces the money supply by selling them.
Figure 9.10 "The Fed and the Flow of Money in the Economy" shows how the Fed
influences the flow of money in the economy. Funds flow from thepublic—individuals and firms—to banks as deposits. Banks use those funds to makeloans to the public—to individuals and firms. The Fed can influence the volume ofbank lending by buying bonds and thus injecting reserves into the system. With
new reserves, banks will increase their lending, which creates still more deposits
and still more lending as the deposit multiplier goes to work. Alternatively, the Fed

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can sell bonds. When it does, reserves flow out of the system, reducing bank lending
and reducing deposits.
The Fed’s purchase or sale of bonds is conducted by theOpen Market Desk at the Federal Reserve Bank of New
York, one of the 12 district banks. Traders at the Open
Market Desk are guided by policy directives issued by
the Federal Open Market Committee (FOMC). The FOMC
consists of the seven members of the Board ofGovernors plus five regional bank presidents. The
president of the New York Federal Reserve Bank serves
as a member of the FOMC; the other 11 bank presidents
take turns filling the remaining four seats.
The FOMC meets eight times per year to chart the Fed’smonetary policies. In the past, FOMC meetings wereclosed, with no report of the committee’s action until
the release of the minutes six weeks after the meeting.
Faced with pressure to open its proceedings, the Fed
began in 1994 issuing a report of the decisions of the
FOMC immediately after each meeting.
In practice, the Fed sets targets for the federal funds
rate. To achieve a lower federal funds rate, the Fed goes
into the open market buying securities and thusincreasing the money supply. When the Fed raises its
target rate for the federal funds rate, it sells securities
and thus reduces the money supply.

Figure 9.10 The Fed and theFlow of Money in the
EconomyIndividuals and firms (thepublic) make deposits in banks;
banks make loans to individuals
and firms. The Fed can buy bonds
to inject new reserves into thesystem, thus increasing banklending, which creates new
deposits, creating still more
lending as the deposit multipliergoes to work. Alternatively, theFed can sell bonds, withdrawing
reserves from the system, thus
reducing bank lending andreducing total deposits.

Traditionally, the Fed has bought and sold short-term government securities;
however, in dealing with the condition of the economy in 2009, wherein the Fed has
already set the target for the federal funds rate at near zero, the Fed has announced
that it will also be buying longer term government securities. In so doing, it hopes
to influence longer term interest rates, such as those related to mortgages.

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KEY TAKEAWAYS• The Fed, the central bank of the United States, acts as a bank for otherbanks and for the federal government. It also regulates banks, setsmonetary policy, and maintains the stability of the financial system.
• The Fed sets reserve requirements and the discount rate and conducts
open-market operations. Of these tools of monetary policy, open-market
operations are the most important.
• Starting in 2007, the Fed began creating additional credit facilities tohelp stabilize the financial system.
• The Fed creates new reserves and new money when it purchases bonds.
It destroys reserves and thus reduces the money supply when it sells
bonds.

TRY IT!
Suppose the Fed sells $8 million worth of bonds.
1. How do bank reserves change?
2. Will the money supply increase or decrease?
3. What is the maximum possible change in the money supply if therequired reserve ratio is 0.2?

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Case in Point: Fed Supports the Financial System by
Creating New Credit Facilities

Well before most of the public became aware of the precarious state of the U.S.
financial system, the Fed began to see signs of growing financial strains and toact on reducing them. In particular, the Fed saw that short-term interest rates
that are often quite close to the federal funds rate began to rise markedly above
it. The widening spread was alarming, because it suggested that lenderconfidence was declining, even for what are generally considered low-riskloans. Commercial paper, in which large companies borrow funds for a period
of about a month to manage their cash flow, is an example. Even companies
with high credit ratings were having to pay unusually high interest rate
premiums in order to get funding, or in some cases could not get funding at all.
To deal with the drying up of credit markets, in late 2007 the Fed began tocreate an alphabet soup of new credit facilities. Some of these were offered inconjunction with the Department of the Treasury, which had more latitude interms of accepting some credit risk. The facilities differed in terms of collateralused, the duration of the loan, which institutions were eligible to borrow, andthe cost to the borrower. For example, the Primary Dealer Credit Facility (PDCF)
allowed primary dealers (i.e., those financial institutions that normally handle
the Fed’s open market operations) to obtain overnight loans. The Term AssetBacked Securities Loan Facility (TALF) allowed a wide range of companies toborrow, using the primary dealers as conduits, based on qualified asset-backed

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securities related to student, auto, credit card, and small business debt, for athree-year period. Most of these new facilities were designed to be temporary.
Starting in 2009 and 2010, the Fed began closing a number of them or at least
preventing them from issuing new loans.
The common goal of all of these various credit facilities was to increaseliquidity in order to stimulate private spending. For example, these credit
facilities encouraged banks to pare down their excess reserves (which grewenormously as the financial crisis unfolded and the economy deteriorated) andto make more loans. In the words of Fed Chairman Ben Bernanke:“Liquidity provision by the central bank reduces systemic risk by assuringmarket participants that, should short-term investors begin to lose confidence,
financial institutions will be able to meet the resulting demands for cashwithout resorting to potentially destabilizing fire sales of assets. Moreover,backstopping the liquidity needs of financial institutions reduces funding
stresses and, all else equal, should increase the willingness of those institutions
to lend and make markets.”
The legal authority for most of these new credit facilities came from aparticular section of the Federal Reserve Act that allows the Board of Governors“in unusual and exigent circumstances” to extend credit to a wide range ofmarket players.
Sources: Ben S. Bernanke, “The Crisis and the Policy Response” (Stemp Lecture,
London School of Economics, London, England, January 13, 2009); Richard
DiCecio and Charles S. Gascon, “New Monetary Policy Tools?” Federal Reserve
Bank of St. Louis Monetary Trends, May 2008; Federal Reserve Board of Governors
Web site at http://www.federalreserve.gov/monetarypolicy/default.htm.

ANSWER TO TRY IT! PROBLEM
1. Bank reserves fall by $8 million.
2. The money supply decreases.
3. The maximum possible decrease is $40 million, since ∆D = (1/0.2) × (−$8
million) = −$40 million.

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9.4 Review and PracticeSummary
In this chapter we investigated the money supply and looked at how it is determined. Money is anything thatserves as a medium of exchange. Whatever serves as money also functions as a unit of account and as a store ofvalue. Money may or may not have intrinsic value. In the United States, the total of currency in circulation,
traveler’s checks, and checkable deposits equals M1. A broader measure of the money supply is M2, which
includes M1 plus assets that are highly liquid, but less liquid than those in M1.
Banks create money when they issue loans. The ability of banks to issue loans is controlled by their reserves.
Reserves consist of cash in bank vaults and bank deposits with the Fed. Banks operate in a fractional reserve
system; that is, they maintain reserves equal to only a small fraction of their deposit liabilities. Banks are heavily
regulated to protect individual depositors and to prevent crises of confidence. Deposit insurance protects
individual depositors. Financial reform legislation was enacted in response to the banking crisis during theGreat Depression and again in response to the financial crisis in 2008 and the Great Recession.
A central bank serves as a bank for banks, a regulator of banks, a manager of the money supply, a bank for anation’s government, and a supporter of financial markets generally. In the financial crisis that rocked theUnited States and much of the world in 2008, the Fed played a central role in keeping bank and nonbank
institutions afloat and in keeping credit available. The Federal Reserve System (Fed) is the central bank for theUnited States. The Fed is governed by a Board of Governors whose members are appointed by the president of
the United States, subject to confirmation by the Senate.
The Fed can lend to banks and other institutions through the discount window and other credit facilities, change
reserve requirements, and engage in purchases and sales of federal government bonds in the open market.
Decisions to buy or sell bonds are made by the Federal Open Market Committee (FOMC); the Fed’s open-market
operations represent its primary tool for influencing the money supply. Purchases of bonds by the Fed initially
increase the reserves of banks. With excess reserves on hand, banks will attempt to increase their loans, and in
the process the money supply will change by an amount less than or equal to the deposit multiplier times thechange in reserves. Similarly, the Fed can reduce the money supply by selling bonds.

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CONCEPT PROBLEMS
1. Airlines have “frequent flier” clubs in which customers accumulate
miles according to the number of miles they have flown with the airline.
Frequent flier miles can then be used to purchase other flights, to rent
cars, or to stay in some hotels. Are frequent flier miles money?
2. Debit cards allow an individual to transfer funds directly in a checkableaccount to a merchant without writing a check. How is this different
from the way credit cards work? Are either credit cards or debit cards
money? Explain.
3. Many colleges sell special cards that students can use to purchase
everything from textbooks or meals in the cafeteria to use of washingmachines in the dorm. Students deposit money in their cards; as they
use their cards for purchases, electronic scanners remove money fromthe cards. To replenish a card’s money, a student makes a cash depositthat is credited to the card. Would these cards count as part of themoney supply?
4. A smart card, also known as an electronic purse, is a plastic cardthat can be loaded with a monetary value. Its developers argue
that, once widely accepted, it could replace the use of currency
in vending machines, parking meters, and elsewhere. Suppose
smart cards came into widespread use. Present your views on thefollowing issues:a. Would you count balances in the purses as part of the money
supply? If so, would they be part of M1? M2?
b. Should any institution be permitted to issue them, or should
they be restricted to banks?
c. Should the issuers be subject to reserve requirements?
d. Suppose they were issued by banks. How do you think theuse of such purses would affect the money supply? Explain
your answer carefully.
5. Which of the following items is part of M1? M2?
a.
b.
c.
d.
e.

9.4 Review and Practice$0.27 cents that has accumulated under a couch cushion.
Your $2,000 line of credit with your Visa account.
The $210 balance in your checking account.
$417 in your savings account.
10 shares of stock your uncle gave you on your 18th birthday,
which are now worth $520.

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Chapter 9 The Nature and Creation of Moneyf. $200 in traveler’s checks you have purchased for yourspring-break trip.
6. In the Middle Ages, goldsmiths took in customers’ deposits (gold coins)and issued receipts that functioned much like checks do today. People
used the receipts as a medium of exchange. Goldsmiths also issued loans
by writing additional receipts against which they were holding no gold
to borrowers. Were goldsmiths engaging in fractional reserve banking?
Why do you think that customers turned their gold over to goldsmiths?
Who benefited from the goldsmiths’ action? Why did such a systemgenerally work? When would it have been likely to fail?
7. A $1,000 deposit in Acme Bank has increased reserves by $1,000. A loan
officer at Acme reasons as follows: “The reserve requirement is 10%.
That means that the $1,000 in new reserves can back $10,000 incheckable deposits. Therefore I’ll loan an additional $10,000.” Is there
any problem with the loan officer’s reasoning? Explain.
8. When the Fed buys and sells bonds through open-market operations, themoney supply changes, but there is no effect on the money supply when
individuals buy and sell bonds. Explain.

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NUMERICAL PROBLEMS

1. Consider the following example of bartering:
1 10-ounce T-bone steak can be traded for 5 soft drinks.
1 soft drink can be traded for 10 apples.
100 apples can be traded for a T-shirt.
5 T-shirts can be exchanged for 1 textbook.
It takes 4 textbooks to get 1 VCR.

a. How many 10-ounce T-bone steaks could you exchange for 1
textbook? How many soft drinks? How many apples?
b. State the price of T-shirts in terms of apples, textbooks, andsoft drinks.
c. Why do you think we use money as a unit of account?
2. Assume that the banking system is loaned up and that any open-market
purchase by the Fed directly increases reserves in the banks. If therequired reserve ratio is 0.2, by how much could the money supply
expand if the Fed purchased $2 billion worth of bonds?
3. Suppose the Fed sells $5 million worth of bonds to Econobank.
a. What happens to the reserves of the bank?
b. What happens to the money supply in the economy as awhole if the reserve requirement is 10%, all payments are
made by check, and there is no net drain into currency?
c. How would your answer in part b be affected if you knewthat some people involved in the money creation process
kept some of their funds as cash?
4. If half the banks in the nation borrow additional reserves totaling $10
million at the Fed discount window, and at the same time the other halfof the banks reduce their excess reserves by a total of $10 million, what
is likely to happen to the money supply? Explain.
5. Suppose a bank with a 10% reserve requirement has $10 million
in reserves and $100 million in checkable deposits, and a major
corporation makes a deposit of $1 million.

9.4 Review and Practice396

Chapter 9 The Nature and Creation of Moneya. Explain how the deposit affects the bank’s reserves andcheckable deposits.
b. By how much can the bank increase its lending?
6. Suppose a bank with a 25% reserve requirement has $50 million
in reserves and $200 million in checkable deposits, and one of thebank’s depositors, a major corporation, writes a check to anothercorporation for $5 million. The check is deposited in anotherbank.
a. Explain how the withdrawal affects the bank’s reserves andcheckable deposits.
b. By how much will the bank have to reduce its lending?
7. Suppose the bank in problem 6 faces a 20% reserve requirement. The
customer writes the same check. How will this affect your answers?
8. Now consider an economy in which the central bank has justpurchased $8 billion worth of government bonds from banks inthe economy. What would be the effect of this purchase on themoney supply in the country, assuming reserve requirements of:
a.
b.
c.
d.

10%.
15%.
20%.
25%.

9. Now consider the same economy, and the central bank sells $8
billion worth of government bonds to local banks. State the likely
effects on the money supply under reserve requirements of:
a.
b.
c.
d.

10%.
15%.
20%.
25%.

10. How would the purchase of $8 billion of bonds by the central bank fromlocal banks be likely to affect interest rates? How about the effect oninterest rates of the sale of $8 billion worth of bonds? Explain youranswers carefully.

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Chapter 10
Financial Markets and the Economy
Start Up: Clamping Down on Money Growth
For nearly three decades, Americans have come to expect very low inflation, on theorder of 2% to 3% a year. How did this expectation come to be? Was it always so?
Absolutely not.
In July 1979, with inflation approaching 14% and interest rates on three-month
Treasury bills soaring past 10%, a desperate President Jimmy Carter took action. He
appointed Paul Volcker, the president of the New York Federal Reserve Bank, as
chairman of the Fed’s Board of Governors. Mr. Volcker made clear that his objective
as chairman was to bring down the inflation rate—no matter what theconsequences for the economy. Mr. Carter gave this effort his full support.
Mr. Volcker wasted no time in putting his policies to work. He slowed the rate ofmoney growth immediately. The economy’s response was swift; the United Statesslipped into a brief recession in 1980, followed by a crushing recession in 1981–1982.
In terms of the goal of reducing inflation, Mr. Volcker’s monetary policies were adazzling success. Inflation plunged below a 4% rate within three years; by 1986 theinflation rate had fallen to 1.1%. The tall, bald, cigar-smoking Mr. Volcker emerged
as a folk hero in the fight against inflation. Indeed he has returned 20 years later aspart of President Obama’s economic team to perhaps once again rescue the U.S.
economy.
The Fed’s seven-year fight against inflation from 1979 to 1986 made the job for Alan
Greenspan, Mr. Volcker’s successor, that much easier. To see how the decisions of
the Federal Reserve affect key macroeconomic variables—real GDP, the price level,
and unemployment—in this chapter we will explore how financial markets1,
markets in which funds accumulated by one group are made available to anothergroup, are linked to the economy.

1. Markets in which funds
accumulated by one group are
made available to anothergroup.

This chapter provides the building blocks for understanding financial markets.
Beginning with an overview of bond and foreign exchange markets, we will
examine how they are related to the level of real GDP and the price level. The
second section completes the model of the money market. We have learned that the398

Chapter 10 Financial Markets and the Economy

Fed can change the amount of reserves in the banking system, and that when it
does the money supply changes. Here we explain money demand—the quantity ofmoney people and firms want to hold—which, together with money supply, leads toan equilibrium rate of interest.
The model of aggregate demand and supply shows how changes in the componentsof aggregate demand affect GDP and the price level. In this chapter, we will learn
that changes in the financial markets can affect aggregate demand—and in turn canlead to changes in real GDP and the price level. Showing how the financial markets
fit into the model of aggregate demand and aggregate supply we developed earlier
provides a more complete picture of how the macroeconomy works.

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10.1 The Bond and Foreign Exchange Markets
LEARNING OBJECTIVES
1. Explain and illustrate how the bond market works and discuss therelationship between the price of a bond and that bond’s interest rate.
2. Explain and illustrate the relationship between a change in demand foror supply of bonds and macroeconomic activity.
3. Explain and illustrate how the foreign exchange market works and how
a change in demand for a country’s currency or a change in its supply
affects macroeconomic activity.

In this section, we will look at the bond market and at the market for foreignexchange. Events in these markets can affect the price level and output for theentire economy.

The Bond Market
In their daily operations and in pursuit of new projects, institutions such as firms
and governments often borrow. They may seek funds from a bank. Many
institutions, however, obtain credit by selling bonds. The federal government is one
institution that issues bonds. A local school district might sell bonds to finance theconstruction of a new school. Your college or university has probably sold bonds tofinance new buildings on campus. Firms often sell bonds to finance expansion. The
market for bonds is an enormously important one.
When an institution sells a bond, it obtains the price paid for the bond as a kind ofloan. The institution that issues the bond is obligated to make payments on thebond in the future. The interest rate is determined by the price of the bond. To
understand these relationships, let us look more closely at bond prices and interest
rates.

Bond Prices and Interest Rates
Suppose the manager of a manufacturing company needs to borrow some money toexpand the factory. The manager could do so in the following way: he or she prints,
say, 500 pieces of paper, each bearing the company’s promise to pay the bearer$1,000 in a year. These pieces of paper are bonds, and the company, as the issuer,
promises to make a single payment. The manager then offers these bonds for sale,400

Chapter 10 Financial Markets and the Economy

announcing that they will be sold to the buyers who offer the highest prices.
Suppose the highest price offered is $950, and all the bonds are sold at that price.
Each bond is, in effect, an obligation to repay buyers $1,000. The buyers of thebonds are being paid $50 for the service of lending $950 for a year.
The $1,000 printed on each bond is the face value of the bond2; it is the amount theissuer will have to pay on the maturity date3 of the bond—the date when the loan
matures, or comes due. The $950 at which they were sold is their price. The
difference between the face value and the price is the amount paid for the use of
the money obtained from selling the bond.
An interest rate4 is the payment made for the use of money, expressed as apercentage of the amount borrowed. Bonds you sold command an interest rateequal to the difference between the face value and the bond price, divided by thebond price, and then multiplied by 100 to form a percentage:
Equation 10.1

Face value − bond price× 100 = interest rate
Bond priceAt a price of $950, the interest rate is 5.3%

$1,000 − $950
× 100 = 5.3%
$950
The interest rate on any bond is determined by its price. As the price falls, theinterest rate rises. Suppose, for example, that the best price the manager can get forthe bonds is $900. Now the interest rate is 11.1%. A price of $800 would mean aninterest rate of 25%; $750 would mean an interest rate of 33.3%; a price of $500
translates into an interest rate of 100%. The lower the price of a bond relative to its
face value, the higher the interest rate.
2. The amount the issuer of abond will have to pay on thematurity date.
3. The date when a bond matures,or comes due.
4. Payment made for the use ofmoney, expressed as apercentage of the amountborrowed.

Bonds in the real world are more complicated than the piece of paper in our
example, but their structure is basically the same. They have a face value (usually
an amount between $1,000 and $100,000) and a maturity date. The maturity datemight be three months from the date of issue; it might be 30 years.
Whatever the period until it matures, and whatever the face value of the bond may
be, its issuer will attempt to sell the bond at the highest possible price. Buyers of

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bonds will seek the lowest prices they can obtain. Newly issued bonds are generally
sold in auctions. Potential buyers bid for the bonds, which are sold to the highest
bidders. The lower the price of the bond relative to its face value, the higher theinterest rate.
Both private firms and government entities issue bonds as a way of raising funds.
The original buyer need not hold the bond until maturity. Bonds can be resold at
any time, but the price the bond will fetch at the time of resale will vary depending
on conditions in the economy and the financial markets.
Figure 10.1 "The Bond Market" illustrates the market for bonds. Their price isdetermined by demand and supply. Buyers of newly issued bonds are, in effect,lenders. Sellers of newly issued bonds are borrowers—recall that corporations, thefederal government, and other institutions sell bonds when they want to borrowmoney. Once a newly issued bond has been sold, its owner can resell it; a bond maychange hands several times before it matures.
Bonds are not exactly the same sort of product as, say,broccoli or some other good or service. Can we expect
bonds to have the same kind of downward-sloping
demand curves and upward-sloping supply curves weencounter for ordinary goods and services? Yes.
Consider demand. At lower prices, bonds pay higher
interest. That makes them more attractive to buyers ofbonds and thus increases the quantity demanded. On
the other hand, lower prices mean higher costs toborrowers—suppliers of bonds—and should reduce thequantity supplied. Thus, the negative relationshipbetween price and quantity demanded and the positive
relationship between price and quantity suppliedsuggested by conventional demand and supply curves
holds true in the market for bonds.

Figure 10.1 The Bond
Market

The equilibrium price for bonds
is determined where the demandand supply curves intersect. The
initial solution here is a price of$950, implying an interest rate of
5.3%. An increase in borrowing,
all other things equal, increases
the supply of bonds to S2 andforces the price of bonds down to$900. The interest rate rises to
11.1%.

If the quantity of bonds demanded is not equal to thequantity of bonds supplied, the price will adjust almost
instantaneously to balance the two. Bond prices are
perfectly flexible in that they change immediately tobalance demand and supply. Suppose, for example, thatthe initial price of bonds is $950, as shown by theintersection of the demand and supply curves in Figure10.1 "The Bond Market". We will assume that all bonds
have equal risk and a face value of $1,000 and that they mature in one year. Now

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suppose that borrowers increase their borrowing by offering to sell more bonds atevery interest rate. This increases the supply of bonds: the supply curve shifts to
the right from S1 to S2. That, in turn, lowers the equilibrium price of bonds—to $900
in Figure 10.1 "The Bond Market". The lower price for bonds means a higher
interest rate.

The Bond Market and Macroeconomic Performance
The connection between the bond market and the economy derives from the way
interest rates affect aggregate demand. For example, investment is one componentof aggregate demand, and interest rates affect investment. Firms are less likely toacquire new capital (that is, plant and equipment) if interest rates are high; they’remore likely to add capital if interest rates are low.Consumption may also be affectedby changes in interest rates. For example, if interest rates fall, consumers can moreeasily obtain credit and thus are more likely to purchase cars and other durable
goods. To simplify, we ignore this effect.
If bond prices fall, interest rates go up. Higher interest rates tend to discourage
investment, so aggregate demand will fall. A fall in aggregate demand, other things
unchanged, will mean fewer jobs and less total output than would have been thecase with lower rates of interest. In contrast, an increase in the price of bonds
lowers interest rates and makes investment in new capital more attractive. Thatchange may boost investment and thus boost aggregate demand.
Figure 10.2 "Bond Prices and Macroeconomic Activity" shows how an event in thebond market can stimulate changes in the economy’s output and price level. In
Panel (a), an increase in demand for bonds raises bond prices. Interest rates thus
fall. Lower interest rates increase the quantity of investment demanded, shifting
the aggregate demand curve to the right, from AD1 to AD2 in Panel (b). Real GDP
rises from Y1 to Y2; the price level rises from P1 to P2. In Panel (c), an increase in the
supply of bonds pushes bond prices down. Interest rates rise. The quantity ofinvestment is likely to fall, shifting aggregate demand to the left, from AD1 to AD2 in
Panel (d). Output and the price level fall from Y1 to Y2 and from P1 to P2,
respectively. Assuming other determinants of aggregate demand remainunchanged, higher interest rates will tend to reduce aggregate demand and lower
interest rates will tend to increase aggregate demand.

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Figure 10.2 Bond Prices and Macroeconomic Activity

An increase in the demand for bonds to D2 in Panel (a) raises the price of bonds to Pb2, which lowers interest rates
and boosts investment. That increases aggregate demand to AD2 in Panel (b); real GDP rises to Y2 and the price level
rises to P2.
An increase in the supply of bonds to S2 lowers bond prices to Pb2 in Panel (c) and raises interest rates. The higher
interest rate, taken by itself, is likely to cause a reduction in investment and aggregate demand. AD1 falls to AD2,
real GDP falls to Y2, and the price level falls to P2 in Panel (d).

In thinking about the impact of changes in interest rates on aggregate demand, wemust remember that some events that change aggregate demand can affect interest
rates. We will examine those events in subsequent chapters. Our focus in thischapter is on the way in which events that originate in financial markets affectaggregate demand.

Foreign Exchange Markets
5. A market in which currencies
of different countries aretraded for one another.

Another financial market that influences macroeconomic variables is the foreignexchange market5, a market in which currencies of different countries are traded10.1 The Bond and Foreign Exchange Markets

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for one another. Since changes in exports and imports affect aggregate demand andthus real GDP and the price level, the market in which currencies are traded has
tremendous importance in the economy.
Foreigners who want to purchase goods and services or assets in the United States
must typically pay for them with dollars. United States purchasers of foreign goods
must generally make the purchase in a foreign currency. An Egyptian family, forexample, exchanges Egyptian pounds for dollars in order to pay for admission to
Disney World. A German financial investor purchases dollars to buy U.S.
government bonds. A family from the United States visiting India, on the other
hand, needs to obtain Indian rupees in order to make purchases there. A U.S. bankwanting to purchase assets in Mexico City first purchases pesos. These transactions
are accomplished in the foreign exchange market.
The foreign exchange market is not a single location in which currencies are traded.
The term refers instead to the entire array of institutions through which people buy
and sell currencies. It includes a hotel desk clerk who provides currency exchange
as a service to hotel guests, brokers who arrange currency exchanges worth billionsof dollars, and governments and central banks that exchange currencies. Major
currency dealers are linked by computers so that they can track currency
exchanges all over the world.

The Exchange Rate
A country’s exchange rate is the price of its currency in terms of another currency
or currencies. On December 12, 2008, for example, the dollar traded for 91.13
Japanese yen, 0.75 euros, 10.11 South African rands, and 13.51 Mexican pesos. There
are as many exchange rates for the dollar as there are countries whose currencies
exchange for the dollar—roughly 200 of them.
Economists summarize the movement of exchange rates with a trade-weighted
exchange rate6, which is an index of exchange rates. To calculate a trade-weighted
exchange rate index for the U.S. dollar, we select a group of countries, weight theprice of the dollar in each country’s currency by the amount of trade between thatcountry and the United States, and then report the price of the dollar based on that
trade-weighted average. Because trade-weighted exchange rates are so widely usedin reporting currency values, they are often referred to as exchange rates
themselves. We will follow that convention in this text.

6. An index of exchange rates.

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Determining Exchange Rates
The rates at which most currencies exchange for one another are determined bydemand and supply. How does the model of demand and supply operate in theforeign exchange market?
The demand curve for dollars relates the number of dollars buyers want to buy inany period to the exchange rate. An increase in the exchange rate means it takes
more foreign currency to buy a dollar. A higher exchange rate, in turn, makes U.S.
goods and services more expensive for foreign buyers and reduces the quantity
they will demand. That is likely to reduce the quantity of dollars they demand.
Foreigners thus will demand fewer dollars as the price of the dollar—the exchange
rate—rises. Consequently, the demand curve for dollars is downward sloping, as in
Figure 10.3 "Determining an Exchange Rate".
The supply curve for dollars emerges from a similar
process. When people and firms in the United Statespurchase goods, services, or assets in foreign countries,
they must purchase the currency of those countries
first. They supply dollars in exchange for foreign
currency. The supply of dollars on the foreign exchange
market thus reflects the degree to which people in the
United States are buying foreign money at various
exchange rates. A higher exchange rate means that adollar trades for more foreign currency. In effect, thehigher rate makes foreign goods and services cheaper to
U.S. buyers, so U.S. consumers will purchase more
foreign goods and services. People will thus supply moredollars at a higher exchange rate; we expect the supply
curve for dollars to be upward sloping, as suggested in
Figure 10.3 "Determining an Exchange Rate".

Figure 10.3 Determining an
Exchange Rate

The equilibrium exchange rate is
the rate at which the quantity ofdollars demanded equals thequantity supplied. Here,equilibrium occurs at exchange
rate E, at which Q dollars areexchanged per period.

In addition to private individuals and firms thatparticipate in the foreign exchange market, most
governments participate as well. A government mightseek to lower its exchange rate by selling its currency; it
might seek to raise the rate by buying its currency.
Although governments often participate in foreign exchange markets, theygenerally represent a very small share of these markets. The most important
traders are private buyers and sellers of currencies.

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Exchange Rates and Macroeconomic Performance
People purchase a country’s currency for two quite different reasons: to purchasegoods or services in that country, or to purchase the assets of that country—its
money, its capital, its stocks, its bonds, or its real estate. Both of these motives must
be considered to understand why demand and supply in the foreign exchange
market may change.
One thing that can cause the price of the dollar to rise, for example, is a reduction
in bond prices in American markets. Figure 10.4 "Shifts in Demand and Supply for
Dollars on the Foreign Exchange Market" illustrates the effect of this change.
Suppose the supply of bonds in the U.S. bond market increases from S1 to S2 in
Panel (a). Bond prices will drop. Lower bond prices mean higher interest rates.
Foreign financial investors, attracted by the opportunity to earn higher returns in
the United States, will increase their demand for dollars on the foreign exchange
market in order to purchase U.S. bonds. Panel (b) shows that the demand curve fordollars shifts from D1 to D2. Simultaneously, U.S. financial investors, attracted by
the higher interest rates at home, become less likely to make financial investments
abroad and thus supply fewer dollars to exchange markets. The fall in the price ofU.S. bonds shifts the supply curve for dollars on the foreign exchange market from
S1 to S2, and the exchange rate rises from E1 to E2.
Figure 10.4 Shifts in Demand and Supply for Dollars on the Foreign Exchange Market

In Panel (a), an increase in the supply of bonds lowers bond prices to Pb2 (and thus raises interest rates). Higher
interest rates boost the demand and reduce the supply for dollars, increasing the exchange rate in Panel (b) to E2.
These developments in the bond and foreign exchange markets are likely to lead to a reduction in net exports and ininvestment, reducing aggregate demand from AD1 to AD2 in Panel (c). The price level in the economy falls to P2, andreal GDP falls from Y1 to Y2.

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The higher exchange rate makes U.S. goods and services more expensive to
foreigners, so it reduces exports. It makes foreign goods cheaper for U.S. buyers, so
it increases imports. Net exports thus fall, reducing aggregate demand. Panel (c)shows that output falls from Y1 to Y2; the price level falls from P1 to P2. Thisdevelopment in the foreign exchange market reinforces the impact of higher
interest rates we observed in Figure 10.2 "Bond Prices and Macroeconomic
Activity", Panels (c) and (d). They not only reduce investment—they reduce net
exports as well.

KEY TAKEAWAYS• A bond represents a borrower’s debt; bond prices are determined bydemand and supply.
• The interest rate on a bond is negatively related to the price of the bond.
As the price of a bond increases, the interest rate falls.
• An increase in the interest rate tends to decrease the quantity ofinvestment demanded and, hence, to decrease aggregate demand. A
decrease in the interest rate increases the quantity of investment
demanded and aggregate demand.
• The demand for dollars on foreign exchange markets represents foreign
demand for U.S. goods, services, and assets. The supply of dollars on
foreign exchange markets represents U.S. demand for foreign goods,
services, and assets. The demand for and the supply of dollars determine
the exchange rate.
• A rise in U.S. interest rates will increase the demand for dollars anddecrease the supply of dollars on foreign exchange markets. As a result,the exchange rate will increase and aggregate demand will decrease. A
fall in U.S. interest rates will have the opposite effect.

TRY IT!
Suppose the supply of bonds in the U.S. market decreases. Show and explain
the effects on the bond and foreign exchange markets. Use the aggregate
demand/aggregate supply framework to show and explain the effects on
investment, net exports, real GDP, and the price level.

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Case in Point: Bill Gross’s Mea Culpa

In October 2011, bond fund manager Bill Gross sent out an extraordinary open
letter titled “Mea Culpa.” He was taking the blame for the poor performance ofPimco Total Return Bond Fund, the huge fund he manages. After years of stellar
performance, what had gone wrong?
Earlier in 2011, Mr. Gross announced that he would avoid U.S. Treasury bonds.
He assumed that as the U.S. and other countries’ economies recovered, interest
rates would begin to rise and, hence, U.S. bond prices would fall. When Mr.
Gross pulled out of U.S. Treasuries, he used some of the cash to buy other typesof debt, such as that of emerging markets. He also held onto some cash. He
warned others to shun Treasuries as well.
However, as the financial situation in Europe weakened over worries about
government debt in various European countries—starting with Greece and thenspilling over to Portugal, Spain, Italy, and others—investors around the world
flocked toward Treasuries, pushing Treasury bond prices up. It was a rally that
Mr. Gross’s customers missed.
From where did the financial investors get the funds to buy Treasuries? In part,these funds were obtained from some of the same types of bonds that were thenin the Pimco fund portfolio. As a result, the prices of bonds in the Pimco fundfell.
In the letter, Mr. Gross wrote, “The simple fact is that the portfolio at midyear
was positioned for what we call a ‘New Normal’ developed world economy—2%
real growth and 2% inflation. When growth estimates quickly changed it was
obvious that I had misjudged the fly ball: E-CF or for nonbaseballaficionados—error centerfield.” In the fall of 2011, he shifted gears and began

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buying U.S. Treasuries, assuming that a weak global economy would keepinterest rates low. He was foiled again, as interest rates started to rise a bit.
In the end, 2011 turned out to be a bad year for the fund, ranking poorly
compared to its peers. But after many successful years, it retained its five-starrating by Morningstar in 2012. We must wait to see whether Mr. Gross will get
his groove back. In the letter, he concluded, “There is no ‘quit’ in me or anyone
else on the Pimco premises. The early morning and even midnight hours havegone up, not down, to match the increasing complexity of the global financial
markets. The competitive fire burns even hotter. I/we respect our competition
but we want to squash them each and every day…”
Source: “Bill Gross Apologizes to Pimco Fund Owners for ‘Bad Year,’” Los
Angeles Times, October 14, 2011, online version.

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ANSWER TO TRY IT! PROBLEM
If the supply of bonds decreases from S1 to S2, bond prices will rise from Pb1
to Pb2, as shown in Panel (a). Higher bond prices mean lower interest rates.
Lower interest rates in the United States will make financial investments in
the United States less attractive to foreigners. As a result, their demand for
dollars will decrease from D1 to D2, as shown in Panel (b). Similarly, U.S.
financial investors will look abroad for higher returns and thus supply moredollars to foreign exchange markets, shifting the supply curve from S1 to S2.
Thus, the exchange rate will decrease. The quantity of investment rises dueto the lower interest rates. Net exports rise because the lower exchange rate
makes U.S. goods and services more attractive to foreigners, thus increasing
exports, and makes foreign goods less attractive to U.S. buyers, thus
reducing imports. Increases in investment and net exports imply arightward shift in the aggregate demand curve from AD1 to AD2. Real GDP
and the price level increase.

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10.2 Demand, Supply, and Equilibrium in the Money Market
LEARNING OBJECTIVES
1. Explain the motives for holding money and relate them to the interest
rate that could be earned from holding alternative assets, such as bonds.
2. Draw a money demand curve and explain how changes in othervariables may lead to shifts in the money demand curve.
3. Illustrate and explain the notion of equilibrium in the money market.
4. Use graphs to explain how changes in money demand or money supply
are related to changes in the bond market, in interest rates, in aggregate
demand, and in real GDP and the price level.

In this section we will explore the link between money markets, bond markets, andinterest rates. We first look at the demand for money. The demand curve for money
is derived like any other demand curve, by examining the relationship between the“price” of money (which, we will see, is the interest rate) and the quantity
demanded, holding all other determinants unchanged. We then link the demand formoney to the concept of money supply developed in the last chapter, to determine
the equilibrium rate of interest. In turn, we show how changes in interest rates
affect the macroeconomy.

The Demand for Money
In deciding how much money to hold, people make a choice about how to hold theirwealth. How much wealth shall be held as money and how much as other assets?
For a given amount of wealth, the answer to this question will depend on therelative costs and benefits of holding money versus other assets. The demand formoney7 is the relationship between the quantity of money people want to hold andthe factors that determine that quantity.

7. The relationship between thequantity of money people wantto hold and the factors that
determine that quantity.

To simplify our analysis, we will assume there are only two ways to hold wealth: as
money in a checking account, or as funds in a bond market mutual fund thatpurchases long-term bonds on behalf of its subscribers. A bond fund is not money.
Some money deposits earn interest, but the return on these accounts is generally
lower than what could be obtained in a bond fund. The advantage of checking
accounts is that they are highly liquid and can thus be spent easily. We will think of
the demand for money as a curve that represents the outcomes of choices between
the greater liquidity of money deposits and the higher interest rates that can be

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earned by holding a bond fund. The difference between the interest rates paid on
money deposits and the interest return available from bonds is the cost of holding
money.

Motives for Holding Money
One reason people hold their assets as money is so that they can purchase goods
and services. The money held for the purchase of goods and services may be foreveryday transactions such as buying groceries or paying the rent, or it may be kept
on hand for contingencies such as having the funds available to pay to have the car
fixed or to pay for a trip to the doctor.
The transactions demand for money8 is money people hold to pay for goods andservices they anticipate buying. When you carry money in your purse or wallet tobuy a movie ticket or maintain a checking account balance so you can purchasegroceries later in the month, you are holding the money as part of yourtransactions demand for money.
The money people hold for contingencies represents their precautionary demand
for money9. Money held for precautionary purposes may include checking accountbalances kept for possible home repairs or health-care needs. People do not know
precisely when the need for such expenditures will occur, but they can prepare forthem by holding money so that they’ll have it available when the need arises.
People also hold money for speculative purposes. Bond prices fluctuate constantly.
As a result, holders of bonds not only earn interest but experience gains or losses inthe value of their assets. Bondholders enjoy gains when bond prices rise and suffer
losses when bond prices fall. Because of this, expectations play an important role asa determinant of the demand for bonds. Holding bonds is one alternative to holding
money, so these same expectations can affect the demand for money.

8. Money people hold to pay forgoods and services they
anticipate buying.
9. The money people hold forcontingencies.
10. The money held in response toconcern that bond prices andthe prices of other financial
assets might change.

John Maynard Keynes, who was an enormously successful speculator in bondmarkets himself, suggested that bondholders who anticipate a drop in bond prices
will try to sell their bonds ahead of the price drop in order to avoid this loss in asset
value. Selling a bond means converting it to money. Keynes referred to the
speculative demand for money10 as the money held in response to concern thatbond prices and the prices of other financial assets might change.
Of course, money is money. One cannot sort through someone’s checking accountand locate which funds are held for transactions and which funds are there because
the owner of the account is worried about a drop in bond prices or is taking a10.2 Demand, Supply, and Equilibrium in the Money Market

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precaution. We distinguish money held for different motives in order to understandhow the quantity of money demanded will be affected by a key determinant of thedemand for money: the interest rate.

Interest Rates and the Demand for Money
The quantity of money people hold to pay for transactions and to satisfy
precautionary and speculative demand is likely to vary with the interest rates theycan earn from alternative assets such as bonds. When interest rates rise relative tothe rates that can be earned on money deposits, people hold less money. Wheninterest rates fall, people hold more money. The logic of these conclusions about
the money people hold and interest rates depends on the people’s motives forholding money.
The quantity of money households want to hold varies according to their income
and the interest rate; different average quantities of money held can satisfy theirtransactions and precautionary demands for money. To see why, suppose ahousehold earns and spends $3,000 per month. It spends an equal amount of money
each day. For a month with 30 days, that is $100 per day. One way the household
could manage this spending would be to leave the money in a checking account,which we will assume pays zero interest. The household would thus have $3,000 in
the checking account when the month begins, $2,900 at the end of the first day,
$1,500 halfway through the month, and zero at the end of the last day of the month.
Averaging the daily balances, we find that the quantity of money the household
demands equals $1,500. This approach to money management, which we will callthe “cash approach,” has the virtue of simplicity, but the household will earn nointerest on its funds.
Consider an alternative money management approach that permits the same
pattern of spending. At the beginning of the month, the household deposits $1,000
in its checking account and the other $2,000 in a bond fund. Assume the bond fundpays 1% interest per month, or an annual interest rate of 12.7%. After 10 days, themoney in the checking account is exhausted, and the household withdraws another$1,000 from the bond fund for the next 10 days. On the 20th day, the final $1,000
from the bond fund goes into the checking account. With this strategy, thehousehold has an average daily balance of $500, which is the quantity of money it
demands. Let us call this money management strategy the “bond fund approach.”
Remember that both approaches allow the household to spend $3,000 per month,$100 per day. The cash approach requires a quantity of money demanded of $1,500,
while the bond fund approach lowers this quantity to $500.

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The bond fund approach generates some interest income. The household has $1,000
in the fund for 10 days (1/3 of a month) and $1,000 for 20 days (2/3 of a month).
With an interest rate of 1% per month, the household earns $10 in interest eachmonth ([$1,000 × 0.01 × 1/3] + [$1,000 × 0.01 × 2/3]). The disadvantage of the bondfund, of course, is that it requires more attention—$1,000 must be transferred fromthe fund twice each month. There may also be fees associated with the transfers.
Of course, the bond fund strategy we have examined here is just one of many. The
household could begin each month with $1,500 in the checking account and $1,500
in the bond fund, transferring $1,500 to the checking account midway through themonth. This strategy requires one less transfer, but it also generates lessinterest—$7.50 (= $1,500 × 0.01 × 1/2). With this strategy, the household demands aquantity of money of $750. The household could also maintain a much smaller
average quantity of money in its checking account and keep more in its bond fund.
For simplicity, we can think of any strategy that involves transferring money in andout of a bond fund or another interest-earning asset as a bond fund strategy.
Which approach should the household use? That is a choice each household must
make—it is a question of weighing the interest a bond fund strategy creates against
the hassle and possible fees associated with the transfers it requires. Our example
does not yield a clear-cut choice for any one household, but we can make some
generalizations about its implications.
First, a household is more likely to adopt a bond fund strategy when the interest
rate is higher. At low interest rates, a household does not sacrifice much income bypursuing the simpler cash strategy. As the interest rate rises, a bond fund strategy
becomes more attractive. That means that the higher the interest rate, the lower
the quantity of money demanded.
Second, people are more likely to use a bond fund strategy when the cost oftransferring funds is lower. The creation of savings plans, which began in the 1970s
and 1980s, that allowed easy transfer of funds between interest-earning assets andcheckable deposits tended to reduce the demand for money.
Some money deposits, such as savings accounts and money market deposit
accounts, pay interest. In evaluating the choice between holding assets as someform of money or in other forms such as bonds, households will look at thedifferential between what those funds pay and what they could earn in the bondmarket. A higher interest rate in the bond market is likely to increase thisdifferential; a lower interest rate will reduce it. An increase in the spread between
rates on money deposits and the interest rate in the bond market reduces the10.2 Demand, Supply, and Equilibrium in the Money Market

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quantity of money demanded; a reduction in the spread increases the quantity ofmoney demanded.
Firms, too, must determine how to manage their earnings and expenditures.
However, instead of worrying about $3,000 per month, even a relatively small firm
may be concerned about $3,000,000 per month. Rather than facing the difference of$10 versus $7.50 in interest earnings used in our household example, this small firm
would face a difference of $2,500 per month ($10,000 versus $7,500). For very large
firms such as Toyota or AT&T, interest rate differentials among various forms ofholding their financial assets translate into millions of dollars per day.
How is the speculative demand for money related to interest rates? When financial
investors believe that the prices of bonds and other assets will fall, their speculative
demand for money goes up. The speculative demand for money thus depends on
expectations about future changes in asset prices. Will this demand also be affectedby present interest rates?
If interest rates are low, bond prices are high. It seems likely that if bond prices are
high, financial investors will become concerned that bond prices might fall. Thatsuggests that high bond prices—low interest rates—would increase the quantity ofmoney held for speculative purposes. Conversely, if bond prices are alreadyrelatively low, it is likely that fewer financial investors will expect them to fall still
further. They will hold smaller speculative balances. Economists thus expect thatthe quantity of money demanded for speculative reasons will vary negatively with
the interest rate.

The Demand Curve for Money
We have seen that the transactions, precautionary, and speculative demands formoney vary negatively with the interest rate. Putting those three sources ofdemand together, we can draw a demand curve for money to show how the interest
rate affects the total quantity of money people hold. The demand curve formoney11 shows the quantity of money demanded at each interest rate, all otherthings unchanged. Such a curve is shown in Figure 10.5 "The Demand Curve forMoney". An increase in the interest rate reduces the quantity of money demanded.
A reduction in the interest rate increases the quantity of money demanded.

11. Curve that shows the quantityof money demanded at eachinterest rate, all other things
unchanged.

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The relationship between interest rates and thequantity of money demanded is an application of thelaw of demand. If we think of the alternative to holding
money as holding bonds, then the interest rate—or thedifferential between the interest rate in the bondmarket and the interest paid on money
deposits—represents the price of holding money. As isthe case with all goods and services, an increase in pricereduces the quantity demanded.

Figure 10.5 The Demand
Curve for Money

Other Determinants of the Demand for Money
We draw the demand curve for money to show thequantity of money people will hold at each interest rate,
all other determinants of money demand unchanged. Achange in those “other determinants” will shift thedemand for money. Among the most importantvariables that can shift the demand for money are thelevel of income and real GDP, the price level,
expectations, transfer costs, and preferences.

The demand curve for moneyshows the quantity of money
demanded at each interest rate.
Its downward slope expresses thenegative relationship between
the quantity of money demanded
and the interest rate.

Real GDPA household with an income of $10,000 per month is likely to demand a larger
quantity of money than a household with an income of $1,000 per month. That
relationship suggests that money is a normal good: as income increases, people
demand more money at each interest rate, and as income falls, they demand less.
An increase in real GDP increases incomes throughout the economy. The demand
for money in the economy is therefore likely to be greater when real GDP is greater.

The Price Level
The higher the price level, the more money is required to purchase a given quantityof goods and services. All other things unchanged, the higher the price level, thegreater the demand for money.

Expectations
The speculative demand for money is based on expectations about bond prices. Allother things unchanged, if people expect bond prices to fall, they will increase their

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demand for money. If they expect bond prices to rise, they will reduce their demand
for money.
The expectation that bond prices are about to change actually causes bond prices tochange. If people expect bond prices to fall, for example, they will sell their bonds,
exchanging them for money. That will shift the supply curve for bonds to the right,
thus lowering their price. The importance of expectations in moving markets canlead to a self-fulfilling prophecy.
Expectations about future price levels also affect the demand for money. The
expectation of a higher price level means that people expect the money they areholding to fall in value. Given that expectation, they are likely to hold less of it inanticipation of a jump in prices.
Expectations about future price levels play a particularly important role during
periods of hyperinflation. If prices rise very rapidly and people expect them tocontinue rising, people are likely to try to reduce the amount of money they hold,knowing that it will fall in value as it sits in their wallets or their bank accounts.
Toward the end of the great German hyperinflation of the early 1920s, prices weredoubling as often as three times a day. Under those circumstances, people tried not
to hold money even for a few minutes—within the space of eight hours money
would lose half its value!

Transfer Costs
For a given level of expenditures, reducing the quantity of money demanded
requires more frequent transfers between nonmoney and money deposits. As thecost of such transfers rises, some consumers will choose to make fewer of them.
They will therefore increase the quantity of money they demand. In general, thedemand for money will increase as it becomes more expensive to transfer between
money and nonmoney accounts. The demand for money will fall if transfer costs
decline. In recent years, transfer costs have fallen, leading to a decrease in money
demand.

Preferences
Preferences also play a role in determining the demand for money. Some people
place a high value on having a considerable amount of money on hand. For others,
this may not be important.

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Household attitudes toward risk are another aspect of preferences that affectmoney demand. As we have seen, bonds pay higher interest rates than money
deposits, but holding bonds entails a risk that bond prices might fall. There is also achance that the issuer of a bond will default, that is, will not pay the amountspecified on the bond to bondholders; indeed, bond issuers may end up paying
nothing at all. A money deposit, such as a savings deposit, might earn a lower yield,
but it is a safe yield. People’s attitudes about the trade-off between risk and yields
affect the degree to which they hold their wealth as money. Heightened concerns
about risk in the last half of 2008 led many households to increase their demand formoney.
Figure 10.6 "An Increase in Money Demand" shows an increase in the demand formoney. Such an increase could result from a higher real GDP, a higher price level, achange in expectations, an increase in transfer costs, or a change in preferences.
Figure 10.6 An Increase in Money Demand

An increase in real GDP, the price level, or transfer costs, for example, will increase the quantity of money demanded
at any interest rate r, increasing the demand for money from D1 to D2. The quantity of money demanded at interest
rate r rises from M to M′. The reverse of any such events would reduce the quantity of money demanded at every
interest rate, shifting the demand curve to the left.

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The Supply of Money
The supply curve of money12 shows the relationship between the quantity ofmoney supplied and the market interest rate, all other determinants of supply
unchanged. We have learned that the Fed, through its open-market operations,determines the total quantity of reserves in the banking system. We shall assume
that banks increase the money supply in fixed proportion to their reserves. Because
the quantity of reserves is determined by Federal Reserve policy, we draw the
supply curve of money in Figure 10.7 "The Supply Curve of Money" as a verticalline, determined by the Fed’s monetary policies. In drawing the supply curve ofmoney as a vertical line, we are assuming the money supply does not depend on theinterest rate. Changing the quantity of reserves and hence the money supply is an
example of monetary policy.
Figure 10.7 The Supply Curve of Money

12. Curve that shows therelationship between thequantity of money supplied
and the market interest rate,
all other determinants ofsupply unchanged.

We assume that the quantity of money supplied in the economy is determined as a fixed multiple of the quantity ofbank reserves, which is determined by the Fed. The supply curve of money is a vertical line at that quantity.

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Equilibrium in the Market for Money
The money market13 is the interaction among institutions through which money issupplied to individuals, firms, and other institutions that demand money. Money
market equilibrium14 occurs at the interest rate at which the quantity of money
demanded is equal to the quantity of money supplied. Figure 10.8 "Money Market
Equilibrium" combines demand and supply curves for money to illustrateequilibrium in the market for money. With a stock of money (M), the equilibrium
interest rate is r.
Figure 10.8 Money Market Equilibrium

The market for money is in equilibrium if the quantity of money demanded is equal to the quantity of money
supplied. Here, equilibrium occurs at interest rate r.

13. The interaction among
institutions through whichmoney is supplied toindividuals, firms, and otherinstitutions that demandmoney.
14. The interest rate at which thequantity of money demanded isequal to the quantity of money
supplied.

Effects of Changes in the Money Market
A shift in money demand or supply will lead to a change in the equilibrium interest
rate. Let’s look at the effects of such changes on the economy.

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Changes in Money Demand
Suppose that the money market is initially in equilibrium at r1 with supply curve S
and a demand curve D1 as shown in Panel (a) of Figure 10.9 "A Decrease in the
Demand for Money". Now suppose that there is a decrease in money demand, allother things unchanged. A decrease in money demand could result from a decreasein the cost of transferring between money and nonmoney deposits, from a change
in expectations, or from a change in preferences.In this chapter we are looking onlyat changes that originate in financial markets to see their impact on aggregate
demand and aggregate supply. Changes in the price level and in real GDP also shift
the money demand curve, but these changes are the result of changes in aggregate
demand or aggregate supply and are considered in more advanced courses inmacroeconomics. Panel (a) shows that the money demand curve shifts to the left toD2. We can see that the interest rate will fall to r2. To see why the interest rate falls,
we recall that if people want to hold less money, then they will want to hold morebonds. Thus, Panel (b) shows that the demand for bonds increases. The higher priceof bonds means lower interest rates; lower interest rates restore equilibrium in themoney market.
Figure 10.9 A Decrease in the Demand for Money

A decrease in the demand for money due to a change in transactions costs, preferences, or expectations, as shown inPanel (a), will be accompanied by an increase in the demand for bonds as shown in Panel (b), and a fall in theinterest rate. The fall in the interest rate will cause a rightward shift in the aggregate demand curve from AD1 to
AD2, as shown in Panel (c). As a result, real GDP and the price level rise.

Lower interest rates in turn increase the quantity of investment. They also
stimulate net exports, as lower interest rates lead to a lower exchange rate. The
aggregate demand curve shifts to the right as shown in Panel (c) from AD1 to AD2.
Given the short-run aggregate supply curve SRAS, the economy moves to a higher
real GDP and a higher price level.

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An increase in money demand due to a change in expectations, preferences, ortransactions costs that make people want to hold more money at each interest rate
will have the opposite effect. The money demand curve will shift to the right andthe demand for bonds will shift to the left. The resulting higher interest rate willlead to a lower quantity of investment. Also, higher interest rates will lead to ahigher exchange rate and depress net exports. Thus, the aggregate demand curve
will shift to the left. All other things unchanged, real GDP and the price level will
fall.

Changes in the Money Supply
Now suppose the market for money is in equilibrium and the Fed changes themoney supply. All other things unchanged, how will this change in the money
supply affect the equilibrium interest rate and aggregate demand, real GDP, and theprice level?
Suppose the Fed conducts open-market operations in which it buys bonds. This isan example of expansionary monetary policy. The impact of Fed bond purchases is
illustrated in Panel (a) of Figure 10.10 "An Increase in the Money Supply". The Fed’spurchase of bonds shifts the demand curve for bonds to the right, raising bondprices to Pb2. As we learned, when the Fed buys bonds, the supply of money
increases. Panel (b) of Figure 10.10 "An Increase in the Money Supply" shows an
economy with a money supply of M, which is in equilibrium at an interest rate of r1.
Now suppose the bond purchases by the Fed as shown in Panel (a) result in an
increase in the money supply to M′; that policy change shifts the supply curve formoney to the right to S2. At the original interest rate r1, people do not wish to holdthe newly supplied money; they would prefer to hold nonmoney assets. To
reestablish equilibrium in the money market, the interest rate must fall to increase
the quantity of money demanded. In the economy shown, the interest rate must fallto r2 to increase the quantity of money demanded to M′.
Figure 10.10 An Increase in the Money Supply

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The Fed increases the money supply by buying bonds, increasing the demand for bonds in Panel (a) from D1 to D2

and the price of bonds to Pb2. This corresponds to an increase in the money supply to M′ in Panel (b). The interest
rate must fall to r2 to achieve equilibrium. The lower interest rate leads to an increase in investment and net
exports, which shifts the aggregate demand curve from AD1 to AD2 in Panel (c). Real GDP and the price level rise.

The reduction in interest rates required to restore equilibrium to the market formoney after an increase in the money supply is achieved in the bond market. The
increase in bond prices lowers interest rates, which will increase the quantity ofmoney people demand. Lower interest rates will stimulate investment and net
exports, via changes in the foreign exchange market, and cause the aggregate
demand curve to shift to the right, as shown in Panel (c), from AD1 to AD2. Given the
short-run aggregate supply curve SRAS, the economy moves to a higher real GDP
and a higher price level.
Open-market operations in which the Fed sells bonds—that is, a contractionary
monetary policy—will have the opposite effect. When the Fed sells bonds, thesupply curve of bonds shifts to the right and the price of bonds falls. The bond sales
lead to a reduction in the money supply, causing the money supply curve to shift tothe left and raising the equilibrium interest rate. Higher interest rates lead to ashift in the aggregate demand curve to the left.
As we have seen in looking at both changes in demand for and in supply of money,
the process of achieving equilibrium in the money market works in tandem withthe achievement of equilibrium in the bond market. The interest rate determinedby money market equilibrium is consistent with the interest rate achieved in thebond market.

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KEY TAKEAWAYS• People hold money in order to buy goods and services (transactions
demand), to have it available for contingencies (precautionary demand),and in order to avoid possible drops in the value of other assets such as
bonds (speculative demand).
• The higher the interest rate, the lower the quantities of money
demanded for transactions, for precautionary, and for speculative
purposes. The lower the interest rate, the higher the quantities ofmoney demanded for these purposes.
• The demand for money will change as a result of a change in real GDP,the price level, transfer costs, expectations, or preferences.
• We assume that the supply of money is determined by the Fed. The
supply curve for money is thus a vertical line. Money market
equilibrium occurs at the interest rate at which the quantity of money
demanded equals the quantity of money supplied.
• All other things unchanged, a shift in money demand or supply will leadto a change in the equilibrium interest rate and therefore to changes in
the level of real GDP and the price level.

TRY IT!
In 2005 the Fed was concerned about the possibility that the United States
was moving into an inflationary gap, and it adopted a contractionary
monetary policy as a result. Draw a four-panel graph showing this policy
and its expected results. In Panel (a), use the model of aggregate demand
and aggregate supply to illustrate an economy with an inflationary gap. In
Panel (b), show how the Fed’s policy will affect the market for bonds. In
Panel (c), show how it will affect the demand for and supply of money. In
Panel (d), show how it will affect the exchange rate. Finally, return to Panel(a) and incorporate these developments into your analysis of aggregate
demand and aggregate supply, and show how the Fed’s policy will affect real
GDP and the price level in the short run.

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Case in Point: Money in Today’s World

The models of the money and bond markets presented in this chapter suggestthat the Fed can control the interest rate by deciding on a money supply thatwould lead to the desired equilibrium interest rate in the money market. Yet,
Fed policy announcements typically focus on what it wants the federal funds
rate to be with scant attention to the money supply. Whereas throughout the
1990s, the Fed would announce a target federal funds rate and also indicate an
expected change in the money supply, in 2000, when legislation requiring it todo so expired, it abandoned the practice of setting money supply targets.
Why the shift? The factors that have made focusing on the money supply as apolicy target difficult for the past 25 years are first banking deregulation in the
1980s followed by financial innovations associated with technologicalchanges—in particular the maturation of electronic payment and transfer
mechanisms—thereafter.
Before the 1980s, M1 was a fairly reliable measure of the money people held,
primarily for transactions. To buy things, one used cash, checks written on
demand deposits, or traveler’s checks. The Fed could thus use reliable estimatesof the money demand curve to predict what the money supply would need to be
in order to bring about a certain interest rate in the money market.

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Legislation in the early 1980s allowed for money market deposit accounts(MMDAs), which are essentially interest-bearing savings accounts on whichchecks can be written. MMDAs are part of M2. Shortly after, other forms of
payments for transactions developed or became more common. For example,
credit and debit card use has mushroomed (from $10.8 billion in 1990 to $30
billion in 2000), and people can pay their credit card bills, electronically or withpaper checks, from accounts that are part of either M1 or M2. Another
innovation of the last 20 years is the automatic transfer service (ATS) thatallows consumers to move money between checking and savings accounts at an
ATM machine, or online, or through prearranged agreements with theirfinancial institutions. While we take these methods of payment for granted
today, they did not exist before 1980 because of restrictive banking legislationand the lack of technological know-how. Indeed, before 1980, being able to pay
bills from accounts that earned interest was unheard of.
Further blurring the lines between M1 and M2 has been the development andgrowing popularity of what are called retail sweep programs. Since 1994, banks
have been using retail-sweeping software to dynamically reclassify balances as
either checking account balances (part of M1) or MMDAs (part of M2). They dothis to avoid reserve requirements on checking accounts. The software not only
moves the funds but also ensures that the bank does not exceed the legal limitof six reclassifications in any month. In the last 10 years these retail sweeps
rose from zero to nearly the size of M1 itself!
Such changes in the ways people pay for transactions and banks do theirbusiness have led economists to think about new definitions of money thatwould better track what is actually used for the purposes behind the money
demand curve. One notion is called MZM, which stands for “money zeromaturity.” The idea behind MZM is that people can easily use any deposits that
do not have specified maturity terms to pay for transactions, as these accounts
are quite liquid, regardless of what classification of money they fall into. Some
research shows that using MZM allows for a stable picture of the money
market. Until more agreement has been reached, though, we should expect the
Fed to continue to downplay the role of the money supply in its policy
deliberations and to continue to announce its intentions in terms of the federal
funds rate.
Source: Pedre Teles and Ruilin Zhou, “A Stable Money Demand: Looking for the
Right Monetary Aggregate,” Federal Reserve Bank of Chicago Economic Perspectives
29 (First Quarter, 2005): 50–59.

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ANSWER TO TRY IT! PROBLEM
In Panel (a), with the aggregate demand curve AD1, short-run aggregate
supply curve SRAS, and long-run aggregate supply curve LRAS, the economy
has an inflationary gap of Y1 − YP. The contractionary monetary policy
means that the Fed sells bonds—a rightward shift of the bond supply curvein Panel (b), which decreases the money supply—as shown by a leftward
shift in the money supply curve in Panel (c). In Panel (b), we see that theprice of bonds falls, and in Panel (c) that the interest rate rises. A higher
interest rate will reduce the quantity of investment demanded. The higher
interest rate also leads to a higher exchange rate, as shown in Panel (d), as
the demand for dollars increases and the supply decreases. The higher
exchange rate will lead to a decrease in net exports. As a result of thesechanges in financial markets, the aggregate demand curve shifts to the left
to AD2 in Panel (a). If all goes according to plan (and we will learn in the next
chapter that it may not!), the new aggregate demand curve will intersect
SRAS and LRAS at YP.

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10.3 Review and PracticeSummary
We began this chapter by looking at bond and foreign exchange markets and showing how each is related to thelevel of real GDP and the price level. Bonds represent the obligation of the seller to repay the buyer the facevalue by the maturity date; their interest rate is determined by the demand and supply for bonds. An increase inbond prices means a drop in interest rates. A reduction in bond prices means interest rates have risen. The priceof the dollar is determined in foreign exchange markets by the demand and supply for dollars.
We then saw how the money market works. The quantity of money demanded varies negatively with the interest
rate. Factors that cause the demand curve for money to shift include changes in real GDP, the price level,
expectations, the cost of transferring funds between money and nonmoney accounts, and preferences, especially
preferences concerning risk. Equilibrium in the market for money is achieved at the interest rate at which thequantity of money demanded equals the quantity of money supplied. We assumed that the supply of money isdetermined by the Fed. An increase in money demand raises the equilibrium interest rate, and a decrease inmoney demand lowers the equilibrium interest rate. An increase in the money supply lowers the equilibrium
interest rate; a reduction in the money supply raises the equilibrium interest rate.

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CONCEPT PROBLEMS
1. What factors might increase the demand for bonds? The supply?
2. What would happen to the market for bonds if a law were passed that
set a minimum price on bonds that was above the equilibrium price?
3. When the price of bonds decreases, the interest rate rises. Explain.
4. One journalist writing about the complex interactions between various
markets in the economy stated: “When the government spends morethan it takes in taxes it must sell bonds to finance its excess
expenditures. But selling bonds drives interest rates down and thus
stimulates the economy by encouraging more investment anddecreasing the foreign exchange rate, which helps our exportindustries.” Carefully analyze the statement. Do you agree? Why or whynot?
5. What do you predict will happen to the foreign exchange rate if interest
rates in the United States increase dramatically over the next year?
Explain, using a graph of the foreign exchange market. How would sucha change affect real GDP and the price level?
6. Suppose the government were to increase its purchases, issuing bonds
to finance these purchases. Use your knowledge of the bond and foreignexchange markets to explain how this would affect investment and net
exports.
7. How would each of the following affect the demand for money?
a. A tax on bonds held by individuals
b. A forecast by the Fed that interest rates will rise sharply inthe next quarterc. A wave of muggingsd. An announcement of an agreement between Congress andthe president that, beginning in the next fiscal year,
government spending will be reduced by an amountsufficient to eliminate all future borrowing
8. Some low-income countries do not have a bond market. In suchcountries, what substitutes for money do you think people would hold?
9. Explain what is meant by the statement that people are holding moremoney than they want to hold.
10. Explain how the Fed’s sale of government bonds shifts the supply curve
for money.
11. Trace the impact of a sale of government bonds by the Fed on bondprices, interest rates, investment, net exports, aggregate demand, realGDP, and the price level.

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NUMERICAL PROBLEMS

1. Compute the rate of interest associated with each of these bondsthat matures in one year:
Face Value

Selling Price

a.

$100

$80

b.

$100

$90

c.

$100

$95

d.

$200

$180

e.

$200

$190

f.

$200

$195

g.

Describe the relationship between the
selling price of a bond and the interestrate.

2. Suppose that the demand and supply schedules for bonds thathave a face value of $100 and a maturity date one year hence areas follows:
Price ($) Quantity Demanded Quantity Supplied

10.3 Review and Practice

100

0

600

95

100

500

90

200

400

85

300

300

80

400

200

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Chapter 10 Financial Markets and the Economy

Price ($) Quantity Demanded Quantity Supplied
75

500

100

70

600

0

a. Draw the demand and supply curves for these bonds, find theequilibrium price, and determine the interest rate.
b. Now suppose the quantity demanded increases by 200 bonds
at each price. Draw the new demand curve and find the new
equilibrium price. What has happened to the interest rate?
3. Compute the dollar price of a German car that sells for 40,000
euros at each of the following exchange rates:
a. $1 = 1 euro
b. $1 = 0.8 euro
c. $1 = 0.75 euro
4. Consider the euro-zone of the European Union and Japan. The
demand and supply curves for euros are given by the following
table (prices for the euro are given in Japanese yen; quantities ofeuros are in millions):
Price (in Euros) Euros Demanded Euros Supplied
75

0

600

70

100

500

65

200

400

60

300

300

55

400

200

50

500

100

45

600

0

a. Draw the demand and supply curves for euros and state theequilibrium exchange rate (in yen) for the euro. How many
euros are required to purchase one yen?
b. Suppose an increase in interest rates in the European Union
increases the demand for euros by 100 million at each price.

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c.
d.
e.
f.

At the same time, it reduces the supply by 100 million at each
price. Draw the new demand and supply curves and state thenew equilibrium exchange rate for the euro. How many
euros are now required to purchase one yen?
How will the event in (b) affect net exports in the European
Union?
How will the event in (b) affect aggregate demand in theEuropean Union?
How will the event in (b) affect net exports in Japan?
How will the event in (b) affect aggregate demand in Japan?

5. Suppose you earn $6,000 per month and spend $200 in each of
the month’s 30 days. Compute your average quantity of money
demanded if:
a. You deposit your entire earnings in your checking account at
the beginning of the month.
b. You deposit $2,000 into your checking account on the 1st,
11th, and 21st days of the month.
c. You deposit $1,000 into your checking account on the 1st,
6th, 11th, 16th, 21st, and 26th days of the month.
d. How would you expect the interest rate to affect yourdecision to opt for strategy (a), (b), or (c)?
6. Suppose the quantity demanded of money at an interest rate of
5% is $2 billion per day, at an interest rate of 3% is $3 billion perday, and at an interest rate of 1% is $4 billion per day. Suppose
the money supply is $3 billion per day.
a. Draw a graph of the money market and find the equilibrium
interest rate.
b. Suppose the quantity of money demanded decreases by $1
billion per day at each interest rate. Graph this situation andfind the new equilibrium interest rate. Explain the process ofachieving the new equilibrium in the money market.
c. Suppose instead that the money supply decreases by $1
billion per day. Explain the process of achieving the new
equilibrium in the money market.
7. We know that the U.S. economy faced a recessionary gap in 2008 andthat the Fed responded with an expansionary monetary policy. Present
the results of the Fed’s action in a four-panel graph. In Panel (a), show

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the initial situation, using the model of aggregate demand and aggregate
supply. In Panel (b), show how the Fed’s policy affects the bond market
and bond prices. In Panel (c), show how the market for U.S. dollars andthe exchange rate will be affected. In Panel (d), incorporate thesedevelopments into your analysis of aggregate demand and aggregate
supply, and show how the Fed’s policy will affect real GDP and the pricelevel in the short run.

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Chapter 11
Monetary Policy and the Fed
Start Up: The Fed’s Extraordinary Challenges in
2008“The Federal Reserve will employ all available tools to promote the resumption ofsustainable economic growth and to preserve price stability. In particular, theCommittee anticipates that weak economic conditions are likely to warrant
exceptionally low levels of the federal funds rate for some time.” So went thestatement issued by the Federal Open Market Committee on December 16, 2008,
that went on to say that the new target range for the federal funds rate would be
between 0% and 0.25%. For the first time in its history, the Fed was targeting a rate
below 1%. It was also acknowledging the difficulty of hitting a specific rate target
when the target is so low. And, finally, it was experimenting with extraordinary
measures based on a section of the Federal Reserve Act that allows it to take suchmeasures when conditions in financial markets are deemed “unusual and exigent.”
The Fed was responding to the broad-based weakness of the U.S. economy, thestrains in financial markets, and the tightness of credit. Unlike some othermoments in U.S. economic history, it did not have to worry about inflation, at least
not in the short term. On the same day, consumer prices were reported to havefallen by 1.7% for the month of November. Indeed, commentators were beginning tofret over the possibility of deflation and how the Fed could continue to support theeconomy when it had already used all of its federal funds rate ammunition.
Anticipating this concern, the Fed’s statement went on to discuss other ways it wasplanning to support the economy over the months to come. These included buying
mortgage-backed securities to support the mortgage and housing markets, buying
long-term Treasury bills, and creating other new credit facilities to make credit
more easily available to households and small businesses. These options recalled aspeech that Ben Bernanke had made six years earlier, when he was a member of theFederal Reserve Board of Governors but still nearly four years away from being
named its chair, titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” In the2002 speech he laid out how these tools, along with tax cuts, were the equivalent ofwhat Nobel prize winning economist Milton Friedman meant by a “helicopter drop”
of money. The speech earned Bernanke the nickname of Helicopter Ben.

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The Fed’s decisions of mid-December put it in uncharted territory. Japan had tried asimilar strategy, though somewhat less comprehensively and more belatedly, in the
1990s when faced with a situation similar to that of the United States in 2008 with
only limited success. In his 2002 speech, Bernanke suggested that Japanese
authorities had not gone far enough. Only history will tell us whether the Fed will
be more successful and how well these new strategies will work.
This chapter examines in greater detail monetary policy and the roles of central
banks in carrying out that policy. Our primary focus will be on the U.S. Federal
Reserve System. The basic tools used by central banks in many countries are
similar, but their institutional structure and their roles in their respective countries
can differ.

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11.1 Monetary Policy in the United States
LEARNING OBJECTIVES
1. Discuss the Fed’s primary and secondary goals and relate these goals tothe legislation that created the Fed as well as to subsequent legislationthat affects the Fed.
2. State and show graphically how expansionary and contractionary
monetary policy can be used to close gaps.

In many respects, the Fed is the most powerful maker of economic policy in the
United States. Congress can pass laws, but the president must execute them; thepresident can propose laws, but only Congress can pass them. The Fed, however,both sets and carries out monetary policy. Deliberations about fiscal policy can dragon for months, even years, but the Federal Open Market Committee (FOMC) can,behind closed doors, set monetary policy in a day—and see that policy implemented
within hours. The Board of Governors can change the discount rate or reserve
requirements at any time. The impact of the Fed’s policies on the economy can bequite dramatic. The Fed can push interest rates up or down. It can promote arecession or an expansion. It can cause the inflation rate to rise or fall. The Fed
wields enormous power.
But to what ends should all this power be directed? With what tools are the Fed’s
policies carried out? And what problems exist in trying to achieve the Fed’s goals?
This section reviews the goals of monetary policy, the tools available to the Fed inpursuing those goals, and the way in which monetary policy affects macroeconomic
variables.

Goals of Monetary Policy
When we think of the goals of monetary policy, we naturally think of standards ofmacroeconomic performance that seem desirable—a low unemployment rate, astable price level, and economic growth. It thus seems reasonable to conclude thatthe goals of monetary policy should include the maintenance of full employment,
the avoidance of inflation or deflation, and the promotion of economic growth.
But these goals, each of which is desirable in itself, may conflict with one another. A
monetary policy that helps to close a recessionary gap and thus promotes full
employment may accelerate inflation. A monetary policy that seeks to reduce

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inflation may increase unemployment and weaken economic growth. You might
expect that in such cases, monetary authorities would receive guidance fromlegislation spelling out goals for the Fed to pursue and specifying what to do whenachieving one goal means not achieving another. But as we shall see, that kind of
guidance does not exist.

The Federal Reserve Act
When Congress established the Federal Reserve System in 1913, it said little about
the policy goals the Fed should seek. The closest it came to spelling out the goals ofmonetary policy was in the first paragraph of the Federal Reserve Act, thelegislation that created the Fed:
“An Act to provide for the establishment of Federal reserve banks, to furnish an
elastic currency, [to make loans to banks], to establish a more effective supervisionof banking in the United States, and for other purposes.”
In short, nothing in the legislation creating the Fed anticipates that the institution
will act to close recessionary or inflationary gaps, that it will seek to spur economic
growth, or that it will strive to keep the price level steady. There is no guidance as
to what the Fed should do when these goals conflict with one another.

The Employment Act of 1946
The first U.S. effort to specify macroeconomic goals came after World War II. The
Great Depression of the 1930s had instilled in people a deep desire to prevent
similar calamities in the future. That desire, coupled with the 1936 publication ofJohn Maynard Keynes’s prescription for avoiding such problems throughgovernment policy (The General Theory of Employment, Interest and Money), led to thepassage of the Employment Act of 1946, which declared that the federal
government should “use all practical means . . . to promote maximum employment,
production and purchasing power.” The act also created the Council of Economic
Advisers (CEA) to advise the president on economic matters.
The Fed might be expected to be influenced by this specification of federal goals,
but because it is an independent agency, it is not required to follow any particularpath. Furthermore, the legislation does not suggest what should be done if the goalsof achieving full employment and maximum purchasing power conflict.

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The Full Employment and Balanced Growth Act of 1978
The clearest, and most specific, statement of federal economic goals came in the
Full Employment and Balanced Growth Act of 1978. This act, generally known as the
Humphrey–Hawkins Act, specified that by 1983 the federal government should
achieve an unemployment rate among adults of 3% or less, a civilian unemployment
rate of 4% or less, and an inflation rate of 3% or less. Although these goals have thevirtue of specificity, they offer little in terms of practical policy guidance. The lasttime the civilian unemployment rate in the United States fell below 4% was 1969,
and the inflation rate that year was 6.2%. In 2000, the unemployment rate touched
4%, and the inflation rate that year was 3.4%, so the goals were close to being met.
Except for 2007 when inflation hit 4.1%, inflation has hovered between 1.6% and3.4% in all the other years between 1991 and 2011, so the inflation goal was met or
nearly met, but unemployment fluctuated between 4.0% and 9.6% during those
years.
The Humphrey-Hawkins Act requires that the chairman of the Fed’s Board ofGovernors report twice each year to Congress about the Fed’s monetary policy.
These sessions provide an opportunity for members of the House and Senate toexpress their views on monetary policy.

Federal Reserve Policy and Goals
Perhaps the clearest way to see the Fed’s goals is to observe the policy choices it
makes. Since 1979, following a bout of double-digit inflation, its actions havesuggested that the Fed’s primary goal is to keep inflation under control. Provided
that the inflation rate falls within acceptable limits, however, the Fed will also use
stimulative measures to attempt to close recessionary gaps.
In 1979, the Fed, then led by Paul Volcker, launched a deliberate program of
reducing the inflation rate. It stuck to that effort through the early 1980s, even in
the face of a major recession. That effort achieved its goal: the annual inflation rate
fell from 13.3% in 1979 to 3.8% in 1982. The cost, however, was great.
Unemployment soared past 9% during the recession. With the inflation rate below
4%, the Fed shifted to a stimulative policy early in 1983.
In 1990, when the economy slipped into a recession, the Fed, with Alan Greenspanat the helm, engaged in aggressive open-market operations to stimulate theeconomy, despite the fact that the inflation rate had jumped to 6.1%. Much of that
increase in the inflation rate, however, resulted from an oil-price boost that camein the wake of Iraq’s invasion of Kuwait that year. A jump in prices that occurs at
the same time as real GDP is slumping suggests a leftward shift in short-run

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aggregate supply, a shift that creates a recessionary gap. Fed officials concluded
that the upturn in inflation in 1990 was a temporary phenomenon and that an
expansionary policy was an appropriate response to a weak economy. Once therecovery was clearly under way, the Fed shifted to a neutral policy, seeking neither
to boost nor to reduce aggregate demand. Early in 1994, the Fed shifted to acontractionary policy, selling bonds to reduce the money supply and raise interest
rates. Then Fed Chairman Greenspan indicated that the move was intended to head
off any possible increase in inflation from its 1993 rate of 2.7%. Although theeconomy was still in a recessionary gap when the Fed acted, Greenspan indicatedthat any acceleration of the inflation rate would be unacceptable.
By March 1997 the inflation rate had fallen to 2.4%. The Fed became concerned that
inflationary pressures were increasing and tightened monetary policy, raising thegoal for the federal funds interest rate to 5.5%. Inflation remained well below 2.0%
throughout the rest of 1997 and 1998. In the fall of 1998, with inflation low, the Fed
was concerned that the economic recession in much of Asia and slow growth inEurope would reduce growth in the United States. In quarter-point steps it reduced
the goal for the federal funds rate to 4.75%. With real GDP growing briskly in thefirst half of 1999, the Fed became concerned that inflation would increase, eventhough the inflation rate at the time was about 2%, and in June 1999, it raised its
goal for the federal funds rate to 5% and continued raising the rate until it reached6.5% in May 2000.
With inflation under control, it then began lowering the federal funds rate tostimulate the economy. It continued lowering through the brief recession of 2001
and beyond. There were 11 rate cuts in 2001, with the rate at the end of that year at
1.75%; in late 2002 the rate was cut to 1.25%, and in mid-2003 it was cut to 1.0%.
Then, with growth picking up and inflation again a concern, the Fed began again in
the middle of 2004 to increase rates. By the end of 2006, the rate stood at 5.25% as aresult of 17 quarter-point rate increases.
Starting in September 2007, the Fed, since 2006 led by Ben Bernanke, shifted gears
and began lowering the federal funds rate, mostly in larger steps or 0.5 to 0.75
percentage points. Though initially somewhat concerned with inflation, it sensed
that the economy was beginning to slow down. It moved aggressively to lower rates
over the course of the next 15 months, and by the end of 2008, the rate was targeted
at between 0% and 0.25%. In late 2008 through 2011, beginning with the threat ofdeflation and then progressing into a period during which inflation ran fairly low,
the Fed seemed quite willing to use all of its options to try to keep financial markets
running smoothly. The Fed attempted, in the initial period, to moderate therecession, and then it tried to support the rather lackluster growth that followed. In

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January 2012, the Fed went on record to say that given its expectation that inflation
would remain under control and that the economy would have slack, it anticipatedkeeping the federal funds rate at extremely low levels through late 2014.
What can we infer from these episodes in the 1980s, 1990s, and the first decade ofthis century? It seems clear that the Fed is determined not to allow the highinflation rates of the 1970s to occur again. When the inflation rate is within
acceptable limits, the Fed will undertake stimulative measures in response to arecessionary gap or even in response to the possibility of a growth slowdown. Thoselimits seem to have tightened over time. In the late 1990s and early 2000s, itappeared that an inflation rate above 3%—or any indication that inflation mightrise above 3%—would lead the Fed to adopt a contractionary policy. While on theFederal Reserve Board in the early 2000s, Ben Bernanke had been an advocate of
inflation targeting. Under that system, the central bank announces its inflation
target and then adjusts the federal funds rate if the inflation rate moves above or
below the central bank’s target. Mr. Bernanke indicated his preferred target to be
an expected increase in the price level, as measured by the price index for
consumer goods and services excluding food and energy, of between 1% and 2%.
Thus, the inflation goal appears to have tightened even more—to a rate of 2% or
less. If inflation were expected to remain below 2%, however, the Fed would
undertake stimulative measures to close a recessionary gap. Whether the Fed willhold to that goal will not really be tested until further macroeconomic experiences
unfold.

Monetary Policy and Macroeconomic Variables
We saw in an earlier chapter that the Fed has three tools at its command to try tochange aggregate demand and thus to influence the level of economic activity. It
can buy or sell federal government bonds through open-market operations, it canchange the discount rate, or it can change reserve requirements. It can also use
these tools in combination. In the next section of this chapter, where we discuss thenotion of a liquidity trap, we will also introduce more extraordinary measures that
the Fed has at its disposal.
Most economists agree that these tools of monetary policy affect the economy, butthey sometimes disagree on the precise mechanisms through which this occurs, on
the strength of those mechanisms, and on the ways in which monetary policy
should be used. Before we address some of these issues, we shall review the ways inwhich monetary policy affects the economy in the context of the model ofaggregate demand and aggregate supply. Our focus will be on open-market
operations, the purchase or sale by the Fed of federal bonds.

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Expansionary Monetary Policy
The Fed might pursue an expansionary monetary policy in response to the initialsituation shown in Panel (a) of Figure 11.1 "Expansionary Monetary Policy to Close a
Recessionary Gap". An economy with a potential output of YP is operating at Y1;
there is a recessionary gap. One possible policy response is to allow the economy tocorrect this gap on its own, waiting for reductions in nominal wages and otherprices to shift the short-run aggregate supply curve SRAS1 to the right until itintersects the aggregate demand curve AD1 at YP. An alternative is a stabilization
policy that seeks to increase aggregate demand to AD2 to close the gap. An
expansionary monetary policy is one way to achieve such a shift.
To carry out an expansionary monetary policy, the Fed will buy bonds, thereby
increasing the money supply. That shifts the demand curve for bonds to D2, as
illustrated in Panel (b). Bond prices rise to Pb2. The higher price for bonds reduces
the interest rate. These changes in the bond market are consistent with the changes
in the money market, shown in Panel (c), in which the greater money supply leads
to a fall in the interest rate to r2. The lower interest rate stimulates investment. In
addition, the lower interest rate reduces the demand for and increases the supply of
dollars in the currency market, reducing the exchange rate to E2 in Panel (d). The
lower exchange rate will stimulate net exports. The combined impact of greater
investment and net exports will shift the aggregate demand curve to the right. The
curve shifts by an amount equal to the multiplier times the sum of the initialchanges in investment and net exports. In Panel (a), this is shown as a shift to AD2,
and the recessionary gap is closed.

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Figure 11.1 Expansionary Monetary Policy to Close a Recessionary Gap

In Panel (a), the economy has a recessionary gap YP − Y1. An expansionary monetary policy could seek to close thisgap by shifting the aggregate demand curve to AD2. In Panel (b), the Fed buys bonds, shifting the demand curve forbonds to D2 and increasing the price of bonds to Pb2. By buying bonds, the Fed increases the money supply to M′ in
Panel (c). The Fed’s action lowers interest rates to r2. The lower interest rate also reduces the demand for andincreases the supply of dollars, reducing the exchange rate to E2 in Panel (d). The resulting increases in investment
and net exports shift the aggregate demand curve in Panel (a).

Contractionary Monetary Policy
The Fed will generally pursue a contractionary monetary policy when it considers
inflation a threat. Suppose, for example, that the economy faces an inflationary gap;
the aggregate demand and short-run aggregate supply curves intersect to the rightof the long-run aggregate supply curve, as shown in Panel (a) of Figure 11.2 "AContractionary Monetary Policy to Close an Inflationary Gap".

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Figure 11.2 A Contractionary Monetary Policy to Close an Inflationary Gap

In Panel (a), the economy has an inflationary gap Y1 − YP. A contractionary monetary policy could seek to close thisgap by shifting the aggregate demand curve to AD2. In Panel (b), the Fed sells bonds, shifting the supply curve forbonds to S2 and lowering the price of bonds to Pb2. The lower price of bonds means a higher interest rate, r2, asshown in Panel (c). The higher interest rate also increases the demand for and decreases the supply of dollars,raising the exchange rate to E2 in Panel (d), which will increase net exports. The decreases in investment and net
exports are responsible for decreasing aggregate demand in Panel (a).

To carry out a contractionary policy, the Fed sells bonds. In the bond market,
shown in Panel (b) of Figure 11.2 "A Contractionary Monetary Policy to Close an
Inflationary Gap", the supply curve shifts to the right, lowering the price of bonds
and increasing the interest rate. In the money market, shown in Panel (c), the Fed’sbond sales reduce the money supply and raise the interest rate. The higher interest
rate reduces investment. The higher interest rate also induces a greater demand for
dollars as foreigners seek to take advantage of higher interest rates in the UnitedStates. The supply of dollars falls; people in the United States are less likely topurchase foreign interest-earning assets now that U.S. assets are paying a higher
rate. These changes boost the exchange rate, as shown in Panel (d), which reduces
exports and increases imports and thus causes net exports to fall. The
contractionary monetary policy thus shifts aggregate demand to the left, by an

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Chapter 11 Monetary Policy and the Fedamount equal to the multiplier times the combined initial changes in investment
and net exports, as shown in Panel (a).

KEY TAKEAWAYS• The Federal Reserve Board and the Federal Open Market Committee areamong the most powerful institutions in the United States.
• The Fed’s primary goal appears to be the control of inflation. Providingthat inflation is under control, the Fed will act to close recessionary
gaps.
• Expansionary policy, such as a purchase of government securities by theFed, tends to push bond prices up and interest rates down, increasing
investment and aggregate demand. Contractionary policy, such as a saleof government securities by the Fed, pushes bond prices down, interest
rates up, investment down, and aggregate demand shifts to the left.

TRY IT!
The figure shows an economy operating at a real GDP of Y1 and a price levelof P1, at the intersection of AD1 and SRAS1.

1. What kind of gap is the economy experiencing?
2. What type of monetary policy (expansionary or contractionary) would
be appropriate for closing the gap?
3. If the Fed decided to pursue this policy, what type of open-market
operations would it conduct?
4. How would bond prices, interest rates, and the exchange rate change?
5. How would investment and net exports change?
6. How would the aggregate demand curve shift?

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Case in Point: A Brief History of the Greenspan Fed
Figure 11.3

With the passage of time and the fact that the fallout on the economy turned
out to be relatively minor, it is hard in retrospect to realize how scary asituation Alan Greenspan and the Fed faced just two months after his
appointment as Chairman of the Federal Reserve Board. On October 12, 1987,
the stock market had its worst day ever. The Dow Jones Industrial Averageplunged 508 points, wiping out more than $500 billion in a few hours of feverish
trading on Wall Street. That drop represented a loss in value of over 22%. In
comparison, the largest daily drop in 2008 of 778 points on September 29, 2008,
represented a loss in value of about 7%.
When the Fed faced another huge plunge in stock prices in 1929—also in
October—members of the Board of Governors met and decided that no action
was necessary. Determined not to repeat the terrible mistake of 1929, one that
helped to usher in the Great Depression, Alan Greenspan immediately
reassured the country, saying that the Fed would provide adequate liquidity, by
buying federal securities, to assure that economic activity would not fall. As it
turned out, the damage to the economy was minor and the stock market
quickly regained value.
In the fall of 1990, the economy began to slip into recession. The Fed respondedwith expansionary monetary policy—cutting reserve requirements, lowering
the discount rate, and buying Treasury bonds.

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Interest rates fell quite quickly in response to the Fed’s actions, but, as is often
the case, changes to the components of aggregate demand were slower incoming. Consumption and investment began to rise in 1991, but their growth
was weak, and unemployment continued to rise because growth in output was
too slow to keep up with growth in the labor force. It was not until the fall of
1992 that the economy started to pick up steam. This episode demonstrates animportant difficulty with stabilization policy: attempts to manipulate aggregate
demand achieve shifts in the curve, but with a lag.
Throughout the rest of the 1990s, with some tightening when the economy
seemed to be moving into an inflationary gap and some loosening when theeconomy seemed to be possibly moving toward a recessionary gap—especiallyin 1998 and 1999 when parts of Asia experienced financial turmoil andrecession and European growth had slowed down—the Fed helped steer what is
now referred to as the Goldilocks (not too hot, not too cold, just right)
economy.
The U.S. economy again experienced a mild recession in 2001 under Greenspan.
At that time, the Fed systematically conducted expansionary policy. Similar to
its response to the 1987 stock market crash, the Fed has been credited withmaintaining liquidity following the dot-com stock market crash in early 2001
and the attacks on the World Trade Center and the Pentagon in September
2001.
When Greenspan retired in January 2006, many hailed him as the greatest
central banker ever. As the economy faltered in 2008 and as the financial crisis
unfolded throughout the year, however, the question of how the policies ofGreenspan’s Fed played into the current difficulties took center stage.
Testifying before Congress in October 2008, he said that the country faces a“once-in-a-century credit tsunami,” and he admitted, “I made a mistake inpresuming that the self-interests of organizations, specifically banks andothers, were such as that they were best capable of protecting their own
shareholders and their equity in their firms.” The criticisms he has faced are
twofold: that the very low interest rates used to fight the 2001 recession andmaintained for too long fueled the real estate bubble and that he did notpromote appropriate regulations to deal with the new financial instrumentsthat were created in the early 2000s. While supporting some additional
regulations when he testified before Congress, he also warned that overreacting
could be dangerous: “We have to recognize that this is almost surely a once-ina-century phenomenon, and, in that regard, to realize the types of regulation

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Chapter 11 Monetary Policy and the Fedthat would prevent this from happening in the future are so onerous as tobasically suppress the growth rate in the economy and . . . the standards ofliving of the American people.”

ANSWERS TO TRY IT! PROBLEMS
1.
2.
3.
4.

Inflationary gap
Contractionary
Open-market sales of bonds
The price of bonds would fall. The interest rate and the exchange ratewould rise.
5. Investment and net exports would fall.
6. The aggregate demand curve would shift to the left.

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11.2 Problems and Controversies of Monetary Policy
LEARNING OBJECTIVES
1. Explain the three kinds of lags that can influence the effectiveness ofmonetary policy.
2. Identify the macroeconomic targets at which the Fed can aim inmanaging the economy, and discuss the difficulties inherent in using
each of them as a target.
3. Discuss how each of the following influences a central bank’s ability toachieve its desired macroeconomic outcomes: political pressures, thedegree of impact on the economy (including the situation of a liquidity
trap), and the rational expectations hypothesis.

The Fed has some obvious advantages in its conduct of monetary policy. The twopolicy-making bodies, the Board of Governors and the Federal Open Market
Committee (FOMC), are small and largely independent from other politicalinstitutions. These bodies can thus reach decisions quickly and implement them
immediately. Their relative independence from the political process, together withthe fact that they meet in secret, allows them to operate outside the glare of
publicity that might otherwise be focused on bodies that wield such enormous
power.
Despite the apparent ease with which the Fed can conduct monetary policy, it still
faces difficulties in its efforts to stabilize the economy. We examine some of the
problems and uncertainties associated with monetary policy in this section.

Lags
Perhaps the greatest obstacle facing the Fed, or any other central bank, is the
problem of lags. It is easy enough to show a recessionary gap on a graph and then toshow how monetary policy can shift aggregate demand and close the gap. In thereal world, however, it may take several months before anyone even realizes that a
particular macroeconomic problem is occurring. When monetary authorities
become aware of a problem, they can act quickly to inject reserves into the systemor to withdraw reserves from it. Once that is done, however, it may be a year or
more before the action affects aggregate demand.

