NINTH EDITION

MACROECONOMICS
Theories and Policies

Richard T. Froyen
University of North Carolina Chapel Hill

PEARSON

Prentice
Hall
Upper Saddle River, New Jersey 07458

Contents
Preface
PART ONE

xix
INTRODUCTION AND MEASUREMENT

CHAPTER 1 Introduction
2
N
1.1 What Is Macroeconomics?
2
1.2 Post-World War II U.S. Economic Performance

1.3

Output
3
Unemployment
4
Inflation
5
Inflation and Unemployment
6
The U.S. Federal Budget and Trade Deficits
8
Central Questions in Macroeconomics
10
Instability of Output
10
Movements in the Inflation Rate
10
The Output-Inflation Relationship
10
Growth Slowdown and Turnaround? 11
Implications of Deficits and Surpluses
11

1.4

Conclusion

12

CHAPTER 2 Measurement of Macroeconomic Variables

2.1 The National Income Accounts
13
2.2 Gross Domestic Product
14
Currently Produced 14
Final Goods and Services 14
Evaluated at Market Prices 15
2.3 National Income
17
2.4 Personal and Disposable Personal Income
20
2.5 Some National Income Accounting Identities
21
2.6 Measuring Price Changes: Real versus Nominal GDP
Real GDP in Prices from a Base Year
Chain-Weighted Real GDP
25

24

13

23

CONTENTS

2.7

The Consumer Price Index and the Producer Price Index

2.8

Measures of Cyclical Variation in Output

2.9

Conclusion
29
Perspectives 2.1 What GDP Is Not
18
Perspectives 2.2 National Income Accounts for England and
Wales in 1688 22
Perspectives 2.3 Dating Business Cycles 29

PART T W O

27

CLASSICAL ECONOMICS A N D THE KEYNESIAN

REVOLUTION
31

CHAPTER 3
. 3.1

Classical Macroeconomics (I): Output

and Employment
32

The Starting Point

32

3.2

The Classical Revolution

3.3

Production

3.4

Employment
37
Labor Demand
37
Labor Supply
39

3.5

Equilibrium Output and Employment

42
The Determinants of Output and Employment
44
Factors That Do Not Affect Output
48

3.6

Conclusion
48
Perspectives 3-1 Real Business Cycles: A First Look

CHAPTER 4
4.1

26

33

34

48

Classical Macroeconomics (II): Money,

Prices, and Interest
51

The Quantity Theory of Money

51
The Equation of Exchange
51
The Cambridge Approach to the Quantity Theory
The Classical Aggregate Demand Curve 54

53

4.2

The Classical Theory of the Interest Rate

56

4.3

Policy Implications of the Classical

Equilibrium Model
60
Fiscal Policy 60
Monetary Policy 66

4.4

Conclusion
66
Perspectives 4-1 Money in Hyperinflations 57
Perspectives 4-2 Supply-Side EconomicsA Modern
Classical View 65

CONTENTS

CHAPTER 5 The Keynesian System (I): The Role of

Aggregate Demand
68
5.1
5.2

The Problem of Unemployment

68
The Simple Keynesian Model: Conditions for
Equilibrium Output
71
5.3 The Components of Aggregate Demand
76
Consumption 76
Investment 78
Government Spending and Taxes 80
5.4 Determining Equilibrium Income
80
5.5 Changes in Equilibrium Income
83
5.6 Fiscal Stabilization Policy
88
5.7 Exports and Imports in the Simple Keynesian Model
^5.8 Conclusion
93
Perspectives 5-1 Macroeconomic Controversies
Perspectives 5-2 Fiscal Policy in Practice 90

90

72

CHAPTER 6
6.1

6.2

6.3

The Keynesian System (II): Money, Interest,

and Income
97
Money in the Keynesian System
97

Interest Rates and Aggregate Demand

97
The Keynesian Theory of the Interest Rate
99
The Keynesian Theory of Money Demand
103
The Effects of an Increase in the Money Supply
107
Some Implications of Interest on Money
107
Going Forward 109
The IS-LM Model
109
Money Market Equilibrium: The LM Schedule
110
Product Market Equilibrium: The IS Schedule
119
The IS and LM Schedules Combined
129
Conclusion
131
Appendix: The A Igebra of the IS-LM Model
132
Perspectives 6-1 Residential Construction and the Interest Rate 100

