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�𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝐴𝐴𝐴𝐴 𝐼𝐼𝐴𝐴 𝑊𝑊�𝑡𝑡𝑃𝑃0,𝑡𝑡� 𝑟𝑟0,𝑡𝑡 𝑌𝑌0,𝑡𝑡 𝑁𝑁0,𝑡𝑡 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃0,𝑡𝑡) 𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑟𝑟𝑡𝑡 𝐴𝐴𝐴𝐴 𝑃𝑃0,𝑡𝑡 Now, let us consider changes in diﬀerent exogenous variables (one at a time) and examine how the equilibrium values of the endogenous variables change. Let’s start with an increase in Mt. Suppose that Mt increases from M0,t to M1,t > M0,t. Holding the price level ﬁxed, this has the eﬀect of shifting the LM curve out to the right. This is shown in Figure D.5 in blue, with the new LM curve holding the price level ﬁxed labeled LM (M1,t, P0,
t). Figure D.5: Eﬀects of Increase in Mt 1018 𝑤𝑤𝑡𝑡 𝑃𝑃𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝐴𝐴𝐴𝐴 𝐼𝐼𝐴𝐴 𝑊𝑊�𝑡𝑡𝑃𝑃0,𝑡𝑡� 𝑟𝑟0,𝑡𝑡 𝑌𝑌0,𝑡𝑡 𝑁𝑁0,𝑡𝑡 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝐿𝐿𝐿𝐿(𝐿𝐿0,𝑡𝑡,𝑃𝑃0,𝑡𝑡) 𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑟𝑟𝑡𝑡 𝐴𝐴𝐴𝐴 𝑃𝑃0,𝑡𝑡 𝐿𝐿𝐿𝐿(𝐿𝐿1,𝑡𝑡,𝑃𝑃0,𝑡𝑡) 𝐴𝐴𝐴𝐴′ 𝑊𝑊
�𝑡𝑡𝑃𝑃1,𝑡𝑡� 𝑌𝑌1,𝑡𝑡 𝑁𝑁1,𝑡𝑡 𝑃𝑃1,𝑡𝑡 𝑟𝑟1,𝑡𝑡 𝐿𝐿𝐿𝐿(𝐿𝐿1,𝑡𝑡,𝑃𝑃1,𝑡𝑡) 0 subscript: original 1 subscript: post-shock Original Post-shock Post-shock, indirect effect of 𝑃𝑃𝑡𝑡 on LM The LM curve shifting out to the right means that the level of output consistent with being on both the IS and LM curves is now higher, holding the price level ﬁxed at P0,t. This means that the AD curve shifts out to the right (which is shown in blue, and labeled AD′ in the ﬁgure). For the economy to be in equilibrium, it must be on both the AD and AS curves. This means that the price level must rise to P1,t and output to Y1,t at the point where the new AD curve intersects the AS curve (which does not shift). The higher price level causes the LM curve to shift inwards. This is shown in green in the ﬁgure, and labeled LM (M1,t, P1,t). The inward shift of the LM curve is such that the IS and LM curves intersect at the same level of output where the AD and AS curves intersect. Having now determined how Yt, Pt, and rt react to a change in Mt, we can now look at the behavior of labor market variables. Since output is higher but there has been no change in productivity (or capital), labor input must be higher. We can graphically determine the new value of labor input by working “backwards” in the graph – take the new value of output, reﬂect it oﬀ the 45 degree line, and determine the value of Nt consistent with this level of output from the production function. The new real wage is read oﬀ the labor demand curve at this new level of labor input. Since Pt rises and the nominal wage is �
�xed, the real wage is lower, while labor input is higher. Since rt is lower, It will be higher. Since rt is lower and Yt is higher, Ct will also be higher. As in the sticky price model, and diﬀerent relative to the neoclassical model, money is non-neutral in the sense that an increase in the money supply results in higher output. The mechanism responsible for this is the fact that the nominal wage is sticky. When the money supply increases, the price level rises. For a ﬁxed nominal wage, a higher price level lowers the real wage that the ﬁrm must pay for labor. This lower real wage induces the ﬁrm to hire more labor, and hence to produce more. In order for total expenditure to increase with output, the real interest rate must fall so that consumption and investment both rise. Compared to the sticky price model, many of the eﬀects on endogenous variables of an increase in Mt are the same (i.e. output rises and the real interest rate falls), though the mechanism giving rise to monetary non-neutrality is diﬀerent. In the sticky wage model, the real wage declines, inducing ﬁrms to hire more labor. In the sticky price model, in contrast, the real wage rises when Mt increases. Next, let’s consider a change in an exogenous variable which results in the IS curve shifting out to the right. We will generically call this an “IS Shock.” This could arise from an increase in At+1, an increase in Gt, or a reduction in Gt+1. In Figure D.6, the IS curve shifts out to the right. Holding the price level ﬁxed, the level of output consistent with being on both the IS and LM curves is now higher. This means that the AD curve shifts out horizontally to the right. Since the economy must be on both the AD and AS curves in equilibrium, the price 1019 level must rise to P1,t, and output must increase to Y1,t (which is smaller than the increase in output would be if the price level were ﬁxed). The higher price level induces an inward shift of the LM curve, shown in the diagram in green and labeled LM (Mt, P1,t). This inward shift of the LM curve is such that the levels of output where the
IS and LM curves intersect is the same as where the AD and AS curves intersect. The real interest rate is higher. Next, we can consider what happens in the labor market. The higher level of output must be supported by higher labor input, since At and Kt are unchanged. This higher level of labor input comes about through a reduction in the real wage, which occurs because the price level rises while the nominal wage is ﬁxed. 1020 Figure D.6: Eﬀects of Positive IS Shock Next, let us consider an exogenous increase in At. These eﬀects are shown graphically in Figure D.7 below: 1021 𝑤𝑤𝑡𝑡 𝑃𝑃𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝐴𝐴𝐴𝐴 𝐼𝐼𝐴𝐴 𝑊𝑊�𝑡𝑡𝑃𝑃0,𝑡𝑡� 𝑟𝑟0,𝑡𝑡 𝑌𝑌0,𝑡𝑡 𝑁𝑁0,𝑡𝑡 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃0,𝑡𝑡) 𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑌𝑌𝑡𝑡
=𝑌𝑌𝑡𝑡 𝑟𝑟𝑡𝑡 𝐴𝐴𝐴𝐴 𝑃𝑃0,𝑡𝑡 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃1,𝑡𝑡) 𝑟𝑟1,𝑡𝑡 𝑃𝑃1,𝑡𝑡 𝐴𝐴𝐴𝐴′ 𝐼𝐼𝐴𝐴′ 𝑌𝑌1,𝑡𝑡 𝑁𝑁1,𝑡𝑡 𝑊𝑊�𝑡𝑡𝑃𝑃1,𝑡𝑡� 0 subscript: original 1 subscript: post-shock Original Post-shock Post-shock, indirect effect of 𝑃𝑃𝑡𝑡 on LM Figure D.7: Eﬀects of Increase in At The increase in At causes the labor demand curve to shift out to the right, which is shown in blue. Holding the price level ﬁxed at P0,t, this results in more labor input. Combined with the production function shifting up, this means that output will be higher for a given price level. Put another way, the AS curve shifts out to the right. There is no shift in the AD curve. To be on both the AD and new AS curves, the price level must fall to P1,t, with output 1022 𝑤𝑤𝑡𝑡 𝑃𝑃𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝐴𝐴𝐴𝐴 𝐼
𝐼𝐴𝐴 𝑊𝑊�𝑡𝑡𝑃𝑃0,𝑡𝑡� 𝑟𝑟0,𝑡𝑡 𝑌𝑌0,𝑡𝑡 𝑁𝑁0,𝑡𝑡 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴0,𝑡𝑡,𝐾𝐾𝑡𝑡) 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃0,𝑡𝑡) 𝐴𝐴0,𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑟𝑟𝑡𝑡 𝐴𝐴𝐴𝐴 𝑃𝑃0,𝑡𝑡 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴1,𝑡𝑡,𝐾𝐾𝑡𝑡) 𝐴𝐴1,𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝐴𝐴𝐴𝐴′ 𝑁𝑁1,𝑡𝑡 𝑊𝑊�𝑡𝑡𝑃𝑃1,𝑡𝑡� 𝑟𝑟1,𝑡𝑡 𝑌𝑌1,𝑡𝑡 𝑃𝑃1,𝑡𝑡 𝐿𝐿𝐿
𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃1,𝑡𝑡) 0 subscript: original 1 subscript: post-shock Original Post-shock Post-shock, indirect effect of 𝑃𝑃𝑡𝑡 on LM rising. The lower price level induces a rightward shift of the LM curve (shown in green) so that the level of output where the IS and LM curves intersect is the same as the level of output where the AD and AS curves intersect. Having now determined how output and the price level react, we can turn attention to the labor market. The higher price level results in the real wage rising. This means that the increase in labor input will be smaller than if the price level were ﬁxed (put another way, the change in equilibrium output is smaller than the horizontal shift of the AS curve). Depending on the relative slopes of the AD and AS curves, labor input could be higher, unchanged, or lower after the increase in At. In the graph, we have drawn it where labor input actually declines. We will return to this issue in more detail when comparing the predictions of the sticky wage model to the neoclassical model. Lastly, consider an exogenous change in ¯Wt. For a given price level, this raises the real wage, and thereby induces the ﬁrm to employ less labor. This results in a reduction in output for a given price level, leading to an inward shift of the AS curve. This is shown in Figure D.8. With the AS curve shifting in, to be on both the AS and AD curves the price level must rise to P1,t. Output falls to Y1,t, but by less than the horizontal shift in the AS curve. The higher price level triggers an inward shift of the LM curve (shown in green), which results in the real interest rate rising. The higher price level also lowers the real wage (relative to what it would be with the higher ¯Wt but the ﬁxed price level), though the real wage remains higher than it would have been in the absence of the increase in ¯Wt. Consequently, labor input falls to N1,t. 1023 Figure D.8: Eﬀects of Increase in ¯Wt Table D.2 below summarizes the qualitative eﬀects of changes in the relevant exogenous variables on the endogenous variables of
the sticky wage model. We omit the eﬀects on Ct and It, which depend upon what drives the IS curve out to the right. 1024 𝑤𝑤𝑡𝑡 𝑃𝑃𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝐴𝐴𝐴𝐴 𝐼𝐼𝐴𝐴 𝑊𝑊�0,𝑡𝑡𝑃𝑃0,𝑡𝑡� 𝑟𝑟0,𝑡𝑡 𝑌𝑌0,𝑡𝑡 𝑁𝑁0,𝑡𝑡 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃0,𝑡𝑡) 𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑟𝑟𝑡𝑡 𝐴𝐴𝐴𝐴 𝑃𝑃0,𝑡𝑡 𝑊𝑊�1,𝑡𝑡𝑃𝑃0,𝑡𝑡� 𝐴𝐴𝐴𝐴′ 𝑊�
��1,𝑡𝑡𝑃𝑃1,𝑡𝑡� 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃1,𝑡𝑡) 𝑟𝑟1,𝑡𝑡 𝑃𝑃1,𝑡𝑡 𝑁𝑁1,𝑡𝑡 𝑌𝑌1,𝑡𝑡 0 subscript: original 1 subscript: post-shock Original Post-shock Post-shock, indirect effect of 𝑃𝑃𝑡𝑡 on LM Table D.2: Qualitative Eﬀects of Exogenous Shocks on Endogenous Variables in the Sticky Wage Model Variable Yt ↑ Mt + Exogenous Shock ↑ At ↑ IS curve + + ↑ ¯Wt - Nt wt rt it Pt + - - - + + - + + +? + - - - - + + + + The entry for the eﬀect of an increase in At on Nt is appears as a? because the eﬀect is ambiguous, as discussed above. We will return to this point more later. D.1.1 Comparing the Sticky Wage Model to the Neoclassical Model Because the sticky wage model generates a non-vertical AS curve, we can immediately conclude that demand shocks (both shocks which shift the LM curve, e.g. changes in Mt, and shocks which shift the IS curve, e.g. Gt) have bigger eﬀects on output than they would in the neoclassical model. This result is qualitatively similar to what we ﬁnd in the text when focusing on either the simple sticky price or partial sticky price models. What about supply shocks? In the sticky wage model, we know that θt has no eﬀect on the equilibrium values of endogenous variables because the labor supply curve is not relevant for the determination of the economy’s equilibrium. Hence, changes in θt have smaller eﬀects on output and other variables than in the neoclassical model. Things are more nuanced in response to an exogenous change in At. Consider Figure D.9 below. There we show how
the AS curves in the sticky wage and neoclassical models shift in response to an increase in At without showing an AD curve. We assume that the economy initially starts with Y0,t = Y f 0,t at P0,t. Focusing ﬁrst on the sticky wage model, the increase in At causes the labor demand curve to shift right and the production function to shift up. Since labor is determined solely oﬀ of the labor demand curve in the sticky wage model, we can determine the new level of output supplied for a ﬁxed initial price by reading labor input oﬀ of the labor demand curve at a ﬁxed real wage (since we are holding the price level ﬁxed at P0,t and the nominal wage is ﬁxed by construction). This gives a new output level of Y1,t, and the sticky wage AS curve 1025 shifts horizontally to the right by the amount Y1,t − Y0,t. These eﬀects are depicted in blue in Figure D.9. Figure D.9: Eﬀects of Increase in At on Sticky Wage AS and Neoclassical AS Consider next what would happen to the AS curve in the neoclassical model. In the neoclassical model, the labor supply curve is relevant for the determination of equilibrium labor input. The labor demand curve and production function would both shift by the same amount as they would in the sticky wage model, but labor input would be determined by the intersection of the new labor demand curve (blue) with the hypothetical labor supply curve (orange). Since the labor supply curve is upward-sloping, labor input would increase by less after an increase in At in the neoclassical model than it would in the sticky wage model with a ﬁxed price level. This then implies that output would increase less in the neoclassical model after an increase in At than it would in the sticky wage model holding the price level 1026 𝑤𝑤𝑡𝑡 𝑃𝑃𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑊𝑊�𝑡�
��𝑃𝑃0,𝑡𝑡� 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴0,𝑡𝑡,𝐾𝐾𝑡𝑡) 𝑁𝑁𝑠𝑠(𝑤𝑤𝑡𝑡,𝜃𝜃𝑡𝑡) 𝐴𝐴0,𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝐴𝐴1,𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴1,𝑡𝑡,𝐾𝐾𝑡𝑡) 𝐴𝐴𝐴𝐴𝑓𝑓 𝐴𝐴𝐴𝐴𝑓𝑓′ 𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴′ 𝑃𝑃0,𝑡𝑡 𝑌𝑌0,𝑡𝑡=𝑌𝑌0,𝑡𝑡𝑓𝑓 𝑌𝑌1,𝑡𝑡 𝑌𝑌1,𝑡𝑡𝑓𝑓 ﬁxed. Put slightly diﬀerently, the AS curve in the sticky wage model shifts out more to the right after an increase in At than the vertical neoclassical AS curve shifts out. The fact that the sticky wage AS curve shifts horizontally more after an increase in At than in the hypothetical neoclassical equilibrium
does not necessarily imply that output and labor input will react more to an increase in At in equilibrium in the sticky wage model. How output reacts in comparison to the neoclassical model depends not just on the magnitude of the horizontal shift in the AS curve, but also on the slope of the AD curve. Figure D.10: Eﬀects of Increase in At on Sticky Wage AS and Neoclassical AS, Slope of AD To see this point clearly, refer to Figure D.10. In this ﬁgure we focus just on the AD-AS curves to make things as clear as possible. We show two AS curves – the neoclassical AS curve, ASf, and the sticky wage AS curve, AS. We consider two diﬀerent AD curves – AD and ̃AD, where ̃AD is ﬂatter than AD. We assume that the initial equilibrium occurs where all of these curves cross at P0,t. Then we consider a rightward shift of the supply curves. As noted above, we show the upward-sloping, sticky wage AS curve shifting horizontally to the right by more (blue) than the vertical neoclassical AS curve (purple). In the neoclassical model, how output reacts in equilibrium is a function solely of the shift of the AS curve – the slope of the AD curve does not matter, and in either case output increases from Y f = Y0,t 0,t to Y f 1,t. In the sticky wage model this is not so. When the AD curve is comparatively steep (as shown in red and demarcated AD), even though the sticky wage AS curve shifts out 1027 𝐴𝐴𝐴𝐴𝑓𝑓 𝐴𝐴𝐴𝐴𝑓𝑓′ 𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴′ 𝑃𝑃𝑡𝑡 𝑌𝑌𝑡𝑡 𝑃𝑃0,𝑡𝑡 𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴� 𝑌𝑌0,𝑡𝑡=𝑌𝑌0,�
�𝑡𝑓𝑓 𝑌𝑌1,𝑡𝑡 𝑌𝑌�1,𝑡𝑡 𝑌𝑌1,𝑡𝑡𝑓𝑓 horizontally more than the neoclassical AS curve does, in equilibrium output nevertheless increases by less. In contrast, if the AD curve is very ﬂat, shown in the ﬁgure in green, output may increase by more in response to an increase in At in the sticky wage model in comparison to the neoclassical model. Without taking a stand on the slope of the AD curve, we cannot determine in which model output will react by more. Table D.3 qualitatively compares the responses of endogenous variables to diﬀerent shocks in both the sticky wage (SW) and neoclassical (NEO) models. For the case of productivity shocks, the table shows several “?” denoting that the relative change in the endogenous variable cannot be deﬁnitively signed. Table D.3: Comparing the Sticky Wage and Neoclassical Models Exogenous Shock Variable Change in Yt ↑ Mt SW > NEO SW > NEO SW? NEO SW < NEO ↑ IS curve ↑ At ↑ θt Change in Nt SW > NEO SW > NEO SW? NEO SW < NEO Change in wt SW < NEO SW < NEO SW? NEO SW < NEO Change in rt SW < NEO SW < NEO SW? NEO SW < NEO Change in it SW < NEO SW < NEO SW? NEO SW < NEO Change in Pt SW < NEO SW < NEO SW? NEO SW < NEO We can therefore see that the sticky wage model has similar implications to the sticky price model. Relative to the neoclassical model, output reacts more to demand shocks and, with the caveat about productivity shocks as discussed above noted, less to supply shocks. Is there any dimension along with the sticky price and sticky wage models make diﬀerent predictions conditional on shocks? Yes, and it relates to the cyclical behavior of the real wage. In the sticky price model, since the real wage is determined along the labor supply curve, the real wage is procylical conditional on demand shocks. By procyclical we mean that the real wage moves in the same direction as output conditional on shocks to the AD curve. The reverse is true in the sticky wage model, where
the real wage is determined from labor demand instead of labor supply. In that model, while demand shocks can aﬀect output, the mechanism through which they do so is a counteryclical real wage – i.e. the real wage declines when output goes up due to a shift in the AD curve. To the extent to which one jointly believes that the real wage is strongly procyclical in the data (see the discussion in Chapter 20) and that demand shocks are major driver of short run output ﬂuctuations, the 1028 sticky price model can do a better job at matching the data than can the sticky wage model. D.2 Dynamics in the Sticky Wage Model We next study the dynamic behavior of the economy as it transitions from short run to medium run in the sticky wage model. D.2.1 A Non-Optimal Short Run Equilibrium Consider an initial equilibrium in which the AS and AD curves intersect at a value of 0,t which is higher than it would be if the nominal wage were ﬂexible, Y f output, Y sr 0,t. This is depicted in Figure D.11. The AD and AS curves intersect to the right of the hypothetical ﬂexible wage AS curve. This means that labor input is higher than it would be if wages were ﬂexible. Put diﬀerently, this means that the equilibrium real wage is lower than the household would like – the household is working more than it would like given the real wage. Given this situation, there will be pressure on the household to demand a higher nominal wage. 1029 Figure D.11: Sticky Wage Model: Y0,t > Y f 0,t The dynamics of this situation are depicted in Figure D.12. The household will demand a suﬃciently higher nominal wage wage, ¯W mr 0,t, such that the AS curve will shift in (shown in gray) by an amount such that it intersects the AD curve at the hypothetical neoclassical equilibrium level of output. The new short run equilibrium, denoted with mr superscripts, will correspond to the hypothetical ﬂexible wage equilibrium. 1030 𝐴𝐴𝐴𝐴 𝐼𝐼𝐴𝐴 𝑊𝑊�0,𝑡𝑡𝑠𝑠𝑠𝑠
𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠� 𝑟𝑟0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠) 𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑟𝑟𝑡𝑡 𝐴𝐴𝐴𝐴 𝑁𝑁𝑠𝑠(𝑤𝑤𝑡𝑡,𝜃𝜃𝑡𝑡) 𝐴𝐴𝐴𝐴𝑓𝑓 𝑁𝑁0,𝑡𝑡𝑓𝑓 𝑌𝑌0,𝑡𝑡𝑓𝑓 𝑃𝑃0,𝑡𝑡𝑓𝑓 𝑤𝑤0,𝑡𝑡𝑓𝑓 𝑟𝑟0,𝑡𝑡𝑓𝑓 𝑤𝑤𝑡𝑡 0 subscript: equilibrium value f superscript: hypothetical flexible price equilibrium sr superscript: short run 𝑃𝑃𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 Sticky wage model
𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 Hypothetical flexible wage model 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃0,𝑡𝑡𝑓𝑓) 𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑌𝑌0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑁𝑁0,𝑡𝑡𝑠𝑠𝑠𝑠 Figure D.12: Sticky Wage Model: Y0,t > Y f 0,t, Dynamic Wage Adjustment D.2.2 Dynamic Responses to Shocks As we did for both variants of the sticky price model, in this subsection we think about the dynamic responses to shocks in the sticky wage model as the economy transitions from short run to medium run. In all exercises, we assume that the economy initially begins in an 1031 𝐴𝐴𝐴𝐴 𝑊𝑊�0,𝑡𝑡𝑠𝑠𝑠𝑠𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠� 𝑟𝑟0,𝑡𝑡𝑠𝑠𝑠𝑠 𝐴𝐴𝐴𝐴 𝑁𝑁𝑠𝑠(𝑤𝑤𝑡𝑡,𝜃𝜃𝑡𝑡) 𝐴𝐴𝐴𝐴𝑓𝑓 𝑁𝑁0,𝑡𝑡𝑓𝑓=𝑁𝑁0,𝑡𝑡𝑚𝑚𝑠𝑠 𝑃𝑃0,𝑡𝑡𝑚�
��𝑠𝑠=𝑃𝑃0,𝑡𝑡𝑓𝑓 𝑊𝑊�0,𝑡𝑡𝑚𝑚𝑠𝑠𝑃𝑃0,𝑡𝑡𝑚𝑚𝑠𝑠=𝑤𝑤0,𝑡𝑡𝑓𝑓 𝑟𝑟0,𝑡𝑡𝑚𝑚𝑠𝑠=𝑟𝑟0,𝑡𝑡𝑓𝑓 𝐿𝐿𝐿𝐿�𝐿𝐿𝑡𝑡,𝑃𝑃0,𝑡𝑡𝑓𝑓�=𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃0,𝑡𝑡𝑚𝑚𝑠𝑠) 𝑤𝑤𝑡𝑡 𝐴𝐴𝐴𝐴′ 𝑃𝑃𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 0 subscript: equilibrium value f superscript: hypothetical flexible wage equilibrium sr/mr superscript: short run or medium run Sticky wage model Hypothetical flexible wage model Sticky wage model, post wage adjustment 𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠 𝐼𝐼𝐴𝐴 𝑁𝑁0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑁𝑁𝑑𝑑(𝑤
𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠) 𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑟𝑟𝑡𝑡 𝑌𝑌0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑌𝑌0,𝑡𝑡𝑓𝑓=𝑌𝑌0,𝑡𝑡𝑚𝑚𝑠𝑠 equilibrium which coincides with the neoclassical model. 1,t and P sr Consider ﬁrst an exogenous increase in Mt. For a given price level, this triggers an outward shift of the LM curve and hence a rightward shift of the AD curve (shown in blue in Figure D.13). The AS curve is upward-sloping. As a result, output and the price level both increase to Y sr 1,t, respectively. The higher price level triggers a leftward shift of the LM curve (shown in green), but not all the way back to where it started. Hence, the real interest rate falls. Higher output means that there must be more labor input. With a ﬁxed nominal wage, a higher price level results in a lower real wage, which supports a higher level of labor input since the labor is determined oﬀ of the labor demand curve. 1032 Figure D.13: Sticky Wage Model: Increase in Mt, Dynamics There would be no change in output in the hypothetical situation in which the nominal wage is ﬂexible (i.e. the hypothetical AS curve is vertical). In terms of the labor market,. This puts the household is working more than it would like at the real wage given by
upward pressure on the nominal wage. The nominal wage will increase to ¯W mr in such a way 1,t that the AS curve will shift inward so as to intersect the AD curve at the original level of ¯W sr 0,t P sr 1,t 1033 𝑊𝑊�0,𝑡𝑡𝑠𝑠𝑠𝑠𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠=𝑊𝑊�1,𝑡𝑡𝑚𝑚𝑠𝑠𝑃𝑃1,𝑡𝑡𝑚𝑚𝑠𝑠 𝑟𝑟1,𝑡𝑡𝑚𝑚𝑠𝑠=𝑟𝑟0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑌𝑌0,𝑡𝑡𝑠𝑠𝑠𝑠=𝑌𝑌1,𝑡𝑡𝑚𝑚𝑠𝑠 𝐿𝐿𝐿𝐿�𝐿𝐿0,𝑡𝑡,𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠�=𝐿𝐿𝐿𝐿(𝐿𝐿1,𝑡𝑡,𝑃𝑃1,𝑡𝑡𝑚𝑚𝑠𝑠) 𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑊𝑊�0,𝑡𝑡𝑠𝑠𝑠𝑠𝑃𝑃1,𝑡𝑡𝑠𝑠𝑠𝑠� 𝑟𝑟1,𝑡𝑡𝑠𝑠𝑠𝑠 𝐿𝐿𝐿𝐿(𝐿�
��1,𝑡𝑡,𝑃𝑃1,𝑡𝑡𝑠𝑠𝑠𝑠) 0 subscript: original 1 subscript: post-shock sr/mr superscript: short run or medium run Original Post-shock Post-shock, post wage adjustment Original, hypothetical flexible wage Post-shock, flexible wage 𝑁𝑁𝑠𝑠(𝑤𝑤𝑡𝑡,𝜃𝜃𝑡𝑡) 𝑤𝑤𝑡𝑡 𝑃𝑃𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝐴𝐴𝐴𝐴′ 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝐴𝐴𝐴𝐴 𝐼𝐼𝐴𝐴 𝐴𝐴𝐴𝐴𝑓𝑓 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑟𝑟𝑡𝑡 Post-shock, indirect effect of 𝑃𝑃𝑡𝑡 on LM 𝑃𝑃1,𝑡𝑡𝑠𝑠𝑠𝑠 𝐴𝐴𝐴𝐴 𝑃𝑃1,𝑡�
�𝑚𝑚𝑠𝑠 𝐿𝐿𝐿𝐿(𝐿𝐿1,𝑡𝑡,𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠) 𝑌𝑌1,𝑡𝑡𝑠𝑠𝑠𝑠 𝐴𝐴𝐴𝐴′ 𝑁𝑁0,𝑡𝑡𝑠𝑠𝑠𝑠=𝑁𝑁1,𝑡𝑡𝑚𝑚𝑠𝑠 𝑁𝑁1,𝑡𝑡𝑠𝑠𝑠𝑠 = Y sr 0,t ). This results in a further increase in the price level, to P mr output (i.e. Y mr 1,t. The 1,t increase in the price level induces the LM curve to shift in further, resulting in no ultimate change in the real interest rate. With output unchanged, ultimately labor input and the real wage are also unchanged as the economy transitions to the medium run after an increase in Mt. Consider next a positive shock to the IS curve (due to an increase in At+1 or Gt, or a decrease in Gt+1). These eﬀects are shown graphically in Figure D.14 below. 1034 Figure D.14: Sticky Wage Model: Positive IS Shock, Dynamics In Figure D.14, the IS curve shifts to the right (shown in blue). This results in the AD curve shifting out to the right as well. With the AS curve upward-sloping but not vertical, both output and the price level rise, to Y sr 1,t, respectively. The higher price level triggers an inward shift of the LM curve (shown in green), though not all the way back to where the LM curve began before the shock. This means that the real interest rate is higher. 1,t and P sr 1035 𝑤𝑤𝑡𝑡 𝑃𝑃𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡�
�� 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝐴𝐴𝐴𝐴 𝐼𝐼𝐴𝐴 𝑌𝑌0,𝑡𝑡𝑠𝑠𝑠𝑠=𝑌𝑌1,𝑡𝑡𝑚𝑚𝑠𝑠 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠) 𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑟𝑟𝑡𝑡 𝐴𝐴𝐴𝐴 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃1,𝑡𝑡𝑠𝑠𝑠𝑠) 𝐴𝐴𝐴𝐴′ 𝐼𝐼𝐴𝐴′ 𝑊𝑊�0,𝑡𝑡𝑠𝑠𝑠𝑠𝑃𝑃1,𝑡𝑡𝑠𝑠𝑠𝑠� 0 subscript: original 1 subscript: post-shock sr/mr superscript: short run or medium run Original
Post-shock Post-shock, indirect effect of 𝑃𝑃𝑡𝑡 on LM Post-shock, post wage adjustment Original, hypothetical flexible wage Post-shock, flexible wage 𝑁𝑁𝑠𝑠(𝑤𝑤𝑡𝑡,𝜃𝜃𝑡𝑡) 𝐴𝐴𝐴𝐴𝑓𝑓 𝐴𝐴𝐴𝐴′ 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃1,𝑡𝑡𝑚𝑚𝑠𝑠) 𝑟𝑟1,𝑡𝑡𝑠𝑠𝑠𝑠 𝑟𝑟0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑟𝑟1,𝑡𝑡𝑚𝑚𝑠𝑠 𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑃𝑃1,𝑡𝑡𝑠𝑠𝑠𝑠 𝑃𝑃1,𝑡𝑡𝑚𝑚𝑠𝑠 𝑌𝑌1,𝑡𝑡𝑠𝑠𝑠𝑠 𝑁𝑁0,𝑡𝑡𝑠𝑠𝑠𝑠=𝑁𝑁1,𝑡𝑡𝑚𝑚𝑠𝑠 𝑁𝑁1,𝑡𝑡𝑠𝑠𝑠𝑠 𝑊𝑊�0,𝑡𝑡𝑠𝑠𝑠𝑠𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠=𝑊𝑊�1,𝑡𝑡�
��𝑚𝑠𝑠𝑃𝑃1,𝑡𝑡𝑚𝑚𝑠𝑠 The higher level of output necessitates higher labor input, N sr 0,t. The higher price level 1,t drives down the real wage, given a ﬁxed nominal wage, which supports the higher level of labor input from the labor demand curve. > N sr The level of output would not change if the nominal wage were ﬂexible and the AS curve vertical, and nor would the real wage or labor input. At the new equilibrium denoted with 1 subscripts, the household is working more than it would like (the quantity of labor demanded exceeds supply). This puts upward pressure on the nominal wage once the household is given a chance to renegotiate the wage. This results in a higher nominal wage, ¯W mr 1,t, which results in an inward shift of the AS curve to AS’ (shown in gray). The AS curve shifts in by an amount such that the level of output is unchanged relative to where it was before the shock (i.e. Y mr 0,t ). The price level is higher. The higher price level causes the LM curve to 1,t shift in further, resulting in a higher real interest rate. There is no ultimate change in labor input or the real wage. = Y sr Next, consider an increase in At. This exercise is depicted in Figure D.15. This results in an outward shift of the upward-sloping sticky wage AS curve, as well as an outward shift of the hypothetical vertical ﬂexible wage AS curve. The outward shift of the sticky wage curve is larger than the outward shift of the vertical ﬂexible wage AS curve. Nevertheless, we assume that the slope of the AD curve is such that output rises by less in the sticky wage model than it would if the wage were ﬂexible. Hence, in the new sticky wage equilibrium after the increase in At, output is lower than it would be if prices were ﬂexible. This means that labor input is less than it would be and the real wage is higher than it would be if the wage were ﬂexible. This means that there is downward pressure on the nominal wage. The nominal wage will fall, to something like ¯W mr 1,t, which results in an outward shift of the AS curve.
The outward shift of the AS curve will be such that it intersects the AD curve at the at the point where the AD curve crosses the vertical ﬂexible wage AS curve. This means that, as we transition to the medium run, the price level will fall, output will rise, the real interest rate will fall, labor input will rise, and the real wage will fall. 1036 Figure D.15: Sticky Wage Model: Increase in At, Dynamics Table D.4 shows the qualitative eﬀects of how diﬀerent endogenous variables react to changes in each exogenous variable along the transition from the short run to the medium run. For the most part, this table is similar to Table 27.1. The primary exception is the behavior of the real wage. In the sticky price model, the real wage moves in the same direction as output as the economy transitions from short run to medium run; in the sticky wage model 1037 𝑟𝑟0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑟𝑟1,𝑡𝑡𝑠𝑠𝑠𝑠 𝑟𝑟1,𝑡𝑡𝑚𝑚𝑠𝑠 𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑃𝑃1,𝑡𝑡𝑠𝑠𝑠𝑠 𝑊𝑊�0,𝑡𝑡𝑠𝑠𝑠𝑠𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠� 𝐴𝐴𝐴𝐴′ 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃1,𝑡𝑡𝑠𝑠𝑠𝑠) 0 subscript: original 1 subscript: post-shock sr/mr superscript: short run or medium run 𝑤𝑤𝑡𝑡 𝑃𝑃𝑡𝑡 𝑌𝑌�
��𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 Original 𝐴𝐴𝐴𝐴 𝐼𝐼𝐴𝐴 Post-shock 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴0,𝑡𝑡,𝐾𝐾𝑡𝑡) Post-shock, indirect effect of 𝑃𝑃𝑡𝑡 on LM 𝐿𝐿𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃0,𝑡𝑡𝑠𝑠𝑠𝑠) 𝐴𝐴0,𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) Post-shock, post wage adjustment 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑟𝑟𝑡𝑡 Original, hypothetical flexible wage Post-shock, flexible wage 𝐴𝐴𝐴𝐴 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴1,𝑡𝑡,𝐾𝐾𝑡𝑡) 𝑁𝑁𝑠𝑠(𝑤𝑤𝑡𝑡,𝜃𝜃𝑡𝑡) 𝐴𝐴1,𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝐿�
�𝐿𝐿(𝐿𝐿𝑡𝑡,𝑃𝑃1,𝑡𝑡𝑚𝑚𝑠𝑠) 𝐴𝐴𝐴𝐴′′ 𝐴𝐴𝐴𝐴𝑓𝑓 𝐴𝐴𝐴𝐴𝑓𝑓′ 𝑃𝑃1,𝑡𝑡𝑚𝑚𝑠𝑠 𝑌𝑌0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑌𝑌1,𝑡𝑡𝑠𝑠𝑠𝑠 𝑌𝑌1,𝑡𝑡𝑚𝑚𝑠𝑠 𝑁𝑁0,𝑡𝑡𝑠𝑠𝑠𝑠 𝑁𝑁1,𝑡𝑡𝑠𝑠𝑠𝑠 𝑁𝑁1,𝑡𝑡𝑚𝑚𝑠𝑠 𝑊𝑊�0,𝑡𝑡𝑠𝑠𝑠𝑠𝑃𝑃1,𝑡𝑡𝑠𝑠𝑠𝑠� 𝑊𝑊�1,𝑡𝑡𝑚𝑚𝑠𝑠𝑃𝑃1,𝑡𝑡𝑚𝑚𝑠𝑠� the opposite is the case. Table D.4: Qualitative Eﬀects of Exogenous Shocks on Endogenous Variables in the Sticky Wage Model, Transition from Short Run to Medium Run Variable Yt Nt wt rt it Pt Exogenous Shock ↑ IS curve - ↑ Mt - ↑ At + - + + + + - + + + + + - - - - 1038 Appendix E Replacing the LM Curve with the MP Curve E.1 The AD Curve when the MP Curve Replaces the LM
Curve In Chapters 24, 26, and 28 we characterize monetary policy with the money supply, Mt. When drawing the LM curve we treat Mt as exogenous, though we can think about how Mt ought to react to shocks so as to implement the eﬃcient equilibrium in Chapter??. Let us now suppose that, instead of choosing Mt, a central bank conducts policy according to a rule similar to (28.11). It turns out that we can derive a graphical representation of the short run equilibrium of the sticky price (simple or partial) New Keynesian model that is similar to what we work with in the text. There are two main diﬀerences relative to what we pursue in the text. First, we replace the LM curve speciﬁcation of money demand with a policy rule written in terms of a target interest rate. We will completely omit the money supply and the money demand function from the analysis. In the background money is still a variable, but it becomes endogenous. In eﬀect, a central bank implements an interest rate target by setting the money supply so as to equal money demand at the desired interest rate, but we need not worry about what that money supply is. Secondly, we will write the AD and AS curves as functions of πt (the growth rate of the price level), rather than Pt, the price level itself. Otherwise, the models will look quite similar and will have very similar implications. To begin, let us start by deﬁning a slightly simpler version of an MP rule than what is given in (28.11). In particular, assume that the monetary policy reaction function is given by: it = r∗ + π∗ + φπ(πt − π∗) + et (E.1) (E.1) looks the same as (28.11), except that (i) we have imposed φy = 0, so that there is no reaction to the output gap; and (ii) we have added an exogenous term to the rule, et. Fluctuations in et will play a similar role to exogenous changes in Mt in the model of the text. Imposing that φy = 0 simpliﬁes the analysis without fundamentally aﬀecting any conclusions. All other variables and parameters have the same interpretation as the presentation of the Taylor rule. We assume that φπ > 1, a point to which we shall return in more
depth below. Recall that the Fisher relationship relates the real interest rate to the nominal rate and 1039 expected inﬂation, which in our baseline model we take to be an exogenous variable. In particular, rt = it − πe t+1. So that we are not dealing with variables referencing diﬀerent dates, let us here make an assumption of adaptive expectations. In particular, assume that expected inﬂation between periods t and t + 1 is equal to realized inﬂation from t − 1 to t. = πt. This is not necessarily an ideal assumption but is also not wholly That is, assume πe implausible. To write the monetary policy reaction function in terms of the real rate, rather than the nominal rate, make use of the adaptive expectations assumption and subtract πt from both sides of (E.1). Re-arranging terms, we get: t+1 rt = r∗ + (1 − φπ)π∗ + (φπ − 1)πt + et (E.2) Deﬁne a new term ¯rt = r∗ + (1 − φπ)π∗ + et as the exogenous component of the policy rule. Changes in et will cause this term to move up or down. We can then write the rule as: rt = ¯rt + (φπ − 1)πt (E.3) We shall henceforth refer to (E.3) as a the “monetary policy rule” and will graphically represent it with the M P curve, where the M P stands for monetary policy. This can be seen in Figure E.1 below: Figure E.1: The MP Curve The MP curve intersects the vertical axis at ¯rt. Since we assume, unless otherwise noted, that φπ > 1, the MP curve is upward-sloping. The MP curve tells us what the central bank’s target real interest rate is for each possible inﬂation rate. The demand side of the economy is governed by the following equations: 1040 𝑟𝑟𝑡𝑡 𝜋𝜋𝑡𝑡 𝑟𝑟̅𝑡𝑡 𝑟𝑟𝑡𝑡=𝑟𝑟̅
𝑡𝑡+(𝜙𝜙𝜋𝜋−1)𝜋𝜋𝑡𝑡 Ct = C d(Yt − Gt, Yt+1 − Gt+1, rt) It = I d(rt, At+1, Kt) Yt = Ct + It + Gt rt = ¯rt + (φπ − 1)πt (E.4) (E.5) (E.6) (E.7) Expressions (E.4)-(E.6) can be graphically summarized by the familiar IS curve, which shows combinations of rt and Yt where these equations jointly hold, taking the values of exogenous variables as given. (E.7) is the MP curve, which shows combinations of rt and πt where the central bank follows is policy rule. These equations can be combined to describe the set of πt and Yt pairs where all four equations hold. This will be the AD curve. Intuitively, if the Fed responds to higher inﬂation by raising the real interest rate, then from the IS curve output will fall as inﬂation increases. The AD curve, expressed with πt on the vertical axis instead of Pt, will be downward-sloping. This new version of the AD curve can be derived graphically as shown in Figure E.2. This is a four part graph. In the lower left hand portion, put πt on the vertical axis and Yt on the horizontal axis. This will be where the AD curve is plotted. The lower right hand portion is simply a plot of πt against πt; i.e. it is a 45 degree line. This is simply a way to reﬂect πt from the vertical axis to the horizontal axis. In the upper right hand portion we plot the MP curve, with rt as a function of πt. In the upper left hand portion, we plot the IS curve with rt on the vertical axis and Yt on the horizontal axis. 1041 Figure E.2: The AD Curve with the MP Curve: Derivation To derive the AD curve graphically, start with some inﬂation rate in the lower left hand plot, say π0,t. Use the 45 degree line in the lower right hand portion to reﬂ
ect this inﬂation rate onto the horizontal axis. Then determine the real interest rate, given this inﬂation rate, from the MP curve in the upper right hand plot. Call this real interest rate r0,t. Then determine the level of output consistent with this real interest rate from the IS curve in the upper left hand plot. Call this Y0,t. We then have a combination (π0,t, Y0,t). Then consider higher or lower values of πt and repeat the exercise. We can graphically trace out a curve that is downward-sloping, and which we will continue to call the AD curve even though it is a slightly diﬀerent construct than the AD curve on which we focus in the text. 1042 𝑟𝑟𝑡𝑡 𝑟𝑟𝑡𝑡 𝑌𝑌𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝑌𝑌𝑡𝑡 𝐼𝐼𝐼𝐼 𝑟𝑟𝑡𝑡=𝑟𝑟̅𝑡𝑡+(𝜙𝜙𝜋𝜋−1)𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡=𝜋𝜋𝑡𝑡 𝑟𝑟̅𝑡𝑡 𝐴𝐴𝐴𝐴 𝜋𝜋0,𝑡𝑡 𝜋𝜋1,𝑡𝑡 𝜋𝜋2,𝑡𝑡 𝑌𝑌0,𝑡𝑡 𝑌𝑌2,𝑡𝑡 𝑌𝑌1,𝑡𝑡 𝑟𝑟0,𝑡𝑡 𝑟𝑟1,𝑡𝑡 �
��𝑟2,𝑡𝑡 Figure E.3: Shift of the AD Curve: Positive IS Shock The AD curve will shift if any of the exogenous variables in (E.4)-(E.7) were to change. Consider ﬁrst a change in some exogenous variable which causes the IS curve to shift (e.g. an increase in Gt or At+1, or a decrease in Gt+1). Holding the inﬂation rate ﬁxed means we can think of holding the real interest rate ﬁxed. This means that the level of output consistent with each possible inﬂation rate will increase. Hence, the AD curve will shift out horizontally to the right by an amount equal to the horizontal shift of the IS curve. This is qualitatively similar to how shifts of the IS curve aﬀect the AD curve when it is deﬁned based oﬀ the LM curve instead of the MP curve. Consider next a change in the exogenous component of the MP rule, ¯rt. Consider a decrease in this variable. A decrease in this variable shifts the MP curve down. Hence, for each possible inﬂation rate, the real interest rate will be lower. From the IS curve, this corresponds to higher output for each possible inﬂation rate. In other words, a reduction in ¯rt causes the AD curve to shift to the right. Again, this is conceptually similar to how the AD curve shifts when it is derived from the LM curve and an increase in Mt is considered. 1043 𝑟𝑟𝑡𝑡 𝑟𝑟𝑡𝑡 𝑌𝑌𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝑌𝑌𝑡𝑡 𝐼𝐼𝐼𝐼 𝑟𝑟𝑡𝑡=𝑟𝑟̅𝑡𝑡+(𝜙𝜙𝜋𝜋−1)𝜋𝜋𝑡�
� 𝜋𝜋𝑡𝑡=𝜋𝜋𝑡𝑡 𝑟𝑟̅𝑡𝑡 𝐴𝐴𝐴𝐴 𝜋𝜋0,𝑡𝑡 𝜋𝜋1,𝑡𝑡 𝜋𝜋2,𝑡𝑡 𝑌𝑌0,𝑡𝑡 𝑌𝑌2,𝑡𝑡 𝑌𝑌1,𝑡𝑡 𝑟𝑟0,𝑡𝑡 𝑟𝑟1,𝑡𝑡 𝑟𝑟2,𝑡𝑡 𝐼𝐼𝐼𝐼′ 𝐴𝐴𝐴𝐴′ 𝑌𝑌2,𝑡𝑡′ 𝑌𝑌0,𝑡𝑡′ 𝑌𝑌1,𝑡𝑡′ Figure E.4: Shift of the AD Curve: Reduction in ¯rt Finally, we pause to ask what impact the parameter φπ has on the AD curve. We maintain the assumption that φπ > 1. Figure E.5 considers two diﬀerent MP curves, one in which φπ is quite large (shown in green), and the other in which it is smaller (but nevertheless still above one). In drawing the graph, we adjust ¯rt for each speciﬁcation so that the MP curves cross at an inﬂation rate of π0,t. Then we proceed with the graphically derivation of the AD curve as we did above. When φπ is bigger, a given change in inﬂation results in a bigger change in the real interest rate, and hence a bigger movement in output. Output is thus more sensitive to the inﬂation rate, and as a consequence the AD curve is ﬂatter when φπ is bigger. 1044 𝑟𝑟𝑡𝑡 𝑟𝑟𝑡𝑡 𝑌�
��𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝑌𝑌𝑡𝑡 𝐼𝐼𝐼𝐼 𝑟𝑟𝑡𝑡=𝑟𝑟̅𝑡𝑡+(𝜙𝜙𝜋𝜋−1)𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡=𝜋𝜋𝑡𝑡 𝑟𝑟̅𝑡𝑡 𝐴𝐴𝐴𝐴 𝜋𝜋0,𝑡𝑡 𝜋𝜋1,𝑡𝑡 𝜋𝜋2,𝑡𝑡 𝑌𝑌0,𝑡𝑡 𝑌𝑌2,𝑡𝑡 𝑌𝑌1,𝑡𝑡 𝑟𝑟0,𝑡𝑡 𝑟𝑟1,𝑡𝑡 𝑟𝑟2,𝑡𝑡 𝑟𝑟̅𝑡𝑡′ 𝑟𝑟𝑡𝑡=𝑟𝑟̅𝑡𝑡′+(𝜙𝜙𝜋𝜋−1)𝜋𝜋𝑡𝑡 𝐴𝐴𝐴𝐴′ 𝑌𝑌1,𝑡𝑡′ 𝑌𝑌0,𝑡𝑡′ 𝑌𝑌2,𝑡𝑡′ 𝑟𝑟0,𝑡𝑡′ 𝑟𝑟1,𝑡𝑡′ 𝑟𝑟2,𝑡�
��′ Figure E.5: The AD Curve with the MP Curve: Role of φπ E.2 The Modiﬁed Supply Side We have shown how we can derive a curve showing a negative relationship between Yt and πt. We still call this curve the AD curve, even though it is a slightly diﬀerent construct than the AD curve presented in the text because it depends on the inﬂation rate, not the price level. The AD curve in this model is derived by combining the IS curve with the MP curve, which shows how the central bank adjusts the nominal (and hence the real, under the assumption of adaptive expectations) interest rate in response to changes in inﬂation. This AD curve explicitly incorporates endogenous monetary policy, whereas the AD curve derived in the text with the IS and LM curves treats monetary policy as exogenous. In this IS-MP-AD setup, we do not need to keep track of the money supply at all. What about the supply side of the model? Recall from Chapter 25 that the partial sticky price AS curve is given as follows: ¯Pt is the predetermined component of the price level, Y f t is the hypothetical neoclassical Pt = ¯Pt + γ(Yt − Y f t ) (E.8) 1045 𝑟𝑟𝑡𝑡 𝑟𝑟𝑡𝑡 𝑌𝑌𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝑌𝑌𝑡𝑡 𝐼𝐼𝐼𝐼 𝜋𝜋𝑡𝑡=𝜋𝜋𝑡𝑡 𝑟𝑟̅𝑡𝑡 𝐴𝐴𝐴𝐴 𝜋𝜋0,𝑡𝑡 𝜋𝜋1,𝑡𝑡 𝜋𝜋2,𝑡𝑡 𝑌𝑌0,𝑡𝑡=𝑌
𝑌0,𝑡𝑡′ 𝑌𝑌2,𝑡𝑡 𝑟𝑟0,𝑡𝑡=𝑟𝑟0,𝑡𝑡′ 𝑟𝑟1,𝑡𝑡 𝑟𝑟2,𝑡𝑡 𝑀𝑀𝑀𝑀 (𝜙𝜙𝜋𝜋 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠) 𝑀𝑀𝑀𝑀 (𝜙𝜙𝜋𝜋 𝑠𝑠𝑠𝑠𝑟𝑟𝑙𝑙𝑙𝑙) 𝑟𝑟1,𝑡𝑡′ 𝑟𝑟2,𝑡𝑡′ 𝑟𝑟̅𝑡𝑡′ 𝐴𝐴𝐴𝐴′ 𝑌𝑌2,𝑡𝑡′ 𝑌𝑌1,𝑡𝑡′ 𝑌𝑌1,𝑡𝑡 equilibrium level of output, and γ ≥ 0 is a parameter governing the degree of price stickiness. This speciﬁcations nests two special cases. When γ = 0 we have the simple sticky price model, whereas when γ → ∞ we have the neoclassical model. As we did in Chapter 25 when introducing the notion of the Phillips Curve, subtract the lagged price level, Pt−1, from both sides of (E.8): Pt − Pt−1 = ¯Pt − Pt−1 + γ(Yt − Y f t ) (E.9) If we normalize Pt−1 = 1, we can treat the change in the price level as the same thing as the percentage change in the price level. This means we can write Pt − Pt−1 = πt. Deﬁne = ¯Pt − Pt−1, and think of this as the expected rate of in�
��ation between t − 1 and t. We will πe t treat this as exogenous. Then we can write the AS curve as: πt = πe t + γ(Yt − Y f t ) (E.10) (E.10) is simply the expectations augmented Phillips Curve introduced in Chapter 25. It is our representation of the supply side of the model, and is essentially identical to what is presented in the text, except that it is written in terms of inﬂation rates rather than price levels. Formally, the equations characterizing the supply side of the model are given below: Nt = N s(wt, θt) Yt = AtF (Kt, Nt) (E.11) (E.12) (E.11)-(E.12), along with (E.10), describe the supply-side of the model. Y f t is determined as the solution to the following equations: N f t = N s(wf t, θt) N f t = N d(wf t, At, Kt) Y f t = AtF (Kt, N f t ) (E.13) (E.14) (E.15) Graphically, the supply side of the model can be characterized as we have done before with a four part graph. In the upper left quadrant we plot the labor market. Only the labor supply curve is directly relevant for the determination of output, but we draw in a hypothetical labor demand curve (in orange) because the intersection of hypothetical labor demand with labor supply determines Y f t. The production function is plotted in the lower left corner. In the southeast corner, we plot a 45 degree line to reﬂect Yt onto the horizontal axis. In the upper right quadrant we plot the AS curve. The AS curve crosses through the 1046 t t, Y f ). Y f t point (πe is determined by combining the level of labor input where labor demand and supply would cross with the production function, and is denoted with a vertical orange line labeled ASf. Other than the fact that πt replaces Pt on the vertical axis, this is exactly the same graphically apparatus as in Chapter 25. Figure E.6: Supply Side of the Model E.3 The IS-MP-AD-AS Model The full equilibrium of the IS-MP-AD-AS model is summarized by the
following equations: Ct = C d(Yt − Gt, Yt+1 − Gt+1, rt) Nt = N s(wt, θt) πt = πe t + γ(Yt − Y f t ) It = I d(rt, At+1Kt) Yt = AtF (Kt, Nt) Yt = Ct + It + Gt rt = ¯rt + (φπ − 1)πt 1047 (E.16) (E.17) (E.18) (E.19) (E.20) (E.21) (E.22) 𝑤𝑤𝑡𝑡 𝜋𝜋𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡=𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝑁𝑁𝑠𝑠(𝑤𝑤𝑡𝑡,𝜃𝜃𝑡𝑡) 𝑌𝑌𝑡𝑡𝑓𝑓 𝜋𝜋𝑡𝑡𝑒𝑒 𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝑓𝑓 rt = it − πt (E.23) These are
the same as in Chapter 26 with three exceptions. First, we replace money demand with the MP rule, (E.22). Second, we write the AS curve in terms of πt instead of Pt. Third, instead of treating expected inﬂation between t and t + 1, πe t+1, as exogenous, we replace this with an assumption of adaptive expectations, which is reﬂected in the Fisher relationship, (E.23). The endogenous variables are Yt, Ct, It, Nt, wt, πt, rt, and it. The exogenous variables are Gt, Gt+1, At+1, Kt, πe t, and ¯rt. We do not worry about Mt, though given the determination of Yt and rt, we could solve for Mt by including a money demand equation. We can graphically summarize the equilibrium with the seven part graph shown below, which simply combines the supply and demand graphs presented above: 1048 Figure E.7: The IS-MP-AD-AS Equilibrium E.3.1 The Eﬀects of Shocks in the IS-MP-AD-AS Model As before, we can consider the eﬀects of changes in exogenous variables on the equilibrium of the model. Consider ﬁrst a shock which causes the IS curve to shift out to the right. This is shown below in Figure E.8: 1049 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝑟𝑟𝑡𝑡 𝑟𝑟𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝑤𝑤𝑡𝑡 𝐼𝐼𝐼𝐼 𝑀�
��𝑀𝑀 𝐴𝐴𝐴𝐴 𝜋𝜋𝑡𝑡=𝜋𝜋𝑡𝑡 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡=𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑁𝑁𝑠𝑠(𝑤𝑤𝑡𝑡,𝜃𝜃𝑡𝑡) 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝑤𝑤0,𝑡𝑡 𝐴𝐴𝐼𝐼 𝑁𝑁0,𝑡𝑡 𝑌𝑌0,𝑡𝑡=𝑌𝑌0,𝑡𝑡𝑓𝑓 𝜋𝜋0,𝑡𝑡 𝑟𝑟0,𝑡𝑡 𝐴𝐴𝐼𝐼𝑓𝑓 Original equilibrium Hypothetical neoclassical equilibrium Figure E.8: Positive IS Shock The rightward shift of the IS curve causes the AD curve to shift to the right. In equilibrium, output and inﬂation both rise. The higher inﬂation results in the central bank raising the real interest from the MP curve, which results in a movement up along the new IS curve so that output increases in equilibrium by less than the rightward shift of the IS curve. This is conceptually similar to how a change in Pt causes the LM curve to shift after an IS shock. To support higher output, labor input must increase. To convince workers to worker more, the real wage must rise. 1050 𝜋𝜋𝑡𝑡
𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝑟𝑟𝑡𝑡 𝑟𝑟𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝑤𝑤𝑡𝑡 𝐼𝐼𝐼𝐼 𝑀𝑀𝑀𝑀 𝐴𝐴𝐴𝐴 𝜋𝜋𝑡𝑡=𝜋𝜋𝑡𝑡 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡=𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑁𝑁𝑠𝑠(𝑤𝑤𝑡𝑡,𝜃𝜃𝑡𝑡) 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝑤𝑤0,𝑡𝑡 𝐴𝐴𝐼𝐼 𝑁𝑁0,𝑡𝑡 𝑌𝑌0,𝑡𝑡=𝑌𝑌0,𝑡𝑡𝑓𝑓 𝜋𝜋0,𝑡𝑡 𝑟�
�0,𝑡𝑡 𝐴𝐴𝐼𝐼𝑓𝑓 Original equilibrium Hypothetical neoclassical equilibrium 𝐼𝐼𝐼𝐼′ 𝐴𝐴𝐴𝐴′ 𝑟𝑟1,𝑡𝑡 𝜋𝜋1,𝑡𝑡 𝑤𝑤1,𝑡𝑡 𝑁𝑁1,𝑡𝑡 𝑌𝑌1,𝑡𝑡 Post-shock Post-shock, hypothetical neoclassical 0 subscripts: original equilibrium 1 subscripts: post-shock equilibrium Consider next an exogenous shock to monetary policy, represented as an increase in ¯rt. This is shown in Figure E.9: Figure E.9: Increase in ¯rt The increase in ¯rt causes the MP curve to shift up, which results in the AD curve shifting in. The inward shift of the AD curve results in output and inﬂation both falling. The fall in inﬂation partially oﬀsets the exogenous increase in ¯rt, so that the real interest rate rises by less, and output falls by less, than it would if the inﬂation rate were held ﬁxed. Lower output 1051 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝑟𝑟𝑡𝑡 𝑟𝑟𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝑤𝑤𝑡𝑡 𝐼𝐼𝐼𝐼 𝑀𝑀𝑀𝑀
𝐴𝐴𝐴𝐴 𝜋𝜋𝑡𝑡=𝜋𝜋𝑡𝑡 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡=𝐴𝐴𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑁𝑁𝑠𝑠(𝑤𝑤𝑡𝑡,𝜃𝜃𝑡𝑡) 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴𝑡𝑡,𝐾𝐾𝑡𝑡) 𝑤𝑤0,𝑡𝑡 𝐴𝐴𝐼𝐼 𝑁𝑁0,𝑡𝑡 𝑌𝑌0,𝑡𝑡=𝑌𝑌0,𝑡𝑡𝑓𝑓 𝜋𝜋0,𝑡𝑡 𝑟𝑟0,𝑡𝑡 𝐴𝐴𝐼𝐼𝑓𝑓 Original equilibrium Hypothetical neoclassical equilibrium 𝑀𝑀𝑀𝑀′ 𝑟𝑟1,𝑡𝑡 𝜋𝜋1,𝑡𝑡 𝐴𝐴𝐴𝐴′ 𝑤𝑤1,𝑡𝑡 𝑁𝑁1,𝑡𝑡 𝑌𝑌1,𝑡𝑡 Post-shock Post-shock, hypothetical neoclassical 0 subscripts: original equilibrium 1 subscripts: post-shock equilibrium necessitates lower labor input, which requires a lower real wage. Next consider an increase in At, the eﬀects of which
are depicted in Figure E.10: Figure E.10: Increase in At There is no direct eﬀect on the demand side of the model. To ﬁgure out how the AS curve shifts, we need to determine how Y f t changes. To do so we note that the hypothetical labor demand curve would shift right. Along a stable labor supply curve, in the neoclassical model this would result in higher labor input. Combined with the upward shift of the production 1052 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝜋𝜋𝑡𝑡 𝑟𝑟𝑡𝑡 𝑟𝑟𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡 𝑁𝑁𝑡𝑡 𝑁𝑁𝑡𝑡 𝑤𝑤𝑡𝑡 𝐼𝐼𝐼𝐼 𝑀𝑀𝑀𝑀 𝐴𝐴𝐴𝐴 𝜋𝜋𝑡𝑡=𝜋𝜋𝑡𝑡 𝑌𝑌𝑡𝑡=𝑌𝑌𝑡𝑡 𝑌𝑌𝑡𝑡=𝐴𝐴0,𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝑁𝑁𝑠𝑠(𝑤𝑤𝑡𝑡,𝜃𝜃𝑡𝑡) 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴0,
𝑡𝑡,𝐾𝐾𝑡𝑡) 𝑤𝑤0,𝑡𝑡 𝐴𝐴𝐼𝐼 𝑁𝑁0,𝑡𝑡 𝑌𝑌0,𝑡𝑡=𝑌𝑌0,𝑡𝑡𝑓𝑓 𝜋𝜋0,𝑡𝑡 𝑟𝑟0,𝑡𝑡 𝐴𝐴𝐼𝐼𝑓𝑓 Original equilibrium Hypothetical neoclassical equilibrium 𝑁𝑁𝑑𝑑(𝑤𝑤𝑡𝑡,𝐴𝐴1,𝑡𝑡,𝐾𝐾𝑡𝑡) 𝑌𝑌𝑡𝑡=𝐴𝐴1,𝑡𝑡𝐹𝐹(𝐾𝐾𝑡𝑡,𝑁𝑁𝑡𝑡) 𝐴𝐴𝐼𝐼𝑓𝑓′ 𝐴𝐴𝐼𝐼′ 𝑟𝑟1,𝑡𝑡 𝜋𝜋1,𝑡𝑡 𝑁𝑁1,𝑡𝑡 𝑤𝑤1,𝑡𝑡 𝑌𝑌1,𝑡𝑡 𝑌𝑌1,𝑡𝑡𝑓𝑓 Post-shock Post-shock, hypothetical neoclassical 0 subscripts: original equilibrium 1 subscripts: post-shock equilibrium increases. The increase in Y f function, this means that Y f t causes the AS curve to shift t out to the right. In equilibrium, this results in an increase in output and a reduction in inﬂation. The reduction in inﬂation causes the central bank to lower the real interest rate from the MP curve, which results in a movement down along the IS curve consistent with the
new equilibrium level of output. Once the new equilibrium level of output is determined by the intersection of the new AS curve with the AD curve, labor market variables can be determined. As in the partial sticky price model presented in the main text, we can determine how Nt and wt react (i.e. whether they go up or down). In the graph, it is shown where both variables increase slightly. We can determine that both Nt and wt increase less than they would if prices were ﬂexible (i.e. if the AS curve were vertical). Depending on the relative slopes of the AD and AS curves, Nt and wt could both fall, could both rise, or could both be unchanged. We leave a graphical analysis of the eﬀects of changes in πe t and θt as exercises. We simply note that the equilibrium eﬀects of these exogenous shocks are qualitatively similar to the IS-LM-AD-AS model in the text. Indeed, the equilibrium eﬀects in both the IS-LM-AD-AS and IS-MP-AD-AS models are very similar to one another for all shocks. We do not study dynamic transitions from short run to medium run in this appendix. The dynamics are similar to the IS-LM-AD-AS model. If Yt ≠ Y f in the short run, then πt ≠ πe t. As time moves t forward, this triggers changes in πe t which shift the AS curve so as to restore the hypothetical neoclassical equilibrium in the medium run. We conclude this appendix by brieﬂy discussing optimal monetary policy in the context of the IS-MP-AD-AS model. In Chapter 28, we noted how we could think about optimal monetary policy in the IS-LM-AD-AS model as adjusting Mt in response to shocks so as to t. For shocks other than changes in ¯Pt, this implies stabilizing the price level target Yt = Y f and allows one to think about an “eﬀective AD” curve that is perfectly horizontal. Something very similar holds in the IS-MP-AD-AS model, though it is perhaps more transparent than in the model presented in the text. In particular, as noted above we can think about the central bank eﬀectively determining the slope of the AD curve through its choice of the parameter
φπ. As φπ gets bigger, the AD curve gets ﬂatter, as shown above in Figure E.5. In the limiting case, as φπ → ∞, the AD curve becomes completely horizontal. With a horizontal AD curve, shocks to the IS curve will not impact output, and shocks to Y f t will result in output moving by the same amount. We say that a central bank following an MP rule with a very large φπ is following a strict inﬂation target. This is the optimal rule to follow provided that exogenous shocks to πe t are not very important. 1053college level textbook. The impetus for this project was the recognition that, while any college level introductory textbook can be adapted for use in an AP Economics course, no existing textbook is sufficient for the task. The existing textbooks cover large amounts of material that is not included on the AP Course Outline and omit important topics that are on the Outline. Teachers using existing textbooks must navigate around unnecessary chapters, cover chapters with some relevant topics but lots of superfluous information, and search for supplementary materials to cover topics not addressed in the text. These problems hinder the effectiveness of standard textbooks and make extra work for both teachers and students. While some other college level books have been printed as “AP Editions,” the changes in those editions are little more than new labels and covers. This book is different. It is made specifically to satisfy the goals of the AP Economics teacher and student. Intent on promoting the efficiency and effectiveness of AP Economics courses, we started with the best available college-level introduction to economics–Krugman and Wells’ Economics, second edition. The first edition of the Krugman and Wells textbook was a resounding success, quickly becoming one of the best-selling college economics textbooks. AP Economics teachers embraced the textbook for its clear explanations and storytelling approach. The second edition of Economics became even more popular and successful. We knew that it would be the best foundation for an AP adaptation. Our goal was to retain the features of Economics that make it a winner, while crafting it to closely follow the AP syllabus and speak to a high school audience. We hope the result will serve as the best possible textbook for teaching and learning AP Economics. xxii The Organization of This Book and How to Use It The organization of this book is inspired by our goal of adapting the parent book to best support AP Economics teachers and students. The sequence of sections and modules conforms to both
the AP Topic Outline and a traditional sequence of material that has been found to be pedagogically effective. The sections and modules are grouped into building blocks in which conceptual material learned at one stage is built upon and then integrated into the conceptual material covered in the next stage. All material included in the AP Economics Course Description is included here, and all material included here is related to AP course requirements. Following is a walkthrough of the sections in the book: Note: The material covered in sections 1 and 2 is found on both the AP Macroeconomics and the AP Micro economics Topic Outlines Section 1: Basic Economic Concepts The first section initiates students into the study of economics, including scarcity, choice and opportunity cost. Module 1 provides students with definitions of basic terms in economics. Module 2 provides an overview of the study of macroeconomics, including economic growth, unemployment, inflation, and the business cycle. Modules 3 and 4 present the production possibilities curve model and use it to explain comparative and absolute advantage, specialization and exchange. Section 2: Supply and Demand Section 2 begins with an opening story that uses the market for coffee beans to illustrate supply and demand, market equilibrium, and surplus and shortage. Modules 5, 6, and 7 introduce the important parts of the supply and demand model; demand, supply, and equilibrium. Module 8 and 9 teach students how to use the model to analyze price and quantity in markets. Macroeconomics Sections 3–8 cover the material found exclusively on the AP Macroeconomics Topic Outline. Section 3: Measurement of Economic Performance In Section 3, we provide an overview of the topics in macroeconomics that provides the foundation for models that are covered in later sections. Modules 10 and 11 introduce the circular flow model and gross domestic product. Modules 12 and 13 teach students how to define, measure, and categorize the types of unemployment. The definition and measurement of inflation, price indices (real versus nominal values), and the costs of inflation are presented in Modules 14 and 15. Section 4: National Income and Price Determination Section 4 introduces national income and price determination and presents the aggregate supply and demand model, which is the foundation for the material presented in later sections. Modules 16, 17, 18, and 19 introduce individual parts for the model; income and expenditures, aggregate demand, aggregate supply, and equilibrium in the model. Macreoconomics equilibrium and economics fluctuations (including fiscal policy and the multiplier) are presented in Modules 20 and 21. Section 5: Financial
Sector In Section 5, money, banks, and the Federal Reserve are added to our model of the macroeconomy. Modules 22, 23, and 24 present basic concepts and their definitions; saving, investment, financial assets, money, the money supply, and the time value of money. Module 25 introduces banking and the creation of money in the economy. Central banks and the Federal Reserve System are included in Modules 26 and 27. Finally, the money market and monetary policy, including the loanable funds market, are presented in Modules 28 and 29. Section 6: Inflation, Unemployment and Stabilization Policies Section 6 continues with coverage of monetary and fiscal policies. Module 30 focuses on fiscal policy and the implications of government deficits and debt. Module 31 focuses on monetary policy and its effect on the interest rate. Modules 32 and 33 look in detail at the types of inflation, disinflation, and deflation, while Module 34 introduces both the short-run and long-run Phillips curve. Finally, Modules 35 and 36 present some history of macroeconomic thought as it leads to the modern macroeconomic consensus, emphasizing the role of expectations in macroeconomic policy. research and development, and technology lead to differences in long-run economic growth and how growth policy can be used to facilitate economic growth in the long run. Finally, Module 40 reviews and highlights how economic growth plays a role in the macroeconomic models developed in earlier sections. Section 8: Open Economy: International Trade and Finance Section 8 adds the international sector to the macreconomic models presented in previous sections. Module 41 introduces balance of payments accounts. Modules 42 and 43 develop the foreign exchange market and exchange rate policy. Module 44 links the foreign exchange market to financial markets and the markets for goods and services through a discussion of exchange rates and macroeconomic policy. Module 45 Module 45 shows students how the models they have studied throughout the course can be applied to answer real-world questions, like the type they will see on the AP exam. Microeconomics Section 9 begins coverage of the material exclusive to the AP Microeconomics Topic Outline. The first section of the AP Microeconomics Topic Outline, “Nature and Function of Product Markets,” is quite large, representing 55–75% of the course material. We break this material into five sections: 2, 9, 10, 11, and 12. Section 9: Behind the Demand Curve: Consumer Choice This section looks more closely at topics related to the demand curve. Module 46 explains how the
income and substitution effects relate to a downward sloping demand curve and presents the concept of elasticity. Module 47 is devoted to developing price elasticity while Module 48 explains three additional elasticity measures important in economics. Consumer and producer surplus are presented in Modules 49 and 50 and are used to explain deadweight loss. Finally, Module 51 presents consumer theory and utility maximization. Section 7: Economic Growth and Productivity Economic growth and the role of productivity are the focus in Section 7. Module 37 defines and discusses longrun economic growth and Module 38 emphasizes the role of productivity in generating economic growth. Module 39 looks at how differences in human and physical capital, Section 10: Behind the Supply Curve: Profit, Production, and Costs Section 10 shifts to a more detailed discussion of the supply curve. This section introduces the production and cost concepts used throughout the following sections. The section begins with a discussion of profit and profit P R E F A C E xxiii Preface Preface maximization in Modules 52 and 53. Module 54 develops the production function. Modules 55 and 56 introduce cost concepts, both short-run and long-run. The last module provides an introduction to the market structures covered in Sections 11 and 12. Section 11: Market Structures: Perfect Competition and Monopoly Section 11 presents the perfect competition and monopoly market structures. Modules 58-60 present perfect competition. Modules 58 and 59 develop the perfect competition model and graphs. Module 60 presents the long-run outcomes under perfect competition. Modules 61–63 present the monopoly market structure. Module 61 develops the basic monopoly model. Module 62 presents public policies toward monopoly and Module 63 explains the practice of price discrimination. Section 12: Market Structures: Imperfect Competition This section introduces the imperfectly competitive market structures: oligopoly and monopolistic competition. Module 64 introduces oligopoly and Module 66 discusses oligopoly market structures in the real world. Game theory as it relates to oligopoly is given special attention in Module 65. Module 67 explains monopolistic competition. Module 68 covers product differentiation under monopolistic competition with special focus on the role of advertising. Section 13: Factor Markets This section begins with Module 69, an introduction to factor markets and factor demand. Modules 70 and 71 present the markets for land, capital, and labor. Module 72 explains how to find the cost-minimizing combination of inputs. The last module in the section discusses the marginal productivity theory of income distribution and various sources of wage differentials. Section 14: Market Failure and the Role of
