P2 principle of economic

350 0 0

Figure 18-5
A SHIFT IN LABOR SUPPLY.
When labor supply increases
from S1 to S2, perhaps because of
an immigration of new workers,
the equilibrium wage falls from
W1 to W2. At this lower wage,
firms hire more labor, so
employment rises from L1 to L2.
The change in the wage reflects a
change in the value of the
marginal product of labor: With
more workers, the added output
from an extra worker is smaller.
408 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY PRODUCTIVITY AND WAGES
One of the Ten Principles of Economics in Chapter 1 is that our standard of living
depends on our ability to produce goods and services. We can now see how this
principle works in the market for labor. In particular, our analysis of labor demand
shows that wages equal productivity as measured by the value of the
marginal product of labor. Put simply, highly productive workers are highly
paid, and less productive workers are less highly paid.
This lesson is key to understanding why workers today are better off than
workers in previous generations. Table 18-2 presents some data on growth in
productivity and growth in wages (adjusted for inflation). From 1959 to 1997,
productivity as measured by output per hour of work grew about 1.8 percent
per year; at this rate, productivity doubles about every 40 years. Over this period,
wages grew at a similar rate of 1.7 percent per year.
producers make greater profit, and apple pickers earn higher wages. When the
price of apples falls, apple producers earn smaller profit, and apple pickers earn
lower wages. This lesson is well known to workers in industries with highly
volatile prices. Workers in oil fields, for instance, know from experience that their
earnings are closely linked to the world price of crude oil.
From these examples, you should now have a good understanding of how
wages are set in competitive labor markets. Labor supply and labor demand together
determine the equilibrium wage, and shifts in the supply or demand curve
for labor cause the equilibrium wage to change. At the same time, profit maximization
by the firms that demand labor ensures that the equilibrium wage always
equals the value of the marginal product of labor.
Wage
(price of
labor)
W1
W2
0 Quantity of
Labor
L1 L2
Supply
Demand, D1
2. . . . increases
the wage . . .
3. . . . and increases employment.
1. An increase in
labor demand . . .
D2
Figure 18-6
A SHIFT IN LABOR DEMAND.
When labor demand increases
from D1 to D2, perhaps because of
an increase in the price of the
firms’ output, the equilibrium
wage rises from W1 to W2, and
employment rises from L1 to L2.
Again, the change in the wage
reflects a change in the value of
the marginal product of labor:
With a higher output price, the
added output from an extra
worker is more valuable.
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 409
Table 18-2 also shows that, beginning around 1973, growth in productivity
slowed from 2.9 to 1.1 percent per year. This 1.8 percentage-point slowdown in
productivity coincided with a slowdown in wage growth of 1.9 percentage
points. Because of this productivity slowdown, workers in the 1980s and 1990s
did not experience the same rapid growth in living standards that their parents
enjoyed. A slowdown of 1.8 percentage points might not seem large, but accumulated
over many years, even a small change in a growth rate is significant. If
productivity and wages had grown at the same rate since 1973 as they did previously,
workers’ earnings would now be about 50 percent higher than they are.
The link between productivity and wages also sheds light on international
experience. Table 18-3 presents some data on productivity growth and wage
growth for a representative group of countries, ranked in order of their productivity
growth. Although these international data are far from precise, a close link
between the two variables is apparent. In South Korea, Hong Kong, and Singapore,
productivity has grown rapidly, and so have wages. In Mexico, Argentina,
and Iran, productivity has fallen, and so have wages. The United States falls
about in the middle of the distribution: By international standards, U.S. productivity
growth and wage growth have been neither exceptionally bad nor exceptionally
good.
What causes productivity and wages to vary so much over time and across
countries? A complete answer to this question requires an analysis of long-run
economic growth, a topic beyond the scope of this chapter. We can, however,
briefly note three key determinants of productivity:
Physical capital: When workers work with a larger quantity of equipment
and structures, they produce more.
Human capital: When workers are more educated, they produce more.
Technological knowledge: When workers have access to more sophisticated
technologies, they produce more.
Physical capital, human capital, and technological knowledge are the ultimate
sources of most of the differences in productivity, wages, and standards of
living.
Table 18-2
PRODUCTIVITY AND WAGE
GROWTH IN THE UNITED STATES
GROWTH RATE GROWTH RATE
TIME PERIOD OF PRODUCTIVITY OF REALWAGES
1959–1997 1.8 1.7
1959–1973 2.9 2.9
1973–1997 1.1 1.0
SOURCE: Economic Report of the President 1999, table B-49, p. 384. Growth in productivity is measured here
as the annualized rate of change in output per hour in the nonfarm business sector. Growth in real
wages is measured as the annualized change in compensation per hour in the nonfarm business sector
divided by the implicit price deflator for that sector. These productivity data measure average
productivity—the quantity of output divided by the quantity of labor—rather than marginal
productivity, but average and marginal productivity are thought to move closely together.
410 PART SIX THE ECONOMICS OF LABOR MARKETS
QUICK QUIZ: How does an immigration of workers affect labor supply,
labor demand, the marginal product of labor, and the equilibrium wage?
THE OTHER FACTORS OF PRODUCTION:
LAND AND CAPITAL
We have seen how firms decide how much labor to hire and how these decisions
determine workers’ wages. At the same time that firms are hiring workers, they
are also deciding about other inputs to production. For example, our appleproducing
firm might have to choose the size of its apple orchard and the number
of ladders to make available to its apple pickers. We can think of the firm’s factors
of production as falling into three categories: labor, land, and capital.
The meaning of the terms labor and land is clear, but the definition of capital is
somewhat tricky. Economists use the term capital to refer to the stock of equipment
and structures used for production. That is, the economy’s capital represents
the accumulation of goods produced in the past that are being used in the present
to produce new goods and services. For our apple firm, the capital stock includes
the ladders used to climb the trees, the trucks used to transport the apples, the
buildings used to store the apples, and even the trees themselves.
EQUILIBRIUM IN THE MARKETS FOR LAND AND CAPITAL
What determines how much the owners of land and capital earn for their contribution
to the production process? Before answering this question, we need to
Table 18-3
PRODUCTIVITY AND WAGE
GROWTH AROUND THE WORLD
GROWTH RATE GROWTH RATE
COUNTRY OF PRODUCTIVITY OF REALWAGES
South Korea 8.5 7.9
Hong Kong 5.5 4.9
Singapore 5.3 5.0
Indonesia 4.0 4.4
Japan 3.6 2.0
India 3.1 3.4
United Kingdom 2.4 2.4
United States 1.7 0.5
Brazil 0.4 2.4
Mexico 0.2 3.0
Argentina 0.9 1.3
Iran 1.4 7.9
SOURCE: World Development Report 1994, table 1, pp. 162–163, and table 7, pp. 174–175. Growth in
productivity is measured here as the annualized rate of change in gross national product per person
from 1980 to 1992. Growth in wages is measured as the annualized change in earnings per employee in
manufacturing from 1980 to 1991.
capital
the equipment and structures used to
produce goods and services
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 411
distinguish between two prices: the purchase price and the rental price. The purchase
price of land or capital is the price a person pays to own that factor of production
indefinitely. The rental price is the price a person pays to use that factor for
a limited period of time. It is important to keep this distinction in mind because, as
we will see, these prices are determined by somewhat different economic forces.
Having defined these terms, we can now apply the theory of factor demand
we developed for the labor market to the markets for land and capital. The wage
is, after all, simply the rental price of labor. Therefore, much of what we have
learned about wage determination applies also to the rental prices of land and capital.
As Figure 18-7 illustrates, the rental price of land, shown in panel (a), and the
rental price of capital, shown in panel (b), are determined by supply and demand.
Moreover, the demand for land and capital is determined just like the demand for
labor. That is, when our apple-producing firm is deciding how much land and
how many ladders to rent, it follows the same logic as when deciding how many
workers to hire. For both land and capital, the firm increases the quantity hired until
the value of the factor’s marginal product equals the factor’s price. Thus, the demand
curve for each factor reflects the marginal productivity of that factor.
We can now explain how much income goes to labor, how much goes to
landowners, and how much goes to the owners of capital. As long as the firms
using the factors of production are competitive and profit-maximizing, each factor’s
rental price must equal the value of the marginal product for that factor.
Labor, land, and capital each earn the value of their marginal contribution to the production
process.
Now consider the purchase price of land and capital. The rental price and the
purchase price are obviously related: Buyers are willing to pay more to buy a piece
of land or capital if it produces a valuable stream of rental income. And, as we
Quantity of
Land
0
Rental
Price of
Land
P
Q
Demand
Supply
Demand
Supply
Quantity of
Capital
0
Rental
Price of
Capital
Q
P
(a) The Market for Land (b) The Market for Capital
THE MARKETS FOR LAND AND CAPITAL. Supply and demand determine the Figur e 18-7
compensation paid to the owners of land, as shown in panel (a), and the compensation
paid to the owners of capital, as shown in panel (b). The demand for each factor, in turn,
depends on the value of the marginal product of that factor.
412 PART SIX THE ECONOMICS OF LABOR MARKETS
have just seen, the equilibrium rental income at any point in time equals the value
of that factor’s marginal product. Therefore, the equilibrium purchase price of a
piece of land or capital depends on both the current value of the marginal product
and the value of the marginal product expected to prevail in the future.
LINKAGES AMONG THE FACTORS OF PRODUCTION
We have seen that the price paid to any factor of production—labor, land, or capital—
equals the value of the marginal product of that factor. The marginal product
of any factor, in turn, depends on the quantity of that factor that is available. Because
of diminishing returns, a factor in abundant supply has a low marginal
product and thus a low price, and a factor in scarce supply has a high marginal
product and a high price. As a result, when the supply of a factor falls, its equilibrium
factor price rises.
When the supply of any factor changes, however, the effects are not limited to
the market for that factor. In most situations, factors of production are used together
in a way that makes the productivity of each factor dependent on the quantities
of the other factors available to be used in the production process. As a result,
a change in the supply of any one factor alters the earnings of all the factors.
For example, suppose that a hurricane destroys many of the ladders that
workers use to pick apples from the orchards. What happens to the earnings of the
various factors of production? Most obviously, the supply of ladders falls and,
Labor income is an easy concept
to understand: It is the
paycheck that workers get from
their employers. The income
earned by capital, however, is
less obvious.
In our analysis, we have
been implicitly assuming that
households own the economy’s
stock of capital—ladders, drill
presses, warehouses, etc.—
and rent it to the firms that use
it. Capital income, in this case,
is the rent that households receive for the use of their capital.
This assumption simplified our analysis of how capital
owners are compensated, but it is not entirely realistic. In
fact, firms usually own the capital they use and, therefore,
they receive the earnings from this capital.
These earnings from capital, however, eventually get
paid to households. Some of the earnings are paid in the
form of interest to those households who have lent money
to firms. Bondholders and bank depositors are two examples
of recipients of interest. Thus, when you receive interest
on your bank account, that income is part of the economy’s
capital income.
In addition, some of the earnings from capital are paid
to households in the form of dividends. Dividends are payments
by a firm to the firm’s stockholders. A stockholder is
a person who has bought a share in the ownership of the
firm and, therefore, is entitled to share in the firm’s profits.
A firm does not have to pay out all of its earnings to
households in the form of interest and dividends. Instead, it
can retain some earnings within the firm and use these
earnings to buy additional capital. Although these retained
earnings do not get paid to the firm’s stockholders, the
stockholders benefit from them nonetheless. Because retained
earnings increase the amount of capital the firm
owns, they tend to increase future earnings and, thereby,
the value of the firm’s stock.
These institutional details are interesting and important,
but they do not alter our conclusion about the income
earned by the owners of capital. Capital is paid according to
the value of its marginal product, regardless of whether this
income gets transmitted to households in the form of interest
or dividends or whether it is kept within firms as retained
earnings.
FYI
What Is
Capital Income?
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 413
CASE STUDY THE ECONOMICS OF THE BLACK DEATH
In fourteenth-century Europe, the bubonic plague wiped out about one-third of
the population within a few years. This event, called the Black Death, provides a
grisly natural experiment to test the theory of factor markets that we have just
developed. Consider the effects of the Black Death on those who were lucky
enough to survive. What do you think happened to the wages earned by workers
and the rents earned by landowners?
To answer this question, let’s examine the effects of a reduced population
on the marginal product of labor and the marginal product of land. With a
smaller supply of workers, the marginal product of labor rises. (This is simply
diminishing marginal product working in reverse.) Thus, we would expect the
Black Death to raise wages.
Because land and labor are used together in production, a smaller supply of
workers also affects the market for land, the other major factor of production in
medieval Europe. With fewer workers available to farm the land, an additional
unit of land produced less additional output. In other words, the marginal
product of land fell. Thus, we would expect the Black Death to lower rents.
In fact, both predictions are consistent with the historical evidence. Wages
approximately doubled during this period, and rents declined 50 percent or
more. The Black Death led to economic prosperity for the peasant classes and
reduced incomes for the landed classes.
therefore, the equilibrium rental price of ladders rises. Those owners who were
lucky enough to avoid damage to their ladders now earn a higher return when
they rent out their ladders to the firms that produce apples.
Yet the effects of this event do not stop at the ladder market. Because there are
fewer ladders with which to work, the workers who pick apples have a smaller
marginal product. Thus, the reduction in the supply of ladders reduces the demand
for the labor of apple pickers, and this causes the equilibrium wage to fall.
This story shows a general lesson: An event that changes the supply of any
factor of production can alter the earnings of all the factors. The change in earnings
of any factor can be found by analyzing the impact of the event on the value of the
marginal product of that factor.
WORKERS WHO SURVIVED THE PLAGUE
WERE LUCKY IN MORE WAYS THAN ONE.
QUICK QUIZ: What determines the income of the owners of land and
capital? How would an increase in the quantity of capital affect the
incomes of those who already own capital? How would it affect the incomes
of workers?
CONCLUSION
This chapter explained how labor, land, and capital are compensated for the roles
they play in the production process. The theory developed here is called the neoclassical
theory of distribution. According to the neoclassical theory, the amount paid
to each factor of production depends on the supply and demand for that factor.
414 PART SIX THE ECONOMICS OF LABOR MARKETS
The demand, in turn, depends on that particular factor’s marginal productivity. In
equilibrium, each factor of production earns the value of its marginal contribution
to the production of goods and services.
The neoclassical theory of distribution is widely accepted. Most economists
begin with the neoclassical theory when trying to explain how the U.S. economy’s
$8 trillion of income is distributed among the economy’s various members. In the
following two chapters, we consider the distribution of income in more detail. As
you will see, the neoclassical theory provides the framework for this discussion.
Even at this point you can use the theory to answer the question that began
this chapter: Why are computer programmers paid more than gas station attendants?
It is because programmers can produce a good of greater market value than
can a gas station attendant. People are willing to pay dearly for a good computer
game, but they are willing to pay little to have their gas pumped and their windshield
washed. The wages of these workers reflect the market prices of the goods
they produce. If people suddenly got tired of using computers and decided to
spend more time driving, the prices of these goods would change, and so would
the equilibrium wages of these two groups of workers.
The economy’s income is distributed in the markets for
the factors of production. The three most important
factors of production are labor, land, and capital.
The demand for factors, such as labor, is a derived
demand that comes from firms that use the factors to
produce goods and services. Competitive, profitmaximizing
firms hire each factor up to the point at
which the value of the marginal product of the factor
equals its price.
The supply of labor arises from individuals’ tradeoff
between work and leisure. An upward-sloping labor
supply curve means that people respond to an increase
in the wage by enjoying less leisure and working more
hours.
The price paid to each factor adjusts to balance the
supply and demand for that factor. Because factor
demand reflects the value of the marginal product of
that factor, in equilibrium each factor is compensated
according to its marginal contribution to the production
of goods and services.
Because factors of production are used together, the
marginal product of any one factor depends on the
quantities of all factors that are available. As a result, a
change in the supply of one factor alters the equilibrium
earnings of all the factors.
Summary
factors of production, p. 398
production function, p. 400
marginal product of labor, p. 400
diminishing marginal product, p. 401
value of the marginal product, p. 401
capital, p. 410
Key Concepts
1. Explain how a firm’s production function is related
to its marginal product of labor, how a firm’s
marginal product of labor is related to the value
of its marginal product, and how a firm’s value
of marginal product is related to its demand for
labor.
Questions for Review
CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION 415
2. Give two examples of events that could shift the
demand for labor.
3. Give two examples of events that could shift the supply
of labor.
4. Explain how the wage can adjust to balance the supply
and demand for labor while simultaneously equaling
the value of the marginal product of labor.
5. If the population of the United States suddenly grew
because of a large immigration, what would happen to
wages? What would happen to the rents earned by the
owners of land and capital?
1. Suppose that the president proposes a new law aimed at
reducing heath care costs: All Americans are to be
required to eat one apple daily.
a. How would this apple-a-day law affect the demand
and equilibrium price of apples?
b. How would the law affect the marginal product
and the value of the marginal product of apple
pickers?
c. How would the law affect the demand and
equilibrium wage for apple pickers?
2. Henry Ford once said: “It is not the employer who pays
wages—he only handles the money. It is the product
that pays wages.” Explain.
3. Show the effect of each of the following events on the
market for labor in the computer manufacturing
industry.
a. Congress buys personal computers for all American
college students.
b. More college students major in engineering and
computer science.
c. Computer firms build new manufacturing plants.
4. Your enterprising uncle opens a sandwich shop that
employs 7 people. The employees are paid $6 per hour,
and a sandwich sells for $3. If your uncle is maximizing
his profit, what is the value of the marginal product of
the last worker he hired? What is that worker’s
marginal product?
5. Imagine a firm that hires two types of workers—some
with computer skills and some without. If technology
advances, so that computers become more useful to the
firm, what happens to the marginal product of the two
types? What happens to equilibrium wages? Explain,
using appropriate diagrams.
6. Suppose a freeze in Florida destroys part of the Florida
orange crop.
a. Explain what happens to the price of oranges and
the marginal product of orange pickers as a result
of the freeze. Can you say what happens to the
demand for orange pickers? Why or why not?
b. Suppose the price of oranges doubles and the
marginal product falls by 30 percent. What happens
to the equilibrium wage of orange pickers?
c. Suppose the price of oranges rises by 30 percent
and the marginal product falls by 50 percent.
What happens to the equilibrium wage of orange
pickers?
7. During the 1980s and 1990s the United States
experienced a significant inflow of capital from other
countries. For example, Toyota, BMW, and other
foreign car companies built auto plants in the United
States.
a. Using a diagram of the U.S. capital market, show
the effect of this inflow on the rental price of capital
in the United States and on the quantity of capital
in use.
b. Using a diagram of the U.S. labor market, show the
effect of the capital inflow on the average wage
paid to U.S. workers.
8. Suppose that labor is the only input used by a perfectly
competitive firm that can hire workers for $50 per day.
The firm’s production function is as follows:
DAYS OF LABOR UNITS OF OUTPUT
0 0
1 7
2 13
3 19
4 25
5 28
6 29
Each unit of output sells for $10. Plot the firm’s demand
for labor. How many days of labor should the firm hire?
Show this point on your graph.
Problems and Applications
416 PART SIX THE ECONOMICS OF LABOR MARKETS
9. (This question is challenging.) In recent years some
policymakers have proposed requiring firms to give
workers certain fringe benefits. For example, in 1993
President Clinton proposed requiring firms to provide
health insurance to their workers. Let’s consider the
effects of such a policy on the labor market.
a. Suppose that a law required firms to give each
worker $3 of fringe benefits for every hour that the
worker is employed by the firm. How does this law
affect the marginal profit that a firm earns from
each worker? How does the law affect the demand
curve for labor? Draw your answer on a graph with
the cash wage on the vertical axis.
b. If there is no change in labor supply, how would
this law affect employment and wages?
c. Why might the labor supply curve shift in response
to this law? Would this shift in labor supply raise or
lower the impact of the law on wages and
employment?
d. As Chapter 6 discussed, the wages of some
workers, particularly the unskilled and
inexperienced, are kept above the equilibrium level
by minimum-wage laws. What effect would a
fringe-benefit mandate have for these workers?
10. (This question is challenging.) This chapter has assumed
that labor is supplied by individual workers acting
competitively. In some markets, however, the supply of
labor is determined by a union of workers.
a. Explain why the situation faced by a labor union
may resemble the situation faced by a monopoly
firm.
b. The goal of a monopoly firm is to maximize profits.
Is there an analogous goal for labor unions?
c. Now extend the analogy between monopoly firms
and unions. How do you suppose that the wage set
by a union compares to the wage in a competitive
market? How do you suppose employment differs
in the two cases?
d. What other goals might unions have that make
unions different from monopoly firms?
IN THIS CHAPTER
YOU WILL . . .
Consider why it is
dif ficult to measure
the impact of
discrimination on
wages
See when market
forces can and
cannot provide a
natural remedy for
discrimination
Consider the debate
over comparable
wor th as a system
for setting wages
Examine why in
some occupations a
few superstars earn
tremendous
incomes
Examine how wages
compensate for
dif ferences in job
characteristics
Learn and compare
the human-capital
and signaling
theories of
education
Learn why wages
rise above the level
that balances
supply and demand
In the United States today, the typical physician earns about $200,000 a year, the
typical police officer about $50,000, and the typical farmworker about $20,000.
These examples illustrate the large differences in earnings that are so common in
our economy. These differences explain why some people live in mansions, ride in
limousines, and vacation on the French Riviera, while other people live in small
apartments, ride the bus, and vacation in their own back yards.
Why do earnings vary so much from person to person? Chapter 18, which developed
the basic neoclassical theory of the labor market, offers an answer to this
question. There we saw that wages are governed by labor supply and labor demand.
Labor demand, in turn, reflects the marginal productivity of labor. In equilibrium,
each worker is paid the value of his or her marginal contribution to the
economy’s production of goods and services.
E A R N I N G S A N D
D I S C R I M I N A T I O N
417
418 PART SIX THE ECONOMICS OF LABOR MARKETS
This theory of the labor market, though widely accepted by economists, is
only the beginning of the story. To understand the wide variation in earnings that
we observe, we must go beyond this general framework and examine more precisely
what determines the supply and demand for different types of labor. That is
our goal in this chapter.
SOME DETERMINANTS OF EQUILIBRIUM WAGES
Workers differ from one another in many ways. Jobs also have differing characteristics—
both in terms of the wage they pay and in terms of their nonmonetary attributes.
In this section we consider how the characteristics of workers and jobs
affect labor supply, labor demand, and equilibrium wages.
COMPENSATING DIFFERENTIALS
When a worker is deciding whether to take a job, the wage is only one of many job
attributes that the worker takes into account. Some jobs are easy, fun, and safe; others
are hard, dull, and dangerous. The better the job as gauged by these nonmonetary
characteristics, the more people there are who are willing to do the job at any
“On the one hand, I know I could make more money if I
left public service for the private sector, but, on the other
hand, I couldn’t chop off heads.”
CHAPTER 19 EARNINGS AND DISCRIMINATION 419
given wage. In other words, the supply of labor for easy, fun, and safe jobs is
greater than the supply of labor for hard, dull, and dangerous jobs. As a result,
“good” jobs will tend to have lower equilibrium wages than “bad” jobs.
For example, imagine you are looking for a summer job in the local beach
community. Two kinds of jobs are available. You can take a job as a beach-badge
checker, or you can take a job as a garbage collector. The beach-badge checkers
take leisurely strolls along the beach during the day and check to make sure the
tourists have bought the required beach permits. The garbage collectors wake up
before dawn to drive dirty, noisy trucks around town to pick up garbage. Which
job would you want? Most people would prefer the beach job if the wages were
the same. To induce people to become garbage collectors, the town has to offer
higher wages to garbage collectors than to beach-badge checkers.
Economists use the term compensating differential to refer to a difference in
wages that arises from nonmonetary characteristics of different jobs. Compensating
differentials are prevalent in the economy. Here are some examples:
Coal miners are paid more than other workers with similar levels of
education. Their higher wage compensates them for the dirty and dangerous
nature of coal mining, as well as the long-term health problems that coal
miners experience.
Workers who work the night shift at factories are paid more than similar
workers who work the day shift. The higher wage compensates them for
having to work at night and sleep during the day, a lifestyle that most people
find undesirable.
Professors are paid less than lawyers and doctors, who have similar amounts
of education. Professors’ lower wages compensate them for the great
intellectual and personal satisfaction that their jobs offer. (Indeed, teaching
economics is so much fun that it is surprising that economics professors get
paid anything at all!)
HUMAN CAPITAL
As we discussed in the previous chapter, the word capital usually refers to the economy’s
stock of equipment and structures. The capital stock includes the farmer’s
tractor, the manufacturer’s factory, and the teacher’s blackboard. The essence of capital
is that it is a factor of production that itself has been produced.
There is another type of capital that, while less tangible than physical capital,
is just as important to the economy’s production. Human capital is the accumulation
of investments in people. The most important type of human capital is education.
Like all forms of capital, education represents an expenditure of resources at
one point in time to raise productivity in the future. But, unlike an investment in
other forms of capital, an investment in education is tied to a specific person, and
this linkage is what makes it human capital.
Not surprisingly, workers with more human capital on average earn more
than those with less human capital. College graduates in the United States, for example,
earn about twice as much as those workers who end their education with a
high school diploma. This large difference has been documented in many countries
around the world. It tends to be even larger in less developed countries,
where educated workers are in scarce supply.
compensating dif ferential
a difference in wages that arises
to offset the nonmonetary
characteristics of different jobs
human capital
the accumulation of investments in
people, such as education and on-thejob
training
420 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY THE INCREASING VALUE OF SKILLS
“The rich get richer, and the poor get poorer.” Like many adages, this one is not
always true, but recently it has been. Many studies have documented that the
earnings gap between workers with high skills and workers with low skills has
increased over the past two decades.
Table 19-1 presents data on the average earnings of college graduates and of
high school graduates without any additional education. These data show the
increase in the financial reward from education. In 1978, a man on average
earned 66 percent more with a college degree than without one; by 1998, this
figure had risen to 118 percent. For woman, the reward for attending college
rose from a 55 percent increase in earnings to a 98 percent increase. The incentive
to stay in school is as great today as it has ever been.
Why has the gap in earnings between skilled and unskilled workers risen in
recent years? No one knows for sure, but economists have proposed two hypotheses
to explain this trend. Both hypotheses suggest that the demand for
skilled labor has risen over time relative to the demand for unskilled labor. The
shift in demand has led to a corresponding change in wages, which in turn has
led to greater inequality.
The first hypothesis is that international trade has altered the relative demand
for skilled and unskilled labor. In recent years, the amount of trade with
other countries has increased substantially. Imports into the United States have
risen from 5 percent of total U.S. production in 1970 to 13 percent in 1998. Exports
from the United States have risen from 6 percent in 1970 to 11 percent in
1998. Because unskilled labor is plentiful and cheap in many foreign countries,
It is easy to see why education raises wages from the perspective of supply
and demand. Firms—the demanders of labor—are willing to pay more for the
highly educated because highly educated workers have higher marginal products.
Workers—the suppliers of labor—are willing to pay the cost of becoming educated
only if there is a reward for doing so. In essence, the difference in wages between
highly educated workers and less educated workers may be considered a compensating
differential for the cost of becoming educated.
Table 19-1
AVERAGE ANNUAL EARNINGS BY
EDUCATIONAL ATTAINMENT.
College graduates have always
earned more than workers
without the benefit of college, but
the salary gap grew even larger
during the 1980s and 1990s.
1978 1998
MEN High school, no college $31,847 $28,742
College graduates $52,761 $62,588
Percent extra for college grads 66% 118%
WOMEN High school, no college $14,953 $17,898
College graduates $23,170 $35,431
Percent extra for college grads 55% 98%
NOTE: Earnings data are adjusted for inflation and are expressed in 1998 dollars. Data apply to workers
age 18 and over.
SOURCE: U.S. Census Bureau.
CHAPTER 19 EARNINGS AND DISCRIMINATION 421
the United States tends to import goods produced with unskilled labor and export
goods produced with skilled labor. Thus, when international trade expands,
the domestic demand for skilled labor rises, and the domestic demand
for unskilled labor falls.
The second hypothesis is that changes in technology have altered the relative
demand for skilled and unskilled labor. Consider, for instance, the introduction
of computers. Computers raise the demand for skilled workers who
can use the new machines and reduce the demand for the unskilled workers
whose jobs are replaced by the computers. For example, many companies now
rely more on computer databases, and less on filing cabinets, to keep business
records. This change raises the demand for computer programmers and reduces
the demand for filing clerks. Thus, as more firms begin to use computers, the
demand for skilled labor rises, and the demand for unskilled labor falls.
Economists have found it difficult to gauge the validity of these two hypotheses.
It is possible, of course, that both are true: Increasing international
trade and technological change may share responsibility for the increasing inequality
we have observed in recent decades.
ABILITY, EFFORT, AND CHANCE
Why do major league baseball players get paid more than minor league players?
Certainly, the higher wage is not a compensating differential. Playing in the major
leagues is not a less pleasant task than playing in the minor leagues; in fact, the opposite
is true. The major leagues do not require more years of schooling or more
experience. To a large extent, players in the major leagues earn more just because
they have greater natural ability.
Natural ability is important for workers in all occupations. Because of heredity
and upbringing, people differ in their physical and mental attributes. Some
people are strong, others weak. Some people are smart, others less so. Some people
are outgoing, others awkward in social situations. These and many other personal
characteristics determine how productive workers are and, therefore, play a
role in determining the wages they earn.
Closely related to ability is effort. Some people work hard; others are lazy. We
should not be surprised to find that those who work hard are more productive and
earn higher wages. To some extent, firms reward workers directly by paying people
on the basis of what they produce. Salespeople, for instance, are often paid as
a percentage of the sales they make. At other times, hard work is rewarded less directly
in the form of a higher annual salary or a bonus.
Chance also plays a role in determining wages. If a person attended a trade
school to learn how to repair televisions with vacuum tubes and then found this
skill made obsolete by the invention of solid-state electronics, he or she would end
up earning a low wage compared to others with similar years of training. The low
wage of this worker is due to chance—a phenomenon that economists recognize
but do not shed much light on.
How important are ability, effort, and chance in determining wages? It is hard
to say, because ability, effort, and chance are hard to measure. But indirect evidence
suggests that they are very important. When labor economists study wages,
they relate a worker’s wage to those variables that can be measured—years of
schooling, years of experience, age, and job characteristics. Although all of these
422 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY THE BENEFITS OF BEAUTY
People differ in many ways. One difference is in how attractive they are. The actor
Mel Gibson, for instance, is a handsome man. In part for this reason, his
movies attract large audiences. Not surprisingly, the large audiences mean a
large income for Mr. Gibson.
How prevalent are the economic benefits of beauty? Labor economists Daniel
Hamermesh and Jeff Biddle tried to answer this question in a study published in
the December 1994 issue of the American Economic Review. Hamermesh and Biddle
examined data from surveys of individuals in the United States and Canada.
The interviewers who conducted the survey were asked to rate each respondent’s
physical appearance. Hamermesh and Biddle then examined how much the
wages of the respondents depended on the standard determinants—education,
experience, and so on—and how much they depended on physical appearance.
Hamermesh and Biddle found that beauty pays. People who are deemed to
be more attractive than average earn 5 percent more than people of average
looks. People of average looks earn 5 to 10 percent more than people considered
less attractive than average. Similar results were found for men and women.
What explains these differences in wages? There are several ways to interpret
the “beauty premium.”
One interpretation is that good looks are themselves a type of innate ability
determining productivity and wages. Some people are born with the attributes
of a movie star; other people are not. Good looks are useful in any job in which
workers present themselves to the public—such as acting, sales, and waiting on
tables. In this case, an attractive worker is more valuable to the firm than an unattractive
worker. The firm’s willingness to pay more to attractive workers reflects
its customers’ preferences.
A second interpretation is that reported beauty is an indirect measure of
other types of ability. How attractive a person appears depends on more than
just heredity. It also depends on dress, hairstyle, personal demeanor, and other
attributes that a person can control. Perhaps a person who successfully projects
an attractive image in a survey interview is more likely to be an intelligent person
who succeeds at other tasks as well.
A third interpretation is that the beauty premium is a type of discrimination,
a topic to which we return later.
measured variables affect a worker’s wage as theory predicts, they account for less
than half of the variation in wages in our economy. Because so much of the variation
in wages is left unexplained, omitted variables, including ability, effort, and
chance, must play an important role.
GOOD LOOKS PAY.
AN ALTERNATIVE VIEW OF EDUCATION: SIGNALING
Earlier we discussed the human-capital view of education, according to which
schooling raises workers’ wages because it makes them more productive. Although
this view is widely accepted, some economists have proposed an alternative
theory, which emphasizes that firms use educational attainment as a way of
sorting between high-ability and low-ability workers. According to this alternative
CHAPTER 19 EARNINGS AND DISCRIMINATION 423
CASE STUDY HUMAN CAPITAL, NATURAL ABILITY, AND
COMPULSORY SCHOOL ATTENDANCE
Does attending school increase wages because it increases productivity, or does
it only appear to increase productivity because high-ability people are more
likely to stay in school? This question is important both for judging the various
theories of education and for evaluating alternative education policies.
If economists could conduct controlled experiments like laboratory scientists,
it would be easy to answer this question. We could choose some experimental
subjects from the school-age population and then randomly divide them
into various groups. For each group we could require a different amount of
school attendance. By comparing the difference in the educational attainment
and the difference in subsequent wages of the various groups, we could see
whether education does in fact increase productivity. Because the groups would
be chosen randomly, we could be sure that the difference in wages was not attributable
to a difference in natural ability.
Although conducting such an experiment might seem difficult, the laws of
the United States inadvertently provide a natural experiment that is quite similar.
All students in the United States are required by law to attend school, but
the laws vary from state to state. Some states allow students to drop out at age
view, when people earn a college degree, for instance, they do not become more
productive, but they do signal their high ability to prospective employers. Because
it is easier for high-ability people to earn a college degree than it is for low-ability
people, more high-ability people get college degrees. As a result, it is rational for
firms to interpret a college degree as a signal of ability.
The signaling theory of education is similar to the signaling theory of advertising
discussed in Chapter 17. In the signaling theory of advertising, the advertisement
itself contains no real information, but the firm signals the quality of its
product to consumers by its willingness to spend money on advertising. In the
signaling theory of education, schooling has no real productivity benefit, but the
worker signals his innate productivity to employers by his willingness to spend
years at school. In both cases, an action is being taken not for its intrinsic benefit
but because the willingness to take that action conveys private information to
someone observing it.
Thus, we now have two views of education: the human-capital theory and the
signaling theory. Both views can explain why more educated workers tend to earn
more than less educated workers. According to the human-capital view, education
makes workers more productive; according to the signaling view, education is correlated
with natural ability. But the two views have radically different predictions
for the effects of policies that aim to increase educational attainment. According to
the human-capital view, increasing educational levels for all workers would raise
all workers’ productivity and thereby their wages. According to the signaling
view, education does not enhance productivity, so raising all workers’ educational
levels would not affect wages.
Most likely, truth lies somewhere between these two extremes. The benefits to
education are probably a combination of the productivity-enhancing effects of human
capital and the productivity-revealing effects of signaling. The open question
is the relative size of these two effects.
424 PART SIX THE ECONOMICS OF LABOR MARKETS
16, while others require attendance until age 17 or 18. Moreover, the laws have
changed over time. Between 1970 and 1980, for instance, Wyoming reduced the
school-attendance age from 17 to 16, while Washington raised it from 16 to 18.
This variation across states and over time provides data with which to study the
effects of compulsory school attendance.
Even within a state, school-attendance laws have different effects on different
people. Students start attending school at different ages, depending on the
month of the year in which they were born. Yet all students can drop out as
soon as they reach the minimum legal age; they are not required to finish out
the school year. As a result, those who start school at a relatively young age are
required to spend more time in school than those who start school at a relatively
old age. This variation across students within a state also provides a way to
study the effects of compulsory attendance.
In an article published in the November 1991 issue of the Quarterly Journal of
Economics, labor economists Joshua Angrist and Alan Krueger used this natural
experiment to study the relationship between schooling and wages. Because the
duration of each student’s compulsory schooling depends on his or her state of
residence and month of birth, and not on natural ability, it was possible to isolate
the productivity-enhancing effect of education from the ability-signaling effect.
According to Angrist and Krueger’s research, those students who were required
to finish more school did earn significantly higher subsequent wages than those
with lower requirements. This finding indicates that education does raise a
worker’s productivity, as the human-capital theory suggests.
Although establishing the benefits of compulsory schooling is useful, it does
not by itself tell us whether these laws are desirable. That policy judgment requires
a more complete analysis of the costs and benefits. At the very least, we
would need to compare the benefits of schooling to the opportunity cost—the
wages that the student could have earned by dropping out. In addition, requiring
a student to stay in school may have external effects on others in society. On
the one hand, compulsory school attendance may reduce crime rates, for young
dropouts are at high risk of engaging in criminal activity. On the other hand, students
who stay in school only because they are required to do so may interfere
with the learning of other students who are more committed to their educations.
THE SUPERSTAR PHENOMENON
Although most actors earn very little and often have to take jobs as waiters to
support themselves, actor Robin Williams earned $23 million in 1997. Similarly,
although most people who play football do it for free as a hobby, Brett Favre earned
$6.75 million as a pro quarterback. Robin Williams and Brett Favre are superstars in
their fields, and their great public appeal is reflected in astronomical incomes.
Why do Robin Williams and Brett Favre earn so much? It is not surprising that
there are differences in incomes within occupations. Good carpenters earn more
than mediocre carpenters, and good plumbers earn more than mediocre plumbers.
People vary in ability and effort, and these differences lead to differences in income.
Yet the best carpenters and plumbers do not earn the many millions that are
common among the best actors and athletes. What explains the difference?
To understand the tremendous incomes of Robin Williams and Brett Favre, we
must examine the special features of the markets in which they sell their services.
Superstars arise in markets that have two characteristics:
CHAPTER 19 EARNINGS AND DISCRIMINATION 425
Every customer in the market wants to enjoy the good supplied by the best
producer.
The good is produced with a technology that makes it possible for the best
producer to supply every customer at low cost.
If Robin Williams is the funniest actor around, then everyone will want to see his
next movie; seeing twice as many movies by an actor half as funny is not a good
substitute. Moreover, it is possible for everyone to enjoy the comedy of Robin
Williams. Because it is easy to make multiple copies of a film, Robin Williams can
provide his service to millions of people simultaneously. Similarly, because football
games are broadcast on television, millions of fans can enjoy the extraordinary
athletic skills of Brett Favre.
We can now see why there are no superstar carpenters and plumbers. Other
things equal, everyone prefers to employ the best carpenter, but a carpenter, unlike
a movie actor, can provide his services to only a limited number of customers. Although
the best carpenter will be able to command a somewhat higher wage than
the average carpenter, the average carpenter will still be able to earn a good living.
ABOVE-EQUILIBRIUM WAGES:
MINIMUM-WAGE LAWS, UNIONS, AND EFFICIENCY WAGES
Most analyses of wage differences among workers are based on the equilibrium
model of the labor market—that is, wages are assumed to adjust to balance labor
supply and labor demand. But this assumption does not always apply. For some
workers, wages are set above the level that brings supply and demand into equilibrium.
Let’s consider three reasons why this might be so.
One reason for above-equilibrium wages is minimum-wage laws, as we first
saw in Chapter 6. Most workers in the economy are not affected by these laws because
their equilibrium wages are well above the legal minimum. But for some
workers, especially the least skilled and experienced, minimum-wage laws raise
wages above the level they would earn in an unregulated labor market.
A second reason that wages might rise above their equilibrium level is the
market power of labor unions. A union is a worker association that bargains with
employers over wages and working conditions. Unions often raise wages above
the level that would prevail without a union, perhaps because they can threaten to
withhold labor from the firm by calling a strike. Studies suggest that union workers
earn about 10 to 20 percent more than similar nonunion workers.
Athird reason for above-equilibrium wages is suggested by the theory of efficiency
wages. This theory holds that a firm can find it profitable to pay high wages
because doing so increases the productivity of its workers. In particular, high
wages may reduce worker turnover, increase worker effort, and raise the quality
of workers who apply for jobs at the firm. If this theory is correct, then some firms
may choose to pay their workers more than they would normally earn.
Above-equilibrium wages, whether caused by minimum-wage laws, unions,
or efficiency wages, have similar effects on the labor market. In particular, pushing
a wage above the equilibrium level raises the quantity of labor supplied and reduces
the quantity of labor demanded. The result is a surplus of labor, or unemployment.
The study of unemployment and the public policies aimed to deal with
it is usually considered a topic within macroeconomics, so it goes beyond the
scope of this chapter. But it would be a mistake to ignore these issues completely
union
a worker association that bargains
with employers over wages and
working conditions
strike
the organized withdrawal of labor
from a firm by a union
ef ficiency wages
above-equilibrium wages paid by
firms in order to increase worker
productivity
426 PART SIX THE ECONOMICS OF LABOR MARKETS
when analyzing earnings. Although most wage differences can be understood
while maintaining the assumption of equilibrium in the labor market, aboveequilibrium
wages play a role in some cases.
QUICK QUIZ: Define compensating differential and give an example.
Give two reasons why more educated workers earn more than less
educated workers.
THE ECONOMICS OF DISCRIMINATION
Another source of differences in wages is discrimination. Discrimination occurs
when the marketplace offers different opportunities to similar individuals who
differ only by race, ethnic group, sex, age, or other personal characteristics. Discrimination
reflects some people’s prejudice against certain groups in society. Although
discrimination is an emotionally charged topic that often generates heated
debate, economists try to study the topic objectively in order to separate myth
from reality.
MEASURING LABOR-MARKET DISCRIMINATION
How much does discrimination in labor markets affect the earnings of different
groups of workers? This question is important, but answering it is not easy.
It might seem natural to gauge the amount of discrimination in labor markets
by looking at the average wages of different groups. For instance, in recent years
the wage of the average black worker in the United States has been about 20 percent
less than the wage of the average white worker. The wage of the average female
worker has been about 30 percent less than the wage of the average male
worker. These wage differentials are sometimes presented in political debate as evidence
that many employers discriminate against blacks and women.
Yet there is an obvious problem with this approach. Even in a labor market free
of discrimination, different people have different wages. People differ in the
amount of human capital they have and in the kinds of work they are able and willing
to do. The wage differences we observe in the economy are, to a large extent, attributable
to the determinants of equilibrium wages we discussed in the preceding
section. Simply observing differences in wages among broad groups—whites and
blacks, men and women—says little about the prevalence of discrimination.
Consider, for example, the role of human capital. About 80 percent of white
male workers have a high school diploma, and 25 percent have a college degree.
By contrast, only 67 percent of black male workers have a high school diploma,
and only 12 percent have a college degree. Thus, at least some of the difference between
the wages of whites and the wages of blacks can be traced to differences in
educational attainment. Similarly, among white workers, 25 percent of men have a
college degree, whereas only 19 percent of women have a college degree, indicating
that some of the difference between the wages of men and women is attributable
to educational attainment.
discrimination
the offering of different opportunities
to similar individuals who differ only
by race, ethnic group, sex, age, or
other personal characteristics
CHAPTER 19 EARNINGS AND DISCRIMINATION 427
In fact, human capital is probably even more important in explaining wage
differentials than the foregoing numbers suggest. For many years, public schools
in predominantly black areas have been of lower quality—as measured by expenditure,
class size, and so on—than public schools in predominantly white areas.
Similarly, for many years, schools directed girls away from science and math
courses, even though these subjects may have had greater value in the marketplace
than some of the alternatives. If we could measure the quality as well as the
quantity of education, the differences in human capital among these groups would
seem even larger.
Human capital acquired in the form of job experience can also help explain
wage differences. In particular, women tend to have less job experience on average
than men. One reason is that female labor-force participation has increased over the
past several decades. Because of this historic change, the average female worker today
is younger than the average male worker. In addition, women are more likely
to interrupt their careers to raise children. For both reasons, the experience of the
average female worker is less than the experience of the average male worker.
Yet another source of wage differences is compensating differentials. Some analysts
have suggested that women take more pleasant jobs on average than men
and that this fact explains some of the earnings differential between men and
women. For example, women are more likely to be secretaries, and men are more
likely to be truck drivers. The relative wages of secretaries and truck drivers depend
in part on the working conditions of each job. Because these nonmonetary aspects
are hard to measure, it is difficult to gauge the practical importance of
compensating differentials in explaining the wage differences that we observe.
In the end, the study of wage differences among groups does not establish any
clear conclusion about the prevalence of discrimination in U.S. labor markets.
Most economists believe that some of the observed wage differentials are attributable
to discrimination, but there is no consensus about how much. The only conclusion
about which economists are in consensus is a negative one: Because the
differences in average wages among groups in part reflect differences in human capital and
job characteristics, they do not by themselves say anything about how much discrimination
there is in the labor market.
Of course, differences in human capital among groups of workers may themselves
reflect discrimination. The inferior schools historically available to black
students, for instance, may be traced to prejudice on the part of city councils and
school boards. But this kind of discrimination occurs long before the worker enters
the labor market. In this case, the disease is political, even if the symptom is
economic.
DISCRIMINATION BY EMPLOYERS
Let’s now turn from measurement to the economic forces that lie behind discrimination
in labor markets. If one group in society receives a lower wage than another
group, even after controlling for human capital and job characteristics, who is to
blame for this differential?
The answer is not obvious. It might seem natural to blame employers for discriminatory
wage differences. After all, employers make the hiring decisions that determine
labor demand and wages. If some groups of workers earn lower wages than
they should, then it seems that employers are responsible. Yet many economists are
428 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY SEGREGATED STREETCARS AND
THE PROFIT MOTIVE
In the early twentieth century, streetcars in many southern cities were segregated
by race. White passengers sat in the front of the streetcars, and black passengers
sat in the back. What do you suppose caused and maintained this
discriminatory practice? And how was this practice viewed by the firms that
ran the streetcars?
In a 1986 article in the Journal of Economic History, economic historian Jennifer
Roback looked at these questions. Roback found that the segregation of
races on streetcars was the result of laws that required such segregation. Before
these laws were passed, racial discrimination in seating was rare. It was far
more common to segregate smokers and nonsmokers.
Moreover, the firms that ran the streetcars often opposed the laws requiring
racial segregation. Providing separate seating for different races raised the
firms’ costs and reduced their profit. One railroad company manager complained
to the city council that, under the segregation laws, “the company has
to haul around a good deal of empty space.”
Here is how Roback describes the situation in one southern city:
The railroad company did not initiate the segregation policy and was not at
all eager to abide by it. State legislation, public agitation, and a threat to
arrest the president of the railroad were all required to induce them to
separate the races on their cars. . . . There is no indication that the
management was motivated by belief in civil rights or racial equality. The
evidence indicates their primary motives were economic; separation was
skeptical of this easy answer. They believe that competitive, market economies provide
a natural antidote to employer discrimination. That antidote is called the profit
motive.
Imagine an economy in which workers are differentiated by their hair color.
Blondes and brunettes have the same skills, experience, and work ethic. Yet, because
of discrimination, employers prefer not to hire workers with blonde hair.
Thus, the demand for blondes is lower than it otherwise would be. As a result,
blondes earn a lower wage than brunettes.
How long can this wage differential persist? In this economy, there is an easy
way for a firm to beat out its competitors: It can hire blonde workers. By hiring
blondes, a firm pays lower wages and thus has lower costs than firms that hire
brunettes. Over time, more and more “blonde” firms enter the market to take advantage
of this cost advantage. The existing “brunette” firms have higher costs
and, therefore, begin to lose money when faced with the new competitors. These
losses induce the brunette firms to go out of business. Eventually, the entry of
blonde firms and the exit of brunette firms cause the demand for blonde workers
to rise and the demand for brunette workers to fall. This process continues until
the wage differential disappears.
Put simply, business owners who care only about making money are at an advantage
when competing against those who also care about discriminating. As a
result, firms that do not discriminate tend to replace those that do. In this way,
competitive markets have a natural remedy for employer discrimination.
CHAPTER 19 EARNINGS AND DISCRIMINATION 429
costly. . . . Officials of the company may or may not have disliked blacks,
but they were not willing to forgo the profits necessary to indulge such
prejudice.
The story of southern streetcars illustrates a general lesson: Business owners are
usually more interested in making profit than in discriminating against a particular
group. When firms engage in discriminatory practices, the ultimate
source of the discrimination often lies not with the firms themselves but elsewhere.
In this particular case, the streetcar companies segregated whites and
blacks because discriminatory laws, which the companies opposed, required
them to do so.
DISCRIMINATION BY CUSTOMERS AND GOVERNMENTS
Although the profit motive is a strong force acting to eliminate discriminatory
wage differentials, there are limits to its corrective abilities. Here we consider two
of the most important limits: customer preferences and government policies.
To see how customer preferences for discrimination can affect wages, consider
again our imaginary economy with blondes and brunettes. Suppose that restaurant
owners discriminate against blondes when hiring waiters. As a result, blonde
waiters earn lower wages than brunette waiters. In this case, a restaurant could
open up with blonde waiters and charge lower prices. If customers only cared
about the quality and price of their meals, the discriminatory firms would be driven
out of business, and the wage differential would disappear.
On the other hand, it is possible that customers prefer being served by brunette
waiters. If this preference for discrimination is strong, the entry of blonde restaurants
need not succeed in eliminating the wage differential between brunettes and
blondes. That is, if customers have discriminatory preferences, a competitive market
is consistent with a discriminatory wage differential. An economy with such
discrimination would contain two types of restaurants. Blonde restaurants hire
blondes, have lower costs, and charge lower prices. Brunette restaurants hire
brunettes, have higher costs, and charge higher prices. Customers who did not care
about the hair color of their waiters would be attracted to the lower prices at the
blonde restaurants. Bigoted customers would go to the brunette restaurants. They
would pay for their discriminatory preference in the form of higher prices.
Another way for discrimination to persist in competitive markets is for the
government to mandate discriminatory practices. If, for instance, the government
passed a law stating that blondes could wash dishes in restaurants but could not
work as waiters, then a wage differential could persist in a competitive market.
The example of segregated streetcars in the foregoing case study is one example of
government-mandated discrimination. More recently, before South Africa abandoned
its system of apartheid, blacks were prohibited from working in some jobs.
Discriminatory governments pass such laws to suppress the normal equalizing
force of free and competitive markets.
To sum up: Competitive markets contain a natural remedy for employer discrimination.
The entry of firms that care only about profit tends to eliminate discriminatory wage
differentials. These wage differentials persist in competitive markets only when customers
are willing to pay to maintain the discriminatory practice or when the government mandates
it.
430 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY DISCRIMINATION IN SPORTS
As we have seen, measuring discrimination is often difficult. To determine
whether one group of workers is discriminated against, a researcher must correct
for differences in the productivity between that group and other workers in
the economy. Yet, in most firms, it is difficult to measure a particular worker’s
contribution to the production of goods and services.
One type of firm in which such corrections are easier is the sports team. Professional
teams have many objective measures of productivity. In baseball, for
instance, we can measure a player’s batting average, the frequency of home
runs, the number of stolen bases, and so on.
Studies of sports teams suggest that racial discrimination is, in fact, common
and that much of the blame lies with customers. One study, published in the Journal
of Labor Economics in 1988, examined the salaries of basketball players. It found
that black players earned 20 percent less than white players of comparable ability.
The study also found that attendance at basketball games was larger for teams
WHY DOES THE AVERAGE FEMALE WORKER
earn less than the average male
worker? In the following article, economist
June O’Neill offers some answers
to this question.
T h e S h r i n k i n g P a y G a p
BY JUNE ELLENOFF O’NEILL
“Fifty-nine cents,” the popular button
said, a symbol of the stubborn fact that
throughout the post–World War II period,
women’s wages hovered at around 60
percent of men’s, despite an increasing
proportion of women working outside
the home. This gender gap did not decline
through the 1960s and the 1970s
despite the rise of the feminist movement,
equal pay and employment legislation,
and affirmative action.
But starting in the Reagan years, the
gender gap in wages began to decline
dramatically. By some measures the ratio
of women’s earnings to men’s rose to
nearly 80 percent; and even this number,
I believe, overstates the gender gap between
men and women with similar skills
and training. Why did this dramatic narrowing
in relative wages happen?
The answer has less to do with politics
or protests than with the realities of
the labor market. Although basic skills
are acquired in school, it is in the labor
market where specialized skills are developed
that bring higher wages. During
the three decades following World War II
women entered the labor market in
record numbers. But many of the new
entrants had been out of the labor force
for considerable periods of time, raising
their children. These women diluted the
skill level of the rapidly expanding group
of employed women. This was the main
reason why the gender gap in pay did
not narrow during the postwar years.
Today’s working women, particularly
those younger than forty, are much more
nearly equal to men in work experience
than were their mothers. Through delayed
marriage, low fertility, and an increasing
tendency for mothers of young children to
work, women have acquired many more
years of continuous work experience than
was true in the past. (Close to 60 percent
of married women with children under age
six are now in the labor force; in 1960, the
proportion was only 19 percent.)
And the work experience gained by
these younger women is likely to have an
even greater impact on their future earnings
because their work experience has
been more correctly anticipated. Many investment
choices affecting careers are
made at younger ages: years of schooling,
subjects in school, other professional
training. In the past, women were much
less likely than men to invest in lengthy
training because they assumed they
would not be working enough years to
justify it.
In fact, the National Longitudinal
Surveys found that even in the late
1960s less than 30 percent of young
IN THE NEWS
Men, Women, and Wages
CHAPTER 19 EARNINGS AND DISCRIMINATION 431
with a greater proportion of white players. One interpretation of these facts is that
customer discrimination makes black players less profitable than white players
for team owners. In the presence of such customer discrimination, a discriminatory
wage gap can persist, even if team owners care only about profit.
A similar situation once existed for baseball players. A study using data
from the late 1960s showed that black players earned less than comparable
white players. Moreover, fewer fans attended games pitched by blacks than
games pitched by whites, even though black pitchers had better records than
white pitchers. Studies of more recent salaries in baseball, however, have found
no evidence of discriminatory wage differentials.
Another study, published in the Quarterly Journal of Economics in 1990, examined
the market prices of old baseball cards. This study found similar evidence
of discrimination. The cards of black hitters sold for 10 percent less than
the cards of comparable white hitters. The cards of black pitchers sold for 13
percent less than the cards of comparable white pitchers. These results suggest
customer discrimination among baseball fans.
women anticipated that they would be
working at age thirty-five, yet when this
group actually reached thirty-five, more
than 70 percent of them were in the labor
force. Their underestimation of future
work activity surely influenced their early
career preparations (or lack thereof).
More recent survey data show a dramatic
change in expectations. The vast
majority of young women now report an
intention to work at age thirty-five.
Those changing work expectations
are reflected in rising female enrollments
in higher education. In 1960, women received
35 percent of all bachelor’s degrees
in the U.S.; by the 1980s, they
received somewhat more than half of
them. In 1968, women received 8 percent
of the medical degrees, 3 percent
of the MBAs, and 4 percent of the law
degrees granted that year. In 1986, they
received 31 percent of the medical degrees
and MBAs and 39 percent of the
law degrees. This recent trend in schooling
is likely to reinforce the rise in work
experience and contribute to continuing
increases in the relative earnings of
women workers. . . .
Despite the advances of the past
decade, women still earn less than men.
The hourly earnings of women were 74
percent of the earnings of men in 1992
when ages twenty-five to sixty-four are
considered, up from 62 percent in 1979.
At ages twenty-five to thirty-four, where
women’s skills have increased the most,
the ratio is 87 percent.
Economist Barbara Bergmann and
others attribute the pay gap to “widespread,
severe, ongoing discrimination by
employers and fellow workers.” But discrimination
cannot be directly measured.
Instead, researchers estimate the extent
to which differences in productivity appear
to explain the gap and then attribute
the rest to discrimination. Such a conclusion
is premature, however, when productivity
differences are not accurately
measured, which is usually the case.
For example, data are seldom available
on lifetime patterns of work experience,
and even less material is available
on factors bearing on work expectations
and the intensity and nature of work investments.
As these are still the key
sources of skill differences between men
and women, there is considerable room
for interpretation and disagreement.
When earnings comparisons are restricted
to men and women more similar
in their experience and life situations, the
measured earnings differentials are typically
quite small. For example, among
people twenty-seven to thirty-three who
have never had a child, the earnings of
women in the National Longitudinal Survey
of Youth are close to 98 percent of
men’s. . . .
It is true that women and men still do
not have the same earnings. But I believe
that the differential is largely due to continuing
gender differences in the priority
placed on market work vs. family responsibilities.
Until family roles are more equal,
women are not likely to have the same
pattern of market work and earnings as
men. Technology has reduced the burden
of housework, but child care remains a
responsibility that is harder to shift to the
market.
SOURCE: The Wall Street Journal, October 7, 1994,
p. A10.
432 PART SIX THE ECONOMICS OF LABOR MARKETS
THE DEBATE OVER COMPARABLE WORTH
Should engineers get paid more than librarians? This question is at the heart of the
debate over comparable worth, a doctrine whereby jobs deemed comparable should
be paid the same wage.
Advocates of comparable worth point out that traditionally male occupations
have higher wages than traditionally female occupations. They believe that these occupational
differences are discriminatory against women. Even if women were paid
the same as men for the same type of work, the gender gap in wages would persist
until comparable occupations were paid similar wages. Comparable-worth advocates
want jobs rated according to a set of impartial criteria—education, experience,
responsibility, working conditions, and so on. Under this system, comparably rated
jobs would pay the same wage. A librarian with a master’s degree, ten years of experience,
and a 40-hour workweek, for instance, would be paid the same as an engineer
with a master’s degree, ten years of experience, and a 40-hour workweek.
Most economists are critical of comparable-worth proposals. They argue that
a competitive market is the best mechanism for setting wages. It would be nearly
impossible, they claim, to measure all of the factors that are relevant for determining
the right wage for any job. Moreover, the fact that traditionally female occupations
pay less than traditionally male occupations is not by itself evidence of
discrimination. Women have in the past spent more time than men raising children.
Women are, therefore, more likely to choose occupations that offer flexible
hours and other working conditions compatible with child-rearing. To some extent,
the gender gap in wages is a compensating differential.
Economists also point out that comparable-worth proposals would have an
important unintended side effect. Comparable-worth advocates want the wages in
traditionally female occupations to be raised by legal decree. Such a policy would
have many of the effects of a minimum wage, which we first discussed in Chapter
6. In particular, when the wage is forced to rise above the equilibrium level, the
quantity of labor supplied to these occupations would rise, and the quantity demanded
would fall. The result would be higher unemployment in traditionally female
occupations. In this way, a comparable-worth law could adversely affect
some members of groups that the policy is aimed at helping.
QUICK QUIZ: Why is it hard to establish whether a group of workers is
being discriminated against? Explain how profit-maximizing firms tend to
eliminate discriminatory wage differentials. How might a discriminatory
wage differential persist?
CONCLUSION
In competitive markets, workers earn a wage equal to the value of their marginal
contribution to the production of goods and services. There are, however, many
things that affect the value of the marginal product. Firms pay more for workers
who are more talented, more diligent, more experienced, and more educated because
these workers are more productive. Firms pay less to those workers against
whom customers discriminate because these workers contribute less to revenue.
comparable wor th
a doctrine according to which jobs
deemed comparable should be paid
the same wage
CHAPTER 19 EARNINGS AND DISCRIMINATION 433
The theory of the labor market we have developed in the last two chapters explains
why some workers earn higher wages than other workers. The theory does
not say that the resulting distribution of income is equal, fair, or desirable in any
way. That is the topic we take up in Chapter 20.
OVER THE PAST SEVERAL YEARS, THE IDEA OF
comparable worth—sometimes called
pay equity—has made a comeback
among some political leaders.
Labor and Wo m e n P u s h f o r E q u a l
P a y f o r E q u i v a l e n t Wo r k
BY MARY LEONARD
WASHINGTON—Nobody says men and
women shouldn’t get equal pay for doing
the same job. But what’s brewing now is
a big push nationally by the president,
organized labor, and women’s rights
groups to level the gender playing field
on wages for different but equivalent
work.
In a strategy session today, Senator
Tom Harkin, an Iowa Democrat who has
been the lonely champion for pay-equity
legislation since 1996, will meet with John
Podesta, the president’s chief of staff,
and other officials on ways the White
House can boost his bill this year. Yesterday,
the AFL-CIO launched a nationwide
campaign to pass comparable-worth bills
in 24 states, including Massachusetts.
What’s going on here? Trying to determine
comparable salaries for jobs traditionally
held by men and women is an
old idea, discredited by some economists
as unwieldy, if not downright dumb. They
wonder who can and will decide the economic
value of a riveter versus a nurse,
the comparable pay for a probation officer
and a librarian, the equivalent pay for
an auto mechanic and a secretary.
Many see pay equity, even if it is difficult
to enforce, as the only remedy for
wage discrimination, a problem that persists
for women, even as they have
earned advanced degrees, climbed the
corporate ladder, and plopped their children
in day care while pursuing full-time
jobs in large numbers. . . .
“For too long, working women have
been seething while politicians have remained
silent,” said Karen Nussbaum,
director of the AFL-CIO’s Working
Women’s department. “Pay equity can
right a long-standing wrong.” . . .
Diana Furchtgott-Roth, a resident fellow
at the American Enterprise Institute,
says there are plenty of reasons why men
and women earn different wages—seniority,
job risk, and market demand for certain
skills—that have nothing to do with
discrimination and would not be erased by
“cockeyed” pay-equity laws. She said
when you compare men and women with
the same qualifications doing the same
jobs, women earn 95 percent of men’s
salaries.
“Comparable worth is certainly making
a comeback,” Furchtgott-Roth said,
“and I believe it’s because feminists who
supported Clinton through the Lewinsky
mess are demanding a political payoff. I
don’t see any Republican support for
these proposals.”
SOURCE: The Boston Globe, February 25, 1999, pp.
A1, A22.
IN THE NEWS
The Recent Push for
Comparable Worth
Workers earn different wages for many reasons. To
some extent, wage differentials compensate workers for
job attributes. Other things equal, workers in hard,
unpleasant jobs get paid more than workers in easy,
pleasant jobs.
Workers with more human capital get paid more than
workers with less human capital. The return to
accumulating human capital is high and has increased
over the past decade.
Although years of education, experience, and job
characteristics affect earnings as theory predicts,
there is much variation in earnings that cannot
be explained by things that economists can
measure. The unexplained variation in earnings is
Summary
434 PART SIX THE ECONOMICS OF LABOR MARKETS
largely attributable to natural ability, effort, and
chance.
Some economists have suggested that more educated
workers earn higher wages not because education raises
productivity but because workers with high natural
ability use education as a way to signal their high ability
to employers. If this signaling theory were correct, then
increasing the educational attainment of all workers
would not raise the overall level of wages.
Wages are sometimes pushed above the level that brings
supply and demand into balance. Three reason for
above-equilibrium wages are minimum-wage laws,
unions, and efficiency wages.
Some differences in earnings are attributable to
discrimination on the basis of race, sex, or other factors.
Measuring the amount of discrimination is difficult,
however, because one must correct for differences in
human capital and job characteristics.
Competitive markets tend to limit the impact of
discrimination on wages. If the wages of a group of
workers are lower than those of another group for
reasons not related to marginal productivity, then
nondiscriminatory firms will be more profitable than
discriminatory firms. Profit-maximizing behavior,
therefore, can act to reduce discriminatory wage
differentials. Discrimination can persist in competitive
markets if customers are willing to pay more to
discriminatory firms or if the government passes laws
requiring firms to discriminate.
compensating differential, p. 419
human capital, p. 419
union, p. 425
strike, p. 425
efficiency wages, p. 425
discrimination, p. 426
comparable worth, p. 432
Key Concepts
1. Why do coal miners get paid more than other workers
with similar amounts of education?
2. In what sense is education a type of capital?
3. How might education raise a worker’s wage without
raising the worker’s productivity?
4. What conditions lead to economic superstars? Would you
expect to see superstars in dentistry? In music? Explain.
5. Give three reasons why a worker’s wage might be
above the level that balances supply and demand.
6. What difficulties arise in deciding whether a group
of workers has a lower wage because of
discrimination?
7. Do the forces of economic competition tend to
exacerbate or ameliorate discrimination on the basis of
race?
8. Give an example of how discrimination might persist in
a competitive market.
Questions for Review
1. College students sometimes work as summer interns for
private firms or the government. Many of these
positions pay little or nothing.
a. What is the opportunity cost of taking such a job?
b. Explain why students are willing to take these jobs.
c. If you were to compare the earnings later in life of
workers who had worked as interns and those who
had taken summer jobs that paid more, what would
you expect to find?
2. As explained in Chapter 6, a minimum-wage law
distorts the market for low-wage labor. To reduce this
distortion, some economists advocate a two-tiered
minimum-wage system, with a regular minimum wage
for adult workers and a lower, “sub-minimum” wage
Problems and Applications
CHAPTER 19 EARNINGS AND DISCRIMINATION 435
for teenage workers. Give two reasons why a single
minimum wage might distort the labor market for
teenage workers more than it would the market for
adult workers.
3. A basic finding of labor economics is that workers who
have more experience in the labor force are paid more
than workers who have less experience (holding
constant the amount of formal education). Why might
this be so? Some studies have also found that experience
at the same job (called “job tenure”) has an extra
positive influence on wages. Explain.
4. At some colleges and universities, economics professors
receive higher salaries than professors in some other
fields.
a. Why might this be true?
b. Some other colleges and universities have a policy
of paying equal salaries to professors in all fields.
At some of these schools, economics professors
have lighter teaching loads than professors in some
other fields. What role do the differences in
teaching loads play?
5. Sara works for Steve, whom she hates because of his
snobbish attitude. Yet when she looks for other jobs, the
best she can do is find a job paying $10,000 less than her
current salary. Should she take the job? Analyze Sara’s
situation from an economic point of view.
6. Imagine that someone were to offer you a choice: You
could spend four years studying at the world’s best
university, but you would have to keep your attendance
there a secret. Or you could be awarded an official
degree from the world’s best university, but you
couldn’t actually attend. Which choice do you think
would enhance your future earnings more? What does
your answer say about the debate over signaling versus
human capital in the role of education?
7. When recording devices were first invented almost 100
years ago, musicians could suddenly supply their music
to large audiences at low cost. How do you suppose this
event affected the income of the best musicians? How
do you suppose it affected the income of average
musicians?
8. Alan runs an economic consulting firm. He hires
primarily female economists because, he says, “they will
work for less than comparable men because women
have fewer job options.” Is Alan’s behavior admirable or
despicable? If more employers were like Alan, what
would happen to the wage differential between men
and women?
9. A case study in this chapter described how customer
discrimination in sports seems to have an important
effect on players’ earnings. Note that this is possible
because sports fans know the players’ characteristics,
including their race. Why is this knowledge important
for the existence of discrimination? Give some specific
examples of industries where customer discrimination is
and is not likely to influence wages.
10. Suppose that all young women were channeled into
careers as secretaries, nurses, and teachers; at the same
time, young men were encouraged to consider these
three careers and many others as well.
a. Draw a diagram showing the combined labor
market for secretaries, nurses, and teachers. Draw a
diagram showing the combined labor market for all
other fields. In which market is the wage higher?
Do men or women receive higher wages on
average?
b. Now suppose that society changed and encouraged
both young women and young men to consider a
wide range of careers. Over time, what effect would
this change have on the wages in the two markets
you illustrated in part (a)? What effect would the
change have on the average wages of men and
women?
11. Economist June O’Neill argues that “until family roles
are more equal, women are not likely to have the same
pattern of market work and earnings as men.” What
does she mean by the “pattern” of market work? How
do these characteristics of jobs and careers affect
earnings?
12. This chapter considers the economics of discrimination
by employers, customers, and governments. Now
consider discrimination by workers. Suppose that some
brunette workers did not like working with blonde
workers. Do you think this worker discrimination could
explain lower wages for blonde workers? If such a wage
differential existed, what would a profit-maximizing
entrepreneur do? If there were many such
entrepreneurs, what would happen over time?

IN THIS CHAPTER
YOU WILL . . .
See how political
philosophers view
the government’s
role in
r edistributing
income
Examine the degree
of economic
inequality in our
society
Consider some
problems that arise
when measuring
economic inequality
Consider the
various policies
aimed at helping
poor families
escape pover ty
“The only difference between the rich and other people,” Mary Colum once said to
Ernest Hemingway, “is that the rich have more money.” Maybe so. But this claim
leaves many questions unanswered. The gap between rich and poor is a fascinating
and important topic of study—for the comfortable rich, for the struggling poor,
and for the aspiring and worried middle class.
From the previous two chapters you should have some understanding about
why different people have different incomes. A person’s earnings depend on the
supply and demand for that person’s labor, which in turn depend on natural ability,
human capital, compensating differentials, discrimination, and so on. Because
labor earnings make up about three-fourths of the total income in the U.S. economy,
the factors that determine wages are also largely responsible for determining
how the economy’s total income is distributed among the various members of society.
In other words, they determine who is rich and who is poor.
I N C O M E I N E Q U A L I T Y
A N D P O V E R T Y
437
438 PART SIX THE ECONOMICS OF LABOR MARKETS
In this chapter we discuss the distribution of income. As we shall see, this
topic raises some fundamental questions about the role of economic policy. One of
the Ten Principles of Economics in Chapter 1 is that governments can sometimes improve
market outcomes. This possibility is particularly important when considering
the distribution of income. The invisible hand of the marketplace acts to
allocate resources efficiently, but it does not necessarily ensure that resources are
allocated fairly. As a result, many economists—though not all—believe that the
government should redistribute income to achieve greater equality. In doing so,
however, the government runs into another of the Ten Principles of Economics: People
face tradeoffs. When the government enacts policies to make the distribution
of income more equitable, it distorts incentives, alters behavior, and makes the allocation
of resources less efficient.
Our discussion of the distribution of income proceeds in three steps. First, we
assess how much inequality there is in our society. Second, we consider some different
views about what role the government should play in altering the distribution
of income. Third, we discuss various public policies aimed at helping society’s
poorest members.
THE MEASUREMENT OF INEQUALITY
We begin our study of the distribution of income by addressing four questions of
measurement:
How much inequality is there in our society?
How many people live in poverty?
“As far as I’m concerned, they can do what they want with the
minimum wage, just as long as they keep their hands off the
maximum wage.”
CHAPTER 20 INCOME INEQUALITY AND POVERTY 439
What problems arise in measuring the amount of inequality?
How often do people move among income classes?
These measurement questions are the natural starting point from which to discuss
public policies aimed at changing the distribution of income.
U.S. INCOME INEQUALITY
There are various ways to describe the distribution of income in the economy.
Table 20-1 presents a particularly simple way. It shows the percentage of families
that fall into each of seven income categories. You can use this table to find where
your family lies in the income distribution.
For examining differences in the income distribution over time or across countries,
economists find it more useful to present the income data as in Table 20-2. To
see how to interpret this table, consider the following thought experiment. Imagine
that you lined up all the families in the economy according to their annual income.
Then you divided the families into five equal groups: the bottom fifth, the
second fifth, the middle fifth, the fourth fifth, and the top fifth. Next you computed
the share of total income that each group of families received. In this way, you
could produce the numbers in Table 20-2.
These numbers give us a way of gauging how the economy’s total income is distributed.
If income were equally distributed across all families, each one-fifth of families
would receive one-fifth (20 percent) of income. If all income were concentrated
among just a few families, the top fifth would receive 100 percent, and the other
fifths would receive 0 percent. The actual economy, of course, is between these two
extremes. The table shows that in 1998 the bottom fifth of all families received 4.2
percent of all income, and the top fifth of all families received 47.3 percent of all income.
In other words, even though the top and bottom fifths include the same number
of families, the top fifth has about ten times as much income as the bottom fifth.
The last column in Table 20-2 shows the share of total income received by the
very richest families. In 1998, the top 5 percent of families received 20.7 percent of
total income. Thus, the total income of the richest 5 percent of families was greater
than the total income of the poorest 40 percent.
Table 20-2 also shows the distribution of income in various years beginning in
1935. At first glance, the distribution of income appears to have been remarkably
stable over time. Throughout the past several decades, the bottom fifth of families
Table 20-1
THE DISTRIBUTION OF INCOME IN
THE UNITED STATES: 1998
ANNUAL FAMILY INCOME PERCENT OF FAMILIES
Less than $15,000 11.7%
$15,000-$24,999 12.3
$25,000-$34,999 12.7
$35,000-$49,999 16.8
$50,000-$74,999 21.5
$75,000-$99,999 11.7
$100,000 and over 13.3
Source: U.S. Bureau of the Census.
440 PART SIX THE ECONOMICS OF LABOR MARKETS
CASE STUDY THE WOMEN’S MOVEMENT AND
THE INCOME DISTRIBUTION
Over the past several decades, there has been a dramatic change in women’s
role in the economy. The percentage of women who hold jobs has risen from
about 32 percent in the 1950s to about 54 percent in the 1990s. As full-time
homemakers have become less common, a woman’s earnings have become a
more important determinant of the total income of a typical family.
Although the women’s movement has led to more equality between men
and women in access to education and jobs, it has also led to less equality in family
incomes. The reason is that the rise in women’s labor-force participation has
not been the same across all income groups. In particular, the women’s movement
has had its greatest impact on women from high-income households.
Women from low-income households have long had high rates of participation
in the labor force, even in the 1950s, and their behavior has changed much less.
In essence, the women’s movement has changed the behavior of the wives
of high-income men. In the 1950s, a male executive or physician was likely to
marry a woman who would stay at home and raise the children. Today, the wife
of a male executive or physician is more likely to be an executive or physician
herself. The result is that rich households have become even richer, a pattern
that raises inequality in family incomes.
has received about 4 to 5 percent of income, while the top fifth has received about
40 to 50 percent of income. Closer inspection of the table reveals some trends in the
degree of inequality. From 1935 to 1970, the distribution gradually became more
equal. The share of the bottom fifth rose from 4.1 to 5.5 percent, and the share of
the top fifth fell from 51.7 percent to 40.9 percent. In more recent years, this trend
has reversed itself. From 1970 to 1998, the share of the bottom fifth fell from 5.5
percent to 4.2 percent, and the share of the top fifth rose from 40.9 to 47.3 percent.
In Chapter 19 we discussed some of the reasons for this recent increase in inequality.
Increases in international trade with low-wage countries and changes in
technology have tended to reduce the demand for unskilled labor and raise the demand
for skilled labor. As a result, the wages of unskilled workers have fallen relative
to the wages of skilled workers, and this change in relative wages has
increased inequality in family incomes.
Table 20-2
INCOME INEQUALITY IN THE
UNITED STATES. This table
shows the percent of total beforetax
income received by families
in each fifth of the income
distribution and by those
families in the top 5 percent.
BOTTOM SECOND MIDDLE FOURTH TOP TOP
YEAR FIFTH FIFTH FIFTH FIFTH FIFTH 5 PERCENT
1998 4.2% 9.9% 15.7% 23.0% 47.3% 20.7%
1990 4.6 10.8 16.6 23.8 44.3 17.4
1980 5.2 11.5 17.5 24.3 41.5 15.3
1970 5.5 12.2 17.6 23.8 40.9 15.6
1960 4.8 12.2 17.8 24.0 41.3 15.9
1950 4.5 12.0 17.4 23.4 42.7 17.3
1935 4.1 9.2 14.1 20.9 51.7 26.5
Source: U.S. Bureau of the Census.
CHAPTER 20 INCOME INEQUALITY AND POVERTY 441
As this example shows, there are social as well as economic determinants of
the distribution of income. Moreover, the simplistic view that “income inequality
is bad” can be misleading. Increasing the opportunities available to women
was surely a good change for society, even if one effect was greater inequality in
family incomes. When evaluating any change in the distribution of income, policymakers
must look at the reasons for that change before deciding whether it
presents a problem for society.
CASE STUDY INCOME INEQUALITY AROUND THE WORLD
How does the amount of income inequality in the United States compare to that
in other countries? This question is interesting, but answering it is problematic.
For many countries, data are not available. Even when they are, not every country
in the world collects data in the same way; for example, some countries collect
data on individual incomes, whereas other countries collect data on family
incomes. As a result, whenever we find a difference between two countries, we
can never be sure whether it reflects a true difference in the economies or
merely a difference in the way data are collected.
With this warning in mind, consider Table 20-3, which compares the income
distribution of the United States to that of seven other countries. The countries
EQUALITY FOR WOMEN HAS MEANT
LESS EQUALITY FOR FAMILY INCOMES.
Table 20-3
COUNTRY BOTTOM FIFTH SECOND FIFTH MIDDLE FIFTH FOURTH FIFTH TOP FIFTH
Germany 9.0% 13.5% 17.5% 22.9% 37.1%
Canada 7.5 12.9 17.2 23.0 39.3
Russia 7.4 12.6 17.7 24.2 38.2
United Kingdom 7.1 12.8 17.2 23.1 39.8
China 5.5 9.8 14.9 22.3 47.5
United States 4.8 10.5 16.0 23.5 45.2
Chile 3.5 6.6 10.9 18.1 61.0
Brazil 2.5 5.7 9.9 17.7 64.2
INCOME INEQUALITY AROUND THE WORLD. This table shows the percent of total beforetax
income received by families in each fifth of the income distribution.
Source: World Development Report: 1998/99, pp. 198–199.
442 PART SIX THE ECONOMICS OF LABOR MARKETS
are ranked from the most equal to the most unequal. On the top of the list is
Germany, where the richest fifth of the population has income only about 4 times
that of the poorest fifth. On the bottom of the list is Brazil, where the richest
fifth has income about 25 times that of the poorest fifth. Although all countries
have substantial inequality in income, the degree of inequality is not the same
everywhere.
When countries are ranked by inequality, the United States ends up slightly
behind the middle of the pack. Compared to other economically advanced
countries, such as Germany and Canada, the United States has substantial inequality.
But the United States has a more equal income distribution than many
developing countries, such as Chile and Brazil.
THE POVERTY RATE
A commonly used gauge of the distribution of income is the poverty rate. The
poverty rate is the percentage of the population whose family income falls below
an absolute level called the poverty line. The poverty line is set by the federal government
at roughly three times the cost of providing an adequate diet. This line is
adjusted every year to account for changes in the level of prices, and it depends on
family size.
To get some idea about what the poverty rate tells us, consider the data for
1998. In that year, the median family had an income of $47,469, and the poverty
line for a family of four was $16,660. The poverty rate was 12.7 percent. In other
words, 12.7 percent of the population were members of families with incomes below
the poverty line for their family size.
Figure 20-1 shows the poverty rate since 1959, when the official data begin. You
can see that the poverty rate fell from 22.4 percent in 1959 to a low of 11.1 percent in
1973. This decline is not surprising, for average income in the economy (adjusted
pover ty line
an absolute level of income set by the
federal government for each family
size below which a family is deemed
to be in poverty
Percent of the
Population
below Poverty
Line
1960 1965 1970 1975 1980 1985 1990 1995 1998
0
5
10
15
20
25
Poverty rate
Figure 20-1
THE POVERTY RATE. The
poverty rate shows the percentage
of the population with incomes
below an absolute level called the
poverty line.
Source: U.S. Bureau of the Census.
pover ty rate
the percentage of the population
whose family income falls below an
absolute level called the poverty line
CHAPTER 20 INCOME INEQUALITY AND POVERTY 443
for inflation) rose more than 50 percent during this period. Because the poverty line
is an absolute rather than a relative standard, more families are pushed above the
poverty line as economic growth pushes the entire income distribution upward. As
John F. Kennedy once put it, a rising tide lifts all boats.
Since the early 1970s, however, the economy’s rising tide has left some boats
behind. Despite continued (although somewhat slower) growth in average income,
the poverty rate has not declined. This lack of progress in reducing poverty
in recent years is closely related to the increasing inequality we saw in Table 20-2.
Although economic growth has raised the income of the typical family, the increase
in inequality has prevented the poorest families from sharing in this greater
economic prosperity.
Poverty is an economic malady that affects all groups within the population,
but it does not affect all groups with equal frequency. Table 20-4 shows the poverty
rates for several groups, and it reveals three striking facts:
Poverty is correlated with race. Blacks and Hispanics are about three times
more likely to live in poverty than are whites.
Poverty is correlated with age. Children are more likely than average to be
members of poor families, and the elderly are less likely than average to be
poor.
Poverty is correlated with family composition. Families headed by a female
adult and without a husband present are more than twice as likely to live in
poverty as the average family.
These three facts have described U.S. society for many years, and they show which
people are most likely to be poor. These effects also work together: Among black
and Hispanic children in female-headed households, more than half live in poverty.
PROBLEMS IN MEASURING INEQUALITY
Although data on the income distribution and the poverty rate help to give us
some idea about the degree of inequality in our society, interpreting these data is
not as straightforward as it might first appear. The data are based on households’
Table 20-4
WHO IS POOR? This table
shows that the poverty rate varies
greatly among different groups
within the population.
GROUP POVERTY RATE
All persons 12.7%
White, not Hispanic 8.2
Black 26.1
Hispanic 25.6
Asian, Pacific Islander 12.5
Children (under age 18) 18.9
Elderly (over age 64) 10.5
Female household, no husband present 33.1
Source: U.S. Bureau of the Census. Data are for 1998.
444 PART SIX THE ECONOMICS OF LABOR MARKETS
annual incomes. What people care about, however, is not their incomes but their
ability to maintain a good standard of living. For various reasons, data on the income
distribution and the poverty rate give an incomplete picture of inequality in
living standards. We examine these reasons below.
In-Kind Transfers Measurements of the distribution of income and the
poverty rate are based on families’ money income. Through various government
programs, however, the poor receive many nonmonetary items, including food
stamps, housing vouchers, and medical services. Transfers to the poor given in the
form of goods and services rather than cash are called in-kind transfers. Standard
measurements of the degree of inequality do not take account of these in-kind
transfers.
Because in-kind transfers are received mostly by the poorest members of society,
the failure to include in-kind transfers as part of income greatly affects the
measured poverty rate. According to a study by the Census Bureau, if in-kind
transfers were included in income at their market value, the number of families in
poverty would be about 10 percent lower than the standard data indicate.
The important role of in-kind transfers makes evaluating changes in poverty
more difficult. Over time, as public policies to help the poor evolve, the composition
of assistance between cash and in-kind transfers changes. Some of the fluctuations
in the measured poverty rate, therefore, reflect the form of government
assistance rather than the true extent of economic deprivation.
The Economic Life Cycle Incomes vary predictably over people’s lives.
A young worker, especially one in school, has a low income. Income rises as the
worker gains maturity and experience, peaks at around age 50, and then falls
sharply when the worker retires at around age 65. This regular pattern of income
variation is called the life cycle.
Because people can borrow and save to smooth out life cycle changes in income,
their standard of living in any year depends more on lifetime income than
on that year’s income. The young often borrow, perhaps to go to school or to buy
a house, and then repay these loans later when their incomes rise. People have
their highest saving rates when they are middle-aged. Because people can save in
anticipation of retirement, the large declines in incomes at retirement need not lead
to similar declines in the standard of living.
This normal life cycle pattern causes inequality in the distribution of annual
income, but it does not represent true inequality in living standards. To gauge
the inequality of living standards in our society, the distribution of lifetime incomes
is more relevant than the distribution of annual incomes. Unfortunately,
data on lifetime incomes are not readily available. When looking at any data on
inequality, however, it is important to keep the life cycle in mind. Because a person’s
lifetime income smooths out the highs and lows of the life cycle, lifetime incomes
are surely more equally distributed across the population than are annual
incomes.
Transitor y versus Permanent Income Incomes vary over people’s
lives not only because of predictable life cycle variation but also because of random
and transitory forces. One year a frost kills off the Florida orange crop, and
Florida orange growers see their incomes fall temporarily. At the same time, the
in-kind transfers
transfers to the poor given in the
form of goods and services rather
than cash
life cycle
the regular pattern of income
variation over a person’s life
CHAPTER 20 INCOME INEQUALITY AND POVERTY 445
Florida frost drives up the price of oranges, and California orange growers see
their incomes temporarily rise. The next year the reverse might happen.
Just as people can borrow and lend to smooth out life cycle variation in income,
they can also borrow and lend to smooth out transitory variation in income.
When California orange growers experience a good year, they would be foolish to
spend all of their additional income. Instead, they save some of it, knowing that
their good fortune is unlikely to persist. Similarly, the Florida orange growers respond
to their temporarily low incomes by drawing down their savings or by borrowing.
To the extent that a family saves and borrows to buffer itself from
transitory changes in income, these changes do not affect its standard of living. A
family’s ability to buy goods and services depends largely on its permanent income,
which is its normal, or average, income.
To gauge inequality of living standards, the distribution of permanent income
is more relevant than the distribution of annual income. Although permanent income
is hard to measure, it is an important concept. Because permanent income
excludes transitory changes in income, permanent income is more equally distributed
than is current income.
permanent income
a person’s normal income
HOW MANY PEOPLE LIVE IN POVERTY? THE
answer is a topic of continuing debate.
Devising New Math
t o D e f i n e P o v e r t y
BY LOUIS UCHITELLE
The Census Bureau has begun to revise
its definition of what constitutes poverty
in the United States, experimenting with
a formula that would drop millions of
more families below the poverty line.
The bureau’s new approach would
in effect raise the income threshold for
living above poverty to $19,500 for a
family of four, from the $16,600 now
considered sufficient. Suddenly, 46 million
Americans, or 17 percent of the population,
would be recognized as officially
below the line, not the 12.7 percent announced
last month, the lowest in nearly
a decade. . . .
Fixing a poverty line has always been
a subjective endeavor. The current formula
was created for President Lyndon B.
Johnson to keep score on his “war on
poverty” and has remained unchanged
since 1965 except for adjustments for inflation.
. . . The Census Bureau’s new Experimental
Measures are an effort to
determine what poor people must spend
on food, clothing, housing, and life’s little
extras.
“There is no scientific way to set a
new poverty line,” said Rebecca M.
Blank, dean of the School of Social Policy
at the University of Michigan. “What
there is here are a set of judgment calls,
now being made, about what is needed
to lift people to a socially acceptable
standard of living.” . . .
Ordinary Americans, in opinion polls,
draw the poverty line above $20,000,
saying it takes at least that much, if not
more, to “get along in their community,”
to “live decently,” or to avoid hardship.
But a higher threshold means government
spending would rise to pay for
benefits tied to the poverty level, like
food stamps and Head Start. That would
require an incursion into the budget surplus
that neither Republicans nor Democrats
seek.
Not surprising, the White House,
which would have to authorize a change
in the poverty formula, is proceeding
cautiously. “We have at least a couple of
years more work to do,” an Administration
official said, passing the decision for
redefining poverty to the next administration.
SOURCE: The New York Times, October 18, 1999,
pp. A1, A14.
IN THE NEWS
Measuring Poverty
446 PART SIX THE ECONOMICS OF LABOR MARKETS
ECONOMIC MOBILITY
People sometimes speak of “the rich” and “the poor” as if these groups consisted
of the same families year after year. In fact, this is not at all the case. Economic mobility,
the movement of people among income classes, is substantial in the U.S.
economy. Movements up the income ladder can be due to good luck or hard work,
and movements down the ladder can be due to bad luck or laziness. Some of this
mobility reflects transitory variation in income, while some reflects more persistent
changes in income.
Because economic mobility is so great, many of those below the poverty line
are there only temporarily. Poverty is a long-term problem for relatively few families.
In a typical ten-year period, about one in four families falls below the poverty
line in at least one year. Yet fewer than 3 percent of families are poor for eight or
more years. Because it is likely that the temporarily poor and the persistently poor
face different problems, policies that aim to combat poverty need to distinguish
between these groups.
Another way to gauge economic mobility is the persistence of economic success
from generation to generation. Economists who have studied this topic find
substantial mobility. If a father earns 20 percent above his generation’s average income,
his son will most likely earn 8 percent above his generation’s average income.
There is almost no correlation between the income of a grandfather and the
income of a grandson. There is much truth to the old saying, “From shirtsleeves to
shirtsleeves in three generations.”
One result of this great economic mobility is that the U.S. economy is filled
with self-made millionaires (as well as with heirs who squandered the fortunes
they inherited). According to estimates for 1996, about 2.7 million households in
the United States had net worth (assets minus debts) that exceeded $1 million.
These households represented the richest 2.8 percent of the population. About four
out of five of these millionaires made their money on their own, such as by starting
and building a business or by climbing the corporate ladder. Only one in five
millionaires inherited their fortunes.
QUICK QUIZ: What does the poverty rate measure? Describe three
potential problems in interpreting the measured poverty rate.
THE POLITICAL PHILOSOPHY
OF REDISTRIBUTING INCOME
We have just seen how the economy’s income is distributed and have considered
some of the problems in interpreting measured inequality. This discussion was positive
in the sense that it merely described the world as it is. We now turn to the normative
question facing policymakers: What should the government do about
economic inequality?
This question is not just about economics. Economic analysis alone cannot tell
us whether policymakers should try to make our society more egalitarian. Our
views on this question are, to a large extent, a matter of political philosophy. Yet
CHAPTER 20 INCOME INEQUALITY AND POVERTY 447
because the government’s role in redistributing income is central to so many debates
over economic policy, here we digress from economic science to consider a
bit of political philosophy.
UTILITARIANISM
A prominent school of thought in political philosophy is utilitarianism. The
founders of utilitarianism are the English philosophers Jeremy Bentham (1748–1832)
and John Stuart Mill (1806–1873). To a large extent, the goal of utilitarians is to apply
the logic of individual decisionmaking to questions concerning morality and
public policy.
The starting point of utilitarianism is the notion of utility—the level of happiness
or satisfaction that a person receives from his or her circumstances. Utility is
a measure of well-being and, according to utilitarians, is the ultimate objective of
all public and private actions. The proper goal of the government, they claim, is to
maximize the sum of utility of everyone in society.
The utilitarian case for redistributing income is based on the assumption of diminishing
marginal utility. It seems reasonable that an extra dollar of income to a
poor person provides that person with more additional utility than does an extra
dollar to a rich person. In other words, as a person’s income rises, the extra wellbeing
derived from an additional dollar of income falls. This plausible assumption,
together with the utilitarian goal of maximizing total utility, implies that the government
should try to achieve a more equal distribution of income.
The argument is simple. Imagine that Peter and Paul are the same, except that
Peter earns $80,000 and Paul earns $20,000. In this case, taking a dollar from Peter
to pay Paul will reduce Peter’s utility and raise Paul’s utility. But, because of diminishing
marginal utility, Peter’s utility falls by less than Paul’s utility rises.
Thus, this redistribution of income raises total utility, which is the utilitarian’s
objective.
At first, this utilitarian argument might seem to imply that the government
should continue to redistribute income until everyone in society has exactly the
same income. Indeed, that would be the case if the total amount of income—
$100,000 in our example—were fixed. But, in fact, it is not. Utilitarians reject complete
equalization of incomes because they accept one of the Ten Principles of
Economics presented in Chapter 1: People respond to incentives.
To take from Peter to pay Paul, the government must pursue policies that redistribute
income, such as the U.S. federal income tax and welfare system. Under
these policies, people with high incomes pay high taxes, and people with low incomes
receive income transfers. Yet, as we have seen in Chapters 8 and 12, taxes
distort incentives and cause deadweight losses. If the government takes away additional
income a person might earn through higher income taxes or reduced
transfers, both Peter and Paul have less incentive to work hard. As they work less,
society’s income falls, and so does total utility. The utilitarian government has to
balance the gains from greater equality against the losses from distorted incentives.
To maximize total utility, therefore, the government stops short of making
society fully egalitarian.
A famous parable sheds light on the utilitarian’s logic. Imagine that Peter and
Paul are thirsty travelers trapped at different places in the desert. Peter’s oasis has
much water; Paul’s has little. If the government could transfer water from one oasis
utilitarianism
the political philosophy according to
which the government should choose
policies to maximize the total utility
of everyone in society
utility
a measure of happiness or
satisfaction
448 PART SIX THE ECONOMICS OF LABOR MARKETS
to the other without cost, it would maximize total utility from water by equalizing
the amount in the two places. But suppose that the government has only a leaky
bucket. As it tries to move water from one place to the other, some of the water is
lost in transit. In this case, a utilitarian government might still try to move some water
from Peter to Paul, depending on how thirsty Paul is and how leaky the bucket
is. But, with only a leaky bucket at its disposal, a utilitarian government will not try
to reach complete equality.