CHAPTER 7
7.1

The Keynesian System (III): Policy Effects

in the IS-LM Model
136
Factors That Affect Equilibrium Income and the
Interest Rate
136

Monetary Influences: Shifts in the LM Schedule

Real Influences: Shifts in the IS Schedule
137

136

xi

xii

CONTENTS
7.2

7.3

The Relative Effectiveness of Monetary and Fiscal Policy

Policy Effectiveness and the Slope of the IS Schedule
144
Monetary Policy Effectiveness and the Slope of the IS Schedule
Policy Effectiveness and the Slope of the LM Schedule
148
Conclusion
152
Appendix: Monetary and Fiscal Policy Multipliers in the
IS-LM Model
157
Perspectives 7-1 The Monetary-Fiscal Policy Mix: Some
Historical Examples 142
Perspectives 7-2 Japan in a Slump and the Liquidity Trap

143
144

153

CHAPTER 8 The Keynesian System (IV): Aggregate Supply

and Demand
160
8.1

The Keynesian Aggregate Demand Schedule

8.2

The Keynesian Aggregate Demand Schedule Combined with the Classical

Theory of Aggregate Supply
166

8.3

A Contractual View of the Labor Market

167
Sources of Wage Rigidity 167
A Flexible Price-Fixed Money Wage Model
169
Labor Supply and Variability in the Money Wage
174
Classical and Keynesian Theories of Labor Supply
174
The Keynesian Aggregate Supply Schedule with a Variable
Money Wage 176
Policy Effects in the Variable-Wage Keynesian Model 176
The Effects of Shifts in the Aggregate Supply Schedule
180
Factors That Shift the Aggregate Supply Schedule 181
More Recent Supply Shocks
184

8.4

8.5

8.6

160

Conclusion: Keynes versus the Classics

188
Keynesian versus Classical Theories ofAggregate Demand
188
Keynesian versus Classical Theories ofAggregate Supply
188
Keynesian versus Classical Policy Conclusions 189
Perspectives 8-1 Price and Quantity Adjustment in
Great Britain, 1929-36 169

PART THREE MACROECONOMIC THEORY AFTER KEYNES

191
]

CHAPTER 9 The Monetarist Counterrevolution

9.1 Monetarist Propositions
192
9.2

192

The Reformulation of the Quantity Theory of Money

Money and the Early Keynesians 194
Friedman's Restatement of the Quantity Theory 196
Friedman's Monetarist Position 200

193

CONTENTS
9.3

9.4

. 9.5

Fiscal and Monetary Policy

203
Fiscal Policy
203
Monetary Policy
205
Unstable Velocity and the Declining Policy Influence
of Monetarism
206
Recent Instability in the Money-Income Relationship
207
Monetarist Reaction
207
Conclusion
208
Perspectives 9.1 The Monetarist View of the Great Depression

197

CHAPTER 10 Output, Inflation, and Unemployment:

Alternative Views
210
10.1 The Natural Rate Theory

210

10.2 Monetary Policy, Output, and Inflation: Friedman's

Monetarist View
213
Monetary Policy in the Short Run
213
Monetary Policy in the Long Run
213
10.3 A Keynesian View of the Output-Inflation Trade-Off
217
The Phillips Curve: A Keynesian Interpretation 218
Stabilization Policies for Output and Employment:
The Keynesian View 221
10.4 Evolution of the Natural Rate Concept
222
Determinants of the Natural Rate of Unemployment 222
Time-Varying Natural Rates of Unemployment 223
Explaining Changing Natural Rates of Unemployment
224
Recent Trends 225
10.5 Conclusion

225

CHAPTER 11 New Classical Economics

11.1 The New Classical Position
227

227

A Review of the Keynesian Position

228
The Rational Expectations Concept and Its Implications
New Classical Policy Conclusions 233
11.2 A Broader View of the New Classical Position

