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Timothy Taylor’s
Principles of Economics
Economics and the Economy
Second Edition
Timothy Taylor
Journal of Economic Perspectives
Macalester College
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Timothy Taylor’s Principles of Economics: Economics and the Economy, Edition 2
Copyright © 2011, 2008 Timothy Taylor. Published by Textbook Media
ISBN 1-930789-13-0
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Printed in the United States of America by Freeload Press.
10 9 8 7 6 5 4 3
Part I: The Interconnected Economy
1. The Interconnected Economy 1
2. Choice in a World of Scarcity 15
3. International Trade 39
Part II: Supply and Demand
4. Demand and Supply 59
5. Labor and Financial Capital Markets 87
6. Globalization and Protectionism 103
Part III: The Fundamentals of Microeconomic Theory
23. Unemployment 417
24. Inflation 437
7. Elasticity 127
25. The Balance of Trade 461
8. Household Decision Making 149
Part VI: A Framework for Macroeconomic Analysis
9. Cost and Industry Structure 169
10. Perfect Competition 187
26. The Aggregate Supply-Aggregate Demand
11. Monopoly 209
Model 479
12. Monopolistic Competition and Oligopoly 225
27. The Keynesian Perspective 501
28. The Neoclassical Perspective 533
Part IV: Microeconomic Policy
Issues Applications
13. Competition and Public Policy 241
Part VII: Monetary and Fiscal Policy
14. Environmental Protection and Negative
29. Money and Banks 547
Externalities 259
30. Monetary Policy and Bank Regulation 563
15. Technology, Positive Externalities, and Public
31. Exchange Rates and International Capital
Goods 275
Flows 589
16. Poverty and Economic Inequality 291
32. Government Budgets and Fiscal Policy 617
17. Issues in Labor Markets: Unions,
33. Government Borrowing and National
Discrimination, Immigration 311
Savings 641
18. Information, Risk, and Insurance 331
34. Macroeconomic Policy around the
19. Financial Markets 347
World 657
20. Public Choice 369
Appendices 675
Glossary 715
Part V: The Macroeconomic Perspective and Goals
Index 727
21. The Macroeconomic Perspective 381
22. Economic Growth 399
iii
Preface xv
About the Author xvii
1 The Interconnected Economy 1
What Is an Economy? 2
Three Implications of Budget Constraints: Opportunity
Cost, Marginal Decision-Making, and Sunk
Costs 26
Market-Oriented vs. Command Economies 2
The Interconnectedness of an Economy 2
Opportunity Cost 26
Marginal Decision-Making and Diminishing Marginal
Utility 27
Sunk Costs 28
The Division of Labor 4
Why the Division of Labor Increases Production 4
Trade and Markets 5
The Production Possibilities Frontier and Social
Choices 29
The Rise of Globalization 5
Microeconomics and Macroeconomics 7
The Shape of the Production Possibilities Frontier and
Diminishing Marginal Returns 30
Productive Efficiency and Allocative Efficiency 32
Why Society Must Choose 33
Microeconomics: The Circular Flow Diagram 7
Macroeconomics: Goals, Frameworks, and Tools 10
Studying Economics Doesn’t Mean Worshiping the
Economy 10
Key Concepts and Summary 12
Confronting Objections to the Economic Approach 33
A First Objection: People, Firms, and Society Don’t
Act Like This 33
A Second Objection: People, Firms, and Society
Shouldn’t Do This 34
Review Questions 13
2 Choice in a World of Scarcity 15
Choosing What to Consume 16
Facing Scarcity and Making Trade-offs 36
Key Concepts and Summary 36
A Consumption Choice Budget Constraint 16
How Changes in Income and Prices Affect the Budget
Constraint 16 Personal Preferences Determine Specific
Choices 18
From a Model with Two Goods to the Real World of
Many Goods 19
Review Questions 38
3 International Trade 39
Absolute Advantage 41
A Numerical Example of Absolute Advantage and
Trade 41
Trade and Opportunity Cost 44
Limitations of the Numerical Example 45
Choosing between Labor and Leisure 20
An Example of a Labor-Leisure Budget
Constraint 20
How a Change in Wages Affects the Labor-Leisure
Budget Constraint 20
Making a Choice Along the Labor-Leisure Budget
Constraint 20
Comparative Advantage 46
Identifying Comparative Advantage 47
Mutually Beneficial Trade with Comparative
Advantage 48
How Opportunity Cost Sets the Boundaries of
Trade 50
Comparative Advantage Goes Camping 51
The Power of the Comparative Advantage
Example 52
Choosing between Present and Future
Consumption 22
Interest Rates: The Price of Intertemporal Choice 22
The Power of Compound Interest 24
An Example of Intertemporal Choice 24
v
vi
Contents
Intra-industry Trade between Similar Economies 52
The Prevalence of Intra-industry Trade between