LIBERALISM
A second way of thinking about inequality might be called liberalism. Philosopher
John Rawls develops this view in his book A Theory of Justice. This book was
first published in 1971, and it quickly became a classic in political philosophy.
Rawls begins with the premise that a society’s institutions, laws, and policies
should be just. He then takes up the natural question: How can we, the members
of society, ever agree on what justice means? It might seem that every person’s
point of view is inevitably based on his or her particular circumstances—whether
he or she is talented or less talented, diligent or lazy, educated or less educated,
born to a wealthy family or a poor one. Could we ever objectively determine what
a just society would be?
To answer this question, Rawls proposes the following thought experiment.
Imagine that before any of us is born, we all get together for a meeting to design
the rules that govern society. At this point, we are all ignorant about the station in
life each of us will end up filling. In Rawls’s words, we are sitting in an “original
position” behind a “veil of ignorance.” In this original position, Rawls argues, we
can choose a just set of rules for society because we must consider how those rules
will affect every person. As Rawls puts it, “Since all are similarly situated and no
one is able to design principles to favor his particular conditions, the principles of
justice are the result of fair agreement or bargain.” Designing public policies and
institutions in this way allows us to be objective about what policies are just.
Rawls then considers what public policy designed behind this veil of ignorance
would try to achieve. In particular, he considers what income distribution a
person would consider just if that person did not know whether he or she would
end up at the top, bottom, or middle of the distribution. Rawls argues that a person
in the original position would be especially concerned about the possibility of
being at the bottom of the income distribution. In designing public policies, therefore,
we should aim to raise the welfare of the worst-off person in society. That is,
rather than maximizing the sum of everyone’s utility, as a utilitarian would do,
Rawls would maximize the minimum utility. Rawls’s rule is called the maximin
criterion.
Because the maximin criterion emphasizes the least fortunate person in society,
it justifies public policies aimed at equalizing the distribution of income. By
transferring income from the rich to the poor, society raises the well-being of the
least fortunate. The maximin criterion would not, however, lead to a completely
egalitarian society. If the government promised to equalize incomes completely,
people would have no incentive to work hard, society’s total income would fall
substantially, and the least fortunate person would be worse off. Thus, the maximin
criterion still allows disparities in income, because such disparities can improve
incentives and thereby raise society’s ability to help the poor. Nonetheless,
liberalism
the political philosophy according to
which the government should choose
policies deemed to be just, as
evaluated by an impartial observer
behind a “veil of ignorance”
maximin criterion
the claim that the government should
aim to maximize the well-being of
the worst-off person in society
CHAPTER 20 INCOME INEQUALITY AND POVERTY 449
INVESTOR WARREN BUFFETT’S $36 BILLION
make him one of the world’s richest
men. Here is how Buffett explained
his personal philosophy to an audience
of college students at the University
of Washington. He is responding
to a question about the importance
of “giving back to your community.”
Notice the echoes of Rawls’s veil of
ignorance.
B u f f e t t ’s Answer
I know in my own case that 99%-plus [of
my wealth] will go back to society, just
because we’ve been treated extraordinarily
well by society.
I’m lucky. I don’t run fast, but I’m
wired in a particular way that I thrive in a
big capitalist economy with a lot of action.
. . . If I had been born some time
ago I would’ve been some animal’s
lunch. . . .
Let me suggest another way to
think about this. Let’s say that it was 24
hours before you were born, and a genie
appeared and said, “You look like a winner.
I have enormous confidence in you,
and what I’m going to do is let you set
the rules for society into which you will
be born. You can set the economic rules
and the social rules, and whatever rules
you set will apply during your lifetime and
your children’s lifetime.”
And you’ll say, “Well, that’s nice,
but what’s the catch?”
And the genie says, “Here’s the
catch. You don’t know if you’re going to
be born rich or poor, black or white, male
or female, able-bodied or infirm, intelligent
or retarded.” So all you know is
that you’re going to get one ball out of a
barrel with, say, 5.8 billion balls in it [each
ball representing one of the 5.8 billion
people on earth]. You’re going to participate
in what I call the ovarian lottery. It’s
the most important thing that will happen
to you in your life, but you have no control
over it. It’s going to determine far
more than your grades at school or anything
else that happens to you.
Now, what rules do you want to
have? I’m not going to tell you the rules,
and nobody will tell you; you have to
make them up for yourself. But they will
affect how you think about what you do
in your will and things of that sort.
You’re going to want to have a system
that turns out more and more goods
and services. You’ve got a great quantity
of people out there, and you want them
to live pretty well, and you want your
kids to live better than you did, and you
want your grandchildren to live better
than your kids. You’re going to want a
system that keeps Bill Gates and Andy
Grove and Jack Welch [heads of Microsoft,
Intel, and General Electric] working
long, long after they don’t need to
work. You’re going to want the most able
people working more than 12 hours a
day. So you’ve got to have a system that
gives them an incentive to turn out the
goods and services.
But you’re also going to want a
system that takes care of the bad balls,
the ones that aren’t lucky. If you have a
system that is turning out enough goods
and services, you can take care of them.
You don’t want people worrying about being
sick in their old age, or fearful about
going home at night. You want a system
where people are free of fear to some
extent.
So you’ll try to design something,
assuming you have the goods and services
to solve that sort of thing. You’ll
want equality of opportunity—namely a
good public school system—to make
you feel that every piece of talent out
there will get the same shot at contributing.
And your tax system will follow from
your reasoning on that. And what you do
with the money you make is another
thing to think about. As you work
through that, everybody comes up with
something a little different. I just suggest
that you play that little game.
SOURCE: Fortune, July 20, 1998, pp. 62–64.
IN THE NEWS
A Rawlsian Billionaire
WARREN BUFFETT
450 PART SIX THE ECONOMICS OF LABOR MARKETS
because Rawls’s philosophy puts weight on only the least fortunate members of
society, it calls for more income redistribution than does utilitarianism.
Rawls’s views are controversial, but the thought experiment he proposes has
much appeal. In particular, this thought experiment allows us to consider the redistribution
of income as a form of social insurance. That is, from the perspective of
the original position behind the veil of ignorance, income redistribution is like an
insurance policy. Homeowners buy fire insurance to protect themselves from the
risk of their housing burning down. Similarly, when we as a society choose policies
that tax the rich to supplement the incomes of the poor, we are all insuring ourselves
against the possibility that we might have been a member of a poor family.
Because people dislike risk, we should be happy to have been born into a society
that provides us this insurance.
It is not at all clear, however, that rational people behind the veil of ignorance
would truly be so averse to risk as to follow the maximin criterion. Indeed, because
a person in the original position might end up anywhere in the distribution
of outcomes, he or she might treat all possible outcomes equally when designing
public policies. In this case, the best policy behind the veil of ignorance would be
to maximize the average utility of members of society, and the resulting notion of
justice would be more utilitarian than Rawlsian.
LIBERTARIANISM
A third view of inequality is called libertarianism. The two views we have considered
so far—utilitarianism and liberalism—both view the total income of society
as a shared resource that a social planner can freely redistribute to achieve
some social goal. By contrast, libertarians argue that society itself earns no income—
only individual members of society earn income. According to libertarians,
the government should not take from some individuals and give to others in order
to achieve any particular distribution of income.
For instance, philosopher Robert Nozick writes the following in his famous
1974 book Anarchy, State and Utopia:
We are not in the position of children who have been given portions of pie by
someone who now makes last minute adjustments to rectify careless cutting.
There is no central distribution, no person or group entitled to control all the
resources, jointly deciding how they are to be doled out. What each person gets,
he gets from others who give to him in exchange for something, or as a gift. In a
free society, diverse persons control different resources, and new holdings arise
out of the voluntary exchanges and actions of persons.
Whereas utilitarians and liberals try to judge what amount of inequality is desirable
in a society, Nozick denies the validity of this very question.
The libertarian alternative to evaluating economic outcomes is to evaluate the
process by which these outcomes arise. When the distribution of income is achieved
unfairly—for instance, when one person steals from another—the government has
the right and duty to remedy the problem. But, as long as the process determining
the distribution of income is just, the resulting distribution is fair, no matter how
unequal.
Nozick criticizes Rawls’s liberalism by drawing an analogy between the distribution
of income in society and the distribution of grades in a course. Suppose
you were asked to judge the fairness of the grades in the economics course you are
liber tarianism
the political philosophy according
to which the government should
punish crimes and enforce voluntary
agreements but not redistribute
income
CHAPTER 20 INCOME INEQUALITY AND POVERTY 451
now taking. Would you imagine yourself behind a veil of ignorance and choose a
grade distribution without knowing the talents and efforts of each student? Or
would you ensure that the process of assigning grades to students is fair without
regard for whether the resulting distribution is equal or unequal? For the case of
grades at least, the libertarian emphasis on process over outcomes is compelling.
Libertarians conclude that equality of opportunities is more important than
equality of incomes. They believe that the government should enforce individual
rights to ensure that everyone has the same opportunity to use his or her talents
and achieve success. Once these rules of the game are established, the government
has no reason to alter the resulting distribution of income.
QUICK QUIZ: Pam earns more than Pauline. Someone proposes taxing
Pam in order to supplement Pauline’s income. How would a utilitarian, a
liberal, and a libertarian evaluate this proposal?
POLICIES TO REDUCE POVERTY
As we have just seen, political philosophers hold various views about what role the
government should take in altering the distribution of income. Political debate
among the larger population of voters reflects a similar disagreement. Despite these
continuing debates, however, most people believe that, at the very least, the government
should try to help those most in need. According to a popular metaphor,
the government should provide a “safety net” to prevent any citizen from falling
too far.
Poverty is one of the most difficult problems that policymakers face. Poor families
are more likely than the overall population to experience homelessness, drug
dependency, domestic violence, health problems, teenage pregnancy, illiteracy, unemployment,
and low educational attainment. Members of poor families are both
more likely to commit crimes and more likely to be victims of crimes. Although it
is hard to separate the causes of poverty from the effects, there is no doubt that
poverty is associated with various economic and social ills.
Suppose that you were a policymaker in the government, and your goal was
to reduce the number of people living in poverty. How would you achieve this
goal? Here we consider some of the policy options that you might consider. Although
each of these options does help some people escape poverty, none of them
is perfect, and deciding which is best is not easy.
MINIMUM-WAGE LAWS
Laws setting a minimum wage that employers can pay workers are a perennial
source of debate. Advocates view the minimum wage as a way of helping the
working poor without any cost to the government. Critics view it as hurting those
it is intended to help.
The minimum wage is easily understood using the tools of supply and demand,
as we first saw in Chapter 6. For workers with low levels of skill and experience, a
452 PART SIX THE ECONOMICS OF LABOR MARKETS
high minimum wage forces the wage above the level that balances supply and demand.
It therefore raises the cost of labor to firms and reduces the quantity of labor
that those firms demand. The result is higher unemployment among those groups of
workers affected by the minimum wage. Although those workers who remain employed
benefit from a higher wage, those who might have been employed at a lower
wage are worse off.
The magnitude of these effects depends crucially on the elasticity of demand.
Advocates of a high minimum wage argue that the demand for unskilled labor is
relatively inelastic, so that a high minimum wage depresses employment only
slightly. Critics of the minimum wage argue that labor demand is more elastic, especially
in the long run when firms can adjust employment and production more
fully. They also note that many minimum-wage workers are teenagers from
middle-class families, so that a high minimum wage is imperfectly targeted as a
policy for helping the poor.
WELFARE
One way to raise the living standards of the poor is for the government to supplement
their incomes. The primary way in which the government does this is
through the welfare system. Welfare is a broad term that encompasses various
government programs. Temporary Assistance for Needy Families (formerly called
Aid to Families with Dependent Children) is a program that assists families where
there are children but no adult able to support the family. In a typical family receiving
such assistance, the father is absent, and the mother is at home raising
small children. Another welfare program is Supplemental Security Income (SSI),
which provides assistance to the poor who are sick or disabled. Note that for both
of these welfare programs, a poor person cannot qualify for assistance simply by
having a low income. He or she must also establish some additional “need,” such
as small children or a disability.
A common criticism of welfare programs is that they create incentives for
people to become “needy.” For example, these programs may encourage families
to break up, for many families qualify for financial assistance only if the father
is absent. The programs may also encourage illegitimate births, for many poor,
single women qualify for assistance only if they have children. Because poor,
single mothers are such an important part of the poverty problem and because
welfare programs seem to raise the number of poor, single mothers, critics of the
welfare system assert that these policies exacerbate the very problems they are
supposed to cure. As a result of these arguments, the welfare system was revised
in a 1996 law that limited the amount of time recipients could stay on
welfare.
How severe are these potential problems with the welfare system? No one
knows for sure. Proponents of the welfare system point out that being a poor, single
mother on welfare is a difficult existence at best, and they are skeptical that
many people would be encouraged to pursue such a life if it were not thrust upon
them. Moreover, trends over time do not support the view that the decline of the
two-parent family is largely a symptom of the welfare system, as the system’s
critics sometimes claim. Since the early 1970s, welfare benefits (adjusted for inflation)
have declined, yet the percentage of children living with only one parent has
risen.
welfare
government programs that
supplement the incomes of the needy
CHAPTER 20 INCOME INEQUALITY AND POVERTY 453
NEGATIVE INCOME TAX
Whenever the government chooses a system to collect taxes, it affects the distribution
of income. This is clearly true in the case of a progressive income tax, whereby
high-income families pay a larger percentage of their income in taxes than do lowincome
families. As we discussed in Chapter 12, equity across income groups is an
important criterion in the design of a tax system.
MANY ANTIPOVERTY PROGRAMS ARE TARgeted
at poor areas of the country. Economist
Edward Glaeser presents the case
against this geographic approach.
H e l p P o o r P e o p l e ,
Not Poor P l a c e s
BY EDWARD L. GLAESER
President Clinton’s six-city “New Markets”
tour earlier this summer signaled a
renewed focus on the problems of the
poor. But while the president’s concern is
appreciated by all of us who care about
the islands of poverty in America’s sea of
affluence, his proposals are fundamentally
flawed. They may still help some of
the poor, but also risk repeating some of
the worst mistakes of the Johnson era.
The trouble with the president’s recommendations
is that they violate the
first economic rule of urban poverty policy:
Programs should be person-based,
not place-based.
Economists have long argued that
place-based programs are a mistake.
They strongly prefer person-based policies
that create transfers, entitlements,
or relief from regulation on the basis of
personal characteristics. Examples of
person-based policies include the Earned
Income Tax Credit and the GI Bill.
Place-based policies, on the other
hand, give transfers or other government
support on the basis of location. Examples
of such policies are housing projects
and enterprise zones. President
Clinton’s recent Rural Housing and Economic
Development Assistance for Kentucky
or the new Empowerment Zone
Grant for East St. Louis, Ill., are quintessential
place-based policies.
The problem with place-based programs
is that they create incentives to
keep the poor in the ghetto. By subsidizing
the place, not the person living there,
these policies make it more attractive for
the poor to stay in high-poverty areas.
Indeed, current research shows that
supposedly benevolent pro-poor housing
and transfer policies play a major role in
herding the poor into inner cities.
It’s hard to see the logic in artificially
limiting migration and concentrating the
poor in areas with low productivity.
Movement out of low-productivity, highunemployment
areas is one reason that
unemployment rates in the U.S. stay
low. Moreover, flight from the ghettos
has enabled many African-Americans to
avoid the social costs of the inner city,
and black-white segregation in the U.S.
has declined substantially because of it.
Place-based programs also suffer
from the fact that their benefits go disproportionately
to property owners in the
targeting areas—and not to the intended
beneficiaries. If the government offers
tax credits to firms that invest in a poor
region, for instance, then firms will locate
there, pushing up property values and
rents. But the benefits of increased economic
activity will evaporate as higher
housing costs eat away the planned benefits
to the needy. . . .
If place-based policies are so bad,
why are they so popular? A cynic might
say that the residents of wealthy suburbs
prefer that the poor remain in ghettos.
A more practical explanation is that
we have place-based politicians who
lobby for place-based policies. . . .
A wise alternative to such faulty
place-based poverty assistance would
be a program that offers tax credits to
companies that employ the disadvantaged.
This would be a less distortionary
means of assisting the poor.
SOURCE: The Wall Street Journal, August 12, 1999,
p. A22.
IN THE NEWS
Should the Government Try
to Help Poor Regions?
454 PART SIX THE ECONOMICS OF LABOR MARKETS
Many economists have advocated supplementing the income of the poor using
a negative income tax. According to this policy, every family would report its
income to the government. High-income families would pay a tax based on their
incomes. Low-income families would receive a subsidy. In other words, they
would “pay” a “negative tax.”
For example, suppose the government used the following formula to compute
a family’s tax liability:
Taxes owed (1/3 of income) $10,000.
In this case, a family that earned $60,000 would pay $10,000 in taxes, and a family
that earned $90,000 would pay $20,000 in taxes. A family that earned $30,000
would owe nothing. And a family that earned $15,000 would “owe” $5,000. In
other words, the government would send this family a check for $5,000.
Under a negative income tax, poor families would receive financial assistance
without having to demonstrate need. The only qualification required to receive assistance
would be a low income. Depending on one’s point of view, this feature
can be either an advantage or a disadvantage. On the one hand, a negative income
tax does not encourage illegitimate births and the breakup of families, as critics of
the welfare system believe current policy does. On the other hand, a negative income
tax would subsidize those who are simply lazy and, in some people’s eyes,
undeserving of government support.
One actual tax provision that works much like a negative income tax is the
Earned Income Tax Credit. This credit allows poor working families to receive income
tax refunds greater than the taxes they paid during the year. Because the
Earned Income Tax Credit applies only to the working poor, it does not discourage
recipients from working, as other antipoverty programs are claimed to do. For the
same reason, however, it also does not help alleviate poverty due to unemployment,
sickness, or other inability to work.
IN-KIND TRANSFERS
Another way to help the poor is to provide them directly with some of the goods
and services they need to raise their living standards. For example, charities provide
the needy with food, shelter, and toys at Christmas. The government gives
poor families food stamps, which are government vouchers that can be used to buy
food at stores; the stores then redeem the vouchers for money. The government
also gives many poor people health care through a program called Medicaid.
Is it better to help the poor with these in-kind transfers or with direct cash
payments? There is no clear answer.
Advocates of in-kind transfers argue that such transfers ensure that the poor
get what they need most. Among the poorest members of society, alcohol and drug
addiction is more common than it is in society as a whole. By providing the poor
with food and shelter, society can be more confident that it is not helping to support
such addictions. This is one reason why in-kind transfers are more politically
popular than cash payments to the poor.
Advocates of cash payments argue that in-kind transfers are inefficient and
disrespectful. The government does not know what goods and services the poor
need most. Many of the poor are ordinary people down on their luck. Despite their
negative income tax
a tax system that collects revenue
from high-income households and
gives transfers to low-income
households
CHAPTER 20 INCOME INEQUALITY AND POVERTY 455
misfortune, they are in the best position to decide how to raise their own living
standards. Rather than giving the poor in-kind transfers of goods and services that
they may not want, it may be better to give them cash and allow them to buy what
they think they need most.
ANTIPOVERTY PROGRAMS AND WORK INCENTIVES
Many policies aimed at helping the poor can have the unintended effect of discouraging
the poor from escaping poverty on their own. To see why, consider the
following example. Suppose that a family needs an income of $15,000 to maintain
a reasonable standard of living. And suppose that, out of concern for the poor, the
government promises to guarantee every family that income. Whatever a family
earns, the government makes up the difference between that income and $15,000.
What effect would you expect this policy to have?
The incentive effects of this policy are obvious: Any person who would make
under $15,000 by working has no incentive to find and keep a job. For every dollar
that the person would earn, the government would reduce the income supplement
by a dollar. In effect, the government taxes 100 percent of additional earnings.
An effective marginal tax rate of 100 percent is surely a policy with a large deadweight
loss.
The adverse effects of this high effective tax rate can persist over time. A person
discouraged from working loses the on-the-job training that a job might offer.
In addition, his or her children miss the lessons learned by observing a parent with
a full-time job, and this may adversely affect their own ability to find and hold
a job.
Although the antipoverty program we have been discussing is hypothetical, it
is not as unrealistic as it might first appear. Welfare, Medicaid, food stamps, and
the Earned Income Tax Credit are all programs aimed at helping the poor, and they
are all tied to family income. As a family’s income rises, the family becomes ineligible
for these programs. When all these programs are taken together, it is common
for families to face effective marginal tax rates that are very high. Sometimes
the effective marginal tax rates even exceed 100 percent, so that poor families are
worse off when they earn more. By trying to help the poor, the government discourages
those families from working. According to critics of antipoverty programs,
these programs alter work attitudes and create a “culture of poverty.”
It might seem that there is an easy solution to this problem: Reduce benefits to
poor families more gradually as their incomes rise. For example, if a poor family
loses 30 cents of benefits for every dollar it earns, then it faces an effective marginal
tax rate of 30 percent. Although this effective tax reduces work effort to some extent,
it does not eliminate the incentive to work completely.
The problem with this solution is that it greatly increases the cost of programs
to combat poverty. If benefits are phased out gradually as a poor family’s income
rises, then families just above the poverty level will also be eligible for substantial
benefits. The more gradual the phase-out, the more families are eligible, and the
greater the cost of the program. Thus, policymakers face a tradeoff between burdening
the poor with high effective marginal tax rates and burdening taxpayers
with costly programs to reduce poverty.
There are various other ways to try to reduce the work disincentive of antipoverty
programs. One is to require any person collecting benefits to accept a
456 PART SIX THE ECONOMICS OF LABOR MARKETS
government-provided job—a system sometimes called workfare. Another possibility
is to provide benefits for only a limited period of time. This route was taken
in a 1996 welfare reform bill. Advocates of time limits point to the falling poverty
rate in the late 1990s as evidence supporting this approach. Critics argue that time
limits are cruel to the least fortunate members of society and that the falling
poverty rate in the late 1990s is due more to a strong economy than to welfare
reform.
QUICK QUIZ: List three policies aimed at helping the poor, and discuss the
pros and cons of each.
CONCLUSION
People have long reflected on the distribution of income in society. Plato, the ancient
Greek philosopher, concluded that in an ideal society the income of the richest
IN 1996 THE U.S. WELFARE SYSTEM UNDERwent
a major reform, including the enactment
of time limits on benefits. In the
following opinion column, economist
Gary Becker evaluates the change in
policy.
Guess What?
Wel f a r e Reform Wo r k s
BY GARY S. BECKER
The welfare reform act of 1996 is one of
the most revolutionary pieces of legislation
since the welfare state began half a
century ago. Contrary to the predictions
of many skeptics, this law has been remarkably
successful—helped, to be
sure, by the strong economy of the past
several years.
The success of earlier reforms by a
few states led to a bipartisan effort by a
Republican Congress and President
Clinton to “end welfare as we know it”
by forcing recipients in all states to look
for work. The 1996 law limits families to
two years of welfare income during any
one spell and caps the total time on welfare
over a mother’s lifetime at five
years.
The number of recipients rose
sharply from the early 1960s, to a peak
in 1993, when over 4 million American
families were on welfare. In that year, an
incredible 1 million residents of New
York City alone were receiving welfare,
up from 250,000 in 1960.
Wisconsin, Massachusetts, New
Jersey, and a few other states decided in
the late 1980s that this upward trend in
welfare was unacceptable and could be
reversed. They introduced reforms that
discouraged women from having children
while on welfare. More important, they
dropped the assumption that most
women on welfare are not capable of
getting and holding jobs, and put pressure
on them to find employment to help
support their families.
These states managed to cut their
welfare populations while at the same
time improving the economic situation of
single-parent families. Recently, a careful
evaluation of the Massachusetts reforms
by economists M. Anne Hill and Thomas
J. Main of the City University of New
York concluded that they not only greatly
reduced that state’s welfare caseload
but also encouraged more young women
to finish high school and sharpen their
economic skills.
What worked in Massachusetts and
other pioneering states was applicable
throughout the nation, but the reassessment
of federal welfare policy
IN THE NEWS
Welfare Reform
CHAPTER 20 INCOME INEQUALITY AND POVERTY 457
person would be no more than four times the income of the poorest person. Although
the measurement of inequality is difficult, it is clear that our society has
much more inequality than Plato recommended.
One of the Ten Principles of Economics discussed in Chapter 1 is that governments
can sometimes improve market outcomes. There is little consensus, however,
about how this principle should be applied to the distribution of income.
Philosophers and policymakers today do not agree on how much income inequality
is desirable, or even whether public policy should aim to alter the distribution
of income. Much of public debate reflects this disagreement. Whenever taxes are
raised, for instance, lawmakers argue over how much of the tax hike should fall on
the rich, the middle class, and the poor.
Another of the Ten Principles of Economics is that people face tradeoffs. This
principle is important to keep in mind when thinking about economic inequality.
Policies that penalize the successful and reward the unsuccessful reduce the incentive
to succeed. Thus, policymakers face a tradeoff between equality and efficiency.
The more equally the pie is divided, the smaller the pie becomes. This is the
one lesson concerning the distribution of income about which almost everyone
agrees.
was opposed by many intellectuals.
Some members of President Clinton’s
team quit after the 1996 federal law,
over what they considered a betrayal of
the welfare state. They argued that most
women forced off welfare would become
homeless or destitute, since they supposedly
are too mentally or physically
handicapped or lacking in requisite skills
to obtain and hold jobs.
However, this law has been highly
successful in reversing the large growth
in the number of welfare recipients in the
United States. Most mothers forced off
welfare found work and provide financial
support for their children.
Certainly, the huge decline—by over
40 percent—in the number of single
mothers on welfare from the 1993 peak
is partly due to the booming economy of
the past seven years. However, most of
this decline took place in the two years
after the passage of the 1996 act. The
study of Massachusetts’ experience
cited earlier confirms the importance of
the new approach to welfare, since the
authors’ research attributes more than
one-third of the decline in that state’s
welfare role since 1995 to the reforms
and not simply to its buoyant economy.
The federal law recognizes that the
number of families in need of assistance
always rises sharply during bad economic
times. This is why each welfare
spell is allowed to last up to two years,
and mothers with dependent children
can have multiple spells, up to a total of
five years over their lifetimes. It further
acknowledges that some women are
handicapped and unable to work. What it
aims to discourage is the attraction of
welfare to able-bodied women during
good times when jobs are available.
The act also recognizes that many
poor working mothers will not earn
enough to provide a decent standard of
living for their families. Children of unmarried
working mothers continue to be
eligible for Medicaid and food stamps,
and they benefit from the earned-income
tax credit that is available only to poorer
working parents with children.
One of the most important, if hardest
to document, gains from taking families
off welfare is their greater self-respect
when they provide for themselves. Mothers
on welfare convey the impression to
their children that it is normal to live off
government handouts. In such an environment,
it is difficult for children to place a
high value on doing well at school and
preparing for work by seeking out training
on jobs and in schools.
Welfare reform has been a resounding
success in inducing unmarried mothers
to find jobs. This revolutionary
approach to welfare is based on the appreciation
that the vast majority of families
do much better when treated as
responsible adults and offered effective
incentives to help themselves.
SOURCE: Business Week, May 24, 1999, p. 18.
458 PART SIX THE ECONOMICS OF LABOR MARKETS
Data on the distribution of income show wide disparity
in our society. The richest fifth of families earns about
ten times as much income as the poorest fifth.
Because in-kind transfers, the economic life cycle,
transitory income, and economic mobility are so
important for understanding variation in income, it is
difficult to gauge the degree of inequality in our society
using data on the distribution of income in a single year.
When these factors are taken into account, they tend to
suggest that economic well-being is more equally
distributed than is annual income.
Political philosophers differ in their views about the role
of government in altering the distribution of income.
Utilitarians (such as John Stuart Mill) would choose the
distribution of income to maximize the sum of utility of
everyone in society. Liberals (such as John Rawls) would
determine the distribution of income as if we were
behind a “veil of ignorance” that prevented us from
knowing our own stations in life. Libertarians (such as
Robert Nozick) would have the government enforce
individual rights to ensure a fair process but then not be
concerned about inequality in the resulting distribution
of income.
Various policies aim to help the poor—minimum-wage
laws, welfare, negative income taxes, and in-kind
transfers. Although each of these policies helps some
families escape poverty, they also have unintended side
effects. Because financial assistance declines as income
rises, the poor often face effective marginal tax rates that
are very high. Such high effective tax rates discourage
poor families from escaping poverty on their own.
Summary
poverty rate, p. 442
poverty line, p. 442
in-kind transfers, p. 444
life cycle, p. 444
permanent income, p. 445
utilitarianism, p. 447
utility, p. 447
liberalism, p. 448
maximin criterion, p. 448
libertarianism, p. 450
welfare, p. 452
negative income tax, p. 454
Key Concepts
1. Does the richest fifth of the U.S. population earn two,
four, or ten times the income of the poorest fifth?
2. How does the extent of income inequality in the United
States compare to that of other nations around the world?
3. What groups in the population are most likely to live in
poverty?
4. When gauging the amount of inequality, why do
transitory and life cycle variations in income cause
difficulties?
5. How would a utilitarian, a liberal, and a libertarian
determine how much income inequality is permissible?
6. What are the pros and cons of in-kind (rather than cash)
transfers to the poor?
7. Describe how antipoverty programs can discourage the
poor from working. How might you reduce this
disincentive? What are the disadvantages with your
proposed policy?
Questions for Review
1. Table 20-2 shows that income inequality in the United
States has increased during the past 20 years. Some
factors contributing to this increase were discussed in
Chapter 19. What are they?
2. Table 20-4 shows that the percentage of children in
families with income below the poverty line is almost
twice the percentage of the elderly in such families.
How might the allocation of government money across
Problems and Applications
CHAPTER 20 INCOME INEQUALITY AND POVERTY 459
different social programs have contributed to this
phenomenon? (Hint: See Chapter 12.)
3. Economists often view life cycle variation in income as
one form of transitory variation in income around
people’s lifetime, or permanent, income. In this sense,
how does your current income compare to your
permanent income? Do you think your current income
accurately reflects your standard of living?
4. The chapter discusses the importance of economic
mobility.
a. What policies might the government pursue to
increase economic mobility within a generation?
b. What policies might the government pursue to
increase economic mobility across generations?
c. Do you think we should reduce spending on
current welfare programs in order to increase
spending on programs that enhance economic
mobility? What are some of the advantages and
disadvantages of doing so?
5. Consider two communities. In one community, ten
families have incomes of $100 each and ten families
have incomes of $20 each. In the other community, ten
families have incomes of $200 each and ten families
have incomes of $22 each.
a. In which community is the distribution of income
more unequal? In which community is the problem
of poverty likely to be worse?
b. Which distribution of income would Rawls prefer?
Explain.
c. Which distribution of income do you prefer?
Explain.
6. The chapter uses the analogy of a “leaky bucket” to
explain one constraint on the redistribution of income.
a. What elements of the U.S. system for redistributing
income create the leaks in the bucket? Be specific.
b. Do you think that Republicans or Democrats
generally believe that the bucket used for
redistributing income is more leaky? How does that
belief affect their views about the amount of income
redistribution that the government should
undertake?
7. Suppose there are two possible income distributions in a
society of ten people. In the first distribution, nine people
would have incomes of $30,000 and one person would
have an income of $10,000. In the second distribution, all
ten people would have incomes of $25,000.
a. If the society had the first income distribution, what
would be the utilitarian argument for redistributing
income?
b. Which income distribution would Rawls consider
more equitable? Explain.
c. Which income distribution would Nozick consider
more equitable? Explain.
8. The poverty rate would be substantially lower if the
market value of in-kind transfers were added to family
income. The government spends more money on
Medicaid than on any other in-kind transfer, with
expenditures per recipient family amounting to roughly
$5,000 annually.
a. If the government gave each recipient family a
check for this amount instead of enrolling them in
the Medicaid program, do you think that most of
these families would spend that much to purchase
health insurance? (Recall that the poverty line is
below $15,000 for a family of four.) Why?
b. How does your answer to part (a) affect your view
about whether we should determine the poverty
rate by valuing in-kind transfers at the price the
government pays for them? Explain.
c. How does your answer to part (a) affect your view
about whether we should provide assistance to the
poor in the form of cash transfers or in-kind
transfers? Explain.
9. Suppose that a family’s tax liability equaled its income
multiplied by one-half, minus $10,000. Under this
system, some families would pay taxes to the
government, and some families would receive money
from the government through a “negative income tax.”
a. Consider families with pre-tax incomes of $0,
$10,000, $20,000, $30,000, and $40,000. Make a table
showing pre-tax income, taxes paid to the
government or money received from the
government, and after-tax income for each family.
b. What is the marginal tax rate in this system? (See
Chapter 12 if you need to review the definition of
marginal tax rate.) What is the maximum amount of
income at which a family receives money from the
government?
c. Now suppose that the tax schedule is changed, so
that a family’s tax liability equals its income
multiplied by one-quarter, minus $10,000. What is
the marginal tax rate in this new system? What is
the maximum amount of income at which a family
receives money from the government?
d. What is the main advantage of each of the tax
schedules discussed here?
10. John and Jeremy are utilitarians. John believes that labor
supply is highly elastic, whereas Jeremy believes that
460 PART SIX THE ECONOMICS OF LABOR MARKETS
labor supply is quite inelastic. How do you suppose
their views about income redistribution differ?
11. Do you agree or disagree with each of the following
statements? What do your views imply for public
policies, such as taxes on inheritance?
a. “Every parent has the right to work hard and save
in order to give his or her children a better life.”
b. “No child should be disadvantaged by the sloth or
bad luck of his or her parents.”
IN THIS CHAPTER
YOU WILL . . .
Decompose the
impact of a price
change into an
income ef fect and a
substitution ef fect
Apply the theor y of
consumer choice to
four questions
about household
behavior
Analyze how a
consumer’s optimal
choices are
determined
See how a budget
constraint
represents the
choices a consumer
can af ford
Learn how
indif ference curves
can be used to
represent a
consumer’s
preferences
See how a consumer
responds to
changes in income
and changes
in prices
When you walk into a store, you are confronted with thousands of goods that you
might buy. Of course, because your financial resources are limited, you cannot buy
everything that you want. You therefore consider the prices of the various goods
being offered for sale and buy a bundle of goods that, given your resources, best
suits your needs and desires.
In this chapter we develop the theory that describes how consumers make decisions
about what to buy. So far throughout this book, we have summarized consumers’
decisions with the demand curve. As we discussed in Chapters 4 through
7, the demand curve for a good reflects consumers’ willingness to pay for it. When
the price of a good rises, consumers are willing to pay for fewer units, so the quantity
demanded falls. We now look more deeply at the decisions that lie behind the
demand curve. The theory of consumer choice presented in this chapter provides
T H E T H E O R Y O F
C O N S U M E R C H O I C E
463
464 PART SEVEN ADVANCED TOPIC
a more complete understanding of demand, just as the theory of the competitive
firm in Chapter 14 provides a more complete understanding of supply.
One of the Ten Principles of Economics discussed in Chapter 1 is that people face
tradeoffs. The theory of consumer choice examines the tradeoffs that people face in
their role as consumers. When a consumer buys more of one good, he can afford
less of other goods. When he spends more time enjoying leisure and less time
working, he has lower income and can afford less consumption. When he spends
more of his income in the present and saves less of it, he must accept a lower level
of consumption in the future. The theory of consumer choice examines how consumers
facing these tradeoffs make decisions and how they respond to changes in
their environment.
After developing the basic theory of consumer choice, we apply it to several
questions about household decisions. In particular, we ask:
Do all demand curves slope downward?
How do wages affect labor supply?
How do interest rates affect household saving?
Do the poor prefer to receive cash or in-kind transfers?
At first, these questions might seem unrelated. But, as we will see, we can use the
theory of consumer choice to address each of them.
THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
Most people would like to increase the quantity or quality of the goods they consume—
to take longer vacations, drive fancier cars, or eat at better restaurants. People
consume less than they desire because their spending is constrained, or limited,
by their income. We begin our study of consumer choice by examining this link between
income and spending.
To keep things simple, we examine the decision facing a consumer who buys
only two goods: Pepsi and pizza. Of course, real people buy thousands of different
kinds of goods. Yet assuming there are only two goods greatly simplifies the problem
without altering the basic insights about consumer choice.
We first consider how the consumer’s income constrains the amount he
spends on Pepsi and pizza. Suppose that the consumer has an income of $1,000 per
month and that he spends his entire income each month on Pepsi and pizza. The
price of a pint of Pepsi is $2, and the price of a pizza is $10.
Table 21-1 shows some of the many combinations of Pepsi and pizza that the
consumer can buy. The first line in the table shows that if the consumer spends all
his income on pizza, he can eat 100 pizzas during the month, but he would not be
able to buy any Pepsi at all. The second line shows another possible consumption
bundle: 90 pizzas and 50 pints of Pepsi. And so on. Each consumption bundle in
the table costs exactly $1,000.
Figure 21-1 graphs the consumption bundles that the consumer can choose.
The vertical axis measures the number of pints of Pepsi, and the horizontal axis
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 465
measures the number of pizzas. Three points are marked on this figure. At point A,
the consumer buys no Pepsi and consumes 100 pizzas. At point B, the consumer
buys no pizza and consumes 500 pints of Pepsi. At point C, the consumer buys
50 pizzas and 250 pints of Pepsi. Point C, which is exactly at the middle of the line
from Ato B, is the point at which the consumer spends an equal amount ($500) on
Pepsi and pizza. Of course, these are only three of the many combinations of Pepsi
and pizza that the consumer can choose. All the points on the line from A to B are
possible. This line, called the budget constraint, shows the consumption bundles
that the consumer can afford. In this case, it shows the tradeoff between Pepsi and
pizza that the consumer faces.
Table 21-1
THE CONSUMER’S
OPPORTUNITIES. This table
shows what the consumer can
afford if his income is $1,000, the
price of Pepsi is $2, and the price
of pizza is $10.
NUMBER SPENDING SPENDING TOTAL
PINTS OF PEPSI OF PIZZAS ON PEPSI ON PIZZA SPENDING
0 100 $ 0 $1,000 $1,000
50 90 100 900 1,000
100 80 200 800 1,000
150 70 300 700 1,000
200 60 400 600 1,000
250 50 500 500 1,000
300 40 600 400 1,000
350 30 700 300 1,000
400 20 800 200 1,000
450 10 900 100 1,000
500 0 1,000 0 1,000
100 Quantity
of Pizza
Quantity
of Pepsi
0
250
50
500
B
C
A
Consumer’s
budget constraint
Figure 21-1
THE CONSUMER’S BUDGET
CONSTRAINT. The budget
constraint shows the various
bundles of goods that the
consumer can afford for a given
income. Here the consumer buys
bundles of Pepsi and pizza. The
more Pepsi he buys, the less
pizza he can afford.
budget constraint
the limit on the consumption
bundles that a consumer can afford
466 PART SEVEN ADVANCED TOPIC
The slope of the budget constraint measures the rate at which the consumer
can trade one good for the other. Recall from the appendix to Chapter 2 that the
slope between two points is calculated as the change in the vertical distance divided
by the change in the horizontal distance (“rise over run”). From point A to
point B, the vertical distance is 500 pints, and the horizontal distance is 100 pizzas.
Thus, the slope is 5 pints per pizza. (Actually, because the budget constraint slopes
downward, the slope is a negative number. But for our purposes we can ignore the
minus sign.)
Notice that the slope of the budget constraint equals the relative price of the two
goods—the price of one good compared to the price of the other. A pizza costs 5
times as much as a pint of Pepsi, so the opportunity cost of a pizza is 5 pints of
Pepsi. The budget constraint’s slope of 5 reflects the tradeoff the market is offering
the consumer: 1 pizza for 5 pints of Pepsi.
QUICK QUIZ: Draw the budget constraint for a person with income of
$1,000 if the price of Pepsi is $5 and the price of pizza is $10. What is the slope
of this budget constraint?
PREFERENCES: WHAT THE CONSUMER WANTS
Our goal in this chapter is to see how consumers make choices. The budget constraint
is one piece of the analysis: It shows what combination of goods the consumer
can afford given his income and the prices of the goods. The consumer’s
choices, however, depend not only on his budget constraint but also on his preferences
regarding the two goods. Therefore, the consumer’s preferences are the next
piece of our analysis.
REPRESENTING PREFERENCES WITH
INDIFFERENCE CURVES
The consumer’s preferences allow him to choose among different bundles of Pepsi
and pizza. If you offer the consumer two different bundles, he chooses the bundle
that best suits his tastes. If the two bundles suit his tastes equally well, we say that
the consumer is indifferent between the two bundles.
Just as we have represented the consumer’s budget constraint graphically, we
can also represent his preferences graphically. We do this with indifference curves.
An indifference curve shows the bundles of consumption that make the consumer
equally happy. In this case, the indifference curves show the combinations of Pepsi
and pizza with which the consumer is equally satisfied.
Figure 21-2 shows two of the consumer’s many indifference curves. The consumer
is indifferent among combinations A, B, and C, because they are all on the
same curve. Not surprisingly, if the consumer’s consumption of pizza is reduced,
say from point A to point B, consumption of Pepsi must increase to keep him
equally happy. If consumption of pizza is reduced again, from point B to point C,
the amount of Pepsi consumed must increase yet again.
indif ference curve
a curve that shows consumption
bundles that give the consumer the
same level of satisfaction
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 467
The slope at any point on an indifference curve equals the rate at which the
consumer is willing to substitute one good for the other. This rate is called the
marginal rate of substitution (MRS). In this case, the marginal rate of substitution
measures how much Pepsi the consumer requires in order to be compensated for
a one-unit reduction in pizza consumption. Notice that because the indifference
curves are not straight lines, the marginal rate of substitution is not the same at all
points on a given indifference curve. The rate at which a consumer is willing to
trade one good for the other depends on the amounts of the goods he is already
consuming. That is, the rate at which a consumer is willing to trade pizza for Pepsi
depends on whether he is more hungry or more thirsty, which in turn depends on
how much pizza and Pepsi he has.
The consumer is equally happy at all points on any given indifference curve,
but he prefers some indifference curves to others. Because he prefers more consumption
to less, higher indifference curves are preferred to lower ones. In Figure
21-2, any point on curve I2 is preferred to any point on curve I1.
A consumer’s set of indifference curves gives a complete ranking of the consumer’s
preferences. That is, we can use the indifference curves to rank any two
bundles of goods. For example, the indifference curves tell us that point D is preferred
to point A because point D is on a higher indifference curve than point A.
(That conclusion may be obvious, however, because point D offers the consumer
both more pizza and more Pepsi.) The indifference curves also tell us that point D
is preferred to point C because point D is on a higher indifference curve. Even
though point D has less Pepsi than point C, it has more than enough extra pizza to
make the consumer prefer it. By seeing which point is on the higher indifference
curve, we can use the set of indifference curves to rank any combinations of Pepsi
and pizza.
Quantity
of Pizza
Quantity
of Pepsi
0
C
B
1
A
D
Indifference
curve, I 1
I 2
MRS
Figure 21-2
THE CONSUMER’S PREFERENCES.
The consumer’s preferences are
represented with indifference
curves, which show the
combinations of Pepsi and pizza
that make the consumer equally
satisfied. Because the consumer
prefers more of a good, points
on a higher indifference curve
(I2 here) are preferred to points on
a lower indifference curve (I1).
The marginal rate of substitution
(MRS) shows the rate at which
the consumer is willing to trade
Pepsi for pizza.
marginal rate of
substitution
the rate at which a consumer is
willing to trade one good for another
468 PART SEVEN ADVANCED TOPIC
FOUR PROPERTIES OF INDIFFERENCE CURVES
Because indifference curves represent a consumer’s preferences, they have certain
properties that reflect those preferences. Here we consider four properties that describe
most indifference curves:
Property 1: Higher indifference curves are preferred to lower ones. Consumers
usually prefer more of something to less of it. (That is why we call this
something a “good” rather than a “bad.”) This preference for greater
quantities is reflected in the indifference curves. As Figure 21-2 shows, higher
indifference curves represent larger quantities of goods than lower
indifference curves. Thus, the consumer prefers being on higher indifference
curves.
Property 2: Indifference curves are downward sloping. The slope of an
indifference curve reflects the rate at which the consumer is willing to
substitute one good for the other. In most cases, the consumer likes both
goods. Therefore, if the quantity of one good is reduced, the quantity of the
other good must increase in order for the consumer to be equally happy. For
this reason, most indifference curves slope downward.
Property 3: Indifference curves do not cross. To see why this is true, suppose that
two indifference curves did cross, as in Figure 21-3. Then, because point A is
on the same indifference curve as point B, the two points would make the
consumer equally happy. In addition, because point B is on the same
indifference curve as point C, these two points would make the consumer
equally happy. But these conclusions imply that points A and C would also
make the consumer equally happy, even though point C has more of both
goods. This contradicts our assumption that the consumer always prefers
more of both goods to less. Thus, indifference curves cannot cross.
Quantity
of Pizza
Quantity
of Pepsi
0
C
A
B
Figure 21-3
THE IMPOSSIBILITY OF
INTERSECTING INDIFFERENCE
CURVES. A situation like this
can never happen. According to
these indifference curves, the
consumer would be equally
satisfied at points A, B, and C,
even though point C has more of
both goods than point A.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 469
Property 4: Indifference curves are bowed inward. The slope of an indifference
curve is the marginal rate of substitution—the rate at which the consumer is
willing to trade off one good for the other. The marginal rate of substitution
(MRS) usually depends on the amount of each good the consumer is
currently consuming. In particular, because people are more willing to trade
away goods that they have in abundance and less willing to trade away
goods of which they have little, the indifference curves are bowed inward. As
an example, consider Figure 21-4. At point A, because the consumer has a lot
of Pepsi and only a little pizza, he is very hungry but not very thirsty. To
induce the consumer to give up 1 pizza, the consumer has to be given 6 pints
of Pepsi: The marginal rate of substitution is 6 pints per pizza. By contrast, at
point B, the consumer has little Pepsi and a lot of pizza, so he is very thirsty
but not very hungry. At this point, he would be willing to give up 1 pizza to
get 1 pint of Pepsi: The marginal rate of substitution is 1 pint per pizza. Thus,
the bowed shape of the indifference curve reflects the consumer’s greater
willingness to give up a good that he already has in large quantity.
TWO EXTREME EXAMPLES OF INDIFFERENCE CURVES
The shape of an indifference curve tells us about the consumer’s willingness to
trade one good for the other. When the goods are easy to substitute for each other,
the indifference curves are less bowed; when the goods are hard to substitute, the
indifference curves are very bowed. To see why this is true, let’s consider the extreme
cases.
Per fect Substitutes Suppose that someone offered you bundles of nickels
and dimes. How would you rank the different bundles?
Quantity
of Pizza
Quantity
of Pepsi
14
8
4
3
0 2 3 6 7
Indifference
curve
1
1
A
B
MRS = 6
MRS = 1
Figure 21-4
BOWED INDIFFERENCE CURVES.
Indifference curves are usually
bowed inward. This shape
implies that the marginal rate of
substitution (MRS) depends on
the quantity of the two goods the
consumer is consuming. At point
A, the consumer has little pizza
and much Pepsi, so he requires a
lot of extra Pepsi to induce him to
give up one of the pizzas: The
marginal rate of substitution is
6 pints of Pepsi per pizza. At
point B, the consumer has much
pizza and little Pepsi, so he
requires only a little extra Pepsi
to induce him to give up one of
the pizzas: The marginal rate of
substitution is 1 pint of Pepsi per
pizza.
470 PART SEVEN ADVANCED TOPIC
Most likely, you would care only about the total monetary value of each bundle.
If so, you would judge a bundle based on the number of nickels plus twice the
number of dimes. In other words, you would always be willing to trade 1 dime for
2 nickels, regardless of the number of nickels and dimes in the bundle. Your marginal
rate of substitution between nickels and dimes would be a fixed number—2.
We can represent your preferences over nickels and dimes with the indifference
curves in panel (a) of Figure 21-5. Because the marginal rate of substitution is
constant, the indifference curves are straight lines. In this extreme case of straight
indifference curves, we say that the two goods are perfect substitutes.
Per fect Complements Suppose now that someone offered you bundles
of shoes. Some of the shoes fit your left foot, others your right foot. How would
you rank these different bundles?
In this case, you might care only about the number of pairs of shoes. In other
words, you would judge a bundle based on the number of pairs you could assemble
from it. Abundle of 5 left shoes and 7 right shoes yields only 5 pairs. Getting 1
more right shoe has no value if there is no left shoe to go with it.
We can represent your preferences for right and left shoes with the indifference
curves in panel (b) of Figure 21-5. In this case, a bundle with 5 left shoes and
5 right shoes is just as good as a bundle with 5 left shoes and 7 right shoes. It is also
just as good as a bundle with 7 left shoes and 5 right shoes. The indifference
curves, therefore, are right angles. In this extreme case of right-angle indifference
curves, we say that the two goods are perfect complements.
In the real world, of course, most goods are neither perfect substitutes (like
nickels and dimes) nor perfect complements (like right shoes and left shoes). More
0 1 2 3 Dimes 5 7
Nickels
6
4
2
(a) Perfect Substitutes
0 Right Shoes
Left
Shoes
7
5
(b) Perfect Complements
I 1 I 2 I 3
I 1
I 2
Figure 21-5
PERFECT SUBSTITUTES AND PERFECT COMPLEMENTS. When two goods are easily
substitutable, such as nickels and dimes, the indifference curves are straight lines, as
shown in panel (a). When two goods are strongly complementary, such as left shoes and
right shoes, the indifference curves are right angles, as shown in panel (b).
per fect substitutes
two goods with straight-line
indifference curves
per fect complements
two goods with right-angle
indifference curves
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 471
typically, the indifference curves are bowed inward, but not so bowed as to become
right angles.
QUICK QUIZ: Draw some indifference curves for Pepsi and pizza. Explain
the four properties of these indifference curves.
OPTIMIZATION: WHAT THE CONSUMER CHOOSES
The goal of this chapter is to understand how a consumer makes choices. We have
the two pieces necessary for this analysis: the consumer’s budget constraint and
the consumer’s preferences. Now we put these two pieces together and consider
the consumer’s decision about what to buy.
THE CONSUMER’S OPTIMAL CHOICES
Consider once again our Pepsi and pizza example. The consumer would like to
end up with the best possible combination of Pepsi and pizza—that is, the combination
on the highest possible indifference curve. But the consumer must also end
up on or below his budget constraint, which measures the total resources available
to him.
Figure 21-6 shows the consumer’s budget constraint and three of his many indifference
curves. The highest indifference curve that the consumer can reach (I2 in
the figure) is the one that just barely touches the budget constraint. The point at
which this indifference curve and the budget constraint touch is called the optimum.
The consumer would prefer point A, but he cannot afford that point because
We have used indifference
curves to represent the consumer’s
preferences. Another
common way to represent preferences
is with the concept of
utility. Utility is an abstract measure
of the satisfaction or happiness
that a consumer receives
from a bundle of goods. Economists
say that a consumer
prefers one bundle of goods to
another if the first provides
more utility than the second.
Indifference curves and utility are closely related. Because
the consumer prefers points on higher indifference
curves, bundles of goods on higher indifference curves provide
higher utility. Because the consumer is equally happy
with all points on the same indifference curve, all these
bundles provide the same utility. Indeed, you can think of an
indifference curve as an “equal-utility” curve. The slope of
the indifference curve (the marginal rate of substitution) reflects
the marginal utility generated by one good compared
to the marginal utility generated by the other good.
When economists discuss the theory of consumer
choice, they might express the theory using different words.
One economist might say that the goal of the consumer is to
maximize utility. Another might say that the goal of the consumer
is to end up on the highest possible indifference
curve. In essence, these are two ways of saying the same
thing.
FYI
Utility: An
Alternative
Way to
Represent a
Consumer’s
Preferences
472 PART SEVEN ADVANCED TOPIC
it lies above his budget constraint. The consumer can afford point B, but that point
is on a lower indifference curve and, therefore, provides the consumer less satisfaction.
The optimum represents the best combination of consumption of Pepsi
and pizza available to the consumer.
Notice that, at the optimum, the slope of the indifference curve equals the
slope of the budget constraint. We say that the indifference curve is tangent to the
budget constraint. The slope of the indifference curve is the marginal rate of substitution
between Pepsi and pizza, and the slope of the budget constraint is the
relative price of Pepsi and pizza. Thus, the consumer chooses consumption of the two
goods so that the marginal rate of substitution equals the relative price.
In Chapter 7 we saw how market prices reflect the marginal value that consumers
place on goods. This analysis of consumer choice shows the same result in
another way. In making his consumption choices, the consumer takes as given the
relative price of the two goods and then chooses an optimum at which his marginal
rate of substitution equals this relative price. The relative price is the rate at
which the market is willing to trade one good for the other, whereas the marginal
rate of substitution is the rate at which the consumer is willing to trade one good for
the other. At the consumer’s optimum, the consumer’s valuation of the two goods
(as measured by the marginal rate of substitution) equals the market’s valuation
(as measured by the relative price). As a result of this consumer optimization, market
prices of different goods reflect the value that consumers place on those goods.
HOW CHANGES IN INCOME AFFECT
THE CONSUMER’S CHOICES
Now that we have seen how the consumer makes the consumption decision, let’s
examine how consumption responds to changes in income. To be specific, suppose
Quantity
of Pizza
Quantity
of Pepsi
0
Optimum
A
B
Budget constraint
I 1
I 2
I 3
Figure 21-6
THE CONSUMER’S OPTIMUM.
The consumer chooses the point
on his budget constraint that lies
on the highest indifference curve.
At this point, called the optimum,
the marginal rate of substitution
equals the relative price of the
two goods. Here the highest
indifference curve the consumer
can reach is I2. The consumer
prefers point A, which lies on
indifference curve I3, but the
consumer cannot afford this
bundle of Pepsi and pizza. By
contrast, point B is affordable, but
because it lies on a lower
indifference curve, the consumer
does not prefer it.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 473
that income increases. With higher income, the consumer can afford more of both
goods. The increase in income, therefore, shifts the budget constraint outward,
as in Figure 21-7. Because the relative price of the two goods has not changed,
the slope of the new budget constraint is the same as the slope of the initial budget
constraint. That is, an increase in income leads to a parallel shift in the budget
constraint.
The expanded budget constraint allows the consumer to choose a better combination
of Pepsi and pizza. In other words, the consumer can now reach a higher
indifference curve. Given the shift in the budget constraint and the consumer’s
preferences as represented by his indifference curves, the consumer’s optimum
moves from the point labeled “initial optimum” to the point labeled “new optimum.”
Notice that, in Figure 21-7, the consumer chooses to consume more Pepsi and
more pizza. Although the logic of the model does not require increased consumption
of both goods in response to increased income, this situation is the most common
one. As you may recall from Chapter 4, if a consumer wants more of a good
when his income rises, economists call it a normal good. The indifference curves
in Figure 21-7 are drawn under the assumption that both Pepsi and pizza are normal
goods.
Figure 21-8 shows an example in which an increase in income induces the consumer
to buy more pizza but less Pepsi. If a consumer buys less of a good when his
income rises, economists call it an inferior good. Figure 21-8 is drawn under the
assumption that pizza is a normal good and Pepsi is an inferior good.
Although most goods are normal goods, there are some inferior goods in the
world. One example is bus rides. High-income consumers are more likely to own
cars and less likely to ride the bus than low-income consumers. Bus rides, therefore,
are an inferior good.
Quantity
of Pizza
Quantity
of Pepsi
0
New optimum
New budget constraint
I 1
I 2
2. . . . raising pizza consumption . . .
3. . . . and
Pepsi
consumption.
Initial
budget
constraint
Initial
optimum
1. An increase in income shifts the
budget constraint outward . . .
Figure 21-7
AN INCREASE IN INCOME.
When the consumer’s income
rises, the budget constraint shifts
out. If both goods are normal
goods, the consumer responds to
the increase in income by buying
more of both of them. Here the
consumer buys more pizza and
more Pepsi.
normal good
a good for which an increase in
income raises the quantity demanded
inferior good
a good for which an increase in
income reduces the quantity
demanded
474 PART SEVEN ADVANCED TOPIC
HOW CHANGES IN PRICES AFFECT
THE CONSUMER’S CHOICES
Let’s now use this model of consumer choice to consider how a change in the price
of one of the goods alters the consumer’s choices. Suppose, in particular, that the
price of Pepsi falls from $2 to $1 a pint. It is no surprise that the lower price expands
the consumer’s set of buying opportunities. In other words, a fall in the
price of any good shifts the budget constraint outward.
Figure 21-9 considers more specifically how the fall in price affects the budget
constraint. If the consumer spends his entire $1,000 income on pizza, then the price
of Pepsi is irrelevant. Thus, point A in the figure stays the same. Yet if the consumer
spends his entire income of $1,000 on Pepsi, he can now buy 1,000 rather
than only 500 pints. Thus, the end point of the budget constraint moves from point
B to point D.
Notice that in this case the outward shift in the budget constraint changes its
slope. (This differs from what happened previously when prices stayed the same
but the consumer’s income changed.) As we have discussed, the slope of the budget
constraint reflects the relative price of Pepsi and pizza. Because the price of
Pepsi has fallen to $1 from $2, while the price of pizza has remained $10, the consumer
can now trade a pizza for 10 rather than 5 pints of Pepsi. As a result, the
new budget constraint is more steeply sloped.
How such a change in the budget constraint alters the consumption of both
goods depends on the consumer’s preferences. For the indifference curves drawn
in this figure, the consumer buys more Pepsi and less pizza.
Quantity
of Pizza
Quantity
of Pepsi
0
Initial
optimum
New optimum
Initial
budget
constraint
New budget constraint
I 1 I 2
1. When an increase in income shifts the
3. . . . but budget constraint outward . . .
Pepsi
consumption
falls, making
Pepsi an
inferior good.
2. . . . pizza consumption rises, making pizza a normal good . . .
Figure 21-8
AN INFERIOR GOOD. A good is
an inferior good if the consumer
buys less of it when his income
rises. Here Pepsi is an inferior
good: When the consumer’s
income increases and the budget
constraint shifts outward, the
consumer buys more pizza but
less Pepsi.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 475
INCOME AND SUBSTITUTION EFFECTS
The impact of a change in the price of a good on consumption can be decomposed
into two effects: an income effect and a substitution effect. To see what these two
effects are, consider how our consumer might respond when he learns that the
price of Pepsi has fallen. He might reason in the following ways:
“Great news! Now that Pepsi is cheaper, my income has greater purchasing
power. I am, in effect, richer than I was. Because I am richer, I can buy both
more Pepsi and more pizza.” (This is the income effect.)
“Now that the price of Pepsi has fallen, I get more pints of Pepsi for every
pizza that I give up. Because pizza is now relatively more expensive, I should
buy less pizza and more Pepsi.” (This is the substitution effect.)
Which statement do you find more compelling?
In fact, both of these statements make sense. The decrease in the price of Pepsi
makes the consumer better off. If Pepsi and pizza are both normal goods, the consumer
will want to spread this improvement in his purchasing power over both
goods. This income effect tends to make the consumer buy more pizza and more
Pepsi. Yet, at the same time, consumption of Pepsi has become less expensive relative
to consumption of pizza. This substitution effect tends to make the consumer
choose more Pepsi and less pizza.
Now consider the end result of these two effects. The consumer certainly buys
more Pepsi, because the income and substitution effects both act to raise purchases
of Pepsi. But it is ambiguous whether the consumer buys more pizza, because the
Quantity
of Pizza
100
Quantity
of Pepsi
1,000
500
0
B
D
A
New optimum
I 1
I 2
Initial optimum
New budget constraint
Initial
budget
constraint
1. A fall in the price of Pepsi rotates
the budget constraint outward . . .
3. . . . and
raising Pepsi
consumption.
2. . . . reducing pizza consumption . . .
Figure 21-9
A CHANGE IN PRICE. When the
price of Pepsi falls, the
consumer’s budget constraint
shifts outward and changes
slope. The consumer moves from
the initial optimum to the new
optimum, which changes his
purchases of both Pepsi and
pizza. In this case, the quantity of
Pepsi consumed rises, and the
quantity of pizza consumed falls.
income ef fect
the change in consumption that
results when a price change moves
the consumer to a higher or lower
indifference curve
substitution ef fect
the change in consumption that
results when a price change moves
the consumer along a given
indifference curve to a point with a
new marginal rate of substitution
476 PART SEVEN ADVANCED TOPIC
income and substitution effects work in opposite directions. This conclusion is
summarized in Table 21-2.
We can interpret the income and substitution effects using indifference curves.
The income effect is the change in consumption that results from the movement to a higher
indifference curve. The substitution effect is the change in consumption that results from
being at a point on an indifference curve with a different marginal rate of substitution.
Figure 21-10 shows graphically how to decompose the change in the consumer’s
decision into the income effect and the substitution effect. When the price
Table 21-2
GOOD INCOME EFFECT SUBSTITUTION EFFECT TOTAL EFFECT
Pepsi Consumer is richer, Pepsi is relatively cheaper, so Income and substitution effects act in
so he buys more Pepsi. consumer buys more Pepsi. same direction, so consumer buys
more Pepsi.
Pizza Consumer is richer, Pizza is relatively more Income and substitution effects act in
so he buys more pizza. expensive, so consumer opposite directions, so the total effect
buys less pizza. on pizza consumption is ambiguous.
INCOME AND SUBSTITUTION EFFECTS WHEN THE PRICE OF PEPSI FALLS
Quantity
of Pizza
Quantity
of Pepsi
0
Income
effect
Substitution
effect
B
A
C New optimum
I 1
I 2
Initial optimum
New budget constraint
Initial
budget
constraint
Substitution effect
Income effect
Figure 21-10
INCOME AND SUBSTITUTION
EFFECTS. The effect of a change
in price can be broken down into
an income effect and a substitution
effect. The substitution
effect—the movement along an
indifference curve to a point with
a different marginal rate of
substitution—is shown here as
the change from point A to
point B along indifference
curve I1. The income effect—the
shift to a higher indifference
curve—is shown here as the
change from point B on
indifference curve I1 to point C on
indifference curve I2.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 477
of Pepsi falls, the consumer moves from the initial optimum, point A, to the new
optimum, point C. We can view this change as occurring in two steps. First, the
consumer moves along the initial indifference curve I1 from point Ato point B. The
consumer is equally happy at these two points, but at point B, the marginal rate of
substitution reflects the new relative price. (The dashed line through point B
reflects the new relative price by being parallel to the new budget constraint.)
Next, the consumer shifts to the higher indifference curve I2 by moving from
point B to point C. Even though point B and point C are on different indifference
curves, they have the same marginal rate of substitution. That is, the slope
of the indifference curve I1 at point B equals the slope of the indifference curve I2
at point C.
Although the consumer never actually chooses point B, this hypothetical point
is useful to clarify the two effects that determine the consumer’s decision. Notice
that the change from point A to point B represents a pure change in the marginal
rate of substitution without any change in the consumer’s welfare. Similarly, the
change from point B to point C represents a pure change in welfare without any
change in the marginal rate of substitution. Thus, the movement from A to B
shows the substitution effect, and the movement from B to C shows the income
effect.
DERIVING THE DEMAND CURVE
We have just seen how changes in the price of a good alter the consumer’s budget
constraint and, therefore, the quantities of the two goods that he chooses to buy.
The demand curve for any good reflects these consumption decisions. Recall that
a demand curve shows the quantity demanded of a good for any given price. We
can view a consumer’s demand curve as a summary of the optimal decisions that
arise from his budget constraint and indifference curves.
For example, Figure 21-11 considers the demand for Pepsi. Panel (a) shows
that when the price of a pint falls from $2 to $1, the consumer’s budget constraint
shifts outward. Because of both income and substitution effects, the consumer increases
his purchases of Pepsi from 50 to 150 pints. Panel (b) shows the demand
curve that results from this consumer’s decisions. In this way, the theory of consumer
choice provides the theoretical foundation for the consumer’s demand
curve, which we first introduced in Chapter 4.
Although it is comforting to know that the demand curve arises naturally
from the theory of consumer choice, this exercise by itself does not justify developing
the theory. There is no need for a rigorous, analytic framework just to establish
that people respond to changes in prices. The theory of consumer choice is,
however, very useful. As we see in the next section, we can use the theory to delve
more deeply into the determinants of household behavior.
QUICK QUIZ: Draw a budget constraint and indifference curves for Pepsi
and pizza. Show what happens to the budget constraint and the consumer’s
optimum when the price of pizza rises. In your diagram, decompose the
change into an income effect and a substitution effect.
478 PART SEVEN ADVANCED TOPIC
FOUR APPLICATIONS
Now that we have developed the basic theory of consumer choice, let’s use it to
shed light on four questions about how the economy works. These four questions
might at first seem unrelated. But because each question involves household
decisionmaking, we can address it with the model of consumer behavior we have
just developed.
DO ALL DEMAND CURVES SLOPE DOWNWARD?
Normally, when the price of a good rises, people buy less of it. Chapter 4 called
this usual behavior the law of demand. This law is reflected in the downward slope
of the demand curve.
As a matter of economic theory, however, demand curves can sometimes slope
upward. In other words, consumers can sometimes violate the law of demand and
buy more of a good when the price rises. To see how this can happen, consider Figure
21-12. In this example, the consumer buys two goods—meat and potatoes. Initially,
the consumer’s budget constraint is the line from point A to point B. The
optimum is point C. When the price of potatoes rises, the budget constraint shifts
inward and is now the line from point A to point D. The optimum is now point E.
Quantity
of Pizza
0 50 150
50 Demand
(a) The Consumer’s Optimum
Quantity
of Pepsi
0
Price of
Pepsi
$2
1
(b) The Demand Curve for Pepsi
Quantity
of Pepsi
150
B A
B
A
I 1
I 2
New budget constraint
Initial budget
constraint
Figure 21-11 DERIVING THE DEMAND CURVE. Panel (a) shows that when the price of Pepsi falls from
$2 to $1, the consumer’s optimum moves from point A to point B, and the quantity of
Pepsi consumed rises from 50 to 150 pints. The demand curve in panel (b) reflects this
relationship between the price and the quantity demanded.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 479
Notice that a rise in the price of potatoes has led the consumer to buy a larger
quantity of potatoes.
Why is the consumer responding in a seemingly perverse way? The reason is
that potatoes here are a strongly inferior good. When the price of potatoes rises,
the consumer is poorer. The income effect makes the consumer want to buy less
meat and more potatoes. At the same time, because the potatoes have become
more expensive relative to meat, the substitution effect makes the consumer want
to buy more meat and less potatoes. In this particular case, however, the income effect
is so strong that it exceeds the substitution effect. In the end, the consumer responds
to the higher price of potatoes by buying less meat and more potatoes.
Economists use the term Giffen good to describe a good that violates the law
of demand. (The term is named for economist Robert Giffen, who first noted this
possibility.) In this example, potatoes are a Giffen good. Giffen goods are inferior
goods for which the income effect dominates the substitution effect. Therefore,
they have demand curves that slope upward.
Economists disagree about whether any Giffen good has ever been discovered.
Some historians suggest that potatoes were in fact a Giffen good during the Irish
potato famine of the nineteenth century. Potatoes were such a large part of people’s
diet that when the price of potatoes rose, it had a large income effect. People
responded to their reduced living standard by cutting back on the luxury of meat
and buying more of the staple food of potatoes. Thus, it is argued that a higher
price of potatoes actually raised the quantity of potatoes demanded.
Whether or not this historical account is true, it is safe to say that Giffen goods
are very rare. The theory of consumer choice does allow demand curves to slope
upward. Yet such occurrences are so unusual that the law of demand is as reliable
a law as any in economics.
Quantity
of Meat
A
Quantity of
Potatoes
0
E
C
I 2
I 1
Initial budget constraint
New budget
constraint
D
B
2. . . . which
increases
potato
consumption
if potatoes
are a Giffen
good.
Optimum with low
price of potatoes
Optimum with high
price of potatoes
1. An increase in the price of
potatoes rotates the budget
constraint inward . . .
Figure 21-12
A GIFFEN GOOD. In this
example, when the price of
potatoes rises, the consumer’s
optimum shifts from point C
to point E. In this case, the
consumer responds to a higher
price of potatoes by buying less
meat and more potatoes.
Gif fen good
a good for which an increase in the
price raises the quantity demanded
480 PART SEVEN ADVANCED TOPIC
HOW DO WAGES AFFECT LABOR SUPPLY?
So far we have used the theory of consumer choice to analyze how a person decides
how to allocate his income between two goods. We can use the same theory
to analyze how a person decides to allocate his time between work and leisure.
Consider the decision facing Sally, a freelance software designer. Sally is
awake for 100 hours per week. She spends some of this time enjoying leisure—riding
her bike, watching television, studying economics, and so on. She spends the
rest of this time at her computer developing software. For every hour she spends
developing software, she earns $50, which she spends on consumption goods.
Thus, her wage ($50) reflects the tradeoff Sally faces between leisure and consumption.
For every hour of leisure she gives up, she works one more hour and
gets $50 of consumption.
Figure 21-13 shows Sally’s budget constraint. If she spends all 100 hours enjoying
leisure, she has no consumption. If she spends all 100 hours working, she
earns a weekly consumption of $5,000 but has no time for leisure. If she works a
normal 40-hour week, she enjoys 60 hours of leisure and has weekly consumption
of $2,000.
Figure 21-13 uses indifference curves to represent Sally’s preferences for consumption
and leisure. Here consumption and leisure are the two “goods” between
which Sally is choosing. Because Sally always prefers more leisure and more consumption,
she prefers points on higher indifference curves to points on lower ones.
At a wage of $50 per hour, Sally chooses a combination of consumption and leisure
represented by the point labeled “optimum.” This is the point on the budget constraint
that is on the highest possible indifference curve, which is curve I2.
Now consider what happens when Sally’s wage increases from $50 to $60 per
hour. Figure 21-14 shows two possible outcomes. In each case, the budget constraint,
shown in the left-hand graph, shifts outward from BC1 to BC2. In the
process, the budget constraint becomes steeper, reflecting the change in relative
0 Hours of Leisure
2,000
$5,000
60
Consumption
100
Optimum
I 3
I 2
I 1
Figure 21-13
THE WORK-LEISURE DECISION.
This figure shows Sally’s budget
constraint for deciding how
much to work, her indifference
curves for consumption and
leisure, and her optimum.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 481
price: At the higher wage, Sally gets more consumption for every hour of leisure
that she gives up.
Sally’s preferences, as represented by her indifference curves, determine the
resulting responses of consumption and leisure to the higher wage. In both panels,
Hours of
Leisure
0
Consumption
(a) For a person with these preferences . . .
Hours of Labor
Supplied
0
Wage
. . . the labor supply curve slopes upward.
Hours of
Leisure
0
Consumption
(b) For a person with these preferences . . .
Hours of Labor
Supplied
0
Wage
. . . the labor supply curve slopes backward.
I 1
BC I 2 2
BC1
I 1
I 2
BC2
BC1
1. When the wage rises . . .
2. . . . hours of leisure increase . . . 3. . . . and hours of labor decrease.
2. . . . hours of leisure decrease . . . 3. . . . and hours of labor increase.
1. When the wage rises . . .
Labor
supply
Labor
supply
AN INCREASE IN THE WAGE. The two panels of this figure show how a person might Figur e 21-14
respond to an increase in the wage. The graphs on the left show the consumer’s initial
budget constraint BC1 and new budget constraint BC2, as well as the consumer’s optimal
choices over consumption and leisure. The graphs on the right show the resulting labor
supply curve. Because hours worked equal total hours available minus hours of leisure,
any change in leisure implies an opposite change in the quantity of labor supplied. In
panel (a), when the wage rises, consumption rises and leisure falls, resulting in a labor
supply curve that slopes upward. In panel (b), when the wage rises, both consumption
and leisure rise, resulting in a labor supply curve that slopes backward.
482 PART SEVEN ADVANCED TOPIC
CASE STUDY INCOME EFFECTS ON LABOR SUPPLY:
HISTORICAL TRENDS, LOTTERY WINNERS,
AND THE CARNEGIE CONJECTURE
The idea of a backward-sloping labor supply curve might at first seem like a mere
theoretical curiosity, but in fact it is not. Evidence indicates that the labor supply
curve, considered over long periods of time, does in fact slope backward. Ahundred
years ago many people worked six days a week. Today five-day workweeks
are the norm. At the same time that the length of the workweek has been falling,
the wage of the typical worker (adjusted for inflation) has been rising.
Here is how economists explain this historical pattern: Over time, advances
in technology raise workers’ productivity and, thereby, the demand for labor.
The increase in labor demand raises equilibrium wages. As wages rise, so does
the reward for working. Yet rather than responding to this increased incentive
by working more, most workers choose to take part of their greater prosperity
in the form of more leisure. In other words, the income effect of higher wages
dominates the substitution effect.
Further evidence that the income effect on labor supply is strong comes
from a very different kind of data: winners of lotteries. Winners of large prizes
consumption rises. Yet the response of leisure to the change in the wage is different
in the two cases. In panel (a), Sally responds to the higher wage by enjoying
less leisure. In panel (b), Sally responds by enjoying more leisure.
Sally’s decision between leisure and consumption determines her supply of
labor, for the more leisure she enjoys the less time she has left to work. In each
panel, the right-hand graph in Figure 21-14 shows the labor supply curve implied
by Sally’s decision. In panel (a), a higher wage induces Sally to enjoy less leisure
and work more, so the labor supply curve slopes upward. In panel (b), a higher
wage induces Sally to enjoy more leisure and work less, so the labor supply curve
slopes “backward.”
At first, the backward-sloping labor supply curve is puzzling. Why would a
person respond to a higher wage by working less? The answer comes from considering
the income and substitution effects of a higher wage.
Consider first the substitution effect. When Sally’s wage rises, leisure becomes
more costly relative to consumption, and this encourages Sally to substitute consumption
for leisure. In other words, the substitution effect induces Sally to work
harder in response to higher wages, which tends to make the labor supply curve
slope upward.
Now consider the income effect. When Sally’s wage rises, she moves to a
higher indifference curve. She is now better off than she was. As long as consumption
and leisure are both normal goods, she tends to want to use this increase
in well-being to enjoy both higher consumption and greater leisure. In other
words, the income effect induces her to work less, which tends to make the labor
supply curve slope backward.
In the end, economic theory does not give a clear prediction about whether an
increase in the wage induces Sally to work more or less. If the substitution effect is
greater than the income effect for Sally, she works more. If the income effect is
greater than the substitution effect, she works less. The labor supply curve, therefore,
could be either upward or backward sloping.
“NO MORE 9-TO-5 FOR ME.”
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 483
in the lottery see large increases in their incomes and, as a result, large outward
shifts in their budget constraints. Because the winners’ wages have not
changed, however, the slopes of their budget constraints remain the same. There
is, therefore, no substitution effect. By examining the behavior of lottery winners,
we can isolate the income effect on labor supply.
The results from studies of lottery winners are striking. Of those winners
who win more than $50,000, almost 25 percent quit working within a year, and
another 9 percent reduce the number of hours they work. Of those winners who
win more than $1 million, almost 40 percent stop working. The income effect on
labor supply of winning such a large prize is substantial.
Similar results were found in a study, published in the May 1993 issue of the
Quarterly Journal of Economics, of how receiving a bequest affects a person’s labor
supply. The study found that a single person who inherits more than
$150,000 is four times as likely to stop working as a single person who inherits
less than $25,000. This finding would not have surprised the nineteenth-century
industrialist Andrew Carnegie. Carnegie warned that “the parent who leaves
his son enormous wealth generally deadens the talents and energies of the son,
and tempts him to lead a less useful and less worthy life than he otherwise
would.” That is, Carnegie viewed the income effect on labor supply to be substantial
and, from his paternalistic perspective, regrettable. During his life and
at his death, Carnegie gave much of his vast fortune to charity.
HOW DO INTEREST RATES AFFECT HOUSEHOLD SAVING?
An important decision that every person faces is how much income to consume today
and how much to save for the future. We can use the theory of consumer
choice to analyze how people make this decision and how the amount they save
depends on the interest rate their savings will earn.
Consider the decision facing Sam, a worker planning ahead for retirement. To
keep things simple, let’s divide Sam’s life into two periods. In the first period, Sam
is young and working. In the second period, he is old and retired. When young,
Sam earns a total of $100,000. He divides this income between current consumption
and saving. When he is old, Sam will consume what he has saved, including
the interest that his savings have earned.
Suppose that the interest rate is 10 percent. Then for every dollar that Sam
saves when young, he can consume $1.10 when old. We can view “consumption
when young” and “consumption when old” as the two goods that Sam must
choose between. The interest rate determines the relative price of these two goods.
Figure 21-15 shows Sam’s budget constraint. If he saves nothing, he consumes
$100,000 when young and nothing when old. If he saves everything, he consumes
nothing when young and $110,000 when old. The budget constraint shows these
and all the intermediate possibilities.
Figure 21-15 uses indifference curves to represent Sam’s preferences for consumption
in the two periods. Because Sam prefers more consumption in both periods,
he prefers points on higher indifference curves to points on lower ones.
Given his preferences, Sam chooses the optimal combination of consumption in
both periods of life, which is the point on the budget constraint that is on the highest
possible indifference curve. At this optimum, Sam consumes $50,000 when
young and $55,000 when old.
484 PART SEVEN ADVANCED TOPIC
Now consider what happens when the interest rate increases from 10 percent
to 20 percent. Figure 21-16 shows two possible outcomes. In both cases, the budget
constraint shifts outward and becomes steeper. At the new higher interest rate,
Sam gets more consumption when old for every dollar of consumption that he
gives up when young.
The two panels show different preferences for Sam and the resulting response
to the higher interest rate. In both cases, consumption when old rises. Yet the response
of consumption when young to the change in the interest rate is different
in the two cases. In panel (a), Sam responds to the higher interest rate by consuming
less when young. In panel (b), Sam responds by consuming more when
young.
Sam’s saving, of course, is his income when young minus the amount he consumes
when young. In panel (a), consumption when young falls when the interest
rate rises, so saving must rise. In panel (b), Sam consumes more when young, so
saving must fall.
The case shown in panel (b) might at first seem odd: Sam responds to an increase
in the return to saving by saving less. Yet this behavior is not as peculiar as
it might seem. We can understand it by considering the income and substitution
effects of a higher interest rate.
Consider first the substitution effect. When the interest rate rises, consumption
when old becomes less costly relative to consumption when young. Therefore, the
substitution effect induces Sam to consume more when old and less when young.
In other words, the substitution effect induces Sam to save more.
Now consider the income effect. When the interest rate rises, Sam moves to a
higher indifference curve. He is now better off than he was. As long as consumption
in both periods consists of normal goods, he tends to want to use this increase
in well-being to enjoy higher consumption in both periods. In other words, the income
effect induces him to save less.
Consumption
when Young
0
55,000
$110,000
$50,000
Consumption
when Old
100,000
Optimum
I 3
I 2
I 1
Budget
constraint
Figure 21-15
THE CONSUMPTION-SAVING
DECISION. This figure shows
the budget constraint for a person
deciding how much to consume
in the two periods of his life, the
indifference curves representing
his preferences, and the
optimum.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 485
The end result, of course, depends on both the income and substitution effects.
If the substitution effect of a higher interest rate is greater than the income effect,
Sam saves more. If the income effect is greater than the substitution effect, Sam
saves less. Thus, the theory of consumer choice says that an increase in the interest
rate could either encourage or discourage saving.
Although this ambiguous result is interesting from the standpoint of economic
theory, it is disappointing from the standpoint of economic policy. It turns out that
an important issue in tax policy hinges in part on how saving responds to interest
rates. Some economists have advocated reducing the taxation of interest and other
capital income, arguing that such a policy change would raise the after-tax interest
rate that savers can earn and would thereby encourage people to save more. Other
economists have argued that because of offsetting income and substitution effects,
such a tax change might not increase saving and could even reduce it. Unfortunately,
research has not led to a consensus about how interest rates affect saving.
As a result, there remains disagreement among economists about whether changes
in tax policy aimed to encourage saving would, in fact, have the intended effect.
DO THE POOR PREFER TO RECEIVE CASH
OR IN-KIND TRANSFERS?
Paul is a pauper. Because of his low income, he has a meager standard of living.
The government wants to help. It can either give Paul $1,000 worth of food
0
(a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving
Consumption
when Old
I 1
I 2
BC1
BC2
0
I 1 I 2
BC1
BC2
Consumption
when Old
Consumption
when Young
1. A higher interest rate rotates
the budget constraint outward . . .
1. A higher interest rate rotates
the budget constraint outward . . .
2. . . . resulting in lower
consumption when young
and, thus, higher saving.
2. . . . resulting in higher
consumption when young
and, thus, lower saving.
Consumption
when Young
AN INCREASE IN THE INTEREST RATE. In both panels, an increase in the interest rate Figur e 21-16
shifts the budget constraint outward. In panel (a), consumption when young falls, and
consumption when old rises. The result is an increase in saving when young. In panel (b),
consumption in both periods rises. The result is a decrease in saving when young.
486 PART SEVEN ADVANCED TOPIC
(perhaps by issuing him food stamps) or simply give him $1,000 in cash. What
does the theory of consumer choice have to say about the comparison between
these two policy options?
Figure 21-17 shows how the two options might work. If the government gives
Paul cash, then the budget constraint shifts outward. He can divide the extra cash
Cash Transfer In-Kind Transfer
Nonfood
Consumption
0
$1,000
Cash Transfer
(a) The Constraint Is Not Binding
(b) The Constraint Is Binding
0
$1,000
In-Kind Transfer
Food
A
B
I I 2 1
BC1
BC2 (with $1,000 cash)
A
B
C
I I 2 1
BC1
BC2 (with $1,000 food stamps)
Food
Nonfood
Consumption
Nonfood
Consumption
0
$1,000
0
$1,000
Food
A
B
I 2
I 1
BC1
BC2 (with $1,000 cash)
A
B
I 2
I 1
BC1
BC2 (with $1,000 food stamps)
Food
Nonfood
Consumption
I 3
Figure 21-17 CASH VERSUS IN-KIND TRANSFERS. Both panels compare a cash transfer and a similar
in-kind transfer of food. In panel (a), the in-kind transfer does not impose a binding
constraint, and the consumer ends up on the same indifference curve under the two
policies. In panel (b), the in-kind transfer imposes a binding constraint, and the consumer
ends up on a lower indifference curve with the in-kind transfer than with the cash
transfer.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 487
between food and nonfood consumption however he pleases. By contrast, if the
government gives Paul an in-kind transfer of food, then his new budget constraint
is more complicated. The budget constraint has again shifted out. But now the
budget constraint has a kink at $1,000 of food, for Paul must consume at least that
amount in food. That is, even if Paul spends all his money on nonfood consumption,
he still consumes $1,000 in food.
The ultimate comparison between the cash transfer and in-kind transfer depends
on Paul’s preferences. In panel (a), Paul would choose to spend at least
$1,000 on food even if he receives a cash transfer. Therefore, the constraint imposed
by the in-kind transfer is not binding. In this case, his consumption moves
from point Ato point B regardless of the type of transfer. That is, Paul’s choice between
food and nonfood consumption is the same under the two policies.
In panel (b), however, the story is very different. In this case, Paul would prefer
to spend less than $1,000 on food and spend more on nonfood consumption.
The cash transfer allows him discretion to spend the money as he pleases, and he
consumes at point B. By contrast, the in-kind transfer imposes the binding constraint
that he consume at least $1,000 of food. His optimal allocation is at the kink,
point C. Compared to the cash transfer, the in-kind transfer induces Paul to consume
more food and less of other goods. The in-kind transfer also forces Paul to
end up on a lower (and thus less preferred) indifference curve. Paul is worse off
than if he had the cash transfer.
Thus, the theory of consumer choice teaches a simple lesson about cash versus
in-kind transfers. If an in-kind transfer of a good forces the recipient to consume
more of the good than he would on his own, then the recipient prefers the cash
transfer. If the in-kind transfer does not force the recipient to consume more of the
good than he would on his own, then the cash and in-kind transfer have exactly
the same effect on the consumption and welfare of the recipient.
QUICK QUIZ: Explain how an increase in the wage can potentially
decrease the amount that a person wants to work.
CONCLUSION: DO PEOPLE
REALLY THINK THIS WAY?
The theory of consumer choice describes how people make decisions. As we have
seen, it has broad applicability. It can explain how a person chooses between Pepsi
and pizza, work and leisure, consumption and saving, and on and on.
At this point, however, you might be tempted to treat the theory of consumer
choice with some skepticism. After all, you are a consumer. You decide what to
buy every time you walk into a store. And you know that you do not decide by
writing down budget constraints and indifference curves. Doesn’t this knowledge
about your own decisionmaking provide evidence against the theory?
The answer is no. The theory of consumer choice does not try to present a literal
account of how people make decisions. It is a model. And, as we first discussed
in Chapter 2, models are not intended to be completely realistic.
The best way to view the theory of consumer choice is as a metaphor for how
consumers make decisions. No consumer (except an occasional economist) goes
488 PART SEVEN ADVANCED TOPIC
through the explicit optimization envisioned in the theory. Yet consumers are
aware that their choices are constrained by their financial resources. And, given
those constraints, they do the best they can to achieve the highest level of satisfaction.
The theory of consumer choice tries to describe this implicit, psychological
process in a way that permits explicit, economic analysis.
The proof of the pudding is in the eating. And the test of a theory is in its applications.
In the last section of this chapter we applied the theory of consumer
choice to four practical issues about the economy. If you take more advanced
courses in economics, you will see that this theory provides the framework for
much additional analysis.
A consumer’s budget constraint shows the possible
combinations of different goods he can buy given his
income and the prices of the goods. The slope of the
budget constraint equals the relative price of the goods.
The consumer’s indifference curves represent his
preferences. An indifference curve shows the various
bundles of goods that make the consumer equally
happy. Points on higher indifference curves are
preferred to points on lower indifference curves. The
slope of an indifference curve at any point is the
consumer’s marginal rate of substitution—the rate at
which the consumer is willing to trade one good for the
other.
The consumer optimizes by choosing the point on his
budget constraint that lies on the highest indifference
curve. At this point, the slope of the indifference curve
(the marginal rate of substitution between the goods)
equals the slope of the budget constraint (the relative
price of the goods).
When the price of a good falls, the impact on the
consumer’s choices can be broken down into an income
effect and a substitution effect. The income effect is the
change in consumption that arises because a lower price
makes the consumer better off. The substitution effect is
the change in consumption that arises because a price
change encourages greater consumption of the good
that has become relatively cheaper. The income effect is
reflected in the movement from a lower to a higher
indifference curve, whereas the substitution effect is
reflected by a movement along an indifference curve to
a point with a different slope.
The theory of consumer choice can be applied in many
situations. It can explain why demand curves can
potentially slope upward, why higher wages could
either increase or decrease the quantity of labor
supplied, why higher interest rates could either increase
or decrease saving, and why the poor prefer cash to
in-kind transfers.
Summary
budget constraint, p. 465
indifference curve, p. 466
marginal rate of substitution, p. 467
perfect substitutes, p. 470
perfect complements, p. 470
normal good, p. 473
inferior good, p. 473
income effect, p. 475
substitution effect, p. 475
Giffen good, p. 479
Key Concepts
1. A consumer has income of $3,000. Wine costs $3 a glass,
and cheese costs $6 a pound. Draw the consumer’s
budget constraint. What is the slope of this budget
constraint?
Questions for Review
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 489
2. Draw a consumer’s indifference curves for wine and
cheese. Describe and explain four properties of these
indifference curves.
3. Pick a point on an indifference curve for wine and
cheese and show the marginal rate of substitution. What
does the marginal rate of substitution tell us?
4. Show a consumer’s budget constraint and indifference
curves for wine and cheese. Show the optimal
consumption choice. If the price of wine is $3 a glass
and the price of cheese is $6 a pound, what is the
marginal rate of substitution at this optimum?
5. A person who consumes wine and cheese gets a raise, so
his income increases from $3,000 to $4,000. Show what
happens if both wine and cheese are normal goods.
Now show what happens if cheese is an inferior good.
6. The price of cheese rises from $6 to $10 a pound, while
the price of wine remains $3 a glass. For a consumer
with a constant income of $3,000, show what happens to
consumption of wine and cheese. Decompose the
change into income and substitution effects.
7. Can an increase in the price of cheese possibly induce a
consumer to buy more cheese? Explain.
8. Suppose a person who buys only wine and cheese is
given $1,000 in food stamps to supplement his $1,000
income. The food stamps cannot be used to buy wine.
Might the consumer be better off with $2,000 in income?
Explain in words and with a diagram.
1. Jennifer divides her income between coffee and
croissants (both of which are normal goods). An early
frost in Brazil causes a large increase in the price of
coffee in the United States.
a. Show the effect of the frost on Jennifer’s budget
constraint.
b. Show the effect of the frost on Jennifer’s optimal
consumption bundle assuming that the substitution
effect outweighs the income effect for croissants.
c. Show the effect of the frost on Jennifer’s optimal
consumption bundle assuming that the income
effect outweighs the substitution effect for
croissants.
2. Compare the following two pairs of goods:
Coke and Pepsi
Skis and ski bindings
In which case do you expect the indifference curves to
be fairly straight, and in which case do you expect the
indifference curves to be very bowed? In which case will
the consumer respond more to a change in the relative
price of the two goods?
3. Mario consumes only cheese and crackers.
a. Could cheese and crackers both be inferior goods
for Mario? Explain.
b. Suppose that cheese is a normal good for Mario
whereas crackers are an inferior good. If the price of
cheese falls, what happens to Mario’s consumption
of crackers? What happens to his consumption of
cheese? Explain.
4. Jim buys only milk and cookies.
a. In 2001, Jim earns $100, milk costs $2 per quart, and
cookies cost $4 per dozen. Draw Jim’s budget
constraint.
b. Now suppose that all prices increase by 10 percent
in 2002 and that Jim’s salary increases by 10 percent
as well. Draw Jim’s new budget constraint. How
would Jim’s optimal combination of milk and
cookies in 2002 compare to his optimal combination
in 2001?
5. Consider your decision about how many hours to
work.
a. Draw your budget constraint assuming that you
pay no taxes on your income. On the same
diagram, draw another budget constraint assuming
that you pay a 15 percent tax.
b. Show how the tax might lead to more hours of
work, fewer hours, or the same number of hours.
Explain.
6. Sarah is awake for 100 hours per week. Using one
diagram, show Sarah’s budget constraints if she earns
$6 per hour, $8 per hour, and $10 per hour. Now draw
indifference curves such that Sarah’s labor supply curve
is upward sloping when the wage is between $6 and $8
per hour, and backward sloping when the wage is
between $8 and $10 per hour.
7. Draw the indifference curve for someone deciding how
much to work. Suppose the wage increases. Is it possible
that the person’s consumption would fall? Is this
Problems and Applications
490 PART SEVEN ADVANCED TOPIC
plausible? Discuss. (Hint: Think about income and
substitution effects.)
8. Suppose you take a job that pays $30,000 and set some
of this income aside in a savings account that pays an
annual interest rate of 5 percent. Use a diagram with a
budget constraint and indifference curves to show how
your consumption changes in each of the following
situations. To keep things simple, assume that you pay
no taxes on your income.
a. Your salary increases to $40,000.
b. The interest rate on your bank account rises to
8 percent.
9. As discussed in the text, we can divide an individual’s
life into two hypothetical periods: “young” and “old.”
Suppose that the individual earns income only when
young and saves some of that income to consume when
old. If the interest rate on savings falls, can you tell what
happens to consumption when young? Can you tell
what happens to consumption when old? Explain.
10. Suppose that your state gives each town $5 million in
aid per year. The way in which the money is spent is
currently unrestricted, but the governor has proposed
that towns be required to spend the entire $5 million on
education. You can illustrate the effect of this proposal
on your town’s spending on education using a budget
constraint and indifference-curve diagram. The two
goods are education and noneducation spending.
a. Draw your town’s budget constraint under the
existing policy, assuming that your town’s only
source of revenue besides the state aid is a property
tax that yields $10 million. On the same diagram,
draw the budget constraint under the governor’s
proposal.
b. Would your town spend more on education under
the governor’s proposal than under the existing
policy? Explain.
c. Now compare two towns—Youngsville and
Oldsville—with the same revenue and the same
state aid. Youngsville has a large school-age
population, and Oldsville has a large elderly
population. In which town is the governor’s
proposal most likely to increase education
spending? Explain.
