Macroeconomics


The Pearson Series in Economics
Abel/Bernanke/Croushore
Macroeconomics*
Bade/Parkin
Foundations of Economics*
Berck/Helfand
The Economics of the Environment
Bierman/Fernandez
Game Theory with Economic Applications
Blanchard
Macroeconomics*
Blau/Ferber/Winkler
The Economics of Women, Men and Work
Boardman/Greenberg/Vining/
Weimer
Cost-Benefit Analysis
Boyer
Principles of Transportation Economics
Branson
Macroeconomic Theory and Policy
Brock/Adams
The Structure of American Industry
Bruce
Public Finance and the American Economy
Carlton/Perloff
Modern Industrial Organization
Case/Fair/Oster

Principles of Economics*
Caves/Frankel/Jones
World Trade and Payments: An Introduction
Chapman
Environmental Economics: Theory,
Application, and Policy
Cooter/Ulen
Law & Economics
Downs
An Economic Theory of Democracy
Ehrenberg/Smith
Modern Labor Economics
Ekelund/Ressler/Tollison
Economics*
Farnham
Economics for Managers
Folland/Goodman/Stano
The Economics of Health and Health Care
Fort
Sports Economics
Froyen
Macroeconomics
Fusfeld
The Age of the Economist
Gerber
International Economics*
Gordon
Macroeconomics*
Greene
Econometric Analysis

Gregory
Essentials of Economics
Gregory/Stuart
Russian and Soviet Economic Performance
and Structure
*denotes

titles

Hartwick/Olewiler
The Economics of Natural Resource Use
Heilbroner/Milberg
The Making of the Economic Society
Heyne/Boettke/Prychitko
The Economic Way of Thinking
Hoffman/Averett
Women and the Economy: Family, Work,
and Pay
Holt
Markets, Games and Strategic Behavior
Hubbard/O’Brien
Economics*
Money, Banking, and the Financial System*
Hughes/Cain
American Economic History
Husted/Melvin
International Economics
Jehle/Reny
Advanced Microeconomic Theory
Johnson-Lans

A Health Economics Primer
Keat/Young
Managerial Economics
Klein
Mathematical Methods for Economics
Krugman/Obstfeld/Melitz
International Economics: Theory & Policy*
Laidler
The Demand for Money
Leeds/von Allmen
The Economics of Sports
Leeds/von Allmen/Schiming
Economics*
Lipsey/Ragan/Storer
Economics*
Lynn
Economic Development: Theory and Practice
for a Divided World
Miller
Economics Today*
Understanding Modern Economics
Miller/Benjamin
The Economics of Macro Issues
Miller/Benjamin/North
The Economics of Public Issues
Mills/Hamilton
Urban Economics
Mishkin
The Economics of Money, Banking, and
Financial Markets*

The Economics of Money, Banking, and
Financial Markets, Business School Edition*
Macroeconomics: Policy and Practice*
Murray
Econometrics: A Modern Introduction
Nafziger
The Economics of Developing Countries
O’Sullivan/Sheffrin/Perez
Economics: Principles, Applications and Tools*

Parkin
Economics*
Perloff
Microeconomics*
Microeconomics: Theory and Applications
with Calculus*
Perman/Common/
McGilvray/Ma
Natural Resources and Environmental
Economics
Phelps
Health Economics
Pindyck/Rubinfeld
Microeconomics*
Riddell/Shackelford/Stamos/
Schneider
Economics: A Tool for Critically
Understanding Society
Ritter/Silber/Udell
Principles of Money, Banking & Financial

Markets*
Roberts
The Choice: A Fable of Free Trade and
Protection
Rohlf
Introduction to Economic Reasoning
Ruffin/Gregory
Principles of Economics
Sargent
Rational Expectations and Inflation
Sawyer/Sprinkle
International Economics
Scherer
Industry Structure, Strategy, and Public Policy
Schiller
The Economics of Poverty and
Discrimination
Sherman
Market Regulation
Silberberg
Principles of Microeconomics
Stock/Watson
Introduction to Econometrics
Introduction to Econometrics, Brief Edition
Studenmund
Using Econometrics:
A Practical Guide
Tietenberg/Lewis
Environmental and Natural Resource
Economics

Environmental Economics and Policy
Todaro/Smith
Economic Development
Waldman
Microeconomics
Waldman/Jensen
Industrial Organization: Theory and Practice
Weil
Economic Growth
Williamson
Macroeconomics
Log onto www.myeconlab.com to learn more


Macroeconomics
Twelfth Edition

Robert J. Gordon
Stanley G. Harris Professor in the Social Sciences
Northwestern University


Editorial Director:
Editor-in-Chief:
Executive Editor:
Editorial Project Manager:
Senior Managing Editor:
Supplements Coordinator:
Director of Marketing:
Senior Marketing Manager:

Marketing Assistant:
Senior Manufacturing Buyer:
Senior Art Director:

Sally Yagan
Donna Battista
David Alexander
Lindsey Sloan
Nancy Fenton
Alison Eusden
Patrice Jones
Lori DeShazo
Kimberly Lovato
Carol Melville
Jonathan Boylan

Cover Designer:
Executive Media Producer:
MyEconLab Content Lead:
Image Manager:
Text Design, Production
Coordination, Photo Research,
Composition, and Illustrations:
Printer/Binder:
Cover Printer:
Text Font:

Christina Gleason
Melissa Honig
Noel Lotz

Rachel Youdelman

Integra
RR Donnelley/Willard
Lehigh-Phoenix
Color/Hagerstown
10/12 Palatino

Cover image: © Collier Campbell Lifeworks/CORBIS
Photo credits: page v photo of Robert J. Gordon by Julie P. Gordon; Chapter 2, page 27: U.S.
Department of Commerce; Chapter 5, page 135: Everett Collection/SuperStock; page 153:
Fotosearch/SuperStock; Chapter 8, page 249: A. H. C./AGE Fotostock; Chapter 10, page 323:
Robert Kradin/AP Images; page 325: MGM/The Kobal Collection; Chapter 11, page 366: Rob
Crandall/The Image Works; Chapter 12, page 404: Iain Masterton/Alamy; page 405: Eye
Ubiquitous/SuperStock; page 407: Holton Collection/SuperStock; Chapter 13, page 437: AFP/
Getty Images; page 440: Digital Vision; Chapter 14, page 454: VisionsofAmerica/Joe Sohm; page 474:
Medioimages/Photodisc; Chapter 15, page 492: Bachrach/Getty Images; page 498: Caro/Alamy;
Chapter 16, page 528: Dmitry Kalinovsky/Shutterstock; page 534: ClassicStock/Alamy; Chapter 17,
page 545 top: Chuck Nacke/Alamy; page 545 bottom: Che Qingjiu/Imaginechina/AP Images;
page 546: Charles Bennett/AP Images; Chapter 18, page 591: Directphoto/Alamy.
Many of the designations used by manufacturers and sellers to distinguish their products are
claimed as trademarks. Where those designations appear in this book, and Addison-Wesley was
aware of a trademark claim, the designations have been printed in initial caps or all caps.
Library of Congress Cataloging-in-Publication Data
Gordon, Robert J. (Robert James),
Macroeconomics/Robert Gordon.—12th ed.
p. cm.
Includes index.
ISBN 978-0-13-801491-9 (student)
1. Macroeconomics. I. Title.

HB172.5 G67 2012
339–dc22
2011006181
Copyright © 2012, 2009, 2006, 2003, 2000 Pearson Education, Inc. 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 the prior written
permission of the publisher. Printed in the United States of America. For information on obtaining
permission for use of material in this work, please submit a written request to Pearson Education,
Inc., Rights and Contracts Department, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your
request to 617-671-3447, or e-mail at />ISBN-13
ISBN-10

978-0-13-801491-9
0-13-801491-4

1 2 3 4 5 6 7 8 9 10—RRD—15 14 13 12 11


About the Author

Robert J. Gordon
Robert J. Gordon is Stanley G. Harris Professor in
the Social Sciences and Professor of Economics at
Northwestern University. He did his undergraduate
work at Harvard and then attended Oxford
University in England on a Marshall Scholarship.
He received his Ph.D. in 1967 at M.I.T. and taught at
Harvard and the University of Chicago before coming to Northwestern in 1973, where he has taught
for 38 years and was chair of the Department of
Economics from 1992 to 1996.

Professor Gordon is one of the world’s leading experts on inflation, unemployment, and productivity growth. His recent work on the rise and fall of the
New Economy, the U.S. productivity growth revival, and the recent stalling of
European productivity growth has been widely cited. He is the author of The
Measurement of Durable Goods Prices, which has become known as the definitive
work showing that government price indexes substantially overstate the rate
of inflation. His book of collected essays, Productivity Growth, Inflation, and
Unemployment, was published in 2004. He is editor of Milton Friedman’s
Monetary Framework: A Debate with His Critics, The American Business Cycle, and
The Economics of New Goods. In addition, he is the author of more than 100 scholarly articles and more than 60 published comments on the research of others. In
addition to his main field of macroeconomics, he is also a frequently quoted
expert and author on the airline industry and is the founder and president of
an Internet chat group on airline management.
Gordon is a Research Associate of the National Bureau of Economic Research
and since 1978 a member of its Business Cycle Dating Committee, a Research
Fellow of the Centre for Economic Policy Research (London), a Research Fellow of
OFCE in Paris, a Guggenheim Fellow, a Fellow of the American Academy of Arts
and Sciences, and a Fellow of the Econometric Society. He has served as the coeditor of the Journal of Political Economy and as an elected at-large member of the
Executive Committee of the American Economic Association. He serves currently
as advisor to the Brookings Panel on Economic Activity and on the economic
advisory panel of the Bureau of Economic Analysis. He has served as a member
of the Technical Panel on Assumptions and Methods of the Social Security
Administration and on the national “Boskin Commission” to assess the accuracy
of the U.S. Consumer Price Index.
Gordon lives in Evanston, Illinois, with his wife, Julie, and their two dogs,
Lucky and Toto (see the box on p. 325 for more about Toto).

v


with love, for Julie



Brief Contents

Preface
PART I

Introduction and Measurement

CHAPTER 1

What Is Macroeconomics?

CHAPTER 2

The Measurement of Income, Prices, and Unemployment

PART II

xvi

1
24

The Short Run: Business Cycles and Policy Responses
Income and Interest Rates: The Keynesian Cross Model
and the IS Curve

54


CHAPTER 4

Strong and Weak Policy Effects in the IS-LM Model

88

CHAPTER 5

Financial Markets, Financial Regulation, and Economic Instability

121

CHAPTER 6

The Government Budget, the Government Debt, and the Limitations
of Fiscal Policy

158

International Trade, Exchanges Rates, and Macroeconomic Policy

190

CHAPTER 3

CHAPTER 7

PART III

The Price Level, Inflation, and Unemployment


CHAPTER 8

Aggregate Demand, Aggregate Supply, and the Great Depression

231

CHAPTER 9

Inflation: Its Causes and Cures

265

The Goals of Stabilization Policy: Low Inflation and Low Unemployment

314

CHAPTER 10

PART IV

The Long Run: Economic Growth, Success, and Failure

CHAPTER 11

The Theory of Economic Growth

358

CHAPTER 12


The Big Questions of Economic Growth

387

PART V

Monetary Policy and the Sources of Instability

CHAPTER 13

Money, Banks, and the Federal Reserve

424

CHAPTER 14

The Goals, Tools, and Rules of Monetary Policy

450

CHAPTER 15

The Economics of Consumption Behavior

481

CHAPTER 16

The Economics of Investment Behavior


517

PART VI

The Evolution of Macroeconomic Ideas

CHAPTER 17

New Classical Macro and New Keynesian Macro

543

CHAPTER 18

Conclusion: Where We Stand

571
vii


Contents

Preface
PART I
CHAPTER 1

Introduction and Measurement
What Is Macroeconomics?


1

1-1

How Macroeconomics Affects Our Everyday Lives

1

Global Economic Crisis Focus: What Makes It Unique?

3

1-2

Defining Macroeconomics

3

1-3

Actual and Natural Real GDP

4

1-4

Macroeconomics in the Short Run and Long Run

7


1-5

CASE STUDY: How Does the Global Economic Crisis Compare

to Previous Business Cycles?

