Ebook Macroeconomics (6th edition): Part 1

(BQ) Part 1 book Macroeconomics hass contents: Introduction to macroeconomics, the measurement and structure of the national economy; productivity, output, and employment; consumption, saving, and investment; saving and investment in the open economy; the asset market, money, and prices,...and other contents.

SIXTH EDITION The Addison-Wesley Series in Economics AbeVBernanke/Crousbore Macmeconomics BadelParkin Foundations of Economics BiermanIFernandez Game Themy with Economic Applications BingerlHoffman Microeconomics with Calculus Boyer Principles a/Transportation Ecollomics Branson Macmecollomic Theory and Policy Bruce Public Finance and the American Economy Byrns!Stone Economics CarltonlPerloff Modern Industrial Organization CaveslFrankeliJones WorLd Trade and Paymellfs: An Introduction Chapman Environmental Economics: Theory, Application, and Policy CooterlUlen Law alld Economics Downs All Economic Theory of Democracy Ehrenberg/Smith Modem Labor Economics Ekelundffollison Economics Fusfeld The Age of the Economist Gerber International Economics Gbiara Learning Economics Gordon Macmeconomics Gregory Essentials oj Economics Gregory/Stuart Russian and Soviet Economic Peljormance and Structure Hartwick/Olewiler The Economics of Natural Resource Use HoffmaniAverett Women and the Economy: FamiLy, Work, and Pay Holt Markets, Games, alld Strategic Behavior Hubbard Money, the Financial System, and the Ecollomy Hughes/Cain American Economic His!01"Y HustedlMelvin International Economics Jehle/Reny Advanced Microeconomic Theory Johnson-Lans A Health Economics Primer Klein Mathematical MethodsJor Economics Krugman/Obstfeld International Economics Laidler The DemandJor Money Leeds/von AllmenlScbiming Economics Leeds!von Allmen The Economics of Sports Lipsey/CourantlRagan Economics Melvin International MOlley and Finance Miller Economics Today Miller Understanding Modem Economics MillerlBenjamin The Economics oj Macro Issues MillerlBenjaminINortb The Economics of Public Issues MillslHamilton Urban Economics Mishkin The Economics oj Money, Banking, and Financial Markets Mishkin The Economics oj Money, Banking, and Financial Markets, Alternate Edition Murray Econometrics: A Modern Introduction Parkin Economics Perloff Microecollomics PermaniCommonIMcGilvraylMa Natural Resources and Environmental Economics Pbelps Health Economics RiddeIIiShackelford/Stamos! Schneider Economics: A Tool for Critically Understanding Society Ritter/SilberlUdell Principles of Money, Banking, alld Financial Markets Rohlf Introduction to Economic Reasoning Ruffin/Gregory Principles oj Economics Sargent Rational Expectations and Inflation Scberer Industry Structure, Strategy, and Public Policy StockIWatson Introduction to Econometrics Studenmund Using Econometrics Tietenberg Environmental and Natural Resource Economics Tietenberg Environmental Economics and Policy Todaro/Smith Economic Development Waldman Microeconomics WaldmanlJensen Industrial Organization: Theory and Practice Weil Economic Growth Williamson Macroeconomics SIXTH EDITION Andrew B Abel The Wharton School of the University of Pennsylvania Ben S Bernanke Dean Croushore Robins School of Business University of Richmond Boston San Francisco New York London Toronto Sydney Tokyo Singapore Madrid Mexico City Munich Paris Cape Town Hong Kong Montreal Publisher: Editor in Chief: Senior Acquisitions Editor: Director of Development: Development Editor: Editorial Assistant: Managing Editor: Senior Production Supervisor: Senior Design Manager: Supplements Supervisor: Director of Media: Senior Media Producer: Content Lead, MyEconLab: Senior Marketing Manager: Senior Manufacturing Buyer: Cover Designer: Text Design, Art, Composition, and Production Coordination: Greg Tobin Denise Clinton Adrienne D' Ambrosio Kay Veno Sylvia Mallory Meg Beste Nancy Fenton Kathryn Dinovo Chuck Spaulding Heather McNally Michelle Neil Melissa Honig Douglas A Ruby Roxarme Hoch Carol Melville MADA Design, Inc Elm Street Publishing Services, Inc Many of the designations used by manufacturers and sellers to distinguish their products are claimed as trademarks Where those designations appear in this book and Addison Wesley was aware of a trademark claim, the designations have been printed in initial caps or all caps Library of Congress Cataloging-in-Publication Data Abel, Andrew B., 1952Macroeconomics / Andrew B Abel, Ben S Bernanke, Dean Croushore -6th ed p em - (Addison-Wesley series in economics) Includes bibliographical references and indexes ISBN 0-321-41554-X Macroeconomics United States-Economic conditions Bernanke, Ben II Dean Croll shore III Title HBl72.5.A24 339-dc22 2008 2006052451 Copyright © 2008 Pearson Education, Inc All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher Printed in the United States of America For information on obtaining permission for use of material in this work, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 75 Arlington Street, Suite 300, Boston, MA 02116, fax your request to 617-848-7047, or e-mail at www.pearsoned.com/lega l/ permissions.hlm ISBN 13: 978-0-321-41554-7 ISBN 10: 0-321-41554-X 10-DOW-1O 09 08 07 06 o rs Andrew B AbeL The Wharton School of the University of Pennsylvania Ronald A Rosen­ feld Professor of Finance a t The Wharton School and professor of economics at the Uni­ versity of Pennsylvania, Andrew Abel received his A.B summa cum laude from Princeton University and his Ph.D from the Massachusetts