ECON 201 SEU Money and Prices During Four Hyperinflations Case Study Questions


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12 Production and Growth
13 Saving, Investment, and the Financial System
14 The Basic Tools of Finance
These chapters describe the forces that in the long run determine
key real variables, including growth in GDP, saving, investment,
real interest rates, and unemployment.
15 Unemployment
16 The Monetary System
17 Money Growth and Inflation
The monetary system is crucial in determining the long-run
behavior of the price level, the inflation rate, and other
nominal variables.
18 Open-Economy Macroeconomics:
Basic Concepts
A nation’s economic interactions with other nations are described
by its trade balance, net foreign investment, and exchange rate.
19 A Macroeconomic Theory of the
Open Economy
A long-run model of the open economy explains the determinants
of the trade balance, the real exchange rate, and other real
20 Aggregate Demand and Aggregate Supply
21 The Influence of Monetary and Fiscal Policy
on Aggregate Demand
22 The Short-Run Trade-off
between Inflation and Unemployment
The model of aggregate demand and aggregate supply explains
short-run economic fluctuations, the short-run effects of monetary
and fiscal policy, and the short-run linkage between real and
nominal variables.
23 Six Debates over Macroeconomic Policy
A capstone chapter presents both sides of six major debates
over economic policy.
Principles of Macroeconomics, 6E
N. Gregory Mankiw
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1 2 3 4 5 6 7 14 13 12 11
Principles of
Sixth Edition
N. Gregory Mankiw
This page intentionally left blank
To Catherine, Nicholas, and Peter,
my other contributions to the next generation
about the
N. Gregory Mankiw is professor of economics
at Harvard University. As a student, he studied
economics at Princeton University and MIT. As
a teacher, 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 regular 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.
I Introduction
1 Ten Principles of Economics 3
2 Thinking Like an Economist 21
3 Interdependence and the Gains from Trade 49
II How Markets Work
III Markets and Welfare
IV The Data of Macroeconomics
VIII Short-Run Economic Fluctuations
V The Real Economy in the Long Run
Aggregate Demand 461
22 The Short-Run Trade-off between Inflation and
Unemployment 489
IX Final Thoughts
23 Six Debates over Macroeconomic Policy 515
10 Measuring a Nation’s Income 195
11 Measuring the Cost of Living 217
VII The Macroeconomics of Open Economies
20 Aggregate Demand and Aggregate Supply 423
21 The Influence of Monetary and Fiscal Policy on
7 Consumers, Producers, and the Efficiency of Markets 135
8 Application: The Costs of Taxation 155
9 Application: International Trade 171
18 Open-Economy Macroeconomics: Basic Concepts 375
19 A Macroeconomic Theory of the Open Economy 399
4 The Market Forces of Supply and Demand 65
5 Elasticity and Its Application 89
6 Supply, Demand, and Government Policies 111
VI Money and Prices in the Long Run
16 The Monetary System 323
17 Money Growth and Inflation 347
Production and Growth 235
Saving, Investment, and the Financial System 259
The Basic Tools of Finance 281
Unemployment 297
ttoo the
the student
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 standards 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
The third reason to study economics is that it will give you a better understanding 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 sitting in the Oval Office, you will be glad that you studied economics.

N. Gregory Mankiw
December 2010
The Art of Instruction, The Power of Engagement,
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If a printed Study Guide better suits your needs
and study habits, the Mankiw 6e Study Guide
is unsurpassed in its careful attention to accuracy,
concise language, and practice that enhances
your study time.
Mankiw 6e Study Guide
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n writing this book, I benefited from the input of many talented people. Indeed, the
list of people who have contributed to this project is so long, and their contributions
so valuable, that it seems an injustice that only a single name appears on the cover.
Let me begin with my colleagues in the economics profession. The six editions
of this text and its supplemental materials have benefited enormously from their
input. In reviews and surveys, they have offered suggestions, identified challenges, and shared ideas from their own classroom experience. I am indebted to them
for the perspectives they have brought to the text. Unfortunately, the list has become too long to thank those who contributed to previous editions, even though
students reading the current edition are still benefiting from their insights.
Most important in this process have been Ron Cronovich (Carthage College)
and David Hakes (University of Northern Iowa). Ron and David, both dedicated
teachers, have served as reliable sounding boards for ideas and hardworking partners with me in putting together the superb package of supplements.
For this new edition, the following diary reviewers recorded their day-to-day
experience over the course of a semester, offering detailed suggestions about how
to improve the text.
Mark Abajian, San Diego Mesa College
Jennifer Bailly, Long Beach City College
J. Ulyses Balderas, Sam Houston State
Antonio Bos, Tusculum College
Greg Brock, Georgia Southern
Donna Bueckman, University of
Tennessee Knoxville
Rita Callahan, Keiser University
Tina Collins, San Joaquin Valley College
Bob Holland, Purdue University
Tom Holmes, University of Minnesota
Simran Kahai, John Carroll University
Miles Kimball, University of Michigan
Jason C. Rudbeck, University of Georgia
Kent Zirlott, University of Alabama
The following reviewers of the fifth edition provided suggestions for refining
the content, organization, and approach in the sixth.
Mark Abajian, San Diego Mesa College
Hamid Bastin, Shippensburg University
Laura Jean Bhadra, Northern Virginia
Community College
Benjamin Blair, Mississippi State
Lane Boyte, Troy University
Greg Brock, Georgia Southern University
Andrew Cassey, Washington State
Joni Charles, Texas State University San Marcos
Daren Conrad, Bowie State University
Diane de Freitas, Fresno City College
Veronika Dolar, Cleveland State
Justin Dubas, Texas Lutheran
Robert L Holland, Purdue University
Andres Jauregui, Columbus State
Miles Kimball, University of Michigan
Andrew Kohen, James Madison
Daniel Lee, Shippensburg University
David Lindauer, Wellesley College
Joshua Long, Ivy Tech Community
James Makokha, Collin College
Jim McAndrew, Luzerne County
Community College
William Mertens, University of Colorado
Cindy Munson, Western Technical
David Mushinski, Colorado State University
Fola Odebunmi, Cypress College
Jeff Rubin, Rutgers University, New
Lynda Rush, California State
Polytechnic University Pomona
Naveen Sarna, Northern Virginia
Community College
Jesse Schwartz, Kennesaw State
Mark Showalter, Brigham Young
Michael Tasto, Southern New
Hampshire University
I received detailed feedback on specific elements in the text, including all end-ofchapter problems and applications, from the following instructors.
Mark Abajian, San Diego Mesa College
Afolabi Adebayo, University of New
Mehdi Afiat, College of Southern
Douglas Agbetsiafa, Indiana University
South Bend
Richard Agnello, University of
Henry Akian, Gibbs College
Constantine Alexandrakis, Hofstra
Michelle Amaral, University of the
Shahina Amin, University of Northern
Larry Angel, South Seattle Community
Kathleen Arano, Fort Hays State
J. J. Arias, Georgia College & State
Nestor Azcona, Babson College
Steve Balassi, St. Mary’s College/Napa
Valley College
Juventino Ulyses Balderas, Sam
Houston State University
Tannista Banerjee, Purdue University
Jason Barr, Rutgers University, Newark
Alan Barreca, Tulane University
Hamid Bastin, Shippensburg University
Tammy Batson, Northern Illinois
University / Rock Valley College
Carl Bauer, Oakton Community College
Klaus Becker, Texas Tech University
Robert Beekman, University of Tampa
Christian Beer, Cape Fear Community
Gary Bennett, State University of New
York Fredonia
Bettina Berch, Borough of Manhattan
Community College
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Technical Community College
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Community College
Prasad Bidarkota, Florida International
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Charles Braymen, Kansas State
William Brennan, Minnesota State
University at Mankato
Greg Brock, Georgia Southern
Ken Brown, University of Northern
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Stan Buck, Huntington University
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Tennessee Knoxville
Joe Bunting, St. Andrews Presbyterian
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Michael G. Carew, Baruch College
John Carter, Modesto Junior College
Kalyan Chakraborty, Emporia State
Henry Check, Penn State University
Xudong Chen, Baldwin-Wallace College
Clifton M. Chow, Mass Bay
Community College
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Sarah Cosgrove, University of
Massachusetts Dartmouth
Dana Costea, Indiana University South
Maria DaCosta, University of Wisconsin
Eau Claire
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Joel Dalafave, Bucks County
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Fisher Donna, Georgia Southern
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College, CUNY
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Daniel Horton, Cleveland State University
Scott Houser, Colorado School of the
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University in St Louis
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Polytechnic University Pomona
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Chris Inama, Golden Gate University
Sarbaum Jeff, University of North
Carolina Greensboro
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Community College
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James Jozefowicz, Indiana University of
Mahbubul Kabir, Lyon College
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Chris Kelton, Naval Postgraduate School
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Alfreda L. King, Lawson State
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Community College
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Washington University
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Mitch Mitchell, Bladen Community
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Peter Olson, Indiana University
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University Institute of Technology
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York at Fredonia
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Oakland University
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York Sullivan
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The team of editors who worked on this book improved it tremendously. Jane
Tufts, developmental editor, provided truly spectacular editing—as she always
does. Mike Worls, economics executive editor, did a splendid job of overseeing the
many people involved in such a large project. Jennifer Thomas (supervising developmental editor) and Katie Yanos (supervising developmental editor) were crucial
in assembling an extensive and thoughtful group of reviewers to give me feedback on the previous edition, while putting together an excellent team to revise the
supplements. Colleen Farmer, senior content project manager, and Malvine Litten,
project manager, had the patience and dedication necessary to turn my manuscript into this book. Michelle Kunkler, senior art director, gave this book its clean,
friendly look. Larry Moore, the illustrator, helped make the book more visually
appealing and the economics in it less abstract. Sheryl Nelson, copyeditor, refined
my prose, and Cindy Kerr, indexer, prepared a careful and thorough index. John
Carey, senior marketing manager, worked long hours getting the word out to potential users of this book. The rest of the Cengage team was also consistently professional, enthusiastic, and dedicated: Allyn Bissmeyer, Darrell Frye, Sarah Greber,
Betty Jung, Deepak Kumar, Kim Kusnerak, Sharon Morgan, Suellen Ruttkay, and
Joe Sabatino.