11

1-6

Macroeconomics at the Extremes

13

1-7

Taming Business Cycles: Stabilization Policy

17

International Perspective: Differences Between the United States
and Europe Before and During the Global Economic Crisis

18

Global Economic Crisis Focus: New Challenges for Monetary
and Fiscal Policy

20


The “Internationalization” of Macroeconomics

20

The Measurement of Income, Prices, and Unemployment

24

2-1

Why We Care About Income

24

2-2

The Circular Flow of Income and Expenditure

24

2-3

What GDP Is, and What GDP Is Not

26

2-4

2-5


Where to Find the Numbers: A Guide to the Data

27

Components of Expenditure

30

Global Economic Crisis Focus: Which Component of GDP Declined
the Most in the Global Economic Crisis?

34

The “Magic” Equation and the Twin Deficits

34

Global Economic Crisis Focus: Chicken or Egg in Recessions?

36

2-6

Where Does Household Income Come From?

37

2-7

Nominal GDP, Real GDP, and the GDP Deflator


39

How to Calculate Inflation, Real GDP Growth, or Any Other
Growth Rate

41

Measuring Unemployment

42

Understanding the Global Economic Crisis: The Ranks of the
Hidden Unemployed

44

2-8

APPENDIX TO CHAPTER 2: How We Measure Real GDP and the Inflation Rate

viii

11

Global Economic Crisis Focus: How It Differs from 1982–83

1-8
CHAPTER 2


xvi

51


Contents

PART II
CHAPTER 3

ix

The Short Run: Business Cycles and Policy Responses
Income and Interest Rates: The Keynesian Cross Model
and the IS Curve

54

3-1

Business Cycles and the Theory of Income Determination

54

Global Economic Crisis Focus: What Were the Shocks That Made
the 2008–09 Economic Crisis So Severe?

56

3-2


Income Determination, Unemployment, and the Price Level

56

3-3

Planned Expenditure

57

Global Economic Crisis Focus: Financial Market Instability as the Main Cause
of the Global Economic Crisis

61

The Economy In and Out of Equilibrium

61

3-4

Understanding the Global Economic Crisis: How Changes in Wealth
Influence Consumer Spending

62

3-5

The Multiplier Effect


67

3-6

Sources of Shifts in Planned Spending

69

3-7

How Can Monetary Policy Affect Planned Spending?

72

3-8

3-9
3-10

The Relation of Autonomous Planned Spending to the Interest Rate

73

Understanding the Global Economic Crisis: A Central Explanation
of Business Cycles Is the Volatility of Investment

74

The IS Curve


76

Conclusion: The Missing Relation

78

Learning About Diagrams: The IS Curve

79

APPENDIX TO CHAPTER 3: Allowing for Income Taxes and

Income-Dependent Net Exports
CHAPTER 4

85

Strong and Weak Policy Effects in the IS-LM Model

88

4-1

88

Introduction: The Power of Monetary and Fiscal Policy

4-2


Income, the Interest Rate, and the Demand for Money

88

4-3

The LM Curve

91

Learning About Diagrams: The LM Curve

93

4-4

The IS Curve Meets the LM Curve

94

4-5
4-6

4-7

4-8
4-9

Global Economic Crisis Focus: Causes of a Leftward Shift in the IS Curve


95

Monetary Policy in Action

96

How Fiscal Expansion Can “Crowd Out” Private Investment

97

Global Economic Crisis Focus: How Monetary Policy Can Be Ineffective
in the IS-LM Model

99

Strong and Weak Effects of Monetary Policy

99

Understanding the Global Economic Crisis: How Easy Money Helped
to Create the Housing Bubble and Bust

102

Strong and Weak Effects of Fiscal Policy

105

Using Fiscal and Monetary Policy Together


107

International Perspective: Monetary Policy Hits the Zero Lower Bound
in Japan and in the United States

110

APPENDIX TO CHAPTER 4: The Elementary Algebra of the IS-LM Model

117


x

Contents
CHAPTER 5

Financial Markets, Financial Regulation, and Economic Instability
5-1

Introduction: Financial Markets and Macroeconomics

5-2

CASE STUDY: Dimensions of the Global Economic Crisis

122

5-3


Financial Institutions, Balance Sheets, and Leverage

127

5-4

A Hardy Perennial: Bubbles and Crashes

133
134

5-5

Financial Innovation and the Subprime Mortgage Market

137

5-6

The IS-LM Model, Financial Markets, and the Monetary Policy Dilemma

139

Why Do Asset Purchases Reduce Interest Rates?

144

Understanding the Global Economic Crisis: The IS-LM Summary of the
Causes of the Global Economic Crisis


146

The Fed’s New Instrument: Quantitative Easing

146

How the Crisis Became Worldwide and the Dilemma for Policymakers

151

International Perspective: Weighing the Causes: Why Did Canada
Perform Better?

153

5-8

The Government Budget, the Government Debt, and the
Limitations of Fiscal Policy
6-1

158

Introduction: Can Fiscal Policy Rescue Monetary Policy
from Ineffectiveness?

158

6-2


The Pervasive Effects of the Government Budget

159

6-3

CASE STUDY: The Government Budget in Historical Perspective

160

6-4

6-5
6-6

Automatic Stabilization and Discretionary Fiscal Policy

162

Global Economic Crisis Focus: Automatic Stabilization and Fiscal Stimulus
in the Crisis

165

Government Debt Basic Concepts

167

Will the Government Remain Solvent?


169

International Perspective: The Debt-GDP Ratio: How Does the
United States Compare?

171

6-7

CASE STUDY: Historical Behavior of the Debt-GDP Ratio Since 1790

172

6-8

Factors Influencing the Multiplier Effect of a Fiscal Policy Stimulus

174

6-9

CASE STUDY: The Fiscal Policy Stimulus of 2008–11

177

6-10

6-11
CHAPTER 7


121

Understanding the Global Economic Crisis: Two Bubbles: 1927–29
in the Stock Market Versus 2000–06 in the Housing Market

5-7

CHAPTER 6

121

Government Spending and Transfers to States/Localities

181

Understanding the Global Economic Crisis: Comparing the Obama
Stimulus with FDR’s New Deal

182

Conclusion: Strengths and Limitations of Fiscal Policy

185

International Trade, Exchanges Rates, and Macroeconomic
Policy

190

7-1


Introduction

7-2

The Current Account and Balance of Payments

191

7-3

Exchange Rates

199

7-4

The Market for Foreign Exchange

200

Real Exchange Rates and Purchasing Power Parity

205

International Perspective: Big Mac Meets PPP

208

7-5


190


Contents
7-6

Exchange Rate Systems

7-7

CASE STUDY: Asia Intervenes with Buckets to Buy Dollars and Finance

the U.S. Current Account Deficit—How Long Can This Continue?

