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M1 246
M2 247
Other Definitions of the Money Supply 247
THE BANKING SYSTEM 248
How Banking Began 248
Principles of Bank Management: Profits versus Safety 250
Bank Regulation 250
THE ORIGINS OF THE MONEY SUPPLY 251
How Bankers Keep Books 251
BANKS AND MONEY CREATION 252
The Limits to Money Creation by a Single Bank 252
Multiple Money Creation by a Series of Banks 254
The Process in Reverse: Multiple Contractions of the Money Supply 256
WHY THE MONEY-CREATION FORMULA IS OVERSIMPLIFIED 258
THE NEED FOR MONETARY POLICY 259
Summary 259
Key Terms 260
Test Yourself 260
Discussion Questions 260

Chapter 13 Managing Aggregate Demand: Monetary Policy 261
ISSUE: JUST WHY IS BEN BERNANKE SO IMPORTANT? 262
MONEY AND INCOME: THE IMPORTANT DIFFERENCE 262
AMERICA™S CENTRAL BANK: THE FEDERAL RESERVE SYSTEM 263
Origins and Structure 263
Central Bank Independence 264
IMPLEMENTING MONETARY POLICY: OPEN-MARKET OPERATIONS 265
The Market for Bank Reserves 265
The Mechanics of an Open-Market Operation 266
Open-Market Operations, Bond Prices, and Interest Rates 268
OTHER METHODS OF MONETARY CONTROL 268
Lending to Banks 269
Changing Reserve Requirements 270
HOW MONETARY POLICY WORKS 270
Investment and Interest Rates 271
Monetary Policy and Total Expenditure 271
MONEY AND THE PRICE LEVEL IN THE KEYNESIAN MODEL 272
Application: Why the Aggregate Demand Curve Slopes Downward 273
FROM MODELS TO POLICY DEBATES 274
Summary 274
Key Terms 275
Test Yourself 275
Discussion Questions 276

Chapter 14 The Debate Over Monetary and Fiscal Policy 277
ISSUE: SHOULD WE FORSAKE STABILIZATION POLICY? 278
Contents
xvi



VELOCITY AND THE QUANTITY THEORY OF MONEY 278
Some Determinants of Velocity 280
Monetarism: The Quantity Theory Modernized 281
FISCAL POLICY, INTEREST RATES, AND VELOCITY 281
Application: The Multiplier Formula Revisited 282
Application: The Government Budget and Investment 283
DEBATE: SHOULD WE RELY ON FISCAL OR MONETARY POLICY? 283
DEBATE: SHOULD THE FED CONTROL THE MONEY SUPPLY OR INTEREST RATES? 284
Two Imperfect Alternatives 286
What Has the Fed Actually Done? 286
DEBATE: THE SHAPE OF THE AGGREGATE SUPPLY CURVE 287
DEBATE: SHOULD THE GOVERNMENT INTERVENE? 289
Lags and the Rules-versus-Discretion Debate 291
DIMENSIONS OF THE RULES-VERSUS-DISCRETION DEBATE 291
How Fast Does the Economy™s Self-Correcting Mechanism Work? 291
How Long Are the Lags in Stabilization Policy? 292
How Accurate Are Economic Forcasts? 292
The Size of Government 292
Uncertainties Caused by Government Policy 293
A Political Business Cycle? 293
ISSUE REVISITED: WHAT SHOULD BE DONE? 295
Summary 295
Key Terms 296
Test Yourself 296
Discussion Questions 297

Chapter 15 Budget Deficits in the Short and Long Run 299
ISSUE: IS THE FEDERAL GOVERNMENT BUDGET DEFICIT TOO LARGE? 300
SHOULD THE BUDGET BE BALANCED? THE SHORT RUN 300
The Importance of the Policy Mix 301
SURPLUSES AND DEFICITS: THE LONG RUN 301
DEFICITS AND DEBT: TERMINOLOGY AND FACTS 303
Some Facts about the National Debt 303
INTERPRETING THE BUDGET DEFICIT OR SURPLUS 305
The Structural Deficit or Surplus 305
On-Budget versus Off-Budget Surpluses 307
Conclusion: What Happened after 1981? 307
WHY IS THE NATIONAL DEBT CONSIDERED A BURDEN? 307
BUDGET DEFICITS AND INFLATION 308
The Monetization Issue 309
DEBT, INTEREST RATES, AND CROWDING OUT 310
The Bottom Line 311
THE MAIN BURDEN OF THE NATIONAL DEBT: SLOWER GROWTH 311
ISSUE REVISITED: IS THE BUDGET DEFICIT TOO LARGE? 313
THE ECONOMICS AND POLITICS OF THE U.S. BUDGET DEFICIT 314
Summary 315
Key Terms 315
Test Yourself 316
Discussion Questions 316

