2 nd Edition Macroeconomics Policy and Practice Frederic S. Mishkin Columbia University Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City São Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo Macroeconomics Matters: The Latest Economic Events and Policy Responses APPLICATIONS apply the analysis POLICY AND PRACTICE MACROECONOMICS IN THE NEWS in each chapter to explain important c examples boxes introduce relevant news real-world situations. of policies and how they were articles and data from the daily executed. press and explain how to read them. Chapter 2 Measuring •CanGDPBuyHappiness? •UnemploymentandEmployment Macroeconomic Data •PolicyandOverstatementsof •InterestRates the Cost of Living Chapter 3 Aggregate •WhyAreSomeCountriesRichand Production and Others Poor? Productivity •ExplainingRealWageGrowth •OilShocks,RealWages,andthe Stock Market Chapter 4 Saving and •HowtheUnitedStatesBecamethe •GovernmentPoliciesto •BalanceofPaymentsAccounts Investment in Closed and Largest Net Debtor in the World Stimulate Saving Open Economies cits •CrowdingOutandtheDebate over the 2009 Fiscal Stimulus Package Chapter 5 Money and •TestingtheQuantityTheoryofMoney •TheZimbabwean •TheMonetaryAggregates ation •TestingtheFisherEffect ation Chapter 5Appendix The • Quantitative Easing and the Money Money Supply Process Supply 2007–2013 Chapter 6 The Sources •EvidenceonConvergence, •China’sOne-ChildPolicy of Growth and the Solow 1960–2012 and Other Policies to Limit Model •U.S.GrowthRatesinthe Population Growth Postwar Period Chapter 7 Drivers of •DoesPopulationGrowthImprove •GovernmentMeasuresto Growth: Technology, Living Standards? Increase Human Capital Policy, and Institutions •TheWorld Bank’s Doing Business •DoesForeignAidWork? Chapter 8 Business •LeadingEconomicIndicators Cycles: An Introduction Chapter 9 The ISCurve •TheVietnamWarBuildup, •TheFiscalStimulusPackage 1964–1969 of 2009 Chapter 10 Monetary • Movements Along the MP Policy and Aggregate Curve: The Rise in the Federal Demand Funds Rate Target, 2004–2006 • Shifts in the MP Curve: Autonomous Monetary Easing at the Onset of the 2007–2009 Financial Crisis Chapter 11 Aggregate •ThePhillipsCurveTradeoff Supply and the Phillips and Macroeconomic Policy in Curve the 1960s Chapter 12 The ation, 1980–1986 Aggregate Demand and •NegativeDemandShocks,2001– Supply Model 2004 •NegativeSupplyShocks,1973–1975 and 1978–1980 •PositiveSupplyShocks,1995–1999 •NegativeSupplyandDemand Shocks and the 2007–2009 Financial Crisis •TheUnitedKingdomandthe 2007–2009 Financial Crisis •Chinaandthe2007–2009Financial Crisis APPLICATIONS apply the analysis POLICY AND PRACTICE MACROECONOMICS IN THE NEWS in each chapter to explain important c examples boxes introduce relevant news real-world situations. of policies and how they were articles and data from the daily executed. press and explain how to read them. Chapter 13 ation • The Federal Reserve’s Use of the Macroeconomic Policy and • Nonconventional Monetary Equilibrium Real Interest Rate, r* Aggregate Demand and Policy and Quantitative Easing •TheActivist/NonactivistDebate Supply Analysis Over the Obama Fiscal Stimulus Package •TheFed’sUseoftheTaylorRule • Abenomics and the Shift in Japanese Monetary Policy in 2013 Chapter 14 The Financial • The Tyranny of Collateral System and Economic •IsChinaaCounter-Example Growth to the Importance of Financial Development to Economic Growth? Chapter 15 Financial •TheMotherofAllFinancialCrises: •WastheFedtoBlameforthe Crises and the Economy The Great Depression Housing Price Bubble? • The Global Financial Crisis of • The Federal Reserve’s 2007–2009 Nonconventional Monetary Policies and Quantitative Easing During the Global Financial Crisis •Japan’sLostDecade,1992–2002 •DebateOver Central Bank Response to Bubbles Chapter 16 Fiscal Policy •TheEntitlementsDebate:Social and the Government Security and Medicare/Medicaid Budget • The European Sovereign