Foundations of MACROECONOMICS

Foundations of

MACROECONOMICS

A01_BADE4019_09_SE_FM.indd 1 23/12/19 9:13 PM


Robin Bade

Michael ParkinUniversity of Western Ontario

Foundations of

MACROECONOMICS

NINTH EDITION


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Library of Congress Cataloging-in-Publication Data

Names: Bade, Robin, author. | Parkin, Michael, author.Title: Foundations of economics / Robin Bade, Michael Parkin, University of Western Ontario.Description: Ninth edition. | New York, NY : Pearson, [2021] | Includes index. Identifiers: LCCN 2019050192 (print) | LCCN 2019050193 (ebook) | ISBN 9780135917725 (paperback) | ISBN 9780135894019 (paperback) | ISBN 9780135814260 (paperback) | ISBN 9780135896952 (epub) Subjects: LCSH: Economics.Classification: LCC HB171.5 .B155 2021 (print) | LCC HB171.5 (ebook) | DDC 330—dc23LC record available at https://lccn.loc.gov/2019050192LC ebook record available at https://lccn.loc.gov/2019050193

ISBN 10: 0-13-589401-8ISBN 13: 978-0-13-589401-9

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To Erin, Tessa, Jack, Abby, and Sophie



vii

About the Authors

Robin Bade was an undergraduate at the University of Queensland, Australia, where she earned degrees in mathematics and economics. After a spell teaching high school math and physics, she enrolled in the Ph.D. program at the Australian National University, from which she graduated in 1970. She has held faculty appointments at the University of Edinburgh in Scotland, at Bond University in Australia, and at the Universities of Manitoba, Toronto, and West-ern Ontario in Canada. Her research on international capital flows appears in the International Economic Review and the Economic Record.

Robin first taught the principles of economics course in 1970 and has taught it (alongside intermediate macroeconomics and international trade and finance) most years since then. She developed many of the ideas found in this text while conducting tutorials with her students at the University of Western Ontario.

Michael Parkin studied economics in England and began his university teaching career immediately after graduating with a B.A. from the University of Leicester. He learned the subject on the job at the University of Essex, England’s most exciting new university of the 1960s, and at the age of 30 became one of the youngest full professors. He is a past president of the Canadian Economics Association and has served on the editorial boards of the American Economic Review and the Journal of Monetary Economics. His research on macroeconomics, monetary economics, and international economics has resulted in more than 160 publications in journals and edited volumes, including the American Economic Review, the Journal of Political Economy, the Review of Economic Studies, the Journal of Monetary Economics, and the Journal of Money, Credit, and Banking. He is author of the best-selling textbook, Economics (Pearson), now in its Thirteenth Edition.

Robin and Michael are a wife-and-husband team. Their most notable joint research created the Bade-Parkin Index of central bank independence and spawned a vast amount of research on that topic. They don’t claim credit for the independence of the new European Central Bank, but its constitution and the movement toward greater independence of central banks around the world were aided by their pioneering work. Their joint textbooks include Macroeco-nomics (Prentice Hall), Modern Macroeconomics (Pearson Education Canada), and Economics: Canada in the Global Environment, the Canadian adaptation of Parkin, Economics (Pearson). They are dedicated to the challenge of explaining econom-ics ever more clearly to a growing body of students.

Music, the theater, art, walking on the beach, and five grandchildren provides their relaxation and fun.

vii



ix

MACROECONOMICS

PART 1 INTRODUCTION 1 Getting Started 1 2 The U.S. and Global Economies 35 3 The Economic Problem 61 4 Demand and Supply 85

PART 2 MONITORING THE MACROECONOMY 5 GDP: A Measure of Total Production and

Income 117 6 Jobs and Unemployment 147 7 The CPI and the Cost of Living 169

PART 3 THE REAL ECONOMY 8 Potential GDP and the Natural Unemployment

Rate 193 9 Economic Growth 217 10 Finance, Saving, and Investment 245

PART 4 THE MONEY ECONOMY 11 The Monetary System 273 12 Money, Interest, and Inflation 303

PART 5 ECONOMIC FLUCTUATIONS 13 Aggregate Supply and Aggregate Demand 331 14 Aggregate Expenditure Multiplier 357 15 The Short-Run Policy Tradeoff 383

Brief Contents


x BRIEF CONTENTS

PART 6 MACROECONOMIC POLICY 16 Fiscal Policy 405 17 Monetary Policy 431 18 International Trade Policy 459 19 International Finance 485

Glossary G-1 Index I-1 Credits C-1


xi

Appendix: Making and Using Graphs 25Basic Idea 25Interpreting Data Graphs 26Interpreting Graphs Used in Economic Models 28The Slope of a Relationship 31Relationships Among More Than Two Variables 32

APPENDIX CHECKPOINT 34

■ EYE on the BENEFIT AND COST OF SCHOOLDid You Make the Right Decision? 12

■ EYE on YOUR LIFEYour Time Allocation 19

■ EYE on the PASTAdam Smith and the Birth of Economics as a Social

Science 20

CHAPTER 2

The U.S. and Global Economies 35CHAPTER CHECKLIST 35

2.1 What, How, and for Whom? 36What Do We Produce? 36How Do We Produce? 38For Whom Do We Produce? 41

CHECKPOINT 2.1 42

2.2 The Global Economy 43The People 43The Economies 43What in the Global Economy 44How in the Global Economy 46For Whom in the Global Economy 46

CHECKPOINT 2.2 49

CHAPTER 1

Getting Started 1CHAPTER CHECKLIST 1

1.1 Definition and Questions 2Scarcity 2Economics Defined 2What, How, and For Whom? 3Can the Pursuit of Self-Interest Be in the Social Interest? 4

