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Principles of Macroeconomics for ® AP Courses 2e SENIOR CONTRIBUTING AUTHORS STEVEN A. GREENLAW, UNIVERSITY OF MARY WASHINGTON DAVID SHAPIRO, PENNSYLVANIA STATE UNIVERSITY Based on the 2nd edition of Principles of Economics, Economics and the Economy, 2e by Timothy Taylor, published in 2011. OpenStax Rice University 6100 Main Street MS-375 Houston, Texas 77005 To learn more about OpenStax, visit https://openstax.org. Individual print copies and bulk orders can be purchased through our website. ©2017 Rice University. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution 4.0 International License (CC BY 4.0). 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For questions regarding this licensing, please contact [email protected]. Trademarks The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, OpenStax CNX logo, OpenStax Tutor name, Openstax Tutor logo, Connexions name, Connexions logo, Rice University name, and Rice University logo are not subject to the license and may not be reproduced without the prior and express written consent of Rice University. Portions of the Demand and Supply chapter were derived from "Why It Matters: Government in Action by Steve Greenlaw and Lumen Learning." Located at: https://courses.lumenlearning.com/waymakermacroxmasterfall2016/chapter/why-it-matters-government- action/. License: CC BY 4.0. 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OpenStax.org Table of Contents Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Chapter1: Welcome to Economics! . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 1.1 What Is Economics, and Why Is It Important? . . . . . . . . . . . . . . . . . . . . . . . . . . 10 1.2 Microeconomics and Macroeconomics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 1.3 How Economists Use Theories and Models to Understand Economic Issues . . . . . . . . . . 15 1.4 How To Organize Economies: An Overview of Economic Systems . . . . . . . . . . . . . . . 18 Chapter2: Choice in a World of Scarcity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 2.1 How Individuals Make Choices Based on Their Budget Constraint . . . . . . . . . . . . . . . 28 2.2 The Production Possibilities Frontier and Social Choices . . . . . . . . . . . . . . . . . . . . 33 2.3 Confronting Objections to the Economic Approach . . . . . . . . . . . . . . . . . . . . . . . 38 Chapter3: Demand and Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services . . . . . . . . . . . . . 46 3.2 Shifts in Demand and Supply for Goods and Services . . . . . . . . . . . . . . . . . . . . . 52 3.3 Changes in Equilibrium Price and Quantity: The Four-Step Process . . . . . . . . . . . . . . 61 3.4 Price Ceilings and Price Floors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67 3.5 Demand, Supply, and Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Chapter4: Labor and Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 4.1 Demand and Supply at Work in Labor Markets . . . . . . . . . . . . . . . . . . . . . . . . . 84 4.2 Demand and Supply in Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92 4.3 The Market System as an Efficient Mechanism for Information . . . . . . . . . . . . . . . . . 98 Chapter5: The Macroeconomic Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 5.1 Measuring the Size of the Economy: Gross Domestic Product . . . . . . . . . . . . . . . . 109 5.2 Adjusting Nominal Values to Real Values . . . . . . . . . . . . . . . . . . . . . . . . . . . 118 5.3 Tracking Real GDP over Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 5.4 Comparing GDP among Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 5.5 How Well GDP Measures the Well-Being of Society . . . . . . . . . . . . . . . . . . . . . . 129 Chapter6: Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 6.1 The Relatively Recent Arrival of Economic Growth . . . . . . . . . . . . . . . . . . . . . . 138 6.2 Labor Productivity and Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . 141 6.3 Components of Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 6.4 Economic Convergence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152 Chapter7: Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163 7.1 How Economists Define and Compute Unemployment Rate . . . . . . . . . . . . . . . . . 164 7.2 Patterns of Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169 7.3 What Causes Changes in Unemployment over the Short Run . . . . . . . . . . . . . . . . 174 7.4 What Causes Changes in Unemployment over the Long Run . . . . . . . . . . . . . . . . . 178 Chapter8: Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191 8.1 Tracking Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192 8.2 How to Measure Changes in the Cost of Living . . . . . . . . . . . . . . . . . . . . . . . . 196 8.3 How the U.S. and Other Countries Experience Inflation . . . . . . . . . . . . . . . . . . . . 201 8.4 The Confusion Over Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206 8.5 Indexing and Its Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211 Chapter9: The International Trade and Capital Flows . . . . . . . . . . . . . . . . . . . . . . . . 219 9.1 Measuring Trade Balances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220 9.2 Trade Balances in Historical and International Context . . . . . . . . . . . . . . . . . . . . 224 9.3 Trade Balances and Flows of Financial Capital . . . . . . . . . . . . . . . . . . . . . . . . 226 9.4 The National Saving and Investment Identity . . . . . . . . . . . . . . . . . . . . . . . . . 229 9.5 The Pros and Cons of Trade Deficits and Surpluses . . . . . . . . . . . . . . . . . . . . . 233 9.6 The Difference between Level of Trade and the Trade Balance . . . . . . . . . . . . . . . . 235 Chapter10: The Aggregate Demand/Aggregate Supply Model . . . . . . . . . . . . . . . . . . . 