Principles of Macroeconomics for AP® Courses 2e-Rice University (2011)

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by  Openstax College Steven A. Greenlaw

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.
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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
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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
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®
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