CHECKPOINT 1.1 7

1.2 The Economic Way of Thinking 8A Choice Is a Tradeoff 8Cost: What You Must Give Up 8Benefit: What You Gain 9Rational Choice 9How Much? Choosing at the Margin 10Choices Respond to Incentives 11

CHECKPOINT 1.2 13

1.3 Economics as a Social Science and Policy Tool 14Economics as a Social Science 14Economics as a Policy Tool 15

CHECKPOINT 1.3 15

1.4 Economics as a Life Skill and Job Skill 16Jobs for an Economics Major 16Will the Number of Economics Jobs Grow? 17How Much Do Economics Majors Earn? 17Skills Needed for Economics Jobs 17Economics for Life 18

CHECKPOINT 1.4 20

CHAPTER SUMMARY 21

CHAPTER CHECKPOINT 22

PART 1 INTRODUCTION

Contents

xi


xii CONTENTS

Increasing Opportunity Costs Are Everywhere 70Your Increasing Opportunity Cost 70

CHECKPOINT 3.2 71

3.3 Economic Growth 72CHECKPOINT 3.3 74

3.4 Specialization and Trade 75Absolute Advantage and Comparative

Advantage 75Comparative Advantage: A Model 76Achieving Gains from Trade 78The Economy’s Production Possibilities

Frontier 79

CHECKPOINT 3.4 80

CHAPTER SUMMARY 81


■ EYE on YOUR LIFEYour Production Possibilities Frontier 66

■ EYE on the ENVIRONMENTIs Wind Power Free? 70

■ EYE on the U.S. ECONOMYExpanding Our Production Possibilities 73

■ EYE on the GLOBAL ECONOMYHong Kong’s Rapid Economic Growth 74

■ EYE on the U.S. ECONOMYNo One Knows How to Make a Pencil 75

■ EYE on YOUR LIFEYour Comparative Advantage 79

CHAPTER 4

Demand and Supply 85CHAPTER CHECKLIST 85

Competitive Markets 86

4.1 Demand 87The Law of Demand 87Demand Schedule and Demand Curve 87Changes in Demand 89Illustrating Changes in Buying Plans 90

CHECKPOINT 4.1 91

2.3 The Circular Flows 50Households and Firms 50Markets 50Real Flows and Money Flows 50Governments 52Governments in the Circular Flow 53Circular Flows in the Global Economy 54

CHECKPOINT 2.3 56

CHAPTER SUMMARY 57


■ EYE on the U.S. ECONOMYWhat We Produce 37

■ EYE on the PASTChanges in What We Produce 38

■ EYE on the U.S. ECONOMYChanges in How We Produce in the Information

Economy 40

■ EYE on the DREAMLINERWho Makes the Dreamliner? 45

■ EYE on the GLOBAL ECONOMYDifferences in How We Produce 47

■ EYE on YOUR LIFEThe U.S. and Global Economies in Your Life 49

■ EYE on the PASTGrowing Government 54

■ EYE on the GLOBAL ECONOMYThe Ups and Downs in International Trade 56

CHAPTER 3

The Economic Problem 61CHAPTER CHECKLIST 61

3.1 Production Possibilities 62Production Possibilities Frontier 62How the PPF Illustrates Scarcity and Its

Consequences 63

CHECKPOINT 3.1 67

3.2 Opportunity Cost 68The Opportunity Cost of a Smartphone 68Opportunity Cost and the Slope of the PPF 69Opportunity Cost Is a Ratio 69


CONTENTS xiii

4.2 Supply 92The Law of Supply 92Supply Schedule and Supply Curve 92Changes in Supply 94Illustrating a Change in Selling Plans 95

CHECKPOINT 4.2 97

4.3 Market Equilibrium 98Price: A Market’s Automatic Regulator 98Predicting Price Changes: Three Questions 99Effects of Changes in Demand 100Effects of Changes in Supply 102Effects of Changes in Both Demand and Supply 104

CHECKPOINT 4.3 106

4.4 PRICE RIGIDITIES 107Price Floor 107

Price Ceiling or Price Cap 109Sticky Price 111

CHECKPOINT 4.4 112

CHAPTER SUMMARY 113


■ EYE on YOUR LIFEUnderstanding and Using Demand and Supply 96

■ EYE on the GLOBAL ECONOMYThe Markets for Cocoa and Chocolate 101

■ EYE on the PRICE OF AVOCADOSWhy Does the Price of Avocados Fluctuate? 103

■ EYE on the U.S. ECONOMYThe Federal Minimum Wage 109

PART 2 MONITORING THE MACROECONOMY

CHAPTER 5

GDP: A Measure of Total Production and Income 117CHAPTER CHECKLIST 117

5.1 GDP, Income, and Expenditure 118GDP Defined 118Circular Flows in the U.S. Economy 119Expenditure Equals Income 120

CHECKPOINT 5.1 122

5.2 Measuring U.S. GDP 123The Expenditure Approach 123The Income Approach 125GDP and Related Measures of Production and

Income 127Real GDP and Nominal GDP 128Calculating Real GDP 128Using the Real GDP Numbers 129

CHECKPOINT 5.2 130

5.3 The Uses and Limitations of Real GDP 131The Standard of Living Over Time 131

Tracking the Course of the Business Cycle 132The Standard of Living Among Countries 134Goods and Services Omitted from GDP 135Other Influences on the Standard of Living 136

CHECKPOINT 5.3 138

CHAPTER SUMMARY 139


Appendix: Measuring Real GDP 143The Problem with Base Year Prices 143Value Production in the Prices of Adjacent Years 143APPENDIX CHECKPOINT 146