11. (This problem is challenging.) The welfare system
provides income to some needy families. Typically, the
maximum payment goes to families that earn no
income; then, as families begin to earn income, the
welfare payment declines gradually and eventually
disappears. Let’s consider the possible effects of this
program on a family’s labor supply.
a. Draw a budget constraint for a family assuming
that the welfare system did not exist. On the same
diagram, draw a budget constraint that reflects the
existence of the welfare system.
b. Adding indifference curves to your diagram, show
how the welfare system could reduce the number of
hours worked by the family. Explain, with reference
to both the income and substitution effects.
c. Using your diagram from part (b), show the effect
of the welfare system on the well-being of the
family.
12. (This problem is challenging.) Suppose that an
individual owed no taxes on the first $10,000 she earned
and 15 percent of any income she earned over $10,000.
(This is a simplified version of the actual U.S. income
tax.) Now suppose that Congress is considering two
ways to reduce the tax burden: a reduction in the tax
rate and an increase in the amount on which no tax is
owed.
a. What effect would a reduction in the tax rate have
on the individual’s labor supply if she earned
$30,000 to start? Explain in words using the income
and substitution effects. You do not need to use a
diagram.
b. What effect would an increase in the amount on
which no tax is owed have on the individual’s labor
supply? Again, explain in words using the income
and substitution effects.
13. (This problem is challenging.) Consider a person
deciding how much to consume and how much to save
for retirement. This person has particular preferences:
Her lifetime utility depends on the lowest level of
consumption during the two periods of her life. That is,
Utility Minimum {consumption when young,
consumption when old}.
a. Draw this person’s indifference curves. (Hint:
Recall that indifference curves show the
combinations of consumption in the two periods
that yield the same level of utility.)
b. Draw the budget constraint and the optimum.
c. When the interest rate increases, does this person
save more or less? Explain your answer using
income and substitution effects.
IN THIS CHAPTER
YOU WILL . . .
Consider whether
GDP is a good
measure of
economic well-being
See the breakdown
of GDP into its four
major components
Consider why an
economy’s total
income equals its
total expenditure
Learn how gross
domestic product
(GDP) is defined and
calculated
Learn the
distinction between
real GDP and
nominal GDP
When you finish school and start looking for a full-time job, your experience will,
to a large extent, be shaped by prevailing economic conditions. In some years,
firms throughout the economy are expanding their production of goods and services,
employment is rising, and jobs are easy to find. In other years, firms are cutting
back on production, employment is declining, and finding a good job takes a
long time. Not surprisingly, any college graduate would rather enter the labor
force in a year of economic expansion than in a year of economic contraction.
Because the condition of the overall economy profoundly affects all of us,
changes in economic conditions are widely reported by the media. Indeed, it is hard
to pick up a newspaper without seeing some newly reported statistic about the
economy. The statistic might measure the total income of everyone in the economy
(GDP), the rate at which average prices are rising (inflation), the percentage of the
labor force that is out of work (unemployment), total spending at stores (retail
M E A S U R I N G A N A T I O N ’ S
I N C O M E
493
494 PART EIGHT THE DATA OF MACROECONOMICS
sales), or the imbalance of trade between the United States and the rest of the world
(the trade deficit). All these statistics are macroeconomic. Rather than telling us about
a particular household or firm, they tell us something about the entire economy.
As you may recall from Chapter 2, economics is divided into two branches:
microeconomics and macroeconomics. Microeconomics is the study of how individual
households and firms make decisions and how they interact with one
another in markets. Macroeconomics is the study of the economy as a whole. The
goal of macroeconomics is to explain the economic changes that affect many
households, firms, and markets at once. Macroeconomists address diverse questions:
Why is average income high in some countries while it is low in others? Why
do prices rise rapidly in some periods of time while they are more stable in other
periods? Why do production and employment expand in some years and contract
in others? What, if anything, can the government do to promote rapid growth in
incomes, low inflation, and stable employment? These questions are all macroeconomic
in nature because they concern the workings of the entire economy.
Because the economy as a whole is just a collection of many households and
many firms interacting in many markets, microeconomics and macroeconomics
are closely linked. The basic tools of supply and demand, for instance, are as central
to macroeconomic analysis as they are to microeconomic analysis. Yet studying
the economy in its entirety raises some new and intriguing challenges.
In this chapter and the next one, we discuss some of the data that economists
and policymakers use to monitor the performance of the overall economy. These
data reflect the economic changes that macroeconomists try to explain. This chapter
considers gross domestic product, or simply GDP, which measures the total
income of a nation. GDP is the most closely watched economic statistic because it
is thought to be the best single measure of a society’s economic well-being.
THE ECONOMY’S INCOME AND EXPENDITURE
If you were to judge how a person is doing economically, you might first look at
his or her income. Aperson with a high income can more easily afford life’s necessities
and luxuries. It is no surprise that people with higher incomes enjoy higher
standards of living—better housing, better health care, fancier cars, more opulent
vacations, and so on.
The same logic applies to a nation’s overall economy. When judging whether the
economy is doing well or poorly, it is natural to look at the total income that everyone
in the economy is earning. That is the task of gross domestic product (GDP).
GDP measures two things at once: the total income of everyone in the economy
and the total expenditure on the economy’s output of goods and services. The
reason that GDP can perform the trick of measuring both total income and total
expenditure is that these two things are really the same. For an economy as a whole,
income must equal expenditure.
Why is this true? The reason that an economy’s income is the same as its expenditure
is simply that every transaction has two parties: a buyer and a seller. Every
dollar of spending by some buyer is a dollar of income for some seller. Suppose, for
instance, that Karen pays Doug $100 to mow her lawn. In this case, Doug is a seller
of a service, and Karen is a buyer. Doug earns $100, and Karen spends $100. Thus,
microeconomics
the study of how households and
firms make decisions and how they
interact in markets
macroeconomics
the study of economy-wide
phenomena, including inflation,
unemployment, and economic
growth
CHAPTER 22 MEASURING A NATION’S INCOME 495
the transaction contributes equally to the economy’s income and to its expenditure.
GDP, whether measured as total income or total expenditure, rises by $100.
Another way to see the equality of income and expenditure is with the circularflow
diagram in Figure 22-1. (You may recall this circular-flow diagram from
Chapter 2.) This diagram describes all the transactions between households and
firms in a simple economy. In this economy, households buy goods and services
from firms; these expenditures flow through the markets for goods and services.
The firms in turn use the money they receive from sales to pay workers’ wages,
landowners’ rent, and firm owners’ profit; this income flows through the markets
for the factors of production. In this economy, money continuously flows from
households to firms and then back to households.
We can compute GDP for this economy in one of two ways: by adding up the
total expenditure by households or by adding up the total income (wages, rent,
and profit) paid by firms. Because all expenditure in the economy ends up as
someone’s income, GDP is the same regardless of how we compute it.
The actual economy is, of course, more complicated than the one illustrated in
Figure 22-1. In particular, households do not spend all of their income. Households
pay some of their income to the government in taxes, and they save and invest
some of their income for use in the future. In addition, households do not buy all
Spending
(= GDP)
Goods and
services
bought
Revenue
(= GDP)
Goods
and services
sold
Labor, land,
and capital
Income (= GDP)
Flow of goods
and services
Flow of dollars
Inputs for
production
Wages, rent,
and profit
(= GDP)
FIRMS HOUSEHOLDS
MARKETS FOR
FACTORS OF
PRODUCTION
MARKETS FOR
GOODS AND
SERVICES
Figure 22-1
THE CIRCULAR-FLOW DIAGRAM.
Households buy goods and
services from firms, and firms use
their revenue from sales to pay
wages to workers, rent to
landowners, and profit to firm
owners. GDP equals the total
amount spent by households in
the market for goods and
services. It also equals the total
wages, rent, and profit paid by
firms in the markets for the
factors of production.
496 PART EIGHT THE DATA OF MACROECONOMICS
goods and services produced in the economy. Some goods and services are bought
by governments, and some are bought by firms that plan to use them in the future
to produce their own output. Yet, regardless of whether a household, government,
or firm buys a good or service, the transaction has a buyer and seller. Thus, for the
economy as a whole, expenditure and income are always the same.
QUICK QUIZ: What two things does gross domestic product measure?
How can it measure two things at once?
THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT
Now that we have discussed the meaning of gross domestic product in general
terms, let’s be more precise about how this statistic is measured. Here is a definition
of GDP:
Gross domestic product (GDP) is the market value of all final goods and
services produced within a country in a given period of time.
This definition might seem simple enough. But, in fact, many subtle issues arise
when computing an economy’s GDP. Let’s therefore consider each phrase in this
definition with some care.
“GDP IS THE MARKET VALUE . . .”
You have probably heard the adage, “You can’t compare apples and oranges.” Yet
GDP does exactly that. GDP adds together many different kinds of products into a
single measure of the value of economic activity. To do this, it uses market prices.
Because market prices measure the amount people are willing to pay for different
goods, they reflect the value of those goods. If the price of an apple is twice the price
of an orange, then an apple contributes twice as much to GDP as does an orange.
“OF ALL . . .”
GDP tries to be comprehensive. It includes all items produced in the economy and
sold legally in markets. GDP measures the market value of not just apples and
oranges, but also pears and grapefruit, books and movies, haircuts and health care,
and on and on.
GDP also includes the market value of the housing services provided by the
economy’s stock of housing. For rental housing, this value is easy to calculate—the
rent equals both the tenant’s expenditure and the landlord’s income. Yet many
people own the place where they live and, therefore, do not pay rent. The government
includes this owner-occupied housing in GDP by estimating its rental value.
That is, GDP is based on the assumption that the owner, in effect, pays rent to himself,
so the rent is included both in his expenditure and in his income.
There are some products, however, that GDP excludes because measuring
them is so difficult. GDP excludes items produced and sold illicitly, such as illegal
gross domestic product
(GDP)
the market value of all final goods
and services produced within a
country in a given period of time
CHAPTER 22 MEASURING A NATION’S INCOME 497
drugs. It also excludes most items that are produced and consumed at home and,
therefore, never enter the marketplace. Vegetables you buy at the grocery store are
part of GDP; vegetables you grow in your garden are not.
These exclusions from GDP can at times lead to paradoxical results. For example,
when Karen pays Doug to mow her lawn, that transaction is part of GDP. If
Karen were to marry Doug, the situation would change. Even though Doug may
continue to mow Karen’s lawn, the value of the mowing is now left out of GDP
because Doug’s service is no longer sold in a market. Thus, when Karen and Doug
marry, GDP falls.
“FINAL . . .”
When International Paper makes paper, which Hallmark then uses to make a
greeting card, the paper is called an intermediate good, and the card is called a final
good. GDP includes only the value of final goods. The reason is that the value of
intermediate goods is already included in the prices of the final goods. Adding the
market value of the paper to the market value of the card would be double counting.
That is, it would (incorrectly) count the paper twice.
An important exception to this principle arises when an intermediate good is
produced and, rather than being used, is added to a firm’s inventory of goods to be
used or sold at a later date. In this case, the intermediate good is taken to be “final”
for the moment, and its value as inventory investment is added to GDP. When the
inventory of the intermediate good is later used or sold, the firm’s inventory investment
is negative, and GDP for the later period is reduced accordingly.
“GOODS AND SERVICES . . .”
GDP includes both tangible goods (food, clothing, cars) and intangible services
(haircuts, housecleaning, doctor visits). When you buy a CD by your favorite
singing group, you are buying a good, and the purchase price is part of GDP.
When you pay to hear a concert by the same group, you are buying a service, and
the ticket price is also part of GDP.
“PRODUCED . . .”
GDP includes goods and services currently produced. It does not include transactions
involving items produced in the past. When General Motors produces and
sells a new car, the value of the car is included in GDP. When one person sells a
used car to another person, the value of the used car is not included in GDP.
“WITHIN A COUNTRY . . .”
GDP measures the value of production within the geographic confines of a country.
When a Canadian citizen works temporarily in the United States, his production
is part of U.S. GDP. When an American citizen owns a factory in Haiti, the
production at his factory is not part of U.S. GDP. (It is part of Haiti’s GDP.) Thus,
items are included in a nation’s GDP if they are produced domestically, regardless
of the nationality of the producer.
498 PART EIGHT THE DATA OF MACROECONOMICS
“. . . IN A GIVEN PERIOD OF TIME.”
GDP measures the value of production that takes place within a specific interval of
time. Usually that interval is a year or a quarter (three months). GDP measures the
economy’s flow of income and expenditure during that interval.
When the government reports the GDP for a quarter, it usually presents
GDP “at an annual rate.” This means that the figure reported for quarterly GDP is
the amount of income and expenditure during the quarter multiplied by 4. The
government uses this convention so that quarterly and annual figures on GDP can
be compared more easily.
In addition, when the government reports quarterly GDP, it presents the data
after they have been modified by a statistical procedure called seasonal adjustment.
The unadjusted data show clearly that the economy produces more goods and
services during some times of year than during others. (As you might guess,
December’s Christmas shopping season is a high point.) When monitoring the
When the U.S. Department
of Commerce computes the
nation’s GDP every three
months, it also computes various
other measures of income
to get a more complete picture
of what’s happening in the economy.
These other measures differ
from GDP by excluding or
including certain categories of
income. What follows is a brief
description of five of these
income measures, ordered from
largest to smallest.
Gross national product (GNP) is the total income
earned by a nation’s permanent residents (called
nationals). It differs from GDP by including income that
our citizens earn abroad and excluding income that foreigners
earn here. For example, when a Canadian citizen
works temporarily in the United States, his
production is part of U.S. GDP, but it is not part of U.S.
GNP. (It is part of Canada’s GNP.) For most countries,
including the United States, domestic residents are
responsible for most domestic production, so GDP and
GNP are quite close.
Net national product (NNP) is the total income of a
nation’s residents (GNP) minus losses from depreciation.
Depreciation is the wear and tear on the economy’s
stock of equipment and structures, such as trucks rusting
and lightbulbs burning out. In the national income
accounts prepared by the Department of Commerce,
depreciation is called the “consumption of fixed capital.”
National income is the total income earned by a
nation’s residents in the production of goods and services.
It differs from net national product by excluding
indirect business taxes (such as sales taxes) and
including business subsidies. NNP and national income
also differ because of a “statistical discrepancy” that
arises from problems in data collection.
Personal income is the income that households and
noncorporate businesses receive. Unlike national
income, it excludes retained earnings, which is income
that corporations have earned but have not paid out to
their owners. It also subtracts corporate income taxes
and contributions for social insurance (mostly Social
Security taxes). In addition, personal income includes
the interest income that households receive from their
holdings of government debt and the income that
households receive from government transfer programs,
such as welfare and Social Security.
Disposable personal income is the income that households
and noncorporate businesses have left after satisfying
all their obligations to the government. It equals
personal income minus personal taxes and certain nontax
payments (such as traffic tickets).
Although the various measures of income differ in detail,
they almost always tell the same story about economic conditions.
When GDP is growing rapidly, these other measures
of income are usually growing rapidly. And when GDP is
falling, these other measures are usually falling as well. For
monitoring fluctuations in the overall economy, it does not
matter much which measure of income we use.
FYI
Other Measures
of Income
CHAPTER 22 MEASURING A NATION’S INCOME 499
condition of the economy, economists and policymakers often want to look
beyond these regular seasonal changes. Therefore, government statisticians adjust
the quarterly data to take out the seasonal cycle. The GDP data reported in the
news are always seasonally adjusted.
Now let’s repeat the definition of GDP:
Gross domestic product (GDP) is the market value of all final goods and
services produced within a country in a given period of time.
It should be apparent that GDP is a sophisticated measure of the value of economic
activity. In advanced courses in macroeconomics, you will learn more of the subtleties
that arise in its calculation. But even now you can see that each phrase in
this definition is packed with meaning.
QUICK QUIZ: Which contributes more to GDP—the production of a pound
of hamburger or the production of a pound of caviar? Why?
THE COMPONENTS OF GDP
Spending in the economy takes many forms. At any moment, the Smith family
may be having lunch at Burger King; General Motors may be building a car factory;
the Navy may be procuring a submarine; and British Airways may be buying
an airplane from Boeing. GDP includes all of these various forms of spending on
domestically produced goods and services.
To understand how the economy is using its scarce resources, economists are
often interested in studying the composition of GDP among various types of spending.
To do this, GDP (which we denote as Y) is divided into four components: consumption
(C), investment (I), government purchases (G), and net exports (NX):
Y C I G NX.
This equation is an identity—an equation that must be true by the way the variables
in the equation are defined. In this case, because each dollar of expenditure
included in GDP is placed into one of the four components of GDP, the total of the
four components must be equal to GDP.
We have just seen an example of each component. Consumption is spending
by households on goods and services, such as the Smiths’ lunch at Burger King.
Investment is the purchase of capital equipment, inventories, and structures, such
as the General Motors factory. Investment also includes expenditure on new housing.
(By convention, expenditure on new housing is the one form of household
spending categorized as investment rather than consumption.) Government purchases
include spending on goods and services by local, state, and federal governments,
such as the Navy’s purchase of a submarine. Net exports equal the
purchases of domestically produced goods by foreigners (exports) minus the
domestic purchases of foreign goods (imports). Adomestic firm’s sale to a buyer in
another country, such as the Boeing sale to British Airways, increases net exports.
The “net” in “net exports” refers to the fact that imports are subtracted from
exports. This subtraction is made because imports of goods and services are
consumption
spending by households on goods
and services, with the exception of
purchases of new housing
investment
spending on capital equipment,
inventories, and structures,
including household purchases of
new housing
government purchases
spending on goods and services by
local, state, and federal governments
net expor ts
spending on domestically produced
goods by foreigners (exports) minus
spending on foreign goods by
domestic residents (imports)
500 PART EIGHT THE DATA OF MACROECONOMICS
included in other components of GDP. For example, suppose that a household
buys a $30,000 car from Volvo, the Swedish carmaker. That transaction increases
consumption by $30,000 because car purchases are part of consumer spending. It
also reduces net exports by $30,000 because the car is an import. In other words,
net exports include goods and services produced abroad (with a minus sign)
because these goods and services are included in consumption, investment, and
government purchases (with a plus sign). Thus, when a domestic household, firm,
or government buys a good or service from abroad, the purchase reduces net
exports—but because it also raises consumption, investment, or government purchases,
it does not affect GDP.
The meaning of “government purchases” also requires a bit of clarification.
When the government pays the salary of an Army general, that salary is part of
government purchases. But what happens when the government pays a Social
Security benefit to one of the elderly? Such government spending is called a transfer
payment because it is not made in exchange for a currently produced good or
service. From a macroeconomic standpoint, transfer payments are like a tax rebate.
Like taxes, transfer payments alter household income, but they do not reflect the
economy’s production. Because GDP is intended to measure income from (and
expenditure on) the production of goods and services, transfer payments are not
counted as part of government purchases.
Table 22-1 shows the composition of U.S. GDP in 1998. In this year, the GDP of
the United States was about $8.5 trillion. If we divide this number by the 1998 U.S.
population of 270 million, we find that GDP per person—the amount of expenditure
for the average American—was $31,522. Consumption made up about twothirds
of GDP, or $21,511 per person. Investment was $5,063 per person.
Government purchases were $5,507 per person. Net exports were –$559 per person.
This number is negative because Americans earned less from selling to foreigners
than they spent on foreign goods.
QUICK QUIZ: List the four components of expenditure. Which is the largest?
REAL VERSUS NOMINAL GDP
As we have seen, GDP measures the total spending on goods and services in all
markets in the economy. If total spending rises from one year to the next, one of
two things must be true: (1) the economy is producing a larger output of goods
Table 22-1
GDP AND ITS COMPONENTS.
This table shows total GDP for
the U.S. economy in 1998 and the
breakdown of GDP among its
four components. When reading
this table, recall the identity
Y C I G NX.
TOTAL PERCENT
(IN BILLIONS) PER PERSON OF TOTAL
Gross domestic product, Y $8,511 $31,522 100%
Consumption, C 5,808 21,511 68
Investment, I 1,367 5,063 16
Government purchases, G 1,487 5,507 18
Net exports, NX 151 559 2
SOURCE: U.S. Department of Commerce.
CHAPTER 22 MEASURING A NATION’S INCOME 501
and services, or (2) goods and services are being sold at higher prices. When
studying changes in the economy over time, economists want to separate these
two effects. In particular, they want a measure of the total quantity of goods and
services the economy is producing that is not affected by changes in the prices of
those goods and services.
To do this, economists use a measure called real GDP. Real GDP answers a
hypothetical question: What would be the value of the goods and services produced
this year if we valued these goods and services at the prices that prevailed
in some specific year in the past? By evaluating current production using prices
that are fixed at past levels, real GDP shows how the economy’s overall production
of goods and services changes over time.
To see more precisely how real GDP is constructed, let’s consider an example.
A NUMERICAL EXAMPLE
Table 22-2 shows some data for an economy that produces only two goods—hot
dogs and hamburgers. The table shows the quantities of the two goods produced
and their prices in the years 2001, 2002, and 2003.
Table 22-2
PRICES AND QUANTITIES
YEAR PRICEOF HOT DOGS QUANTITY OF HOT DOGS PRICEOF HAMBURGERS QUANTITY OF HAMBURGERS
2001 $1 100 $2 50
2002 2 150 3 100
2003 3 200 4 150
YEAR CALCULATING NOMINAL GDP
2001 ($1 per hot dog 100 hot dogs) ($2 per hamburger 50 hamburgers) $200
2002 ($2 per hot dog 150 hot dogs) ($3 per hamburger 100 hamburgers) $600
2003 ($3 per hot dog 200 hot dogs) ($4 per hamburger 150 hamburgers) $1,200
YEAR CALCULATING REAL GDP (BASEYE AR 2001)
2001 ($1 per hot dog 100 hot dogs) ($2 per hamburger 50 hamburgers) $200
2002 ($1 per hot dog 150 hot dogs) ($2 per hamburger 100 hamburgers) $350
2003 ($1 per hot dog 200 hot dogs) ($2 per hamburger 150 hamburgers) $500
YEAR CALCULATING THE GDP DEFLATOR
2001 ($200/$200) 100 100
2002 ($600/$350) 100 171
2003 ($1,200/$500) 100 240
REAL AND NOMINAL GDP. This table shows how to calculate real GDP, nominal GDP,
and the GDP deflator for a hypothetical economy that produces only hot dogs and
hamburgers.
502 PART EIGHT THE DATA OF MACROECONOMICS
To compute total spending in this economy, we would multiply the quantities
of hot dogs and hamburgers by their prices. In the year 2001, 100 hot dogs are sold
at a price of $1 per hot dog, so expenditure on hot dogs equals $100. In the same
year, 50 hamburgers are sold for $2 per hamburger, so expenditure on hamburgers
also equals $100. Total expenditure in the economy—the sum of expenditure on
hot dogs and expenditure on hamburgers—is $200. This amount, the production
of goods and services valued at current prices, is called nominal GDP.
The table shows the calculation of nominal GDP for these three years. Total
spending rises from $200 in 2001 to $600 in 2002 and then to $1,200 in 2003. Part of
this rise is attributable to the increase in the quantities of hot dogs and hamburgers,
and part is attributable to the increase in the prices of hot dogs and hamburgers.
To obtain a measure of the amount produced that is not affected by changes in
prices, we use real GDP, which is the production of goods and services valued at
constant prices. We calculate real GDP by first choosing one year as a base year. We
then use the prices of hot dogs and hamburgers in the base year to compute the
value of goods and services in all of the years. In other words, the prices in the
base year provide the basis for comparing quantities in different years.
Suppose that we choose 2001 to be the base year in our example. We can then
use the prices of hot dogs and hamburgers in 2001 to compute the value of goods
and services produced in 2001, 2002, and 2003. Table 22-2 shows these calculations.
To compute real GDP for 2001, we use the prices of hot dogs and hamburgers in
2001 (the base year) and the quantities of hot dogs and hamburgers produced in
2001. (Thus, for the base year, real GDP always equals nominal GDP.) To compute
real GDP for 2002, we use the prices of hot dogs and hamburgers in 2001 (the base
year) and the quantities of hot dogs and hamburgers produced in 2002. Similarly,
to compute real GDP for 2003, we use the prices in 2001 and the quantities in 2003.
When we find that real GDP has risen from $200 in 2001 to $350 in 2002 and then
to $500 in 2003, we know that the increase is attributable to an increase in the quantities
produced, because the prices are being held fixed at base-year levels.
To sum up: Nominal GDP uses current prices to place a value on the economy’s production
of goods and services. Real GDP uses constant base-year prices to place a value on
the economy’s production of goods and services. Because real GDP is not affected by
changes in prices, changes in real GDP reflect only changes in the amounts being
produced. Thus, real GDP is a measure of the economy’s production of goods and
services.
Our goal in computing GDP is to gauge how well the overall economy is performing.
Because real GDP measures the economy’s production of goods and services,
it reflects the economy’s ability to satisfy people’s needs and desires. Thus,
real GDP is a better gauge of economic well-being than is nominal GDP. When
economists talk about the economy’s GDP, they usually mean real GDP rather than
nominal GDP. And when they talk about growth in the economy, they measure
that growth as the percentage change in real GDP from one period to another.
THE GDP DEFLATOR
As we have just seen, nominal GDP reflects both the prices of goods and services
and the quantities of goods and services the economy is producing. By contrast, by
holding prices constant at base-year levels, real GDP reflects only the quantities
produced. From these two statistics, we can compute a third, called the GDP deflator,
which reflects the prices of goods and services but not the quantities produced.
nominal GDP
the production of goods and services
valued at current prices
real GDP
the production of goods and services
valued at constant prices
CHAPTER 22 MEASURING A NATION’S INCOME 503
CASE STUDY REAL GDP OVER RECENT HISTORY
Now that we know how real GDP is defined and measured, let’s look at what this
macroeconomic variable tells us about the recent history of the United States. Figure
22-2 shows quarterly data on real GDP for the U.S. economy since 1970.
The GDP deflator is calculated as follows:
GDP deflator 100.
Because nominal GDP and real GDP must be the same in the base year, the GDP
deflator for the base year always equals 100. The GDP deflator for subsequent
years measures the rise in nominal GDP from the base year that cannot be attributable
to a rise in real GDP.
The GDP deflator measures the current level of prices relative to the level of
prices in the base year. To see why this is true, consider a couple of simple examples.
First, imagine that the quantities produced in the economy rise over time but
prices remain the same. In this case, both nominal and real GDP rise together, so
the GDP deflator is constant. Now suppose, instead, that prices rise over time but
the quantities produced stay the same. In this second case, nominal GDP rises but
real GDP remains the same, so the GDP deflator rises as well. Notice that, in both
cases, the GDP deflator reflects what’s happening to prices, not quantities.
Let’s now return to our numerical example in Table 22-2. The GDP deflator is
computed at the bottom of the table. For year 2001, nominal GDP is $200, and real
GDP is $200, so the GDP deflator is 100. For the year 2002, nominal GDP is $600,
and real GDP is $350, so the GDP deflator is 171. Because the GDP deflator rose in
year 2002 from 100 to 171, we can say that the price level increased by 71 percent.
The GDP deflator is one measure that economists use to monitor the average
level of prices in the economy. We examine another—the consumer price index—in
the next chapter, where we also describe the differences between the two measures.
Nominal GDP
Real GDP
GDP deflator
a measure of the price level
calculated as the ratio of nominal
GDP to real GDP times 100
Billions of
1992 Dollars
3,000
4,000
5,000
6,000
$8,000
$7,000
1970 1975 1980 1985 1990 1995 2000
Figure 22-2
REAL GDP IN THE UNITED
STATES. This figure shows
quarterly data on real GDP for
the U.S. economy since 1970.
Recessions—periods of falling
real GDP—are marked with the
shaded vertical bars.
SOURCE: U.S. Department of Commerce.
504 PART EIGHT THE DATA OF MACROECONOMICS
The most obvious feature of these data is that real GDP grows over time.
The real GDP of the U.S. economy in 1999 was more than twice its 1970 level.
Put differently, the output of goods and services produced in the United States
has grown on average about 3 percent per year since 1970. This continued
growth in real GDP enables the typical American to enjoy greater economic
prosperity than his or her parents and grandparents did.
A second feature of the GDP data is that growth is not steady. The upward
climb of real GDP is occasionally interrupted by periods during which GDP
declines, called recessions. Figure 22-2 marks recessions with shaded vertical
bars. (There is no ironclad rule for when the official business cycle dating committee
will declare that a recession has occurred, but a good rule of thumb is
two consecutive quarters of falling real GDP.) Recessions are associated not only
with lower incomes but also with other forms of economic distress: rising
unemployment, falling profits, increased bankruptcies, and so on.
Much of macroeconomics is aimed at explaining the long-run growth
and short-run fluctuations in real GDP. As we will see in the coming chapters,
we need different models for these two purposes. Because the short-run
fluctuations represent deviations from the long-run trend, we first examine the
behavior of the economy in the long run. In particular, Chapters 24 through 30
examine how key macroeconomic variables, including real GDP, are determined
in the long run. We then build on this analysis to explain short-run fluctuations
in Chapters 31 through 33.
QUICK QUIZ: Define real and nominal GDP. Which is a better measure of
economic well-being? Why?
GDP AND ECONOMIC WELL-BEING
Earlier in this chapter, GDP was called the best single measure of the economic wellbeing
of a society. Now that we know what GDP is, we can evaluate this claim.
As we have seen, GDP measures both the economy’s total income and the economy’s
total expenditure on goods and services. Thus, GDP per person tells us the
income and expenditure of the average person in the economy. Because most people
would prefer to receive higher income and enjoy higher expenditure, GDP per person
seems a natural measure of the economic well-being of the average individual.
Yet some people dispute the validity of GDP as a measure of well-being. When
Senator Robert Kennedy was running for president in 1968, he gave a moving critique
of such economic measures:
[Gross domestic product] does not allow for the health of our children, the
quality of their education, or the joy of their play. It does not include the beauty
of our poetry or the strength of our marriages, the intelligence of our public
debate or the integrity of our public officials. It measures neither our courage,
nor our wisdom, nor our devotion to our country. It measures everything, in
short, except that which makes life worthwhile, and it can tell us everything
about America except why we are proud that we are Americans.
CHAPTER 22 MEASURING A NATION’S INCOME 505
Much of what Robert Kennedy said is correct. Why then do we care about GDP?
The answer is that a large GDP does in fact help us to lead a good life. GDP
does not measure the health of our children, but nations with larger GDP can
afford better health care for their children. GDP does not measure the quality of
their education, but nations with larger GDP can afford better educational systems.
GDP does not measure the beauty of our poetry, but nations with larger GDP
can afford to teach more of their citizens to read and to enjoy poetry. GDP does not
take account of our intelligence, integrity, courage, wisdom, or devotion to country,
but all of these laudable attributes are easier to foster when people are less concerned
about being able to afford the material necessities of life. In short, GDP does
not directly measure those things that make life worthwhile, but it does measure
our ability to obtain the inputs into a worthwhile life.
GDP measures the value of the economy’s
output of goods and services.
What do you think we would learn if,
instead, we measured the weight of the
economy’s output?
F r o m G r e e n s p a n , a ( Tr u l y )
Wei g h t y I d e a
BY DAVID WESSEL
Having weighed the evidence carefully,
Federal Reserve Chairman Alan
Greenspan wants you to know that the
U.S. economy is getting lighter.
Literally.
When he refers to “downsizing” in
this instance, Mr. Greenspan means that
a dollar’s worth of the goods and services
produced in the mighty U.S. economy
weighs a lot less than it used to,
even after adjusting for inflation.
A modern 10-story office building,
he says, weighs less than a 10-story
building erected in the late 19th century.
With synthetic fibers, clothes weigh less.
And the electronics revolution has produced
televisions so light they can be
worn on the wrist.
By conventional measures, the [real]
gross domestic product—the value of all
goods and services produced in the
nation—is five times as great as it was
50 years ago. Yet “the physical weight
of our gross domestic product is evidently
only modestly higher than it was
50 or 100 years ago,” Mr. Greenspan
told an audience in Dallas recently.
When you think about it, it’s not so
surprising that the economy is getting
lighter. An ever-growing proportion of
the U.S. GDP consists of things that
don’t weigh anything at all—lawyers’
services, psychotherapy, e-mail, online
information.
But Mr. Greenspan has a way of
making the obvious sound profound.
Only “a small fraction” of the nation’s
economic growth in the past several
decades “represents growth in the tonnage
of physical materials—oil, coal,
ores, wood, raw chemicals,” he has
observed. “The remainder represents
new insights into how to rearrange those
physical materials to better serve human
needs.” . . .
The incredible shrinking GDP helps
explain why American workers can produce
more for each hour of work than
ever before. . . . [It] also helps explain
why there is so much international trade
these days. “The . . . downsizing of output,”
Mr. Greenspan said recently,
“meant that products were easier and
hence less costly to move, and most
especially across national borders.” . . .
“The world of 1948 was vastly different,”
Mr. Greenspan observed a few
years back. “The quintessential model of
industry might in those days was the
array of vast, smoke-encased integrated
steel mills . . . on the shores of Lake
Michigan. Output was things, big physical
things.”
Today, one exemplar of U.S. economic
might is Microsoft Corp., with its
almost weightless output. “Virtually
unimaginable a half-century ago was the
extent to which concepts and ideas
would substitute for physical resources
and human brawn in the production of
goods and services,” he has said.
Of course, one thing Made in the
U.S. is heavier than it used to be: people.
The National Institutes of Health
says 22.3% of Americans are obese, up
from 12.8% in the early 1960. But Mr.
Greenspan doesn’t talk about that.
SOURCE: The Wall Street Journal, May 20, 1999,
p. B1.
IN THE NEWS
GDP Lightens Up
506 PART EIGHT THE DATA OF MACROECONOMICS
CASE STUDY INTERNATIONAL DIFFERENCES IN GDP AND THE
QUALITY OF LIFE
One way to gauge the usefulness of GDP as a measure of economic well-being
is to examine international data. Rich and poor countries have vastly different
levels of GDP per person. If a large GDP leads to a higher standard of living,
then we should observe GDP to be strongly correlated with measures of the
quality of life. And, in fact, we do.
Table 22-3 shows 12 of the world’s most populous countries ranked in order
of GDP per person. The table also shows life expectancy (the expected life span
at birth) and literacy (the percentage of the adult population that can read).
These data show a clear pattern. In rich countries, such as the United States,
Japan, and Germany, people can expect to live into their late seventies, and
almost all of the population can read. In poor countries, such as Nigeria,
Bangladesh, and Pakistan, people typically live only until their fifties or early
sixties, and only about half of the population is literate.
Although data on other aspects of the quality of life are less complete, they
tell a similar story. Countries with low GDP per person tend to have more
infants with low birth weight, higher rates of infant mortality, higher rates of
GDP is not, however, a perfect measure of well-being. Some things that contribute
to a good life are left out of GDP. One is leisure. Suppose, for instance, that
everyone in the economy suddenly started working every day of the week, rather
than enjoying leisure on weekends. More goods and services would be produced,
and GDP would rise. Yet, despite the increase in GDP, we should not conclude that
everyone would be better off. The loss from reduced leisure would offset the gain
from producing and consuming a greater quantity of goods and services.
Because GDP uses market prices to value goods and services, it excludes the
value of almost all activity that takes place outside of markets. In particular, GDP
omits the value of goods and services produced at home. When a chef prepares a
delicious meal and sells it at his restaurant, the value of that meal is part of GDP.
But if the chef prepares the same meal for his spouse, the value he has added to the
raw ingredients is left out of GDP. Similarly, child care provided in day care centers
is part of GDP, whereas child care by parents at home is not. Volunteer work
also contributes to the well-being of those in society, but GDP does not reflect these
contributions.
Another thing that GDP excludes is the quality of the environment. Imagine
that the government eliminated all environmental regulations. Firms could then
produce goods and services without considering the pollution they create, and
GDP might rise. Yet well-being would most likely fall. The deterioration in the
quality of air and water would more than offset the gains from greater production.
GDP also says nothing about the distribution of income. A society in which
100 people have annual incomes of $50,000 has GDP of $5 million and, not surprisingly,
GDP per person of $50,000. So does a society in which 10 people earn
$500,000 and 90 suffer with nothing at all. Few people would look at those two situations
and call them equivalent. GDP per person tells us what happens to the
average person, but behind the average lies a large variety of personal experiences.
In the end, we can conclude that GDP is a good measure of economic wellbeing
for most—but not all—purposes. It is important to keep in mind what GDP
includes and what it leaves out.
GDP REFLECTS THE FACTORY’S
PRODUCTION, BUT NOT THE HARM THAT IT
INFLICTS ON THE ENVIRONMENT.
CHAPTER 22 MEASURING A NATION’S INCOME 507
Table 22-3
GDP, LIFE EXPECTANCY, AND
LITERACY. The table shows
GDP per person and two
measures of the quality of life for
12 major countries.
REAL GDP PER LIFE ADULT
COUNTRY PERSON, 1997 EXPECTANCY LITERACY
United States $29,010 77 years 99%
Japan 24,070 80 99
Germany 21,260 77 99
Mexico 8,370 72 90
Brazil 6,480 67 84
Russia 4,370 67 99
Indonesia 3,490 65 85
China 3,130 70 83
India 1,670 63 53
Pakistan 1,560 64 41
Bangladesh 1,050 58 39
Nigeria 920 50 59
Source: Human Development Report 1999, United Nations.
Measuring a nation’s gross domestic
product is never easy, but it becomes
especially difficult when people have
every incentive to hide their economic
activities from the eyes of government.
T h e R u s s i a n E c o n o m y :
Notes from Underground
BY MICHAEL R. GORDON
If you want to know what is happening in
the Russian economy, it helps to think
about bread. Government statistics show
that people are eating more bread and
bakeries are selling less. Or consider vodka.
Distillers are able to produce far more
vodka than is officially being sold. But given
the well-deserved Russian fondness for
vodka there is every reason to think the
distilleries are operating at full capacity.
The Russian Government’s top
number crunchers say the contradictions
are easy to explain: high taxes, government
red tape, and the simple desire to
sock away some extra cash have driven
much of Russia’s economic activity
underground.
For the last six years, the Russian
economy has been going down, down,
down. But as President Boris N. Yeltsin
tries to deliver the growth he has
promised, economists are taking a closer
look at the murky but vibrant shadow
economy. It includes everything from
small businesses that never report their
sales to huge companies that understate
their production to avoid taxes.
Government experts insist that if the
shadow economy is taken into account,
the overall economy is finally starting to
grow. In turn, Mr. Yeltsin’s critics complain
that the new calculations are more
propaganda than economics. . . .
There is no question that measuring
economic activity in a former Communist
country on the road to capitalism is a
frustratingly elusive task.
“There is a serious problem with
post-socialist statistics,” said Yegor T.
Gaidar, the former Prime Minister and
pro-reform director of the Institute of
Economic Problems of the Transitional
Period.
“Seven years ago to report an
increase in the amount of production
was to become a Hero of Socialist
Labor,” he said. “Now it is to get additional
visits from the tax collector.”
SOURCE: The New York Times, May 18, 1997, Week
in Review, p. 4.
IN THE NEWS
Hidden GDP
508 PART EIGHT THE DATA OF MACROECONOMICS
maternal mortality, higher rates of child malnutrition, and less common access
to safe drinking water. In countries with low GDP per person, fewer school-age
children are actually in school, and those who are in school must learn with
fewer teachers per student. These countries also tend to have fewer televisions,
fewer telephones, fewer paved roads, and fewer households with electricity.
International data leave no doubt that a nation’s GDP is closely associated with
its citizens’ standard of living.
QUICK QUIZ: Why should policymakers care about GDP?
CONCLUSION
This chapter has discussed how economists measure the total income of a nation.
Measurement is, of course, only a starting point. Much of macroeconomics is
aimed at revealing the long-run and short-run determinants of a nation’s gross
domestic product. Why, for example, is GDP higher in the United States and Japan
than in India and Nigeria? What can the governments of the poorest countries do
to promote more rapid growth in GDP? Why does GDP in the United States rise
rapidly in some years and fall in others? What can U.S. policymakers do to reduce
the severity of these fluctuations in GDP? These are the questions we will take up
shortly.
At this point, it is important to acknowledge the importance of just measuring
GDP. We all get some sense of how the economy is doing as we go about our lives.
But the economists who study changes in the economy and the policymakers who
formulate economic policies need more than this vague sense—they need concrete
data on which to base their judgments. Quantifying the behavior of the economy
with statistics such as GDP is, therefore, the first step to developing a science of
macroeconomics.
Because every transaction has a buyer and a seller, the
total expenditure in the economy must equal the total
income in the economy.
Gross domestic product (GDP) measures an economy’s
total expenditure on newly produced goods and
services and the total income earned from the
production of these goods and services. More precisely,
GDP is the market value of all final goods and services
produced within a country in a given period of time.
GDP is divided among four components of expenditure:
consumption, investment, government purchases, and
net exports. Consumption includes spending on goods
and services by households, with the exception of
purchases of new housing. Investment includes
spending on new equipment and structures, including
households’ purchases of new housing. Government
purchases include spending on goods and services by
local, state, and federal governments. Net exports equal
the value of goods and services produced domestically
and sold abroad (exports) minus the value of goods and
services produced abroad and sold domestically
(imports).
Nominal GDP uses current prices to value the
economy’s production of goods and services. Real GDP
uses constant base-year prices to value the economy’s
production of goods and services. The GDP deflator—
Summary
CHAPTER 22 MEASURING A NATION’S INCOME 509
calculated from the ratio of nominal to real GDP—
measures the level of prices in the economy.
GDP is a good measure of economic well-being because
people prefer higher to lower incomes. But it is not a
perfect measure of well-being. For example, GDP
excludes the value of leisure and the value of a clean
environment.
Key Concepts
microeconomics, p. 494
macroeconomics, p. 494
gross domestic product (GDP), p. 496
consumption, p. 499
investment, p. 499
government purchases, p. 499
net exports, p. 499
nominal GDP, p. 502
real GDP, p. 502
GDP deflator, p. 503
Questions for Review
1. Explain why an economy’s income must equal its
expenditure.
2. Which contributes more to GDP—the production of an
economy car or the production of a luxury car? Why?
3. A farmer sells wheat to a baker for $2. The baker uses
the wheat to make bread, which is sold for $3. What is
the total contribution of these transactions to GDP?
4. Many years ago Peggy paid $500 to put together a
record collection. Today she sold her albums at a garage
sale for $100. How does this sale affect current GDP?
5. List the four components of GDP. Give an example of
each.
6. Why do economists use real GDP rather than nominal
GDP to gauge economic well-being?
7. In the year 2001, the economy produces 100 loaves of
bread that sell for $2 each. In the year 2002, the economy
produces 200 loaves of bread that sell for $3 each.
Calculate nominal GDP, real GDP, and the GDP deflator
for each year. (Use 2001 as the base year.) By what
percentage does each of these three statistics rise from
one year to the next?
8. Why is it desirable for a country to have a large GDP?
Give an example of something that would raise GDP
and yet be undesirable.
Problems and Applications
1. What components of GDP (if any) would each of the
following transactions affect? Explain.
a. A family buys a new refrigerator.
b. Aunt Jane buys a new house.
c. Ford sells a Thunderbird from its inventory.
d. You buy a pizza.
e. California repaves Highway 101.
f. Your parents buy a bottle of French wine.
g. Honda expands its factory in Marysville, Ohio.
2. The “government purchases” component of GDP does
not include spending on transfer payments such as
Social Security. Thinking about the definition of GDP,
explain why transfer payments are excluded.
3. Why do you think households’ purchases of new
housing are included in the investment component of
GDP rather than the consumption component? Can you
think of a reason why households’ purchases of new
cars should also be included in investment rather than
in consumption? To what other consumption goods
might this logic apply?
4. As the chapter states, GDP does not include the value of
used goods that are resold. Why would including such
transactions make GDP a less informative measure of
economic well-being?
5. Below are some data from the land of milk and honey.
PRICE QUANTITY PRICEOF QUANTITY
YEAR OFMILK OFMILK HONEY OF HONEY
2001 $1 100 qts. $2 50 qts.
2002 $1 200 $2 100
2003 $2 200 $4 100
510 PART EIGHT THE DATA OF MACROECONOMICS
a. Compute nominal GDP, real GDP, and the GDP
deflator for each year, using 2001 as the base year.
b. Compute the percentage change in nominal GDP,
real GDP, and the GDP deflator in 2002 and 2003
from the preceding year. For each year, identify the
variable that does not change. Explain in words
why your answer makes sense.
c. Did economic well-being rise more in 2002 or 2003?
Explain.
6. Consider the following data on U.S. GDP:
NOMINAL GDP GDP DEFLATOR
YEAR (IN BILLIONS) (BASEYE AR 1992)
1996 7,662 110
1997 8,111 112
a. What was the growth rate of nominal GDP between
1996 and 1997? (Note: The growth rate is the
percentage change from one period to the next.)
b. What was the growth rate of the GDP deflator
between 1996 and 1997?
c. What was real GDP in 1996 measured in 1992
prices?
d. What was real GDP in 1997 measured in 1992
prices?
e. What was the growth rate of real GDP between
1996 and 1997?
f. Was the growth rate of nominal GDP higher or
lower than the growth rate of real GDP? Explain.
7. If prices rise, people’s income from selling goods
increases. The growth of real GDP ignores this gain,
however. Why, then, do economists prefer real GDP as a
measure of economic well-being?
8. Revised estimates of U.S. GDP are usually released by
the government near the end of each month. Go to a
library and find a newspaper article that reports on the
most recent release. Discuss the recent changes in real
and nominal GDP and in the components of GDP.
(Alternatively, you can get the data at www.bea.doc.gov,
the Web site of the U.S. Bureau of Economic Analysis.)
9. One day Barry the Barber, Inc., collects $400 for haircuts.
Over this day, his equipment depreciates in value by
$50. Of the remaining $350, Barry sends $30 to the
government in sales taxes, takes home $220 in wages,
and retains $100 in his business to add new equipment
in the future. From the $220 that Barry takes home, he
pays $70 in income taxes. Based on this information,
compute Barry’s contribution to the following measures
of income:
a. gross domestic product
b. net national product
c. national income
d. personal income
e. disposable personal income
10. Goods and services that are not sold in markets, such as
food produced and consumed at home, are generally
not included in GDP. Can you think of how this might
cause the numbers in the second column of Table 22-3 to
be misleading in a comparison of the economic wellbeing
of the United States and India? Explain.
11. Until the early 1990s, the U.S. government emphasized
GNP rather than GDP as a measure of economic wellbeing.
Which measure should the government prefer if
it cares about the total income of Americans? Which
measure should it prefer if it cares about the total
amount of economic activity occurring in the United
States?
12. The participation of women in the U.S. labor force has
risen dramatically since 1970.
a. How do you think this rise affected GDP?
b. Now imagine a measure of well-being that includes
time spent working in the home and taking leisure.
How would the change in this measure of wellbeing
compare to the change in GDP?
c. Can you think of other aspects of well-being that
are associated with the rise in women’s labor force
participation? Would it be practical to construct a
measure of well-being that includes these aspects?
511
IN THIS CHAPTER
YOU WILL . . .
Learn the
distinction between
real and nominal
interest rates
Compare the CPI
and the GDP
deflator as
measures of the
overall price level
Learn how the
consumer price
index (CPI) is
constructed
Consider why the
CPI is an imper fect
measure of the cost
of living
See how to use a
price index to
compare dollar
figur es from
dif ferent times
In 1931, as the U.S. economy was suffering through the Great Depression, famed
baseball player Babe Ruth earned $80,000. At the time, this salary was extraordinary,
even among the stars of baseball. According to one story, a reporter asked
Ruth whether he thought it was right that he made more than President Herbert
Hoover, who had a salary of only $75,000. Ruth replied, “I had a better year.”
Today the average baseball player earns more than 10 times Ruth’s 1931 salary,
and the best players can earn 100 times as much. At first, this fact might lead you
to think that baseball has become much more lucrative over the past six decades.
But, as everyone knows, the prices of goods and services have also risen. In 1931,
a nickel would buy an ice-cream cone, and a quarter would buy a ticket at the local
movie theater. Because prices were so much lower in Babe Ruth’s day than they
are in ours, it is not clear whether Ruth enjoyed a higher or lower standard of living
than today’s players.
M E A S U R I N G T H E
C O S T O F L I V I N G
512 PART EIGHT THE DATA OF MACROECONOMICS
In the preceding chapter we looked at how economists use gross domestic
product (GDP) to measure the quantity of goods and services that the economy is
producing. This chapter examines how economists measure the overall cost of living.
To compare Babe Ruth’s salary of $80,000 to salaries from today, we need to
find some way of turning dollar figures into meaningful measures of purchasing
power. That is exactly the job of a statistic called the consumer price index. After seeing
how the consumer price index is constructed, we discuss how we can use such
a price index to compare dollar figures from different points in time.
The consumer price index is used to monitor changes in the cost of living over
time. When the consumer price index rises, the typical family has to spend more
dollars to maintain the same standard of living. Economists use the term inflation
to describe a situation in which the economy’s overall price level is rising. The
inflation rate is the percentage change in the price level from the previous period.
As we will see in the coming chapters, inflation is a closely watched aspect of
macroeconomic performance and is a key variable guiding macroeconomic policy.
This chapter provides the background for that analysis by showing how economists
measure the inflation rate using the consumer price index.
THE CONSUMER PRICE INDEX
The consumer price index (CPI) is a measure of the overall cost of the goods and
services bought by a typical consumer. Each month the Bureau of Labor Statistics,
which is part of the Department of Labor, computes and reports the consumer
price index. In this section we discuss how the consumer price index is calculated
and what problems arise in its measurement. We also consider how this index
compares to the GDP deflator, another measure of the overall level of prices, which
we examined in the preceding chapter.
HOW THE CONSUMER PRICE INDEX IS CALCULATED
When the Bureau of Labor Statistics calculates the consumer price index and the
inflation rate, it uses data on the prices of thousands of goods and services. To see
exactly how these statistics are constructed, let’s consider a simple economy in
which consumers buy only two goods—hot dogs and hamburgers. Table 23-1
shows the five steps that the Bureau of Labor Statistics follows.
1. Fix the Basket. The first step in computing the consumer price index is to
determine which prices are most important to the typical consumer. If the
typical consumer buys more hot dogs than hamburgers, then the price of hot
dogs is more important than the price of hamburgers and, therefore, should
be given greater weight in measuring the cost of living. The Bureau of Labor
Statistics sets these weights by surveying consumers and finding the basket
of goods and services that the typical consumer buys. In the example in the
table, the typical consumer buys a basket of 4 hot dogs and 2 hamburgers.
consumer price
index (CPI)
a measure of the overall cost of
the goods and services bought
by a typical consumer
CHAPTER 23 MEASURING THE COST OF LIVING 513
2. Find the Prices. The second step in computing the consumer price index is to
find the prices of each of the goods and services in the basket for each point
in time. The table shows the prices of hot dogs and hamburgers for three
different years.
3. Compute the Basket’s Cost. The third step is to use the data on prices
to calculate the cost of the basket of goods and services at different times.
The table shows this calculation for each of the three years. Notice that only
the prices in this calculation change. By keeping the basket of goods the
same (4 hot dogs and 2 hamburgers), we are isolating the effects of price
changes from the effect of any quantity changes that might be occurring
at the same time.
4. Choose a Base Year and Compute the Index. The fourth step is to designate
one year as the base year, which is the benchmark against which other years
are compared. To calculate the index, the price of the basket of goods and
Table 23-1
CALCULATING THE CONSUMER
PRICE INDEX AND THE INFLATION
RATE: AN EXAMPLE. This table
shows how to calculate the
consumer price index and the
inflation rate for a hypothetical
economy in which consumers
buy only hot dogs and
hamburgers.
STEP 1: SURVEY CONSUMERS TO DETERMINE A FIXED BASKET OF GOODS
4 hot dogs, 2 hamburgers
STEP 2: FIND THE PRICE OF EACH GOOD IN EACH YEAR
YEAR PRICE OF HOT DOGS PRICE OF HAMBURGERS
2001 $1 $2
2002 2 3
2003 3 4
STEP 3: COMPUTE THE COST OF THE BASKET OF GOODS IN EACH YEAR
2001 ($1 per hot dog 4 hot dogs) ($2 per hamburger 2 hamburgers) $8
2002 ($2 per hot dog 4 hot dogs) ($3 per hamburger 2 hamburgers) $14
2003 ($3 per hot dog 4 hot dogs) ($4 per hamburger 2 hamburgers) $20
STEP 4: CHOOSE ONE YEA R A S ABASE YEAR (2001) AND COMPUTE THE CONSUMER
PRICE INDEX IN EACH YEAR
2001 ($8/$8) 100 100
2002 ($14/$8) 100 175
2003 ($20/$8) 100 250
STEP 5: USE THE CONSUMER PRICE INDEX TO COMPUTE THE INFLATIONRATE FROM
PREVIOUS YEAR
2002 (175 100)/100 100 75%
2003 (250 175)/175 100 43%
514 PART EIGHT THE DATA OF MACROECONOMICS
services in each year is divided by the price of the basket in the base year,
and this ratio is then multiplied by 100. The resulting number is the
consumer price index.
In the example in the table, the year 2001 is the base year. In this year,
the basket of hot dogs and hamburgers costs $8. Therefore, the price of the
basket in all years is divided by $8 and multiplied by 100. The consumer
price index is 100 in 2001. (The index is always 100 in the base year.) The
consumer price index is 175 in 2002. This means that the price of the basket
in 2002 is 175 percent of its price in the base year. Put differently, a basket
of goods that costs $100 in the base year costs $175 in 2002. Similarly, the
consumer price index is 250 in 2003, indicating that the price level in 2003
is 250 percent of the price level in the base year.
5. Compute the Inflation Rate. The fifth and final step is to use the consumer price
index to calculate the inflation rate, which is the percentage change in the
price index from the preceding period. That is, the inflation rate between two
consecutive years is computed as follows:
inflation rate
the percentage change in the price
index from the preceding period
When constructing the consumer
price index, the Bureau
of Labor Statistics tries to
include all the goods and services
that the typical consumer
buys. Moreover, it tries to
weight these goods and services
according to how much
consumers buy of each item.
Figure 23-1 shows the
breakdown of consumer spending
into the major categories of
goods and services. By far the
largest category is housing, which makes up 40 percent of
the typical consumer’s budget. This category includes the
cost of shelter (30 percent), fuel and other utilities (5 percent),
and household furnishings and operation (5 percent).
The next largest category, at 17 percent, is transportation,
which includes spending on cars, gasoline, buses, subways,
and so on. The next category, at 16 percent, is food and
beverages; this includes food at home (9 percent), food
away from home (6 percent), and alcoholic beverages (1 percent).
Next are medical care at 6 percent, recreation at 6
percent, apparel at 5 percent, and education and communication
at 5 percent. This last category includes, for example,
college tuition and personal computers.
Also included in the figure, at 5 percent of spending, is
a category for other goods and services. This is a catchall
for things consumers buy that do not naturally fit into the
other categories, such as cigarettes, haircuts, and funeral
expenses.
FYI
What Is in the
CPI’s Basket? 16%
Food and
beverages
17%
Transportation
Other goods
and services
Medical care
Apparel
Recreation
5%
6%
5% 5%
6%
40%
Housing
Education and
communication
Figure 23-1
THE TYPICAL BASKET OF GOODS AND SERVICES. This
figure shows how the typical consumer divides his
spending among various categories of goods and services.
The Bureau of Labor Statistics calls each percentage the
“relative importance” of the category.
SOURCE: Bureau of Labor Statistics.
CHAPTER 23 MEASURING THE COST OF LIVING 515
Inflation rate in year 2 100.
In our example, the inflation rate is 75 percent in 2002 and 43 percent in 2003.
Although this example simplifies the real world by including only two goods,
it shows how the Bureau of Labor Statistics (BLS) computes the consumer price
index and the inflation rate. The BLS collects and processes data on the prices of
thousands of goods and services every month and, by following the five foregoing
steps, determines how quickly the cost of living for the typical consumer is rising.
When the bureau makes its monthly announcement of the consumer price index,
you can usually hear the number on the evening television news or see it in the
next day’s newspaper.
In addition to the consumer price index for the overall economy, the BLS calculates
several other price indexes. It reports the index for specific regions within
the country (such as Boston, New York, and Los Angeles) and for some narrow
categories of goods and services (such as food, clothing, and energy). It also calculates
the producer price index, which measures the cost of a basket of goods and
services bought by firms rather than consumers. Because firms eventually pass on
their costs to consumers in the form of higher consumer prices, changes in the producer
price index are often thought to be useful in predicting changes in the consumer
price index.
PROBLEMS IN MEASURING THE COST OF LIVING
The goal of the consumer price index is to measure changes in the cost of living. In
other words, the consumer price index tries to gauge how much incomes must rise
in order to maintain a constant standard of living. The consumer price index, however,
is not a perfect measure of the cost of living. Three problems with the index
are widely acknowledged but difficult to solve.
The first problem is called substitution bias. When prices change from one year
to the next, they do not all change proportionately: Some prices rise by more than
others. Consumers respond to these differing price changes by buying less of the
goods whose prices have risen by large amounts and by buying more of the goods
whose prices have risen less or perhaps even have fallen. That is, consumers substitute
toward goods that have become relatively less expensive. Yet the consumer
price index is computed assuming a fixed basket of goods. By not taking into
account the possibility of consumer substitution, the index overstates the increase
in the cost of living from one year to the next.
Let’s consider a simple example. Imagine that in the base year, apples are
cheaper than pears, and so consumers buy more apples than pears. When the
Bureau of Labor Statistics constructs the basket of goods, it will include more
apples than pears. Suppose that next year pears are cheaper than apples. Consumers
will naturally respond to the price changes by buying more pears and fewer
apples. Yet, when computing the consumer price index, the Bureau of Labor
Statistics uses a fixed basket, which in essence assumes that consumers continue
buying the now expensive apples in the same quantities as before. For this reason,
the index will measure a much larger increase in the cost of living than consumers
actually experience.
CPI in year 2 CPI in year 1
CPI in year 1
producer price index
a measure of the cost of a basket of
goods and services bought by firms
516 PART EIGHT THE DATA OF MACROECONOMICS
The second problem with the consumer price index is the introduction of new
goods. When a new good is introduced, consumers have more variety from which
to choose. Greater variety, in turn, makes each dollar more valuable, so consumers
need fewer dollars to maintain any given standard of living. Yet because the consumer
price index is based on a fixed basket of goods and services, it does not
reflect this change in the purchasing power of the dollar.
Again, let’s consider an example. When VCRs were introduced, consumers
were able to watch their favorite movies at home. Compared to going to a movie
theater, the convenience is greater and the cost is less. Aperfect cost-of-living index
would reflect the introduction of the VCR with a decrease in the cost of living. The
consumer price index, however, did not decrease in response to the introduction of
the VCR. Eventually, the Bureau of Labor Statistics did revise the basket of goods
BEHIND EVERY MACROECONOMIC STATISTIC
are thousands of individual pieces of
data on the economy. This article follows
some of the people who collect
these data.
I s t h e C P I A c c u r a t e ?
Ask t h e F e d e r a l S l e u t h s
Who G e t the Numbers
BY CHRISTINA DUFF
TRENTON, N.J.—The hospital’s finance
director is relentlessly unhelpful, but she
is still no match for Sabina Bloom, government
gumshoe.
Mrs. Bloom wants to know the
exact prices of some hospital services.
“Nothing’s changed,” the woman says.
“Well, do you have the ledger?” Mrs.
Bloom asks. “We haven’t changed any
prices,” the woman insists. Mrs.
Bloom’s fast talk finally pries the woman
from behind her desk, and she gets the
numbers. It turns out that a semiprivate
surgery recovery room now costs
$753.80 a day—or $0.04 less than a
month ago.
Chalk up another small success for
Mrs. Bloom, one of about 300 Bureau of
Labor Statistics employees who gather
the information that is fed into the
monthly Consumer Price Index. . . .
Mrs. Bloom’s travails sometimes
read like a detective novel. Each month,
she covers 900 miles in her beat-up Geo
Prizm (three accidents in the past 18
months) to visit about 150 sites. Her
mission: to record the prices of certain
items, time and again. If prices change,
she needs to find out why. Each month,
some 90,000 prices are shipped to
Washington, plugged into a computer,
scrutinized, aggregated, adjusted for
seasonal ups or downs, and then spit
out as the monthly CPI report.
Choosing what to price—for example,
the “regular” or “fancy” baby
parakeet—can seem arbitrary. After consulting
surveys that track consumer buying
habits, the labor statistics bureau
selects popular stores and item categories—
say, women’s tops. The pricetaker
then asks a store employee to help
zero in on an item of the price-taker’s
choosing. They narrow to the size of the
top, its style (short-sleeve, long-sleeve,
tank, or turtleneck), and so on; items
that generate the most revenue in a category
have the best chance of getting
picked.
Shoppers know that relying on
employees for anything can be chancy.
At a downtown Chicago department
store (the government doesn’t disclose
IN THE NEWS
Shopping for the CPI
THE INTRODUCTION OF NEW PRODUCTS
BIASES THE CPI.
CHAPTER 23 MEASURING THE COST OF LIVING 517
to include VCRs, and subsequently the index reflected changes in VCR prices. But
the reduction in the cost of living associated with the initial introduction of the
VCR never showed up in the index.
The third problem with the consumer price index is unmeasured quality change.
If the quality of a good deteriorates from one year to the next, the value of a dollar
falls, even if the price of the good stays the same. Similarly, if the quality rises from
one year to the next, the value of a dollar rises. The Bureau of Labor Statistics does
its best to account for quality change. When the quality of a good in the basket
changes—for example, when a car model has more horsepower or gets better gas
mileage from one year to the next—the BLS adjusts the price of the good to
account for the quality change. It is, in essence, trying to compute the price of a
basket of goods of constant quality. Despite these efforts, changes in quality
remain a problem, because quality is so hard to measure.
names) price-taker Mary Ann Latter
squints at a sale sign above an ivory
shell blouse. “Save 45%–60% when you
take an additional 30% off permanently
reduced merchandise. Markdown taken
at register,” the sign says.
Confused, Ms. Latter asks a clerk
to scan the item. There is a pause. “It’s
30 percent off,” she says, just before
the lunch-hour rush.
“I know,” Ms. Latter says, “but can
you scan it just to make sure?” Under
her breath, she mumbles, “So helpful.”
Downstairs in the jewelry department,
Ms. Latter tries to price the one
18-inch silver necklace left, but there is
no tag. “Do I have to look it up now?”
moans the employee behind the counter.
Ms. Latter watches her wait on several
customers, then asks again: “Could you
find it?” The harried saleswoman throws
on the counter a thick notebook with a
dizzying array of jewelry sketches. Ms.
Latter finally locates a silver weave that
looks about right.
When the exact item can’t be found,
price-takers must substitute. That can be
difficult. Consider a haircut: If the stylist
leaves, his fill-in must have about the
same experience; a newer stylist, for
example, might charge less. This frigid
winter afternoon, Ms. Latter needs to
substitute a coat because clothing items
rarely remain on the racks for more than
a couple months. It must be a lightweight
swing coat of less than half wool. After
digging through heavy winter wear, trying
to locate tags in three departments on
two floors, she gives up. It is off season
anyway, so she will have to wait months
to choose a substitute.
Making it harder for price detectives
to grasp the true cost of living is that the
master list of 207 categories they
price—called the market basket—is
updated only once every ten years. Cellular
phones? Too new to be priced
because they don’t fit into any of the categories
set up in the 1980s. They probably
will be included when the new
categories arrive [next year].
Some changes within these categories
are made every five years. So
within “new cars,” for example, if
domestic autos overtake imports in a
big way, price-takers might examine
more Fords and fewer Toyotas. But that
doesn’t happen often enough, critics
say. Ms. Latter, a city-dwelling Generation
X’er, continually must price “Always
Twenty-One” girdles, yet ignore the new,
popular WonderBras behind her. . . .
Ms. Latter’s colleague in suburban
Chicago, Sheila Ward, must ignore the
hoopla over Tickle Me Elmo and instead
price a GI Joe Extreme doll with “painted,
molded hair.” Reliance on outdated
goods, says Mrs. Ward, “would be one
of the criticisms of us.” She recalls a
music store owner who became frustrated
because she kept seeking prices on a
guitar he could never imagine playing—
much less selling. He finally threw her
out of his shop, screaming, “The
damned government! Is this what I’m
paying taxes for?”
Price-takers can’t do much about
these problems. What they can do is
interrogate. At a simple restaurant, Mrs.
Ward asks if food portions have
changed. The owner says they haven’t.
But she remembers that the price of
bacon has been climbing, and asks again
about his BLT. Suddenly, he recalls that
he has cut the number of bacon slices
from three to two. And that is a very different
sandwich.
SOURCE: The Wall Street Journal, January 16, 1997,
p. A1.
518 PART EIGHT THE DATA OF MACROECONOMICS
There is still much debate among economists about how severe these measurement
problems are and what should be done about them. The issue is important
because many government programs use the consumer price index to adjust
for changes in the overall level of prices. Recipients of Social Security, for instance,
get annual increases in benefits that are tied to the consumer price index. Some
economists have suggested modifying these programs to correct for the measurement
problems. For example, most studies conclude that the consumer price index
overstates inflation by about 1 percentage point per year (although recent
improvements in the CPI have reduced this upward bias somewhat). In response
to these findings, Congress could change the Social Security program so that benefits
increased every year by the measured inflation rate minus 1 percentage point.
Such a change would provide a crude way of offsetting the measurement problems
and, at the same time, reduce government spending by billions of dollars
each year.
ALTHOUGH THE CONSUMER PRICE INDEX
may overstate the true rate of inflation
facing the typical consumer, it may
understate inflation for certain types of
consumers. In particular, according to
some economists, the elderly have
experienced more rapid cost-of-living
increases than the general population.
P r i c e s T h a t
D o n ’t F i t t h e P r o f i l e :
I s I n d e x M i s m a t c h e d t o
R e t i r e e s ’ R e a l i t y ?
BY LAURA CASTANEDA
Low inflation, a driving force behind the
nation’s economic boom, is having the
perverse effect of making life harder for
millions of elderly Americans.
That is because increases in Social
Security payments are based on an inflation
index—the Consumer Price Index
for Urban Wage Earners and Clerical
Workers—that may not accurately
reflect their expenses.
Based on that index, monthly Social
Security payments will rise an average of
1.3 percent next year. But the costs that
drain the resources of many retired
people—notably medical treatment, prescription
drugs, and special housing—
are rising faster than consumer prices in
general. . . .
Now the Bureau of Labor Statistics,
which calculates the indexes, has
devised an experimental index that does
track some spending habits of older
Americans, and it has shown a widening
gap between cost increases for them
and those for the general population.
Between December 1982 and September
1998, the experimental index rose
73.9 percent, while the official index
rose 63.5 percent, said Patrick Jackman,
an economist at the bureau. . . .
The official index “is understating
the true rate of inflation for the elderly,”
said Dean Baker, an economist at the
Economic Policy Institute, an independent
research organization in Washington,
and the disparity is likely to get
worse over time.
But Mr. Baker, the author of
“Getting Prices Right: The Battle Over
the Consumer Price Index,” said older
people’s higher spending on some
goods and services was not the only
reason. The official index also considers
price declines for consumer goods that
they rarely buy, like television sets and
computers.
While Congress balks at the cost,
he added, a separate CPI for the elderly
“would be the way to go” to correct the
problem.
SOURCE: The New York Times, Business Section,
November 8, 1998, p. 10.
IN THE NEWS
A CPI for Senior Citizens
CHAPTER 23 MEASURING THE COST OF LIVING 519
THE GDP DEFLATOR VERSUS THE CONSUMER PRICE INDEX
In the preceding chapter, we examined another measure of the overall level of
prices in the economy—the GDP deflator. The GDP deflator is the ratio of nominal
GDP to real GDP. Because nominal GDP is current output valued at current prices
and real GDP is current output valued at base-year prices, the GDP deflator
reflects the current level of prices relative to the level of prices in the base year.
Economists and policymakers monitor both the GDP deflator and the consumer
price index to gauge how quickly prices are rising. Usually, these two statistics
tell a similar story. Yet there are two important differences that can cause
them to diverge.
The first difference is that the GDP deflator reflects the prices of all goods and
services produced domestically, whereas the consumer price index reflects the prices
of all goods and services bought by consumers. For example, suppose that the price
of an airplane produced by Boeing and sold to the Air Force rises. Even though the
plane is part of GDP, it is not part of the basket of goods and services bought by a
typical consumer. Thus, the price increase shows up in the GDP deflator but not in
the consumer price index.
As another example, suppose that Volvo raises the price of its cars. Because
Volvos are made in Sweden, the car is not part of U.S. GDP. But U.S. consumers
buy Volvos, and so the car is part of the typical consumer’s basket of goods.
Hence, a price increase in an imported consumption good, such as a Volvo, shows
up in the consumer price index but not in the GDP deflator.
This first difference between the consumer price index and the GDP deflator
is particularly important when the price of oil changes. Although the United
States does produce some oil, much of the oil we use is imported from the
Middle East. As a result, oil and oil products such as gasoline and heating oil
comprise a much larger share of consumer spending than they do of GDP. When
the price of oil rises, the consumer price index rises by much more than does the
GDP deflator.
The second and more subtle difference between the GDP deflator and the consumer
price index concerns how various prices are weighted to yield a single
number for the overall level of prices. The consumer price index compares the
price of a fixed basket of goods and services to the price of the basket in the base
year. Only occasionally does the Bureau of Labor Statistics change the basket of
goods. By contrast, the GDP deflator compares the price of currently produced
goods and services to the price of the same goods and services in the base year.
Thus, the group of goods and services used to compute the GDP deflator changes
automatically over time. This difference is not important when all prices are
changing proportionately. But if the prices of different goods and services are
changing by varying amounts, the way we weight the various prices matters for
the overall inflation rate.
Figure 23-2 shows the inflation rate as measured by both the GDP deflator and
the consumer price index for each year since 1965. You can see that sometimes the
two measures diverge. When they do diverge, it is possible to go behind these
numbers and explain the divergence with the two differences we have discussed.
The figure shows, however, that divergence between these two measures is the
exception rather than the rule. In the late 1970s, both the GDP deflator and the consumer
price index show high rates of inflation. In the late 1980s and 1990s, both
measures show low rates of inflation.
520 PART EIGHT THE DATA OF MACROECONOMICS
QUICK QUIZ: Explain briefly what the consumer price index is trying to
measure and how it is constructed.
CORRECTING ECONOMIC VARIABLES FOR THE
EFFECTS OF INFLATION
The purpose of measuring the overall level of prices in the economy is to permit
comparison between dollar figures from different points in time. Now that we
know how price indexes are calculated, let’s see how we might use such an index
to compare a dollar figure from the past to a dollar figure in the present.
DOLLAR FIGURES FROM DIFFERENT TIMES
We first return to the issue of Babe Ruth’s salary. Was his salary of $80,000 in 1931
high or low compared to the salaries of today’s players?
To answer this question, we need to know the level of prices in 1931 and the
level of prices today. Part of the increase in baseball salaries just compensates players
for the higher level of prices today. To compare Ruth’s salary to those of today’s
players, we need to inflate Ruth’s salary to turn 1931 dollars into today’s dollars.
A price index determines the size of this inflation correction.
1965
Percent
per Year
15
CPI
GDP deflator
10
5
0
1970 1975 1980 1985 1990 1995 1998
Figure 23-2
TWO MEASURES OF INFLATION.
This figure shows the inflation
rate—the percentage change in
the level of prices—as measured
by the GDP deflator and the
consumer price index using
annual data since 1965. Notice
that the two measures of inflation
generally move together.
SOURCE: U.S. Department of Labor; U.S.
Department of Commerce.
”The price may seem a little high,
but you have to remember that’s
in today’s dollars.”
CHAPTER 23 MEASURING THE COST OF LIVING 521
CASE STUDY MR. INDEX GOES TO HOLLYWOOD
What was the most popular movie of all time? The answer might surprise you.
Movie popularity is usually gauged by box office receipts. By that measure,
Titanic is the No. 1 movie of all time, followed by Star Wars, Star Wars: The
Phantom Menace, and ET. But this ranking ignores an obvious but important
fact: Prices, including the price of movie tickets, have been rising over time.
When we correct box office receipts for the effects of inflation, the story is very
different.
Table 23-2 shows the top ten movies of all time, ranked by inflationadjusted
box office receipts. The No. 1 movie is Gone with the Wind, which was
released in 1939 and is well ahead of Titanic. In the 1930s, before everyone had
televisions in their homes, about 90 million Americans went to the cinema each
week, compared to about 25 million today. But the movies from that era rarely
show up in popularity rankings because ticket prices were only a quarter. Scarlett
and Rhett fare a lot better once we correct for the effects of inflation.
Government statistics show a consumer price index of 15.2 for 1931 and 166
for 1999. Thus, the overall level of prices has risen by a factor of 10.9 (which equals
166/15.2). We can use these numbers to measure Ruth’s salary in 1999 dollars. The
calculation is as follows:
Salary in 1999 dollars Salary in 1931 dollars
$80,000
$873,684.
We find that Babe Ruth’s 1931 salary is equivalent to a salary today of just under
$1 million. That is not a bad income, but it is less than the salary of the average
baseball player today, and it is far less than the amount paid to today’s baseball
superstars. Chicago Cubs hitter Sammy Sosa, for instance, was paid about $10 million
in 1999.
Let’s also examine President Hoover’s 1931 salary of $75,000. To translate that
figure into 1999 dollars, we again multiply the ratio of the price levels in the two
years. We find that Hoover’s salary is equivalent to $75,000 (166/15.2), or
$819,079, in 1999 dollars. This is well above President Clinton’s salary of $200,000
(and even above the $400,000 salary that, according to recent legislation, will be
paid to Clinton’s successor). It seems that President Hoover did have a pretty good
year after all.
166
15.2
Price level in 1999
Price level in 1931
INDEXATION
As we have just seen, price indexes are used to correct for the effects of inflation
when comparing dollar figures from different times. This type of correction shows
up in many places in the economy. When some dollar amount is automatically
corrected for inflation by law or contract, the amount is said to be indexed for
inflation.
indexation
the automatic correction of a dollar
amount for the effects of inflation
by law or contract
“FRANKLY, MY DEAR, I DON’T CARE MUCH
FOR THE EFFECTS OF INFLATION.”
522 PART EIGHT THE DATA OF MACROECONOMICS
For example, many long-term contracts between firms and unions include
partial or complete indexation of the wage to the consumer price index. Such a
provision is called a cost-of-living allowance, or COLA. ACOLAautomatically raises
the wage when the consumer price index rises.
Indexation is also a feature of many laws. Social Security benefits, for example,
are adjusted every year to compensate the elderly for increases in prices. The
brackets of the federal income tax—the income levels at which the tax rates
change—are also indexed for inflation. There are, however, many ways in which
the tax system is not indexed for inflation, even when perhaps it should be. We
discuss these issues more fully when we discuss the costs of inflation later in
this book.
REAL AND NOMINAL INTEREST RATES
Correcting economic variables for the effects of inflation is particularly important,
and somewhat tricky, when we look at data on interest rates. When you deposit
your savings in a bank account, you will earn interest on your deposit. Conversely,
when you borrow from a bank to pay your tuition, you will pay interest on your
student loan. Interest represents a payment in the future for a transfer of money in
the past. As a result, interest rates always involve comparing amounts of money at
different points in time. To fully understand interest rates, we need to know how
to correct for the effects of inflation.
Let’s consider an example. Suppose that Sally Saver deposits $1,000 in a bank
account that pays an annual interest rate of 10 percent. After a year passes, Sally
has accumulated $100 in interest. Sally then withdraws her $1,100. Is Sally $100
richer than she was when she made the deposit a year earlier?
The answer depends on what we mean by “richer.” Sally does have $100 more
than she had before. In other words, the number of dollars has risen by 10 percent.
But if prices have risen at the same time, each dollar now buys less than it did a
year ago. Thus, her purchasing power has not risen by 10 percent. If the inflation
Table 23-2
THE MOST POPULAR MOVIES OF
ALL TIME, INFLATION ADJUSTED
YEAR OF TOTAL DOMESTIC GROSS
FILM RELEASE (IN MILLIONS OF 1999 DOLLARS)
1. Gone with the Wind 1939 $920
2. Star Wars 1977 798
3. The Sound of Music 1965 638
4. Titanic 1997 601
5. E.T. The Extra-Terrestrial 1982 601
6. The Ten Commandments 1956 587
7. Jaws 1975 574
8. Doctor Zhivago 1965 543
9. The Jungle Book 1967 485
10. Snow White and the Seven Dwarfs 1937 476
SOURCE: The Movie Times, online Web site (www.the-movie-times.com).
CHAPTER 23 MEASURING THE COST OF LIVING 523
rate was 4 percent, then the amount of goods she can buy has increased by only
6 percent. And if the inflation rate was 15 percent, then the price of goods has
increased proportionately more than the number of dollars in her account. In that
case, Sally’s purchasing power has actually fallen by 5 percent.
The interest rate that the bank pays is called the nominal interest rate, and the
interest rate corrected for inflation is called the real interest rate.We can write the
relationship among the nominal interest rate, the real interest rate, and inflation as
follows:
Real interest rate Nominal interest rate Inflation rate.
The real interest rate is the difference between the nominal interest rate and the
rate of inflation. The nominal interest rate tells you how fast the number of dollars
in your bank account rises over time. The real interest rate tells you how fast the
purchasing power of your bank account rises over time.
Figure 23-3 shows real and nominal interest rates since 1965. The nominal
interest rate is the interest rate on three-month Treasury bills. The real interest rate
is computed by subtracting inflation—the percentage change in the consumer
price index—from this nominal interest rate.
You can see that real and nominal interest rates do not always move together.
For example, in the late 1970s, nominal interest rates were high. But because inflation
was very high, real interest rates were low. Indeed, in some years, real interest
rates were negative, for inflation eroded people’s savings more quickly than nominal
interest payments increased them. By contrast, in the late 1990s, nominal interest
rates were low. But because inflation was also low, real interest rates were
relatively high. In the coming chapters, when we study the causes and effects of
nominal interest rate
the interest rate as usually reported
without a correction for the effects
of inflation
r eal interest rate
the interest rate corrected for the
effects of inflation
1965
Interest Rates
(percent
per year)
15
Real interest rate
10
5
0
5
1970 1975 1980 1985 1990 1995 1998
Nominal interest rate
Figure 23-3
REAL AND NOMINAL
INTEREST RATES. This figure
shows nominal and real interest
rates using annual data since
1965. The nominal interest rate
is the rate on a three-month
Treasury bill. The real interest
rate is the nominal interest rate
minus the inflation rate as
measured by the consumer price
index. Notice that nominal and
real interest rates often do not
move together.
SOURCE: U.S. Department of Labor;
U.S. Department of Treasury.
524 PART EIGHT THE DATA OF MACROECONOMICS
changes in interest rates, it will be important for us to keep in mind the distinction
between real and nominal interest rates.
QUICK QUIZ: Henry Ford paid his workers $5 a day in 1914. If the
consumer price index was 10 in 1914 and 166 in 1999, how much was the Ford
paycheck worth in 1999 dollars?
CONCLUSION
“A nickel ain’t worth a dime anymore,” baseball player Yogi Berra once quipped.
Indeed, throughout recent history, the real values behind the nickel, the dime, and
the dollar have not been stable. Persistent increases in the overall level of prices
have been the norm. Such inflation reduces the purchasing power of each unit of
money over time. When comparing dollar figures from different times, it is important
to keep in mind that a dollar today is not the same as a dollar 20 years ago or,
most likely, 20 years from now.
This chapter has discussed how economists measure the overall level of prices
in the economy and how they use price indexes to correct economic variables for
the effects of inflation. This analysis is only a starting point. We have not yet examined
the causes and effects of inflation or how inflation interacts with other economic
variables. To do that, we need to go beyond issues of measurement. Indeed,
that is our next task. Having explained how economists measure macroeconomic
quantities and prices in the past two chapters, we are now ready to develop the
models that explain long-run and short-run movements in these variables.
Summary
The consumer price index shows the cost of a basket of
goods and services relative to the cost of the same
basket in the base year. The index is used to measure the
overall level of prices in the economy. The percentage
change in the consumer price index measures the
inflation rate.
The consumer price index is an imperfect measure of the
cost of living for three reasons. First, it does not take
into account consumers’ ability to substitute toward
goods that become relatively cheaper over time. Second,
it does not take into account increases in the purchasing
power of the dollar due to the introduction of new
goods. Third, it is distorted by unmeasured changes in
the quality of goods and services. Because of these
measurement problems, the CPI overstates annual
inflation by about 1 percentage point.
Although the GDP deflator also measures the overall
level of prices in the economy, it differs from the
consumer price index because it includes goods and
services produced rather than goods and services
consumed. As a result, imported goods affect the
consumer price index but not the GDP deflator. In
addition, whereas the consumer price index uses a
fixed basket of goods, the GDP deflator automatically
changes the group of goods and services over time as
the composition of GDP changes.
Dollar figures from different points in time do not
represent a valid comparison of purchasing power. To
compare a dollar figure from the past to a dollar figure
today, the older figure should be inflated using a price
index.
CHAPTER 23 MEASURING THE COST OF LIVING 525
Various laws and private contracts use price indexes to
correct for the effects of inflation. The tax laws, however,
are only partially indexed for inflation.
A correction for inflation is especially important when
looking at data on interest rates. The nominal interest
rate is the interest rate usually reported; it is the rate at
which the number of dollars in a savings account
increases over time. By contrast, the real interest rate
takes into account changes in the value of the dollar
over time. The real interest rate equals the nominal
interest rate minus the rate of inflation.
consumer price index (CPI), p. 512
inflation rate, p. 514
producer price index, p. 515
indexation, p. 521
nominal interest rate, p. 523
real interest rate, p. 523
1. Which do you think has a greater effect on the consumer
price index: a 10 percent increase in the price of chicken
or a 10 percent increase in the price of caviar? Why?
2. Describe the three problems that make the consumer
price index an imperfect measure of the cost of living.
3. If the price of a Navy submarine rises, is the consumer
price index or the GDP deflator affected more? Why?
4. Over a long period of time, the price of a candy bar rose
from $0.10 to $0.60. Over the same period, the consumer
price index rose from 150 to 300. Adjusted for overall
inflation, how much did the price of the candy bar
change?
5. Explain the meaning of nominal interest rate and real
interest rate. How are they related?
Key Concepts
Questions for Review
1. Suppose that people consume only three goods, as
shown in this table:
TENNIS TENNIS
BALLS RACQUETS GATORADE
2001 price $2 $40 $1
2001 quantity 100 10 200
2002 price $2 $60 $2
2002 quantity 100 10 200
a. What is the percentage change in the price of each
of the three goods? What is the percentage change
in the overall price level?
b. Do tennis racquets become more or less expensive
relative to Gatorade? Does the well-being of some
people change relative to the well-being of others?
Explain.
2. Suppose that the residents of Vegopia spend all of their
income on cauliflower, broccoli, and carrots. In 2001
they buy 100 heads of cauliflower for $200, 50 bunches
of broccoli for $75, and 500 carrots for $50. In 2002 they
buy 75 heads of cauliflower for $225, 80 bunches of
broccoli for $120, and 500 carrots for $100. If the base
year is 2001, what is the CPI in both years? What is the
inflation rate in 2002?
3. From 1947 to 1997 the consumer price index in the
United States rose 637 percent. Use this fact to adjust
each of the following 1947 prices for the effects of
inflation. Which items cost less in 1997 than in 1947 after
adjusting for inflation? Which items cost more?
ITEM 1947 PRICE 1997 PRICE
University of Iowa tuition $130 $2,470
Gallon of gasoline $0.23 $1.22
Three-minute phone call
from New York to L.A. $2.50 $0.45
One-day hospital stay in
intensive care unit $35 $2,300
McDonald’s hamburger $0.15 $0.59
Problems and Applications
526 PART EIGHT THE DATA OF MACROECONOMICS
4. Beginning in 1994, environmental regulations have
required that gasoline contain a new additive to reduce
air pollution. This requirement raised the cost of
gasoline. The Bureau of Labor Statistics (BLS) decided
that this increase in cost represented an improvement in
quality.
a. Given this decision, did the increased cost of
gasoline raise the CPI?
b. What is the argument in favor of the BLS’s
decision? What is the argument for a different
decision?
5. Which of the problems in the construction of the CPI
might be illustrated by each of the following situations?
Explain.
a. the invention of the Sony Walkman
b. the introduction of air bags in cars
c. increased personal computer purchases in response
to a decline in their price
d. more scoops of raisins in each package of Raisin
Bran
e. greater use of fuel-efficient cars after gasoline prices
increase
6. The New York Times cost $0.15 in 1970 and $0.75 in 1999.
The average wage in manufacturing was $3.35 per hour
in 1970 and $13.84 in 1999.
a. By what percentage did the price of a newspaper
rise?
b. By what percentage did the wage rise?
c. In each year, how many minutes does a worker
have to work to earn enough to buy a newspaper?
d. Did workers’ purchasing power in terms of
newspapers rise or fall?
7. The chapter explains that Social Security benefits are
increased each year in proportion to the increase in the
CPI, even though most economists believe that the CPI
overstates actual inflation.
a. If the elderly consume the same market basket as
other people, does Social Security provide the
elderly with an improvement in their standard of
living each year? Explain.
b. In fact, the elderly consume more health care than
younger people, and health care costs have risen
faster than overall inflation. What would you do to
determine whether the elderly are actually better
off from year to year?
8. How do you think the basket of goods and services you
buy differs from the basket bought by the typical U.S.
household? Do you think you face a higher or lower
inflation rate than is indicated by the CPI? Why?
9. Income tax brackets were not indexed until 1985. When
inflation pushed up people’s nominal incomes during
the 1970s, what do you think happened to real tax
revenue? (Hint: This phenomenon was known as
“bracket creep.”)
10. When deciding how much of their income to save for
retirement, should workers consider the real or the
nominal interest rate that their savings will earn?
Explain.
11. Suppose that a borrower and a lender agree on the
nominal interest rate to be paid on a loan. Then inflation
turns out to be higher than they both expected.
a. Is the real interest rate on this loan higher or lower
than expected?
b. Does the lender gain or lose from this unexpectedly
high inflation? Does the borrower gain or lose?
c. Inflation during the 1970s was much higher than
most people had expected when the decade began.
How did this affect homeowners who obtained
fixed-rate mortgages during the 1960s? How did
it affect the banks who lent the money?
Examine how a
country’s policies
influence its
productivity growth
Consider why
productivity is the
key determinant
of a country’s
standard of living
IN THIS CHAPTER
YOU WILL . . .
See how economic
growth dif fers
around the world
Analyze the factors
that determine
a countr y’s
When you travel around the world, you see tremendous variation in the standard product ivi ty
of living. The average person in a rich country, such as the United States, Japan, or
Germany, has an income more than ten times as high as the average person in a
poor country, such as India, Indonesia, or Nigeria. These large differences in
income are reflected in large differences in the quality of life. Richer countries have
more automobiles, more telephones, more televisions, better nutrition, safer housing,
better health care, and longer life expectancy.
Even within a country, there are large changes in the standard of living over
time. In the United States over the past century, average income as measured by
real GDP per person has grown by about 2 percent per year. Although 2 percent
might seem small, this rate of growth implies that average income doubles every
35 years. Because of this growth, average income today is about eight times as high
as average income a century ago. As a result, the typical American enjoys much
P R O D U C T I O N A N D G R O W T H
529
530 PART NINE THE REAL ECONOMY IN THE LONG RUN
greater economic prosperity than did his or her parents, grandparents, and greatgrandparents.
Growth rates vary substantially from country to country. In some East Asian
countries, such as Singapore, South Korea, and Taiwan, average income has risen
about 7 percent per year in recent decades. At this rate, average income doubles
every ten years. These countries have, in the length of one generation, gone from
being among the poorest in the world to being among the richest. By contrast, in
some African countries, such as Chad, Ethiopia, and Nigeria, average income has
been stagnant for many years.
What explains these diverse experiences? How can the rich countries be sure
to maintain their high standard of living? What policies should the poor countries
pursue to promote more rapid growth in order to join the developed world? These
are among the most important questions in macroeconomics. As economist Robert
Lucas put it, “The consequences for human welfare in questions like these are simply
staggering: Once one starts to think about them, it is hard to think about anything
else.”
In the previous two chapters we discussed how economists measure macroeconomic
quantities and prices. In this chapter we start studying the forces that
determine these variables. As we have seen, an economy’s gross domestic product
(GDP) measures both the total income earned in the economy and the total expenditure
on the economy’s output of goods and services. The level of real GDP is a
good gauge of economic prosperity, and the growth of real GDP is a good gauge of
economic progress. Here we focus on the long-run determinants of the level and
growth of real GDP. Later in this book we study the short-run fluctuations of real
GDP around its long-run trend.
We proceed here in three steps. First, we examine international data on real
GDP per person. These data will give you some sense of how much the level and
growth of living standards vary around the world. Second, we examine the role of
productivity—the amount of goods and services produced for each hour of a worker’s
time. In particular, we see that a nation’s standard of living is determined by
the productivity of its workers, and we consider the factors that determine a
nation’s productivity. Third, we consider the link between productivity and the
economic policies that a nation pursues.
ECONOMIC GROWTH AROUND THE WORLD
As a starting point for our study of long-run growth, let’s look at the experiences
of some of the world’s economies. Table 24-1 shows data on real GDP per person
for 13 countries. For each country, the data cover about a century of history. The
first and second columns of the table present the countries and time periods. (The
time periods differ somewhat from country to country because of differences in
data availability.) The third and fourth columns show estimates of real GDP per
person about a century ago and for a recent year.
The data on real GDP per person show that living standards vary widely from
country to country. Income per person in the United States, for instance, is about 8
times that in China and about 15 times that in India. The poorest countries have
average levels of income that have not been seen in the United States for many
CHAPTER 24 PRODUCTION AND GROWTH 531
decades. The typical citizen of China in 1997 had about as much real income as the
typical American in 1870. The typical person in Pakistan in 1997 had about onehalf
the real income of a typical American a century ago.
The last column of the table shows each country’s growth rate. The growth
rate measures how rapidly real GDP per person grew in the typical year. In the
United States, for example, real GDP per person was $3,188 in 1870 and $28,740 in
1997. The growth rate was 1.75 percent per year. This means that if real GDP per
person, beginning at $3,188, were to increase by 1.75 percent for each of 127 years,
it would end up at $28,740. Of course, real GDP per person did not actually rise
exactly 1.75 percent every year: Some years it rose by more and other years by less.
The growth rate of 1.75 percent per year ignores short-run fluctuations around the
long-run trend and represents an average rate of growth for real GDP per person
over many years.
The countries in Table 24-1 are ordered by their growth rate from the most to
the least rapid. Japan tops the list, with a growth rate of 2.82 percent per year. A
hundred years ago, Japan was not a rich country. Japan’s average income was only
somewhat higher than Mexico’s, and it was well behind Argentina’s. To put the
issue another way, Japan’s income in 1890 was less than India’s income in 1997.
But because of its spectacular growth, Japan is now an economic superpower, with
average income only slightly behind that of the United States. At the bottom of the
list of countries is Bangladesh, which has experienced growth of only 0.78 percent
per year over the past century. As a result, the typical resident of Bangladesh continues
to live in abject poverty.
Because of differences in growth rates, the ranking of countries by income
changes substantially over time. As we have seen, Japan is a country that has risen
Table 24-1
REAL GDP PER PERSON REAL GDP PER PERSON GROWTH RATE
COUNTRY PERIOD AT BEGINNING OF PERIODa AT END OF PERIODa PER YEAR
Japan 1890–1997 $1,196 $23,400 2.82%
Brazil 1900–1997 619 6,240 2.41
Mexico 1900–1997 922 8,120 2.27
Germany 1870–1997 1,738 21,300 1.99
Canada 1870–1997 1,890 21,860 1.95
China 1900–1997 570 3,570 1.91
Argentina 1900–1997 1,824 9,950 1.76
United States 1870–1997 3,188 28,740 1.75
Indonesia 1900–1997 708 3,450 1.65
India 1900–1997 537 1,950 1.34
United Kingdom 1870–1997 3,826 20,520 1.33
Pakistan 1900–1997 587 1,590 1.03
Bangladesh 1900–1997 495 1,050 0.78
aReal GDP is measured in 1997 dollars.
SOURCE: Robert J. Barro and Xavier Sala-i-Martin, Economic Growth (New York: McGraw-Hill, 1995), tables 10.2 and 10.3; World Development Report
1998/99, table 1; and author’s calculations.