Government This section focuses on the conditions under which markets fail and explains public and private approaches to market failure. Modules 74 and 75 discuss externalities and the public policies and private remedies available to address them. Module 76 covers public goods. Module 77 presents the use of antitrust law and government regulation to promote competition. Module 78 explains theories of income distribution and income inequality. The appendix to Section 14 provides enrichment modules. While not currently part of the material on the AP xxiv P R E F A C E Topic Outline, these modules contain extensions of the material presented in AP courses. They provide enrichment materials for advanced students or for coverage after the AP exam. This material may also be considered for inclusion on the AP Topic Outline in the future. Module 79 presents the economics of information, including adverse selection and moral hazard. Module 80 discusses indifference curves and consumer choice, an extension of the material in Module 51. The AP Edition: What’s Different? Perhaps the most important feature of the AP adaptation of Economics is what has been left unchanged. We retain Paul Krugman’s fresh voice and lively writing style, which AP students find easy to understand. We also adhere to the general approach of the parent book: “To achieve deeper levels of understanding of the real world through economics, students must learn to appreciate the kinds of trade-offs and ambiguities that economists and policy makers face when applying their models to real-world problems. We believe this approach will make students more insightful and more effective participants in our common economic, social, and political lives.” Finally, we have been careful to maintain the international focus and global coverage of issues from Economics, 2e. However, we have made significant changes in the original book to meet the specific needs of AP Economics teachers and students. Here are the major adaptations: Close Adherence to the AP Topic Outline and Terminology We have carefully followed the AP Topic Outlines for Macroeconomics and Microeconomics and included all of the material required for the course. The book covers the course material using the same terminology students will see on the AP Economics Exam. When there is more than one term that can be used in a particular situation, we have introduced students to each of the terms they might see on the exam and made it clear that the terms are synonymous. Because it closely conforms to the required course material and introduces AP exam terminology, this book helps students learn the material and terminology they will see on their AP Economics Exam. AP Course-friendly Organization This book is arranged
by sections that correspond to the AP Topic Outline provided by the College Board. Each section is divided into 4–7 modules. Each module breaks the course material into a pedagogically appropriate unit that is designed to be presented in one class period, with additional class periods for activities, demonstrations, and reinforcement, as needed. This organization takes teachers and students through the required AP course material in a sequence and at a pace designed for optimal success for students in AP economics classes. Relevant Examples The Krugman and Wells textbook was lauded for its use of relevant and interesting examples to teach economic principles. We have retained this approach and many of the examples from the parent book. However, we have modified, added, or replaced examples to speak specifically to a high school audience. Practice for the AP Exam Each module in the book ends with AP review material including sample multiple-choice and free-response questions related to the content in the module. The multiplechoice questions are written in the style of the AP exam with five distracters. Two sample free-response questions are included for each module, the first of which includes a sample grading rubric. Providing the rubric helps students to prepare for the format of the AP exam and to better understand how their responses will be graded (which will help them to provide better responses on the exam). In addition, Module 45 “Putting it All Together” is devoted to showing students how to use the economic principles they have learned in macroeconomics to answer comprehensive questions like the long question typically found on the AP Eco nom ics Exams. Supplements The teacher and student supplements have been designed by experts in AP economics to facilitate teaching and learning. The instructor’s resources are comprehensive enough to guide new AP teachers through their first years of teaching AP economics but also provide unique ideas and suggestions that will help experienced teachers enhance their courses. The student’s resources help students through both the course and preparation for the AP exam. All supplement materials are developed to adhere to the AP course outline, goals, and testing format. Economics by Example David Anderson’s Economics by Example has become a leading supplemental resource for AP economics courses. Each book is bundled with a copy of the Anderson book, and suggestions for how to use it in an AP economics course are integrated throughout the text and the instructor materials. Advantages of This Book This book has all of the advantages found in the parent book as well as many new advantages unique to the AP adaptation: ➤ Created by a Team with Insight. The
team of authors for this project has a wealth of experience with AP economics. This book is the result of extensive collaboration within the team as well as incredible support from highly qualified AP content reviewers and accuracy checkers at all points along the way. ➤ Created Specifically to Meet the Needs of AP Economics Teachers and Students. From the Table of Contents through the supplements, this project is specifically designed to meet the needs of AP teachers and students. The outline of the book follows the AP topic outline, the terminology in the book conforms to accepted terminology used in AP materials and on the AP exam, and supplements provide everything new or experienced teachers and students need to be sucessful in an AP economics course. ➤ Chapters build intuition through realistic examples. In every chapter, real-world examples, stories, applications, and case studies teach the core concepts and motivate student learning. The best way to introduce concepts and reinforce them is through realworld examples; students simply relate more easily to them. ➤ Pedagogical features reinforce learning. The book includes a genuinely helpful set of features that are illustrated and described later in the Preface. ➤ Modules are accessible and entertaining. A fluid and friendly writing style makes concepts accessible. Whenever possible, the book uses examples that are familiar to students: choosing which college to attend, paying a high price for a cup of coffee, or deciding where to eat at the food court at the local shopping mall. ➤ Although easy to understand, the book also prepares students for the AP exam and further coursework. Too often, instructors find that selecting a textbook means choosing between two unappealing alternatives: a textbook that is “easy to teach” but leaves major gaps in students’ understanding, or a textbook that is “hard to teach” but adequately prepares students for the AP exam and future coursework. This is an easy-to-understand textbook that offers the best of both worlds. P R E F A C E xxv Preface Tools for Learning...Getting the Most from This Book Each section and its modules are structured around a common set of features designed to help students learn while keeping them engaged. s e c t i o n Module 16 Income and Expenditure Module 17 Aggregate Demand: Introduction and Determinants Module 18 Aggregate Supply: Introduction and Determinants Module 19 Equilibrium in the Aggregate Demand–Aggregate Supply Model Module 20 Economic Policy and the Aggregate Demand–Aggregate Supply Model Module 21 Fiscal Policy and the Multi
plier Economics by Example: “How Much Debt Is Too Much?” 4 National Income and Price Determination The section outline lists the modules that comprise the section and suggests a relevant chapter in Dave Anderson’s book, Economics by Example, which is packaged with this text. F R O M B O O M TO B U S T Ft. Myers, Florida, was a boom town in 2003, 2004, and most of 2005. Jobs were plentiful: by 2005 the unemployment rate was less than 3%. The shopping malls were humming, and new stores were opening everywhere. But then the boom went bust. Jobs became scarce, and by 2009 the unemployment rate had reached 14%. Stores had few customers, and many were closing. One new business was flourishing, however. Marc Joseph, a real estate agent, began offering “foreclosure tours”: visits to homes that had been seized by banks after the owners were unable to make mortgage payments. What happened? Ft. Myers boomed from 2003 to 2005 because of a surge in home construction, fueled in part by speculators who bought houses not to live in, but because they believed they could resell those houses at much higher prices. Home construction gave jobs to construction workers, electricians, real estate agents, and others. And these workers, in turn, spent money locally, creating jobs for sales workers, waiters, gardeners, pool cleaners, and more. These workers also spent money locally, creating further expansion, and so on. The boom turned into a bust when home construction came to a virtual halt. It turned out that speculation had been feeding on itself: people were buying houses as investments, then selling them to other people who were also buying houses as investments, and the prices had risen to levels far beyond what people who actually wanted to live in houses were willing to pay The abrupt collapse of the housing market pulled the local economy down with it, as the process that had created the earlier boom operated in reverse. The boom and bust in Ft. Myers illustrates, on a small scale, the way booms and busts often happen for the economy as a whole. The business cycle is often driven by ups or downs in investment spending—either residential investment spending (that is, spending on home construction) or nonresidential investment spending (such as spending on construction of office buildings, factories, and shopping malls). Changes in investment spending, in turn, indirectly lead to changes in consumer spending, which magnify—or multiply—the effect of the investment
spending changes on the economy as a whole. In this section we’ll study how this process works on a grand scale. As a first step, we introduce multiplier analysis and show how it helps us understand the business cycle. In Module 17 we explain aggregate demand and its two most important components, consumer spending and investment spending. Module 18 introduces aggregate supply, the other half of the model used to analyze economic fluctuations. We will then be ready to explore how aggregate supply and aggregate demand determine the levels of prices and real output in an economy. Finally, we will use the aggregate demandaggregate supply model to visualize the state of the economy and examine the effects of economic policy. 157 Opening Story Each section opens with a compelling story that often extends through the modules. The opening stories are designed to illustrate important concepts, to build intuition with realistic examples, and then to encourage students to read on and learn more. xxvi P R E F A C E What You Will Learn in This Module Each module has an easy-to-review bulleted list format that alerts students to critical concepts and module objectives. Key Terms Every key term is defined in the text and then again in the margin, making it easier for students to study and review important vocabulary. f y i The Great Tortilla Crisis “Thousands in Mexico City protest rising food prices.” So read a recent headline in the New York Times. Speciﬁcally, the demonstrators were protesting a sharp rise in the price of tortillas, a staple food of Mexico’s poor, which had gone from 25 cents a pound to between 35 and 45 cents a pound in just a few months. Why were tortilla prices soaring? It was a classic example of what happens to equilibrium prices when supply falls. Tortillas are made from corn; much of Mexico’s corn is imported from the United States, with the price of corn in both countries basically set in the U.S. corn market. And U.S. corn prices were rising rapidly thanks to surging demand in a new market: the market for ethanol. What you will learn in this Module: • How scarcity and choice are central to the study of economics • The importance of opportunity cost in individual choice and decision making • The difference between positive economics and normative economics • When economists agree and why they sometimes disagree • What makes macroeconomics different from microeconomics Economics is the study of scarcity and choice. Individual choice is decisions by individuals about what to do, which necessarily involve decisions about what not to
do. An economy is a system for coordinating a society’s productive and consumptive activities. In a market economy, the decisions of individual producers and consumers largely determine what, how, and for whom to produce, with little government involvement in the decisions. Module 1 The Study of Economics Individual Choice: The Core of Economics Economics is the study of scarcity and choice. Every economic issue involves, at its most basic level, individual choice—decisions by individuals about what to do and what not to do. In fact, you might say that it isn’t economics if it isn’t about choice. Step into a big store such as Walmart or Target. There are thousands of different products available, and it is extremely unlikely that you—or anyone else—could afford to buy everything you might want to have. And anyway, there’s only so much space in your room. Given the limitations on your budget and your living space, you must choose which products to buy and which to leave on the shelf. The fact that those products are on the shelf in the first place involves choice—the store manager chose to put them there, and the manufacturers of the products chose to produce them. The economy is a system that coordinates choices about production with choices about consumption, and distributes goods and services to the people who want them. The United States has a market economy, in which production and consumption are the result of decentralized decisions by many firms and individuals. There is no central authority telling people what to produce or where to ship it. Each individual producer makes what he or she thinks will be most profitable, and each consumer buys what he or she chooses. All economic activities involve individual choice. Let’s take a closer look at what this means for the study of economics. Resources Are Scarce You can’t always get what you want. Almost everyone would like to have a beautiful house in a great location (and help with the housecleaning), two or three luxury cars, and frequent vacations in fancy hotels. But even in a rich country like the United States, not many families can afford all of that. So they must make choices—whether to go to Disney World this year or buy a better car, whether to make do with a small backyard or accept a longer commute in order to live where land is cheaper Ethanol’s big break came with the Energy Policy Act of 2005, which mandated the use of a large quantity of “renewable” fuels starting in 2006, and rising
steadily thereafter. In practice, that meant increased use of ethanol. Ethanol producers rushed to build new production facilities and quickly began buying lots of corn. The result was a rightward shift of the demand curve for corn, leading to a sharp rise in the price of corn. And since corn is an input in the production of tortillas, a sharp rise in the price of corn led to a fall in the supply of tortillas and higher prices for tortilla consumers. The increase in the price of corn was good news in Iowa, where farmers began planting cook prepares tortillas made with four different types of corn in a restaurant in Mexico City. more corn than ever before. But it was bad news for Mexican consumers, who found themselves paying more for their tortillas. FYI The FYI feature provides a short but compelling application of the major concept just covered in a module. Students experience an immediate payoff when they can apply concepts they’ve just read about to real phenomena. For example, we use the tortilla crisis of 2007 to illustrate how changes in supply impact consumers as bread-and-butter (and tortilla) issues. P R E F A C E xxvii Preface Engaging examples provide a context for important concepts s e c t i o n Module 5 Supply and Demand: Introduction and Demand Module 6 Supply and Demand: Supply and Equilibrium Module 7 Supply and Demand: Changes in Supply and Demand Module 8 Supply and Demand: Price Controls (Ceilings and Floors) Module 9 Supply and Demand: Quantity Controls Economics by Example: “The Coffee Market’s Hot; Why Are Bean Prices Not?” 2 Supply and Demand For those who need a cappuccino, mocha latte, or Frappuccino to get through the day, coffee drinking can become an expensive habit. And on October 6, 2006, the habit got a little more expensive. On that day, Starbucks raised its drink prices for the first time in six years. The average price of coffee beverages at the world’s leading chain of coffeehouses rose about 11 cents per cup. Starbucks had kept its prices unchanged for six years. So what compelled them to finally raise their prices in the fall of 2006? Mainly the fact that the cost of a major ingredient—coffee beans—had gone up significantly. In fact, coffee bean prices doubled between 2002 and 2006. Who decided to raise the prices of coffee beans? Nobody: prices went up because of events outside anyone’s control
. Specifically, the main cause of rising bean prices was a significant decrease in the supply of coffee beans from the world’s two leading coffee exporters: Brazil and Vietnam. In Brazil, the decrease in supply was a delayed reaction to low prices earlier in the decade, which led coffee growers to cut back on planting. In Vietnam, the problem was weather: a prolonged drought sharply reduced coffee harvests. And a lower supply of coffee beans from Vietnam or Brazil inevitably translates into a higher price of coffee on Main Street. It’s just a matter of supply and demand. What do we mean by that? Many people use “supply and demand” as a sort of catchphrase to mean “the laws of the marketplace at work.” To economists, however, the concept of supply and demand has a precise meaning: it is a model of how a market behaves. In this section, we lay out the pieces that make up the supply and demand model, put them together, and show how this model can be used to understand how many—but not all—markets behave. 47 Section 2 uses the supply of coffee beans and the price of coffee at the local Starbucks to teach the supply and demand model xxviii P R E F A C E Clearly labeled graphs help to explain complex ideas f i g u r e 5.3 A Movement Along the Demand Curve Versus a Shift of the Demand Curve The rise in the quantity demanded when going from point A to point B reflects a movement along the demand curve: it is the result of a fall in the price of the good. The rise in the quantity demanded when going from point A to point C reflects a change in demand: this shift to the right is the result of a rise in the quantity demanded at Figure 5.3 shows the any given price. difference between movement along the demand curve and a shift in demand, providing a clear presentation of a difficult topic. Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 A shift of the demand curve... A C B... is not the same thing as a movement along the demand curve. D1 D2 0 7 8.1 9.7 10 15 13 Quantity of coffee beans (billions of pounds) 17 f i g u r e 6.3 Figure 6.3 in the following module illustrates the same concept for the supply curve Movement Along the Supply Curve Versus Shift of
