Understanding

MACROECONOMICS
F OUR TH EDITION

d
KISHORE G. KULKARNI
Professor of Economics, Metropolitan State College of Denver

EDWIN G. DOLAN
Ph.D. Yale University
E DITOR : Kristin Van Gaasbeck
T EXT D ESIGN AND C OMPOSITION : Archetype Book Composition
C OVER D ESIGN : Walker Printing

ISBN: 1-60229-239-6
Copyright 2007 by Horizon Textbook Publishing, LLC

All rights reserved. Printed in the United States of America. No part of this book may be used or repro-
duced in any manner whatsoever without written permission, except in the case of brief quotations
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P.O. Box 494658, Redding, CA 96049-4658.
 TABLE OF CONTENTS

d
Preface xi

PART 1 Introduction to Economics

CHAPTER 1 ECONOMICSTHE SCIENCE OF CHOICE AND

EXCHANGE 3
What? How? For Whom? 5
Deciding What to Produce: Opportunity Cost 5
Deciding How to Produce: Efficiency and Entrepreneurship 6
Deciding Who Will Do Which Work: The Division of Labor 10
Deciding for Whom Goods will be Produced: Positive and Normative
Economics 12
Coordinating Economic Choices 14
A Non-economic Example 15
Spontaneous Order in Markets 15
The Role of Hierarchy 17
Economic Method 17
Theories and Models 18
The Use of Graphs4 19
Theory and Evidence 21
Theories and Forecasts 21
Theory and Policy 23
Summary 24
Key Terms 25
Problems and Topics for Discussion 25
Case for Discussion 26
End Notes 27
Appendix to Chapter 1: Working with Graphs 29
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CHAPTER 2 SUPPLY AND DEMAND: THE BASICS 39

Law of Demand 40
The Demand Curve 41
Shifts in the Demand Curve1 42
THE LAW OF Supply 47
The Supply Curve 47
Shifts in the Supply Curve 50
The Interaction of Market Supply and Demand: Market Mechanism 52
Market Equilibrium 53
Equilibrium as Spontaneous Order 53
Shortages 55
Surpluses 56
Changes in Market Conditions: Outside Shocks to Market Mechanism) 56
Price Floors and Ceilings: An Application 60
Price Supports: The Market for Milk 60
Price Ceilings: The Case of Rent Control 62
Summary 67
Key Terms 68
Problems and Topics for Discussion 68
Case for Discussion 69
End Notes 70

CHAPTER 3 SUPPLY, DEMAND, AND ELASTICITY 71

Elasticity Of Demand 72
Price Elasticity of Demand 72
Calculating Elasticity of Demand 74
Varying- and Constant-Elasticity Demand Curves 77
Determinants of Elasticity of Demand 78
Income Elasticity of Demand 80
Cross-Elasticity of Demand 81
Price Elasticity of Supply 81
Applications of Elasticity 83
Elasticity and Tax Incidence 83
Elasticity and Prohibition 87
Summary 90
Key Terms 91
Problems and Topics for Discussion 91
Case for Discussion 92
End Notes 93
 Contents v

PART 2 Macroeconomic Goals and Relationships

CHAPTER 4 IN SEARCH OF PROSPERITY AND STABILITY 97

Macroeconomics in the Long Run: Economic Growth 98
Measuring Economic Growth 99
Sources of Economic Growth 99
The Benefits and Costs of Economic Growth 100
Short-Run Macroeconomics and: The Business Cycle 103
Phases of the Business Cycle 104
Employment and the Business Cycle 105
Price Stability 112
Short-Run Costs of Inflation 112
Long-Run Costs of Inflation 114
Summary 116
Key Terms 117
Problems and Topics For Discussion 117
Case for Discussion 118
End Notes 119