I am grateful also to Stacy Carlson and Daniel Norris, two star Harvard undergraduates, who helped me refine the manuscript and check the page proofs for
this edition. Josh Bookin, a former Advanced Placement economics teacher and
recently an extraordinary section leader for Harvard’s Ec 10, gave invaluable
advice on some of the new material in this edition.
As always, I must thank my “in-house” editor Deborah Mankiw. As the first
reader of most things I write, she continued to offer just the right mix of criticism
and encouragement.
Finally, I would like to mention my three children Catherine, Nicholas, and
Peter. Their contribution to this book was putting up with a father spending too
many hours in his study. The four of us have much in common—not least of
which is our love of ice cream (which becomes apparent in Chapter 4). Maybe
sometime soon one of them will pick up my passion for economics as well.
N. Gregory Mankiw
December 2010
table of
Preface: To the Student viii
FYI: Adam Smith and the Invisible Hand 12
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
Acknowledgments xi
Conclusion 17
Chapter 2
Thinking Like an Economist 21
I Introduction
Chapter 1
Ten Principles of Economics 3
How People Make Decisions 4
Principle 1: People Face Trade-offs 4
Principle 2: The Cost of Something Is What You Give Up
to Get It 5
Principle 3: Rational People Think at the Margin 6
Principle 4: People Respond to Incentives 7
Case Study: The Incentive Effects of Gasoline Prices 8
In The News: Incentive Pay 9
How People Interact 10
Principle 5: Trade Can Make Everyone Better Off 10
Principle 6: Markets Are Usually a Good Way to Organize
Economic Activity 10
Principle 7: Governments Can Sometimes Improve Market
Outcomes 11
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
Our Second Model: The Production Possibilities Frontier 26
Microeconomics and Macroeconomics 29
The Economist as Policy Adviser 29
FYI: Who Studies Economics? 30
Positive versus Normative Analysis 30
Economists in Washington 31
In The News: The Economics of President Obama 32
Why Economists’ Advice Is Not Always Followed 32
Why Economists Disagree 34
Differences in Scientific Judgments 34
Differences in Values 34
Perception versus Reality 35
Let’s Get Going 35
In The News: Environmental Economics 37
APPENDIX Graphing: A Brief Review 40
Graphs of a Single Variable 40
Graphs of Two Variables: The Coordinate System 41
Curves in the Coordinate System 42
Slope 44
Cause and Effect 46
Chapter 3
Interdependence and the Gains from
Trade 49
A Parable for the Modern Economy 50
Production Possibilities 50
Specialization and Trade 52
Comparative Advantage: The Driving Force of
Specialization 54
Absolute Advantage 54
Opportunity Cost and Comparative Advantage 54
Comparative Advantage and Trade 55
The Price of the Trade 56
FYI: The Legacy of Adam Smith and David Ricardo 57
Applications of Comparative Advantage 57
Should Tom Brady Mow His Own Lawn? 57
Should the United States Trade with Other Countries? 58
In The News: The Changing Face of International Trade 59
Conclusion 59
Demand 67
The Demand Curve: The Relationship between Price and
Quantity Demanded 67
Market Demand versus Individual Demand 68
Shifts in the Demand Curve 69
Case Study: Two Ways to Reduce the Quantity of Smoking
Demanded 71
Supply 73
The Supply Curve: The Relationship between Price and
Quantity Supplied 73
Market Supply versus Individual Supply 73
Shifts in the Supply Curve 74
Supply and Demand Together 77
Equilibrium 77
Three Steps to Analyzing Changes in Equilibrium 79
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
II How
Chapter 4
The Market Forces of Supply
and Demand 65
Markets and Competition 66
What Is a Market? 66
What Is Competition? 66
Three Applications of Supply, Demand, and Elasticity 101
Can Good News for Farming Be Bad News for Farmers? 101
Why Did OPEC Fail to Keep the Price of Oil High? 103
Does Drug Interdiction Increase or Decrease Drug-Related
Crime? 105
Conclusion 106
Chapter 6
Supply, Demand, and Government
Policies 111
Controls on Prices 112
How Price Ceilings Affect Market Outcomes 112
Case Study: Lines at the Gas Pump 114
Case Study: Rent Control in the Short Run and the Long
Run 115
How Price Floors Affect Market Outcomes 116
Case Study: The Minimum Wage 117
Evaluating Price Controls 119
In The News: Should Unpaid Internships Be Allowed? 120
Taxes 121
How Taxes on Sellers Affect Market Outcomes 121
How Taxes on Buyers Affect Market Outcomes 123
Case Study: Can Congress Distribute the Burden of a
Payroll Tax? 124
Elasticity and Tax Incidence 125
Case Study: Who Pays the Luxury Tax? 127
Conclusion 128
The Benevolent Social Planner 145
Evaluating the Market Equilibrium 146
In The News: Ticket Scalping 148
Case Study: Should There Be a Market in
Organs? 149
Conclusion: Market Efficiency and Market
Failure 150
Chapter 8
Application: The Costs of Taxation 155
The Deadweight Loss of Taxation 156
How a Tax Affects Market Participants 157
Deadweight Losses and the Gains from Trade 159
The Determinants of the Deadweight Loss 160
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
III Markets
Chapter 7
Consumers, Producers, and the Efficiency
of Markets 135
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
Other Benefits of International Trade 180
In The News: Trade Skirmishes 181
Producer Surplus 141
Cost and the Willingness to Sell 141
Using the Supply Curve to Measure Producer Surplus 142
How a Higher Price Raises Producer Surplus 144
The Arguments for Restricting Trade 182
The Jobs Argument 182
In The News: Should the Winners from Free Trade
Compensate the Losers? 183
The National-Security Argument 184
In The News: Second Thoughts about Free
Trade 184
The Infant-Industry Argument 185
The Unfair-Competition Argument 186
The Protection-as-a-Bargaining-Chip Argument 186
Case Study: Trade Agreements and the World Trade
Organization 186
Market Efficiency 145
Conclusion 187
Consumer Surplus 136
Willingness to Pay 136
Using the Demand Curve to Measure Consumer Surplus 137
How a Lower Price Raises Consumer Surplus 138
What Does Consumer Surplus Measure? 140
Chapter 11
Measuring the Cost of Living 217
The Consumer Price Index 218
How the Consumer Price Index Is Calculated 218
FYI: What Is in the CPI’s Basket? 220
Problems in Measuring the Cost of Living 221