243 10.1 Macroeconomic Perspectives on Demand and Supply . . . . . . . . . . . . . . . . . . . . 245 10.2 Building a Model of Aggregate Demand and Aggregate Supply . . . . . . . . . . . . . . . 246 10.3 Shifts in Aggregate Supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252 10.4 Shifts in Aggregate Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254 10.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation . . . . . . . . . 258 10.6 Keynes’ Law and Say’s Law in the AD/AS Model . . . . . . . . . . . . . . . . . . . . . . 261 Chapter11: The Keynesian Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271 11.1 Aggregate Demand in Keynesian Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 272 11.2 The Building Blocks of Keynesian Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 276 11.3 The Expenditure-Output (or Keynesian Cross) Model . . . . . . . . . . . . . . . . . . . . 279 11.4 The Phillips Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297 11.5 The Keynesian Perspective on Market Forces . . . . . . . . . . . . . . . . . . . . . . . . 301 Chapter12: The Neoclassical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309 12.1 The Building Blocks of Neoclassical Analysis . . . . . . . . . . . . . . . . . . . . . . . . 311 12.2 The Policy Implications of the Neoclassical Perspective . . . . . . . . . . . . . . . . . . . 316 12.3 Balancing Keynesian and Neoclassical Models . . . . . . . . . . . . . . . . . . . . . . . 323 Chapter13: Money and Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329 13.1 Defining Money by Its Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 13.2 Measuring Money: Currency, M1, and M2 . . . . . . . . . . . . . . . . . . . . . . . . . . 332 13.3 The Role of Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335 13.4 How Banks Create Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340 Chapter14: Monetary Policy and Bank Regulation . . . . . . . . . . . . . . . . . . . . . . . . . 349 14.1 The Federal Reserve Banking System and Central Banks . . . . . . . . . . . . . . . . . . 350 14.2 Bank Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 14.3 How a Central Bank Executes Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . 356 14.4 Monetary Policy and Economic Outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . 359 14.5 Pitfalls for Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 364 Chapter15: Exchange Rates and International Capital Flows . . . . . . . . . . . . . . . . . . . . 375 15.1 How the Foreign Exchange Market Works . . . . . . . . . . . . . . . . . . . . . . . . . . 376 15.2 Demand and Supply Shifts in Foreign Exchange Markets . . . . . . . . . . . . . . . . . . 384 15.3 Macroeconomic Effects of Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . 389 15.4 Exchange Rate Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391 Chapter16: Government Budgets and Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . 403 16.1 Government Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404 16.2 Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407 16.3 Federal Deficits and the National Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409 16.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation . . . . . . . . . . . . 412 16.5 Automatic Stabilizers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415 16.6 Practical Problems with Discretionary Fiscal Policy . . . . . . . . . . . . . . . . . . . . . 417 16.7 The Question of a Balanced Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421 Chapter17: The Impacts of Government Borrowing . . . . . . . . . . . . . . . . . . . . . . . . . 429 17.1 How Government Borrowing Affects Investment and the Trade Balance . . . . . . . . . . 430 17.2 Fiscal Policy, Investment, and Economic Growth . . . . . . . . . . . . . . . . . . . . . . . 433 17.3 How Government Borrowing Affects Private Saving . . . . . . . . . . . . . . . . . . . . . 438 17.4 Fiscal Policy and the Trade Balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439 Chapter18: Macroeconomic Policy Around the World . . . . . . . . . . . . . . . . . . . . . . . 447 18.1 The Diversity of Countries and Economies across the World . . . . . . . . . . . . . . . . 449 18.2 Improving Countries’ Standards of Living . . . . . . . . . . . . . . . . . . . . . . . . . . . 452 18.3 Causes of Unemployment around the World . . . . . . . . . . . . . . . . . . . . . . . . . 457 18.4 Causes of Inflation in Various Countries and Regions . . . . . . . . . . . . . . . . . . . . 458 18.5 Balance of Trade Concerns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459 A|The Use of Mathematics in Principles of Economics . . . . . . . . . . . . . . . . . . . . . . . 469 B|Indifference Curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 485 C|Present Discounted Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 499 Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535 This OpenStax book is available for free at http://cnx.org/content/col23729/1.3 Preface 1 PREFACE Welcome to Principles of Macroeconomics for AP® Courses 2e (2nd Edition), an OpenStax resource. This textbook was written to increase student access to high-quality learning materials, maintaining highest standards of academic rigor at little to no cost. About OpenStax OpenStax is a nonprofit based at Rice University, and it’s our mission to improve student access to education. Our first openly licensed college textbook was published in 2012, and our library has since scaled to over 25 books for college and AP® courses used by hundreds of thousands of students. OpenStax Tutor, our low-cost personalized learning tool, is being used in college courses throughout the country. Through our partnerships with philanthropic foundations and our alliance with other educational resource organizations, OpenStax is breaking down the most common barriers to learning and empowering students and instructors