CHAPTER 5 THE CIRCULAR FLOW OF INCOME AND PRODUCT 121

The Circular Flow 122
Gross Domestic Product and Gross Domestic Income 123
Components of GDP 123
Injections and Leakages 124
The Determinants of Planned Expenditure 126
Planned Versus Unplanned Expenditure 126
Consumption Expenditure 129
Planned Investment 130
Government Purchases 131
Net Exports 132
Equilibrium in The Circular Flow 132
An Expansion of Planned Expenditure 132
A Contraction of Planned Expenditure 133
The Multiplier Effect and the Business Cycle 134
Summary 135
Key Terms 136
Problems and Topics For Discussion 136
Case for Discussion 137
End Notes 138
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Appendix to Chapter 5: The Planned Expenditure Model 139

CHAPTER 6 MEASURING ECONOMIC ACTIVITY 145

The National Income Accounts in Nominal Terms 146
Gross Domestic Product 146
The Expenditure Approach to Measuring GDP 148
The Income Approach to Measuring Aggregate Economic Activity 151
Measuring International Linkages 153
The Current Account 153
The Capital and Financial Account 154
Relationship of the Accounts 156
Measuring Real Income and the Price Level 157
Real Gross Domestic Product and the Deflator 157
Producer Price Indexes 159
How Good are the National Income Accounts? 159
Summary 164
Key Terms 164
Problems and Topics for Discussion 164
Case for Discussion 165
End Notes 166
Appendix to Chapter 6: Computation of Price Indexes 167

PART 3 Macroeconomics and Money

CHAPTER 7 MONEY AND THE BANKING SYSTEM 173

Money: What It Is and What It Does 174
The Functions of Money 174
Money as a Liquid Asset 175
Measuring the Stock of Money 175
Why Money Matters 178
The Banking System 180
Types of Depository Institutions 180
The Banking Balance Sheet 181
The Central Bank 183
Ensuring the Safety and Stability of the Banking System 186
Risks of Banking 186
Policies to Ensure Safety and Soundness 187
International Banking 189
Summary 191
Key Terms 191
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Problems and Topics For Discussion 191

Case for Discussion 192
End Notes 193

CHAPTER 8 CENTRAL BANKING AND MONETARY POLICY 195

Determining the Quantity Money 196
A Balance-Sheet View of Money 196
The Monetary Base 197
A Closer Look at Bank Reserves 197
How Banks Create Money 199
Limits to Banks Ability to Create Money 201
The Instruments of Monetary Policy 205
Open Market Operations 205
The Discount Rate 207
Changes in Required-Reserve Ratios 208
Other Factors Affecting the Money Multiplier 209
Central Banking in the International Economy 210
The Structure of the Foreign-Exchange Market 210
Supply and Demand in the Foreign-Exchange Market 212
Central Bank Intervention in the Foreign-Exchange Market 213
Summary 217
Key Terms 218
Problems and Topics for Discussion 218
Case for Discussion 219
End Notes 220

CHAPTER 9 MONEY AND INTEREST RATES 221

The Demand for Money 222
The Demand for Money as a Stock 222
Money Demand and Nominal Income 222
Opportunity Cost and the Demand for Money 223
The Money Demand Curve 224
Supply, Demand, and Interest Rates 226
Equilibrium in the Monetary Sector (Equilibrium of Money Market) 227
Effects of a Change in the Money Supply 228
Effects of an Increase in Income 229
The Monetary Sector, Interest Rates, and Planned Expenditure 230
Monetary Policy Instruments and Targets 232
Summary 235
Key Terms 236
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Problems and Topics for Discussion 236

Case for Discussion 237
End Notes 238

CHAPTER 10 PRICES AND REAL OUTPUT IN THE SHORT RUN 239

The Aggregate Demand Curve 240
Aggregate and Market Demand Curves 240
The Slope of the Aggregate Demand Curve 242
The Elasticity of Aggregate Demand 244
Shifts in the Aggregate Demand Curve 245
The Aggregate Supply curve 248
The Importance of Input Prices 248
Long-Run and Short-Run Aggregate Supply Curves 249
Shifts in the Short-Run Aggregate Supply Curve 251
Shifts in the Long-Run Aggregate Supply Curve 254
The Interaction of Aggregate Supply and Demand in the Short Run 255
Characteristics of Short- and Long-Run Equilibrium 255
Short-Run Effects of an Increase in Aggregate Demand 257
Transition to a New Long-Run Equilibrium 257
Effects of a Decrease in Aggregate Demand 259
Aggregate Supply, Demand, and the Business Cycle 261
Summary 262
Key Terms 263
Problems and Topics for Discussion 263
Case for Discussion 264
End Notes 265

