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N. Gregory Mankiw
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 Economics
Principles of

Sixth Edition

N. Gregory Mankiw
HARVARD UNIVERSITY

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 about the
author
N. Gregory Mankiw is professor of economics at
Harvard University. As a student, he studied eco-
nomics at Princeton University and MIT. As a teach-
er, he has taught macroeconomics, microeconomics,
statistics, and principles of economics. He even
spent one summer long ago as a sailing instructor
on Long Beach Island.
Professor Mankiw is a prolific writer and a regu-
lar participant in academic and policy debates. His
work has been published in scholarly journals, such
as the American Economic Review, Journal of Political
Economy, and Quarterly Journal of Economics, and in
more popular forums, such as The New York Times
and The Wall Street Journal. He is also author of
the best-selling intermediate-level textbook Macroeconomics (Worth Publishers).
In addition to his teaching, research, and writing, Professor Mankiw has been a
research associate of the National Bureau of Economic Research, an adviser to the
Congressional Budget Office and the Federal Reserve Banks of Boston and New
York, and a member of the ETS test development committee for the Advanced
Placement exam in economics. From 2003 to 2005, he served as chairman of the
President’s Council of Economic Advisers.
Professor Mankiw lives in Wellesley, Massachusetts, with his wife, Deborah,
three children, Catherine, Nicholas, and Peter, and their border terrier, Tobin.

vi

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 brief
contents

Part I Introduction 1 Part VII Topics for Further Study 437

1 Ten Principles of Economics 3 21 The Theory of Consumer Choice 439
2 Thinking Like an Economist 21 22 Frontiers of Microeconomics 467
3 Interdependence and the Gains from Trade 49

Part VIII The Data of Macroeconomics 489

Part II How Markets Work 63 23 Measuring a Nation’s Income 491
4 The Market Forces of Supply and Demand 65 24 Measuring the Cost of Living 513
5 Elasticity and Its Application 89
6 Supply, Demand, and Government Policies 111
Part IX The Real Economy in the Long Run 529
25 Production and Growth 531
Part III Markets and Welfare 133 26 Saving, Investment, and the Financial System 555
7 Consumers, Producers, and the Efficiency of Markets 135 27 The Basic Tools of Finance 577
8 Application: The Costs of Taxation 155 28 Unemployment 593
9 Application: International Trade 171

Part X Money and Prices in the Long Run 617

Part IV The Economics of the Public Sector 193 29 The Monetary System 619
10 Externalities 195 30 Money Growth and Inflation 643
11 Public Goods and Common Resources 217
12 The Design of the Tax System 233
Part XI The Macroeconomics of Open Economies 669
31 Open-Economy Macroeconomics: Basic Concepts 671
Part V Firm Behavior and the Organization of 32 A Macroeconomic Theory of the Open Economy 695
Industry 257
13
XII Short-Run Economic Fluctuations
The Costs of Production 259
14 Firms in Competitive Markets 279 Part 717
15 Monopoly 299 33 Aggregate Demand and Aggregate Supply 719
16 Monopolistic Competition 329 34 The Influence of Monetary and Fiscal Policy on
17 Oligopoly 349 Aggregate Demand 757
35 The Short-Run Trade-off between Inflation
and Unemployment 785
Part VI The Economics of Labor Market 373
18 The Markets for the Factors of Production
19 Earnings and Discrimination 397
375
Part XIII Final Thoughts 809
20 Income Inequality and Poverty 415 36 Six Debates over Macroeconomic Policy 811

vii

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 preface
to the student

E
“ conomics is a study of mankind in the ordinary business of life.” So
wrote Alfred Marshall, the great 19th-century economist, in his textbook,
Principles of Economics. Although we have learned much about the economy
since Marshall’s time, this definition of economics is as true today as it
was in 1890, when the first edition of his text was published.
Why should you, as a student at the beginning of the 21st century, embark on
the study of economics? There are three reasons.
The first reason to study economics is that it will help you understand the
world in which you live. There are many questions about the economy that might
spark your curiosity. Why are apartments so hard to find in New York City? Why
do airlines charge less for a round-trip ticket if the traveler stays over a Saturday
night? Why is Johnny Depp paid so much to star in movies? Why are living stan-
dards so meager in many African countries? Why do some countries have high
rates of inflation while others have stable prices? Why are jobs easy to find in
some years and hard to find in others? These are just a few of the questions that a
course in economics will help you answer.
The second reason to study economics is that it will make you a more astute
participant in the economy. As you go about your life, you make many economic
decisions. While you are a student, you decide how many years to stay in school.
Once you take a job, you decide how much of your income to spend, how much
to save, and how to invest your savings. Someday you may find yourself running
a small business or a large corporation, and you will decide what prices to charge
for your products. The insights developed in the coming chapters will give you
a new perspective on how best to make these decisions. Studying economics will
not by itself make you rich, but it will give you some tools that may help in that
endeavor.
The third reason to study economics is that it will give you a better understand-
ing of both the potential and the limits of economic policy. Economic questions
are always on the minds of policymakers in mayors’ offices, governors’ mansions,
and the White House. What are the burdens associated with alternative forms of
taxation? What are the effects of free trade with other countries? What is the best
way to protect the environment? How does a government budget deficit affect
the economy? As a voter, you help choose the policies that guide the allocation of
society’s resources. An understanding of economics will help you carry out that
responsibility. And who knows: Perhaps someday you will end up as one of those
policymakers yourself.
Thus, the principles of economics can be applied in many of life’s situations.
Whether the future finds you reading the newspaper, running a business, or sit-
ting in the Oval Office, you will be glad that you studied economics.
N. Gregory Mankiw
December 2010

