PRINCIPLES OF

ECONOMICSBrief Edition

ROBERT H. FRANKCornell University

BEN S. BERNANKEPrinceton University [affiliated]

Chairman, Board of Governors of the Federal Reserve System

with special contribution by

LOUIS D.JOHNSTONCollege of Saint Benedict I Saint John's University

McGraw-HillIrwin

Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. LouisBangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico CityMilan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

B R I E F C O N T E N T S

PART II23

PART 24

5

6

7

PART 389

10

Preface vii

IntroductionThinking Like an Economist 3

Comparative Advantage 35

Supply and Demand 61

Competition and the Invisible HandElasticity 97

Demand 123

Perfectly Competitive Supply 147

Efficiency, Exchange, and the Invisible Hand in Action 173

Market ImperfectionsMonopoly, Oligopoly, and Monopolistic Competition 207

Games and Strategic Behavior 239

Externalities and Property Rights 267

PART 4 Economics of Public Policy11 Using Economics to Make Better Policy Decisions 297

PART 5 Macroeconomics: Data and Issues12 Spending, Income, and GDP 321

13 Inflation and the Price Level 349

14 Wages and Unemployment 377

PART 6 The Economy in the Long Run15 Economic Growth 413

16 Saving, Capital Formation, and Financial Markets 445

17 The Financial System, Money, and Prices 475

PART 7 The Economy in the Short Run18 Short-Term Economic Fluctuations 507

19 Spending and Output in the Short Run 527

xxiii

BRIEF CONTENTS

20 Stabilizing the Economy: The Role of the Federal Reserve 569

21 Aggregate Demand, Aggregate Supply, and Macroeconomic Policy 607

PART 8 The International Economy

22 Exchange Rates, International Trade, and Capital Flows 643

Glossary G-l

Index 1-1

C O N T E N T S

Preface vii

PART I Introduction

Chapter I Thinking Like an Economist 3

Economics: Studying Choice in a World of Scarcity 4Applying the Cost-Benefit Principle 6

Economic Surplus 6Opportunity Cost 7The Role of Economic Models 7

Three Important Decision Pitfalls 8Pitfall 1: Measuring Costs and Benefits as Proportions RatherThan Absolute Dollar Amounts 9Pitfall 2: Ignoring Implicit Costs 9Pitfall 3: Failure to Think at the Margin 11

Normative Economics versus Positive Economics 15Economics: Micro and Macro 15The Approach of This Text 16Economic Naturalism 17EXAMPLE I.I THE ECONOMIC NATURALIST: Why do many hardware

manufacturers include more than $1,000 worth of "free" software with a computer

selling for only slightly more than that? 17

EXAMPLE 1.2 THE ECONOMIC NATURALIST: Why don't auto manufacturers

make cars without heaters? 18

EXAMPLE 1.3 THE ECONOMIC NATURALIST: Why do the keypad buttons

on drive-up automatic teller machines have Braille dots? 18

Summary 19

Core Principles 20

Key Terms 20

Review Questions 20

Problems 20

Answers to In-Chapter Exercises 22Appendix: Working with Equations, Graphs, and Tables 23

CONTENTS

Chapter 2 Comparative Advantage 35

Exchange and Opportunity Cost 36The Principle of Comparative Advantage 37

EXAMPLE 2.1 THE ECONOMIC NATURALIST: Where have all the

400 hitters gone? 39

Sources of Comparative Advantage 40EXAMPLE 2.2 THE ECONOMIC NATURALIST: Televisions and videocassette

recorders were developed and first produced in the United States, but today the

United States accounts for only a minuscule share of the total world production

of these products. Why did the United States fail to retain its lead in these

markets? 41

Comparative Advantage and Production Possibilities 41The Production Possibilities Curve 41How Individual Productivity Affects the Slope and Positionof the PPC 44The Gains from Specialization and Exchange 46A Production Possibilities Curve for a Many-Person Economy 47

Factors That Shift the Economy's Production Possibilities Curve 49Why Have Some Countries Been Slow to Specialize? 51Can We Have Too Much Specialization? 52