the Supply Curve The increase in quantity supplied when going from point A to point B reflects a movement along the supply curve: it is the result of a rise in the price of the good. The increase in quantity supplied when going from point A to point C reflects a change in supply: this shift to the right is the result of an increase in the quantity supplied at any given price. Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 S1 S2 A movement along the supply curve... B A C... is not the same thing as a shift of the supply curve. Color is used consistently to distinguish between demand (blue) and supply (red) curves. 0 7 10 11.2 12 15 17 Quantity of coffee beans (billions of pounds) P R E F A C E xxix Preface Each module concludes with a unique AP Review M o d u l e 1 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. What are the four categories of resources? Give an example of a resource from each category. 2. What type of resource is each of the following? a. time spent flipping hamburgers at a restaurant b. a bulldozer c. a river 3. You make $45,000 per year at your current job with Whiz Kids Consultants. You are considering a job offer from Brainiacs, Inc., which would pay you $50,000 per year. Which of the following are elements of the opportunity cost of accepting the new job at Brainiacs, Inc.? Answer yes or no, and explain your answer. a. the increased time spent commuting to your new job b. the $45,000 salary from your old job c. the more spacious office at your new job 4. Identify each of the following statements as positive or normative, and explain your answer. a. Society should take measures to prevent people from engaging in dangerous personal behavior. b. People who engage in dangerous personal behavior impose higher costs on society through higher medical costs. Check Your Understanding review questions allow students to immediately test their understanding of a module. By checking their answers with those found in the back of the book, students will know when they need to reread the module before moving on. Tackle the Test: Multiple-Choice Questions 1. Which of the following is an example of a resource? I. petroleum II. a factory III
. a cheeseburger dinner a. I only b. II only III only c. d. I and II only I, II, and III e. 2. Which of the following situations represent(s) resource scarcity? I. Rapidly growing economies experience increasing levels of water pollution. II. There is a finite amount of petroleum in the physical environment. III. Cassette tapes are no longer being produced. a. I only b. II only c. III only d. I and II only I, II, and III e. 3. Suppose that you prefer reading a book you already own to watching TV and that you prefer watching TV to listening to music. If these are your only three choices, what is the opportunity cost of reading? Tackle the Test: Free-Response Questions 1. Define resources, and list the four categories of resources. What characteristic of resources results in the need to make choices? Answer (6 points) 1 point: Resources are anything that can be used to produce something else. 1 point each: The four categories of the economy’s resources are land, labor, capital, and entrepreneurship. 1 point: The characteristic that results in the need to make choices is scarcity. watching TV and listening to music b. watching TV c. d. sleeping e. the price of the book listening to music 4. Which of the following statements is/are normative? I. The price of gasoline is rising. II. The price of gasoline is too high. III. Gas prices are expected to fall in the near future. a. I only b. II only III only c. d. I and III only I, II, and III e. 5. Which of the following questions is studied in microeconomics? a. Should I go to college or get a job after I graduate? b. What government policies should be adopted to promote employment in the economy? c. How many people are employed in the economy this year? d. Has the overall level of prices in the economy increased or decreased this year? e. What determines the overall salary levels paid to workers in a given year? 2. In what type of economic analysis do questions have a “right” or “wrong” answer? In what type of economic analysis do questions not necessarily have a “right” answer? On what type of economic analysis do economists tend to disagree most frequently? Why might economists disagree? Explain. In addition, two AP-style freeresponse questions are provided. A sample
grading rubric is given for the first FRQ to teach students how these question are graded on the AP exam and to help them learn how to write thoughtful answers. The Tackle the Test feature presents five AP-style multiplechoice questions, with solutions, to help students become comfortable with the types of questions they will see in the multiple choice section of the AP exam. xxx Review Section 4 Summary Each Section ends with a comprehensive review and problem set Key Terms Summary 1. The consumption function shows how an individual household’s consumer spending is determined by its current disposable income. The aggregate consumption function shows the relationship for the entire economy. According to the life-cycle hypothesis, households try to smooth their consumption over their lifetimes. As a result, the aggregate consumption function shifts in response to changes in expected future disposable income and changes in aggregate wealth. Interest rate effect of a change in the aggregate price level, p. 174 Marginal propensity to consume (MPC), p. 159 Marginal propensity to save (MPS), p. 159 Autonomous change in aggregate spending, p. 160 Multiplier, p. 160 Consumption function, p. 162 Autonomous consumer spending, p. 162 Aggregate consumption function, p. 164 Fiscal policy, p. 176 2. Planned investment spending depends negatively on the interest rate and on existing production capacity; it Monetary policy, p. 177 depends positively on expected future real GDP. Aggregate supply curve, p. 179 Nominal wage, p. 180 Sticky wages, p. 180 3. Firms hold inventories of goods so that they can satisfy consumer demand quickly. Inventory investment is positive when firms add to their inventories, negative when they reduce them. Often, however, changes in inventories are not a deliberate decision but the result of mistakes in forecasts about sales. The result is unplanned inventory investment, which can be either positive or negative. Actual investment spending is ner says that this represents a movement down the aggregate demand curve because foreigners are demanding more in response to a lower price. You, however, insist that this represents a rightward shift of the aggregate demand curve. Who is right? Explain. Short -run aggregate supply curve, p. 181 Problems 1. A fall in the value of the dollar against other currencies makes U.S. final goods and services cheaper to foreigners even though the U.S. aggregate price level stays the same. As a result, foreigners demand more American aggregate output. Your study part- 216. Changes in commodity prices, nominal wages, and
productivity lead to changes in producers’ profits and shift the short -run aggregate supply curve. Demand shock, p. 191 Supply shock, p. 192 Stagflation, p. 193 Long -run macroeconomic equilibrium, p. 194 10. In the long run, all prices, including nominal wages, are flexible and the economy produces at its potential output. If actual aggregate output exceeds potential output, nominal wages will eventually rise in response to low unemployment and aggregate output will fall. If potential output exceeds actual aggregate output, nominal wages will eventually fall in response to high unemployEnd-of-Section Review and ment and aggregate output will rise. So the long-run aggregate supply curve is vertical at potential output. Problems In addition to the 11. In the AD–AS model, the intersection of the short -run opportunities for review at the end of aggregate supply curve and the aggregate demand curve every module, each section ends is the point of short-run macroeconomic equilibrium. It determines the short-run equilibrium aggrewith a brief but complete Summary gate price level and the level of short-run equilibrium of the key concepts, a list of key aggregate output. terms, and a comprehensive set of 12. Economic fluctuations occur because of a shift of the aggregate demand curve (a demand shock) or the short end-of-chapter problems. Recessionary gap, p. 195 Inflationary gap, p. 196 Output gap, p. 196 Self -correcting, p. 196 Putting it All Together The final module in the macro part of the book, Module 45, shows students how to use what they have learned to answer comprehensive, “realworld” questions about the macroeconomy, like the type they will see in the free-response section of the AP exam. Appendix 14 provides enrichment modules for greater insight into microeconomics. Module 45 Putting It All Together What you will learn in this Module: • How to use macroeconomic models to conduct policy analysis • How to approach free-response macroeconomics questions s e c t i o n Module 79: The Economics of Information Economics by Example: “How Gullible Are We?” Module 80: Indifference Curves and Consumer Choice Economics by Example: “Why Is Cash the Ultimate Gift?” Having completed our study of the basic macroeconomic models, we can use them to analyze scenarios and evaluate policy recommendations. In this module we develop a step-by-step approach to macroeconomic analysis. You can adapt this approach to problems
involving any macroeconomic model, including models of aggregate demand and supply, production possibilities, money markets, and the Phillips curve. By the end of this module you will be able to combine mastery of the principles of macroeconomics with problem solving skills to analyze a new scenario on your own. 14 Appendix A Structure for Macroeconomic Analysis In our study of macroeconomics we have seen questions about the macroeconomy take many different forms. No matter what the specific question, most macroeconomic problems have the following components: 1) A starting point. To analyze any situation, you have to know where to start. 2) A pivotal event. This might be a change in the economy or a policy response to the initial situation. 3) Initial effects of the event. An event will generally have some initial, short-run effects. 4) Secondary and long-run effects of the event. After the short-run effects run their course, there are typically secondary effects and the economy will move toward its longrun equilibrium. For example, you might be asked to consider the following scenario and answer the associated questions. Assume the U.S. economy is currently operating at an aggregate output level above potential output. Draw a correctly labeled graph showing aggregate demand, short-run aggregate supply, long-run aggregate supply, equilibrium output, and the aggregate price level. Now assume that the Federal Reserve conducts contractionary monetary policy. Identify the open-market operation the Fed would conduct xxxi Preface Supplements and Media We are pleased to offer an enhanced and completely revised supplements and media package to accompany this textbook. The package has been crafted by experienced AP teachers to help instructors teach their AP Economics course and to give students the tools to develop their skills in economics and succeed on the AP Economics Exam. For Instructors Teachers Resource Binder The TRB, written by Eric Dodge, is a comprehensive resource for AP Economics teachers that provides suggestions for organizing an AP Economics course, including a sample syllabus, teaching strategies, suggested resources, and AP tips that will prove helpful for new and experienced AP teachers alike. In addition, the following components are provided for each module: ➤ Student learning objectives ➤ Key economic concepts ➤ Common student difficulties ➤ Class presentation ideas ➤ Pacing guides to suggest how much class time to spend on the module ➤ Sample lectures ➤ In-class demonstrations and activities ➤ Solutions to AP Review problems from the textbook Instructor’s Resource CD-ROM The CD-ROM
contains all text figures (in JPEG and PPT formats), PowerPoint lecture slides, and detailed solutions to all of CYU, Tackle the Test, and end-of-section problems. Using the Instructor’s Resource CD-ROM, the teacher can easily build classroom presentations or enhance online courses. Printed Test Bank The Test Bank, written by Eric Dodge, provides a wide range of AP-style multiple choice and short answer questions appropriate for assessing student comprehension, interpretation, analysis, and synthesis skills. With close to 3000 questions, the Test Bank offers multiple-choice questions designed for comprehensive coverage of the AP course concepts. Questions have been checked for correlation with the text content and notation, overall usability, and accuracy. The questions are organized by Section, keyed to the pertinent module(s), and categorized by degree of difficulty. The Test Bank includes questions designed to represent the various question formats used on the AP exam. It contains questions based on the graphs that appear in the book. These questions ask students to use the graphical xxxii P R E F A C E models developed in the textbook and to interpret the information presented in the graph. Selected questions are paired with scenarios to reinforce comprehension. ExamView® Software The Printed Test Bank is available in computerized format with ExamView. ExamView Test Generator guides teachers through the process of creating online or paper tests and quizzes quickly and easily. Users may select from our extensive bank of more than 3000 test questions or use the step-by-step tutorial to write their own questions. Tests may be printed in many different types of formats to provide maximum flexibility or may be administered on line using the ExamView Player. Questions may be sorted according to various information fields and scrambled to create different versions of tests. Lecture PowerPoint Presentation Created by David Mayer and Margaret Ray, the enhanced PowerPoint presentation slides are designed to assist teachers with lecture preparation and presentations. The slides contain graphs, data tables, and bulleted lists of key concepts suitable for lecture presentation. Key figures from the text are replicated and animated to demonstrate how they build. Notes to the Instructor are included to provide added tips, class exercises, examples, and explanations to enhance classroom presentations. The PowerPoint presentations may also be customized by adding personalized data, questions, and lecture notes. The files may be accessed on the instructor’s side of the Web site or on the Instructor’s Resource CD-ROM. For Students Strive for a 5 Prepared by Margaret Ray and David Mayer, this guide serves as a study guide for students as
they complete the course and as an AP test preparation resource. It reinforces the topics and key concepts covered in the text and on the AP exam. The study guide component of Strive for a 5 begins with an overview of the sections to provide a big picture context and to review how the textbook content correlates to the AP exam weighting and then shifts to a module by module review. The coverage for each module is organized as follows: Before You Read the Module ➤ Summary: an opening paragraph that provides a brief overview of the chapter. ➤ Learning Objectives: a numbered list outlining and describing the most important concepts in the module. ➤ A review and discussion of key models and/or graphs introduced in the module. While You Read the Module ➤ Key Terms: a list of boldface key terms —including room for definitions and note-taking. ➤ What to watch for: A list of questions that prompt students to look for key information as they read, with space left for answers and note taking. After You Read the Module ➤ Review questions: fill-in-the blank questions that review important material in the module. ➤ Featured graph: a graphing exercise that helps students understand and draw the important graphs in the module. ➤ Practice questions: study questions, and sample free response questions to help review the material in the module. Answer Key ➤ Solutions: detailed solutions to the Questions, and Exercises in the Study Guide. The AP preparation section of Strive for a 5 is a comprehensive test review resource. It begins with a diagnostic pre-test and instructions to help students determine where to focus their test preparation efforts. Test preparation tips, suggestions for setting a test preparation schedule, and advice on how to study effectively and efficiently in preparation for the AP exam are also featured. Finally, sample practice tests that simulate the AP exam with solutions and sample grading rubrics are provided. Information about purchasing the Strive for a 5 guide may be found on the Web site. Krugman’s Economics for AP*, eBook The eBook fully integrates the text with the student media including animated graphs. The eBook also offers a range of customization features including bookmarking, highlighting, notetaking, plus a convenient glossary. Book Companion Web Site for Students and Instructors www.bfwpub.com/highschool/Krugman_AP_Econ The companion Web site offers valuable tools for both instructors—including access to the contents of the Instruc tors Resource
CD and suggestions for additional resources— and for students—additional opportunities for self-testing and review. For additional information on the supplements package and other offerings check out the Web site. Acknowledgments Our deep appreciation and heartfelt thanks to the following individuals who wrote and/or helped to develop and critique various components in the supplements package: Melanie Fox, Austin College, Sherman, TX, who wrote the Online Tests and Quizzes and Cumulative AP Tests for Macroeconomics Amy Shrout, Holy Cross College at Notre Dame, Indiana who wrote the Online Tests and Quizzes and Cumulative AP Tests for Microeconomics Mike Fullington, Port Charlotte High School, Port Charlotte, FL. Robert Graham, Hanover College, Hanover, IN Brian Held, Loyola High School, Los Angeles, CA Woodrow W. Hughes, Jr., Converse College, Spartansburg, SC Holly Jones, The Pennington School, Pennington, NJ Robert Zywicki, Montgomery High School, Skillman, NJ We are also want to offer our gratitude to the following experienced AP-teacher reviewers who helped us to shape this text. Patricia Brazill, Irondequoit High School, Rochester, NY Matthew Bohnenkamp, Marian Catholic High School, Chicago Heights, IL Ralph Colson, Stephen F. Austin High School, Austin, TX Anthony O. Gyapong, Penn State University, Abington, PA Martin Inde, Willis High School, Willis, TX Mary Kohelis, Brooke High School, Follansbee, WV David Mayer, Winston Churchill High School, San Antonio, TX Francis C. McMann, George Washington High, Cedar Rapids, IA Dianna Miller, Florida Virtual School, FL Diana Reichenbach, Miami Palmetto Senior High School, Miami, FL James Spellicy, Lowell High School, San Francisco, CA Kevin Starnes, Garden Grove HS, Lake Forest, CA Shaun Waldron, Niles West High School, Skokie, IL Marsha Williams, The Bronx High School of Science, Bronx, NY Sandra Wright, Adlai Stevenson High School, Lincolnshire, IL We are indebted to the following reviewers, class testers, survey participants, and other contributors whose input helped guide the second edition of Krugman and Wells’ Economics. Carlos Aguilar, El Paso Community College; Terence Alexander, Iowa State University; Morris Altman, University of Saskatchewan; Farhad Ameen, State University of New York, Westchester Community College; Christopher P.