ix

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 table of
contents
Preface: To the Student ix FYI: Adam Smith and the Invisible Hand 12

Acknowledgments xiii How the Economy as a Whole Works 13

Principle 8: A Country’s Standard of Living Depends on Its
Ability to Produce Goods and Services 13
In The News: Why You Should Study Economics 14
Principle 9: Prices Rise When the Government Prints Too
Much Money 15
Principle 10: Society Faces a Short-Run Trade-off between
Inflation and Unemployment 16
FYI: How to Read This Book 17
Conclusion 17

Chapter 2
Thinking Like an Economist 21
The Economist as Scientist 22
The Scientific Method: Observation, Theory, and More
Observation 22
The Role of Assumptions 23
Economic Models 24
Our First Model: The Circular-Flow Diagram 24

I Introduction
Our Second Model: The Production Possibilities
Frontier 26
Microeconomics and Macroeconomics 29
PART 1 The Economist as Policy Adviser 29
FYI: Who Studies Economics? 30
Chapter 1 Positive versus Normative Analysis 30
Economists in Washington 31
Ten Principles of Economics 3 In The News: The Economics of President
Obama 32
How People Make Decisions 4 Why Economists’ Advice Is Not Always Followed 32
Principle 1: People Face Trade-offs 4
Why Economists Disagree 34
Principle 2: The Cost of Something Is What You Give
Differences in Scientific Judgments 34
Up to Get It 5
Differences in Values 34
Principle 3: Rational People Think at the Margin 6
Perception versus Reality 35
Principle 4: People Respond to Incentives 7
Case Study: The Incentive Effects of Gasoline Prices 8 Let’s Get Going 35
In The News: Incentive Pay 9 In The News: Environmental Economics 37
How People Interact 10 APPENDIX Graphing: A Brief Review 40
Principle 5: Trade Can Make Everyone Better Off 10 Graphs of a Single Variable 40
Principle 6: Markets Are Usually a Good Way to Organize Graphs of Two Variables: The Coordinate System 41
Economic Activity 10 Curves in the Coordinate System 42
Principle 7: Governments Can Sometimes Improve Market Slope 44
Outcomes 11 Cause and Effect 46

xix

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xx CONTENTS

Chapter 3 Chapter 4
Interdependence and the Gains The Market Forces of Supply
from Trade 49 and Demand 65
A Parable for the Modern Economy 50 Markets and Competition 66
Production Possibilities 50 What Is a Market? 66
Specialization and Trade 52 What Is Competition? 66
Comparative Advantage: The Driving Force Demand 67
of Specialization 54 The Demand Curve: The Relationship between Price and
Absolute Advantage 54 Quantity Demanded 67
Opportunity Cost and Comparative Market Demand versus Individual Demand 68
Advantage 54 Shifts in the Demand Curve 69
Comparative Advantage and Trade 55 Case Study: Two Ways to Reduce the Quantity of
The Price of the Trade 56 Smoking Demanded 71
FYI: The Legacy of Adam Smith and David Supply 73
Ricardo 57 The Supply Curve: The Relationship between Price and
Applications of Comparative Advantage 57 Quantity Supplied 73
Should Tom Brady Mow His Own Lawn? 57 Market Supply versus Individual Supply 73
Should the United States Trade with Other Shifts in the Supply Curve 74
Countries? 58 Supply and Demand Together 77
In The News: The Changing Face of International Equilibrium 77
Trade 59 Three Steps to Analyzing Changes in Equilibrium 79
Conclusion 59 In The News: Price Increases after Disasters 82
Conclusion: How Prices Allocate Resources 84

Chapter 5
Elasticity and Its Application 89
The Elasticity of Demand 90
The Price Elasticity of Demand and Its Determinants 90
Computing the Price Elasticity of Demand 91
The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities 91
The Variety of Demand Curves 92
FYI: A Few Elasticities from the Real World 94
Total Revenue and the Price Elasticity of Demand 94
Elasticity and Total Revenue along a Linear Demand Curve 96
Other Demand Elasticities 97
The Elasticity of Supply 98
The Price Elasticity of Supply and Its Determinants 98
Computing the Price Elasticity of Supply 98
The Variety of Supply Curves 99
Three Applications of Supply, Demand, and Elasticity 101

