CHAPTER 23: MEASURE A NATION'S INCOME

- Microeconomics is the study of how individual households and firms make

decisions and how they interact with one another in markets.
- Macroeconomics is the study of the economy as a whole. The goal of
macroeconomics is to explain the economic changes that affect many households,
firms, and markets simultaneously.
- Macroeconomics is the study of economy-wide phenomena, including inflation,
unemployment, and economic growth.
1. The economy’s income and expenditure
- GDP (Gross Domestic Product) measures 2 things at once:
 total income of everyone in the economy
 total expenditure on the economy’s output of goods and services
- For an economy as a whole, income must equal expenditure.
- GDP can be computed for this economy in 2 ways:
 by adding up the total expenditure by households
 by adding up the total income (wages, profit, rent) paid by firms
2. The measurement of GDP
- Gross domestic product (GDP) is the market value of all final goods and services
produced within a country in a given period of time.
 “GDP is the market value…”: market prices measure the amount people are
willing to pay for different goods, they reflect the value of those goods.
 “...of all…”: it includes all items produced in the economy and sold legally
in markets. GDP excludes illicit items, items produced and consumed at
home.
 “...final…”: GDP includes only the value of final goods because the value of
intermediate goods is already included in the prices of the final goods. When
an intermediate good is produced and added to a firm’s inventory of goods
for use or sale at a later date, the intermediate good is taken to be “final” for
the moment, and its value as inventory investment is included as part of
GDP. Thus, when the goods in inventory are later sold or used, the
reductions in inventory subtract from GDP
 “...goods and services…”: GDP includes tangible goods (food, clothing,
cars) and intangible goods (haircuts, housecleaning, doctor visits)
 “...produced…”: When Ford produces and sells a new car, the value of the
car is included in GDP. But when one person sells a used car to another
person, the value of the used car is not included in GDP.
 “...within a country…”: When a Canadian citizen works temporarily in the
United States, her production counts towards US GDP. Thus, items are
included in a nation’s GDP if they are produced domestically, regardless of
the nationality of the producer.
  “...in a given period of time…”
3. The components of GDP
Y = C + I + G + NX
 Consumption (C): is spending by households on goods (durable goods:
automobiles and appliances & nondurable goods: food and clothing) and
services, with the exception of purchases of new house
 Investment (I): is the purchase of goods (capital goods) that will be used in
the future to produce more goods and services. Investment is spending on
business capital (business structures, equipment, intellectual property
products), residential capital (landlord’s apartment building and a
homeowner’s personal residence), and inventories.
 Purchase of a new house is the one type of household spending
categorized as investment rather than consumption.
 When Apple produces a computer and adds it to inventory instead of
selling it, Apple is assumed to have “purchased” the computer for
itself. That is, the national income accountants treat the computer as
part of Apple’s investment spending.
 Government Purchases: is spending on goods and services by local, state,
and federal governments, including the salaries of government workers as
well as expenditure on public works.
 When the government pays the salary of an Army general or a
schoolteacher, that salary is included in government purchases
 Transfer payment: the government pays a Social Security benefit to an
elderly person or an unemployment insurance benefit to a recently laid
off worker.
 Transfer payments are not counted as government purchases
 Net exports = Exports - Imports: is spending on domestically produced
goods by foreigners (exports) minus spending on foreign goods by domestic

⇒ When a domestic household, firm, or government buys a good or service from

residents (imports)

abroad, the purchase does not affect GDP because it reduces net exports by the
same amount that it raises consumption, investment, or government purchases.
4. Real versus Nominal GDP
- If total spending rises from one year to the next, at least one of two things must
be true:
 the economy is producing a larger output of goods and services
 goods and services are being sold at higher prices
- Nominal GDP: is the production of goods and services valued at current prices
- Real GDP: is the production of goods and services valued at constant prices. We
calculate real GDP by first designating one year as a base year
- Because price changes do not affect real GDP, changes in real GDP reflect only
changes in the quantities produced. Real GDP measures the economy’s production
of goods and services
- Real GDP is a better gauge of economic well-being than is nominal GDP
- GDP deflator = (Nominal GDP/Real GDP)x100
- GDP deflator is a measure of the price level calculated as the ratio of nominal
GDP to real GDP times 100
- Because nominal GDP and real GDP must be the same in the base year, the GDP
deflator for the base year always equals 100
- Economists use the term inflation to describe a situation in which the economy’s
overall price level is rising.
- Inflation rate is the percentage change in some measure of the price level from
one period to the next.
Inflation rate in year 2 = (GDP deflator in year 2 - GDP deflator in year
1)/GDP deflator in year 1 x 100
- GDP deflator is one measure that economists use to monitor the average level of
price in the economy.
- GDP deflator can be used to take inflation out of nominal GDP
5. GDP is a good measure of Economic Well-being
- GDP was called the single best measure of the economic well-being of a society
for most - but not all - purposes.

CHAPTER 24: MEASURING THE COST OF LIVING

1. The Consumer Price Index

- The Consumer Price Index (CPI) is a measure of the overall cost of the goods and
services bought by a typical consumer
- Every month, the Bureau of Labor Statistics (BLS), which is part of the
Department of Labor, computes and reports the CPI
- Five steps to calculate CPI:
1. Fix the basket: Determine which prices are most important to the typical
consumer.
2. Find the prices: Find the prices of each of the goods and services in the
basket at each point in time.
3. Compute the basket’s cost: Use the date on prices to calculate the cost of the
basket of goods and services at different times. By keeping the basket of
goods the same, we isolate the effects of price changes from the effects of
any quantity changes that might be occurring at the same time.
4. Choose a base year and compute the index:
 Consumer price index = (Price of basket of goods and services in current
year/Price of basket in base year)x100
5. Compute the inflation rate:
Inflation rate in year 2 = (CPI in year 2 - CPI in year 1)/CPI in year 1*100
- Core CPI: is a measure of the overall cost of consumer goods and services
excluding food and energy because food and energy prices show substantial short-
run volatility.
- In the typical basket of goods and services, the largest component is housing
2. Problems in measuring the cost of living
- The goal of the CPI is to measure changes in the cost of living, or to gauge how
much incomes must rise to maintain a constant standard of living.
- There are 3 problems in measuring cost of living:
 Substitution bias: Consumers respond to these differing price changes by
buying less of the goods whose prices have risen by relatively large amounts
and by buying more of the goods whose prices have risen less or perhaps
even have fallen. If a price index is computed assuming a fixed basket of
goods, it ignores the possibility of consumer substitution → overstates the
increase in the cost of living from one year to the next.
 Introduction of new goods: new goods are introduced, consumers have more
choices, and each dollar is worth more. Because the CPI is based on a fixed
basket of goods and services, it does not reflect the increase in the value of
the dollar that results from the introduction of new goods.
 Unmeasured quality change: If the quality of a good deteriorates from one
year to the next while its price remains the same, you are getting a lesser
good for the same amount of money, the value of a dollar falls. If the quality
rises from one year to the next, the value of a dollar rises. When the quality
changes, the Bureau adjusts the price of the goods to account for the quality
change. In doing so, it is trying to compute the price of a basket of goods of
constant quality.
3. The GDP deflator versus the consumer price index
- Economists and policymakers monitor both the GDP deflator and the CPI to
gauge how quickly prices are rising.

GDP deflator CPI

- Reflects the prices of all goods and - Reflects the prices of all goods
services produced domestically. and services bought by
- Imported consumer goods are excluded consumers.
from GDP d - Imported consumer goods are
 - Capital goods are included in GDP included in CPI
deflator if produced domestically - Capital goods are excluded from
CPI
→ important when the price of oil changes. When the price of oil rises, the
CPI rises by much more than does the GDP deflator.
- GDP deflator compares the price of - CPI compares the price of a
currently produced goods and services fixed basket of goods and services
with the price of those goods and services with the price of the basket in the
in the base year. base year.

4. Correcting Economic Variables for the Effects of Inflation

- The formula for turning dollar figures from year T into today’s dollars is:

Amount in today’s dollars = Amount in year T dollars x

Price level today
- Housing services are particularly important for Price level in year T
understanding regional differences in the cost of living.
5. Indexation
- Price indexes are used to correct for the effects of inflation when comparing
dollar figures from different times
- Indexation for inflation is the automatic correction by law or contract of a dollar
amount for the effects of inflation.
- Future dollars could have a different value than today’s dollar.
- The higher the rate of inflation, the smaller the increase in purchasing power. If
the rate of inflation exceeds the rate of interest, purchasing power actually falls and
if there is deflation, her purchasing power rises by more than the rate of inflation
- Nominal interest rate is the interest rate as usually reported without a correction
for the effects of inflation. It tells you how fast the number of dollars in your bank
account rises over time.
- Real interest rate is the interest rate corrected for the effects of inflation. It tells
you how fast the purchasing power of your bank account rises over time.
Real interest rate = Nominal interest rate - Inflation rate