THE VARIETY OF GROWTH EXPERIENCES
532 PART NINE THE REAL ECONOMY IN THE LONG RUN
relative to others. One country that has fallen behind is the United Kingdom. In
1870, the United Kingdom was the richest country in the world, with average
income about 20 percent higher than that of the United States and about twice that
of Canada. Today, average income in the United Kingdom is below average
income in its two former colonies.
These data show that the world’s richest countries have no guarantee they will
stay the richest and that the world’s poorest countries are not doomed forever to
remain in poverty. But what explains these changes over time? Why do some
countries zoom ahead while others lag behind? These are precisely the questions
that we take up next.
QUICK QUIZ: What is the approximate growth rate of real GDP per person
in the United States? Name a country that has had faster growth and a country
that has had slower growth.
PRODUCTIVITY: ITS ROLE AND DETERMINANTS
Explaining the large variation in living standards around the world is, in one
sense, very easy. As we will see, the explanation can be summarized in a single
word—productivity. But, in another sense, the international variation is deeply
It may be tempting to dismiss
differences in growth rates as
insignificant. If one country
grows at 1 percent while another
grows at 3 percent, so what?
What difference can 2 percent
make?
The answer is: a big difference.
Even growth rates that
seem small when written in percentage
terms seem large after
they are compounded for many
years. Compounding refers to
the accumulation of a growth
rate over a period of time.
Consider an example. Suppose that two college graduates—
Jerry and Elaine—both take their first jobs at the age
of 22 earning $30,000 a year. Jerry lives in an economy
where all incomes grow at 1 percent per year, while Elaine
lives in one where incomes grow at 3 percent per year.
Straightforward calculations show what happens. Forty
years later, when both are 62 years old, Jerry earns
$45,000 a year, while Elaine earns $98,000. Because of
that difference of 2 percentage points in the growth rate,
Elaine’s salary is more than twice Jerry’s.
An old rule of thumb, called the rule of 70, is helpful in
understanding growth rates and the effects of compounding.
According to the rule of 70, if some variable grows at a rate
of x percent per year, then that variable doubles in approximately
70/x years. In Jerry’s economy, incomes grow at 1
percent per year, so it takes about 70 years for incomes to
double. In Elaine’s economy, incomes grow at 3 percent per
year, so it takes about 70/3, or 23, years for incomes to
double.
The rule of 70 applies not only to a growing economy
but also to a growing savings account. Here is an example:
In 1791, Ben Franklin died and left $5,000 to be invested
for a period of 200 years to benefit medical students and
scientific research. If this money had earned 7 percent per
year (which would, in fact, have been very possible to do),
the investment would have doubled in value every 10 years.
Over 200 years, it would have doubled 20 times. At the end
of 200 years of compounding, the investment would have
been worth 220 $5,000, which is about $5 billion. (In fact,
Franklin’s $5,000 grew to only $2 million over 200 years
because some of the money was spent along the way.)
As these examples show, growth rates compounded
over many years can lead to some spectacular results. That
is probably why Albert Einstein once called compounding
“the greatest mathematical discovery of all time.”
FYI
The Magic of
Compounding
and the
Rule of 70
CHAPTER 24 PRODUCTION AND GROWTH 533
puzzling. To explain why incomes are so much higher in some countries than in
others, we must look at the many factors that determine a nation’s productivity.
WHY PRODUCTIVITY IS SO IMPORTANT
Let’s begin our study of productivity and economic growth by developing a simple
model based loosely on Daniel DeFoe’s famous novel Robinson Crusoe. Robinson
Crusoe, as you may recall, is a sailor stranded on a desert island. Because
Crusoe lives alone, he catches his own fish, grows his own vegetables, and makes
his own clothes. We can think of Crusoe’s activities—his production and consumption
of fish, vegetables, and clothing—as being a simple economy. By examining
Crusoe’s economy, we can learn some lessons that also apply to more
complex and realistic economies.
What determines Crusoe’s standard of living? The answer is obvious. If Crusoe
is good at catching fish, growing vegetables, and making clothes, he lives well.
If he is bad at doing these things, he lives poorly. Because Crusoe gets to consume
only what he produces, his living standard is tied to his productive ability.
The term productivity refers to the quantity of goods and services that a worker
can produce for each hour of work. In the case of Crusoe’s economy, it is easy to
see that productivity is the key determinant of living standards and that growth in
productivity is the key determinant of growth in living standards. The more fish
Crusoe can catch per hour, the more he eats at dinner. If Crusoe finds a better place
to catch fish, his productivity rises. This increase in productivity makes Crusoe
better off: He could eat the extra fish, or he could spend less time fishing and
devote more time to making other goods he enjoys.
The key role of productivity in determining living standards is as true for
nations as it is for stranded sailors. Recall that an economy’s gross domestic product
(GDP) measures two things at once: the total income earned by everyone in the
economy and the total expenditure on the economy’s output of goods and services.
The reason why GDP can measure these two things simultaneously is that,
for the economy as a whole, they must be equal. Put simply, an economy’s income
is the economy’s output.
Like Crusoe, a nation can enjoy a high standard of living only if it can produce
a large quantity of goods and services. Americans live better than Nigerians
because American workers are more productive than Nigerian workers. The
Japanese have enjoyed more rapid growth in living standards than Argentineans
because Japanese workers have experienced more rapidly growing productivity.
Indeed, one of the Ten Principles of Economics in Chapter 1 is that a country’s standard
of living depends on its ability to produce goods and services.
Hence, to understand the large differences in living standards we observe
across countries or over time, we must focus on the production of goods and services.
But seeing the link between living standards and productivity is only the
first step. It leads naturally to the next question: Why are some economies so much
better at producing goods and services than others?
HOW PRODUCTIVITY IS DETERMINED
Although productivity is uniquely important in determining Robinson Crusoe’s
standard of living, many factors determine Crusoe’s productivity. Crusoe will be
productivity
the amount of goods and services
produced from each hour of a
worker’s time
534 PART NINE THE REAL ECONOMY IN THE LONG RUN
better at catching fish, for instance, if he has more fishing poles, if he has been
trained in the best fishing techniques, if his island has a plentiful fish supply, and
if he invents a better fishing lure. Each of these determinants of Crusoe’s productivity—
which we can call physical capital, human capital, natural resources, and
technological knowledge—has a counterpart in more complex and realistic
economies. Let’s consider each of these factors in turn.
Physical Capital Workers are more productive if they have tools with
which to work. The stock of equipment and structures that are used to produce
goods and services is called physical capital, or just capital. For example, when
woodworkers make furniture, they use saws, lathes, and drill presses. More tools
allow work to be done more quickly and more accurately. That is, a worker with
only basic hand tools can make less furniture each week than a worker with
sophisticated and specialized woodworking equipment.
As you may recall from Chapter 2, the inputs used to produce goods and services—
labor, capital, and so on—are called the factors of production. An important
feature of capital is that it is a produced factor of production. That is, capital is an
input into the production process that in the past was an output from the production
process. The woodworker uses a lathe to make the leg of a table. Earlier the
lathe itself was the output of a firm that manufactures lathes. The lathe manufacturer
in turn used other equipment to make its product. Thus, capital is a factor
of production used to produce all kinds of goods and services, including more
capital.
Human Capital A second determinant of productivity is human capital.
Human capital is the economist’s term for the knowledge and skills that workers
acquire through education, training, and experience. Human capital includes the
skills accumulated in early childhood programs, grade school, high school, college,
and on-the-job training for adults in the labor force.
Although education, training, and experience are less tangible than lathes,
bulldozers, and buildings, human capital is like physical capital in many ways.
Like physical capital, human capital raises a nation’s ability to produce goods and
services. Also like physical capital, human capital is a produced factor of production.
Producing human capital requires inputs in the form of teachers, libraries,
and student time. Indeed, students can be viewed as “workers” who have the important
job of producing the human capital that will be used in future production.
Natural Resources A third determinant of productivity is natural
resources. Natural resources are inputs into production that are provided by
nature, such as land, rivers, and mineral deposits. Natural resources take two
forms: renewable and nonrenewable. A forest is an example of a renewable
resource. When one tree is cut down, a seedling can be planted in its place to be
harvested in the future. Oil is an example of a nonrenewable resource. Because oil
is produced by nature over many thousands of years, there is only a limited supply.
Once the supply of oil is depleted, it is impossible to create more.
Differences in natural resources are responsible for some of the differences in
standards of living around the world. The historical success of the United States
was driven in part by the large supply of land well suited for agriculture. Today,
some countries in the Middle East, such as Kuwait and Saudi Arabia, are rich
physical capital
the stock of equipment and
structures that are used to produce
goods and services
human capital
the knowledge and skills that
workers acquire through education,
training, and experience
natural resources
the inputs into the production of
goods and services that are provided
by nature, such as land, rivers, and
mineral deposits
CHAPTER 24 PRODUCTION AND GROWTH 535
simply because they happen to be on top of some of the largest pools of oil in the
world.
Although natural resources can be important, they are not necessary for an
economy to be highly productive in producing goods and services. Japan, for
instance, is one of the richest countries in the world, despite having few natural
resources. International trade makes Japan’s success possible. Japan imports many
of the natural resources it needs, such as oil, and exports its manufactured goods
to economies rich in natural resources.
Technological Knowledge Afourth determinant of productivity is technological
knowledge—the understanding of the best ways to produce goods and
services. A hundred years ago, most Americans worked on farms, because farm
technology required a high input of labor in order to feed the entire population.
Today, thanks to advances in the technology of farming, a small fraction of the
population can produce enough food to feed the entire country. This technological
change made labor available to produce other goods and services.
Technological knowledge takes many forms. Some technology is common
knowledge—after it becomes used by one person, everyone becomes aware of it.
For example, once Henry Ford successfully introduced production in assembly
lines, other carmakers quickly followed suit. Other technology is proprietary—it is
known only by the company that discovers it. Only the Coca-Cola Company, for
instance, knows the secret recipe for making its famous soft drink. Still other technology
is proprietary for a short time. When a pharmaceutical company discovers
a new drug, the patent system gives that company a temporary right to be the
technological knowledge
society’s understanding of the best
ways to produce goods and services
Economists often use a production
function to describe the
relationship between the quantity
of inputs used in production
and the quantity of output from
production. For example, suppose
Y denotes the quantity of
output, L the quantity of labor,
K the quantity of physical capital,
H the quantity of human
capital, and N the quantity of
natural resources. Then we
might write
Y A F (L, K, H, N ),
where F ( ) is a function that shows how the inputs are combined
to produce output. A is a variable that reflects the
available production technology. As technology improves, A
rises, so the economy produces more output from any given
combination of inputs.
Many production functions have a property called constant
returns to scale. If a production function has constant
returns to scale, then a doubling of all the inputs causes the
amount of output to double as well. Mathematically, we
write that a production function has constant returns to
scale if, for any positive number x,
xY A F(xL, xK, xH, xN).
A doubling of all inputs is represented in this equation by
x = 2. The right-hand side shows the inputs doubling, and
the left-hand side shows output doubling.
Production functions with constant returns to scale
have an interesting implication. To see what it is, set x =
1/L. Then the equation above becomes
Y/L A F(1, K/L, H/L, N/L).
Notice that Y/L is output per worker, which is a measure of
productivity. This equation says that productivity depends on
physical capital per worker (K/L), human capital per worker
(H/L), and natural resources per worker (N/L). Productivity
also depends on the state of technology, as reflected by the
variable A. Thus, this equation provides a mathematical
summary of the four determinants of productivity we have
just discussed.
FYI
The Production
Function
536 PART NINE THE REAL ECONOMY IN THE LONG RUN
CASE STUDY ARE NATURAL RESOURCES
A LIMIT TO GROWTH?
The world’s population is far larger today than it was a century ago, and many
people are enjoying a much higher standard of living. A perennial debate concerns
whether this growth in population and living standards can continue in
the future.
Many commentators have argued that natural resources provide a limit to
how much the world’s economies can grow. At first, this argument might seem
hard to ignore. If the world has only a fixed supply of nonrenewable natural
resources, how can population, production, and living standards continue to
grow over time? Eventually, won’t supplies of oil and minerals start to run out?
When these shortages start to occur, won’t they stop economic growth and, perhaps,
even force living standards to fall?
Despite the apparent appeal of such arguments, most economists are less
concerned about such limits to growth than one might guess. They argue that
technological progress often yields ways to avoid these limits. If we compare
the economy today to the economy of the past, we see various ways in which
the use of natural resources has improved. Modern cars have better gas
mileage. New houses have better insulation and require less energy to heat and
cool them. More efficient oil rigs waste less oil in the process of extraction. Recycling
allows some nonrenewable resources to be reused. The development of
alternative fuels, such as ethanol instead of gasoline, allows us to substitute
renewable for nonrenewable resources.
Fifty years ago, some conservationists were concerned about the excessive
use of tin and copper. At the time, these were crucial commodities: Tin was used
to make many food containers, and copper was used to make telephone wire.
Some people advocated mandatory recycling and rationing of tin and copper so
that supplies would be available for future generations. Today, however, plastic
has replaced tin as a material for making many food containers, and phone calls
often travel over fiber-optic cables, which are made from sand. Technological
progress has made once crucial natural resources less necessary.
But are all these efforts enough to permit continued economic growth? One
way to answer this question is to look at the prices of natural resources. In a
market economy, scarcity is reflected in market prices. If the world were running
out of natural resources, then the prices of those resources would be rising
exclusive manufacturer of this particular drug. When the patent expires, however,
other companies are allowed to make the drug. All these forms of technological
knowledge are important for the economy’s production of goods and services.
It is worthwhile to distinguish between technological knowledge and human
capital. Although they are closely related, there is an important difference. Technological
knowledge refers to society’s understanding about how the world
works. Human capital refers to the resources expended transmitting this understanding
to the labor force. To use a relevant metaphor, knowledge is the quality of
society’s textbooks, whereas human capital is the amount of time that the population
has devoted to reading them. Workers’ productivity depends on both the
quality of textbooks they have available and the amount of time they have spent
studying them.
CHAPTER 24 PRODUCTION AND GROWTH 537
over time. But, in fact, the opposite is more nearly true. The prices of most natural
resources (adjusted for overall inflation) are stable or falling. It appears that
our ability to conserve these resources is growing more rapidly than their supplies
are dwindling. Market prices give no reason to believe that natural
resources are a limit to economic growth.
QUICK QUIZ: List and describe four determinants of a country’s
productivity.
ECONOMIC GROWTH AND PUBLIC POLICY
So far, we have determined that a society’s standard of living depends on its ability
to produce goods and services and that its productivity depends on physical
capital, human capital, natural resources, and technological knowledge. Let’s now
turn to the question faced by policymakers around the world: What can government
policy do to raise productivity and living standards?
THE IMPORTANCE OF SAVING AND INVESTMENT
Because capital is a produced factor of production, a society can change the
amount of capital it has. If today the economy produces a large quantity of new
capital goods, then tomorrow it will have a larger stock of capital and be able to
produce more of all types of goods and services. Thus, one way to raise future productivity
is to invest more current resources in the production of capital.
One of the Ten Principles of Economics presented in Chapter 1 is that people face
tradeoffs. This principle is especially important when considering the accumulation
of capital. Because resources are scarce, devoting more resources to producing
capital requires devoting fewer resources to producing goods and services for current
consumption. That is, for society to invest more in capital, it must consume
less and save more of its current income. The growth that arises from capital accumulation
is not a free lunch: It requires that society sacrifice consumption of goods
and services in the present in order to enjoy higher consumption in the future.
TECHNOLOGICAL PROGRESS LEADS TO
NEW PRODUCTS, SUCH AS THIS HYBRID
ELECTRIC/GAS-POWERED CAR, THAT
REDUCE OUR DEPENDENCE ON
NONRENEWABLE RESOURCES.
538 PART NINE THE REAL ECONOMY IN THE LONG RUN
The next chapter examines in more detail how the economy’s financial markets
coordinate saving and investment. It also examines how government policies
influence the amount of saving and investment that takes place. At this point it is
important to note that encouraging saving and investment is one way that a government
can encourage growth and, in the long run, raise the economy’s standard
of living.
To see the importance of investment for economic growth, consider Figure
24-1, which displays data on 15 countries. Panel (a) shows each country’s growth
rate over a 31-year period. The countries are ordered by their growth rates, from
most to least rapid. Panel (b) shows the percentage of GDP that each country
devotes to investment. The correlation between growth and investment, although
not perfect, is strong. Countries that devote a large share of GDP to investment,
such as Singapore and Japan, tend to have high growth rates. Countries that
devote a small share of GDP to investment, such as Rwanda and Bangladesh, tend
to have low growth rates. Studies that examine a more comprehensive list of countries
confirm this strong correlation between investment and growth.
There is, however, a problem in interpreting these data. As the appendix
to Chapter 2 discussed, a correlation between two variables does not establish
which variable is the cause and which is the effect. It is possible that high investment
causes high growth, but it is also possible that high growth causes high
(a) Growth Rate 1960–1991 (b) Investment 1960–1991
South Korea
Singapore
Japan
Israel
Canada
Brazil
West Germany
Mexico
United Kingdom
Nigeria
United States
India
Bangladesh
Chile
Rwanda
South Korea
Singapore
Japan
Israel
Canada
Brazil
West Germany
Mexico
United Kingdom
Nigeria
United States
India
Bangladesh
Chile
Rwanda
Growth Rate (percent) Investment (percent of GDP)
0 1 2 3 4 5 6 7 0 10 20 30 40
Figure 24-1 GROWTH AND INVESTMENT. Panel (a) shows the growth rate of GDP per person for
15 countries over the period from 1960 to 1991. Panel (b) shows the percentage of GDP
that each country devoted to investment over this period. The figure shows that
investment and growth are positively correlated.
CHAPTER 24 PRODUCTION AND GROWTH 539
investment. (Or, perhaps, high growth and high investment are both caused by a
third variable that has been omitted from the analysis.) The data by themselves
cannot tell us the direction of causation. Nonetheless, because capital accumulation
affects productivity so clearly and directly, many economists interpret these
data as showing that high investment leads to more rapid economic growth.
DIMINISHING RETURNS AND THE CATCH-UP EFFECT
Suppose that a government, convinced by the evidence in Figure 24-1, pursues
policies that raise the nation’s saving rate—the percentage of GDP devoted to
saving rather than consumption. What happens? With the nation saving more,
fewer resources are needed to make consumption goods, and more resources are
available to make capital goods. As a result, the capital stock increases, leading to
rising productivity and more rapid growth in GDP. But how long does this higher
rate of growth last? Assuming that the saving rate remains at its new higher level,
does the growth rate of GDP stay high indefinitely or only for a period of time?
The traditional view of the production process is that capital is subject to
diminishing returns: As the stock of capital rises, the extra output produced from
an additional unit of capital falls. In other words, when workers already have a
large quantity of capital to use in producing goods and services, giving them an
additional unit of capital increases their productivity only slightly. Because of
diminishing returns, an increase in the saving rate leads to higher growth only for
a while. As the higher saving rate allows more capital to be accumulated, the benefits
from additional capital become smaller over time, and so growth slows down.
In the long run, the higher saving rate leads to a higher level of productivity and income,
but not to higher growth in these variables. Reaching this long run, however, can take
quite a while. According to studies of international data on economic growth,
increasing the saving rate can lead to substantially higher growth for a period of
several decades.
The diminishing returns to capital has another important implication: Other
things equal, it is easier for a country to grow fast if it starts out relatively poor.
This effect of initial conditions on subsequent growth is sometimes called the
catch-up effect. In poor countries, workers lack even the most rudimentary tools
and, as a result, have low productivity. Small amounts of capital investment would
substantially raise these workers’ productivity. By contrast, workers in rich countries
have large amounts of capital with which to work, and this partly explains
their high productivity. Yet with the amount of capital per worker already so high,
additional capital investment has a relatively small effect on productivity. Studies
of international data on economic growth confirm this catch-up effect: Controlling
for other variables, such as the percentage of GDP devoted to investment, poor
countries do tend to grow faster than rich countries.
This catch-up effect can help explain some of the puzzling results in Figure 24-1.
Over this 31-year period, the United States and South Korea devoted a similar
share of GDP to investment. Yet the United States experienced only mediocre
growth of about 2 percent, while Korea experienced spectacular growth of more
than 6 percent. The explanation is the catch-up effect. In 1960, Korea had GDP per
person less than one-tenth the U.S. level, in part because previous investment had
been so low. With a small initial capital stock, the benefits to capital accumulation
were much greater in Korea, and this gave Korea a higher subsequent growth rate.
diminishing returns
the property whereby the benefit
from an extra unit of an input
declines as the quantity of the
input increases
catch-up ef fect
the property whereby countries
that start off poor tend to grow
more rapidly than countries
that start off rich
540 PART NINE THE REAL ECONOMY IN THE LONG RUN
This catch-up effect shows up in other aspects of life. When a school gives an
end-of-year award to the “Most Improved” student, that student is usually one
who began the year with relatively poor performance. Students who began the
year not studying find improvement easier than students who always worked
hard. Note that it is good to be “Most Improved,” given the starting point, but it is
even better to be “Best Student.” Similarly, economic growth over the last several
decades has been much more rapid in South Korea than in the United States, but
GDP per person is still higher in the United States.
INVESTMENT FROM ABROAD
So far we have discussed how policies aimed at increasing a country’s saving rate
can increase investment and, thereby, long-term economic growth. Yet saving by
domestic residents is not the only way for a country to invest in new capital. The
other way is investment by foreigners.
Investment from abroad takes several forms. Ford Motor Company might
build a car factory in Mexico. A capital investment that is owned and operated by
a foreign entity is called foreign direct investment. Alternatively, an American might
buy stock in a Mexican corporation (that is, buy a share in the ownership of the
corporation); the Mexican corporation can use the proceeds from the stock sale to
build a new factory. An investment that is financed with foreign money but operated
by domestic residents is called foreign portfolio investment. In both cases, Americans
provide the resources necessary to increase the stock of capital in Mexico.
That is, American saving is being used to finance Mexican investment.
When foreigners invest in a country, they do so because they expect to earn a
return on their investment. Ford’s car factory increases the Mexican capital stock
and, therefore, increases Mexican productivity and Mexican GDP. Yet Ford takes
some of this additional income back to the United States in the form of profit. Similarly,
when an American investor buys Mexican stock, the investor has a right to
a portion of the profit that the Mexican corporation earns.
Investment from abroad, therefore, does not have the same effect on all measures
of economic prosperity. Recall that gross domestic product (GDP) is the
income earned within a country by both residents and nonresidents, whereas
gross national product (GNP) is the income earned by residents of a country both
at home and abroad. When Ford opens its car factory in Mexico, some of the
income the factory generates accrues to people who do not live in Mexico. As a
result, foreign investment in Mexico raises the income of Mexicans (measured by
GNP) by less than it raises the production in Mexico (measured by GDP).
Nonetheless, investment from abroad is one way for a country to grow. Even
though some of the benefits from this investment flow back to the foreign owners,
this investment does increase the economy’s stock of capital, leading to higher productivity
and higher wages. Moreover, investment from abroad is one way for
poor countries to learn the state-of-the-art technologies developed and used in
richer countries. For these reasons, many economists who advise governments in
less developed economies advocate policies that encourage investment from
abroad. Often this means removing restrictions that governments have imposed
on foreign ownership of domestic capital.
An organization that tries to encourage the flow of investment to poor countries
is the World Bank. This international organization obtains funds from the
CHAPTER 24 PRODUCTION AND GROWTH 541
world’s advanced countries, such as the United States, and uses these resources to
make loans to less developed countries so that they can invest in roads, sewer systems,
schools, and other types of capital. It also offers the countries advice about
how the funds might best be used. The World Bank, together with its sister organization,
the International Monetary Fund, was set up after World War II. One lesson
from the war was that economic distress often leads to political turmoil,
international tensions, and military conflict. Thus, every country has an interest in
promoting economic prosperity around the world. The World Bank and the International
Monetary Fund are aimed at achieving that common goal.
EDUCATION
Education—investment in human capital—is at least as important as investment
in physical capital for a country’s long-run economic success. In the United States,
each year of schooling raises a person’s wage on average by about 10 percent. In
less developed countries, where human capital is especially scarce, the gap
between the wages of educated and uneducated workers is even larger. Thus, one
way in which government policy can enhance the standard of living is to provide
good schools and to encourage the population to take advantage of them.
Investment in human capital, like investment in physical capital, has an
opportunity cost. When students are in school, they forgo the wages they could
have earned. In less developed countries, children often drop out of school at an
early age, even though the benefit of additional schooling is very high, simply
because their labor is needed to help support the family.
Some economists have argued that human capital is particularly important for
economic growth because human capital conveys positive externalities. An externality
is the effect of one person’s actions on the well-being of a bystander. An educated
person, for instance, might generate new ideas about how best to produce
goods and services. If these ideas enter society’s pool of knowledge, so everyone
can use them, then the ideas are an external benefit of education. In this case, the
return to schooling for society is even greater than the return for the individual.
This argument would justify the large subsidies to human-capital investment that
we observe in the form of public education.
One problem facing some poor countries is the brain drain—the emigration of
many of the most highly educated workers to rich countries, where these workers
can enjoy a higher standard of living. If human capital does have positive externalities,
then this brain drain makes those people left behind poorer than they otherwise
would be. This problem offers policymakers a dilemma. On the one hand,
the United States and other rich countries have the best systems of higher education,
and it would seem natural for poor countries to send their best students
abroad to earn higher degrees. On the other hand, those students who have spent
time abroad may choose not to return home, and this brain drain will reduce the
poor nation’s stock of human capital even further.
PROPERTY RIGHTS AND POLITICAL STABILITY
Another way in which policymakers can foster economic growth is by protecting
property rights and promoting political stability. As we first noted when we
542 PART NINE THE REAL ECONOMY IN THE LONG RUN
discussed economic interdependence in Chapter 3, production in market
economies arises from the interactions of millions of individuals and firms. When
you buy a car, for instance, you are buying the output of a car dealer, a car manufacturer,
a steel company, an iron ore mining company, and so on. This division of
production among many firms allows the economy’s factors of production to be
used as effectively as possible. To achieve this outcome, the economy has to coordinate
transactions among these firms, as well as between firms and consumers.
Market economies achieve this coordination through market prices. That is, market
prices are the instrument with which the invisible hand of the marketplace
brings supply and demand into balance.
An important prerequisite for the price system to work is an economy-wide
respect for property rights. Property rights refer to the ability of people to exercise
authority over the resources they own. Amining company will not make the effort
to mine iron ore if it expects the ore to be stolen. The company mines the ore only
if it is confident that it will benefit from the ore’s subsequent sale. For this reason,
courts serve an important role in a market economy: They enforce property rights.
Through the criminal justice system, the courts discourage direct theft. In addition,
through the civil justice system, the courts ensure that buyers and sellers live up to
their contracts.
Although those of us in developed countries tend to take property rights for
granted, those living in less developed countries understand that lack of property
rights can be a major problem. In many countries, the system of justice does not
work well. Contracts are hard to enforce, and fraud often goes unpunished.
In more extreme cases, the government not only fails to enforce property rights
but actually infringes upon them. To do business in some countries, firms are
expected to bribe powerful government officials. Such corruption impedes the
coordinating power of markets. It also discourages domestic saving and investment
from abroad.
One threat to property rights is political instability. When revolutions and
coups are common, there is doubt about whether property rights will be respected
in the future. If a revolutionary government might confiscate the capital of some
businesses, as was often true after communist revolutions, domestic residents have
less incentive to save, invest, and start new businesses. At the same time, foreigners
have less incentive to invest in the country. Even the threat of revolution can act
to depress a nation’s standard of living.
Thus, economic prosperity depends in part on political prosperity. A country
with an efficient court system, honest government officials, and a stable constitution
will enjoy a higher economic standard of living than a country with a poor
court system, corrupt officials, and frequent revolutions and coups.
FREE TRADE
Some of the world’s poorest countries have tried to achieve more rapid economic
growth by pursuing inward-oriented policies. These policies are aimed at raising productivity
and living standards within the country by avoiding interaction with the
rest of the world. As we discussed in Chapter 9, domestic firms sometimes claim
they need protection from foreign competition in order to compete and grow. This
infant-industry argument, together with a general distrust of foreigners, has at
CHAPTER 24 PRODUCTION AND GROWTH 543
times led policymakers in less developed countries to impose tariffs and other
trade restrictions.
Most economists today believe that poor countries are better off pursuing
outward-oriented policies that integrate these countries into the world economy.
Chapters 3 and 9 showed how international trade can improve the economic wellbeing
of a country’s citizens. Trade is, in some ways, a type of technology. When a
country exports wheat and imports steel, the country benefits in the same way as
if it had invented a technology for turning wheat into steel. A country that eliminates
trade restrictions will, therefore, experience the same kind of economic
growth that would occur after a major technological advance.
The adverse impact of inward orientation becomes clear when one considers
the small size of many less developed economies. The total GDP of Argentina,
for instance, is about that of Philadelphia. Imagine what would happen if the
Philadelphia City Council were to prohibit city residents from trading with people
living outside the city limits. Without being able to take advantage of the gains
from trade, Philadelphia would need to produce all the goods it consumes.
It would also have to produce all its own capital goods, rather than importing
state-of-the-art equipment from other cities. Living standards in Philadelphia
would fall immediately, and the problem would likely only get worse over time.
This is precisely what happened when Argentina pursued inward-oriented policies
throughout much of the twentieth century. By contrast, countries pursuing
outward-oriented policies, such as South Korea, Singapore, and Taiwan, have
enjoyed high rates of economic growth.
The amount that a nation trades with others is determined not only by government
policy but also by geography. Countries with good natural seaports find
trade easier than countries without this resource. It is not a coincidence that many
of the world’s major cities, such as New York, San Francisco, and Hong Kong, are
located next to oceans. Similarly, because landlocked countries find international
trade more difficult, they tend to have lower levels of income than countries with
easy access to the world’s waterways.
THE CONTROL OF POPULATION GROWTH
A country’s productivity and living standard are determined in part by its population
growth. Obviously, population is a key determinant of a country’s labor
force. It is no surprise, therefore, that countries with large populations (such as the
United States and Japan) tend to produce greater GDP than countries with small
populations (such as Luxembourg and the Netherlands). But total GDP is not a
good measure of economic well-being. For policymakers concerned about living
standards, GDP per person is more important, for it tells us the quantity of goods
and services available for the typical individual in the economy.
How does growth in the number of people affect the amount of GDP per person?
Standard theories of economic growth predict that high population growth
reduces GDP per person. The reason is that rapid growth in the number of workers
forces the other factors of production to be spread more thinly. In particular,
when population growth is rapid, equipping each worker with a large quantity of
capital is more difficult. A smaller quantity of capital per worker leads to lower
productivity and lower GDP per worker.
544 PART NINE THE REAL ECONOMY IN THE LONG RUN
This problem is most apparent in the case of human capital. Countries with
high population growth have large numbers of school-age children. This places
a larger burden on the educational system. It is not surprising, therefore, that
educational attainment tends to be low in countries with high population
growth.
The differences in population growth around the world are large. In developed
countries, such as the United States and western Europe, the population has
risen about 1 percent per year in recent decades, and it is expected to rise even
more slowly in the future. By contrast, in many poor African countries, population
growth is about 3 percent per year. At this rate, the population doubles every
23 years.
Reducing the rate of population growth is widely thought to be one way less
developed countries can try to raise their standards of living. In some countries,
this goal is accomplished directly with laws regulating the number of children
families may have. China, for instance, allows only one child per family; couples
who violate this rule are subject to substantial fines. In countries with greater
You may have heard economics
called “the dismal science.”
The field was pinned with this
label many years ago because
of a theory proposed
by Thomas Robert Malthus
(1766–1834), an English minister
and early economic
thinker. In a famous book
called An Essay on the Principle
of Population as It Affects
the Future Improvement of
Society, Malthus offered what
may be history’s most chilling forecast. Malthus argued that
an ever increasing population would continually strain society’s
ability to provide for itself. As a result, mankind was
doomed to forever live in poverty.
Malthus’s logic was very simple. He began by noting
that “food is necessary to the existence of man” and that
“the passion between the sexes is necessary and will
remain nearly in its present state.” He concluded that “the
power of population is infinitely greater than the power in the
earth to produce subsistence for man.” According to
Malthus, the only check on population growth was “misery
and vice.” Attempts by charities or governments to alleviate
poverty were counterproductive, he argued, because they
merely allowed the poor to have more children, placing even
greater strains on society’s productive capabilities.
Fortunately, Malthus’s dire forecast was far off the
mark. Although the world population has increased about
sixfold over the past two centuries, living standards around
the world are on average much
higher. As a result of economic
growth, chronic hunger and malnutrition
are less common now than
they were in Malthus’s day.
Famines occur from time to time,
but they are more often the result
of an unequal income distribution
or political instability than an inadequate
production of food.
Where did Malthus go wrong?
He failed to appreciate that growth
in mankind’s ingenuity would
exceed growth in population. New
ideas about how to produce and even the kinds of goods to
produce have led to greater prosperity than Malthus—or
anyone else of his era—ever imagined. Pesticides, fertilizers,
mechanized farm equipment, and new crop varieties
have allowed each farmer to feed ever greater numbers of
people. The wealth-enhancing effects of technological
progress have exceeded whatever wealth-diminishing
effects might be attributed to population growth.
Indeed, some economists now go so far as to suggest
that population growth may even have helped mankind
achieve higher standards of living. If there are more people,
then there are more scientists, inventors, and engineers to
contribute to technological progress, which benefits everyone.
Perhaps world population growth, rather than being a
source of economic deprivation as Malthus predicted, has
actually been an engine of technological progress and economic
prosperity.
THOMAS MALTHUS
FYI
Thomas
Malthus on
Population
Growth
CHAPTER 24 PRODUCTION AND GROWTH 545
CASE STUDY THE PRODUCTIVITY SLOWDOWN
From 1959 to 1973, productivity, as measured by output per hour worked in
U.S. businesses, grew at a rate of 3.2 percent per year. From 1973 to 1998, productivity
grew by only 1.3 percent per year. Not surprisingly, this slowdown in
productivity growth has been reflected in reduced growth in real wages and
family incomes. It is also reflected in a general sense of economic anxiety.
freedom, the goal of reduced population growth is accomplished less directly by
increasing awareness of birth control techniques.
The final way in which a country can influence population growth is to apply
one of the Ten Principles of Economics: People respond to incentives. Bearing a child,
like any decision, has an opportunity cost. When the opportunity cost rises, people
will choose to have smaller families. In particular, women with the opportunity to
receive good education and desirable employment tend to want fewer children
than those with fewer opportunities outside the home. Hence, policies that foster
equal treatment of women are one way for less developed economies to reduce the
rate of population growth.
RESEARCH AND DEVELOPMENT
The primary reason that living standards are higher today than they were a century
ago is that technological knowledge has advanced. The telephone, the transistor,
the computer, and the internal combustion engine are among the thousands
of innovations that have improved the ability to produce goods and services.
Although most technological advance comes from private research by firms
and individual inventors, there is also a public interest in promoting these efforts.
To a large extent, knowledge is a public good: Once one person discovers an idea,
the idea enters society’s pool of knowledge, and other people can freely use it. Just
as government has a role in providing a public good such as national defense, it
also has a role in encouraging the research and development of new technologies.
The U.S. government has long played a role in the creation and dissemination
of technological knowledge. A century ago, the government sponsored research
about farming methods and advised farmers how best to use their land. More
recently, the U.S. government has, through the Air Force and NASA, supported
aerospace research; as a result, the United States is a leading maker of rockets and
planes. The government continues to encourage advances in knowledge with
research grants from the National Science Foundation and the National Institutes
of Health and with tax breaks for firms engaging in research and development.
Yet another way in which government policy encourages research is through
the patent system. When a person or firm invents a new product, such as a new
drug, the inventor can apply for a patent. If the product is deemed truly original,
the government awards the patent, which gives the inventor the exclusive right to
make the product for a specified number of years. In essence, the patent gives the
inventor a property right over his invention, turning his new idea from a public
good into a private good. By allowing inventors to profit from their inventions—
even if only temporarily—the patent system enhances the incentive for individuals
and firms to engage in research.
546 PART NINE THE REAL ECONOMY IN THE LONG RUN
Because it has accumulated over so many years, this fall in productivity growth
of 1.9 percentage points has had a large effect on incomes. If this slowdown had
not occurred, the income of the average American would today be about 60 percent
higher.
The slowdown in economic growth has been one of the most important
problems facing economic policymakers. Economists are often asked what
caused the slowdown and what can be done to reverse it. Unfortunately, despite
much research on these questions, the answers remain elusive.
Two facts are well established. First, the slowdown in productivity growth
is a worldwide phenomenon. Sometime in the mid-1970s, economic growth
slowed not only in the United States but also in other industrial countries,
including Canada, France, Germany, Italy, Japan, and the United Kingdom.
Although some of these countries have had more rapid growth than the United
States, all of them have had slow growth compared to their own past experience.
To explain the slowdown in U.S. growth, therefore, it seems necessary to
look beyond our borders.
Second, the slowdown cannot be traced to those factors of production that
are most easily measured. Economists can measure directly the quantity of
physical capital that workers have available. They can also measure human capital
in the form of years of schooling. It appears that the slowdown in productivity
is not primarily attributable to reduced growth in these inputs.
Technology appears to be one of the few remaining culprits. That is, having
ruled out most other explanations, many economists attribute the slowdown in
economic growth to a slowdown in the creation of new ideas about how to produce
goods and services. Because the quantity of “ideas” is hard to measure,
this explanation is difficult to confirm or refute.
In some ways, it is odd to say that the last 25 years have been a period of
slow technological progress. This period has witnessed the spread of computers
across the economy—an historic technological revolution that has affected
almost every industry and almost every firm. Yet, for some reason, this change
has not yet been reflected in more rapid economic growth. As economist Robert
Solow put it, “You can see the computer age everywhere but in the productivity
statistics.”
What does the future of economic growth hold? An optimistic scenario is
that the computer revolution will rejuvenate economic growth once these new
machines are integrated into the economy and their potential is fully understood.
Economic historians note that the discovery of electricity took many
decades to have a large impact on productivity and living standards because
people had to figure out the best ways to use the new resource. Perhaps the
computer revolution will have a similar delayed effect. Some observers believe
this may be starting to happen already, for productivity growth did pick up a bit
in the late 1990s. It is still too early to say, however, whether this change will
persist.
A more pessimistic scenario is that, after a period of rapid scientific and
technological advance, we have entered a new phase of slower growth in
knowledge, productivity, and incomes. Data from a longer span of history seem
to support this conclusion. Figure 24-2 shows the average growth of real GDP
per person in the developed world going back to 1870. The productivity slowdown
is apparent in the last two entries: Around 1970, the growth rate slowed
from 3.7 to 2.2 percent. But compared to earlier periods of history, the anomaly
CHAPTER 24 PRODUCTION AND GROWTH 547
is not the slow growth of recent years but rather the rapid growth during the
1950s and 1960s. Perhaps the decades after World War II were a period of
unusually rapid technological advance, and growth has slowed down simply
because technological progress has returned to a more normal rate.
Growth Rate
(percent
per year)
1.0
1.5
2.0
2.5
3.0
3.5
4.0
1870–
1890
1890–
1910
1910–
1930
1930–
1950
1950–
1970
1970–
1990
0
Figure 24-2
THE GROWTH IN REAL GDP
PER PERSON. This figure shows
the average growth rate of real
GDP per person for 16 advanced
economies, including the major
countries of Europe, Canada,
the United States, Japan, and
Australia. Notice that the growth
rate rose substantially after 1950
and then fell after 1970.
SOURCE: Robert J. Barro and Xavier Sala-i-
Martin, Economic Growth (New York:
McGraw-Hill, 1995), p. 6.
QUICK QUIZ: Describe three ways in which a government policymaker
can try to raise the growth in living standards in a society. Are there any
drawbacks to these policies?
CONCLUSION:
THE IMPORTANCE OF LONG-RUN GROWTH
In this chapter we have discussed what determines the standard of living in a
nation and how policymakers can endeavor to raise the standard of living through
policies that promote economic growth. Most of this chapter is summarized in one
of the Ten Principles of Economics: A country’s standard of living depends on its
ability to produce goods and services. Policymakers who want to encourage
growth in standards of living must aim to increase their nation’s productive ability
by encouraging rapid accumulation of the factors of production and ensuring that
these factors are employed as effectively as possible.
548 PART NINE THE REAL ECONOMY IN THE LONG RUN
Economists differ in their views of the role of government in promoting economic
growth. At the very least, government can lend support to the invisible
hand by maintaining property rights and political stability. More controversial is
whether government should target and subsidize specific industries that might be
ECONOMIST JEFFREY SACHS HAS BEEN A
prominent adviser to governments
seeking to reform their economies and
raise economic growth. He has also
been a critic of the World Bank and the
International Monetary Fund (IMF), the
international policy organizations that
dispense advice and money to struggling
countries. Here Sachs discusses
how the countries of Africa can escape
their continuing poverty.
G r o w t h i n A f r i c a : I t C a n B e D o n e
BY JEFFREY SACHS
In the old story, the peasant goes to
the priest for advice on saving his dying
chickens. The priest recommends
prayer, but the chickens continue to
die. The priest then recommends music
for the chicken coop, but the deaths
continue unabated. Pondering again,
the priest recommends repainting the
chicken coop in bright colors. Finally, all
the chickens die. “What a shame,” the
priest tells the peasant. “I had so many
more good ideas.”
Since independence, African countries
have looked to donor nations—
often their former colonial rulers—and to
the international finance institutions for
guidance on growth. Indeed, since the
onset of the African debt crises of the
1980s, the guidance has become a kind
of economic receivership, with the policies
of many African nations decided in a
seemingly endless cycle of meetings
with the IMF, the World Bank, donors,
and creditors.
What a shame. So many good
ideas, so few results. Output per head
fell 0.7 percent between 1978 and 1987,
and 0.6 percent during 1987–1994.
Some growth is estimated for 1995 but
only at 0.6 percent—far below the fastergrowing
developing countries. . . .
The IMF and World Bank would be
absolved of shared responsibility for
slow growth if Africa were structurally
incapable of growth rates seen in other
parts of the world or if the continent’s
low growth were an impenetrable mystery.
But Africa’s growth rates are
not huge mysteries. The evidence on
cross-country growth suggests that
Africa’s chronically low growth can be
explained by standard economic variables
linked to identifiable (and remediable)
policies. . . .
Studies of cross-country growth
show that per capita growth is related to:
• the initial income level of the country,
with poorer countries tending to
grow faster than richer countries;
• the extent of overall market orientation,
including openness to trade,
domestic market liberalization,
private rather than state ownership,
protection of private property
rights, and low marginal tax rates;
• the national saving rate, which in
turn is strongly affected by the government’s
own saving rate; and
• the geographic and resource structure
of the economy. . . .
These four factors can account
broadly for Africa’s long-term growth
predicament. While it should have grown
faster than other developing areas
because of relatively low income per
head (and hence larger opportunity for
“catch-up” growth), Africa grew more
slowly. This was mainly because of much
IN THE NEWS
A Solution to
Africa’s Problems
CHAPTER 24 PRODUCTION AND GROWTH 549
especially important for technological progress. There is no doubt that these issues
are among the most important in economics. The success of one generation’s policymakers
in learning and heeding the fundamental lessons about economic
growth determines what kind of world the next generation will inherit.
higher trade barriers; excessive tax
rates; lower saving rates; and adverse
structural conditions, including an unusually
high incidence of inaccessibility to
the sea (15 of 53 countries are landlocked).
. . .
If the policies are largely to blame,
why, then, were they adopted? The historical
origins of Africa’s antimarket orientation
are not hard to discern. After
almost a century of colonial depredations,
African nations understandably if
erroneously viewed open trade and foreign
capital as a threat to national sovereignty.
As in Sukarno’s Indonesia,
Nehru’s India, and Peron’s Argentina,
“self sufficiency” and “state leadership,”
including state ownership of much
of industry, became the guideposts of
the economy. As a result, most of Africa
went into a largely self-imposed economic
exile. . . .
Adam Smith in 1755 famously
remarked that “little else is requisite to
carry a state to the highest degrees of
opulence from the lowest barbarism, but
peace, easy taxes, and tolerable administration
of justice.” A growth agenda
need not be long and complex. Take his
points in turn.
Peace, of course, is not so easily
guaranteed, but the conditions for peace
on the continent are better than today’s
ghastly headlines would suggest. Several
of the large-scale conflicts that have
ravaged the continent are over or nearly
so. . . . The ongoing disasters, such as in
Liberia, Rwanda and Somalia, would be
better contained if the West were willing
to provide modest support to Africanbased
peacekeeping efforts.
“Easy taxes” are well within the
ambit of the IMF and World Bank. But
here, the IMF stands guilty of neglect, if
not malfeasance. African nations need
simple, low taxes, with modest revenue
targets as a share of GDP. Easy taxes
are most essential in international trade,
since successful growth will depend,
more than anything else, on economic
integration with the rest of the world.
Africa’s largely self-imposed exile from
world markets can end quickly by cutting
import tariffs and ending export taxes on
agricultural exports. Corporate tax rates
should be cut from rates of 40 percent
and higher now prevalent in Africa, to
rates between 20 percent and 30 percent,
as in the outward-oriented East
Asian economies. . . .
Adam Smith spoke of a “tolerable”
administration of justice, not perfect justice.
Market liberalization is the primary
key to strengthening the rule of law. Free
trade, currency convertibility and automatic
incorporation of business vastly
reduce the scope for official corruption
and allow the government to focus on
the real public goods—internal public
order, the judicial system, basic public
health and education, and monetary
stability. . . .
All of this is possible only if the government
itself has held its own spending
to the necessary minimum. The Asian
economies show how to function with
government spending of 20 percent of
GDP or less (China gets by with just 13
percent). Education can usefully absorb
around 5 percent of GDP; health, another
3 percent; public administration,
2 percent; the army and police, 3 percent.
Government investment spending
can be held to 5 percent of GDP but only
if the private sector is invited to provide
infrastructure in telecommunications,
port facilities, and power. . . .
This fiscal agenda excludes many
popular areas for government spending.
There is little room for transfers or social
spending beyond education and health
(though on my proposals, these would
get a hefty 8 percent of GDP). Subsidies
to publicly owned companies or marketing
boards should be scrapped. Food
and housing subsidies for urban workers
cannot be financed. And, notably, interest
payments on foreign debt are not
budgeted for. This is because most
bankrupt African states need a fresh
start based on deep debt-reduction,
which should be implemented in conjunction
with far-reaching domestic
reforms.
Source: Economist, June 29, 1996, pp. 19–21.
550 PART NINE THE REAL ECONOMY IN THE LONG RUN
Economic prosperity, as measured by GDP per person,
varies substantially around the world. The average
income in the world’s richest countries is more than ten
times that in the world’s poorest countries. Because
growth rates of real GDP also vary substantially, the
relative positions of countries can change dramatically
over time.
The standard of living in an economy depends on the
economy’s ability to produce goods and services.
Productivity, in turn, depends on the amounts of
physical capital, human capital, natural resources, and
technological knowledge available to workers.
Government policies can influence the economy’s
growth rate in many ways: encouraging saving and
investment, encouraging investment from abroad,
fostering education, maintaining property rights and
political stability, allowing free trade, controlling
population growth, and promoting the research and
development of new technologies.
The accumulation of capital is subject to diminishing
returns: The more capital an economy has, the less
additional output the economy gets from an extra unit
of capital. Because of diminishing returns, higher saving
leads to higher growth for a period of time, but growth
eventually slows down as the economy approaches a
higher level of capital, productivity, and income. Also
because of diminishing returns, the return to capital is
especially high in poor countries. Other things equal,
these countries can grow faster because of the catch-up
effect.
Summary
productivity, p. 533
physical capital, p. 534
human capital, p. 534
natural resources, p. 534
technological knowledge, p. 535
diminishing returns, p. 539
catch-up effect, p. 539
Key Concepts
1. What does the level of a nation’s GDP measure? What
does the growth rate of GDP measure? Would you
rather live in a nation with a high level of GDP and a
low growth rate, or in a nation with a low level and a
high growth rate?
2. List and describe four determinants of productivity.
3. In what way is a college degree a form of capital?
4. Explain how higher saving leads to a higher standard of
living. What might deter a policymaker from trying to
raise the rate of saving?
5. Does a higher rate of saving lead to higher growth
temporarily or indefinitely?
6. Why would removing a trade restriction, such as a tariff,
lead to more rapid economic growth?
7. How does the rate of population growth influence the
level of GDP per person?
8. Describe two ways in which the U.S. government tries
to encourage advances in technological knowledge.
Questions for Review
1. Most countries, including the United States, import
substantial amounts of goods and services from other
countries. Yet the chapter says that a nation can enjoy a
high standard of living only if it can produce a large
quantity of goods and services itself. Can you reconcile
these two facts?
2. List the capital inputs necessary to produce each of the
following:
a. cars
b. high school educations
c. plane travel
d. fruits and vegetables
Problems and Applications
CHAPTER 24 PRODUCTION AND GROWTH 551
3. U.S. income per person today is roughly eight times
what it was a century ago. Many other countries have
also experienced significant growth over that period.
What are some specific ways in which your standard of
living differs from that of your great-grandparents?
4. The chapter discusses how employment has declined
relative to output in the farm sector. Can you think of
another sector of the economy where the same
phenomenon has occurred more recently? Would you
consider the change in employment in this sector to
represent a success or a failure from the standpoint of
society as a whole?
5. Suppose that society decided to reduce consumption
and increase investment.
a. How would this change affect economic growth?
b. What groups in society would benefit from this
change? What groups might be hurt?
6. Societies choose what share of their resources to devote
to consumption and what share to devote to investment.
Some of these decisions involve private spending;
others involve government spending.
a. Describe some forms of private spending that
represent consumption, and some forms that
represent investment.
b. Describe some forms of government spending that
represent consumption, and some forms that
represent investment.
7. What is the opportunity cost of investing in capital? Do
you think a country can “over-invest” in capital? What
is the opportunity cost of investing in human capital?
Do you think a country can “over-invest” in human
capital? Explain.
8. Suppose that an auto company owned entirely by
German citizens opens a new factory in South Carolina.
a. What sort of foreign investment would this
represent?
b. What would be the effect of this investment on U.S.
GDP? Would the effect on U.S. GNP be larger or
smaller?
9. In the 1980s Japanese investors made significant direct
and portfolio investments in the United States. At the
time, many Americans were unhappy that this
investment was occurring.
a. In what way was it better for the United States to
receive this Japanese investment than not to receive
it?
b. In what way would it have been better still for
Americans to have done this investment?
10. In the countries of South Asia in 1992, only 56 young
women were enrolled in secondary school for every 100
young men. Describe several ways in which greater
educational opportunities for young women could lead
to faster economic growth in these countries.
11. International data show a positive correlation between
political stability and economic growth.
a. Through what mechanism could political stability
lead to strong economic growth?
b. Through what mechanism could strong economic
growth lead to political stability?

IN THIS CHAPTER
YOU WILL . . .
Consider how
government budget
deficits af fect the
U.S. economy
Develop a model of
the supply and
demand for loanable
funds in financial
markets
Learn about some of
the impor tant
financial
institutions in the
U.S. economy
Consider how the
financial system is
related to key
macroeconomic
variables
Use the loanablefunds
model to
analyze various
government policies
Imagine that you have just graduated from college (with a degree in economics, of
course) and you decide to start your own business—an economic forecasting firm.
Before you make any money selling your forecasts, you have to incur substantial
costs to set up your business. You have to buy computers with which to make your
forecasts, as well as desks, chairs, and filing cabinets to furnish your new office.
Each of these items is a type of capital that your firm will use to produce and sell
its services.
How do you obtain the funds to invest in these capital goods? Perhaps you are
able to pay for them out of your past savings. More likely, however, like most entrepreneurs,
you do not have enough money of your own to finance the start of
your business. As a result, you have to get the money you need from other sources.
S A V I N G , I N V E S T M E N T , A N D
T H E F I N A N C I A L S Y S T E M
553
554 PART NINE THE REAL ECONOMY IN THE LONG RUN
There are various ways for you to finance these capital investments. You could
borrow the money, perhaps from a bank or from a friend or relative. In this case,
you would promise not only to return the money at a later date but also to pay interest
for the use of the money. Alternatively, you could convince someone to provide
the money you need for your business in exchange for a share of your future
profits, whatever they might happen to be. In either case, your investment
in computers and office equipment is being financed by someone else’s
saving.
The financial system consists of those institutions in the economy that help to
match one person’s saving with another person’s investment. As we discussed in
the previous chapter, saving and investment are key ingredients to long-run
economic growth: When a country saves a large portion of its GDP, more resources
are available for investment in capital, and higher capital raises a country’s
productivity and living standard. The previous chapter, however, did not explain
how the economy coordinates saving and investment. At any time, some people
want to save some of their income for the future, and others want to borrow in order
to finance investments in new and growing businesses. What brings these
two groups of people together? What ensures that the supply of funds from
those who want to save balances the demand for funds from those who want to
invest?
This chapter examines how the financial system works. First, we discuss the
large variety of institutions that make up the financial system in our economy. Second,
we discuss the relationship between the financial system and some key
macroeconomic variables—notably saving and investment. Third, we develop a
model of the supply and demand for funds in financial markets. In the model, the
interest rate is the price that adjusts to balance supply and demand. The model
shows how various government policies affect the interest rate and, thereby, society’s
allocation of scarce resources.
FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY
At the broadest level, the financial system moves the economy’s scarce resources
from savers (people who spend less than they earn) to borrowers (people who
spend more than they earn). Savers save for various reasons—to put a child
through college in several years or to retire comfortably in several decades. Similarly,
borrowers borrow for various reasons—to buy a house in which to live or to
start a business with which to make a living. Savers supply their money to the financial
system with the expectation that they will get it back with interest at a later
date. Borrowers demand money from the financial system with the knowledge
that they will be required to pay it back with interest at a later date.
The financial system is made up of various financial institutions that help coordinate
savers and borrowers. As a prelude to analyzing the economic forces that
drive the financial system, let’s discuss the most important of these institutions. Financial
institutions can be grouped into two categories—financial markets and financial
intermediaries. We consider each category in turn.
financial system
the group of institutions in the
economy that help to match one
person’s saving with another
person’s investment
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 555
FINANCIAL MARKETS
Financial markets are the institutions through which a person who wants to save
can directly supply funds to a person who wants to borrow. The two most important
financial markets in our economy are the bond market and the stock market.
The Bond Market When Intel, the giant maker of computer chips, wants to
borrow to finance construction of a new factory, it can borrow directly from the
public. It does this by selling bonds. A bond is a certificate of indebtedness that
specifies the obligations of the borrower to the holder of the bond. Put simply, a
bond is an IOU. It identifies the time at which the loan will be repaid, called the
date of maturity, and the rate of interest that will be paid periodically until the loan
matures. The buyer of a bond gives his or her money to Intel in exchange for this
promise of interest and eventual repayment of the amount borrowed (called the
principal ). The buyer can hold the bond until maturity or can sell the bond at an
earlier date to someone else.
There are literally millions of different bonds in the U.S. economy. When large
corporations, the federal government, or state and local governments need to borrow
to finance the purchase of a new factory, a new jet fighter, or a new school,
they usually do so by issuing bonds. If you look at The Wall Street Journal or the
business section of your local newspaper, you will find a listing of the prices and
interest rates on some of the most important bond issues. Although these bonds
differ in many ways, three characteristics of bonds are most important.
The first characteristic is a bond’s term—the length of time until the bond matures.
Some bonds have short terms, such as a few months, while others have
terms as long as 30 years. (The British government has even issued a bond that
never matures, called a perpetuity. This bond pays interest forever, but the principal
is never repaid.) The interest rate on a bond depends, in part, on its term. Longterm
bonds are riskier than short-term bonds because holders of long-term bonds
have to wait longer for repayment of principal. If a holder of a long-term bond
needs his money earlier than the distant date of maturity, he has no choice but to
sell the bond to someone else, perhaps at a reduced price. To compensate for this
risk, long-term bonds usually pay higher interest rates than short-term bonds.
The second important characteristic of a bond is its credit risk—the probability
that the borrower will fail to pay some of the interest or principal. Such a failure to
pay is called a default. Borrowers can (and sometimes do) default on their loans by
declaring bankruptcy. When bond buyers perceive that the probability of default
is high, they demand a higher interest rate to compensate them for this risk. Because
the U.S. government is considered a safe credit risk, government bonds tend
to pay low interest rates. By contrast, financially shaky corporations raise money
by issuing junk bonds, which pay very high interest rates. Buyers of bonds can
judge credit risk by checking with various private agencies, such as Standard &
Poor’s, which rate the credit risk of different bonds.
The third important characteristic of a bond is its tax treatment—the way in
which the tax laws treat the interest earned on the bond. The interest on most
bonds is taxable income, so that the bond owner has to pay a portion of the interest
in income taxes. By contrast, when state and local governments issue bonds,
called municipal bonds, the bond owners are not required to pay federal income tax
on the interest income. Because of this tax advantage, bonds issued by state and
financial markets
financial institutions through
which savers can directly
provide funds to borrowers
bond
a certificate of indebtedness
556 PART NINE THE REAL ECONOMY IN THE LONG RUN
local governments pay a lower interest rate than bonds issued by corporations or
the federal government.
The Stock Market Another way for Intel to raise funds to build a new
semiconductor factory is to sell stock in the company. Stock represents ownership
in a firm and is, therefore, a claim to the profits that the firm makes. For example,
if Intel sells a total of 1,000,000 shares of stock, then each share represents ownership
of 1/1,000,000 of the business.
The sale of stock to raise money is called equity finance, whereas the sale of
bonds is called debt finance. Although corporations use both equity and debt finance
to raise money for new investments, stocks and bonds are very different.
The owner of shares of Intel stock is a part owner of Intel; the owner of an Intel
bond is a creditor of the corporation. If Intel is very profitable, the stockholders enjoy
the benefits of these profits, whereas the bondholders get only the interest on
their bonds. And if Intel runs into financial difficulty, the bondholders are paid
what they are due before stockholders receive anything at all. Compared to bonds,
stocks offer the holder both higher risk and potentially higher return.
After a corporation issues stock by selling shares to the public, these shares
trade among stockholders on organized stock exchanges. In these transactions, the
corporation itself receives no money when its stock changes hands. The most important
stock exchanges in the U.S. economy are the New York Stock Exchange,
the American Stock Exchange, and NASDAQ (National Association of Securities
Dealers Automated Quotation system). Most of the world’s countries have their
own stock exchanges on which the shares of local companies trade.
The prices at which shares trade on stock exchanges are determined by the
supply and demand for the stock in these companies. Because stock represents
ownership in a corporation, the demand for a stock (and thus its price) reflects
people’s perception of the corporation’s future profitability. When people become
optimistic about a company’s future, they raise their demand for its stock and
thereby bid up the price of a share of stock. Conversely, when people come to expect
a company to have little profit or even losses, the price of a share falls.
Various stock indexes are available to monitor the overall level of stock prices.
A stock index is computed as an average of a group of stock prices. The most famous
stock index is the Dow Jones Industrial Average, which has been computed
regularly since 1896. It is now based on the prices of the stocks of 30 major U.S.
companies, such as General Motors, General Electric, Microsoft, Coca-Cola, AT&T,
and IBM. Another well-known stock index is the Standard & Poor’s 500 Index,
which is based on the prices of 500 major companies. Because stock prices reflect
expected profitability, these stock indexes are watched closely as possible indicators
of future economic conditions.
FINANCIAL INTERMEDIARIES
Financial intermediaries are financial institutions through which savers can indirectly
provide funds to borrowers. The term intermediary reflects the role of these
institutions in standing between savers and borrowers. Here we consider two of
the most important financial intermediaries—banks and mutual funds.
stock
a claim to partial ownership in a firm
THE NEW YORK STOCK EXCHANGE
financial intermediaries
financial institutions through which
savers can indirectly provide funds
to borrowers
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 557
Banks
If the owner of a small grocery store wants to finance an expansion of his business,
he probably takes a strategy quite different from Intel. Unlike Intel, a small grocer
Most daily newspapers include
stock tables, which contain information
about recent trading
in the stocks of several thousand
companies. Here is the
kind of information these tables
usually provide:
Price. The single most important
piece of information
about a stock is the
price of a share. The
newspaper usually presents
several prices. The
“last” or “closing” price is the price of the last transaction
that occurred before the stock exchange closed
the previous day. Many newspapers also give the “high”
and “low” prices over the past day of trading and,
sometimes, over the past year as well.
Volume. Most newspapers present the number of
shares sold during the past day of trading. This figure is
called the daily volume.
Dividend. Corporations pay out some of their profits to
their stockholders; this amount is called the dividend.
(Profits not paid out are called retained earnings and
are used by the corporation for additional investment.)
Newspapers often report the dividend paid over the previous
year for each share of stock. They sometimes
report the dividend yield, which is the dividend expressed
as a percentage of the stock’s price.
Price-earnings ratio. A corporation’s earnings, or profit,
is the amount of revenue it receives for the sale of its
products minus its costs of production as measured by
its accountants. Earnings per share is the company’s
total earnings divided by the number of shares of stock
outstanding. Companies use some of their earnings to
pay dividends to stockholders; the rest is kept in the
firm to make new investments. The price–earnings
ratio, often called the P/E, is the price of a corporation’s
stock divided by the amount the corporation
earned per share over the past year. Historically, the
typical price–earnings ratio is about 15. A higher P/E indicates
that a corporation’s stock is expensive relative
to its recent earnings; this might indicate either that
people expect earnings to rise in the future or that the
stock is overvalued. Conversely, a lower P/E indicates
that a corporation’s stock is cheap relative to its recent
earnings; this might indicate either that people expect
earnings to fall or that the stock is undervalued.
Why does the newspaper report all these data every day?
Many people who invest their savings in stock follow these
numbers closely when deciding which stocks to buy and sell.
By contrast, other stockholders follow a buy-and-hold strategy:
They buy the stock of well-run companies, hold it for
long periods of time, and do not respond to the daily fluctuations
reported in the paper.
Name of
company
Symbol for
company’s stock
52 Weeks
Hi Lo Stock Sym Div
Yld
% PE
Vol
100s Hi Lo Close
Net
Chg
263/16
127/8
757/16
221/2
237/16
67/8
475/16
93/4
CslFnl
Coastcast
CocaCola
CCFemsa ADR
TOPrS
PAR
KO
KOF
2.09
.64
.12e
8.6
...
1.3
.9
...
17
40
...
59
171
39384
2121
241/4
113/8
51
1313/16
2313/16
107/8
493/4
127/8
241/4
113/8
51
133/4
+ 1/16
+ 3/8
+ 11/16
+ 1/16
Dividend
amount
Dividend
yield
Price–
earnings
ratio
Trading volume over
the previous day
Highest and
lowest price over
the previous day
Last price at which
the stock traded
Change in
closing price
from the
day before
Highest and lowest
price of the stock
over the past year
FYI
How to Read
the Newspaper’s
Stock Tables
558 PART NINE THE REAL ECONOMY IN THE LONG RUN
would find it difficult to raise funds in the bond and stock markets. Most buyers of
stocks and bonds prefer to buy those issued by larger, more familiar companies.
The small grocer, therefore, most likely finances his business expansion with a loan
from a local bank.
Banks are the financial intermediaries with which people are most familiar. A
primary job of banks is to take in deposits from people who want to save and use
these deposits to make loans to people who want to borrow. Banks pay depositors
interest on their deposits and charge borrowers slightly higher interest on their
loans. The difference between these rates of interest covers the banks’ costs and returns
some profit to the owners of the banks.
Besides being financial intermediaries, banks play a second important role in
the economy: They facilitate purchases of goods and services by allowing people
to write checks against their deposits. In other words, banks help create a special
asset that people can use as a medium of exchange.Amedium of exchange is an item
that people can easily use to engage in transactions. A bank’s role in providing a
medium of exchange distinguishes it from many other financial institutions.
Stocks and bonds, like bank deposits, are a possible store of value for the wealth that
people have accumulated in past saving, but access to this wealth is not as easy,
cheap, and immediate as just writing a check. For now, we ignore this second
role of banks, but we will return to it when we discuss the monetary system in
Chapter 27.
Mutual Funds Afinancial intermediary of increasing importance in the U.S.
economy is the mutual fund. A mutual fund is an institution that sells shares to
the public and uses the proceeds to buy a selection, or portfolio, of various types of
stocks, bonds, or both stocks and bonds. The shareholder of the mutual fund accepts
all the risk and return associated with the portfolio. If the value of the portfolio
rises, the shareholder benefits; if the value of the portfolio falls, the
shareholder suffers the loss.
The primary advantage of mutual funds is that they allow people with small
amounts of money to diversify. Buyers of stocks and bonds are well advised to
heed the adage: Don’t put all your eggs in one basket. Because the value of any
single stock or bond is tied to the fortunes of one company, holding a single kind
of stock or bond is very risky. By contrast, people who hold a diverse portfolio of
stocks and bonds face less risk because they have only a small stake in each company.
Mutual funds make this diversification easy. With only a few hundred dollars,
a person can buy shares in a mutual fund and, indirectly, become the part
owner or creditor of hundreds of major companies. For this service, the company
mutual fund
an institution that sells shares
to the public and uses the proceeds
to buy a portfolio of stocks and bonds
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 559
operating the mutual fund charges shareholders a fee, usually between 0.5 and 2.0
percent of assets each year.
A second advantage claimed by mutual fund companies is that mutual funds
give ordinary people access to the skills of professional money managers. The
managers of most mutual funds pay close attention to the developments and
prospects of the companies in which they buy stock. These managers buy the stock
of those companies that they view as having a profitable future and sell the stock
of companies with less promising prospects. This professional management, it is
argued, should increase the return that mutual fund depositors earn on their savings.
Financial economists, however, are often skeptical of this second argument.
With thousands of money managers paying close attention to each company’s
prospects, the price of a company’s stock is usually a good reflection of the company’s
true value. As a result, it is hard to “beat the market” by buying good stocks
and selling bad ones. In fact, mutual funds called index funds, which buy all the
stocks in a given stock index, perform somewhat better on average than mutual
funds that take advantage of active management by professional money managers.
The explanation for the superior performance of index funds is that they
keep costs low by buying and selling very rarely and by not having to pay the
salaries of the professional money managers.
SUMMING UP
The U.S. economy contains a large variety of financial institutions. In addition to
the bond market, the stock market, banks, and mutual funds, there are also pension
funds, credit unions, insurance companies, and even the local loan shark.
These institutions differ in many ways. When analyzing the macroeconomic role
of the financial system, however, it is more important to keep in mind the similarity
of these institutions than the differences. These financial institutions all serve
the same goal—directing the resources of savers into the hands of borrowers.
QUICK QUIZ: What is stock? What is a bond? How are they different?
How are they similar?
SAVING AND INVESTMENT
IN THE NATIONAL INCOME ACCOUNTS
Events that occur within the financial system are central to understanding developments
in the overall economy. As we have just seen, the institutions that make
up this system—the bond market, the stock market, banks, and mutual funds—
have the role of coordinating the economy’s saving and investment. And as we
saw in the previous chapter, saving and investment are important determinants of
long-run growth in GDP and living standards. As a result, macroeconomists need
to understand how financial markets work and how various events and policies
affect them.
560 PART NINE THE REAL ECONOMY IN THE LONG RUN
As a starting point for an analysis of financial markets, we discuss in this section
the key macroeconomic variables that measure activity in these markets. Our
emphasis here is not on behavior but on accounting. Accounting refers to how various
numbers are defined and added up. A personal accountant might help an individual
add up his income and expenses. A national income accountant does the
same thing for the economy as a whole. The national income accounts include, in
particular, GDP and the many related statistics.
The rules of national income accounting include several important identities.
Recall that an identity is an equation that must be true because of the way the variables
in the equation are defined. Identities are useful to keep in mind, for they
clarify how different variables are related to one another. Here we consider some
accounting identities that shed light on the macroeconomic role of financial
markets.
SOME IMPORTANT IDENTITIES
Recall that gross domestic product (GDP) is both total income in an economy
and the total expenditure on the economy’s output of goods and services. GDP
THE U.S. STOCK MARKET EXPERIENCED A
quadrupling of stock prices during the
1990s. The following article tries to explain
this remarkable boom. It suggests
that people bid up stock prices because
they came to view stocks as less risky
than they previously thought.
A r e S t o c k s O v e r v a l u e d ?
Not a Chance
BY JAMES K. GLASSMAN
AND KEVIN A. HASSETT
The Dow Jones Industrial Average has
returned more than 200 percent over
the past five years, and the past three
have set an all-time record. So it’s
hardly surprising that many observers
worry the stock market is overvalued.
One of the most popular measures of
valuation, the ratio of a stock’s price to
its earnings per share, P/E, is close to
an all-time high. The P/E of the average
stock on the Dow is 22.5, meaning that
it costs $22.50 to buy $1 in profits—or,
conversely, that an investor’s return
(earnings divided by price) is just 4.4
percent, vs. 5.9 percent for long-term
Treasury bonds.
Yet Warren Buffett, chairman of
Berkshire Hathaway Corp. and the
most successful large-scale investor of
our time, told shareholders in a March
14 letter that “there is no reason to
think of stocks as generally overvalued”
as long as interest rates remain
low and businesses continue to operate
as profitably as they have in recent
years. Investors were buoyed by this
statement, even though Mr. Buffett
provided no analysis to back up his assertion.
Mr. Buffett is right—and we have
the numbers and the theory to back him
up. Worries about overvaluation, we believe,
are based on a serious and widespread
misunderstanding of the returns
and risks associated with equities. We
are not so foolish as to predict the shortterm
course of stocks, but we are not reluctant
to state that, based on modest
assumptions about interest rates and
profit levels, current P/E levels give us
no great concern—nor would levels as
much as twice as high.
The fact is that if you hold stocks instead
of bonds the amount of money
flowing into your pockets will be higher
over time. Why? Both bonds and stocks
provide their owners with a flow of cash
over time. For bonds, the arithmetic is
simple: If you buy a $10,000 bond paying
6 percent interest today, you’ll receive
$600 every year. For equities, the math
is more complicated: Assume that a
stock currently yields 2 percent, or $2
for each share priced at $100. Say you
own 100 shares; total dividend payments
are $200—much lower than for bonds.
IN THE NEWS
The Stock Market Boom
of the 1990s
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 561
(denoted as Y) is divided into four components of expenditure: consumption (C),
investment (I), government purchases (G), and net exports (NX). We write
Y C I G NX.
This equation is an identity because every dollar of expenditure that shows up on
the left-hand side also shows up in one of the four components on the right-hand
side. Because of the way each of the variables is defined and measured, this equation
must always hold.
In this chapter, we simplify our analysis by assuming that the economy we are
examining is closed. A closed economy is one that does not interact with other
economies. In particular, a closed economy does not engage in international trade
in goods and services, nor does it engage in international borrowing and lending.
Of course, actual economies are open economies—that is, they interact with other
economies around the world. (We will examine the macroeconomics of open
economies later in this book.) Nonetheless, assuming a closed economy is a useful
simplification by which we can learn some lessons that apply to all economies.
Moreover, this assumption applies perfectly to the world economy (inasmuch as
interplanetary trade is not yet common).
But wait. There is a big difference.
Profits grow over time. If that dividend
should increase with profits, say at a
rate of 5 percent annually, then, by the
30th year, your annual dividend payment
will be over $800, or one-third more than
the bond is yielding. The price of the
stock almost certainly will have risen
as well.
By this simple exercise, we can see
that stocks—even with their profits
growing at a moderate 5 percent—will
return far more than bonds over long periods.
Over the past 70 years, stocks
have annually returned 4.8 percentage
points more than long-term U.S.
Treasury bonds and 6.8 points more
than Treasury bills, according to Ibbotson
Associates Inc., a Chicago research
firm.
But isn’t that extra reward—what
economists call the “equity premium”—
merely the bonus paid by the market to
investors who accept higher risk, since
returns for stocks are so much more uncertain
than for bonds? To this question,
we respond: What extra risk?
In his book “Stocks for the Long
Run,” Jeremy J. Siegel of the University
of Pennsylvania concludes: “It is widely
known that stock returns, on average,
exceed bonds in the long run. But it is little
known that in the long run, the risks in
stocks are less than those found in
bonds or even bills!” Mr. Siegel looked
at every 20-year holding period from
1802 to 1992 and found that the worst
real return for stocks was an annual average
of 1.2 percent and the best was
an annual average of 12.6 percent. For
long-term bonds, the range was minus
3.1 percent to plus 8.8 percent; for Tbills,
minus 3.0 percent to plus 8.3 percent.
Based on these findings, it would
seem that there should be no need for
an equity risk premium at all—and that
the correct valuation for the stock market
would be one that equalizes the
present value of cash flow between
stocks and bonds in the long run. Think
of the market as offering you two assets,
one that will pay you $1,000 over the
next 30 years in a steady stream and
another that, just as surely, will pay you
the $1,000, but the cash flow will vary
from year to year. Assuming you’re investing
for the long term, you will value
them about the same. . . .
Allow us now to suggest a hypothesis
about the huge returns posted by the
stock market over the past few years:
As mutual funds have advertised the reduction
of risk acquired by taking the
long view, the risk premium required by
shareholders has gradually drifted down.
Since Siegel’s results suggest that the
correct risk premium might be zero, this
drift downward—and the corresponding
trend toward higher stock prices—may
not be over. . . . In the current environment,
we are very comfortable both in
holding stocks and in saying that pundits
who claim the market is overvalued are
foolish.
Source: The Wall Street Journal, Monday, March 30,
1998, p. A18.
562 PART NINE THE REAL ECONOMY IN THE LONG RUN
Because a closed economy does not engage in international trade, imports and
exports are exactly zero. Therefore, net exports (NX) are also zero. In this case, we
can write
Y C I G.
This equation states that GDP is the sum of consumption, investment, and government
purchases. Each unit of output sold in a closed economy is consumed, invested,
or bought by the government.
To see what this identity can tell us about financial markets, subtract C and G
from both sides of this equation. We obtain
Y C G I.
The left-hand side of this equation (Y C G) is the total income in the economy
that remains after paying for consumption and government purchases: This
amount is called national saving, or just saving, and is denoted S. Substituting
S for Y C G, we can write the last equation as
S I.
This equation states that saving equals investment.
To understand the meaning of national saving, it is helpful to manipulate the
definition a bit more. Let T denote the amount that the government collects from
households in taxes minus the amount it pays back to households in the form of
transfer payments (such as Social Security and welfare). We can then write national
saving in either of two ways:
S Y C G
or
S (Y T C) (T G).
These equations are the same, because the two T’s in the second equation cancel
each other, but each reveals a different way of thinking about national saving. In
particular, the second equation separates national saving into two pieces: private
saving (Y T C) and public saving (T G).
Consider each of these two pieces. Private saving is the amount of income that
households have left after paying their taxes and paying for their consumption. In
particular, because households receive income of Y, pay taxes of T, and spend C on
consumption, private saving is Y T C. Public saving is the amount of tax revenue
that the government has left after paying for its spending. The government receives
T in tax revenue and spends G on goods and services. If T exceeds G, the
government runs a budget surplus because it receives more money than it spends.
This surplus of T G represents public saving. If the government spends more
than it receives in tax revenue, then G is larger than T. In this case, the government
runs a budget deficit, and public saving T G is a negative number.
Now consider how these accounting identities are related to financial markets.
The equation S I reveals an important fact: For the economy as a whole, saving must
national saving (saving)
the total income in the
economy that remains after
paying for consumption and
government purchases
private saving
the income that households
have left after paying for taxes
and consumption
public saving
the tax revenue that the government
has left after paying for its spending
budget surplus
an excess of tax revenue over
government spending
budget deficit
a shortfall of tax revenue from
government spending
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 563
be equal to investment. Yet this fact raises some important questions: What mechanisms
lie behind this identity? What coordinates those people who are deciding
how much to save and those people who are deciding how much to invest? The
answer is: the financial system. The bond market, the stock market, banks, mutual
funds, and other financial markets and intermediaries stand between the two sides
of the S I equation. They take in the nation’s saving and direct it to the nation’s
investment.
THE MEANING OF SAVING AND INVESTMENT
The terms saving and investment can sometimes be confusing. Most people use
these terms casually and sometimes interchangeably. By contrast, the macroeconomists
who put together the national income accounts use these terms carefully
and distinctly.
Consider an example. Suppose that Larry earns more than he spends and deposits
his unspent income in a bank or uses it to buy a bond or some stock from a
corporation. Because Larry’s income exceeds his consumption, he adds to the nation’s
saving. Larry might think of himself as “investing” his money, but a macroeconomist
would call Larry’s act saving rather than investment.
In the language of macroeconomics, investment refers to the purchase of new
capital, such as equipment or buildings. When Moe borrows from the bank to
build himself a new house, he adds to the nation’s investment. Similarly, when the
USING SOME OF YOUR INCOME TO BUY STOCK? MOST PEOPLE CALL THIS INVESTING.
MACROECONOMISTS CALL IT SAVING.
564 PART NINE THE REAL ECONOMY IN THE LONG RUN
Curly Corporation sells some stock and uses the proceeds to build a new factory,
it also adds to the nation’s investment.
Although the accounting identity S I shows that saving and investment are
equal for the economy as a whole, this does not have to be true for every individual
household or firm. Larry’s saving can be greater than his investment, and he
can deposit the excess in a bank. Moe’s saving can be less than his investment, and
he can borrow the shortfall from a bank. Banks and other financial institutions
make these individual differences between saving and investment possible by allowing
one person’s saving to finance another person’s investment.
QUICK QUIZ: Define private saving, public saving, national saving, and
investment. How are they related?
THE MARKET FOR LOANABLE FUNDS
Having discussed some of the important financial institutions in our economy and
the macroeconomic role of these institutions, we are ready to build a model of financial
markets. Our purpose in building this model is to explain how financial
markets coordinate the economy’s saving and investment. The model also gives us
a tool with which we can analyze various government policies that influence saving
and investment.
To keep things simple, we assume that the economy has only one financial
market, called the market for loanable funds. All savers go to this market to deposit
their saving, and all borrowers go to this market to get their loans. Thus, the
term loanable funds refers to all income that people have chosen to save and lend
out, rather than use for their own consumption. In the market for loanable funds,
there is one interest rate, which is both the return to saving and the cost of borrowing.
The assumption of a single financial market, of course, is not literally true. As
we have seen, the economy has many types of financial institutions. But, as we discussed
in Chapter 2, the art in building an economic model is simplifying the
world in order to explain it. For our purposes here, we can ignore the diversity of
financial institutions and assume that the economy has a single financial market.
SUPPLY AND DEMAND FOR LOANABLE FUNDS
The economy’s market for loanable funds, like other markets in the economy, is
governed by supply and demand. To understand how the market for loanable
funds operates, therefore, we first look at the sources of supply and demand in
that market.
The supply of loanable funds comes from those people who have some extra
income they want to save and lend out. This lending can occur directly, such as
when a household buys a bond from a firm, or it can occur indirectly, such as when
a household makes a deposit in a bank, which in turn uses the funds to make
loans. In both cases, saving is the source of the supply of loanable funds.
market for loanable funds
the market in which those who
want to save supply funds and
those who want to borrow to
invest demand funds
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 565
The demand for loanable funds comes from households and firms who wish
to borrow to make investments. This demand includes families taking out mortgages
to buy homes. It also includes firms borrowing to buy new equipment or
build factories. In both cases, investment is the source of the demand for loanable
funds.
The interest rate is the price of a loan. It represents the amount that borrowers
pay for loans and the amount that lenders receive on their saving. Because a high
interest rate makes borrowing more expensive, the quantity of loanable funds demanded
falls as the interest rate rises. Similarly, because a high interest rate makes
saving more attractive, the quantity of loanable funds supplied rises as the interest
rate rises. In other words, the demand curve for loanable funds slopes downward,
and the supply curve for loanable funds slopes upward.
Figure 25-1 shows the interest rate that balances the supply and demand for
loanable funds. In the equilibrium shown, the interest rate is 5 percent, and the
quantity of loanable funds demanded and the quantity of loanable funds supplied
both equal $1,200 billion. The adjustment of the interest rate to the equilibrium
level occurs for the usual reasons. If the interest rate were lower than the equilibrium
level, the quantity of loanable funds supplied would be less than the quantity
of loanable funds demanded. The resulting shortage of loanable funds would
encourage lenders to raise the interest rate they charge. Conversely, if the interest
rate were higher than the equilibrium level, the quantity of loanable funds supplied
would exceed the quantity of loanable funds demanded. As lenders competed
for the scarce borrowers, interest rates would be driven down. In this way,
“Whoops! There go those darned interest rates again!”
566 PART NINE THE REAL ECONOMY IN THE LONG RUN
the interest rate approaches the equilibrium level at which the supply and demand
for loanable funds exactly balance.
Recall that economists distinguish between the real interest rate and the nominal
interest rate. The nominal interest rate is the interest rate as usually reported—
the monetary return to saving and cost of borrowing. The real interest rate is the
nominal interest rate corrected for inflation; it equals the nominal interest rate minus
the inflation rate. Because inflation erodes the value of money over time, the
real interest rate more accurately reflects the real return to saving and cost of borrowing.
Therefore, the supply and demand for loanable funds depend on the real
(rather than nominal) interest rate, and the equilibrium in Figure 25-1 should be interpreted
as determining the real interest rate in the economy. For the rest of this
chapter, when you see the term interest rate, you should remember that we are talking
about the real interest rate.
This model of the supply and demand for loanable funds shows that financial
markets work much like other markets in the economy. In the market for milk, for
instance, the price of milk adjusts so that the quantity of milk supplied balances
the quantity of milk demanded. In this way, the invisible hand coordinates the behavior
of dairy farmers and the behavior of milk drinkers. Once we realize that
saving represents the supply of loanable funds and investment represents the demand,
we can see how the invisible hand coordinates saving and investment.
When the interest rate adjusts to balance supply and demand in the market for
loanable funds, it coordinates the behavior of people who want to save (the suppliers
of loanable funds) and the behavior of people who want to invest (the demanders
of loanable funds).
We can now use this analysis of the market for loanable funds to examine various
government policies that affect the economy’s saving and investment. Because
this model is just supply and demand in a particular market, we analyze any
policy using the three steps discussed in Chapter 4. First, we decide whether the
policy shifts the supply curve or the demand curve. Second, we determine the direction
of the shift. Third, we use the supply-and-demand diagram to see how the
equilibrium changes.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
5%
Supply
Demand
$1,200
Figure 25-1
THE MARKET FOR LOANABLE
FUNDS. The interest rate in the
economy adjusts to balance the
supply and demand for loanable
funds. The supply of loanable
funds comes from national
saving, including both private
saving and public saving.
The demand for loanable
funds comes from firms and
households that want to borrow
for purposes of investment.
Here the equilibrium interest
rate is 5 percent, and $1,200
billion of loanable funds are
supplied and demanded.
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 567
Imagine that someone offered
to give you $100 today or
$100 in ten years. Which
would you choose? This is an
easy question. Getting $100
today is clearly better, because
you can always deposit the
money in a bank, still have it in
ten years, and earn interest
along the way. The lesson:
Money today is more valuable
than the same amount of
money in the future.
Now consider a harder
question: Imagine that someone offered you $100 today or
$200 in ten years. Which would you choose? To answer
this question, you need some way to compare sums of
money from different points in time. Economists do this
with a concept called present value. The present value of
any future sum of money is the amount today that would
be needed, at current interest rates, to produce that future
sum.
To learn how to use the concept of present value, let’s
work through a couple of simple problems:
Question: If you put $100 in a bank account today,
how much will it be worth in N years? That is, what will be
the future value of this $100?
Answer: Let’s use r to denote the interest rate expressed
in decimal form (so an interest rate of 5 percent
means r 0.05). If interest is paid each year, and if the interest
paid remains in the bank account to earn more interest
(a process called compounding), the $100 will
become (1 r ) $100 after one year, (1 r ) (1 r )
$100 after two years, (1 r ) (1 r ) (1 r ) $100
after three years, and so on. After N years, the $100 becomes
(1 r )N $100. For example, if we are investing at
an interest rate of 5 percent for ten years, then the future
value of the $100 will be (1.05)10 $100, which is $163.
Question: Now suppose you are going to be paid $200
in N years. What is the present value of this future payment?
That is, how much would you have to deposit in a
bank right now to yield $200 in N years?
Answer: To answer this question, just turn the previous
answer on its head. In the last question, we computed a future
value from a present value by multiplying by the factor
(1 r )N. To compute a present value from a future value,
we divide by the factor (1 r )N. Thus, the present value of
$200 in N years is $200/(1 r )N. If that amount is deposited
in a bank today, after N years it would become
(1 r )N [$200/(1 r )N], which is $200. For instance, if
the interest rate is 5 percent, the present value of $200 in
ten years is $200/(1.05)10, which is $123.
This illustrates the general formula: If r is the interest rate,
then an amount X to be received in N years has present
value of X/(1 r) N.
Let’s now return to our earlier question: Should you
choose $100 today or $200 in ten years? We can infer
from our calculation of present value that if the interest
rate is 5 percent, you should prefer the $200 in ten years.
The future $200 has a present value of $123, which is
greater than $100. You are, therefore, better off waiting for
the future sum.
Notice that the answer to our question depends on the
interest rate. If the interest rate were 8 percent, then the
$200 in ten years would have a present value of $200/
(1.08)10, which is only $93. In this case, you should take
the $100 today. Why should the interest rate matter for
your choice? The answer is that the higher the interest rate,
the more you can earn by depositing your money at the
bank, so the more attractive getting $100 today becomes.
The concept of present value is useful in many applications,
including the decisions that companies face when
evaluating investment projects. For instance, imagine that
General Motors is thinking about building a new automobile
factory. Suppose that the factory will cost $100 million today
and will yield the company $200 million in ten years.
Should General Motors undertake the project? You can see
that this decision is exactly like the one we have been
studying. To make its decision, the company will compare
the present value of the $200 million return to the $100
million cost.
The company’s decision, therefore, will depend on the
interest rate. If the interest rate is 5 percent, then the
present value of the $200 million return from the factory is
$123 million, and the company will choose to pay the $100
million cost. By contrast, if the interest rate is 8 percent,
then the present value of the return is only $93 million, and
the company will decide to forgo the project. Thus, the concept
of present value helps explain why investment—and
thus the quantity of loanable funds demanded—declines
when the interest rate rises.
Here is another application of present value: Suppose
you win a million-dollar lottery, but the prize is going to be
paid out as $20,000 a year for 50 years. How much is the
prize really worth? After performing 50 calculations similar
to those above (one calculation for each payment) and
adding up the results, you would learn that the present
value of this prize at a 7 percent interest rate is only
$276,000. This is one way that state lotteries make
money—by selling tickets in the present, and paying out
prizes in the future.
FYI
Present
Value
568 PART NINE THE REAL ECONOMY IN THE LONG RUN
POLICY 1: TAXES AND SAVING
American families save a smaller fraction of their incomes than their counterparts
in many other countries, such as Japan and Germany. Although the reasons for
these international differences are unclear, many U.S. policymakers view the low
level of U.S. saving as a major problem. One of the Ten Principles of Economics in
Chapter 1 is that a country’s standard of living depends on its ability to produce
goods and services. And, as we discussed in the preceding chapter, saving is an
important long-run determinant of a nation’s productivity. If the United States
could somehow raise its saving rate to the level that prevails in other countries, the
growth rate of GDP would increase, and over time, U.S. citizens would enjoy a
higher standard of living.
Another of the Ten Principles of Economics is that people respond to incentives.
Many economists have used this principle to suggest that the low saving rate in
the United States is at least partly attributable to tax laws that discourage saving.
The U.S. federal government, as well as many state governments, collects revenue
by taxing income, including interest and dividend income. To see the effects of this
policy, consider a 25-year-old individual who saves $1,000 and buys a 30-year
bond that pays an interest rate of 9 percent. In the absence of taxes, the $1,000
grows to $13,268 when the individual reaches age 55. Yet if that interest is taxed at
a rate of, say, 33 percent, then the after-tax interest rate is only 6 percent. In this
case, the $1,000 grows to only $5,743 after 30 years. The tax on interest income substantially
reduces the future payoff from current saving and, as a result, reduces
the incentive for people to save.
In response to this problem, many economists and lawmakers have proposed
changing the tax code to encourage greater saving. In 1995, for instance, when
Congressman Bill Archer of Texas became chairman of the powerful House Ways
and Means Committee, he proposed replacing the current income tax with a
consumption tax. Under a consumption tax, income that is saved would not be
taxed until the saving is later spent; in essence, a consumption tax is like the sales
taxes that many states now use to collect revenue. A more modest proposal is to
expand eligibility for special accounts, such as Individual Retirement Accounts,
that allow people to shelter some of their saving from taxation. Let’s consider the
effect of such a saving incentive on the market for loanable funds, as illustrated in
Figure 25-2.
First, which curve would this policy affect? Because the tax change would alter
the incentive for households to save at any given interest rate, it would affect the
quantity of loanable funds supplied at each interest rate. Thus, the supply of loanable
funds would shift. The demand for loanable funds would remain the same,
because the tax change would not directly affect the amount that borrowers want
to borrow at any given interest rate.
Second, which way would the supply curve shift? Because saving would be
taxed less heavily than under current law, households would increase their saving
by consuming a smaller fraction of their income. Households would use this additional
saving to increase their deposits in banks or to buy more bonds. The supply
of loanable funds would increase, and the supply curve would shift to the right
from S1 to S2, as shown in Figure 25-2.
Finally, we can compare the old and new equilibria. In the figure, the increased
supply of loanable funds reduces the interest rate from 5 percent to 4 percent. The
lower interest rate raises the quantity of loanable funds demanded from $1,200
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 569
billion to $1,600 billion. That is, the shift in the supply curve moves the market
equilibrium along the demand curve. With a lower cost of borrowing, households
and firms are motivated to borrow more to finance greater investment. Thus, if a
change in the tax laws encouraged greater saving, the result would be lower interest rates
and greater investment.
Although this analysis of the effects of increased saving is widely accepted
among economists, there is less consensus about what kinds of tax changes should
be enacted. Many economists endorse tax reform aimed at increasing saving in order
to stimulate investment and growth. Yet others are skeptical that these tax
changes would have much effect on national saving. These skeptics also doubt the
equity of the proposed reforms. They argue that, in many cases, the benefits of the
tax changes would accrue primarily to the wealthy, who are least in need of tax relief.
We examine this debate more fully in the final chapter of this book.
POLICY 2: TAXES AND INVESTMENT
Suppose that Congress passed a law giving a tax reduction to any firm building a
new factory. In essence, this is what Congress does when it institutes an investment
tax credit, which it does from time to time. Let’s consider the effect of such a law on
the market for loanable funds, as illustrated in Figure 25-3.
First, would the law affect supply or demand? Because the tax credit would
reward firms that borrow and invest in new capital, it would alter investment at
any given interest rate and, thereby, change the demand for loanable funds. By
contrast, because the tax credit would not affect the amount that households save
at any given interest rate, it would not affect the supply of loanable funds.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
4%
5%
Supply, S1 S2
$1,200 $1,600
2. ...which
reduces the
equilibrium
interest rate...
3. ...and raises the equilibrium
quantity of loanable funds.
Demand
1. Tax incentives for
saving increase the
supply of loanable
funds...
Figure 25-2
AN INCREASE IN THE SUPPLYOF
LOANABLE FUNDS. A change
in the tax laws to encourage
Americans to save more would
shift the supply of loanable funds
to the right from S1 to S2. As a
result, the equilibrium interest
rate would fall, and the lower
interest rate would stimulate
investment. Here the equilibrium
interest rate falls from 5 percent
to 4 percent, and the equilibrium
quantity of loanable funds saved
and invested rises from $1,200
billion to $1,600 billion.
570 PART NINE THE REAL ECONOMY IN THE LONG RUN
Second, which way would the demand curve shift? Because firms would have
an incentive to increase investment at any interest rate, the quantity of loanable
funds demanded would be higher at any given interest rate. Thus, the demand
curve for loanable funds would move to the right, as shown by the shift from D1 to
D2 in the figure.
Third, consider how the equilibrium would change. In Figure 25-3, the increased
demand for loanable funds raises the interest rate from 5 percent to 6 percent,
and the higher interest rate in turn increases the quantity of loanable funds
supplied from $1,200 billion to $1,400 billion, as households respond by increasing
the amount they save. This change in household behavior is represented here as a
movement along the supply curve. Thus, if a change in the tax laws encouraged
greater investment, the result would be higher interest rates and greater saving.