II How
Can Good News for Farming Be Bad News for Farmers? 101
Why Did OPEC Fail to Keep the Price of Oil High? 103
PART Markets Does Drug Interdiction Increase or Decrease Drug-Related

Work 63
Crime? 105
Conclusion 106

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 CONTENTS xxi

How a Lower Price Raises Consumer Surplus 138

Chapter 6 What Does Consumer Surplus Measure? 140
Supply, Demand, and Government Producer Surplus 141
Cost and the Willingness to Sell 141
Policies 111 Using the Supply Curve to Measure Producer Surplus 142
Controls on Prices 112 How a Higher Price Raises Producer Surplus 144
How Price Ceilings Affect Market Outcomes 112 Market Efficiency 145
Case Study: Lines at the Gas Pump 114 The Benevolent Social Planner 145
Case Study: Rent Control in the Short Run and Evaluating the Market Equilibrium 146
the Long Run 115 In The News: Ticket Scalping 148
How Price Floors Affect Market Outcomes 116 Case Study: Should There Be a Market in Organs? 149
Case Study: The Minimum Wage 117
Conclusion: Market Efficiency and Market Failure 150
Evaluating Price Controls 119
In The News: Should Unpaid Internships Be Allowed? 120
Taxes 121 Chapter 8
How Taxes on Sellers Affect Market Outcomes 121
How Taxes on Buyers Affect Market Outcomes 123 Application: The Costs of Taxation 155
Case Study: Can Congress Distribute the Burden of a Payroll The Deadweight Loss of Taxation 156
Tax? 124 How a Tax Affects Market Participants 157
Elasticity and Tax Incidence 125 Deadweight Losses and the Gains from Trade 159
Case Study: Who Pays the Luxury Tax? 127
The Determinants of the Deadweight Loss 160
Conclusion 128 Case Study: The Deadweight Loss Debate 162
Deadweight Loss and Tax Revenue as Taxes Vary 163
Case Study: The Laffer Curve and Supply-Side Economics 165
In The News: New Research on Taxation 166
Conclusion 166

Chapter 9
Application: International Trade 171
The Determinants of Trade 172
The Equilibrium without Trade 172
The World Price and Comparative Advantage 173
The Winners and Losers from Trade 174
The Gains and Losses of an Exporting Country 174
The Gains and Losses of an Importing Country 175
The Effects of a Tariff 177
FYI: Import Quotas: Another Way to Restrict Trade 179
The Lessons for Trade Policy 179

III Markets
Other Benefits of International Trade 180
In The News: Trade Skirmishes 181
PART and The Arguments for Restricting Trade 182

Welfare 133 The Jobs Argument 182

In The News: Should the Winners from Free Trade
Compensate the Losers? 183
Chapter 7 The National-Security Argument 184
In The News: Second Thoughts about Free Trade 184
Consumers, Producers, and the The Infant-Industry Argument 185
The Unfair-Competition Argument 186
Efficiency of Markets 135 The Protection-as-a-Bargaining-Chip Argument 186
Consumer Surplus 136 Case Study: Trade Agreements and the World Trade
Willingness to Pay 136 Organization 186
Using the Demand Curve to Measure Consumer Surplus 137 Conclusion 187

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xxii CONTENTS

Chapter 11
Public Goods and Common
Resources 217
The Different Kinds of Goods 218
Public Goods 220
The Free-Rider Problem 220
Some Important Public Goods 220
Case Study: Are Lighthouses Public
Goods? 222
The Difficult Job of Cost–Benefit Analysis 223
Case Study: How Much Is a Life Worth? 223
Common Resources 224
The Tragedy of the Commons 224
Some Important Common Resources 225
In The News: The Case for Toll Roads 226
Case Study: Why the Cow Is Not Extinct 228

IV The
Conclusion: The Importance of Property

Economics
Rights 229
PART
of the Public Chapter 12
Sector 193 The Design of the Tax System 233
A Financial Overview of the U.S. Government 234
Chapter 10
The Federal Government 235
Externalities 195 Case Study: The Fiscal Challenge
Ahead 238
Externalities and Market Inefficiency 197 State and Local Government 240
Welfare Economics: A Recap 197 Taxes and Efficiency 242
Negative Externalities 198 Deadweight Losses 242
Positive Externalities 199 Case Study: Should Income or Consumption
In The News: The Externalities of Country Be Taxed? 243
Living 200 In The News: The Temporarily Disappearing
Case Study: Technology Spillovers, Industrial Policy, and Estate Tax 244
Patent Protection 201 Administrative Burden 244
Public Policies toward Externalities 202 Marginal Tax Rates versus Average
Command-and-Control Policies: Regulation 203 Tax Rates 245
Market-Based Policy 1: Corrective Taxes and Lump-Sum Taxes 245
Subsidies 203 Taxes and Equity 246
Case Study: Why Is Gasoline Taxed So Heavily? 204 The Benefits Principle 246
Market-Based Policy 2: Tradable Pollution The Ability-to-Pay Principle 247
Permits 205 Case Study: How the Tax Burden Is
Objections to the Economic Analysis of Pollution 207 Distributed 248
In The News: Cap and Trade 208 Tax Incidence and Tax Equity 249
Private Solutions to Externalities 209 Case Study: Who Pays the Corporate
The Types of Private Solutions 210 Income Tax? 250
The Coase Theorem 210 In The News: The Value-Added Tax 250
Why Private Solutions Do Not Always Work 211 Conclusion: The Trade-off between Equity and
Conclusion 212 Efficiency 252