Similar Economies 52
Gains from Specialization and Learning 53
Economies of Scale, Competition, Variety 54
Dynamic Comparative Advantage 55
The Size of Benefits from International Trade 56
From Interpersonal to International Trade 57
Key Concepts and Summary 58
Review Questions 58
4 Demand and Supply 59
Demand, Supply, and Equilibrium in Markets for Goods
and Services 60
Demand for Goods and Services 60
Supply of Goods and Services 61
Equilibrium: Where Demand and Supply Cross 63
Shifts in Demand and Supply for Goods and
Services 64
The Ceteris Paribus Assumption 65
An Example of a Shifting Demand Curve 65
Factors That Shift Demand Curves 66
Summing Up Factors That Change Demand 67
An Example of a Shift in a Supply Curve 67 Factors That Shift Supply Curves 68
Summing Up Factors That Change Supply 70
Shifts in Equilibrium Price and Quantity: The Four-Step
Process 71
Good Weather for Salmon Fishing 71
Seal Hunting and New Drugs 72
The Interconnections and Speed of Adjustment in
Real Markets 73
Price Ceilings and Price Floors in Markets for Goods
and Services 74
Price Ceilings 75
Price Floors 77
Responses to Price Controls: Many Margins for
Action 78
Policy Alternatives to Price Ceilings and Price
Floors 79
Supply, Demand, and Efficiency 81
Consumer Surplus, Producer Surplus, Social
Surplus 81
Inefficiency of Price Floors and Price Ceilings 82 Demand and Supply as a Social Adjustment
Mechanism 84
Key Concepts and Summary 84
Review Questions 86
5 Labor and Financial Capital Markets 87
Demand and Supply at Work in Labor Markets 87
Equilibrium in the Labor Market 88
Shifts in Labor Demand 89 Shifts in Labor Supply 90
Technology and Wage Inequality: The Four-Step
Process 90
Price Floors in the Labor Market: Living Wages and
Minimum Wages 92
The Minimum Wage as an Example of a Price
Floor 92
Demand and Supply in Financial Capital Markets 94
Who Demands and Who Supplies in Financial Capital
Markets 94
Equilibrium in Financial Capital Markets 95
Shifts in Demand and Supply in Financial Capital
Markets 96
The United States as a Global Borrower: The Four-Step
Process 97
Price Ceilings in Financial Capital Markets: Usury
Laws 98
Don’t Kill the Price Messengers 99
Key Concepts and Summary 101
Review Questions 102
6 Globalization and Protectionism 103
Protectionism: An Indirect Subsidy from Consumers to
Producers 104
Demand and Supply Analysis of Protectionism 105
Who Benefits and Who Pays? 106
International Trade and Its Effects on Jobs, Wages, and
Working Conditions 108
Fewer Jobs? 108
Trade and Wages 109
Labor Standards 110
The Infant Industry Argument 112
The Dumping Argument 113
The Growth of Anti-Dumping Cases 113
Why Might Dumping Occur? 113
Should Anti-Dumping Cases Be Limited? 114
The Environmental Protection Argument 114
The Race to the Bottom Scenario 115
Pressuring Low-Income Countries for Higher
Environmental Standards 116
The Unsafe Consumer Products Argument 117
The National Interest Argument 117
How Trade Policy Is Enacted: Global, Regional, and
National 119
The World Trade Organization 119
Regional Trading Agreements 120
Contents
Trade Policy at the National Level 121
Long-Term Trends in Barriers to Trade 121
The Trade-offs of Trade Policy 123
Key Concepts and Summary 124
Review Questions 126
7 Elasticity 127
Price Elasticity of Demand 128
Calculating the Elasticity of Demand 129
A Possible Confusion, a Clarification, and a Warning 131
Price Elasticity of Supply 132
Calculating the Elasticity of Supply 132
Elastic, Inelastic, and Unitary Elasticity 134
Applications of Elasticity 137
Does Raising Price Bring in More Revenue? 137
Passing on Costs to Consumers? 138
Long-Run vs. Short-Run Impact 141
Elasticity as a Gener al Concept 142
Income Elasticity of Demand 142
Cross-Price Elasticity of Demand 143
Elasticity in Labor and Financial Capital Markets 143
Stretching the Concept of Elasticity 144
Conclusion 145 Key Concepts and Summary 145
Review Questions 146
8 Household Decision Making 149
Consumption Choices 149
Total Utility and Diminishing Marginal Utility 150
Choosing with Marginal Utility 152
A Rule for Maximizing Utility 152
Measuring Utility with Numbers 153
How Changes in Income and Prices Affect Consumption
Choices 154
How Changes in Income Affect Consumer
Choices 154
How Price Changes Affect Consumer Choices 155
The Foundations of Demand Curves 156
Applications in Business and Government 157
Labor-Leisure Choices 159
The Labor-Leisure Budget Constraint 160
Applications of Utility Maximizing with the LaborLeisure Budget Constraint 161
Intertemporal Choices in Financial Capital
Markets 163