PART 4 Macroeconomic Policy

CHAPTER 11 FISCAL POLICY AND ECONOMIC STABILITY 269

The Theory of Fiscal Policy 270
Using Government Purchases to Combat a Negative Output Gap 270
Using a Change in Taxes or Transfer Payments to Combat a Negative
Output Gap 272
Fiscal Policy and Inflation 274
Automatic Fiscal Policy 275
The Budget Process 277
The Federal Budgetary System 277
Fiscal Policy and the Federal Deficit 279
Automatic Fiscal Policy: The Structural Versus Cyclical Deficit 279
 Contents ix

Economic Priorities 281

International Comparisons 283
The Deficit as a Policy Issue 283
Reasons Not to Worry About the Deficit 283
Reasons to Worry About the Deficit 285
Summary 287
Key Terms 287
Problems and Topics for Discussion 288
Case for Discussion 288
End Notes 289

CHAPTER 12 AN INTEGRATED VIEW OF MONETARY AND

FISCAL POLICY 291
Short-Run Effects of Monetary Policy 292
Long-Run Effects and the Neutrality of Money 295
Money and Fiscal Policy 297
The Crowding-Out Effect 297
Fiscal Policy in the Long Run 299
The Importance of the Fiscal-Monetary Policy Mix 301
Monetarism Versus Keynesianism: A Historical Note 301
Summary 305
Key Terms 306
Problems and Topics for Discussion 306
Case for Discussion 306
End Notes 308

CHAPTER 13 POLICIES FOR PRICE STABILITY 309

Inflation and Deflation in the Aggregate Supply and Demand Model 311
Demand-Side (Pull) Inflation 311
Supply-Side (Cost-Push) Inflation and Supply Shocks 312
Inflationary Expectations and Inflationary Recession 315
Deflation and Recession 318
The Phillips Curve 321
The Phillips Curve as a Policy Menu 321
The Phillips Curve and the Natural Rate of Unemployment 323
The Long-Run Phillips Curve (Monetarists View) 324
Strategies for Lasting Price Stability 325
What Policy Instruments Are Available? 326
The Importance of Credibility 328
Inflation Targeting 328
Exchange-Rate Based Stabilization Policy 330
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Problems with ERB Stabilization 333

Summary 334
Key Terms 335
Problems and Topics for Discussion 335
Case for Discussion 336
End Notes 338

CHAPTER 14 ECONOMIC GROWTH, PRODUCTIVITY, AND

SAVING 339
Economic Growth and Demand Management 340
Demand Management as Inputs Grow 341
Demand Management and Productivity Growth 345
Recent Trends in Economic Growth and Productivity 347
Explaining the Productivity Slowdown and Its Reversals 348
International Productivity Trends 349
Measurement Problems 350
Policies for Promoting Economic Growth and Saving 352
Economic Growth and the Fiscal-Monetary Policy Mix 352
Growth and Saving 353
How Much Saving Is Enough? 355
Summary 356
Key Terms 356
Problems and Topics for Discussion 356
Case for Discussion 357
End Notes 358