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 CONTENTS xxiii

Chapter 14
Firms in Competitive Markets 279
What Is a Competitive Market? 280
The Meaning of Competition 280
The Revenue of a Competitive Firm 280
Profit Maximization and the Competitive Firm’s
Supply Curve 282
A Simple Example of Profit Maximization 282
The Marginal-Cost Curve and the Firm’s Supply
Decision 283
The Firm’s Short-Run Decision to Shut Down 285
Spilt Milk and Other Sunk Costs 286
Case Study: Near-Empty Restaurants and Off-Season
Miniature Golf 287
The Firm’s Long-Run Decision to Exit or Enter a
Market 288
Measuring Profit in Our Graph for the Competitive

V Firm
Firm 288
The Supply Curve in a Competitive Market 289
PART Behavior and The Short Run: Market Supply with a Fixed

the Organization
Number of Firms 290
The Long Run: Market Supply with Entry and Exit 290

of Industry 257
Why Do Competitive Firms Stay in Business If They Make
Zero Profit? 292
A Shift in Demand in the Short Run and Long Run 293
Why the Long-Run Supply Curve Might Slope
Chapter 13 Upward 293
The Costs of Production 259 Conclusion: Behind the Supply Curve 295

What Are Costs? 260

Total Revenue, Total Cost, and Profit 260 Chapter 15
Costs as Opportunity Costs 260
The Cost of Capital as an Opportunity Cost 261 Monopoly 299
Economic Profit versus Accounting Profit 262
Why Monopolies Arise 300
Production and Costs 263
Monopoly Resources 301
The Production Function 263
Government-Created Monopolies 301
From the Production Function to the Total-Cost
Natural Monopolies 302
Curve 265
How Monopolies Make Production and
The Various Measures of Cost 265
Pricing Decisions 303
Fixed and Variable Costs 266
Monopoly versus Competition 303
Average and Marginal Cost 267
A Monopoly’s Revenue 304
Cost Curves and Their Shapes 268
Profit Maximization 306
Typical Cost Curves 270
A Monopoly’s Profit 308
Costs in the Short Run and in the FYI: Why a Monopoly Does Not Have a Supply
Long Run 271 Curve 308
The Relationship between Short-Run and Long-Run Average Case Study: Monopoly Drugs versus Generic
Total Cost 271 Drugs 309
Economies and Diseconomies of Scale 272
The Welfare Cost of Monopolies 310
FYI: Lessons from a Pin Factory 273
The Deadweight Loss 311
Conclusion 274 The Monopoly’s Profit: A Social Cost? 313

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xxiv CONTENTS

Price Discrimination 314 Case Study: OPEC and the World Oil Market 358
A Parable about Pricing 314 Other Examples of the Prisoners’ Dilemma 358
The Moral of the Story 315 The Prisoners’ Dilemma and the Welfare of Society 360
The Analytics of Price Discrimination 315 Why People Sometimes Cooperate 360
Examples of Price Discrimination 317 Case Study: The Prisoners’ Dilemma
Tournament 361
Public Policy toward Monopolies 318
In The News: TKTS and Other Schemes 318 Public Policy toward Oligopolies 362
Increasing Competition with Antitrust Laws 319 Restraint of Trade and the Antitrust Laws 362
In The News: President Obama’s Antitrust Case Study: An Illegal Phone Call 363
Policy 320 Controversies over Antitrust Policy 363
Regulation 321 Case Study: The Microsoft Case 365
Public Ownership 323
Conclusion 366
Doing Nothing 323
In The News: The Next Big Antitrust Target? 367
Conclusion: The Prevalence of Monopolies 323

Chapter 16
Monopolistic Competition 329
Between Monopoly and Perfect Competition 330
Competition with Differentiated Products 332
The Monopolistically Competitive Firm in the
Short Run 332
The Long-Run Equilibrium 332
Monopolistic versus Perfect Competition 335
Monopolistic Competition and the Welfare of
Society 336
In The News: Insufficient Variety as a Market
Failure 338
Advertising 338
The Debate over Advertising 340
Case Study: Advertising and the Price of
Eyeglasses 340