Using Marginal Utility to Make Intertemporal
Choices 163
Applications of the Model of Intertemporal
Choice 166
vii
The Unifying Power of the Utility-Maximizing Budget
Set Framework 167
Key Concepts and Summary 167
Review Questions 168
9 Cost and Industry Structure 169
The Structure of Costs in the Short Run 170
Fixed and Variable Costs 170
Average Costs, Average Variable Costs, Marginal
Costs 173
Lessons Taught by Alternative Measures of Costs 174
A Variety of Cost Patterns 175
The Structure of Costs in the Long Run 176
Choice of Production Technology 176
Economies of Scale 178
Shapes of Long-Run Average Cost Curves 179
The Size and Number of Firms in an Industry 181
Shifting Patterns of Long-Run Average Cost 183
Conclusion 184
Key Concepts and Summary 185
Review Questions 186
10 Perfect Competition 187
Quantity Produced by a Perfectly Competitive
Firm 188
Comparing Total Revenue and Total Cost 188
Comparing Marginal Revenue and Marginal
Costs 190
Marginal Cost and the Supply Curve 191
Profits and Losses with the Average Cost
Curve 192
The Shutdown Point 192
Short-Run Outcomes for Perfectly Competitive
Firms 194
Entry and Exit in the Long Run Output 196
How Entry and Exit Lead to Zero Profits 196
Economic Profit vs. Accounting Profit 197
The Economic Function of Profits 198
Factors of Production in Perfectly Competitive
Markets 199
The Derived Demand for Labor 199
The Marginal Revenue Product of Labor 200
Are Workers Paid as Much as They Deserve? 201
Physical Capital Investment and the Hurdle Rate 202
Physical Capital Investment and Long-Run Average
Cost 203
Efficiency in Perfectly Competitive Markets 204
Conclusion 205
Key Concepts and Summary 205
Review Questions 207
viii
Contents
11 Monopoly 209
Barriers to Entry 210
Legal Restrictions 210
Control of a Physical Resource 211
Technological Superiority 211
Natural Monopoly 212
Intimidating Potential Competition 213
Summing Up Barriers to Entry 214
How a Profit-Maximizing Monopoly Chooses Output
and Price 214
Demand Curves Perceived by a Perfectly Competitive
Firm and by a Monopoly 214
Total and Marginal Revenue for a Monopolist 216
Marginal Revenue and Marginal Cost for a
Monopolist 216
Illustrating Monopoly Profits 219
The Inefficiency of Monopoly 220
Conclusion 221
Key Concepts and Summary 222
Review Questions 223
12 Monopolistic Competition and
Oligopoly 225
Monopolistic Competition 226
Differentiated Products 226
Perceived Demand for a Monopolistic Competitor 227
How a Monopolistic Competitor Chooses Price and
Quantity 227
Monopolistic Competitors and Entry 230
Monopolistic Competition and Efficiency 231
The Benefits of Variety and Product Differentiation 232
Oligopoly 233
Why Do Oligopolies Exist? 233
Collusion or Competition? 234
The Prisoner’s Dilemma 234
The Oligopoly Version of the Prisoner’s Dilemma 235
How to Enforce Cooperation 236
Trade-offs of Imperfect Competition 238
Key Concepts and Summary 239
Review Questions 240
13 Competition and Public Policy 241
Corporate Mergers 242
Regulations for Approving Mergers 242
The Four-Firm Concentration Ratio 244
The Herfindahl-Hirshman Index 245
New Directions for Antitrust 246
Regulating Anticompetitive Behavior 247
Restrictive Practices 247
The Microsoft® Case 248
An Evolving Set of Standards 249
When Breaking Up Is Hard to Do: Regulating Natural
Monopolies 249
The Choices in Regulating a Natural Monopoly 250
Cost-Plus versus Price Cap Regulation 251
The Great Deregulation Experiment 252
Doubts about Regulation of Prices and
Quantities 252
The Effects of Deregulation 253
Frontiers of Deregulation 254
Around the World: From Nationalization to
Privatization 255
Key Concepts and Summary 256
Review Questions 257
14 Environmental Protection and Negative
Externalities 259
Externalities 261
Pollution as a Negative Externality 261
Command-and-Control Regulation 263
Market-Oriented Environmental Tools 264
Market-Friendly Environmental Tool #1: Pollution
Charges 264
Market-Friendly Environmental Tool #2: Marketable
Permits 265
Market-Friendly Environmental Tool #3: Better-Defined
Property Rights 267
Applying Market-Oriented Environmental Tools 268
The Benefits and Costs of U.S. Environmental
Laws 268
Benefits and Costs of Clean Air and Clean
Water 268
Marginal Benefits and Marginal Costs 269
The Unrealistic Goal of Zero Pollution 271
International Environmental Issues 271
The Trade-off between Economic Output and
Environmental Protection 272
Key Concepts and Summary 273
Review Questions 274
15 Technology, Positive Externalities, and Public
Goods 275
The Incentives for Developing New
Technology 277
