P R I N C I P L E S O F

T H I R D E D I T I O N

N. GREGORY MANKIWHARVARD UNIVERSITY

THOIVISOIM

SOUTH-WESTERN

A u s t r a l i a • C a n a d a • M e x i c o • S i n g a p o r e • S p a i n • U n i t e d K i n g d o m • U n i t e d S t a t e s

T A B L E O F C O N T E N T S

Preface: To the Instructor vPreface: To the Student xxiii

PART HINTRODUCTION 1

Key Concepts 16Questions for Review 16Problems and Applications 16

CHAPTER 2THINKING LIKE AN ECONOMIST 19

The Economist as Scientist 20The Scientific Method: Observation, Theory,

and More Observation 21The Role of Assumptions 21Economic Models 22Our First Model: The Circular-Flow Diagram 23Our Second Model: The Production Possibilities

Frontier 24Microeconomics and Macroeconomics 26

CHAPTER 1TEN PRINCIPLES OF ECONOMICS 3

How People Make Decisions 4Principle #1: People Face Tradeoffs 4Principle #2: The Cost of Something

Is What You Give Up to Get It 5Principle #3: Rational People Think at the MarginPrinciple #4: People Respond to Incentives 7

How People Interact 8Principle #5: Trade Can Make Everyone Better OffPrinciple #6: Markets Are Usually a Good Way

to Organize Economic Activity 9FYI: Adam Smith and the Invisible HandPrinciple #7: Governments Can Sometimes

Improve Market Outcomes 10

How the Economy as a Whole Works 11Principle #8: A Country's Standard of Living

Depends on Its Ability to Produce Goodsand Services 11

Principle #9: Prices Rise When the GovernmentPrints Too Much Money 12

Principle #10: Society Faces a Short-Run Tradeoffbetween Inflation and Unemployment 13

FYI: How to Read This BookConclusion 15Summary 15

The Economist as Policy Adviser 28Positive versus Normative Analysis 28Economists in Washington 29

Why Economists Disagree 30Differences in Scientific Judgments 30Differences in Values 31Perception versus Reality 31

Let's Get Going 32Summary 33Key Concepts 33Questions for Review 33Problems and Applications 34

Appendix Graphing: A Brief Review 36Graphs of a Single Variable 36Graphs of Two Variables: The Coordinate System 36Curves in the Coordinate System 37Slope 41Cause and Effect 42

CHAPTER 3INTERDEPENDENCE AND THE GAINS FROM TRADE 45

A Parable for the Modern Economy 46Production Possibilities 46Specialization and Trade 48

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TABLE OF CONTENTS XXVII

The Principle of Comparative Advantage 50Absolute Advantage 51Opportunity Cost and Comparative Advantage 51Comparative Advantage and Trade 52FYI: The Legacy of Adam Smith

and David Ricardo

Applications of Comparative Advantage 54Should Tiger Woods Mow His Own Lawn? 54Should the United States Trade with

Other Countries? 56IN THE NEWS: Who Has a Comparative Advantage in

Producing Lamb?Conclusion 56Summary 57Key Concepts 57Questions for Review 57Problems and Applications 57

SUPPLY AND DEMAND I:HOW MARKETS WORK 61

CHAPTER 4THE MARKET FORCES OF SUPPLY AND DEMAND 63

Markets and Competition 64Competitive Markets 64Competition: Perfect and Otherwise 64

Demand 65The Demand Curve: The Relationship between Price and

Quantity Demanded 65 x

Market Demand versus Individual Demand 66Shifts in the Demand Curve 67CASE STUDY: Two Ways to Reduce the Quantity

of Smoking Demanded

Supply 71The Supply Curve: The Relationship

between Price and Quantity Supplied 71Market Supply versus Individual Supply 72Shifts in the Supply Curve 73

Supply and Demand Together 75Equilibrium 75Three Steps to Analyzing Changes in Equilibrium 77IN THE NEWS: Mother Nature Shifts the Supply

CurveConclusion: How Prices Allocate Resources 83Summary 84Key Concepts 85Questions for Review 85Problems and Applications 86

CHAPTER 5ELASTICITY AND ITS APPLICATION 89

The Elasticity of Demand 90The Price Elasticity of Demand and Its Determinants 90Computing the Price Elasticity of Demand 91The Midpoint Method: A Better Way to Calculate

Percentage Changes and Elasticities 92The Variety of Demand Curves 94Total Revenue and the Price Elasticity of Demand 94Elasticity and Total Revenue along a Linear Demand