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The delay between the time a macroeconomic problem arises and the time at which
policy makers become aware of it is called a recognition lag1. The 1990–1991
recession, for example, began in July 1990. It was not until late October thatmembers of the FOMC noticed a slowing in economic activity, which prompted a
stimulative monetary policy. In contrast, the most recent recession began in
December 2007, and Fed easing began in September 2007.
Recognition lags stem largely from problems in collecting economic data. First, data
are available only after the conclusion of a particular period. Preliminary estimatesof real GDP, for example, are released about a month after the end of a quarter.
Thus, a change that occurs early in a quarter will not be reflected in the data until
several months later. Second, estimates of economic indicators are subject torevision. The first estimates of real GDP in the third quarter of 1990, for example,
showed it increasing. Not until several months had passed did revised estimatesshow that a recession had begun. And finally, different indicators can lead todifferent interpretations. Data on employment and retail sales might be pointing in
one direction while data on housing starts and industrial production might bepointing in another. It is one thing to look back after a few years have elapsed anddetermine whether the economy was expanding or contracting. It is quite anotherto decipher changes in real GDP when one is right in the middle of events. Even in aworld brimming with computer-generated data on the economy, recognition lags
can be substantial.
Only after policy makers recognize there is a problem can they take action to deal
with it. The delay between the time at which a problem is recognized and the timeat which a policy to deal with it is enacted is called the implementation lag2. For
monetary policy changes, the implementation lag is quite short. The FOMC meetseight times per year, and its members may confer between meetings throughconference calls. Once the FOMC determines that a policy change is in order, therequired open-market operations to buy or sell federal bonds can be put into effectimmediately.
1. The delay between the time amacroeconomic problem arises
and the time at which policy
makers become aware of it.
2. The delay between the time atwhich a problem is recognized
and the time at which a policy
to deal with it is enacted.
3. The delay between the time a
policy is enacted and the timethat policy has its impact on
the economy.

Policy makers at the Fed still have to contend with the impact lag3, the delay
between the time a policy is enacted and the time that policy has its impact on theeconomy.
The impact lag for monetary policy occurs for several reasons. First, it takes sometime for the deposit multiplier process to work itself out. The Fed can inject newreserves into the economy immediately, but the deposit expansion process of banklending will need time to have its full effect on the money supply. Interest rates areaffected immediately, but the money supply grows more slowly. Second, firms needsome time to respond to the monetary policy with new investment spending—if

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they respond at all. Third, a monetary change is likely to affect the exchange rate,
but that translates into a change in net exports only after some delay. Thus, theshift in the aggregate demand curve due to initial changes in investment and in net
exports occurs after some delay. Finally, the multiplier process of an expenditurechange takes time to unfold. It is only as incomes start to rise that consumption
spending picks up.
The problem of lags suggests that monetary policy should respond not to statisticalreports of economic conditions in the recent past but to conditions expected to exist
in the future. In justifying the imposition of a contractionary monetary policy earlyin 1994, when the economy still had a recessionary gap, Greenspan indicated that
the Fed expected a one-year impact lag. The policy initiated in 1994 was a response
not to the economic conditions thought to exist at the time but to conditions
expected to exist in 1995. When the Fed used contractionary policy in the middle of1999, it argued that it was doing so to forestall a possible increase in inflation. When
the Fed began easing in September 2007, it argued that it was doing so to forestall
adverse effects to the economy of falling housing prices. In these examples, the Fed
appeared to be looking forward. It must do so with information and forecasts thatare far from perfect.
Estimates of the length of time required for the impact lag to work itself out range
from six months to two years. Worse, the length of the lag can vary—when theytake action, policy makers cannot know whether their choices will affect theeconomy within a few months or within a few years. Because of the uncertain
length of the impact lag, efforts to stabilize the economy through monetary policy
could be destabilizing. Suppose, for example, that the Fed responds to arecessionary gap with an expansionary policy but that by the time the policy begins
to affect aggregate demand, the economy has already returned to potential GDP.
The policy designed to correct a recessionary gap could create an inflationary gap.
Similarly, a shift to a contractionary policy in response to an inflationary gap might
not affect aggregate demand until after a self-correction process had already closed
the gap. In that case, the policy could plunge the economy into a recession.

Choosing Targets
In attempting to manage the economy, on what macroeconomic variables should
the Fed base its policies? It must have some target, or set of targets, that it wants toachieve. The failure of the economy to achieve one of the Fed’s targets would thentrigger a shift in monetary policy. The choice of a target, or set of targets, is a
crucial one for monetary policy. Possible targets include interest rates, money
growth rates, and the price level or expected changes in the price level.

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Interest Rates
Interest rates, particularly the federal funds rate, played a key role in recent Fed
policy. The FOMC does not decide to increase or decrease the money supply. Rather,it engages in operations to nudge the federal funds rate up or down.
Up until August 1997, it had instructed the trading desk at the New York Federal
Reserve Bank to conduct open-market operations in a way that would either
maintain, increase, or ease the current “degree of pressure” on the reserve
positions of banks. That degree of pressure was reflected by the federal funds rate;
if existing reserves were less than the amount banks wanted to hold, then thebidding for the available supply would send the federal funds rate up. If reserves
were plentiful, then the federal funds rate would tend to decline. When the Fed
increased the degree of pressure on reserves, it sold bonds, thus reducing the
supply of reserves and increasing the federal funds rate. The Fed decreased thedegree of pressure on reserves by buying bonds, thus injecting new reserves into
the system and reducing the federal funds rate.
The current operating procedures of the Fed focus explicitly on interest rates. At
each of its eight meetings during the year, the FOMC sets a specific target or target
range for the federal funds rate. When the Fed lowers the target for the federal
funds rate, it buys bonds. When it raises the target for the federal funds rate, it sells
bonds.

Money Growth Rates
Until 2000, the Fed was required to announce to Congress at the beginning of eachyear its target for money growth that year and each report dutifully did so. At thesame time, the Fed report would mention that its money growth targets were
benchmarks based on historical relationships rather than guides for policy. As soon
as the legal requirement to report targets for money growth ended, the Fed stopped
doing so. Since in recent years the Fed has placed more importance on the federal
funds rate, it must adjust the money supply in order to move the federal funds rate
to the level it desires. As a result, the money growth targets tended to fall by thewayside, even over the last decade in which they were being reported. Instead, as
data on economic conditions unfolded, the Fed made, and continues to make,adjustments in order to affect the federal funds interest rate.

Price Level or Expected Changes in the Price Level
Some economists argue that the Fed’s primary goal should be price stability. If so,
an obvious possible target is the price level itself. The Fed could target a particular

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price level or a particular rate of change in the price level and adjust its policies
accordingly. If, for example, the Fed sought an inflation rate of 2%, then it could
shift to a contractionary policy whenever the rate rose above 2%. One difficultywith such a policy, of course, is that the Fed would be responding to past economic
conditions with policies that are not likely to affect the economy for a year or more.
Another difficulty is that inflation could be rising when the economy isexperiencing a recessionary gap. An example of this, mentioned earlier, occurred in1990 when inflation increased due to the seemingly temporary increase in oil prices
following Iraq’s invasion of Kuwait. The Fed faced a similar situation in the first halfof 2008 when oil prices were again rising. If the Fed undertakes contractionary
monetary policy at such times, then its efforts to reduce the inflation rate could
worsen the recessionary gap.
The solution proposed by Chairman Bernanke, who is an advocate of inflation rate
targeting, is to focus not on the past rate of inflation or even the current rate of
inflation, but on the expected rate of inflation, as revealed by various indicators,
over the next year.
By 2010, the central banks of about 30 developed or developing countries had
adopted specific inflation targeting. Inflation targeters include Australia, Brazil,
Canada, Great Britain, New Zealand, South Korea, and, most recently, Turkey andIndonesia. A study by economist Carl Walsh found that inflationary experiencesamong developed countries have been similar, regardless of whether their central
banks had explicit or more flexible inflation targets. For developing countries,
however, he found that inflation targeting enhanced macroeconomic performance,in terms of both lower inflation and greater overall stability.Carl E. Walsh,“Inflation Targeting: What Have We Learned?,” International Finance 12, no. 2 (2009):
195–233.

Political Pressures
The institutional relationship between the leaders of the Fed and the executive andlegislative branches of the federal government is structured to provide for the Fed’s
independence. Members of the Board of Governors are appointed by the president,with confirmation by the Senate, but the 14-year terms of office provide a
considerable degree of insulation from political pressure. A president exercises
greater influence in the choice of the chairman of the Board of Governors; thatappointment carries a four-year term. Neither the president nor Congress has any
direct say over the selection of the presidents of Federal Reserve district banks.
They are chosen by their individual boards of directors with the approval of theBoard of Governors.

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Chapter 11 Monetary Policy and the Fed

The degree of independence that central banks around the world have varies. A
central bank is considered to be more independent if it is insulated from thegovernment by such factors as longer term appointments of its governors andfewer requirements to finance government budget deficits. Studies in the 1980s andearly 1990s showed that, in general, greater central bank independence wasassociated with lower average inflation and that there was no systematic
relationship between central bank independence and other indicators of economic
performance, such as real GDP growth or unemployment.See, for example, Alberto
Alesina and Lawrence H. Summers, “Central Bank Independence andMacroeconomic Performance: Some Comparative Evidence,” Journal of Money, Credit,and Banking 25, no. 2 (May 1993): 151–62. By the rankings used in those studies, theFed was considered quite independent, second only to Switzerland and the German
Bundesbank at the time. Perhaps as a result of such findings, a number of countries
have granted greater independence to their central banks in the last decade. The
charter for the European Central Bank, which began operations in 1998, wasmodeled on that of the German Bundesbank. Its charter states explicitly that its
primary objective is to maintain price stability. Also, since 1998, central bankindependence has increased in the United Kingdom, Canada, Japan, and New
Zealand.
While the Fed is formally insulated from the political process, the men and women
who serve on the Board of Governors and the FOMC are human beings. They are notimmune to the pressures that can be placed on them by members of Congress andby the president. The chairman of the Board of Governors meets regularly with thepresident and the executive staff and also reports to and meets with congressional
committees that deal with economic matters.
The Fed was created by the Congress; its charter could be altered—or evenrevoked—by that same body. The Fed is in the somewhat paradoxical situation of
having to cooperate with the legislative and executive branches in order topreserve its independence.

The Degree of Impact on the Economy
The problem of lags suggests that the Fed does not know with certainty when its
policies will work their way through the financial system to have an impact onmacroeconomic performance. The Fed also does not know with certainty to what
extent its policy decisions will affect the macroeconomy.
For example, investment can be particularly volatile. An effort by the Fed to reduce
aggregate demand in the face of an inflationary gap could be partially offset byrising investment demand. But, generally, contractionary policies do tend to slow

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Chapter 11 Monetary Policy and the Fed

down the economy as if the Fed were “pulling on a rope.” That may not be the casewith expansionary policies. Since investment depends crucially on expectations
about the future, business leaders must be optimistic about economic conditions inorder to expand production facilities and buy new equipment. That optimism might
not exist in a recession. Instead, the pessimism that might prevail during an
economic slump could prevent lower interest rates from stimulating investment.
An effort to stimulate the economy through monetary policy could be like “pushingon a string.” The central bank could push with great force by buying bonds andengaging in quantitative easing, but little might happen to the economy at theother end of the string.
What if the Fed cannot bring about a change in interest rates? A liquidity trap4 is
said to exist when a change in monetary policy has no effect on interest rates. This
would be the case if the money demand curve were horizontal at some interest rate,
as shown in Figure 11.4 "A Liquidity Trap". If a change in the money supply from M
to M′ cannot change interest rates, then, unless there is some other change in theeconomy, there is no reason for investment or any other component of aggregate
demand to change. Hence, traditional monetary policy is rendered totallyineffective; its degree of impact on the economy is nil. At an interest rate of zero,
since bonds cease to be an attractive alternative to money, which is at least usefulfor transactions purposes, there would be a liquidity trap.

4. Situation that exists when achange in monetary policy has
no effect on interest rates.

With the federal funds rate in the United States close tozero at the end of 2008, the possibility that the country
Figure 11.4 A Liquidity Trap
was in or nearly in a liquidity trap could not bedismissed. As discussed in the introduction to thechapter, at the same time the Fed lowered the federal
funds rate to close to zero, it mentioned that it intended
to pursue additional, nontraditional measures. What the
Fed seeks to do is to make firms and consumers want tospend now by using a tool not aimed at reducing theinterest rate, since it cannot reduce the interest rate
below zero. It thus shifts its focus to the price level andWhen a change in the money
to avoiding expected deflation. For example, if the
supply has no effect on the
public expects the price level to fall by 2% and theinterest rate, the economy is saidinterest rate is zero, by holding money, the money is
to be in a liquidity trap.
actually earning a positive real interest rate of 2%—thedifference between the nominal interest rate and the
expected deflation rate. Since the nominal rate ofinterest cannot fall below zero (Who would, forexample, want to lend at an interest rate below zero when lending is risky whereas
cash is not? In short, it does not make sense to lend $10 and get less than $10 back.),
expected deflation makes holding cash very attractive and discourages spending

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Chapter 11 Monetary Policy and the Fed

since people will put off purchases because goods and services are expected to getcheaper.
To combat this “wait-and-see” mentality, the Fed or another central bank, using astrategy referred to as quantitative easing5, must convince the public that it willkeep interest rates very low by providing substantial reserves for as long as isnecessary to avoid deflation. In other words, it is aimed at creating expected
inflation. For example, at the Fed’s October 2003 meeting, it announced that it
would keep the federal funds rate at 1% for “a considerable period.” When the Fed
lowered the rate to between 0% and 0.25% in December 2008, it added that “thecommittee anticipates that weak economic conditions are likely to warrant
exceptionally low levels of the federal funds rate for some time.” After working so
hard to convince economic players that it will not tolerate inflation above 2%, theFed, when in such a situation, must convince the public that it will tolerate
inflation, but of course not too much! If it is successful, this extraordinary form of
expansionary monetary policy will lead to increased purchases of goods andservices, compared to what they would have been with expected deflation. Also, by
providing banks with lots of liquidity, the Fed is hoping to encourage them to lend.
The Japanese economy provides an interesting modern example of a country that
attempted quantitative easing. With a recessionary gap starting in the early 1990s
and deflation in most years from 1995 on, Japan’s central bank, the Bank of Japan,
began to lower the call money rate (equivalent to the federal funds rate in the
United States), reaching near zero by the late 1990s. With growth still languishing,
Japan appeared to be in a traditional liquidity trap. In late 1999, the Bank of Japanannounced that it would maintain a zero interest rate policy for the foreseeable
future, and in March 2001 it officially began a policy of quantitative easing. In 2006,
with the price level rising modestly, Japan ended quantitative easing and began
increasing the call rate again. It should be noted that the government
simultaneously engaged in expansionary fiscal policy.

5. Policy in which a bankconvinces the public that it willkeep interest rates very low by
providing substantial reserves
for as long as is necessary to
avoid deflation.

How well did these policies work in Japan? The economy began to grow modestly in
2003, though deflation between 1% and 2% remained. Some researchers feel that the
Bank of Japan ended quantitative easing too early. Also, delays in implementing thepolicy, as well as delays in restructuring the banking sector, exacerbated Japan’s
problems.“Bringing an End to Deflation under the New Monetary Policy
Framework,” OECD Economic Surveys: Japan 2008 4 (April 2008): 49–61 and Mark M.
Spiegel, “Did Quantitative Easing by the Bank of Japan Work?” FRBSF Economic Letter
2006, no. 28 (October 20, 2006): 1–3.
Fed Chairman Bernanke and other Fed officials have argued that the Fed is also
engaged in credit easing.Ben S. Bernanke, “The Crisis and the Policy Response”

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Chapter 11 Monetary Policy and the Fed(Stamp Lecture, London School of Economics, London, England, January 13, 2009)
and Janet L. Yellen, “U.S. Monetary Policy Objectives in the Short Run and the Long
Run” (speech, Allied Social Sciences Association annual meeting, San Francisco,California, January 4, 2009). Credit easing6 is a strategy that involves the extensionof central bank lending to influence more broadly the proper functioning of credit
markets and to improve liquidity. The specific new credit facilities that the Fed has
created were discussed in the Case in Point in the chapter on the nature andcreation of money. In general, the Fed is hoping that these new credit facilities will
improve liquidity in a variety of credit markets, ranging from those used by money
market mutual funds to those involved in student and car loans.

Rational Expectations
One hypothesis suggests that monetary policy may affect the price level but not realGDP. The rational expectations hypothesis7 states that people use all available
information to make forecasts about future economic activity and the price level,
and they adjust their behavior to these forecasts.
Figure 11.5 "Monetary Policy and Rational Expectations" uses the model ofaggregate demand and aggregate supply to show the implications of the rational
expectations argument for monetary policy. Suppose the economy is operating at
YP, as illustrated by point A. An increase in the money supply boosts aggregate
demand to AD2. In the analysis we have explored thus far, the shift in aggregate
demand would move the economy to a higher level of real GDP and create an
inflationary gap. That, in turn, would put upward pressure on wages and otherprices, shifting the short-run aggregate supply curve to SRAS2 and moving the
economy to point B, closing the inflationary gap in the long run. The rational
expectations hypothesis, however, suggests a quite different interpretation.

6. A strategy that involves theextension of central banklending to influence more
broadly the proper functioningof credit markets and to
improve liquidity.
7. Individuals form expectations
about the future based on theinformation available to them,and they act on those
expectations.

Suppose people observe the initial monetary policychange undertaken when the economy is at point A andcalculate that the increase in the money supply will
ultimately drive the price level up to point B.
Anticipating this change in prices, people adjust their
behavior. For example, if the increase in the price levelfrom P1 to P2 is a 10% change, workers will anticipate
that the prices they pay will rise 10%, and they will
demand 10% higher wages. Their employers,
anticipating that the prices they will receive will also
rise, will agree to pay those higher wages. As nominal
wages increase, the short-run aggregate supply curve
immediately shifts to SRAS2. The result is an upward

11.2 Problems and Controversies of Monetary Policy

Figure 11.5 Monetary Policy
and Rational Expectations

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Chapter 11 Monetary Policy and the Fed

movement along the long-run aggregate supply curve,
LRAS. There is no change in real GDP. The monetary
policy has no effect, other than its impact on the pricelevel. This rational expectations argument relies on
wages and prices being sufficiently flexible—not sticky,
as described in an earlier chapter—so that the change in
expectations will allow the short-run aggregate supply
curve to shift quickly to SRAS2.

Suppose the economy isoperating at point A and that
individuals have rational
expectations. They calculate thatan expansionary monetary policy
undertaken at price level P1 willraise prices to P2. They adjust
their expectations—and wage
demands—accordingly, quickly
shifting the short-run aggregate
supply curve to SRAS2. The result
is a movement along the longrun aggregate supply curve LRAS
to point B, with no change in realGDP.

One important implication of the rational expectations
argument is that a contractionary monetary policy
could be painless. Suppose the economy is at point B in
Figure 11.5 "Monetary Policy and Rational
Expectations", and the Fed reduces the money supply inorder to shift the aggregate demand curve back to AD1.
In the model of aggregate demand and aggregate
supply, the result would be a recession. But in a rational expectations world,
people’s expectations change, the short-run aggregate supply immediately shifts to
the right, and the economy moves painlessly down its long-run aggregate supply
curve LRAS to point A. Those who support the rational expectations hypothesis,
however, also tend to argue that monetary policy should not be used as a tool ofstabilization policy.
For some, the events of the early 1980s weakened support for the rational
expectations hypothesis; for others, those same events strengthened support forthis hypothesis. As we saw in the introduction to an earlier chapter, in 1979
President Jimmy Carter appointed Paul Volcker as Chairman of the Federal Reserveand pledged his full support for whatever the Fed might do to contain inflation. Mr.
Volcker made it clear that the Fed was going to slow money growth and boost
interest rates. He acknowledged that this policy would have costs but said that the
Fed would stick to it as long as necessary to control inflation. Here was a monetary
policy that was clearly announced and carried out as advertised. But the policy
brought on the most severe recession since the Great Depression—a result that
seems inconsistent with the rational expectations argument that changing
expectations would prevent such a policy from having a substantial effect on realGDP.
Others, however, argue that people were aware of the Fed’s pronouncements but
were skeptical about whether the anti-inflation effort would persist, since the Fed
had not vigorously fought inflation in the late 1960s and the 1970s. Against thishistory, people adjusted their estimates of inflation downward slowly. In essence,

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Chapter 11 Monetary Policy and the Fed

the recession occurred because people were surprised that the Fed was serious
about fighting inflation.
Regardless of where one stands on this debate, one message does seem clear: once
the Fed has proved it is serious about maintaining price stability, doing so in the
future gets easier. To put this in concrete terms, Volcker’s fight made Greenspan’s
work easier, and Greenspan’s legacy of low inflation should make Bernanke’s easier.

KEY TAKEAWAYS• Macroeconomic policy makers must contend with recognition,
implementation, and impact lags.
• Potential targets for macroeconomic policy include interest rates,
money growth rates, and the price level or expected rates of change inthe price level.
• Even if a central bank is structured to be independent of politicalpressure, its officers are likely to be affected by such pressure.
• To counteract liquidity traps or the possibility thereof, central banks
have used quantitative-easing and credit-easing strategies.
• No central bank can know in advance how its policies will affect theeconomy; the rational expectations hypothesis predicts that central
bank actions will affect the money supply and the price level but not thereal level of economic activity.

TRY IT!
The scenarios below describe the U.S. recession and recovery in the early
1990s. Identify the lag that may have contributed to the difficulty in using
monetary policy as a tool of economic stabilization.
1. The U.S. economy entered into a recession in July 1990. The Fed
countered with expansionary monetary policy in October 1990,
ultimately lowering the federal funds rate from 8% to 3% in 1992.
2. Investment began to increase, although slowly, in early 1992, and surged
in 1993.

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Chapter 11 Monetary Policy and the Fed

Case in Point: The Fed and the ECB: A Tale of Divergent
Monetary Policies

In the spring of 2011, the European Central Bank (ECB) began to raise interest
rates, while the Federal Reserve Bank held fast to its low rate policy. With theeconomies of both Europe and the United States weak, why the split indirection?
For one thing, at the time, the U.S. economy looked weaker than did Europe’s
economy as a whole. Moreover, the recession in the United States had been
deeper. For example, the unemployment rate in the United States more thandoubled during the Great Recession and its aftermath, while in the eurozone, it
had risen only 40%.
But the divergence also reflected the different legal environments in which thetwo central banks operate. The ECB has a clear mandate to fight inflation, while
the Fed has more leeway in pursuing both price stability and full employment.
The ECB has a specific inflation target, and the inflation measure it uses covers
all prices. The Fed, with its more flexible inflation target, has tended to focus on“core” inflation, which excludes gasoline and food prices, both of which are apt
to be volatile. Using each central bank’s preferred inflation measure, European
inflation was, at the time of the ECB rate hike, running at 2.6%, while in the
United States, it was at 1.6%.
Europe also differs from the United States in its degree of unionization. Becauseof Europe’s higher level of unionization and collective bargaining, there is asense that any price increases in Europe will translate into sustained inflation
more rapidly there than they will in the United States.
Recall, however, that the eurozone is made up of 17 diverse countries. As madeevident by the headline news from most of 2011 and into 2012, a number ofcountries in the eurozone were experiencing sovereign debt crises (meaning

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Chapter 11 Monetary Policy and the Fedthat there was fear that their governments could not meet their debt
obligations) as well as more severe economic conditions. Higher interest rates
make their circumstances that much more difficult. While it is true that various
states in the United States can experience very different economic
circumstances when the Fed sets what is essentially a “national” monetary
policy, having a single monetary policy for different countries presents
additional problems. One reason for this this difference is that labor mobility ishigher in the United States than it is across the countries of Europe. Also, theUnited States can use its “national” fiscal policy to help weaker states.
In the fall of 2011, the ECB reversed course. At its first meeting under its newpresident, Mario Draghi, in November 2011, it lowered rates, citing slower
growth and growing concerns about the sovereign debt crisis. A further rate cut
followed in December. Interestingly, the inflation rate at the time of the cuts
was running at about 3%, which was above the ECB’s stated goal of 2%. The ECB
argued that it was forecasting lower inflation for the future. So even the ECB
has some flexibility and room for discretion.
Sources: Emily Kaiser and Mark Felsenthal, “Seven Reasons Why the Fed Won’t
Follow the ECB,” Reuters Business and Financial News, April 7, 2011, available
http://www.reuters.com/article/2011/04/07/us-usa-fed-ecbidUSTRE73663420110407; David Mchugh, “ECB Cuts Key Rate a Quarter Point toHelp Economy,” USA Today, December 8, 2011, available
http://www.usatoday.com/money/economy/story/2011-12-08/ecb-rate-cut/
51733442/1; Fernanda Nechio, “Monetary Policy When One Size Does Not Fit
All,” Federal Reserve Bank of San Francisco Economic Letter, June 13, 2011.

ANSWERS TO TRY IT! PROBLEMS
1. The recognition lag: the Fed did not seem to “recognize” that theeconomy was in a recession until several months after the recession
began.
2. The impact lag: investment did not pick up quickly after interest rates
were reduced. Alternatively, it could be attributed to the expansionary
monetary policy’s not having its desired effect, at least initially, on
investment.

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11.3 Monetary Policy and the Equation of Exchange
LEARNING OBJECTIVES
1. Explain the meaning of the equation of exchange, MV = PY, and tell why
it must hold true.
2. Discuss the usefulness of the quantity theory of money in explaining the
behavior of nominal GDP and inflation in the long run.
3. Discuss why the quantity theory of money is less useful in analyzing theshort run.

So far we have focused on how monetary policy affects real GDP and the price levelin the short run. That is, we have examined how it can be used—however
imprecisely—to close recessionary or inflationary gaps and to stabilize the pricelevel. In this section, we will explore the relationship between money and theeconomy in the context of an equation that relates the money supply directly tonominal GDP. As we shall see, it also identifies circumstances in which changes in
the price level are directly related to changes in the money supply.

The Equation of Exchange
We can relate the money supply to the aggregate economy by using the equation of
exchange:
Equation 11.1

MV = nominal GDP
The equation of exchange8 shows that the money supply M times its velocity V
equals nominal GDP. Velocity9 is the number of times the money supply is spent toobtain the goods and services that make up GDP during a particular time period.
8. The money supply (M) times its
velocity (V) equals nominal
GDP.
9. The number of times themoney supply is spent toobtain the goods and services
that make up GDP during aparticular time period.

To see that nominal GDP is the price level multiplied by real GDP, recall from anearlier chapter that the implicit price deflator P equals nominal GDP divided by real
GDP:

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Chapter 11 Monetary Policy and the Fed

Equation 11.2

P=

Nominal GDP
Real GDP

Multiplying both sides by real GDP, we have
Equation 11.3

Nominal GDP = P × real GDP
Letting Y equal real GDP, we can rewrite the equation of exchange as
Equation 11.4

MV = PY
We shall use the equation of exchange to see how it represents spending in ahypothetical economy that consists of 50 people, each of whom has a car. Each
person has $10 in cash and no other money. The money supply of this economy isthus $500. Now suppose that the sole economic activity in this economy is car
washing. Each person in the economy washes one other person’s car once a month,and the price of a car wash is $10. In one month, then, a total of 50 car washes areproduced at a price of $10 each. During that month, the money supply is spent once.
Applying the equation of exchange to this economy, we have a money supply M of$500 and a velocity V of 1. Because the only good or service produced is car
washing, we can measure real GDP as the number of car washes. Thus Y equals 50
car washes. The price level P is the price of a car wash: $10. The equation of
exchange for a period of 1 month is$500 × 1 = $10 × 50
Now suppose that in the second month everyone washes someone else’s car again.
Over the full two-month period, the money supply has been spent twice—thevelocity over a period of two months is 2. The total output in the economy is$1,000—100 car washes have been produced over a two-month period at a price of$10 each. Inserting these values into the equation of exchange, we have$500 × 2 = $10 × 100

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Chapter 11 Monetary Policy and the Fed

Suppose this process continues for one more month. For the three-month period,
the money supply of $500 has been spent three times, for a velocity of 3. We have$500 × 3 = $10 × 150
The essential thing to note about the equation of exchange is that it always holds.
That should come as no surprise. The left side, MV, gives the money supply times
the number of times that money is spent on goods and services during a period. Itthus measures total spending. The right side is nominal GDP. But that is a measureof total spending on goods and services as well. Nominal GDP is the value of all final
goods and services produced during a particular period. Those goods and services
are either sold or added to inventory. If they are sold, then they must be part of
total spending. If they are added to inventory, then some firm must have eitherpurchased them or paid for their production; they thus represent a portion of total
spending. In effect, the equation of exchange says simply that total spending on
goods and services, measured as MV, equals total spending on goods and services,
measured as PY (or nominal GDP). The equation of exchange is thus an identity, amathematical expression that is true by definition.
To apply the equation of exchange to a real economy, we need measures of each of
the variables in it. Three of these variables are readily available. The Department ofCommerce reports the price level (that is, the implicit price deflator) and real GDP.
The Federal Reserve Board reports M2, a measure of the money supply. For thesecond quarter of 2008, the values of these variables at an annual rate wereM = $7,635.4 billion
P = 1.22
Y = 11,727.4 billion
To solve for the velocity of money, V, we divide both sides of Equation 11.4 by M:
Equation 11.5

V=

11.3 Monetary Policy and the Equation of Exchange

PY
M

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Chapter 11 Monetary Policy and the Fed

Using the data for the second quarter of 2008 to compute velocity, we find that V
then was equal to 1.87. A velocity of 1.87 means that the money supply was spent
1.87 times in the purchase of goods and services in the second quarter of 2008.

Money, Nominal GDP, and Price-Level Changes⎯⎯⎯

Assume for the moment that velocity is constant, expressed as V . Our equation of
exchange is now written as
Equation 11.6⎯⎯⎯
MV = PY
A constant value for velocity would have two important implications:
1. Nominal GDP could change only if there were a change in the money
supply. Other kinds of changes, such as a change in government
purchases or a change in investment, could have no effect on nominal
GDP.
2. A change in the money supply would always change nominal GDP, andby an equal percentage.
In short, if velocity were constant, a course in macroeconomics would be quite
simple. The quantity of money would determine nominal GDP; nothing else would
matter.
Indeed, when we look at the behavior of economies over long periods of time, theprediction that the quantity of money determines nominal output holds rather well.
Figure 11.6 "Inflation, M2 Growth, and GDP Growth" compares long-term averages
in the growth rates of M2 and nominal GNP for 11 countries (Canada, Denmark,France, Italy, Japan, the Netherlands, Norway, Sweden, Switzerland, the United
Kingdom, and the United States) for more than a century. These are the only
countries that have consistent data for such a long period. The lines representing
inflation, M2 growth, and nominal GDP growth do seem to move together most of
the time, suggesting that velocity is constant when viewed over the long run.

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Chapter 11 Monetary Policy and the Fed

Figure 11.6 Inflation, M2 Growth, and GDP Growth

The chart shows the behavior of price-level changes, the growth of M2, and the growth of nominal GDP for 11
countries using the average value of each variable. Viewed in this light, the relationship between money growth andnominal GDP seems quite strong.
Source: Alfred A. Haug and William G. Dewald, “Longer-Term Effects of Monetary Growth on Real and Nominal
Variables, Major Industrial Countries, 1880–2001” (European Central Bank Working Paper Series No. 382, August2004).

Moreover, price-level changes also follow the same pattern that changes in M2 andnominal GNP do. Why is this?

⎯⎯⎯We can rewrite the equation of exchange, M V = PY, in terms of percentage rates of⎯⎯⎯change. When two products, such as M V and PY, are equal, and the variables
themselves are changing, then the sums of the percentage rates of change areapproximately equal:
Equation 11.7

%ΔM + %ΔV ≅ %ΔP + %ΔY
The Greek letter Δ (delta) means “change in.” Assume that velocity is constant in
the long run, so that %ΔV = 0. We also assume that real GDP moves to its potential
level, YP, in the long run. With these assumptions, we can rewrite Equation 11.7 asfollows:

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Chapter 11 Monetary Policy and the Fed

Equation 11.8

%ΔM ≅ %ΔP + %ΔY P
Subtracting %ΔYP from both sides of Equation 11.8, we have the following:
Equation 11.9

%ΔM − %ΔY P ≅ %ΔP
Equation 11.9 has enormously important implications for monetary policy. It tells
us that, in the long run, the rate of inflation, %ΔP, equals the difference between
the rate of money growth and the rate of increase in potential output, %ΔYP, given
our assumption of constant velocity. Because potential output is likely to rise by atmost a few percentage points per year, the rate of money growth will be close to therate of inflation in the long run.
Several recent studies that looked at all the countries on which they could get dataon inflation and money growth over long periods found a very high correlation
between growth rates of the money supply and of the price level for countries withhigh inflation rates, but the relationship was much weaker for countries with
inflation rates of less than 10%.For example, one study examined data on 81
countries using inflation rates averaged for the period 1980 to 1993 (John R.
Moroney, “Money Growth, Output Growth, and Inflation: Estimation of a Modern
Quantity Theory,” Southern Economic Journal 69, no. 2 [2002]: 398–413) while anotherexamined data on 160 countries over the period 1969–1999 (Paul De Grauwe andMagdalena Polan, “Is Inflation Always and Everywhere a Monetary Phenomenon?”Scandinavian Journal of Economics 107, no. 2 [2005]: 239–59). These findings support
the quantity theory of money10, which holds that in the long run the price levelmoves in proportion with changes in the money supply, at least for high-inflation
countries.

Why the Quantity Theory of Money Is Less Useful in Analyzing
the Short Run

10. In the long run, the price levelmoves in proportion withchanges in the money supply,
at least for high-inflation
countries.

The stability of velocity in the long run underlies the close relationship we haveseen between changes in the money supply and changes in the price level. But
velocity is not stable in the short run; it varies significantly from one period to thenext. Figure 11.7 "The Velocity of M2, 1970–2011" shows annual values of thevelocity of M2 from 1960 to 2011. Velocity is quite variable, so other factors must
affect economic activity. Any change in velocity implies a change in the demand formoney. For analyzing the effects of monetary policy from one period to the next,

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Chapter 11 Monetary Policy and the Fed

we apply the framework that emphasizes the impact of changes in the money
market on aggregate demand.
Figure 11.7 The Velocity of M2, 1970–2011

The annual velocity of M2 varied about an average of 1.78 between 1970 and 2011.
Source: Economic Report of the President, 2012, Tables B-1 and B-69.

The factors that cause velocity to fluctuate are those that influence the demand formoney, such as the interest rate and expectations about bond prices and future
price levels. We can gain some insight about the demand for money and its
significance by rearranging terms in the equation of exchange so that we turn theequation of exchange into an equation for the demand for money. If we multiply
both sides of Equation 11.1 by the reciprocal of velocity, 1/V, we have this equation
for money demand:
Equation 11.10

M=

1
PY
V

The equation of exchange can thus be rewritten as an equation that expresses thedemand for money as a percentage, given by 1/V, of nominal GDP. With a velocity of
1.87, for example, people wish to hold a quantity of money equal to 53.4% (1/1.87) of

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nominal GDP. Other things unchanged, an increase in money demand reduces
velocity, and a decrease in money demand increases velocity.
If people wanted to hold a quantity of money equal to a larger percentage of
nominal GDP, perhaps because interest rates were low, velocity would be a smaller
number. Suppose, for example, that people held a quantity of money equal to 80% of
nominal GDP. That would imply a velocity of 1.25. If people held a quantity ofmoney equal to a smaller fraction of nominal GDP, perhaps owing to high interest
rates, velocity would be a larger number. If people held a quantity of money equal
to 25% of nominal GDP, for example, the velocity would be 4.
As another example, in the chapter on financial markets and the economy, welearned that money demand falls when people expect inflation to increase. In
essence, they do not want to hold money that they believe will only lose value, sothey turn it over faster, that is, velocity rises. Expectations of deflation lower thevelocity of money, as people hold onto money because they expect it will rise invalue.
In our first look at the equation of exchange, we noted some remarkableconclusions that would hold if velocity were constant: a given percentage change inthe money supply M would produce an equal percentage change in nominal GDP,and no change in nominal GDP could occur without an equal percentage change in
M. We have learned, however, that velocity varies in the short run. Thus, theconclusions that would apply if velocity were constant must be changed.
First, we do not expect a given percentage change in the money supply to produce
an equal percentage change in nominal GDP. Suppose, for example, that the money
supply increases by 10%. Interest rates drop, and the quantity of money demanded
goes up. Velocity is likely to decline, though not by as large a percentage as themoney supply increases. The result will be a reduction in the degree to which agiven percentage increase in the money supply boosts nominal GDP.
Second, nominal GDP could change even when there is no change in the money
supply. Suppose government purchases increase. Such an increase shifts theaggregate demand curve to the right, increasing real GDP and the price level. That
effect would be impossible if velocity were constant. The fact that velocity varies,
and varies positively with the interest rate, suggests that an increase in government
purchases could boost aggregate demand and nominal GDP. To finance increased
spending, the government borrows money by selling bonds. An increased supply ofbonds lowers their price, and that means higher interest rates. The higher interest
rates produce the increase in velocity that must occur if increased government
purchases are to boost the price level and real GDP.

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Just as we cannot assume that velocity is constant when we look at macroeconomic
behavior period to period, neither can we assume that output is at potential. With
both V and Y in the equation of exchange variable, in the short run, the impact of achange in the money supply on the price level depends on the degree to which
velocity and real GDP change.
In the short run, it is not reasonable to assume that velocity and output are
constants. Using the model in which interest rates and other factors affect thequantity of money demanded seems more fruitful for understanding the impact ofmonetary policy on economic activity in that period. However, the empiricalevidence on the long-run relationship between changes in money supply andchanges in the price level that we presented earlier gives us reason to pause. As
Federal Reserve Governor from 1996 to 2002 Laurence H. Meyer put it: “I believe
monitoring money growth has value, even for central banks that follow a
disciplined strategy of adjusting their policy rate to ongoing economic
developments. The value may be particularly important at the extremes: during
periods of very high inflation, as in the late 1970s and early 1980s in the UnitedStates … and in deflationary episodes.”Laurence H. Meyer, “Does Money Matter?”Federal Reserve Bank of St. Louis Review 83, no. 5 (September/October 2001): 1–15.
It would be a mistake to allow short-term fluctuations in velocity and output to leadpolicy makers to completely ignore the relationship between money and price levelchanges in the long run.

KEY TAKEAWAYS• The equation of exchange can be written MV = PY.
• When M, V, P, and Y are changing, then %ΔM + %ΔV = %ΔP + %ΔY, where
Δ means “change in.”• In the long run, V is constant, so %ΔV = 0. Furthermore, in the long run
Y tends toward YP, so %ΔM = %ΔP.
• In the short run, V is not constant, so changes in the money supply canaffect the level of income.

TRY IT!
The Case in Point on velocity in the Confederacy during the Civil War showsthat, assuming real GDP in the South was constant, velocity rose. What
happened to money demand? Why did it change?

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Case in Point: Velocity and the Confederacy

The Union and the Confederacy financed their respective efforts during the
Civil War largely through the issue of paper money. The Union roughly doubled
its money supply through this process, and the Confederacy printed enough“Confederates” to increase the money supply in the South 20-fold from 1861 to1865. That huge increase in the money supply boosted the price level in the
Confederacy dramatically. It rose from an index of 100 in 1861 to 9,200 in 1865.
Estimates of real GDP in the South during the Civil War are unavailable, but it
could hardly have increased very much. Although production undoubtedly rose
early in the period, the South lost considerable capital and an appalling numberof men killed in battle. Let us suppose that real GDP over the entire period
remained constant. For the price level to rise 92-fold with a 20-fold increase in
the money supply, there must have been a 4.6-fold increase in velocity. People
in the South must have reduced their demand for Confederates.
An account of an exchange for eggs in 1864 from the diary of Mary Chestnut
illustrates how eager people in the South were to part with their Confederatemoney. It also suggests that other commodities had assumed much greater
relative value:“She asked me 20 dollars for five dozen eggs and then said she would take it in“Confederate.” Then I would have given her 100 dollars as easily. But if she hadtaken my offer of yarn! I haggle in yarn for the millionth part of a thread! …
When they ask for Confederate money, I never stop to chafer [bargain or
argue]. I give them 20 or 50 dollars cheerfully for anything.”
Sources: C. Vann Woodward, ed., Mary Chestnut’s Civil War (New Haven, CT: Yale
University Press, 1981), 749. Money and price data from E. M. Lerner, “Money,

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Prices, and Wages in the Confederacy, 1861–1865,” Journal of Political Economy 63(February 1955): 20–40.

ANSWER TO TRY IT! PROBLEM
People in the South must have reduced their demand for money. The fall inmoney demand was probably due to the expectation that the price level
would continue to rise. In periods of high inflation, people try to get rid ofmoney quickly because it loses value rapidly.

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11.4 Review and PracticeSummary
Part of the Fed’s power stems from the fact that it has no legislative mandate to seek particular goals. Thatleaves the Fed free to set its own goals. In recent years, its primary goal has seemed to be the maintenance of an
inflation rate below 2% to 3%. Given success in meeting that goal, the Fed has used its tools to stimulate theeconomy to close recessionary gaps. Once the Fed has made a choice to undertake an expansionary or
contractionary policy, we can trace the impact of that policy on the economy.
There are a number of problems in the use of monetary policy. These include various types of lags, the issue ofthe choice of targets in conducting monetary policy, political pressures placed on the process of policy setting,and uncertainty as to how great an impact the Fed’s policy decisions have on macroeconomic variables. We
highlighted the difficulties for monetary policy if the economy is in or near a liquidity trap and discussed the useof quantitative easing and credit easing in such situations. If people have rational expectations and respond to
those expectations in their wage and price choices, then changes in monetary policy may have no effect on realGDP.
We saw in this chapter that the money supply is related to the level of nominal GDP by the equation of exchange.
A crucial issue in that relationship is the stability of the velocity of money and of real GDP. If the velocity ofmoney were constant, nominal GDP could change only if the money supply changed, and a change in the money
supply would produce an equal percentage change in nominal GDP. If velocity were constant and real GDP wereat its potential level, then the price level would change by about the same percentage as the money supply.
While these predictions seem to hold up in the long run, there is less support for them when we look at
macroeconomic behavior in the short run. Nonetheless, policy makers must be mindful of these long-run
relationships as they formulate policies for the short run.

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CONCEPT PROBLEMS
1. Suppose the Fed were required to conduct monetary policy so as to holdthe unemployment rate below 4%, the goal specified in the
Humphrey–Hawkins Act. What implications would this have for the
economy?
2. The statutes of the recently established European Central Bank (ECB)
state that its primary objective is to maintain price stability. How does
this charter differ from that of the Fed? What significance does it havefor monetary policy?
3. Do you think the Fed should be given a clearer legislative mandate
concerning macroeconomic goals? If so, what should it be?
4. Referring to the Case in Point on targeting, what difference does it makewhether the target is the inflation rate of the past year or the expected
inflation rate over the next year?
5. In a speech in January 1995,Speech by Alan Greenspan before theBoard of Directors of the National Association of Home Builders,January 28, 1995. Federal Reserve Chairman Alan Greenspan useda transportation metaphor to describe some of the difficulties of
implementing monetary policy. He referred to the criticism
levied against the Fed for shifting in 1994 to an anti-inflation,
contractionary policy when the inflation rate was still quite low:
“To successfully navigate a bend in the river, the barge must
begin the turn well before the bend is reached. Even so, currents
are always changing and even an experienced crew cannot
foresee all the events that might occur as the river is being
navigated. A year ago, the Fed began its turn (a shift toward an
expansionary monetary policy), and it was successful.”
Mr. Greenspan was referring, of course, to the problem of lags.
What kind of lag do you think he had in mind? What do you
suppose the reference to changing currents means?
6. In a speech in August 1999,Alan Greenspan, “New challenges formonetary policy,” speech delivered before a symposium
sponsored by the Federal Reserve Bank of Kansas City in Jackson
Hole, Wyoming, on August 27, 1999. Mr. Greenspan was famousfor his convoluted speech, which listeners often found difficult tounderstand. CBS correspondent Andrea Mitchell, to whom Mr.
Greenspan is married, once joked that he had proposed to her

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three times and that she had not understood what he was talking
about on his first two efforts. Mr. Greenspan said,
We no longer have the luxury to look primarily to the flow ofgoods and services, as conventionally estimated, whenevaluating the macroeconomic environment in which monetary
policy must function. There are important—but extremely
difficult—questions surrounding the behavior of asset prices andthe implications of this behavior for the decisions of households
and businesses.
The asset price that Mr. Greenspan was referring to was the U.S.
stock market, which had been rising sharply in the weeks andmonths preceding this speech. Inflation and unemployment wereboth low at that time. What issues concerning the conduct ofmonetary policy was Mr. Greenspan raising?
7. Suppose we observed an economy in which changes in the money supply
produce no changes whatever in nominal GDP. What could we conclude
about velocity?
8. Suppose price levels were falling 10% per day. How would this affect thedemand for money? How would it affect velocity? What can you
conclude about the role of velocity during periods of rapid price change?
9. Suppose investment increases and the money supply does not change.
Use the model of aggregate demand and aggregate supply to predict the
impact of such an increase on nominal GDP. Now what happens in termsof the variables in the equation of exchange?
10. The text notes that prior to August 1997 (when it began
specifying a target value for the federal funds rate), the FOMC
adopted directives calling for the trading desk at the New York
Federal Reserve Bank to increase, decrease, or maintain theexisting degree of pressure on reserve positions. On the meeting
dates given in the first column, the FOMC voted to decreasepressure on reserve positions (that is, adopt a more expansionary
policy). On the meeting dates given in the second column, it
voted to increase reserve pressure:July 5–6, 1995

February 3–4, 1994

December 19, 1995

January 31–February 1, 1995

January 30–31, 1996 March 25, 1997

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Recent minutes of the FOMC can be found at the Federal Reserve
Board of Governors website. Pick one of these dates on which a
decrease in reserve pressure was ordered and one on which anincrease was ordered and find out why that particular policy waschosen.
11. Since August 1997, the Fed has simply set a specific target for thefederal funds rate. The four dates below show the first four times
after August 1997 that the Fed voted to set a new target for thefederal funds rate on the following dates:
September 29, 1998 November 17, 1998
June 29, 1999

August 24, 1999

Pick one of these dates and find out why it chose to change its
target for the federal funds rate on that date.
12. Four meetings in 2008 at which the Fed changed the target for
the federal funds rate are shown below.
January 30, 2008 March 18, 2008
October 8, 2008

October 29, 2008

Pick one of these dates and find out why it chose to change its
target for the federal funds rate on that date.
13. The text notes that a 10% increase in the money supply may not increase
the price level by 10% in the short run. Explain why.
14. Trace the impact of an expansionary monetary policy on bond prices,interest rates, investment, the exchange rate, net exports, real GDP, andthe price level. Illustrate your analysis graphically.
15. Trace the impact of a contractionary monetary policy on bond prices,interest rates, investment, the exchange rate, net exports, real GDP, andthe price level. Illustrate your analysis graphically.

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Chapter 11 Monetary Policy and the Fed

NUMERICAL PROBLEMS

1. Here are annual values for M2 and for nominal GDP (all figures
are in billions of dollars) for the mid-1990s.
Year

M2

Nominal GDP

1993 3,482.0$6,657.4

1994 3,498.1

7,072.2

1995 3,642.1

7,397.7

1996 3,820.5

7,816.9

1997 4,034.1

8,304.3

a. Compute the velocity for each year.
b. Compute the fraction of nominal GDP that was being held asmoney.
c. What is your conclusion about the stability of velocity in thisfive-year period?
2. Here are annual values for M2 and for nominal GDP (all figures
are in billions of dollars) for the mid-2000s.
Year

M2

Nominal GDP

2003 6,055.5$10,960.8

2004 6,400.7

11,685.9

2005 6,659.7

12,421.9

2006 7,012.3

13,178.4

2007 7,404.3

13,807.5

a. Compute the velocity for each year.
b. Compute the fraction of nominal GDP that was being held asmoney.
c. What is your conclusion about the stability of velocity in thisfive-year period?

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Chapter 11 Monetary Policy and the Fed

3. The following data show M1 for the years 1993 to 1997,
respectively (all figures are in billions of dollars): 1,129.6; 1,150.7;
1,127.4; 1,081.3; 1,072.5.
a. Compute the M1 velocity for these years. (Nominal GDP for
these years is shown in problem 1.)
b. If you were going to use a money target, would M1 or M2
have been preferable during the 1990s? Explain yourreasoning.
4. The following data show M1 for the years 2003 to 2007,
respectively (all figures are in billions of dollars): 1,306.1; 1,376.3;
1,374.5; 1,366.5; 1,366.5
a. Compute the M1 velocity for these years. (Nominal GDP for
these years is shown in problem 2.)
b. If you were going to use a money target, would M1 or M2
have been preferable during the 2000s? Explain yourreasoning.
5. Assume a hypothetical economy in which the velocity is constantat 2 and real GDP is always at a constant potential of $4,000.
Suppose the money supply is $1,000 in the first year, $1,100 in
the second year, $1,200 in the third year, and $1,300 in the fourthyear.
a. Using the equation of exchange, compute the price level ineach year.
b. Compute the inflation rate for each year.
c. Explain why inflation varies, even though the money supply
rises by $100 each year.
d. If the central bank wanted to keep inflation at zero, whatshould it have done to the money supply each year?
e. If the central bank wanted to keep inflation at 10% each year,
what money supply should it have targeted in each year?
6. Suppose the velocity of money is constant and potential output
grows by 3% per year. By what percentage should the money
supply grow in order to achieve the following inflation rate
targets?

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Chapter 11 Monetary Policy and the Fed

a. 0%
b. 1%
c. 2%
7. Suppose the velocity of money is constant and potential output
grows by 5% per year. For each of the following money supply
growth rates, what will the inflation rate be?
a. 4%
b. 5%
c. 6%
8. Suppose that a country whose money supply grew by about 20% a year
over the long run had an annual inflation rate of about 20% and that acountry whose money supply grew by about 50% a year had an annual
inflation rate of about 50%. Explain this finding in terms of the equationof exchange.

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Chapter 12
Government and Fiscal Policy
Start Up: A Massive Stimulus
Shaken by the severity of both the recession that began in December 2007 and thefinancial crisis that occurred in the fall of 2008, Congress passed a huge $784 billion
stimulus package in February 2009. President Obama described the measure as only
“the beginning” of what the federal government ultimately would do to right theeconomy.
Over a quarter of the American Recovery and Reinvestment Act (ARRA) was for avariety of temporary tax rebates and credits for individuals and firms. For example,
each worker making less than $75,000 a year received $400 ($800 for a working
couple earning up to $150,000) as a kind of rebate for payroll taxes. That works out
to $8 a week. Qualifying college students became eligible for $2,500 tax credits foreducational expenses. During a certain period, a first-time homebuyer was eligible
for a tax credit. The other roughly three-quarters of the ARRA were for a variety of
government spending programs, including temporary transfers to state and local
governments, extended unemployment insurance and other transfers to people(such as food stamps), and increased infrastructure spending. The president said
that the measure would “ignite spending by businesses and consumers … and makethe investment necessary for lasting growth and economic prosperity.”Barack
Obama, Weekly Address of the President to the Nation, February 14, 2009, available
at http://www.whitehouse.gov/blog/09/02/14/A-major-milestone/. Shortly after
the passage of the ARRA, Congress passed the Cash for Clunkers program, which fora limited period of time allowed car buyers to trade in less-fuel-efficient cars forrebates of up to $4,500 toward buying new cars that met certain higher fuelefficiency standards.
The ARRA illustrates an important difficulty of using fiscal policy in an effort tostabilize economic activity. It was passed over a year after the recession began. Only
about 20% of the spending called for by the legislation took place in 2009, rising toabout two-thirds through the middle of 2010. It was a guess what state the economy
would be in then. As it turned out, the recession had officially ended, but there wasstill a large recessionary gap, and unemployment was still a major concern. There
was a great deal of media controversy about how effective the policy had been andwhether the resulting increase in national debt was worth it. Concern over the481

Chapter 12 Government and Fiscal Policy

expanded size of the federal government created by the stimulus measures becamea rallying cry for the Tea Party movement. A fiscal stimulus package of over $150
billion had already been tried earlier in February 2008 under President George W.
Bush. It included $100 billion in temporary tax rebates to households—up to $600
for individuals and $1,200 for couples—and over $50 billion in tax breaks forbusinesses. The boost to aggregate demand seemed slight—consumers saved muchof their rebate money. In November 2008, unemployment insurance benefits wereextended for seven additional weeks, in recognition of the growing unemployment
problem.
President Obama argued that his proposals for dealing with the economy in the
short term would, coincidentally, also promote long-term economic health. Somecritics argued for a greater focus on actual tax cuts while others were concerned
about whether the spending would focus on getting the greatest employment
increase or be driven by political considerations.
How do government tax and expenditure policies affect real GDP and the pricelevel? Why do economists differ so sharply in assessing the likely impact of suchpolicies? Can fiscal policy be used to stabilize the economy in the short run? What
are the long-run effects of government spending and taxing?
We begin with a look at the government’s budget to see how it spends the tax
revenue it collects. Clearly, the government’s budget is not always in balance, so wewill also look at government deficits and debt. We will then look at how fiscal policy
works to stabilize the economy, distinguishing between built-in stabilization
methods and discretionary measures. We will end the chapter with a discussion of
why fiscal policy is so controversial.
As in the previous chapter on monetary policy, our primary focus will be U.S.
policy. However, the tools available to governments around the world are quite
similar, as are the issues surrounding the use of fiscal policy.

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12.1 Government and the Economy
LEARNING OBJECTIVES
1. Understand the major components of U.S. government spending andsources of government revenues.
2. Define the terms budget surplus, budget deficit, balanced budget, andnational debt, and discuss their trends over time in the United States.

We begin our analysis of fiscal policy with an examination of government
purchases, transfer payments, and taxes in the U.S. economy.

Government Purchases
The government-purchases component of aggregate demand includes all purchasesby government agencies of goods and services produced by firms, as well as direct
production by government agencies themselves. When the federal government
buys staples and staplers, the transaction is part of government purchases. The
production of educational and research services by public colleges and universities
is also counted in the government-purchases component of GDP.
While government spending has grown over time, government purchases as a shareof GDP declined from over 20% until the early 1990s to under 18% in 2001. Since
then, though, the percentage of government purchases in GDP began to increaseback toward 20% and then beyond. This first occurred as military spending pickedup, and then, more recently, it rose even further during the 2007–2009 recession.
Figure 12.1 "Federal, State, and Local Purchases Relative to GDP, 1960–2011" shows
federal as well as state and local government purchases as a percentage of GDP from1960 to 2011. Notice the changes that have occurred over this period. In 1960, thefederal government accounted for the majority share of total purchases. Since then,however, federal purchases have fallen by almost half relative to GDP, while stateand local purchases relative to GDP have risen.

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Chapter 12 Government and Fiscal Policy

Figure 12.1 Federal, State, and Local Purchases Relative to GDP, 1960–2011

Government purchases were generally above 20% of GDP from 1960 until the early 1990s and then below 20% of GDP
until the 2007-2009 recession. The share of government purchases in GDP began rising in the 21st century.
Source: Bureau of Economic Analysis, NIPA Table 1.1 and 3.1 (revised February 29, 2012).

Transfer Payments
A transfer payment1 is the provision of aid or money to an individual who is not
required to provide anything in exchange for the payment. Social Security andwelfare benefits are examples of transfer payments. During the 2007-2009
recession, transfers rose.
A number of changes have influenced transfer payments over the past several
decades. First, they increased rapidly during the late 1960s and early 1970s. This
was the period in which federal programs such as Medicare (health insurance forthe elderly) and Medicaid (health insurance for the poor) were created and otherprograms were expanded.
1. The provision of aid or money
to an individual who is not
required to provide anything
in exchange.

Figure 12.2 "Federal, State, and Local Transfer Payments as a Percentage of GDP,
1960–2011" shows that transfer payment spending by the federal government andby state and local governments has risen as a percentage of GDP. In 1960, such

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Chapter 12 Government and Fiscal Policy

spending totaled about 6% of GDP; by 2009, it had risen to about 18%. The federal
government accounts for the bulk of transfer payment spending in the UnitedStates.
Figure 12.2 Federal, State, and Local Transfer Payments as a Percentage of GDP, 1960–2011

The chart shows transfer payment spending as a percentage of GDP from 1960 through 2011. This spending rose
dramatically relative to GDP during the late 1960s and the 1970s as federal programs expanded. More recently,
sharp increases in health-care costs have driven upward the spending for transfer payment programs such as
Medicare and Medicaid. Transfer payments fluctuate with the business cycle, rising in times of recession and falling
during times of expansion. As such, they rose sharply during the deep 2007-2009 recession.
Source: Bureau of Economic Analysis, NIPA Table 1.1, 3.2, and 3.3 (revised February 29, 2012).

Transfer payment spending relative to GDP tends to fluctuate with the businesscycle. Transfer payments fell during the late 1970s, a period of expansion, then roseas the economy slipped into a recessionary gap during the 1979–1982 period.
Transfer payments fell during the expansion that began late in 1982, then began
rising in 1989 as the expansion began to slow. Transfer payments continued to rise
relative to GDP during the recessions of 1990–1991 and 2001–2002 and then fell as
the economy entered expansionary phases after each of those recessions. During
the 2007—2009 recession, transfer payments rose again.

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Chapter 12 Government and Fiscal Policy

When economic activity falls, incomes fall, people lose jobs, and more people
qualify for aid. People qualify to receive welfare benefits, such as cash, food stamps,
or Medicaid, only if their income falls below a certain level. They qualify for
unemployment compensation by losing their jobs. More people qualify for transfer
payments during recessions. When the economy expands, incomes and employmentrise, and fewer people qualify for welfare or unemployment benefits. Spending for
those programs therefore tends to fall during an expansion.
Figure 12.3 "Government Spending as a Percentage of GDP, 1960–2011" summarizes
trends in government spending since 1960. It shows three categories of government
spending relative to GDP: government purchases, transfer payments, and net
interest. Net interest includes payments of interest by governments at all levels onmoney borrowed, less interest earned on saving.
Figure 12.3 Government Spending as a Percentage of GDP, 1960–2011

This chart shows three major categories of government spending as percentages of GDP: government purchases,transfer payments, and net interest.
Source: Bureau of Economic Analysis, NIPA Table 1.1 and 3.1 (revised February 29, 2012).

12.1 Government and the Economy

486Chapter 12 Government and Fiscal Policy

Taxes
Taxes affect the relationship between real GDP and personal disposable income;they therefore affect consumption. They also influence investment decisions. Taxes
imposed on firms affect the profitability of investment decisions and therefore
affect the levels of investment firms will choose. Payroll taxes imposed on firms
affect the costs of hiring workers; they therefore have an impact on employment
and on the real wages earned by workers.
The bulk of federal receipts come from the personal income tax and from payroll
taxes. State and local tax receipts are dominated by property taxes and sales taxes.
The federal government, as well as state and local governments, also collects taxes
imposed on business firms, such as taxes on corporate profits. Figure 12.4 "TheComposition of Federal, State, and Local Revenues" shows the composition offederal, state, and local receipts in a recent year.
Figure 12.4 The Composition of Federal, State, and Local Revenues

Federal receipts come primarily from payroll taxes and from personal taxes such as the personal income tax. Stateand local tax receipts come from a variety of sources; the most important are property taxes, sales taxes, income
taxes, and grants from the federal government. Data are for third-quarter 2011, in billions of dollars, seasonallyadjusted at annual rates.
Source: Bureau of Economic Analysis, NIPA Table 3.2 and 3.3 (revised February 29, 2012).

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The Government Budget Balance
The government’s budget balance is the difference between the government’s
revenues and its expenditures. A budget surplus2 occurs if government revenues
exceed expenditures. A budget deficit3 occurs if government expenditures exceed
revenues. The minus sign is often omitted when reporting a deficit. If the budget
surplus equals zero, we say the government has a balanced budget4.
Figure 12.5 "Government Revenue and Expenditure as a Percentage of GDP,
1960–2011" compares federal, state, and local government revenues to expenditures
relative to GDP since 1960. The government’s budget was generally in surplus in the
1960s, then mostly in deficit since, except for a brief period between 1998 and 2001.
Bear in mind that these data are for all levels of government.
Figure 12.5 Government Revenue and Expenditure as a Percentage of GDP, 1960–2011

2. Situation that occurs if
government revenues exceed
expenditures.
3. Situation that occurs if
government expenditures
exceed revenues.
4. Situation that occurs if thebudget surplus equals zero.

The government’s budget was generally in surplus in the 1960s, then mostly in deficit since, except for a brief period
between 1998 and 2001.
Source: Bureau of Economic Analysis, NIPA Table 1.1 and 3.1 (revised February 29, 2012).

The administration of George W. Bush saw a large increase in the federal deficit. In
part, this was the result of the government’s response to the terrorist attacks in

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2001. It also results, however, from large increases in federal spending at all levels
together with tax cuts in 2001, 2002, and 2003. The federal deficit grew even larger
during the administration of Barack Obama. The increase stemmed from both
reduced revenues and increased spending resulting from the recession that began
in 2007 and the stimulus.

The National Debt
The national debt5 is the sum of all past federal deficits, minus any surpluses.
Figure 12.6 "The National Debt and the Economy, 1929–2010" shows the national
debt as a percentage of GDP. It suggests that, relative to the level of economic
activity, the debt is well below the levels reached during World War II. The ratio ofdebt to GDP rose from 1981 to 1996 and fell in the last years of the 20th century; itbegan rising again in 2002 and has risen substantially since the recession that began
in 2007.
Figure 12.6 The National Debt and the Economy, 1929–2010

The national debt relative to GDP is much smaller today than it was during World War II. The ratio of debt to GDP
rose from 1981 to 1996 and fell in the last years of the 20th century; it began rising again in 2002, markedly so in 2009
and 2010.
Sources: Data for 1929–1938 from Historical Statistics of the United States, Colonial Times to 1957—not strictly
comparable with later data. Data for remaining years from Office of Management and Budget, Budget of the UnitedStates Government, Fiscal Year 2012, Historical Tables.

5. The sum of all past federal
deficits, minus any surpluses.

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Judged by international standards, the U.S. national debt relative to its GDP is above
average. Figure 12.7 "Debts and Deficits for 32 Nations, 2010" shows national debt as
a percentage of GDP for 32 countries in 2010. It also shows deficits or surpluses as apercentage of GDP.
In an intense struggle between the Republican-majority U.S. House ofRepresentatives and the Obama administration and the Democratic-majority U.S.
Senate in the summer of 2011 that almost resulted in a government shutdown, theBudget Control Act of 2011 resulted in a $1 trillion deficit reduction for the current
fiscal year with additional reductions of $1.2–1.5 trillion scheduled to follow. The
one thing that all politicians seem to agree on is that this measure will not beenough to put the U.S. government deficit and debt back onto a sustainable longterm path. The various factions differ on what mix of spending cuts and tax
increases should be used to control the deficit and debt over the long term. They
also disagree on when these changes should take place, given the still-fragile stateof the U.S. economy in 2012.
Figure 12.7 Debts and Deficits for 32 Nations, 2010

The chart shows national debt as a percentage of GDP and deficits or surpluses as a percentage of GDP in 2010. The
national debt of the United States relative to its GDP was above average among these nations.

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Source: Organisation for Economic Co-operation and Development (OECD). Factbook 2011–2012: Economic,
Environmental and Social Statistics. OECD Publishing, 2011.

KEY TAKEAWAYS• Over the last 50 years, government purchases fell from about 20% of U.S.
GDP to below 20%, but have been rising over the last decade.
• Transfer payment spending has risen sharply, both in absolute terms
and as a percentage of real GDP since 1960.
• The bulk of federal revenues comes from income and payroll taxes. Stateand local revenues consist primarily of sales and property taxes.
• The government budget balance is the difference between government
revenues and government expenditures.
• The national debt is the sum of all past federal deficits minus any
surpluses.

TRY IT!
What happens to the national debt when there is a budget surplus? What
happens to it when there is a budget deficit? What happens to the national
debt if there is a decrease in a surplus? What happens to it if the deficit falls?

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Case in Point: Generational Accounting

One method of assessing the degree to which current fiscal policies affectfuture generations is through a device introduced in the early 1990s called
generational accounting. It measures the impact of current fiscal policies on
different generations in the economy, including future generations.
Generational accounting is now practiced by governments in many countries,
including the United States and the European Union.
As populations age, the burden of current fiscal policy is increasingly borne byyounger people in the population. In most countries, economists computing
generational accounts have found that people age 40 or below will pay more intaxes than they receive in transfer payments, while those age 60 or above will
receive more in transfers than they pay in taxes. The differences are huge.
According to a recent study by Jagadeesh Gokhale, summarized in the tablebelow, in 2004 in the United States, a male age 30 could expect to pay $201,300
more than he receives in government transfers during his lifetime, while
another male age 75 could expect to receive $171,100 more in transfers than hepaid in taxes during his lifetime. That is a difference of $372,400! For future
generations, those born after the year 2004, the difference is even morestaggering. A male born after the year 2005 can expect to pay $332,200 more intaxes than he will receive in transfer payments. For a woman, the differences
are also large but not as great. A woman age 30 in 2004 could expect to pay$30,200 more in taxes than she will receive in transfers during her lifetime,
while a woman age 75 could expect to receive transfers of $184,100 in excess ofher lifetime tax burden.
The table below gives generational accounting estimates for the United States
for the year 2004 for males and females. Figures shown are in thousands of 2004
dollars. Notice that the net burden on females is much lower than for males.
That is because women live longer than men and thus receive Social Security

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and Medicare benefits over a longer period of time. Women also have lower
labor force participation rates and earn less than men, and pay lower taxes as aresult.
Year of birth

Age in 2004

Male

Female2005 (future born)

−1

333.2

26.0

2004 (newborn)

0

104.3

8.1

1989

15

185.7

42.0

1974

30

201.3

30.2

1959

45

67.8

−54.1

1944

60

−162.6−189.4

1929

75−171.1−184.1

1914

90

−65.0

−69.2

Generational accounting has its critics—for example, the table above only
measures direct taxes and transfers but omits benefits from government
spending on public goods and services. In addition, government spending
programs can be modified, which would alter the impact on future generations.
Nonetheless, it does help to focus attention on the sustainability of current
fiscal policies. Can future generations pay for Social Security, Medicare, andother retirement and health care spending as currently configured? Should
they be asked to do so?
Source: Jagadeesh Gokhale, “Generational Accounting,” The New Palgrave
Dictionary of Economics Online, 2nd ed., 2008.

ANSWER TO TRY IT! PROBLEM
A budget surplus leads to a decline in national debt; a budget deficit causes
the national debt to grow. If there is a decrease in a budget surplus, national
debt still declines but by less than it would have had the surplus not gotten
smaller. If there is a decrease in the budget deficit, the national debt still
grows, but by less than it would have if the deficit had not gotten smaller.

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12.2 The Use of Fiscal Policy to Stabilize the Economy
LEARNING OBJECTIVES
1. Define automatic stabilizers and explain how they work.
2. Explain and illustrate graphically how discretionary fiscal policy works
and compare the changes in aggregate demand that result from changes
in government purchases, income taxes, and transfer payments.

Fiscal policy—the use of government expenditures and taxes to influence the levelof economic activity—is the government counterpart to monetary policy. Like
monetary policy, it can be used in an effort to close a recessionary or an
inflationary gap.
Some tax and expenditure programs change automatically with the level of
economic activity. We will examine these first. Then we will look at how
discretionary fiscal policies work. Four examples of discretionary fiscal policy
choices were the tax cuts introduced by the Kennedy, Reagan, and George W. Bushadministrations and the increase in government purchases proposed by President
Clinton in 1993. The 2009 fiscal stimulus bill passed in the first months of theadministration of Barack Obama included both tax rebates and spending increases.
All were designed to stimulate aggregate demand and close recessionary gaps.

Automatic Stabilizers
Certain government expenditure and taxation policies tend to insulate individuals
from the impact of shocks to the economy. Transfer payments have this effect.
Because more people become eligible for income supplements when income isfalling, transfer payments reduce the effect of a change in real GDP on disposable
personal income and thus help to insulate households from the impact of thechange. Income taxes also have this effect. As incomes fall, people pay less inincome taxes.
Any government program that tends to reduce fluctuations in GDP automatically iscalled an automatic stabilizer6. Automatic stabilizers tend to increase GDP when it
is falling and reduce GDP when it is rising.
6. Any government program thattends to reduce fluctuations in
GDP automatically.

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To see how automatic stabilizers work, consider the decline in real GDP that
occurred during the recession of 1990–1991. Real GDP fell 1.6% from the peak to thetrough of that recession. The reduction in economic activity automatically reduced
tax payments, reducing the impact of the downturn on disposable personal income.
Furthermore, the reduction in incomes increased transfer payment spending,boosting disposable personal income further. Real disposable personal income thus
fell by only 0.9% during the 1990—1991 recession, a much smaller percentage than
the reduction in real GDP. Rising transfer payments and falling tax collections
helped cushion households from the impact of the recession and kept real GDP fromfalling as much as it would have otherwise.
Automatic stabilizers have emerged as key elements of fiscal policy. Increases inincome tax rates and unemployment benefits have enhanced their importance as
automatic stabilizers. The introduction in the 1960s and 1970s of means-tested
federal transfer payments, in which individuals qualify depending on their income,added to the nation’s arsenal of automatic stabilizers. The advantage of automaticstabilizers is suggested by their name. As soon as income starts to change, they go
to work. Because they affect disposable personal income directly, and becausechanges in disposable personal income are closely linked to changes in
consumption, automatic stabilizers act swiftly to reduce the degree of changes inreal GDP.
It is important to note that changes in expenditures and taxes that occur throughautomatic stabilizers do not shift the aggregate demand curve. Because they areautomatic, their operation is already incorporated in the curve itself.

Discretionary Fiscal Policy Tools
As we begin to look at deliberate government efforts to stabilize the economy
through fiscal policy choices, we note that most of the government’s taxing andspending is for purposes other than economic stabilization. For example, theincrease in defense spending in the early 1980s under President Ronald Reagan andin the administration of George W. Bush were undertaken primarily to promotenational security. That the increased spending affected real GDP and employment
was a by-product. The effect of such changes on real GDP and the price level issecondary, but it cannot be ignored. Our focus here, however, is on discretionary
fiscal policy that is undertaken with the intention of stabilizing the economy. As wehave seen, the tax cuts introduced by the Bush administration were justified as
expansionary measures.
Discretionary government spending and tax policies can be used to shift aggregate
demand. Expansionary fiscal policy might consist of an increase in government

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purchases or transfer payments, a reduction in taxes, or a combination of thesetools to shift the aggregate demand curve to the right. A contractionary fiscal policy
might involve a reduction in government purchases or transfer payments, anincrease in taxes, or a mix of all three to shift the aggregate demand curve to theleft.
Figure 12.8 "Expansionary and Contractionary Fiscal Policies to Shift Aggregate
Demand" illustrates the use of fiscal policy to shift aggregate demand in response toa recessionary gap and an inflationary gap. In Panel (a), the economy produces areal GDP of Y1, which is below its potential level of Yp. An expansionary fiscal policy
seeks to shift aggregate demand to AD2 in order to close the gap. In Panel (b), theeconomy initially has an inflationary gap at Y1. A contractionary fiscal policy seeks
to reduce aggregate demand to AD2 and close the gap. Now we shall look at how
specific fiscal policy options work. In our preliminary analysis of the effects of fiscal
policy on the economy, we will assume that at a given price level these policies do
not affect interest rates or exchange rates. We will relax that assumption later inthe chapter.
Figure 12.8 Expansionary and Contractionary Fiscal Policies to Shift Aggregate Demand

In Panel (a), the economy faces a recessionary gap (YP − Y1). An expansionary fiscal policy seeks to shift aggregate
demand to AD2 to close the gap. In Panel (b), the economy faces an inflationary gap (Y1 − YP). A contractionary fiscal
policy seeks to reduce aggregate demand to AD2 to close the gap.

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Changes in Government Purchases
One policy through which the government could seek to shift the aggregate demand
curve is a change in government purchases. We learned that the aggregate demand
curve shifts to the right by an amount equal to the initial change in government
purchases times the multiplier. This multiplied effect of a change in government
purchases occurs because the increase in government purchases increases income,which in turn increases consumption. Then, part of the impact of the increase inaggregate demand is absorbed by higher prices, preventing the full increase in real
GDP that would have occurred if the price level did not rise.
Figure 12.9 "An Increase in Government Purchases" shows the effect of an increasein government purchases of $200 billion. The initial price level is P1 and the initial
equilibrium real GDP is $12,000 billion. Suppose the multiplier is 2. The $200 billion
increase in government purchases increases the total quantity of goods and services
demanded, at a price level of P1, by $400 billion (the $200 billion increase ingovernment purchases times the multiplier) to $12,400 billion. The aggregate
demand thus shifts to the right by that amount to AD2. The equilibrium level of real
GDP rises to $12,300 billion, and the price level rises to P2.
A reduction in government purchases would have theopposite effect. The aggregate demand curve would
shift to the left by an amount equal to the initial change
in government purchases times the multiplier. Real GDP
and the price level would fall.

Figure 12.9 An Increase in
Government Purchases

The economy shown here isinitially in equilibrium at a real
GDP of $12,000 billion and a pricelevel of P1. An increase of $200
billion in the level of government
purchases (ΔG) shifts theaggregate demand curve to theright by $400 billion to AD2. The
equilibrium level of real GDP

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Changes in Business Taxes
rises to $12,300 billion, while theprice level rises to P2.

One of the first fiscal policy measures undertaken by the
Kennedy administration in the 1960s was an investment
tax credit. An investment tax credit allows a firm to
reduce its tax liability by a percentage of the investment
it undertakes during a particular period. With aninvestment tax credit of 10%, for example, a firm that engaged in $1 million worthof investment during a year could reduce its tax liability for that year by $100,000.
The investment tax credit introduced by the Kennedy administration was later
repealed. It was reintroduced during the Reagan administration in 1981, thenabolished by the Tax Reform Act of 1986. President Clinton called for a newinvestment tax credit in 1993 as part of his job stimulus proposal, but that proposal
was rejected by Congress. The Bush administration reinstated the investment tax
credit as part of its tax cut package.
An investment tax credit is intended, of course, to stimulate additional private
sector investment. A reduction in the tax rate on corporate profits would be likely
to have a similar effect. Conversely, an increase in the corporate income tax rate ora reduction in an investment tax credit could be expected to reduce investment.
A change in investment affects the aggregate demand curve in precisely the samemanner as a change in government purchases. It shifts the aggregate demand curveby an amount equal to the initial change in investment times the multiplier.
An increase in the investment tax credit, or a reduction in corporate income tax
rates, will increase investment and shift the aggregate demand curve to the right.
Real GDP and the price level will rise. A reduction in the investment tax credit, oran increase in corporate income tax rates, will reduce investment and shift theaggregate demand curve to the left. Real GDP and the price level will
fall.Investment also affects the long-run aggregate supply curve, since a change inthe capital stock changes the potential level of real GDP. We examined this earlier
in the chapter on economic growth.

Changes in Income Taxes
Income taxes affect the consumption component of aggregate demand. An increase
in income taxes reduces disposable personal income and thus reduces consumption(but by less than the change in disposable personal income). That shifts theaggregate demand curve leftward by an amount equal to the initial change in
consumption that the change in income taxes produces times the multiplier.Achange in tax rates will change the value of the multiplier. The reason is explained

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in another chapter. A reduction in income taxes increases disposable personal
income, increases consumption (but by less than the change in disposable personal
income), and increases aggregate demand.
Suppose, for example, that income taxes are reduced by $200 billion. Only some of
the increase in disposable personal income will be used for consumption and therest will be saved. Suppose the initial increase in consumption is $180 billion. Thenthe shift in the aggregate demand curve will be a multiple of $180 billion; if themultiplier is 2, aggregate demand will shift to the right by $360 billion. Thus, ascompared to the $200-billion increase in government purchases that we saw inFigure 12.9 "An Increase in Government Purchases", the shift in the aggregate
demand curve due to an income tax cut is somewhat less, as is the effect on real
GDP and the price level.

Changes in Transfer Payments
Changes in transfer payments, like changes in income taxes, alter the disposable
personal income of households and thus affect their consumption, which is acomponent of aggregate demand. A change in transfer payments will thus shift theaggregate demand curve because it will affect consumption. Because consumption
will change by less than the change in disposable personal income, a change intransfer payments of some amount will result in a smaller change in real GDP thanwould a change in government purchases of the same amount. As with income
taxes, a $200-billion increase in transfer payments will shift the aggregate demand
curve to the right by less than the $200-billion increase in government purchasesthat we saw in Figure 12.9 "An Increase in Government Purchases".
Table 12.1 "Fiscal Policy in the United States Since 1964" summarizes U.S. fiscal
policies undertaken to shift aggregate demand since the 1964 tax cuts. We see that
expansionary policies have been chosen in response to recessionary gaps and that
contractionary policies have been chosen in response to inflationary gaps. Changes
in government purchases and in taxes have been the primary tools of fiscal policyin the United States.
Table 12.1 Fiscal Policy in the United States Since 1964
Year

1968

Situation
Inflationarygap

12.2 The Use of Fiscal Policy to Stabilize the Economy

Policy response
A temporary tax increase, first recommended by President
Johnson’s Council of Economic Advisers in 1965, goes into
effect. This one-time surcharge of 10% is added to individual
income tax liabilities.

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Chapter 12 Government and Fiscal Policy

Year

Situation

Policy response

1969

Inflationary
gap

1975

President Ford, facing a recession induced by an OPEC oil-price
Recessionary
increase, proposes a temporary 10% tax cut. It is passed almost
gap
immediately and goes into effect within two months.

1981

President Reagan had campaigned on a platform of increased
defense spending and a sharp cut in income taxes. The tax cuts
are approved in 1981 and are implemented over a period ofRecessionary
three years. The increased defense spending begins in 1981.
gap
While the Reagan administration rejects the use of fiscal policy
as a stabilization tool, its policies tend to increase aggregate
demand early in the 1980s.

1992

President Bush had rejected the use of expansionary fiscal
policy during the recession of 1990–1991. Indeed, he agreed late
Recessionary in 1990 to a cut in government purchases and a tax increase. Ingapa campaign year, however, he orders a cut in withholding rates
designed to increase disposable personal income in 1992 and toboost consumption.

1993

President Clinton calls for a $16-billion jobs package consisting
Recessionary of increased government purchases and tax cuts aimed atgap
stimulating investment. The president says the plan will create
500,000 new jobs. The measure is rejected by Congress.

2001

President Bush campaigned to reduce taxes in order to reduce
the size of government and encourage long-term growth. When
he took office in 2001, the economy was weak and theRecessionary $1.35-billion tax cut was aimed at both long-term tax relief andgap
at stimulating the economy in the short term. It included, forexample, a personal income tax rebate of $300 to $600 per
household. With unemployment still high a couple of years into
the expansion, another tax cut was passed in 2003.

2008

Fiscal stimulus package of $150 billion to spur economy. It
Recessionary
included $100 billion in tax rebates and $50 billion in tax cuts
gap
for businesses.

2009

Fiscal stimulus package of $784 billion included tax rebates andRecessionary
increased government spending passed in early days ofgap
President Obama’s administration.

2010–2012

Recessionary Extensions of the payroll tax reduction and unemployment
gap
insurance benefits continued.

12.2 The Use of Fiscal Policy to Stabilize the Economy

President Nixon, facing a continued inflationary gap, orders
cuts in government purchases.

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KEY TAKEAWAYS• Discretionary fiscal policy may be either expansionary or
contractionary.
• A change in government purchases shifts the aggregate demand curve at
a given price level by an amount equal to the initial change ingovernment purchases times the multiplier. The change in real GDP,
however, will be reduced by the fact that the price level will change.
• A change in income taxes or government transfer payments shifts theaggregate demand curve by a multiple of the initial change in
consumption (which is less than the change in personal disposable
income) that the change in income taxes or transfer payments causes.
Then, the change in real GDP will be reduced by the fact that the pricelevel will change.
• A change in government purchases has a larger impact on the aggregate
demand curve than does an equal change in income taxes or transfers.
• Changes in business tax rates, including an investment tax credit, can beused to influence the level of investment and thus the level of aggregate
demand.

TRY IT!
Suppose the economy has an inflationary gap. What fiscal policies might beused to close the gap? Using the model of aggregate demand and aggregate
supply, illustrate the effect of these policies.

12.2 The Use of Fiscal Policy to Stabilize the Economy

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Case in Point: How Large Is the Fiscal Multiplier?

There is a wide range of opinions among economists regarding the size of the
fiscal multiplier. In 2011, the American Economic Association’s Journal of
Economic Literature published three papers on this topic in a special section
titled “Forum: The Multiplier.” The papers provide at least two-and-a-halfdifferent answers!
In her paper titled “Can Government Purchases Stimulate the Economy?,”Valerie Ramey concludes that the size of the government purchases multiplierdepends on many factors but that, when the increase in government purchases
is temporary and financed by government borrowing, the multiplier “isprobably between 0.8 and 1.5. Reasonable people can argue, however, that thedata do not reject 0.5 to 2.” This is quite a wide range.
In “An Empirical Analysis of the Revival of Fiscal Activism in the 2000s,” John
Taylor argues that the various components of the recent fiscal packages (taxcuts, aid to states, and increased government purchases) had little effect on theeconomy—implying a multiplier of zero or nearly so. Using aggregate quarterly
data simulations for the 2000s, he argues that transfers and tax cuts were usedby households to increase saving, that the increase in government purchases
were too small to have made much of a difference, and that state and local
governments used their stimulus dollars for transfers or to reduce theirborrowing.
In “On Measuring the Effects of Fiscal Policy in Recessions,” Jonathan Parker
essentially argues that the statistical models built to date are ultimately
inadequate and that we will only be able to get at the answer as better andmore refined studies are conducted. Noting that the multiplier effect of fiscal
policy is likely to depend on the state of the economy, he concludes that “animportant difficulty with further investigation is the limited macroeconomic

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data available on the effects of policy in recessions (or deep recessions).”
Perhaps we need a few more Great Recessions in order to figure this out.
In another American Economic Association publication, the Journal of Economic
Perspectives, Alan Auerbach, William Gale, and Benjamin Harris provide anextensive review of the variety in multiplier estimates, which they
acknowledge is “embarrassingly large” after so many years of trying tomeasure it. Concerning the 2009 American Recovery and Reinvestment Act,
though, they write, “If a fiscal stimulus were ever to be considered appropriate,
the beginning of 2009 was such a time.…In these circumstances, our judgment
is that a fiscal expansion carried much smaller risks than the lack of one would
have.”
Sources: Alan J. Auerbach, William G. Gale, and Benjamin H. Harris, “Activist
Fiscal Policy,” Journal of Economic Perspectives 24, no. 4 (Fall 2010): 141–64;
Jonathan A. Parker, “On Measuring the Effects of Fiscal Policy in Recessions,”
Journal of Economic Literature 49, no. 3 (September 2011): 703–18; Valerie A.
Ramey, “Can Government Purchases Stimulate the Economy?,” Journal of
Economic Literature 49, no. 3 (September 2011): 673–85; John B. Taylor, “AnEmpirical Analysis of the Revival of Fiscal Activism in the 2000s,” Journal of
Economic Literature 49, no. 3 (September 2011): 686–702.

ANSWER TO TRY IT! PROBLEM
Fiscal policies that could be used to close an inflationary gap include
reductions in government purchases and transfer payments and increases intaxes. As shown in Panel (b) of Figure 12.8 "Expansionary andContractionary Fiscal Policies to Shift Aggregate Demand", the goal would be
to shift the aggregate demand curve to the left so that it will intersect the
short-run aggregate supply curve at YP.

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12.3 Issues in Fiscal Policy
LEARNING OBJECTIVES
1. Explain how the various kinds of lags influence the effectiveness of
discretionary fiscal policy.
2. Explain and illustrate graphically how crowding out (and its reverse)
influences the impact of expansionary or contractionary fiscal policy.
3. Discuss the controversy concerning which types of fiscal policies to use,
including the arguments from supply-side economics.

The discussion in the previous section about the use of fiscal policy to close gaps
suggests that economies can be easily stabilized by government actions to shift theaggregate demand curve. However, as we discovered with monetary policy in theprevious chapter, government attempts at stabilization are fraught with difficulties.

Lags
Discretionary fiscal policy is subject to the same lags that we discussed formonetary policy. It takes some time for policy makers to realize that a recessionaryor an inflationary gap exists—the recognition lag. Recognition lags stem largely fromthe difficulty of collecting economic data in a timely and accurate fashion. The
current recession was not identified until October 2008, when the Business Cycle
Dating Committee of the National Bureau of Economic Research announced that it
had begun in December 2007. Then, more time elapses before a fiscal policy, such asa change in government purchases or a change in taxes, is agreed to and put into
effect—the implementation lag. Finally, still more time goes by before the policy has
its full effect on aggregate demand—the impact lag.
Changes in fiscal policy are likely to involve a particularly long implementation lag.
A tax cut was proposed to presidential candidate John F. Kennedy in 1960 as ameans of ending the recession that year. He recommended it to Congress in 1962. It
was not passed until 1964, three years after the recession had ended. Someeconomists have concluded that the long implementation lag for discretionary
fiscal policy makes this stabilization tool ineffective. Fortunately, automaticstabilizers respond automatically to changes in the economy. They thus avoid not
only the implementation lag but also the recognition lag.

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Chapter 12 Government and Fiscal Policy

The implementation lag results partly from the nature of bureaucracy itself. The
CBO estimate that only a portion of the spending for the stimulus plan passed in2009 will be spent in the next two years is an example of the implementation lag.
Government spending requires bureaucratic approval of that spending. For
example, a portion of the stimulus plan must go through the Department of Energy.
One division of the department focuses on approving loan guarantees for energysaving industrial projects. It was created early in 2007 as part of another effort tostimulate economic activity. A Minnesota company, Sage Electrochromics, hasdeveloped a process for producing windows that can be darkened or lightened on
demand to reduce energy use in buildings. Sage applied two years ago for aguarantee on a loan of $66 million to build a plant that would employ 250 workers.
Its application has not been approved. In fact, the loan approval division, which willbe crucial for projects in the stimulus plan, has never approved any application
made to it in its two years in existence!
Energy Secretary Steven Chu, a Nobel Prize-winning physicist, recognizes theurgency of the problem. In an interview with the Wall Street Journal, Dr. Chu said
that his agency would have to do better. “Otherwise, it’s just going to be a bust,” hesaid.Stephen Power and Neil King, Jr., “Next Challenge on Stimulus: Spending All
That Money,” Wall Street Journal, February 13, 2009, p. A1.

Crowding Out
Because an expansionary fiscal policy either increases government spending or
reduces revenues, it increases the government budget deficit or reduces thesurplus. A contractionary policy is likely to reduce a deficit or increase a surplus. In
either case, fiscal policy thus affects the bond market. Our analysis of monetary
policy showed that developments in the bond market can affect investment and net
exports. We shall find in this section that the same is true for fiscal policy.
Figure 12.10 "An Expansionary Fiscal Policy and Crowding Out" shows the impact ofan expansionary fiscal policy: an increase in government purchases. The increase ingovernment purchases increases the deficit or reduces the surplus. In either case,
the Treasury will sell more bonds than it would have otherwise, shifting the supply
curve for bonds to the right in Panel (a). That reduces the price of bonds, raising theinterest rate. The increase in the interest rate reduces the quantity of private
investment demanded. The higher interest rate increases the demand for andreduces the supply of dollars in the foreign exchange market, raising the exchange
rate in Panel (b). A higher exchange rate reduces net exports. Panel (c) shows theeffects of all these changes on the aggregate demand curve. Before the change ingovernment purchases, the economy is in equilibrium at a real GDP of Y1,
determined by the intersection of AD1 and the short-run aggregate supply curve.

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Chapter 12 Government and Fiscal Policy

The increase in government expenditures would shift the curve outward to AD2 if
there were no adverse impact on investment and net exports. But the reduction in
investment and net exports partially offsets this increase. Taking the reduction in
investment and net exports into account means that the aggregate demand curve
shifts only to AD3. The tendency for an expansionary fiscal policy to reduce othercomponents of aggregate demand is called crowding out7. In the short run, thispolicy leads to an increase in real GDP to Y2 and a higher price level, P2.
Figure 12.10 An Expansionary Fiscal Policy and Crowding Out

In Panel (a), increased government purchases are financed through the sale of bonds, lowering their price to Pb2. In
Panel (b), the higher interest rate causes the exchange rate to rise, reducing net exports. Increased government
purchases would shift the aggregate demand curve to AD2 in Panel (c) if there were no crowding out. Crowding out
of investment and net exports, however, causes the aggregate demand curve to shift only to AD3. Then a higher
price level means that GDP rises only to Y2.

7. The tendency for an
expansionary fiscal policy to
reduce other components ofaggregate demand.

12.3 Issues in Fiscal Policy

Crowding out reduces the effectiveness of any expansionary fiscal policy, whether it
be an increase in government purchases, an increase in transfer payments, or areduction in income taxes. Each of these policies increases the deficit and thus506

Chapter 12 Government and Fiscal Policy

increases government borrowing. The supply of bonds increases, interest rates rise,investment falls, the exchange rate rises, and net exports fall.
Note, however, that it is private investment that is crowded out. The expansionary
fiscal policy could take the form of an increase in the investment component ofgovernment purchases. As we have learned, some government purchases are forgoods, such as office supplies, and services. But the government can also purchaseinvestment items, such as roads and schools. In that case, government investment
may be crowding out private investment.
The reverse of crowding out occurs with a contractionary fiscal policy—a cut ingovernment purchases or transfer payments, or an increase in taxes. Such policies
reduce the deficit (or increase the surplus) and thus reduce government borrowing,
shifting the supply curve for bonds to the left. Interest rates drop, inducing agreater quantity of investment. Lower interest rates also reduce the demand forand increase the supply of dollars, lowering the exchange rate and boosting net
exports. This phenomenon is known as “crowding in8.”
Crowding out and crowding in clearly weaken the impact of fiscal policy. An
expansionary fiscal policy has less punch; a contractionary policy puts less of adamper on economic activity. Some economists argue that these forces are so
powerful that a change in fiscal policy will have no effect on aggregate demand.
Because empirical studies have been inconclusive, the extent of crowding out (andits reverse) remains a very controversial area of study.
Also, the fact that government deficits today may reduce the capital stock thatwould otherwise be available to future generations does not imply that such deficits
are wrong. If, for example, the deficits are used to finance public sector investment,
then the reduction in private capital provided to the future is offset by theincreased provision of public sector capital. Future generations may have fewer
office buildings but more schools.

Choice of Policy

8. The tendency for acontractionary fiscal policy toincrease other components ofaggregate demand.

12.3 Issues in Fiscal Policy

Suppose Congress and the president agree that something needs to be done to closea recessionary gap. We have learned that fiscal policies that increase government
purchases, reduce taxes, or increase transfer payments—or do a combination ofthese—all have the potential, theoretically, to raise real GDP. The government must
decide which kind of fiscal policy to employ. Because the decision makers who
determine fiscal policy are all elected politicians, the choice among the policy
options available is an intensely political matter, often reflecting the ideology of thepoliticians.