Some Grumpy Inventors 278
The Positive Externalities of New Technology 278
Contrasting Positive Externalities and Negative
Externalities 280
How to Raise the Rate of Return for Innovators 281
Intellectual Property Rights 281
Government Spending on Research and
Development 282
Contents
Tax Breaks for Research and Development 283
Cooperative Research and Development 284
A Balancing Act 284
Public Goods 284
The Definition of a Public Good 285
The Free Rider Problem 286
The Role of Government in Paying for Public
Goods 288
Positive Externalities and Public Goods 288
Key Concepts and Summary 289
Review Questions 290
16 Poverty and Economic Inequality 291
Drawing the Poverty Line 292
The Poverty Trap 294
The Safety Net 297
Temporary Assistance for Needy Families 297
Earned Income Credit (EIC) 297
Food Stamps 298
Medicaid 299
Other Safety Net Programs 299
Measuring Income Inequality 299
Income Distribution by Quintiles 300
Lorenz Curve 301
Causes of Growing Income Inequality 302
The Changing Composition of American
Households 302
A Shift in the Distribution of Wages 303
Government Policies to Reduce Income Inequality 304
Redistribution 305
The Ladder of Opportunity 306
Inheritance Taxes 307
The Trade-off between Incentives and Income Equality 308
Key Concepts and Summary 309
Review Questions 310
17 Issues in Labor Markets: Unions,
Discrimination, Immigration 311
Labor Unions 312
Facts about Union Membership and Pay 313
Higher Wages for Union Workers 314
The Decline in U.S. Union Membership 317
Concluding Thoughts about the Economics of
Unions 319
Employment Discrimination 320
Earnings Gaps by Race and Gender 320
Investigating the Female/Male Earnings Gap 321
Investigating the Black/White Earnings Gap 322
Competitive Markets and Discrimination 323
Public Policies to Reduce Discrimination 324
An Increasingly Diverse Workforce 325
Immigration 326
Historical Patterns of Immigration 3261
Economic Effects of Immigration 326
Proposals for Immigration Reform 327
Conclusion 328
Key Concepts and Summary 328
Review Questions 329
18 Information, Risk, and Insurance 331
The Problem of Imperfect Information 332
“Lemons” and Other Examples of Imperfect
Information 332
How Imperfect Information Can Affect Equilibrium
Price and Quantity 333
When Price Mixes with Imperfect Information about
Quality 334
Mechanisms to Reduce the Risk of Imperfect
Information 334
Insurance and Imperfect Information 336
How Insurance Works 337
Risk Groups and Actuarial Fairness 339
The Moral Hazard Problem 339
The Adverse Selection Problem 341
Government Regulation of Insurance 342
Conclusion 344
Key Concepts and Summary 344
Review Questions 346
19 Financial Markets 347
How Businesses Raise Financial Capital 348
Early Stage Financial Capital 348
Profits as a Source of Financial Capital 349
Borrowing: Banks and Bonds 349
Corporate Stock and Public Firms 350
How Firms Choose between Sources of Financial
Capital 351
How Households Supply Financial Capital 353
Bank Accounts 353
Bonds 355
Stocks 357
Mutual Funds 361
Housing and Other Tangible Assets 361
The Trade-offs between Return and Risk 363
How to Become Rich 364
Why It’s Hard to Get Rich Quick: The Random Walk
Theory 364 Getting Rich the Slow, Boring Way 365
How Capital Markets Transform Financial
Flows 366
Key Concepts and Summary 366
Review Questions 368
ix
x
Contents
20 Public Choice 369
When Voters Don’t Participate 370
Special-Interest Politics 372
Identifiable Winners, Anonymous Losers 373
Pork Barrels and Logrolling 374
Voting Cycles 375
Where Is Government’s Self-Correcting
Mechanism? 376
A Balanced View of Markets and Government 377
Key Concepts and Summary 378
Review Questions 379
21 The Macroeconomic Perspective 381
Measuring the Size of the Economy: Gross Domestic
Product 383
GDP Measured by Components of Demand 383
GDP Measured by What Is Produced 386
The Problem of Double Counting 387
Comparing GDP among Countries 388
Converting Currencies with Exchange Rates 388
Converting to Per Capita GDP 390
The Pattern of GDP over Time 391
How Well Does GDP Measure the Well-Being of
Society? 393
Some Differences between GDP and Standard of
Living 393
Does a Rise in GDP Overstate or Understate the Rise
in the Standard of Living? 395
GDP Is Rough, but Useful 396
Conclusion 396
Key Concepts and Summary 396
Review Questions 397
22 Economic Growth 399
The Relatively Recent Arrival of Economic
Growth 400
Worker Productivity and Economic Growth 401
The Power of Sustained Economic Growth 403
The Aggregate Production Function 404
Components of the Aggregate Production
Function 405
Growth Accounting Studies 407