Curve 96CASE STUDY: Pricing Admission to a MuseumIN THE NEWS: On the Road with ElasticityOther Demand Elasticities 99

The Elasticity of Supply 100The Price Elasticity of Supply and Its Determinants 100Computing the Price Elasticity of Supply 101The Variety of Supply Curves 101

Three Applications of Supply, Demand,and Elasticity 104Can Good News for Farming Be Bad News for

Farmers? 104Why Did OPEC Fail to Keep the Price of Oil High? 106Does Drug Interdiction Increase or Decrease

Drug-Related Crime? 108Conclusion 109Summary 110Key Concepts 110Questions for Review 110Problems and Applications 111

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CHAPTER 6SUPPLY, DEMAND, AND GOVERNMENT POLICIES 113

Controls on Prices 114How Price Ceilings Affect Market Outcomes 114CASE STUDY: Lines at the Gas PumpIN THE NEWS: Does a Drought Need to Cause a Water

Shortage?CASE STUDY: Rent Control in the Short Run and

Long RunHow Price Floors Affect Market Outcomes 120CASE STUDY: The Minimum WageEvaluating Price Controls 123

Taxes 124How Taxes on Buyers Affect Market Outcomes 124How Taxes on Sellers Affect Market Outcomes 126CASE STUDY: Can Congress Distribute the Burden of

a Payroll Tax?Elasticity and Tax Incidence 128CASE STUDY: Who Pays the Luxury Tax?

Conclusion 131Summary 131Key Concepts 131Questions for Review 131Problems and Applications 132

PART 3SUPPLY AND DEMAND

MARKETS AND WELFARE

How a Lower Price Raises Consumer Surplus 140What Does Consumer Surplus Measure? 141

Producer Surplus 143Cost and the Willingness to Sell 143Using the Supply Curve to Measure Producer Surplus 144How a Higher Price Raises Producer Surplus 146

Market Efficiency 147The Benevolent Social Planner 147Evaluating the Market Equilibrium 148IN THE NEWS: Ticket ScalpingCASE STUDY: Should There Be a Market in Organs?IN THE NEWS: How Pilgrims Embraced the Market

Conclusion: Market Efficiency and Market Failure 154Summary 155Key Concepts 155Questions for Review 155Problems and Applications 156

CHAPTER 8APPLICATION: THE COSTS OF TAXATION 159

163

135

The Deadweight Loss of Taxation 160How a Tax Affects Market Participants 161Deadweight Losses and the Gains from Trade

The Determinants of the Deadweight Loss 164CASE STUDY: The Deadweight Loss DebateFYI: Henry George and the Land Tax

Deadweight Loss and Tax Revenue as Taxes Vary 167CASE STUDY: The Laffer Curve and Supply-Side

EconomicsConclusion 171Summary 172Key Concepts 172Questions for Review 172Problems and Applications 172

CHAPTER 7CONSUMERS, PRODUCERS,

AND THE EFFICIENCY OF MARKETS 137

Consumer Surplus 138Willingness to Pay 138Using the Demand Curve to Measure Consumer

Surplus 139

CHAPTER 9APPLICATION: INTERNATIONAL TRADE 175

The Determinants of Trade 176The Equilibrium without Trade 176The World Price and Comparative Advantage 177

The Winners and Losers from Trade 178The Gains and Losses of an Exporting Country 178

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The Gains and Losses of an Importing Country 180The Effects of a Tariff 182IN THE NEWS: Life in IsolandThe Effects of an Import Quota 185The Lessons for Trade Policy 187FYI: Other Benefits of International Trade

The Arguments for Restricting Trade 188The Jobs Argument 188The National-Security Argument 189The Infant-Industry Argument 190The Unfair-Competition Argument 190IN THE NEWS: Trade Policy in IndiaThe Protection-as-a-Bargaining-Chip Argument 191CASE STUDY: Trade Agreements and the World Trade

OrganizationIN THE NEWS: Globalization

Conclusion 194Summary 195Key Concepts 196Questions for Review 196Problems and Applications 196

PAIR! 4THE ECONOMICS OF

THE PUBLIC SECTOR 201

CHAPTER 10EXTERNALITIES 203

204Externalities and Market InefficiencyWelfare Economics: A Recap 205Negative Externalities 206Positive Externalities 207CASE STUDY: Technology Spillovers and