Ball, P R E F A C E xxxiii Preface Quinnipiac University; Sue Bartlett, University of South Florida; Scott Beaulier, Mercer University; David Bernotas, University of Georgia; Marc Bilodeau, Indiana University and Purdue University, Indianapolis; Kelly Blanchard, Purdue University; Anne Bresnock, California State Polytechnic University; Douglas M. Brown, Georgetown University; Joseph Calhoun, Florida State University; Douglas Campbell, University of Memphis; Kevin Carlson, University of Massachusetts, Boston; Andrew J. Cassey, Washington State University; Shirley Cassing, University of Pittsburgh; Sewin Chan, New York University; Mitchell M. Charkiewicz, Central Connecticut State University; Joni S. Charles, Texas State University, San Marcos; Adhip Chaudhuri, Georgetown University; Eric P. Chiang, Florida Atlantic University; Hayley H. Chouinard, Washington State University; Kenny Christianson, Binghamton University; Lisa Citron, Cascadia Community College; Steven L. Cobb, University of North Texas; Barbara Z. Connolly, Westchester Community College; Stephen Conroy, University of San Diego; Thomas E. Cooper, Georgetown University; Cesar Corredor, Texas A&M University and University of Texas, Tyler; Jim F. Couch, University of Northern Alabama; Daniel Daly, Regis University; H. Evren Damar, Pacific Lutheran University; Antony Davies, Duquesne University; Greg Delemeester, Marietta College; Patrick Dolenc, Keene State College; Christine Doyle-Burke, Framingham State College; Ding Du, South Dakota State University; Jerry Dunn, Southwestern Oklahoma State University; Robert R. Dunn, Washington and Jefferson College; Ann Eike, University of Kentucky; Tisha L. N. Emerson, Baylor University; Hadi Salehi Esfahani, University of Illinois; William Feipel, Illinois Central College; Rudy Fichtenbaum, Wright State University; David W. Findlay, Colby College; Mary Flannery, University of California, Santa Cruz; Robert Francis, Shoreline Community College; Shelby Frost, Georgia State University; Frank Gallant, George Fox University; Robert Gazzale, Williams College; Robert Godby, University of Wyoming; Michael Goode, Central Piedmont Community College; Douglas E. Goodman, University of Puget Sound; Marvin Gordon, University of Illinois at Chicago; Kathryn Graddy, Brande
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Miller, Miami University (of Ohio); Khan A. Mohabbat, Northern Illinois University; Myra L. Moore, Jay Morris, Champlain College in University of Georgia; Burlington; Akira Motomura, Stonehill College; Kevin J. Murphy, Oakland University; Robert Murphy, Boston College; Ranganath Murthy, Bucknell University; Anthony Myatt, University of New Brunswick, Canada; Randy A. Nelson, Colby College; Charles Newton, Houston Community College; Daniel X. Nguyen, Purdue University; Dmitri Nizovtsev, Washburn University; Thomas A. Odegaard, Baylor University; Constantin Oglobin, Georgia Southern University; Charles C. Okeke, College of Southern Nevada; Terry Olson, Truman State University; Una Okonkwo Osili, Indiana University and Purdue University, Indianapolis; Maxwell Oteng, University of California, Davis; P. Marcelo Oviedo, Iowa State University; Jeff Owen, Gustavus Adolphus College; James Palmieri, Simpson College; Walter G. Park, American University; Elliott Parker, University of Nevada, Reno; Michael Perelman, California State University, Chico; Nathan Perry, Utah State University; Dean Peterson, Seattle University; Ken Peterson, Furman University; Paul Pieper, University of Illinois at Chicago; Dennis L. Placone, Clemson University; Michael Polcen, Northern Virginia Community College; Raymond A. Polchow, Zane State College; Linnea Polgreen, University of Iowa; Eileen Rabach, Santa Monica College; Matthew Rafferty, Quinnipiac University; Jaishankar Raman, Valparaiso University; Margaret Ray, Mary Washington College; Helen Roberts, University of Illinois at Chicago; Jeffrey Rubin, Rutgers University, New Brunswick; Rose M. Rubin, University of Memphis; Lynda Rush, California State Polytechnic University, Pomona; Michael Ryan, Western Michigan University; Sara Saderion, Houston Community College; Djavad Salehi-Isfahani, Virginia Tech; Elizabeth Sawyer Kelly, University of Wisconsin; Jesse A. Schwartz, Kennesaw State University; Chad Settle, University of Tulsa; Steve Shapiro, University of North Florida; Robert L. Shoffner III, Central Piedmont Community College; Joseph Sicilian, University of Kansas; Judy Smrha, Baker University; John Solow, University of Iowa; John Somers, Portland Community College; Stephen Stageberg, University of Mary
Washington; Monty Stanford, DeVry University; Rebecca Stein, University of Pennsylvania; William K. Tabb, Queens College, City University of New York (retired); Sarinda Taengnoi, University of Wisconsin, Oshkosh; Henry Terrell, University of Maryland; Rebecca Achée Thornton, University of Houston; Michael Toma, Armstrong Atlantic State University; Brian Trinque, University of Texas, Austin; Boone A. Turchi, University of North Carolina, Chapel Hill; Nora Underwood, University of Central Florida; J. S. Uppal, State University of New York, Albany; John Vahaly, University of Louisville; Jose J. VazquezCognet, University of Illinois, Urbana-Champaign; Daniel Vazzana, Georgetown College; Roger H. von Haefen, North Carolina State University; Andreas Waldkirch, Colby College; Christopher Waller, University of Notre Dame; Gregory Wassall, Northeastern University; Robert Whaples, Wake Forest University; Thomas White, Assumption College; Jennifer P. Wissink, Cornell University; Mark Witte, Northwestern University; Kristen M. Wolfe, St. Johns River Community College; Larry Wolfenbarger, Macon State College; Louise B. Wolitz, University of Texas, Austin; Gavin Wright, Stanford University; Bill Yang, Georgia Southern University; Jason Zimmerman, South Dakota State University. We must also thank the many people at Worth Publishers for their contributions and the talented team of consultants and contributors they assembled to work with us. Executive Editor Ann Heath was a mastermind behind the scenes, juggling documents, encouraging excellence, and gracefully putting out fires. Dora Figueiredo, assistant editor extraordinaire, assisted with manuscript preparation and helped to coordinate the impressive collection of print supplements that accompany our book. As in Krugman and Wells’ Economics, 2e, Andreas Bentz did yeoman’s work, granting us the ability to focus on larger issues because we could trust him to focus on the details. Andreas helped to ensure consistency and accuracy as we developed the manuscript. We count ourselves fortu- nate to have Andreas help us with this adaptation. Development editor Rebecca Kohn’s sharp eye and commonsense appraisals were critical in helping us to make good decisions about how to rework the material from Krugman and Well’s Econcomics, 2e to meet the organizational needs of this book. Executive Development Editor Sharon Balbos played
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inon; p. 387, FocusJapan/Alamy; p. 398, Jetta Productions/Getty Images; p. 410, © Picture Partners/Alamy; p. 421, Photo by Udo Weitz/Bloomberg via Getty Images; p. 431, Udo Weitz/Bloomberg via Getty Images; p. 437, PhotosIndia.com LLC/Alamy; p. 443, iStockphoto; p. 458, © Joe Belanger/Alamy; p. 466, iStockphoto; p. 475, iStockphoto; p. 482, Photoedit; p. 495, © Chloe Johnson/Alamy; p. 511, © DAJ/Imagestate; p. 530, iStockphoto; p. 536, Michael Melford/National Geographic/Getty Images; p. 542, Felipe Dupouy/Lifesize/Getty Images; p. 548, © Terrance Klassen/AgeFotostock; p. 559, © Modern Landscapes/Alamy; p. 567, © Chris A Crumley/Alamy; p. 584, © UpperCut Images/Alamy; p. 590, Brand New Images/Getty Images; p. 599, Getty Images; p. 608, Corbis; p. 617, Mario Tama/Getty Images; p. 624, Dena Digilio Betz; p. 638, Bloomberg via Getty Images; p. 644, Frances M. Roberts; p. 652, © Richard Levine/Alamy; p. 659, AP Photo/Kiichiro Sato; p. 668, Alamy; p. 680, Digital Vision; p. 690, iStockphoto; p. 695, © LOOK Die Bildagentur der Fotografen GmbH/Alamy; p. 706, © Barry Sweet/epa/Corbis; p. 711, Getty Images/Hola Images RF; p. 724, iStockphoto; p. 731, iStockphoto; p. 743, © imac/Alamy; p. 754, AP Photo/The Record, Mike McMahon; p. 761, iStockphoto; p. 782, iStockphoto; p. 787, iStockphoto. This page intentionally left blank KRUGMAN’S ECON
OMICS for AP* *AP is a trademark registered and/or owned by the College Board, which was not involved in the production of, and does not endorse, this product. This page intentionally left blank I s e c t i o n Module 1: The Study of Economics Module 2: Introduction to Macroeconomics Module 3: The Production Possibilities Curve Model Module 4: Comparative Advantage and Trade Appendix: Graphs in Economics Economics by Example: What’s to Love About Economics Basic Economic Concepts The annual meeting of the American Economic Association draws thousands of economists, young and old, famous and obscure. There are booksellers, business meetings, and quite a few job interviews. But mainly the economists gather to talk and listen. During the busiest times, 60 or more presentations may be taking place simultaneously, on questions that range from the future of the stock market to who does the cooking in twoearner families. individual What do these people have in common? An expert on the stock market probably knows very little about the economics of housework, and vice versa. Yet an economist who wanders into the wrong seminar and ends up listening to presentations on some unfamiliar topic is nonetheless likely to hear much that is familiar. The reason is that all economic analysis is based on a set of common principles that apply to many different issues. Some of these principles involve choice—for economics is, first of all, about the choices that individuals make. Do you choose to work during the summer or take a backpacking trip? Do you buy a new CD or go to a movie? These decisions involve making a choice from among a limited number of alternatives— limited because no one can have everything that he or she wants. Every question in economics at its most basic level involves individuals making choices.? One must choose! But to understand how an economy works, you need to understand more than how individ- uals make choices. None of us lives like Robinson Crusoe, alone on an island—we must make decisions in an environment that is shaped by the decisions of others. Indeed, in our global economy even the simplest decisions you make— say, what to have for breakfast—are shaped by the decisions of thousands of other people, from the banana grower in Costa Rica who decided to grow the fruit you eat to the farmer in Iowa who provided the corn in your cornflakes. And because each of us depends on so many others—and they, in turn, depend on us—our choices interact. So although all economics at a
basic level is about individual choice, in order to understand behavior within an economy we must also understand economic interaction—how my choices affect your choices, and vice versa. Many important economic interactions can be understood by looking at the markets for individual goods—for example, the market for corn. But we must also understand economy-wide interactions in order to understand how they can lead to the ups and downs we see in the economy as a whole. In this section we discuss the study of economics and the difference between microeconomics and macroeconomics. We also introduce the major topics within macroeconomics and the use of models to study the macroeconomy. Finally, we present the production possibilities curve model and use it to understand basic economic activity, including trade between two econ o mies. Because the study of economics relies on graphical models, an appendix on the use of graphs follows the end of this section. 1 What you will learn in this Module: • How scarcity and choice are central to the study of economics • The importance of opportunity cost in individual choice and decision making • The difference between positive economics and normative economics • When economists agree and why they sometimes disagree • What makes macroeconomics different from microeconomics Economics is the study of scarcity and choice. Individual choice is decisions by individuals about what to do, which necessarily involve decisions about what not to do. An economy is a system for coordinating a society’s productive and consumptive activities. In a market economy, the decisions of individual producers and consumers largely determine what, how, and for whom to produce, with little government involvement in the decisions. In a command economy, industry is publicly owned and a central authority makes production and consumption decisions. Incentives are rewards or punishments that motivate particular choices. Module 1 The Study of Economics Individual Choice: The Core of Economics Economics is the study of scarcity and choice. Every economic issue involves, at its most basic level, individual choice—decisions by individuals about what to do and what not to do. In fact, you might say that it isn’t economics if it isn’t about choice. Step into a big store such as Walmart or Target. There are thousands of different products available, and it is extremely unlikely that you—or anyone else—could afford to buy everything you might want to have. And anyway, there’s only so much space in your room. Given the limitations on your budget and your living space, you must choose which products to buy and which to leave on the shelf.
