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PUZZLE: WHAT HAPPENED TO OIL PRICES? 56
THE INVISIBLE HAND 56
DEMAND AND QUANTITY DEMANDED 57
The Demand Schedule 58
The Demand Curve 58
Shifts of the Demand Curve 58
SUPPLY AND QUANTITY SUPPLIED 61
The Supply Schedule and the Supply Curve 61
Shifts of the Supply Curve 62
SUPPLY AND DEMAND EQUILIBRIUM 64
The Law of Supply and Demand 66
EFFECTS OF DEMAND SHIFTS ON SUPPLY-DEMAND EQUILIBRIUM 66
SUPPLY SHIFTS AND SUPPLY-DEMAND EQUILIBRIUM 67
THOSE LEAPING OIL PRICES: PUZZLE RESOLVED 68
Application: Who Really Pays that Tax? 69
BATTLING THE INVISIBLE HAND: THE MARKET FIGHTS BACK 70
Restraining the Market Mechanism: Price Ceilings 70
Case Study: Rent Controls in New York City 72
Restraining the Market Mechanism: Price Floors 73
Case Study: Farm Price Supports and the Case of Sugar Prices 74
A Can of Worms 75
Contents xi



A SIMPLE BUT POWERFUL LESSON 76
Summary 76
Key Terms 77
Test Yourself 77
Discussion Questions 78


PART 2 THE MACROECONOMY: AGGREGATE SUPPLY AND DEMAND 81
Chapter 5 An Introduction to Macroeconomics 83
ISSUE: WHY DID GROWTH SLOW IN 2006-2007? 84
DRAWING A LINE BETWEEN MACROECONOMICS AND MICROECONOMICS 84
Aggregation and Macroeconomics 84
The Foundations of Aggregation 85
The Line of Demarcation Revisited 85
SUPPLY AND DEMAND IN MACROECONOMICS 85
A Quick Review 86
Moving to Macroeconomic Aggregates 86
Inflation 87
Recession and Unemployment 87
Economic Growth 87
GROSS DOMESTIC PRODUCT 87
Money as the Measuring Rod: Real versus Nominal GDP 88
What Gets Counted in GDP? 88
Limitations of the GDP: What GDP Is Not 90
THE ECONOMY ON A ROLLER COASTER 91
Growth, but with Fluctuations 91
Inflation and Deflation 93
The Great Depression 94
From World War II to 1973 95
The Great Stagflation, 1973“1980 96
Reaganomics and Its Aftermath 97
Clintonomics: Deficit Reduction and the “New Economy” 97
Tax Cuts and the Bush Economy 98
ISSUE REVISITED: WAS IT GEORGE BUSH™S FAULT? 99
THE PROBLEM OF MACROECONOMIC STABILIZATION: A SNEAK PREVIEW 99
Combating Unemployment 99
Combating Inflation 100
Does It Really Work? 100
Summary 101
Key Terms 102
Test Yourself 102
Discussion Questions 103

Chapter 6 The Goals of Macroeconomic Policy 105
PART 1: THE GOAL OF ECONOMIC GROWTH 106
PRODUCTIVITY GROWTH: FROM LITTLE ACORNS . . . 106
ISSUE: IS FASTER GROWTH ALWAYS BETTER? 108
THE CAPACITY TO PRODUCE: POTENTIAL GDP AND THE PRODUCTION FUNCTION 108
THE GROWTH RATE OF POTENTIAL GDP 109
ISSUE REVISITED: IS FASTER GROWTH ALWAYS BETTER? 110
PART 2: THE GOAL OF LOW UNEMPLOYMENT 111
THE HUMAN COSTS OF HIGH UNEMPLOYMENT 112
COUNTING THE UNEMPLOYED: THE OFFICIAL STATISTICS 113
TYPES OF UNEMPLOYMENT 114
Contents
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HOW MUCH EMPLOYMENT IS “FULL EMPLOYMENT”? 115
UNEMPLOYMENT INSURANCE: THE INVALUABLE CUSHION 115
PART 3: THE GOAL OF LOW INFLATION 116
INFLATION: THE MYTH AND THE REALITY 117
Inflation and Real Wages 117
The Importance of Relative Prices 119
INFLATION AS A REDISTRIBUTOR OF INCOME AND WEALTH 120
REAL VERSUS NOMINAL INTEREST RATES 120
INFLATION DISTORTS MEASUREMENTS 121
Confusing Real and Nominal Interest Rates 122
The Malfunctioning Tax System 122
OTHER COSTS OF INFLATION 122
THE COSTS OF LOW VERSUS HIGH INFLATION 123
LOW INFLATION DOES NOT NECESSARILY LEAD TO HIGH INFLATION 125
Summary 125
Key Terms 126
Test Yourself 126
Discussion Questions 127
APPENDIX: HOW STATISTICIANS MEASURE INFLATION 127
Index Numbers for Inflation 127
The Consumer Price Index 128
Using a Price Index to “Deflate” Monetary Figures 128
Using a Price Index to Measure Inflation 129
The GDP Deflator 129
Summary 130
Key Terms 130
Test Yourself 130


