economy in the short run.
4. Microeconomics is the study of how firms and individuals make decisions and how these decisionmakers interact. Because macroeconomic events arise from many microeconomic interactions, all macroeconomic models must be consistent with microeconomic foundations, even if those foundations are only implicit. Chapter 2
1. Gross domestic product (GDP) measures the income of everyone in the economy and, equivalently, the total expenditure on the economy’s output of goods and services.
2. Nominal GDP values goods and services at current prices. Real GDP values goods and services at constant prices. Real GDP rises only when the amount of goods and services has increased, whereas nominal GDP can rise either because output has increased or because prices have increased.
3. GDP is the sum of four categories of expenditure: consumption, investment, government purchases, and net exports.
4. The consumer price index (CPI) measures the price of a fixed basket of goods and services purchased by a typical consumer. Like the GDP deflator, which is the ratio of nominal GDP to real GDP, the CPI measures the overall level of prices.
5. The labor-force participation rate shows the fraction of adults who are working or want to work. The unemployment rate shows what fraction of those who would like to work do not have a job. Chapter 3
1. The factors of production and the production technology determine the economy’s output of goods and services. An increase in one of the factors of production or a technological advance raises output.
2. Competitive, profit-maximizing firms hire labor until the marginal product of labor equals the real wage. Similarly, these firms rent capital until the marginal product of capital equals the real rental price. Therefore, each factor of production is paid its marginal product. If the production function has constant returns to scale, then according to Euler’s theorem, all output is used to compensate the inputs.
3. The economy’s output is used for consumption, investment, and government purchases. Consumption depends positively on disposable income. Investment depends negatively on the real interest rate. Government purchases and taxes are the exogenous variables of fiscal policy.
4. The real interest rate adjusts to equilibrate the supply and demand for the economy’s output—or, equivalently, the supply of loanable funds (saving) and the demand for loanable funds (investment). A decrease in national saving, perhaps because of an increase in
government purchases or a decrease in taxes, reduces the equilibrium amount of investment and raises the interest rate. An increase in investment demand, perhaps because of a
technological innovation or a tax incentive for investment, also raises the interest rate. An increase in investment demand increases the quantity of investment only if higher interest rates stimulate additional saving. Chapter 4
1. Money is the stock of assets used for transactions. It serves as a store of value, a unit of account, and a medium of exchange. Different sorts of assets are used as money: commodity
money systems use an asset with intrinsic value, whereas fiat money systems use an asset whose sole function is to serve as money. In modern economies, a central bank such as the Federal Reserve is responsible for controlling the supply of money.
2. The quantity theory of money assumes that the velocity of money is stable and concludes that nominal GDP is proportional to the stock of money. Because the factors of production and the production function determine real GDP, the quantity theory implies that the price level is proportional to the quantity of money. Therefore, the rate of growth in the quantity of money determines the inflation rate.
3. Seigniorage is the revenue that the government raises by printing money. It is a tax on money holding. Although seigniorage is quantitatively small in most economies, it is often a major source of government revenue in economies experiencing hyperinflation.
4. The nominal interest rate is the sum of the real interest rate and the inflation rate. The Fisher effect says that the nominal interest rate moves one-for-one with expected inflation. 5. The nominal interest rate is the opportunity cost of holding money. Thus, one might expect the demand for money to depend on the nominal interest rate. If it does, then the price level depends on both the current quantity of money and the quantities of money expected in the future.
6. The costs of expected inflation include shoeleather costs, menu costs, the cost of relative price variability, tax distortions, and the inconvenience of making inflation corrections. In addition, unexpected inflation causes arbitrary redistributions of wealth between debtors and creditors. One possible benefit of inflation is that it improves the functioning of labor markets by allowing real wages to reach equilibrium levels without cuts in nominal wages.
7. During hyperinflations, most of the costs of inflation become severe. Hyperinflations
typically begin when governments finance large budget deficits by printing money. They end when fiscal reforms eliminate the need for seigniorage.
8. According to classical economic theory, money is neutral: the money supply does not affect real variables. Therefore, classical theory allows us to study how real variables are determined without any reference to the money supply. The equilibrium in the money market then determines the price level and, as a result, all other nominal variables. This theoretical separation of real and nominal variables is called the classical dichotomy. Chapter 6
1. The natural rate of unemployment is the steady-state rate of unemployment. It depends on the rate of job separation and the rate of job finding.