The fact that those products are on the shelf in the first place involves choice—the store manager chose to put them there, and the manufacturers of the products chose to produce them. The economy is a system that coordinates choices about production with choices about consumption, and distributes goods and services to the people who want them. The United States has a market economy, in which production and consumption are the result of decentralized decisions by many firms and individuals. There is no central authority telling people what to produce or where to ship it. Each individual producer makes what he or she thinks will be most profitable, and each consumer buys what he or she chooses. An alternative to a market economy is a command economy, in which industry is publicly owned and there is a central authority making production and consumption decisions. Command economies have been tried, most notably in the Soviet Union between 1917 and 1991, but they didn’t work very well. Producers in the Soviet Union routinely found themselves unable to produce because they did not have crucial raw materials, or they succeeded in producing but then found nobody wanted what the central authority had them produce. Consumers were often unable to find necessary items—command economies are famous for long lines at shops. At the root of the problem with command economies is a lack of incentives, which are rewards or punishments that motivate particular choices. In market economies, producers are free to charge higher prices when there is a shortage of something, and to Property rights establish ownership and grant individuals the right to trade goods and services with each other. Marginal analysis is the study of the costs and benefits of doing a little bit more of an activity versus a little bit less. A resource is anything that can be used to produce something else. Land refers to all resources that come from nature, such as minerals, timber and petroleum. Labor is the effort of workers. Capital refers to manufactured goods used to make other goods and services. Entrepreneurship describes the efforts of entrepreneurs in organizing resources for production, taking risks to create new enterprises, and innovating to develop new products and production processes. A scarce resource is not available in sufficient quantities to satisfy all the various ways a society wants to use it. keep the resulting profits. High prices and profits provide incentives for producers to make more of the most-needed goods and services and eliminate shortages. In fact, economists tend to be skeptical of any attempt to change people’s behavior that doesn’t change their incentives. For example, a plan that calls on manufacturers to reduce pollution voluntarily probably won’
t be effective; a plan that gives them a financial incentive to do so is more likely to succeed. Property rights, which establish ownership and grant individuals the right to trade goods and services with each other, create many of the incentives in market economies. With the right to own property comes the incentive to produce things of value, either to keep, or to trade for mutual gain. And ownership creates an incentive to put resources to their best possible use. Property rights to a lake, for example, give the owners an incentive not to pollute that lake if its use for recreation, serenity, or sale has greater value. In any economy, the decisions of what to do with the next ton of pollution, the next hour of free time, and the next dollar of spending money are marginal decisions. They involve trade-offs at the margin: comparing the costs and benefits of doing a little bit more of an activity versus a little bit less. The gain from doing something one more time is called the marginal benefit. The cost of doing something one more time is the marginal cost. If the marginal benefit of making another car, reading another page, or buying another latte exceeds the marginal cost, the activity should continue. Otherwise, it should not. The study of such decisions is known as marginal analysis, plays a central role in economics because the formula of doing things until the marginal benefit no longer exceeds the marginal cost is the key to deciding “how much” to do of any activity. All economic activities involve individual choice. Let’s take a closer look at what this means for the study of economics. Resources Are Scarce You can’t always get what you want. Almost everyone would like to have a beautiful house in a great location (and help with the housecleaning), two or three luxury cars, and frequent vacations in fancy hotels. But even in a rich country like the United States, not many families can afford all of that. So they must make choices—whether to go to Disney World this year or buy a better car, whether to make do with a small backyard or accept a longer commute in order to live where land is cheaper. Limited income isn’t the only thing that keeps people from having everything they want. Time is also in limited supply: there are only 24 hours in a day. And because the time we have is limited, choosing to spend time on one activity also means choosing not to spend time on a different activity—spending time studying for an exam means forgoing a
night at the movies. Indeed, many people feel so limited by the number of hours in the day that they are willing to trade money for time. For example, convenience stores usually charge higher prices than larger supermarkets. But they fulfill a valuable role by catering to customers who would rather pay more than spend the time traveling farther to a supermarket where they might also have to wait in longer lines. Why do individuals have to make choices? The ultimate reason is that resources are scarce. A resource is anything that can be used to produce something else. The economy’s resources, sometimes called factors of production, can be classified into four categories: land (including timber, water, minerals, and all other resources that come from nature), labor (the effort of workers), capital (machinery, buildings, tools, and all other manufactured goods used to make other goods and services), and entrepreneurship (risk taking, innovation, and the organization of resources for production). A resource is scarce when there is not enough of it available to satisfy the various ways a society wants to use it. For example, there are limited supplies of oil and coal, which currently provide most of the energy used to produce and deliver everything we buy. And in a growing world economy with a rapidly increasing human population, even clean air and water have become scarce resources. Just as individuals must make choices, the scarcity of resources means that society as a whole must make choices. One way for a society to make choices is simply to allow The real cost of an item is its opportunity cost: what you must give up in order to get it LeBron James understood the concept of opportunity cost. them to emerge as the result of many individual choices. For example, there are only so many hours in a week, and Americans must decide how to spend their time. How many hours will they spend going to supermarkets to get lower prices rather than saving time by shopping at convenience stores? The answer is the sum of individual decisions: each of the millions of individuals in the economy makes his or her own choice about where to shop, and society’s choice is simply the sum of those individual decisions. For various reasons, there are some decisions that a society decides are best not left to individual choice. For example, two of the authors live in an area that until recently was mainly farmland but is now being rapidly built up. Most local residents feel that the community would be a more pleasant place to live if some of the land were left undeveloped. But no individual has an incentive to keep his
or her land as open space, rather than sell it to a developer. So a trend has emerged in many communities across the United States of local governments purchasing undeveloped land and preserving it as open space. Decisions about how to use scarce resources are often best left to individuals but sometimes should be made at a higher, community-wide, level. Opportunity Cost: The Real Cost of Something Is What You Must Give Up to Get It Suppose it is the last term before you graduate and you must decide which college to attend. You have narrowed your choices to a small liberal arts college near home or a large state university several hours away. If you decide to attend the local liberal arts college, what is the cost of that decision? Of course, you will have to pay for tuition, books, and housing, no matter which college you choose. Added to the cost of choosing the local college is the forgone opportunity to attend the large state university, your next best alternative. Economists call the value of what you must give up when you make a particular choice an opportunity cost. Opportunity costs are crucial to individual choice because, in the end, all costs are opportunity costs. That’s because with every choice, an alternative is forgone—money or time spent on one thing can’t be spent on another. If you spend $15 on a pizza, you forgo the opportunity to spend that $15 on a steak. If you spend Saturday afternoon at the park, you can’t spend Saturday afternoon doing homework. And if you attend one school, you can’t attend another. The park and school examples show that economists are concerned with more than just costs paid in dollars and cents. The forgone opportunity to do homework has no direct monetary cost, but it is an opportunity cost nonetheless. And if the local college and the state university have the same tuition and fees, the cost of choosing one school over the other has nothing to do with payments and everything to do with forgone opportunities. Now suppose tuition and fees at the state university are $5,000 less than at the local college. In that case, what you give up to attend the local college is the ability to attend the state university plus the enjoyment you could have gained from spending $5,000 on other things. So the opportunity cost of a choice includes all the costs, whether or not they are monetary costs, of making that choice. The choice to go to college at all provides an important final example of opportunity costs. High school
graduates can either go to college or seek immediate employment. Even with a full scholarship that would make college “free” in terms of monetary costs, going to college would still be an expensive proposition because most young people, if they were not in college, would have a job. By going to college, students forgo the income they could have earned if they had gone straight to work instead. Therefore, the opportunity cost of attending college is the value of all necessary monetary payments for tuition and fees plus the forgone income from the best available job that could take the place of going to college. For most people the value of a college degree far exceeds the value of alternative earnings, with notable exceptions. The opportunity cost of going to college is high for people who could earn a lot during what would otherwise be their college years. Basketball Microeconomics is the study of how people make decisions and how those decisions interact. Macroeconomics is concerned with the overall ups and downs in the economy. Economic aggregates are economic measures that summarize data across many different markets star LeBron James bypassed college because the opportunity cost would have included his $13 million contract with the Cleveland Cavaliers and even more from corporate sponsors Nike and Coca-Cola. Golfer Tiger Woods, Microsoft co-founder Bill Gates, and actor Matt Damon are among the high achievers who decided the opportunity cost of completing college was too much to swallow. Microeconomics Versus Macroeconomics We have presented economics as the study of choices and described how, at its most basic level, economics is about individual choice. The branch of economics concerned with how individuals make decisions and how these decisions interact is called microeconomics. Microeconomics focuses on choices made by individuals, households, or firms—the smaller parts that make up the economy as a whole. Macroeconomics focuses on the bigger picture—the overall ups and downs of the economy. When you study macroeconomics, you learn how economists explain these fluctuations and how governments can use economic policy to minimize the damage they cause. Macroeconomics focuses on economic aggregates—economic measures such as the unemployment rate, the inflation rate, and gross domestic product—that summarize data across many different markets. Table 1.1 lists some typical questions that involve economics. A microeconomic version of the question appears on the left, paired with a similar macroeconomic question on the right. By comparing the questions, you can begin to get a sense of the difference between microeconomics and macroeconomics. t a b l e 1.1 Microeconomic
Versus Macroeconomic Questions Microeconomic Questions Macroeconomic Questions Should I go to college or get a job after high How many people are employed in the economy school? as a whole this year? What determines the salary that Citibank offers What determines the overall salary levels paid to to a new college graduate? workers in a given year? What determines the cost to a high school of What determines the overall level of prices in the offering a new course? economy as a whole? What government policies should be adopted to make it easier for low-income students to attend college? What government policies should be adopted to promote employment and growth in the economy as a whole? What determines the number of iPhones exported to France? What determines the overall trade in goods, services, and financial assets between the United States and the rest of the world? As these questions illustrate, microeconomics focuses on how individuals and firms make decisions, and the consequences of those decisions. For example, a school will use microeconomics to determine how much it would cost to offer a new course, which includes the instructor’s salary, the cost of class materials, and so on. By weighing the costs and benefits, the school can then decide whether or not to offer the course. Macroeconomics, in contrast, examines the overall behavior of the economy—how the actions of all of the individuals and firms in the economy interact to produce a particular economy-wide level of economic performance. For example, macroeconomics is concerned with the general level of prices in the economy and how high or low they are relative to prices last year, rather than with the price of a particular good or service Positive economics is the branch of economic analysis that describes the way the economy actually works. Normative economics makes prescriptions about the way the economy should work. Should the toll be raised? Positive Versus Normative Economics Economic analysis, as we will see throughout this book, draws on a set of basic economic principles. But how are these principles applied? That depends on the purpose of the analysis. Economic analysis that is used to answer questions about the way the world works, questions that have definite right and wrong answers, is known as positive economics. In contrast, economic analysis that involves saying how the world should work is known as normative economics. Imagine that you are an economic adviser to the governor of your state and the governor is considering a change to the toll charged along the state turnpike. Below are three questions the governor might ask you. 1. How much revenue will the tolls yield next
year? 2. How much would that revenue increase if the toll were raised from $1.00 to $1.50? 3. Should the toll be raised, bearing in mind that a toll increase would likely reduce traffic and air pollution near the road but impose some financial hardship on frequent commuters? There is a big difference between the first two questions and the third one. The first two are questions about facts. Your forecast of next year’s toll revenue without any increase will be proved right or wrong when the numbers actually come in. Your estimate of the impact of a change in the toll is a little harder to check—the increase in revenue depends on other factors besides the toll, and it may be hard to disentangle the causes of any change in revenue. Still, in principle there is only one right answer. But the question of whether or not tolls should be raised may not have a “right” answer—two people who agree on the effects of a higher toll could still disagree about whether raising the toll is a good idea. For example, someone who lives near the turnpike but doesn’t commute on it will care a lot about noise and air pollution but not so much about commuting costs. A regular commuter who doesn’t live near the turnpike will have the opposite priorities. This example highlights a key distinction between the two roles of economic analysis and presents another way to think about the distinction between positive and normative analysis: positive economics is about description, and normative economics is about prescription. Positive economics occupies most of the time and effort of the economics profession. Looking back at the three questions the governor might ask, it is worth noting a subtle but important difference between questions 1 and 2. Question 1 asks for a simple prediction about next year’s revenue—a forecast. Question 2 is a “what if” question, asking how revenue would change if the toll were to change. Economists are often called upon to answer both types of questions. Economic models, which provide simplified representations of reality such as graphs or equations, are especially useful for answering “what if” questions. The answers to such questions often serve as a guide to policy, but they are still predictions, not prescriptions. That is, they tell you what will happen if a policy is changed, but they don’t tell you whether or not that result is good. Suppose that your economic model tells you that the governor’s proposed increase in highway tolls will raise property values in
communities near the road but will tax or inconvenience people who currently use the turnpike to get to work. Does that information make this proposed toll increase a good idea or a bad one? It depends on whom you ask. As we’ve just seen, someone who is very concerned with the communities near the road will support the increase, but someone who is very concerned with the welfare of drivers will feel differently. That’s a value judgment—it’s not a question of positive economic analysis. Still, economists often do engage in normative economics and give policy advice. How can they do this when there may be no “right” answer? One answer is that economists are also citizens, and we all have our opinions. But economic analysis can often be used to show that some policies are clearly better than others, regardless of individual opinions Suppose that policies A and B achieve the same goal, but policy A makes everyone better off than policy B—or at least makes some people better off without making other people worse off. Then A is clearly more efficient than B. That’s not a value judgment: we’re talking about how best to achieve a goal, not about the goal itself. For example, two different policies have been used to help low-income families obtain housing: rent control, which limits the rents landlords are allowed to charge, and rent subsidies, which provide families with additional money with which to pay rent. Almost all economists agree that subsidies are the more efficient policy. (In a later module we’ll see why this is so.) And so the great majority of economists, whatever their personal politics, favor subsidies over rent control. When policies can be clearly ranked in this way, then economists generally agree. But it is no secret that economists sometimes disagree. When and Why Economists Disagree Economists have a reputation for arguing with each other. Where does this reputation come from? One important answer is that media coverage tends to exaggerate the real differences in views among economists. If nearly all economists agree on an issue—for example, the proposition that rent controls lead to housing shortages—reporters and editors are likely to conclude that there is no story worth covering, and so the professional consensus tends to go unreported. But when there is some issue on which prominent economists take opposing sides—for example, whether cutting taxes right now would help the economy—that does make a good news story. So you hear much more about the areas of disagreement among economists than you do about
the many areas of agreement. It is also worth remembering that economics is, unavoidably, often tied up in politics. On a number of issues, powerful interest groups know what opinions they want to hear. Therefore, they have an incentive to find and promote economists who profess those opinions, which gives these economists a prominence and visibility out of proportion to their support among their colleagues. Although the appearance of disagreement among economists exceeds the reality, it remains true that economists often do disagree about important things. For example, some highly respected economists argue vehemently that the U.S. government should replace the income tax with a value-added tax (a national sales tax, which is the main source of government revenue in many European countries). Other equally respected economists disagree. What are the sources of this difference of opinion? One important source of differences is in values: as in any diverse group of individuals, reasonable people can differ. In comparison to an income tax, a value-added tax typically falls more heavily on people with low incomes. So an economist who values a society with more social and income equality will likely oppose a value-added tax. An economist with different values will be less likely to oppose it. A second important source of differences arises from the way economists conduct economic analysis. Economists base their conclusions on models formed by making simplifying assumptions about reality. Two economists can legitimately disagree about which simplifications are appropriate—and therefore arrive at different conclusions. Suppose that the U.S. government was considering a valueadded tax. Economist A may rely on a simplification of reality that focuses on the administrative costs of tax systems—that is, the costs of monitoring compliance, processing tax forms, collecting the tax, and so on. This economist might then point to the well-known high costs of administering a value-added tax and argue against the change. But economist B may think that the right way to approach the question is to ignore the administrative fyi When Economists Agree “If all the economists in the world were laid end to end, they still couldn’t reach a conclusion.” So goes one popular economist joke. But do economists really disagree that much? Not according to a classic survey of members of the American Economic Association, reported in the May 1992 issue of the American Economic Review. The authors asked respondents to agree or disagree with a number of statements about the economy; what they found was a high level of agreement among professional economists on many of the statements. At the top of the list, with more than 90% of
the economists agreeing, were the statements “Tariffs and import quotas usually reduce general economic welfare” and “A ceiling on rents reduces the quantity and quality of housing available.” What’s striking about these two statements is that many noneconomists disagree: tariffs and im- port quotas to keep out foreign-produced goods are favored by many voters, and proposals to do away with rent control in cities like New York and San Francisco have met fierce political opposition. So is the stereotype of quarreling economists a myth? Not entirely. Economists do disagree quite a lot on some issues, especially in macroeconomics, but they also find a great deal of common ground. costs and focus on how the proposed law would change individual savings behavior. This economist might point to studies suggesting that value-added taxes promote higher consumer saving, a desirable result. Because the economists have made different simplifying assumptions, they arrive at different conclusions. And so the two economists may find themselves on different sides of the issue. Most such disputes are eventually resolved by the accumulation of evidence that shows which of the various simplifying assumptions made by economists does a better job of fitting the facts. However, in economics, as in any science, it can take a long time before research settles important disputes—decades, in some cases. And since the economy is always changing in ways that make old approaches invalid or raise new policy questions, there are always new issues on which economists disagree. The policy maker must then decide which economist to believe. M o d u l e 1 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. What are the four categories of resources? Give an example of a resource from each category. 2. What type of resource is each of the following? a. time spent flipping hamburgers at a restaurant b. a bulldozer c. a river 3. You make $45,000 per year at your current job with Whiz Kids Consultants. You are considering a job offer from Brainiacs, Inc., which would pay you $50,000 per year. Which of the following are elements of the opportunity cost of accepting the new job at Brainiacs, Inc.? Answer yes or no, and explain your answer. the increased time spent commuting to your new job b. the $45,000 salary from your old job c. the more spacious office at your new job 4. Identify each of the following statements as positive or normative, and explain your
answer. a. Society should take measures to prevent people from engaging in dangerous personal behavior. b. People who engage in dangerous personal behavior impose higher costs on society through higher medical costs. Tackle the Test: Multiple-Choice Questions 1. Which of the following is an example of a resource? I. petroleum II. a factory III. a cheeseburger dinner a. I only b. II only c. III only d. I and II only I, II, and III e. 2. Which of the following situations represent(s) resource scarcity? I. Rapidly growing economies experience increasing levels of water pollution. II. There is a finite amount of petroleum in the physical environment. III. Cassette tapes are no longer being produced. a. I only b. II only c. III only d. I and II only I, II, and III e. 3. Suppose that you prefer reading a book you already own to watching TV and that you prefer watching TV to listening to music. If these are your only three choices, what is the opportunity cost of reading? Tackle the Test: Free-Response Questions 1. Define resources, and list the four categories of resources. What characteristic of resources results in the need to make choices? Answer (6 points) 1 point: Resources are anything that can be used to produce something else. 1 point each: The four categories of the economy’s resources are land, labor, capital, and entrepreneurship. 1 point: The characteristic that results in the need to make choices is scarcity. watching TV and listening to music b. watching TV c. d. sleeping e. the price of the book listening to music 4. Which of the following statements is/are normative? I. The price of gasoline is rising. II. The price of gasoline is too high. III. Gas prices are expected to fall in the near future. a. I only b. II only c. III only d. I and III only I, II, and III e. 5. Which of the following questions is studied in microeconomics? a. Should I go to college or get a job after I graduate? b. What government policies should be adopted to promote employment in the economy? c. How many people are employed in the economy this year? d. Has the overall level of prices in the economy increased or decreased this year? e. What determines the overall salary levels paid to workers in a given year? 2. In what type of economic analysis do questions have a “
right” or “wrong” answer? In what type of economic analysis do questions not necessarily have a “right” answer? On what type of economic analysis do economists tend to disagree most frequently? Why might economists disagree? Explain What you will learn in this Module: • What a business cycle is and why policy makers seek to diminish the severity of business cycles • How employment and unemployment are measured and how they change over the business cycle • The definition of aggregate output and how it changes over the business cycle • The meaning of inflation and deflation and why price stability is preferred • How economic growth determines a country’s standard of living • Why models—simplified representations of reality—play a crucial role in economics The business cycle is the short-run alternation between economic downturns, known as recessions, and economic upturns, known as expansions. A depression is a very deep and prolonged downturn. Recessions are periods of economic downturns when output and employment are falling. Expansions, or recoveries, are periods of economic upturns when output and employment are rising. Module 2 Introduction to Macroeconomics Today many people enjoy walking, biking, and horseback riding through New York’s beautiful Central Park. But in 1932 there were many people living there in squalor. At that time, Central Park contained one of the many “Hoovervilles”—the shantytowns that had sprung up across America as a result of a catastrophic economic slump that had started in 1929. Millions of people were out of work and unable to feed, clothe, and house themselves and their families. Beginning in 1933, the U.S. economy would stage a partial recovery. But joblessness stayed high throughout the 1930s—a period that came to be known as the Great Depression. Why “Hooverville”? These shantytowns were named after President Herbert Hoover, who had been elected president in 1928. When the Depression struck, people blamed the president: neither he nor his economic advisers seemed to understand what had happened or to know what to do. At that time, the field of macroeconomics was still in its infancy. It was only after the economy was plunged into catastrophe that economists began to closely examine how the macroeconomy works and to develop policies that might prevent such disasters in the future. To this day, the effort to understand economic slumps and find ways to prevent them is at the core of macroeconomics. In