Comparative Advantage and International Trade 53EXAMPLE 2.3 THE ECONOMIC NATURALIST: If trade between nations

is so beneficial, why are free-trade agreements so controversial? 53

Outsourcing 53EXAMPLE 2.4 THE ECONOMIC NATURALIST: Is PBS economics reporter

Paul Solman's job a likely candidate for outsourcing? 54

Summary 56

Core Principles 56

Key Terms 56

Review Questions 57

Problems 57

Answers to In-Cbapter Exercises 58

Chapter 3 Supply and Demand 61

What, How, and for Whom? Central Planning versusthe Market 63Buyers and Sellers in Markets 64

The Demand Curve 65The Supply Curve 66

Market Equilibrium 68Rent Controls Reconsidered 71Pizza Price Controls? 73

Predicting and Explaining Changes in Prices and Quantities 74Shifts in Demand 75

EXAMPLE 3.1 THE ECONOMIC NATURALIST: When the federal government

implements a large pay increase for its employees, why do rents for apartments

located near Washington Metro stations go up relative to rents for

apartments located far away from Metro stations? 77

Shifts in the Supply Curve 78

CONTENTS xxvii

EXAMPLE 3.2 THE ECONOMIC NATURALIST: Why do major term papers go

through so many more revisions today than in'the 1970s? 80

Four Simple Rules 81

EXAMPLE 3.3 THE ECONOMIC NATURALIST: Why do the prices of some

goods, like airline tickets to Europe, go up during the months of heaviest

consumption, while others, like sweet corn, go down? 84

Efficiency and Equilibrium 84

Cash on the Table 85

Smart for One, Dumb for All 86

Summary 87

Core Principles 88

Key Terms 89

Review Questions 89

Problems 89

Answers to In-Chapter Exercises 90

Appendix: The Algebra of Supply and Demand 93

PART 2 Competition and the Invisible Hand

Chapter 4 Elasticity 97

' Price Elasticity of Demand 98

Price Elasticity Defined 98

Determinants of Price Elasticity of Demand 100

Some Representative Elasticity Estimates 101

Using Price Elasticity of Demand 102

EXAMPLE 4.1 THE ECONOMIC NATURALIST: Will a higher tax on

cigarettes curb teenage smoking? 102

EXAMPLE 4.2 THE ECONOMIC NATURALIST: Why was the luxury tax

on yachts such a disaster? 102

A Graphical Interpretation of Price Elasticity 103

Price Elasticity Changes along a Straight-Line

Demand Curve 105

Two Special Cases 106

Elasticity and Total Expenditure 107

Income Elasticity and Cross-Price Elasticity

of Demand 111

The Price Elasticity of Supply 112

Determinants of Supply Elasticity 114

EXAMPLE 4.3 THE ECONOMIC NATURALIST: Why are gasoline prices so much

more volatile than car prices? 116

Unique and Essential Inputs: The Ultimate

Supply Bottleneck 117

Summary 118

Key Terms 119

Review Questions 119

Problems 119

Answers to In-Chapter Exercises 121

xxviii CONTENTS

Chapter 5 Demand 123

The Law of Demand 124The Origins of Demand 124Needs versus Wants 125

EXAMPLE 5.1 THE ECONOMIC NATURALIST: Why does Californiaexperience chronic water shortages? 126Translating Wants into Demand 126

Measuring Wants: The Concept of Utility 126Allocating a Fixed Income between Two Goods 130The Rational Spending Rule 133Income and Substitution Effects Revisited 133

Applying the Rational Spending Rule 136Substitution at Work 136

EXAMPLE 5.2 THE ECONOMIC NATURALIST: Why do the wealthy in

Manhattan live in smaller houses than the wealthy in Seattle? 136

EXAMPLE 5.3 THE ECONOMIC NATURALIST: Why did people turn to four-

cylinder cars in the 1970s, only to shift back to six- and eight-cylinder cars in

the 1990s? 136

EXAMPLE 5.4 THE ECONOMIC NATURALIST: Why are automobile engines smaller

in England than in the United States? 138

The Importance of Income Differences 138EXAMPLE 5.5 THE ECONOMIC NATURALIST: Why are waiting lines longer

in poorer neighborhoods? 138

Individual and Market Demand Curves 138

Horizontal Addition 139Demand and Consumer Surplus 140

Calculating Consumer Surplus 140Summary 143Key Terms 143Review Questions 143Problems 144Answers to In-Chapter Exercises 145