Institute of Technology He began his teaching career at the University of Chicago and Harvard Uni­ versity, and has held visiting appoint­ ments at both Tel Aviv University and The Hebrew University of Jerusalem A prolific researcher, Abel has pub­ lished extensively on fiscal policy, cap­ ital formation, monetary policy, asset pricing, and Social Security-as well as serving on the editorial boards of numerous journals He has been hon­ ored as an Alfred P Sloan Fellow, a Fellow of the Econometric Socie ty, and a recipient of the John Kenneth Galbraith Award for teaching excel­ lence Abel has served as a visiting scholar at the Federal Reserve Bank of Philadelphia, as a member of the Panel of Economic Advisers at the Congres­ sional Budget Office, and as a member of the Technical Ad visory Panel on Assumptions and Methods for the Social Security Advisory Board He is also a Research Associa t e of the National Bureau of Economic Research and a member of the Advisory Board of the Carnegie-Rochester Conference Series Ben S Bernanke Previously the Howard Harrison Gabrielle and Snyder Beck Pro­ fessor of Economics and Public Affairs at Princeton University, Ben Bernanke received his B.A in economics from Har­ vard University sUlI1ma cllm laude-cap­ turing both the Allyn Young Prize for best Harvard undergraduate economics thesis and the John H Williams prize for outstanding senior in the economics department Like coauthor Abel, he holds a PhD from the Massachusetts Institute of Technology Bernanke began his career a t the Stanford Graduate School of Business in 1979 In 1985 he moved to Princeton University, where he served as chair of the Economics Department from 1995 to 2002 He has twice been visiting pro­ fessor at M.I.T and once at New York University, and has taught in under­ graduate, M.B.A., M.P.A., and Ph.D programs He has authored more than 60 publications in macroeconomics, macroeconomic history, and finance Bernanke has served as a visiting scholar and advisor to the Federal Reserve System He is a Guggenheim Fellow and a Fellow of the Econometric Society He has also been variously hon­ ored as an Alfred P Sloan Research Fellow, a Hoover Institution National Fellow, a National Science Foundation Graduate Fellow, and a Research Asso­ ciate of the National Bureau of Economic Research He has served as editor of the American Economic Review In 2005 he became Chairman of the President's Council of Economic Advisors He is currently Chairman and a member of the Board of Governors of the Federal Reserve System Dean Croushore Robins School of Business, University ofRichmond Dean Croushore is associate professor of economics and Rigsby Fellow at the University of Richmond He received his A.B from Ohio University and his PhD from Ohio State University Croushore began his career at Penn­ sylvania State University in 1984 After teaching for five years, he moved to the Federal Reserve Bank of Philadel­ phia, where he was vice president and economist His duties during his four­ teen years a t the Philadelphia Fed included heading the macroeconomics section, briefing the bank's president and board of directors on the state of the economy and advising them about for­ mulating monetary policy, writing arti­ cles about the economy, administering two national surveys of forecasters, and researching current issues in monetary policy In his role a t the Fed, he crea ted the Survey of Professional Forecasters (taking over the defunct ASAjNBER survey and revita lizing it) and devel­ oped the Real-Time Data Set for Macro­ economists Croushore returned to academia at the University of Richmond in 2003 The focus of his research in recent years has been on forecasting and on how data revisions affect monetary policy, forecasting, and macroeconomic research Croushore's publications include articles in many leading eco­ nomics journals and a textbook on money and banking He is associate editor of several journals and visiting scholar at the Federal Reserve Bank of Philadelphia v • ne Prelace on en s xv Introduction PART 1 Introduction to Macroeconomics 2 The Measurement and Structure of the National Economy long-Run Economic Performance PART 23 61 Productivity, Output, and Employment 62 Consumption, Saving, and Investment 110 Saving and Investment in the Open Economy 173 Long-Run Economic Growth 212 The Asset Market, Money, and Prices 247 PART Business Cycles and Macroeconomic Policy 281 Business Cycles 282 The IS-LM/AO-AS Model: A General Framework for Macroeconomic Analysis 310 10 Classical Business Cycle Analysis: Market-Clearing Macroeconomics 360 11 Keynesianism: The Macroeconomics of Wage and Price Rigidity PART Macroeconomic Policy: Its Environment and Institutions 443 12 Unemployment and Inflation 444 13 Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy 476 14 Monetary Policy and the Federal Reserve System 529 15 Government Spending and Its Financing 573 Appendix A: Glossarv 617 Name Index Subject Index VI • Some Useful Analytical Tools 610 629 631 398 • e al e Preface xv on en s 2.2 Gross Domestic Product 27 The Product Approach to Measuring GOP 27 PART Introduction BOX 2.1 Natural Resources, the Environment, and the National Income Accounts CHAPTER 30 The Expenditure Approach to Measuring GOP 31 Introduction to Macroeconomics 1 What Macroeconomics Is About The Income Approach to Measuring GOP 34 2.3 Saving and Wealth 37 Long-Run Economic Growth Measures of Aggregate Saving 37 Business Cycles The Uses of Private Saving 39 Unemployment Relating Saving and Wealth 40 Inflation APPLICATION The International Economy 46 Real GOP 46 10 Price Indexes 48 Macroeconomic Forecasting Macroeconomic Analysis 12 Macroeconomic Research 13 BOX 2.2 The Computer Revolution 11 1.2 What Macroeconomists Do BOX 1.1 42 2.4 Real GOP, Price Indexes, and Inflation Macroeconomic Policy Aggregation Wealth Versus Saving and Chain-Weighted GDP 11 BOX 2.3 Does CPI Inflation Overstate Increases in the Cost of Living? 