A Healthy Climate for Economic Growth 408
Future Economic Convergence? 409
Arguments Favoring Convergence 410
Arguments That Convergence Is Neither Inevitable
Nor Likely 412
The Slowness of Convergence 413
Key Concepts and Summary 414
Review Questions 415
23 Unemployment 417
Unemployment and the Labor Force 418
In or Out of the Labor Force? 418
Calculating the Unemployment Rate 419
Controversies over Measuring Unemployment 419
Patterns of Unemployment 420
The Historical U.S. Unemployment Rate 420
Unemployment Rates by Group 421
International Unemployment Comparisons 423
Why Unemployment Is a Puzzle for Economists 424
Looking for Unemployment with Flexible
Wages 424
Why Wages Might Be Sticky Downward 425
The Short Run: Cyclical Unemployment 426
The Long Run: The Natural Rate of
Unemployment 427
Frictional Unemployment 428
Productivity Shifts and the Natural Rate of
Unemployment 429
Public Policy and the Natural Rate of
Unemployment 430
The Natural Rate of Unemployment in Recent
Years 432
The Natural Rate of Unemployment in Europe 432
A Preview of Policies to Fight Unemployment 433
Key Concepts and Summary 434
Review Questions 435
24 Inflation 437
Combining Prices to Measure the Inflation
Rate 438
The Changing Price of a Basket of Goods 438
Index Numbers 440
Measuring Changes in the Cost of Living 442
Practical Solutions for the Substitution and the
Quality/New Goods Biases 444
Alternative Price Indexes: PPI, GDP Deflator, and
More 445
Inflation Experiences 446
Historical Inflation in the U.S. Economy 446
Inflation around the World 447
Adjusting Nominal Values to Real Values 448
Nominal to Real GDP 448
Nominal to Real Interest Rates 450
The Dislocations of Inflation 451
The Land of Funny Money 451
Unintended Redistributions of Purchasing
Power 452
Blurred Price Signals 454
Problems of Long-Term Planning 454
Some Benefits of Inflation? 455
Contents
Indexing and Its Limitations 455
Indexing in Private Markets 456
Indexing in Government Programs 456
Might Indexing Reduce Concern Over
Inflation? 457
A Preview of Policy Discussions of Inflation 457
Key Concepts and Summary 458
Review Questions 459
25 The Balance of Trade 461
Measuring Trade Balances 462
Components of the U.S. Current Account
Balance 462
Trade Balances in Historical and International
Context 464
The Intimate Connection between Trade Balances and
Flows of Financial Capital 465
The Parable of Robinson Crusoe and Friday 466
The Balance of Trade as the Balance of
Payments 467
The National Saving and Investment Identity 468
The National Saving and Investment Identity 468
Domestic Saving and Investment Determine the Trade
Balance 469
Exploring Trade Balances One Factor at a
Time 470
How Short-Term Movements in the Business Cycle
Can Affect the Trade Balance 471
When Are Trade Deficits and Surpluses Beneficial or
Harmful? 472
The Difference between Level of Trade and the Trade
Balance 473
Final Thoughts about Trade Balances 475
Key Concepts and Summary 476
Review Questions 477
26 The Aggregate Supply-Aggregate Demand
Model 479
Macroeconomic Perspectives on Demand and
Supply 480
Say’s Law and the Macroeconomics of Supply 480
Keynes’ Law and the Macroeconomics of
Demand 481
Combining Supply and Demand in
Macroeconomics 482
Building a Model of Aggregate Supply and Aggregate
Demand 482
The Aggregate Supply Curve and Potential GDP 482
The Aggregate Demand Curve 484
Equilibrium in the Aggregate Supply-Aggregate
Demand Model 485
AS and AD Are Macro, not Micro 485
xi
Shifts in Aggregate Supply 487
How Productivity Growth Shifts the AS Curve 487
How Changes in Input Prices Shift the AS Curve 488
Shifts in Aggregate Demand 488
How Changes by Consumers and Firms Can Affect
AD 489
How Government Macroeconomic Policy Choices
Can Shift AD 491
How the AS-AD Model Combines Growth,
Unemployment, Inflation, and the Balance of
Trade 492
Growth and Recession in the AS-AD Diagram 493
Unemployment in the AS-AD Diagram 493
Inflationary Pressures in the AS-AD Diagram 493
The Balance of Trade and the AS-AD Diagram 495
Keynes’ Law and Say’s Law in the AS-AD Model 496
Key Concepts and Summary 498
Review Questions 500
27 The Keynesian Perspective 501
The Building Blocks of Keynesian Analysis 502
The Importance of Aggregate Demand in
Recessions 502
Wage and Price Stickiness 503
The Two Keynesian Assumptions in the AS-AD
Model 504
The Components of Aggregate Demand 505
What Causes Consumption to Shift? 505
What Causes Investment to Shift? 506
What Causes Government Demand to Shift? 507
What Causes Exports and Imports to Shift? 507
The Phillips Curve 509
The Discovery of the Phillips Curve 509