In The News: Shopping for the CPI 222
The GDP Deflator versus the Consumer Price Index 224
Correcting Economic Variables for the Effects of Inflation 225
Dollar Figures from Different Times 226
Indexation 226
FYI: Mr. Index Goes to Hollywood 227
Real and Nominal Interest Rates 227
Case Study: Interest Rates in the U.S. Economy 229
Conclusion 230
IV The
of Macro-
Chapter 10
Measuring a Nation’s Income 195
The Economy’s Income and Expenditure 196
The Measurement of Gross Domestic Product 198
“GDP Is the Market Value…” 198
“…of All…” 198
“…Final…” 199
“…Goods and Services…” 199
“…Produced…” 199
“…Within a Country…” 199
“…In a Given Period of Time.” 199
The Components of GDP 200
FYI: Other Measures of Income 201
Consumption 201
Investment 201
Government Purchases 202
Net Exports 202
Case Study: The Components of U.S. GDP 203
Real versus Nominal GDP 203
A Numerical Example 204
The GDP Deflator 205
Case Study: Real GDP over Recent History 206
Is GDP a Good Measure of Economic Well-Being? 207
In The News: The Underground Economy 208
In The News: Beyond Gross Domestic Product 210
Case Study: International Differences in GDP and the
Quality of Life 211
Conclusion 212
V The
Real Economy
in the Long Run
Chapter 12
Production and Growth 235
Economic Growth around the World 236
FYI: A Picture Is Worth a Thousand Statistics 238
FYI: Are You Richer Than the Richest American? 240
Productivity: Its Role and Determinants 240
Why Productivity Is So Important 240
How Productivity Is Determined 241
FYI: The Production Function 243
Case Study: Are Natural Resources a Limit to Growth? 243
Economic Growth and Public Policy 244
Saving and Investment 244
Diminishing Returns and the Catch-Up Effect 245
Investment from Abroad 246
Education 247
Health and Nutrition 248
In The News: Promoting Human Capital 249
Property Rights and Political Stability 250
Free Trade 251
Research and Development 252
Population Growth 252
In The News: One Economist’s Answer 254
Conclusion: The Importance of Long-Run Growth 256
Chapter 13
Saving, Investment, and the
Financial System 259
Financial Institutions in the U.S. Economy 260
Financial Markets 260
Financial Intermediaries 262
FYI: Key Numbers for Stock Watchers 263
Summing Up 264
FYI: Financial Crises 265
Saving and Investment in the National Income Accounts 265
Some Important Identities 266
The Meaning of Saving and Investment 267
Chapter 15
Unemployment 297
Identifying Unemployment 298
How Is Unemployment Measured? 298
Case Study: Labor-Force Participation of Men and Women
in the U.S. Economy 301
Does the Unemployment Rate Measure What We
Want It To? 302
How Long Are the Unemployed without Work? 304
Why Are There Always Some People Unemployed? 304
In The News: The Rise of Long-Term Unemployment 305
FYI: The Jobs Number 306
Job Search 306
Why Some Frictional Unemployment Is Inevitable 307
Public Policy and Job Search 307
Unemployment Insurance 308
In The News: How Much Do the Unemployed Respond to
Incentives? 308
Minimum-Wage Laws 310
FYI: Who Earns the Minimum Wage? 312
Unions and Collective Bargaining 312
The Economics of Unions 313
Are Unions Good or Bad for the Economy? 314
The Market for Loanable Funds 268
Supply and Demand for Loanable Funds 268
Policy 1: Saving Incentives 270
Policy 2: Investment Incentives 272
Policy 3: Government Budget Deficits and Surpluses 272
Case Study: The History of U.S. Government Debt 274
The Theory of Efficiency Wages 314
Worker Health 315
Worker Turnover 315
Worker Quality 315
Worker Effort 316
Case Study: Henry Ford and the Very Generous $5-a-Day
Wage 316
Conclusion 276
Conclusion 317
Chapter 14
The Basic Tools of Finance 281
Present Value: Measuring the Time Value of Money 282
FYI: The Magic of Compounding and the Rule of 70 284
Managing Risk 284
Risk Aversion 284
The Markets for Insurance 285
Diversification of Firm-Specific Risk 286
The Trade-off between Risk and Return 287
Asset Valuation 288
Fundamental Analysis 289
The Efficient Markets Hypothesis 289
In The News: A Cartoonist’s Guide to Stock Picking 290
Case Study: Random Walks and Index Funds 291
In The News: Is the Efficient Markets
Hypothesis Kaput? 292
Market Irrationality 294
Conclusion 294
VI Money
and Prices
in the Long Run
Chapter 16
The Monetary System 323
The Meaning of Money 324
The Functions of Money 325
The Kinds of Money 325
In The News: Mackereleconomics 326
Money in the U.S. Economy 327
FYI: Why Credit Cards Aren’t Money 328
Case Study: Where Is All the Currency? 328
Menu Costs 362
Relative-Price Variability and the Misallocation
of Resources 362
Inflation-Induced Tax Distortions 363
Confusion and Inconvenience 364
A Special Cost of Unexpected Inflation: Arbitrary
Redistributions of Wealth 365
Inflation Is Bad, But Deflation May Be Worse 366
Case Study: The Wizard of Oz and the Free-Silver
Debate 366
In The News: Inflationary Threats 368
Conclusion 368
The Federal Reserve System 329
The Fed’s Organization 330
The Federal Open Market Committee 330
Banks and the Money Supply 331
The Simple Case of 100-Percent-Reserve Banking 331
Money Creation with Fractional-Reserve Banking 332
The Money Multiplier 333
Bank Capital, Leverage, and the Financial Crisis
of 2008–2009 335
The Fed’s Tools of Monetary Control 336
How the Fed Influences the Quantity of Reserves 337
How the Fed Influences the Reserve Ratio 338
Problems in Controlling the Money Supply 339
Case Study: Bank Runs and the Money Supply 340
The Federal Funds Rate 340
In The News: Bernanke on the Fed’s Toolbox 342
Conclusion 344
Macroeconomics of Open
Chapter 17
Money Growth and Inflation 347
The Classical Theory of Inflation 348
The Level of Prices and the Value of Money 349
Money Supply, Money Demand, and Monetary
Equilibrium 349
The Effects of a Monetary Injection 351
A Brief Look at the Adjustment Process 352
The Classical Dichotomy and Monetary Neutrality 353
Velocity and the Quantity Equation 354
Case Study: Money and Prices during Four
Hyperinflations 356
The Inflation Tax 356
FYI: Hyperinflation in Zimbabwe 358
The Fisher Effect 359
The Costs of Inflation 360
A Fall in Purchasing Power? The Inflation Fallacy 360
Shoeleather Costs 361
Chapter 18
Open-Economy Macroeconomics: Basic
Concepts 375
The International Flows of Goods and Capital 376
The Flow of Goods: Exports, Imports, and Net Exports 376
Case Study: The Increasing Openness of the U.S.