this module we will begin to explore the key features of macroeconomic analysis. We will look at some of the field’s major concerns, including business cycles, employment, aggregate output, price stability, and economic growth. The Business Cycle The alternation between economic downturns and upturns in the macroeconomy is known as the business cycle. A depression is a very deep and prolonged downturn; fortunately, the United States hasn’t had one since the Great Depression of the 1930s. Instead, we have experienced less prolonged economic downturns known as recessions, periods in which output and employment are falling. These are followed by economic upturns—periods in which output and employment are rising—known as expansions (sometimes called recoveries). According to the National Bureau of Economic Research 10.1 The U.S. Unemployment Rate and the Timing of Business Cycles, 1989–2009 The unemployment rate, a measure of joblessness, rises sharply during recessions (indicated by shaded areas) and usually falls during expansions. Source: Bureau of Labor Statistics. Unemployment rate 10% 9 8 7 6 5 4 3 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 Year there have been 11 recessions in the United States since World War II. During that period the average recession has lasted 10 months, and the average expansion has lasted 57 months. The average length of a business cycle, from the beginning of a recession to the beginning of the next recession, has been 5 years and 7 months. The shortest business cycle was 18 months, and the longest was 10 years and 8 months. The most recent economic downturn started in December, 2007. Figure 2.1 shows the history of the U.S. unemployment rate since 1989 and the timing of business cycles. Recessions are indicated in the figure by the shaded areas. The business cycle is an enduring feature of the economy. But even though ups and downs seem to be inevitable, most people believe that macroeconomic analysis has guided policies that help smooth out the business cycle and stabilize the economy. What happens during a business cycle, and how can macroeconomic policies address the downturns? Let’s look at three issues: employment and unemployment, aggregate output, and inflation and deflation. fyi Defining Recessions and Expansions Some readers may be wondering exactly how recessions and expansions are defined. The answer is that there is no exact definition! In many countries, economists adopt the rule that a recession is a period of at least two consecutive quarters (
a quarter is three months), during which aggregate output falls. The two-consecutive-quarter requirement is designed to avoid classifying brief hiccups in the economy’s performance, with no lasting significance, as recessions. Sometimes, however, this definition seems too strict. For example, an economy that has three months of sharply declining output, then three months of slightly positive growth, then another three months of rapid decline, should surely be considered to have endured a nine-month recession. In the United States, we try to avoid such misclassifications by assigning the task of determining when a recession begins and ends to an independent panel of experts at the National Bureau of Economic Research (NBER). This panel looks at a variety of economic indicators, with the main focus on employment and produc- tion, but ultimately, the panel makes a judgment call. Sometimes this judgment is controversial. In fact, there is lingering controversy over the 2001 recession. According to the NBER, that recession began in March 2001 and ended in November 2001, when output began rising. Some critics argue, however, that the recession really began several months earlier, when industrial production began falling. Other critics argue that the recession didn’t really end in 2001 because employment continued to fall and the job market remained weak for another year and a half 11 Employment, Unemployment, and the Business Cycle Although not as severe as a depression, a recession is clearly an undesirable event. Like a depression, a recession leads to joblessness, reduced production, reduced incomes, and lower living standards. To understand how job loss relates to the adverse effects of recessions, we need to understand something about how the labor force is structured. Employment is the total number of people currently working for pay, and unemployment is the total number of people who are actively looking for work but aren’t currently employed. A country’s labor force is the sum of employment and unemployment. The unemployment rate—the percentage of the labor force that is unemployed—is usually a good indicator of what conditions are like in the job market: a high unemployment rate signals a poor job market in which jobs are hard to find; a low unemployment rate indicates a good job market in which jobs are relatively easy to find. In general, during recessions the unemployment rate is rising, and during expansions it is falling. Look again at Figure 2.1, which shows the unemployment rate from 1989 through 2009. The graph shows significant changes in the unemployment rate. Note that even in the most prosperous times there
is some unemployment. A booming economy, like that of the late 1990s, can push the unemployment rate down to 4% or even lower. But a severe recession, like the one that began in 2007, can push the unemployment rate into double digits. Aggregate Output and the Business Cycle Rising unemployment is the most painful consequence of a recession, and falling unemployment the most urgently desired feature of an expansion. But the business cycle isn’t just about jobs—it’s also about output: the quantity of goods and services produced. During the business cycle, the economy’s level of output and its unemployment rate move in opposite directions. At lower levels of output, fewer workers are needed, and the unemployment rate is relatively high. Growth in output requires the efforts of more workers, which lowers the unemployment rate. To measure the rise and fall of an economy’s output, we look at aggregate output—the economy’s total production of goods and services for a given time period, usually a year. Aggregate output normally falls during recessions and rises during expansions. Inflation, Deflation, and Price Stability In 1970 the average production worker in the United States was paid $3.40 an hour. By October 2009 the average hourly earnings for such a worker had risen to $18.74 an hour. Three cheers for economic progress! But wait—American workers were paid much more in 2009, but they also faced a much higher cost of living. In 1970 a dozen eggs cost only about $0.58; by October 2009 that was up to $1.60. The price of a loaf of white bread went from about $0.20 to $1.39. And the price of a gallon of gasoline rose from just $0.33 to $2.61. If we compare the percentage increase in hourly earnings between 1970 and October 2009 with the increases in the prices of some standard items, we see that the average worker’s paycheck goes just about as far today as it did in 1970. In other words, the increase in the cost of living wiped out many, if not all, of the wage gains of the typical worker from 1970 to 2009. What caused this situation? Between 1970 and 2009 the economy experienced substantial inflation, a rise in the overall price level. The opposite of inflation is deflation, a fall in the overall price level. A change in the prices of a few goods changes the opportunity cost of purchasing those goods but does not constitute inflation or deflation. These terms are reserved
for more general changes in the prices of goods and services throughout the economy Finding a job was difficult in 2009. Employment is the number of people currently employed in the economy. Unemployment is the number of people who are actively looking for work but aren’t currently employed. The labor force is equal to the sum of employment and unemployment. The unemployment rate is the percentage of the labor force that is unemployed. Output is the quantity of goods and services produced. Aggregate output is the economy’s total production of goods and services for a given time period. A rising overall price level is inflation. A falling overall price level is deflation. 12 The economy has price stability when the aggregate price level is changing only slowly. Economic growth is an increase in the maximum amount of goods and services an economy can produce Both inflation and deflation can pose problems for the economy. Inflation discourages people from holding on to cash, because if the price level is rising, cash loses value. That is, if the price level rises, a dollar will buy less than it would before. As we will see later in our more detailed discussion of inflation, in periods of rapidly rising prices, people stop holding cash altogether and instead trade goods for goods. Deflation can cause the opposite problem. That is, if the overall price level falls, a dollar will buy more than it would before. In this situation it can be more attractive for people with cash to hold on to it than to invest in new factories and other productive assets. This can deepen a recession. In later modules we will look at other costs of inflation and deflation. For now we note that, in general, economists regard price stability—meaning that the overall price level is changing either not at all or only very slowly—as a desirable goal because it helps keep the economy stable. Economic Growth In 1955 Americans were delighted with the nation’s prosperity. The economy was expanding, consumer goods that had been rationed during World War II were available for everyone to buy, and most Americans believed, rightly, that they were better off than citizens of any other nation, past or present. Yet by today’s standards Americans were quite poor in 1955. For example, in 1955 only 33% of American homes contained washing machines, and hardly anyone had air conditioning. If we turn the clock back to 1905, we find that life for most Americans was startlingly primitive by today’s standards. Why are the vast majority of Americans today able to afford conveniences that many lacked in 1955? The answer is
economic growth, an increase in the maximum possible output of an economy. Unlike the short-term increases in aggregate output that occur as an economy recovers from a downturn in the business cycle, economic growth is an increase in productive capacity that permits a sustained rise in aggregate output over time. Figure 2.2 shows annual figures for U.S. real gross domestic product (GDP) per capita—the value of final goods and services produced in the U.S. per person—from 1900 to 2009. As a result of this economic growth, the U.S. economy’s aggregate output per person was almost nine times as large in 2009 as it was in 1900.2 Growth, the Long View Over the long run, growth in real GDP per capita has dwarfed the ups and downs of the business cycle. Except for the recession that began the Great Depression, recessions are almost invisible. Source: Angus Maddison, “Statistics on World Population, GDP and Per Capita GDP, 1–2006 AD,” http://www.ggdc.net/maddison; Bureau of Economic Analysis. Real GDP per capita (2005 dollars) $50,000 40,000 30,000 20,000 10,000 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2009 Year 13 A model is a simplified representation used to better understand a real-life situation. The other things equal assumption means that all other relevant factors remain unchanged. This is also known as the ceteris paribus assumption. Economic growth is fundamental to a nation’s prosperity. A sustained rise in output per person allows for higher wages and a rising standard of living. The need for economic growth is urgent in poorer, less developed countries, where a lack of basic necessities makes growth a central concern of economic policy. As you will see when studying macroeconomics, the goal of economic growth can be in conflict with the goal of hastening recovery from an economic downturn. What is good for economic growth can be bad for short-run stabilization of the business cycle, and vice versa. We have seen that macroeconomics is concerned with the long-run trends in aggregate output as well as the short-run ups and downs of the business cycle. Now that we have a general understanding of the important topics studied in macroeconomics, we are almost ready to apply economic principles to real economic issues. To do this requires one more step—an understanding of how economists use models. The Use of Models in Economics In 1901, one year after
their first glider flights at Kitty Hawk, the Wright brothers built something else that would change the world—a wind tunnel. This was an apparatus that let them experiment with many different designs for wings and control surfaces. These experiments gave them knowledge that would make heavier-than-air flight possible. Needless to say, testing an airplane design in a wind tunnel is cheaper and safer than building a full-scale version and hoping it will fly. More generally, models play a crucial role in almost all scientific research—economics included. A model is any simplified version of reality that is used to better understand real-life situations. But how do we create a simplified representation of an economic situation? One possibility—an economist’s equivalent of a wind tunnel—is to find or create a real but simplified economy. For example, economists interested in the economic role of money have studied the system of exchange that developed in World War II prison camps, in which cigarettes became a universally accepted form of payment, even among prisoners who didn’t smoke. Another possibility is to simulate the workings of the economy on a computer. For example, when changes in tax law are proposed, government officials use tax models— large mathematical computer programs—to assess how the proposed changes would affect different groups of people. Models are important because their simplicity allows economists to focus on the effects of only one change at a time. That is, they allow us to hold everything else constant and to study how one change affects the overall economic outcome. So when building economic models, an important assumption is the other things equal assumption, which means that all other relevant factors remain unchanged. Sometimes the Latin phrase ceteris paribus, which means “other things equal,” is used. But it isn’t always possible to find or create a small-scale version of the whole economy, and a computer program is only as good as the data it uses. (Programmers have a saying: garbage in, garbage out.) For many purposes, the most effective form of economic modeling is the construction of “thought experiments”: simplified, hypothetical versions of real-life situations. And as you will see throughout this book, economists’ models are very often in the form of a graph. In the next module, we will look at the production possibilities curve, a model that helps economists think about the choices every economy faces. 14 AP R e v i e w Solutions appear at the back of the book. Check Your Understanding 1. Why do we talk about business
cycles for the economy as a whole, rather than just talking about the ups and downs of particular industries? Tackle the Test: Multiple-Choice Questions 1. During the recession phase of a business cycle, which of the following is likely to increase? a. the unemployment rate b. the price level c. economic growth rates d. the labor force e. wages 2. The labor force is made up of everyone who is a. employed. b. old enough to work. c. actively seeking work. d. employed or unemployed. e. employed or capable of working. 3. A sustained increase in aggregate output over several decades represents a. an expansion. b. a recovery. Tackle the Test: Free-Response Questions. Describe who gets hurt in a recession and how they are hurt. c. a recession. d. a depression. e. economic growth. 4. Which of the following is the most likely result of inflation? a. falling employment b. a dollar will buy more than it did before c. people are discouraged from holding cash d. price stability e. low aggregate output per capita 5. The other things equal assumption allows economists to a. avoid making assumptions about reality. b. focus on the effects of only one change at a time. c. oversimplify. d. allow nothing to change in their model. e. reflect all aspects of the real world in their model. 1. Define an expansion and economic growth, and explain the 2. Define inflation, and explain why an increase in the price of difference between the two concepts. donuts does not indicate that inflation has occurred. Answer (3 points) 1 point: An expansion is the period of recovery after an economic downturn. 1 point: Economic growth is an increase in the productive capacity of the economy. 1 point: An expansion can occur regardless of any increase in the economy’s long-term potential for production, and it only lasts until the next downturn, while economic growth increases the economy’s ability to produce more goods and services over the long term 15 What you will learn in this Module: • The importance of trade-offs in economic analysis • What the production possibilities curve model tells us about efficiency, opportunity cost, and economic growth • The two sources of economic growth—increases in the availability of resources and improvements in technology Module 3 The Production Possibilities Curve Model A good economic model can be a tremendous aid to understanding. In this module, we look at the production possibilities curve, a model that helps economists think
about the tradeoffs every economy faces. The production possibilities curve helps us understand three important aspects of the real economy: efficiency, opportunity cost, and economic growth. Trade-offs: The Production Possibilities Curve The 2000 hit movie Cast Away, starring Tom Hanks, was an update of the classic story of Robinson Crusoe, the hero of Daniel Defoe’s eighteenth-century novel. Hanks played the role of a sole survivor of a plane crash who was stranded on a remote island. As in the original story of Robinson Crusoe, the Hanks character had limited resources: the natural resources of the island, a few items he managed to salvage from the plane, and, of course, his own time and effort. With only these resources, he had to make a life. In effect, he became a one-man economy. One of the important principles of economics we introduced in Module 1 was that resources are scarce. As a result, any economy—whether it contains one person or millions of people—faces trade-offs. You make a trade-off when you give up something in order to have something else. For example, if a castaway devotes more resources to catching fish, he benefits by catching more fish, but he cannot use those same resources to gather coconuts, so the trade-off is that he has fewer coconuts. To think about the trade-offs necessary in any economy, economists often use the production possibilities curve model. The idea behind this model is to improve our understanding of trade-offs by considering a simplified economy that produces only two goods. This simplification enables us to show the trade-offs graphically. Figure 3.1 shows a hypothetical production possibilities curve for Tom, a castaway alone on an island, who must make a trade-off between fish production and coconut You make a trade-off when you give up something in order to have something else. The production possibilities curve illustrates the trade-offs facing an economy that produces only two goods. It shows the maximum quantity of one good that can be produced for each possible quantity of the other good produced. 16.1 The Production Possibilities Curve The production possibilities curve illustrates the tradeoffs facing an economy that produces two goods. It shows the maximum quantity of one good that can be produced, given the quantity of the other good produced. Here, the maximum quantity of coconuts that Tom can gather depends on the quantity of fish he catches, and vice versa. His feasible production is shown by the area inside or
on the curve. Production at point C is feasible but not efficient. Points A and B are feasible and efficient in production, but point D is not feasible. Quantity of coconuts 30 15 9 0 Feasible and efﬁcient in production A C B 20 28 D Not feasible Production possibilities curve (PPC) 40 Quantity of ﬁsh Feasible but not efﬁcient production. The curve shows the maximum quantity of fish Tom can catch during a week given the quantity of coconuts he gathers, and vice versa. That is, it answers questions of the form, “What is the maximum quantity of fish Tom can catch if he also gathers 9 (or 15, or 30) coconuts?” There is a crucial distinction between points inside or on the production possibilities curve (the shaded area) and points outside the production possibilities curve. If a production point lies inside or on the curve—like point C, at which Tom catches 20 fish and gathers 9 coconuts—it is feasible. After all, the curve tells us that if Tom catches 20 fish, he could also gather a maximum of 15 coconuts, so he could certainly gather 9 coconuts. However, a production point that lies outside the curve—such as point D, which would have Tom catching 40 fish and gathering 30 coconuts—isn’t feasible. In Figure 3.1 the production possibilities curve intersects the horizontal axis at 40 fish. This means that if Tom devoted all his resources to catching fish, he would catch 40 fish per week but would have no resources left over to gather coconuts. The production possibilities curve intersects the vertical axis at 30 coconuts. This means that if Tom devoted all his resources to gathering coconuts, he could gather 30 coconuts per week but would have no resources left over to catch fish. Thus, if Tom wants 30 coconuts, the trade-off is that he can’t have any fish. The curve also shows less extreme trade-offs. For example, if Tom decides to catch 20 fish, he would be able to gather at most 15 coconuts; this production choice is illustrated by point A. If Tom decides to catch 28 fish, he could gather at most 9 coconuts, as shown by point B. Thinking in terms of a production possibilities curve simplifies the complexities of reality. The real-world economy produces millions of different goods. Even a cast
away on an island would produce more than two different items (for example, he would need clothing and housing as well as food). But in this model we imagine an economy that produces only two goods, because in a model with many goods, it would be much harder to study trade-offs, efficiency, and economic growth. Efficiency The production possibilities curve is useful for illustrating the general economic concept of efficiency. An economy is efficient if there are no missed opportunities— meaning that there is no way to make some people better off without making other people worse off. For example, suppose a course you are taking meets in a classroom that is An economy is efficient if there is no way to make anyone better off without making at least one person worse off 17 too small for the number of students—some may be forced to sit on the floor or stand—despite the fact that a larger classroom nearby is empty during the same period. Economists would say that this is an inefficient use of resources because there is a way to make some people better off without making anyone worse off—after all, the larger classroom is empty. The school is not using its resources efficiently. When an economy is using all of its resources efficiently, the only way one person can be made better off is by rearranging the use of resources in such a way that the change makes someone else worse off. So in our classroom example, if all larger classrooms were already fully occupied, we could say that the school was run in an efficient way; your classmates could be made better off only by making people in the larger classroom worse off—by moving them to the room that is too small. Returning to our castaway example, as long as Tom produces a combination of coconuts and fish that is on the production possibilities curve, his production is efficient. At point A, the 15 coconuts he gathers are the maximum quantity he can get given that he has chosen to catch 20 fish; at point B, the 9 coconuts he gathers are the maximum he can get given his choice to catch 28 fish; and so on. If an economy is producing at a point on its production possibilities curve, we say that the economy is efficient in production. But suppose that for some reason Tom was at point C, producing 20 fish and 9 coconuts. Then this one-person economy would definitely not be efficient in production, and would therefore be inefficient: it is missing the opportunity to produce more of both goods. Another example of inefficiency in production occurs when people in an economy are
involuntarily unemployed: they want to work but are unable to find jobs. When that happens, the economy is not efficient in production because it could produce more output if those people were employed. The production possibilities curve shows the amount that can possibly be produced if all resources are fully employed. In other words, changes in unemployment move the economy closer to, or further away from, the production possibilities curve (PPC). But the curve itself is determined by what would be possible if there were full employment in the economy. Greater unemployment is represented by points farther below the PPC—the economy is not reaching its possibilities if it is not using all of its resources. Lower unemployment is represented by points closer to the PPC—as unemployment decreases, the economy moves closer to reaching its possibilities. Although the production possibilities curve helps clarify what it means for an economy to be efficient in production, it’s important to understand that efficiency in production is only part of what’s required for the economy as a whole to be efficient. Efficiency also requires that the economy allocate its resources so that consumers are as well off as possible. If an economy does this, we say that it is efficient in allocation. To see why efficiency in allocation is as important as efficiency in production, notice that points A and B in Figure 3.1 both represent situations in which the economy is efficient in production, because in each case it can’t produce more of one good without producing less of the other. But these two situations may not be equally desirable. Suppose that Tom prefers point B to point A—that is, he would rather consume 28 fish and 9 coconuts than 20 fish and 15 coconuts. Then point A is inefficient from the point of view of the economy as a whole: it’s possible to make Tom better off without making anyone else worse off. (Of course, in this castaway economy there isn’t anyone else; Tom is all alone.) This example shows that efficiency for the economy as a whole requires both efficiency in production and efficiency in allocation. To be efficient, an economy must produce as much of each good as it can, given the production of other goods, and it must also produce the mix of goods that people want to consume. F R y m a A l A crowded classroom reflects inefficiency if switching to a larger classroom would make some students better off without making anyone worse off 18 Opportunity Cost The production possibilities curve is also useful as a reminder that the true cost of any good is not only its
price, but also everything else in addition to money that must be given up in order to get that good—the opportunity cost. If, for example, Tom decides to go from point A to point B, he will produce 8 more fish but 6 fewer coconuts. So the opportunity cost of those 8 fish is the 6 coconuts not gathered. Since 8 extra fish have an opportunity cost of 6 coconuts, 1 fish has an opportunity cost of 6⁄8 = 3⁄4 of a coconut. Is the opportunity cost of an extra fish in terms of coconuts always the same, no matter how many fish Tom catches? In the example illustrated by Figure 3.1, the answer is yes. If Tom increases his catch from 28 to 40 fish, an increase of 12, the number of coconuts he gathers falls from 9 to zero. So his opportunity cost per additional fish is 9⁄12 = 3⁄4 of a coconut, the same as it was when his catch went from 20 fish to 28. However, the fact that in this example the opportunity cost of an additional fish in terms of coconuts is always the same is a result of an assumption we’ve made, an assumption that’s reflected in the way Figure 3.1 is drawn. Specifically, whenever we assume that the opportunity cost of an additional unit of a good doesn’t change regardless of the output mix, the production possibilities curve is a straight line. Moreover, as you might have already guessed, the slope of a straight-line production possibilities curve is equal to the opportunity cost—specifically, the opportunity cost for the good measured on the horizontal axis in terms of the good measured on the vertical axis. In Figure 3.1, the production possibilities curve has a constant slope of −3⁄4, implying that Tom faces a constant opportunity cost per fish equal to 3⁄4 of a coconut. (A review of how to calculate the slope of a straight line is found in the Section I Appendix.) This is the simplest case, but the production possibilities curve model can also be used to examine situations in which opportunity costs change as the mix of output changes. Figure 3.2 illustrates a different assumption, a case in which Tom faces increasing opportunity cost. Here, the more fish he catches, the more coconuts he has to give up to catch an additional fish, and vice versa. For example, to go from producing zero fish to producing 20 fish, he has to
give up 5 coconuts. That is, the opportunity cost of those 20 fish is 5 coconuts. But to increase his fish production from 20 to 40—that is, to produce an additional 20 fish—he must give up 25 more coconuts, a much higher opportunity cost. As you can see in Figure 3.2, when opportunity costs are increasing rather f i g u r e 3.2 Increasing Opportunity Cost The bowed-out shape of the production possibilities curve reflects increasing opportunity cost. In this example, to produce the first 20 fish, Tom must give up 5 coconuts. But to produce an additional 20 fish, he must give up 25 more coconuts. Quantity of coconuts 35 30 25 20 15 10 5 0 Producing the ﬁrst 20 ﬁsh...... requires giving up 5 coconuts. But producing 20 more ﬁsh... A... requires giving up 25 more coconuts. PPC 40 50 Quantity of ﬁsh 10 20 30 19 than constant, the production possibilities curve is a bowed-out curve rather than a straight line. Although it’s often useful to work with the simple assumption that the production possibilities curve is a straight line, economists believe that in reality, opportunity costs are typically increasing. When only a small amount of a good is produced, the opportunity cost of producing that good is relatively low because the economy needs to use only those resources that are especially well suited for its production. For example, if an economy grows only a small amount of corn, that corn can be grown in places where the soil and climate are perfect for growing corn but less suitable for growing anything else, such as wheat. So growing that corn involves giving up only a small amount of potential wheat output. Once the economy grows a lot of corn, however, land that is well suited for wheat but isn’t so great for corn must be used to produce corn anyway. As a result, the additional corn production involves sacrificing considerably more wheat production. In other words, as more of a good is produced, its opportunity cost typically rises because well-suited inputs are used up and less adaptable inputs must be used instead. Economic Growth Finally, the production possibilities curve helps us understand what it means to talk about economic growth. We introduced the concept of economic growth in Module 2, saying that it allows a sustained rise in aggregate output. We learned that economic growth is one of the fundamental features of

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