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For example, those who believe that government is too big would argue for tax cuts
to close recessionary gaps and for spending cuts to close inflationary gaps. Those
who believe that the private sector has failed to provide adequately a host ofservices that would benefit society, such as better education or public
transportation systems, tend to advocate increases in government purchases toclose recessionary gaps and tax increases to close inflationary gaps.
Another area of contention comes from those who believe that fiscal policy should
be constructed primarily so as to promote long-term growth. Supply-side
economics9 is the school of thought that promotes the use of fiscal policy tostimulate long-run aggregate supply. Supply-side economists advocate reducing tax
rates in order to encourage people to work more or more individuals to work andproviding investment tax credits to stimulate capital formation.
While there is considerable debate over how strong the supply-side effects are in
relation to the demand-side effects, such considerations may affect the choice ofpolicies. Supply-siders tend to favor tax cuts over increases in government
purchases or increases in transfer payments. President Reagan advocated tax cutsin 1981 on the basis of their supply-side effects. Coupled with increased defense
spending in the early 1980s, fiscal policy under Mr. Reagan clearly stimulated
aggregate demand by increasing both consumption and investment. Fallinginflation and accelerated growth are signs that supply-side factors may also havebeen at work during that period. President George W. Bush’s chief economic
adviser, N. Gregory Mankiw, argued that the Bush tax cuts would encourage
economic growth, a supply-side argument. Mr. Bush’s next chief economic adviser,
Ben Bernanke, who became the next chairman of the Federal Reserve Board in 2006,
made a similar argument and urged that the Bush tax cuts be made permanent.
Finally, even when there is agreement to stimulate the economy, say throughincreasing government expenditures on highways, the how question remains. How
should the expenditures be allocated? Specifically, which states should thehighways run through? Each member of Congress has a political stake in theoutcome. These types of considerations make the implementation lag particularly
long for fiscal policy.

9. The school of thought that
promotes the use of fiscal
policy to stimulate long-run
aggregate supply.

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KEY TAKEAWAYS• Discretionary fiscal policy involves the same kind of lags as monetary
policy. However, the implementation lag in fiscal policy is likely to be
more pronounced, while the impact lag is likely to be less pronounced.
• Expansionary fiscal policy may result in the crowding out of private
investment and net exports, reducing the impact of the policy. Similarly,
contractionary policy may “crowd in” additional investment and net
exports, reducing the contractionary impact of the policy.
• Supply-side economics stresses the use of fiscal policy to stimulate
economic growth. Advocates of supply-side economics generally favor
tax cuts to stimulate economic growth.

TRY IT!
Do the following hypothetical situations tend to enhance or make moredifficult the use of fiscal policy as a stabilization tool?
1. Better and more speedily available data on the state of the economy
2. A finding that private sector investment spending is not much affectedby interest rate changes
3. A finding that the supply-side effects of a tax cut are substantial

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Case in Point: Crowding Out in Canada

In an intriguing study, economist Baotai Wang examined the degree ofcrowding out of Canadian private investment as a result of government
expenditures from 1961–2000. What made Professor Wang’s analysis unusual
was that he divided Canadian government expenditures into five categories:
expenditures for health and education, expenditures for capital andinfrastructure, expenditures for the protection of persons and property (which
included defense spending), expenditures for debt services, and expenditures
for government and social services.
Mr. Wang found that only government expenditures for capital andinfrastructure crowded out private investment. While these expenditures
reduced private investment, they represented increased public sector
investment for things such as highways and ports.
Expenditures for health and education actually “crowded in” private sector
investment. These expenditures, Mr. Wang argued, represented increases inhuman capital. Such increases complement returns on private sector
investment and therefore increase it.
Mr. Wang found that Canadian government expenditures for debt service, theprotection of persons and property, and for government and social services had
no effect on private sector investment. He argued that expenditures forprotection of persons and property may involve some crowding out, but thatthey also stimulated private investment by firms winning government
contracts for defense purchases. The same explanation could be applied togovernment expenditures for government and social services. These also
include an element of investment in human capital.

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His results suggest that crowding out depends on the nature of spending doneby the government. Some kinds of spending clearly did not crowd out private
sector investment in Canada.
Source: Baotai Wang, “Effects of Government Expenditure on Private
Investment: Canadian Empirical Evidence,” Empirical Economics 30, no. 2(September 2005): 493–504.

ANSWERS TO TRY IT! PROBLEMS
1. Data on the economy that are more accurate and more speedily
available should enhance the use of fiscal policy by reducing the lengthof the recognition lag.
2. If private sector investment does not respond much to interest ratechanges, then there will be less crowding out when expansionary
policies are undertaken. That is, the rising interest rates that accompany
expansionary fiscal policy will not reduce investment spending much,making the shift in the aggregate demand curve to the right greaterthan it would be otherwise. Also, the use of contractionary fiscal policy
would be more effective, since the fall in interest rates would “invite in”
less investment spending, making the shift in the aggregate demand
curve to the left greater than it would otherwise be.
3. Large supply-side effects enhance the impact of tax cuts. For a given
expansionary policy, without the supply-side effects, GDP would
advance only to the point where the aggregate demand curve intersects
the short-run aggregate supply curve. With the supply-side effects, boththe short-run and long-run aggregate supply curves shift to the right.
The intersection of the AD curve with the now increased short-run
aggregate supply curve will be farther to the right than it would havebeen in the absence of the supply-side effects. The potential level of real
GDP will also increase.

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12.4 Review and PracticeSummary
The government sector plays a major role in the economy. The spending, tax, and transfer policies of local, state,
and federal agencies affect aggregate demand and aggregate supply and thus affect the level of real GDP and theprice level. An expansionary policy tends to increase real GDP. Such a policy could be used to close arecessionary gap. A contractionary fiscal policy tends to reduce real GDP. A contractionary policy could be used
to close an inflationary gap.
Government purchases of goods and services have a direct impact on aggregate demand. An increase ingovernment purchases shifts the aggregate demand curve by the amount of the initial change in government
purchases times the multiplier. Changes in personal income taxes or in the level of transfer payments affectdisposable personal income. They change consumption, though initially by less than the amount of the change
in taxes or transfers. They thus cause somewhat smaller shifts in the aggregate demand curve than do equalchanges in government purchases.
There are several issues in the use of fiscal policies for stabilization purposes. They include lags associated withfiscal policy, crowding out, the choice of which fiscal policy tool to use, and the possible burdens ofaccumulating national debt.

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CONCEPT PROBLEMS
1. What is the difference between government expenditures andgovernment purchases? How do the two variables differ in terms of
their effect on GDP?
2. Federally funded student aid programs generally reduce benefits by $1
for every $1 that recipients earn. Do such programs represent
government purchases or transfer payments? Are they automaticstabilizers?
3. Crowding out reduces the degree to which a change in government
purchases influences the level of economic activity. Is it a form of
automatic stabilizer?
4. Why is it important to try to determine the size of the fiscal policy
multiplier?
5. Suppose an economy has an inflationary gap. How does thegovernment’s actual budget deficit or surplus compare to the deficit or
surplus it would have at potential output?
6. Suppose the president was given the authority to increase or decrease
federal spending by as much as $100 billion in order to stabilize
economic activity. Do you think this would tend to make the economy
more or less stable?
7. Suppose the government increases purchases in an economy with arecessionary gap. How would this policy affect bond prices, interest
rates, investment, net exports, real GDP, and the price level? Show yourresults graphically.
8. Suppose the government cuts transfer payments in an economy with an
inflationary gap. How would this policy affect bond prices, interest
rates, investment, the exchange rate, net exports, real GDP, and theprice level? Show your results graphically.
9. Suppose that at the same time the government undertakes expansionary
fiscal policy, such as a cut in taxes, the Fed undertakes contractionary
monetary policy. How would this policy affect bond prices, interest
rates, investment, net exports, real GDP, and the price level? Show yourresults graphically.
10. Given the nature of the implementation lag discussed in the text, discusspossible measures that might reduce the lag.

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NUMERICAL PROBLEMS

1. Look up the table on Federal Receipts and Outlays, by Major
Category, in the most recent Economic Report of the President
available in your library or on the Internet.

a. Complete the following table:
CategoryTotaloutlays

Percentage of total
outlaysNational
defenseInternational
affairs
HealthMedicare
IncomesecuritySocial Security
Net interest
Other

b. Construct a pie chart showing the percentages of spendingfor each category in the total.
2. Look up the table on ownership of U.S. Treasury securities in themost recent Economic Report of the President available on theInternet.
a. Make a pie chart showing the percentage owned by various
groups in the earliest year shown in the table.
b. Make a pie chart showing the percentage owned by various
groups in the most recent year shown in the table.
c. What are some of the major changes in ownership of U.S.
government debt over the period?

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Chapter 12 Government and Fiscal Policy

3. Suppose a country has a national debt of $5,000 billion, a GDP of$10,000 billion, and a budget deficit of $100 billion.
a. How much will its new national debt be?
b. Compute its debt-GDP ratio.
c. Suppose its GDP grows by 1% in the next year and the budget
deficit is again $100 billion. Compute its new level of national
debt and its new debt-GDP ratio.
4. Suppose a country’s debt rises by 10% and its GDP rises by 12%.
a. What happens to the debt-GDP ratio?
b. Does the relative level of the initial values affect youranswer?
5. The data below show a country’s national debt and its prime
lending rate.
Year National debt (billions of $) Lending rate (%)
1992

4,064

6.0

1993

4,411

6.0

1994

4,692

8.5

1995

4,973

8.7

1996

5,224

8.3

1997

5,413

8.5

a. Plot the relationship between national debt and the lendingrate.
b. Based on your graph, does crowding out appear to be a
problem?
6. Suppose a country increases government purchases by $100
billion. Suppose the multiplier is 1.5 and the economy’s real GDP
is $5,000 billion.
a. In which direction will the aggregate demand curve shift andby how much?

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Chapter 12 Government and Fiscal Policyb. Explain using a graph why the change in real GDP is likely tobe smaller than the shift in the aggregate demand curve.
7. Suppose a country decreases government purchases by $100
billion. Suppose the multiplier is 1.5 and the economy’s real GDP
is $5,000 billion.
a. In which direction will the aggregate demand curve shift andby how much?
b. Explain using a graph why the change in real GDP is likely tobe smaller than the shift in the aggregate demand curve.
8. Suppose a country decreases income taxes by $100 billion, andthis leads to an increase in consumption spending of $90 billion.
Suppose the multiplier is 1.5 and the economy’s real GDP is$5,000 billion.
a. In which direction will the aggregate demand curve shift andby how much?
b. Explain using a graph why the change in real GDP is likely tobe smaller than the shift in the aggregate demand curve.
9. Suppose a country increases income taxes by $100 billion, andthis leads to a decrease in consumption spending of $90 billion.
Suppose the multiplier is 1.5 and the economy’s real GDP is$5,000 billion.
a. In which direction will the aggregate demand curve shift andby how much?
b. Explain using a graph why the change in real GDP is likely tobe smaller than the shift in the aggregate demand curve.
10. Suppose a country institutes an investment tax credit, and thisleads to an increase in investment spending of $100 billion.
Suppose the multiplier is 1.5 and the economy’s real GDP is$5,000 billion.
a. In which direction will the aggregate demand curve shift andby how much?
b. Explain using a graph why the change in real GDP is likely tobe smaller than the shift in the aggregate demand curve.

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Chapter 12 Government and Fiscal Policy

11. Suppose a country repeals an investment tax credit, and thisleads to a decrease in investment spending of $100 billion.
Suppose the multiplier is 1.5 and the economy’s real GDP is$5,000 billion.
a. In which direction will the aggregate demand curve shift andby how much?
b. Explain using a graph why the change in real GDP is likely tobe smaller than the shift in the aggregate demand curve.
12. Explain why the shifts in the aggregate demand curves in questions 7
through 11 above are the same or different in absolute value.

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Chapter 13
Consumption and the Aggregate Expenditures Model
Start Up: A Dismal 2008 for Retailers
2008 turned out to be the worst holiday shopping season in decades. Why? U.S.
consumers were battered from many directions. Housing prices had fallen nearly
20% over the year. The stock market had fallen over 40%. Interest rates were falling,
but credit was extremely hard to come by. By December, consumer confidence hit
an all-time low amid concerns of rising unemployment. Cutting back seemed likethe best defense for weathering this tough environment.
Consumption accounts for the bulk of aggregate demand in the United States and inother countries. In this chapter, we will examine the determinants of consumption
and introduce a new model, the aggregate expenditures model, which will giveinsights into the aggregate demand curve. Any change in aggregate demand causesa change in income, and a change in income causes a change in
consumption—which changes aggregate demand and thus income and thus
consumption. The aggregate expenditures model will help us to unravel theimportant relationship between consumption and real GDP.

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Chapter 13 Consumption and the Aggregate Expenditures Model

13.1 Determining the Level of Consumption
LEARNING OBJECTIVES
1. Explain and graph the consumption function and the saving function,
explain what the slopes of these curves represent, and explain how thetwo are related to each other.
2. Compare the current income hypothesis with the permanent income
hypothesis, and use each to predict the effect that temporary versus
permanent changes in income will have on consumption.
3. Discuss two factors that can cause the consumption function to shift
upward or downward.

J. R. McCulloch, an economist of the early nineteenth century, wrote, “Consumption… is, in fact, the object of industry.”J. R. Mc Culloch, A Discourse on the Rise, Progress,
Peculiar Objects, and Importance, of Political Economy: Containing the Outline of a Course of
Lectures on the Principles and Doctrines of That Science (Edinburgh: Archibald
Constable, 1824), 103. Goods and services are produced so that people can use them.
The factors that determine consumption thus determine how successful an
economy is in fulfilling its ultimate purpose: providing goods and services forpeople. So, consumption is not just important because it is such a large componentof economic activity. It is important because, as McCulloch said, consumption is at
the heart of the economy’s fundamental purpose.

Consumption and Disposable Personal Income
It seems reasonable to expect that consumption spending by households will beclosely related to their disposable personal income, which equals the income
households receive less the taxes they pay. Note that disposable personal income
and GDP are not the same thing. GDP is a measure of total income; disposable
personal income is the income households have available to spend during a
specified period.
Real values of disposable personal income and consumption per year from 1960
through 2011 are plotted in Figure 13.1 "The Relationship between Consumption
and Disposable Personal Income, 1960–2011". The data suggest that consumption
generally changes in the same direction as does disposable personal income.

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The relationship between consumption and disposable personal income is called theconsumption function1. It can be represented algebraically as an equation, as aschedule in a table, or as a curve on a graph.
Figure 13.1 The Relationship between Consumption and Disposable Personal Income, 1960–2011

Plots of consumption and disposable personal income over time suggest that consumption increases as disposable
personal income increases.
Source: U. S. Department of Commerce, Bureau of Economic Analysis, NIPA Tables 1.1.6 and 2.1 (revised February
29, 2012).

1. The relationship between
consumption and disposable
personal income.

Figure 13.2 "Plotting a Consumption Function" illustrates the consumptionfunction. The relationship between consumption and disposable personal incomethat we encountered in Figure 13.1 "The Relationship between Consumption and
Disposable Personal Income, 1960–2011" is evident in the table and in the curve:
consumption in any period increases as disposable personal income increases inthat period. The slope of the consumption function tells us by how much. Consider
points C and D. When disposable personal income (Yd) rises by $500 billion,
consumption rises by $400 billion. More generally, the slope equals the change in
consumption divided by the change in disposable personal income. The ratio of thechange in consumption (ΔC) to the change in disposable personal income (ΔYd) is
the marginal propensity to consume2 (MPC). The Greek letter delta (Δ) is used todenote “change in.”2. The ratio of the change in
consumption (ΔC) to thechange in disposable personal
income (ΔYd).

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Chapter 13 Consumption and the Aggregate Expenditures Model

Equation 13.1

MPC =

ΔC
ΔY d

In this case, the marginal propensity to consume equals $400/$500 = 0.8. It can beinterpreted as the fraction of an extra $1 of disposable personal income that people
spend on consumption. Thus, if a person with an MPC of 0.8 received an extra $1,000
of disposable personal income, that person’s consumption would rise by $0.80 foreach extra $1 of disposable personal income, or $800.
We can also express the consumption function as an equation
Equation 13.2

C = $300 billion + 0.8Y d
Figure 13.2 Plotting a Consumption Function

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Chapter 13 Consumption and the Aggregate Expenditures Model

The consumption function relates consumption C to disposable personal income Yd. The equation for the
consumption function shown here in tabular and graphical form is C = $300 billion + 0.8Yd.

Heads Up!
It is important to note carefully the definition of the marginal propensity toconsume. It is the change in consumption divided by the change in disposable
personal income. It is not the level of consumption divided by the level ofdisposable personal income. Using Equation 13.2, at a level of disposable
personal income of $500 billion, for example, the level of consumption will be$700 billion so that the ratio of consumption to disposable personal income willbe 1.4, while the marginal propensity to consume remains 0.8. The marginal
propensity to consume is, as its name implies, a marginal concept. It tells us
what will happen to an additional dollar of personal disposable income.

Notice from the curve in Figure 13.2 "Plotting a Consumption Function" that when
disposable personal income equals 0, consumption is $300 billion. The verticalintercept of the consumption function is thus $300 billion. Then, for every $500
billion increase in disposable personal income, consumption rises by $400 billion.
Because the consumption function in our example is linear, its slope is the same
between any two points. In this case, the slope of the consumption function, whichis the same as the marginal propensity to consume, is 0.8 all along its length.
We can use the consumption function to show the relationship between personalsaving and disposable personal income. Personal saving3 is disposable personal
income not spent on consumption during a particular period; the value of personalsaving for any period is found by subtracting consumption from disposable
personal income for that period:
Equation 13.3
3. Disposable personal income
not spent on consumption
during a particular period.
4. The relationship between
personal saving in any period
and disposable personal
income in that period.

Personal saving = disposable personal income − consumption
The saving function4 relates personal saving in any period to disposable personal
income in that period. Personal saving is not the only form of saving—firms andgovernment agencies may save as well. In this chapter, however, our focus is on the13.1 Determining the Level of Consumption522

Chapter 13 Consumption and the Aggregate Expenditures Modelchoice households make between using disposable personal income for
consumption or for personal saving.
Figure 13.3 "Consumption and Personal Saving" shows how the consumptionfunction and the saving function are related. Personal saving is calculated bysubtracting values for consumption from values for disposable personal income, as
shown in the table. The values for personal saving are then plotted in the graph.
Notice that a 45-degree line has been added to the graph. At every point on the
45-degree line, the value on the vertical axis equals that on the horizontal axis. The
consumption function intersects the 45-degree line at an income of $1,500 billion(point D). At this point, consumption equals disposable personal income andpersonal saving equals 0 (point D′ on the graph of personal saving). Using the graphto find personal saving at other levels of disposable personal income, we subtract
the value of consumption, given by the consumption function, from disposable
personal income, given by the 45-degree line.
Figure 13.3 Consumption and Personal Saving

Personal saving equals disposable personal income minus consumption. The table gives hypothetical values forthese variables. The consumption function is plotted in the upper part of the graph. At points along the 45-degreeline, the values on the two axes are equal; we can measure personal saving as the distance between the 45-degreeline and consumption. The curve of the saving function is in the lower portion of the graph.

13.1 Determining the Level of Consumption

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Chapter 13 Consumption and the Aggregate Expenditures ModelAt a disposable personal income of $2,000 billion, for example, consumption is$1,900 billion (point E). Personal saving equals $100 billion (point E′)—the verticaldistance between the 45-degree line and the consumption function. At an income of$500 billion, consumption totals $700 billion (point B). The consumption function
lies above the 45-degree line at this point; personal saving is −$200 billion (point B′).
A negative value for saving means that consumption exceeds disposable personal
income; it must have come from saving accumulated in the past, from selling assets,
or from borrowing.
Notice that for every $500 billion increase in disposable personal income, personalsaving rises by $100 billion. Consider points C′ and D′ in Figure 13.3 "Consumption
and Personal Saving". When disposable personal income rises by $500 billion,
personal saving rises by $100 billion. More generally, the slope of the saving
function equals the change in personal saving divided by the change in disposable
personal income. The ratio of the change in personal saving (ΔS) to the change indisposable personal income (ΔYd) is the marginal propensity to save5 (MPS).
Equation 13.4

MPS =

ΔS
ΔY d

In this case, the marginal propensity to save equals $100/$500 = 0.2. It can beinterpreted as the fraction of an extra $1 of disposable personal income that people
save. Thus, if a person with an MPS of 0.2 received an extra $1,000 of disposable
personal income, that person’s saving would rise by $0.20 for each extra $1 ofdisposable personal income, or $200. Since people have only two choices of what to
do with additional disposable personal income—that is, they can use it either for
consumption or for personal saving—the fraction of disposable personal incomethat people consume (MPC) plus the fraction of disposable personal income thatpeople save (MPS) must add to 1:
Equation 13.5

MPC + MPS = 1
5. The ratio of the change inpersonal saving (ΔS) to thechange in disposable personal
income (ΔYd).
6. Consumption in any one perioddepends on income during that
period.

Current versus Permanent Income
The discussion so far has related consumption in a particular period to income inthat same period. The current income hypothesis6 holds that consumption in any
one period depends on income during that period, or current income.

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Chapter 13 Consumption and the Aggregate Expenditures Model

Although it seems obvious that consumption should be related to disposable
personal income, it is not so obvious that consumers base their consumption in any
one period on the income they receive during that period. In buying a new car, forexample, consumers might base their decision not only on their current income buton the income they expect to receive during the three or four years they expect to
be making payments on the car. Parents who purchase a college education for theirchildren might base their decision on their own expected lifetime income.
Indeed, it seems likely that virtually all consumption choices could be affected by
expectations of income over a very long period. One reason people save is toprovide funds to live on during their retirement years. Another is to build an estate
they can leave to their heirs through bequests. The amount people save for theirretirement or for bequests depends on the income they expect to receive for the
rest of their lives. For these and other reasons, then, personal saving (and thus
consumption) in any one year is influenced by permanent income. Permanent
income7 is the average annual income people expect to receive for the rest of theirlives.
People who have the same current income but different permanent incomes mightreach very different saving decisions. Someone with a relatively low current income
but a high permanent income (a college student planning to go to medical school,for example) might save little or nothing now, expecting to save for retirement andfor bequests later. A person with the same low income but no expectation of higher
income later might try to save some money now to provide for retirement orbequests later. Because a decision to save a certain amount determines how much
will be available for consumption, consumption decisions can also be affected by
expected lifetime income. Thus, an alternative approach to explaining consumption
behavior is the permanent income hypothesis8, which assumes that consumption
in any period depends on permanent income. An important implication of thepermanent income hypothesis is that a change in income regarded as temporary
will not affect consumption much, since it will have little effect on average lifetime
income; a change regarded as permanent will have an effect. The current income
hypothesis, though, predicts that it does not matter whether consumers view achange in disposable personal income as permanent or temporary; they will movealong the consumption function and change consumption accordingly.

7. The average annual income
people expect to receive for the
rest of their lives.
8. Consumption in any perioddepends on permanent income.

The question of whether permanent or current income is a determinant ofconsumption arose in 1992 when President George H. W. Bush ordered a change inthe withholding rate for personal income taxes. Workers have a fraction of theirpaychecks withheld for taxes each pay period; Mr. Bush directed that this fraction
be reduced in 1992. The change in the withholding rate did not change income tax
rates; by withholding less in 1992, taxpayers would either receive smaller refund

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Chapter 13 Consumption and the Aggregate Expenditures Modelchecks in 1993 or owe more taxes. The change thus left taxpayers’ permanent
income unaffected.
President Bush’s measure was designed to increase aggregate demand and close therecessionary gap created by the 1990–1991 recession. Economists who subscribed tothe permanent income hypothesis predicted that the change would not have any
effect on consumption. Those who subscribed to the current income hypothesis
predicted that the measure would boost consumption substantially in 1992. A
survey of households taken during this period suggested that households plannedto spend about 43% of the temporary increase in disposable personal income
produced by the withholding experiment.Matthew D. Shapiro and Joel Slemrod,“Consumer Response to the Timing of Income: Evidence from a Change in Tax
Withholding,” American Economic Review 85 (March 1995): 274–83. That is
considerably less than would be predicted by the current income hypothesis, butmore than the zero change predicted by the permanent income hypothesis. This
result, together with related evidence, suggests that temporary changes in income
can affect consumption, but that changes regarded as permanent will have a muchstronger impact.
Many of the tax cuts passed during the administration of President George W. Bushare set to expire at the end of 2012. The proposal to make these tax cuts permanentis aimed toward having a stronger impact on consumption, since tax cuts regarded
as permanent have larger effects than do changes regarded as temporary.

Other Determinants of Consumption
The consumption function graphed in Figure 13.2 "Plotting a Consumption
Function" and Figure 13.3 "Consumption and Personal Saving" relates consumption
spending to the level of disposable personal income. Changes in disposable personal
income cause movements along this curve; they do not shift the curve. The curve
shifts when other determinants of consumption change. Examples of changes that
could shift the consumption function are changes in real wealth and changes in
expectations. Figure 13.4 "Shifts in the Consumption Function" illustrates how
these changes can cause shifts in the curve.

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Chapter 13 Consumption and the Aggregate Expenditures Model

Figure 13.4 Shifts in the Consumption Function

An increase in the level of consumption at each level of disposable personal income shifts the consumption function
upward in Panel (a). Among the events that would shift the curve upward are an increase in real wealth and anincrease in consumer confidence. A reduction in the level of consumption at each level of disposable personal income
shifts the curve downward in Panel (b). The events that could shift the curve downward include a reduction in real
wealth and a decline in consumer confidence.

Changes in Real Wealth
An increase in stock and bond prices, for example, would make holders of theseassets wealthier, and they would be likely to increase their consumption. An
increase in real wealth shifts the consumption function upward, as illustrated inPanel (a) of Figure 13.4 "Shifts in the Consumption Function". A reduction in real
wealth shifts it downward, as shown in Panel (b).
A change in the price level changes real wealth. We learned in an earlier chapterthat the relationship among the price level, real wealth, and consumption is called
the wealth effect. A reduction in the price level increases real wealth and shifts theconsumption function upward, as shown in Panel (a). An increase in the price level
shifts the curve downward, as shown in Panel (b).

Changes in Expectations
Consumers are likely to be more willing to spend money when they are optimistic
about the future. Surveyors attempt to gauge this optimism using “consumer
confidence” surveys that ask respondents to report whether they are optimistic or
pessimistic about their own economic situation and about the prospects for the13.1 Determining the Level of Consumption

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Chapter 13 Consumption and the Aggregate Expenditures Modeleconomy as a whole. An increase in consumer optimism tends to shift theconsumption function upward as in Panel (a) of Figure 13.4 "Shifts in theConsumption Function"; an increase in pessimism tends to shift it downward as inPanel (b). The sharp reduction in consumer confidence in 2008 and early in 2009
contributed to a downward shift in the consumption function and thus to theseverity of the recession.
The relationship between consumption and consumer expectations concerning
future economic conditions tends to be a form of self-fulfilling prophecy. If
consumers expect economic conditions to worsen, they will cut theirconsumption—and economic conditions will worsen! Political leaders often try to
persuade people that economic prospects are good. In part, such efforts are an
attempt to increase economic activity by boosting consumption.

KEY TAKEAWAYS• Consumption is closely related to disposable personal income and isrepresented by the consumption function, which can be presented in atable, in a graph, or in an equation.
• Personal saving is disposable personal income not spent on
consumption.
• The marginal propensity to consume is MPC = ΔC/ΔYd and the marginal
propensity to save is MPS = ΔS/ΔYd. The sum of the MPC and MPS is 1.
• The current income hypothesis holds that consumption is a function ofcurrent disposable personal income, whereas the permanent income
hypothesis holds that consumption is a function of permanent income,which is the income households expect to receive annually during their
lifetime. The permanent income hypothesis predicts that a temporarychange in income will have a smaller effect on consumption than ispredicted by the current income hypothesis.
• Other factors that affect consumption include real wealth andexpectations.

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Chapter 13 Consumption and the Aggregate Expenditures Model

TRY IT!
For each of the following events, draw a curve representing theconsumption function and show how the event would affect the curve.
1. A sharp increase in stock prices increases the real wealth of mosthouseholds.
2. Consumers decide that a recession is ahead and that their incomes arelikely to fall.
3. The price level falls.

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Chapter 13 Consumption and the Aggregate Expenditures Model

Case in Point: Consumption and the Tax Rebate of 2001

The first round of the Bush tax cuts was passed in 2001. Democrats in Congressinsisted on a rebate aimed at stimulating consumption. In the summer of 2001,
rebates of $300 per single taxpayer and of $600 for married couples were
distributed. The Department of Treasury reported that 92 million people
received the rebates. While the rebates were intended to stimulate
consumption, the extent to which the tax rebates stimulated consumption,
especially during the recession, is an empirical question.
It is difficult to analyze the impact of a tax rebate that is a single event
experienced by all households at the same time. If spending does change at thatmoment, is it because of the tax rebate or because of some other event that
occurred at that time?
Fortunately for researchers Sumit Agarwal, Chunlin Liu, and Nicholas Souleles,
using data from credit card accounts, the 2001 tax rebate checks were
distributed over 10 successive weeks from July to September of 2001. The
timing of receipt was random, since it was based on the next-to-last digit ofone’s Social Security number, and taxpayers were informed well in advancethat the checks were coming. The researchers found that consumers initiallysaved much of their rebates, by paying down their credit card debts, but over anine-month period, spending increased to about 40% of the rebate. They also
found that consumers who were most liquidity constrained (for example, close
to their credit card debt limits) spent more than consumers who were lessconstrained.
The researchers thus conclude that their findings do not support thepermanent income hypothesis, since consumers responded to spending basedon when they received their checks and because the results indicate that
consumers do respond to what they call “lumpy” changes in income, such as

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Chapter 13 Consumption and the Aggregate Expenditures Model

those generated by a tax rebate. In other words, current income does seem tomatter.
Two other studies of the 2001 tax rebate reached somewhat different
conclusions. Using survey data, researchers Matthew D. Shapiro and Joel
Slemrod estimated an MPC of about one-third. They note that this low increased
spending is particularly surprising, since the rebate was part of a general tax
cut that was expected to last a long time. At the other end, David S. Johnson,
Jonathan A. Parker, and Nicholas S. Souleles, using yet another data set, foundthat looking over a six-month period, the MPC was about two-thirds. So, while
there is disagreement on the size of the MPC, all conclude that the impact was
non-negligible.
Sources: Sumit Agarwal, Chunlin Liu, and Nicholas S. Souleles, “The Reaction ofConsumer Spending and Debt to Tax Rebates—Evidence from Consumer Credit
Data,” NBER Working Paper No. 13694, December 2007; David S. Johnson,
Jonathan A. Parker, and Nicholas S. Souleles, “Household Expenditure and theIncome Tax Rebates of 2001,” American Economic Review 96, no. 5 (December2006): 1589–1610; Matthew D. Shapiro and Joel Slemrod, “Consumer Response
to Tax Rebates,” American Economic Review 93, no. 1 (March 2003): 381–96; andMatthew D. Shapiro and Joel Slemrod, “Did the 2001 Rebate Stimulate
Spending? Evidence from Taxpayer Surveys," NBER Tax Policy & the Economy 17,
no. 1 (2003): 83–109.

ANSWERS TO TRY IT! PROBLEMS
1. A sharp increase in stock prices makes people wealthier and shifts theconsumption function upward, as in Panel (a) of Figure 13.4 "Shifts in
the Consumption Function".
2. This would be reported as a reduction in consumer confidence.
Consumers are likely to respond by reducing their purchases,
particularly of durable items such as cars and washing machines. The
consumption function will shift downward, as in Panel (b) of Figure 13.4
"Shifts in the Consumption Function".
3. A reduction in the price level increases real wealth and thus boosts
consumption. The consumption function will shift upward, as in Panel(a) of Figure 13.4 "Shifts in the Consumption Function".

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Chapter 13 Consumption and the Aggregate Expenditures Model

13.2 The Aggregate Expenditures Model
LEARNING OBJECTIVES
1. Explain and illustrate the aggregate expenditures model and the conceptof equilibrium real GDP.
2. Distinguish between autonomous and induced aggregate expendituresand explain why a change in autonomous expenditures leads to a
multiplied change in equilibrium real GDP.
3. Discuss how adding taxes, government purchases, and net exports to asimplified aggregate expenditures model affects the multiplier andhence the impact on real GDP that arises from an initial change inautonomous expenditures.

The consumption function relates the level of consumption in a period to the levelof disposable personal income in that period. In this section, we incorporate othercomponents of aggregate demand: investment, government purchases, and net
exports. In doing so, we shall develop a new model of the determination ofequilibrium real GDP, the aggregate expenditures model9. This model relates
aggregate expenditures10, which equal the sum of planned levels of consumption,
investment, government purchases, and net exports at a given price level, to thelevel of real GDP. We shall see that people, firms, and government agencies may notalways spend what they had planned to spend. If so, then actual real GDP will not be
the same as aggregate expenditures, and the economy will not be at the equilibrium
level of real GDP.

9. Model that relates aggregate
expenditures to the level ofreal GDP.
10. The sum of planned levels of
consumption, investment,
government purchases, and net
exports at a given price level.

One purpose of examining the aggregate expenditures model is to gain a deeper
understanding of the “ripple effects” from a change in one or more components ofaggregate demand. As we saw in the chapter that introduced the aggregate demand
and aggregate supply model, a change in investment, government purchases, or net
exports leads to greater production; this creates additional income for households,
which induces additional consumption, leading to more production, more income,more consumption, and so on. The aggregate expenditures model provides acontext within which this series of ripple effects can be better understood. A second
reason for introducing the model is that we can use it to derive the aggregate
demand curve for the model of aggregate demand and aggregate supply.
To see how the aggregate expenditures model works, we begin with a very
simplified model in which there is neither a government sector nor a foreign sector.

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Chapter 13 Consumption and the Aggregate Expenditures Model

Then we use the findings based on this simplified model to build a more realistic
model. The equations for the simplified economy are easier to work with, and we
can readily apply the conclusions reached from analyzing a simplified economy todraw conclusions about a more realistic one.

The Aggregate Expenditures Model: A Simplified View
To develop a simple model, we assume that there are only two components ofaggregate expenditures: consumption and investment. In the chapter on measuring
total output and income, we learned that real gross domestic product and real grossdomestic income are the same thing. With no government or foreign sector, grossdomestic income in this economy and disposable personal income would be nearly
the same. To simplify further, we will assume that depreciation and undistributed
corporate profits (retained earnings) are zero. Thus, for this example, we assume
that disposable personal income and real GDP are identical.
Finally, we shall also assume that the only component of aggregate expendituresthat may not be at the planned level is investment. Firms determine a level ofinvestment they intend to make in each period. The level of investment firms
intend to make in a period is called planned investment11. Some investment is
unplanned. Suppose, for example, that firms produce and expect to sell more goods
during a period than they actually sell. The unsold goods will be added to the firms’
inventories, and they will thus be counted as part of investment. Unplanned
investment12 is investment during a period that firms did not intend to make. It isalso possible that firms may sell more than they had expected. In this case,inventories will fall below what firms expected, in which case, unplanned
investment would be negative. Investment during a period equals the sum ofplanned investment (IP) and unplanned investment (IU).
Equation 13.6

I = IP + IU
We shall find that planned and unplanned investment play key roles in theaggregate expenditures model.
11. The level of investment firms
intend to make in a period.
12. Investment during a periodthat firms did not intend tomake.
13. Expenditures that do not varywith the level of real GDP.

Autonomous and Induced Aggregate Expenditures
Economists distinguish two types of expenditures. Expenditures that do not varywith the level of real GDP are called autonomous aggregate expenditures13. In our
example, we assume that planned investment expenditures are autonomous.
Expenditures that vary with real GDP are called induced aggregate

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Chapter 13 Consumption and the Aggregate Expenditures Model

expenditures14. Consumption spending that rises with real GDP is an example of an
induced aggregate expenditure. Figure 13.5 "Autonomous and Induced Aggregate
Expenditures" illustrates the difference between autonomous and induced
aggregate expenditures. With real GDP on the horizontal axis and aggregate
expenditures on the vertical axis, autonomous aggregate expenditures are shown as
a horizontal line in Panel (a). A curve showing induced aggregate expenditures hasa slope greater than zero; the value of an induced aggregate expenditure changes
with changes in real GDP. Panel (b) shows induced aggregate expenditures that are
positively related to real GDP.
Figure 13.5 Autonomous and Induced Aggregate Expenditures

Autonomous aggregate expenditures do not vary with the level of real GDP; induced aggregate expenditures do.
Autonomous aggregate expenditures are shown by the horizontal line in Panel (a). Induced aggregate expenditures
vary with real GDP, as in Panel (b).

Autonomous and Induced Consumption
The concept of the marginal propensity to consume suggests that consumption
contains induced aggregate expenditures; an increase in real GDP raises
consumption. But consumption contains an autonomous component as well. The
level of consumption at the intersection of the consumption function and thevertical axis is regarded as autonomous consumption; this level of spending would
occur regardless of the level of real GDP.

14. Expenditures that vary withreal GDP.

Consider the consumption function we used in deriving the schedule and curve
illustrated in Figure 13.2 "Plotting a Consumption Function":13.2 The Aggregate Expenditures Model

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Chapter 13 Consumption and the Aggregate Expenditures Model

C = $300 billion + 0.8Y
We can omit the subscript on disposable personal income because of thesimplifications we have made in this section, and the symbol Y can be thought of as
representing both disposable personal income and GDP. Because we assume that theprice level in the aggregate expenditures model is constant, GDP equals real GDP. At
every level of real GDP, consumption includes $300 billion in autonomous aggregate
expenditures. It will also contain expenditures “induced” by the level of real GDP.
At a level of real GDP of $2,000 billion, for example, consumption equals $1,900
billion: $300 billion in autonomous aggregate expenditures and $1,600 billion in
consumption induced by the $2,000 billion level of real GDP.
Figure 13.6 "Autonomous and Induced Consumption" illustrates these twocomponents of consumption. Autonomous consumption, Ca, which is always $300
billion, is shown in Panel (a); its equation is
Equation 13.7

Ca = $300 billion
Induced consumption Ci is shown in Panel (b); its equation is
Equation 13.8

Ci = 0.8Y
The consumption function is given by the sum of Equation 13.7 and Equation 13.8; itis shown in Panel (c) of Figure 13.6 "Autonomous and Induced Consumption". It is
the same as the equation C = $300 billion + 0.8Yd, since in this simple example, Y and
Yd are the same.

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Chapter 13 Consumption and the Aggregate Expenditures Model

Figure 13.6 Autonomous and Induced Consumption

Consumption has an autonomous component and an induced component. In Panel (a), autonomous consumption Ca
equals $300 billion at every level of real GDP. Panel (b) shows induced consumption Ci. Total consumption C is shownin Panel (c).

Plotting the Aggregate Expenditures Curve
In this simplified economy, investment is the only other component of aggregate
expenditures. We shall assume that investment is autonomous and that firms plan
to invest $1,100 billion per year.
Equation 13.9

IP = $1,100 billion
The level of planned investment is unaffected by the level of real GDP.
15. The relationship of aggregate
expenditures to the value ofreal GDP.

Aggregate expenditures equal the sum of consumption C and planned investment IP.
The aggregate expenditures function15 is the relationship of aggregate

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Chapter 13 Consumption and the Aggregate Expenditures Model

expenditures to the value of real GDP. It can be represented with an equation, as atable, or as a curve.
We begin with the definition of aggregate expenditures AE when there is nogovernment or foreign sector:
Equation 13.10

AE = C + IP
Substituting the information from above on consumption and planned investment
yields (throughout this discussion all values are in billions of base-year dollars)

AE = $300 + 0.8Y + $1,100orEquation 13.11

AE = $1,400 + 0.8Y
Equation 13.11 is the algebraic representation of the aggregate expenditures
function. We shall use this equation to determine the equilibrium level of real GDP
in the aggregate expenditures model. It is important to keep in mind that aggregate
expenditures measure total planned spending at each level of real GDP (for any
given price level). Real GDP is total production. Aggregate expenditures and real
GDP need not be equal, and indeed will not be equal except when the economy isoperating at its equilibrium level, as we will see in the next section.
In Equation 13.11, the autonomous component of aggregate expenditures is $1,400
billion, and the induced component is 0.8Y. We shall plot this aggregate
expenditures function. To do so, we arbitrarily select various levels of real GDP andthen use Equation 13.10 to compute aggregate expenditures at each level. At a levelof real GDP of $6,000 billion, for example, aggregate expenditures equal $6,200
billion:

AE = $1,400 + 0.8 ($6,000) = $6,200

The table in Figure 13.7 "Plotting the Aggregate Expenditures Curve" shows thevalues of aggregate expenditures at various levels of real GDP. Based on thesevalues, we plot the aggregate expenditures curve. To obtain each value for13.2 The Aggregate Expenditures Model

537

Chapter 13 Consumption and the Aggregate Expenditures Modelaggregate expenditures, we simply insert the corresponding value for real GDP into
Equation 13.11. The value at which the aggregate expenditures curve intersects thevertical axis corresponds to the level of autonomous aggregate expenditures. In our
example, autonomous aggregate expenditures equal $1,400 billion. That figure
includes $1,100 billion in planned investment, which is assumed to be autonomous,and $300 billion in autonomous consumption expenditure.
Figure 13.7 Plotting the Aggregate Expenditures Curve

Values for aggregate expenditures AE are computed by inserting values for real GDP into Equation 13.10; these are
given in the aggregate expenditures schedule. The point at which the aggregate expenditures curve intersects thevertical axis is the value of autonomous aggregate expenditures, here $1,400 billion. The slope of this aggregate
expenditures curve is 0.8.

The Slope of the Aggregate Expenditures Curve
The slope of the aggregate expenditures curve, given by the change in aggregate
expenditures divided by the change in real GDP between any two points, measures
the additional expenditures induced by increases in real GDP. The slope for theaggregate expenditures curve in Figure 13.7 "Plotting the Aggregate Expenditures
Curve" is shown for points B and C: it is 0.8.

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Chapter 13 Consumption and the Aggregate Expenditures Model

In Figure 13.7 "Plotting the Aggregate Expenditures Curve", the slope of theaggregate expenditures curve equals the marginal propensity to consume. This isbecause we have assumed that the only other expenditure, planned investment, isautonomous and that real GDP and disposable personal income are identical.
Changes in real GDP thus affect only consumption in this simplified economy.

Equilibrium in the Aggregate Expenditures Model
Real GDP is a measure of the total output of firms. Aggregate expenditures equal
total planned spending on that output. Equilibrium in the model occurs where
aggregate expenditures in some period equal real GDP in that period. One way tothink about equilibrium is to recognize that firms, except for some inventory thatthey plan to hold, produce goods and services with the intention of selling them.
Aggregate expenditures consist of what people, firms, and government agencies
plan to spend. If the economy is at its equilibrium real GDP, then firms are selling
what they plan to sell (that is, there are no unplanned changes in inventories).
Figure 13.8 "Determining Equilibrium in the Aggregate Expenditures Model"
illustrates the concept of equilibrium in the aggregate expenditures model. A
45-degree line connects all the points at which the values on the two axes,
representing aggregate expenditures and real GDP, are equal. Equilibrium mustoccur at some point along this 45-degree line. The point at which the aggregate
expenditures curve crosses the 45-degree line is the equilibrium real GDP, here
achieved at a real GDP of $7,000 billion.

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Chapter 13 Consumption and the Aggregate Expenditures Model

Figure 13.8 Determining Equilibrium in the Aggregate Expenditures Model

The 45-degree line shows all the points at which aggregate expenditures AE equal real GDP, as required forequilibrium. The equilibrium solution occurs where the AE curve crosses the 45-degree line, at a real GDP of $7,000
billion.

Equation 13.11 tells us that at a real GDP of $7,000 billion, the sum of consumption
and planned investment is $7,000 billion—precisely the level of output firms
produced. At that level of output, firms sell what they planned to sell and keep
inventories that they planned to keep. A real GDP of $7,000 billion represents
equilibrium in the sense that it generates an equal level of aggregate expenditures.
If firms were to produce a real GDP greater than $7,000 billion per year, aggregate
expenditures would fall short of real GDP. At a level of real GDP of $9,000 billion peryear, for example, aggregate expenditures equal $8,600 billion. Firms would be left
with $400 billion worth of goods they intended to sell but did not. Their actual levelof investment would be $400 billion greater than their planned level of investment.
With those unsold goods on hand (that is, with an unplanned increase ininventories), firms would be likely to cut their output, moving the economy toward
its equilibrium GDP of $7,000 billion. If firms were to produce $5,000 billion,
aggregate expenditures would be $5,400 billion. Consumers and firms would

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Chapter 13 Consumption and the Aggregate Expenditures Modeldemand more than was produced; firms would respond by reducing theirinventories below the planned level (that is, there would be an unplanned decrease
in inventories) and increasing their output in subsequent periods, again moving the
economy toward its equilibrium real GDP of $7,000 billion. Figure 13.9 "Adjusting toEquilibrium Real GDP" shows possible levels of real GDP in the economy for theaggregate expenditures function illustrated in Figure 13.8 "Determining
Equilibrium in the Aggregate Expenditures Model". It shows the level of aggregate
expenditures at various levels of real GDP and the direction in which real GDP willchange whenever AE does not equal real GDP. At any level of real GDP other thanthe equilibrium level, there is unplanned investment.
Figure 13.9 Adjusting to Equilibrium Real GDP

Each level of real GDP will result in a particular amount of aggregate expenditures. If aggregate expenditures areless than the level of real GDP, firms will reduce their output and real GDP will fall. If aggregate expenditures exceed
real GDP, then firms will increase their output and real GDP will rise. If aggregate expenditures equal real GDP, thenfirms will leave their output unchanged; we have achieved equilibrium in the aggregate expenditures model. At
equilibrium, there is no unplanned investment. Here, that occurs at a real GDP of $7,000 billion.

Changes in Aggregate Expenditures: The MultiplierIn the aggregate expenditures model, equilibrium is found at the level of real GDP atwhich the aggregate expenditures curve crosses the 45-degree line. It follows that ashift in the curve will change equilibrium real GDP. Here we will examine themagnitude of such changes.
Figure 13.10 "A Change in Autonomous Aggregate Expenditures Changes
Equilibrium Real GDP" begins with the aggregate expenditures curve shown in
Figure 13.8 "Determining Equilibrium in the Aggregate Expenditures Model". Now
suppose that planned investment increases from the original value of $1,100 billion
to a new value of $1,400 billion—an increase of $300 billion. This increase inplanned investment shifts the aggregate expenditures curve upward by $300 billion,
all other things unchanged. Notice, however, that the new aggregate expenditures

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Chapter 13 Consumption and the Aggregate Expenditures Model

curve intersects the 45-degree line at a real GDP of $8,500 billion. The $300 billion
increase in planned investment has produced an increase in equilibrium real GDP of$1,500 billion.
Figure 13.10 A Change in Autonomous Aggregate Expenditures Changes Equilibrium Real GDP

An increase of $300 billion in planned investment raises the aggregate expenditures curve by $300 billion. The $300
billion increase in planned investment results in an increase in equilibrium real GDP of $1,500 billion.

How could an increase in aggregate expenditures of $300 billion produce anincrease in equilibrium real GDP of $1,500 billion? The answer lies in the operationof the multiplier. Because firms have increased their demand for investment goods(that is, for capital) by $300 billion, the firms that produce those goods will have$300 billion in additional orders. They will produce $300 billion in additional real
GDP and, given our simplifying assumption, $300 billion in additional disposable
personal income. But in this economy, each $1 of additional real GDP induces $0.80
in additional consumption. The $300 billion increase in autonomous aggregate
expenditures initially induces $240 billion (= 0.8 × $300 billion) in additional
consumption.

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Chapter 13 Consumption and the Aggregate Expenditures Model

The $240 billion in additional consumption boosts production, creating another$240 billion in real GDP. But that second round of increase in real GDP induces $192
billion (= 0.8 × $240) in additional consumption, creating still more production, still
more income, and still more consumption. Eventually (after many additionalrounds of increases in induced consumption), the $300 billion increase in aggregate
expenditures will result in a $1,500 billion increase in equilibrium real GDP. Table
13.1 "The Multiplied Effect of an Increase in Autonomous Aggregate Expenditures"shows the multiplied effect of a $300 billion increase in autonomous aggregate
expenditures, assuming each $1 of additional real GDP induces $0.80 in additional
consumption.
Table 13.1 The Multiplied Effect of an Increase in Autonomous Aggregate
Expenditures
Round of spending

Increase in real GDP (billions of dollars)

1

$300

2

240

3

192

4

154

5

123

6

98

7

79

8

63

9

50

10

40

11

32

12

26

Subsequent rounds+103

Total increase in real GDP$1,500The size of the additional rounds of expenditure is based on the slope of theaggregate expenditures function, which in this example is simply the marginal
propensity to consume. Had the slope been flatter (if the marginal propensity toconsume were smaller), the additional rounds of spending would have been smaller.
A steeper slope would mean that the additional rounds of spending would havebeen larger.

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Chapter 13 Consumption and the Aggregate Expenditures Model

This process could also work in reverse. That is, a decrease in planned investment
would lead to a multiplied decrease in real GDP. A reduction in planned investment
would reduce the incomes of some households. They would reduce theirconsumption by the MPC times the reduction in their income. That, in turn, would
reduce incomes for households that would have received the spending by the firstgroup of households. The process continues, thus multiplying the impact of the
reduction in aggregate expenditures resulting from the reduction in planned
investment.

Computation of the Multiplier
The multiplier16 is the number by which we multiply an initial change in aggregate
demand to get the full amount of the shift in the aggregate demand curve. Because
the multiplier shows the amount by which the aggregate demand curve shifts at agiven price level, and the aggregate expenditures model assumes a given pricelevel, we can use the aggregate expenditures model to derive the multiplier
explicitly.
Let Yeq be the equilibrium level of real GDP in the aggregate expenditures model,
and let A be autonomous aggregate expenditures. Then the multiplier is
Equation 13.12

Multiplier =

ΔY eq
⎯⎯⎯
ΔA

In the example we have just discussed, a change in autonomous aggregate
expenditures of $300 billion produced a change in equilibrium real GDP of $1,500
billion. The value of the multiplier is therefore $1,500/$300 = 5.

16. The number by which we
multiply an initial change inaggregate demand to get thefull amount of the shift in theaggregate demand curve.

The multiplier effect works because a change in autonomous aggregate
expenditures causes a change in real GDP and disposable personal income, inducing
a further change in the level of aggregate expenditures, which creates still more
GDP and thus an even higher level of aggregate expenditures. The degree to which agiven change in real GDP induces a change in aggregate expenditures is given inthis simplified economy by the marginal propensity to consume, which, in this case,is the slope of the aggregate expenditures curve. The slope of the aggregate
expenditures curve is thus linked to the size of the multiplier. We turn now to an
investigation of the relationship between the marginal propensity to consume andthe multiplier.

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Chapter 13 Consumption and the Aggregate Expenditures Model

The Marginal Propensity to Consume and the MultiplierWe can compute the multiplier for this simplified economy from the marginal
propensity to consume. We know that the amount by which equilibrium real GDP
will change as a result of a change in aggregate expenditures consists of two parts:⎯⎯⎯
the change in autonomous aggregate expenditures itself, ΔA , and the inducedchange in spending. This induced change equals the marginal propensity toconsume times the change in equilibrium real GDP, ΔYeq. Thus
Equation 13.13⎯⎯⎯
ΔY eq = ΔA + MPC ΔY eq
Subtract the MPCΔYeq term from both sides of the equation:⎯⎯⎯
ΔY eq − MPC ΔY eq = ΔA
Factor out the ΔYeq term on the left:⎯⎯⎯
ΔY eq (1 − MPC) = ΔA⎯⎯⎯

Finally, solve for the multiplier ΔY eq /ΔA by dividing both sides of the equation
above by ΔA and by dividing both sides by (1 − MPC). We get the following:
Equation 13.14

ΔY eq
1⎯⎯⎯ = 1 − MPC
ΔA
We thus compute the multiplier by taking 1 minus the marginal propensity toconsume, then dividing the result into 1. In our example, the marginal propensity
to consume is 0.8; the multiplier is 5, as we have already seen [multiplier = 1/(1 −MPC) = 1/(1 − 0.8) = 1/0.2 = 5]. Since the sum of the marginal propensity to consume
and the marginal propensity to save is 1, the denominator on the right-hand side ofEquation 13.13 is equivalent to the MPS, and the multiplier could also be expressed
as 1/MPS.

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Chapter 13 Consumption and the Aggregate Expenditures Model

Equation 13.15

Multiplier =1
MPS

We can rearrange terms in Equation 13.14 to use the multiplier to compute theimpact of a change in autonomous aggregate expenditures. We simply multiply⎯⎯⎯
both sides of the equation by A to obtain the following:
Equation 13.16⎯⎯⎯
ΔA
ΔY eq =
1 − MPC
The change in the equilibrium level of income in the aggregate expenditures model(remember that the model assumes a constant price level) equals the change inautonomous aggregate expenditures times the multiplier. Thus, the greater themultiplier, the greater will be the impact on income of a change in autonomous
aggregate expenditures.

The Aggregate Expenditures Model in a More Realistic Economy
Four conclusions emerge from our application of the aggregate expenditures modelto the simplified economy presented so far. These conclusions can be applied to amore realistic view of the economy.
1. The aggregate expenditures function relates aggregate expenditures toreal GDP. The intercept of the aggregate expenditures curve shows thelevel of autonomous aggregate expenditures. The slope of theaggregate expenditures curve shows how much increases in real GDP
induce additional aggregate expenditures.
2. Equilibrium real GDP occurs where aggregate expenditures equal realGDP.
3. A change in autonomous aggregate expenditures changes equilibrium
real GDP by a multiple of the change in autonomous aggregate
expenditures.
4. The size of the multiplier depends on the slope of the aggregate
expenditures curve. The steeper the aggregate expenditures curve, thelarger the multiplier; the flatter the aggregate expenditures curve, thesmaller the multiplier.

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Chapter 13 Consumption and the Aggregate Expenditures Model

These four points still hold as we add the two other components of aggregate
expenditures—government purchases and net exports—and recognize thatgovernment not only spends but also collects taxes. We look first at the effect ofadding taxes to the aggregate expenditures model and then at the effect of adding
government purchases and net exports.

Taxes and the Aggregate Expenditure Function
Suppose that the only difference between real GDP and disposable personal income
is personal income taxes. Let us see what happens to the slope of the aggregate
expenditures function.
As before, we assume that the marginal propensity to consume is 0.8, but we now
add the assumption that income taxes take ¼ of real GDP. This means that for every
additional $1 of real GDP, disposable personal income rises by $0.75 and, in turn,consumption rises by $0.60 (= 0.8 × $0.75). In the simplified model in which
disposable personal income and real GDP were the same, an additional $1 of real
GDP raised consumption by $0.80. The slope of the aggregate expenditures curve
was 0.8, the marginal propensity to consume. Now, as a result of taxes, theaggregate expenditures curve will be flatter than the one shown in Figure 13.7
"Plotting the Aggregate Expenditures Curve" and Figure 13.9 "Adjusting toEquilibrium Real GDP". In this example, the slope will be 0.6; an additional $1 of real
GDP will increase consumption by $0.60.
Other things the same, the multiplier will be smaller than it was in the simplified
economy in which disposable personal income and real GDP were identical. The
wedge between disposable personal income and real GDP created by taxes meansthat the additional rounds of spending induced by a change in autonomous
aggregate expenditures will be smaller than if there were no taxes. Hence, themultiplied effect of any change in autonomous aggregate expenditures is smaller.

The Addition of Government Purchases and Net Exports
Suppose that government purchases and net exports are autonomous. If so, they
enter the aggregate expenditures function in the same way that investment did.
Compared to the simplified aggregate expenditures model, the aggregate
expenditures curve shifts up by the amount of government purchases and net
exports.An even more realistic view of the economy might assume that imports are
induced, since as a country’s real GDP rises it will buy more goods and services,
some of which will be imports. In that case, the slope of the aggregate expenditures
curve would change.

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Chapter 13 Consumption and the Aggregate Expenditures Model

Figure 13.11 "The Aggregate Expenditures Function: Comparison of a Simplified
Economy and a More Realistic Economy" shows the difference between theaggregate expenditures model of the simplified economy in Figure 13.8
"Determining Equilibrium in the Aggregate Expenditures Model" and a more
realistic view of the economy. Panel (a) shows an AE curve for an economy with
only consumption and investment expenditures. In Panel (b), the AE curve includes
all four components of aggregate expenditures.
Figure 13.11 The Aggregate Expenditures Function: Comparison of a Simplified Economy and a More Realistic
EconomyPanel (a) shows an aggregate expenditures curve for a simplified view of the economy; Panel (b) shows an aggregate
expenditures curve for a more realistic model. The AE curve in Panel (b) has a higher intercept than the AE curve inPanel (a) because of the additional components of autonomous aggregate expenditures in a more realistic view ofthe economy. The slope of the AE curve in Panel (b) is flatter than the slope of the AE curve in Panel (a). In a
simplified economy, the slope of the AE curve is the marginal propensity to consume (MPC). In a more realistic viewof the economy, it is less than the MPC because of the difference between real GDP and disposable personal income.

There are two major differences between the aggregate expenditures curves shownin the two panels. Notice first that the intercept of the AE curve in Panel (b) ishigher than that of the AE curve in Panel (a). The reason is that, in addition to theautonomous part of consumption and planned investment, there are two othercomponents of aggregate expenditures—government purchases and net
exports—that we have also assumed are autonomous. Thus, the intercept of theaggregate expenditures curve in Panel (b) is the sum of the four autonomous
aggregate expenditures components: consumption (Ca), planned investment (IP),government purchases (G), and net exports (Xn). In Panel (a), the intercept includes
only the first two components.

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Chapter 13 Consumption and the Aggregate Expenditures Model

Second, notice that the slope of the aggregate expenditures curve is flatter for the
more realistic economy in Panel (b) than it is for the simplified economy in Panel(a). This can be seen by comparing the slope of the aggregate expenditures curve
between points A and B in Panel (a) to the slope of the aggregate expenditures
curve between points A′ and B′ in Panel (b). Between both sets of points, real GDP
changes by the same amount, $1,000 billion. In Panel (a), consumption rises by $800
billion, whereas in Panel (b) consumption rises by only $600 billion. This difference
occurs because, in the more realistic view of the economy, households have only afraction of real GDP available as disposable personal income. Thus, for a givenchange in real GDP, consumption rises by a smaller amount.
Let us examine what happens to equilibrium real GDP in each case if there is a shift
in autonomous aggregate expenditures, such as an increase in planned investment,
as shown in Figure 13.12 "A Change in Autonomous Aggregate Expenditures:Comparison of a Simplified Economy and a More Realistic Economy". In bothpanels, the initial level of equilibrium real GDP is the same, Y1. Equilibrium real GDP
occurs where the given aggregate expenditures curve intersects the 45-degree line.
The aggregate expenditures curve shifts up by the same amount—ΔA is the same inboth panels. The new level of equilibrium real GDP occurs where the new AE curveintersects the 45-degree line. In Panel (a), we see that the new level of equilibrium
real GDP rises to Y2, but in Panel (b) it rises only to Y3. Since the same change inautonomous aggregate expenditures led to a greater increase in equilibrium real
GDP in Panel (a) than in Panel (b), the multiplier for the more realistic model of theeconomy must be smaller. The multiplier is smaller, of course, because the slope of
the aggregate expenditures curve is flatter.
Figure 13.12 A Change in Autonomous Aggregate Expenditures: Comparison of a Simplified Economy and aMore Realistic Economy

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Chapter 13 Consumption and the Aggregate Expenditures Model

In Panels (a) and (b), equilibrium real GDP is initially Y1. Then autonomous aggregate expenditures rise by the sameamount, ΔIP. In Panel (a), the upward shift in the AE curve leads to a new level of equilibrium real GDP of Y2; inPanel (b) equilibrium real GDP rises to Y3. Because equilibrium real GDP rises by more in Panel (a) than in Panel (b),the multiplier in the simplified economy is greater than in the more realistic one.

KEY TAKEAWAYS• The aggregate expenditures model relates aggregate expenditures toreal GDP. Equilibrium in the model occurs where aggregate expendituresequal real GDP and is found graphically at the intersection of theaggregate expenditures curve and the 45-degree line.
• Economists distinguish between autonomous and induced aggregate
expenditures. The former do not vary with GDP; the latter do.
• Equilibrium in the aggregate expenditures model implies thatunintended investment equals zero.
• A change in autonomous aggregate expenditures leads to a change inequilibrium real GDP, which is a multiple of the change in autonomous
aggregate expenditures.
• The size of the multiplier depends on the slope of the aggregate
expenditures curve. In general, the steeper the aggregate expenditures
curve, the greater the multiplier. The flatter the aggregate expenditures
curve, the smaller the multiplier.
• Income taxes tend to flatten the aggregate expenditures curve.

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Chapter 13 Consumption and the Aggregate Expenditures Model

TRY IT!
Suppose you are given the following data for an economy. All data are inbillions of dollars. Y is actual real GDP, and C, IP, G, and Xn are theconsumption, planned investment, government purchases, and net exports
components of aggregate expenditures, respectively.
Y

C
$0

Ip

G

Xn

$800 $1,000 $1,400 −$200

2,500 2,300

1,000

1,400

−200

5,000 3,800

1,000

1,400

−200

7,500 5,300

1,000

1,400

−200

10,000 6,800

1,000

1,400

−200

1. Plot the corresponding aggregate expenditures curve and draw in the
45-degree line.
2. What is the intercept of the AE curve? What is its slope?
3. Determine the equilibrium level of real GDP.
4. Now suppose that net exports fall by $1,000 billion and that this is the
only change in autonomous aggregate expenditures. Plot the new
aggregate expenditures curve. What is the new equilibrium level of realGDP?
5. What is the value of the multiplier?

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Chapter 13 Consumption and the Aggregate Expenditures Model

Case in Point: Fiscal Policy in the Kennedy
Administration

It was the first time expansionary fiscal policy had ever been proposed. The
economy had slipped into a recession in 1960. Presidential candidate John
Kennedy received proposals from several economists that year for a tax cut
aimed at stimulating the economy. As a candidate, he was unconvinced. But, aspresident he proposed the tax cut in 1962. His chief economic adviser, Walter
Heller, defended the tax cut idea before Congress and introduced what waspolitically a novel concept: the multiplier.
In testimony to the Senate Subcommittee on Employment and Manpower, Mr.
Heller predicted that a $10 billion cut in personal income taxes would boost
consumption “by over $9 billion.”
To assess the ultimate impact of the tax cut, Mr. Heller applied the aggregate
expenditures model. He rounded the increased consumption off to $9 billion
and explained,“This is far from the end of the matter. The higher production of consumer
goods to meet this extra spending would mean extra employment, higher
payrolls, higher profits, and higher farm and professional and service incomes.
This added purchasing power would generate still further increases in spending
and incomes. … The initial rise of $9 billion, plus this extra consumption
spending and extra output of consumer goods, would add over $18 billion to
our annual GDP.”

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Chapter 13 Consumption and the Aggregate Expenditures ModelWe can summarize this continuing process by saying that a “multiplier” ofapproximately 2 has been applied to the direct increment of consumption
spending.
Mr. Heller also predicted that proposed cuts in corporate income tax rates
would increase investment by about $6 billion. The total change in autonomous
aggregate expenditures would thus be $15 billion: $9 billion in consumption
and $6 billion in investment. He predicted that the total increase in equilibrium
GDP would be $30 billion, the amount the Council of Economic Advisers had
estimated would be necessary to reach full employment.
In the end, the tax cut was not passed until 1964, after President Kennedy’s
assassination in 1963. While the Council of Economic Advisers concluded thatthe tax cut had worked as advertised, it came long after the economy had
recovered and tended to push the economy into an inflationary gap. As we will
see in later chapters, the tax cut helped push the economy into a period ofrising inflation.
Source: Economic Report of the President 1964 (Washington, DC: U.S. Government
Printing Office, 1964), 172–73.

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Chapter 13 Consumption and the Aggregate Expenditures ModelANSWERS TO TRY IT! PROBLEMS
1. The aggregate expenditures curve is plotted in the accompanying chart
as AE1.
2. The intercept of the AE1 curve is $3,000. It is the amount of
aggregate expenditures (C + IP + G + Xn) when real GDP is zero.
The slope of the AE1 curve is 0.6. It can be found by determining
the amount of aggregate expenditures for any two levels of real
GDP and then by dividing the change in aggregate expendituresby the change in real GDP over the interval. For example,
between real GDP of $2,500 and $5,000, aggregate expenditures
go from $4,500 to $6,000. Thus,

ΔAE 1$6,000 − $4,500$1,500=== 0.6
ΔY$5,000 − $2,500$2,5003. The equilibrium level of real GDP is $7,500. It can be found bydetermining the intersection of AE1 and the 45-degree line. At Y = $7,500,
AE1 = $5,300 + 1,000 + 1,400 − 200 = $7,500.
4. A reduction of net exports of $1,000 shifts the aggregate expenditures
curve down by $1,000 to AE2. The equilibrium real GDP falls from $7,500
to $5,000. The new aggregate expenditures curve, AE2, intersects the
45-degree line at real GDP of $5,000.
5. The multiplier is 2.5 [= (−$2,500)/(−$1,000)].

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Chapter 13 Consumption and the Aggregate Expenditures Model

13.3 Aggregate Expenditures and Aggregate Demand
LEARNING OBJECTIVES
1. Explain and illustrate how a change in the price level affects theaggregate expenditures curve.
2. Explain and illustrate how to derive an aggregate demand curve fromthe aggregate expenditures curve for different price levels.
3. Explain and illustrate how an increase or decrease in autonomous
aggregate expenditures affects the aggregate demand curve.

We can use the aggregate expenditures model to gain greater insight into theaggregate demand curve. In this section we shall see how to derive the aggregate
demand curve from the aggregate expenditures model. We shall also see how toapply the analysis of multiplier effects in the aggregate expenditures model to theaggregate demand–aggregate supply model.

Aggregate Expenditures Curves and Price Levels
An aggregate expenditures curve assumes a fixed price level. If the price level wereto change, the levels of consumption, investment, and net exports would all change,
producing a new aggregate expenditures curve and a new equilibrium solution in
the aggregate expenditures model.
A change in the price level changes people’s real wealth. Suppose, for example, thatyour wealth includes $10,000 in a bond account. An increase in the price level would
reduce the real value of this money, reduce your real wealth, and thus reduce yourconsumption. Similarly, a reduction in the price level would increase the real valueof money holdings and thus increase real wealth and consumption. The tendency
for price level changes to change real wealth and consumption is called the wealtheffect17.
17. The tendency for price levelchanges to change real wealthand consumption.
18. The tendency for a higher pricelevel to reduce the realquantity of money, raiseinterest rates, and reduceinvestment.

Because changes in the price level also affect the real quantity of money, we can
expect a change in the price level to change the interest rate. A reduction in theprice level will increase the real quantity of money and thus lower the interest rate.
A lower interest rate, all other things unchanged, will increase the level ofinvestment. Similarly, a higher price level reduces the real quantity of money,raises interest rates, and reduces investment. This is called the interest rate
effect18.

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Chapter 13 Consumption and the Aggregate Expenditures Model

Finally, a change in the domestic price level will affect exports and imports. A
higher price level makes a country’s exports fall and imports rise, reducing net
exports. A lower price level will increase exports and reduce imports, increasing net
exports. This impact of different price levels on the level of net exports is called theinternational trade effect19.
Panel (a) of Figure 13.13 "From Aggregate Expenditures to Aggregate Demand"shows three possible aggregate expenditures curves for three different price levels.
For example, the aggregate expenditures curve labeled AEP=1.0 is the aggregate
expenditures curve for an economy with a price level of 1.0. Since that aggregate
expenditures curve crosses the 45-degree line at $6,000 billion, equilibrium real GDP
is $6,000 billion at that price level. At a lower price level, aggregate expenditures
would rise because of the wealth effect, the interest rate effect, and theinternational trade effect. Assume that at every level of real GDP, a reduction in theprice level to 0.5 would boost aggregate expenditures by $2,000 billion to AEP = 0.5,
and an increase in the price level from 1.0 to 1.5 would reduce aggregate
expenditures by $2,000 billion. The aggregate expenditures curve for a price level of
1.5 is shown as AEP=1.5. There is a different aggregate expenditures curve, and adifferent level of equilibrium real GDP, for each of these three price levels. A pricelevel of 1.5 produces equilibrium at point A, a price level of 1.0 does so at point B,
and a price level of 0.5 does so at point C. More generally, there will be a different
level of equilibrium real GDP for every price level; the higher the price level, thelower the equilibrium value of real GDP.

19. The impact of different pricelevels on the level of net
exports.

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Figure 13.13 From Aggregate Expenditures to Aggregate Demand

Because there is a different aggregate expenditures curve for each price level, there is a different equilibrium real
GDP for each price level. Panel (a) shows aggregate expenditures curves for three different price levels. Panel (b)shows that the aggregate demand curve, which shows the quantity of goods and services demanded at each pricelevel, can thus be derived from the aggregate expenditures model. The aggregate expenditures curve for a price levelof 1.0, for example, intersects the 45-degree line in Panel (a) at point B, producing an equilibrium real GDP of $6,000
billion. We can thus plot point B′ on the aggregate demand curve in Panel (b), which shows that at a price level of
1.0, a real GDP of $6,000 billion is demanded.

Panel (b) of Figure 13.13 "From Aggregate Expenditures to Aggregate Demand"shows how an aggregate demand curve can be derived from the aggregate
expenditures curves for different price levels. The equilibrium real GDP associatedwith each price level in the aggregate expenditures model is plotted as a point
showing the price level and the quantity of goods and services demanded(measured as real GDP). At a price level of 1.0, for example, the equilibrium level ofreal GDP in the aggregate expenditures model in Panel (a) is $6,000 billion at point
B. That means $6,000 billion worth of goods and services is demanded; point B' on
the aggregate demand curve in Panel (b) corresponds to a real GDP demanded of$6,000 billion and a price level of 1.0. At a price level of 0.5 the equilibrium GDP
demanded is $10,000 billion at point C', and at a price level of 1.5 the equilibrium
real GDP demanded is $2,000 billion at point A'. The aggregate demand curve thus

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Chapter 13 Consumption and the Aggregate Expenditures Modelshows the equilibrium real GDP from the aggregate expenditures model at each
price level.

The Multiplier and Changes in Aggregate Demand
In the aggregate expenditures model, a change in autonomous aggregate
expenditures changes equilibrium real GDP by the multiplier times the change inautonomous aggregate expenditures. That model, however, assumes a constantprice level. How can we incorporate the concept of the multiplier into the model ofaggregate demand and aggregate supply?
Consider the aggregate expenditures curves given in Panel (a) of Figure 13.14"Changes in Aggregate Demand", each of which corresponds to a particular pricelevel. Suppose net exports rise by $1,000 billion. Such a change increases aggregate
expenditures at each price level by $1,000 billion.
A $1,000-billion increase in net exports shifts each of the aggregate expenditures
curves up by $1,000 billion, to AE′P=1.0 and AE′P=1.5. That changes the equilibrium
real GDP associated with each price level; it thus shifts the aggregate demand curve
to AD2 in Panel (b). In the aggregate expenditures model, equilibrium real GDP
changes by an amount equal to the initial change in autonomous aggregate
expenditures times the multiplier, so the aggregate demand curve shifts by thesame amount. In this example, we assume the multiplier is 2. The aggregate demand
curve thus shifts to the right by $2,000 billion, two times the $1,000-billion change
in autonomous aggregate expenditures.
Figure 13.14 Changes in Aggregate Demand

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Chapter 13 Consumption and the Aggregate Expenditures Model

The aggregate expenditures curves for price levels of 1.0 and 1.5 are the same as in Figure 13.13 "From Aggregate
Expenditures to Aggregate Demand", as is the aggregate demand curve. Now suppose a $1,000-billion increase in net
exports shifts each of the aggregate expenditures curves up; AEP=1.0, for example, rises to AE′P=1.0. The aggregate
demand curve thus shifts to the right by $2,000 billion, the change in aggregate expenditures times the multiplier,assumed to be 2 in this example.

In general, any change in autonomous aggregate expenditures shifts the aggregate
demand curve. The amount of the shift is always equal to the change in autonomous
aggregate expenditures times the multiplier. An increase in autonomous aggregate
expenditures shifts the aggregate demand curve to the right; a reduction shifts it to
the left.

KEY TAKEAWAYS• There will be a different aggregate expenditures curve for each pricelevel.
• Aggregate expenditures will vary with the price level because of thewealth effect, the interest rate effect, and the international trade effect.
The higher the price level, the lower the aggregate expenditures curve
and the lower the equilibrium level of real GDP. The lower the pricelevel, the higher the aggregate expenditures curve and the higher theequilibrium level of real GDP.
• A change in autonomous aggregate expenditures shifts the aggregate
expenditures curve for each price level. That shifts the aggregate
demand curve by an amount equal to the change in autonomous
aggregate expenditures times the multiplier.

TRY IT!
Sketch three aggregate expenditures curves for price levels of P1, P2, and P3,
where P1 is the lowest price level and P3 the highest (you do not havenumbers for this exercise; simply sketch curves of the appropriate shape).
Label the equilibrium levels of real GDP Y1, Y2, and Y3. Now draw theaggregate demand curve implied by your analysis, labeling points that
correspond to P1, P2, and P3 and Y1, Y2, and Y3. You can use Figure 13.13"From Aggregate Expenditures to Aggregate Demand" as a model for yourwork.

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Case in Point: Predicting the Impact of Alternative Fiscal
Policies

Using a large-scale model of the U.S. economy to simulate the effects ofgovernment policies, Princeton University professor Alan Blinder and Moody
Analytics chief economist Mark Zandi concluded that the expansionary fiscal,monetary, and other policies aimed at relieving the financial crisis (such as theTroubled Asset Relief Program, or TARP) worked together from 2008 onward toeffectively combat the Great Recession and probably kept it from turning into
the Great Depression 2.0. Specifically, they estimated that U.S. GDP would havefallen about 12% peak-to-trough and that the unemployment rate would havehit 16.5% without these policies, instead of GDP declining about 4% and theunemployment rate reaching about 10%. While they attribute the bulk of the
improvement to monetary and other financial policies, they found that fiscal
policies also played a substantial role. For example, they concluded that fiscal
stimulus added more than 3% to real GDP in 2010.
How much did the different components of the fiscal policies contribute? The
following table provides estimates for the multiplied effects of various stimulus
measures that were considered. In general, they estimate a stronger “bang forthe buck,” or multiplier, from spending increases than from tax cuts.

Tax cuts

Bang for thebuckNonrefundable lump-sum tax rebate

1.01

Refundable lump-sum tax rebate

1.22

Temporary tax cuts
Payroll tax holiday

1.24

Across-the-board tax cut

1.02

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Accelerated depreciation

0.25

Permanent tax cuts
Extend alternative minimum tax patch

0.51

Make Bush income tax cuts permanent

0.32

Make dividend and capital gains tax cuts
permanent

0.32

Spending increases
Extending UI benefits

1.61

Temporary increase in food stamps

1.74

General aid to state governments

1.41

Increased infrastructure spending

1.57

While Blinder and Zandy acknowledge that no one can know for sure what
would have happened without the policy responses and that not all aspects ofthe programs were perfectly designed or implemented, they feel strongly thatthe aggressive policies were, overall, appropriate and worth taking.
Source: Alan S. Blinder and Mark Zandi, “How the Great Recession Was Brought
to an End,” Moody’s Economy.com, July 27, 2010.

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Chapter 13 Consumption and the Aggregate Expenditures ModelANSWER TO TRY IT! PROBLEM
The lowest price level, P1, corresponds to the highest AE curve, AEP = P1, asshown. This suggests a downward-sloping aggregate demand curve. Points
A, B, and C on the AE curve correspond to points A′, B′, and C′ on the AD
curve, respectively.

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Chapter 13 Consumption and the Aggregate Expenditures Model

SummaryThis chapter presented the aggregate expenditures model. Aggregate expenditures are the sum of planned levelsof consumption, investment, government purchases, and net exports at a given price level. The aggregate
expenditures model relates aggregate expenditures to the level of real GDP.
We began by observing the close relationship between consumption and disposable personal income. A
consumption function shows this relationship. The saving function can be derived from the consumptionfunction.
The time period over which income is considered to be a determinant of consumption is important. The current
income hypothesis holds that consumption in one period is a function of income in that same period. The
permanent income hypothesis holds that consumption in a period is a function of permanent income. An
important implication of the permanent income hypothesis is that the marginal propensity to consume will besmaller for temporary than for permanent changes in disposable personal income.
Changes in real wealth and consumer expectations can affect the consumption function. Such changes shift the
curve relating consumption to disposable personal income, the graphical representation of the consumptionfunction; changes in disposable personal income do not shift the curve but cause movements along it.
An aggregate expenditures curve shows total planned expenditures at each level of real GDP. This curve is usedin the aggregate expenditures model to determine the equilibrium real GDP (at a given price level). A change inautonomous aggregate expenditures produces a multiplier effect that leads to a larger change in equilibrium
real GDP. In a simplified economy, with only consumption and investment expenditures, in which the slope of
the aggregate expenditures curve is the marginal propensity to consume (MPC), the multiplier is equal to 1/(1 −MPC). Because the sum of the marginal propensity to consume and the marginal propensity to save (MPS) is 1,
the multiplier in this simplified model is also equal to 1/MPS.
Finally, we derived the aggregate demand curve from the aggregate expenditures model. Each point on theaggregate demand curve corresponds to the equilibrium level of real GDP as derived in the aggregate
expenditures model for each price level. The downward slope of the aggregate demand curve (and the shifting of
the aggregate expenditures curve at each price level) reflects the wealth effect, the interest rate effect, and theinternational trade effect. A change in autonomous aggregate expenditures shifts the aggregate demand curveby an amount equal to the change in autonomous aggregate expenditures times the multiplier.
In a more realistic aggregate expenditures model that includes all four components of aggregate expenditures(consumption, investment, government purchases, and net exports), the slope of the aggregate expenditures
curve shows the additional aggregate expenditures induced by increases in real GDP, and the size of the

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multiplier depends on the slope of the aggregate expenditures curve. The steeper the aggregate expenditures
curve, the larger the multiplier; the flatter the aggregate expenditures curve, the smaller the multiplier.

CONCEPT PROBLEMS
1. Explain the difference between autonomous and induced expenditures.
Give examples of each.
2. The consumption function we studied in the chapter predicted that
consumption would sometimes exceed disposable personal income. How
could this be?
3. The consumption function can be represented as a table, as an equation,or as a curve. Distinguish among these three representations.
4. The introduction to this chapter described the behavior of consumer
spending at the end of 2008. Explain this phenomenon in terms of theanalysis presented in this chapter.
5. Explain the role played by the 45-degree line in the aggregate
expenditures model.
6. Your college or university, if it does what many others do, occasionallyreleases a news story claiming that its impact on the total employment
in the local economy is understated by its own employment statistics. If
the institution keeps accurate statistics, is that possible?
7. Suppose the level of investment in a certain economy changes when thelevel of real GDP changes; an increase in real GDP induces an increase ininvestment, while a reduction in real GDP causes investment to fall. How
do you think such behavior would affect the slope of the aggregate
expenditures curve? The multiplier?
8. Give an intuitive explanation for how the multiplier works on a
reduction in autonomous aggregate expenditures. Why does equilibrium
real GDP fall by more than the change in autonomous aggregate
expenditures?
9. Explain why the marginal propensity to consume out of a temporary tax
rebate would be lower than that for a permanent rebate.
10. Pretend you are a member of the Council of Economic Advisers and aretrying to persuade the members of the House Appropriations Committee
to purchase $100 billion worth of new materials, in part to stimulate theeconomy. Explain to the members how the multiplier process will work.

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NUMERICAL PROBLEMS

1. Suppose the following information describes a simple economy.
Figures are in billion of dollars.
Disposable personal income Consumption

a.
b.
c.
d.

0

100

100

120

200

140

300

160

What is the marginal propensity to consume?
What is the marginal propensity to save?
Write an equation that describes consumption.
Write an equation that describes saving.

2. The graph below shows a consumption function.

a. When disposable personal income is equal to zero, how muchis consumption?
b. When disposable personal income is equal to $4,000 billion,
how much is consumption?
c. At what level of personal disposable income are consumption
and disposable personal income equal?
d. How much is personal saving when consumption is $2,500
billion?
e. How much is personal saving when consumption is $5,000
billion?
f. What is the marginal propensity to consume?
g. What is the marginal propensity to save?

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Chapter 13 Consumption and the Aggregate Expenditures Modelh. Draw the saving function implied by the consumptionfunction above.
3. For the purpose of this exercise, assume that the consumptionfunction is given by C = $500 billion + 0.8Yd. Construct a
consumption and saving table showing how income is divided
between consumption and personal saving when disposable
personal income (in billions) is $0, $500, $1,000, $1,500, $2,000,$2,500, $3,000, and $3,500.
a. Graph your results, placing disposable personal income on
the horizontal axis and consumption on the vertical axis.
b. What is the value of the marginal propensity to consume?
c. What is the value of the marginal propensity to save?
4. The graph below characterizes a simple economy with only two
components of aggregate expenditures, consumption andinvestment.

a. How much is planned investment? How do you know?
b. Is planned investment autonomous or induced? How do youknow?
c. How much is autonomous aggregate expenditures?
d. What is the value of equilibrium real GDP?
e. If real GDP were $2,000 billion, how much would unplanned
investment be? How would you expect firms to respond?
f. If real GDP were $4,000 billion, how much would unplanned
investment be? How would you expect firms to respond?
g. Write an equation for aggregate expenditures based on thegraph above.
h. What is the value of the multiplier in this example?

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5. Explain and illustrate graphically how each of the following
events affects aggregate expenditures and equilibrium real GDP.
In each case, state the nature of the change in aggregate
expenditures, and state the relationship between the change in
AE and the change in equilibrium real GDP.
a. Investment falls.
b. Government purchases go up.
c. The government sends $1,000 to every person in the UnitedStates.
d. Real GDP rises by $500 billion.
6. Mary Smith, whose marginal propensity to consume is 0.75, is faced withan unexpected increase in taxes of $1,000. Will she cut back her
consumption expenditures by the full $1,000? How will she pay for thehigher tax? Explain.
7. The equations below give consumption functions for economies
in which planned investment is autonomous and is the only
other component of GDP. Compute the marginal propensity toconsume and the multiplier for each economy.
a.
b.
c.
d.

C = $650 + 0.33Y
C = $180 + 0.9Y
C = $1,500
C = $700 + 0.8Y

8. Suppose that in Economies A and B the only components of aggregate
expenditure are consumption and planned investment. The marginal
propensity to consume in Economy A is 0.9, while in Economy B it is 0.7.
Both economies experience an increase in planned investment, which isassumed to be autonomous, of $100 billion. Compare the changes in theequilibrium level of real GDP and the shifts in aggregate demand thiswill produce in the two economies.
9. Assume an economy in which people would spend $200 billion on
consumption even if real GDP were zero and, in addition,
increase their consumption by $0.50 for each additional $1 of realGDP. Assume further that the sum of planned investment plus
government purchases plus net exports is $200 billion regardlessof the level of real GDP.
a. What is the equilibrium level of income in this economy?

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Chapter 13 Consumption and the Aggregate Expenditures Modelb. If the economy is currently operating at an output level of$1,200 billion, what do you predict will happen to real GDP in
the future?
10. Suppose the aggregate expenditures curve in Numerical Problem 9 isdrawn for a price level of 1.2. A reduction in the price level to 1
increases aggregate expenditures by $400 billion at each level of realGDP. Draw the implied aggregate demand curve.

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Investment and Economic Activity
Start Up: Jittery Firms Slash Investment
In the recession that began in late 2007 in the United States, the first main elementof GDP that faltered was the part of investment called residential structures. Whenhousing prices started falling in 2006, new home construction slowed down. In 2008,
this sector had shrunk by more than 40% from where it had been just a few years
earlier.
In 2008, the part of investment that reflects business spending on equipment
ranging from computers to machines to trucks also turned down. The only majorpart of investment left standing was business spending on structures—factories,
hospitals, office buildings, and such. In late 2008, firms around the world seemed to
be trying to outdo each other in announcing cutbacks.
Among automakers, it was not just the Detroit 3 cutting back. Toyota announced an
indefinite delay in building a Prius hybrid sedan plant in Mississippi.Kate
Linebaugh, “Toyota Delays Mississippi Prius Factor Amid Slump,” Wall Street Journal,
December 16, 2008, p. B1. Walgreen’s, which had been increasing drugstore
locations by about 8% a year, said it would expand by only about 4% in 2009 and byless than 3% in 2010.Amy Merrick, “Walgreen to Cut Back on Opening New Stores,”
Wall Street Journal, December 23, 2008, p. B1. Package carrier FedEx announced a 20%
decline in capital spending, on top of suspending pension contributions and cutting
salaries.Darren Shannon, “FedEx Takes More Measures to Offset Fiscal
Uncertainty,” Aviation Daily, December 19, 2008, p. 6. Even hospitals began scaling
back on construction.Reed Abelson, “Hurting for Business,” New York Times,
November 7, 2008, p. B1.
Companies around the world were announcing similar cutbacks. Consumer
electronics maker Sony announced is was not only closing plants but also notmoving forward in constructing an LCD television plant in Slovakia.Bettina
Wassener, “Sony to Cut 8,000 Workers and Shut Plants,” New York Times, December
10, 2008, p. B8. With the drop in oil prices, oil companies were also cancelling
planned projects right and left.Steve LeVine, “Pullback in the Oil Patch,” Business
Week, December 8, 2008, p. 60.

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Choices about how much to invest must always be made in the face of uncertainty;
firms cannot know what the marketplace has in store. Investment is a gamble; firmsthat make the gamble hope for a profitable payoff. And, if they are concerned thatthe payoff may not materialize, they will be quick to take the kinds of actions cited
above—to slash investment spending.
Private investment plays an important role, not only in the short run, by
influencing aggregate demand, but also in the long run, for it influences the rate at
which the economy grows. That is, it influences long-run aggregate supply.
In this chapter, we will examine factors that determine investment by firms, and wewill study its relationship to output in the short run and in the long run. One
determinant of investment is public policy; we will examine the ways in which
public policy affects investment.
Private firms are not the only source of investment; government agencies engage ininvestment as well. We examined the impact of the public sector on macroeconomic
performance in the chapter devoted to fiscal policy. When we refer to “investment”
in this chapter, we will be referring to investment carried out in the private sector.

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14.1 The Role and Nature of Investment
LEARNING OBJECTIVES
1. Discuss the components of the investment spending category of GDP anddistinguish between gross and net investment.
2. Discuss the relationship between consumption, saving, and investment,
and explain the relationship using the production possibilities model.

How important is investment? Consider any job you have ever performed. Your
productivity in that job was largely determined by the investment choices that had
been made before you began to work. If you worked as a clerk in a store, theequipment used in collecting money from customers affected your productivity. It
may have been a simple cash register, or a sophisticated computer terminal thatscanned purchases and was linked to the store’s computer, which computed thestore’s inventory and did an analysis of the store’s sales as you entered each sale. If
you have worked for a lawn maintenance firm, the kind of equipment you had towork with influenced your productivity. You were more productive if you had thelatest mulching power lawn mowers than if you struggled with a push mower.
Whatever the work you might have done, the kind and quality of capital you had towork with strongly influenced your productivity. And that capital was available
because investment choices had provided it.
Investment adds to the nation’s capital stock. We saw in the chapter on economic
growth that an increase in capital shifts the aggregate production function
outward, increases the demand for labor, and shifts the long-run aggregate supply
curve to the right. Investment therefore affects the economy’s potential output andthus its standard of living in the long run.
Investment is a component of aggregate demand. Changes in investment shift theaggregate demand curve and thus change real GDP and the price level in the shortrun. An increase in investment shifts the aggregate demand curve to the right; areduction shifts it to the left.

Components of Investment
Additions to the stock of private capital are called Gross Private Domestic
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1. Nonresidential Structures. This category of investment includes theconstruction of business structures such as private office buildings,
warehouses, factories, private hospitals and universities, and otherstructures in which the production of goods and services takes place. A
structure is counted as GPDI only during the period in which it is built.
It may be sold several times after being built, but such sales are notcounted as investment. Recall that investment is part of GDP, and GDP
is the value of production in any period, not total sales.
2. Nonresidential Equipment and Software. Producers’ equipment
includes computers and software, machinery, trucks, cars, and desks,
that is, any business equipment that is expected to last more than ayear. Equipment and software are counted as investment only in the
period in which they are produced.
3. Residential Investment. This category includes all forms of residential
construction, whether apartment houses or single-family homes, aswell as residential equipment such as computers and software.
4. Change in Private Inventories. Private inventories are considered partof the nation’s capital stock, because those inventories are used to
produce other goods. All private inventories are capital; additions to
private inventories are thus investment. When private inventories fall,that is recorded as negative investment.
Figure 14.1 "Components of Gross Private Domestic Investment, 1995–2011" shows
the components of gross private domestic investment from 1995 through 2011. We
see that producers’ equipment and software constitute the largest component of
GPDI in the United States. Residential investment was the second largest
component of GPDI for most of the period shown but it shrank considerably during
the 2007–2009 recession and has yet to recover.

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Figure 14.1 Components of Gross Private Domestic Investment, 1995–2011

This chart shows the levels of each of the four components of gross private domestic investment from 1995 through2011. Nonresidential equipment and software is the largest component of GPDI and has shown the most substantial
growth over the period.
Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised February 29, 2012).

Gross and Net Investment
As capital is used, some of it wears out or becomes obsolete; it depreciates (theCommerce Department reports depreciation as “consumption of fixed capital”).
Investment adds to the capital stock, and depreciation reduces it. Gross investment
minus depreciation is net investment. If gross investment is greater thandepreciation in any period, then net investment is positive and the capital stockincreases. If gross investment is less than depreciation in any period, then net
investment is negative and the capital stock declines.
In the official estimates of total output, gross investment (GPDI) minus depreciation
equals net private domestic investment (NPDI). The value for NPDI in any period

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gives the amount by which the privately held stock of physical capital changed
during that period.
Figure 14.2 "Gross Private Domestic Investment, Depreciation, and Net Private
Domestic Investment, 1990–2011" reports the real values of GPDI, depreciation, and
NPDI from 1990 to 2011. We see that the bulk of GPDI replaces capital that has been
depreciated. Notice the sharp reductions in NPDI during the recessions of
1990–1991, 2001, and especially 2007–2009.
Figure 14.2 Gross Private Domestic Investment, Depreciation, and Net Private Domestic Investment, 1990–2011

The bulk of gross private domestic investment goes to the replacement of capital that has depreciated, as shown by
the experience of the past two decades.
Source: Bureau of Economic Analysis, NIPA Table 5.2.6 (revised February 29, 2012).

The Volatility of Investment
Investment, measured as GPDI, is among the most volatile components of GDP. In
percentage terms, year-to-year changes in GPDI are far greater than the year-toyear changes in consumption or government purchases. Net exports are also quite
volatile, but they represent a much smaller share of GDP. Figure 14.3 "Changes in
Components of Real GDP, 1990–2011" compares annual percentage changes in GPDI,

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personal consumption, and government purchases. Of course, a dollar change ininvestment will be a much larger change in percentage terms than a dollar change
in consumption, which is the largest component of GDP. But compare investment
and government purchases: their shares in GDP are comparable, but investment isclearly more volatile.
Figure 14.3 Changes in Components of Real GDP, 1990–2011

Annual percentage changes in real GPDI have been much greater than annual percentage changes in the real valuesof personal consumption or government purchases.
Source: Bureau of Economic Analysis, NIPA Table 1.1.1 (revised February 29, 2012).

Given that the aggregate demand curve shifts by an amount equal to the multipliertimes an initial change in investment, the volatility of investment can cause real
GDP to fluctuate in the short run. Downturns in investment may trigger recessions.

