M Macroeconomics a c Robert J. Gordon r o Twelfth Edition e c o n o m i c s G o r d o n T w e l f t h E d i t i o n ISBN 978-1-29202-207-9 9 781292 022079 Macroeconomics Robert J. Gordon Twelfth Edition ISBN 10: 1-292-02207-8 ISBN 13: 978-1-292-02207-9 Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsoned.co.uk © Pearson Education Limited 2014 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affi liation with or endorsement of this book by such owners. ISBN 10: 1-292-02207-8 ISBN 13: 978-1-292-02207-9 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Printed in the United States of America 1122233442592604727041971399575573 P E A R S O N C U S T O M L I B R AR Y Table of Contents 1. What Is Macroeconomics? Robert J. Gordon 1 2. The Measurement of Income, Prices, and Unemployment Robert J. Gordon 25 3. Income and Interest Rates: The Keynesian Cross Model and the IS Curve Robert J. Gordon 57 4. Strong and Weak Policy Effects in the IS-LM Model Robert J. Gordon 93 5. Financial Markets, Financial Regulation, and Economic Instability Robert J. Gordon 129 6. The Government Budget, the Government Debt, and the Limitations of Fiscal Policy Robert J. Gordon 167 7. International Trade, Exchanges Rates, and Macroeconomic Policy Robert J. Gordon 201 8. Aggregate Demand, Aggregate Supply, and the Great Depression Robert J. Gordon 243 9. Inflation: Its Causes and Cures Robert J. Gordon 279 10. The Goals of Stabilization Policy: Low Inflation and Low Unemployment Robert J. Gordon 329 11. the Theory of Economic Growth Robert J. Gordon 375 12. The Big Questions of Economic Growth Robert J. Gordon 407 13. The Goals, Tools, and Rules of Monetary Policy Robert J. Gordon 445 I 455556671479019733997 14. The Economics of Consumption Behavior Robert J. Gordon 479 15. The Economics of Investment Behavior Robert J. Gordon 517 16. New Classical Macro and New Keynesian Macro Robert J. Gordon 543 17. Conclusion: Where We Stand Robert J. Gordon 573 Appendix: International Annual Time Series Data for Selected Countries: 1960-2010 Robert J. Gordon 599 Glossary Robert J. Gordon 609 Index 617 II What Is Macroeconomics? Business will be better or worse. —CalvinCoolidge, 1928 1 How Macroeconomics Affects Our Everyday Lives Macroeconomicsis concerned with the big economic issues that determine your Macroeconomicsis the study own economic well-being as well as that of your family and everyone you know. of the major economic totals, Each of these issues involves the overall economic performance of the nation oraggregates. rather than whether one particular individual earns more or less than another. The nation’s overall macroeconomic performance matters, not only for its own sake but because many individuals experience its consequences. The Global Economic Crisis that began in late 2007 has created enormous losses The Global Economic Crisis of income and jobs for millions of American families. Not only were almost isthe crisis that began in 2007 15 million people unemployed in late 2010, but many more have given up that simultaneously depressed looking for jobs, have been forced to work part-time instead of full-time, or economic activity in most of the world’s economies. have experienced pay cuts or furlough days when they have not been paid. By one estimate, more than half of American families since 2007 have experi- enced the job loss of a family member, a pay cut, or being forced to work part- time instead of full-time. Macroeconomic performance can also determine whether inflation will erode the value of family savings, as occurred in the 1970s when the annual inflation rate reached 10 percent. Today’s students also care about economic growth, which will determine whether in their future lives they will have a higher standard of living than their parents do today. The “Big Three” Concepts of Macroeconomics Each of these connections between the overall economy and the lives of indi- viduals involves a central macroeconomic concept introduced in this chapter— unemployment, inflation, and economic growth. The basic task of macroeco- nomics is to study the causes of good or bad performance of these three concepts, why each matters to individuals, and what (if anything) the govern- ment can do to improve macroeconomic performance. While there are numer- ous other important macroeconomic concepts, we start by focusing just on Theunemployment rate these, which are the “Big Three” concepts of macroeconomics: isthe number of persons unemployed (jobless individuals 1. The unemployment rate. The higher the overall unemployment rate, the who are actively looking for work harder it is for each individual who wants a job to find work. College sen- or are on temporary layoff) iors who want permanent jobs after graduation are likely to have fewer job divided by the total of those offers if the national unemployment rate is high, as in 2009–10, than low, as employed and unemployed. From Chapter 1 of Macroeconomics, Twelfth Edition. Robert J. Gordon. Copyright © 2012 by Pearson Education, Inc. Published by Pearson Addison Wesley. All rights reserved. 