POLICY 3:
GOVERNMENT BUDGET DEFICITS AND SURPLUSES
Throughout the 1980s and 1990s, one of the most pressing policy issues was the
size of the government budget deficit. Recall that a budget deficit is an excess of
government spending over tax revenue. Governments finance budget deficits by
borrowing in the bond market, and the accumulation of past government borrowing
is called the government debt. In the 1980s and 1990s, the U.S. federal government
ran large budget deficits, resulting in a rapidly growing government debt. As
a result, much public debate centered on the effects of these deficits both on the allocation
of the economy’s scarce resources and on long-term economic growth.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
5%
6%
$1,200 $1,400
1. An investment
tax credit
increases the
demand for
loanable funds...
2. ...which
raises the
equilibrium
interest rate...
3. ...and raises the equilibrium
quantity of loanable funds.
Supply
Demand, D1
D2
Figure 25-3
AN INCREASE IN THE DEMAND
FOR LOANABLE FUNDS. If the
passage of an investment tax
credit encouraged U.S. firms
to invest more, the demand for
loanable funds would increase.
As a result, the equilibrium
interest rate would rise, and
the higher interest rate would
stimulate saving. Here, when the
demand curve shifts from D1 to
D2, the equilibrium interest rate
rises from 5 percent to 6 percent,
and the equilibrium quantity
of loanable funds saved and
invested rises from $1,200 billion
to $1,400 billion.
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 571
We can analyze the effects of a budget deficit by following our three steps in
the market for loanable funds, which is illustrated in Figure 25-4. First, which
curve shifts when the budget deficit rises? Recall that national saving—the source
of the supply of loanable funds—is composed of private saving and public saving.
A change in the government budget deficit represents a change in public saving
and, thereby, in the supply of loanable funds. Because the budget deficit does not
influence the amount that households and firms want to borrow to finance investment
at any given interest rate, it does not alter the demand for loanable funds.
Second, which way does the supply curve shift? When the government runs a
budget deficit, public saving is negative, and this reduces national saving. In other
words, when the government borrows to finance its budget deficit, it reduces the
supply of loanable funds available to finance investment by households and firms.
Thus, a budget deficit shifts the supply curve for loanable funds to the left from
S1 to S2, as shown in Figure 25-4.
Third, we can compare the old and new equilibria. In the figure, when the
budget deficit reduces the supply of loanable funds, the interest rate rises from
5 percent to 6 percent. This higher interest rate then alters the behavior of the
households and firms that participate in the loan market. In particular, many
demanders of loanable funds are discouraged by the higher interest rate. Fewer
families buy new homes, and fewer firms choose to build new factories. The fall in
investment because of government borrowing is called crowding out and is represented
in the figure by the movement along the demand curve from a quantity of
$1,200 billion in loanable funds to a quantity of $800 billion. That is, when the government
borrows to finance its budget deficit, it crowds out private borrowers
who are trying to finance investment.
Loanable Funds
(in billions of dollars)
0
Interest
Rate
$800 $1,200
3. ...and reduces the equilibrium
quantity of loanable funds.
S2
2. ...which
raises the
equilibrium
interest rate...
Supply, S1
Demand
5%
6% 1. A budget deficit
decreases the
supply of loanable
funds...
Figure 25-4
THE EFFECT OF A GOVERNMENT
BUDGET DEFICIT. When the
government spends more than
it receives in tax revenue, the
resulting budget deficit lowers
national saving. The supply of
loanable funds decreases, and
the equilibrium interest rate rises.
Thus, when the government
borrows to finance its budget
deficit, it crowds out households
and firms who otherwise would
borrow to finance investment.
Here, when the supply shifts
from S1 to S2, the equilibrium
interest rate rises from 5 percent
to 6 percent, and the equilibrium
quantity of loanable funds saved
and invested falls from $1,200
billion to $800 billion.
crowding out
a decrease in investment that results
from government borrowing
572 PART NINE THE REAL ECONOMY IN THE LONG RUN
CASE STUDY THE DEBATE OVER THE BUDGET SURPLUS
Our analysis shows why, other things being the same, budget surpluses are better
for economic growth than budget deficits. Making economic policy, however,
is not as simple as this observation may make it sound. A good example
occurred in the late 1990s, when the U.S. government found itself with a budget
surplus, and much debate centered on what to do with it.
Many policymakers favored leaving the budget surplus alone, rather than
dissipating it with a spending increase or tax cut. They based their conclusion
on the analysis we have just seen: Using the surplus to retire some of the government
debt would stimulate private investment and economic growth.
Other policymakers took a different view. Some thought the surplus should
be used to increase government spending on infrastructure and education because,
they argued, the return to these public investments is greater than the
typical return to private investment. Some thought taxes should be cut, arguing
that lower tax rates would distort decisionmaking less and lead to a more efficient
allocation of resources; they also cautioned that without such a tax cut,
Thus, the most basic lesson about budget deficits follows directly from their effects
on the supply and demand for loanable funds: When the government reduces
national saving by running a budget deficit, the interest rate rises, and investment falls.
Because investment is important for long-run economic growth, government budget
deficits reduce the economy’s growth rate.
Government budget surpluses work just the opposite as budget deficits. When
government collects more in tax revenue than it spends, its saves the difference by
retiring some of the outstanding government debt. This budget surplus, or public
saving, contributes to national saving. Thus, a budget surplus increases the supply of
loanable funds, reduces the interest rate, and stimulates investment. Higher investment,
in turn, means greater capital accumulation and more rapid economic growth.
“Our debt-reduction
plan is simple, but it
will require a great
deal of money.”
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 573
Congress would be tempted to spend the surplus on “pork barrel” projects of
dubious value.
As this book was going to press, the debate over the budget surplus was
still raging. There is room for reasonable people to disagree. The right policy
depends on how valuable you view private investment, how valuable you view
public investment, how distortionary you view taxation, and how reliable you
view the political process.
CASE STUDY THE HISTORY OF U.S. GOVERNMENT DEBT
How indebted is the U.S. government? The answer to this question varies substantially
over time. Figure 25-5 shows the debt of the U.S. federal government
expressed as a percentage of U.S. GDP. It shows that the government debt has
fluctuated from zero in 1836 to 107 percent of GDP in 1945. In recent years, government
debt has been about 50 percent of GDP.
The behavior of the debt–GDP ratio is one gauge of what’s happening with
the government’s finances. Because GDP is a rough measure of the government’s
tax base, a declining debt–GDP ratio indicates that the government indebtedness
is shrinking relative to its ability to raise tax revenue. This suggests
that the government is, in some sense, living within its means. By contrast, a rising
debt–GDP ratio means that the government indebtedness is increasing relative
to its ability to raise tax revenue. It is often interpreted as meaning that
fiscal policy—government spending and taxes—cannot be sustained forever at
current levels.
Throughout history, the primary cause of fluctuations in government
debt is war. When wars occur, government spending on national defense rises
Percent
of GDP
1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990
Revolutionary
War
2010
Civil
War World War I
World War II
0
20
40
60
80
100
120
Figure 25-5
THE U.S. GOVERNMENT DEBT.
The debt of the U.S. federal
government, expressed here as
a percentage of GDP, has varied
substantially throughout history.
It reached its highest level after
the large expenditures of World
War II, but then declined throughout
the 1950s and 1960s. It began
rising again in the early 1980s
when Ronald Reagan’s tax cuts
were not accompanied by similar
cuts in government spending.
It then stabilized and even
declined slightly in the late 1990s.
Source: U.S. Department of Treasury; U.S.
Department of Commerce; and T. S. Berry,
“Production and Population since 1789,”
Bostwick Paper No. 6, Richmond, 1988.
574 PART NINE THE REAL ECONOMY IN THE LONG RUN
substantially to pay for soldiers and military equipment. Taxes typically rise as
well but by much less than the increase in spending. The result is a budget
deficit and increasing government debt. When the war is over, government
spending declines, and the debt–GDP ratio starts declining as well.
There are two reasons to believe that debt financing of war is an appropriate
policy. First, it allows the government to keep tax rates smooth over time.
Without debt financing, tax rates would have to rise sharply during wars, and
as we saw in Chapter 8, this would cause a substantial decline in economic
efficiency. Second, debt financing of wars shifts part of the cost of wars to future
generations, who will have to pay off the government debt. This is arguably
a fair distribution of the burden, for future generations get some of the
benefit when one generation fights a war to defend the nation against foreign
aggressors.
One large increase in government debt that cannot be explained by war is
the increase that occurred beginning around 1980. When President Ronald Reagan
took office in 1981, he was committed to smaller government and lower
taxes. Yet he found cutting government spending to be more difficult politically
than cutting taxes. The result was the beginning of a period of large budget
deficits that continued not only through Reagan’s time in office but also for
many years thereafter. As a result, government debt rose from 26 percent of
GDP in 1980 to 50 percent of GDP in 1993.
As we discussed earlier, government budget deficits reduce national saving,
investment, and long-run economic growth, and this is precisely why the
rise in government debt during the 1980s troubled so many economists. Policymakers
from both political parties accepted this basic argument and viewed
persistent budget deficits as an important policy problem. When Bill Clinton
moved into the Oval Office in 1993, deficit reduction was his first major goal.
Similarly, when the Republicans took control of Congress in 1995, deficit reduction
was high on their legislative agenda. Both of these efforts substantially reduced
the size of the government budget deficit, and it eventually turned into a
small surplus. As a result, by the late 1990s, the debt–GDP ratio was declining
once again.
QUICK QUIZ: If more Americans adopted a “live for today” approach to
life, how would this affect saving, investment, and the interest rate?
CONCLUSION
“Neither a borrower nor a lender be,” Polonius advises his son in Shakespeare’s
Hamlet. If everyone followed this advice, this chapter would have been
unnecessary.
Few economists would agree with Polonius. In our economy, people borrow
and lend often, and usually for good reason. You may borrow one day to start your
own business or to buy a home. And people may lend to you in the hope that the
interest you pay will allow them to enjoy a more prosperous retirement. The financial
system has the job of coordinating all this borrowing and lending activity.
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 575
In many ways, financial markets are like other markets in the economy. The
price of loanable funds—the interest rate—is governed by the forces of supply and
demand, just as other prices in the economy are. And we can analyze shifts in supply
or demand in financial markets as we do in other markets. One of the Ten Principles
of Economics introduced in Chapter 1 is that markets are usually a good way
to organize economic activity. This principle applies to financial markets as well.
When financial markets bring the supply and demand for loanable funds into balance,
they help allocate the economy’s scarce resources to their most efficient use.
In one way, however, financial markets are special. Financial markets, unlike
most other markets, serve the important role of linking the present and the future.
Those who supply loanable funds—savers—do so because they want to convert
some of their current income into future purchasing power. Those who demand
loanable funds—borrowers—do so because they want to invest today in order to
have additional capital in the future to produce goods and services. Thus, wellfunctioning
financial markets are important not only for current generations but
also for future generations who will inherit many of the resulting benefits.
The U.S. financial system is made up of many types of
financial institutions, such as the bond market, the stock
market, banks, and mutual funds. All these institutions
act to direct the resources of households who want to
save some of their income into the hands of households
and firms who want to borrow.
National income accounting identities reveal some
important relationships among macroeconomic
variables. In particular, for a closed economy, national
saving must equal investment. Financial institutions are
the mechanism through which the economy matches
one person’s saving with another person’s investment.
The interest rate is determined by the supply and
demand for loanable funds. The supply of loanable
funds comes from households who want to save some
of their income and lend it out. The demand for
loanable funds comes from households and firms who
want to borrow for investment. To analyze how any
policy or event affects the interest rate, one must
consider how it affects the supply and demand for
loanable funds.
National saving equals private saving plus public
saving. A government budget deficit represents negative
public saving and, therefore, reduces national saving
and the supply of loanable funds available to finance
investment. When a government budget deficit crowds
out investment, it reduces the growth of productivity
and GDP.
Summary
financial system, p. 554
financial markets, p. 555
bond, p. 555
stock, p. 556
financial intermediaries, p. 556
mutual fund, p. 558
national saving (saving), p. 562
private saving, p. 562
public saving, p. 562
budget surplus, p. 562
budget deficit, p. 562
market for loanable funds, p. 564
crowding out, p. 571
Key Concepts
1. What is the role of the financial system? Name and
describe two markets that are part of the financial
system in our economy. Name and describe two
financial intermediaries.
Questions for Review
576 PART NINE THE REAL ECONOMY IN THE LONG RUN
2. Why is it important for people who own stocks and
bonds to diversify their holdings? What type of financial
institution makes diversification easier?
3. What is national saving? What is private saving? What
is public saving? How are these three variables related?
4. What is investment? How is it related to national
saving?
5. Describe a change in the tax code that might increase
private saving. If this policy were implemented, how
would it affect the market for loanable funds?
6. What is a government budget deficit? How does it affect
interest rates, investment, and economic growth?
1. For each of the following pairs, which bond would you
expect to pay a higher interest rate? Explain.
a. a bond of the U.S. government or a bond of an
eastern European government
b. a bond that repays the principal in 2005 or a bond
that repays the principal in 2025
c. a bond from Coca-Cola or a bond from a software
company you run in your garage
d. a bond issued by the federal government or a bond
issued by New York State
2. Look up in a newspaper the stock of two companies you
know something about (perhaps as a customer). What is
the price–earnings ratio for each company? Why do you
think they differ? If you were to buy one of these stocks,
which would you choose? Why?
3. Theodore Roosevelt once said, “There is no moral
difference between gambling at cards or in lotteries or
on the race track and gambling in the stock market.”
What social purpose do you think is served by the
existence of the stock market?
4. Use the Internet to look at the Web site for a mutual
fund company, such as Vanguard (www.vanguard.com).
Compare the return on an actively managed mutual
fund with the return on an index fund. What explains
the difference in these returns?
5. Declines in stock prices are sometimes viewed as
harbingers of future declines in real GDP. Why do you
suppose that might be true?
6. When the Russian government defaulted on its debt to
foreigners in 1998, interest rates rose on bonds issued by
many other developing countries. Why do you suppose
this happened?
7. Many workers hold large amounts of stock issued by
the firms at which they work. Why do you suppose
companies encourage this behavior? Why might a
person not want to hold stock in the company where
he works?
8. Your roommate says that he buys stock only in
companies that everyone believes will experience big
increases in profits in the future. How do you suppose
the price–earnings ratio of these companies compares
to the price–earnings ratio of other companies? What
might be the disadvantage of buying stock in these
companies?
9. Explain the difference between saving and investment
as defined by a macroeconomist. Which of the following
situations represent investment? Saving? Explain.
a. Your family takes out a mortgage and buys a new
house.
b. You use your $200 paycheck to buy stock in AT&T.
c. Your roommate earns $100 and deposits it in her
account at a bank.
d. You borrow $1,000 fr om a bank to buy a car to use
in your pizza delivery business.
10. Suppose GDP is $8 trillion, taxes are $1.5 trillion, private
saving is $0.5 trillion, and public saving is $0.2 trillion.
Assuming this economy is closed, calculate consumption,
government purchases, national saving, and
investment.
11. Suppose that Intel is considering building a new chipmaking
factory.
a. Assuming that Intel needs to borrow money in the
bond market, why would an increase in interest
rates affect Intel’s decision about whether to build
the factory?
b. If Intel has enough of its own funds to finance the
new factory without borrowing, would an increase
in interest rates still affect Intel’s decision about
whether to build the factory? Explain.
12. Suppose the government borrows $20 billion more next
year than this year.
a. Use a supply-and-demand diagram to analyze this
policy. Does the interest rate rise or fall?
b. What happens to investment? To private saving? To
public saving? To national saving? Compare the
Problems and Applications
CHAPTER 25 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 577
size of the changes to the $20 billion of extra
government borrowing.
c. How does the elasticity of supply of loanable
funds affect the size of these changes? (Hint: See
Chapter 5 to review the definition of elasticity.)
d. How does the elasticity of demand for loanable
funds affect the size of these changes?
e. Suppose households believe that greater
government borrowing today implies higher
taxes to pay off the government debt in the future.
What does this belief do to private saving and the
supply of loanable funds today? Does it increase
or decrease the effects you discussed in parts
(a) and (b)?
13. Over the past ten years, new computer technology has
enabled firms to reduce substantially the amount of
inventories they hold for each dollar of sales. Illustrate
the effect of this change on the market for loanable
funds. (Hint: Expenditure on inventories is a type of
investment.) What do you think has been the effect on
investment in factories and equipment?
14. “Some economists worry that the aging populations of
industrial countries are going to start running down
their savings just when the investment appetite of
emerging economies is growing” (Economist, May 6,
1995). Illustrate the effect of these phenomena on the
world market for loanable funds.
15. This chapter explains that investment can be increased
both by reducing taxes on private saving and by
reducing the government budget deficit.
a. Why is it difficult to implement both of these
policies at the same time?
b. What would you need to know about private
saving in order to judge which of these two policies
would be a more effective way to raise investment?

IN THIS CHAPTER
YOU WILL . . .
Examine how
unemployment
results when firms
choose to pay
ef ficiency wages
Consider how
unemployment can
r esult from
minimum-wage laws
Learn about the
data used to
measure the amount
of unemployment
Consider how
unemployment
arises from the
process of job
search
See how
unemployment can
arise from
bargaining between
f i rms and unions
Losing a job can be the most distressing economic event in a person’s life. Most
people rely on their labor earnings to maintain their standard of living, and many
people get from their work not only income but also a sense of personal accomplishment.
A job loss means a lower living standard in the present, anxiety about
the future, and reduced self-esteem. It is not surprising, therefore, that politicians
campaigning for office often speak about how their proposed policies will help
create jobs.
In the preceding two chapters we have seen some of the forces that determine
the level and growth of a country’s standard of living. Acountry that saves and invests
a high fraction of its income, for instance, enjoys more rapid growth in its
capital stock and its GDP than a similar country that saves and invests less. An
even more obvious determinant of a country’s standard of living is the amount of
unemployment it typically experiences. People who would like to work but cannot
U N E M P L O Y M E N T
A N D I T S N A T U R A L R A T E
579
580 PART NINE THE REAL ECONOMY IN THE LONG RUN
find a job are not contributing to the economy’s production of goods and services.
Although some degree of unemployment is inevitable in a complex economy with
thousands of firms and millions of workers, the amount of unemployment varies
substantially over time and across countries. When a country keeps its workers as
fully employed as possible, it achieves a higher level of GDP than it would if it left
many of its workers standing idle.
This chapter begins our study of unemployment. The problem of unemployment
is usefully divided into two categories—the long-run problem and the shortrun
problem. The economy’s natural rate of unemployment refers to the amount of
unemployment that the economy normally experiences. Cyclical unemployment
refers to the year-to-year fluctuations in unemployment around its natural rate,
and it is closely associated with the short-run ups and downs of economic activity.
Cyclical unemployment has its own explanation, which we defer until we study
short-run economic fluctuations later in this book. In this chapter we discuss the
determinants of an economy’s natural rate of unemployment. As we will see, the
designation natural does not imply that this rate of unemployment is desirable.
Nor does it imply that it is constant over time or impervious to economic policy. It
merely means that this unemployment does not go away on its own even in the
long run.
We begin the chapter by looking at some of the relevant facts that describe unemployment.
In particular, we examine three questions: How does the government
measure the economy’s rate of unemployment? What problems arise in
interpreting the unemployment data? How long are the unemployed typically
without work?
We then turn to the reasons why economies always experience some unemployment
and the ways in which policymakers can help the unemployed. We discuss
four explanations for the economy’s natural rate of unemployment: job
search, minimum-wage laws, unions, and efficiency wages. As we will see, longrun
unemployment does not arise from a single problem that has a single solution.
Instead, it reflects a variety of related problems. As a result, there is no easy way
for policymakers to reduce the economy’s natural rate of unemployment and, at
the same time, to alleviate the hardships experienced by the unemployed.
IDENTIFYING UNEMPLOYMENT
We begin this chapter by examining more precisely what the term unemployment
means. We consider how the government measures unemployment, what problems
arise in interpreting the unemployment data, and how long the typical spell
of unemployment lasts.
HOW IS UNEMPLOYMENT MEASURED?
Measuring unemployment is the job of the Bureau of Labor Statistics (BLS), which
is part of the Department of Labor. Every month the BLS produces data on unemployment
and on other aspects of the labor market, such as types of employment,
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 581
length of the average workweek, and the duration of unemployment. These data
come from a regular survey of about 60,000 households, called the Current Population
Survey.
Based on the answers to survey questions, the BLS places each adult (aged sixteen
and older) in each surveyed household into one of three categories:
Employed
Unemployed
Not in the labor force
A person is considered employed if he or she spent most of the previous week
working at a paid job. Aperson is unemployed if he or she is on temporary layoff,
is looking for a job, or is waiting for the start date of a new job. A person who fits
neither of the first two categories, such as a full-time student, homemaker, or retiree,
is not in the labor force. Figure 26-1 shows this breakdown for 1998.
Once the BLS has placed all the individuals covered by the survey in a category,
it computes various statistics to summarize the state of the labor market. The
BLS defines the labor force as the sum of the employed and the unemployed:
Labor force Number employed number of unemployed
Adult
population
(205.2 million)
Labor force
(137.7 million)
Employed
(131.5 million)
Not in labor force
(67.5 million)
Unemployed (6.2 million)
Figure 26-1
THE BREAKDOWN OF THE
POPULATION IN 1998. The
Bureau of Labor Statistics
divides the adult population
into three categories: employed,
unemployed, and not in the
labor force.
SOURCE: Bureau of Labor Statistics.
labor force
the total number of workers,
including both the employed
and the unemployed
582 PART NINE THE REAL ECONOMY IN THE LONG RUN
The BLS defines the unemployment rate as the percentage of the labor force that
is unemployed:
Unemployment rate 100.
The BLS computes unemployment rates for the entire adult population and for
more narrow groups—blacks, whites, men, women, and so on.
The BLS uses the same survey to produce data on labor-force participation.
The labor-force participation rate measures the percentage of the total adult population
of the United States that is in the labor force:
Labor-force participation rate 100.
This statistic tells us the fraction of the population that has chosen to participate in
the labor market. The labor-force participation rate, like the unemployment rate, is
computed both for the entire adult population and for more narrow groups.
To see how these data are computed, consider the figures for 1998. In that year,
131.5 million people were employed, and 6.2 million people were unemployed.
The labor force was
Labor force 131.5 6.2 137.7 million.
The unemployment rate was
Unemployment rate (6.2/137.7) 100 4.5 percent.
Because the adult population was 205.2 million, the labor-force participation
rate was
Labor-force participation rate (137.7/205.2) 100 67.1 percent.
Hence, in 1998, two-thirds of the U.S. adult population were participating in the
labor market, and 4.5 percent of those labor-market participants were without
work.
Table 26-1 shows the statistics on unemployment and labor-force participation
for various groups within the U.S. population. Three comparisons are most apparent.
First, women have lower rates of labor-force participation than men, but once
in the labor force, women have similar rates of unemployment. Second, blacks
have similar rates of labor-force participation as whites, and they have much
higher rates of unemployment. Third, teenagers have lower rates of labor-force
participation and much higher rates of unemployment than the overall population.
More generally, these data show that labor-market experiences vary widely
among groups within the economy.
The BLS data on the labor market also allow economists and policymakers to
monitor changes in the economy over time. Figure 26-2 shows the unemployment
rate in the United States since 1960. The figure shows that the economy always has
some unemployment and that the amount changes from year to year. The normal
rate of unemployment around which the unemployment rate fluctuates is called
the natural rate of unemployment, and the deviation of unemployment from its
Labor force
Adult population
Number of unemployed
Labor force
unemployment rate
the percentage of the labor force
that is unemployed
labor-force
par ticipation rate
the percentage of the adult
population that is in the labor force
natural rate of
unemployment
the normal rate of unemployment
around which the unemployment
rate fluctuates
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 583
natural rate is called cyclical unemployment. In the figure, the natural rate is
shown as a horizontal line at 5.5 percent, which is a rough estimate of the natural
rate for the U.S. economy during this period. Later in this book we discuss
UNEMPLOYMENT LABOR-FORCE
DEMOGRAPHIC GROUP RATE PARTICIPATION RATE
ADULTS (AGES 20 AND OVER)
White, male 3.2% 77.2%
White, female 3.4 59.7
Black, male 7.4 72.5
Black, female 7.9 64.8
TEENAGERS (AGES 16–19)
White, male 14.1 56.6
White, female 10.9 55.4
Black, male 30.1 40.7
Black, female 25.3 42.5
SOURCE: Bureau of Labor Statistics.
Table 26-1
THE LABOR-MARKET
EXPERIENCES OF VARIOUS
DEMOGRAPHIC GROUPS.
This table shows the
unemployment rate and
the labor-force participation
rate of various groups in the
U.S. population for 1998.
10
8
6
4
2
0
1960 1965 1970 1975 1980 1985 1990 2000
Percent of
Labor Force
1995
Natural rate of
unemployment
Unemployment rate
Figure 26-2 UNEMPLOYMENT RATE SINCE 1960. This graph uses annual data on the unemployment
rate to show the fraction of the labor force without a job.
Source: U.S. Department of Labor.
cyclical unemployment
the deviation of unemployment from
its natural rate
584 PART NINE THE REAL ECONOMY IN THE LONG RUN
CASE STUDY LABOR-FORCE PARTICIPATION
OF MEN AND WOMEN IN THE U.S. ECONOMY
Women’s role in American society has changed dramatically over the past century.
Social commentators have pointed to many causes for this change. In part,
it is attributable to new technologies such as the washing machine, clothes
dryer, refrigerator, freezer, and dishwasher, which have reduced the amount of
time required to complete routine household tasks. In part, it is attributable to
improved birth control, which has reduced the number of children born to the
typical family. And, of course, this change in women’s role is also partly attributable
to changing political and social attitudes. Together these developments
have had a profound impact on society in general and on the economy in
particular.
Nowhere is that impact more obvious than in data on labor-force participation.
Figure 26-3 shows the labor-force participation rates of men and women in
the United States since 1950. Just after World War II, men and women had very
different roles in society. Only 33 percent of women were working or looking for
work, in contrast to 87 percent of men. Over the past several decades, the difference
between the participation rates of men and women has gradually diminished,
as growing numbers of women have entered the labor force and
some men have left it. Data for 1998 show that 60 percent of women were in the
labor force, in contrast to 75 percent of men. As measured by labor-force participation,
men and women are now playing a more equal role in the economy.
The increase in women’s labor-force participation is easy to understand, but
the fall in men’s may seem puzzling. There are several reasons for this decline.
short-run economic fluctuations, including the year-to-year fluctuations in unemployment
around its natural rate. In the rest of this chapter, however, we ignore the
short-run fluctuations and examine why unemployment is a chronic problem for
market economies.
MORE WOMEN ARE WORKING
NOW THAN EVER BEFORE.
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 585
First, young men now stay in school longer than their fathers and grandfathers
did. Second, older men now retire earlier and live longer. Third, with more
women employed, more fathers now stay at home to raise their children. Fulltime
students, retirees, and stay-at-home fathers are all counted as out of the
labor force.
DOES THE UNEMPLOYMENT RATE MEASURE
WHAT WE WANT IT TO?
Measuring the amount of unemployment in the economy might seem straightforward.
In fact, it is not. Whereas it is easy to distinguish between a person with a
full-time job and a person who is not working at all, it is much harder to distinguish
between a person who is unemployed and a person who is not in the labor
force.
Movements into and out of the labor force are, in fact, very common. More
than one-third of the unemployed are recent entrants into the labor force. These
entrants include young workers looking for their first jobs, such as recent college
graduates. They also include, in greater numbers, older workers who had previously
left the labor force but have now returned to look for work. Moreover, not all
unemployment ends with the job seeker finding a job. Almost half of all spells of
unemployment end when the unemployed person leaves the labor force.
Because people move into and out of the labor force so often, statistics on unemployment
are difficult to interpret. On the one hand, some of those who report
being unemployed may not, in fact, be trying hard to find a job. They may be
calling themselves unemployed because they want to qualify for a government
100
80
60
40
20
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 '98
Labor-Force
Participation
Rate (in percent)
Women
Men
Figure 26-3
LABOR-FORCE PARTICIPATION
RATES FOR MEN AND WOMEN
SINCE 1950. This figure shows
the percentage of adult men and
women who are members of the
labor force. It shows that over
the past several decades, women
have entered the labor force, and
men have left it.
SOURCE: U.S. Department of Labor.
586 PART NINE THE REAL ECONOMY IN THE LONG RUN
program that financially assists the unemployed or because they are actually
working and being paid “under the table.” It may be more realistic to view these
individuals as out of the labor force or, in some cases, employed. On the other
hand, some of those who report being out of the labor force may, in fact, want to
work. These individuals may have tried to find a job but have given up after an
unsuccessful search. Such individuals, called discouraged workers, do not show
up in unemployment statistics, even though they are truly workers without jobs.
According to most estimates, adding discouraged workers would increase the
measured unemployment rate by about one-half of one percentage point.
There is no easy way to fix the unemployment rate as reported by the BLS to
make it a more reliable indicator of conditions in the labor market. In the end, it is
best to view the reported unemployment rate as a useful but imperfect measure of
joblessness.
HOW LONG ARE THE UNEMPLOYED WITHOUT WORK?
In judging how serious the problem of unemployment is, one question to consider
is whether unemployment is typically a short-term or long-term condition. If unemployment
is short-term, one might conclude that it is not a big problem. Workers
may require a few weeks between jobs to find the openings that best suit their
tastes and skills. Yet if unemployment is long-term, one might conclude that it is a
serious problem. Workers unemployed for many months are more likely to suffer
economic and psychological hardship.
Because the duration of unemployment can affect our view about how big a
problem unemployment is, economists have devoted much energy to studying
data on the duration of unemployment spells. In this work, they have uncovered a
result that is important, subtle, and seemingly contradictory: Most spells of unemployment
are short, and most unemployment observed at any given time is long-term.
To see how this statement can be true, consider an example. Suppose that you
visited the government’s unemployment office every week for a year to survey the
unemployed. Each week you find that there are four unemployed workers. Three
of these workers are the same individuals for the whole year, while the fourth person
changes every week. Based on this experience, would you say that unemployment
is typically short-term or long-term?
Some simple calculations help answer this question. In this example, you meet
a total of 55 unemployed people; 52 of them are unemployed for one week, and
three are unemployed for the full year. This means that 52/55, or 95 percent, of unemployment
spells end in one week. Thus, most spells of unemployment are short.
Yet consider the total amount of unemployment. The three people unemployed for
one year (52 weeks) make up a total of 156 weeks of unemployment. Together with
the 52 people unemployed for one week, this makes 208 weeks of unemployment.
In this example, 156/208, or 75 percent, of unemployment is attributable to those
individuals who are unemployed for a full year. Thus, most unemployment observed
at any given time is long-term.
This subtle conclusion implies that economists and policymakers must be
careful when interpreting data on unemployment and when designing policies to
help the unemployed. Most people who become unemployed will soon find jobs.
Yet most of the economy’s unemployment problem is attributable to the relatively
few workers who are jobless for long periods of time.
discouraged workers
individuals who would like to work
but have given up looking for a job
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 587
WHY ARE THERE ALWAYS SOME PEOPLE UNEMPLOYED?
We have discussed how the government measures the amount of unemployment,
the problems that arise in interpreting unemployment statistics, and the findings
of labor economists on the duration of unemployment. You should now have a
good idea about what unemployment is.
This discussion, however, has not explained why economies experience unemployment.
In most markets in the economy, prices adjust to bring quantity supplied
and quantity demanded into balance. In an ideal labor market, wages would
adjust to balance the quantity of labor supplied and the quantity of labor demanded.
This adjustment of wages would ensure that all workers are always fully
employed.
Of course, reality does not resemble this ideal. There are always some workers
without jobs, even when the overall economy is doing well. In other words, the
unemployment rate never falls to zero; instead, it fluctuates around the natural
rate of unemployment. To understand this natural rate, we now examine the reasons
why actual labor markets depart from the ideal of full employment.
To preview our conclusions, we will find that there are four ways to explain
unemployment in the long run. The first explanation is that it takes time for workers
to search for the jobs that are best suited for them. The unemployment that results
from the process of matching workers and jobs is sometimes called frictional
unemployment, and it is often thought to explain relatively short spells of unemployment.
The next three explanations for unemployment suggest that the number of
jobs available in some labor markets may be insufficient to give a job to everyone
who wants one. This occurs when the quantity of labor supplied exceeds the quantity
demanded. Unemployment of this sort is sometimes called structural unemployment,
and it is often thought to explain longer spells of unemployment. As we
will see, this kind of unemployment results when wages are, for some reason, set
above the level that brings supply and demand into equilibrium. We will examine
three possible reasons for an above-equilibrium wage: minimum-wage laws,
unions, and efficiency wages.
QUICK QUIZ: How is the unemployment rate measured? How might
the unemployment rate overstate the amount of joblessness? How might it
understate it?
JOB SEARCH
One reason why economies always experience some unemployment is job search.
Job search is the process of matching workers with appropriate jobs. If all workers
and all jobs were the same, so that all workers were equally well suited for all jobs,
job search would not be a problem. Laid-off workers would quickly find new
jobs that were well suited for them. But, in fact, workers differ in their tastes and
skills, jobs differ in their attributes, and information about job candidates and job
frictional unemployment
unemployment that results because
it takes time for workers to search
for the jobs that best suit their
tastes and skills
structural unemployment
unemployment that results because
the number of jobs available in
some labor markets is insufficient
to provide a job for everyone
who wants one
job search
the process by which workers
find appropriate jobs given
their tastes and skills
588 PART NINE THE REAL ECONOMY IN THE LONG RUN
vacancies is disseminated slowly among the many firms and households in the
economy.
WHY SOME FRICTIONAL UNEMPLOYMENT IS INEVITABLE
Frictional unemployment is often the result of changes in the demand for labor
among different firms. When consumers decide that they prefer Compaq over Dell
computers, Compaq increases employment, and Dell lays off workers. The former
Dell workers must now search for new jobs, and Compaq must decide which new
workers to hire for the various jobs that have opened up. The result of this transition
is a period of unemployment.
Similarly, because different regions of the country produce different goods,
employment can rise in one region while it falls in another. Consider, for instance,
what happens when the world price of oil falls. Oil-producing firms in Texas respond
to the lower price by cutting back on production and employment. At the
same time, cheaper gasoline stimulates car sales, so auto-producing firms in
Michigan raise production and employment. Changes in the composition of demand
among industries or regions are called sectoral shifts. Because it takes time for
workers to search for jobs in the new sectors, sectoral shifts temporarily cause unemployment.
Frictional unemployment is inevitable simply because the economy is always
changing. A century ago, the four industries with the largest employment in the
United States were cotton goods, woolen goods, men’s clothing, and lumber. Today,
the four largest industries are autos, aircraft, communications, and electrical
components. As this transition took place, jobs were created in some firms, and
jobs were destroyed in others. The end result of this process has been higher productivity
and higher living standards. But, along the way, workers in declining industries
found themselves out of work and searching for new jobs.
Data show that at least 10 percent of U.S. manufacturing jobs are destroyed
every year. In addition, more than 3 percent of workers leave their jobs in a typical
month, sometimes because they realize that the jobs are not a good match for their
tastes and skills. Many of these workers, especially younger ones, find new jobs
at higher wages. This churning of the labor force is normal in a well-functioning
and dynamic market economy, but the result is some amount of frictional
unemployment.
PUBLIC POLICY AND JOB SEARCH
Even if some frictional unemployment is inevitable, the precise amount is not. The
faster information spreads about job openings and worker availability, the more
rapidly the economy can match workers and firms. The Internet, for instance, may
help facilitate job search and reduce frictional unemployment. In addition, public
policy may play a role. If policy can reduce the time it takes unemployed workers
to find new jobs, it can reduce the economy’s natural rate of unemployment.
Government programs try to facilitate job search in various ways. One way is
through government-run employment agencies, which give out information about
job vacancies. Another way is through public training programs, which aim to
ease the transition of workers from declining to growing industries and to help
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 589
disadvantaged groups escape poverty. Advocates of these programs believe that
they make the economy operate more efficiently by keeping the labor force more
fully employed, and that they reduce the inequities inherent in a constantly changing
market economy.
Critics of these programs question whether the government should get involved
with the process of job search. They argue that it is better to let the private
market match workers and jobs. In fact, most job search in our economy takes
place without intervention by the government. Newspaper ads, job newsletters,
college placement offices, headhunters, and word of mouth all help spread information
about job openings and job candidates. Similarly, much worker education
is done privately, either through schools or through on-the-job training. These critics
contend that the government is no better—and most likely worse—at disseminating
the right information to the right workers and deciding what kinds of
worker training would be most valuable. They claim that these decisions are best
made privately by workers and employers.
UNEMPLOYMENT INSURANCE
One government program that increases the amount of frictional unemployment,
without intending to do so, is unemployment insurance. This program is designed
to offer workers partial protection against job loss. The unemployed who
quit their jobs, were fired for cause, or just entered the labor force are not eligible.
Benefits are paid only to the unemployed who were laid off because their previous
employers no longer needed their skills. Although the terms of the program vary
over time and across states, a typical American worker covered by unemployment
insurance receives 50 percent of his or her former wages for 26 weeks.
While unemployment insurance reduces the hardship of unemployment, it
also increases the amount of unemployment. The explanation is based on one of
the Ten Principles of Economics in Chapter 1: People respond to incentives. Because
unemployment benefits stop when a worker takes a new job, the unemployed devote
less effort to job search and are more likely to turn down unattractive job offers.
In addition, because unemployment insurance makes unemployment less
onerous, workers are less likely to seek guarantees of job security when they negotiate
with employers over the terms of employment.
Many studies by labor economists have examined the incentive effects of unemployment
insurance. One study examined an experiment run by the state of Illinois
in 1985. When unemployed workers applied to collect unemployment
insurance benefits, the state randomly selected some of them and offered each a
$500 bonus if they found new jobs within 11 weeks. This group was then compared
to a control group not offered the incentive. The average spell of unemployment
for the group offered the bonus was 7 percent shorter than the average spell
for the control group. This experiment shows that the design of the unemployment
insurance system influences the effort that the unemployed devote to job search.
Several other studies examined search effort by following a group of workers
over time. Unemployment insurance benefits, rather than lasting forever, usually
run out after six months or a year. These studies found that when the unemployed
become ineligible for benefits, the probability of their finding a new job rises
markedly. Thus, receiving unemployment insurance benefits does reduce the
search effort of the unemployed.
unemployment insurance
a government program that partially
protects workers’ incomes when
they become unemployed
590 PART NINE THE REAL ECONOMY IN THE LONG RUN
MANY EUROPEAN COUNTRIES HAVE UNemployment
insurance that is far more
generous than that offered to U.S.
workers, and some economists believe
that these programs explain the high
European unemployment rates. The
following article discusses the recent
debate over unemployment insurance
in Germany.
For Germany,
B e n e f i t s A r e A l s o a Burden
BY ELIZABETH NEUFFER
BERLIN—They grumble and grouse as
they wait for their benefit checks at a
local unemployment office here—about
the lack of jobs, about the stupidity of
German politicians, about how outrageously
high taxes are.
What today’s unemployed Germans
don’t complain about is this: the size of
their benefit checks.
“I get unemployment benefits, I
make some money working on the black
market, I make a living,” says Michael
Steinbach, a 30-year-old electrician who
sports a well-ironed shirt, fashionable
glasses, and a briefcase as he waits his
turn at the Prenzlauer Berg unemployment
office. “For now, it’s comfortable.”
Germany’s social welfare system
takes good care of the jobless, with initial
average monthly checks of nearly
$900 per month for someone married—
and the prospect, for those who know
how to work the system, of remaining on
benefits for life. So blatantly do people
abuse this system that Chancellor Helmut
Kohl once critically described his
country as “Leisurepark Germany.” . . .
Now—partly because . . . such generous
benefits are seriously straining the
nation’s economy—questions are being
raised about whether one way to combat
unemployment is to reform the social
welfare system itself. . . .
Combating unemployment, always a
hot topic here, leapt back into public debate
last week, after the German Labor
office released figures showing that joblessness
inched up to 11.7 percent in
September, the fifth consecutive postwar
record. . . .
The unease here also stems from
memories of when Germany last faced
such levels of joblessness: 1933, when
the unemployed were so desperate they
begged in the streets for spare change,
relied on soup kitchens for meals, and
ushered the Nazis into power.
Postwar Germany’s reaction was to
create a massive welfare state, designed
to squelch social unrest through social
benevolence. “It’s more important to
have modestly happy people on benefits
than poverty and all its side effects such
as a high crime rate as in the United
States,” said Heiner Geissler, a leading
figure in the ruling CDU party.
It is becoming increasingly clear,
though, that preserving benefits has
trapped Germany in something of a vicious
circle.
The nation’s high-cost social welfare
system is one reason its labor costs are
among the highest in the world: Both
employees and employers must pay
generously into the system, so they
need higher wages and profits. More
than half of a worker’s paycheck goes to
taxes. Employer/employee-funded taxes
this year alone totaled 52.8 billion
deutsche marks, or nearly $30 billion.
But high labor costs are a major
reason companies are now fleeing for
cheaper, neighboring Poland—meaning
job losses for Germany. At the same
time, unemployment benefits have become
something of a velvet coffin for the
unemployed, discouraging them from
taking jobs. Until recently, workers who
worked part-time were effectively penalized,
as they would receive less unemployment
benefits if they were laid off.
And generous unemployment benefits
mean there is no incentive to take
part-time or low-paid work—a strategy
adopted to fight unemployment in
other countries, including the United
States. . . .
These benefits are so good that exploiting
them is something of a national
sport. In a recent, and not uncommon,
conversation overheard in a Berlin cafe,
a woman bragged about how she was
using her Sozialhilfe to pay for a vacation
in Italy. Some Germans even register in
several districts, knowing it’s unlikely
they will be caught for receiving multiple
benefits.
Not surprisingly, more than 60 percent
of Germany’s unemployed are longterm
unemployed.
“People are used to, and heavily
rely on, ‘Father State,’ ” said Dieter
Hundt, president of the Confederation of
Germany Employers’ Association. “We
are a bit spoiled by a too tightly woven
social net, which doesn’t encourage the
individual enough to improve his own
situation.”
SOURCE: The Boston Globe, October 12, 1997, p. F1.
IN THE NEWS
German Unemployment
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 591
Even though unemployment insurance reduces search effort and raises unemployment,
we should not necessarily conclude that the policy is a bad one. The
program does achieve its primary goal of reducing the income uncertainty that
workers face. In addition, when workers turn down unattractive job offers, they
have the opportunity to look for jobs that better suit their tastes and skills. Some
economists have argued that unemployment insurance improves the ability of the
economy to match each worker with the most appropriate job.
The study of unemployment insurance shows that the unemployment rate is
an imperfect measure of a nation’s overall level of economic well-being. Most
economists agree that eliminating unemployment insurance would reduce the
amount of unemployment in the economy. Yet economists disagree on whether
economic well-being would be enhanced or diminished by this change in policy.
QUICK QUIZ: How would an increase in the world price of oil affect the
amount of frictional unemployment? Is this unemployment undesirable?
What public policies might affect the amount of unemployment caused by this
price change?
MINIMUM-WAGE LAWS
Having seen how frictional unemployment results from the process of matching
workers and jobs, let’s now examine how structural unemployment results when
the number of jobs is insufficient for the number of workers.
To understand structural unemployment, we begin by reviewing how unemployment
arises from minimum-wage laws—a topic we first analyzed in
Chapter 6. Although minimum wages are not the predominant reason for unemployment
in our economy, they have an important effect on certain groups with
particularly high unemployment rates. Moreover, the analysis of minimum wages
is a natural place to start because, as we will see, it can be used to understand some
of the other reasons for structural unemployment.
Figure 26-4 reviews the basic economics of a minimum wage. When a
minimum-wage law forces the wage to remain above the level that balances supply
and demand, it raises the quantity of labor supplied and reduces the quantity
of labor demanded compared to the equilibrium level. There is a surplus of labor.
Because there are more workers willing to work than there are jobs, some workers
are unemployed.
Because we discussed minimum-wage laws extensively in Chapter 6, we will
not discuss them further here. It is, however, important to note why minimumwage
laws are not a predominant reason for unemployment: Most workers in the
economy have wages well above the legal minimum. Minimum-wage laws are
binding most often for the least skilled and least experienced members of the labor
force, such as teenagers. It is only among these workers that minimum-wage laws
explain the existence of unemployment.
Although Figure 26-4 is drawn to show the effects of a minimum-wage law, it
also illustrates a more general lesson: If the wage is kept above the equilibrium level for
any reason, the result is unemployment. Minimum-wage laws are just one reason why
592 PART NINE THE REAL ECONOMY IN THE LONG RUN
wages may be “too high.” In the remaining two sections of this chapter, we consider
two other reasons why wages may be kept above the equilibrium level—
unions and efficiency wages. The basic economics of unemployment in these cases
is the same as that shown in Figure 26-4, but these explanations of unemployment
can apply to many more of the economy’s workers.
At this point, however, we should stop and notice that the structural unemployment
that arises from an above-equilibrium wage is, in an important sense,
different from the frictional unemployment that arises from the process of job
search. The need for job search is not due to the failure of wages to balance labor
supply and labor demand. When job search is the explanation for unemployment,
workers are searching for the jobs that best suit their tastes and skills. By contrast,
when the wage is above the equilibrium level, the quantity of labor supplied exceeds
the quantity of labor demanded, and workers are unemployed because they
are waiting for jobs to open up.
QUICK QUIZ: Draw the supply curve and the demand curve for a labor
market in which the wage is fixed above the equilibrium level. Show the
quantity of labor supplied, the quantity demanded, and the amount of
unemployment.
UNIONS AND COLLECTIVE BARGAINING
A union is a worker association that bargains with employers over wages and
working conditions. Whereas only 16 percent of U.S. workers now belong to
WE
Quantity of
Labor
0 LE
Surplus of labor
Unemployment
Labor
supply
Labor
demand
Wage
Minimum
wage
LD LS
Figure 26-4
UNEMPLOYMENT FROM A
WAGE ABOVE THE EQUILIBRIUM
LEVEL. In this labor market,
the wage at which supply and
demand balance is WE. At this
equilibrium wage, the quantity of
labor supplied and the quantity
of labor demanded both equal LE.
By contrast, if the wage is forced
to remain above the equilibrium
level, perhaps because of a
minimum-wage law, the quantity
of labor supplied rises to LS, and
the quantity of labor demanded
falls to LD. The resulting surplus
of labor, LS–LD, represents
unemployment.
union
a worker association that bargains
with employers over wages and
working conditions
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 593
unions, unions played a much larger role in the U.S. labor market in the past. In
the 1940s and 1950s, when unions were at their peak, about a third of the U.S. labor
force was unionized. Moreover, unions continue to play a large role in many
European countries. In Sweden and Denmark, for instance, more than threefourths
of workers belong to unions.
THE ECONOMICS OF UNIONS
A union is a type of cartel. Like any cartel, a union is a group of sellers acting together
in the hope of exerting their joint market power. Most workers in the U.S.
economy discuss their wages, benefits, and working conditions with their employers
as individuals. By contrast, workers in a union do so as a group. The
process by which unions and firms agree on the terms of employment is called collective
bargaining.
When a union bargains with a firm, it asks for higher wages, better benefits,
and better working conditions than the firm would offer in the absence of a union.
If the union and the firm do not reach agreement, the union can organize a withdrawal
of labor from the firm, called a strike. Because a strike reduces production,
sales, and profit, a firm facing a strike threat is likely to agree to pay higher wages
than it otherwise would. Economists who study the effects of unions typically find
that union workers earn about 10 to 20 percent more than similar workers who do
not belong to unions.
When a union raises the wage above the equilibrium level, it raises the quantity
of labor supplied and reduces the quantity of labor demanded, resulting in unemployment.
Those workers who remain employed are better off, but those who
were previously employed and are now unemployed at the higher wage are worse
off. Indeed, unions are often thought to cause conflict between different groups of
workers—between the insiders who benefit from high union wages and the outsiders
who do not get the union jobs.
The outsiders can respond to their status in one of two ways. Some of them
remain unemployed and wait for the chance to become insiders and earn the high
union wage. Others take jobs in firms that are not unionized. Thus, when unions
raise wages in one part of the economy, the supply of labor increases in other parts
of the economy. This increase in labor supply, in turn, reduces wages in industries
that are not unionized. In other words, workers in unions reap the benefit of collective
bargaining, while workers not in unions bear some of the cost.
The role of unions in the economy depends in part on the laws that govern
union organization and collective bargaining. Normally, explicit agreements
among members of a cartel are illegal. If firms that sell a common product were to
agree to set a high price for that product, the agreement would be a “conspiracy in
restraint of trade.” The government would prosecute these firms in civil and criminal
court for violating the antitrust laws. By contrast, unions are exempt from
these laws. The policymakers who wrote the antitrust laws believed that workers
needed greater market power as they bargained with employers. Indeed, various
laws are designed to encourage the formation of unions. In particular, the Wagner
Act of 1935 prevents employers from interfering when workers try to organize
unions and requires employers to bargain with unions in good faith. The National
Labor Relations Board (NLRB) is the government agency that enforces workers’
right to unionize.
collective bargaining
the process by which unions
and firms agree on the
terms of employment
strike
the organized withdrawal of
labor from a firm by a union
594 PART NINE THE REAL ECONOMY IN THE LONG RUN
Legislation affecting the market power of unions is a perennial topic of political
debate. State lawmakers sometimes debate right-to-work laws, which give workers
in a unionized firm the right to choose whether to join the union. In the absence
of such laws, unions can insist during collective bargaining that firms make union
membership a requirement for employment. In recent years, lawmakers in Washington
have debated a proposed law that would prevent firms from hiring permanent
replacements for workers who are on strike. This law would make strikes
more costly for firms and, thereby, would increase the market power of unions.
These and similar policy decisions will help determine the future of the union
movement.
ARE UNIONS GOOD OR BAD FOR THE ECONOMY?
Economists disagree about whether unions are good or bad for the economy as a
whole. Let’s consider both sides of the debate.
Critics of unions argue that unions are merely a type of cartel. When unions
raise wages above the level that would prevail in competitive markets, they reduce
the quantity of labor demanded, cause some workers to be unemployed, and reduce
the wages in the rest of the economy. The resulting allocation of labor is, critics
argue, both inefficient and inequitable. It is inefficient because high union
wages reduce employment in unionized firms below the efficient, competitive
level. It is inequitable because some workers benefit at the expense of other
workers.
“Gentlemen, nothing stands in the way of a final accord except that management
wants profit maximization and the union wants more moola.”
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 595
SOMEDAY YOU MAY FACE THE DECISION
about whether to vote for or against a
union in your workplace. The following
article discusses some issues you
might consider.
On Payday,
Union Jobs S t a c k Up Very We l l
BY DAVID CAY JOHNSTON
With the teamsters’ success in their
two-week strike against United Parcel
Service, and with the A.F.L.-C.I.O. training
thousands of union organizers in a
drive to reverse a quarter-century of declining
membership, millions of workers
will be asked over the next few years
whether they want a union to represent
them.
It is a complicated question, the answer
to which rests on a jumble of determinations:
Do you favor collective action
or individual initiative? Do you trust the
union’s leaders? Do you want somebody
else speaking for you in dealings with
your employer? Do you think you will be
dismissed if you sign a union card—or
that the company will send your job overseas
if a union is organized?
But in one regard, the choice is simple—
and it is not the choice that most
workers have made during the labor
movement’s recent decades in the economic
wilderness.
From a pocketbook perspective,
workers are absolutely better off joining
a union. Economists across the political
spectrum agree. Turning a nonunion job
into a union job very likely will have a bigger
effect on lifetime finances than all the
advice employees will ever read about investing
their 401(k) plans, buying a
home or otherwise making more of what
they earn.
Here is how the equation works,
said Prof. Richard B. Freeman of Harvard
University: “For an existing worker in a
firm, if you can carry out an organizing
drive, it is all to your benefit. If there are
going to be losers, they are people who
might have gotten a job in the future, the
shareholders whose profits will go down,
the managers because there will be less
profit to distribute to them in pay and,
maybe, consumers will pay a little more
for the product. But as a worker, it is awfully
hard to see why you wouldn’t want a
union.”
Overall, union workers are paid
about 20 percent more than nonunion
workers, and their fringe benefits are
typically worth two to four times as
much, economists with a wide array of
views have found. The financial advantage
is even greater for workers with little
formal education and training and for
women, blacks, and Hispanic workers.
Moreover, 85 percent of union
members have health insurance, compared
with 57 percent of nonunion
workers, said Barry Bluestone, a laborfriendly
economics professor at the University
of Massachusetts.
The conclusion draws no argument
even from Prof. Leo Troy of Rutgers University,
who is widely known in academic
circles and among union leaders for his
hostility to organized labor. “From a
standpoint of wages and fringe benefits,”
Professor Troy said, “the answer is
yes, you are better off in a union.”
His objections to unions concern
how they reduce profits for owners and
distort investment decisions in ways that
slow the overall growth of the economy—
not how they affect workers who
bargain collectively. Professor Troy
points out that he belongs to a union
himself—the American Association of
University Professors.
Donald R. Deere, an economist at
the Bush School of Government and
Public Service at Texas A & M University,
studied the wage differential for comparable
union and nonunion workers between
1974 and 1996, a period when
union membership fell to 15 percent of
American workers from 22 percent.
In every educational and age category
that he studied, Professor Deere
found that union members increased
their wage advantage over nonunion
workers during those years. Last year,
he estimates, unionized workers with
less than a high school education earned
22 percent more than their nonunion
counterparts. The differential declined as
education levels rose, reaching 10 percent
for college graduates.
“It makes sense to belong to a
union,” Professor Deere said, “so long
as you don’t lose your job in the long
term.”
Source: The New York Times, Money & Business
Section, August 31, 1997, p. 1.
IN THE NEWS
Should You Join a Union?
596 PART NINE THE REAL ECONOMY IN THE LONG RUN
Advocates of unions contend that unions are a necessary antidote to the market
power of the firms that hire workers. The extreme case of this market power is
the “company town,” where a single firm does most of the hiring in a geographic
region. In a company town, if workers do not accept the wages and working conditions
that the firm offers, they have little choice but to move or stop working. In
the absence of a union, therefore, the firm could use its market power to pay lower
wages and offer worse working conditions than would prevail if it had to compete
with other firms for the same workers. In this case, a union may balance the
firm’s market power and protect the workers from being at the mercy of the firm
owners.
Advocates of unions also claim that unions are important for helping firms respond
efficiently to workers’ concerns. Whenever a worker takes a job, the worker
and the firm must agree on many attributes of the job in addition to the wage:
hours of work, overtime, vacations, sick leave, health benefits, promotion schedules,
job security, and so on. By representing workers’ views on these issues,
unions allow firms to provide the right mix of job attributes. Even if unions have
the adverse effect of pushing wages above the equilibrium level and causing unemployment,
they have the benefit of helping firms keep a happy and productive
workforce.
In the end, there is no consensus among economists about whether unions are
good or bad for the economy. Like many institutions, their influence is probably
beneficial in some circumstances and adverse in others.
QUICK QUIZ: How does a union in the auto industry affect wages and
employment at General Motors and Ford? How does it affect wages and
employment in other industries?
THE THEORY OF EFFICIENCY WAGES
A fourth reason why economies always experience some unemployment—in addition
to job search, minimum-wage laws, and unions—is suggested by the theory
of efficiency wages. According to this theory, firms operate more efficiently if
wages are above the equilibrium level. Therefore, it may be profitable for firms to
keep wages high even in the presence of a surplus of labor.
In some ways, the unemployment that arises from efficiency wages is similar
to the unemployment that arises from minimum-wage laws and unions. In all
three cases, unemployment is the result of wages above the level that balances the
quantity of labor supplied and the quantity of labor demanded. Yet there is also
an important difference. Minimum-wage laws and unions prevent firms from
lowering wages in the presence of a surplus of workers. Efficiency-wage theory
states that such a constraint on firms is unnecessary in many cases because firms
may be better off keeping wages above the equilibrium level.
Why should firms want to keep wages high? In some ways, this decision
seems odd, for wages are a large part of firms’ costs. Normally, we expect profitmaximizing
firms to want to keep costs—and therefore wages—as low as possible.
ef ficiency wages
above-equilibrium wages paid
by firms in order to increase
worker productivity
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 597
The novel insight of efficiency-wage theory is that paying high wages might be
profitable because they might raise the efficiency of a firm’s workers.
There are several types of efficiency-wage theory. Each type suggests a different
explanation for why firms may want to pay high wages. Let’s now consider
four of these types.
WORKER HEALTH
The first and simplest type of efficiency-wage theory emphasizes the link between
wages and worker health. Better paid workers eat a more nutritious diet, and
workers who eat a better diet are healthier and more productive. A firm may find
it more profitable to pay high wages and have healthy, productive workers than to
pay lower wages and have less healthy, less productive workers.
This type of efficiency-wage theory is not relevant for firms in rich countries
such as the United States. In these countries, the equilibrium wages for most
workers are well above the level needed for an adequate diet. Firms are not
concerned that paying equilibrium wages would place their workers’ health in
jeopardy.
This type of efficiency-wage theory is more relevant for firms in less developed
countries where inadequate nutrition is a more common problem. Unemployment
is high in the cities of many poor African countries, for example. In these
countries, firms may fear that cutting wages would, in fact, adversely influence
their workers’ health and productivity. In other words, concern over nutrition may
explain why firms do not cut wages despite a surplus of labor.
WORKER TURNOVER
A second type of efficiency-wage theory emphasizes the link between wages and
worker turnover. Workers quit jobs for many reasons—to take jobs in other firms,
to move to other parts of the country, to leave the labor force, and so on. The frequency
with which they quit depends on the entire set of incentives they face, including
the benefits of leaving and the benefits of staying. The more a firm pays its
workers, the less often its workers will choose to leave. Thus, a firm can reduce
turnover among its workers by paying them a high wage.
Why do firms care about turnover? The reason is that it is costly for firms to
hire and train new workers. Moreover, even after they are trained, newly hired
workers are not as productive as experienced workers. Firms with higher
turnover, therefore, will tend to have higher production costs. Firms may find it
profitable to pay wages above the equilibrium level in order to reduce worker
turnover.
WORKER EFFORT
A third type of efficiency-wage theory emphasizes the link between wages
and worker effort. In many jobs, workers have some discretion over how hard to
work. As a result, firms monitor the efforts of their workers, and workers caught
598 PART NINE THE REAL ECONOMY IN THE LONG RUN
shirking their responsibilities are fired. But not all shirkers are caught immediately
because monitoring workers is costly and imperfect. A firm can respond to this
problem by paying wages above the equilibrium level. High wages make workers
more eager to keep their jobs and, thereby, give workers an incentive to put forward
their best effort.
This particular type of efficiency-wage theory is similar to the old Marxist idea
of the “reserve army of the unemployed.” Marx thought that employers benefited
from unemployment because the threat of unemployment helped to discipline
those workers who had jobs. In the worker-effort variant of efficiency-wage theory,
unemployment fills a similar role. If the wage were at the level that balanced supply
and demand, workers would have less reason to work hard because if they
were fired, they could quickly find new jobs at the same wage. Therefore, firms
raise wages above the equilibrium level, causing unemployment and providing an
incentive for workers not to shirk their responsibilities.
WORKER QUALITY
A fourth and final type of efficiency-wage theory emphasizes the link between
wages and worker quality. When a firm hires new workers, it cannot perfectly
gauge the quality of the applicants. By paying a high wage, the firm attracts a better
pool of workers to apply for its jobs.
To see how this might work, consider a simple example. Waterwell Company
owns one well and needs one worker to pump water from the well. Two workers,
Bill and Ted, are interested in the job. Bill, a proficient worker, is willing to work
for $10 per hour. Below that wage, he would rather start his own lawn-mowing
business. Ted, a complete incompetent, is willing to work for anything above $2
per hour. Below that wage, he would rather sit on the beach. Economists say that
Bill’s reservation wage—the lowest wage he would accept—is $10, and Ted’s reservation
wage is $2.
What wage should the firm set? If the firm were interested in minimizing
labor costs, it would set the wage at $2 per hour. At this wage, the quantity of
workers supplied (one) would balance the quantity demanded. Ted would take
the job, and Bill would not apply for it. Yet suppose Waterwell knows that only
one of these two applicants is competent, but it does not know whether it is Bill or
Ted. If the firm hires the incompetent worker, he will damage the well, causing
the firm huge losses. In this case, the firm has a better strategy than paying the
DILBERT® By Scott Adams
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 599
equilibrium wage of $2 and hiring Ted. It can offer $10 per hour, inducing both Bill
and Ted to apply for the job. By choosing randomly between these two applicants
and turning the other away, the firm has a fifty-fifty chance of hiring the competent
one. By contrast, if the firm offers any lower wage, it is sure to hire the incompetent
worker.
In many situations in life, information
is asymmetric: One
person in a transaction knows
more about what is going on
than the other person. This
possibility raises a variety of
interesting problems for economic
theory. Some of these
problems were highlighted in
our description of the theory of
efficiency wages. These problems,
however, go beyond the
study of unemployment.
The worker-quality variant
of efficiency-wage theory illustrates
a general principle called adverse selection. Adverse
selection arises when one person knows more about the attributes
of a good than another and, as a result, the uninformed
person runs the risk of being sold a good of low
quality. In the case of worker quality, for instance, workers
have better information about their own abilities than firms
do. When a firm cuts the wage it pays, the selection of workers
changes in a way that is adverse to the firm.
Adverse selection arises in many other circumstances.
Here are two examples:
Sellers of used cars know their vehicles’ defects,
whereas buyers often do not. Because owners of the
worst cars are more likely to sell them than are the
owners of the best cars, buyers are correctly apprehensive
about getting a “lemon.” As a result, many people
avoid buying cars in the used car market.
Buyers of health insurance know more about their own
health problems than do insurance companies. Because
people with greater hidden health problems are
more likely to buy health insurance than are other people,
the price of health insurance reflects the costs of a
sicker-than-average person. As a result, people with average
health problems are discouraged by the high
price from buying health insurance.
In each case, the market for the product—used cars or
health insurance—does not work as well as it might because
of the problem of adverse selection.
Similarly, the worker-effort variant of efficiency-wage
theory illustrates a general phenomenon called moral hazard.
Moral hazard arises when one person, called the agent,
is performing some task on behalf of another person, called
the principal. Because the principal cannot perfectly monitor
the agent’s behavior, the agent tends to undertake less effort
than the principal considers desirable. The term moral
hazard refers to the risk of dishonest or otherwise inappropriate
behavior by the agent. In such a situation, the principal
tries various ways to encourage the agent to act more
responsibly.
In an employment relationship, the firm is the principal
and the worker is the agent. The moral-hazard problem is
the temptation of imperfectly monitored workers to shirk
their responsibilities. According to the worker-effort variant
of efficiency-wage theory, the principal can encourage the
agent not to shirk by paying a wage above the equilibrium
level because then the agent has more to lose if caught
shirking. In this way, high wages reduce the problem of
moral hazard.
Moral hazard arises in many other situations. Here are
some examples:
A homeowner with fire insurance buys too few fire extinguishers.
The reason is that the homeowner bears
the cost of the extinguisher while the insurance company
receives much of the benefit.
A babysitter allows children to watch more television
than the parents of the children prefer. The reason is
that more educational activities require more energy
from the babysitter, even though they are beneficial for
the children.
A family lives near a river with a high risk of flooding.
The reason it continues to live there is that the family
enjoys the scenic views, and the government will bear
part of the cost when it provides disaster relief after
a flood.
Can you identify the principal and the agent in each of these
three situations? How do you think the principal in each
case might solve the problem of moral hazard?
FYI
The Economics
of Asymmetric
Information
600 PART NINE THE REAL ECONOMY IN THE LONG RUN
CASE STUDY HENRY FORD AND THE VERY GENEROUS
$5-A-DAY WAGE
Henry Ford was an industrial visionary. As founder of the Ford Motor Company,
he was responsible for introducing modern techniques of production.
Rather than building cars with small teams of skilled craftsmen, Ford built cars
on assembly lines in which unskilled workers were taught to perform the same
simple tasks over and over again. The output of this assembly process was the
Model T Ford, one of the most famous early automobiles.
In 1914, Ford introduced another innovation: the $5 workday. This might
not seem like much today, but back then $5 was about twice the going wage. It
was also far above the wage that balanced supply and demand. When the new
$5-a-day wage was announced, long lines of job seekers formed outside the
Ford factories. The number of workers willing to work at this wage far exceeded
the number of workers Ford needed.
Ford’s high-wage policy had many of the effects predicted by efficiencywage
theory. Turnover fell, absenteeism fell, and productivity rose. Workers
were so much more efficient that Ford’s production costs were lower even
though wages were higher. Thus, paying a wage above the equilibrium level
This story illustrates a general phenomenon. When a firm faces a surplus of
workers, it might seem profitable to reduce the wage it is offering. But by reducing
the wage, the firm induces an adverse change in the mix of workers. In this case,
at a wage of $10, Waterwell has two workers applying for one job. But if Waterwell
responds to this labor surplus by reducing the wage, the competent worker (who
has better alternative opportunities) will not apply. Thus, it is profitable for the
firm to pay a wage above the level that balances supply and demand.
WORKERS OUTSIDE AN EARLY FORD FACTORY
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 601
was profitable for the firm. Henry Ford himself called the $5-a-day wage “one
of the finest cost-cutting moves we ever made.”
Historical accounts of this episode are also consistent with efficiency-wage
theory. An historian of the early Ford Motor Company wrote, “Ford and his associates
freely declared on many occasions that the high-wage policy turned out
to be good business. By this they meant that it had improved the discipline of
the workers, given them a more loyal interest in the institution, and raised their
personal efficiency.”
Why did it take Henry Ford to introduce this efficiency wage? Why were
other firms not already taking advantage of this seemingly profitable business
strategy? According to some analysts, Ford’s decision was closely linked to his
use of the assembly line. Workers organized in an assembly line are highly interdependent.
If one worker is absent or works slowly, other workers are less
able to complete their own tasks. Thus, while assembly lines made production
more efficient, they also raised the importance of low worker turnover, high
worker quality, and high worker effort. As a result, paying efficiency wages
may have been a better strategy for the Ford Motor Company than for other
businesses at the time.
QUICK QUIZ: Give four explanations for why firms might find it
profitable to pay wages above the level that balances quantity of labor
supplied and quantity of labor demanded.
CONCLUSION
In this chapter we discussed the measurement of unemployment and the reasons
why economies always experience some degree of unemployment. We have seen
how job search, minimum-wage laws, unions, and efficiency wages can all help explain
why some workers do not have jobs. Which of these four explanations for the
natural rate of unemployment are the most important for the U.S. economy and
other economies around the world? Unfortunately, there is no easy way to tell.
Economists differ in which of these explanations of unemployment they consider
most important.
The analysis of this chapter yields an important lesson: Although the economy
will always have some unemployment, its natural rate is not immutable. Many
events and policies can change the amount of unemployment the economy typically
experiences. As the information revolution changes the process of job search,
as Congress adjusts the minimum wage, as workers form or quit unions, and as
firms alter their reliance on efficiency wages, the natural rate of unemployment
evolves. Unemployment is not a simple problem with a simple solution. But how
we choose to organize our society can profoundly influence how prevalent a problem
it is.
602 PART NINE THE REAL ECONOMY IN THE LONG RUN
The unemployment rate is the percentage of those who
would like to work who do not have jobs. The Bureau of
Labor Statistics calculates this statistic monthly based on
a survey of thousands of households.
The unemployment rate is an imperfect measure of
joblessness. Some people who call themselves
unemployed may actually not want to work, and some
people who would like to work have left the labor force
after an unsuccessful search.
In the U.S. economy, most people who become
unemployed find work within a short period of time.
Nonetheless, most unemployment observed at any
given time is attributable to the few people who are
unemployed for long periods of time.
One reason for unemployment is the time it takes for
workers to search for jobs that best suit their tastes and
skills. Unemployment insurance is a government policy
that, while protecting workers’ incomes, increases the
amount of frictional unemployment.
A second reason why our economy always has some
unemployment is minimum-wage laws. By raising the
wage of unskilled and inexperienced workers above the
equilibrium level, minimum-wage laws raise the
quantity of labor supplied and reduce the quantity
demanded. The resulting surplus of labor represents
unemployment.
A third reason for unemployment is the market power
of unions. When unions push the wages in unionized
industries above the equilibrium level, they create a
surplus of labor.
A fourth reason for unemployment is suggested by the
theory of efficiency wages. According to this theory,
firms find it profitable to pay wages above the
equilibrium level. High wages can improve worker
health, lower worker turnover, increase worker effort,
and raise worker quality.
Summary
labor force, p. 581
unemployment rate, p. 582
labor-force participation rate, p. 582
natural rate of unemployment, p. 582
cyclical unemployment, p. 583
discouraged workers, p. 586
frictional unemployment, p. 587
structural unemployment, p. 587
job search, p. 587
unemployment insurance, p. 589
union, p. 592
collective bargaining, p. 593
strike, p. 593
efficiency wages, p. 596
Key Concepts
1. What are the three categories into which the Bureau of
Labor Statistics divides everyone? How does it compute
the labor force, the unemployment rate, and the laborforce
participation rate?
2. Is unemployment typically short-term or long-term?
Explain.
3. Why is frictional unemployment inevitable? How might
the government reduce the amount of frictional
unemployment?
4. Are minimum-wage laws a better explanation for
structural unemployment among teenagers or among
college graduates? Why?
5. How do unions affect the natural rate of
unemployment?
6. What claims do advocates of unions make to argue that
unions are good for the economy?
7. Explain four ways in which a firm might increase its
profits by raising the wages it pays.
Questions for Review
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 603
1. The Bureau of Labor Statistics announced that in
December 1998, of all adult Americans, 138,547,000 were
employed, 6,021,000 were unemployed, and 67,723,000
were not in the labor force. How big was the labor
force? What was the labor-force participation rate?
What was the unemployment rate?
2. As shown in Figure 26-3, the overall labor-force
participation rate of men declined between 1970 and
1990. This overall decline reflects different patterns
for different age groups, however, as shown in the
following table.
MEN MEN MEN
ALLMEN 16–24 25–54 55 AND OVER
1970 80% 69% 96% 56%
1990 76 72 93 40
Which group experienced the largest decline? Given this
information, what factor may have played an important
role in the decline in overall male labor-force
participation over this period?
3. The labor-force participation rate of women increased
sharply between 1970 and 1990, as shown in Figure 26-3.
As with men, however, there were different patterns for
different age groups, as shown in this table.
ALL WOMEN WOMEN WOMEN WOMEN
WOMEN 25-54 25-34 35-44 45-54
1970 43% 50% 45% 51% 54%
1990 58 74 74 77 71
Why do you think that younger women experienced
a bigger increase in labor-force participation than
older women?
4. Between 1997 and 1998, total U.S. employment
increased by 2.1 million workers, but the number of
unemployed workers declined by only 0.5 million.
How are these numbers consistent with each other?
Why might one expect a reduction in the number of
people counted as unemployed to be smaller than the
increase in the number of people employed?
5. Are the following workers more likely to experience
short-term or long-term unemployment? Explain.
a. a construction worker laid off because of
bad weather
b. a manufacturing worker who loses her job at a
plant in an isolated area
c. a stagecoach-industry worker laid off because of
competition from railroads
d. a short-order cook who loses his job when a new
restaurant opens across the street
e. an expert welder with little formal education who
loses her job when the company installs automatic
welding machinery
6. Using a diagram of the labor market, show the effect of
an increase in the minimum wage on the wage paid to
workers, the number of workers supplied, the number
of workers demanded, and the amount of
unemployment.
7. Do you think that firms in small towns or cities have
more market power in hiring? Do you think that firms
generally have more market power in hiring today than
50 years ago, or less? How do you think this change
over time has affected the role of unions in the
economy? Explain.
8. Consider an economy with two labor markets, neither of
which is unionized. Now suppose a union is established
in one market.
a. Show the effect of the union on the market in which
it is formed. In what sense is the quantity of labor
employed in this market an inefficient quantity?
b. Show the effect of the union on the nonunionized
market. What happens to the equilibrium wage in
this market?
9. It can be shown that an industry’s demand for labor will
become more elastic when the demand for the
industry’s product becomes more elastic. Let’s consider
the implications of this fact for the U.S. automobile
industry and the auto workers’ union (the UAW).
a. What happened to the elasticity of demand for
American cars when the Japanese developed
a strong auto industry? What happened to the
elasticity of demand for American autoworkers?
Explain.
b. As the chapter explains, a union generally faces
a tradeoff in deciding how much to raise wages,
because a bigger increase is better for workers
who remain employed but also results in a greater
reduction in employment. How did the rise in auto
imports from Japan affect the wage-employment
tradeoff faced by the UAW?
Problems and Applications
604 PART NINE THE REAL ECONOMY IN THE LONG RUN
c. Do you think the growth of the Japanese auto
industry increased or decreased the gap between
the competitive wage and the wage chosen by the
UAW? Explain.
10. Some workers in the economy are paid a flat salary and
some are paid by commission. Which compensation
scheme would require more monitoring by supervisors?
In which case do firms have an incentive to pay more
than the equilibrium level (as in the worker-effort
variant of efficiency-wage theory)? What factors do you
think determine the type of compensation firms choose?
11. Each of the following situations involves moral hazard.
In each case, identify the principal and the agent, and
explain why there is asymmetric information. How does
the action described reduce the problem of moral
hazard?
a. Landlords require tenants to pay security deposits.
b. Firms compensate top executives with options to
buy company stock at a given price in the future.
c. Car insurance companies offer discounts to
customers who install antitheft devices in their cars.
12. Suppose that the Live-Long-and-Prosper Health
Insurance Company charges $5,000 annually for a
family insurance policy. The company’s president
suggests that the company raise the annual price to
$6,000 in order to increase its profits. If the firm
followed this suggestion, what economic problem might
arise? Would the firm’s pool of customers tend to
become more or less healthy on average? Would the
company’s profits necessarily increase?
13. (This problem is challenging.) Suppose that Congress
passes a law requiring employers to provide employees
some benefit (such as health care) that raises the cost of
an employee by $4 per hour.
a. What effect does this employer mandate have on
the demand for labor? (In answering this and the
following questions, be quantitative when you can.)
b. If employees place a value on this benefit exactly
equal to its cost, what effect does this employer
mandate have on the supply of labor?
c. If the wage is free to balance supply and demand,
how does this law affect the wage and the level of
employment? Are employers better or worse off?
Are employees better or worse off?
d. If a minimum-wage law prevents the wage from
balancing supply and demand, how does the
employer mandate affect the wage, the level of
employment, and the level of unemployment? Are
employers better or worse off? Are employees
better or worse off?
e. Now suppose that workers do not value the
mandated benefit at all. How does this alternative
assumption change your answers to parts (b), (c),
and (d) above?
607
IN THIS CHAPTER
YOU WILL . . .
Examine how the
banking system
helps determine the
supply of money
Consider the nature
of money and its
functions in the
economy
Learn about the
Federal Reserve
System
Examine the tools
used by the Federal
Reserve to alter the
supply of money
When you walk into a restaurant to buy a meal, you get something of value—a full
stomach. To pay for this service, you might hand the restaurateur several worn-out
pieces of greenish paper decorated with strange symbols, government buildings,
and the portraits of famous dead Americans. Or you might hand him a single
piece of paper with the name of a bank and your signature. Whether you pay by
cash or check, the restaurateur is happy to work hard to satisfy your gastronomical
desires in exchange for these pieces of paper which, in and of themselves, are
worthless.
To anyone who has lived in a modern economy, this social custom is not at all
odd. Even though paper money has no intrinsic value, the restaurateur is confident
that, in the future, some third person will accept it in exchange for something
that the restaurateur does value. And that third person is confident that some
fourth person will accept the money, with the knowledge that yet a fifth person
will accept the money . . . and so on. To the restaurateur and to other people in our
society, your cash or check represents a claim to goods and services in the future.
T H E M O N E T A R Y S Y S T E M
608 PART TEN MONEY AND PRICES IN THE LONG RUN
The social custom of using money for transactions is extraordinarily useful in
a large, complex society. Imagine, for a moment, that there was no item in the
economy widely accepted in exchange for goods and services. People would have
to rely on barter—the exchange of one good or service for another—to obtain the
things they need. To get your restaurant meal, for instance, you would have to
offer the restaurateur something of immediate value. You could offer to wash
some dishes, clean his car, or give him your family’s secret recipe for meat loaf. An
economy that relies on barter will have trouble allocating its scarce resources
efficiently. In such an economy, trade is said to require the double coincidence of
wants—the unlikely occurrence that two people each have a good or service that
the other wants.
The existence of money makes trade easier. The restaurateur does not care
whether you can produce a valuable good or service for him. He is happy to accept
your money, knowing that other people will do the same for him. Such a convention
allows trade to be roundabout. The restaurateur accepts your money and uses
it to pay his chef; the chef uses her paycheck to send her child to day care; the day
care center uses this tuition to pay a teacher; and the teacher hires you to mow his
lawn. As money flows from person to person in the economy, it facilitates production
and trade, thereby allowing each person to specialize in what he or she does
best and raising everyone’s standard of living.
In this chapter we begin to examine the role of money in the economy. We discuss
what money is, the various forms that money takes, how the banking system
helps create money, and how the government controls the quantity of money in
circulation. Because money is so important in the economy, we devote much effort
in the rest of this book to learning how changes in the quantity of money affect
various economic variables, including inflation, interest rates, production, and employment.
Consistent with our long-run focus in the previous three chapters, in the
next chapter we will examine the long-run effects of changes in the quantity of
money. The short-run effects of monetary changes are a more complex topic, which
we will take up later in the book. This chapter provides the background for all of
this further analysis.
THE MEANING OF MONEY
What is money? This might seem like an odd question. When you read that billionaire
Bill Gates has a lot of money, you know what that means: He is so rich that
he can buy almost anything he wants. In this sense, the term money is used to mean
wealth.
Economists, however, use the word in a more specific sense: Money is the set
of assets in the economy that people regularly use to buy goods and services from
other people. The cash in your wallet is money because you can use it to buy a
meal at a restaurant or a shirt at a clothing store. By contrast, if you happened to
own most of Microsoft Corporation, as Bill Gates does, you would be wealthy, but
this asset is not considered a form of money. You could not buy a meal or a shirt
with this wealth without first obtaining some cash. According to the economist’s
definition, money includes only those few types of wealth that are regularly
accepted by sellers in exchange for goods and services.
money
the set of assets in an economy that
people regularly use to buy goods
and services from other people
CHAPTER 27 THE MONETARY SYSTEM 609
THE FUNCTIONS OF MONEY
Money has three functions in the economy: It is a medium of exchange, a unit of account,
and a store of value. These three functions together distinguish money from
other assets, such as stocks, bonds, real estate, art, and even baseball cards. Let’s
examine each of these functions of money in turn.
A medium of exchange is an item that buyers give to sellers when they purchase
goods and services. When you buy a shirt at a clothing store, the store gives
you the shirt, and you give the store your money. This transfer of money from
buyer to seller allows the transaction to take place. When you walk into a store,
you are confident that the store will accept your money for the items it is selling
because money is the commonly accepted medium of exchange.
A unit of account is the yardstick people use to post prices and record debts.
When you go shopping, you might observe that a shirt costs $20 and a hamburger
costs $2. Even though it would be accurate to say that the price of a shirt is 10 hamburgers
and the price of a hamburger is 1/10 of a shirt, prices are never quoted in
this way. Similarly, if you take out a loan from a bank, the size of your future loan
repayments will be measured in dollars, not in a quantity of goods and services.
When we want to measure and record economic value, we use money as the unit
of account.
A store of value is an item that people can use to transfer purchasing power
from the present to the future. When a seller accepts money today in exchange for
a good or service, that seller can hold the money and become a buyer of another
good or service at another time. Of course, money is not the only store of value in
the economy, for a person can also transfer purchasing power from the present to
the future by holding other assets. The term wealth is used to refer to the total of all
stores of value, including both money and nonmonetary assets.
Economists use the term liquidity to describe the ease with which an asset can
be converted into the economy’s medium of exchange. Because money is the economy’s
medium of exchange, it is the most liquid asset available. Other assets vary
widely in their liquidity. Most stocks and bonds can be sold easily with small cost,
so they are relatively liquid assets. By contrast, selling a house, a Rembrandt painting,
or a 1948 Joe DiMaggio baseball card requires more time and effort, so these
assets are less liquid.
When people decide in what form to hold their wealth, they have to balance
the liquidity of each possible asset against the asset’s usefulness as a store of value.
Money is the most liquid asset, but it is far from perfect as a store of value. When
prices rise, the value of money falls. In other words, when goods and services become
more expensive, each dollar in your wallet can buy less. This link between
the price level and the value of money will turn out to be important for understanding
how money affects the economy.
THE KINDS OF MONEY
When money takes the form of a commodity with intrinsic value, it is called commodity
money. The term intrinsic value means that the item would have value
even if it were not used as money. One example of commodity money is gold.
Gold has intrinsic value because it is used in industry and in the making of jewelry.
Although today we no longer use gold as money, historically gold has been a
common form of money because it is relatively easy to carry, measure, and verify
medium of exchange
an item that buyers give to sellers
when they want to purchase goods
and services
unit of account
the yardstick people use to post
prices and record debts
store of value
an item that people can use to
transfer purchasing power from the
present to the future
liquidity
the ease with which an asset can be
converted into the economy’s
medium of exchange
commodity money
money that takes the form of a
commodity with intrinsic value
for impurities. When an economy uses gold as money (or uses paper money that
is convertible into gold on demand), it is said to be operating under a gold standard.
610 PART TEN MONEY AND PRICES IN THE LONG RUN
THE ROLE OF SOCIAL CUSTOM IN THE MONetary
system is most apparent in foreign
cultures with customs very
different from our own. The following
article describes the money on the island
of Yap. As you read the article, ask
yourself whether Yap is using a type of
commodity money, a type of fiat
money, or something in between.
F i x e d A s s e t s , o r W h y a L o a n
i n Ya p I s H a r d t o R o l l O v e r
BY ART PINE
YAP, MICRONESIA—On this tiny South Pacific
island, life is easy and the currency
is hard.
Elsewhere, the world’s troubled
monetary system creaks along; floating
exchange rates wreak havoc on currency
markets, and devaluations are commonplace.
But on Yap the currency is as
solid as a rock. In fact, it is rock. Limestone
to be precise.
For nearly 2,000 years the Yapese
have used large stone wheels to pay for
major purchases, such as land, canoes
and permissions to marry. Yap is a U.S.
trust territory, and the dollar is used in
grocery stores and gas stations. But reliance
on stone money, like the island’s
ancient caste system and the traditional
dress of loincloths and grass skirts,
continues.
Buying property with stones is
“much easier than buying it with U.S.
dollars,” says John Chodad, who recently
purchased a building lot with a 30-
inch stone wheel. “We don’t know the
value of the U.S. dollar.” . . .
Stone wheels don’t make good
pocket money, so for small transactions,
Yapese use other forms of currency,
such as beer. Beer is proffered as payment
for all sorts of odd jobs, including
construction. The 10,000 people on Yap
consume 40,000 to 50,000 cases a
year, mostly of Budweiser. . . .
The people of Yap have been using
stone money ever since a Yapese warrior
named Anagumang first brought the
huge stones from limestone caverns on
neighboring Palau, some 1,500 to 2,000
years ago. Inspired by the moon, he
fashioned the stone into large circles.
The rest is history.
Yapese lean the stone wheels
against their houses or prop up rows of
them in village “banks.” Most of the
stones are 2 1/2 to 5 feet in diameter,
but some are as much as 12 feet across.
Each has a hole in the center so it can be
slipped onto the trunk of a fallen betel
nut tree and carried. It takes 20 men to
lift some stones.
By custom, the stones are worthless
when broken. You never hear people
on Yap musing about wanting a piece
of the rock. Rather than risk a broken
stone—or back—Yapese tend to leave
the larger stones where they are and
make a mental accounting that the ownership
has been transferred—much as
gold bars used in international transactions
change hands without leaving the
vaults of the New York Federal Reserve
Bank. . . .
There are some decided advantages
to using massive stones for
money. They are immune to blackmarket
trading, for one thing, and they
pose formidable obstacles to pickpockets.
In addition, there aren’t any
sterile debates about how to stabilize the
Yapese monetary system. With only
6,600 stone wheels remaining on the
island, the money supply stays put. . . .
Meanwhile, Yap’s stone money may
be about to take on international significance.
Just yesterday, Washington received
notice that Tosiho Nakayama, the
president of Micronesia, plans to bring a
stone disk when he visits the United
States next month. It will be flown by Air
Force jet.
Officials say Mr. Nakayama intends
the stone as Micronesia’s symbolic contribution
toward reducing the U.S. budget
deficit.
SOURCE: The Wall Street Journal, March 29, 1984,
p. A1.
IN THE NEWS
Money on the Island of Yap
MONEY ON THE ISLAND OF YAP: NOT EXACTLY
POCKET CHANGE
CHAPTER 27 THE MONETARY SYSTEM 611
Another example of commodity money is cigarettes. In prisoner-of-war camps
during World War II, prisoners traded goods and services with one another using
cigarettes as the store of value, unit of account, and medium of exchange. Similarly,
as the Soviet Union was breaking up in the late 1980s, cigarettes started replacing
the ruble as the preferred currency in Moscow. In both cases, even
nonsmokers were happy to accept cigarettes in an exchange, knowing that they
could use the cigarettes to buy other goods and services.
Money without intrinsic value is called fiat money.Afiat is simply an order or
decree, and fiat money is established as money by government decree. For example,
compare the paper dollars in your wallet (printed by the U.S. government)
and the paper dollars from a game of Monopoly (printed by the Parker Brothers
game company). Why can you use the first to pay your bill at a restaurant but not
the second? The answer is that the U.S. government has decreed its dollars to be
valid money. Each paper dollar in your wallet reads: “This note is legal tender for
all debts, public and private.”
Although the government is central to establishing and regulating a system of
fiat money (by prosecuting counterfeiters, for example), other factors are also required
for the success of such a monetary system. To a large extent, the acceptance
of fiat money depends as much on expectations and social convention as on government
decree. The Soviet government in the 1980s never abandoned the ruble as
the official currency. Yet the people of Moscow preferred to accept cigarettes (or
even American dollars) in exchange for goods and services, because they were
more confident that these alternative monies would be accepted by others in the
future.
MONEY IN THE U.S. ECONOMY
As we will see, the quantity of money circulating in the economy, called the money
stock, has a powerful influence on many economic variables. But before we consider
why that is true, we need to ask a preliminary question: What is the quantity
of money? In particular, suppose you were given the task of measuring how much
money there is in the U.S. economy. What would you include in your measure?
The most obvious asset to include is currency—the paper bills and coins in the
hands of the public. Currency is clearly the most widely accepted medium of exchange
in our economy. There is no doubt that it is part of the money stock.
Yet currency is not the only asset that you can use to buy goods and services.
Many stores also accept personal checks. Wealth held in your checking account is
almost as convenient for buying things as wealth held in your wallet. To measure
the money stock, therefore, you might want to include demand deposits—
balances in bank accounts that depositors can access on demand simply by writing
a check.
Once you start to consider balances in checking accounts as part of the money
stock, you are led to consider the large variety of other accounts that people hold
at banks and other financial institutions. Bank depositors usually cannot write
checks against the balances in their savings accounts, but they can easily transfer
funds from savings into checking accounts. In addition, depositors in money market
mutual funds can often write checks against their balances. Thus, these other
accounts should plausibly be part of the U.S. money stock.
fiat money
money without intrinsic value
that is used as money because
of government decree
currency
the paper bills and coins in the
hands of the public
demand deposits
balances in bank accounts that
depositors can access on demand
by writing a check
“Gee, these new twenties look
just like Monopoly money.”
612 PART TEN MONEY AND PRICES IN THE LONG RUN
CASE STUDY WHERE IS ALL THE CURRENCY?
One puzzle about the money stock of the U.S. economy concerns the amount of
currency. In 1998 there was about $460 billion of currency outstanding. To put
this number in perspective, we can divide it by 205 million, the number of
adults (age sixteen and over) in the United States. This calculation implies that
the average adult holds about $2,240 of currency. Most people are surprised to
learn that our economy has so much currency because they carry far less than
this in their wallets.
Who is holding all this currency? No one knows for sure, but there are two
plausible explanations.
The first explanation is that much of the currency is being held abroad. In
foreign countries without a stable monetary system, people often prefer U.S.
dollars to domestic assets. It is, in fact, not unusual to see U.S. dollars being
used overseas as the medium of exchange, unit of account, and store of value.
The second explanation is that much of the currency is being held by drug
dealers, tax evaders, and other criminals. For most people in the U.S. economy,
In a complex economy such as ours, it is not easy to draw a line between assets
that can be called “money” and assets that cannot. The coins in your pocket are
clearly part of the money stock, and the Empire State Building clearly is not, but
there are many assets in between these extremes for which the choice is less clear.
Therefore, various measures of the money stock are available for the U.S. economy.
Table 27-1 shows the two most important, designated M1 and M2. Each of these
measures uses a slightly different criterion for distinguishing monetary and nonmonetary
assets.
For our purposes in this book, we need not dwell on the differences between
the various measures of money. The important point is that the money stock for the
U.S. economy includes not just currency but also deposits in banks and other financial
institutions that can be readily accessed and used to buy goods and services.
Table 27-1
TWO MEASURES OF THE MONEY
STOCK FOR THE U.S. ECONOMY.
The two most widely followed
measures of the money stock
are M1 and M2.
MEASURE AMOUNT IN 1998 WHAT’S INCLUDED
M1 $1,092 billion Currency
Traveler’s checks
Demand deposits
Other checkable deposits
M2 $4,412 billion Everything in M1
Savings deposits
Small time deposits
Money market mutual funds
A few minor categories
SOURCE: Federal Reserve.
CHAPTER 27 THE MONETARY SYSTEM 613
currency is not a particularly good way to hold wealth. Not only can currency
be lost or stolen, but it also does not earn interest, whereas a bank deposit does.
Thus, most people hold only small amounts of currency. By contrast, criminals
may avoid putting their wealth in banks, because a bank deposit gives police a
paper trail with which to trace their illegal activities. For criminals, currency
may be the best store of value available.
QUICK QUIZ: List and describe the three functions of money.
THE FEDERAL RESERVE SYSTEM
Whenever an economy relies on a system of fiat money, as the U.S. economy does,
some agency must be responsible for regulating the system. In the United States,
that agency is the Federal Reserve, often simply called the Fed. If you look at the
top of a dollar bill, you will see that it is called a “Federal Reserve Note.” The Fed
is an example of a central bank—an institution designed to oversee the banking
system and regulate the quantity of money in the economy. Other major central
It might seem natural to include
credit cards as part of
the economy’s stock of money.
After all, people use credit
cards to make many of
their purchases. Aren’t credit
cards, therefore, a medium of
exchange?
Although at first this argument
may seem persuasive,
credit cards are excluded from
all measures of the quantity of
money. The reason is that
credit cards are not really a
method of payment but a method of deferring payment.
When you buy a meal with a credit card, the bank that issued
the card pays the restaurant what it is due. At a later
date, you will have to repay the bank (perhaps with interest).
When the time comes to pay your credit card bill, you will
probably do so by writing a check against your checking account.
The balance in this checking account is part of the
economy’s stock of money.
Notice that credit cards are very different from debit
cards, which automatically withdraw funds from a bank
account to pay for
items bought. Rather
than allowing the user
to postpone payment
for a purchase, a
debit card allows the
user immediate access
to deposits in a
bank account. In this
sense, a debit card is
more similar to a
check than to a credit
card. The account balances that lie behind debit cards are
included in measures of the quantity of money.
Even though credit cards are not considered a form of
money, they are nonetheless important for analyzing the
monetary system. People who have credit cards can pay
many of their bills all at once at the end of the month, rather
than sporadically as they make purchases. As a result, people
who have credit cards probably hold less money on
average than people who do not have credit cards. Thus, the
introduction and increased popularity of credit cards may
reduce the amount of money that people choose to hold.
IS THIS MONEY?
Federal Reser ve (Fed)
the central bank of the United States
FYI
Credit Cards,
Debit Cards,
and Money
central bank
an institution designed to oversee
the banking system and regulate the
quantity of money in the economy
614 PART TEN MONEY AND PRICES IN THE LONG RUN
banks around the world include the Bank of England, the Bank of Japan, and the
European Central Bank.