14 Data Development 14 1.3 Why Macroeconomists Disagree Classicals Versus Keynesians 51 2.5 Interest Rates Developing and Testing an Economic Theory 48 52 Real Versus Nominal Interest Rates 53 15 16 PART A Unified Approach to Macroeconomics 18 CHAPTER The M easurement and Structure of the National Economy 23 2.1 National Income Accounting: The Measurement of Production, Income, and Expenditure 23 In Touch with the Macroeconomy: The National Income and Product Accounts 25 Long-Run Economic Performance 61 CHAPTER Productivity Output and Employment 62 3.1 How Much Does the Economy Produce? The Production Function 63 APPLICATION The Production Function of the U.S Economy and U.S Productivity Growth 64 The Shape of the Production Function 66 Supply Shocks 71 Why the Three Approaches Are Equivalent 26 VII • • viii Detailed Contents 72 3.2 The Demand for Labor APPLICATION Consumer Sentiment The Marginal Product of Labor and Labor Demand: An Example 73 and Forecasts of Consumer Spending A Change in the Wage 75 Effect of Changes in the Real Interest Rate 119 The Marginal Product of Labor and the Labor Demand Curve 75 Fiscal Policy Factors That Shift the Labor Demand Curve 77 Interest Rates Aggregate Labor Demand 3.3 The Supply of Labor Effect of Changes in Wealth 79 118 121 I n Touch with the Macroeconomy: APPLICATION 79 115 4.2 Investment 122 A Ricardian Tax Cut? 25 127 The Income-Leisure Trade-off 80 The Desired Ca pitaI Stock Real Wages and Labor Supply 80 Changes in the Desired Capital Stock 130 The Labor Supply Curve 83 APPLICATION Aggregate Labor Supply 84 of Taxes on Investment APPLICATION Comparing U.S and European Labor Markets 85 From the Desired Capital Stock to Investment 135 3.4 Labor Market Equilibrium 87 BOX 4.1 APPLICATION 90 APPLICATION 91 3.5 Unemployment Investment and the Stock Market 139 Macroeconomic Consequences of the Boom and Bust in Stock Prices 144 Appendix 4.A A Formal Model of Consumption and Saving 156 93 Measuring Unemployment 94 In Touch with the Macroeconomy: Labor Market Data 95 CHAPTER Changes in Employment Status 95 How Long Are People Unemployed? 96 Saving and Investment in the Open Economy 173 Why There Always Are Unemployed People 97 5.1 Balance of Payments Accounting 174 3.6 Relating Output and Unemployment: Okun's Law 99 The Current Account 174 Appendix 3.A The Balance of Payments Accounts 176 of Okun's Law In Touch with the Macroec o no my: The Growth Rate Form 109 The Capital and Financial Account 177 The Relationship Between the Current Account and the Capital and Financial Account 179 CHAPTER Consumption Saving and Investment 38 The Saving-Investment Diagram 140 Technical Change and Wage Inequality 34 4.3 Goods Market Equilibrium Output, Employment, and the Real Wage During Oil Price Shocks Measuring the Effects Investment in Inventories and Housing 137 Full-Employment Output 89 APPLICATION 127 110 4.1 Consumption and Saving 111 BOX 5.1 Does Mars Have a Current Account Surplus? 181 Net Foreign Assets and the Balance of Payments Accounts 181 The Consumption and Saving Decision of an Individual 112 APPLICATION Effect of Changes in Current Income 114 as International Debtor Effect of Changes in Expected Future Income 114 The United States 183 IX Detailed Contents CHAPTER 5.2 Goods Market Equilibrium in an Open Economy 184 The Asset M arket, Money, and Prices 5.3 Saving and Investment in a Small Open Economy 185 7.1 What Is Money? The Effects of Economic Shocks in a Small Open Economy 189 BOX 7.1 APPLICATION APPLICATION 191 193 196 The Monetary Aggregates 251 Where Have All the Dollars Gone? 252 7.2 Portfolio Allocation and the Demand for Assets 253 The Critical Factor: The Response of National Saving 200 Expected Return 254 Risk 254 The Government Budget Deficit and National Saving 201 The Twin Deficits 248 In Touch with the Macroeconomy: BOX 7.2 5.5 Fiscal Policy and the Current Account 199 APPLICATION Money in a Prisoner-of-War Camp The Money Supply 251 Recent Trends in the U.S Current Account Deficit 247 Measuring Money: The Monetary Aggregates 250 The Impact of Globalization on the U.S Economy 47 The Functions of Money 248 5.4 Saving and Investment in Large Open Economies • Liquidity 254 Time to Maturity 255 202 Asset Demands 256 CHAPTER Long-Run Economic G rowth The Demand for Money 212 The Price Level 6.1 The Sources of Economic G rowth 213 Growth Accounting 215 APPLICATION The Post-1973 Slowdown in Productivity Growth APPLICATION 220 The Money Demand Function 259 Elasticities of Money Demand 261 Financial Regulation, Innovation, and the Instability of Money Demand 7.4 Asset Market Equilibrium The Fundamental Determinants of Long-Run Living Standards 231 264 266 Asset Market Equilibrium: An Aggregation Assumption 266 236 Endogenous Growth Theory 238 6.3 Government Policies to Raise Long-Run Living Standards 240 Policies to Affect the Saving Rate 240 Policies to Raise the Rate of Productivity Growth 241 Interest Rates 258 APPLICATION Setup of the Solow Model 224 The Growth of China Real Income 257 Velocity and the Quantity Theory of Money 262 6.2 Growth Dynamics: The Solow Model 223 APPLICATION 257 Other Factors Affecting Money Demand 260 217 The Recent Surge in U.S Productivity Growth 256 The Asset Market Equilibrium Condition 268 7,5 Money Growth and Inflation APPLICATION 269 Money Growth and Inflation in European Countries in Transition 270 The Expected Inflation Rate and the Nominal Interest Rate 272 APPLICATION Measuring Inflation Expectations 273 x Detailed Contents PART Business Cycles and Macroeconomic Policy CHAPTER Business Cycles 281 8.1 What Is a Business Cycle? 