VI The
Advertising as a Signal of Quality 341
FYI: Galbraith versus Hayek 342
Brand Names 343
Conclusion 344 PART Economics
of Labor Markets 373
Chapter 17
Oligopoly 349 Chapter 18
Markets with Only a Few Sellers 350 The Markets for the Factors of
A Duopoly Example 350
Competition, Monopolies, and Cartels 351 Production 375
In The News: Public Price Fixing 352 The Demand for Labor 376
The Equilibrium for an Oligopoly 353 The Competitive Profit-Maximizing Firm 377
How the Size of an Oligopoly Affects the The Production Function and the Marginal Product of
Market Outcome 354 Labor 377
The Economics of Cooperation 355 The Value of the Marginal Product and the Demand
The Prisoners’ Dilemma 355 for Labor 379
Oligopolies as a Prisoners’ Dilemma 357 What Causes the Labor-Demand Curve to Shift? 380

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 CONTENTS xxv

FYI: Input Demand and Output Supply: Two Sides of the The Measurement of Inequality 416
Same Coin 381 U.S. Income Inequality 416
FYI: The Luddite Revolt 382 Inequality around the World 417
The Supply of Labor 383 The Poverty Rate 419
The Trade-off between Work and Leisure 383 Problems in Measuring Inequality 420
What Causes the Labor-Supply Curve to Shift? 383 Case Study: Alternative Measures of Inequality 421
In The News: What’s Wrong with the
Equilibrium in the Labor Market 384
Poverty Rate? 422
Shifts in Labor Supply 385
Economic Mobility 423
In The News: The Economics of Immigration 386
Shifts in Labor Demand 386 The Political Philosophy of Redistributing
Case Study: Productivity and Wages 387 Income 424
FYI: Monopsony 389 Utilitarianism 424
Liberalism 425
The Other Factors of Production: Land and Capital 389
Libertarianism 427
Equilibrium in the Markets for Land and Capital 390
FYI: What Is Capital Income? 391 Policies to Reduce Poverty 427
Linkages among the Factors of Production 391 Minimum-Wage Laws 428
Case Study: The Economics of the Black Death 392 Welfare 428
Negative Income Tax 429
Conclusion 393
In-Kind Transfers 430
In The News: The Root Cause of a Financial
Chapter 19 Crisis 430
Antipoverty Programs and Work Incentives 431
Earnings and Discrimination 397 Conclusion 432
Some Determinants of Equilibrium Wages 398
Compensating Differentials 398
Human Capital 398
Case Study: The Increasing Value of Skills 399
Ability, Effort, and Chance 400
Case Study: The Benefits of Beauty 401
An Alternative View of Education: Signaling 402
The Superstar Phenomenon 402
In The News: The Human Capital of Terrorists 403
Above-Equilibrium Wages: Minimum-Wage Laws, Unions,
and Efficiency Wages 404
The Economics of Discrimination 405
Measuring Labor-Market Discrimination 405
Case Study: Is Emily More Employable than
Lakisha? 407
Discrimination by Employers 407
Case Study: Segregated Streetcars and the Profit
Motive 408
Discrimination by Customers and Governments 408
Case Study: Discrimination in Sports 409
In The News: Gender Differences 410
Conclusion 411

Chapter 20
Income Inequality and Poverty 415
PART VII Topics
Study
for Further
437

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xxvi CONTENTS

Chapter 21 People Aren’t Always Rational 480

People Care about Fairness 481
The Theory of Consumer Choice 439 In The News: Sin Taxes 482
People Are Inconsistent over Time 484
The Budget Constraint: What the Consumer
Conclusion 485
Can Afford 440
Preferences: What the Consumer Wants 441
Representing Preferences with Indifference Curves 442
Four Properties of Indifference Curves 443
Two Extreme Examples of Indifference Curves 444
Optimization: What the Consumer Chooses 446
The Consumer’s Optimal Choices 446
FYI: Utility: An Alternative Way to Describe Preferences and
Optimization 447
How Changes in Income Affect the Consumer’s
Choices 448
How Changes in Prices Affect the Consumer’s
Choices 449
Income and Substitution Effects 450
Deriving the Demand Curve 452
Three Applications 453
Do All Demand Curves Slope Downward? 453
Case Study: The Search for Giffen Goods 454
How Do Wages Affect Labor Supply? 454
Case Study: Income Effects on Labor Supply: Historical
Trends, Lottery Winners, and the Carnegie