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Investment, Consumption, and Saving
Earlier we used the production possibilities curve to illustrate how choices are
made about investment, consumption, and saving. Because such choices are crucial
to understanding how investment affects living standards, it will be useful toreexamine them here.
Figure 14.4 "The Choice between Consumption and Investment" shows a production
possibilities curve for an economy that can produce two kinds of goods:
consumption goods and investment goods. An economy operating at point A on
PPC1 is using its factors of production fully and efficiently. It is producing CA unitsof consumption goods and IA units of investment each period. Suppose that
depreciation equals IA, so that the quantity of investment each period is justsufficient to replace depreciated capital; net investment equals zero. If there is nochange in the labor force, in natural resources, or in technology, the production
possibilities curve will remain fixed at PPC1.
Now suppose decision makers in this economy decide tosacrifice the production of some consumption goods infavor of greater investment. The economy moves topoint B on PPC1. Production of consumption goods falls
to CB, and investment rises to IB. Assuming depreciation
remains IA, net investment is now positive. As thenation’s capital stock increases, the production
possibilities curve shifts outward to PPC2. Once that shift
occurs, it will be possible to select a point such as D on
the new production possibilities curve. At this point,
consumption equals CD, and investment equals ID. By
sacrificing consumption early on, the society is able toincrease both its consumption and investment in the
future. That early reduction in consumption requires anincrease in saving.
We see that a movement along the production
possibilities curve in the direction of the production of
more investment goods and fewer consumption goods
allows the production of more of both types of goods inthe future.

14.1 The Role and Nature of Investment

Figure 14.4 The Choice
between Consumption and
Investment

A society with production
possibilities curve PPC1 could
choose to produce at point A,
producing CA consumption goods
and investment of IA. If
depreciation equals IA, then net
investment is zero, and the
production possibilities curve
will not shift, assuming no other
determinants of the curvechange. By cutting its productionof consumption goods and577

Chapter 14 Investment and Economic Activity

increasing investment to IB,
however, the society can, overtime, shift its production
possibilities curve out to PPC2,
making it possible to enjoy
greater production of
consumption goods in the future.

KEY TAKEAWAYS• Investment adds to the nation’s capital stock.
• Gross private domestic investment includes the construction of
nonresidential structures, the production of equipment and software,
private residential construction, and changes in inventories.
• The bulk of gross private domestic investment goes to the replacementof depreciated capital.
• Investment is the most volatile component of GDP.
• Investment represents a choice to postpone consumption—it requires
saving.

TRY IT!
Which of the following would be counted as gross private domestic
investment?
1.
2.
3.
4.

14.1 The Role and Nature of Investment

Millie hires a contractor to build a new garage for her home.
Millie buys a new car for her teenage son.
Grandpa buys Tommy a savings bond.
General Motors builds a new automobile assembly plant.

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Case in Point: The Reduction of Private Capital in the
Depression and in the Great Recession

Net private domestic investment (NPDI) has been negative during only three
periods in the last 80 years. During one period, World War II, massive defense
spending forced cutbacks in private sector spending. (Recall that government
investment is not counted as part of net private domestic investment in theofficial accounts; production of defense capital thus is not reflected in thesefigures.) The second period in which NPDI was negative was the Great
Depression.
Aggregate demand plunged during the first four years of the Depression. As
firms cut their output in response to reductions in demand, their need forcapital fell as well. They reduced their capital by holding gross private domestic
investment below depreciation beginning in 1931. That produced negative net
private domestic investment; it remained negative until 1936 and became
negative again in 1938. In all, firms reduced the private capital stock by morethan $529.5 billion (in 2007 dollars) during the period.

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A third—very brief and very small—encounter with negative net private
domestic investment occurred in 2009, when it fell by $1 billion (in 2005
dollars).
The two graphs in this case present a contrast between the Great Depression
and the Great Recession. The Great Recession was bad, but the Great Depression
was ever so much worse.

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ANSWERS TO TRY IT! PROBLEMS
1. A new garage would be part of residential construction and thus part of
GPDI.
2. Consumer purchases of cars are part of the consumption component of
the GDP accounts and thus not part of GPDI.
3. The purchase of a savings bond is an example of a financial investment.
Since it is not an addition to the nation’s capital stock, it is not part of
GPDI.
4. The construction of a new factory is counted in the nonresidential
structures component of GPDI.

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14.2 Determinants of Investment
LEARNING OBJECTIVES
1. Draw a hypothetical investment demand curve, and explain what it
shows about the relationship between investment and the interest rate.
2. Discuss the factors that can cause an investment demand curve to shift.

We will see in this section that interest rates play a key role in the determination of
the desired stock of capital and thus of investment. Because investment is a process
through which capital is increased in one period for use in future periods,
expectations play an important role in investment as well.
Capital is one factor of production, along with labor and natural resources. A
decision to invest is a decision to use more capital in producing goods and services.
Factors that affect firms’ choices in the mix of capital, labor, and natural resources
will affect investment as well.
We will also see in this section that public policy affects investment. Some
investment is done by government agencies as they add to the public stock of
capital. In addition, the tax and regulatory policies chosen by the public sector canaffect the investment choices of private firms and individuals.

Interest Rates and Investment
We often hear reports that low interest rates have stimulated housing constructionor that high rates have reduced it. Such reports imply a negative relationshipbetween interest rates and investment in residential structures. This relationshipapplies to all forms of investment: higher interest rates tend to reduce the quantityof investment, while lower interest rates increase it.
To see the relationship between interest rates and investment, suppose you own asmall factory and are considering the installation of a solar energy collection
system to heat your building. You have determined that the cost of installing thesystem would be $10,000 and that the system would lower your energy bills by$1,000 per year. To simplify the example, we shall suppose that these savings willcontinue forever and that the system will never need repair or maintenance. Thus,
we need to consider only the $10,000 purchase price and the $1,000 annual savings.

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If the system is installed, it will be an addition to the capital stock and will therefore
be counted as investment. Should you purchase the system?
Suppose that your business already has the $10,000 on hand. You are considering
whether to use the money for the solar energy system or for the purchase of a bond.
Your decision to purchase the system or the bond will depend on the interest rate
you could earn on the bond.
Putting $10,000 into the solar energy system generates an effective income of $1,000
per year—the saving the system will produce. That is a return of 10% per year.
Suppose the bond yields a 12% annual interest. It thus generates interest income of$1,200 per year, enough to pay the $1,000 in heating bills and have $200 left over. At
an interest rate of 12%, the bond is the better purchase. If, however, the interest
rate on bonds were 8%, then the solar energy system would yield a higher income
than the bond. At interest rates below 10%, you will invest in the solar energy
system. At interest rates above 10%, you will buy a bond instead. At an interest rateof precisely 10%, it is a toss-up.
If you do not have the $10,000 on hand and would need to borrow the money topurchase the solar energy system, the interest rate still governs your decision. Atinterest rates below 10%, it makes sense to borrow the money and invest in thesystem. At interest rates above 10%, it does not.
In effect, the interest rate represents the opportunity cost of putting funds into thesolar energy system rather than into a bond. The cost of putting the $10,000 into
the system is the interest you would forgo by not purchasing the bond.
At any one time, millions of investment choices hinge on the interest rate. Eachdecision to invest will make sense at some interest rates but not at others. The
higher the interest rate, the fewer potential investments will be justified; the lower
the interest rate, the greater the number that will be justified. There is thus anegative relationship between the interest rate and the level of investment.

1. A curve that shows thequantity of investment
demanded at each interest
rate, with all other
determinants of investment
unchanged.

14.2 Determinants of Investment

Figure 14.5 "The Investment Demand Curve" shows an investment demand curve1
for the economy—a curve that shows the quantity of investment demanded at eachinterest rate, with all other determinants of investment unchanged. At an interest
rate of 8%, the level of investment is $950 billion per year at point A. At a lower
interest rate of 6%, the investment demand curve shows that the quantity ofinvestment demanded will rise to $1,000 billion per year at point B. A reduction in
the interest rate thus causes a movement along the investment demand curve.

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Figure 14.5 The Investment Demand Curve

The investment demand curve shows the volume of investment spending per year at each interest rate, assuming allother determinants of investment are unchanged. The curve shows that as the interest rate falls, the level ofinvestment per year rises. A reduction in the interest rate from 8% to 6%, for example, would increase investment
from $950 billion to $1,000 billion per year, all other determinants of investment unchanged.

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Heads Up!
To make sense of the relationship between interest rates and investment, youmust remember that investment is an addition to capital, and that capital issomething that has been produced in order to produce other goods andservices. A bond is not capital. The purchase of a bond is not an investment. We
can thus think of purchasing bonds as a financial investment—that is, as analternative to investment. The more attractive bonds are (i.e., the higher theirinterest rate), the less attractive investment becomes. If we forget thatinvestment is an addition to the capital stock and that the purchase of a bond is
not investment, we can fall into the following kind of error: “Higher interest
rates mean a greater return on bonds, so more people will purchase them.
Higher interest rates will therefore lead to greater investment.” That is a
mistake, of course, because the purchase of a bond is not an investment. Higher
interest rates increase the opportunity cost of using funds for investment. They
reduce investment.

Other Determinants of Investment Demand
Perhaps the most important characteristic of the investment demand curve is not
its negative slope, but rather the fact that it shifts often. Although investment
certainly responds to changes in interest rates, changes in other factors appear toplay a more important role in driving investment choices.
This section examines eight additional determinants of investment demand:
expectations, the level of economic activity, the stock of capital, capacity
utilization, the cost of capital goods, other factor costs, technological change, andpublic policy. A change in any of these can shift the investment demand curve.

Expectations
A change in the capital stock changes future production capacity. Therefore, plansto change the capital stock depend crucially on expectations. A firm considers likely
future sales; a student weighs prospects in different occupations and their required
educational and training levels. As expectations change in a way that increases the
expected return from investment, the investment demand curve shifts to the right.
Similarly, expectations of reduced profitability shift the investment demand curveto the left.

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The Level of Economic Activity
Firms need capital to produce goods and services. An increase in the level ofproduction is likely to boost demand for capital and thus lead to greater
investment. Therefore, an increase in GDP is likely to shift the investment demand
curve to the right.
To the extent that an increase in GDP boosts investment, the multiplier effect of an
initial change in one or more components of aggregate demand will be enhanced.
We have already seen that the increase in production that occurs with an initial
increase in aggregate demand will increase household incomes, which will increase
consumption, thus producing a further increase in aggregate demand. If theincrease also induces firms to increase their investment, this multiplier effect will
be even stronger.

The Stock of Capital
The quantity of capital already in use affects the level of investment in two ways.
First, because most investment replaces capital that has depreciated, a greater
capital stock is likely to lead to more investment; there will be more capital toreplace. But second, a greater capital stock can tend to reduce investment. That is
because investment occurs to adjust the stock of capital to its desired level. Given
that desired level, the amount of investment needed to reach it will be lower when
the current capital stock is higher.
Suppose, for example, that real estate analysts expect that 100,000 homes will beneeded in a particular community by 2010. That will create a boom in
construction—and thus in investment—if the current number of houses is 50,000.
But it will create hardly a ripple if there are now 99,980 homes.
How will these conflicting effects of a larger capital stock sort themselves out?
Because most investment occurs to replace existing capital, a larger capital stock islikely to increase investment. But that larger capital stock will certainly act toreduce net investment. The more capital already in place, the less new capital will
be required to reach a given level of capital that may be desired.

Capacity Utilization

2. A measure of the percentage ofthe capital stock in use.

14.2 Determinants of Investment

The capacity utilization rate2 measures the percentage of the capital stock in use.
Because capital generally requires downtime for maintenance and repairs, themeasured capacity utilization rate typically falls below 100%. For example, the586Chapter 14 Investment and Economic Activity

average manufacturing capacity utilization rate was 79.7% for the period from 1972
to 2007. In November 2008 it stood at 72.3.
If a large percentage of the current capital stock is being utilized, firms are more
likely to increase investment than they would if a large percentage of the capitalstock were sitting idle. During recessions, the capacity utilization rate tends to fall.
The fact that firms have more idle capacity then depresses investment even further.
During expansions, as the capacity utilization rate rises, firms wanting to produce
more often must increase investment to do so.

The Cost of Capital Goods
The demand curve for investment shows the quantity of investment at each interest
rate, all other things unchanged. A change in a variable held constant in drawing
this curve shifts the curve. One of those variables is the cost of capital goods
themselves. If, for example, the construction cost of new buildings rises, then thequantity of investment at any interest rate is likely to fall. The investment demand
curve thus shifts to the left.
The $10,000 cost of the solar energy system in the example given earlier certainly
affects a decision to purchase it. We saw that buying the system makes sense atinterest rates below 10% and does not make sense at interest rates above 10%. If thesystem costs $5,000, then the interest return on the investment would be 20% (theannual saving of $1,000 divided by the $5,000 initial cost), and the investment would
be undertaken at any interest rate below 20%.

Other Factor Costs
Firms have a range of choices concerning how particular goods can be produced. A
factory, for example, might use a sophisticated capital facility and relatively few
workers, or it might use more workers and relatively less capital. The choice to use
capital will be affected by the cost of the capital goods and the interest rate, but it
will also be affected by the cost of labor. As labor costs rise, the demand for capitalis likely to increase.
Our solar energy collector example suggests that energy costs influence the demandfor capital as well. The assumption that the system would save $1,000 per year inenergy costs must have been based on the prices of fuel oil, natural gas, andelectricity. If these prices were higher, the savings from the solar energy system
would be greater, increasing the demand for this form of capital.

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Technological Change
The implementation of new technology often requires new capital. Changes intechnology can thus increase the demand for capital. Advances in computer
technology have encouraged massive investments in computers. The developmentof fiber-optic technology for transmitting signals has stimulated huge investments
by telephone and cable television companies.

Public Policy
Public policy can have significant effects on the demand for capital. Such policies
typically seek to affect the cost of capital to firms. The Kennedy administration
introduced two such strategies in the early 1960s. One strategy, accelerated
depreciation, allowed firms to depreciate capital assets over a very short period oftime. They could report artificially high production costs in the first years of anasset’s life and thus report lower profits and pay lower taxes. Accelerated
depreciation did not change the actual rate at which assets depreciated, of course,
but it cut tax payments during the early years of the assets’ use and thus reduced
the cost of holding capital.
The second strategy was the investment tax credit, which permitted a firm to
reduce its tax liability by a percentage of its investment during a period. A firm
acquiring new capital could subtract a fraction of its cost—10% under the Kennedy
administration’s plan—from the taxes it owed the government. In effect, thegovernment “paid” 10% of the cost of any new capital; the investment tax credit
thus reduced the cost of capital for firms.
Though less direct, a third strategy for stimulating investment would be a reduction
in taxes on corporate profits (called the corporate income tax). Greater after-tax
profits mean that firms can retain a greater portion of any return on an investment.
A fourth measure to encourage greater capital accumulation is a capital gains tax
rate that allows gains on assets held during a certain period to be taxed at adifferent rate than other income. When an asset such as a building is sold for morethan its purchase price, the seller of the asset is said to have realized a capital gain.
Such a gain could be taxed as income under the personal income tax. Alternatively,
it could be taxed at a lower rate reserved exclusively for such gains. A lower capitalgains tax rate makes assets subject to the tax more attractive. It thus increases thedemand for capital. Congress reduced the capital gains tax rate from 28% to 20% in
1996 and reduced the required holding period in 1998. The Jobs and Growth Tax
Relief Reconciliation Act of 2003 reduced the capital gains tax further to 15% andalso reduced the tax rate on dividends from 38% to 15%. A proposal to eliminate

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capital gains taxation for smaller firms was considered but dropped before thestimulus bill of 2009 was enacted.
Accelerated depreciation, the investment tax credit, and lower taxes on corporate
profits and capital gains all increase the demand for private physical capital. Public
policy can also affect the demands for other forms of capital. The federal
government subsidizes state and local government production of transportation,
education, and many other facilities to encourage greater investment in public
sector capital. For example, the federal government pays 90% of the cost ofinvestment by local government in new buses for public transportation.

KEY TAKEAWAYS• The quantity of investment demanded in any period is negatively
related to the interest rate. This relationship is illustrated by theinvestment demand curve.
• A change in the interest rate causes a movement along the investment
demand curve. A change in any other determinant of investment causesa shift of the curve.
• The other determinants of investment include expectations, the level of
economic activity, the stock of capital, the capacity utilization rate, thecost of capital goods, other factor costs, technological change, andpublic policy.

TRY IT!
Show how the investment demand curve would be affected by each of thefollowing:
1. A sharp increase in taxes on profits earned by firms
2. An increase in the minimum wage
3. The expectation that there will be a sharp upsurge in the level of
economic activity
4. An increase in the cost of new capital goods
5. An increase in interest rates
6. An increase in the level of economic activity
7. A natural disaster that destroys a significant fraction of the capital stock

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Case in Point: Assessing the Impact of a One-Year Tax
Break on Investment

The U.S. economy was expanding in 2004, but there was a feeling that it still
was not functioning as well as it could, as job growth was rather sluggish. To try
to spur growth, Congress, supported by President Bush, passed a law in 2004
called the American Jobs Creation Act that gave businesses a one-year special
tax break on any profits accumulating overseas that were transferred to theUnited States. Such profits are called repatriated profits and were estimated at
the time to be about $800 billion. For 2005, the tax rate on repatriated profits
essentially fell from 25% to 5.25%.
Did the tax break have the desired effect on the economy? To some extent yes,though business also found other uses for the repatriated funds. There were 843
companies that repatriated $312 billion that qualified for the tax break. The Act
thus generated about $18 billion in tax revenue, a higher level than had been
expected. Some companies announced they were repatriating profits andcontinuing to downsize. For example, Colgate-Palmolive brought back $800
million and made known it was closing a third of its factories and eliminating
12% of its workforce. However, other companies’ plans seemed more in linewith the objectives of the special tax break—to create jobs and spur investment.
For example, spokesman Chuck Mulloy of Intel, which repatriated over $6
billion, said the company was building a $3-billion wafer fabrication facility andspending $345 million on expanding existing facilities. “I can’t say dollar-fordollar how much of the funding for those comes from off-shore cash,” but hefelt that the repatriated funds were contributing to Intel’s overall investments.
Spokeswoman Margaret Graham of Bausch and Lomb, which makes eye-care
products and repatriated $805 million, said, “We plan to use that cash for14.2 Determinants of Investment

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capital expenditures, investment in research and development, and paying
nonofficer compensation.”
Analysts are skeptical, though, that the repatriated profits really contributed toinvestment. The New York Times reported on one study that suggested it had
not. Rather, the repatriated funds were used for other purposes, such as stock
repurchases. The argument is that the companies made investments that they
were planning to make and the repatriated funds essentially freed up fundingfor other purposes.
Sources: Timothy Aeppel, “Tax Break Brings Billion to U.S., But Impact on
Hiring Is Unclear,” Wall Street Journal, October 5, 2005, p. A1; Lynnley Browning,“A One-Time Tax Break Saved 843 U.S. Corporations $265 Billion,” New YorkTimes, June 24, 2008, p. C3.

ANSWERS TO TRY IT! PROBLEMS
1. The investment demand curve shifts to the left: Panel (b).
2. A higher minimum wage makes labor more expensive. Firms are likely
to shift to greater use of capital, so the investment demand curve shifts
to the right: Panel (a).
3. The investment demand curve shifts to the right: Panel (a).
4. The investment demand curve shifts to the left: Panel (b).
5. An increase in interest rates causes a movement along the investment
demand curve: Panel (c).
6. The investment demand curve shifts to the right: Panel (a).
7. The need to replace capital shifts the investment demand curve to theright: Panel (a).

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14.3 Investment and the Economy
LEARNING OBJECTIVES
1. Explain how investment affects aggregate demand.
2. Explain how investment affects economic growth.

We shall examine the impact of investment on the economy in the context of themodel of aggregate demand and aggregate supply. Investment is a component of
aggregate demand; changes in investment shift the aggregate demand curve by theamount of the initial change times the multiplier. Investment changes the capitalstock; changes in the capital stock shift the production possibilities curve and theeconomy’s aggregate production function and thus shift the long- and short-run
aggregate supply curves to the right or to the left.

Investment and Aggregate Demand
In the short run, changes in investment cause aggregate demand to change.
Consider, for example, the impact of a reduction in the interest rate, given theinvestment demand curve (ID). In Figure 14.6 "A Change in Investment andAggregate Demand", Panel (a), which uses the investment demand curve introducedin Figure 14.5 "The Investment Demand Curve", a reduction in the interest ratefrom 8% to 6% increases investment by $50 billion per year. Assume that themultiplier is 2. With an increase in investment of $50 billion per year and amultiplier of 2, the aggregate demand curve shifts to the right by $100 billion to AD2
in Panel (b). The quantity of real GDP demanded at each price level thus increases.
At a price level of 1.0, for example, the quantity of real GDP demanded rises from
$8,000 billion to $8,100 billion per year.

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Figure 14.6 A Change in Investment and Aggregate Demand

A reduction in the interest rate from 8% to 6% increases the level of investment by $50 billion per year in Panel (a).
With a multiplier of 2, the aggregate demand curve shifts to the right by $100 billion in Panel (b). The total quantityof real GDP demanded increases at each price level. Here, for example, the quantity of real GDP demanded at a pricelevel of 1.0 rises from $8,000 billion per year at point C to $8,100 billion per year at point D.

A reduction in investment would shift the aggregate demand curve to the left by anamount equal to the multiplier times the change in investment.
The relationship between investment and interest rates is one key to theeffectiveness of monetary policy to the economy. When the Fed seeks to increase
aggregate demand, it purchases bonds. That raises bond prices, reduces interest
rates, and stimulates investment and aggregate demand as illustrated in Figure 14.6
"A Change in Investment and Aggregate Demand". When the Fed seeks to decrease
aggregate demand, it sells bonds. That lowers bond prices, raises interest rates, andreduces investment and aggregate demand. The extent to which investment
responds to a change in interest rates is a crucial factor in how effective monetary
policy is.

Investment and Economic Growth
Investment adds to the stock of capital, and the quantity of capital available to an
economy is a crucial determinant of its productivity. Investment thus contributes toeconomic growth. We saw in Figure 14.4 "The Choice between Consumption and
Investment" that an increase in an economy’s stock of capital shifts its production
possibilities curve outward. (Recall from the chapter on economic growth that it
also shifts the economy’s aggregate production function upward.) That also shifts

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its long-run aggregate supply curve to the right. At the same time, of course, anincrease in investment affects aggregate demand, as we saw in Figure 14.6 "AChange in Investment and Aggregate Demand".

KEY TAKEAWAYS• Changes in investment shift the aggregate demand curve to the right orleft by an amount equal to the initial change in investment times themultiplier.
• Investment adds to the capital stock; it therefore contributes toeconomic growth.

TRY IT!
The text notes that rising investment shifts the aggregate demand curve tothe right and at the same time shifts the long-run aggregate supply curve tothe right by increasing the nation’s stock of physical and human capital.
Show this simultaneous shifting in the two curves with three graphs. One
graph should show growth in which the price level rises, one graph should
show growth in which the price level remains unchanged, and anothershould show growth with the price level falling.

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Case in Point: Investment by Businesses Saves theAustralian Expansion

With consumer and export spending faltering in 2005, increased business
investment spending seemed to be keeping the Australian economy afloat.
“Corporate Australia is solidly behind the steering wheel of the Australianeconomy,” said Craig James, an economist for Commonwealth Securities, anAustralian Internet securities brokerage firm. “The clear message from thelatest investment survey is that corporate Australia is flush with cash and readyto spend,” he continued.
The data supported his conclusions. The level of investment spending inAustralia on new buildings, plant, and equipment was 17% higher in 2005 thanin 2004. Within the investment category, mining investment, spurred on byhigh prices for natural resources, was particularly strong.
Source: Scott Murdoch, “Equipment Investment Gives Boost to Economy,”
Courier Mail (Queensland, Australia), September 2, 2005, Finance section, p. 35.

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ANSWER TO TRY IT! PROBLEM
Panel (a) shows AD shifting by more than LRAS; the price level will rise in thelong run.
Panel (b) shows AD and LRAS shifting by equal amounts; the price level willremain unchanged in the long run.
Panel (c) shows LRAS shifting by more than AD; the price level falls in thelong run.

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14.4 Review and PracticeSummary
Investment is an addition to the capital stock. Investment may occur as a net addition to capital or as areplacement of depreciated capital. The bulk of investment spending in the United States falls into the latter
category. Investment is a highly volatile component of GDP.
The decision to save is linked directly to the decision to invest. If a nation is to devote a larger share of its
production to investment, then it must devote a smaller share to consumption, all other things unchanged. And
that requires people to save more.
Investment is affected by the interest rate; the negative relationship between investment and the interest rate isillustrated by the investment demand curve. The position of this curve is affected by expectations, the level of
economic activity, the stock of capital, the price of capital, the prices of other factors, technology, and public
policy.
Because investment is a component of aggregate demand, a change in investment shifts the aggregate demand
curve to the right or left. The amount of the shift will equal the initial change in investment times themultiplier.
In addition to its impact on aggregate demand, investment can also affect economic growth. Investment shifts
the production possibilities curve outward, shifts the economy’s aggregate production function upward, andshifts the long-run aggregate supply curve to the right.

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CONCEPT PROBLEMS

1. Which of the following would be counted as gross private
domestic investment?
a. General Motors issues 1 million shares of stock.
b. Consolidated Construction purchases 1,000 acres of land for aregional shopping center it plans to build in a few years.
c. A K-Mart store adds 1,000 T-shirts to its inventory.
d. Crew buys computers for its office staff.
e. Your family buys a house.
2. If saving dropped sharply in the economy, what would likely happen toinvestment? Why?
3. Suppose local governments throughout the United States increase theirtax on business inventories. What would you expect to happen to U.S.
investment? Why?
4. Suppose the government announces it will pay for half of any new
investment undertaken by firms. How will this affect the investment
demand curve?
5. White House officials often exude more confidence than they actually
feel about future prospects for the economy. Why might this be a goodstrategy? Are there any dangers inherent in it?
6. Suppose everyone expects investment to rise sharply in three months.
How would this expectation be likely to affect bond prices?
7. Suppose that every increase of $1 in real GDP automatically stimulates$0.20 in additional investment spending. How would this affect themultiplier?
8. If environmental resources were counted as part of the capital stock,
how would a major forest fire affect net investment?
9. In the Case in Point on reducing private capital in the Great Depression,
we saw that net investment was negative during that period. Could grossinvestment ever be negative? Explain.
10. The Case in Point on lowering the tax rate for one year for companies
that repatriated profits suggests that investment did not increase, eventhough company representatives are quoted as saying that they wereusing the repatriated profits for investment. Explain this seeming
contradiction.
11. Use the model of aggregate demand and aggregate supply to evaluate
the argument that an increase in investment would raise the standard ofliving.

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NUMERICAL PROBLEMS

1. Suppose a construction company is trying to decide whether tobuy a new nail gun. The table below shows the hypothetical costs
for the nail gun and the amount the gun will save the company
each year. Assume the gun will last forever. In each case,determine the highest interest rate the company should pay for aloan that makes purchase of the nail gun possible.
Cost

Savingsa. $1,000$100

b. $1,000$200

c. $1,000$300

2. A car company currently has capital stock of $100 million anddesires a capital stock of $110 million.
a. If it experiences no depreciation, how much will it need toinvest to get to its desired level of capital stock?
b. If its annual depreciation is 5%, how much will it need toinvest to get to its desired level?
c. If its annual depreciation is 10%, how much will it need toinvest to get to its desired level?
3. Burger World is contemplating installing an automated orderingsystem. The ordering system will allow Burger World topermanently replace five employees for an annual (andpermanent) cost savings of $100,000.
a. If the automated system cost $1,000,000, what is the rate of
return on the investment?
b. If the system cost $2,000,000, what would be its rate of
return?
c. If the government were to introduce an investment tax
credit that allows firms to deduct 10% of its investment fromits tax liability, what would happen to the rate of return if
the system costs $1,000,000?

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d. If Burger World has to pay 8% to borrow the funds topurchase the system, what is the most it should pay for thesystem? Assume that there is no investment tax credit.
4. The table below shows a number of investment projects and theireffective earned interest rates or returns. Given the market
interest rates shown below, identify which projects will be
undertaken and the total amount of investment spending thatwill ensue.
Project Return on project

a.
b.
c.
d.
e.
f.

Cost

A

30%

$1,000

B

28

500

C

22

2,500

D

17

1,000

E

8

750

F

4

1,200

20%
15%
10%
5%
3%
Sketch out the investment demand curve implied by thesedata.

5. The table below describes the amounts of investment fordifferent interest rates.
Interest rate Amount of investment (billions)14.4 Review and Practice

25%

$5

20

$10

15

$15

10

$20

5

$25

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Chapter 14 Investment and Economic Activity

a. Draw the investment demand curve for this economy.
b. Show the effect you would expect a decrease in the cost ofcapital goods to have on this investment demand curve.
c. Show the effect you would expect an investment tax credit tohave on this investment demand curve.
d. Show the effect you would expect a recession to have on thisinvestment demand curve.
6. Suppose real GDP in an economy equals its potential output of$2,000 billion, the multiplier is 2.5, investment is raised by $200
billion, and the increased investment does not affect theeconomy’s potential.
a. Show the short- and long-run effects of the change upon real
GDP and the price level, using the graphical framework forthe model of aggregate demand and aggregate supply.
b. Would real GDP rise by the multiplier times the change ininvestment in the short run? In the long run? Explain.
7. Use the information below to compute the levels of gross and net
private domestic investment. Data are in billions of dollars.
Change in business inventories $ 59.3
Residential construction 369.6
Producers’ durable equipment 691.3
Nonresidential structures 246.9
Depreciation 713.9
8. Complete the table, which shows investment in the United Statesin billions of 2000 chained dollars.

Yeara. 2005

14.4 Review and Practice

Gross private
domestic
investment

Depreciation

1,873.5

1,266.6

Net private
domestic
investment

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Year

Gross private
domestic
investmentb. 2006c. 200714.4 Review and Practice

1,809.7

Depreciation

Net private
domestic
investment

1,216.1

696.4
546.7

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Chapter 15
Net Exports and International FinanceStart Up: Currency Crises Shake the WorldIt became known as the “Asian Contagion,” and it swept the world as the 20th
century came to a close.
Japan, crippled by the threat of collapse of many of its banks, seemed stuck in arecessionary gap for most of the decade. Because Japan was a major market for theexports of economies throughout East Asia, the slump in Japan translated into
falling exports in neighboring economies. Slowed growth in a host of economies
that had grown accustomed to phenomenal growth set the stage for trouble
throughout the world.
The first crack appeared in Thailand, whose central bank had successfully
maintained a stable exchange rate between the baht, Thailand’s currency, and the
U.S. dollar. But weakened demand for Thai exports, along with concerns about thestability of Thai banks, put downward pressure on the baht. Thailand’s effort toshore up its currency ultimately failed, and the country’s central bank gave up theeffort in July of 1997. The baht’s value dropped nearly 20% in a single day.
Holders of other currencies became worried about their stability and began selling.
Central banks that, like Thailand’s, had held their currencies stable relative to thedollar, gave up their efforts as well. Malaysia quit propping up the ringgit less than
two weeks after the baht’s fall. Indonesia’s central bank gave up trying to hold therupiah’s dollar value a month later. South Korea let the won fall in November.
Currency crises continued to spread in 1998, capped by a spectacular plunge in the
Russian ruble. As speculators sold other currencies, they bought dollars, driving the
U.S. exchange rate steadily upward.
What was behind the currency crises that shook the world? How do changes in acountry’s exchange rate affect its economy? How can events such as the fall of thebaht and the ringgit spread to other countries?

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We will explore the answers to these questions by looking again at how changes in acountry’s exchange rate can affect its economy—and how changes in one economy
can spread to others. We will be engaged in a study of international finance1, thefield that examines the macroeconomic consequences of the financial flows
associated with international trade.
We will begin by reviewing the reasons nations trade. International trade has thepotential to increase the availability of goods and services to everyone. We will lookat the effects of trade on the welfare of people and then turn to the macroeconomic
implications of financing trade.

1. The field that examines themacroeconomic consequencesof the financial flows
associated with international
trade.

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Chapter 15 Net Exports and International Finance15.1 The International Sector: An Introduction
LEARNING OBJECTIVES
1. Discuss the main arguments economists make in support of free trade.
2. Explain the determinants of net exports and tell how each affects
aggregate demand.

How important is international trade?
Take a look at the labels on some of your clothing. You are likely to find that theclothes in your closet came from all over the globe. Look around any parking lot.
You may find cars from Japan, Korea, Sweden, Britain, Germany, France, andItaly—and even the United States! Do you use a computer? Even if it is an Americancomputer, its components are likely to have been assembled in Indonesia or in someother country. Visit the grocery store. Much of the produce may come from Latin
America and Asia.
The international market is important not just in terms of the goods and services it
provides to a country but also as a market for that country’s goods and services.
Because foreign demand for U.S. exports is almost as large as investment andgovernment purchases as a component of aggregate demand, it can be very
important in terms of growth. The increase in exports in 2011, for example,
accounted for about half of the gain in U.S. real GDP in that year.

The Case for Trade
International trade increases the quantity of goods and services available to theworld’s consumers. By allocating resources according to the principle ofcomparative advantage, trade allows nations to consume combinations of goods andservices they would be unable to produce on their own, combinations that lie
outside each country’s production possibilities curve.
A country has a comparative advantage in the production of a good if it can producethat good at a lower opportunity cost than can other countries. If each country
specializes in the production of goods in which it has a comparative advantage andtrades those goods for things in which other countries have a comparative605

Chapter 15 Net Exports and International Financeadvantage, global production of all goods and services will be increased. The result
can be higher levels of consumption for all.
If international trade allows expanded world production of goods and services, itfollows that restrictions on trade will reduce world production. That, in a nutshell,is the economic case for free trade. It suggests that restrictions on trade, such as atariff2, a tax imposed on imported goods and services, or a quota3, a ceiling on thequantity of specific goods and services that can be imported, reduce world living
standards.
The conceptual argument for free trade is a compelling one; virtually all economists
support policies that reduce barriers to trade. Economists were among the mostoutspoken advocates for the 1993 ratification of the North American Free Trade
Agreement (NAFTA), which virtually eliminated trade restrictions between Mexico,
the United States, and Canada, and the 2004 Central American Free Trade
Agreement (CAFTA), which did the same for trade between the United States,
Central America, and the Dominican Republic. They supported the 2007 free trade
agreement with Peru and the 2011 agreements with Colombia, Panama, and South
Korea. Most economists have also been strong supporters of worldwide reductions
in trade barriers, including the 1994 ratification of the General Agreement on
Tariffs and Trade (GATT), a pact slashing tariffs and easing quotas among 117
nations, including the United States, and the Doha round of World Trade
Organization negotiations, named after the site of the first meeting in Doha, Qatar,in 2001 and still continuing. In Europe, member nations of the European Union (EU)have virtually eliminated trade barriers among themselves, and 17 EU nations now
have a common currency, the euro, and a single central bank, the European Central
Bank, established in 1999. Trade barriers have also been slashed among the
economies of Latin America and of Southeast Asia. A treaty has been signed that
calls for elimination of trade barriers among the developed nations of the Pacific
Rim (including the United States and Japan) by 2010 (although this deadline was
missed) and among all Pacific rim nations by 2020.
The global embrace of the idea of free trade demonstrates the triumph of economic
ideas over powerful forces that oppose free trade. One source of opposition to free
trade comes from the owners of factors of production used in industries in which anation lacks a comparative advantage.
2. A tax imposed on imported
goods and services.
3. A ceiling on the quantity of
specific goods and services thatcan be imported, which
reduces world living standards.

A related argument against free trade is that it not only reduces employment insome sectors but also reduces employment in the economy as a whole. In the longrun, this argument is clearly wrong. The economy’s natural level of employment isdetermined by forces unrelated to trade policy, and employment moves to its
natural level in the long run.

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Chapter 15 Net Exports and International FinanceFurther, trade has no effect on real wage levels for the economy as a whole. The
equilibrium real wage depends on the economy’s demand for and supply curve oflabor. Trade affects neither.
In the short run, trade does affect aggregate demand. Net exports are one
component of aggregate demand; a change in net exports shifts the aggregate
demand curve and affects real GDP in the short run. All other things unchanged, areduction in net exports reduces aggregate demand, and an increase in net exports
increases it.
Protectionist sentiment always rises during recessions. Unlike what happened
during the Great Depression of the 1930s, there was a lot of talk during the GreatRecession about more protection, but most countries avoided imposing
substantially increased trade restrictions.

The Rising Importance of International Trade
International trade is important, and its importance is increasing. For example,
from 1990 to 2010, world output growth was about 3% per year on average, whileworld export growth averaged about 6% per year.
While international trade was rising around the world, it was playing a moresignificant role in the United States as well. In 1960, exports represented just 3.5%of real GDP; by 2011, exports accounted for more than 13% of real GDP. Figure 15.1
"U.S. Exports and Imports Relative to U.S. Real GDP, 1960–2011" shows the growthin exports and imports as a percentage of real GDP in the United States from 1960 to2011.
Why has world trade risen so spectacularly? Two factors have been important. First,
advances in transportation and communication have dramatically reduced the costsof moving goods around the globe. The development of shipping containerizationthat allows cargo to be moved seamlessly from trucks or trains to ships, whichbegan in 1956, drastically reduced the cost of moving goods around the world, by asmuch as 90%. As a result, the numbers of container ships and their capacities havemarkedly increased.For an interesting history of this remarkable development, see
Marc Levinson, The Box: How the Shipping Container Made the World Smaller and theWorld Economy Bigger (Princeton: Princeton University Press, 2006). Second, we havealready seen that trade barriers between countries have fallen and are likely tocontinue to fall.

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Figure 15.1 U.S. Exports and Imports Relative to U.S. Real GDP, 1960–2011

The chart shows exports and imports as a percentage of real GDP from 1960 through 2011.
Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised February 29, 2012).

Net Exports and the Economy
As trade has become more important worldwide, exports and imports have assumed
increased importance in nearly every country on the planet. We have alreadydiscussed the increased shares of U.S. real GDP represented by exports and byimports. We will find in this section that the economy both influences, and is
influenced by, net exports. First, we will examine the determinants of net exports
and then discuss the ways in which net exports affect aggregate demand.

Determinants of Net Exports
Net exports equal exports minus imports. Many of the same forces affect both
exports and imports, albeit in different ways.

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IncomeAs incomes in other nations rise, the people of those nations will be able to buy
more goods and services—including foreign goods and services. Any one country’s
exports thus will increase as incomes rise in other countries and will fall as incomesdrop in other countries.
A nation’s own level of income affects its imports the same way it affects
consumption. As consumers have more income, they will buy more goods andservices. Because some of those goods and services are produced in other nations,
imports will rise. An increase in real GDP thus boosts imports; a reduction in real
GDP reduces imports. Figure 15.2 "U.S. Real GDP and Imports, 1960–2011" shows therelationship between real GDP and the real level of import spending in the UnitedStates from 1960 through 2011. Notice that the observations lie close to a straightline one could draw through them and resemble a consumption function.
Figure 15.2 U.S. Real GDP and Imports, 1960–2011

The chart shows annual values of U.S. real imports and real GDP from 1960 through 2011. The observations lie quite
close to a straight line.
Source: Bureau of Economic Analysis, NIPA Table 1.1.6 (revised February 29, 2012).

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Relative Prices
A change in the price level within a nation simultaneously affects exports andimports. A higher price level in the United States, for example, makes U.S. exports
more expensive for foreigners and thus tends to reduce exports. At the same time, ahigher price level in the United States makes foreign goods and services relatively
more attractive to U.S. buyers and thus increases imports. A higher price level
therefore reduces net exports. A lower price level encourages exports and reduces
imports, increasing net exports. As we saw in the chapter that introduced theaggregate demand and supply model, the negative relationship between net exports
and the price level is called the international trade effect and is one reason for thenegative slope of the aggregate demand curve.

The Exchange Rate
The purchase of U.S. goods and services by foreign buyers generally requires thepurchase of dollars, because U.S. suppliers want to be paid in their own currency.
Similarly, purchases of foreign goods and services by U.S. buyers generally require
the purchase of foreign currencies, because foreign suppliers want to be paid in
their own currencies. An increase in the exchange rate means foreigners must pay
more for dollars, and must thus pay more for U.S. goods and services. It therefore
reduces U.S. exports. At the same time, a higher exchange rate means that a dollar
buys more foreign currency. That makes foreign goods and services cheaper for U.S.
buyers, so imports are likely to rise. An increase in the exchange rate should thus
tend to reduce net exports. A reduction in the exchange rate should increase net
exports.

Trade Policies
A country’s exports depend on its own trade policies as well as the trade policies ofother countries. A country may be able to increase its exports by providing someform of government assistance (such as special tax considerations for companies
that export goods and services, government promotional efforts, assistance withresearch, or subsidies). A country’s exports are also affected by the degree to which
other countries restrict or encourage imports. The United States, for example, hassought changes in Japanese policies toward products such as U.S.-grown rice. Japanbanned rice imports in the past, arguing it needed to protect its own producers.
That has been a costly strategy; consumers in Japan typically pay as much as 10times the price consumers in the United States pay for rice. Japan has given in topressure from the United States and other nations to end its ban on foreign rice aspart of the GATT accord. That will increase U.S. exports and lower rice prices inJapan.

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Similarly, a country’s imports are affected by its trade policies and by the policies of
its trading partners. A country can limit its imports of some goods and services by
imposing tariffs or quotas on them—it may even ban the importation of some items.
If foreign governments subsidize the manufacture of a particular good, thendomestic imports of the good might increase. For example, if the governments ofcountries trading with the United States were to subsidize the production of steel,then U.S. companies would find it cheaper to purchase steel from abroad than athome, increasing U.S. imports of steel.

Preferences and Technology
Consumer preferences are one determinant of the consumption of any good orservice; a shift in preferences for a foreign-produced good will affect the level ofimports of that good. The preference among the French for movies and music
produced in the United States has boosted French imports of these services. Indeed,
the shift in French preferences has been so strong that the government of France,
claiming a threat to its cultural heritage, has restricted the showing of films
produced in the United States. French radio stations are fined if more than 40% of
the music they play is from “foreign” (in most cases, U.S.) rock groups.
Changes in technology can affect the kinds of capital firms import. Technologicalchanges have changed production worldwide toward the application of computers
to manufacturing processes, for example. This has led to increased demand forhigh-tech capital equipment, a sector in which the United States has a comparativeadvantage and tends to dominate world production. This has boosted net exports in
the United States.

Net Exports and Aggregate Demand
Net exports affect both the slope and the position of the aggregate demand curve. Achange in the price level causes a change in net exports that moves the economy
along its aggregate demand curve. This is the international trade effect. A change innet exports produced by one of the other determinants of net exports listed above(incomes and price levels in other nations, the exchange rate, trade policies, andpreferences and technology) will shift the aggregate demand curve. The magnitudeof this shift equals the change in net exports times the multiplier, as shown in
Figure 15.3 "Changes in Net Exports and Aggregate Demand". Panel (a) shows anincrease in net exports; Panel (b) shows a reduction. In both cases, the aggregate
demand curve shifts by the multiplier times the initial change in net exports,
provided there is no other change in the other components of aggregate demand.

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Chapter 15 Net Exports and International Finance

Figure 15.3 Changes in Net Exports and Aggregate Demand

In Panel (a), an increase in net exports shifts the aggregate demand curve to the right by an amount equal to themultiplier times the initial change in net exports. In Panel (b), an equal reduction in net exports shifts the aggregate
demand curve to the left by the same amount.

Changes in net exports that shift the aggregate demand curve can have a significant
impact on the economy. The United States, for example, experienced a slowdown in
the rate of increase in real GDP in the second and third quarters of 1998—virtually
all of this slowing was the result of a reduction in net exports caused by recessions
that staggered economies throughout Asia. The Asian slide reduced incomes there
and thus reduced Asian demand for U.S. goods and services. We will see in the next
section another mechanism through which difficulties in other nations can causechanges in a nation’s net exports and its level of real GDP in the short run.

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Chapter 15 Net Exports and International Finance

KEY TAKEAWAYS• International trade allows the world’s resources to be allocated on thebasis of comparative advantage and thus allows the production of alarger quantity of goods and services than would be available without
trade.
• Trade affects neither the economy’s natural level of employment nor its
real wage in the long run; those are determined by the demand for andthe supply curve of labor.
• Growth in international trade has outpaced growth in world output overthe past five decades.
• The chief determinants of net exports are domestic and foreign incomes,
relative price levels, exchange rates, domestic and foreign trade policies,
and preferences and technology.
• A change in the price level causes a change in net exports that moves
the economy along its aggregate demand curve. This is the international
trade effect. A change in net exports produced by one of the other
determinants of net exports will shift the aggregate demand curve by anamount equal to the initial change in net exports times the multiplier.

TRY IT!
Draw graphs showing the aggregate demand and short-run aggregate supply
curves in each of four countries: Mexico, Japan, Germany, and the UnitedStates. Assume that each country is initially in equilibrium with a real GDP
of Y1 and a price level of P1. Now show how each of the following four eventswould affect aggregate demand, the price level, and real GDP in the country
indicated.
1. The United States is the largest foreign purchaser of goods and services
from Mexico. How does an expansion in the United States affect real
GDP and the price level in Mexico?
2. Japan’s exchange rate falls sharply. How does this affect the price level
and real GDP in Japan?
3. A wave of pro-German sentiment sweeps France, and the French sharply
increase their purchases of German goods and services. How does thisaffect real GDP and the price level in Germany?
4. Canada, the largest importer of U.S. goods and services, slips into a
recession. How does this affect the price level and real GDP in the UnitedStates?

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Chapter 15 Net Exports and International FinanceCase in Point: Canadian Net Exports Survive the Loonie’s
Rise

Throughout 2003 and the first half of 2004, the Canadian dollar, nicknamed theloonie after the Canadian bird that is featured on its one-dollar coin, rose
sharply in value against the U.S. dollar. Because the United States and Canada
are major trading partners, the changing exchange rate suggested that, otherthings equal, Canadian exports to the United States would fall and imports rise.
The resulting fall in net exports, other things equal, could slow the rate of
growth in Canadian GDP.
Fortunately for Canada, “all other things” were not equal. In particular, strong
income growth in the United States and China increased the demand for
Canadian exports. In addition, the loonie’s appreciation against othercurrencies was less dramatic, and so Canadian exports remained competitive inthose markets. While imports did increase, as expected due to the exchange
rate change, exports grew at a faster rate, and hence net exports increased overthe period.
In sum, Canadian net exports grew, although not by as much as they would
have had the loonie not appreciated. As Beata Caranci, an economist for
Toronto Dominion Bank put it, “We might have some bumpy months ahead but
it definitely looks like the worst is over. … While Canadian exports appear tohave survived the loonie’s run-up, their fortunes would be much brighter if theexchange rate were still at 65 cents.”

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Chapter 15 Net Exports and International FinanceSource: Steven Theobald, “Exports Surviving Loonie’s Rise: Study,” Toronto Star,
July 13, 2004, p. D1.

ANSWERS TO TRY IT! PROBLEMS
1. Mexico’s exports increase, shifting its aggregate demand curve to theright. Mexico’s real GDP and price level rise, as shown in Panel (a).
2. Japan’s net exports rise. This event shifts Japan’s aggregate demand
curve to the right, increasing its real GDP and price level, as shown inPanel (b).
3. Germany’s net exports increase, shifting Germany’s aggregate demand
curve to the right, increasing its price level and real GDP, as shown inPanel (c).
4. U.S. exports fall, shifting the U.S. aggregate demand curve to the left,
which will reduce the price level and real GDP, as shown in Panel (d).

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Chapter 15 Net Exports and International Finance15.2 International Finance
LEARNING OBJECTIVES
1. Define a country’s balance of payments, and explain what is included on
the current and capital accounts.
2. Assuming that the market for a country’s currency is in equilibrium,
explain why the current account balance will always be the negative of
the capital account balance.
3. Summarize the economic arguments per se against public opposition toa current account deficit and a capital account surplus.

There is an important difference between trade that flows, say, from one city toanother and trade that flows from one nation to another. Unless they share acommon currency, as some of the nations of the European Union do, trade among
nations requires that currencies be exchanged as well as goods and services.
Suppose, for example, that buyers in Mexico purchase silk produced in China. The
Mexican buyers will pay in Mexico’s currency, the peso; the manufacturers of thesilk must be paid in China’s currency, the yuan. The flow of trade between Mexico
and China thus requires an exchange of pesos for yuan.
This section examines the relationship between spending that flows into a country
and spending that flows out of it. These spending flows include not only spending
for a nation’s exports and imports, but payments to owners of assets in othercountries, international transfer payments, and purchases of foreign assets. Thebalance between spending flowing into a country and spending flowing out of it iscalled its balance of payments4.
We will simplify our analysis by ignoring international transfer payments, which
occur when an individual, firm, or government makes a gift to an individual, firm,or government in another country. Foreign aid is an example of an internationaltransfer payment. International transfer payments play a relatively minor role in
the international financial transactions of most countries; ignoring them will notchange our basic conclusions.

4. The balance between spending
flowing into a country andspending flowing out.

A second simplification will be to treat payments to foreign owners of factors of
production used in a country as imports and payments received by owners offactors of production used in other countries as exports. This is the approach when
we use GNP rather than GDP as the measure of a country’s output.

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Chapter 15 Net Exports and International Finance

These two simplifications leave two reasons for demanding a country’s currency:
for foreigners to purchase a country’s goods and services (that is, its exports) and topurchase assets in the country. A country’s currency is supplied in order topurchase foreign currencies. A country’s currency is thus supplied for two reasons:to purchase goods and services from other countries (that is, its imports) and topurchase assets in other countries.
We studied the determination of exchange rates in the chapter on how financial
markets work. We saw that, in general, exchange rates are determined by demandand supply and that the markets for the currencies of most nations can be regarded
as being in equilibrium. Exchange rates adjust quickly, so that the quantity of acurrency demanded equals the quantity of the currency supplied.
Our analysis will deal with flows of spending between the domestic economy andthe rest of the world. Suppose, for example, that we are analyzing Japan’s economy
and its transactions with the rest of the world. The purchase by a buyer in, say,Germany of bonds issued by a Japanese corporation would be part of the rest-ofworld demand for yen to buy Japanese assets. Adding export demand to asset
demand by people, firms, and governments outside a country, we get the total
demand for a country’s currency.
A domestic economy’s currency is supplied to purchase currencies in the rest of theworld. In an analysis of the market for Japanese yen, for example, yen are supplied
when people, firms, and government agencies in Japan purchase goods and services
from the rest of the world. This part of the supply of yen equals Japanese imports.
Yen are also supplied so that holders of yen can acquire assets from other countries.
Equilibrium in the market for a country’s currency implies that the quantity of aparticular country’s currency demanded equals the quantity supplied. Equilibrium
thus implies that
Equation 15.1

Quantity of currency demanded = quantity of currency supplied
In turn, the quantity of a currency demanded is from two sources:
1. Exports
2. Rest-of-world purchases of domestic assets

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Chapter 15 Net Exports and International Finance

The quantity supplied of a currency is from two sources:
1. Imports
2. Domestic purchases of rest-of-world assets
Therefore, we can rewrite Equation 15.1 as
Equation 15.2

Exports + (rest-of-world purchases of domestic assets) = imports + (domAccounting for International Payments
In this section, we will build a set of accounts to track international payments. To
do this, we will use the equilibrium condition for foreign exchange markets given in
Equation 15.2. We will see that the balance between a country’s purchases of foreign
assets and foreign purchases of the country’s assets will have important effects on
net exports, and thus on aggregate demand.
We can rearrange the terms in Equation 15.2 to write the following:
Equation 15.3

Exports − imports = − [(rest-of-world purchases of domestic assets) − (dEquation 15.3 represents an extremely important relationship. Let us examine it
carefully.

5. An accounting statement that
includes all spending flows
across a nation’s border except
those that represent purchasesof assets.
6. Spending flowing into an
economy from the rest of theworld on current account lessspending flowing from thenation to the rest of the world
on current account.

15.2 International Finance

The left side of the equation is net exports. It is the balance between spending
flowing from foreign countries into a particular country for the purchase of its
goods and services and spending flowing out of the country for the purchase ofgoods and services produced in other countries. The current account5 is anaccounting statement that includes all spending flows across a nation’s border
except those that represent purchases of assets. The balance on current account6
equals spending flowing into an economy from the rest of the world on current
account less spending flowing from the nation to the rest of the world on current
account. Given our two simplifying assumptions—that there are no internationaltransfer payments and that we can treat rest-of-world purchases of domestic factor
services as exports and domestic purchases of rest-of-world factor services asimports—the balance on current account equals net exports. When the balance on
current account is positive, spending flowing in for the purchase of goods and618

Chapter 15 Net Exports and International Financeservices exceeds spending that flows out, and the economy has a current accountsurplus7 (i.e., net exports are positive in our simplified analysis). When the balanceon current account is negative, spending for goods and services that flows out of
the country exceeds spending that flows in, and the economy has a current
account deficit8 (i.e., net exports are negative in our simplified analysis).
A country’s capital account9 is an accounting statement of spending flows into andout of the country during a particular period for purchases of assets. The term
within the parentheses on the right side of the equation gives the balance between
rest-of-world purchases of domestic assets and domestic purchases of rest-of-world
assets; this balance is a country’s balance on capital account10. A positive balanceon capital account is a capital account surplus11. A capital account surplus meansthat buyers in the rest of the world are purchasing more of a country’s assets thanbuyers in the domestic economy are spending on rest-of-world assets. A negativebalance on capital account is a capital account deficit12. It implies that buyers in
the domestic economy are purchasing a greater volume of assets in other countries
than buyers in other countries are spending on the domestic economy’s assets.
Remember that the balance on capital account is the term inside the parentheses on
the right-hand side of Equation 15.3 and that there is a minus sign outside theparentheses.

7. Situation that occurs whenspending flowing in for thepurchase of goods and services
exceeds spending that flowsout.
8. Situation that occurs whenspending for goods andservices that flows out of thecountry exceeds spending thatflows in.
9. An accounting statement ofspending flows into and out of
the country during a particularperiod for purchases of assets.
10. The balance between rest-ofworld purchases of domestic
assets and domestic purchasesof rest-of-world assets.
11. A positive balance on capital
account.
12. A negative balance on capital
account.

15.2 International Finance

Equation 15.3 tells us that a country’s balance on current account equals thenegative of its balance on capital account. Suppose, for example, that buyers in therest of the world are spending $100 billion per year acquiring assets in a country,
while that country’s buyers are spending $70 billion per year to acquire assets in
the rest of the world. The country thus has a capital account surplus of $30 billion
per year. Equation 15.3 tells us the country must have a current account deficit of$30 billion per year.
Alternatively, suppose buyers from the rest of the world acquire $25 billion of acountry’s assets per year and that buyers in that country buy $40 billion per year inassets in other countries. The economy has a capital account deficit of $15 billion;
its capital account balance equals −$15 billion. Equation 15.3 tells us it thus has acurrent account surplus of $15 billion. In general, we may write the following:
Equation 15.4

Current account balance = − (capital account balance)
Assuming the market for a nation’s currency is in equilibrium, a capital accountsurplus necessarily means a current account deficit. A capital account deficit
necessarily means a current account surplus. Similarly, a current account surplus

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Chapter 15 Net Exports and International Financeimplies a capital account deficit; a current account deficit implies a capital accountsurplus. Whenever the market for a country’s currency is in equilibrium, and it
virtually always is in the absence of exchange rate controls, Equation 15.3 is an
identity—it must be true. Thus, any surplus or deficit in the current account means
the capital account has an offsetting deficit or surplus.
The accounting relationships underlying international finance hold as long as acountry’s currency market is in equilibrium. But what are the economic forces atwork that cause these equalities to hold? Consider how global turmoil in 1997 and1998, discussed in the chapter opening, affected the United States. Holders of assets,
including foreign currencies, in the rest of the world were understandably
concerned that the values of those assets might fall. To avoid a plunge in the valuesof their own holdings, many of them purchased U.S. assets, including U.S. dollars.
Those purchases of U.S. assets increased the U.S. surplus on capital account. To buy
those assets, foreign purchasers had to purchase dollars. Also, U.S. citizens becameless willing to hold foreign assets, and their preference for holding U.S. assets
increased. United States citizens were thus less willing to supply dollars to theforeign exchange market. The increased demand for dollars and the decreased
supply of dollars sent the U.S. exchange rate higher, as shown in Panel (a) of Figure
15.4 "A Change in the Exchange Rate Affected the U.S. Current and Capital Accounts
in 1997 and 1998". Panel (b) shows the actual movement of the U.S. exchange rate in1997 and 1998. Notice the sharp increases in the exchange rate throughout most of
the period. A higher exchange rate in the United States reduces U.S. exports andincreases U.S. imports, increasing the current account deficit. Panel (c) shows the
movement of the current and capital accounts in the United States in 1997 and1998. Notice that as the capital account surplus increased, the current accountdeficit rose. A reduction in the U.S. exchange rate at the end of 1998 coincided witha movement of these balances in the opposite direction.
Figure 15.4 A Change in the Exchange Rate Affected the U.S. Current and Capital Accounts in 1997 and 1998

Turmoil in currency markets all over the world in 1997 and 1998 increased the demand for dollars and decreased the
supply of dollars in the foreign exchange market, which caused an increase in the U.S. exchange rate, as shown inPanel (a). Panel (b) shows actual values of the U.S. exchange rate during that period; Panel (c) shows U.S. balances

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Chapter 15 Net Exports and International Financeon current and on capital accounts. Notice that the balance on capital account generally rose while the balance on
current account generally fell.

Deficits and Surpluses: Good or Bad?
For the past quarter century, the United States has had a current account deficit
and a capital account surplus. Is this good or bad?
Viewed from the perspective of consumers, neither phenomenon seems to pose a
problem. A current account deficit is likely to imply a trade deficit. That means
more goods and services are flowing into the country than are flowing out. A capital
account surplus means more spending is flowing into the country for the purchaseof assets than is flowing out. It is hard to see the harm in any of that.
Public opinion, however, appears to regard a current account deficit and capital
account surplus as highly undesirable, perhaps because people associate a trade
deficit with a loss of jobs. But that is erroneous; employment in the long run isdetermined by forces that have nothing to do with a trade deficit. An increase in the
trade deficit (that is, a reduction in net exports) reduces aggregate demand in the
short run, but net exports are only one component of aggregate demand. Other
factors—consumption, investment, and government purchases—affect aggregate
demand as well. There is no reason a trade deficit should imply a loss of jobs.
What about foreign purchases of U.S. assets? One objection to such purchases is that
if foreigners own U.S. assets, they will receive the income from thoseassets—spending will flow out of the country. But it is hard to see the harm in
paying income to financial investors. When someone buys a bond issued byMicrosoft, interest payments will flow from Microsoft to the bond holder. Does
Microsoft view the purchase of its bond as a bad thing? Of course not. Despite thefact that Microsoft’s payment of interest on the bond and the ultimate repaymentof the face value of the bond will exceed what the company originally received fromthe bond purchaser, Microsoft is surely not unhappy with the arrangement. It
expects to put that money to more productive use; that is the reason it issued thebond in the first place.
A second concern about foreign asset purchases is that the United States in somesense loses sovereignty when foreigners buy its assets. But why should this be a
problem? Foreign-owned firms competing in U.S. markets are at the mercy of thosemarkets, as are firms owned by U.S. nationals. Foreign owners of U.S. real estate
have no special power. What about foreign buyers of bonds issued by the U.S.
government? Foreigners owned about 52% of these bonds at the end of December

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Chapter 15 Net Exports and International Finance2010; they are thus the creditors for about half the national debt. But this position
hardly puts them in control of the government of the United States. They hold an
obligation of the U.S. government to pay them a certain amount of U.S. dollars on acertain date, nothing more. A foreign owner could sell his or her bonds, but morethan $100 billion worth of these bonds are sold every day. The resale of U.S. bonds
by a foreign owner will not affect the U.S. government.
In short, there is no economic justification for concern about having a current
account deficit and a capital account surplus—nor would there be an economic
reason to be concerned about the opposite state of affairs. The important feature ofinternational trade is its potential to improve living standards for people. It is not agame in which current account balances are the scorecard.

KEY TAKEAWAYS• The balance of payments shows spending flowing into and out of acountry.
• The current account is an accounting statement that includes all
spending flows across a nation’s border except those that represent
purchases of assets. In our simplified analysis, the balance on current
account equals net exports.
• A nation’s balance on capital account equals rest-of-world purchases of
its assets during a period less its purchases of rest-of-world assets.
• Provided that the market for a nation’s currency is in equilibrium, thebalance on current account equals the negative of the balance on capital
account.
• There is no economic justification for viewing any particular current
account balance as a good or bad thing.

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Chapter 15 Net Exports and International FinanceTRY IT!
Use Equation 15.3 and Equation 15.4 to compute the variables given in eachof the following. Assume that the market for a nation’s currency is inequilibrium and that the balance on current account equals net exports.
1. Suppose U.S. exports equal $300 billion, imports equal $400 billion, andrest-of-world purchases of U.S. assets equal $150 billion. What is the U.S.
balance on current account? The balance on capital account? What is thevalue of U.S. purchases of rest-of-world assets?
2. Suppose Japanese exports equal ¥200 trillion (¥ is the symbol for theyen, Japan’s currency), imports equal ¥120 trillion, and Japan’spurchases of rest-of-world assets equal ¥90 trillion. What is the balance
on Japan’s current account? The balance on Japan’s capital account?
What is the value of rest-of-world purchases of Japan’s assets?
3. Suppose Britain’s purchases of rest-of-world assets equal £70 billion (£ isthe symbol for the pound, Britain’s currency), rest-of-world purchasesof British assets equal £90 billion, and Britain’s exports equal £40 billion.
What is Britain’s balance on capital account? Its balance on current
account? Its total imports?
4. Suppose Mexico’s purchases of rest-of-world assets equal $500 billion ($is the symbol for the peso, Mexico’s currency), rest-of-world purchasesof Mexico’s assets equal $700 billion, and Mexico’s imports equal $550
billion. What is Mexico’s balance on capital account? Its balance on
current account? Its total exports?

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Chapter 15 Net Exports and International FinanceCase in Point: Alan Greenspan on the U.S. Current
Account Deficit

The growing U.S. current account deficit has generated considerable alarm.
But, is there cause for alarm? In a speech in December 2005, former Federal
Reserve Chairman Alan Greenspan analyzed what he feels are the causes of thegrowing deficit and explains how the U.S. current account deficit may, undercertain circumstances, decrease over time without a crisis.
“In November 2003, I noted that we saw little evidence of stress in funding the
U.S. current account deficit even though the real exchange rate for the dollar,
on net, had declined more than 10% since early 2002. … Two years later, little
has changed except that our current account deficit has grown still larger. Most
policy makers marvel at the seeming ease with which the United States
continues to finance its current account deficit.
“Of course, deficits that cumulate to ever-increasing net external debt, with its
attendant rise in servicing costs, cannot persist indefinitely. At some point,
foreign investors will balk at a growing concentration of claims against U.S.
residents … and will begin to alter their portfolios. … The rise of the U.S.
current account deficit over the past decade appears to have coincided with apronounced new phase of globalization that is characterized by a major
acceleration in U.S. productivity growth and the decline in what economists
call home bias. In brief, home bias is the parochial tendency of persons, though
faced with comparable or superior foreign opportunities, to invest domestic
savings in the home country. The decline in home bias is reflected in savers
increasingly reaching across national borders to invest in foreign assets. The
rise in U.S. productivity attracted much of those savings toward investments in
the United States. …

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Chapter 15 Net Exports and International Finance“Accordingly, it is tempting to conclude that the U.S. current account deficit isessentially a byproduct of long-term secular forces, and thus is largely benign.
After all, we do seem to have been able to finance our international current
account deficit with relative ease in recent years.
“But does the apparent continued rise in the deficits of U.S. individual
households and nonfinancial businesses themselves reflect growing economic
strain? (We do not think so.) And does it matter how those deficits of individual
economic entities are being financed? Specifically, does the recent growing
proportion of these deficits being financed, net, by foreigners matter? …
“If the currently disturbing drift toward protectionism is contained andmarkets remain sufficiently flexible, changing terms of trade, interest rates,
asset prices, and exchange rates will cause U.S. saving to rise, reducing the needfor foreign finance, and reversing the trend of the past decade toward
increasing reliance on it. If, however, the pernicious drift toward fiscal
instability in the United States and elsewhere is not arrested and iscompounded by a protectionist reversal of globalization, the adjustment
process could be quite painful for the world economy.”
Source: Alan Greenspan, “International Imbalances” (speech, Advancing
Enterprise Conference, London, England, December 2, 2005), available at
http://www.federalreserve.gov/boarddocs/speeches/2005/200512022/
default.htm.

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Chapter 15 Net Exports and International Finance

ANSWERS TO TRY IT! PROBLEMS

1. All figures are in billions of U.S. dollars per period. The left-handside of Equation 15.3 is the current account balance
Exports − imports = $300 − $400 = −$100
Using Equation 15.4, the balance on capital account is−$100 = −(capital account balance)
Solving this equation for the capital account balance, we findthat it is $100. The term in parentheses on the right-hand side ofEquation 15.3 is also the balance on capital account. We thus
have$100 = $150 − U.S. purchases of rest-of-world assets
Solving this for U.S. purchase of rest-of-world assets, we findthey are $50.
2. All figures are in trillions of yen per period. The left-hand side ofEquation 15.3 is the current account balance
Exports − imports = ¥200 − ¥120 = ¥80
Using Equation 15.4, the balance on capital account is¥80 = −(capital account balance)
Solving this equation for the capital account balance, we findthat it is −¥80. The term in parentheses on the right-hand side ofEquation 15.3 is also the balance on capital account. We thushave−¥80 = rest-of-world purchases of Japan’s assets − ¥90
Solving this for the rest-of-world purchases of Japan’s assets, wefind they are ¥10.

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Chapter 15 Net Exports and International Finance3. All figures are in billions of pounds per period. The term inparentheses on the right-hand side of Equation 15.3 is thebalance on capital account. We thus have
£90 − £70 = £20
Using Equation 15.4, the balance on current account isCurrent account balance = −(£20)
The left-hand side of Equation 15.3 is also the current accountbalance£40 − imports = −£20
Solving for imports, we find they are £60. Britain’s balance on
current account is −£20 billion, its balance on capital account is£20 billion, and its total imports equal £60 billion per period.
4. All figures are in billions of pesos per period. The term inparentheses on the right-hand side of Equation 15.3 is thebalance on capital account. We thus have$700 − $500 = $200
Using Equation 15.4, the balance on current account isCurrent account balance = −($200)
The left-hand side of Equation 15.3 is also the current accountbalance
Exports − $550 = −$200
Solving for exports, we find they are $350.

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Chapter 15 Net Exports and International Finance15.3 Exchange Rate Systems
LEARNING OBJECTIVES
1. Define the various types of exchange rate systems.
2. Discuss some of the pros and cons of different exchange rate systems.

Exchange rates are determined by demand and supply. But governments caninfluence those exchange rates in various ways. The extent and nature ofgovernment involvement in currency markets define alternative systems of
exchange rates. In this section we will examine some common systems and explore
some of their macroeconomic implications.
There are three broad categories of exchange rate systems. In one system, exchange
rates are set purely by private market forces with no government involvement.
Values change constantly as the demand for and supply of currencies fluctuate. In
another system, currency values are allowed to change, but governments
participate in currency markets in an effort to influence those values. Finally,
governments may seek to fix the values of their currencies, either throughparticipation in the market or through regulatory policy.

Free-Floating Systems
In a free-floating exchange rate system13, governments and central banks do notparticipate in the market for foreign exchange. The relationship between
governments and central banks on the one hand and currency markets on the otheris much the same as the typical relationship between these institutions and stock
markets. Governments may regulate stock markets to prevent fraud, but stock
values themselves are left to float in the market. The U.S. government, for example,
does not intervene in the stock market to influence stock prices.

13. System in which governments
and central banks do notparticipate in the market forforeign exchange.

The concept of a completely free-floating exchange rate system is a theoretical one.
In practice, all governments or central banks intervene in currency markets in aneffort to influence exchange rates. Some countries, such as the United States,intervene to only a small degree, so that the notion of a free-floating exchange rate
system comes close to what actually exists in the United States.

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Chapter 15 Net Exports and International Finance

A free-floating system has the advantage of being self-regulating. There is no needfor government intervention if the exchange rate is left to the market. Market
forces also restrain large swings in demand or supply. Suppose, for example, that adramatic shift in world preferences led to a sharply increased demand for goods
and services produced in Canada. This would increase the demand for Canadiandollars, raise Canada’s exchange rate, and make Canadian goods and services more
expensive for foreigners to buy. Some of the impact of the swing in foreign demand
would thus be absorbed in a rising exchange rate. In effect, a free-floating exchange
rate acts as a buffer to insulate an economy from the impact of international events.
The primary difficulty with free-floating exchange rates lies in theirunpredictability. Contracts between buyers and sellers in different countries must
not only reckon with possible changes in prices and other factors during the lives of
those contracts, they must also consider the possibility of exchange rate changes.
An agreement by a U.S. distributor to purchase a certain quantity of Canadianlumber each year, for example, will be affected by the possibility that the exchange
rate between the Canadian dollar and the U.S. dollar will change while the contract
is in effect. Fluctuating exchange rates make international transactions riskier andthus increase the cost of doing business with other countries.

Managed Float Systems
Governments and central banks often seek to increase or decrease their exchange
rates by buying or selling their own currencies. Exchange rates are still free to float,
but governments try to influence their values. Government or central bankparticipation in a floating exchange rate system is called a managed float14.
Countries that have a floating exchange rate system intervene from time to time inthe currency market in an effort to raise or lower the price of their own currency.
Typically, the purpose of such intervention is to prevent sudden large swings in thevalue of a nation’s currency. Such intervention is likely to have only a small impact,
if any, on exchange rates. Roughly $1.5 trillion worth of currencies changes hands
every day in the world market; it is difficult for any one agency—even an agency thesize of the U.S. government or the Fed—to force significant changes in exchange
rates.

14. Government or central bankparticipation in a floatingexchange rate system.

15.3 Exchange Rate Systems

Still, governments or central banks can sometimes influence their exchange rates.
Suppose the price of a country’s currency is rising very rapidly. The country’s
government or central bank might seek to hold off further increases in order toprevent a major reduction in net exports. An announcement that a further increase
in its exchange rate is unacceptable, followed by sales of that country’s currency by
the central bank in order to bring its exchange rate down, can sometimes convince629

Chapter 15 Net Exports and International Financeother participants in the currency market that the exchange rate will not risefurther. That change in expectations could reduce demand for and increase supplyof the currency, thus achieving the goal of holding the exchange rate down.

Fixed Exchange Rates
In a fixed exchange rate system15, the exchange rate between two currencies is set
by government policy. There are several mechanisms through which fixedexchange rates may be maintained. Whatever the system for maintaining these
rates, however, all fixed exchange rate systems share some important features.

A Commodity Standard
In a commodity standard system16, countries fix the value of their respective
currencies relative to a certain commodity or group of commodities. With eachcurrency’s value fixed in terms of the commodity, currencies are fixed relative to
one another.
For centuries, the values of many currencies were fixed relative to gold. Suppose,for example, that the price of gold were fixed at $20 per ounce in the United States.
This would mean that the government of the United States was committed to
exchanging 1 ounce of gold to anyone who handed over $20. (That was the case in
the United States—and $20 was roughly the price—up to 1933.) Now suppose thatthe exchange rate between the British pound and gold was £5 per ounce of gold.
With £5 and $20 both trading for 1 ounce of gold, £1 would exchange for $4. No one
would pay more than $4 for £1, because $4 could always be exchanged for 1/5 ounceof gold, and that gold could be exchanged for £1. And no one would sell £1 for lessthan $4, because the owner of £1 could always exchange it for 1/5 ounce of gold,
which could be exchanged for $4. In practice, actual currency values could varyslightly from the levels implied by their commodity values because of the costs
involved in exchanging currencies for gold, but these variations are slight.

15. System in which the exchange
rate between two currencies is
set by government policy.

Under the gold standard, the quantity of money was regulated by the quantity ofgold in a country. If, for example, the United States guaranteed to exchange dollars
for gold at the rate of $20 per ounce, it could not issue more money than it could
back up with the gold it owned.

16. System in which countries fix
the value of their respective
currencies relative to a certain
commodity or group ofcommodities.

The gold standard was a self-regulating system. Suppose that at the fixed exchange
rate implied by the gold standard, the supply of a country’s currency exceeded thedemand. That would imply that spending flowing out of the country exceeded
spending flowing in. As residents supplied their currency to make foreignpurchases, foreigners acquiring that currency could redeem it for gold, since

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Chapter 15 Net Exports and International Financecountries guaranteed to exchange gold for their currencies at a fixed rate. Goldwould thus flow out of the country running a deficit. Given an obligation to
exchange the country’s currency for gold, a reduction in a country’s gold holdings
would force it to reduce its money supply. That would reduce aggregate demand in
the country, lowering income and the price level. But both of those events would
increase net exports in the country, eliminating the deficit in the balance of
payments. Balance would be achieved, but at the cost of a recession. A country witha surplus in its balance of payments would experience an inflow of gold. That would
boost its money supply and increase aggregate demand. That, in turn, would
generate higher prices and higher real GDP. Those events would reduce net exports
and correct the surplus in the balance of payments, but again at the cost of changes
in the domestic economy.
Because of this tendency for imbalances in a country’s balance of payments to becorrected only through changes in the entire economy, nations began abandoning
the gold standard in the 1930s. That was the period of the Great Depression, during
which world trade virtually was ground to a halt. World War II made the shipmentof goods an extremely risky proposition, so trade remained minimal during the war.
As the war was coming to an end, representatives of the United States and its allies
met in 1944 at Bretton Woods, New Hampshire, to fashion a new mechanism
through which international trade could be financed after the war. The system wasto be one of fixed exchange rates, but with much less emphasis on gold as a backing
for the system.
In recent years, a number of countries have set up currency board
arrangements17, which are a kind of commodity standard, fixed exchange rate
system in which there is explicit legislative commitment to exchange domestic
currency for a specified foreign currency at a fixed rate and a currency board toensure fulfillment of the legal obligations this arrangement entails. In its simplest
form, this type of arrangement implies that domestic currency can be issued only
when the currency board has an equivalent amount of the foreign currency towhich the domestic currency is pegged. With a currency board arrangement, thecountry’s ability to conduct independent monetary policy is severely limited. It cancreate reserves only when the currency board has an excess of foreign currency. If
the currency board is short of foreign currency, it must cut back on reserves.

17. Fixed exchange rate systems inwhich there is explicit
legislative commitment toexchange domestic currency
for a specified foreign currency
at a fixed rate.

15.3 Exchange Rate Systems

Argentina established a currency board in 1991 and fixed its currency to the U.S.
dollar. For an economy plagued in the 1980s with falling real GDP and rising
inflation, the currency board served to restore confidence in the government’s
commitment to stabilization policies and to a restoration of economic growth. The
currency board seemed to work well for Argentina for most of the 1990s, as
inflation subsided and growth of real GDP picked up.

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Chapter 15 Net Exports and International FinanceThe drawbacks of a currency board are essentially the same as those associated withthe gold standard. Faced with a decrease in consumption, investment, and net
exports in 1999, Argentina could not use monetary and fiscal policies to try to shift
its aggregate demand curve to the right. It abandoned the system in 2002.

Fixed Exchange Rates Through Intervention
The Bretton Woods Agreement called for each currency’s value to be fixed relative
to other currencies. The mechanism for maintaining these rates, however, was to beintervention by governments and central banks in the currency market.
Again suppose that the exchange rate between the dollar and the British pound isfixed at $4 per £1. Suppose further that this rate is an equilibrium rate, as
illustrated in Figure 15.5 "Maintaining a Fixed Exchange Rate ThroughIntervention". As long as the fixed rate coincides with the equilibrium rate, thefixed exchange rate operates in the same fashion as a free-floating rate.
Now suppose that the British choose to purchase more
U.S. goods and services. The supply curve for pounds
increases, and the equilibrium exchange rate for thepound (in terms of dollars) falls to, say, $3. Under theterms of the Bretton Woods Agreement, Britain and theUnited States would be required to intervene in themarket to bring the exchange rate back to the rate fixedin the agreement, $4. If the adjustment were to be madeby the British central bank, the Bank of England, itwould have to purchase pounds. It would do so byexchanging dollars it had previously acquired in othertransactions for pounds. As it sold dollars, it would takein checks written in pounds. When a central bank sells
an asset, the checks that come into the central bankreduce the money supply and bank reserves in thatcountry. We saw in the chapter explaining the money
supply, for example, that the sale of bonds by the Fed
reduces the U.S. money supply. Similarly, the sale ofdollars by the Bank of England would reduce the British
money supply. In order to bring its exchange rate backto the agreed-to level, Britain would have to carry out acontractionary monetary policy.

Figure 15.5 Maintaining a
Fixed Exchange Rate
Through Intervention

Initially, the equilibrium price of
the British pound equals $4, thefixed rate between the pound andthe dollar. Now suppose anincreased supply of British
pounds lowers the equilibrium
price of the pound to $3. The
Bank of England could purchasepounds by selling dollars in orderto shift the demand curve forpounds to D2. Alternatively, theFed could shift the demand curveto D2 by buying pounds.

Alternatively, the Fed could intervene. It could purchasepounds, writing checks in dollars. But when a central

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Chapter 15 Net Exports and International Financebank purchases assets, it adds reserves to the system and increases the money
supply. The United States would thus be forced to carry out an expansionary
monetary policy.
Domestic disturbances created by efforts to maintain fixed exchange rates brought
about the demise of the Bretton Woods system. Japan and West Germany gave up
the effort to maintain the fixed values of their currencies in the spring of 1971 andannounced they were withdrawing from the Bretton Woods system. President
Richard Nixon pulled the United States out of the system in August of that year, andthe system collapsed. An attempt to revive fixed exchange rates in 1973 collapsed
almost immediately, and the world has operated largely on a managed float eversince.
Under the Bretton Woods system, the United States had redeemed dollars held byother governments for gold; President Nixon terminated that policy as he withdrew
the United States from the Bretton Woods system. The dollar is no longer backed by
gold.
Fixed exchange rate systems offer the advantage of predictable currency
values—when they are working. But for fixed exchange rates to work, the countries
participating in them must maintain domestic economic conditions that will keep
equilibrium currency values close to the fixed rates. Sovereign nations must be
willing to coordinate their monetary and fiscal policies. Achieving that kind of
coordination among independent countries can be a difficult task.
The fact that coordination of monetary and fiscal policies is difficult does not mean
it is impossible. Eleven members of the European Union not only agreed to fix theirexchange rates to one another, they agreed to adopt a common currency, the euro.
The new currency was introduced in 1998 and became fully adopted in 1999. Since
then, six other nations have joined. The nations that adopted it agreed to strict
limits on their fiscal policies. Each continues to have its own central bank, but thesenational central banks operate similarly to the regional banks of the Federal
Reserve System in the United States. The new European Central Bank conductsmonetary policy throughout the area. Details of this revolutionary venture and theextraordinary problems it has encountered in recent years are provided in theaccompanying Case in Point.
When exchange rates are fixed but fiscal and monetary policies are not coordinated,equilibrium exchange rates can move away from their fixed levels. Once exchange
rates start to diverge, the effort to force currencies up or down through market
intervention can be extremely disruptive. And when countries suddenly decide togive that effort up, exchange rates can swing sharply in one direction or another.

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Chapter 15 Net Exports and International Finance

When that happens, the main virtue of fixed exchange rates, their predictability, islost.
Thailand’s experience with the baht illustrates the potential difficulty withattempts to maintain a fixed exchange rate. Thailand’s central bank had held theexchange rate between the dollar and the baht steady, at a price for the baht of$0.04. Several factors, including weakness in the Japanese economy, reduced thedemand for Thai exports and thus reduced the demand for the baht, as shown inPanel (a) of Figure 15.6 "The Anatomy of a Currency Collapse". Thailand’s central
bank, committed to maintaining the price of the baht at $0.04, bought baht toincrease the demand, as shown in Panel (b). Central banks buy their own currency
using their reserves of foreign currencies. We have seen that when a central banksells bonds, the money supply falls. When it sells foreign currency, the result is nodifferent. Sales of foreign currency by Thailand’s central bank in order to purchasethe baht thus reduced Thailand’s money supply and reduced the bank’s holdings offoreign currencies. As currency traders began to suspect that the bank might giveup its effort to hold the baht’s value, they sold baht, shifting the supply curve to theright, as shown in Panel (c). That forced the central bank to buy even morebaht—selling even more foreign currency—until it finally gave up the effort andallowed the baht to become a free-floating currency. By the end of 1997, the baht
had lost nearly half its value relative to the dollar.
Figure 15.6 The Anatomy of a Currency Collapse

Weakness in the Japanese economy, among other factors, led to a reduced demand for the baht (Panel [a]). That put
downward pressure on the baht’s value relative to other currencies. Committed to keeping the price of the baht at$0.04, Thailand’s central bank bought baht to increase the demand, as shown in Panel (b). However, as holders ofbaht and other Thai assets began to fear that the central bank might give up its effort to prop up the baht, they soldbaht, shifting the supply curve for baht to the right (Panel [c]) and putting more downward pressure on the baht’s
price. Finally, in July of 1997, the central bank gave up its effort to prop up the currency. By the end of the year, thebaht’s dollar value had fallen to about $0.02.

As we saw in the introduction to this chapter, the plunge in the baht was the first ina chain of currency crises that rocked the world in 1997 and 1998. International

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Chapter 15 Net Exports and International Finance

trade has the great virtue of increasing the availability of goods and services to theworld’s consumers. But financing trade—and the way nations handle that
financing—can create difficulties.

KEY TAKEAWAYS• In a free-floating exchange rate system, exchange rates are determinedby demand and supply.
• Exchange rates are determined by demand and supply in a managed
float system, but governments intervene as buyers or sellers ofcurrencies in an effort to influence exchange rates.
• In a fixed exchange rate system, exchange rates among currencies are
not allowed to change. The gold standard and the Bretton Woods systemare examples of fixed exchange rate systems.

TRY IT!
Suppose a nation’s central bank is committed to holding the value of its
currency, the mon, at $2 per mon. Suppose further that holders of the monfear that its value is about to fall and begin selling mon to purchase U.S.
dollars. What will happen in the market for mon? Explain your answer
carefully, and illustrate it using a demand and supply graph for the market
for mon. What action will the nation’s central bank take? Use your graph toshow the result of the central bank’s action. Why might this action fuelconcern among holders of the mon about its future prospects? Whatdifficulties will this create for the nation’s central bank?

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Chapter 15 Net Exports and International FinanceCase in Point: The EuroIt was the most dramatic development in international finance since thecollapse of the Bretton Woods system. A new currency, the euro, began trading
among 11 European nations—Austria, Belgium, Finland, France, Germany,
Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain—in 1999.
During a three-year transition, each nation continued to have its own currency,
which traded at a fixed rate with the euro. In 2001, Greece joined, and in 2002,
the currencies of the participant nations disappeared altogether and were
replaced by the euro. In 2007, Slovenia adopted the euro, as did Cyprus andMalta in 2008, Slovakia in 2009, and Estonia in 2011. Notable exceptions are
Britain, Sweden, Switzerland, and Denmark. Still, most of Europe now operates
as the ultimate fixed exchange rate regime, a region with a single currency.
To participate in this radical experiment, the nations switching to the euro had
to agree to give up considerable autonomy in monetary and fiscal policy. Whileeach nation continues to have its own central bank, those central banks operate
more like regional banks of the Federal Reserve System in the United States;
they have no authority to conduct monetary policy. That authority is vested ina new central bank, the European Central Bank.
The participants also agreed in principle to strict limits on their fiscal policies.
Their deficits could be no greater than 3% of nominal GDP, and their total
national debt could not exceed 60% of nominal GDP.
The fact that many of the euro nations had disregarded these limits became amajor problem for the new currency when the recession and financial crisis hit
in 2008. The biggest “sinner” turned out to be Greece, but there were others,
such as Italy, that also had not adhered to the agreement. The fiscal situation ofother countries, such as Ireland, went sour as the recession and financial
problems deepened. The countries that seemed most at risk of being unable to15.3 Exchange Rate Systems

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Chapter 15 Net Exports and International Financepay their sovereign (government) debts as they became due came to be known
as the PIIGS—Portugal, Ireland, Italy, Greece, and Spain—but there was a period
in 2011 when even the interest rate on French bonds was abnormally high. The
whole world seemed to be waiting throughout most of 2011 to see if the euro
would hold together and, in particular, if Greece would default on its debt.
Finally, in early 2012, the situation seemed to calm down. The European Union
nations (excluding the United Kingdom and the Czech Republic, which are notpart of the eurozone) agreed to a new treaty that again requires fiscal discipline
but this time has more enforcement associated with it. The European Union
was setting up the European Stability Mechanism: a fund to help out withshort-term liquidity problems that nations might encounter. Greece agreed totough demands to reduce its deficit and then became eligible for a second EU
bailout. It also managed to negotiate a debt-restricting deal with its privatesector lenders.
The euro has been a mixed blessing for eurozone countries trying to getthrough this difficult period. For example, guarantees that the Irish
government made concerning bank deposits and debt have been better
received, because Ireland is part of the euro system. On the other hand, if
Ireland had a floating currency, its depreciation might enhance Irish exports,
which would help Ireland to get out of its recession. The euro exchange rate has
probably benefited German exports, since a German currency would probably
trade at a premium over the euro, but it has hurt exports from countries whose
single-nation currencies would likely be weaker.
Also, even though there is a single currency, each country in the eurozone
issues its own debt. The smaller market for each country’s debt, each withdifferent risk premiums, makes them less liquid, especially in difficult financial
times. In contrast, the U.S. government is a single issuer of federal debt.
Even with general regulation of overall parameters, fiscal policy for the 17
nations is largely a separate matter. Each has its own retirement andunemployment insurance programs, for example. In the United States, if one
state is experiencing high unemployment, more federal unemployment
insurance benefits will flow to that state. But if unemployment rises in
Portugal, for example, its budget deficit will be negatively impacted, andPortugal will have to undertake additional austerity measures to stay within
the EU-imposed deficit limit.

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Chapter 15 Net Exports and International Finance

As of mid-2012, the fate of the euro was again dominating news on a nearly
daily basis, and the currency experiment was still not out of the woods. Even
with the restructuring and bailouts, would Greece be able to meet its debt
obligations? With some EU countries slipping into another recession, would theausterity measures they were taking to meet the EU guidelines be self-defeatingby making government budget balances even worse as tax revenues fell withthe worsening states of their economies? Were countries taking on the marketorienting reforms that might increase their long-term growth rates andproductivity? This last possibility seemed the most likely to help over time, but
implementation was certainly not a foregone conclusion.

ANSWER TO TRY IT! PROBLEM
The value of the mon is initially $2. Fear that the mon might fall will lead toan increase in its supply to S2, putting downward pressure on the currency.
To maintain the value of the mon at $2, the central bank will buy mon, thus
shifting the demand curve to D2. This policy, though, creates two difficulties.
First, it requires that the bank sell other currencies, and a sale of any asset
by a central bank is a contractionary monetary policy. Second, the saledepletes the bank’s holdings of foreign currencies. If holders of the mon fear
the central bank will give up its effort, then they might sell mon, shifting the
supply curve farther to the right and forcing even more vigorous action by
the central bank.

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Chapter 15 Net Exports and International Finance15.4 Review and PracticeSummary
In this chapter we examined the role of net exports in the economy. We found that export and import demand
are influenced by many different factors, the most important being domestic and foreign income levels, changes
in relative prices, the exchange rate, and preferences and technology. An increase in net exports shifts theaggregate demand curve to the right; a reduction shifts it to the left.
In the foreign exchange market, the equilibrium exchange rate is determined by the intersection of the demandand supply curves for a currency. Given the ease with which most currencies can be traded, we can assume thisequilibrium is achieved, so that the quantity of a currency demanded equals the quantity supplied. An economy
can experience current account surpluses or deficits. The balance on current account equals the negative of thebalance on capital account. We saw that one reason for the current account deficit in the United States is the
U.S. capital account surplus; the United States has attracted a great deal of foreign financial investment.
The chapter closed with an examination of floating and fixed exchange rate systems. Fixed exchange rate
systems include commodity-based systems and fixed rates that are maintained through intervention. Exchange
rate systems have moved from a gold standard, to a system of fixed rates with intervention, to a mixed set ofarrangements of floating and fixed exchange rates.

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CONCEPT PROBLEMS
1. David Ricardo, a famous English economist of the 19th century, stressedthat a nation has a comparative advantage in those products for which
its efficiency relative to other nations is the highest. He argued in favorof specialization and trade based on comparative, not absolute,advantage. From a global perspective, what would be the “advantage” ofsuch a system?
2. For several months prior to your vacation trip to Naples, Italy, you notethat the exchange rate for the dollar has been increasing relative to theeuro (that is, it takes more euro to buy a dollar). Are you pleased or sad?
Explain.
3. Who might respond in a way different from your own to the falling valueof the euro in Question 2?
4. Suppose a nation has a deficit on capital account. What does this mean?
What can you conclude about its balance on current account?
5. Suppose a nation has a surplus on capital account. What does this mean?
What can you conclude about its balance on current account?
6. The following analysis appeared in a newspaper editorial:“If foreigners own our businesses and land, that’s one thing, butwhen they own billions in U.S. bonds, that’s another. We don’tcare who owns the businesses, but our grandchildren will have to
put up with a lower standard of living because of the interest
payments sent overseas. Therefore, we must reduce our trade
deficit.”Critically analyze this editorial view. Are the basic premises
correct? The conclusion?
7. In the years prior to the abandonment of the gold standard, foreigners
cashed in their dollars and the U.S. Treasury “lost gold” atunprecedented rates. Today, the dollar is no longer tied to gold and is
free to float. What are the fundamental differences between a currency
based on the gold standard and one that is allowed to float? What would
the U.S. “lose” if foreigners decided to “cash in” their dollars today?
8. Can there be a deficit on current account and a deficit on capital accountat the same time? Explain.
9. Suppose the people of a certain economy increase their spending on
foreign-produced goods and services. What will be the effect on real GDP
and the price level in the short run? In the long run?

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Chapter 15 Net Exports and International Finance

10. Now suppose the people of a certain economy reduce their spending on
foreign-produced goods and services. What will be the effect on real GDP
and the price level in the short run? In the long run?
11. Canada, Mexico, and the United States have a free trade zone. Whatwould be some of the advantages of having a common currency as well?
The disadvantages? Do you think it would be a good idea? Why or whynot?
12. The text says that the U.S. capital account surplus necessarily implies acurrent account deficit. Suppose that the United States were toundertake measures to eliminate its capital account surplus. What sortsof measures might it take? Do you think such measures would be a goodidea? Why or why not?