1 What Is Macroeconomics? in 2005–2007. All adults fear a high unemployment rate, which raises the chances that they will be laid off, be unable to pay their bills, have their cars repossessed, lose their health insurance, or even lose their homes through mortgage foreclosures. In “bad times,” when the unemployment rate is high, crime, mental illness, and suicide also increase. The wide- spread consensus that unemployment is the most important macroeco- nomic issue has been further highlighted by the dismal labor market of 2009–10, when fully half of the unemployed were jobless for more than six months. And the recognized harm created by high unemployment is nothing new. Robert Burton, an English clergyman, wrote in 1621 that “employment is so essential to human happiness that indolence is justly considered the mother of misery.” The inflation rateis the 2. The inflation rate.Ahigh inflation rate means that prices, on average, are percentage rate of increase in rising rapidly, while a low inflation rate means that prices, on average, are the economy’s average level rising slowly. An inflation rate of zero means that prices remain essentially ofprices. the same, month after month. In inflationary periods, retired people, or those about to retire, lose the most, since their hard-earned savings buy less as prices go up. Even college students lose as the rising prices of room, board, and textbooks erode what they have saved from previous summer and after-school jobs. While a high inflation rate harms those who have saved, it helps those who have borrowed. Great harm comes from this capricious aspect of inflation, taking from some and giving to others. People want their lives to be predictable, but inflation throws a monkey wrench into individual decision making, creating pervasive uncertainty. Productivityis the aggregate 3. Productivity growth. “Productivity” is the aggregate output per hour of output produced per hour. work that a nation produces in total goods and services; it was about $61 per worker-hour in the United States in 2010. The faster aggregate produc- tivity grows, the easier it is for each member of society to improve his or her standard of living. If productivity were to grow at 3 percent from 2010 to the year 2030, U.S. productivity would rise from $61 per worker-hour to $111 per worker-hour. When multiplied by all the hours worked by all the employees in the country, this extra $50 per worker-hour would make it possible for the nation to have more houses, cars, hospitals, roads, schools, and to combat greenhouse gas emissions that worsen global warming. But if the growth rate of productivity were zero instead of 3 percent, U.S. productivity would remain at $61 in the year 2030. To have more houses and cars, we would have to sacrifice by building fewer hospitals and schools. Such an economy, with no productivity growth, has been called the “zero-sum society,” because any extra good or service enjoyed by one person requires that something be taken away from someone else. Many have argued that the achievement of rapid productivity growth and the avoidance of a zero-sum society form the most important macroeco- nomic challenge of all. The first two of the “Big Three” macroeconomic concepts, the unemploy- ment and inflation rates, appear in the newspaper every day. When economic conditions are poor—as in 2009–10—daily headlines announce that one large company or another is laying off thousands of workers. In the past, sharp increases inthe rate of inflation have also made headlines, as when the price of gasoline jumped during 2006–08. The third major concept, productivity growth, has received widespread attention since 1995 as a source of an improving American standard of living compared to that in Europe and Japan. 2 What Is Macroeconomics? Macroeconomic concepts also play a big role in politics. Incumbent political parties benefit when unemployment and inflation are relatively low, as in the landslide victories of Lyndon Johnson in 1964 and Richard Nixon in 1972. Incumbent presidents who fail to gain reelection often are the victims of a sour economy, as in the cases of Herbert Hoover in 1932, Jimmy Carter in 1980, and more recently George W. Bush in 2008. The defeat of Al Gore by George W. Bush in 2000 was an exception since the strong economy of 2000 should have helped Gore’s incumbent Democratic party win the presidency. GLOBAL ECONOMIC CRISIS FOCUS What Makes It Unique? The Global Economic Crisis that started in 2008 is by most measures the most severe downturn since the Great Depression of the 1930s. Its severity is most apparent in the high level of the unemployment rate (10 percent) reached in 2009–10, in the relatively long duration of unemployment suffered by those who lost their jobs, and in the prediction that the unemployment rate would not return to its normal level of around 5 percent until perhaps 2015 or 2016. Thus, of our three big macro concepts, the Global Economic Crisis mainly af- fected the unemployment rate, while the inflation rate remained low and pro- ductivity growth was relatively robust. 2 Defining Macroeconomics How Macroeconomics Differs from Microeconomics Most topics in economics can be placed in one of two categories: macroeconom- ics or microeconomics. Macro comes from a Greek word meaning large; micro comes from a Greek word meaning small. Put another way, macroeconomics deals with the totals, or aggregates,of the economy, and microeconomics deals Anaggregateis the total with the parts. amount of an economic Microeconomics is devoted to the relationships among the different partsof magnitude for the economy the economy. For example, in micro we try to explain the wage or salary of one asa whole. type of worker in relation to another. For example, why is a professor’s salary more than that of a secretary but less than that of an investment banker? In con- trast, macroeconomics asks why the total income of all citizens rises strongly in some periods but declines in others. Economic Theory: A Process of Simplification Economic theory helps us understand the economy by simplifying complexity. Theory throws a spotlight on just a few key relations. Macroeconomic theory examines the behavior of aggregates such as the unemployment rate and the inflation rate while ignoring differences among individual households. It stud- ies the causes and possible cures of the Global Economic Crisis at the level of individual nations, instead of trying to explain why some individuals are more prone than others to losing their jobs. It is this process of simplification that makes the study of economics so exciting. By learning a few basic macroeconomic relations, you can quickly 3 What Is Macroeconomics? learn how to sift out the hundreds of irrelevant details in the news in order to focus on the few key items that foretell where the economy is going. You also will begin to understand which national and personal economic goals can be attained and which are “pie in the sky.” You will learn when it is fair to credit a president for strong economic performance or blame a president for poor performance. 