283 9.2 The IS Curve: Equilibrium in the Goods Market 313 Factors That Shift the IS Curve The Pre-World War I Period 285 The Great Depression and World War II 285 Post-World War II U.s Business Cycles 287 290 Factors That Shift the LM Curve 321 9.4 General Equilibrium in the Complete IS-LM Model 325 291 Applying the IS-LM Framework: A Temporary Adverse Supply Shock 326 In Touch with the Macroeconomy: 292 APPLICATION Expenditure 294 BOX 9.1 Employment and Unemployment 295 InternationaI Aspects of the Business Cycle 300 the Business Cycle 301 Aggregate Demand and Aggregate Supply: A Brief Introduction 302 Econometric Models and Macroeconomic 329 The Effects of a Monetary Expansion 330 Financial Variables 299 The Seasonal Cycle and 328 9.5 Price Adjustment and the Attainment of General Equilibrium 330 Money Growth and Inflation 298 BOX 8.1 Oil Price Shocks Revisited Forecasts for Monetary Policy Analysis Average Labor Productivity and the Real Wage 297 8.4 Business Cycle Analysis: A Preview 9.3 The LM Curve: Asset Market Equilibrium 317 The Equality of Money Demanded and Money Supplied 318 The Cyclical Behavior of Economic Variables: Direction and Timing 290 Leading Indicators 315 The Interest Rate and the Price of a Nonmonetary Asset 318 288 Have American Business Cycles Become Less Severe? 288 Production 310 Factors That Shift the FE Line 312 8.2 The American Business Cycle: The Historical Record 285 8.3 Business Cycle Facts Framework for Macroeconomic Analysis 9.1 The FE Line: Equilibrium in the Labor Market 311 282 The "Long Boom" CHAPTER The IS-LM/AO-AS Model: A General 301 Classical Versus Keynesian Versions of the IS-LM Model 334 9.6 Aggregate Demand and Aggregate Supply 336 The Aggregate Demand Curve 336 The Aggregate Supply Curve 338 Equilibrium in the AD-AS Model 341 Monetary Neutrality in the AD-AS Model 341 Appendix 9.A Worked-Out Numerical Exercise for Solving the IS-LMIAD-AS Model 351 Appendix 9.B Algebraic Versions of the IS-LM and AD-AS Models 353 266 Chapter The Asset Market, Money, and Prices in M2, to MMDAs, which are also in M2 Nevertheless, the demand for M2 has also demonstrated instability Throughout the 1990s, people pulled their deposits out of banks (that is, out of accounts included in M2) and placed their savings in mutual funds, either bond funds that purchased government and corporate bonds, or stock funds that purchased shares of corporate stock As a result, M2 velocity rose to a higher level than it had ever reached in the preceding thirty years Only in the early 2000s did M2 velocity return to the range it was in before 1992 The general lesson from these episodes of money demand instability is not that money demand equations are useless In fact, they can be quite useful for forecast­ ing money demand when the regulatory environment is stable and when no major financial innovations occur When regulations change or new financial instruments are developed, however, these changes must be taken into account when using money demand equations to predict the levels of money holdings Asset Market Equi l i hr i Recall that the asset market actually is a set of markets, in which real and financial assets are traded The demand for any asset (say, government bonds) is the quan­ tity of the asset that holders of wealth want in their portfolios The demand for each asset depends on its expected return, risk, liquidity, and time to maturity relative to other assets The supply of each asset is the quantity of that asset that is available At any particular time the supplies of individual assets are typically fixed, although over time asset supplies change (the government may issue more bonds, firms may issue new shares, more gold may be mined, and so on) The asset market is in equilibrium when the quantity of each asset that holders of wealth demand equals the (fixed) available supply of that asset In this section we examine asset market equilibrium, focusing on the role of money We then show how asset market equilibrium is linked to the price level Asset M a rket E q u i l i b r i u m : A n A g g r e g a t i o n Ass u m pt i o n In analyzing the labor market in Chapter and the goods market in Chapter 4, we relied on aggregation to keep things manageable That is, instead of looking at the supply and demand for each of the many different types of labor and goods in the economy, we studied the supply and demand for both labor and goods in general Aggregating in this way allowed us to analyze the behavior of the economy as a whole without getting lost in the details Because there are many different types of assets, aggregation is equally necessary for studying the asset market Thus we adopt an aggregation assumption for the asset market that economists often make for macroeconomic analysis: We assume that all assets may be grouped into two categories, money and nonmonetary assets Money includes assets