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Chapter 15 Net Exports and International Finance

NUMERICAL PROBLEMS

1. For each of the following scenarios, determine whether theaggregate demand curve will shift. If so, in which direction will it
shift and by how much?
a. A change in consumer preferences leads to an initial$25-billion decrease in net exports. The multiplier is 1.5.
b. A change in trade policies leads to an initial $25-billion
increase in net exports. The multiplier is 1.
c. There is an increase in the domestic price level from 1 to
1.05, while the price level of the country’s major trading
partner does not change. The multiplier is 2.
d. Recession in a country’s trading partner lowers exports by$20 billion. The multiplier is 2.
2. Fill in the missing items in the table below. All figures are in U.S.
billions of dollars.
U.S.
U.S.
exports imports
a.

100

100

b.

100

200

c.

300

d.

800

Domestic
purchases offoreign assets

Rest-of-worldpurchases of U.S.
assets

400
200
400

600

800

1,100

3. Suppose the market for a country’s currency is in equilibrium
and that its exports equal $700 billion, its purchases of rest-ofworld assets equal $1,000 billion, and foreign purchases of its
assets equal $1,200 billion. Assuming it has no internationaltransfer payments and that output is measured as GNP:
a. What are the country’s imports?
b. What is the country’s balance on current account?
c. What is the country’s balance on capital account?
4. Suppose that the market for a country’s currency is inequilibrium and that its exports equal $400, its imports equal

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Chapter 15 Net Exports and International Finance$500 billion, and rest-of-world purchases of the country’s assets
equal $100. Assuming it has no international transfer payments
and that output is measured as GNP:
a. What is the country’s balance on current account?
b. What is the country’s balance on capital account?
c. What is the value of the country’s purchases of rest-of-world
assets?
5. The information below describes the trade-weighted exchange
rate for the dollar (standardized at a value of 100) and net
exports (in billions of dollars) for an eight-month period.
MonthTrade-weighted exchange rate Net exports

January

100.5

−9.8

February

99.9

−11.6

March

100.5

−13.5

April

100.3

−14.0

May

99.6

−15.6

June

100.9

−14.2

July

101.4

−14.9

August

101.8

−16.7

a. Plot the data on a graph.
b. Do the data support the expected relationship between the
trade-weighted exchange rate and net exports? Explain.
6. The graph below shows the foreign exchange market between
the United States and Japan before and after an increase in the
demand for Japanese goods by U.S. consumers.
a. If the exchange rate was free-floating prior to the change indemand for Japanese goods, what was its likely value?
b. After the change in demand, the free-floating exchange ratewould be how many yen per dollar?

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Chapter 15 Net Exports and International Financec. If the Japanese central bank wanted to keep the exchange
rate fixed at its initial value, how many dollars would it haveto buy?

7. Suppose Japan relaxes its restrictions on imports of foreign goods andservices and begins importing more from the United States. Illustrategraphically how this will affect the U.S. exchange rate, price level, andlevel of real GDP in the short run and in the long run. How will it affectthese same variables in Japan? (Assume both economies are initiallyoperating at their potential levels of output.)
8. Suppose U.S. investors begin purchasing assets in Mexico. Illustrategraphically how this will affect the U.S. exchange rate, price level, andlevel of real GDP in the short run and in the long run. How will it affectthese same variables in Mexico? (Assume both economies are initiallyoperating at their potential levels of output.)
9. Suppose foreigners begin buying more assets in the United States.
Illustrate graphically how this will affect the U.S. exchange rate, pricelevel, and level of real GDP in the short run and in the long run. (Assume
the economy is initially operating at its potential output.)

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Chapter 16
Inflation and Unemployment
Start Up: The Inflation/Unemployment Conundrum
As the twentieth century drew to a close, the people of the United States could lookback on a remarkable achievement. From 1992 through 2000, the unemployment
rate fell every year. The inflation rate, measured as the annual percentage change in
the implicit price deflator, was about 2% or less during this period. The dramatic
reduction in the two rates provided welcome relief to a nation that had seensoaring unemployment early in the 1980s, soaring inflation in the late 1970s, andpainful increases in both rates early in the 1970s.
Unemployment and inflation rates remained fairly low during the early 2000s.
Following a brief recession in 2001, in which unemployment reached nearly 6%(though this actually occurred after the recession officially ended), it fell back to
4.6% in 2006 and 2007. Through 2007, inflation never exceeded 3.3%. With the startof the recession in December 2007, the unemployment rate began to rise. At first,
though, it appeared that inflation was becoming a bigger problem, as rising gas andfood prices until summer 2008 seemed to be driving up other prices and increasing
inflationary expectations. Indeed, through much of 2008, a debate over theappropriate direction of monetary policy occurred over just this issue: should the
Fed ease the federal funds rate in an attempt to reduce unemployment or at least to
keep it from rising as much as it would otherwise have, or should it stem rising
inflation and inflationary expectations by holding the federal funds rate constant oreven increasing it? While the Fed voted during most of its 2008 meetings for easing,
the year is notable in that there were often dissenters at the Federal Open Market
Committee meetings. For example, the minutes of the March 18, 2008, meeting notethat two members, Richard W. Fisher of the Dallas Fed and Charles I. Plosser of the
Philadelphia Fed voted against the 0.75% point drop approved at that meeting.
Their rationale was that the inflation risks were simply too great. The minutes
state,“Incoming data suggested a weaker near-term outlook for economic growth, but
the Committee’s earlier policy moves had already reduced the target federal funds
rate by 225 basis points to address risks to growth, and the full effect of those ratecuts had yet to be felt. … Both Messrs. Fisher and Plosser were concerned that
inflation expectations could potentially become unhinged should the Committee

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continue to lower the funds rate in the current environment. They pointed tomeasures of inflation and indicators of inflation expectations that had risen and Mr.
Fisher stressed the international influences on U.S. inflation rates. Mr. Plosser
noted that the Committee could not afford to wait until there was clear evidence
that inflation expectations were no longer anchored, as by then it would be too late
to prevent a further increase in inflation pressures.”Minutes of the Federal Open
Market Committee March 18, 2008.
But as the depth of the recession increased toward the latter part of 2008, with the
unemployment rate reaching 7.2% in December and prices of both oil and othercommodities falling back substantially, the inflation threat had dissipated.
Unanimity had returned to the FOMC: the Fed should use all of its powers to fightthe recession.
This chapter examines the relationship between inflation and unemployment. We
will find that there have been periods in which a clear trade-off between inflation
and unemployment seemed to exist. During such periods, the economy achieved
reductions in unemployment at the expense of increased inflation. But there havealso been periods in which inflation and unemployment rose together and periods
in which both variables fell together. We will examine some explanations for thesometimes perplexing relationship between the two variables.
We will see that the use of stabilization policy, coupled with the lags for monetaryand for fiscal policy, have at times led to a cyclical relationship between inflation
and unemployment. The explanation for the fact that Americans enjoyed such along period of falling inflation and unemployment in the 1990s lies partly in
improved policy, policy that takes those lags into account. We will see that a bit ofmacroeconomic luck in aggregate supply has also played a role.

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16.1 Relating Inflation and Unemployment
LEARNING OBJECTIVES
1. Draw a short-run Phillips curve and describe the relationship between
inflation and unemployment that it expresses.
2. Describe the other relationships or phases that have been observed
between inflation and unemployment.

It has often been the case that progress against inflation comes at the expense of
greater unemployment, and that reduced unemployment comes at the expense of
greater inflation. This section looks at the record and traces the emergence of theview that a simple trade-off between these macroeconomic “bad guys” exists.
Clearly, it is desirable to reduce unemployment and inflation. Unemployment
represents a lost opportunity for workers to engage in productive effort—and toearn income. Inflation erodes the value of money people hold, and more
importantly, the threat of inflation adds to uncertainty and makes people lesswilling to save and firms less willing to invest. If there were a trade-off between thetwo, we could reduce the rate of inflation or the rate of unemployment, but not
both. The fact that the United States did make progress against unemployment andinflation through most of the 1990s and early 2000s represented a macroeconomic
triumph, one that appeared impossible just a few years earlier. The next section
examines the argument that once dominated macroeconomic thought—that asimple trade-off between inflation and unemployment did, indeed, exist. The
argument continues to appear in discussions of macroeconomic policy today; it will
be useful to examine it.

The Phillips Curve in the Short Run

1. A curve that suggests a
negative relationship between
inflation and unemployment.

In 1958, New Zealand–born economist Almarin Phillips reported that his analysis ofa century of British wage and unemployment data suggested that an inverse
relationship existed between rates of increase in wages and British
unemployment.Almarin W. Phillips, “The Relation between Unemployment and theRate of Change of Money Wage Rates in the United Kingdom, 1861–1957,” Economica
25 (November 1958): 283–99. Economists were quick to incorporate this idea into
their thinking, extending the relationship to the rate of price-levelchanges—inflation—and unemployment. The notion that there is a trade-off
between the two is expressed by a short-run Phillips curve1, a curve that suggests

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Chapter 16 Inflation and Unemploymenta negative relationship between inflation and unemployment. Figure 16.1 "TheShort-Run Phillips Curve" shows a short-run Phillips curve.
The short-run Phillips curve seemed to make goodtheoretical sense. The dominant school of economic
thought in the 1960s suggested that the economy was
likely to experience either a recessionary or an
inflationary gap. An economy with a recessionary gap
would have high unemployment and little or no
inflation. An economy with an inflationary gap would
have very little unemployment and a higher rate of
inflation. The Phillips curve suggested a smoothtransition between the two. As expansionary policies
were undertaken to move the economy out of arecessionary gap, unemployment would fall andinflation would rise. Policies to correct an inflationary
gap would bring down the inflation rate, but at a cost of
higher unemployment.

Figure 16.1 The Short-Run
Phillips Curve

The relationship between
inflation and unemployment
suggested by the work of Almarin
Phillips is shown by a short-run
Phillips curve.

The experience of the 1960s suggested that precisely thekind of trade-off the Phillips curve implied did, in fact, exist in the United States.
Figure 16.2 "The Short-Run Phillips Curve in the 1960s" shows annual rates ofinflation (computed using the implicit price deflator) plotted against annual rates of
unemployment from 1961 to 1969. The points appear to follow a path quite similar
to a Phillips curve relationship. The civilian unemployment rate fell from 6.7% in
1961 to 3.5% in 1969. The inflation rate rose from 1.1% in 1961 to 4.8% in 1969. While
inflation dipped slightly in 1963, it appeared that, for the decade as a whole, areduction in unemployment had been “traded” for an increase in inflation.
In the mid-1960s, the economy moved into an
inflationary gap as unemployment fell below its naturallevel. The economy had already reached its full
employment level of output when the 1964 tax cut was
passed. The Fed undertook a more expansionary
monetary policy at the same time. The combined effectof the two policies increased aggregate demand andpushed the economy beyond full employment and into
an inflationary gap. Aggregate demand continued to riseas U.S. spending for the war in Vietnam expanded andas President Lyndon Johnson launched an ambitious
program aimed at putting an end to poverty in the
United States.

16.1 Relating Inflation and Unemployment

Figure 16.2 The Short-Run
Phillips Curve in the 1960s

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Chapter 16 Inflation and Unemployment

By the end of the decade, unemployment at 3.5% wassubstantially below its natural level, estimated by theCongressional Budget Office to be 5.6% that year. When
Richard Nixon became president in 1969, it was widelybelieved that, with an economy operating with an
inflationary gap, it was time to move back down thePhillips curve, trading a reduction in inflation for an
increase in unemployment. President Nixon moved to
do precisely that, serving up a contractionary fiscal
policy by ordering cuts in federal government
purchases. The Fed pursued a contractionary monetary
policy aimed at bringing inflation down.

Values of U.S. inflation andunemployment rates during the
1960s generally conformed to thetrade-off implied by the shortrun Phillips curve. The points foreach year lie close to a curve withthe shape that Phillips’s analysis
predicted.
Source: Economic Report of the
President, 2011, Tables B-3 and
B-42.

The Short-Run Phillips Curve Goes Awry
The effort to nudge the economy back down the Phillips curve to an unemployment
rate closer to the natural level and a lower rate of inflation met with an unhappy
surprise in 1970. Unemployment increased as expected. But inflation rose! The
inflation rate rose to 5.3% from its 1969 rate of 4.8%.
The tidy relationship between inflation and unemployment that had been suggestedby the experience of the 1960s fell apart in the 1970s. Unemployment rose
substantially, but inflation remained the same in 1971. In 1972, both rates fell. The
economy seemed to fall back into the pattern described by the Phillips curve in
1973, as inflation rose while unemployment fell. But the next two years saw
increases in both rates. The negatively sloped Phillips curve relationship between
inflation and unemployment that had seemed to hold true in the 1960s no longer
prevailed.
Indeed, a look at annual rates of inflation and unemployment since 1961 suggeststhat the 1960s were quite atypical. Figure 16.3 "Inflation and Unemployment,
1961–2011" shows the two variables over the period from 1961 through 2011. It is
hard to see a negatively sloped Phillips curve lurking within that seemingly random
scatter of points.

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Chapter 16 Inflation and Unemployment

Figure 16.3 Inflation and Unemployment, 1961–2011

Annual observations of inflation and unemployment in the United States from 1961 to 2011 do not seem consistent
with a Phillips curve.
Sources: Economic Report of the President, 2011, Table B-42; Bureau of Economic Analysis, Implicit Price Deflators
for Gross Domestic Product, NIPA Table 1.1.9. Unemployment rate for 2011 is annual average from Bureau of Labor
Statistics home page.

Inflation and Unemployment Relationships Over Time
Although the points plotted in Figure 16.3 "Inflation and Unemployment,
1961–2011" are not consistent with a negatively sloped, stable Phillips curve,
connecting the inflation/unemployment points over time allows us to focus onvarious ways that these two variables may be related.

2. Period in which inflation andunemployment are inversely
related.

In Figure 16.4 "Connecting the Points: Inflation and Unemployment" we draw
connecting lines through the sequence of observations. By doing so, we see periods
in which inflation and unemployment are inversely related (as in the 1960s, late1970s, late 1980s, the end of the twentieth century, and the first decade of the
2000s). We refer to a period when inflation and unemployment are inversely related
as a Phillips phase2.

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650Chapter 16 Inflation and Unemployment

During other periods, both inflation and unemployment were increasing (as from1973 to 1975 or 1979 to 1981). A period of rising inflation and unemployment iscalled a stagflation phase3. Finally, a recovery phase4 is a period in which bothunemployment and inflation fall (as from 1975 to 1976, 1982 to 1984, and 1992 to1998). Figure 16.5 "Inflation—Unemployment Phases" presents a stylized version ofthese three phases.
Figure 16.4 Connecting the Points: Inflation and Unemployment

Connecting observed values for unemployment and inflation sequentially suggests a cyclical pattern of clockwise
loops over the 1961–2002 period, after which we see a series of inverse relationships.
Sources: Economic Report of the President, 2011, Tables B-3 and B-42.

3. Period in which inflation
remains high while
unemployment increases.
4. Period in which inflation andunemployment both decline.

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Chapter 16 Inflation and Unemployment

Trace the path of inflation and unemployment as it
unfolds in Figure 16.4 "Connecting the Points: Inflationand Unemployment". Starting with the Phillips phase in
the 1960s, we see that the economy went through threeclockwise loops, representing a stagflation phase, then arecovery phase, a Phillips phase, and so on. Each took
the United States to successively higher rates ofinflation and unemployment. Following the stagflationof the late 1970s and early 1980s, however, somethingquite significant happened. The economy suffered avery high rate of unemployment but also achieved very
dramatic gains against inflation. The recovery phase of
the 1990s was the longest since the U.S. government
began tracking inflation and unemployment. Good luck
explains some of that: oil prices fell in the late 1990s,
shifting the short-run aggregate supply curve to theright. That boosted real GDP and put downward
pressure on the price level. But one cause of that
improved performance seemed to be the better
understanding economists gained from some policy
mistakes of the 1970s.

Figure 16.5
Inflation—Unemployment
Phases

The figure shows the way an
economy may move from a
Phillips phase to a stagflation
phase and then to a recovery
phase.

The 2000s look like a series of Phillips phases. The brief recession in 2001 brought
higher unemployment and slightly lower inflation. Unemployment fell from 2003 to2006 but with slightly higher inflation each year. The Great Recession, which beganat the end of 2007, was characterized by higher unemployment and lower inflation.
The next section will explain these experiences in a stylized way in terms of theaggregate demand and supply model.

KEY TAKEAWAYS• The view that there is a trade-off between inflation and unemployment
is expressed by a short-run Phillips curve.
• While there are periods in which a trade-off between inflation andunemployment exists, the actual relationship between these variables ismore varied.
• In a Phillips phase, the inflation rate rises and unemployment falls. A
stagflation phase is marked by rising unemployment while inflation
remains high. In a recovery phase, inflation and unemployment both
fall.

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Chapter 16 Inflation and Unemployment

TRY IT!
Suppose an economy has experienced the rates of inflation and ofunemployment shown below. Plot these data graphically in a grid with the
inflation rate on the vertical axis and the unemployment rate on thehorizontal axis. Identify the periods during which the economy experienced
each of the three phases of the inflation-unemployment cycle identified in
the text.
Period Unemployment Rate (%) Inflation Rate (%)

16.1 Relating Inflation and Unemployment

1

2.5

6.3

2

2.6

5.9

3

2.8

4.8

4

4.7

4.1

5

4.9

5.0

6

5.0

6.1

7

4.5

5.7

8

4.0

5.1

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Chapter 16 Inflation and Unemployment

Case in Point: Some Reflections on the 1970s

Looking back, we may find it difficult to appreciate how stunning theexperience of 1970 and 1971 was. But those two years changed the face ofmacroeconomic thought.
Introductory textbooks of that time contained no mention of aggregate supply.
The model of choice was the aggregate expenditures model. Students learned
that the economy could be in equilibrium below full employment, in which case
unemployment would be the primary macroeconomic problem. Alternatively,
equilibrium could occur at an income greater than the full employment level, in
which case inflation would be the main culprit to worry about.
These ideas could be summarized using a Phillips curve, a new analyticaldevice. It suggested that economists could lay out for policy makers a menu ofpossibilities. Policy makers could then choose the mix of inflation andunemployment they were willing to accept. Economists would then show them
how to attain that mix with the appropriate fiscal and monetary policies.
Then 1970 and 1971 came crashing in on this well-ordered fantasy. President
Richard Nixon had come to office with a pledge to bring down inflation. The
consumer price index had risen 4.7% during 1968, the highest rate since 1951.
Mr. Nixon cut government purchases in 1969, and the Fed produced a sharpslowing in money growth. The president’s economic advisers predicted at the
beginning of 1970 that inflation and unemployment would both fall. Appraising
the 1970 debacle early in 1971, the president’s economists said that theexperience had not been consistent with what standard models would predict.

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Chapter 16 Inflation and Unemployment

The economists suggested, however, that this was probably due to a number oftransitory factors. Their forecast that inflation and unemployment would
improve in 1971 proved wide of the mark—the unemployment rate rose from
4.9% to 5.9% (an increase of 20%), while the rate of inflation measured by thechange in the implicit price deflator barely changed from 5.3% to 5.2%.
As we will see, the experience can be readily explained using the model ofaggregate demand and aggregate supply. But this tool was not well developed
then. The experience of the 1970s forced economists back to their analyticaldrawing boards and spawned dramatic advances in our understanding ofmacroeconomic events. We will explore many of those advances in the next
chapter.
Source: Economic Report of the President, 1971, pp. 60–84.

ANSWER TO TRY IT! PROBLEM

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Chapter 16 Inflation and Unemployment

16.2 Explaining Inflation–Unemployment Relationships
LEARNING OBJECTIVE
1. Use the model of aggregate demand and aggregate supply to explain aPhillips phase, a stagflation phase, and a recovery phase.

We have examined the inflation and unemployment experience in the United States
during the past half century. Our task now is to explain it. We will apply the modelof aggregate demand and aggregate supply, along with our knowledge of monetaryand fiscal policy, to explain just why the economy performed as it did. We will findthat the relationship between inflation and unemployment depends crucially on
events, macroeconomic policy, and expectations.
The next three sections discuss the pattern that unfolded from the 1970s throughthe 1990s in which stagflation and then recovery followed Phillips phases. We will
also look at the behavior of the economy in the first decade of the 21st century.
Each phase results from a specific pattern of shifts in the aggregate demand andshort-run aggregate supply curves.
It is important to be careful in thinking about the meaning of changes in inflation as
we examine the cycle of inflation and unemployment. The rise in inflation during a
Phillips phase does not simply mean that the price level rises. It means that theprice level rises by larger and larger percentages. Rising inflation means that theprice level is rising at an increasing rate. In a recovery phase, a falling rate of
inflation does not imply a falling price level. It means the price level is rising, but by
smaller and smaller percentages. Falling inflation means that the price level isrising more slowly, not that the price level is falling.

The Phillips Phase: Increasing Aggregate Demand
As we saw in the last section, the Phillips phase of the inflation-unemployment
relationship conforms to the concept of a short-run Phillips curve. It is a period inwhich inflation tends to rise and unemployment tends to fall.
Figure 16.6 "A Phillips Phase" shows how a Phillips phase can unfold. Panel (a)shows the model of aggregate demand and aggregate supply; Panel (b) shows thecorresponding path of inflation and unemployment.

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Chapter 16 Inflation and Unemployment

Figure 16.6 A Phillips Phase

A Phillips phase is marked by increases in aggregate demand pushing real GDP and the price level up along theshort-run aggregate supply curve SRAS1,2,3. The result is rising inflation and falling unemployment. The points
labeled in Panels (a) and (b) correspond to one another; point 1 in Panel (a) corresponds to point 1 in Panel (b), andso on.

We shall assume in Figure 16.6 "A Phillips Phase" and in the next two figures thatthe following relationship between real GDP and the unemployment rate holds. In
our example, the level of potential output will be $1,000 billion, while the naturalrate of unemployment is 5.0%. The numbers given in the table correspond to thenumbers used in Figure 16.6 "A Phillips Phase" through Figure 16.8 "The Recovery
Phase". Notice that the higher the level of real GDP, the lower the unemployment
rate. That is because the production of more goods and services requires more
employment. For a given labor force, a higher level of employment implies a lower
rate of unemployment.
Real GDP (Billions) Unemployment Rate (%)
$880

9.0

910

8.0

940

7.0

970

6.0

1,000

5.0

1,030

4.0

1,060

3.0

1,090

2.0

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Chapter 16 Inflation and Unemployment

Suppose that in Period 1 the price level is 1.01 and real GDP equals $880 billion. The
economy is operating below its potential level. The unemployment rate is 9.0%; weshall assume the price level in Period 1 has risen by 0.8% from the previous period.
Point 1 in Panel (b) thus shows an initial rate of inflation of 0.8% and an
unemployment rate of 9.0%.
Now suppose policy makers respond to the recessionary gap of the first period withan expansionary monetary or fiscal policy. Aggregate demand in Period 2 shifts to
AD2. In Panel (a), we see that the price level rises to 1.02 and real GDP rises to $940
billion. Unemployment falls to 7.0%. The price increase from 1.01 to 1.02 gives us an
inflation rate of about 1.0%. Panel (b) shows the new combination of inflation andunemployment rates for Period 2.
Impact lags mean that expansionary policies, even those undertaken in response to
the recessionary gap in Periods 1 and 2, continue to expand aggregate demand in
Period 3. In the case shown, aggregate demand rises to AD3, pushing the economy
well past its level of potential output into an inflationary gap. Real GDP rises to$1,090 billion, and the price level rises to 1.045 in Panel (a) of Figure 16.6 "A Phillips
Phase". The increase in real GDP lowers the unemployment rate to 2.0%, and theinflation rate rises to 2.5% at point 3 in Panel (b). Unemployment has fallen at a costof rising inflation.
The shifts from point 1 to point 2 to point 3 in Panel (b) are characteristic of thePhillips phase. It is crucial to note how these changes occurred. Inflation rose andunemployment fell, because increasing aggregate demand moved along the original
short-run aggregate supply curve SRAS1,2,3. We saw in the chapter that introduced
the model of aggregate demand and aggregate supply that a short-run aggregate
supply curve is drawn for a given level of the nominal wage and for a given set of
expected prices. The Phillips phase, however, drives prices above what workers andfirms expected when they agreed to a given set of nominal wages; real wages arethus driven below their expected level during this phase. Firms that have sticky
prices are in the same situation. Firms set their prices based on some expected pricelevel. As rising inflation drives the price level beyond their expectations, theirprices will be too low relative to the rest of the economy. Because some firms andworkers are committed to their present set of prices and wages for some period oftime, they will be stuck with the wrong prices and wages for a while. During thattime, their lower-than-expected relative prices will mean greater sales and greater
production. The combination of increased production and lower real wages means
greater employment and, thus, lower unemployment.
Ultimately, we should expect that workers and firms will begin adjusting nominal
wages and other sticky prices to reflect the new, higher level of prices that emerges

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Chapter 16 Inflation and Unemployment

during the Phillips phase. It is this adjustment that can set the stage for a
stagflation phase.

Changes in Expectations and a Stagflation Phase
As workers and firms become aware that the general price level is rising, they will
incorporate this fact into their expectations of future prices. In reaching new
agreements on wages, they are likely to settle on higher nominal wages. Firms withsticky prices will adjust their prices upward as they anticipate higher prices
throughout the economy.
As we saw in the chapter introducing the model of aggregate demand and aggregate
supply, increases in nominal wages and in prices that were sticky will shift the
short-run aggregate supply curve to the left. Such a shift is illustrated in Panel (a) of
Figure 16.7 "A Stagflation Phase", where SRAS1,2,3 shifts to SRAS4. The result is a
shift to point 4; the price level rises to 1.075, and real GDP falls to $970 billion. The
increase in the price level to 1.075 from 1.045 implies an inflation rate of 2.9%([1.075 − 1.045] / 1.045 = 2.9%); unemployment rises to 6.0% with the decrease in realGDP. The new combination of inflation and unemployment is given by point 4 inPanel (b).
Figure 16.7 A Stagflation Phase

In a stagflation phase, workers and firms adjust their expectations to a higher price level. As they act on their
expectations, the short-run aggregate supply curve shifts leftward in Panel (a). The price level rises to 1.075, andreal GDP falls to $970 billion. The inflation rate rises to 2.9% as unemployment rises to 6.0% at point 4 in Panel (b).

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Chapter 16 Inflation and Unemployment

The essential feature of a stagflation phase is a change in expectations. Workers andfirms that were blindsided by rising prices during a Phillips phase ended up withlower real wages and lower relative price levels than they intended. In a stagflation
phase, they catch up. But the catching up shifts the short-run aggregate supply
curve to the left, producing a reduction in real GDP and an increase in the pricelevel.

A Recovery Phase
The stagflation phase shown in Figure 16.7 "A Stagflation Phase" leaves the
economy with a recessionary gap at point 4 in Panel (a). The economy is bumped
into a recession by changing expectations. Policy makers can be expected torespond to a recessionary gap by boosting aggregate demand. That increase inaggregate demand will lead the economy into a recovery phase.
Figure 16.8 "The Recovery Phase" illustrates a recovery phase. In Panel (a),aggregate demand increases to AD5, boosting the price level to 1.09 and real GDP to$1,060. The new price level represents a 1.4% ([1.09 − 1.075] / 1.075 = 1.4%) increaseover the previous price level. The price level is higher, but the inflation rate has
fallen sharply. Meanwhile, the increase in real GDP cuts the unemployment rate to
3.0%, shown by point 5 in Panel (b).
Figure 16.8 The Recovery Phase

Policy makers act to increase aggregate demand in order to move the economy out of a recessionary gap createdduring a stagflation phase. Here, aggregate demand shifts to AD4, boosting the price level to 1.09 and real GDP to$1,060 billion at point 5 in Panel (a). The increase in real GDP reduces unemployment. The price level has risen, but
at a slower rate than in the previous period. The result is a reduction in inflation. The new combination ofunemployment and inflation is shown by point 5 in Panel (b).

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Chapter 16 Inflation and Unemployment

Policies that stimulate aggregate demand and changes in expected price levels are
not the only forces that affect the values of inflation and unemployment. Changes
in production costs shift the short-run aggregate supply curve. Depending on whenthese changes occur, they can reinforce or reduce the swings in inflation andunemployment. For example, Figure 16.4 "Connecting the Points: Inflation andUnemployment" shows that inflation was exceedingly low in the late 1990s. During
this period, oil prices were very low—only $12.50 per barrel in 1998, for example. In
terms of Figure 16.7 "A Stagflation Phase", we can represent the low oil prices by ashort-run aggregate supply curve that is to the right of SRAS4,5. That would meanthat output would be somewhat higher, unemployment somewhat lower, andinflation somewhat lower than what is shown as point 5 in Panels (a) and (b) of
Figure 16.8 "The Recovery Phase".

The U.S. Economy in the 21st Century: A Series of Phillips Phases
Comparing the very late 1990s to the early 2000s, Figure 16.4 "Connecting the
Points: Inflation and Unemployment" shows that both periods exhibit Phillips
phases, but that the early 2000s has both higher inflation and higher
unemployment. One way to explain these back-to-back Phillips phases is to look at
Figure 16.6 "A Phillips Phase". Assume point 1 represents the economy in 2001, withaggregate demand increasing. At the same time, though, oil and other commodity
prices were rising markedly—tripling between 2001 and 2007. Thus, the short-run
aggregate supply curve was also shifting to the left of SRAS1,2,3. This would meanthat output would be somewhat lower, unemployment somewhat higher, andinflation somewhat higher than what is shown as points 2 and 3 in Panels (a) and (b)of Figure 16.6 "A Phillips Phase". The 2000s Phillips curve would thus be above thelate 1990s Phillips curve. While the Phillips phase of the early 2000s is farther fromthe origin than that of the late 1990s, it is noteworthy that the economy did not go
through a severe stagflation phase, suggesting some learning about how to conductmonetary and fiscal policy.
The recession that began in late 2007 is largely seen as a shift to the left inaggregate demand due to the marked fall in housing prices and financial market
stresses. As a result, the economy went through a Phillips phase of higher
unemployment and lower inflation. The expansionary monetary and fiscal policiesof the late 2000s were geared toward pushing the aggregate demand curve backtoward the right, thereby cajoling the economy back up the negatively sloped
short-run Phillips curve.
We can conclude that policy efforts to change aggregate demand, together withchanges in expectations and a wide variety of factors that cause the aggregate
demand or aggregate supply curve to shift, have played an important role in

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Chapter 16 Inflation and Unemployment

generating the inflation-unemployment patterns we observe in the past half
century.
Lags have played a crucial role in the cycle as well. If policy makers respond to arecessionary gap with an expansionary fiscal or monetary policy, then we knowthat aggregate demand will increase, but with a lag. Policy makers could thus
undertake an expansionary policy and see little or no response at first. They might
respond by making further expansionary efforts. When the first efforts finally shift
aggregate demand, subsequent expansionary efforts can shift it too far, pushingreal GDP beyond potential and creating an inflationary gap. These increases inaggregate demand create a Phillips phase. The economy’s correction of the gap
creates a stagflation phase. If policy makers respond to the stagflation phase with a
new round of expansionary policies, the initial result will be a recovery phase.
Sufficiently large increases in aggregate demand can then push the economy intoanother Phillips phase, and so on.

KEY TAKEAWAYS• In a Phillips phase, aggregate demand rises and boosts real GDP,lowering the unemployment rate. The price level rises by larger andlarger percentages. Inflation thus rises while unemployment falls.
• A stagflation phase is marked by a leftward shift in short-run aggregate
supply as wages and sticky prices are adjusted upwards. Unemployment
rises while inflation remains high.
• In a recovery phase, policy makers boost aggregate demand. The pricelevel rises, but at a slower rate than in the stagflation phase, so inflation
falls. Unemployment falls as well.

TRY IT!
Using the model of aggregate demand and aggregate supply; sketch thechanges in the curve(s) that produced each of the phases you identified in
Try It! 16-1. Do not worry about specific numbers; just show the direction ofchanges in aggregate demand and/or short-run aggregate supply in eachphase.

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Chapter 16 Inflation and Unemployment

Case in Point: From the Challenging 1970s to the Calm
1990s

The path of U.S. inflation and unemployment followed a fairly consistentpattern of clockwise loops from 1961 to 2002, but the nature of these loops
changed with changes in policy.
If we follow the cycle shown in Figure 16.4 "Connecting the Points: Inflationand Unemployment", we see that the three Phillips phases that began in 1961,
1972, and 1976 started at successively higher rates of inflation. Fiscal andmonetary policy became expansionary at the beginnings of each of thesephases, despite rising rates of inflation.
As inflation soared into the double-digit range in 1979, President Jimmy Carterappointed a new Fed chairman, Paul Volcker. The president gave the newchairman a clear mandate: bring inflation under control, regardless of the cost.
The Fed responded with a sharply contractionary monetary policy and stuckwith it even as the economy experienced its worse recession since the Great
Depression.
Falling oil prices after 1982 contributed to an unusually long recovery phase:
Inflation and unemployment both fell from 1982 to 1986. The inflation rate at
which the economy started its next Phillips phase was the lowest since thePhillips phase of the 1960s.

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Chapter 16 Inflation and Unemployment

The Fed’s policies since then have clearly shown a reduced tolerance for
inflation. The Fed shifted to a contractionary monetary policy in 1988, so that
inflation during the 1986–1989 Phillips phase never exceeded 4%. When oil
prices rose at the outset of the Persian Gulf War in 1990, the resultant swings ininflation and unemployment were much less pronounced than they had been in
the 1970s.
The Fed continued its effort to restrain inflation in 1994 and 1995. It shifted to acontractionary policy early in 1994 when the economy was still in arecessionary gap left over from the 1990–1991 recession. The Fed’s announced
intention was to prevent any future increase in inflation. In effect, the Fed wastaking explicit account of the lag in monetary policy. Had it continued an
expansionary monetary policy, it might well have put the economy in another
Phillips phase. Instead, the Fed has conducted a carefully orchestrated series ofslight shifts in policy that succeeded in keeping the economy in the longest
recovery phase since World War II.
To be sure, the stellar economic performance of the United States in the late
1990s was due in part to falling oil prices, which shifted the short-run aggregate
supply curve to the right and helped push inflation and unemployment down.
But it seems clear that a good deal of the credit can be claimed by the Fed,
which paid closer attention to the lags inherent in macroeconomic policy.
Ignoring those lags helped create the inflation-unemployment cycles thatemerged with activist stabilization policies in the 1960s.

ANSWER TO TRY IT! PROBLEM

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Chapter 16 Inflation and Unemployment

16.3 Inflation and Unemployment in the Long Run
LEARNING OBJECTIVES
1. Use the equation of exchange to explain what determines the inflation
rate in the long run.
2. Explain why in the long run the Phillips curve is vertical.
3. Describe frictional and structural unemployment and the factors that
may affect these two types of unemployment.
4. Describe efficiency wage theory and its predictions concerning cyclicalunemployment.

In the last section, we saw how stabilization policy, together with changes in
expectations, can produce the cycles of inflation and unemployment thatcharacterized the past several decades. These cycles, though, are short-run
phenomena. They involve swings in economic activity around the economy’s
potential output.
This section examines forces that affect the values of inflation and theunemployment rate in the long run. We shall see that the rates of money growthand of economic growth determine the inflation rate. Unemployment that persistsin the long run includes frictional and structural unemployment. We shall examinesome of the forces that affect both types of unemployment, as well as a new theoryof unemployment.

The Inflation Rate in the Long Run
What factors determine the inflation rate? The price level is determined by theintersection of aggregate demand and short-run aggregate supply; anything thatshifts either of these two curves changes the price level and thus affects the
inflation rate. We have seen how these shifts can generate different inflationunemployment combinations in the short run. In the long run, the rate of inflation
will be determined by two factors: the rate of money growth and the rate of
economic growth.
Economists generally agree that the rate of money growth is one determinant of an
economy’s inflation rate in the long run. The conceptual basis for that conclusion
lies in the equation of exchange: MV = PY. That is, the money supply times thevelocity of money equals the price level times the value of real GDP.

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Given the equation of exchange, which holds by definition, we learned in thechapter on monetary policy that the sum of the percentage rates of change in M and
V will be roughly equal to the sum of the percentage rates of change in P and Y.
That is,Equation 16.1

%ΔM + %ΔV ≅ %ΔP + %ΔY
Suppose that velocity is stable in the long run, so that %ΔV equals zero. Then, theinflation rate (%ΔP) roughly equals the percentage rate of change in the money
supply minus the percentage rate of change in real GDP:
Equation 16.2

%ΔP ≅ %ΔM − %ΔY
In the long run, real GDP moves to its potential level, YP. Thus, in the long run we
can write Equation 16.2 as follows:
Equation 16.3

%ΔP ≅ %ΔM − %ΔY P
There is a limit to how fast the economy’s potential output can grow. Economists
generally agree that potential output increases at only about a 2% to 3% annual ratein the United States. Given that the economy stays close to its potential, this puts arough limit on the speed with which Y can grow. Velocity can vary, but it is not
likely to change at a rapid rate over a sustained period. These two facts suggest thatvery rapid increases in the quantity of money, M, will inevitably produce very rapid
increases in the price level, P. If the money supply grows more slowly than potential
output, then the right-hand side of Equation 16.3 will be negative. The price level
will fall; the economy experiences deflation.
Numerous studies point to the strong relationship between money growth andinflation, especially for high-inflation countries. Figure 16.9 "Money Growth Rates
and Inflation over the Long Run" is from a recent study by economist John
Thornton. It is based on a sample of 116 countries from 1960 to 2007. Panel (a)includes all 116 countries, while Panel (b) excludes 6 outlier countries with inflation
rates ranging from 200% to more than 850%. While the relationship is clearly notprecise, the graphs suggest support for the quantity theory of money. A more

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detailed statistical analysis shows that when the annual inflation rate averages
more than 10%, the relationship seems to hold. The Thornton study uses currency
as the monetary aggregate because the definitions of M1 and M2 are not stable
across such a wide sample of countries over long periods of time.John Thornton,“Further Evidence on Money and Inflation in the Long Run,” Applied Economics
Letters 18 (2011): 1443–447.
Figure 16.9 Money Growth Rates and Inflation over the Long Run

Data for 116 countries from 1960 to 2007 suggest a positive relationship between the rate of money growth andinflation.
Source: John Thornton, “Further Evidence on Money and Inflation in the Long Run,” Applied Economics Letters 18(2011): 1443–447.

In the model of aggregate demand and aggregate supply, increases in the money
supply shift the aggregate demand curve to the right and thus force the price levelupward. Money growth thus produces inflation.

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Of course, other factors can shift the aggregate demand curve as well. For example,
expansionary fiscal policy or an increase in investment will shift aggregate demand.
We have already seen that changes in the expected price level or in production
costs shift the short-run aggregate supply curve. But such increases are not likely tocontinue year after year, as money growth can. Factors other than money growth
may influence the inflation rate from one year to the next, but they are not likely tocause sustained inflation.

Inflation Rates and Economic Growth
Our conclusion is a simple and an important one. In the long run, the inflation rateis determined by the relative values of the economy’s rate of money growth and of
its rate of economic growth. If the money supply increases more rapidly than therate of economic growth, inflation is likely to result. A money growth rate equal to
the rate of economic growth will, in the absence of a change in velocity, produce azero rate of inflation. Finally, a money growth rate that falls short of the rate of
economic growth is likely to lead to deflation.

Unemployment and the Phillips Curve in the Long Run

5. A vertical line at the naturalrate of unemployment,
showing that in the long run,there is no trade-off between
inflation and unemployment.

Economists distinguish three types of unemployment: frictional unemployment,
structural unemployment, and cyclical unemployment. The first two exist at all
times, even when the economy operates at its potential. These two types of
unemployment together determine the natural rate of unemployment. In the longrun, the economy will operate at potential, and the unemployment rate will be thenatural rate of unemployment. For this reason, in the long run the Phillips curve
will be vertical at the natural rate of unemployment. Thus, the long-run Phillips
curve5 is a vertical line at the natural rate of unemployment, showing that in thelong run, there is no trade-off between inflation and unemployment. Figure 16.10"The Phillips Curve in the Long Run" explains why. Suppose the economy isoperating at YP on AD1 and SRAS1. Suppose the price level is P0, the same as in thelast period. In that case, the inflation rate is zero. Panel (b) shows that the
unemployment rate is UP, the natural rate of unemployment. Now suppose that theaggregate demand curve shifts to AD2. In the short run, output will increase to Y1.
The price level will rise to P1, and the unemployment rate will fall to U1. In Panel (b)we show the new unemployment rate, U1, to be associated with an inflation rate of
π1, and the beginnings of the negatively sloped short-run Phillips curve emerges. In
the long run, as price and nominal wages increase, the short-run aggregate supply
curve moves to SRAS2 and output returns to YP, as shown in Panel (a). In Panel (b),unemployment returns to UP, regardless of the rate of inflation. Thus, in the longrun, the Phillips curve is vertical.

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Figure 16.10 The Phillips Curve in the Long Run

Suppose the economy is operating at YP on AD1 and SRAS1 in Panel (a) with price level of P0, the same as in the lastperiod. Panel (b) shows that the unemployment rate is UP, the natural rate of unemployment. If the aggregate
demand curve shifts to AD2, in the short run output will increase to Y1, and the price level will rise to P1. In Panel(b), the unemployment rate will fall to U1, and the inflation rate will be π1. In the long run, as price and nominal
wages increase, the short-run aggregate supply curve moves to SRAS2, and output returns to YP, as shown in Panel(a). In Panel (b), unemployment returns to UP, regardless of the rate of inflation. Thus, in the long-run, the Phillips
curve is vertical.

An economy operating at its potential would have no cyclical unemployment.
Because an economy achieves its potential output in the long run, an analysis ofunemployment in the long run is an analysis of frictional and structural
unemployment. In this section, we will also look at some new research thatchallenges the very concept of an economy achieving its potential output.

Frictional Unemployment
Frictional unemployment occurs because it takes time for people seeking jobs andemployers seeking workers to find each other. If the amount of time could be
reduced, frictional unemployment would fall. The economy’s natural rate ofunemployment would drop, and its potential output would rise. This section
presents a model of frictional unemployment and examines some issues in reducing
the frictional unemployment rate.
A period of frictional unemployment ends with the individual getting a job. The
process through which the job is obtained suggests some important clues to thenature of frictional unemployment.

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By definition, a person who is unemployed is seeking work. At the outset of a job
search, we presume that the individual has a particular wage in mind as he or she
considers various job possibilities. The lowest wage that an unemployed worker
would accept, if it were offered, is called the reservation wage6. This is the wage an
individual would accept; any offer below it would be rejected. Once a firm offers thereservation wage, the individual will take it and the job search will be terminated.
Many people may hold out for more than just a wage—they may be seeking acertain set of working conditions, opportunities for advancement, or a job in aparticular area. In practice, then, an unemployed worker might be willing to accept
a variety of combinations of wages and other job characteristics. We shall simplify
our analysis by lumping all these other characteristics into a single reservation
wage.
A worker’s reservation wage is likely to change as his or her search continues. One
might initiate a job search with high expectations and thus have a high reservation
wage. As the job search continues, however, this reservation wage might beadjusted downward as the worker obtains better information about what is likely to
be available in the market and as the financial difficulties associated with
unemployment mount. We can thus draw a reservation wage curve (Figure 16.11 "A
Model of a Job Search"), that suggests a negative relationship between thereservation wage and the duration of a person’s job search. Similarly, as a job
search continues, the worker will accumulate better offers. The “best-offerreceived” curve shows what its name implies; it is the best offer the individual hasreceived so far in the job search. The upward slope of the curve suggests that, as aworker’s search continues, the best offer received will rise.

6. The lowest wage that an
unemployed worker would
accept, if it were offered.

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Figure 16.11 A Model of a Job Search

An individual begins a job search at time t0 with a reservation wage W0. As long as the reservation wage exceeds thebest offer received, the individual will continue searching. A job is accepted, and the search is terminated, at time tc,
at which the reservation and “best-offer-received” curves intersect at wage Wc.

The search begins at time t0, with the unemployed worker seeking wage W0.
Because the worker’s reservation wage exceeds the best offer received, the worker
continues the search. The worker reduces his or her reservation wage andaccumulates better offers until the two curves intersect at time tc. The worker
accepts wage Wc, and the job search is terminated.
The job search model in Figure 16.11 "A Model of a Job Search" does not determine
an equilibrium duration of job search or an equilibrium initial wage. The
reservation wage and best-offer-received curves will be unique to each individual’s
experience. We can, however, use the model to reach some conclusions about
factors that affect frictional unemployment.
First, the duration of search will be shorter when more job market information isavailable. Suppose, for example, that the only way to determine what jobs andwages are available is to visit each firm separately. Such a situation would require alengthy period of search before a given offer was received. Alternatively, suppose
there are agencies that make such information readily available and that link

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unemployed workers to firms seeking to hire workers. In that second situation, thetime required to obtain a given offer would be reduced, and the best-offer-received
curves for individual workers would shift to the left. The lower the cost for
obtaining job market information, the lower the average duration ofunemployment. Government and private agencies that provide job information andplacement services help to reduce information costs to unemployed workers andfirms. They tend to lower frictional unemployment by shifting the best-offerreceived curves for individual workers to the left, as shown in Panel (a) of Figure
16.12 "Public Policy and Frictional Unemployment". Workers obtain higher-paying
jobs when they do find work; the wage at which searches are terminated rises to W2.
Figure 16.12 Public Policy and Frictional Unemployment

Public policy can influence the time required for job-seeking workers and worker-seeking firms to find each other.
Programs that provide labor-market information tend to shift the best-offer-received (BOR) curves of individual
workers to the left, reducing the duration of job search and reducing unemployment, as in Panel (a). Note that thewage these workers obtain also rises to W2. Unemployment compensation tends to increase the period over which aworker will hold out for a particular wage, shifting the reservation wage (RW) curve to the right, as in Panel (b).
Unemployment compensation thus boosts the unemployment rate and increases the wage workers obtain when theyfind employment.

Unemployment compensation, which was introduced in the United States during
the Great Depression to help workers who had lost jobs through unemployment,
also affects frictional unemployment. Because unemployment compensation
reduces the financial burden of being unemployed, it is likely to increase theamount of time people will wait for a given wage. It thus shifts the reservation wage
curve to the right, raises the average duration of unemployment, and increases thewage at which searches end, as shown in Panel (b). An increase in the average
duration of unemployment implies a higher unemployment rate. Unemployment
compensation thus has a paradoxical effect—it tends to increase the problem
against which it protects.

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Structural Unemployment
Structural unemployment occurs when a firm is looking for a worker and an
unemployed worker is looking for a job, but the particular characteristics the firmseeks do not match up with the characteristics the worker offers. Technologicalchange is one source of structural unemployment. New technologies are likely torequire different skills than old technologies. Workers with training to equip themfor the old technology may find themselves caught up in a structural mismatch.
Technological and managerial changes have, for example, changed thecharacteristics firms seek in workers they hire. Firms looking for assembly-line
workers once sought men and women with qualities such as reliability, integrity,
strength, and manual dexterity. Reliability and integrity remain important, butmany assembly-line jobs now require greater analytical and communications skills.
Automobile manufacturers, for example, now test applicants for entry-level factory
jobs on their abilities in algebra, in trigonometry, and in written and oral
communications. Strong, agile workers with weak analytical and language skills
may find many job openings for which they do not qualify. They would be examplesof the structurally unemployed.
Changes in demand can also produce structural unemployment. As consumers shift
their demands to different products, firms that are expanding and seeking moreworkers may need different skills than firms for which demand has shrunk.
Similarly, firms may shift their use of different types of jobs in response tochanging market conditions, leaving some workers with the “wrong” set of skills.
Regional shifts in demand can produce structural unemployment as well. The
economy of one region may be expanding rapidly, creating job vacancies, while
another region is in a slump, with many workers seeking jobs but not finding them.
Public and private job training firms seek to reduce structural unemployment by
providing workers with skills now in demand. Employment services that provide
workers with information about jobs in other regions also reduce the extent ofstructural unemployment.

Cyclical Unemployment and Efficiency Wages
In our model, unemployment above the natural level occurs if, at a given real wage,
the quantity of labor supplied exceeds the quantity of labor demanded. In theanalysis we’ve done so far, the failure to achieve equilibrium is a short-run
phenomenon. In the long run, wages and prices will adjust so that the real wage
reaches its equilibrium level. Employment reaches its natural level.

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Some economists, however, argue that a real wage that achieves equilibrium in thelabor market may never be reached. They suggest that firms may intentionally pay awage greater than the market equilibrium. Such firms could hire additional workers
at a lower wage, but they choose not to do so. The idea that firms may hold to a real
wage greater than the equilibrium wage is called efficiency-wage theory7.
Why would a firm pay higher wages than the market requires? Suppose that bypaying higher wages, the firm is able to boost the productivity of its workers.
Workers become more contented and more eager to perform in ways that boost thefirm’s profits. Workers who receive real wages above the equilibrium level may also
be less likely to leave their jobs. That would reduce job turnover. A firm that pays
its workers wages in excess of the equilibrium wage expects to gain by retaining its
employees and by inducing those employees to be more productive. Efficiency-wagetheory thus suggests that the labor market may divide into two segments. Workers
with jobs will receive high wages. Workers without jobs, who would be willing towork at an even lower wage than the workers with jobs, find themselves closed outof the market.
Whether efficiency wages really exist remains a controversial issue, but theargument is an important one. If it is correct, then the wage rigidity thatperpetuates a recessionary gap is transformed from a temporary phenomenon thatwill be overcome in the long run to a permanent feature of the market. The
argument implies that the ordinary processes of self-correction will not eliminate arecessionary gap.For a discussion of the argument, see Janet Yellen, “Efficiency
Wage Models of Unemployment,” American Economic Review, Papers and Proceedings(May 1984): 200–205.

7. The idea that firms may hold toa real wage greater than theequilibrium wage.

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KEY TAKEAWAYS• Two factors that can influence the rate of inflation in the long run are
the rate of money growth and the rate of economic growth.
• In the long run, the Phillips curve will be vertical since when output is atpotential, the unemployment rate will be the natural rate ofunemployment, regardless of the rate of inflation.
• The rate of frictional unemployment is affected by information costs
and by the existence of unemployment compensation.
• Policies to reduce structural unemployment include the provision of job
training and information about labor-market conditions in otherregions.
• Efficiency-wage theory predicts that profit-maximizing firms will
maintain the wage level at a rate too high to achieve full employment in
the labor market.

TRY IT!
Using the model of a job search (see Figure 16.11 "A Model of a Job Search"),show graphically how each of the following would be likely to affect the
duration of an unemployed worker’s job search and thus the unemployment
rate:
1. A new program provides that workers who have lost their jobs will
receive unemployment compensation from the government equal to the
pay they were earning when they lost their jobs, and that thiscompensation will continue for at least five years.
2. Unemployment compensation is provided, but it falls by 20% eachmonth a person is out of work.
3. Access to the Internet becomes much more widely available and is usedby firms looking for workers and by workers seeking jobs.

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Case in Point: Altering the Incentives for Unemployment
Insurance Claimants

While the rationale for unemployment insurance is clear—to help people
weather bouts of unemployment—especially during economic downturns,
designing programs that reduce adverse incentives is challenging. A review
article by economists Peter Fredriksson and Bertil Holmlund examined decadesof research that looks at how unemployment insurance programs could be
improved. In particular, they consider the value of changing the duration andprofile of benefit payments, increasing monitoring and sanctions imposed on
unemployment insurance recipients, and changing work requirements. Some of
the research is theoretical, while some comes out of actual experiments.
Concerning benefit payments, they suggest that reducing payments over time
provides better incentives than either keeping payments constant or increasing
them over time. Research also suggests that a waiting period might also be
useful. Concerning monitoring and sanctions, most unemployment insurance
systems require claimants to demonstrate in some way that they have looked
for work. For example, they must report regularly to employment agencies orprovide evidence they have applied for jobs. If they do not, the benefit may be
temporarily cut. A number of experiments support the notion that greater
search requirements reduce the length of unemployment. One experimentconducted in Maryland assigned recipients to different processes ranging fromthe standard requirement at the time of two employer contacts per week torequiring at least four contacts per week, attending a four-day job search

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workshop, and telling claimants that their employer contacts would be verified.
The results showed that increasing the number of employer contacts reduced
the duration by 6%, attending the workshop reduced duration by 5%, and thepossibility of verification reduced it by 7.5%. Indeed, just telling claimants thatthey were going to have to attend the workshop led to a reduction in claimants.
Evidence on instituting some kind of work requirement is similar to that ofinstituting workshop attendance.
The authors conclude that the effectiveness of all these instruments resultsfrom the fact that they encourage more active job search.
Source: Peter Fredriksson and Bertil Holmlund, “Improving Incentives in
Unemployment Insurance: A Review of Recent Research,” Journal of Economic
Surveys 20, no. 3 (July 2006): 357–86.

ANSWER TO TRY IT! PROBLEM
The duration of an unemployed worker's job search increases in situation(1), as illustrated in panel (a) and decreases in situations (2) and (3), as
illustrated in panels (b) and (c) respectively. Thus, the unemployment rateincreases in situation (1) and decreases in situations (2) and (3).

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Summary
During the 1960s, it appeared that there was a stable trade-off between the rate of unemployment and the rateof inflation. The short-run Phillips curve, which describes such a trade-off, suggests that lower rates of
unemployment come with higher rates of inflation, and that lower rates of inflation come with higher rates of
unemployment. But during subsequent decades, the actual values for unemployment and inflation have notalways followed the trade-off script.
There has, however, been a relationship between unemployment and inflation over the four decades from 1961.
Periods of rising inflation and falling unemployment were often followed by periods of rising unemployment
and continued or higher inflation; those periods, in turn, were followed by periods in which both the inflation
rate and the unemployment rate fell. These periods are defined as the Phillips phase, the stagflation phase, andthe recovery phase. Following the recession of 2001, the economy returned quickly to a Phillips phase.
The Phillips phase is a period in which aggregate demand increases, boosting output and the price level.
Unemployment drops and inflation rises. An essential feature of a Phillips phase is that the price increases that
occur are unexpected. Workers thus experience lower real wages than they anticipated. Firms with sticky prices
find that their prices are low relative to other prices. As workers and firms adjust to the higher inflation of thePhillips phase, they demand higher wages and post higher prices, so the short-run aggregate supply curve shifts
leftward. Inflation continues, but real GDP falls. This is a stagflation phase. Finally, aggregate demand begins toincrease again, boosting both real GDP and the price level. The higher price level, however, is likely to represent
a much smaller percentage increase than had occurred during the stagflation phase. This is a recovery phase:
inflation and unemployment fall together.
There is nothing inherent in a market economy that would produce the inflation-unemployment pattern weobserved from 1961 until 2000. The cycle can begin if expansionary policies are launched to correct arecessionary gap, producing a Phillips phase. If those policies push the economy into an inflationary gap, thenthe adjustment of short-run aggregate supply will produce a stagflation phase. And, in the economy’s first
response to an expansionary policy launched to deal with the recession of the stagflation phase, the price level
rises, but at a slower rate than before. The economy experiences falling inflation and falling unemployment at
the same time: a recovery phase. The years since 2000 look more like a series of Phillips phases.
In the long run, the Phillips curve is vertical, and inflation is essentially a monetary phenomenon. Assuming
stable velocity of money over the long run, the inflation rate roughly equals the money growth rate minus therate of growth of real GDP. For a given money growth rate, inflation is thus reduced by faster economic growth.
Frictional unemployment is affected by information costs in the labor market. A reduction in those costs would
reduce frictional unemployment. Hastening the retraining of workers would reduce structural unemployment.

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Reductions in frictional or structural unemployment would lower the natural rate of unemployment and thus
raise potential output. Unemployment compensation is likely to increase frictional unemployment.
Some economists believe that cyclical unemployment may persist because firms have an incentive to maintainreal wages above the equilibrium level. Whether this efficiency-wage argument holds is controversial.

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CONCEPT PROBLEMS
1. The Case in Point titled “Some Reflections on the 1970s” describes thechanges in inflation and in unemployment in 1970 and 1971 as awatershed development for macroeconomic thought. Why was anincrease in unemployment such a significant event?
2. As the economy slipped into recession in 1980 and 1981, the Fed wasunder enormous pressure to adopt an expansionary monetary policy.
Suppose it had begun an expansionary policy early in 1981. What does
the text’s analysis of the inflation-unemployment cycle suggest about
how the macroeconomic history of the 1980s might have been changed?
3. Here are some news reports covering events of the past 35 years.
In each case, identify the phase (Phillips, stagflation, or recovery)
the economy is in, and suggest what change in aggregate demandor aggregate supply might have caused it.
a. “President Nixon expressed satisfaction with last year’s
economic performance. He said that with inflation andunemployment heading down, the nation ‘is on the rightcourse.’”b. “The nation’s inflation rate rose to a record high last month,
the government reported yesterday. The consumer priceindex jumped 0.3% in January. Coupled with theannouncement earlier this month that unemployment hadrisen by 0.5 percentage points, the reports suggested that thefirst month of President Nixon’s second term had gotten off
to a rocky start.”c. “President Carter expressed concern about reports of rising
inflation but insisted the economy is on the right course. He
pointed to recent reductions in unemployment as evidence
that his economic policies are working.”
4. The text notes that changes in oil prices can affect the inflationunemployment outcome. Explain what effect changes in oil prices may
have on these two variables.
5. The introduction to this chapter suggests that unemployment fell, andinflation generally fell, through most of the 1990s. What phase (Phillips,
stagflation, or recovery) does this represent? Relative to U.S. experiencefrom the 1960s until the 1990s, what was unusual about this?
6. Suppose that declining resource supplies reduce potential output ineach period by 4%. What kind of monetary policy would be needed tomaintain a zero rate of inflation at full employment?

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7. The Humphrey–Hawkins Act of 1978 required that the federal
government maintain an unemployment rate of 4% and hold theinflation rate to less than 3%. What does the inflation-unemployment
relationship tell you about achieving such goals?
8. The American Economic Association publishes a newsletter (which isavailable on the AEA’s Internet site at http://www.aeaweb.org/joe/)called Job Openings for Economists (JOE). Virtually all academic and manynonacademic positions for which applicants are being sought foreconomics positions are listed in the newsletter, which is quite
inexpensive. How do you think that the publication of this journal
affects the unemployment rate among economists? What type of
unemployment does it affect?
9. Many people think that the process of putting computer technology towork and incorporating computers into the workplace is causing a
massive restructuring of virtually every institution of modern life. Ifthey are right, what are the implications for unemployment? What kindof unemployment would be affected?
10. The natural unemployment rate in the United States has varied over thelast 50 years. According to the Congressional Budget Office, the naturalrate was 5.5% in 1960, rose to about 6.5% in the 1970s, and had declined
to about 4.8% by 2000. What do you think might have caused thisvariation?
11. Suppose the Fed begins carrying out an expansionary monetary policyin order to close a recessionary gap. Relate what happens during thenext two phases of the inflation-unemployment cycle to the maxim“You can fool some of the people some of the time, but you can’t fool allof the people all of the time.”

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NUMERICAL PROBLEMS

1. Here are annual data for the inflation and unemployment rates
for the United States for the 1948–1961 period.
Year Unemployment Rate (%) Inflation Rate (%)
1948

3.8

3.0

1949

5.9

−2.1

1950

5.3

5.9

1951

3.3

6.0

1952

3.0

0.8

1953

2.9

0.7

1954

5.5

−0.7

1955

4.4

0.4

1956

4.1

3.0

1957

4.3

2.9

1958

6.8

1.8

1959

5.5

1.7

1960

5.5

1.4

1961

6.7

0.7

a. Plot these observations and connect the points as in Figure
16.5 "Inflation—Unemployment Phases".
b. How does this period compare to the decades that followed?
c. What do you think accounts for the difference?
2. Here are hypothetical inflation and unemployment data for
Econoland.
Time Period Inflation Rate (%) Unemployment Rate (%)

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0

6

2

3

4

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Time Period Inflation Rate (%) Unemployment Rate (%)
3

7

3

4

8

5

5

7

7

6

3

6

a. Plot these points.
b. Identify which points correspond to a Phillips phase, whichcorrespond to a stagflation phase, and which correspond to arecovery phase.
3. Relate the observations in Numerical Problem 2 to what must have been
happening in the aggregate demand–aggregate supply model.
4. Suppose the full-employment level of real GDP is increasing at a rate of
3% per period and the money supply is growing at a 4% rate. What will
happen to the long-run inflation rate, assuming constant velocity?

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Chapter 17
A Brief History of Macroeconomic Thought and Policy
Start Up: Three Revolutions in Macroeconomic
Thought
It is the 1930s. Many people have begun to wonder if the United States will everescape the Great Depression’s cruel grip. Forecasts that prosperity lies just aroundthe corner take on a hollow ring.
The collapse seems to defy the logic of the dominant economic view—that
economies should be able to reach full employment through a process of selfcorrection. The old ideas of macroeconomics do not seem to work, and it is not clear
what new ideas should replace them.
In Britain, Cambridge University economist John Maynard Keynes is struggling withideas that he thinks will stand the conventional wisdom on its head. He is confident
that he has found the key not only to understanding the Great Depression but also
to correcting it.
It is the 1960s. Most economists believe that Keynes’s ideas best explain fluctuationsin economic activity. The tools Keynes suggested have won widespread acceptanceamong governments all over the world; the application of expansionary fiscal policyin the United States appears to have been a spectacular success. But economist
Milton Friedman of the University of Chicago continues to fight a lonely battle
against what has become the Keynesian orthodoxy. He argues that money, not fiscal
policy, is what affects aggregate demand. He insists not only that fiscal policy
cannot work, but that monetary policy should not be used to move the economy
back to its potential output. He counsels a policy of steady money growth, leaving
the economy to adjust to long-run equilibrium on its own.
It is 1970. The economy has just taken a startling turn: Real GDP has fallen, but
inflation has remained high. A young economist at Carnegie–Mellon University,
Robert E. Lucas, Jr., finds this a paradox, one that he thinks cannot be explained byKeynes’s theory. Along with several other economists, he begins work on a radicallynew approach to macroeconomic thought, one that will challenge Keynes’s viewhead-on. Lucas and his colleagues suggest a world in which self-correction is swift,685

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rational choices by individuals generally cancel the impact of fiscal and monetary
policies, and stabilization efforts are likely to slow economic growth.
John Maynard Keynes, Milton Friedman, and Robert E. Lucas, Jr., each helped toestablish a major school of macroeconomic thought. Although their ideas clashedsharply, and although there remains considerable disagreement among economists
about a variety of issues, a broad consensus among economists concerning
macroeconomic policy seemed to emerge in the 1980s, 1990s, and early 2000s. The
Great Recession and the financial crisis in the late 2000s, though, set off anotherround of controversy.
In this chapter we will examine the macroeconomic developments of six decades:the 1930s, 1960s, 1970s, 1980s, 1990s, and 2000s. We will use the aggregate
demand–aggregate supply model to explain macroeconomic changes during these
periods, and we will see how the three major economic schools were affected bythese events. We will also see how these schools of thought affected macroeconomic
policy. Finally, we will see how the evolution of macroeconomic thought and policy
influenced how economists design policy prescriptions for dealing with therecession that began in late 2007, which turned out to be the largest since the Great
Depression.
In examining the ideas of these schools, we will incorporate concepts such as thepotential output and the natural level of employment. While such terms had notbeen introduced when some of the major schools of thought first emerged, we will
use them when they capture the ideas economists were presenting.

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17.1 The Great Depression and Keynesian Economics
LEARNING OBJECTIVES
1. Explain the basic assumptions of the classical school of thought that
dominated macroeconomic thinking before the Great Depression, andtell why the severity of the Depression struck a major blow to this view.
2. Compare Keynesian and classical macroeconomic thought, discussing
the Keynesian explanation of prolonged recessionary and inflationary
gaps as well as the Keynesian approach to correcting these problems.

It is hard to imagine that anyone who lived during the Great Depression was notprofoundly affected by it. From the beginning of the Depression in 1929 to the timethe economy hit bottom in 1933, real GDP plunged nearly 30%. Real per capita
disposable income sank nearly 40%. More than 12 million people were thrown out
of work; the unemployment rate soared from 3% in 1929 to 25% in 1933. Some
85,000 businesses failed. Hundreds of thousands of families lost their homes. By
1933, about half of all mortgages on all urban, owner-occupied houses weredelinquent.David C. Wheelock, “The Federal Response to Home Mortgage Distress:
Lessons from the Great Depression,” Federal Reserve Bank of St. Louis Review 90, no. 3(Part 1) (May/June 2008): 133–48.
The economy began to recover after 1933, but a huge recessionary gap persisted.
Another downturn began in 1937, pushing the unemployment rate back up to 19%
the following year.
The contraction in output that began in 1929 was not, of course, the first time theeconomy had slumped. But never had the U.S. economy fallen so far and for so longa period. Economic historians estimate that in the 75 years before the Depression
there had been 19 recessions. But those contractions had lasted an average of lessthan two years. The Great Depression lasted for more than a decade. The severity
and duration of the Great Depression distinguish it from other contractions; it is forthat reason that we give it a much stronger name than “recession.”
Figure 17.1 "The Depression and the Recessionary Gap" shows the course of real
GDP compared to potential output during the Great Depression. The economy did
not approach potential output until 1941, when the pressures of world war forced
sharp increases in aggregate demand.

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Figure 17.1 The Depression and the Recessionary Gap

The dark-shaded area shows real GDP from 1929 to 1942, the upper line shows potential output, and the light-shaded
area shows the difference between the two—the recessionary gap. The gap nearly closed in 1941; an inflationary gap
had opened by 1942. The chart suggests that the recessionary gap remained very large throughout the 1930s.

The Classical School and the Great Depression
The Great Depression came as a shock to what was then the conventional wisdom of
economics. To see why, we must go back to the classical tradition ofmacroeconomics that dominated the economics profession when the Depression
began.
Classical economics1 is the body of macroeconomic thought associated primarily
with 19th-century British economist David Ricardo. His Principles of Political Economy
and Taxation, published in 1817, established a tradition that dominatedmacroeconomic thought for over a century. Ricardo focused on the long run and on
the forces that determine and produce growth in an economy’s potential output. He
emphasized the ability of flexible wages and prices to keep the economy at or nearits natural level of employment.
1. The body of macroeconomic
thought, associated primarily
with 19th-century British
economist David Ricardo, that
focused on the long run and on
the forces that determine andproduce growth in an
economy’s potential output.

According to the classical school, achieving what we now call the natural level of
employment and potential output is not a problem; the economy can do that on its
own. Classical economists recognized, however, that the process would take time.
Ricardo admitted that there could be temporary periods in which employment would

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fall below the natural level. But his emphasis was on the long run, and in the longrun all would be set right by the smooth functioning of the price system.
Economists of the classical school saw the massive slump that occurred in much of
the world in the late 1920s and early 1930s as a short-run aberration. The economy
would right itself in the long run, returning to its potential output and to thenatural level of employment.

Keynesian Economics
In Britain, which had been plunged into a depression of its own, John Maynard
Keynes had begun to develop a new framework of macroeconomic analysis, one thatsuggested that what for Ricardo were “temporary effects” could persist for a longtime, and at terrible cost. Keynes’s 1936 book, The General Theory of Employment,Interest and Money, was to transform the way many economists thought aboutmacroeconomic problems.

Keynes versus the Classical Tradition
In a nutshell, we can say that Keynes’s book shifted the thrust of macroeconomic
thought from the concept of aggregate supply to the concept of aggregate demand.
Ricardo’s focus on the tendency of an economy to reach potential output inevitably
stressed the supply side—an economy tends to operate at a level of output given by
the long-run aggregate supply curve. Keynes, in arguing that what we now callrecessionary or inflationary gaps could be created by shifts in aggregate demand,
moved the focus of macroeconomic analysis to the demand side. He argued thatprices in the short run are quite sticky and suggested that this stickiness would
block adjustments to full employment.
Keynes dismissed the notion that the economy would achieve full employment in
the long run as irrelevant. “In the long run,” he wrote acidly, “we are all dead.”

2. The body of macroeconomic
thought that asserts thatchanges in aggregate demandcan create gaps between theactual and potential levels of
output, and that such gaps canbe prolonged. It stresses theuse of fiscal and monetary
policy to close such gaps.

Keynes’s work spawned a new school of macroeconomic thought, the Keynesianschool. Keynesian economics2 asserts that changes in aggregate demand cancreate gaps between the actual and potential levels of output, and that such gaps
can be prolonged. Keynesian economists stress the use of fiscal and of monetary
policy to close such gaps.

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Keynesian Economics and the Great Depression
The experience of the Great Depression certainly seemed consistent with Keynes’s
argument. A reduction in aggregate demand took the economy from above its
potential output to below its potential output, and, as we saw in Figure 17.1 "The
Depression and the Recessionary Gap", the resulting recessionary gap lasted formore than a decade. While the Great Depression affected many countries, we shallfocus on the U.S. experience.
The plunge in aggregate demand began with a collapse in investment. The
investment boom of the 1920s had left firms with an expanded stock of capital. As
the capital stock approached its desired level, firms did not need as much newcapital, and they cut back investment. The stock market crash of 1929 shookbusiness confidence, further reducing investment. Real gross private domestic
investment plunged nearly 80% between 1929 and 1932. We have learned of thevolatility of the investment component of aggregate demand; it was very much inevidence in the first years of the Great Depression.
Other factors contributed to the sharp reduction in aggregate demand. The stock
market crash reduced the wealth of a small fraction of the population (just 5% of
Americans owned stock at that time), but it certainly reduced the consumption of
the general population. The stock market crash also reduced consumer confidence
throughout the economy. The reduction in wealth and the reduction in confidence
reduced consumption spending and shifted the aggregate demand curve to the left.
Fiscal policy also acted to reduce aggregate demand. As consumption and income
fell, governments at all levels found their tax revenues falling. They responded byraising tax rates in an effort to balance their budgets. The federal government, forexample, doubled income tax rates in 1932. Total government tax revenues as apercentage of GDP shot up from 10.8% in 1929 to 16.6% in 1933. Higher tax rates
tended to reduce consumption and aggregate demand.
Other countries were suffering declining incomes as well. Their demand for U.S.
goods and services fell, reducing the real level of exports by 46% between 1929 and
1933. The Smoot–Hawley Tariff Act of 1930 dramatically raised tariffs on products
imported into the United States and led to retaliatory trade-restricting legislation
around the world. This act, which more than 1,000 economists opposed in a formal
petition, contributed to the collapse of world trade and to the recession.
As if all this were not enough, the Fed, in effect, conducted a sharply contractionary
monetary policy in the early years of the Depression. The Fed took no action toprevent a wave of bank failures that swept the country at the outset of the17.1 The Great Depression and Keynesian Economics

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Depression. Between 1929 and 1933, one-third of all banks in the United States
failed. As a result, the money supply plunged 31% during the period.
The Fed could have prevented many of the failures by engaging in open-market
operations to inject new reserves into the system and by lending reserves totroubled banks through the discount window. But it generally refused to do so; Fed
officials sometimes even applauded bank failures as a desirable way to weed out bad
management!
Figure 17.2 "Aggregate Demand and Short-Run
Aggregate Supply: 1929–1933" shows the shift inaggregate demand between 1929, when the economy
was operating just above its potential output, and 1933.
The plunge in aggregate demand produced arecessionary gap. Our model tells us that such a gap
should produce falling wages, shifting the short-run
aggregate supply curve to the right. That happened;nominal wages plunged roughly 20% between 1929 and
1933. But we see that the shift in short-run aggregate
supply was insufficient to bring the economy back to its
potential output.
The failure of shifts in short-run aggregate supply tobring the economy back to its potential output in theearly 1930s was partly the result of the magnitude of the
reductions in aggregate demand, which plunged theeconomy into the deepest recessionary gap everrecorded in the United States. We know that the shortrun aggregate supply curve began shifting to the rightin 1930 as nominal wages fell, but these shifts, which
would ordinarily increase real GDP, were overwhelmedby continued reductions in aggregate demand.

Figure 17.2 Aggregate
Demand and Short-Run
Aggregate Supply: 1929–1933

Slumping aggregate demandbrought the economy well below
the full-employment level of
output by 1933. The short-run
aggregate supply curve increased
as nominal wages fell. In thisanalysis, and in subsequent
applications in this chapter ofthe model of aggregate demand
and aggregate supply tomacroeconomic events, we are
ignoring shifts in the long-run
aggregate supply curve in order
to simplify the diagram.

A further factor blocking the economy’s return to its
potential output was federal policy. President Franklin
Roosevelt thought that falling wages and prices were in large part to blame for the
Depression; programs initiated by his administration in 1933 sought to block
further reductions in wages and prices. That stopped further reductions in nominal
wages in 1933, thus stopping further shifts in aggregate supply. With recovery
blocked from the supply side, and with no policy in place to boost aggregate
demand, it is easy to see now why the economy remained locked in a recessionary
gap so long.

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Keynes argued that expansionary fiscal policy represented the surest tool forbringing the economy back to full employment. The United States did not carry out
such a policy until world war prompted increased federal spending for defense. New
Deal policies did seek to stimulate employment through a variety of federal
programs. But, with state and local governments continuing to cut purchases andraise taxes, the net effect of government at all levels on the economy did notincrease aggregate demand during the Roosevelt administration until the onset ofworld war.For a discussion of fiscal policy during the Great Depression, see E. Cary
Brown, “Fiscal Policy in the ’Thirties: A Reappraisal,” American Economic Review 46,
no. 5 (December 1956): 857–79. As Figure 17.3 "World War II Ends the Great
Depression" shows, expansionary fiscal policies forced by the war had brought
output back to potential by 1941. The U.S. entry into World War II after Japan’s
attack on American forces in Pearl Harbor in December of 1941 led to much sharperincreases in government purchases, and the economy pushed quickly into an
inflationary gap.
Figure 17.3 World War II Ends the Great Depression

Increased U.S. government purchases, prompted by the beginning of World War II, ended the Great Depression. By
1942, increasing aggregate demand had pushed real GDP beyond potential output.

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For Keynesian economists, the Great Depression provided impressive confirmationof Keynes’s ideas. A sharp reduction in aggregate demand had gotten the trouble
started. The recessionary gap created by the change in aggregate demand had
persisted for more than a decade. And expansionary fiscal policy had put a swift end
to the worst macroeconomic nightmare in U.S. history—even if that policy had been
forced on the country by a war that would prove to be one of the worst episodes ofworld history.

KEY TAKEAWAYS• Classical economic thought stressed the ability of the economy toachieve what we now call its potential output in the long run. It thus
stressed the forces that determine the position of the long-run
aggregate supply curve as the determinants of income.
• Keynesian economics focuses on changes in aggregate demand and theirability to create recessionary or inflationary gaps. Keynesian economists
argue that sticky prices and wages would make it difficult for the
economy to adjust to its potential output.
• Because Keynesian economists believe that recessionary andinflationary gaps can persist for long periods, they urge the use of fiscal
and monetary policy to shift the aggregate demand curve and to close
these gaps.
• Aggregate demand fell sharply in the first four years of the Great
Depression. As the recessionary gap widened, nominal wages began tofall, and the short-run aggregate supply curve began shifting to theright. These shifts, however, were not sufficient to close therecessionary gap. World War II forced the U.S. government to shift to a
sharply expansionary fiscal policy, and the Depression ended.

TRY IT!
Imagine that it is 1933. President Franklin Roosevelt has just been
inaugurated and has named you as his senior economic adviser. Devise a
program to bring the economy back to its potential output. Using the modelof aggregate demand and aggregate supply, demonstrate graphically how
your proposal could work.

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Case in Point: Early Views on StickinessAlthough David Ricardo’s focus on the long run emerged as the dominant
approach to macroeconomic thought, not all of his contemporaries agreed withhis perspective. Many 18th- and 19th-century economists developed theoreticalarguments suggesting that changes in aggregate demand could affect the reallevel of economic activity in the short run. Like the new Keynesians, they based
their arguments on the concept of price stickiness.
Henry Thornton’s 1802 book, An Enquiry into the Nature and Effects of the Paper
Credit of Great Britain, argued that a reduction in the money supply could,
because of wage stickiness, produce a short-run slump in output:“The tendency, however, of a very great and sudden reduction of theaccustomed number of bank notes, is to create an unusual and temporary
distress, and a fall of price arising from that distress. But a fall arising from
temporary distress, will be attended probably with no correspondent fall in therate of wages; for the fall of price, and the distress, will be understood to be
temporary, and the rate of wages, we know, is not so variable as the price ofgoods. There is reason, therefore, to fear that the unnatural and extraordinary
low price arising from the sort of distress of which we now speak, would
occasion much discouragement of the fabrication of manufactures.”
A half-century earlier, David Hume had noted that an increase in the quantityof money would boost output in the short run, again because of the stickiness of

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prices. In an essay titled “Of Money,” published in 1752, Hume described theprocess through which an increased money supply could boost output:“At first, no alteration is perceived; by degrees the price rises, first of one
commodity, then of another, till the whole at least reaches a just proportion
with the new quantity of (money) which is in the kingdom. In my opinion, it is
only in this interval or intermediate situation … that the encreasing quantity ofgold and silver is favourable to industry.”
Hume’s argument implies sticky prices; some prices are slower to respond to
the increase in the money supply than others.
Economists of the 18th and 19th century are generally lumped together asadherents to the classical school, but their views were anything but uniform.
Many developed an analytical framework that was quite similar to the essential
elements of new Keynesian economists today. Economist Thomas Humphrey, at
the Federal Reserve Bank of Richmond, marvels at the insights shown by early
economists: “When you read these old guys, you find out first that they didn’t
speak with one voice. There was no single body of thought to which everyone
subscribed. And second, you find out how much they knew. You could take
Henry Thornton’s 1802 book as a textbook in any money course today.”
Source: Thomas M. Humphrey, “Nonneutrality of Money in Classical MonetaryThought,” Federal Reserve Bank of Richmond Economic Review 77, no. 2 (March/
April 1991): 3–15, and personal interview.

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ANSWER TO TRY IT! PROBLEM
An expansionary fiscal or monetary policy, or a combination of the two,would shift aggregate demand to the right as shown in Panel (a), ideally
returning the economy to potential output. One piece of evidence suggestingthat fiscal policy would work is the swiftness with which the economy
recovered from the Great Depression once World War II forced thegovernment to carry out such a policy. An alternative approach would be to
do nothing. Ultimately, that should force nominal wages down further,producing increases in short-run aggregate supply, as in Panel (b). We do
not know if such an approach might have worked; federal policies enacted in1933 prevented wages and prices from falling further than they already had.

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17.2 Keynesian Economics in the 1960s and 1970s
LEARNING OBJECTIVES
1. Briefly summarize the monetarist school of thought that emerged in the
1960s, and discuss how the experiences of the 1960s and 1970s seemed to
be broadly consistent with it.
2. Briefly summarize the new classical school of thought that emerged in
the 1970s, and discuss how the experiences of the 1970s seemed to bebroadly consistent with it.
3. Summarize the lessons that economists learned from the decade of the
1970s.

The experience of the Great Depression led to the widespread acceptance ofKeynesian ideas among economists, but its acceptance as a basis for economic
policy was slower. The administrations of Presidents Roosevelt, Truman, andEisenhower rejected the notion that fiscal policy could or should be used tomanipulate real GDP. Truman vetoed a 1948 Republican-sponsored tax cut aimed at
stimulating the economy after World War II (Congress, however, overrode the veto),and Eisenhower resisted stimulative measures to deal with the recessions of 1953,
1957, and 1960.
It was the administration of President John F. Kennedy that first used fiscal policy
with the intent of manipulating aggregate demand to move the economy toward its
potential output. Kennedy’s willingness to embrace Keynes’s ideas changed thenation’s approach to fiscal policy for the next two decades.

Expansionary Policy in the 1960s
We can think of the macroeconomic history of the 1960s as encompassing two
distinct phases. The first showed the power of Keynesian policies to correct
economic difficulties. The second showed the power of these same policies to create
them.

Correcting a Recessionary Gap
President Kennedy took office in 1961 with the economy in a recessionary gap. He
had appointed a team of economic advisers who believed in Keynesian economics,

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and they advocated an activist approach to fiscal policy. The new president wasquick to act on their advice.
Expansionary policy served the administration’s foreign-policy purposes. Kennedy
argued that the United States had fallen behind the Soviet Union, its avowed
enemy, in military preparedness. He won approval from Congress for sharp
increases in defense spending in 1961.
The Kennedy administration also added accelerated depreciation to the tax code.
Under the measure, firms could deduct depreciation expenses more quickly,
reducing their taxable profits—and thus their taxes—early in the life of a capital
asset. The measure encouraged investment. The administration also introduced aninvestment tax credit, which allowed corporations to reduce their income taxes by
10% of their investment in any one year. The combination of increased defense
spending and tax measures to stimulate investment provided a quick boost to
aggregate demand.
The Fed followed the administration’s lead. It, too, shifted to an expansionary policy
in 1961. The Fed purchased government bonds to increase the money supply andreduce interest rates.
As shown in Panel (a) of Figure 17.4 "The Two Faces of Expansionary Policy in the
1960s", the expansionary fiscal and monetary policies of the early 1960s had pushed
real GDP to its potential by 1963. But the concept of potential output had not beendeveloped in 1963; Kennedy administration economists had defined full
employment to be an unemployment rate of 4%. The actual unemployment rate in1963 was 5.7%; the perception of the time was that the economy needed further
stimulus.
Figure 17.4 The Two Faces of Expansionary Policy in the 1960s

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Expansionary fiscal and monetary policy early in the 1960s (Panel [a]) closed a recessionary gap, but continued
expansionary policy created an inflationary gap by the end of the decade (Panel [b]). The short-run aggregate
supply curve began shifting to the left, but expansionary policy continued to shift aggregate demand to the rightand kept the economy in an inflationary gap.

Expansionary Policy and an Inflationary Gap
Kennedy proposed a tax cut in 1963, which Congress would approve the following
year, after the president had been assassinated. In retrospect, we may regard thetax cut as representing a kind of a recognition lag— policy makers did not realize
the economy had already reached what we now recognize was its potential output.
Instead of closing a recessionary gap, the tax cut helped push the economy into an
inflationary gap, as illustrated in Panel (b) of Figure 17.4 "The Two Faces ofExpansionary Policy in the 1960s".
The expansionary policies, however, did not stop with the tax cut. Continued
increases in federal spending for the newly expanded war in Vietnam and for
President Lyndon Johnson’s agenda of domestic programs, together with continued
high rates of money growth, sent the aggregate demand curve further to the right.
While President Johnson’s Council of Economic Advisers recommended
contractionary policy as early as 1965, macroeconomic policy remained generally
expansionary through 1969. Wage increases began shifting the short-run aggregate
supply curve to the left, but expansionary policy continued to increase aggregate
demand and kept the economy in an inflationary gap for the last six years of the
1960s. Panel (b) of Figure 17.4 "The Two Faces of Expansionary Policy in the 1960s"
shows expansionary policies pushing the economy beyond its potential output after
1963.
The 1960s had demonstrated two important lessons about Keynesian
macroeconomic policy. First, stimulative fiscal and monetary policy could be used
to close a recessionary gap. Second, fiscal policies could have a long implementation
lag. The tax cut recommended by President Kennedy’s economic advisers in 1961
was not enacted until 1964—after the recessionary gap it was designed to fight had
been closed. The tax increase recommended by President Johnson’s economic
advisers in 1965 was not passed until 1968—after the inflationary gap it was
designed to close had widened.
Macroeconomic policy after 1963 pushed the economy into an inflationary gap. The
push into an inflationary gap did produce rising employment and a rising real GDP.
But the inflation that came with it, together with other problems, would create realdifficulties for the economy and for macroeconomic policy in the 1970s.

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The 1970s: Troubles from the Supply SideFor many observers, the use of Keynesian fiscal and monetary policies in the 1960s
had been a triumph. That triumph turned into a series of macroeconomic disasters
in the 1970s as inflation and unemployment spiraled to ever-higher levels. The
fiscal and monetary medicine that had seemed to work so well in the 1960s seemedcapable of producing only instability in the 1970s. The experience of the period
shook the faith of many economists in Keynesian remedies and made them
receptive to alternative approaches.
This section describes the major macroeconomic events of the 1970s. It thenexamines the emergence of two schools of economic thought as major challengers
to the Keynesian orthodoxy that had seemed so dominant a decade earlier.

Macroeconomic Policy: Coping with the Supply Side
When Richard Nixon became president in 1969, he faced a very different economic
situation than the one that had confronted John Kennedy eight years earlier. The
economy had clearly pushed beyond full employment; the unemployment rate had
plunged to 3.6% in 1968. Inflation, measured using the implicit price deflator, hadsoared to 4.3%, the highest rate that had been recorded since 1951. The economy
needed a cooling off. Nixon, the Fed, and the economy’s own process of selfcorrection delivered it.
Figure 17.5 "The Economy Closes an Inflationary Gap" tells the story—it is a simple
one. The economy in 1969 was in an inflationary gap. It had been in such a gap for
years, but this time policy makers were no longer forcing increases in aggregate
demand to keep it there. The adjustment in short-run aggregate supply brought theeconomy back to its potential output.
But what we can see now as a simple adjustment seemedanything but simple in 1970. Economists did not think interms of shifts in short-run aggregate supply. Keynesian
economics focused on shifts in aggregate demand, notsupply.

Figure 17.5 The Economy
Closes an Inflationary Gap

For the Nixon administration, the slump in real GDP in
1970 was a recession, albeit an odd one. The price level
had risen sharply. That was not, according to theKeynesian story, supposed to happen; there was simply
no reason to expect the price level to soar when real
GDP and employment were falling.

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The administration dealt with the recession by shifting
to an expansionary fiscal policy. By 1973, the economy
was again in an inflationary gap. The economy’s 1974
adjustment to the gap came with another jolt. The
Organization of Petroleum Exporting Countries (OPEC)
tripled the price of oil. The resulting shift to the left inshort-run aggregate supply gave the economy anotherrecession and another jump in the price level.

The Nixon administration andthe Fed joined to end the
expansionary policies that had
prevailed in the 1960s, so that
aggregate demand did not rise in1970, but the short-run aggregate
supply curve shifted to the left as
the economy responded to an
inflationary gap.

The second half of the decade was, in some respects, a
repeat of the first. The administrations of Gerald Fordand then Jimmy Carter, along with the Fed, pursued
expansionary policies to stimulate the economy. Those helped boost output, butthey also pushed up prices. As we saw in the chapter on inflation andunemployment, inflation and unemployment followed a cycle to higher and higher
levels.
The 1970s presented a challenge not just to policy makers, but to economists aswell. The sharp changes in real GDP and in the price level could not be explained by
a Keynesian analysis that focused on aggregate demand. Something else was
happening. As economists grappled to explain it, their efforts would produce themodel with which we have been dealing and around which a broad consensus of
economists has emerged. But, before that consensus was to come, two additional
elements of the puzzle had to be added. The first was the recognition of theimportance of monetary policy. The second was the recognition of the role ofaggregate supply, both in the long and in the short run.

The Monetarist Challenge
The idea that changes in the money supply are the principal determinant of thenominal value of total output is one of the oldest in economic thought; it is impliedby the equation of exchange, assuming the stability of velocity. Classical economists
stressed the long run and thus the determination of the economy’s potential
output. This meant that changes in the price level were, in the long run, the resultof changes in the money supply.
At roughly the same time Keynesian economics was emerging as the dominantschool of macroeconomic thought, some economists focused on changes in themoney supply as the primary determinant of changes in the nominal value of
output. Led by Milton Friedman, they stressed the role of changes in the money
supply as the principal determinant of changes in nominal output in the short run
as well as in the long run. They argued that fiscal policy had no effect on the17.2 Keynesian Economics in the 1960s and 1970s

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economy. Their “money rules” doctrine led to the name monetarists. The
monetarist school3 holds that changes in the money supply are the primary causeof changes in nominal GDP.
Monetarists generally argue that the impact lags of monetary policy—the lags fromthe time monetary policy is undertaken to the time the policy affects nominal
GDP—are so long and variable that trying to stabilize the economy using monetary
policy can be destabilizing. Monetarists thus are critical of activist stabilization
policies. They argue that, because of crowding-out effects, fiscal policy has no effecton GDP. Monetary policy does, but it should not be used. Instead, most monetarists
urge the Fed to increase the money supply at a fixed annual rate, preferably therate at which potential output rises. With stable velocity, that would eliminate
inflation in the long run. Recessionary or inflationary gaps could occur in the shortrun, but monetarists generally argue that self-correction will take care of themmore effectively than would activist monetary policy.
While monetarists differ from Keynesians in their assessment of the impact of fiscal
policy, the primary difference in the two schools lies in their degree of optimism
about whether stabilization policy can, in fact, be counted on to bring the economy
back to its potential output. For monetarists, the complexity of economic life andthe uncertain nature of lags mean that efforts to use monetary policy to stabilize
the economy can be destabilizing. Monetarists argued that the difficulties
encountered by policy makers as they tried to respond to the dramatic events of the
1970s demonstrated the superiority of a policy that simply increased the money
supply at a slow, steady rate.
Monetarists could also cite the apparent validity of an adjustment mechanism
proposed by Milton Friedman in 1968. As the economy continued to expand in the
1960s, and as unemployment continued to fall, Friedman said that unemployment
had fallen below its natural rate, the rate consistent with equilibrium in the labormarket. Any divergence of unemployment from its natural rate, he insisted, would
necessarily be temporary. He suggested that the low unemployment of 1968 (therate was 3.6% that year) meant that workers had been surprised by rising prices.
Higher prices had produced a real wage below what workers and firms had
expected. Friedman predicted that as workers demanded and got higher nominal
wages, the price level would shoot up and unemployment would rise. That, ofcourse, is precisely what happened in 1970 and 1971. Friedman’s notion of thenatural rate of unemployment buttressed the monetarist argument that theeconomy moves to its potential output on its own.
3. The body of macroeconomic
thought that holds thatchanges in the money supply
are the primary cause ofchanges in nominal GDP.

Perhaps the most potent argument from the monetarist camp was the behavior of
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could argue that economic performance was consistent with their respective viewsof the world. Keynesians could point to expansions in economic activity that they
could ascribe to expansionary fiscal policy, but economic activity also moved
closely with changes in the money supply, just as monetarists predicted. During the1970s, however, it was difficult for Keynesians to argue that policies that affected
aggregate demand were having the predicted impact on the economy. Changes inaggregate supply had repeatedly pushed the economy off a Keynesian course. But
monetarists, once again, could point to a consistent relationship between changes
in the money supply and changes in economic activity.
Figure 17.6 "M2 and Nominal GDP, 1960–1980" shows the movement of nominal GDP
and M2 during the 1960s and 1970s. In the figure, annual percentage changes in M2
are plotted against percentage changes in nominal GDP a year later to account for
the lagged effects of changes in the money supply. We see that there was a close
relationship between changes in the quantity of money and subsequent changes innominal GDP.
Figure 17.6 M2 and Nominal GDP, 1960–1980

The chart shows annual rates of change in M2 and in nominal GDP, lagged one year. The observation for 1961, forexample, shows that nominal GDP increased 3.5% and that M2 increased 4.9% in the previous year, 1960. The twovariables showed a close relationship in the 1960s and 1970s.

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Monetarist doctrine emerged as a potent challenge to Keynesian economics in the
1970s largely because of the close correspondence between nominal GDP and themoney supply. The next section examines another school of thought that came toprominence in the 1970s.