Chapter 16 The Trade-off between Inflation and Unemployment 317
ISSUE: IS THE TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT A RELIC OF THE PAST? 318
DEMAND-SIDE INFLATION VERSUS SUPPLY-SIDE INFLATION: A REVIEW 318
ORIGINS OF THE PHILLIPS CURVE 319
SUPPLY-SIDE INFLATION AND THE COLLAPSE OF THE PHILLIPS CURVE 321
Contents xvii



Explaining the Fabulous 1990s 321
ISSUE RESOLVED: WHY INFLATION AND UNEMPLOYMENT BOTH DECLINED 322
WHAT THE PHILLIPS CURVE IS NOT 322
FIGHTING UNEMPLOYMENT WITH FISCAL AND MONETARY POLICY 324
WHAT SHOULD BE DONE? 325
The Costs of Inflation and Unemployment 325
The Slope of the (Short-Run) Phillips Curve 325
The Efficiency of the Economy™s Self-Correcting Mechanism 325
INFLATIONARY EXPECTATIONS AND THE PHILLIPS CURVE 326
THE THEORY OF RATIONAL EXPECTATIONS 328
What Are Rational Expectations? 328
Rational Expectations and the Trade-Off 329
An Evaluation 329
WHY ECONOMISTS (AND POLITICIANS) DISAGREE 330
THE DILEMMA OF DEMAND MANAGEMENT 331
ATTEMPTS TO REDUCE THE NATURAL RATE OF UNEMPLOYMENT 331
INDEXING 332
Summary 333
Key Terms 334
Test Yourself 334
Discussion Questions 334


PART 4 THE UNITED STATES IN THE WORLD ECONOMY 337
Chapter 17 International Trade and Comparative Advantage 339
ISSUE: HOW CAN AMERICANS COMPETE WITH “CHEAP FOREIGN LABOR”? 340
WHY TRADE? 341
Mutual Gains from Trade 341
INTERNATIONAL VERSUS INTRANATIONAL TRADE 342
Political Factors in International Trade 342
The Many Currencies Involved in International Trade 342
Impediments to Mobility of Labor and Capital 342
THE LAW OF COMPARATIVE ADVANTAGE 343
The Arithmetic of Comparative Advantage 343
The Graphics of Comparative Advantage 344
Must Specialization Be Complete? 347
ISSUE RESOLVED: COMPARATIVE ADVANTAGE EXPOSES THE “CHEAP FOREIGN LABOR” FALLACY 347
TARIFFS, QUOTAS, AND OTHER INTERFERENCES WITH TRADE 348
Tariffs versus Quotas 349
WHY INHIBIT TRADE? 350
Gaining a Price Advantage for Domestic Firms 350
Protecting Particular Industries 350
National Defense and Other Noneconomic Considerations 351
The Infant-Industry Argument 352
Strategic Trade Policy 353
CAN CHEAP IMPORTS HURT A COUNTRY? 353
A LAST LOOK AT THE “CHEAP FOREIGN LABOR” ARGUMENT 354
Summary 356
Key Terms 356
Test Yourself 357
Discussion Questions 357

| APPENDIX | SUPPLY, DEMAND, AND PRICING IN WORLD TRADE 358
HOW TARIFFS AND QUOTAS WORK 359
Summary 360
Test Yourself 360
Contents
xviii



Chapter 18 The International Monetary System: Order or Disorder? 361
PUZZLE: WHY HAS THE DOLLAR SAGGED? 362
WHAT ARE EXCHANGE RATES? 362
EXCHANGE RATE DETERMINATION IN A FREE MARKET 363
Interest Rates and Exchange Rates: The Short Run 365
Economic Activity and Exchange Rates: The Medium Run 366
The Purchasing-Power Parity Theory: The Long Run 366
Market Determination of Exchange Rates: Summary 368
WHEN GOVERNMENTS FIX EXCHANGE RATES: THE BALANCE OF PAYMENTS 369
A BIT OF HISTORY: THE GOLD STANDARD AND THE BRETTON WOODS SYSTEM 370
The Classical Gold Standard 371
The Bretton Woods System 371
ADJUSTMENT MECHANISMS UNDER FIXED EXCHANGE RATES 372
WHY TRY TO FIX EXCHANGE RATES? 372
THE CURRENT “NONSYSTEM” 373
The Role of the IMF 374
The Volatile Dollar 374
The Birth of the Euro 375
PUZZLE RESOLVED: WHY THE DOLLAR ROSE AND THEN FELL 376
Summary 377
Key Terms 377
Test Yourself 378
Discussion Questions 378