The Instability of the Phillips Curve 510
Keynesian Policy for Fighting Unemployment and
Inflation 512
The Expenditure-Output Model 513
The Axes of the Expenditure-Output Diagram 513
The Potential GDP Line and the 45-degree Line 513
The Aggregate Expenditure Schedule 514
Building the Aggregate Expenditure Schedule 514
Consumption as a Function of National Income 515
Investment as a Function of National Income 516
Government Spending and Taxes as a Function of
National Income 517
Exports and Imports as a Function of National
Income 518
Building the Combined Aggregate Expenditure
Function 519
Equilibrium in the Keynesian Cross Model 520
Where Equilibrium Occurs 520
Recessionary and Inflationary Gaps 521
xii
Contents
The Multiplier Effect 523
How Does the Multiplier Work? 523
Calculating the Multiplier 525
Calculating Keynesian Policy Interventions 526
Multiplier Trade-offs: Stability vs. the Power of
Macroeconomic Policy 527
Is Keynesian Economics Pro-Market or
Anti-Market? 528
Key Concepts and Summary 529
Review Questions 531
28 The Neoclassical Perspective 533
The Building Blocks of Neoclassical Analysis 534
The Importance of Potential GDP in the Long Run 534
The Role of Flexible Prices 535
How Fast Is the Speed of Macroeconomic
Adjustment? 538
Policy Implications of the Neoclassical
Perspective 539
Fighting Recession or Encouraging Long-Term
Growth? 540
Fighting Unemployment or Inflation? 541
The Neoclassical Phillips Curve Trade-off 542
Macroeconomists Riding Two Horses 543 Key Concepts and Summary 545
Review Questions 546
29 Money and Banks 547
Defining Money by Its Functions 548
Barter and the Double Coincidence of Wants 548
Three Functions for Money 549
Measuring Money: Currency, M1, and M2 550
How Banks Work 552
Banks as Financial Intermediaries 552
A Bank’s Balance Sheet 554
How Banks Go Bankrupt 555
How Banks Create Money 557
The Story of System Bank 557
The Money Multiplier 558
Cautions about the Money Multiplier 559
Conclusions 560
Key Concepts and Summary 561
Review Questions 562
30 Monetary Policy and Bank Regulation 563
Monetary Policy and the Central Bank 564
The Federal Reserve 564
Other Tasks and Funding of Central Banks 564
How a Central Bank Affects the Money Supply 566
Open Market Operations 566
Reserve Requirements 568
The Discount Rate 569
Quantitative Easing 569
Monetary Policy and Economic Outcomes 570
The Effect of Monetary Policy on Interest Rates 570
The Effect of Monetary Policy on Aggregate
Demand 571
What the Federal Reserve Has Done 572
Pitfalls for Monetary Policy 574
Long and Variable Time Lags 575
Excess Reserves 575
Unpredictable Movements of Velocity 576
Is Unemployment or Inflation More Important? 578
Should the Central Bank Tackle Asset Bubbles
and Leverage Cycles? 579
Bank Regulation 581
Bank Runs 581
A Weakened Banking Sector 582
Deposit Insurance 582
Bank Supervision 583
Lender of Last Resort 583
Summary 584
Conclusion 585
Key Concepts and Summary 585
Review Questions 586
31 Exchange Rates and International Capital
Flows 589
How the Foreign Exchange Market Works 590
The Extraordinary Size of the Foreign Exchange
Markets 590
Demanders and Suppliers of Currency in Foreign
Exchange Markets 590
Participants in the Exchange Rate Market 593
Strengthening and Weakening Currency 594
Demand and Supply Shifts in Foreign Exchange
Markets 597
Expectations about Future Exchange Rates 598
Differences across Countries in Rates of Return 599
Relative Inflation 599
Purchasing Power Parity 600
Macroeconomic Effects of Exchange Rates 601
Exchange Rates, Aggregate Demand, and Aggregate
Supply 601
Fluctuations in Exchange Rates 603
Exchange Rates, Trade Balances, and International
Capital Flows 605
Summing Up Public Policy and Exchange Rates 607
Exchange Rate Policies 608
Floating Exchange Rates 608
Using Soft Pegs and Hard Pegs 609
Trade-offs of Soft Pegs and Hard Pegs 611
A Single Currency 612
Contents
Conclusion 613
Key Concepts and Summary 614
Review Questions 616
32 Government Budgets and Fiscal Policy 617
An Overview of Government Spending 618
Total U.S. Government Spending 618
Keeping Federal Budget Numbers in
Perspective 620
State and Local Government Spending 621
An Overview of Taxation 621
State and Local Taxes 624
Federal Deficits and Debt 625
Debt/GDP Ratio 626
The Path from Deficits to Surpluses to Deficits 626
Using Fiscal Policy to Affect Recession, Unemployment,
and Inflation 628
Expansionary Fiscal Policy 629
Contractionary Fiscal Policy 630
Automatic Stabilizers 631
Counterbalancing Recession and Boom 631
The Standardized Employment Deficit or