Chapter 6 Perfectly Competitive Supply 147

Thinking about Supply: The Importance of Opportunity Cost 148Individual and Market Supply Curves 150Profit-Maximizing Firms in Perfectly CompetitiveMarkets 151

Profit Maximization 151The Demand Curve Facing a Perfectly Competitive Firm 152Production in the Short Run 153Some Important Cost Concepts 154Choosing Output to Maximize Profit 155A Note on the Firm's Shutdown Condition 157Average Variable Cost and Average Total Cost 157A Graphical Approach to Profit Maximization 157Price = Marginal Cost: The Maximum-Profit Condition 159The "Law" of Supply 161

CONTENTS

Determinants of Supply Revisited 162Technology 162Input Prices 162The Number of Suppliers 163Expectations 163Changes in Prices of Other Products 163

Applying the Theory of Supply 163EXAMPLE 6.1 THE ECONOMIC NATURALIST: When recycling is leftto private market forces, why are many more aluminum beverage

containers recycled than glass ones? 163

Supply and Producer Surplus 166Calculating Producer Surplus 166

Summary 167Key Terms 168Review Questions 168Problems 168Answers to In-Chapter Exercises 171

Chapter 7 Efficiency, Exchange, and the Invisible Hand in Action 173

The Central Role of Economic Profit 174Three Types of Profit 174

The Invisible Hand Theory 178Two Functions of Price 178Responses of Profits and Losses 178The Importance of Free Entry and Exit 184

Economic Rent versus Economic Profit 185The Invisible Hand in Action 187

The Invisible Hand at the Supermarket and onthe Freeway 187

EXAMPLE 7.1 THE ECONOMIC NATURALIST: Why do supermarketcheckout lines all tend to be roughly the same length? 187

The Invisible Hand and Cost-Saving Innovations 187The Distinction between an Equilibrium and aSocial Optimum 188

Smart for One, Dumb for All 189EXAMPLE 7.2 THE ECONOMIC NATURALIST: Are there "too many"smart people working as corporate earnings forecasters? 189

Market Equilibrium and Efficiency 190Efficiency Is Not the Only Goal 193Why Efficiency Should Be the First Goal 193

The Cost of Preventing Price Adjustments 194Price Ceilings 194Price Subsidies 197

Summary 199Key Terms 200Review Questions 200Problems 201Answers to In-Chapter Exercises 203

CONTENTS

PART 3 Market Imperfections

Chapter 8 Monopoly, Oligopoly, and Monopolistic Competition 207

Imperfect Competition 208Different Forms of Imperfect Competition 208The Essential Difference between Perfectly and ImperfectlyCompetitive Firms 210

Five Sources of Market Power 211Exclusive Control over Important Inputs 211Patents and Copyrights 211Government Licenses or Franchises 211Economies of Scale and Natural Monopolies 212Network Economies 212

Economies of Scale and the Importance of Start-Up Costs 213EXAMPLE 8.1 THE ECONOMIC NATURALIST: Why does Intel sell the

overwhelming majority of all microprocessors used in personal computers? 215

Profit Maximization for the Monopolist 216

Marginal Revenue for the Monopolist 216The Monopolist's Profit-Maximizing Decision Rule 218Being a Monopolist Doesn't Guarantee an Economic Profit 220

Why the Invisible Hand Breaks Down under Monopoly 221Using Discounts to Expand the Market 223

Price Discrimination Defined 223EXAMPLE 8.2 THE ECONOMIC NATURALIST: Why do many movie theaters

offer discount tickets to students? 224

How Price Discrimination Affects Output 224The Hurdle Method of Price Discrimination 226Is Price Discrimination a Bad Thing? 229Examples of Price Discrimination 229