■ EYE on the U.S. ECONOMYIs a Computer Program an Intermediate Good or a Final

Good? 124

■ EYE on BOOMS AND BUSTSHow Do We Track Economic Booms and Busts? 134

■ EYE on YOUR LIFEMaking GDP Personal 136

■ EYE on the GLOBAL ECONOMYWhich Country Has the Highest Standard of

Living? 137


xiv CONTENTS

CHAPTER 7

The CPI and the Cost of Living 169CHAPTER CHECKLIST 169

7.1 The Consumer Price Index 170Reading the CPI Numbers 170Constructing the CPI 170The CPI Market Basket 170The Monthly Price Survey 171Calculating the CPI 172Measuring Inflation and Deflation 173The Price Level, Inflation, and Deflation in the United

States 173

CHECKPOINT 7.1 175

7.2 The CPI and Other Price Level Measures 176Sources of Bias in the CPI 176The Magnitude of the Bias 177Two Consequences of the CPI Bias 178Alternative Consumer Price Indexes 178

CHECKPOINT 7.2 181

7.3 Nominal and Real Values 182Dollars and Cents at Different Dates 182Nominal and Real Values in Macroeconomics 183Nominal GDP and Real GDP 183Nominal Wage Rate and Real Wage Rate 184Nominal Interest Rate and Real Interest Rate 186

CHECKPOINT 7.3 188

CHAPTER SUMMARY 189


■ EYE on the PAST700 Years of Inflation and Deflation 174

■ EYE on the U.S. ECONOMYMeasuring and Forecasting Inflation: The Sticky-Price

CPI 180

CHAPTER 6

Jobs and Unemployment 147CHAPTER CHECKLIST 147

6.1 Labor Market Indicators 148Current Population Survey 148Population Survey Criteria 148Three Labor Market Indicators 149Alternative Measures of Unemployment 150

CHECKPOINT 6.1 152

6.2 Labor Market Trends and Fluctuations 153The Unemployment Rate 153The Participation Rate 154Alternative Measures of Unemployment 156

CHECKPOINT 6.2 157

6.3 Unemployment and Full Employment 158Frictional Unemployment 158Structural Unemployment 158Cyclical Unemployment 159“Natural” Unemployment 159Unemployment and Real GDP 161

CHECKPOINT 6.3 164

CHAPTER SUMMARY 165


■ EYE on the U.S. ECONOMYThe Current Population Survey 151

■ EYE on the GLOBAL ECONOMYUnemployment and Labor Force Participation 155

■ EYE on the U.S. ECONOMYHow Long Does It Take to Find a Job? 159

■ EYE on FULL EMPLOYMENTAre We at Full Employment? 160

■ EYE on YOUR LIFEYour Labor Market Status and Activity 163


CONTENTS xv

■ EYE on the U.S. ECONOMYDeflating the GDP Balloon 183

■ EYE on the PASTThe Nominal and Real Wage Rates of Presidents of the

United States 185

■ EYE on BOX OFFICE HITSWhich Movie Really Was the Biggest Box Office

Hit? 186

■ EYE on YOUR LIFEA Student’s CPI 187

PART 3 THE REAL ECONOMY

CHAPTER 8

Potential GDP and the Natural Unemployment Rate 193CHAPTER CHECKLIST 193

Macroeconomic Approaches and Pathways 194

The Three Main Schools of Thought 194Today’s Consensus 195The Road Ahead 196

8.1 Potential GDP 197The Production Function 198The Labor Market 199

CHECKPOINT 8.1 205

8.2 The Natural Unemployment Rate 206Job Search 207Job Rationing 208

CHECKPOINT 8.2 212

CHAPTER SUMMARY 213


■ EYE on the U.S. ECONOMYThe Lucas Wedge and the Okun Gap 196

■ EYE on the GLOBAL ECONOMYPotential GDP in the United States and the European

Union 197

■ EYE on POTENTIAL GDPWhy Do Americans Earn More and Produce

More Than Europeans? 204

■ EYE on the PASTThe Natural Unemployment Rate Over Seven

Decades 206

■ EYE on the GLOBAL ECONOMYUnemployment Benefits and the Natural

Unemployment Rate 208

■ EYE on the U.S. ECONOMYThe Federal Minimum Wage 211

■ EYE on YOUR LIFENatural Unemployment 211

CHAPTER 9

Economic Growth 217CHAPTER CHECKLIST 217

9.1 The Basics of Economic Growth 218Calculating Growth Rates 218The Magic of Sustained Growth 220

CHECKPOINT 9.1 221

9.2 Labor Productivity Growth 222Labor Productivity 222Saving and Investment in Physical Capital 222


xvi CONTENTS

Expansion of Human Capital and Discovery of New Technologies 224

Combined Influences Bring Labor Productivity Growth 226

CHECKPOINT 9.2 229

9.3 Causes and Effects of Economic Growth 230Old Growth Theory 230New Growth Theory 230Economic Growth and the Distribution

of Income 232

CHECKPOINT 9.3 235

9.4 Achieving Faster Growth 236Preconditions for Economic Growth 236Policies to Achieve Faster Growth 237How Much Difference Can Policy Make? 238

CHECKPOINT 9.4 240

CHAPTER SUMMARY 241


■ EYE on the PASTHow Fast Has Real GDP per Person Grown? 219

■ EYE on the U.S. ECONOMYU.S. Growth Is Slowing 220

■ EYE on the U.S. ECONOMYU.S. Labor Productivity Growth Since 1960 228

■ EYE on the U.S. ECONOMYThe Changing Shares in the Gains from Economic

Growth 233

■ EYE on YOUR LIFEHow You Influence and Are Influenced by Economic

Growth 234

■ EYE on RICH AND POOR NATIONSWhy Are Some Nations Rich and Others Poor? 239

CHAPTER 10

Finance, Saving, and Investment 245CHAPTER CHECKLIST 245

10.1 Financial Markets and Financial Institutions 246Some Finance Definitions 246Markets for Financial Capital 247Financial Institutions 248Interest Rates and Bond and Stock Prices 249The Economic Benefits of Financial Markets and

