MACROECONOMICS This page intentionally left blank S E V E N T H E D I T I O N MACROECONOMICS . N GREGORY MANKIW Harvard University Worth Publishers Senior Publishers: Catherine Woods and Craig Bleyer Senior Acquisitions Editor: Sarah Dorger Senior Marketing Manager: Scott Guile Consulting Editor: Paul Shensa Senior Development Editor: Marie McHale Development Editor: Jane Tufts Assistant Editor, Media and Supplements: Tom Acox Associate Managing Editor: Tracey Kuehn Project Editor: Dana Kasowitz Art Director: Babs Reingold Cover and Text Designer: Kevin Kall Production Manager: Barbara Anne Seixas Composition: TSI Graphics Printing and Binding: RR Donnelley Cover art: Barbara Ellmann WHAT’S YOUR ANGLE? Encaustic on Wood Panel 24'' x 24'' © 2005 Library of Congress Cataloging-in-Publication Number: 2009924581 ISBN-13: 978-1-4292-1887-0 ISBN-10: 1-4292-1887-8 © 2010, 2007, 2003 by N. Gregory Mankiw All rights reserved. Printed in the United States of America First Printing 2009 Worth Publishers 41 Madison Avenue New York, NY 10010 www.worthpublishers.com about the author w ki n a M h a or b e D by o ot h P N. Gregory Mankiw is Professor of Economics at Harvard University. He began his study of economics at Princeton University, where he received an A.B. in 1980. After earning a Ph.D. in economics from MIT, he began teaching at Harvard in 1985 and was promoted to full professor in 1987. Today, he regularly teaches both undergraduate and graduate courses in macroeconomics. He is also author of the popular introductory textbook Principles of Economics (Cengage Learning). Professor Mankiw is a regular participant in academic and policy debates. His research ranges across macroeconomics and includes work on price adjustment, consumer behavior, financial markets, monetary and fiscal policy, and economic growth. In addition to his duties at Harvard, he has been a research associate of the National Bureau of Economic Research, a member of the Brookings Panel on Economic Activity, and an adviser to the Federal Reserve Bank of Boston and the Congressional Budget Office. From 2003 to 2005 he was chairman of the President’s Council of Economic Advisers. Professor Mankiw lives in Wellesley, Massachusetts, with his wife, Deborah; children, Catherine, Nicholas, and Peter; and their border terrier, Tobin. v To Deborah T hose branches of politics, or of the laws of social life, on which there exists a collection of facts sufficiently sifted and methodized to form the beginning of a science should be taught ex professo. Among the chief of these is Political Economy, the sources and conditions of wealth and material prosperity for aggregate bodies of human beings. . . . The same persons who cry down Logic will generally warn you against Polit- ical Economy. It is unfeeling, they will tell you. It recognises unpleasant facts. For my part, the most unfeeling thing I know of is the law of gravitation: it breaks the neck of the best and most amiable person without scruple, if he forgets for a single moment to give heed to it. The winds and waves too are very unfeeling. Would you advise those who go to sea to deny the winds and waves – or to make use of them, and find the means of guarding against their dangers? My advice to you is to study the great writers on Political Economy, and hold firmly by what- ever in them you find true; and depend upon it that if you are not selfish or hard- hearted already, Political Economy will not make you so. John Stuart Mill, 1867 brief contents Preface xxiii Supplements and Media xxxii part I Chapter 11 Aggregate Demand II: Applying the Introduction 1 IS–LMModel 311 Chapter 12 The Open Economy Revisited: The Chapter 1 The Science of Macroeconomics 3 Mundell–Fleming Model and the Chapter 2 The Data of Macroeconomics 17 Exchange-Rate Regime 339 Chapter 13 Aggregate Supply and the Short-Run Tradeoff Between Inflation and part II Unemployment 379 Classical Theory: The Economy in the Chapter 14 A Dynamic Model of Aggregate Long Run 43 Demand and Aggregate Supply 409 Chapter 3 National Income: Where It Comes From and Where It Goes 45 part V Chapter 4 Money and Inflation 79 Macroeconomic Policy Debates 443 Chapter 5 The Open Economy 119 Chapter 6 Unemployment 163 Chapter 15 Stabilization Policy 445 Chapter 16 Government Debt and Budget Deficits 467 part III Growth Theory: The Economy in the part VI Very Long Run 189 More on the Microeconomics Behind Chapter 7 Economic Growth I: Capital Macroeconomics 493 Accumulation and Population Growth 191 Chapter 17 Consumption 495 Chapter 8 Economic Growth II: Technology, Chapter 18 Investment 525 Empirics, and Policy 221 Chapter 19 Money Supply, Money Demand, and the Banking System 547 part IV EpilogueWhat We Know, What We Don’t 567 Business Cycle Theory: The Economy in the Short Run 255 Glossary 575 Chapter 9 Introduction to Economic Index 585 Fluctuations 257 Chapter 10 Aggregate Demand I: Building the IS–LMModel 287 viii| contents Preface xxiii Supplements and Media xxxii part I Introduction 1 Chapter 1 The Science of Macroeconomics 3 1-1 What Macroeconomists Study 3 (cid:2) CASE STUDY The Historical Performance of the U.S. Economy 4 1-2 How Economists Think 7 Theory as Model Building 7 (cid:2) FYI Using Functions to Express Relationships Among Variables 11 The Use of Multiple Models 12 Prices: Flexible Versus Sticky 12 Microeconomic Thinking and Macroeconomic Models 13 (cid:2) FYI Nobel Macroeconomists 14 1-3 How This Book Proceeds 15 Chapter 2 The Data of Macroeconomics 17 2-1 Measuring the Value of Economic Activity: Gross Domestic Product 18 Income, Expenditure, and the Circular Flow 18 (cid:2) FYI Stocks and Flows 20 Rules for Computing GDP 20 Real GDP Versus Nominal GDP 23 The GDP Deflator 25 Chain-Weighted Measures of Real GDP 25 (cid:2) FYI Two Arithmetic Tricks for Working With Percentage Changes 26 The Components of Expenditure 27 (cid:2) FYI What Is Investment? 28 (cid:2) CASE STUDY GDP and Its Components 28 Other Measures of Income 29 Seasonal Adjustment 31 2-2 Measuring the Cost of Living: The Consumer Price Index 32 The Price of a Basket of Goods 32 The CPI Versus the GDP Deflator 33 (cid:2) CASE STUDY Does the CPI Overstate Inflation? 35 2-3 Measuring Joblessness: The Unemployment Rate 36 The Household Survey 36 | ix