CHAPTER 25: PRODUCTION AND GROWTH

 1. Economic Growth around the World
- The growth rate measures how rapidly real income per person grew in the typical
year.
2. Productivity: Its Role and Determinants
- Productivity is the quantity of goods and services produced from each unit of
labor input
- Productivity is the key determinant of living standards and that growth in
productivity is the key determinant of growth in living standards.
- A nation can enjoy a high standard of living only if it can produce a large
quantity of goods and services because one of the Ten Principles of Economics is
that a country’s standard of living depends on its ability to produce goods and
services
- Determinants of productivity are physical capital, human capital, natural capital,
natural resources, technological knowledge:
 Physical Capital: The stock of equipment and structures used to produce
goods and services. The inputs used to produce goods and services - labor,
capital - are called the factors of production. An important feature of the
capital is that it is a produced factor of production. Capital is an input into
the production process that in the past was an output from the production
process. Capital is a factor of production used to produce all kinds of goods
and services, including more capital
 Human Capital: The knowledge and skills that workers acquire through
education, training, and experience. Human capital raises a nation’s ability
to produce goods and services. It is a produced factor of production that is a
product of teaching and is used to produce other products.
 Natural Resources: the inputs into the production of goods and services
that are provided by nature, such as land, rivers, mineral deposits. Natural
resources take two forms: renewable (forest) and non - renewable (oil).
Differences in natural resources are responsible for some of the differences
in standards of living around the world. Although natural resources are
important, they are not necessary for an economy to be highly productive in
producing goods and services.
 Technology Knowledge: society’s understanding of the best ways to
produce goods and services. Technological knowledge takes many forms.
(1) Some technology is common knowledge - after one person uses it,
everyone becomes aware of it. (2) Other technology is proprietary - it is
known only by the company that discovers it.
→ Distinguish between technological knowledge and human capital:
Technological knowledge Human capital
- Refer to society’s understanding - Refer to the resources expended
about how the world works. transmitting this understanding to the
- Technological knowledge is the labor force.
quality of society’s textbooks. - Human capital is the amount of time that
the population has spent reading them.
3. The Production Function
- Economists often use a production function to describe the relationship between
the quantity of inputs used in production and the quantity of output from
production.
Y = AF(L, H, K, N)
 F( ) is a function that shows how the inputs are combined to produce output.
 A is a variable that reflects the available production technology. As
technology rises, A rises, the economy produces more output from any given
combination of inputs.
* Notes: In a market economy, scarcity is reflected in market prices. Natural
resource prices exhibit substantial short-run fluctuations, but over long spans of
time, the prices of most natural resources are stable or falling → Our ability to
conserve these resources is growing more rapidly than their supplies are
dwindling.
4. Economic Growth and Public Policy
- Saving and Investment: If today the economy produces a large quantity of new
capital goods, then tomorrow it will have a larger stock of capital and be able to
produce more goods and services. Thus, one way to raise future productivity is to
devote more current resources to the production of capital. Because resources are
scarce, devoting more resources to producing capital requires devoting fewer
resources to producing goods and services for current consumption. The growth
that arises from capital accumulation is not a free lunch: It requires that society
sacrifice consumption of goods and services in the present to enjoy higher
consumption in the future. Encouraging saving and investment is one way that a
government can encourage growth, and, in the long run, raise an economy’s
standard of living.
- Diminishing Returns: As the stock of capital rises, the extra output produced
from an additional unit of capital falls. It means that when workers already have a
large quantity of capital to use in producing goods and services, giving them an
additional unit of capital increases their productivity only slightly. Diminishing
capital is called the diminishing marginal product of capital. Due to diminishing
returns, an increase in the saving rate leads to higher growth only for a while → In
the long run, the higher saving rate leads to a higher level of productivity and
income but not to higher growth in these variables.
- The Catch-up Effect: Other things being equal, it is easier for a country to grow
fast if it starts out relatively poor. In poor countries, workers lack even the most
rudimentary tools and, as a result, have low productivity. Thus, small amounts of
capital investment can substantially raise these workers’ productivity → Poor
countries tend to grow at faster rates than rich countries.
- Investment from abroad is one way for a country to grow and for poor countries
to learn the state-of-the-art technologies developed and used in richer countries:
 Foreign direct investment: a capital investment that is owned and operated
by a foreign entity.
 Foreign portfolio investment: an investment financed with foreign money
but operated by domestic residents.
→ An organization that tries to encourage the flow of capital to poor countries is
the World Bank. Its sister organization is the International Monetary Fund.
- Education - invest in human capital - has an opportunity cost. When students are
in school, they forgo the wages they could have earned as members of the labor
force. Human capital confers positive externalities. Externality is the effect of one
person’s actions on the well-being of a bystander. An educated person, for
instance, might generate new ideas about how best to produce goods and services.
If these ideas enter society’s pool of knowledge so that everyone can use them,
then the ideas are an external benefit of education. The brain drain is the
emigration of many of the most highly educated workers to rich countries, where
these workers can enjoy a higher standard of living. The brain drain will reduce the
poor nation’s stock of human capital even further.
- Health and nutrition: Other things being equal, healthier workers are more
productive. The right investments in the health of the population provide one way
for a nation to increase productivity and raise living standards. Height is an
indicator of productivity. The causal link between health and wealth runs in both
directions:
 Vicious circle: Poor countries are poor in part because their populations are
not healthy, and their populations are not healthy in part because they are
poor and cannot afford adequate healthcare and nutrition.
 Virtuous circle: Policies that lead to more rapid economic growth would
naturally improve health outcomes, which in turn would further promote
economic growth.
- Property rights and political stability: Market prices are the instrument with
which the invisible hand of the marketplace brings supply and demand into balance
in each of the many thousands of markets that make up the economy.
 An important prerequisite for the price system to work is an economy-wide
respect for property rights. Property rights refer to the ability of people to
exercise authority over the resources they own. Such corruption impedes the
 coordinating power of markets and discourages domestic saving and
investment from abroad.
 One threat to property rights is political instability. If a revolutionary
government might confiscate the capital of some businesses, domestic
residents have less incentive to save, invest, and start new businesses,
foreigners have less incentive to invest in the country → the threat of
revolution can depress a nation’s standard of living.
→ A country with an effective court system, honest government officials, and a
stable constitution will enjoy a higher standard of living than a country with a poor
court system, corrupt officials, and frequent revolutions and coups.
- Free trade:
 Some of the world’s poorest countries have tried to achieve more rapid
economic growth by pursuing inward-oriented policies → aim to increase
productivity and living standards within the country by avoiding interaction
with the rest of the world. Together with a general distrust of foreigners, this
argument has at times led policymakers in less developed countries to
impose tariffs and other trade restrictions.
 Poor countries are better off pursuing outward-oriented policies that
integrate these countries into the world economy. International trade in
goods and services can improve the economic well-being of a country’s
citizens. Trade, in some ways, is a type of technology.
 The amount that a nation trades with others is determined not only by
government policy but also by geography. Countries with natural seaports
find trade easier than those without this resource. Landlocked countries find
international trade more difficult, they tend to have lower levels of income
than countries with easy access to the world’s waterways.
- Research and Development: The primary reason that living standards are higher
today than they were a century ago is that technological knowledge has advanced.
Most technological advances come from private research by firms and individual
inventors. Knowledge is a public good because once one person discovers an idea,
the idea enters society’s pool of knowledge and other people can freely use it.
- Population Growth: The most effect is on the size of the labor force: A large
population means there are more workers to produce goods and services. At the
same time, however, a large population means there are more people to consume
those goods and services.
 Stretching Natural Resources: An ever-increasing population would
continually strain society’s ability to provide for itself → mankind was
doomed to forever live in poverty. Attempts by charities or governments to
alleviate poverty were counterproductive, because they merely allowed the
poor to have more children, placing even greater strains on society’s
 productive capabilities. Growth in human ingenuity has offset the effects of
a larger population.
 Diluting the Capital Stock: High population growth reduces GDP per worker
because rapid growth in the number of workers forces the capital stock to be
spread more thinly. Policies that foster equal treatment of women are one
way for less developed countries to reduce their rates of population growth
and raise their standards of living.
 Promoting Technological Progress: Rapid population growth may depress
economic prosperity by reducing the amount of capital each worker has, but
it may also have some benefits. If there are more people, then there are more
scientists, inventors, engineers to contribute to technological advance, which
benefits everyone.
5. Why is so much of Africa poor?
- Low capital investment - Geographic disadvantages
- Low educational attainment - Restricted freedom
- Poor health - Rampant corruption
- High population growth - The legacy of colonization

CHAPTER 26: SAVING, INVESTMENT AND THE FINANCIAL SYSTEM

- Financial system is the group of institutions in the economy that help to match
one person’s savings with another person’s investment.
- Savings and investment are key ingredients to long-run economic growth.
1. Financial Institutions
- The financial institutions can be grouped into 2 categories: financial markets and
financial intermediaries.
- Financial Markets: are financial institutions through which savers can directly
provide funds to borrowers. There are 2 most important financial markets in our
economy are the bond market and the stock market
 The bond market: A bond is a certificate of indebtedness that specifies the
obligations of the borrower to the buyer of the bond. The bond identifies the
time at which the loan will be repaid, called the date of maturity, the rate of
interest that the borrower will pay periodically until the loan matures. The
bond buyer gives his money in exchange for this promise of interest and
eventual repayment of the amount borrowed (principal). These bonds differ
according to four significant characteristics:
 bond’s term: the length of time until the bond matures. (Perpetuity is a
bond that pays interest forever but the principal is never paid). Long-
term bonds are riskier than short-term bonds because holders of long-
 term bonds have to wait longer for repayment of principal. Long-term
bonds pay higher interest rates than short-term bonds.
 credit risk: the probability that the borrower will fail to pay some of
the interest or principal. Borrowers can default on their loans by
declaring bankruptcy. Financially shaky corporations raise money by
issuing junk bonds (high interest rates)
 tax treatment: the way the tax laws treat the interest earned on the
bond. The interest on most bonds is taxable income - the bond owner
has to pay a portion of the interest he earns in income taxes. When
state and local governments issue bonds (municipal bonds), the bond
owners are not required to pay federal income tax on the interest
income.
 inflation protection: most bonds are written in nominal terms - that is
they promise to pay interest and principal in a specific of dollars. If
prices rise and dollars have less purchasing power, the bondholder is
worse off.
 The stock market: A share of stock represents ownership in a firm and is a
claim to some of the profits that the firm makes.
Stock Bond
- The sale of stock to raise money is - The sale of bond is called debt
called equity finance finance
- The owner of shares of Intel stock - The owner of an Intel bond is a
is a part owner of Intel creditor of the corporation
- If Intel is very profitable, the - If Intel is very profitable, the
stockholders enjoy the benefits of bondholders get only the stated interest
these profits on their bonds
If Intel runs into financial difficulty, the bondholders are paid what they are
due before stockholders receive anything at all
→ Compared to bonds, stocks carry greater risk but offer potentially higher
returns.
 The prices at which shares trade on stock exchanges are determined
by the supply of and demand for the stock in these companies. Stock
represents ownership in a corporation, the demand for a stock reflects
people’s perception of the corporation’s future profitability. When
people become optimistic about the company’s future, they raise their
demand for its stock and when people’s expectations of a company’s
prospects decline, the price of a share falls.
  Various stock indexes are available to monitor the overall level of
stock prices. A stock index is computed as an average of a group of
stock prices.
- Financial Intermediaries: are the financial institutions through which savers can
indirectly provide funds to borrowers. There are 2 of the most important financial
intermediaries: banks and mutual funds.
 Banks (act on credit market): A primary job of banks is to take in deposits
from people who want to save and use these deposits to make loans to
people who want to borrow. Besides, banks help create a special asset that
people can use as a medium of exchange (is an item that people can easily
use to engage in transactions)
 Mutual funds (act on stock market): is an institution that sells shares to the
public and uses the proceeds to buy a selection, or portfolio, of various types
of stocks, bonds, or both stock and bonds.
 The primary advantage of mutual funds is that they allow people with
small amounts of money to diversify their holdings. With only a few
hundred dollars, a person can buy shares in a mutual fund, and
indirectly become the part owner or creditor of hundreds of major
companies. For this service, the company operating the mutual fund
charges shareholders a fee, usually between 0.1 and 1.5 percent of
assets each year.
 The second advantage is that mutual funds give ordinary people
access to the skills of professional money managers. Mutual funds
(index funds) which buy all the stocks in a given stock index, perform
somewhat better on average than mutual funds that take advantage of
active trading by professional money managers.
2. Saving and Investment in the National Income Accounts
- An open economy: is one that interacts with other economies around the world.
- A closed economy: is one that does not interact with other economies, does not
engage in international trade in goods and services, international borrowing and
lending

⇒Y-C-G=I⇒S=I
Y = C + I + G (NX is zero in a closed economy)

 where (Y - C - G) is the total income in the economy that remains after

paying for consumption and government purchases → national saving
(saving)
S = Y - C - G = (Y - T - C) + (T - G)
where
 (Y - T - C) is private saving: the amount of income that households have left
after paying their taxes and paying for their consumption.
  (T - G) is public saving: the amount of tax revenue that the government has
left after paying for its spending.
 If T > G → public saving is positive → run a budget surplus
 If T < G → public saving is negative → run a budget deficit
- Investment refers to the purchase of new capital, such as equipment or buildings
3. The market for Loanable Funds
- Market for loanable funds: is the market in which those who want to save supply
funds and those who want to borrow to invest demand funds
- Supply of loanable funds comes from people who have some extra income they
want to save and lend out → Saving is the source of the supply of loanable funds
- Demand for loanable funds comes from households and firms who wish to
borrow to make investments → Investment is the source of the demand for
loanable funds
- Interest rate is the price of a loan. If a high interest rate makes borrowing more
expensive, the quantity of loanable funds demanded falls as the interest rate rises.
A high interest rate makes saving more attractive, the quantity of loanable funds
supplied rises as the interest rate rises → the demand curve for loanable funds
slopes downward, the supply curve for loanable funds slopes upward.
 If the interest rate were lower than the equilibrium level, the quantity of
loanable funds supplied would be less than the quantity of loanable funds
demanded → shortage of loanable funds would encourage lenders to raise
the interest rate they charge
 If the interest rate were higher than the equilibrium level, the quantity of
loanable funds supplied would exceed the quantity of loanable funds
demanded → interest rate would be driven down
- The supply and demand for loanable funds depend on the real interest rate.
- Policy 1: Saving incentives
 Tax changes would alter the incentive for households to save at any given
interest rate → affect the quantity of loanable funds supplied at each interest
rate while the demand for loanable funds would remain the same because the
tax change would not directly affect the amount that borrowers want to
borrow at any given interest rate. Saving would be taxed less heavily than
under current law, households would increase their saving → the supply of

⇒ If a reform of the tax laws encouraged greater saving, the result would be lower
loanable funds would increase and the supply curve would shift to the right

interest rates and greater investment.