Chapter 19 Exchange Rates and the Macroeconomy 379
ISSUE: SHOULD THE U.S. GOVERNMENT TRY TO STOP THE DOLLAR FROM FALLING? 380
INTERNATIONAL TRADE, EXCHANGE RATES, AND AGGREGATE DEMAND 380
Relative Prices, Exports, and Imports 381
The Effects of Changes in Exchange Rates 381
AGGREGATE SUPPLY IN AN OPEN ECONOMY 382
THE MACROECONOMIC EFFECTS OF EXCHANGE RATES 383
Interest Rates and International Capital Flows 384
FISCAL AND MONETARY POLICIES IN AN OPEN ECONOMY 384
Fiscal Policy Revisited 384
Monetary Policy Revisited 386
INTERNATIONAL ASPECTS OF DEFICIT REDUCTION 386
The Loose Link between the Budget Deficit and the Trade Deficit 387
SHOULD WE WORRY ABOUT THE TRADE DEFICIT? 388
ON CURING THE TRADE DEFICIT 388
Change the Mix of Fiscal and Monetary Policy 388
More Rapid Economic Growth Abroad 389
Raise Domestic Saving or Reduce Domestic Investment 389
Protectionism 389
CONCLUSION: NO NATION IS AN ISLAND 390
ISSUE REVISITED: SHOULD THE UNITED STATES LET THE DOLLAR FALL? 391
Summary 391
Key Terms 392
Test Yourself 392
Discussion Questions 392

| APPENDIX | Answers to Odd-Numbered Test Yourself Questions 393

Glossary 405
Index 413
Preface


A s usual, when preparing a new edition, we have made many small changes to
improve clarity of exposition and to update the text both for recent economics
events and for relevant advances in the literature. But this time we have focused on one
particular addition that will, so far as we have been able to find out, differentiate this book
from all other introductory texts.
We have included in the eleventh edition a substantial discussion of the role of the en-
trepreneurs and of the microtheory of their activities, their pricing and their earnings, and
the implications for economic growth. Several studies of the place of the entrepreneur in
economics textbooks (including earlier editions of this one) have all reached the same con-
clusion: that entrepreneurs are either completely invisible or are virtually so. Indeed, in a
substantial set of the textbooks the word entrepreneur does not even appear in the index.
Now, this omission should appear strange because entrepreneurs are often classified as
one of the four factors of production”but the only one to which no chapter is devoted.
More than that, it seems universally recognized by economists that economic growth is the
prime contributor to the general welfare and that more than 80 percent of the current in-
come of the average American was contributed by growth in the past century alone. More-
over, it is clear that, even though entrepreneurs did not produce this growth by themselves,
much if not most of this historically unprecedented achievement would not have occurred
without them. Yet, in the textbooks, they have been the invisible men and women.
This eleventh edition is the product of nearly 30 years of the existence and modification
of this book. In the responses to a survey of faculty users, it became clear that a number of
chapters were generally not covered by instructors for lack of time, although the material
is of considerable interest to students and is not”or need not be”technically demanding.
So we simplified several such chapters further”notably Chapter 9 on the stock and bond
markets, Chapter 13 on regulation and antitrust, Chapter 17 on environmental economics,
and Chapter 21 on poverty and inequality”to make it practical for an instructor to assign
any or all of them to the students for reading entirely by themselves.
In the macroeconomic portions of the book, we try to make the links between the short
run and the long run clearer and more explicit with each passing edition. For the eleventh
edition, we have also added much new material on the problems in the subprime mort-
gage markets, the ensuing financial crisis and possible recession, and several economic is-
sues in the 2008 presidential campaign”even though, at this writing, no one yet knows
who the Democratic nominee will be! As is our practice, these new materials are scattered
over many chapters of the text, so as to locate the discussions of current events and policy
close to the places where the relevant principles are taught. This edition also adds a bit
more material on China; sadly, the experience in Zimbabwe has provided a contemporary
example of hyperinflation.
We ended this section of the preface to the tenth edition by singling out the critical con-
tributions of one colleague and friend of amazingly long duration. We now repeat some
of our words about the late Sue Anne Batey Blackman, who worked closely with us
through 10 editions of this book; for all practical purposes, she had become a coauthor.
Indeed, the chapter on environmental matters is now largely her product. Her creative

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