EXAMPLE 8.3 THE ECONOMIC NATURALIST: Why might an appliance retailer

instruct its clerks to hammer dents into the sides of its stoves and refrigerators? 230

Summary 231

Key Terms 231

Review Questions 232

Problems 232

Answers to In-Chapter Exercises 234Appendix: The Algebra of Monopoly Profit Maximization 237

Chapter 9 Games and Strategic Behavior 239

Using Game Theory to Analyze Strategic Decisions 240The Three Elements of a Game 240Nash Equilibrium 242

The Prisoner's Dilemma 244The Original Prisoner's Dilemma 244The Economics of Cartels 245

EXAMPLE 9.1 THE ECONOMIC NATURALIST: Why are cartel agreements

notoriously unstable? 245

Tit-for-Tat and the Repeated Prisoner's Dilemma 247

CONTENTS xxxi

EXAMPLE 9.2 THE ECONOMIC NATURALIST: How did Congress unwittingly solve

the television advertising dilemma confronting cigarette producers? 248

EXAMPLE 9.3 THE ECONOMIC NATURALIST: Why do people shout

at parties? 249

Games in Which Timing Matters 250

Credible Threats and Promises 252

Monopolistic Competition When Location Matters 253

EXAMPLE 9.4 THE ECONOMIC NATURALIST: Why do we often see

convenience stores located on adjacent street corners? 254

Commitment Problems 255

The Strategic Role of Preferences 257

Are People Fundamentally Selfish? 258

Preferences as Solutions to Commitment

Problems 258

Summary 258

Key Terms 260

Review Questions 260

Problems 260

Answers to In-Chapter Exercises 264

Chapter 10 Externalities and Property Rights 267

External Costs and Benefits 268

How Externalities Affect Resource Allocation 268

How Do Externalities Affect Supply and Demand? 269

The Coase Theorem 271

Legal Remedies for Externalities 275

EXAMPLE 10.1 THE ECONOMIC NATURALIST: What is the purpose of

free speech laws? 276

EXAMPLE 10.2 THE ECONOMIC NATURALIST: Why does government

subsidize private property owners to plant trees on their hillsides? 276

The Optimal Amount of Negative Externalities Is Not Zero 277

Compensatory Taxes and Subsidies 277

Property Rights and the Tragedy of the Commons 279

The Problem of Unpriced Resources 279

The Effect of Private Ownership 281

When Private Ownership Is Impractical 282

EXAMPLE 10.3 THE ECONOMIC NATURALIST: Why do blackberries in

public parks get picked too soon? 283

EXAMPLE 10.4 THE ECONOMIC NATURALIST: Why are shared milkshakes

consumed too quickly? 283

Positional Externalities 284

Payoffs That Depend on Relative Performance 284

EXAMPLE 10.5 THE ECONOMIC NATURALIST: Why do football players

take anabolic steroids? 285

Positional Arms Races and Positional Arms Control

Agreements 286

Social Norms as Positional Arms Control Agreements 287

Summary 289

Key Terms 290

XXXII CONTENTS

Review Questions 290Problems 290Answers to In-Chapter Exercises 293

PART 4 Economics of Public Policy

Chapter 11 Using Economics to Make Better Policy Choices 297

The Economics of Health Care 298The Case for Mandatory Immunization Laws 298

Explaining Rising Health Care Costs 299 jDesigning a Solution 301The HMO Revolution 302

EXAMPLE 11.1 THE ECONOMIC NATURALIST: Why is a patient with a sore knee

more likely to receive on MRI exam if he has conventional health insurnace than if he

belongs to a Health Maintenance Organization? 302

Paying for Health Insurance 303EXAMPLE 11.2 THE ECONOMIC NATURALIST: In the richest country on Earth, why

do so many people lack basic health insurance? 304

Using Price Incentives In Environmental Regulation 305

Taxing Pollution 305Auctioning Pollution Permits 307

Overcoming Opposition to International Trade 308Welfare Payments and In-Kind Transfers 310Means-Tested Benefit Programs 311The Negative Income Tax 311Minimum Wages 312The Earned-Income Tax Credit 313Public Employment for the Poor 313A Combination of Methods 313