New Classical Economics: A Focus on Aggregate Supply
Much of the difficulty policy makers encountered during the decade of the 1970s
resulted from shifts in aggregate supply. Keynesian economics and, to a lesser
degree, monetarism had focused on aggregate demand. As it became clear that an
analysis incorporating the supply side was an essential part of the macroeconomic
puzzle, some economists turned to an entirely new way of looking at
macroeconomic issues.
These economists started with what we identified at the beginning of this text as a
distinguishing characteristic of economic thought: a focus on individuals and theirdecisions. Keynesian economics employed aggregate analysis and paid little
attention to individual choices. Monetarist doctrine was based on the analysis ofindividuals’ maximizing behavior with respect to money demand, but it did notextend that analysis to decisions that affect aggregate supply. The new approach
aimed at an analysis of how individual choices would affect the entire spectrum of
economic activity.
These economists rejected the entire framework of conventional macroeconomic
analysis. Indeed, they rejected the very term. For them there is no macroeconomics,
nor is there something called microeconomics. For them, there is only economics,
which they regard as the analysis of behavior based on individual maximization.
The analysis of the determination of the price level and real GDP becomes anapplication of basic economic theory, not a separate body of thought. The approachto macroeconomic analysis built from an analysis of individual maximizing choices
is called new classical economics4.

4. The approach tomacroeconomic analysis built
from an analysis of individual
maximizing choices andemphasizing wage and priceflexibility.

Like classical economic thought, new classical economics focuses on thedetermination of long-run aggregate supply and the economy’s ability to reach thislevel of output quickly. But the similarity ends there. Classical economics emergedin large part before economists had developed sophisticated mathematical models
of maximizing behavior. The new classical economics puts mathematics to work in
an extremely complex way to generalize from individual behavior to aggregate
results.
Because the new classical approach suggests that the economy will remain at ornear its potential output, it follows that the changes we observe in economic

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activity result not from changes in aggregate demand but from changes in long-run
aggregate supply. New classical economics suggests that economic changes don’tnecessarily imply economic problems.
New classical economists pointed to the supply-side shocks of the 1970s, both fromchanges in oil prices and changes in expectations, as evidence that their emphasison aggregate supply was on the mark. They argued that the large observed swings
in real GDP reflected underlying changes in the economy’s potential output. The
recessionary and inflationary gaps that so perplexed policy makers during the1970s were not gaps at all, the new classical economists insisted. Instead, theyreflected changes in the economy’s own potential output.
Two particularly controversial propositions of new classical theory relate to theimpacts of monetary and of fiscal policy. Both are implications of the rational
expectations hypothesis5, which assumes that individuals form expectations about
the future based on the information available to them, and that they act on those
expectations.
The rational expectations hypothesis suggests that monetary policy, even though it
will affect the aggregate demand curve, might have no effect on real GDP. Thispossibility, which was suggested by Robert Lucas, is illustrated in Figure 17.7
"Contractionary Monetary Policy: With and Without Rational Expectations".
Suppose the economy is initially in equilibrium at point 1 in Panel (a). Real GDP
equals its potential output, YP. Now suppose a reduction in the money supply causes
aggregate demand to fall to AD2. In our model, the solution moves to point 2; theprice level falls to P2, and real GDP falls to Y2. There is a recessionary gap. In thelong run, the short-run aggregate supply curve shifts to SRAS2, the price level falls
to P3, and the economy returns to its potential output at point 3.

5. Individuals form expectations
about the future based on theinformation available to them,and they act on those
expectations.

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Figure 17.7 Contractionary Monetary Policy: With and Without Rational Expectations

Panels (a) and (b) show an economy operating at potential output (1); a contractionary monetary policy shifts
aggregate demand to AD2. Panel (a) shows the kind of response we have studied up to this point; real GDP falls to Y2
in period (2); the recessionary gap is closed in the long run by falling nominal wages that cause an increase in shortrun aggregate supply in period (3). Panel (b) shows the rational expectations argument. People anticipate theimpact of the contractionary policy when it is undertaken, so that the short-run aggregate supply curve shifts to theright at the same time the aggregate demand curve shifts to the left. The result is a reduction in the price level but
no change in real GDP; the solution moves from (1) to (2).

The new classical story is quite different. Consumers and firms observe that themoney supply has fallen and anticipate the eventual reduction in the price level to
P3. They adjust their expectations accordingly. Workers agree to lower nominal
wages, and the short-run aggregate supply curve shifts to SRAS2. This occurs as
aggregate demand falls. As suggested in Panel (b), the price level falls to P3, andoutput remains at potential. The solution moves from (1) to (2) with no loss in realGDP.
In this new classical world, there is only one way for a change in the money supply
to affect output, and that is for the change to take people by surprise. An
unexpected change cannot affect expectations, so the short-run aggregate supply
curve does not shift in the short run, and events play out as in Panel (a). Monetary
policy can affect output, but only if it takes people by surprise.
The new classical school offers an even stronger case against the operation of fiscal
policy. It argues that fiscal policy does not shift the aggregate demand curve at all!
Consider, for example, an expansionary fiscal policy. Such a policy involves anincrease in government purchases or transfer payments or a cut in taxes. Any of

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these policies will increase the deficit or reduce the surplus. New classicaleconomists argue that households, when they observe the government carrying out
a policy that increases the debt, will anticipate that they, or their children, or theirchildren’s children, will end up paying more in taxes. And, according to the newclassical story, these households will reduce their consumption as a result. This will,
the new classical economists argue, cancel any tendency for the expansionary
policy to affect aggregate demand.

Lessons from the 1970s
The 1970s put Keynesian economics and its prescription for activist policies on the
defensive. The period lent considerable support to the monetarist argument thatchanges in the money supply were the primary determinant of changes in thenominal level of GDP. A series of dramatic shifts in aggregate supply gave credence
to the new classical emphasis on long-run aggregate supply as the primary
determinant of real GDP. Events did not create the new ideas, but they produced anenvironment in which those ideas could win greater support.
For economists, the period offered some important lessons. These lessons, as we
will see in the next section, forced a rethinking of some of the ideas that had
dominated Keynesian thought. The experience of the 1970s suggested the following:
1. The short-run aggregate supply curve could not be viewed as
something that provided a passive path over which aggregate demand
could roam. The short-run aggregate supply curve could shift in waysthat clearly affected real GDP, unemployment, and the price level.
2. Money mattered more than Keynesians had previously suspected.
Keynes had expressed doubts about the effectiveness of monetary
policy, particularly in the face of a recessionary gap. Work bymonetarists suggested a close correspondence between changes in M2
and subsequent changes in nominal GDP, convincing many Keynesian
economists that money was more important than they had thought.
3. Stabilization was a more difficult task than many economists had
anticipated. Shifts in aggregate supply could frustrate the efforts ofpolicy makers to achieve certain macroeconomic goals.

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KEY TAKEAWAYS• Beginning in 1961, expansionary fiscal and monetary policies were used
to close a recessionary gap; this was the first major U.S. application ofKeynesian macroeconomic policy.
• The experience of the 1960s and 1970s appeared to be broadly consistent
with the monetarist argument that changes in the money supply are theprimary determinant of changes in nominal GDP.
• The new classical school’s argument that the economy operates at its
potential output implies that real GDP is determined by long-run
aggregate supply. The experience of the 1970s, in which changes inaggregate supply forced changes in real GDP and in the price level,
seemed consistent with the new classical economists’ arguments that
focused on aggregate supply.
• The experience of the 1970s suggested that changes in the money supply
and in aggregate supply were more important determinants of economic
activity than many Keynesians had previously thought.

TRY IT!
Draw the aggregate demand and the short-run and long-run aggregate
supply curves for an economy operating with an inflationary gap. Show how
expansionary fiscal and/or monetary policies would affect such an economy.
Now show how this economy could experience a recession and an increasein the price level at the same time.

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Case in Point: Tough Medicine Is Hard to Stomach:
Macroeconomic Policy in the 1960s

The Keynesian prescription for an inflationary gap seems simple enough. The
federal government applies contractionary fiscal policy, or the Fed applies
contractionary monetary policy, or both. But what seems simple in a graph canbe maddeningly difficult in the real world. The medicine for an inflationary gap
is tough, and it is tough to take.
President Johnson’s new chairman of the Council of Economic Advisers,
Gardner Ackley, urged the president in 1965 to adopt fiscal policies aimed at
nudging the aggregate demand curve back to the left. The president reluctantly
agreed and called in the chairman of the House Ways and Means Committee,
the committee that must initiate all revenue measures, to see what he thoughtof the idea. Wilbur Mills flatly told Johnson that he wouldn’t even hold hearings
to consider a tax increase. For the time being, the tax boost was dead.
The Federal Reserve System did slow the rate of money growth in 1966. But
fiscal policy remained sharply expansionary. Mr. Ackley continued to press hiscase, and in 1967 President Johnson proposed a temporary 10% increase inpersonal income taxes. Mr. Mills now endorsed the measure. The temporary tax
boost went into effect the following year. The Fed, concerned that the tax hikewould be too contractionary, countered the administration’s shift in fiscal
policy with a policy of vigorous money growth in 1967 and 1968.

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The late 1960s suggested a sobering reality about the new Keynesian orthodoxy.
Stimulating the economy was politically more palatable than contracting it.
President Kennedy, while he was not able to win approval of his tax cut during
his lifetime, did manage to put the other expansionary aspects of his program
into place early in his administration. The Fed reinforced his policies. Dealing
with an inflationary gap proved to be quite another matter. President Johnson,
a master of the legislative process, took three years to get even a mildly
contractionary tax increase put into place, and the Fed acted to counter the
impact of this measure by shifting to an expansionary policy.
The second half of the 1960s was marked, in short, by persistent efforts to boost
aggregate demand, efforts that kept the economy in an inflationary gap
through most of the decade. It was a gap that would usher in a series of supplyside troubles in the next decade.

ANSWER TO TRY IT! PROBLEM
Even with an inflationary gap, it is possible to pursue expansionary fiscal
and monetary policies, shifting the aggregate demand curve to the right, asshown. The inflationary gap will, however, produce an increase in nominal
wages, reducing short-run aggregate supply over time. In the case shown
here, real GDP rises at first, then falls back to potential output with the
reduction in short-run aggregate supply.

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17.3 Macroeconomics for the 21st Century
LEARNING OBJECTIVES
1. Discuss how the Fed incorporated a strong inflation constraint and lags
into its policies from the 1980s onwards.
2. Describe the fiscal policies that were undertaken from the 1980s
onwards and their rationales.
3. Discuss the challenges that events from the 1980s onwards raised for themonetarist and new classical schools of thought.
4. Summarize the views and policy approaches of the new Keynesianschool of economic thought.

Following the recession that ended in 1982, the last two decades of the 20th century
and the early years of the 21st century have sometimes been referred to as theGreat Moderation. Yes, there were recessions, but they were fairly mild and shortlived. Prematurely, economists began to pat themselves on the backs for having
tamed the business cycle. There was a sense that macroeconomic theory and policy
had helped with this improved performance. The ideas associated withmacroeconomic theory and policy incorporated elements of Keynesian economics,
monetarism, and new classical economics. All three schools of macroeconomic
thought contributed to the development of a new school of macroeconomic
thought: the new Keynesian school.

6. A body of macroeconomic
thought that stresses the
stickiness of prices and theneed for activist stabilization
policies through themanipulation of aggregate
demand to keep the economy
operating close to its potential
output. It incorporatesmonetarist ideas about theimportance of monetary policy
and new classical ideas about
the importance of aggregate
supply, both in the long run
and in the short run.

New Keynesian economics6 is a body of macroeconomic thought that stresses the
stickiness of prices and the need for activist stabilization policies through themanipulation of aggregate demand to keep the economy operating close to its
potential output. It incorporates monetarist ideas about the importance ofmonetary policy and new classical ideas about the importance of aggregate supply,
both in the long and in the short run.
Another “new” element in new Keynesian economic thought is the greater use of
microeconomic analysis to explain macroeconomic phenomena, particularly the
analysis of price and wage stickiness. We saw in the chapter that introduced themodel of aggregate demand and aggregate supply, for example, that sticky prices
and wages may be a response to the preferences of consumers and of firms. That
idea emerged from research by economists of the new Keynesian school.

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New Keynesian ideas guide macroeconomic policy; they are the basis for the modelof aggregate demand and aggregate supply with which we have been working. To
see how the new Keynesian school has come to dominate macroeconomic policy, we
shall review the major macroeconomic events and policies of the 1980s, 1990s, andearly 2000s.

The 1980s and Beyond: Advances in Macroeconomic Policy
The exercise of monetary and of fiscal policy has changed dramatically in the lastfew decades.

The Revolution in Monetary Policy
It is fair to say that the monetary policy revolution of the last two decades began on
July 25, 1979. On that day, President Jimmy Carter appointed Paul Volcker to bechairman of the Fed’s Board of Governors. Mr. Volcker, with President Carter’s
support, charted a new direction for the Fed. The new direction damaged Mr. Carter
politically but ultimately produced dramatic gains for the economy.
Oil prices rose sharply in 1979 as war broke out between Iran and Iraq. Such anincrease would, by itself, shift the short-run aggregate supply curve to the left,causing the price level to rise and real GDP to fall. But expansionary fiscal andmonetary policies had pushed aggregate demand up at the same time. As a result,real GDP stayed at potential output, while the price level soared. The implicit pricedeflator jumped 8.1%; the CPI rose 13.5%, the highest inflation rate recorded in the20th century. Public opinion polls in 1979 consistently showed that most people
regarded inflation as the leading problem facing the nation.
Chairman Volcker charted a monetarist course of fixing
the growth rate of the money supply at a rate thatwould bring inflation down. After the high rates ofmoney growth of the past, the policy was sharply
contractionary. Its first effects were to shift theaggregate demand curve to the left. Continued oil priceincreases produced more leftward shifts in the shortrun aggregate supply curve, and the economy suffered arecession in 1980. Inflation remained high. Figure 17.8
"The Fed’s Fight Against Inflation" shows how the
combined shifts in aggregate demand and short-run
aggregate supply produced a reduction in real GDP and
an increase in the price level.

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Figure 17.8 The Fed’s Fight
Against Inflation

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The Fed stuck to its contractionary guns, and theinflation rate finally began to fall in 1981. But therecession worsened. Unemployment soared, shooting
above 10% late in the year. It was, up to that point, theworst recession since the Great Depression. The
inflation rate, though, fell sharply in 1982, and the Fed
began to shift to a modestly expansionary policy in1983. But inflation had been licked. Inflation, measured
by the implicit price deflator, dropped to a 4.1% ratethat year, the lowest since 1967.

By 1979, expansionary fiscal andmonetary policies had brought
the economy to its potential
output. Then war between Iranand Iraq caused oil prices toincrease, shifting the short-run
aggregate supply curve to theleft. In the second half of 1979,
the Fed launched an aggressive
contractionary policy aimed at
reducing inflation. The Fed’s
action shifted the aggregate
demand curve to the left. The
result in 1980 was a recession
with continued inflation.

The Fed’s actions represented a sharp departure fromthose of the previous two decades. Faced with soaring
unemployment, the Fed did not shift to an expansionary
policy until inflation was well under control. Inflation
continued to edge downward through most of theremaining years of the 20th century and into the new century. The Fed has clearlyshifted to a stabilization policy with a strong inflation constraint. It shifts to
expansionary policy when the economy has a recessionary gap, but only if itregards inflation as being under control.
This concern about inflation was evident again when the U.S. economy began toweaken in 2008, and there was initially discussion among the members of theFederal Open Market Committee about whether or not easing would contribute toinflation. At that time, it looked like inflation was becoming a more serious
problem, largely due to increases in oil and other commodity prices. Some membersof the Fed, including Chairman Bernanke, argued that these price increases werelikely to be temporary and the Fed began using expansionary monetary policy earlyon. By late summer and early fall, inflationary pressures had subsided, and all themembers of the FOMC were behind continued expansionary policy. Indeed, at thatpoint, the Fed let it be known that it was willing to do anything in its power to fightthe current recession.
The next major advance in monetary policy came in the 1990s, under Federal
Reserve Chairman Alan Greenspan. The Fed had shifted to an expansionary policy
as the economy slipped into a recession when Iraq’s invasion of Kuwait in 1990
began the Persian Gulf War and sent oil prices soaring. By early 1994, real GDP was
rising, but the economy remained in a recessionary gap. Nevertheless, the Fedannounced on February 4, 1994, that it had shifted to a contractionary policy,
selling bonds to boost interest rates and to reduce the money supply. While theeconomy had not reached its potential output, Chairman Greenspan explained that
the Fed was concerned that it might push past its potential output within a year.

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The Fed, for the first time, had explicitly taken the impact lag of monetary policy
into account. The issue of lags was also a part of Fed discussions in the 2000s.

Fiscal Policy: A Resurgence of Interest
President Ronald Reagan, whose 1980 election victory was aided by a recession thatyear, introduced a tax cut, combined with increased defense spending, in 1981.
While this expansionary fiscal policy was virtually identical to the policy President
Kennedy had introduced 20 years earlier, President Reagan rejected Keynesian
economics, embracing supply-side arguments instead. He argued that the cut in tax
rates, particularly in high marginal rates, would encourage work effort. He
reintroduced an investment tax credit, which stimulated investment. With people
working harder and firms investing more, he expected long-run aggregate supply
to increase more rapidly. His policy, he said, would stimulate economic growth.
The tax cut and increased defense spending increased the federal deficit. Increased
spending for welfare programs and unemployment compensation, both of whichwere induced by the plunge in real GDP in the early 1980s, contributed to the deficit
as well. As deficits continued to rise, they began to dominate discussions of fiscal
policy. In 1990, with the economy slipping into a recession, President George H. W.
Bush agreed to a tax increase despite an earlier promise not to do so. President Bill
Clinton, whose 1992 election resulted largely from the recession of 1990–1991,
introduced another tax increase in 1994, with the economy still in a recessionary
gap. Both tax increases were designed to curb the rising deficit.
Congress in the first years of the 1990s rejected the idea of using an expansionary
fiscal policy to close a recessionary gap on grounds it would increase the deficit.
President Clinton, for example, introduced a stimulus package of increased
government investment and tax cuts designed to stimulate private investment in
1993; a Democratic Congress rejected the proposal. The deficit acted like astraitjacket for fiscal policy. The Bush and Clinton tax increases, coupled withspending restraint and increased revenues from economic growth, brought an end
to the deficit in 1998.
Initially, it was expected that the budget surplus would continue well into the new
century. But, this picture changed rapidly. President George W. Bush campaigned
on a platform of large tax cuts, arguing that less government intervention in theeconomy would be good for long-term economic growth. His administration saw
the enactment of two major pieces of tax-cutting legislation in 2001 and 2003.
Coupled with increases in government spending, in part for defense but also fordomestic purposes including a Medicare prescription drug benefit, the government
budget surpluses gave way to budget deficits. To deal with times of economic

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weakness during President Bush’s administration, temporary tax cuts were enacted,
both in 2001 and again in 2008.
As the economy continued to weaken in 2008, there was a resurgence of interest in
using discretionary increases in government spending, as discussed in the Case in
Point, to respond to the recession. Three factors were paramount: (1) the temporary
tax cuts had provided only a minor amount of stimulus to the economy, as sizable
portions had been used for saving rather than spending, (2) expansionary monetary
policy, while useful, had not seemed adequate, and (3) the recession threatening the
global economy was larger than those in recent economic history.

The Rise of New Keynesian Economics
New Keynesian economics emerged in the last three decades as the dominantschool of macroeconomic thought for two reasons. First, it successfully
incorporated important monetarist and new classical ideas into Keynesian
economics. Second, developments in the 1980s and 1990s shook economists’confidence in the ability of the monetarist or the new classical school alone to
explain macroeconomic change.

Monetary Change and Monetarism
Look again at Figure 17.6 "M2 and Nominal GDP, 1960–1980". The close relationshipbetween M2 and nominal GDP in the 1960s and 1970s helped win over many
economists to the monetarist camp. Now look at Figure 17.9 "M2 and Nominal GDP,
1980–2011". It shows the same two variables, M2 and nominal GDP, from the 1980s
through 2011. The tidy relationship between the two seems to have vanished. What
happened?

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Figure 17.9 M2 and Nominal GDP, 1980–2011

The close relationship between M2 and nominal GDP a year later that had prevailed in the 1960s and 1970s seemed
to vanish from the 1980s onward.

The sudden change in the relationship between the money stock and nominal GDP
has resulted partly from public policy. Deregulation of the banking industry in theearly 1980s produced sharp changes in the ways individuals dealt with money, thuschanging the relationship of money to economic activity. Banks have been freed tooffer a wide range of financial alternatives to their customers. One of the mostimportant developments has been the introduction of bond funds offered by banks.
These funds allowed customers to earn the higher interest rates paid by long-termbonds while at the same time being able to transfer funds easily into checking
accounts as needed. Balances in these bond funds are not counted as part of M2. As
people shifted assets out of M2 accounts and into bond funds, velocity rose. Thatchanged the once-close relationship between changes in the quantity of money andchanges in nominal GDP.
Many monetarists have argued that the experience of the 1980s, 1990s, and 2000s
reinforces their view that the instability of velocity in the short run makes
monetary policy an inappropriate tool for short-run stabilization. They continue toinsist, however, that the velocity of M2 remains stable in the long run. But thevelocity of M2 appears to have diverged in recent years from its long-run path.
Although it may return to its long-run level, the stability of velocity remains very

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much in doubt. Because of this instability, in 2000, when the Fed was no longer
required by law to report money target ranges, it discontinued the practice.

The New Classical School and Responses to Policy
New classical economics suggests that people should have responded to the fiscal
and monetary policies of the 1980s in predictable ways. They did not, and that hascreated new doubts among economists about the validity of the new classicalargument.
The rational expectations hypothesis predicts that if a shift in monetary policy by
the Fed is anticipated, it will have no effect on real GDP. The slowing in the rate of
growth of the money supply over the period from 1979 to 1982 was surely wellknown. The Fed announced at the outset what it was going to do, and then did it. It
had the full support first of President Carter and then of President Reagan. But thepolicy plunged the economy into what was then its worst recession since the Great
Depression. The experience hardly seemed consistent with new classical logic. New
classical economists argued that people may have doubted the Fed would keep its
word, but the episode still cast doubt on the rational expectations argument.
The public’s response to the huge deficits of the Reagan era also seemed to belie
new classical ideas. One new classical argument predicts that people will increase
their saving rate in response to an increase in public sector borrowing. The
resultant reduction in consumption will cancel the impact of the increase in deficitfinanced government expenditures. But the private saving rate in the United Statesfell during the 1980s. New classical economists contend that standard measures ofsaving do not fully represent the actual saving rate, but the experience of the 1980s
did not seem to support the new classical argument.
The events of the 1980s do not suggest that either monetarist or new classical ideas
should be abandoned, but those events certainly raised doubts about relying solely
on these approaches. Similarly, doubts about Keynesian economics raised by theevents of the 1970s led Keynesians to modify and strengthen their approach.

A Macroeconomic Consensus?
While there is less consensus on macroeconomic policy issues than on some othereconomic issues (particularly those in the microeconomic and international areas),
surveys of economists generally show that the new Keynesian approach has
emerged as the preferred approach to macroeconomic analysis. The finding thatabout 80% of economists agree that expansionary fiscal measures can deal withrecessionary gaps certainly suggests that most economists can be counted in the17.3 Macroeconomics for the 21st Century

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new Keynesian camp. Neither monetarist nor new classical analysis would support
such measures. At the same time, there is considerable discomfort about actuallyusing discretionary fiscal policy, as the same survey shows that about 70% of
economists feel that discretionary fiscal policy should be avoided and that thebusiness cycle should be managed by the Fed.Dan Fuller and Doris Geide-Stevenson,“Consensus among Economists: Revisited,” Journal of Economic Education 34, no. 4(Fall 2003): 369–87. Just as the new Keynesian approach appears to have won
support among most economists, it has become dominant in terms ofmacroeconomic policy. In the United States, the Great Recession was fought using
traditional monetary and fiscal policies, while other policies were usedconcurrently to deal with the financial crisis that occurred at the same time.
Did the experience of the 2007–2009 recession affect economists’ views concerning
macroeconomic policy? One source for gauging possible changes in the opinions of
economists is the twice-yearly survey of economic policy among the National
Association for Business Economics (NABE).National Association for BusinessEconomics, Economic Policy Surveys, March 2009 and August 2010, available at
http://www.nabe.com. According to the August 2010 survey of 242 members of
NABE, almost 60% were supportive of monetary policy at that time, which was
expansionary and continued to be so at least through the middle of 2012.
Concerning fiscal policy, there was less agreement. Still, according to the survey
taken at the time the 2009 fiscal stimulus was being debated, 22% characterized it as“about right,” another third found it too restrictive, and only one third found it too
stimulative. In the August 2010 survey, 39% thought fiscal policy “about right,” 24%
found it too restrictive, and 37% found it too stimulative. Also, nearly 75% ranked
promotion of economic growth as more important than deficit reduction, roughly
two thirds supported the extension of unemployment benefits, and 60% agreed thatawarding states with federal assistance funds from the 2009 stimulus package wasappropriate. Taken together, the new Keynesian approach still seems to reflect thedominant opinion.

Is the Great Moderation Over?
As did the Great Depression of the 1930s, the Great Recession of the late 2000s
generated great fear. Even though it officially ended in the middle of 2009, the stateof the economy was the major issue over which the 2012 U.S. presidential election
was fought, as the two major political parties offered their competing visions.
Unemployment was still high, the housing sector had still not recovered, and theEuropean debt situation loomed in the background. Another lurking question waswhether the experience of the recent deep recession, the related financial crisis,
and the slow recovery from them would become the new “normal” or whether
macroeconomic performance would return to being less volatile.

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Economist Todd Clark at the Federal Reserve Bank of Kansas attempted to answer
this question.Todd E. Clark, “Is the Great Moderation Over? An Empirical Analysis,”
Federal Reserve Bank of Kansas City Economic Review 94, no. 4 (Fourth Quarter 2009):
5–42. He first looked at the various explanations for the lower volatility of the U.S.
economy during the 25-year period that preceded the Great Recession. Three broad
reasons were given: structural changes, improved monetary policy, and good luck.
While there is disagreement in the literature as to the relative importance of eachof these, Clark argues that there is no reason to assume that the first two
explanations for moderation will not continue to have moderating influences. For
example, one positive structural change has been better inventory management,
and he sees no reason why firms should become less able in the future to manage
their inventories using the newly developed techniques. Similarly, in the future,monetary authorities should be able to continue to make the better decisions thatthey made during the Great Moderation. The element that can vary is luck. During
the Great Moderation, the economy experienced fewer serious shocks. For example,
oil prices were fairly stable. In contrast, during the recent recession, the price of oilrose from $54 per barrel in January 2007 to $134 per barrel in June 2008. The
bursting of the housing price bubble and the ensuing crisis in financial markets wasanother major shock contributing to the depth and length of the recent recession.
Clark says, “Accordingly, once the crisis subsides and the period of very bad luck
passes, macroeconomic volatility will likely decline. In the future, the permanenceof structural change and improved monetary policy that occurred in years pastshould ensure that low volatility is the norm.”Ibid., 27. Let’s hope that he is correct.

KEY TAKEAWAYS• The actions of the Fed starting in late 1979 reflected a strong inflation
constraint and a growing recognition of the impact lag for monetary
policy.
• Reducing the deficit dominated much of fiscal policy discussion during
the 1980s and 1990s.
• The events of the 1980s and early 1990s do not appear to have been
consistent with the hypotheses of either the monetarist or new classicalschools.
• New Keynesian economists have incorporated major elements of theideas of the monetarist and new classical schools into their formulationof macroeconomic theory.

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TRY IT!
Show the effect of an expansionary monetary policy on real GDP
1. according to new Keynesian economics
2. according to the rational expectations hypothesis
In both cases, consider both the short-run and the long-run effects.

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Case in Point: Steering on a Difficult Course

Imagine that you are driving a test car on a special course. You get to steer,accelerate, and brake, but you cannot be sure whether the car will respond to
your commands within a few feet or within a few miles. The windshield andside windows are blackened, so you cannot see where you are going or even
where you are. You can only see where you have been with the rear-view
mirror. The course is designed so that you will face difficulties you have neverexperienced. Your job is to get through the course unscathed. Oh, and by theway, you have to observe the speed limit, but you do not know what it is. Have anice trip.
Now imagine that the welfare of people all over the world will be affected by
how well you drive the course. They are watching you. They are giving you agreat deal of often-conflicting advice about what you should do. Thinking about
the problems you would face driving such a car will give you some idea of the
obstacle course fiscal and monetary authorities must negotiate. They cannot
know where the economy is going or where it is—economic indicators such as
GDP and the CPI only suggest where the economy has been. And the perils
through which it must steer can be awesome indeed.
One policy response that most acknowledge as having been successful was how
the Fed dealt with the financial crises in Southeast Asia and elsewhere thatshook the world economy in 1997 and 1998. There were serious concerns at thetime that economic difficulties around the world would bring the high-flying
U.S. economy to its knees and worsen an already difficult economic situation inother countries. The Fed had to steer through the pitfalls that global economic
crises threw in front of it.
In the fall of 1998, the Fed chose to accelerate to avoid a possible downturn. The
Federal Open Market Committee (FOMC) engaged in expansionary monetary

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policy by lowering its target for the federal funds rate. Some critics argued at
the time that the Fed’s action was too weak to counter the impact of world
economic crisis. Others, though, criticized the Fed for undertaking an
expansionary policy when the U.S. economy seemed already to be in an
inflationary gap.
In the summer of 1999, the Fed put on the brakes, shifting back to a slightly
contractionary policy. It raised the target for the federal funds rate, first to
5.0% and then to 5.25%. These actions reflected concern about speeding whenin an inflationary gap.
But was the economy speeding? Was it in an inflationary gap? Certainly, theU.S. unemployment rate of 4.2% in the fall of 1999 stood well below standard
estimates of the natural rate of unemployment. There were few, if any,
indications that inflation was a problem, but the Fed had to recognize that
inflation might not appear for a very long time after the Fed had taken aparticular course. As noted in the text, this was also during a time when theonce-close relationship between money growth and nominal GDP seemed tobreak down. The shifts in demand for money created unexplained andunexpected changes in velocity.
The outcome of the Fed’s actions has been judged a success. While with 20/20
hindsight the Fed’s decisions might seem obvious, in fact it was steering a carwhose performance seemed less and less predictable over a course that was
becoming more and more treacherous.
Since 2008, both the Fed and the government have been again trying to get theeconomy back on track. In this case, the car was already in the ditch. The Fed
decided on a “no holds barred” approach. It moved aggressively to lower thefederal funds rate target and engaged in a variety of other measures to improveliquidity to the banking system, to lower other interest rates by purchasing
longer-term securities (such as 10-year treasuries and those of Fannie Mae andFreddie Mac), and, working with the Treasury Department, to provide loans
related to consumer and business debt.
Continuing on smaller expansionary fiscal policy begun under President George
W. Bush, the Obama administration for its part advocated and Congress passed
a massive spending and tax relief package of more than $800 billion. Besides themembers of his economic team, many economists seem to be on board in using

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discretionary fiscal policy in this instance. Federal Reserve Bank of San
Francisco President Janet Yellen put it this way: “The new enthusiasm for fiscal
stimulus, and particularly government spending, represents a huge evolution
in mainstream thinking.” A notable convert to using fiscal policy to deal withthis recession was Harvard economist and former adviser to President Ronald
Reagan, Martin Feldstein. His spending proposal encouraged increased militaryspending and he stated, “While good tax policy can contribute to ending therecession, the heavy lifting will have to be done by increased government
spending.”
Predictably, not all economists jumped onto the fiscal policy bandwagon.
Concerns included whether so-called shovel-ready projects could really be
implemented in time, whether government spending would crowd out private
spending, whether monetary policy alone was providing enough stimulus, andwhether the spending would flow efficiently to truly worthwhile projects. As
discussed elsewhere in this text, the controversy persists. But the fact that avariety of expansionary policies were used to ease the recession and spur therecovery is not in doubt.
Sources: Ben S. Bernanke, “The Crisis and the Policy Response” (speech,
London School of Economics, January 13, 2009); Louis Uchitelle, “Economists
Warm to Government Spending but Debate Its Form,” New York Times, January
7, 2009, p. B1.

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ANSWER TO TRY IT! PROBLEM
Panel (a) shows an expansionary monetary policy according to newKeynesian economics. Aggregate demand increases, with no immediate
reduction in short-run aggregate supply. Real GDP rises to Y2. In the longrun, nominal wages rise, reducing short-run aggregate supply and returning
real GDP to potential. Panel (b) shows what happens with rational
expectations. When the Fed increases the money supply, people anticipate
the rise in prices. Workers and firms agree to an increase in nominal wages,
so that there is a reduction in short-run aggregate supply at the same time
there is an increase in aggregate demand. The result is no change in real
GDP; it remains at potential. There is, however, an increase in the pricelevel.

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Summary
We have surveyed the experience of the United States in light of the economic theories that prevailed or
emerged during five decades. We have seen that events in the past century have had significant effects on theways in which economists look at and interpret macroeconomic ideas.
Before the Great Depression, macroeconomic thought was dominated by the classical school. That body oftheory stressed the economy’s ability to reach full employment equilibrium on its own. The severity andduration of the Depression caused many economists to rethink their acceptance of natural equilibrating forcesin the economy.
John Maynard Keynes issued the most telling challenge. He argued that wage rigidities and other factors could
prevent the economy from closing a recessionary gap on its own. Further, he showed that expansionary fiscal
and monetary policies could be used to increase aggregate demand and move the economy to its potential
output. Although these ideas did not immediately affect U.S. policy, the increases in aggregate demand broughtby the onset of World War II did bring the economy to full employment. Many economists became convinced of
the validity of Keynes’s analysis and his prescriptions for macroeconomic policy.
Keynesian economics dominated economic policy in the United States in the 1960s. Fiscal and monetary policies
increased aggregate demand and produced what was then the longest expansion in U.S. history. But theeconomy pushed well beyond full employment in the latter part of the decade, and inflation increased. While
Keynesians were dominant, monetarist economists argued that it was monetary policy that accounted for the
expansion of the 1960s and that fiscal policy could not affect aggregate demand.
Efforts by the Nixon administration in 1969 and 1970 to cool the economy ran afoul of shifts in the short-run
aggregate supply curve. The ensuing decade saw a series of shifts in aggregate supply that contributed to three
more recessions by 1982. As economists studied these shifts, they developed further the basic notions we now
express in the aggregate demand–aggregate supply model: that changes in aggregate demand and aggregate
supply affect income and the price level; that changes in fiscal and monetary policy can affect aggregate
demand; and that in the long run, the economy moves to its potential level of output.
The events of the 1980s and beyond raised serious challenges for the monetarist and new classical schools. New
Keynesian economists formulated revisions in their theories, incorporating many of the ideas suggested bymonetarist and new classical economists. The new, more powerful theory of macroeconomic events has won
considerable support among economists today.

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PROBLEMS
1. “For many years, the hands-off fiscal policies advocated by the classicaleconomists held sway with American government. When times were
hard, the prevailing response was to tough it out, awaiting the‘inevitable’ turnaround. The lessons of the Great Depression and abooming wartime economy have since taught us, however, thatgovernment intervention is sometimes necessary and desirable—andthat to an extent, we can take charge of our own economic lives.”
Evaluate the foregoing quotation based upon the discussion in thischapter. How would you classify the speaker in terms of a school of
economic thought?
2. In his 1982 Economic Report of the President, Ronald Reagan said, “We
simply cannot blame crop failures and oil price increases for our basic
inflation problem. The continuous, underlying cause was poor
government policy.” What policies might he have been referring to?
3. Many journalists blamed economic policies of the Reagan administration
for the extremely high levels of unemployment in 1982 and 1983. Given
the record of the rest of the decade, do you agree that President
Reagan’s economic policies were a failure? Why or why not?
4. The day after the U.S. stock market crash of October 19, 1987, Federal
Reserve Board Chairman Alan Greenspan issued the following
statement: “The Federal Reserve, consistent with its responsibilities as
the nation’s central bank, affirmed today its readiness to serve as asource of liquidity to support the economic and financial system.”
Evaluate why the Fed chairman might have been prompted to makesuch a statement.
5. Compare the rationale of the Reagan administration for the 1981 tax
reductions with the rationale behind the Kennedy–Johnson tax cut of
1964, the Bush tax cut of 2001, and the Bush tax cut of 2003.
6. If the economy is operating below its potential output, what kind of gap
exists? What kinds of fiscal or monetary policies might you use to close
this gap? Can you think of any objection to the use of such policies?
7. If the economy is operating above its potential output, what kind of gap
exists? What kinds of fiscal or monetary policies might you use to close
this gap? Can you think of any objection to the use of such policies?
8. In General Theory, Keynes wrote of the importance of ideas. The world, hesaid, is ruled by little else. How important do you think his ideas havebeen for economic policy today?

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9. State whether each of the following events appears to be theresult of a shift in short-run aggregate supply or aggregate
demand, and state the direction of the shift involved.
a.
b.
c.
d.

The price level rises sharply while real GDP falls.
The price level and real GDP rise.
The price level falls while real GDP rises.
The price level and real GDP fall.

10. Explain whether each of the following events and policies willaffect the aggregate demand curve or the short-run aggregate
supply curve, and state what will happen to the price level andreal GDP.
a.
b.
c.
d.
e.
f.

Oil prices rise
The Fed sells bonds
Government purchases increase
Federal taxes increase
The government slashes transfer payment spending
Oil prices fall

11. Using the model of aggregate demand and aggregate supply, illustrate
an economy with a recessionary gap. Show how a policy ofnonintervention would ultimately close the gap. Show the alternative of
closing the gap through stabilization policy.
12. Using the model of aggregate demand and aggregate supply, illustrate
an economy with an inflationary gap. Show how a policy ofnonintervention would ultimately close the gap. Show the alternative of
closing the gap through stabilization policy.

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Chapter 18
Inequality, Poverty, and Discrimination
Start Up: Occupy Wall Street and the WorldIt all began September 17, 2011, with a march by thousands of demonstrators
unhappy with all sorts of things about the United States—the distribution ofincome, with rallying cries on behalf of the 99%; “greed” on Wall Street; the bailoutof many banks; capitalism in general; and a variety of other perceived ills, fromhostility to certain nonfinancial companies such as Walmart and Starbucks to calls
for the United States to pull out of military operations around the world and toabolish the Federal Reserve Bank. The symbol of the movement became theoccupation of a small park in the neighborhood of Wall Street—Zuccotti Park. Twomonths later, the park continued to be jammed with demonstrators using it as a
campground, after which New York City Mayor Michael Bloomberg shut it down as
a place for overnight lodging.
Well before then, the “Occupy Wall Street” movement had become a national
phenomenon and then an international phenomenon. The Economist in mid-October
reported demonstrations in more than 900 cities and in more than 80 countries. The
demonstrators generally rejected the entire concept of making specific demands,
preferring instead to protest in support of an ill-defined, but clearly compelling,message—whatever that message might have been.
Who were the demonstrators? Douglas Schoen, who once worked as a pollster for
President Bill Clinton, had his survey firm interview about 200 protesters occupying
Zuccotti Park in mid-October of 2011 about their views. According to Schoen's
survey, the Zuccotti Park demonstrators were committed to a radical redistributionof income and sharp increases in government regulation of the economy, with 98%
of them supporting civil disobedience to further their aims and 31% advocating
violent measures to achieve their goals. A Pew survey at about the same time foundAmericans divided in their opinion about the “Occupy Wall Street” movement, withnearly 40% in support and about 35% opposed. At the same time, support andopposition for the Tea Party were running 32% in favor and 44% opposed.“Not Quite
Together,” Economist, October 22, 2011; Douglas Schoen, “Polling the Occupy WallStreet Crowd,” Wall Street Journal Online, October 18, 2011; “Public Divided Over
Occupy Wall Street Movement,” Pew Charitable Trust Pew Research Center for the729

Chapter 18 Inequality, Poverty, and Discrimination

People & the Press, http://www.people-press.org/2011/10/24/public-divided-overoccupy-wall-street-movement/.
Whatever the makeup of the groups demonstrating throughout the world, theyclearly brought the issues examined in this chapter—poverty, discrimination, andthe distribution of income—to the forefront of public attention. It was not obvious
why inequality and related complaints had suddenly become an important issue. As
we will see on this chapter, inequality in the U.S. distribution of income had begun
increasing in 1967; it has continued to rise ever since.
At about the same time as the movement was in the news, the poverty rate in the
United States reached its highest level since 1993. The number of people below the
U.S. poverty line in 2010—an annual income of $22,314 for a family of four—rose to15.1% of the population. The number of people considered to be below the poverty
level rose to 46.2 million, the highest number ever recorded in the history of theUnited States. Those statistics came more than four decades after President Lyndon
B. Johnson stood before the Congress of the United States to make his first State of
the Union address in 1964 to declare a new kind of war, a War on Poverty. “Thisadministration today here and now declares unconditional war on poverty in
America,” the President said. “Our aim is not only to relieve the symptoms ofpoverty but to cure it; and, above, all, to prevent it.” In the United States that year,
35.1 million people, about 22% of the population, were, by the official definition,poor.
The President’s plan included stepped-up federal aid to low-income people, an
expanded health-care program for the poor, new housing subsidies, expandedfederal aid to education, and job training programs. The proposal became law laterthat same year. More than four decades and trillions of dollars in federal
antipoverty spending later, the nation seems to have made little progress toward
the President’s goal.
In this chapter, we shall also explore the problem of discrimination. Being at thelower end of the income distribution and being poor are more prevalent among
racial minorities and among women than among white males. To a degree, thissituation may reflect discrimination. We shall investigate the economics of
discrimination and its consequences for the victims and for the economy. We shallalso assess efforts by the public sector to eliminate discrimination.
Questions of fairness often accompany discussions of income inequality, poverty,
and discrimination. Answering them ultimately involves value judgments; they arenormative questions, not positive ones. You must decide for yourself if a particular
distribution of income is fair or if society has made adequate progress toward730

Chapter 18 Inequality, Poverty, and Discrimination

reducing poverty or discrimination. The material in this chapter will not answer
those questions for you; rather, in order for you to have a more informed basis formaking your own value judgments, it will shed light on what economists havelearned about these issues through study and testing of hypotheses.

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18.1 Income Inequality
LEARNING OBJECTIVES
1. Explain how the Lorenz curve and the Gini coefficient provide
information on a country’s distribution of income.
2. Discuss and evaluate the factors that have been looked at to explainchanges in the distribution of income in the United States.

Income inequality in the United States has soared in the last half century.
According to the Congressional Budget Office, between 1979 and 2007, real average
household income—taking into account government transfers and federal
taxes—rose 62%. For the top 1% of the population, it grew 275%. For others in the
top 20% of the population, it grew 65%. For the 60% of the population in the middle,
it grew a bit under 40% and for the 20% of the population at the lowest end of theincome distribution, it grew about 18%.Congressional Budget Office, “Trends in theDistribution of Household Income Between 1979 and 2007,” October 2011,
http://www.cbo.gov/ftpdocs/124xx/doc12485/10-25-HouseholdIncome.pdf.
Increasingly, education is the key to a better material life. The gap between the
average annual incomes of high school graduates and those with a bachelor’s
degree increased substantially over the last half century. A recent study undertaken
at the Georgetown University Center on Education and the Workforce concluded
that people with a bachelor’s degree earn 84% more over a lifetime than do people
who are high school graduates only. That college premium is up from 75% in
1999.Anthony P. Carnevale, Stephen J. Rose, and Ban Cheah, The College Payoff:
Education, Occupation, and Lifetime Earnings, Georgetown University Center on
Education and the Workforce: 2011, http://cew.georgetown.edu/collegepayoff.
Moreover, education is not an equal opportunity employer. A student from a family
in the upper end of the income distribution is much more likely to get a college
degree than a student whose family is in the lower end of the income distribution.
That inequality perpetuates itself. College graduates marry other college graduatesand earn higher incomes. Those who do not go to college earn lower incomes. Somemay have children out of wedlock—an almost sure route to poverty. That does not,of course, mean that young people who go to college are assured high incomeswhile those who do not are certain to experience poverty, but the odds certainly
push in that direction.

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We shall learn in this section how the degree of inequality can be measured. We
shall examine the sources of rising inequality and consider what policy measures, ifany, are suggested. In this section on inequality we are essentially focusing the way
the economic pie is shared, while setting aside the important fact that the size ofthe economic pie has certainly grown over time.

A Changing Distribution of Income
We have seen that the income distribution has become more unequal. This section
describes a graphical approach to measuring the equality, or inequality, of the
distribution of income.

Measuring Inequality
The primary evidence of growing inequality is provided by census data. Households
are asked to report their income, and they are ranked from the household with thelowest income to the household with the highest income. The Census Bureau thenreports the percentage of total income earned by those households ranked among
the bottom 20%, the next 20%, and so on, up to the top 20%. Each 20% of households
is called a quintile. The bureau also reports the share of income going to the top 5%of households.
Income distribution data can be presented graphically using a Lorenz curve1, acurve that shows cumulative shares of income received by individuals or groups. It
was developed by economist Max O. Lorenz in 1905. To plot the curve, we begin
with the lowest quintile and mark a point to show the percentage of total income
those households received. We then add the next quintile and its share and mark apoint to show the share of the lowest 40% of households. Then, we add the third
quintile, and then the fourth. Since the share of income received by all the quintiles
will be 100%, the last point on the curve always shows that 100% of households
receive 100% of the income.

1. A curve that shows cumulative
shares of income received byindividuals or groups.

18.1 Income Inequality

If every household in the United States received the same income, the Lorenz curve
would coincide with the 45-degree line drawn in Figure 18.1 "The Distribution of
U.S. Income, 1968 and 2010". The bottom 20% of households would receive 20% ofincome; the bottom 40% would receive 40%, and so on. If the distribution of income
were completely unequal, with one household receiving all the income and the rest
zero, then the Lorenz curve would be shaped like a backward L, with a horizontal
line across the bottom of the graph at 0% income and a vertical line up the righthand side. The vertical line would show, as always, that 100% of families still receive
100% of income. Actual Lorenz curves lie between these extremes. The closer a
Lorenz curve lies to the 45-degree line, the more equal the distribution. The more733

Chapter 18 Inequality, Poverty, and Discrimination

bowed out the curve, the less equal the distribution. We see in Figure 18.1 "TheDistribution of U.S. Income, 1968 and 2010" that the Lorenz curve for the UnitedStates became more bowed out between 1968 and 2010.
Figure 18.1 The Distribution of U.S. Income, 1968 and 2010

The distribution of income among households in the United States became more unequal from 1968 to 2010. The
shares of income received by each of the first four quintiles fell, while the share received by the top 20% rose
sharply. The Lorenz curve for 2010 was more bowed out than was the curve for 1968. (Mean income adjusted for
inflation and reported in 2010 dollars; percentages do not sum to 100% due to rounding.)
Sources: Carmen DeNavas-Walt, Bernadette D. Proctor, and Jessica C. Smith, U.S. Census Bureau, Current Population
Reports, P60-239, Income, Poverty, and Health Insurance Coverage in the United States: 2010, U.S. Government
Printing Office, Washington, DC, 2011, Table A-3; U.S. Census Bureau, Current Population Survey, 2010 Annual Socialand Economic Supplement, Table HINC-05.

The degree of inequality is often measured with a Gini coefficient2, the ratio
between the Lorenz curve and the 45° line and the total area under the 45° line. The
smaller the Gini coefficient, the more equal the income distribution. Larger Gini
coefficients mean more unequal distributions. The Census Bureau reported that theGini coefficient was 0.359 in 1968 and 0.457 in 2010.Carmen DeNavas-Walt,
Bernadette D. Proctor, and Jessica C. Smith, U.S. Census Bureau, Current Population
Reports, P60-239, Income, Poverty, and Health Insurance Coverage in the United States:
2010, U.S. Government Printing Office, Washington, DC, 2011.

Mobility and Income Distribution

2. A measure of inequality
expressed as the ratio of thearea between the Lorenz curveand a 45° line and the total
area under the 45° line.

18.1 Income Inequality

When we speak of the bottom 20% or the middle 20% of families, we are notspeaking of a static group. Some families who are in the bottom quintile one year
move up to higher quintiles in subsequent years; some families move down. Because
people move up and down the distribution, we get a quite different picture ofincome change when we look at the incomes of a fixed set of persons over timerather than comparing average incomes for a particular quintile at a particular734

Chapter 18 Inequality, Poverty, and Discrimination

point in time, as was done in Figure 18.1 "The Distribution of U.S. Income, 1968 and2010".
Addressing the question of mobility requires that researchers follow a specificgroup of families over a long period of time. Since 1968, the Panel Survey of Income
Dynamics (PSID) at the University of Michigan has followed more than 5,000
families and their descendents. The effort has produced a much deeper
understanding of changes in income inequality than it is possible to obtain fromcensus data, which simply take a snapshot of incomes at a particular time.
Based on the University of Michigan’s data, Federal Reserve Bank of Boston
economist Katharine Bradbury compared mobility over the decades through 2005.
She concluded that on most mobility measures, family income mobility wassignificantly lower in the 1990s and early 2000s than in earlier periods. Moreover,when families move out of a quintile, they move less. Finally, she notes that for the
recent decades moving across quintiles has become harder to achieve precisely
because of the increased income inequality.Katharine Bradbury, “Trends in U.S.
Family Income Mobility, 1969–2006,” Federal Reserve Bank of Boston Working
Paper no. 11-10, October 20, 2011.

Explaining Inequality
Everyone agrees that the distribution of income in the United States generally
became more equal during the first two decades after World War II and that it has
become more unequal since 1968. While some people conclude that this increase ininequality suggests the latter period was unfair, others want to know why the
distribution changed. We shall examine some of the explanations.

Family Structure
Clearly, an important source of rising inequality since 1968 has been the sharp
increase in the number of families headed by women. In 2010, the median income offamilies headed by married couples was 2.5 times that of families headed by women
without a spouse. The percentage of families headed by women with no spousepresent has nearly doubled since 1968 and is thus contributing to increased
inequality across households.

Technological and Managerial Change
Technological change has affected the demand for labor. One of the most dramaticchanges since the late 1970s has been an increase in the demand for skilled laborand a reduction in the demand for unskilled labor.

18.1 Income Inequality735Chapter 18 Inequality, Poverty, and Discrimination

The result has been an increase in the gap between the wages of skilled andunskilled workers. That has produced a widening gap between college- and highschool-trained workers.
Technological change has meant the integration of computers into virtually every
aspect of production. And that has increased the demand for workers with theknowledge to put new methods to work—and to adapt to the even more dramaticchanges in production likely to come. At the same time, the demand for workers
who do not have that knowledge has fallen.
Along with new technologies that require greater technical expertise, firms are
adopting new management styles that require stronger communication skills. The
use of production teams, for example, shifts decision-making authority to small
groups of assembly-line workers. That means those workers need more than the
manual dexterity that was required of them in the past. They need strong
communication skills. They must write effectively, speak effectively, and interact
effectively with other workers. Workers who cannot do so simply are not in demand
to the degree they once were.
The “intellectual wage gap” seems likely to widen as we move even further into thetwenty-first century. That is likely to lead to an even higher degree of inequality
and to pose a challenge to public policy for decades to come. Increasing educationand training could lead to reductions in inequality. Indeed, individuals seem to havealready begun to respond to this changing market situation, since the percentage
who graduate from high school and college is rising.

Tax Policy
Did tax policy contribute to rising inequality over the past four decades? The tax
changes most often cited in the fairness debate are the Reagan tax cuts introduced
in 1981 and the Bush tax cuts introduced in 2001, 2002, and 2003.
An analysis of the Bush tax cuts by the Tax Foundation combines the three Bush tax
cuts and assumes they occurred in 2003. Table 18.1 "Income Tax Liability Before andAfter the Bush Tax Cuts" gives the share of total income tax liability for eachquintile before and after the Bush tax cuts. It also gives the share of the Bush tax
cuts received by each quintile.

18.1 Income Inequality736Chapter 18 Inequality, Poverty, and Discrimination

Table 18.1 Income Tax Liability Before and After the Bush Tax Cuts

Quintile

Share of income tax liability
before tax cuts

Share of income tax
liability after tax cuts

Share of total
tax reliefFirst
quintile

0.5%

0.3%

1.2%

Secondquintile

2.3%

1.9%

4.2%

Third
quintile

5.9%

5.2%

9.4%

Fourthquintile

12.6%

11.6%

17.5%

Top
quintile

78.7%

81.0%

67.7%

The share of total tax relief received by the first four quintiles was modest, while
those in the top quintile received more than two-thirds of the total benefits of thethree tax cuts. However, the share of income taxes paid by each of the first four
quintiles fell as a result of the tax cuts, while the share paid by the top quintile rose.
Source: William Ahean, “Comparing the Kennedy, Reagan, and Bush Tax Cuts,” Tax
Foundation Fiscal Facts, August 24, 2004.
Tax cuts under George W. Bush were widely criticized as being tilted unfairly
toward the rich. And certainly, Table 18.1 "Income Tax Liability Before and Afterthe Bush Tax Cuts" shows that the share of total tax relief received by the first four
quintiles was modest, while those in the top quintile garnered more than two-thirdsof the total benefits of the three tax cuts. Looking at the second and third columnsof the table, however, gives a different perspective. The share of income taxes paidby each of the first four quintiles fell as a result of the tax cuts, while the share paidby the top quintile rose. Further, we see that each of the first four quintiles paid avery small share of income taxes before and after the tax cuts, while those in the
top quintile ended up shouldering more than 80% of the total income tax burden.
We saw in Figure 18.1 "The Distribution of U.S. Income, 1968 and 2010" that those in
the top quintile received just over half of total income. After the Bush tax cuts, they
paid 81% of income taxes. Others are quick to point out that those same tax cuts
were accompanied by reductions in expenditures for some social service programs
designed to help lower income families. Still others point out that the tax cuts
contributed to an increase in the federal deficit and, therefore, are likely to have
distributional effects over many years and across several generations. Whether

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Chapter 18 Inequality, Poverty, and Discriminationthese changes increased or decreased fairness in the society is ultimately anormative question.

Methodology
The method by which the Census Bureau computes income shares has beenchallenged by some observers. For example, quintiles of households do not containthe same number of people. Rea Hederman of the Heritage Foundation, aconservative think tank, notes that the top 20% of households contains about 25% of
the population. Starting in 2006, the Census Bureau report began calculating ameasure called “equivalence-adjusted income” to take into account family size. The
Gini coefficient for 2010 using this adjustment fell slightly from 0.469 to 0.457. The
trend over time in the two Gini coefficients is similar. Two other flaws pointed out
by Mr. Hederman are that taxes and benefits from noncash programs that help thepoor are not included. While some Census studies attempt to take these into
account and report lower inequality, other studies do not receive as much attention
as the main Census annual report.Rea S. Hederman, Jr., “Census Report Adds New
Twist to Income Inequality Data,” Heritage Foundation, Policy Research andAnalysis, No. 1592, August 29, 2007.
Even studies that look at incomes over a decade may not capture lifetime income.
For example, people in retirement may have a low income but their consumption
may be bolstered by drawing on their savings. Younger people may be borrowing to
go to school, buy a house, or for other things. The annual income approach of the
Census data does not capture this and even the ten-year look in the mobility study
mentioned above is too short a period.
This suggests that more precise measurements may provide more insight into
explaining inequality.

18.1 Income Inequality738Chapter 18 Inequality, Poverty, and Discrimination

KEY TAKEAWAYS• The distribution of income can be illustrated with a Lorenz curve. If allhouseholds had the same income, the Lorenz curve would be a 45° line.
In general, the more equal the distribution of income, the closer the
Lorenz curve will be to the 45° line. A more bowed out curve shows a lessequal distribution. The Gini coefficient is another method for describing
the distribution of income.
• The distribution of income has, according to the Census Bureau, become
somewhat more unequal in the United States during the past 40 years.
• The degree of mobility up and down the distribution of income appears
to have declined in recent years.
• Among the factors explaining increased inequality have been changes infamily structure and changes in the demand for labor that haverewarded those with college degrees and have penalized unskilledworkers.

TRY IT!
The accompanying Lorenz curves show the distribution of income in acountry before taxes and welfare benefits are taken into account (curve A)
and after taxes and welfare benefits are taken into account (curve B). Do
taxes and benefits serve to make the distribution of income in the country
more equal or more unequal?

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Chapter 18 Inequality, Poverty, and Discrimination

Case in Point: Attitudes and Inequality© 2010 Jupiterimages
Corporation

In a fascinating examination of attitudes in the United States and in continental
Western Europe, economists Alberto Alesina of Harvard University and GeorgeMarios Angeletos of the Massachusetts Institute of Technology suggest that
attitudes about the nature of income earning can lead to quite different
economic systems and outcomes concerning the distribution of income.
The economists cite survey evidence from the World Values Survey, whichconcludes that 71% of Americans, and only 40% of Europeans, agree with theproposition: “The poor could become rich if they worked hard enough.” Further,
Americans are much more likely to attribute material success to hard work,
while Europeans tend to attribute success to factors such as luck, connections,and even corruption. The result, according to Professors Alesina and Angeletos,
is that Americans select a government that is smaller and engages in lessredistributive activity than is selected by Europeans. Government incontinental Western Europe is 50% larger than in the United States, the tax
system in Europe is much more progressive than in the United States,
regulation of labor and product markets is more extensive in Europe, andredistributive programs are more extensive in Europe than in the UnitedStates. As a result, the income distribution in Europe is much more equal thanin the United States.

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Chapter 18 Inequality, Poverty, and Discrimination

People get what they expect. The economists derive two sets of equilibria.
Equilibrium in a society in which people think incomes are a result of luck,connections, and corruption turns out to be precisely that. And, in a society inwhich people believe incomes are chiefly the result of effort and skill, they are.
In the latter society, people work harder and invest more. In the United States,
the average worker works 1,600 hours per year. In Europe, the average worker
works 1,200 hours per year.
So, who is right—Americans with their “you get what you deserve” orEuropeans with their “you get what luck, connections, and corruption bringyou” attitude? The two economists show that people get, in effect, what they
expect. European values and beliefs produce societies that are more egalitarian.
American values and beliefs produce the American result: a society in which
the distribution of income is more unequal, the government smaller, andredistribution relatively minor. Professors Alesina and Angeletos conclude that
Europeans tend to underestimate the degree to which people can improve theirmaterial well-being through hard work, while Americans tend to overestimatethat same phenomenon.
Source: Alberto Alesina and George-Marios Angeletos, “Fairness andRedistribution,” American Economic Review 95:4 (September, 2005) 960–80.

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Chapter 18 Inequality, Poverty, and Discrimination

ANSWER TO TRY IT! PROBLEM
The Lorenz curve showing the distribution of income after taxes andbenefits are taken into account is less bowed out than the Lorenz curveshowing the distribution of income before taxes and benefits are taken into
account. Thus, income is more equally distributed after taking them into
account.

18.1 Income Inequality742Chapter 18 Inequality, Poverty, and Discrimination

18.2 The Economics of Poverty
LEARNING OBJECTIVES
1. Distinguish between relative and absolute measures of poverty anddiscuss the uses and merits of each.
2. Describe the demographics of poverty in the United States.
3. Describe the forms of welfare programs in the United States and thereform of welfare in the mid-1990s.
4. Discuss the factors that have been looked at to explain the persistence ofpoverty in the United States.

Poverty in the United States is something of a paradox. Per capita incomes in thiscountry are among the highest on earth. Yet, the United States has a greater
percentage of its population below the official poverty line than in the otherindustrialized nations. How can a nation that is so rich have so many people whoare poor?
There is no single answer to the question of why so many people are poor. But weshall see that there are economic factors at work that help to explain poverty. We
shall also examine the nature of the government’s response to poverty and theimpact that response has. First, however, we shall examine the definition of poverty
and look at some characteristics of the poor in the United States.

Defining Poverty
Suppose you were asked to determine whether a particular family was poor or not
poor. How would you do it?
You might begin by listing the goods and services that would be needed to provide aminimum standard of living and then finding out if the family’s income was enoughto purchase those items. If it were not, you might conclude that the family waspoor. Alternatively, you might examine the family’s income relative to the incomesof other families in the community or in the nation. If the family was on the low endof the income scale, you might classify it as poor.
3. Income test that sets a specificincome level and defines aperson as poor if his or her
income falls below that level.

These two approaches represent two bases on which poverty is defined. The first isan absolute income test3, which sets a specific income level and defines a person as

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Chapter 18 Inequality, Poverty, and Discrimination

poor if his or her income falls below that level. The second is a relative income
test4, in which people whose incomes fall at the bottom of the income distribution
are considered poor. For example, we could rank households according to income as
we did in the previous section on income inequality and define the lowest one-fifthof households as poor. In 2010, any U.S. household with an annual income below$20,000 fell in this category.
In contrast, to determine who is poor according to the absolute income test, we
define a specific level of income, independent of how many households fall above or
below it. The federal government defines a household as poor if the household’s
annual income falls below a dollar figure called the poverty line5. In 2010 thepoverty line for a family of four was an income of $22,314. Figure 18.2 "Weighted
Average Poverty Thresholds in 2010, by Size of Family" shows the poverty line forvarious family sizes.
Figure 18.2 Weighted Average Poverty Thresholds in 2010, by Size of Family

4. Income test in which people
whose incomes fall at thebottom of the income
distribution are consideredpoor.
5. Amount of annual income
below which the federal
government defines ahousehold as poor.

18.2 The Economics of Poverty

The Census Bureau uses a set of 48 money income thresholds that vary by family size and composition to determine
who is in poverty. The “Weighted Average Poverty Thresholds” in the accompanying table is a summary of the 48
thresholds used by the census bureau. It provides a general sense of the “poverty line” based on the relative numberof families by size and composition.
Source: DeNavas-Walt, Carmen, Bernadette D. Proctor, and Jessica Smith, U.S. Census Bureau, Current Population
Reports, P60-239, Income, Poverty, and Health Insurance Coverage in the United States: 2010, U.S. Government
Printing Office, Washington, D.C., 2011; p. 61.

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Chapter 18 Inequality, Poverty, and Discrimination

The concept of a poverty line grew out of a Department of Agriculture study in 1955
that found families spending one-third of their incomes on food. With the one-third
figure as a guide, the Department then selected food plans that met the minimum
daily nutritional requirements established by the federal government. The cost of
the least expensive plan for each household size was multiplied by three todetermine the income below which a household would be considered poor. The
government used this method to count the number of poor people from 1959 to
1969. The poverty line was adjusted each year as food prices changed. Beginning in
1969, the poverty line was adjusted annually by the average percentage pricechange for all consumer goods, not just changes in the price of food.
There is little to be said for this methodology for defining poverty. No attempt ismade to establish an income at which a household could purchase basic necessities.
Indeed, no attempt is made in the definition to establish what such necessities
might be. The day has long passed when the average household devoted one-thirdof its income to food purchases; today such purchases account for less than oneseventh of household income. Still, it is useful to have some threshold that is
consistent from one year to the next so that progress—or the lack thereof—in thefight against poverty can be assessed. In addition, the U.S. Census Bureau and the
Bureau of Labor Statistics have begun working on more broad-based alternative
measures of poverty. The new Supplemental Poverty Measure is based on expenses
for food, clothing, shelter, and utilities; adjusts for geographic differences; adds invarious in-kind benefits such as school lunches, housing subsidies, and energy
assistance; includes tax credits; and then subtracts out taxes, work expenses, andout-of-pocket medical expenses.Kathleen Short, U.S. Census Bureau, Current
Population Reports P60-241, Supplemental Poverty Measure: 2010, U.S. Government
Printing Office, Washington, DC, November 2011.
The percentage of the population that falls below the poverty line is called thepoverty rate6. Figure 18.3 "The Poverty Rate in the United States, 1959–2010"shows both the number of people and the percentage of the population that fell
below the poverty line each year since 1959.

6. The percentage of the
population that falls below thepoverty line.

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Chapter 18 Inequality, Poverty, and Discrimination

Figure 18.3 The Poverty Rate in the United States, 1959–2010

The curve shows the percentage of people who lived in households that fell below the poverty line in each year from1959 to 2010. The poverty rate fell through the 1960s and since has been hovering between about 12% and 15%. It
tends to rise during recessions.
Source: DeNavas-Walt, Carmen, Bernadette D. Proctor, and Jessica Smith, U.S. Census Bureau, Current Population
Reports P60-239, Income, Poverty, and Health Insurance Coverage in the United States: 2010, U.S. Government
Printing Office, Washington DC, 2011; Figure 4, p. 14.

Despite its shortcomings, measuring poverty using an absolute measure allows forthe possibility of progress in reducing it; using a relative measure of poverty does
not, since there will always be a lowest 1/5, or 1/10 of the population. But relative
measures do make an important point: Poverty is in large measure a relative
concept. In the United States, people defined as poor have much higher incomesthan most of the world’s people or even than average Americans did as recently as
the early 1970s. By international and historical standards, the average poor personin the United States is rich! The material possessions of America’s poor would beconsidered lavish in another time and in another place. For example, based on datafrom 2005 to 2009, 42% of poor households in the United States owned their own
homes, nearly 75% owned a car, and 64% have cable or satellite TV. Over 80% ofpoor households had air conditioning. Forty years ago, only 36% of the entire
population in the United States had air conditioning. The average poor person in
the United States has more living space than the average person in London, Paris,
Vienna, or Athens.Robert Rector and Rachel Sheffield, “Understanding Poverty in
the United States: Surprising Facts about America’s Poor,” Heritage Foundation,
Policy Research & Analysis, No. 2607, September 13, 2011.
We often think of poverty as meaning that poor people are unable to purchaseadequate food. Yet, according to Department of Agriculture surveys, 83% of poor

18.2 The Economics of Poverty

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Chapter 18 Inequality, Poverty, and Discrimination

people report that they have adequate food and 96% of poor parents report that
their children are never hungry because they cannot afford food. In short, poor
people in the United States enjoy a standard of living that would be consideredquite comfortable in many parts of the developed world—and lavish in the lessdeveloped world.Ibid.
But people judge their incomes relative to incomes of people around them, notrelative to people everywhere on the planet or to people in years past. You may feelpoor when you compare yourself to some of your classmates who may have fanciercars or better clothes. And a family of four in a Los Angeles slum with an annual
income of $13,000 surely does not feel rich because its income is many times higher
than the average family income in Ethiopia or of Americans of several decades ago.
While the material possessions of poor Americans are vast by Ethiopian standards,
they are low in comparison to how the average American lives. What we think of as
poverty clearly depends more on what people around us are earning than on someabsolute measure of income.
Both the absolute and relative income approaches are used in discussions of thepoverty problem. When we speak of the number of poor people, we are typicallyusing an absolute income test of poverty. When we speak of the problems of thoseat the bottom of the income distribution, we are speaking in terms of a relative
income test. In the European Union, for example, the poverty line is set at 60% of
the median income of each member nation in a particular year. That is an example
of a relative measure of poverty. In the rest of this section, we focus on the absoluteincome test of poverty used in the United States.

The Demographics of Poverty
There is no iron law of poverty that dictates that a household with certain
characteristics will be poor. Nonetheless, poverty is much more highly
concentrated among some groups than among others. The six characteristics offamilies that are important for describing who in the United States constitute thepoor are whether or not the family is headed by a female, age, the level of
education, whether or not the head of the family is working, the race of thehousehold, and geography.
Figure 18.4 "The Demographics of Poverty in the United States, 2010" shows
poverty rates for various groups and for the population as a whole in 2010. What
does it tell us?

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Chapter 18 Inequality, Poverty, and Discrimination

1. A family headed by a female is more than five times as likely to live inpoverty as compared to a family with a husband present. This fact
contributes to child poverty.
2. Children under 18 are about two times more likely to be poor than
“middle-aged” (45–64) persons.
3. The less education the adults in the family have, the more likely thefamily is to be poor. A college education is an almost sure ticket out ofpoverty; the poverty rate for college graduates is just 4.7%.
4. The poverty rate is higher among those who do not work than among
those who do. The poverty rate for people who did not work was aboutnine times the poverty rate of those who worked full time.
5. The prevalence of poverty varies by race and ethnicity. Specifically, thepoverty rate in 2010 for whites (non-Hispanic origin) was less than halfthat for Hispanics or of blacks.
6. The poverty rate in cities is higher than in other areas of residence.
The incidence of poverty soars when several of these demographic factors
associated with poverty are combined. For example, the poverty rate for families
with children that are headed by women who lack a high school education is higher
than 50%.
The new, more broad-based Supplemental Poverty Measure shows an increase of
only 0.1 compared to the official poverty rate measure, but bigger differences fordifferent segments of the population. For example, a smaller percentage of people
under the age of 18 are poor according to the supplemental poverty measure (18.2%
versus 22.5%), while a larger percentage of those over 64 years of age areconsidered poor (15.9% versus 9.0%). The new measure also shows lower poverty
rates among blacks, renters, people living outside metropolitan areas, and those
covered by only public health insurance. Other groups show the same or higher
poverty rates.Kathleen Short, U.S. Census Bureau, Current Population Reports
P60-241, Supplemental Poverty Measure: 2010, U.S. Government Printing Office,Washington, DC, November 2011.

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Chapter 18 Inequality, Poverty, and Discrimination

Figure 18.4 The Demographics of Poverty in the United States, 2010

Poverty rates in the United States vary significantly according to a variety of demographic factors. Panels (a)through (f) compare poverty rates among different groups of the U.S. population. The data are for 2010.
Source: DeNavas-Walt, Carmen, Bernadette D. Proctor, and Jessica C. Smith, U.S. Census Bureau, Current Population
Reports, P60-239, Income, Poverty, and Health Insurance Coverage: 2010, U.S. Government Printing Office,Washington DC, 2011. Data for educational attainment, employment status, and residence from the Annual Socialand Economic Supplement 2010, poverty tables at http://www.census.gov/hhes/www/cpstables/032011/pov/
toc.htm.

Government Policy and Poverty
Consider a young single parent with three small children. The parent is not
employed and has no support from other relatives. What does the government
provide for the family?
The primary form of cash assistance is likely to come from a program called
Temporary Assistance for Needy Families (TANF). This program began with thepassage of the Personal Responsibility and Work Opportunity Reconciliation Act of
1996. It replaced Aid to Families with Dependent Children (AFDC). TANF is funded

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Chapter 18 Inequality, Poverty, and Discriminationby the federal government but administered through the states. Eligibility is limited
to two years of continuous payments and to five years in a person’s lifetime,
although 20% of a state’s caseload may be exempted from this requirement.
In addition to this assistance, the family is likely to qualify for food stamps, which
are vouchers that can be exchanged for food at the grocery store. The family may
also receive rent vouchers, which can be used as payment for private housing. The
family may qualify for Medicaid, a program that pays for physician and hospitalcare as well as for prescription drugs.
A host of other programs provide help ranging from counseling in nutrition to job
placement services. The parent may qualify for federal assistance in attending
college. The children may participate in the Head Start program, a program ofpreschool education designed primarily for low-income children. If the poverty ratein the area is unusually high, local public schools the children attend may receive
extra federal aid. Welfare programs7 are the array of programs that government
provides to alleviate poverty.
In addition to public sector support, a wide range of help is available from private
sector charities. These may provide scholarships for education, employment
assistance, and other aid.
Figure 18.5 "Welfare Programs and the Poor" shows participation rates in the major
federal programs to help the poor.
Figure 18.5 Welfare Programs and the Poor

7. The array of programs thatgovernment provides toalleviate poverty.

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Chapter 18 Inequality, Poverty, and Discrimination

Many people who fall below the poverty line have not received aid from particular programs.
Source: U.S. Census Bureau, Current Population Survey, 2010 Annual Social and Economic Supplement.

Not all people whose incomes fall below the poverty line received aid. In 2010, a
substantial majority of those counted as poor received some form of aid. However,as shown in Figure 18.5 "Welfare Programs and the Poor", the percentages who
were helped by individual programs were much lower. Less than 20% of people
below the poverty line received some form of cash assistance in 2010. About 45%
received food stamps and nearly 60% lived in a household in which one or more
people received medical services through Medicaid. Only about one-seventh of thepeople living in poverty received some form of housing aid.
Although for the most part poverty programs are federally funded, individual states
set eligibility standards and administer the programs. Allowing states to establish
their own programs was a hallmark feature of the 1996 welfare reform. As statebudgets have come under greater pressure, many states have tightened standards.

Cash Versus Noncash AssistanceAid provided to people falls into two broad categories: cash and noncash assistance.
Cash assistance8 is a money payment that a recipient can spend as he or she
wishes. Noncash assistance9 is the provision of specific goods and services, such as
food or medical services, job training, or subsidized child care rather than cash.
Noncash assistance is the most important form of aid to the poor. The large share ofnoncash relative to cash assistance raises two issues. First, since the poor would bebetter off (that is, reach a higher level of satisfaction) with cash rather thannoncash assistance, why is noncash aid such a large percentage of total aid to thepoor? Second, the importance of noncash assistance raises an important issue
concerning the methodology by which the poverty rate is measured in the UnitedStates. We examine these issues in turn.

8. A money payment that an aid
recipient can spend as he or
she wishes.
9. The provision of specific goods
and services, such as food or
medical services, job training,or subsidized child care rather
than cash.

18.2 The Economics of Poverty

1. Why Noncash Aid?
Suppose you had a choice between receiving $515 or a television set
worth $515. Neither gift is taxable. Which would you take?
Given a choice between cash and an equivalent value in merchandise,you would probably take the cash. Unless the television set happened
to be exactly what you would purchase with the $515, you could find751

Chapter 18 Inequality, Poverty, and Discriminationsome other set of goods and services that you would prefer to the TV
set. The same is true of funds that you can spend on anything versus
funds whose spending is restricted. Given a choice of $515 that you
could spend on anything and $515 that you could spend only on food,
which would you choose? A given pool of funds allows consumers agreater degree of satisfaction than does a specific set of goods andservices.
We can conclude that poor people who receive government aid would
be better off from their own perspectives with cash grants than with
noncash aid. Why, then, is most government aid given as noncash
benefits?
Economists have suggested two explanations. The first is based on thepreferences of donors. Recipients might prefer cash, but thepreferences of donors matter also. The donors, in this case, aretaxpayers. Suppose they want poor people to have specificthings—perhaps food, housing, and medical care.
Given such donor preferences, it is not surprising to find aid targetedat providing these basic goods and services. A second explanation has
to do with the political clout of the poor. The poor are not likely to be
successful competitors in the contest to be at the receiving end of
public sector income redistribution efforts; most redistribution goes topeople who are not poor. But firms that provide services such as
housing or medical care might be highly effective lobbyists for
programs that increase the demand for their products. They could be
expected to seek more help for the poor in the form of noncash aidthat increases their own demand and profits.Students who havestudied rent seeking behavior will recognize this argument. It falls
within the public choice perspective of public finance theory.
2. Poverty Management and Noncash Aid
Only cash income is counted in determining the official poverty rate.
The value of food, medical care, or housing provided through various
noncash assistance programs is not included in household income.
That is an important omission, because most government aid is
noncash aid. Data for the official poverty rate thus do not reflect thefull extent to which government programs act to reduce poverty.
The Census Bureau estimates the impact of noncash assistance onpoverty. If a typical household would prefer, say, $515 in cash to $515
in food stamps, then $515 worth of food stamps is not valued at $515 incash. Economists at the Census Bureau adjust the value of noncash aid
downward to reflect an estimate of its lesser value to households.

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Chapter 18 Inequality, Poverty, and Discrimination

Suppose, for example, that given the choice between $515 in foodstamps and $475 in cash, a household reports that it is indifferent
between the two—either would be equally satisfactory. That implies
that $515 in food stamps generates satisfaction equal to $475 in cash;
the food stamps are thus “worth” $475 to the household.

Welfare Reform
The welfare system in the United States came under increasing attack in the 1980s
and early 1990s. It was perceived to be expensive, and it had clearly failed toeliminate poverty. Many observers worried that welfare was becoming a way of life
for people who had withdrawn from the labor force, and that existing welfare
programs did not provide an incentive for people to work. President Clinton madewelfare reform one of the key issues in the 1992 presidential campaign.
The Personal Responsibility and Work Opportunity Reconciliation Act of 1996 was
designed to move people from welfare to work. It eliminated the entitlement aspectof welfare by defining a maximum period of eligibility. It gave states considerable
scope in designing their own programs. In the first years following welfare reform,
the number of people on welfare dropped by several million. Much research on theimpact of reform showed that caseloads declined and employment increased andthat the law did not have an adverse effect on poverty or the well-being of children.
This positive outcome seemed to have resulted from an expansion of the earned
income tax credit that also occurred, the overall low unemployment rate until themost recent few years, and larger behavioral responses than had been
expected.Marianne P. Bitler and Hilary W. Hoynes, “The State of the Social Safety
Net in the Post-Welfare Reform Era,” Brookings Papers on Economic Activity (Fall 2010):
71–127.
Advocates of welfare reform proclaimed victory, while critics pointed to thebooming economy, the tight labor market, and the general increase in the numberof jobs over the same period. The recession that began at the end of 2007 and theensuing slow recovery in the unemployment rate provided a real-time test of theeffects of the reform. Economists Marianne Bitler and Hilary Hoynes analyzed theimpact of welfare reform during the Great Recession on nonelderly families withchildren. They found that participation in cash assistance programs seemed lessresponsive to the downturn but that participation in noncash safety net programs,
particularly the food stamp program, had become more responsive. They did findsome evidence that the increase in poverty or near-poverty status might have been
greater than it would have been without the reform.Marianne P. Bitler and Hilary
W. Hoynes, “The State of the Social Safety Net in the Post-Welfare Reform Era,”
Brookings Papers on Economic Activity (Fall 2010): 71–127.

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Chapter 18 Inequality, Poverty, and Discrimination

Explaining Poverty
Just as the increase in income inequality begs for explanation, so does the questionof why poverty seems so persistent. Should not the long periods of economic
growth in the 1980s and 1990s and from 2003 to late 2007 have substantiallyreduced poverty? Have the various government programs been ineffective?
Clearly, some of the same factors that have contributed to rising income inequality
have also contributed to the persistence of poverty. In particular, the increases inhouseholds headed by females and the growing gaps in wages between skilled andunskilled workers have been major contributors.
Tax policy changes have reduced the extent of poverty. In addition to general
reductions in tax rates, the Earned Income Tax Credit, which began in 1975 and was
expanded in the 1990s, provides people below a certain income level with asupplement for each dollar of income earned. This supplement, roughly 30 cents forevery dollar earned, is received as a tax refund at the end of the year.
Figure 18.6 Percentages of Population in Eight Countries with Disposable Incomes Less Than 1/2 the National
MedianSource: Timothy M. Smeeding, “Public Policy, Economic Inequality, and Poverty: The United States in Comparative
Perspectives,” Social Science Quarterly, 86 (December 2005): 955–983.

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Taken together, though, transfer payment and tax programs in the United States
are less effective in reducing poverty than are the programs of other developed
countries. Figure 18.6 "Percentages of Population in Eight Countries with Disposable
Incomes Less Than 1/2 the National Median" shows the percentage of the
population in eight developed countries with a disposable income (income aftertaxes) less than one-half the national median. The figure shows this percentage
both before and after tax and transfer payment programs are considered. Clearly,
the United States is the least aggressive in seeking to eliminate poverty among theeight countries shown.

Poverty and WorkHow does poverty relate to work? Look back at Figure 18.4 "The Demographics ofPoverty in the United States, 2010". Many of the poor are children or adults overage 65 and some are already working full time. Taken together, these three groups
represent more than half of those in poverty. Also included amongst the poor are
people who are ill or disabled, people who do not work due to family or homereasons, and people who are in school. The Census Bureau found in 2010 that of thenation’s 46.2 million poor people, nearly 3 million reported they were not working
or worked only part of the year or part time because they could not find full-timework.Current Population Survey, Annual Social and Economic Supplement 2010,
Table POV24. So, while more employment opportunities would partly alleviate
poverty, reducing unemployment is clearly only part of the answer.

Poverty and Welfare Programs
How effective have government programs been in alleviating poverty? The Census
Bureau’s supplemental poverty measure begins to answer that question. For
example, those calculations show a reduction of two percentage points in thepoverty rate, from 18% to 16%, when the earned income tax credit is included,
ceteris paribus. Inclusion of the Supplemental Nutritional Assistance Program
reduced the poverty rate by 1.7%, and housing subsidies reduced it by 0.9%. Other
programs each had smaller effects on poverty reduction. But it is also important todistinguish between the poverty rate and the degree of poverty. Cash programsmight reduce the degree of poverty but might not affect a family’s income enoughto actually move that family above the poverty line. Thus, even though the gap
between the family’s income and the poverty line is lessened, the family is stillclassified as poor and would thus still be included in the poverty-rate figures.

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KEY TAKEAWAYS• Poverty may be defined according to a relative or an absolute definition.
• Official estimates of the number of people who are “poor” are typically
based on an absolute definition of poverty, one that many view as
inadequate and dated.
• Several demographic factors appear to be associated with poverty.
Families headed by single women are three times as likely to be poor as
are other families. Poverty is also associated with low levels of education
and with minority status.
• There is a wide range of welfare programs; the majority of welfare
spending is for noncash assistance. Those receiving this aid do not haveit counted as income in the official calculations of poverty.
• Welfare reform has focused on requiring recipients to enter the labor
force. Many poor people, however, are not candidates for the labor
force.

TRY IT!
The Smiths, a family of four, have an income of $20,500 in 2006. Using theabsolute income test approach and the data given in the chapter, determine
if this family is poor. Use the relative income test to determine if this family
is poor.

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Case in Point: Welfare Reform in Britain and in the
United States© 2010 Jupiterimages
Corporation

The governments of the United States and of Great Britain have taken sharply
different courses in their welfare reform efforts. In the United States, theprimary reform effort was undertaken in 1996, with the declaration toeliminate welfare as an entitlement and the beginning of programs that
required recipients to enter the labor force within two years. President Clinton
promised to “end welfare as we know it.”
In Britain, the government of Tony Blair took a radically different approach.
Prime Minister Blair promised to “make welfare popular again.” His
government undertook to establish what he called a “third way” to welfare
reform, one that emphasized returning recipients to the workforce but that
also sought explicitly to end child poverty.
The British program required recipients to get counseling aimed at
encouraging them to return to the labor force. It did not, however, require thatthey obtain jobs. It also included a program of “making work pay,” the primaryfeature of which was the creation of a National Minimum Wage, one that was
set higher than the minimum wage in the United States. In the United States,

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the minimum wage equaled 34% of median private sector wages in 2002; theBritish minimum wage was set at 45% of the median private sector wage in
2002.
The British program, which was called the New Deal, featured tax benefits forpoor families with children, whether they worked or not. It also included a Sure
Start program of child care for poor people with children under three years old.
In short, the Blair program was a more extensive social welfare program than
the 1996 act in the United States.
The table below compares results of the two programs in terms of their impact
on child poverty, using an “absolute” poverty line and also using a relative
poverty line.
Child Poverty Rates, Pre- and Post- Reform
United Kingdom Absolute (percent) Relative (percent)
1997–199824

25

2002–2003

12

21

Change−12−4United States

Absolute (percent) Relative (percent)

1992

19

38

2001

13

35

Change−6−3Child Poverty Rates in Single-Mother Families, Pre- and PostReform
United Kingdom

Absolute (percent)Relative (percent)

1997–199840

41

2002–2003

15

33

Change−25−8Absolute (percent)Relative (percent)

1992

44

67

2001

28

59

United States

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Child Poverty Rates in Single-Mother Families, Pre- and PostReform
Change−16−8

The relative measure of child poverty is the method of measuring poverty
adopted by the European Union. It draws the poverty line at 60% of medianincome. The poverty line is thus a moving target against which it is moredifficult to make progress.
Hills and Waldfogel compared the British results to those in the United Statesin terms of the relative impact on welfare caseloads, employment of women
having families, and reduction in child poverty. They note that reduction in
welfare caseloads was much greater in the United States, with caseloads fallingfrom 5.5 million to 2.3 million. In Britain, the reduction in caseloads was muchsmaller. In terms of impact on employment among women, the United Statesagain experienced a much more significant increase. In terms of reduction ofchild poverty, however, the British approach clearly achieved a greater
reduction. The British approach also increased incomes of families in thebottom 10% of the income distribution (i.e., the bottom decile) by more thanthat achieved in the United States. In Britain, incomes of families in the bottom
decile rose 22%, and for families with children they rose 24%. In the UnitedStates, those in the bottom decile had more modest gains.
Would the United States ever adopt a New Deal program such as the Blair
program in Great Britain? That, according to Hills and Waldfogel, would requirea change in attitudes in the United States that they regard as unlikely.
Source: John Hills and Jane Waldfogel, “A ‘Third Way’ in Welfare Reform?
Evidence from the United Kingdom,” Journal of Policy Analysis and Management,
23(4) (2004): 765–88.

ANSWER TO TRY IT! PROBLEM
According to the absolute income test, the Smiths are poor because theirincome of $20,500 falls below the 2006 poverty threshold of $20,614.
According to the relative income test, they are not poor because their$20,500 income is above the upper limit of the lowest quintile, $20,035.

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18.3 The Economics of Discrimination
LEARNING OBJECTIVES
1. Define discrimination, identify some sources of it, and illustrate Becker’s
model of discrimination using demand and supply in a hypotheticallabor market.
2. Assess the effectiveness of government efforts to reduce discriminationin the United States.

We have seen that being a female head of household or being a member of a racial
minority increases the likelihood of being at the low end of the income distribution
and of being poor. In the real world, we know that on average women and membersof racial minorities receive different wages from white male workers, even though
they may have similar qualifications and backgrounds. They might be charged
different prices or denied employment opportunities. This section examines the
economic forces that create such discrimination, as well as the measures that canbe used to address it.

Discrimination in the Marketplace: A Model
Discrimination10 occurs when people with similar economic characteristics
experience different economic outcomes because of their race, sex, or othernoneconomic characteristics. A black worker whose skills and experience are
identical to those of a white worker but who receives a lower wage is a victim ofdiscrimination. A woman denied a job opportunity solely on the basis of her genderis the victim of discrimination. To the extent that discrimination exists, a country
will not be allocating resources efficiently; the economy will be operating inside its
production possibilities curve.

10. When people with similar
economic characteristics
experience different economic
outcomes because of their race,
sex, or other noneconomic
characteristics.

Pioneering work on the economics of discrimination was done by Gary S. Becker, aneconomist at the University of Chicago, who won the Nobel Prize in economics in1992. He suggested that discrimination occurs because of people’s preferences orattitudes. If enough people have prejudices against certain racial groups, or against
women, or against people with any particular characteristic, the market will
respond to those preferences.
In Becker’s model, discriminatory preferences drive a wedge between the outcomes
experienced by different groups. Discriminatory preferences can make salespeople

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less willing to sell to one group than to another or make consumers less willing tobuy from the members of one group than from another or to make workers of one
race or sex or ethnic group less willing to work with those of another race, sex, or
ethnic group.
Let us explore Becker’s model by examining labor-market discrimination against
black workers. We begin by assuming that no discriminatory preferences orattitudes exist. For simplicity, suppose that the supply curves of black and white
workers are identical; they are shown as a single curve in Figure 18.7 "Prejudice andDiscrimination". Suppose further that all workers have identical marginal products;
they are equally productive. In the absence of racial preferences, the demand forworkers of both races would be D. Black and white workers would each receive awage W per unit of labor. A total of L black workers and L white workers would be
employed.
Now suppose that employers have discriminatory
attitudes that cause them to assume that a black worker
is less productive than an otherwise similar white
worker. Now employers have a lower demand, DB, forblack than for white workers. Employers pay black
workers a lower wage, WB, and employ fewer of them, LB
instead of L, than they would in the absence of
discrimination.

Figure 18.7 Prejudice andDiscrimination

Sources of Discrimination
As illustrated in Figure 18.7 "Prejudice andDiscrimination", racial prejudices on the part of
employers produce discrimination against black
workers, who receive lower wages and have fewer
employment opportunities than white workers.
Discrimination can result from prejudices among othergroups in the economy as well.

If employers, customers, or
employees have discriminatory
preferences, and those
preferences are widespread, thenthe marketplace will result in
discrimination. Here, black
workers receive a lower wage andfewer of them are employed thanwould be the case in the absenceof discriminatory preferences.

One source of discriminatory prejudices is otherworkers. Suppose, for example, that white workers
prefer not to work with black workers and require awage premium for doing so. Such preferences would, in effect, raise the cost to thefirm of hiring black workers. Firms would respond by demanding fewer of them,and wages for black workers would fall.

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Chapter 18 Inequality, Poverty, and Discrimination

Another source of discrimination against black workers could come from
customers. If the buyers of a firm’s product prefer not to deal with black employees,
the firm might respond by demanding fewer of them. In effect, prejudice on thepart of consumers would lower the revenue that firms can generate from the outputof black workers.
Whether discriminatory preferences exist among employers, employees, or
consumers, the impact on the group discriminated against will be the same. Fewer
members of that group will be employed, and their wages will be lower than thewages of other workers whose skills and experience are otherwise similar.
Race and sex are not the only characteristics that affect hiring and wages. Somestudies have found that people who are short, overweight, or physicallyunattractive also suffer from discrimination, and charges of discrimination havebeen voiced by disabled people and by homosexuals. Whenever discrimination
occurs, it implies that employers, workers, or customers have discriminatory
preferences. For the effects of such preferences to be felt in the marketplace, theymust be widely shared.
There are, however, market pressures that can serve to lessen discrimination. For
example, if some employers hold discriminatory preferences but others do not, it
will be profit enhancing for those who do not to hire workers from the group being
discriminated against. Because workers from this group are less expensive to hire,
costs for non-discriminating firms will be lower. If the market is at least somewhat
competitive, firms who continue to discriminate may be driven out of business.

Discrimination in the United States Today
Reacting to demands for social change brought on most notably by the civil rights
and women’s movements, the federal government took action against
discrimination. In 1954, the U.S. Supreme Court rendered its decision that so-called
separate but equal schools for black and white children were inherently unequal,
and the Court ordered that racially segregated schools be integrated. The Equal Pay
Act of 1963 requires employers to pay the same wages to men and women who do
substantially the same work. Federal legislation was passed in 1965 to ensure thatminorities were not denied the right to vote.
Congress passed the most important federal legislation against discrimination in
1964. The Civil Rights Act barred discrimination on the basis of race, sex, or
ethnicity in pay, promotion, hiring, firing, and training. An Executive Order issued
by President Lyndon Johnson in 1967 required federal contractors to implement
affirmative action programs to ensure that members of minority groups and women18.3 The Economics of Discrimination

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were given equal opportunities in employment. The practical effect of the order
was to require that these employers increase the percentage of women andminorities in their work forces. Affirmative action programs for minorities followed
at most colleges and universities.
What has been the outcome of these efforts to reduce discrimination? A starting
point is to look at wage differences among different groups. Gaps in wages between
males and females and between blacks and whites have fallen over time. In 1955,
the wages of black men were about 60% of those of white men; in 2010, they were
74% of those of white men. For black men, the reduction in the wage gap occurred
primarily between 1965 and 1973. In contrast, the gap between the wages of black
women and white men closed more substantially, and progress in closing the gap
continued after 1973, albeit at a slower rate. Specifically, the wages of black women
were about 35% of those of white men in 1955, 58% in 1975, and 70% in 2010. For
white women, the pattern of gain is still different. The wages of white women wereabout 65% of those of white men in 1955 and fell to about 60% from the mid-1960s
to the late 1970s. The wages of white females relative to white males have
improved, however, over the last 40 years. In 2010, white female wages were 80% of
white male wages. While there has been improvement in wage gaps between blackmen, black women, and white women vis-à-vis white men, a substantial gap still
remains. Figure 18.8 "The Wage Gap" shows the wage differences for the period
1969–2010.
Figure 18.8 The Wage Gap

The exhibit shows the wages of white women, black women, and black men as a percentage of the wages of white
men from 1969–2010. As you can see, the gap has closed considerably, but there remains a substantial gap between
the wages of white men and those of other groups in the economy. Part of the difference is a result of discrimination.