THE FED’S ORGANIZATION
The Federal Reserve was created in 1914, after a series of bank failures in 1907 convinced
Congress that the United States needed a central bank to ensure the health
of the nation’s banking system. Today, the Fed is run by its Board of Governors,
which has seven members appointed by the president of the United States and
confirmed by the Senate. The governors have 14-year terms. Just as federal judges
are given lifetime appointments to insulate them from politics, Fed governors are
given long terms to give them independence from short-term political pressures
when they formulate monetary policy.
Among the seven members of the Board of Governors, the most important is
the chairman. The chairman directs the Fed staff, presides over board meetings,
and testifies regularly about Fed policy in front of congressional committees. The
president appoints the chairman to a four-year term. As this book was going to
press, the chairman of the Fed was Alan Greenspan, who was originally appointed
in 1987 by President Reagan and later reappointed by Presidents Bush and
Clinton.
The Federal Reserve System is made up of the Federal Reserve Board in Washington,
D.C., and 12 regional Federal Reserve Banks located in major cities around
the country. The presidents of the regional banks are chosen by each bank’s board
of directors, whose members are typically drawn from the region’s banking and
business community.
The Fed has two related jobs. The first job is to regulate banks and ensure the
health of the banking system. This task is largely the responsibility of the regional
Federal Reserve Banks. In particular, the Fed monitors each bank’s financial condition
and facilitates bank transactions by clearing checks. It also acts as a bank’s
bank. That is, the Fed makes loans to banks when banks themselves want to borrow.
When financially troubled banks find themselves short of cash, the Fed acts
as a lender of last resort—a lender to those who cannot borrow anywhere else—in
order to maintain stability in the overall banking system.
The Fed’s second and more important job is to control the quantity of money
that is made available in the economy, called the money supply. Decisions by
policymakers concerning the money supply constitute monetary policy. At the
Federal Reserve, monetary policy is made by the Federal Open Market Committee
(FOMC). The FOMC meets about every six weeks in Washington, D.C., to discuss
the condition of the economy and consider changes in monetary policy.
THE FEDERAL OPEN MARKET COMMITTEE
The Federal Open Market Committee is made up of the seven members of the
Board of Governors and five of the 12 regional bank presidents. All 12 regional
presidents attend each FOMC meeting, but only five get to vote. The five with voting
rights rotate among the 12 regional presidents over time. The president of the
New York Fed always gets a vote, however, because New York is the traditional
money supply
the quantity of money available
in the economy
monetary policy
the setting of the money supply by
policymakers in the central bank
CHAPTER 27 THE MONETARY SYSTEM 615
financial center of the U.S. economy and because all Fed purchases and sales of
government bonds are conducted at the New York Fed’s trading desk.
Through the decisions of the FOMC, the Fed has the power to increase or decrease
the number of dollars in the economy. In simple metaphorical terms, you
can imagine the Fed printing up dollar bills and dropping them around the country
by helicopter. Similarly, you can imagine the Fed using a giant vacuum cleaner
to suck dollar bills out of people’s wallets. Although in practice the Fed’s methods
for changing the money supply are more complex and subtle than this, the
helicopter-vacuum metaphor is a good first approximation to the meaning of
monetary policy.
We discuss later in this chapter how the Fed actually changes the money supply,
but it is worth noting here that the Fed’s primary tool is open-market operations—
the purchase and sale of U.S. government bonds. (Recall that a U.S.
government bond is a certificate of indebtedness of the federal government.) If the
FOMC decides to increase the money supply, the Fed creates dollars and uses
them to buy government bonds from the public in the nation’s bond markets.
After the purchase, these dollars are in the hands of the public. Thus, an openmarket
purchase of bonds by the Fed increases the money supply. Conversely, if
the FOMC decides to decrease the money supply, the Fed sells government bonds
from its portfolio to the public in the nation’s bond markets. After the sale, the dollars
it receives for the bonds are out of the hands of the public. Thus, an openmarket
sale of bonds by the Fed decreases the money supply.
The Fed is an important institution because changes in the money supply can
profoundly affect the economy. One of the Ten Principles of Economics in Chapter 1
is that prices rise when the government prints too much money. Another of the
Ten Principles of Economics is that society faces a short-run tradeoff between inflation
and unemployment. The power of the FOMC rests on these principles. For
reasons we discuss more fully in the coming chapters, the FOMC’s policy decisions
have an important influence on the economy’s rate of inflation in the long
run and the economy’s employment and production in the short run. Indeed, the
chairman of the Federal Reserve has been called the second most powerful person
in the United States.
QUICK QUIZ: What are the primary responsibilities of the Federal
Reserve? If the Fed wants to increase the supply of money, how does it
usually do it?
BANKS AND THE MONEY SUPPLY
So far we have introduced the concept of “money” and discussed how the Federal
Reserve controls the supply of money by buying and selling government bonds in
open-market operations. Although this explanation of the money supply is correct,
it is not complete. In particular, it omits the central role that banks play in the monetary
system.
616 PART TEN MONEY AND PRICES IN THE LONG RUN
Recall that the amount of money you hold includes both currency (the bills in
your wallet and coins in your pocket) and demand deposits (the balance in your
checking account). Because demand deposits are held in banks, the behavior of
banks can influence the quantity of demand deposits in the economy and, therefore,
the money supply. This section examines how banks affect the money supply
and how they complicate the Fed’s job of controlling the money supply.
THE SIMPLE CASE OF 100-PERCENT-RESERVE BANKING
To see how banks influence the money supply, it is useful to imagine first a world
without any banks at all. In this simple world, currency is the only form of money.
To be concrete, let’s suppose that the total quantity of currency is $100. The supply
of money is, therefore, $100.
Now suppose that someone opens a bank, appropriately called First National
Bank. First National Bank is only a depository institution—that is, it accepts deposits
but does not make loans. The purpose of the bank is to give depositors a
safe place to keep their money. Whenever a person deposits some money, the bank
keeps the money in its vault until the depositor comes to withdraw it or writes a
check against his or her balance. Deposits that banks have received but have not
loaned out are called reserves. In this imaginary economy, all deposits are held as
reserves, so this system is called 100-percent-reserve banking.
We can express the financial position of First National Bank with a T-account,
which is a simplified accounting statement that shows changes in a bank’s assets
and liabilities. Here is the T-account for First National Bank if the economy’s entire
$100 of money is deposited in the bank:
FIRST NATIONAL BANK
ASSETS LIABILITIES
Reserves $100.00 Deposits $100.00
”I’ve heard a lot about money, and now I’d like to try some.”
reserves
deposits that banks have received but
have not loaned out
CHAPTER 27 THE MONETARY SYSTEM 617
On the left-hand side of the T-account are the bank’s assets of $100 (the reserves it
holds in its vaults). On the right-hand side of the T-account are the bank’s liabilities
of $100 (the amount it owes to its depositors). Notice that the assets and liabilities
of First National Bank exactly balance.
Now consider the money supply in this imaginary economy. Before First National
Bank opens, the money supply is the $100 of currency that people are holding.
After the bank opens and people deposit their currency, the money supply is
the $100 of demand deposits. (There is no longer any currency outstanding, for it
is all in the bank vault.) Each deposit in the bank reduces currency and raises demand
deposits by exactly the same amount, leaving the money supply unchanged.
Thus, if banks hold all deposits in reserve, banks do not influence the supply of money.
MONEY CREATION WITH FRACTIONAL-RESERVE BANKING
Eventually, the bankers at First National Bank may start to reconsider their policy
of 100-percent-reserve banking. Leaving all that money sitting idle in their vaults
seems unnecessary. Why not use some of it to make loans? Families buying
houses, firms building new factories, and students paying for college would all be
happy to pay interest to borrow some of that money for a while. Of course, First
National Bank has to keep some reserves so that currency is available if depositors
want to make withdrawals. But if the flow of new deposits is roughly the same as
the flow of withdrawals, First National needs to keep only a fraction of its deposits
in reserve. Thus, First National adopts a system called fractional-reserve banking.
The fraction of total deposits that a bank holds as reserves is called the reserve
ratio. This ratio is determined by a combination of government regulation and
bank policy. As we discuss more fully later in the chapter, the Fed places a minimum
on the amount of reserves that banks hold, called a reserve requirement. In addition,
banks may hold reserves above the legal minimum, called excess reserves, so
they can be more confident that they will not run short of cash. For our purpose
here, we just take reserve ratio as given and examine what fractional-reserve banking
means for the money supply.
Let’s suppose that First National has a reserve ratio of 10 percent. This means
that it keeps 10 percent of its deposits in reserve and loans out the rest. Now let’s
look again at the bank’s T-account:
FIRST NATIONAL BANK
ASSETS LIABILITIES
Reserves $10.00 Deposits $100.00
Loans 90.00
First National still has $100 in liabilities because making the loans did not alter the
bank’s obligation to its depositors. But now the bank has two kinds of assets: It has
$10 of reserves in its vault, and it has loans of $90. (These loans are liabilities of the
people taking out the loans but they are assets of the bank making the loans, because
the borrowers will later repay the bank.) In total, First National’s assets still
equal its liabilities.
Once again consider the supply of money in the economy. Before First
National makes any loans, the money supply is the $100 of deposits in the bank.
fractional-reser ve banking
a banking system in which banks
hold only a fraction of deposits
as reserves
reser ve ratio
the fraction of deposits that
banks hold as reserves
618 PART TEN MONEY AND PRICES IN THE LONG RUN
Yet when First National makes these loans, the money supply increases. The
depositors still have demand deposits totaling $100, but now the borrowers hold
$90 in currency. The money supply (which equals currency plus demand deposits)
equals $190. Thus, when banks hold only a fraction of deposits in reserve, banks create
money.
At first, this creation of money by fractional-reserve banking may seem too
good to be true because it appears that the bank has created money out of thin air.
To make this creation of money seem less miraculous, note that when First National
Bank loans out some of its reserves and creates money, it does not create any
wealth. Loans from First National give the borrowers some currency and thus the
ability to buy goods and services. Yet the borrowers are also taking on debts, so
the loans do not make them any richer. In other words, as a bank creates the asset
of money, it also creates a corresponding liability for its borrowers. At the end
of this process of money creation, the economy is more liquid in the sense that
there is more of the medium of exchange, but the economy is no wealthier than
before.
THE MONEY MULTIPLIER
The creation of money does not stop with First National Bank. Suppose the borrower
from First National uses the $90 to buy something from someone who then
deposits the currency in Second National Bank. Here is the T-account for Second
National Bank:
SECOND NATIONAL BANK
ASSETS LIABILITIES
Reserves $ 9.00 Deposits $90.00
Loans 81.00
After the deposit, this bank has liabilities of $90. If Second National also has a reserve
ratio of 10 percent, it keeps assets of $9 in reserve and makes $81 in loans.
In this way, Second National Bank creates an additional $81 of money. If this $81
is eventually deposited in Third National Bank, which also has a reserve ratio of
10 percent, this bank keeps $8.10 in reserve and makes $72.90 in loans. Here is the
T-account for Third National Bank:
THIRD NATIONAL BANK
ASSETS LIABILITIES
Reserves $ 8.10 Deposits $81.00
Loans 72.90
The process goes on and on. Each time that money is deposited and a bank loan is
made, more money is created.
CHAPTER 27 THE MONETARY SYSTEM 619
How much money is eventually created in this economy? Let’s add it up:
Original deposit $ 100.00
First National lending $ 90.00 [ .9 $100.00]
Second National lending $ 81.00 [ .9 $90.00]
Third National lending $ 72.90 [ .9 $81.00]
• •
• •
• •
Total money supply $1,000.00
It turns out that even though this process of money creation can continue forever,
it does not create an infinite amount of money. If you laboriously add the infinite
sequence of numbers in the foregoing example, you find the $100 of reserves generates
$1,000 of money. The amount of money the banking system generates with
each dollar of reserves is called the money multiplier. In this imaginary economy,
where the $100 of reserves generates $1,000 of money, the money multiplier is 10.
What determines the size of the money multiplier? It turns out that the answer
is simple: The money multiplier is the reciprocal of the reserve ratio. If R is the reserve
ratio for all banks in the economy, then each dollar of reserves generates 1/R dollars
of money. In our example, R 1/10, so the money multiplier is 10.
This reciprocal formula for the money multiplier makes sense. If a bank holds
$1,000 in deposits, then a reserve ratio of 1/10 (10 percent) means that the bank
must hold $100 in reserves. The money multiplier just turns this idea around: If the
banking system as a whole holds a total of $100 in reserves, it can have only $1,000
in deposits. In other words, if R is the ratio of reserves to deposits at each bank
(that is, the reserve ratio), then the ratio of deposits to reserves in the banking system
(that is, the money multiplier) must be 1/R.
This formula shows how the amount of money banks create depends on the
reserve ratio. If the reserve ratio were only 1/20 (5 percent), then the banking system
would have 20 times as much in deposits as in reserves, implying a money
multiplier of 20. Each dollar of reserves would generate $20 of money. Similarly, if
the reserve ratio were 1/5 (20 percent), deposits would be 5 times reserves, the
money multiplier would be 5, and each dollar of reserves would generate $5 of
money. Thus, the higher the reserve ratio, the less of each deposit banks loan out, and the
smaller the money multiplier. In the special case of 100-percent-reserve banking, the
reserve ratio is 1, the money multiplier is 1, and banks do not make loans or create
money.
THE FED’S TOOLS OF MONETARY CONTROL
As we have already discussed, the Federal Reserve is responsible for controlling
the supply of money in the economy. Now that we understand how fractionalreserve
banking works, we are in a better position to understand how the Fed carries
out this job. Because banks create money in a system of fractional-reserve
banking, the Fed’s control of the money supply is indirect. When the Fed decides
to change the money supply, it must consider how its actions will work through
the banking system.
The Fed has three tools in its monetary toolbox: open-market operations,
reserve requirements, and the discount rate. Let’s discuss how the Fed uses each of
these tools.
money multiplier
the amount of money the
banking system generates
with each dollar of reserves
620 PART TEN MONEY AND PRICES IN THE LONG RUN
Open-Market Operations As we noted earlier, the Fed conducts openmarket
operations when it buys or sells government bonds from the public. To increase
the money supply, the Fed instructs its bond traders at the New York Fed to
buy bonds in the nation’s bond markets. The dollars the Fed pays for the bonds increase
the number of dollars in circulation. Some of these new dollars are held as
currency, and some are deposited in banks. Each new dollar held as currency increases
the money supply by exactly $1. Each new dollar deposited in a bank increases
the money supply to an even greater extent because it increases reserves
and, thereby, the amount of money that the banking system can create.
To reduce the money supply, the Fed does just the opposite: It sells government
bonds to the public in the nation’s bond markets. The public pays for these
bonds with its holdings of currency and bank deposits, directly reducing the
amount of money in circulation. In addition, as people make withdrawals from
banks, banks find themselves with a smaller quantity of reserves. In response,
banks reduce the amount of lending, and the process of money creation reverses
itself.
Open-market operations are easy to conduct. In fact, the Fed’s purchases and
sales of government bonds in the nation’s bond markets are similar to the transactions
that any individual might undertake for his own portfolio. (Of course, when
an individual buys or sells a bond, money changes hands, but the amount of
money in circulation remains the same.) In addition, the Fed can use open-market
operations to change the money supply by a small or large amount on any day
without major changes in laws or bank regulations. Therefore, open-market operations
are the tool of monetary policy that the Fed uses most often.
Reserve Requirements The Fed also influences the money supply with
reserve requirements, which are regulations on the minimum amount of reserves
that banks must hold against deposits. Reserve requirements influence how much
money the banking system can create with each dollar of reserves. An increase in
reserve requirements means that banks must hold more reserves and, therefore,
can loan out less of each dollar that is deposited; as a result, it raises the reserve ratio,
lowers the money multiplier, and decreases the money supply. Conversely, a
decrease in reserve requirements lowers the reserve ratio, raises the money multiplier,
and increases the money supply.
The Fed uses changes in reserve requirements only rarely because frequent
changes would disrupt the business of banking. When the Fed increases reserve
requirements, for instance, some banks find themselves short of reserves, even
though they have seen no change in deposits. As a result, they have to curtail lending
until they build their level of reserves to the new required level.
The Discount Rate The third tool in the Fed’s toolbox is the discount rate,
the interest rate on the loans that the Fed makes to banks. Abank borrows from the
Fed when it has too few reserves to meet reserve requirements. This might occur
because the bank made too many loans or because it has experienced recent withdrawals.
When the Fed makes such a loan to a bank, the banking system has more
reserves than it otherwise would, and these additional reserves allow the banking
system to create more money.
The Fed can alter the money supply by changing the discount rate. A higher
discount rate discourages banks from borrowing reserves from the Fed. Thus, an
increase in the discount rate reduces the quantity of reserves in the banking
open-market operations
the purchase and sale of U.S.
government bonds by the Fed
reser ve requirements
regulations on the minimum amount
of reserves that banks must hold
against deposits
discount rate
the interest rate on the loans that the
Fed makes to banks
CHAPTER 27 THE MONETARY SYSTEM 621
system, which in turn reduces the money supply. Conversely, a lower discount
rate encourages bank borrowing from the Fed, increases the quantity of reserves,
and increases the money supply.
The Fed uses discount lending not only to control the money supply but also
to help financial institutions when they are in trouble. For example, in 1984, rumors
circulated that Continental Illinois National Bank had made a large number
of bad loans, and these rumors induced many depositors to withdraw their deposits.
As part of an effort to save the bank, the Fed acted as a lender of last resort
and loaned Continental Illinois more than $5 billion. Similarly, when the stock
market crashed on October 19, 1987, many Wall Street brokerage firms found
themselves temporarily in need of funds to finance the high volume of stock trading.
The next morning, before the stock market opened, Fed Chairman Alan
Greenspan announced the Fed’s “readiness to serve as a source of liquidity to support
the economic and financial system.” Many economists believe that
Greenspan’s reaction to the stock crash was an important reason why it had so few
repercussions.
PROBLEMS IN CONTROLLING THE MONEY SUPPLY
The Fed’s three tools—open-market operations, reserve requirements, and the discount
rate—have powerful effects on the money supply. Yet the Fed’s control of
the money supply is not precise. The Fed must wrestle with two problems, each
of which arises because much of the money supply is created by our system of
fractional-reserve banking.
The first problem is that the Fed does not control the amount of money that
households choose to hold as deposits in banks. The more money households deposit,
the more reserves banks have, and the more money the banking system can
create. And the less money households deposit, the less reserves banks have, and
the less money the banking system can create. To see why this is a problem, suppose
that one day people begin to lose confidence in the banking system and,
therefore, decide to withdraw deposits and hold more currency. When this happens,
the banking system loses reserves and creates less money. The money supply
falls, even without any Fed action.
The second problem of monetary control is that the Fed does not control the
amount that bankers choose to lend. When money is deposited in a bank, it creates
more money only when the bank loans it out. Because banks can choose to hold
excess reserves instead, the Fed cannot be sure how much money the banking system
will create. For instance, suppose that one day bankers become more cautious
about economic conditions and decide to make fewer loans and hold greater reserves.
In this case, the banking system creates less money than it otherwise
would. Because of the bankers’ decision, the money supply falls.
Hence, in a system of fractional-reserve banking, the amount of money in the
economy depends in part on the behavior of depositors and bankers. Because
the Fed cannot control or perfectly predict this behavior, it cannot perfectly control
the money supply. Yet, if the Fed is vigilant, these problems need not be large. The
Fed collects data on deposits and reserves from banks every week, so it is quickly
aware of any changes in depositor or banker behavior. It can, therefore, respond to
these changes and keep the money supply close to whatever level it chooses.
622 PART TEN MONEY AND PRICES IN THE LONG RUN
CASE STUDY BANK RUNS AND THE MONEY SUPPLY
Although you have probably never witnessed a bank run in real life, you may
have seen one depicted in movies such as Mary Poppins or It’s a Wonderful Life.
A bank run occurs when depositors suspect that a bank may go bankrupt and,
therefore, “run” to the bank to withdraw their deposits.
Bank runs are a problem for banks under fractional-reserve banking. Because
a bank holds only a fraction of its deposits in reserve, it cannot satisfy
withdrawal requests from all depositors. Even if the bank is in fact solvent
(meaning that its assets exceed its liabilities), it will not have enough cash on
hand to allow all depositors immediate access to all of their money. When a run
occurs, the bank is forced to close its doors until some bank loans are repaid or
until some lender of last resort (such as the Fed) provides it with the currency it
needs to satisfy depositors.
Bank runs complicate the control of the money supply. An important example
of this problem occurred during the Great Depression in the early 1930s. After
a wave of bank runs and bank closings, households and bankers became
more cautious. Households withdrew their deposits from banks, preferring to
hold their money in the form of currency. This decision reversed the process of
money creation, as bankers responded to falling reserves by reducing bank
loans. At the same time, bankers increased their reserve ratios so that they
would have enough cash on hand to meet their depositors’ demands in any future
bank runs. The higher reserve ratio reduced the money multiplier, which
also reduced the money supply. From 1929 to 1933, the money supply fell by 28
percent, even without the Federal Reserve taking any deliberate contractionary
action. Many economists point to this massive fall in the money supply to explain
the high unemployment and falling prices that prevailed during this period.
(In future chapters we examine the mechanisms by which changes in the
money supply affect unemployment and prices.)
Today, bank runs are not a major problem for the banking system or the
Fed. The federal government now guarantees the safety of deposits at most
banks, primarily through the Federal Deposit Insurance Corporation (FDIC).
Depositors do not run on their banks because they are confident that, even
if their bank goes bankrupt, the FDIC will make good on the deposits. The
A NOT-SO-WONDERFUL
BANK RUN
CHAPTER 27 THE MONETARY SYSTEM 623
policy of government deposit insurance has costs: Bankers whose deposits
are guaranteed may have too little incentive to avoid bad risks when making
loans. (This behavior is an example of a phenomenon, introduced in the preceding
chapter, called moral hazard.) But one benefit of deposit insurance is a
more stable banking system. As a result, most people see bank runs only in the
movies.
QUICK QUIZ: Describe how banks create money. If the Fed wanted
to use all three of its policy tools to decrease the money supply, what
would it do?
CONCLUSION
Some years ago, a book made the best-seller list with the title Secrets of the Temple:
How the Federal Reserve Runs the Country. Although no doubt an exaggeration, this
title did highlight the important role of the monetary system in our daily lives.
Whenever we buy or sell anything, we are relying on the extraordinarily useful social
convention called “money.” Now that we know what money is and what determines
its supply, we can discuss how changes in the quantity of money affect
the economy. We begin to address that topic in the next chapter.
The term money refers to assets that people regularly use
to buy goods and services.
Money serves three functions. As a medium of
exchange, it provides the item used to make
transactions. As a unit of account, it provides the way in
which prices and other economic values are recorded.
As a store of value, it provides a way of transferring
purchasing power from the present to the future.
Commodity money, such as gold, is money that has
intrinsic value: It would be valued even if it were not
used as money. Fiat money, such as paper dollars, is
money without intrinsic value: It would be worthless if
it were not used as money.
In the U.S. economy, money takes the form of currency
and various types of bank deposits, such as checking
accounts.
The Federal Reserve, the central bank of the United
States, is responsible for regulating the U.S. monetary
system. The Fed chairman is appointed by the president
and confirmed by Congress every four years. The
chairman is the lead member of the Federal Open
Market Committee, which meets about every six weeks
to consider changes in monetary policy.
The Fed controls the money supply primarily through
open-market operations: The purchase of government
bonds increases the money supply, and the sale of
government bonds decreases the money supply. The
Fed can also expand the money supply by lowering
reserve requirements or decreasing the discount rate,
and it can contract the money supply by raising reserve
requirements or increasing the discount rate.
When banks loan out some of their deposits, they
increase the quantity of money in the economy.
Because of this role of banks in determining the
money supply, the Fed’s control of the money supply
is imperfect.
Summary
624 PART TEN MONEY AND PRICES IN THE LONG RUN
money, p. 608
medium of exchange, p. 609
unit of account, p. 609
store of value, p. 609
liquidity, p. 609
commodity money, p. 609
fiat money, p. 611
currency, p. 611
demand deposits, p. 611
Federal Reserve (Fed), p. 613
central bank, p. 613
money supply, p. 614
monetary policy, p. 614
reserves, p. 616
fractional-reserve banking, p. 617
reserve ratio, p. 617
money multiplier, p. 619
open-market operations, p. 620
reserve requirements, p. 620
discount rate, p. 620
Key Concepts
1. What distinguishes money from other assets in the
economy?
2. What is commodity money? What is fiat money? Which
kind do we use?
3. What are demand deposits, and why should they be
included in the stock of money?
4. Who is responsible for setting monetary policy in the
United States? How is this group chosen?
5. If the Fed wants to increase the money supply with
open-market operations, what does it do?
6. Why don’t banks hold 100 percent reserves? How is the
amount of reserves banks hold related to the amount of
money the banking system creates?
7. What is the discount rate? What happens to the money
supply when the Fed raises the discount rate?
8. What are reserve requirements? What happens to the
money supply when the Fed raises reserve
requirements?
9. Why can’t the Fed control the money supply perfectly?
Questions for Review
1. Which of the following are money in the U.S. economy?
Which are not? Explain your answers by discussing
each of the three functions of money.
a. a U.S. penny
b. a Mexican peso
c. a Picasso painting
d. a plastic credit card
2. Every month Yankee magazine includes a “Swopper’s
[sic] Column” of offers to barter goods and services.
Here is an example: “Will swop custom-designed
wedding gown and up to 6 bridesmaids’ gowns for
2 round-trip plane tickets and 3 nights’ lodging in the
countryside of England.” Why would it be difficult to
run our economy using a “Swopper’s Column” instead
of money? In light of your answer, why might the Yankee
“Swopper’s Column” exist?
3. What characteristics of an asset make it useful as a
medium of exchange? As a store of value?
4. Consider how the following situations would affect the
economy’s monetary system.
a. Suppose that the people on Yap discovered an easy
way to make limestone wheels. How would this
development affect the usefulness of stone wheels
as money? Explain.
b. Suppose that someone in the United States
discovered an easy way to counterfeit $100 bills.
How would this development affect the U.S.
monetary system? Explain.
5. Your uncle repays a $100 loan from Tenth National Bank
by writing a $100 check from his TNB checking account.
Use T-accounts to show the effect of this transaction on
your uncle and on TNB. Has your uncle’s wealth
changed? Explain.
6. Beleaguered State Bank (BSB) holds $250 million in
deposits and maintains a reserve ratio of 10 percent.
a. Show a T-account for BSB.
b. Now suppose that BSB’s largest depositor
withdraws $10 million in cash from her account.
If BSB decides to restore its reserve ratio by
reducing the amount of loans outstanding,
show its new T-account.
Problems and Applications
CHAPTER 27 THE MONETARY SYSTEM 625
c. Explain what effect BSB’s action will have on
other banks.
d. Why might it be difficult for BSB to take the action
described in part (b)? Discuss another way for BSB
to return to its original reserve ratio.
7. You take $100 you had kept under your pillow and
deposit it in your bank account. If this $100 stays in the
banking system as reserves and if banks hold reserves
equal to 10 percent of deposits, by how much does the
total amount of deposits in the banking system increase?
By how much does the money supply increase?
8. The Federal Reserve conducts a $10 million openmarket
purchase of government bonds. If the required
reserve ratio is 10 percent, what is the largest possible
increase in the money supply that could result? Explain.
What is the smallest possible increase? Explain.
9. Suppose that the T-account for First National Bank is as
follows:
ASSETS LIABILITIES
Reserves $100,000 Deposits $500,000
Loans 400,000
a. If the Fed requires banks to hold 5 percent of
deposits as reserves, how much in excess reserves
does First National now hold?
b. Assume that all other banks hold only the required
amount of reserves. If First National decides to
reduce its reserves to only the required amount,
by how much would the economy’s money
supply increase?
10. Suppose that the reserve requirement for checking
deposits is 10 percent and that banks do not hold any
excess reserves.
a. If the Fed sells $1 million of government bonds,
what is the effect on the economy’s reserves and
money supply?
b. Now suppose the Fed lowers the reserve
requirement to 5 percent, but banks choose to hold
another 5 percent of deposits as excess reserves.
Why might banks do so? What is the overall change
in the money multiplier and the money supply as a
result of these actions?
11. Assume that the banking system has total reserves of
$100 billion. Assume also that required reserves are 10
percent of checking deposits, and that banks hold no
excess reserves and households hold no currency.
a. What is the money multiplier? What is the money
supply?
b. If the Fed now raises required reserves to 20 percent
of deposits, what is the change in reserves and the
change in the money supply?
12. (This problem is challenging.) The economy of
Elmendyn contains 2,000 $1 bills.
a. If people hold all money as currency, what is the
quantity of money?
b. If people hold all money as demand deposits and
banks maintain 100 percent reserves, what is the
quantity of money?
c. If people hold equal amounts of currency and
demand deposits and banks maintain 100 percent
reserves, what is the quantity of money?
d. If people hold all money as demand deposits and
banks maintain a reserve ratio of 10 percent, what is
the quantity of money?
e. If people hold equal amounts of currency and
demand deposits and banks maintain a reserve
ratio of 10 percent, what is the quantity of money?

627
IN THIS CHAPTER
YOU WILL . . .
Consider the various
costs that inflation
imposes on society
See why some
countries print so
much money that
they experience
hyperinflation
See why inflation
r esults from rapid
growth in the money
supply
Learn the meaning
of the classical
dichotomy and
monetary neutrality
Examine how the
nominal interest
rate responds to the
inflation rate
Although today you need a dollar or two to buy yourself an ice-cream cone, life
was very different 60 years ago. In one Trenton, New Jersey, candy store (run, incidentally,
by this author’s grandmother in the 1930s), ice-cream cones came in two
sizes. A cone with a small scoop of ice cream cost three cents. Hungry customers
could buy a large scoop for a nickel.
You are probably not surprised at the increase in the price of ice cream. In our
economy, most prices tend to rise over time. This increase in the overall level of
prices is called inflation. Earlier in the book we examined how economists measure
the inflation rate as the percentage change in the consumer price index, the GDP
deflator, or some other index of the overall price level. These price indexes show
that, over the past 60 years, prices have risen on average about 5 percent per year.
M O N E Y G R O W T H
A N D I N F L A T I O N
628 PART TEN MONEY AND PRICES IN THE LONG RUN
Accumulated over so many years, a 5 percent annual inflation rate leads to an
18-fold increase in the price level.
Inflation may seem natural and inevitable to a person who grew up in the
United States during the second half of the twentieth century, but in fact it is not
inevitable at all. There were long periods in the nineteenth century during which
most prices fell—a phenomenon called deflation. The average level of prices in the
U.S. economy was 23 percent lower in 1896 than in 1880, and this deflation was a
major issue in the presidential election of 1896. Farmers, who had accumulated
large debts, were suffering when the fall in crop prices reduced their incomes and
thus their ability to pay off their debts. They advocated government policies to reverse
the deflation.
Although inflation has been the norm in more recent history, there has been
substantial variation in the rate at which prices rise. During the 1990s, prices rose
at an average rate of about 2 percent per year. By contrast, in the 1970s, prices rose
by 7 percent per year, which meant a doubling of the price level over the decade.
The public often views such high rates of inflation as a major economic problem.
In fact, when President Jimmy Carter ran for reelection in 1980, challenger Ronald
Reagan pointed to high inflation as one of the failures of Carter’s economic policy.
International data show an even broader range of inflation experiences.
Germany after World War I experienced a spectacular example of inflation. The
price of a newspaper rose from 0.3 marks in January 1921 to 70,000,000 marks less
than two years later. Other prices rose by similar amounts. An extraordinarily high
rate of inflation such as this is called hyperinflation. The German hyperinflation had
such an adverse effect on the German economy that it is often viewed as one contributor
to the rise of Nazism and, as a result, World War II. Over the past 50 years,
with this episode still in mind, German policymakers have been extraordinarily
averse to inflation, and Germany has had much lower inflation than the United
States.
What determines whether an economy experiences inflation and, if so, how
much? This chapter answers this question by developing the quantity theory of
money. Chapter 1 summarized this theory as one of the Ten Principles of Economics:
Prices rise when the government prints too much money. This insight has a long
and venerable tradition among economists. The quantity theory was discussed by
the famous eighteenth-century philosopher David Hume and has been advocated
more recently by the prominent economist Milton Friedman. This theory of inflation
can explain both moderate inflations, such as those we have experienced in
the United States, and hyperinflations, such as those experienced in interwar Germany
and, more recently, in some Latin American countries.
After developing a theory of inflation, we turn to a related question: Why is inflation
a problem? At first glance, the answer to this question may seem obvious:
Inflation is a problem because people don’t like it. In the 1970s, when the United
States experienced a relatively high rate of inflation, opinion polls placed inflation
as the most important issue facing the nation. President Ford echoed this sentiment
in 1974 when he called inflation “public enemy number one.” Ford briefly
wore a “WIN” button on his lapel—for “Whip Inflation Now.”
But what, exactly, are the costs that inflation imposes on a society? The answer
may surprise you. Identifying the various costs of inflation is not as straightforward
as it first appears. As a result, although all economists decry hyperinflation,
some economists argue that the costs of moderate inflation are not nearly as large
as the general public believes.
CHAPTER 28 MONEY GROWTH AND INFLATION 629
THE CLASSICAL THEORY OF INFLATION
We begin our study of inflation by developing the quantity theory of money. This
theory is often called “classical” because it was developed by some of the earliest
thinkers about economic issues. Most economists today rely on this theory to explain
the long-run determinants of the price level and the inflation rate.
THE LEVEL OF PRICES AND THE VALUE OF MONEY
Suppose we observe over some period of time the price of an ice-cream cone rising
from a nickel to a dollar. What conclusion should we draw from the fact that people
are willing to give up so much more money in exchange for a cone? It is possible
that people have come to enjoy ice cream more (perhaps because some chemist
has developed a miraculous new flavor). Yet that is probably not the case. It is
more likely that people’s enjoyment of ice cream has stayed roughly the same and
that, over time, the money used to buy ice cream has become less valuable. Indeed,
the first insight about inflation is that it is more about the value of money than
about the value of goods.
This insight helps point the way toward a theory of inflation. When the consumer
price index and other measures of the price level rise, commentators are
often tempted to look at the many individual prices that make up these price
indexes: “The CPI rose by 3 percent last month, led by a 20 percent rise in the
price of coffee and a 30 percent rise in the price of heating oil.” Although this approach
does contain some interesting information about what’s happening in the
”So what’s it going to be? The same size as last year or the same price as last year?”
630 PART TEN MONEY AND PRICES IN THE LONG RUN
economy, it also misses a key point: Inflation is an economy-wide phenomenon
that concerns, first and foremost, the value of the economy’s medium of exchange.
The economy’s overall price level can be viewed in two ways. So far, we have
viewed the price level as the price of a basket of goods and services. When the
price level rises, people have to pay more for the goods and services they buy. Alternatively,
we can view the price level as a measure of the value of money. A rise
in the price level means a lower value of money because each dollar in your wallet
now buys a smaller quantity of goods and services.
It may help to express these ideas mathematically. Suppose P is the price level
as measured, for instance, by the consumer price index or the GDP deflator. Then
P measures the number of dollars needed to buy a basket of goods and services.
Now turn this idea around: The quantity of goods and services that can be bought
with $1 equals 1/P. In other words, if P is the price of goods and services measured
in terms of money, 1/P is the value of money measured in terms of goods
and services. Thus, when the overall price level rises, the value of money falls.
MONEY SUPPLY, MONEY DEMAND,
AND MONETARY EQUILIBRIUM
What determines the value of money? The answer to this question, like many in
economics, is supply and demand. Just as the supply and demand for bananas determines
the price of bananas, the supply and demand for money determines the
value of money. Thus, our next step in developing the quantity theory of money is
to consider the determinants of money supply and money demand.
First consider money supply. In the preceding chapter we discussed how the
Federal Reserve, together with the banking system, determines the supply of
money. When the Fed sells bonds in open-market operations, it receives dollars in
exchange and contracts the money supply. When the Fed buys government bonds,
it pays out dollars and expands the money supply. In addition, if any of these dollars
are deposited in banks who then hold them as reserves, the money multiplier
swings into action, and these open-market operations can have an even greater effect
on the money supply. For our purposes in this chapter, we ignore the complications
introduced by the banking system and simply take the quantity of money
supplied as a policy variable that the Fed controls directly and completely.
Now consider money demand. There are many factors that determine the
quantity of money people demand, just as there are many determinants of the
quantity demanded of other goods and services. How much money people choose
to hold in their wallets, for instance, depends on how much they rely on credit
cards and on whether an automatic teller machine is easy to find. And, as we will
emphasize in Chapter 32, the quantity of money demanded depends on the interest
rate that a person could earn by using the money to buy an interest-bearing
bond rather than leaving it in a wallet or low-interest checking account.
Although many variables affect the demand for money, one variable stands
out in importance: the average level of prices in the economy. People hold money
because it is the medium of exchange. Unlike other assets, such as bonds or stocks,
people can use money to buy the goods and services on their shopping lists. How
much money they choose to hold for this purpose depends on the prices of those
goods and services. The higher prices are, the more money the typical transaction
requires, and the more money people will choose to hold in their wallets and
CHAPTER 28 MONEY GROWTH AND INFLATION 631
checking accounts. That is, a higher price level (a lower value of money) increases
the quantity of money demanded.
What ensures that the quantity of money the Fed supplies balances the quantity
of money people demand? The answer, it turns out, depends on the time horizon
being considered. Later in this book we will examine the short-run answer,
and we will see that interest rates play a key role. In the long run, however, the answer
is different and much simpler. In the long run, the overall level of prices adjusts
to the level at which the demand for money equals the supply. If the price level is above
the equilibrium level, people will want to hold more money than the Fed has created,
so the price level must fall to balance supply and demand. If the price level is
below the equilibrium level, people will want to hold less money than the Fed has
created, and the price level must rise to balance supply and demand. At the equilibrium
price level, the quantity of money that people want to hold exactly balances
the quantity of money supplied by the Fed.
Figure 28-1 illustrates these ideas. The horizontal axis of this graph shows the
quantity of money. The left-hand vertical axis shows the value of money, 1/P, and
the right-hand vertical axis shows the price level, P. Notice that the price-level axis
on the right is inverted: A low price level is shown near the top of this axis, and a
high price level is shown near the bottom. This inverted axis illustrates that when
the value of money is high (as shown near the top of the left axis), the price level is
low (as shown near the top of the right axis).
The two curves in this figure are the supply and demand curves for money.
The supply curve is vertical because the Fed has fixed the quantity of money available.
The demand curve for money is downward sloping, indicating that when the
value of money is low (and the price level is high), people demand a larger quantity
of it to buy goods and services. At the equilibrium, shown in the figure as
point A, the quantity of money demanded balances the quantity of money supplied.
This equilibrium of money supply and money demand determines the value
of money and the price level.
Quantity fixed
by the Fed
Quantity of
Money
Value of
Money, 1/P
Price
Level, P
A
Money supply
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4
Equilibrium
value of
money
Equilibrium
price level
Money
demand
Figure 28-1
HOW THE SUPPLY AND DEMAND
FOR MONEY DETERMINE THE
EQUILIBRIUM PRICE LEVEL.
The horizontal axis shows the
quantity of money. The left
vertical axis shows the value of
money, and the right vertical axis
shows the price level. The supply
curve for money is vertical
because the quantity of money
supplied is fixed by the Fed.
The demand curve for money
is downward sloping because
people want to hold a larger
quantity of money when
each dollar buys less. At the
equilibrium, point A, the value
of money (on the left axis) and
the price level (on the right
axis) have adjusted to bring the
quantity of money supplied
and the quantity of money
demanded into balance.
632 PART TEN MONEY AND PRICES IN THE LONG RUN
THE EFFECTS OF A MONETARY INJECTION
Let’s now consider the effects of a change in monetary policy. To do so, imagine
that the economy is in equilibrium and then, suddenly, the Fed doubles the supply
of money by printing some dollar bills and dropping them around the country
from helicopters. (Or, less dramatically and more realistically, the Fed could inject
money into the economy by buying some government bonds from the public in
open-market operations.) What happens after such a monetary injection? How
does the new equilibrium compare to the old one?
Figure 28-2 shows what happens. The monetary injection shifts the supply
curve to the right from MS1 to MS2, and the equilibrium moves from point A to
point B. As a result, the value of money (shown on the left axis) decreases from 1/2
to 1/4, and the equilibrium price level (shown on the right axis) increases from
2 to 4. In other words, when an increase in the money supply makes dollars more
plentiful, the result is an increase in the price level that makes each dollar less
valuable.
This explanation of how the price level is determined and why it might change
over time is called the quantity theory of money. According to the quantity theory,
the quantity of money available in the economy determines the value of money,
and growth in the quantity of money is the primary cause of inflation. As economist
Milton Friedman once put it, “Inflation is always and everywhere a monetary
phenomenon.”
A BRIEF LOOK AT THE ADJUSTMENT PROCESS
So far we have compared the old equilibrium and the new equilibrium after an injection
of money. How does the economy get from the old to the new equilibrium?
Quantity of
Money
Value of
Money, 1/P
Price
Level, P
A
B
Money
demand
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4
M1
MS1
M2
MS2
2. …decreases
the value of
money…
3. …and
increases
the price
level.
1. An increase
in the money
supply...
Figure 28-2
AN INCREASE IN THE
MONEY SUPPLY. When the Fed
increases the supply of money,
the money supply curve shifts
from MS1 to MS2. The value of
money (on the left axis) and the
price level (on the right axis)
adjust to bring supply and
demand back into balance. The
equilibrium moves from point
A to point B. Thus, when an
increase in the money supply
makes dollars more plentiful, the
price level increases, making each
dollar less valuable.
quantity theory of money
a theory asserting that the quantity
of money available determines the
price level and that the growth rate
in the quantity of money available
determines the inflation rate
CHAPTER 28 MONEY GROWTH AND INFLATION 633
A complete answer to this question requires an understanding of short-run
fluctuations in the economy, which we examine later in this book. Yet, even now, it
is instructive to consider briefly the adjustment process that occurs after a change
in money supply.
The immediate effect of a monetary injection is to create an excess supply
of money. Before the injection, the economy was in equilibrium (point A in Figure
28-2). At the prevailing price level, people had exactly as much money as they
wanted. But after the helicopters drop the new money and people pick it up off the
streets, people have more dollars in their wallets than they want. At the prevailing
price level, the quantity of money supplied now exceeds the quantity demanded.
People try to get rid of this excess supply of money in various ways. They
might buy goods and services with their excess holdings of money. Or they might
use this excess money to make loans to others by buying bonds or by depositing
the money in a bank savings account. These loans allow other people to buy goods
and services. In either case, the injection of money increases the demand for
goods and services.
The economy’s ability to supply goods and services, however, has not
changed. As we saw in Chapter 24, the economy’s production is determined by the
available labor, physical capital, human capital, natural resources, and technological
knowledge. None of these is altered by the injection of money.
Thus, the greater demand for goods and services causes the prices of goods
and services to increase. The increase in the price level, in turn, increases the quantity
of money demanded because people are using more dollars for every transaction.
Eventually, the economy reaches a new equilibrium (point B in Figure 28-2) at
which the quantity of money demanded again equals the quantity of money supplied.
In this way, the overall price level for goods and services adjusts to bring
money supply and money demand into balance.
THE CLASSICAL DICHOTOMY AND MONETARY NEUTRALITY
We have seen how changes in the money supply lead to changes in the average
level of prices of goods and services. How do these monetary changes affect other
important macroeconomic variables, such as production, employment, real wages,
and real interest rates? This question has long intrigued economists. Indeed, the
great philosopher David Hume wrote about it in the eighteenth century. The answer
we give today owes much to Hume’s analysis.
Hume and his contemporaries suggested that all economic variables should be
divided into two groups. The first group consists of nominal variables—variables
measured in monetary units. The second group consists of real variables—variables
measured in physical units. For example, the income of corn farmers is a
nominal variable because it is measured in dollars, whereas the quantity of corn
they produce is a real variable because it is measured in bushels. Similarly, nominal
GDP is a nominal variable because it measures the dollar value of the economy’s
output of goods and services, while real GDP is a real variable because it
measures the total quantity of goods and services produced. This separation of
variables into these groups is now called the classical dichotomy. (A dichotomy is a
division into two groups, and classical refers to the earlier economic thinkers.)
Application of the classical dichotomy is somewhat tricky when we turn
to prices. Prices in the economy are normally quoted in terms of money and,
nominal variables
variables measured in
monetary units
real variables
variables measured in physical units
classical dichotomy
the theoretical separation of nominal
and real variables
634 PART TEN MONEY AND PRICES IN THE LONG RUN
therefore, are nominal variables. For instance, when we say that the price of corn
is $2 a bushel or that the price of wheat is $1 a bushel, both prices are nominal variables.
But what about a relative price—the price of one thing compared to another?
In our example, we could say that the price of a bushel of corn is two bushels of
wheat. Notice that this relative price is no longer measured in terms of money.
When comparing the prices of any two goods, the dollar signs cancel, and the resulting
number is measured in physical units. The lesson is that dollar prices are
nominal variables, whereas relative prices are real variables.
This lesson has several important applications. For instance, the real wage (the
dollar wage adjusted for inflation) is a real variable because it measures the rate at
which the economy exchanges goods and services for each unit of labor. Similarly,
the real interest rate (the nominal interest rate adjusted for inflation) is a real variable
because it measures the rate at which the economy exchanges goods and services
produced today for goods and services produced in the future.
Why bother separating variables into these two groups? Hume suggested that
the classical dichotomy is useful in analyzing the economy because different forces
influence real and nominal variables. In particular, he argued, nominal variables
are heavily influenced by developments in the economy’s monetary system,
whereas the monetary system is largely irrelevant for understanding the determinants
of important real variables.
Notice that Hume’s idea was implicit in our earlier discussions of the real
economy in the long run. In previous chapters, we examined how real GDP, saving,
investment, real interest rates, and unemployment are determined without
any mention of the existence of money. As explained in that analysis, the economy’s
production of goods and services depends on productivity and factor supplies,
the real interest rate adjusts to balance the supply and demand for loanable
funds, the real wage adjusts to balance the supply and demand for labor, and unemployment
results when the real wage is for some reason kept above its equilibrium
level. These important conclusions have nothing to do with the quantity of
money supplied.
Changes in the supply of money, according to Hume, affect nominal variables
but not real variables. When the central bank doubles the money supply, the price
level doubles, the dollar wage doubles, and all other dollar values double. Real
variables, such as production, employment, real wages, and real interest rates, are
unchanged. This irrelevance of monetary changes for real variables is called monetary
neutrality.
An analogy sheds light on the meaning of monetary neutrality. Recall that, as
the unit of account, money is the yardstick we use to measure economic transactions.
When a central bank doubles the money supply, all prices double, and the
value of the unit of account falls by half. A similar change would occur if the government
were to reduce the length of the yard from 36 to 18 inches: As a result of
the new unit of measurement, all measured distances (nominal variables) would
double, but the actual distances (real variables) would remain the same. The dollar,
like the yard, is merely a unit of measurement, so a change in its value should not
have important real effects.
Is this conclusion of monetary neutrality a realistic description of the world in
which we live? The answer is: not completely. A change in the length of the yard
from 36 to 18 inches would not matter much in the long run, but in the short run it
would certainly lead to confusion and various mistakes. Similarly, most economists
today believe that over short periods of time—within the span of a year or
monetary neutrality
the proposition that changes in
the money supply do not affect
real variables
CHAPTER 28 MONEY GROWTH AND INFLATION 635
two—there is reason to think that monetary changes do have important effects on
real variables. Hume himself also doubted that monetary neutrality would apply
in the short run. (We will turn to the study of short-run nonneutrality in Chapters
31 to 33, and this topic will shed light on the reasons why the Fed changes the
supply of money over time.)
Most economists today accept Hume’s conclusion as a description of the economy
in the long run. Over the course of a decade, for instance, monetary changes
have important effects on nominal variables (such as the price level) but only negligible
effects on real variables (such as real GDP). When studying long-run
changes in the economy, the neutrality of money offers a good description of how
the world works.
VELOCITY AND THE QUANTITY EQUATION
We can obtain another perspective on the quantity theory of money by considering
the following question: How many times per year is the typical dollar bill used
to pay for a newly produced good or service? The answer to this question is given
by a variable called the velocity of money. In physics, the term velocity refers to the
speed at which an object travels. In economics, the velocity of money refers to
the speed at which the typical dollar bill travels around the economy from wallet
to wallet.
To calculate the velocity of money, we divide the nominal value of output
(nominal GDP) by the quantity of money. If P is the price level (the GDP deflator),
Y the quantity of output (real GDP), and M the quantity of money, then velocity is
V (P Y)/M.
To see why this makes sense, imagine a simple economy that produces only pizza.
Suppose that the economy produces 100 pizzas in a year, that a pizza sells for
$10, and that the quantity of money in the economy is $50. Then the velocity of
money is
V ($10 100)/$50
20.
In this economy, people spend a total of $1,000 per year on pizza. For this $1,000 of
spending to take place with only $50 of money, each dollar bill must change hands
on average 20 times per year.
With slight algebraic rearrangement, this equation can be rewritten as
M V P Y.
This equation states that the quantity of money (M) times the velocity of money
(V) equals the price of output (P) times the amount of output (Y). It is called the
quantity equation because it relates the quantity of money (M) to the nominal
value of output (P Y). The quantity equation shows that an increase in the quantity
of money in an economy must be reflected in one of the other three variables:
velocity of money
the rate at which money
changes hands
quantity equation
the equation M V P Y, which
relates the quantity of money, the
velocity of money, and the dollar
value of the economy’s output of
goods and services
636 PART TEN MONEY AND PRICES IN THE LONG RUN
The price level must rise, the quantity of output must rise, or the velocity of money
must fall.
In many cases, it turns out that the velocity of money is relatively stable. For
example, Figure 28-3 shows nominal GDP, the quantity of money (as measured by
M2), and the velocity of money for the U.S. economy since 1960. Although the velocity
of money is not exactly constant, it has not changed dramatically. By contrast,
the money supply and nominal GDP during this period have increased more
than tenfold. Thus, for some purposes, the assumption of constant velocity may be
a good approximation.
We now have all the elements necessary to explain the equilibrium price level
and inflation rate. Here they are:
1. The velocity of money is relatively stable over time.
2. Because velocity is stable, when the Fed changes the quantity of money (M),
it causes proportionate changes in the nominal value of output (P Y).
3. The economy’s output of goods and services (Y) is primarily determined by
factor supplies (labor, physical capital, human capital, and natural resources)
and the available production technology. In particular, because money is
neutral, money does not affect output.
4. With output (Y) determined by factor supplies and technology, when the
Fed alters the money supply (M) and induces proportional changes in
the nominal value of output (P Y), these changes are reflected in
changes in the price level (P).
5. Therefore, when the Fed increases the money supply rapidly, the result is a
high rate of inflation.
These five steps are the essence of the quantity theory of money.
Indexes
(1960 = 100)
1,500
1,000
500
0
1960 1965 1970 1975 1980 1985 1990 1995 2000
Velocity
M2
Nominal GDP
Figure 28-3
NOMINAL GDP, THE
QUANTITY OF MONEY, AND
THE VELOCITY OF MONEY. This
figure shows the nominal value
of output as measured by
nominal GDP, the quantity of
money as measured by M2,
and the velocity of money as
measured by their ratio. For
comparability, all three series
have been scaled to equal 100 in
1960. Notice that nominal GDP
and the quantity of money have
grown dramatically over this
period, while velocity has been
relatively stable.
SOURCE: U.S. Department of Commerce;
Federal Reserve Board.
CHAPTER 28 MONEY GROWTH AND INFLATION 637
CASE STUDY MONEY AND PRICES DURING
FOUR HYPERINFLATIONS
Although earthquakes can wreak havoc on a society, they have the beneficial
by-product of providing much useful data for seismologists. These data can
shed light on alternative theories and, thereby, help society predict and deal
with future threats. Similarly, hyperinflations offer monetary economists a natural
experiment they can use to study the effects of money on the economy.
Hyperinflations are interesting in part because the changes in the money
supply and price level are so large. Indeed, hyperinflation is generally defined
(a) Austria (b) Hungary
Money supply
Price level
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
(c) Germany
Price level
1
Index
(Jan. 1921 = 100)
(d) Poland
100,000,000,000,000
1,000,000
10,000,000,000
1,000,000,000,000
100,000,000
10,000
100
100,000
10,000
1,000
100
1921 1922 1923 1924 1925
Money supply
Money
supply
Price level
100,000
10,000
1,000
100
1921 1922 1923 1924 1925
1921 1922 1923 1924 1925
Price level
Money
supply
Index
(Jan. 1921 = 100)
100
10,000,000
100,000
1,000,000
10,000
1,000
1921 1922 1923 1924 1925
MONEY AND PRICES DURING FOUR HYPERINFLATIONS. This figure shows the quantity Figur e 28-4
of money and the price level during four hyperinflations. (Note that these variables are
graphed on logarithmic scales. This means that equal vertical distances on the graph
represent equal percentage changes in the variable.) In each case, the quantity of money
and the price level move closely together. The strong association between these two
variables is consistent with the quantity theory of money, which states that growth in
the money supply is the primary cause of inflation.
SOURCE: Adapted from Thomas J. Sargent, “The End of Four Big Inflations,” in Robert Hall, ed., Inflation, Chicago:
University of Chicago Press, 1983, pp. 41-93.
638 PART TEN MONEY AND PRICES IN THE LONG RUN
THE INFLATION TAX
If inflation is so easy to explain, why do countries experience hyperinflation? That
is, why do the central banks of these countries choose to print so much money that
its value is certain to fall rapidly over time?
The answer is that the governments of these countries are using money creation
as a way to pay for their spending. When the government wants to build
roads, pay salaries to police officers, or give transfer payments to the poor or elderly,
it first has to raise the necessary funds. Normally, the government does this
by levying taxes, such as income and sales taxes, and by borrowing from the public
by selling government bonds. Yet the government can also pay for spending by
simply printing the money it needs.
When the government raises revenue by printing money, it is said to levy an
inflation tax. The inflation tax is not exactly like other taxes, however, because no
one receives a bill from the government for this tax. Instead, the inflation tax is
more subtle. When the government prints money, the price level rises, and the dollars
in your wallet are less valuable. Thus, the inflation tax is like a tax on everyone
who holds money.
The importance of the inflation tax varies from country to country and over
time. In the United States in recent years, the inflation tax has been a trivial source
of revenue: It has accounted for less than 3 percent of government revenue. During
the 1770s, however, the Continental Congress of the fledgling United States relied
heavily on the inflation tax to pay for military spending. Because the new
government had a limited ability to raise funds through regular taxes or borrowing,
printing dollars was the easiest way to pay the American soldiers. As the
quantity theory predicts, the result was a high rate of inflation: Prices measured in
terms of the continental dollar rose more than 100-fold over a few years.
Almost all hyperinflations follow the same pattern as the hyperinflation during
the American Revolution. The government has high spending, inadequate tax
revenue, and limited ability to borrow. As a result, it turns to the printing press
to pay for its spending. The massive increases in the quantity of money lead to
inflation tax
the revenue the government
raises by creating money
as inflation that exceeds 50 percent per month. This means that the price level increases
more than 100-fold over the course of a year.
The data on hyperinflation show a clear link between the quantity of money
and the price level. Figure 28-4 graphs data from four classic hyperinflations
that occurred during the 1920s in Austria, Hungary, Germany, and Poland. Each
graph shows the quantity of money in the economy and an index of the price
level. The slope of the money line represents the rate at which the quantity of
money was growing, and the slope of the price line represents the inflation rate.
The steeper the lines, the higher the rates of money growth or inflation.
Notice that in each graph the quantity of money and the price level are almost
parallel. In each instance, growth in the quantity of money is moderate at
first, and so is inflation. But over time, the quantity of money in the economy
starts growing faster and faster. At about the same time, inflation also takes off.
Then when the quantity of money stabilizes, the price level stabilizes as well.
These episodes illustrate well one of the Ten Principles of Economics: Prices rise
when the government prints too much money.
CHAPTER 28 MONEY GROWTH AND INFLATION 639
massive inflation. The inflation ends when the government institutes fiscal
reforms—such as cuts in government spending—that eliminate the need for the
inflation tax.
THE FISHER EFFECT
According to the principle of monetary neutrality, an increase in the rate of money
growth raises the rate of inflation but does not affect any real variable. An important
application of this principle concerns the effect of money on interest rates. Interest
rates are important variables for macroeconomists to understand because
they link the economy of the present and the economy of the future through their
effects on saving and investment.
To understand the relationship between money, inflation, and interest rates,
recall from Chapter 23 the distinction between the nominal interest rate and the
real interest rate. The nominal interest rate is the interest rate you hear about at your
bank. If you have a savings account, for instance, the nominal interest rate tells you
how fast the number of dollars in your account will rise over time. The real interest
rate corrects the nominal interest rate for the effect of inflation in order to tell you
how fast the purchasing power of your savings account will rise over time. The
real interest rate is the nominal interest rate minus the inflation rate:
Real interest rate Nominal interest rate Inflation rate.
WHENEVER GOVERNMENTS FIND THEMselves
short of cash, they are tempted to
solve the problem simply by printing
some more. In 1998, Russian policymakers
found this temptation hard to
resist, and the inflation rate rose to
more than 100 percent per year.
R u s s i a ’s N e w L e a d e r s P l a n t o P a y
D e b t s b y P r i n t i n g M o n e y
BY MICHAEL WINES
MOSCOW—Russia’s new Communistinfluenced
Government indicated today
that it plans to satisfy old debts and bail
out old friends by printing new rubles, a
decision that drew a swift and strong reaction
from President Boris N. Yeltsin’s
old capitalist allies.
The deputy head of the central bank
said today that the bank intends to bail
out many of the nation’s bankrupt financial
institutions by buying back their
multibillion-ruble portfolios of Government
bonds and Treasury bills. The Government
temporarily froze $40 billion
worth of notes when the fiscal crisis
erupted last month because it lacked
the money to pay investors who hold
them.
Asked by the Reuters news service
how the near-broke Government would
find the money to pay off the banks,
the deputy, Andrei Kozlov, replied,
“Emissions, of course, emissions.”
“Emissions” is a euphemism for printing
money.
Hours later in Washington, Deputy
Treasury Secretary Lawrence H. Summers
told a House subcommittee that
Russia was heading toward a return
of the four-digit inflation rates that savaged
consumers and almost toppled Mr.
Yeltsin’s Government in 1993.
Russia’s new leaders cannot repeal
“basic economic laws,” he said.
SOURCE: The New York Times, September 18, 1998,
p. A3.
IN THE NEWS
Russia Turns to
the Inflation Tax
640 PART TEN MONEY AND PRICES IN THE LONG RUN
For example, if the bank posts a nominal interest rate of 7 percent per year and the
inflation rate is 3 percent per year, then the real value of the deposits grows by 4
percent per year.
We can rewrite this equation to show that the nominal interest rate is the sum
of the real interest rate and the inflation rate:
Nominal interest rate Real interest rate Inflation rate.
This way of looking at the nominal interest rate is useful because different economic
forces determine each of the two terms on the right-hand side of this equation.
As we discussed in Chapter 25, the supply and demand for loanable funds
determine the real interest rate. And, according to the quantity theory of money,
growth in the money supply determines the inflation rate.
Let’s now consider how the growth in the money supply affects interest rates.
In the long run over which money is neutral, a change in money growth should
not affect the real interest rate. The real interest rate is, after all, a real variable. For
the real interest rate not to be affected, the nominal interest rate must adjust onefor-
one to changes in the inflation rate. Thus, when the Fed increases the rate of money
growth, the result is both a higher inflation rate and a higher nominal interest rate. This
adjustment of the nominal interest rate to the inflation rate is called the Fisher
effect, after economist Irving Fisher (1867-1947), who first studied it.
The Fisher effect is, in fact, crucial for understanding changes over time in the
nominal interest rate. Figure 28-5 shows the nominal interest rate and the inflation
rate in the U.S. economy since 1960. The close association between these two variables
is clear. The nominal interest rate rose from the early 1960s through the 1970s
because inflation was also rising during this time. Similarly, the nominal interest
rate fell from the early 1980s through the 1990s because the Fed got inflation under
control.
Fisher ef fect
the one-for-one adjustment
of the nominal interest rate to
the inflation rate
Percent
(per year)
1960 1965 1970 1975 1980 1985 1990 1995
Inflation
Nominal interest rate
0
3
6
9
12
15
Figure 28-5
THE NOMINAL INTEREST RATE
AND THE INFLATION RATE.
This figure uses annual data since
1960 to show the nominal interest
rate on three-month Treasury
bills and the inflation rate as
measured by the consumer price
index. The close association
between these two variables is
evidence for the Fisher effect:
When the inflation rate rises, so
does the nominal interest rate.
SOURCE: U.S. Department of Treasury;
U.S. Department of Labor.
CHAPTER 28 MONEY GROWTH AND INFLATION 641
QUICK QUIZ: The government of a country increases the growth rate
of the money supply from 5 percent per year to 50 percent per year. What
happens to prices? What happens to nominal interest rates? Why might the
government be doing this?
THE COSTS OF INFLATION
In the late 1970s, when the U.S. inflation rate reached about 10 percent per year, inflation
dominated debates over economic policy. And even though inflation was
low during the 1990s, inflation remained a closely watched macroeconomic variable.
One 1996 study found that inflation was the economic term mentioned most
often in U.S. newspapers (far ahead of second-place finisher unemployment and
third-place finisher productivity).
Inflation is closely watched and widely discussed because it is thought to be a
serious economic problem. But is that true? And if so, why?
A FALL IN PURCHASING POWER? THE INFLATION FALLACY
If you ask the typical person why inflation is bad, he will tell you that the answer
is obvious: Inflation robs him of the purchasing power of his hard-earned dollars.
When prices rise, each dollar of income buys fewer goods and services. Thus, it
might seem that inflation directly lowers living standards.
Yet further thought reveals a fallacy in this answer. When prices rise, buyers of
goods and services pay more for what they buy. At the same time, however, sellers
of goods and services get more for what they sell. Because most people earn their
incomes by selling their services, such as their labor, inflation in incomes goes
hand in hand with inflation in prices. Thus, inflation does not in itself reduce people’s
real purchasing power.
People believe the inflation fallacy because they do not appreciate the principle
of monetary neutrality. A worker who receives an annual raise of 10 percent
tends to view that raise as a reward for her own talent and effort. When an inflation
rate of 6 percent reduces the real value of that raise to only 4 percent, the
worker might feel that she has been cheated of what is rightfully her due. In fact,
as we discussed in Chapter 24, real incomes are determined by real variables, such
as physical capital, human capital, natural resources, and the available production
technology. Nominal incomes are determined by those factors and the overall
price level. If the Fed were to lower the inflation rate from 6 percent to zero, our
worker’s annual raise would fall from 10 percent to 4 percent. She might feel less
robbed by inflation, but her real income would not rise more quickly.
If nominal incomes tend to keep pace with rising prices, why then is inflation
a problem? It turns out that there is no single answer to this question. Instead,
economists have identified several costs of inflation. Each of these costs shows
some way in which persistent growth in the money supply does, in fact, have
some effect on real variables.
642 PART TEN MONEY AND PRICES IN THE LONG RUN
SHOELEATHER COSTS
As we have discussed, inflation is like a tax on the holders of money. The tax itself
is not a cost to society: It is only a transfer of resources from households to the government.
Yet, as we first saw in Chapter 8, most taxes give people an incentive to
alter their behavior to avoid paying the tax, and this distortion of incentives causes
deadweight losses for society as a whole. Like other taxes, the inflation tax also
causes deadweight losses because people waste scarce resources trying to avoid it.
How can a person avoid paying the inflation tax? Because inflation erodes the
real value of the money in your wallet, you can avoid the inflation tax by holding
less money. One way to do this is to go to the bank more often. For example, rather
than withdrawing $200 every four weeks, you might withdraw $50 once a week.
By making more frequent trips to the bank, you can keep more of your wealth in
your interest-bearing savings account and less in your wallet, where inflation
erodes its value.
The cost of reducing your money holdings is called the shoeleather cost of
inflation because making more frequent trips to the bank causes your shoes to
wear out more quickly. Of course, this term is not to be taken literally: The actual
cost of reducing your money holdings is not the wear and tear on your shoes but
the time and convenience you must sacrifice to keep less money on hand than you
would if there were no inflation.
The shoeleather costs of inflation may seem trivial. And, in fact, they are in the
U.S. economy, which has had only moderate inflation in recent years. But this cost
is magnified in countries experiencing hyperinflation. Here is a description of one
person’s experience in Bolivia during its hyperinflation (as reported in the August
13, 1985, issue of The Wall Street Journal, p. 1):
When Edgar Miranda gets his monthly teacher’s pay of 25 million pesos, he
hasn’t a moment to lose. Every hour, pesos drop in value. So, while his wife
rushes to market to lay in a month’s supply of rice and noodles, he is off with the
rest of the pesos to change them into black-market dollars.
Mr. Miranda is practicing the First Rule of Survival amid the most out-ofcontrol
inflation in the world today. Bolivia is a case study of how runaway
inflation undermines a society. Price increases are so huge that the figures build
up almost beyond comprehension. In one six-month period, for example, prices
soared at an annual rate of 38,000 percent. By official count, however, last year’s
inflation reached 2,000 percent, and this year’s is expected to hit 8,000 percent—
though other estimates range many times higher. In any event, Bolivia’s rate
dwarfs Israel’s 370 percent and Argentina’s 1,100 percent—two other cases of
severe inflation.
It is easier to comprehend what happens to the 38-year-old Mr. Miranda’s
pay if he doesn’t quickly change it into dollars. The day he was paid 25 million
pesos, a dollar cost 500,000 pesos. So he received $50. Just days later, with the rate
at 900,000 pesos, he would have received $27.
As this story shows, the shoeleather costs of inflation can be substantial. With the
high inflation rate, Mr. Miranda does not have the luxury of holding the local
money as a store of value. Instead, he is forced to convert his pesos quickly into
goods or into U.S. dollars, which offer a more stable store of value. The time and
effort that Mr. Miranda expends to reduce his money holdings are a waste of
shoeleather costs
the resources wasted when inflation
encourages people to reduce their
money holdings
CHAPTER 28 MONEY GROWTH AND INFLATION 643
resources. If the monetary authority pursued a low-inflation policy, Mr. Miranda
would be happy to hold pesos, and he could put his time and effort to more
productive use. In fact, shortly after this article was written, the Bolivian inflation
rate was reduced substantially with more restrictive monetary policy.
WHENEVER GOVERNMENTS TURN TO THE
printing press to finance substantial
amounts of spending, the result is hyperinflation.
As residents of Serbia
learned in the early 1990s, life under
such circumstances is far from easy.
S p e c i a l , To d a y O n l y : 6 M i l l i o n
D i n a r s f o r a S n i c k e r s B a r
BY ROGER THUROW
BELGRADE, YUGOSLAVIA—At the Luna
boutique, a Snickers bar costs 6 million
dinars. Or at least it does until manager
Tihomir Nikolic reads the overnight fax
from his boss.
“Raise prices 99 percent,” the document
tersely orders. It would be an
even 100 percent except that the computers
at the boutique, which would be
considered a dime store in other parts
of the world, can’t handle three-digit
changes.
So for the second time in three
days, Mr. Nikolic sets about raising
prices. He jams a mop across the door
frame to keep customers from getting
away with a bargain. The computer spits
out the new prices on perforated paper.
The manager and two assistants rip
the paper into tags and tape them to the
shelves. They used to put the prices
directly on the goods, but there were so
many stickers it was getting difficult to
read the labels.
After four hours, the mop is removed
from the door. The customers
wander in, rub their eyes and squint at
the tags, counting the zeros. Mr. Nikolic
himself squints as the computer prints
another price, this one for a video
recorder.
“Is that billions?” he asks himself. It
is: 20,391,560,223 dinars, to be precise.
He points to his T-shirt, which is emblazoned
with the words “Far Out,” the
name of a fruit juice he once sold. He
suggests it is an ideal motto for Serbia’s
bizarre economic situation. “It fits the
craziness,” he says.
How else would you describe it?
Since the international community imposed
economic sanctions, the inflation
rate has been at least 10 percent daily.
This translates to an annual rate in the
quadrillions—so high as to be meaningless.
In Serbia, one U.S. dollar will get
you 10 million dinars at the Hyatt hotel,
12 million from the shady money changers
on Republic Square, and 17 million
from a bank run by Belgrade’s underworld.
Serbs complain that the dinar is
as worthless as toilet paper. But for the
moment, at least, there is plenty of toilet
paper to go around.
The government mint, hidden in the
park behind the Belgrade racetrack, is
said to be churning out dinars 24 hours a
day, furiously trying to keep up with the
inflation that is fueled, in turn, by its own
nonstop printing. The government, which
believes in throwing around money to
damp dissent, needs dinars to pay workers
for not working at closed factories
and offices. It needs them to buy the harvest
from the farmers. It needs them to
finance its smuggling forays and other
ways to evade the sanctions, bringing
in everything from oil to Mr. Nikolic’s
Snickers bars. It also needs them to supply
brother Serbs fighting in Bosnia-
Herzegovina and Croatia.
The money changers, whose fingertips
detect the slightest change in paper
quality, insist that the mint is even contracting
out to private printers to meet
demand.
“We’re experts. They can’t fool
us,” says one of the changers as he
hands over 800 million worth of 5-milliondinar
bills. “These,” he notes confidently,
“are fresh from the mint.” He
says he got them from a private bank,
which got them from the central bank,
which got them from the mint—an unholy
circuit linking the black market with
the Finance Ministry. “It’s collective lunacy,”
the money changer says, laughing
wickedly.
SOURCE: The Wall Street Journal, August 4, 1993,
p. A1.
IN THE NEWS
The Hyperinflation in Serbia
644 PART TEN MONEY AND PRICES IN THE LONG RUN
MENU COSTS
Most firms do not change the prices of their products every day. Instead, firms often
announce prices and leave them unchanged for weeks, months, or even years.
One survey found that the typical U.S. firm changes its prices about once a year.
Firms change prices infrequently because there are costs of changing prices.
Costs of price adjustment are called menu costs, a term derived from a restaurant’s
cost of printing a new menu. Menu costs include the cost of deciding on new
prices, the cost of printing new price lists and catalogs, the cost of sending these
new price lists and catalogs to dealers and customers, the cost of advertising the
new prices, and even the cost of dealing with customer annoyance over price
changes.
Inflation increases the menu costs that firms must bear. In the current U.S.
economy, with its low inflation rate, annual price adjustment is an appropriate
business strategy for many firms. But when high inflation makes firms’ costs rise
rapidly, annual price adjustment is impractical. During hyperinflations, for example,
firms must change their prices daily or even more often just to keep up with
all the other prices in the economy.
RELATIVE-PRICE VARIABILITY
AND THE MISALLOCATION OF RESOURCES
Suppose that the Eatabit Eatery prints a new menu with new prices every January
and then leaves its prices unchanged for the rest of the year. If there is no inflation,
Eatabit’s relative prices—the prices of its meals compared to other prices in the
economy—would be constant over the course of the year. By contrast, if the inflation
rate is 12 percent per year, Eatabit’s relative prices will automatically fall by 1
percent each month. The restaurant’s relative prices (that is, its prices compared
with others in the economy) will be high in the early months of the year, just after
it has printed a new menu, and low in the later months. And the higher the inflation
rate, the greater is this automatic variability. Thus, because prices change only
once in a while, inflation causes relative prices to vary more than they otherwise
would.
Why does this matter? The reason is that market economies rely on relative
prices to allocate scarce resources. Consumers decide what to buy by comparing
the quality and prices of various goods and services. Through these decisions, they
determine how the scarce factors of production are allocated among industries and
firms. When inflation distorts relative prices, consumer decisions are distorted,
and markets are less able to allocate resources to their best use.
INFLATION-INDUCED TAX DISTORTIONS
Almost all taxes distort incentives, cause people to alter their behavior, and lead
to a less efficient allocation of the economy’s resources. Many taxes, however,
become even more problematic in the presence of inflation. The reason is that
lawmakers often fail to take inflation into account when writing the tax laws.
menu costs
the costs of changing prices
CHAPTER 28 MONEY GROWTH AND INFLATION 645
Economists who have studied the tax code conclude that inflation tends to raise
the tax burden on income earned from savings.
One example of how inflation discourages saving is the tax treatment of capital
gains—the profits made by selling an asset for more than its purchase price. Suppose
that in 1980 you used some of your savings to buy stock in Microsoft Corporation
for $10 and that in 2000 you sold the stock for $50. According to the tax law,
you have earned a capital gain of $40, which you must include in your income
when computing how much income tax you owe. But suppose the overall price
level doubled from 1980 to 2000. In this case, the $10 you invested in 1980 is equivalent
(in terms of purchasing power) to $20 in 2000. When you sell your stock for
$50, you have a real gain (an increase in purchasing power) of only $30. The tax
code, however, does not take account of inflation and assesses you a tax on a gain
of $40. Thus, inflation exaggerates the size of capital gains and inadvertently increases
the tax burden on this type of income.
Another example is the tax treatment of interest income. The income tax treats
the nominal interest earned on savings as income, even though part of the nominal
interest rate merely compensates for inflation. To see the effects of this policy, consider
the numerical example in Table 28-1. The table compares two economies,
both of which tax interest income at a rate of 25 percent. In Economy 1, inflation is
zero, and the nominal and real interest rates are both 4 percent. In this case, the
25 percent tax on interest income reduces the real interest rate from 4 percent to
3 percent. In Economy 2, the real interest rate is again 4 percent, but the inflation
rate is 8 percent. As a result of the Fisher effect, the nominal interest rate is 12 percent.
Because the income tax treats this entire 12 percent interest as income, the
government takes 25 percent of it, leaving an after-tax nominal interest rate of only
9 percent and an after-tax real interest rate of only 1 percent. In this case, the
25 percent tax on interest income reduces the real interest rate from 4 percent to
1 percent. Because the after-tax real interest rate provides the incentive to save,
saving is much less attractive in the economy with inflation (Economy 2) than in
the economy with stable prices (Economy 1).
Table 28-1
HOW INFLATION RAISES THE
TAX BURDEN ON SAVING.
In the presence of zero inflation, a
25 percent tax on interest income
reduces the real interest rate from
4 percent to 3 percent. In the
presence of 8 percent inflation,
the same tax reduces the real
interest rate from 4 percent to
1 percent.
ECONOMY1 ECONOMY 2
(PRICE STABILITY) (INFLATION)
Real interest rate 4% 4%
Inflation rate 0 8
Nominal interest rate
(real interest rate inflation rate) 4 12
Reduced interest due to 25 percent tax
(.25 nominal interest rate) 1 3
After-tax nominal interest rate
(.75 nominal interest rate) 3 9
After-tax real interest rate
(after-tax nominal interest
rate inflation rate) 3 1
646 PART TEN MONEY AND PRICES IN THE LONG RUN
The taxes on nominal capital gains and on nominal interest income are two
examples of how the tax code interacts with inflation. There are many others.
Because of these inflation-induced tax changes, higher inflation tends to discourage
people from saving. Recall that the economy’s saving provides the resources
for investment, which in turn is a key ingredient to long-run economic growth.
Thus, when inflation raises the tax burden on saving, it tends to depress the economy’s
long-run growth rate. There is, however, no consensus among economists
about the size of this effect.
One solution to this problem, other than eliminating inflation, is to index the
tax system. That is, the tax laws could be rewritten to take account of the effects of
inflation. In the case of capital gains, for example, the tax code could adjust the
purchase price using a price index and assess the tax only on the real gain. In the
case of interest income, the government could tax only real interest income by excluding
that portion of the interest income that merely compensates for inflation.
To some extent, the tax laws have moved in the direction of indexation. For example,
the income levels at which income tax rates change are adjusted automatically
each year based on changes in the consumer price index. Yet many other aspects of
the tax laws—such as the tax treatment of capital gains and interest income—are
not indexed.
In an ideal world, the tax laws would be written so that inflation would not
alter anyone’s real tax liability. In the world in which we live, however, tax laws
are far from perfect. More complete indexation would probably be desirable, but
it would further complicate a tax code that many people already consider too
complex.
CONFUSION AND INCONVENIENCE
Imagine that we took a poll and asked people the following question: “This year
the yard is 36 inches. How long do you think it should be next year?” Assuming
we could get people to take us seriously, they would tell us that the yard
should stay the same length—36 inches. Anything else would just complicate life
needlessly.
What does this finding have to do with inflation? Recall that money, as the
economy’s unit of account, is what we use to quote prices and record debts. In
other words, money is the yardstick with which we measure economic transactions.
The job of the Federal Reserve is a bit like the job of the Bureau of Standards—
to ensure the reliability of a commonly used unit of measurement. When
the Fed increases the money supply and creates inflation, it erodes the real value
of the unit of account.
It is difficult to judge the costs of the confusion and inconvenience that arise
from inflation. Earlier we discussed how the tax code incorrectly measures real incomes
in the presence of inflation. Similarly, accountants incorrectly measure
firms’ earnings when prices are rising over time. Because inflation causes dollars
at different times to have different real values, computing a firm’s profit—the difference
between its revenue and costs—is more complicated in an economy with
inflation. Therefore, to some extent, inflation makes investors less able to sort out
successful from unsuccessful firms, which in turn impedes financial markets in
their role of allocating the economy’s saving to alternative types of investment.
CHAPTER 28 MONEY GROWTH AND INFLATION 647
CASE STUDY THE WIZARD OF OZ
AND THE FREE-SILVER DEBATE
As a child, you probably saw the movie The Wizard of Oz, based on a children’s
book written in 1900. The movie and book tell the story of a young girl,
Dorothy, who finds herself lost in a strange land far from home. You probably
did not know, however, that the story is actually an allegory about U.S. monetary
policy in the late nineteenth century.
From 1880 to 1896, the price level in the U.S. economy fell by 23 percent.
Because this event was unanticipated, it led to a major redistribution of
A SPECIAL COST OF UNEXPECTED INFLATION:
ARBITRARY REDISTRIBUTIONS OF WEALTH
So far, the costs of inflation we have discussed occur even if inflation is steady and
predictable. Inflation has an additional cost, however, when it comes as a surprise.
Unexpected inflation redistributes wealth among the population in a way that has
nothing to do with either merit or need. These redistributions occur because many
loans in the economy are specified in terms of the unit of account—money.
Consider an example. Suppose that Sam Student takes out a $20,000 loan at a
7 percent interest rate from Bigbank to attend college. In ten years, the loan will
come due. After his debt has compounded for ten years at 7 percent, Sam will owe
Bigbank $40,000. The real value of this debt will depend on inflation over the
decade. If Sam is lucky, the economy will have a hyperinflation. In this case, wages
and prices will rise so high that Sam will be able to pay the $40,000 debt out of
pocket change. By contrast, if the economy goes through a major deflation, then
wages and prices will fall, and Sam will find the $40,000 debt a greater burden
than he anticipated.
This example shows that unexpected changes in prices redistribute wealth
among debtors and creditors. Ahyperinflation enriches Sam at the expense of Bigbank
because it diminishes the real value of the debt; Sam can repay the loan in
less valuable dollars than he anticipated. Deflation enriches Bigbank at Sam’s expense
because it increases the real value of the debt; in this case, Sam has to repay
the loan in more valuable dollars than he anticipated. If inflation were predictable,
then Bigbank and Sam could take inflation into account when setting the nominal
interest rate. (Recall the Fisher effect.) But if inflation is hard to predict, it imposes
risk on Sam and Bigbank that both would prefer to avoid.
This cost of unexpected inflation is important to consider together with another
fact: Inflation is especially volatile and uncertain when the average rate of inflation
is high. This is seen most simply by examining the experience of different
countries. Countries with low average inflation, such as Germany in the late twentieth
century, tend to have stable inflation. Countries with high average inflation,
such as many countries in Latin America, tend also to have unstable inflation.
There are no known examples of economies with high, stable inflation. This relationship
between the level and volatility of inflation points to another cost of inflation.
If a country pursues a high-inflation monetary policy, it will have to bear
not only the costs of high expected inflation but also the arbitrary redistributions
of wealth associated with unexpected inflation.
648 PART TEN MONEY AND PRICES IN THE LONG RUN
wealth. Most farmers in the western part of the country were debtors. Their
creditors were the bankers in the east. When the price level fell, it caused the
real value of these debts to rise, which enriched the banks at the expense of the
farmers.
According to populist politicians of the time, the solution to the farmers’
problem was the free coinage of silver. During this period, the United States
was operating with a gold standard. The quantity of gold determined the
money supply and, thereby, the price level. The free-silver advocates wanted
silver, as well as gold, to be used as money. If adopted, this proposal would
have increased the money supply, pushed up the price level, and reduced the
real burden of the farmers’ debts.
The debate over silver was heated, and it was central to the politics of the
1890s. A common election slogan of the populists was “We Are Mortgaged. All
But Our Votes.” One prominent advocate of free silver was William Jennings
Bryan, the Democratic nominee for president in 1896. He is remembered in part
for a speech at the Democratic party’s nominating convention in which he said,
“You shall not press down upon the brow of labor this crown of thorns. You
shall not crucify mankind upon a cross of gold.” Rarely since then have politicians
waxed so poetic about alternative approaches to monetary policy.
Nonetheless, Bryan lost the election to Republican William McKinley, and the
United States remained on the gold standard.
L. Frank Baum, the author of the book The Wonderful Wizard of Oz, was a
midwestern journalist. When he sat down to write a story for children, he made
the characters represent protagonists in the major political battle of his time.
Although modern commentators on the story differ somewhat in the interpretation
they assign to each character, there is no doubt that the story highlights
the debate over monetary policy. Here is how economic historian Hugh
Rockoff, writing in the August 1990 issue of the Journal of Political Economy,
interprets the story:
DOROTHY: Traditional American values
TOTO: Prohibitionist party, also called the
Teetotalers
SCARECROW: Farmers
TIN WOODSMAN: Industrial workers
COWARDLY LION: William Jennings Bryan
MUNCHKINS: Citizens of the east
WICKED WITCH OF THE EAST: Grover Cleveland
WICKED WITCH OF THE WEST: William McKinley
WIZARD: Marcus Alonzo Hanna, chairman of the
Republican party
OZ: Abbreviation for ounce of gold
YELLOW BRICK ROAD: Gold standard
In the end of Baum’s story, Dorothy does find her way home, but it is not by just
following the yellow brick road. After a long and perilous journey, she learns
that the wizard is incapable of helping her or her friends. Instead, Dorothy
finally discovers the magical power of her silver slippers. (When the book was
made into a movie in 1939, Dorothy’s slippers were changed from silver to ruby.
Apparently, the Hollywood filmmakers were not aware that they were telling a
story about nineteenth-century monetary policy.)
Although the populists lost the debate over the free coinage of silver, they
did eventually get the monetary expansion and inflation that they wanted. In
1898 prospectors discovered gold near the Klondike River in the Canadian
Yukon. Increased supplies of gold also arrived from the mines of South Africa.
As a result, the money supply and the price level started to rise in the United
States and other countries operating on the gold standard. Within 15 years,
prices in the United States were back to the levels that had prevailed in the
1880s, and farmers were better able to handle their debts.
QUICK QUIZ: List and describe six costs of inflation.
CONCLUSION
This chapter discussed the causes and costs of inflation. The primary cause of inflation
is simply growth in the quantity of money. When the central bank creates
money in large quantities, the value of money falls quickly. To maintain stable
prices, the central bank must maintain strict control over the money supply.
The costs of inflation are more subtle. They include shoeleather costs, menu
costs, increased variability of relative prices, unintended changes in tax liabilities,
confusion and inconvenience, and arbitrary redistributions of wealth. Are these
costs, in total, large or small? All economists agree that they become huge during
hyperinflation. But their size for moderate inflation—when prices rise by less than
10 percent per year—is more open to debate.
Although this chapter presented many of the most important lessons about inflation,
the discussion is incomplete. When the Fed reduces the rate of money
growth, prices rise less rapidly, as the quantity theory suggests. Yet as the economy
makes the transition to this lower inflation rate, the change in monetary policy will
have disruptive effects on production and employment. That is, even though monetary
policy is neutral in the long run, it has profound effects on real variables in
CHAPTER 28 MONEY GROWTH AND INFLATION 649
AN EARLY DEBATE OVER
MONETARY POLICY
650 PART TEN MONEY AND PRICES IN THE LONG RUN
the short run. Later in this book we will examine the reasons for short-run monetary
nonneutrality in order to enhance our understanding of the causes and costs
of inflation.
AS WE HAVE SEEN, UNEXPECTED CHANGES
in the price level redistribute wealth
among debtors and creditors. This
would no longer be true if debt contracts
were written in real, rather than
nominal, terms. In 1997 the U.S. Treasury
started issuing bonds with a
return indexed to the price level. In
the following article, written a few
months before the policy was implemented,
two prominent economists
discuss the merits of this policy.
I n f l a t i o n F i g h t e r s
f o r t h e Long Term
BY JOHN Y. CAMPBELL
AND ROBERT J. SHILLER
Treasury Secretary Robert Rubin announced
on Thursday that the government
plans to issue inflation-indexed
bonds—that is, bonds whose interest
and principal payments are adjusted
upward for inflation, guaranteeing their
real purchasing power in the future.
This is a historic moment. Economists
have been advocating such
bonds for many long and frustrating
years. Index bonds were first called for
in 1822 by the economist Joseph
Lowe. In the 1870s, they were championed
by the British economist William
Stanley Jevons. In the early part of
this century, the legendary Irving
Fisher made a career of advocating
them.
In recent decades, economists of
every political stripe—from Milton
Friedman to James Tobin, Alan Blinder
to Alan Greenspan—have supported
them. Yet, because there was little
public clamor for such an investment,
the government never issued indexed
bonds.
Let’s hope this lack of interest
does not continue now that they will
become available. The success of the
indexed bonds depends on whether the
public understands them—and buys
them. Until now, inflation has made
government bonds a risky investment.
In 1966, when the inflation rate was
only 3 percent, if someone had bought
a 30-year government bond yielding
5 percent, he would have expected
that by now his investment would be
worth 180 percent of its original value.
However, after years of higher-thanexpected
inflation, the investment is
worth only 85 percent of its original
value.
Because inflation has been modest
in recent years, many people today
are not worried about how it will affect
their savings. This complacency is dangerous:
Even a low rate of inflation can
seriously erode savings over long periods
of time.
Imagine that you retire today with a
pension invested in Treasury bonds
that pay a fixed $10,000 each year,
IN THE NEWS
How to Protect Your Savings
from Inflation
The overall level of prices in an economy adjusts to
bring money supply and money demand into balance.
When the central bank increases the supply of money, it
causes the price level to rise. Persistent growth in the
quantity of money supplied leads to continuing
inflation.
The principle of monetary neutrality asserts that
changes in the quantity of money influence nominal
variables but not real variables. Most economists believe
that monetary neutrality approximately describes the
behavior of the economy in the long run.
Summary
CHAPTER 28 MONEY GROWTH AND INFLATION 651
regardless of inflation. If there is no inflation,
in 20 years the pension will have
the same purchasing power that it does
today. But if there is an inflation rate of
only 3 percent per year, in 20 years
your pension will be worth only $5,540
in today’s dollars. Five percent inflation
over 20 years will cut your purchasing
power to $3,770, and 10 percent will
reduce it to a pitiful $1,390. Which
of these scenarios is likely? No one
knows. Inflation ultimately depends on
the people who are elected and appointed
as guardians of our money
supply.
At a time when Americans are living
longer and planning for several
decades of retirement, the insidious effects
of inflation should be of serious
concern. For this reason alone, the creation
of inflation-indexed bonds, with
their guarantee of a safe return over
long periods of time, is a welcome development.
No other investment offers this
kind of safety. Conventional government
bonds make payments that are
fixed in dollar terms; but investors
should be concerned about purchasing
power, not about the number of dollars
they receive. Money market funds
make dollar payments that increase
with inflation to some degree, since
short-term interest rates tend to rise
with inflation. But many other factors
also influence interest rates, so the real
income from a money market fund is
not secure.
The stock market offers a high rate
of return on average, but it can fall as
well as rise. Investors should remember
the bear market of the 1970s as
well as the bull market of the 1980s
and 1990s.
Inflation-indexed government bonds
have been issued in Britain for 15
years, in Canada for five years, and in
many other countries, including Australia,
New Zealand, and Sweden. In
Britain, which has the world’s largest indexed-
bond market, the bonds have offered
a yield 3 to 4 percent higher than
the rate of inflation. In the United
States, a safe long-term return of this
sort should make indexed bonds an important
part of retirement savings.
We expect that financial institutions
will take advantage of the new
inflation-indexed bonds and offer innovative
new products. Indexed-bond
funds will probably appear first, but indexed
annuities and even indexed mortgages—
monthly payments would be
adjusted for inflation—should also become
available. [ Author’s note: Since
this article was written, some of these
indexed products have been introduced,
but their use is not yet widespread.]
Although the Clinton administration
may not get much credit for it today,
the decision to issue inflation-indexed
bonds is an accomplishment that historians
decades hence will single out for
special recognition.
SOURCE: The New York Times, May 18, 1996, p. 19.
A government can pay for some of its spending simply
by printing money. When countries rely heavily on this
“inflation tax,” the result is hyperinflation.
One application of the principle of monetary neutrality
is the Fisher effect. According to the Fisher effect, when
the inflation rate rises, the nominal interest rate rises by
the same amount, so that the real interest rate remains
the same.
Many people think that inflation makes them poorer
because it raises the cost of what they buy. This view is
a fallacy, however, because inflation also raises nominal
incomes.
Economists have identified six costs of inflation:
shoeleather costs associated with reduced money
holdings, menu costs associated with more frequent
adjustment of prices, increased variability of relative
prices, unintended changes in tax liabilities due to
nonindexation of the tax code, confusion and
inconvenience resulting from a changing unit of
account, and arbitrary redistributions of wealth between
debtors and creditors. Many of these costs are large
during hyperinflation, but the size of these costs for
moderate inflation is less clear.
652 PART TEN MONEY AND PRICES IN THE LONG RUN
quantity theory of money, p. 632
nominal variables, p. 633
real variables, p. 633
classical dichotomy, p. 633
monetary neutrality, p. 634
velocity of money, p. 635
quantity equation, p. 635
inflation tax, p. 638
Fisher effect, p. 640
shoeleather costs, p. 642
menu costs, p. 644
Key Concepts
1. Explain how an increase in the price level affects the real
value of money.
2. According to the quantity theory of money, what is the
effect of an increase in the quantity of money?
3. Explain the difference between nominal and real
variables, and give two examples of each. According to
the principle of monetary neutrality, which variables are
affected by changes in the quantity of money?
4. In what sense is inflation like a tax? How does thinking
about inflation as a tax help explain hyperinflation?
5. According to the Fisher effect, how does an increase in
the inflation rate affect the real interest rate and the
nominal interest rate?
6. What are the costs of inflation? Which of these costs do
you think are most important for the U.S. economy?
7. If inflation is less than expected, who benefits—debtors
or creditors? Explain.
Questions for Review
1. Suppose that this year’s money supply is $500 billion,
nominal GDP is $10 trillion, and real GDP is $5 trillion.
a. What is the price level? What is the velocity of
money?
b. Suppose that velocity is constant and the
economy’s output of goods and services rises by
5 percent each year. What will happen to nominal
GDP and the price level next year if the Fed keeps
the money supply constant?
c. What money supply should the Fed set next year if
it wants to keep the price level stable?
d. What money supply should the Fed set next year if
it wants inflation of 10 percent?
2. Suppose that changes in bank regulations expand the
availability of credit cards, so that people need to hold
less cash.
a. How does this event affect the demand for money?
b. If the Fed does not respond to this event, what will
happen to the price level?
c. If the Fed wants to keep the price level stable, what
should it do?
3. It is often suggested that the Federal Reserve try to
achieve zero inflation. If we assume that velocity is
constant, does this zero-inflation goal require that the
rate of money growth equal zero? If yes, explain why. If
no, explain what the rate of money growth should
equal.
4. The economist John Maynard Keynes wrote: “Lenin is
said to have declared that the best way to destroy the
capitalist system was to debauch the currency. By a
continuing process of inflation, governments can
confiscate, secretly and unobserved, an important part
of the wealth of their citizens.” Justify Lenin’s assertion.