Summary 314Key Terms 315Review Questions 315Problems 315Answers to In-Chapter Exercises 317

PART 5 Macroeconomics: Data and Issues

Chapter 12 Spending, Income, and GDP 321

Gross Domestic Product: Measuring the Nation's Output 322Market Value 322

EXAMPLE 12.1 THE ECONOMIC NATURALIST: Why has female participation in the

labor market increased by so much? What explains the trends illustrated in Figure 12.1 ? 324

Final Goods and Services 325Produced within a Country during a Given Period 328

The Expenditure Method for Measuring GDP 329GDP and the Incomes of Capital and Labor 333

CONTENTS xxxiii

Nominal GDP versus Real GDP 334EXAMPLE 12.2 THE ECONOMIC NATURALIST: Can nominal and real GDP ever

move in different directions? 336

Real GDP Is Not the Same as Economic Weil-Being 338Leisure Time 338

EXAMPLE 12.3 THE ECONOMIC NATURALIST: Why do people work fewer hours

today than their great-grandparents did? 338

Nonmarket Economic Activities 339Environmental Quality and Resource Depletion 340Quality of Life 340Poverty and Economic Inequality 340

But GDP Is Related to Economic Well-Being 341Availability of Goods and Services 341Health and Education 341

EXAMPLE 12.4 THE ECONOMIC NATURALIST: Why do far fewer children

complete high school in poor countries than in rich countries? 343

Summary 343

Key Terms 344

Review Questions 344

Problems 344

Answers to In-Chapter Exercises 347

Chapter 13 Inflation and the Price Level 349

The Consumer Price Index: Measuring the Price Level 350Inflation 352Adjusting for Inflation 354

Deflating a Nominal Quantity 354Indexing to Maintain Buying Power 356

Does the CPI Measure "True" Inflation? 357The Costs of Inflation: Not What You Think 360The True Costs of Inflation 361

"Noise" in the Price System 361Distortions of the Tax System 362

"Shoe-Leather" Costs 363Unexpected Redistribution of Wealth 364Interference with Long-Run Planning 365

Hyperinflation 366, Inflation and Interest Rates 367

Inflation and the Real Interest Rate 368The Fisher Effect 370

Summary 371Key Terms 372Review Questions 372Problems 373Answers to In-Chapter Exercises 375

Chapter 14 Wages and Unemployment 377

Five Important Labor Market Trends 378

CONTENTS

Trends in Real Wages 378Trends in Employment and Unemployment 379

Supply and Demand in the Labor Market 380Wages and the Demand for Labor 380Shifts in the Demand for Labor 382The Supply of Labor 385Shifts in the Supply of Labor 386

Explaining the Trends in Real Wages and Employment 387Why Have Real Wages Increased by So Much in the IndustrializedCountries? 388Since the 1970s, Real Wage Growth in the United States HasSlowed, While Employment Has Expanded Rapidly 388Increasing Wage Inequality: The Effects ofGlobalization 390Increasing Wage Inequality: Technological Change 392

Unemployment and the Unemployment Rate 395Measuring Unemployment 395The Costs of Unemployment 397The Duration of Unemployment 397The Unemployment Rate versus "True"Unemployment 398

Types of Unemployment and Their Costs 398Frictional Unemployment 399Structural Unemployment 399Cyclical Unemployment 400

Impediments to Full Employment 400Minimum Wage Laws 401

. Labor Unions 401Unemployment Insurance 402Other Government Regulations 402Why Are Unemployment Rates So High in Western Europe? 403

Summary 404Key Terms 406Review Questions 406Problems 406Answers to In-Chapter Exercises 408

PART 6 The Economy in the Long Run

Chapter 15 Economic Growth 413

The Remarkable Rise in Living Standards: The Record 415Why "Small" Differences in Growth Rates Matter 417Why Nations Become Rich: The Crucial Role of Average LaborProductivity 419The Determinants of Average Labor Productivity 422