Economy 377
In The News: Breaking Up the Chain of Production 378
The Flow of Financial Resources: Net Capital Outflow 380
The Equality of Net Exports and Net Capital Outflow 381
Saving, Investment, and Their Relationship to the International
Flows 382
Summing Up 383
Case Study: Is the U.S. Trade Deficit a National
Problem? 384
The Prices for International Transactions: Real and
Nominal Exchange Rates 386
Nominal Exchange Rates 386
FYI: The Euro 387
Real Exchange Rates 388
A First Theory of Exchange-Rate Determination:
Purchasing-Power Parity 389
The Basic Logic of Purchasing-Power Parity 390
Implications of Purchasing-Power Parity 390
Case Study: The Nominal Exchange Rate during a
Hyperinflation 392
Limitations of Purchasing-Power Parity 393
Case Study: The Hamburger Standard 393
Conclusion 394
Chapter 19
A Macroeconomic Theory of the Open
Economy 399
VIII Short-Run
Chapter 20
Aggregate Demand and Aggregate
Supply 423
Three Key Facts about Economic Fluctuations 424
Fact 1: Economic Fluctuations Are Irregular and
Unpredictable 424
Fact 2: Most Macroeconomic Quantities Fluctuate
Together 426
Fact 3: As Output Falls, Unemployment Rises 426
Supply and Demand for Loanable Funds and for ForeignCurrency Exchange 400
The Market for Loanable Funds 400
The Market for Foreign-Currency Exchange 402
FYI: Purchasing-Power Parity as a Special Case 404
Explaining Short-Run Economic Fluctuations 426
The Assumptions of Classical Economics 426
The Reality of Short-Run Fluctuations 427
In The News: The Social Influences of Economic
Downturns 428
The Model of Aggregate Demand and Aggregate
Supply 428
Equilibrium in the Open Economy 405
Net Capital Outflow: The Link between the Two Markets 405
Simultaneous Equilibrium in Two Markets 406
FYI: Disentangling Supply and Demand 408
The Aggregate-Demand Curve 430
Why the Aggregate-Demand Curve Slopes
Downward 430
Why the Aggregate-Demand Curve Might Shift 433
How Policies and Events Affect an Open Economy 408
Government Budget Deficits 408
Trade Policy 410
Political Instability and Capital Flight 413
Case Study: Capital Flows from China 415
In The News: Alternative Exchange-Rate Regimes 416
The Aggregate-Supply Curve 435
Why the Aggregate-Supply Curve Is Vertical in
the Long Run 435
Why the Long-Run Aggregate-Supply Curve Might
Shift 436
Using Aggregate Demand and Aggregate Supply to Depict
Long-Run Growth and Inflation 438
Why the Aggregate-Supply Curve Slopes Upward in the Short
Run 438
Why the Short-Run Aggregate-Supply Curve Might
Shift 442
Conclusion 416
Two Causes of Economic Fluctuations 444
The Effects of a Shift in Aggregate Demand 444
FYI: Monetary Neutrality Revisited 447
Case Study: Two Big Shifts in Aggregate Demand:
The Great Depression and World War II 448
Case Study: The Recession of 2008–2009 449
In The News: Modern Parallels to the Great
Depression 450
The Effects of a Shift in Aggregate Supply 452
Case Study: Oil and the Economy 454
FYI: The Origins of the Model of Aggregate Demand and
Aggregate Supply 455
Conclusion 456
Chapter 21
The Influence of Monetary and Fiscal
Policy on Aggregate Demand 461
How Monetary Policy Influences Aggregate Demand 462
The Theory of Liquidity Preference 463
The Downward Slope of the Aggregate-Demand Curve 465
FYI: Interest Rates in the Long Run and the Short Run 466
Changes in the Money Supply 468
The Role of Interest-Rate Targets in Fed Policy 469
FYI: The Zero Lower Bound 470
Case Study: Why the Fed Watches the Stock Market (and
Vice Versa) 470
How Fiscal Policy Influences Aggregate Demand 471
Changes in Government Purchases 472
The Multiplier Effect 472
A Formula for the Spending Multiplier 473
Other Applications of the Multiplier Effect 474
The Crowding-Out Effect 475
Changes in Taxes 476
FYI: How Fiscal Policy Might Affect Aggregate Supply 477
Using Policy to Stabilize the Economy 477
The Case for Active Stabilization Policy 477
Case Study: Keynesians in the White House 479
The Case against Active Stabilization Policy 479
In The News: How Large Is the Fiscal Policy Multiplier? 480
Automatic Stabilizers 481
In The News: Offbeat Indicators 483
Conclusion 484
Chapter 22
The Short-Run Trade-off between Inflation
and Unemployment 489
The Phillips Curve 490
Origins of the Phillips Curve 490
Aggregate Demand, Aggregate Supply, and the Phillips Curve 491
Shifts in the Phillips Curve: The Role of Expectations 493
The Long-Run Phillips Curve 493
The Meaning of “Natural” 495
Reconciling Theory and Evidence 496
The Short-Run Phillips Curve 497
The Natural Experiment for the Natural-Rate Hypothesis 498
Shifts in the Phillips Curve: The Role of Supply Shocks 500
The Cost of Reducing Inflation 502
The Sacrifice Ratio 503
Rational Expectations and the Possibility of Costless
Disinflation 504
The Volcker Disinflation 505
The Greenspan Era 506
The Phillips Curve during the Financial Crisis 508
In The News: Do We Need More Inflation? 509
Conclusion 510
IX Final Thoughts
Chapter 23
Six Debates over Macroeconomic Policy 515
Should Monetary and Fiscal Policymakers Try to Stabilize the
Economy? 516
Pro: Policymakers Should Try to Stabilize the Economy 516
Con: Policymakers Should Not Try to Stabilize the Economy 516
Should the Government Fight Recessions with Spending
Hikes Rather Than Tax Cuts? 518
Pro: The Government Should Fight Recessions with Spending
Hikes 518
Con: The Government Should Fight Recessions with Tax Cuts 519
Should Monetary Policy Be Made by Rule Rather Than by
Discretion? 520
Pro: Monetary Policy Should Be Made by Rule 521
Con: Monetary Policy Should Not Be Made by Rule 522
FYI: Inflation Targeting 523
Should the Central Bank Aim for Zero Inflation? 523
Pro: The Central Bank Should Aim for Zero Inflation 524
Con: The Central Bank Should Not Aim For Zero Inflation 525
In The News: What Is the Optimal Inflation Rate? 526
Should the Government Balance Its Budget? 527
Pro: The Government Should Balance Its Budget 527
Con: The Government Should Not Balance Its Budget 528
In The News: Dealing with Debt and Deficits 530
Should the Tax Laws Be Reformed to Encourage Saving? 530
Pro: The Tax Laws Should Be Reformed to Encourage Saving 530
Con: The Tax Laws Should Not Be Reformed to Encourage
Saving 532
Conclusion 533
Glossary 537
Index 541
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Ten Principles of
he word economy comes from the Greek word oikonomos, which means
“one who manages a household.” At first, this origin might seem peculiar. But in fact, households and economies have much in common.
A household faces many decisions. It must decide which members of
the household do which tasks and what each member gets in return: Who cooks
dinner? Who does the laundry? Who gets the extra dessert at dinner? Who gets to
choose what TV show to watch? In short, the household must allocate its scarce
resources among its various members, taking into account each member’s abilities, efforts, and desires.
Like a household, a society faces many decisions. A society must find some
way to decide what jobs will be done and who will do them. It needs some people
to grow food, other people to make clothing, and still others to design computer
software. Once society has allocated people (as well as land, buildings, and
machines) to various jobs, it must also allocate the output of goods and services
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the limited nature of
society’s resources
the study of how society
manages its scarce
they produce. It must decide who will eat caviar and who will eat potatoes. It
must decide who will drive a Ferrari and who will take the bus.
The management of society’s resources is important because resources are
scarce. Scarcity means that society has limited resources and therefore cannot
produce all the goods and services people wish to have. Just as each member of
a household cannot get everything he or she wants, each individual in a society
cannot attain the highest standard of living to which he or she might aspire.
Economics is the study of how society manages its scarce resources. In most
societies, resources are allocated not by an all-powerful dictator but through the
combined actions of millions of households and firms. Economists therefore study
how people make decisions: how much they work, what they buy, how much they
save, and how they invest their savings. Economists also study how people interact with one another. For instance, they examine how the multitude of buyers and
sellers of a good together determine the price at which the good is sold and the
quantity that is sold. Finally, economists analyze forces and trends that affect the
economy as a whole, including the growth in average income, the fraction of
the population that cannot find work, and the rate at which prices are rising.
The study of economics has many facets, but it is unified by several central
ideas. In this chapter, we look at Ten Principles of Economics. Don’t worry if you
don’t understand them all at first or if you aren’t completely convinced. We will
explore these ideas more fully in later chapters. The ten principles are introduced
here to give you an overview of what economics is all about. Consider this chapter
a “preview of coming attractions.”
How People Make Decisions
There is no mystery to what an economy is. Whether we are talking about the
economy of Los Angeles, the United States, or the whole world, an economy
is just a group of people dealing with one another as they go about their lives.
Because the behavior of an economy reflects the behavior of the individuals who
make up the economy, we begin our study of economics with four principles of
individual decision making.
Principle 1: People Face Trade-offs
You may have heard the old saying, “There ain’t no such thing as a free lunch.”
Grammar aside, there is much truth to this adage. To get one thing that we like,
we usually have to give up another thing that we like. Making decisions requires
trading off one goal against another.
Consider a student who must decide how to allocate her most valuable
resource—her time. She can spend all her time studying economics, spend all of
it studying psychology, or divide it between the two fields. For every hour she
studies one subject, she gives up an hour she could have used studying the other.
And for every hour she spends studying, she gives up an hour that she could have
spent napping, bike riding, watching TV, or working at her part-time job for some
extra spending money.
Or consider parents deciding how to spend their family income. They can buy
food, clothing, or a family vacation. Or they can save some of the family income
for retirement or the children’s college education. When they choose to spend an
extra dollar on one of these goods, they have one less dollar to spend on some
other good.
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When people are grouped into societies, they face different kinds of trade-offs.
One classic trade-off is between “guns and butter.” The more a society spends
on national defense (guns) to protect its shores from foreign aggressors, the less
it can spend on consumer goods (butter) to raise the standard of living at home.
