MACROECONOMICS. Theories and Policies NINTH EDITION. Richard T. Froyen. Prentice Hall. University of North Carolina Chapel Hill PEARSON

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1 NINTH EDITION MACROECONOMICS Theories and Policies Richard T. Froyen University of North Carolina Chapel Hill PEARSON Prentice Hall Upper Saddle River, New Jersey 07458

2 Contents Preface xix PART ONE INTRODUCTION AND MEASUREMENT l CHAPTER 1 Introduction 2 N 1.1 What Is Macroeconomics? Post-World War II U.S. Economic Performance 3 Output 3 Unemployment 4 Inflation 5 Inflation and Unemployment 6 The U.S. Federal Budget and Trade Deficits Central Questions in Macroeconomics 10 Instability of Output 10 Movements in the Inflation Rate 10 The Output-Inflation Relationship 10 Growth Slowdown and Turnaround? 11 Implications of Deficits and Surpluses Conclusion 12 CHAPTER 2 Measurement of Macroeconomic Variables The National Income Accounts Gross Domestic Product 14 Currently Produced 14 Final Goods and Services 14 Evaluated at Market Prices National Income Personal and Disposable Personal Income Some National Income Accounting Identities Measuring Price Changes: Real versus Nominal GDP 23 Real GDP in Prices from a Base Year 24 Chain-Weighted Real GDP 25

3 x CONTENTS 2.7 The Consumer Price Index and the Producer Price Index Measures of Cyclical Variation in Output Conclusion 29 Perspectives 2.1 What GDP Is Not 18 Perspectives 2.2 National Income Accounts for England and Wales in Perspectives 2.3 Dating Business Cycles 29 PART TWO CLASSICAL ECONOMICS AND THE KEYNESIAN REVOLUTION 31 CHAPTER 3 Classical Macroeconomics (I): Output and Employment The Starting Point The Classical Revolution Production Employment 37 Labor Demand 37 Labor Supply Equilibrium Output and Employment 42 The Determinants of Output and Employment 44 Factors That Do Not Affect Output Conclusion 48 Perspectives 3-1 Real Business Cycles: A First Look 48 CHAPTER 4 Classical Macroeconomics (II): Money, Prices, and Interest The Quantity Theory of Money 51 The Equation of Exchange 51 The Cambridge Approach to the Quantity Theory 53 The Classical Aggregate Demand Curve The Classical Theory of the Interest Rate Policy Implications of the Classical Equilibrium Model 60 Fiscal Policy 60 Monetary Policy Conclusion 66 Perspectives 4-1 Money in Hyperinflations 57 Perspectives 4-2 Supply-Side Economics A Modern Classical View 65

4 CONTENTS xi CHAPTER 5 The Keynesian System (I): The Role of Aggregate Demand The Problem of Unemployment The Simple Keynesian Model: Conditions for Equilibrium Output The Components of Aggregate Demand 76 Consumption 76 Investment 78 Government Spending and Taxes Determining Equilibrium Income Changes in Equilibrium Income Fiscal Stabilization Policy Exports and Imports in the Simple Keynesian Model 90 ^5.8 Conclusion 93 Perspectives 5-1 Macroeconomic Controversies 72 Perspectives 5-2 Fiscal Policy in Practice 90 CHAPTER 6 The Keynesian System (II): Money, Interest, and Income Money in the Keynesian System 97 Interest Rates and Aggregate Demand 97 The Keynesian Theory of the Interest Rate 99 The Keynesian Theory of Money Demand 103 The Effects of an Increase in the Money Supply 107 Some Implications of Interest on Money 107 Going Forward The IS-LM Model 109 Money Market Equilibrium: The LM Schedule 110 Product Market Equilibrium: The IS Schedule 119 The IS and LM Schedules Combined Conclusion 131 Appendix: The A Igebra of the IS-LM Model 132 Perspectives 6-1 Residential Construction and the Interest Rate 100 CHAPTER 7 The Keynesian System (III): Policy Effects in the IS-LM Model Factors That Affect Equilibrium Income and the Interest Rate 136 Monetary Influences: Shifts in the LM Schedule 136 Real Influences: Shifts in the IS Schedule 137