Institutions 250

CHECKPOINT 10.1 251

10.2 The Loanable Funds Market 252Flows in the Loanable Funds Market 252The Demand for Loanable Funds 252The Supply of Loanable Funds 255Equilibrium in the Loanable Funds

Market 258Changes in Demand and Supply 259

CHECKPOINT 10.2 261

10.3 Government in Loanable Funds Market 262A Government Budget Surplus 262A Government Budget Deficit 263

CHECKPOINT 10.3 266


CONTENTS xvii

Appendix: Present Value 267Comparing Current and Future Dollars 267Compound Interest 267Present Value of a Sequence of Future Sums 268

CHAPTER SUMMARY 269


■ EYE on the U.S. ECONOMYInterest Rate Patterns 248

■ EYE on the U.S. ECONOMYThe Scale of Lending and Borrowing 250

■ EYE on the U.S. ECONOMYCryptocurrencies and Blockchain Technology 260

■ EYE on YOUR LIFEYour Participation in the Loanable Funds Market 264

■ EYE on FINTECHWhat Is Fintech and How Is Technology Changing

Financial Markets? 265

11.3 The Federal Reserve System 285The Structure of the Federal Reserve 285The Fed’s Policy Tools 286How the Fed’s Policy Tools Work 287

CHECKPOINT 11.3 288

11.4 Regulating the Quantity of Money 289

Creating Deposits by Making Loans 289How Open Market Operations Change the Monetary

Base 291The Multiplier Effect of an Open Market

Operation 294The Money Multiplier 295

CHECKPOINT 11.4 298

CHAPTER SUMMARY 299


■ EYE on the PASTThe “Invention” of Banking 281

CHAPTER 11

The Monetary System 273CHAPTER CHECKLIST 273

11.1 What is Money? 274Definition of Money 274The Functions of Money 274Money Today 276Official Measures of Money: M1

and M2 276Checks, Credit Cards, Debit Cards,

and Mobile Wallets 277An Embryonic New Money: E-Cash 278

CHECKPOINT 11.1 279

11.2 The Banking System 280Commercial Banks 280Thrift Institutions 283Money Market Funds 283

CHECKPOINT 11.2 284

PART 4 THE MONEY ECONOMY


xviii CONTENTS

■ EYE on the U.S. ECONOMYCommercial Banks Under Stress in the Financial

Crisis 283

■ EYE on YOUR LIFEMoney and Your Role in Its Creation 289

■ EYE on CREATING MONEYHow Does the Fed Create Money and Regulate Its

Quantity? 296

CHAPTER 12

Money, Interest, and Inflation 303CHAPTER CHECKLIST 303

Where We are and Where We’re Heading 304The Real Economy 304The Money Economy 304Real and Money Interactions and Policy 304

12.1 Money and the Interest Rate 305The Demand for Money 305Changes in the Demand for Money 307The Supply of Money 308The Nominal Interest Rate 308Changing the Interest Rate 310

CHECKPOINT 12.1 312

12.2 Money, the Price Level, and Inflation 313The Money Market in the Long Run 313A Change in the Quantity of Money 315The Price Level in a Baby-Sitting Club 316The Quantity Theory of Money 316Inflation and the Quantity Theory of Money 318Hyperinflation 321

CHECKPOINT 12.2 322

12.3 The Cost of Inflation 323Tax Costs 323Shoe-Leather Costs 324Confusion Costs 324Uncertainty Costs 325How Big Is the Cost of Inflation? 325

CHECKPOINT 12.3 326

CHAPTER SUMMARY 327


■ EYE on the U.S. ECONOMYCredit Cards and Money 310

■ EYE on YOUR LIFEMoney Holding and Fed Watching 311

■ EYE on INFLATIONWhat Causes Inflation? 320

■ EYE on the PASTHyperinflation in Germany in the 1920s 321

PART 5 ECONOMIC FLUCTUATIONS

CHAPTER 13

Aggregate Supply and Aggregate Demand 331CHAPTER CHECKLIST 331

13.1 Aggregate Supply 332Aggregate Supply Basics 332Changes in Aggregate Supply 335

CHECKPOINT 13.1 337

13.2 Aggregate Demand 338Aggregate Demand Basics 338Changes in Aggregate Demand 340The Aggregate Demand Multiplier 342

CHECKPOINT 13.2 343

13.3 Explaining Economic Trends and Fluctuations 344Macroeconomic Equilibrium 344Three Types of Macroeconomic Equilibrium 345Economic Growth and Inflation Trends 346The Business Cycle 347Inflation Cycles 348Deflation and the Great Depression 350

CHECKPOINT 13.3 352

CHAPTER SUMMARY 353


■ EYE on the U.S. ECONOMYU.S. Economic Growth, Inflation, and the Business

Cycle 346


CONTENTS xix

■ EYE on YOUR LIFEUsing the AS-AD Model 350

■ EYE on RECESSIONWhat Causes a Recession? 351

CHAPTER 14

Aggregate Expenditure Multiplier 357CHAPTER CHECKLIST 357

14.1 Expenditure Plans and Real GDP 358The Consumption Function 358Imports and Real GDP 362

CHECKPOINT 14.1 363

14.2 Equilibrium Expenditure 364Induced Expenditure and Autonomous

Expenditure 364Aggregate Planned Expenditure and

Real GDP 364Equilibrium Expenditure 366Convergence to Equilibrium 367

CHECKPOINT 14.2 369

14.3 Expenditure Multipliers 370The Basic Idea of the Multiplier 370The Size of the Multiplier 371The Multiplier and the MPC 371The Multiplier, Imports, and Income