Industrial Policy "x

Private Solutions to Externalities 209The Types of Private Solutions 209

The Coase Theorem 210Why Private Solutions Do Not Always Work 211

Public Policies toward Externalities 212Regulation 212Pigovian Taxes and Subsidies 213CASE STUDY: Why Is Gasoline Taxed So Heavily?Tradable Pollution Permits 215Objections to the Economic Analysis of Pollution 216IN THE NEWS: Children as Externalities

Conclusion 217Summary 218Key Concepts 219Questions for Review 220Problems and Applications 220

CHAPTER 11PUBLIC GOODS AND COMMON RESOURCES

The Different Kinds of Goods 224

223

Public Goods 225The Free-Rider Problem 226Some Important Public Goods 226CASE STUDY: Are Lighthouses Public Goods?The Difficult Job of Cost-Benefit Analysis 229CASE STUDY: How Much Is a Life Worth?

Common Resources 231The Tragedy of the Commons 231Some Important Common Resources 232IN THE NEWS: The Singapore SolutionCASE STUDY: Why the Cow Is Not ExtinctIN THE NEWS: Should Yellowstone Charge as Much as

Disney World?

Conclusion: The Importance of Property Rights 236

Summary 237Key Concepts 237Questions for Review 237Problems and Applications 237

CHAPTER 12THE DESIGN OF THE TAX SYSTEM 241

A Financial Overview of the U.S. GovernmentThe Federal Government 242State and Local Government 246

Taxes and Efficiency 248Deadweight Losses 248

242

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CASE STUDY: Should Income or ConsumptionBe Taxed?

Administrative Burden 250Marginal Tax Rates versus Average Tax Rates 250CASE STUDY: Iceland's Natural ExperimentLump-Sum Taxes 251IN THE NEWS: How Taxes Affect Married Women

Taxes and Equity 253The Benefits Principle 254The Ability-to-Pay Principle 254CASE STUDY: How the Tax Burden Is DistributedCASE STUDY. Horizontal Equity and

the Marriage TaxTax Incidence and Tax Equity 258CASE STUDY: Who Pays the Corporate Income Tax?IN THE NEWS: The Case against Taxing

Capital IncomeConclusion: The Tradeoff between Equity and

Efficiency 260Summary 261Key Concepts 261Questions for Review 262Problems and Applications 262

PART 5FIRM BEHAVIOR AND

THE ORGANIZATION OF INDUSTRY 265

CHAPTER 13THE COSTS OF PRODUCTION 267

268What Are Costs? 268

Total Revenue, Total Cost, and ProfitCosts as Opportunity Costs 268The Cost of Capital as an Opportunity Cost 269Economic Profit versus Accounting Profit 270

IN THE NEWS: True Profit versus Fictitious Profit

Production and Costs 271The Production Function 272From the Production Function to the Total-Cost

Curve 273

The Various Measures of Cost 275Fixed and Variable Costs 276Average and Marginal Cost 277Cost Curves and Their Shapes 278Typical Cost Curves 279

Costs in the Short Run and in the Long Run 280The Relationship between Short-Run and Long-Run

Average Total Cost 280Economies and Diseconomies of Scale 283FYI: Lessons from a Pin Factory

Conclusion 284Summary 285Key Concepts 285Questions for Review 285Problems and Applications 286

CHAPTER 14FIRMS IN COMPETITIVE MARKETS 289

What Is a Competitive Market? 290The Meaning of Competition 290The Revenue of a Competitive Firm 291

Profit Maximization and the Competitive Firm's SupplyCurve 292A Simple Example of Profit Maximization 292The Marginal-Cost Curve and the Firm's Supply

Decision 294The Firm's Short-Run Decision to Shut Down 295Spilt Milk and Other Sunk Costs 297CASE STUDY: Near-Empty Restaurants and Off-Season

Miniature GolfThe Firm's Long-Run Decision to Exit or Enter

a Market 298Measuring Profit in Our Graph for the Competitive

Firm 299

The Supply Curve in a Competitive Market 301The Short Run: Market Supply with a Fixed Number

of Firms 301The Long Run: Market Supply with Entry and Exit 302Why Do Competitive Firms Stay in Business If They Make

Zero Profit? 303

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A Shift in Demand in the Short Run and Long RunIN THE NEWS: Entry or Overinvestment?Why the Long-Run Supply Curve Might Slope