5. Suppose that a country’s inflation rate increases sharply.
What happens to the inflation tax on the holders of
money? Why is wealth that is held in savings accounts
not subject to a change in the inflation tax? Can you
think of any way in which holders of savings accounts
are hurt by the increase in the inflation rate?
6. Hyperinflations are extremely rare in countries whose
central banks are independent of the rest of the
government. Why might this be so?
Problems and Applications
CHAPTER 28 MONEY GROWTH AND INFLATION 653
7. Let’s consider the effects of inflation in an economy
composed only of two people: Bob, a bean farmer, and
Rita, a rice farmer. Bob and Rita both always consume
equal amounts of rice and beans. In 2000, the price of
beans was $1, and the price of rice was $3.
a. Suppose that in 2001 the price of beans was $2 and
the price of rice was $6. What was inflation? Was
Bob better off, worse off, or unaffected by the
changes in prices? What about Rita?
b. Now suppose that in 2001 the price of beans was $2
and the price of rice was $4. What was inflation?
Was Bob better off, worse off, or unaffected by the
changes in prices? What about Rita?
c. Finally, suppose that in 2001 the price of beans
was $2 and the price of rice was $1.50. What
was inflation? Was Bob better off, worse off,
or unaffected by the changes in prices?
What about Rita?
d. What matters more to Bob and Rita—the overall
inflation rate or the relative price of rice and beans?
8. If the tax rate is 40 percent, compute the before-tax real
interest rate and the after-tax real interest rate in each of
the following cases:
a. The nominal interest rate is 10 percent and the
inflation rate is 5 percent.
b. The nominal interest rate is 6 percent and the
inflation rate is 2 percent.
c. The nominal interest rate is 4 percent and the
inflation rate is 1 percent.
9. What are your shoeleather costs of going to the bank?
How might you measure these costs in dollars? How do
you think the shoeleather costs of your college president
differ from your own?
10. Recall that money serves three functions in the
economy. What are those functions? How does inflation
affect the ability of money to serve each of these
functions?
11. Suppose that people expect inflation to equal 3 percent,
but in fact prices rise by 5 percent. Describe how this
unexpectedly high inflation rate would help or hurt the
following:
a. the government
b. a homeowner with a fixed-rate mortgage
c. a union worker in the second year of a labor
contract
d. a college that has invested some of its endowment
in government bonds
12. Explain one harm associated with unexpected inflation
that is not associated with expected inflation. Then
explain one harm associated with both expected and
unexpected inflation.
13. Explain whether the following statements are true, false,
or uncertain.
a. “Inflation hurts borrowers and helps lenders,
because borrowers must pay a higher rate of
interest.”
b. “If prices change in a way that leaves the overall
price level unchanged, then no one is made better
or worse off.”
c. “Inflation does not reduce the purchasing power of
most workers.”

IN THIS CHAPTER
YOU WILL . . .
Learn the meaning of
the nominal exchange
rate and the real
exchange rate
Examine purchasingpower
parity as
a theor y of how
exchange rates
are determined
Consider why net
expor ts must always
equal net foreign
investment
Learn how net
expor ts measure the
international flow of
goods and ser vices
Learn how net foreign
investment measures
the international
flow of capital
See how saving,
domestic investment,
and net foreign
investment are
related
When you decide to buy a car, you may compare the latest models offered by Ford
and Toyota. When you take your next vacation, you may consider spending it on
a beach in Florida or in Mexico. When you start saving for your retirement, you
may choose between a mutual fund that buys stock in U.S. companies and one that
buys stock in foreign companies. In all of these cases, you are participating not just
in the U.S. economy but in economies around the world.
There are clear benefits to being open to international trade: Trade allows people
to produce what they produce best and to consume the great variety of goods
and services produced around the world. Indeed, one of the Ten Principles of Economics
highlighted in Chapter 1 is that trade can make everyone better off. Chapters
3 and 9 examined the gains from trade more fully. We learned that
international trade can raise living standards in all countries by allowing each
O P E N - E C O N O M Y
M A C R O E C O N O M I C S :
B A S I C C O N C E P T S
657
658 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
country to specialize in producing those goods and services in which it has a comparative
advantage.
So far our development of macroeconomics has largely ignored the economy’s
interaction with other economies around the world. For most questions in macroeconomics,
international issues are peripheral. For instance, when we discussed
the natural rate of unemployment in Chapter 26 and the causes of inflation in
Chapter 28, the effects of international trade could safely be ignored. Indeed, to
keep their analysis simple, macroeconomists often assume a closed economy—an
economy that does not interact with other economies.
Yet some new macroeconomic issues arise in an open economy—an economy
that interacts freely with other economies around the world. This chapter and the
next one, therefore, provide an introduction to open-economy macroeconomics.
We begin in this chapter by discussing the key macroeconomic variables that describe
an open economy’s interactions in world markets. You may have noticed
mention of these variables—exports, imports, the trade balance, and exchange
rates—when reading the newspaper or watching the nightly news. Our first job is
to understand what these data mean. In the next chapter we develop a model to
explain how these variables are determined and how they are affected by various
government policies.
THE INTERNATIONAL FLOWS
OF GOODS AND CAPITAL
An open economy interacts with other economies in two ways: It buys and sells
goods and services in world product markets, and it buys and sells capital assets
in world financial markets. Here we discuss these two activities and the close relationship
between them.
THE FLOW OF GOODS: EXPORTS, IMPORTS,
AND NET EXPORTS
As we first noted in Chapter 3, exports are domestically produced goods and services
that are sold abroad, and imports are foreign-produced goods and services
that are sold domestically. When Boeing, the U.S. aircraft manufacturer, builds a
plane and sells it to Air France, the sale is an export for the United States and an
import for France. When Volvo, the Swedish car manufacturer, makes a car and
sells it to a U.S. resident, the sale is an import for the United States and an export
for Sweden.
The net exports of any country are the value of its exports minus the value of
its imports. The Boeing sale raises U.S. net exports, and the Volvo sale reduces U.S.
net exports. Because net exports tell us whether a country is, in total, a seller or a
buyer in world markets for goods and services, net exports are also called the
trade balance. If net exports are positive, exports are greater than imports, indicating
that the country sells more goods and services abroad than it buys from
other countries. In this case, the country is said to run a trade surplus. If net
closed economy
an economy that does not interact
with other economies in the world
open economy
an economy that interacts freely with
other economies around the world
expor ts
goods and services that are produced
domestically and sold abroad
impor ts
goods and services that are produced
abroad and sold domestically
net expor ts
the value of a nation’s exports minus
the value of its imports, also called
the trade balance
trade balance
the value of a nation’s exports minus
the value of its imports, also called
net exports
trade surplus
an excess of exports over imports
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 659
CASE STUDY THE INCREASING OPENNESS
OF THE U.S. ECONOMY
Perhaps the most dramatic change in the U.S. economy over the past five
decades has been the increasing importance of international trade and finance.
This change is illustrated in Figure 29-1, which shows the total value of goods
and services exported to other countries and imported from other countries expressed
as a percentage of gross domestic product. In the 1950s exports of goods
and services averaged less than 5 percent of GDP. Today they are more than
twice that level and still rising. Imports of goods and services have risen by a
similar amount.
exports are negative, exports are less than imports, indicating that the country sells
fewer goods and services abroad than it buys from other countries. In this case, the
country is said to run a trade deficit. If net exports are zero, its exports and imports
are exactly equal, and the country is said to have balanced trade.
In the next chapter we develop a theory that explains an economy’s trade balance,
but even at this early stage it is easy to think of many factors that might influence
a country’s exports, imports, and net exports. Those factors include the
following:
The tastes of consumers for domestic and foreign goods
The prices of goods at home and abroad
The exchange rates at which people can use domestic currency to buy foreign
currencies
The incomes of consumers at home and abroad
The cost of transporting goods from country to country
The policies of the government toward international trade
As these variables change over time, so does the amount of international trade.
“But we’re not just talking about buying a car—we’re talking
about confronting this country’s trade deficit with Japan.”
trade deficit
an excess of imports over exports
balanced trade
a situation in which exports
equal imports
660 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
This increase in international trade is partly due to improvements in transportation.
In 1950 the average merchant ship carried less than 10,000 tons of
cargo; today, many ships carry more than 100,000 tons. The long-distance jet
was introduced in 1958, and the wide-body jet in 1967, making air transport far
cheaper. Because of these developments, goods that once had to be produced locally
can now be traded around the world. Cut flowers, for instance, are now
grown in Israel and flown to the United States to be sold. Fresh fruits and vegetables
that can grow only in summer can now be consumed in winter as well,
because they can be shipped to the United States from countries in the southern
hemisphere.
The increase in international trade has also been influenced by advances in
telecommunications, which have allowed businesses to reach overseas customers
more easily. For example, the first transatlantic telephone cable was not
laid until 1956. As recently as 1966, the technology allowed only 138 simultaneous
conversations between North America and Europe. Today, communications
satellites permit more than 1 million conversations to occur at the same time.
Technological progress has also fostered international trade by changing the
kinds of goods that economies produce. When bulky raw materials (such as
steel) and perishable goods (such as foodstuffs) were a large part of the world’s
output, transporting goods was often costly and sometimes impossible. By contrast,
goods produced with modern technology are often light and easy to transport.
Consumer electronics, for instance, have low weight for every dollar of
value, which makes them easy to produce in one country and sell in another. An
even more extreme example is the film industry. Once a studio in Hollywood
makes a movie, it can send copies of the film around the world at almost zero
cost. And, indeed, movies are a major export of the United States.
The government’s trade policies have also been a factor in increasing international
trade. As we discussed in Chapters 3 and 9, economists have long believed
that free trade between countries is mutually beneficial. Over time,
policymakers around the world have come to accept these conclusions. International
agreements, such as the North American Free Trade Agreement
(NAFTA) and the General Agreement on Tariffs and Trade (GATT), have gradually
lowered trade barriers, such as tariffs and import quotas. The pattern of
INTERNATIONAL TRADE IS
INCREASINGLY IMPORTANT
FOR THE U.S. ECONOMY.
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 661
increasing trade illustrated in Figure 29-1 is a phenomenon that most economists
and policymakers endorse and encourage.
THE FLOW OF CAPITAL: NET FOREIGN INVESTMENT
So far we have been discussing how residents of an open economy participate in
world markets for goods and services. In addition, residents of an open economy
participate in world financial markets. A U.S. resident with $20,000 could use that
money to buy a car from Toyota, but he could instead use that money to buy stock
in the Toyota corporation. The first transaction would represent a flow of goods,
whereas the second would represent a flow of capital.
The term net foreign investment refers to the purchase of foreign assets by
domestic residents minus the purchase of domestic assets by foreigners. When a
U.S. resident buys stock in Telmex, the Mexican phone company, the purchase
raises U.S. net foreign investment. When a Japanese resident buys a bond issued
by the U.S. government, the purchase reduces U.S. net foreign investment.
Recall that foreign investment takes two forms. If McDonald’s opens up a fast
food outlet in Russia, that is an example of foreign direct investment. Alternatively,
if an American buys stock in a Russian corporation, that is an example of foreign
portfolio investment. In the first case, the American owner is actively managing the
investment, whereas in the second case the American owner has a more passive
role. In both cases, U.S. residents are buying assets located in another country, so
both purchases increase U.S. net foreign investment.
We develop a theory to explain net foreign investment in the next chapter.
Here, let’s consider briefly some of the more important variables that influence net
foreign investment:
The real interest rates being paid on foreign assets
The real interest rates being paid on domestic assets
Percent
of GDP
Exports
Imports
0
5
10
15
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Figure 29-1
THE INTERNATIONALIZATION
OF THE U.S. ECONOMY. This
figure shows exports and imports
of the U.S. economy
as a percentage of U.S. gross
domestic product since 1950.
The substantial increases over
time show the increasing
importance of international
trade and finance.
SOURCE: U.S. Department of Commerce.
net foreign investment
the purchase of foreign assets
by domestic residents minus
the purchase of domestic
assets by foreigners
662 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
The perceived economic and political risks of holding assets abroad
The government policies that affect foreign ownership of domestic assets
For example, consider U.S. investors deciding whether to buy Mexican government
bonds or U.S. government bonds. (Recall that a bond is, in effect, an IOU of
the issuer.) To make this decision, U.S. investors compare the real interest rates
offered on the two bonds. The higher a bond’s real interest rate, the more attractive
it is. While making this comparison, however, U.S. investors must also take into
account the risk that one of these governments might default on its debt (that is,
not pay interest or principal when it is due), as well as any restrictions that the
WHEN YOU HEAR ABOUT A FACTORY BEING
built in Asia or Latin America, have you
ever wondered who is financing that
project? The answer might surprise you.
The Wo r l d ’s N e w F i n a n c i e r I s You
BY EDWARD WYATT
Investors flocked to Eastern Europe after
the Berlin Wall fell in 1989, eager to
scoop up bargains in what they were
sure would be a quick economic revival.
A year later, the technology boom drew
their money to the Far East. Then Latin
America heated up—that is, until the
Mexican peso went bust, which sent
investors scurrying back to the Pacific
Rim. Russia got sexy as an investment
early [in 1997], and more recently South
America has had allure.
Billions of dollars are sloshing back
and forth over the globe with seemingly
little rhyme or reason, chasing investments
in once-obscure markets from
Santiago to Kuala Lumpur. But there is at
least some method to the madness—despite
occasional debacles like the recent
Bre-X gold mining fraud, in which mutual
fund managers poured scads of money
into what amounted to little more than
holes in the ground in Borneo.
To begin with, foreign stock and
bond markets are growing much faster
than those in America, providing much
higher returns to investors. In 1970, foreign
markets accounted for only a third
of the value of the world’s stock and
bond markets, with the United States
alone accounting for the other twothirds.
But by last year, they had grown
to nearly 60 percent of the total.
Stock markets in newly emerging
economies like those of Turkey, Argentina,
and South Africa now account
for 14 percent of the world’s total stock
market value, up from 4 percent 10
years ago.
Investors have flocked to them as
global economic trends have shifted
since the end of the cold war. Centralized,
state-planned economies have
been scuttled for ones favoring private
ownership of industry. With the transformation,
the resulting vibrant new
economies no longer need to rely on
international development agencies or
giant New York banks for foreign investment,
as they did in the 1970s and
1980s; instead, much of their seed capital
since 1990 has come from a surprising
source: millions of average
Americans who invest in mutual funds.
“This is a trend that has been led by
America, which pushed the international
lending agencies to encourage the development
of private enterprise, to open
up these markets and get the hands of
government out of industrial ownership,”
said J. Mark Mobius, who oversees several
Templeton mutual funds that invest
in emerging markets. “That led to the
development of capital markets—bond
markets and stock markets—in many of
these countries, and now to people like
me trying to invest all the money that is
flowing into our mutual funds.” . . .
And these days, when the finance
minister of a developing country wants
to encourage foreigners to invest in his
country, he is less likely to court the
World Bank or the Agency for International
Development than someone like
Mr. Mobius.
SOURCE: The New York Times, May 25, 1997, Week
in Review, p. 3.
IN THE NEWS
It’s the 21st Century,
Do You Know Where
Your Capital Is?
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 663
Mexican government has imposed, or might impose in the future, on foreign
investors in Mexico.
THE EQUALITY OF NET EXPORTS
AND NET FOREIGN INVESTMENT
We have seen that an open economy interacts with the rest of the world in two
ways—in world markets for goods and services and in world financial markets.
Net exports and net foreign investment each measure a type of imbalance in these
markets. Net exports measure an imbalance between a country’s exports and its
imports. Net foreign investment measures an imbalance between the amount of
foreign assets bought by domestic residents and the amount of domestic assets
bought by foreigners.
An important but subtle fact of accounting states that, for an economy as a
whole, these two imbalances must offset each other. That is, net foreign investment
(NFI) always equals net exports (NX):
NFI NX.
This equation holds because every transaction that affects one side of this equation
must also affect the other side by exactly the same amount. This equation is an
identity—an equation that must hold because of the way the variables in the equation
are defined and measured.
To see why this accounting identity is true, consider an example. Suppose that
Boeing, the U.S. aircraft maker, sells some planes to a Japanese airline. In this sale,
a U.S. company gives planes to a Japanese company, and a Japanese company
gives yen to a U.S. company. Notice that two things have occurred simultaneously.
The United States has sold to a foreigner some of its output (the planes), and this
sale increases U.S. net exports. In addition, the United States has acquired some
foreign assets (the yen), and this acquisition increases U.S. net foreign investment.
Although Boeing most likely will not hold on to the yen it has acquired in this
sale, any subsequent transaction will preserve the equality of net exports and net
foreign investment. For example, Boeing may exchange its yen for dollars with a
U.S. mutual fund that wants the yen to buy stock in Sony Corporation, the Japanese
maker of consumer electronics. In this case, Boeing’s net export of planes
equals the mutual fund’s net foreign investment in Sony stock. Hence, NX and NFI
rise by an equal amount.
Alternatively, Boeing may exchange its yen for dollars with another U.S. company
that wants to buy computers from Toshiba, the Japanese computer maker. In
this case, U.S. imports (of computers) exactly offset U.S. exports (of planes). The
sales by Boeing and Toshiba together affect neither U.S. net exports nor U.S. net
foreign investment. That is, NX and NFI are the same as they were before these
transactions took place.
The equality of net exports and net foreign investment follows from the fact
that every international transaction is an exchange. When a seller country transfers
a good or service to a buyer country, the buyer country gives up some asset to pay
for this good or service. The value of that asset equals the value of the good or service
sold. When we add everything up, the net value of goods and services sold by
a country (NX) must equal the net value of assets acquired (NFI). The international
664 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
flow of goods and services and the international flow of capital are two sides of
the same coin.
SAVING, INVESTMENT, AND THEIR RELATIONSHIP
TO THE INTERNATIONAL FLOWS
Anation’s saving and investment are, as we have seen in Chapters 24 and 25, crucial
to its long-run economic growth. Let’s therefore consider how these variables
are related to the international flows of goods and capital, as measured by net
exports and net foreign investment. We can do this most easily with the help of
some simple mathematics.
As you may recall, the term net exports first appeared earlier in the book when
we discussed the components of gross domestic product. The economy’s gross
domestic product (Y) is divided among four components: consumption (C),
investment (I ), government purchases (G), and net exports (NX). We write
this as
Y C I G NX.
WILL THE WORLD’SDEVELOPING COUNtries,
such as those in Latin America,
flood the world’s industrial countries
with cheap exports while refusing to
import goods from the industrial countries?
Will the developing countries use
the world’s saving to finance investment
and growth, leaving the industrial
countries with insufficient funds
for their own capital accumulation?
Some people fear that both of these outcomes
might occur. But an accounting
identity, and economist Paul Krugman,
tell us not to worry.
Fantasy Economics
BY PAUL KRUGMAN
Reports by international organizations
are usually greeted with well deserved
yawns. Occasionally, however, such a
report is a leading indicator of a sea
change in opinion.
A few weeks ago, the World Economic
Forum—which every year draws
an unmatched assemblage of the world’s
political and business elite to its conference
in Davos, Switzerland—released
its annual report on international competitiveness.
The report made headlines because
it demoted Japan and declared
America the world’s most competitive
economy.
The revealing part of the report,
however, is not its more or less meaningless
competitiveness rankings but its
introduction, which offers what seems to
be a very clear vision of the global economic
future.
That vision, shared by many powerful
people, is compelling and alarming. It
is also nonsense. And the fact that this
nonsense is being taken seriously by
many people who believe themselves to
be sophisticated about economics is itself
an ominous portent for the world
economy.
The report finds that the spread
of modern technology to newly industrializing
nations is deindustrializing
high-wage nations: Capital is flowing to
the Third World and low-cost producers
in these countries are flooding
world markets with cheap manufactured
goods.
The report predicts that these
trends will accelerate, that service jobs
will soon begin to follow the lost jobs in
manufacturing and that the future of the
high-wage nations offers a bleak choice
between declining wages and rising unemployment.
This vision resonates with many
people. Yet as a description of what has
IN THE NEWS
Flows between
the Developing South
and the Industrial North
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 665
Total expenditure on the economy’s output of goods and services is the sum of
expenditure on consumption, investment, government purchases, and net exports.
Because each dollar of expenditure is placed into one of these four components,
this equation is an accounting identity: It must be true because of the way the variables
are defined and measured.
Recall that national saving is the income of the nation that is left after paying
for current consumption and government purchases. National saving (S) equals
Y C G. If we rearrange the above equation to reflect this fact, we obtain
Y C G I NX
S I NX.
Because net exports (NX) also equal net foreign investment (NFI), we can write
this equation as
S I NFI
Saving
Domestic

Net foreign
investment investment.
actually happened in recent years, it is almost
completely untrue.
Rapidly growing Third World economies
have indeed increased their exports
of manufactured goods. But today
these exports absorb only about 1 percent
of First World income. Moreover,
Third World nations have also increased
their imports.
Overall, the effect of Third World
growth on the number of industrial jobs
in Western nations has been minimal:
Growing exports to the newly industrializing
countries have created about as
many jobs as growing imports have
displaced.
What about capital flows? The numbers
sound impressive. Last year, $24
billion flowed to Mexico, $11 billion to
China. The total movement of capital
from advanced to developing nations
was about $60 billion. But though this
sounds like a lot, it is pocket change in a
world economy that invests more than
$4 trillion a year.
In other words, if the vision of a
Western economy battered by low-wage
competition is meant to describe today’s
world, it is a fantasy with hardly any basis
in reality.
Even if the vision does not describe
the present, might it describe the future?
Well, growing exports of manufactured
goods from South to North will lead to a
net loss of northern industrial jobs only if
they are not matched by growth in exports
from North to South.
The authors of the report evidently
envision a future of large-scale Third
World trade surpluses. But it is an unavoidable
fact of accounting that a country
that runs a trade surplus must also
be a net investor in other countries. So
large-scale deindustrialization can take
place only if low-wage nations are major
exporters of capital to high-wage nations.
This seems unlikely. In any case, it
contradicts the rest of the story, which
predicts huge capital flows into low-wage
nations.
Thus, the vision offered by the
world competitiveness report conflicts
not only with the facts but with itself. Yet
it is a vision that a growing number of the
world’s most influential men and women
seem to share. That is a dangerous
trend.
Not everyone who worries about
low-wage competition is a protectionist.
Indeed, the authors of the world competitiveness
report would surely claim to be
champions of free trade. Nonetheless,
the fact that such ideas have become respectable
. . . suggests that the intellectual
consensus that has kept world trade
relatively free, and that has allowed hundreds
of millions of people in the Third
World to get their first taste of prosperity,
may be unraveling.
SOURCE: The New York Times, September 26, 1994,
p. A17.
666 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
CASE STUDY ARE U.S. TRADE DEFICITS
A NATIONAL PROBLEM?
You may have heard the press call the United States “the world’s largest
debtor.” The nation earned that description by borrowing heavily in world financial
markets during the 1980s and 1990s to finance large trade deficits. Why
did the United States do this, and should this event give Americans reason to
worry?
To answer these questions, let’s see what these macroeconomic accounting
identities tell us about the U.S. economy. Panel (a) of Figure 29-2 shows national
saving and domestic investment as a percentage of GDP since 1960. Panel (b)
shows net foreign investment as a percentage of GDP. Notice that, as the identities
require, net foreign investment always equals national saving minus domestic
investment.
The figure shows a dramatic change beginning in the early 1980s. Before
1980, national saving and domestic investment were very close, and so net foreign
investment was small. Yet after 1980, national saving fell dramatically, in
part because of increased government budget deficits and in part because of a
fall in private saving. Because this fall in saving did not coincide with a similar
fall in domestic investment, net foreign investment became a large negative
number, indicating that foreigners were buying more assets in the United States
than Americans were buying abroad. Put simply, the United States was going
into debt.
As we have seen, accounting identities require that net exports must equal
net foreign investment. Thus, when net foreign investment became negative,
net exports became negative as well. The United States ran a trade deficit:
This equation shows that a nation’s saving must equal its domestic investment
plus its net foreign investment. In other words, when U.S. citizens save a dollar of
their income for the future, that dollar can be used to finance accumulation of domestic
capital or it can be used to finance the purchase of capital abroad.
This equation should look somewhat familiar. Earlier in the book, when we
analyzed the role of the financial system, we considered this identity for the special
case of a closed economy. In a closed economy, net foreign investment is zero
(NFI 0), so saving equals investment (S I ). By contrast, an open economy has
two uses for its saving: domestic investment and net foreign investment.
As before, we can view the financial system as standing between the two sides
of this identity. For example, suppose the Smith family decides to save some of its
income for retirement. This decision contributes to national saving, the left-hand
side of our equation. If the Smiths deposit their saving in a mutual fund, the mutual
fund may use some of the deposit to buy stock issued by General Motors,
which uses the proceeds to build a factory in Ohio. In addition, the mutual fund
may use some of the Smiths’ deposit to buy stock issued by Toyota, which uses the
proceeds to build a factory in Osaka. These transactions show up on the righthand
side of the equation. From the standpoint of U.S. accounting, the General
Motors expenditure on a new factory is domestic investment, and the purchase of
Toyota stock by a U.S. resident is net foreign investment. Thus, all saving in the
U.S. economy shows up as investment in the U.S. economy or as U.S. net foreign
investment.
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 667
Imports of goods and services exceeded exports. In 1998, the trade deficit was
$151 billion, or about 1.8 percent of GDP.
Are these trade deficits a problem for the U.S. economy? Most economists
believe that they are not a problem in themselves, but perhaps are a symptom
of a problem—reduced national saving. Reduced national saving is potentially
a problem because it means that the nation is putting away less to provide for
its future. Once national saving has fallen, however, there is no reason to deplore
the resulting trade deficits. If national saving fell without inducing a trade
deficit, investment in the United States would have to fall. This fall in investment,
in turn, would adversely affect the growth in the capital stock, labor
Percent
of GDP
20
18
16
14
12
10
1960 1965 1970 1975 1980 1985 1990 1995
National saving
Domestic investment
Percent
of GDP
4
4
3
2
1
0
1
2
3
Net foreign
investment
(a) National Saving and Domestic Investment (as a percentage of GDP)
(b) Net Foreign Investment (as a percentage of GDP)
2000
1960 1965 1970 1975 1980 1985 1990 1995 2000
Figure 29-2
NATIONAL SAVING,
DOMESTIC INVESTMENT, AND
NET FOREIGN INVESTMENT.
Panel (a) shows national saving
and domestic investment as
a percentage of GDP. Panel
(b) shows net foreign investment
as a percentage of GDP. You can
see from the figure that national
saving has been lower since 1980
than it was before 1980. This fall
in national saving has been
reflected primarily in reduced net
foreign investment rather than in
reduced domestic investment.
SOURCE: U.S. Department of Commerce.
668 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
productivity, and real wages. In other words, given the fact that U.S. citizens are
not saving much, it is better to have foreigners invest in the U.S. economy than
no one at all.
QUICK QUIZ: Define net exports and net foreign investment. Explain how
they are related.
THE PRICES FOR INTERNATIONAL TRANSACTIONS:
REAL AND NOMINAL EXCHANGE RATES
So far we have discussed measures of the flow of goods and services and the flow
of capital across a nation’s border. In addition to these quantity variables, macroeconomists
also study variables that measure the prices at which these international
transactions take place. Just as the price in any market serves the important
role of coordinating buyers and sellers in that market, international prices help coordinate
the decisions of consumers and producers as they interact in world markets.
Here we discuss the two most important international prices—the nominal
and real exchange rates.
NOMINAL EXCHANGE RATES
The nominal exchange rate is the rate at which a person can trade the currency of
one country for the currency of another. For example, if you go to a bank, you
might see a posted exchange rate of 80 yen per dollar. If you give the bank one U.S.
dollar, it will give you 80 Japanese yen; and if you give the bank 80 Japanese yen,
it will give you one U.S. dollar. (In actuality, the bank will post slightly different
prices for buying and selling yen. The difference gives the bank some profit for offering
this service. For our purposes here, we can ignore these differences.)
An exchange rate can always be expressed in two ways. If the exchange rate is
80 yen per dollar, it is also 1/80 ( 0.0125) dollar per yen. Throughout this book,
we always express the nominal exchange rate as units of foreign currency per U.S.
dollar, such as 80 yen per dollar.
If the exchange rate changes so that a dollar buys more foreign currency, that
change is called an appreciation of the dollar. If the exchange rate changes so that
a dollar buys less foreign currency, that change is called a depreciation of the dollar.
For example, when the exchange rate rises from 80 to 90 yen per dollar, the dollar
is said to appreciate. At the same time, because a Japanese yen now buys less of
the U.S. currency, the yen is said to depreciate. When the exchange rate falls from
80 to 70 yen per dollar, the dollar is said to depreciate, and the yen is said to appreciate.
At times you may have heard the media report that the dollar is either
“strong” or “weak.” These descriptions usually refer to recent changes in the nominal
exchange rate. When a currency appreciates, it is said to strengthen because it
can then buy more foreign currency. Similarly, when a currency depreciates, it is
said to weaken.
nominal exchange rate
the rate at which a person can trade
the currency of one country for the
currency of another
appreciation
an increase in the value of a currency
as measured by the amount of foreign
currency it can buy
depreciation
a decrease in the value of a currency
as measured by the amount of foreign
currency it can buy
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 669
For any country, there are many nominal exchange rates. The U.S. dollar can
be used to buy Japanese yen, British pounds, French francs, Mexican pesos, and so
on. When economists study changes in the exchange rate, they often use indexes
that average these many exchange rates. Just as the consumer price index turns the
many prices in the economy into a single measure of the price level, an exchange
rate index turns these many exchange rates into a single measure of the international
value of the currency. So when economists talk about the dollar appreciating
or depreciating, they often are referring to an exchange rate index that takes into
account many individual exchange rates.
REAL EXCHANGE RATES
The real exchange rate is the rate at which a person can trade the goods and services
of one country for the goods and services of another. For example, suppose
that you go shopping and find that a case of German beer is twice as expensive as
a case of American beer. We would then say that the real exchange rate is 1/2 case
of German beer per case of American beer. Notice that, like the nominal exchange
rate, we express the real exchange rate as units of the foreign item per unit of the
domestic item. But in this instance the item is a good rather than a currency.
Real and nominal exchange rates are closely related. To see how, consider an
example. Suppose that a bushel of American rice sells for $100, and a bushel of
Japanese rice sells for 16,000 yen. What is the real exchange rate between American
and Japanese rice? To answer this question, we must first use the nominal exchange
rate to convert the prices into a common currency. If the nominal exchange
rate is 80 yen per dollar, then a price for American rice of $100 per bushel is equivalent
to 8,000 yen per bushel. American rice is half as expensive as Japanese rice.
The real exchange rate is 1/2 bushel of Japanese rice per bushel of American rice.
We can summarize this calculation for the real exchange rate with the following
formula:
Real exchange rate .
Using the numbers in our example, the formula applies as follows:
Real exchange rate

1/2 bushel of Japanese rice per bushel of American rice.
Thus, the real exchange rate depends on the nominal exchange rate and on the
prices of goods in the two countries measured in the local currencies.
Why does the real exchange rate matter? As you might guess, the real exchange
rate is a key determinant of how much a country exports and imports.
When Uncle Ben’s, Inc., is deciding whether to buy U.S. rice or Japanese rice to put
into its boxes, for example, it will ask which rice is cheaper. The real exchange rate
8,000 yen per bushel of American rice
16,000 yen per bushel of Japanese rice
(80 yen per dollar) ($100 per bushel of American rice)
16,000 yen per bushel of Japanese rice
Nominal exchange rate Domestic price
Foreign price
real exchange rate
the rate at which a person can trade
the goods and services of one country
for the goods and services of another
670 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
gives the answer. As another example, imagine that you are deciding whether to
take a seaside vacation in Miami, Florida, or in Cancun, Mexico. You might ask
your travel agent the price of a hotel room in Miami (measured in dollars), the
price of a hotel room in Cancun (measured in pesos), and the exchange rate between
pesos and dollars. If you decide where to vacation by comparing costs, you
are basing your decision on the real exchange rate.
When studying an economy as a whole, macroeconomists focus on overall
prices rather than the prices of individual items. That is, to measure the real exchange
rate, they use price indexes, such as the consumer price index, which measure
the price of a basket of goods and services. By using a price index for a U.S.
basket (P), a price index for a foreign basket (P*), and the nominal exchange rate
between the U.S. dollar and foreign currencies (e), we can compute the overall real
exchange rate between the United States and other countries as follows:
Real exchange rate (e P)/P*.
This real exchange rate measures the price of a basket of goods and services available
domestically relative to a basket of goods and services available abroad.
As we examine more fully in the next chapter, a country’s real exchange rate is
a key determinant of its net exports of goods and services. A depreciation (fall) in
the U.S. real exchange rate means that U.S. goods have become cheaper relative to
foreign goods. This change encourages consumers both at home and abroad to buy
more U.S. goods and fewer goods from other countries. As a result, U.S. exports
rise, and U.S. imports fall, and both of these changes raise U.S. net exports. Conversely,
an appreciation (rise) in the U.S. real exchange rate means that U.S. goods
have become more expensive compared to foreign goods, so U.S. net exports fall.
QUICK QUIZ: Define nominal exchange rate and real exchange rate, and
explain how they are related. If the nominal exchange rate goes from 100 to
120 yen per dollar, has the dollar appreciated or depreciated?
A FIRST THEORY OF EXCHANGE-RATE
DETERMINATION: PURCHASING-POWER PARITY
Exchange rates vary substantially over time. In 1970, a U.S. dollar could be used to
buy 3.65 German marks or 627 Italian lira. In 1998, a U.S. dollar bought 1.76 German
marks or 1,737 Italian lira. In other words, over this period the value of the
dollar fell by more than half compared to the mark, while it more than doubled
compared to the lira.
What explains these large and opposite changes? Economists have developed
many models to explain how exchange rates are determined, each emphasizing
just some of the many forces at work. Here we develop the simplest theory of exchange
rates, called purchasing-power parity. This theory states that a unit of any
given currency should be able to buy the same quantity of goods in all countries.
Many economists believe that purchasing-power parity describes the forces that
determine exchange rates in the long run. We now consider the logic on which this
purchasing-power parity
a theory of exchange rates whereby a
unit of any given currency should
be able to buy the same quantity
of goods in all countries
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 671
long-run theory of exchange rates is based, as well as the theory’s implications and
limitations.
THE BASIC LOGIC OF PURCHASING-POWER PARITY
The theory of purchasing-power parity is based on a principle called the law of one
price. This law asserts that a good must sell for the same price in all locations. Otherwise,
there would be opportunities for profit left unexploited. For example, suppose
that coffee beans sold for less in Seattle than in Boston. A person could buy
coffee in Seattle for, say, $4 a pound and then sell it in Boston for $5 a pound, making
a profit of $1 per pound from the difference in price. The process of taking advantage
of differences in prices in different markets is called arbitrage. In our
example, as people took advantage of this arbitrage opportunity, they would increase
the demand for coffee in Seattle and increase the supply in Boston. The price
of coffee would rise in Seattle (in response to greater demand) and fall in Boston
(in response to greater supply). This process would continue until, eventually, the
prices were the same in the two markets.
Now consider how the law of one price applies to the international marketplace.
If a dollar (or any other currency) could buy more coffee in the United States
than in Japan, international traders could profit by buying coffee in the United
States and selling it in Japan. This export of coffee from the United States to Japan
Some of the currencies mentioned
in this chapter, such as
the French franc, the German
mark, and the Italian lira, are in
the process of disappearing.
Many European nations have
decided to give up their national
currencies and start using
a new common currency
called the euro. A newly formed
European Central Bank, with
representatives from all of the
participating countries, issues
the euro and controls the quantity in circulation, much as
the Federal Reserve controls the quantity of dollars in the
U.S. economy.
Why are these countries adopting a common currency?
One benefit of a common currency is that it makes trade
easier. Imagine that each of the 50 U.S. states had a different
currency. Every time you crossed a state border you
would need to change your money and perform the kind of
exchange-rate calculations discussed in the text. This would
be inconvenient, and it might deter you from buying goods
and services outside your own state. The countries of
Europe decided
that as their
economies became
more integrated,
it would
be better to
avoid this inconvenience.
There are,
however, costs
of choosing a
common currency.
If the nations
of Europe
have only one
money, they can
have only one monetary policy. If they disagree about what
monetary policy is best, they will have to reach some kind of
agreement, rather than each going its own way. Because
adopting a single money has both benefits and costs, there
is debate among economists about whether Europe’s recent
adoption of the euro was a good decision. Only time will tell
what effect the decision will have.
FYI
The Euro
672 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
would drive up the U.S. price of coffee and drive down the Japanese price. Conversely,
if a dollar could buy more coffee in Japan than in the United States, traders
could buy coffee in Japan and sell it in the United States. This import of coffee into
the United States from Japan would drive down the U.S. price of coffee and drive
up the Japanese price. In the end, the law of one price tells us that a dollar must
buy the same amount of coffee in all countries.
This logic leads us to the theory of purchasing-power parity. According to this
theory, a currency must have the same purchasing power in all countries. That is,
a U.S. dollar must buy the same quantity of goods in the United States and Japan,
and a Japanese yen must buy the same quantity of goods in Japan and the United
States. Indeed, the name of this theory describes it well. Parity means equality, and
purchasing power refers to the value of money. Purchasing-power parity states that a
unit of all currencies must have the same real value in every country.
IMPLICATIONS OF PURCHASING-POWER PARITY
What does the theory of purchasing-power parity say about exchange rates? It tells
us that the nominal exchange rate between the currencies of two countries depends
on the price levels in those countries. If a dollar buys the same quantity of
goods in the United States (where prices are measured in dollars) as in Japan
(where prices are measured in yen), then the number of yen per dollar must reflect
the prices of goods in the United States and Japan. For example, if a pound of coffee
costs 500 yen in Japan and $5 in the United States, then the nominal exchange
rate must be 100 yen per dollar (500 yen/$5 100 yen per dollar). Otherwise, the
purchasing power of the dollar would not be the same in the two countries.
To see more fully how this works, it is helpful to use just a bit of mathematics.
Suppose that P is the price of a basket of goods in the United States (measured in
dollars), P* is the price of a basket of goods in Japan (measured in yen), and e is the
nominal exchange rate (the number of yen a dollar can buy). Now consider the
quantity of goods a dollar can buy at home and abroad. At home, the price level is
P, so the purchasing power of $1 at home is 1/P. Abroad, a dollar can be exchanged
into e units of foreign currency, which in turn have purchasing power e/P*. For the
purchasing power of a dollar to be the same in the two countries, it must be the
case that
1/P e/P*.
With rearrangement, this equation becomes
1 eP/P*.
Notice that the left-hand side of this equation is a constant, and the right-hand side
is the real exchange rate. Thus, if the purchasing power of the dollar is always the same
at home and abroad, then the real exchange rate—the relative price of domestic and foreign
goods—cannot change.
To see the implication of this analysis for the nominal exchange rate, we can
rearrange the last equation to solve for the nominal exchange rate:
e P*/P.
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 673
CASE STUDY THE NOMINAL EXCHANGE RATE
DURING A HYPERINFLATION
Macroeconomists can only rarely conduct controlled experiments. Most often,
they must glean what they can from the natural experiments that history gives
them. One natural experiment is hyperinflation—the high inflation that arises
when a government turns to the printing press to pay for large amounts of government
spending. Because hyperinflations are so extreme, they illustrate some
basic economic principles with clarity.
Consider the German hyperinflation of the early 1920s. Figure 29-3 shows
the German money supply, the German price level, and the nominal exchange
rate (measured as U.S. cents per German mark) for that period. Notice that
these series move closely together. When the supply of money starts growing
quickly, the price level also takes off, and the German mark depreciates. When
the money supply stabilizes, so does the price level and the exchange rate.
The pattern shown in this figure appears during every hyperinflation. It
leaves no doubt that there is a fundamental link among money, prices, and the
nominal exchange rate. The quantity theory of money discussed in the previous
chapter explains how the money supply affects the price level. The theory of
purchasing-power parity discussed here explains how the price level affects the
nominal exchange rate.
That is, the nominal exchange rate equals the ratio of the foreign price level (measured
in units of the foreign currency) to the domestic price level (measured in
units of the domestic currency). According to the theory of purchasing-power parity, the
nominal exchange rate between the currencies of two countries must reflect the different
price levels in those countries.
A key implication of this theory is that nominal exchange rates change when
price levels change. As we saw in the preceding chapter, the price level in any
country adjusts to bring the quantity of money supplied and the quantity of
money demanded into balance. Because the nominal exchange rate depends on
the price levels, it also depends on the money supply and money demand in each
country. When a central bank in any country increases the money supply and
causes the price level to rise, it also causes that country’s currency to depreciate
relative to other currencies in the world. In other words, when the central bank prints
large quantities of money, that money loses value both in terms of the goods and services it
can buy and in terms of the amount of other currencies it can buy.
We can now answer the question that began this section: Why has the U.S. dollar
lost value compared to the German mark and gained value compared to the
Italian lira? The answer is that Germany has pursued a less inflationary monetary
policy than the United States, and Italy has pursued a more inflationary monetary
policy. From 1970 to 1998, inflation in the United States was 5.3 percent per year.
By contrast, inflation was 3.5 percent in Germany, and 9.6 percent in Italy. As U.S.
prices rose relative to German prices, the value of the dollar fell relative to the
mark. Similarly, as U.S. prices fell relative to Italian prices, the value of the dollar
rose relative to the lira.
674 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
LIMITATIONS OF PURCHASING-POWER PARITY
Purchasing-power parity provides a simple model of how exchange rates are determined.
For understanding many economic phenomena, the theory works well.
In particular, it can explain many long-term trends, such as the depreciation of the
U.S. dollar against the German mark and the appreciation of the U.S. dollar
against the Italian lira. It can also explain the major changes in exchange rates that
occur during hyperinflations.
Yet the theory of purchasing-power parity is not completely accurate. That is,
exchange rates do not always move to ensure that a dollar has the same real value
in all countries all the time. There are two reasons why the theory of purchasingpower
parity does not always hold in practice.
The first reason is that many goods are not easily traded. Imagine, for instance,
that haircuts are more expensive in Paris than in New York. International travelers
might avoid getting their haircuts in Paris, and some haircutters might move from
New York to Paris. Yet such arbitrage would probably be too limited to eliminate
the differences in prices. Thus, the deviation from purchasing-power parity might
persist, and a dollar (or franc) would continue to buy less of a haircut in Paris than
in New York.
The second reason that purchasing-power parity does not always hold is that
even tradable goods are not always perfect substitutes when they are produced in
different countries. For example, some consumers prefer German beer, and others
prefer American beer. Moreover, consumer tastes for beer change over time. If German
beer suddenly becomes more popular, the increase in demand will drive up
10,000,000,000
1,000,000,000,000,000
100,000
1
.00001
.0000000001
1921 1922 1923 1924
Exchange rate
Money supply
Price level
1925
Indexes
(Jan. 1921 100)
Figure 29-3
MONEY, PRICES, AND THE
NOMINAL EXCHANGE RATE
DURING THE GERMAN
HYPERINFLATION. This figure
shows the money supply, the
price level, and the exchange rate
(measured as U.S. cents per
mark) for the German
hyperinflation from January 1921
to December 1924. Notice how
similarly these three variables
move. When the quantity of
money started growing quickly,
the price level followed, and the
mark depreciated relative to the
dollar. When the German central
bank stabilized the money
supply, the price level and
exchange rate stabilized as well.
SOURCE: Adapted from Thomas J. Sargent,
“The End of Four Big Inflations,” in Robert
Hall, ed., Inflation (Chicago: University of
Chicago Press, 1983), pp. 41–93.
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 675
CASE STUDY THE HAMBURGER STANDARD
When economists apply the theory of purchasing-power parity to explain exchange
rates, they need data on the prices of a basket of goods available in different
countries. One analysis of this sort is conducted by The Economist, an
international newsmagazine. The magazine occasionally collects data on a basket
of goods consisting of “two all beef patties, special sauce, lettuce, cheese,
pickles, onions, on a sesame seed bun.” It’s called the “Big Mac” and is sold by
McDonald’s around the world.
Once we have the prices of Big Macs in two countries denominated in the
local currencies, we can compute the exchange rate predicted by the theory of
purchasing-power parity. The predicted exchange rate is the one that makes the
cost of the Big Mac the same in the two countries. For instance, if the price of a
Big Mac is $2 in the United States and 200 yen in Japan, purchasing-power parity
would predict an exchange rate of 100 yen per dollar.
How well does purchasing-power parity work when applied using Big Mac
prices? Here are some examples from an Economist article published on April 3,
1999, when the price of a Big Mac was $2.43 in the United States:
PRICE OF PREDICTED ACTUAL
COUNTRY A BIGMAC EXCHANGE RATE EXCHANGE RATE
Italy 4,500 lira 1,852 lira/$ 1,799 lira/$
Japan 294 yen 121 yen/$ 120 yen/$
Russia 33.5 rubles 13.8 rubles/$ 24.7 rubles/$
Germany 4.95 marks 2.04 marks/$ 1.82 marks/$
Brazil 2.95 reals 1.21 reals/$ 1.73 reals/$
Britain 1.90 pounds 0.78 pound/$ 0.62 pound/$
You can see that the predicted and actual exchange rates are not exactly the
same. After all, international arbitrage in Big Macs is not easy. Yet the two
exchange rates are usually in the same ballpark. Purchasing-power parity is not
the price of German beer. As a result, a dollar (or a mark) might then buy more
beer in the United States than in Germany. But despite this difference in prices in
the two markets, there might be no opportunity for profitable arbitrage because
consumers do not view the two beers as equivalent.
Thus, both because some goods are not tradable and because some tradable
goods are not perfect substitutes with their foreign counterparts, purchasingpower
parity is not a perfect theory of exchange-rate determination. For these reasons,
real exchange rates fluctuate over time. Nonetheless, the theory of
purchasing-power parity does provide a useful first step in understanding exchange
rates. The basic logic is persuasive: As the real exchange rate drifts from the
level predicted by purchasing-power parity, people have greater incentive to move
goods across national borders. Even if the forces of purchasing-power parity do
not completely fix the real exchange rate, they provide a reason to expect that
changes in the real exchange rate are most often small or temporary. As a result,
large and persistent movements in nominal exchange rates typically reflect
changes in price levels at home and abroad.
IN THE UNITED STATESTHE PRICE OF
A BIG MAC IS $2.43; IN JAPAN IT IS
294 YEN.
676 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
a precise theory of exchange rates, but it often provides a reasonable first
approximation.
QUICK QUIZ: Over the past 20 years, Spain has had high inflation, and
Japan has had low inflation. What do you predict has happened to the number
of Spanish pesetas a person can buy with a Japanese yen?
CONCLUSION
The purpose of this chapter has been to develop some basic concepts that macroeconomists
use to study open economies. You should now understand why a nation’s
net exports must equal its net foreign investment, and why national saving
must equal domestic investment plus net foreign investment. You should also understand
the meaning of the nominal and real exchange rates, as well as the implications
and limitations of purchasing-power parity as a theory of how exchange
rates are determined.
The macroeconomic variables defined here offer a starting point for analyzing
an open economy’s interactions with the rest of the world. In the next chapter we
develop a model that can explain what determines these variables. We can then
discuss how various events and policies affect a country’s trade balance and the
rate at which nations make exchanges in world markets.
Net exports are the value of domestic goods and
services sold abroad minus the value of foreign goods
and services sold domestically. Net foreign investment
is the acquisition of foreign assets by domestic residents
minus the acquisition of domestic assets by foreigners.
Because every international transaction involves an
exchange of an asset for a good or service, an economy’s
net foreign investment always equals its net exports.
An economy’s saving can be used either to finance
investment at home or to buy assets abroad. Thus,
national saving equals domestic investment plus net
foreign investment.
The nominal exchange rate is the relative price of the
currency of two countries, and the real exchange rate
is the relative price of the goods and services of two
countries. When the nominal exchange rate changes so
that each dollar buys more foreign currency, the dollar is
said to appreciate or strengthen. When the nominal
exchange rate changes so that each dollar buys less
foreign currency, the dollar is said to depreciate or weaken.
According to the theory of purchasing-power parity, a
dollar (or a unit of any other currency) should be able to
buy the same quantity of goods in all countries. This
theory implies that the nominal exchange rate between
the currencies of two countries should reflect the price
levels in those countries. As a result, countries with
relatively high inflation should have depreciating
currencies, and countries with relatively low inflation
should have appreciating currencies.
Summary
CHAPTER 29 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS 677
closed economy, p. 658
open economy, p. 658
exports, p. 658
imports, p. 658
net exports, p. 658
trade balance, p. 658
trade surplus, p. 658
trade deficit, p. 659
balanced trade, p. 659
net foreign investment, p. 661
nominal exchange rate, p. 668
appreciation, p. 668
depreciation, p. 668
real exchange rate, p. 669
purchasing-power parity, p. 670
Key Concepts
1. Define net exports and net foreign investment. Explain
how and why they are related.
2. Explain the relationship among saving, investment, and
net foreign investment.
3. If a Japanese car costs 500,000 yen, a similar American
car costs $10,000, and a dollar can buy 100 yen, what are
the nominal and real exchange rates?
4. Describe the economic logic behind the theory of
purchasing-power parity.
5. If the Fed started printing large quantities of U.S.
dollars, what would happen to the number of Japanese
yen a dollar could buy?
Questions for Review
1. How would the following transactions affect U.S.
exports, imports, and net exports?
a. An American art professor spends the summer
touring museums in Europe.
b. Students in Paris flock to see the latest Arnold
Schwarzenegger movie.
c. Your uncle buys a new Volvo.
d. The student bookstore at Oxford University sells a
pair of Levi’s 501 jeans.
e. A Canadian citizen shops at a store in northern
Vermont to avoid Canadian sales taxes.
2. International trade in each of the following products has
increased over time. Suggest some reasons why this
might be so.
a. wheat
b. banking services
c. computer software
d. automobiles
3. Describe the difference between foreign direct
investment and foreign portfolio investment. Who is
more likely to engage in foreign direct investment—a
corporation or an individual investor? Who is more
likely to engage in foreign portfolio investment?
4. How would the following transactions affect U.S. net
foreign investment? Also, state whether each involves
direct investment or portfolio investment.
a. An American cellular phone company establishes
an office in the Czech Republic.
b. Harrod’s of London sells stock to the General
Electric pension fund.
c. Honda expands its factory in Marysville, Ohio.
d. A Fidelity mutual fund sells its Volkswagen stock to
a French investor.
5. Holding national saving constant, does an increase in
net foreign investment increase, decrease, or have no
effect on a country’s accumulation of domestic capital?
6. The business section of most major newspapers contains
a table showing U.S. exchange rates. Find such a table
and use it to answer the following questions.
a. Does this table show nominal or real exchange
rates? Explain.
b. What are the exchange rates between the United
States and Canada and between the United States
and Japan? Calculate the exchange rate between
Canada and Japan.
c. If U.S. inflation exceeds Japanese inflation over
the next year, would you expect the U.S. dollar
to appreciate or depreciate relative to the
Japanese yen?
7. Would each of the following groups be happy or
unhappy if the U.S. dollar appreciated? Explain.
Problems and Applications
678 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
a. Dutch pension funds holding U.S. government
bonds
b. U.S. manufacturing industries
c. Australian tourists planning a trip to the United
States
d. an American firm trying to purchase property
overseas
8. What is happening to the U.S. real exchange rate in each
of the following situations? Explain.
a. The U.S. nominal exchange rate is unchanged, but
prices rise faster in the United States than abroad.
b. The U.S. nominal exchange rate is unchanged, but
prices rise faster abroad than in the United States.
c. The U.S. nominal exchange rate declines, and prices
are unchanged in the United States and abroad.
d. The U.S. nominal exchange rate declines, and prices
rise faster abroad than in the United States.
9. List three goods for which the law of one price is likely
to hold, and three goods for which it is not. Justify your
choices.
10. A can of soda costs $0.75 in the United States and 12
pesos in Mexico. What would the peso-dollar exchange
rate be if purchasing-power parity holds? If a monetary
expansion caused all prices in Mexico to double, so that
soda rose to 24 pesos, what would happen to the pesodollar
exchange rate?
11. Assume that American rice sells for $100 per bushel,
Japanese rice sells for 16,000 yen per bushel, and the
nominal exchange rate is 80 yen per dollar.
a. Explain how you could make a profit from this
situation. What would be your profit per bushel of
rice? If other people exploit the same opportunity,
what would happen to the price of rice in Japan
and the price of rice in the United States?
b. Suppose that rice is the only commodity in the
world. What would happen to the real exchange
rate between the United States and Japan?
12. A case study in the chapter analyzed purchasing-power
parity for several countries using the price of a Big Mac.
Here are data for a few more countries:
PRICE OF PREDICTED ACTUAL
COUNTRY A BIGMAC EXCHANGE RATE EXCHANGE RATE
South Korea 3,000 won _____ won/$ 1,218 won/$
Spain 375 pesetas _____ pesetas/$ 155 pesetas/$
Mexico 19.9 pesos _____ pesos/$ 9.54 pesos/$
Netherlands 5.45 guilders _____ guilders/$ 2.05 guilders/$
a. For each country, compute the predicted exchange
rate of the local currency per U.S. dollar. (Recall that
the U.S. price of a Big Mac was $2.43.) How well
does the theory of purchasing-power parity explain
exchange rates?
b. According to purchasing-power parity, what is the
predicted exchange rate between the South Korean
won and Spanish peseta? What is the actual
exchange rate?
c. Which of these countries offers the cheapest Big
Mac? Why do you think that might be the case?
IN THIS CHAPTER
YOU WILL . . .
Use the model
to analyze
political instability
and capital flight
Use the model
to analyze the
macroeconomic
ef fects of trade
policies
Build a model to
explain an open
economy’s trade
balance and
exchange rate
Use the model
to analyze the
ef fects of
government
budget deficits
Over the past decade, the United States has persistently imported more goods and
services than it has exported. That is, U.S. net exports have been negative. Although
economists debate whether these trade deficits are a problem for the U.S.
economy, the nation’s business community has a strong opinion. Many business
leaders claim that the trade deficits reflect unfair competition: Foreign firms are allowed
to sell their products in U.S. markets, they contend, while foreign governments
impede U.S. firms from selling U.S. products abroad.
Imagine that you are the president and you want to end these trade deficits.
What should you do? Should you try to limit imports, perhaps by imposing a
quota on the import of cars from Japan? Or should you try to influence the nation’s
trade deficit in some other way?
To understand what factors determine a country’s trade balance and how
government policies can affect it, we need a macroeconomic theory of the open
A M A C R O E C O N O M I C T H E O R Y
O F T H E O P E N E C O N O M Y
679
680 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
economy. The preceding chapter introduced some of the key macroeconomic variables
that describe an economy’s relationship with other economies—including
net exports, net foreign investment, and the real and nominal exchange rates. This
chapter develops a model that shows what forces determine these variables and
how these variables are related to one another.
To develop this macroeconomic model of an open economy, we build on our
previous analysis in two important ways. First, the model takes the economy’s
GDP as given. We assume that the economy’s output of goods and services, as
measured by real GDP, is determined by the supplies of the factors of production
and by the available production technology that turns these inputs into output.
Second, the model takes the economy’s price level as given. We assume the price
level adjusts to bring the supply and demand for money into balance. In other
words, this chapter takes as a starting point the lessons learned in Chapters 24 and
28 about the determination of the economy’s output and price level.
The goal of the model in this chapter is to highlight those forces that determine
the economy’s trade balance and exchange rate. In one sense, the model is simple:
It merely applies the tools of supply and demand to an open economy. Yet the
model is also more complicated than others we have seen because it involves looking
simultaneously at two related markets—the market for loanable funds and the
market for foreign-currency exchange. After we develop this model of the open
economy, we use it to examine how various events and policies affect the economy’s
trade balance and exchange rate. We will then be able to determine the government
policies that are most likely to reverse the trade deficits that the U.S.
economy has experienced over the past decade.
SUPPLY AND DEMAND FOR LOANABLE FUNDS
AND FOR FOREIGN-CURRENCY EXCHANGE
To understand the forces at work in an open economy, we focus on supply and demand
in two markets. The first is the market for loanable funds, which coordinates
the economy’s saving and investment (including its net foreign investment). The
second is the market for foreign-currency exchange, which coordinates people
who want to exchange the domestic currency for the currency of other countries.
In this section we discuss supply and demand in each of these markets. In the next
section we put these markets together to explain the overall equilibrium for an
open economy.
THE MARKET FOR LOANABLE FUNDS
When we first analyzed the role of the financial system in Chapter 25, we made the
simplifying assumption that the financial system consists of only one market,
called the market for loanable funds. All savers go to this market to deposit their saving,
and all borrowers go to this market to get their loans. In this market, there is
one interest rate, which is both the return to saving and the cost of borrowing.
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 681
To understand the market for loanable funds in an open economy, the place to
start is the identity discussed in the preceding chapter:
S I NFI
Saving Domestic investment Net foreign investment.
Whenever a nation saves a dollar of its income, it can use that dollar to finance the
purchase of domestic capital or to finance the purchase of an asset abroad. The two
sides of this identity represent the two sides of the market for loanable funds. The
supply of loanable funds comes from national saving (S). The demand for loanable
funds comes from domestic investment (I) and net foreign investment (NFI). Note
that the purchase of a capital asset adds to the demand for loanable funds, regardless
of whether that asset is located at home or abroad. Because net foreign investment
can be either positive or negative, it can either add to or subtract from the
demand for loanable funds that arises from domestic investment.
As we learned in our earlier discussion of the market for loanable funds, the
quantity of loanable funds supplied and the quantity of loanable funds demanded
depend on the real interest rate. A higher real interest rate encourages people to
save and, therefore, raises the quantity of loanable funds supplied. Ahigher interest
rate also makes borrowing to finance capital projects more costly; thus, it discourages
investment and reduces the quantity of loanable funds demanded.
In addition to influencing national saving and domestic investment, the real
interest rate in a country affects that country’s net foreign investment. To see why,
consider two mutual funds—one in the United States and one in Germany—deciding
whether to buy a U.S. government bond or a German government bond.
The mutual funds would make this decision in part by comparing the real interest
rates in the United States and Germany. When the U.S. real interest rate rises, the
U.S. bond becomes more attractive to both mutual funds. Thus, an increase in
the U.S. real interest rate discourages Americans from buying foreign assets and
encourages foreigners to buy U.S. assets. For both reasons, a high U.S. real interest
rate reduces U.S. net foreign investment.
We represent the market for loanable funds on the familiar supply-anddemand
diagram in Figure 30-1. As in our earlier analysis of the financial system,
the supply curve slopes upward because a higher interest rate increases the quantity
of loanable funds supplied, and the demand curve slopes downward because
a higher interest rate decreases the quantity of loanable funds demanded. Unlike
the situation in our previous discussion, however, the demand side of the market
now represents the behavior of both domestic investment and net foreign investment.
That is, in an open economy, the demand for loanable funds comes not only
from those who want to borrow funds to buy domestic capital goods but also from
those who want to borrow funds to buy foreign assets.
The interest rate adjusts to bring the supply and demand for loanable funds
into balance. If the interest rate were below the equilibrium level, the quantity of
loanable funds supplied would be less than the quantity demanded. The resulting
shortage of loanable funds would push the interest rate upward. Conversely, if the
interest rate were above the equilibrium level, the quantity of loanable funds supplied
would exceed the quantity demanded. The surplus of loanable funds would
drive the interest rate downward. At the equilibrium interest rate, the supply of
loanable funds exactly balances the demand. That is, at the equilibrium interest rate,
682 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
the amount that people want to save exactly balances the desired quantities of domestic investment
and net foreign investment.
THE MARKET FOR FOREIGN-CURRENCY EXCHANGE
The second market in our model of the open economy is the market for foreigncurrency
exchange. Participants in this market trade U.S. dollars in exchange for
foreign currencies. To understand the market for foreign-currency exchange, we
begin with another identity from the last chapter:
NFI NX
Net foreign investment Net exports.
This identity states that the imbalance between the purchase and sale of capital assets
abroad (NFI) equals the imbalance between exports and imports of goods and
services (NX). When U.S. net exports are positive, for instance, foreigners are buying
more U.S. goods and services than Americans are buying foreign goods and
services. What are Americans doing with the foreign currency they are getting
from this net sale of goods and services abroad? They must be adding to their
holdings of foreign assets, which means U.S. net foreign investment is positive.
Conversely, if U.S. net exports are negative, Americans are spending more on foreign
goods and services than they are earning from selling abroad; this trade
deficit must be financed by selling American assets abroad, so U.S. net foreign investment
is negative as well.
Our model of the open economy assumes that the two sides of this identity
represent the two sides of the market for foreign-currency exchange. Net foreign
investment represents the quantity of dollars supplied for the purpose of buying
assets abroad. For example, when a U.S. mutual fund wants to buy a Japanese
Equilibrium
quantity
Quantity of
Loanable Funds
Real
Interest
Rate
Equilibrium
real interest
rate
Supply of loanable funds
(from national saving)
Demand for loanable
funds (for domestic
investment and net
foreign investment)
Figure 30-1
THE MARKET FOR
LOANABLE FUNDS. The interest
rate in an open economy, as in a
closed economy, is determined by
the supply and demand for
loanable funds. National saving
is the source of the supply of
loanable funds. Domestic
investment and net foreign
investment are the sources of the
demand for loanable funds. At
the equilibrium interest rate,
the amount that people want to
save exactly balances the amount
that people want to borrow for
the purpose of buying domestic
capital and foreign assets.
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 683
government bond, it needs to change dollars into yen, so it supplies dollars in the
market for foreign-currency exchange. Net exports represent the quantity of dollars
demanded for the purpose of buying U.S. net exports of goods and services.
For example, when a Japanese airline wants to buy a plane made by Boeing,
it needs to change its yen into dollars, so it demands dollars in the market for
foreign-currency exchange.
What price balances the supply and demand in the market for foreigncurrency
exchange? The answer is the real exchange rate. As we saw in the preceding
chapter, the real exchange rate is the relative price of domestic and foreign
goods and, therefore, is a key determinant of net exports. When the U.S. real exchange
rate appreciates, U.S. goods become more expensive relative to foreign
goods, making U.S. goods less attractive to consumers both at home and abroad.
As a result, exports from the United States fall, and imports into the United States
rise. For both reasons, net exports fall. Hence, an appreciation of the real exchange
rate reduces the quantity of dollars demanded in the market for foreign-currency
exchange.
Figure 30-2 shows supply and demand in the market for foreign-currency exchange.
The demand curve slopes downward for the reason we just discussed:
A higher real exchange rate makes U.S. goods more expensive and reduces the
quantity of dollars demanded to buy those goods. The supply curve is vertical
because the quantity of dollars supplied for net foreign investment does not
depend on the real exchange rate. (As discussed earlier, net foreign investment
depends on the real interest rate. When discussing the market for foreign-currency
exchange, we take the real interest rate and net foreign investment as given.)
The real exchange rate adjusts to balance the supply and demand for dollars
just as the price of any good adjusts to balance supply and demand for that good.
If the real exchange rate were below the equilibrium level, the quantity of dollars
supplied would be less than the quantity demanded. The resulting shortage of dollars
would push the value of the dollar upward. Conversely, if the real exchange
Equilibrium
quantity
Quantity of Dollars Exchanged
into Foreign Currency
Real
Exchange
Rate
Equilibrium
real exchange
rate
Supply of dollars
(from net foreign investment)
Demand for dollars
(for net exports)
Figure 30-2
THE MARKET FOR FOREIGNCURRENCY
EXCHANGE. The real
exchange rate is determined by
the supply and demand for
foreign-currency exchange. The
supply of dollars to be exchanged
into foreign currency comes from
net foreign investment. Because
net foreign investment does not
depend on the real exchange rate,
the supply curve is vertical. The
demand for dollars comes from
net exports. Because a lower real
exchange rate stimulates net
exports (and thus increases the
quantity of dollars demanded to
pay for these net exports), the
demand curve is downward
sloping. At the equilibrium real
exchange rate, the number of
dollars people supply to buy
foreign assets exactly balances
the number of dollars people
demand to buy net exports.
684 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
rate were above the equilibrium level, the quantity of dollars supplied would exceed
the quantity demanded. The surplus of dollars would drive the value of the
dollar downward. At the equilibrium real exchange rate, the demand for dollars by foreigners
arising from the U.S. net exports of goods and services exactly balances the supply
of dollars from Americans arising from U.S. net foreign investment.
At this point, it is worth noting that the division of transactions between “supply”
and “demand” in this model is somewhat artificial. In our model, net exports
are the source of the demand for dollars, and net foreign investment is the source
of the supply. Thus, when a U.S. resident imports a car made in Japan, our model
treats that transaction as a decrease in the quantity of dollars demanded (because
net exports fall) rather than an increase in the quantity of dollars supplied. Similarly,
when a Japanese citizen buys a U.S. government bond, our model treats that
transaction as a decrease in the quantity of dollars supplied (because net foreign
investment falls) rather than an increase in the quantity of dollars demanded. This
use of language may seem somewhat unnatural at first, but it will prove useful
when analyzing the effects of various policies.
QUICK QUIZ: Describe the sources of supply and demand in the market
for loanable funds and the market for foreign-currency exchange.
EQUILIBRIUM IN THE OPEN ECONOMY
So far we have discussed supply and demand in two markets—the market for
loanable funds and the market for foreign-currency exchange. Let’s now consider
how these markets are related to each other.
An alert reader of this book
might ask: Why are we developing
a theory of the exchange
rate here? Didn’t we already do
that in the preceding chapter?
As you may recall, the preceding
chapter developed a
theory of the exchange rate
called purchasing-power parity.
This theory asserts that a dollar
(or any other currency) must
buy the same quantity of goods
and services in every country.
As a result, the real exchange rate is fixed, and all changes
in the nominal exchange rate between two currencies reflect
changes in the price levels in the two countries.
The model of the exchange rate developed here is related
to the theory of purchasing-power parity. According to
the theory of purchasing-power parity, international trade responds
quickly to international price differences. If goods
were cheaper in one country than in another, they would be
exported from the first country and imported into the second
until the price difference disappeared. In other words,
the theory of purchasing-power parity assumes that net exports
are highly responsive to small changes in the real exchange
rate. If net exports were in fact so responsive, the
demand curve in Figure 30-2 would be horizontal.
Thus, the theory of purchasing-power parity can be
viewed as a special case of the model considered here. In
that special case, the demand curve for foreign-currency exchange,
rather than being downward sloping, is horizontal at
the level of the real exchange rate that ensures parity of
purchasing power at home and abroad. That special case is
a good place to start when studying exchange rates, but it is
far from the end of the story.
This chapter, therefore, concentrates on the more realistic
case in which the demand curve for foreign-currency exchange
is downward sloping. This allows for the possibility
that the real exchange rate changes over time, as in fact it
sometimes does in the real world.
FYI
Purchasing-
Power Parity as
a Special Case
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 685
NET FOREIGN INVESTMENT:
THE LINK BETWEEN THE TWO MARKETS
We begin by recapping what we’ve learned so far in this chapter. We have been
discussing how the economy coordinates four important macroeconomic variables:
national saving (S), domestic investment (I), net foreign investment (NFI),
and net exports (NX). Keep in mind the following identities:
S I NFI
and
NFI NX.
In the market for loanable funds, supply comes from national saving, demand
comes from domestic investment and net foreign investment, and the real interest
rate balances supply and demand. In the market for foreign-currency exchange,
supply comes from net foreign investment, demand comes from net exports, and
the real exchange rate balances supply and demand.
Net foreign investment is the variable that links these two markets. In the market
for loanable funds, net foreign investment is a piece of demand. Aperson who
wants to buy an asset abroad must finance this purchase by borrowing in the market
for loanable funds. In the market for foreign-currency exchange, net foreign investment
is the source of supply. A person who wants to buy an asset in another
country must supply dollars in order to exchange them for the currency of that
country.
The key determinant of net foreign investment, as we have discussed, is the
real interest rate. When the U.S. interest rate is high, owning U.S. assets is more
attractive, and U.S. net foreign investment is low. Figure 30-3 shows this negative
0 Net Foreign
Investment
Net foreign investment
is negative.
Net foreign investment
is positive.
Real
Interest
Rate
Figure 30-3
HOW NET FOREIGN INVESTMENT
DEPENDS ON THE INTEREST RATE.
Because a higher domestic real
interest rate makes domestic
assets more attractive, it reduces
net foreign investment. Note the
position of zero on the horizontal
axis: Net foreign investment can
be either positive or negative.
686 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
relationship between the interest rate and net foreign investment. This net-foreigninvestment
curve is the link between the market for loanable funds and the market
for foreign-currency exchange.
SIMULTANEOUS EQUILIBRIUM IN TWO MARKETS
We can now put all the pieces of our model together in Figure 30-4. This figure
shows how the market for loanable funds and the market for foreign-currency
(a) The Market for Loanable Funds (b) Net Foreign Investment
Net foreign
investment,
NFI
Real
Interest
Rate
Real
Interest
Rate
(c) The Market for Foreign-Currency Exchange
Quantity of
Dollars
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
r1 r1
E1
Supply
Supply
Demand
Demand
Figure 30-4 THE REAL EQUILIBRIUM IN AN OPEN ECONOMY. In panel (a), the supply and demand for
loanable funds determine the real interest rate. In panel (b), the interest rate determines
net foreign investment, which provides the supply of dollars in the market for foreigncurrency
exchange. In panel (c), the supply and demand for dollars in the market for
foreign-currency exchange determine the real exchange rate.
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 687
exchange jointly determine the important macroeconomic variables of an open
economy.
Panel (a) of the figure shows the market for loanable funds (taken from Figure
30-1). As before, national saving is the source of the supply of loanable funds.
Domestic investment and net foreign investment are the source of the demand for
loanable funds. The equilibrium real interest rate (r1) brings the quantity of loanable
funds supplied and the quantity of loanable funds demanded into balance.
Panel (b) of the figure shows net foreign investment (taken from Figure 30-3).
It shows how the interest rate from panel (a) determines net foreign investment.
A higher interest rate at home makes domestic assets more attractive, and this in
turn reduces net foreign investment. Therefore, the net-foreign-investment curve
in panel (b) slopes downward.
Panel (c) of the figure shows the market for foreign-currency exchange (taken
from Figure 30-2). Because net foreign investment must be paid for with foreign
currency, the quantity of net foreign investment from panel (b) determines the supply
of dollars to be exchanged into foreign currencies. The real exchange rate does
not affect net foreign investment, so the supply curve is vertical. The demand for
dollars comes from net exports. Because a depreciation of the real exchange rate increases
net exports, the demand curve for foreign-currency exchange slopes downward.
The equilibrium real exchange rate (E1) brings into balance the quantity of
dollars supplied and the quantity of dollars demanded in the market for foreigncurrency
exchange.
The two markets shown in Figure 30-4 determine two relative prices—the real
interest rate and the real exchange rate. The real interest rate determined in panel
(a) is the price of goods and services in the present relative to goods and services
in the future. The real exchange rate determined in panel (c) is the price of domestic
goods and services relative to foreign goods and services. These two relative
prices adjust simultaneously to balance supply and demand in these two markets.
As they do so, they determine national saving, domestic investment, net foreign
investment, and net exports. In a moment, we will use this model to see how
all these variables change when some policy or event causes one of these curves
to shift.
QUICK QUIZ: In the model of the open economy just developed, two
markets determine two relative prices. What are the markets? What are the
two relative prices?
HOW POLICIES AND EVENTS
AFFECT AN OPEN ECONOMY
Having developed a model to explain how key macroeconomic variables are determined
in an open economy, we can now use the model to analyze how changes
in policy and other events alter the economy’s equilibrium. As we proceed, keep in
mind that our model is just supply and demand in two markets—the market for
loanable funds and the market for foreign-currency exchange. When using the
model to analyze any event, we can apply the three steps outlined in Chapter 4.
688 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
First, we determine which of the supply and demand curves the event affects.
Second, we determine which way the curves shift. Third, we use the supply-anddemand
diagrams to examine how these shifts alter the economy’s equilibrium.
GOVERNMENT BUDGET DEFICITS
When we first discussed the supply and demand for loanable funds earlier in the
book, we examined the effects of government budget deficits, which occur when
government spending exceeds government revenue. Because a government budget
deficit represents negative public saving, it reduces national saving (the sum of
public and private saving). Thus, a government budget deficit reduces the supply
of loanable funds, drives up the interest rate, and crowds out investment.
Now let’s consider the effects of a budget deficit in an open economy. First,
which curve in our model shifts? As in a closed economy, the initial impact of the
budget deficit is on national saving and, therefore, on the supply curve for loanable
funds. Second, which way does this supply curve shift? Again as in a closed
economy, a budget deficit represents negative public saving, so it reduces national
saving and shifts the supply curve for loanable funds to the left. This is shown as
the shift from S1 to S2 in panel (a) of Figure 30-5.
Our third and final step is to compare the old and new equilibria. Panel (a)
shows the impact of a U.S. budget deficit on the U.S. market for loanable funds.
With fewer funds available for borrowers in U.S. financial markets, the interest
rate rises from r1 to r2 to balance supply and demand. Faced with a higher interest
rate, borrowers in the market for loanable funds choose to borrow less. This
change is represented in the figure as the movement from point Ato point B along
the demand curve for loanable funds. In particular, households and firms reduce
their purchases of capital goods. As in a closed economy, budget deficits crowd out
domestic investment.
In an open economy, however, the reduced supply of loanable funds has additional
effects. Panel (b) shows that the increase in the interest rate from r1 to r2 reduces
net foreign investment. [This fall in net foreign investment is also part of the
decrease in the quantity of loanable funds demanded in the movement from point
A to point B in panel (a).] Because saving kept at home now earns higher rates of
return, investing abroad is less attractive, and domestic residents buy fewer foreign
assets. Higher interest rates also attract foreign investors, who want to earn
the higher returns on U.S. assets. Thus, when budget deficits raise interest rates,
both domestic and foreign behavior cause U.S. net foreign investment to fall.
Panel (c) shows how budget deficits affect the market for foreign-currency exchange.
Because net foreign investment is reduced, people need less foreign currency
to buy foreign assets, and this induces a leftward shift in the supply curve
for dollars from S1 to S2. The reduced supply of dollars causes the real exchange
rate to appreciate from E1 to E2. That is, the dollar becomes more valuable compared
to foreign currencies. This appreciation, in turn, makes U.S. goods more expensive
compared to foreign goods. Because people both at home and abroad
switch their purchases away from the more expensive U.S. goods, exports from the
United States fall, and imports into the United States rise. For both reasons, U.S.
net exports fall. Hence, in an open economy, government budget deficits raise real interest
rates, crowd out domestic investment, cause the dollar to appreciate, and push the trade
balance toward deficit.
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 689
An important example of this lesson occurred in the United States in the 1980s.
Shortly after Ronald Reagan was elected president in 1980, the fiscal policy of
the U.S. federal government changed dramatically. The president and Congress
enacted large cuts in taxes, but they did not cut government spending by nearly as
(a) The Market for Loanable Funds (b) Net Foreign Investment
Real
Interest
Rate
Real
Interest
Rate
(c) The Market for Foreign-Currency Exchange
Quantity of
Dollars
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
r1 r1
E1
E2
Demand
Demand
r2 r2
NFI
S2 S1
S2 S1
B
A
1. A budget deficit reduces
the supply of loanable funds . . .
2. . . . which
increases
the real
interest
rate . . .
4. The decrease
in net foreign
investment reduces
the supply of dollars
to be exchanged
into foreign
currency . . .
5. . . . which
causes the
real exchange
rate to
appreciate.
3. . . . which in
turn reduces
net foreign
investment.
Figure 30-5 THE EFFECTS OF A GOVERNMENT BUDGET DEFICIT. When the government runs a budget
deficit, it reduces the supply of loanable funds from S1 to S2 in panel (a). The interest rate
rises from r1 to r2 to balance the supply and demand for loanable funds. In panel (b), the
higher interest rate reduces net foreign investment. Reduced net foreign investment, in
turn, reduces the supply of dollars in the market for foreign-currency exchange from S1 to
S2 in panel (c). This fall in the supply of dollars causes the real exchange rate to appreciate
from E1 to E2. The appreciation of the exchange rate pushes the trade balance toward
deficit.
690 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
much, so the result was a large budget deficit. Our model of the open economy
predicts that such a policy should lead to a trade deficit, and in fact it did, as we
saw in a case study in the preceding chapter. The budget deficit and trade deficit
during this period were so closely related in both theory and practice that they
earned the nickname the twin deficits.We should not, however, view these twins as
identical, for many factors beyond fiscal policy can influence the trade deficit.
TRADE POLICY
A trade policy is a government policy that directly influences the quantity of
goods and services that a country imports or exports. As we saw in Chapter 9,
trade policy takes various forms. One common trade policy is a tariff, a tax on imported
goods. Another is an import quota, a limit on the quantity of a good that can
be produced abroad and sold domestically. Trade policies are common throughout
the world, although sometimes they are disguised. For example, the U.S. government
has often pressured Japanese automakers to reduce the number of cars they
sell in the United States. These so-called “voluntary export restrictions” are not really
voluntary and, in essence, are a form of import quota.
Let’s consider the macroeconomic impact of trade policy. Suppose that the U.S.
auto industry, concerned about competition from Japanese automakers, convinces
the U.S. government to impose a quota on the number of cars that can be imported
from Japan. In making their case, lobbyists for the auto industry assert that the
trade restriction would shrink the size of the U.S. trade deficit. Are they right? Our
model, as illustrated in Figure 30-6, offers an answer.
The first step in analyzing the trade policy is to determine which curve shifts.
The initial impact of the import restriction is, not surprisingly, on imports. Because
net exports equal exports minus imports, the policy also affects net exports. And
because net exports are the source of demand for dollars in the market for foreigncurrency
exchange, the policy affects the demand curve in this market.
The second step is to determine which way this demand curve shifts. Because
the quota restricts the number of Japanese cars sold in the United States, it reduces
imports at any given real exchange rate. Net exports, which equal exports minus
imports, will therefore rise for any given real exchange rate. Because foreigners
need dollars to buy U.S. net exports, there is an increased demand for dollars in
the market for foreign-currency exchange. This increase in the demand for dollars
is shown in panel (c) of Figure 30-6 as the shift from D1 to D2.
The third step is to compare the old and new equilibria. As we can see in panel
(c), the increase in the demand for dollars causes the real exchange rate to appreciate
from E1 to E2. Because nothing has happened in the market for loanable funds
in panel (a), there is no change in the real interest rate. Because there is no change
in the real interest rate, there is also no change in net foreign investment, shown in
panel (b). And because there is no change in net foreign investment, there can be
no change in net exports, even though the import quota has reduced imports.
The reason why net exports can stay the same while imports fall is explained
by the change in the real exchange rate: When the dollar appreciates in value in the
market for foreign-currency exchange, domestic goods become more expensive
relative to foreign goods. This appreciation encourages imports and discourages
exports—and both of these changes work to offset the direct increase in net exports
trade policy
a government policy that directly
influences the quantity of goods
and services that a country
imports or exports
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 691
due to the import quota. In the end, an import quota reduces both imports and
exports, but net exports (exports minus imports) are unchanged.
We have thus come to a surprising implication: Trade policies do not affect the
trade balance. That is, policies that directly influence exports or imports do not alter
(a) The Market for Loanable Funds (b) Net Foreign Investment
Real
Interest
Rate
Real
Interest
Rate
(c) The Market for Foreign-Currency Exchange
Quantity of
Dollars
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
r1 r1
Supply
Supply
Demand
NFI
D2
D1
3. Net exports,
however, remain
the same.
2. . . . and
causes the
real exchange
rate to
appreciate.
E1
E2
1. An import
quota increases
the demand for
dollars . . .
Figure 30-6
THE EFFECTS OF AN IMPORT QUOTA. When the U.S. government imposes a quota on the
import of Japanese cars, nothing happens in the market for loanable funds in panel (a) or
to net foreign investment in panel (b). The only effect is a rise in net exports (exports
minus imports) for any given real exchange rate. As a result, the demand for dollars in the
market for foreign-currency exchange rises, as shown by the shift from D1 to D2 in panel
(c). This increase in the demand for dollars causes the value of the dollar to appreciate
from E1 to E2. This appreciation of the dollar tends to reduce net exports, offsetting the
direct effect of the import quota on the trade balance.
692 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
net exports. This conclusion seems less surprising if one recalls the accounting
identity:
NX NFI S I.
Net exports equal net foreign investment, which equals national saving minus
domestic investment. Trade policies do not alter the trade balance because they do
not alter national saving or domestic investment. For given levels of national
saving and domestic investment, the real exchange rate adjusts to keep the trade
balance the same, regardless of the trade policies the government puts in place.
Although trade policies do not affect a country’s overall trade balance, these
policies do affect specific firms, industries, and countries. When the U.S. government
imposes an import quota on Japanese cars, General Motors has less competition
from abroad and will sell more cars. At the same time, because the dollar has
appreciated in value, Boeing, the U.S. aircraft maker, will find it harder to compete
with Airbus, the European aircraft maker. U.S. exports of aircraft will fall, and U.S.
imports of aircraft will rise. In this case, the import quota on Japanese cars will increase
net exports of cars and decrease net exports of planes. In addition, it will
increase net exports from the United States to Japan and decrease net exports from
the United States to Europe. The overall trade balance of the U.S. economy, however,
stays the same.
The effects of trade policies are, therefore, more microeconomic than macroeconomic.
Although advocates of trade policies sometimes claim (incorrectly) that
these policies can alter a country’s trade balance, they are usually more motivated
by concerns about particular firms or industries. One should not be surprised, for
instance, to hear an executive from General Motors advocating import quotas for
Japanese cars. Economists almost always oppose such trade policies. As we saw in
Chapters 3 and 9, free trade allows economies to specialize in doing what they do
best, making residents of all countries better off. Trade restrictions interfere with
these gains from trade and, thus, reduce overall economic well-being.
POLITICAL INSTABILITY AND CAPITAL FLIGHT
In 1994 political instability in Mexico, including the assassination of a prominent
political leader, made world financial markets nervous. People began to view
Mexico as a much less stable country than they had previously thought. They
decided to pull some of their assets out of Mexico in order to move these funds to
the United States and other “safe havens.” Such a large and sudden movement of
funds out of a country is called capital flight. To see the implications of capital
flight for the Mexican economy, we again follow our three steps for analyzing a
change in equilibrium, but this time we apply our model of the open economy
from the perspective of Mexico rather than the United States.
Consider first which curves in our model capital flight affects. When investors
around the world observe political problems in Mexico, they decide to sell some of
their Mexican assets and use the proceeds to buy U.S. assets. This act increases
Mexican net foreign investment and, therefore, affects both markets in our model.
Most obviously, it affects the net-foreign-investment curve, and this in turn influences
the supply of pesos in the market for foreign-currency exchange. In addition,
because the demand for loanable funds comes from both domestic investment and
net foreign investment, capital flight affects the demand curve in the market for
loanable funds.
capital flight
a large and sudden reduction in
the demand for assets located
in a country
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 693
Now consider which way these curves shift. When net foreign investment increases,
there is greater demand for loanable funds to finance these purchases.
Thus, as panel (a) of Figure 30-7 shows, the demand curve for loanable funds shifts
to the right from D1 to D2. In addition, because net foreign investment is higher for
(a) The Market for Loanable Funds in Mexico (b) Mexican Net Foreign Investment
Real
Interest
Rate
Real
Interest
Rate
(c) The Market for Foreign-Currency Exchange
Quantity of
Pesos
Quantity of
Loanable Funds
Net Foreign
Investment
Real
Exchange
Rate
r1 r1
D1
D2
E2
E1
Demand
r2 r2
S1 S2
Supply
NFI1 NFI2
1. An increase
in net foreign
investment . . .
3. . . . which
increases
the interest
rate.
2. . . . increases the demand
for loanable funds . . .
4. At the same
time, the increase
in net foreign
investment
increases the
5. . . . which supply of pesos . . .
causes the
peso to
depreciate.
THE EFFECTS OF CAPITAL FLIGHT. If people decide that Mexico is a risky place to keep Figur e 30-7
their savings, they will move their capital to safer havens such as the United States,
resulting in an increase in Mexican net foreign investment. Consequently, the demand for
loanable funds in Mexico rises from D1 to D2, as shown in panel (a), and this drives up the
Mexican real interest rate from r1 to r2. Because net foreign investment is higher for any
interest rate, that curve also shifts to the right from NFI1 to NFI2 in panel (b). At the same
time, in the market for foreign-currency exchange, the supply of pesos rises from S1 to S2,
as shown in panel (c). This increase in the supply of pesos causes the peso to depreciate
from E1 to E2, so the peso becomes less valuable compared to other currencies.
694 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
any interest rate, the net-foreign-investment curve also shifts to the right from NFI1
to NFI2, as in panel (b).
To see the effects of capital flight on the economy, we compare the old and new
equilibria. Panel (a) of Figure 30-7 shows that the increased demand for loanable
funds causes the interest rate in Mexico to rise from r1 to r2. Panel (b) shows that
Mexican net foreign investment increases. (Although the rise in the interest rate
does make Mexican assets more attractive, this development only partly offsets
the impact of capital flight on net foreign investment.) Panel (c) shows that the
increase in net foreign investment raises the supply of pesos in the market for
foreign-currency exchange from S1 to S2. That is, as people try to get out of Mexican
assets, there is a large supply of pesos to be converted into dollars. This increase
in supply causes the peso to depreciate from E1 to E2. Thus, capital flight from
Mexico increases Mexican interest rates and decreases the value of the Mexican peso in the
market for foreign-currency exchange. This is exactly what was observed in 1994.
From November 1994 to March 1995, the interest rate on short-term Mexican government
bonds rose from 14 percent to 70 percent, and the peso depreciated in
value from 29 to 15 U.S. cents per peso.
Although capital flight has its largest impact on the country from which capital
is fleeing, it also affects other countries. When capital flows out of Mexico into
the United States, for instance, it has the opposite effect on the U.S. economy as it
has on the Mexican economy. In particular, the rise in Mexican net foreign investment
coincides with a fall in U.S. net foreign investment. As the peso depreciates
in value and Mexican interest rates rise, the dollar appreciates in value and U.S. interest
rates fall. The size of this impact on the U.S. economy is small, however, because
the economy of the United States is so large compared to that of Mexico.
The events that we have been describing in Mexico could happen to any economy
in the world, and in fact they do from time to time. In 1997, the world learned
that the banking systems of several Asian economies, including Thailand, South
Korea, and Indonesia, were at or near the point of bankruptcy, and this news induced
capital to flee from these nations. In 1998, the Russian government defaulted
on its debt, inducing international investors to take whatever money they
could and run. In each of these cases of capital flight, the results were much as our
model predicts: rising interest rates and a falling currency.
Could capital flight ever happen in the United States? Although the U.S. economy
has long been viewed as a safe economy in which to invest, political developments
in the United States have at times induced small amounts of capital
flight. For example, the September 22, 1995, issue of The New York Times reported
that on the previous day, “House Speaker Newt Gingrich threatened to send the
United States into default on its debt for the first time in the nation’s history, to
force the Clinton administration to balance the budget on Republican terms”
(p. A1). Even though most people believed such a default was unlikely, the effect
of the announcement was, in a small way, similar to that experienced by Mexico in
1994. Over the course of that single day, the interest rate on a 30-year U.S. government
bond rose from 6.46 percent to 6.55 percent, and the exchange rate fell from
102.7 to 99.0 yen per dollar. Thus, even the stable U.S. economy is potentially susceptible
to the effects of capital flight.
QUICK QUIZ: Suppose that Americans decided to spend a smaller fraction
of their incomes. What would be the effect on saving, investment, interest
rates, the real exchange rate, and the trade balance?
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 695
CONCLUSION
International economics is a topic of increasing importance. More and more,
American citizens are buying goods produced abroad and producing goods to be
sold overseas. Through mutual funds and other financial institutions, they borrow
and lend in world financial markets. As a result, a full analysis of the U.S. economy
requires an understanding of how the U.S. economy interacts with other economies
in the world. This chapter has provided a basic model for thinking about the
macroeconomics of open economies.
Although the study of international economics is valuable, we should be careful
not to exaggerate its importance. Policymakers and commentators are often
quick to blame foreigners for problems facing the U.S. economy. By contrast, economists
more often view these problems as homegrown. For example, politicians
often discuss foreign competition as a threat to American living standards. Economists
are more likely to lament the low level of national saving. Low saving impedes
growth in capital, productivity, and living standards, regardless of whether
the economy is open or closed. Foreigners are a convenient target for politicians
because blaming foreigners provides a way to avoid responsibility without insulting
any domestic constituency. Whenever you hear popular discussions of international
trade and finance, therefore, it is especially important to try to separate
myth from reality. The tools you have learned in the past two chapters should help
in that endeavor.
To analyze the macroeconomics of open economies, two
markets are central—the market for loanable funds and
the market for foreign-currency exchange. In the market
for loanable funds, the interest rate adjusts to balance
the supply of loanable funds (from national saving) and
the demand for loanable funds (from domestic
investment and net foreign investment). In the market
for foreign-currency exchange, the real exchange rate
adjusts to balance the supply of dollars (for net foreign
investment) and the demand for dollars (for net
exports). Because net foreign investment is part of the
demand for loanable funds and provides the supply of
dollars for foreign-currency exchange, it is the variable
that connects these two markets.
A policy that reduces national saving, such as a
government budget deficit, reduces the supply of
loanable funds and drives up the interest rate. The
higher interest rate reduces net foreign investment,
which reduces the supply of dollars in the market for
foreign-currency exchange. The dollar appreciates, and
net exports fall.
Although restrictive trade policies, such as tariffs or
quotas on imports, are sometimes advocated as a way to
alter the trade balance, they do not necessarily have that
effect. A trade restriction increases net exports for a
given exchange rate and, therefore, increases the
demand for dollars in the market for foreign-currency
exchange. As a result, the dollar appreciates in value,
making domestic goods more expensive relative to
foreign goods. This appreciation offsets the initial
impact of the trade restriction on net exports.
When investors change their attitudes about holding
assets of a country, the ramifications for the country’s
economy can be profound. In particular, political
instability can lead to capital flight, which tends to
increase interest rates and cause the currency to
depreciate.
Summary
696 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
THIS ARTICLE DESCRIBES HOW CAPITAL IS
flowing from China into the United
States. Can you predict what would
happen to the U.S. economy if these
capital flows stopped?
C h i n a , o f A l l P l a c e s ,
Sends C a p i t a l t o U . S .
BY CRAIG S. SMITH
SHANGHAI, CHINA—A giant, developing
nation bordered by an economic quagmire
is an unlikely source of capital for
the world’s industrialized powers. But
China, with fat trade surpluses and bulging
foreign-exchange reserves, is buying
U.S. government securities, especially
Treasury bonds and bonds issued by
Fannie Mae and Freddie Mac.
That’s good for America. Such investments
add liquidity to the U.S. housing
market and help hold down U.S.
interest rates. And China is likely to continue
to buy a lot of U.S. debt for years
to come.
Thanks to high domestic savings, a
continuing inflow of foreign investment
and tight controls on domestic spending,
China is awash in capital. Last year’s
capital surplus . . . reached an estimated
$67 billion.
China squirrels more than half of
that away into foreign reserves, which
are invested abroad. Chinese companies
funnel much of the rest directly overseas
through bank transfers—sometimes
skirting Chinese capital restrictions to
do so. So while the financial crisis has
transformed the rest of East Asia into a
capital-sucking hole, China has become
a gushing fountain of capital.
This isn’t the first time a developing
country has sent abroad funds that could
IN THE NEWS
How the Chinese Help
American Home Buyers
THEIR SAVING HELPS US GET
CHEAP MORTGAGES.
trade policy, p. 690 capital flight, p. 692
Key Concepts
1. Describe supply and demand in the market for loanable
funds and the market for foreign-currency exchange.
How are these markets linked?
2. Why are budget deficits and trade deficits sometimes
called the twin deficits?
3. Suppose that a textile workers’ union encourages people
to buy only American-made clothes. What would this
policy do to the trade balance and the real exchange
rate? What is the impact on the textile industry? What is
the impact on the auto industry?
4. What is capital flight? When a country experiences
capital flight, what is the effect on its interest rate and
exchange rate?
Questions for Review
CHAPTER 30 A MACROECONOMIC THEORY OF THE OPEN ECONOMY 697
be used productively at home. Often,
such money was fleeing instability, as
it was in Latin America in the 1980s,
Russia in the 1990s, and Africa in both
decades.