- Policy 2: Investment incentives
 Tax credit would reward firms that borrow and invest in new capital, it
would alter investment at any given interest rate → change the demand for
loanable funds while it would not affect the supply of loanable funds. Firms
 would have an incentive to increase investment at any interest rate → the
quantity of loanable funds demanded would be higher at any given interest

⇒ If a reform of the tax laws encouraged greater investment, the result would be
rate → the demand curve for loanable funds would shift to the right

higher interest rates and greater saving

- Policy 3: Government Budget Deficits and Surpluses
 Governments finance budget deficits by borrowing in the bond market, and
the accumulation of past government borrowing is called the government
debt.
 A budget surplus can be used to repay some of the government debt. If
government spending exactly equal tax revenue, the government is said to
have a balanced budget
 A change in government budget balance represents a change in public saving
and in the supply of loanable funds. Because the budget deficit does not
influence the amount that households and firms want to borrow to finance
investment at any given interest rate → alter the demand for loanable funds.
When the government runs a budget deficit → national saving declines → a
budget deficit shifts the supply curve to the left → higher interest rates and
lower quantity of loanable funds demanded.
 When the government reduces national saving by running a budget deficit,
the interest rate rises and investment falls → reduce the economy’s growth
rate.
 A budget surplus increases the supply of loanable funds, reduces the interest
rate, stimulates investment → greater capital accumulation and more rapid
economic growth.
- Crowding out: a decrease in investment that results from government borrowing.
That is, when the government borrows to finance its budget deficit, it crowds out
private borrowers who are trying to finance investment.

CHAPTER 27: THE BASIC TOOLS OF FINANCE

1. Present value: Measuring the Time Value of Money
- Money today is more valuable than the same amount of money in the future
- Present value is the amount of money today needed to produce a future amount of
money, given prevailing interest rates.
- Future value is the amount of money in the future that an amount of money today
will yield, given prevailing interest rates
- Compounding is the accumulation of a sum of money in, say, a bank account,
where the interest earned remains in the account to earn additional interest in the
future
- Compute a future value from a present value:
Future value = Present value x (1+r)^N
- Compute a present value from a future value:
Present value = Future value/(1+r)^N
- According to an old rule of thumb, called the rule of 70, if some amount grows at
a rate of x percent per year, then that amount doubles in approximately 70/x years.
2. Risk aversion
- Most people are risk averse. This means more than that people dislike bad things
happening to them. It means that they dislike bad things more than they like
comparable good things
- The more wealth a person has, the less utility she gets from an additional dollar
→ diminishing marginal utility is the reason most people are risk averse
3. The market for insurance
- One way to deal with risk is to buy insurance.
- The general feature of insurance contracts is that a person facing a risk pays a fee
to an insurance company, which in return agrees to accept all or part of the risk.
- Every insurance contract is a gamble. In most years, you will pay the insurance
company the premium and get nothing in return except peace of mind.
- From the standpoint of the economy as a whole, the role of insurance is not to
eliminate the risks inherent in life but to spread them around more efficiently.
- The markets for insurance suffer from 2 types of problems that impede their
ability to spread risk
 adverse selection: A high-risk person is more likely to apply for insurance
than a low-risk person because a high-risk person would benefit more from
insurance protection.
 moral hazard: After people buy insurance, they have less incentive to be
careful about their risky behavior because the insurance company will cover
much of the resulting losses. An insurance company cannot perfectly
distinguish between high-risk and low-risk customers and it cannot monitor
all of its customers’ risky behavior. The price of insurance reflects the actual
risks that the insurance company will face after the insurance is bought. The
high price of the insurance is why some people, especially those who know
themselves to be low-risk, decide against buying it, instead, endure some of
life’s uncertainty on their own.
4. Diversification of Firm-Specific Risk
- Diversification is the reduction of risk achieved by replacing a single risk with a
large number of smaller, unrelated risks.
- Risk can be reduced by placing a large number of small bets, rather than a small
number of large ones
- Risk is measured by standard deviation. The higher the standard deviation of a
portfolio’s return, the more volatile its return is likely to be, and the riskier it is that
someone holding the portfolio will fail to get the return that she expected.
- Diversification can eliminate firm-specific risk that affects only a single company
but it cannot eliminate market risk that affects all companies in the stock market
5. Trade-off between Risk and Return
- The choice of a particular combination of risk and return depends on a person’s
risk aversion, which reflects her own preferences. But it is important for
stockholders to recognize that the higher average return that they enjoy comes at
the price of higher risk.
6. Asset Valuation
- As for most prices, supply and demand determine the price of a share of stock.
- To decide which businesses you want to own, it is natural to consider 2 things:
 value of that share of the business
 the price at which the shares are being sold
- If the price is more than the value, the stock is said to be overvalued
- If the price and the value are equal, the stock is said to be fairly valued
- If the price is less than the value, the stock is said to be undervalued → a bargain
because you pay less than the business is worth
- Fundamental analysis is the study of a company’s accounting statements and
future prospects to determine its value.
- The value of a stock to a stockholder is what she gets out of owning it, which
includes the present value of the stream of dividend payments and the final sale
price.
- Company’s profitability depends on a large number of factors:
 the demand for its product
 the amount and kinds of capital it has in place
 the degree of competition it confronts
 the extent of unionization of its workers
 the loyalty of its customers
 the government regulations
 taxes it faces
- The goal of fundamental analysis is to take all these factors into account to
determine how much a share of stock in the company is worth.
- If you want to rely on fundamental analysis to pick a stock portfolio:
  One way is to do all the necessary research yourself by reading through
companies’ annual reports
 Second way is to rely on the advice of Wall Street analysts
 Third way is to buy shares in a mutual fund, which has a manager who
conducts fundamental analysis and makes decisions for you
7. The efficient Markets Hypothesis
- The efficient markets hypothesis is the theory that asset prices reflect all publicly
available information about the value of an asset
- The stock market exhibits informational efficiency: It reflects all available
information about the value of an asset. Stock prices change when information
changes. When good news about a company’s prospects becomes public, the
company’s value and stock price both rise and contrast.
- At any moment in time, the market price is the best guess of the company’s value
based on available information
- One implication of the efficient markets hypothesis is that stock prices should
follow a random walk
- Random walk is the path of a variable whose changes are impossible to predict.
8. Market Irrationality
- Whenever the price of an asset rises above what appears to be its fundamental
value, the market is said to be experiencing a speculative bubble.
- The possibility of speculative bubbles in the stock market arises in part because
the value of the stock to a stockholder depends not only on the stream of dividend
payments but also on the final sale price.
- When evaluating a stock, you have to estimate not only the value of the business
but also what other people will think the business is worth in the future.
- Believers in market irrationality point out that the stock market often moves in
ways that are hard to explain on the basis of news that might alter a rational
valuation while believers in the efficient markets hypothesis point out that it is
impossible to know the correct.
- If the market were irrational, a rational person should be able to take advantage of
this fact and beat the market but beating the market is nearly impossible.

CHAPTER 28: UNEMPLOYMENT

- The economy’s natural rate of unemployment refers to the amount of
unemployment that the economy normally experiences
- Cyclical unemployment refers to the year-to-year fluctuations in unemployment
around its natural rate and is closely associated with the short-run fluctuations in
economic activity.
1. Identifying Unemployment
- Measuring unemployment is the job of the Bureau of Labor Statistics, which is
part of the Department of Labor.
- The BLS places each adult (age 16 and older) in each surveyed household into
one of three categories:
 Employed: includes those who worked as paid employees, worked in their
own business, worked as unpaid workers in a family member’s business,
full-time or part-time workers, those who were not working but who had
jobs from which they were temporarily absent because of vacation, illness,
bad weather.
 Unemployed: includes those who were not
employed, were Number of unemployed available for work, and had
tried to find Labor force employment during the
previous four weeks, those waiting to be
recalled to a job from which they had been laid off.
 Not in the labor force: includes those who fit neither of the first two
categories, such as full-time students, homemakers,
and retirees. Labor force
- The BLS defines the labor force as the sum of the
employed and the unemployed: Adult population
Labor force = number of employed + number of
unemployed
- The BLS defines the unemployment rate as the percentage of the labor force that
is unemployed:

Unemployment rate = x 100

- The labor-force participation rate measures the percentage of the total adult
population of the United States that is in the labor force:

Labor-force participation rate = x 100

- Natural rate of unemployment is the normal rate of unemployment around which

the unemployment rate fluctuates
- The deviation of unemployment from its natural rate is called cyclical
unemployment
- Discouraged workers who are individuals who would like to work but have given
up looking for a job do not show up in unemployment statistics, even though they
are truly prospective workers who cannot find jobs.
- Marginally attached workers are persons who currently are neither working nor
looking for work but indicate that they want and are available for a job and have
looked for work sometime in the recent past.
- Persons employed part-time for economic reasons are those who want and are
available for full-time work but have had to settle for a part-time schedule.
- Most spells of unemployment are short, but most unemployment observed at any
given time is long-term.
- The unemployment rate never falls to zero, it fluctuates around the natural rate of
unemployment
- There are explanations unemployment in the long run:
 It takes time for workers to search for the jobs that are best suited for them.
The unemployment that results from the process of matching workers and
jobs is sometimes called frictional unemployment → thought to explain
relatively short spells of unemployment.
 The number of jobs available in some labor markets may be insufficient to
give a job to everyone who wants one. This occurs when the quantity of
labor supplied exceeds the quantity demanded → structural unemployment
→ thought to explain longer spells of unemployment. This kind of
unemployment results when wages are set above the level that brings supply
and demand into equilibrium.
2. Job Search
- Job search is the process by which workers find appropriate jobs given their
tastes and skills
- Frictional unemployment is often the result of changes in the demand for labor
among different firms.
- Changes in the composition of demand among industries or regions are called
sectoral shifts because it takes time for workers to search for jobs in the new
sectors, sectoral shifts temporarily cause unemployment.
- Frictional unemployment is inevitable simply because the economy is always
changing
- If policy can reduce the time it takes unemployed workers to find new jobs, it can
reduce the economy’s natural rate of unemployment
- Government programs try to facilitate job search in various ways:
 Through government-run employment agencies, which give out information
about job vacancies
  Through public training programs, which aim to ease workers’ transition
from declining to growing industries and to help disadvantaged groups
escape poverty.
3. Unemployment Insurance
- One government program that increases the amount of frictional unemployment,
without intending to do so, is unemployment insurance.
- Benefits are paid only to the unemployed who were laid off because their
previous employers no longer needed their skills
- While unemployment insurance reduces the hardship of unemployment, it also
increases the amount of unemployment because unemployment benefits stop when
a worker takes a new job, the unemployed devote less effort to job search and are
less likely to seek guarantees of job security when they negotiate with employers
over the terms of their employment.
4. Minimum-wage Laws
- Minimum wages are not the predominant reason for unemployment in our
economy, but they have an important effect on certain groups with particularly
high unemployment rates
- When a minimum-wage law forces the wage to remain above the level that
balances supply and demand, it raises the quantity of labor supplied and reduces
the quantity of labor demanded compared to the equilibrium level → a surplus of
labor because there are more workers willing to work than there are jobs
- If the wage is kept above the equilibrium level for any reason, the result is
unemployment.
- Minimum-wage workers tend to be young, less educated, working part-time
5. Unions and Collective Bargaining
- A union is a worker association that bargains with employers over wages,
benefits, and working conditions.
- A union is a type of cartel, a union is a group of sellers acting together in the
hope of exerting their joint market power.
- The process by which unions and firms agree on the terms of employment is
called collective bargaining
- When a union bargains with a firm, it asks for higher wages, better benefits, and
better working conditions than the firm would offer in the absence of a union. If
the union and the firm do not reach an agreement, the union can organize a
withdrawal of labor from the firm, called a strike.
- When a union raises the wage above the equilibrium level, it raises the quantity
of labor supplied and reduces the quantity of labor demanded, resulting in
unemployment.
- The outsiders can respond to their status in one of two ways:
  Some of them remain unemployed and wait for the chance to become
insiders and earn the high union wage
 Others take jobs in firms that are not unionized
- This increase in labor supply, in turn, reduces wages in industries that are not
unionized → Workers in unions reap the benefits of collective bargaining while
workers not in unions bear some of the cost.
- Unions cause an inefficient and inequitable allocation of labor because high
union wages reduce employment in unionized firms below the efficient,
competitive level and some workers benefit at the expense of other workers.
- Unions are necessary to check the firm’s market power and protect the workers
from being at the mercy of the firm’s owners.
- Even if unions have the adverse effect of pushing wages above the equilibrium
level and causing unemployment, they have the benefit of helping firms keep a
happy and productive workforce.
6. Theory of Efficiency Wages
- Efficiency wages is above-equilibrium wages paid by firms to increase worker
productivity
- Minimum-wage laws and unions prevent firms from lowering wages in the
presence of a surplus of workers, efficiency wage theory states that such a
constraint on firms is unnecessary because firms may be better off keeping wages
above the equilibrium level
- Worker health: Better-paid workers eat a more nutritious diet and workers who
eat a better diet are healthier and more productive. Nutrition concerns may explain
why firms maintain above-equilibrium wages despite a surplus of labor
- Worker Turnover: The more a firm pays its workers, the less often its workers
will choose to leave. Thus, a firm can reduce turnover among its workers by
paying them high wages
- Worker Quality: when a firm pays high wages, it attracts a better pool of workers
to apply for its jobs and thereby increases the quality of its workforce.
- Worker Effort: firms monitor the efforts of their workers, and workers caught
shirking their responsibilities are fired. But because monitoring is costly and
imperfect firms cannot quickly catch all shirkers. High wages make workers more
eager to keep their jobs and motivate them to put forward their best effort .

CHAPTER 29: THE MONETARY SYSTEM

- Barter is the exchange of one good or service for another to obtain the things they
need
- In such an economy, trade is said to require the double coincidence of wants - the
unlikely occurrence that two people each have a good or service that the other
wants
1. The meaning of money
- Money is the set of assets in the economy that people regularly use to buy goods
and services from each other.
- The large share of Amazon that makes up much of Jeff Bezos’s wealth is not
considered a form of money because Mr Bezos could not buy a meal or a shirt with
this wealth without first obtaining some cash.
- Money has three functions:
 A medium of exchange is an item that buyers give to sellers when they
purchase goods and services
 A unit of account is the yardstick people use to post prices and record debts
 A store of value is an item that people can use to transfer purchasing power
from the present to the future. A person can also transfer purchasing power
from the present to the future by holding nonmonetary assets such as bonds
and stocks. The term wealth is used to refer to the total of all stores of value,
including both money and nonmonetary.
- Liquidity is the ease with which an asset can be converted into the economy’s
medium of exchange.
- Money is the most liquid asset available
- Most stocks and bonds can be sold easily with low cost, so they are relatively
liquid assets
- Selling a house, painting or baseball card requires more time and effort, so these
assets are less liquid.
- When people decide how to allocate their wealth, they have to balance the
liquidity of each possible asset against the asset’s usefulness as a store of value.
- When money takes the form of a commodity with intrinsic value, it is called
commodity money. Intrinsic value means that the item would have value even if it
were not used as money
- Gold is a commodity money
- Money without intrinsic value that is used as money by government decree is
called fiat money
- Cryptocurrencies may be the money of the future, or they may be a passing fad
- Currency is the paper bills and coins in the hands of the public, it is accepted
medium of exchange in our economy and is part of the money stock
- Demand deposits are the balances in bank accounts that depositors can access on
demand simply by writing a check or swiping a debit card at a store.
- Who is holding all this currency?
  The first explanation is that much of the currency is held abroad. In foreign
countries without a stable monetary system, people often prefer U.S. dollars
to domestic assets
 The second explanation is that much of the currency is held by drug dealers,
tax evaders, and other criminals
2. The federal reserve system
- The central bank is an institution designed to oversee the banking system and
regulate the quantity of money in the economy
- The Federal Reserve is the central bank of the United States
- The Fed has two related jobs:
 Regulate banks and ensure the health of the banking system
 Control the quantity of money that is made available in the economy, called
the money supply
- Monetary policy is the setting of the money supply by policymakers in the central
bank
- The Fed has the power to increase or decrease the number of dollars in the
economy.
- The Fed’s primary tool is the open-market operation - the purchase and sale of
US government bonds
- If the FOMC decides to increase the money supply, the Fed creates dollars and
uses them to buy government bonds from the public in the nation’s bond markets.
After purchasing, these dollars are in the hands of the public.
- If the FOMC decides to decrease the money supply, the Fed sells government
bonds from its portfolio to the public in the nation’s bond markets. After the sale,
the dollars the Fed receives for the bonds are out of the hands of the public.
3. Banks and the Money Supply
- Reserves are deposits that banks have received but have not loaned out
- All deposits are held as reserves, this system is called 100%-reserve banking
- If banks hold all deposits in reserve, banks do not influence the supply of money.
- Fractional-reserve banking is a banking system in which banks hold only a
fraction of deposits as reserves.
- Reserve ratio is the fraction of deposits that banks hold as reserves. This ratio is
influenced by both government regulation and bank policy. The Fed sets a
minimum amount of reserves that banks must hold, called a reserve requirement.
Banks may hold reserves above the legal minimum, called excess reserves → they
will not run short of cash.
- When banks hold only a fraction of deposits in reserve, the banking system
creates money.
- Money multiplier is the amount of money the banking system generates with each
dollar of reserves is called the monetary multiplier.
- The money multiplier is the reciprocal of the reserve ratio. If R is the reserve ratio
for all banks in the economy, then each dollar of reserves generates 1/R dollars of
money.
- The higher the reserve ratio, the less of each deposit banks loan out, and the
smaller the money multiplier
- In the special case of 100%-reserve banking, the reserve ratio is 1, money
multiplier is 1 and banks do not make loans or create money
- The resources that a bank obtains from issuing equity to its owners are called
bank capital
- Leverage is the use of borrowed money to supplement existing funds for
investment purposes
- Leverage ratio is the ratio of the bank’s total assets to bank capital. For example,
a leverage ratio of 20 means that for every dollar of capital that the bank owners
have contributed, the bank has $20 of assets. Of the $20 of assets, $19 are financed
with borrowed money - either by taking in deposits or issuing debt.
- When the leverage ratio is 20, a 5% fall in the value of the bank’s assets leads to
a 100% fall in bank capital.
4. The Fed’s Tools of Monetary Control
- The Fed can change the money supply by changing the quantity of reserves. The
Fed alters the quantity of reserves by two ways:
 by buying or selling bonds in open-market operations
 by making loans to banks
 Banks can borrow from the Fed when they feel they do not have
enough reserves on hand, either to satisfy bank regulators, meet
depositor withdrawals, make new loans
 Banks can borrow from the Fed’s discount window and pay an
interest rate on that loan called the discount rate. The Fed can alter the
money supply by changing the discount rate: A higher discount rate
discourages banks from borrowing from the Fed, decreasing the
quantity of reserves in the banking system and in turn the money
supply. A lower discount rate encourages banks to borrow from the
Fed, increasing the quantity of reserves and the money supply.
- In addition to influencing the quantity of reserves, the Fed changes the money
supply by influencing the reserve ratio and the money multiplier through:
 regulating the quantity of reserves banks must hold
 An increase in reserve requirements means that banks must hold more
reserves and can loan out less of each dollar that is deposited → raises
the reserve ratio, lowers the money multiplier and decreases the
money supply.
  A decrease in reserve requirements lowers the reserve ratio, raises the
money multiplier, and increases the money supply.
 the interest rate that the Fed pays banks on their reserves
 When a bank holds reserves at the Fed, the Fed now pays the bank
interest on those deposits
 The higher the interest rate on reserves, the more reserves banks will
choose to hold → an increase in the interest rate on reserves increases
the reserve ratio, lower the money multiplier and lower the money
supply.
- The Fed must wrestle with 2 problems, each of which arises because much of the
money supply is created by our system of fractional-reserve banking:
 The Fed does not control the amount of money that households choose to
hold as deposits in banks. The more money households deposit, the more
reserves banks have, the more money the banking system can create. One
day, people lose confidence in the banking system and withdraw some of
their deposits to hold more currency → the banking system loses reserves
and creates less money. The money supply falls, even without any Fed
action.
 The Fed does not control the amount that bankers choose to lend. When
money is deposited in a bank, it creates more money only when the bank
loans it out. Because the banks can hold excess reserves instead, the Fed
cannot be sure how much money the banking system will create. One day,
bankers become more cautious about economic conditions and decide to
make fewer loans and hold greater reserves → creates less money → the
money supply falls.
- In a system of fractional-reserve banking, the amount of money in the economy
depends in part on the behavior of depositors and bankers.
- The federal funds rate is the interest rate at which banks make overnight loans to
one another.
- The discount rate is the interest rate banks pay to borrow directly from the
Federal Reserve through the discount window. Borrowing reserves from another
bank in the federal funds market is an alternative to borrowing reserves from the
Fed, and a bank short of reserves will typically do whichever is cheaper.