that can be used in payment, such as currency and checking accounts All money is assumed to have the same risk and liquidity and to pay the same nominal interest rate, im The fixed nominal supply of money is M Nonmon­ etary assets include all assets other than money, such as stocks, bonds, land, and so on All nonmonetary assets are assumed to have the same risk and liquidity and to 7.4 Asset Market Equilibrium 267 pay a nominal interest rate of i = r +1I:e, where r is the expected real interest rate and rr' is the expected rate of inflation The fixed nominal supply of nonmonetary assets is NM Although the assumption that assets can be aggregated into two types ignores many interesting differences among assets, it greatly simplifies our analysis and has proved to be very useful One immediate benefit of making this assumption is that, if we allow for only two types of assets, asset market equilibrium reduces to the condition that the quantity of money supplied equals the quantity of money demanded To demonstrate this point, let's look at the portfolio allocation decision of an individual named Ed Ed has a fixed amount of wealth that he allocates between money and nonmonetary assets If md is the nominal amount of money and nmd is the nominal amount of nonmonetary assets that Ed wants to hold, the sum of Ed's desired money holdings and his desired holdings of nonmonetary assets must be his total wealth, or md + nmd = Ed's total nominal wealth This equation has to be true for every holder of wealth in the economy Suppose that we sum this equation across all holders of wealth in the economy Then the sum of all individual money demands, md, equals the aggregate demand for money, Md The sum of all individual demands for nonmonetary assets is the aggregate demand for nonmonetary assets, NMd Finally, adding nominal wealth for all holders of wealth gives the aggregate nominal wealth of the economy, or Md + NMd = aggregate nominal wealth (7.6) Equation (7.6) states that the total demand for money in the economy plus the total demand for nonmonetary assets must equal the economy's total nominal wealth Next, we relate the total supplies of money and nonmonetary assets to aggre­ gate wealth Because money and nonmonetary assets are the only assets in the economy, aggregate nominal wealth equals the supply of money, M, plus the supply of nonmonetary assets, NM, or M + NM = aggregate nominal wealth (7.7) Finally, we subtract Eq (7.7) from Eq (7.6) to obtain (Md - M) + (NMd - NM) = O (7.8) The term Md - M in Eq (7.8) is the excess demand for money, or the amount by which the total amount of money demanded exceeds the money supply Similarly, the term NMd - NM in Eq (7.8) is the excess demand for nonmonetary assets Now suppose that the demand for money, Md, equals the money supply, M, so that the excess demand for money, Md - M, is zero Equation (7.8) shows that, if Md - M is zero, NMd - NM must also be zero; that is, if the amounts of money supplied and demanded are equal, the amounts of nonmonetary assets supplied and demanded also must be equal By definition, if quantities supplied and demanded are equal for each type of asset, the asset market is in equilibrium If we make the simplifying assumption that assets can be lumped into mone­ tary and nonmonetary categories, the asset market is in equilibrium if the quantity of money supplied equals the quantity of money demanded This result is convenient, 268 Chapter The Asset Market, Money, and Prices because it means that in studying asset market equilibrium we have to look at only the supply and demand for money and can ignore nonmonetary assets As long as the amounts of money supplied and demanded are equal, the entire asset market will be in equilibrium T h e Asset M a rket E q u i l i b r i u m C o n d i t i o n Equilibrium in the asset market occurs when the quantity of money supplied equals the quantity of money demanded This condition is valid whether money supply and demand are expressed in nominal terms or real terms We work with this condition in real terms, or M p - = L(Y, r + reel (7.9) The left side of Eq (7.9) is the nominal supply of money, M, divided by the price level, P, which is the supply of money measured in real terms The right side of the equation is the same as the real demand for money, Md/p, as in Eq (7.3) Equation (7.9), which states that the real quantity of money supplied equals the real quantity of money demanded, is called the asset market equilibrium condition The asset market equilibrium condition involves five variables: the nominal money supply, M; the price level, P; real income, Y; the real interest rate, r; and the expected rate of inflation, ree• The nominal money supply, M, is determined by the central bank through its open-market operations For now, we treat the expected rate of inflation, ree, as fixed (we return to the determination of expected inflation later in the chapter) That leaves three variables in the asset market equilibrium condition whose values we haven't yet specified: output, Y; the real interest rate, r; and the price level, P In this part of the book we have made the assumption that the economy is at full employment or, equivalently, that all markets are in equilibrium Both classical and Keynesian economists agree that the full-employment assumption is reason­ able for analyzing the long-term behavior of the economy If we continue to assume full employment,13 we can use the analysis from previous chapters to