3 Actual and Natural Real GDP We have learned that the “Big Three” macroeconomic concepts are the unem- ployment rate, the inflation rate, and the rate of productivity growth. Linked to each of these is the total level of output produced in the economy. The higher the level of output, the lower the unemployment rate. The higher the level of output, the faster tends to be the rate of inflation. Finally, for any given number of hours worked, a higher level of output automatically boosts output per hour, that is, productivity. Gross domestic productis The official measure of the economy’s total output is called gross domestic the value of all currently product and is abbreviated GDP. Real GDP includes all currently produced produced goods and services goods and services sold on the market within a given time period and excludes sold on the market during a certain other types of economic activity. As you will also learn, the adjective particular time interval. “real” means that our measure of output reflects the quantity produced, cor- rected for any changes in prices. Actual real GDPis the value Actual real GDP is the amount an economy actually produces at any oftotal output corrected for given time. But we need some criterion to judge the desirability of that level anychanges in prices. of actual real GDP. Perhaps actual real GDP is too low, causing high unem- ployment. Perhaps actual real GDP is too high, putting upward pressure on the inflation rate. Which level of real GDP is desirable, neither too low nor too high? This intermediate compromise level of real GDPis called “natural,” a level of real GDP in which there is no tendency for the rate of inflation to rise or fall. Figure 1 illustrates the relationship between actual real GDP, natural real GDP, and the rate of inflation. In the upper frame the red line is actual real GDP. The lower frame shows the inflation rate. The thin dashed vertical lines connect the two frames. The first dashed vertical line marks time period t . 0 Notice in the bottom frame that the inflation rate is constant at t , neither 0 speeding up nor slowing down. Natural real GDPdesignates By definition, natural real GDPis equal to actual real GDPwhen the infla- the level of real GDP at which tion rate is constant. Thus, in the upper frame, at t the red actual real GDPline 0 the inflation rate is constant, is crossed by the black natural real GDPline. To the right of t , actual real GDP 0 with no tendency to accelerate falls below natural real GDP, and we see in the bottom frame that inflation or decelerate. slows down. This continues until time period t , when actual real GDP once 1 again is equal to natural real GDP. Here the inflation rate stops falling and is constant for a moment before it begins to rise. This cycle repeats itself again and again. Only when actual real GDP is equal to natural real GDP is the inflation rate constant.For this reason, natural real GDP is a compromise level to be singled out for special attention. During a period of low actual real GDP, designated by the blue area, the inflation rate slows down. During a period of high actual real GDP, designated by the shaded red area, the inflation rate speeds up. 4 What Is Macroeconomics? Why Too Much Real GDP Is Undesirable Figure 1 The Relation Between Actual and Natural Real GDP and Natural theInflation Rate real GDP In the upper frame the solid black line shows the steady growth of natural real GDP—the amount the economy can produce at a constant inflation rate. The Actual red line shows the path of actual real P D real GDP GDP. In the blue region in the top frame, G al actual real GDPis below natural real Re GDP, so the inflation rate, shown in the bottom frame, slows down. In the region designated by the red area, actual real GDPis above natural real GDP, so in the bottom frame inflation speeds up. Inflation e at rate n r o ati nfl I Inflation Inflation Inflation Inflation slows speeds speeds slows down up up down t t t t t 0 1 2 3 4 Time Unemployment: Actual and Natural When actual real GDPis low, many people lose their jobs, and the unemploy- ment rate is high, as shown in Figure 2. The top frame duplicates Figure 1 exactly, comparing actual real GDPwith natural real GDP. The blue line in the bottom frame is the actual percentage unemployment rate, the first of the three central concepts of macroeconomics. The thin vertical dashed lines connecting the upper frame and lower frame show that whenever actual and natural real GDPare equal in the top frame, the actual unemployment rate is equal to the natural rate of unemploymentin the bottom frame. Thenatural rate of The definition of the natural rate of unemployment corresponds exactly to unemploymentdesignates the natural real GDP, describing a situation in which there is no tendency for the in- level of unemployment at which flation rate to change. When the actual unemployment rate is high, actual real the inflation rate is constant, with no tendency to accelerate GDP is low (shown by blue shading in both frames), and the inflation rate or decelerate. slows down. In periods when actual real GDP is high and the economy pros- pers, the actual unemployment rate is low (shown by red shading in both frames) and the inflation rate speeds up. It is easy to remember the mirror- image behavior of real GDPand the unemployment rate. We use the shorthand 5