Surplus 632
Practical Problems with Discretionary Fiscal
Policy 633
Fiscal Policy and Interest Rates 634
Long and Variable Time Lags 634
Temporary and Permanent Fiscal Policy 635
Structural Economic Change Takes Time 636
The Limitations of Potential GDP and the Natural Rate
of Unemployment 636
Educating Politicians 636
Summing Up Discretionary Fiscal Policy 637
Requiring a Balanced Budget? 637
Conclusion 638
Key Concepts and Summary 638
Review Questions 640
33 Government Borrowing and National
Savings 641
How Government Borrowing Affects Investment and the
Trade Balance 641
The National Saving and Investment Identity 642
What about Budget Surpluses and Trade
Surpluses? 642
Fiscal Policy, Investment, and Economic Growth 643
Crowding Out Physical Capital Investment 644
The Interest Rate Connection 644
Public Investment in Physical Capital 646
Public Investment in Human Capital 647
How Fiscal Policy Can Improve Technology 649
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Summary of Fiscal Policy, Investment, and Economic
Growth 649
Will Private Saving Offset Government
Borrowing? 650
Fiscal Policy and the Trade Balance 651
Twin Deficits? 651
Fiscal Policy and Exchange Rates 652
From Budget Deficits to International Economic
Crisis 653
Using Fiscal Policy to Address Trade
Imbalances 654
Conclusion 655
Key Concepts and Summary 655
Review Questions 656
34 Macroeconomic Policy around the World 657
The Diversity of Countries and Economies across the
World 658
Economic Growth 659
Growth Policies for the Technological Leaders 660
Growth Policies for the Converging Economies 660
Growth Policies for the Technologically
Disconnected 661
Lower Unemployment 663
Unemployment from a Recession 663
The Natural Rate of Unemployment 664
Undeveloped Labor Markets 665
Policies for Lower Inflation 666
Policies for a Sustainable Balance of Trade 667
Concerns over International Trade in Goods and
Services 668
Concerns over International Flows of Capital 668
Final Thoughts on Economics and Market
Institutions 670
Key Concepts and Summary 672
Review Questions 673
Chapter Appendices
1 Interpreting Graphics 675
8 Indifference Curves 689
19 Present Discounted Value 705
27 An Algebraic Approach to the
Expenditure-Output Model 709
Glossary 715
Index 727
W
hen authors describe their reasons for writing
an economics textbook, it seems customary
to proclaim lofty goals, like teaching students
“to think like economists” so that they can become more
informed voters and citizens. Paul Samuelson, the author
of the most famous introductory economics textbook for
the second half of the twentieth century, famously said: “I
don’t care who writes a nation’s laws--or crafts its advanced
treaties--if I can write its economics textbooks.” On my best
days, I have sufficient time and energy to lift my eyes to
the horizon, strike a statuesque pose, and proclaim exalted
goals. But most of the time, I’m just a workaday teacher
and my goals are more limited and concrete.
The pedagogical approach of this textbook is rooted
in helping students master the tools that they need to solve
problems for a course in introductory economics. Indeed,
one of the great pleasures of writing the book is having
the opportunity to open up and to share my teaching toolkit of step-by-step explanations, practical examples, and
metaphors that stick in the mind. On quizzes and exams, I
do not ask broad or open-ended questions about informed
citizenship and thinking like an economist. At the most
basic level, my goal for an economics class is that students
should feel well-prepared for quizzes and exams.
The preparation that students need to perform well in
an introductory economics class can be divided into three
parts. First, an introductory economics class involves
mastering a specialized vocabulary. I sometimes tell
students that learning economics is akin to learning a
foreign language – with the added difficulty that terms in
economics like “demand” or “supply” or “money” sound
like standard English, and thus learning economics often
requires that students to drop their preconceptions about
what certain words mean.
Second, students need to acquire some basic analytical
tools. There are four central analytical models in an
introductory economics course: budget constraints, supply
and demand, cost curves, and aggregate demand/aggregate
supply. These four models are used for a very wide variety
of applications; still, there are only four of them. There are
also a few key formulas and equations to learn with regard
to topics like growth rates over time and elasticity.