215

7-9

The Real Exchange Rate and Interest Rate

218

Effects of Monetary and Fiscal Policy with Fixed and Flexible
Exchange Rates

220

Global Economic Crisis Focus: Is the United States Prevented from Implementing
a Fiscal Policy Stimulus by Its Flexible Exchange Rate?


223

Summary of Monetary and Fiscal Policy Effects in Open Economies

224

Conclusion: Economic Policy in the Open Economy

224

The Price Level, Inflation, and Unemployment
Aggregate Demand, Aggregate Supply, and the Great
Depression

231

8-1

Combining Aggregate Demand with Aggregate Supply

231

8-2

Flexible Prices and the AD Curve

232

8-3


Shifting the Aggregate Demand Curve with Monetary
and Fiscal Policy

234

Global Economic Crisis Focus: The Crisis Was a Demand Problem
Not Involving Supply

236

Learning About Diagrams: The AD Curve

237

8-4

Alternative Shapes of the Short-Run Aggregate Supply Curve

237

8-5

The Short-Run Aggregate Supply (SAS) Curve When the Nominal
Wage Rate Is Constant

239

Learning About Diagrams: The SAS Curve


242

8-6

Fiscal and Monetary Expansion in the Short and Long Run

243

Summary of the Economy’s Adjustment to an Increase in Aggregate Demand

245

8-7

Classical Macroeconomics: The Quantity Theory of Money
and the Self-Correcting Economy

246

8-8

The Keynesian Revolution: The Failure of Self-Correction

249

Global Economic Crisis Focus: The Zero Lower Bound as Another
Source of Monetary Impotence

250


CASE STUDY: What Caused the Great Depression?

253

International Perspective: Why Was the Great Depression Worse
in the United States Than in Europe?

258

8-9

CHAPTER 9

212

Determinants of Net Exports

7-11

CHAPTER 8

208

7-8
7-10

PART III

xi


Inflation: Its Causes and Cures

265

9-1

Introduction

265

9-2

Real GDP, the Inflation Rate, and the Short-Run Phillips Curve

268

The Adjustment of Expectations

271

9-3

Learning About Diagrams: The Short-Run (SP) and Long-Run (LP)
Phillips Curves

273

9-4

Nominal GDP Growth and Inflation


273

9-5

Effects of an Acceleration in Nominal GDP Growth

275

9-6

Expectations and the Inflation Cycle

277


xii

Contents
9-7

9-8

Recession as a Cure for Inflation

280

International Perspective: Did Disinflation in Europe Differ from That
in the United States?


282

Global Economic Crisis Focus: Policymakers Face the Perils of Deflation

283

The Importance of Supply Shocks

284

Types of Supply Shocks and When They Mattered

286

The Response of Inflation and the Output Ratio to a Supply Shock

288

Understanding the Global Economic Crisis: The Role of Inflation During
the Housing Bubble and Subsequent Economic Collapse

290

9-10

Inflation and Output Fluctuations: Recapitulation of Causes and Cures

293

9-11


How Is the Unemployment Rate Related to the Inflation Rate?

9-9

APPENDIX TO CHAPTER 9: The Elementary Algebra of the SP-DG Model

CHAPTER 10

The Goals of Stabilization Policy: Low Inflation and Low
Unemployment
Global Economic Crisis Focus: Inflation Versus Unemployment in the Crisis

314

The Costs and Causes of Inflation

315

10-2

Money and Inflation

316

International Perspective: Money Growth and Inflation

319

10-3


Why Inflation Is Not Harmless

320

Global Economic Crisis Focus: The Housing Bubble as Surprise Inflation
Followed by Surprise Deflation

322

The Wizard of Oz as a Monetary Allegory

325

Indexation and Other Reforms to Reduce the Costs of Inflation

328

The Indexed Bond (TIPS) Protects Investors from Inflation

329

The Government Budget Constraint and the Inflation Tax

330

Understanding the Global Economic Crisis: How a Large Recession
Can Create a Large Fiscal Deficit

332


10-6

Starting and Stopping a Hyperinflation

334

10-7

Why the Unemployment Rate Cannot Be Reduced to Zero

337

10-8

Sources of Mismatch Unemployment

340

Global Economic Crisis Focus: The Crisis Raises the Incidence
of Structural Unemployment

342

Turnover Unemployment and Job Search

342

The Costs of Persistently High Unemployment


346

Understanding the Global Economic Crisis: Why Did Unemployment Rise
Less in Europe Than in the United States After 2007?

350

10-5

10-9
10-10

10-11 Conclusion: Solutions to the Inflation and Unemployment Dilemma

CHAPTER 11

314

10-1

10-4

PART IV

297
306

350

The Long Run: Economic Growth, Success, and Failure

The Theory of Economic Growth

358

11-1

The Importance of Economic Growth

358

11-2

Standards of Living as the Consequence of Economic Growth

359

International Perspective: The Growth Experience of Seven Countries
Over the Past Century

360


Contents

xiii

11-3

The Production Function and Economic Growth


362

11-4

Solow’s Theory of Economic Growth

365

11-5

Technology in Theory and Practice

369

11-6

Puzzles That Solow’s Theory Cannot Explain

372

11-7

Human Capital, Immigration, and the Solow Puzzles

375

11-8

Endogenous Growth Theory: How Is Technological Change Produced?


377

11-9

Conclusion: Are There Secrets of Growth?