CHAPTER 30: MONEY GROWTH AND INFLATION

- Deflation is a phenomenon that there were long periods during which most prices
fell
- An extraordinarily high rate of inflation is called hyperinflation
1. The classical theory of inflation
- The first insight about inflation is that it is more about the value of money than
about the value of goods.
- Inflation is an economy-wide phenomenon that concerns, first and foremost, the
value of the economy’s medium of exchange.
- The economy’s overall price level can be viewed in 2 ways:
 We have viewed the price level as the price of a basket of goods and
services. When the price level rises, people have to pay more for the goods
and services they buy
 We can view the price level as a measure of the value of money. A rise in
the price level means a lower value of money because each dollar in your
wallet now buys a smaller quantity of goods and services.
- When the overall price level rises, the value of money falls.
- The value of money is supply and demand. The supply and demand for money
determines the value of money.
- Money supply:
 When the Fed sells bonds in open-market operations, it receives dollars in
exchange and contracts the money supply
 When the Fed buys government bonds, it pays out dollars and expands the
money supply.
- Money demand: the demand for money reflects how much wealth people want to
hold in liquid form.
 The quantity of money demanded depends on the interest rate that a person
could earn by using the money to buy an interest-bearing bond rather than
leaving it in his wallet or low-interest checking account.
 The average level of prices in the economy is a particularly important
variable affecting the demand for money: The higher prices are, the more
money the typical transaction requires, and the more money people will
choose to hold in their wallets and checking accounts → A higher price
level, a lower value of money increases the quantity of money demanded.
- In the long run, money supply and money demand are brought into equilibrium
by the overall level of prices.
 If the price level is above the equilibrium level, people will want to hold
more money than the Fed has created → the price level must fall to balance
supply and demand.
 If the price level is below the equilibrium level, people will want to hold less
money than the Fed has created → the price level must rise to balance
supply and demand
 At the equilibrium price level, the quantity of money that people want to
hold exactly balances the quantity of money supplied by the Fed.
- The supply curve is vertical because the Fed has fixed the quantity of money
available.
- The demand curve for money slopes downward, indicating that when the value of
money is low and the price level is high, people demand a larger quantity of money
to buy goods and services.
- The effects of a monetary injection: When an increase in the money supply
makes dollars more plentiful, the result is an increase in the price level that makes
each dollar less valuable. This explanation of how the price level is determined and
why it might change over time is called the quantity theory of money. According to
the quantity theory of money, the quantity of money available in an economy
determines the value of money, and growth in the quantity of money is the primary
cause of inflation.
- The immediate effect of a monetary injection is to create an excess supply of
money. The injection of money increases the demand for goods and services while
the economy’s ability to supply goods and services has not changed → prices of
goods and services increase → the quantity of money demanded increases
- There are 2 groups of economic variables:
 Nominal variables: variables measured in monetary units. Dollar prices are
nominal variables
 Real variables: variables measured in physical units. Relative prices are real
variables.
- The separation of real and nominal variables is now called the classical
dichotomy. According to classical analysis, nominal variables are influenced by
developments in the economy’s monetary system, whereas real variables are not.
- When the central bank doubles the money supply, the price level doubles, the
dollar wage doubles, and all other dollar values double. Real variables, such as
production, employment, real wages, and real interest rates, are unchanged.
- The irrelevance of monetary changes to real variables is called monetary
neutrality.
- Velocity and the quantity equation:
 Velocity of money is the rate at which money changes hands
 To calculate the velocity of money, we divide the nominal value of output
by the quantity of money.
V = (P x Y)/M
where: P is the price level, Y is the quantity of output, M is the quantity of
money
 Quantity equation: V x M = P x Y
 An increase in the quantity of money in an economy must be reflected in one
of the other three variables:
 the price level must rise
  the quantity of output must rise
 the velocity of money must fall
- The velocity of money is relatively stable over time
- Because velocity is stable, when the central bank changes the quantity of money
(M), it causes proportionate changes in the nominal value of output (P x Y)
- The economy’s output of goods and services (Y) is determined by factor supplies
(labor, physical capital, human capital, and natural resources) and the available
production technology. In particular, since money is neutral, money does not affect
output
- Because output (Y) is fixed by factor supplies and technology, when the central
bank alters the money supply (M) and induces a proportional change in the
nominal value of output (P x Y), this change is reflected in a change in the price
level (P)
- When the central bank increases the money supply rapidly, the result is a high
rate of inflation
- Hyperinflation is defined as inflation that exceeds 50% per month.
- Inflation tax is the revenue the government raises by creating money. When the
government prints money, the price level rises, and the dollars in your wallet
become less valuable → the inflation tax is like a tax on everyone who holds
money.
- The hyperinflation ends when the government institutes fiscal reforms - such as
cuts in government spending - that eliminate the need for the inflation tax.
- The fisher effect:
 The nominal interest rate is the interest rate you hear about at your bank. The
nominal interest rate tells you how fast the number of dollars in your account
will rise over time
 The real interest rate corrects the nominal interest rate for the effect of
inflation to tell you how fast the purchasing power of your savings account
will rise over time.
Real interest rate = Nominal interest rate - Inflation rate
- When the Fed raises the rate of money growth, the long-run result is both a higher
inflation rate and a higher nominal interest rate.
- Fisher effect is the one-for-one adjustment of the nominal interest rate to the
inflation rate
2. The costs of inflation
- Inflation robs him of the purchasing power of his hard-earned dollars. When
prices rise, each dollar of income buys fewer goods and services → inflation
directly lowers living standards
- Real incomes are determined by real variables, such as physical capital, human
capital, natural resources and the available production technology.
- Nominal incomes are determined by a combination of those factors and the
overall price level.
- Because inflation erodes the real value of the money in your wallet, you can
avoid the inflation tax by holding less money. One way to do this is to go to the
bank more often.
- Shoeleather costs are the resources wasted when inflation encourages people to
reduce their money holdings. The actual cost of reducing your money holdings is
the time and convenience you must sacrifice to keep less money on hand than you
would if there were no inflation.
- Menu costs are the costs of changing prices. Menu costs include the costs of
deciding on new prices, printing new price lists and catalogs, sending these new
price lists and catalogs to dealers and customers, advertising the new prices,
dealing with customer annoyance over price changes. Inflation increases the menu
costs that firms must bear. During hyperinflation, firms must change their prices
daily or even more often just to keep up with all the other prices in the economy.
- Market economies rely on relative prices to allocate scarce resources. Consumers
decide what to buy by comparing the quality and prices of various goods and
services. Through these decisions, they determine how the scarce factors of
production are allocated among industries and firms. When inflation distorts
relative prices, consumer decisions are distorted and markets are less able to
allocate resources to their best use.
- When inflation raises the tax burden on saving, it tends to depress the economy’s
long-run growth rate. One solution is to index the tax system.
- Inflation makes investors less able to sort successful firms from unsuccessful
firms, impeding financial markets in their role of allocating the economy’s savings
among alternative types of investment.
- Unexpected inflation redistributes wealth among the population in a way that has
nothing to do with either merit or need. These redistributions occur because many
loans in the economy are specified in terms of the unit of account - money.
- If a country pursues a high-inflation monetary policy, it will have to bear not only
the costs of high expected inflation but also the arbitrary redistributions of wealth
associated with unexpected inflation
- Deflation is a symptom of deeper economic problems.

CHAPTER 31: OPEN-ECONOMY, MACROECONOMIC BASIC

CONCEPTS
1. The international flows of goods and capital
- An open economy interacts with other economies in 2 ways:
 It buys and sells goods and services in world product markets
  It buys and sells capital assets such as stocks and bonds in world financial
markets.
- The flow of goods: exports, imports, and net exports:
 Exports are goods and services that are produced domestically and sold
abroad
 Imports are goods and services that are produced abroad and sold
domestically
 Net exports are the difference between the value of its exports and the value
of its imports. Net exports are also trade balance:
Net exports = Value of country’s exports - value of country’s imports
 Trade surplus is an excess of exports over imports, indicating that the
country sells more goods and services than it buys from other countries
 Trade deficit is an excess of imports over exports, indicating that the country
sells fewer goods and services than it buys from other countries
 Balanced trade is a situation in which imports equal exports
- Factors that might influence a country’s exports, imports, and net exports:
 Consumer tastes for domestic and foreign goods
 The prices of goods at home and abroad
 The exchange rates at which people can use domestic currency to buy
foreign currencies
 The incomes of consumers at home and abroad
 The cost of transporting goods from country to country
 Government policies toward international trade
- The flow of financial resources: Net capital outflow:
 Net capital outflow is the purchase of foreign assets by domestic residents
minus the purchase of domestic assets by foreigners:
Net capital outflow = Purchase of foreign assets by domestic residents
- Purchase of domestic assets by foreigners
- The flow of capital between the U.S economy and the rest of the world takes two
forms:
 Foreign direct investment: McDonald’s opening up a fast-food outlet in
Russia
 Foreign portfolio investment: an American buying stock in a Russian
corporation.
- The net capital outflow is called net foreign investment.
 When it is positive, domestic residents are buying more foreign assets than
foreigners are buying domestic assets, capital is said to be flowing out of the
country
  When it is negative, domestic residents are buying fewer foreign assets than
foreigners are buying domestic assets, capital is said to be flowing into the
country.
- There are some important variables that influence net capital outflow:
 The real interest rates paid on foreign assets
 The real interest rates paid on domestic assets
 The perceived economic and political risks of holding assets abroad
 The government policies that affect foreign ownership of domestic assets
- For an economy as a whole, net capital outflow (NCO) must always equal net
exports (NX): NCO = NX
- National saving is the income of the nation that is left after paying for current
consumption and government purchases:
Y - C - G = I + NX
S = I + NX
S = I + NCO
- When a US citizen saves a dollar of her income for the future, that dollar can be
used to finance the accumulation of domestic capital or it can be used to finance
the purchase of foreign capital.
- An open economy has two uses for its saving: domestic investment and net
capital outflow.
- When a nation’s savings exceeds its domestic investment, its net capital outflow
is positive, indicating that the nation is using some of its savings to buy assets
abroad.
- When a nation’s domestic investment exceeds its savings, its net capital outflow
is negative, indicating that foreigners are financing some of this investment by
purchasing domestic assets.
Trade Deficit Balanced Trade Trade Surplus
Exports < Imports Exports = Imports Exports > Imports
Net Exports < 0 Net Exports = 0 Net Exports > 0
Y<C+I+G Y=C+I+G Y>C+I+G
Saving < Investment Saving = Investment Saving > Investment
Net Capital Outflow < 0 Net Capital Outflow = 0 Net Capital Outflow > 0
- There are three prominent historical episodes:
 Unbalanced fiscal policy: These budget deficits arose because President
Ronald Reagan cut taxes and increased defense spending without being able
to enact his proposed cuts in nondefense spending
 An investment boom: Saving increased over this time, as the government’s
budget switched from deficit to surplus. But the investment increased as the
 economy Nominal exchange rate x Domestic price enjoyed a
boom in information
technology and Foreign price many firms
were eager to make these
high-tech investments.
 An economic downturn and recovery: Investment fell because tough
economic times made capital accumulation less profitable, while national
saving fell because the government began running extraordinarily large
budget deficits in response to the downturn. After that, as the economy
recovered, these forces reversed themselves, and both saving and investment
increased.
2. The prices for international transactions: Real and Nominal Exchange
Rates
- The nominal exchange rate is the rate at which a person can trade the currency of
one country for the currency of another.
- We always express the nominal exchange rate as units of foreign currency per US
dollar
- If the exchange rate changes so that a dollar buys more foreign currency, that
change is called an appreciation of the dollar.
- If the exchange rate changes so that a dollar buys less foreign currency, that
change is called depreciation of the dollar.
- The dollar is either “strong” or “weak”, which refers to recent changes in the
nominal exchange rate. When a currency appreciates, it is said to strengthen
because it can then buy more foreign currency. When a currency depreciates, it is
said to weaken.
- The real exchange rate is the rate at which a person can trade the goods and
services of one country for the goods and services of another.
- This calculation for the real exchange rate with the following formula:

Real exchange rate =

→ The real exchange rate depends on the nominal exchange rate and on the prices
of goods in the two countries measủed in the local currencies.
- A depreciation in the US real exchange rate means that US goods have become
cheaper relative to foreign goods. This change encourages consumers both at home
and abroad to buy more US goods and fewer goods from other countries → US
exports rise and US imports fall → raise net exports
- An appreciation in the US real exchange rate means that US goods have become
more expensive compared to foreign goods → US net exports fall.
3. A first theory of exchange-rate Determination: Purchasing-power parity
- Purchasing-power parity is a theory of exchange rates whereby a unit of any
given currency should be able to buy the same quantity of goods in all countries.
- Purchasing-power parity describes the forces that determine exchange rates in the
long run.
- The theory of purchasing-power parity is based on a principle called the law of
one price. This law asserts that a good must sell for the same price in all locations.
- The process of taking advantage of price differences for the same item in
different markets is called arbitrage.
- If a dollar could buy more coffee in the US than in Japan, international traders
could profit by buying coffee in the US and selling it in Japan. This export of
coffee from the US to Japan would drive up the US price of coffee and drive down
the Japanese price.
- The nominal exchange rate between the currencies of 2 countries depends on the
price levels in those countries
- If the purchasing power of the dollar is always the same at home and abroad, then
the real exchange rate - the relative price of domestic and foreign goods - cannot
change
- The nominal exchange rate equals the ratio of the foreign price level to the
domestic price level: e = P*/P
- Nominal exchange rates change when price levels change. When a central bank
in any country increases the money supply and causes the price level to rise, it also
causes that country’s currency to depreciate relative to other currencies in the
world.
- Purchasing-power parity provides a simple model of how exchange rates are
determined. There are 2 reasons the theory of purchasing-power parity does not
always hold in practice:
 Many goods are not easily traded.
 Even tradable goods are not always perfect substitutes when they are
produced in different countries.
- As the real exchange rate drifts from the level predicted by purchasing-power
parity, people have greater incentive to move goods across national borders.