5 xii CONTENTS 7.2 The Relative Effectiveness of Monetary and Fiscal Policy 143 Policy Effectiveness and the Slope of the IS Schedule 144 Monetary Policy Effectiveness and the Slope of the IS Schedule 144 Policy Effectiveness and the Slope of the LM Schedule Conclusion 152 Appendix: Monetary and Fiscal Policy Multipliers in the IS-LM Model 157 Perspectives 7-1 The Monetary-Fiscal Policy Mix: Some Historical Examples 142 Perspectives 7-2 Japan in a Slump and the Liquidity Trap 153 CHAPTER 8 The Keynesian System (IV): Aggregate Supply and Demand The Keynesian Aggregate Demand Schedule The Keynesian Aggregate Demand Schedule Combined with the Classical Theory of Aggregate Supply A Contractual View of the Labor Market 167 Sources of Wage Rigidity 167 A Flexible Price-Fixed Money Wage Model Labor Supply and Variability in the Money Wage 174 Classical and Keynesian Theories of Labor Supply 174 The Keynesian Aggregate Supply Schedule with a Variable Money Wage 176 Policy Effects in the Variable-Wage Keynesian Model The Effects of Shifts in the Aggregate Supply Schedule 180 Factors That Shift the Aggregate Supply Schedule 181 More Recent Supply Shocks Conclusion: Keynes versus the Classics 188 Keynesian versus Classical Theories ofaggregate Demand 188 Keynesian versus Classical Theories of Aggregate Supply 188 Keynesian versus Classical Policy Conclusions 189 Perspectives 8-1 Price and Quantity Adjustment in Great Britain, PART THREE MACROECONOMIC THEORY AFTER KEYNES 191 ] CHAPTER 9 The Monetarist Counterrevolution Monetarist Propositions The Reformulation of the Quantity Theory of Money 193 Money and the Early Keynesians 194 Friedman's Restatement of the Quantity Theory 196 Friedman's Monetarist Position 200

6 CONTENTS xiii 9.3 Fiscal and Monetary Policy 203 Fiscal Policy 203 Monetary Policy Unstable Velocity and the Declining Policy Influence of Monetarism 206 Recent Instability in the Money-Income Relationship 207 Monetarist Reaction Conclusion 208 Perspectives 9.1 The Monetarist View of the Great Depression 197 CHAPTER 10 Output, Inflation, and Unemployment: Alternative Views The Natural Rate Theory Monetary Policy, Output, and Inflation: Friedman's Monetarist View 213 Monetary Policy in the Short Run 213 Monetary Policy in the Long Run A Keynesian View of the Output-Inflation Trade-Off 217 The Phillips Curve: A Keynesian Interpretation 218 Stabilization Policies for Output and Employment: The Keynesian View Evolution of the Natural Rate Concept 222 Determinants of the Natural Rate of Unemployment 222 Time-Varying Natural Rates of Unemployment 223 Explaining Changing Natural Rates of Unemployment 224 Recent Trends Conclusion 225 CHAPTER 11 New Classical Economics The New Classical Position 227 A Review of the Keynesian Position 228 The Rational Expectations Concept and Its Implications 228 New Classical Policy Conclusions A Broader View of the New Classical Position The Keynesian Countercritique 239 The Question of Persistence 239 The Extreme Informational Assumptions of Rational Expectations 240 Auction Market Versus Contractual Views of the Labor Market Conclusion 244 Perspectives 11.1 U.S. Stock Prices: Rational Expectations or Irrational Exuberance? 236 Perspectives 11.2 The Great Depression: New Classical Views 243

7 xiv CONTENTS CHAPTER 12 Real Business Cycles and New Keynesian Economics Real Business Cycle Models 246 Central Features of Real Business Cycle Models 246 A Simple Real Business Cycle Model 248 Effects of a Positive Technology Shock 249 Macroeconomic Policy in a Real Business Cycle Model 250 Questions About Real Business Cycle Models 253 Concluding Comment New Keynesian Economics 254 Sticky Price (Menu Cost) Models 256 Efficiency Wage Models 258 Insider-Outsider Models and Hysteresis Conclusion 262 Perspectives 12-1 Robert Lucas and Real Business Cycle Theory 252 Perspectives 12-2 Labor Market Flows 255 Perspectives 12-3 Are Prices Sticky? 258 CHAPTER 13 Macroeconomic Models: A Summary Theoretical Issues Policy Issues Consensus as Well as Controversy 269 PART FOUR OPEN ECONOMY MACROECONOMICS 2 71 CHAPTER 14 Exchange Rates and the International Monetary System The U.S. Balance of Payments Accounts 272 The Current Account 273 The Capital Account 274 Statistical Discrepancy 274 Official Reserve Transactions Exchange Rates and the Market for Foreign Exchange 275 Demand and Supply in the Foreign Exchange Market 277 Exchange Rate Determination: Flexible Exchange Rates 279 Exchange Rate Determination: Fixed Exchange Rates The Current Exchange Rate System 284 Exchange Rate Arrangements 284 How Much Managing? How Much Floating? 285 The Breakdown of the Bretton Woods System 286