379

APPENDIX TO CHAPTER 11: General Functional Forms and the Production

Function
CHAPTER 12

The Big Questions of Economic Growth
Answering the Big Questions

387

12-2

The Standard of Living and Concepts of Productivity

389

12-3

The Failure of Convergence

392


12-4

Human Capital and Technology

398

12-5

Political Capital, Infrastructure, and Geography

399

International Perspective: A Symptom of Poverty: Urban Slums in the
Poor Cities

401

International Perspective: Institutions Matter: South Korea Versus
North Korea

404

International Perspective: Growth Success and Failure in the Tropics

407

CASE STUDY: Uneven U.S. Productivity Growth Across Eras

408


Global Economic Crisis Focus: Lingering Effects of the 2007–09 Recession
on Long-Term Economic Growth

414

12-7

CASE STUDY: The Productivity Growth Contrast Between Europe

12-8

Conclusion on the Great Questions of Growth

and the United States

CHAPTER 13

415
419

Monetary Policy and the Sources of Instability
Money, Banks, and the Federal Reserve

424

13-1

Money as a Tool of Stabilization Policy

424


13-2

Definitions of Money

425

13-3

High-Powered Money and Determinants of the Money Supply

427

13-4

The Fed’s Three Tools for Changing the Money Supply

431

13-5

Theories of the Demand for Money

436

International Perspective: Plastic Replaces Cash, and the Cell Phone
Replaces Plastic

440


Why the Federal Reserve “Sets” Interest Rates

443

13-6
CHAPTER 14

387

12-1

12-6

PART V

385

The Goals, Tools, and Rules of Monetary Policy
14-1

14-2

450

The Central Role of Demand Shocks

450

Global Economic Crisis Focus: The Weakness of Monetary Policy
After 2008 Reveals a More General Problem


451

Stabilization Targets and Instruments in the Activists’ Paradise

451

Rules Versus Activism in a Nutshell: The Optimism-Pessimism Grid

454


xiv

Contents
14-3

Policy Rules

455

14-4

Policy Pitfalls: Lags and Uncertain Multipliers

457

14-5

CASE STUDY: Was the Fed Responsible for the Great Moderation


of 1986–2007?
14-6

Time Inconsistency, Credibility, and Reputation

14-7

CASE STUDY: The Taylor Rule and the Changing Fed Attitude

Toward Inflation and Output

14-8
14-9
CHAPTER 15

466
468

Global Economic Crisis Focus: Taylor’s Rule Confronts the Zero
Lower Bound

471

Rules Versus Discretion: An Assessment

471

International Perspective: The Debate About the Euro


474

CASE STUDY: Should Monetary Policy Target the Exchange Rate?

476

The Economics of Consumption Behavior

481

15-1

Consumption and Economic Stability

481

15-2

CASE STUDY: Main Features of U.S. Consumption Data

482

15-3

Background: The Conflict Between the Time-Series and Cross-Section
Evidence

485

15-4


Forward-Looking Behavior: The Permanent-Income Hypothesis

488

15-5

Forward-Looking Behavior: The Life-Cycle Hypothesis

492

Global Economic Crisis Focus: The Modigliani Theory Helps Explain
the Crisis and Recession of 2007–09

493

Rational Expectations and Other Amendments to the Simple
Forward-Looking Theories

497

15-6

15-7
15-8

Understanding the Global Economic Crisis: Did Households Spend
or Save the 2008 Economic Stimulus Payments?

498


Bequests and Uncertainty

501

International Perspective: Why Do Some Countries Save So Much?

502

CASE STUDY: Did the Rise and Collapse of Household Assets

Cause the Decline and Rise of the Household Saving Rate?
15-9
15-10
CHAPTER 16

461

506

Why the Official Household Saving Data Are Misleading

509

Conclusion: Does Consumption Stabilize the Economy?

512

The Economics of Investment Behavior


517

16-1

Investment and Economic Stability

517

16-2

CASE STUDY: The Historical Instability of Investment

518

16-3

The Accelerator Hypothesis of Net Investment

521

16-4

CASE STUDY: The Simple Accelerator and the Postwar U.S. Economy

524

16-5

The Flexible Accelerator


526

Tobin’s q: Does It Explain Investment Better Than the Accelerator
or Neoclassical Theories?

528

16-6

The Neoclassical Theory of Investment Behavior

528

16-7

User Cost and the Role of Monetary and Fiscal Policy

531

16-8

Business Confidence and Speculation

533

Investment in the Great Depression and World War II

534

International Perspective: The Level and Variability of Investment

Around the World

536


Contents
16-9
16-10

PART VI
CHAPTER 17

Investment as a Source of Instability of Output and Interest Rates

536

Conclusion: Investment as a Source of Instability

538

The Evolution of Macroeconomic Ideas
New Classical Macro and New Keynesian Macro

543

17-1

Introduction: Classical and Keynesian Economics, Old and New

543


17-2

Imperfect Information and the “Fooling Model”

544

17-3

The Lucas Model and the Policy Ineffectiveness Proposition

546

17-4

The Real Business Cycle Model

548

17-5

New Classical Macroeconomics: Limitations and Positive
Contributions

551

International Perspective: Productivity Fluctuations in the United States and Japan

552


Global Economic Crisis Focus: The 2007–09 Crisis and the Real Business
Cycle Model

554

17-6

Essential Features of the New Keynesian Economics

556

17-7

Why Small Nominal Rigidities Have Large Macroeconomic Effects

557

17-8

Coordination Failures and Indexation

561

17-9

Long-Term Labor Contracts as a Source of the Business Cycle

562

The New Keynesian Model Evolves into the DSGE Model


564

17-10
CHAPTER 18

xv

Conclusion: Where We Stand
18-1

571

The Evolution of Events and Ideas

571

Global Economic Crisis Focus: Can Economics Explain the Crisis
or Does the Crisis Require New Ideas?

572

18-2

The Reaction of Ideas to Events, 1923–47

572

18-3


The Reaction of Ideas to Events, 1947–69

575

18-4

The Reaction of Ideas to Events, 1970–2010

578

Global Economic Crisis Focus: Termites Were Nibbling Away
at the Prosperity of 2003–07

583

18-5

The Reaction of Ideas to Events in the World Economy

586

18-6

Macro Mysteries: Unsettled Issues and Debates

588

International Perspective: How Does Macroeconomics Differ
in the United States and Europe?


590

APPENDIXES
A

Time Series Data for the U.S. Economy: 1875–2010

B

International Annual Time Series Data for Selected Countries: 1960–2010

A-10

C

Data Sources and Methods

A-17

Glossary
Index

A-1

G-1
I-1


Preface


As in previous editions this book begins with business cycles, unemployment, and inflation. Experience teaches us that students want to understand
what is happening today, and particularly why the Global Economic Crisis
occurred and why the unemployment rate was above 9 percent during the
first two years of the economic recovery. The curiosity of students about what
is wrong with today’s economy engages them with the subject matter, in no
small measure because they know that the economy will influence their job
prospects after graduation. This book provides an immediate payoff to that
curiosity within the first few chapters by placing its treatment of business
cycles first. The economics of long-term growth are important but should
come later, after students learn about the models, answers, and puzzles
surrounding business cycles.