Taxes 372Business-Cycle Turning Points 374

CHECKPOINT 14.3 375

14.4 The AD Curve and Equilibrium Expenditure 376Deriving the AD Curve from Equilibrium

Expenditure 376

CHECKPOINT 14.4 378

CHAPTER SUMMARY 379


■ EYE on the U.S. ECONOMYThe U.S. Consumption Function 362

■ EYE on the PASTSay’s Law and Keynes’ Principle of Effective

Demand 368

■ EYE on YOUR LIFELooking for Multipliers 373

■ EYE on the MULTIPLIERHow Big Is the Government Expenditure

Multiplier? 374

CHAPTER 15

The Short-Run Policy Tradeoff 383CHAPTER CHECKLIST 383

15.1 The Short-Run Phillips Curve 384Aggregate Supply and the Short-Run Phillips

Curve 385Aggregate Demand Fluctuations 387Why Bother with the Phillips Curve? 388

CHECKPOINT 15.1 389

15.2 Short-Run and Long-Run Phillips Curves 390The Long-Run Phillips Curve 390Expected Inflation 391The Natural Rate Hypothesis 392Changes in the Natural Unemployment Rate 393Have Changes in the Natural Unemployment Rate

Changed the Tradeoff? 394

CHECKPOINT 15.2 396

15.3 Influencing Inflation and Unemployment 397Influencing the Expected Inflation Rate 397Targeting the Unemployment Rate 398

CHECKPOINT 15.3 400

CHAPTER SUMMARY 401


■ EYE on the GLOBAL ECONOMYInflation and Unemployment 387

■ EYE on the PASTThe U.S. Phillips Curve 388

■ EYE on the PASTA Live Test of the Natural Rate Hypothesis 393

■ EYE on the TRADEOFFCan We Have Low Unemployment and Low

Inflation? 395

■ EYE on YOUR LIFEThe Short-Run Tradeoff in Your Life 399


xx CONTENTS

PART 6 MACROECONOMIC POLICY

CHAPTER 16

Fiscal Policy 405CHAPTER CHECKLIST 405

16.1 The Federal Budget 406The Institutions and Laws 406Budget Balance and Debt 406The Federal Budget in Fiscal 2020 407A Fiscal Policy Challenge 410Generational Accounting 410

CHECKPOINT 16.1 412

16.2 Fiscal Stimulus 413Fiscal Policy and Aggregate Demand 413Automatic Fiscal Policy 413Cyclical and Structural Budget Balances 414Discretionary Fiscal Policy 415A Successful Fiscal Stimulus 416Limitations of Discretionary Fiscal Policy 418

CHECKPOINT 16.2 419

16.3 The Supply Side: Potential GDP and Growth 420Full Employment and Potential GDP 420Fiscal Policy, Employment, and Potential

GDP 420Fiscal Policy and Potential GDP: A Graphical

Analysis 422Taxes, Deficits, and Economic Growth 423The Supply-Side Debate 424Long-Run Fiscal Policy Effects 425

CHECKPOINT 16.3 426

CHAPTER SUMMARY 427


■ EYE on the GLOBAL ECONOMYThe U.S. Budget in Global Perspective 408

■ EYE on the PASTFederal Tax Revenues, Outlays, Deficits, and Debt 409

■ EYE on the U.S. ECONOMYFiscal and Generational Imbalances 411

■ EYE on the U.S. ECONOMYThe U.S. Structural and Cyclical Budget Balances 414

■ EYE on FISCAL STIMULUSCan Fiscal Stimulus End a Recession? 417

■ EYE on the GLOBAL ECONOMYSome Real-World Tax Wedges 421

■ EYE on YOUR LIFEYour Views on Fiscal Policy and How Fiscal Policy

Affects You 425

CHAPTER 17

Monetary Policy 431CHAPTER CHECKLIST 431

17.1 How the Fed Conducts Monetary Policy 432Monetary Policy Objectives 432Operational “Maximum Employment”

Goal 433Operational “Stable Prices” Goal 433Responsibility for Monetary Policy 434Policy Instrument 434Hitting the Federal Funds Rate Target 436Restoring Financial Stability in a Financial

Crisis 437

CHECKPOINT 17.1 439

17.2 Monetary Policy Transmission 440Quick Overview 440Interest Rate Changes 440Exchange Rate Changes 442Money and Bank Loans 442The Long-Term Real Interest Rate 443Expenditure Plans 443The Fed Fights Recession 444The Fed Fights Inflation 446Loose Links and Long and Variable Lags 448A Final Reality Check 448

CHECKPOINT 17.2 449

17.3 Alternative Monetary Policy Strategies 450An Interest Rate Rule 450A Monetary Base Rule 450Inflation Targeting 451Money Targeting Rule 453

CHECKPOINT 17.3 454

CHAPTER SUMMARY 455



CONTENTS xxi

■ EYE on the FED IN A CRISISDid the Fed Save Us From Another Great

Depression 438

■ EYE on the U.S. ECONOMYThe Fed’s Decisions Versus Two Rules 451

■ EYE on the GLOBAL ECONOMYInflation Targeting Around the World 452

■ EYE on YOUR LIFEYour Views on Monetary Policy and How Monetary

Policy Affects You 453

CHAPTER 18

International Trade Policy 459CHAPTER CHECKLIST 459

18.1 How Global Markets Work 460International Trade Today 460What Drives International Trade? 460Why the United States Imports T-Shirts 462Why the United States Exports Airplanes 463Winners, Losers, and Net Gains From Trade 464

CHECKPOINT 18.1 466

18.2 International Trade Restrictions 467Tariffs 467Import Quotas 471Other Import Barriers 472

CHECKPOINT 18.2 474

18.3 The Case Against Protection 475Three Traditional Arguments for Protection 475Four Newer Arguments for Protection 477Why Is International Trade Restricted? 478CHECKPOINT 18.3 480