Chapter 7 Economic Growth: Theory and Policy 133
PUZZLE: WHY DOES COLLEGE EDUCATION KEEP GETTING MORE EXPENSIVE? 134
THE THREE PILLARS OF PRODUCTIVITY GROWTH 134
Capital 135
Technology 135
Labor Quality: Education and Training 136
LEVELS, GROWTH RATES, AND THE CONVERGENCE HYPOTHESIS 136
GROWTH POLICY: ENCOURAGING CAPITAL FORMATION 138
GROWTH POLICY: IMPROVING EDUCATION AND TRAINING 140
GROWTH POLICY: SPURRING TECHNOLOGICAL CHANGE 142
THE PRODUCTIVITY SLOWDOWN AND SPEED-UP IN THE UNITED STATES 143
The Productivity Slowdown, 1973“1995 143
The Productivity Speed-up, 1995“? 144
PUZZLE RESOLVED: WHY THE RELATIVE PRICE OF COLLEGE TUITION KEEPS RISING 146
GROWTH IN THE DEVELOPING COUNTRIES 147
The Three Pillars Revisited 147
Some Special Problems of the Developing Countries 148
FROM THE LONG RUN TO THE SHORT RUN 149
Summary 149
Key Terms 150
Test Yourself 150
Discussion Questions 151


Chapter 8 Aggregate Demand and the Powerful Consumer 153
ISSUE: DEMAND MANAGEMENT AND THE ORNERY CONSUMER 154
AGGREGATE DEMAND, DOMESTIC PRODUCT, AND NATIONAL INCOME 154
Contents xiii



THE CIRCULAR FLOW OF SPENDING, PRODUCTION, AND INCOME 155
CONSUMER SPENDING AND INCOME: THE IMPORTANT RELATIONSHIP 157
THE CONSUMPTION FUNCTION AND THE MARGINAL PROPENSITY TO CONSUME 160
FACTORS THAT SHIFT THE CONSUMPTION FUNCTION 161
ISSUE REVISITED: WHY THE TAX REBATES FAILED IN 1975 AND 2001 162
THE EXTREME VARIABILITY OF INVESTMENT 164
THE DETERMINANTS OF NET EXPORTS 165
National Incomes 165
Relative Prices and Exchange Rates 165
HOW PREDICTABLE IS AGGREGATE DEMAND? 166
Summary 166
Key Terms 167
Test Yourself 167
Discussion Questions 168
APPENDIX: NATIONAL INCOME ACCOUNTING 168
Defining GDP: Exceptions to the Rules 168
GDP as the Sum of Final Goods and Services 169
GDP as the Sum of All Factor Payments 169
GDP as the Sum of Values Added 171
Summary 172
Key Terms 173
Test Yourself 173
Discussion Questions 174