Also important in modern society is the trade-off between a clean environment
and a high level of income. Laws that require firms to reduce pollution raise the
cost of producing goods and services. Because of the higher costs, these firms end
up earning smaller profits, paying lower wages, charging higher prices, or some
combination of these three. Thus, while pollution regulations yield the benefit of
a cleaner environment and the improved health that comes with it, the regulations
come at the cost of reducing the incomes of the regulated firms’ owners, workers,
and customers.
Another trade-off society faces is between efficiency and equality. Efficiency
means that society is getting the maximum benefits from its scarce resources.
Equality means that those benefits are distributed uniformly among society’s
members. In other words, efficiency refers to the size of the economic pie, and
equality refers to how the pie is divided into individual slices.
When government policies are designed, these two goals often conflict. Consider, for instance, policies aimed at equalizing the distribution of economic
well-being. Some of these policies, such as the welfare system or unemployment
insurance, try to help the members of society who are most in need. Others, such
as the individual income tax, ask the financially successful to contribute more than
others to support the government. While achieving greater equality, these policies
reduce efficiency. When the government redistributes income from the rich to the
poor, it reduces the reward for working hard; as a result, people work less and
produce fewer goods and services. In other words, when the government tries to
cut the economic pie into more equal slices, the pie gets smaller.
Recognizing that people face trade-offs does not by itself tell us what decisions
they will or should make. A student should not abandon the study of psychology just because doing so would increase the time available for the study of
economics. Society should not stop protecting the environment just because environmental regulations reduce our material standard of living. The poor should
not be ignored just because helping them distorts work incentives. Nonetheless,
people are likely to make good decisions only if they understand the options they
have available. Our study of economics, therefore, starts by acknowledging life’s
the property of society
getting the most it can
from its scarce resources
the property of distributing economic prosperity
uniformly among the
members of society
Principle 2: The Cost of Something Is
What You Give Up to Get It
Because people face trade-offs, making decisions requires comparing the costs
and benefits of alternative courses of action. In many cases, however, the cost of
an action is not as obvious as it might first appear.
Consider the decision to go to college. The main benefits are intellectual enrichment and a lifetime of better job opportunities. But what are the costs? To answer
this question, you might be tempted to add up the money you spend on tuition,
books, room, and board. Yet this total does not truly represent what you give up
to spend a year in college.
There are two problems with this calculation. First, it includes some things
that are not really costs of going to college. Even if you quit school, you need a
place to sleep and food to eat. Room and board are costs of going to college only
to the extent that they are more expensive at college than elsewhere. Second, this
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opportunity cost
whatever must be given
up to obtain some item
calculation ignores the largest cost of going to college—your time. When you
spend a year listening to lectures, reading textbooks, and writing papers, you cannot spend that time working at a job. For most students, the earnings given up to
attend school are the largest single cost of their education.
The opportunity cost of an item is what you give up to get that item. When
making any decision, decision makers should be aware of the opportunity costs
that accompany each possible action. In fact, they usually are. College athletes
who can earn millions if they drop out of school and play professional sports are
well aware that their opportunity cost of college is very high. It is not surprising
that they often decide that the benefit of a college education is not worth the cost.
Principle 3: Rational People Think at the Margin
rational people
people who systematically
and purposefully do the
best they can to achieve
their objectives
marginal change
a small incremental
adjustment to a plan of
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Economists normally assume that people are rational. Rational people systematically and purposefully do the best they can to achieve their objectives, given the
available opportunities. As you study economics, you will encounter firms that
decide how many workers to hire and how much of their product to manufacture
and sell to maximize profits. You will also encounter individuals who decide how
much time to spend working and what goods and services to buy with the resulting income to achieve the highest possible level of satisfaction.
Rational people know that decisions in life are rarely black and white but usually involve shades of gray. At dinnertime, the decision you face is not between
fasting or eating like a pig but whether to take that extra spoonful of mashed potatoes. When exams roll around, your decision is not between blowing them off or
studying 24 hours a day but whether to spend an extra hour reviewing your notes
instead of watching TV. Economists use the term marginal change to describe
a small incremental adjustment to an existing plan of action. Keep in mind that
margin means “edge,” so marginal changes are adjustments around the edges of
what you are doing. Rational people often make decisions by comparing marginal
benefits and marginal costs.
For example, consider an airline deciding how much to charge passengers who
fly standby. Suppose that flying a 200-seat plane across the United States costs the
airline $100,000. In this case, the average cost of each seat is $100,000/200, which is
$500. One might be tempted to conclude that the airline should never sell a ticket
for less than $500. Actually, a rational airline can often find ways to raise its profits
by thinking at the margin. Imagine that a plane is about to take off with ten empty
seats, and a standby passenger waiting at the gate will pay $300 for a seat. Should
the airline sell the ticket? Of course it should. If the plane has empty seats, the cost
of adding one more passenger is tiny. Although the average cost of flying a passenger is $500, the marginal cost is merely the cost of the bag of peanuts and can
of soda that the extra passenger will consume. As long as the standby passenger
pays more than the marginal cost, selling the ticket is profitable.
Marginal decision making can help explain some otherwise puzzling economic phenomena. Here is a classic question: Why is water so cheap, while
diamonds are so expensive? Humans need water to survive, while diamonds
are unnecessary; but for some reason, people are willing to pay much more for
a diamond than for a cup of water. The reason is that a person’s willingness to
pay for a good is based on the marginal benefit that an extra unit of the good
would yield. The marginal benefit, in turn, depends on how many units a person
already has. Water is essential, but the marginal benefit of an extra cup is small
because water is plentiful. By contrast, no one needs diamonds to survive, but
because diamonds are so rare, people consider the marginal benefit of an extra
diamond to be large.
09/12/10 8:02 PM
A rational decision maker takes an action if and only if the marginal benefit of the
action exceeds the marginal cost. This principle can explain why airlines are willing to sell a ticket below average cost and why people are willing to pay more for
diamonds than for water. It can take some time to get used to the logic of marginal
thinking, but the study of economics will give you ample opportunity to practice.
Principle 4: People Respond to Incentives
An incentive is something that induces a person to act, such as the prospect of a
punishment or a reward. Because rational people make decisions by comparing
costs and benefits, they respond to incentives. You will see that incentives play
a central role in the study of economics. One economist went so far as to suggest
that the entire field could be summarized simply: “People respond to incentives.
The rest is commentary.”
Incentives are crucial to analyzing how markets work. For example, when the
price of an apple rises, people decide to eat fewer apples. At the same time, apple
orchards decide to hire more workers and harvest more apples. In other words,
a higher price in a market provides an incentive for buyers to consume less and
an incentive for sellers to produce more. As we will see, the influence of prices on
the behavior of consumers and producers is crucial for how a market economy
allocates scarce resources.
Public policymakers should never forget about incentives: Many policies change
the costs or benefits that people face and, therefore, alter their behavior. A tax on
gasoline, for instance, encourages people to drive smaller, more fuel-efficient cars.
That is one reason people drive smaller cars in Europe, where gasoline taxes are
high, than in the United States, where gasoline taxes are low. A gasoline tax also
encourages people to carpool, take public transportation, and live closer to where
they work. If the tax were larger, more people would be driving hybrid cars, and
if it were large enough, they would switch to electric cars.
When policymakers fail to consider how their policies affect incentives, they
often end up with unintended consequences. For example, consider public policy
regarding auto safety. Today, all cars have seat belts, but this was not true 50 years
ago. In the 1960s, Ralph Nader’s book Unsafe at Any Speed generated much public
concern over auto safety. Congress responded with laws requiring seat belts as
standard equipment on new cars.
How does a seat belt law affect auto safety? The direct effect is obvious: When
a person wears a seat belt, the probability of surviving an auto accident rises. But
that’s not the end of the story because the law also affects behavior by altering
incentives. The relevant behavior here is the speed and care with which drivers
operate their cars. Driving slowly and carefully is costly because it uses the
driver’s time and energy. When deciding how safely to drive, rational people compare, perhaps unconsciously, the marginal benefit from safer driving to the marginal cost. As a result, they drive more slowly and carefully when the benefit of
increased safety is high. For example, when road conditions are icy, people drive
more attentively and at lower speeds than they do when road conditions are clear.
Consider how a seat belt law alters a driver’s cost–benefit calculation. Seat belts
make accidents less costly because they reduce the likelihood of injury or death.
In other words, seat belts reduce the benefits of slow and careful driving. People
respond to seat belts as they would to an improvement in road conditions—by
driving faster and less carefully. The result of a seat belt law, therefore, is a larger
number of accidents. The decline in safe driving has a clear, adverse impact on
pedestrians, who are more likely to find themselves in an accident but (unlike the
drivers) don’t have the benefit of added protection.