CHAPTER 32: A MACROECONOMIC THEORY OF THE OPEN

ECONOMY
1. Supply and Demand for Loanable Funds and for Foreign-currency
Exchange
* To understand the forces at work in an open economy, we focus on supply and
demand in 2 markets:
- The market for loanable funds, which coordinates the economy’s saving,
investment and the net capital outflow. In this market, there is one interest rate,
which is both the return to saving and the cost of borrowing.
S = I + NCO
 The two sides of this identity represent the two sides of the market for
loanable funds. The supply of loanable funds comes from national saving
(S), and the demand for loanable funds comes from domestic investment (I)
and net capital outflow (NCO)
 When NCO > 0, the country is experiencing a net outflow of capital,
the net purchase of capital overseas adds to the demand for
domestically generated loanable funds
 When NCO < 0, the country is experiencing a net inflow of capital,
the capital resources coming from abroad reduce the demand for
domestically generated loanable funds
 A higher real interest rate means a higher return to saving, which encourages
people to save and therefore raises the quantity of loanable funds supplied. A
higher interest rate also means a higher cost of borrowing to finance capital
projects, which discourages investment and reduces the quantity of loanable
funds demanded.
 In addition to influencing national saving and domestic investment, a
country’s real interest rate affects its net capital outflow. When the US real
interest rate rises, the US bond becomes more attractive to both mutual funds
→ an increase in the US real interest rate discourages Americans from
buying foreign assets and encourages foreigners to buy US assets → a rise in
the US real interest rate reduces US net capital outflow.
 In an open economy, the demand for loanable funds comes not only from
those who want loanable funds to buy domestic capital goods but also from
those who want loanable funds to buy foreign goods.
- The market for foreign-currency exchange, which coordinates people who want
to exchange the domestic currency for the currency of other countries.
 When the US economy is running a trade surplus (NX > 0), foreigners are
buying more US goods and services than Americans are buying foreign
goods and services. They must be buying foreign assets, so US capital is
flowing abroad (NCO < 0)
 If the US is running a trade deficit (NX < 0), Americans are spending more
on foreign goods and services than they are earning from selling goods and
services abroad. Some of this spending must be financed by selling
American assets abroad, so foreign capital is flowing into the US (NCO < 0)
  When the US real exchange rate appreciates, US goods become more
expensive relative to foreign goods, making US goods less attractive to
customers both at home and abroad → exports from US fall, and imports
into the US rise → net exports fall → An appreciation of the real exchange
rate reduces the quantity of dollars demanded in the market for foreign-
currency exchange.
 The supply curve is vertical because the quantity of dollars supplied for net
capital outflow does not depend on the real exchange rate. Because changes
in the exchange rate influence both the cost of buying foreign assets and the
benefit of owning them → 2 effects offset each other.
2. Equilibrium in the Open Economy
- Net capital outflow: the link between the Two markets:
 In the market for loanable funds, supply comes from national savings (S),
demand comes from domestic investment (I) and net capital outflow (NCO)
and the real interest rate balances supply and demand.
 In the market for foreign-currency exchange, supply comes from net capital
outflow (NCO), demand comes from net exports (NX), and the real
exchange rate balances supply and demand.
 Net capital outflow is the variable that links between these two markets. In
the market for loanable funds, net capital outflow is a component of demand.
In the market for foreign-currency exchange, net capital outflow is the
source of supply.
3. How Policies and Events Affect an Open Economy
- Government Budget Deficits: represents negative public saving, it reduces
national saving → a government deficit reduces the supply of loanable funds,
drives up the interest rate, and crowds out investment
 In an open economy, the reduced supply of loanable funds has additional
effects. When budget deficits raise interest rates, both domestic and foreign
behavior cause US net capital outflow to fall.
 Net capital outflow is reduced, Americans need less foreign currency to buy
foreign assets and supply fewer dollars in the market for foreign-currency
exchange → supply curve shifts to the left. In an open economy, government
budget deficits raise real interest rates, crowd out domestic investment,
cause the currency to appreciate, and push the rate balance toward deficit
- Trade Policy: is government policy that directly influences the quantity of goods
and services that a country imports or exports.
 One common trade policy is a tariff, a tax on imported goods. Another is an
import quota, a limit on the quantity of a good produced abroad that can be
sold domestically.
  The initial impact of the import restriction is on imports. Net exports are the
source of demand for dollars in the market for foreign-currency exchange →
the policy affects the demand curve in this market.
 Foreigners need dollars to buy US net exports, the rise in net exports
increases the demand for dollars in the market for foreign-currency
exchange
 When the dollar appreciates in the market for foreign-currency exchange,
domestic goods become more expensive relative to foreign goods →
encourages imports and discourages exports, and both of these changes
offset the direct increase in net exports due to the import quota.
→ Trade policies do not affect the trade balance but these policies do affect
specific firms, industries, and countries.
4. Political Instability and Capital Flight
- Capital flight is a large and sudden reduction in the demand for assets located in a
country
 It affects the net capital outflow curve → the supply of pesos in the market
for foreign-currency exchange shifts.
 The demand for loanable funds comes from both domestic investment and
net capital outflow, capital flights affects the demand curve in the market for
loanable funds
 An increase in net capital outflow increases the demand for loanable funds
which increases the interest rate. At the same time, the increase in net capital
outflow increases the supply of pesos which causes the peso to depreciate.
 The depreciation of the currency makes exports cheaper and imports more
expensive, pushing the trade balance toward surplus. At the same time, the
increase in the interest rate reduces domestic investment, showing capital
accumulation and economic growth.