What’s New in This Edition?
• The book’s organization is an ideal home for systematic treatment of the
Global Economic Crisis, the single most important macroeconomic event
since the Great Depression. It poses a challenge for intermediate macro
instructors whose students will be expecting answers, not only about the
causes of the Crisis but also the reasons why the recovery has been so
slow. Fortunately, the structure of previous editions allows the treatment
of the Crisis and recovery to fit seamlessly into the existing organization.
Chapter 4 on the IS-LM model has always ended with sections on “strong
and weak effects of monetary and fiscal policy” (pp. 102–06 in this
edition).
• The new Chapter 5, “Financial Markets, Financial Regulation, and
Economic Instability,” introduces the concepts relevant to the housing
bubble and financial market meltdown, including risk, leverage, securitization, and bubbles. Balance sheets are introduced to contrast traditional
banks with the “wild west” of finance in which loans are financed not
from deposits but by borrowing. The post-2001 housing bubble is compared with the stock market bubble of 1927–29 that led to the Great
Depression.
• Financial market concepts are integrated into the IS-LM analysis of

monetary policy weakness. The “zero lower bound” is interpreted as a
horizontal LM curve lying along the horizontal axis to the left of full
employment, and the economy’s problem is portrayed as a leftward shift
in the IS curve that pushes its full-employment equilibrium interest rate
into negative territory, below the zero lower bound. In addition to shifting
leftward, the IS curve becomes steeper, i.e., less sensitive to interest rate
changes, due to the effect of the post-bubble “hangover” on demand
(foreclosures and excess consumer debt) and on supply (too many unsold
houses and condos).
xvi


Preface

• Term premium and risk premium add to the Fed’s problem and motivate
quantitative easing. The traditional textbook focus on a single short-term
interest rate is supplemented by the government bond rate, which exceeds
the short-term rate by the term premium. And the corporate bond rate relevant for the borrowing of business firms exceeds the government bond rate
by the risk premium. These two premiums provide the context for the new
concept “quantitative easing” as the attempt by the Fed, hamstrung by the
zero lower bound for the short rate, to reduce the term premium and/or
the risk premium.
• Bank and Federal Reserve balance sheets. A colorful graph shows not
only the now-familiar explosion of the Fed’s assets in 2008–11 but also the
counterpart of that explosion on the liability side, that is, the emergence of
more than $1 trillion of excess reserves. A comparison shows that excess
reserves were about the same share of GDP in 2009–10 as in 1938–39, one
of many comparisons in the book of the Global Economic Crisis and the
Great Depression.
• Chapter 6 asks, “Can fiscal policy come to the rescue?” It includes material from the previous edition on the deficit-GDP and debt-GDP ratios, the

structural deficit, automatic stabilizers vs. discretionary policy, and stability conditions to avoid a long-term explosion of the debt-GDP ratio. The
debate about the Obama stimulus motivates a new section that explains
why fiscal multipliers are so different for alternative types of policies and
why it is so difficult to design a stimulus program (e.g., multipliers of tax
cuts may be small, “shovel-ready” projects may not be available in sufficient numbers). A unique set of graphs compares fiscal policy in 1933–41
with 2005–10.
• The twin concepts of the “output gap” and the “unemployment gap” are
introduced in the first chapter. Students become familiar from the outset
with the concept of an aggregate demand shock. Charts in several chapters compare aspects of output and labor-market behavior in the 1980–86
and 2006–11 cycles, and students learn about the stark difference in the
causes and cures of the two largest postwar cycles.
• New “Global Economic Crisis Focus” in-text mini-boxes. A new
pedagogical tool uses the reality of the Crisis and its aftermath to energize
student learning throughout the book. Sprinkled throughout many chapters, at a rate of roughly two or three per chapter, are small in-text boxes
of one or two paragraphs called “Global Economic Crisis Focus.” These
are used not just to reinforce the teaching of the causes and cures of the
Crisis itself, but also to provide the student with a jolt that emphasizes
“a basic concept about which you are reading right now is directly relevant to understanding the Crisis.” Just within the first three chapters,
including the introductory and measurement chapters, there are seven
of these focus mini-boxes.
• ”International Perspective” boxes. In addition to these mini-boxes, every
chapter in the book has one or more topic boxes, usually appearing as a
two-page spread on a left and right page. Continuing the tradition from
previous editions, some of these are called “International Perspective Box”
and highlight differences among countries. In this edition all of these
“IP” boxes have been updated to provide new material relevant to understanding the Crisis.

xvii



xviii

Preface

• New “Understanding the Global Economic Crisis” topic boxes. Several
new topic boxes are directly relevant to explanations of the Global
Economic Crisis. An example in an early chapter is “How Changes in
Wealth Affect Consumer Spending” (pp. 62–63), which traces the aftermath of the housing and stock market debacles for household assets, liabilities, net worth, and the household saving rate. Another example in
Chapter 5 (pp. 134–35) is “Two Bubbles: 1927–29 in the Stock Market
Versus 2000–06 in the Housing Market.”
• Theoretical treatment has been simplified. Numerical examples have
been removed from the graphs in Chapter 3 and 4 on the Keynesian
45-degree model and the IS-LM model; this simplifies the exposition
while still allowing numerical examples both within the text itself and
also in the end-of-chapter questions and problems. The derivation of
the short-run aggregate supply (SAS) curve in Chapter 8 (previous
Chapter 7) has been simplified to eliminate graphs showing the demand
for and supply of labor.
• Sections have been moved to improve the book’s organization. The
introduction to financial institutions has been moved from Chapter 13
to the new Chapter 5. Material on the debt-GDP ratio and the solvency
condition has been moved from the previous Chapter 12 to the new
Chapter 6. To make room for new content on the Crisis, the last half of
the previous Chapter 12 (supply-side economics and Social Security)
has been deleted.
• Unique custom-made graphs. This book’s tradition continues of providing unique data graphs that go far beyond the standard graphs that other
textbooks download from government data Web sites. From the beginning
of Chapter 1, students view custom graphs illustrating the concepts of the
output and unemployment gaps, the disparate behavior of unemployment
and productivity growth since 2007 for Europe versus the United States,

and the comparison of the zero-lower-bound periods in the United States
in the late 1930s and since 2009. Unique graphs include the price level versus the output gap in the Great Depression, the real and nominal prices of
oil compared with the overall inflation rate, the actual and natural rates of
unemployment, the failure of convergence of many poor countries, and
many others.