describe how output and the real interest rate are determined Recall from Chapter that, if the labor market is in equilibrium with employment at its full-employment level output equals full-employment output, Y In Chapter we showed that, for any level of output, the real interest rate in a closed economy must take the value that makes desired national saving and desired investment equal (the goods market equilibrium condition) With the values of output and the real interest rate established by equilibrium in the labor and goods markets, the only variable left to be determined by the asset market equilibrium condition is the price level, P To emphasize that the price level is the variable determined by asset market equilibrium, we multiply both sides of Eq (7.9) by P and divide both sides by real money demand, L(Y, r + reel, to obtain P= M L(Y, r + ree ) DWe relax this assumption in Part when we discuss short-run economic fluctuations (7.10) 7.5 Money G rowth and Inflation 269 According to Eq (7.10), the economy's price level, P, equals the ratio of the nominal money supply, M, to the real demand for money, L(Y, r + n') For given values of real output, Y, the real interest rate, r, and the expected rate of inflation, rr', the real demand for money, L(Y, r + n'), is fixed Thus Eq (7.10) states that the price level is proportional to the nominal money supply A doubling of the nomi­ nal money supply, M, for instance, would double the price level, P, with other fac­ tors held constant The existence of a close link between the price level and the money supply in an economy is one of the oldest and most reliable conclusions about macroeconomic behavior, having been recognized in some form for hun­ dreds if not thousands of years We discuss the empirical support for this link in Section 7.5 What forces lead the price level to its equilibrium value, Eq (7.10)? A complete description of how the price level adjusts to its equilibrium value involves an analysis of the goods market as well as the asset market; we leave this task until Chapter 9, where we discuss the links among the three main markets of the econ­ omy in more detail Briefly, in Chapter we show that an increase in the money supply leads people to increase their nominal spending on goods and services; this increased nominal demand for output leads prices to rise Prices continue to rise until people are content to hold the increased nominal quantity of money in their portfolios, satisfying the asset market equilibrium condition (rewritten as Eq 7.10) 7.5 Money Growth and Inflation In Section 7.4 we established that, when the markets for labor, goods, and assets are all in equilibrium, the price level, P, is proportional to the nominal money supply, M However, the price level itself generally is of less concern to policymakers and the public than is the rate of inflation, or the percentage rate of increase of the price level In this section we extend our analysis of the price level to show how inflation is determined We conclude that the inflation rate, which is the growth rate of the price level, is closely related to the growth rate of the nominal money supply To obtain an equation for the rate of inflation, we set the growth rate of the left side of Eq (7.10) equal to the growth rate of its right side to obtain M P M1 M M(Y, r + ne ) , L(Y, r + ne ) (7.11) where the symbol � indicates the change in a variable from one year to the next The left side of Eq (7.11) is the growth rate of the price level, M/p, which is the same as the inflation rate, n The right side of Eq (7.11) expresses the growth rate of the ratio on the right side of Eq (7.10) as the growth rate of the numerator, M, minus the growth rate of the denominator, L(Y, r +rr') (In Appendix A, Section A.7, we provide some useful formulas for calculating growth rates.) Equation (7.11) shows that, if the asset market is in equilibrium, the rate of inflation equals the growth rate of the nominal money supply minus the growth rate of real money demand Equation (7.11) highlights the point that the rate of inflation is closely related to the rate of growth of the nominal money supply However, to use Eq (7.11) to predict the behavior of inflation we must also know how quickly real money demand is growing The money demand function, Eq (7.3), focused on two 270 Chapter The Asset Market, Money, and Prices macroeconomic variables with significant effects on real money demand: income (or output), Y, and the nominal interest rate, r + rr" We show later in this section that, in a long-run equilibrium with a constant growth rate of money, the nominal interest rate will be constant Therefore here we look only at growth in income as a source of growth in real money demand Earlier we defined the income elasticity of money demand to be the percentage change in money demand resulting from a 1% increase in real income If ll.Y/Y is the percentage change in real income from one year to the next and lly is the income elasticity of money demand, llyll.Y / Y is the resulting increase in the real demand for money, with other factors affecting money demand held constant Substituting 1'[ for !'