228

238

11.3 The Keynesian Countercritique

239
The Question of Persistence 239
The Extreme Informational Assumptions of Rational Expectations 240
Auction Market Versus Contractual Views of the Labor Market
242
11.4 Conclusion
244
Perspectives 11.1 U.S. Stock Prices: Rational Expectations or Irrational
Exuberance? 236
Perspectives 11.2 The Great Depression: New Classical Views
243

xiii

xiv

CONTENTS

CHAPTER 12 Real Business Cycles and New

Keynesian Economics
246
12.1 Real Business Cycle Models
246
Central Features of Real Business Cycle Models
246
A Simple Real Business Cycle Model
248
Effects of a Positive Technology Shock
249
Macroeconomic Policy in a Real Business Cycle Model
Questions About Real Business Cycle Models
253
Concluding Comment
254

250

12.2 New Keynesian Economics

254
Sticky Price (Menu Cost) Models
256
Efficiency Wage Models
258
Insider-Outsider Models and Hysteresis 260
12.3 Conclusion
262
Perspectives 12-1 Robert Lucas and Real Business
Cycle Theory
252
Perspectives 12-2 Labor Market Flows
255
Perspectives 12-3 Are Prices Sticky?
258

CHAPTER 13 Macroeconomic Models: A Summary

13.1 Theoretical Issues
264
13.2 Policy Issues
268
13.3 Consensus as Well as Controversy

PART FOUR

264

269

OPEN ECONOMY MACROECONOMICS

2 71

CHAPTER 14 Exchange Rates and the International

Monetary System
272
14.1 The U.S. Balance of Payments Accounts

272

The Current Account

273
The Capital Account
274
Statistical Discrepancy 274
Official Reserve Transactions 275
14.2 Exchange Rates and the Market for Foreign Exchange
275
Demand and Supply in the Foreign Exchange Market
277
Exchange Rate Determination: Flexible Exchange Rates
279
Exchange Rate Determination: Fixed Exchange Rates
281
14.3 The Current Exchange Rate System
284
Exchange Rate Arrangements
284
How Much Managing? How Much Floating? 285
The Breakdown of the Bretton Woods System
286

CONTENTS

14.4 Advantages of Alternative Exchange Rate Regimes

Advantages of Exchange Rate Flexibility 287
Arguments for Fixed Exchange Rates 292
14.5 Experience with Floating Exchange Rates
293
The Dollar in Decline, 1976-80 296
The Rising Dollar, 1981-85 297
The Dollar's Slide, 1985-88 298
The Dollar: 1990 to the Present 299
14.6 Global Trade Imbalances
300
Implication of Some Identities 301
Causes and Effects of Global Trade Imbalances 302
14.7 Conclusion
303
Perspectives 14-1 U.S. Current Account DeficitsAre
They Sustainable? 276
Perspectives 14-2 Currency Boards and Dollarization
Perspectives 14-3 The Euro
299

287

285

CHAPTER 15 Monetary and Fiscal Policy in the

Open Economy
305
15.1 The Mundell-Fleming Model

305

15.2 Imperfect Capital Mobility

308
Policy Under Fixed Exchange Rates 308
Policy Under Flexible Exchange Rates 311
15.3 Perfect Capital Mobility
314
Policy Effects Under Fixed Exchange Rates 315
Policy Effects Under Flexible Exchange Rates 317
15.4 Conclusion
321
Perspectives 15-1 The Saving-Investment Correlation Puzzle

PART FIVE

ECONOMIC POLICY

323

CHAPTER 16 Money, the Banking System, and

Interest Rates
324
16.1 The Definition of Money
324
The Functions of Money 324
Components of the Money Supply
325
16.2 Interest Rates and Financial Assets

326

16.3 The Federal Reserve System

327
The Structure of the Central Bank
327
Federal Reserve Control of the Money Supply
The Tools of Federal Reserve Control 329

328

319

xv

xvi

CONTENTS

16.4 Bank Reserves and Bank Deposits

331

A Model of Deposit Creation 332

Deposit Creation: More General Cases 336
Open-Market Operations and the Federal
Funds Rate
338
16.5 Who Controls the Money Supply?
339
16.6 Conclusion
344
Perspectives 16-1 The Money Supply During the
Great Depression 342