Debt Crisis •TaxSmoothing •The2009DebateOverTax-Based Versus Spending-Based Fiscal Stimulus • Two Expansionary Fiscal Contractions: Denmark and Ireland • The Debate Over Fiscal Austerity in Europe •TheBushTaxCutsandRicardian Equivalence Chapter 17 Exchange • The Global Financial Crisis and • Will the Euro Survive? •ForeignExchangeRates Rates and International the Dollar •TheCollapseoftheArgentine Economic Policy •WhyAreExchangeRatesSo Currency Board Volatile? •HowDidChinaAccumulateOver $3 Trillion of International Reserves? Chapter 18 Consumption • Consumer Confidence and the •The2008TaxRebate • The Consumer Confidence and and Saving Business Cycle •BehavioralPoliciestoIncrease Consumer Sentiment Indices •Housing,theStockMarket,andthe Saving Collapse of Consumption in 2008 and 2009 Chapter 19 • Stock Market Crashes and •U.S.Government Policies and the Investment Recessions Housing Market Chapter 20 The Labor •WhyHasLaborForceParticipation •UnemploymentInsuranceand Market, Employment, and of Women Increased? Unemployment Unemployment • Why Are Income Inequality and •MinimumWageLaws Returns to Education Increasing? •WhyAreEuropeanUnemployment Rates Generally Much Higher Than U.S. Unemployment Rates? Chapter 21 The Role •TheConsumptionFunction •ThePoliticalBusinessCycleand of Expectations in •ATaleofThreeOilPriceShocks Richard Nixon Macroeconomic Policy •TheDemiseofMonetary Targeting in Switzerland • Ben Bernanke and the Federal Reserve Adoption of Inflation Targeting •TheAppointmentofPaulVolcker, ation Hawk Editor in Chief: Donna Battista Executive Acquisitions Editor: Adrienne D’Ambrosio Acquisitions Editor: Christina Masturzo Program Manager: Carolyn Philips Editorial Assistant: Patrick Henning Executive Marketing Manager: Lori DeShazo Managing Editor: Jeff Holcomb Project Manager: Alison Eusden Operations Specialist: Carol Melville Senior Art Director: Jonathan Boylan Cover Art: Pal Teravagimov/Shutterstock MyEconLab Content Project Manager: Noel Lotz Executive Media Producer: Melissa Honig Associate Project Manager, Rights and Permissions: Samantha Graham Full-Service Project Management and Composition: Cenveo® Publisher Services Printer/Binder: R.R. 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Cataloging-in-Publication Data is on file at the Library of Congress 10 9 8 7 6 5 4 3 2 1 ISBN 10: 0-13-342431-6 ISBN 13: 978-0-13-342431-7 To My Mom This page intentionally left blank Brief Contents 1 PART Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Chapter 1 The Policy and Practice of Macroeconomics . . . . . . . . . . 3 Chapter 2 Measuring Macroeconomic Data . . . . . . . . . . . . . . . . . 19 2 PART Macroeconomic Basics . . . . . . . . . . . . . . . . . . . . . . . 48 Chapter 3 Aggregate Production and Productivity . . . . . . . . . . . . . 50 Chapter 4 Saving and Investment in Closed and Open Economies . 73 Chapter 5 Money and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . 101 3 PART Long-Run Economic Growth . . . . . . . . . . . . . . . . . . . 144 Chapter 6 The Sources of Growth and the Solow Model . . . . . . . . 146 Chapter 7 Drivers of Growth: Technology, Policy, and Institutions . 178 4 PART Business Cycles: The Short Run . . . . . . . . . . . . . . . . 204 Chapter 8 Business Cycles: An Introduction . . . . . . . . . . . . . . . . 207 Chapter 9 The IS Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231 Chapter 10 Monetary Policy and Aggregate Demand . . . . . . . . . . 251 Chapter 11 Aggregate Supply and the Phillips Curve . . . . . . . . . . 281 Chapter 12 The Aggregate Demand and Supply Model . . . . . . . . 299 Chapter 13 Macroeconomic Policy and Aggregate Demand and Supply Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327 5 PART Finance and the Macroeconomy . . . . . . . . . . . . . . . . 370 Chapter 14 The Financial System and Economic Growth . . . . . . . 372 Chapter 15 Financial Crises and the Economy . . . . . . . . . . . . . . 