Guiding Principles of the Text
This text has been guided by five organizing principles since its inception, and
the Twelfth Edition develops them further.
1. Macro questions have answers. The use of traditional macro models can
be enormously fruitful in developing answers to macro puzzles. Unlike
other texts, this book introduces the natural level of output and natural
rate of unemployment in the first few pages of Chapter 1. Students learn
from the beginning that the output and unemployment gaps move in
opposite directions and that to understand why output is so low is the
same as understanding why unemployment is so high. Similarly, the fully
developed dynamic inflation model of Chapter 9 shows that we have a
solid answer to the puzzle of why inflation was so high in the 1970s and
so low in the 1990s.


Preface

When an economic model fails, this is not swept under the rug but
rather is used to highlight what the model misses, as in the lively treatment
in Chapter 11 of “Puzzles That Solow’s [Growth] Theory Cannot Explain”
(see pp. 372–77). The Solow failure opens the way to a unique treatment of
the debate between the new institutional economics versus the exponents
of a tropical geography explanation for the failure of poor countries to
converge to the income level of rich countries (pp. 398–408).

2. Up-front treatment of business cycles and inflation. Students come to the
macro classroom caring most about today’s economy, starting with how they
and their family members can avoid unemployment. Responding to this
basic curiosity of students, a core principle of this book is that students should
be taught about business cycles first, instead of beginning the text with the
dry abstractions of classical economics and growth theory. Accordingly, this
text introduces the IS-LM model immediately after the first two introductory
chapters, with a goal in each edition of having the IS and LM curves cross by
p. 100 (it happens on p. 95 of this edition). An integrated treatment links the
standard monetary and fiscal policy multipliers with the cases when monetary and fiscal policy could be weak or strong. This is immediately followed
by the new Chapter 5 that creates links between the IS-LM framework and
the new analysis of balance sheets, leverage, securitization, and bubbles.
After a comprehensive chapter on international economics and exchange
rates, the AS-AD model then allows an in-depth treatment of the Great
Depression and its similarities and differences with the recent Global
Economic Crisis. The static AS-AD model then flows naturally into the
dynamic version of the AS-AD model, called the SP (for short-run Phillips
curve) and DG (for demand growth) model. The treatment in this textbook
allows us to explain why both inflation and unemployment were both so
high in the 1970s and so low in the late 1990s; this is a parallel overlooked
by most other competing intermediate macro texts. By the end of Chapter 9,
students have learned the core theory of business cycles and inflation, and
the text then turns to growth theory, the puzzles that Solow’s theory cannot
explain, and the big issues of economic growth and the non-convergence of
so many poor countries.
3. Integration of models. The challenge many instructors face is that most
intermediate macro texts overload the simple models, offering a new model
every chapter or two without telling students how the models connect and
work together. This book adopts the core distinction between short-run
macro, devoted to explaining business cycles and their prevention, and longrun macro, dedicated to explaining economic growth.

This text is unique in its cohesive presentation of the macro concepts.
The aggregate demand curve is explicitly derived from the IS-LM model (pp.
231–36), and then the short-run Phillips Curve is explicitly derived from the
short-run aggregate supply curve (pp. 267–70). In discussing the biggest
question of economic growth—why so many nations are still so poor—the
text provides an integration of the production function in the Solow growth
theory with the added elements of human capital, political capital (i.e., legal
systems and property rights), geography, and infrastructure (pp. 398–408).
4. Simple graphs can convey important research results. The graphs in this
book go beyond those in the typical macro textbook in several dimensions,
including the use of original data, the double-stacking of graphs plotting
related concepts (see pp. 266 and 284), the extensive use of shading between

xix


xx

Preface

lines to convey concepts like a positive and negative output gap, and the
integrated use of color.
5. The economy is open from the start. Students come to their macroeconomics classroom concerned about the open economy. They carry iPhones
made in China, and they worry about whether their future jobs will be outsourced to India and whether a further slump in the dollar will make
future trips to Europe unaffordable. This text avoids the false distinction
between the closed and open economy. As early as pp. 34–35, the linkage
between saving, investment, government budget, and foreign lending
or borrowing is emphasized by the label “magic equation” to dramatize
the importance of a basic accounting identity. In the IS-LM model of aggregate demand, net exports can be a source of instability from the start. Fiscal
deficits can be financed by foreign borrowing, but international crowding

out and growing international indebtedness reduce the future standard
of living.

Pedagogy
The Use of Color
The graphs in the Twelfth Edition continue to use consistent colors to connect
macro concepts and discussions, thereby strengthening conceptual ties throughout the text.
The supply curve of money, the LM curve, and plots of short-term interest
rates are always shown in green. Government expenditures are red, and revenues are green; a government surplus is shown by green shading and a deficit
by red shading. The government debt and long-term interest rates appear in
purple. Data on inflation and the AD curve are plotted in orange. The SAS and
SP curves are plotted in blue. Long-run “natural” concepts like natural real
GDP, the natural rate of unemployment, the LAS curve, and the LP curve are all
plotted in black.
Color is also used consistently for country-specific data. The U.S. is always
red, the U.K. (or EU) is blue, Canada is gray, Japan is orange, Germany is black,
France is purple, and Italy is green.

Continuing Pedagogical Features
The Twelfth Edition retains the main pedagogical features of the previous
editions that aid student understanding.
• Key terms are introduced in bold type, defined in the margin, and listed at
the end of each chapter.
• Self-Test questions appear at intervals within each chapter, so that students
can immediately determine whether they understand what they have
read. Answers are provided at the end of every chapter.
• Learning About Diagrams boxes. Each of these boxes covers on a single page
every aspect of the key schedules—IS, LM, AS, AD, and SP—and
discusses why they slope as they do, what makes them rotate and shift,
and what is true on and off the curves. There are also summary boxes,

including one summarizing all the sources of negative demand shocks in
2007–09 and another summarizing the different effects of monetary and
fiscal policy in an open economy.