CHAPTER 17 Optimal Monetary Policy

346

17.1 The Monetary Policymaking Process

346
17.2 Competing Strategies for Monetary Policy: Targeting Monetary Aggregates or
Interest Rates
347
Targeting Monetary Aggregates 349
Targeting Interest Rate
350
17.3 Money versus Interest Rate Targets in the Presence
of Shocks
350
Implications of Targeting a Monetary Aggregate 351
Implications of Targeting the Interest Rate
354

11A The Relative Merits of the Two Strategies

357

The Sources of Uncertainty and the Choice of a Monetary

Policy Strategy 358
Other Considerations 358
17.5 The Evolution of Federal Reserve Strategy
359
1970-79: Targeting the Federal Funds Rate
359
1979-82: Targeting Monetary Aggregates 359
1982-2007: A Gradual Return to Federal Funds
Rate Targeting 360
1994-2007: A Move toward Greater Transparency 360
17.6 Changes in Central Bank Institutions: Recent International
Experience
362
The Time Inconsistency Problem
362
Other Arguments for Inflation Targeting 364
17.7 Conclusion
366
Perspectives 17-1 Central Bank Independence and
Economic Performance 348
Perspectives 17-2 The Taylor Rule
361
Perspectives 17-3 Inflation Targeting in Practice: The New Zealand
Experiment
363
Perspectives 17-4 Inflation Targeting for the United States:
Three Influential Views 365

<

CONTENTS
CHAPTER 18 Fiscal Policy

xvii

368

18.1 The Goals of Macroeconomic Policy

368

18.2 The Goals of Macroeconomic Policymakers

369
The Public-Choice View 369
The Partisan Theory 372
Public-Choice and Partisan Theories from the Perspective
of2007
372
18.3 The Federal Budget

374

18.4 The Economy and the Federal Budget: The Concept of Automatic Fiscal
Stabilizers
379
18.5 Fiscal Policy Controversies: From the Reagan Years to
the Present
384
The Pros and Cons of Fiscal Policy Rules
384
What About the Deficit? 385
The Federal Budget in the Late 1990s and into the
Twenty-First Century 387
18.6 Conclusion
388
Perspectives 18-1 Rational Expectations and the
Partisan Theory 373
Perspectives 18-2 State and Local Government Finances

PART SIX

ECONOMIC GROWTH

391

CHAPTER 19 Policies for Intermediate-Run Growth

19.1 U.S. Economic Growth, 1960-2006

377

392

393

19.2 The Supply-Side Position

394
Intermediate-Run Output Growth Is Supply-Determined 395
Saving and Investment Depend on After- Tax Rates of Return 396
Labor Supply Is Responsive to Changes in the After-Tax Real Wage 399
Government Regulation Contributed to the Slowdown in the U.S. Economic Growth Rate
400
19.3 The Keynesian Critique of Supply-Side Economics
402
The Supply-Determined Nature of Intermediate-Run Growth 402
Saving and Investment and After- Tax Rates of Return
402
>
The Effect of Income Tax Cuts on Labor Supply
403
Regulation As a Source of Inflation and Slow Growth 403
19 A Growth Policies From Ronald Reagan To George W. Bush
404
Economic Redirection in the Reagan Years 404
Initiatives in the First Bush Administration 405
Growth Policies During the Clinton Administrations 406
Tax Cuts During the Administration of George W. Bush
406

xviii

CONTENTS
19.5 Conclusion
409
Perspectives 19-1 Growth and Productivity Slowdowns in Other
Industrialized Economies 394
Perspectives 19-2 The Laffer Curve 401
Perspectives 19-3 Equality and Efficiency: The Big Trade-off 407
CHAPTER 20 Long-Run Economic Growth: Origins of the Wealth
of Nations
410
20.1 The Neoclassical Growth Model
410
Growth and the Aggregate Production Function 410
Sources of Growth in the Neoclassical Model 414
20.2 Recent Developments in the Theory of Economic Growth
416
Endogenous Growth Models 417
Implications of Endogenous Technological Change 419
Policy Implications of Endogenous Growth 420
20.3 Intercountry Income Differences Revisited
420
Perspectives 20-1 Growth Accounting for the United States:
An Example 417
Perspectives 20-2 Muck, Money, and the Moral Consequences of
Economic Growth 423
20.4 Conclusion

Glossary
Index

425
430

424