Upward 304Conclusion: Behind the Supply Curve 307Summary 308

Key Concepts 308Questions for Review 308Problems and Applications 309

304 Summary 341

Key Concepts 341Questions for Review 341Problems and Applications 342

CHAPTER 16OLIGOPOLY 345

Between Monopoly and Perfect Competition 346

CHAPTER 15MONOPOLY 313

Why Monopolies Arise 314Monopoly Resources 315CASE STUDY: The DeBeers Diamond MonopolyGovernment-Created Monopolies 316Natural Monopolies 316

How Monopolies Make Productionand Pricing Decisions 318Monopoly versus Competition 318A Monopoly's Revenue 319Profit Maximization 321FYI: Why a Monopoly Does Not Have

a Supply CurveA Monopoly's Profit 323CASE STUDY: Monopoly Drugs versus

Generic Drugs

The Welfare Cost of Monopoly 325The Deadweight Loss 326The Monopoly's Profit: A Social Cost? 328

329Public Policy toward Monopolies 329

Increasing Competition with Antitrust LawsRegulation 330Public Ownership 331Doing Nothing 331IN THE NEWS: Public Transport and

Private Enterprise

Price Discrimination 334A Parable about Pricing 334The Moral of the Story 335The Analytics of Price Discrimination 336Examples of Price Discrimination 337IN THE NEWS: Why People Pay More Than Dogs

Conclusion: The Prevalence of Monopoly 340

Markets with Only a Few Sellers 347A Duopoly Example 348Competition, Monopolies, and Cartels 348IN THE NEWS: Modern PiratesThe Equilibrium for an Oligopoly 349How the Size of an Oligopoly Affects

the Market Outcome 352CASE STUDY: OPEC and the World Oil MarketIN THE NEWS: The Growth of Oligopoly

Game Theory and the Economics of Cooperation 354The Prisoners' Dilemma 355Oligopolies as a Prisoners' Dilemma 356Other Examples of the Prisoners' Dilemma 357The Prisoners' Dilemma and the Welfare of Society 360Why People Sometimes Cooperate 361CASE STUDY: The Prisoners' Dilemma Tournament

Public Policy toward Oligopolies 362Restraint of Trade and the Antitrust Laws 363CASE STUDY: An Illegal Phone CallControversies over Antitrust Policy 364CASE STUDY: The Microsoft CaseIN THE NEWS: Antitrust in the New Economy

Conclusion 368Summary 369Key Concepts 369Questions for Review 369Problems and Applications 369

CHAPTER 17MONOPOLISTIC COMPETITION 373

Competition with Differentiated ProductsThe Monopolistically Competitive Firm

in the Short Run 374The Long-Run Equilibrium 375Monopolistic versus Perfect Competition

374

377

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Monopolistic Competition and the Welfare of Society 379FYI: Is Excess Capacity a Social Problem?

Advertising 380The Debate over Advertising 381CASE STUDY: Advertising and the Price

of EyeglassesAdvertising as a Signal of Quality 382Brand Names 383

Conclusion 385Summary 386Key Concepts 386Questions for Review 386Problems and Applications 387

CASE STUDY: Productivity and WagesFYI: Monopsony

The Other Factors of Production:Land and Capital 404Equilibrium in the Markets for Land and CapitalFYI: What Is Capital Income?Linkages among the Factors of Production 406CASE STUDY: The Economics of the Black Death

Conclusion 408Summary 408Key Concepts 408Questions for Review 409Problems and Applications 409

404

PART 6THE ECONOMICS

OF LABOR MARKETS 389

CHAPTER 18THE MARKETS FOR THE FACTORS OF PRODUCTION 391

The Demand for Labor 392The Competitive Profit-Maximizing Firm 393The Production Function

and the Marginal Product of Labor 394The Value of the Marginal Product

and the Demand for Labor 395FYI: Input Demand and Output Supply:

Two Sides of the Same CoinWhat Causes the Labor Demand Curve to Shift? 397

The Supply of Labor 398"The Tradeoff between Work and Leisure 398

What Causes the Labor Supply Curve to Shift? 399

Equilibrium in the Labor MarketShifts in Labor Supply 400Shifts in Labor Demand 401