VIII The
Conjecture 457
In The News: Backward-sloping Labor Supply
in Kiribati 458
How Do Interest Rates Affect Household Saving? 459 PART Data of
Conclusion: Do People Really Think This Way? 461 Macro-
economics 489
Chapter 22
Frontiers of Microeconomics 467 Chapter 23
Asymmetric Information 468
Hidden Actions: Principals, Agents, and Moral Hazard 468
Measuring a Nation’s Income 491
FYI: Corporate Management 469 The Economy’s Income and Expenditure 492
Hidden Characteristics: Adverse Selection and the
The Measurement of Gross Domestic Product 494
Lemons Problem 470
“GDP Is the Market Value…” 494
Signaling to Convey Private Information 471
“… of All …” 494
Case Study: Gifts as Signals 471
“… Final …” 495
Screening to Uncover Private Information 472
“… Goods and Services …” 495
Asymmetric Information and Public Policy 473
“… Produced …” 495
Political Economy 473 “… Within a Country …” 495
The Condorcet Voting Paradox 474 “… In a Given Period of Time.” 495
Arrow’s Impossibility Theorem 475
The Components of GDP 496
In The News: Arrow’s Problem in Practice 476
FYI: Other Measures of Income 497
The Median Voter Is King 478
Consumption 497
Politicians Are People Too 479
Investment 497
Behavioral Economics 480 Government Purchases 498

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 CONTENTS xxvii

IX The
Net Exports 498
Case Study: The Components of U.S. GDP 499
Real versus Nominal GDP 499 PART Real Economy
A Numerical Example 500 in the Long
The GDP Deflator 501
Case Study: Real GDP over Recent History 502 Run 529
Is GDP a Good Measure of Economic Well-Being? 503
In The News: The Underground Economy 504 Chapter 25
In The News: Beyond Gross Domestic Product 506
Case Study: International Differences in GDP and the
Quality of Life 507
Production and Growth 531
Economic Growth around the World 532
Conclusion 508
FYI: A Picture Is Worth a Thousand Statistics 534
FYI: Are You Richer Than the Richest American? 536
Chapter 24 Productivity: Its Role and Determinants 536
Why Productivity Is So Important 536
Measuring the Cost of Living 513 How Productivity Is Determined 537
FYI: The Production Function 539
The Consumer Price Index 514 Case Study: Are Natural Resources a Limit to
How the Consumer Price Index Is Calculated 514 Growth? 539
FYI: What Is in the CPI’s Basket? 516
Problems in Measuring the Cost of Living 517 Economic Growth and Public Policy 540
In The News: Shopping for the CPI 518 Saving and Investment 540
The GDP Deflator versus the Consumer Price Diminishing Returns and the Catch-Up Effect 541
Index 520 Investment from Abroad 542
Education 543
Correcting Economic Variables for the Effects of Health and Nutrition 544
Inflation 521 In The News: Promoting Human Capital 545
Dollar Figures from Different Times 522 Property Rights and Political Stability 546
Indexation 522 Free Trade 547
FYI: Mr. Index Goes to Hollywood 523 Research and Development 548
Real and Nominal Interest Rates 523 Population Growth 548
Case Study: Interest Rates in the In The News: One Economist’s Answer 550
U.S. Economy 525
Conclusion: The Importance of Long-Run Growth 552
Conclusion 526

Chapter 26
Saving, Investment, and the
Financial System 555
Financial Institutions in the U.S. Economy 556
Financial Markets 556
Financial Intermediaries 558
FYI: Key Numbers for Stock Watchers 559
Summing Up 560
FYI: Financial Crises 561
Saving and Investment in the National
Income Accounts 561
Some Important Identities 562
The Meaning of Saving and Investment 563
The Market for Loanable Funds 564
Supply and Demand for Loanable Funds 564
Policy 1: Saving Incentives 566

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xxviii CONTENTS

Policy 2: Investment Incentives 568 Minimum-Wage Laws 606

Policy 3: Government Budget Deficits and FYI: Who Earns the Minimum Wage? 608
Surpluses 568
Unions and Collective Bargaining 608
Case Study: The History of U.S. Government
The Economics of Unions 609
Debt 570
Are Unions Good or Bad for the Economy? 610
Conclusion 572
The Theory of Efficiency Wages 610
Worker Health 611
Chapter 27 Worker Turnover 611
Worker Quality 611
The Basic Tools of Finance 577 Worker Effort 612
Case Study: Henry Ford and the Very Generous
Present Value: Measuring the Time Value of Money 578 $5-a-Day Wage 612
FYI: The Magic of Compounding and the Rule of 70 580
Conclusion 613
Managing Risk 580
Risk Aversion 580
The Markets for Insurance 581
Diversification of Firm-Specific Risk 582
The Trade-off between Risk and Return 583
Asset Valuation 584
Fundamental Analysis 585
The Efficient Markets Hypothesis 585
In The News: A Cartoonist’s Guide to Stock
Picking 586
Case Study: Random Walks and Index Funds 587
In The News: Is the Efficient Markets Hypothesis
Kaput? 588
Market Irrationality 590
Conclusion 590