Glossary 359

Index 373
 PREFACE

T
H E M O S T R E L I A B L E constant of life in a market economy is constant change.
Sitting down to work on this new edition of this textbook has brought many
changes to my attention..
Some of them are trivial. One chapter mentioned some authors who were on the
best-seller list at the time of the last editiongood books they wrote, but just as the
market economy is in constant change, so is the publishing industry. Out they go, to
be replaced by J.K. Rowling and Dan Brown.
Other changes are much more fundamental, such as the trend toward globaliza-
tion of both the macro- and micro-economy. Professional economists will know that
this trend is not really new. If one looks at the data, trends in imports and exports,
integration of labor and financial markets, and global brand penetration started long
ago. Yet, although statistically well established, these trends have clearly hit a new
threshold of public awareness in the first decade of the 21st century. For that reason
alone, a modern textbook must reflect the global nature of the economy.
One of the signs of its increased global outlook is the disappearance of a separate
chapter on foreign exchange markets and international monetary policy. Because
these topics are more important than ever, it is no longer appropriate to isolate them
in the last chapter of the macroeconomics course, too easily skipped in the rush
toward final exams. Instead, topics like the effects of exchange rates on aggregate
demand and the relationship between price stability and exchange rate policy are
now integrated directly into the various macro chapters that deal with related issues
for the domestic economy. The result is a book that is both more up-to-date and more
streamlined. Numerous globally-oriented cases and topics appear in the micro chap-
ters as well.
One final change is in the textbook market itself. Earlier editions of this book
reflected the college publishing world of the past: Fat, heavy volumes with fat, heavy
price tags that, over time, came to be one of the most resented financial burdens of a
college education. And students didnt even get their moneys worth from those texts

xi
xii Preface

of an earlier era. The technology of the day meant long lead times and the sheer costs
of production meant substantial intervals between revisions, so that textbooks were
often several years out of date before they hit the classroom. Things were even worse
for students who, because of financial pressure, depended on lower-cost used copies
of earlier editions. Happily, that model of publishing is now in retreat.
It is a great pleasure to me to see this new edition come out through Horizon
Textbook Publishing. The advantages of working with a publisher who uses the latest
technology to bring the book to market just a few months after final revisions are
made makes the pleasure all the greater. I hope you, as a user of the book, will com-
plete the cycle by providing me, as author, with your feedback so that your suggested
changes can be quickly incorporated in future editions.

Acknowledgments
My first thanks must go to my long-time co-author, David E. Lindsey, with whom I
worked on earlier editions of this text over a period of many years. During his years
as Deputy Director of the Division of Monetary Affairs of the Board of Governors of
the Federal Reserve System, David was able to find the ideal balance between the the-
ory and practice of economics. Although he did not contribute directly to prepara-
tion of this new edition, his strong influence can still be seen in both the
macroeconomic and microeconomic chapters.
Second, I would like to thank Kristin van Gaasbeck, Ph.D for her innovative
work in updating data sources, news items, and many other elements for the new edi-
tion. Her work has made a big difference in keeping the content of the book fresh and
up to date, and in bringing it to market faster than could ever have been done with-
out her able contribution.
Finally, I thank the entire publishing and editorial staff of Horizon Textbook Pub-
lishing for introducing me to this great new concept in college publishing. I hope
you, the user, benefit as much as I have.

EDWIN G. DOLAN
Lopez Island, Washington

Acknowledgments byKishore G. Kulkarni

The last few months have been very exciting time of my life. I not only added my favorite
ways of explaining concepts to this textbook, but also derived satisfaction in interacting
with numerous colleagues and students who complimented on the earlier edition of this
book. After making numerous changes to the original product created by Prof. Dolan, I
am satisfied and confident that the book will be able to clarify macro concepts in the easi-
est possible way. This edition uses as little mathematics as is necessary, and gives abun-
dant real world examples to make the concepts more applied and interesting.
 Preface xiii

I am very thankful to the wonderful staff of Horizon Textbook Publishing Com-

pany for making this project possible in such a short time. My special thanks to my
wonderful wife who understood my absences from many family obligations when I
was working on this project. I dedicate this edition to her cheerfulness and co-opera-
tion. Our daughters Lina and Aditi deserve appreciation for making life so worth-
while.
Several of my colleagues have already used this book for their classes, and many
more are seriously considering adopting it in future semesters. Notable amongst
them are: Debasri Mukherjee, Western Michigan University, Jesus Valencia, Slippery
Rock University, Vani Kotcherlakota, University of Nebraska-Kearney, and Vijay
Sharma, University of Colorado-Denver. I am grateful to all these individuals. Most
of all, thanks to hundreds (and probably thousands) of my students who would
attend classes and read these chapters. Teaching is an enjoyable exercise when stu-
dents show enthusiasm to learn, and are willing to study. I invite all of you to send
me comments by e-mail.