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Chapter 18 Inequality, Poverty, and Discrimination

Source: Table 37. Median weekly earnings of full-time wage and salary workers, by selected characteristics. For
recent years, http://www.bls.gov/cps/tables.htm.

One question that economists try to answer is the extent to which the gaps are due
to discrimination per se and the extent to which they reflect other factors, such as
differences in education, job experience, or choices that individuals in particulargroups make about labor-force participation. Once these factors are accounted for,the amount of the remaining wage differential due to discrimination is less than theraw differentials presented in Figure 18.8 "The Wage Gap" would seem to indicate.
There is evidence as well that the wage differential due to discrimination against
women and blacks, as measured by empirical studies, has declined over time. For
example, a number of studies have concluded that black men in the 1980s and 1990s
experienced a 12 to 15% loss in earnings due to labor-market
discrimination.William A. Darity and Patrick L. Mason, “Evidence on Discriminationin Employment,” Journal of Economic Perspectives 12:2 (Spring 1998): 63–90. Universityof Chicago economist James Heckman denies that the entire 12% to 15% differential
is due to racial discrimination, pointing to problems inherent in measuring andcomparing human capital among individuals. Nevertheless, he reports that theearnings loss due to discrimination similarly measured would have been between 30
and 40% in 1940 and still over 20% in 1970.James J. Heckman, “Detecting
Discrimination,” Journal of Economic Perspectives 12:2 (Spring 1998): 101–16.
Can civil rights legislation take credit for the reductions in labor-market
discrimination over time? To some extent, yes. A study by Heckman and John J.
Donohue III, a law professor at Northwestern University, concluded that thelandmark 1964 Civil Rights Act, as well as other civil rights activity leading up to theact, had the greatest positive impact on blacks in the South during the decadefollowing its passage. Evidence of wage gains by black men in other regions of thecountry was, however, minimal. Most federal activity was directed toward theSouth, and the civil rights effort shattered an entire way of life that had subjugatedblack Americans and had separated them from mainstream life.John J. Donohue III
and James Heckman, “Continuous Versus Episodic Change: The Impact of Civil
Rights Policy on the Economic Status of Blacks,” Journal of Economic Literature 29(December 1991): 1603–43.
In recent years, affirmative action programs have been under attack. Proposition
209, passed in California in 1996, and Initiative 200, passed in Washington State in1998, bar preferential treatment due to race in admission to public colleges anduniversities in those states. The 1996 Hopwood case against the University of Texas,
decided by the United States Court of Appeals for the Fifth Circuit, eliminated the18.3 The Economics of Discrimination

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Chapter 18 Inequality, Poverty, and Discrimination

use of race in university admissions, both public and private, in Texas, Louisiana,
and Mississippi. Then Supreme Court decisions in 2003 concerning the use ofaffirmative action at the University of Michigan upheld race conscious admissions,so long as applicants are still considered individually and decisions are based on
multiple criteria.
Controversial research by two former Ivy League university presidents, politicalscientist Derek Bok of Harvard University and economist William G. Bowen of
Princeton University, concluded that affirmative action policies have created the
backbone of the black middle class and taught white students the value of
integration. The study focused on affirmative action at 28 elite colleges anduniversities. It found that while blacks enter those institutions with lower testscores and grades than those of whites, receive lower grades, and graduate at alower rate, after graduation blacks earn advanced degrees at rates identical to thoseof their former white classmates and are more active in civic affairs.Derek Bok andWilliam G. Bowen, The Shape of the River: Long-Term Consequences of Considering Race inCollege and University Admissions (Princeton, N. J.: Princeton University Press, 1998).
While stricter enforcement of civil rights laws or new programs designed to reducelabor-market discrimination may serve to further improve earnings of groups thathave been historically discriminated against, wage gaps between groups also reflect
differences in choices and in “premarket” conditions, such as family environment
and early education. Some of these premarket conditions may themselves be theresult of discrimination.
The narrowing in wage differentials may reflect the dynamics of the Becker model
at work. As people’s preferences change, or are forced to change due to competitive
forces and changes in the legal environment, discrimination against various groups
will decrease. However, it may be a long time before discrimination disappears fromthe labor market, not only due to remaining discriminatory preferences but also
because the human capital and work characteristics that people bring to the labormarket are decades in the making. The election of Barack Obama as president of theUnited States in 2008 is certainly a hallmark in the long and continued struggle
against discrimination.

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Chapter 18 Inequality, Poverty, and Discrimination

KEY TAKEAWAYS• Discrimination means that people of similar economic characteristics
experience unequal economic outcomes as a result of noneconomic
factors such as race or sex.
• Discrimination occurs in the marketplace only if employers, employees,
or customers have discriminatory preferences and if such preferences
are widely shared.
• Competitive markets will tend to reduce discrimination if enoughindividuals lack such prejudices and take advantage of discrimination
practiced by others.
• Government intervention in the form of antidiscrimination laws may
have reduced the degree of discrimination in the economy. There isconsiderable disagreement on this question but wage gaps have declined
over time in the United States.

TRY IT!
Use a production possibilities curve to illustrate the impact of
discrimination on the production of goods and services in the economy.
Label the horizontal axis as consumer goods per year. Label the vertical axis
as capital goods per year. Label a point A that shows an illustrative bundle ofthe two which can be produced given the existence of discrimination. Labelanother point B that lies on the production possibilities curve above and to
the right of point A. Use these two points to describe the outcome thatmight be expected if discrimination were eliminated.

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Case in Point: Early Intervention Programs© 2010 Jupiterimages Corporation

Many authors have pointed out that differences in “pre-market” conditions
may drive observed differences in market outcomes for people in different
groups. Significant inroads to the reduction of poverty may lie in improving the
educational opportunities available to minority children and others living inpoverty-level households, but at what point in their lives is the pay-off tointervention the largest? Professor James Heckman, in an op-ed essay in The
Wall Street Journal, argues that the key to improving student performance andadult competency lies in early intervention in education.
Professor Heckman notes that spending on children after they are already inschool has little impact on their later success. Reducing class sizes, for example,
does not appear to promote gains in factors such as attending college or
earning higher incomes. What does seem to matter is earlier intervention. By
the age of eight , differences in learning abilities are essentially fixed. But, earlyintervention to improve cognitive and especially non-cognitive abilities (thelatter include qualities such as perseverance, motivation, and self-restraint) has
been shown to produce significant benefits. In an experiment begun several
decades ago known as the Perry intervention, four-year-old children fromdisadvantaged homes were given programs designed to improve their chances
for success in school. Evaluations of the program 40 years later found that it
had a 15 to 17% rate of return in terms of the higher wages earned by men and18.3 The Economics of Discrimination

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Chapter 18 Inequality, Poverty, and Discrimination

women who had participated in the program compared to those from similar
backgrounds who did not—the program’s benefit-cost ratio was 8 to 1.
Professor Heckman argues that even earlier intervention among disadvantaged
groups would be desirable—perhaps as early as six months of age.
Economists Rob Grunewald and Art Rolnick of the Federal Reserve Bank of
Minneapolis have gone so far as to argue that, because of the high returns toearly childhood development programs, which they estimate at 12% per year tothe public, state and local governments, can promote more economic
development in their areas by supporting early childhood programs than they
currently do by offering public subsidies to attract new businesses to theirlocales or to build new sports stadiums, none of which offers the prospects ofsuch a high rate of return.
Sources: James Heckman, “Catch ’em Young,” The Wall Street Journal, January 10,
2006, p. A-14; Rob Grunewald and Art Rolnick, “Early Childhood Development
on a Large Scale,” Federal Reserve Bank of Minneapolis The Region, June 2005.

ANSWER TO TRY IT! PROBLEM
Discrimination leads to an inefficient allocation of resources and results in
production levels that lie inside the production possibilities curve (PPC)(point A). If discrimination were eliminated, the economy could increase
production to a point on the PPC, such as B.

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18.4 Review and PracticeSummary
In this chapter, we looked at three issues related to the question of fairness: income inequality, poverty, anddiscrimination.
The distribution of income in the United States has become more unequal in the last four decades. Among thefactors contributing to increased inequality have been changes in family structure, technological change, andtax policy. While rising inequality can be a concern, there is a good deal of movement of families up and down
the distribution of income, though recently mobility may have decreased somewhat.
Poverty can be measured using an absolute or a relative income standard. The official measure of poverty in the
United States relies on an absolute standard. This measure tends to overstate the poverty rate because it does
not count noncash welfare aid as income. The new supplemental poverty measures have begun to take these
programs into account. Poverty is concentrated among female-headed households, minorities, people withrelatively little education, and people who are not in the labor force. Children have a particularly high poverty
rate.
Welfare reform in 1996 focused on moving people off welfare and into work. It limits the number of years that
individuals can receive welfare payments and allows states to design the specific parameters of their own
welfare programs. Following the reform, the number of people on welfare fell dramatically. The long-term
impact on poverty is still under investigation.
Federal legislation bans discrimination. Affirmative action programs, though controversial, are designed toenhance opportunities for minorities and women. Wage gaps between women and white males and between
blacks and white males have declined since the 1950s. For black males, however, most of the reduction occurred
between 1965 and 1973. Much of the decrease in wage gaps is due to acquisition of human capital by women andblacks, but some of the decrease also reflects a reduction in discrimination.

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CONCEPT PROBLEMS
1. Explain how rising demand for college-educated workers and fallingdemand for high-school-educated workers contributes to increased
inequality of the distribution of income.
2. Discuss the advantages and disadvantages of the following threealternatives for dealing with the rising inequality of wages.
1. Increase the minimum wage each year so that wages forunskilled workers rise as fast as wages for skilled workers.
2. Subsidize the wages of unskilled workers.
3. Do nothing.
3. How would you define poverty? How would you determine whether aparticular family is poor? Is the test you have proposed an absolute or a
relative test?
4. Why does the failure to adjust the poverty line for regional differencesin living costs lead to an understatement of poverty in some states andan overstatement of poverty in others?
5. The text argues that welfare recipients could achieve higher levels ofsatisfaction if they received cash rather than in-kind aid. Use the same
argument to make a case that gifts given at Christmas should be in cash
rather than specific items. Why do you suppose they usually are not?
6. Suppose a welfare program provides a basic grant of $10,000 per year topoor families but reduces the grant by $1 for every $1 of income earned.
How would such a program affect a household’s incentive to work?
7. Welfare reform calls for a two-year limit on welfare payments, after
which recipients must go to work. Suppose a recipient with children
declines work offers. Should aid be cut? What about the children?
8. How would you tackle the welfare problem? State the goals you would
seek, and explain how the measures you propose would work to meetthose goals.
9. Suppose a common but unfounded belief held that people with blue eyes
were not as smart as people with brown eyes. What would we expect tohappen to the relative wages of the two groups? Suppose you were an
entrepreneur who knew that the common belief was wrong. What could
you do to enhance your profits? Suppose other entrepreneurs acted in
the same way. How would the wages of people with blue eyes beaffected?
10. The Case in Point on Income Inequality in the United States versus
continental Western Europe argues that people get, in effect, what they
expect. People in the United States attribute success to hard work and18.4 Review and Practice770

Chapter 18 Inequality, Poverty, and Discrimination

11.

12.

13.

14.

18.4 Review and Practiceskill, while people in Continental Western Europe attribute success toconnections, luck, and corruption. With what set of views do you agree?
Explain.
The Case in Point on welfare reform in Britain versus that in the UnitedStates argues that the British system, before it could be adopted in the
United States, would require a change in attitudes in the United States.
What sort of change would it require? Do you prefer the British
approach? Why or why not?
James Heckman of the University of Chicago advocates a program ofearly intervention targeted at low income families. What are theadvantages of such an approach? The disadvantages?
Give five reasons that the income distribution in the United States has
become more unequal in the last several decades. Do you regard this as aproblem for society? Why or why not?
Suppose that all welfare aid were converted to programs of cash
assistance. Total spending on welfare would remain unchanged. How
would this affect the poverty rate? Why?

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NUMERICAL PROBLEMS

1. Here are income distribution data for three countries, from the
Human Development Report 2005, table 15. Note that here we report
only four data points rather than the five associated with eachquintile. These emphasize the distribution at the extremes of the
distribution.
Poorest10%

Poorest20%

Richest20%

Richest10%

Panama

0.7

2.4

60.3

43.3

Sweden

3.6

9.1

36.6

22.2

Singapore

1.9

5.0

49.0

32.8

1. Plot the Lorenz curves for each in a single graph.
2. Compare the degree of inequality for the three countries. (Donot forget to convert the data to cumulative shares; e.g., thelowest 80% of the population in Panama receives 39.7% of
total income.)
3. Compare your results to the Lorenz curve given in the text
for the United States. Which country in your chart appears
closest to the United States in terms of its income
distribution?
2. Looking at Figure 18.7 "Prejudice and Discrimination" suppose
the wage that black workers are receiving in a discriminatoryenvironment, WB, is $25 per hour, while the wage that white
workers receive, W, is $30 per hour. Now suppose a regulation is
imposed that requires that black workers be paid $30 per houralso.
1. How does this affect the employment of black workers?
2. How does this affect the wages of black workers?
3. How does this affect their total income? Explain.
3. Suppose the poverty line in the United States was set according
to the test required in the European Union: a household is poor if
its income is less than 60% of the median household income.
Here are annual data for median household income in the United

18.4 Review and Practice772

Chapter 18 Inequality, Poverty, and Discrimination

States for the period 1994–2004. The data also give thepercentage of the households that fall below 60% of the medianhousehold income.
Source: U.S Census Bureau, Current Population
Reports, P60-229; Income in 2004 CPI-U-RS adjusted
dollars; column 3 estimated by authors using Table
A-1, p. 31.
Median Household
Income in the U.S.

Percent of households withincome below 60% of median

1994

40,67730.1

1995

41,94330.4

1996

42,54429.9

199743,43029.1

1998

45,00327.8

1999

46,12927.1

2000

46,05826.4

2001

45,06227.4

2002

44,54627.8

2003

44,48228.3

2004

44,38928.3

1. Plot the data on a graph.
2. Is this a relative or an absolute definition of poverty?
3. Why do you think the percent of households with incomes
below 60% of the median fell from 1994 to 2000 and has risen
since?
4. Discuss the measurement issues involved in the data you
have presented.
5. Discuss the elements of the system of counting the incomesof low income people in the United States and explain how it
relates to your answer in (d).
4. Consider the following model of the labor market in the UnitedStates. Suppose that the labor market consists of two parts, amarket for skilled workers and the market for unskilled workers,

18.4 Review and Practice773

Chapter 18 Inequality, Poverty, and Discrimination

with different demand and supply curves for each as given
below. The initial wage for skilled workers is $20 per hour; theinitial wage for unskilled workers is $7 per hour.
1. Draw the demand and supply curves for the two markets sothat they intersect at the wages given above.
2. How does increased demand for skilled workers and areduced demand for unskilled workers affect the initialsolution?
3. How is the Lorenz curve for the United States economy
affected by this development? Illustrate the old and the new
Lorenz curves.
4. Suppose there is an increase in immigration from Mexico.
How will this affect the two markets for labor?
5. Suppose Professor Heckman’s recommendation for earlyintervention for low income children is followed and that it
has the impact he predicts. How will this affect the twomarkets today? In 20 years? Illustrate and explain how thedemand and/or supply curves in each market will beaffected.
6. What would the impact of the change in (d) be on the Lorenz
curve for the United States 20 years from now?

18.4 Review and Practice774

Chapter 19
Economic Development
Start Up: Being Poor in a Poor Country
You are four years old. You live with your family in the vicinity of Lagos, the capitalof Nigeria. You are poor. Very poor.
You and your father, mother, four brothers and sisters, and grandmother live in ashack with a dirt floor. It commands a rather nice view of the Gulf of Guinea to thesouth, but the amenities end there. Drinking water, which you are learning to help
fetch, is badly polluted—so you are sick much of the time. As for sanitation, there is
not any in your neighborhood. You are also hungry. You think of the gnawing
feeling in your stomach, the slight dizziness you always feel, as normal.
Your newest brother, who was born last month, just died of cholera. Your mother
tried to get him to the clinic, but it was closed when your brother needed it. Your
father’s usual optimism has vanished—he talks of going east to Abuja to find work.
He has given up finding a job here.
Your father worked in the peanut fields in the eastern part of the country forseveral years, but he lost his job. After some very tough years marked by ethnic
violence, your family came to the city. You were born shortly after that—you havenever known your father to have a regular job. Your mother has had better luckfinding work as a maid for some of the wealthy people, with real homes, acrosstown.
You will be old enough to start school next year and are looking forward to that.
Your parents say you will be fed there. But if you are like your older brothers andsisters, you will not go to school for more than a couple of years. Your family willneed you to earn some money in the streets—begging, running errands, hustling.
You have no reason to think your life will ever get any better. Your own family’s
fortunes seem to have declined, not risen, all your life.

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Chapter 19 Economic Development

You cannot know it, but you are not alone. The World Bank estimated that in 2005
about 1.4 billion people, about a quarter of the population of developing countries,
were poor, defined as living on less than $1.25 a day, the international poverty line.
You are on the poor end even of that group, but there are plenty of others who live
pretty much the way you do.
In this chapter, we will take a look at the economies of poor countries. We will seethat malnutrition, inadequate health care, high infant mortality, highunemployment, and low levels of education prevail in much of the world. But, we
will also see that overall, and especially in some countries, great strides in
improving living standards have been made. In 1980, about half of the population ofdeveloping countries, or 1.9 billion people, were poor. Poverty reduction in East
Asia has been phenomenal, with the poverty rate falling from around 80% to lessthan 20% over the last 25 years. Declines in the poverty rate, at about 50%, havebeen minimal in Sub-Saharan Africa over that period.Shaohua Chen and Martin
Ravallion, “The Developing World Is Poorer than We Thought, but No Less
Successful in the Fight against Poverty,” World Bank Policy Research Working
Paper 4703, August 1, 2008.
In 2000, eight Millennium Development Goals were adopted by the international
community. They are (1) to eradicate extreme poverty and hunger, (2) to achieve
universal primary education, (3) to promote gender equality, (4) to reduce childmortality, (5) to improve maternal health, (6) to combat HIV/AIDS, malaria, andother diseases, (7) to ensure environmental sustainability, and (8) to develop a
global partnership for development.
The United Nations monitors progress on these goals, which have been concretely
specified (e.g., between 1990 and 2015, halve the proportion of people whose
income is less than $1 a day, reduce the under-five mortality rate by two-thirds,
halt and begin to reverse the spread of HIV/AIDS). The United Nations’ most recent
annual goals report notes that not only have governments been supportive of thegoals, but so have many private foundations. As might be expected, it appears thatsome of the goals will be reached by their target dates, mostly 2015, while othergoals are less likely to be achieved. Some that are likely to be achieved are thehalving of the absolute poverty rate, the increase in primary school enrollment,
reductions in deaths from measles and AIDS, the increase in access to safe drinking
water, and the reduction in the use of ozone-depleting substances. Goals that arelikely to be missed are reaching the absolute poverty reduction goal in Sub-SaharanAfrica, improvements in gender parity and job security, and improvements inconditions in slums.United Nations, The Millennium Development Goals Report 2008
(New York: United Nations, 2008).

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Chapter 19 Economic Development

The challenge of economic development is to find ways to achieve sustained
economic growth in poor countries and to improve the living conditions of most of
the world’s people. It is an enormous task, one often marked by failure. But there
have been successes. With those successes have come lessons that can guide us as
we face what surely must be the most urgent of global tasks: economic
development.

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Chapter 19 Economic Development

19.1 The Nature and Challenge of Economic Development
LEARNING OBJECTIVES
1. Define a developing country and discuss how incomes are comparedacross countries.
2. State and explain the general characteristics of low-income countries.
3. Discuss what is meant by economic development.

Throughout most of history, poverty has been the human condition. For mostpeople life was, in the words of 17th-century English philosopher Thomas Hobbes,“solitary, poor, nasty, brutish, and short.” Only within the past 200 years have ahandful or so of countries been able to break the chains of economic deprivationand poverty.
Consider these facts:United Nations Development Program, Human Development
Report 2007/2008 (New York: Palgrave Macmillan, 2007).
• Over a third of the world’s people live in countries in which total per
capita income in 2005 was less than $610 per year; 85% live in countries
in which total per capita income in 2005 was $2,808 or less. Adjustingfor purchasing power, the per capita income levels would be $2,531 and$7,416, respectively. The latter numbers compare to per capita income
in high-income countries of over $30,000.
• Babies born in poor countries are 16 times more likely to die in theirfirst five years than are babies born in rich countries.
• About a quarter of the populations of low-income countries isundernourished.
• About 40% (over 50% for women) of the people 15 years old and older
in low-income countries are illiterate.
• Roughly one-fourth of the people in low-income countries do not haveaccess to safe drinking water.
Clearly, the high standards of living enjoyed by people in the world’s developed
economies are the global exception, not the rule. This chapter looks at the problem
of improving the standard of living in poor countries.

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Chapter 19 Economic Development

Rich and Poor Nations
The World Bank, an international organization designed to support economic
development by providing financial assistance, advice, and other resources to poor
countries, classifies over 200 countries according to their levels of per capita grossnational income. The categories in its 2008 report, as shown in Table 19.1 "World
Incomes, Selected Countries", were as follows:• Low-income countries: These countries had per capita incomes of $935
or less in 2007. There were 49 countries in this category. About 20% of
the world’s total population of about 6.5 billion people lived in lowincome countries in 2007.
• Middle-income countries: There were 95 countries with per capita
incomes of more than $936 but less than $11,455. Middle-income
countries are further subdivided into lower middle-income and upper
middle-income countries. Roughly two-thirds of the world’s population
lived in middle-income countries in 2007. We should note that thepercentage of the world’s population living in middle-income countries
increased dramatically (and the percentage living in low-income
countries decreased dramatically) when China and India moved frombeing low-income to middle-income countries.
• High-income countries: There were 65 nations with per capita incomesof $11,456 or more. Just 16% of the world’s total population lived inhigh-income countries in 2007.
Countries in the low- and middle-income categories are often called developing
countries. A developing country1 is thus a country that is not among the highincome nations of the world.The World Development Report 2006 (New York: Oxford
University Press, 2006), xiv, comments on this usage: “The term developing countries
includes low- and middle-income economies and thus may include economies intransition from central planning, as a matter of convenience. The term advanced
countries may be used as a matter of convenience to denote high-income
economics.” Developing countries are sometimes referred to as third-world
countries.

1. A country that is not among
the high-income nations of theworld.

How does the World Bank compare incomes across countries? The World Bank
converts gross national income (GNI) figures to dollars in two ways. One is to take
GNI in a local currency and convert using the exchange rate, averaged over a threeyear period in order to smooth out the effects of currency fluctuations. This type ofcomparison can, however, be misleading. A country could have a relatively highstandard of living but, for a variety of reasons, a low exchange rate. The per capita
GNI figure would be quite low; the country would appear to be poorer than it is.

19.1 The Nature and Challenge of Economic Development

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Chapter 19 Economic Development

A better approach to comparing incomes converts currencies to dollars on the basisof purchasing power. This measure is reported in what are called international
dollars. An international dollar has the same purchasing power as does a U.S. dollar
in the United States. This is reported in the column labeled “2007 International $”in Table 19.1 "World Incomes, Selected Countries".
Table 19.1 World Incomes, Selected Countries
Gross National Income per Capita, 2007
Low-income countries

Middle-income countries

High-income countri

Countries

2007
2007
2007
2007
International Countries
International Countries
$
$
$
$

2007
$

Burundi

110

330

India

950

2,740

Czech
Republic

14,45022

Sierra Leone

260

660

China

2,360

5,370

Saudi
Arabia15,44022

Mozambique

320

690

Thailand

3,400

7,880

Israel

21,90025

Bangladesh

470

1,340

Iran

3,470

10,800

Greece29,630

32

Haiti

560

1,150

Jamaica

3,710

6,210

Japan

37,67034

Uzbekistan

730

2,430

Costa Rica

5,560

10,700France38,50033

Vietnam

790

2,550

Brazil

5,910

9,370

Canada39,42035

Zambia800

1,220

Argentina

6,050

12,990

UnitedStates46,04045

Pakistan

870

2,570

Russian
7,560
Federation

14,400

Ireland48,14037

Nigeria

930

1,770

Turkey8,020

12,350

Norway76,45053

Average

578

1,494

Average

2,872

5,952

Average

37,566

36

Ave.,
lower
middle

1,887

4,543

Ave.,
upper
middle6,987

11,86819.1 The Nature and Challenge of Economic Development780

20InternChapter 19 Economic Development

Source: World Development Indicators database, World Bank, revised October 17,
2008.
The international dollar estimates typically show higher incomes than estimates
based on an exchange rate conversion. For example, in 2007 Mozambique’s per
capita GNI, based on exchange rates, was $320. Its per capita GNI based theinternational dollars was $690.
Ranking of countries, both rich and poor, by per capita GNI differs depending on themeasure used. According to the per capita GNI figures in Table 19.1 "World Incomes,
Selected Countries", which convert data in domestic currencies to dollars using
exchange rates, the United States ranked fifteenth of all countries in 2007. Using
the international dollars method, its rank is tenth. China is ranked at 132 when percapita GNI is based on the exchange rate conversion method but rises to 122 basedon the international dollar method.

Characteristics of Low-Income Countries
Low incomes are often associated with other characteristics: severe inequality, poor
health care and education, high unemployment, heavy reliance on agriculture, andrapid population growth. We will examine most of these problems in this section.
Population growth in low-income nations is examined later in the chapter.

Inequality
Not only are incomes in low-income countries quite low; income distribution isoften highly unequal. Poverty is far more prevalent than per capita numberssuggest, as illustrated by Lorenz curves, introduced in the chapter on inequality,that show the cumulative shares of income received by individuals or groups.
Consider Costa Rica and Panama, two Latin American countries with roughly
equivalent levels of per capita GNI (Costa Rica’s was $5,560 and Panama’s $5,510 in2007). Panama’s income distribution is comparatively less equal, while Costa Rica’s
is far more equal. Figure 19.1 "Poverty and the Distribution of Income: Costa Rica
versus Panama" compares the 2003 Lorenz curves for Costa Rica and Panama, themost recent year for which the information was available. The 20% of thehouseholds with the lowest incomes in Costa Rica had twice as large a share of theircountry’s total income as did the bottom 20% of households in Panama. That means
Costa Rica’s poor were about twice as well off, in material terms, as Panama’s poor.

19.1 The Nature and Challenge of Economic Development

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Chapter 19 Economic Development

Figure 19.1 Poverty and the Distribution of Income: Costa Rica versus Panama

Costa Rica had about the same per capita GNI as Panama in 2003, but Panama’s income distribution was far moreunequal. Panama’s poor had much lower living standards than Costa Rica’s poor, as suggested by the Lorenz curves
for the two nations.
Source: World Development Indicators Online (revised October 17, 2008).

In general, the greater the degree of inequality, the more desperate is the conditionof people at the bottom of an income distribution. Given the high degree of
inequality in many low-income countries, it is very important to look at income
distributions when we compare living standards in different countries.

Health and Education
Poor nations are typically characterized by low levels of human capital. Where
health-care facilities are inadequate, that human capital can be reduced further by
disease. Where educational resources are poor, there will be little progress in
improving human capital.
One indicator of poor health care appears on the supply side. Low-income countries
have fewer doctors, relative to their populations, than high-income countries. For
example, the UN estimates that in 2006 about 60% of mothers giving birth in

19.1 The Nature and Challenge of Economic Development

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Chapter 19 Economic Development

developing countries had access to a skilled health-care provider (doctor, nurse, or
midwife). While that is up from 47% in 1990, the lack of access to a health-careprovider may explain much of the difference in maternal death rates between
developed and developing countries: about nine maternal deaths per 100,000 live
births in developed countries compared to about 450 per 100,000 in developing
countries.United Nations, The Millennium Development Goals Report 2008, 27.
We can also see the results of poor health care in statistics on health. Among theworld’s developing countries, the infant mortality rate, which reports deaths in thefirst year of life, was 57 per 1,000 live births in 2005. There were six infant deaths
per 1,000 live births among the high-income countries that year.United Nations
Development Program, Human Development Report 2007/2008 (New York: Palgrave
Macmillan, 2007), 264.
Another health issue facing the world’s low-income countries is malnutrition.
Malnutrition rates in all developing countries in the 2002 to 2004 period averaged
17%, 35% in the least developed countries.
Still another issue is the spread of HIV/AIDS. Here there is some progress. The
number of people newly infected declined from 3 million in 2001 to 2.7 million in2005. Antiretroviral treatments are also leading to a reduction in deaths from 2.2
million in 2005 to 2 million in 2007. Longer survival means that the number ofpeople living with HIV (from just under 30 million in 2001 to about 33 million in2007) is rising and most of the people living with HIV are in Sub-SaharanAfrica.United Nations, The Millennium Development Goals Report 2008, 30.
Education in poor and middle-income nations is improving. In 1991, about 80% ofchildren in developing countries were enrolled in primary schools. In 2005, about
85% were. The comparable numbers in developed countries are about 95%.
Enrollment rates taper off for high school (about 53% in 2005 in developing
countries compared to 91% in developed countries).United Nations Development
Program, Human Development Report 2007/2008 (New York: Palgrave Macmillan, 2007),
272.

Unemployment
Unemployment is pervasive in low-income nations. These nations, already facedwith low levels of potential output, are producing well below their potential.
Unemployment rates in low-income countries vary widely, reaching as high as 15%
or more in some countries. If we count discouraged workers, people who have given
up looking for work but who would take it if it were available, and people who work

19.1 The Nature and Challenge of Economic Development

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Chapter 19 Economic Development

less than full time, not by choice but because more work is unavailable, thenunemployment in low-income countries soars—often to more than 30%.
Migration within low-income countries often contributes to unemployment inurban areas. Factors such as ethnic violence, poverty, and drought often force
people to move from rural areas to cities, where unemployment rates are alreadyhigh.

Reliance on Agriculture
One of the dominant characteristics of poor nations is the concentration of
employment in agriculture. Another is the very low productivity of that
employment. Agriculture in low-income countries often employs a majority of the
population but produces less than one-third of GDP.
One of the primary forces behind income growth in wealthy countries has been theshift of labor out of agriculture and into more productive sectors such as
manufacturing. This shift is also occurring in low-income nations but has lagged far
behind.
The solution to these problems lies in economic development, to which we turnnext.

Economic Development: A Definition
If the problems of low-income nations are pervasive, the development that helps tosolve those problems must transform the very nature of their societies. The late
Austrian economist Joseph Schumpeter described economic development as arevolutionary process. Whereas economic growth implies quantitative change inproduction processes that are already familiar to the society, economic
development requires qualitative change in virtually every aspect of life.
Robert Heilbroner, an economist at the New School for Social Research in New York,
has argued,“Economic development is political and social change on a wrenching and tearing
scale. … It is a process of institutional birth and institutional death. It is a time whenpower shifts, often violently and abruptly, a time when old regimes go under andnew ones rise in their places. And these are not just the unpleasant side effects ofdevelopment. They are part and parcel of the process, the very driving force of

19.1 The Nature and Challenge of Economic Development

784

Chapter 19 Economic Developmentchange itself.”Robert Heilbroner, Between Capitalism and Socialism (New York:
Vintage Books, 1970), 53–54.
Economic development transforms a nation at its core. But what, precisely, isdevelopment? Many definitions follow Heilbroner in noting the massive
institutional and cultural changes economic development involves. But whatever
the requirements of development, its primary characteristics are rising incomes
and improving standards of living. That means output must increase—and it must
increase relative to population growth. And because inequality is so serious a
problem in low-income nations, development must deliver widespread
improvement in living conditions. It therefore seems useful to define economic
development2 as a process that produces sustained and widely shared gains in percapita real GDP.
In recent years, the United Nations has constructed measures incorporating
dimensions of economic development that go beyond the level of per capita GDP.
The Human Development Index (HDI) includes three dimensions—life expectancy,
educational attainment (adult literacy and combined primary, secondary, and postsecondary enrollment), as well as purchasing-power-adjusted per capita real GDP.
The Gender Development Index (GDI) uses the same variables as the HDI but adjusts
them downward to take into account the extent of gender inequality. A third index,
the Human Poverty Index (HPI), measures human deprivation and includes such
indicators as the percentage of people expected to die before age 40, the percentage
of underweight children under age 5, the percentage of adults who are illiterate,
and the percentage of people who live in poverty. The number reported for the HPIshows the percentage of people in the country who suffer these deprivations.
Table 19.2 "Human Development Index, Gender Development Index, and Human
Poverty Index" shows the HDI, the GDI rank, and the HPI for selected countries, by
HDI rank. The HDI is constructed to have an upper limit of 1. Canada’s HDI is 0.96;
the United States’ is 0.95. As the table shows, the HDIs for developing countries
range from 0.87 in Argentina to 0.34 in Sierra Leone. The greater the difference
between the HDI and the GDI of a country, the greater the disparity in achievement
between males and females in the country. Countries can have similar HDIs but
different GDIs or HPIs. By looking at a variety of measures, we come closer toexamining the extent to which the gains in income growth have been shared or not.

2. A process that produces
sustained and widely sharedgains in per capita real GDP.

19.1 The Nature and Challenge of Economic Development

785

Chapter 19 Economic Development

Table 19.2 Human Development Index, Gender Development Index, and Human
Poverty Index
GenderHuman
RelatedDevelopment
Development
Index (HDI),
Index (GDI)
2005
2005, Rank

Human Poverty Index (HPI), %2005The definition of deprivation
for developed countries applies ahigher standard than it does fordeveloping countries.

HDI
rank

Country

1

Iceland

0.968

1

NA

2

Norway

0.968

3

6.8

4

Canada

0.961

4

10.9

10

France

0.952

7

11.2

12

UnitedStates

0.951

16

15.4

24

Greece

0.926

24

NA

32

Czech
Republic

0.891

29

NA

38

Argentina

0.869

36

4.1

48

Costa Rica

0.846

47

4.4

61

Saudi
Arabia

0.812

70

NA

67

RussianFederation

0.802

59

NA

70

Brazil

0.8

60

9.7

78

Thailand

0.781

71

10.0

81

China

0.777

73

11.7

84

Turkey

0.775

79

9.2

90

Philippines

0.771

77

15.3

94

Iran

0.759

84

12.9

101

Jamaica

0.736

90

14.3

105

Viet Nam

0.733

91

15.2

114

Mongolia

0.7

100

NA

117

Bolivia

0.695

103

13.6

126

Morocco

0.646

112

33.4

19.1 The Nature and Challenge of Economic Development

786

Chapter 19 Economic Development

GenderHuman
RelatedDevelopment
Development
Index (HDI),
Index (GDI)
2005
2005, Rank

Human Poverty Index (HPI), %2005The definition of deprivation
for developed countries applies ahigher standard than it does fordeveloping countries.

HDI
rank

Country

128

India

0.619

113

31.3

135

Ghana

0.553

117

32.3

136

Pakistan

0.551

125

36.2

148

Kenya

0.521

127

30.8

154

Uganda

0.505

132

34.7

156

Senegal

0.499

135

42.9

173

Mali

0.38

151

56.4

177

Sierra
Leone

0.336

157

51.7

Source: United Nations Development Program, Human Development Report 2007/2008(New York: Palgrave Macmillan, 2007).

KEY TAKEAWAYS• The World Bank classifies countries as being low-income, middleincome, or high-income. More than 80% of the world’s people live in
low- and middle-income countries.
• Among the problems facing low-income nations are low living
standards, inequality, inadequate health care and education, highunemployment, and the concentration of the labor force in lowproductivity agricultural work.
• Economic development is a process that generates sustained and widely
shared gains in per capita real GDP.

19.1 The Nature and Challenge of Economic Development

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Chapter 19 Economic Development

TRY IT!
Provided below is information about two low-income developing countries
in Western Africa, Côte d’Ivoire, and Guinea. Use the information to plot
their Lorenz curves for consumption, which are similar to Lorenz curves forincome distribution, discussed in the chapter on inequality, poverty, anddiscrimination. Then, based on the material in this section, contrast theconcept of economic growth, as discussed in the chapter on that topic, withthe concept of economic development, the subject of this chapter. Which of
the two countries do you believe fits better the definition of development?
Explain.
Averageannualgrowthrate of
GNP (%)

Averageannualgrowthrate of
GNP per
capitaCoted’Ivoire

6.9

4.2

6.8

11.2

15.8

22.2

44.1

Guinea

7.2

4.6

3.0

8.3

14.6

23.9

50.2

19.1 The Nature and Challenge of Economic Development

Percentage Share of Consumption

Lowest Second Third Fourth Highest
20%
20%
20%
20%
20%

788

Chapter 19 Economic Development

Case in Point: (Growth and Development) or (Growth orDevelopment)?

The 1971 Nobel laureate in economics, Simon Kuznets, hypothesized that, at
low levels of per capita income, increases in income would lead to increases inincome inequality. The Kuznets hypothesis was later extended to include
concern that early growth might not be associated with improvements in otheraspects of development, such as those measured by the HDI or HPI. The
rationale for growth pessimism was that the structural changes that often
accompany early growth—such as rural–urban migration, occupationalchanges, and environmental degradation—disproportionately hurt poorer
people.
The passage of time and the availability of more information on developing
countries’ experiences allow us to test whether such pessimism is warranted.
The results of a recent study of 95 decade-long episodes of economic growthand decline around the world show that the distribution of income can goeither way. Clearly, as the table below shows, with the direction of change inthe distribution of income split almost 50-50 during periods of growth, there is
no longer any reason to think that growth necessarily increases income
inequality. As the table also shows, by a ratio of 7 to 1, the income of the poor
usually improves during periods of growth. This means that even wheninequality increases, the poor usually gain in absolute terms as income grows.

19.1 The Nature and Challenge of Economic Development

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Chapter 19 Economic Development

There were only seven periods of income decline included in the study, but, ingeneral, during those periods the distribution of income grew more unequaland the incomes of the poor fell.
Broad-based measures of development, such as the HDI and the HPI, have notbeen calculated for a long enough period to allow us to see the trend in thesesocial indicators of development, but we can look at various aspects of humandevelopment and poverty over time. As shown in the graphs accompanying thiscase, there have generally been improvements in the percentage of people withaccess to safe water, in the adult literacy rate, and in the percentage ofunderweight children under age 5. On this last indicator, the improvement in
Sub-Saharan Africa is very small, but keep in mind that the rate of growth ofreal GNP per capita in this region has been just over 1% per year.
There is no guarantee that economic growth will improve the plight of theworld’s poor—there is indeed wide variation in individual countries’
experiences. In general, though, economic growth makes most people,
including most poor people, better off. As former World Bank Senior Vice
President and Chief Economist Joseph Stiglitz put it, “Aggregate economic
growth benefits most of the people most of the time; and it is usually associatedwith progress in other, social dimensions of development.”
Periods of growth (88) Periods of decline (7)Indicator

Improved

Worsened Improved Worsened

Inequality

45

43

2

5

Income of the poor

77

11

2

5

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Source: World Development Indicators database, World Bank, revised October 17, 2006.

Sources: United Nations, Human Development Report, 1997 (New York: Oxford
University Press, 1997), 72, 224; Human Development Report, 1998 (New York:
Oxford University Press, 1998), 206; Joseph Stiglitz, “International
Development: Is It Possible?” Foreign Policy 110 (Spring 1998): 138–51.

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ANSWER TO TRY IT! PROBLEM
Economic growth refers to the process of increasing a country’s potential
output. Graphically, this can be represented by rightward shifts in the longrun aggregate supply curve or by the shifting outward of the production
possibilities curve. The challenge of economic development, however, is forcountries to move toward their level of potential output and to achieve
widely shared gains in GDP per capita. This process usually involves
widespread structural changes in the way people live—their standards ofliving, the kinds of jobs they have, their health, and so forth. When
comparing Côte d’Ivoire and Guinea, for example, it is clear that the
distribution of consumption is much more equal in the former. This implies
that Côte d’Ivoire is coming closer to generating widely shared gains in percapita real GDP.

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19.2 Population Growth and Economic Development
LEARNING OBJECTIVES
1. Explain the relationship between population growth and the rate ofincrease in per capita income.
2. Summarize Thomas Malthus’s reasoning that led to the concept of aMalthusian trap, and explain why his dire predictions have not occurredin many countries in modern times.
3. Explain what is meant by a demographic transition, and describe how it
has proceeded in very different ways in developed versus developing
countries.

It is easy to see why some people have become alarmists when it comes topopulation growth rates in developing nations. Looking at the world’s low-income
countries, they see a population of more than 2 billion growing at a rate thatsuggests a doubling every 31 years. How will we cope with so many more people?
The following statement captures the essence of widely expressed concerns:“At the end of each day, the world now has over two hundred thousand more
mouths to feed than it had the day before; at the end of each week, one and one-halfmillion more; at the close of each year, an additional eighty million. … Humankind,
now doubling its numbers every thirty-five years, has fallen into an ambush of its
own making; economists call it the “Malthusian trap,” after the man who mostforcefully stated our biological predicament: population growth tends to outstrip
the supply of food.”Phillip Appleman, ed., Thomas Robert Malthus: An Essay on the
Principle of Population—Text, Sources and Background, Criticism (New York: Norton,
1976), xi.
But what are we to make of such a statement? Certainly, if the world’s population
continues to increase at the rate that it grew in the past 50 years, economic growthis less likely to be translated into an improvement in the average standard of living.
But the rate of population growth is not a constant; it is affected by other economic
forces. This section begins with a discussion of the relationship between population
growth and income growth, then turns to an explanation of the sources of
population growth in low-income countries, and closes with a discussion of theMalthusian warning suggested in the quote above.

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Population Growth and Income Growth
On a simplistic level, the relationship between growth in population and growth inper capita income is clear. After all, per capita income equals total income divided
by population. The growth rate of per capita income roughly equals the difference
between the growth rate of income and the growth rate of population. Kenya’s
annual growth rate in real GDP from 1975 to 2005, for example, was 3.3%. Its
population growth rate during that period was 3.2%, leaving it a growth rate of percapita GDP of just 0.1%. A slower rate of population growth, together with the samerate of GDP increase, would have left Kenya with more impressive gains in percapita income. The implication is that if the developing countries want to increase
their rate of growth of per capita GDP relative to the developed nations, they must
limit their population growth.
Figure 19.2 "Population and Income Growth, 1975–2005" plots growth rates in
population versus growth rates in per capita GDP from 1975 to 2005 for more than
100 developing countries. We do not see a simple relationship. Many countries
experienced both rapid population growth and negative changes in real per capita
GDP. But still others had relatively rapid population growth, yet they had a rapid
increase in per capita GDP. Clearly, there is more to achieving gains in per capita
income than a simple slowing in population growth. But the challenge raised at the
beginning of this section remains: Can the world continue to feed a population thatis growing exponentially—that is, doubling over fixed intervals?
Figure 19.2 Population and Income Growth, 1975–2005

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A scatter chart of population growth rates versus GNP per capita growth rates for various developing countries forthe period 1975–2005 suggests no systematic relationship between the rates of population and of income growth.
Source: United Nations Development Program, Human Development Report 2007/2008 (New York: Palgrave
Macmillan, 2007).

The Malthusian Trap and the Demographic Transition
In 1798, Thomas Robert Malthus published his Essay on the Principle of Population. It
proved to be one of the most enduring works of the time. Malthus’s fundamental
argument was that population growth will inevitably collide with diminishingreturns.
Diminishing returns imply that adding more labor to a fixed quantity of land
increases output, but by ever smaller amounts. Eventually, Malthus concluded,
increases in food production would be too small to sustain the increased number ofhuman beings who consume that output. As the population continued to growunchecked, the number of people would eventually outstrip the ability of the landto generate enough food. There would be an inevitable Malthusian trap3, a point at
which the world is no longer able to meet the food requirements of the population,and starvation becomes the primary check to population growth.
A Malthusian trap is illustrated in Figure 19.3 "The Malthusian Trap". We candetermine the total amount of food needed by multiplying the population in any
period by the amount of food required to keep one person alive. Because population
grows exponentially, food requirements rise at an increasing rate, as shown by the
curve labeled “Food required.” Food produced, according to Malthus, rises by aconstant amount each period; its increase is shown by an upward-sloping straightline labeled “Food produced.” Food required eventually exceeds food produced, andthe Malthusian trap is reached at time t1. The faster the rate of population growth,
the sooner t1 is reached.

3. A point at which the world is
no longer able to meet the foodrequirements of the
population, and starvation
becomes the primary check topopulation growth.

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What happens at the Malthusian trap? Clearly, there is
not enough food to support the population growth
implied by the “Food required” curve. Instead, people
starve, and population begins rising arithmetically, heldin check by the “Food produced” curve. Starvation
becomes the limiting force for population; thepopulation lives at the margin of subsistence. For
Malthus, the long-run fate of human beings was astandard of living barely sufficient to keep them alive.
As he put it, “the view has a melancholy hue.”Happily, Malthus’s predictions do not match theexperience of Western societies in the 19th and 20th
centuries. One weakness of his argument is that hefailed to take into account the gains in output that could
be achieved through increased use of physical capitaland new technologies in agriculture. Increases in theamount of capital per worker in the form of machines,
improved seed, irrigation, and fertilization have madepossible huge increases in agricultural output at thesame time as the supply of labor was rising. Agricultural
productivity rose rapidly in the United States over thelast two centuries, just the opposite of the fall in
productivity expected by Malthus. Productivity has
continued to expand.

Figure 19.3 The MalthusianTrap

If population grows at a fixed
exponential rate, the amount offood required will increase
exponentially. But Malthus heldthat the output of food could
increase only by a constantamount each period. Given thesetwo different growth processes,
food requirements would
eventually catch up with foodproduction. The population hits
the subsistence level of foodproduction at the Malthusiantrap, shown here at point T.

Malthus was wrong as well about the relationship between population growth andincome. He believed that any increase in income would boost population growth.
But the law of demand tells us that the opposite may be true: higher incomes tend
to reduce population growth. The primary cost of having children is theopportunity cost of the parents’ time in raising them—higher incomes increase thisopportunity cost. Higher incomes increase the cost of having children and tend to
reduce the number of children people want and thus to slow population growth.
Panel (a) of Figure 19.4 "Income Levels and Population Growth" shows the birthrates of low-, middle-, and high-income countries for the period 2000–2005. We seethat the higher the income level, the lower the birth rate. Fewer births translate
into slower population growth. In Panel (b), we see that high-income nations hadmuch slower rates of population growth than did middle- and low-income nations
over the last 30 years.

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Figure 19.4 Income Levels and Population Growth

Panel (a) shows that low-income nations had much higher total fertility rates (births per woman) during the
2000–2005 period than did high-income nations. In Panel (b), we see that low-income nations had a much higher rateof population growth during the 1975–2005 period.
Source: World Development Indicators database, World Bank, revised October 17, 2008.

An increase in a nation’s income can be expected to slow its rate of population
growth. Hong Kong, for example, has enjoyed dramatic gains in income since the1960s. Its birth rate and rate of population growth have fallen by over half duringthat time.
But if economic development can slow population growth, it can also increase it.
One of the first gains a developing nation can achieve is improvements in suchbasics as the provision of clean drinking water, improved sanitation, and publichealth measures such as vaccination against childhood diseases. Such gains candramatically reduce disease and death rates. As desirable as such gains are, theyalso boost the rate of population growth. Nations are likely to enjoy sharp
reductions in death rates before they achieve gains in per capita income. That canaccelerate population growth early in the development process. Demographers19.2 Population Growth and Economic Development

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have identified a process of demographic transition4 in which population growth
rises with a fall in death rates and then falls with a reduction in birth rates.
The process of demographic transition has unfolded in a strikingly different
manner in developed versus less developed nations over the past two centuries. In
1800, birth rates barely exceeded death rates in both developed and less developed
countries. The result was a rate of population growth of only about 0.5% per year
worldwide. By 1900, the death rate in developed nations had fallen by about 25%,
with little change in the birth rate. Among developing nations, the birth rate wasunchanged, while the death rate was down only slightly. The combined result was amodest increase in the rate of world population growth.
Changes were much more rapid in the 20th century. By 1965, the death rate amongdeveloped nations had plunged to about one-quarter of its 1800 level, while thebirth rate had fallen by half. In developing nations, death rates took a similarly
dramatic drop, while birth rates showed little change. The result was dramaticworld population growth.
The world’s high-income economies have completed the demographic transition.
Less developed nations have begun to make progress, with birth rates falling by aslightly greater percentage than death rates. The results have been a sharp slowing
in the rate of population growth among high-income nations and a more modest
slowing among low-income nations. Continued slowing in population growth at all
income levels is suggested in Figure 19.5 "The Demographic Transition at Work:
Actual and Projected Population Growth".
Between 1965 and 1980, the world population grew at an annual rate of 2%,
suggesting a doubling time of 36 years. For the world as a whole, it is predicted that
population growth will slow to a 1.1% rate during the 2005–2015 period, a rate thatwould imply a doubling time of 65 years.

4. Situation in which population
growth rises with a fall indeath rates and then falls witha reduction in birth rates.

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Figure 19.5 The Demographic Transition at Work: Actual and Projected Population Growth

Population growth has slowed considerably in the past several decades.
Source: United Nations Development Program, Human Development Report 2007/2008 (New York: Palgrave
Macmillan, 2007) for periods 1975–2000 and 2005–2015, United Nations Development Program, Human Development
Report 1990 (New York, Oxford: Oxford University Press, 1990) for the 1960–1988 period, in which categories refer tolow, middle, and high human development rankings.

KEY TAKEAWAYS• The rate of increase in per capita income roughly equals the rate ofincrease in income minus the rate of increase in population. High rates
of population growth do not necessarily imply low rates of growth in percapita income.
• Malthus’s prediction of a world in which production would be barely
sufficient to keep people alive has proven incorrect because of gains
generated by increased physical and human capital, advances intechnology, and the tendency of higher incomes to slow population
growth.
• A demographic transition is achieved when rising incomes begin to
reduce birth rates and bring population growth in check.

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TRY IT!
The text gives two main reasons why the Malthusian trap did not occur: (1)increased use of physical capital and human capital and technologicalimprovements in agriculture and (2) higher income leading to fewer
children. How do these two reasons alter Figure 19.3 "The MalthusianTrap"?

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Case in Point: China Curtails Population Growth

China is an example of a country that has achieved a very low rate of
population growth and a very high rate of growth in per capita GNP.
China’s low rate of population growth represents a dramatic shift. As recently
as the early 1970s, China had a relatively high rate of population growth; its
population expanded at an annual rate of 2.7% from 1965 to 1973. By the 1980s,
that rate had plunged to 1.5%. The World Bank reports a growth rate in China’s
population of about 1% in the early part of the 21st century.
This dramatic drop in the population growth rate was brought about by a strict
government policy by which couples are allowed to have only one child.
Disincentives have been known to include fines, loss of employment,
confiscation of property, demolition of homes, forced abortions, andsterilization. While the Chinese government has denied that forced abortions
and sterilizations are part of its strategy, policies are administered locally, andall of the above means of coercion seem to have been employed at one time oranother. If a woman who already has one child becomes pregnant, she will most
likely be forced to have an abortion.
Although the policy has achieved its desired result—reduced population
growth—it has had some horrible side effects. Given a strong cultural tradition
favoring having a son, some couples resort to infanticide as a means ofeliminating newborn daughters. When the sex of an unborn baby is determined
to be female, abortion is common.
The coercive aspects of China’s policies and their undesirable side effects havebeen condemned by many governments around the world, as well as bynongovernmental organizations. Declarations from United Nations’19.2 Population Growth and Economic Development

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conferences—the UN Conference on Population in Cairo in 1994 and the UN
Conference on Women in Beijing in 1995—have emphasized that birth rates arelinked to the economic conditions of women and that improving health,education, and employment opportunities for women constitutes a better andmore humane way of reducing birth rates. Fearful that pro-democracy andhuman rights activists from other countries might stir up those movements
locally, the Chinese government actually designed the 1995 Beijing Conference
so as to minimize contact between Chinese and foreigners.
There are signs, though, that Chinese officials may have heard the message. In anumber of counties in China, experimental programs with slogans such as“Carry out Contraception and Family Planning Measures Voluntarily” areunderway. The new approach to family planning emphasizes health care,education, and reduction in poverty to encourage women to have fewer
children.
International pressures may only be part of the reason for the emerging
Chinese change of heart. In the late 1980s, Chinese officials discovered that the
number of births in China was being underreported by about 30%. The
aggressive policies may not have been as successful as they were cracked up tobe.

ANSWER TO TRY IT! PROBLEM
The first reason raises the curve labeled “Food produced” and suggests that
it is exponential rather than linear. The second reason lowers the curvelabeled “Food required.” The result is that the time t1, when the amount offood required exceeds the amount produced, is pushed further into the
future, perhaps indefinitely if the “Food produced” stays above the “Foodrequired” curve. The latter seems to have been the experience of today’srich countries.

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19.3 Keys to Economic Development
LEARNING OBJECTIVES
1. List and discuss domestic policies that contribute to economic growth.
2. State the dependency theory view of trade and developing nations,relate this theory to the strategy of import substitution, and evaluatethat strategy.
3. Outline some of the factors underlying the successes of newly
industrialized countries.

What are the keys to economic development? Clearly, each nation’s experience isunique; we cannot isolate the sources of development success in the laboratory. We
can, however, identify some factors that appear to have played an important role insuccessful economic development. We will look separately at policies that relate to
the domestic economy and at policies in international trade.

Domestic Policy and Economic Development
What domestic policies contribute to development? Looking at successful
economies, those that have achieved high and sustained increases in per capita
output, we can see some clear tendencies. They include a market economy, a highsaving rate, and investment in infrastructure and in human capital.

Market Economies and Development
There can be no clearer lesson than that a market-oriented economy is a necessary
condition for economic development. We saw in the chapter that introduced the
production possibilities model that economic systems can be categorized as market
capitalist, command socialist, or as mixed economic systems. There are no examples
of development success among command socialist systems, although some people
still believe that the former Soviet Union experienced some development advancesin its early years.
One of the most dramatic examples is provided by China. Its shift in the late 1970s
to a more market-based economy has ushered in a period of phenomenal growth.
China, which has shifted from a command socialist to what could most nearly be
categorized as a mixed economy, has been among the fastest-growing economies in
the world for the past 20 years. Its growth has catapulted China from being one of803

Chapter 19 Economic Development

the world’s poorest countries a few decades ago to being a middle-income country
today.
The experience of other economies reinforces the general observation that markets
matter. South Korea, Hong Kong, Taiwan, Singapore, and Chile—all have achieved
gigantic gains with a market-based approach to economic growth.
We should not conclude, however, that growth has been independent of any public
sector activity. China, for example, remains a nominally socialist state; its
government continues to play a major role. The governments of South Korea,
Taiwan, and Singapore all targeted specific sectors for growth and provided
government help to those sectors. Even Hong Kong, which became part of China in
1997, has a high degree of government involvement in the provision of housing,health care, and education. A market economy is not a nongovernment economy.
But those countries that have left the task of resource allocation primarily to themarket have achieved dramatic gains. Hong Kong and Singapore, in fact, are now
included in the World Bank’s list of high-income economies.

The Rule of Law and Development
If a market is to thrive, individuals must be secure in their property. If crime orgovernment corruption makes it likely that individuals will regularly be subjected
to a loss of property, then exchange will be difficult and little investment will occur.
Also, the rule of law is necessary for contracts; that is, the rule of law is necessary toprovide an institutional framework within which an economy can operate.
We will see in the chapter on socialist economies in transition, for example, that
Russia’s effort to achieve economic development through the adoption of a market
economy has been hampered by widespread lawlessness. An important difficulty of
economies with extensive regulation is that the power they grant to government
officials inevitably results in widespread corruption that saps entrepreneurial effort
and economic growth.

Investment and Saving
Saving is a key to growth and the achievement of high incomes. All other things
equal, higher saving allows more resources to be devoted to increases in physicaland human capital and to technological improvement. In other words, saving,which is income not spent on consumption, promotes economic growth by making
available resources that can be channeled into growth-enhancing uses.

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High saving rates generally accompany high levels of investment. The productivityof this investment, however, can be quite variable. Government efforts to invest in
human capital by promoting education, for example, may or may not be successfulin actually achieving education. Development projects sponsored by internationalrelief agencies may or may not foster development.
However, investment in infrastructure, such as transportation and communication,clearly plays an important role in economic development. Investment in improved
infrastructure facilitates the exchange of goods and services and thus fosters
development.

International Economic Issues in Development
In 1974, the poorest nations among the developing nations introduced into theUnited Nations a Declaration on the Establishment of a New International Economic
Order. The program called upon the rich nations to help them reduce the growing
gap in real per capita income levels between the developed and developing nations.
The declaration has come to be known as the New International Economic Order or
NIEO for short.
NIEO called for different and special treatment of the developing nations in theinternational arena in areas such as trade policy and control over multinational
corporations. NIEO reflected a widely held view of international relations known as
dependency theory.

Dependency Theory and Trade Policy
Conventional economic theory concerning international trade is based on the ideaof comparative advantage. As we have seen in other chapters, the principle ofcomparative advantage suggests that free trade between two countries will benefit
both and, in general, the freer the trade the better. But some economists haveproposed a doctrine that challenges this idea. Dependency theory5 concludes thatpoverty in developing nations is the result of their dependence on high-income
nations.

5. The idea that poverty indeveloping nations is the resultof their dependence on highincome nations.

Dependency theory holds that the industrialized nations control the destiny of thedeveloping nations, particularly in terms of being the ultimate markets for theirexports, serving as the source of capital required for development, and controlling
the relative prices and exchange rates at which market transactions occur. In
addition, export industries in a developing nation are assumed to have small
multiplier effects throughout the rest of the economy, severely limiting any
positive role than an expanded export sector might play. Specifically, limited

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transportation, a poorly developed financial sector, and an uneducated work force
stand in the way of “multiplying” any positive effects of export expansion. A poor
country thus may not experience the kind of development and growth enjoyed by
the rich country pursuing free trade. Also, increased trade makes the poor country
more dependent on the rich country and its export service firms. In short, thebenefits of trade between a rich country and a poor country will go almost entirely
to the rich country.
The development strategy that this line of argument suggests is that developing
countries would need to become independent of the already developed nations inorder to achieve economic development. In relative terms, free trade would leave
the poor country poorer and the rich country richer. Some dependency theorists
even argued that trade is likely to make poor countries poorer in absolute terms.
Tanzania’s president, Julius Nyerere, speaking before the United Nations in 1975,
put it bluntly, “I am poor because you are rich.”

Import Substitution Strategies and Export-Led Development
If free trade widens the gap between rich and poor nations and makes poor nations
poorer, it follows that a poor country should avoid free trade. Many developing
countries, particularly in Latin America, attempted to overcome the implications ofdependency theory by adopting a strategy of import substitution6, a strategy ofblocking most imports and substituting domestic production of those goods.
The import substitution strategy calls for rapidly increasing industrialization by
mimicking the already industrialized nations. The intent is to reduce thedependence of the developing country on imports of consumer and capital goods
from the industrialized countries by manufacturing these goods at home. But inorder to protect these relatively high-cost industries at home, the developing
country must establish very high protective tariffs. Moreover, the types ofindustries that produce the previously imported consumer goods and capital goods
are unlikely to increase the demand for unskilled labor. Yet unskilled labor is themost abundant resource in the poor countries. Adopting the import substitution
strategy raises the demand for expensive capital, managerial talent, and skilledlabor—resources in short supply.

6. A strategy of blocking mostimports and substituting
domestic production of those
goods.

High tariffs insulate domestic firms from competition, but that tends to increase
their monopoly power. Recognizing that some imported goods, particularly spareparts for industrial equipment, will be needed, countries can establish complex
permit systems through which firms can import vital parts and other equipment.
But that leaves a company’s fortunes in the hands of the government bureaucrats

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Chapter 19 Economic Developmentissuing the permits. A highly corrupt system quickly evolves in which a few firms
bribe their way to easy access to foreign markets, reducing competition still
further. Instead of the jobs expected to result from import substitution, countries
implementing the import substitution strategy get the high prices, reduced
production, and poor quality that come from reduced competition.
No country that has relied on a general strategy of import substitution has beensuccessful in its development efforts. It is an idea whose time has not come. In
contrast, more successful economies in Asia and elsewhere have kept theireconomies fairly open to both imports and exports. They have shown the greatest
ability to move the development process along.

Development and International Financial Markets
Successful development in the developing nations requires more than justredirecting labor and capital resources into newly emerging sectors of theeconomy. That could be accomplished by both domestic firms and internationalfirms located within the economy. But to complement the reorientation of
traditional production processes, economic infrastructure such as roads, schools,
communication facilities, ports, warehouses, and many other prerequisites togrowth must be put into place. Paying for the projects requires a high level ofsaving.
The sources of saving are private saving, government saving, and foreign saving.
Grants in the form of foreign aid from the developed nations supplement thesesources, but they form a relatively small part of the total.
Private domestic saving is an important source of funds. But even high rates ofprivate saving cannot guarantee sufficient funds in a poor economy, where the bulkof the population lives close to the subsistence level. Government saving in theform of tax revenues in excess of government expenditures is almost universally
negative. If the required investments are to take place, the developing nations haveto borrow the money from foreign savers.
The problem for developing nations borrowing funds from foreigners is the samepotential difficulty any borrower faces: the debt can be difficult to repay. Unlike,say, the national debt of the United States government, whose obligations are in its
own currency, developing nations typically commit to make loan payments in thecurrency of the lending institution. Money borrowed by Brazil from a U.S. bank, forexample, must generally be paid back in U.S. dollars.

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Many developing nations borrowed heavily during the 1970s, only to findthemselves in trouble in the 1980s. Countries such as Brazil suspended payments on
their debt when required payments exceeded net exports. Much foreign debt was
simply written off as bad debt by lending institutions. While foreign debts created amajor crisis in the 1980s, subsequent growth appeared to make these payments
more manageable.
A somewhat different international financial crisis emerged in the late 1990s. It
started in Thailand in the summer of 1997. Thailand had experienced 20 years ofimpressive economic growth and rising living standards. One element of its
development strategy was to maintain a fixed exchange rate between its currency,
the baht, and the dollar. The slowing of Japanese growth, which reduced demand
for Thai exports, and weaknesses in the Thai banking sector were putting
downward pressure on the baht, which Thailand’s central bank initially tried tocounteract. As discussed there, this effort was abandoned, and the value of thecurrency declined.
The Thai government, in an effort to keep its exchange rate somewhat stable,
appealed to the International Monetary Fund (IMF) for support. The IMF is aninternational agency that makes financial assistance available to member countries
experiencing problems in their international balance of payments in order tosupport adjustment and reform in those countries. In an agreement between
Thailand and the IMF, Thailand’s central bank tightened monetary policy, thereby
raising interest rates there. The logic behind this move was that higher interest
rates in Thailand would make the baht more attractive to both Thai and foreign
financial investors, who could thus earn more on Thai bonds and on other Thaifinancial assets. This would increase the demand for baht and help to keep thecurrency from falling further. Thailand also agreed to tighten fiscal policy, therationale for which was to prepare for the anticipated future costs of restructuring
its banking system. As we have learned throughout macroeconomics, however,contractionary monetary and fiscal policies will reduce real GDP in the short run.
The hope was that growth would resume once the immediate currency crisis wasover and plans had been put into place for correcting other imbalances in the Thai
economy.
Other countries, such as South Korea and Brazil, soon experienced similar currency
disturbances and entered into similar IMF programs to put their domestic houses inorder in exchange for financial assistance from the IMF. For some of the othercountries that went through similar experiences, notably Indonesia and Malaysia,
the situation in 1999 was very unstable. Malaysia decided to forgo IMF assistanceand to impose massive currency controls. In Indonesia, the financial crisis and theensuing economic crisis led to political unrest. It held its first free elections in June
1999, but violence erupted in late 1999, when the overwhelming majority of people

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Chapter 19 Economic Developmentin East Timor voted against an Indonesian proposal that the province have limited
autonomy within Indonesia and voted for independence from Indonesia.
Remarkably, in the early 2000s, the economies of most of these countries
rebounded, though they are now caught up in the global economic downturn.

Development Successes
As we have seen throughout this chapter, the greatest success stories are foundamong the newly industrializing economies (NIEs) in East Asia. These economies,
including Hong Kong, South Korea, Singapore, and Taiwan, share two common
traits. First, they have allowed their economies to develop through an emphasis onexport-based, market capitalist strategies. The NIEs achieved higher per capita
income and output by entering and competing in the global market for products
such as computers, automobiles, plastics, chemicals, steel, shipbuilding, andsporting goods. These countries have succeeded largely by linking standardized
production technologies with low-cost labor.
Second, the role of government was relatively limited in the NIEs, which made lessuse of regulation and bureaucratic controls. Governments were clearly involved insome strategic industries, and, in the wake of recent financial crises, in some cases
it appears that this involvement led to some decisions in those industries being
made on political rather than on economic grounds. But the principal contributionof governments in the Far Eastern NIEs has been to create a modern infrastructure(especially up-to-date communications facilities essential for the development of astrong financial sector), to provide a stable incentive system (including stableexchange rates), and to ensure that government bureaucracy will help rather thanhinder exports (especially by not regulating export trade, labor markets, andcapital markets).Bela Balassa, “The Lessons of East Asian Development,” Economic
Development and Cultural Change 36, no. 3 (April 1988): S247–S290.
Chile adopted sweeping market reforms in the late 1970s, creating the freest
economy in Latin America. Chile’s growth has accelerated sharply, and the country
has moved to the upper-middle-income group of nations. Perhaps more dramatic,
the dictator who instituted market reforms, General Augusto Pinochet, agreed todemocratic elections that removed him from power in 1989. Chile now has a greatly
increased degree of political as well as economic freedom—and has emerged as themost prosperous country in Latin America.
Over the last decade, Mexico also shifted from a strategy of import substitution andbegan to follow more free-trade-oriented policies. The North American Free Trade
Agreement (NAFTA) turned all of North America into a free trade zone. This could

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not have occurred had Mexico not undergone such a dramatic shift in its
development strategy. Mexico’s commitment to the new strategy was tested in
1994, when the country underwent a currency crisis, similar to that experienced inmany Asian countries in 1997 and 1998. At that time, Mexico, too, entered into anagreement with the IMF to address economic imbalances in return for financial
assistance. The U.S. government also provided support to help Mexico at that time.
By 1996, the Mexican economy was growing again, and Mexican commitment tomore open policies has endured. Only with the passage of time will we know forsure whether the changed strategy worked in Mexico as well, but the early signs arethat it is working.
Although the trend in developing countries toward market reforms has been lessheralded than the collapse of communism, it is surely significant. Will market
reforms translate into development success? The jury is still out. Market reform
requires that many wealthy—and powerful—interests be swept aside. Whether thatcan be achieved, and whether poor people who lack human capital can be includedin the development effort, remain open questions. But some dramatic successstories have shown that economic development can be achieved. The fate of billionsof desperately poor people rests in the ability of their countries to match thatsuccess.

KEY TAKEAWAYS• A market economy, perhaps with a substantial role for government,
appears to be one key to economic growth. A system in which laws andproperty rights are well established and enforced also promotes growth.
• High rates of saving and investment can boost economic growth.
• Dependency theory suggests that poor countries should seek to insulatethemselves from international trade. The import substitution strategies
suggested by dependency theory have not been successful in generating
economic growth, and a number of countries have moved away fromthis strategy.

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Case in Point: Democracy and Economic Development

Democracy as an economic institution has typically received mixed notices
from economists. While virtually all the world’s rich nations have democraticsystems of government, it isn’t clear that democracy is necessary fordevelopment.
India long provided the strongest counterexample to the idea that democracy
promotes development. It has long been a democracy, yet its per capita income
has kept it among the world’s poor countries. India’s government has
traditionally opted for extensive regulation that has curtailed development.
Countries such as China, with no democracy and a repressive government, havemanaged to generate very high rates of economic growth. China’s per capita
income now exceeds that of India by about 50%. Lee Kuan Yew, Singapore’s
former prime minister, put it this way: “I believe what a country needs todevelop is discipline more than democracy. The exuberance of democracy leads
to indiscipline and disorderly conduct which are inimical to development.”
Many economists have reached the conclusion that countries are likely to
become democratic once they achieve a high degree of economic development.
Political freedom, they argue, is a normal good. The demand for freedom thusincreases as incomes rise, making the creation of democratic institutions a
product of economic growth, not a cause of it.
Two recent studies—one by economists John Mukum Mbaku and Mwangi S.
Kimenyi and the other by economists Michael A. Nelson and Ram D.
Singh—challenge the conventional view, arguing instead that democracy andeconomic growth are compatible. Using statistical models that control for avariety of factors that affect economic growth, such as investment andpopulation growth, both studies concluded that there is a positive relationshipbetween political freedom and economic growth. In the latter study, the19.3 Keys to Economic Development

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authors separately tested the direction of causality: does growth cause
democracy or does democracy cause growth? They conclude that the directionof causality goes from democracy to economic growth. They also controlled forthe level of economic freedom (an index of price stability, government size,
discriminatory taxation, and trade restrictions), which many studies haveconcluded is critical for development. As argued in this chapter, more
economic freedom does lead to higher economic growth, but so does morepolitical freedom.
Just as pessimism that economic growth has a negative impact on the poor isdissipating, likewise the notion that developing countries must wait until they
are developed in order for their citizens to experience political freedom is also
falling by the wayside.
Sources: Jagdish Bhagwati, “Democracy and Development,” American Enterprise6, no. 2 (March/April 1995): 69; John Mukum Mbaku and Mwangi S. Kimenyi,“Macroeconomic Determinants of Growth: Further Evidence on the Role of
Political Freedom,” Journal of Economic Development 22, no. 2 (December 1997):
119–32; Michael A. Nelson and Ram D. Singh, “Democracy, Economic Freedom,
Fiscal Policy, and Growth in LDC: A Fresh Look,” Economic Development andCultural Change 64, no. 4 (July 1998): 677–96.

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19.4 Review and PracticeSummary
Developing nations face a host of problems: low incomes; unequal distributions of income; inadequate healthcare and education; high unemployment; and a concentration of workers in agriculture, where productivity islow. Economic development, the process that generates widely shared gains in income, can alleviate these
problems.
The sources of economic growth in developing countries are not substantially different from those that apply tothe developed countries. Market economies with legal systems that provide for the reliable protection ofproperty rights and enforcement of contracts tend to promote economic growth. Saving and investment,
particularly investment in appropriate technologies and human capital, appear to be critical. So, too, does theability of developing nations to match their population growth rate with the ability of the economy to increase
real output.
Dependency theory, the notion that developing countries are in the grip of the industrialized countries, led toimport substitution schemes that proved detrimental to the long-run growth prospects of developing nations.
The movement of Latin American countries such as Mexico and Chile to market systems is a rejection of
dependency theory. There is a general movement toward market-based strategies to support economic
development in the future. But even market-based strategies will work only if efforts are made to ensure anadequate infrastructure, including the development of financial institutions capable of providing the required
signals to guide individual decision making.

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CONCEPT PROBLEMS
1. What is the difference between economic development and economic
growth?
2. Look at the Case in Point on the relationship between growth anddevelopment. Why do you think that the distribution of income is more
likely to become more unequal during economic downturns?
3. What are the implications for the long-run development of a society thatis unable to reduce its population growth rate below, say, 4% per year?
4. Explain how technological progress averts the Malthusian trap.
5. China reduced its rate of population growth by force (see the Case in
Point). Given the likely effects of population growth on living standards,
do you think such a policy is reasonable? Are there other ways agovernment might seek to limit population growth?
6. On what basis might a poor country argue that its poverty is a result ofhigh incomes in another country? Do you think Mexico’s poverty
contributed to U.S. wealth?
7. Given the arguments presented in the text, what do you think theUnited States should do to assist Mexico in its development efforts?

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NUMERICAL PROBLEMS
1. Consider two economies, one with an initial per capita income of $16,000(about the income of Israel) growing at a rate of 1.8% per year, the otherwith an initial per capita income of $600 (about the income of Guinea)
growing twice as fast (that is, at a rate of 3.6% per year). Using the ruleof 72 from the chapter on economic growth, calculate how long it willtake for the lower-income country to achieve the per capita income
enjoyed by the richer one. How long will it take to literally “catch up” tothe richer nation, assuming that the growth rates continue unchangedin the future?
2. Use the most recent copy of the World Development Report available inyour library (or at www.worldbank.org) to determine the five poorest
countries in the world. Look up data on the distribution of income,education, health and nutrition, and demography for each country(information on some of these variables will not be available for every
country). Do you think that low incomes cause the observations you
have made, or do you think that low levels of education, health, andnutrition and high rates of population growth tend to cause poverty?
3. A country’s rate of GDP growth is 3% per year. Its population is growing
4% per year. At what rate is its GDP per capita changing?

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Chapter 20
Socialist Economies in Transition
Start Up: The Collapse of Socialism
It is hard, even in retrospect, to appreciate how swiftly the collapse came.
Command socialism, which had reigned supreme in Russia for more than 70 years
and in much of the rest of the world for more than 40 years, appeared to be apermanent institution. Indeed, many observers had expected its influence toincrease by the end of the twentieth century. But in the span of five months in 1989,
command socialist systems fell in six Eastern European nations. The Soviet Union,
which had been the main enemy of the United States in the post-World War II
period, and which possesses enough nuclear arms to destroy the world (as does theUnited States), broke up in 1991.
The start of the collapse can be dated to 1980. The government of Poland, acommand socialist state that was part of the Soviet bloc, raised meat prices. The
price boosts led to widespread protests and to the organization of Solidarity, thefirst independent labor union permitted in a Soviet bloc state. After nine years ofpolitical clashes, Solidarity won an agreement from the Polish government for
wide-ranging economic reforms and for free elections. Solidarity-backed candidates
swept the elections in June 1989, and a new government, pledged to democracy andto market capitalism, came to power in August.
Command socialist governments in the rest of the Soviet bloc disappeared quickly
in the wake of Poland’s transformation. Hungary’s government fell in October. East
Germany opened the Berlin Wall in November, and the old regime, for which thatwall had been a symbol, collapsed. Bulgaria and Czechoslovakia kicked out theircommand socialist leaders the same month. Romania’s dictator, Nicolae Ceausescu,
was executed after a bloody uprising in December. Ultimately, every nation in the
Warsaw Pact, the bloc making up the Soviet Union and its Eastern European
satellite nations, announced its intention to discard the old system of commandsocialism. The collapse of the command socialist regimes of the former Soviet bloc
precipitated an often painful process of transition as countries tried to put in place
the institutions of a market capitalist economy. But, by the beginning of the 21 st
century, many of them were already admitted as members of the European Union.

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Meanwhile, a very different process of transition has been under way in China. The
Chinese began a gradual process of transition toward a market economy in 1979. It
has been a process marked by spectacular economic gain ever since.
In this chapter we will examine the rise of command socialist systems and explore
their ideological roots. Then we will see how these economic systems operated andtrace the sources of their collapse. Finally, we will investigate the problems andprospects for the transition from command socialism to market capitalism.

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20.1 The Theory and Practice of Socialism
LEARNING OBJECTIVE
1. Discuss and assess Karl Marx’s theory of capitalism, including mentionof the labor theory of value, the concept of surplus value, periodic
capitalist crises, and worker solidarity.

Socialism has a very long history. The earliest recorded socialist society is describedin the Book of Acts in the Bible. Following the crucifixion of Jesus, Christians inJerusalem established a system in which all property was owned in common.
There have been other socialist experiments in which all property was held incommon, effectively creating socialist societies. Early in the nineteenth century,
such reformers as Robert Owen, Count Claude-Henri de Rouvroy de Saint-Simon,
and Charles Fourier established almost 200 communities in which workers shared in
the proceeds of their labor. These men, while operating independently, shared acommon ideal—that in the appropriate economic environment, people will strive
for the good of the community rather than for their own self-interest. Althoughsome of these communities enjoyed a degree of early success, none survived.
Socialism as the organizing principle for a national economy is in large part the
product of the revolutionary ideas of one man, Karl Marx. His analysis of what hesaw as the inevitable collapse of market capitalist economies provided a rallying
spark for the national socialist movements of the twentieth century. Anotherimportant contributor to socialist thought was Vladimir Ilyich Lenin, who modified
many of Marx’s theories for application to the Soviet Union. Lenin put his ideas into
practice as dictator of that country from 1917 until his death in 1924. It fell toJoseph Stalin to actually implement the Soviet system. We shall examine the ideasof Marx, Lenin, and Stalin and investigate the operation of the economic systems
based upon them.

The Economics of Karl Marx
Marx is perhaps best known for the revolutionary ideas expressed in the ringing
phrases of the Communist Manifesto, such as those shown in the Case in Point.
Written with Friedrich Engels in 1848, the Manifesto was a call to arms. But it was
Marx’s exhaustive, detailed theoretical analysis of market capitalism, Das Kapital(Capital), that was his most important effort. This four-volume work, most of which818

Chapter 20 Socialist Economies in Transition

was published after Marx’s death, examines a theoretical economy that we would
now describe as perfect competition. In this context, Marx outlined a dynamic
process that would, he argued, inevitably result in the collapse of capitalism.
Marx stressed a historical approach to the analysis of economics. Indeed, he was
sharply critical of his contemporaries, complaining that their work was whollylacking in historical perspective. To Marx, capitalism was merely a stage in thedevelopment of economic systems. He explained how feudalism would tend to give
way to capitalism and how capitalism would give way to socialism. Marx’s
conclusions stemmed from his labor theory of value and from his perception of therole of profit in a capitalist economy.

The Labor Theory of Value and Surplus Value
In The Wealth of Nations, Adam Smith proposed the idea of the labor theory ofvalue1, which states that the relative values of different goods are ultimately
determined by the relative amounts of labor used in their production. This idea was
widely accepted at the time Marx was writing. Economists recognized the roles ofdemand and supply but argued that these would affect prices only in the short run.
In the long run, it was labor that determined value.
Marx attached normative implications to the ideas of the labor theory of value. Not
only was labor the ultimate determinant of value, it was the only legitimate
determinant of value. The price of a good in Marx’s system equaled the sum of thelabor and capital costs of its production, plus profit to the capitalist. Marx argued
that capital costs were determined by the amount of labor used to produce thecapital, so the price of a good equaled a return to labor plus profit. Marx defined
profit as surplus value2, the difference between the price of a good or service andthe labor cost of producing it. Marx insisted that surplus value was unjustified andrepresented exploitation of workers.

1. Theory that states that therelative values of different
goods are ultimately
determined by the relative
amounts of labor used in theirproduction.

Marx accepted another piece of conventional economic wisdom of the nineteenth
century, the concept of subsistence wages. This idea held that wages would, in thelong run, tend toward their subsistence level, a level just sufficient to keep workers
alive. Any increase in wages above their subsistence level would simply attract
more workers—or induce an increase in population, forcing wages back down. Marxsuggested that unemployed workers were important in this process; they
represented a surplus of labor that acted to push wages down.

2. The difference between theprice of a good or service andthe labor cost of producing it.

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Capital Accumulation and Capitalist Crises
The concepts of surplus value and subsistence wages provide the essential dynamics
of Marx’s system. He said that capitalists, in an effort to increase surplus value,
would seek to acquire more capital. But as they expanded capital, their profit rates,
expressed as a percentage of the capital they held, would fall. In a desperate effort
to push profit rates up, capitalists would acquire still more capital, which would
only push their rate of return down further.
A further implication of Marx’s scheme was that as capitalists increased their use ofcapital, the wages received by workers would become a smaller share of the total
value of goods. Marx assumed that capitalists used all their funds to acquire more
capital. Only workers, then, could be counted on for consumption. But their wages
equaled only a fraction of the value of the output they produced—they could not
possibly buy all of it. The result, Marx said, would be a series of crises in which
capitalists throughout the economy, unable to sell their output, would cut backproduction. This would cause still more reductions in demand, exacerbating thedownturn in economic activity. Crises would drive the weakest capitalists out ofbusiness; they would become unemployed and thus push wages down further. The
economy could recover from such crises, but each one would weaken the capitalist
system.
Faced with declining surplus values and reeling from occasional crises, capitalists
would seek out markets in other countries. As they extended their reachthroughout the world, Marx said, the scope of their exploitation of workers would
expand. Although capitalists could make temporary gains by opening up
international markets, their continuing acquisition of capital meant that profit
rates would resume their downward trend. Capitalist crises would now become
global affairs.
According to Marx, another result of capitalists’ doomed efforts to boost surplus
value would be increased solidarity among the working class. At home, capitalist
acquisition of capital meant workers would be crowded into factories, building theirsense of class identity. As capitalists extended their exploitation worldwide,
workers would gain a sense of solidarity with fellow workers all over the planet.
Marx argued that workers would recognize that they were the victims of
exploitation by capitalists.
Marx was not clear about precisely what forces would combine to bring about thedownfall of capitalism. He suggested other theories of crisis in addition to the one
based on insufficient demand for the goods and services produced by capitalists.
Indeed, modern theories of the business cycle owe much to Marx’s discussion of the20.1 The Theory and Practice of Socialism

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possible sources of economic downturns. Although Marx spoke sometimes of bloody
revolution, it is not clear that this was the mechanism he thought would bring on
the demise of capitalism. Whatever the precise mechanism, Marx was confident
that capitalism would fall, that its collapse would be worldwide, and that socialism
would replace it.

Marx’s Theory: An Assessment
To a large degree, Marx’s analysis of a capitalist economy was a logical outgrowth ofwidely accepted economic doctrines of his time. As we have seen, the labor theoryof value was conventional wisdom, as was the notion that workers would receive
only a subsistence wage. The notion that profit rates would fall over time was
widely accepted. Doctrines similar to Marx’s notion of recurring crises had beendeveloped by several economists of the period.
What was different about Marx was his tracing of the dynamics of a system in which
values would be determined by the quantity of labor, wages would tend toward thesubsistence level, profit rates would fall, and crises would occur from time to time.
Marx saw these forces as leading inevitably to the fall of capitalism and its
replacement with a socialist economic system. Other economists of the period
generally argued that economies would stagnate; they did not anticipate thecollapse predicted by Marx.
Marx’s predictions have turned out to be wildly off the mark. Profit rates have notdeclined; they have remained relatively stable over the long run. Wages have nottended downward toward their subsistence level; they have risen. Labor’s share of
total income in market economies has not fallen; it has increased. Most important,the predicted collapse of capitalist economies has not occurred.
Revolutions aimed at establishing socialism have been rare. Perhaps mostimportant, none has occurred in a market capitalist economy. The Cuban economy,
for example, had some elements of market capitalism before Castro but also hadfeatures of command systems as well.While resources in Cuba were generally
privately owned, the government had broad powers to dictate their use. In othercases where socialism has been established through revolution it has replaced
systems that could best be described as feudal. The Russian Revolution of 1917 that
established the Soviet Union and the revolution that established the People’s
Republic of China in 1949 are the most important examples of this form of
revolution. In the countries of Eastern Europe, socialism was imposed by the former
Soviet Union in the wake of World War II. In the early 2000s, a number of Latin
American countries, such as Venezuela and Bolivia, seemed to be moving towards

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nationalizing, rather than privatizing assets, but it is too early to know the longterm direction of these economies.
Whatever the shortcomings of Marx’s economic prognostications, his ideas have
had enormous influence. Politically, his concept of the inevitable emergence ofsocialism promoted the proliferation of socialist-leaning governments during the
middle third of the twentieth century. Before socialist systems began collapsing in
1989, fully one-third of the earth’s population lived in countries that had adopted
Marx’s ideas. Ideologically, his vision of a market capitalist system in which oneclass exploits another has had enormous influence.

KEY TAKEAWAYS• Marx’s theory, based on the labor theory of value and the presumptionthat wages would approach the subsistence level, predicted theinevitable collapse of capitalism and its replacement by socialist
regimes.
• Lenin modified many of Marx’s theories for application to the Soviet
Union and put his ideas into practice as dictator of that country from
1917 until his death in 1924.
• Before socialist systems began collapsing in 1989, fully one-third of theearth’s population lived in countries that had adopted Marx’s ideas.

TRY IT!
Briefly explain how each of the following would contribute to the downfallof capitalism: 1) capital accumulation, 2) subsistence wages, and 3) the
factory system.

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Case in Point: The Powerful Images in the Communist
Manifesto© 2010 Jupiterimages Corporation

The Communist Manifesto by Karl Marx and Friedrich Engels was originallypublished in London in 1848, a year in which there were a number of uprisings
across Europe that at the time could have been interpreted as the beginning of
the end of capitalism. This relatively short (12,000 words) document was thus
more than an analysis of the process of historical change, in which classstruggles propel societies from one type of economic system to the next, and a
prediction about how capitalism would evolve and why it would end. It was alsoa call to action. It contains powerful images that cannot be easily forgotten. It
begins,20.1 The Theory and Practice of Socialism

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Chapter 20 Socialist Economies in Transition“A specter is haunting Europe—the specter of communism. All the Powers of old Europe
have entered into a holy alliance to exorcise this specter: Pope and Czar, Metternich andGuizot, French Radicals and German police-spies.”
Its description of history begins,“The history of all hitherto existing society is the history of class struggles. Freeman andslave, patrician and plebeian, lord and serf, guild-master and journeyman, in a word,
oppressor and oppressed, stood in constant opposition to one another …”
In capitalism, the divisions are yet more stark:“Society as a whole is more and more splitting up into two great hostile camps, into two
great classes directly facing each other: Bourgeoisie and Proletariat.”
Foreshadowing the globalization of capitalism, Marx and Engels wrote,“The bourgeoisie, by the rapid improvement of all instruments of production, by theimmensely facilitated means of communication, draws all, even the most barbarian,nations into civilization. The cheap prices of its commodities are the heavy artillery withwhich it batters down all Chinese walls, with which it forces the barbarians’ intensely
obstinate hatred of foreigners to capitulate. It compels all nations, on pain of extinction,
to adopt the bourgeois mode of production: it compels them to introduce what it calls
civilization into their midst. … In one word, it creates a world after its own image.”
But the system, like all other class-based systems before it, brings about its own
demise:“The weapons with which the bourgeoisie felled feudalism to the ground are now turned
against the bourgeoisie itself. … Masses of laborers, crowded into the factory, areorganized like soldiers. … It was just this contact that was needed to centralize thenumerous local struggles, all of the same character, into one national struggle between
classes.”
The national struggles eventually become an international struggle in which:20.1 The Theory and Practice of Socialism

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Chapter 20 Socialist Economies in Transition“What the bourgeoisie, therefore, produces, above all, is its own gravediggers.”
The Manifesto ends,“Let the ruling classes tremble at a Communistic revolution. The proletarians havenothing to lose but their chains. They have a world to win. WORKING MEN OF ALL
COUNTRIES, UNITE!”ANSWER TO TRY IT!
Marx predicted that capital accumulation would lead to falling profit rates
over the long term. Subsistence wages meant that workers would not be able
to consume enough of what was produced and this would lead to ever larger
economic downturns. Because of the factory system, worker solidarity
would grow and workers would come to understand that they were being
exploited by capitalists.

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20.2 Socialist Systems in Action
LEARNING OBJECTIVES
1. Describe the operation of the command socialist system in the Soviet
Union, including its major problems.
2. Explain how Yugoslavian-style socialism differed from that of the Soviet
Union.
3. Discuss the factors that brought an end to command socialist systems inmuch of the world.

The most important example of socialism was the economy of the Union of Soviet
Socialist Republics, the Soviet Union. The Russian Revolution succeeded in 1917 in
overthrowing the czarist regime that had ruled the Russian Empire for centuries.
Leaders of the revolution created the Soviet Union in its place and sought toestablish a socialist state based on the ideas of Karl Marx.
The leaders of the Soviet Union faced a difficulty in using Marx’s writings as afoundation for a socialist system. He had sought to explain why capitalism would
collapse; he had little to say about how the socialist system that would replace itwould function. He did suggest the utopian notion that, over time, there would beless and less need for a government and the state would wither away. But his
writings did not provide much of a blueprint for running a socialist economic
system.
Lacking a guide for establishing a socialist economy, the leaders of the new regime
in Russia struggled to invent one. In 1917, Lenin attempted to establish what hecalled “war communism.” The national government declared its ownership of mostfirms and forced peasants to turn over a share of their output to the government.
The program sought to eliminate the market as an allocative mechanism;
government would control production and distribution. The program of war
communism devastated the economy. In 1921, Lenin declared a New Economic
Policy. It returned private ownership to some sectors of the economy andreinstituted the market as an allocative mechanism.
Lenin’s death in 1924 precipitated a power struggle from which Joseph Stalin
emerged victorious. It was under Stalin that the Soviet economic system wascreated. Because that system served as a model for most of the other commandsocialist systems that emerged, we shall examine it in some detail. We shall also826Chapter 20 Socialist Economies in Transition

examine an intriguing alternative version of socialism that was created in
Yugoslavia after World War II.

Command Socialism in the Soviet Union
Stalin began by seizing virtually all remaining privately-owned capital and natural
resources in the country. The seizure was a brutal affair; he eliminated opposition
to his measures through mass executions, forced starvation of whole regions, anddeportation of political opponents to prison camps. Estimates of the number ofpeople killed during Stalin’s centralization of power range in the tens of millions.
With the state in control of the means of production, Stalin established a rigid
system in which a central administration in Moscow determined what would be
produced.
The justification for the brutality of Soviet rule lay in the quest to develop “socialistman.” Leaders of the Soviet Union argued that the tendency of people to behave intheir own self-interest was a by-product of capitalism, not an inherent
characteristic of human beings. A successful socialist state required that thepreferences of people be transformed so that they would be motivated by thecollective interests of society, not their own self-interest. Propaganda was widelyused to reinforce a collective identity. Those individuals who were deemed beyond
reform were likely to be locked up or executed.
The political arm of command socialism was the Communist party. Party officials
participated in every aspect of Soviet life in an effort to promote the concept ofsocialist man and to control individual behavior. Party leaders were represented inevery firm and in every government agency. Party officials charted the generalcourse for the economy as well.
A planning agency, Gosplan, determined the quantities of output that key firms
would produce each year and the prices that would be charged. Other government
agencies set output levels for smaller firms. These determinations were made in aseries of plans. A 1-year plan specified production targets for that year. Soviet
planners also developed 5-year and 20-year plans.
Managers of state-owned firms were rewarded on the basis of their ability to meet
the annual quotas set by the Gosplan. The system of quotas and rewards createdinefficiency in several ways. First, no central planning agency could incorporate
preferences of consumers and costs of factors of production in its decisions
concerning the quantity of each good to produce. Decisions about what to produce
were made by political leaders; they were not a response to market forces. Further,planners could not select prices at which quantities produced would clear their

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Chapter 20 Socialist Economies in Transition

respective markets. In a market economy, prices adjust to changes in demand andsupply. Given that demand and supply are always changing, it is inconceivable that
central planners could ever select market-clearing prices. Soviet central planners
typically selected prices for consumer goods that were below market-clearing
levels, causing shortages throughout the economy. Changes in prices were rare.
Plant managers had a powerful incentive for meeting their quotas; they could
expect bonuses equal to about 35% of their base salary for producing the quantities
required of their firms. Those who exceeded their quotas could boost this to 50%. In
addition, successful managers were given vacations, better apartments, bettermedical care, and a host of other perquisites. Managers thus had a direct interest inmeeting their quotas; they had no incentive to select efficient production
techniques or to reduce costs.
Perhaps most important, there was no incentive for plant managers to adopt newtechnologies. A plant implementing a new technology risked start-up delays that
could cause it to fall short of its quota. If a plant did succeed in boosting output, it
was likely to be forced to accept even larger quotas in the future. A plant manager
who introduced a successful technology would only be slapped with tougher quotas;
if the technology failed, he or she would lose a bonus. With little to gain and a great
deal to lose, Soviet plant managers were extremely reluctant to adopt newtechnologies. Soviet production was, as a result, characterized by outdated
technologies. When the system fell in 1991, Soviet manufacturers were using
production methods that had been obsolete for decades in other countries.
Centrally controlled systems often generated impressive numbers for total output
but failed in satisfying consumer demands. Gosplan officials, recognizing that
Soviet capital was not very productive, ordered up a lot of it. The result was a heavyemphasis on unproductive capital goods and relatively little production of
consumer goods. On the eve of the collapse of the Soviet Union, Soviet economists
estimated that per capita consumption was less than one-sixth of the U.S. level.
The Soviet system also generated severe environmental problems. In principle, asocialist system should have an advantage over a capitalist system in allocating
environmental resources for which private property rights are difficult to define.
Because a socialist government owns all capital and natural resources, theownership problem is solved. The problem in the Soviet system, however, camefrom the labor theory of value. Since natural resources are not produced by labor,
the value assigned to them was zero. Soviet plant managers thus had no incentive
to limit their exploitation of environmental resources, and terrible environmental
tragedies were common.