Usually, however, developing countries
invest their capital in their own
growing economies. And some Chinese
officials believe that’s what China should
be doing, too. One former Chinese central
bank official calls it “scandalous”
that a country of poor peasants is financing
investment of an industrialized power
such as the United States.
Others complain that China isn’t
even getting good returns on its investments.
It pays an average of 7 to 8 percent
on its $130 billion foreign debt but
earns only about 5 percent on the $140
billion of its reserves invested abroad.
That’s partly because yields on U.S.
debt—widely considered the safest securities
in the world—are relatively low.
But China has good reasons to
send some of its capital overseas. Its investment
in fixed assets as a percentage
of its gross domestic product was an extraordinarily
high 34 percent in 1996, the
latest year for which figures are available.
It’s doubtful that China could increase
that ratio without wasting money
or fueling inflation. Thailand’s ratio was
40 percent and Korea’s 37 percent
before their overspending undermined
those nations’ economies. . . .
“They’re already investing as much
as they can absorb,” says Andy Xie, an
economist for Morgan Stanley Dean
Witter & Co. in Hong Kong.
Yet while investment is constrained,
savings keep growing. The percentage
of working-age people in the population
has climbed to 62 percent from 51 percent
in the past 30 years. And those
workers, often allowed only one child on
which to spend, are hitting their peak
saving years. With consumption low, the
pileup of money pushes capital offshore.
The result: Chinese capital is
spreading everywhere. The country is
a big buyer of oil fields, for example,
having pledged more than $8 billion for
concessions in Sudan, Venezuela, Iraq
and Kazakstan. Mainland capital also has
poured into Hong Kong, where it helped
inflate property prices before East Asia’s
crisis began letting out some of that air.
The capital surplus has even allowed
China to help its neighbors when they
got into trouble: Beijing pledged $1 billion
to the International Monetary Fund
bailouts in Thailand and Indonesia. Most
of the money, though, goes into U.S.
Treasury bonds. China won’t say how
much, but estimates run as high as
40 percent.
And China’s central bank, like 50
others around the world, lends money to
Fannie Mae and Freddie Mac, which use
the funds to buy mortgage loans that
banks and others extend to ordinary
Americans. The flood of money keeps
the market liquid and reduces the rates
that U.S. home buyers pay.
SOURCE: The Wall Street Journal, March 30, 1998,
The Outlook, p. 1.
1. Japan generally runs a significant trade surplus. Do you
think this is most related to high foreign demand for
Japanese goods, low Japanese demand for foreign
goods, a high Japanese saving rate relative to Japanese
investment, or structural barriers against imports into
Japan? Explain your answer.
2. An article in The New York Times (Apr. 14, 1995)
regarding a decline in the value of the dollar reported
that “the president was clearly determined to signal that
the United States remains solidly on a course of deficit
reduction, which should make the dollar more attractive
to investors.” Would deficit reduction in fact raise the
value of the dollar? Explain.
3. Suppose that Congress passes an investment tax credit,
which subsidizes domestic investment. How does this
policy affect national saving, domestic investment, net
foreign investment, the interest rate, the exchange rate,
and the trade balance?
4. The chapter notes that the rise in the U.S. trade deficit
during the 1980s was due largely to the rise in the U.S.
budget deficit. On the other hand, the popular press
sometimes claims that the increased trade deficit
resulted from a decline in the quality of U.S. products
relative to foreign products.
a. Assume that U.S. products did decline in relative
quality during the 1980s. How did this affect net
exports at any given exchange rate?
b. Use a three-panel diagram to show the effect of this
shift in net exports on the U.S. real exchange rate
and trade balance.
Problems and Applications
698 PART ELEVEN THE MACROECONOMICS OF OPEN ECONOMIES
c. Is the claim in the popular press consistent with the
model in this chapter? Does a decline in the quality
of U.S. products have any effect on our standard of
living? (Hint: When we sell our goods to foreigners,
what do we receive in return?)
5. An economist discussing trade policy in The New
Republic wrote: “One of the benefits of the United States
removing its trade restrictions [is] the gain to U.S.
industries that produce goods for export. Export
industries would find it easier to sell their goods
abroad—even if other countries didn’t follow our
example and reduce their trade barriers.” Explain in
words why U.S. export industries would benefit from a
reduction in restrictions on imports to the United States.
6. Suppose the French suddenly develop a strong taste for
California wines. Answer the following questions in
words and using a diagram.
a. What happens to the demand for dollars in the
market for foreign-currency exchange?
b. What happens to the value of dollars in the market
for foreign-currency exchange?
c. What happens to the quantity of net exports?
7. A senator renounces her past support for protectionism:
“The U.S. trade deficit must be reduced, but import
quotas only annoy our trading partners. If we subsidize
U.S. exports instead, we can reduce the deficit by
increasing our competitiveness.” Using a three-panel
diagram, show the effect of an export subsidy on net
exports and the real exchange rate. Do you agree with
the senator?
8. Suppose that real interest rates increase across Europe.
Explain how this development will affect U.S. net
foreign investment. Then explain how it will affect U.S.
net exports by using a formula from the chapter and by
using a diagram. What will happen to the U.S. real
interest rate and real exchange rate?
9. Suppose that Americans decide to increase their saving.
a. If the elasticity of U.S. net foreign investment with
respect to the real interest rate is very high, will this
increase in private saving have a large or small
effect on U.S. domestic investment?
b. If the elasticity of U.S. exports with respect to the
real exchange rate is very low, will this increase in
private saving have a large or small effect on the
U.S. real exchange rate?
10. Over the past decade, some of Japanese saving has been
used to finance American investment. That is, American
net foreign investment in Japan has been negative.
a. If the Japanese decided they no longer wanted to
buy U.S. assets, what would happen in the U.S.
market for loanable funds? In particular, what
would happen to U.S. interest rates, U.S. saving,
and U.S. investment?
b. What would happen in the market for foreigncurrency
exchange? In particular, what would
happen to the value of the dollar and the U.S.
trade balance?
11. In 1998 the Russian government defaulted on its debt
payments, leading investors worldwide to raise their
preference for U.S. government bonds, which are
considered very safe. What effect do you think this
“flight to safety” had on the U.S. economy? Be sure
to note the impact on national saving, domestic
investment, net foreign investment, the interest rate,
the exchange rate, and the trade balance.
12. Suppose that U.S. mutual funds suddenly decide to
invest more in Canada.
a. What happens to Canadian net foreign investment,
Canadian saving, and Canadian domestic
investment?
b. What is the long-run effect on the Canadian
capital stock?
c. How will this change in the capital stock affect the
Canadian labor market? Does this U.S. investment
in Canada make Canadian workers better off or
worse off?
d. Do you think this will make U.S. workers better off
or worse off? Can you think of any reason why the
impact on U.S. citizens generally may be different
from the impact on U.S. workers?
IN THIS CHAPTER
YOU WILL . . .
See how shifts in
aggregate demand or
aggregate supply can
cause booms and
recessions
Use the model of
aggregate demand
and aggregate supply
to explain economic
fluctuations
Learn three key facts
about shor t - run
economic
fluctuations
Consider how the
economy in the
shor t r un dif fers from
the economy in
the long run
Economic activity fluctuates from year to year. In most years, the production of
goods and services rises. Because of increases in the labor force, increases in the
capital stock, and advances in technological knowledge, the economy can produce
more and more over time. This growth allows everyone to enjoy a higher standard
of living. On average over the past 50 years, the production of the U.S. economy as
measured by real GDP has grown by about 3 percent per year.
In some years, however, this normal growth does not occur. Firms find themselves
unable to sell all of the goods and services they have to offer, so they cut
back on production. Workers are laid off, unemployment rises, and factories are
left idle. With the economy producing fewer goods and services, real GDP and
other measures of income fall. Such a period of falling incomes and rising
A G G R E G A T E D E M A N D
A N D A G G R E G A T E S U P P L Y
701
702 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
unemployment is called a recession if it is relatively mild and a depression if it is
more severe.
What causes short-run fluctuations in economic activity? What, if anything,
can public policy do to prevent periods of falling incomes and rising unemployment?
When recessions and depressions occur, how can policymakers reduce their
length and severity? These are the questions that we take up in this and the next
two chapters.
The variables that we study in the coming chapters are largely those we have
already seen. They include GDP, unemployment, interest rates, exchange rates,
and the price level. Also familiar are the policy instruments of government spending,
taxes, and the money supply. What differs in the next few chapters is the time
horizon of our analysis. Our focus in the previous seven chapters has been on the
behavior of the economy in the long run. Our focus now is on the economy’s shortrun
fluctuations around its long-run trend.
Although there remains some debate among economists about how to analyze
short-run fluctuations, most economists use the model of aggregate demand and
aggregate supply. Learning how to use this model for analyzing the short-run effects
of various events and policies is the primary task ahead. This chapter introduces
the model’s two key pieces—the aggregate-demand curve and the aggregatesupply
curve. After getting a sense of the overall structure of the model in this
chapter, we examine the pieces of the model in more detail in the next two
chapters.
THREE KEY FACTS
ABOUT ECONOMIC FLUCTUATIONS
Short-run fluctuations in economic activity occur in all countries and in all times
throughout history. As a starting point for understanding these year-to-year fluctuations,
let’s discuss some of their most important properties.
FACT 1: ECONOMIC FLUCTUATIONS ARE
IRREGULAR AND UNPREDICTABLE
Fluctuations in the economy are often called the business cycle. As this term suggests,
economic fluctuations correspond to changes in business conditions. When
real GDP grows rapidly, business is good. Firms find that customers are plentiful
and that profits are growing. On the other hand, when real GDP falls, businesses
have trouble. In recessions, most firms experience declining sales and profits.
The term business cycle is somewhat misleading, however, because it seems to
suggest that economic fluctuations follow a regular, predictable pattern. In fact,
economic fluctuations are not at all regular, and they are almost impossible to predict
with much accuracy. Panel (a) of Figure 31-1 shows the real GDP of the U.S.
economy since 1965. The shaded areas represent times of recession. As the figure
shows, recessions do not come at regular intervals. Sometimes recessions are close
recession
a period of declining real incomes
and rising unemployment
depression
a severe recession
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 703
Billions of
1992 Dollars
Real GDP
(a) Real GDP
Billions of
1992 Dollars
Investment spending
(b) Investment Spending
Percent of
Labor Force
Unemployment rate
(c) Unemployment Rate
300
400
500
600
700
800
900
1,000
$1,100
2,500
3,000
3,500
4,000
4,500
5,000
5,500
6,000
6,500
$7,000
0
2
4
6
8
10
12
1965 1970 1975 1980 1985 1990 1995
1965 1970 1975 1980 1985 1990 1995
1965 1970 1975 1980 1985 1990 1995
Figure 31-1
A LOOK AT SHORT-RUN
ECONOMIC FLUCTUATIONS.
This figure shows real GDP in
panel (a), investment spending
in panel (b), and unemployment
in panel (c) for the U.S. economy
using quarterly data since 1965.
Recessions are shown as the
shaded areas. Notice that real
GDP and investment spending
decline during recessions, while
unemployment rises.
SOURCE: U.S. Department of Commerce;
U.S. Department of Labor.
704 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
together, such as the recessions of 1980 and 1982. Sometimes the economy goes
many years without a recession.
FACT 2: MOST MACROECONOMIC
QUANTITIES FLUCTUATE TOGETHER
Real GDP is the variable that is most commonly used to monitor short-run changes
in the economy because it is the most comprehensive measure of economic activity.
Real GDP measures the value of all final goods and services produced within a
given period of time. It also measures the total income (adjusted for inflation) of
everyone in the economy.
It turns out, however, that for monitoring short-run fluctuations, it does
not really matter which measure of economic activity one looks at. Most macroeconomic
variables that measure some type of income, spending, or production fluctuate
closely together. When real GDP falls in a recession, so do personal
income, corporate profits, consumer spending, investment spending, industrial
production, retail sales, home sales, auto sales, and so on. Because recessions are
economy-wide phenomena, they show up in many sources of macroeconomic data.
Although many macroeconomic variables fluctuate together, they fluctuate by
different amounts. In particular, as panel (b) of Figure 31-1 shows, investment
spending varies greatly over the business cycle. Even though investment averages
about one-seventh of GDP, declines in investment account for about two-thirds of
the declines in GDP during recessions. In other words, when economic conditions
deteriorate, much of the decline is attributable to reductions in spending on new
factories, housing, and inventories.
“You’re fired. Pass it on.”
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 705
FACT 3: AS OUTPUT FALLS, UNEMPLOYMENT RISES
Changes in the economy’s output of goods and services are strongly correlated
with changes in the economy’s utilization of its labor force. In other words, when
real GDP declines, the rate of unemployment rises. This fact is hardly surprising:
When firms choose to produce a smaller quantity of goods and services, they lay
off workers, expanding the pool of unemployed.
Panel (c) of Figure 31-1 shows the unemployment rate in the U.S. economy
since 1965. Once again, recessions are shown as the shaded areas in the figure. The
figure shows clearly the impact of recessions on unemployment. In each of the recessions,
the unemployment rate rises substantially. When the recession ends and
real GDP starts to expand, the unemployment rate gradually declines. The unemployment
rate never approaches zero; instead, it fluctuates around its natural rate
of about 5 percent.
QUICK QUIZ: List and discuss three key facts about economic fluctuations.
EXPLAINING SHORT-RUN
ECONOMIC FLUCTUATIONS
Describing the regular patterns that economies experience as they fluctuate over
time is easy. Explaining what causes these fluctuations is more difficult. Indeed,
compared to the topics we have studied in previous chapters, the theory of economic
fluctuations remains controversial. In this and the next two chapters, we develop
the model that most economists use to explain short-run fluctuations in
economic activity.
HOW THE SHORT RUN DIFFERS FROM THE LONG RUN
In previous chapters we developed theories to explain what determines most important
macroeconomic variables in the long run. Chapter 24 explained the level
and growth of productivity and real GDP. Chapter 25 explained how the real interest
rate adjusts to balance saving and investment. Chapter 26 explained why
there is always some unemployment in the economy. Chapters 27 and 28 explained
the monetary system and how changes in the money supply affect the
price level, the inflation rate, and the nominal interest rate. Chapters 29 and 30 extended
this analysis to open economies in order to explain the trade balance and
the exchange rate.
All of this previous analysis was based on two related ideas—the classical dichotomy
and monetary neutrality. Recall that the classical dichotomy is the separation
of variables into real variables (those that measure quantities or relative
prices) and nominal variables (those measured in terms of money). According to
classical macroeconomic theory, changes in the money supply affect nominal variables
but not real variables. As a result of this monetary neutrality, Chapters 24, 25,
706 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
and 26 were able to examine the determinants of real variables (real GDP, the real
interest rate, and unemployment) without introducing nominal variables (the
money supply and the price level).
Do these assumptions of classical macroeconomic theory apply to the world in
which we live? The answer to this question is of central importance to understanding
how the economy works: Most economists believe that classical theory describes
the world in the long run but not in the short run. Beyond a period of several
years, changes in the money supply affect prices and other nominal variables but
do not affect real GDP, unemployment, or other real variables. When studying
year-to-year changes in the economy, however, the assumption of monetary neutrality
is no longer appropriate. Most economists believe that, in the short run, real
and nominal variables are highly intertwined. In particular, changes in the money
supply can temporarily push output away from its long-run trend.
To understand the economy in the short run, therefore, we need a new model.
To build this new model, we rely on many of the tools we have developed in previous
chapters, but we have to abandon the classical dichotomy and the neutrality
of money.
THE BASIC MODEL OF ECONOMIC FLUCTUATIONS
Our model of short-run economic fluctuations focuses on the behavior of two variables.
The first variable is the economy’s output of goods and services, as measured
by real GDP. The second variable is the overall price level, as measured by
the CPI or the GDP deflator. Notice that output is a real variable, whereas the price
level is a nominal variable. Hence, by focusing on the relationship between these
two variables, we are highlighting the breakdown of the classical dichotomy.
We analyze fluctuations in the economy as a whole with the model of aggregate
demand and aggregate supply, which is illustrated in Figure 31-2. On the vertical
axis is the overall price level in the economy. On the horizontal axis is the
overall quantity of goods and services. The aggregate-demand curve shows the
quantity of goods and services that households, firms, and the government want
to buy at each price level. The aggregate-supply curve shows the quantity of
goods and services that firms produce and sell at each price level. According to
this model, the price level and the quantity of output adjust to bring aggregate demand
and aggregate supply into balance.
It may be tempting to view the model of aggregate demand and aggregate
supply as nothing more than a large version of the model of market demand and
market supply, which we introduced in Chapter 4. Yet in fact this model is quite
different. When we consider demand and supply in a particular market—ice
cream, for instance—the behavior of buyers and sellers depends on the ability of
resources to move from one market to another. When the price of ice cream rises,
the quantity demanded falls because buyers will use their incomes to buy products
other than ice cream. Similarly, a higher price of ice cream raises the quantity
supplied because firms that produce ice cream can increase production by hiring
workers away from other parts of the economy. This microeconomic substitution
from one market to another is impossible when we are analyzing the economy as
a whole. After all, the quantity that our model is trying to explain—real GDP—
measures the total quantity produced in all of the economy’s markets. To understand
why the aggregate-demand curve is downward sloping and why the
model of aggregate
demand and
aggregate supply
the model that most economists
use to explain short-run
fluctuations in economic activity
around its long-run trend
aggregate-demand curve
a curve that shows the quantity of
goods and services that households,
firms, and the government want to
buy at each price level
aggregate-supply curve
a curve that shows the quantity of
goods and services that firms choose
to produce and sell at each price level
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 707
aggregate-supply curve is upward sloping, we need a macroeconomic theory.
Developing such a theory is our next task.
QUICK QUIZ: How does the economy’s behavior in the short run differ
from its behavior in the long run? Draw the model of aggregate demand
and aggregate supply. What variables are on the two axes?
THE AGGREGATE-DEMAND CURVE
The aggregate-demand curve tells us the quantity of all goods and services demanded
in the economy at any given price level. As Figure 31-3 illustrates, the
aggregate-demand curve is downward sloping. This means that, other things
equal, a fall in the economy’s overall level of prices (from, say, P1 to P2) tends to
raise the quantity of goods and services demanded (from Y1 to Y2).
WHY THE AGGREGATE-DEMAND CURVE
SLOPES DOWNWARD
Why does a fall in the price level raise the quantity of goods and services demanded?
To answer this question, it is useful to recall that GDP (which we denote
as Y) is the sum of consumption (C), investment (I), government purchases (G),
and net exports (NX):
Equilibrium
output
Quantity of
Output
Price
Level
0
Equilibrium
price level
Aggregate
supply
Aggregate
demand
Figure 31-2
AGGREGATE DEMAND
AND AGGREGATE SUPPLY.
Economists use the model of
aggregate demand and aggregate
supply to analyze economic
fluctuations. On the vertical
axis is the overall level of prices.
On the horizontal axis is the
economy’s total output of
goods and services. Output
and the price level adjust
to the point at which
the aggregate-supply
and aggregate-demand
curves intersect.
708 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
Y C I G NX.
Each of these four components contributes to the aggregate demand for goods and
services. For now, we assume that government spending is fixed by policy. The
other three components of spending—consumption, investment, and net exports—
depend on economic conditions and, in particular, on the price level. To understand
the downward slope of the aggregate-demand curve, therefore, we must
examine how the price level affects the quantity of goods and services demanded
for consumption, investment, and net exports.
The Price Level and Consumption: The Wealth Ef fect Consider
the money that you hold in your wallet and your bank account. The nominal
value of this money is fixed, but its real value is not. When prices fall, these dollars
are more valuable because then they can be used to buy more goods and services.
Thus, a decrease in the price level makes consumers feel more wealthy, which in turn encourages
them to spend more. The increase in consumer spending means a larger quantity
of goods and services demanded.
The Price Level and Investment: The Interest-Rate Ef fect
As we discussed in Chapter 28, the price level is one determinant of the quantity
of money demanded. The lower the price level, the less money households need to
hold to buy the goods and services they want. When the price level falls, therefore,
households try to reduce their holdings of money by lending some of it out. For instance,
a household might use its excess money to buy interest-bearing bonds. Or
it might deposit its excess money in an interest-bearing savings account, and the
bank would use these funds to make more loans. In either case, as households try
to convert some of their money into interest-bearing assets, they drive down
Quantity of
Output
Price
Level
0
Aggregate
demand
P1
Y1 Y2
P2
1. A decrease
in the price
level . . .
2. . . . increases the quantity of
goods and services demanded.
Figure 31-3
THE AGGREGATE-DEMAND
CURVE. A fall in the price level
from P1 to P2 increases the
quantity of goods and services
demanded from Y1 to Y2. There
are three reasons for this negative
relationship. As the price level
falls, real wealth rises, interest
rates fall, and the exchange rate
depreciates. These effects
stimulate spending on
consumption, investment, and
net exports. Increased spending
on these components of output
means a larger quantity of goods
and services demanded.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 709
interest rates. Lower interest rates, in turn, encourage borrowing by firms that
want to invest in new plants and equipment and by households who want to invest
in new housing. Thus, a lower price level reduces the interest rate, encourages
greater spending on investment goods, and thereby increases the quantity of goods and
services demanded.
The Price Level and Net Expor ts: The Exchange-Rate E f -
fect As we have just discussed, a lower price level in the United States lowers
the U.S. interest rate. In response, some U.S. investors will seek higher returns by
investing abroad. For instance, as the interest rate on U.S. government bonds falls,
a mutual fund might sell U.S. government bonds in order to buy German government
bonds. As the mutual fund tries to move assets overseas, it increases the supply
of dollars in the market for foreign-currency exchange. The increased supply
of dollars causes the dollar to depreciate relative to other currencies. Because each
dollar buys fewer units of foreign currencies, foreign goods become more expensive
relative to domestic goods. This change in the real exchange rate (the relative
price of domestic and foreign goods) increases U.S. exports of goods and services
and decreases U.S. imports of goods and services. Net exports, which equal exports
minus imports, also increase. Thus, when a fall in the U.S. price level causes U.S.
interest rates to fall, the real exchange rate depreciates, and this depreciation stimulates
U.S. net exports and thereby increases the quantity of goods and services demanded.
Summary There are, therefore, three distinct but related reasons why a fall in
the price level increases the quantity of goods and services demanded: (1) Consumers
feel wealthier, which stimulates the demand for consumption goods. (2)
Interest rates fall, which stimulates the demand for investment goods. (3) The exchange
rate depreciates, which stimulates the demand for net exports. For all three
reasons, the aggregate-demand curve slopes downward.
It is important to keep in mind that the aggregate-demand curve (like all demand
curves) is drawn holding “other things equal.” In particular, our three explanations
of the downward-sloping aggregate-demand curve assume that the
money supply is fixed. That is, we have been considering how a change in the
price level affects the demand for goods and services, holding the amount of
money in the economy constant. As we will see, a change in the quantity of money
shifts the aggregate-demand curve. At this point, just keep in mind that the
aggregate-demand curve is drawn for a given quantity of money.
WHY THE AGGREGATE-DEMAND CURVE MIGHT SHIFT
The downward slope of the aggregate-demand curve shows that a fall in the price
level raises the overall quantity of goods and services demanded. Many other factors,
however, affect the quantity of goods and services demanded at a given price
level. When one of these other factors changes, the aggregate-demand curve shifts.
Let’s consider some examples of events that shift aggregate demand. We can
categorize them according to which component of spending is most directly
affected.
Shifts Arising f rom Consumption Suppose Americans suddenly become
more concerned about saving for retirement and, as a result, reduce their
current consumption. Because the quantity of goods and services demanded at
710 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
any price level is lower, the aggregate-demand curve shifts to the left. Conversely,
imagine that a stock market boom makes people feel wealthy and less concerned
about saving. The resulting increase in consumer spending means a greater quantity
of goods and services demanded at any given price level, so the aggregatedemand
curve shifts to the right.
Thus, any event that changes how much people want to consume at a given
price level shifts the aggregate-demand curve. One policy variable that has this
effect is the level of taxation. When the government cuts taxes, it encourages
people to spend more, so the aggregate-demand curve shifts to the right. When
the government raises taxes, people cut back on their spending, and the aggregatedemand
curve shifts to the left.
Shifts Arising f rom Investment Any event that changes how much
firms want to invest at a given price level also shifts the aggregate-demand curve.
For instance, imagine that the computer industry introduces a faster line of
computers, and many firms decide to invest in new computer systems. Because
the quantity of goods and services demanded at any price level is higher, the
aggregate-demand curve shifts to the right. Conversely, if firms become pessimistic
about future business conditions, they may cut back on investment spending,
shifting the aggregate-demand curve to the left.
Tax policy can also influence aggregate demand through investment. As we
saw in Chapter 25, an investment tax credit (a tax rebate tied to a firm’s investment
spending) increases the quantity of investment goods that firms demand at any
given interest rate. It therefore shifts the aggregate-demand curve to the right.
The repeal of an investment tax credit reduces investment and shifts the aggregatedemand
curve to the left.
Another policy variable that can influence investment and aggregate demand
is the money supply. As we discuss more fully in the next chapter, an increase
in the money supply lowers the interest rate in the short run. This makes borrowing
less costly, which stimulates investment spending and thereby shifts the
aggregate-demand curve to the right. Conversely, a decrease in the money supply
raises the interest rate, discourages investment spending, and thereby shifts the
aggregate-demand curve to the left. Many economists believe that throughout U.S.
history changes in monetary policy have been an important source of shifts in aggregate
demand.
Shifts Arising f rom Government Purchases The most direct way
that policymakers shift the aggregate-demand curve is through government purchases.
For example, suppose Congress decides to reduce purchases of new
weapons systems. Because the quantity of goods and services demanded at any
price level is lower, the aggregate-demand curve shifts to the left. Conversely, if
state governments start building more highways, the result is a greater quantity of
goods and services demanded at any price level, so the aggregate-demand curve
shifts to the right.
Shifts Arising f rom Net Expor ts Any event that changes net exports
for a given price level also shifts aggregate demand. For instance, when Europe experiences
a recession, it buys fewer goods from the United States. This reduces
U.S. net exports and shifts the aggregate-demand curve for the U.S. economy to
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 711
the left. When Europe recovers from its recession, it starts buying U.S. goods again,
shifting the aggregate-demand curve to the right.
Net exports sometimes change because of movements in the exchange rate.
Suppose, for instance, that international speculators bid up the value of the U.S.
dollar in the market for foreign-currency exchange. This appreciation of the dollar
would make U.S. goods more expensive compared to foreign goods, which would
depress net exports and shift the aggregate-demand curve to the left. Conversely,
a depreciation of the dollar stimulates net exports and shifts the aggregatedemand
curve to the right.
Summary In the next chapter we analyze the aggregate-demand curve in
more detail. There we examine more precisely how the tools of monetary and fiscal
policy can shift aggregate demand and whether policymakers should use these
tools for that purpose. At this point, however, you should have some idea about
why the aggregate-demand curve slopes downward and what kinds of events and
policies can shift this curve. Table 31-1 summarizes what we have learned so far.
Table 31-1
THE AGGREGATE-DEMAND
CURVE: SUMMARY
WHY DOES THE AGGREGATE-DEMAND CURVE SLOPE DOWNWARD?
1. The Wealth Effect: A lower price level increases real wealth, which encourages
spending on consumption.
2. The Interest-Rate Effect: A lower price level reduces the interest rate, which
encourages spending on investment.
3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to
depreciate, which encourages spending on net exports.
WHYMIGHT THE AGGREGATE-DEMAND CURVE SHIFT?
1. Shifts Arising from Consumption: An event that makes consumers spend more
at a given price level (a tax cut, a stock market boom) shifts the aggregatedemand
curve to the right. An event that makes consumers spend less at a
given price level (a tax hike, a stock market decline) shifts the aggregatedemand
curve to the left.
2. Shifts Arising from Investment: An event that makes firms invest more at a
given price level (optimism about the future, a fall in interest rates due to an
increase in the money supply) shifts the aggregate-demand curve to the
right. An event that makes firms invest less at a given price level (pessimism
about the future, a rise in interest rates due to a decrease in the money
supply) shifts the aggregate-demand curve to the left.
3. Shifts Arising from Government Purchases: An increase in government
purchases of goods and services (greater spending on defense or highway
construction) shifts the aggregate-demand curve to the right. A decrease
in government purchases on goods and services (a cutback in defense or
highway spending) shifts the aggregate-demand curve to the left.
4. Shifts Arising from Net Exports: An event that raises spending on net exports
at a given price level (a boom overseas, an exchange-rate depreciation) shifts
the aggregate-demand curve to the right. An event that reduces spending on
net exports at a given price level (a recession overseas, an exchange-rate
appreciation) shifts the aggregate-demand curve to the left.
712 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
QUICK QUIZ: Explain the three reasons why the aggregate-demand curve
slopes downward. Give an example of an event that would shift the
aggregate-demand curve. Which way would this event shift the curve?
THE AGGREGATE-SUPPLY CURVE
The aggregate-supply curve tells us the total quantity of goods and services that
firms produce and sell at any given price level. Unlike the aggregate-demand
curve, which is always downward sloping, the aggregate-supply curve shows a
relationship that depends crucially on the time horizon being examined. In the long
run, the aggregate-supply curve is vertical, whereas in the short run, the aggregate-supply
curve is upward sloping. To understand short-run economic fluctuations, and
how the short-run behavior of the economy deviates from its long-run behavior,
we need to examine both the long-run aggregate-supply curve and the short-run
aggregate-supply curve.
WHY THE AGGREGATE-SUPPLY CURVE
IS VERTICAL IN THE LONG RUN
What determines the quantity of goods and services supplied in the long run? We
implicitly answered this question earlier in the book when we analyzed the
process of economic growth. In the long run, an economy’s production of goods and services
(its real GDP) depends on its supplies of labor, capital, and natural resources and on
the available technology used to turn these factors of production into goods and services.
Because the price level does not affect these long-run determinants of real GDP, the
long-run aggregate-supply curve is vertical, as in Figure 31-4. In other words, in
the long run, the economy’s labor, capital, natural resources, and technology determine
the total quantity of goods and services supplied, and this quantity supplied
is the same regardless of what the price level happens to be.
The vertical long-run aggregate-supply curve is, in essence, just an application
of the classical dichotomy and monetary neutrality. As we have already discussed,
classical macroeconomic theory is based on the assumption that real variables do
not depend on nominal variables. The long-run aggregate-supply curve is consistent
with this idea because it implies that the quantity of output (a real variable)
does not depend on the level of prices (a nominal variable). As noted earlier, most
economists believe that this principle works well when studying the economy
over a period of many years, but not when studying year-to-year changes. Thus,
the aggregate-supply curve is vertical only in the long run.
One might wonder why supply curves for specific goods and services can be
upward sloping if the long-run aggregate-supply curve is vertical. The reason is
that the supply of specific goods and services depends on relative prices—the prices
of those goods and services compared to other prices in the economy. For example,
when the price of ice cream rises, suppliers of ice cream increase their production,
taking labor, milk, chocolate, and other inputs away from the production of other
goods, such as frozen yogurt. By contrast, the economy’s overall production of
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 713
goods and services is limited by its labor, capital, natural resources, and technology.
Thus, when all prices in the economy rise together, there is no change in
the overall quantity of goods and services supplied.
WHY THE LONG-RUN AGGREGATESUPPLY
CURVE MIGHT SHIFT
The position of the long-run aggregate-supply curve shows the quantity of goods
and services predicted by classical macroeconomic theory. This level of production
is sometimes called potential output or full-employment output. To be more accurate,
we call it the natural rate of output because it shows what the economy produces
when unemployment is at its natural, or normal, rate. The natural rate of output is
the level of production toward which the economy gravitates in the long run.
Any change in the economy that alters the natural rate of output shifts the
long-run aggregate-supply curve. Because output in the classical model depends
on labor, capital, natural resources, and technological knowledge, we can categorize
shifts in the long-run aggregate-supply curve as arising from these sources.
Shifts Arising f rom Labor Imagine that an economy experiences an increase
in immigration from abroad. Because there would be a greater number of
workers, the quantity of goods and services supplied would increase. As a result,
the long-run aggregate-supply curve would shift to the right. Conversely, if many
workers left the economy to go abroad, the long-run aggregate-supply curve
would shift to the left.
The position of the long-run aggregate-supply curve also depends on the natural
rate of unemployment, so any change in the natural rate of unemployment
shifts the long-run aggregate-supply curve. For example, if Congress were to raise
Quantity of
Output
Natural rate
of output
Price
Level
0
Long-run
aggregate
supply
P2
1. A change
in the price
level . . .
2. . . . does not affect
the quantity of goods
and services supplied
in the long run.
P1
Figure 31-4
THE LONG-RUN AGGREGATESUPPLY
CURVE. In the long run,
the quantity of output supplied
depends on the economy’s
quantities of labor, capital, and
natural resources and on the
technology for turning these
inputs into output. The quantity
supplied does not depend on the
overall price level. As a result, the
long-run aggregate-supply curve
is vertical at the natural rate of
output.
714 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
the minimum wage substantially, the natural rate of unemployment would rise,
and the economy would produce a smaller quantity of goods and services. As a
result, the long-run aggregate-supply curve would shift to the left. Conversely, if
a reform of the unemployment insurance system were to encourage unemployed
workers to search harder for new jobs, the natural rate of unemployment would
fall, and the long-run aggregate-supply curve would shift to the right.
Shifts Arising f rom Capital An increase in the economy’s capital stock
increases productivity and, thereby, the quantity of goods and services supplied.
As a result, the long-run aggregate-supply curve shifts to the right. Conversely, a
decrease in the economy’s capital stock decreases productivity and the quantity of
goods and services supplied, shifting the long-run aggregate-supply curve to the
left.
Notice that the same logic applies regardless of whether we are discussing
physical capital or human capital. An increase either in the number of machines or
in the number of college degrees will raise the economy’s ability to produce goods
and services. Thus, either would shift the long-run aggregate-supply curve to
the right.
Shifts Arising f rom Natural Resources An economy’s production
depends on its natural resources, including its land, minerals, and weather. A discovery
of a new mineral deposit shifts the long-run aggregate-supply curve to the
right. A change in weather patterns that makes farming more difficult shifts the
long-run aggregate-supply curve to the left.
In many countries, important natural resources are imported from abroad.
A change in the availability of these resources can also shift the aggregate-supply
curve. As we discuss later in this chapter, events occurring in the world oil market
have historically been an important source of shifts in aggregate supply.
Shifts Arising f rom Technological Knowledge Perhaps the most
important reason that the economy today produces more than it did a generation
ago is that our technological knowledge has advanced. The invention of the computer,
for instance, has allowed us to produce more goods and services from any
given amounts of labor, capital, and natural resources. As a result, it has shifted the
long-run aggregate-supply curve to the right.
Although not literally technological, there are many other events that act like
changes in technology. As Chapter 9 explains, opening up international trade has
effects similar to inventing new production processes, so it also shifts the longrun
aggregate-supply curve to the right. Conversely, if the government passed
new regulations preventing firms from using some production methods, perhaps
because they were too dangerous for workers, the result would be a leftward shift
in the long-run aggregate-supply curve.
Summary The long-run aggregate-supply curve reflects the classical model of
the economy we developed in previous chapters. Any policy or event that raised
real GDP in previous chapters can now be viewed as increasing the quantity of
goods and services supplied and shifting the long-run aggregate-supply curve to
the right. Any policy or event that lowered real GDP in previous chapters can now
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 715
be viewed as decreasing the quantity of goods and services supplied and shifting
the long-run aggregate-supply curve to the left.
A NEW WAY TO DEPICT
LONG-RUN GROWTH AND INFLATION
Having introduced the economy’s aggregate-demand curve and the long-run
aggregate-supply curve, we now have a new way to describe the economy’s longrun
trends. Figure 31-5 illustrates the changes that occur in the economy from
decade to decade. Notice that both curves are shifting. Although there are many
forces that govern the economy in the long run and can in principle cause such
shifts, the two most important in practice are technology and monetary policy.
Technological progress enhances the economy’s ability to produce goods and services,
and this continually shifts the long-run aggregate-supply curve to the right.
At the same time, because the Fed increases the money supply over time, the
aggregate-demand curve also shifts to the right. As the figure illustrates, the result
is trend growth in output (as shown by increasing Y) and continuing inflation (as
shown by increasing P). This is just another way of representing the classical
analysis of growth and inflation we conducted in Chapters 24 and 28.
The purpose of developing the model of aggregate demand and aggregate
supply, however, is not to dress our long-run conclusions in new clothing. Instead,
Quantity of
Output
Y1980
AD1980
Y1990
AD1990
Y2000
Aggregate
Demand, AD2000
Price
Level
0
Long-run
aggregate
supply,
LRAS1980 LRAS1990 LRAS2000
P1980
1. In the long run,
technological
progress shifts
long-run aggregate
supply . . .
4. . . . and
ongoing inflation.
3. . . . leading to growth
in output . . .
P1990
P2000
2. . . . and growth in the
money supply shifts
aggregate demand . . .
Figure 31-5
LONG-RUN GROWTH AND
INFLATION IN THE MODEL OF
AGGREGATE DEMAND AND
AGGREGATE SUPPLY. As the
economy becomes better able to
produce goods and services over
time, primarily because of
technological progress, the longrun
aggregate-supply curve shifts
to the right. At the same time, as
the Fed increases the money
supply, the aggregate-demand
curve also shifts to the right. In
this figure, output grows from
Y1980 to Y1990 and then to Y2000, and
the price level rises from P1980 to
P1990 and then to P2000. Thus, the
model of aggregate demand and
aggregate supply offers a new
way to describe the classical
analysis of growth and inflation.
716 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
it is to provide a framework for short-run analysis, as we will see in a moment. As
we develop the short-run model, we keep the analysis simple by not showing the
continuing growth and inflation depicted in Figure 31-5. But always remember
that long-run trends provide the background for short-run fluctuations. Short-run
fluctuations in output and the price level should be viewed as deviations from the continuing
long-run trends.
WHY THE AGGREGATE-SUPPLY CURVE
SLOPES UPWARD IN THE SHORT RUN
We now come to the key difference between the economy in the short run and
in the long run: the behavior of aggregate supply. As we have already discussed,
the long-run aggregate-supply curve is vertical. By contrast, in the short run, the
aggregate-supply curve is upward sloping, as shown in Figure 31-6. That is, over
a period of a year or two, an increase in the overall level of prices in the economy
tends to raise the quantity of goods and services supplied, and a decrease in the
level of prices tends to reduce the quantity of goods and services supplied.
What causes this positive relationship between the price level and output?
Macroeconomists have proposed three theories for the upward slope of the shortrun
aggregate-supply curve. In each theory, a specific market imperfection causes
the supply side of the economy to behave differently in the short run than it does
in the long run. Although each of the following theories will differ in detail, they
share a common theme: The quantity of output supplied deviates from its longrun,
or “natural,” level when the price level deviates from the price level that
people expected. When the price level rises above the expected level, output rises
above its natural rate, and when the price level falls below the expected level, output
falls below its natural rate.
Quantity of
Output
Price
Level
0
Short-run
aggregate
supply
Y2 Y1
1. A decrease
in the price
level . . .
2. . . . reduces the quantity
of goods and services
supplied in the short run.
P1
P2
Figure 31-6
THE SHORT-RUN AGGREGATESUPPLY
CURVE. In the short run,
a fall in the price level from P1 to
P2 reduces the quantity of output
supplied from Y1 to Y2. This
positive relationship could be
due to misperceptions, sticky
wages, or sticky prices. Over
time, perceptions, wages, and
prices adjust, so this positive
relationship is only temporary.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 717
The Misperceptions Theory One approach to the short-run aggregatesupply
curve is the misperceptions theory. According to this theory, changes in the
overall price level can temporarily mislead suppliers about what is happening in
the individual markets in which they sell their output. As a result of these shortrun
misperceptions, suppliers respond to changes in the level of prices, and this
response leads to an upward-sloping aggregate-supply curve.
To see how this might work, suppose the overall price level falls below the
level that people expected. When suppliers see the prices of their products fall,
they may mistakenly believe that their relative prices have fallen. For example,
wheat farmers may notice a fall in the price of wheat before they notice a fall in the
prices of the many items they buy as consumers. They may infer from this observation
that the reward to producing wheat is temporarily low, and they may respond
by reducing the quantity of wheat they supply. Similarly, workers may
notice a fall in their nominal wages before they notice a fall in the prices of the
goods they buy. They may infer that the reward to working is temporarily low and
respond by reducing the quantity of labor they supply. In both cases, a lower price
level causes misperceptions about relative prices, and these misperceptions induce suppliers
to respond to the lower price level by decreasing the quantity of goods and services
supplied.
The Sticky-Wage Theory A second explanation of the upward slope of
the short-run aggregate-supply curve is the sticky-wage theory. According to this
theory, the short-run aggregate-supply curve slopes upward because nominal
wages are slow to adjust, or are “sticky,” in the short run. To some extent, the slow
adjustment of nominal wages is attributable to long-term contracts between workers
and firms that fix nominal wages, sometimes for as long as three years. In addition,
this slow adjustment may be attributable to social norms and notions of
fairness that influence wage setting and that change only slowly over time.
To see what sticky nominal wages mean for aggregate supply, imagine that a
firm has agreed in advance to pay its workers a certain nominal wage based on
what it expected the price level to be. If the price level P falls below the level that
was expected and the nominal wage remains stuck at W, then the real wage W/P
rises above the level the firm planned to pay. Because wages are a large part of a
firm’s production costs, a higher real wage means that the firm’s real costs have
risen. The firm responds to these higher costs by hiring less labor and producing
a smaller quantity of goods and services. In other words, because wages do not adjust
immediately to the price level, a lower price level makes employment and production
less profitable, which induces firms to reduce the quantity of goods and services
supplied.
The Sticky-Price Theory Recently, some economists have advocated a
third approach to the short-run aggregate-supply curve, called the sticky-price theory.
As we just discussed, the sticky-wage theory emphasizes that nominal wages
adjust slowly over time. The sticky-price theory emphasizes that the prices of
some goods and services also adjust sluggishly in response to changing economic
conditions. This slow adjustment of prices occurs in part because there are costs to
adjusting prices, called menu costs. These menu costs include the cost of printing
and distributing catalogs and the time required to change price tags. As a result of
these costs, prices as well as wages may be sticky in the short run.
718 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
To see the implications of sticky prices for aggregate supply, suppose that each
firm in the economy announces its prices in advance based on the economic conditions
it expects to prevail. Then, after prices are announced, the economy experiences
an unexpected contraction in the money supply, which (as we have
learned) will reduce the overall price level in the long run. Although some firms
reduce their prices immediately in response to changing economic conditions,
other firms may not want to incur additional menu costs and, therefore, may temporarily
lag behind. Because these lagging firms have prices that are too high, their
sales decline. Declining sales, in turn, cause these firms to cut back on production
and employment. In other words, because not all prices adjust instantly to changing
conditions, an unexpected fall in the price level leaves some firms with higher-than-desired
prices, and these higher-than-desired prices depress sales and induce firms to reduce the
quantity of goods and services they produce.
Summary There are three alternative explanations for the upward slope of the
short-run aggregate-supply curve: (1) misperceptions, (2) sticky wages, and (3)
sticky prices. Economists debate which of these theories is correct. For our purposes
in this book, however, the similarities of the theories are more important
than the differences. All three theories suggest that output deviates from its natural
rate when the price level deviates from the price level that people expected.
We can express this mathematically as follows:
a
where a is a number that determines how much output responds to unexpected
changes in the price level.
Notice that each of the three theories of short-run aggregate supply emphasizes
a problem that is likely to be only temporary. Whether the upward slope of
the aggregate-supply curve is attributable to misperceptions, sticky wages, or
sticky prices, these conditions will not persist forever. Eventually, as people adjust
their expectations, misperceptions are corrected, nominal wages adjust, and prices
become unstuck. In other words, the expected and actual price levels are equal
in the long run, and the aggregate-supply curve is vertical rather than upward
sloping.
WHY THE SHORT-RUN AGGREGATE-SUPPLY
CURVE MIGHT SHIFT
The short-run aggregate-supply curve tells us the quantity of goods and services
supplied in the short run for any given level of prices. We can think of this curve
as similar to the long-run aggregate-supply curve but made upward sloping by
the presence of misperceptions, sticky wages, and sticky prices. Thus, when think-
Expected
price level
Actual
price level
Natural rate of
output
Quantity of
output supplied
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 719
ing about what shifts the short-run aggregate-supply curve, we have to consider
all those variables that shift the long-run aggregate-supply curve plus a new
variable—the expected price level—that influences misperceptions, sticky wages,
and sticky prices.
Let’s start with what we know about the long-run aggregate-supply curve. As
we discussed earlier, shifts in the long-run aggregate-supply curve normally arise
from changes in labor, capital, natural resources, or technological knowledge.
These same variables shift the short-run aggregate-supply curve. For example,
when an increase in the economy’s capital stock increases productivity, both the
long-run and short-run aggregate-supply curves shift to the right. When an increase
in the minimum wage raises the natural rate of unemployment, both the
long-run and short-run aggregate-supply curves shift to the left.
The important new variable that affects the position of the short-run
aggregate-supply curve is people’s expectation of the price level. As we have discussed,
the quantity of goods and services supplied depends, in the short run, on
misperceptions, sticky wages, and sticky prices. Yet perceptions, wages, and prices
are set on the basis of expectations of the price level. So when expectations change,
the short-run aggregate-supply curve shifts.
To make this idea more concrete, let’s consider a specific theory of aggregate
supply—the sticky-wage theory. According to this theory, when people expect the
price level to be high, they tend to set wages high. High wages raise firms’ costs
and, for any given actual price level, reduce the quantity of goods and services that
firms supply. Thus, when the expected price level rises, wages rise, costs rise, and
firms choose to supply a smaller quantity of goods and services at any given actual
price level. Thus, the short-run aggregate-supply curve shifts to the left. Conversely,
when the expected price level falls, wages fall, costs fall, firms increase
production, and the short-run aggregate-supply curve shifts to the right.
A similar logic applies in each theory of aggregate supply. The general lesson
is the following: An increase in the expected price level reduces the quantity of goods and
services supplied and shifts the short-run aggregate-supply curve to the left. A decrease in
the expected price level raises the quantity of goods and services supplied and shifts the
short-run aggregate-supply curve to the right. As we will see in the next section, this
influence of expectations on the position of the short-run aggregate-supply curve
plays a key role in reconciling the economy’s behavior in the short run with its behavior
in the long run. In the short run, expectations are fixed, and the economy
finds itself at the intersection of the aggregate-demand curve and the short-run
aggregate-supply curve. In the long run, expectations adjust, and the shortrun
aggregate-supply curve shifts. This shift ensures that the economy eventually
finds itself at the intersection of the aggregate-demand curve and the long-run
aggregate-supply curve.
You should now have some understanding about why the short-run
aggregate-supply curve slopes upward and what events and policies can cause
this curve to shift. Table 31-2 summarizes our discussion.
QUICK QUIZ: Explain why the long-run aggregate-supply curve is
vertical. Explain three theories for why the short-run aggregate-supply
curve is upward sloping.
720 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
TWO CAUSES OF ECONOMIC FLUCTUATIONS
Now that we have introduced the model of aggregate demand and aggregate supply,
we have the basic tools we need to analyze fluctuations in economic activity.
In the next two chapters we will refine our understanding of how to use these
tools. But even now we can use what we have learned about aggregate demand
and aggregate supply to examine the two basic causes of short-run fluctuations.
Figure 31-7 shows an economy in long-run equilibrium. Equilibrium output
and the price level are determined by the intersection of the aggregate-demand
curve and the long-run aggregate-supply curve, shown as point Ain the figure. At
this point, output is at its natural rate. The short-run aggregate-supply curve
passes through this point as well, indicating that perceptions, wages, and prices
Table 31-2
THE SHORT-RUN
AGGREGATE-SUPPLY
CURVE: SUMMARY
WHY DOES THE SHORT-RUN AGGREGATE-SUPPLY CURVE SLOPE UPWARD?
1. The Misperceptions Theory: An unexpectedly low price level leads some
suppliers to think their relative prices have fallen, which induces a fall
in production.
2. The Sticky-Wage Theory: An unexpectedly low price level raises the real wage,
which causes firms to hire fewer workers and produce a smaller quantity of
goods and services.
3. The Sticky-Price Theory: An unexpectedly low price level leaves some firms
with higher-than-desired prices, which depresses their sales and leads them
to cut back production.
WHYMIGHT THE SHORT-RUN AGGREGATE-SUPPLY CURVE SHIFT?
1. Shifts Arising from Labor: An increase in the quantity of labor available
(perhaps due to a fall in the natural rate of unemployment) shifts the
aggregate-supply curve to the right. A decrease in the quantity of labor
available (perhaps due to a rise in the natural rate of unemployment) shifts
the aggregate-supply curve to the left.
2. Shifts Arising from Capital: An increase in physical or human capital shifts the
aggregate-supply curve to the right. A decrease in physical or human capital
shifts the aggregate-supply curve to the left.
3. Shifts Arising from Natural Resources: An increase in the availability of natural
resources shifts the aggregate-supply curve to the right. A decrease in the
availability of natural resources shifts the aggregate-supply curve to the left.
4. Shifts Arising from Technology: An advance in technological knowledge shifts
the aggregate-supply curve to the right. A decrease in the available
technology (perhaps due to government regulation) shifts the aggregatesupply
curve to the left.
5. Shifts Arising from the Expected Price Level: A decrease in the expected price
level shifts the short-run aggregate-supply curve to the right. An increase
in the expected price level shifts the short-run aggregate-supply curve
to the left.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 721
have fully adjusted to this long-run equilibrium. That is, when an economy is in its
long-run equilibrium, perceptions, wages, and prices must have adjusted so that
the intersection of aggregate demand with short-run aggregate supply is the same
as the intersection of aggregate demand with long-run aggregate supply.
THE EFFECTS OF A SHIFT IN AGGREGATE DEMAND
Suppose that for some reason a wave of pessimism suddenly overtakes the economy.
The cause might be a scandal in the White House, a crash in the stock market,
or the outbreak of a war overseas. Because of this event, many people lose confidence
in the future and alter their plans. Households cut back on their spending
and delay major purchases, and firms put off buying new equipment.
What is the impact of such a wave of pessimism on the economy? Such an
event reduces the aggregate demand for goods and services. That is, for any given
price level, households and firms now want to buy a smaller quantity of goods
and services. As Figure 31-8 shows, the aggregate-demand curve shifts to the left
from AD1 to AD2.
In this figure we can examine the effects of the fall in aggregate demand. In the
short run, the economy moves along the initial short-run aggregate-supply curve
AS1, going from point Ato point B. As the economy moves from point Ato point B,
output falls from Y1 to Y2, and the price level falls from P1 to P2. The falling level of
output indicates that the economy is in a recession. Although not shown in the
figure, firms respond to lower sales and production by reducing employment.
Thus, the pessimism that caused the shift in aggregate demand is, to some extent,
self-fulfilling: Pessimism about the future leads to falling incomes and rising
unemployment.
Natural rate
of output
Quantity of
Output
Price
Level
0
Equilibrium
price
Short-run
aggregate
supply
Long-run
aggregate
supply
Aggregate
demand
A
Figure 31-7
THE LONG-RUN EQUILIBRIUM.
The long-run equilibrium of
the economy is found where the
aggregate-demand curve crosses
the long-run aggregate-supply
curve (point A). When the
economy reaches this long-run
equilibrium, perceptions, wages,
and prices will have adjusted so
that the short-run aggregatesupply
curve crosses this
point as well.
722 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
What should policymakers do when faced with such a recession? One possibility
is to take action to increase aggregate demand. As we noted earlier, an increase
in government spending or an increase in the money supply would increase
the quantity of goods and services demanded at any price and, therefore, would
shift the aggregate-demand curve to the right. If policymakers can act with sufficient
speed and precision, they can offset the initial shift in aggregate demand, return
the aggregate-demand curve back to AD1, and bring the economy back to
point A. (The next chapter discusses in more detail the ways in which monetary
and fiscal policy influence aggregate demand, as well as some of the practical difficulties
in using these policy instruments.)
Even without action by policymakers, the recession will remedy itself over a
period of time. Because of the reduction in aggregate demand, the price level falls.
Eventually, expectations catch up with this new reality, and the expected price
level falls as well. Because the fall in the expected price level alters perceptions,
wages, and prices, it shifts the short-run aggregate-supply curve to the right from
AS1 to AS2 in Figure 31-8. This adjustment of expectations allows the economy
over time to approach point C, where the new aggregate demand-curve (AD2)
crosses the long-run aggregate-supply curve.
In the new long-run equilibrium, point C, output is back to its natural rate.
Even though the wave of pessimism has reduced aggregate demand, the price
level has fallen sufficiently (to P3) to offset the shift in the aggregate-demand
curve. Thus, in the long run, the shift in aggregate demand is reflected fully in the
price level and not at all in the level of output. In other words, the long-run effect
of a shift in aggregate demand is a nominal change (the price level is lower) but
not a real change (output is the same).
Quantity of
Output
Price
Level
0
Short-run aggregate
supply, AS1
Long-run
aggregate
supply
Aggregate
demand, AD1
A
B
C
P1
P2
P3
Y2 Y1
AD2
AS2
1. A decrease in
aggregate demand . . .
2. . . . causes output to fall in the short run . . .
3. . . . but over
time, the short-run
aggregate-supply
curve shifts . . .
4. . . . and output returns
to its natural rate.
Figure 31-8
A CONTRACTION IN AGGREGATE
DEMAND. A fall in aggregate
demand, which might be due to a
wave of pessimism in the
economy, is represented with a
leftward shift in the aggregatedemand
curve from AD1 to AD2.
The economy moves from point
A to point B. Output falls from Y1
to Y2, and the price level falls
from P1 to P2. Over time, as
perceptions, wages, and prices
adjust, the short-run aggregatesupply
curve shifts to the right
from AS1 to AS2, and the
economy reaches point C, where
the new aggregate-demand curve
crosses the long-run aggregatesupply
curve. The price level
falls to P3, and output returns
to its natural rate, Y1.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 723
CASE STUDY TWO BIG SHIFTS IN AGGREGATE DEMAND:
THE GREAT DEPRESSION AND WORLD WAR II
At the beginning of this chapter we established three key facts about economic
fluctuations by looking at data since 1965. Let’s now take a longer look at U.S.
economic history. Figure 31-9 shows data on real GDP going back to 1900. Most
short-run economic fluctuations are hard to see in this figure; they are dwarfed
by the 25-fold rise in GDP over the past century. Yet two episodes jump out as
being particularly significant—the large drop in real GDP in the early 1930s and
the large increase in real GDP in the early 1940s. Both of these events are attributable
to shifts in aggregate demand.
The economic calamity of the early 1930s is called the Great Depression, and
it is by far the largest economic downturn in U.S. history. Real GDP fell by
27 percent from 1929 to 1933, and unemployment rose from 3 percent to 25
To sum up, this story about shifts in aggregate demand has two important
lessons:
In the short run, shifts in aggregate demand cause fluctuations in the
economy’s output of goods and services.
In the long run, shifts in aggregate demand affect the overall price level but
do not affect output.
Real GDP
(billions of
1992 dollars)
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
8,000
4,000
2,000
1,000
500
250
The Great
Depression The World War II
Boom Real GDP
Figure 31-9
U.S. REAL GDP SINCE 1900.
Over the course of U.S. economic
history, two fluctuations stand
out as being especially large.
During the early 1930s, the
economy went through the Great
Depression, when the production
of goods and services
plummeted. During the early
1940s, the United States entered
World War II, and the economy
experienced rapidly rising
production. Both of these events
are usually explained by large
shifts in aggregate demand.
NOTE: Real GDP is graphed here using a proportional scale. This means that equal distances on the vertical axis
represent equal percentage changes. For example, the distance between 1,000 and 2,000 (a 100 percent increase) is
the same as the distance between 2,000 and 4,000 (a 100 percent increase). With such a scale, stable growth—say,
3 percent per year—would show up as an upward-sloping straight line.
SOURCE: U.S. Department of Commerce.
724 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
percent. At the same time, the price level fell by 22 percent over these four years.
Many other countries experienced similar declines in output and prices during
this period.
Economic historians continue to debate the causes of the Great Depression,
but most explanations center on a large decline in aggregate demand. What
caused aggregate demand to contract? Here is where the disagreement arises.
Many economists place primary blame on the decline in the money supply:
From 1929 to 1933, the money supply fell by 28 percent. As you may recall from
our discussion of the monetary system in Chapter 27, this decline in the money
supply was due to problems in the banking system. As households withdrew
their money from financially shaky banks and bankers became more cautious
and started holding greater reserves, the process of money creation under
fractional-reserve banking went into reverse. The Fed, meanwhile, failed to offset
this fall in the money multiplier with expansionary open-market operations.
As a result, the money supply declined. Many economists blame the Fed’s failure
to act for the Great Depression’s severity.
Other economists have suggested alternative reasons for the collapse in
aggregate demand. For example, stock prices fell about 90 percent during this
period, depressing household wealth and thereby consumer spending. In addition,
the banking problems may have prevented some firms from obtaining the
financing they wanted for investment projects, and this would have depressed
investment spending. Of course, all of these forces may have acted together to
contract aggregate demand during the Great Depression.
The second significant episode in Figure 31-9—the economic boom of the
early 1940s—is easier to explain. The obvious cause of this event is World War
II. As the United States entered the war overseas, the federal government had to
devote more resources to the military. Government purchases of goods and
services increased almost fivefold from 1939 to 1944. This huge expansion in
aggregate demand almost doubled the economy’s production of goods and
services and led to a 20 percent increase in the price level (although widespread
government price controls limited the rise in prices). Unemployment fell from
17 percent in 1939 to about 1 percent in 1944—the lowest level in U.S. history.
WARS: ONE WAY TO STIMULATE AGGREGATE DEMAND
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 725
THE EFFECTS OF A SHIFT IN AGGREGATE SUPPLY
Imagine once again an economy in its long-run equilibrium. Now suppose that
suddenly some firms experience an increase in their costs of production. For example,
bad weather in farm states might destroy some crops, driving up the cost
AS WE HAVE SEEN, WHEN PEOPLE CHANGE
their perceptions and spending, they
shift the aggregate-demand curve and
cause short-run fluctuations in the
economy. According to the following
article, such a shift occurred in 1996,
just as the presidential campaign of that
year was getting under way.
C o n s u m e r s G e t t h e C r e d i t
f o r Expanding Economy
BY RICHARD W. STEVENSON
WASHINGTON—President Clinton claims
the credit for himself, and analysts cite
an array of other possible factors, but
the most important source of the economy’s
remarkable resilience and vibrancy
this year appears to be the consumer.
For most of this year, Americans
have spent prodigiously on homes, cars,
refrigerators, and dinners out, carrying
forward an aging economic expansion
that as recently as January seemed in
danger of expiring. In the process, they
have largely ignored warning signs that
they are becoming overextended.
The consumer spending spree was
a major force in the surprisingly robust
economic data released Friday, economists
said. The Labor Department estimated
that the economy created
239,000 jobs in June, far more than
expected, making that month the fifth
consecutive one with strong employment
gains. The unemployment rate now
stands at 5.3 percent, the lowest in six
years, and economic growth is so rapid
that it has revived fears of inflation.
Among the industries showing the
biggest gains was retailing, which added
75,000 jobs in June, nearly half of them
in what the government classifies as eating
and drinking places. Job growth was
also strong at car dealers, gas stations,
hotels, and stores selling building materials,
garden supplies, and home furnishings.
Employment in construction was up
by 23,000, reflecting in part the continued
upward strength of home building.
Just how long consumers can carry
on with their free-spending ways, however,
remains an open question and one
that is critical to policymakers at the Federal
Reserve as they decide whether to
raise interest rates to keep the economy
from accelerating enough to generate increased
inflation.
Some economists believe that consumers
have amassed so much debt
that they will be forced to rein in their
spending for the rest of the year, resulting
in a slackening of economic growth.
Credit card delinquencies in the first
quarter were at their highest level since
1981, and personal bankruptcies were
up 15 percent from the first three
months of 1995. . . .
Most economists also agree that
the surge in spending this year has been
driven in large part by temporary factors—
including low interest rates, higherthan-
expected tax refunds, and rebates
from automakers—that have been reversed
or phased out. . . .
One wild card in assessing the
course of consumer spending is the
stock market, which has been making
relatively affluent consumers feel flush
with its continued boom. Economists
have grappled for years with the question
of the extent to which paper gains
on stock market investments lead consumers
to spend more, and they still do
not agree on an answer. But they said it
was relatively clear that the bull market
of recent years—and the fact that more
and more Americans invest in the market
through retirement plans and mutual
funds—has provided some impetus to
consumers to spend more.
SOURCE: The New York Times, July 8, 1996, p. D3.
IN THE NEWS
How Consumers Shift
Aggregate Demand
CONSUMERS: AGGREGATE-DEMAND SHIFTERS
726 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
of producing food products. Or a war in the Middle East might interrupt the shipping
of crude oil, driving up the cost of producing oil products.
What is the macroeconomic impact of such an increase in production costs?
For any given price level, firms now want to supply a smaller quantity of goods
and services. Thus, as Figure 31-10 shows, the short-run aggregate-supply curve
shifts to the left from AS1 to AS2. (Depending on the event, the long-run aggregatesupply
curve might also shift. To keep things simple, however, we will assume
that it does not.)
In this figure we can trace the effects of the leftward shift in aggregate supply.
In the short run, the economy moves along the existing aggregate-demand curve,
going from point A to point B. The output of the economy falls from Y1 to Y2, and
the price level rises from P1 to P2. Because the economy is experiencing both stagnation
(falling output) and inflation (rising prices), such an event is sometimes
called stagflation.
What should policymakers do when faced with stagflation? As we will discuss
more fully later in this book, there are no easy choices. One possibility is to do
nothing. In this case, the output of goods and services remains depressed at Y2 for
a while. Eventually, however, the recession will remedy itself as perceptions,
wages, and prices adjust to the higher production costs. A period of low output
and high unemployment, for instance, puts downward pressure on workers’
wages. Lower wages, in turn, increase the quantity of output supplied. Over time,
as the short-run aggregate-supply curve shifts back toward AS1, the price level
falls, and the quantity of output approaches its natural rate. In the long run, the
economy returns to point A, where the aggregate-demand curve crosses the longrun
aggregate-supply curve.
Alternatively, policymakers who control monetary and fiscal policy might
attempt to offset some of the effects of the shift in the short-run aggregate-supply
stagflation
a period of falling output
and rising prices
Quantity of
Output
Price
Level
0
Aggregate demand
A
B
Y2 Y1
3. . . . and
the price
level to rise.
2. . . . causes output to fall . . .
1. An adverse shift in the shortrun
aggregate-supply curve . . .
Short-run
aggregate
supply, AS1
Long-run
aggregate
supply
P2
P1
AS2
Figure 31-10
AN ADVERSE SHIFT IN
AGGREGATE SUPPLY. When
some event increases firms’ costs,
the short-run aggregate-supply
curve shifts to the left from AS1 to
AS2. The economy moves from
point A to point B. The result is
stagflation: Output falls from Y1
to Y2, and the price level rises
from P1 to P2.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 727
CASE STUDY OIL AND THE ECONOMY
Some of the largest economic fluctuations in the U.S. economy since 1970 have
originated in the oil fields of the Middle East. Crude oil is a key input into the
production of many goods and services, and much of the world’s oil comes
from Saudi Arabia, Kuwait, and other Middle Eastern countries. When some
event (usually political in origin) reduces the supply of crude oil flowing from
this region, the price of oil rises around the world. U.S. firms that produce gasoline,
tires, and many other products experience rising costs. The result is a leftward
shift in the aggregate-supply curve, which in turn leads to stagflation.
curve by shifting the aggregate-demand curve. This possibility is shown in Figure
31-11. In this case, changes in policy shift the aggregate-demand curve to the
right from AD1 to AD2—exactly enough to prevent the shift in aggregate supply
from affecting output. The economy moves directly from point A to point C. Output
remains at its natural rate, and the price level rises from P1 to P3. In this case,
policymakers are said to accommodate the shift in aggregate supply because they
allow the increase in costs to affect the level of prices permanently.
To sum up, this story about shifts in aggregate supply has two important
implications:
Shifts in aggregate supply can cause stagflation—a combination of recession
(falling output) and inflation (rising prices).
Policymakers who can influence aggregate demand cannot offset both of
these adverse effects simultaneously.
Quantity of
Output
Natural rate
of output
Price
Level
0
Short-run
aggregate
supply, AS1
Long-run
aggregate
supply
Aggregate demand, AD1
A
C
P2
P3
P1
AS2
3. . . . which
causes the
price level
to rise
further . . .
4. . . . but keeps output
at its natural rate.
2. . . . policymakers can
accommodate the shift
by expanding aggregate
demand . . .
1. When short-run aggregate
supply falls . . .
AD2
Figure 31-11
ACCOMMODATING AN ADVERSE
SHIFT IN AGGREGATE SUPPLY.
Faced with an adverse shift in
aggregate supply from AS1 to
AS2, policymakers who can
influence aggregate demand
might try to shift the aggregatedemand
curve to the right from
AD1 to AD2. The economy would
move from point A to point C.
This policy would prevent the
supply shift from reducing
output in the short run, but the
price level would permanently
rise from P1 to P3.
728 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
The first episode of this sort occurred in the mid-1970s. The countries with
large oil reserves got together as members of OPEC, the Organization of Petroleum
Exporting Countries. OPEC was a cartel—a group of sellers that attempts
to thwart competition and reduce production in order to raise prices. And, indeed,
oil prices rose substantially. From 1973 to 1975, oil approximately doubled
in price. Oil-importing countries around the world experienced simultaneous
inflation and recession. The U.S. inflation rate as measured by the CPI exceeded
10 percent for the first time in decades. Unemployment rose from 4.9 percent in
1973 to 8.5 percent in 1975.
Almost the same thing happened again a few years later. In the late 1970s,
the OPEC countries again restricted the supply of oil to raise the price. From
1978 to 1981, the price of oil more than doubled. Once again, the result was
stagflation. Inflation, which had subsided somewhat after the first OPEC event,
again rose above 10 percent per year. But because the Fed was not willing to accommodate
such a large rise in inflation, a recession was soon to follow. Unemployment
rose from about 6 percent in 1978 and 1979 to about 10 percent a few
years later.
The world market for oil can also be a source of favorable shifts in aggregate
supply. In 1986 squabbling broke out among members of OPEC. Member
countries reneged on their agreements to restrict oil production. In the world
market for crude oil, prices fell by about half. This fall in oil prices reduced costs
to U.S. firms, which shifted the aggregate-supply curve to the right. As a result,
the U.S. economy experienced the opposite of stagflation: Output grew rapidly,
unemployment fell, and the inflation rate reached its lowest level in many
years.
In recent years, the world market for oil has been relatively quiet. The only
exception has been a brief period during 1990, just before the Persian Gulf War,
when oil prices temporarily spiked up out of fear that a long military conflict
might disrupt oil production. Yet this recent tranquillity does not mean that the
United States no longer needs to worry about oil prices. Political troubles in
the Middle East (or greater cooperation among the members of OPEC) could
always send oil prices higher. The macroeconomic result of a large rise in oil
prices could easily resemble the stagflation of the 1970s.
QUICK QUIZ: Suppose that the election of a popular presidential candidate
suddenly increases people’s confidence in the future. Use the model of
aggregate demand and aggregate supply to analyze the effect on the economy.
CONCLUSION: THE ORIGINS OF AGGREGATE
DEMAND AND AGGREGATE SUPPLY
This chapter has achieved two goals. First, we have discussed some of the important
facts about short-run fluctuations in economic activity. Second, we have introduced
a basic model to explain those fluctuations, called the model of aggregate
demand and aggregate supply. In the next two chapters we look at each piece of
CHANGES IN MIDDLE EASTERN OIL
PRODUCTION ARE ONE SOURCE OF
U.S. ECONOMIC FLUCTUATIONS.
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 729
this model in more detail in order to understand more fully what causes fluctuations
in the economy and how policymakers might respond to these fluctuations.
Now that we have a preliminary understanding of this model, it is worthwhile
to step back from it and consider its history. How did this model of short-run fluctuations
develop? The answer is that this model, to a large extent, is a by-product
of the Great Depression of the 1930s. Economists and policymakers at the time
were puzzled about what had caused this calamity and were uncertain about how
to deal with it.
In 1936, economist John Maynard Keynes published a book titled The General
Theory of Employment, Interest, and Money, which attempted to explain short-run
economic fluctuations in general and the Great Depression in particular. Keynes’s
primary message was that recessions and depressions can occur because of inadequate
aggregate demand for goods and services. Keynes had long been a critic of
classical economic theory—the theory we examined in Chapters 24 through 30—
because it could explain only the long-run effects of policies. Afew years before offering
The General Theory, Keynes had written the following about classical
economics:
The long run is a misleading guide to current affairs. In the long run we are all
dead. Economists set themselves too easy, too useless a task if in tempestuous
seasons they can only tell us when the storm is long past, the ocean will be flat.
Keynes’s message was aimed at policymakers as well as economists. As the
world’s economies suffered with high unemployment, Keynes advocated policies
to increase aggregate demand, including government spending on public works.
In the next chapter we examine in detail how policymakers can try to use the tools
of monetary and fiscal policy to influence aggregate demand. The analysis in the
next chapter, as well as in this one, owes much to the legacy of John Maynard
Keynes.
All societies experience short-run economic fluctuations
around long-run trends. These fluctuations are irregular
and largely unpredictable. When recessions do occur,
real GDP and other measures of income, spending, and
production fall, and unemployment rises.
Economists analyze short-run economic fluctuations
using the model of aggregate demand and aggregate
supply. According to this model, the output of goods
and services and the overall level of prices adjust to
balance aggregate demand and aggregate supply.
The aggregate-demand curve slopes downward for
three reasons. First, a lower price level raises the real
value of households’ money holdings, which stimulates
consumer spending. Second, a lower price level reduces
the quantity of money households demand; as
households try to convert money into interest-bearing
assets, interest rates fall, which stimulates investment
spending. Third, as a lower price level reduces interest
rates, the dollar depreciates in the market for foreigncurrency
exchange, which stimulates net exports.
Any event or policy that raises consumption,
investment, government purchases, or net exports at a
given price level increases aggregate demand. Any
event or policy that reduces consumption, investment,
government purchases, or net exports at a given price
level decreases aggregate demand.
The long-run aggregate-supply curve is vertical. In the
long run, the quantity of goods and services supplied
depends on the economy’s labor, capital, natural
resources, and technology, but not on the overall
level of prices.
Summary
730 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
Three theories have been proposed to explain the
upward slope of the short-run aggregate-supply curve.
According to the misperceptions theory, an unexpected
fall in the price level leads suppliers to mistakenly
believe that their relative prices have fallen, which
induces them to reduce production. According to the
sticky-wage theory, an unexpected fall in the price level
temporarily raises real wages, which induces firms to
reduce employment and production. According to the
sticky-price theory, an unexpected fall in the price level
leaves some firms with prices that are temporarily too
high, which reduces their sales and causes them to cut
back production. All three theories imply that output
deviates from its natural rate when the price level
deviates from the price level that people expected.
Events that alter the economy’s ability to produce
output, such as changes in labor, capital, natural
resources, or technology, shift the short-run aggregatesupply
curve (and may shift the long-run aggregatesupply
curve as well). In addition, the position of
the short-run aggregate-supply curve depends on the
expected price level.
One possible cause of economic fluctuations is a shift in
aggregate demand. When the aggregate-demand curve
shifts to the left, for instance, output and prices fall in
the short run. Over time, as a change in the expected
price level causes perceptions, wages, and prices to
adjust, the short-run aggregate-supply curve shifts to
the right, and the economy returns to its natural rate of
output at a new, lower price level.
A second possible cause of economic fluctuations is a
shift in aggregate supply. When the aggregate-supply
curve shifts to the left, the short-run effect is falling
output and rising prices—a combination called
stagflation. Over time, as perceptions, wages, and
prices adjust, the price level falls back to its original
level, and output recovers.
recession, p. 702
depression, p. 702
model of aggregate demand and
aggregate supply, p. 706
aggregate-demand curve, p. 706
aggregate-supply curve, p. 706
stagflation, p. 726
Key Concepts
1. Name two macroeconomic variables that decline when
the economy goes into a recession. Name one
macroeconomic variable that rises during a recession.
2. Draw a diagram with aggregate demand, short-run
aggregate supply, and long-run aggregate supply. Be
careful to label the axes correctly.
3. List and explain the three reasons why the aggregatedemand
curve is downward sloping.
4. Explain why the long-run aggregate-supply curve is
vertical.
5. List and explain the three theories for why the short-run
aggregate-supply curve is upward sloping.
6. What might shift the aggregate-demand curve to the
left? Use the model of aggregate demand and aggregate
supply to trace through the effects of such a shift.
7. What might shift the aggregate-supply curve to the left?
Use the model of aggregate demand and aggregate
supply to trace through the effects of such a shift.
Questions for Review
1. Why do you think that investment is more variable over
the business cycle than consumer spending? Which
category of consumer spending do you think would be
most volatile: durable goods (such as furniture and car
Problems and Applications
CHAPTER 31 AGGREGATE DEMAND AND AGGREGATE SUPPLY 731
purchases), nondurable goods (such as food and
clothing), or services (such as haircuts and medical
care)? Why?
2. Suppose that the economy is undergoing a recession
because of a fall in aggregate demand.
a. Using an aggregate-demand/aggregate-supply
diagram, depict the current state of the economy.
b. What is happening to the unemployment rate?
c. “Capacity utilization” is a measure of how
intensively the capital stock is being used. In a
recession, is capacity utilization above or below its
long-run average? Explain.
3. Explain whether each of the following events will
increase, decrease, or have no effect on long-run
aggregate supply.
a. The United States experiences a wave of
immigration.
b. Congress raises the minimum wage to $10 per hour.
c. Intel invents a new and more powerful
computer chip.
d. A severe hurricane damages factories along the
east coast.
4. In Figure 31-8, how does the unemployment rate at
points B and C compare to the unemployment rate
at point A? Under the sticky-wage explanation of the
short-run aggregate-supply curve, how does the real
wage at points B and C compare to the real wage at
point A?
5. Explain why the following statements are false.
a. “The aggregate-demand curve slopes downward
because it is the horizontal sum of the demand
curves for individual goods.”
b. “The long-run aggregate-supply curve is vertical
because economic forces do not affect long-run
aggregate supply.”
c. “If firms adjusted their prices every day, then the
short-run aggregate-supply curve would be
horizontal.”
d. “Whenever the economy enters a recession, its
long-run aggregate-supply curve shifts to the left.”
6. For each of the three theories for the upward slope of
the short-run aggregate-supply curve, carefully explain
the following:
a. how the economy recovers from a recession and
returns to its long-run equilibrium without any
policy intervention
b. what determines the speed of that recovery
7. Suppose the Fed expands the money supply, but
because the public expects this Fed action, it
simultaneously raises its expectation of the price level.
What will happen to output and the price level in the
short run? Compare this result to the outcome if the Fed
expanded the money supply but the public didn’t
change its expectation of the price level.
8. Suppose that the economy is currently in a recession. If
policymakers take no action, how will the economy
evolve over time? Explain in words and using an
aggregate-demand/aggregate-supply diagram.
9. Suppose workers and firms suddenly believe that
inflation will be quite high over the coming year.
Suppose also that the economy begins in long-run
equilibrium, and the aggregate-demand curve does not
shift.
a. What happens to nominal wages? What happens to
real wages?
b. Using an aggregate-demand/aggregate-supply
diagram, show the effect of the change in
expectations on both the short-run and long-run
levels of prices and output.
c. Were the expectations of high inflation accurate?
Explain.
10. Explain whether each of the following events shifts the
short-run aggregate-supply curve, the aggregatedemand
curve, both, or neither. For each event that does
shift a curve, use a diagram to illustrate the effect on the
economy.
a. Households decide to save a larger share of their
income.
b. Florida orange groves suffer a prolonged period of
below-freezing temperatures.
c. Increased job opportunities overseas cause many
people to leave the country.
11. For each of the following events, explain the short-run
and long-run effects on output and the price level,
assuming policymakers take no action.
a. The stock market declines sharply, reducing
consumers’ wealth.
b. The federal government increases spending on
national defense.
c. A technological improvement raises productivity.
d. A recession overseas causes foreigners to buy fewer
U.S. goods.
12. Suppose that firms become very optimistic about future
business conditions and invest heavily in new capital
equipment.
a. Use an aggregate-demand/aggregate-supply
diagram to show the short-run effect of this
optimism on the economy. Label the new levels of
732 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
prices and real output. Explain in words why the
aggregate quantity of output supplied changes.
b. Now use the diagram from part (a) to show the
new long-run equilibrium of the economy. (For
now, assume there is no change in the long-run
aggregate-supply curve.) Explain in words why the
aggregate quantity of output demanded changes
between the short run and the long run.
c. How might the investment boom affect the longrun
aggregate-supply curve? Explain.
13. In 1939, with the U.S. economy not fully recovered from
the Great Depression, President Roosevelt proclaimed
that Thanksgiving Day would fall a week earlier than
usual so that the shopping period before Christmas
would be lengthened. Explain this decision, using the
model of aggregate demand and aggregate supply.
IN THIS CHAPTER
YOU WILL . . .
Analyze how fiscal
policy af fects
interest rates and
aggregate demand
Learn the theor y of
liquidity pr eference
as a shor t - run theory
of the interest rate
Analyze how
monetary policy
af fects interest
rates and aggregate
demand
Discuss the debate
over whether
policymakers should
tr y to stabilize
the economy
Imagine that you are a member of the Federal Open Market Committee, which sets
monetary policy. You observe that the president and Congress have agreed to cut
government spending. How should the Fed respond to this change in fiscal policy?
Should it expand the money supply, contract the money supply, or leave the
money supply the same?
To answer this question, you need to consider the impact of monetary and fiscal
policy on the economy. In the preceding chapter we saw how to explain shortrun
economic fluctuations using the model of aggregate demand and aggregate
supply. When the aggregate-demand curve or the aggregate-supply curve shifts,
the result is fluctuations in the economy’s overall output of goods and services and
in its overall level of prices. As we noted in the previous chapter, monetary and
T H E I N F L U E N C E O F
M O N E T A R Y A N D F I S C A L P O L I C Y
O N A G G R E G A T E D E M A N D
733
734 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
fiscal policy can each influence aggregate demand. Thus, a change in one of these
policies can lead to short-run fluctuations in output and prices. Policymakers will
want to anticipate this effect and, perhaps, adjust the other policy in response.
In this chapter we examine in more detail how the government’s tools of monetary
and fiscal policy influence the position of the aggregate-demand curve. We
have previously discussed the long-run effects of these policies. In Chapters 24 and
25 we saw how fiscal policy affects saving, investment, and long-run economic
growth. In Chapters 27 and 28 we saw how the Fed controls the money supply and
how the money supply affects the price level in the long run. We now see how
these policy tools can shift the aggregate-demand curve and, in doing so, affect
short-run economic fluctuations.
As we have already learned, many factors influence aggregate demand besides
monetary and fiscal policy. In particular, desired spending by households
and firms determines the overall demand for goods and services. When desired
spending changes, aggregate demand shifts. If policymakers do not respond, such
shifts in aggregate demand cause short-run fluctuations in output and employment.
As a result, monetary and fiscal policymakers sometimes use the policy
levers at their disposal to try to offset these shifts in aggregate demand and
thereby stabilize the economy. Here we discuss the theory behind these policy actions
and some of the difficulties that arise in using this theory in practice.
HOW MONETARY POLICY
INFLUENCES AGGREGATE DEMAND
The aggregate-demand curve shows the total quantity of goods and services demanded
in the economy for any price level. As you may recall from the preceding
chapter, the aggregate-demand curve slopes downward for three reasons:
The wealth effect: A lower price level raises the real value of households’
money holdings, and higher real wealth stimulates consumer spending.
The interest-rate effect: A lower price level lowers the interest rate as people try
to lend out their excess money holdings, and the lower interest rate
stimulates investment spending.
The exchange-rate effect: When a lower price level lowers the interest rate,
investors move some of their funds overseas and cause the domestic
currency to depreciate relative to foreign currencies. This depreciation makes
domestic goods cheaper compared to foreign goods and, therefore,
stimulates spending on net exports.
These three effects should not be viewed as alternative theories. Instead, they occur
simultaneously to increase the quantity of goods and services demanded when
the price level falls and to decrease it when the price level rises.
Although all three effects work together in explaining the downward slope of
the aggregate-demand curve, they are not of equal importance. Because money
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 735
holdings are a small part of household wealth, the wealth effect is the least important
of the three. In addition, because exports and imports represent only a small
fraction of U.S. GDP, the exchange-rate effect is not very large for the U.S. economy.
(This effect is much more important for smaller countries because smaller
countries typically export and import a higher fraction of their GDP.) For the U.S.
economy, the most important reason for the downward slope of the aggregate-demand
curve is the interest-rate effect.
To understand how policy influences aggregate demand, therefore, we examine
the interest-rate effect in more detail. Here we develop a theory of how the interest
rate is determined, called the theory of liquidity preference. After we
develop this theory, we use it to understand the downward slope of the aggregatedemand
curve and how monetary policy shifts this curve. By shedding new light
on the aggregate-demand curve, the theory of liquidity preference expands our
understanding of short-run economic fluctuations.
THE THEORY OF LIQUIDITY PREFERENCE
In his classic book, The General Theory of Employment, Interest, and Money, John
Maynard Keynes proposed the theory of liquidity preference to explain what factors
determine the economy’s interest rate. The theory is, in essence, just an application
of supply and demand. According to Keynes, the interest rate adjusts to
balance the supply and demand for money.
You may recall from Chapter 23 that economists distinguish between two interest
rates: The nominal interest rate is the interest rate as usually reported, and the
real interest rate is the interest rate corrected for the effects of inflation. Which interest
rate are we now trying to explain? The answer is both. In the analysis that
follows, we hold constant the expected rate of inflation. (This assumption is reasonable
for studying the economy in the short run, as we are now doing). Thus,
when the nominal interest rate rises or falls, the real interest rate that people expect
to earn rises or falls as well. For the rest of this chapter, when we refer to
changes in the interest rate, you should envision the real and nominal interest
rates moving in the same direction.
Let’s now develop the theory of liquidity preference by considering the supply
and demand for money and how each depends on the interest rate.
Money Supply The first piece of the theory of liquidity preference is the supply
of money. As we first discussed in Chapter 27, the money supply in the U.S.
economy is controlled by the Federal Reserve. The Fed alters the money supply
primarily by changing the quantity of reserves in the banking system through the
purchase and sale of government bonds in open-market operations. When the Fed
buys government bonds, the dollars it pays for the bonds are typically deposited
in banks, and these dollars are added to bank reserves. When the Fed sells government
bonds, the dollars it receives for the bonds are withdrawn from the banking
system, and bank reserves fall. These changes in bank reserves, in turn, lead to
changes in banks’ ability to make loans and create money. In addition to these
open-market operations, the Fed can alter the money supply by changing reserve
requirements (the amount of reserves banks must hold against deposits) or the
discount rate (the interest rate at which banks can borrow reserves from the Fed).
theor y of liquidity
preference
Keynes’s theory that the interest rate
adjusts to bring money supply and
money demand into balance
736 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
These details of monetary control are important for the implementation of Fed
policy, but they are not crucial in this chapter. Our goal here is to examine how
changes in the money supply affect the aggregate demand for goods and services.
For this purpose, we can ignore the details of how Fed policy is implemented and
simply assume that the Fed controls the money supply directly. In other words, the
quantity of money supplied in the economy is fixed at whatever level the Fed
decides to set it.
Because the quantity of money supplied is fixed by Fed policy, it does not depend
on other economic variables. In particular, it does not depend on the interest
rate. Once the Fed has made its policy decision, the quantity of money supplied is
the same, regardless of the prevailing interest rate. We represent a fixed money
supply with a vertical supply curve, as in Figure 32-1.
Money Demand The second piece of the theory of liquidity preference is the
demand for money. As a starting point for understanding money demand, recall
that any asset’s liquidity refers to the ease with which that asset is converted into
the economy’s medium of exchange. Money is the economy’s medium of exchange,
so it is by definition the most liquid asset available. The liquidity of money
explains the demand for it: People choose to hold money instead of other assets
that offer higher rates of return because money can be used to buy goods and services.
Although many factors determine the quantity of money demanded, the one
emphasized by the theory of liquidity preference is the interest rate. The reason is
that the interest rate is the opportunity cost of holding money. That is, when you
hold wealth as cash in your wallet, instead of as an interest-bearing bond, you lose
the interest you could have earned. An increase in the interest rate raises the cost
of holding money and, as a result, reduces the quantity of money demanded. Adecrease
in the interest rate reduces the cost of holding money and raises the quantity
demanded. Thus, as shown in Figure 32-1, the money-demand curve slopes
downward.
Quantity of
Money
Interest
Rate
Equilibrium
interest
rate
0
Money
demand
Quantity fixed
by the Fed
Money
supply
r1
r2
Md
1 Md
2
Figure 32-1
EQUILIBRIUM IN THE
MONEY MARKET. According to
the theory of liquidity preference,
the interest rate adjusts to bring
the quantity of money supplied
and the quantity of money
demanded into balance. If the
interest rate is above the
equilibrium level (such as at r1),
the quantity of money people
want to hold (Md
1) is less than the
quantity the Fed has created, and
this surplus of money puts
downward pressure on the
interest rate. Conversely, if the
interest rate is below the
equilibrium level (such as at r2),
the quantity of money people
want to hold (Md2
) is greater than
the quantity the Fed has created,
and this shortage of money puts
upward pressure on the interest
rate. Thus, the forces of supply
and demand in the market for
money push the interest rate
toward the equilibrium interest
rate, at which people are content
holding the quantity of
money the Fed has created.
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 737
Equilibrium i n the Money Market According to the theory of
liquidity preference, the interest rate adjusts to balance the supply and demand
for money. There is one interest rate, called the equilibrium interest rate, at which
the quantity of money demanded exactly balances the quantity of money supplied.
If the interest rate is at any other level, people will try to adjust their portfolios
of assets and, as a result, drive the interest rate toward the equilibrium.
For example, suppose that the interest rate is above the equilibrium level,
such as r1 in Figure 32-1. In this case, the quantity of money that people want
to hold, Md
1, is less than the quantity of money that the Fed has supplied. Those
people who are holding the surplus of money will try to get rid of it by buying
interest-bearing bonds or by depositing it in an interest-bearing bank account.
Because bond issuers and banks prefer to pay lower interest rates, they
respond to this surplus of money by lowering the interest rates they offer. As the
interest rate falls, people become more willing to hold money until, at the equilibrium
interest rate, people are happy to hold exactly the amount of money the Fed
has supplied.
Conversely, at interest rates below the equilibrium level, such as r2 in Figure
32-1, the quantity of money that people want to hold, Md
2 , is greater than the
quantity of money that the Fed has supplied. As a result, people try to increase
their holdings of money by reducing their holdings of bonds and other interestbearing
assets. As people cut back on their holdings of bonds, bond issuers find
that they have to offer higher interest rates to attract buyers. Thus, the interest rate
rises and approaches the equilibrium level.
THE DOWNWARD SLOPE OF
THE AGGREGATE-DEMAND CURVE
Having seen how the theory of liquidity preference explains the economy’s equilibrium
interest rate, we now consider its implications for the aggregate demand
for goods and services. As a warm-up exercise, let’s begin by using the theory to
reexamine a topic we already understand—the interest-rate effect and the downward
slope of the aggregate-demand curve. In particular, suppose that the overall
level of prices in the economy rises. What happens to the interest rate that balances
the supply and demand for money, and how does that change affect the quantity
of goods and services demanded?
As we discussed in Chapter 28, the price level is one determinant of the quantity
of money demanded. At higher prices, more money is exchanged every time a
good or service is sold. As a result, people will choose to hold a larger quantity of
money. That is, a higher price level increases the quantity of money demanded
for any given interest rate. Thus, an increase in the price level from P1 to P2 shifts
the money-demand curve to the right from MD1 to MD2, as shown in panel (a) of
Figure 32-2.
Notice how this shift in money demand affects the equilibrium in the money
market. For a fixed money supply, the interest rate must rise to balance money
supply and money demand. The higher price level has increased the amount of
money people want to hold and has shifted the money demand curve to the right.
Yet the quantity of money supplied is unchanged, so the interest rate must rise
from r1 to r2 to discourage the additional demand.
738 PART TWELVE SHORT-RUN ECONOMIC FLUCTUATIONS
This increase in the interest rate has ramifications not only for the money market
but also for the quantity of goods and services demanded, as shown in panel
(b). At a higher interest rate, the cost of borrowing and the return to saving are
greater. Fewer households choose to borrow to buy a new house, and those who
do buy smaller houses, so the demand for residential investment falls. Fewer firms
choose to borrow to build new factories and buy new equipment, so business investment
falls. Thus, when the price level rises from P1 to P2, increasing money demand
from MD1 to MD2 and raising the interest rate from r1 to r2, the quantity of
goods and services demanded falls from Y1 to Y2.
Quantity
of Money
Quantity fixed
by the Fed
0
Interest
Rate
r2
r1
Money demand at
price level P2, MD2
Money demand at
price level P1, MD1
Money
supply
(a) The Money Market
(b) The Aggregate-Demand Curve
3. . . . which
increases the
equilibrium
interest rate . . .
2. . . . increases the
demand for money . . .
Quantity
of Output
0
Price
Level
Aggregate
demand
P2
Y2 Y1
P1
4. . . . which in turn reduces the quantity
of goods and services demanded.
1. An
increase
in the price
level . . .
Figure 32-2
THE MONEY MARKET AND
THE SLOPE OF THE
AGGREGATE-DEMAND CURVE.
An increase in the price level
from P1 to P2 shifts the moneydemand
curve to the right, as in
panel (a). This increase in money
demand causes the interest rate
to rise from r1 to r2. Because
the interest rate is the cost of
borrowing, the increase in the
interest rate reduces the quantity
of goods and services demanded
from Y1 to Y2. This negative
relationship between the price
level and quantity demanded is
represented with a downwardsloping
aggregate-demand curve,
as in panel (b).
CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 739
Hence, this analysis of the interest-rate effect can be summarized in three
steps: (1) A higher price level raises money demand. (2) Higher money demand
leads to a higher interest rate. (3) A higher interest rate reduces the quantity of
goods and services demanded.
Of course, the same logic works in reverse as well: Alower price level reduces
money demand, which leads to a lower interest rate, and this in turn increases the
quantity of goods and services demanded. The end result of this analysis is a negative
relationship between the price level and the quantity of goods and services
demanded, which is illustrated with a downward-sloping aggregate-demand
curve.
At this point, we should pause
and reflect on a seemingly awkward
embarrassment of riches.
It might appear as if we now
have two theories for how interest
rates are determined.
Chapter 25 said that the interest
rate adjusts to balance the
supply and demand for loanable
funds (that is, national
saving and desired investment).
By contrast, we just established
here that the interest
rate adjusts to balance the supply and demand for money.
How can we reconcile these two theories?
To answer this question, we must again consider the
differences between the long-run and short-run behavior of
the economy. Three macroeconomic variables are of central
importance: the economy’s output of goods and services,
the interest rate, and the price level. According to the classical
macroeconomic theory we developed in Chapters 24,
25, and 28, these variables are determined as follows:
1. Output is determined by the supplies of capital and
labor and the available production technology for
turning capital and labor into output. (We call this the
natural rate of output.)
2. For any given level of output, the interest rate adjusts
to balance the supply and demand for loanable funds.
3. The price level adjusts to balance the supply and
demand for money. Changes in the supply of money
lead to proportionate changes in the price level.
These are three of the essential propositions of classical
economic theory. Most economists believe that these
propositions do a good job of describing how the economy
works in the long run.
Yet these propositions do not hold in the short run. As
we discussed in the preceding chapter, many prices are
slow to adjust to changes in the money supply; this is reflected
in a short-run aggregate-supply curve that is upward
sloping rather than vertical. As a result, the overall price
level cannot, by itself, balance the supply and demand for
money in the short run. This stickiness of the price level
forces the interest rate to move in order to bring the money
market into equilibrium. These changes in the interest rate,
in turn, affect the aggregate demand for goods and services.
As aggregate demand fluctuates, the economy’s output
of goods and services moves away from the level
determined by factor supplies and technology.
For issues concerning the short run, then, it is best to
think about the economy as follows:<