CHAPTER SUMMARY 481


■ EYE on the U.S. ECONOMYU.S. Exports and Imports 461

■ EYE on the GLOBAL ECONOMYWho Wins and Who Loses from Globalization? 465

■ EYE on the PASTThe History of U.S. Tariffs 467

■ EYE on the U.S. ECONOMYA Tariff on Softwood Lumber 470

■ EYE on the U.S. ECONOMYAn Import Quota on Sugar 473

■ EYE on YOUR LIFEInternational Trade 479

CHAPTER 19

International Finance 485CHAPTER CHECKLIST 485

19.1 Financing International Trade 486Balance of Payments Accounts 486Borrowers and Lenders, Debtors and Creditors 488Current Account Balance 489

CHECKPOINT 19.1 492

19.2 The Exchange Rate 493Demand in the Foreign Exchange Market 494The Law of Demand for Foreign Exchange 494Changes in the Demand for Dollars 495Supply in the Foreign Exchange Market 497The Law of Supply of Foreign Exchange 497Changes in the Supply of Dollars 498Market Equilibrium 500Exchange Rate Expectations 502Monetary Policy and the Exchange Rate 504Pegging the Exchange Rate 504The People’s Bank of China in the Foreign Exchange

Market 505

CHECKPOINT 19.2 508

CHAPTER SUMMARY 509


■ EYE on the U.S. ECONOMYThe U.S. Balance of Payments 487

■ EYE on the GLOBAL ECONOMYCurrent Account Balances Around the World 491

■ EYE on the DOLLARWhy Does Our Dollar Fluctuate? 501

■ EYE on the GLOBAL ECONOMYPurchasing Power Parity 503

■ EYE on the GLOBAL ECONOMYThe Managed Yuan 507

■ EYE on YOUR LIFEYour Foreign Exchange Transactions 507

Glossary G-1Index I-1Credits C-1



FOUNDATIONS OF MACROECONOMICS

Confidence-Building Graphsuse color to show the direction of shifts and detailed, numbered captions guide students step-by-step through the action.

A Learning-by-Doing ApproachThe Checklist that begins each chapter highlights the key topics covered and the chapter is divided into sections that directly correlate to the Checklist.

The Checkpoint that ends each section provides a full page of practice problems to encourage students to review the material while it is fresh in their minds.

Each chapter opens with a question about a central issue that sets the stage for the material.

delivers a complete, hands-on learning system designed around active learning.

Eye On boxes apply theory to important issues and problems that shape our global society and individual decisions.

CHECKPOINT 4.1

Distinguish between quantity demanded and demand, and explain what determines demand.

Practice ProblemsThe following events occur one at a time in the market for smartphones:

• The price of a smartphone falls.• Producers announce that the price of a smartphone will fall next month.• The price of a call made from a smartphone falls.• The price of a call made from a land-line phone increases.• An increase in memory makes smartphones more popular.

1. Explain the effect of each event on the demand for smartphones.2. Use a graph to illustrate the effect of each event.3. Does any event (or events) illustrate the law of demand?

In the NewsNetflix hikes its price

avocados, which we will assume was the same in both months.

At the end of July, the supply curve was SJul, the equilibrium price was $1.03 per avocado, and the equi-librium quantity of avocados was 48 million pounds.

During August, decreased produc-tion in California decreased supply to SSep by the start of September.

The equilibrium price rose to $1.29 per avocado and the equilib-rium quantity decreased to 36 million pounds.

The higher price brought a de-crease in the quantity of avocados demanded, which is shown by the movement up along the demand curve.

EYE on the PRICE OF AVOCADOSWhy Does the Price of Avocados Fluctuate?

In August each year, the Californian avo-cado crop winds down and the Mexican crop takes over. But if Mexican produc-tion is not ramped up enough to replace the Californian crop, the quantity of avocados produced decreases and the price rises.

The table below provides some data on the quantity and price of avocados at the end of July 2018 and the start of Sep-tember 2018. What do the data tell us?

The data tell us that the quantity of avocados produced decreased by 25 percent from 48 million pounds in July to 36 million pounds in September, and the price rose by 25 percent from $1.03 to $1.29 per avocado.

Did the price rise because the demand increased or because the supply decreased?

You can answer this question from the information provided. You know that an increase in demand brings a rise in the price and an increase in the quantity traded, while a decrease in supply brings a rise in the price and a decrease in the quantity traded.

Because the quantity of avoca-dos bought decreased and the price increased, the supply of avocados must have decreased.

The information that Californian production wound down before Mexi-cian production fully ramped up tells us that avocado production decreased, which decreased the supply.

The figure illustrates the market for avocados during 2018. The de-mand curve D shows the demand for

Price (dollars per bottle)

Quantity (millions of bottles per day)

2.00

1.50

1.00

0.50

0

2.50

D1

D0

D2

A decrease in thequantity demandedThe quantity demanded decreasesand there is a movement up alongthe demand curve D if the priceof the good rises and other thingsremain the same.

A decrease in demandDemand decreases and thedemand curve shifts leftward(from D to D ) if0 1

The price of a substitutefalls or the price of acomplement rises.The price of the good isexpected to fall.Income decreases.*

Expected future incomeor credit decreases.

The number of buyersdecreases.* Bottled water is a normal good.

8 9 01 11 21 31

An increase in thequantity demandedThe quantity demanded increasesand there is a movement downalong the demand curve D ifthe price of the good falls andother things remain the same.

An increase in demandDemand increases and thedemand curve shifts rightward(from D to D ) if

The price of a substituterises or the price of acomplement falls.The price of the good isexpected to rise.

Income increases.

Expected future incomeor credit increases.

The number of buyersincreases.