Chapter 28
Unemployment 593

X Money
Identifying Unemployment 594
How Is Unemployment Measured? 594
Case Study: Labor-Force Participation of Men and PART and Prices
Women in the U.S. Economy 597
Does the Unemployment Rate Measure What We in the Long
Want It To? 598
How Long Are the Unemployed without Work? 600
Run 617
Why Are There Always Some People
Unemployed? 600
In The News: The Rise of Long-Term Chapter 29
Unemployment 601
FYI: The Jobs Number 602 The Monetary System 619
Job Search 602 The Meaning of Money 620
Why Some Frictional Unemployment Is The Functions of Money 621
Inevitable 603 The Kinds of Money 621
Public Policy and Job Search 603 In The News: Mackereleconomics 622
Unemployment Insurance 604 Money in the U.S. Economy 623
In The News: How Much Do the Unemployed FYI: Why Credit Cards Aren’t Money 624
Respond to Incentives? 604 Case Study: Where Is All the Currency? 624

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 CONTENTS xxix

The Federal Reserve System 625

The Fed’s Organization 626
The Federal Open Market Committee 626
Banks and the Money Supply 627
The Simple Case of 100-Percent-Reserve
Banking 627
Money Creation with Fractional-Reserve
Banking 628
The Money Multiplier 629
Bank Capital, Leverage, and the Financial Crisis
of 2008–2009 631
The Fed’s Tools of Monetary Control 632
How the Fed Influences the Quantity of Reserves 633
How the Fed Influences the Reserve Ratio 634
Problems in Controlling the Money Supply 635
Case Study: Bank Runs and the Money Supply 636
The Federal Funds Rate 636
In The News: Bernanke on the Fed’s Toolbox 638

XI The
Conclusion 640

Chapter 30
PART Macro-
Money Growth and Inflation 643
economics
of Open
The Classical Theory of Inflation 644
The Level of Prices and the Value of Money 645 Economies 669
Money Supply, Money Demand, and
Monetary Equilibrium 645
Chapter 31
The Effects of a Monetary Injection 647
A Brief Look at the Adjustment Process 648
The Classical Dichotomy and Monetary
Open-Economy Macroeconomics:
Neutrality 649 Basic Concepts 671
Velocity and the Quantity Equation 650
The International Flows of Goods and Capital 672
Case Study: Money and Prices during
The Flow of Goods: Exports, Imports, and Net
Four Hyperinflations 652
Exports 672
The Inflation Tax 652
Case Study: The Increasing Openness of the U.S.
FYI: Hyperinflation in Zimbabwe 654
Economy 673
The Fisher Effect 655
In The News: Breaking Up the Chain of
The Costs of Inflation 656 Production 674
A Fall in Purchasing Power? The Inflation Fallacy 656 The Flow of Financial Resources: Net Capital
Shoeleather Costs 657 Outflow 676
Menu Costs 658 The Equality of Net Exports and Net Capital
Relative-Price Variability and the Misallocation Outflow 677
of Resources 658 Saving, Investment, and Their Relationship to the
Inflation-Induced Tax Distortions 659 International Flows 678
Confusion and Inconvenience 660 Summing Up 679
A Special Cost of Unexpected Inflation: Arbitrary Case Study: Is the U.S. Trade Deficit a National
Redistributions of Wealth 661 Problem? 680
Inflation Is Bad, But Deflation May Be Worse 662
The Prices for International Transactions: Real and Nominal
Case Study: The Wizard of Oz and the
Free-Silver Debate 662 Exchange Rates 682
In The News: Inflationary Threats 664 Nominal Exchange Rates 682
FYI: The Euro 683
Conclusion 664 Real Exchange Rates 684

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xxx CONTENTS

XII Short-Run
A First Theory of Exchange-Rate Determination:
Purchasing-Power Parity 685
The Basic Logic of Purchasing-Power Parity 686 PART
Implications of Purchasing-Power Parity 686
Case Study: The Nominal Exchange Rate during a Economic
Hyperinflation 688
Limitations of Purchasing-Power Parity 689
Fluctuations 717
Case Study: The Hamburger Standard 689
Conclusion 690 Chapter 33
Aggregate Demand and
Chapter 32 Aggregate Supply 719
A Macroeconomic Theory of the Open Three Key Facts about Economic Fluctuations 720
Economy 695 Fact 1: Economic Fluctuations Are Irregular and
Unpredictable 720
Supply and Demand for Loanable Funds and for Fact 2: Most Macroeconomic Quantities Fluctuate
Foreign-Currency Exchange 696 Together 722
The Market for Loanable Funds 696 Fact 3: As Output Falls, Unemployment Rises 722
The Market for Foreign-Currency Exchange 698 Explaining Short-Run Economic Fluctuations 722
FYI: Purchasing-Power Parity as a Special Case 700 The Assumptions of Classical Economics 722
Equilibrium in the Open Economy 701 The Reality of Short-Run Fluctuations 723
Net Capital Outflow: The Link between the Two In The News: The Social Influences of Economic
Markets 701 Downturns 724
Simultaneous Equilibrium in Two Markets 702 The Model of Aggregate Demand and Aggregate
FYI: Disentangling Supply and Demand 704 Supply 724
How Policies and Events Affect an Open The Aggregate-Demand Curve 726
Economy 704 Why the Aggregate-Demand Curve Slopes
Government Budget Deficits 704 Downward 726
Trade Policy 706 Why the Aggregate-Demand Curve Might Shift 729
Political Instability and Capital Flight 709 The Aggregate-Supply Curve 731
Case Study: Capital Flows from China 711 Why the Aggregate-Supply Curve Is Vertical in the
In The News: Alternative Exchange-Rate Long Run 731
Regimes 712 Why the Long-Run Aggregate-Supply Curve Might
Conclusion 712 Shift 732
Using Aggregate Demand and Aggregate Supply to Depict
Long-Run Growth and Inflation 734
Why the Aggregate-Supply Curve Slopes Upward in
the Short Run 734
Why the Short-Run Aggregate-Supply Curve Might
Shift 738
Two Causes of Economic Fluctuations 740
The Effects of a Shift in Aggregate Demand 740
FYI: Monetary Neutrality Revisited 743
Case Study: Two Big Shifts in Aggregate Demand: The Great
Depression and World War II 744
Case Study: The Recession of 2008–2009 745
In The News: Modern Parallels to the Great
Depression 746
The Effects of a Shift in Aggregate Supply 748
Case Study: Oil and the Economy 750
FYI: The Origins of the Model of Aggregate Demand and
Aggregate Supply 751
Conclusion 752