CHE-MANKIW-10-0603-001.indd 7
something that induces a
person to act
09/12/10 8:02 PM
At first, this discussion of incentives and seat belts might seem like idle speculation. Yet in a classic 1975 study, economist Sam Peltzman argued that auto-safety
laws have had many of these effects. According to Peltzman’s evidence, these
laws produce both fewer deaths per accident and more accidents. He concluded
that the net result is little change in the number of driver deaths and an increase
in the number of pedestrian deaths.
Peltzman’s analysis of auto safety is an offbeat and controversial example of
the general principle that people respond to incentives. When analyzing any policy, we must consider not only the direct effects but also the less obvious indirect
effects that work through incentives. If the policy changes incentives, it will cause
people to alter their behavior.
The Incentive Effects of
Gasoline Prices
From 2005 to 2008 the price of oil in world oil markets skyrocketed, the result of
limited supplies together with surging demand from robust world growth, especially in China. The price of gasoline in the United States rose from about $2 to
about $4 a gallon. At the time, the news was filled with stories about how people
responded to the increased incentive to conserve, sometimes in obvious ways,
sometimes in less obvious ways.
Here is a sampling of various stories:


Hip-hop mogul Sean
“Diddy” Combs responds
to incentives.
CHE-MANKIW-10-0603-001.indd 8

“As Gas Prices Soar, Buyers Are Flocking to Small Cars”
“As Gas Prices Climb, So Do Scooter Sales”
“Gas Prices Knock Bicycles Sales, Repairs into Higher Gear”
“Gas Prices Send Surge of Riders to Mass Transit”
“Camel Demand Up as Oil Price Soars“: Farmers in the Indian state of
Rajasthan are rediscovering the humble camel. As the cost of running gasguzzling tractors soars, even-toed ungulates are making a comeback.
“The Airlines Are Suffering, But the Order Books of Boeing and Airbus
Are Bulging“: Demand for new, more fuel-efficient aircraft has never been
greater. The latest versions of the Airbus A320 and Boeing 737, the singleaisle workhorses for which demand is strongest, are up to 40% cheaper to
run than the vintage planes some American airlines still use.
“Home Buying Practices Adjust to High Gas Prices“: In his hunt for a new
home, Demetrius Stroud crunched the numbers to find out that, with gas
prices climbing, moving near an Amtrak station is the best thing for his wallet.
“Gas Prices Drive Students to Online Courses“: For Christy LaBadie, a sophomore at Northampton Community College, the 30-minute drive from her
home to the Bethlehem, Pa., campus has become a financial hardship now
that gasoline prices have soared to more than $4 a gallon. So this semester she
decided to take an online course to save herself the trip—and the money.
“Diddy Halts Private Jet Flights Over Fuel Prices“: Fuel prices have
grounded an unexpected frequent-flyer: Sean “Diddy” Combs. . . . The
hip-hop mogul said he is now flying on commercial airlines instead of in
private jets, which Combs said had previously cost him $200,000 and up for
a roundtrip between New York and Los Angeles. ”I’m actually flying commercial,“ Diddy said before walking onto an airplane, sitting in a first-class
seat and flashing his boarding pass to the camera. ”That’s how high gas
prices are.”
09/12/10 8:02 PM
Many of these developments proved transitory. The economic downturn that
began in 2008 and continued into 2009 reduced the world demand for oil, and the
price of gasoline declined substantially. No word yet on whether Mr. Combs has
returned to his private jet. Q
QUICK QUIZ Describe an important trade-off you recently faced. • Give an example of
some action that has both a monetary and nonmonetary opportunity cost. • Describe an
incentive your parents offered to you in an effort to influence your behavior.
in the news
Incentive Pay
As this article illustrates, how people are paid affects their incentives and
the decisions they make. (The article’s author, by the way, subsequently
became one of the chief economic advisers to President Barack Obama.)
Where the Buses
Run on Time
n a summer afternoon, the drive home
from the University of Chicago to the
north side of the city must be one of the
most beautiful commutes in the world. On
the left on Lake Shore Drive you pass Grant
Park, some of the world’s first skyscrapers,
and the Sears Tower. On the right is the
intense blue of Lake Michigan. But for all the
beauty, the traffic can be hell. So, if you drive
the route every day, you learn the shortcuts.
You know that if it backs up from the Buckingham Fountain all the way to McCormick
Place, you’re better off taking the surface
streets and getting back onto Lake Shore
Drive a few miles north.
A lot of buses, however, wait in the traffic jams. I have always wondered about that:
Why don’t the bus drivers use the shortcuts?
Surely they know about them—they drive
the same route every day, and they probably
avoid the traffic when they drive their own
cars. Buses don’t stop on Lake Shore Drive,
so they wouldn’t strand anyone by detouring around the congestion. And when buses
get delayed in heavy traffic, it wreaks havoc
on the scheduled service. Instead of arriving
once every 10 minutes, three buses come in
at the same time after half an hour. That sort
of bunching is the least efficient way to run
a public transportation system. So, why not
take the surface streets if that would keep
the schedule properly spaced and on time?
You might think at first that the problem
is that the drivers aren’t paid enough to
strategize. But Chicago bus drivers are the
seventh-highest paid in the nation; full-timers
earned more than $23 an hour, according to
a November 2004 survey. The problem may
have to do not with how much they are paid,
but how they are paid. At least, that’s the
implication of a new study of Chilean bus drivers by Ryan Johnson and David Reiley of the
University of Arizona and Juan Carlos Muñoz
of Pontificia Universidad Católica de Chile.
Companies in Chile pay bus drivers one
of two ways: either by the hour or by the
passenger. Paying by the passenger leads
to significantly shorter delays. Give them
incentives, and drivers start acting like regular people do. They take shortcuts when the
traffic is bad. They take shorter meal breaks
and bathroom breaks. They want to get on
the road and pick up more passengers as
quickly as they can. In short, their productivity increases….
Not everything about incentive pay is
perfect, of course. When bus drivers start
moving from place to place more quickly,
they get in more accidents (just like the rest
of us). Some passengers also complain that
the rides make them nauseated because the
drivers stomp on the gas as soon as the last
passenger gets on the bus. Yet when given
the choice, people overwhelmingly choose
the bus companies that get them where
they’re going on time. More than 95 percent
of the routes in Santiago use incentive pay.
Perhaps we should have known that
incentive pay could increase bus driver productivity. After all, the taxis in Chicago take
the shortcuts on Lake Shore Drive to avoid
the traffic that buses just sit in. Since taxi
drivers earn money for every trip they make,
they want to get you home as quickly as
possible so they can pick up somebody else.
Source:, March 16, 2006.
CHE-MANKIW-10-0603-001.indd 9
09/12/10 8:02 PM
How People Interact
The first four principles discussed how individuals make decisions. As we go
about our lives, many of our decisions affect not only ourselves but other people
as well. The next three principles concern how people interact with one another.
Principle 5: Trade Can Make Everyone Better Off
“For $5 a week you can
watch baseball without
being nagged to cut the
You may have heard on the news that the Japanese are our competitors in the
world economy. In some ways, this is true because American and Japanese firms
produce many of the same goods. Ford and Toyota compete for the same customers
in the market for automobiles. Apple and Sony compete for the same customers in
the market for digital music players.
Yet it is easy to be misled when thinking about competition among countries.
Trade between the United States and Japan is not like a sports contest in which
one side wins and the other side loses. In fact, the opposite is true: Trade between
two countries can make each country better off.
To see why, consider how trade affects your family. When a member of your
family looks for a job, he or she competes against members of other families who
are looking for jobs. Families also compete against one another when they go
shopping because each family wants to buy the best goods at the lowest prices. In
a sense, each family in the economy is competing with all other families.
Despite this competition, your family would not be better off isolating itself
from all other families. If it did, your family would need to grow its own food,
make its own clothes, and build its own home. Clearly, your family gains much
from its ability to trade with others. Trade allows each person to specialize in the
activities he or she does best, whether it is farming, sewing, or home building.
By trading with others, people can buy a greater variety of goods and services at
lower cost.
Countries as well as families benefit from the ability to trade with one another.
Trade allows countries to specialize in what they do best and to enjoy a greater
variety of goods and services. The Japanese, as well as the French and the
Egyptians and the Brazilians, are as much our partners in the world economy as
they are our competitors.
market economy
an economy that allocates
resources through the
decentralized decisions
of many firms and
households as they
interact in markets for
goods and services
CHE-MANKIW-10-0603-001.indd 10
The collapse of communism in the Soviet Union and Eastern Europe in the 1980s
may be the most important change in the world during the past half century.