!.P/P and lly ll.Y/Y for the growth rate of real money demand in Eq (7.11) yields 1'[ = ll.M ll.Y - lly M Y (7.12) Equation (7.12) is a useful simple expression for the rate of inflation According to Eq (7.12), the rate of inflation equals the growth rate of the nominal money supply minus an adjustment for the growth rate of real money demand arising from growth in real output For example, suppose that nominal money supply growth is 10% per year, real income is growing by 3% per year, and the income elasticity of money demand is 2/3 Then Eq (7.12) predicts that the inflation rate will be 10% ­ (2/3)(3%), or 8% per year Money Growth and Inflation in European Countries in Transition The fall of communism in Eastern Europe and the breakup of the Soviet Union led to economic, political, and social upheaval All of these countries, to varying degrees, have introduced reforms intended to make their economies more market­ oriented, and many (particularly the new countries formed from the breakup of the Soviet Union) have introduced new currencies However, Russia and many of the Eastern European economies have continued to face serious problems, including very high rates of inflation The main reason for the high inflation rates is the rapid rates of money growth in these countries In general, both the growth of the nominal money supply and the growth of real money demand (resulting from real income growth, for example) affect the rate of inflation (see Eq 7.12) In countries with high inflation, however, the growth of the nominal money supply usually is the much more important of these two factors To illustrate, if the income elasticity of money demand in a country is 2/3, and real output were to grow at the stunning rate of 15% per year, then in Eq (7.12) real money demand would grow at 10% per year (2/3 x 15%) in that country If a second country also has an income elasticity of 2/3, but its income is falling at the painful rate of 15% per year, the rate of growth of real money demand is -10% per year Thus even with these radically different income growth rates, the difference in the growth rates of real money demand is only 20 percentage points per year In contrast to the relatively modest differences among countries in the growth rates of real money demand, rates of growth of nominal money supplies may vary Money G rowth and Inflation 7.5 271 Figure 7.3 The relationship between money growth and inflation Nominal money growth and inflation during the period 1995-2001 are plotted for the European countries in transition for which complete data are available There is a strong relationship between money growth rates and inflation rates, with countries having money growth rates in excess of 80% per year also having inflation rates in excess of 80% per year 40 Be l arus 20 00 • Bu l gar i a Turkey 80 • Romania Maced on i a Czec h Repub li c Cyprus Latv i a Li t h uan i a • Russ i a • Kazak h stan 60 40 20 Source: Money growth rates and consumer price inflation from intemntiol1ai Financial Statistics, February 2003, International Monetary Fund Figure shows European coun­ tries in transition for which there are complete data r' -:-' -c:-' , o= o 20 Ma l ta -':- - 40 ,L- - Croat i a 60 :: :-'-::- =-' - 80 - 00 .,.-l-, :: - -"-=-:- ,-,L - 20 40 - -,-J - 60 80 Money growth (percent per year) among countries by hundreds of percentage points per year Thus large differ­ ences in inflation rates among countries almost always are the result of large dif­ ferences in rates of money growth The link between the money growth rate and the inflation rate is illustrated in Fig 7.3, which shows the average annual values of these rates during the period 1995-2001 for the European countries designated by the International Monetary Fund as "countries in transition." Most of these countries were in the process of moving from communism to free-market capitalism The three countries that had inflation rates that averaged more than 80% per year during this period Belarus, Turkey, and Bulgaria also had money growth rates that averaged more than 80% per year Whether we compare inflation rates among these three countries or com­ pare the high inflation rates of these three countries with the relatively low inflation rates of the remaining sixteen countries, large differences in inflation rates clearly are associated with large differences in rates of money growth If rapid money growth causes inflation, why countries allow their money supplies to grow so quickly? As we discussed earlier, governments sometimes find that printing money (borrowing from the central bank) is the only way that they can finance their expenditures This situation is most likely to occur in poor coun­ tries or countries that undergo economic upheavals associated with war, natural disaster, or (as in the case of the European countries in transition) major political and economic change Unfortunately, the almost inevitable result of financing gov­ ernment expenditures in this way is increased inflation 272 Chapter The Asset Market, Money, and Prices T h e Expected I nf l a t i o n Rate a n d t h e N o m i n a l I nterest Rate In our earlier discussion of asset market equilibrium, we made the assumption that the expected inflation rate is fixed For a given real interest rate, r (which is determined by the goods market equilibrium condition), if the expected inflation rate, rr", is fixed, so is the nominal interest rate, at r + rr" We close the chapter with a brief look at the factors that determine the expected inflation rate and the nominal interest rate What should holders of wealth and others expect the inflation rate to be in the future? As we demonstrated, Eq (7.12), which relates inflation to the growth rates of the nominal money supply and real income, is useful for predicting inflation