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 CONTENTS xxxi

Rational Expectations and the Possibility of Costless

Chapter 34 Disinflation 800
The Influence of Monetary and Fiscal The Volcker Disinflation 801
The Greenspan Era 802
Policy on Aggregate Demand 757 The Phillips Curve during the Financial Crisis 804
In The News: Do We Need More Inflation? 805
How Monetary Policy Influences Aggregate Demand 758
The Theory of Liquidity Preference 759 Conclusion 806
The Downward Slope of the Aggregate-Demand Curve 761
FYI: Interest Rates in the Long Run and the Short Run 762
Changes in the Money Supply 764
The Role of Interest-Rate Targets in Fed Policy 765
FYI: The Zero Lower Bound 766
Case Study: Why the Fed Watches the Stock Market
(and Vice Versa) 766
How Fiscal Policy Influences Aggregate Demand 767
Changes in Government Purchases 768
The Multiplier Effect 768
A Formula for the Spending Multiplier 769
Other Applications of the Multiplier Effect 770
The Crowding-Out Effect 771
Changes in Taxes 772
FYI: How Fiscal Policy Might Affect Aggregate Supply 773
Using Policy to Stabilize the Economy 773
The Case for Active Stabilization Policy 773
Case Study: Keynesians in the White House 775
The Case against Active Stabilization Policy 775
In The News: How Large Is the Fiscal Policy
Multiplier? 776
Automatic Stabilizers 777

XIII Final
In The News: Offbeat Indicators 779
Conclusion 780
PART
Chapter 35 Thoughts 809
The Short-Run Trade-off between
Chapter 36
Inflation and Unemployment 785
The Phillips Curve 786 Six Debates over Macroeconomic
Origins of the Phillips Curve 786
Aggregate Demand, Aggregate Supply, and the Phillips
Policy 811
Curve 787 Should Monetary and Fiscal Policymakers Try to
Shifts in the Phillips Curve: The Role of Expectations 789 Stabilize the Economy? 812
The Long-Run Phillips Curve 789 Pro: Policymakers Should Try to Stabilize the
The Meaning of “Natural” 791 Economy 812
Reconciling Theory and Evidence 792 Con: Policymakers Should Not Try to Stabilize the
The Short-Run Phillips Curve 793 Economy 812
The Natural Experiment for the Natural-Rate Should the Government Fight Recessions with Spending
Hypothesis 794 Hikes Rather Than Tax Cuts? 814
Shifts in the Phillips Curve: The Role of Supply Shocks 796 Pro: The Government Should Fight Recessions with Spending
Hikes 814
The Cost of Reducing Inflation 798 Con: The Government Should Fight Recessions with
The Sacrifice Ratio 799 Tax Cuts 815

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xxxii CONTENTS

Should Monetary Policy Be Made by Rule Rather Than by In The News: Dealing with Debt and Deficits 826
Discretion? 816 Should the Tax Laws Be Reformed to Encourage
Pro: Monetary Policy Should Be Made by Rule 817
Saving? 826
Con: Monetary Policy Should Not Be Made by Rule 818
Pro: The Tax Laws Should Be Reformed to Encourage
FYI: Inflation Targeting 819
Saving 826
Should the Central Bank Aim for Zero Inflation? 819 Con: The Tax Laws Should Not Be Reformed to Encourage
Pro: The Central Bank Should Aim for Zero Saving 828
Inflation 820
Conclusion 829
Con: The Central Bank Should Not Aim for
Zero Inflation 821
In The News: What Is the Optimal Inflation Rate? 822 Glossary 833
Should the Government Balance Its Budget? 823 Index 839
Pro: The Government Should Balance Its Budget 823
Con: The Government Should Not Balance Its
Budget 824

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