399

CHAPTER 19EARNINGS AND DISCRIMINATION 411

Some Determinants of Equilibrium Wages 412Compensating Differentials 412Human Capital 412CASE STUDY: The Increasing Value of SkillsFYI: Looking for True Love? Go to SchoolAbility, Effort, and Chance 414CASE STUDY: The Benefits of BeautyAn Alternative View of Education: Signaling 416IN THE NEWS: Are Elite Colleges Worth

the Cost?The Superstar Phenomenon 417Above-Equilibrium Wages: Minimum-Wage Laws,

Unions, and Efficiency Wages 418

The Economics of Discrimination 420Measuring Labor-Market Discrimination 420Discrimination by Employers 422CASE STUDY: Segregated Streetcars and

the Profit MotiveDiscrimination by Customers and Governments 423CASE STUDY: Discrimination in Sports

Conclusion 425Summary 425Key Concepts 426Questions for Review 426Problems and Applications 426

CHAPTER 20INCOME INEQUALITY AND POVERTY 429

The Measurement of InequalityU.S. Income Inequality 430

430

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CASE STUDY: The Women's Movement and the IncomeDistribution

CASE STUDY: Inequality Around the WorldThe Poverty Rate 433Problems in Measuring Inequality 434Economic Mobility 436

The Political Philosophy of Redistributing Income 437Utilitarianism 437Liberalism 438Libertarianism 439

Policies to Reduce Poverty 440Minimum-Wage Laws 441Welfare 441IN THE NEWS: Should the Government Try to Help

Poor Regions?Negative Income Tax 443In-Kind Transfers 444Antipoverty Programs and Work Incentives 444IN THE NEWS: School Vouchers

Conclusion 445Summary 447Key Concepts 448Questions for Review 448Problems and Applications 448

Four Properties of Indifference Curves 457Two Extreme Examples of Indifference Curves 458

Optimization: What the Consumer Chooses 460The Consumer's Optimal Choices 461FYI: Utility: An Alternative Way to Describe Preferences

and OptimizationHow Changes in Income Affect the Consumer's

Choices 462How Changes in Prices Affect the Consumer's

Choices 463Income and Substitution Effects 464Deriving the Demand Curve 466

Three Applications 468Do All Demand Curves Slope Downward? 468How Do Wages Affect Labor Supply? 469CASE STUDY: Income Effects on Labor Supply:

Historical Trends, Lottery Winners, andthe Carnegie Conjecture

How Do Interest Rates Affect Household Saving? 473Conclusion: Do People Really Think This Way? 475Summary 476Key Concepts 476Questions for Review 476Problems and Applications 477

P A H T 7TOPICS FOR FURTHER STUDY 451

CHAPTER 21THE THEORY OF CONSUMER CHOICE 453

The Budget Constraint: What the ConsumerCan Afford 454

Preferences: What the Consumer Wants 456Representing Preferences with Indifference

Curves 456

CHAPTER 22FRONTIERS OF MICROECONOMICS 479

Asymmetric Information 480Hidden Actions: Principals, Agents,

and Moral Hazard 480Hidden Characteristics: Adverse Selection

and the Lemons Problem 481Signaling to Convey Private Information 482CASE STUDY: Gifts as SignalsScreening to Induce Information Revelation 483Asymmetric Information and Public Policy 484

Political Economy 485The Condorcet Voting Paradox 485Arrow's Impossibility Theorem 486The Median Voter Is King 487Politicians Are People Too 488IN THE NEWS: Farm Policy and Politics

Behavioral Economics 489People Aren't Always Rational 489People Care About Fairness 492People Are Inconsistent over Time 493

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Conclusion 493Summary 494Key Concepts 494Questions for Review 494Problems and Applications 495

PART 8THE DATA OF MACROECONOMICS 497

". . . In a Given Period of Time"FYI: Other Measures of Income

503

The Components of GDP 505Consumption 505Investment 505Government Purchases 506Net Exports 506CASE STUDY: The Components of U.S. GDP

Real versus Nominal GDP 507A Numerical Example 508The GDP Deflator 509CASE STUDY: Real GDP over Recent HistoryIN THE NEWS: GDP Lightens Up

GDP and Economic Well-Being 512CASE STUDY: International Differences in GDP

and the Quality of Life

CASE STUDY: Who Wins at the Olympics?Conclusion 515Summary 515Key Concepts 516Questions for Review 516Problems and Applications 516

CHAPTER 24MEASURING THE COST OF LIVING 519

CHAPTER 23MEASURING A NATION'S INCOME 499

The Economy's Income and Expenditure 500

The Measurement of Gross Domestic Product 502"GDP Is the Market Value .. ." 502".. . Of All. . ." 502".. . Final. .." 503".. . Goods and Services . . ." 503".. . Produced . . ." 503". .. Within a Country . .." 503