2. Because it takes time for workers to search for the job that best suits their individual skills and tastes, some frictional unemployment is inevitable. Various government policies, such as unemployment insurance, alter the amount of frictional unemployment.
3. Structural unemployment results when the real wage remains above the level that
equilibrates labor supply and labor demand. Minimum-wage legislation is one cause of wage rigidity. Unions and the threat of unionization are another. Finally, efficiency-wage theories suggest that, for various reasons, firms may find it profitable to keep wages high despite an excess supply of labor.
4. Whether we conclude that most unemployment is short-term or long-term depends on how we look at the data. Most spells of unemployment are short. Yet most weeks of unemployment are attributable to the small number of long-term unemployed.
5. The unemployment rates among demographic groups differ substantially. In particular, the unemployment rates for younger workers are much higher than for older workers. This results from a difference in the rate of job separation rather than from a difference in the rate of job finding.
6. The natural rate of unemployment in the United States has exhibited longterm trends. In particular, it rose from the 1950s to the 1970s and then started drifting downward again in the 1990s and early 2000s. Various explanations of the trends have been proposed, including the changing demographic composition of the labor force, changes in the prevalence of sectoral shifts, and changes in the rate of productivity growth.
7. Individuals who have recently entered the labor force, including both new entrants and reentrants, make up about one-third of the unemployed. Transitions into and out of the labor force make unemployment statistics more difficult to interpret.
8. American and European labor markets exhibit some significant differences. In recent years, Europe has experienced significantly more unemployment than the United States. In addition, because of higher unemployment, shorter workweeks, more holidays, and earlier retirement, Europeans work fewer hours than Americans. Chapter 7
1. The Solow growth model shows that in the long run, an economy’s rate of saving
determines the size of its capital stock and thus its level of production. The higher the rate of saving, the higher the stock of capital and the higher the level of output.
2. In the Solow model, an increase in the rate of saving has a level effect on income per
person: it causes a period of rapid growth, but eventually that growth slows as the new steady state is reached. Thus, although a high saving rate yields a high steady-state level of output, saving by itself cannot generate persistent economic growth.
3. The level of capital that maximizes steady-state consumption is called the Golden Rule level. If an economy has more capital than in the Golden Rule steady state, then reducing saving will increase consumption at all points in time. By contrast, if the economy has less capital than in the Golden Rule steady state, then reaching the Golden Rule requires increased investment and thus lower consumption for current generations.
4. The Solow model shows that an economy’s rate of population growth is another long-run determinant of the standard of living. According to the Solow model, the higher the rate of population growth, the lower the steady-state levels of capital per worker and output per worker. Other theories highlight other effects of population growth. Malthus suggested that population growth will strain the natural resources necessary to produce food; Kremer suggested that a large population may promote technological progress. Chapter 8
1. In the steady state of the Solow growth model, the growth rate of income per person is determined solely by the exogenous rate of technological progress.
2. Many empirical studies have examined to what extent the Solow model can help explain long-run economic growth. The model can explain much of what we see in the data, such as balanced growth and conditional convergence. Recent studies have also found that international variation in standards of living is attributable to a combination of capital accumulation and the efficiency with which capital is used.
3. In the Solow model with population growth and technological progress, the Golden Rule
(consumption-maximizing) steady state is characterized by equality between the net marginal product of capital (MPK ? d) and the steady-state growth rate of total income (n + g). In the U.S. economy, the net marginal product of capital is well in excess of the growth rate, indicating that the U.S. economy has a lower saving rate and less capital than it would have in the Golden Rule steady state.
4. Policymakers in the United States and other countries often claim that their nations should devote a larger percentage of their output to saving and investment. Increased public saving and tax incentives for private saving are two ways to encourage capital accumulation.
Policymakers can also promote economic growth by setting up the right legal and financial institutions so that resources are allocated efficiently and by ensuring proper incentives to encourage research and technological progress.
5. In the early 1970s, the rate of growth of income per person fell substantially in most
industrialized countries, including the United States. The cause of this slowdown is not well understood. In the mid-1990s, the U.S. growth rate increased, most likely because of advances in information technology.