Human Capital 422Physical Capital 424Land and Other Natural Resources 427

CONTENTS

Technology 427Entrepreneurship and Management 428

EXAMPLE 15.1 THE ECONOMIC NATURALIST: Why did medieval China

stagnate economically? 429

The Political and Legal Environment 430The Costs of Economic Growth 433Promoting Economic Growth 434

Policies to Increase Human Capital 434EXAMPLE 15.2 THE ECONOMIC NATURALIST: Why do almost all countries

provide free public education? 434

Policies That Promote Saving and Investment 435Policies That Support Research and Development 436The Legal and Political Framework 436The Poorest Countries: A Special Case? 436

Are There Limits to Growth? 437Summary 440Key Terms 440Review Questions 440Problems 441Answers to In-Chapter Exercises 443

Chapter 16 Saving, Capital Formation, and Financial Markets 445

Saving and Wealth 447Stocks and Flows 448Capital Gains and Losses 449

National Saving and Its Components 451The Measurement of National Saving 451Private and Public Components of National Saving 452Public Saving and the Government Budget 453Is Low Household Saving a Problem? 456

Why Do People Save? 457Saving and the Real Interest Rate 458Saving, Self-Control, and Demonstration Effects 460

Investment and Capital Formation 462EXAMPLE 16.1 THE ECONOMIC NATURALIST: Why has investment in

computers increased so much in recent decades? 464

Saving, Investment, and Financial Markets 466Summary 469Key Terms 470Review Questions 470Problems 471Answers to In-Chapter Exercises 473

Chapter 17 The Financial System, Money, and Prices 475

The Financial System and the Allocation of Saving to ProductiveUses 476

The Banking System 476

xxxvi CONTENTS

Bonds and Stocks 478Bond Markets, Stock Markets, and the Allocation of Savings 483

EXAMPLE 17.1 THE ECONOMIC NATURALIST: Why did the U.S. stockmarket rise sharply in the 1990s, then fall in the new millennium? 485Money and Its Uses 485

Measuring Money 487Commercial Banks and the Creation of Money 489

The Money Supply with Both Currency and Deposits 492Central Banks, the Money Supply, and Prices 494

Controlling the Money Supply with Open-MarketOperations 494Money and Prices 495Velocity 496Money and Inflation in the Long Run 497

Summary 499Key Terms 500Review Questions 500Problems 501Answers to In-Chapter Exercises 503

PART 7 The Economy in the Short Run

Chapter 18 Short-Term Economic Fluctuations 507

Recessions and Expansions 509Some Facts about Short-Term Economic Fluctuations 512Output Gaps and Cyclical Unemployment 515

Potential Output and the Output Gap 515The Natural Rate of Unemployment and CyclicalUnemployment 517Okun's Law 519

Why Do Short-Term Fluctuations Occur? A Preview and a Parable 521EXAMPLE 18.1 THE ECONOMIC NATURALIST: Why did the Coca-Cola Company

test a vending machine that "knows" when the weather is hot? 523Summary 524Key Terms 525Review Questions 525Problems 525Answers to In-Chapter Exercises 526

Chapter 19 Spending and Output in the Short Run 527

The Keynesian Model's Crucial Assumption: Firms Meet Demandat Preset Prices 530Planned Aggregate Expenditure 531

Planned Spending versus Actual Spending 532Consumer Spending and the Economy 533Planned Aggregate Expenditure and Output 536

Short-Run Equilibrium Output 539

CONTENTS xxxvii

Finding Short-Run Equilibrium Output: Numerical Approach 539Finding Short-Run Equilibrium Output: Graphical Approach 541Planned Spending and the Output Gap 542The Multiplier 545

Stabilizing Planned Spending: The Role of Fiscal Policy 547Government Purchases and Planned Spending 547

EXAMPLE 19.1 THE ECONOMIC NATURALIST: Why did Japan build roads

that nobody wanted to use? 548

Taxes, Transfers, and Aggregate Spending 551Fiscal Policy as a Stabilization Tool: Three Qualifications 553