00

0 2

■ FIGURE 4.4

Change in Quantity Demanded Versus Change in Demand

4Demand and Supply

CHAPTER CHECKLISTWhen you have completed your study of this chapter, you will be able to

1 Distinguish between quantity demanded and demand, and explain what determines demand.

2 Distinguish between quantity supplied and supply, and explain what determines supply.

3 Explain how demand and supply determine price and quantity in a market, and explain the effects of changes in demand and supply.

Why does the price of avocados fluctuate?



xxv

Students know that throughout their lives they will make

economic decisions and be influenced by economic forces. They

want to understand the economic principles that can help them

navigate these forces and guide their decisions. Foundations of

Macroeconomics is our attempt to satisfy this want.

The response to our earlier editions from hundreds of

colleagues across the United States and throughout the world

tells us that most of you agree with our view that the principles course must do

four things well. It must

• Motivate with compelling issues and questions• Focus on core ideas• Steer a path between an overload of detail and too much left unsaid• Encourage and aid learning by doing

The Foundations icon with its four blocks (on the cover and throughout the

book) symbolizes this four-point approach that has guided all our choices in

writing this text and creating its comprehensive teaching and learning features.

WHAT’S NEW IN THE NINTH EDITION

New in this Ninth Edition revision are: Fine-tuning of the content; several notable content changes in micro and macro; an emphasis on economics as a foundation for effective citizenship; and highlighting the role of economics as a life skill and a job skill.

Fine-Tuning the ContentThe content of this revision is driven by the drama of the extraordinary period of economic history in which we are living and its rich display of events and forces through which students can be motivated to discover the economic way of thinking. Persistent slow economic growth; increasing concentration of wealth; headwinds from Europe’s stagnant economy and the UK decision to leave the economic union (Brexit); ongoing tensions arising from the loss of American jobs to offshore outsourcing and the political popularity of trade protection; a slowing pace of China’s expansion; enhanced concern about carbon emission and climate change; relentless pressure on the federal budget from the demands of an aging

Preface


xxvi PREFACE

population and a sometimes dysfunctional Congress with its associated rising government debt; the dilemma posed by slow, more than decade-long recovery from a global financial crisis and recession and the related question of when and how fast to exit an era of extreme monetary stimulus. These are just a few of these interest-arousing events. All of them feature at the appropriate points in our new edition.

Every chapter contains many small changes, all designed to enhance clar-ity and currency, and the text and examples are all updated to reflect the most recently available data and events.

Notable Content ChangesIn Chapter 1, Getting Started, we have expanded and reorganized our explana-tion of economics as a social science and as a policy decision tool. And we have broadened our explanation of how economics is used as an aid to critical think-ing and a job tool. In a new section, Economics as a Life Skill and Job Skill, we describe the jobs that economics majors do and the incomes they earn.

In Chapter 4, Demand and Supply, we explain and illustrate the power of the demand-supply model to predict and explain large recent swings in the price of avocados.

In Chapter 5, GDP: A Measure of Total Production and Income, Chapter 6, Jobs and Unemployment, Chapter 7, The CPI and the Cost of Living, and Chapter 9, Economic Growth, have all been updated to include the latest avail-able data on the national accounts, the labor market, price indexes, and global economic growth.

Chapter 10, Finance, Saving, and Investment, has five major changes. It explains the yield curve and its occasional inversion, which occured in 2019; it reports the data on the enormous scale of borrowing and lending; it describes the role of cryptocurrencies and blockchain technology; it describes recent in-novations in financial technology, fintech, and their effects on the supply of and demand for loanable funds; and it includes a new appendix on the concept and calculation of present value.

Chapter 11, The Monetary System, and Chapter 12, Money, Interest, and Inflation, have been updated to include the latest data on banks and the money market. Chapter 13, Aggregate Supply and Aggregate Demand, has been updat-ed to include the latest state of the business cycle.

In Chapter 15, The Short-Run Tradeoff, the coverage of the Phillips curve provides a look at the changing natural unemployment rate and expected infla-tion rate and their effects on the short-run and long-run Phillips curves and explains why we have low inflation along with low unemployment.

Chapter 16, Fiscal Policy, and Chapter 17, Monetary Policy, have been up-dated to include recent developments in fiscal and monetary stimulus. Chapter 18, International Trade Policy, provides the student with the tools needed to evaluate the Trump upheaval of global trade and illustrates the effects of protec-tion by examining U.S. tariffs on Canadian softwood imports and the U.S. import quota on sugar.


PREFACE xxvii

THE FOUNDATIONS VISION

Focus on Core ConceptsEach chapter of Foundations concentrates on a manageable number of main ideas (most commonly three or four) and reinforces each idea several times throughout the chapter. This patient, confidence-building approach guides students through unfamiliar terrain and helps them to focus their efforts on the most important tools and concepts of our discipline.

Showing the Action and Telling the Whole StoryThrough earlier editions, we have developed the style of our diagrams and set the standard of their clarity. The ninth edition continues to uphold this tradi-tion. Our goal is to show “where the economic action is.” Our diagrams continue to generate an enormously positive response, which confirms our view that graphical analysis is the most powerful tool available for teaching and learning economics at the principles level. Recognizing that some students find graphs hard to work with, we have developed the entire art program with the study and review needs of the student in mind.

Because beginning students of economics are often apprehensive about working with graphs, we have made a special effort to present the information in as many as three ways—with graphs, words, and tables—in the same figure. In an innovation that seems necessary, but is to our knowledge unmatched, nearly all of the information supporting a figure appears on the same page as the figure itself. No more flipping pages back and forth!

Real-World Connections That Bring Theory to LifeStudents learn best when they can see the purpose of what they are studying, apply it to illuminate the world around them, and use it in their lives.