The Consumer Price Index 520How the Consumer Price Index Is Calculated 520FYI: What Is in the CPI's Basket?IN THE NEWS: Shopping for the CPIProblems in Measuring the Cost of Living 523The GDP Deflator versus the Consumer Price Index

Correcting Economic Variables for the Effectsof Inflation 527Dollar Figures from Different Times 527CASE STUDY: Mr. Index Goes to HollywoodIndexation 528Real and Nominal Interest Rates 529

Conclusion 531Summary 531Key Concepts 532Questions for Review 532Problems and Applications 532

526

PART 9THE REAL ECONOMY

IN THE LONG RUN 535

CHAPTER 25PRODUCTION AND GROWTH 537

Economic Growth around the World 538FYI: Are You Richer Than the Richest American?

TABLE OF CONTENTS XXXV

Productivity: Its Role and Determinants 540Why Productivity Is So Important 540How Productivity Is Determined 541FYI: The Production FunctionCASE STUDY: Are Natural Resources a Limit

to Growth?

Economic Growth and Public Policy 545The Importance of Saving and Investment 545Diminishing Returns and the Catch-Up Effect 546Investment from Abroad 547Education 549IN THE NEWS: Promoting Human CapitalProperty Rights and Political Stability 550Free Trade 551Research and Development 552CASE STUDY: The Productivity Slowdown

and SpeedupPopulation Growth 554IN THE NEWS: A Solution to Africa's Problems

Conclusion: The Importance of Long-Run Growth 558Summary 558Key Concepts 558Questions for Review 559Problems and Applications 559

CHAPTER 26SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 561

Financial Institutions in the U.S. Economy 562Financial Markets 562FYI: How to Read the Newspaper's Stock TablesFinancial Intermediaries 564Summing Up 567IN THE NEWS: Finance in China

Saving and Investment inthe National Income Accounts 568Some Important Identities 568The Meaning of Saving and Investment 570

The Market for Loanable Funds 570Supply and Demand for Loanable Funds 571Policy 1: Saving Incentives 573Policy 2: Investment Incentives 574Policy 3: Government Budget Deficits and

Surpluses 575CASE STUDY: The History of U.S. Government

Debt

Conclusion 579Summary 580

Key Concepts 580Questions for Review 580Problems and Applications 581

CHAPTER 27THE BASIC TOOLS OF FINANCE 583

Present Value: Measuring the Time Value of Money 584FYI: The Magic of Compounding and

the Rule of 70

Managing Risk 586Risk Aversion 586The Markets for Insurance 587Diversification of Idiosyncratic Risk 588The Tradeoff between Risk and Return 590

Asset Valuation 591Fundamental Analysis 591The Efficient Markets Hypothesis 592CASE STUDY: Random Walks and Index FundsMarket Irrationality 593IN THE NEWS: Some Lessons from Enron

Conclusion 595Summary 596Key Concepts 596Questions for Review 597Problems and Applications 597

CHAPTER 28UNEMPLOYMENT AND ITS NATURAL RATE 599

Identifying Unemployment 600How Is Unemployment Measured? 600CASE STUDY: Labor-Force Participation of Men and

Women in the U.S. EconomyDoes the Unemployment Rate Measure What

We Want It To? 605How Long Are the Unemployed without Work? 605Why Are There Always Some People Unemployed? 607

Job Search 607Why Some Frictional Unemployment Is Inevitable 608Public Policy and Job Search 608Unemployment Insurance 609IN THE NEWS: German Unemployment

Minimum-Wage Laws 611

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Unions and Collective Bargaining 613The Economics of Unions 613Are Unions Good or Bad for the Economy?IN THE NEWS: Should You Join a Union?

614

The Theory of Efficiency Wages 616Worker Health 617Worker Turnover 617Worker Effort 617Worker Quality 618CASE STUDY: Henry Ford and the Very Generous

$5-a-Day WageConclusion 620Summary 620Key Concepts 621Questions for Review 621Problems and Applications 621

PART 10MONEY AND PRICES

IN THE LONG RUN 625

CHAPTER 29THE MONETARY SYSTEM 627

The Meaning of Money 628The Functions of Money 628The Kinds of Money 629IN THE NEWS: Money on the Island of YapMoney in the U.S. Economy 631FYI: Credit Cards, Debit Cards, and MoneyCASE STUDY: Where Is All the Currency?