CHAPTER 33: AGGREGATE DEMAND AND AGGREGATE SUPPLY

- The business cycle:
 expansion: real GDP increases → Quantity increases
 recession: real GDP decreases → Quantity decreases
 depression: real GDP decreases remarkably → Quantity decreases
remarkably
 recovery: real GDP increases → Quantity increases
- Recession: a period of declining real incomes and rising unemployment
- Depression: a severe recession
1. Three key facts about Economic Fluctuations
- Fact 1: Economic Fluctuations Are Irregular and Unpredictable
 Fluctuations in the economy are often called the business cycle.
  Recessions do not come at regular intervals: Sometimes recessions are close
together, sometimes the economy goes many years without a recession.
- Fact 2: Most Macroeconomic Quantities Fluctuate Together
 When real GDP falls in a recession, so do personal income, corporate
profits, consumer spending, investment spending, industrial production,
retail sales, home sales, auto sales, and so on.
 When the economy contracts, much of the contraction is due to reduced
spending on new factories, housing, and inventories.
- Fact 3: As output falls, unemployment rises
 Changes in the economy’s output of goods and services are strongly
correlated with changes in the economy’s utilization of its labor force.
 When real GDP declines, the rate of unemployment rises. Because when
firms choose to produce a smaller quantity of goods and services, they lay
off workers, expanding the pool of unemployed.
 When the recession ends and real GDP starts to expand, the unemployment
rate gradually declines.
 The unemployment rate often fluctuates around its natural rate of about 5%
2. Explaining Short-run Economic Fluctuations
- The Assumptions of Classical Economics:
 All of these previous assumptions are based on 2 related ideas: the classical
dichotomy (real and nominal) and monetary neutrality.
 Changes in the money supply affect nominal variables but not real variables.
- The reality of short-run fluctuations:
 Most economists believe that classical theory describes the world in the long
run but not in the short run
- The model of Aggregate demand and Aggregate Supply:
 The model of aggregate demand and aggregate supply is the model that most
economists use to explain short-run fluctuations in economic activity around
its long-run trend.
 Our model of short-run economic fluctuations focuses on the behavior of
two variables: the economy’s output of goods and services (measured by real
GDP), the average level of prices (measured by the CPI or the GDP deflator)
 The aggregate-demand curve is a curve that shows the quantity of goods and
services that households, firms, the government, and customers abroad want
to buy at each price level
 The aggregate-supply curve is a curve that shows the quantity of goods and
services that firms choose to produce and sell at each price level.
3. The aggregate-demand curve
- Other things being equal, a decrease in the economy’s overall level of prices
raises the quantity of goods and services demanded. An increase in the price level
reduces the quantity of goods and services demanded. There are 3 reasons that the
aggregate-demand curve downslope:
- The Price Level and Consumption: The Wealth Effect
 A decrease in the price level raises the real value of money and makes
consumers wealthier, thereby encouraging them to spend more. The increase
in consumer spending means a larger quantity of goods and services
demanded. Conversely, an increase in the price level reduces the real value
of money and makes consumers poorer, thereby reducing consumer
spending and the quantity of goods and services demanded.
- The Price Level and Investment: the interest-rate Effect
 The price level is one determinant of the quantity of money demanded.
When the price level is lower, households do not need to hold as much
money to buy the goods and services they want → reduce their holdings of
money by lending some of it out → convert some of their money into
interest-bearing assets, they drive down interest rates.
 A lower price level reduces the interest rate, encourages greater spending on
investment goods, and increases the quantity of goods and services
demanded. A higher price level raises the interest rate, discourages
investment spending, and decreases the quantity of goods and services
demanded.
- The Price Level and Net Exports: The exchange-rate effect
 When a fall in the US price level causes US interest rates to fall, the real
value of the dollar declines in foreign exchange markets. This depreciation
stimulates US net exports and increases the quantity of goods and services
demanded. Conversely, when the US price level rises and causes US interest
rates to rise, the real value of the dollar increases, and this appreciation
reduces US net exports and the quantity of goods and services demanded
- There are three distinct but related reasons a fall in the price level increases the
quantity of goods and services demanded:
 Consumers become wealthier, stimulating the demand for consumption
goods
 Interest rates fall stimulating the demand for investment goods
 The currency depreciates, stimulating the demand for net exports
- The reasons the aggregate-demand curve might shift:
 Shifts arising from changes in consumption:
 Americans become more concerned about saving for retirement and
reduce their current consumption → the aggregate-demand curve
shifts to the left.
 A stock market boom makes people wealthier and less concerned
about saving → an increase in consumer spending means a greater
 quantity of goods and services demanded at any given price level →
the aggregate demand curve shifts to the right.
 One policy variable that has this effect is the level of taxation. When
the government cuts taxes, it encourages people to spend more, so the
aggregate-demand curve shifts to the right. When the government
raises taxes, people cut back on their spending and the aggregate-
demand curve shifts to the left.
 Shifts arising from changes in investment:
 The computer industry introduces a faster line of computers and many
firms decide to invest in new computer systems. The quantity of
goods and services demanded at any price level is now higher, the
aggregate-demand curve shifts to the right. Conversely, if firms
become pessimistic about future business conditions, they may cut
back on investment spending, shifting the aggregate demand curve to
the left.
 Tax policy influences aggregate demand through investment. An
investment tax credit increases the quantity of investment goods that
firms demand at any given interest rate and shifts the aggregate
demand curve to the right. The repeal of an investment tax credit
reduces investment and shifts the aggregate demand curve to the left
 The money supply influences investment and aggregate demand
curve. An increase in the money supply lowers the interest rate in the
short run → a decrease in the interest rate makes borrowing less
costly, stimulating investment spending and thereby shifting the
aggregate-demand curve to the right. A decrease in the money supply
raises the interest rate, discourages investment spending, and thereby
shifts the aggregate-demand curve to the left.
 Shifts arising from changes in Government Purchases: the most direct way
 Congress decides to reduce purchases of new weapons systems.
Because the quantity of goods and services demanded at any price
level is lower, the aggregate-demand curve shifts to the left.
Conversely, if state governments start building more highways, the
result is a greater quantity of goods and services demanded at any
price level, the aggregate-demand curve shifts to the right.
 Shifts arising from changes in net exports:
 When Europe experiences a recession, it buys fewer goods from the
US. US net exports decline at every price level, shifting the aggregate
demand curve for the US economy to the left. When Europe recovers
from its recession, it buys more US goods and the aggregate-demand
curve shifts to the right.
 4. The aggregate-supply curve
- In the long run, the aggregate-supply curve is vertical, whereas in the short run,
the aggregate supply curve slopes upward.
- The aggregate supply curve is vertical in the long run because:
 In the long run, an economy’s production of goods and services (its real
GDP) depends on its supplies of labor, capital, and natural resources and on
the available technology used to turn these factors of production into goods
and services
 Price level does not affect the long-run determinants of real GDP, the long-
run aggregate supply curve is vertical
 The vertical long-run aggregate supply curve is a graphical representation of
the classical dichotomy and monetary neutrality.
- The long-run aggregate supply curve might shift because:
 The long-run level of production is sometimes called potential output of full-
employment output. To be more precise, we call it the natural level of output
because it shows what the economy produces when unemployment is at its
natural, or normal, rate. The natural level of output is the production of
goods and services that an economy achieves in the long run when
unemployment is at its normal rate
 Shifts arising from changes in labor:
 Increased immigration results in a greater number of workers, the
quantity of goods and services supplied would increase → the long-
run aggregate supply curve shifts to the right. If many workers left the
economy to go abroad, the long-run aggregate-supply curve would
shift to the left.
 The position of the long-run aggregate supply curve also depends on
the natural rate of unemployment shifts the long-run aggregate-supply
curve.
 Shifts arising from changes in capital:
 An increase in the economy’s capital stock increases productivity and
increases the quantity of goods and services supplied → the long-run
aggregate supply curve shifts to the right.
 A decrease in the economy’s capital stock decreases productivity and
the quantity of goods and services supplied → shifting the long run
aggregate supply curve to the left.
 Shifts arising from changes in natural resources:
 An economy’s production depends on its natural resources, including
its land, minerals, and weather.
 The discovery of a new mineral deposit shifts the long-run aggregate-
supply curve to the right
  A change in weather patterns that makes farming more difficult shifts
the long-run aggregate-supply curve to the left.
 Shifts arising from changes in technological knowledge:
 The most important reason that the economy today produces more
than it did a generation ago is that our technological knowledge has
advanced.
 The invention of the computer has allowed us to produce more goods
and services → shifting the long-run aggregate-supply curve to the
right.
 If the government passes new regulations preventing firms from using
some production methods, to address worker safety or environment
concerns, the result is a leftward shift in the long-run aggregate-
supply curve.
- Using Aggregate Demand and Aggregate Supply to Depict Long-run Growth and
Inflation:
 The most important forces in practice are technology and monetary policy.
Technological progress enhances an economy’s ability to produce goods and
services, and the resulting increases in output are reflected in continual shifts
of the long-run aggregate supply curve to the right.
 The short-run fluctuations in output and the price level that we will be
studying should be viewed as deviations from the long-run trends of output
growth and inflation.
- The aggregate-supply curve slopes upward in the short run because:
 The sticky-wage theory: nominal wages are slow to adjust to changing
economic conditions.
 Wages are “sticky” in the short run. To some extent, the slow
adjustment of nominal wages is attributable to long-term contracts
between workers and firms that fix nominal wages. This prolonged
adjustment may be attributable to slowly changing social norms and
notions of fairness that influence wage setting.
 According to the sticky-wage theory, the short-run aggregate-supply
curve slopes upward because nominal wages are based on expected
prices and do not respond immediately when the actual price level
turns out to be different from what was expected.
 This stickiness of wages gives firms an incentive to produce less
output when the price level turns out lower than expected and to
produce more when the price level turns out higher than expected.
 The sticky-price theory: emphasizes that the prices of some goods and
services also adjust sluggishly in response to changing economic
conditions.
  This slow adjustment of prices occurs in part because there are costs
to adjusting prices, called menu costs → prices as well as wages may
be sticky in the short run.
 When the money supply and price level turn out to be above what
firms expected when they originally set their prices. While some firms
raise their prices quickly in response to the new economic
environment, other firms lag behind, keeping their prices at the lower-
than-desired levels. These low prices attract customers, including
these firms to increase employment and production. During this time
these lagging firms are operating with outdated prices, there is a
positive association between the overall price level and the quantity of
output. This positive association is represented by the upward slope of
the short-run aggregate-supply curve.
 The misperceptions theory: Changes in the overall price level can
temporarily mislead suppliers about what is happening in the individual
markets in which they sell their output.
 A lower price level causes misperceptions about relative prices, and
these misperceptions induce suppliers to respond to the lower price
level by decreasing the quantity of goods and services supplied.
 Misperceptions arise when the price level is above what was expected.
Suppliers of goods and services may notice the price of their output
rising and infer, mistakenly, that their relative prices are rising. They
would produce more.
Quantity of output supplied = Natural level of output + a(Actual price level -
Expected price level)
whereby: a is a number that determines how much output responds to
unexpected changes in the price level.
- The short-run aggregate-supply curve might shift because of changes in labor,
capital, natural resources, or technological knowledge and the price level that
people expected to prevail → when people change their expectations of the price
level, the short-run aggregate supply curve shifts.
 When the expected price level rises, wages are higher, costs increase, and
firms produce a smaller quantity of goods and services at any given actual
price level → shifts the short-run aggregate supply curve to the left
 A decrease in the expected price level raises the quantity of goods and
services supplied and shifts the short-run aggregate supply curve to the
right.
- Two causes of Economic Fluctuations: shifts in aggregate demand and shifts in
aggregate supply. When an economy is in its long-run equilibrium, the expected
price level must equal the actual price level so that the intersection of aggregate
demand with short-run aggregate supply is the same as the intersection of
aggregate demand with long-run aggregate supply.
 The effects of a shift in aggregate demand: The pessimism that caused the
shift in aggregate demand is self-fulfilling: Pessimism about the future leads
to falling incomes and rising unemployment.
 In the short run, shifts in aggregate demand cause fluctuations in the
economy’s output of goods and services
 In the long run, shifts in aggregate demand affect the overall price
level but do not affect output
 Because policymakers influence aggregate demand, they can
potentially mitigate the severity of economic fluctuations.
 The effects of a shift in aggregate supply:
 Stagflation is a period of falling output and rising prices.
 This phenomenon of higher prices leading to higher wages, in turn
leading to even higher prices, is sometimes called a wage-price spiral.
 Shifts in aggregate supply can cause stagflation - a combination of
recession (falling output) and inflation (rising prices)
 Policymakers who can influence aggregate demand can mitigate the
adverse impact on output but only at the cost of exacerbating the
problem of inflation.