Fiscal Policy and the Supply Side 553The Problem of Deficits 554The Relative Inflexibility of Fiscal Policy 554

Summary 555Key Terms 556Review Questions 556Problems 556Answers to In-Chapter Exercises 559Appendix A: An Algebraic Solution of the Basic Keynesian Model 563Appendix B: The Multiplier in the Basic Keynesian Model 567

Chapter 20 Stabilizing the Economy: The Role of the Federal Reserve 569

The Federal Reserve 570The History and Structure of the Federal Reserve System 570The Fed's Role in Stabilizing Financial Markets: BankingPanics 572

The Effects of Federal Reserve Actions on the Economy 574.Can the Fed Control the Real Interest Rate? 574Planned Aggregate Expenditure and the Real Interest Rate 576The Fed Fights a Recession 578The Fed Fights Inflation 581

EXAMPLE 20.1 THE ECONOMIC NATURALIST: Why does news of inflation

hurt the stock market? 583

The Fed's Monetary Policy Rule 584The Federal Reserve and Interest Rates 588

The Demand for Money 588Macroeconomic Factors That Affect the Demand for Money 589The Money Demand Curve 590

EXAMPLE 20.2 THE ECONOMIC NATURALIST: Why does the average Argentine

hold more U.S. dollars than the average U.S. citizen? 592

The Supply of Money and Money Market Equilibrium 593How the Fed Controls the Nominal Interest Rate 595A Second Way the Fed Controls the Money Supply: DiscountWindow Lending 596A Third Way of Controlling the Money Supply: ChangingReserve Requirements 597

Summary 598Key Terms 598Review Questions 599

xxxviii CONTENTS

Problems 599Answers to In-Chapter Exercises 601Appendix: Monetary Policy in the Basic Keynesian Model 605

Chapter 21 Aggregate Demand, Aggregate Supply, and Macroeconomic Policy 607

The Aggregate Demand-Aggregate Supply Model: A Brief Overview 608Inflation, Spending, and Output: The AggregateDemand Curve 609

Inflation, the Fed, and the AD Curve 609Shifts of the AD Curve 611

Inflation and Aggregate Supply 615Inflation Inertia, Output Gaps, and the AS Curve 615Shifts of the AS Curve 620

Aggregate Demand-Aggregate Supply Analysis 621An Expansionary Gap 621A Recessionary Gap 622The Self-Correcting Economy 623

Monetary Policy and Inflation 624Excessive Aggregate Spending 624Responding to Shocks in Aggregate Supply 627The Core Rate of Inflation 629

Inflationary Expectations and Credibility 631Central Bank Independence 631Announcing a Numerical Inflation Target 632Central Bank Reputation 635

Summary 636Key Terms 637Review Questions 637Problems 638Answers to In-Chapter Exercises 639

PART 8: The International Economy

Chapter 22 Exchange Rates, International Trade, and Capital Flows 643

Exchange Rates 644Nominal Exchange Rates 645Flexible versus Fixed Exchange Rates 647

The Determination of the Exchange Rate in the Short Run 648A Supply and Demand Analysis 648Changes in the Supply of Dollars 650Changes in the Demand for Dollars 652

Monetary Policy and the Exchange Rate 652The Exchange Rate as a Tool of Monetary Policy 654

Fixed Exchange Rates 655How to Fix an Exchange Rate 655Monetary Policy and the Fixed Exchange Rate 658

CONTENTS xxxix

Should Exchange Rates Be Fixed or Flexible? 661The Euro: A Common Currency for Europe 662

Determination of the Exchange Rate in the Long Run 663The Real Exchange Rate 663A Simple Theory of Exchange Rates: Purchasing Power Parity (PPP) 665Shortcomings of the PPP Theory 667

The Trade Balance and Net Capital Inflows 669International Capital Flows 670

The Determinants of International Capital Flows 671Saving, Investment, and Capital Inflows 673The Saving Rate and the Trade Deficit 674

Summary 677Key Terms 678Review Questions 679Problems 679Answers to In-Chapter Exercises 681

Glossary G-l

Index 1-1