Communist countries worked on the premise that government officials were in
the best position to allocate the economy’s scarce resources. These central planners decided what goods and services were produced, how much was produced,
and who produced and consumed these goods and services. The theory behind
central planning was that only the government could organize economic activity
in a way that promoted economic well-being for the country as a whole.
Most countries that once had centrally planned economies have abandoned
the system and are instead developing market economies. In a market economy,
the decisions of a central planner are replaced by the decisions of millions of
firms and households. Firms decide whom to hire and what to make. Households
decide which firms to work for and what to buy with their incomes. These firms
Principle 6: Markets Are Usually a Good Way to
Organize Economic Activity
09/12/10 8:02 PM
and households interact in the marketplace, where prices and self-interest guide
their decisions.
At first glance, the success of market economies is puzzling. In a market
economy, no one is looking out for the economic well-being of society as a whole.
Free markets contain many buyers and sellers of numerous goods and services,
and all of them are interested primarily in their own well-being. Yet despite
decentralized decision making and self-interested decision makers, market economies have proven remarkably successful in organizing economic activity to promote overall economic well-being.
In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations,
economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an
“invisible hand” that leads them to desirable market outcomes. One of our goals
in this book is to understand how this invisible hand works its magic.
As you study economics, you will learn that prices are the instrument with
which the invisible hand directs economic activity. In any market, buyers look at
the price when determining how much to demand, and sellers look at the price
when deciding how much to supply. As a result of the decisions that buyers and
sellers make, market prices reflect both the value of a good to society and the
cost to society of making the good. Smith’s great insight was that prices adjust to
guide these individual buyers and sellers to reach outcomes that, in many cases,
maximize the well-being of society as a whole.
Smith’s insight has an important corollary: When the government prevents
prices from adjusting naturally to supply and demand, it impedes the invisible
hand’s ability to coordinate the decisions of the households and firms that make
up the economy. This corollary explains why taxes adversely affect the allocation of resources, for they distort prices and thus the decisions of households
and firms. It also explains the great harm caused by policies that directly control
prices, such as rent control. And it explains the failure of communism. In communist countries, prices were not determined in the marketplace but were dictated by central planners. These planners lacked the necessary information about
consumers’ tastes and producers’ costs, which in a market economy is reflected
in prices. Central planners failed because they tried to run the economy with one
hand tied behind their backs—the invisible hand of the marketplace.
Principle 7: Governments Can Sometimes
Improve Market Outcomes
If the invisible hand of the market is so great, why do we need government? One
purpose of studying economics is to refine your view about the proper role and
scope of government policy.
One reason we need government is that the invisible hand can work its magic
only if the government enforces the rules and maintains the institutions that are
key to a market economy. Most important, market economies need institutions
to enforce property rights so individuals can own and control scarce resources.
A farmer won’t grow food if he expects his crop to be stolen; a restaurant won’t
serve meals unless it is assured that customers will pay before they leave; and an
entertainment company won’t produce DVDs if too many potential customers
avoid paying by making illegal copies. We all rely on government-provided
police and courts to enforce our rights over the things we produce—and the invisible hand counts on our ability to enforce our rights.
CHE-MANKIW-10-0603-001.indd 11
property rights
the ability of an individual
to own and exercise
control over scarce
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Adam Smith and the Invisible Hand
t may be only a coincidence that Adam Smith’s great book The
Wealth of Nations was published in 1776, the exact year American revolutionaries signed the Declaration of Independence. But
the two documents share a point of view that was prevalent at the
time: Individuals are usually best left to their own devices, without
the heavy hand of government guiding their actions. This political
philosophy provides the intellectual basis for the market economy
and for free society more generally.
Why do decentralized market economies work so well? Is it
because people can be counted on to treat one another with love
and kindness? Not at all. Here is Adam Smith’s description of how
people interact in a market economy:
Man has almost constant occasion for the
help of his brethren, and it is in vain for him to
expect it from their benevolence only. He will
be more likely to prevail if he can interest their
self-love in his favour, and show them that it
is for their own advantage to do for him what
he requires of them. . . . Give me that which I
want, and you shall have this which you want,
is the meaning of every such offer; and it is in
this manner that we obtain from one another
the far greater part of those good offices
which we stand in need of.
market failure
a situation in which a
market left on its own
fails to allocate resources
the impact of one
person’s actions on the
well-being of a bystander
CHE-MANKIW-10-0603-001.indd 12
It is not from the benevolence of the butcher, the brewer,
or the baker that we expect our dinner, but from their regard
to their own interest. We address ourselves, not to their
humanity but to their self-love, and never talk to them of
our own necessities but of their advantages. Nobody but a
beggar chooses to depend chiefly upon the benevolence of
his fellow-citizens. . . .
Every individual . . . neither intends to promote the public
interest, nor knows how much he is promoting it. . . . He
intends only his own gain, and he is in this, as in many other
cases, led by an invisible hand to promote an end which was
no part of his intention. Nor is it always the worse for the
society that it was no part of it. By pursuing his own interest he
frequently promotes that of the society more effectually than when he really intends to promote it.
Adam Smith
Smith is saying that participants in the economy
are motivated by self-interest and that the “invisible
hand” of the marketplace guides this self-interest
into promoting general economic well-being.
Many of Smith’s insights remain at the center of
modern economics. Our analysis in the coming chapters will allow us to express Smith’s conclusions more
precisely and to analyze more fully the strengths and
weaknesses of the market’s invisible hand.
Yet there is another reason we need government: The invisible hand is powerful,
but it is not omnipotent. There are two broad reasons for a government to intervene
in the economy and change the allocation of resources that people would choose
on their own: to promote efficiency or to promote equality. That is, most policies
aim either to enlarge the economic pie or to change how the pie is divided.
Consider first the goal of efficiency. Although the invisible hand usually leads
markets to allocate resources to maximize the size of the economic pie, this is not
always the case. Economists use the term market failure to refer to a situation in
which the market on its own fails to produce an efficient allocation of resources.
As we will see, one possible cause of market failure is an externality, which is
the impact of one person’s actions on the well-being of a bystander. The classic
09/12/10 8:02 PM
example of an externality is pollution. Another possible cause of market failure
is market power, which refers to the ability of a single person (or small group)
to unduly influence market prices. For example, if everyone in town needs water
but there is only one well, the owner of the well is not subject to the rigorous
competition with which the invisible hand normally keeps self-interest in check.
In the presence of externalities or market power, well-designed public policy can
enhance economic efficiency.
Now consider the goal of equality. Even when the invisible hand is yielding
efficient outcomes, it can nonetheless leave sizable disparities in economic wellbeing. A market economy rewards people according to their ability to produce
things that other people are willing to pay for. The world’s best basketball
player earns more than the world’s best chess player simply because people are
willing to pay more to watch basketball than chess. The invisible hand does not
ensure that everyone has sufficient food, decent clothing, and adequate healthcare. This inequality may, depending on one’s political philosophy, call for government intervention. In practice, many public policies, such as the income tax
and the welfare system, aim to achieve a more equal distribution of economic
To say that the government can improve on market outcomes at times does
not mean that it always will. Public policy is made not by angels but by a political
process that is far from perfect. Sometimes policies are designed simply to reward
the politically powerful. Sometimes they are made by well-intentioned leaders
who are not fully informed. As you study economics, you will become a better
judge of when a government policy is justifiable because it promotes efficiency or
equality and when it is not.
market power
the ability of a single
economic actor (or small
group of actors) to have
a substantial influence on
market prices
QUICK QUIZ Why is a country better off not isolating itself from all other countries? • Why do we have markets, and, according to economists, what roles should
government play in them?
How the Economy as a Whole Works
We started by discussing how individuals make decisions and then looked at how
people interact with one another. All these decisions and interactions together
make up “the economy.” The last three principles concern the workings of the
economy as a whole.
Principle 8: A Country’s Standard of Living Depends
on Its Ability to Produce Goods and Services
The differences in living standards around the world are staggering. In 2008, the
average American had an income of about $47,000. In the same year, the average
Mexican earned about $10,000, and the average Nigerian earned only $1,400. Not
surprisingly, this large variation in average income is reflected in various measures of the quality of life. Citizens of high-income countries have more TV sets,
more cars, better nutrition, better healthcare, and a longer life expectancy than
citizens of low-income countries.