CHAPTER 34: THE INFLUENCE OF MONETARY AND FISCAL POLICY

ON AGGREGATE DEMAND
1. How monetary policy influences aggregate demand
- Because money holdings are a small part of household wealth, the wealth effect is
the least important of the three.
- Because exports and imports represent only a small fraction of US GDP, the
exchange-rate effect is not large for the US economy. This effect is more important
for smaller countries, which typically export and import a higher fraction of their
GDP.
- For the US economy, the most important reason for the downward slope of the
aggregate-demand curve is the interest-rate effect
- Theory of liquidity preference is Keynes’s theory that the interest rate adjusts to
bring money supply and money demand into balance
 When borrowers and lenders expect prices to rise over the term of the loan,
they agree to a nominal interest rate that exceeds the real interest rate by the
expected rate of inflation. The higher nominal interest rate compensates for
the fact that they expect the loan to be repaid in less valuable dollars.
 When the nominal interest rate rises or falls, the real interest rate that people
expect to earn rises or falls by the same amount.
  Money supply: The Fed alters the money supply primarily by changing the
quantity of reserves in the banking system through the purchase and sale of
government bonds in open-market operations.
 When the Fed buys government bonds, the dollars it pays for the
bonds are typically deposited in banks, and these dollars it receives for
the bonds are added to bank reserves.
 When the Fed sells government bonds, the dollars it receives for the
bonds are withdrawn from the banking system, and bank reserves
fall.
 Because the quantity of money supplied is fixed by Fed policy, it does
not depend on other economic variables. In particular, it does not
depend on the interest rate
 Money demand: People choose to hold money instead of other assets that
offer higher rates of return so they can use the money to buy goods and
services.
 When you hold wealth as cash in your wallet, rather than as an
interest-bearing bond or in an interest-bearing bank account, you lose
the interest you could have earned.
 An increase in the interest rate raises the cost of holding money and,
as a result, reduces the quantity of money demanded. A decrease in
the interest rate reduces the cost of holding money and raises the
quantity demanded.
 Equilibrium in the Money Market: there is one interest rate, called the
equilibrium interest rate, at which the quantity of money demanded exactly
balances the quantity of money supplied.
 As the interest rate falls, people become more willing to hold money
until, at the equilibrium interest rate, people are happy to hold exactly
the amount of money the Fed has supplied.
 At interest rates below the equilibrium level, the quantity of money
that people want to hold exceeds the quantity of money that the Fed
has supplied → people try to increase their holdings of money by
reducing their holdings of bonds and other interest-bearing assets. As
people cut back on their holdings of bonds, bond issuers find that they
have to offer higher interest rates to attract buyers → the interest rate
rises until it reaches the equilibrium level.
- The interest-rate effect can be summarized in three steps:
 A higher price level raises money demand.
 Higher money demand leads to a higher interest rate.
 A higher interest rate reduces the quantity of goods and services demanded
- Changes in the money supply: One important variable that shifts the aggregate-
demand curve is monetary policy.
 When the Fed increases the money supply, it lowers the interest rate and
increases the quantity of goods and services demanded for any given price
level, shifting the aggregate-demand curve to the right
 When the Fed contracts the money supply, it raises the interest rate and
reduces the quantity of goods and services demanded for any given price
level, shifting the aggregate-demand curve to the left.
- The role of interest-rate targets in Fed policy: The Fed now conducts policy by
setting a target for the federal funds rate - the interest rate that banks charge one
another for short-term loans. There are some reasons for that:
 One is that the money supply is hard to measure with sufficient precision.
 Another is that the money demand fluctuates over time. For any given
money supply, fluctuations in money demand lead to fluctuations in interest
rates, aggregate demand, and output.
 Changes in monetary policy aimed at expanding aggregate demand can be
described either as increasing the money supply or as lowering the interest
rate.
 Changes in monetary policy aimed at contracting aggregate demand can be
described either as decreasing the money supply or as raising the interest
rate.
- According to the theory of liquidity preference, expansionary monetary policy
works by reducing interest rates and stimulating investment spending. But if
interest rates have already fallen to around zero, monetary policy may no longer be
effective.
- Nominal interest rates cannot fall much below zero: Rather than making a loan at
a negative nominal interest rate, a person would just hold cash. In this
environment, expansionary monetary policy raises the supply of money, making
the public’s asset portfolio more liquid, but because interest rates cannot fall any
further, the extra liquidity might not have any effect.
 To have the central bank commit itself to keeping interest rates low for an
extended period of time. Such a policy is sometimes called forward
guidance
 To have the central bank conduct expansionary open-market operations
using a larger variety of financial instruments. It could also buy mortgage-
backed securities and longer-term government bonds to lower the interest
rates on these kinds of loans. This type of unconventional monetary policy is
sometimes called quantitative easing because it increases the quantity of
bank reserves.
2. Fiscal policy influences aggregate demand
- Fiscal policy is the setting of the levels of government spending and taxation by
government policymakers
- There are two macroeconomic effects that cause the size of the shift in aggregate
demand to differ from the change in government purchases.
 The first is the multiplier effect - suggests the shift in aggregate demand
could be larger than $20 billion.
 The second is the crowding-out effect - suggests the shift in aggregate
demand could be smaller than $20 billion
- The multiplier effect: is the additional shifts in aggregate demand that result when
expansionary fiscal policy increases income and thereby increases consumer
spending
 When consumer spending rises, the firms that produce these consumer goods
hire more people and experience higher profits. Higher earnings and profits
stimulate consumer spending once again and so on. Once all these effects are
added together, the total impact on the quantity of goods and services
demanded can be much larger than the initial boost from higher government
spending.
 This multiplier effect arising from the response of consumer spending can be
strengthened by the response of investment to higher levels of demand.
Higher government demand spurs higher demand for investment goods. This
positive feedback from demand to investment is sometimes called the
investment accelerator.
- A formula for the spending multiplier:
 The marginal propensity to consume (MPC) is the fraction of extra income
that a household consumes rather than saves.
 To determine the total impact on the demand for goods and services:
Multiplier = 1/(1 - MPC)
 The size of the multiplier depends on the marginal propensity to consume.
 A higher MPC means a larger multiplier. The multiplier arises because
higher income induces greater consumer spending. The higher the MPC, the
more consumption responds to a change in income, and the larger the
multiplier.
- The Crowding-out Effect: is the offset in aggregate demand that results when
expansionary fiscal policy raises the interest rate and thereby reduces investment
spending.
 While an increase in government purchases stimulates the aggregate demand
for goods and services, it also causes the interest rate to rise, reducing
investment spending and putting downward pressure on aggregate demand.
  When the government increases its purchases by $20 billion, the aggregate
demand for goods and services could rise by more or less than $20 billion
depending on the sizes of the multiplier and crowding-out effects.
- Changes in taxes:
 When the government cuts personal income taxes, it increases households’
take-home pay. Households will save some of this additional income but
they will spend some of it on consumer goods. Because it increases
consumer spending, the tax cut shifts the aggregate-demand curve to the
right.
 When the government cuts taxes and stimulates consumer spending,
earnings and profits rise, further stimulating consumer spending →
multiplier effect
 The increase in income raises money demand, increasing interest rates → a
higher cost of borrowing → reduces investment spending → crowding-out
effect.
 Another important determinant of the size of the shift in aggregate demand
that results from a tax change: households’ perceptions about whether the
tax change is permanent or temporary
3. Using Policy to stabilize the economy
- The case for active stabilization policy: The Employment Act has two
implications:
 The government should avoid being a cause of economic fluctuations, such
as large and sudden changes in monetary and fiscal policy. When large
changes do occur, it is important that monetary and fiscal policymakers be
aware of and respond to each others’ actions.
 The government should respond to changes in the private economy to
stabilize aggregate-demand. The government should actively stimulate
aggregate-demand when aggregate demand appears insufficient to maintain
production at its full-employment level
 When people are excessively pessimistic, the Fed can expand the money
supply to lower interest rates and expand aggregate demand.
 When people are excessively optimistic, it can contract the money supply to
raise interest rates and dampen aggregate demand
- The case against active stabilization policy:
 Fiscal policy also works with a lag, but unlike the lag in monetary policy,
the lag in fiscal policy is largely attributable to the political process.
 These lags in monetary and fiscal policy are a problem in part because
economic forecasting is so imprecise. If forecasters could accurately predict
the condition of the economy a year in advance, then monetary and fiscal
policymakers could look ahead when making policy decisions.
  The best that policymakers can do is to respond to economic changes as they
occur.
- Automatic Stabilizers: are changes in fiscal policy that stimulate aggregate
demand when the economy goes into a recession but that occur without
policymakers having to take any deliberate action
 The most important automatic stabilizer is the tax system. When the
economy goes into a recession, the amount of taxes collected by the
government falls automatically because almost all taxes are closely tied to
economic activity. The automatic tax cut stimulates aggregate demand and
reduces the magnitude of economic fluctuations.
 When the economy goes into a recession and workers are laid off, more
people become eligible for unemployment insurance benefits, welfare
benefits, and other forms of income support → taxes fall, government
spending rises, and the government’s budget moves toward deficit.
- Policymakers face only a temporary trade-off between inflation and
unemployment. In the long run, expanding aggregate demand more rapidly will
yield higher inflation without any reduction in unemployment.
- The natural-rate hypothesis is the claim that unemployment eventually returns to
its normal, or natural, rate, regardless of the rate of inflation.

CHAPTER 35: THE SHORT-RUN TRADE-OFF BETWEEN INFLATION

AND UNEMPLOYMENT
1. The Phillips Curve
- The Phillips Curve is the short-run relationship between inflation and
unemployment
- Phillips showed a negative correlation between the rate of unemployment and the
rate of inflation.
- This correlation arose because low unemployment was associated with high
aggregate demand, which in turn put upward pressure on wages and prices
throughout the economy.
- The Phillips curve shows the combination of inflation and unemployment that
arise in the short run as shifts in the aggregate-demand curve move the economy
along the short-run aggregate-supply curve
- In the short run, an increase in the aggregate demand for goods and services leads
to a larger output of goods and services and a higher price level
 Larger output means greater employment → a lower rate of unemployment
 A higher price level translates into a higher rate of inflation.
- Because monetary and fiscal policy can shift the aggregate-demand curve, they
can move an economy along the Phillips curve.
  Increases in the money supply, increases in government spending, or cuts in
taxes expand aggregate demand and move the economy to a point on the
Phillips curve with higher inflation and lower unemployment.
 Decreases in the money supply, cuts in government spending, or increases in
taxes contract aggregate demand and move the economy to a point on the
Phillips curve with lower inflation and higher unemployment.
2. Shifts in the Phillips Curve: The role of expectations
- The long-run Phillips Curve: The vertical long-run Phillips curve illustrates that
unemployment does not depend on money growth and inflation in the long run.
When the Fed increases the growth rate of the money supply, the rate of inflation
increases but unemployment remains at its natural rate in the long run.
- The reconciling theory: A negative relationship between inflation and
unemployment exists in the short run but that it cannot be used by policymakers as
a menu of outcomes in the long run. Policymakers can pursue expansionary
monetary policy to achieve lower unemployment for a while, but eventually,
unemployment will return to its natural rate. In the long run, more expansionary
monetary policy leads only to higher inflation.
 The aggregate-supply curve slopes upward only in the short run, the trade-
off between inflation and unemployment holds only in the short run. As the
long-run aggregate supply curve is vertical, the long-run Phillips curve is
also vertical. Once again, expectations are the key to understanding how the
short run and the long run are related.
 Expected inflation measures how much people expect the overall price level
to change. Because the expected price level affects nominal wages, expected
inflation is one factor that determines the position of the short-run aggregate
supply curve.
3. Shifts in the Phillips Curve: The role of Supply Shocks
- Supply shock is an event that directly alters firms’ costs and prices, shifting the
economy’s aggregate-supply curve and thus the Phillips curve
- Firms need fewer workers to produce the smaller output, employment falls and
unemployment rises. The price level is higher, the inflation rate is also higher →
the shift in aggregate supply leads to higher unemployment and higher inflation. →
the short-run Phillips curve moves to the right
- If they contract aggregate demand to fight inflation, they will raise
unemployment further. If they expand aggregate demand to fight unemployment,
they will raise inflation further → They have to live with a higher rate of inflation
for a given rate of unemployment, a higher rate of unemployment for a given rate
of inflation, or some combination of higher unemployment and higher inflation.
- Faced with such an adverse shift in the Phillips curve, policymakers will ask
whether the shift is temporary or permanent. It depends on how people adjust their
expectations of inflation.
 If people view the rise in inflation due to the supply shock as a temporary
aberration, expected inflation will not change and the Phillips curve will
soon revert to its former position.
 If people believe the shock will lead to a new era of higher inflation, then
expected inflation will rise and the Phillips curve will remain at its new, less
desirable position.
4. The cost of reducing inflation
- Disinflation is a reduction in the rate of inflation, and it should not be confused
with deflation, a reduction in the price level.
- The sacrifice ratio: is the number of percentage points of annual output lost in the
process of reducing inflation by percentage point. The size of this cost depends on
the slope of the Phillips curve and how quickly expectations of inflation adjust to
the new monetary policy
- If a nation wants to reduce inflation, it must endure a period of high
unemployment and low output.
- Inflation was running at almost 10% per year. To reach moderate inflation of 4%
per year would mean reducing inflation by 6% points. If each percentage point
costs 5% of the economy’s annual output, then reducing inflation by 6% points
would require sacrificing 30% of annual output
- Rational expectations is the theory that people optimally use all the information
they have, including information about government policies, when forecasting the
future.
- If the government made a credible commitment to a policy of low inflation,
people would be rational enough to lower their expectations of inflation
immediately. The short-run Phillips curve would shift downward, and the economy
would reach low inflation quickly without the cost of temporarily high
unemployment and low output
- The Volcker Disinflation: there are 2 reasons not to reject the conclusions of the
rational-expectations theorists so quickly.
 Even though the Volcker disinflation did impose a cost of temporarily high
unemployment, the cost was not as large as many economists had predicted.
Most estimates of the sacrifice ratio based on the Volcker disinflation are
smaller than estimates that had been obtained from previous data →
Volcker’s tough stand on inflation did have some direct effect on
expectations, as the rational-expectations theorists claimed.
 Even though Volcker announced that he would aim monetary policy to
lower inflation, much of the public did not believe him. Because few people
 thought Volcker would reduce inflation as quickly as he did, expected
inflation did not fall immediately, as a result, the short-run Phillips curve
comes from the forecasts made by commercial forecasting firms: Their
forecasts of inflation fell more slowly in the 1980s than did actual inflation
→ the Volcker disinflation does not necessarily refute the rational-
expectations view that credible disinflation can be costless. It does show,
however, that policymakers cannot count on people to immediately believe
them when they announce a policy of disinflation
- The resulting financial crisis resulted in a large decline in aggregate demand and
a steep increase in unemployment.
- Expected inflation appears to have remained steady at keeping the short-run
Phillips curve relatively stable because the Federal Reserve had established a lot of
credibility in its commitment to keep inflation and expected inflation well-
anchored → the short-run Phillips curve reacted less to the dramatic short-run
events.