Chapter 9 Demand-Side Equilibrium: Unemployment or Inflation? 175
ISSUE: WHY DOES THE MARKET PERMIT UNEMPLOYMENT? 176
THE MEANING OF EQUILIBRIUM GDP 176
THE MECHANICS OF INCOME DETERMINATION 178
THE AGGREGATE DEMAND CURVE 180
DEMAND-SIDE EQUILIBRIUM AND FULL EMPLOYMENT 182
THE COORDINATION OF SAVING AND INVESTMENT 183
CHANGES ON THE DEMAND SIDE: MULTIPLIER ANALYSIS 185
The Magic of the Multiplier 185
Demystifying the Multiplier: How It Works 186
Algebraic Statement of the Multiplier 187
THE MULTIPLIER IS A GENERAL CONCEPT 189
THE MULTIPLIER AND THE AGGREGATE DEMAND CURVE 190
Summary 191
Key Terms 192
Test Yourself 192
Discussion Questions 193
APPENDIX A: THE SIMPLE ALGEBRA OF INCOME DETERMINATION AND THE MULTIPLIER 193
Test Yourself 194
Discussion Questions 194
APPENDIX B: THE MULTIPLIER WITH VARIABLE IMPORTS 194
Summary 197
Test Yourself 197
Discussion Question 197

Chapter 10 Bringing in the Supply-Side: Unemployment and Inflation? 199
PUZZLE: WHAT CAUSES STAGFLATION? 200
THE AGGREGATE SUPPLY CURVE 200
Why the Aggregate Supply Curve Slopes Upward 200
Shifts of the Agregate Supply Curve 201
Contents
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EQUILIBRIUM OF AGGREGATE DEMAND AND SUPPLY 203
INFLATION AND THE MULTIPLIER 204
RECESSIONARY AND INFLATIONARY GAPS REVISITED 205
ADJUSTING TO A RECESSIONARY GAP: DEFLATION OR UNEMPLOYMENT? 207
Why Nominal Wages and Prices Won™t Fall (Easily) 207
Does the Economy Have a Self-Correcting Mechanism? 208
An example from Recent History: Deflation in Japan 209
ADJUSTING TO AN INFLATIONARY GAP: INFLATION 209
Demand Inflation and Stagflation 210
A U.S. Example 210
STAGFLATION FROM A SUPPLY SHOCK 211
APPLYING THE MODEL TO A GROWING ECONOMY 212
Demand-Side Fluctuations 213
Supply-Side Fluctuations 214
PUZZLE RESOLVED: EXPLAINING STAGFLATION 216
A ROLE FOR STABILIZATION POLICY 216
Summary 216
Key Terms 217
Test Yourself 217
Discussion Questions 218


PART 3 FISCAL AND MONETARY POLICY 219
Chapter 11 Managing Aggregate Demand: Fiscal Policy 221
ISSUE: AGGREGATE DEMAND, AGGREGATE SUPPLY, AND THE CAMPAIGN OF 2008 222
INCOME TAXES AND THE CONSUMPTION SCHEDULE 222
THE MULTIPLIER REVISITED 223
The Tax Multiplier 223
Income Taxes and the Multiplier 224
Automatic Stabilizers 225
Government Transfer Payments 225
ISSUE REVISITED: THE 2008 DEBATE OVER TAXES AND SPENDING 226
PLANNING EXPANSIONARY FISCAL POLICY 226
PLANNING CONTRACTIONARY FISCAL POLICY 227
THE CHOICE BETWEEN SPENDING POLICY AND TAX POLICY 227
ISSUE REDUX: DEMOCRATS VERSUS REPUBLICANS 228
SOME HARSH REALITIES 228
THE IDEA BEHIND SUPPLY-SIDE TAX CUTS 229
Some Flies in the Ointment 230
ISSUE: THE PARTISAN DEBATE ONCE MORE 231
Toward an Assessment of Supply-Side Economics 232
Summary 233
Key Terms 233
Test Yourself 234
Discussion Questions 234

| APPENDIX A | GRAPHICAL TREATMENT OF TAXES AND FISCAL POLICY 235
MULTIPLIERS FOR TAX POLICY 237
Summary 237
Key Terms 237
Test Yourself 238
Discussion Questions 238

| APPENDIX B | ALGEBRAIC TREATMENT OF TAXES AND FISCAL POLICY 238
Test Yourself 240
Contents xv



Chapter 12 Money and the Banking System 241
ISSUE: WHY ARE BANKS SO HEAVILY REGULATED? 242
THE NATURE OF MONEY 242
Barter versus Monetary Exchange 243
The Conceptual Definition of Money 244
What Serves as Money? 244
HOW THE QUANTITY OF MONEY IS MEASURED 246

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