Changes in living standards over time are also large. In the United States,
incomes have historically grown about 2 percent per year (after adjusting for
CHE-MANKIW-10-0603-001.indd 13
09/12/10 8:02 PM
the quantity of goods and
services produced from
each unit of labor input
changes in the cost of living). At this rate, average income doubles every 35 years.
Over the past century, average U.S. income has risen about eightfold.
What explains these large differences in living standards among countries and
over time? The answer is surprisingly simple. Almost all variation in living standards is attributable to differences in countries’ productivity—that is, the amount
of goods and services produced from each unit of labor input. In nations where
workers can produce a large quantity of goods and services per unit of time, most
people enjoy a high standard of living; in nations where workers are less productive, most people endure a more meager existence. Similarly, the growth rate of a
nation’s productivity determines the growth rate of its average income.
The fundamental relationship between productivity and living standards is
simple, but its implications are far-reaching. If productivity is the primary determinant of living standards, other explanations must be of secondary importance.
For example, it might be tempting to credit labor unions or minimum-wage laws
for the rise in living standards of American workers over the past century. Yet the
real hero of American workers is their rising productivity. As another example,
some commentators have claimed that increased competition from Japan and
other countries explained the slow growth in U.S. incomes during the 1970s and
1980s. Yet the real villain was not competition from abroad but flagging productivity growth in the United States.
The relationship between productivity and living standards also has profound
implications for public policy. When thinking about how any policy will affect living standards, the key question is how it will affect our ability to produce goods
and services. To boost living standards, policymakers need to raise productivity
by ensuring that workers are well educated, have the tools needed to produce
goods and services, and have access to the best available technology.
in the news
Why You Should Study Economics
In this excerpt from a commencement address, the former president
of the Federal Reserve Bank of Dallas makes the case for studying
The Dismal Science?
y take on training in economics is that
it becomes increasingly valuable as
you move up the career ladder. I can’t imagine a better major for corporate CEOs, congressmen, or American presidents. You’ve
CHE-MANKIW-10-0603-001.indd 14
learned a systematic, disciplined way of
thinking that will serve you well. By contrast,
the economically challenged must be perplexed about how it is that economies work
better the fewer people they have in charge.
Who does the planning? Who makes decisions? Who decides what to produce?
For my money, Adam Smith’s invisible
hand is the most important thing you’ve
learned by studying economics. You understand how we can each work for our own
self-interest and still produce a desirable
social outcome. You know how uncoordinated activity gets coordinated by the market
to enhance the wealth of nations. You understand the magic of markets and the dangers
of tampering with them too much. You know
better what you first learned in kindergarten:
that you shouldn’t kill or cripple the goose
that lays the golden eggs. . . .
Economics training will help you understand fallacies and unintended consequences.
09/12/10 8:02 PM
Principle 9: Prices Rise When the Government
Prints Too Much Money
In January 1921, a daily newspaper in Germany cost 0.30 marks. Less than two
years later, in November 1922, the same newspaper cost 70,000,000 marks. All
other prices in the economy rose by similar amounts. This episode is one of history’s most spectacular examples of inflation, an increase in the overall level of
prices in the economy.
Although the United States has never experienced inflation even close to
that of Germany in the 1920s, inflation has at times been an economic problem. During the 1970s, for instance, when the overall level of prices more
than doubled, President Gerald Ford called inflation “public enemy number
one.” By contrast, inflation in the first decade of the 21st century has run
about 2½ percent per year; at this rate, it would take almost 30 years for
prices to double. Because high inflation imposes various costs on society,
keeping inflation at a low level is a goal of economic policymakers around
the world.
What causes inflation? In almost all cases of large or persistent inflation, the
culprit is growth in the quantity of money. When a government creates large
quantities of the nation’s money, the value of the money falls. In Germany in
the early 1920s, when prices were on average tripling every month, the quantity
of money was also tripling every month. Although less dramatic, the economic
history of the United States points to a similar conclusion: The high inflation of
the 1970s was associated with rapid growth in the quantity of money, and the
low inflation of more recent experience was associated with slow growth in the
quantity of money.
In fact, I am inclined to define economics as
the study of how to anticipate unintended
consequences. . . .
Little in the literature seems more relevant to contemporary economic debates
than what usually is called the broken
window fallacy. Whenever a government
program is justified not on its merits but by
the jobs it will create, remember the broken
window: Some teenagers, being the little
beasts that they are, toss a brick through
a bakery window. A crowd gathers and
laments, “What a shame.” But before you
know it, someone suggests a silver lining to
the situation: Now the baker will have to
spend money to have the window repaired.
This will add to the income of the repairman, who will spend his additional income,
which will add to another seller’s income,
and so on. You know the drill. The chain of
spending will multiply and generate higher
income and employment. If the broken
window is large enough, it might produce
an economic boom! . . .
Most voters fall for the broken window
fallacy, but not economics majors. They will
say, “Hey, wait a minute!” If the baker
hadn’t spent his money on window repair,
he would have spent it on the new suit he
was saving to buy. Then the tailor would
have the new income to spend, and so on.
The broken window didn’t create net new
spending; it just diverted spending from
somewhere else. The broken window does
not create new activity, just different activity. People see the activity that takes place.
They don’t see the activity that would have
taken place.
The broken window fallacy is perpetuated in many forms. Whenever job creation
an increase in the overall
level of prices in the
“Well it may have
been 68 cents when
you got in line, but
it’s 74 cents now!”
or retention is the primary objective I call
it the job-counting fallacy. Economics
majors understand the non-intuitive reality that real progress comes from job
destruction. It once took 90 percent of
our population to grow our food. Now it
takes 3 percent. Pardon me, Willie, but are
we worse off because of the job losses in
agriculture? The would-have-been farmers
are now college professors and computer
gurus. . . .
So instead of counting jobs, we
should make every job count. We will
occasionally hit a soft spot when we
have a mismatch of supply and demand
in the labor market. But that is temporary. Don’t become a Luddite and destroy
the machinery, or become a protectionist
and try to grow bananas in New York
Source: The Wall Street Journal, June 4, 2003.
CHE-MANKIW-10-0603-001.indd 15
09/12/10 8:02 PM
Principle 10: Society Faces a Short-Run Trade-off
between Inflation and Unemployment
Although a higher level of prices is, in the long run, the primary effect of
increasing the quantity of money, the short-run story is more complex and controversial. Most economists describe the short-run effects of monetary injections
as follows:
• Increasing the amount of money in the economy stimulates the overall level
of spending and thus the demand for goods and services.
• Higher demand may over time cause firms to raise their prices, but in the

business cycle
fluctuations in
economic activity, such
as employment and
meantime, it also encourages them to hire more workers and produce a
larger quantity of goods and services.
More hiring means lower unemployment.
This line of reasoning leads to one final economy-wide trade-off: a short-run
trade-off between inflation and unemployment.
Although some economists still question these ideas, most accept that society
faces a short-run trade-off between inflation and unemployment. This simply
means that, over a period of a year or two, many economic policies push inflation and unemployment in opposite directions. Policymakers face this trade-off
regardless of whether inflation and unemployment both start out at high levels (as
they did in the early 1980s), at low levels (as they did in the late 1990s), or someplace in between. This short-run trade-off plays a key role in the analysis of the
business cycle—the irregular and largely unpredictable fluctuations in economic
activity, as measured by the production of goods and services or the number of
people employed.
Policymakers can exploit the short-run trade-off between inflation and
unemployment using various policy instruments. By changing the amount
that the government spends, the amount it taxes, and the amount of money
it prints, policymakers can influence the overall demand for goods and services. Changes in demand in turn influence the combination of inflation and
unemployment that the economy experiences in the short run. Because these
instruments of economic policy are potentially so powerful, how policymakers
should use these instruments to control the economy, if at all, is a subject of
continuing debate.
This debate heated up in the early years of Barack Obama’s presidency. In 2008
and 2009, the U.S. economy, as well as many other economies around the world,
experienced a deep economic downturn. Problems in the financial system, caused
by bad bets on the housing market, spilled over into the rest of the economy,
causing incomes to fall and unemployment to soar. Policymakers responded in
various ways to increase the overall demand for goods and services. President
Obama’s first major initiative was a stimulus package of reduced taxes and
increased government spending. At the same time, the nation’s central bank, the
Federal Reserve, increased the supply of money. The goal of these policies was to
reduce unemployment. Some feared, however, that these policies might over time
lead to an excessive level of inflation.
QUICK QUIZ List and briefly explain the three principles that describe how the
economy as a whole works.
CHE-MANKIW-10-0603-001.indd 16

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