to succeed. About OpenStax resources Customization Principles of Macroeconomics for AP® Courses 2e is licensed under a Creative Commons Attribution 4.0 International (CC BY) license, which means that you can distribute, remix, and build upon the content, as long as you provide attribution to OpenStax and its content contributors. Because our books are openly licensed, you are free to use the entire book or pick and choose the sections that are most relevant to the needs of your course. Feel free to remix the content by assigning your students certain chapters and sections in your syllabus, in the order that you prefer. You can even provide a direct link in your syllabus to the sections in the web view of your book. Instructors also have the option of creating a customized version of their OpenStax book. The custom version can be made available to students in low-cost print or digital form through their campus bookstore. Visit the Instructor Resources section of your book page on openstax.org for more information. Errata All OpenStax textbooks undergo a rigorous review process. However, like any professional-grade textbook, errors sometimes occur. Since our books are web based, we can make updates periodically when deemed pedagogically necessary. If you have a correction to suggest, submit it through the link on your book page on openstax.org. Subject matter experts review all errata suggestions. OpenStax is committed to remaining transparent about all updates, so you will also find a list of past errata changes on your book page on openstax.org. Format You can access this textbook for free in web view or PDF through openstax.org, and for a low cost in print. ® About Principles of Macroeconomics for AP Courses 2e Principles of Macroeconomics for AP® Courses 2e (2nd edition) covers the scope and sequence requirements of most introductory macroeconomics courses. The text includes many current examples, which are handled in a politically equitable way. The outcome is a balanced approach to both Keynesian and classical views, and to the theory and application of economics concepts. The second edition has been thoroughly revised to increase clarity, update data and current event impacts, and incorporate the feedback from many reviewers and adopters. Coverage and scope For the second edition, we received expansive and actionable feedback from hundreds of adopters who had used the book for several academic terms. These knowledgeable instructors informed the pedagogical courses, learning objective development and fulfillment, and the chapter arrangements. Faculty who taught from the material provided critical and detailed commentary. 2 Preface The result is a book that covers the breadth of economics topics and also provides the necessary depth to ensure the course is manageable for instructors and students alike. We strove to balance theory and application, as well as the amount of calculation and mathematical examples. The book is organized into seven main parts: What is Economics? The first two chapters introduce students to the study of economics with a focus on making choices in a world of scarce resources. Supply and Demand, Chapters 3 and 4, introduces and explains the first analytical model in economics: supply, demand, and equilibrium, before showing applications in the markets for labor and finance. Elasticity and Price, Chapter 5, introduces and explains elasticity and price, two key concepts in economics. TheMacroeconomicPerspectiveandGoals,Chapters6through10,introducesanumberofkeyconceptsin macro: economic growth, unemployment and inflation, and international trade and capital flows. A Framework for Macroeconomic Analysis, Chapters 11 through 13, introduces the principal analytic model in macro, namely the aggregate demand/aggregate supply Model. The model is then applied to the Keynesian and Neoclassical perspectives. The expenditure-output model is fully explained in a stand-alone appendix. Monetary and Fiscal Policy, Chapters 14 through 18, explains the role of money and the banking system, aswellasmonetarypolicyandfinancialregulation.Thenthediscussionswitchestogovernmentdeficitsand fiscal policy. International Economics, Chapters 19 through 21, the final part of the text, introduces the international dimensions of economics, including international trade and protectionism. Alternate Sequencing Principles of Macroeconomics for AP® Courses 2e was conceived and written to fit a particular topical sequence, but it can be used flexibly to accommodate other course structures. One such potential structure, which will fit reasonably well with the textbook content, is provided below. Please consider, however, that the chapters were not written to be completely independent, and that the proposed alternate sequence should be carefully considered for student preparation and textual consistency. Chapter 1 Welcome to Economics! Chapter 2 Choice in a World of Scarcity Chapter 3 Demand and Supply Chapter 4 Labor and Financial Markets Chapter 5 Elasticity Chapter 20 International Trade Chapter 6 The Macroeconomic Perspective Chapter 7 Economic Growth Chapter 8 Unemployment Chapter 9 Inflation Chapter 10 The International Trade and Capital Flows Chapter 12 The Keynesian Perspective Chapter 13 The Neoclassical Perspective Chapter 14 Money and Banking Chapter 15 Monetary Policy and Bank Regulation Chapter 16 Exchange Rates and International Capital Flows Chapter 17 Government Budgets and Fiscal Policy Chapter 11 The Aggregate Demand/Aggregate Supply Model Chapter 18 The Impacts of Government Borrowing Chapter 19 Macroeconomic Policy Around the World Chapter 21 Globalization and Protectionism Appendix A The Use of Mathematics in Principles of Economics Appendix B The Expenditure-Output Model This OpenStax book is available for free at http://cnx.org/content/col23729/1.3

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