Preface

• End-of-chapter elements include a summary, a list of key terms, a revised
and expanded set of questions and problems, and answers to the self-test
questions.
• The Glossary at the end of the book lists definitions to every key term, with
a cross-reference to the sections where they are first introduced.
• Data Appendixes provide annual data for the U.S. back to 1875, quarterly
data for the U.S. back to 1947, and annual data since 1960 for other leading
nations. This data can now be downloaded from the book’s Companion
Website for use in your course. Appendix C lists data sources and Web
sites that offer the latest data on key macroeconomic variables.
• Data diagrams have been replotted electronically to ensure accuracy, and
include annual and quarterly data to the end of 2010.

Supplements
With each edition, the supplements get more robust with the aim of helping
you to prepare your lectures and your students to master the material.
• MyEconLab. This powerful assessment and tutorial system works handin-hand with Macroeconomics. MyEconLab includes comprehensive homework, quiz, test, and tutorial options, where instructors can manage all
assessment needs in one program. Here are the key features of
MyEconLab:
• Select end-of-chapter Questions and Problems, including algorithmic,
graphing, and numerical, are available for student practice, or instructor assignment.
• Test Item File questions are available for assignment as homework.
• The Custom Exercise Builder allows instructors the flexibility of creating their own problems for assignment.

• The powerful Gradebook records each student’s performance and time
spent on the Tests and Study Plan and generates reports by student or
chapter.
Visit www.myeconlab.com for more information and an online demonstration of instructor and student features. MyEconLab content has been created through the efforts of Melissa Honig, Executive Media Producer, and
Noel Lotz, Content Lead.
• Online Instructor’s Manual. Subarna Samanta of the College of New
Jersey revised the manual for this edition, providing chapter outlines,
chapter overviews, a discussion of how the Twelfth Edition differs
from the Eleventh Edition, and answers to the end-of-chapter questions
and problems. The manual is available for download as PDF or Word
files on the Instructor’s Resource Center (www.pearsonhighered
.com/irc).
• Online Test Item File. Completely revised by Mihajlo Balic of Palm Beach
Community College, the Online Test Item File offers more than 2,000
questions specific to the book. It is available in Word format on the
Instructor’s Resource Center.
• Online Computerized Test Bank. The Computerized Test Bank reproduces
the Test Item File material in the TestGen software that is available for
Windows and Macintosh. With TestGen, instructors can easily edit

xxi


xxii

Preface

•

•


•

•

existing questions, add questions, generate tests, and print the tests in a
variety of formats. It is available in both Mac and PC formats on the
Instructor’s Resource Center.
Online PowerPoint with Art, Figures, and Lecture Notes. PowerPoint
presentations, revised by Richard Stahnke of Bryn Mawr College, contain
the figures and tables in the text, as well as new lecture notes that
correspond with the information in each chapter. The PowerPoint presentations are available on the Instructor’s Resource Center.
Companion Website. The open-access Web site
/>offers the following resources:
The Data Appendixes from the text are available for download, as is the
robust data set created explicitly for the text that includes the historical
data and natural level of output.
Excel®-based problems, written by David Ring of SUNY College at
Oneonta, offer students one to two questions per chapter using the Excel
program and data. Solutions to all Excel-based problems are available on
the Instructor’s Resource Center.

Acknowledgments
I remain grateful to all those who have given thoughtful comments on this
book over the years. In recent years, these colleagues include:
Terence J. Alexander, Iowa State University
Mihajlo Balic, Palm Beach Community College
Jeffrey H. Bergstrand, University of Notre Dame
William Branch, University of California, Irvine
John P. Burkett, University of Rhode Island

Henry Chen, University of West Florida
Andrew Foshee, McNeese State University
Donald E. Frey, Wake Forest University
John Graham, Rutgers University
Luc Hens, Vesalius College, Vrije Universiteit Brussel
Tracy Hofer, University of Wisconsin, Stevens Point
Brad R. Humphreys, University of Illinois, Urbana-Champaign
Alan G. Isaac, American University
Thomas Kelly, Baylor University
Barry Kotlove, Edmonds Community College
Philip Lane, Fairfield University
Sandeep Mazumder, Wake Forest University
Ilir Miteza, University of Michigan, Dearborn
Gary Mongiovi, St. John’s University
Jan Ondrich, Syracuse University
Chris Papageorgiou, International Monetary Fund
Walter Park, American University
Prosper Raynold, Miami University, Oxford
Michael Reed, University of Kentucky
Kevin Reffett, WP Cary School of Business, ASU
Charles F. Revier, Colorado State University


Preface

David Ring, State University of New York, Oneonta
Wayne Saint Aubyn Henry, University of the West Indies
Subarna K. Samanta, The College of New Jersey
Richard Sheeham, University of Notre Dame
William Doyle Smith, University of Texas, El Paso

Richard Stahnke, Bryn Mawr College
Manly E. Staley, San Francisco State University
Mark Thoma, University of Oregon
David Tufte, Southern Utah University
Kristin Van Gaasbeck, California State University, Sacramento
Anne Ramstetter Wenzel, San Francisco State University
Henry Woudenberg, Kent State University
An expanded set of questions and problems was provided by David Ring
of SUNY at Oneonta. In addition, the book contains a great deal of data, some
of it originally created for this book, both in the text and the Data Appendix.
Geoffrey Bery with speed, accuracy, and frequent intiative created all the data,
tables and graphs, as well as the Data Appendix.
Many thanks go to the staff at Addison-Wesley. I am extremely grateful to
David Alexander for suggesting and then implementing the development of the
Twelfth Edition. Lindsey Sloan handled her role as assistant editor with enthusiasm and accuracy. The final stages of handling proofs and other pre-publication
details were managed efficiently, with tact and courtesy, by Nancy Fenton of
Pearson and Allison Campbell of Integra. Thanks to Lori DeShazo, the marketing manager, and to Kimberly Lovato, the marketing assistant for this title, for
their marketing efforts.
Finally, thanks go to my wife, Julie, for her patience at the distractions not
just of writing the revised edition but also of the endless extra weeks of proofreading. A real bonus of modern technology for our household is the conversion of this revision to electronic editing, which allows my corrections to be
made on the computer screen and then instantly e-mailed to the publisher.
That has eliminated the role both of Fed Ex and of vast piles of paper in the revision process, which has been a great relief for me and especially to Julie. As
always, her unfailing encouragement and welcome diversions made the book
possible.
Robert J. Gordon
Evanston, IL
February 2011

xxiii



This page intentionally left blank