The Federal Reserve System 634The Fed's Organization 634The Federal Open Market Committee 634

Banks and the Money Supply 635The Simple Case of 100-Percent-Reserve Banking

Money Creation with Fractional-ReserveBanking 636

The Money Multiplier 637The Fed's Tools of Monetary Control 639Problems in Controlling the Money Supply 640CASE STUDY: Bank Runs and the Money

SupplyConclusion 642Summary 642Key Concepts 643Questions for Review 643Problems and Applications 643

CHAPTER 30MONEY GROWTH AND INFLATION 645

636

The Classical Theory of Inflation 646The Level Of Prices and the Value of Money 647Money Supply, Money Demand, and Monetary

Equilibrium 647The Effects of a Monetary Injection 649A Brief Look at the Adjustment Process 650The Classical Dichotomy and Monetary Neutrality 651Velocity and the Quantity Equation 653CASE STUDY: Money and Prices during

Four HyperinflationsThe Inflation Tax 656IN THE NEWS: Russia Turns to the Inflation TaxThe Fisher Effect 657

The Costs of Inflation 659A Fall in Purchasing Power? The Inflation Fallacy 659Shoeleather Costs 660Menu Costs 661Relative-Price Variability and the Misallocation

of Resources 661Inflation-Induced Tax Distortions 662Confusion and Inconvenience 663IN THE NEWS: The Hyperinflation in SerbiaA Special Cost of Unexpected Inflation:

Arbitrary Redistributions of Wealth 664CASE STUDY: The Wizard of Oz and the Free-Silver

DebateIN THE NEWS: How to Protect Your Savings

from InflationConclusion 669Summary 669Key Concepts 670Questions for Review 670Problems and Applications 670

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PART 111THE MACROECONOMICS

OF OPEN ECONOMIES 673

CHAPTER 31OPEN-ECONOMY MACROECONOMICS:BASIC CONCEPTS 675

The International Flows of Goods and Capital 676The Flow of Goods: Exports, Imports,

and Net Exports 676CASE STUDY: The Increasing Openness

of the U.S. EconomyThe Flow of Financial Resources:

Net Capital Outflow 678IN THE NEWS: How the Chinese Help American

Home BuyersThe Equality of Net Exports and Net Capital Outflow 679Saving, Investment, and Their Relationship

to the International Flows 681Summing Up 682CASE STUDY: Is the U.S. Trade Deficit a National

Problem?

The Prices for International Transactions: Real and NominalExchange Rates 685Nominal Exchange Rates 685Real Exchange Rates 686FYI: The Euro

A First Theory of Exchange-Rate Determination:Purchasing-Power Parity 688The Basic Logic of Purchasing-Power Parity 689Implications of Purchasing-Power Parity 689CASE STUDY: The Nominal Exchange Rate during

a HyperinflationLimitations of Purchasing-Power Parity 692CASE STUDY: The Hamburger Standard

Conclusion 693Summary 694

Key Concepts 694Questions for Review 694Problems and Applications 694

CHAPTER 32A MACROECONOMIC THEORYOF THE OPEN ECONOMY 697

Supply and Demand for Loanable Fundsand for Foreign-Currency Exchange 698The Market for Loanable Funds 698The Market for Foreign-Currency Exchange 700FYI: Purchasing-Power Parity as a Special Case

Equilibrium in the Open Economy 703Net Capital Outflow: The Link between

the Two Markets 703Simultaneous Equilibrium in Two Markets 704

How Policies and Events Affect an Open Economy 706Government Budget Deficits 706Trade Policy 708Political Instability and Capital Flight 712IN THE NEWS: The U.S. Trade Deficit

Conclusion 715Summary 715Key Concepts 716Questions for Review 716Problems and Applications 717

SHORT-RUN ECONOMICFLUCTUATIONS 721

CHAPTER 33AGGREGATE DEMAND AND AGGREGATE SUPPLY 723

Three Key Facts about Economic Fluctuations 724

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Fact 1: Economic Fluctuations Are Irregularand Unpredictable 724

Fact 2: Most Macroeconomic QuantitiesFluctuate Together 724

Fact 3: As Output Falls, Unemployment RisesIN THE NEWS: The Trash Indicator

727

Explaining Short-Run Economic Fluctuations 727How the Short Run Differs from the Long Run 727The Basic Model of Economic Fluctuations 728