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Systems similar to that created in the Soviet Union were established in other Soviet
bloc countries as well. The most important exceptions were Yugoslavia, which is
discussed in the next section, and China, which started with a Soviet-style systemand then moved away from it. The Chinese case is examined later in this chapter.

Yugoslavia: Another Socialist Experiment
Although the Soviet Union was able to impose a system of command socialism onnearly all the Eastern European countries it controlled after World War II,
Yugoslavia managed to forge its own path. Yugoslavia’s communist leader, Marshal
Tito, charted an independent course, accepting aid from Western nations such as
the United States and establishing a unique form of socialism that made greater use
of markets than the Soviet-style systems did. Most important, however, Tito quickly
moved away from the centralized management style of the Soviet Union to adecentralized system in which workers exercised considerable autonomy.
In the Yugoslav system, firms with five or more employees were owned by the state
but made their own decisions concerning what to produce and what prices tocharge. Workers in these firms elected their managers and established their own
systems for sharing revenues. Each firm paid a fee for the use of its state-owned
capital. In effect, firms operated as labor cooperatives. Firms with fewer than five
employees could be privately owned and operated.
Economic performance in Yugoslavia was impressive. Living standards there weregenerally higher than those in other Soviet bloc countries. The distribution ofincome was similar to that of command socialist economies; it was generally moreequal than distributions achieved in market capitalist economies. The Yugoslav
economy was plagued, however, by persistent unemployment, high inflation, andincreasing disparities in regional income levels.
Yugoslavia began breaking up shortly after command socialist systems began fallingin Eastern Europe. It had been a country of republics and provinces with uneasy
relationships among them. Tito had been the glue that held them together. After his
death, the groups began to move apart and a number of countries have formed outof what was once Yugoslavia, in several cases accompanied by war. They all seem to
be moving in the market capitalist direction, with Slovenia and Macedonia leading
the way. Over time, the others—Croatia, Bosnia, and Herzegovina, and even Serbia
and Montenegra–have been following suit.

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Evaluating Economic Performance Under Socialism
Soviet leaders placed great emphasis on Marx’s concept of the inevitable collapse ofcapitalism. While they downplayed the likelihood of a global revolution, theyargued that the inherent superiority of socialism would gradually become apparent.
Countries would adopt the socialist model in order to improve their living
standards, and socialism would gradually assert itself as the dominant world
system.
One key to achieving the goal of a socialist world was to outperform the UnitedStates economically. Stalin promised in the 1930s that the Soviet economy would
surpass that of the United States within a few decades. The goal was clearly notachieved. Indeed, it was the gradual realization that the command socialist system
could not deliver high living standards that led to the collapse of the old system.
Figure 20.1 "Per Capita Output in Former Soviet Bloc States and in the UnitedStates, 1995" shows the World Bank’s estimates of per capita output, measured indollars of 1995 purchasing power, for the republics that made up the Soviet Union,
for the Warsaw Pact nations of Eastern Europe for which data are available, and for
the United States in 1995. Nations that had operated within the old Soviet system
had quite low levels of per capita output. Living standards were lower still, giventhat these nations devoted much higher shares of total output to investment and to
defense than did the United States.

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Figure 20.1 Per Capita Output in Former Soviet Bloc States and in the United States, 1995

Per capita output was far lower in the former republics of the Soviet Union and in Warsaw Pact countries in 1995
than in the United States. All values are measured in units of equivalent purchasing power.
Source: United Nations, Human Development Report, 1998.

Ultimately, it was the failure of the Soviet system to deliver living standards on apar with those achieved by market capitalist economies that brought the system
down. Market capitalist economic systems create incentives to allocate resources
efficiently; socialist systems do not. Of course, a society may decide that otherattributes of a socialist system make it worth retaining. But the lesson of the 1980s
was that few that had lived under command socialist systems wanted to continue todo so.

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KEY TAKEAWAYS• In the Soviet Union a central planning agency, Gosplan, set output
quotas for enterprises and determined prices.
• The Soviet central planning system was highly inefficient. Sources ofthis inefficiency included failure to incorporate consumer preferences
into decisions about what to produce, failure to take into account costsof factors of production, setting of prices without regard to market
equilibrium, lack of incentives for incorporating new technologies,
overemphasis on capital goods production, and inattention toenvironmental problems.
• Yugoslavia developed an alternative system of socialism in which firms
were run by their workers as labor cooperatives.
• It was the realization that command socialist systems could not deliver
high living standards that contributed to their collapse.

TRY IT!
What specific problem of a command socialist system does each of the
cartoons in the Case in Point parodying that system highlight?

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Case in Point: Socialist Cartoons
These cartoons came from the Soviet press. Soviet citizens were clearly awareof many of the problems of their planned system.

“But where is the equipment thatwas sent to us?”
“Which year are you talking about?”“But Santa, it’s winter, so we asked
for boots for our son!”“Why are they sending us newtechnology when the old still works?”“I know, but the only thing available
in the state store was a pair ofsandals.”

ANSWER TO TRY IT!
The first cartoon shows the inefficiency that resulted because of the failure
to take into account the costs of factors of production. The second cartoon
shows the difficulty involved in getting business to incorporate newtechnologies. The third shows the system’s failure to respond to consumers’
demands.

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20.3 Economies in Transition: China and Russia
LEARNING OBJECTIVES
1. Discuss the major problems in transitioning from a command socialist
economy to a market capitalist one.
2. Compare the approaches to economic transition taken in China andRussia.

Just as leaders of the Soviet Union had to create their own command socialist
systems, leaders of the economies making the transition to market capitalist
economies must find their own paths to new economic systems. It is a task without
historical precedent.
In this section we will examine two countries and the strategies they have chosen
for the transition. China was the first socialist nation to begin the process, and inmany ways it has been the most successful. Russia was the dominant republic in theold Soviet Union; whether its transition is successful will be crucially important.
Before turning to the transition process in these two countries, we will consider
some general problems common to all countries seeking to establish market
capitalism in the wake of command socialism.

Problems in Transition
Establishing a system of market capitalism in a command socialist economy is adaunting task. The nations making the attempt must invent the process as they goalong. Each of them, though, faces similar problems. Former command socialist
economies must establish systems of property rights, establish banking systems,
deal with the problem of inflation, and work through a long tradition of ideologicalantipathy toward the basic nature of a capitalist system.

Property Rights
A market system requires property rights before it can function. A property rightdetails what one can and cannot do with a particular asset. A market system
requires laws that specify the actions that are permitted and those that areproscribed, and it also requires institutions for the enforcement of agreements
dealing with property rights. These include a court system and lawyers trained inproperty law and contract law. For the system to work effectively, there must be

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widespread understanding of the basic nature of private property and of thetransactions through which it is allocated.
Command socialist economies possess virtually none of these prerequisites formarket capitalism. When the state owned virtually all capital and natural resources,
there was little need to develop a legal system that would spell out individual
property rights. Governments were largely free to do as they wished.
Countries seeking a transition from command socialism to market capitalism must
develop a legal system comparable to those that have evolved in market capitalist
countries over centuries. The problem of creating a system of property rights andthe institutions necessary to support it is a large hurdle for economies making thetransition to a market economy.
One manifestation of the difficulties inherent in establishing clear and widely
recognized property rights in formerly socialist countries is widespread criminal
activity. Newly established private firms must contend with racketeers who offer
protection at a price. Firms that refuse to pay the price may find their property
destroyed or some of their managers killed. Criminal activity has been rampant ineconomies struggling toward a market capitalist system.

Banking
Banks in command socialist countries were operated by the state. There was no
tradition of banking practices as they are understood in market capitalist countries.
In a market capitalist economy, a privately owned bank accepts deposits from
customers and lends these deposits to borrowers. These borrowers are typicallyfirms or consumers. Banks in command socialist economies generally acceptedsaving deposits, but checking accounts for private individuals were virtually
unknown. Decisions to advance money to firms were made through the economicplanning process, not by individual banks. Banks did not have an opportunity toassess the profitability of individual enterprises; such considerations wereirrelevant in the old command socialist systems. Bankers in these economies werethus unaccustomed to the roles that would be required of them in a market
capitalist system.

Inflation
One particularly vexing problem facing transitional economies is inflation. Undercommand socialist systems, the government set prices; it could abolish inflation by

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decree. But such systems were characterized by chronic shortages of consumer
goods. Consumers, unable to find the goods they wanted to buy, simply
accumulated money. As command socialist economies began their transitions, there
was typically a very large quantity of money available for consumers to spend. A
first step in transitions was the freeing of prices. Because the old state-determined
prices were generally below equilibrium levels, prices typically surged in the earlystages of transition. Prices in Poland, for example, shot up 400% within a few
months of price decontrol. Prices in Russia went up tenfold within six months.
One dilemma facing transitional economies has been the plight of bankrupt state
enterprises. In a market capitalist economy, firms unable to generate revenues thatexceed their costs go out of business. In command socialist economies, the central
bank simply wrote checks to cover their deficits. As these economies have begun
the transition toward market capitalism, they have generally declared theirintention to end these bailouts and to let failing firms fail. But the phenomenon ofstate firms earning negative profits is so pervasive that allowing all of them to failat once could cause massive disruption.
The practical alternative to allowing firms to fail has been continued bailouts. But
in transitional economies, that has meant issuing money to failed firms. This
practice increases the money supply and contributes to continuing inflation. Most
transition economies experienced high inflation in the initial transition years, butwere subsequently able to reduce it.

Ideology
Soviet citizens, and their counterparts in other command socialist economies, weretold for decades that market capitalism is an evil institution, that it fosters greed
and human misery. They were told that some people become rich in the system, butthat they do so only at the expense of others who become poorer.
In the context of a competitive market, this view of market processes as a zero-sum
game—one in which the gains for one person come only as a result of losses foranother—is wrong. In market transactions, one person gains only by making others
better off. But the zero-sum view runs deep, and it is a source of lingering hostility
toward market forces.
Countries seeking to transform their economies from command socialist to moremarket-oriented systems face daunting challenges. Given these challenges, it isremarkable that they have persisted in the effort. There are a thousand reasons for
economic reform to fail, but the reform effort has, in general, continued to move
forward.

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China: A Gradual Transition
China is a giant by virtually any standard. Larger than the continental UnitedStates, it is home to more than 1.3 billion people—more than one-fifth of the earth’s
population. Although China is poor, its economy has been among the fastest
growing in the world since 1980. That rapid growth is the result of a gradual shift
toward a market capitalist economy. The Chinese have pursued their transition in amanner quite different from the paths taken by former Soviet bloc nations.

Recent History
China was invaded by Japan during World War II. After Japan’s defeat, civil war
broke out between Chinese communists, led by Mao Zedong, and nationalists. The
communists prevailed, and the People’s Republic of China was proclaimed in 1949.
Mao set about immediately to create a socialist state in China. He nationalized many
firms and redistributed land to peasants. Many of those who had owned land under
the old regime were executed. China’s entry into the Korean War in 1950 led tomuch closer ties to the Soviet Union, which helped China to establish a commandsocialist economy.
China’s first five-year plan, launched in 1953, followed the tradition of Soviet
economic development. It stressed capital-intensive production and thedevelopment of heavy industry. But China had far less capital and a great many
more people than did the Soviet Union. Capital-intensive development made little
sense. In 1958, Mao declared a uniquely Chinese approach to development, which
he dubbed the Great Leap Forward. It focused on labor-intensive development andthe organization of small productive units to quickly turn China into anindustrialized country. Indeed, households were encouraged to form their own
productive units under the slogan “An iron and steel foundry in every backyard.”
The Great Leap repudiated the bonuses and other material incentives stressed by
the Soviets; motivation was to come from revolutionary zeal, not self-interest.
In agriculture, the new plan placed greater emphasis on collectivization. Farmers
were organized into communes containing several thousand households each. Small
private plots of land, which had been permitted earlier, were abolished. China’s
adoption of the plan was a victory for radical leaders in the government.
The Great Leap was an economic disaster. Output plunged and a large-scale famine
ensued. Moderate leaders then took over, and the economy got back to its 1957
level of output by the mid-1960s.

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Then, again in the mid-1960s, power shifted back towards the radicals with thelaunching of the Great Proletarian Cultural Revolution. During that time, students
formed groups called “red guards” and were encouraged to expose “capitalist
roaders.” A group dubbed the “Gang of Four,” led by Mao’s wife Jiang Qing, tried tosteer Chinese society towards an ever more revolutionary course until Mao’s deathin 1976.

China’s Reforms
Following Mao’s death, pragmatists within the Communist Party, led by Deng
Xiaoping, embarked on a course of reform that promoted a more market-oriented
economy coupled with retention of political power by the Communists. This policy
combination was challenged in 1989 by a large demonstration in Beijing’s
Tiananmen Square. The authorities ordered the military to remove thedemonstrators, resulting in the deaths of several hundred civilians. A period ofretrenchment in the reform process followed and lasted for several years. Then, in
1992, Deng ushered in a period of reinvigorated economic reform in a highly
publicized trip to southern China, where reforms had progressed farther. Throughseveral leadership changes since then, the path of economic reform, managed by
the Communist Party, has continued. The result has been a decades-long period ofphenomenal economic growth.
What were some of the major elements of the economic reform? Beginning in 1979,
many Chinese provincial leaders instituted a system called bao gan dao
hu—“contracting all decisions to the household.” Under the system, provincial
officials contracted the responsibility for operating collectively owned farmland toindividual households. Government officials gave households production quotas
they were required to meet and purchased that output at prices set by central
planners. But farmers were free to sell any additional output they could produce atwhatever prices they could get in the marketplace and to keep the profits forthemselves.
By 1984, 93% of China’s agricultural land had been contracted to individual
households and the rate of growth in agricultural output had soared.
At the industrial level, state-owned enterprises (SOEs) were told to meet their
quotas and then were free to engage in additional production for sale in freemarkets. Over time, even those production directives were discontinued. More
importantly, manufacturing boomed with the development of township and village
enterprises, as well as various types of private endeavors, with much participationfrom foreign firms. Most price controls were abolished. The entry of China into the20.3 Economies in Transition: China and Russia

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World Trade Organization in 2001 symbolized a commitment towards moving evenfurther down the road of economic reform.
In effect, China’s economy is increasingly directed by market forces. Even though
five-year plans are still announced, they are largely advisory rather thancommanding in nature. Recognizing the incomplete nature of the reforms, Chinese
authorities continue to work on making the SOEs more competitive, as well asprivatizing them, creating a social security system in which social benefits are nottied to a worker’s place of employment, and reforming the banking sector.
How well has the gradual approach to transition worked? Between 1980 and 2011,
China had one of the fastest-growing economies in the world. Its per capita output,
measured in dollars of constant purchasing power, more than quadrupled. The
country, which as late as 1997 was one of the poorest of the 59 low-incomecountries in the world, is now situated comfortably among the more prosperous
lower-middle-income countries, according to the World Bank. Figure 20.2 "Soaring
Output in China" compares growth rates in China to those achieved by Japan andthe United States and to the average annual growth rate of all world economies
between 1985 and 2009.
Figure 20.2 Soaring Output in China

China’s growth in per capita output from 1985 to 2009 greatly exceeded rates recorded for Japan, the United States,or the average of all nations.
Source: World Bank, World Development Reports, 1997, 1998, 2008, 2009, 2010, 2011 Table 1.

Where will China’s reforms lead? While the Chinese leadership has continued to be
repressive politically, it has generally supported the reform process. The result has

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been continued expansion of the free economy and a relative shrinking of the staterun sector. Given the rapid progress China has achieved with its gradual approachto reform, it is hard to imagine that the country would reverse course. Given thecourse it is on, China seems likely to become a market capitalist economy—and aprosperous one—within a few decades.

Russia: An Uncertain Path to Reform
Russia dominated the former Soviet Union. It contained more than half the Soviet
people and more than three-fourths of the nation’s land area. Russia’s capital,
Moscow, was the capital and center of power for the entire country.
Today, Russia retains control over the bulk of the military power that had been
accumulated by the former Soviet Union. While it is now an ally of the UnitedStates, Russia still possesses the nuclear capability to destroy life on earth. Its
success in making the transition to market capitalism and joining as a full partnerin the world community thus has special significance for peace.

Recent History
Russia’s shift toward market capitalism has its roots in a reform process initiatedduring the final years of the existence of the Soviet Union. That effort presaged
many of the difficulties that have continued to plague Russia.
The Soviet Union, as we have already seen, had a well-established system ofcommand socialism. Leading Soviet economists, however, began arguing as early as
the 1970s that the old system could never deliver living standards comparable tothose achieved in market capitalist economies. The first political leader to embrace
the idea of radical reform was Mikhail Gorbachev, who became General Secretary of
the Communist party—the highest leadership post in the Soviet Union—in 1985.
Mr. Gorbachev instituted political reforms that allowed Soviet citizens to speak out,
and even to demonstrate, against their government. This policy was dubbed
glasnost, or “openness.” Economically, he called for much greater autonomy forstate enterprises and a system in which workers’ wages would be tied to
productivity. The new policy, dubbed perestroika, or “restructuring,” appeared to bean effort to move the system toward a mixed economy.
But Mr. Gorbachev’s economic advisers wanted to go much further. A small groupof economists, which included his top economic adviser, met in August 1990 to draft
a radical plan to transform the economy to a market capitalist system—and to do it

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Chapter 20 Socialist Economies in Transitionin 500 days. Stanislav Shatalin, a Soviet economist, led the group. Mr. Gorbachev
endorsed the Shatalin plan the following month, and it appeared that the Soviet
Union was on its way to a new system. The new plan, however, threatened theSoviet power elite. It called for sharply reduced funding for the military and for theSoviet Union’s secret police force, the KGB. It would have stripped central planners,
who were very powerful, of their authority. The new plan called for nothing lessthan the destruction of the old system—and the elimination of the power base of
most government officials.
Top Soviet bureaucrats and military leaders reacted to the Shatalin plan withpredictable rage. They delivered an ultimatum to Mr. Gorbachev: dump the Shatalin
plan or be kicked out.
Caught between advisers who had persuaded him of the necessity for radical reformand Communist party leaders who would have none of it, Mr. Gorbachev chose toleave the command system in place and to seek modest reforms. He announced a
new plan that retained control over most prices and he left in place the state’sownership of enterprises. In an effort to deal with shortages of other goods, heordered sharp price increases early in 1991.
These measures, however, accomplished little. Black market prices for basic
consumer goods were typically 10 to 20 times the level of state prices. Those prices,which respond to demand and supply, may be taken as a rough gauge of equilibrium
prices. People were willing to pay the higher black market prices because they
simply could not find goods at the state-decreed prices. Mr. Gorbachev’s order todouble and even triple some state prices narrowed the gap between official andequilibrium prices, but did not close it. Table 20.1 "Official Versus Black Market
Prices in the Soviet Union, 1991" shows some of the price changes imposed andcompares them to black market prices.
Table 20.1 Official Versus Black Market Prices in the Soviet Union, 1991
Item

Old price

New price

Black market priceChildren’s shoes 2–10 rubles

10–50 rubles

50–300 rubles

Toilet paper

32–40 kopeks 60–75 kopeks 2–3 rubles

Compact car

7,000 rubles

35,000 rubles 70,000–100,000 rubles

Bottle of vodka

10.5 rubles

10.5 rubles

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30–35 rubles

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Mikhail Gorbachev ordered sharp increases in the prices of most consumer goods
early in 1991 in an effort to eliminate shortages. As the table shows, however, alarge gap remained between official and black market prices.
Source: Komsomolskaya pravda
Perhaps the most important problem for Mr. Gorbachev’s price hikes was that there
was no reason for state-owned firms to respond to them by increasing their output.
The managers and workers in these firms, after all, were government employees
receiving government-determined salaries. There was no mechanism throughwhich they would gain from higher prices. A private firm could be expected toincrease its quantity supplied in response to a higher price. State-owned firms didnot.
The Soviet people faced the worst of economic worlds in 1991. Soviet output
plunged sharply, prices were up dramatically, and there was no relief from severe
shortages. A small group of government officials opposed to economic reform
staged a coup in the fall of 1991, putting Mr. Gorbachev under house arrest. The
coup produced massive protests throughout the country and failed within a few
days. Chaos within the central government created an opportunity for the republicsof the Soviet Union to declare their independence, and they did. These defections
resulted in the collapse of the Soviet Union late in 1991, with Russia as one of 15
countries that emerged.

The Reform Effort
Boris Yeltsin, the first elected president of Russia, had been a leading proponent ofmarket capitalism even before the Soviet Union collapsed. He had supported the
Shatalin plan and had been sharply critical of Mr. Gorbachev’s failure to implement
it. Once Russia became an independent republic, Mr. Yeltsin sought a rapidtransition to market capitalism.
Mr. Yeltsin’s reform efforts, however, were slowed by Russian legislators, most ofthem former Communist officials who were appointed to their posts under the oldregime. They fought reform and repeatedly sought to impeach Mr. Yeltsin. Citing
health reasons, he abruptly resigned from the presidency in 1999, and appointed
Vladimir Putin, who had only recently been appointed as Yeltsin’s prime minister,as acting president. Mr. Putin has since been elected and re-elected, though manyobservers have questioned the fairness of those elections as well as Mr. Putin’scommitment to democracy. Barred constitutionally from re-election in 2008, Putin
became prime minister. Dimitry Medvedev, Putin’s close ally, became president.

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Despite the hurdles, Russian reformers have accomplished a great deal. Prices ofmost goods have been freed from state controls. Most state-owned firms have been
privatized, and most of Russia’s output of goods and services is now produced by
the private sector.
To privatize state firms, Russian citizens were issued vouchers that could be used topurchase state enterprises. Under this plan, state enterprises were auctioned off.
Individuals, or groups of individuals, could use their vouchers to bid on them. By
1995 most state enterprises in Russia had been privatized.
While Russia has taken major steps toward transforming itself into a market
economy, it has not been able to institute its reforms in a coherent manner. For
example, despite privatization, restructuring of Russian firms to increase efficiency
has been slow. Establishment and enforcement of rules and laws that undergird
modern, market-based systems have been lacking in Russia. Corruption has become
endemic.
While the quality of the data is suspect, there is no doubt that output and thestandard of living fell through the first half of the 1990s. Despite a financial crisis in
1998, when the Russian government defaulted on its debt, output recovered
through the last half of the 1990s and Russia has seen substantial growth in theearly years of the twenty-first century. In addition, government finances have
improved following a major tax reform and inflation has come down from near
hyperinflation levels. Despite these gains, there is uneasiness about the long-termsustainability of this progress because of the over-importance of oil and high oil
prices in the recovery. Mr. Putin’s fight, whether justified or not, with several of
Russia’s so-called oligarchs, a small group of people who were able to amass large
fortunes during the early years of privatization, creates unease for domestic andforeign investors.
To be fair, overcoming the legacy of the Soviet Union would have been difficult atbest. Overall, though, most would argue that Russian transition policies have madea difficult situation worse. Why has the transition in Russia been so difficult? One
reason may be that Russians lived with command socialism longer than did anyother country. In addition, Russia had no historical experience with market
capitalism. In countries that did have it, such as the Czech Republic, the switch backto capitalism has gone far more smoothly and has met with far more success.

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TRY IT!
Table 20.1 "Official Versus Black Market Prices in the Soviet Union, 1991"
shows three prices for various goods in the Soviet Union in 1991. Illustrate
the market for compact cars using a demand and supply diagram. On yourdiagram, show the old price, the new price, and the black market price.

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Case in Point: Eastern Germany’s Surprisingly Difficult
Transition Experience© 2010 Jupiterimages Corporation

The transition of eastern Germany was supposed to be the easiest of them all.
Quickly merged with western Germany, given its new “Big Brother’s” deep
pockets, the ease with which it could simply adopt the rules and laws andpolicies of western Germany, and its automatic entry into the European Union,
how could it not do well? And yet, eastern Germany seems to be languishing
while some other central European countries that had also been part of theSoviet bloc are doing much better. Specifically, growth in real GDP in eastern
Germany was 6% to 8% in the early 1990s, but since then has mostly beenaround 1%, with three years of negative growth in the early 2000s. In the early
1990s, the Polish economy grew at less than half east Germany’s rate, but sincethen has averaged more than 4% per year. Why the reversal of fortunes?
Most observers point to the quick rise of wages to western German levels,
despite the low productivity in the east. Initially, Germans from both east andwest supported the move. East Germans obviously liked the idea of huge wage
increases while west German workers thought that prolonged low wages in theeastern part of the country would cause companies to relocate there and saw

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the higher east German wages as protecting their own jobs. While the German
government offered subsidies and tax breaks to firms that would move to theeast despite the high wages, companies were by and large still reluctant tomove their factories there. Instead they chose to relocate in other central
European countries, such as the Czech Republic, Slovakia, and Poland. As aresult, unemployment in eastern Germany has remained stubbornly high at
about 15% and transfer payments to east Germans have totaled $1.65 trillion
with no end in sight. “East Germany had the wrong prices: Labor was too
expensive, and capital was too cheap,” commented Klaus Deutsch, an economist
at Deutsche Bank.
While the flow of labor has primarily been from Poland to Germany since thebreak-up of the Soviet bloc, with mostly senior managers moving from
Germany to Poland, there are some less-skilled, unemployed east Germans whoare starting to look for jobs in Poland. Tassilo Schlicht is an east German who
repaired bicycles and washing machines at a Soviet-era factory and lost his job
in 1990. He then worked for a short time at a gas station in his town for no pay
with the hope that the experience would be helpful, but he was never hired. He
undertook some government-sponsored retraining but still could not find a job.
Finally, he was hired at a gas station across the border in Poland. The pay is far
less than what employed Germans make for doing similar jobs but it is twice
what he had been receiving in unemployment benefits. “These days, a job is ajob, wherever it is.”Sources: Marcus Walker and Matthew Karnitschnig, “Eastern Europe Eclipses
Eastern Germany,” Wall Street Journal, November 9, 2004, p. A16; Keven J.
O’Brien, “For Jobs, Some Germans Look to Poland,” New York Times, January 8,
2004, p. W1; Doug Saunders, “What’s the Matter with Eastern Germany?” The
Globe and Mail (Canada), November 27, 2007, p. F3.

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TRY IT!
There is a shortage of cars at both the old price of 7,000 rubles and at the
new price of 35,000, although the shortage is less at the new price.
Equilibrium price is assumed to be 70,000 rubles.

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20.4 Review and PracticeSummary
Socialism, a system in which factors of production are owned in common or by the public sector, is a very old
idea. The impetus for installing it as a national economic system came from the writings of Karl Marx.
Marx argued that capitalism would inevitably collapse and give way to socialism. He argued that undercapitalism workers would receive only a subsistence wage. Capitalists would extract the difference between
what workers receive and what they produce as surplus value, a concept roughly equivalent to profit. As
capitalists struggled to maintain surplus value, the degree and extent of exploitation of workers would rise.
Capitalist systems would suffer through a series of crises in which firms cut back their output. The suffering ofworkers would increase, and the capitalist class would be weakened. Ultimately, workers would overthrow themarket capitalist system and establish socialism in its place.
Marx’s predictions about capitalist development have not come to fruition, but his ideas have been enormously
influential. By the 1980s, roughly one-third of the world’s people lived in economies built on the basis of his
ideas.
The most important command socialist economy was the Soviet Union. In this economy, central planners
determined what would be produced and at what price. Quotas were given to each state-owned firm. The
system, which was emulated in most socialist nations, failed to deliver living standards on a par with thoseachieved by market economies. This failure ultimately brought down the system.
A very different approach to socialism was pioneered by Yugoslavia. State-owned firms were managed by theirworkers, who shared in their profits. Yugoslavia’s economic system fell apart as the country broke up andsuffered from ethnic strife and civil war.
As the governments of command socialist nations fell in 1989 and early in the 1990s, new governments launchedefforts to achieve transition to market capitalism. We examined two cases of transition. China’s gradual strategy
has produced rapid growth, but in a politically repressive regime. As this book went to press, China continued to
be one of the fastest growing economies in the world.
Russia’s transition has been much more difficult. Although its growth rate has improved in the last decade, there
is still concern over the coherence of its reform efforts and the sustainability of recent improvements.

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CONCEPT PROBLEMS
1. There is a gap between what workers receive and the value of whatworkers produce in a market capitalist system. Why? Does thisconstitute exploitation? Does it create the kinds of crises Marx
anticipated? Why or why not?
2. What is meant by the labor theory of value? What are the shortcomingsof the theory?
3. What would you say is the theory of value offered in this book? How
does it differ from the labor theory of value?
4. In what ways does reliance on the labor theory of value create a problem
for the allocation of natural resources?
5. What do you think would be the advantages of labor-managed firms of
the kind that operated in the former Yugoslavia? The disadvantages?
6. Suppose you were the manager of a Soviet enterprise under the oldcommand system. You have been given a quota and the promise of a big
bonus if your firm meets it. How might your production choices differ
from those of the management of a profit-maximizing firm in a market
capitalist economy?
7. What are some government-operated enterprises in the United States?
Do you see any parallels between the problems command economies
faced with the production of goods and services and problems in the
United States with state-run enterprises?
8. A Chinese firm operating as a state-owned enterprise had an incentive
to produce the efficient level of output, even though some of its output
was claimed by the state at state-determined prices. Why is that thecase?
9. Given that market capitalist systems generate much higher standards ofliving than do command socialist systems, why do you think many
Russian government officials have opposed the adoption of a market
system?
10. How does widespread criminal activity sap economic growth?

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Appendix A: Graphs in Economics
A glance through the pages of this book should convince you that there are a lot ofgraphs in economics. The language of graphs is one means of presenting economic
ideas. If you are already familiar with graphs, you will have no difficulty with this
aspect of your study. If you have never used graphs or have not used them in sometime, this appendix will help you feel comfortable with the graphs you willencounter in this text.

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21.1 How to Construct and Interpret Graphs
LEARNING OBJECTIVES
1. Understand how graphs show the relationship between two or morevariables and explain how a graph elucidates the nature of therelationship.
2. Define the slope of a curve.
3. Distinguish between a movement along a curve, a shift in a curve, and arotation in a curve.

Much of the analysis in economics deals with relationships between variables. A
variable is simply a quantity whose value can change. A graph1 is a pictorial
representation of the relationship between two or more variables. The key tounderstanding graphs is knowing the rules that apply to their construction andinterpretation. This section defines those rules and explains how to draw a graph.

Drawing a Graph
To see how a graph is constructed from numerical data, we will consider ahypothetical example. Suppose a college campus has a ski club that organizes daylong bus trips to a ski area about 100 miles from the campus. The club leases the bus
and charges $10 per passenger for a round trip to the ski area. In addition to therevenue the club collects from passengers, it also receives a grant of $200 from theschool’s student government for each day the bus trip is available. The club thus
would receive $200 even if no passengers wanted to ride on a particular day.
The table in Figure 21.1 "Ski Club Revenues" shows the relationship between two
variables: the number of students who ride the bus on a particular day and therevenue the club receives from a trip. In the table, each combination is assigned aletter (A, B, etc.); we will use these letters when we transfer the information fromthe table to a graph.

1. A pictorial representation of
the relationship between two
or more variables.

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Figure 21.1 Ski Club Revenues

The ski club receives $10 from each passenger riding its bus for a trip to and from the ski area plus a payment of$200 from the student government for each day the bus is available for these trips. The club’s revenues from any
single day thus equal $200 plus $10 times the number of passengers. The table relates various combinations of thenumber of passengers and club revenues.

We can illustrate the relationship shown in the table with a graph. The procedure
for showing the relationship between two variables, like the ones in Figure 21.1 "SkiClub Revenues", on a graph is illustrated in Figure 21.2 "Plotting a Graph". Let us
look at the steps involved.

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Figure 21.2 Plotting a Graph

Here we see how to show the information given in Figure 21.1 "Ski Club Revenues" in a graph.

Step 1. Draw and Label the Axes
The two variables shown in the table are the number of passengers taking the bus
on a particular day and the club’s revenue from that trip. We begin our graph in
Panel (a) of Figure 21.2 "Plotting a Graph" by drawing two axes to form a rightangle. Each axis will represent a variable. The axes should be carefully labeled toreflect what is being measured on each axis.
It is customary to place the independent variable on the horizontal axis and thedependent variable on the vertical axis. Recall that, when two variables are related,the dependent variable is the one that changes in response to changes in the
independent variable. Passengers generate revenue, so we can consider the numberof passengers as the independent variable and the club’s revenue as the dependent
variable. The number of passengers thus goes on the horizontal axis; the club’s
revenue from a trip goes on the vertical axis. In some cases, the variables in a graphcannot be considered independent or dependent. In those cases, the variables may
be placed on either axis; we will encounter such a case in the chapter that
introduces the production possibilities model. In other cases, economists simply
ignore the rule; we will encounter that case in the chapter that introduces themodel of demand and supply. The rule that the independent variable goes on thehorizontal axis and the dependent variable goes on the vertical usually holds, but
not always.
2. The point at which the axes ofa graph intersect.

The point at which the axes intersect is called the origin2 of the graph. Notice thatin Figure 21.2 "Plotting a Graph" the origin has a value of zero for each variable.

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In drawing a graph showing numeric values, we also need to put numbers on theaxes. For the axes in Panel (a), we have chosen numbers that correspond to thevalues in the table. The number of passengers ranges up to 40 for a trip; clubrevenues from a trip range from $200 (the payment the club receives from student
government) to $600. We have extended the vertical axis to $800 to allow somechanges we will consider below. We have chosen intervals of 10 passengers on thehorizontal axis and $100 on the vertical axis. The choice of particular intervals is
mainly a matter of convenience in drawing and reading the graph; we have chosen
the ones here because they correspond to the intervals given in the table.
We have drawn vertical lines from each of the values on the horizontal axis andhorizontal lines from each of the values on the vertical axis. These lines, called
gridlines, will help us in Step 2.

Step 2. Plot the Points
Each of the rows in the table in Figure 21.1 "Ski Club Revenues" gives a combinationof the number of passengers on the bus and club revenue from a particular trip. We
can plot these values in our graph.
We begin with the first row, A, corresponding to zero passengers and club revenueof $200, the payment from student government. We read up from zero passengers
on the horizontal axis to $200 on the vertical axis and mark point A. This pointshows that zero passengers result in club revenues of $200.
The second combination, B, tells us that if 10 passengers ride the bus, the clubreceives $300 in revenue from the trip—$100 from the $10-per-passenger chargeplus the $200 from student government. We start at 10 passengers on the horizontal
axis and follow the gridline up. When we travel up in a graph, we are traveling withrespect to values on the vertical axis. We travel up by $300 and mark point B.
Points in a graph have a special significance. They relate the values of the variableson the two axes to each other. Reading to the left from point B, we see that it shows$300 in club revenue. Reading down from point B, we see that it shows 10
passengers. Those values are, of course, the values given for combination B in thetable.
We repeat this process to obtain points C, D, and E. Check to be sure that you seethat each point corresponds to the values of the two variables given in thecorresponding row of the table.

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The graph in Panel (b) is called a scatter diagram. A scatter diagram3 shows
individual points relating values of the variable on one axis to values of the variable
on the other.

Step 3. Draw the Curve
The final step is to draw the curve that shows the relationship between the numberof passengers who ride the bus and the club’s revenues from the trip. The term
“curve” is used for any line in a graph that shows a relationship between two
variables.
We draw a line that passes through points A through E. Our curve shows clubrevenues; we shall call it R1. Notice that R1 is an upward-sloping straight line. Noticealso that R1 intersects the vertical axis at $200 (point A). The point at which a curveintersects an axis is called the intercept4 of the curve. We often refer to the verticalor horizontal intercept of a curve; such intercepts can play a special role ineconomic analysis. The vertical intercept in this case shows the revenue the club
would receive on a day it offered the trip and no one rode the bus.
To check your understanding of these steps, we recommend that you try plotting
the points and drawing R1 for yourself in Panel (a). Better yet, draw the axes foryourself on a sheet of graph paper and plot the curve.

The Slope of a Curve
In this section, we will see how to compute the slope of a curve. The slopes of curves
tell an important story: they show the rate at which one variable changes withrespect to another.

3. A graph that shows individual
points relating values of thevariable on one axis to valuesof the variable on the other.
4. The point at which a curveintersects an axis.

The slope5 of a curve equals the ratio of the change in the value of the variable on
the vertical axis to the change in the value of the variable on the horizontal axis,
measured between two points on the curve. You may have heard this called “therise over the run.” In equation form, we can write the definition of the slope as
Equation 21.1

5. The ratio of the change in thevalue of the variable on thevertical axis to the change inthe value of the variable on thehorizontal axis measured
between two points on the
curve.

21.1 How to Construct and Interpret Graphs

Slope =

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Equation 21.1 is the first equation in this text. Figure 21.3 "Reading and Using
Equations" provides a short review of working with equations. The material in thistext relies much more heavily on graphs than on equations, but we will use
equations from time to time. It is important that you understand how to use them.
Figure 21.3 Reading and Using Equations

Many equations in economics begin in the form of Equation 21.1, with the statement that one thing (in this case theslope) equals another (the vertical change divided by the horizontal change). In this example, the equation is written
in words. Sometimes we use symbols in place of words. The basic idea though, is always the same: the term
represented on the left side of the equals sign equals the term on the right side. In Equation 21.1 there are threevariables: the slope, the vertical change, and the horizontal change. If we know the values of two of the three, we cancompute the third. In the computation of slopes that follow, for example, we will use values for the two variables on
the right side of the equation to compute the slope.

Figure 21.4 "Computing the Slope of a Curve" shows R1 and the computation of its
slope between points B and D. Point B corresponds to 10 passengers on the bus;
point D corresponds to 30. The change in the horizontal axis when we go from B to
D thus equals 20 passengers. Point B corresponds to club revenues of $300; point D
corresponds to club revenues of $500. The change in the vertical axis equals $200.
The slope thus equals $200/20 passengers, or $10/passenger.

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Figure 21.4 Computing the Slope of a Curve

1. Select two points; we have selected points B and D.
2. The slope equals the vertical change divided by the horizontal change
between the two points.
3. Between points B and D, the slope equals $200/20 passengers = $10/
passenger.
4. The slope of this curve is the price per passenger. The fact that it ispositive suggests a positive relationship between revenue per trip andthe number of passengers riding the bus. Because the slope of thiscurve is $10/passenger between any two points on the curve, therelationship between club revenue per trip and the number ofpassengers is linear.

We have applied the definition of the slope of a curve to compute the slope of R1
between points B and D. That same definition is given in Equation 21.1. Applying
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Slope =

vertical change$200== $10/passenger
horizontal change
20 passengers

The slope of this curve tells us the amount by which revenues rise with an increasein the number of passengers. It should come as no surprise that this amount equals
the price per passenger. Adding a passenger adds $10 to the club’s revenues.
Notice that we can compute the slope of R1 between any two points on the curveand get the same value; the slope is constant. Consider, for example, points A and E.
The vertical change between these points is $400 (we go from revenues of $200 at A
to revenues of $600 at E). The horizontal change is 40 passengers (from zero
passengers at A to 40 at E). The slope between A and E thus equals $400/(40passengers) = $10/passenger. We get the same slope regardless of which pair ofpoints we pick on R1 to compute the slope. The slope of R1 can be considered aconstant, which suggests that it is a straight line. When the curve showing therelationship between two variables has a constant slope, we say there is a linear
relationship6 between the variables. A linear curve7 is a curve with constant slope.
The fact that the slope of our curve equals $10/passenger tells us something else
about the curve—$10/passenger is a positive, not a negative, value. A curve whose
slope is positive is upward sloping. As we travel up and to the right along R1, wetravel in the direction of increasing values for both variables. A positive
relationship8 between two variables is one in which both variables move in thesame direction. Positive relationships are sometimes called direct relationships.
There is a positive relationship between club revenues and passengers on the bus.
We will look at a graph showing a negative relationship between two variables in
the next section.

A Graph Showing a Negative Relationship
6. Relationship that exists
between two variables when
the curve between them has aconstant slope.
7. A curve with constant slope.
8. Relationship that exists
between two variables whenboth variables move in thesame direction.
9. Relationship that exists
between two variables whenthe variables move in opposite
directions.

A negative relationship9 is one in which two variables move in opposite directions.
A negative relationship is sometimes called an inverse relationship. The slope of acurve describing a negative relationship is always negative. A curve with a negative
slope is always downward sloping.
As an example of a graph of a negative relationship, let us look at the impact of thecancellation of games by the National Basketball Association during the 1998–1999
labor dispute on the earnings of one player: Shaquille O’Neal. During the 1998–1999
season, O’Neal was the center for the Los Angeles Lakers.

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O’Neal’s salary with the Lakers in 1998–1999 would have been about $17,220,000 had
the 82 scheduled games of the regular season been played. But a contract dispute
between owners and players resulted in the cancellation of 32 games. Mr. O’Neal’ssalary worked out to roughly $210,000 per game, so the labor dispute cost him wellover $6 million. Presumably, he was able to eke out a living on his lower income,but the cancellation of games cost him a great deal.
We show the relationship between the number of games canceled and O’Neal’s
1998–1999 basketball earnings graphically in Figure 21.5 "Canceling Games andReducing Shaquille O’Neal’s Earnings". Canceling games reduced his earnings, so
the number of games canceled is the independent variable and goes on thehorizontal axis. O’Neal’s earnings are the dependent variable and go on the verticalaxis. The graph assumes that his earnings would have been $17,220,000 had nogames been canceled (point A, the vertical intercept). Assuming that his earnings
fell by $210,000 per game canceled, his earnings for the season were reduced to$10,500,000 by the cancellation of 32 games (point B). We can draw a line between
these two points to show the relationship between games canceled and O’Neal’s
1998–1999 earnings from basketball. In this graph, we have inserted a break in thevertical axis near the origin. This allows us to expand the scale of the axis over therange from $10,000,000 to $18,000,000. It also prevents a large blank space between
the origin and an income of $10,500,000—there are no values below this amount.

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Figure 21.5 Canceling Games and Reducing Shaquille O’Neal’s Earnings

If no games had been canceled during the 1998–1999 basketball season, Shaquille O’Neal would have earned$17,220,000 (point A). Assuming that his salary for the season fell by $210,000 for each game canceled, thecancellation of 32 games during the dispute between NBA players and owners reduced O’Neal’s earnings to$10,500,000 (point B).

What is the slope of the curve in Figure 21.5 "Canceling Games and Reducing
Shaquille O’Neal’s Earnings"? We have data for two points, A and B. At A, O’Neal’sbasketball salary would have been $17,220,000. At B, it is $10,500,000. The verticalchange between points A and B equals -$6,720,000. The change in the horizontal
axis is from zero games canceled at A to 32 games canceled at B. The slope is thus

Slope =

vertical change−$6,720,000== −$210,000/gamehorizontal change
32 games

Notice that this time the slope is negative, hence the downward-sloping curve. As
we travel down and to the right along the curve, the number of games canceledrises and O’Neal’s salary falls. In this case, the slope tells us the rate at which O’Neallost income as games were canceled.

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The slope of O’Neal’s salary curve is also constant. That means there was a linear
relationship between games canceled and his 1998–1999 basketball earnings.

Shifting a Curve
When we draw a graph showing the relationship between two variables, we makean important assumption. We assume that all other variables that might affect therelationship between the variables in our graph are unchanged. When one of thoseother variables changes, the relationship changes, and the curve showing that
relationship shifts.
Consider, for example, the ski club that sponsors bus trips to the ski area. The graphwe drew in Figure 21.2 "Plotting a Graph" shows the relationship between clubrevenues from a particular trip and the number of passengers on that trip,
assuming that all other variables that might affect club revenues are unchanged.
Let us change one. Suppose the school’s student government increases the payment
it makes to the club to $400 for each day the trip is available. The payment was $200
when we drew the original graph. Panel (a) of Figure 21.6 "Shifting a Curve: An
Increase in Revenues" shows how the increase in the payment affects the table we
had in Figure 21.1 "Ski Club Revenues"; Panel (b) shows how the curve shifts. Eachof the new observations in the table has been labeled with a prime: A′, B′, etc. The
curve R1 shifts upward by $200 as a result of the increased payment. A shift in a
curve10 implies new values of one variable at each value of the other variable. The
new curve is labeled R2. With 10 passengers, for example, the club’s revenue was$300 at point B on R1. With the increased payment from the student government, its
revenue with 10 passengers rises to $500 at point B′ on R2. We have a shift in the
curve.

10. Change in the graph of a
relationship between two
variables that implies newvalues of one variable at eachvalue of the other variable.

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Figure 21.6 Shifting a Curve: An Increase in Revenues

The table in Panel (a) shows the new level of revenues the ski club receives with varying numbers of passengers as aresult of the increased payment from student government. The new curve is shown in dark purple in Panel (b). The
old curve is shown in light purple.

It is important to distinguish between shifts in curves and movements along curves.
A movement along a curve11 is a change from one point on the curve to anotherthat occurs when the dependent variable changes in response to a change in the
independent variable. If, for example, the student government is paying the club$400 each day it makes the ski bus available and 20 passengers ride the bus, the clubis operating at point C′ on R2. If the number of passengers increases to 30, the club
will be at point D′ on the curve. This is a movement along a curve; the curve itself
does not shift.

11. Change from one point on the
curve to another that occurs
when the dependent variablechanges in response to achange in the independent
variable.

Now suppose that, instead of increasing its payment, the student government
eliminates its payments to the ski club for bus trips. The club’s only revenue from atrip now comes from its $10/passenger charge. We have again changed one of thevariables we were holding unchanged, so we get another shift in our revenue curve.
The table in Panel (a) of Figure 21.7 "Shifting a Curve: A Reduction in Revenues"
shows how the reduction in the student government’s payment affects clubrevenues. The new values are shown as combinations A″ through E″ on the new
curve, R3, in Panel (b). Once again we have a shift in a curve, this time from R1 to R3.

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Figure 21.7 Shifting a Curve: A Reduction in Revenues

The table in Panel (a) shows the impact on ski club revenues of an elimination of support from the student
government for ski bus trips. The club’s only revenue now comes from the $10 it charges to each passenger. The new
combinations are shown as A″ – E″. In Panel (b) we see that the original curve relating club revenue to the numberof passengers has shifted down.

The shifts in Figure 21.6 "Shifting a Curve: An Increase in Revenues" and Figure 21.7
"Shifting a Curve: A Reduction in Revenues" left the slopes of the revenue curves
unchanged. That is because the slope in all these cases equals the price per ticket,
and the ticket price remains unchanged. Next, we shall see how the slope of a curvechanges when we rotate it about a single point.

Rotating a Curve

12. Change In a curve that occurs
when its slope changes with
one point on the curve fixed.

A rotation of a curve12 occurs when we change its slope, with one point on the
curve fixed. Suppose, for example, the ski club changes the price of its bus rides tothe ski area to $30 per trip, and the payment from the student government remains$200 for each day the trip is available. This means the club’s revenues will remain$200 if it has no passengers on a particular trip. Revenue will, however, be different
when the club has passengers. Because the slope of our revenue curve equals theprice per ticket, the slope of the revenue curve changes.

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Panel (a) of Figure 21.8 "Rotating a Curve" shows what happens to the original
revenue curve, R1, when the price per ticket is raised. Point A does not change; theclub’s revenue with zero passengers is unchanged. But with 10 passengers, theclub’s revenue would rise from $300 (point B on R1) to $500 (point B′ on R4). With 20
passengers, the club’s revenue will now equal $800 (point C′ on R4).
Figure 21.8 Rotating a Curve

A curve is said to rotate when a single point remains fixed while other points on the curve move; a rotation always
changes the slope of a curve. Here an increase in the price per passenger to $30 would rotate the revenue curve from
R1 to R4 in Panel (a). The slope of R4 is $30 per passenger.

The new revenue curve R4 is steeper than the original curve. Panel (b) shows thecomputation of the slope of the new curve between points B′ and C′. The slope
increases to $30 per passenger—the new price of a ticket. The greater the slope of apositively sloped curve, the steeper it will be.
We have now seen how to draw a graph of a curve, how to compute its slope, andhow to shift and rotate a curve. We have examined both positive and negative

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relationships. Our work so far has been with linear relationships. Next we will turnto nonlinear ones.

KEY TAKEAWAYS• A graph shows a relationship between two or more variables.
• An upward-sloping curve suggests a positive relationship between two
variables. A downward-sloping curve suggests a negative relationshipbetween two variables.
• The slope of a curve is the ratio of the vertical change to the horizontal
change between two points on the curve. A curve whose slope isconstant suggests a linear relationship between two variables.
• A change from one point on the curve to another produces a movement
along the curve in the graph. A shift in the curve implies new values of
one variable at each value of the other variable. A rotation in the curve
implies that one point remains fixed while the slope of the curvechanges.

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TRY IT!
The following table shows the relationship between the number of gallons ofgasoline people in a community are willing and able to buy per week and theprice per gallon. Plot these points in the grid provided and label each pointwith the letter associated with the combination. Notice that there are breaks
in both the vertical and horizontal axes of the grid. Draw a line through thepoints you have plotted. Does your graph suggest a positive or a negative
relationship? What is the slope between A and B? Between B and C? Between
A and C? Is the relationship linear?

Now suppose you are given the following information about the relationshipbetween price per gallon and the number of gallons per week gas stations in
the community are willing to sell.

Plot these points in the grid provided and draw a curve through the points
you have drawn. Does your graph suggest a positive or a negative
relationship? What is the slope between D and E? Between E and F? Between
D and F? Is this relationship linear?

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ANSWER TO TRY IT!
Here is the first graph. The curve’s downward slope tells us there is anegative relationship between price and the quantity of gasoline people arewilling and able to buy. This curve, by the way, is a demand curve (the next
one is a supply curve). We will study demand and supply soon; you will beusing these curves a great deal. The slope between A and B is −0.002 (slope =vertical change/horizontal change = −0.20/100). The slope between B and C
and between A and C is the same. That tells us the curve is linear, which, ofcourse, we can see—it is a straight line.
Here is the supply curve. Its upward slope tells us there is a positive
relationship between price per gallon and the number of gallons per week
gas stations are willing to sell. The slope between D and E is 0.002 (slope
equals vertical change/horizontal change = 0.20/100). Because the curve islinear, the slope is the same between any two points, for example, between E
and F and between D and F.

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21.2 Nonlinear Relationships and Graphs without Numbers
LEARNING OBJECTIVES
1. Understand nonlinear relationships and how they are illustrated withnonlinear curves.
2. Explain how to estimate the slope at any point on a nonlinear curve.
3. Explain how graphs without numbers can be used to understand thenature of relationships between two variables.

In this section we will extend our analysis of graphs in two ways: first, we will
explore the nature of nonlinear relationships; then we will have a look at graphs
drawn without numbers.

Graphs of Nonlinear Relationships
In the graphs we have examined so far, adding a unit to the independent variable
on the horizontal axis always has the same effect on the dependent variable on thevertical axis. When we add a passenger riding the ski bus, the ski club’s revenues
always rise by the price of a ticket. The cancellation of one more game in the
1998–1999 basketball season would always reduce Shaquille O’Neal’s earnings by$210,000. The slopes of the curves describing the relationships we have been
discussing were constant; the relationships were linear.
Many relationships in economics are nonlinear. A nonlinear relationship13
between two variables is one for which the slope of the curve showing therelationship changes as the value of one of the variables changes. A nonlinear
curve14 is a curve whose slope changes as the value of one of the variables changes.

13. Relationship between two
variables in which the slope ofthe curve showing therelationship changes as thevalue of one of the variables
changes.

Consider an example. Suppose Felicia Alvarez, the owner of a bakery, has recorded
the relationship between her firm’s daily output of bread and the number of bakers
she employs. The relationship she has recorded is given in the table in Panel (a) of
Figure 21.9 "A Nonlinear Curve". The corresponding points are plotted in Panel (b).
Clearly, we cannot draw a straight line through these points. Instead, we shall haveto draw a nonlinear curve like the one shown in Panel (c).

14. A curve whose slope changes as
the value of one of thevariables changes.

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Figure 21.9 A Nonlinear Curve

The table in Panel (a) shows the relationship between the number of bakers Felicia Alvarez employs per day and thenumber of loaves of bread produced per day. This information is plotted in Panel (b). This is a nonlinear
relationship; the curve connecting these points in Panel (c) (Loaves of bread produced) has a changing slope.

Inspecting the curve for loaves of bread produced, we see that it is upward sloping,suggesting a positive relationship between the number of bakers and the output ofbread. But we also see that the curve becomes flatter as we travel up and to theright along it; it is nonlinear and describes a nonlinear relationship.
How can we estimate the slope of a nonlinear curve? After all, the slope of such a
curve changes as we travel along it. We can deal with this problem in two ways. One
is to consider two points on the curve and to compute the slope between those twopoints. Another is to compute the slope of the curve at a single point.
When we compute the slope of a curve between two points, we are really computing
the slope of a straight line drawn between those two points. In Figure 21.10"Estimating Slopes for a Nonlinear Curve", we have computed slopes between pairsof points A and B, C and D, and E and F on our curve for loaves of bread produced.

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These slopes equal 400 loaves/baker, 200 loaves/baker, and 50 loaves/baker,
respectively. They are the slopes of the dashed-line segments shown. These dashedsegments lie close to the curve, but they clearly are not on the curve. After all, thedashed segments are straight lines. Our curve relating the number of bakers to dailybread production is not a straight line; the relationship between the bakery’s daily
output of bread and the number of bakers is nonlinear.
Figure 21.10 Estimating Slopes for a Nonlinear Curve

We can estimate the slope of a nonlinear curve between two points. Here, slopes are computed between points A and
B, C and D, and E and F. When we compute the slope of a nonlinear curve between two points, we are computing theslope of a straight line between those two points. Here the lines whose slopes are computed are the dashed lines
between the pairs of points.

15. A straight line that touches,but does not intersect, anonlinear curve at only one
point.

Every point on a nonlinear curve has a different slope. To get a precise measure of
the slope of such a curve, we need to consider its slope at a single point. To do that,
we draw a line tangent to the curve at that point. A tangent line15 is a straight linethat touches, but does not intersect, a nonlinear curve at only one point. The slopeof a tangent line equals the slope of the curve at the point at which the tangent line
touches the curve.

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Consider point D in Panel (a) of Figure 21.11 "Tangent Lines and the Slopes ofNonlinear Curves". We have drawn a tangent line that just touches the curveshowing bread production at this point. It passes through points labeled M and N.
The vertical change between these points equals 300 loaves of bread; the horizontal
change equals two bakers. The slope of the tangent line equals 150 loaves of bread/baker (300 loaves/2 bakers). The slope of our bread production curve at point D
equals the slope of the line tangent to the curve at this point. In Panel (b), we havesketched lines tangent to the curve for loaves of bread produced at points B, D, and
F. Notice that these tangent lines get successively flatter, suggesting again that theslope of the curve is falling as we travel up and to the right along it.
Figure 21.11 Tangent Lines and the Slopes of Nonlinear Curves

Because the slope of a nonlinear curve is different at every point on the curve, the precise way to compute slope is todraw a tangent line; the slope of the tangent line equals the slope of the curve at the point the tangent line touches
the curve. In Panel (a), the slope of the tangent line is computed for us: it equals 150 loaves/baker. Generally, we will
not have the information to compute slopes of tangent lines. We will use them as in Panel (b), to observe what
happens to the slope of a nonlinear curve as we travel along it. We see here that the slope falls (the tangent lines
become flatter) as the number of bakers rises.

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Notice that we have not been given the information we need to compute the slopesof the tangent lines that touch the curve for loaves of bread produced at points B
and F. In this text, we will not have occasion to compute the slopes of tangent lines.
Either they will be given or we will use them as we did here—to see what ishappening to the slopes of nonlinear curves.
In the case of our curve for loaves of bread produced, the fact that the slope of thecurve falls as we increase the number of bakers suggests a phenomenon that plays acentral role in both microeconomic and macroeconomic analysis. As we add
workers (in this case bakers), output (in this case loaves of bread) rises, but by
smaller and smaller amounts. Another way to describe the relationship between thenumber of workers and the quantity of bread produced is to say that as the numberof workers increases, the output increases at a decreasing rate. In Panel (b) of
Figure 21.11 "Tangent Lines and the Slopes of Nonlinear Curves" we express thisidea with a graph, and we can gain this understanding by looking at the tangent
lines, even though we do not have specific numbers. Indeed, much of our work withgraphs will not require numbers at all.
We turn next to look at how we can use graphs to express ideas even when we do
not have specific numbers.

Graphs Without Numbers
We know that a positive relationship between two variables can be shown with an
upward-sloping curve in a graph. A negative or inverse relationship can be shownwith a downward-sloping curve. Some relationships are linear and some are
nonlinear. We illustrate a linear relationship with a curve whose slope is constant; anonlinear relationship is illustrated with a curve whose slope changes. Using thesebasic ideas, we can illustrate hypotheses graphically even in cases in which we do
not have numbers with which to locate specific points.
Consider first a hypothesis suggested by recent medical research: eating more fruits
and vegetables each day increases life expectancy. We can show this idea
graphically. Daily fruit and vegetable consumption (measured, say, in grams perday) is the independent variable; life expectancy (measured in years) is thedependent variable. Panel (a) of Figure 21.12 "Graphs Without Numbers" shows the
hypothesis, which suggests a positive relationship between the two variables.
Notice the vertical intercept on the curve we have drawn; it implies that evenpeople who eat no fruit or vegetables can expect to live at least a while!

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Figure 21.12 Graphs Without Numbers

We often use graphs without numbers to suggest the nature of relationships between variables. The graphs in thefour panels correspond to the relationships described in the text.

Panel (b) illustrates another hypothesis we hear often: smoking cigarettes reduces
life expectancy. Here the number of cigarettes smoked per day is the independent
variable; life expectancy is the dependent variable. The hypothesis suggests a
negative relationship. Hence, we have a downward-sloping curve.
Now consider a general form of the hypothesis suggested by the example of Felicia
Alvarez’s bakery: increasing employment each period increases output each period,
but by smaller and smaller amounts. As we saw in Figure 21.9 "A Nonlinear Curve",
this hypothesis suggests a positive, nonlinear relationship. We have drawn a curvein Panel (c) of Figure 21.12 "Graphs Without Numbers" that looks very much likethe curve for bread production in Figure 21.11 "Tangent Lines and the Slopes ofNonlinear Curves". It is upward sloping, and its slope diminishes as employment
rises.

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Finally, consider a refined version of our smoking hypothesis. Suppose we assertthat smoking cigarettes does reduce life expectancy and that increasing the numberof cigarettes smoked per day reduces life expectancy by a larger and larger amount.
Panel (d) shows this case. Again, our life expectancy curve slopes downward. But
now it suggests that smoking only a few cigarettes per day reduces life expectancy
only a little but that life expectancy falls by more and more as the number ofcigarettes smoked per day increases.
We have sketched lines tangent to the curve in Panel (d). The slopes of thesetangent lines are negative, suggesting the negative relationship between smoking
and life expectancy. They also get steeper as the number of cigarettes smoked per
day rises. Whether a curve is linear or nonlinear, a steeper curve is one for which
the absolute value of the slope rises as the value of the variable on the horizontal
axis rises. When we speak of the absolute value of a negative number such as −4, we
ignore the minus sign and simply say that the absolute value is 4. The absolutevalue of −8, for example, is greater than the absolute value of −4, and a curve with aslope of −8 is steeper than a curve whose slope is −4.
Thus far our work has focused on graphs that show a relationship between
variables. We turn finally to an examination of graphs and charts that show valuesof one or more variables, either over a period of time or at a single point in time.

KEY TAKEAWAYS• The slope of a nonlinear curve changes as the value of one of thevariables in the relationship shown by the curve changes.
• A nonlinear curve may show a positive or a negative relationship.
• The slope of a curve showing a nonlinear relationship may be estimatedby computing the slope between two points on the curve. The slope at
any point on such a curve equals the slope of a line drawn tangent to thecurve at that point.
• We can illustrate hypotheses about the relationship between two
variables graphically, even if we are not given numbers for the
relationships. We need only draw and label the axes and then draw acurve consistent with the hypothesis.

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TRY IT!
Consider the following curve drawn to show the relationship between two
variables, A and B (we will be using a curve like this one in the next chapter).
Explain whether the relationship between the two variables is positive or
negative, linear or nonlinear. Sketch two lines tangent to the curve at
different points on the curve, and explain what is happening to the slope ofthe curve.

ANSWER TO TRY IT!
The relationship between variable A shown on the vertical axis and variable
B shown on the horizontal axis is negative. This is sometimes referred to as
an inverse relationship. Variables that give a straight line with a constantslope are said to have a linear relationship. In this case, however, therelationship is nonlinear. The slope changes all along the curve. In this casethe slope becomes steeper as we move downward to the right along the
curve, as shown by the two tangent lines that have been drawn. As thequantity of B increases, the quantity of A decreases at an increasing rate.

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21.3 Using Graphs and Charts to Show Values of Variables
LEARNING OBJECTIVE
1. Understand and use time-series graphs, tables, pie charts, and bar charts
to illustrate data and relationships among variables.

You often see pictures representing numerical information. These pictures may
take the form of graphs that show how a particular variable has changed over time,or charts that show values of a particular variable at a single point in time. We willclose our introduction to graphs by looking at both ways of conveying information.

Time-Series Graphs
One of the most common types of graphs used in economics is called a time-seriesgraph. A time-series graph16 shows how the value of a particular variable orvariables has changed over some period of time. One of the variables in a timeseries graph is time itself. Time is typically placed on the horizontal axis in timeseries graphs. The other axis can represent any variable whose value changes overtime.
The table in Panel (a) of Figure 21.13 "A Time-Series Graph" shows annual values of
the unemployment rate, a measure of the percentage of workers who are looking
for and available for work but are not working, in the United States from 1998 to2007. The grid with which these values are plotted is given in Panel (b). Notice thatthe vertical axis is scaled from 3 to 8%, instead of beginning with zero. Time-seriesgraphs are often presented with the vertical axis scaled over a certain range. The
result is the same as introducing a break in the vertical axis, as we did in Figure 21.5
"Canceling Games and Reducing Shaquille O’Neal’s Earnings".

16. A graph that shows how thevalue of a particular variable orvariables has changed oversome period of time.

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Figure 21.13 A Time-Series Graph

Panel (a) gives values of the U.S. unemployment rate from 1998 to 2010. These points are then plotted in Panel (b). To
draw a time-series graph, we connect these points, as in Panel (c).

The values for the U.S. unemployment rate are plotted in Panel (b) of Figure 21.13"A Time-Series Graph". The points plotted are then connected with a line in Panel(c).

Scaling the Vertical Axis in Time-Series Graphs
The scaling of the vertical axis in time-series graphs can give very different views of
economic data. We can make a variable appear to change a great deal, or almost not
at all, depending on how we scale the axis. For that reason, it is important to notecarefully how the vertical axis in a time-series graph is scaled.
Consider, for example, the issue of whether an increase or decrease in income tax
rates has a significant effect on federal government revenues. This became a big
issue in 1993, when President Clinton proposed an increase in income tax rates. The
measure was intended to boost federal revenues. Critics of the president’s proposal
argued that changes in tax rates have little or no effect on federal revenues. Higher
tax rates, they said, would cause some people to scale back their income-earning
efforts and thus produce only a small gain—or even a loss—in revenues. Op-ed

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essays in The Wall Street Journal, for example, often showed a graph very much likethat presented in Panel (a) of Figure 21.14 "Two Tales of Taxes and Income". It
shows federal revenues as a percentage of gross domestic product (GDP), a measureof total income in the economy, since 1960. Various tax reductions and increases
were enacted during that period, but Panel (a) appears to show they had little effecton federal revenues relative to total income.
Figure 21.14 Two Tales of Taxes and Income

A graph of federal revenues as a percentage of GDP emphasizes the stability of the relationship when plotted withthe vertical axis scaled from 0 to 100, as in Panel (a). Scaling the vertical axis from 16 to 21%, as in Panel (b), stresses
the short-term variability of the percentage and suggests that major tax rate changes have affected federal
revenues.

Laura Tyson, then President Clinton’s chief economic adviser, charged that thosegraphs were misleading. In a Wall Street Journal piece, she noted the scaling of thevertical axis used by the president’s critics. She argued that a more reasonablescaling of the axis shows that federal revenues tend to increase relative to total
income in the economy and that cuts in taxes reduce the federal government’s
share. Her alternative version of these events does, indeed, suggest that federal
receipts have tended to rise and fall with changes in tax policy, as shown in Panel(b) of Figure 21.14 "Two Tales of Taxes and Income".
Which version is correct? Both are. Both graphs show the same data. It is certainly
true that federal revenues, relative to economic activity, have been remarkably
stable over the past several decades, as emphasized by the scaling in Panel (a). But
it is also true that the federal share has varied between about 17 and 20%. And asmall change in the federal share translates into a large amount of tax revenue.

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It is easy to be misled by time-series graphs. Large changes can be made to appear
trivial and trivial changes to appear large through an artful scaling of the axes. The
best advice for a careful consumer of graphical information is to note carefully therange of values shown and then to decide whether the changes are reallysignificant.

Testing Hypotheses with Time-Series Graphs
John Maynard Keynes, one of the most famous economists ever, proposed in 1936 ahypothesis about total spending for consumer goods in the economy. He suggested
that this spending was positively related to the income households receive. One way
to test such a hypothesis is to draw a time-series graph of both variables to see
whether they do, in fact, tend to move together. Figure 21.15 "A Time-Series Graphof Disposable Income and Consumption" shows the values of consumption spending
and disposable income, which is after-tax income received by households. Annual
values of consumption and disposable income are plotted for the period 1960–2007.
Notice that both variables have tended to move quite closely together. The close
relationship between consumption and disposable income is consistent with
Keynes’s hypothesis that there is a positive relationship between the two variables.
Figure 21.15 A Time-Series Graph of Disposable Income and Consumption

Plotted in a time-series graph, disposable income and consumption appear to move together. This is consistent withthe hypothesis that the two are directly related.
Source: Department of Commerce

The fact that two variables tend to move together in a time series does not by itself
prove that there is a systematic relationship between the two. Figure 21.16 "Stock21.3 Using Graphs and Charts to Show Values of Variables

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Prices and a Mystery Variable" shows a time-series graph of monthly values in 1987
of the Dow Jones Industrial Average, an index that reflects the movement of theprices of common stock. Notice the steep decline in the index beginning in October,not unlike the steep decline in October 2008.
Figure 21.16 Stock Prices and a Mystery Variable

The movement of the monthly average of the Dow Jones Industrial Average, a widely reported index of stock values,
corresponded closely to changes in a mystery variable, X. Did the mystery variable contribute to the crash?

It would be useful, and certainly profitable, to be able to predict such declines.
Figure 21.16 "Stock Prices and a Mystery Variable" also shows the movement ofmonthly values of a “mystery variable,” X, for the same period. The mysteryvariable and stock prices appear to move closely together. Was the plunge in the
mystery variable in October responsible for the stock crash? The answer is: Not
likely. The mystery value is monthly average temperatures in San Juan, Puerto Rico.
Attributing the stock crash in 1987 to the weather in San Juan would be an exampleof the fallacy of false cause.
Notice that Figure 21.16 "Stock Prices and a Mystery Variable" has two verticalaxes. The left-hand axis shows values of temperature; the right-hand axis shows

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values for the Dow Jones Industrial Average. Two axes are used here because thetwo variables, San Juan temperature and the Dow Jones Industrial Average, arescaled in different units.

Descriptive Charts
We can use a table to show data. Consider, for example, the information compiled
each year by the U.S. National Center for Education Statistics. The table in Panel (a)of Figure 21.17 "Bachelor’s Degrees Earned by Field, 2009" shows the results of the2009 survey. In the groupings given, economics is included among the social
sciences.
Figure 21.17 Bachelor’s Degrees Earned by Field, 2009

Panels (a), (b), and (c) show bachelor’s degrees earned by field in 2009 in United States. All three panels present thesame information. Panel (a) is an example of a table, Panel (b) is an example of a pie chart, and Panel (c) is an
example of a vertical bar chart.
Source: Statistical Abstracts of the United States, 2012, Table 302. Bachelor’s Degrees Earned by Field, 1980 to 2009,
based on data from U.S. National Center for Education Statistics, Digest of Educational Statistics. Percentages shown
are for broad academic areas, each of which includes several majors.

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Panels (b) and (c) of Figure 21.17 "Bachelor’s Degrees Earned by Field, 2009" present
the same information in two types of charts. Panel (b) is an example of a pie chart;
Panel (c) gives the data in a bar chart. The bars in this chart are horizontal; they
may also be drawn as vertical. Either type of graph may be used to provide a pictureof numeric information.

KEY TAKEAWAYS• A time-series graph shows changes in a variable over time; one axis isalways measured in units of time.
• One use of time-series graphs is to plot the movement of two or morevariables together to see if they tend to move together or not. The factthat two variables move together does not prove that changes in one ofthe variables cause changes in the other.
• Values of a variable may be illustrated using a table, a pie chart, or a bar
chart.

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TRY IT!
The table in Panel (a) shows a measure of the inflation rate, the percentagechange in the average level of prices below. Panels (b) and (c) provide blankgrids. We have already labeled the axes on the grids in Panels (b) and (c). It
is up to you to plot the data in Panel (a) on the grids in Panels (b) and (c).
Connect the points you have marked in the grid using straight lines between
the points. What relationship do you observe? Has the inflation rate
generally increased or decreased? What can you say about the trend of
inflation over the course of the 1990s? Do you tend to get a different“interpretation” depending on whether you use Panel (b) or Panel (c) toguide you?

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ANSWER TO TRY IT!
Here are the time-series graphs, Panels (b) and (c), for the information in
Panel (a). The first thing you should notice is that both graphs show that the
inflation rate generally declined throughout the 1990s (with the exception of
1996, when it increased). The generally downward direction of the curve
suggests that the trend of inflation was downward. Notice that in this case
we do not say negative, since in this instance it is not the slope of the linethat matters. Rather, inflation itself is still positive (as indicated by the factthat all the points are above the origin) but is declining. Finally, comparing
Panels (b) and (c) suggests that the general downward trend in the inflation
rate is emphasized less in Panel (b) than in Panel (c). This impression would
be emphasized even more if the numbers on the vertical axis were increasedin Panel (b) from 20 to 100. Just as in Figure 21.14 "Two Tales of Taxes andIncome", it is possible to make large changes appear trivial by simply
changing the scaling of the axes.

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PROBLEMS

1. Panel (a) shows a graph of a positive relationship; Panel (b)shows a graph of a negative relationship. Decide whether each
proposition below demonstrates a positive or negative
relationship, and decide which graph you would expect toillustrate each proposition. In each statement, identify which
variable is the independent variable and thus goes on thehorizontal axis, and which variable is the dependent variable andgoes on the vertical axis.

1. An increase in national income in any one year increases thenumber of people killed in highway accidents.
2. An increase in the poverty rate causes an increase in thecrime rate.
3. As the income received by households rises, they purchasefewer beans.
4. As the income received by households rises, they spend moreon home entertainment equipment.
5. The warmer the day, the less soup people consume.
2. Suppose you have a graph showing the results of a survey asking
people how many left and right shoes they owned. The results
suggest that people with one left shoe had, on average, one rightshoe. People with seven left shoes had, on average, seven rightshoes. Put left shoes on the vertical axis and right shoes on thehorizontal axis; plot the following observations:
Left shoes

1 2 3 4 5 6 7

Right shoes 1 2 3 4 5 6 7

Is this relationship positive or negative? What is the slope of thecurve?

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3. Suppose your assistant inadvertently reversed the order of
numbers for right shoe ownership in the survey above. You thus
have the following table of observations:
Left shoes

1 2 3 4 5 6 7

Right shoes 7 6 5 4 3 2 1

Is the relationship between these numbers positive or negative?
What’s implausible about that?
4. Suppose some of Ms. Alvarez’s kitchen equipment breaks down.
The following table gives the values of bread output that wereshown in Figure 21.9 "A Nonlinear Curve". It also gives the newlevels of bread output that Ms. Alvarez’s bakers produce
following the breakdown. Plot the two curves. What has
happened?
A

B

C

D

E

F

G

Bakers/day

0

1

2

3

4

5

6

Loaves/day

0 400 700 900 1,000 1,050 1,075

Loaves/day after
breakdown

0 380 670 860

950

990 1,005

5. Steven Magee has suggested that there is a relationship between
the number of lawyers per capita in a country and the country’s
rate of economic growth. The relationship is described with thefollowing Magee curve.

What do you think is the argument made by the curve? Whatkinds of countries do you think are on the upward- sloping

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region of the curve? Where would you guess the United States is?
Japan? Does the Magee curve seem plausible to you?
6. Draw graphs showing the likely relationship between each of thefollowing pairs of variables. In each case, put the first variable
mentioned on the horizontal axis and the second on the verticalaxis.
1. The amount of time a student spends studying economics
and the grade he or she receives in the course
2. Per capita income and total expenditures on health care
3. Alcohol consumption by teenagers and academic
performance
4. Household income and the likelihood of being the victim of aviolent crime

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Chapter 22
Appendix B: Extensions of the Aggregate Expenditures ModelIn this appendix, we will extend the aggregate expenditures model in two ways.
First, we will express the model in general algebraic form and show how to solve it
for the equilibrium level of real GDP. The advantage of using general algebraic
expressions in place of the specific numbers that we used in the chapter is that we
can then use the results to solve for any specific value that may pertain to a given
economy. Second, we will show how the aggregate expenditures model can be used
to analyze the impact of fiscal policies on the economy.

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22.1 The Algebra of Equilibrium
Suppose an economy can be represented by the following equations:
Equation 22.1

C = Ca + bY d
Equation 22.2

T = T a + tY
Equation 22.3

Ip = Ia
Equation 22.4

G = GaEquation 22.5

X n = X na
As in our specific example in the chapter, the consumption function given in
Equation 22.1 has an autonomous component (Ca) and an induced component (bYd),
where b is the marginal propensity to consume (MPC). In the example in thechapter, Ca was $300 billion and the MPC, or b, was 0.8. Equation 22.2 shows that
total taxes, T, include an autonomous component Ta (for example, property taxes,
licenses, fees, and any other taxes that do not vary with the level of income) and an
induced component that is a fraction of real GDP, Y. That fraction is the tax rate, t.
Disposable personal income is just the difference between real GDP and total taxes:
Equation 22.6

Ya = Y − T
In Equation 22.3, Equation 22.4, and Equation 22.5, Ia, Ga, and X na are specific values
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Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model

purchases (G), and net exports (Xn). In this model, planned investments,
government purchases, and net exports are all assumed to be autonomous. For thisreason, we add the subscript “a” to each of them.
We use the equations that describe each of the components as aggregate
expenditures to solve for the equilibrium level of real GDP. The equilibrium
condition in the aggregate expenditures model requires that aggregate
expenditures for a period equal real GDP in the period. We specify that condition
algebraically:
Equation 22.7

Y = AE
Aggregate expenditures AE consist of consumption plus planned investment plus
government purchases plus net exports. We thus replace the right-hand side ofEquation 22.7 with those terms to get
Equation 22.8

Y = C + Ip + G + X n
Consumption is given by Equation 22.1 and the other components of aggregate
expenditures by Equation 22.3, Equation 22.4, and Equation 22.5. Inserting theseequations into Equation 22.8, we have
Equation 22.9

Y = Ca + bY d + Ia + Ga + X n a
We have one equation with two unknowns, Y and Yd. We therefore need to express
Yd in terms of Y. From Equation 22.2 and Equation 22.6, we can write

Y d = Y − (T a + tY)
And remove the parentheses to obtain
Equation 22.10

Y d = Y − T a − tY

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Chapter 22 Appendix B: Extensions of the Aggregate Expenditures ModelWe then factor out the Y term on the right-hand side to get
Equation 22.11

Y d = (1 − t) Y − T a
We now substitute this expression for Yd into Equation 22.9 to get

Y = Ca + b [(1 − t) Y − T a ] + Ia + Ga + X n a
Equation 22.12

Y = Ca − bT a + b (1 − t) Y + Ia + Ga + X n a
The first two terms (Ca − bTa) show that the autonomous portion of consumption is
reduced by the marginal propensity to consume times autonomous taxes. For
example, suppose Ta is $10 billion. If the marginal propensity to consume is 0.8,
then consumption is $8 billion less than it would have been if Ta were zero.
Combining the autonomous terms in Equation 22.12 in brackets, we have
Equation 22.13

Y = [Ca − b (T a ) + Ia + Ga + X n a ] + b (1 − t) (Y)⎯⎯⎯Letting A stand for all the terms in brackets, we can simplify Equation 22.13:
Equation 22.14⎯⎯⎯
Y = A + b (1 − t) Y
The coefficient of real GDP (Y) on the right-hand side of Equation 22.14, b(1 − t),gives the fraction of an additional dollar of real GDP that will be spent for
consumption: it is the slope of the aggregate expenditures function for thisrepresentation of the economy. The aggregate expenditures function for thesimplified economy that we presented in the chapter has a slope that was simply
the marginal propensity to consume; there were no taxes in that model, anddisposable personal income and real GDP were assumed to be the same. Notice thatin using this more realistic aggregate expenditures function, the slope is less by afactor of (1 − t).

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We solve Equation 22.14 for Y:⎯⎯⎯
Y − b (1 − t) (Y) = A⎯⎯⎯
Y [1 − b (1 − t)] = A
Equation 22.15

Y=

1
⎯⎯⎯
(A )
1 − b (1 − t)

In Equation 22.15, 1/[1 − b(1 − t)] is the multiplier. Equilibrium real GDP is achieved
at a level of income equal to the multiplier times the amount of autonomous
spending. Notice that because the slope of the aggregate expenditures function isless than it would be in an economy without induced taxes, the value of themultiplier is also less, all other things the same. In this representation of theeconomy, the value of the multiplier depends on the marginal propensity toconsume and on the tax rate. The higher the tax rate, the lower the multiplier; thelower the tax rate, the greater the multiplier.
For example, suppose the marginal propensity to consume is 0.8. If the tax rate
were 0, then the multiplier would be 5. If the tax rate were 0.25, then the multiplierwould be 2.5.

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22.2 The Aggregate Expenditures Model and Fiscal Policy
In this appendix, we use the aggregate expenditures model to explain the impact offiscal policy on aggregate demand in more detail than was given in the chapter on
government and fiscal policy. As we did in the chapter, we will look at the impact ofvarious types of fiscal policy changes. The possibility of crowding out was discussed
in the fiscal policy chapter and will not be repeated here.

Changes in Government Purchases
All other things unchanged, a change in government purchases shifts the aggregate
expenditures curve by an amount equal to the change in government purchases. A$200-billion increase in government purchases, for example, shifts the aggregate
expenditures curve upward by $200 billion. A $75-billion reduction in government
purchases shifts the aggregate expenditures curve downward by that amount.
Panel (a) of Figure 22.1 "An Increase in Government Purchases" shows an economy
that is initially in equilibrium at an income of $7,000 billion. Suppose that the slopeof the aggregate expenditures function (that is, b[1 − t]) is 0.6, so that the multiplieris 2.5. An increase of $200 billion in government purchases shifts the aggregate
expenditures curve upward by that amount to AE2. In the aggregate expendituresmodel, real GDP increases by an amount equal to the multiplier times the change inautonomous aggregate expenditures. Real GDP in that model thus rises by $500
billion to a level of $7,500 billion.
Figure 22.1 An Increase in Government Purchases

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The economy shown here is initially in equilibrium at a real GDP of $7,000 billion and a price level of P1. In Panel (a),an increase of $200 billion in the level of government purchases shifts the aggregate expenditures curve upward bythat amount to AE2, increasing the equilibrium level of income in the aggregate expenditures model by $500 billion.
In Panel (b), the aggregate demand curve thus shifts to the right by $500 billion to AD2. The equilibrium level of real
GDP rises to $7,300 billion, while the price level rises to P2.

The aggregate expenditures model, of course, assumes a constant price level. To geta more complete picture of what happens, we use the model of aggregate demand
and aggregate supply. In that model shown in Panel (b), the initial price level is P1,
and the initial equilibrium real GDP is $7,000 billion. That is the price level assumed
to hold the aggregate expenditures model. The $200-billion increase in government
purchases increases the total quantity of goods and services demanded, at a pricelevel of P1 by $500 billion. The aggregate demand curve thus shifts to the right bythat amount to AD2. The equilibrium level of real GDP, however, only rises to $7,300
billion, and the price level rises to P2. Part of the impact of the increase in aggregate
demand is absorbed by higher prices, preventing the full increase in real GDP
predicted by the aggregate expenditures model.
A reduction in government purchases would have the opposite effect. All otherthings unchanged, aggregate expenditures would shift downward by an amountequal to the reduction in aggregate purchases. In the model of aggregate demand
and aggregate supply, the aggregate demand curve would shift to the left by anamount equal to the initial change in autonomous aggregate expenditures times themultiplier. Real GDP and the price level would fall. The fall in real GDP is less thanwould occur if the price level stayed constant.
In the remainder of this appendix, we will focus on the shift in the aggregate
expenditures curve. To determine what happens to equilibrium real GDP and theprice level, we must look at the intersection of the new aggregate demand curve
and the short-run aggregate supply curve, as we did in Panel (b) of Figure 22.1 "An
Increase in Government Purchases".

Change in Autonomous Taxes
A change in autonomous taxes shifts the aggregate expenditures in the opposite
direction of the change in government purchases. If the autonomous taxes go up,
for example, aggregate expenditures go down by a fraction of the change. Because
the initial change in consumption is less than the change in taxes (because it ismultiplied by the MPC, which is less than 1), the shift caused by a change in taxes isless than an equal change (in the opposite direction) in government purchases.

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Now suppose that autonomous taxes fall by $200 billion and that the marginal
propensity to consume is 0.8. Then the shift up in the aggregate expenditures curveis $160 billion (= 0.8 × $200). As we saw, a $200-billion increase in government
purchases shifted the aggregate expenditures curve up by $200 billion. Assuming a
multiplier of 2.5, the reduction in autonomous taxes causes equilibrium real GDP in
the aggregate expenditures model to rise by $400 billion. This is less than thechange of $500 billion caused by an equal (but opposite) change in government
purchases. The impact of a $200-billion decrease in autonomous taxes is shown in
Figure 22.2 "A Decrease in Autonomous Taxes".
Figure 22.2 A Decrease in Autonomous Taxes

A decrease of $200 billion in autonomous taxes shifts the aggregate expenditures curve upward by the marginal
propensity to consume of 0.8 times the changes in autonomous taxes of $200 billion, or $160 billion, to AE2. The
equilibrium level of income in the aggregate expenditures model increases by $400 billion to $7,400 billion. All
figures are in billions of base-year dollars.

Similarly, an increase in autonomous taxes of, for example, $75 billion, would shift
the aggregate expenditures curve downward by $60 billion (= 0.8 × $75) and cause
the equilibrium level of real GDP to decrease by $150 billion (= 2.5 × $60).

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Changes in Income Tax Rates
Changes in income tax rates produce an important complication that we have notencountered thus far. When government purchases or autonomous taxes changed,
the aggregate expenditures curve shifted up or down. The new aggregate
expenditures curve had the same slope as the old curve; the multiplier was thesame before and after the change in government purchases or autonomous taxes.
When income tax rates change, however, the aggregate expenditures curve will
rotate, that is, its slope will change. As a result, the value of the multiplier itself willchange.
We saw in the first section of this appendix that when taxes are related to income,the multiplier depends on both the marginal propensity to consume and the tax
rate. An increase in income tax rates will make the aggregate expenditures curve
flatter and reduce the multiplier. A higher income tax rate thus rotates theaggregate expenditures curve downward. Similarly, a lower income tax rate rotates
the aggregate expenditures curve upward, making it steeper.
Suppose that an economy with an initial real GDP of $7,000 billion has an income
tax rate of 0.25. To simplify, we will assume there are no autonomous taxes (that is,
Ta = 0). So T = tY. Thus, disposable personal income Yd is 75% of real GDP:
Equation 22.16

T = 0.25Y
Equation 22.17

Y a = Y − T = 0.75Y
Suppose the marginal propensity to consume is 0.8. A $1 change in real GDP
produces an increase in disposable personal income of $0.75, and that produces anincrease in consumption of $0.60 (= 0.8 × 0.75 × $1). If the other components ofaggregate expenditures are autonomous, then the multiplier is 2.5 (= 1 / [1 − 0.6]).
The impact of a tax rate change is illustrated in Figure 22.3 "The Impact of an
Increase in Income Tax Rates". It shows the original aggregate expenditures curve
AE1 intersecting the 45-degree line at the income of $7,000 billion. The curve has aslope of 0.6. Now suppose that the tax rate is increased to 0.375. The higher tax rate
will rotate this curve downward, making it flatter. The slope of the new aggregate

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expenditures curve AE2 will be 0.5 (= 1 − 0.8[1 − 0.375]). The value of the multiplierthus falls from 2.5 to 2 (= 1 / [1 − 0.5]).
Figure 22.3 The Impact of an Increase in Income Tax Rates

An increase in the income tax rate rotates the aggregate expenditures curve downward by an amount equal to theinitial change in consumption at the original equilibrium value of real GDP found in the aggregate expendituresmodel, $7,000 billion in this case, assuming no other change in aggregate expenditures. It reduces the slope of theaggregate expenditures curve and thus reduces the multiplier. Here, an increase in the income tax rate from 0.25 to
0.375 reduces the slope from 0.6 to 0.5; it thus reduces the multiplier from 2.5 to 2. The higher tax reduces
consumption by $700 billion and reduces equilibrium real GDP in the aggregate expenditures model by $1,400 billion.

At the original level of income, $7,000 billion, tax collection equaled $1,750 billion(again, for this example, we assume Ta = 0, so T = 0.25 × $7,000). At the new tax rate
and original level of income, they equal $2,625 billion (0.375 × $7,000 billion).
Disposable personal income at a real GDP of $7,000 billion thus declines by $875
billion. With a marginal propensity to consume of 0.8, consumption drops by $700
billion (= 0.8 × $875 billion). The aggregate expenditures curve rotates down by thisamount at the initial level of income of $7,000 billion, assuming no other changes inaggregate expenditures occur.

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Before the tax rate increase, an additional $1 of real GDP induced $0.60 in additional
consumption. At the new tax rate, an additional $1 of real GDP creates $0.625 indisposable personal income ($1 in income minus $0.375 in taxes). Given a marginal
propensity to consume of 0.8, this $1 increase in real GDP increases consumption by
only $0.50 (= [$1 × (0.8 × 0.625)]). The new aggregate expenditures curve, AE2 in
Figure 22.3 "The Impact of an Increase in Income Tax Rates", shows the end resultof the tax rate change in the aggregate expenditures model. Its slope is 0.5. The
equilibrium of the level of real GDP in the aggregate expenditures model falls to$5,600 billion from its original level of $7,000. The $1,400-billion reduction in
equilibrium real GDP in the aggregate expenditures model is equal to the$700-billion initial reduction in consumption (at the original equilibrium level ofreal GDP) times the new multiplier of 2. The tax rate increase has reduced aggregate
expenditures and reduced the multiplier impact of this change (from 2.5 to 2). The
aggregate demand curve will shift to the left by $1,400 billion, the new multipliertimes the initial change in aggregate expenditures.
In the model of aggregate demand and aggregate supply, a tax rate increase will
shift the aggregate demand curve to the left by an amount equal to the initialchange in aggregate expenditures induced by the tax rate boost times the new valueof the multiplier. Similarly, a reduction in the income tax rate rotates the aggregate
expenditures curve upward by an amount equal to the initial increase in
consumption (at the original equilibrium level of real GDP found in the aggregate
expenditures model) created by the lower tax rate. It also increases the value of themultiplier. Aggregate demand shifts to the right by an amount equal to the initialchange in aggregate expenditures times the new multiplier.

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Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model

NUMERICAL PROBLEMS

1. Suppose an economy is characterized by the following equations.
All figures are in billions of dollars.
C = 400 + ⅔(Yd)
T = 300 + ¼(Y)G = 400
I = 200
Xn = 100
a. Solve for the equilibrium level of income.
b. Now let G rise to 500. What happens to the solution?
c. What is the multiplier?
2. Consider the following economy. All figures are in billions ofdollars.
C = 180 + 0.8(Yd)T = 100 + 0.25Y
I = 300
G = 400
Xn = 200
a. Solve for the equilibrium level of real GDP.
b. Now suppose investment falls to $200 billion. What happens
to the equilibrium real GDP?
c. What is the multiplier?
3. Suppose an economy has a consumption function C = $100 + ⅔ Yd.
Autonomous taxes, Ta, equal 0, the income tax rate is 10%, and Yd

22.3 Review and Practice900

Chapter 22 Appendix B: Extensions of the Aggregate Expenditures Model= 0.9Y. Government purchases, investment, and net exports eachequal $100. Solve the following problems.
a. Draw the aggregate expenditures curve, and find theequilibrium income for this economy in the aggregate
expenditures model.
b. Now suppose the tax rate rises to 25%, so Yd = 0.75Y. Assume
that government purchases, investments, and net exports
are not affected by the change. Show the new aggregate
expenditures curve and the new level of income in theaggregate expenditures model. Relate your answer to themultiplier effect of the tax change.
c. Compare your result in the aggregate expenditures model towhat the aggregate demand–aggregate supply model wouldshow.
4. Suppose a program of federally funded public-works spending wasintroduced that was tied to the unemployment rate. Suppose theprogram was structured so that public-works spending would be $200
billion per year if the economy had an unemployment rate of 5% at the
beginning of the fiscal year. Public-works spending would be increased
by $20 billion for each percentage point by which the unemployment
rate exceeded 5%. It would be reduced by $20 billion for every
percentage point by which unemployment fell below 5%. If theunemployment rate were 8%, for example, public-works spending would
be $260 billion. How would this program affect the slope of theaggregate expenditures curve?

22.3 Review and Practice901