Eye On boxes offer fresh new examples to help students see that economics is everywhere. Current and recent events appear in Eye on the U.S. Economy boxes; we place current U.S. economic events in global and historical perspectives in our Eye on the Global Economy and Eye on the Past boxes; and we show how students can use economics in day-to-day decisions in Eye on Your Life boxes.

Each chapter-opening question is answered in an Eye On box that helps students see the economics behind a key issue facing the world and highlights a major aspect of the chapter's story.

Foundation for Job and LifeA centerpiece of the Foundations vision is enabling the principles of economics course to prepare the student for a productive career and life. It identifies three skills that further this goal:

• Problem solving• Critical thinking• Decision making

Problem solving is central to the Foundations story. A Checkpoint at the end of each topic, typically three per chapter, provides a pause and oppor-tunity to check understanding with problems, one of which is driven by a recent news clip, and worked solutions.


xxviii PREFACE

Critical thinking is encouraged and supported through a series of exercises. In each chapter, there is one exercise that is based on the question or issue that opens and motivates the chapter, and a second that builds from an Economics in Your Life feature.

Decision making is at the core of economics, and the principles course, with its emphasis on choice at the margin and opportuntiy cost, teaches decision-making skills like no other subject.

Foundation for Effective CitizenshipAn effective citizen is a person who participates in the public conversation and votes in elections with a solid sense of the efficiency and fairness of alternative public, collective decisions.

This text lays the foundation for effective citizenship by explaining the principles of welfare economics and the competing ideas about fairness, and repeatedly applying these principles to a comprehensive range of public choice problems. And our Economics in Your Life feature connects these principles with the student's own life and public choices.

ORGANIZATION

We have organized the sequence of topics and chapters in what we think is the most natural order in which to cover the material. But we recognize that there are alternative views on the best order. We have kept this fact and the need for flexibil-ity firmly in mind throughout the text. Many alternative sequences work, and the Flexibility Chart on p. xxxi explain the alternative pathways through the chapters. In using the flexibility information, keep in mind that the best sequence is the one in which we present the topics. And even chapters that the flexibility charts iden-tify as strictly optional are better covered than omitted.


PREFACE xxix

ACKNOWLEDGMENTS

Working on a project such as this one generates many debts that can never be repaid. But they can be acknowledged, and it is a special pleasure to be able to do so here and to express our heartfelt thanks to each and every one on the following long list, without whose contributions we could not have produced Foundations.

Mark Rush again coordinated, managed, and contributed to our Solutions Manual, Instructor’s Manual, and Test Item Files. He assembled, polished, wrote, and rewrote these materials to ensure their close consistency with the text. He and we were in constant contact as all the elements of our text and package came together. Mark also made many valuable suggestions for improving the text and the Checkpoint Problems. His contribution went well beyond that of a reviewer, and his effervescent sense of humor kept us all in good spirits along the way.

The ideas from which Foundations grew began to form over dinner at the Andover Inn in Andover, Massachusetts, with Denise Clinton and Sylvia Mallory. We gratefully acknowledge Sylvia‘s role not only at the birth of this project but also in managing its initial development team. Denise was an ongoing inspira-tion for 15 years, and we are privileged to have had the benefit of her enormous experience.

The success of Foundations owes much to its outstanding editors: Director of Product Management, Adrienne D’Ambrosio. Adrienne’s acute intelligence and sensitive understanding of the market have helped sharpen our vision of this text and package over earlier editions. The value-added of Adrienne has been huge and we hope it will, for many future editions, remain a joy to work with her.

As the revision progressed, Christopher DeJohn, Samantha Lewis, and Thomas Hayward brought fresh new ideas to our ninth edition.

Sugandh Juneja, our Content Producer, worked with a talented team at Integra, Project Editor, Heather Johnson, and the designer, art coordinator, and typesetter. Our copy editor, Catherine Baum, gave our work a thorough review and helpful polish, and our proofreader ensured the most error-free text we have yet produced.

Our marketing team, comprised of Nayke Heine and Ashley DePace, has been an integral part of this revision process. They have provided great knowledge and strategies to help continuously improve our suite of materials and keep them relevant and valuable in these ever-changing times.

Richard Parkin, our technical illustrator, created the figures in the text and the PowerPoint presentations. Jeannie Shearer, our long-standing personal assistant, worked closely with us to create assignment problems.

Finally, our reviewers, whose names appear on the following pages, have made an enormous contribution to this text. Once again we find ourselves using superlatives, but they are called for. In the many texts that we’ve written, we’ve not seen reviewing of the quality that we enjoyed on this revision. It has been a pleasure (if at times a challenge) to respond constructively to their many excel-lent suggestions.

Robin BadeMichael ParkinLondon, Ontario, [email protected]@uwo.ca



PREFACE xxxi

Chapter 8

Potential GDPand the Natural

Unemployment Rate

Start here ... … then jump toany of these …

… and jump to any of these afterdoing the prerequisites indicated

Chapter 16

Fiscal Policy

Flexibility

Chapter 1

Getting Started

Chapter 2

The U.S. and GlobalEconomies

Chapter 3

The EconomicProblem

Chapter 4

Demand and Supply

Chapter 7

The CPI and theCost of Living

Chapter 6

Jobs andUnemployment

Chapter 5

GDP: A Measure of Total Production and Income

Chapter 9

Economic Growth

Chapter 10

Finance, Saving,and Investment

Chapter 13

Aggregate Supply andAggregate Demand

Chapter 11

The MonetarySystem

Chapter 14

Aggregate ExpenditureMultiplier

Chapter 18

InternationalTrade Policy

Chapter 12

Money, Interest,and Inflation

Chapter 17

Monetary Policy

Chapter 19

International Finance

Chapter 15

The Short-RunPolicy Tradeoff

FOUNDATIONS OF ECONOMICS: FLEXIBILITY CHART


Ninth edition

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xxxii

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Foundations of MACROECONOMICS