The Aggregate-Demand Curve 729Why the Aggregate-Demand Curve

Slopes Downward 729Why the Aggregate-Demand Curve Might Shift 731

The Aggregate-Supply Curve 734Why the Aggregate-Supply Curve

Is Vertical in the Long Run 734Why the Long-Run Aggregate-Supply Curve

Might Shift 735A New Way to Depict Long-Run Growth

and Inflation 737Why the Aggregate-Supply Curve

Slopes Upward in the Short Run 738Why the Short-Run Aggregate-Supply Curve

Might Shift 740

Two Causes of Economic Fluctuations 742The Effects of a Shift in Aggregate Demand 742CASE STUDY: Two Big Shifts in Aggregate Demand:

The Great Depression and World War IICASE STUDY: The Recession of 2001The Effects of a Shift in Aggregate Supply 747CASE STUDY: Oil and the EconomyFYI: The Origins of Aggregate Demand

and Aggregate SupplyConclusion 751Summary 751Key Concepts 752Questions for Review 752Problems and Applications 753

CHAPTER 34THE INFLUENCE OF MONETARY ANDFISCAL POLICY ON AGGREGATE DEMAND 755

How Monetary Policy Influences Aggregate DemandThe Theory of Liquidity Preference 757

756

FYI: Interest Rates in the Long Runand the Short Run

The Downward Slope of the Aggregate-DemandCurve 760

Changes in the Money Supply 761The Role of Interest-Rate Targets in Fed Policy 763CASE STUDY: Why the Fed Watches the Stock Market

(and Vice Versa)

How Fiscal Policy Influences Aggregate Demand 765Changes in Government Purchases 765The Multiplier Effect 765A Formula for the Spending Multiplier 766Other Applications of the Multiplier Effect 768The Crowding-Out Effect 768Changes in Taxes 769FYI: How Fiscal Policy Might Affect

Aggregate Supply

Using Policy to Stabilize the Economy 771The Case for Active Stabilization Policy 771CASE STUDY: Keynesians in the White HouseThe Case against Active Stabilization Policy 773Automatic Stabilizers 774IN THE NEWS: The Independence of

the Federal ReserveConclusion 776Summary 777Key Concepts 777Questions for Review 777Problems and Applications 778

CHAPTER 35THE SHORT-RUN TRADEOFF BETWEENINFLATION AND UNEMPLOYMENT 781

The Phillips Curve 782Origins of the Phillips Curve 782Aggregate Demand, Aggregate Supply,

and the Phillips Curve 783

Shifts in the Phillips Curve:The Role of Expectations 785The Long-Run Phillips Curve 785Expectations and the Short-Run Phillips Curve 788The Natural Experiment for the Natural-Rate

Hypothesis 790IN THE NEWS: The Benefits of Low Expected

Inflation

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Shifts in the Phillips Curve:The Role of Supply Shocks 792

796The Cost of Reducing InflationThe Sacrifice Ratio 796Rational Expectations and the Possibility

of Costless Disinflation 797The Volcker Disinflation 798The Greenspan Era 800CASE STUDY: Why Were Inflation and Unemployment

So Low at the End of the 1990s?IN THE NEWS: The Case for Inflation Targeting

Conclusion 804Summary 804Key Concepts 805Questions for Review 805Problems and Applications 805

PART 13FINAL THOUGHTS 809

Should Monetary Policy Be Made by Rule Rather Thanby Discretion? 814Pro: Monetary Policy Should Be Made by Rule 814IN THE NEWS: Alan Greenspan versus the PCCon: Monetary Policy Should Not Be Made

by Rule 816

Should the Central Bank Aim for Zero Inflation? 817Pro: The Central Bank Should Aim for Zero Inflation 817Con: The Central Bank Should Not Aim for

Zero Inflation 818

Should the Government Balance Its Budget? 820Pro: The Government Should Balance Its Budget 820Con: The Government Should Not Balance

Its Budget 821

Should the Tax Laws Be Reformed to EncourageSaving? 822Pro: The Tax Laws Should Be Reformed

to Encourage Saving 823Con: The Tax Laws Should Not Be Reformed

to Encourage Saving 824Conclusion 825Summary 825Questions for Review 826Problems and Applications 827

Glossary 829Index 835

CHAPTER 36FIVE DEBATES OVER MACROECONOMIC POLICY 811

Should Monetary and Fiscal Policymakers Try to Stabilizethe Economy? 812Pro: Policymakers Should Try to Stabilize

the Economy 812Con: Policymakers Should Not Try to Stabilize

the Economy 812