6. Modern theories of endogenous growth attempt to explain the rate of technological progress, which the Solow model takes as exogenous. These models try to explain the decisions that determine the creation of knowledge through research and development. Chapter 9
1. Economies experience short-run fluctuations in economic activity, measured most broadly by real GDP. These fluctuations are associated with movement in many macroeconomic variables. In particular, when GDP growth declines, consumption growth falls (typically by a smaller amount), investment growth falls (typically by a larger amount), and unemployment rises. Although economists look at various leading indicators to forecast movements in the economy, these short-run fluctuations are largely unpredictable.
2. The crucial difference between how the economy works in the long run and how it works in the short run is that prices are flexible in the long run but sticky in the short run. The model of aggregate supply and aggregate demand provides a framework to analyze economic
fluctuations and see how the impact of policies and events varies over different time horizons. 3. The aggregate demand curve slopes downward. It tells us that the lower the price level, the greater the aggregate quantity of goods and services demanded.
4. In the long run, the aggregate supply curve is vertical because output is determined by the amounts of capital and labor and by the available technology but not by the level of prices. Therefore, shifts in aggregate demand affect the price level but not output or employment. 5. In the short run, the aggregate supply curve is horizontal, because wages and prices are sticky at predetermined levels. Therefore, shifts in aggregate demand affect output and employment.
6. Shocks to aggregate demand and aggregate supply cause economic fluctuations. Because the Fed can shift the aggregate demand curve, it can attempt to offset these shocks to maintain output and employment at their natural levels. Chapter 10
1. The Keynesian cross is a basic model of income determination. It takes fiscal policy and planned investment as exogenous and then shows that there is one level of national income at which actual expenditure equals planned expenditure. It shows that changes in fiscal policy
have a multiplied impact on income.
2. Once we allow planned investment to depend on the interest rate, the Keynesian cross yields a relationship between the interest rate and national income. A higher interest rate
lowers planned investment, and this in turn lowers national income. The downward-sloping IS curve summarizes this negative relationship between the interest rate and income.
3. The theory of liquidity preference is a basic model of the determination of the interest rate. It takes the money supply and the price level as exogenous and assumes that the interest rate adjusts to equilibrate the supply and demand for real money balances. The theory implies that increases in the money supply lower the interest rate.
4. Once we allow the demand for real money balances to depend on national income, the theory of liquidity preference yields a relationship between income and the interest rate. A higher level of income raises the demand for real money balances, and this in turn raises the interest rate. The upward-sloping LM curve summarizes this positive relationship between income and the interest rate.
5. The IS–LM model combines the elements of the Keynesian cross and the elements of the theory of liquidity preference. The IS curve shows the points that satisfy equilibrium in the goods market, and the LM curve shows the points that satisfy equilibrium in the money market. The intersection of the IS and LM curves shows the interest rate and income that satisfy equilibrium in both markets for a given price level. Chapter 11
1. The IS–LM model is a general theory of the aggregate demand for goods and services. The exogenous variables in the model are fiscal policy, monetary policy, and the price level. The model explains two endogenous variables: the interest rate and the level of national income. 2. The IS curve represents the negative relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services. The LM curve represents the positive relationship between the interest rate and the level of income that arises from equilibrium in the market for real money balances. Equilibrium in the IS–LM model—the intersection of the IS and LM curves—represents simultaneous equilibrium in the market for goods and services and in the market for real money balances.
3. The aggregate demand curve summarizes the results from the IS–LM model by showing equilibrium income at any given price level. The aggregate demand curve slopes downward because a lower price level increases real money balances, lowers the interest rate, stimulates investment spending, and thereby raises equilibrium income.
4. Expansionary fiscal policy—an increase in government purchases or a decrease in
taxes—shifts the IS curve to the right. This shift in the IS curve increases the interest rate and income. The increase in income represents a rightward shift in the aggregate demand curve. Similarly, contractionary fiscal policy shifts the IS curve to the left, lowers the interest rate and income, and shifts the aggregate demand curve to the left.
5. Expansionary monetary policy shifts the LM curve downward. This shift in the LM curve lowers the interest rate and raises income. The increase in income represents a rightward shift of the aggregate demand curve. Similarly, contractionary monetary policy shifts the LM curve upward, raises the interest rate, lowers income, and shifts the aggregate demand curve to the left. Chapter 13