KISHORE G. KULKARNI,
Denver, Colorado. E-mail: kulkarnk@mscd.edu

Features of This Edition

State of the art pedagogy. An abundance of case studies introduce and illus-
trate the subject matter of every chapter.
Integrated international economics. As the world economy itself comes
closer together, international economics must be more closely integrated
into the principles course. Accordingly, topics in international economic
theory and policy, ranging from balance of payments accounts to the for-
eign exchange operations of the Fed, are introduced in the chapters in
which they occur naturally, rather than presented separately in a single
chapter.

Supplements
Test Bank
The accompanying Test Bank contains over 2,000 questions in a variety of formats
including multiple choice, true/false, and essay questions.

Instructors Manual
The expanded Instructors Manual contains material which can be easily included in
lectures. The manual also includes all of its traditional elements, including instruc-
tional objectives, lecture notes, and suggestions.
xiv Preface

Study Guide
The Study Guide has hands-on applications and self-testing programs. It is available
in two versions, Macroeconomics, and Microeconomics. Students can gain an advan-
tage by reinforcing their reading and lecture notes with the following study guide
features:

Where Youre Going. The objectives and terms for each chapter are recapped to
tie concepts together.
Walking Tour. The Walking Tour section provides a narrative summary of the
chapter and incorporates questions on key points. Answers are given in the
margin.
Hands On. Geographical and numerical exercises clarify concepts and better
prepare students for tests and quizzes.
Economics in the News. A news item illustrates how concepts covered in the
chapter can appear in the real world. Questions and answers reinforce the
concepts.
Questions for Review. These questions and answers follow the key chapter con-
cepts, preparing students for the self-test.
Self-Test. Extra test preparation increases a students understanding and ability
to succeed.
Careers in Economics. Formerly an appendix in the text, this material provides
students with an understanding of where the study of economics could lead
them.

Online Student Tutorial

Created to support and enhance the student's comprehension of the economic prin-
ciples discussed in the textbook. The online tutorial includes chapters objectives and
study questions. To access the tutorial please visit our Students section on our Web
site www.htpublishing.com. Username: Economics Password: DolanLindsey
 Contents xv

About the Authors

PROF. KISHORE G. KULKARNI has been teaching in Economics Department at the
Metropolitan State College of Denver for numerous years. He has taught on a visiting
(or Adjunct) basis at the University of Colorado-Boulder, Colorado School of Mines
and University of Denver. After being a top ranked student in B.A. and M.A. degrees
at the University of Poona, (India), he completed M.A. and Ph.D. degrees from Uni-
versity of Pittsburgh. He has received several awards including Distinguished Service
to the College, Outstanding Teacher, Outstanding Researcher/Scholar and Outstand-
ing Contributions to the Professional Development (8 times) from different institu-
tions. An author of 4 other books and 75 journal articles, Prof. Kulkarni enjoys
teaching and research. His unending love for the profession makes his classes excit-
ing, rewarding and entertaining. He has taught on the Semester at Sea Program as
well as visited several other countries on research missions.

EDWIN G. DOLAN was born in Oklahoma and grew up in a small town in Oregon.
He attended Earlham College and Indiana University, where he majored in Russian
Studies and received the Certificate of Indiana Universitys famed Russian and East-
European Institute. After earning a doctorate in economics from Yale University, he
taught at Dartmouth College, the University of Chicago, George Mason University
and Gettysburg College. In 1990, he began teaching in Moscow, Russia, where he and
his wife founded the American Institute of Business and Economics, an independent,
not-for-profit MBA program. Since retiring as President of that institution in 2001, he
has lectured on global macroeconomics and managerial economics in Riga, Latvia;
Budapest, Hungary; and Zagreb, Croatia. When not lecturing abroad, he makes his
home in Washingtons San Juan Islands.