Third, students must learn to recognize when these
terms and tools apply and to practice using them. I often
tell students not to bother memorizing particular questions
and answers from the textbook or homework, because
my quiz and exam questions will ask them to apply what
they have learned in contexts they have not seen before.
To provide a variety of contexts, this book describes
many economic issues and events, drawn from recent
times and past history, and also drawn both from U.S. and
international experiences. When students see a concept or
analytical skill applied in a number of ways, they learn to
focus on the underlying and unifying idea. I’ve also found
that students do take away knowledge of many economic
events and episodes – although different students seem
to focus on an unpredictable (to me) array of examples,
which is perhaps as it should be in an introductory course. As a workaday teacher, the goal of helping students
master the material so that they can perform well on my
quizzes and exams is lofty enough—and tough enough—
for me. There’s an old joke that economics is the science of
taking what is obvious about human behavior and making
it incomprehensible. Actually, in my experience, the
process works in the other direction. Many students spend
the opening weeks of an introductory economics course
feeling as if the material is difficult, even impossible,
but by the middle and the end of the class, what seemed
so difficult early in the term has become obvious and
straightforward. As a course in introductory economics
focuses on one lesson after another and one chapter after
another, it’s easy to get tunnel vision. But when raise your
eyes at the end of class, it can be quite astonishing to look
back and see how far you have come. As students apply
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the terms and models they have learned to a series of real
and hypothetical examples, they often find to their surprise
that they have also imbibed a considerable amount about
economic thinking and the real-world economy. Learning
always has an aspect of the miraculous.
As always, my family makes a significant contribution
to the existence of this book. In the three years since
the first edition, the U.S. and world economy has been
convulsed by a Great Recession. The task of updating
figures and examples for this second edition is inevitably
large, but thinking about how to building connections
from the concepts in the text to the economic events of
Preface
the last few years made it larger. During the process of
preparing this second edition, my wife has dealt lovingly
with a distracted husband; my children, with a father who
was sleep-deprived or “at the office.” In a very real sense,
then, this book is from my dear ones to the students and
instructors who use it. I hope that it serves you well.
Timothy Taylor
St. Paul, Minnesota
October 6, 2010
Timothy T. Taylor
Journal of Economic Perspectives
Macalester College St. Paul, MN 55105
For 20 years the Managing Editor, Journal of Economic Perspectives, Saint Paul, MN.
Published quarterly by the American Economic Association. Circulation: 22,000.
Education
September 1982-May 1984 M.A. Stanford University, Stanford, CA.
Studied economics, focusing on public finance,
industrial organization, and economic history.
September 1978-May 1982
B.A. Haverford College, Haverford, PA.
ajored in economics and political science. Graduated
M
magna cum laude and Phi Beta Kappa.
Selected Papers
“Recommendations for Further Reading,” Journal of Economic Perspectives. A regular
column, eight pages in length and containing 25-30 recommended articles, reports, or
interviews that Tim Taylor has been writing for this quarterly journal since the Spring
2005 issue.
“Medicare: Apocalypse … Later,” Milken Institute Review, Third Quarter 2005, pp. 42‑47.
Available at http://www.milken-inst.org.
“In Defense of Outsourcing,” Cato Journal, Spring/Summer 2005, 25:2, pp. 367-377.
Available at http://www.cato.org/pubs/journal/index.html.
“Shortfalls in the Long Run: Predictions about the Social Security Trust Fund,” co‑authored
with James R. Hines Jr., Journal of Economic Perspectives, Spring 2005, 19:2, pp. 3-9.
“The Economy in Perspective,” The Public Interest, Fall 2004, pp. 85-99.
“Dumping the Lump: A Century of Misunderstanding,” Milken Institute Review, Third
Quarter 2004, pp. 82-87. Available at http://www.milken-inst.org.
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About the Author
“The Truth about Globalization,” The Public Interest, Spring 2002, pp. 24-44. Available at
http://www.thepublicinterest.com. Reprinted in Harf, James E. and Mark Owen Lombardi.
2005. Taking Sides: Clashing Views on Controversial Global Issues. McGraw-Hill/Dushkin,
Dubuque, Iowa. pp. 208-216.
Teaching Awards
Lecturer for Economics 5010, “Economic Immersion,” at the Hubert H. Humphrey Institute
of Public Affairs at the University of Minnesota during Fall 1996. In 1997, voted by students
as Teacher of the Year for the Humphrey Institute.
Lecturer for Economics 1101 and 1102, courses in principles of micro- and macroeconomics,
at the University of Minnesota during Fall 1995 and Winter 1996, respectively. Based on
student and departmental evaluations, named a Distinguished Instructor by the Department
of Economics.
Lecturer for Economics 1 at Stanford University, at least one quarter each year from 1989
to 1993. Enrollment ranged from 300-500 students. In 1992, winner of the award for
excellent teaching in a large class (more than 30 students) from Associated Students of
Stanford University.