8 CONTENTS xv 14.4 Advantages of Alternative Exchange Rate Regimes 287 Advantages of Exchange Rate Flexibility 287 Arguments for Fixed Exchange Rates Experience with Floating Exchange Rates 293 The Dollar in Decline, The Rising Dollar, The Dollar's Slide, The Dollar: 1990 to the Present Global Trade Imbalances 300 Implication of Some Identities 301 Causes and Effects of Global Trade Imbalances Conclusion 303 Perspectives 14-1 U.S. Current Account Deficits Are They Sustainable? 276 Perspectives 14-2 Currency Boards and Dollarization 285 Perspectives 14-3 The Euro 299 CHAPTER 15 Monetary and Fiscal Policy in the Open Economy The Mundell-Fleming Model Imperfect Capital Mobility 308 Policy Under Fixed Exchange Rates 308 Policy Under Flexible Exchange Rates Perfect Capital Mobility 314 Policy Effects Under Fixed Exchange Rates 315 Policy Effects Under Flexible Exchange Rates Conclusion 321 Perspectives 15-1 The Saving-Investment Correlation Puzzle 319 PART FIVE ECONOMIC POLICY 323 CHAPTER 16 Money, the Banking System, and Interest Rates The Definition of Money 324 The Functions of Money 324 Components of the Money Supply Interest Rates and Financial Assets The Federal Reserve System 327 The Structure of the Central Bank 327 Federal Reserve Control of the Money Supply 328 The Tools of Federal Reserve Control 329

9 xvi CONTENTS 16.4 Bank Reserves and Bank Deposits 331 A Model of Deposit Creation 332 Deposit Creation: More General Cases 336 Open-Market Operations and the Federal Funds Rate Who Controls the Money Supply? Conclusion 344 Perspectives 16-1 The Money Supply During the Great Depression 342 CHAPTER 17 Optimal Monetary Policy The Monetary Policymaking Process Competing Strategies for Monetary Policy: Targeting Monetary Aggregates or Interest Rates 347 Targeting Monetary Aggregates 349 Targeting Interest Rate Money versus Interest Rate Targets in the Presence of Shocks 350 Implications of Targeting a Monetary Aggregate 351 Implications of Targeting the Interest Rate A The Relative Merits of the Two Strategies 357 The Sources of Uncertainty and the Choice of a Monetary Policy Strategy 358 Other Considerations The Evolution of Federal Reserve Strategy : Targeting the Federal Funds Rate : Targeting Monetary Aggregates : A Gradual Return to Federal Funds Rate Targeting : A Move toward Greater Transparency Changes in Central Bank Institutions: Recent International Experience 362 The Time Inconsistency Problem 362 Other Arguments for Inflation Targeting Conclusion 366 < Perspectives 17-1 Central Bank Independence and Economic Performance 348 Perspectives 17-2 The Taylor Rule 361 Perspectives 17-3 Inflation Targeting in Practice: The New Zealand Experiment 363 Perspectives 17-4 Inflation Targeting for the United States: Three Influential Views 365

10 CONTENTS xvii CHAPTER 18 Fiscal Policy The Goals of Macroeconomic Policy The Goals of Macroeconomic Policymakers 369 The Public-Choice View 369 The Partisan Theory 372 Public-Choice and Partisan Theories from the Perspective of The Federal Budget The Economy and the Federal Budget: The Concept of Automatic Fiscal Stabilizers Fiscal Policy Controversies: From the Reagan Years to the Present 384 The Pros and Cons of Fiscal Policy Rules 384 What About the Deficit? 385 The Federal Budget in the Late 1990s and into the Twenty-First Century Conclusion 388 Perspectives 18-1 Rational Expectations and the Partisan Theory 373 Perspectives 18-2 State and Local Government Finances 377 PART SIX ECONOMIC GROWTH 391 CHAPTER 19 Policies for Intermediate-Run Growth U.S. Economic Growth, The Supply-Side Position 394 Intermediate-Run Output Growth Is Supply-Determined 395 Saving and Investment Depend on After- Tax Rates of Return 396 Labor Supply Is Responsive to Changes in the After-Tax Real Wage 399 Government Regulation Contributed to the Slowdown in the U.S. Economic Growth Rate The Keynesian Critique of Supply-Side Economics 402 The Supply-Determined Nature of Intermediate-Run Growth 402 Saving and Investment and After- Tax Rates of Return 402 > The Effect of Income Tax Cuts on Labor Supply 403 Regulation As a Source of Inflation and Slow Growth A Growth Policies From Ronald Reagan To George W. Bush 404 Economic Redirection in the Reagan Years 404 Initiatives in the First Bush Administration 405 Growth Policies During the Clinton Administrations 406 Tax Cuts During the Administration of George W. Bush 406

11 xviii CONTENTS 19.5 Conclusion 409 Perspectives 19-1 Growth and Productivity Slowdowns in Other Industrialized Economies 394 Perspectives 19-2 The Laffer Curve 401 Perspectives 19-3 Equality and Efficiency: The Big Trade-off 407 CHAPTER 20 Long-Run Economic Growth: Origins of the Wealth of Nations The Neoclassical Growth Model 410 Growth and the Aggregate Production Function 410 Sources of Growth in the Neoclassical Model Recent Developments in the Theory of Economic Growth 416 Endogenous Growth Models 417 Implications of Endogenous Technological Change 419 Policy Implications of Endogenous Growth Intercountry Income Differences Revisited 420 Perspectives 20-1 Growth Accounting for the United States: An Example 417 Perspectives 20-2 Muck, Money, and the Moral Consequences of Economic Growth Conclusion 424 Glossary 425 Index 430