391 6 PART Macroeconomic Policy . . . . . . . . . . . . . . . . . . . . . . . 425 Chapter 16 Fiscal Policy and the Government Budget . . . . . . . . . 427 Chapter 17 Exchange Rates and International Economic Policy . . 450 7 PART Microeconomic Foundations of Macroeconomics . . . . 492 Chapter 18 Consumption and Saving . . . . . . . . . . . . . . . . . . . . . 494 Chapter 19 Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 523 Chapter 20 The Labor Market, Employment, and Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 544 vii viii     brief Contents 8 PART Modern Business Cycle Analysis and Macroeconomic Policy . . . . . . . . . . . . . . . . . . . . 571 Chapter 21 The Role of Expectations in Macroeconomic Policy . . 573 Chapter 22 Modern Business Cycle Theory . . . . . . . . . . . . . . . . . 597 Epilogue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 619 Web Chapter Financial Crises in Emerging Market Economies Go to the Companion Website, www .pearsonhighered .com/mishkin Contents Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xxxi 1 PART Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Chapter 1 ThE PoLICy And PRACTICE oF MACRoEConoMICS . . . . . . . . . . 3 PREvIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 ThE PRACTICE OF MACROECOnOMICS . . . . . . . . . . . . . . . . . . . . 3 The Process: Developing Macroeconomic Models . . . . . . . . . . . . . . . . . . 3 The Purpose: Interpreting Macroeconomic Data . . . . . . . . . . . . . . . . . . . 5 MACROECOnOMIC POLICy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 how Can Poor Countries Get Rich? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Is Saving Too Low? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Do Government Budget Deficits Matter? . . . . . . . . . . . . . . . . . . . . . . . 11 how Costly Is It to Reduce Inflation? . . . . . . . . . . . . . . . . . . . . . . . . . 11 how Can We Make Financial Crises Less Likely? . . . . . . . . . . . . . . . . . 12 how Active Should Stabilization Policy Be? . . . . . . . . . . . . . . . . . . . . . 12 Should Macroeconomic Policy Follow Rules? . . . . . . . . . . . . . . . . . . . . 13 Are Global Trade Imbalances a Danger? . . . . . . . . . . . . . . . . . . . . . . . . 13 hOW WE WILL STUDy MACROECOnOMICS . . . . . . . . . . . . . . . . 13 Emphasis on Policy and Practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 SUMMARy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 KEy TERMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 REvIEW QUESTIOnS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 PROBLEMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 DATA AnALySIS PROBLEMS . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Chapter 2 MEASuRInG MACRoEConoMIC dATA . . . . . . . . . . . . . . . . . . . . 19 PREvIEW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 MEASURInG ECOnOMIC ACTIvITy: nATIOnAL InCOME ACCOUnTInG . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 MEASURInG GDP: ThE PRODUCTIOn APPROACh . . . . . . . . . . . 20 Market value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Final Goods and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 newly Produced Goods and Services . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Fixed Period of Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 PoLICy And PRACTICE: Can GdP Buy happiness? . . . . . . . . . . . . . . . 23 Stocks Versus Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 MEASURInG GDP: ThE ExPEnDITURE APPROACh . . . . . . . . . . . 24 Consumption Expenditure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Government Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Meaning of the Word Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 net Exports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 ix      Changes in the Spending Components of GDP over Time . . . . . . . . . . . . 27