For expected values of money growth (based, for example, on plans announced by the central bank) and real income growth, as well as an estimate of the income elastic­ ity of money demand, Eq (7.12) can be used to calculate the expected inflation rate Suppose that people in a particular country expect their nation's money supply to grow much more rapidly over the next two years because the government is com­ mitted to large military expenditures and can pay for these expenditures only by printing money In this case, Eq (7.12) shows that people should expect much higher inflation rates in the future The inflation prediction equation, Eq (7.12), is particularly easy to apply when the growth rates of the nominal money supply and real income are constant over time In this case, the expected growth rates of the nominal money supply and real income equal their current growth rates, and (from Eq 7.12) the expected inflation rate equals the current inflation rate (assuming no change in the income elasticity of money demand) In practice, the current inflation rate often approximates the expected inflation rate, as long as people don't expect money or income growth to change too much in the near future The public'S expected inflation rate is not directly observable, except perhaps through surveys and similar methods However, an observable economic variable that is strongly affected by expected inflation is the nominal interest rate At any real interest rate, r, which is determined by the goods market equilibrium condition that desired national saving equals desired investment, the nominal interest rate, r + ne, changes one-for-one with changes in the expected inflation rate, ne Thus policy actions (such as rapid expansion of the money supply) that cause people to fear future increases in inflation should cause nominal interest rates to rise, all else being equal But, as already noted, if people don't expect large changes in the growth rates of the money supply or real income, expected inflation won't be much different from current inflation In this case, nominal interest rates and current inflation rates should move together If current inflation is high, for example, expected infla­ tion also is likely to be high; but high expected inflation also causes nominal inter­ est rates to be high, all else being equal The historical relationship between nominal interest rates and inflation is illus­ trated by Fig 7.4, which shows monthly data on the nominal interest rate on one-year Treasury bills and the twelve-month inflation rate measured by the consumer price index in the United States from January 1960 to May 2006 The nominal interest rate and the inflation rate have tended to move together, rising during the 1960s and 1970s and then falling sharply after reaching a peak in the early 1980s However, movements in the inflation rate aren't perfectly matched by movements in the 7.5 Figure Money G rowth and Inflation 273 7.4 Inflation and the nominal interest rate in the United States, 1960-2006 The figure shows the nominal interest rate on one-year Treasury bills and the twelve-month fate of infla tian as mea­ sured by the consumer price index The nominal interest rate tends to move with inflation, although there are peri­ ods such as the early 19805 when the two variables diverge � " ,., � " � 16 NO MI N AL I N TERE ST RATE " = � � 14 12 10 I NF LATIO N RATE Source: FRED database of the Federal Reserve Bank of St Louis, series GS] (interest rate) and CPLAUCN5 (CPL) �6�0 �19�6�5 �19�7�0 �19�7�5 -'�9L8�0-'�9L85��1�9L90��1�99�5��20�0�0 �20�0�5-­ Year nominal interest rate because the real interest rate hasn't been constant over this period In particular, during the late 1970s and early 1980s, the rise in the nominal interest rate was much greater than the rise in the inflation rate, reflecting an increase in the real interest rate from a negative value in the mid 19705 to much higher, posi­ tive values in the 1980s (See Fig 2.5, p 54, for a graph of the real interest rate.) APPLI ATI ; :, N : - _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ M easuring Inflation Expectations Equilibrium in the asset market depends on people's expectations for the inflation rate But how people form expectations of inflation? They may so by looking at surveys of economists who specialize in forecasting the economy.14 If so, we can gather information about people's long-term inflation expectations from surveys that ask people what they think inflation will be in the long run, such as the Survey of Pro­ fessional Forecasters or the University of Michigan Survey of Consumers However, survey information may be umeliable if the people surveyed not have a strong stake in understanding the determinants of the inflation rate On the other hand, people who purchase bonds are more likely to care about inflation, because a change 14See Christopher D Carroll, "Macroeconomic Expectations of Households and Professional Forecasters," QlIarterly JOllrnal of Economics 118 (February 2003), pp 269-298 274 Chapter The Asset Market, Money, and Prices Figure 7.5 Interest rates on nominal and TIIS ten­ year notes, 1997-2006 The chart shows quarterly values for the nominal interest rate on nominal ten-year U.s government Treasury notes and the real interest rate on Trea­ sury lnflation Indexed Securities (TIIS) ten year notes for the period 1997:Ql to 2006:Q2 - Sources: Nominal interest rate: Federal Reserve Board of Gov­ ernors, available at research